Datasets:

PleIAs

/

SEC

like 3

23752_1993.txt

23752_1993

1993

23752

3153_1993.txt

3153_1993

1993

3153

ITEM 1. BUSINESS SOUTHERN was incorporated under the laws of Delaware on November 9, 1945. SOUTHERN is domesticated under the laws of Georgia and is qualified to do business as a foreign corporation under the laws of Alabama. SOUTHERN owns all the outstanding common stock of ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH, each of which is an operating public utility company. ALABAMA and GEORGIA each own 50% of the outstanding common stock of SEGCO. The operating affiliates supply electric service in the states of Alabama, Georgia, Florida, Mississippi and Georgia, respectively, and SEGCO owns generating units at a large electric generating station which supplies power to ALABAMA and GEORGIA. More particular information relating to each of the operating affiliates is as follows: ALABAMA is a corporation organized under the laws of the State of Alabama on November 10, 1927, by the consolidation of a predecessor Alabama Power Company, Gulf Electric Company and Houston Power Company. The predecessor Alabama Power Company had had a continuous existence since its incorporation in 1906. GEORGIA was incorporated under the laws of the State of Georgia on June 26, 1930, and admitted to do business in Alabama on September 15, 1948. GULF is a corporation which was organized under the laws of the State of Maine on November 2, 1925, and admitted to do business in Florida on January 15, 1926, in Mississippi on October 25, 1976 and in Georgia on November 20, 1984. MISSISSIPPI was incorporated under the laws of the State of Mississippi on July 12, 1972, was admitted to do business in Alabama on November 28, 1972, and effective December 21, 1972, by the merger into it of the predecessor Mississippi Power Company, succeeded to the business and properties of the latter company. The predecessor Mississippi Power Company was incorporated under the laws of the State of Maine on November 24, 1924, and was admitted to do business in Mississippi on December 23, 1924, and in Alabama on December 7, 1962. SAVANNAH is a corporation existing under the laws of Georgia; its charter was granted by the Secretary of State on August 5, 1921. SOUTHERN also owns all the outstanding common stock of SEI, Southern Nuclear, SCS (the system service company), and various other subsidiaries related to foreign operations and domestic non-utility operations (see Exhibit 21 herein). At this time, the operations of the other subsidiaries are not material. SEI designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. A further description of SEI's business and organization follows later in this section. Southern Nuclear provides services to the Southern electric system's nuclear plants. SEGCO owns electric generating units with an aggregate capacity of 1,019,680 kilowatts at Plant Gaston on the Coosa River near Wilsonville, Alabama, and ALABAMA and GEORGIA are each entitled to one-half of SEGCO's capacity and energy. ALABAMA acts as SEGCO's agent in the operation of SEGCO's units and furnishes coal to SEGCO as fuel for its units. SEGCO also owns three 230,000 volt transmission lines extending from Plant Gaston to the Georgia state line at which point connection is made with the GEORGIA transmission line system. THE SOUTHERN SYSTEM The transmission facilities of each of the operating affiliates and SEGCO are connected to the respective company's own generating plants and other sources of power and are interconnected with the transmission facilities of the other operating affiliates and SEGCO by means of heavy-duty high voltage lines. (In the case of GEORGIA's integrated transmission system, see Item 1 - BUSINESS - "Territory Served" herein.) Operating contracts covering arrangements in effect with principal neighboring utility systems provide for capacity exchanges, capacity purchases and sales, transfers of economy energy and other similar transactions. Additionally, the operating affiliates have entered into voluntary reliability agreements with the subsidiaries of Entergy Corporation, Florida Electric Power Coordinating Group and TVA and with Carolina Power & Light Company, Duke Power Company, South Carolina Electric & Gas Company and Virginia Electric I-1 and Power Company, each of which provides for the establishment and periodic review of principles and procedures for planning and operation of generation and transmission facilities, maintenance schedules, load retention programs, emergency operations, and other matters affecting the reliability of bulk power supply. The operating affiliates have joined with other utilities in the Southeast (including those referred to above) to form the SERC to augment further the reliability and adequacy of bulk power supply. Through the SERC, the operating affiliates are represented on the National Electric Reliability Council. An intra-system interchange agreement provides for coordinating operations of the power producing facilities of the operating affiliates and SEGCO and the capacities available to such companies from non-affiliated sources and for the pooling of surplus energy available for interchange. Coordinated operation of the entire interconnected system is conducted through a central power supply coordination office maintained by SCS. The available sources of energy are allocated to the operating affiliates to provide the most economical sources of power consistent with good operation. The resulting benefits and savings are apportioned among the operating affiliates. SCS has contracted with each operating affiliate, SEI, various of the other subsidiaries, Southern Nuclear and SEGCO to furnish, at cost and upon request, the following services: general executive and advisory services, power pool operations, general engineering, design engineering, purchasing, accounting and statistical, finance and treasury, taxes, insurance and pensions, corporate, rates, budgeting, public relations, employee relations, systems and procedures and other services with respect to business and operations. SOUTHERN also has a contract with SCS for certain of these specialized services. Southern Nuclear has contracted with ALABAMA to operate its Farley Nuclear Plant, as authorized by amendments to the plant operating licenses. Southern Nuclear also has a contract to provide GEORGIA with technical and other services to support GEORGIA's operation of plants Hatch and Vogtle. Applications are now pending before the NRC for amendments to the Hatch and Vogtle operating licenses which would authorize Southern Nuclear to become the operator. See Item 1 - BUSINESS - "Regulation - Atomic Energy Act of 1954" herein. NEW BUSINESS DEVELOPMENT SOUTHERN continues to consider new business opportunities, particularly those which allow use of the expertise and resources developed through its regulated utility experience. These endeavors began in 1981 and are conducted through SEI and other existing subsidiaries. SEI's primary business focus is international and domestic cogeneration, the independent power market, and the privatization of generation facilities in the international market. SEI currently operates two domestic independent power production projects totaling 225 megawatts and is one-third owner of one of these (which produces 180 megawatts). It has a contract to sell electric energy to Virginia Electric and Power Company from a facility SEI is developing (through subsidiaries) in King George, Virginia. Upon completion, currently planned for 1996, SEI will operate the 220 megawatt coal-fired plant and own 50% of the project. In April 1993, SOUTHERN completed the purchase of a 50% interest in Freeport, an electric utility on the Island of Grand Bahama, for a purchase price of $35.5 million. Freeport has generating capacity of about 112 megawatts. In August 1993, SOUTHERN completed the purchase of a 55% interest in Alicura, an entity that owns the right to use the generation from a 1,000 megawatt hydroelectric generating facility in Argentina, for a net purchase price of approximately $188 million. In December 1993, SOUTHERN completed the purchase of a 35% interest in Edelnor for the purchase price of $73 million. Edelnor is a utility located in Northern Chile that owns and operates a transmission grid and a 96 megawatt generating facility and is building an additional 150 megawatt facility. SEI has continued to render consulting services and market SOUTHERN system expertise in the United States and throughout the world. It contracts with other public utilities, commercial concerns and government agencies for the rendition of services and the licensing of intellectual property. In addition, SEI engages in energy management-related services and activities. These continuing efforts to invest in and develop new business opportunities offer the potential of earning returns which may exceed those of rate-regulated operations. However, because of the absence of any assured return or rate of return, they also involve a higher I-2 degree of risk. SOUTHERN expects to make substantial investments over the period 1994-1996 in these and other new businesses. CERTAIN FACTORS AFFECTING THE INDUSTRY The electric utility industry is expected to become increasingly competitive in the future as a result of the enactment of the Energy Act (see each registrant's "Management's Discussion and Analysis - Future Earnings Potential" in Item 7 herein), deregulation, competing technologies and other factors. In recent years the electric utility industry in general has experienced problems in a number of areas including the uncertain cost of capital needed for construction programs, difficulty in obtaining sufficient return on invested capital and in securing adequate rate increases when required, high costs and other issues associated with compliance with environmental and nuclear regulations, changes in regulatory climate, prudence audits and the effects of inflation and other factors on the costs of operations and construction expenditures. The SOUTHERN system has been experiencing certain of these problems in varying degrees and management is unable to predict the future effect of these or other factors upon its operations and financial condition. CONSTRUCTION PROGRAMS The subsidiary companies of SOUTHERN are engaged in continuous construction programs to accommodate existing and estimated future loads on their respective systems. Construction additions or acquisitions of property during 1994 through 1996 by the operating affiliates, SEGCO, SCS and Southern Nuclear are estimated as follows: (in millions) *Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. Reference is made to Note 4 to the financial statements of each registrant in Item 8 herein for the amounts of AFUDC included in the above estimates. The construction estimates for the period 1994 through 1996 do not include amounts which may be spent by SEI (or the subsidiary(s) created to effect such project(s)) on future power production projects or the projects discussed earlier under "New Business Development." (See also Item 1 - BUSINESS - "Financing Programs" herein.) I-3 Estimated construction costs in 1994 are expected to be apportioned approximately as follows: (in millions) *SCS and Southern Nuclear plan capital additions to general plant in 1994 of $26 million and $1 million, respectively, while SEGCO plans capital additions of $14 million to generating facilities. Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing cost of labor, equipment and materials; cost of capital and SEI securing a contract(s) to buy or build additional generating facilities. The operating affiliates do not have any baseload generating plants under construction and current energy demand forecasts do not require any additional baseload generating facilities before 2011. However, within the service area, the construction of combustion turbine peaking units with an aggregate capacity of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. During 1991, the Georgia legislature passed legislation which requires GEORGIA and SAVANNAH each to file an Integrated Resource Plan for approval by the Georgia PSC. Under the plan rules, the Georgia PSC must pre-certify the construction of new power plants. (See Item 1 - BUSINESS - "Rate Matters - Integrated Resource Planning" herein.) See Item 1 - BUSINESS - "Regulation - Environmental Regulation" herein for information with respect to certain existing and proposed environmental requirements and Item 2 ITEM 2. PROPERTIES ELECTRIC PROPERTIES The operating affiliates and SEGCO, at December 31, 1993, operated 33 hydroelectric generating stations, 31 fossil fuel generating stations and three nuclear generating stations. The amounts of capacity owned by each company are shown in the table below. I-18 Notes: (1) Owned by ALABAMA and MISSISSIPPI as tenants in common in the proportions of 60% and 40%, respectively. (2) Excludes the capacity owned by AEC. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) (3) Capacity shown is GEORGIA's or GULF's (Unit 3 only) current portion: 8.4% of Units 1 and 2, 75% (25% for GULF) for Unit 3 and 33.1% for Unit 4 of total plant capacity. See Item 2 - PROPERTIES - "Proposed Sales of Property" and "Jointly-Owned Facilities" herein. (4) Capacity shown is GEORGIA's portion (53.5%) of total plant capacity. (5) Represents 50% of the plant which is owned as tenants in common by GULF and MISSISSIPPI. (6) SEGCO is jointly-owned by ALABAMA and GEORGIA. (See Item 1 - BUSINESS herein.) (7) Capacity shown is GEORGIA's portion (50.1%) of total plant capacity. (8) Capacity shown is GEORGIA's portion (45.7%) of total plant capacity. (9) Generation is dedicated to a single industrial customer. Except as discussed below under "Titles to Property", the principal plants and other important units of the SOUTHERN system are owned in fee by the operating affiliates and SEGCO. It is the opinion of management of each such company that its operating properties are adequately maintained and are substantially in good operating condition. MISSISSIPPI owns a 79-mile length of 500-kilovolt transmission line which is leased to Gulf States. The line, completed in 1984, extends from Plant Daniel to the Louisiana state line. Gulf States is paying a use fee over a forty-year period covering all expenses and the amortization of the original $57 million cost of the line. The all-time maximum demand on the SOUTHERN system was 25,936,900 kilowatts and occurred in July 1993. This amount excludes demand served by generation retained by OPC, MEAG and Dalton and excludes demand associated with power purchased from SEPA by its preference customers. At that time, 27,342,700 kilowatts were supplied by SOUTHERN system generation and 1,405,800 kilowatts (net) were sold to other parties through net purchased and interchanged power. The reserve margin for the Southern electric system at that time was 13.2%. For information on the other registrants' peak demands reference is made to Item 6 - SELECTED FINANCIAL DATA herein. ALABAMA and GEORGIA will incur significant costs in decommissioning their nuclear units at the end of their useful lives. (See Item 1 - BUSINESS - I-19 "Regulation - Atomic Energy Act of 1954" and Note 1 to SOUTHERN's, ALABAMA's and GEORGIA's financial statements in Item 8 herein.) OTHER ELECTRIC GENERATION FACILITIES Through special purpose subsidiaries, SOUTHERN owns a 50% interest in Freeport, a 35% interest in Edelnor, a 55.3% interest Alicura and a 33.3% interest in a co-generation facility in Hawaii. For further discussion of other SEI projects, see Item 1 - BUSINESS - "New Business Development" herein. The generating capacity of these utilities (or facilities) at December 31, 1993, was as follows: * Represents a concession contract that provides SEI with the rights to use the generation. I-20 JOINTLY-OWNED FACILITIES ALABAMA has sold an undivided interest in two units of Plant Miller to AEC. GEORGIA has sold undivided interests in certain generating plants and other related facilities to OPC, MEAG, Dalton, FP&L and JEA. The percentages of ownership resulting from these sales are as follows: ALABAMA and GEORGIA have contracted to operate and maintain the respective units in which each has an interest (other than Rocky Mountain, as described below) as agent for the joint owners. See "Proposed Sales of Property" below for a description of the proposed sale of GEORGIA's remaining unsold ownership interest in Plant Scherer Unit 4. In connection with the joint ownership arrangements for Plant Vogtle, GEORGIA has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy until 1994 for Unit 1 and 1996 for Unit 2 and, with regard to a portion of a 5% interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest. The payments for capacity are required whether any capacity is available. The energy cost is a function of each unit's variable operating costs. Except for the portion of the capacity payments related to the 1987 and 1990 write-offs of Plant Vogtle costs, the cost of such capacity and energy is included in purchased power in the Statements of Income in Item 8 herein. In December 1988, GEORGIA and OPC completed a joint ownership agreement for the Rocky Mountain project under which GEORGIA will retain its present investment in the project and OPC will finance, complete and operate the facility. Upon completion (scheduled for 1995), GEORGIA will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). For purposes of the ownership formula, GEORGIA's investment will be expressed in nominal dollars and OPC's investment will be expressed in constant 1987 dollars. Based on current cost estimates, GEORGIA's final ownership is estimated at approximately 25% of the project at completion. GEORGIA has held preliminary discussions regarding the potential disposition of its remaining interest in the project. PROPOSED SALES OF PROPERTY In 1991 and 1993, GEORGIA completed the first two in a series of four separate transactions to sell Unit 4 of Plant Scherer to FP&L and JEA for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4% of this unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to off-system sales contracts with Gulf States that were suspended in 1988. GEORGIA will continue to operate the unit. I-21 The 1991 and 1993 sales and the remaining transactions are scheduled as follows: Plant Scherer, a jointly owned coal-fired generating plant, has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. TITLES TO PROPERTY The operating affiliates' and SEGCO's interests in the principal plants (other than certain pollution control facilities, one small hydroelectric generating station leased by GEORGIA and the land on which four combustion turbine generators of MISSISSIPPI are located, which is held by easement) and other important units of the respective companies are owned in fee by such companies, subject only to the liens of applicable mortgage indentures (except for SEGCO) and to excepted encumbrances as defined therein. The operating affiliates own the fee interests in certain of their principal plants as tenants in common. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) Properties such as electric transmission and distribution lines and steam heating mains are constructed principally on rights-of-way which are maintained under franchise or are held by easement only. A substantial portion of lands submerged by reservoirs is held under flood right easements. In substantially all of its coal reserve lands, SEGCO owns or will own the coal only, with adequate rights for the mining and removal thereof. PROPERTY ADDITIONS AND RETIREMENTS During the period from January 1, 1989, to December 31, 1993, the operating affiliates, SEGCO, and other (i.e. SCS, Southern Nuclear and, beginning in 1993, various of the special purpose subsidiaries) gross property additions and retirements were as follows: (1) Includes approximately $62 million attributable to property sold to AEC in 1992. (2) Includes approximately $480 million attributable to property sold to OPC, FP&L and JEA, but excludes $231 million from the write-off of certain Plant Vogtle costs in 1990. (3) Net of intercompany eliminations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS (1) STEPAK V. CERTAIN SOUTHERN OFFICIALS (U.S. District Court for the Southern District of Georgia) In April 1991, two SOUTHERN stockholders filed a derivative action suit against certain current and former directors and officers of SOUTHERN. The suit alleges violations of RICO by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages, including treble damages pursuant to RICO, in an unspecified amount, which if awarded, would be payable to SOUTHERN. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that the I-22 SOUTHERN board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs appealed the dismissal to the U.S. Court of Appeals for the Eleventh Circuit. (2) JOHNSON V. ALABAMA (Circuit Court of Shelby County, Alabama) In September 1990, two customers of ALABAMA filed a civil complaint in the Circuit Court of Shelby County, Alabama, against ALABAMA seeking to represent all persons who, prior to June 23, 1989, entered into agreements with ALABAMA for the financing of heat pumps and other merchandise purchased from vendors other than ALABAMA. The plaintiffs contended that ALABAMA was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring ALABAMA to refund all payments, principal and interest, made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered ALABAMA to refund or forfeit interest of approximately $10 million because of ALABAMA's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. ALABAMA has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot be determined; however, in management's opinion, the final outcome will not have a material adverse effect on SOUTHERN's or ALABAMA's financial statements. (3) OHIO RIVER COMPANY, ET AL.VS. GULF, ET AL. (U.S. District Court for Southern District of Ohio, Western Division) In 1993, a complaint against GULF and SCS was filed in federal district court in Ohio by two companies with which GULF had contracted for the transportation by barge for certain GULF coal supplies. The complaint alleges breach of the contract by GULF and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on SOUTHERN's or GULF's financial statements. See Item 1 - BUSINESS - "Construction Programs," "Fuel Supply," "Regulation - - Federal Power Act" and "Rate Matters", for a description of certain other administrative and legal proceedings discussed therein. Additionally, each of the operating affiliates and SEI are, in the normal course of business, engaged in litigation or administrative proceedings that include, but are not limited to, acquisition of property, injuries and damages claims, and complaints by present and former employees. In management's opinion these various actions will not have a material adverse effect on any of the registrants' financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-23 EXECUTIVE OFFICERS OF SOUTHERN (Inserted in Part I in accordance with Regulation S-K, Item 401(b), Instruction 3) EDWARD L. ADDISON Chairman and CEO Age 63 Elected in 1983; responsible primarily for the formation of overall corporate policy. He was elected Chairman of SOUTHERN effective January 1994. A. W. DAHLBERG President and Director Age 53 Elected in 1985; President and Chief Executive Officer of GEORGIA from 1988 through 1993. He was elected Executive Vice President of SOUTHERN in 1991. He was elected President of SOUTHERN effective January 1994. PAUL J. DENICOLA Executive Vice President and Director Age 45 Elected in 1989; Executive Vice President of SOUTHERN since 1991. Elected President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 to 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. H. ALLEN FRANKLIN Executive Vice President and Director Age 49 Elected in 1988; President and Chief Executive Officer of SCS from 1988 through 1993 and, beginning 1991, Executive Vice President of SOUTHERN. He was elected President and CEO of GEORGIA effective January 1994. ELMER B. HARRIS Executive Vice President and Director Age 54 Elected in 1989; President and Chief Executive Officer of ALABAMA since 1989 and, beginning 1991, Executive Vice President of SOUTHERN. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. W. L. WESTBROOK Financial Vice President Age 54 Elected in 1986; responsible primarily for all aspects of financing for SOUTHERN. He has served as Executive Vice President of SCS since 1986. BILL M. GUTHRIE Vice President Age 60 Elected in 1991; serves as Chief Production Officer for the SOUTHERN system. Senior Executive Vice President of SCS effective January 1994. He has also served as Executive Vice President of ALABAMA since 1988. Each of the above is currently an officer of SOUTHERN, serving a term running from the last annual meeting of the directors (May 26, 1993) for one year until the next annual meeting or until his successor is elected and qualified. I-24 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The common stock of SOUTHERN is listed and traded on the New York Stock Exchange. The stock is also traded on regional exchanges across the United States. High and low stock prices, per the New York Stock Exchange Composite Tape and as adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994, during each quarter for the past two years were as follows: There is no market for the other registrants' common stock, all of which is owned by SOUTHERN. On February 28, 1994, the closing price of SOUTHERN's common stock was $20-5/8. (b) Number of SOUTHERN's common stockholders at December 31, 1993: 237,105 Each of the other registrants have one common stockholder, SOUTHERN. (c) Common dividends are payable at the discretion of each registrant's board of directors. The common dividends paid by SOUTHERN and the operating affiliates to their stockholder(s) for the past two years were as follows: (in thousands) In January 1994, SOUTHERN's board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. II-1 The dividend paid per share by SOUTHERN was 27.5c. for each quarter of 1992 and 28.5c. for each quarter of 1993. SOUTHERN's common dividend for the first quarter of 1994 was raised to 29.5c. per share. The amount of common dividends that may be paid by the subsidiary registrants is restricted in accordance with their respective first mortgage bond indenture and charter. The amounts of earnings retained in the business and the amounts restricted against the payment of cash dividends on common stock at December 31, 1993, were as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SOUTHERN. Reference is made to information under the heading "Selected Consolidated Financial and Operating Data," contained herein at pages II-38 through II-49. ALABAMA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-78 through II-91. GEORGIA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-123 through II-137. GULF. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II- 166 through II-179. MISSISSIPPI. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-207 through II-220. SAVANNAH. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-245 through II-258. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION SOUTHERN. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-8 through II-15. ALABAMA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-53 through II-58. GEORGIA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-95 through II-101. GULF. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-141 through II-147. MISSISSIPPI. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-183 through II-189. SAVANNAH. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-224 through II-230. II-2 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO 1993 FINANCIAL STATEMENTS II-3 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-4 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES FINANCIAL SECTION II-5 MANAGEMENT'S REPORT The Southern Company and Subsidiary Companies 1993 Annual Report The management of The Southern Company has prepared -- and is responsible for - -- the consolidated financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of three directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of The Southern Company and its subsidiaries in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ E. L. Addison /s/ W. L. Westbrook - ------------------------------------ ---------------------------- Edward L. Addison W. L. Westbrook Chairman and Chief Executive Officer Financial Vice President II-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS AND TO THE STOCKHOLDERS OF THE SOUTHERN COMPANY: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of The Southern Company (a Delaware corporation) and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, paid-in capital, 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 (pages II-16 through II-37) referred to above present fairly, in all material respects, the financial position of The Southern Company and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The Southern Company and Subsidiary Companies 1993 Annual Report RESULTS OF OPERATIONS EARNINGS AND DIVIDENDS The Southern Company's 1993 financial performance exceeded the strong results recorded for 1992, and set several new records. The company's financial strength continued to gain momentum for the third consecutive year. In January 1994, The Southern Company board of directors increased the quarterly dividend rate by 3.5 percent, and approved a two-for-one common stock split in the form of a stock distribution. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. For 1993, The Southern Company's net income of $1.0 billion established a new record high and the company's common stock reached an all-time high closing price during the year of 23 3/8 -- surpassing the record of 19 1/2 set in 1992. Also, return on average common equity reached the highest level since 1986. Earnings reported for 1993 totaled $1,002 million or $1.57 per share, an increase of $49 million or 6 cents per share from the previous year. Both 1993 and 1992 earnings were affected by special non-operating or non-recurring items. After excluding these special items in both years, earnings from operations of the ongoing business of selling electricity were $1,016 million or $1.59 per share, an increase of $77 million or 10 cents per share compared with 1992. The special items that affected 1993 and 1992 earnings were as follows: In 1993, several items -- both positive and negative -- had an impact on earnings, which resulted in a net reduction of $14 million. These items were: (1) The conclusion of a settlement agreement -- discussed later -- with Gulf States Utilities (Gulf States) increased earnings. (2) The second in a series of four separate transactions to sell Plant Scherer Unit 4 to two Florida utilities increased earnings. (3) Environmental clean-up costs incurred at sites located in Alabama and Georgia decreased earnings. (4) Costs associated with a transportation fleet reduction program decreased earnings. The improvements in 1993 earnings resulted primarily from increased retail energy sales and continued emphasis on effective cost controls. The special items that increased 1992 earnings were primarily related to additional settlement provisions from Gulf States, and to gains on the sale of Gulf States common stock received in 1991. Returns on average common equity were 13.43 percent in 1993, 13.42 percent in 1992, and 12.74 percent in 1991. Dividends paid on common stock during 1993 were $1.14 per share or 28 1/2 cents per quarter. During 1992 and 1991, dividends paid per share were $1.10 and $1.07, respectively. In January 1994, The Southern Company board of directors raised the quarterly dividend to 29 1/2 cents per share or an annual rate of $1.18 per share. REVENUES Operating revenues increased in 1993 and 1992 and decreased in 1991 as a result of the following factors: II-8 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Retail revenues of $7.3 billion in 1993 increased 7.4 percent from last year, compared with an increase of 1.6 percent in 1992. Under fuel cost recovery provisions, fuel revenues generally equal fuel expense -- including the fuel component of purchased energy -- and do not affect net income. Sales for resale revenues within the service area were $447 million in 1993, up 9.2 percent from the prior year. This increase resulted primarily from the prolonged hot summer weather, which increased the demand for electricity. Revenues from sales for resale within the service area were $409 million in 1992, down 1.9 percent from the prior year. The decrease resulted from certain municipalities and cooperatives in the service area retaining more of their own generation at facilities jointly owned with Georgia Power. Revenues from sales to utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Capacity revenues decreased in 1993 and 1992 because the amount of capacity under contract declined by some 500 megawatts and 300 megawatts, respectively. In 1994, the contracted capacity will decline another 400 megawatts. Changes in revenues are influenced heavily by the amount of energy sold each year. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The rate of growth in 1993 retail energy sales was the highest since 1986. Residential energy sales registered the highest annual increase in two decades as a result of hotter-than-normal summer weather and the addition of 46,000 new customers. Commercial sales were also affected by the warm summer. Industrial energy sales in 1993 and 1992 showed moderate growth, reflecting a recovery in the business and economic conditions in The Southern Company's service area. Energy sales to retail customers are projected to grow at an average annual rate of 1.7 percent during the period 1994 through 2004. Energy sales for resale outside the service area are predominantly unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale outside the service area. Sales to customers outside the service area have decreased for the third consecutive year primarily as a result of the scheduled decline in megawatts of capacity under contract. In addition, the decline in 1992 and 1991 sales was also influenced by fluctuations in prices for oil and natural gas, the primary fuel sources for utilities with which the company has long-term contracts. When oil and gas prices fall below a certain level, these customers can generate electricity to meet their requirements more economically. However, the fluctuation in these energy sales, excluding the impact of contractual declines, had minimal effect on earnings because The Southern Company is paid for dedicating specific amounts of its generating capacity to these utilities. EXPENSES Total operating expenses of $6.7 billion for 1993 were up 6.5 percent compared with the prior year. The increase was attributable to higher production expenses of $75 million to meet increased energy demands and an additional $50 million in depreciation expenses and property taxes resulting from additional utility plant being placed into service. The transportation fleet reduction program and environmental clean-up costs discussed earlier increased expenses by some $62 million. Also, a $67 million change in deferred Plant Vogtle expenses compared with the amount in 1992 contributed to the rise in total operating expenses. In 1992, total operating expenses of $6.3 billion were at the same level reported for 1991. The costs to produce and deliver electricity in 1992 declined by $165 million primarily as a result of less energy being sold and continued effective cost controls. However, expenses in 1991 were reduced by proceeds from a settlement II-9 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report agreement with Gulf States that more than offset the decline in 1992 expenses when compared with 1991. Deferred expenses related to Plant Vogtle in 1992 increased by $47 million when compared with the prior year. Fuel costs constitute the single largest expense for The Southern Company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. The amount and sources of generation and the average cost of fuel per net kilowatt-hour generated were as follows: Fuel and purchased power expenses of $2.6 billion in 1993 increased 1.3 percent compared with the prior year because of increased energy demands and slightly higher average cost of fuel per net kilowatt-hour generated. Fuel and purchased power costs in 1992 decreased $137 million or 5.0 percent compared with 1991 primarily because 1.1 billion fewer kilowatt-hours were needed to meet customer requirements. Also, the decrease in these costs was attributable to a lower average cost of fuel per net kilowatt-hour generated. Income taxes for 1993 increased $69 million compared with the prior year. The increase is attributable to a number of factors, including a 1 percent increase in the corporate federal income tax rate effective January 1993, the second sale of additional ownership interest in Plant Scherer Unit 4, and the increase in taxable income from operations. For 1992, income taxes rose $11 million or 1.7 percent above the amount reported for 1991. For the fifth consecutive year, total gross interest charges and preferred stock dividends declined from amounts reported in the previous year. The declines are attributable to lower interest rates and significant refinancing activities during the past two years. In 1993, these costs were $831 million - -- down $21 million or 2.3 percent. These costs for 1992 decreased $71 million. As a result of favorable market conditions during 1993, some $3.0 billion of senior securities was issued for the primary purpose of retiring higher-cost debt and preferred stock. EFFECTS OF INFLATION The Southern Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on The Southern Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, Georgia Power could realize an after-tax gain currently estimated to total approximately $20 million. See Note 7 to the financial statements for additional information. In early 1994, Georgia Power and the system service company announced work force reduction programs that are estimated to reduce 1994 earnings by some $55 million. These actions will assist in efforts to control the growth in operating expenses. II-10 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report See Note 4 to the financial statements for information on an uncertainty regarding full recovery of an investment in the Rocky Mountain pumped storage hydroelectric project. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The Southern Company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If The Southern Company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. An important part of the Energy Act was to amend the Public Utility Holding Company Act of 1935 (PUHCA) and allow holding companies to form exempt wholesale generators and foreign utility companies to sell power largely free of regulation under PUHCA. These new entities are able to sell power to affiliates -- under certain restrictions -- and to own and operate power generating facilities in other domestic and international markets. To take advantage of these opportunities, Southern Electric International (Southern Electric) -- founded in 1981 -- is focusing on international and domestic cogeneration, the independent power market, and the privatization of generating facilities in the international market. During 1993, investments of some $315 million were made in entities that own and operate generating facilities in various international markets. In the near term, Southern Electric is expected to have minimal effect on earnings, but the possibility exists that it could be a prime contributor to future earnings growth. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been implemented by some of the system operating companies and are a significant part of integrated resource planning. See Note 3 to the financial statements under "Georgia Power's Demand-Side Conservation Programs" for information concerning the recovery of certain costs. Customers can receive cash incentives for participating in these programs as well as reduce their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the utility. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects in conjunction with precertification approval processes of such projects by the respective state public service commissions in Alabama, Georgia, and Mississippi will diminish the possible exposure to prudency disallowances and the resulting impact on earnings. In addition, Georgia Power has conducted a competitive bidding process for additional peaking capacity needed in 1996 and 1997. To meet expected requirements for 1996, Georgia Power has filed a plan with the state public service commission for certification of a four-year purchase power contract and for an ownership interest in a combustion turbine peaking unit. Rates to retail customers served by the system operating companies are regulated by the respective state public service commissions in Alabama, Florida, Georgia, and Mississippi. Rates for Alabama Power and Mississippi Power are adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that The Southern Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in some of these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." II-11 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, The Southern Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Southern Company adopted the new rules January 1, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The Southern Company's financial condition is now the strongest since the mid-1980s. Record levels of performance were set in 1993 related to earnings, market price of common stock, and energy sold to retail customers. In January 1994, The Southern Company board of directors increased the common stock dividend for the third consecutive year, and approved a two-for-one common stock split in the form of a stock distribution. Another major change in The Southern Company's financial condition was gross property additions of $1.4 billion to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Consolidated Statements of Cash Flows provide additional details. On January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 9 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company achieved a ratio of common equity to total capitalization -- including short-term debt -- of 43.5 percent in 1993, compared with 42.8 percent in 1992 and 41.5 percent in 1991. The company's goal is to maintain the common equity ratio generally within a range of 40 percent to 45 percent. During 1993, the operating companies sold $2.2 billion of first mortgage bonds and, through public authorities, $385 million of pollution control revenue bonds, at a combined weighted interest rate of 6.5 percent. Preferred stock of $426 million was issued at a weighted dividend rate of 5.7 percent. The operating companies continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $2.5 billion during 1993, $2.8 billion during 1992, and $1.0 billion during 1991. Retirements of preferred stock totaled $516 million during 1993, $326 million during 1992, and $125 million during 1991. As a result, the composite interest rate on long-term debt decreased from 9.2 percent at December 31, 1990, to 7.6 percent at December 31, 1993. During this same period, the composite dividend rate on preferred stock declined from 8.5 percent to 6.4 percent. In 1993, The Southern Company raised $205 million from the issuance of new common stock under the Dividend Reinvestment and Stock Purchase Plan (DRIP) and the Employee Savings Plan. At the close of 1993, the company's common stock had a market value of $22.00 per share, compared with a book value of $11.96 per share. The market-to-book value ratio was 184 percent at the end of 1993, compared with 168 percent at year-end 1992 and 156 percent at year-end 1991. CAPITAL REQUIREMENTS FOR CONSTRUCTION The construction program of the operating companies is budgeted at $1.5 billion for 1994, $1.3 billion for 1995, and $1.5 billion for 1996. The total is $4.3 billion for the three years. Actual construction costs may vary from this estimate because of factors such as changes in environmental regulations; changes in existing nuclear plants to meet new regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The operating companies do not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload facilities until well into the future. However, within the II-12 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts of capacity is planned to be completed by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $789 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of long-term debt. Also, the operating subsidiaries plan to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV II-13 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report requirements, on some Georgia Power plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Southern Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL In early 1994, The Southern Company sold -- through a public offering -- common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. Any portion of the common stock required during 1994 for the DRIP and the employee stock plans that is not provided from the issuance of new stock will be acquired on the open market in accordance with the terms of such plans. The operating subsidiaries plan to obtain the funds required for construction and other purposes from sources similar to those used in the past. However, the type and timing of any financings -- if needed -- will depend on market conditions and regulatory approval. II-14 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Completing the sale of Unit 4 of Plant Scherer will provide some $260 million of cash during the years 1994 and 1995. As required by the Nuclear Regulatory Commission, Alabama Power and Georgia Power established external sinking funds for nuclear decommissioning costs. For 1994 through 2000, the combined amount to be funded for both Alabama Power and Georgia Power totals $36 million annually. The cumulative effect of funding over this period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." To meet short-term cash needs and contingencies, the system companies had approximately $178 million of cash and cash equivalents and $1.1 billion of unused credit arrangements with banks at the beginning of 1994. To issue additional first mortgage bonds and preferred stock, the operating companies must comply with certain earnings coverage requirements designated in their mortgage indentures and corporate charters. The ability to issue securities in the future will depend on coverages at that time. The coverage ratios were, at the end of the respective years, as follows: *Savannah Electric's requirement is 2.50. II-15 CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report CONSOLIDATED STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-16 CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-17 CONSOLIDATED STATEMENTS OF BALANCE SHEETS At December 31, 1993, and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-18 CONSOLIDATED BALANCE SHEETS (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-19 CONSOLIDATED STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report II-20 CONSOLIDATED STATEMENTS OF CAPITALIZATION (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-21 NOTES TO FINANCIAL STATEMENTS The Southern Company and Subsidiary Companies 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Southern Company is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both the company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The operating companies also are subject to regulation by the FERC and their respective state regulatory commissions. The companies follow generally accepted accounting principles and comply with the accounting policies and practices prescribed by their respective commissions. All material intercompany items have been eliminated in consolidation. Consolidated retained earnings at December 31, 1993, include $2.6 billion of undistributed retained earnings of subsidiaries. Certain prior years' data presented in the consolidated financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The operating companies accrue revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The operating companies' electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $137 million in 1993, $132 million in 1992, and $162 million in 1991. Alabama Power and Georgia Power have contracts with the U.S. Department of Energy (DOE) that provide for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2003 at Plant Hatch, into 2009 at Plant Vogtle, and into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. Georgia Power -- based on its ownership interests -- and Alabama Power currently estimate their liability under this law to be approximately $39 million and $46 million, respectively. These obligations are recorded in the Consolidated Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected costs of decommissioning nuclear facilities. II-22 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. Alabama Power and Georgia Power have established external sinking funds to comply with the NRC's regulations. Prior to the enactment of these regulations, Alabama Power and Georgia Power had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. Alabama Power and Georgia Power have filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amounts prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Alabama Power's Plant Farley and Georgia Power's plants Hatch and Vogtle -- based on its ownership interests -- were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a set period of time as approved by the respective state public service commissions. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the Georgia Public Service Commission (GPSC) ordered that the allowed costs of Plant Vogtle, a two-unit nuclear facility of which Georgia Power owns 45.7 percent, be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. Under these plans, Georgia Power deferred financing costs and depreciation expense until the allowed investment was fully reflected in rates as of October 1991. In 1991, the GPSC modified the Plant Vogtle phase-in plan to begin earlier amortization of the costs deferred under the plan. Also, the GPSC levelized capacity buyback expense from co-owners of Plant Vogtle. See Note 3 for additional information regarding Georgia Power's 1991 rate order. Previously, pursuant to two separate interim accounting orders by the GPSC, Georgia Power deferred substantially all operating expenses and financing costs related to Plant Vogtle. Units 1 and 2 began commercial operation in May 1987 and May 1989, respectively. The accounting orders were for the periods from the date of each unit's commercial operation until October 1987 and 1989, respectively. Under phase-in plans and accounting orders from the GPSC, Georgia Power deferred and began amortizing the costs -- recovered through rates -- related to Plant Vogtle as follows: The unrecovered balance above includes approximately $160 million related to the adoption in 1993 of FASB Statement No. 109, Accounting for Income Taxes. See Note 9 for information about Statement No. 109. II-23 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Each GPSC order calls for recovery of deferred costs within 10 years. Also, the orders authorized Georgia Power to impute a return similar to allowance for funds used during construction (AFUDC) on its investment in Plant Vogtle units 1 and 2 after the units began commercial operation. These deferred returns are included in the above amounts, except for the equity component in the case of the Unit 2 accounting order. INCOME TAXES The companies provide deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 for additional information about Statement No. 109. AFUDC AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the companies to calculate AFUDC during the years 1991 through 1993 ranged from a before-income-tax rate of 4.9 percent to 11.4 percent. Deferred income taxes related to capitalized debt cost were $5 million, $4 million, and $7 million in 1993, 1992, and 1991, respectively. After Plant Vogtle units 1 and 2 began commercial operation in 1987 and 1989, respectively, Georgia Power imputed a deferred return similar to AFUDC on its investment in the units under the short-term cost deferrals and phase-in plans, as discussed earlier. AFUDC and the deferred return, net of income tax, as a percent of consolidated net income were 1.7 percent in 1993, 1.8 percent in 1992, and 6.0 percent in 1991. The deferred return was discontinued in October 1991 after the allowed investment in Plant Vogtle was fully reflected in rates. UTILITY PLANT Utility plant is stated at original cost less regulatory disallowances. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Consolidated Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of The Southern Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred II-24 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In 1992, Georgia Power converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that will be amortized as a credit to income over approximately four years. This conversion will not have a material effect on net income. VACATION PAY The operating companies' employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the companies accrue a current liability for earned vacation pay and record a current asset representing the future recoverability of this cost. The amount was $73 million and $70 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 71 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The system companies have defined benefit, trusteed, non-contributory pension plans that cover substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. Primarily, the companies use the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The system companies also provide certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the system companies adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered Georgia Power to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional costs would be expensed in 1993 and the remaining costs would be deferred. An additional one-fifth of the costs would be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The costs deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of regulatory treatment allowed by the operating companies' respective public service commissions, the adoption of Statement No. 106 did not have a material impact on consolidated net income. Prior to 1993, the system companies, except for Georgia Power and Savannah Electric, recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. Consistent with regulatory treatment in these years, Georgia Power and Savannah Electric recognized these costs on a cash basis as payments were made. The total costs of such benefits recognized by system companies in 1992 and 1991 were $42 million and $36 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement II-25 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1 percent would increase the accumulated medical benefit obligation at December 31, 1993, by $129 million and the aggregate of the service and interest cost components of the net retiree medical cost by $14 million. Components of the plans' net cost are shown below: Of the above net pension amounts, pension income of $9 million in 1993 and pension expense of $2 million in 1992 and $11 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $64 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. II-26 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report WORK FORCE REDUCTION PROGRAMS The system companies have incurred additional costs for work force reduction programs. The costs related to these programs were $35 million, $37 million, and $72 million for the years 1993, 1992, and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $19 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected, and this matter is concluded. STOCKHOLDER SUIT In April 1991, two Southern Company stockholders filed a derivative action suit in the U.S. District Court for the Southern District of Georgia against certain current and former directors and officers of The Southern Company. The suit alleges violations of the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages -- including treble damages pursuant to RICO -- in an unspecified amount, which if awarded, would be payable to The Southern Company. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that The Southern Company board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs have appealed the dismissal to the U.S. Court of Appeals for the 11th Circuit. ALABAMA POWER HEAT PUMP FINANCING SUIT In September 1990, two customers of Alabama Power filed a civil complaint in the Circuit Court of Shelby County, Alabama, against Alabama Power seeking to represent all persons who, prior to June 23, 1989, entered into agreements with Alabama Power for the financing of heat pumps and other merchandise purchased from vendors other than Alabama Power. The plaintiffs contended that Alabama Power was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring Alabama Power to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered Alabama Power to refund or forfeit interest of approximately $10 million because of Alabama Power's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. Alabama Power has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GULF POWER COAL BARGE TRANSPORTATION SUIT In 1993, a complaint against Gulf Power and the system service company was filed in federal district court in Ohio by two companies with which Gulf Power had contracted for the transportation by barge for certain Gulf Power coal supplies. The complaint alleges breach of the contract by Gulf Power and seeks damages estimated by the plaintiffs to be in excess of $85 million. II-27 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. ALABAMA POWER RATE ADJUSTMENT PROCEDURES In November 1982, the Alabama Public Service Commission (APSC) adopted rates that provide for periodic adjustments based upon Alabama Power's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement -- amounting to some $60 million -- is being amortized to income to offset the rate reduction in accordance with the APSC's rate order. See Note 8 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. GEORGIA POWER'S DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of Georgia Power's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. Georgia Power suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved Georgia Power's request for an accounting order allowing Georgia Power to defer all current unrecovered and future costs related to these programs until the superior court's decision is reversed or until the next general rate case proceedings. An association of industrial customers has filed a petition for review of the accounting order in superior court. Georgia Power's costs related to these conservation programs through 1993 were $60 million, of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GEORGIA POWER 1991 RATE ORDER; PHASE-IN PLAN MODIFICATIONS Georgia Power received a rate order in 1991 from the GPSC that modified the Plant Vogtle phase-in plans to begin earlier amortization of the costs deferred under the plans. The amortization period began October 1991 -- rather than October 1994 as originally scheduled -- and extends through September 1999. In addition, the GPSC ordered the levelization of capacity buyback expense from the co-owners of Plant Vogtle over a six-year period beginning October 1991. This results in net cost deferrals during the first three years and subsequent amortization of the deferred amounts in the last three years. MISSISSIPPI POWER RETAIL RATE ADJUSTMENT PLAN Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986 with various modifications in 1991 and the latest in 1994. In 1993, the Mississippi Public Service Commission (MPSC) ordered Mississippi Power to review and propose changes that would enhance the plan. Mississippi Power filed a revised plan, and the MPSC approved PEP-2 on January 4, 1994. Under PEP-2, Mississippi Power's rate of return will be measured on retail net investment rather than on common equity, as previously calculated. Also, the number of indicators used to evaluate Mississippi Power's performance was reduced to three with emphasis on price and service to the customer. In addition, PEP-2 provides for the sharing of rate adjustments based on low rates and on the performance rating. The evaluation periods for PEP-2 are semiannual. Any change in rates is limited to 2 percent of retail revenues per period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. II-28 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. 4. CONSTRUCTION PROGRAM GENERAL The operating companies are engaged in continuous construction programs, currently estimated to total some $1.5 billion in 1994, $1.3 billion in 1995, and $1.5 billion in 1996. These estimates include AFUDC of $34 million in 1994, $41 million in 1995, and $35 million in 1996. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The operating companies do not have any new baseload generating plants under construction. However, within the service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 was not economically justifiable and reasonable and withheld authorization for Georgia Power to spend funds from approved securities issuances on that project. In 1988, Georgia Power and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 6. However, full recovery of Georgia Power's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event Georgia Power cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off. At December 31, 1993, Georgia Power's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, Georgia Power's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL In early 1994, The Southern Company sold -- through a public offering -- 5.6 million shares of common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. II-29 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report To the extent possible, the operating companies' construction programs are expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The subsidiary companies may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FOREIGN UTILITY OPERATIONS During 1993, The Southern Company made investments of approximately $315 million in utilities that own and operate generating facilities in various foreign markets. The consolidated financial statements reflect these investments in majority-owned subsidiaries on a consolidated basis and other investments on an equity basis. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with banks totaled $1.1 billion, of which approximately $500 million expires at various times during 1994 and 1995; $130 million expires at May 1, 1996; $400 million expires at June 30, 1996; and $70 million expires at December 1, 1996. Georgia Power's revolving credit agreements of $150 million, of which $130 million remained unused as of December 31, 1993, expire May 1, 1996. During the term of these agreements, Georgia Power may convert short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Georgia Power's option. In connection with these credit arrangements, Georgia Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing The Southern Company, Alabama Power, and Georgia Power up to the total credit amount of $400 million. To provide liquidity support to commercial paper programs, $135 million and $165 million of the $400 million available credit are currently dedicated to the exclusive use of Alabama Power and Georgia Power, respectively. During the term of these agreements, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Mississippi Power has $70 million of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Mississippi Power's option. In connection with these credit arrangements, Mississippi Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. Savannah Electric has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Savannah Electric's option. In connection with these credit arrangements, Savannah Electric agrees to pay commitment fees based on the unused portions of the commitments. In connection with all other lines of credit, the companies have the option of paying fees or maintaining compensating balances, which are substantially all the cash of the companies except for daily working funds and similar items. These balances are not legally restricted from withdrawal. In addition, the companies from time to time borrow under uncommitted lines of credit with banks, and in the case of Alabama Power and Georgia Power, through commercial paper programs that have the liquidity support of committed bank credit arrangements. ASSETS SUBJECT TO LIEN The operating companies' mortgages, which secure the first mortgage bonds issued by the companies, constitute a direct first lien on substantially all of the companies' respective fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of the system's generating plants, the subsidiary companies have II-30 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels, and other financial commitments. Total estimated long-term obligations were approximately $15 billion at December 31, 1993. Additional commitments for coal and nuclear fuel will be required in the future to supply the operating companies' fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 for the payment of $121 million to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Gulf Power and Mississippi Power. Also, in March 1988, Gulf Power made an advance payment of $60 million to a coal supplier under an agreement to lower the cost of future coal purchased under an existing contract. These amounts are being amortized to expense. The remaining unamortized amount included in deferred charges at December 31, 1993, was $70 million. OPERATING LEASES The operating companies have entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $11 million, $9 million, and $7 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated minimum rental commitments for noncancelable operating leases were as follows: 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS In 1992, Alabama Power sold an undivided interest in units 1 and 2 of Plant Miller and related facilities to Alabama Electric Cooperative, Inc. Since 1975, Georgia Power has sold undivided interests in plants Vogtle, Hatch, Scherer, and Wansley in varying amounts, together with transmission facilities, to OPC, the Municipal Electric Authority of Georgia (MEAG), and the city of Dalton, Georgia. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. See Note 7 for additional information concerning these sales. In addition, Georgia Power has entered into a joint ownership agreement with OPC with respect to the Rocky Mountain project, as discussed later. At December 31, 1993, Alabama Power's and Georgia Power's ownership and investment (exclusive of nuclear fuel) in jointly owned facilities with the above entities were as follows: *Estimated ownership at date of completion. Georgia Power and OPC have entered into a joint ownership agreement regarding the 848-megawatt Rocky Mountain pumped storage hydroelectric project. Under the agreement, Georgia Power will retain its present investment in the project and OPC will finance, complete, and operate the facility. Upon completion, Georgia Power will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). Based on current cost estimates, Georgia Power's final ownership is estimated at approximately 25 percent of the project at completion. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. II-31 NOTES (continued) THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES 1993 ANNUAL REPORT Alabama Power and Georgia Power have contracted to operate and maintain the jointly owned facilities -- except for the Rocky Mountain project -- as agents for their respective co-owners. The companies' proportionate share of their plant operating expenses is included in the corresponding operating expenses in the Consolidated Statements of Income. In connection with a joint ownership arrangement at Plant Vogtle, Georgia Power has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from this plant for periods of up to 10 years following commercial operation (and, with regard to a portion of the 5 percent additional interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for such capacity are required whether any capacity is available. The energy cost of these purchases is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power in the Consolidated Statements of Income. Capacity payments totaled $183 million, $289 million, and $320 million, for 1993, 1992, and 1991, respectively. Projected capacity payments for the next five years are as follows: $132 million in 1994; $77 million in 1995; $70 million in 1996; $59 million in 1997; and $59 million in 1998. Also, a portion of the above capacity payments relates to Plant Vogtle costs that were written off after being disallowed for retail ratemaking purposes. In 1991, the GPSC ordered that the Plant Vogtle capacity buyback expense be levelized over a six-year period. The amounts deferred and not expensed in the year paid totaled $38 million in 1993, $100 million in 1992, and $30 million in 1991. The projected net amount to be deferred in 1994 is $1 million. The projected net amortization of the deferred expense is $49 million in 1995, $62 million in 1996, and $57 million in 1997. 7. PLANNED SALES OF INTEREST IN PLANT SCHERER Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FP&L) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to long-term power sales contracts with Gulf States that were suspended in 1988. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Plant Scherer -- a jointly owned coal-fired generating plant -- has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. See Note 6 for information regarding current plant ownership. 8. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from specific generating plants is currently being sold to FP&L, FPC, JEA, and the city of Tallahassee, Florida. Under these agreements, an average II-32 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report of 1,700 megawatts of capacity is scheduled to be sold during 1994 and 1995. Thereafter, these sales will decline to some 1,600 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts to be refunded to customers and the amounts previously included in income -- The Southern Company recorded an increase in consolidated net income of $114 million, or 18 cents per share, in November 1991. With respect to Alabama Power's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. 9. INCOME TAXES Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on consolidated net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $1.5 billion are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $1.1 billion are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities, are as follows: II-33 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Consolidated Statements of Income. Credits amortized in this manner amounted to $29 million in 1993, $41 million in 1992, and $48 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. COMMON STOCK STOCK DISTRIBUTION In January 1994, The Southern Company board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. SHARES RESERVED At December 31, 1993, a total of 24 million shares was reserved for issuance pursuant to the Dividend Reinvestment and Stock Purchase Plan, the Employee Savings Plan, and the Executive Stock Option Plan. EXECUTIVE STOCK OPTION PLAN The Southern Company's Executive Stock Option Plan authorizes the granting of non-qualified stock options to key employees of The Southern Company, including officers. Currently, 34 employees are eligible to participate in the plan. As of December 31, 1993, 38 current and former employees participated in the plan. The maximum number of shares of common stock that may be issued under the Executive Stock Option Plan may not exceed 6 million. The price of options granted to date has been at the fair market value of the shares on the date of grant. Options granted to date become exercisable pro rata over a maximum period of four years from date of grant, such that all options generally are exercisable by 1997. Options outstanding will expire upon termination of the plan, which will occur on December 7, 1997, unless terminated earlier by the board of directors. Stock option activity in 1992 and 1993 is summarized below: II-34 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 11. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: With respect to the collateralized pollution control revenue bonds, the operating companies have authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under installment sale or loan agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. Assets acquired under capital leases are recorded as utility plant in service, and the related obligation is classified as other long-term debt. The net book value of capitalized leases was $217 million and $236 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the composite interest rates for nuclear fuel, buildings, and other were 3.6 percent, 9.7 percent, and 12.0 percent, respectively. Sinking fund requirements and/or serial maturities through 1998 applicable to other long-term debt are as follows: $89 million in 1994; $154 million in 1995; $58 million in 1996; $26 million in 1997; and $7 million in 1998. 12. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 166 2/3 percent of such requirements. II-35 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 13. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, Alabama Power and Georgia Power maintain agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the companies' nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for Alabama Power and Georgia Power -- based on its ownership and buyback interests -- is $159 million and $171 million, respectively, per incident but not more than an aggregate of $20 million and $22 million, respectively, to be paid for each incident in any one year. Alabama Power and Georgia Power are members of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. Alabama Power's and Georgia Power's maximum annual assessments are limited to $14 million and $18 million, respectively, under current policies. Additionally, both companies have policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments under current policies for Alabama Power and Georgia Power for excess property damage would be $16 million and $15 million, respectively. The replacement power assessments are $9 million for Alabama Power and $13 million for Georgia Power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. Alabama Power and Georgia Power participate in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, Alabama Power and Georgia Power could be subject to a maximum total assessment of $6 million and $7 million, respectively. II-36 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 14. COMMON STOCK DIVIDEND RESTRICTIONS The income of The Southern Company is derived primarily from equity in earnings of its operating subsidiaries. At December 31, 1993, $1.6 billion of consolidated retained earnings was restricted against the payment by the operating companies of cash dividends on common stock under terms of bond indentures or charters. 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: *Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. The company's business is influenced by seasonal weather conditions and the timing of rate changes. II-37 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) Note: Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. II-38 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) II-39 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-40 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-41 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-42 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-43 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-44 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-45 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-46 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-47 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-48 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-49 ALABAMA POWER COMPANY FINANCIAL SECTION II-50 MANAGEMENT'S REPORT Alabama Power Company 1993 Annual Report The management of Alabama Power Company has prepared -- and is responsible for - -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Alabama Power Company in conformity with generally accepted accounting principles. /s/ Elmer B. Harris /s/ William B. Hutchins, III - -------------------------- ------------------------------ Elmer B. Harris William B. Hutchins III President Senior Vice President and Chief Executive Officer and Chief Financial Officer II-51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF ALABAMA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Alabama Power Company (an Alabama corporation and wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, 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 (pages II-59 through II-77) referred to above present fairly, in all material respects, the financial position of Alabama Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 II-52 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Alabama Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS The company's 1993 net income after dividends on preferred stock was $346 million, representing a 2.3 percent increase over the prior year. This improvement can be attributed to higher retail energy sales and lower financing costs. Retail energy sales increased 5.1 percent from 1992 levels. This was primarily due to the extreme weather during 1993, especially when compared to the unusually mild weather of 1992. Long-term debt interest expense and preferred stock dividends decreased in 1993 reflecting the continued redemption and refinancing of higher cost debt and preferred stock. These positive factors were partially offset by higher operating costs and a scheduled reduction in capacity sales to non-affiliated utilities. When comparing 1992 earnings with the prior year, it should be noted that 1991 earnings included an unusual item -- the settlement of litigation with Gulf States Utilities Company (Gulf States) that resulted in an after-tax gain of $9 million. A comparison of 1992 to 1991, excluding this unusual item, would reflect a 1992 increase in earnings of $8 million. The return on average common equity for 1993 was 13.9 percent compared to 14.0 percent in 1992, and 14.6 percent in 1991. REVENUES The following table summarizes the principal factors that affected operating revenues for the past three years: Retail revenues of $2.4 billion in 1993 increased $180 million (8.0 percent) over the prior year, compared with no increase in 1992. The extreme weather during 1993 and sales growth contributed to the increase in retail revenues over 1992. Fuel revenues increased substantially during 1993. However, changes in fuel revenues are offset with corresponding changes in recoverable fuel expenses and have no effect on net income. Gains in 1992 retail revenues, due to higher rates and sales growth, were partially offset by lower fuel cost recovery revenues. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: II-53 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report Capacity revenues decreased in 1993 due to a scheduled reduction in capacity dedicated to unit power sales customers for the first five months of the year. The major factor contributing to the increase in capacity revenues in 1992 and 1991 was a new generating unit, Plant Miller Unit 4, that was placed in commercial service in March 1991 and dedicated to unit power sales. This unit's fixed costs are higher than those of the unit it replaced, which previously provided energy to unit power sales customers. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: EXPENSES Total operating expenses of $2.4 billion for 1993 were up 7.0 percent compared with the prior year. The increase was mainly attributable to higher production expenses of $95 million to meet increased energy demands. Total operating expenses for 1992 increased moderately over those recorded in 1991. However, absent the Gulf States settlement, which reduced 1991 operating expenses, total operating expenses would have decreased $6 million. Fuel costs are the single largest expense for the company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. Fuel expense increases in 1993 represent $83 million of the production expense increase mentioned above. Fuel expense decreased in 1992 as a result of the reduction in the cost of both coal and nuclear fuel, offset somewhat by a small increase in generation. Fuel cost per kilowatt-hour generated was 1.73 cents in 1993, 1.64 cents in 1992 and 1.69 cents in 1991. Purchased power expenses decreased in 1992 primarily due to less purchased energy and a decrease in the price of such energy. Other operation expenses increased 6.0 percent in 1993 following a minimal increase in 1992. The increase in 1993 is primarily the result of environmental cleanup costs, net expenses of a March snowstorm, and the one-time cost of a transportation fleet reduction program, which together totaled $16.1 million. Depreciation and amortization expense increased 3.4 percent in 1993 and 3.5 percent in 1992. This is principally due to continued growth in depreciable plant in service. Taxes other than income taxes increased 4.0 percent in 1993 and 1.4 percent in 1992. These increases were the result of the addition of new facilities and higher revenue-related taxes. The increase in income tax expense of 2.6 percent for 1993 is primarily attributable to a one percent increase in the corporate federal income tax rate effective January 1, 1993. Interest expense and dividends on preferred stock decreased $7.5 million (2.8 percent) and $7.2 million (2.6 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. II - 54 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report EFFECTS OF INFLATION The company is subject to rate regulation that is based on the recovery of historical costs and, therefore is subject to economic losses caused by inflation. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will also depend upon growth in electric sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. In addition, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as any new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Rates to retail customers served by the company are regulated by the Alabama Public Service Commission (APSC). Rates for the company can be adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The company adopted the new rules January 1, 1994, with no material effect on the financial statements. II-55 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report FINANCIAL CONDITION OVERVIEW The company's financial condition remained stable in 1993. Growth in energy sales combined with a significant lowering of the cost of capital, achieved through the refinancing and/or redemption of higher-cost long-term debt and preferred stock contributed to this stability. The company had gross property additions of $436 million in 1993. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Statements of Cash Flows provide additional details. On January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company's ratio of common equity to total capitalization was 47.4 percent in 1993, compared with 47.6 percent in 1992, and 45.4 percent in 1991. In 1993, the company issued $860 million of first mortgage bonds, $158 million of preferred stock and, through public authorities, $144 million of pollution control revenue bonds. The company continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $835 million, and preferred stock retirements totaled $207 million. Composite financing rates as of year-end for 1991 through 1993 were as follows: The company's current securities ratings are as follows: CAPITAL REQUIREMENTS Capital expenditures are estimated to be $588 million for 1994, $572 million for 1995, and $531 million for 1996. The total is $1.7 billion for the three years. Actual capital costs may vary from this estimate because of factors such as changes in environmental regulations; changes in the existing nuclear plant to meet new regulations; revised load projections; increasing costs of labor, equipment, and materials; and the cost of capital. The company does not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload generating units until well into the future. However, the construction of combustion turbine peaking units of approximately 720 megawatts of capacity is planned by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will continue. In addition to the funds needed for the capital budget, approximately $80 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of first mortgage bonds. Also, the company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 II-56 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the company's portion is approximately $30 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company, of which the company's portion is approximately $225 million to $350 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in annual revenue requirements from customers could be necessary to fully recover the company's cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard II-57 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Southern electric system. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL It is anticipated that the funds required will be derived from sources in form and quantity similar to those used in the past. To issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements designated in its mortgage indenture and corporate charter. The company's coverages are at a level that would permit any necessary amount of security sales at current interest and dividend rates. As required by the Nuclear Regulatory Commission and as ordered by the APSC, the company has established external trust funds for nuclear decommissioning costs. Also, during 1993, the APSC issued a policy statement which will require external funding of postretirement benefits. The cumulative effect of funding these items over a long period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." II-58 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-59 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-60 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-61 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-62 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-63 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-64 NOTES TO FINANCIAL STATEMENTS Alabama Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The company is a wholly owned subsidiary of The Southern Company which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly-owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services upon request to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The company is also regulated by the FERC and the Alabama Public Service Commission (APSC). The company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The company's electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $62 million in 1993, $48 million in 1992, and $69 million in 1991. The company has a contract with the U.S. Department of Energy (DOE) that provides for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The company currently estimates its liability under this law to be approximately $46 million. This obligation is recognized in the accompanying Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected cost of decommissioning nuclear facilities. II-65 NOTES (continued) Alabama Power Company 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external trust fund, a surety method, or prepayment. The company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the company had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The company has filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amount prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Plant Farley were as follows: The amount in the internal reserve is being transferred into the external trust funds over the remaining life of the license for Plant Farley as approved by the APSC. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. INCOME TAXES The company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the company adopted Financial Accounting Standards Board (FASB) Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rate used to determine the amount of allowance, net of deferred income tax, was 6.2 percent in 1991. Such method of computing AFUDC ceased upon the commercial operation of Plant Miller Unit 4 in March 1991. For construction projects begun after 1986, deferral of taxes related to capitalized interest is no longer permitted. For those projects, the composite rate used to determine the amount of allowance was 7.8 percent in 1993, 7.9 percent in 1992, and 8.3 percent in 1991. AFUDC, net of income tax, as a percent of net income after dividends on preferred stock was 1.5 percent in 1993, 1.1 percent in 1992, and 2.0 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs and replacements of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive II-66 NOTES (continued) Alabama Power Company 1993 Annual Report of minor items of property) is charged to utility plant. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the company accrues a current liability for earned vacation pay and records a current asset representing future recoverability of this cost. The amount was $23 million and $22 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 65 percent of the 1993 deferred vacation cost will be expensed and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. However, in December 1993, the APSC issued an accounting policy statement which requires the company to externally fund all postretirement benefits. It is expected that an external funding program will begin in 1994. Effective January 1, 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-67 NOTES (continued) Alabama Power Company 1993 Annual Report Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, the company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the company in 1992 and 1991 were $15.2 million and $15.4 million, respectively. Status and Cost of Benefits Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $32.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $3.4 million. II-68 NOTES(continued) Alabama Power Company 1993 Annual Report Components of the plans' net cost are shown below: Of the above net pension amounts, $(8.9) million in 1993, $(5.1) million in 1992, and $0.7 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $22 million was charged to operating expenses and the remainder was charged to construction and other accounts. WORK FORCE REDUCTION PROGRAM The company has incurred additional costs for work force reduction programs. The costs related to these programs were $16.1 million, $13.4 million and $6.7 million for the years 1993, 1992 and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $15.3 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATE ADJUSTMENT PROCEDURES In November 1982, the APSC adopted rates that provide for periodic adjustments based upon the company's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement amounting to approximately $60 million is being amortized to revenues to offset the rate reduction in accordance with the APSC's rate order. See Note 7 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. In February 1993, the APSC ordered - at the company's request - a moratorium on rate increases for the first two quarters of 1993, which facilitated the transition of an accounting change. This accounting change permitted the accrual of estimated operation and maintenance expenses related to nuclear refueling outages during the period between outages rather than at the time the expenses are incurred. HEAT PUMP FINANCING SUIT In September 1990, two customers of the company filed a civil complaint in the Circuit Court of Shelby County, Alabama, against the company seeking to represent all II-69 NOTES(continued) Alabama Power Company 1993 Annual Report persons who, prior to June 23, 1989, entered into agreements with the company for the financing of heat pumps and other merchandise purchased from vendors other than the company. The plaintiffs contended that the company was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring the company to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June, 1993, the court ordered the company to refund or forfeit interest of approximately $10 million because of the company's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. The company has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. 4. CAPITAL BUDGET The company's capital expenditures are currently estimated to total $588 million in 1994, $572 million in 1995 and $531 million in 1996. The estimates include AFUDC of $10 million in 1994, $11 million in 1995 and $12 million in 1996. The estimates for property additions for the three-year period includes $36.5 million committed to meeting the requirements of the Clean Air Act. The capital budget is subject to periodic review and revision, and actual capital cost incurred may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth projections; changes in environmental regulations; changes in the existing nuclear plant to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The company does not have any new baseload generating plants under construction. However, the construction of combustion turbine peaking units of approximately 720 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL To the extent possible, the company's construction program is expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FINANCING The ability of the company to finance its capital budget depends on the amount of funds generated internally and the funds it can raise by external financing. The II-70 NOTES(continued) Alabama Power Company 1993 Annual Report company's primary sources of external financing are sales of first mortgage bonds and preferred stock to the public, receipt of additional paid-in capital from The Southern Company, and leasing of nuclear material. In order to issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements contained in its mortgage indenture and corporate charter. The most restrictive of these provisions requires, for the issuance of additional first mortgage bonds, that before-income-tax earnings, as defined, cover pro forma annual interest charges on outstanding first mortgage bonds at least twice; and for the issuance of additional preferred stock, that gross income available for interest cover pro forma annual interest charges and preferred stock dividends at least one and one-half times. These coverages, for first mortgage bonds and for preferred stock for the year ended December 31, 1993, were 5.70 and 2.71, respectively. BANK CREDIT ARRANGEMENTS The company, along with The Southern Company and Georgia Power Company, has entered into agreements with several banks outside the service area to provide $400 million of revolving credit to the companies through June 30, 1996. To provide liquidity support for commercial paper programs, the company and Georgia Power Company have exclusive right to $135 million and $165 million, respectively, of the available credit. The companies have the option of converting the short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements provide for payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Additionally, the company maintains committed lines of credit in the amount of $350 million which expire at various times during 1994 and, in certain cases, provide for average annual compensating balances. Because the arrangements are based on an average balance, the company does not consider any of its cash balances to be restricted as of any specific date. Moreover, the company borrows from time to time pursuant to arrangements with banks for uncommitted lines of credit. In connection with all other lines of credit, the company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. At December 31, 1993, the company had regulatory approval to have outstanding up to $450 million of short-term borrowings. ASSETS SUBJECT TO LIEN The company's mortgage, as amended and supplemented, securing the first mortgage bonds issued by the company, constitutes a direct lien on substantially all of the company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations through the year 2013 were approximately $8 billion at December 31, 1993. In addition, a contract with a certain coal contractor requires reimbursement or purchase, at net book value, of the investment in the mine or equipment upon termination of the contract. At December 31, 1993, such net book value was approximately $13 million. Additional commitments for coal and for nuclear fuel will be required in the future to supply the company's fuel needs. 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS The company and Georgia Power Company own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,019,680 kilowatts, together with associated transmission facilities. The capacity of these units is sold equally to the company and Georgia Power Company under a contract expiring in 1994 which, in substance, requires payments sufficient to provide for the operating expenses, taxes, interest expense II-71 NOTES(continued) Alabama Power Company 1993 Annual Report and a return on equity, whether or not SEGCO has any capacity and energy available. The company's share of expenses totaled $86 million in 1993, $73 million in 1992 and $82 million in 1991, and is included in "Purchased power from affiliates" in the Statements of Income. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two years' notice. In addition, the company has guaranteed unconditionally the obligation of SEGCO under an installment sale agreement for the purchase of certain pollution control facilities at SEGCO's generating units, pursuant to which $24.5 million principal amount of pollution control revenue bonds are outstanding. Georgia Power Company has agreed to reimburse the company for the pro rata portion of such obligation corresponding to its then proportionate ownership of stock of SEGCO if the company is called upon to make such payment under its guaranty. At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. SEGCO paid dividends totaling $11.3 million in 1993, $12.0 million in 1992, and $4.5 million in 1991, of which one-half of each was paid to the company. SEGCO's net income was $8.3 million, $9.3 million and $9.2 million for 1993, 1992 and 1991, respectively. In June 1992 the company completed the sale of a portion of Plant Miller Units 1 and 2 to Alabama Electric Cooperative, Inc. (AEC). The company's percentage ownership and investment in jointly-owned generating plants at December 31, 1993, follows: (1) Jointly owned with an affiliate, Mississippi Power Company. (2) Jointly owned with AEC. 7. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company, including the company, have entered into long-term and short-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The company's portion of off-system capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from Plant Miller is being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA) and the City of Tallahassee, Florida (Tallahassee). Under these agreements, an average of 1,100 megawatts of capacity is scheduled to be II-72 NOTES(continued) Alabama Power Company 1993 Annual Report sold during 1994. Thereafter, these sales will increase to some 1,200 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. With respect to the company's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. ALABAMA MUNICIPAL ELECTRIC AUTHORITY (AMEA) CAPACITY CONTRACTS In August 1986, the company entered into a firm power purchase contract with AMEA entitling AMEA to scheduled amounts of capacity (to a maximum 100 megawatts) for a period of 15 years commencing September 1, 1986 (1986 Contract). In October 1991, the company entered into a second firm power purchase contract with AMEA entitling AMEA to scheduled amounts of additional capacity (to a maximum 80 megawatts) for a period of 15 years commencing October 1, 1991 (1991 Contract). In both contracts the power will be sold to AMEA for its member municipalities that previously were served directly by the company as wholesale customers. Under the terms of the contracts, the company received payments from AMEA representing the net present value of the revenues associated with the respective capacity entitlements, discounted at effective annual rates of 9.96 percent and 11.19 percent for the 1986 and 1991 Contracts, respectively. These payments are being recognized as operating revenues and the discounts are being amortized to other interest expense as scheduled capacity is made available over the terms of the contracts. In order to secure AMEA's advance payments and the company's performance obligation under the contracts, the company issued and delivered to an escrow agent first mortgage bonds representing the maximum amount of liquidated damages payable by the company in the event of a default under the contracts. No principal or interest is payable on such bonds unless and until a default by the company occurs. As the liquidated damages decline under the contracts, a portion of the bonds equal to the decreases are returned to the company. At December 31, 1993, $153 million of such bonds were held by the escrow agent under the contracts. 8. INCOME TAXES Effective January 1, 1993, the company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $469 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $441 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-73 NOTES (continued) Alabama Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $13 million in 1993, $18 million in 1992, and $16 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-74 NOTES (continued) Alabama Power Company 1993 Annual Report 9. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: Pollution control obligations represent installment purchases of pollution control facilities financed by funds derived from sales by public authorities of revenue bonds. The company is required to make payments sufficient for the authorities to meet principal and interest requirements of such bonds. With respect to $154.5 million of such pollution control obligations, the company has authenticated and delivered to the trustees a like principal amount of first mortgage bonds as security for its obligations under the installment purchase agreements. No principal or interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase agreements. The company has capitalized leased nuclear material and recorded the related lease obligations. The arrangement provides for the payment of interest at varying rates and times dependent on options selected by the company from types of loans available under the arrangement. At the end of 1993 the effective rate of this lease arrangement, including applicable fees, was 3.58 percent. Principal payments are required under the arrangement based on the cost of fuel burned. The company has also capitalized certain office building leases and a street light lease. Monthly principal payments plus interest are required, and at December 31, 1993, the interest rate was 9.5 percent for office buildings and 13.0 percent for street lights. The net book value of capitalized leases included in utility plant in service was $94.7 million and $103.0 million at December 31, 1993 and 1992, respectively. The estimated aggregate annual maturities of other long-term debt through 1998 are as follows: $38.9 million in 1994, $33.3 million in 1995, $18.7 million in 1996, $6.4 million in 1997 and $3.0 million in 1998. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The annual first mortgage bond improvement fund requirement is one percent of the aggregate principal amount of bonds of each series authenticated, so long as a portion of that series is outstanding, and may be satisfied by the deposit of cash and/or reacquired bonds, the certification of unfunded property additions or a combination thereof. The 1994 requirement of $20.1 million was satisfied by the deposit of cash in 1994, which was used for the partial redemption of various series of outstanding bonds. In addition, maturing in 1994 are other long-term debt of $38.9 million consisting primarily of capitalized nuclear fuel obligations. II-75 NOTES (continued) Alabama Power Company 1993 Annual Report 11. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988 (Act), the company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at Plant Farley. The Act limits to $9.4 billion, public liability claims that could arise from a single nuclear incident. Plant Farley is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums which could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for the company is $159 million per incident but not more than an aggregate of $20 million to be paid for each incident in any one year. The company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The company's maximum annual assessment per incident is limited to $14 million under the current policy. Additionally, the company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional cost that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased cost of replacement power in an amount up to $3.5 million per week (starting 21 weeks after the outage) for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments per incident under current policies for the company would be $16 million for excess property damage and $9 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and then, any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under applicable trust indentures. The company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the company could be subject to a maximum total assessment of $6.4 million. II-76 NOTES (continued) Alabama Power Company 1993 Annual Report 12. COMMON STOCK DIVIDEND RESTRICTIONS The company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $653 million of retained earnings was restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. 13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: The company's business is influenced by seasonal weather conditions and the timing of rate adjustments. II-77 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-78 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-79 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company Notes: (1) Generating capacity and fuel data includes Alabama Power Company's 50% portion of SEGCO. (2) Includes Southeastern Power Administration allotment. * Less than one-tenth of one percent. II-80 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company II-81 STATEMENTS OF INCOME Alabama Power Company * Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-82 STATEMENTS OF INCOME Alabama Power Company II-83 STATEMENTS OF CASH FLOWS Alabama Power Company ( ) Denotes use of cash. II-84 STATEMENTS OF CASH FLOWS Alabama Power Company II-85 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-86 BALANCE SHEETS Alabama Power Company II-87 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-88 BALANCE SHEETS Alabama Power Company II-89 ALABAMA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-90 ALABAMA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS II-91 GEORGIA POWER COMPANY FINANCIAL SECTION II-92 MANAGEMENT'S REPORT Georgia Power Company 1993 Annual Report The management of Georgia Power Company has prepared this annual report and is responsible for the financial statements and related information. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls based upon the recognition that the cost of the system should not exceed its benefits. The Company believes that its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, which is composed of five directors who are not employees, provides a broad overview of management's financial reporting and control functions. At least three times a year this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal control and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted with a high standard of business ethics. In management's opinion, the financial statements present fairly the financial position, results of operations and cash flows of Georgia Power Company in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ H. Allen Franklin /s/ Warren Y. Jobe - --------------------- -------------------------- H. Allen Franklin Warren Y. Jobe President and Chief Executive Vice President, Executive Officer Treasurer and Chief Financial Officer II-93 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GEORGIA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Georgia Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-102 through II-122) referred to above present fairly, in all material respects, the financial position of Georgia Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding the recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-94 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Georgia Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Georgia Power Company's 1993 earnings totaled $570 million, representing a $49 million (9.5 percent) increase over the prior year. This improvement is primarily a result of higher retail revenues and lower financing costs. Also, during the period, the Company had an $18 million after-tax gain on the sale of a portion of Plant Scherer Unit 4. Higher retail revenues reflect growth in energy sales of 6.1 percent from 1992 levels primarily due to exceptionally hot summer weather during 1993. Interest expense and preferred stock dividends decreased in 1993 due to the redemption and refinancing of higher-cost debt and preferred stock. These positive events were partially offset by higher operating expenses. In comparing 1992 earnings to the prior year, it should be noted that 1991 earnings included two unusual items that significantly affect this comparison. Earnings in 1991 were $89 million higher due to the completion of a settlement agreement with Gulf States Utilities Company (Gulf States) related to power sales contracts. This increase was partially offset by an after-tax charge of $33 million in 1991 for a work force reduction program. A comparison of 1992 to 1991 -- excluding these unusual items -- would reflect a 1992 increase in earnings of $102 million. REVENUES The following table summarizes the factors impacting operating revenues for the 1991-1993 period: Retail revenues of $3.8 billion in 1993 increased $262 million (7.4 percent) over the prior year, compared with an increase of $87 million (2.5 percent) in 1992. The exceptionally hot weather during the summer of 1993 was the primary factor affecting the increase in retail revenues over 1992. The increase in retail revenues for 1992 was a result of higher retail rates and sales growth, partially offset by mild weather and lower fuel revenues. Fuel revenues generally represent the direct recovery of fuel expense, including the fuel component of purchased energy, and do not affect net income. Revenues from demand-side options programs generally represent the direct recovery of program costs. See Note 3 to the financial statements for further information on these programs. Revenues from sales to non-affiliated utilities decreased in both 1993 and 1992. Contractual unit power sales to Florida utilities for 1993 and 1992 are down compared with prior years, primarily due to scheduled reductions that corresponded with the sales to these utilities of portions of Plant Scherer Unit 4 in July 1991 and June II-95 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report 1993. Sales to municipalities and cooperatives increased slightly in 1993 due to the hot summer weather. Generally, these sales have been decreasing as these customers retain more of their own generation at facilities jointly owned with the Company. Revenues from sales to non-affiliated utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Revenues from sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. Sales to affiliated companies do not have a significant impact on earnings. Changes in revenues are a function of the amount of energy sold each year. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: The hot summer weather during 1993 contributed primarily to the sales growth in the residential and commercial classes. Continued improvement in economic conditions positively impacted sales growth in the commercial and industrial classes. Residential energy sales growth in 1992 reflected mild weather. Commercial and industrial sales growth in 1992 is attributable to improved economic conditions. The decrease in energy sales to non-affiliated utilities reflects scheduled reductions in contractual power sales. EXPENSES Fuel expense increased 2.3 percent in 1993 due to higher generation, which was partially offset by lower nuclear fuel costs. In 1992, fuel expense decreased 6.9 percent due to lower generation and lower fuel costs. Purchased power expense has decreased significantly since 1991, reflecting declining contractual capacity purchases from the co-owners of plants Vogtle and Scherer. Purchased power expense decreased $88 million in 1993 and $43 million in 1992. The declines in Plant Vogtle contractual capacity purchases did not have a significant impact on earnings in 1993 or 1992 as these costs are being levelized over six years under the terms of the 1991 Georgia Public Service Commission (GPSC) retail rate order. The levelization is reflected in the amortization of deferred Plant Vogtle expenses in the income statements. See Note 3 to the financial statements for additional information. Other Operation and Maintenance (O & M) expenses increased 9.0 percent in 1993 after remaining relatively flat in 1992. The increase in 1993 is primarily the result of environmental remediation costs at various current and former operating sites, the one- time costs of an automotive fleet reduction program and the recognition of higher employee benefit costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information concerning these new rules. Also, during 1993, O & M expenses reflect costs associated with new demand-side option programs. These costs were offset by increases in retail revenues. See Note 3 to the financial statements for additional information on the recovery of demand-side option program costs. Depreciation and amortization expense increased slightly due to additional plant investment. The 1992 decrease is due to the effects of lower depreciation rates effective in October 1991. Taxes other than income taxes increased 7.4 percent in 1993 and 3.8 percent in 1992. II-96 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report These increases reflect higher ad valorem taxes. The 1993 increase also includes higher taxes paid to municipalities as a result of increased sales. Income tax expense increased $62 million in 1993 due primarily to higher earnings and the effect of a one percent increase in the federal tax rate effective January, 1993. Also, the Company incurred $27 million of tax expense in connection with the second in a series of four separate transactions to sell Plant Scherer Unit 4. The sale resulted in an after-tax gain of $18 million. Interest expense and dividends on preferred stock decreased $19 million (4.0 percent) and $49 million (9.3 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. The Company refinanced $1.7 billion of securities in both 1993 and 1992. In addition, the Company has retired $544 million of long-term debt with the proceeds from the 1991 and 1993 Plant Scherer Unit 4 sales. Other interest charges in 1993 include interest related to the settlement of an Internal Revenue Service audit. The settlement, in total, did not have an effect on 1993 net income. The Company has deferred certain expenses and recorded a deferred return related to Plant Vogtle under phase-in plans. See Note 3 to the financial statements under "Plant Vogtle Phase-In-Plans" for information regarding the deferral and subsequent amortization of costs related to Plant Vogtle. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize either this economic loss or the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Growth in energy sales is subject to a number of factors which traditionally have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. Assuming normal weather, retail sales growth is projected to be approximately 2 percent annually on average during 1994 through 1996. The scheduled addition of four combustion turbine generating units in 1994, four units in 1995 and one unit in 1996, as well as the Rocky Mountain pumped storage hydroelectric project in 1995, will increase related O & M and depreciation expenses. See Note 4 to the financial statements for information on regulatory uncertainties related to the Rocky Mountain project. The GPSC has certified the construction of the 1994 and 1995 combustion turbine generating units for meeting peak generating needs. In addition, the Company has completed a demonstration competitive bidding process for its supply-side requirements expected for 1996. The Company has filed with the GPSC for certification of a four-year purchase power agreement beginning in 1996, and for construction of a jointly owned combustion turbine to be completed in 1996 to meet these needs. As part of efforts to curtail growth in operating expenses, the Company is reducing its work force through an early-retirement program announced in January 1994. The program resulted in a first quarter 1994 after-tax charge to earnings of $39 million. The program has an expected payback period of approximately two years. Pursuant to an Integrated Resource Plan approved by the GPSC in 1992, the Company has implemented various demand-side option programs and has been authorized by the GPSC to recover associated program costs through rate riders. On October 15, 1993, a superior court judge ruled that recovery of these costs through rate riders is unlawful. The Company has ceased collection of the rate riders and is deferring program costs as ordered by the II-97 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report GPSC pending the final outcome of this matter. See Note 3 to the financial statements for additional information. The Company has completed two in a series of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, the Company would realize an additional after-tax gain estimated to total approximately $20 million. See Note 5 to the financial statements for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs cannot be billed to customers. The Clean Air Act is discussed later under "Environmental Issues." The Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition among electric utilities. The law also includes provisions to streamline the licensing process for new nuclear generating plants. The Energy Act marks the beginning of a major change in the traditional business practices of selling electricity. The Energy Act allows Independent Power Producers (IPPs) and other electric suppliers access to a utility's transmission lines to sell their electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. If the Company does not remain a low cost producer and provide quality service, the Company's sales growth could be limited and this could significantly erode earnings. The Company continues to compete with other electric suppliers within the state. In Georgia, most new retail customers with more than 900 kilowatts of connected load may choose their electricity supplier. In addition, the bulk power market has become very competitive as utilities, IPPs and cogenerators seek to supply future capacity needs. Competition can create new business opportunities, but it increases risk and has the potential to adversely affect earnings. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Review of Equity Returns" for additional information. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be adopted by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which will be effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules in January, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition in 1993 were gross utility plant additions of $674 million and the lowering of the cost of capital achieved through the refinancing or retirement of $1.7 billion of long-term debt and preferred stock. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See Notes 2 and 7 to the financial statements regarding the impact of these changes. The funds needed for gross property additions are currently provided from operations. The Statements of Cash Flows provide additional details. II-98 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report FINANCING ACTIVITIES In 1993, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring or repaying high-cost issues. New issues during 1991 through 1993 totaled $3.0 billion and retirement or repayment of securities totaled $4.2 billion. The retirements included the redemption of $253 million and $291 million in 1993 and 1991, respectively, of first mortgage bonds with the proceeds from the Plant Scherer Unit 4 sales. Composite financing rates for the years 1991 through 1993, as of year-end, were as follows: The Company's current securities ratings are as follows: * Not rated by Duff & Phelps LIQUIDITY AND CAPITAL REQUIREMENTS Cash provided from operations increased by $236 million in 1993, primarily due to higher retail sales, lower interest costs, decreasing capacity purchases from the co-owners of plants Vogtle and Scherer and the receipt of cash payments from Gulf States that completed the settlement of litigation. The Company estimates that construction expenditures for the years 1994 through 1996 will total $688 million, $555 million and $629 million, respectively. The Company will continue to invest in transmission and distribution facilities and enhance existing generating plants. These expenditures also include amounts for nine combustion turbine generating units and equipment that will be required to comply with the provisions of the Clean Air Act. The Company's contractual capacity purchases will decline by $113 million over the next three years. Cash requirements for sinking fund requirements, redemptions announced, and maturities of long-term debt are expected to total $377 million during 1994 through 1996. As a result of requirements by the Nuclear Regulatory Commission, the Company has established external sinking funds for the purpose of funding nuclear decommissioning costs. For 1994 through 1996, the amount to be funded for the Company totals $16 million annually. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Nuclear Decommissioning." SOURCES OF CAPITAL The Company expects to meet future capital requirements primarily using funds generated from operations and, if needed, by the issuance of new debt and equity securities, term loans, and short-term borrowings. To meet short-term cash needs and contingencies, the Company had approximately $540 million of unused credit arrangements with banks at the beginning of 1994. See Note 8 to the financial statements for additional information. Completing the remaining two transactions for the sale of Plant Scherer Unit 4 will generate approximately $130 million in both 1994 and in 1995. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's ability to satisfy all coverage requirements is such that it could issue new first mortgage bonds and preferred stock to provide sufficient funds for all anticipated requirements. ENVIRONMENTAL ISSUES In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts II-99 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, Georgia Power's construction expenditures are estimated to total approximately $150 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total Georgia Power construction expenditures ranging from approximately $150 million to $325 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in Georgia Power's annual revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV requirements, on some Company plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a II-100 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standards will depend on the level chosen for the standards and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the nonhazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either nonhazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. These laws include the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA or Superfund). Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized costs to clean-up known sites in the financial statements. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. II-101 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-102 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-103 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-104 STATEMENTS OF CAPITALIZATION AT December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report II-105 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-106 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-107 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-108 NOTES TO FINANCIAL STATEMENTS Georgia Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), and Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Intracompany contracts dealing with jointly owned generating facilities, transmission lines and exchange of electric power are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and each of the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides support services for nuclear power plants in the Southern electric system. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935. Both The Southern Company and its subsidiaries are subject to the regulatory provisions of this act. The Company is also subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective regulatory commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company is authorized by state law and FERC regulations to recover fuel costs and the fuel component of purchased energy costs through fuel cost recovery provisions, which are periodically adjusted to reflect increases or decreases in such costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel costs were under recovered by $79 million and $4 million at December 31, 1993, and 1992, respectively. These amounts are included in customer accounts receivable on the balance sheets. The fuel cost recovery rate was increased effective December 6, 1993. The cost of nuclear fuel is amortized to fuel expense based on estimated thermal units used to generate electric energy and includes a provision for the disposal of spent fuel. Total charges for nuclear fuel amortized to expense were $75 million in 1993, $84 million in 1992, and $93 million in 1991. The Company has contracted with the U.S. Department of Energy (DOE) for permanent disposal of spent fuel beginning in 1998; however, the actual year this service will begin is uncertain. Pending permanent disposition of the spent fuel, sufficient storage capacity is available at Plant Hatch into 2003 and at Plant Vogtle into 2009. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund which is to be funded, in part, by a special assessment on utilities with nuclear plants. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The Company -- based on its ownership interest -- estimates its total assessment under this law to be approximately $42 million to be paid over a 15-year period beginning in 1993. This obligation is recognized in the accompanying Balance Sheets and is being recovered through the fuel cost recovery provisions. The remaining liability at December 31, 1993, is $39 million. II-109 NOTES (continued) Georgia Power Company 1993 Annual Report NUCLEAR REFUELING OUTAGE COSTS Prior to 1992, the Company expensed nuclear refueling outage costs as incurred during the outage period. Pursuant to the 1991 GPSC retail rate order, the Company began accounting for these costs on a normalized basis in 1992. Under this method of accounting, refueling outage costs are deferred and subsequently amortized to expense over the operating cycle of each unit, which is normally 18 months. Deferred nuclear outage costs were $17 million and $6 million at December 31, 1993 and 1992, respectively. DEPRECIATION Depreciation is provided on the cost of depreciable utility plant in service and is calculated primarily on the straight-line basis over the estimated composite service life of the property. The composite rate of depreciation was 3.1 percent in 1993 and 1992, and 3.2 percent in 1991. Effective October 1991, the Company adopted lower depreciation rates consistent with the 1991 GPSC retail rate order. When a property unit is retired or otherwise disposed of in the normal course of business, its costs and the costs of removal, less salvage, are charged to the accumulated provision for depreciation. Minor items of property included in the cost of the plant are retired when the related property unit is retired. NUCLEAR DECOMMISSIONING In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial nuclear power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. The Company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the Company had internally reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for the Company's ownership interest in plants Hatch and Vogtle were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a period of approximately nine years as approved by the GPSC in its 1991 retail rate order. The estimates approved by the GPSC for ratemaking exclude costs of non-radiated structures and site contingency costs. The actual decommissioning cost may vary from the above estimates because of regulatory requirements, changes in technology, and increased costs of labor, materials, and equipment. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The Company expects the GPSC to periodically review and adjust, if necessary, the amounts collected in rates for the anticipated cost of decommissioning. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the GPSC ordered that the costs of Plant Vogtle Units 1 and 2 be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. In 1991, the GPSC modified the phase-in plans. In addition, the Company deferred certain Plant Vogtle operating expenses and financing costs under accounting orders issued by the GPSC. See Note 3 for further information. II-110 NOTES (continued) Georgia Power Company 1993 Annual Report INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. See Note 7 to the financial statements for further information. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. For the years 1993, 1992 and 1991, the average AFUDC rates were 4.87 percent, 7.16 percent and 9.90 percent, respectively. The reduction in the average AFUDC rate since 1991 reflects the Company's greater use of lower cost short-term debt. The Company also imputed a return on its investment in Plant Vogtle Units 1 and 2 after they began commercial operation, under short-term cost deferrals and phase-in plans as described in Note 3. AFUDC and the Vogtle deferred returns, net of taxes, as a percentage of net income after dividends on preferred stock, amounted to 1.4 percent, 2.1 percent and 9.2 percent for 1993, 1992 and 1991, respectively. UTILITY PLANT Utility plant is stated at original cost with the exception of Plant Vogtle, which is stated at cost less regulatory disallowances. Original cost includes materials; labor; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS All financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In December 1992, the Company converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that is being amortized as credits to income over II-111 NOTES (continued) Georgia Power Company 1993 Annual Report approximately four years. This conversion will not have a material effect on income in any year. VACATION PAY Company employees earn vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. This amount was $42 million at December 31, 1993, and $40 million at December 31, 1992. In 1994, approximately 72 percent of the 1993 deferred vacation costs will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan covering substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the projected unit credit actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. For medical care benefits, a qualified trust has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered the Company to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional expense was recognized -- approximately $6 million -- in 1993 and the remaining additional expense was deferred. An additional one-fifth of the costs will be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The cost deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of the regulatory treatment allowed by the GPSC, the adoption of Statement No. 106 did not have a material impact on net income. Prior to 1993, the Company recognized these cost on a cash basis as payments were made. The total costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $56 million, $13 million, and $9 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as II-112 NOTES (continued) Georgia Power Company 1993 Annual Report of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: Weighted average rates used in actuarial calculations: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $68 million and the aggregate of the service and interest cost components of the net retiree medical cost by $7 million. The components of the plans' net costs are shown below: Of net pension costs (income) recorded, $(6) million in 1993 and $5 million in 1991, were recorded to operating expense, with the balance being recorded to construction and other accounts. II-113 NOTES (continued) Georgia Power Company 1993 Annual Report Of the above net postretirement medical and life insurance costs recorded in 1993, $21 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of the Company's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. The Company has suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved the Company's request for an accounting order allowing the Company to defer all current unrecovered and future costs related to these programs until the court's decision is reversed or until the next general rate case proceeding. An association of industrial customers has filed a petition for review of such accounting order in the Superior Court of Fulton County, Georgia. The Company's costs related to these conservation programs through 1993 were $60 million of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on these financial statements. RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected. This matter is now concluded. GULF STATES SETTLEMENT On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received, the Company recorded increases of $3 million in 1992 and $89 million in 1991 net income. FERC REVIEW OF EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. II-114 NOTES (continued) Georgia Power Company 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. PLANT VOGTLE PHASE-IN PLANS Pursuant to orders from the GPSC, the Company recorded a deferred return under phase-in plans for Plant Vogtle Units 1 and 2 until October 1991 when the allowed investment was fully reflected in rates. In addition, the GPSC issued two separate accounting orders that required the Company to defer substantially all operating and financing costs related to both units until rate orders addressed these costs. These GPSC orders provide for the recovery of deferred costs within 10 years. The GPSC modified the phase-in plans in 1991 to accelerate the recognition of costs previously deferred under the Plant Vogtle Unit 2 phase-in plan and to levelize the remaining Plant Vogtle declining capacity buyback expenses. Under these orders, the Company has deferred and begun amortizing these costs (as recovered through rates) as follows: NUCLEAR PERFORMANCE STANDARDS In October 1989, the GPSC adopted a nuclear performance standard for the Company's nuclear generating units under which the performance of plants Hatch and Vogtle will be evaluated every three years. The performance standard is based on each unit's capacity factor as compared to the average of all U.S. nuclear units operating at a capacity factor of 50% or higher during the three-year period of evaluation. Depending on the performance of the units, the Company could receive a monetary reward or penalty under the performance standards criteria. The first evaluation was conducted in 1993 for performance during the 1990-92 period. During this three-year period, the Company's units performed at an average capacity factor of 81 percent compared to an industry average of approximately 73 percent. Based on these results, the GPSC approved a performance reward of approximately $8.5 million for the Company. This reward is being collected through the retail fuel cost recovery provision and recognized in income over a 36- month period beginning November, 1993. 4. COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program and currently estimates property additions to be approximately $688 million in 1994, $555 million in 1995 and $629 million in 1996. These estimated additions include AFUDC of $19 million in 1994, $27 million in 1995, and $18 million in 1996. The estimates for property additions for the three-year period include $88 million committed to meeting the requirements of the Clean Air Act. While the Company has no new baseload generating plants under construction, the construction of nine combustion turbine peaking units is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities, and upgrading and extending the useful life of generating plants will continue. The construction program is subject to periodic review and revision, and actual construction costs may vary from estimates because of numerous factors, including, but not limited to, changes in business conditions, load growth estimates, environmental regulations, and regulatory requirements. II-115 NOTES (continued) Georgia Power Company 1993 Annual Report FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $4.8 billion at December 31, 1993. Additional commitments for coal and for nuclear fuel will be required in the future to supply the Company's fuel needs. OPERATING LEASES The Company has entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $8 million, $7 million, and $5 million for 1993, 1992, and 1991, respectively. Minimum annual rental commitments for noncancellable rail car leases are $9 million annually for years 1994 through 1998, and total approximately $191 million thereafter. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 as then planned was not economically justifiable and reasonable and withheld authorization for the Company to spend funds from approved securities issuances on that project. In 1988, the Company and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 5. The joint ownership agreement significantly reduces the risk of the project being canceled. However, full recovery of the Company's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event the Company cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off in accordance with FASB Statement No. 90, Accounting for Abandonments and Disallowed Plant Costs. At December 31, 1993, the Company's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, the Company's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. The Company has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, the Company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the Company's nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment for the Company -- based on its ownership and buyback interests -- is $171 million per incident but not more than an aggregate of $22 million to be paid for each incident in any one year. The Company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The Company's maximum assessment per incident is limited to $18 million under current policies. Additionally, the Company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric II-116 NOTES (continued) Georgia Power Company 1993 Annual Report Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum assessments per incident under the current policies for the Company would be $15 million for excess property damage and $13 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the Company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. The Company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the Company could be subject to a maximum total assessment of $7 million. 5. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS Since 1975, the Company has sold undivided interests in plants Hatch, Wansley, Vogtle, and Scherer Units 1 and 2, together with transmission facilities, to OPC, an electric membership generation and transmission corporation; the Municipal Electric Authority of Georgia (MEAG), a public corporation and an instrumentality of the state of Georgia; and the City of Dalton, Georgia. The Company has sold an interest in Plant Scherer Unit 3 to Gulf Power, an affiliate. Additionally, the Company has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FPL) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FPL will eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Except as otherwise noted, the Company has contracted to operate and maintain all jointly owned facilities. The Company includes its proportionate share of plant operating expenses in the corresponding operating expenses in the Statements of Income. As discussed in Note 4, the Company and OPC have a joint ownership arrangement for the Rocky Mountain pumped storage hydroelectric project under which the Company will retain its present investment in the project and OPC will finance and complete the remainder of the project and operate the completed facility. Based on current cost estimates the Company's ownership will be approximately 25% of the project (194 megawatts of capacity) at completion. The Company will own six of eight 80 megawatt combustion turbine generating units and 75% of the related common facilities being jointly constructed with Savannah Electric, an affiliate. The Company's investment in the project at December 31, 1993, was $100 million and is expected to total approximately $182 million when the project is completed. All units are II-117 NOTES (continued) Georgia Power Company 1993 Annual Report expected to be completed by June, 1995. Savannah Electric will operate these units. In connection with the joint ownership arrangements for plants Vogtle and Scherer, the Company has made commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from these units. These commitments are in effect during periods of up to 10 years following commercial operation (and with regard to a portion of a 5 percent interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for capacity are required whether or not any capacity is available. The energy cost is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power from non-affiliates in the Company's Statements of Income. Capacity payments totaled $183 million, $289 million and $320 million in 1993, 1992 and 1991, respectively. The Plant Scherer buyback agreements ended in 1993. The current projected Plant Vogtle capacity payments for the next five years are as follows: $132 million in 1994, $77 million in 1995, $70 million in 1996, $59 million in 1997 and $59 million in 1998. Portions of the payments noted above relate to costs in excess of Plant Vogtle's allowed investment for ratemaking purposes. The present value of these portions was written off in 1987 and 1990. Additionally, the Plant Vogtle declining capacity buyback expense is being levelized over a six-year period. See Note 3 for further information. At December 31, 1993, the Company's percentage ownership and investment (exclusive of nuclear fuel) in jointly owned facilities in commercial operation, were as follows: (1) Investment net of write-offs. The Company and an affiliate, Alabama Power, own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,020 megawatts, as well as associated transmission facilities. The capacity of the units has been sold equally to the Company and Alabama Power under a contract expiring in 1994, which, in substance, requires payments sufficient to provide for the operating expenses, taxes, debt service and return on investment, whether or not SEGCO has any capacity and energy available. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two year's notice. The Company's share of expenses included in purchased power from affiliates in the Statements of II-118 NOTES (continued) Georgia Power Company 1993 Annual Report Income, is as follows: At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. 6. LONG-TERM POWER SALES AGREEMENTS The Company and the operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service territory. Certain of these agreements are non-firm and are based on the capacity of the Southern system. Other agreements are firm and pertain to capacity related to specific generating units. Because energy is generally sold at cost under these agreements, it is primarily the capacity revenues that affect the Company's profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). This amount decreases to 200 megawatts in 1994 and the contract expires at year-end. Sales under these long-term non-firm power sales agreements are made from available power pool energy, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is being sold to FPL, JEA, and the City of Tallahassee, Florida and beginning in 1994 to FPC. Under these agreements, the Company sold approximately 830 megawatts of capacity in 1993 and is scheduled to sell approximately 403 megawatts of capacity in 1994. Thereafter, these sales will decline to an estimated 157 megawatts by the end of 1996 and will remain at that approximate level through 1999. After 2000, capacity sales will decline to approximately 101 megawatts -- unless reduced by FPL and JEA -- until the expiration of the contracts in 2010. 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $993 million are revenues to be received from customers. These assets are attributable to tax benefits flowed-through to customers in prior years, and taxes applicable to capitalized AFUDC. The related liabilities of $453 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: II-119 NOTES (continued) Georgia Power Company 1993 Annual Report The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax basis, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $19 million in 1993, $19 million in 1992, and $27 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory tax rate to effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 8. CAPITALIZATION COMMON STOCK DIVIDEND RESTRICTIONS The Company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $742 million of retained earnings were restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. The Company's charter limits cash dividends on common stock to the lesser of the retained earnings balance or 75 percent of net income available for such stock during a prior period of 12 months if the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend, is below 25 percent, and to 50 percent of such net income if such ratio is less than 20 percent. At December 31, 1993, the ratio as defined was 46.1 percent. II-120 NOTES (continued) Georgia Power Company 1993 Annual Report REMARKETED BONDS In 1992, the Company issued two series of variable rate first mortgage bonds each with principal amounts of $100 million due 2032. The current composite interest rate on the bonds is 6.20 percent and is fixed for the first three years of the issues. POLLUTION CONTROL BONDS The Company has incurred obligations in connection with the sale by public authorities of tax-exempt pollution control and industrial development revenue bonds. The Company has authenticated and delivered to trustees an aggregate of $407.7 million of its first mortgage bonds, which are pledged as security for its obligations under pollution control and industrial development contracts. No interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase or loan agreements. An aggregate of approximately $1.3 billion of the pollution control and industrial development bonds is secured by a subordinated interest in specific property of the Company. Details of pollution control bonds are as follows: BANK CREDIT ARRANGEMENTS At the beginning of 1994, the Company had unused credit arrangements with banks totaling $540 million, of which $10 million expires June 30, 1994, $130 million expires at May 1, 1996, and $400 million expires at June 30, 1996. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing the Company, Alabama Power, and The Southern Company up to a total credit amount of $400 million. To provide liquidity support for commercial paper programs and for other short-term cash needs, $165 million and $135 million of the $400 million available credit are currently dedicated for the Company and Alabama Power, respectively. However, the allocations can be changed among the borrowers by notifying the respective banks. During the term of the agreements expiring in 1996, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. The $10 million credit arrangement expiring in 1994 allows borrowings for up to 90 days. Commitment fees are based on the unused portion of the commitment. In addition, the Company borrows under uncommitted lines of credit with banks and through a $150 million commercial paper program that has the liquidity support of committed bank credit arrangements. Average compensating balances held under these committed facilities were not material in 1993. OTHER LONG-TERM DEBT Assets acquired under capital leases are recorded in the Balance Sheets as utility plant in service, and the related obligations are classified as long-term debt. At December 31, 1993, the Company had a capitalized lease obligation for its corporate headquarters building of $88 million with an interest rate of 8.1 percent. Other capitalized lease obligations were $137 thousand with a composite interest rate of 6.8 percent. The maturities of capital lease obligations through 1998 are approximately as follows: $423 thousand in 1994, $309 thousand in 1995, $335 thousand in 1996, $362 thousand in 1997, and $392 thousand in 1998. The lease agreement for the corporate headquarters building provides for payments that are minimal in early years and escalate through the first 21 years of the lease. For ratemaking purposes, the GPSC has treated the lease as an operating lease and has allowed only the lease II-121 NOTES (continued) Georgia Power Company 1993 Annual Report payments in cost of service. The difference between the accrued expense and the lease payments allowed for ratemaking purposes is being deferred as a cost to be recovered in the future as ordered by the GPSC. At December 31, 1993, and 1992, the interest and lease amortization deferred on the Balance Sheets are $47 million and $48 million, respectively. In December 1993, the Company borrowed $37 million through a long-term note due in 1995. ASSETS SUBJECT TO LIEN The Company's mortgage dated as of March 1, 1941, as amended and supplemented, securing the first mortgage bonds issued by the Company, constitutes a direct lien on substantially all of the Company's fixed property and franchises. LONG-TERM DEBT DUE WITHIN ONE YEAR The current portion of the Company's long-term debt is as follows: *Less than .1 million The indenture's first mortgage bond improvement fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash or reacquired bonds, or by pledging additional property equal to 1 2/3 times the requirement. The 1993 and 1992 requirements were met in the first quarter of each year by depositing cash subsequently used to redeem bonds. The 1994 requirement was funded in December 1993. REDEMPTION OF HIGH-COST SECURITIES The Company plans to continue a program of redeeming or replacing high-cost debt and preferred stock in cases where opportunities exist to reduce financing costs. High-cost issues may be repurchased in the open market or called at premiums as specified under terms of the issue. They may also be redeemed at face value to meet improvement fund and sinking fund requirements, to meet replacement provisions of the mortgage, or by use of proceeds from the sale of property pledged under the mortgage. In general, for the first five years a series is outstanding the Company is prohibited from redeeming for improvement fund purposes more than 1 percent annually of the original issue amount. 9. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial information for 1993 and 1992 is as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate increases. II-122 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-123 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-124 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report Note: As of 9/1/91, Georgia Power Company's sales to Oglethorpe Power Company are not included in Peak-Hour Demand * Less than one-tenth of one percent. II-125 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report II-126 STATEMENTS OF INCOME Georgia Power Company Note: Reflects major sales of facilities to Jacksonville Electric Authority, Florida Power & Light Company, OPC, MEAG, and Dalton. Increases in net income, after total taxes, from these sales were $18,391,000 in 1993, $14,542,000 in 1991, $6,336,000 in 1990, $3,851,000 in 1987, and $21,250,000 in 1984. II-127 STATEMENTS OF INCOME Georgia Power Company II-128 STATEMENTS OF CASH FLOWS Georgia Power Company ( ) Denotes use of cash. II-129 STATEMENTS OF CASH FLOWS Georgia Power Company II-130 BALANCE SHEETS Georgia Power Company II-131 BALANCE SHEETS Georgia Power Company II-132 BALANCE SHEETS Georgia Power Company II-133 BALANCE SHEETS Georgia Power Company II-134 GEORGIA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-135 GEORGIA POWER COMPANY OUTSTANDING SECURITIES (Continued) AT DECEMBER 31, 1993 (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. II-136 GEORGIA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. * Less than $500. II-137 GULF POWER COMPANY FINANCIAL SECTION II-138 MANAGEMENT'S REPORT Gulf Power Company 1993 Annual Report The management of Gulf Power Company has prepared and is responsible for the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of the directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Gulf Power Company in conformity with generally accepted accounting principles. /s/ D. L. McCrary /s/ A. E. Scarbrough - -------------------------- ------------------------ Douglas L. McCrary Arlan E. Scarbrough Chairman of the Board Vice President - Finance and Chief Executive Officer II-139 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GULF POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Gulf Power Company (a Maine corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-148 through II-165) referred to above present fairly, in all material respects, the financial position of Gulf Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, Gulf Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-140 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Gulf Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Gulf Power Company's net income after preferred stock dividends was $54.3 million for 1993, a $0.2 million increase over 1992 net income. Earnings reflect a $2.3 million gain on the sale of Gulf States Utilities Company (Gulf States) stock and the reversal of a $1.7 million wholesale rate refund as the result of a court order which is further discussed in Note 3 to the financial statements under "Recovery of Contract Buyout Costs". The company also experienced growth in residential and commercial sales and a decrease in interest expense on long-term debt as a result of security refinancings, offset by higher operation and maintenance expense, and decreased industrial sales reflecting the loss of the Company's largest industrial customer, Monsanto, which began cogeneration in August of 1993. The Company's 1992 net income after dividends on preferred stock decreased $3.7 million compared to the prior year. The 1991 earnings included an after-tax gain of $12.7 million representing the settlement of litigation with Gulf States. See Note 7 to the financial statements under "Gulf States Settlement Completed" for further details. Excluding this settlement from 1991, earnings for 1992 increased $8.4 million -- or approximately -- 18.7 percent over 1991. This improvement was due to increased energy sales; lower interest expense and preferred dividends as a result of security refinancings; and continued emphasis on cost controls. The Company's return on average common equity was 13.29 percent for 1993, a slight decrease from the 13.62 percent return earned in 1992, which was up from the 12.03 percent earned in 1991 (excluding the Gulf States settlement). REVENUES Changes in operating revenues over the last three years are the result of the following factors: * Includes the non-interest portion of the wholesale rate refund reversal discussed in "Earnings." Retail revenues of $471.7 million in 1993 increased $10.2 million or 2.2 percent from last year, compared with an increase of 1.2 percent in 1992 and 4.9 percent in 1991. Revenues increased in the residential and commercial classes primarily due to customer growth, and favorable weather and economic conditions. Revenues in the industrial class declined due to the loss of the Company's largest industrial customer, Monsanto, which began operating its cogeneration facility in August 1993. See "Future Earnings Potential" for further details. The change in base rates for 1993 and 1992 reflects the expiration of a retail rate penalty in September 1992. Sales for resale were $95.4 million in 1993, increasing $1.2 million or 1.3 percent over 1992. Sales to affiliated companies vary from year to year depending on demand and the availability and cost of generating resources at each company. The majority of non-affiliated energy sales arise from long-term contractual agreements. Non-affiliated long-term contracts include capacity and energy components. Capacity revenues reflect the recovery of II-141 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report fixed costs and return on investment. Energy is sold at its variable cost. The capacity and energy components under these long-term contracts were as follows: Beginning in June 1992, all the capacity from the Company's ownership portion of Plant Scherer Unit No. 3 was sold through unit power sales, resulting in increased capacity revenues. In 1993, changes in other operating revenues are primarily due to the recognition of $2.6 million under the Environmental Cost Recovery (ECR) clause which is fully discussed in Note 3 to the financial statements under "Environmental Cost Recovery", which is offset by true-ups of other regulatory cost recovery clauses. The increase in other operating revenues in 1992 was primarily due to true-ups of regulatory cost recovery clauses and the changes in franchise fee collections and Florida gross receipts taxes (discussed under "Expenses") which had no effect on earnings. Energy sales for 1993 and percent changes in sales since 1991 are reported below. Overall retail sales remained relatively flat in 1993. Increases in residential and commercial sales -- reflecting customer growth, favorable weather and an improving economy -- were offset by the decreased sales in the industrial class reflecting the loss of Monsanto. Retail sales increased 3.8 percent in 1992 primarily due to an increase in the number of customers served and a moderately improving economy. Energy sales for resale to non-affiliates increased 2.0 percent and are predominantly unit power sales under long-term contracts to Florida utilities which are discussed above. Energy sales to affiliated companies vary from year to year as mentioned above. EXPENSES Total operating expenses for 1993 increased $16.6 million or 3.5 percent over 1992 primarily due to increased operation and maintenance expenses and higher taxes. Other operation expenses increased $10.9 million or 11.1 percent from the 1992 level. The increase is attributable to additional costs of $7.4 million related to increases in the buyout of coal supply contracts and $1.4 million of environmental clean-up costs. Also, higher employee benefit costs and the costs of an automotive fleet reduction program increased expenses by $2.1 million. Operating expenses for 1992 increased by approximately $16 million over 1991. Excluding the Gulf States settlement, an after-tax reduction of $0.6 million in 1992 and $12.7 million in 1991, 1992 total operating expenses increased $4.3 million or 0.9 percent over 1991. Fuel and purchased power expenses decreased $3.8 million or 1.8 percent from 1992 reflecting the lower cost of fuel. Total 1992 fuel and purchased power increased $1.4 million or 0.7 percent from 1991. Maintenance expense increased $4.1 million or 9.7 percent over 1992 due to scheduled maintenance of production facilities. The 1992 maintenance expense was down $3.5 million or 7.7 percent from 1991 due to a decrease in scheduled maintenance. Federal income taxes increased $0.7 million primarily due to a corporate federal income tax rate increase from 34 percent to 35 percent effective January 1993. Taxes other than income taxes increased $2.3 million in 1993, an increase of 6.1 percent over the 1992 expense II-142 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report primarily due to increases in property taxes and gross receipt taxes. Taxes other than income taxes decreased $4.5 million, or 10.5 percent in 1992 compared to 1991 due primarily to the Company discontinuing the collection of franchise fees for two Florida counties which was partially offset by an increase in gross receipt taxes. Changes in franchise fee collections and gross receipt taxes had no impact on earnings. Interest expense decreased $3.2 million or 8.1 percent from the 1992 level and 1992 interest expense decreased $5.6 million or 12.5 percent from 1991. The decrease in both years is primarily attributable to refinancing some of the Company's higher cost securities. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its cost of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on a number of factors. It is expected that higher operating costs and carrying charges on increased investment in plant, if not offset by proportionate increases in operating revenues (either by periodic rate increases or increases in sales), will adversely affect future earnings. Growth in energy sales will be subject to a number of factors, including the volume of sales to neighboring utilities, energy conservation practiced by customers, the elasticity of demand, customer growth, weather, competition, and the rate of economic growth in the service area. In addition to the traditional factors discussed above, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Company is preparing to meet the challenges of a major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access the Company's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for the Company's large industrial and commercial customers and sell excess energy generation to the Company or other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, its ability to retain large industrial and commercial customers, and obtain new long-term contracts for energy sales outside the Company's service area, could be limited, and this could significantly erode earnings. The future effect of cogeneration and small-power production facilities cannot be fully determined at this time, but may be adverse. One effect of cogeneration which the Company has experienced is the loss of its largest industrial customer, Monsanto, in August of 1993. The loss of the Monsanto load reduced revenues, and will result in a reduction in net income of approximately $3 million in the first twelve months. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts that have a return on common equity of 13.75 percent or greater, and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters". II-143 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Also, recently enacted legislation that provides for recovery of prudent environmental compliance costs is discussed in Note 3 to the financial statements under "Environmental Cost Recovery." The Company filed a notice with the Florida Public Service Commission (FPSC) of its intent to obtain rate relief in February 1993. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case. The stipulation also allowed the Company to retain, for the next four years, its existing method for calculating accruals for future power plant dismantlement costs. The existing method provides a more even allocation of expenses over the life of the plants and results in an avoided increase in expenses of about $6 million annually over the next four years when compared to the FPSC method. The stipulation also provided for the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. After the February 1993 filing date, interest rates continued to remain low, resulting in lower cost of capital. Also, the Florida legislature adopted legislation which allows utilities to petition the FPSC for recovery of environmental costs through an adjustment clause if these costs are not being recovered in base rates. See Note 3 to the financial statements under "Environmental Cost Recovery" for further details. The combination of the circumstances discussed above, placed the Company in a better position to manage its finances without an increase in base rates while still providing a fair return for the Company's investors. Consequently, the Company agreed, as a part of this stipulation, to cancel the filing of the rate case. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, which resulted in a decrease in earnings of $0.3 million. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company does not have any investments that qualify for FASB Statement No. 115 treatment. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition during 1993 were gross property additions of $79 million. Funds for these additions were provided by internal sources. The Company continued to refinance higher cost securities to lower the Company's cost of capital. See "Financing Activities" below and the Statements of Cash Flows for further details. On January 1, 1993, the Company changed its method of calculating the accruals for postretirement benefits other than pensions and its method of accounting for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. FINANCING ACTIVITIES As mentioned above, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring higher-cost issues in 1993. The Company sold $75 million of first mortgage bonds and, through public authorities, $53.4 million of pollution control revenue bonds, issued $35 million of preferred stock, and obtained $25 million with a long-term bank note. Retirements, including maturities during 1993, totaled $88.8 million of first mortgage bonds, $40.7 million of pollution control revenue bonds, and $21.1 million of preferred stock. (See the Statements of Cash Flows for further details.) II-144 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Composite financing rates for the years 1991 through 1993 as of year end were as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's gross property additions, including those amounts related to environmental compliance, are budgeted at $200 million for the three years beginning 1994 ($77 million in 1994, $55 million in 1995, and $68 million in 1996). The estimates of property additions for the three-year period include $25 million committed to meeting the requirements of the Clean Air Act, the cost of which is expected to be recovered through the ECR clause which is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Actual construction costs may vary from this estimate because of factors such as the granting of timely and adequate rate increases; changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The Company does not have any baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. Significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $86 million will be required by the end of 1996 in connection with maturities of long-term debt and preferred stock subject to mandatory redemption. Also, the Company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million for The Southern Company including $34 million for Gulf Power Company through 1995. II-145 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company including approximately $30 million to $40 million for Gulf Power Company. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. Following adoption of legislation in April of 1992, allowing electric utilities in Florida to seek FPSC approval of their Clean Air Act Compliance Plans, the Company filed its petition for approval. The Commission approved the Company's plan for Phase I compliance, deferring until a later date approval of its Phase II Plan. An average increase of up to 4 percent in annual revenue requirements from Gulf Power Company customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. The Florida Legislature recently adopted legislation that allows a utility to petition the FPSC for recovery of prudent environmental compliance costs through an ECR clause without lengthy regulatory full revenue requirements rate proceedings. The legislation is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Gulf Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. II-146 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of Gulf Power Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect Gulf Power Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. COAL STOCKPILE DECREASES To reduce the working capital invested in the coal stockpile inventory, the Company implemented a coal stockpile reduction program in 1992. The Company's actual year end inventory at December 31, 1993 was $20.7 million which is considerably lower than the desired level of $31.4 million. This situation exists because a limited supply of coal was available at competitive prices primarily due to the United Mine Workers strike from July to December 1993. In addition, barge transportation was stranded due to floods in the Midwest. As a result of these circumstances, management chose to allow the existing coal inventory to decline until coal prices stabilized. Current market conditions indicate that substantial coal supplies at competitive prices are now available. Therefore, the Company plans to increase purchases and return the coal stockpile inventory to the desired level by the end of the third quarter, 1994. SOURCES OF CAPITAL At December 31, 1993, the Company had $5.6 million of cash and cash equivalents to meet its short-term cash needs. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations; the sale of additional first mortgage bonds, pollution control bonds, and preferred stock; and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficient to permit, at present interest and preferred dividend levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-147 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-148 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-149 BALANCE SHEETS At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-150 BALANCE SHEETS (continued) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-151 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report II-152 STATEMENTS OF CAPITALIZATION (CONTINUED) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-153 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-154 NOTES TO FINANCIAL STATEMENTS At December 31, 1993, 1992 and 1991 Gulf Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: GENERAL Gulf Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services, Inc. (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear) and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company is also subject to regulation by the FERC and the Florida Public Service Commission (FPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by these commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company's electric rates include provisions to periodically adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. The FPSC has also approved the recovery of purchased power capacity costs, energy conservation costs, and environmental compliance costs in cost recovery clauses that are similar to the method used to recover fuel costs. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily using composite straight-line rates which approximated 3.8 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. The Company is included in the consolidated federal income tax return of The Southern Company. II-155 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of certain new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of plant through a higher rate base and higher depreciation expense. The FPSC-approved composite rate used to calculate AFUDC was 7.27 percent effective on July 1, 1993 and 8.03 percent for the first half of 1993, and for 1992, and 1991. AFUDC amounts for 1993, 1992, and 1991 were $966 thousand, $60 thousand, and $149 thousand, respectively. The increase in 1993 is due to an increase in construction projects at Plant Daniel. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The Company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. The amount was $4.0 million and $3.8 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 84 percent of the 1993 deferred vacation cost II-156 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report will be expensed and the balance will be charged to construction. PROVISION FOR INJURIES AND DAMAGES The Company is subject to claims and suits arising in the ordinary course of business. As permitted by regulatory authorities, the Company is providing for the uninsured costs of injuries and damages by charges to income amounting to $1.2 million annually. The expense of settling claims is charged to the provision to the extent available. The accumulated provision of $2.2 million and $2.5 million at December 31, 1993 and 1992, respectively, is included in miscellaneous current liabilities in the accompanying Balance Sheets. PROVISION FOR PROPERTY DAMAGE Due to a significant increase in the cost of traditional insurance, effective in 1993, the Company became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provides for the estimated cost of uninsured property damage by charges to income amounting to $1.2 million annually. At December 31, 1993 and 1992, the accumulated provision for property damage amounted to $10.5 million and $9.7 million, respectively. The expense of repairing such damage as occurs from time to time is charged to the provision to the extent it is available. 2. RETIREMENT BENEFITS: PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension trust fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Prior to the adoption of Statement No. 106, Gulf Power Company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $3.9 million, $3.1 million, and $2.7 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. II-157 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $4.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $543 thousand. Components of the plans' net cost are shown below: Of the above net pension amounts, $(601) thousand in 1993, $3 thousand in 1992, and $518 thousand in 1991, were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance amounts recorded in 1993, $3.0 million was recorded in operating expenses, and the remainder was recorded in construction and other accounts. II-158 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 3. LITIGATION AND REGULATORY MATTERS: COAL BARGE TRANSPORTATION SUIT On August 19, 1993, a complaint against the Company and Southern Company Services, an affiliate, was filed in federal district court in Ohio by two companies with which the Company had contracted for the transportation by barge for certain of the Company's coal supplies. The complaint alleges breach of the contract by the Company and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on the Company's financial statements. FPSC APPROVES STIPULATION In February 1993, the Company filed a notice with the FPSC of its intent to obtain rate relief. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case and to allow the Company to retain for the next four years its existing method for calculating accruals for future power plant dismantlement costs. The stipulation also required the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. See Management's Discussion and Analysis under "Future Earnings Potential" for further details of circumstances that contributed to the company canceling the rate case. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. RECOVERY OF CONTRACT BUYOUT COSTS In July 1990, the Company filed a request for waiver of FERC's fuel adjustment charge regulation to permit recovery of coal contract buyout costs from wholesale customers. On April 4, 1991, the FERC issued an order granting recovery of the buyout costs from wholesale customers from July 19, 1990, forward, but denying retroactive recovery of the buyout costs from January 1, 1987 through July 18, 1990. The Company's request for rehearing was denied by the FERC. The Company refunded $2.7 million (including interest) in June 1991 to its wholesale customers. On July 31, 1991, the Company filed a petition for review of the FERC's decision to the U.S. Court of Appeals for the District of Columbia Circuit. On January 22, 1993, the Court vacated the Commission's order, finding FERC's denial of the Company's request for a retroactive waiver to be arbitrary and capricious. The Court remanded the matter to FERC for consideration consistent with its opinion. Management expects that the commission will ultimately allow the Company to recover the amount refunded plus interest. Accordingly, the Company recorded the reversal of the $2.7 million refund to income in 1993. ENVIRONMENTAL COST RECOVERY In April 1993, the Florida Legislature adopted legislation for an Environmental Cost Recovery (ECR) clause, which allows a utility to petition the FPSC for recovery of all prudent environmental compliance costs that are not being recovered through base rates or any other rate-adjustment clause. Such environmental costs include operation and maintenance expense, depreciation, and a return on invested capital. II-159 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report On January 12, 1994, the FPSC approved the Company's petition under the ECR clause for recovery of environmental costs that were projected to be incurred from July 1993 through September 1994. The order allows the recovery from customers of such costs amounting to $7.8 million during the period, February through September 1994. Thereafter, recovery under ECR will be determined semi-annually and will include a true-up of the prior period and a projection of the ensuing six-month period. In December 1993, the Company recorded $2.6 million as additional revenue for the portion of costs incurred during 1993. 4. CONSTRUCTION PROGRAM: The Company is engaged in a continuous construction program, the cost of which is currently estimated to total $77 million in 1994, $55 million in 1995, and $68 million in 1996. These estimates include AFUDC of approximately $0.7 million, $0.3 million, and $0.2 million, in 1994, 1995, and 1996, respectively. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. 5. FINANCING AND COMMITMENTS: GENERAL Current projections indicate that funds required for construction and other purposes, including compliance with environmental regulations will be derived primarily from internal sources. Requirements not met from internal sources will be financed from the sale of additional first mortgage bonds, preferred stock, and capital contributions from The Southern Company. In addition, the Company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and redemptions of higher-cost securities. Because of the attractiveness of current short term interest rates, the Company may maintain a higher level of short term indebtedness than has historically been true. At December 31, 1993, the Company had $49 million of lines of credit with banks of which $6.1 million was committed to cover checks presented for payment. These credit arrangements are subject to renewal June 1 of each year. In connection with these committed lines of credit, the Company has agreed to pay certain fees and/or maintain compensating balances with the banks. The compensating balances, which represent substantially all the cash of the Company except for daily working funds and like items, are not legally restricted from withdrawal. In addition, the Company has bid-loan facilities with eight major money center banks that total $180 million, of which, none was committed at December 31, 1993. ASSETS SUBJECT TO LIEN The Company's mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $1.4 billion at December 31, 1993. Additional commitments will be required in the future to supply the Company's fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 to terminate two long-term contracts for the supply of coal to Plant Daniel, which is jointly owned by the Company and Mississippi Power, an operating affiliate. The Company's portion of II-160 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report this payment was some $60 million. This amount is being amortized to expense on a per ton basis over a nine-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $18 million at December 31, 1993. In 1988, the Company made an advance payment of $60 million to another coal supplier under an arrangement to lower the cost of future coal purchased under an existing contract. This amount is being amortized to expense on a per ton basis over a ten-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $36 million at December 31, 1993. Also, in 1993 the Company made a payment of $16.4 million to a coal supplier under an arrangement to suspend the purchase of coal under an existing contract for one year. This amount is being amortized to expense on a per ton basis over a one year period. The remaining unamortized amount, which is included in current assets, was $11 million at December 31, 1993. The amortization of these payments is being recovered through the fuel cost recovery clause discussed under "Revenues and Fuel Costs" in Note 1. LEASE AGREEMENT In 1989, the Company entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Mississippi Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million in 1992 and $1.3 million in 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option, after three years from the date of the original contract, to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, the Company has the option to renew the lease. 6. JOINT OWNERSHIP AGREEMENTS: The Company and Mississippi Power jointly own Plant Daniel, a steam-electric generating plant, located in Jackson County, Mississippi. In accordance with an operating agreement, Mississippi Power acts as the Company's agent with respect to the construction, operation, and maintenance of the plant. The Company and Georgia Power jointly own Plant Scherer Unit No. 3, a steam-electric generating plant, located near Forsyth, Georgia. In accordance with an operating agreement, Georgia Power acts as the Company's agent with respect to the construction, operation, and maintenance of the unit. The Company's pro rata share of expenses related to both plants is included in the corresponding operating expense accounts in the Statements of Income. At December 31, 1993, the Company's percentage ownership and its amount of investment in these jointly owned facilities were as follows: (1) Includes net plant acquisition adjustment. (2) Total megawatt nameplate capacity: Plant Scherer Unit No. 3: 818 Plant Daniel: 1,000 II-161 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL The Company and the other operating affiliates of The Southern Company have contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Certain of these agreements are non-firm and are based on the capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, the capacity revenues from these sales primarily affect profitability. The Company's capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC) by the Southern electric system. In 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end 1994. Capacity and energy sales under these long-term non-firm power sales agreements are made from available power pool capacity, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is currently being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA), and the City of Tallahassee, Florida. Under these agreements, 209 megawatts of net dependable capacity were sold by the Company during 1993, and sales will remain at that approximate level until the expiration of the contracts in 2010, unless reduced by FPC, FP&L and JEA after 1999. Capacity and energy sales to FP&L, the Company's largest single customer, provided revenues of $39.5 million in 1993, $46.2 million in 1992, and $42.1 million in 1991, or 6.8 percent, 8.1 percent, and 7.5 percent of operating revenues, respectively. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, the subsidiaries of The Southern Company entered into a settlement agreement with Gulf States Utilities Company (Gulf States) that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received - less the amounts previously included in income - the Company recorded increases in net income of approximately $0.6 million in 1992 and $12.7 million in 1991. In 1993, the Company sold all of its remaining Gulf States common stock received in the settlement, resulting in a gain of $2.3 million after tax. 8. INCOME TAXES: Effective January 1, 1993, Gulf Power Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $31.3 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $76.9 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-162 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $2.3 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: Gulf Power Company and the other subsidiaries of The Southern Company file a consolidated federal tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-163 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 9. LONG-TERM DEBT: POLLUTION CONTROL OBLIGATIONS Obligations incurred in connection with the sale by public authorities of tax-exempt pollution control revenue bonds are as follows: * Sinking fund requirement applicable to the 6 percent pollution control bonds is $100 thousand for 1994 with increasing increments thereafter through 2005, with the remaining balance due in 2006. With respect to the collateralized pollution control revenue bonds, the Company has authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. OTHER LONG-TERM DEBT Long-term debt also includes $17.5 million for the Company's portion of notes payable issued in connection with the termination of Plant Daniel coal contracts (see Note 5 for information on fuel commitments). The notes bear interest at 8.25 percent with the principal being amortized through 1995. Also included in long-term debt is a 30-month note payable for $25 million which was obtained to refinance higher cost securities. The principal is due in June 1996 and bears interest at 4.69 percent which is payable quarterly beginning March 1994. The estimated annual maturities of the notes payable through 1996 are as follows: $8.4 million in 1994, $9.1 million in 1995, and $25 million in 1996. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirement and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash, reacquiring bonds, or by pledging additional property equal to 1 and 2/3 times the requirement. In 1994, $12 million of 4 5/8 percent First Mortgage Bonds due October 1, 1994 and $15 million of 6 percent First Mortgage Bonds due June 1, 1996 are scheduled to be redeemed. II-164 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 11. COMMON STOCK DIVIDEND RESTRICTIONS: The Company's first mortgage bond indenture contains various common stock dividend restrictions which remain in effect as long as the bonds are outstanding. At December 31, 1993, $101 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the mortgage indenture. The Company's charter limits cash dividends on common stock to 50 percent of net income available for such stock during a prior period if the capitalization ratio is below 20 percent and to 75 percent of such net income if such ratio is 20 percent or more but less than 25 percent. The capitalization ratio is defined as the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend. At December 31, 1993, the ratio was 44.4 percent. 12. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate changes, among other factors. II-165 SELECTED FINANCIAL AND OPERATING DATA Gulf Power Company 1993 Annual Report II-166 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-167 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-168 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-169 STATEMENTS OF INCOME Gulf Power Company II-170 STATEMENTS OF INCOME Gulf Power Company II-171 STATEMENTS OF CASH FLOWS Gulf Power Company II-172 STATEMENTS OF CASH FLOWS Gulf Power Company II-173 BALANCE SHEETS Gulf Power Company II-174 BALANCE SHEETS Gulf Power Company II-175 BALANCE SHEETS Gulf Power Company II-176 BALANCE SHEETS Gulf Power Company II-177 GULF POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK (1) Subject to mandatory redemption of 5% annually on or before February 1. II-178 GULF POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-179 MISSISSIPPI POWER COMPANY FINANCIAL SECTION II-180 MANAGEMENT'S REPORT Mississippi Power Company 1993 Annual Report The management of Mississippi Power Company has prepared--and is responsible for--the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist, however, in any system of internal control, based upon a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting control maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Mississippi Power Company in conformity with generally accepted accounting principles. /s/ David M. Ratcliffe -------------------------------------------------- David M. Ratcliffe President and Chief Executive Officer /s/ Thomas A. Fanning -------------------------------------------------- Thomas A. Fanning Vice President and Chief Financial Officer II-181 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF MISSISSIPPI POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Mississippi Power Company (a Mississippi corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-190 through II-206) referred to above present fairly, in all material respects, the financial position of Mississippi Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, Mississippi Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16 , 1994 II-182 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Mississippi Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Mississippi Power Company's net income after dividends on preferred stock for 1993 totaled $42.4 million, an increase of $5.6 million over the prior year. This improvement is attributable primarily to increased energy sales and retail rate increases. A retail rate increase under the Company's Performance Evaluation Plan (PEP-1A) of $6.4 million annually became effective in July 1993. Under the Environmental Compliance Overview Plan (ECO Plan) retail rates increased by $2.6 million annually effective April 1993. A comparison of 1992 to 1991 - excluding the events occurring in 1991 discussed below - would reflect a 1992 increase in earnings of $4.9 million or 15.5 percent. The Company's financial performance in 1991 reflected the after-tax operating and disposal losses of $11.9 million recorded by the Company's former merchandise subsidiary. These losses were partially offset by a $2.6 million positive impact on earnings from the settlement of the contract dispute with Gulf States Utilities Company (Gulf States). REVENUES The following table summarizes the factors impacting operating revenues for the past three years: *Includes the effect of the retail rate increase approved under the ECO Plan. Retail revenues of $368 million in 1993 increased 9.0 percent over the prior year, compared with an increase of 2.2 percent for 1992 and a decrease of 1.5 percent in 1991. The increase in retail revenues for 1993 was a result of growth in energy sales and customers, the favorable impact of weather, and retail rate increases. Changes in base rates reflect rate changes made under the PEP plans and the ECO Plan as approved by the Mississippi Public Service Commission (MPSC). The increase in revenues for the recovery of fuel costs for 1993 reversed two years of decline. Under the fuel cost recovery provision, recorded fuel revenues are equal to recorded fuel expenses, including the fuel component and the operation and maintenance component of purchased energy. Therefore, changes in recoverable fuel expenses are offset with corresponding changes in fuel revenues and have no effect on net income. II-183 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Included in sales for resale to non-affiliates are revenues from rural electric cooperative associations and municipalities located in southeastern Mississippi. Energy sales to these customers in 1993 increased 9.0 percent over the prior year with the related revenues rising 14.1 percent. The customer demand experienced by these utilities is determined by factors very similar to Mississippi Power's. Sales for resale to non-affiliated non-territorial utilities are primarily under long-term contracts consisting of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Capacity revenues for Mississippi Power increased in 1993 and 1992 due to a change in the allocation of transmission capacity revenues throughout the Southern electric system. Most of the Company's capacity revenues are derived from transmission charges. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. The increase in other operating revenues for 1993 was due to increased rents collected from microwave equipment use and the transmission of non-associated companies' electricity. Below is a breakdown of kilowatt-hour sales for 1993 and the percent change for the last three years: Total retail energy sales in 1993 increased compared to the previous year, due primarily to weather influences and the improvement in the economy. The increase in commercial energy sales also reflects the impact of recently established casinos within the Company's service area. Industrial sales increased in 1992 as a result of new contracts with two large industrial customers. The decrease in energy sales for resale to non-affiliates is predominantly due to reductions in unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale to non-affiliates. Sales for resale to non-affiliates are influenced by those utilities' own customer demand, plant availability, and the cost of their predominant fuels -- oil and natural gas. EXPENSES Total operating expenses for 1993 were higher than the previous year because of higher production expenses, which reflects increased demand, an increase in the federal income tax rate, and higher employee-related costs. (See Note 2 to the financial statements for information regarding employee and retiree benefits.) Additionally, included in other operation expenses are increased costs associated with environmental remediation of a Southern electric system research facility. Expenses in 1992 were lower than 1991, excluding the Gulf States settlement, primarily because of lower production expenses stemming from decreased demand. II-184 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Fuel costs constitute the single largest expense for Mississippi Power. These costs increased in 1993 due to an 11.0 percent increase in generation, which reflects higher demand. Fuel expenses in 1992, compared to 1991, were lower because of less generation and the negotiation of new coal contracts. Generation decreased primarily because of the availability of lower cost generation elsewhere within the Southern electric system. Purchased power consists primarily of energy purchases from the affiliates of the Southern electric system. Purchased power transactions (both sales and purchases) among Mississippi Power and its affiliates will vary from period to period depending on demand and the availability and variable production cost at each generating unit in the Southern electric system. Taxes other than income taxes increased in 1993 because of higher ad valorem taxes, which are property based, and municipal franchise taxes, which are revenue based. The decline in 1992 was attributable to lower franchise taxes. Income tax expense in 1993 increased because of the enactment of a higher corporate income tax rate retroactive to January 1, 1993, coupled with higher earnings. The change in income taxes for 1992 and 1991 reflected the change in operating income. EFFECTS OF INFLATION Mississippi Power is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical costs does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from regulatory matters to growth in energy sales. Expenses are subject to constant review and cost control programs. Among the efforts to control costs are utilizing employees more effectively through a functionalization program for the Southern electric system, redesigning compensation and benefit packages, and re- engineering work processes. Mississippi Power is also maximizing the utility of invested capital and minimizing the need for capital by refinancing, decreasing the average fuel stockpile, raising generating plant availability and efficiency, and curbing the construction budget. Operating revenues will be affected by any changes in rates under the PEP-2, the Company's revised performance based ratemaking plan. The PEP plans have proved to be a stabilizing force on electric rates, with only moderate changes in rates taking place. The ECO Plan, approved by the MPSC in 1992, provides for recovery of costs associated with environmental projects approved by the MPSC, most of which are required to comply with Clean Air Act Amendments of 1990 regulations. The ECO Plan is operated independently of PEP-2. The FERC regulates wholesale rate schedules and power sales contracts that Mississippi Power has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. Also, pending before the FERC is the Company's request for a $3.6 million wholesale rate increase. Further discussion of the PEP plans, the ECO Plan, and proceedings before the FERC is made in Note 3 to the financial statements herein. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in Mississippi Power's service area. However, the Energy II-185 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive of IPPs to build cogeneration plants for a utility's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. Mississippi Power is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. If Mississippi Power does not remain a low-cost producer and provider of quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, which could significantly reduce earnings. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, Mississippi Power adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. In January 1994, Mississippi Power adopted the new rules, with no material effect on the financial statements. On January 1, 1993, Mississippi Power changed its methods of accounting for postretirement benefits other than pensions and income taxes. See Notes 2 and 9 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal changes in Mississippi Power's financial condition during 1993 were gross property additions of $140 million to utility plant, a significant lowering of cost of capital through refinancings, and the resolution of PEP and ratepayer litigation. Funding for gross property additions came primarily from capital contributions from The Southern Company, earnings and other operating cash flows. The Statements of Cash Flows provide additional details. FINANCING ACTIVITY Mississippi Power continued to lower its financing costs in 1993 by issuing new debt and equity securities and retiring high- cost issues. The Company sold $132 million of first mortgage bonds, preferred stock and, through public authorities, pollution control revenue bonds. Retirements, including maturities during 1993, totaled some $101 million of such securities. (See the Statements of Cash Flows for further details.) Composite financing rates for the years 1991 through 1993 as of year-end were as follows: II-186 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report CAPITAL STRUCTURE At year-end 1993, the Company's ratio of common equity to total capitalization was 49.8 percent, compared to 47.3 percent in 1992 and 44.4 percent in 1991. The increase in the ratio in 1993 can be attributed primarily to the receipt of $30 million of capital contributions from The Southern Company. CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $256 million ($96 million in 1994, $62 million in 1995, and $98 million in 1996). The major emphasis within the construction program will be on complying with Clean Air Act regulations, completion of a 78-megawatt combustion turbine, and upgrading existing facilities. The estimates for property additions for the three-year period include $39 million committed to meeting the requirements of Clean Air Act regulations. Revisions may be necessary because of factors such as revised load projections, the availability and cost of capital, and changes in environmental regulations. OTHER CAPITAL REQUIREMENTS In addition to the funds required for the Company's construction program, approximately $51 million will be required by the end of 1996 for present sinking fund requirements and maturities of long-term debt. Mississippi Power plans to continue, when economically feasible, to retire high-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act Amendments of 1990 (Clean Air Act) were signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on Mississippi Power and the other operating companies of The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10 thousand megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing more slowly than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which Mississippi Power's portion is approximately $60 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance for The Southern Company could require total construction expenditures ranging from approximately $450 million to $800 million, II-187 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report of which Mississippi Power's portion is approximately $25 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover The Southern Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. Mississippi Power's ECO Plan is designed to allow recovery of costs of compliance with the Clean Air Act, as well as other environmental statutes and regulations. The MPSC reviews environmental projects and the Company's environmental policy through the ECO Plan. Under the ECO Plan, any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. Mississippi Power's management believes that the ECO Plan will provide for recovery of the Clean Air Act costs. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standard could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provisions of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the II-188 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $70 million of committed credit in revolving credit agreements and also had $21 million of committed short-term credit lines. The $40 million of notes payable outstanding at year end 1993 were apart from the committed credit facilities. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations will be derived from operations, the sale of additional first mortgage bonds, pollution control obligations, and preferred stock, and the receipt of additional capital contributions from The Southern Company. Mississippi Power is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest rate levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-189 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-190 STATEMENTS OF CASH FLOWS For the Years ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-191 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-192 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report II-193 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-194 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-195 NOTES TO FINANCIAL STATEMENTS Mississippi Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Mississippi Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Contracts among the companies--dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power--are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. Mississippi Power is also subject to regulation by the FERC and the Mississippi Public Service Commission (MPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. The 1991 financial statements of the Company included the accounts of Electric City Merchandise Company, Inc. (Electric City), which discontinued operations in 1991. All significant intercompany transactions were eliminated in consolidation. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES Mississippi Power accrues revenues for service rendered but unbilled at the end of each fiscal period. The Company's retail and wholesale rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power. Retail rates also include provisions to adjust billings for fluctuations in costs for ad valorem taxes. Revenues are adjusted for differences between the recoverable fuel and ad valorem expenses and the amounts actually recovered in current rates. DEPRECIATION Depreciation of the original cost of depreciable utility plant in service is provided by using composite straight-line rates which approximated 3.1 percent in 1993 and 3.3 percent in 1992 and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES Mississippi Power provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 to the financial statements for additional information about Statement No. 109. II-196 NOTES (continued) Mississippi Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used to capitalize the cost of funds devoted to construction were 6.8 percent in 1993, 8.2 percent in 1992, and 9.8 percent in 1991. AFUDC (net of income taxes), as a percent of net income after dividends on preferred stock, was 3.5 percent in 1993, 2.7 percent in 1992, and 4.8 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. This cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repair, and replacement of minor items of property is charged to maintenance expense except for the maintenance of coal cars and a portion of the railway track maintenance, which are charged to fuel stock. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair value of investment securities was based on listed closing market prices. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when used or installed. VACATION PAY Mississippi Power's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. Such amounts were $4.8 million and $4.7 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 80 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. II-197 NOTES (continued) Mississippi Power Company 1993 Annual Report PROVISION FOR PROPERTY DAMAGE Due to the significant increase in the cost of traditional insurance, effective in 1993, Mississippi Power became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provided for the cost of storm, fire and other uninsured casualty damage by charges to income of $1.5 million in 1993, 1992, and 1991. The cost of repairing damage resulting from such events that individually exceed $50 thousand is charged to the accumulated provision to the extent it is available. As of December 31, 1993, the accumulated provision amounted to $10.5 million. Regulatory treatment by the MPSC allows a maximum accumulated provision of $10.9 million. DISCONTINUED OPERATIONS Electric City began operating as a subsidiary of Mississippi Power in October 1987 and was formally dissolved as of December 31, 1991. Under an agreement reached in October 1991, a portion of Electric City's assets, including inventory and fixed assets, was sold to a concern independent of Mississippi Power. The remaining assets and liabilities, which were not material, were transferred to the Company. The impact of Electric City on Mississippi Power's consolidated earnings in 1991 consisted of (a) a pretax operating loss of $10.2 million ($6.4 million after income taxes) and (b) the pretax loss of $8.7 million ($5.5 million after income taxes) resulting from the disposal of Electric City. 2. RETIREMENT BENEFITS: PENSION PLAN Mississippi Power has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS Mississippi Power also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, Mississippi Power recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the Company in 1992 and 1991 were $3.6 million and $3.0 million, respectively. II-198 NOTES (continued) Mississippi Power Company 1993 Annual Report STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $6.4 million and the aggregate of the service and interest cost components of the net retiree medical cost by $722 thousand. Components of the plans' net cost are shown below: II-199 NOTES (continued) Mississippi Power Company 1993 Annual Report Of the above net pension amounts recorded, ($170 thousand) in 1993, $269 thousand in 1992, and $576 thousand in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $3.9 million was charged to operating expense and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS: RETAIL RATE ADJUSTMENT PLANS Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986. During 1993, all matters related to the original PEP case were finally resolved when the Supreme Court of Mississippi granted a joint motion to dismiss pending appeals. Also in 1993, the MPSC ordered Mississippi Power to review and propose changes to the plan that would reduce the impact of rate changes on the customer and provide incentives for Mississippi Power to keep customer prices low. In response, Mississippi Power filed a revised plan and, on January 4, 1994, the MPSC approved PEP-2. The revised plan includes a mechanism for sharing rate adjustments based on the Company's ability to maintain low rates for customers and on the Company's performance as measured by three performance indicators that emphasize those factors which most directly impact the customers. PEP-2 provides for semiannual evaluations of Mississippi's performance-based return on investment, rather than on common equity as previously calculated. As in previous plans, any change in rates is limited to 2 percent of retail revenues per evaluation period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. ENVIRONMENTAL COMPLIANCE OVERVIEW PLAN The MPSC approved Mississippi Power's ECO Plan in 1992. The plan establishes procedures to facilitate the MPSC's overview of the Company's environmental strategy and provides for recovery of costs associated with environmental projects approved by the MPSC. Under the ECO Plan any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. The ECO Plan resulted in an annual retail rate increase of $2.6 million effective April 1993. FERC REVIEWS EQUITY RETURNS AND OTHER REGULATORY MATTERS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts, including the Company's Transmission Facilities Agreement (TFA) discussed in Note 8 under "Lease Agreements." Any changes in rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, an administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on Mississippi Power's financial statements. In 1988, the Company and its operating affiliates filed with the FERC a contract governing the pricing and other aspects of power transactions among the companies. In 1989, the FERC ordered hearings on the contract and made revenues collected under the contract subject to refund. In 1992, the II-200 NOTES (continued) Mississippi Power Company 1993 Annual Report FERC ruled that certain production costs under the contract had not been properly classified and ordered that the contract be revised and that refunds be made. Under reconsideration, the FERC determined that refunds were not necessary and ordered that its mandated changes in computing certain expenses under the system interchange contract become effective in August 1993. The changes mandated by the FERC will not materially affect the Company's net income. WHOLESALE RATE FILING On September 1, 1993, Mississippi Power filed a $3.6 million wholesale rate increase request with the FERC. Prior to this filing, the Company conferred and negotiated a settlement with all of its wholesale all requirements customers, who have executed a Settlement Agreement and Certificates of Concurrence to be included in this filing with the FERC. The Company is awaiting a response from the FERC. RETAIL RATEPAYERS' SUITS CONCLUDED In 1989, three retail ratepayers of the Company filed a civil complaint in the U.S. District Court for the Southern District of Mississippi against Mississippi Power and other parties. The complaint alleged that Mississippi Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated to be at least $10 million, plus treble and punitive damages, on behalf of all retail ratepayers of the Company for alleged violations of the federal Racketeer Influenced and Corrupt Organizations Act, federal and state antitrust laws, other federal and state statutes, and common law fraud. Mississippi Power also was named as a defendant, together with other parties in a similar civil action filed in the U.S. District Court for the Northern District of Florida. The defendants' motions for dismissal were granted by the courts, resolving these suits. 4. CONSTRUCTION PROGRAM: Mississippi Power is engaged in continuous construction programs, the costs of which are currently estimated to total some $96 million in 1994, $62 million in 1995, and $98 million in 1996. These estimates include AFUDC of $1.6 million in 1994, $1.6 million in 1995, and $2.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the construction of a combustion turbine generation unit of 78 megawatts was completed in February 1994. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act and other environmental matters. 5. FINANCING AND COMMITMENTS: FINANCING Mississippi Power's construction program is expected to be financed from internal and other sources, such as the issuance of additional long-term debt and preferred stock and the receipt of capital contributions from The Southern Company. The amounts of first mortgage bonds and preferred stock which can be issued in the future will be contingent upon market conditions, adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis under "Sources of Capital" for information regarding the Company's coverage requirements. At December 31, 1993, Mississippi Power had committed credit agreements (360 day committed lines) with banks for $21 million. Additionally, Mississippi Power had $70 million of unused committed credit agreements in the form of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. As of December 31, 1993, Mississippi Power had $40 million in short-term bank borrowings all of which were made apart from committed credit arrangements. II-201 NOTES (continued) Mississippi Power Company 1993 Annual Report ASSETS SUBJECT TO LIEN Mississippi Power's mortgage indenture dated as of September 1, 1941, as amended and supplemented, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, Mississippi Power has entered into various long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum production levels, and other financial commitments. Total estimated obligations were approximately $243 million at December 31, 1993. Additional commitments for fuel will be required in the future to supply the Company's fuel needs. In order to take advantage of lower cost coal supplies, agreements were reached in December 1986 to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Mississippi Power and Gulf Power, an operating affiliate. The Company's portion of this payment was about $60 million. In accordance with the ratemaking treatment, the cost to terminate the contracts is being amortized through 1995 to match costs with savings achieved. The remaining unamortized amount of Mississippi Power's share of principal payments to the suppliers including the current portion totaled $18 million at December 31, 1993. 6. JOINT OWNERSHIP AGREEMENTS: Mississippi Power and Alabama Power own as tenants in common Greene County Electric Generating Plant (coal) located in Alabama; and Mississippi Power and Gulf Power own as tenants in common Daniel Electric Generating Plant (coal) located in Mississippi. At December 31, 1993, Mississippi Power's percentage ownership and investment in these jointly owned facilities were as follows: Mississippi Power's share of plant operating expenses is included in the corresponding operating expenses in the Statements of Income. 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL Mississippi Power and the other operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Some of these agreements (unit power sales) are firm commitments and pertain to capacity related to specific generating units. Mississippi Power's participation in firm production capacity unit power sales ended in January 1989. However, the Company continues to participate in transmission and energy sales under the unit power sales agreements. The other agreements (other long-term sales) are non-firm commitments and are based on capacity of the system in general. Because the energy is generally sold at variable costs under these agreements, only revenues from capacity sales affect profitability. Off-system capacity revenues for the Company have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 by the Southern electric system to Florida Power Corporation. In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-202 NOTES (continued) Mississippi Power Company 1993 Annual Report GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts previously included in income -- Mississippi Power recorded an increase in net income of approximately $2.6 million in 1991. 8. LEASE AGREEMENTS: In 1984, Mississippi Power and Gulf States entered into a forty-year transmission facilities agreement whereby Gulf States began paying a use fee to the Company covering all expenses relative to ownership and operation and maintenance of a 500 kV line, including amortization of its original $57 million cost. In 1993, 1992, and 1991 the use fees collected under the agreement, net of related expenses, amounted to $3.9 million, $3.9 million and $4.0 million, respectively, and are included with other income, net, in the Statements of Income. For other information see Note 3 under "FERC Reviews Equity Returns and Other Regulatory Matters." In 1989, Mississippi Power entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Gulf Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million for 1992 and $1.3 million for 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and in 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option after three years to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, Mississippi Power has the option to renew the lease. 9. INCOME TAXES: Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $48 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-203 NOTES (continued) Mississippi Power Company 1993 Annual Report Details of the federal and state income tax provisions are shown below: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: In 1989, under order of the MPSC, Mississippi Power began amortizing deferred income taxes not covered by the Internal Revenue Service normalization requirements, that had been recorded at rates higher than those specified by the current statutory income tax rules. This amortization occurred over a 60-month period, the effect of which was a reduction of income tax expense of approximately $2.7 million per year. At December 31, 1993, this tax rate differential was fully amortized. Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $1.5 million in 1993, $1.4 million in 1992 and $1.5 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. II-204 NOTES (continued) Mississippi Power Company 1993 Annual Report The total provision for income taxes as a percentage of pre-tax income and the differences between those effective rates and the statutory federal tax rates were as follows: Mississippi Power and its affiliates file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. OTHER LONG-TERM DEBT: Details of other long-term debt are as follows: Pollution control obligations represent installment or lease purchases of pollution control facilities financed by application of funds derived from sales by public authorities of tax-exempt revenue bonds. Mississippi Power has authenticated and delivered to the Trustee a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under these agreements. The 5.8% Series of pollution control obligations has a cash sinking fund requirement of $10 thousand annually through 1997 and $20 thousand in 1998. At December 31, 1993, under "Other Property and Investments" approximately $6 million related to the 6.20% Series of Pollution Control Obligations remains available for completion of certain solid waste disposal facilities. The 8.25 percent notes payable relate to the termination of two coal contracts. See Note 5 under "Fuel Commitments" for information on these coal contracts. The annual estimated maturities of total notes payable are $8.8 million in 1994 and $10.8 million in 1995. II-205 NOTES (continued) Mississippi Power Company 1993 Annual Report 11. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement fund requirement is one percent of each outstanding series authenticated under the indenture of Mississippi Power prior to January 1 of each year, other than first mortgage bonds issued as collateral security for certain pollution control obligations. The requirement must be satisfied by June 1 of each year by depositing cash or reacquiring bonds, or by pledging additional property equal to 166-2/3 percent of such requirement. 12. COMMON STOCK DIVIDEND RESTRICTIONS: Mississippi Power's first mortgage bond indenture and the Articles of Incorporation contain various common stock dividend restrictions. At December 31, 1993, $86 million of retained earnings was restricted against the payment of cash dividends on common stock under the most restrictive terms of the mortgage indenture or Articles of Incorporation. 13. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: Mississippi Power's business is influenced by seasonal weather conditions and the timing of rate changes. II-206 SELECTED FINANCIAL AND OPERATING DATA Mississippi Power Company 1993 Annual Report II-207 II-208 II-209 II-210 STATEMENTS OF INCOME Mississippi Power Company II-211 STATEMENTS OF INCOME Mississippi Power Company II-212 STATEMENTS OF CASH FLOWS Mississippi Power Company II-213 STATEMENTS OF CASH FLOWS Mississippi Power Company II-214 BALANCE SHEETS Mississippi Power Company II-215 BALANCE SHEETS Mississippi Power Company II-216 BALANCE SHEETS Mississippi Power Company II-217 BALANCE SHEETS Mississippi Power Company II-218 MISSISSIPPI POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-219 MISSISSIPPI POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-220 SAVANNAH ELECTRIC AND POWER COMPANY FINANCIAL SECTION II-221 MANAGEMENT'S REPORT Savannah Electric and Power Company 1993 Annual Report The management of Savannah Electric and Power Company has prepared -- and is responsible for -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Savannah Electric and Power Company in conformity with generally accepted accounting principles. /s/ Arthur M. Gignilliat, Jr. /s/ K. R. Willis - -------------------------------- ------------------------------------- Arthur M. Gignilliat, Jr. K. R. Willis President Vice-President and Chief Executive Officer Treasurer and Chief Financial Officer II-222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF SAVANNAH ELECTRIC AND POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Savannah Electric and Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-231 through II-244) referred to above present fairly, in all material respects, the financial position of Savannah Electric and Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia, February 16, 1994 II-223 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Savannah Electric and Power Company 1993 Annual Report RESULTS OF OPERATIONS Earnings Savannah Electric and Power Company's net income after dividends on preferred stock for 1993 totaled $21.5 million, representing a $1.0 million (4.6 percent) increase from the prior year. The revenue impact of an increase in retail energy sales due to exceptionally hot summer weather was partially offset by the implementation of a work force reduction program which resulted in a one-time charge to operating expenses of approximately $4.5 million. In 1992, earnings were $20.5 million, representing a $3.5 million (14.6 percent) decrease from the prior year. This decrease resulted primarily from increases in maintenance and administrative and general expenses, partially offset by a 4.6 percent increase in retail operating revenues. Operating revenues increased despite the negative impact of a $2.8 million annual reduction in retail base rates effective in June 1992, and mild weather. REVENUES Total revenues for 1993 were $218.4 million, reflecting a 10.5 percent increase over 1992, primarily due to an increase in retail energy sales. The following table summarizes the factors impacting operating revenues compared to the prior year for the 1991-1993 period: Total retail revenues increased 11.5 percent in 1993, compared to a 4.6 percent increase in 1992. The increase in 1993 retail revenues attributable to growth in both retail customers and average use per customer was enhanced by exceptionally hot weather during the summer. The substantial increase in fuel cost recovery and other revenues reflects increases in net generation and the unit cost of purchased power. The increase in 1992 retail revenues resulted from growth in both retail customers and average use per customer, but was substantially offset by mild weather and the June 1992 base rate reduction. II-224 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Under the Company's fuel cost recovery provisions, fuel revenues equal fuel expense, including the fuel and capacity components of purchased energy, and have no effect on earnings. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Sales to affiliated companies within the Southern electric system vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have little impact on earnings. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The increases in energy sales in 1993 and 1992 continue to reflect a growing customer base, an increase in average energy sales per customer, and improved economic conditions in the Company's service area. Sales were enhanced in 1993 by temperature extremes in the summer months and in December. EXPENSES Total operating expenses for 1993 increased $20.3 million (12.4 percent) over the prior year. This increase includes a $10.8 million increase in fuel expense, and an $8.7 million increase in other operation expenses. Fuel expenses increased primarily because of higher generation due to extremely hot weather and higher cost fuel sources. In 1992 an increase in purchased power reflected a 15.4 percent decrease in generation compared to 1991. Despite the decrease in generation, total 1992 fuel expenses were substantially unchanged from the prior year reflecting generation from higher cost fuel sources. The increase in other operation expenses reflects a $4.5 million cost associated with a one-time charge related to a work force reduction program. The Company also recognized higher employee benefits costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information on these new rules. In 1992, the increase in other operation expenses was primarily a result of increases in outside services and administrative and general expenses, which reflected higher employee training and benefits expenses. Total interest expense on long-term debt was reduced by 5.4 percent in 1992, as the Company refinanced higher-cost debt. II-225 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The mix of energy supply is determined primarily by system load, the unit cost of fuel consumed and the availability of units. The amount and sources of energy supply and the average cost of fuel per net kilowatt-hour generated and purchased power were as follows: EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will depend upon growth in energy sales, which is subject to a number of factors. Traditionally, these factors included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network to sell electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. The Company is preparing now to meet the challenge of these major changes in the traditional business practices of selling electricity. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been initiated by the Company and are a significant part of integrated resource planning. Customers can receive cash incentives for participating in these programs in addition to reducing their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the Company. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects, in conjunction with the precertification approval process for such projects by the Georgia Public Service Commission (GPSC), will II-226 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report diminish the possible exposure to prudency disallowances and the resulting impact on earnings. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." Rates to retail customers served by the Company are regulated by the GPSC. In May 1992, the Company requested, and subsequently received, approval by the GPSC to reduce annual base revenues by $2.8 million, effective June 1992. The reduction includes a base rate reduction of approximately $2.5 million spread among all classes of retail customers. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers. As part of this rate settlement, it was informally agreed that the Company's earned rate of return on common equity should be 12.95 percent. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be implemented by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115, supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules January 1, 1994, with no material effect on the financial statements. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 7 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal change in the Company's financial condition in 1993 was additions of $73 million to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. See Statements of Cash Flows for additional information. CAPITAL STRUCTURE As of December 31, 1993, the Company's capital structure consisted of 45.3 percent common equity, 10.3 percent preferred stock and 44.4 percent long-term debt, excluding amounts due within one year. The Company's long-term financial objective for capitalization ratios is to maintain a capital structure of common equity at 45 percent, preferred stock at 10 percent and debt at 45 percent. Maturities and retirements of long-term debt were $4 million in 1993, $53 million in 1992 and $23 million in 1991. In November 1993, the Company issued 1,400,000 shares of 6.64 percent series preferred stock. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent series preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. The composite interest rates for the years 1991 through 1993 as of year-end were as follows: II-227 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The Company's current securities ratings are as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $98 million ($33 million in 1994, $32 million in 1995, and $33 million in 1996). Actual construction costs may vary from this estimate because of such factors as changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment and materials; and the cost of capital. The largest project during this period is the addition of two 80 megawatt combustion turbine units, to be placed into service in 1994. The estimated cost of this project is $61 million. The Company is also constructing six combustion turbine units for Georgia Power Company. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $5.9 million will be needed by the end of 1996 for present sinking fund requirements and maturities. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the new law -- will have a significant impact on the Company and other subsidiaries of the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this would require some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the Company's portion is approximately $2 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I and increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 through 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million of which the Company's portion is expected to be approximately $25 million. However, the full impact of II-228 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 5 percent in annual revenue requirements from customers could be necessary to fully recover the Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any - -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matters, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes--coal ash and other utility wastes--as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Savannah Electric and Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and will recognize in the financial statements any costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act, the Comprehensive Environmental Response, Compensation, and Liability Act, and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $3.9 million of cash and $14.5 million of unused credit arrangements with banks to meet its short-term cash needs. The Company had $3 million of short-term bank borrowings at December 31, 1993. In January 1994, the Company renegotiated a two-year revolving credit arrangement with four of its II-229 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report existing banks for a total credit line of $20 million. The primary purpose of this additional credit is to provide interim funding for the Company's combustion turbine construction program. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations and the sale of additional first mortgage bonds and preferred stock and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-230 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-231 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-232 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-233 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-234 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-235 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-236 NOTES TO FINANCIAL STATEMENTS Savannah Electric and Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Savannah Electric and Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company also is subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the GPSC. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The Company's electric rates include provisions to adjust billings for fluctuations in capacity and the energy components of purchased power costs. Revenues include the actual cost of fuel and purchased power incurred. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 2.9 percent in 1993 and 3.2 percent in 1992, and 1991. The decrease in 1993 reflects the Company's implementation of new depreciation rates approved by the GPSC. These new rates provide for a timely recovery of the investments in the Company's depreciable properties. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company, which is included in the consolidated federal income tax return filed by The Southern Company, provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 7 for additional information about Statement No. 109. II-237 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the Company to calculate AFUDC were 8.77 percent in 1993, 11.27 percent in 1992, and 11.38 percent in 1991. UTILITY PLANT Utility plant is stated at original cost, which includes materials, labor, minor items of property, appropriate administrative and general costs, payroll-related costs such as taxes, pensions and other benefits and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, items for which the carrying amount does not approximate fair value must be disclosed. At December 31, 1993, the fair value of long-term debt was $164 million and the carrying amount was $154 million. The fair value of long-term debt was $117 million and the carrying amount was $109 million at December 31, 1992. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. 2. RETIREMENT BENEFITS PENSION PLANS The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits under this plan reflect the employee's years of service, age at retirement and average compensation for the three years immediately preceding retirement. The Company uses the projected unit credit actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and debt securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-238 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Consistent with regulatory treatment, the Company recognized these costs on a cash basis as payments were made in 1992 and 1991. The total costs of such benefits recognized by the Company amounted to $375 thousand in 1992 and $487 thousand in 1991. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statements Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown for 1993 only because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: In accordance with Statement No. 87, an additional liability related to under-funded accumulated benefit obligations was recognized at December 31, 1993. A corresponding net-of-tax charge of $2.1 million was recognized as a separate component of Common Stock Equity in the Statements of Capitalization. The assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $1.7 million and the aggregate of the service and interest cost components of the net retiree medical cost by $0.2 million. II-239 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Components of the plans' net costs are shown below: Of the above net pension amounts, $2.0 million in 1993, $1.7 million in 1992 and $1.5 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Net postretirement medical and life insurance costs of $1.8 million in 1993 were charged to operating expenses. The Company has a supplemental retirement plan for certain executive employees. The plan is unfunded and payable from the general funds of the Company. The Company has purchased life insurance on participating executives, and plans to use these policies to satisfy this obligation. Benefit costs associated with this plan for 1993, 1992 and 1991 were $980 thousand, $316 thousand and $338 thousand, respectively. The 1993 benefit costs reflect a one-time expense related to employees who were part of the work force reduction program. WORK FORCE REDUCTION PROGRAM The Company has incurred additional costs for a one-time charge related to the implementation of a work force reduction program. In 1993, $4.5 million was charged to operating expenses and $0.6 million was charged to other income (expense). 3. REGULATORY MATTERS RATE MATTERS In May 1992, the Company filed for, and subsequently received, GPSC approval to implement new base rates designed to decrease base operating revenues by $2.8 million annually. The reduction included a base rate reduction of approximately $2.5 million spread among all classes of customers, effective June 1992. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers in August 1992. 4. CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program, currently estimated to total $33 million in 1994, $32 million in 1995 and $33 million in 1996. The estimates include AFUDC of $1.6 million in 1994, $0.6 million in 1995 and $0.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include: changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing cost of labor, equipment and materials; and cost of capital. The construction of two combustion turbine peaking units totaling 160 megawatts is planned to be completed in mid 1994. The Company is also constructing six combustion turbine peaking units owned by Georgia Power Company. The construction is to be completed in 1996. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. II-240 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 5. FINANCING AND COMMITMENTS GENERAL To the extent possible, the Company's construction program is expected to be financed from internal sources and from the issuance of additional long-term debt and preferred stock and capital contributions from The Southern Company. Should the Company be unable to obtain funds from these sources, the Company would have to use short-term indebtedness or other alternative, and possibly costlier, means of financing. The amounts of long-term debt and preferred stock that can be issued in the future will be contingent on market conditions, the maintenance of adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis for information regarding the Company's earnings coverage requirements. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with four banks totaled $14.5 million, and expire at various times during 1994. The Company has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitments fees based on the unused portions of the commitments. In connection with all other lines of credit, the Company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the Company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. ASSETS SUBJECT TO LIEN As amended and supplemented, the Company's Indenture of Mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. OPERATING LEASES The Company has rental agreements with various terms and expiration dates. Rental expenses totaled $1.5 million, $1.5 million, and $1.4 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated future minimum lease payments for non-cancelable operating leases were as follows: 6. LONG-TERM POWER SALES AGREEMENTS The operating subsidiaries of The Southern Company, including the Company, have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to the capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The Company's portion of capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-241 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $26 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $0.7 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the effective income tax rate to the statutory tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-242 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 8. CUMULATIVE PREFERRED STOCK In November 1993, the Company issued 1,400,000 shares of 6.64 percent Series Preferred stock which has redemption provisions of $26.66 per share plus accrued dividends if on or prior to November 1, 1998, and at $25 per share plus accrued dividends thereafter. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent Series Preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. Cumulative preferred stock dividends are preferential to the payment of dividends on common stock. 9. LONG-TERM DEBT The Company's Indenture related to its First Mortgage Bonds is unlimited as to the authorized amount of bonds which may be issued, provided that required property additions, earnings and other provisions of such Indenture are met. On February 19, 1993, the Company refunded its $4.1 million, 6.25 percent Series Pollution Control Bonds, due 1998 with $4.1 million of variable rate Series Pollution Control Bonds due 2016. In 1994, there is a first mortgage bond maturity of $3.7 million. The sinking fund requirements of first mortgage bonds are being satisfied by certification of property additions. See Note 10 "Long-Term Debt Due Within One Year" for details. Details of other long-term debt are as follows: Sinking fund requirements and /or maturities through 1998 applicable to long-term debt are as follows: $4.5 million in 1994; $0.7 million in 1995; $0.7 million in 1996; $0.1 million in 1997 and no requirement is needed for 1998. Assets acquired under capital leases are recorded as utility plant in service and the related obligation is classified as other long-term debt. Leases are capitalized at the net present value of the future lease payments. However, for ratemaking purposes, these obligations are treated as operating leases, and as such, lease payments are charged to expense as incurred. The Company leases combustion turbine generating equipment under a non-cancelable lease expiring in 1995, with renewal options extending until 2010. The Company also leases a portion of its transportation fleet. Under the terms of these leases, the Company is responsible for taxes, insurance and other expenses. II-243 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund/sinking fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 1 2/3 times the requirements. 11. COMMON STOCK DIVIDEND RESTRICTIONS The Company's Charter and Indentures contain certain limitations on the payment of cash dividends on the preferred and common stocks. At December 31, 1993, approximately $55 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the Mortgage Indenture. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows (in thousands): The Company's business is influenced by seasonal weather conditions, a seasonal rate structure and the timing of rate changes, among other factors. II-244 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report Note: NR = Not Rated II-245 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report II-246 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-247 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-248 STATEMENTS OF INCOME Savannah Electric and Power Company * Tax-free common stock/bond exchange II-249 STATEMENTS OF INCOME Savannah Electric and Power Company II-250 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-251 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-252 BALANCE SHEETS Savannah Electric and Power Company II-253 BALANCE SHEETS Savannah Electric and Power Company II-254 BALANCE SHEETS Savannah Electric and Power Company II-255 BALANCE SHEETS Savannah Electric and Power Company II-256 SAVANNAH ELECTRIC AND POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-257 SAVANNAH ELECTRIC AND POWER COMPANY SECURITIES RETIRED DURING 1993 POLLUTION CONTROL BONDS II-258 PART III Items 10, 11, 12 and 13 for SOUTHERN are incorporated by reference to ELECTION OF DIRECTORS in SOUTHERN's definitive Proxy Statement relating to the 1994 annual meeting of stockholders. Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS ALABAMA (a) (1) Identification of directors of ALABAMA. ELMER B. HARRIS (1) President and Chief Executive Officer of ALABAMA Age 54 Served as Director since 3-1-89. BILL M. GUTHRIE Executive Vice President of ALABAMA Age 60 Served as Director since 12-16-88 EDWARD L. ADDISON (2) Age 63 Served as Director since 11-1-83 WHIT ARMSTRONG (2) Age 46 Served as Director since 9-24-82 PHILIP E. AUSTIN (2) Age 52 Served as Director since 1-25-91 MARGARET A. CARPENTER (2) Age 69 Served as Director since 2-26-93 PETER V. GREGERSON, SR. (2) Age 65 Served as Director since 10-22-93 CRAWFORD T. JOHNSON, III (2) Age 68 Served as Director since 4-18-69 CARL E. JONES, JR. (2) Age 53 Served as Director since 4-22-88 WALLACE D. MALONE, JR. (2) Age 57 Served as Director since 6-22-90 WILLIAM V. MUSE (2) Age 54 Served as Director since 2-26-93 JOHN T. PORTER (2) Age 62 Served as Director since 10-22-93 GERALD H. POWELL (2) Age 67 Served as Director since 2-28-86 ROBERT D. POWERS (2) Age 43 Served as Director since 1-24-92 JOHN W. ROUSE (2) Age 56 Served as Director since 4-22-88 WILLIAM J. RUSHTON, III (2) Age 64 Served as Director Since 9-18-70 JAMES H. SANFORD (2) Age 49 Served as Director since 8-1-83 JOHN C. WEBB, IV (2) Age 51 Served as Director since 4-22-77 LOUIS J. WILLIE (2) Age 70 Served as Director since 3-23-84 JOHN W. WOODS (2) Age 62 Served as Director since 4-20-73 (1) Previously served as Director of ALABAMA from 1980 to 1985. (2) No position other than Director. Each of the above is currently a director of ALABAMA, serving a term running from the last annual meeting of ALABAMA's stockholder (April 23, 1993) for III-1 meeting of ALABAMA's stockholder (April 23, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for the individuals elected in October 1993. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of ALABAMA acting solely in their capacities as such. (b)(1) Identification of executive officers of ALABAMA. ELMER B. HARRIS (1) President, Chief Executive Officer and Director Age 54 Served as Executive Officer since 3-1-89 BANKS H. FARRIS Senior Vice President Age 59 Served as Executive Officer since 12-3-91 WILLIAM B. HUTCHINS, III Senior Vice President and Chief Financial Officer Age 50 Served as Executive Officer since 12-3-91 T. HAROLD JONES Senior Vice President Age 63 Served as Executive Officer since 12-1-91 CHARLES D. MCCRARY Senior Vice President Age 42 Served as Executive Officer since 1-1-91 (1) Previously served as executive officer of ALABAMA from 1979 to 1985. Each of the above is currently an executive officer of ALABAMA, serving a term running from the last annual meeting of the directors (April 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of ALABAMA acting solely in their capacities as such. (c)(1) Identification of certain significant employees. None. (d)(1) Family relationships. None. (e)(1) Business experience. ELMER B. HARRIS - Elected in 1989; Chief Executive Officer. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. Director of SOUTHERN and AmSouth Bancorporation. BILL M. GUTHRIE - Elected in 1988; also served since 1991 as Chief Production Officer of SOUTHERN system and Executive Vice President and Chief Production Officer of SCS; Vice President of SOUTHERN, GULF, MISSISSIPPI and SAVANNAH and Executive Vice President of GEORGIA. Responsible primarily for providing overall management of materials management, fuel services, operating and planning services, fossil, hydro and bulk power operations of the Southern electric system. EDWARD L. ADDISON - Elected in 1983; President of SOUTHERN from 1983 until elected Chairman of the Board in 1994. Director of SOUTHERN, GEORGIA, Phelps Dodge Corporation, Protective Life Corporation, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia and CSX Corporation. WHIT ARMSTRONG - President, Chairman and Chief Executive Officer of The Citizens Bank, Enterprise, Alabama. Also, President and Chairman of the Board of Enterprise Capital Corporation, Inc. PHILIP E. AUSTIN - Chancellor, The University of Alabama System. Previously President and Chancellor of Colorado State University. MARGARET A. CARPENTER - President, Compos-it, Inc. (typographics), Montgomery, Alabama. PETER V. GREGERSON, SR. - Chairman Emeritus of Gregerson's Foods, Inc. (retail groceries), Gadsden, Alabama. Director of AmSouth Bank of Gadsden, Alabama. III-2 CRAWFORD T. JOHNSON, III - Chairman of Coca-Cola Bottling Company United, Inc., Birmingham, Alabama. Director of Protective Life Corporation, AmSouth Bancorporation and Russell Corporation. CARL E. JONES, JR. - Chairman and Chief Executive Officer of First Alabama Bank, Mobile, Alabama. WALLACE D. MALONE, JR. - Chairman and Chief Executive Officer of SouthTrust Corporation, bank holding company, Birmingham, Alabama. WILLIAM V. MUSE - President and Chief Executive Officer of Auburn University. He previously served as President of the University of Akron from 1984 to 1992. JOHN T. PORTER - Pastor of Sixth Avenue Baptist Church, Birmingham, Alabama. Director of Citizen Federal Bank. GERALD H. POWELL - President, Dixie Clay Company of Alabama, Inc. (refractory clay producer), Jacksonville, Alabama. ROBERT D. POWERS - President, The Eufaula Agency, Inc. (real estate and insurance), Eufaula, Alabama. JOHN W. ROUSE - President and Chief Executive Officer of Southern Research Institute (non-profit research institute), Birmingham, Alabama. Director of Protective Life Corporation. WILLIAM J. RUSHTON, III - Chairman of the Board, Protective Life Corporation (insurance holding company), Birmingham, Alabama. Director of SOUTHERN and AmSouth Bancorporation. JAMES H. SANFORD - President, HOME Place Farms Inc. (diversified farmers and ginners), Prattville, Alabama. JOHN C. WEBB, IV - President, Webb Lumber Company, Inc. (wholesale lumber), Demopolis, Alabama. LOUIS J. WILLIE - Chairman of the Board and President of Booker T. Washington Insurance Co. Director of SOUTHERN. JOHN W. WOODS - Chairman and Chief Executive Officer, AmSouth Bancorporation (multi-bank holding company), Birmingham, Alabama. Director of Protective Life Corporation. BANKS H. FARRIS - Elected in 1991; responsible primarily for providing the overall management of the Human Resources, Information Resources, Power Delivery and Marketing Departments and the six geographic divisions. He previously served as Vice President - Human Resources from 1989 to 1991 and Division Vice President from 1985 to 1989. WILLIAM B. HUTCHINS, III - Elected in 1991; Chief Financial Officer, responsible primarily for providing the overall management of accounting and financial planning activities. He previously served as Vice President and Treasurer from 1983 to 1991. T. HAROLD JONES - Elected in 1991; responsible primarily for providing the overall management of the Fossil Generation, Hydro Generation, Power Generation Services and Fuels Departments. He previously served as Vice President - Fossil Generation from 1986 to 1991. CHARLES D. MCCRARY - Elected in 1991; responsible for the External Relations Department, Operating Services and Corporate Services. Also, assumes responsibility for financial matters while Mr. Hutchins is on medical leave. He previously served as Vice President of Administrative Services - Nuclear of SCS from 1988 to 1991. (f)(1) Involvement in certain legal proceedings. None. III-3 GEORGIA (a)(2) Identification of directors of GEORGIA. H. ALLEN FRANKLIN President and Chief Executive Officer. Age 49 Served as Director since 1-1-94. WARREN Y. JOBE Executive Vice President, Treasurer and Chief Financial Officer. Age 53 Served as Director since 8-1-82 EDWARD L. ADDISON (1) Age 63 Served as Director since 11-1-83 BENNETT A. BROWN (1) Age 64 Served as Director since 5-15-80 WILLIAM P. COPENHAVER (1) Age 69 Served as Director since 6-18-86 A. W. DAHLBERG (1) Age 53 Served as Director since 6-1-88 WILLIAM A. FICKLING, JR. (1) Age 61 Served as Director since 4-18-73 L. G. HARDMAN, III (1) Age 54 Served as Director since 6-25-79 JAMES R. LIENTZ, JR. (1) Age 50 Served as Director since 7-1-93 WILLIAM A. PARKER, JR. (1) Age 66 Served as Director since 5-19-65 G. JOSEPH PRENDERGAST (1) Age 48 Served as Director since 1-20-93 HERMAN J. RUSSELL (1) AGE 63 Served as Director since 5-18-88 GLORIA M. SHATTO (1) Age 62 Served as Director since 2-20-80 ROBERT STRICKLAND (1) Age 66 Served as Director since 11-21-79 WILLIAM JERRY VEREEN (1) Age 53 Served as Director since 5-18-88 THOMAS R. WILLIAMS (1) Age 65 Served as Director since 3-17-82 (1) No position other than Director. Each of the above is currently a director of GEORGIA, serving a term running from the last annual meeting of GEORGIA's stockholder (May 19, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except Messrs. Franklin and Lientz. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GEORGIA acting solely in their capacities as such. (b)(2) Identification of executive officers of GEORGIA. H. ALLEN FRANKLIN President, Chief Executive Officer and Director Age 49 Served as Executive Officer since 1-1-94 WARREN Y. JOBE Executive Vice President, Treasurer, Chief Financial Officer and Director Age 53 Served as Executive Officer since 5-19-82 III-4 DWIGHT H. EVANS Executive Vice President - External Affairs Age 45 Served as Executive Officer since 4-19-89 GENE R. HODGES Executive Vice President - Customer Operations Age 55 Served as Executive Officer since 11-19-86 KERRY E. ADAMS Senior Vice President - Fossil and Hydro Power Age 49 Served as Executive Officer since 5-1-89 WAYNE T. DAHLKE Senior Vice President - Power Delivery Age 53 Served as Executive Officer since 4-19-89 JAMES K. DAVIS Senior Vice President - Corporate Relations Age 53 Served as Executive Officer since 10-1-93 ROBERT H. HAUBEIN Senior Vice President - Administrative Services Age 54 Served as Executive Officer since 2-19-92 GALE E. KLAPPA Senior Vice President - Marketing Age 43 Served as Executive Officer since 2-19-92 FRED D. WILLIAMS Senior Vice President - Bulk Power Markets Age 49 Served as Executive Officer since 11-18-92 Each of the above is currently an executive officer of GEORGIA, serving a term running from the last annual meeting of the directors (May 19,1993) for one year until the next annual meeting or until his successor is elected and qualified, except Messrs. Franklin and Davis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GEORGIA acting solely in their capacities as such. (c)(2) Identification of certain significant employees. None. (d)(2) Family relationships. None. (e)(2) Business experience. H. ALLEN FRANKLIN - President and Chief Executive Officer since January 1994. He previously served as President and Chief Executive Officer of SCS from 1988 through 1993. Director of SOUTHERN and SouthTrust Bank. WARREN Y. JOBE - Executive Vice President and Chief Financial Officer since 1982 and Treasurer since 1992. Responsible for financial and accounting operations and planning, internal auditing, procurement, corporate secretary and treasury operations. EDWARD L. ADDISON - President of SOUTHERN from 1983 until his election as Chairman of Board in 1994. Director of SOUTHERN, ALABAMA, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia, Phelps Dodge Corporation, Protective Life Corporation and CSX Corporation. BENNETT A. BROWN - Retired from serving as Chairman of the Board of NationsBank on December 31, 1992. Previously Chairman of the Board and Chief Executive Officer of C&S/Sovran Corporation. Director of Confederation Life Insurance Company. WILLIAM P. COPENHAVER - Director, Arcadian Fertilizer, L.P. (agricultural and industrial chemicals). Director of SOUTHERN and Georgia Bank & Trust Company. A. W. DAHLBERG - President of SOUTHERN effective in 1994. He previously served as President and Chief Executive Officer of GEORGIA from 1988 through 1993. Director of SOUTHERN, Trust Company Bank, Trust Company of Georgia, Protective Life Corporation and Equifax, Inc. WILLIAM A. FICKLING, JR. - Chairman of the Board, Mulberry Street Investment Company, Macon, Georgia, and Co-chairman of Beech Street Corporation (insurance). III-5 L. G. HARDMAN, III - Chairman of the Board of First National Bank of Commerce, Georgia and Chairman of the Board and Chief Executive Officer of First Commerce Bancorp. Chairman of the Board, President and Treasurer of Harmony Grove Mills, Inc. (real estate investments). Director of SOUTHERN. JAMES R. LIENTZ, JR. - President of NationsBank of Georgia since 1993. He previously served as President and Chief Executive Officer of former Citizens & Southern Bank of South Carolina (now NationsBank) from 1990 to 1993, and from 1987 to 1990, he was head of Corporate Bank Group of NationsBank of Georgia, N.A. WILLIAM A. PARKER, JR. - Chairman of the Board, Cherokee Investment Company, Inc. (private investments), Atlanta, Georgia. Director of SOUTHERN, Genuine Parts Company, Life Insurance Company of Georgia, First Union Real Estate Investment Trust, Atlantic Realty Company, ING North America Insurance Company, Post Properties, Inc. and Haverty Furniture Companies, Inc. G. JOSEPH PRENDERGAST - President and Chief Executive Officer, Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. since 1993. From 1988 to 1993, he served as Executive Vice President of Wachovia Corporation and President of Wachovia Corporate Services, Inc. HERMAN J. RUSSELL - Chairman of the Board and Chief Executive Officer, H. J. Russell & Company (construction), Atlanta, Georgia. Chairman of the Board, Citizens Trust Bank, and Citizens Bancshares Corporation Atlanta, Georgia. Director of Wachovia Corporation. GLORIA M. SHATTO - President, Berry College, Mount Berry, Georgia. Director of SOUTHERN, Becton Dickinson & Company, Kmart Corporation and Texas Instruments, Inc. ROBERT STRICKLAND - Retired Chairman of the Board and Chief Executive Officer of SunTrust Banks, Inc. Director of Georgia US Corporation, Equifax, Inc., Life Insurance Company of Georgia, Oxford Industries, Inc. and The Investment Centre. WILLIAM JERRY VEREEN - President and Chief Executive Officer of Riverside Manufacturing Company (manufacture and sale of uniforms), Moultrie, Georgia. Director of Gerber Garment Technology, Inc. and Textile Clothing Technology Corp. THOMAS R. WILLIAMS - President of The Wales Group, Inc. (investments) Atlanta, Georgia. Director of ConAgra, Inc., BellSouth Corporation, National Life Insurance Company of Vermont, AppleSouth, Inc., and American Software, Inc. DWIGHT H. EVANS - Executive Vice President - External Affairs since 1989. Senior Vice President - Public Affairs from 1988 to 1989. GENE R. HODGES - Executive Vice President - Customer Operations since 1992. Senior Vice President - Region/Land Operations from 1990 to 1992. Senior Vice President - Division Operations from 1986 to 1990. KERRY E. ADAMS - Senior Vice President - Fossil and Hydro Power since 1989. WAYNE T. DAHLKE - Senior Vice President - Power Delivery since February 1992. Senior Vice President - Marketing from 1989 to 1992. JAMES K. DAVIS - Senior Vice President - Corporate Relations since October 1993. Vice President of Corporate Relations from 1988 to 1993. ROBERT H. HAUBEIN - Senior Vice President - Administrative Services since 1992. Vice President - Northern Region from 1990 to 1992. Division Vice President of ALABAMA from 1985 to 1990. GALE E. KLAPPA - Senior Vice President - Marketing since 1992. Vice President - - Public Relations of SCS from 1981 to 1992. FRED D. WILLIAMS - Senior Vice President - Bulk Markets since 1992. Vice President - Bulk Power Markets from 1984 to 1992. (f)(2) Involvement in certain legal proceedings. None. III-6 GULF (a)(3) Identification of directors of GULF. D. L. MCCRARY (1) Chairman of the Board and Chief Executive Officer Age 64 Served as Director since 4-28-83 TRAVIS J. BOWDEN President Age 55 Served as Director since 2-1-94 PAUL J. DENICOLA (2) Age 45 Served as Director since 4-19-91 REED BELL, SR., M.D. (2) Age 67 Served as Director since 1-17-86 FRED C. DONOVAN, SR. (2) Age 53 Served as Director since 1-18-91 W. D. HULL, JR. (2) Age 61 Served as Director since 10-14-83 C. W. RUCKEL (2) Age 66 Served as Director since 4-20-62 J. K. TANNEHILL (2) Age 60 Served as Director since 7-19-85 (1) Retires May 1, 1994. (2) No position other than Director. Each of the above is currently a director of GULF, serving a term running from the last annual meeting of GULF's stockholder (June 29, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for Mr. Bowden. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GULF acting solely in their capacities as such. (b)(3) Identification of executive officers of GULF. D. L. MCCRARY Chairman of the Board and Chief Executive Officer Age 64 Served as Executive Officer since 5-1-83 TRAVIS J. BOWDEN President Age 55 Served as Executive Officer since 2-1-94 F. M. FISHER, JR. Vice President - Employee and External Relations Age 45 Served as Executive Officer since 5-19-89 JOHN E. HODGES, JR. Vice President - Customer Operations Age 50 Served as Executive Officer since 5-19-89 G. EDISON HOLLAND, JR. Vice President and Corporate Counsel Age 41 Served as Executive Officer since 4-25-92 EARL B. PARSONS, JR. Vice President - Power Generation and Transmission Age 55 Served as Executive Officer since 4-14-78 A. E. SCARBROUGH Vice President - Finance Age 57 Served as Executive Officer since 9-21-77 Each of the above is currently an executive officer of GULF, serving a term running from the last annual meeting of the directors (July 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except for Mr. Bowden. III-7 There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GULF acting solely in their capacities as such. (c)(3) Identification of certain significant employees. None. (d)(3) Family relationships. None. (e)(3) Business experience. D. L. MCCRARY - Elected Chairman of the Board effective February 1994. He previously served as President and Chief Executive Officer from 1983 to 1994; responsible primarily for formation of overall corporate policy. TRAVIS J. BOWDEN - Elected President effective February 1994 and, upon Mr. McCrary's retirement May 1994, Chief Executive Officer. He previously served as Executive Vice President of ALABAMA from 1985 to 1994. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 through 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, MISSISSIPPI and SAVANNAH. REED BELL, SR., M.D. - Medical Doctor and since 1989, employee of the State of Florida. He serves as Medical Director of Children's Medical Services, District 1. He previously served as Medical Director of the Escambia County Public Health Unit until July 1992. He also previously maintained a private medical practice and served as Medical Director of Children's Medical Services from 1988 to 1989. FRED C. DONOVAN, SR. - President of Baskerville - Donovan, Inc., Pensacola, Florida, an architectural and engineering firm. Director of Baptist Health Care, Inc. W. D. HULL, JR. - Vice Chairman of the Sun Bank/West Florida, Panama City, Florida. He previously served as President and Chief Executive Officer and Director of the Sun Commercial Bank, Panama City, Florida from 1987 to 1992. C. W. RUCKEL - Chairman of the Board of The Vanguard Bank and Trust Company, Valparaiso, Florida. President and owner of Ruckel Properties, Inc., Valparaiso, Florida. J. K. TANNEHILL - President and Chief Executive Officer of Tannehill International Industries, Lynn Haven, Florida. He previously served as President and Chief Executive Officer of Stock Equipment Company, Chagrin Falls, Ohio, until 1991. Director of Sun Bank/West Florida, Panama City, Florida. F. M. FISHER, JR. - Elected Vice President - Employee and External Relations in 1989. He previously served as General Manager of Central Division from 1988 to 1989. JOHN E. HODGES, JR. - Elected Vice President - Customer Operations in 1989. He previously served as General Manager of Western Division from 1986 to 1989. G. EDISON HOLLAND, JR. - Elected Vice President and Corporate Counsel in 1992; responsible for all legal matters associated with GULF and serves as compliance officer. Also served, since 1982, as a partner in the law firm, Beggs & Lane. EARL B. PARSONS, JR. - Elected Vice President - Power Generation and Transmission in 1989; responsible for generation and transmission of electrical energy. He previously served as Vice President - Electric Operations from 1978 to 1989. A. E. SCARBROUGH - Elected Vice President - Finance in 1980; responsible for all accounting and financial services of GULF. (f)(3) Involvement in certain legal proceedings. None. III-8 MISSISSIPPI (a)(4) Identification of directors of MISSISSIPPI. DAVID M. RATCLIFFE President and Chief Executive Officer Age 45 Served as Director since 4-24-91 PAUL J. DENICOLA (1) Age 45 Served as Director since 5-1-89 EDWIN E. DOWNER (1) Age 62 Served as Director since 4-24-84 ROBERT S. GADDIS (1) Age 62 Served as Director since 1-21-86 WALTER H. HURT, III (1) Age 58 Served as Director since 4-6-82 AUBREY K. LUCAS (1) Age 59 Served as Director since 4-24-84 EARL D. MCLEAN, JR. (1) Age 68 Served as Director since 10-21-78 GERALD J. ST. Pe (1) Age 54 Served as Director since 1-21-86 LEO W. SEAL, JR. (1) Age 69 Served as Director since 4-4-67 N. EUGENE WARR (1) Age 58 Served as Director since 1-21-86 (1) No position other than Director. Each of the above is currently a director of MISSISSIPPI, serving a term running from the last annual meeting of MISSISSIPPI's stockholder (April 6, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he or she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of MISSISSIPPI acting solely in their capacities as such. (b)(4) Identification of executive officers of MISSISSIPPI. DAVID M. RATCLIFFE President, Chief Executive Officer and Director Age 45 Served as Executive Officer since 4-24-91 H. E. BLAKESLEE Vice President - Customer Services and Marketing Age 53 Served as Executive Officer since 1-25-84 THOMAS A. FANNING Vice President and Chief Financial Officer Age 37 Served as Executive Officer since 4-1-92 DON E. MASON Vice President - External Affairs and Corporate Services Age 52 Served as Executive Officer since 7-27-83 Each of the above is currently an executive officer of MISSISSIPPI, serving a term running from the last annual meeting of the directors (April 28, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of MISSISSIPPI acting solely in their capacities as such. (c)(4) Identification of certain significant employees. None. (d)(4) Family relationships. None. (e)(4) Business experience. III-9 DAVID M. RATCLIFFE - President and Chief Executive Officer since 1991. He previously served as Executive Vice President of SCS from 1989 to 1991 and Vice President of SCS from 1985 to 1989. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, SAVANNAH and GULF. EDWIN E. DOWNER - Business consultant specializing in economic analysis, management controls and procedural studies since 1990. President and Chief Executive Officer, Unifirst Bank for Savings, F.A., Midland Division, Meridian, Mississippi from 1985 to 1990. ROBERT S. GADDIS - President of the Trustmark National Bank - Laurel, Mississippi. WALTER H. HURT, III - President and Director of NPC Inc. (Investments). Vicar, All Saints Church, Inverness, Mississippi, and St. Thomas Church, Belzoni, Mississippi. Retired newspaper editor and publisher. AUBREY K. LUCAS - President of the University of Southern Mississippi, Hattiesburg, Mississippi. EARL D. MCLEAN, JR. - Co-owner of the T. C. Griffith Insurance Agency, Inc. (insurance and real estate), Columbia, Mississippi. Director of SOUTHERN. GERALD J. ST. Pe - President of Ingalls Shipbuilding and Corporate Vice President of Litton Industries, Inc. since 1985. Director of Merchants and Marine Bank, Pascagoula, Mississippi. LEO W. SEAL, JR. - Chairman of the Board and Chief Executive Officer of Hancock Bank, Gulfport, Mississippi, and Chairman of the Board of Harrison Life Insurance Company. Director of Hancock Bank and Bank of Wiggins. N. EUGENE WARR - Retailer (Biloxi and Gulfport, Mississippi.) Chairman of the Board of First Jefferson Corporation and the Jefferson Bank of Biloxi, Mississippi. H. E. BLAKESLEE - Elected Vice President in 1984. Primarily responsible for rate design, economic analysis and revenue forecasting, economic development, marketing and district operations. THOMAS A. FANNING - Elected Vice President in 1992; responsible primarily for accounting, treasury, finance, information resources and risk management. He previously served as Treasurer of SEI from 1986 to 1992 and Director of Corporate Finance of SCS from 1988 to 1992. DON E. MASON - Elected Vice President in 1983. Primarily responsible for the external affairs functions, including governmental and regulatory affairs, corporate communications, security, materials and general services, as well as the human resources function. (f)(4) Involvement in certain legal proceedings. None. SAVANNAH (a)(5) Identification of directors of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President and Chief Executive Officer Age 61 Served as Director since 8-31-82 HELEN QUATTLEBAUM ARTLEY (1) Age 66 Served as Director since 5-17-77 PAUL J. DENICOLA (1) Age 45 Served as Director since 3-14-91 BRIAN R. FOSTER (1) Age 44 Served as Director since 5-16-89 WALTER D. GNANN (1) Age 58 Served as Director since 5-17-83 JOHN M. MCINTOSH (1) Age 69 Served as Director since 2-27-68 III-10 ROBERT B. MILLER, III (1) Age 48 Served as Director since 5-17-83 JAMES M. PIETTE (1) Age 69 Served as Director since 6-12-73 ARNOLD M. TENEBAUM (1) Age 57 Served as Director since 5-17-77 FREDERICK F. WILLIAMS, JR. (1) Age 66 Served as Director since 7-2-75 (1) No Position other than Director. Each of the above is currently a director of SAVANNAH, serving a term running from the last annual meeting of SAVANNAH's stockholder (May 18, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of SAVANNAH acting solely in their capacities as such. (b)(5) Identification of executive officers of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President, Chief Executive Officer and Director Age 61 Served as Executive Officer since 2-15-72 W. MILES GREER Vice President - Marketing and Customer Services Age 50 Served as Executive Officer since 11-20-85 LARRY M. PORTER Vice President - Operations Age 49 Served as Executive Officer since 7-1-91 KIRBY R. WILLIS Vice President, Treasurer and Chief Financial Officer Age 42 Served as Executive Officer since 1-1-94 Each of the above is currently an executive officer of SAVANNAH, serving a term running from the last annual meeting of the directors (May 18, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except Mr. Willis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of SAVANNAH acting solely in their capacities as such. (c)(5) Identification of certain significant employees. None. (d)(5) Family relationships. None. (e)(5) Business experience. ARTHUR M. GIGNILLIAT, JR. - Elected President and Chief Executive Officer in 1985. Director of Savannah Foods and Industries, Inc. HELEN QUATTLEBAUM ARTLEY - Homemaker and Civic Worker. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, GULF and MISSISSIPPI. BRIAN R. FOSTER - President of NationsBank of Georgia, N.A., in Savannah since 1988. WALTER D. GNANN - President of Walt's TV, Appliance and Furniture Co., Inc., Springfield, Georgia. Past Chairman of the Development Authority of Effingham County, Georgia. III-11 JOHN M. MCINTOSH - Chairman of the Executive Committee, SAVANNAH; retired Chairman of the Board of Directors and Chief Executive Officer, SAVANNAH from 1974 to 1984. Director of SOUTHERN. ROBERT B. MILLER, III - President of American Builders of Savannah. JAMES M. PIETTE - Vice President - Special Projects, Union Camp Corporation, since 1989. Retired Vice Chairman, Board of Directors, Union Camp Corporation from 1987 to 1989. ARNOLD M. TENENBAUM - President of Chatham Steel Corporation. Director of First Union National Bank of Georgia and Savannah Foods and Industries, Inc. FREDERICK F. WILLIAMS, JR. - Retired Partner and Consultant, Hilb, Rogal and Hamilton Employee Benefits, Incorporated (Insurance Brokers), formerly Jones, Hill & Mercer. W. MILES GREER - Vice President - Marketing and Customer Services effective January 1994. Formerly served as Vice President - Economic Development and Corporate Services from 1989 through 1993 and Vice President - Economic Development and Governmental Affairs from 1985 to 1989. LARRY M. PORTER - Vice President - Operations since 1991. Responsible for managing the areas of fuel procurement, power production, transmission and distribution, engineering and system operation. Previously he served as Assistant Plant Manager of GEORGIA's Plant Scherer from 1984 to 1991. KIRBY R. WILLIS - Vice President, Treasurer and Chief Financial Officer effective January 1994. Responsible for all financial activities, Information Resources, Human Resources, Corporate Services, and Environmental Affairs and Safety. He previously served as Treasurer, Controller and Assistant Secretary from 1991 to 1993 and Treasurer and Secretary from 1987 to 1991. (f)(5) Involvement in certain legal proceedings. None. III-12 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (A) SUMMARY COMPENSATION TABLES. The following tables set forth information concerning the Chief Executive Officer and the four most highly compensated executive officers for each of the operating affiliates (ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH), serving as of December 31, 1993 whose total annual salary and bonus exceeded $100,000. No information is provided for any person for any year in which such person did not serve as an executive officer of the operating affiliate. The number of SOUTHERN common shares do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. KEY TERMS used in this Item will have the following meanings:- AME........... ABOVE-MARKET EARNINGS ON DEFERRED COMPENSATION ESP........... EMPLOYEE SAVINGS PLAN ESOP.......... EMPLOYEE STOCK OWNERSHIP PLAN SBP........... SUPPLEMENTAL BENEFIT PLAN VBP........... VEHICLE BUYOUT PROGRAM ALABAMA SUMMARY COMPENSATION TABLE III-13 ALABAMA SUMMARY COMPENSATION TABLE (CONTINUED) (1) Tax reimbursement by ALABAMA and certain personal benefits, including membership fee of $28,402 for Mr. Jones in 1992. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) ALABAMA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans), and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- E. B. Harris $6,746 $1,709 $12,933 $18,000 T. J. Bowden 8,369 1,709 3,193 18,000 B. H. Farris 7,193 1,499 726 18,000 T. H. Jones 6,908 1,331 754 5,100 W. B. Hutchins, III 6,746 1,400 671 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective January 31, 1994, Mr. Bowden resigned to become president of GULF. III-14 GEORGIA SUMMARY COMPENSATION TABLE (1) Due to the pay schedules at GEORGIA, 1992 salary reflects one additional pay period compared with 1991. (2) Tax reimbursement by GEORGIA on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (3) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (4) GEORGIA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- A. W. Dahlberg $6,746 $1,709 $18,092 $18,000 D. H. Evans 8,592 1,709 1,218 18,000 W. Y. Jobe 7,667 1,709 1,882 18,000 G. R. Hodges 7,349 1,620 3,660 18,000 K. E. Adams 7,204 1,634 1,462 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (5) Effective December 31, 1993, Mr. Dahlberg resigned to become president of SOUTHERN. III-15 GULF SUMMARY COMPENSATION TABLE (1) Tax reimbursement by GULF on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) GULF contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- D. L. McCrary $9,300 $1,709 $6,057 $ 2,788 G. E. Holland, Jr. 4,652 - - 16,363 E. B. Parsons, Jr 6,948 1,709 410 16,363 A. E. Scarbrough 6,746 1,338 282 16,363 J. E. Hodges, Jr. 6,651 1,313 - 16,363 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Employee and executive officer of GULF since April 25, 1992. Not eligible to participate in the Long-Term Incentive Plan until January 1, 1993. (5) "All Other Compensation" previously reported as $4,149 for Mr. Holland in the Form 10-K for the year ended December 31, 1992, should have been $0 since Mr. Holland was not yet eligible to participate in ESP and ESOP. III-16 MISSISSIPPI SUMMARY COMPENSATION TABLE (1) Tax reimbursement by MISSISSIPPI on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) MISSISSIPPI contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- David M. Ratcliffe $7,895 $1,709 $2,774 $5,509 R. G. Dawson 6,746 1,252 - 7,045 H. E. Blakeslee 6,843 1,355 - 7,452 D. E. Mason 6,671 1,286 - 7,452 T. A. Fanning 5,520 1,019 - 8,116 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective March 1, 1994, Mr. Dawson resigned to become a vice president of SEI. (5) Benefits under MISSISSIPPI's VBP for 1992 in the amounts of $13,169 and $12,425 to Messrs. Dawson and Fanning, respectively, previously reported in the Form 10-K for the year ended December 31, 1992, under the "Other Annual Compensation" column have been moved to the "All Other Compensation" column. III-17 SAVANNAH SUMMARY COMPENSATION TABLE (1) Tax reimbursement by SAVANNAH on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) SAVANNAH contributions to the ESP, under Section 401(k) of the Internal Revenue Code, ESOP, AME and payments under a VBP for the following:- Name ESP ESOP AME VBP - ---- --- ---- --- --- A. M. Gignilliat $6,746 $3,092 $7,479 $14,195 E. O. Veale 6,163 2,359 5,702 - L. M. Porter 4,943 1,774 658 14,195 W. M. Greer 5,045 1,764 877 14,195 J. L. Rayburn 2,284 1,650 1,911 14,195 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Retired effective December 31, 1993. (5) Not eligible for Long-term Incentive Payout until January 1, 1994. (6) Resigned effective December 31, 1993. III-18 STOCK OPTION GRANTS IN 1993 (B) STOCK OPTION GRANTS. The following table sets forth all stock option grants to the named executive officers of each operating subsidiary during the year ending December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-19 STOCK OPTION GRANTS IN 1993 (1) Grants were made on July 19, 1993, and vest 25% per year on the anniversary date of the grant. Grants fully vest upon termination incident to death, disability, or retirement. The exercise price is the average of the high and low fair market value of SOUTHERN's common stock on the date granted. In accordance with the terms of the Executive Stock Plan, Mr. Jones' unexercised options expire on April 1, 1998, three years after his normal retirement date; Mr. McCrary's unexercised options expire on May 1, 1997, three years after his normal retirement date; and Mr. Gignilliat's unexercised options expire on September 3, 2000, three years after his normal retirement date. (2) A total of 179,746 stock options were granted in 1993 to key executives participating in SOUTHERN's Executive Stock Plan. (3) Based on the Black-Scholes option valuation model. The actual value, if any, an executive officer may realize ultimately depends on the market value of SOUTHERN's common stock at a future date. This valuation is provided pursuant to SEC disclosure rules and there is no assurance that the value realized will be at or near the value estimated by the Black-Scholes model. Assumptions used to calculate this value: price volatility - 12.45%; risk-free rate of return - 5.81%; dividend yield - 5.37%; and time to exercise - ten years. III-20 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (C) AGGREGATED STOCK OPTION EXERCISES. The following table sets forth information concerning options exercised during the year ending December 31, 1993, by the named executive officers and the value of unexercised options held by them as of December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-21 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (1) This represents the excess of the fair market value of SOUTHERN's common stock of $44.125 per share, as of December 31, 1993, above the exercise price of the options. One column reports the "value" of options that are vested and therefore could be exercised; the other "value" of options that are not vested and therefore could not be exercised as of December 31, 1993. (2) The "Value Realized" is ordinary income, before taxes, and represents the amount equal to the excess of the fair market value of the shares at the time of exercise over the exercise price. III-22 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 (D) LONG-TERM INCENTIVE PLANS. The following table sets forth the long-term incentive plan awards made to the named executive officers for the performance period January 1, 1993 through December 31, 1996. See next page for footnotes. III-23 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 III-24 PENSION PLAN TABLE (e)(1) The following table sets forth the estimated combined annual pension benefits under the pension and supplemental defined benefit plans in effect during 1993 for ALABAMA, GEORGIA, GULF and MISSISSIPPI. Employee compensation covered by the pension and supplemental benefit plans for pension purposes is limited to the average of the highest three of the final 10 years' base salary and wages (reported under column titled "Salary" in the Summary Compensation Tables on pages III-13 through III-18). The amounts shown in the table were calculated according to the final average pay formula and are based on a single life annuity without reduction for joint and survivor annuities (although married employees are required to have their pension benefits paid in one of various joint and survivor annuity forms, unless the employee elects otherwise with the spouse's consent) or computation of the Social Security offset which would apply in most cases. This offset amounts to one-half of the estimated Social Security benefit (primary insurance amount) in excess of $3,000 per year times the number of years of accredited service, divided by the total possible years of accredited service to normal retirement age. As of December 31, 1993, the applicable compensation levels and years of accredited service are presented in the following tables: III-25 SAVANNAH has in effect a qualified, trusteed, noncontributory, defined benefit pension plan which provides pension benefits to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. The plan provides pension benefits under a formula which includes each participant's years of service with the Southern system and average annual earnings of the highest three of the final ten years of service with the Southern system preceding retirement. Plan benefits are reduced by a portion of the benefits participants are entitled to receive under Social Security. The plan provides for reduced early retirement benefits at age 55 and a pension for the surviving spouse equal to one-half of the deceased retiree's pension. The following table sets forth the estimated annual pension benefits under the pension plan in effect during 1993 which are payable by SAVANNAH to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. (1)The number of accredited years of service includes ten years credited to Mr. Holland pursuant to a supplemental pension agreement. III-26 As of December 31, 1993, the applicable compensation levels and years of accredited service is presented in the following table: (e)(2) DEFERRED COMPENSATION PLAN; SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN. SAVANNAH has in effect a voluntary deferred compensation plan for certain executive employees pursuant to which such employees may defer a portion of their respective annual salaries. In addition, SAVANNAH has a supplemental executive retirement plan for certain of its executive employees which became effective January 1, 1984. The deferred compensation plan is designed to provide supplemental retirement or survivor benefit payments. The supplemental executive retirement plan is also designed to provide retiring executives of SAVANNAH with a supplemental retirement benefit, which, in conjunction with social security and benefits under SAVANNAH's qualified pension plan, will equal 70 percent of the highest three of the final ten years average annual compensation (including deferrals under the deferred compensation plan). Both of these plans are unfunded and the liability is payable from general funds of SAVANNAH. The deferred compensation plan became effective December 1, 1983, and all of SAVANNAH's executive officers are participating in the plan. In addition, all executives are participating in the supplemental executive retirement plan. In order to provide for its liabilities under the deferred compensation plan and the supplemental executive retirement plan, SAVANNAH has purchased life insurance on participating executive employees in actuarially determined amounts which, based upon assumptions as to mortality experience, policy dividends, tax effects, and other factors which, if realized, along with compensation deferred by employees and the death benefits payable to (1) The plan benefits are subject to the maximum benefit limitations set forth in Section 415 of the Internal Revenue Code. III-27 SAVANNAH, are expected to cover all such insurance premium payments, and all benefit payments to participants, plus a factor for the cost of funds of SAVANNAH. (f) COMPENSATION OF DIRECTORS. (1) Standard Arrangements. The following table presents compensation paid to the directors, during 1993 for service as a member of the board of directors and any board committee(s), except that employee directors received no fees or compensation for service as a member of the board of directors or any board committee. All or a portion of these fees may be deferred until membership on the board is terminated. ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH also provide retirement benefits to non-employee directors who are credited with a minimum of 60 months of service on the board of directors of one or more system companies, under the Outside Directors Pension Plan. Eligible directors are entitled to benefits under the Plan upon retirement from the board on the retirement date designated in the respective companies by-laws. The annual benefit payable ranges from 75 to 100 percent of the annual retainer fee in effect on the date of retirement, based upon length of service. Payments continue for the greater of the lifetime of the participant or 10 years. (2) Other Arrangements. No director received other compensation for services as a director during the year ending December 31, 1993 in addition to or in lieu of that specified by the standard arrangements specified above. (1) Committee Chairmen receive an additional $500 per year fee. (2) Established for period September 15, 1993 through May 31, 1994. (3) Chairman of Executive Committee receives an additional $3,000 per month fee. III-28 (g) EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL ARRANGEMENTS. None. (h) REPORT ON REPRICING OF OPTIONS. None. (i) ADDITIONAL INFORMATION WITH RESPECT TO COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISION. ALABAMA Elmer B. Harris serves on the Compensation Committee of AmSouth Bancorporation. John W. Woods, a director of ALABAMA is an executive officer of AmSouth Bancorporation. GULF Messrs. Paul J. DeNicola and Douglas L. McCrary are ex officio members of its Compensation Committee. III-29 ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. SOUTHERN is the beneficial owner of 100% of the outstanding common stock of registrants ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH. (B) SECURITY OWNERSHIP OF MANAGEMENT. The following table shows the number of shares of SOUTHERN common stock and operating subsidiary preferred stock owned by the directors, nominees and executive officers as of December 31, 1993. It is based on information furnished by the directors, nominees and executive officers. The shares owned by all directors, nominees and executive officers as a group constitute less than one percent of the total number of shares of the respective classes outstanding on December 31, 1993. The number of SOUTHERN common shares shown do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN'S board of directors in January, 1994. III-30 III-31 III-32 III-33 (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security (i.e., the power to dispose of, or to direct the disposition of, a security). (2) The shares shown include shares of common stock of which certain directors and executive officers have the right to acquire beneficial ownership within 60 days pursuant to the Executive Stock Plan, as follows: Mr. Addison, 86,357 shares; Mr. Blakeslee, 660 shares; Mr. Bowden, 5,763 shares; Mr. Dahlberg, 4,278 shares; Mr. Farris, 863 shares; Mr. Gignilliat, 8,556 shares; Mr. Guthrie 15,720 shares; Mr. Harris, 14,215 shares; Mr. Haubein, 835 shares; Mr. Hodges, 5,429 shares; Mr. Holland, 698 shares; Mr. Hutchins, 706 shares; Mr. Jones, 848 shares; Mr. Klappa, 671 shares, Mr. C. D. McCrary, 691 shares; Mr. D. L. McCrary, 9,668 shares; and Mr. Ratcliffe, 5,643 shares. Also included are shares of SOUTHERN common stock held by the spouses of the following directors: Mr. Addison, 670 shares; Mr. Copenhaver, 350 shares; Mr. Harris, 155 shares; Mr. Parker, 22 shares; and Dr. Shatto, 5,067 shares. III-34 (C) CHANGES IN CONTROL. The operating affiliates know of no arrangements which may at a subsequent date result in any change in control. GEORGIA'S Mr. Russell failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MISSISSIPPI'S Messrs. McLean, Jr., Hurt and Seal, Jr. each failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. SAVANNAH'S Mr. Gnann failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MR. DENICOLA, a director of GULF, MISSISSIPPI and SAVANNAH, failed to file on a timely basis a single report, disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. III-35 ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALABAMA (a) Transactions with management and others. During 1993, ALABAMA, in the ordinary course of business, paid premiums amounting to approximately $400,000 for various types of insurance policies purchased from Protective Life Insurance Company, a subsidiary of Protective Life Corporation, a company in which Mr. William J. Rushton, III, a director of ALABAMA, owns an interest and of which he serves as Chairman. The firm of Inzer, Stivender, Haney & Johnson, P.A., performed certain legal services for ALABAMA during 1993. Mr. James C. Inzer, Jr., partner in this firm, is also a director of ALABAMA. ALABAMA purchased automobiles and parts in the amount of approximately $200,000 from companies in which Mr. Blount, a director of ALABAMA, owns 85% interests. ALABAMA purchased electrical supplies in the amount of approximately $200,000 from L & K Electric Supply Company, Ltd. during 1993. Mr. Willie, director of ALABAMA and SOUTHERN, owns an interest in and serves as president of this firm. ALABAMA believes that these transactions have been on terms representing competitive market prices that are no less favorable than those available from others. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GEORGIA (a) Transactions with management and others. In 1993, GEORGIA was indebted in a maximum amount of $105 million to Wachovia Bank and its affiliates, of which G. Joseph Prendergast serves as President and Chief Executive Officer of Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. In 1993, GEORGIA was indebted in a maximum amount of $285 million to NationsBank and its affiliates of which Mr. James R. Lientz, Jr. serves as President of NationsBank of Georgia. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GULF (a) Transactions with management and others. The firm of Beggs & Lane, P.A. serves as local counsel for GULF and received from GULF approximately $800,000 for services rendered. Mr. G. Edison Holland, Jr. is a partner in the firm and also serves as Vice President and Corporate Counsel of GULF. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. MISSISSIPPI (a) Certain business relationships. During 1993, MISSISSIPPI was indebted in a maximum amount of $12.4 million to Hancock Bank, of which Leo W. Seal, Jr. serves as Chairman of the Board and Chief Executive Officer. (b) Certain business relationships. None. (c) Indebtedness of management. None. III-36 (d) Transactions with promoters. None. SAVANNAH (a) Transactions with management and others. Mr. Tenenbaum is a Director of First Union national Bank of Georgia, and Mr. Foster is President of NationsBank of Georgia, N.A., in Savannah. During 1993, these banks furnished a number of regular banking services in the ordinary course of business to SAVANNAH. SAVANNAH intends to maintain normal banking relations with all of the aforesaid banks in the future. (b) Certain business relationships. (c) Indebtedness of management. None. (d) Transactions with promoters. None. III-37 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 on this Form 10-K: (1) Financial Statements: Reports of Independent Public Accountants on the financial statements for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. The financial statements filed as a part of this report for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. (2) Financial Statement Schedules: Reports of Independent Public Accountants as to Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are included herein on pages IV-12 through IV-17. Financial Statement Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Index to the Financial Statement Schedules at page S-1. (3) Exhibits: Exhibits for SOUTHERN, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Exhibit Index at page E-1. (b) Reports on Form 8-K: During the fourth quarter of 1993 the registrants filed Current Reports on Form 8-K as follows: ALABAMA filed Forms 8-K dated October 27, 1993, and November 16, 1993, to facilitate security sales. GEORGIA filed a Form 8-K dated October 20, 1993, to facilitate a security sale. GULF filed a Form 8-K dated November 3, 1993, to facilitate a security sale. SAVANNAH filed a Form 8-K dated November 9, 1993, to facilitate a security sale. IV-1 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 SOUTHERN COMPANY By Edward L. Addison, Chairman By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Edward L. Addison Chairman of the Board (Principal Executive Officer) W. L. Westbrook Financial Vice President (Principal Financial and Accounting Officer) Directors: W. P. Copenhaver John M. McIntosh. A. W. Dahlberg Earl D. McLean, Jr. Paul J. DeNicola William A. Parker Jack Edwards William J. Rushton, III H. Allen Franklin Gloria M. Shatto L. G. Hardman, III Herbert Stockham Elmer B. Harris Louis J. Willie By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. ALABAMA POWER COMPANY By Elmer B. Harris, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Elmer B. Harris President, Chief Executive Officer and Director (Principal Executive Officer) Charles D. McCrary Senior Vice President (Principal Financial Officer) David L. Whitson Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison William V. Muse Whit Armstrong John T. Porter Philip E. Austin Gerald H. Powell Margaret A. Carpenter Robert D. Powers Peter V. Gregerson, Sr. John W. Rouse Bill M. Guthrie James H. Sanford Crawford T. Johnson, III John Cox Webb, IV Carl E. Jones, Jr. Louis J. Willie Wallace D. Malone, Jr. John W. Woods By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-2 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. GEORGIA POWER COMPANY By H. Allen Franklin, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. H. Allen Franklin President, Chief Executive Officer and Director (Principal Executive Officer) Warren Y. Jobe Executive Vice President, Treasurer, Chief Financial Officer and Director (Principal Financial Officer) C. B. Harreld Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison G. Joseph Prendergast Bennett A. Brown Herman J. Russell William P. Copenhaver Gloria M. Shatto A. W. Dahlberg Robert Strickland William A. Fickling, Jr. William Jerry Vereen L. G. Hardman, III Thomas R. Williams James R. Lientz, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. GULF POWER COMPANY By D. L. McCrary, Chairman of the Board By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. D. L. McCrary Chairman of the Board and Chief Executive Officer (Principal Executive Officer) A. E. Scarbrough Vice President - Finance (Principal Financial and Accounting Officer) Directors: Reed Bell Travis J. Bowden Paul J. DeNicola Fred C. Donovan W. D. Hull, Jr. C. W. Ruckel J. K. Tannehill By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25,1994 IV-3 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 COMPANY By David M. Ratcliffe, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. David M. Ratcliffe President, Chief Executive Officer and Director (Principal Executive Officer) Thomas A. Fanning Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Paul J. DeNicola Edwin E. Downer Robert S. Gaddis Walter H. Hurt, III Aubrey K. Lucas Earl D. McLean, Jr. Gerald J. St. Pe' Leo W. Seal, Jr. N. Eugene Warr By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. SAVANNAH ELECTRIC AND POWER COMPANY By Arthur M. Gignilliat, Jr., President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Arthur M. Gignilliat, Jr. President, Chief Executive Officer and Director (Principal Executive Officer) Kirby R. Willis Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Helen Q. Artley Paul J. DeNicola Brian R. Foster Walter D. Gnann John M. McIntosh Robert B. Miller, III James M. Piette Arnold M. Tenenbaum Frederick F. Williams, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-4 EXHIBIT 21. SUBSIDIARIES OF THE REGISTRANTS. (1) Owned by Alabama Power Company. (2) Owned by Georgia Power Company. (3) Owned by SEI Holdings, Inc. (4) 94% owned jointly by Asociados de Electricidad, S. A. (14%) and SEI Holdings, Inc. (80%) (5) 59% owned by SEI y Asociados de Argentina, S. A. (6) Owned by SEI Holdings III, Inc. (7) 36% owned by SEI Chile, S. A. (8) Owned by SEI Holdings IV, Inc. (9) Owned jointly by Inversores de Electricidad, S. A. (15%) and SEI Bahamas Argentina I, Inc. (85%) (10) Owned by Southern Electric Bahamas Holdings, Ltd. (11) 50% owned by Southern Electric Bahamas, Ltd. (12) Owned equally by Alabama Power Company and Georgia Power Company. (13) Owned by Southern Electric International, Inc. (14) Owned by Southern Electric Wholesale Generators, Inc. IV-5 ARTHUR ANDERSEN & CO. Exhibit 23(a) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of The Southern Company and its subsidiaries and the related financial statement schedules, included in this Form 10-K, into The Southern Company's previously filed Registration Statement File Nos. 2-78617, 33-3546, 33-23152, 33-30171, 33-23153 and 33-51433. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-6 ARTHUR ANDERSEN & CO. Exhibit 23(b) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Alabama Power Company and the related financial statement schedules, included in this Form 10-K, into Alabama Power Company's previously filed Registration Statement File No. 33-49653. /s/ Arthur Andersen & Co. Birmingham, Alabama March 25, 1994 IV-7 ARTHUR ANDERSEN & CO. Exhibit 23(c) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Georgia Power Company and the related financial statement schedules, included in this Form 10-K, into Georgia Power Company's previously filed Registration Statement File No. 33-49661. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-8 ARTHUR ANDERSEN & CO. Exhibit 23(d) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Gulf Power Company and the related financial statement schedules, included in this Form 10-K, into Gulf Power Company's previously filed Registration Statement File No. 33-50165. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-9 ARTHUR ANDERSEN & CO. Exhibit 23(e) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Mississippi Power Company and the related financial statement schedules, included in this Form 10-K, into Mississippi Power Company's previously filed Registration Statement File Nos. 33-49320 and 33-49649. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-10 ARTHUR ANDERSEN & CO. Exhibit 23(f) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Savannah Electric and Power Company and the related financial statement schedules, included in this Form 10-K, into Savannah Electric and Power Company's previously filed Registration Statement File Nos. 33-45757 and 33-52509. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-11 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To The Southern Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of The Southern Company and its subsidiaries included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the consolidated financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to The Southern Company's consolidated financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to The Southern Company and its subsidiaries (pages S-2 and S-3, S-11 through S-14, S-35 through S-37, S-53, and S-59) are the responsibility of The Southern 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 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-12 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Alabama Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Alabama Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Alabama Power Company (pages S-4, S-15 through S-18, S-38 through S-40, S-54, and S-60) are the responsibility of Alabama Power 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. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 IV-13 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Georgia Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Georgia Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding the recoverability of Georgia Power Company's investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to Georgia Power Company's financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Georgia Power Company (pages S-5, S-19 through S-22, S-41 through S-43, S-55, and S-61) are the responsibility of Georgia Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-14 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Gulf Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Gulf Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Gulf Power Company (pages S-6, S-23 through S-26, S-44 through S-46, S-56, and S-62) are the responsibility of Gulf Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-15 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Mississippi Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Mississippi Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Mississippi Power Company (pages S-7 and S-8, S-27 through S-30, S-47 through S-49, S-57, and S-63) are the responsibility of Mississippi Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-16 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Savannah Electric and Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Savannah Electric and Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Savannah Electric and Power Company (pages S-9 and S-10, S-31 through S-34, S-50 through S-52, S-58, and S-64) are the responsibility of Savannah Electric and Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-17 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules I through XIV not listed above are omitted as not applicable or not required. Columns omitted from schedules filed have been omitted because the information is not applicable or not required. S-1 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) See Summary of Transactions and Notes on Page S-3 S-2 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of retirements to acquisition adjustments. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. (NOTE 1) OTHER CHANGES INCLUDE THE FOLLOWING (STATED IN THOUSANDS OF DOLLARS) S-3 ALABAMA POWER COMPANY SCHEDULE V -- UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements below include non-depreciable plant retirements. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes include a reduction to utility plant of $61,960,000 for the partial sale of Miller Steam Plant in 1992. S-4 GEORGIA POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of Plant Scherer acquisition adjustment retired for sales in 1991 and 1993. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes for 1993, include an increase to plant of $46,473,000 for the taxes applicable to capitalized AFUDC debt. S-5 GULF POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances 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. S-6 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-8. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-7 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31,1993 (STATED IN THOUSANDS OF DOLLARS) S-8 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-10. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-9 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) S-10 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-11 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-12 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-13 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-14 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-15 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-16 ALABAMA POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-17 ALABAMA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-18 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-19 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-20 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-21 GEORGIA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-22 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-23 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-24 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-25 GULF POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-26 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-27 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-28 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-29 MISSISSIPPI POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PL FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-30 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-31 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-32 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-33 SAVANNAH ELECTRIC AND POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-34 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (3) See Note 1 to SOUTHERN's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (4) Represents additional funding to reserve. (5) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-35 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. (4) Capitalized. S-36 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 8 to SOUTHERN's financial statements in Item 8 herein for a description of the Gulf States settlement. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (4) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-37 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------ Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-38 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further Information. S-39 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) See Note 7 to the financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-40 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-41 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-42 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Note: (1) See Note 3 to GEORGIA's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible accounts was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. S-43 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-44 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - -------------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-45 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 7 to GULF's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-46 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-47 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ------------------ Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-48 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in thousands of Dollars) - ----------------- Notes: (1) See Note 7 to MISSISSIPPI's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-49 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-50 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ---------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-51 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-52 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end. (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) This note payable is an obligation of SEI and does not include borrowings from SOUTHERN. (4) See Note 5 to SOUTHERN's financial statements in Item 8 herein for details regarding SOUTHERN's and its subsidiaries lines of credit and general terms of commitment agreements. S-53 ALABAMA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992, 1991 (Stated in Thousands of Dollars) - ----------------- Notes: (1) At month-end. (2) Average based on daily borrowings during the period (averages and rates quoted on an actual day year basis). (3) ALABAMA also issued commercial paper during 1993, although none was outstanding at year-end. The data shown reflects the issuance of commercial paper. (4) See Note 5 to ALABAMA's financial statements in Item 8 herein for details regarding ALABAMA's lines of credit. S-54 GEORGIA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - -------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 8 to GEORGIA's financial statements in Item 8 herein for details regarding GEORGIA's lines of credit and general terms of its commitment agreements. S-55 GULF POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to GULF's financial statements in Item 8 herein for a description of this short-term indebtedness. (4) See Note 5 to GULF's financial statements in Item 8 herein for details regarding GULF's lines of credit and general terms of its commitment agreements. S-56 MISSISSIPPI POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to MISSISSIPPI's financial statements in Item 8 herein for details regarding MISSISSIPPI's lines of credit and general terms of its commitment agreements. S-57 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to SAVANNAH's financial statements in Item 8 herein for details regarding SAVANNAH's lines of credit and general terms of its commitment agreements. S-58 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-59 ALABAMA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-60 GEORGIA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-61 GULF POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-62 MISSISSIPPI POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-63 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-64 EXHIBIT INDEX The following exhibits indicated by an asterisk preceding the exhibit number are filed herewith. The balance of the exhibits have heretofore been filed with the SEC, respectively, as the exhibits and in the file numbers indicated and are incorporated herein by reference. Reference is made to a duplicate list of exhibits being filed as a part of this Form 10-K, which list, prepared in accordance with Item 601 of Regulation S-K of the SEC, immediately precedes the exhibits being physically filed with this Form 10-K. (3) ARTICLES OF INCORPORATION AND BY-LAWS SOUTHERN (a) 1 - Composite Certificate of Incorporation of SOUTHERN, reflecting all amendments to date. (Designated in Registration No. 33-3546 as Exhibit 4(a), in Certificate of Notification, File No. 70-7341, as Exhibit A and in Certificate of Notification, File No. 70-8181, as Exhibit A.) (a) 2 - By-laws of SOUTHERN as amended effective October 21, 1991, and as presently in effect. (Designated in Form U-1, File No. 70-8181 as Exhibit A-2.) ALABAMA (b) 1 - Charter of ALABAMA and amendments thereto through November 19, 1993. (Designated in Registration Nos. 2-59634 as Exhibit 2(b), 2-60209 as Exhibit 2(c), 2-60484 as Exhibit 2(b), 2-70838 as Exhibit 4(a)-2, 2-85987 as Exhibit 4(a)-2, 33-25539 as Exhibit 4(a)-2, 33-43917 as Exhibit 4(a)-2, in Form 8-K dated February 5, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated July 8, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated October 27, 1993, File No. 1-3164, as Exhibits 4(a) and 4(b) and in Form 8-K dated November 16, 1993, File No. 1-3164, as Exhibit 4(a).) (b) 2 - By-laws of ALABAMA as amended effective April 24, 1992, and as presently in effect. (Designated in Registration No. 33-48885 as Exhibit 4(c).) GEORGIA (c) 1 - Charter of GEORGIA and amendments thereto through October 25, 1993. (Designated in Registration Nos. 2-63392 as Exhibit 2(a)-2, 2-78913 as Exhibits 4(a)-(2) and 4(a)-(3), 2-93039 as Exhibit 4(a)-(2), 2-96810 as Exhibit 4(a)-2, 33-141 as Exhibit 4(a)-(2), 33-1359 as Exhibit 4(a)(2), 33-5405 as Exhibit 4(b)(2), 33-14367 as Exhibits 4(b)-(2) and 4(b)-(3), 33-22504 as Exhibits 4(b)-(2), 4(b)-(3) and 4(b)-(4), in GEORGIA's Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibits 4(a)(2) and 4(a)(3), in Registration No. 33-48895 as Exhibits 4(b)-(2) and 4(b)-(3), in Form 8-K dated December 10, 1992, File No. 1-6468 as Exhibit 4(b), in Form 8-K dated June 17, 1993, File No. 1-6468, as Exhibit 4(b) and in Form 8-K dated October 20, 1993, File No. 1-6468, as Exhibit 4(b).) E-1 (c) 2 - By-laws of GEORGIA as amended effective July 18, 1990, and as presently in effect. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No.1-6468, as Exhibit 3.) GULF (d) 1 - Restated Articles of Incorporation of GULF and amendments thereto through November 8, 1993. (Designated in Registration No. 33-43739 as Exhibit 4(b)-1, in Form 8-K dated January 15, 1992, File No. 0-2429, as Exhibit 1(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(b)-2, in Form 8-K dated September 22, 1993, File No. 0-2429, as Exhibit 4 and in Form 8-K dated November 3, 1993, File No. 0-2429, as Exhibit 4.) *(d) 2 - By-laws of GULF as amended effective February 25, 1994, and as presently in effect. MISSISSIPPI (e) 1 - Articles of incorporation of MISSISSIPPI, articles of merger of Mississippi Power Company (a Maine corporation) into MISSISSIPPI and articles of amendment to the articles of incorporation of MISSISSIPPI through August 19, 1993. (Designated in Registration No. 2-71540 as Exhibit 4(a)-1, in Form U5S for 1987, File No. 30-222-2, as Exhibit B-10, in Registration No. 33-49320 as Exhibit 4(b)-(1), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibits 4(b)-2 and 4(b)-3, in Form 8-K dated August 4, 1993, File No. 0-6849, as Exhibit 4(b)-3 and in Form 8-K dated August 18, 1993, File No. 0-6849, as Exhibit 4(b)-3.) (e) 2 - By-laws of MISSISSIPPI as amended effective August 22, 1989, and as presently in effect. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1989, as Exhibit 3(b).) SAVANNAH (f) 1 - Charter of SAVANNAH and amendments thereto through November 10, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(b)-(1), 33-45757 as Exhibit 4(b)-(2) and in Form 8-K dated November 9, 1993, File No. 1-5072, as Exhibit 4(b).) *(f) 2 - By-laws of SAVANNAH as amended effective February 16, 1994, and as presently in effect. (4) INSTRUMENTS DESCRIBING RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES ALABAMA (b) - Indenture dated as of January 1, 1942, between ALABAMA and Chemical Bank, as Trustee, and indentures supplemental thereto through that dated as of January 1, 1994. (Designated in Registration Nos. 2-59843 as Exhibit 2(a)-2, 2-60484 as Exhibits 2(a)-3 and 2(a)-4, 2-60716 as Exhibit 2(c), 2-67574 as E-2 Exhibit 2(c), 2-68687 as Exhibit 2(c), 2-69599 as Exhibit 4(a)-2, 2-71364 as Exhibit 4(a)-2, 2- 73727 as Exhibit 4(a)-2, 33-5079 as Exhibit 4(a)-2, 33-17083 as Exhibit 4(a)-2, 33-22090 as Exhibit 4(a)-2, in ALABAMA's Form 10-K for the year ended December 31, 1990, File No. 1-3164, as Exhibit 4(c), in Registration Nos. 33-43917 as Exhibit 4(a)-2, 33-45492 as Exhibit 4(a)-2, 33- 48885 as Exhibit 4(a)-2, 33-48917 as Exhibit 4(a)-2, in Form 8-K dated January 20, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Form 8-K dated February 17, 1993, File No.1-3436, as Exhibit 4(a)-3, in Form 8-K dated March 10, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Certificate of Notification, File No. 70-8069, as Exhibits A and B, in Form 8-K dated June 24, 1993, File No. 1- 3436, as Exhibit 4, in Certificate of Notification, File No. 70-8069, as Exhibit A, in Form 8-K dated November 16, 1993, File No. 1-3436, as Exhibit 4(b) and in Certificate of Notification, File No. 70-8069, as Exhibits A and B.) GEORGIA (d) - Indenture dated as of March 1, 1941, between GEORGIA and Chemical Bank, as Trustee, and indentures supplemental thereto dated as of March 1, 1941, March 3, 1941 (3 indentures), March 6, 1941 (139 indentures), March 1, 1946 (88 indentures) and December 1, 1947, through January 1, 1994. (Designated in Registration Nos. 2-4663 as Exhibits B-3 and B-3(a), 2-7299 as Exhibit 7(a)-2, 2- 61116 as Exhibit 2(a)-3 and 2(a)-4, 2-62488 as Exhibit 2(a)-3, 2-63393 as Exhibit 2(a)-4, 2-63705 as Exhibit 2(a)-3, 2-68973 as Exhibit 2(a)-3, 2-70679 as Exhibit 4(a)-(2), 2-72324 as Exhibit 4(a)-2, 2-73987 as Exhibit 4(a)-(2), 2-77941 as Exhibits 4(a)-(2) and 4(a)-(3), 2-79336 as Exhibit 4(a)-(2), 2-81303 as Exhibit 4(a)-(2), 2-90105 as Exhibit 4(a)-(2), 33-5405 as Exhibit 4(a)-(2), 33-14367 as Exhibits 4(a)-(2) and 4(a)-(3), 33-22504 as Exhibits 4(a)-(2), 4(a)-(3) and 4(a)-(4), 33-32420 as Exhibit 4(a)-(2), 33-35683 as Exhibit 4(a)-(2), in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 4(a)(3), in Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibit 4(a)(5), in Registration No. 33-48895 as Exhibit 4(a)-(2), in Form 8-K dated August 26, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-K dated September 9, 1992, File No. 1-6468, as Exhibits 4(a)-(3) and 4(a)-(4), in Form 8-K dated September 23, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-A dated October 12, 1992, as Exhibit 2(b), in Form 8-K dated January 27, 1993, File No. 1-6468, as Exhibit 4(a)-(3), in Registration No. 33-49661 as Exhibit 4(a)-(2), in Form 8-K dated July 26, 1993, File No. 1-6468, as Exhibit 4, in Certificate of Notification, File No. 70-7832, as Exhibit M and in Certificate of Notification, File No. 70-7832, as Exhibit C.) GULF (e) - Indenture dated as of September 1, 1941, between GULF and The Chase Manhattan Bank (National Association) and The Citizens & Peoples National Bank of Pensacola, as Trustees, and indentures supplemental thereto through E-3 November 1, 1993. (Designated in Registration Nos. 2-4833 as Exhibit B-3, 2-62319 as Exhibit 2(a)-3, 2-63765 as Exhibit 2(a)-3, 2-66260 as Exhibit 2(a)-3, 33-2809 as Exhibit 4(a)-2, 33-43739 as Exhibit 4(a)-2, in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 4(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(a)-3, in Registration No. 33-50165 as Exhibit 4(a)-2, in Form 8-K dated July 12, 1993, File No. 0-2429, as Exhibit 4 and in Certificate of Notification, File No. 70-8229, as Exhibit A.) MISSISSIPPI (f) - Indenture dated as of September 1, 1941, between MISSISSIPPI and Morgan Guaranty Trust Company of New York, as Trustee, and indentures supplemental thereto through November 1, 1993. (Designated in Registration Nos. 2-4834 as Exhibit B-3, 2-62965 as Exhibit 2(b)-2, 2-66845 as Exhibit 2(b)-2, 2-71537 as Exhibit 4(a)-(2), 33-5414 as Exhibit 4(a)-(2), 33-39833 as Exhibit 4(a)-2, in MISSISSIPPI's Form 10-K for the year ended December 31, 1991, File No. 0-6849, as Exhibit 4(b), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibit 4(a)-2, in Second Certificate of Notification, File No. 70-7941, as Exhibit I, in MISSISSIPPI's Form 8-K dated February 26, 1993, File No. 0-6849, as Exhibit 4(a)-2, in Certificate of Notification, File No. 70-8127, as Exhibit A, in Form 8-K dated June 22, 1993, File No. 0-6849, as Exhibit 1 and in Certificate of Notification, File No. 70-8127, as Exhibit A.) SAVANNAH (g) - Indenture dated as of March 1, 1945, between SAVANNAH and NationsBank of Georgia, National Association, as Trustee, and indentures supplemental thereto through July 1, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(a)-(1), 33-41496 as Exhibit 4(a)-(2), 33-45757 as Exhibit 4(a)-(2), in SAVANNAH's Form 10-K for the year ended December 31, 1991, File No. 1-5072, as Exhibit 4(b), in Form 8-K dated July 8, 1992, File No. 1-5072, as Exhibit 4(a)-3, in Registration No. 33-50587 as Exhibit 4(a)-(2) and in Form 8-K dated July 22, 1993, File No. 1-5072, as Exhibit 4.) (10) MATERIAL CONTRACTS SOUTHERN (a) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(a) and in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(3).) (a) 2 - Service contract dated as of July 17, 1981, between SCS and SEI. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(2).) E-4 (a) 3 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1987, File No. 1-5072, as Exhibit 10-p.) (a) 4 - Service contract dated as of January 15, 1991, between SCS and Southern Nuclear. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1991, File No. 1-3526, as Exhibit 10(a)(4).) (a) 5 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(b).) (a) 6 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. (Designated in Registration No. 2-59634 as Exhibit 5(c) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(d)(2).) (a) 7 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Registration No. 2-61116 as Exhibit 5(d).) (a) 8 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(1).) (a) 9 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(3).) (a) 10 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(g).) (a) 11 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit A.) (a) 12 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit B.) (a) 13 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(1).) E-5 (a) 14 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-1 and in Form 8-K for January 1977, File No. 1-6468, as Exhibit (B)(3).) (a) 16 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-2.) (a) 17 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1983, File No. 1-6468, as Exhibit 10(k)(4).) (a) 18 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 19 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 20 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(8).) (a) 21 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 22 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(3).) (a) 23 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(7).) (a) 24 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-3, in SOUTHERN's Form 10-K for the year ended December 31, 1987, File E-6 No. 1-3526, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, File No. 1-3526, as Exhibit 10(n)(2).) (a) 25 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-4 and in SOUTHERN's Form 10-K for the year ended December 31, 1987, File No. 1-3526, as Exhibit 10(o)(4).) (a) 26 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. (Designated in Form U-1, File No. 70-6481, as Exhibit B-1.) (a) 27 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-2.) (a) 28 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-4, in SOUTHERN's Form 10-K for the year ended December 31, 1987, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, as Exhibit 10(n)(2).) (a) 29 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-5.) (a) 30 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-1.) (a) 31 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-2.) (a) 32 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(c)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(r)(3).) (a) 33 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in GEORGIA's Form 10-K for the year E-7 ended December 31, 1982, File No. 1-6468, as Exhibit 10(s)(2), in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(r)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468 as Exhibit 10(s)(2).) (a) 34 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(d).) (a) 35 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(e).) (a) 36 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(f).) (a) 37 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(x).) (a) 38 - The Southern Company Executive Stock Plan For the Southern Electric System and the First Amendment thereto. (Designated in Registration No. 33-30171 as Exhibit 4(c).) (a) 39 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(1).) (a) 40 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(m).) (a) 41 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(x).) (a) 42 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(y).) E-8 (a) 43 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-1.) (a) 44 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-2.) (a) 45 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(f), in MISSISSIPPI's Form 10-K for the year ended December 31, 1982, File No. 0-6849, as Exhibit 10(f)(2) and in MISSISSIPPI's Form 10-K for the year ended December 31, 1983, File No. 0-6849, as Exhibit 10(f)(3).) (a) 46 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. (Designated in Form U-1, File No. 70-7738, as Exhibit A-5 and in Form U-1, File No. 70-7937, as A-5(b).) (a) 47 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(cc).) (a) 48 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(dd).) *(a) 49 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. (a) 50 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(ff).) (a) 51 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(gg).) (a) 52 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(hh).) E-9 (a) 53 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1992, File No. 1-3526, as Exhibit 10(a)53.) *(a) 54 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. *(a) 55 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. *(a) 56 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. *(a) 57 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 58 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 59 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. ALABAMA (b) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. (Designated in Registration No. 2-59843 as Exhibit 2(a)-8.) (b) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (b) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (b) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (b) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. E-10 (b) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2, dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (b) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)34 herein. (b) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)35 herein. (b) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)36 herein. (b) 10 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (b) 11 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)39 herein. (b) 12 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)40 herein. (b) 13 - Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Certificate of Notification, File No. 70-7212, as Exhibit B.) (b) 14 - 1991 Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Form U-1, File No. 70- 7873, as Exhibit B-1.) (b) 15 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)43 herein. (b) 16 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)44 herein. (b) 17 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. E-11 (b) 18 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. GEORGIA (c) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. See Exhibit 10(b)1 herein. (c) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIP PI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (c) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (c) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (c) 5 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)7 herein. (c) 6 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)8 herein. (c) 7 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)9 herein. (c) 8 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. See Exhibit 10(a)10 herein. (c) 9 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a) 11 herein. (c) 10 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a)12 herein. (c) 11 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)13 herein. (c) 12 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)14 herein. E-12 (c) 13 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)15 herein. (c) 14 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)16 herein. (c) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. See Exhibit 10(a)17 herein. (c) 16 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)18 herein. (c) 17 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)19 herein. (c) 18 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. See Exhibit 10(a)20 herein. (c) 19 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)21 herein. (c) 20 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)22 herein. (c) 21 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)23 herein. (c) 22 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)24 herein. (c) 23 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)25 herein. (c) 24 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. See Exhibit 10(a)26 herein. (c) 25 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. See Exhibit 10(a)27 herein. E-13 (c) 26 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (c) 27 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (c) 28 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a) 30 herein. (c) 29 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a)31 herein. (c) 30 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (c) 31 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (c) 32 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (c) 33 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (c) 34 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (c) 35 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. *(c) 36 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. See Exhibit 10(a) 59 herein. (c) 37 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. E-14 (c) 38 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (c) 39 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)41 herein. (c) 40 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)42 herein. (c) 41 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (c) 42 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)47 herein. (c) 43 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)48 herein. *(c) 44 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. See Exhibit 10(a)49 herein. (c) 45 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)50 herein. (c) 46 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. See Exhibit 10(a)51 herein. (c) 47 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. See Exhibit 10(a)52 herein. *(c) 48 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. See Exhibit 10(a)54 herein. *(a) 49 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. See Exhibit 10(a)55 herein. *(c) 50 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. See Exhibit 10(a)56 herein. E-15 *(c) 51 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)57 herein. *(c) 52 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)58 herein. GULF (d) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (d) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (d) 3 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (d) 4 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (d) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (d) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (d) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (d) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (d) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-16 (d) 10 - Agreement between GULF and AEC, effective August 1, 1985. (Designated in GULF's Form 10-K for the year ended December 31, 1985, File No. 0-2429, as Exhibit 10(g).) (d) 11 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (d) 12 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (d) 13 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. MISSISSIPPI (e) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (e) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (e) 3 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (e) 4 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984, and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (e) 5 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (e) 6 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (e) 7 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-17 (e) 8 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (e) 9 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (e) 10 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (e) 11 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. See Exhibit 10(a)45 herein. (e) 12 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (e) 13 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. SAVANNAH (f) 1 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. See Exhibit 10(a)3 herein. (f) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (f) 3 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (f) 4 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (f) 5 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (f) 6 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. E-18 (f) 7 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (f) 8 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. *(f) 9 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a) 57 herein. *(f) 10 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated December 15, 1992. See Exhibit 10(a)58 herein. (21) *SUBSIDIARIES OF REGISTRANTS - Contained herein at page IV-5. (23) CONSENTS OF EXPERTS AND COUNSEL SOUTHERN *(a) - The consent of Arthur Andersen & Co. is contained herein at page IV-6. ALABAMA *(b) - The consent of Arthur Andersen & Co. is contained herein at page IV-7. GEORGIA *(c) - The consent of Arthur Andersen & Co. is contained herein at page IV-8. GULF *(d) - The consent of Arthur Andersen & Co. is contained herein at page IV-9. MISSISSIPPI *(e) - The consent of Arthur Andersen & Co. is contained herein at page IV-10. SAVANNAH *(f) - The consent of Arthur Andersen & Co. is contained herein at page IV-11. E-19 (24) POWERS OF ATTORNEY AND RESOLUTIONS SOUTHERN *(a) - Power of Attorney and resolution. ALABAMA *(b) - Power of Attorney and resolution. GEORGIA *(c) - Power of Attorney and resolution. GULF *(d) - Power of Attorney and resolution. MISSISSIPPI *(e) - Power of Attorney and resolution. SAVANNAH *(f) - Power of Attorney and resolution. E-20

55454_1993.txt

55454_1993

1993

55454

ITEM 1. BUSINESS 1. General Kerr Group, Inc. (the "Registrant"), a Delaware corporation which was founded in 1903, currently operates in two business segments: the Plastic Products segment and the Consumer Products segment. Operations in the Plastic Products segment include the manufacture and sale of a variety of plastic products, including child- resistant closures, tamper-evident closures, prescription packaging products, jars, other closures and containers and the sale of glass prescription products (the "Plastic Products Business"). Operations in the Consumer Products segment include the manufacture and sale of caps and lids and the sale of glass jars and a line of pickling spice and pectin products for home canning (the "Home Canning Supplies Business"), which together with the sale of other related products, including iced tea tumblers and beverage mugs, constitutes the "Consumer Products Business." The Plastic Products Business and the Consumer Products Business are referred to herein as "Continuing Businesses". a. Principal Products and Markets; Sales and Customers The Plastic Products segment accounted for approximately 77% of the Registrant's total net sales in 1993. Plastic closures of the Plastic Products Segment are sold to customers in the pharmaceutical, food, distilled spirits, toiletries and cosmetics and household chemical industries. Plastic and glass prescription products are sold to drug wholesalers, drug chains and independent pharmacists. Plastic bottles and jars are sold to customers in the pharmaceutical and toiletries and cosmetics industries. Plastic products are sold nationally, principally by the Registrant's sales force. The Consumer Products Business accounted for approximately 23% of the Registrant's total net sales in 1993. The Home Canning Supplies Business represents substantially all of the Consumer Products Business. The Consumer Products Business sells its products primarily through food brokers to grocery retailers, food wholesalers and mass merchandisers. No customer accounted for more than 10% of the Registrant's net sales in 1993. b. Competition Competition in the markets in which the Plastic Products Business operates is highly fragmented and the Registrant has a number of large competitors with respect to its Plastic Products Business who compete for sales on the basis of price, service and quality of product. The Registrant believes that it is one of the three largest manufacturers of child-resistant plastic closures. The Registrant has one major competitor in the prescription products business, who has substantially larger market share than the Registrant. The Registrant also believes it is the largest manufacturer of plastic closures incorporating a tamper-evident feature for the liquor market and that it is one of the leading suppliers of single and double walled jars to the personal care and cosmetic markets. The Registrant's one major competitor in the Home Canning Supplies Business is Alltrista Corporation. The Registrant believes it has a significant share of the market for home canning caps, lids and jars. c. Backlog The Registrant does not believe that recorded sales backlog is a significant factor in its business. d. Raw Materials and Supplies; Fuel and Energy Matters The primary raw materials used by the Registrant's Plastic Products Business are resins. The Registrant has historically been able to obtain adequate supplies of these items from a number of sources. However, since resins are derived from petroleum or fossil fuel, shortages of petroleum or fossil fuel could affect the supply of resins. From time to time, the Registrant has experienced increases in the cost of resins. To the extent that the Registrant is unable to reflect such price increases in the price for products manufactured by it, increases in the cost of resins could have a significant impact on the results of the Registrant's operations. Currently, a majority of the sales of Plastic Products are made pursuant to agreements that provide for increases in the cost of resin to be passed on to the customer. The Registrant purchases glass jars for its Home Canning Business from a single supplier under a multi-year contract. The Registrant believes that it could obtain adequate supplies of glass jars from alternate sources at reasonable prices if its current supply was interrupted. In addition to glass jars, the primary raw material used by the Registrant's Home Canning Supplies Business in the manufacture of its caps and lids is tin-plate. During 1993, the Registrant was able to obtain adequate supplies of these items from a number of sources. e. Product Development, Engineering, Patents and Licensing The Registrant carries on a product development and engineering program with respect to its Plastic Products Business. Expenditures for such programs during the years ended December 31, 1993, 1992 and 1991 were approximately $2,000,000, $1,400,000 and $1,300,000, respectively. Although the Registrant owns a number of United States patents, including patents for its tamper-evident closures and certain of its child-resistant closures, it is of the opinion that no one or combination of these patents is of material importance to its business. The Registrant has granted licenses on some of its patents, although the income from these sources is not material. f. Environmental Matters; Legislation Several states have enacted recycling laws which require consumers to recycle certain items including containers. These mandatory recycling laws are not expected to have an adverse effect on the Registrant's business. The Registrant is subject to laws and regulations governing the protection of the environment, disposal of waste, discharges into water and emissions into the atmosphere. The Registrant's expenditures for environmental control equipment in each of the last three years have not been material and the standards required by such regulations have not significantly affected the Registrant's operations. g. Employees As of December 31, 1993, the Registrant had approximately 1,100 employees, of which approximately 280 were office, supervisory and sales personnel. h. Seasonality The Registrant's sales and earnings are usually higher in the second and third calendar quarters and lower in the first and fourth calendar quarters. Most of the sales by the Home Canning Supplies Business occur in the second and third calendar quarters. In addition, substantially all returns of home canning supplies occur in the fourth calendar quarter of each year. Because of the foregoing factors, the Registrant generally records a low level of profitability in the first and fourth calendar quarters. Demand for home canning supplies is adversely affected by poor crop growing conditions, such as occurred in 1993. The Registrant's Home Canning Supplies Business normally manufactures its inventory of caps and lids in anticipation of expected orders, and, consistent with practice followed in the industry, grants extended payment terms to home canning customers and accepts the return of unsold home canning merchandise in the fourth calendar quarter of each year. i. Working Capital In general, the working capital practices followed by the Registrant are typical of the businesses in which it operates. The seasonal nature of the Registrant's Home Canning Supplies Business requires periodic short-term borrowing by the Registrant. As of December 31, 1993, the Registrant had two unsecured $6,000,000 lines of credit with two banks to provide for the seasonal working capital needs of the Company. One of the lines of credit is committed through October 28, 1994 with borrowings to bear interest at either the prime rate of the lender or, alternatively, Eurodollar rate plus 2%. In addition, a facility fee of 0.5% per annum is charged on the unused amount of the commitment. The other line of credit is committed through September 30, 1994 with borrowings to bear interest at the prime rate of the lender. A facility fee of 0.75% per annum is charged on the total amount of this commitment. The lines of credit provide the Registrant with a source of working capital which the Registrant believes will be sufficient to meet its anticipated needs. 2. The Discontinued Businesses a. The Metal Crown Business On December 11, 1992, the Registrant sold substantially all of its assets (the "Sale of the Metal Crown Assets") relating to the manufacture and sale of metal crowns for beer and beverage bottles (the "Metal Crown Business") to Crown Cork & Seal Company, Inc. ("Crown Cork") pursuant to the terms of an asset purchase agreement for approximately $7,200,000 in cash. Included among the assets of the Metal Crown Business sold to Crown Cork were essentially all of the assets of the Registrant's Arlington, Texas plant. The Sale of the Metal Crown Assets was more fully described in the Registrant's Current Report on Form 8-K dated December 11, 1992 filed with the Securities and Exchange Commission. As a result of the Sale of the Metal Crown Assets, the Registrant no longer operates its Metal Crown Business. b. The Commercial Glass Container Business On February 28, 1992, the Registrant consummated the sale of substantially all of its assets (the "Sale of the Glass Container Assets") relating to the manufacture and sale of glass containers (the "Commercial Glass Container Business") to Ball Corporation pursuant to the terms of an asset purchase agreement for approximately $68,000,000 in cash. The Sale of the Glass Container Assets was more fully described in the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 (the "1991 10-K"). As a result of the Sale of the Glass Container Assets, the Registrant no longer operates its Commercial Glass Container Business. 3. Segment Information The Registrant's 1993 Annual Report to Stockholders contains on pages 29 and 30 additional financial information regarding each of the Registrant's two industry segments for each of the last three fiscal years required by Item 1 and such information is incorporated herein by reference. The Registrant's 1993 Annual Report to Stockholders contains on pages 34 through 36 Management's Discussion and Analysis of Financial Condition and Results of Operations and such information is incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES The Registrant's manufacturing activities with respect to its Continuing Businesses are conducted at the five facilities described in the following table. The Lancaster, Pennsylvania and Ahoskie, North Carolina facilities are owned by the Registrant. The Chicago, Illinois; Jackson, Tennessee and the Santa Fe Springs, California facilities are leased by the Registrant. The Registrant's principal executive offices are located at 1840 Century Park East, Los Angeles, California 90067, in approximately 26,000 square feet of leased space. In addition, the Registrant rents three area sales offices and one warehouse. During 1994, the Registrant will relocate its home canning cap and lid manufacturing operations from Chicago, Illinois to a new, leased 168,000 square foot manufacturing facility in Jackson, Tennessee and permanently cease operations in its leased facility in Chicago. In the opinion of the Registrant's management, its manufacturing facilities are suitable and adequate for the purposes for which they are being used. The Registrant owns land and buildings used in connection with a former glass container manufacturing plant that are being held for sale. In addition, pursuant to a sublease dated January 6, 1992, Fluidmaster, Inc., a California corporation, subleases a 28,000 square foot manufacturing facility located in Santa Fe Springs, California from a wholly-owned subsidiary of the Registrant. Prior to 1992, the Registrant manufactured custom molded plastic parts at this facility. In 1993, the Registrant's plastic products manufacturing facilities operated at approximately 83% of capacity, and the home canning cap and lid manufacturing facility operated at approximately 76% of capacity. ITEM 3. ITEM 3. LEGAL PROCEEDINGS As the Registrant reported in its Quarterly Report on Form 10-Q for the quarter ended June 30, 1990, in February 1986, the Registrant was advised by the United States Environmental Protection Agency ("EPA") that Phoenix Closures, Inc. ("Phoenix") was one of several companies which disposed of wastes at the American Chemical Services ("ACS") site located near Griffith, Indiana. The EPA indicated that the wastes were disposed of by Phoenix's Chicago plant between 1955 and 1975. The Registrant has advised the EPA that it did not lease the Chicago plant during the period from 1955 to 1975. The Registrant has also advised Phoenix of its responsibilities with respect to environmental matters, including the environmental matters at the ACS site, under the lease relating to the Chicago plant. As the Registrant reported in its Quarterly Report on Form 10-Q for the quarter ended June 30, 1990, in March 1986, the Registrant and other parties were designated by the EPA as potentially responsible parties ("PRPs") responsible for the cleanup of certain hazardous wastes that have been disposed of at the Wayne Waste Oil ("WWO") site located near Columbia City, Indiana. In October 1986, the Registrant and other PRPs entered into a Consent Order with the EPA which allowed the PRPs to complete a Remedial Investigation and Feasibility Study ("RI/FS") for the WWO site. In March 1990, the EPA issued a Record of Decision ("ROD") for the site. The ROD documents the EPA's cleanup plan for the site, which includes capping the former municipal landfill, groundwater extraction and treatment, and soil vapor extraction. On July 20, 1992, a Consent Decree between the EPA and the PRPs at the site was entered in the United States District Court for the Northern District of Indiana, captioned United States v. Active Products Corp., No.-00247. Based upon the Registrant's percentage share of the total amount of wastes disposed of at the WWO site, the Registrant estimates its share of the costs under the Consent Decree will be approximately $109,000. A reserve has been established for such costs. As the Registrant reported in its Quarterly Report on Form 10-Q for the quarter ended June 30, 1990, on April 12, 1990, the State of New Jersey, Department of Environmental Protection and Energy ("NJDEPE"), filed a lawsuit in the United States District Court for the District of New Jersey against the Registrant, among others, entitled State of New Jersey, Department of Environmental Protection v. Gloucester Environmental Management Services, Inc., et al., No. 84-0152 (D.N.J.). The suit alleges that the Registrant was a "generator" of hazardous wastes and other hazardous substances which were disposed of at the Gloucester Environmental Management Services, Inc. ("GEMS") facility in the Township of Gloucester. The suit seeks cleanup costs, compensatory and treble damages, and a declaration that the Registrant and others are responsible for NJDEPE's past and future response costs at the GEMS site. On March 27, 1990, NJDEPE issued a Directive to the Registrant and other parties pursuant to the New Jersey Spill Compensation and Control Act, N.J.S.A. 58:10-23.11 et seq. Pursuant to the Directive, the Registrant and other parties have been ordered to undertake the second phase of remedial action at the site, including the construction and operation of a groundwater treatment system and operation of the remedial action performed in the first phase, and to reimburse NJDEPE's alleged past and future response costs. The estimated cost of second phase remedial action related to the GEMS site is approximately $20 million. The amount that the NJDEPE is seeking as reimbursement for past costs and damages is approximately $10 million. Notwithstanding the issuance of the Directive by the NJDEPE, the Registrant believes that it has no material liability with respect to the GEMS site because the only reason it has been named as a defendant (there are over 550 named defendants) is that a transporter that was used by the Registrant is known to have disposed of waste at the site. However, there is no evidence that any waste disposed of at the site by such transporter was waste of the Registrant and the Registrant has a motion for summary judgment pending in which it seeks dismissal from the case on these grounds. If such motion is granted, the Registrant would have a good faith basis to not comply with the Directive. The Registrant does not believe that any of its waste was disposed of at the site. One of the Registrant's insurance carriers has agreed to defend the current lawsuit and has funded the Registrant's participation in settlement efforts, which may result in the Registrant's dismissal from the lawsuit for a payment of approximately $100,000. Participation in the settlement will not be considered an admission of liability for the disposal of waste at the site. A reserve has been established for such costs. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below are the names, ages, positions and offices held, and a brief account of the business experience during the past five years of each executive officer of the Registrant. Business Experience Roger W. Norian has served in an executive capacity with the Registrant for more than the past five years. Norman N. Broadhurst joined the Registrant in 1988 as Senior Vice President, General Manager, Consumer Products. Prior to that time he was President and Chief Operating Officer of the Famous Amos Chocolate Chip Cookie Corporation and Vice President, Marketing, Beatrice Companies, Inc. Robert S. Reeves has served in an executive capacity with the Registrant for more than the past five years. D. Gordon Strickland has served in an executive capacity with the Registrant for more than the past five years. J. Stephen Grassbaugh has served in an executive capacity with the Registrant for more than the past five years. John F. Thelen joined the Registrant in 1993 as Vice President, Employee Relations. Prior to that time he was Vice President, Compensation, Benefits and Human Resource Information Systems of Mattel, Inc. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Registrant's Annual Report to Stockholders for the year ended December 31, 1993, contains on page 12 the information required by Item 5 of Form 10-K and such information is incorporated herein by this reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993, contains on pages 32 and 33 the information required by Item 6 of Form 10-K and such information is incorporated herein by this reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993, contains on pages 34 through 36 the information required by Item 7 of Form 10-K and such information is incorporated herein by this reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993, contains on pages 12 through 31 the information required by Item 8 of Form 10-K and such information is incorporated herein by this reference. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Certain of the information required by Item 10 of Form 10-K is included in a separate item captioned "Executive Officers of the Registrant" in Part I of this Form 10-K. With respect to reports required to be filed pursuant to Section 16(a) of the Securities Exchange Act of 1934 regarding the Registrant's common stock, par value $.50 per share, the Registrant believes that, based solely on a review by the Registrant of copies of such reports received by it, during its fiscal year 1993, all filing requirements of Section 16(a) with respect to its common stock were complied with. The Registrant's Proxy Statement to be used in connection with the Annual Meeting of Stockholders to be held on April 26, 1994 contains on pages 2 through 6 the remaining information required by Item 10 of Form 10-K and such information is incorporated herein by this reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Registrant's Proxy Statement to be used in connection with the Annual Meeting of Stockholders to be held on April 26, 1994 contains on pages 7 through 10 the information required by Item 11 of Form 10-K, and such information is incorporated herein by this reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Registrant's Proxy Statement to be used in connection with the Annual Meeting of Stockholders to be held on April 26, 1994 contains on pages 2 through 4 the information required by Item 12 of Form 10-K, and such information is incorporated herein by this reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Registrant's Proxy Statement to be used in connection with the Annual Meeting of Stockholders to be held on April 26, 1994 contains on page 12 the information required by Item 13 of Form 10-K, and such information is incorporated herein by this reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a. (i) Financial Statements The Financial Statements and related financial data contained in the Registrant's Annual Report to Stockholders for the year ended December 31, 1993, on pages 13 through 33 thereof and the Independent Auditors' Report on page 12 of the Registrant's Annual Report to Stockholders for the year ended December 31, 1993, are incorporated herein by reference. With the exception of information specifically incorporated by reference, however, the Registrant's Annual Report to Stockholders for the year ended December 31, 1993 is not to be deemed filed as a part of this report. Consolidated Financial Statements: Consolidated Statements of Earnings (Loss) for the years ended December 31, 1993, 1992 and 1991. Consolidated Balance Sheets as of December 31, 1993 and 1992. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Common Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. In addition to such Consolidated Financial Statements and Independent Auditors' Report, the following are included herein: Independent Auditors' Report on Supporting Schedules, page 21. Schedules for the three years ended December 31, 1993: All other Schedules have been omitted as inapplicable, or not required, or because the required information is included in the Consolidated Financial Statements or the notes thereto. (ii) Exhibits The Registrant has no additional long-term debt instruments in which the total amount of securities authorized under any instrument exceeds 10% of total assets of the Registrant and its subsidiaries on a consolidated basis. The Registrant hereby agrees to furnish a copy of any such long-term debt instrument upon the request of the Securities and Exchange Commission. b. Reports on Form 8-K On October 19, 1993, the Registrant filed a Form 8-K Current Report announcing its intention to call for redemption on December 15, 1993 all of the Registrant's outstanding 13% Subordinated Notes Due December 15, 1996. 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. KERR GROUP, INC. By: Roger W. Norian ------------------------------- Roger W. Norian, Chairman President and Chief Executive Officer Dated: March 29, 1994 Los Angeles, California 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. INDEPENDENT AUDITOR'S REPORT To the Stockholders and Board of Directors of Kerr Group, Inc.: Under date of February 23, 1994, we reported on the consolidated balance sheets of Kerr Group, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of earnings (loss), common stockholders' 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 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 supplementary financial statement schedules as listed in Item 14a(i). These supplementary financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these supplementary financial statement schedules based on our audits. In our opinion, such supplementary financial statement schedules, when considered in relation to the basic consolidated financial statement taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG Peat Marwick Los Angeles, California February 23, 1994 SCHEDULE II KERR GROUP, INC. Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties Three years ended December 31, 1993 (in thousands) (a) Includes both note receivable and related accrued interest. The loan accrued interest at an annual rate of 9.23%. On February 28, 1992, $400,000 of remaining principal and $128,319 of related accrued interest was forgiven by the Registrant. (b) Consists of two loans dated January 16, 1990 and June 11, 1991 in the original amount of $30,000 and $100,000, respectively, and related accrued interest. The principal of the loan dated January 16, 1990 is to be paid in six equal annual installments in 1991 through 1996, however, on January 1, 1992, $15,000 of principal was forgiven by the Registrant. This loan bears interest at 6% annually and accrued interest is paid annually. The principal and related accrued interest of the loan dated June 11, 1990 is to be paid in 1996. This loan bears interest at 7.76% per annum. SCHEDULE V KERR GROUP, INC. Property, Plant and Equipment Three years ended December 31, 1993 (in thousands) 1.) Amounts for property, plant and equipment presented in the table above are related to continuing operations only. Property, plant and equipment associated with the Commercial Glass Container Business and Metal Crown Business of the Registrant in 1991 and 1992 has been reported as a component of net non-current assets related to discontinued operations in the Registrant's Consolidated Balance Sheets. 2.) As to Column E, which is omitted, the answers are "None". SCHEDULE VI KERR GROUP, INC. Accumulated Depreciation and Amortization of Property, Plant and Equipment Three years ended December 31, 1993 (in thousands) 1.) Amounts for accumulated depreciation and amortization of property, plant and equipment presented in the table above are related to continuing operations only. Accumulated depreciation and amortization of property, plant and equipment associated with the Commercial Glass Container Business and Metal Crown Business of the Registrant in 1991 and 1992 has been reported as a component of net non- current assets related to discontinued operations in the Registrant's Consolidated Balance Sheets. 2.) See note 1 of notes to Consolidated Financial Statements for description of the Registrant's depreciation policy. 3.) As to Column E, which is omitted, the answers are "None". SCHEDULE VIII KERR GROUP, INC. Valuation and Qualifying Accounts Three years ended December 31, 1993 (in thousands) Note: Allowance for doubtful accounts presented in the table above is related to continuing operations only. Allowance for doubtful accounts associated with the Commercial Glass Container Business and Metal Crown Business of the Registrant in 1991 and 1992 has been reported as a component of net current assets related to discontinued operations in the Registrant's Consolidated Balance Sheets. (a) These deductions represent uncollectible amounts charged against the reserve. SCHEDULE X KERR GROUP, INC. Supplementary Income Statement Information Three years ended December 31, 1993 (in thousands) Note: Income statement information presented in the table above are for the Registrant's continuing operations. * Less than 1% of annual net sales from continuing operations. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 KERR GROUP, INC. FORM 10-K for year ended December 31, 1993 INDEX TO EXHIBITS FILED SEPARATELY WITH FORM 10-K

40867_1993.txt

40867_1993

1993

40867

Item 1. Business GTE North Incorporated (the Company) was incorporated in Wisconsin on January 27, 1987 and was the successor to the merger of eight telephone companies into the Company on March 31, 1987. All of the Common Stock of the Company was owned by GTE Corporation (GTE). Prior to March 31, 1993, the Company provided communication services in the states of Ilinois, Indiana, Iowa, Michigan, Minnesota, Missouri, Nebraska, Ohio, Pennsylvania and Wisconsin. On March 31, 1993, the Company transferred its assets and operations in Iowa, Minnesota, Missouri and Nebraska to GTE Midwest Incorporated, which is a wholly-owned subsidiary of GTE (the Midwest Transfer). Contel North Incorporated was incorporated in Wisconsin on June 22, 1992. Prior to April 1, 1993, Contel North Incorporated had no business operations and no material assets. On April 1, 1993, the Company, along with Contel of Illinois, Inc., Contel of Indiana, Inc. and Contel of Pennsylvania, Inc. (the Contel Subsidiaries), merged with and into Contel North Incorporated. On April 2, 1993, Contel North Incorporated changed its name to GTE North Incorporated. The Contel Subsidiaries were wholly-owned subsidiaries of GTE. They provided communication services in the states of Illinois, Indiana and Pennsylvania. The Contel Subsidiaries were, individually and in the aggregate, significantly smaller in terms of operating revenues, net income and total assets than the Company prior to the Midwest Transfer. There is no public trading market for the Common Stock of the Company because all of the Common Stock is owned by GTE, a New York corporation. The Company has one wholly-owned subsidiary, GTW Telephone Systems Incorporated, which markets and services telecommunications customer premises equipment. The Company provides local telephone service within its franchise areas and intraLATA (Local Access Transport Area) long distance service between the Company's facilities and the facilities of other telephone companies within the Company's LATAs. InterLATA service to other points in and out of the states in which the Company operates is provided through connection with interexchange (long distance) common carriers. These common carriers are charged fees (access charges) for interconnection to the Company's local facilities. End user business and residential customers are also charged access charges for access to the facilities of the long distance carriers. The Company also earns other revenues by leasing interexchange plant facilities and providing such services as billing and collection and operator services to interexchange carriers, primarily the American Telephone and Telegraph Company (AT&T). The number of access lines served has grown steadily from 3,537,907 on January 1, 1989 to 4,031,547 on December 31, 1993. The following table denotes the access lines in the states in which the Company operates as of December 31, 1993: Access State Lines Served ------------ ------------- Ohio 763,545 Indiana 838,220 Illinois 787,016 Michigan 605,126 Pennsylvania 598,781 Wisconsin 438,859 ------------ Total 4,031,547 ============ The Company's principal line of business is providing telecommunication services. These services fall into five major classes: local network, network access, long distance, equipment sales and services, and other. Revenues from each of these classes over the last three years are as follows: Years Ended December 31 --------------------------------------------- 1993 1992 1991 ----- ---- ---- (Thousands of Dollars) Local Network Services $ 980,039 $ 945,175 $ 916,302 % of Total Revenues 38% 37% 36% Network Access Services $ 963,918 $ 973,661 $ 966,500 % of Total Revenues 37% 38% 39% Long Distance Services $ 391,050 $ 332,150 $ 319,674 % of Total Revenues 15% 13% 13% Equipment Sales and Services $ 106,288 $ 103,607 $ 127,485 % of Total Revenues 4% 4% 5% Other $ 160,952 $ 205,449 $ 175,026 % of Total Revenues 6% 8% 7% Telephone Competition At December 31, 1993, the Company had 17,382 employees. In 1993, agreements were reached on six contracts with the International Brotherhood of Electrical Workers (IBEW), two contracts with the Communication Workers of America (CWA) and one contract with the Bakers, Confectioners and Chocolate Workers (BCT). During 1994, five contracts with the IBEW and one contract with the CWA will expire. The Company holds franchises, licenses and permits adequate for the conduct of its business in the territory which it serves. The Company is subject to regulation by the regulatory bodies of the states of Illinois, Indiana, Michigan, Ohio, Pennsylvania and Wisconsin as to its intrastate business operations and by the Federal Communications Commission (FCC) as to its interstate business operations. Information regarding the Company's activities with the various regulatory agencies and revenue arrangements with other telephone companies can be found in Note 11 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. The year was marked by important changes in the U.S. telecommunications industry. Rapid advances in technology, together with government and industry initiatives to eliminate certain legal and regulatory barriers are accelerating and expanding the level of competition and opportunities available to the Company. As a result, the Company faces increasing competition in virtually all aspects of its business. Specialized communications companies have constructed new systems in certain markets to bypass the local exchange network. Additional competition from interexchange carriers as well as wireless companies continues to evolve for both intrastate and interstate communications. During 1994, the Company will begin implementation of a re-engineering plan that will redesign and streamline processes. Implementation of its re- engineering plan will allow the Company to continue to respond aggressively to these competitive and regulatory developments through reduced costs, improved service quality, competitive prices and new product offerings. Moreover, implementation of this program will position the Company to accelerate delivery of a full array of voice, video and data services. The re-engineering program will be implemented over three years. During the year, the company continued to introduce new business and consumer services utilizing advanced technology, offering new features and pricing options while at the same time reducing costs and prices. During 1993, the FCC announced its decision to auction licenses during 1994 in 51 major markets and 492 basic trading areas across the United States to encourage the development of a new generation of wireless personal communications services (PCS). These services will both complement and compete with the Company's traditional wireline services. The Company will be permitted to fully participate in the license auctions in areas outside of GTE's existing cellular service areas. Limited participation will be permitted in areas in which GTE has an existing cellular presence. In 1992, the FCC issued a "video dialtone" ruling that allows telephone companies to transmit video signals over their networks. The FCC also recommended that Congress amend the Cable Act of 1984 to permit telephone companies to supply video programming in their service areas. Activity directed toward changing the traditional cost-based rate of return regulatory framework for intrastate and interstate telephone services has continued. Various forms of alternative regulation have been adopted, which provide economic incentives to telephone service providers to improve productivity and provide the foundation for the pricing flexibility necessary to address competitive entry into the markets the Company serves. In September 1993, the FCC released an order allowing competing carriers to interconnect to the local-exchange network for the purpose of providing switched access transport services. This ruling complements similar interconnect arrangements for private line services ordered during 1992. The order encourages competition for the transport of telecommunications traffic between local exchange carriers' (LECs) switching offices and interexchange carrier locations. In addition, the order allows LECs flexibility in pricing competitive services. The GTE Consent Decree, which was issued in connection with the 1983 acquisition of GTE Sprint (since divested) and GTE Spacenet, prohibits GTE's domestic telephone operating subsidiaries from providing long distance service beyond the boundaries of the LATA. This prohibition restricts their direct provision of long distance service to relatively short distances. The degree of competition allowed in the intraLATA market is subject to state regulation. However, regulatory constraints on intraLATA competition are gradually being relaxed. In fact, some form of intraLATA competition is authorized in many of the states in which the Company provides service. These and other actions to eliminate the existing legal and regulatory barriers, together with rapid advances in technology, are facilitating a convergence of the computer, media and telecommunications industries. In addition to allowing new forms of competition, these developments are also creating new opportunities to develop interactive communications networks. The Company supports these initiatives to assure greater competition in telecommunications, provided that overall the changes allow an opportunity for all service providers to participate equally in a competitive marketplace under comparable conditions. Item 2. Item 2. Properties The Company's property consists of network facilities (81%), company facilities (13%), customer premises equipment (3%) and other (3%). From January 1, 1989 to December 31, 1993, the Company made gross property additions in the amount of $2.8 billion and property retirements of $1.7 billion. Substantially all of the Company's property is subject to liens securing long-term debt. In the opinion of management, the Company's telephone plant is substantially in good repair. Item 3. Item 3. Legal Proceedings There are no pending legal proceedings, either for or against the Company, which would have a material impact on the Company's financial statements. 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 Market information is omitted since the Company's common stock is wholly-owned by GTE Corporation. Item 6. Item 6. Selected Financial Data Reference is made to the Registrant's Annual Report to Shareholders, page 32, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to the Registrant's Annual Report to Shareholders, pages 27 to 31, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 8. Item 8. Financial Statements and Supplementary Data Reference is made to the Registrant's Annual Report to Shareholders, pages 5 to 25, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. 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 names, ages and positions of all the directors and executive officers of the Company as of March 21, 1994, are listed below along with their business experience during the past five years. a. Identification of Directors Director Name Age Since Business Experience - --------------- ---- -------- ------------------------------------------ Kent B. Foster 50 1993 Vice Chairman of the Board of Directors of GTE Corporation, October 1993. President, GTE Telephone Operations, 1989; Director, GTE Corporation, 1992; Director, all GTE domestic telephone subsidiaries, 1993; Director, BC Telecom, Inc.; Director, Compania Anonima Nacional Telefonos de Venezuela; Director, National Bank of Texas. Richard M. Cahill 55 1993 Vice President - General Counsel of GTE Telephone Operations, 1988; Director, all GTE domestic telephone subsidiaries, 1993; Director, GTE Vantage Incorporated, 1991; Director, GTE Intelligent Network Services Incorporated, 1993. Gerald K. Dinsmore 44 1993 Senior Vice President - Finance and Planning for GTE Telephone Operations, 1994. Vice President - Finance, GTE Telephone Operations, 1993; Vice President - Intermediary Customer Markets, GTE Telephone Operations, 1991. President, South Area, GTE Telephone Operations, 1992; Director, all GTE domestic telephone subsidiaries, 1993. Michael B. Esstman 47 1993 Executive Vice President-Operations, GTE Telephone Operations, 1993; President, Central Area, GTE Telephone Operations, 1991. President, Contel Eastern Region, Telephone Operations Sector, 1983; Director, AG Communications System; Director, all GTE domestic telephone subsidiaries, 1993. Earl A. Goode 53 1991 President, GTE North Incorporated; Various positions with GTE including President - GTE Southwest and Vice President - General Manager/Wisconsin; Director, Legacy Fund, COMMIT, NBD Financial Corporation, Indiana State Symphony Society, United Way of Central Indiana, Goodwill Industries of Central Indiana, Indianapolis Chamber of Commerce, Indianapolis Community Hospital Foundation, Indiana Fiscal Policy Institute, National Art Museum of Sport, Corporate Community Council and the Georgetown College Foundation Board; Executive Committee, GTE North Classic; President's Advisory Council, Purdue University; Dean's Advisory Council, Purdue University Krannert School of Management and the State of Indiana Commission for Higher Education. Thomas W. White 47 1993 Executive Vice President of GTE Telephone Operations, 1993; Senior Vice President - General Office Staff, GTE Telephone Operations, 1989; Director, all GTE domestic telephone subsidiaries, 1993; Director, Quebec-Telephone. Directors are elected annually. The term of each director expires on the date of the next annual meeting of shareholders, which may be held on any day during March, as specified in the notice of the meeting. There are no family relationships between any of the directors or executive officers of the Company. All of the directors, with the exception of Mr. Goode, were elected December 16, 1993 following the resignations from the Board of Raymond C. Burroughs, Gilbert L. Homstad, James C. McGill, Don W. Montgomery, James D. Reigle, Ian M. Rolland, Donald E. Smith and Jane Theuerkauf. Long-Term Incentive Plan - Awards in Last Fiscal Year The GTE Long-Term Incentive Plan (LTIP) provides for awards, currently in the form of stock options with tandem stock appreciation rights and cash bonuses, to participating employees. The stock options and stock appreciation rights awarded under the LTIP to the five most highly compensated individuals in 1993 are shown in the table on page 10. Under the LTIP, performance bonuses are paid in cash based on the achievement of pre-established goals for GTE's return on equity (ROE) over a three-year award cycle. Performance bonuses are denominated in units of GTE Common Stock ("Common Stock Units") and are maintained in a Common Stock Unit Account. At the time performance targets are established for the three-year cycle, a Common Stock Unit Account is set up for each participant who is eligible to receive a cash award under the LTIP. An initial dollar amount for each account is determined based on the competitive performance bonus grant practices of other major companies in the telecommunications industry and with other selected corporations that are comparable to GTE in terms of revenue, market value and other quantitative measures. That amount is then divided by the average market price of GTE Common Stock for the calendar week preceding the day the account is established to determine the number of Common Stock Units in the account. The value of the account increases or decreases based on the market price of the GTE Common Stock. An amount equal to the dividends declared on an equivalent number of shares of GTE Common Stock is added each time a dividend is paid. This amount is then converted into the number of Common Stock Units obtained by dividing the amount of the dividend by the average price of the GTE Common Stock on the composite tape of the New York Stock Exchange on the dividend payment date and added to the Common Stock Unit Account. Messrs. Goode and Foster are the only individuals of the five most highly compensated individuals eligible to receive a cash award under the LTIP. The number of Common Stock Units initially allocated in 1993 to their accounts and estimated future payouts under the LTIP are shown in the following table. Executive Agreements GTE has entered into agreements (the Agreements) with Messrs. Goode and Foster regarding benefits to be paid in the event of a change in control of GTE (a "Change in Control"). A Change in Control is deemed to have occurred if a majority of the members of the Board do not consist of members of the incumbent Board (as defined in the Agreements) or if, in any 12-month period, three or more directors are elected without the approval of the incumbent Board. An individual whose initial assumption of office occurred pursuant to an agreement to avoid or settle a proxy or other election contest is not considered a member of the incumbent Board. In addition, a director who is elected pursuant to such a settlement agreement will not be deemed a director who is elected or nominated by the incumbent Board for purposes of determining whether a Change in Control has occurred. A Change in Control will not occur in the following situations: (1) certain merger transactions in which there is at least 50% GTE shareholder continuity in the surviving corporation, at least a majority of the members of the board of directors of the surviving corporation consists of members of the Board of GTE and no person owns more than 20% (or under certain circumstances, a lower percentage, not less than 10%) of the voting power of the surviving corporation following the transaction, and (2) transactions in which GTE's securities are acquired directly from GTE. The Agreements provide for benefits to be paid in the event this individual separates from service and has a "good reason" for leaving or is terminated without "cause" within two years after a Change in Control of GTE. Good reason for leaving includes but is not limited to the following events: demotion, relocation or a reduction in total compensation or benefits, or the new entity's failure to expressly assume obligations under the Agreements. Termination for cause includes certain unlawful acts on the part of the executive or a material violation of his or her responsibilities to the Corporation resulting in material injury to the Corporation. An executive who experiences a qualifying separation from service will be entitled to receive up to two times the sum of (i) base salary and (ii) the average of his or her other percentage awards under the EIP for the previous three years. The executive will also continue to receive medical and life insurance coverage for up to two years and will be provided with financial and outplacement counseling. In addition, the Agreements with Messrs. Goode and Foster provide that in the event of a separation from service, they will receive service credit in the following amounts: two times years of service otherwise credited if the executive has five or fewer years of credited service; 10 years if credited service is more than five and not more than 10 years; and, if the executive's credited service exceeds 10 years, the actual number of credited years of service. These additional years of service will apply towards vesting, retirement eligibility, benefit accrual and all other purposes under the Supplemental Executive Retirement Plan and the Executive Retired Life Insurance Plan. In addition, each executive will be considered to have not less than 76 points and 15 years of accredited service for the purpose of determining his or her eligibility for early retirement benefits. However, there will be no duplication of benefits. The Agreements remain in effect until the earlier of July 1 of each successive year or the date on which the executive reaches age 65, unless the Agreement is terminated earlier pursuant to its terms. The Agreements will be automatically renewed on each successive July 1 unless, not later than December 31 of the preceding year, one of the parties notifies the other that he does not wish to extend the Agreement. If a Change in Control occurs, the Agreements will remain in effect until the obligations of GTE (or its successor) under the Agreements have been satisfied. Retirement Programs Pension Plans The estimated annual benefits payable, calculated on a single life annuity basis, under GTE's defined benefit pension plans at normal retirement at age 65, based upon final average earnings and years of employment, are illustrated in the table below: PENSION PLAN TABLE Years of Service Final Average -------------------------------------------------------------- Earnings 15 20 25 30 35 - ------------------------------------------------------------------------------ $ 150,000 $ 31,604 $ 42,138 $ 52,672 $ 63,207 $ 73,742 200,000 42,479 56,638 70,797 84,957 99,117 300,000 64,229 85,638 107,048 128,457 149,867 400,000 85,979 114,638 143,298 171,957 200,617 500,000 107,729 143,638 179,548 215,457 251,367 600,000 129,479 172,638 215,798 258,957 302,117 700,000 151,229 201,638 252,048 302,457 352,867 800,000 172,979 230,638 288,298 345,957 403,617 900,000 194,729 259,638 324,548 389,457 454,367 1,000,000 216,479 288,638 360,798 432,957 505,117 1,200,000 259,979 346,638 433,298 519,957 606,617 GTE Service Corporation, a wholly-owned subsidiary of GTE, maintains a noncontributory pension plan for the benefit of GTE employees based on years of service. Pension benefits to be paid from this plan and contributions to this plan are related to basic salary exclusive of overtime, differentials, incentive compensation (except as otherwise described) and other similar types of payment. Under this plan, pensions are computed on a two-rate formula basis of 1.15% and 1.45% for each year of service, with the 1.15% service credit being applied to that portion of the average annual salary for the five highest consecutive years that does not exceed the Social Security Integration Level (the portion of salary subject to the Federal Security Act), and the 1.45% service credit being applied to that portion of the average annual salary that exceeds said level. As of March 21, 1994, the credited years of service under the plan for Messrs. Goode, Foster, Keith, Blanchard and Zeilke are 31, 23, 27, 31 and 22, respectively. Under Federal law, an employee's benefits under a qualified pension plan such as the GTE Service Corporation plan are limited to certain maximum amounts. GTE maintains a Supplemental Executive Retirement Plan (SERP), which supplements the benefits of any participant in the qualified pension plan by direct payment of a lump sum or by an annuity, on an unfunded basis, of the amount by which any participant's benefits under the GTE Service Corporation pension plan are limited by law. In addition, the SERP includes a provision permitting the payment of additional retirement benefits determined in a similar manner as under the qualified pension plan on remuneration accrued under management incentive plans as determined by the Executive Compensation and Organizational Structure Committee. Executive Retired Life Insurance Plan The Executive Retired Life Insurance Plan (ERLIP) provides Messrs. Goode, Foster, Keith, Blanchard and Zeilke a maximum postretirement life insurance benefit of three times final base salary. Upon retirement, ERLIP benefits may be paid as life insurance or optionally, an equivalent amount may be paid as a lump sum payment equal to the present value of the life insurance amount (based on actuarial factors and the interest rate then in effect), as an annuity or as installment payments. If an optional payment method is selected, the ERLIP benefit will be based on the actuarial equivalent of the present value of the insurance amount. Directors' Compensation The current directors, all of whom are employees of GTE, are not paid any fees or remuneration, as such, for service on the Board. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners as of February 28, 1994: Name and Shares of Title Address of Beneficial Percent of Class Beneficial Owner Ownership of Class --------------- ---------------------- ------------ ------------- Common Stock of GTE Corporation 978,351 100% GTE North One Stamford Forum shares of Incorporated Stamford, Connecticut record (b) Security Ownership of Management as of December 31, 1993: Common Stock of Name of Director or Nominee All less GTE Corporation ---------------------------- than 1% Richard M. Cahill 37,188 Gerald K. Dinsmore 18,503 Michael B. Esstman 54,051 Thomas W. White 83,071 Earl A. Goode 56,634 Kent B. Foster 168,299 ------- 417,746 ======= Executive Officers(1)(2) --------------------------- Earl A. Goode 56,634 Kent B. Foster 168,299 M. L. Keith, Jr. 9,904 James D. Blanchard 17,933 William A. Zielke 15,283 ------- 268,053 ======= All directors and executive officers as a group(1)(2) 824,013 ======= (1) Includes shares acquired through participation in GTE's Consolidated Employee Stock Ownership Plan and/or the GTE Savings Plan. (2) Included in the number of shares beneficially owned by Messrs. Goode, Foster, Keith, Blanchard and Zeilke and all directors and executive officers as a group are 48,833; 115,583; 7,132; 7,300; 14,278 and 559,603 shares, respectively, which such persons have the right to acquire within 60 days pursuant to stock options. (c) There were no changes in control of the Company during 1993. Item 13. Item 13. Certain Relationships and Related Transactions The Company`s executive officers or directors were not materially indebted to the Company or involved in any material transaction in which they had a direct or indirect material interest. None of the Company's directors were involved in any business relationships with the Company. 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 Registrant's Annual Report to Shareholders, pages 5 - 25 for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Report of Independent Public Accountants. Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Income for the years ended December 31, 1993-1991. Consolidated Statements of Reinvested Earnings for the years ended December 31, 1993-1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993-1991. Notes to Consolidated Financial Statements. (2) Financial Statement Schedules - Included in Part IV of this report for the years ended December 31, 1993-1991: Page(s) --------- Report of Independent Public Accountants 21 Schedules: V - Property, Plant and Equipment 22-24 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 25 VIII - Valuation and Qualifying Accounts 26 X - Supplementary Income Statement Information 27 Note: Schedules other than those listed above are omitted as not applicable, not required, or the information is included in the financial statements or notes thereto. (3) Exhibits - Included in this report or incorporated by reference. 3* Bylaws. Articles of Incorporation and amendments are referenced in the 1986 and 1987 Form 10-K's, respectively. 13 Annual Report to Shareholders for the year ended December 31, 1993, filed herein as Exhibit 13. (b) Reports on Form 8-K - No reports on Form 8-K were filed during the fourth quarter of 1993. - ---------- * Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To GTE North Incorporated: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in GTE North Incorporated and subsidiary's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 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 in 1992 as discussed in Note 1 to the consolidated financial statements. Our audit was made for the purpose of forming an opinion on those 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 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. Dallas, Texas January 28, 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. GTE NORTH INCORPORATED ---------------------- (Registrant) Date March 21, 1994 By EARL A. GOODE --------------------- ----------------------------- EARL A. GOODE President Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EARL A. GOODE President and Director March 21, 1994 - ----------------------- (Principal Executive Officer) EARL A. GOODE GERALD K. DINSMORE Senior Vice President - Finance March 21, 1994 - ------------------------ and Planning and Director GERALD K. DINSMORE (Principal Financial Officer) WILLIAM M. EDWARDS, III Controller March 21, 1994 - ------------------------ (Principal Accounting Officer) WILLIAM M. EDWARDS, III RICHARD M. CAHILL Director March 21, 1994 - ------------------------ RICHARD M. CAHILL MICHAEL B. ESSTMAN Director March 21. 1994 - ----------------------- MICHAEL B. ESSTMAN KENT B. FOSTER Director March 21, 1994 - ----------------------- KENT B. FOSTER THOMAS W. WHITE Director March 21, 1994 - ---------------------- THOMAS W. WHITE

51434_1993.txt

51434_1993

1993

51434

ITEM 1. BUSINESS GENERAL International Paper Company,* a New York corporation incorporated in 1941 as the successor to the New York corporation of the same name organized in 1898, is a worldwide producer of printing and writing papers, paperboard and packaging, wood products and distributes paper and office supply products in both the United States and Europe. It also produces pulp, laminated products, and specialty products, including photosensitive films and papers, nonwovens, chemicals and minerals. In the United States, the Company operates 26 pulp and paper mills, 54 converting and packaging plants, 43 wood products facilities, 15 specialty panels and laminated products plants, six nonwoven products facilities and seven envelope plants. Production facilities in Europe, Asia, Latin America and Canada include 14 pulp and paper mills, 32 converting and packaging plants, three wood products facilities, three specialty panels and laminated products plants and five nonwoven products facilities. The Company distributes fine paper, printing and industrial products and building materials, primarily manufactured by other companies, through about 255 distribution branches located primarily in the United States. In addition, the Company produces photosensitive films and papers and photographic equipment (three U.S. and six international locations) and specialty chemicals (seven U.S. and two international locations), and engages in domestic oil and gas and real estate activities. In March 1994, the Company, through a subsidiary, acquired approximately one-half of Brierley Investments Limited's (Brierley) holdings in Carter Holt Harvey Limited (Carter Holt), a major New Zealand forest products and paper company with substantial assets in Chile. The purchase increased the Company's ownership of Carter Holt to 24 percent and leaves Brierley with 8 percent. In April 1993, the Company acquired certain assets of the Los Angeles-based Ingram Paper Company, a distributor of industrial and fine printing papers. In December, JB Papers, Inc., a paper distribution company located in Union, N.J., was purchased. Also in December, the assets of Monsanto Company's Kentucky-based Fome-Cor division, a manufacturer of polystyrene foam products, were acquired. In the first quarter of 1992, the operating assets of Western Paper Company (Western Pacific), a printing and industrial paper distribution business based in Portland, Oregon, were purchased. In the second quarter, the Company acquired an equity interest in Scitex Corporation Ltd. (Scitex), an Israel-based world leader in color electronic prepress systems for the graphic design, printing and publishing industries. In the third quarter, Zaklady Celulozowa-Papierniecze S.A. w Kwidzynie (Kwidzyn) was acquired from the Government of the Republic of Poland. Kwidzyn is Poland's largest white papers manufacturer and the only integrated bleached pulp and paper company. In the fourth quarter, certain assets of the chemical division of Norway-based M. Peterson & Son AS (Peterson) were acquired. In the first quarter of 1991, the Company purchased certain packaging and sheeting facilities located in France (the Rhone Valley packaging business) from Georgia-Pacific Corporation. In April, the packaging equipment division of United Dominion Industries Ltd. (Evergreen Packaging Equipment) was purchased. Also in April, the Company acquired the common stock of Dillard Paper Company, a wholesale distributor of printing and industrial papers, packaging equipment and supplies based in the southern United States. In August, the Company completed a merger with Leslie Paper Co., a paper distribution firm headquartered in Minneapolis, Minnesota, using the pooling-of-interests method of accounting. In November, the Company entered into a joint venture agreement with Brierley to control 32% of Carter Holt. In December, the common stock of Scaldia Papier BV, a paper distribution company based in Nijmegen, Netherlands, primarily distributing coated and uncoated papers to the graphics industry, was purchased. - ------------------ * Unless otherwise indicated by the context, the terms 'Company' and 'International Paper' are used interchangeably to describe International Paper Company and its consolidated subsidiaries. All of the 1993, 1992 and 1991 acquisitions, except the merger with Leslie Paper Co., were accounted for using the purchase method. The effects of these mergers and acquisitions, individually or in the aggregate, were not significant to the Company's consolidated financial statements. A further discussion of mergers and acquisitions can be found on page 48 of the Company's 1993 Annual Report to Shareholders (the 'Annual Report'), which information is incorporated herein by reference. From 1989 through 1993, International Paper's capital expenditures approximated $5.7 billion, excluding mergers and acquisitions. These expenditures reflect continuing efforts to improve product quality, environmental performance, lower costs, expand production capacity, and acquire and improve forestlands. Capital spending in 1993 was $954 million and is expected to exceed $1.1 billion in 1994. A further discussion of capital expenditures can be found on pages 37 and 38 of the Annual Report, which information is incorporated herein by reference. The Company, which owns a majority interest in IP Timberlands, Ltd., a Texas limited partnership ('IPT'), controlled approximately 6.2 million acres of forestlands in the United States at December 31, 1993. IPT was formed to succeed to substantially all of International Paper's forest products business for the period 1985 through 2035, unless earlier terminated. A further discussion of IPT can be found on pages 28 and 47 of the Annual Report, which information is incorporated herein by reference. FINANCIAL INFORMATION CONCERNING INDUSTRY SEGMENTS The financial information concerning industry segments is set forth on pages 37 and 41 of the Annual Report, which information is incorporated herein by reference. FINANCIAL INFORMATION ABOUT INTERNATIONAL AND DOMESTIC OPERATIONS The financial information concerning international and domestic operations and export sales is set forth on page 40 of the Annual Report, which information is incorporated herein by reference. COMPETITION AND COSTS Despite the size of the Company's manufacturing capacities for paper, paperboard, packaging and pulp products, the markets in all of the cited product lines are large and highly fragmented. The markets for wood and specialty products are similarly large and fragmented. There are numerous competitors, and the major markets, both domestic and international, in which the Company sells its principal products are very competitive. These products are in competition with similar products produced by others, and in some instances, with products produced by other industries from other materials. Many factors influence the Company's competitive position, including prices, costs, product quality and services. Information on the impact of prices and costs on operating profits is contained on pages 10, 16, 20, 26, 30 and 36 through 39 of the Annual Report, which information is incorporated herein by reference. MARKETING AND DISTRIBUTION Paper and packaging products are sold through the Company's own sales organization directly to users or converters for manufacture. Sales offices are located throughout the United States as well as internationally. Significant volumes of products are also sold through paper merchants and distributors, including facilities in the Company's distribution network. The Company's U.S. production of lumber and plywood is marketed through independent and Company-owned distribution centers. Specialty products are marketed through various channels of distribution. DESCRIPTION OF PRINCIPAL PRODUCTS The Company's principal products are described on pages 6 through 31 of the Annual Report, which information is incorporated herein by reference. Production of major products for 1993, 1992 and 1991 was as follows: PRODUCTION BY PRODUCTS (UNAUDITED) - ------------------ (1) This excludes market pulp purchases of approximately 600,000 tons annually. (2) A significant portion of this tonnage was fabricated from paperboard and paper produced at the Company's own mills and included in the containerboard, bleached packaging board and industrial papers figures in this table. (3) Panels include plywood and oriented strand board. RESEARCH AND DEVELOPMENT The Company operates research and development centers at Sterling Forest, New York; Mobile, Alabama; Erie, Pennsylvania; Kaukauna, Wisconsin; Binghamton, New York; South Walpole, Massachusetts; St. Charles, Illinois; Jacksonville, Florida; Holyoke, Massachusetts; Mobberley, United Kingdom; Morley, United Kingdom; Munich, Germany; Fribourg, Switzerland; Saint-Priest, France; and Annecy, France; a regional center for applied forest research in Bainbridge, Georgia; and several product laboratories. Research and development activities are directed to short-term, long-term and technical assistance needs of customers and operating divisions; process, equipment and product innovations; and improvements of profits through tree generation and propagation research. Activities include studies on improved forest species and management; innovation and improvement of pulping, bleaching, chemical recovery, papermaking and coating processes; innovation and improvement of photographic materials and processes, printing plates, pressroom/plate chemistries and plate processors; reduction of environmental discharges; re-use of raw materials in manufacturing processes; recycling of consumer and packaging paper products; energy conservation; applications of computer controls to manufacturing operations; innovations and improvement of products; and development of various new products. Product development efforts specifically address product safety as well as the minimization of solid waste. The cost to the Company of its research and development operations was $94.7 million in 1993, $91.1 million in 1992 and $82.7 million in 1991. ENVIRONMENTAL PROTECTION Control over discharges of pollutants into the air, water and groundwater to avoid significant adverse impacts on the environment and to achieve 100% compliance with regulations is a continuing objective of the Company. The Company has invested substantial funds to modify facilities to assure compliance with applicable environmental quality laws and plans to make substantial capital expenditures for these purposes in the future. A total of $100 million was spent in 1993 to control air and water pollution and to assure environmentally sound disposal of solid waste. The Company expects to spend in the order of $160 million in 1994 for similar capital programs. Amounts to be spent for environmental control facilities in future years will depend on new laws and regulations and other changes in legal requirements, and changes in environmental concerns. Taking these uncertainties into account, the Company's preliminary estimate for additional environmental appropriations during the period 1995 through 1996 is in the range of $500 to $600 million. In December 1993, the United States Environmental Protection Agency ('EPA') proposed new guidelines for air emissions and water discharge for the pulp and paper industry to meet in 1998 known as 'Cluster Rulemaking'. It also proposed regulations implementing the Great Lakes Initiative ('GLI') covering water quality and implementation procedures. Future spending will be heavily influenced by the final standards included within each of the sets of proposed regulations. We estimate the Company's future capital spending to comply with the Cluster Rulemaking and GLI requirements to be between $700 million and $1.5 billion depending upon the methods allowed by the regulations to meet overall requirements. A portion of this spending is reflected in the 1995 to 1996 spending forecast. In addition, annual operating costs, excluding depreciation, are expected to increase between $60 million and $120 million when these regulations are fully implemented in 1998. The Company expects the significant effort it has made in the analysis of environmental issues and the development of environmental control technology to enable it to keep costs for compliance with environmental regulations at, or below, industry averages. A further discussion of environmental issues can be found on pages 33, 34, 38 and 39 of the Annual Report, which information is incorporated herein by reference. As of December 31, 1993, $755 million of industrial and pollution control revenue bonds, secured by Company contractual obligations, were outstanding in 51 political subdivisions of various states, counties and municipalities, primarily to finance environmental control projects located at or in conjunction with the Company's plants in those subdivisions. It is contemplated that additional industrial revenue bonds will be issued from time to time to finance other environmental control projects, provided tax law changes do not curtail the Company's access to the municipal bond market. EMPLOYEES As of December 31, 1993, the Company had approximately 72,500 employees, of whom approximately 52,000 were located in the United States and the remainder overseas. Of these, approximately 44,500 are hourly employees, many of whom are represented by the United Paperworkers International Union. During 1993, new labor agreements were reached at the Mobile, Oswego, Riverdale and Millers Falls mills. At year end, negotiations were still in progress at the Beckett, Erie and Pine Bluff mills. During 1994, labor agreements are scheduled to be negotiated at the following mills: Camden and Natchez. During 1995 labor agreements are scheduled to be negotiated at the following mills: Georgetown, Turners Falls, Ward and Hudson River. During 1993, labor agreements expired at 17 packaging plants, one forest research facility, one chemical plant, two wood products plants, three specialty products plants and seven distribution operations. Multiyear labor agreements were negotiated at each location, except one converted paper products plant in South San Francisco, California, where negotiations were still in progress at year end. One packaging plant at Mount Carmel, Pennsylvania and one distribution operation at Minneapolis, Minnesota have contracts remaining open from a previous year. RAW MATERIALS For information as to the sources and availability of raw materials essential to the Company's business, see Item 2 ITEM 2. PROPERTIES. FORESTLANDS The principal raw material used by International Paper is wood in various forms. At December 31, 1993, IPT, a limited partnership in which the Company has a majority ownership interest, controlled approximately 6.0 million acres of forestlands in the U.S. while an additional 0.2 million acres are held under short term leases to International Paper. During 1993, such forestlands supplied 1.4 million cords of roundwood to the Company's U.S. facilities. This amounted to the following percentages of the roundwood requirements of its mills and forest products facilities: 15% in its Northern mills, 14% in its Southern mills and none in its Western mill. The balance was acquired from other private industrial and nonindustrial forestland owners, as well as the United States government. In addition, 3.3 million cords of IPT's wood were sold to other users in 1993. MILLS AND PLANTS A listing of the Company's production facilities can be found in Appendix I hereto, which information is incorporated herein by reference. All mills and converting facilities are owned by the Company, except one mill and 13 plants in the United States and two non-U.S. facilities, which are leased. The Company believes that these facilities are in good operating condition and are suited for the purposes for which they are presently being used. The Company continues to study the economics of modernizing or adopting other alternatives for higher cost facilities. Further discussions of new mill and plant projects can be found on pages 37 and 38 of the Annual Report, which information is incorporated herein by reference. CAPITAL INVESTMENTS AND DISPOSITIONS Given the size, scope and complexity of its business interests, International Paper continuously examines and evaluates a wide variety of business opportunities and planning alternatives, including possible acquisitions and sales or other dispositions of properties. Planned capital investments for 1994, as of December 31, 1993, are set forth on pages 37 and 38 of the Annual Report, which information is incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. DIOXIN LITIGATION On July 31, 1992, 77 plaintiffs, all residents of Arkansas, filed a lawsuit in the U.S. District Court for the Western District of Arkansas, alleging that the Company polluted the Sulfur River by discharging chemicals, including dioxin, from its Domino, Texas plant. This case was settled in December, 1993 at which time there were 54 plaintiffs remaining in the litigation. The terms of the settlement are confidential. On June 11, 1993, a lawsuit purporting to be a class action was filed by individuals against the Company, Dow Chemical and other individual employees of both companies in the 18th Judicial District of Louisiana seeking compensatory and punitive damages of an unspecified amount for alleged claims similar to those raised in the previously-filed lawsuits. The case has been removed to the U.S. District Court for the Middle District of Louisiana. Beginning in November of 1990, the Company has been named as a defendant in 88 lawsuits by individuals filed in state or federal court in Mississippi alleging that it has polluted and damaged the Pascagoula, Leaf and Escatawpa Rivers by releasing dioxin and over 40 other chemicals into those rivers. Georgia-Pacific was initially named in most of these suits but an order severing it from the Company in all the then pending cases was entered on September 15, 1992. Following the severance order, nine of the State cases were removed from state court to Federal District Court for the Southern District of Mississippi. Of the nine cases that were removed, two have been dismissed. On May 24, 1993, a wrongful death action was filed in Mississippi state court against the Company claiming that decedent's death was related to exposure to hazardous and toxic substances from the Moss Point mill. The lawsuit also included the independent survivorship claims of the widow. The complaint raises claims similar to those in the previously-filed lawsuits and also contains specific allegations relating to the disposal of sludge by the mill. The plaintiff seeks compensatory damages of $1 million and punitive damages of $20 million. The case has been removed to the U.S. District Court for the Southern District of Mississippi. On June 26, 1993, a lawsuit was filed against the Company, Georgia-Pacific and individual employees of both companies in Mississippi state court by 20 plaintiffs alleging claims similar to those raised in previously-filed lawsuits. The plaintiffs seek an unspecified amount of compensatory and punitive damages. On October 22, 1993, Georgia-Pacific and its individual employee-defendants were severed from the Company. On September 28, 1993, 221 plaintiffs filed a lawsuit in the state court of Mississippi claiming that the Company polluted the Pascagoula and Escatawpa Rivers by discharging chemicals, including dioxin from its Moss Point mill. The plaintiffs seek compensatory damages of $33 million, punitive damages of $221 million and injunctive relief. On December 15, 1992, a lawsuit purporting to be a class action was filed against the Company in U.S. District Court for the Southern District of Mississippi (Biloxi). The plaintiffs seek unspecified compensatory and punitive damages for the alleged violation by the Company of Federal environmental laws relating to dioxin and other chemicals associated with the operations of the Moss Point Mill. On February 18, 1994, the judge denied the plaintiffs' motion to certify the class and the lawsuit will proceed forward with only the two named individuals as plaintiffs. In summary, taking into account various dismissals and new filings, there are 71 cases pending in state court and eight pending in federal court for a total of 79 Mississippi cases as of February 1, 1994. In these cases, both state and federal, there are a total of 5,093 plaintiffs seeking total compensatory damages of approximately $1.0 billion, punitive damages of approximately $8.4 billion and injunctive relief. While any of this litigation has an element of uncertainty, the Company believes that the outcome of any of these proceedings, lawsuits or claims, pending or threatened, or all of them combined, will not have a materially adverse effect on its consolidated financial position or results of operations. OTHER LITIGATION On October 14, 1993, the Town of Jay, Maine assessed a penalty of $394,000 against the Company's Androscoggin mill for violations of its air permit under the Town's Environmental Control and Improvement Ordinance attributable to excess emissions of particulate from one of the mill's lime kilns, as well as violations of certain reporting requirements. The Town's penalty assessment has been appealed. The Maine Department of Environmental Protection proposed on October 15, 1992 that the Androscoggin mill enter into an Administrative Consent Agreement and Enforcement Order and pay a civil penalty of $217,892 because the particulate emissions from the same lime kiln which was the subject of the foregoing proceeding with the Town of Jay, had exceeded the limits in the state air license. Settlement discussions are no longer being conducted and the State has filed a lawsuit against the Company. Although no specific amount is claimed in the complaint, presumably the State will seek civil penalties in excess of the amount it had originally proposed. On November 15, 1993, the Thilmany division of the Company agreed with the EPA, Region 5, to pay a penalty of $150,000 for alleged violations of the Clean Air Act in 1988 at the Thilmany mill located in Kaukauna, Wisconsin. The settlement in the form of a consent decree must be approved by the federal court having jurisdiction of the civil action. In 1990, the Missouri Attorney General's office notified the Company that it was preparing an enforcement action alleging violations of the hazardous waste management rules at the Company's treated wood plant in Joplin, Missouri. Settlement discussions with the Attorney General's office are in progress. In 1989, Masonite Corporation, a wholly-owned subsidiary of the Company ('Masonite'), modified a production line to make a new product at a facility in Ukiah, California. The facility obtained the necessary Authority to Construct permits from the appropriate authority. In May 1992 the EPA, Region 9, issued an order alleging that an additional Prevention of Significant Deterioration permit was required for the new product line. The Company and the EPA are in settlement discussions and civil penalties are anticipated. Separate lawsuits were filed in the Superior Court, Mendocino County, California, in July 1992 against Masonite by the Mendocino County Air Pollution Control District and the California Air Resources Board. Both lawsuits, which were later consolidated, allege non-compliance with the California Air Toxics Hot Spots Information and Assessment Act of 1987 by Masonite's Ukiah, California, facility. The alleged non-compliance relates to an emissions plan allegedly required to be filed by August 1, 1989 but allegedly not filed until November 5, 1990. Additionally, the lawsuits allege that the molded products line was operated without a required permit. The lawsuits were settled in April 1993 for a civil penalty of $250,000 and a commitment to conduct additional environmental audits. This settlement terminated the proceeding. In May 1992 the EPA, Region 4, filed an administrative action alleging that Arizona Chemical Company, a wholly-owned subsidiary of the Company, at a facility located in Gulfport, Mississippi, failed to comply with regulations that govern the burning of hazardous wastes in the facility's boiler. The action, which sought a civil penalty of $274,500, was settled in February 1994 for a civil penalty of $95,000. This settlement terminated the proceedings. On September 21, 1993 the EPA, Region 4, filed an administrative action alleging that an Arizona Chemical facility in Panama City, Florida, failed to comply with regulations that govern the burning of hazardous wastes in the facility's boiler. The action seeks a civil penalty of $334,600. Settlement negotiations are in progress. The Company has been advised by the State of New York of an impending enforcement action concerning the power boiler at the Company's Ticonderoga, New York, paper mill. The action would involve civil penalties. Settlement discussions are in progress. As of March 30, 1994, there were no other pending judicial proceedings, brought by governmental authorities against the Company, for alleged violations of applicable environmental laws or regulations. The Company is engaged in various administrative proceedings that arise under applicable environmental and safety laws or regulations, including approximately 62 active 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 large commercial landfills that received waste from many different sources. While joint and several liability is authorized under the CERCLA, as a practical matter, liability for CERCLA cleanups is allocated among the many waste generators. Based upon previous experience with respect to the cleanup of hazardous substances and upon presently available information, the Company believes that it has no or de minimus liability with respect to 18 of these sites; that liability is not likely to be significant at 21 sites; and that estimates of liability at 23 of these sites is likely to be significant but not material to the Company's consolidated financial position or results of operations. The Company is also involved in other contractual disputes, administrative and legal proceedings and investigations of various types. While any litigation, proceeding or investigation has an element of uncertainty, the Company believes that the outcome of any proceeding, lawsuit or claim that is pending or threatened, or all of them combined, will not have a materially adverse effect on its consolidated financial position or results of operations. 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 ended December 31, 1993. SPECIAL ITEM. EXECUTIVE OFFICERS OF THE COMPANY. INTERNATIONAL PAPER COMPANY EXECUTIVE OFFICERS AS OF MARCH 31, 1994 INCLUDING NAME, AGE, OFFICES AND POSITIONS HELD* AND BUSINESS EXPERIENCE DURING THE PAST FIVE YEARS JOHN A. GEORGES, 63, chief executive officer and chairman of the board of directors of the Company. He became president, chief operating officer and a director in 1981, chief executive officer in 1984 and chairman of the board in 1985. JOHN T. DILLON, 55, executive vice president-packaging. In 1982, he was elected vice president and group executive-forest products and assumed additional responsibilities for the wood products group in late 1985. In 1986, he was elected a senior vice president-forest products, liquid packaging, and folding carton and label. He was elected to his present position in 1987 and a director in 1991. JAMES P. MELICAN, 53, executive vice president-legal and external affairs. He was elected vice president and general counsel in 1984, senior vice president and general counsel in 1987 and assumed his present position in 1991. C. WESLEY SMITH, 54, executive vice president-printing papers. He was elected vice president manufacturing-white papers businesses in 1987 and president-International Paper Europe in 1989. He assumed his present position in 1992. MARK A. SUWYN, 51, executive vice president-forest and specialty products. He was senior vice president-imaging systems, medical products and corporate marketing with E.I. DuPont De Nemours & Company from 1990 to 1991 and prior to that held the position of group vice president-imaging systems and medical products from 1988 to 1990. He joined the Company in his present position in 1992. ROBERT C. BUTLER, 63, senior vice president and chief financial officer. In 1983, he became group executive vice president and chief financial officer of the National Broadcasting Company. He joined the Company in his present position in 1988. ROBERT M. BYRNES, 56, senior vice president-human resources. He was senior vice president-human resources at Emhart Corporation from 1986 to 1989. He joined the Company in his present position in 1989. ANDREW R. LESSIN, 51, controller. He served as a staff vice president and director-taxes of the Company from 1988 to 1990. He was elected to his current position in 1990. - ------------------ * Officers of International Paper are elected to hold office until the next annual meeting of the board of directors following the annual meeting of shareholders and until election of successors, subject to removal by the board. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Dividend per share data on the Company's common stock and the high and low sale prices for the Company's common stock for each of the four quarters in 1993 and 1992 are set forth on page 56 of the Annual Report and are incorporated herein by reference. As of March 22, 1994, there were 31,237 holders of record of the Company's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The comparative columnar table showing selected financial data for the Company is set forth on pages 54 and 55 of the Annual Report and is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's review and comments on the consolidated financial statements are set forth on pages 10, 16, 20, 26, 30 and 36 through 39 of the Annual Report and are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Company's consolidated financial statements, the notes thereto and the reports of the independent public accountants and Company management are set forth on pages 42 through 53 of the Annual Report and are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The directors of the Company and their business experience are set forth on pages 6 through 9 of the Company's Notice of 1994 Annual Meeting and Proxy Statement, dated March 31, 1994 (the 'Proxy Statement') and are incorporated herein by reference. The discussion of executive officers of the Company is included in Part I under 'Executive Officers of the Company.' As required by the Securities and Exchange Commission rules under Section 16 of the Securities Exchange Act of 1934, the Company notes that during 1993, two officers inadvertently filed untimely reports on transactions in the Company's common stock: Robert Byrnes, one report regarding two purchases by his wife and Robert Butler, two reports regarding gifts. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. A description of the compensation of the Company's executive officers is set forth on pages 17, 18 and 20 through 23 of the Proxy Statement and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The Company knows of no one owning beneficially more than five percent (5%) of the Company's common stock other than the State Street Bank and Trust Co., N.A., as Trustee of the Company's Salaried Savings Plan and Retirement Savings Plan, respectively, which in the aggregate own 8.26% of the Company's shares of common stock as of December 31, 1993. State Street Bank and Trust Co., N.A. holds 8.924% of the Company's common stock and disclaims beneficial ownership of the 8.26% which it holds as Trustee for the Company's benefit plans. The table showing ownership of the Company's common stock by directors and by directors and executive officers as a group is set forth on pages 5 and 6 of the Proxy Statement, which information is incorporated herein by reference. In 1989, the Company announced that it had authorized the purchase, from time to time, of additional shares of its common stock for use in the Company's benefit and shareholder plans and for general corporate purposes. As of December 31, 1993, 4.9 million common shares may be repurchased under this program. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None, other than those described under Item 11. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. EXHIBITS: - ------------------ * Previously filed in the Annual Report on Form 10-K, for the year ended December 31, 1992. REPORTS ON FORM 8-K Current Reports on Form 8-K were filed by the Company on October 28, 1993, February 9, 1994 and March 11, 1994. FINANCIAL STATEMENT SCHEDULES The consolidated balance sheets as of December 31, 1993 and 1992 and the related consolidated statements of earnings, cash flows and common shareholders' equity for each of the three years ended December 31, 1993 and the related Notes to Consolidated Financial Statements, together with the report thereon of Arthur Andersen & Co., dated February 4, 1994, appearing on pages 42 through 53 of the Annual Report, are incorporated herein by reference. With the exception of the aforementioned information and the information incorporated by reference in Items 1, 2 and 5 through 8, the Annual Report is not to be deemed filed as part of this report. The following additional financial data should be read in conjunction with the financial statements in the 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. ADDITIONAL FINANCIAL DATA 1993, 1992 AND 1991 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES TO INTERNATIONAL PAPER COMPANY: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in the Company's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 4, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the accompanying index 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. New York, N.Y. February 4, 1994 SCHEDULE V INTERNATIONAL PAPER COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS) - ------------------ (A) The Company does not maintain detailed property accounts for all of its properties classified as to land, buildings, equipment, etc. (B) Includes currency translation effects, write-downs of assets under the productivity improvement program and reclassifications related to the adoption of SFAS No. 109. - ------------------ Note: Certain reclassifications have been made to prior-year amounts to conform with the current-year presentation. SCHEDULE V INTERNATIONAL PAPER COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT--(CONTINUED) (IN MILLIONS) - ------------------ Note: Certain reclassifications have been made to prior-year amounts to conform with the current-year presentation. SCHEDULE VI INTERNATIONAL PAPER COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN MILLIONS) - ------------------ Note: Certain reclassifications have been made to prior-year amounts to conform with the current-year presentation. SCHEDULE VIII INTERNATIONAL PAPER COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS (IN MILLIONS) - ------------------ (A) Primarily write-offs, less recoveries, of accounts determined to be uncollectible. SCHEDULE IX INTERNATIONAL PAPER COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS (IN MILLIONS) - ------------------ (1) Consists of domestic and international bank borrowings with various due dates. (2) Generally matures thirty days from date of issue with no provisions for extension of maturity. (3) Computed based on an average of month-end balances. (4) Computed using monthly principal balances and stated month-end interest rates. SCHEDULE X INTERNATIONAL PAPER COMPANY AND CONSOLIDATED SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY EARNINGS STATEMENT INFORMATION (IN MILLIONS) 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. INTERNATIONAL PAPER COMPANY By: JAMES W. GUEDRY ---------------------------------- JAMES W. GUEDRY, SECRETARY March 31, 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: APPENDIX I 1993 LISTING OF FACILITIES PRINTING PAPERS COATED AND UNCOATED PAPERS AND BRISTOLS Domestic: Mobile, Alabama Selma, Alabama (Riverdale Mill) Camden, Arkansas Pine Bluff, Arkansas Bastrop, Louisiana (Louisiana Mill) Springhill, Louisiana (C&D Center) Jay, Maine (Androscoggin Mill) Moss Point, Mississippi Corinth, New York (Hudson River Mill) Oswego, New York Ticonderoga, New York Erie, Pennsylvania Lock Haven, Pennsylvania Georgetown, South Carolina International: Cali, Colombia Coloto, Colombia Strasbourg, France (La Robertsau Mill) Clermont-Ferrand, France (Corimex Mill) Annecy, France (Cran Mill) Saillat, France Genoble, France (Lancey and Pont De Claix Mills) Maresquel, France Saint Die, France (Anould Mill) Bergisch Gladbach, Germany (Gorhrsmuhle Mill) Duren, Germany (Reflex and Neumuhl Mills) Kwidzyn, Poland PAPER AND SPECIALTY PULPS Selma, Alabama (Riverdale Mill) Jay, Maine (Androscoggin Mill) Natchez, Mississippi Erie, Pennsylvania Georgetown, South Carolina Texarkana, Texas FINE & PRINTING PAPERS Strathmore Paper Company Miller Falls, Massachusetts Turners Falls, Massachusetts Westfield, Massachusetts West Springfield, Massachusetts Woronoco, Massachusetts Merrill, Wisconsin Beckett Paper Company Hamilton, Ohio PACKAGING CONTAINERBOARD Domestic: Mansfield, Louisiana Pineville, Louisiana Vicksburg, Mississippi Gardiner, Oregon International: Arles, France CORRUGATED CONTAINER Domestic: Mobile, Alabama Russellville, Arkansas Carson, California Modesto, California San Jose, California Stockton, California Putnam, Connecticut Auburndale, Florida Chicago, Illinois Shreveport, Louisiana Springhill, Louisiana Presque Isle, Maine Detroit, Michigan Minneapolis, Minnesota Geneva, New York Tallman, New York Statesville, North Carolina Cincinnati, Ohio Wooster, Ohio Mount Carmel, Pennsylvania Georgetown, South Carolina Nashville, Tennessee Dallas, Texas Edinburg, Texas El Paso, Texas Delevan, Wisconsin Fond du Lac, Wisconsin International: Las Palmas, Canary Islands Arles, France Chalon-sur-Saone, France Chantilly, France Creil, France LePuy, France Mortagne, France Guadeloupe, French West Indies Martinique, French West Indies Bellusco, Italy Catania, Italy Pedemonte, Italy Pomezia, Italy San Felice, Italy Barcelona, Spain Bilbao, Spain Valladolid, Spain Winsford, United Kingdom A-1 BLEACHED BOARD Pine Bluff, Arkansas Bastrop, Louisiana (Louisiana Mill) Moss Point, Mississippi Georgetown, South Carolina Texarkana, Texas LIQUID PACKAGING Domestic: Turlock, California Plant City, Florida Atlanta, Georgia Cedar Rapids, Iowa Kansas City, Kansas Framingham, Massachusetts Kalamazoo, Michigan Raleigh, North Carolina Philadelphia, Pennsylvania International: Edmonton, Alberta, Canada Burnaby, British Columbia, Canada London, Ontario, Canada Longueil, Quebec, Canada Santiago, Dominican Republic Tel Aviv, Israel Perugia, Italy Kingston, Jamaica Tokyo, Japan Seoul, Korea Taipei, Taiwan Caracas, Venezuela FOLDING CARTON Clinton, lowa Hopkinsville, Kentucky Raleigh, North Carolina Cincinnati, Ohio Richmond, Virginia LABEL Commerce, California Newark, California Peoria, Illinois Bowling Green, Kentucky KRAFT PACKAGING Mobile, Alabama Camden, Arkansas Jay, Maine (Androscoggin Mill) Moss Point, Mississippi GROCERY BAGS & SACKS Mobile, Alabama Jackson, Tennessee MULTIWALL BAGS Camden, Arkansas Pittsburg, Kansas Wilmington, Ohio ENVELOPES Glendale, California Los Angeles, California San Francisco, California Chicago, Illinois Westfield, Massachusetts Richmond, Virginia (2 plants) DISTRIBUTION WHOLESALE AND RETAIL DISTRIBUTION (255 distribution branches) ResourceNet International/Domestic: Arvey Paper and Office Products Chicago, Illinois 25 locations nationwide Carter Rice Boston, Massachusetts 16 branches in New England, Middle Atlantic States and District of Columbia CDA Distributors Erlanger, Kentucky 21 branches in the Midwest, South, New England and Middle Atlantic States Dillard Paper Greensboro, North Carolina 85 branches in the Middle Atlantic States and Southeast Dixon Paper Company Denver, Colorado 23 branches in the West and Midwest Industrial Materials Distributors Erlanger, Kentucky 13 branches in New England, and Middle Atlantic States, Midwest, South and West Ingram Paper City of Industry, California 7 locations in the Southwest and Hawaii JB Papers, Inc. Union, New Jersey 3 locations in the Northeast Leslie Paper Company Minneapolis, Minnesota 16 locations in the Midwest Western Pacific Portland, Oregon 3 locations in the Northwest Western Paper Company Overland Park, Kansas 43 branches in the West, Midwest and South A-2 International: Plastic & Paper Sales, Ltd. Toronto, Ontario, Canada Aussedat Rey France Distribution S.A., Pantin, France Scaldia Papier BV, Nijmegen, Netherlands Masonite CP Ltd. Leeds, United Kingdom FOREST PRODUCTS Domestic: Maplesville, Alabama Tuscaloosa, Alabama Gurdon, Arkansas Leola, Arkansas Whelen Springs, Arkansas DeRidder, Louisiana Springhill, Louisiana Morton, Mississippi Wiggins, Mississippi Joplin, Missouri Pleasant Hill, Missouri Madison, New Hampshire Sampit, South Carolina Henderson, Texas Mineola, Texas Nacogdoches, Texas New Boston, Texas Building Products Ukiah, California Lisbon Falls, Maine Laurel, Mississippi Gulfport, Mississippi Fiberboard Spring Hope, North Carolina Pilot Rock, Oregon Marion, South Carolina Particleboard Danville, Virginia Stuart, Virginia Waverly, Virginia Slaughter Dallas, Texas 2 branches in the Southwest and Northwest McEwen Lumber Company High Point, North Carolina 14 branches in the Southeast International: INTAMASA Cella, Spain Masonite Africa Limited Estcourt Plant Ezebilt Products (PTY) Ltd. FORESTLANDS Approximately 6.2 million acres in the South, Northeast and Northwest REALTY PROJECTS Haig Point Plantation Daufuskie Island, South Carolina SPECIALTY PRODUCTS NONWOVEN PRODUCTS Domestic: Athens, Georgia Griswoldville, Massachusetts Walpole, Massachusetts Lewisburg, Pennsylvania Bethune, South Carolina Green Bay, Wisconsin International: Liege, Belgium Toronto, Ontario, Canada Yokohama, Japan Braunton, United Kingdom Hong Kong IMAGING PRODUCTS Domestic: Jacksonville, Florida Holyoke, Massachusetts Binghamton, New York International: Melbourne, Australia Saint-Priest, France Munich, Germany Mobberley, Great Britain Morley, Great Britain Fribourg, Switzerland CHEMICAL PRODUCTS Domestic: Panama City, Florida Pensacola, Florida Port St. Joe, Florida Oakdale, Louisiana Springhill, Louisiana Gulfport, Mississippi Picayune, Mississippi International: Sandarne, Sweden Greaker, Norway MINERALS Alvin, Texas Houston, Texas Midland, Texas SPECIALTY PANELS AND LAMINATED PRODUCTS Domestic: Chino, California Cordele, Georgia Elkhart, Indiana Newton, Kansas Glasgow, Kentucky Louisville, Kentucky Monticello, Kentucky Odenton, Maryland Montevideo, Minnesota Statesville, North Carolina Tarboro, North Carolina Towanda, Pennsylvania Portland, Tennessee Marshfield, Wisconsin Oshkosh, Wisconsin International: Bergerac, France (Couze Mill) Ussel, France Barcelona, Spain (Durion Mill) INDUSTRIAL AND PACKAGING PAPERS Thilmany Pulp & Paper Company Knoxville, Tennessee Kaukauna, Wisconsin Nicolet Paper Company De Pere, Wisconsin Jay, Maine (Androscoggin Mill) Akrosil Domestic: Menasha, Wisconsin Lancaster, Ohio International: Limburg, Netherlands A-3 (INTERNATIONAL PAPER LOGO) PRINTED ON HAMMERMILL PAPERS ACCENT OPAQUE, 50 LBS. HAMMERMILL PAPERS IS A DIVISION OF INTERNATIONAL PAPER. EXHIBIT INDEX Exhibits: Page No. --------- -------- (10)(a) Form of Termination Agreement Tier I* (b) Form of Termination Agreement, Tier II* (c) Form of Termination Agreement, Tier III* (11) Statement of Computation of Per Share Earnings (13) 1993 Annual Report to Shareholders of the Company (21) List of Significant Subsidiaries (22) Proxy Statement, dated March 31, 1994 (23) Consent of Independent Public Accountants (24) Power of Attorney (99)(a) Management Incentive Plan* (b) Long-Term Incentive Compensation Plan* (c) Supplemental Unfunded Savings Plan for Senior Managers* - ---------- * Previously filed in the Annual Report on Form 10-K, for the year ended December 31, 1992.

894651_1993.txt

894651_1993

1993

894651

ITEM 1 Business ________ Introduction ____________ American Annuity Group, Inc. ("American Annuity", "AAG", or "the Company") is a holding company whose only significant asset is the capital stock of Great American Life Insurance Company ("GALIC"). American Annuity is the successor to STI Group, Inc., formerly known as Sprague Technologies, Inc. ("STI"). STI was formed in May 1987 by The Penn Central Corporation ("Penn Central") for the purpose of divesting its electronics components businesses. STI subsequently sold substantially all of its assets and retired its debt, netting approximately $100 million in cash and cash equivalents. In September 1992, STI reached an agreement with Great American Insurance Company ("GAI") to purchase 100% of the capital stock of GALIC for $468 million. The acquisition was consummated on December 31, 1992. The purchase of GALIC was financed with (a) $230 million of borrowings, (b) $156 million of new equity raised from the sale of common and preferred stock to GAI, and (c) cash available at the Company. American Financial Corporation ("AFC"), the parent of GAI, beneficially owned approximately 80% of American Annuity's Common Stock at March 1, 1994. GALIC _____ For definitions of many of the insurance terms used throughout this section, please see the glossary beginning on page 11. GALIC is an insurance company which was incorporated in New Jersey in 1959 and redomiciled as an Ohio corporation in 1982. GALIC was acquired by AFC in 1973 through AFC's acquisition of GAI. GALIC entered the tax-deferred annuity business in 1976; prior to that time it wrote primarily whole-life, term-life, and accident and health insurance policies. GALIC is currently rated "A" (Excellent) by A.M. Best. Annuities are long-term retirement savings plans that benefit from interest accruing on a tax-deferred basis. The issuer of the annuity collects contributions, credits interest or investment income and pays out a benefit upon surrender or annuitization. Annuity contracts can be either variable rate or fixed rate. With a variable rate annuity, the rate at which interest is credited to the contract is tied to an underlying securities portfolio or other performance index. With a fixed rate annuity, an interest crediting rate is set by the issuer, periodically reviewed by the issuer, and changed from time to time as determined to be appropriate. GALIC is engaged in the sale of fixed rate annuities primarily to employees of qualified not-for-profit organizations under Section 403(b) of the Internal Revenue Code. These employees are eligible to save for retirement through contributions made on a before-tax basis to purchase 403(b) annuities. Contributions are made at the discretion of the participants through payroll deductions. Federal income taxes are not payable on contributions or earnings until amounts are withdrawn. GALIC markets its annuities principally to employees of educational institutions in the kindergarten through high school ("K-12") segment. Management believes that the K-12 segment is attractive because of the growth potential and persistency rate it has demonstrated. In 1993, written premiums from the K-12 segment represented approximately 90% of GALIC's total tax-qualified premiums, with sales of annuities to other not-for- profit groups accounting for the balance. The following table (in millions) presents information concerning GALIC in accordance with generally accepted accounting principles ("GAAP"), unless otherwise noted. Sales of annuities are affected by many factors, including: (i) competitive rates and products; (ii) the general level of interest rates; (iii) the favorable tax treatment of annuities; (iv) commissions paid to agents; (v) services offered; (vi) ratings from independent insurance rating agencies; and (vii) general economic conditions. Annuity receipts in 1993 increased primarily due to the introduction of new single premium products in the second half of 1992. Receipts in 1992 were lower than anticipated due to (i) a reduction in receipts relating to a new product introduced in 1990 which encouraged rollovers of other retirement funds and (ii) unfavorable economic and market conditions, including the impact of the negative publicity associated with a number of highly publicized insolvencies in the life insurance industry. GALIC's Corporate Strategy GALIC's primary business objective is to maximize its long-term profitability through the sale of 403(b) annuities. GALIC seeks to achieve this objective through a strategy of: (i) offering annuity products that are tailored to meet its policyholders' financial needs and designed to encourage a high level of persistency; (ii) providing competitive commission structures and high-quality service in order to foster long-term relationships with its independent agents; (iii) maintaining a conservative investment portfolio in order to demonstrate financial stability to its policyholders; (iv) maintaining competitive crediting rates on annuity policies to encourage new, as well as renewal, business while achieving the desired spread between investment earnings and interest credited; (v) developing complementary distribution channels; and (vi) maintaining high ratings from independent insurance rating agencies. Annuity Products GALIC's principal products are Flexible Premium Deferred Annuities ("FPDAs") and Single Premium Deferred Annuities ("SPDAs"). In 1993, FPDAs accounted for approximately two-thirds of GALIC's total annuity receipts, with SPDAs accounting for the remainder. GALIC's annuity products are designed to discourage early terminations and withdrawals through the use of various surrender charges. Over the past five years, the annual persistency rate of GALIC's annuity products has averaged approximately 92%. The following table summarizes GALIC's written premiums and policyholder benefit reserves on a statutory basis by product line (dollars in millions). Policyholder 1993 Premiums Written Benefit Reserves at _____________________ First % of December 31, 1993 ___________________ YearRenewal Total Amount % ____________ _____ ______ ___ Flexible Premium: 403(b) Single-tier $ 14 $ 14 7.0% $ 70 1.6% 403(b) Two-tier 31 202 58.0 2,739 63.5 Other Single-tier 2 1 0.7 39 0.9 Other Two-tier 2 6 2.0 187 4.4 ____ ____ _____ ______ _____ Total 49 223 67.7 3,035 70.4 ____ ____ _____ ______ _____ Single Premium: Single-tier 13 - 3.2 27 0.6 Two-tier 115 - 28.6 1,012 23.5 ____ ____ _____ ______ _____ Total 128 - 31.8 1,039 24.1 ____ ____ _____ ______ _____ Annuities in Pay Out - - - 217 5.0 Life, Accident & Health - 2 0.5 23 0.5 ____ ____ _____ ______ _____ Total $177 $225 100.0% $4,314 100.0% ____ ____ _____ ______ _____ GALIC's FPDAs are characterized by premium payments that are flexible in amount and timing as determined by the policyholder. GALIC's SPDAs require a one-time lump-sum premium payment. Since January 1, 1988, approximately three-fourths of GALIC's SPDA receipts have resulted from rollovers of tax- deferred funds previously maintained by policyholders with other insurers. All of GALIC's annuity products are fixed rate annuities which provide minimum interest rate guarantees of 3% to 4% per annum. At December 31, 1993, approximately 95% of GALIC's policyholder liabilities consisted of annuities which offered a minimum interest rate guarantee of 4%. All of GALIC's annuity policies permit GALIC to change the crediting rate at any time (subject to the minimum guaranteed interest rate). In determining the frequency and extent of changes in the crediting rate, GALIC takes into account the profitability of its annuity business and the relative competitive position of its products. The average rate being credited on funds held by GALIC was approximately 5.3%, 6.2%, and 7.2% at December 31, 1993, 1992, and 1991, respectively. GALIC seeks to maintain a desired spread between the yield on its investment portfolio and the rate it credits to its policies. GALIC accomplishes this by (i) offering flexible crediting rates, (ii) designing annuity products that encourage persistency and (iii) maintaining an appropriate matching of assets and liabilities. Tax qualified annuity policyholders maintain access to their funds without incurring penalties through a provision in the contract which allows policy loans in accordance with the Internal Revenue Code. The persistency rates of GALIC's products are helped by the two-tier design contained in most of GALIC's products. Two-tier annuities have a permanent surrender charge for funds withdrawn in a lump sum in excess of the amount permitted to be withdrawn pursuant to the contract. Two account values are maintained for two-tier annuities -- the annuitization (or upper-tier) value and the surrender (or lower-tier) value. The annuitization value is paid only if the policyholder chooses to annuitize (withdraw funds in a series of periodic payments for at least the minimum number of years specified in the contract). If a lump sum payment is desired, the surrender value is paid. After the initial surrender charges have been reduced to zero, single-tier annuities have only one value which is available whether the policy is surrendered or annuitized. With some two-tier annuities, the annuitization value and the surrender value are the same at inception of the policy, but since each value accumulates interest at a different rate, over time, the annuitization value will grow to an amount which is greater than the surrender value. Other two-tier annuities credit the same interest rate to both the surrender and the annuitization value but withhold a portion of the first-year premiums when calculating the surrender value; no such amounts are withheld in calculating the annuitization value. GALIC's two-tier annuities are particularly attractive to policyholders who intend to utilize funds accumulated to provide retirement income since the annuitization value is accumulated at a competitive long-term interest rate. Management believes that over time, as the policyholder population ages, the percentage of policyholders annuitizing will increase. In addition to its use of two-tier structures, GALIC imposes certain surrender charges and front-end fees during the first five to ten years of a new policy to discourage customers from withdrawing funds in the early years of a policy. As a result of these features, GALIC's annuity products have achieved high persistency. As the following table illustrates, GALIC's annual persistency rates for its major products have averaged approximately 92% over the past five years. Persistency Rates ___________________________________________ Product Group 1993 1992 1991 1990 1989 _____________ ____ ____ ____ ____ ____ Flexible Premium 92.0% 90.6% 89.3% 91.2% 94.4% Single Premium 93.3 93.8 92.8 92.6 92.0 Annuity surrender payments represented 6.9%, 7.8% and 9.4% of average statutory reserves in 1993, 1992 and 1991, respectively. At December 31, 1993, GALIC had approximately 230,000 annuity policies in force, nearly all of which were individual contracts. GALIC's policyholders are employees of over 8,300 institutions nationwide. Of the $4.3 billion in total statutory reserves held by GALIC as of December 31, 1993, approximately 95% were attributable to policies in the accumulation phase. Marketing and Distribution GALIC markets its annuity products through approximately 55 managing general agents ("MGAs") who, in turn, direct more than 1,000 actively producing independent agents. GALIC has developed its business since 1980 on the basis of its relationships with MGAs and independent agents primarily through a consistent marketing approach and responsive service. GALIC seeks to attract and retain MGAs who are experienced and highly motivated and who consistently place a high volume of the types of annuities offered by GALIC. Toward this end, GALIC has established a "President's Advisory Council" consisting of 10 of the top producers each year, all of whom must market primarily GALIC products. The President's Advisory Council serves as a major influence on new product design and marketing strategy. To extend the distribution of GALIC annuities to a broader customer base, the Company began to develop a Personal Producing General Agent ("PPGA") distribution system. Over 85 PPGAs are contracted to sell GALIC annuities to both qualified and non-qualified customers. These new appointments will give the Company the opportunity to expand the premium writings in those territories not served by an MGA. GALIC's strategy is to offer its agents competitive commission rates and to provide prompt processing of agent requests, with the objective of attracting and retaining agents on the basis of service, as well as compensation. Commissions paid on first year premiums are significantly higher than those paid on renewal premiums. Commissions are generally lower for sales of annuities to older policyholders, reflecting the lower profit potential available from policyholders who maintain their funds with GALIC for a shorter period. GALIC is licensed to sell its products in all states (except Kansas and New York) and in the District of Columbia. The geographical distribution of GALIC's annuity premiums written in 1993 compared to 1989 was as follows (dollars in millions): Investments GALIC's annuity products are structured to generate a stable flow of investable funds. GALIC earns a spread by investing these funds at an investment earnings rate in excess of the crediting rate payable to its policyholders. The Ohio Insurance Code contains rules governing the types and amounts of investments which are permissible for an Ohio life insurer, including GALIC. These rules are designed to ensure the safety and liquidity of the insurer's investment portfolio by placing restrictions on the quality, quantity and diversification of permitted investments. Investments comprise approximately 96% of American Annuity's assets and are the principal source of its income. Fixed income securities (including policy loans, mortgage loans and short-term investments) comprise over 98% of AAG's investment portfolio. Risks inherent in connection with fixed income securities include loss upon default and market price volatility. Factors which can affect the market price of these securities include: (i) creditworthiness of issuers; (ii) changes in market interest rates; (iii) the number of market makers and investors; and (iv) defaults by major issuers of securities. In recent years, GALIC has reduced its holdings in non-investment grade fixed maturity securities and equity securities of affiliates. This shift in investment strategy has placed an emphasis on high quality fixed income securities which management believes should produce a more consistent and predictable level of investment income. The National Association of Insurance Commissioners ("NAIC") assigns quality ratings to publicly traded as well as privately placed securities. These ratings range from Class 1 (highest quality) to Class 6 (lowest quality). The following table shows GALIC's fixed maturity portfolio by NAIC designation (and comparable Standard & Poor's Corporation rating) at December 31: GALIC's primary investment objective in selecting securities for its fixed maturity portfolio is to optimize interest yields while maintaining an appropriate relationship of maturities between GALIC's assets and expected liabilities. GALIC invests in bonds that have primarily intermediate-term maturities. This practice provides GALIC with additional flexibility to respond to fluctuations in the marketplace. The table below sets forth the maturities of GALIC's fixed maturity investments based on their carrying value. At December 31, 1993, the average maturity of GALIC's fixed maturity investments was approximately 6 years (including CMOs, which had an estimated average life of approximately 4 years). The following table shows the performance of GALIC's investment portfolio, excluding equity investments in affiliates (dollars in millions): GALIC's investment portfolio is managed by American Money Management ("AMM"), a subsidiary of AFC. As part of the acquisition by STI, GALIC and AMM executed an investment services agreement which established the investment management fee paid to AMM at a maximum of one-tenth of one percent of GALIC's invested assets. Independent Ratings GALIC is currently rated "A" (Excellent) by A.M. Best and "A+" (High claims paying ability) by Duff & Phelps. Publications of A.M. Best indicate that an "A" rating is assigned to those companies which in A.M. Best's opinion have achieved excellent overall performance when compared to the standards established by A.M. Best as norms of the life insurance industry and which generally have demonstrated a strong ability to meet their obligations to policyholders over a long period of time. In evaluating a company's financial and operating performance, independent rating agencies review the company's profitability, leverage and liquidity, as well as the company's book of business, the quality and estimated market value of its assets, the adequacy of its policy reserves and the experience and competency of its management. Their ratings are based upon factors of concern to policyholders and agents and are not directed toward the protection of investors. Management believes that the ratings assigned to GALIC by independent insurance rating agencies are important because potential policyholders often use a company's rating as an initial screening device in considering annuity products. Management also believes that the majority of purchasers of 403(b) annuities would not be willing to purchase annuities from an issuer that had an A.M. Best rating below certain levels. In addition, certain school districts, hospitals and banks do not allow insurers with an A.M. Best rating below certain levels to sell annuity products through their institutions. Policy Liabilities and Reserves GALIC establishes and carries reserves to meet future obligations under its annuity policies. GALIC's $4.3 billion liability for accumulated policyholders' funds at December 31, 1993, is calculated based upon assumptions of future interest rate spreads expected to be realized and expected mortality, maturity and surrender rates to be experienced on the annuity policies in force. Annuity premiums are generally recorded under GAAP as increases to the liability for accumulated policyholders' funds rather than as revenues. Accumulated interest also increases this liability. Benefit payments are recorded as decreases to this liability instead of as expenses. Competition GALIC operates in a highly competitive environment. More than 100 insurance companies offer tax-deferred annuities. GALIC competes with other insurers and financial institutions based on many factors, including ratings, financial strength, reputation, service to policyholders, product design (including interest rates credited), commissions and service to agents. Since GALIC markets and distributes policies through independent agents, it must also compete for agents. Management believes that consistently targeting the same market and emphasizing service to agents and policyholders give GALIC a competitive advantage. No single insurer dominates the marketplace. Competitors include (i) individual insurers and insurance groups, (ii) mutual funds and (iii) other financial institutions of varying sizes, some of which are mutual insurance companies possessing competitive advantages in that all of their profits inure to their policyholders, and many of which possess financial resources substantially in excess of those available to GALIC. In a broader sense, GALIC competes for retirement savings with a variety of financial institutions offering a full range of financial services. Regulation GALIC is subject to comprehensive regulation under the insurance laws of the States of Ohio and California and the other states in which it operates. These laws, in general, require approval of the particular insurance regulators prior to certain actions such as the payment of dividends in excess of statutory limitations, continuing service arrangements with affiliates and certain other transactions. Regulation and supervision are administered by a state insurance commissioner who has broad statutory powers with respect to granting and revoking licenses, approving forms of insurance contracts and determining types and amounts of business which may be conducted in light of the financial strength and size of the particular company. State insurance departments conduct periodic financial examinations of insurance companies. GALIC's state of domicile, Ohio, requires that examinations be conducted at least every three years and its most recent examination was for the three-year period ended December 31, 1990. State insurance laws also regulate the character of each insurance company's investments, reinsurance and security deposits. GALIC may be required, under the solvency or guaranty laws of most states in which it does business, to pay assessments (up to certain prescribed limits) to fund policyholder losses or liabilities of insurance companies that become insolvent. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength and, in certain instances, may be offset against future premium taxes. The incurrence and amount of such assessments have increased in recent years. In connection with the GALIC purchase, GALIC's costs for state guarantee funds are set at $1 million per year for a five-year period with respect to insurance companies in receivership, rehabilitation, liquidation or similar situations at December 31, 1992. For any year in which GALIC pays more than $1 million to the various states, GAI will reimburse GALIC for the excess assessments. For any year in which GALIC pays less than $1 million, AAG will pay GAI the difference between $1 million and the assessed amounts. GALIC paid $2.2 million in assessments in 1993 and, accordingly, has recorded a receivable from GAI at December 31, 1993 of $1.2 million. The Ohio Department of Insurance is GALIC's principal regulatory agency. GALIC is deemed to be "commercially domiciled" in California based on past premium volume written in the state and, as a result, is subject to certain provisions of the California Insurance Holding Company laws, particularly those governing the payment of stockholder dividends, changes in control and intercompany transactions. An insurer's status as "commercially domiciled" is determined annually under a statutory formula. GALIC's status may change in California in the future if its premium volume there decreases to below 20% of its overall premium volume over the most recent three years. The NAIC is an organization comprised of the chief insurance regulator for each of the 50 states and the District of Columbia. One of its major roles is to develop model laws and regulations affecting insurance company operations and encourage uniform regulation through the adoption of such models in all states. As part of the overall insurance regulatory process, the NAIC forms numerous task forces to review, analyze and recommend changes to a variety of areas affecting both the operating and financial aspects of insurance companies. Recently, increased scrutiny has been placed upon the insurance regulatory framework, and a number of state legislatures have considered or enacted legislative proposals that alter, and in many cases increase, state authority to regulate insurance companies and their holding company systems. In light of recent legislative developments, the NAIC and state insurance regulators have also become involved in a process of re- examining existing laws and regulations and their application to insurance companies. Legislation has also been introduced in Congress which could result in the federal government's assuming some role in the insurance industry, although none has been enacted to date. In 1990, the NAIC began an accreditation program to ensure that states have adequate procedures in place for effective insurance regulation, especially with respect to financial solvency. The accreditation program requires that a state meet specific minimum standards in over 15 regulatory areas to be considered for accreditation. The accreditation program is an ongoing process and once accredited, a state must enact any new or modified standards approved by the NAIC within two years following adoption. As of December 31, 1993, 32 states, including Ohio and California, were accredited. In December 1992, the NAIC adopted a model law enacting risk-based capital formulas which became effective in 1993. The model law sets thresholds for regulatory action, and currently GALIC's capital significantly exceeds risk- based capital requirements. If the NAIC elects to impose more stringent risk-based capital rules in the future, GALIC's ability to pay dividends could be adversely affected. The current NAIC model for extraordinary dividends requires prior regulatory approval of any dividend that exceeds the "lesser of" 10% of statutory surplus or 100% of the prior year's net gain from operations. Prior to 1986, the model standard was the "greater of" such amounts. The NAIC has approved eight alternative provisions which may be considered "substantially similar" to the model. The NAIC model or one of the alternatives must be adopted by a state in order to be accredited by the NAIC. In October 1993, Ohio revised its dividend law to adopt one of the eight alternatives. The standard in Ohio requires 30 days prior notice of any dividend which, together with all such amounts paid in the preceding twelve months, exceeds the "greater of" 10% of statutory surplus or 100% of the prior year's net income, but not exceeding earned surplus as of the prior year-end. The maximum dividend permitted by law is not indicative of an insurer's actual ability to pay dividends, which may be constrained by business and regulatory considerations. These considerations include the impact of dividends on surplus, which could affect (i) an insurer's ratings, (ii) its competitive position and (iii) the amount of premiums that can be written. Furthermore, the Ohio Insurance Department has broad discretion to limit the payment of dividends by insurance companies domiciled in Ohio. California amended its dividend law effective January 1, 1994, adopting one of the alternative provisions approved by the NAIC. Under the new California law, approval is required for dividends which exceed the "greater of" 10% of statutory surplus or 100% of "net gain from operations", but not exceeding earned surplus, in any twelve month period. The NAIC has been considering the adoption of a model investment law for several years. The current projection for adoption of a model law is the end of 1994, at the earliest. A draft is not scheduled to be released until the second quarter of 1994. In addition, it is not yet determined whether the model law would be added to the NAIC accreditation standards so that consideration of the model for adoption in states would be required for the achievement or continuation of any state's accreditation. It is not possible to predict the impact of these activities on GALIC. In 1991, the NAIC adopted additional disclosure requirements relating to the marketing and sale of two-tier annuities. Certain states have adopted regulations or interpreted existing regulations to restrict the sale of two- tier annuity products or impose limitations on the terms of such products that make their sale less attractive to GALIC. To date, these additional disclosure requirements and restrictions have not had a material impact on GALIC's business. The NAIC is also considering the adoption of actuarial guidelines with respect to two-tier annuity products. In connection with the sale of GALIC, GAI is obligated to neutralize the financial effects of implementing any such guidelines on GALIC's statutory earnings and capital, except for the initial, one-time impact on GALIC's statutory earnings. GAI's obligations will apply only to GALIC's annuity business at the date of adoption and only if the guidelines are (i) adopted prior to January 1, 1996, or (ii) on the NAIC agenda for adoption as of December 31, 1995, and actually adopted on or prior to December 31, 1996. Management cannot predict whether or when the guidelines will be adopted nor can it predict the form of the guidelines and, therefore, cannot predict the final impact on GALIC. There can be no assurance that existing insurance-related laws and regulations will not become more restrictive in the future and thereby have a material adverse effect on the operations of GALIC and on the ability of GALIC to pay dividends. Discontinued Manufacturing Operations _____________________________________ Prior to 1993, the Company sold most of its manufacturing operations. These actions were taken in light of an ongoing strategic review process that led management and the Board of Directors to conclude that such operations either lacked a strong competitive position in the relevant product markets or did not have strong growth prospects or provide sufficiently high returns on investment. In 1991, the Company sold its interest in a manufacturing operation for $18 million in cash. In 1992, the Company sold substantially all of its remaining operations for $130 million in cash, notes and property. In 1993, AAG recorded a $14.8 million pretax provision related to discontinued operations. Approximately $9.7 million of the provision represented employee related obligations resulting primarily from a decrease in the discount rate used to calculate pension obligations; approximately $3.3 million related to adjustments for certain property and inventory associated with the Company's former manufacturing properties. At December 31, 1993, the Company owned an electronic components manufacturer with assets of approximately $8.6 million and 1993 revenues of approximately $11.9 million. Employees _________ As of December 31, 1993, AAG employed approximately 15 persons and GALIC employed approximately 425 persons. None of the employees are represented by a labor union. AAG believes that its employee relations are excellent. In 1993, AAG and GALIC moved their offices to Cincinnati from Stamford, Connecticut and Los Angeles, California, respectively. Most of the manufacturing facilities are currently being leased to companies using them for manufacturing operations. The Company is attempting to sell or extend leases on these facilities. In addition, the Company has agreed to contribute a facility in North Adams, Massachusetts which has been vacant for several years to a not-for-profit entity which intends to develop the property into a multi-discipline art center. Environmental Matters Federal and state laws and regulations, including the federal Comprehensive Environmental Response, Compensation, and Liability Act and similar state laws, impose liability on the Company (as the successor to Sprague) for the investigation and cleanup of hazardous substances disposed of or spilled by its discontinued manufacturing operations, at facilities still owned by the Company and facilities transferred in connection with the sales of certain operations, as well as at disposal sites operated by third parties. In addition, the Company has indemnified the purchasers of its former operations for the cost of such activities. At several sites, the Company is conducting cleanup activities of soil and ground water contamination in accordance with consent agreements between the Company and state environmental agencies. The Company has also conducted or is aware of investigations at a number of other locations of its former operations that have disclosed environmental contamination that could cause the Company to incur additional costs of investigation and remediation. The Company has also been identified by state and federal regulators as a potentially responsible party at a number of other disposal sites. Based on the costs incurred by the Company over the past several years and discussions with its independent environmental consultants, management believes that reserves recorded for such clean-up activities are sufficient in all material respects to satisfy the known liabilities. However, the regulatory standards for clean-up are continually evolving toward more stringent requirements. In addition, many of the environmental investigations at the Company's former operating locations and third-party sites are still preliminary, and where clean-up plans have been proposed, they have not yet received full approval from the relevant regulatory agencies. Further, the presence of the Company generated wastes at third-party disposal sites exposes the Company to joint and several liability for the potential additional costs of cleaning up wastes generated by others. Accordingly, there can be no assurance that the costs of environmental clean-up for the Company may not be significantly higher in future years, possibly necessitating additional charges. Except as set forth below, the Company considers any administrative or judicial proceedings involving the Company which are related to environmental matters to be ordinary routine litigation incidental to its business. The Maine Department of Environmental Protection has issued a proposed Administrative Consent Agreement and Enforcement Order calling for a $328,000 fine based on alleged 1991 violations of certain reporting regulations. The Company is working with the Department of Environmental Protection to resolve this matter and is negotiating the amount of the fine. ITEM 3 ITEM 3 Legal Proceedings _________________ American Annuity (as the successor to STI), its directors and AFC are defendants in seven class and derivative actions which were filed in the Court of Chancery of the State of Delaware. These actions were filed following the public announcement on June 26, 1992 that STI was considering a proposal from GAI relating to the purchase of GALIC. The actions are captioned: (a) William Steiner v. STI Group, Inc., et al., Civil Action No. ___________________________________________ 12614 filed June 29, 1992; (b) Frank Seinfeld v. STI Group, Inc., et al., __________________________________________ Civil Action No. 12616 filed June 29, 1992; (c) Frederick Rand v. STI Group, ____________________________ Inc., et al., Civil Action No. 12622 filed June 30, 1992; (d) Eli Ballan, et _____________ ______________ al., v. Carl H. Lindner, et al., Civil Action No. 12619 filed June 30, 1992; ________________________________ (e) Seymour Arkin v. Carl H. Lindner, et al., Civil Action No. 12620 filed _________________________________________ June 20, 1992; (f) Jeffrey Rubenstein v. Carl H. Lindner, et al., Civil ______________________________________________ Action No. 12532 filed July 7, 1992; and (g) Harry Lewis v. Carl H. Lindner, _______________________________ et al., Civil Action No. 12633 filed July 7, 1992. On September 24, 1992, _______ all of the foregoing actions were consolidated under the caption In re STI _________ Group, Inc. Shareholders Litigation, Consolidated Civil Action No. 12619. ___________________________________ The consolidated action asserts both class and derivative claims against American Annuity, its directors and AFC. The consolidated action alleges that the acquisition of GALIC by the Company was a self-dealing transaction designed to benefit AFC, was a waste of the Company's assets and constituted a breach of fiduciary duties by AFC and the Company's directors. Following the filing of the suits, the Company and AFC engaged in active settlement discussions with the plaintiffs. These discussions resulted in an agreement to settle the consolidated action on the basis of the earlier increase in the per share consideration paid by AFC for shares of the Company's common stock in connection with the acquisition and the decrease in the price paid by the Company for GALIC. The plaintiffs' counsel have applied to the Court of Chancery for an award of fees and expenses in the amount of $550,000. The Company has not opposed this application. The Court is scheduled to consider approval of the settlement and an award of attorneys' fees in April 1994. AAG and GALIC are subject to litigation and arbitration in the normal course of its business. GALIC is not a party to any material pending litigation or arbitration. PART II ITEM 5 ITEM 5 Market for Registrant's Common Equity and Related Stockholder Matters _______________________________ AAG's Common Stock is listed and traded principally on the New York Stock Exchange ("NYSE") under the symbol AAG. On March 1, 1994, there were approximately 10,000 holders of record of Common Stock. The following table sets forth the range of high and low sales prices for the Common Stock on the NYSE Composite Tape. _________________ _________________ High Low High Low ____ ___ ____ ___ First Quarter $11.38 $5.63 $8.00 $6.13 Second Quarter 11.38 8.75 6.75 5.63 Third Quarter 11.00 7.88 6.75 5.63 Fourth Quarter 10.38 8.25 6.75 5.88 The Company paid annual dividends of $.05 per share in 1993, 1992 and 1991. AAG has not determined a dividend paying policy for the future; the amount of dividends available to be paid at December 31, 1993 is limited to $2.5 million by certain indenture covenants. In December 1993, AAG announced an offer to purchase stock from holders of ten or fewer shares of its Common Stock. In February 1994, AAG repurchased 4,107 shares at $11 per share from approximately 1,100 shareholders. ITEM 6 ITEM 6 Selected Financial Data _______________________ The following financial data have been summarized from, and should be read in conjunction with, the Company's consolidated financial statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations". The data reflects the purchase of GALIC as of December 31, 1992 (in millions, except per share amounts). Operations Statement Data: 1993 1992 1991 1990 1989 __________________________ ____ ____ ____ ____ ____ Net investment income $353.3 $ 3.6 $ 1.9 $ 0.4 $ 1.2 Total revenues 387.2 3.6 1.9 0.4 1.2 Earnings (loss) from continuing operations 53.0 (9.0) (4.7) (6.0) (6.9) Loss from discontinued operations (9.6) (16.8) (47.8) (43.3) (89.9) Extraordinary item (3.4) - - - - Change in accounting principle - (3.1) - - - ______ _____ _____ _____ _____ Net earnings (loss) $ 40.0 ($28.9) ($52.5) ($49.3) ($96.8) ______ _____ _____ _____ _____ Earnings (loss) per common share: Continuing operations $1.41 ($0.50)($0.26) ($0.33) ($0.37) Discontinued operations (.27) (.94) (2.66) (2.37) (4.94) Extraordinary item (.10) - - - - Change in accounting principle - (.17) - - - _____ _____ _____ _____ _____ Net earnings (loss) $1.04 ($1.61) ($2.92) ($2.70) ($5.31) _____ _____ _____ _____ _____ Balance Sheet Data: ___________________ Total assets $4,913.8 $4,480.4 $170.1 $294.8 $382.6 Long-term debt 225.9 230.9 27.9 30.6 65.7 Total stockholders' equity 250.3 186.6 108.5 171.8 216.7 ITEM 7 ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations ________________________________________________ General Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of AAG's financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page. AAG is organized as a holding company with nearly all of its operations being conducted by Great American Life Insurance Company ("GALIC"), which was acquired by AAG on December 31, 1992. The parent corporation, however, has continuing expenditures for administrative expenses, corporate services, liabilities in connection with discontinued operations and, most importantly, for the payment of interest on borrowings and dividends on preferred stock. Since its business is financial in nature, AAG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful. Liquidity and Capital Resources Ratios The ratio of AAG's long-term debt to equity was .90 at December 31, ______ 1993, compared to 1.24 at December 31, 1992. AAG's ratio of earnings to fixed charges was 4.7 in 1993; the ratio of earnings to fixed charges and preferred dividends was 3.8 for the same period. Sources and Uses of Funds In connection with the GALIC acquisition, AAG _________________________ sold common and preferred stock to GALIC's parent, Great American Insurance Company, for $156 million in cash. The proceeds of those stock sales together with $230 million in new borrowings and most of the accumulated cash funds of the Company were used to purchase GALIC. The total cost to acquire GALIC was approximately $486 million, including transaction costs and fees of $17.4 million. The borrowings used to fund the GALIC acquisition were repaid during 1993 from the sales of $125 million of 11-1/8% Senior Subordinated Notes due 2003 and $100 million of 9-1/2% Senior Notes due 2001. As a result of the refinancings, AAG has no scheduled principal maturities until the year 2001. Annual interest and dividend payments on AAG's debt and preferred stock are approximately $26.6 million. AAG's ability to make interest and principal payments on its debt, and pay dividends on its preferred stock and other holding company costs is dependent on cash payments from GALIC. In 1993, AAG received $53.6 million in tax allocation payments (including $19 million for 1992) and $18.2 million in capital distributions from GALIC. In the second quarter of 1993, AAG made a capital contribution of $13.0 million to GALIC. Capital distributions by GALIC are subject to various laws and regulations which limit the amount of dividends that can be paid without regulatory approval. (See Note L to the financial statements.) The maximum amount of dividends payable by GALIC in 1994 without approval is approximately $44.0 million. In January 1994, AAG entered into a four-year $20 million revolving line of credit agreement with a bank. AAG has not made any cash draws under this agreement. Based upon the current level of GALIC's operations and anticipated growth, AAG believes that it will have sufficient resources from GALIC's dividends and tax allocation payments to meet its liquidity requirements. Investments The National Association of Insurance Commissioners ("NAIC") ___________ assigns quality ratings to publicly traded as well as privately placed securities. At December 31, 1993, 95% of GALIC's fixed maturity portfolio was comprised of investment grade bonds (NAIC rating of "1" or "2") compared to 91% at December 31, 1992. Management believes that the high credit quality of GALIC's investment portfolio should generate a stable and predictable investment return. GALIC invests primarily in fixed income investments which approximated 98% of its investment portfolio at December 31, 1993. GALIC generally invests in securities with intermediate term maturities with an objective of optimizing interest yields while maintaining an appropriate relationship of maturities between GALIC's assets and expected liabilities. GALIC's fixed maturity portfolio is classified into two categories: "held to maturity" and "available for sale". (See Note A to the financial statements.) At December 31, 1993, GALIC had approximately $206 million in net unrealized gains on its fixed maturity portfolio compared to $117 million at December 31, 1992. At December 31, 1993, none of the Company's fixed maturity investments were non-performing. In addition, GALIC has little exposure to mortgage loans and real estate. As of December 31, 1993, these investments represented only 1.6% of total assets. The majority of mortgage loans and real estate was purchased in the latter half of 1993. At December 31, 1993, collateralized mortgage obligations ("CMOs") represented approximately 35% of fixed maturity investments compared to 42% at December 31, 1992. As of December 31, 1993, interest only (I/O), principal only (P/O) and other "high risk" CMOs represented approximately 0.2% of total CMOs. GALIC invests primarily in CMOs which are structured to minimize prepayment risk. In addition, the majority of CMOs held by GALIC were purchased at a discount to par value. Management believes that the structure and discounted nature of the CMOs will minimize the effect of prepayments on earnings over the anticipated life of the CMO portfolio. Substantially all of GALIC's CMOs are AAA-rated by Standard & Poor's Corporation and are collateralized by GNMA, FNMA and FHLMC single-family residential pass-through certificates. The market in which these securities trade is highly liquid. Aside from interest rate risk, AAG does not believe a material risk (relative to earnings or liquidity) is inherent in holding such investments. The Ohio Insurance Code contains rules restricting the types and amounts of investments which are permissible for an Ohio life insurer, including GALIC. These rules are designed to ensure the safety and liquidity of the insurer's investment portfolio. The NAIC is considering the formulation of a model investment law which, if adopted, would have to be considered by Ohio for adoption. The formulation is in the preliminary stages and management believes its impact on GALIC's operations will not be material. Results of Operations Net Earnings and General Net earnings were $40.0 million or $1.04 per ________________________ common share in 1993. GALIC was acquired by AAG on December 31, 1992; accordingly, its results are not included in the Company's statement of operations prior to 1993. All of GALIC's products are fixed rate annuities which permit GALIC to change the crediting rate at any time (subject to minimum interest rate guarantees of 3% to 4% per annum). As a result, management has been able to react to changes in interest rates and maintain a desired interest rate "spread" with little or no effect on persistency. The following table provides a comparison of certain amounts for GALIC (in millions): Total annuity receipts increased primarily due to the introduction of new single premium products in the second half of 1992. Net Investment Income GALIC's net investment income increased 7% over the _____________________ comparable 1992 period. An increase in average fixed maturity investments more than offset a decrease in interest rates available in the marketplace. Investment income is reflected in the Statement of Operations net of investment expenses of $4.9 million in 1993. Realized Gains Individual securities are sold from time to time as market ______________ opportunities appear to present optimal situations under AAG's investment strategies. Equity in Net Loss of Affiliate Equity in net loss of affiliate represents _______________________________ AAG's proportionate share of Chiquita's losses in 1993. Chiquita reported a net loss for 1993 of $51 million compared to a net loss of $284 million for 1992. The improvement in 1993 was attributed primarily to a multi-year investment spending program and the ongoing impact of its restructuring and cost reduction efforts. Interest on Annuity Policyholders' Funds GALIC's interest on annuity ________________________________________ policyholders' funds decreased 5% from its comparable 1992 period. The average crediting rate on funds held by GALIC has decreased from 7.2% at December 31, 1991, to 6.2% at December 31, 1992 and to 5.3% at December 31, 1993. The rate at which GALIC credits interest on annuity policyholders' funds is subject to change based on management's judgment of market conditions. Provision for Relocation Expenses In 1993, GALIC relocated its corporate _________________________________ offices from Los Angeles to Cincinnati; the estimated cost of this move ($8.0 million) was included in 1993 continuing operations. Also in 1993, AAG relocated its corporate offices from Stamford to Cincinnati; the estimated cost of this relocation and related shutdown and severance costs ($5.0 million) was provided for in discontinued operations in 1992. Discontinued Operations The Company has sold virtually all of its former _______________________ manufacturing businesses. A small Belgium based subsidiary continues to be held for sale along with certain properties, most of which are currently leased to companies using them for manufacturing operations. The Company has certain obligations related to its former business activities. Among these obligations is the funding of pension plans, environmental remediation costs, lease payments for two former plant sites, certain retiree medical benefits, and certain obligations associated with the sales of the Company's manufacturing operations. In 1992, the Company recorded pretax charges related to discontinued operations totalling $24.5 million. In the fourth quarter of 1993, AAG recorded pretax charges for discontinued operations totalling $14.8 million. These charges included employee related obligations of approximately $9.7 million resulting primarily from a decrease (from 9.5% to 7.125%) in the discount rate used to calculate pension obligations. The remaining charges reflected write-downs and other estimated expenses associated with the Company's former manufacturing properties. (See Note H to the financial statements.) While it is difficult to estimate future environmental remediation costs accurately, management believes the aggregate cost of remediation at all sites for which it has responsibility will range from $10 million to $15 million. The reserve for environmental remediation work was $10.6 million at December 31, 1993. Changes in regulatory standards and further investigation of these sites could affect estimated costs in the future. Management believes, based on the costs incurred by the Company over the past several years and discussions with its independent environmental consultants, that reserves recorded for such clean-up activities are sufficient to satisfy the known liabilities and that the outcome of the contingencies will not, individually or in the aggregate, have a material adverse effect on the financial condition or results of operations of AAG. Extraordinary Item In August 1993, AAG prepaid its Bank Term Loan and wrote __________________ off $5.2 million ($3.4 million net of tax) of related unamortized debt issuance costs. Accounting Change Effective January 1, 1992, AAG implemented Statement of _________________ Financial Accounting Standards ("SFAS") No. 106, "Accounting for Postretirement Benefits Other Than Pensions", and recorded a provision of $3.1 million for the projected future costs of providing postretirement benefits to retirees in its discontinued manufacturing operations. New Accounting Standard to be Implemented The FASB has issued SFAS No. 112, _________________________________________ "Employers' Accounting for Postemployment Benefits", which became effective in 1994. The FASB has also issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", which is scheduled to become effective in 1995. Implementation of these standards is not expected to have a material effect on AAG. ITEM 8 ITEM 8 Financial Statements and Supplementary Data ___________________________________________ PAGE ____ Reports of Independent Auditors Consolidated Balance Sheet: December 31, 1993 and 1992 Consolidated Statement of Operations: Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Stockholders' Equity: Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows: Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements "Selected Quarterly Financial Data" has been included in Note M to the Consolidated Financial Statements. PART III The information required by the following Items will be included in American Annuity's definitive Proxy Statement for the 1994 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission within 120 days of the Company's fiscal year end and is herein incorporated by reference: 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 ______________________________________________ REPORTS OF INDEPENDENT AUDITORS American Annuity Group, Inc.: We have audited the accompanying consolidated balance sheets of American Annuity Group, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the years then ended. 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. The consolidated financial statements of American Annuity Group, Inc. for the year ended December 31, 1991, were audited by other auditors whose report thereon dated March 24, 1992, expressed an unqualified opinion on those statements prior to adjustment for reclassification of discontinued operations. 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 American Annuity Group, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for the years then ended, 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. In 1992, the Company discontinued its manufacturing operations. As a result, these operations were reclassified and reported as discontinued operations. We also audited the adjustments that were applied to reclassify the discontinued operations in the 1991 consolidated financial statements. In our opinion such reclassifications were appropriate and properly applied. As discussed in Note A to the consolidated financial statements, the Company changed its method of accounting in 1993 for certain investments in debt and equity securities and in 1992 for income taxes and postretirement benefits other than pensions. Ernst & Young Cincinnati, Ohio March 11, 1994 American Annuity Group, Inc.: We have audited the consolidated balance sheet of American Annuity Group, Inc., formerly Sprague Technologies, Inc., and subsidiaries (not presented separately herein) as of December 31, 1991, and the related consolidated statements of operations, common stockholders' equity and cash flows for the year then ended (before adjustments and reclassifications to conform with the presentation for 1992). Our audit also included the 1991 financial statement schedule listed in the Index at Item 14(a) for the year ended December 31, 1993. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and the financial statement 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, such consolidated financial statements (before adjustments and reclassifications to conform with the presentation for 1992) present fairly, in all material respects, the financial position of American Annuity Group, Inc. and subsidiaries as of December 31, 1991, 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 financial statement schedule for 1991, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. Deloitte & Touche Stamford, Connecticut March 24, 1992 AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in millions) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (In millions, except per share amounts) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (In millions) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In millions) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying consolidated financial statements include the accounts of American Annuity Group, Inc. and its subsidiaries ("American Annuity", "AAG" or "the Company"). Intercompany transactions and balances are eliminated in consolidation. Certain reclassifications have been made to prior periods to conform to the current year's presentation. American Financial Corporation and subsidiaries ("AFC") owned 28,081,467 shares (80%) of AAG's Common Stock at December 31, 1993. The acquisition of Great American Life Insurance Company ("GALIC"), a subsidiary of AFC, on December 31, 1992, was recorded as a transfer of net assets between companies under common control. As a result, the net assets of GALIC were recorded by AAG at AFC's historical basis and the excess consideration paid over AFC's historical basis was treated as a reduction of common stockholders' equity. The results of GALIC's operations have been included in AAG's consolidated financial statements since its acquisition. Investments When available, fair values for investments are based on prices quoted in the most active market for each security. If quoted prices are not available, fair value is estimated based on present values, fair values of comparable securities, or similar methods. AAG implemented Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities", beginning December 31, 1993. This standard requires that (i) debt securities be classified as "held to maturity" and reported at amortized cost if AAG has the positive intent and ability to hold them to maturity, (ii) debt and equity securities be classified as "trading" and reported at fair value, with unrealized gains and losses included in earnings, if they are bought and held principally for selling in the near term and (iii) debt and equity securities not classified as held to maturity or trading be classified as "available for sale" and reported at fair value, with unrealized gains and losses reported as a separate component of stockholders' equity. Only in certain limited circumstances, such as significant issuer credit deterioration or if required by insurance or other regulators, may a company change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. Prior to the implementation of SFAS No. 115, AAG carried a portion of its fixed maturity securities at fair value with unrealized gains and losses carried as a separate component of stockholders' equity with the remainder of such securities carried at amortized cost. In connection with implementing SFAS No. 115, AAG reviewed its investment portfolio resulting in a reclassification at December 31, 1993 of approximately $704 million of its fixed maturity portfolio (including approximately $485 million in CMOs) from "held to maturity" to "available for sale" which, in turn, resulted in (i) an increase of $36 million in the carrying value of fixed maturity investments and (ii) an increase of $23 million in stockholders' equity. The reclassification reflects management's intention to reduce the proportion of CMOs owned and more actively manage the duration of its fixed maturity portfolio. The implementation of SFAS No. 115 had no effect on net income. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Short-term investments are carried at cost; mortgage loans on real estate are generally carried at amortized cost; policy loans are stated at the aggregate unpaid balance. Carrying amounts of these investments approximate their fair value. Gains or losses on sales of securities are recognized at the time of disposition with the amount of gain or loss determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings and the carrying value of that investment is reduced. Premiums and discounts on CMOs are amortized over their expected average lives using the interest method. Investment in Affiliates AAG's investments in equity securities of companies that are 20% to 50% owned by AFC and its subsidiaries are carried at cost, adjusted for a proportionate share of their undistributed earnings or losses. Deferred Policy Acquisition Costs ("DPAC") DPAC (principally new commissions, advertising, underwriting, policy issuance and sales expenses that vary with and are primarily related to the production of new business) is deferred and amortized, with interest, in relation to the present value of expected gross profits on the policies. These gross profits consist principally of net investment income and future surrender charges, less interest on policyholders' funds and future policy administration expenses. DPAC is reported net of unearned revenue relating to certain policy charges that represent compensation for future services. These unearned revenues are recognized as income using the same assumptions and factors used to amortize DPAC. Beginning with the implementation of SFAS No. 115 in 1993, to the extent that unrealized gains from securities classified as "available for sale" would result in adjustments to DPAC, unearned revenues and policyholder liabilities had those gains actually been realized, such balance sheet amounts are adjusted, net of deferred taxes. Annuity Policyholders' Funds Accumulated Annuity premium deposits and benefit payments are generally recorded as increases or decreases in "annuity policyholders' funds accumulated" rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for surrender charges are credited to other income. The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. The aggregate fair value of all annuity liabilities, net of DPAC, at December 31, 1993, approximates the amounts recorded in the financial statements. Income Taxes As of December 31, 1992, AAG and its 80%-owned U.S. subsidiaries were consolidated with AFC for federal income tax purposes. For periods prior to December 31, 1992, AAG filed consolidated tax returns which included all of its 80%-owned U.S. subsidiaries. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued AAG and GALIC have separate tax allocation agreements with AFC which designate how tax payments are shared by members of the tax group. In general, both companies compute taxes on a separate return basis. GALIC is obligated to make payments to (or receive benefits from) AFC based on taxable income without regard to temporary differences. In accordance with terms of AAG's indentures, AAG receives GALIC's tax allocation payments for the benefit of AAG's deductions arising from current operations. If GALIC's taxable income (computed on a statutory accounting basis) exceeds a current period net operating loss of AAG, the taxes payable by GALIC associated with the excess are payable to AFC. If the AFC tax group utilizes any of AAG's net operating losses or deductions that originated prior to 1993, AFC will pay to AAG an amount equal to the benefit received. Effective January 1, 1992, the Company implemented SFAS No. 109, "Accounting for Income Taxes". As permitted under the Statement, AAG's prior year financial statements have not been restated and no adjustment was necessary for the cumulative effect of the change. Under SFAS No. 109, the liability method used in accounting for income taxes is less restrictive than the liability method under SFAS No. 96, previously used by the Company. The provisions of SFAS No. 109 allow AAG to recognize deferred tax assets if it is more likely than not that a benefit will be realized. Under SFAS No. 109, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Current and deferred tax assets and liabilities are aggregated with other amounts receivable from or payable to affiliates. Debt Issuance Costs Debt expenses are amortized over the terms of the respective borrowings on the interest method. Statement of Cash Flows For cash flow purposes, "investing activities" are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. "Financing activities" include annuity receipts, surrenders and withdrawals and obtaining resources from owners and providing them with a return on their investments. All other activities are considered "operating". Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements. Benefit Plans AAG participates in AFC's Employee Stock Ownership Retirement Plan ("ESORP") covering all employees who are qualified as to age and length of service. The ESORP is a trusteed, noncontributory plan which invests in securities of AFC for the benefit of the employees of AFC and its subsidiaries. Contributions are discretionary by the directors of AAG and are charged against earnings in the year for which they are declared. Qualified employees having vested rights in the plan are entitled to benefit payments at age 60. AAG and certain of its subsidiaries provide health care and life insurance benefits to eligible retirees. Effective January 1, 1992, AAG implemented SFAS No. 106, "Accounting for Postretirement Benefits Other Than Pensions". Prior to 1992, the cost of these benefits had generally been recognized as claims were incurred. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued B. ACQUISITION OF GALIC On December 31, 1992, AAG acquired GALIC from Great American Insurance Company ("GAI"), a wholly owned subsidiary of AFC, for $468 million. In connection with the acquisition, GAI purchased from AAG 17,076,923 shares of AAG's Common Stock at $6.50 per share, and 450,000 shares of its Series A Preferred Stock at $100 per share. Concurrent with the acquisition, GAI purchased 5,140,973 shares of AAG's Common Stock pursuant to a cash tender offer. C. INVESTMENTS Fixed maturity investments at December 31, consisted of the following (in millions): Distribution based on market value is generally the same. Collateralized mortgage obligations had an expected average life of approximately 4 years at December 31, 1993. The carrying values of investments were determined after deducting cumulative provisions for impairment aggregating $14.4 million and $20.0 million at December 31, 1993 and 1992, respectively. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued Gross gains of $45.3 million and gross losses of $11.0 million were realized on sales of fixed maturity investments during 1993. The carrying value of investments in any entity in excess of 10% of stockholders' equity at December 31, 1993, other than investments in affiliates and investments issued or guaranteed by the U.S. Government or government agencies, were as follows (in millions): At December 31, 1993, gross unrealized gains on marketable equity securities were $13.1 million and gross unrealized losses were zero. Realized gains and changes in unrealized appreciation on fixed maturity and equity security investments are summarized as follows (in millions): GALIC's investment portfolio is managed by a subsidiary of AFC. Investment expenses included investment management charges of $4.4 million, which represented approximately one-tenth of one percent of GALIC's invested assets during 1993. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued D. INVESTMENT IN AFFILIATES Investment in affiliates at December 31, 1993, reflects AAG's 5% ownership (2.7 million shares) of the common stock of Chiquita Brands International ("Chiquita") which is accounted for under the equity method. At that same date, AFC and its other subsidiaries owned an additional 41% interest in the common stock of Chiquita. Chiquita is a leading international marketer, processor and producer of quality food products. The carrying value of AAG's investment in Chiquita at December 31, 1993 was $25.2 million. The market value of AAG's investment in Chiquita was approximately $30.7 million at December 31, 1993 and $46.1 million at March 1, 1994. In addition to AAG's investment in Chiquita, investment in affiliates at December 31, 1992, included a $9.0 million investment in the preferred stock of Spelling Entertainment Group Inc. The Spelling preferred stock was redeemed in November 1993. Included in AAG's retained earnings (deficit) at December 31, 1993, was approximately $2.6 million applicable to equity in undistributed net losses of Chiquita. E. DEFERRED POLICY ACQUISITION COSTS The DPAC balances at December 31, 1993 and 1992 are shown net of unearned revenues of $146.2 million and $152.8 million, respectively. F. LONG-TERM DEBT Long-term debt consisted of the following at December 31, (in millions): In connection with the GALIC acquisition, AAG borrowed $180 million under a Bank Term Loan Agreement and $50 million under a Bridge Loan. In 1993, AAG sold $225 million principal amount of Notes to the public and used the proceeds to repay the Bank and Bridge Loans. As a result, AAG has no scheduled principal maturities until the year 2001. AAG recorded an extraordinary loss of $5.2 million ($3.4 million net of tax) representing unamortized bank debt issue costs which were written off upon retirement of the bank debt. The fair value of AAG's outstanding debt exceeds the carrying value (net of unamortized debt issuance costs) by approximately $19 million at December 31, 1993. Interest payments were $11.7 million in 1993, $2.0 million in 1992 and $4.9 million in 1991. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued G. STOCKHOLDERS' EQUITY The Company is authorized to issue 25,000,000 shares of Preferred Stock, par value $1.00 per share. On December 31, 1992, AAG issued 17,076,923 shares of Common Stock and 450,000 shares of Series A Cumulative Preferred Stock, $100 redemption value, in connection with the acquisition of GALIC. Holders of the Series A Preferred Stock are entitled to receive dividends at the rate of $7.00 per share per annum. The preferred shares issued were recorded at $29.4 million (imputed dividend rate of 12% through 2007) with the excess paid of $15.6 million credited to capital surplus and accreting over 15 years. If the preferred shares are outstanding after January 1, 2008, substantial limitations on the ability of AAG and its subsidiaries to borrow funds, issue stock or pay common stock dividends will become effective. In 1993, 1992 and 1991, AAG paid annual dividends of $.05 per common share. At December 31, 1993, AAG's cash dividends were limited to $2.5 million under indenture covenants. Under the Company's 1987 Stock Option Plan ("Option Plan"), stock options were granted to officers and other key employees of the Company to purchase shares of Common Stock. The Company also had a Spin-Off Stock Option Plan ("Spin-Off Plan") under which a one-time grant of options was made to directors, officers and employees of the Company who had held options or shares of STI's former parent on the STI distribution date. As a result of the sales of subsidiaries and pursuant to the terms of the plans, all options became fully vested and exercisable in January 1992. In February 1992, 1.5 million options were exercised; a total of 93,550 shares under the Option Plan and 377,804 shares under the Spin-Off Plan expired. Also in February 1992, under the Company's Redemption Program, AAG purchased from employees (i) 499,025 shares of Common Stock at a price of $6.725 per share and (ii) 867,000 shares of Common Stock at a price of $6.8125 per share. A charge to income of $2.8 million was recorded in 1991 to reflect the exercise of stock options and the repurchase of Common Stock pursuant to the Redemption Program. H. DISCONTINUED OPERATIONS The results of discontinued operations included in the Statement of Operations were as follows (in millions): Year ended December 31, _______________________ 1993 1992 1991 ____ ____ ____ Net sales $ - $ 80.7 $294.1 Cost of sales - (80.7)(258.8) Interest and debt expense - (1.2) (3.7) Selling, general and administrative costs - - (37.3) Loss on sales of businesses and restructuring provisions (14.8) (24.5) (55.1) Gain on sale of investment in affiliate - - 8.5 _____ _____ _____ Loss from discontinued operations before tax (14.8) (25.7) (52.3) Income tax benefit (5.2) (8.9) (4.5) _____ ______ _____ Loss from discontinued operations ($ 9.6) ($16.8)($47.8) _____ _____ _____ AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued All of the Company's former manufacturing businesses are reported as discontinued operations. At December 31, 1993, the Company's last manufacturing unit, Electromag NV, was being held for sale and was carried at estimated net realizable value. The loss from discontinued operations in 1993 included charges for employee related obligations of approximately $9.7 million resulting primarily from a decrease (from 9.5% to 7.125%) in the discount rate used to calculate pension obligations. The remaining charges reflected additional write-downs and other estimated expenses associated with the Company's former manufacturing properties. During 1992, the Company recorded charges related to discontinued operations as follows: employee related obligations -- $6.8 million; environmental liabilities -- $5.0 million; corporate office shutdown and severance costs - - $5.0 million; property valuation adjustments -- $3.6 million; potential merchandise returns -- $2.0 million and other -- $2.1 million. In 1992, AAG sold its capacitor and thick film network businesses for approximately $130 million in cash, notes and property. The Company recorded provisions of $42.6 million related to the anticipated sales of these operations during 1991. In 1991, the Company sold its 45.3% interest in a manufacturing operation for a cash payment of $18.0 million, recognizing a pretax gain of $8.5 million on the sale. The Company has a noncontributory defined benefit pension plan covering former U.S. employees of its discontinued manufacturing operations. The former employees in this plan generally receive pension benefits that are based upon formulas that reflect all past service with the Company and the employee's compensation during employment. Contributions are made on an actuarial basis in amounts necessary to satisfy requirements of ERISA. At December 31, 1993, the actuarial value of the benefit obligations, which are being discounted at 7.125%, exceeded the plan assets by $15.1 million, which has been included in accrued expenses in the financial statements. Effective January 1, 1992, AAG implemented SFAS No. 106 and recorded a provision of $3.1 million for the projected future costs of providing postretirement medical benefits to retirees in its discontinued manufacturing operations. I. INCOME TAXES Provision (benefit) for income taxes consisted of (in millions): 1993 1992 1991 ____ ____ ____ Federal: Current $27.4 $ - $2.6 Deferred (7.4) (8.9) (5.0) Foreign: Current - - 0.3 Deferred - - (2.6) State - 0.5 0.4 _____ ____ ____ Total $20.0 ($8.4) ($4.3) _____ ____ ____ AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued At December 31, 1993, AAG had net operating loss carryforwards for federal income tax purposes of approximately $161 million which are scheduled to expire as follows: $18.6 million in 1994, $24.1 million in 1995 through 2001 and $118.3 in 2002 through 2005. An income tax refund of $1.1 million was received in 1991. Cash disbursements for income taxes were not material. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued J. LEASES Leases relate principally to certain administrative facilities and discontinued operations. Future minimum lease payments, net of sublease revenues, under operating leases having initial or remaining noncancellable lease terms in excess of one year at December 31, 1993 are payable as follows: 1994 -- $700,000; 1995 -- $1.0 million; 1996 -- $1.1 million; 1997 -- $1.1 million; 1998 -- $800,000; 1999 and beyond -- $2.8 million. Rental expense for operating leases was $900,000 in 1993, $1.5 million in 1992 and $6.7 million in 1991. K. CONTINGENCIES The Company is presently conducting investigations or clean-up activities in accordance with consent agreements with state environmental agencies. Based on the costs incurred over the past several years and discussions with independent environmental consultants, the Company believes the aggregate cost of environmental remediation work at all sites for which it has responsibility will range from $10 million to $15 million. The reserve for environmental remediation work was $10.6 million at December 31, 1993. Management does not believe that these clean-up activities will have a material effect upon the Company's financial position, results of operations or cash flows. "Marketable securities, restricted in use" consists primarily of amounts held in escrow with respect to certain clean-up activities due to sales of various discontinued operations. In 1991, the Company identified possible deficiencies in procedures for reporting quality assurance information to the Defense Electronics Supply Center ("DESC") with respect to the manufacturing of capacitors utilized by, among others, the United States Government. The Company has certain indemnification obligations for losses, if any, which result from these matters. Management believes an adequate accrual has been recorded at December 31, 1993, and that any future impact on AAG's operations will not be material. L. STATUTORY INFORMATION; RESTRICTIONS ON TRANSFERS OF FUNDS AND ASSETS OF SUBSIDIARIES GALIC is required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). For the year ended December 31, 1993, GALIC's statutory net earnings were $44.0 million. Certain statutory balance sheet amounts at December 31, were as follows (in millions): 1993 1992 ____ ____ Policyholders' surplus $251.3 $216.2 Asset valuation reserve 70.3 70.9 Interest maintenance reserve 35.7 17.2 The amount of dividends which can be paid by GALIC without prior approval of regulatory authorities is subject to restrictions relating to capital and surplus and statutory net income. GALIC may pay approximately $44.0 million in dividends in 1994, based on statutory net income, without prior approval. AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued 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 are Included in Part II, Item 8. 2. Financial Statement Schedules: Selected Quarterly Financial Data is included in Note M to the Consolidated Financial Statements. Schedules filed herewith: For 1993, 1992 and 1991 Page _______________________ ____ II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties S-2 III - Condensed Financial Information of Registrant S-3 All other schedules for which provisions are made in the applicable regulation of the Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Financial Statements or the notes thereto. 3. Exhibits - See Exhibit Index on Page E-1. (b) Reports on Form 8-K's: None AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In millions) AMERICAN ANNUITY GROUP, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In millions) Condensed Statement of Cash Flows _________________________________ Year ended December 31 _____ Operating Activities: Net earnings $40.0 Adjustments: Discontinued operations 9.6 Extraordinary item 3.4 Equity in net earnings of affiliates (77.6) Increase in receivables from affiliates (2.8) Amortization of debt expense 1.2 Decrease in other assets 0.4 Increase in payables to affiliates 42.8 Decrease in other liabilities (10.7) Dividends from GALIC 18.2 Other, net (0.1) _____ 24.4 _____ Investing Activities: Additional investment in GALIC (13.0) _____ Financing Activities: Additional long-term borrowings 225.0 Reductions of long-term debt (230.0) Cash dividends paid (4.1) _____ (9.1) _____ Net Increase in Cash and Short-term Investments 2.3 Cash and short-term investments at beginning of period 8.1 _____ Cash and short-term investments at end of period $10.4 _____ AMERICAN ANNUITY GROUP, INC. INDEX TO EXHIBITS Number Exhibit Description ______ ___________________ 3.1 Certificate of Incorporation of Registrant 3.2 By-laws of Registrant 4.1 Indenture dated as of February 2, 1993, between the Registrant and Star Bank, National Association, as Trustee, relating to the Registrant's 11-1/8% Senior Subordinated Notes due 2003, incorporated herein by reference to Exhibit 4.2 to the Registrant's Current Report on Form 8-K, dated February 5, 1993. 4.2 Indenture dated as of August 18, 1993, between the Registrant and NationsBank, National Association, as Trustee, relating to the Registrant's 9-1/2% Senior Notes due 2001, incorporated herein by reference to Exhibit 4.1 to the Registrant's Registration Statement on Form S-2 dated August 11, 1993. 10.1 Agreement of Allocation of Payment of Federal Income Taxes ("American Annuity Tax Allocation Agreement"), dated December 31, 1992, between American Financial Corporation and the Registrant incorporated herein by reference to Exhibit 10.12 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.2 Assignment of Tax Allocation Payments dated December 31, 1992, between American Financial Corporation and the Registrant incorporated herein by reference to Exhibit 10.15 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.3 Agreement for the Allocation of Federal Income Taxes dated May 13, 1974, between American Financial Corporation and Great American Life Insurance Company, as supplemented on January 1, 1987 incorporated herein by reference to Exhibit 10.16 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.4 Investment Services Agreement, dated December 31, 1992, between Great American Life Insurance Company and American Money Management Corporation incorporated herein by reference to Exhibit 10.17 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.5 Common Stock Registration Agreement, dated December 31, 1992, between the Registrant and American Financial Corporation and its wholly owned subsidiary Great American Insurance Company incorporated herein by reference to Exhibit 10.22 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.6 Preferred Stock Registration Agreement, dated December 31, 1992, between the Registrant and American Financial Corporation and its wholly owned subsidiary Great American Insurance Company incorporated herein by reference to Exhibit 10.23 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. AMERICAN ANNUITY GROUP, INC. INDEX TO EXHIBITS - Continued Number Exhibit Description ______ ___________________ 10.7 Common Stock Registration Agreement, dated December 31, 1992 between Chiquita Brands International, Inc. and Great American Life Insurance Company incorporated herein by reference to Exhibit 10.24 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993. 10.8 American Annuity Group's 1993 Stock Appreciation Rights Plan. Signatures __________ Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, American Annuity Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned, duly authorized. American Annuity Group, Inc. Signed: March 25, 1994 BY:s/CARL H. LINDNER _______________________________ Carl H. Lindner 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: Signature Capacity Date _________ ________ ____ s/CARL H. LINDNER Chairman of the Board March 25, 1994 _______________________ Carl H. Lindner of Directors s/S. CRAIG LINDNER Director March 25, 1994 ________________________ S. Craig Lindner s/ROBERT A. ADAMS Director March 25, 1994 _______________________ Robert A. Adams s/A. LEON FERGENSON Director March 25, 1994 _______________________ A. Leon Fergenson s/RONALD F. WALKER Director March 25, 1994 _______________________ Ronald F. Walker s/WILLIAM J. MANEY Senior Vice President, March 25, 1994 _______________________ William J. Maney Treasurer and Chief Financial Officer

851945_1993.txt

851945_1993

1993

851945

Item 1. BUSINESS Ogden Projects, Inc. and its subsidiaries (the "Company") provide waste disposal services throughout the United States. Its principal business, conducted through wholly-owned subsidiaries, including Ogden Martin Systems, Inc. ("OMS"), is providing waste-to-energy services. Waste-to- energy facilities combust municipal solid waste to make saleable energy in the form of electricity or steam. Approximately 84.2% of the Company's common stock is held by Ogden Corporation ("Ogden"). The Company was organized as a wholly-owned subsidiary of Ogden in 1984. Through OMS, it holds the exclusive rights to use the proprietary technology (the "Martin Technology") of Martin GmbH fur Umwelt-und Energietechnik of Germany ("Martin") in the United States, other Western Hemisphere locations, and Israel. In addition, the Company has exclusive rights to use the Martin Technology only on a full service design, construct, and operate basis in Germany, the Netherlands, Denmark, Norway, Sweden, Finland, Poland, and Italy. See "Waste-to-Energy Services -- (h) The Cooperation Agreement". The Martin Technology is used in over 150 waste-to-energy facilities operating worldwide, principally in Europe, the Far East, and the United States. Worldwide and in the United States, the Martin Technology is the leading waste-to-energy technology in terms of daily municipal solid waste processing capacity as determined from information available to the Company from Martin and other sources. The Company completed construction of its first waste-to-energy facility in 1986 and currently operates 25 waste-to-energy projects at 24 locations. Three facilities are under construction. The Company is the owner or lessee of 17 of these projects. Additional projects are in various stages of development. See "Waste-to-Energy Services -- (e) The Company's Waste-to- Energy Projects." In 1993 the Company acquired the United States waste-to-energy business of Asea Brown Boveri Inc. through the acquisition of the stock of one of its indirect, wholly-owned subsidiaries. By virtue of the acquisition, the Company became the operator of three facilities. These three facilities do not employ the Martin Technology. The Company owns and operates four additional facilities that do not utilize the Martin Technology. The Company has been awarded three additional projects that are not yet under construction. See "Waste-To-Energy Services -- The Company's Waste- to-Energy Projects" herein. The Company has taken preliminary steps toward expanding its waste-to-energy business internationally. It also is pursuing opportunities to develop independent power projects that utilize fuels other than waste. In addition, the Company is pursuing opportunities to operate and maintain water and wastewater processing facilities. See "Other Services" herein. Waste-To-Energy Services In most cases, the Company, through wholly-owned subsidiaries ("Operating Subsidiaries"), provides waste-to-energy services pursuant to long-term service contracts ("Service Agreements") with local governmental units sponsoring the waste-to-energy project ("Client Communities"). The Company has projects currently under development for which there is no sponsoring Client Community and may in the future undertake other such projects. (a) Terms and Conditions of Service Agreements. Projects generally are awarded by Client Communities pursuant to competitive procurement. The Company has also built and is operating projects that were not competitively bid. Following award of the project, the Client Community and the winning vendor must agree upon the final terms of the Service Agreement. Following execution of a Service Agreement between the Operating Subsidiary and the Client Community, several conditions must be met before construction commences. These usually include, among other things, financing the facility, executing an agreement providing for the sale of the energy produced by the facility, purchasing or leasing the facility site, and obtaining of required regulatory approvals, including the issuance of environmental and other permits required for construction. In many respects, satisfaction of these conditions is not wholly within the Company's control and, accordingly, implementation of an awarded project is not assured, or may occur only after substantial delays. The Company incurs substantial costs in preparing bids and, if it is the successful bidder, implementing the project so it meets all conditions precedent to the commencement of construction. In some instances the Company has made contractual arrangements with communities that provide partial recovery of development costs if the project fails to go into construction for reasons beyond the Company's control. Each Service Agreement is different in order to reflect the specific needs and concerns of the Client Community, applicable regulatory requirements, and other factors. The following description sets forth terms that are generally common to these agreements. Pursuant to the Service Agreement, the Operating Subsidiary designs the facility, generally applies for the principal permits required for its construction and operation, and helps to arrange for financing. The Operating Subsidiary then constructs and equips the facility on a fixed price and schedule basis. The actual construction and installation of equipment is performed by contractors under the supervision of the Operating Subsidiary. The Operating Subsidiary bears the risk of costs exceeding the fixed price of the facility and may be charged liquidated damages for construction delays, unless caused by the Client Community or by unforeseen circumstances beyond the Company's control, such as changes of law ("Unforeseen Circumstances"). After the facility successfully completes acceptance testing, the Operating Subsidiary operates and maintains the facility for an extended term, generally 20 years or more. Under the Service Agreement, the Operating Subsidiary generally guarantees that the facility will meet minimum processing capacity and efficiency standards, energy production levels, and environmental standards. The Operating Subsidiary's failure to meet these guarantees or to otherwise observe the material terms of the Service Agreement (unless caused by the Client Community or by Unforeseen Circumstances) may result in liquidated damages to the Operating Subsidiary or, if the breach is substantial, continuing, and unremedied, the termination of the Service Agreement. In the case of such Service Agreement termination, the Operating Subsidiary may be obligated to discharge project indebtedness. The Service Agreement requires the Client Community to deliver minimum quantities of municipal solid waste ("MSW") to the facility and, regardless of whether that quantity of waste is delivered to the facility, to pay a service fee. See "Waste-to-Energy Services -- (d) Revenues and Income." Generally, the Client Community also provides or arranges for debt financing. Additionally, the Client Community bears the costs of disposing ash residue from the facility and, in many cases, of transporting the residue to the disposal site. Generally, expenses resulting from the delivery of unacceptable and hazardous waste to the facility, and from the presence of hazardous materials on the site, are also borne by the Client Community. In addition, the Client Community is also generally responsible to pay increased expenses and capital costs resulting from Unforeseen Circumstances, subject to limits which may be specified in the Service Agreement. Ogden typically guarantees each Operating Subsidiary's performance under its respective Service Agreement. (b) Other Arrangements for Providing Waste-to-Energy Services. The Company owns two facilities that are not operated pursuant to Service Agreements with Client Communities, and is currently developing, and may undertake in the future, additional such projects. In such projects, the Company must obtain sufficient waste under contracts with haulers or communities to ensure sufficient project revenues. The Company is subject to risks usually assumed by the Client Community, such as those associated with Unforeseen Circumstances and the supply and price of municipal waste to the extent not contractually assumed by other parties. The Company's current contracts with waste suppliers for these two facilities provide that the fee charged for waste disposal service is subject to increase to a limited extent in the event that costs of operation increase as a result of Unforeseen Circumstances. On the other hand, the Company generally retains all of the energy revenues from sales of power to utilities or industrial power users and disposal fees for waste accepted at these facilities. Accordingly, the Company believes that such projects carry both greater risks and greater potential rewards than projects in which there is a Client Community. As a result of the declining number of municipal procurements in the United States, which is anticipated to continue in the near future, such projects are likely to become more common. (c) Project Financing. Financing for projects is generally accomplished through the issuance of a combination of tax-exempt and taxable revenue bonds issued by a public authority. If the facility is owned by the Operating Subsidiary, the authority lends the bond proceeds to the Operating Subsidiary and the Operating Subsidiary contributes additional equity to pay the total cost of the project. For such facilities, project- related debt is included as a liability in the Company's consolidated financial statements. Generally, such debt is secured by the revenues pledged under the respective indenture and is collateralized by the assets of the Operating Subsidiary and otherwise provides no recourse to the Company. The Operating Subsidiaries are able to realize value from facilities owned by them either by selling the facilities and leasing them from the purchaser for extended terms or by selling limited partnership interests in the entity owning the facility. The Company has taken advantage of these financing mechanisms by selling its interests in Tulsa I and Tulsa II to a leveraged lessor and leasing the facility back under a long term lease. In addition, in 1991, limited partnership interests in, and the related tax benefits of, the partnership that owns the Huntington, New York, facility were sold to third party investors. In 1992 the Company sold the subsidiary that held the remaining limited partnership interests in, and certain related tax benefits of, that partnership. Under the limited partnership agreement, an Operating Subsidiary is the general partner and retains responsibility for the operation and maintenance of the facility. The Operating Subsidiary retained 85% of the residual value of the facility after the initial term of the Service Agreement. In 1991, the Company acquired a facility from Blount, Inc. which was sold through a sale- leaseback arrangement. An Operating Subsidiary is the owner of the facility under construction in Onondaga, New York, and a sale of equity interests in such facility is under consideration. (d) Revenues and Income. During the construction period, for facilities owned by Client Communities, construction income is recognized on the percentage-of-completion method based on the percentage of costs incurred to total estimated costs. Construction revenues also include amounts relating to sales of limited partnership interests and related tax benefits in facilities not yet in commercial operation as well as other amounts received with respect to activities conducted by the Company prior to the commencement of commercial operation. After construction is completed and the facility is accepted, the Client Community pays the Operating Subsidiary a fixed operating fee which escalates in accordance with specified indices, reimburses the Operating Subsidiary for certain costs specified in the Service Agreement including taxes, governmental impositions (other than income taxes), ash disposal and utility expenses, and shares with the Operating Subsidiary a portion of the energy revenues (generally 10%) generated by the facility. If the facility is owned by the Operating Subsidiary, the Client Community also pays as part of the Service Fee an amount equal to the debt service due to be paid on the bonds issued to finance the facility. At most facilities, the Company may earn additional fees from accepting waste from the Client Community or others utilizing the capacity of the facility which exceeds the amount of waste committed by the Client Community. For the projects that are not operated pursuant to a Service Agreement, tipping fees, which are generally subject to escalation in accordance with specified indices, and energy revenues are paid to the Company. Electricity generated by these projects is sold to public utilities and in one instance, steam and a portion of the electricity generated is sold to industrial users. Under certain of the contracts under which waste is provided to these facilities, the Company may be entitled to fee adjustments to reflect certain Unforeseen Circumstances. Information about construction revenues, construction costs, service revenues, and operating costs for all of the Company's operations for each of the three years ended December 31, 1993, 1992, and 1991 are presented in the Company's Statements of Consolidated Income incorporated by reference to Part IV of this report. (e) The Company's Waste-to-Energy Projects. Certain information with respect to the Company's projects as of February 28, 1994 is summarized in the following table: ____________________ (1) Facility is owned by an owner/trustee pursuant to a sale/leaseback arrangement. (2) Facility has been designed (or, with respect to awarded facilities and facilities under construction, will be designed) to allow for the addition of another unit. (3) Facility is owned (or, with respect to facilities not under construction, is to be owned) by the Client Community. (4) Phase II of the Tulsa facility, which was financed as a separate project, expanded the capacity of the facility from two to three units. (5) Operating Subsidiaries were purchased after completion, and use a mass-burn technology that is not the Martin Technology. (6) Owned by a limited partnership in which the limited partners are not affiliated with the Company. See "Waste-to-Energy Services -- (c) Project Financing." (7) Under contracts with the Connecticut Resource Recovery Authority and Northeast Utilities, the Company operates only the boiler and turbine for this facility. (8) Operating contracts were acquired after completion. Facility uses a refuse-derived fuel technology and does not employ the Martin Technology. (9) In addition, the Company is presently constructing environmental improvements to the Detroit Facility. The total price for this project is approximately $117,800,000 (subject to escalation), and the Company expects construction to be completed by April 1996. (10) On May 19, 1993, the Company entered into a Development Agreement, a Steam Purchase and Sale Agreement, and an Operation and Maintenance Agreement with Ohio Edison Company. On June 8, 1993, the Company entered into a Host Community Agreement for the Construction and Operation of a Waste-to-Energy Incinerator with the Clark County Solid Waste Management District. This contract is the subject of litigation brought by a local landfill in which an intermediate appellate court recently enjoined performance by the County. The County and the Company are determining whether to appeal to the Ohio Supreme Court or whether to rebid the Project. The Company is in the process of procuring additional waste contracts for the facility. (11) This facility is substantially complete and is processing waste. The Company expects to recognize an additional $7.2 million in construction revenues in 1994. (f) Markets and Competition. The Company markets its services principally to governmental entities, including city, county, and state governments as well as public authorities or special purpose districts established by one or more local government units for the purpose of managing the collection and/or disposal of MSW. For certain projects, the Company may market its services directly to private firms in the business of MSW collection and/or disposal. The quantity of MSW generated in 1993 in the United States was estimated to be 201 million tons. This amount is projected to increase to approximately 222 million tons by the year 2000. During 1993, approximately 16% of the total MSW generated was processed in waste-to-energy facilities and approximately 1% was incinerated without energy recovery; and approximately 17% was recycled. The remainder was landfilled. The Company believes that no single waste disposal technique can properly manage all MSW and that an effective waste management program should include waste minimization, recycling, and in many circumstances waste to energy to utilize as much waste as possible for reuse and energy production. Steps to minimize the quantity of MSW produced are being taken at the manufacturing and consumer levels. Some jurisdictions, for example, have banned the use of certain plastic containers. These efforts have not yet had an appreciable impact on the quantities of MSW being generated. Increased recycling is a goal of many state and local governments, and some have legislated ambitious mandatory targets. The Company believes that increased recycling is an important aspect of waste disposal planning in the United States and that the amount of MSW recycled in the United States will continue to grow. However, the Company believes that the inherent limitations on the types of materials that can successfully be recycled will continue to require municipalities to use other disposal methods such as waste to energy or landfilling for much of the waste produced. Most of the Company's facilities have been sized to accommodate the accomplishment of communities recycling goals. Waste-to-energy facilities compete with other disposal methods, such as landfills. In most of the markets the Company serves, the cost of waste- to-energy services is competitive with landfilling. Compliance with regulations promulgated by the United States Environmental Protection Agency (the "EPA") in 1991 will to some extent increase the cost of landfilling, although landfills may be less expensive in some cases, in the short term, than waste-to-energy facilities. Landfills generally do not commit their capacity for extended periods. Much of the landfilling done in the United States is done on a spot market or through short term contracts (less than 5 years). Accordingly, landfill pricing tends to be more volatile as a result of periodic changes in waste generation and available capacity than the Company's pricing, which is based on long-term contracts. Another factor affecting the competitiveness of waste-to-energy fees are the additional charges imposed by Client Communities and included in such fees to support recycling programs, household hazardous waste collections, citizen education, and similar initiatives. The cost competitiveness of waste-to-energy facilities also depends on the prices at which the facility can sell the energy it generates. See "Regulation" herein. Waste-to-energy facilities also compete with other disposal technologies such as mixed solid-waste composting. Mixed waste composting is not a proven technology, and the Company believes that it has not been applied successfully to date in a large scale facility. Mass-burn waste-to-energy systems compete with various refuse-derived fuel ("RDF") systems in which MSW is preprocessed to remove various non- combustibles and is shredded for sizing prior to burning. The Company believes that the large-scale facilities being contracted for today are primarily mass-burn systems. Although the Company operates four RDF projects, these were all acquired after construction. The Company does not intend to develop any new RDF facilities. Since 1989 there has been a decline in the number of communities requesting proposals for waste-to-energy facilities. The Company believes that this decline has resulted from a number of factors that adversely affected communities' willingness to make long-term capital commitments to waste disposal projects, including: the economic downturn which adversely affected local government finances and slowed waste generation; uncertainties about the impact of recycling on the waste stream; and concerns arising from the Clean Air Act Amendments of 1990 and the regulatory actions currently being proposed pursuant to its terms. In addition, there was aggressive opposition to proposed waste disposal projects of all types by individuals and organizations during this period. The Company believes that legislative developments, increased public acceptance of the safety and cost effectiveness of waste-to-energy, and economic recovery will resolve many of these uncertainties. The Company also believes that waste-to-energy facilities and recycling are complimentary methods of managing a community's waste disposal needs. The fact that many of the Company's Client Communities have recycling rates in excess of national averages demonstrates that a properly sized waste-to- energy facility does not hinder achievement of aggressive recycling goals. In response to the decline in the number of requests for proposals, the Company has sought projects for which there are no sponsoring Client Communities. See "Waste-to-Energy Services -- (b) Other Arrangements for Providing Waste-to-Energy Services." In 1993, the Company negotiated a waste disposal agreement with Clark County, Ohio, for the disposal of MSW at such a project. The Company also completed negotiation of contracts with Ohio Edison Company pursuant to which Ohio Edison leases a site to the Company and purchases steam generated at the proposed waste-to-energy facility. This project is conditional upon obtaining commitments of additional MSW from other sources and satisfactory resolution of litigation described herein under "Waste-to-Energy Services -- (e) the Company's Waste-to-Energy Projects." There is substantial competition within the waste-to-energy field. The Company competes with a number of firms, some of which have greater financial resources than the Company. Some competitors have licenses or similar contractual arrangements for competing technologies in the waste- to-energy field, and a limited number of competitors have their own proprietary technology. The Company believes it is the largest operator of large scale (greater than 400 tons per day) waste-to-energy facilities. There are presently 77 such facilities in the United States. The Company believes Wheelabrator Technologies, Inc., which operates 14 such facilities is the second largest operator. Waste-to-energy facilities are also operated by other private companies and municipalities. Approximately 16% of the nation's waste is disposed of at waste-to-energy facilities. The balance of waste not recycled is disposed of by landfilling. The landfilling industry is dominated by several large companies of which Waste Management, Inc. and Browning Ferris, Inc. are the largest. Other technologies utilized in mass-burn type facilities in the United States include those of Von Roll, W+E, Takuma, Volund, Steinmueller, Deutsche Babcock, O'Connor, and Detroit Stoker. The principal factors influencing selection of vendors for governmentally sponsored waste-to-energy projects are technology, financial strength, performance guarantees, experience, reputation for environmental compliance, service, and price. (g) Technology. The principal feature of the Martin Technology is the reverse-reciprocating stoker grate upon which the waste is burned. The patent for the basic stoker grate technology used in the Martin Technology expired in 1989. The Company has no information that would cause it to believe that any other company uses the basic stoker grate technology that was protected by the expired patent. Moreover, the Company believes that unexpired patents on other portions of the Martin Technology would limit the ability of other companies to effectively use the basic stoker grate technology in competition with the Company. There are several unexpired patents related to the Martin Technology including: (i) Apparatus for Discharging Cinders from an Incinerator - expires 9/20/94; (ii) Apparatus for the Processing of Slag - expires 2/14/95; (iii) Grate Bar for Grate Linings, especially in Incinerators - expires 2/9/99; (iv) Method and Arrangement for Reducing NOx Emissions from Furnaces - expires 7/19/00; (v) Method and Apparatus for Regulating the Furnace Output of Incineration Plants - expires 9/4/07; (vi) Method for Regulating the Furnace Output in Incineration Plants - expires 1/1/08; and (vii) Feed Device with Filling Hopper and Adjoining Feed Chute for Feeding Waste to Incineration Plants - expires 4/23/08. More importantly, the Company believes that it is Martin's know-how in manufacturing grate components and in designing and operating mass-burn facilities and Martin's worldwide reputation in the waste-to-energy field and the Company's know-how in operating waste-to- energy facilities, rather than the use of patented technology, that is important to the Company's competitive position in the waste-to-energy industry in the United States. The Company does not believe that the expiration of the patent covering the basic stoker grate technology or patents on other portions of the Martin Technology will have a material adverse effect on the Company's financial condition or competitive position. (h) The Cooperation Agreement. Under an agreement between the Company and Martin (the "Cooperation Agreement"), the Company has the exclusive right to use the Martin Technology in waste-to-energy facilities in the United States, Canada, Mexico, Bermuda, certain Caribbean countries, most of Central and South America, and Israel. In addition, in Germany, Turkey, Saudi Arabia, Kuwait, the Netherlands, Denmark, Norway, Sweden, Finland, Poland, and Italy the Company has exclusive rights to use the Martin Technology, but only on a full service design, construct, and operate basis. The Company may not use any other technology to market, develop, or build refuse incineration facilities without Martin's permission. The Company may, however, acquire, own, commission, and/or operate facilities that use technology other than the Martin technology that have been constructed by entities other than the Company or its affiliates. Martin is obligated to assist the Company in installing, operating, and maintaining facilities incorporating the Martin Technology. The fifteen year term of the Cooperation Agreement renews automatically each year unless notice of termination is given, in which case the Cooperation Agreement would terminate 15 years after such notice. Additionally, the Cooperation Agreement may be terminated by either party if the other fails to remedy its material default within 90 days of notice. The Cooperation Agreement is also terminable by Martin if there is a change of control (as defined in the Cooperation Agreement) of OMS or any direct or indirect parent of OMS not approved by its respective board of directors. Although termination would not affect the rights of the Company to design, construct, operate, maintain, or repair waste-to-energy facilities for which contracts have been entered into or proposals made prior to the date of termination, the loss of the Company's right to use the Martin Technology could have a material adverse effect on the Company's future business and prospects. (i) International Business Development. In 1993, the Company continued the development of its waste-to-energy business in selected international markets. The Company opened an office in Munich, Germany, in 1993 and, as indicated above, extended its right to use the Martin system to develop full service projects in much of Europe. The Company has not had operations outside the United States previously, although Ogden Corporation does conduct its aviation services at several European airports and entertainment services at several venues. Furthermore, in Europe, waste-to-energy facilities have been built as turn-key construction projects and then operated by local governmental units or by utilities under cost-plus contracts. The Company emphasizes developing projects which it will build and then operate for a fixed fee. Thus, developing this market will require the Company to both become better known in Europe and to successfully market its service concept. The Company believes that its concept of service coupled with the Company's extensive operational experience offers local government units more economical service. Some European countries are seeking to substantially reduce their dependency on landfilling. For example, Germany has enacted legislation which would prevent the landfilling of untreated raw municipal waste by the end of the decade. The Company therefore believes this is an appropriate time to seek to expand its business in these markets. (j) Backlog. The Company's backlog as of December 31, 1993 is set forth under (e) above. As of the same date of the prior year, the estimated unrecognized construction revenues for projects under construction was $192,935,000, and the estimated construction revenues for projects awarded but not yet under construction was $513,488,000 (includes $99,620,000 expressed in Canadian Dollars). The changes reflect construction progress on four projects. Generally, the construction period for a waste-to-energy Facility is approximately 28 to 34 months. The backlog does not reflect the cancellation of projects owned by the Company or the cancellation of the Quonset Point and Johnston Rhode Island projects. See (f) "Markets and Competition" herein. Other Services. The Company operates transfer stations in connection with some of its waste-to-energy facilities and, in connection with the Montgomery County, Maryland, project, the Company will use a railway system to transport MSW and ash residue to and from the facility. The Company leases and operates a landfill located at its Haverhill, Massachusetts, facility, and leases, but does not operate, a landfill in connection with its Bristol, Connecticut, facility. In 1991, the Company announced that it would discontinue the on-site remediation business utilizing a mobile technology then conducted by OWTS. OWTS, which was formed by Ogden in 1986 to conduct on-site remediations of hazardous wastes using a proprietary incineration process, operated at sites located in Alaska and California. Certain of these operations continued into 1993, and certain contractual obligations resulting from the disposal of assets are expected to conclude in 1994. In 1993, the Company announced that it would discontinue the fixed-site hazardous waste business conducted through American Envirotech, Inc., an indirect subsidiary. In light of substantial and adverse changes in the market for hazardous waste incineration services and regulatory uncertainty stemming from EPA pronouncements. The Company has ceased all development activities and in 1994 intends to dispose of the assets related to this business, primarily a permit to build and operate a hazardous waste incineration facility which is the subject of a pending approval. The Company, through its wholly-owned subsidiary, Ogden Power Systems, Inc., intends to develop, operate and, in some cases, own power projects ("alternative energy projects") which cogenerate electricity and steam or generate electricity alone for sale to utilities both in the United States and abroad. These power systems may use, among other fuels, wood, tires, coal, other wastes, or natural gas. The Company believes that its experience in operating waste-to-energy facilities is applicable to other forms of power generation. Although, presently the Company does not operate any alternative energy projects, it is seeking opportunities in this business, through discussions with potential partners and by making proposals on projects that the Company believes have a substantial likelihood of profitable development. The Company currently operates 10 fossil fuel boilers and co-fires coal with MSW at another of its facilities. The Company does not believe that the development activities for this business are likely to require a material amount of the assets of the Company. Competition for alternative energy projects is intense. Many domestic utilities and other purchasers of power are required to or elect to select vendors of power by competitive bidding in which price is the dominant determination in making an award, thereby reducing returns on such projects. Consequently, the Company seeks opportunities in which contract terms are set by negotiation and where the Company is able to stress its ability to run facilities in a highly reliable manner or where other considerations such as the Company's willingness to guarantee project availability are attractive to the power purchaser. There are numerous companies currently operating alternative power projects in the United States and internationally today. Many of these companies are able to commit substantially greater funds to this business and have greater experience in running alternative power projects using fuels other than MSW. The Company seeks to compete by entering into joint ventures with other companies which will as a group have necessary assets available and experience. Proprietary technologies are not significant in this business. The Company, through Ogden Water Systems, Inc., intends to develop, operate and, in some cases, own projects that purify water, treat wastewater, and treat and manage biosolids and compost organic wastes. As with the Company's waste-to-energy business, water and wastewater projects involve various contractual arrangements with a variety of private and public entities including municipalities, lenders, joint venture partners (which provide financing or technical support), and contractors and subcontractors which build the facilities. The Company also intends to develop, operate and, in some cases, own projects that process recyclable paper products into linerboard for reuse in the commercial sector. As with the Company's waste-to-energy business, such projects involve various contractual arrangements with a variety of private and public entities, including municipalities, lenders, joint venture partners (which provide financing or technical support) and contractors and subcontractors which build the facilities. In addition, such projects require significant amounts of energy in the form of steam, which may be provided by present or future waste-to-energy projects operated by the Company. Regulation Environmental regulations. The Company's business activities are pervasively regulated pursuant to federal, state, and local environmental laws. Federal laws, such as the Clean Air Act and Clean Water Act, and their state counterparts, govern discharges of pollutants to air and water. Other federal, state, and local laws, such as RCRA, comprehensively govern the generation, transportation, storage, treatment, and disposal of solid waste, including hazardous waste (such laws and the regulations thereunder, "Environmental Regulatory Laws"). The Environmental Regulatory Laws and other federal, state, and local laws, such as the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"), make the Company potentially liable for any environmental contamination which may be associated with its activities or properties (collectively, "Environmental Remediation Laws"). Many states have mandated local and regional solid waste planning, and require that new solid waste facilities may be constructed only in conformity with these plans. State laws may authorize the planning agency to require that waste generated within its jurisdiction be brought to a designated facility, which may help that facility become economically viable but preclude the development of other facilities in that jurisdiction. Such ordinances are sometimes referred to as legal flow control. Legal flow control has been challenged in a number of law suites on the basis that it is a state regulation of interstate commerce prohibited by the United States Constitution. The decisions on these cases have not been consistent. However several recent decisions have invalidated ordinances creating legal flow control. In 1993, the United States Supreme Court granted an appeal from a decision of a New York State Court upholding a New York municipality's ordinance requiring that all waste generated within its jurisdiction be disposed of at a transfer station operating under contract with the municipality. The case was argued in December 1993 and a decision is expected during the Court's Spring 1994 term. The Company believes that legal flow control is an important tool used by municipalities in fulfilling their obligations to provide safe and environmentally sound waste disposal services to their constituencies. Although a decision invalidating legal flow control would reduce the number of options local government would have in meeting this obligation, the Company does not believe it would materially impact the Company's existing facilities or its ability to develop new ones. This view is based on a number of considerations. Most of the contracts pursuant to which the Company provides disposal services require the Client Community to deliver stated minimum quantities of waste on a put-or-pay basis. The Company does not believe these obligations would be negated by an adverse Supreme Court decision. Furthermore, only a few of the Client Communities served by the Company rely solely on legal flow control to provide waste to the Company's facilities, a factor influenced in part by past difficulties in enforcing legal flow control ordinances. Although some municipalities may experience temporary difficulties in meeting delivery commitments as they address required changes in their waste disposal plans, such difficulties should not be long-lived as indicated by the experience of municipalities served by the Company which adopted alternative measures. The Company believes that there are other methods for providing incentives to use integrated waste systems incorporating waste to energy that do not entail legal flow control, which incentives should not be affected by the Court's decision. These include mandating that charges for utilization of the system be maintained at competitive levels and that revenue shortfalls be funded from tax revenues or special assessments on residents. This type of incentive will be utilized at the facility being constructed and which will be operated by the Company in Montgomery County, Maryland. Furthermore, in most of the municipalities where the Company provides services, information available to the Company indicates that the cost to the Client Community of waste to energy is competitive with alternative disposal facilities, and therefore the Company's facilities should be able to compete for waste economically. As indicated, however, certain additional waste disposal services are financed by the Client Community's increasing the cost for disposal at waste-to-energy facilities, and these services may have to be paid for by other mechanisms. A number of bills are presently pending in Congress to authorize legal flow control. Whether Congress will enact legislation on this subject is uncertain. In addition, state laws have been enacted in some jurisdictions that may also restrict the intrastate and interstate movement of solid waste. Restrictions on importation of waste from other states have generally been voided by Federal courts as invalid restrictions on interstate commerce. Bills proposed in past sessions of Congress would authorize such designations and restrictions. Bills of this nature have been introduced in the current session of Congress, but it remains uncertain whether Congress will act to authorize such laws. The Environmental Regulatory Laws require that many permits be obtained before the commencement of construction and operation of any waste-to- energy facility, including: air quality construction and operating permits, stormwater discharge permits, solid waste facility permits in most cases, and,in many cases, wastewater discharge permits. There can be no assurance that all required permits will be issued, and the process of obtaining such permits can often cause lengthy delays, including delays caused by third party appeals challenging permit issuance. The Environmental Regulatory Laws and regulations and permits issued pursuant to them also establish operational standards, including specific limitations upon emissions of certain air and water pollutants. Failure to meet these standards subject an Operating Subsidiary to regulatory enforcement actions by the appropriate governmental unit, which could include fines, and orders limiting or prohibiting operation. To date, the Company has not incurred material fines, been required to incur material capital costs or additional expenses, or been subjected to material restrictions on its operations as a result of violations of environmental laws, regulations, or permits. Certain of the Environmental Regulatory Laws also authorize suits by private parties for damages and injunctive relief. Repeated unexcused failure to comply with environmental standards may also constitute a default by the Operating Subsidiary under its Service Agreement. The Environmental Regulatory Laws and governmental policies governing their enforcement are subject to revision. New technology may be required or stricter standards may be established for the control of discharges of air or water pollutants or for solid waste or ash handling and disposal. Most federal Environmental Regulatory Laws encourage development of new technology to achieve increasingly stringent standards; they also often require use of the best available technology at the time a permit is issued. The federal Prevention of Significant Deterioration of air quality program requires that new or substantially modified waste-to-energy facilities of the size constructed by the Company that are located in areas of the country that are in compliance with national ambient air quality standards ("NAAQS") employ the Best Available Control Technology ("BACT"). The selection of control technology and the emission limits that must be achieved are made on a case-by-case basis considering economic impacts, energy and other environmental impacts and costs, and may include requirements that certain components of the mixed waste stream be separated for treatment by other means than combustion in the Operating Subsidiary's facility. For facilities developed in areas where NAAQS are not met, federal law requires that control technology capable of achieving the Lowest Achievable Emission Rate ("LAER") must be employed. LAER means the most stringent emission limit achievable in practice by emission sources similar to the facility in question, which does not involve any consideration of the economic impacts or costs to achieve such a limitation. Existing facilities in areas where LAER is now required for new facilities may be required to retro-fit Reasonably Available Control Technology ("RACT") established by EPA applicable to selected pollutants to enhance progress toward these areas achieving the NAAQS. RACT is that technology which EPA or state agencies determine to be available, proven, reliable, and affordable to reduce targeted emissions from specific types of existing sources of air emissions within geographic areas in which NAAQS for the target emissions is not being met. Thus, as new technology is developed and proven, it must be incorporated into new facilities or major modifications to existing facilities. This new technology may often be more expensive than that used previously. EPA has promulgated regulations establishing New Source Performance Standards ("NSPS") and Emission Guidelines ("EG") applicable to new and existing municipal waste combustion units with a capacity of greater than 250 tons per day. The EG and NSPS establish limitations upon the flue gas pollutant concentrations entering the ambient air for particulate matter (opacity), organics (dioxins and furans), carbon monoxide and acid gases (sulfur dioxide and hydrogen chloride). The NSPS also establish emissions limitations for nitrogen oxides. The NSPS apply to facilities beginning construction after December 20, 1989 and the EG will become effective three years after each individual state adopts them, but no later than five years after promulgation. Additional air pollution control equipment is likely to be required at four of the Company's existing waste-to-energy facilities to achieve the EG limitations. The Clean Air Act required EPA to re-evaluate the NSPS and EG for particulate matter (total and fine), opacity (as appropriate), sulfur dioxide, hydrogen chloride, oxides of nitrogen, carbon monoxide, dioxins and dibenzofurans, and to establish new NSPS and EG for lead, cadmium, and mercury no later than November 15, 1991 for all waste combustion facilities. Such re-evaluation and regulations were not completed by that date. These standards must reflect maximum achievable control technology ("MACT") for both new and existing waste-to-energy units. "MACT" means the maximum degree of reduction in emissions, considering the cost, energy requirements, and non air quality related health and environmental impacts. For new facilities, these limits may not be less stringent than the best performing similar facility. For existing facilities, these limits may not be less stringent than the performance of the top 12% non-LAER facilities. The Company cannot predict what standards will be proposed or finally promulgated, although EPA is reviewing data from existing facilities. The revised standards for new facilities will become effective six months after the date of promulgation of the revised standards. Standards for lead, cadmium, and mercury are expected to be proposed in 1994 under a consent order entered in 1993 in connection with litigation commenced by several parties against the EPA. The Clean Air Act also requires each state to implement a state implementation plan in conformity with federal law that outlines how areas out of compliance with NAAQS will be returned to compliance. One aspect of the state implementation plan must be an operating permit program. Most states are now in the process of developing or augmenting their implementation plans to meet these requirements. The state implementation plans and the operating permits issued under them may place new requirements on waste-to-energy facilities. Under federal law, the new operating permits may have a term of up to 12 years after issuance or renewal, subject to review every 5 years. Changes in Clean Air Act standards can affect the manner in which the Company operates existing projects and could require significant additional expenditures to achieve compliance. The Clean Air Act Requirements, which the Company believes will be issued in final form between 1994 and 1996, will require capital improvements to the facilities operated by the Company. The exact timing and cost of such improvements cannot be stated definitively because State regulations embodying the Clean Air Act Requirements have generally not been finally adopted. The cost of capital improvements to meet the Clean Air Act Requirements for facilities owned by Client Communities will be borne by the Client Communities. For projects owned or leased by the Company and operated under a Service Agreement, the Client Community has the obligation to fund such capital improvements, to which the Company must make an equity contribution, generally 20%. Such equity contributions are likely to range, in total for all such facilities, from $9 million to $15 million. With respect to a project owned by the Company and not operated pursuant to a Service Agreement, such capital improvements will cost between $8 million and $15 million. The Company believes that costs incurred to meet Clean Air Act Requirements at facilities it operates may be recovered from Client Communities and other users of its facilities through increased tipping fees permitted under applicable contracts. The Environmental Remediation Laws, including CERCLA, may subject the Company, like other entities that manage waste, to joint and several liability for the costs of remediating contamination at sites, including landfills, which the Company has owned, operated, or leased or at which there has been disposal of residue or other waste handled or processed by the Company. The Company leases and operates a landfill in Haverhill, Massachusetts, and leases a landfill in Bristol, Connecticut, in connection with its projects at those locations. Some state and local laws also impose liabilities for injury to persons or property caused by site contamination. Some Service Agreements provide for indemnification of the Operating Subsidiaries from some such liabilities. Environmental Regulatory Laws, such as RCRA and state and local solid waste laws, impose significantly more stringent requirements upon disposal of hazardous waste than upon disposal of MSW and other non-hazardous wastes. These laws prohibit disposal of hazardous waste other than in small, household-generated quantities at the Company's municipal solid waste facilities and generally make disposal of hazardous waste more expensive than management of non-hazardous waste. The Service Agreements recognize the potential for improper deliveries of hazardous wastes and specify procedures for dealing with hazardous waste that is delivered to a facility. Although certain Service Agreements require the Operating Subsidiary to be responsible for some costs related to hazardous waste deliveries, to date, no Operating Subsidiary has incurred material hazardous waste disposal costs. No ash residue from a fully operational facility operated by the Company has been characterized as hazardous under the present or past prescribed EPA test procedures and such ash residue is currently disposed of in permitted landfills as non-hazardous waste. Some state laws or regulations provide that if prescribed test procedures demonstrate that ash residue has hazardous characteristics, it must be treated as hazardous waste. In certain states, ash residue from certain waste-to-energy facilities of other vendors or communities has, on occasion, been found to have hazardous characteristics under these test procedures. There is a conflict between the two federal courts of appeal which have decided whether municipal solid waste ash residue having hazardous characteristics is subject to RCRA's provisions for management as a hazardous waste. The Second Circuit Court of Appeals has held that it is not. The Seventh Circuit Court of Appeals reached the opposite result. In September 1992, the Administrator of the EPA officially stated that EPA policy was that waste-to-energy ash residue was exempt from treatment as a hazardous waste as a matter of law and could be safely disposed of in MSW landfills that met the EPA's criteria. In reaching its decision, the Seventh Circuit refused to give deference to the EPA's policy. An appeal from the Seventh Circuit's determination was filed in early 1993 in the United States Supreme Court and a decision is expected during the Court's Spring 1994 term. The Company does not expect that a decision that requires ash residue having hazardous characteristics to be managed as a hazardous waste would have significant impacts on the Company's business. Eight of the Company's facilities are located in states or dispose of their ash residue in states which require testing to determine whether such residue must be managed as a hazardous waste under state law. Furthermore, ash processing technology is available which could be used to further ensure that ash does not exhibit characteristics of hazardous waste. From time to time, state and federal moratoria on waste to energy have been proposed in legislation, regulation, and by executive action. Generally, such proposals have not been adopted, and where they have, as in the State of New Jersey, following the moratorium, waste to energy has continued to be included in the options available to local municipalities. In 1992, as previously reported, the State of Rhode Island eliminated waste to energy from its unique legislation in which the state's solid waste management plan was enacted as law. As a consequence of this legislation, the Company brought an action against the state challenging the validity of the change in the plan which has been settled by the State's agreement to pay the Company approximately $5.5 million in 1994, a portion of which must be shared with Blount, Inc., the former developer of the Quonset, Rhode Island project. OWTS' business activities were regulated under federal, state, and local environmental laws governing air and water emissions and the generation, transportation, storage, treatment, and disposal of solid wastes, and hazardous and toxic materials. In particular, RCRA, its implementing regulations, and parallel state laws create a cradle-to-grave system for regulating hazardous waste; and CERCLA and similar state laws create programs for remediation of contaminated sites and for the imposition of liability upon those who owned or operated such sites or who generated or transported hazardous substances disposed of at such sites. The Company believes that OWTS's units and projects were operated in compliance in all material respects with regulatory requirements that apply to its business. The Company's waste-to-energy business is subject to the provisions of the federal Public Utility Regulatory Policies Act ("PURPA"). Pursuant to PURPA, the Federal Energy Regulatory Commission ("FERC") has promulgated regulations that exempt qualifying facilities (facilities meeting certain size, fuel and ownership requirements) from compliance with certain provisions of the Federal Power Act, the Public Utility Holding Company Act of 1935, and, except under certain limited circumstances, state laws regulating the rates charged by electric utilities. PURPA was promulgated to encourage the development of cogeneration facilities and small facilities making use of non-fossil fuel power sources, including waste-to- energy facilities. The exemptions afforded by PURPA to qualifying facilities from the Federal Power Act and the Public Utility Holding Company Act of 1935 are of great importance to the Company and its competitors in the waste-to-energy industry. State public utility commissions must approve the rates, and in some instances other contract terms, by which public utilities purchase electric power from the Company's projects. PURPA requires that electric utilities purchase electric energy produced by qualifying facilities at negotiated rates or at a price equal to the incremental or "avoided" cost that would have been incurred by the utility if it were to generate the power itself or purchase it from another source. While public utilities are not required by PURPA to enter into long-term contracts, PURPA creates a regulatory environment in which such contracts can typically be negotiated. In October, 1992, Congress enacted, and the President signed into law, comprehensive energy legislation, several provisions of which are intended to foster the development of competitive, efficient bulk power generation markets throughout the country. Although the impact of the legislation will not be fully known until any judicial challenges are resolved and Federal and State regulatory agencies develop policies and promulgate implementing regulations, the Company believes that, over the long term, the legislation will create business opportunities both in the waste-to- energy field as well as in other power generation fields. Other Information (a) Raw Materials. The construction of each of the Company's waste-to- energy facilities is generally carried out by a general contractor selected by the Company. The general contractor is usually responsible for the procurement of bulk commodities used in the construction of the facility, such as steel and concrete. These commodities are generally readily available from many suppliers. The Company generally directs the procurement of all major equipment utilized in the facility, which equipment is also generally readily available from many suppliers. The stoker grates utilized in facilities constructed by the Company are required to be obtained from Martin pursuant to the Cooperation Agreement. In connection with the currently operating waste-to-energy facilities, the Company has entered into long-term waste disposal agreements which obligate the relevant Client Communities (or in the case of the Haverhill projects, the private haulers) to deliver specified amounts of waste on an annual basis. The Company believes that sufficient amounts of waste are being produced in the United States to support current and future waste-to-energy projects. Other commodities used in the operation of the Company's facilities are readily available from many suppliers. See "Regulation" herein. (b) Employees. As of February 1, 1994, the Company had 355 full-time employees. Substantially all of the personnel operating the Company's waste-to-energy facilities are employees of subsidiaries of an affiliate of the Company, Ogden Services Corporation ("Ogden Services"). Some of the employees at certain facilities are employed by subsidiaries of Ogden Services pursuant to collective bargaining agreements. Each facility's staff is typically supervised by a Facility Manager who is an employee of a subsidiary of Ogden Services, and a Manager of Facility Administration, who is an employee of the Company. There were approximately 1310 employees of a subsidiary of Ogden Services working at the Company's waste-to-energy facilities as of February 1, 1994. The Company considers relations with its employees to be good. (c) Dependence on Ogden. Ogden has provided, at no cost to the Company, guarantees of performance of the obligations of the Operating Subsidiaries for their waste-to-energy projects and has provided other forms of credit support. Such credit support is typically required in connection with the Company's proposals to Client Communities, and without such credit support for future projects, there is no assurance that the Company could continue to compete effectively in the waste-to-energy industry. Credit support has also been provided in connection with acquisitions made by the Company. Ogden also provided certain guarantees with respect to OWTS operations. Ogden has also supported the Company by providing other guarantees related to project financing and project energy agreements, by providing support services in areas such as investor relations, tax, legal, internal audit, cash management, employee benefits administration, and insurance, and by funding working and other capital requirements, including the equity requirements of Company-owned projects, to the extent not provided by the Company. The Company pays a fee for these services. Under the cash management arrangements the Company is charged interest by Ogden if it is a net borrower from, or is paid interest by Ogden if it is a net depositor with, Ogden. Ogden has further supported the Company by providing certain personnel, either directly or through a subsidiary. Substantially all of the personnel utilized by the Company in operating its waste-to-energy facilities are provided on a cost-plus basis by Ogden Services under the technical and budgetary supervision of the Company. The Board of Directors of Ogden has adopted a Statement of Intent providing that it intends to continue to provide support services to the Company. However, the Statement of Intent does not represent a contractual obligation of Ogden and there can be no assurance that Ogden will continue to provide such support. Item 2. Item 2. PROPERTIES The Company's principal executive offices are located in Fairfield, New Jersey, in an office building located on a 5.4-acre site owned by the Company. The following table summarizes certain information relating to the locations of the properties owned or leased by the Company or its subsidiaries as of January 31, 1994(1). Item 3. Item 3. LEGAL PROCEEDINGS In the ordinary course of its business, the Company becomes involved in federal, state, and local proceedings relating to the laws regulating the discharge of materials into the environment and the protection of the environment. These include proceedings for the issuance, amendment, or renewal of the licenses and permits pursuant to which the Company operates. Such proceedings also include actions brought by individuals or local governmental authorities seeking to overrule governmental decisions on matters relating to the Company's operations in which the Company may be, but is not necessarily, a party. Most proceedings brought against the Company by governmental authorities under these laws relate to alleged technical violations of regulations, licenses, or permits pursuant to which the Company operates. To date the Company, has resolved the proceedings to which it is a party through settlements that generally involve the payment of civil fines or penalties and, in some instances, changing operational procedures. None of these resolutions require the Company to make any material capital expenditures. At September 30, 1993, the Company was involved in one such proceeding in which the Company believes sanctions involved may exceed $100,000. The Company believes that such proceeding will not have a material adverse effect on it or its business. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable EXECUTIVE OFFICERS OF THE COMPANY The executive officers (as defined by Rule 3b-7 of the Securities Exchange Act of 1934) of the Company are named in the table below. Officers are appointed by the Board of Directors and serve at the discretion of the Board. Information about the executive officers of the Company is set forth below: Mr. Ablon has been Chairman of the Board and Chief Executive Officer of the Company since November 1990. Since May 1990, he has been President and Chief Executive Officer of Ogden. From January 1987 to May 1990, he was President- and Chief Operating Officer, Operating Services, Ogden. Mr. Mackin has been President and Chief Operating Officer of the Company since January 1991. From November 1990 to January 1991, he was Co- President, Co-Chief Operating Officer, General Counsel and Secretary of the Company. From 1988 to November 1990, he was First Executive Vice President and Managing Director, General Counsel of the Company and since December 1989 Secretary of the Company. From 1987 to 1988, he was Vice President and General Counsel of the Company, and from 1987 to May 1989, he was Secretary of the Company. Mr. Stone has been Executive Vice President and Managing Director of the Company since January 1991. From November 1990 to January 1991, he was Co- President and Co-Chief Operating Officer of the Company. From 1988 through November 1990, he was First Executive Vice President and Managing Director- - -Project Implementation of the Company. Mr. Mack has been Executive Vice President of the Company since January 1991. He was Secretary of the Company from January 1991 until November 1991. From 1988 to January 1991, he was First Executive Vice President and Managing Director--Operations of the Company. Mr. Klett has been Executive Vice President--Operations of the Company since January 1991. From January 1990 to January 1991, he was Executive Vice President--Plant Operations of OMS. From March 1989 to January 1990, he was Senior Vice President--Plant Operations of OMS. Ms. Mills has been Executive Vice President--Business Development of the Company since January 1991. From 1988 to January 1991, she was First Executive Vice President and Managing Director--Marketing of the Company. Mr. Whitman has been Executive Vice President of the Company since February, 1994 and Chief Financial Officer and Treasurer of the Company since September 1990. He was also Senior Vice President of the Company from December 1990 through February 1994 and Vice President of the Company from September 1990 through December 1990. From January 1990 to September 1990, he was Assistant Vice President, Facility Administration of OMS. From November 1987 to January 1990, he was first a Senior Cost Analyst, then Director, Facility Administration, of the Company. Mr. Delle Donne has been Senior Vice President of the Company since May 1990, and has been President and Chief Operating Officer of OWTS since November 1989. From October 1987 through October 1989, he was Director, Marketing at Westinghouse Environmental Services. Mr. Horowitz has been a Senior Vice President and General Counsel of the Company since July, 1991 and Secretary since November 1991. From 1982 until 1991 he was a partner in the law firm of Schnader, Harrison, Segal and Lewis. Mr. Torosian has been Vice President of the Company since February 1992 and Controller of the Company since November 1987. PART II Item 5. Item 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The information required by this item is incorporated herein by reference to the material captioned "Price Range of Common Stock and Dividend Data" on page 44 of the Company's 1993 Annual Report to Stockholders. As of February 28, 1994, there were 5,103 holders of record of the Company's Common Stock. Item 6. Item 6. SELECTED FINANCIAL DATA. The information required by this item is incorporated herein by reference to the material captioned "Selected Financial Data" on page 24 of the Company's 1993 Annual Report to Stockholders. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. The information required by this item is incorporated herein by reference to the material captioned "Management's Discussion and Analysis of Consolidated Operations" on pages 22 and 23 of the Company's 1993 Annual Report to Stockholders. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by this item is incorporated herein by reference to pages 25 through 42 and 44 of the Company's 1993 Annual Report to Stockholders. For other financial statements and schedules required under this item, reference is made to Item 14 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 COMPANY. (a) Directors. The information with respect to directors required by this item is incorporated herein by reference to the Company's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. (b) Executive Officers. The information with respect to officers required by this item is included at the end of PART I of this document under the heading Executive Officers of the Company. Item 11. Item 11. EXECUTIVE COMPENSATION. The information required by this item is incorporated herein by reference to the Company's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this item is incorporated herein by reference to the Company's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this item is incorporated herein by reference from the Company's 1994 Proxy Statement to be filed with the Securities and Exchange Commission. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Listed below are the documents filed as a part of this report: 1. Consolidated Financial Statements and the Independent Auditors' Report incorporated herein by reference to pages 25 through 42 of the Company's 1993 Annual Report to Stockholders: Independent Auditors' Report. Consolidated Balance Sheets, December 31, 1993 and 1992. Statements of Consolidated Income for the Years Ended December 31, 1993, 1992, and 1991. Statements of Consolidated Cash Flows for the Years Ended December 31, 1993, 1992, and 1991. Statements of Common Stockholders' Equity for the Years Ended December 31, 1993, 1992, and 1991. Notes to Consolidated Financial Statements. 2. Financial Statement Schedules: Independent Auditors' Report 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, Depletion, 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, have been omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements or the notes thereto. 3. Exhibits: 3.1 Third Restated Certificate of Incorporation.* (i) Certificate of Retirement of Stock and Reduction of Capital, dated March 1, 1990.*. (ii) Certificate of Retirement of Stock and Reduction of Capital, dated April 26, 1990.* (iii) Certificate of Ownership and Merger, dated December 1, 1989.* 3.2 Third Restated By-Laws of Ogden Projects, Inc. as amended.* 4.1 (a) Trust Indenture, dated as of December 1, 1986, and amended and restated as of July 1, 1987, between Shawmut Bank, N.A., as trustee, and Massachusetts Industrial Finance Agency.* (i) Amendment No. 2, dated as of April 1, 1992, to Amended and Restated Trust Indenture, as amended, between Shawmut Bank, N.A., as trustee, and Massachusetts Industrial Finance Agency.* (ii) Supplemental and Amending Trust Indenture, dated as of May 1, 1992, between Shawmut Bank, N.A., as trustee, and Massachusetts Industrial Finance Agency.* (b) OHA Loan Agreement, dated as of December 1, 1986, and as amended as of August 1, 1988, between Ogden Haverhill Associates and Massachusetts Industrial Finance Agency.* (i) Amendment No. 2, dated as of May 1, 1992, to the OHA Loan Agreement, as amended, between Ogden Haverhill Associates and Massachusetts Industrial Finance Agency.* (c) OHA (Ogden Haverhill Project) Massachusetts Industrial Finance Agency Series A Note, dated December 23, 1986, and as amended as of August 1, 1988 (Amendment incorporated by reference to Exhibit No. 4.1(e)), by Ogden Haverhill Associates to Shawmut Bank, N.A., as trustee.* (d) OHA (Ogden Haverhill Project) Massachusetts Industrial Finance Agency Series B Note, dated December 23, 1986, and as amended as of August 1, 1988 (Amendment incorporated by reference to Exhibit No. 4.1(e)), by Ogden Haverhill Associates to Shawmut Bank, N.A., as trustee.* (e) OHA (Ogden Haverhill Project) Massachusetts Industrial Finance Agency Series C Note, dated December 23, 1986, and as amended as of August 1, 1988, by Ogden Haverhill Associates to Shawmut Bank, N.A., as trustee.* (i) Amendment No. 2, dated as of May 29, 1992, to OHA (Ogden Haverhill Project) Massachusetts Industrial Finance Agency Series C Note, as amended , by Ogden Haverhill Associates to Shawmut Bank, N.A., as trustee.* (f) SBR Loan Agreement, dated as of December 1, 1986, and as amended through August 1, 1988, between SBR Associates and Massachusetts Industrial Finance Agency.* (i) Amendment No. 2, dated as of May 1, 1992, to SBR Loan Agreement, as amended, between SBR Associates and Massachusetts Industrial Finance Agency.* (g) SBR (Ogden Haverhill Project) Massachusetts Industrial Finance Agency Series D Note, dated December 23, 1986, and as amended as of August 1, 1988, by SBR Associates to Shawmut Bank, N.A., as trustee.* (i) Amendment No. 2, dated as of May 28, 1992, to SBR (Ogden Haverhill Project) Massachusetts Industrial Finance Agency, Series D Note, as amended, by SBR Associates to Shawmut Bank, N.A., as trustee.* (h) Letter of Credit and Reimbursement Agreement, dated as of December 1, 1986, between Ogden Martin Systems of Haverhill, Inc. and Union Bank of Switzerland, New York Branch.* (i) Reimbursement Agreement Amendment, dated August 1, 1988, between Ogden Martin Systems of Haverhill, Inc. and Union Bank of Switzerland, New York Branch.* (ii) Second Reimbursement Agreement Amendment, dated August 1, 1989, between Ogden Martin Systems of Haverhill, Inc. and Union Bank of Switzerland, New York Branch.* (iii) Third Reimbursement Agreement, dated October 13, 1989, between Ogden Martin Systems of Haverhill, Inc. and Union Bank of Switzerland, New York Branch.* (iv) Fourth Reimbursement Agreement Amendment, dated as of September 23, 1991, between Ogden Martin Systems of Haverhill, Inc. and Union Bank of Switzerland, New York Branch.* (v) Fifth Reimbursement Agreement Amendment, dated as of May 1, 1992, between Ogden Martin Systems of Haverhill, Inc. and Union Bank of Switzerland, New York Branch.* (i) Reimbursement Agreement, dated as of May 31, 1989, between Ogden Haverhill Properties, Inc. and Swiss Bank Corporation, New York Branch.* (i) First Amendment to the Reimbursement Agreement dated as of May 28, 1992 between Ogden Haverhill Properties, Inc. and Swiss Bank Corporation, New York Branch.* 4.2 (a) Second Amended and Restated Trust Indenture, dated as of February 1, 1989, between the Fairfax County Economic Development Authority and Crestar Bank, as trustee.* (b) Conditional Sale and Security Agreement, dated as of February 1, 1988, between the Fairfax County Solid Waste Authority and Ogden Martin Systems of Fairfax, Inc.* 4.3 Specimen Stock Certificate for Company's Common Stock.* 4.4 Demand Note, dated May 31, 1989, by Company to Ogden Corporation.* 4.5 Demand Note, dated December 19, 1984, by Company to Bouldin Development Corporation.* 10.1 Tax Sharing Agreement, dated as of January 1, 1989, among Ogden Corporation, Company and Subsidiaries, Ogden Allied Services, Inc. and Subsidiaries, and Ogden Financial Services, Inc. and Subsidiaries.* 10.2 (a) Amended and Restated Cooperation Agreement, dated April 30, 1983 and amended and restated as of April 1, 1985, and as further amended through May 25, 1989 between Ogden Martin Systems, Inc. and Martin GmbH fur Umwelt- und Energietechnik of West Germany (confidential status has been granted for certain provisions thereof pursuant to Commission Order No. 810132).* (i) Amendment to Section 5.3.1 of the Amended and Restated Cooperation Agreement, effective as of January 1, 1989, between Ogden Martin Systems, Inc. and Martin GmbH fur Umwelt- und Energietechnik of West Germany (confidential status has been granted for certain provisions thereof pursuant to Rule 24b-2.)* (ii) Amendment No. 6 to Amended and Restated Cooperation Agreement, effective as of January 1, 1991, between Ogden Martin Systems, Inc. and Martin GmbH fur Umwelt-und Energietechnik of West Germany.* (b) Rights of First Refusal, dated June 2, 1989, among Walter Josef Martin, Anneliese Martin, Johannes Josef Edmund Martin and Ogden Martin Systems, Inc.* 10.3 Ogden Projects, Inc. Directors' Stock Option Plan.* 10.4 Letter Agreement, dated October 5, 1990, between David L. Sokol and Ogden Corporation.* 10.5 Ogden Projects, Inc. Employees' Stock Option Plan.* 10.6 Ogden Corporation Pension Plan, as amended and restated, effective as of January 1, 1988.* 10.7 Ogden Corporation Supplementary Deferred Benefit Plan, adopted December 13, 1976, and amended as of January 5, 1988.* 10.8 Ogden Corporation Stock Option Plan, effective as of March 11, 1986.* 10.9 Ogden Corporation 1990 Stock Option Plan, effective as of October 11, 1990.* 10.10 Ogden Projects, Inc. Pension Plan effective as of January 1, 1989.* (i) Amendment to Ogden Projects, Inc. Pension Plan effective as of January 1, 1994. 10.11 Form of Supplementary Deferred Benefit Plan of Ogden Projects, Inc. effective as of January 1, 1989.* 10.12 Ogden Projects, Inc. Profit Sharing Plan effective as of January 1, 1989.* (i) Ogden Projects Profit Sharing Plan amendment by Unanimous Written Consent of the Administrative Committee, dated March 7, 1990.* (ii) Amendment to Ogden Projects, Inc. Profit Sharing Plan effective as of January 1, 1994. 10.13 Ogden Allied Services Saving and Security Plan, as amended and restated, effective as of August 1, 1986.* 10.14 Ogden Services Corporation Profit Sharing Plan, as amended and restated, effective as of January 1, 1989, as further amended July 18, 1990.* 10.15 (a) Ogden Services Corporation Executive Pension Plan, effective as of January 1, 1989.* (b) Ogden Services Corporation Executive Pension Plan Trust Agreement, dated as of October 1, 1990, between Ogden Services Corporation and The Bank of New York.* 10.16 (a) Ogden Services Corporation Select Savings Plan, dated as of October 1, 1990.* (b) Ogden Services Corporation Select Savings Plan Trust Agreement, dated as of October 1, 1990, between Ogden Services Corporation and The Bank of New York.* 10.17 Form of Supplemental Defined Benefit Plan of Ogden Allied Services effective as of January 1, 1989.* 10.18 Ogden Environmental Services Pension Plan effective as of January 1, 1989.* 10.19 Ogden Environmental Services Profit Sharing Plan effective as of January 1, 1989.* (i) Ogden Environmental Services Profit Sharing Plan amendment by Unanimous Written Consent of the Administrative Committee, dated March 7, 1990.* 10.20 Form of Supplementary Deferred Benefit Plan of Ogden Environmental Services, Inc., effective as of January 1, 1989.* 10.21 Stock Purchase Agreement, dated as of May 31, 1989, between Company and Ogden Corporation.* 10.22 Stock Purchase Option Agreement, dated June 14, 1989, between Ogden Corporation and Company.* (i) Amendment to Stock Purchase Option Agreement, dated November 16, 1989, between Ogden Corporation and Company.* 10.23 Employment Agreement, dated as of June 1, 1990, between Company and William C. Mack.* 10.24 Employment Agreement, dated as of June 1, 1990, between Company and Scott G. Mackin.* (i) Employment Agreement dated January 1, 1994 between Company and Scott G. Mackin. 10.25 Employment Agreement, dated as of June 1, 1990, between Company and Gloria A. Mills.* 10.26 Employment Agreement, dated as of June 1, 1990, between Company and Bruce W. Stone.* 10.27 Employment Agreement, dated as of June 1, 1990, between Company and John M. Klett.* 10.28 Employment Agreement, dated as of May 24, 1990, between Ogden Corporation and R. Richard Ablon, as amended October 11, 1990.* 10.29 Agreement and Plan of Merger dated September 20, 1990 by and among Ogden Environmental Services of Houston, Inc., Ogden Acquisition Company and American Envirotech, Inc.* (i) Amendment dated June 12, 1991 by and among Ogden Environmental Services of Houston, Inc., Ogden Acquisition Company, and American Envirotech, Inc.* 10.30 Ogden Projects, Inc. Core Executive Benefit Program.* 13.0 Annual Report to Stockholders for the year ended December 31, 1993. 21.0 Subsidiaries of the Company. 24.0 Consent of Deloitte & Touche. _______________ * Incorporated by reference as set forth in the Exhibit Index of this Annual Report on Form 10-K. Note: Long term debt instruments of the Company and its consolidated subsidiaries under which the total amount of securities authorized do not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis will be furnished to the Commission upon request. (b) The Company filed the following reports on Form 8-K during 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 Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OGDEN PROJECTS, INC. By:/s/ R. Richard Ablon Chairman and Chief Executive Officer 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 Company in the capacities indicated on March 29, 1994. Signature Title /s/ R. Richard Ablon Chairman of the Board and R. Richard Ablon Chief Executive Officer /s/ Scott G. Mackin President, Chief Operating Scott G. Mackin Officer and Director /s/ Bruce W. Stone Executive Vice President, Bruce W. Stone Managing Director and Director /s/ William E. Whitman Executive Vice President, William E. Whitman Chief Financial Officer and Treasurer (Chief Financial Officer) /s/ Kenneth G. Torosian Vice President and Controller Kenneth G. Torosian (Chief Accounting Officer) /s/ William M. Batten Director William M. Batten /s/ Constantine G. Caras Director Constantine G. Caras /s/ Lynde H. Coit Director Lynde H. Coit /s/ Philip G. Husby Director Philip G. Husby /s/ Robert E. Smith Director Robert E. Smith /s/ Jeffrey F. Friedman Director Jeffrey F. Friedman DELOITTE & TOUCHE One World Trade Center Facsimile:(212)524-0890 New York, New York 10048-0601 International & Domestic Telephone:(212)669-5000 Telex: 4995706 1633 Broadway Facsimile:(212)489-6944 New York, New York 10019-6754 International & Domestic Telephone:(212)489-1600 Telex: 4995706 INDEPENDENT AUDITORS' REPORT Ogden Projects, Inc. We have audited the consolidated financial statements of Ogden Projects, Inc. 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 2, 1994, which report includes an explanatory paragraph relating to the adoption of Statement of Financial Accounting Standards No. 109; 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 consolidated financial statement schedules of Ogden Projects, Inc. and subsidiaries, listed in Item 14. These consolidated 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 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. /S/ Deloitte & Touche February 2, 1994 SCHEDULE II SCHEDULE V SCHEDULE VI SCHEDULE VIII

833890_1993.txt

833890_1993

1993

833890

ITEM 1. BUSINESS Ashland Coal, Inc. (Ashland Coal or the Company) is engaged in the mining, processing, marketing and distribution of low-sulfur bituminous coal. The Company sells its coal primarily to electric utilities in the eastern United States. The Company also exports coal, primarily to European customers. Ashland Coal was incorporated in Delaware in 1975. The Company's consolidated results for 1993 were significantly affected by a selective strike by the United Mine Workers of America (UMWA) from May to December 1993 against the operations of two subsidiaries of the Company's Dal-Tex Coal Corporation subsidiary (Dal-Tex) and the operations of the Company's Hobet Mining, Inc. subsidiary (Hobet). These Dal-Tex subsidiaries (Dal-Tex Subsidiaries) and Hobet were signatories to the National Bituminous Coal Wage Agreement of 1988 (1988 Wage Agreement). For further information about the strike and the terms of its settlement, see "Employees" on page 4. The Company was engaged in preliminary discussions with Arch Mineral Corporation about a possible business combination of the two entities, but the parties terminated these discussions in mid-February 1994. For the year ended December 31, 1993, the Company and its independent operating subsidiaries sold approximately 16 million tons of coal, as compared to approximately 19.1 and 14.3 million tons sold in 1992 and 1991, respectively. Approximately 57% of the total number of tons sold during 1993 was sold under long-term contracts as compared to approximately 66% for 1992 and 67% for 1991. The balance was sold on the spot market (which includes contracts with a duration of one year or less). In 1993, the Company sold approximately 2.1 million tons of coal in the export market, compared to approximately 3.9 million tons in 1992 and 3.8 million tons in 1991. Approximately 61%, 71% and 71% of total revenues for 1993, 1992 and 1991, respectively, were derived from long-term contracts. For the year ended December 31, 1993, the Company's independent operating subsidiaries produced approximately 14.2 million tons of coal as compared to approximately 16.7 and 12.2 million tons for 1992 and 1991, respectively. In addition, the Company purchased for resale approximately 1.6 million tons of coal during 1993 and approximately 2.0 million tons of coal during each of 1992 and 1991. Selling prices in many of the Company's long-term coal sales contracts are adjusted for changes in broad price indices and labor costs, including wage rates and other benefits under the National Bituminous Coal Wage Agreement of 1993 (Wage Agreement) between the UMWA and the Bituminous Coal Operators' Association (BCOA), or any successor agreement. Some of these contracts also provide for price adjustment if certain federal and state levies on coal mining and processing are changed. In addition, most of the Company's long-term contracts provide that the customer may vary from the base annual quantity, usually by not more than 15%, the quantity of coal purchased under the contract in a particular year. In addition to customary adjustment provisions, in order to accommodate changing market or operational conditions, the renegotiation of coal sales contract terms after execution of the contract is not unusual in the industry. During 1993, the Company completed the renegotiation of three low-sulfur coal supply agreements with Appalachian Power Company (APCO), an operating subsidiary of the American Electric Power Company and two supply agreements with Consumers Power Company (Consumers). The coal under all the APCO contracts is for delivery principally to APCO's John E. Amos Plant in Putnam County, West Virginia. One APCO contract, which is supplied by Hobet, was to expire on September 30, 1998, but has now been extended to December 31, 2003. Under the original contract, approximately 1.1 million tons would have been shipped in 1994, and thereafter the tonnage was scheduled to decline each year until the contract's 1998 expiration. The amended contract calls for annual coal deliveries of 1.2 million tons beginning January 1, 1994, and continuing to December 31, 2003. It also provides for significant price reductions on January 1, 1994, July 1, 1994 and January 1, 1995. In addition, the price under a second APCO contract, which is supplied by Dal-Tex and expires on December 31, 1994, was reduced and will be reduced again on July 1, 1994. In connection with the foregoing price reductions, a third APCO contract, under which shipments from Dal-Tex are to begin on January 1, 1995, and which originally was to expire on December 31, 1999, has been extended through December 31, 2003. One Consumers contract, which is supplied by Dal-Tex, was renegotiated to decrease the annual tonnage from 1 million tons a year to 970,000 tons, and the price was reduced through December 31, 1994. Thereafter, the contract price returns to the price that was in effect before the reduction, as adjusted under the terms of the contract to December 31, 1994. The per ton price of a second Consumers contract was reduced pursuant to a price reopener provision. In addition, the parties amended the quality provisions and extended the term of this contract two years. The quantities deliverable under this contract did not change. The Company estimates that as of December 31, 1993, approximately 723 million recoverable tons of proven and probable coal reserves were held by the Company's subsidiaries in West Virginia and eastern Kentucky, of which approximately 276 million tons are recoverable using surface mining methods. A more detailed discussion of the Company's coal reserves is set forth below in Item 2. Item 2. PROPERTIES, Coal Reserves, on page 8. Based upon limited information obtained from preliminary prospecting, drilling and coal seam analysis, the Company estimates that a substantial portion of this coal has a sulfur content of 1 percent or less, some of which is compliance coal. Sulfur content of 1 percent or less refers to percentage by weight, while "compliance coal" is coal which emits 1.2 pounds or less of sulfur dioxide per million BTU upon combustion without the aid of sulfur reduction technology. OPERATIONS MINGO LOGAN COAL COMPANY Mingo Logan Coal Company (Mingo Logan), an independent operating subsidiary of the Company, conducts its operations in Mingo County, West Virginia, on approximately 20,600 acres containing approximately 110 million recoverable tons of low-sulfur and compliance coal. Mingo Logan's operations consist of surface mining operations conducted by two independent contract miners, four underground mines operated by two other independent contract miners, and a longwall mine (Mountaineer Mine) operated by Mingo Logan. Mingo Logan's Black Bear preparation plant has a plant feed capacity of 1,600 tons per hour, and is connected to the Mountaineer Mine by a 2-mile overland conveyor. The Black Bear preparation plant is connected to the loadout on the Norfolk Southern Railway Company (Norfolk Southern) railroad by a second overland conveyor that is approximately seven-tenths of a mile in length. The preparation plant, loadout and conveyors are located on land leased from Pocahontas Land Corporation, an affiliate of Norfolk Southern. The Black Bear preparation plant and loadout have silo storage capacity of approximately 19,500 tons of raw coal and approximately 24,000 tons of clean coal, respectively. In addition, the loadout has ground storage capacity of approximately 100,000 tons. The loadout facility is capable of loading a 13,000-ton unit train in less than four hours. Mingo Logan operations produced approximately 7 million tons of coal during 1993. DAL-TEX COAL CORPORATION Dal-Tex, an independent operating subsidiary of the Company, conducts its operations on approximately 22,000 acres of coal lands located primarily in Logan County, West Virginia, containing approximately 214 million tons of recoverable reserves of low-sulfur and compliance coal. Dal-Tex's operations currently consist of two surface mines operated by a Dal-Tex subsidiary using mountaintop removal techniques and three deep mines, two operated by a Dal-Tex subsidiary and one operated by a contract miner. At the surface mines, two 51-cubic-yard shovels and other large excavators are used for overburden removal. Continuous miner units are utilized in the deep mine operations. The Dal-Tex operations include the Monclo preparation plant located on the CSX Transportation (CSXT) rail system which is capable of a raw coal feed of 2,000 tons per hour. This plant is capable of loading a 14,000-ton unit train in less than four hours. Approximately 2.8 million tons of coal were produced at all of the Dal-Tex operations during 1993. HOBET MINING, INC. Hobet, an independent operating subsidiary of the Company, operates two large surface mines in southern West Virginia. The Hobet 21 mine in Boone County, West Virginia, currently has reserves dedicated to it of approximately 62 million recoverable tons of coal, of which 42 million tons are recoverable by surface mining. This mine uses mountaintop removal techniques and modern surface mining equipment, including a 72-cubic-yard walking dragline and a 51-cubic-yard shovel. The mine's operations include the 850-ton-per-hour Beth Station preparation plant. The Company expects to expand the raw coal handling and blending capabilities of this plant by late 1994 or early 1995. A 5-mile overland conveyor belt system transports the coal from the mine to the Beth Station preparation plant where the coal is cleaned and loaded into railcars at the adjacent 125-car rail siding for shipment on the CSXT rail system. The Beth Station preparation plant has a storage capacity in silos of 5,000 tons of raw coal and 10,000 tons of clean coal. The Hobet 21 mine produced about 1.5 million marketable tons of coal during 1993. A new underground mine with an initial production rate of 250,000 tons per year is planned to be opened at the Hobet 21 mine in the third quarter of 1994. The Hobet 07 mine, located in Mingo and Logan Counties, West Virginia, currently has reserves dedicated to it of approximately 42 million recoverable tons of coal. This mine uses mountaintop removal techniques and modern surface mining equipment including a 72-cubic-yard walking dragline and two 27-cubic-yard shovels. The mine's operations include the 950-ton-per-hour Pine Creek preparation plant. This plant has the capability of loading a 10,000-ton unit train in less than eight hours. Coal is loaded into railcars on the facility's 100-car rail siding, which is served by the CSXT rail system. The Pine Creek preparation plant has a storage capacity in silos of 10,000 tons of raw coal and 15,000 tons of clean coal. This mine produced about .8 million marketable tons of coal during 1993. It is currently anticipated that operations at the Hobet 07 mine will be suspended by the end of the decade based on current coal price and mining cost projections. See the Outlook section of Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS beginning on page 13 below. COAL-MAC, INC. Coal-Mac, Inc. (Coal-Mac), another independent operating subsidiary of the Company, conducts mining operations in eastern Kentucky. Coal-Mac and other subsidiaries of the Company control approximately 51 million recoverable tons of coal reserves in Johnson, Martin, Pike, and Floyd Counties, Kentucky. Coal-Mac operates surface mines and independent contractors operate underground mines in Floyd County, Kentucky. Total production from Coal-Mac's surface and underground operations during 1993 was approximately 2.0 million tons of coal. TRANSPORTATION Coal from the mines of the Company's independent operating subsidiaries is transported by rail, truck and barge to domestic customers and to inland waterway and Atlantic seaboard transloading facilities for shipment to international customers. During 1993, approximately 74% of the coal sold by the Company was shipped to the customer by rail, 21% was shipped by barge and 5% was shipped by truck. Tri-State Terminals, Inc., an independent operating subsidiary of the Company, operates the Lockwood Dock situated on a 60-acre tract on the Big Sandy River approximately seven miles upstream from its confluence with the Ohio River. The Lockwood Dock is comprised of a truck receiving and coal storage facility, a 1,400-ton-per-hour crushing and blending facility and a barge loading facility capable of loading a 1,500-ton barge every 70 minutes. In addition, coal sold through this facility may be loaded into trucks for delivery to customers. During 1993, 3.6 million tons of coal were loaded and shipped from the Lockwood Dock. Of this amount, 3.2 million tons were loaded and shipped for the Company's account and .4 million tons were loaded and shipped for third parties for a fee. The Company owns a 17.5 percent interest in Dominion Terminal Associates (DTA), which leases and operates a ground storage-to-vessel coal transloading facility (the DTA Facility) in Newport News, Virginia. The DTA Facility has a throughput capacity of 20 million tons of coal per year and ground storage capacity of approximately 1.7 million tons. During 1993, DTA loaded through the DTA Facility approximately 1.0 million tons of coal for the Company's account. The DTA Facility serves international customers, as well as domestic coal users located on the eastern seaboard of the United States. For additional information concerning the Company's investment in DTA, see Note 4 to the Company's Consolidated Financial Statements on page 27 below, and incorporated by reference in this Item 1. EMPLOYEES As of March 1, 1994, the Company and its independent operating subsidiaries employed a total of 1,687 people (including 24 part-time employees), of whom 772 are represented by the UMWA. Hobet and the Dal-Tex Subsidiaries were signatories to the 1988 Wage Agreement, which expired by its terms on February 1, 1993. On February 2, 1993, a selective strike was commenced by the UMWA against another coal company, which strike later expanded to other coal companies. The operations of the Company's independent operating subsidiaries were not interrupted by that strike, but pursuant to an agreement (Assistance Agreement) among members of the BCOA, Hobet and the Dal-Tex Subsidiaries made payments for the benefit of BCOA members that were struck. The selective strike ended and obligations in respect of such strike under the Assistance Agreement also ended on March 2, 1993, when the UMWA and BCOA agreed to extend the 1988 Wage Agreement to May 3, 1993. However, on May 18, 1993, each of Hobet and the Dal-Tex Subsidiaries were struck by the UMWA. On December 16, 1993, union miners returned to work at the mines of Hobet and the Dal-Tex Subsidiaries following ratification of the Wage Agreement on December 14, 1993. The Wage Agreement provides for a total wage increase of $1.30 per hour over the first three years of the contract, changes in medical coverage providing for deductibles and copayments, more flexible work rules that will permit coal production to take place 24 hours a day and seven days a week, increases in employer contributions to an education and retraining fund, and employer contributions to fund the new Labor Management Positive Change Program and the new 1993 Benefit Fund created by the Wage Agreement. The contract provisions of the Wage Agreement applicable to wages, pensions and medical benefits are fixed for the first three years of the contract, but thereafter wages and pension benefits are subject to renegotiation at the UMWA's election and certain provisions of the medical plan are subject to renegotiation at either the UMWA's or the BCOA's election. The Labor Management Positive Change Program mandated by the Wage Agreement establishes a board comprised of union and management representatives to explore methods of increasing productivity and efficiency. In connection with the Wage Agreement, the UMWA and BCOA also entered into a Memorandum of Understanding that requires that certain jobs at mines of Ashland Coal's nonunion subsidiaries be offered to UMWA miners under the following conditions. At any existing, new or newly acquired operation of a nonunion subsidiary of Ashland Coal, the subsidiary must offer the first three of every five job openings for certain jobs to active and laid-off employees of any union subsidiary. The first two jobs must be filled from among the senior laid-off and active miners of any union subsidiary of the Company provided such miners have the ability to step in and perform the job at the time the job is awarded. The third job must be filled with the senior laid-off or active miner of any union subsidiary provided such miner has the ability to step in and perform the work of the job at the time the job is awarded and has actually performed the job within the last three years. The final two out of five jobs may be filled from any source at the sole discretion of the nonunion subsidiary's management. Similarly, Ashland Coal's nonunion coal mining subsidiaries must require certain of their lessees, licensees, contractors and subcontractors that are engaged after the date of execution of the Memorandum of Understanding to offer the first three of every five job openings for certain jobs to active and laid-off UMWA-represented employees at any Ashland Coal union subsidiary. Generally, this requirement applies only where both (i) the lessees, licensees, contractors and subcontractors produce and process coal for the nonunion subsidiaries and (ii) the coal is sold by the nonunion subsidiaries. Ashland Coal's union subsidiaries do not currently have any laid-off union workers. Finally, the Memorandum of Understanding prohibits Ashland Coal and its nonunion subsidiaries from engaging in any transaction, restructuring or reorganization for the purpose of evading obligations under the Memorandum of Understanding. For additional discussion, see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS beginning below on page 11. The Company believes that the provisions of the Wage Agreement and the Memorandum of Understanding, taken as a whole, will not significantly change the costs experienced under the 1988 Wage Agreement. REGULATIONS AFFECTING COAL MINING Coal mining is subject to strict regulation by federal, state and local authorities, including, most significantly, with respect to permitting and environmental matters and health and safety matters. PERMITTING AND ENVIRONMENTAL MATTERS Numerous permits are required for mining operations. The Company believes all permits required to conduct present mining operations have been obtained. The Company believes that, upon the filing of the required information with the appropriate regulatory agencies, all permits necessary for continuing operations will be obtained. The federal Surface Mining Control and Reclamation Act of 1977 (SMCRA) was enacted to regulate certain surface mining of coal and the surface effects of underground mining. Kentucky and West Virginia have similar laws and regulations regulating surface and deep mining that impose, among other requirements, reclamation and environmental requirements and standards. The federal Clean Water Act affects coal mining operations by imposing effluent discharge restrictions on pollutants discharged into waters. Kentucky and West Virginia also have laws restricting discharges of pollutants into the waters of those states. In addition, the United States Environmental Protection Agency (EPA) has permitting requirements for storm water discharges from industrial facilities. These regulations require permits for some aspects of mining operations. Regular monitoring, as well as compliance with reporting requirements and performance standards, are preconditions for the issuance and renewal of permits governing the discharge of pollutants into waters. Further, as a result of a recent court decision, mining operations may be subject to Clean Water Act regulations for discharges into some ponds created to treat coal mining wastes. Previously, these ponds were not considered waters regulated by the Clean Water Act. Kentucky and West Virginia are also developing groundwater protection programs, but such programs have not been implemented and consequently the effect such programs may have on coal mining operations is unclear. The federal Resource Conservation and Recovery Act (RCRA) and implementing federal regulations exclude from the definition of hazardous waste all coal extraction, beneficiation and processing wastes. Additionally, other coal mining wastes which are subject to a SMCRA permit are exempt from RCRA permits and standards. Kentucky and West Virginia similarly exempt coal mine waste from their respective state hazardous waste laws and regulations. The federal Comprehensive Environmental Response, Compensation and Liability Act, as amended by the Superfund Amendments and Reauthorization Act, affects coal mining operations by imposing a cleanup requirement for threatened or actual releases of hazardous substances, other than the foregoing exempted hazardous waste, that may endanger public health or welfare or the environment. The federal Clean Air Act, as amended in 1990, imposes numerous requirements on various categories of emission sources. While the new statutory requirements do not directly impose new requirements on coal mining emission sources, it is possible that the EPA will implement the statute in a way that will impose additional regulatory requirements on industry sources including a duty to obtain an operating permit not previously required. The EPA previously published rules which do not require coal mines to include fugitive emissions in determining the applicability of the Clean Air Act's Prevention of Significant Deterioration Program. Although this rule was challenged, the rule was upheld and no appeal to the decision was filed. In addition, West Virginia state air regulations impose permitting obligations and performance standards on certain coal preparation plants and coal handling facilities such as crushers and screeners. HEALTH AND SAFETY MATTERS The federal Mine Safety and Health Act of 1977 imposes health and safety standards on all mining operations. Regulations are comprehensive and affect numerous aspects of mining operations, including training of mine personnel, mining procedures, blasting and the equipment used in mining operations. The Black Lung Benefits Reform Act of 1977 generally requires each coal mine operator to secure payment of federal and state black lung benefits to its employees through insurance, bonds or contributions to a state-controlled fund. The Black Lung Benefits Reform Act of 1977 also provides for the payment from a trust fund of benefits and medical expenses to employees for whom no benefits have been obtainable from their employer. This trust is financed by a tax on coal sales. The Coal Industry Retiree Health Benefit Act of 1992 (Benefit Act) addressed two underfunded trust funds which were to provide medical benefits for certain UMWA retirees. The Benefit Act provides for the funding of medical and death benefits for certain retired members of the UMWA through premiums to be paid by assigned operators (former employers), transfers of monies from an overfunded pension trust established for the benefit of retired UMWA members, and transfers from the Abandoned Mine Lands Fund, which is funded by a federal tax on coal production. This funding arrangement commenced February 1, 1993. Some former employers have filed suits challenging the constitutionality of the Benefit Act, but the eventual outcome of such litigation is uncertain. COMPLIANCE WITH REGULATORY REQUIREMENTS AND EXISTING ENVIRONMENTAL LIABILITY The Company's independent operating subsidiaries endeavor to conduct their operations in compliance with all applicable federal, state and local laws and regulations. However, because of the extensive and comprehensive regulatory requirements, violations during mining operations are not unusual in the industry. Mingo Logan and Dal-Tex are each a party to civil proceedings as a result of alleged failures to comply with mandatory federal or state health and safety regulations. Each of these proceedings involves a fatality and could result in the imposition of civil penalties. The Company believes that any adverse result, if incurred, would not have a material adverse effect on the Company's consolidated financial condition, results of operations or liquidity. Hobet, Sharples Coal Company, which is a subsidiary of Dal-Tex, Mingo Logan and other unrelated coal mining companies, individually, are parties to a civil proceeding with respect to the alleged failure of each of them to handle a respirable dust sampling cassette in accordance with regulations of the Mine Safety and Health Administration. Violations of federal and state health and safety regulations can result in civil and criminal penalties. To date, the monetary penalties assessed in respect of violations of these regulations have not been material and the Company does not anticipate that future assessments in respect of violations to date will be material to the Company's financial condition, results of operations or liquidity. Mingo Logan is a party to civil and administrative proceedings brought by owners of commercial surface property overlying part of Mingo Logan's Mountaineer Mine. These proceedings seek revocation of mining permits for the Mountaineer Mine and seek damages for alleged business disruptions and loss of a water well. It is unlikely that Mingo Logan's mining permits will be revoked as a result of these proceedings. It is impossible to predict the outcome of the damage claim at this stage of the proceedings, but any adverse result, if incurred, is not expected to have a material adverse effect on the Company's consolidated financial condition, results of operations or liquidity. The Company is not aware of any existing conditions on property in which it has an ownership or other interest that would give rise to material liability under federal, state and local environmental laws, regulations or ordinances. The Company believes that continued compliance with regulatory standards will not substantially affect its ability to compete with similarly situated coal mining companies. The cost of regulatory compliance, however, frequently increases the cost of mining coal and to this extent makes coal less competitive with alternative fuels. TRADEMARKS AND TRADENAMES Under an agreement executed in 1993, Ashland Oil, Inc. (Ashland Oil) granted the Company permission to continue using the Ashland name on a year to year basis after August 11, 1993, absent written notice from Ashland Oil to cease using the name at the end of the then applicable one year period. The Company also is permitted to use Ashland trademarks until July 1, 1994. If Ashland Oil's ownership in the Company ever falls below 35%, Ashland Oil may require the Company to remove the name Ashland from the Company's and its subsidiaries' names. RELIANCE ON MAJOR CUSTOMERS The Company's total sales to subsidiaries of American Electric Power Company and Cincinnati Gas & Electric Company accounted for approximately 20 and 16 percent, respectively, of the Company's total revenues in 1993. The loss of these customers could have a material adverse effect on the Company's business and results of operations. COMPETITION The coal industry is highly competitive, and the Company competes (principally in price, location and quality of coal) with a large number of other coal producers, some of which are substantially larger and have greater financial resources and larger reserve bases than the Company. Most long-term supply agreements and spot market orders are the result of competitive bidding. Coal also competes with other energy sources such as oil, natural gas, hydropower and nuclear energy for steam and electrical power generation. Over time, the cost and other factors, such as safety and environmental considerations, relating to these alternative fuels will affect the overall demand for coal as a fuel. ITEM 2. PROPERTIES As of December 31, 1993, the Company's subsidiaries controlled, primarily through long-term leases, approximately 130,604 and 114,581 acres of coal lands in West Virginia and eastern Kentucky, respectively. The Company's subsidiaries also control through ownership or long-term leases 917 acres of land in eastern Kentucky and West Virginia, which are used either for its coal processing facilities or are being held for possible future development. The Pine Creek, Beth Station and Black Bear preparation plants are located on properties held under leases which expire in 2030, 2022 and 2007 (with an optional 20-year extension), respectively. The Company's headquarters occupy approximately 52,000 square feet of leased space at 2205 Fifth Street Road, Huntington, West Virginia. The headquarters lease expires March 31, 1998. The descriptions of the Mingo Logan, Dal-Tex, Hobet and Coal-Mac mines set forth above in Item 1. BUSINESS are hereby incorporated into this Item 2. by reference. The Company's subsidiaries currently own or lease the equipment that is significant to their mining operations. Hobet leases equipment under leases that expire in 2003 and 1995. Hobet and Dal-Tex also utilize surface mining equipment leased pursuant to a sale and leaseback transaction entered into in January 1993. The lease term expires in January 1996. For further information about this 1993 transaction see Note 18 to the Company's Consolidated Financial Statements on page 36 below. The Company, through its subsidiaries, owns a 17.5 percent interest in DTA, which is the lessee and operator of a ground storage-to-vessel coal transloading facility at Newport News, Virginia (see Item 1. BUSINESS -- Transportation). COAL RESERVES The Company estimates that Company subsidiaries had, as of December 31, 1993, approximately 723 million recoverable tons of proven and probable coal reserves. Reserve totals vary from year to year for each Company subsidiary depending upon the amount of coal mined in any year, the acquisition and disposition of reserves in such year and exploration and development activity. The following table presents the Company's estimate of such reserves: RECOVERABLE COAL Substantially all of the coal reserves held by the Company's subsidiaries are controlled by leases which will not expire until the exhaustion of minable and merchantable coal. The remaining leases have primary terms expiring in various years ranging from 1994 to 2013, and most contain options to renew for stated periods. Royalties are paid to lessors either as a fixed price per ton or as a percentage of the gross sales price of the mined coal. The majority of the significant leases are on a percentage royalty basis. In certain cases a lease bonus is required, payable either at the time of execution of the lease or in annual installments following such execution. In most cases, the lease bonus amount is applied to reduce future production royalties. Subsidiaries of the Company own, lease or control 28,679 acres of coal lands upon which exploration has not been conducted. Federal and state legislation controlling air pollution affects the demand for certain types of coal by limiting the amount of sulfur dioxide which may be emitted as a result of fuel combustion and, thereby, encourages a greater demand for low-sulfur coal. Based upon limited information obtained from preliminary prospecting, drilling and coal seam analysis, the Company estimates that a substantial portion of the reserves held by Company subsidiaries consists of low-sulfur coal with a sulfur content of 1 percent or less, some of which is compliance coal. Most of the Company's reserves are primarily suitable for the steam coal markets. However, a substantial portion of the coal reserves at Mingo Logan may also be used as a high-volatile, low-sulfur metallurgical grade coal. The net book value, based on historical cost, of such mineral reserves at December 31, 1993, was $460 million, consisting of $15 million of prepaid royalties included in current assets, $54 million of prepaid royalties classified as an other asset and $391 million net book value of coal lands and mineral rights. Of this carrying value, approximately $31 million is attributable to certain reserves which are not currently in production and for which there are no current plans for significant production. In addition, as of December 31, 1993, future royalty commitments relating to these properties were approximately $3 million. See Note 6 to the Company's Consolidated Financial Statements beginning on Page 28 below and incorporated by reference in this Item 2. Consistent with industry practice, a limited investigation of title to coal properties is conducted prior to leasing. The titles of the lessors or grantors and the boundaries of leased properties are not completely verified until such time as the Company's independent operating subsidiaries prepare to mine such reserves. If defects in title or boundaries of undeveloped reserves are discovered in the future, control of and the right to mine such reserves could be adversely affected. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There is a pending suit in Circuit Court for Mingo County, West Virginia, filed September 3, 1993, by the administrator of an estate of a deceased employee of Mingo Logan. The employee died in an accident involving the longwall mining equipment at the Mountaineer Mine. The suit is based on product liability, breach of warranty, and negligence claims against Mingo Logan and other unrelated defendants, including the equipment manufacturer, and alleges compensatory and punitive damages of $45 million. Mingo Logan denies responsibility for the accident and the Company believes that the claim will not have a material adverse effect on its financial condition, results of operations or liquidity. 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 the Company through the solicitation of proxies or otherwise during the fourth quarter of 1993. ITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list of the Company's executive officers, their ages and their positions and offices held during the last five years (Senior Vice Presidents are listed alphabetically): WILLIAM C. PAYNE, 61, is Chairman of the Board of Directors, and President and Chief Executive Officer, and has served in such capacities since 1992 and 1987, respectively. He has served as a Director since 1987. C. HENRY BESTEN, JR., 46, is Senior Vice President, Marketing, and has served in this capacity since July 1990. From 1987 to 1990, he served as Administrative Vice President, Administration and Coal Resources. MARC R. SOLOCHEK, 48, is Senior Vice President and Chief Financial Officer and has served in these capacities since July 1990. From 1983 to 1990, he served as Administrative Vice President and Chief Financial Officer and from 1983 to 1992, he served as Treasurer. KENNETH G. WOODRING, 44, is Senior Vice President, Operations, and has served in this capacity since 1989. ROY F. LAYMAN, 48, is Administrative Vice President, Law and Human Resources, and Secretary, and has served in these capacities since April 1993. From 1987 to 1990, he served as Vice President, General Counsel and Secretary and from July 1990 to April 1993 he served as Administrative Vice President, General Counsel and Secretary. PART II. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's par value $.01 Common Stock (Common Stock) is listed and traded on the New York Stock Exchange and also has unlisted trading privileges on the Chicago Stock Exchange (symbol: ACI). Information regarding the Company's Common Stock is shown in the following table. The Company paid its first quarterly dividend in the fourth quarter of 1988. The Company increased its dividend in the fourth quarter of 1989 and the third quarter of 1990. The Company expects to continue paying regular cash dividends, although there is no assurance as to the amount or payment of dividends in the future because they are dependent on the Company's future earnings, capital requirements and financial condition. In addition, the payment of dividends is subject to the restriction described in Note 7 to the Company's Consolidated Financial Statements below on Page 29. Information available as of February 16, 1994, indicates that there were 579 holders of record of the Company's Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FIVE-YEAR SELECTED FINANCIAL INFORMATION ASHLAND COAL, INC. AND SUBSIDIARIES ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT'S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS 1993 COMPARED TO 1992 Ashland Coal's earnings for the year ended December 31, 1993, were $45.4 million before adjustments for the cumulative effect of the changes in accounting required by the adoption 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. This compares to net income of $35.7 million in 1992. After the cumulative effect of changes in accounting, net income for 1993 was $26.5 million. With the adoption of SFAS No. 106 effective January 1, 1993, Ashland Coal (the Company) immediately recognized an accumulated postretirement benefit obligation of $40.9 million ($25.3 million net of tax), which decreased income by the same amount. The adoption of SFAS No. 109, effective the same date, required the adjustment of the carrying value of certain assets, which had been acquired in prior business combinations, to their pretax amounts. That adjustment increased income by $10.5 million ($6.5 million net of tax). The net-of-tax amounts are reflected in the consolidated income statement as the cumulative effect of changes in accounting. Exclusive of the cumulative effect of changes in accounting, the combined effect of the adoption of SFAS No. 106 and SFAS No. 109 on income before income taxes and net income for 1993 was a decrease of $8.6 million and $5.3 million, respectively. In addition to the accounting changes discussed above, three other factors significantly affected earnings during 1993. First, there was an income tax benefit of $50.2 million principally as a result of the Company's election to deduct for federal tax purposes the amortization of goodwill associated with the April 1992 acquisition of Dal-Tex Coal Corporation. This amortization was not previously deductible, however the deduction is now permitted over 15 years as a result of the Omnibus Budget Reconciliation Act of 1993 (OBRA). The second factor was a special charge of $9.9 million ($6.0 million after tax) to increase the valuation allowance for certain prepaid royalties. The mineral reserves represented by those royalties are not conducive to large-scale, low-cost mining, and, given the Company's current expectations for future market prices for coal, the Company now believes that the recoverability of those royalties is doubtful. Finally, the seven-month strike by the United Mine Workers of America (UMWA) against Hobet Mining, Inc. and two subsidiaries of Dal-Tex adversely affected the operations of those companies and, therefore, consolidated net income. The strike ended December 16, 1993, with the ratification of a new five-year contract. Coal sales volume of 16.0 million tons and coal sales revenue of $484.4 million declined from 1992's levels by 3.0 million tons and $79.5 million, respectively. Sales volume and revenue were positively affected by the presence of Dal-Tex for the full year in 1993, as compared to nine months in 1992, and by increased production from the Mountaineer longwall mine of Mingo Logan Coal Company. These positive factors, however, were more than offset by the negative effects of the UMWA strike during the last three quarters of 1993. The average selling price increased $.65 per ton primarily because of strike-related higher selling prices in the spot market. The unit cost of coal sold increased $2.79 per ton because of the effects of the UMWA strike, the special charge relative to prepaid royalties, and the effects of the adoption of the new accounting standards. In addition, early in the year, Dal-Tex experienced a higher than normal level of equipment failures, and Mingo Logan's longwall mine operated in difficult mining conditions with resultant unfavorable costs. Selling, general, and administrative expenses increased $3.8 million primarily because of a full year's amortization of the carrying value of one of Dal-Tex's sales contracts, higher costs for salaries, payroll taxes, and benefits (including the effect of SFAS No. 106), and costs related to the investigation of a possible business combination with Arch Mineral Corporation. The Company and Arch terminated their discussions regarding such a combination in mid-February 1994. Interest expense increased $3.6 million over 1992 largely due to the discontinuation of the capitalization of construction period interest after the start-up of Mingo Logan's longwall equipment late in 1992. The income tax benefit recorded in 1993 was a result of OBRA and decreases in profitability coupled with higher percentage depletion relative to income. The Company's effective tax rate is sensitive to changes in profitability because of the effect of percentage depletion. 1992 COMPARED TO 1991 Ashland Coal's net income for the year ended December 31, 1992, was $35.7 million compared to $38.6 million in 1991, a decrease of $2.9 million, or 7.5 percent. Coal sales volume of 19.1 million tons and coal sales revenue of $563.9 million in 1992 were above 1991's levels by 4.8 million tons and $133.6 million, respectively. The acquisition of Dal-Tex on April 1, 1992, and expanded production from the mines at Mingo Logan were the major contributors to the increase in coal sales volume and revenue. Partially offsetting these contributions were declines in sales volume and revenue at Coal-Mac, Inc. The average selling price declined from 1991's level as the result of the lower average selling prices of the Dal-Tex sales agreements and weakness in the domestic spot and export markets, partially offset by an increase in the proportion of shipments to higher-priced domestic contract customers. The unit cost of coal sold increased slightly during 1992, reflecting less favorable mining conditions and consequent higher costs at the mines of Hobet. This increase was partially offset by the addition of low-cost production at Dal-Tex and the continued expansion of low-cost production at Mingo Logan. Selling, general, and administrative expenses increased $8.6 million, primarily due to $7.6 million in amortization of the carrying value of one of Dal-Tex's sales contracts. Interest expense increased $11.9 million over 1991 due to the higher level of debt resulting from the Dal-Tex acquisition and the development expenditures at Mingo Logan and due to lower amounts of construction period interest being capitalized. The effective tax rate for 1992 was significantly below 1991's rate. This decrease resulted from a decrease in profitability in 1992, the effects of the Dal-Tex acquisition, and higher percentage depletion at Mingo Logan. The acquisition of Dal-Tex had a significant beneficial impact on operating income, leading to a significant increase in percentage depletion. However, due to the interest expense incurred in funding the acquisition, income before income taxes was affected only moderately by the acquisition. BALANCE SHEET Cash equivalents declined from $37.0 million at December 31, 1992, to zero at the end of 1993. Late in 1992, Ashland Coal borrowed funds in excess of its immediate needs in order to improve liquidity in early 1993. These borrowings were repaid in February 1993. Subsequently, the Company again borrowed additional funds and maintained those funds as cash equivalents in order to be assured of adequate liquidity during the course of the strike by the UMWA. Those cash equivalents were utilized to repay borrowings at the conclusion of the strike. The balance of trade accounts receivable at December 31, 1993, declined $21.3 million from the balance at December 31, 1992. Ashland Coal's trade accounts receivable balance generally represents four to five weeks of coal sales, dependent upon the specific customer accounts and payment terms thereon. The balances of trade receivables at December 31, 1992, and December 31, 1993, reflect the levels of coal sales in December 1992 and December 1993, respectively. Coal sales in December 1993 were markedly lower because of the strike by the UMWA and its aftereffects. Inventories at December 31, 1993, were $2.2 million less than at December 31, 1992, principally as the result of lower inventories of coal. Coal inventories declined $4.0 million because stockpiles were drawn down during the strike. This decrease was partially offset, however, by an increase in supplies inventories of $1.8 million, primarily at Mingo Logan. The latter increase reflects a buildup during 1993 of parts and supplies in support of the fully developed longwall mine and, to a lesser extent, as a precaution against interruptions in the delivery of supplies during the strike. Because of the strike by the UMWA, prepaid royalties which are typically recovered in the normal course of mining each year were not fully recovered in 1993. This has resulted in temporarily higher current prepaid balances, but is not expected to affect the ultimate recoverability of these royalties. The balance of accounts payable declined $7.3 million from the balance at December 31, 1992, to $27.3 million at December 31, 1993. Purchases of goods and services were reduced during the strike, and deliveries of goods and services had not reached normal levels by the end of the year. Accrued expenses changed little largely because production had resumed at the struck mines, and accrued compensation was therefore at a normal level by the end of the year. The balance of the net deferred income tax liability at December 31, 1993, declined $86.6 million from the balance at December 31, 1992. This change arose principally as a result of tax law changes contained in OBRA (discussed above), which accounted for $50.2 million of the reduction, and the adoption of SFAS No. 106, which caused Ashland Coal to record a $15.5 million deferred tax asset related to the immediate recognition of the accumulated postretirement benefit obligation. In 1988, Ashland Coal and the holder of Ashland Coal's convertible Class C preferred stock entered into an agreement granting the holder the right to require, during the thirty-day period beginning August 18, 1993, Ashland Coal to purchase all the Class C shares. The holder did not exercise its put during the specified period, and all rights under the put have expired. The convertible Class C preferred stock has therefore been classified as an element of stockholders' equity in the December 31, 1993, balance sheet rather than outside stockholders' equity as was done at December 31, 1992. OUTLOOK The Company's 1994 results of operations will be adversely affected by the first-quarter aftereffects of the UMWA strike, which was settled late in 1993, and severe weather conditions. The severe winter weather experienced in early 1994 has had a significant adverse effect on the Company's mining and processing operations. In addition, the severe weather has adversely affected both rail and barge movements of coal. The combination of these factors will likely result in reduced volumes and increased costs in the first quarter of 1994. The Company expects that earnings for the first quarter will be approximately break-even. For the full year of 1994, Ashland Coal believes that average cost per ton will approximate the 1992 level. With higher sales volume than in 1993 and resultant lower fixed costs per ton, the Company expects operating income in 1994 to improve significantly over 1993's level. Since the settlement of the UMWA strike, spot market prices have fallen, but have remained above the level that prevailed prior to the strike. The combination of low utility inventories and severe weather is having a positive impact on current spot market prices. In addition, the demand for low-sulfur coal should continue to increase as the economy grows and as the effective date of the Clean Air Act amendments approaches. Sales to a major contract customer are expected to be above normal levels during 1994 as shortfalls in shipments that were scheduled for the strike-affected period are made up. The price on these contract sales is above the Company's average selling price. The Company has completed negotiations with two customers, including the Company's largest customer, concerning the price, extension of the term, and the quality and quantity of future deliveries under existing coal sales contracts with these customers. These new agreements will result in reduced coal sales revenues and cash flow in 1994. A substantial part of these decreases will be offset by additional sales volumes in later years. In addition, adjustments will be made in the rates of amortization of the carrying value of certain of these contracts, reducing amortization expense in 1994. Contracts with another major customer are expected to expire at the end of 1995, but could be renegotiated prior to then, based on current market prices. Because these contracts are priced above current market prices, these expirations will have a significant effect on earnings in 1996 and subsequent years. During 1993, export sales by Ashland Coal declined to 2.1 million tons from 3.9 million tons in 1992 because of weakness in the European economy and increased competition from both other fuels and other exporting countries. Because of strike-related factors in the domestic market, this decline had little effect on 1993's results of operations. The Company expects its export sales to show gradual growth from 1993 levels, but does not expect that export sales will have any significant effect on its results of operations. Also in 1993, the Company sold 1.6 million tons of metallurgical coal, which is used in the manufacture of steel. Although metallurgical coal ordinarily results in somewhat better profitability than similar sales of steam coal sold to electric utilities, Ashland Coal does not expect that sales of metallurgical coal will become a significant part of its total marketing strategy. Both export and metallurgical coal sales do, however, enhance Ashland Coal's market flexibility. The Company does not now expect that coal prices will be as high during the remainder of this decade as was anticipated in the mid-1980's, when the dragline development at Hobet 07 commenced. To compensate for these expected lower prices, it may be necessary, if costs at Hobet's 07 mine are not reduced, for Hobet to suspend operations at such mine by the end of the decade. In addition, costs are expected to be reduced by an expansion of the Hobet 21 mine. This expansion is expected to include the development of contract underground mines beginning in 1994, the construction of a raw coal handling and blending facility in 1994, and expansion of the preparation plant in 1995. The National Bituminous Coal Wage Agreement of 1993, which covers the UMWA employees of Hobet and of Dal-Tex's subsidiaries, provides for wage increases totaling $1.30 per hour over the first three years, changes in the health care plan intended to reduce costs, and improvements in work rules. Wage levels are subject to renegotiation after both the third and fourth years of the contract. In connection with the Agreement, a Memorandum of Understanding was entered into that provides for positions at mines of Ashland Coal's nonunion subsidiaries to be offered to UMWA miners under certain conditions. The Company believes that the provisions of the new Agreement and the Memorandum, taken as a whole, will not significantly change the costs experienced under the prior agreement. LIQUIDITY AND CAPITAL RESOURCES The following is a summary of cash provided by or used in each of the indicated types of activities during the past three years. Cash provided by operating activities before changes in operating assets and liabilities decreased in 1993 from 1992 primarily because of reduced sales volume resulting from the strike by the UMWA. Cash provided by operating activities before changes in operating assets and liabilities increased in 1992 from 1991 primarily because of increases in sales volume that resulted from the April 1992 acquisition of Dal-Tex and expanded operations at Mingo Logan. The reduction in 1993 from 1992 in cash used for changes in operating assets and liabilities primarily resulted from a reduction in accounts receivable balances during 1993, principally as a result of the UMWA strike. The significant increase in 1992 compared to 1991 in cash used for changes in operating assets and liabilities reflects higher accounts receivable balances, primarily because of the addition of Dal-Tex and the expansion of operations at Mingo Logan, and higher expenditures for prepaid royalties, primarily because of required payments under a lease held by Dal-Tex. Cash provided by investing activities in 1993 resulted from the sale and leaseback of certain mining equipment (discussed below). Cash used in investing activities in 1992 reflects the acquisition of Dal-Tex and construction activity at Mingo Logan. Cash used during 1991 for investing activities was primarily for construction activity at Mingo Logan. Cash used in financing activities in 1993 chiefly represents payments of $141.4 million on long-term borrowings from cash provided by the sale and leaseback of mining equipment, the liquidation of cash equivalents, and cash provided by operating activities. Cash provided by financing activities during 1992 and 1991 represents the proceeds of borrowings (and the sale of common stock in 1992) for the purpose of funding the 1992 Dal-Tex acquisition and capital expenditures not funded by cash provided by operating activities. The Company's capital expenditures during 1993 were $20.6 million, which was $76.6 million lower than in 1992. Expenditures for 1992 included $55 million related to the development of the Mingo Logan mine complex, which was completed in 1992. During 1993, the Company deferred some planned capital expenditures until 1994 to the extent possible in order to improve liquidity during the UMWA strike and in advance of the potential exercise of the put on convertible Class C preferred stock. Ashland Coal estimates that during 1994 capital expenditures will be approximately $65 million, including $11 million for the construction of a raw coal handling and blending facility at Hobet 21. On January 29, 1993, mining equipment valued at approximately $64 million being used by Dal-Tex and Hobet was sold and leased back under an operating lease. The sale and leaseback of this equipment gives Ashland Coal additional liquidity under its revolving credit agreement with little impact on financial results. The Company is no longer pursuing an agreement with a bank which would have allowed for sales of up to $35 million of trade accounts receivable at any given time. Ashland Coal has a revolving credit agreement with a group of banks providing for borrowings of up to $215 million, of which $50 million was borrowed at December 31, 1993. This commitment will be reduced in each calendar quarter until termination in 1997. The Company has $175 million of indebtedness under senior unsecured notes maturing in 1996 through 2006. Ashland Coal also periodically establishes uncommitted lines of credit with banks. These agreements generally provide for short-term borrowings at market rates. At December 31, 1993, there were $222.9 million of such agreements in effect with $56.3 million of indebtedness under these agreements. Of that amount, $19.3 million was classified as long-term debt, because Ashland Coal has the intent to maintain these borrowings on a long-term basis and the ability to do so through the use of the revolving credit agreement. The Company expects to repay the remaining $37 million of indebtedness under these lines of credit during 1994 and, accordingly, that amount was included in the current portion of long-term debt at December 31, 1993. The Company expects 1994 cash flow provided by operating activities to increase significantly from 1993 as a result of the conclusion of the UMWA strike and anticipated higher sales by Hobet and Dal-Tex during 1994. Ashland Coal believes that 1994 cash flow generated by operating activities will be adequate to fund anticipated capital expenditures and make the discretionary debt prepayments discussed above. Over the longer term, Ashland Coal believes that cash flow from operations will be adequate to fund anticipated capital expenditures, to make discretionary debt prepayments on indebtedness under lines of credit and the revolving credit agreement, and to pay scheduled debt maturities and other commitments when due. CONTINGENCIES Under the 1977 Surface Mining Control and Reclamation Act, a mine operator is responsible for postmining reclamation on every mine for at least five years after the mine is closed. Ashland Coal performs a substantial amount of reclamation of disturbed acreage as an integral part of its normal mining process. All such costs are expensed as incurred. The remaining costs of reclamation are estimated and accrued as mining progresses. The accrual for such reclamation (included in other long-term liabilities and in accrued expenses) was $2.5 million and $3.0 million at December 31, 1993 and 1992, respectively. In addition, the Company accrues the costs of removal at the conclusion of mining of roads, preparation plants, and other facilities and other costs (closing costs) over the lives of the various mines. Closing costs, in the aggregate, are estimated to be approximately $46.0 million. At December 31, 1993 and 1992, the accrual for closing costs, which is included in other long-term liabilities and in accrued expenses, was $4.7 million and $3.9 million, respectively. Ashland Coal is a party to numerous claims and lawsuits with respect to various matters, such as personal injury claims, claims for property damage, and claims by lessors, that are typical of the sorts of claims encountered in the coal industry. The Company provides for costs related to contingencies when a loss is probable and the amount is reasonably determinable. The Company estimates that its probable aggregate loss as a result of such claims is $4.6 million (included in other long-term liabilities) and believes that probable insurance recoveries of $3.9 million (included in other assets) related to these claims will be realized. The Company estimates that its reasonably possible aggregate losses from all currently pending litigation could be as much as $5.5 million (before tax) in excess of the probable loss previously recognized. However, the Company believes it is probable that substantially all of such losses, if any occur, will be insured. After conferring with counsel, it is the opinion of management that the ultimate resolution of these claims, to the extent not previously provided for, will not have a material adverse effect on the consolidated financial condition, results of operations, or liquidity of the Company. Ashland Coal has claims outstanding against a construction contractor for business interruption losses sustained by the Company when a coal silo failed and a second silo was unavailable during repairs. Recoveries under these claims are not expected to be material. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT AUDITORS To the Stockholders and Board of Directors Ashland Coal, Inc. We have audited the accompanying consolidated balance sheets of Ashland Coal, Inc. 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. 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 Ashland Coal, 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 taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, effective January 1, 1993, the Company changed its methods of accounting for income taxes and for postretirement benefits other than pensions. /s/ ERNST & YOUNG Louisville, Kentucky January 28, 1994 CONSOLIDATED STATEMENTS OF INCOME ASHLAND COAL, INC. AND SUBSIDIARIES SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED BALANCE SHEETS ASHLAND COAL, INC. AND SUBSIDIARIES SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ASHLAND COAL, INC. AND SUBSIDIARIES THREE YEARS ENDED DECEMBER 31, 1993 SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF CASH FLOWS ASHLAND COAL, INC. AND SUBSIDIARIES SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ASHLAND COAL, INC. AND SUBSIDIARIES DECEMBER 31, 1993 1. ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Ashland Coal, Inc. and its subsidiaries (the Company or Ashland Coal), which operate in the coal mining industry. All subsidiaries are wholly owned. Significant intercompany transactions and accounts have been eliminated in consolidation. Ashland Coal's 17.5% partnership interest in Dominion Terminal Associates is accounted for on the equity method in the consolidated balance sheet. Allocable costs of the partnership for coal loading and storage are included in costs and expenses in the statement of income. CHANGES IN ACCOUNTING METHODS Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 106, EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS. SFAS No. 106 requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined costs to be recognized over the period the employee provides service to the Company. As of January 1, 1993, the Company recognized the full amount of its actuarially estimated accumulated postretirement benefit obligation (APBO) as of that date which had not been previously recognized. The APBO represents the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. The pretax charge to 1993 earnings was $40,856,000, which was $25,331,000 ($1.44 per share on a primary basis and $1.34 per share on a fully diluted basis) net of tax. The latter amount has been reflected in the consolidated statement of income as a cumulative effect of an accounting change. The incremental cost, excluding the cumulative effect adjustment, in 1993 for postretirement health and life insurance benefits under the new accounting method amounted to $6,341,000 before tax and $3,868,000 ($.22 per share on a primary basis and $.20 per share on a fully diluted basis) net of tax. In prior years, the Company expensed claims for such postretirement benefits as paid. The amount included in postretirement benefit expense for 1992 under the previous accounting method was $884,000. Also in 1992, $1,262,000 of interest expense was recognized in connection with the April 1, 1992, acquisition of Dal-Tex Coal Corporation (Dal-Tex) and its estimated $19,305,000 obligation for retiree health and life insurance benefits at acquisition, which was recorded in the purchase price allocation. In the absence of the accounting change, the Company would have recognized postretirement health and life insurance costs of $1,167,000 and related interest expense of $1,716,000 in 1993. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 109, ACCOUNTING FOR INCOME TAXES. SFAS No. 109 requires a liability approach for measuring deferred taxes based on temporary differences between the financial statement and tax bases of assets and liabilities existing at each balance sheet date using enacted tax rates for years during which taxes are expected to be paid or recovered. Adoption of SFAS No. 109 required the adjustment of the carrying value of certain assets, which had been acquired in prior business combinations, to their pretax amounts. That adjustment increased 1993 income by $10,476,000, which was $6,495,000 ($.37 per share on a primary basis and $.34 per share on a fully diluted basis) net of tax. The latter amount has been reflected in the consolidated statement of income as a cumulative effect of an accounting change. Exclusive of the cumulative effect adjustment, the effect of adopting SFAS No. 109 on income before income taxes and 1. ACCOUNTING POLICIES (CONTINUED) net income for 1993 was a decrease of $2,267,000 and $1,383,000 ($.08 per share on a primary basis and $.07 per share on a fully diluted basis), respectively, as a result of increased depreciation and amortization expense on assets acquired in prior business combinations. INVENTORIES Inventories are comprised of the following: Coal inventories are stated at the lower of cost (determined by the first-in, first-out method) or market. Supplies inventories are valued at the lower of average cost or market. DEPRECIATION Depreciation is provided principally on the straight-line method over the estimated useful lives of the assets. EXPLORATION AND DEVELOPMENT COSTS Coal exploration costs are expensed as incurred. Development costs, which are recoverable, are capitalized and amortized by the units-of-production method over the estimated recoverable reserves. COAL ACQUISITION COSTS AND PREPAID ROYALTIES Coal lease rights obtained through acquisition of other companies are capitalized and amortized primarily by the units-of-production method over the estimated recoverable reserves. Rights to leased coal lands are often acquired through royalty payments. Where royalty payments represent prepayments recoupable against future production, they are capitalized, and amounts expected to be recouped within one year are classified as a current asset. As mining occurs on these leases, the prepayment is offset against earned royalties and is included in the cost of coal mined. The Company provides a valuation allowance for royalties estimated to be nonrecoupable. COAL SUPPLY AGREEMENTS Acquisition costs allocated to coal supply agreements (sales contracts) are capitalized and amortized to selling expense on the basis of coal to be shipped over the term of the contract. Accumulated amortization for sales contracts was $44,882,000 and $31,638,000 at December 31, 1993 and 1992, respectively. DEFERRED GAIN ON SALE AND LEASEBACK OF ASSETS Gain resulting from the sale and leaseback of assets is deferred and amortized over the term of the operating lease as a reduction of rental expense. REVENUE RECOGNITION Coal sales revenues include sales to customers of coal produced at Company operations and purchased from other companies. The Company recognizes revenue from coal sales at the time title passes to the customer. Revenues other than from coal sales are included in operating revenues and are recognized in income as services are performed. OTHER Cash equivalents (none at December 31, 1993, and $36,979,000 at December 31, 1992) represent highly liquid investments with a maturity of three months or less when purchased. Cash equivalents are recorded at cost, plus accrued interest, which approximates market. 1. ACCOUNTING POLICIES (CONTINUED) Interest costs on borrowed funds are capitalized for significant asset construction projects. Capitalized interest costs were $4,911,000 in 1992 and $6,497,000 in 1991. No interest was capitalized in 1993. Certain 1992 amounts included in the consolidated balance sheet have been reclassified to conform to 1993 classifications. 2. ACQUISITION On April 1, 1992, Ashland Coal acquired Dal-Tex for consideration of approximately $242,000,000, which included the issuance to the seller of 400,000 shares of Ashland Coal's common stock valued at $12,400,000. The cash portion was financed through bank borrowings and the issuance of 1,550,000 shares of common stock. This acquisition has been accounted for as a purchase, with the cost of the acquisition allocated to the assets acquired and liabilities assumed based on their respective estimated fair values at the date of acquisition. Such allocations were based on appraisals and Ashland Coal's evaluation of fair value. The results of operations of Dal-Tex have been included in Ashland Coal's consolidated financial statements since the acquisition date. 3. RELATED PARTIES The financial statements include transactions with Ashland Oil, Inc. (Ashland Oil), Saarbergwerke A.G. (Saarberg), and Carboex International, Ltd. (Carboex) and their affiliates. Ashland Oil owns 6,998,129 shares of the issued and outstanding common stock and Saarberg and Carboex own the issued and outstanding convertible Class B preferred stock and convertible Class C preferred stock, respectively. Revenues include sales of coal to Saarberg and miscellaneous items of income resulting from transactions with Ashland Oil. In addition, Ashland Coal receives certain services from and provides certain services to Ashland Oil for which fees are charged between the companies. Ashland Coal purchases fuel, oil, and other products for use in its mining operations from Ashland Oil. In 1991, Ashland Coal appointed Saarberg and Carboex as its exclusive agents for the purpose of selling metallurgical coal to the steel industry in Europe. Under the terms of the agreement, Ashland Coal pays a 2% commission on all such sales. Transactions with related parties are summarized below: Management believes that charges between Ashland Coal and Ashland Oil for services were reasonable and that the other transactions summarized above were concluded on terms equivalent to those prevailing among unaffiliated parties. 4. DOMINION TERMINAL ASSOCIATES Ashland Coal holds a 17.5% general partnership interest in Dominion Terminal Associates (DTA), which operates a ground storage-to-vessel coal transloading facility in Newport News, Virginia. DTA leases the facility from Peninsula Ports Authority of Virginia (PPAV) for amounts sufficient to meet debt service requirements. Financing is provided through $132,800,000 of tax-exempt bonds issued by PPAV which mature July 1, 2016. Under the terms of a throughput and handling agreement with DTA, each partner is charged its share of cash operating and debt service costs in exchange for the right to use its share of the facility's loading capacity and is required to make periodic cash advances to DTA to fund such costs. On a cumulative basis, costs exceeded cash advances by $6,497,000 and $6,044,000 at December 31, 1993 and 1992, respectively (included in other long-term liabilities). Costs and cash advances for the last three years follow: Future payments for fixed operating costs and debt service will approximate $3,300,000 annually through 2015 and $26,000,000 in 2016. 5. TAXES Significant components of the provision for income tax expense (benefit) are as follows: A reconciliation of the normal statutory federal income tax on Ashland Coal's pretax income with the Company's actual income tax expense (benefit) follows: Income tax benefit for 1993 includes a net $50,231,000 deferred tax benefit resulting from the enactment of the Omnibus Budget Reconciliation Act of 1993 (OBRA). OBRA increased the marginal tax rate on corporations by 1%, which resulted in Ashland Coal's recognizing an additional net deferred tax liability of $3,307,000 and a like amount of deferred income tax expense. The new law also permits the Company to elect to deduct the amortization of goodwill over 15 years. Such amortization 5. TAXES (CONTINUED) was not previously deductible. Ashland Coal has elected to deduct for federal tax purposes the amortization of goodwill associated with the April 1992 acquisition of Dal-Tex. As a result of this election, the Company recognized a $53,538,000 deferred tax asset and an equal deferred tax benefit. Significant components of the Company's deferred tax liabilities and assets that result from carryforwards and temporary differences between the financial statement basis and tax basis of assets and liabilities are summarized as follows: At December 31, 1993, the Company had $3,584,000 of U.S. net operating loss carryforwards (expiring $222,000 in 2003 and $3,362,000 in 2008) which may be applied against future taxable income. 6. PREPAID ROYALTIES Ashland Coal has entered into various noncancellable royalty lease agreements under which future minimum payments are approximately $25,000,000 annually in 1994 through 1998 and amounts aggregating $261,000,000 thereafter. Coal lands and mineral rights with a carrying value of $2,963,000, prepaid royalties with a carrying value of $27,788,000 (net of the valuation allowance described below), and future royalty commitments of $2,818,000 at December 31, 1993, represent amounts attributable to coal properties for which there are no immediate plans for significant production. Geological surveys performed by outside consultants indicate that there are sufficient reserves relative to these properties to permit recovery of Ashland Coal's investment. In 1993, Ashland Coal recorded a special charge of $9,900,000, which reduced net income $6,039,000 ($.34 per share on a primary basis and $.32 per share on a fully diluted basis), to increase the valuation allowance for prepaid royalties relative to certain properties. Because the reserves represented by those royalties are not conducive to large-scale, low-cost mining, the Company believes 6. PREPAID ROYALTIES (CONTINUED) that the recoverability of those royalties is doubtful, given the Company's current expectations for future market prices for coal. The valuation allowance for prepaid royalties was $22,062,000 and $10,634,000 at December 31, 1993 and 1992, respectively. 7. LONG-TERM DEBT AND FINANCING ARRANGEMENTS Long-term debt consists of the following: Ashland Coal has a revolving credit agreement with a group of banks providing for borrowings of up to $215,000,000. The rate of interest on borrowings under this agreement is, at Ashland Coal's option, a money market rate determined by a competitive bid process, the Continental Bank N.A. reference rate, or a rate based upon LIBOR. This commitment will be reduced in each calendar quarter until termination in 1997. The provisions of the revolving credit agreement require a facility fee of 1/4% per annum on the outstanding commitment. Ashland Coal periodically establishes uncommitted lines of credit with banks. These agreements generally provide for short-term borrowings at market rates. At December 31, 1993, there were $222,900,000 of such agreements in effect. Aggregate maturities of long-term debt are $37,260,000 in 1994, $66,715,000 in 1995, $24,727,000 in 1996, $25,000,000 in 1997, $25,000,000 in 1998, and $102,900,000 thereafter. Included in these maturities are discretionary prepayments of $37,000,000 in 1994, $66,705,000 in 1995, and $2,627,000 in 1996. Excluded from current maturities are $19,332,000 of borrowings under lines of credit with banks. These borrowings are classified as long-term debt since Ashland Coal has the intent to maintain these borrowings on a long-term basis and the ability to do so through the use of the revolving credit agreement. The credit agreements contain, among other covenants, provisions setting forth certain requirements for current ratio and consolidated net worth and restrictions on the payment of dividends and the creation of additional debt. At December 31, 1993, retained earnings of $46,824,000 were available for dividends. 8. ACCRUED BLACK LUNG BENEFITS Ashland Coal is liable under the federal Coal Mine Health and Safety Act of 1969, as amended, to provide for pneumoconiosis (black lung) benefits to eligible employees, former employees, and dependents with respect to claims filed by such persons on or after July 1, 1973. Ashland Coal is also liable under various states' statutes for black lung benefits. Ashland Coal currently provides for federal and state claims principally through a self-insurance program. Charges are being made to current operations in amounts sufficient to amortize the actuarially computed liability for black lung benefits over 8. ACCRUED BLACK LUNG BENEFITS (CONTINUED) 10-25 years at an assumed 8% after-tax investment return. The accrual for black lung benefits (included in other long-term liabilities) was $14,430,000 and $14,014,000 at December 31, 1993 and 1992, respectively. 9. ACCRUED POSTMINING RECLAMATION AND MINE CLOSING COSTS Under the 1977 Surface Mining Control and Reclamation Act, a mine operator is responsible for postmining reclamation on every mine for at least five years after the mine is closed. Ashland Coal performs a substantial amount of reclamation of disturbed acreage as an integral part of its normal mining process. All such costs are expensed as incurred. The remaining costs of reclamation are estimated and accrued as mining progresses. The accrual for such reclamation (included in other long-term liabilities and in accrued expenses) was $2,500,000 and $3,017,000 at December 31, 1993 and 1992, respectively. In addition, the Company accrues the costs of removal at the conclusion of mining of roads, preparation plants, and other facilities and other costs (closing costs) over the lives of the various mines. Closing costs, in the aggregate, are estimated to be approximately $46,000,000. At December 31, 1993 and 1992, the accrual for closing costs, which is included in other long-term liabilities and in accrued expenses, was $4,692,000 and $3,925,000, respectively. 10. ACCRUED EXPENSES Accrued expenses are comprised of the following: 11. CONVERTIBLE CLASS C PREFERRED STOCK Ashland Coal and Carboex entered into a put agreement in 1988 granting to Carboex the right to require Ashland Coal to purchase its 100 shares of Class C preferred stock for $37,500,000 to be paid over two years. Carboex could exercise its right during the thirty day period beginning August 18, 1993, but did not do so. These securities were recorded at their fair market value at date of issue, and the carrying value was increased to the 1993 present value of the redemption amount by periodic charges to retained earnings ($770,000 in 1993, $1,280,000 in 1992, and $1,232,000 in 1991). After the expiration of the put agreement, the Class C preferred stock was reclassified as an element of stockholders' equity. 12. CAPITAL STOCK Holders of shares of Class A, B, and C preferred stock are entitled to receive dividends at such times and in such amounts as shall be equal to the dividends payable on the number of shares of common stock into which each such share of preferred stock is convertible. In addition, holders of Class B and C preferred stock are entitled to receive cumulative dividends in preference to common stock of $4,200 per share per annum for the first five years from August 1988 and $2,800 for the next five years, with preference dividend amounts decreasing to zero at the end of fifteen years. Each share of Class A preferred stock (if issued) is convertible into 13,846 shares of common stock. 12. CAPITAL STOCK (CONTINUED) Each share of Class B and C preferred stock is convertible into shares of common stock as follows: Holders of Class B and C preferred stock, voting cumulatively and together as a class, have the right to elect one director for each 63 shares of such Class B and C preferred stock held by them, up to a maximum of three directors. The 1992 acquisition of Dal-Tex was funded in part by the private placement of 1,550,000 shares of Ashland Coal's common stock to accredited institutional investors and the issuance of 400,000 shares to the seller of Dal-Tex. On the sale of these shares, Ashland Coal realized $60,310,000 after underwriting and stock issuance expenses of $1,739,000. 13. EARNINGS PER SHARE Earnings per share of common stock are based on the weighted average number of common and common equivalent shares outstanding during each year. Shares of common stock issuable under the Company's stock incentive plan are treated as common stock equivalents when dilutive. Fully diluted earnings per share are based on conversion rights that become effective within 10 years of the respective balance sheet date. Computations of earnings per share, using the "two class" method, are as follows: 13. EARNINGS PER SHARE (CONTINUED) Weighted average shares for computing earnings per share were as follows: 14. STOCK INCENTIVE PLAN On August 8, 1988, the stockholders approved a stock incentive plan reserving 750,000 shares of Ashland Coal common stock for awards to officers and key employees. The plan provides for the granting of incentive stock options (qualified stock options), nonqualified stock options, stock appreciation rights (SARs) and restricted stock awards. Stock options generally become exercisable in full or in part one year from date of grant and are granted at a price equal to 100% of the fair market value of the stock on the date of grant. SARs entitle employees to surrender stock options and receive cash or stock in an amount equal to the excess of the market value of the optioned shares over their option price. Unexercised options and any accompanying SARs lapse ten years after the date of grant. Restricted stock awards may entitle employees to purchase shares at a nominal cost. Such awards entitle employees to vote shares acquired and to receive any dividends thereon, but such shares cannot be sold or transferred and are subject to forfeiture if employees terminate their employment prior to the prescribed period, which can be from one to five years. As of December 31, 1993, no SARs or restricted stock awards have been granted. Information regarding this plan follows: 15. EMPLOYEE BENEFIT PLANS DEFINED BENEFIT PENSION PLAN The Company has a noncontributory defined benefit pension plan covering certain of its salaried and nonunion hourly employees. Benefits for salaried employees generally are based on years of service and the employee's compensation during the three years prior to retirement. For hourly employees, the plan provides for a stated benefit for each year of service. Ashland Coal funds the plan in an amount not less than minimum statutory funding requirements nor more than the maximum amount that can be deducted for federal income tax purposes. Plan assets consist primarily of equity securities and fixed income securities. 15. EMPLOYEE BENEFIT PLANS (CONTINUED) The net pension expense of the plan included the following components: The following table sets forth the plan's funded status and amounts recognized in the consolidated balance sheet at December 31, 1993 and 1992: The assumptions used in computing the information above were as follows: MULTIEMPLOYER PENSION AND BENEFIT PLANS Under the labor contract with the United Mine Workers of America (UMWA), Ashland Coal made payments of $475,000 in 1993, $1,105,000 in 1992, and $669,000 in 1991 into a multiemployer defined benefit pension plan trust established for the benefit of union employees. Payments are based on hours worked. Under the Multiemployer Pension Plan Amendments Act of 1980, a contributor to a multiemployer pension plan may be liable, under certain circumstances, for its proportionate share of the plan's unfunded vested benefits (withdrawal liability). Ashland Coal has estimated its share of such amount to be $16,500,000 at December 31, 1993. Ashland Coal is not aware of any circumstances which would require it to reflect its share of unfunded vested pension benefits in its financial statements. The Coal Industry Retiree Health Benefit Act of 1992 (Benefit Act) provides for the funding of medical and death benefits for certain retired members of the UMWA through premiums to be paid by assigned operators (former employers), transfers of monies from an overfunded pension trust established for the benefit of retired UMWA members, and transfers from the Abandoned Mine Lands 15. EMPLOYEE BENEFIT PLANS (CONTINUED) Fund, which is funded by a federal tax on coal production. This funding arrangement commenced February 1, 1993. Some former employers, however, have filed suits challenging the constitutionality of the Benefit Act. Ashland Coal treats its obligation under the Benefit Act as a participation in a multiemployer plan and recognizes expense as premiums are paid. During 1993, Ashland Coal recognized $240,000 in expense relative to premiums paid pursuant to the Benefit Act. The Company believes that the amount of its obligation under the Benefit Act is not significant. Under the prior funding arrangement for retirees now covered by the Benefit Act, Ashland Coal paid $609,000 in 1993, $4,809,000 in 1992, and $2,606,000 in 1991 into two multiemployer benefit trusts. OTHER POSTRETIREMENT BENEFIT PLANS Ashland Coal and its subsidiaries currently provide certain postretirement health and life insurance coverage for eligible employees. Generally, covered employees who terminate employment after meeting the eligibility requirements for pension benefits are also eligible for postretirement coverage for themselves and their dependents. The salaried employee postretirement medical and dental plans are contributory, with retiree contributions adjusted periodically, and contain other cost-sharing features such as deductibles and coinsurance. The postretirement medical plan for retirees who were members of the UMWA is not contributory. The Company's current funding policy is to fund the cost of all postretirement health and life insurance benefits as they are paid. The net periodic postretirement benefit expense of these plans for 1993 included the following components: The following table sets forth the amounts recognized in the consolidated balance sheet at December 31, 1993, none of which have been funded: The discount rate used in determining the accumulated postretirement benefit obligation was 7% and 8.25% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate for 1994 is 13%, decreasing to 5% in the year 2010. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing 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 $12,300,000, or 17.9%, and the net periodic postretirement benefit cost for 1993 by $2,000,000, or 21.7%. 15. EMPLOYEE BENEFIT PLANS (CONTINUED) OTHER PLANS Ashland Coal sponsors three savings plans which were established to assist eligible employees in providing for their future retirement needs. Ashland Coal's contributions to the plans were $1,464,000 in 1993, $1,135,000 in 1992, and $616,000 in 1991. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, EMPLOYERS' ACCOUNTING FOR POSTEMPLOYMENT BENEFITS, which requires that employers who provide benefits to former or inactive employees after employment but before retirement recognize the obligation for those benefits under certain conditions. Ashland Coal will adopt SFAS No. 112 in 1994. Ashland Coal does not believe that SFAS No. 112 will have a significant effect on the consolidated financial statements. 16. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS Ashland Coal places its cash equivalents in investment grade short-term investments and limits the amount of credit exposure to any one commercial issuer. Ashland Coal markets its coal principally to electric utilities in the United States and Europe. As of December 31, 1993 and 1992, accounts receivable from electric utilities located in the United States totaled $31,609,000 and $49,908,000, respectively, and accounts receivable from electric utilities located in Europe totaled $2,491,000 and $10,738,000, respectively. Credit is extended based on an evaluation of the customer's financial condition, and collateral is not generally required. Credit losses are provided for in the financial statements and consistently have been minimal. Ashland Coal is committed under several long-term contracts to supply coal that meets certain quality requirements at specified prices. These prices are generally adjusted based on indices. Quantities sold under some of these contracts may vary from year to year within certain limits at the option of the customer. Sales (including spot sales) to major customers were as follows: In 1993, 1992, and 1991, Ashland Coal had export sales, principally to European customers, of $50,364,000, $93,832,000, and $95,229,000, respectively. 17. FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by Ashland Coal in estimating its fair value disclosures for financial instruments: CASH AND CASH EQUIVALENTS: The carrying amount reported in the balance sheet for cash and cash equivalents approximates its fair value. LONG-TERM AND SHORT-TERM DEBT: The carrying amounts of Ashland Coal's borrowings under its revolving credit agreement and under lines of credit approximate their fair value. The fair values of Ashland Coal's senior notes are estimated using discounted cash flow analyses, based on Ashland Coal's current incremental borrowing rates for similar types of borrowing arrangements. 17. FAIR VALUES OF FINANCIAL INSTRUMENTS (CONTINUED) The carrying amounts and fair values of Ashland Coal's financial instruments at December 31, 1993, are as follows: 18. SALE AND LEASEBACK On January 29, 1993, Ashland Coal sold mining equipment valued at approximately $64,000,000 and leased back the equipment under an operating lease. The proceeds of this transaction were used to repay borrowings under Ashland Coal's revolving credit agreement. The lease has a term of three years and provides for minimum annual rental payments of $9,467,000 in 1994, $9,160,000 in 1995, and $2,242,000 in 1996. At the end of the lease term, the Company has the option to purchase the equipment for $43,172,000. Alternatively, the equipment may be sold by the lessor to a third party. In the event of such a sale, the Company will be required to make payment to the lessor in the event and to the extent that the proceeds are below $35,631,000. 19. COMMITMENTS AND CONTINGENCIES Ashland Coal leases office space, mining equipment, land, and various other properties under noncancellable long-term leases, expiring at various dates. Rental expense related to these operating leases amounted to $10,772,000 in 1993, $3,510,000 in 1992, and $4,371,000 in 1991. Minimum annual rentals due in future years under lease agreements in effect at January 1, 1994, are approximately $13,241,000 in 1994, $12,293,000 in 1995, $5,449,000 in 1996, $3,239,000 in 1997, $2,928,000 in 1998, and additional amounts thereafter aggregating $14,910,000 through 2011. Ashland Coal is a party to numerous claims and lawsuits with respect to various matters. The Company provides for costs related to contingencies when a loss is probable and the amount is reasonably determinable. The Company estimates that its probable aggregate loss as a result of such claims is $4,600,000 (included in other-long-term liabilities) and believes that probable insurance recoveries of $3,900,000 (included in other assets) related to these claims will be realized. The Company estimates that its reasonably possible aggregate losses from all currently pending litigation could be as much as $5,500,000 (before tax) in excess of the probable loss previously recognized. However, the Company believes it is probable that substantially all of such losses, if any occur, will be insured. After conferring with counsel, it is the opinion of management that the ultimate resolution of these claims, to the extent not previously provided for, will not have a material adverse effect on the consolidated financial condition, results of operations, or liquidity of the Company. Ashland Coal has claims outstanding against a construction contractor for business interruption losses sustained by the Company when a coal silo failed and a second silo was unavailable during repairs. Recoveries under these claims are not expected to be material. 20. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Quarterly financial data for 1993 and 1992 are summarized below. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no changes in accountants or disagreements with accountants with respect to accounting and financial disclosure during the two most recent fiscal years. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT There is hereby incorporated by reference into this Annual Report on Form 10-K the information appearing under the subcaption "Nominees for Director" which appears under the caption "Election of Directors" beginning on Page 4 in the Company's 1994 Proxy Statement. See also the list of the Company's executive officers and related information under "Executive Officers of the Registrant" in Part I, Item X herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION There is hereby incorporated by reference into this Annual Report on Form 10-K the information appearing under the "Summary Compensation Table", the "Option Grants in Last Fiscal Year" table, the "Aggregated Option Exercises in Last Fiscal Year and FY-End Option Values" table, the "Long Term Incentive Plans Awards in Last Fiscal Year" table, the Other Compensation Plans section (including the Pension Plan Table), the Employment Contracts and Termination of Employment and Change in Control Arrangements section, the Compensation of Directors section, and the Compensation Committee Interlocks and Insider Participation section appearing on Pages 19 to 28 in the Company's 1994 Proxy Statement. No portion of the Personnel and Compensation Committee and Key Employee Stock Administration Committee Report on Executive Compensation for 1993 or the "Comparison of Cumulative Total Return" table is incorporated herein in reliance on Regulation S-K, Item 402(a)(8). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is hereby incorporated by reference into this Annual Report on Form 10-K the information appearing under the caption "Security Ownership of Certain Beneficial Owners and Management" beginning on Page 9 of the Company's 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is hereby incorporated by reference into this Annual Report on Form 10-K the information appearing under the subcaptions "Restated Shareholders Agreement" and "Registration Rights Agreement" on Pages 11 and 12 of the Company's 1994 Proxy Statement and the information appearing under the caption "Certain Relationships and Related Transactions" beginning on Page 28 of the Company's 1994 Proxy Statement. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this Report (2) The following consolidated financial statement schedules of Ashland Coal, Inc. and subsidiaries are included in Item 14 at the page indicated: 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. (3) Exhibits filed as part of this Report are as follows: Items 10.14, 10.15, 10.16, 10.17, 10.18, 10.20, 10.23 and 10.24 are executive compensation plans. Upon written or oral request to the Company's Secretary, a copy of any of the above exhibits will be furnished at cost. (b) Reports on Form 8-K A current Report on Form 8-K was filed on December 22, 1993 to report UMWA ratification of the Wage Agreement and the return of UMWA workers to the mines of Hobet and the Dal-Tex Subsidiaries. ASHLAND COAL, INC. AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) ASHLAND COAL, INC. AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) ASHLAND COAL, INC. AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) ASHLAND COAL, INC. AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION (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. ASHLAND COAL, INC. (Registrant) By: /s/ MARC R. SOLOCHEK ----------------------------------- Marc R. Solochek SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER 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 indicated on March 30, 1994. ORIGINAL POWERS OF ATTORNEY AUTHORIZING WILLIAM C. PAYNE, MARC R. SOLOCHEK, AND ROY F. LAYMAN, AND EACH OF THEM, TO SIGN THIS ANNUAL REPORT ON FORM 10-K AND AMENDMENTS THERETO ON BEHALF OF THE ABOVE-NAMED PERSONS HAVE BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION AS EXHIBIT 25 TO THIS REPORT. EXHIBIT INDEX

92122_1993.txt

92122_1993

1993

92122

ITEM 1. BUSINESS SOUTHERN was incorporated under the laws of Delaware on November 9, 1945. SOUTHERN is domesticated under the laws of Georgia and is qualified to do business as a foreign corporation under the laws of Alabama. SOUTHERN owns all the outstanding common stock of ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH, each of which is an operating public utility company. ALABAMA and GEORGIA each own 50% of the outstanding common stock of SEGCO. The operating affiliates supply electric service in the states of Alabama, Georgia, Florida, Mississippi and Georgia, respectively, and SEGCO owns generating units at a large electric generating station which supplies power to ALABAMA and GEORGIA. More particular information relating to each of the operating affiliates is as follows: ALABAMA is a corporation organized under the laws of the State of Alabama on November 10, 1927, by the consolidation of a predecessor Alabama Power Company, Gulf Electric Company and Houston Power Company. The predecessor Alabama Power Company had had a continuous existence since its incorporation in 1906. GEORGIA was incorporated under the laws of the State of Georgia on June 26, 1930, and admitted to do business in Alabama on September 15, 1948. GULF is a corporation which was organized under the laws of the State of Maine on November 2, 1925, and admitted to do business in Florida on January 15, 1926, in Mississippi on October 25, 1976 and in Georgia on November 20, 1984. MISSISSIPPI was incorporated under the laws of the State of Mississippi on July 12, 1972, was admitted to do business in Alabama on November 28, 1972, and effective December 21, 1972, by the merger into it of the predecessor Mississippi Power Company, succeeded to the business and properties of the latter company. The predecessor Mississippi Power Company was incorporated under the laws of the State of Maine on November 24, 1924, and was admitted to do business in Mississippi on December 23, 1924, and in Alabama on December 7, 1962. SAVANNAH is a corporation existing under the laws of Georgia; its charter was granted by the Secretary of State on August 5, 1921. SOUTHERN also owns all the outstanding common stock of SEI, Southern Nuclear, SCS (the system service company), and various other subsidiaries related to foreign operations and domestic non-utility operations (see Exhibit 21 herein). At this time, the operations of the other subsidiaries are not material. SEI designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. A further description of SEI's business and organization follows later in this section. Southern Nuclear provides services to the Southern electric system's nuclear plants. SEGCO owns electric generating units with an aggregate capacity of 1,019,680 kilowatts at Plant Gaston on the Coosa River near Wilsonville, Alabama, and ALABAMA and GEORGIA are each entitled to one-half of SEGCO's capacity and energy. ALABAMA acts as SEGCO's agent in the operation of SEGCO's units and furnishes coal to SEGCO as fuel for its units. SEGCO also owns three 230,000 volt transmission lines extending from Plant Gaston to the Georgia state line at which point connection is made with the GEORGIA transmission line system. THE SOUTHERN SYSTEM The transmission facilities of each of the operating affiliates and SEGCO are connected to the respective company's own generating plants and other sources of power and are interconnected with the transmission facilities of the other operating affiliates and SEGCO by means of heavy-duty high voltage lines. (In the case of GEORGIA's integrated transmission system, see Item 1 - BUSINESS - "Territory Served" herein.) Operating contracts covering arrangements in effect with principal neighboring utility systems provide for capacity exchanges, capacity purchases and sales, transfers of economy energy and other similar transactions. Additionally, the operating affiliates have entered into voluntary reliability agreements with the subsidiaries of Entergy Corporation, Florida Electric Power Coordinating Group and TVA and with Carolina Power & Light Company, Duke Power Company, South Carolina Electric & Gas Company and Virginia Electric I-1 and Power Company, each of which provides for the establishment and periodic review of principles and procedures for planning and operation of generation and transmission facilities, maintenance schedules, load retention programs, emergency operations, and other matters affecting the reliability of bulk power supply. The operating affiliates have joined with other utilities in the Southeast (including those referred to above) to form the SERC to augment further the reliability and adequacy of bulk power supply. Through the SERC, the operating affiliates are represented on the National Electric Reliability Council. An intra-system interchange agreement provides for coordinating operations of the power producing facilities of the operating affiliates and SEGCO and the capacities available to such companies from non-affiliated sources and for the pooling of surplus energy available for interchange. Coordinated operation of the entire interconnected system is conducted through a central power supply coordination office maintained by SCS. The available sources of energy are allocated to the operating affiliates to provide the most economical sources of power consistent with good operation. The resulting benefits and savings are apportioned among the operating affiliates. SCS has contracted with each operating affiliate, SEI, various of the other subsidiaries, Southern Nuclear and SEGCO to furnish, at cost and upon request, the following services: general executive and advisory services, power pool operations, general engineering, design engineering, purchasing, accounting and statistical, finance and treasury, taxes, insurance and pensions, corporate, rates, budgeting, public relations, employee relations, systems and procedures and other services with respect to business and operations. SOUTHERN also has a contract with SCS for certain of these specialized services. Southern Nuclear has contracted with ALABAMA to operate its Farley Nuclear Plant, as authorized by amendments to the plant operating licenses. Southern Nuclear also has a contract to provide GEORGIA with technical and other services to support GEORGIA's operation of plants Hatch and Vogtle. Applications are now pending before the NRC for amendments to the Hatch and Vogtle operating licenses which would authorize Southern Nuclear to become the operator. See Item 1 - BUSINESS - "Regulation - Atomic Energy Act of 1954" herein. NEW BUSINESS DEVELOPMENT SOUTHERN continues to consider new business opportunities, particularly those which allow use of the expertise and resources developed through its regulated utility experience. These endeavors began in 1981 and are conducted through SEI and other existing subsidiaries. SEI's primary business focus is international and domestic cogeneration, the independent power market, and the privatization of generation facilities in the international market. SEI currently operates two domestic independent power production projects totaling 225 megawatts and is one-third owner of one of these (which produces 180 megawatts). It has a contract to sell electric energy to Virginia Electric and Power Company from a facility SEI is developing (through subsidiaries) in King George, Virginia. Upon completion, currently planned for 1996, SEI will operate the 220 megawatt coal-fired plant and own 50% of the project. In April 1993, SOUTHERN completed the purchase of a 50% interest in Freeport, an electric utility on the Island of Grand Bahama, for a purchase price of $35.5 million. Freeport has generating capacity of about 112 megawatts. In August 1993, SOUTHERN completed the purchase of a 55% interest in Alicura, an entity that owns the right to use the generation from a 1,000 megawatt hydroelectric generating facility in Argentina, for a net purchase price of approximately $188 million. In December 1993, SOUTHERN completed the purchase of a 35% interest in Edelnor for the purchase price of $73 million. Edelnor is a utility located in Northern Chile that owns and operates a transmission grid and a 96 megawatt generating facility and is building an additional 150 megawatt facility. SEI has continued to render consulting services and market SOUTHERN system expertise in the United States and throughout the world. It contracts with other public utilities, commercial concerns and government agencies for the rendition of services and the licensing of intellectual property. In addition, SEI engages in energy management-related services and activities. These continuing efforts to invest in and develop new business opportunities offer the potential of earning returns which may exceed those of rate-regulated operations. However, because of the absence of any assured return or rate of return, they also involve a higher I-2 degree of risk. SOUTHERN expects to make substantial investments over the period 1994-1996 in these and other new businesses. CERTAIN FACTORS AFFECTING THE INDUSTRY The electric utility industry is expected to become increasingly competitive in the future as a result of the enactment of the Energy Act (see each registrant's "Management's Discussion and Analysis - Future Earnings Potential" in Item 7 herein), deregulation, competing technologies and other factors. In recent years the electric utility industry in general has experienced problems in a number of areas including the uncertain cost of capital needed for construction programs, difficulty in obtaining sufficient return on invested capital and in securing adequate rate increases when required, high costs and other issues associated with compliance with environmental and nuclear regulations, changes in regulatory climate, prudence audits and the effects of inflation and other factors on the costs of operations and construction expenditures. The SOUTHERN system has been experiencing certain of these problems in varying degrees and management is unable to predict the future effect of these or other factors upon its operations and financial condition. CONSTRUCTION PROGRAMS The subsidiary companies of SOUTHERN are engaged in continuous construction programs to accommodate existing and estimated future loads on their respective systems. Construction additions or acquisitions of property during 1994 through 1996 by the operating affiliates, SEGCO, SCS and Southern Nuclear are estimated as follows: (in millions) *Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. Reference is made to Note 4 to the financial statements of each registrant in Item 8 herein for the amounts of AFUDC included in the above estimates. The construction estimates for the period 1994 through 1996 do not include amounts which may be spent by SEI (or the subsidiary(s) created to effect such project(s)) on future power production projects or the projects discussed earlier under "New Business Development." (See also Item 1 - BUSINESS - "Financing Programs" herein.) I-3 Estimated construction costs in 1994 are expected to be apportioned approximately as follows: (in millions) *SCS and Southern Nuclear plan capital additions to general plant in 1994 of $26 million and $1 million, respectively, while SEGCO plans capital additions of $14 million to generating facilities. Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing cost of labor, equipment and materials; cost of capital and SEI securing a contract(s) to buy or build additional generating facilities. The operating affiliates do not have any baseload generating plants under construction and current energy demand forecasts do not require any additional baseload generating facilities before 2011. However, within the service area, the construction of combustion turbine peaking units with an aggregate capacity of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. During 1991, the Georgia legislature passed legislation which requires GEORGIA and SAVANNAH each to file an Integrated Resource Plan for approval by the Georgia PSC. Under the plan rules, the Georgia PSC must pre-certify the construction of new power plants. (See Item 1 - BUSINESS - "Rate Matters - Integrated Resource Planning" herein.) See Item 1 - BUSINESS - "Regulation - Environmental Regulation" herein for information with respect to certain existing and proposed environmental requirements and Item 2 ITEM 2. PROPERTIES ELECTRIC PROPERTIES The operating affiliates and SEGCO, at December 31, 1993, operated 33 hydroelectric generating stations, 31 fossil fuel generating stations and three nuclear generating stations. The amounts of capacity owned by each company are shown in the table below. I-18 Notes: (1) Owned by ALABAMA and MISSISSIPPI as tenants in common in the proportions of 60% and 40%, respectively. (2) Excludes the capacity owned by AEC. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) (3) Capacity shown is GEORGIA's or GULF's (Unit 3 only) current portion: 8.4% of Units 1 and 2, 75% (25% for GULF) for Unit 3 and 33.1% for Unit 4 of total plant capacity. See Item 2 - PROPERTIES - "Proposed Sales of Property" and "Jointly-Owned Facilities" herein. (4) Capacity shown is GEORGIA's portion (53.5%) of total plant capacity. (5) Represents 50% of the plant which is owned as tenants in common by GULF and MISSISSIPPI. (6) SEGCO is jointly-owned by ALABAMA and GEORGIA. (See Item 1 - BUSINESS herein.) (7) Capacity shown is GEORGIA's portion (50.1%) of total plant capacity. (8) Capacity shown is GEORGIA's portion (45.7%) of total plant capacity. (9) Generation is dedicated to a single industrial customer. Except as discussed below under "Titles to Property", the principal plants and other important units of the SOUTHERN system are owned in fee by the operating affiliates and SEGCO. It is the opinion of management of each such company that its operating properties are adequately maintained and are substantially in good operating condition. MISSISSIPPI owns a 79-mile length of 500-kilovolt transmission line which is leased to Gulf States. The line, completed in 1984, extends from Plant Daniel to the Louisiana state line. Gulf States is paying a use fee over a forty-year period covering all expenses and the amortization of the original $57 million cost of the line. The all-time maximum demand on the SOUTHERN system was 25,936,900 kilowatts and occurred in July 1993. This amount excludes demand served by generation retained by OPC, MEAG and Dalton and excludes demand associated with power purchased from SEPA by its preference customers. At that time, 27,342,700 kilowatts were supplied by SOUTHERN system generation and 1,405,800 kilowatts (net) were sold to other parties through net purchased and interchanged power. The reserve margin for the Southern electric system at that time was 13.2%. For information on the other registrants' peak demands reference is made to Item 6 - SELECTED FINANCIAL DATA herein. ALABAMA and GEORGIA will incur significant costs in decommissioning their nuclear units at the end of their useful lives. (See Item 1 - BUSINESS - I-19 "Regulation - Atomic Energy Act of 1954" and Note 1 to SOUTHERN's, ALABAMA's and GEORGIA's financial statements in Item 8 herein.) OTHER ELECTRIC GENERATION FACILITIES Through special purpose subsidiaries, SOUTHERN owns a 50% interest in Freeport, a 35% interest in Edelnor, a 55.3% interest Alicura and a 33.3% interest in a co-generation facility in Hawaii. For further discussion of other SEI projects, see Item 1 - BUSINESS - "New Business Development" herein. The generating capacity of these utilities (or facilities) at December 31, 1993, was as follows: * Represents a concession contract that provides SEI with the rights to use the generation. I-20 JOINTLY-OWNED FACILITIES ALABAMA has sold an undivided interest in two units of Plant Miller to AEC. GEORGIA has sold undivided interests in certain generating plants and other related facilities to OPC, MEAG, Dalton, FP&L and JEA. The percentages of ownership resulting from these sales are as follows: ALABAMA and GEORGIA have contracted to operate and maintain the respective units in which each has an interest (other than Rocky Mountain, as described below) as agent for the joint owners. See "Proposed Sales of Property" below for a description of the proposed sale of GEORGIA's remaining unsold ownership interest in Plant Scherer Unit 4. In connection with the joint ownership arrangements for Plant Vogtle, GEORGIA has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy until 1994 for Unit 1 and 1996 for Unit 2 and, with regard to a portion of a 5% interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest. The payments for capacity are required whether any capacity is available. The energy cost is a function of each unit's variable operating costs. Except for the portion of the capacity payments related to the 1987 and 1990 write-offs of Plant Vogtle costs, the cost of such capacity and energy is included in purchased power in the Statements of Income in Item 8 herein. In December 1988, GEORGIA and OPC completed a joint ownership agreement for the Rocky Mountain project under which GEORGIA will retain its present investment in the project and OPC will finance, complete and operate the facility. Upon completion (scheduled for 1995), GEORGIA will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). For purposes of the ownership formula, GEORGIA's investment will be expressed in nominal dollars and OPC's investment will be expressed in constant 1987 dollars. Based on current cost estimates, GEORGIA's final ownership is estimated at approximately 25% of the project at completion. GEORGIA has held preliminary discussions regarding the potential disposition of its remaining interest in the project. PROPOSED SALES OF PROPERTY In 1991 and 1993, GEORGIA completed the first two in a series of four separate transactions to sell Unit 4 of Plant Scherer to FP&L and JEA for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4% of this unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to off-system sales contracts with Gulf States that were suspended in 1988. GEORGIA will continue to operate the unit. I-21 The 1991 and 1993 sales and the remaining transactions are scheduled as follows: Plant Scherer, a jointly owned coal-fired generating plant, has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. TITLES TO PROPERTY The operating affiliates' and SEGCO's interests in the principal plants (other than certain pollution control facilities, one small hydroelectric generating station leased by GEORGIA and the land on which four combustion turbine generators of MISSISSIPPI are located, which is held by easement) and other important units of the respective companies are owned in fee by such companies, subject only to the liens of applicable mortgage indentures (except for SEGCO) and to excepted encumbrances as defined therein. The operating affiliates own the fee interests in certain of their principal plants as tenants in common. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) Properties such as electric transmission and distribution lines and steam heating mains are constructed principally on rights-of-way which are maintained under franchise or are held by easement only. A substantial portion of lands submerged by reservoirs is held under flood right easements. In substantially all of its coal reserve lands, SEGCO owns or will own the coal only, with adequate rights for the mining and removal thereof. PROPERTY ADDITIONS AND RETIREMENTS During the period from January 1, 1989, to December 31, 1993, the operating affiliates, SEGCO, and other (i.e. SCS, Southern Nuclear and, beginning in 1993, various of the special purpose subsidiaries) gross property additions and retirements were as follows: (1) Includes approximately $62 million attributable to property sold to AEC in 1992. (2) Includes approximately $480 million attributable to property sold to OPC, FP&L and JEA, but excludes $231 million from the write-off of certain Plant Vogtle costs in 1990. (3) Net of intercompany eliminations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS (1) STEPAK V. CERTAIN SOUTHERN OFFICIALS (U.S. District Court for the Southern District of Georgia) In April 1991, two SOUTHERN stockholders filed a derivative action suit against certain current and former directors and officers of SOUTHERN. The suit alleges violations of RICO by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages, including treble damages pursuant to RICO, in an unspecified amount, which if awarded, would be payable to SOUTHERN. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that the I-22 SOUTHERN board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs appealed the dismissal to the U.S. Court of Appeals for the Eleventh Circuit. (2) JOHNSON V. ALABAMA (Circuit Court of Shelby County, Alabama) In September 1990, two customers of ALABAMA filed a civil complaint in the Circuit Court of Shelby County, Alabama, against ALABAMA seeking to represent all persons who, prior to June 23, 1989, entered into agreements with ALABAMA for the financing of heat pumps and other merchandise purchased from vendors other than ALABAMA. The plaintiffs contended that ALABAMA was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring ALABAMA to refund all payments, principal and interest, made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered ALABAMA to refund or forfeit interest of approximately $10 million because of ALABAMA's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. ALABAMA has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot be determined; however, in management's opinion, the final outcome will not have a material adverse effect on SOUTHERN's or ALABAMA's financial statements. (3) OHIO RIVER COMPANY, ET AL.VS. GULF, ET AL. (U.S. District Court for Southern District of Ohio, Western Division) In 1993, a complaint against GULF and SCS was filed in federal district court in Ohio by two companies with which GULF had contracted for the transportation by barge for certain GULF coal supplies. The complaint alleges breach of the contract by GULF and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on SOUTHERN's or GULF's financial statements. See Item 1 - BUSINESS - "Construction Programs," "Fuel Supply," "Regulation - - Federal Power Act" and "Rate Matters", for a description of certain other administrative and legal proceedings discussed therein. Additionally, each of the operating affiliates and SEI are, in the normal course of business, engaged in litigation or administrative proceedings that include, but are not limited to, acquisition of property, injuries and damages claims, and complaints by present and former employees. In management's opinion these various actions will not have a material adverse effect on any of the registrants' financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-23 EXECUTIVE OFFICERS OF SOUTHERN (Inserted in Part I in accordance with Regulation S-K, Item 401(b), Instruction 3) EDWARD L. ADDISON Chairman and CEO Age 63 Elected in 1983; responsible primarily for the formation of overall corporate policy. He was elected Chairman of SOUTHERN effective January 1994. A. W. DAHLBERG President and Director Age 53 Elected in 1985; President and Chief Executive Officer of GEORGIA from 1988 through 1993. He was elected Executive Vice President of SOUTHERN in 1991. He was elected President of SOUTHERN effective January 1994. PAUL J. DENICOLA Executive Vice President and Director Age 45 Elected in 1989; Executive Vice President of SOUTHERN since 1991. Elected President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 to 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. H. ALLEN FRANKLIN Executive Vice President and Director Age 49 Elected in 1988; President and Chief Executive Officer of SCS from 1988 through 1993 and, beginning 1991, Executive Vice President of SOUTHERN. He was elected President and CEO of GEORGIA effective January 1994. ELMER B. HARRIS Executive Vice President and Director Age 54 Elected in 1989; President and Chief Executive Officer of ALABAMA since 1989 and, beginning 1991, Executive Vice President of SOUTHERN. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. W. L. WESTBROOK Financial Vice President Age 54 Elected in 1986; responsible primarily for all aspects of financing for SOUTHERN. He has served as Executive Vice President of SCS since 1986. BILL M. GUTHRIE Vice President Age 60 Elected in 1991; serves as Chief Production Officer for the SOUTHERN system. Senior Executive Vice President of SCS effective January 1994. He has also served as Executive Vice President of ALABAMA since 1988. Each of the above is currently an officer of SOUTHERN, serving a term running from the last annual meeting of the directors (May 26, 1993) for one year until the next annual meeting or until his successor is elected and qualified. I-24 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The common stock of SOUTHERN is listed and traded on the New York Stock Exchange. The stock is also traded on regional exchanges across the United States. High and low stock prices, per the New York Stock Exchange Composite Tape and as adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994, during each quarter for the past two years were as follows: There is no market for the other registrants' common stock, all of which is owned by SOUTHERN. On February 28, 1994, the closing price of SOUTHERN's common stock was $20-5/8. (b) Number of SOUTHERN's common stockholders at December 31, 1993: 237,105 Each of the other registrants have one common stockholder, SOUTHERN. (c) Common dividends are payable at the discretion of each registrant's board of directors. The common dividends paid by SOUTHERN and the operating affiliates to their stockholder(s) for the past two years were as follows: (in thousands) In January 1994, SOUTHERN's board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. II-1 The dividend paid per share by SOUTHERN was 27.5c. for each quarter of 1992 and 28.5c. for each quarter of 1993. SOUTHERN's common dividend for the first quarter of 1994 was raised to 29.5c. per share. The amount of common dividends that may be paid by the subsidiary registrants is restricted in accordance with their respective first mortgage bond indenture and charter. The amounts of earnings retained in the business and the amounts restricted against the payment of cash dividends on common stock at December 31, 1993, were as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SOUTHERN. Reference is made to information under the heading "Selected Consolidated Financial and Operating Data," contained herein at pages II-38 through II-49. ALABAMA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-78 through II-91. GEORGIA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-123 through II-137. GULF. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II- 166 through II-179. MISSISSIPPI. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-207 through II-220. SAVANNAH. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-245 through II-258. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION SOUTHERN. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-8 through II-15. ALABAMA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-53 through II-58. GEORGIA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-95 through II-101. GULF. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-141 through II-147. MISSISSIPPI. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-183 through II-189. SAVANNAH. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-224 through II-230. II-2 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO 1993 FINANCIAL STATEMENTS II-3 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-4 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES FINANCIAL SECTION II-5 MANAGEMENT'S REPORT The Southern Company and Subsidiary Companies 1993 Annual Report The management of The Southern Company has prepared -- and is responsible for - -- the consolidated financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of three directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of The Southern Company and its subsidiaries in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ E. L. Addison /s/ W. L. Westbrook - ------------------------------------ ---------------------------- Edward L. Addison W. L. Westbrook Chairman and Chief Executive Officer Financial Vice President II-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS AND TO THE STOCKHOLDERS OF THE SOUTHERN COMPANY: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of The Southern Company (a Delaware corporation) and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, paid-in capital, 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 (pages II-16 through II-37) referred to above present fairly, in all material respects, the financial position of The Southern Company and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The Southern Company and Subsidiary Companies 1993 Annual Report RESULTS OF OPERATIONS EARNINGS AND DIVIDENDS The Southern Company's 1993 financial performance exceeded the strong results recorded for 1992, and set several new records. The company's financial strength continued to gain momentum for the third consecutive year. In January 1994, The Southern Company board of directors increased the quarterly dividend rate by 3.5 percent, and approved a two-for-one common stock split in the form of a stock distribution. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. For 1993, The Southern Company's net income of $1.0 billion established a new record high and the company's common stock reached an all-time high closing price during the year of 23 3/8 -- surpassing the record of 19 1/2 set in 1992. Also, return on average common equity reached the highest level since 1986. Earnings reported for 1993 totaled $1,002 million or $1.57 per share, an increase of $49 million or 6 cents per share from the previous year. Both 1993 and 1992 earnings were affected by special non-operating or non-recurring items. After excluding these special items in both years, earnings from operations of the ongoing business of selling electricity were $1,016 million or $1.59 per share, an increase of $77 million or 10 cents per share compared with 1992. The special items that affected 1993 and 1992 earnings were as follows: In 1993, several items -- both positive and negative -- had an impact on earnings, which resulted in a net reduction of $14 million. These items were: (1) The conclusion of a settlement agreement -- discussed later -- with Gulf States Utilities (Gulf States) increased earnings. (2) The second in a series of four separate transactions to sell Plant Scherer Unit 4 to two Florida utilities increased earnings. (3) Environmental clean-up costs incurred at sites located in Alabama and Georgia decreased earnings. (4) Costs associated with a transportation fleet reduction program decreased earnings. The improvements in 1993 earnings resulted primarily from increased retail energy sales and continued emphasis on effective cost controls. The special items that increased 1992 earnings were primarily related to additional settlement provisions from Gulf States, and to gains on the sale of Gulf States common stock received in 1991. Returns on average common equity were 13.43 percent in 1993, 13.42 percent in 1992, and 12.74 percent in 1991. Dividends paid on common stock during 1993 were $1.14 per share or 28 1/2 cents per quarter. During 1992 and 1991, dividends paid per share were $1.10 and $1.07, respectively. In January 1994, The Southern Company board of directors raised the quarterly dividend to 29 1/2 cents per share or an annual rate of $1.18 per share. REVENUES Operating revenues increased in 1993 and 1992 and decreased in 1991 as a result of the following factors: II-8 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Retail revenues of $7.3 billion in 1993 increased 7.4 percent from last year, compared with an increase of 1.6 percent in 1992. Under fuel cost recovery provisions, fuel revenues generally equal fuel expense -- including the fuel component of purchased energy -- and do not affect net income. Sales for resale revenues within the service area were $447 million in 1993, up 9.2 percent from the prior year. This increase resulted primarily from the prolonged hot summer weather, which increased the demand for electricity. Revenues from sales for resale within the service area were $409 million in 1992, down 1.9 percent from the prior year. The decrease resulted from certain municipalities and cooperatives in the service area retaining more of their own generation at facilities jointly owned with Georgia Power. Revenues from sales to utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Capacity revenues decreased in 1993 and 1992 because the amount of capacity under contract declined by some 500 megawatts and 300 megawatts, respectively. In 1994, the contracted capacity will decline another 400 megawatts. Changes in revenues are influenced heavily by the amount of energy sold each year. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The rate of growth in 1993 retail energy sales was the highest since 1986. Residential energy sales registered the highest annual increase in two decades as a result of hotter-than-normal summer weather and the addition of 46,000 new customers. Commercial sales were also affected by the warm summer. Industrial energy sales in 1993 and 1992 showed moderate growth, reflecting a recovery in the business and economic conditions in The Southern Company's service area. Energy sales to retail customers are projected to grow at an average annual rate of 1.7 percent during the period 1994 through 2004. Energy sales for resale outside the service area are predominantly unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale outside the service area. Sales to customers outside the service area have decreased for the third consecutive year primarily as a result of the scheduled decline in megawatts of capacity under contract. In addition, the decline in 1992 and 1991 sales was also influenced by fluctuations in prices for oil and natural gas, the primary fuel sources for utilities with which the company has long-term contracts. When oil and gas prices fall below a certain level, these customers can generate electricity to meet their requirements more economically. However, the fluctuation in these energy sales, excluding the impact of contractual declines, had minimal effect on earnings because The Southern Company is paid for dedicating specific amounts of its generating capacity to these utilities. EXPENSES Total operating expenses of $6.7 billion for 1993 were up 6.5 percent compared with the prior year. The increase was attributable to higher production expenses of $75 million to meet increased energy demands and an additional $50 million in depreciation expenses and property taxes resulting from additional utility plant being placed into service. The transportation fleet reduction program and environmental clean-up costs discussed earlier increased expenses by some $62 million. Also, a $67 million change in deferred Plant Vogtle expenses compared with the amount in 1992 contributed to the rise in total operating expenses. In 1992, total operating expenses of $6.3 billion were at the same level reported for 1991. The costs to produce and deliver electricity in 1992 declined by $165 million primarily as a result of less energy being sold and continued effective cost controls. However, expenses in 1991 were reduced by proceeds from a settlement II-9 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report agreement with Gulf States that more than offset the decline in 1992 expenses when compared with 1991. Deferred expenses related to Plant Vogtle in 1992 increased by $47 million when compared with the prior year. Fuel costs constitute the single largest expense for The Southern Company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. The amount and sources of generation and the average cost of fuel per net kilowatt-hour generated were as follows: Fuel and purchased power expenses of $2.6 billion in 1993 increased 1.3 percent compared with the prior year because of increased energy demands and slightly higher average cost of fuel per net kilowatt-hour generated. Fuel and purchased power costs in 1992 decreased $137 million or 5.0 percent compared with 1991 primarily because 1.1 billion fewer kilowatt-hours were needed to meet customer requirements. Also, the decrease in these costs was attributable to a lower average cost of fuel per net kilowatt-hour generated. Income taxes for 1993 increased $69 million compared with the prior year. The increase is attributable to a number of factors, including a 1 percent increase in the corporate federal income tax rate effective January 1993, the second sale of additional ownership interest in Plant Scherer Unit 4, and the increase in taxable income from operations. For 1992, income taxes rose $11 million or 1.7 percent above the amount reported for 1991. For the fifth consecutive year, total gross interest charges and preferred stock dividends declined from amounts reported in the previous year. The declines are attributable to lower interest rates and significant refinancing activities during the past two years. In 1993, these costs were $831 million - -- down $21 million or 2.3 percent. These costs for 1992 decreased $71 million. As a result of favorable market conditions during 1993, some $3.0 billion of senior securities was issued for the primary purpose of retiring higher-cost debt and preferred stock. EFFECTS OF INFLATION The Southern Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on The Southern Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, Georgia Power could realize an after-tax gain currently estimated to total approximately $20 million. See Note 7 to the financial statements for additional information. In early 1994, Georgia Power and the system service company announced work force reduction programs that are estimated to reduce 1994 earnings by some $55 million. These actions will assist in efforts to control the growth in operating expenses. II-10 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report See Note 4 to the financial statements for information on an uncertainty regarding full recovery of an investment in the Rocky Mountain pumped storage hydroelectric project. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The Southern Company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If The Southern Company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. An important part of the Energy Act was to amend the Public Utility Holding Company Act of 1935 (PUHCA) and allow holding companies to form exempt wholesale generators and foreign utility companies to sell power largely free of regulation under PUHCA. These new entities are able to sell power to affiliates -- under certain restrictions -- and to own and operate power generating facilities in other domestic and international markets. To take advantage of these opportunities, Southern Electric International (Southern Electric) -- founded in 1981 -- is focusing on international and domestic cogeneration, the independent power market, and the privatization of generating facilities in the international market. During 1993, investments of some $315 million were made in entities that own and operate generating facilities in various international markets. In the near term, Southern Electric is expected to have minimal effect on earnings, but the possibility exists that it could be a prime contributor to future earnings growth. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been implemented by some of the system operating companies and are a significant part of integrated resource planning. See Note 3 to the financial statements under "Georgia Power's Demand-Side Conservation Programs" for information concerning the recovery of certain costs. Customers can receive cash incentives for participating in these programs as well as reduce their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the utility. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects in conjunction with precertification approval processes of such projects by the respective state public service commissions in Alabama, Georgia, and Mississippi will diminish the possible exposure to prudency disallowances and the resulting impact on earnings. In addition, Georgia Power has conducted a competitive bidding process for additional peaking capacity needed in 1996 and 1997. To meet expected requirements for 1996, Georgia Power has filed a plan with the state public service commission for certification of a four-year purchase power contract and for an ownership interest in a combustion turbine peaking unit. Rates to retail customers served by the system operating companies are regulated by the respective state public service commissions in Alabama, Florida, Georgia, and Mississippi. Rates for Alabama Power and Mississippi Power are adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that The Southern Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in some of these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." II-11 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, The Southern Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Southern Company adopted the new rules January 1, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The Southern Company's financial condition is now the strongest since the mid-1980s. Record levels of performance were set in 1993 related to earnings, market price of common stock, and energy sold to retail customers. In January 1994, The Southern Company board of directors increased the common stock dividend for the third consecutive year, and approved a two-for-one common stock split in the form of a stock distribution. Another major change in The Southern Company's financial condition was gross property additions of $1.4 billion to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Consolidated Statements of Cash Flows provide additional details. On January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 9 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company achieved a ratio of common equity to total capitalization -- including short-term debt -- of 43.5 percent in 1993, compared with 42.8 percent in 1992 and 41.5 percent in 1991. The company's goal is to maintain the common equity ratio generally within a range of 40 percent to 45 percent. During 1993, the operating companies sold $2.2 billion of first mortgage bonds and, through public authorities, $385 million of pollution control revenue bonds, at a combined weighted interest rate of 6.5 percent. Preferred stock of $426 million was issued at a weighted dividend rate of 5.7 percent. The operating companies continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $2.5 billion during 1993, $2.8 billion during 1992, and $1.0 billion during 1991. Retirements of preferred stock totaled $516 million during 1993, $326 million during 1992, and $125 million during 1991. As a result, the composite interest rate on long-term debt decreased from 9.2 percent at December 31, 1990, to 7.6 percent at December 31, 1993. During this same period, the composite dividend rate on preferred stock declined from 8.5 percent to 6.4 percent. In 1993, The Southern Company raised $205 million from the issuance of new common stock under the Dividend Reinvestment and Stock Purchase Plan (DRIP) and the Employee Savings Plan. At the close of 1993, the company's common stock had a market value of $22.00 per share, compared with a book value of $11.96 per share. The market-to-book value ratio was 184 percent at the end of 1993, compared with 168 percent at year-end 1992 and 156 percent at year-end 1991. CAPITAL REQUIREMENTS FOR CONSTRUCTION The construction program of the operating companies is budgeted at $1.5 billion for 1994, $1.3 billion for 1995, and $1.5 billion for 1996. The total is $4.3 billion for the three years. Actual construction costs may vary from this estimate because of factors such as changes in environmental regulations; changes in existing nuclear plants to meet new regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The operating companies do not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload facilities until well into the future. However, within the II-12 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts of capacity is planned to be completed by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $789 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of long-term debt. Also, the operating subsidiaries plan to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV II-13 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report requirements, on some Georgia Power plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Southern Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL In early 1994, The Southern Company sold -- through a public offering -- common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. Any portion of the common stock required during 1994 for the DRIP and the employee stock plans that is not provided from the issuance of new stock will be acquired on the open market in accordance with the terms of such plans. The operating subsidiaries plan to obtain the funds required for construction and other purposes from sources similar to those used in the past. However, the type and timing of any financings -- if needed -- will depend on market conditions and regulatory approval. II-14 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Completing the sale of Unit 4 of Plant Scherer will provide some $260 million of cash during the years 1994 and 1995. As required by the Nuclear Regulatory Commission, Alabama Power and Georgia Power established external sinking funds for nuclear decommissioning costs. For 1994 through 2000, the combined amount to be funded for both Alabama Power and Georgia Power totals $36 million annually. The cumulative effect of funding over this period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." To meet short-term cash needs and contingencies, the system companies had approximately $178 million of cash and cash equivalents and $1.1 billion of unused credit arrangements with banks at the beginning of 1994. To issue additional first mortgage bonds and preferred stock, the operating companies must comply with certain earnings coverage requirements designated in their mortgage indentures and corporate charters. The ability to issue securities in the future will depend on coverages at that time. The coverage ratios were, at the end of the respective years, as follows: *Savannah Electric's requirement is 2.50. II-15 CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report CONSOLIDATED STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-16 CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-17 CONSOLIDATED STATEMENTS OF BALANCE SHEETS At December 31, 1993, and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-18 CONSOLIDATED BALANCE SHEETS (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-19 CONSOLIDATED STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report II-20 CONSOLIDATED STATEMENTS OF CAPITALIZATION (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-21 NOTES TO FINANCIAL STATEMENTS The Southern Company and Subsidiary Companies 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Southern Company is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both the company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The operating companies also are subject to regulation by the FERC and their respective state regulatory commissions. The companies follow generally accepted accounting principles and comply with the accounting policies and practices prescribed by their respective commissions. All material intercompany items have been eliminated in consolidation. Consolidated retained earnings at December 31, 1993, include $2.6 billion of undistributed retained earnings of subsidiaries. Certain prior years' data presented in the consolidated financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The operating companies accrue revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The operating companies' electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $137 million in 1993, $132 million in 1992, and $162 million in 1991. Alabama Power and Georgia Power have contracts with the U.S. Department of Energy (DOE) that provide for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2003 at Plant Hatch, into 2009 at Plant Vogtle, and into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. Georgia Power -- based on its ownership interests -- and Alabama Power currently estimate their liability under this law to be approximately $39 million and $46 million, respectively. These obligations are recorded in the Consolidated Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected costs of decommissioning nuclear facilities. II-22 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. Alabama Power and Georgia Power have established external sinking funds to comply with the NRC's regulations. Prior to the enactment of these regulations, Alabama Power and Georgia Power had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. Alabama Power and Georgia Power have filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amounts prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Alabama Power's Plant Farley and Georgia Power's plants Hatch and Vogtle -- based on its ownership interests -- were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a set period of time as approved by the respective state public service commissions. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the Georgia Public Service Commission (GPSC) ordered that the allowed costs of Plant Vogtle, a two-unit nuclear facility of which Georgia Power owns 45.7 percent, be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. Under these plans, Georgia Power deferred financing costs and depreciation expense until the allowed investment was fully reflected in rates as of October 1991. In 1991, the GPSC modified the Plant Vogtle phase-in plan to begin earlier amortization of the costs deferred under the plan. Also, the GPSC levelized capacity buyback expense from co-owners of Plant Vogtle. See Note 3 for additional information regarding Georgia Power's 1991 rate order. Previously, pursuant to two separate interim accounting orders by the GPSC, Georgia Power deferred substantially all operating expenses and financing costs related to Plant Vogtle. Units 1 and 2 began commercial operation in May 1987 and May 1989, respectively. The accounting orders were for the periods from the date of each unit's commercial operation until October 1987 and 1989, respectively. Under phase-in plans and accounting orders from the GPSC, Georgia Power deferred and began amortizing the costs -- recovered through rates -- related to Plant Vogtle as follows: The unrecovered balance above includes approximately $160 million related to the adoption in 1993 of FASB Statement No. 109, Accounting for Income Taxes. See Note 9 for information about Statement No. 109. II-23 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Each GPSC order calls for recovery of deferred costs within 10 years. Also, the orders authorized Georgia Power to impute a return similar to allowance for funds used during construction (AFUDC) on its investment in Plant Vogtle units 1 and 2 after the units began commercial operation. These deferred returns are included in the above amounts, except for the equity component in the case of the Unit 2 accounting order. INCOME TAXES The companies provide deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 for additional information about Statement No. 109. AFUDC AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the companies to calculate AFUDC during the years 1991 through 1993 ranged from a before-income-tax rate of 4.9 percent to 11.4 percent. Deferred income taxes related to capitalized debt cost were $5 million, $4 million, and $7 million in 1993, 1992, and 1991, respectively. After Plant Vogtle units 1 and 2 began commercial operation in 1987 and 1989, respectively, Georgia Power imputed a deferred return similar to AFUDC on its investment in the units under the short-term cost deferrals and phase-in plans, as discussed earlier. AFUDC and the deferred return, net of income tax, as a percent of consolidated net income were 1.7 percent in 1993, 1.8 percent in 1992, and 6.0 percent in 1991. The deferred return was discontinued in October 1991 after the allowed investment in Plant Vogtle was fully reflected in rates. UTILITY PLANT Utility plant is stated at original cost less regulatory disallowances. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Consolidated Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of The Southern Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred II-24 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In 1992, Georgia Power converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that will be amortized as a credit to income over approximately four years. This conversion will not have a material effect on net income. VACATION PAY The operating companies' employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the companies accrue a current liability for earned vacation pay and record a current asset representing the future recoverability of this cost. The amount was $73 million and $70 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 71 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The system companies have defined benefit, trusteed, non-contributory pension plans that cover substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. Primarily, the companies use the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The system companies also provide certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the system companies adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered Georgia Power to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional costs would be expensed in 1993 and the remaining costs would be deferred. An additional one-fifth of the costs would be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The costs deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of regulatory treatment allowed by the operating companies' respective public service commissions, the adoption of Statement No. 106 did not have a material impact on consolidated net income. Prior to 1993, the system companies, except for Georgia Power and Savannah Electric, recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. Consistent with regulatory treatment in these years, Georgia Power and Savannah Electric recognized these costs on a cash basis as payments were made. The total costs of such benefits recognized by system companies in 1992 and 1991 were $42 million and $36 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement II-25 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1 percent would increase the accumulated medical benefit obligation at December 31, 1993, by $129 million and the aggregate of the service and interest cost components of the net retiree medical cost by $14 million. Components of the plans' net cost are shown below: Of the above net pension amounts, pension income of $9 million in 1993 and pension expense of $2 million in 1992 and $11 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $64 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. II-26 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report WORK FORCE REDUCTION PROGRAMS The system companies have incurred additional costs for work force reduction programs. The costs related to these programs were $35 million, $37 million, and $72 million for the years 1993, 1992, and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $19 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected, and this matter is concluded. STOCKHOLDER SUIT In April 1991, two Southern Company stockholders filed a derivative action suit in the U.S. District Court for the Southern District of Georgia against certain current and former directors and officers of The Southern Company. The suit alleges violations of the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages -- including treble damages pursuant to RICO -- in an unspecified amount, which if awarded, would be payable to The Southern Company. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that The Southern Company board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs have appealed the dismissal to the U.S. Court of Appeals for the 11th Circuit. ALABAMA POWER HEAT PUMP FINANCING SUIT In September 1990, two customers of Alabama Power filed a civil complaint in the Circuit Court of Shelby County, Alabama, against Alabama Power seeking to represent all persons who, prior to June 23, 1989, entered into agreements with Alabama Power for the financing of heat pumps and other merchandise purchased from vendors other than Alabama Power. The plaintiffs contended that Alabama Power was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring Alabama Power to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered Alabama Power to refund or forfeit interest of approximately $10 million because of Alabama Power's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. Alabama Power has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GULF POWER COAL BARGE TRANSPORTATION SUIT In 1993, a complaint against Gulf Power and the system service company was filed in federal district court in Ohio by two companies with which Gulf Power had contracted for the transportation by barge for certain Gulf Power coal supplies. The complaint alleges breach of the contract by Gulf Power and seeks damages estimated by the plaintiffs to be in excess of $85 million. II-27 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. ALABAMA POWER RATE ADJUSTMENT PROCEDURES In November 1982, the Alabama Public Service Commission (APSC) adopted rates that provide for periodic adjustments based upon Alabama Power's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement -- amounting to some $60 million -- is being amortized to income to offset the rate reduction in accordance with the APSC's rate order. See Note 8 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. GEORGIA POWER'S DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of Georgia Power's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. Georgia Power suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved Georgia Power's request for an accounting order allowing Georgia Power to defer all current unrecovered and future costs related to these programs until the superior court's decision is reversed or until the next general rate case proceedings. An association of industrial customers has filed a petition for review of the accounting order in superior court. Georgia Power's costs related to these conservation programs through 1993 were $60 million, of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GEORGIA POWER 1991 RATE ORDER; PHASE-IN PLAN MODIFICATIONS Georgia Power received a rate order in 1991 from the GPSC that modified the Plant Vogtle phase-in plans to begin earlier amortization of the costs deferred under the plans. The amortization period began October 1991 -- rather than October 1994 as originally scheduled -- and extends through September 1999. In addition, the GPSC ordered the levelization of capacity buyback expense from the co-owners of Plant Vogtle over a six-year period beginning October 1991. This results in net cost deferrals during the first three years and subsequent amortization of the deferred amounts in the last three years. MISSISSIPPI POWER RETAIL RATE ADJUSTMENT PLAN Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986 with various modifications in 1991 and the latest in 1994. In 1993, the Mississippi Public Service Commission (MPSC) ordered Mississippi Power to review and propose changes that would enhance the plan. Mississippi Power filed a revised plan, and the MPSC approved PEP-2 on January 4, 1994. Under PEP-2, Mississippi Power's rate of return will be measured on retail net investment rather than on common equity, as previously calculated. Also, the number of indicators used to evaluate Mississippi Power's performance was reduced to three with emphasis on price and service to the customer. In addition, PEP-2 provides for the sharing of rate adjustments based on low rates and on the performance rating. The evaluation periods for PEP-2 are semiannual. Any change in rates is limited to 2 percent of retail revenues per period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. II-28 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. 4. CONSTRUCTION PROGRAM GENERAL The operating companies are engaged in continuous construction programs, currently estimated to total some $1.5 billion in 1994, $1.3 billion in 1995, and $1.5 billion in 1996. These estimates include AFUDC of $34 million in 1994, $41 million in 1995, and $35 million in 1996. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The operating companies do not have any new baseload generating plants under construction. However, within the service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 was not economically justifiable and reasonable and withheld authorization for Georgia Power to spend funds from approved securities issuances on that project. In 1988, Georgia Power and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 6. However, full recovery of Georgia Power's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event Georgia Power cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off. At December 31, 1993, Georgia Power's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, Georgia Power's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL In early 1994, The Southern Company sold -- through a public offering -- 5.6 million shares of common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. II-29 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report To the extent possible, the operating companies' construction programs are expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The subsidiary companies may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FOREIGN UTILITY OPERATIONS During 1993, The Southern Company made investments of approximately $315 million in utilities that own and operate generating facilities in various foreign markets. The consolidated financial statements reflect these investments in majority-owned subsidiaries on a consolidated basis and other investments on an equity basis. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with banks totaled $1.1 billion, of which approximately $500 million expires at various times during 1994 and 1995; $130 million expires at May 1, 1996; $400 million expires at June 30, 1996; and $70 million expires at December 1, 1996. Georgia Power's revolving credit agreements of $150 million, of which $130 million remained unused as of December 31, 1993, expire May 1, 1996. During the term of these agreements, Georgia Power may convert short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Georgia Power's option. In connection with these credit arrangements, Georgia Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing The Southern Company, Alabama Power, and Georgia Power up to the total credit amount of $400 million. To provide liquidity support to commercial paper programs, $135 million and $165 million of the $400 million available credit are currently dedicated to the exclusive use of Alabama Power and Georgia Power, respectively. During the term of these agreements, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Mississippi Power has $70 million of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Mississippi Power's option. In connection with these credit arrangements, Mississippi Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. Savannah Electric has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Savannah Electric's option. In connection with these credit arrangements, Savannah Electric agrees to pay commitment fees based on the unused portions of the commitments. In connection with all other lines of credit, the companies have the option of paying fees or maintaining compensating balances, which are substantially all the cash of the companies except for daily working funds and similar items. These balances are not legally restricted from withdrawal. In addition, the companies from time to time borrow under uncommitted lines of credit with banks, and in the case of Alabama Power and Georgia Power, through commercial paper programs that have the liquidity support of committed bank credit arrangements. ASSETS SUBJECT TO LIEN The operating companies' mortgages, which secure the first mortgage bonds issued by the companies, constitute a direct first lien on substantially all of the companies' respective fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of the system's generating plants, the subsidiary companies have II-30 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels, and other financial commitments. Total estimated long-term obligations were approximately $15 billion at December 31, 1993. Additional commitments for coal and nuclear fuel will be required in the future to supply the operating companies' fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 for the payment of $121 million to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Gulf Power and Mississippi Power. Also, in March 1988, Gulf Power made an advance payment of $60 million to a coal supplier under an agreement to lower the cost of future coal purchased under an existing contract. These amounts are being amortized to expense. The remaining unamortized amount included in deferred charges at December 31, 1993, was $70 million. OPERATING LEASES The operating companies have entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $11 million, $9 million, and $7 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated minimum rental commitments for noncancelable operating leases were as follows: 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS In 1992, Alabama Power sold an undivided interest in units 1 and 2 of Plant Miller and related facilities to Alabama Electric Cooperative, Inc. Since 1975, Georgia Power has sold undivided interests in plants Vogtle, Hatch, Scherer, and Wansley in varying amounts, together with transmission facilities, to OPC, the Municipal Electric Authority of Georgia (MEAG), and the city of Dalton, Georgia. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. See Note 7 for additional information concerning these sales. In addition, Georgia Power has entered into a joint ownership agreement with OPC with respect to the Rocky Mountain project, as discussed later. At December 31, 1993, Alabama Power's and Georgia Power's ownership and investment (exclusive of nuclear fuel) in jointly owned facilities with the above entities were as follows: *Estimated ownership at date of completion. Georgia Power and OPC have entered into a joint ownership agreement regarding the 848-megawatt Rocky Mountain pumped storage hydroelectric project. Under the agreement, Georgia Power will retain its present investment in the project and OPC will finance, complete, and operate the facility. Upon completion, Georgia Power will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). Based on current cost estimates, Georgia Power's final ownership is estimated at approximately 25 percent of the project at completion. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. II-31 NOTES (continued) THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES 1993 ANNUAL REPORT Alabama Power and Georgia Power have contracted to operate and maintain the jointly owned facilities -- except for the Rocky Mountain project -- as agents for their respective co-owners. The companies' proportionate share of their plant operating expenses is included in the corresponding operating expenses in the Consolidated Statements of Income. In connection with a joint ownership arrangement at Plant Vogtle, Georgia Power has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from this plant for periods of up to 10 years following commercial operation (and, with regard to a portion of the 5 percent additional interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for such capacity are required whether any capacity is available. The energy cost of these purchases is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power in the Consolidated Statements of Income. Capacity payments totaled $183 million, $289 million, and $320 million, for 1993, 1992, and 1991, respectively. Projected capacity payments for the next five years are as follows: $132 million in 1994; $77 million in 1995; $70 million in 1996; $59 million in 1997; and $59 million in 1998. Also, a portion of the above capacity payments relates to Plant Vogtle costs that were written off after being disallowed for retail ratemaking purposes. In 1991, the GPSC ordered that the Plant Vogtle capacity buyback expense be levelized over a six-year period. The amounts deferred and not expensed in the year paid totaled $38 million in 1993, $100 million in 1992, and $30 million in 1991. The projected net amount to be deferred in 1994 is $1 million. The projected net amortization of the deferred expense is $49 million in 1995, $62 million in 1996, and $57 million in 1997. 7. PLANNED SALES OF INTEREST IN PLANT SCHERER Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FP&L) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to long-term power sales contracts with Gulf States that were suspended in 1988. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Plant Scherer -- a jointly owned coal-fired generating plant -- has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. See Note 6 for information regarding current plant ownership. 8. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from specific generating plants is currently being sold to FP&L, FPC, JEA, and the city of Tallahassee, Florida. Under these agreements, an average II-32 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report of 1,700 megawatts of capacity is scheduled to be sold during 1994 and 1995. Thereafter, these sales will decline to some 1,600 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts to be refunded to customers and the amounts previously included in income -- The Southern Company recorded an increase in consolidated net income of $114 million, or 18 cents per share, in November 1991. With respect to Alabama Power's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. 9. INCOME TAXES Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on consolidated net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $1.5 billion are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $1.1 billion are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities, are as follows: II-33 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Consolidated Statements of Income. Credits amortized in this manner amounted to $29 million in 1993, $41 million in 1992, and $48 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. COMMON STOCK STOCK DISTRIBUTION In January 1994, The Southern Company board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. SHARES RESERVED At December 31, 1993, a total of 24 million shares was reserved for issuance pursuant to the Dividend Reinvestment and Stock Purchase Plan, the Employee Savings Plan, and the Executive Stock Option Plan. EXECUTIVE STOCK OPTION PLAN The Southern Company's Executive Stock Option Plan authorizes the granting of non-qualified stock options to key employees of The Southern Company, including officers. Currently, 34 employees are eligible to participate in the plan. As of December 31, 1993, 38 current and former employees participated in the plan. The maximum number of shares of common stock that may be issued under the Executive Stock Option Plan may not exceed 6 million. The price of options granted to date has been at the fair market value of the shares on the date of grant. Options granted to date become exercisable pro rata over a maximum period of four years from date of grant, such that all options generally are exercisable by 1997. Options outstanding will expire upon termination of the plan, which will occur on December 7, 1997, unless terminated earlier by the board of directors. Stock option activity in 1992 and 1993 is summarized below: II-34 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 11. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: With respect to the collateralized pollution control revenue bonds, the operating companies have authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under installment sale or loan agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. Assets acquired under capital leases are recorded as utility plant in service, and the related obligation is classified as other long-term debt. The net book value of capitalized leases was $217 million and $236 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the composite interest rates for nuclear fuel, buildings, and other were 3.6 percent, 9.7 percent, and 12.0 percent, respectively. Sinking fund requirements and/or serial maturities through 1998 applicable to other long-term debt are as follows: $89 million in 1994; $154 million in 1995; $58 million in 1996; $26 million in 1997; and $7 million in 1998. 12. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 166 2/3 percent of such requirements. II-35 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 13. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, Alabama Power and Georgia Power maintain agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the companies' nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for Alabama Power and Georgia Power -- based on its ownership and buyback interests -- is $159 million and $171 million, respectively, per incident but not more than an aggregate of $20 million and $22 million, respectively, to be paid for each incident in any one year. Alabama Power and Georgia Power are members of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. Alabama Power's and Georgia Power's maximum annual assessments are limited to $14 million and $18 million, respectively, under current policies. Additionally, both companies have policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments under current policies for Alabama Power and Georgia Power for excess property damage would be $16 million and $15 million, respectively. The replacement power assessments are $9 million for Alabama Power and $13 million for Georgia Power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. Alabama Power and Georgia Power participate in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, Alabama Power and Georgia Power could be subject to a maximum total assessment of $6 million and $7 million, respectively. II-36 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 14. COMMON STOCK DIVIDEND RESTRICTIONS The income of The Southern Company is derived primarily from equity in earnings of its operating subsidiaries. At December 31, 1993, $1.6 billion of consolidated retained earnings was restricted against the payment by the operating companies of cash dividends on common stock under terms of bond indentures or charters. 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: *Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. The company's business is influenced by seasonal weather conditions and the timing of rate changes. II-37 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) Note: Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. II-38 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) II-39 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-40 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-41 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-42 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-43 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-44 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-45 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-46 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-47 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-48 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-49 ALABAMA POWER COMPANY FINANCIAL SECTION II-50 MANAGEMENT'S REPORT Alabama Power Company 1993 Annual Report The management of Alabama Power Company has prepared -- and is responsible for - -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Alabama Power Company in conformity with generally accepted accounting principles. /s/ Elmer B. Harris /s/ William B. Hutchins, III - -------------------------- ------------------------------ Elmer B. Harris William B. Hutchins III President Senior Vice President and Chief Executive Officer and Chief Financial Officer II-51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF ALABAMA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Alabama Power Company (an Alabama corporation and wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, 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 (pages II-59 through II-77) referred to above present fairly, in all material respects, the financial position of Alabama Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 II-52 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Alabama Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS The company's 1993 net income after dividends on preferred stock was $346 million, representing a 2.3 percent increase over the prior year. This improvement can be attributed to higher retail energy sales and lower financing costs. Retail energy sales increased 5.1 percent from 1992 levels. This was primarily due to the extreme weather during 1993, especially when compared to the unusually mild weather of 1992. Long-term debt interest expense and preferred stock dividends decreased in 1993 reflecting the continued redemption and refinancing of higher cost debt and preferred stock. These positive factors were partially offset by higher operating costs and a scheduled reduction in capacity sales to non-affiliated utilities. When comparing 1992 earnings with the prior year, it should be noted that 1991 earnings included an unusual item -- the settlement of litigation with Gulf States Utilities Company (Gulf States) that resulted in an after-tax gain of $9 million. A comparison of 1992 to 1991, excluding this unusual item, would reflect a 1992 increase in earnings of $8 million. The return on average common equity for 1993 was 13.9 percent compared to 14.0 percent in 1992, and 14.6 percent in 1991. REVENUES The following table summarizes the principal factors that affected operating revenues for the past three years: Retail revenues of $2.4 billion in 1993 increased $180 million (8.0 percent) over the prior year, compared with no increase in 1992. The extreme weather during 1993 and sales growth contributed to the increase in retail revenues over 1992. Fuel revenues increased substantially during 1993. However, changes in fuel revenues are offset with corresponding changes in recoverable fuel expenses and have no effect on net income. Gains in 1992 retail revenues, due to higher rates and sales growth, were partially offset by lower fuel cost recovery revenues. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: II-53 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report Capacity revenues decreased in 1993 due to a scheduled reduction in capacity dedicated to unit power sales customers for the first five months of the year. The major factor contributing to the increase in capacity revenues in 1992 and 1991 was a new generating unit, Plant Miller Unit 4, that was placed in commercial service in March 1991 and dedicated to unit power sales. This unit's fixed costs are higher than those of the unit it replaced, which previously provided energy to unit power sales customers. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: EXPENSES Total operating expenses of $2.4 billion for 1993 were up 7.0 percent compared with the prior year. The increase was mainly attributable to higher production expenses of $95 million to meet increased energy demands. Total operating expenses for 1992 increased moderately over those recorded in 1991. However, absent the Gulf States settlement, which reduced 1991 operating expenses, total operating expenses would have decreased $6 million. Fuel costs are the single largest expense for the company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. Fuel expense increases in 1993 represent $83 million of the production expense increase mentioned above. Fuel expense decreased in 1992 as a result of the reduction in the cost of both coal and nuclear fuel, offset somewhat by a small increase in generation. Fuel cost per kilowatt-hour generated was 1.73 cents in 1993, 1.64 cents in 1992 and 1.69 cents in 1991. Purchased power expenses decreased in 1992 primarily due to less purchased energy and a decrease in the price of such energy. Other operation expenses increased 6.0 percent in 1993 following a minimal increase in 1992. The increase in 1993 is primarily the result of environmental cleanup costs, net expenses of a March snowstorm, and the one-time cost of a transportation fleet reduction program, which together totaled $16.1 million. Depreciation and amortization expense increased 3.4 percent in 1993 and 3.5 percent in 1992. This is principally due to continued growth in depreciable plant in service. Taxes other than income taxes increased 4.0 percent in 1993 and 1.4 percent in 1992. These increases were the result of the addition of new facilities and higher revenue-related taxes. The increase in income tax expense of 2.6 percent for 1993 is primarily attributable to a one percent increase in the corporate federal income tax rate effective January 1, 1993. Interest expense and dividends on preferred stock decreased $7.5 million (2.8 percent) and $7.2 million (2.6 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. II - 54 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report EFFECTS OF INFLATION The company is subject to rate regulation that is based on the recovery of historical costs and, therefore is subject to economic losses caused by inflation. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will also depend upon growth in electric sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. In addition, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as any new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Rates to retail customers served by the company are regulated by the Alabama Public Service Commission (APSC). Rates for the company can be adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The company adopted the new rules January 1, 1994, with no material effect on the financial statements. II-55 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report FINANCIAL CONDITION OVERVIEW The company's financial condition remained stable in 1993. Growth in energy sales combined with a significant lowering of the cost of capital, achieved through the refinancing and/or redemption of higher-cost long-term debt and preferred stock contributed to this stability. The company had gross property additions of $436 million in 1993. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Statements of Cash Flows provide additional details. On January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company's ratio of common equity to total capitalization was 47.4 percent in 1993, compared with 47.6 percent in 1992, and 45.4 percent in 1991. In 1993, the company issued $860 million of first mortgage bonds, $158 million of preferred stock and, through public authorities, $144 million of pollution control revenue bonds. The company continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $835 million, and preferred stock retirements totaled $207 million. Composite financing rates as of year-end for 1991 through 1993 were as follows: The company's current securities ratings are as follows: CAPITAL REQUIREMENTS Capital expenditures are estimated to be $588 million for 1994, $572 million for 1995, and $531 million for 1996. The total is $1.7 billion for the three years. Actual capital costs may vary from this estimate because of factors such as changes in environmental regulations; changes in the existing nuclear plant to meet new regulations; revised load projections; increasing costs of labor, equipment, and materials; and the cost of capital. The company does not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload generating units until well into the future. However, the construction of combustion turbine peaking units of approximately 720 megawatts of capacity is planned by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will continue. In addition to the funds needed for the capital budget, approximately $80 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of first mortgage bonds. Also, the company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 II-56 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the company's portion is approximately $30 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company, of which the company's portion is approximately $225 million to $350 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in annual revenue requirements from customers could be necessary to fully recover the company's cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard II-57 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Southern electric system. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL It is anticipated that the funds required will be derived from sources in form and quantity similar to those used in the past. To issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements designated in its mortgage indenture and corporate charter. The company's coverages are at a level that would permit any necessary amount of security sales at current interest and dividend rates. As required by the Nuclear Regulatory Commission and as ordered by the APSC, the company has established external trust funds for nuclear decommissioning costs. Also, during 1993, the APSC issued a policy statement which will require external funding of postretirement benefits. The cumulative effect of funding these items over a long period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." II-58 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-59 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-60 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-61 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-62 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-63 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-64 NOTES TO FINANCIAL STATEMENTS Alabama Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The company is a wholly owned subsidiary of The Southern Company which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly-owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services upon request to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The company is also regulated by the FERC and the Alabama Public Service Commission (APSC). The company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The company's electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $62 million in 1993, $48 million in 1992, and $69 million in 1991. The company has a contract with the U.S. Department of Energy (DOE) that provides for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The company currently estimates its liability under this law to be approximately $46 million. This obligation is recognized in the accompanying Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected cost of decommissioning nuclear facilities. II-65 NOTES (continued) Alabama Power Company 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external trust fund, a surety method, or prepayment. The company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the company had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The company has filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amount prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Plant Farley were as follows: The amount in the internal reserve is being transferred into the external trust funds over the remaining life of the license for Plant Farley as approved by the APSC. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. INCOME TAXES The company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the company adopted Financial Accounting Standards Board (FASB) Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rate used to determine the amount of allowance, net of deferred income tax, was 6.2 percent in 1991. Such method of computing AFUDC ceased upon the commercial operation of Plant Miller Unit 4 in March 1991. For construction projects begun after 1986, deferral of taxes related to capitalized interest is no longer permitted. For those projects, the composite rate used to determine the amount of allowance was 7.8 percent in 1993, 7.9 percent in 1992, and 8.3 percent in 1991. AFUDC, net of income tax, as a percent of net income after dividends on preferred stock was 1.5 percent in 1993, 1.1 percent in 1992, and 2.0 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs and replacements of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive II-66 NOTES (continued) Alabama Power Company 1993 Annual Report of minor items of property) is charged to utility plant. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the company accrues a current liability for earned vacation pay and records a current asset representing future recoverability of this cost. The amount was $23 million and $22 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 65 percent of the 1993 deferred vacation cost will be expensed and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. However, in December 1993, the APSC issued an accounting policy statement which requires the company to externally fund all postretirement benefits. It is expected that an external funding program will begin in 1994. Effective January 1, 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-67 NOTES (continued) Alabama Power Company 1993 Annual Report Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, the company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the company in 1992 and 1991 were $15.2 million and $15.4 million, respectively. Status and Cost of Benefits Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $32.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $3.4 million. II-68 NOTES(continued) Alabama Power Company 1993 Annual Report Components of the plans' net cost are shown below: Of the above net pension amounts, $(8.9) million in 1993, $(5.1) million in 1992, and $0.7 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $22 million was charged to operating expenses and the remainder was charged to construction and other accounts. WORK FORCE REDUCTION PROGRAM The company has incurred additional costs for work force reduction programs. The costs related to these programs were $16.1 million, $13.4 million and $6.7 million for the years 1993, 1992 and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $15.3 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATE ADJUSTMENT PROCEDURES In November 1982, the APSC adopted rates that provide for periodic adjustments based upon the company's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement amounting to approximately $60 million is being amortized to revenues to offset the rate reduction in accordance with the APSC's rate order. See Note 7 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. In February 1993, the APSC ordered - at the company's request - a moratorium on rate increases for the first two quarters of 1993, which facilitated the transition of an accounting change. This accounting change permitted the accrual of estimated operation and maintenance expenses related to nuclear refueling outages during the period between outages rather than at the time the expenses are incurred. HEAT PUMP FINANCING SUIT In September 1990, two customers of the company filed a civil complaint in the Circuit Court of Shelby County, Alabama, against the company seeking to represent all II-69 NOTES(continued) Alabama Power Company 1993 Annual Report persons who, prior to June 23, 1989, entered into agreements with the company for the financing of heat pumps and other merchandise purchased from vendors other than the company. The plaintiffs contended that the company was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring the company to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June, 1993, the court ordered the company to refund or forfeit interest of approximately $10 million because of the company's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. The company has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. 4. CAPITAL BUDGET The company's capital expenditures are currently estimated to total $588 million in 1994, $572 million in 1995 and $531 million in 1996. The estimates include AFUDC of $10 million in 1994, $11 million in 1995 and $12 million in 1996. The estimates for property additions for the three-year period includes $36.5 million committed to meeting the requirements of the Clean Air Act. The capital budget is subject to periodic review and revision, and actual capital cost incurred may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth projections; changes in environmental regulations; changes in the existing nuclear plant to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The company does not have any new baseload generating plants under construction. However, the construction of combustion turbine peaking units of approximately 720 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL To the extent possible, the company's construction program is expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FINANCING The ability of the company to finance its capital budget depends on the amount of funds generated internally and the funds it can raise by external financing. The II-70 NOTES(continued) Alabama Power Company 1993 Annual Report company's primary sources of external financing are sales of first mortgage bonds and preferred stock to the public, receipt of additional paid-in capital from The Southern Company, and leasing of nuclear material. In order to issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements contained in its mortgage indenture and corporate charter. The most restrictive of these provisions requires, for the issuance of additional first mortgage bonds, that before-income-tax earnings, as defined, cover pro forma annual interest charges on outstanding first mortgage bonds at least twice; and for the issuance of additional preferred stock, that gross income available for interest cover pro forma annual interest charges and preferred stock dividends at least one and one-half times. These coverages, for first mortgage bonds and for preferred stock for the year ended December 31, 1993, were 5.70 and 2.71, respectively. BANK CREDIT ARRANGEMENTS The company, along with The Southern Company and Georgia Power Company, has entered into agreements with several banks outside the service area to provide $400 million of revolving credit to the companies through June 30, 1996. To provide liquidity support for commercial paper programs, the company and Georgia Power Company have exclusive right to $135 million and $165 million, respectively, of the available credit. The companies have the option of converting the short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements provide for payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Additionally, the company maintains committed lines of credit in the amount of $350 million which expire at various times during 1994 and, in certain cases, provide for average annual compensating balances. Because the arrangements are based on an average balance, the company does not consider any of its cash balances to be restricted as of any specific date. Moreover, the company borrows from time to time pursuant to arrangements with banks for uncommitted lines of credit. In connection with all other lines of credit, the company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. At December 31, 1993, the company had regulatory approval to have outstanding up to $450 million of short-term borrowings. ASSETS SUBJECT TO LIEN The company's mortgage, as amended and supplemented, securing the first mortgage bonds issued by the company, constitutes a direct lien on substantially all of the company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations through the year 2013 were approximately $8 billion at December 31, 1993. In addition, a contract with a certain coal contractor requires reimbursement or purchase, at net book value, of the investment in the mine or equipment upon termination of the contract. At December 31, 1993, such net book value was approximately $13 million. Additional commitments for coal and for nuclear fuel will be required in the future to supply the company's fuel needs. 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS The company and Georgia Power Company own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,019,680 kilowatts, together with associated transmission facilities. The capacity of these units is sold equally to the company and Georgia Power Company under a contract expiring in 1994 which, in substance, requires payments sufficient to provide for the operating expenses, taxes, interest expense II-71 NOTES(continued) Alabama Power Company 1993 Annual Report and a return on equity, whether or not SEGCO has any capacity and energy available. The company's share of expenses totaled $86 million in 1993, $73 million in 1992 and $82 million in 1991, and is included in "Purchased power from affiliates" in the Statements of Income. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two years' notice. In addition, the company has guaranteed unconditionally the obligation of SEGCO under an installment sale agreement for the purchase of certain pollution control facilities at SEGCO's generating units, pursuant to which $24.5 million principal amount of pollution control revenue bonds are outstanding. Georgia Power Company has agreed to reimburse the company for the pro rata portion of such obligation corresponding to its then proportionate ownership of stock of SEGCO if the company is called upon to make such payment under its guaranty. At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. SEGCO paid dividends totaling $11.3 million in 1993, $12.0 million in 1992, and $4.5 million in 1991, of which one-half of each was paid to the company. SEGCO's net income was $8.3 million, $9.3 million and $9.2 million for 1993, 1992 and 1991, respectively. In June 1992 the company completed the sale of a portion of Plant Miller Units 1 and 2 to Alabama Electric Cooperative, Inc. (AEC). The company's percentage ownership and investment in jointly-owned generating plants at December 31, 1993, follows: (1) Jointly owned with an affiliate, Mississippi Power Company. (2) Jointly owned with AEC. 7. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company, including the company, have entered into long-term and short-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The company's portion of off-system capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from Plant Miller is being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA) and the City of Tallahassee, Florida (Tallahassee). Under these agreements, an average of 1,100 megawatts of capacity is scheduled to be II-72 NOTES(continued) Alabama Power Company 1993 Annual Report sold during 1994. Thereafter, these sales will increase to some 1,200 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. With respect to the company's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. ALABAMA MUNICIPAL ELECTRIC AUTHORITY (AMEA) CAPACITY CONTRACTS In August 1986, the company entered into a firm power purchase contract with AMEA entitling AMEA to scheduled amounts of capacity (to a maximum 100 megawatts) for a period of 15 years commencing September 1, 1986 (1986 Contract). In October 1991, the company entered into a second firm power purchase contract with AMEA entitling AMEA to scheduled amounts of additional capacity (to a maximum 80 megawatts) for a period of 15 years commencing October 1, 1991 (1991 Contract). In both contracts the power will be sold to AMEA for its member municipalities that previously were served directly by the company as wholesale customers. Under the terms of the contracts, the company received payments from AMEA representing the net present value of the revenues associated with the respective capacity entitlements, discounted at effective annual rates of 9.96 percent and 11.19 percent for the 1986 and 1991 Contracts, respectively. These payments are being recognized as operating revenues and the discounts are being amortized to other interest expense as scheduled capacity is made available over the terms of the contracts. In order to secure AMEA's advance payments and the company's performance obligation under the contracts, the company issued and delivered to an escrow agent first mortgage bonds representing the maximum amount of liquidated damages payable by the company in the event of a default under the contracts. No principal or interest is payable on such bonds unless and until a default by the company occurs. As the liquidated damages decline under the contracts, a portion of the bonds equal to the decreases are returned to the company. At December 31, 1993, $153 million of such bonds were held by the escrow agent under the contracts. 8. INCOME TAXES Effective January 1, 1993, the company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $469 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $441 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-73 NOTES (continued) Alabama Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $13 million in 1993, $18 million in 1992, and $16 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-74 NOTES (continued) Alabama Power Company 1993 Annual Report 9. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: Pollution control obligations represent installment purchases of pollution control facilities financed by funds derived from sales by public authorities of revenue bonds. The company is required to make payments sufficient for the authorities to meet principal and interest requirements of such bonds. With respect to $154.5 million of such pollution control obligations, the company has authenticated and delivered to the trustees a like principal amount of first mortgage bonds as security for its obligations under the installment purchase agreements. No principal or interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase agreements. The company has capitalized leased nuclear material and recorded the related lease obligations. The arrangement provides for the payment of interest at varying rates and times dependent on options selected by the company from types of loans available under the arrangement. At the end of 1993 the effective rate of this lease arrangement, including applicable fees, was 3.58 percent. Principal payments are required under the arrangement based on the cost of fuel burned. The company has also capitalized certain office building leases and a street light lease. Monthly principal payments plus interest are required, and at December 31, 1993, the interest rate was 9.5 percent for office buildings and 13.0 percent for street lights. The net book value of capitalized leases included in utility plant in service was $94.7 million and $103.0 million at December 31, 1993 and 1992, respectively. The estimated aggregate annual maturities of other long-term debt through 1998 are as follows: $38.9 million in 1994, $33.3 million in 1995, $18.7 million in 1996, $6.4 million in 1997 and $3.0 million in 1998. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The annual first mortgage bond improvement fund requirement is one percent of the aggregate principal amount of bonds of each series authenticated, so long as a portion of that series is outstanding, and may be satisfied by the deposit of cash and/or reacquired bonds, the certification of unfunded property additions or a combination thereof. The 1994 requirement of $20.1 million was satisfied by the deposit of cash in 1994, which was used for the partial redemption of various series of outstanding bonds. In addition, maturing in 1994 are other long-term debt of $38.9 million consisting primarily of capitalized nuclear fuel obligations. II-75 NOTES (continued) Alabama Power Company 1993 Annual Report 11. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988 (Act), the company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at Plant Farley. The Act limits to $9.4 billion, public liability claims that could arise from a single nuclear incident. Plant Farley is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums which could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for the company is $159 million per incident but not more than an aggregate of $20 million to be paid for each incident in any one year. The company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The company's maximum annual assessment per incident is limited to $14 million under the current policy. Additionally, the company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional cost that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased cost of replacement power in an amount up to $3.5 million per week (starting 21 weeks after the outage) for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments per incident under current policies for the company would be $16 million for excess property damage and $9 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and then, any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under applicable trust indentures. The company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the company could be subject to a maximum total assessment of $6.4 million. II-76 NOTES (continued) Alabama Power Company 1993 Annual Report 12. COMMON STOCK DIVIDEND RESTRICTIONS The company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $653 million of retained earnings was restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. 13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: The company's business is influenced by seasonal weather conditions and the timing of rate adjustments. II-77 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-78 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-79 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company Notes: (1) Generating capacity and fuel data includes Alabama Power Company's 50% portion of SEGCO. (2) Includes Southeastern Power Administration allotment. * Less than one-tenth of one percent. II-80 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company II-81 STATEMENTS OF INCOME Alabama Power Company * Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-82 STATEMENTS OF INCOME Alabama Power Company II-83 STATEMENTS OF CASH FLOWS Alabama Power Company ( ) Denotes use of cash. II-84 STATEMENTS OF CASH FLOWS Alabama Power Company II-85 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-86 BALANCE SHEETS Alabama Power Company II-87 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-88 BALANCE SHEETS Alabama Power Company II-89 ALABAMA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-90 ALABAMA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS II-91 GEORGIA POWER COMPANY FINANCIAL SECTION II-92 MANAGEMENT'S REPORT Georgia Power Company 1993 Annual Report The management of Georgia Power Company has prepared this annual report and is responsible for the financial statements and related information. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls based upon the recognition that the cost of the system should not exceed its benefits. The Company believes that its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, which is composed of five directors who are not employees, provides a broad overview of management's financial reporting and control functions. At least three times a year this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal control and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted with a high standard of business ethics. In management's opinion, the financial statements present fairly the financial position, results of operations and cash flows of Georgia Power Company in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ H. Allen Franklin /s/ Warren Y. Jobe - --------------------- -------------------------- H. Allen Franklin Warren Y. Jobe President and Chief Executive Vice President, Executive Officer Treasurer and Chief Financial Officer II-93 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GEORGIA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Georgia Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-102 through II-122) referred to above present fairly, in all material respects, the financial position of Georgia Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding the recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-94 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Georgia Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Georgia Power Company's 1993 earnings totaled $570 million, representing a $49 million (9.5 percent) increase over the prior year. This improvement is primarily a result of higher retail revenues and lower financing costs. Also, during the period, the Company had an $18 million after-tax gain on the sale of a portion of Plant Scherer Unit 4. Higher retail revenues reflect growth in energy sales of 6.1 percent from 1992 levels primarily due to exceptionally hot summer weather during 1993. Interest expense and preferred stock dividends decreased in 1993 due to the redemption and refinancing of higher-cost debt and preferred stock. These positive events were partially offset by higher operating expenses. In comparing 1992 earnings to the prior year, it should be noted that 1991 earnings included two unusual items that significantly affect this comparison. Earnings in 1991 were $89 million higher due to the completion of a settlement agreement with Gulf States Utilities Company (Gulf States) related to power sales contracts. This increase was partially offset by an after-tax charge of $33 million in 1991 for a work force reduction program. A comparison of 1992 to 1991 -- excluding these unusual items -- would reflect a 1992 increase in earnings of $102 million. REVENUES The following table summarizes the factors impacting operating revenues for the 1991-1993 period: Retail revenues of $3.8 billion in 1993 increased $262 million (7.4 percent) over the prior year, compared with an increase of $87 million (2.5 percent) in 1992. The exceptionally hot weather during the summer of 1993 was the primary factor affecting the increase in retail revenues over 1992. The increase in retail revenues for 1992 was a result of higher retail rates and sales growth, partially offset by mild weather and lower fuel revenues. Fuel revenues generally represent the direct recovery of fuel expense, including the fuel component of purchased energy, and do not affect net income. Revenues from demand-side options programs generally represent the direct recovery of program costs. See Note 3 to the financial statements for further information on these programs. Revenues from sales to non-affiliated utilities decreased in both 1993 and 1992. Contractual unit power sales to Florida utilities for 1993 and 1992 are down compared with prior years, primarily due to scheduled reductions that corresponded with the sales to these utilities of portions of Plant Scherer Unit 4 in July 1991 and June II-95 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report 1993. Sales to municipalities and cooperatives increased slightly in 1993 due to the hot summer weather. Generally, these sales have been decreasing as these customers retain more of their own generation at facilities jointly owned with the Company. Revenues from sales to non-affiliated utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Revenues from sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. Sales to affiliated companies do not have a significant impact on earnings. Changes in revenues are a function of the amount of energy sold each year. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: The hot summer weather during 1993 contributed primarily to the sales growth in the residential and commercial classes. Continued improvement in economic conditions positively impacted sales growth in the commercial and industrial classes. Residential energy sales growth in 1992 reflected mild weather. Commercial and industrial sales growth in 1992 is attributable to improved economic conditions. The decrease in energy sales to non-affiliated utilities reflects scheduled reductions in contractual power sales. EXPENSES Fuel expense increased 2.3 percent in 1993 due to higher generation, which was partially offset by lower nuclear fuel costs. In 1992, fuel expense decreased 6.9 percent due to lower generation and lower fuel costs. Purchased power expense has decreased significantly since 1991, reflecting declining contractual capacity purchases from the co-owners of plants Vogtle and Scherer. Purchased power expense decreased $88 million in 1993 and $43 million in 1992. The declines in Plant Vogtle contractual capacity purchases did not have a significant impact on earnings in 1993 or 1992 as these costs are being levelized over six years under the terms of the 1991 Georgia Public Service Commission (GPSC) retail rate order. The levelization is reflected in the amortization of deferred Plant Vogtle expenses in the income statements. See Note 3 to the financial statements for additional information. Other Operation and Maintenance (O & M) expenses increased 9.0 percent in 1993 after remaining relatively flat in 1992. The increase in 1993 is primarily the result of environmental remediation costs at various current and former operating sites, the one- time costs of an automotive fleet reduction program and the recognition of higher employee benefit costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information concerning these new rules. Also, during 1993, O & M expenses reflect costs associated with new demand-side option programs. These costs were offset by increases in retail revenues. See Note 3 to the financial statements for additional information on the recovery of demand-side option program costs. Depreciation and amortization expense increased slightly due to additional plant investment. The 1992 decrease is due to the effects of lower depreciation rates effective in October 1991. Taxes other than income taxes increased 7.4 percent in 1993 and 3.8 percent in 1992. II-96 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report These increases reflect higher ad valorem taxes. The 1993 increase also includes higher taxes paid to municipalities as a result of increased sales. Income tax expense increased $62 million in 1993 due primarily to higher earnings and the effect of a one percent increase in the federal tax rate effective January, 1993. Also, the Company incurred $27 million of tax expense in connection with the second in a series of four separate transactions to sell Plant Scherer Unit 4. The sale resulted in an after-tax gain of $18 million. Interest expense and dividends on preferred stock decreased $19 million (4.0 percent) and $49 million (9.3 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. The Company refinanced $1.7 billion of securities in both 1993 and 1992. In addition, the Company has retired $544 million of long-term debt with the proceeds from the 1991 and 1993 Plant Scherer Unit 4 sales. Other interest charges in 1993 include interest related to the settlement of an Internal Revenue Service audit. The settlement, in total, did not have an effect on 1993 net income. The Company has deferred certain expenses and recorded a deferred return related to Plant Vogtle under phase-in plans. See Note 3 to the financial statements under "Plant Vogtle Phase-In-Plans" for information regarding the deferral and subsequent amortization of costs related to Plant Vogtle. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize either this economic loss or the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Growth in energy sales is subject to a number of factors which traditionally have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. Assuming normal weather, retail sales growth is projected to be approximately 2 percent annually on average during 1994 through 1996. The scheduled addition of four combustion turbine generating units in 1994, four units in 1995 and one unit in 1996, as well as the Rocky Mountain pumped storage hydroelectric project in 1995, will increase related O & M and depreciation expenses. See Note 4 to the financial statements for information on regulatory uncertainties related to the Rocky Mountain project. The GPSC has certified the construction of the 1994 and 1995 combustion turbine generating units for meeting peak generating needs. In addition, the Company has completed a demonstration competitive bidding process for its supply-side requirements expected for 1996. The Company has filed with the GPSC for certification of a four-year purchase power agreement beginning in 1996, and for construction of a jointly owned combustion turbine to be completed in 1996 to meet these needs. As part of efforts to curtail growth in operating expenses, the Company is reducing its work force through an early-retirement program announced in January 1994. The program resulted in a first quarter 1994 after-tax charge to earnings of $39 million. The program has an expected payback period of approximately two years. Pursuant to an Integrated Resource Plan approved by the GPSC in 1992, the Company has implemented various demand-side option programs and has been authorized by the GPSC to recover associated program costs through rate riders. On October 15, 1993, a superior court judge ruled that recovery of these costs through rate riders is unlawful. The Company has ceased collection of the rate riders and is deferring program costs as ordered by the II-97 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report GPSC pending the final outcome of this matter. See Note 3 to the financial statements for additional information. The Company has completed two in a series of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, the Company would realize an additional after-tax gain estimated to total approximately $20 million. See Note 5 to the financial statements for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs cannot be billed to customers. The Clean Air Act is discussed later under "Environmental Issues." The Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition among electric utilities. The law also includes provisions to streamline the licensing process for new nuclear generating plants. The Energy Act marks the beginning of a major change in the traditional business practices of selling electricity. The Energy Act allows Independent Power Producers (IPPs) and other electric suppliers access to a utility's transmission lines to sell their electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. If the Company does not remain a low cost producer and provide quality service, the Company's sales growth could be limited and this could significantly erode earnings. The Company continues to compete with other electric suppliers within the state. In Georgia, most new retail customers with more than 900 kilowatts of connected load may choose their electricity supplier. In addition, the bulk power market has become very competitive as utilities, IPPs and cogenerators seek to supply future capacity needs. Competition can create new business opportunities, but it increases risk and has the potential to adversely affect earnings. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Review of Equity Returns" for additional information. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be adopted by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which will be effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules in January, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition in 1993 were gross utility plant additions of $674 million and the lowering of the cost of capital achieved through the refinancing or retirement of $1.7 billion of long-term debt and preferred stock. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See Notes 2 and 7 to the financial statements regarding the impact of these changes. The funds needed for gross property additions are currently provided from operations. The Statements of Cash Flows provide additional details. II-98 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report FINANCING ACTIVITIES In 1993, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring or repaying high-cost issues. New issues during 1991 through 1993 totaled $3.0 billion and retirement or repayment of securities totaled $4.2 billion. The retirements included the redemption of $253 million and $291 million in 1993 and 1991, respectively, of first mortgage bonds with the proceeds from the Plant Scherer Unit 4 sales. Composite financing rates for the years 1991 through 1993, as of year-end, were as follows: The Company's current securities ratings are as follows: * Not rated by Duff & Phelps LIQUIDITY AND CAPITAL REQUIREMENTS Cash provided from operations increased by $236 million in 1993, primarily due to higher retail sales, lower interest costs, decreasing capacity purchases from the co-owners of plants Vogtle and Scherer and the receipt of cash payments from Gulf States that completed the settlement of litigation. The Company estimates that construction expenditures for the years 1994 through 1996 will total $688 million, $555 million and $629 million, respectively. The Company will continue to invest in transmission and distribution facilities and enhance existing generating plants. These expenditures also include amounts for nine combustion turbine generating units and equipment that will be required to comply with the provisions of the Clean Air Act. The Company's contractual capacity purchases will decline by $113 million over the next three years. Cash requirements for sinking fund requirements, redemptions announced, and maturities of long-term debt are expected to total $377 million during 1994 through 1996. As a result of requirements by the Nuclear Regulatory Commission, the Company has established external sinking funds for the purpose of funding nuclear decommissioning costs. For 1994 through 1996, the amount to be funded for the Company totals $16 million annually. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Nuclear Decommissioning." SOURCES OF CAPITAL The Company expects to meet future capital requirements primarily using funds generated from operations and, if needed, by the issuance of new debt and equity securities, term loans, and short-term borrowings. To meet short-term cash needs and contingencies, the Company had approximately $540 million of unused credit arrangements with banks at the beginning of 1994. See Note 8 to the financial statements for additional information. Completing the remaining two transactions for the sale of Plant Scherer Unit 4 will generate approximately $130 million in both 1994 and in 1995. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's ability to satisfy all coverage requirements is such that it could issue new first mortgage bonds and preferred stock to provide sufficient funds for all anticipated requirements. ENVIRONMENTAL ISSUES In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts II-99 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, Georgia Power's construction expenditures are estimated to total approximately $150 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total Georgia Power construction expenditures ranging from approximately $150 million to $325 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in Georgia Power's annual revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV requirements, on some Company plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a II-100 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standards will depend on the level chosen for the standards and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the nonhazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either nonhazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. These laws include the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA or Superfund). Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized costs to clean-up known sites in the financial statements. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. II-101 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-102 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-103 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-104 STATEMENTS OF CAPITALIZATION AT December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report II-105 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-106 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-107 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-108 NOTES TO FINANCIAL STATEMENTS Georgia Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), and Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Intracompany contracts dealing with jointly owned generating facilities, transmission lines and exchange of electric power are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and each of the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides support services for nuclear power plants in the Southern electric system. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935. Both The Southern Company and its subsidiaries are subject to the regulatory provisions of this act. The Company is also subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective regulatory commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company is authorized by state law and FERC regulations to recover fuel costs and the fuel component of purchased energy costs through fuel cost recovery provisions, which are periodically adjusted to reflect increases or decreases in such costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel costs were under recovered by $79 million and $4 million at December 31, 1993, and 1992, respectively. These amounts are included in customer accounts receivable on the balance sheets. The fuel cost recovery rate was increased effective December 6, 1993. The cost of nuclear fuel is amortized to fuel expense based on estimated thermal units used to generate electric energy and includes a provision for the disposal of spent fuel. Total charges for nuclear fuel amortized to expense were $75 million in 1993, $84 million in 1992, and $93 million in 1991. The Company has contracted with the U.S. Department of Energy (DOE) for permanent disposal of spent fuel beginning in 1998; however, the actual year this service will begin is uncertain. Pending permanent disposition of the spent fuel, sufficient storage capacity is available at Plant Hatch into 2003 and at Plant Vogtle into 2009. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund which is to be funded, in part, by a special assessment on utilities with nuclear plants. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The Company -- based on its ownership interest -- estimates its total assessment under this law to be approximately $42 million to be paid over a 15-year period beginning in 1993. This obligation is recognized in the accompanying Balance Sheets and is being recovered through the fuel cost recovery provisions. The remaining liability at December 31, 1993, is $39 million. II-109 NOTES (continued) Georgia Power Company 1993 Annual Report NUCLEAR REFUELING OUTAGE COSTS Prior to 1992, the Company expensed nuclear refueling outage costs as incurred during the outage period. Pursuant to the 1991 GPSC retail rate order, the Company began accounting for these costs on a normalized basis in 1992. Under this method of accounting, refueling outage costs are deferred and subsequently amortized to expense over the operating cycle of each unit, which is normally 18 months. Deferred nuclear outage costs were $17 million and $6 million at December 31, 1993 and 1992, respectively. DEPRECIATION Depreciation is provided on the cost of depreciable utility plant in service and is calculated primarily on the straight-line basis over the estimated composite service life of the property. The composite rate of depreciation was 3.1 percent in 1993 and 1992, and 3.2 percent in 1991. Effective October 1991, the Company adopted lower depreciation rates consistent with the 1991 GPSC retail rate order. When a property unit is retired or otherwise disposed of in the normal course of business, its costs and the costs of removal, less salvage, are charged to the accumulated provision for depreciation. Minor items of property included in the cost of the plant are retired when the related property unit is retired. NUCLEAR DECOMMISSIONING In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial nuclear power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. The Company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the Company had internally reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for the Company's ownership interest in plants Hatch and Vogtle were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a period of approximately nine years as approved by the GPSC in its 1991 retail rate order. The estimates approved by the GPSC for ratemaking exclude costs of non-radiated structures and site contingency costs. The actual decommissioning cost may vary from the above estimates because of regulatory requirements, changes in technology, and increased costs of labor, materials, and equipment. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The Company expects the GPSC to periodically review and adjust, if necessary, the amounts collected in rates for the anticipated cost of decommissioning. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the GPSC ordered that the costs of Plant Vogtle Units 1 and 2 be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. In 1991, the GPSC modified the phase-in plans. In addition, the Company deferred certain Plant Vogtle operating expenses and financing costs under accounting orders issued by the GPSC. See Note 3 for further information. II-110 NOTES (continued) Georgia Power Company 1993 Annual Report INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. See Note 7 to the financial statements for further information. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. For the years 1993, 1992 and 1991, the average AFUDC rates were 4.87 percent, 7.16 percent and 9.90 percent, respectively. The reduction in the average AFUDC rate since 1991 reflects the Company's greater use of lower cost short-term debt. The Company also imputed a return on its investment in Plant Vogtle Units 1 and 2 after they began commercial operation, under short-term cost deferrals and phase-in plans as described in Note 3. AFUDC and the Vogtle deferred returns, net of taxes, as a percentage of net income after dividends on preferred stock, amounted to 1.4 percent, 2.1 percent and 9.2 percent for 1993, 1992 and 1991, respectively. UTILITY PLANT Utility plant is stated at original cost with the exception of Plant Vogtle, which is stated at cost less regulatory disallowances. Original cost includes materials; labor; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS All financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In December 1992, the Company converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that is being amortized as credits to income over II-111 NOTES (continued) Georgia Power Company 1993 Annual Report approximately four years. This conversion will not have a material effect on income in any year. VACATION PAY Company employees earn vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. This amount was $42 million at December 31, 1993, and $40 million at December 31, 1992. In 1994, approximately 72 percent of the 1993 deferred vacation costs will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan covering substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the projected unit credit actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. For medical care benefits, a qualified trust has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered the Company to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional expense was recognized -- approximately $6 million -- in 1993 and the remaining additional expense was deferred. An additional one-fifth of the costs will be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The cost deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of the regulatory treatment allowed by the GPSC, the adoption of Statement No. 106 did not have a material impact on net income. Prior to 1993, the Company recognized these cost on a cash basis as payments were made. The total costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $56 million, $13 million, and $9 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as II-112 NOTES (continued) Georgia Power Company 1993 Annual Report of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: Weighted average rates used in actuarial calculations: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $68 million and the aggregate of the service and interest cost components of the net retiree medical cost by $7 million. The components of the plans' net costs are shown below: Of net pension costs (income) recorded, $(6) million in 1993 and $5 million in 1991, were recorded to operating expense, with the balance being recorded to construction and other accounts. II-113 NOTES (continued) Georgia Power Company 1993 Annual Report Of the above net postretirement medical and life insurance costs recorded in 1993, $21 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of the Company's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. The Company has suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved the Company's request for an accounting order allowing the Company to defer all current unrecovered and future costs related to these programs until the court's decision is reversed or until the next general rate case proceeding. An association of industrial customers has filed a petition for review of such accounting order in the Superior Court of Fulton County, Georgia. The Company's costs related to these conservation programs through 1993 were $60 million of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on these financial statements. RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected. This matter is now concluded. GULF STATES SETTLEMENT On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received, the Company recorded increases of $3 million in 1992 and $89 million in 1991 net income. FERC REVIEW OF EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. II-114 NOTES (continued) Georgia Power Company 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. PLANT VOGTLE PHASE-IN PLANS Pursuant to orders from the GPSC, the Company recorded a deferred return under phase-in plans for Plant Vogtle Units 1 and 2 until October 1991 when the allowed investment was fully reflected in rates. In addition, the GPSC issued two separate accounting orders that required the Company to defer substantially all operating and financing costs related to both units until rate orders addressed these costs. These GPSC orders provide for the recovery of deferred costs within 10 years. The GPSC modified the phase-in plans in 1991 to accelerate the recognition of costs previously deferred under the Plant Vogtle Unit 2 phase-in plan and to levelize the remaining Plant Vogtle declining capacity buyback expenses. Under these orders, the Company has deferred and begun amortizing these costs (as recovered through rates) as follows: NUCLEAR PERFORMANCE STANDARDS In October 1989, the GPSC adopted a nuclear performance standard for the Company's nuclear generating units under which the performance of plants Hatch and Vogtle will be evaluated every three years. The performance standard is based on each unit's capacity factor as compared to the average of all U.S. nuclear units operating at a capacity factor of 50% or higher during the three-year period of evaluation. Depending on the performance of the units, the Company could receive a monetary reward or penalty under the performance standards criteria. The first evaluation was conducted in 1993 for performance during the 1990-92 period. During this three-year period, the Company's units performed at an average capacity factor of 81 percent compared to an industry average of approximately 73 percent. Based on these results, the GPSC approved a performance reward of approximately $8.5 million for the Company. This reward is being collected through the retail fuel cost recovery provision and recognized in income over a 36- month period beginning November, 1993. 4. COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program and currently estimates property additions to be approximately $688 million in 1994, $555 million in 1995 and $629 million in 1996. These estimated additions include AFUDC of $19 million in 1994, $27 million in 1995, and $18 million in 1996. The estimates for property additions for the three-year period include $88 million committed to meeting the requirements of the Clean Air Act. While the Company has no new baseload generating plants under construction, the construction of nine combustion turbine peaking units is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities, and upgrading and extending the useful life of generating plants will continue. The construction program is subject to periodic review and revision, and actual construction costs may vary from estimates because of numerous factors, including, but not limited to, changes in business conditions, load growth estimates, environmental regulations, and regulatory requirements. II-115 NOTES (continued) Georgia Power Company 1993 Annual Report FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $4.8 billion at December 31, 1993. Additional commitments for coal and for nuclear fuel will be required in the future to supply the Company's fuel needs. OPERATING LEASES The Company has entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $8 million, $7 million, and $5 million for 1993, 1992, and 1991, respectively. Minimum annual rental commitments for noncancellable rail car leases are $9 million annually for years 1994 through 1998, and total approximately $191 million thereafter. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 as then planned was not economically justifiable and reasonable and withheld authorization for the Company to spend funds from approved securities issuances on that project. In 1988, the Company and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 5. The joint ownership agreement significantly reduces the risk of the project being canceled. However, full recovery of the Company's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event the Company cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off in accordance with FASB Statement No. 90, Accounting for Abandonments and Disallowed Plant Costs. At December 31, 1993, the Company's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, the Company's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. The Company has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, the Company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the Company's nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment for the Company -- based on its ownership and buyback interests -- is $171 million per incident but not more than an aggregate of $22 million to be paid for each incident in any one year. The Company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The Company's maximum assessment per incident is limited to $18 million under current policies. Additionally, the Company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric II-116 NOTES (continued) Georgia Power Company 1993 Annual Report Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum assessments per incident under the current policies for the Company would be $15 million for excess property damage and $13 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the Company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. The Company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the Company could be subject to a maximum total assessment of $7 million. 5. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS Since 1975, the Company has sold undivided interests in plants Hatch, Wansley, Vogtle, and Scherer Units 1 and 2, together with transmission facilities, to OPC, an electric membership generation and transmission corporation; the Municipal Electric Authority of Georgia (MEAG), a public corporation and an instrumentality of the state of Georgia; and the City of Dalton, Georgia. The Company has sold an interest in Plant Scherer Unit 3 to Gulf Power, an affiliate. Additionally, the Company has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FPL) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FPL will eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Except as otherwise noted, the Company has contracted to operate and maintain all jointly owned facilities. The Company includes its proportionate share of plant operating expenses in the corresponding operating expenses in the Statements of Income. As discussed in Note 4, the Company and OPC have a joint ownership arrangement for the Rocky Mountain pumped storage hydroelectric project under which the Company will retain its present investment in the project and OPC will finance and complete the remainder of the project and operate the completed facility. Based on current cost estimates the Company's ownership will be approximately 25% of the project (194 megawatts of capacity) at completion. The Company will own six of eight 80 megawatt combustion turbine generating units and 75% of the related common facilities being jointly constructed with Savannah Electric, an affiliate. The Company's investment in the project at December 31, 1993, was $100 million and is expected to total approximately $182 million when the project is completed. All units are II-117 NOTES (continued) Georgia Power Company 1993 Annual Report expected to be completed by June, 1995. Savannah Electric will operate these units. In connection with the joint ownership arrangements for plants Vogtle and Scherer, the Company has made commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from these units. These commitments are in effect during periods of up to 10 years following commercial operation (and with regard to a portion of a 5 percent interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for capacity are required whether or not any capacity is available. The energy cost is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power from non-affiliates in the Company's Statements of Income. Capacity payments totaled $183 million, $289 million and $320 million in 1993, 1992 and 1991, respectively. The Plant Scherer buyback agreements ended in 1993. The current projected Plant Vogtle capacity payments for the next five years are as follows: $132 million in 1994, $77 million in 1995, $70 million in 1996, $59 million in 1997 and $59 million in 1998. Portions of the payments noted above relate to costs in excess of Plant Vogtle's allowed investment for ratemaking purposes. The present value of these portions was written off in 1987 and 1990. Additionally, the Plant Vogtle declining capacity buyback expense is being levelized over a six-year period. See Note 3 for further information. At December 31, 1993, the Company's percentage ownership and investment (exclusive of nuclear fuel) in jointly owned facilities in commercial operation, were as follows: (1) Investment net of write-offs. The Company and an affiliate, Alabama Power, own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,020 megawatts, as well as associated transmission facilities. The capacity of the units has been sold equally to the Company and Alabama Power under a contract expiring in 1994, which, in substance, requires payments sufficient to provide for the operating expenses, taxes, debt service and return on investment, whether or not SEGCO has any capacity and energy available. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two year's notice. The Company's share of expenses included in purchased power from affiliates in the Statements of II-118 NOTES (continued) Georgia Power Company 1993 Annual Report Income, is as follows: At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. 6. LONG-TERM POWER SALES AGREEMENTS The Company and the operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service territory. Certain of these agreements are non-firm and are based on the capacity of the Southern system. Other agreements are firm and pertain to capacity related to specific generating units. Because energy is generally sold at cost under these agreements, it is primarily the capacity revenues that affect the Company's profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). This amount decreases to 200 megawatts in 1994 and the contract expires at year-end. Sales under these long-term non-firm power sales agreements are made from available power pool energy, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is being sold to FPL, JEA, and the City of Tallahassee, Florida and beginning in 1994 to FPC. Under these agreements, the Company sold approximately 830 megawatts of capacity in 1993 and is scheduled to sell approximately 403 megawatts of capacity in 1994. Thereafter, these sales will decline to an estimated 157 megawatts by the end of 1996 and will remain at that approximate level through 1999. After 2000, capacity sales will decline to approximately 101 megawatts -- unless reduced by FPL and JEA -- until the expiration of the contracts in 2010. 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $993 million are revenues to be received from customers. These assets are attributable to tax benefits flowed-through to customers in prior years, and taxes applicable to capitalized AFUDC. The related liabilities of $453 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: II-119 NOTES (continued) Georgia Power Company 1993 Annual Report The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax basis, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $19 million in 1993, $19 million in 1992, and $27 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory tax rate to effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 8. CAPITALIZATION COMMON STOCK DIVIDEND RESTRICTIONS The Company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $742 million of retained earnings were restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. The Company's charter limits cash dividends on common stock to the lesser of the retained earnings balance or 75 percent of net income available for such stock during a prior period of 12 months if the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend, is below 25 percent, and to 50 percent of such net income if such ratio is less than 20 percent. At December 31, 1993, the ratio as defined was 46.1 percent. II-120 NOTES (continued) Georgia Power Company 1993 Annual Report REMARKETED BONDS In 1992, the Company issued two series of variable rate first mortgage bonds each with principal amounts of $100 million due 2032. The current composite interest rate on the bonds is 6.20 percent and is fixed for the first three years of the issues. POLLUTION CONTROL BONDS The Company has incurred obligations in connection with the sale by public authorities of tax-exempt pollution control and industrial development revenue bonds. The Company has authenticated and delivered to trustees an aggregate of $407.7 million of its first mortgage bonds, which are pledged as security for its obligations under pollution control and industrial development contracts. No interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase or loan agreements. An aggregate of approximately $1.3 billion of the pollution control and industrial development bonds is secured by a subordinated interest in specific property of the Company. Details of pollution control bonds are as follows: BANK CREDIT ARRANGEMENTS At the beginning of 1994, the Company had unused credit arrangements with banks totaling $540 million, of which $10 million expires June 30, 1994, $130 million expires at May 1, 1996, and $400 million expires at June 30, 1996. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing the Company, Alabama Power, and The Southern Company up to a total credit amount of $400 million. To provide liquidity support for commercial paper programs and for other short-term cash needs, $165 million and $135 million of the $400 million available credit are currently dedicated for the Company and Alabama Power, respectively. However, the allocations can be changed among the borrowers by notifying the respective banks. During the term of the agreements expiring in 1996, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. The $10 million credit arrangement expiring in 1994 allows borrowings for up to 90 days. Commitment fees are based on the unused portion of the commitment. In addition, the Company borrows under uncommitted lines of credit with banks and through a $150 million commercial paper program that has the liquidity support of committed bank credit arrangements. Average compensating balances held under these committed facilities were not material in 1993. OTHER LONG-TERM DEBT Assets acquired under capital leases are recorded in the Balance Sheets as utility plant in service, and the related obligations are classified as long-term debt. At December 31, 1993, the Company had a capitalized lease obligation for its corporate headquarters building of $88 million with an interest rate of 8.1 percent. Other capitalized lease obligations were $137 thousand with a composite interest rate of 6.8 percent. The maturities of capital lease obligations through 1998 are approximately as follows: $423 thousand in 1994, $309 thousand in 1995, $335 thousand in 1996, $362 thousand in 1997, and $392 thousand in 1998. The lease agreement for the corporate headquarters building provides for payments that are minimal in early years and escalate through the first 21 years of the lease. For ratemaking purposes, the GPSC has treated the lease as an operating lease and has allowed only the lease II-121 NOTES (continued) Georgia Power Company 1993 Annual Report payments in cost of service. The difference between the accrued expense and the lease payments allowed for ratemaking purposes is being deferred as a cost to be recovered in the future as ordered by the GPSC. At December 31, 1993, and 1992, the interest and lease amortization deferred on the Balance Sheets are $47 million and $48 million, respectively. In December 1993, the Company borrowed $37 million through a long-term note due in 1995. ASSETS SUBJECT TO LIEN The Company's mortgage dated as of March 1, 1941, as amended and supplemented, securing the first mortgage bonds issued by the Company, constitutes a direct lien on substantially all of the Company's fixed property and franchises. LONG-TERM DEBT DUE WITHIN ONE YEAR The current portion of the Company's long-term debt is as follows: *Less than .1 million The indenture's first mortgage bond improvement fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash or reacquired bonds, or by pledging additional property equal to 1 2/3 times the requirement. The 1993 and 1992 requirements were met in the first quarter of each year by depositing cash subsequently used to redeem bonds. The 1994 requirement was funded in December 1993. REDEMPTION OF HIGH-COST SECURITIES The Company plans to continue a program of redeeming or replacing high-cost debt and preferred stock in cases where opportunities exist to reduce financing costs. High-cost issues may be repurchased in the open market or called at premiums as specified under terms of the issue. They may also be redeemed at face value to meet improvement fund and sinking fund requirements, to meet replacement provisions of the mortgage, or by use of proceeds from the sale of property pledged under the mortgage. In general, for the first five years a series is outstanding the Company is prohibited from redeeming for improvement fund purposes more than 1 percent annually of the original issue amount. 9. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial information for 1993 and 1992 is as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate increases. II-122 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-123 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-124 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report Note: As of 9/1/91, Georgia Power Company's sales to Oglethorpe Power Company are not included in Peak-Hour Demand * Less than one-tenth of one percent. II-125 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report II-126 STATEMENTS OF INCOME Georgia Power Company Note: Reflects major sales of facilities to Jacksonville Electric Authority, Florida Power & Light Company, OPC, MEAG, and Dalton. Increases in net income, after total taxes, from these sales were $18,391,000 in 1993, $14,542,000 in 1991, $6,336,000 in 1990, $3,851,000 in 1987, and $21,250,000 in 1984. II-127 STATEMENTS OF INCOME Georgia Power Company II-128 STATEMENTS OF CASH FLOWS Georgia Power Company ( ) Denotes use of cash. II-129 STATEMENTS OF CASH FLOWS Georgia Power Company II-130 BALANCE SHEETS Georgia Power Company II-131 BALANCE SHEETS Georgia Power Company II-132 BALANCE SHEETS Georgia Power Company II-133 BALANCE SHEETS Georgia Power Company II-134 GEORGIA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-135 GEORGIA POWER COMPANY OUTSTANDING SECURITIES (Continued) AT DECEMBER 31, 1993 (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. II-136 GEORGIA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. * Less than $500. II-137 GULF POWER COMPANY FINANCIAL SECTION II-138 MANAGEMENT'S REPORT Gulf Power Company 1993 Annual Report The management of Gulf Power Company has prepared and is responsible for the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of the directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Gulf Power Company in conformity with generally accepted accounting principles. /s/ D. L. McCrary /s/ A. E. Scarbrough - -------------------------- ------------------------ Douglas L. McCrary Arlan E. Scarbrough Chairman of the Board Vice President - Finance and Chief Executive Officer II-139 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GULF POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Gulf Power Company (a Maine corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-148 through II-165) referred to above present fairly, in all material respects, the financial position of Gulf Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, Gulf Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-140 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Gulf Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Gulf Power Company's net income after preferred stock dividends was $54.3 million for 1993, a $0.2 million increase over 1992 net income. Earnings reflect a $2.3 million gain on the sale of Gulf States Utilities Company (Gulf States) stock and the reversal of a $1.7 million wholesale rate refund as the result of a court order which is further discussed in Note 3 to the financial statements under "Recovery of Contract Buyout Costs". The company also experienced growth in residential and commercial sales and a decrease in interest expense on long-term debt as a result of security refinancings, offset by higher operation and maintenance expense, and decreased industrial sales reflecting the loss of the Company's largest industrial customer, Monsanto, which began cogeneration in August of 1993. The Company's 1992 net income after dividends on preferred stock decreased $3.7 million compared to the prior year. The 1991 earnings included an after-tax gain of $12.7 million representing the settlement of litigation with Gulf States. See Note 7 to the financial statements under "Gulf States Settlement Completed" for further details. Excluding this settlement from 1991, earnings for 1992 increased $8.4 million -- or approximately -- 18.7 percent over 1991. This improvement was due to increased energy sales; lower interest expense and preferred dividends as a result of security refinancings; and continued emphasis on cost controls. The Company's return on average common equity was 13.29 percent for 1993, a slight decrease from the 13.62 percent return earned in 1992, which was up from the 12.03 percent earned in 1991 (excluding the Gulf States settlement). REVENUES Changes in operating revenues over the last three years are the result of the following factors: * Includes the non-interest portion of the wholesale rate refund reversal discussed in "Earnings." Retail revenues of $471.7 million in 1993 increased $10.2 million or 2.2 percent from last year, compared with an increase of 1.2 percent in 1992 and 4.9 percent in 1991. Revenues increased in the residential and commercial classes primarily due to customer growth, and favorable weather and economic conditions. Revenues in the industrial class declined due to the loss of the Company's largest industrial customer, Monsanto, which began operating its cogeneration facility in August 1993. See "Future Earnings Potential" for further details. The change in base rates for 1993 and 1992 reflects the expiration of a retail rate penalty in September 1992. Sales for resale were $95.4 million in 1993, increasing $1.2 million or 1.3 percent over 1992. Sales to affiliated companies vary from year to year depending on demand and the availability and cost of generating resources at each company. The majority of non-affiliated energy sales arise from long-term contractual agreements. Non-affiliated long-term contracts include capacity and energy components. Capacity revenues reflect the recovery of II-141 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report fixed costs and return on investment. Energy is sold at its variable cost. The capacity and energy components under these long-term contracts were as follows: Beginning in June 1992, all the capacity from the Company's ownership portion of Plant Scherer Unit No. 3 was sold through unit power sales, resulting in increased capacity revenues. In 1993, changes in other operating revenues are primarily due to the recognition of $2.6 million under the Environmental Cost Recovery (ECR) clause which is fully discussed in Note 3 to the financial statements under "Environmental Cost Recovery", which is offset by true-ups of other regulatory cost recovery clauses. The increase in other operating revenues in 1992 was primarily due to true-ups of regulatory cost recovery clauses and the changes in franchise fee collections and Florida gross receipts taxes (discussed under "Expenses") which had no effect on earnings. Energy sales for 1993 and percent changes in sales since 1991 are reported below. Overall retail sales remained relatively flat in 1993. Increases in residential and commercial sales -- reflecting customer growth, favorable weather and an improving economy -- were offset by the decreased sales in the industrial class reflecting the loss of Monsanto. Retail sales increased 3.8 percent in 1992 primarily due to an increase in the number of customers served and a moderately improving economy. Energy sales for resale to non-affiliates increased 2.0 percent and are predominantly unit power sales under long-term contracts to Florida utilities which are discussed above. Energy sales to affiliated companies vary from year to year as mentioned above. EXPENSES Total operating expenses for 1993 increased $16.6 million or 3.5 percent over 1992 primarily due to increased operation and maintenance expenses and higher taxes. Other operation expenses increased $10.9 million or 11.1 percent from the 1992 level. The increase is attributable to additional costs of $7.4 million related to increases in the buyout of coal supply contracts and $1.4 million of environmental clean-up costs. Also, higher employee benefit costs and the costs of an automotive fleet reduction program increased expenses by $2.1 million. Operating expenses for 1992 increased by approximately $16 million over 1991. Excluding the Gulf States settlement, an after-tax reduction of $0.6 million in 1992 and $12.7 million in 1991, 1992 total operating expenses increased $4.3 million or 0.9 percent over 1991. Fuel and purchased power expenses decreased $3.8 million or 1.8 percent from 1992 reflecting the lower cost of fuel. Total 1992 fuel and purchased power increased $1.4 million or 0.7 percent from 1991. Maintenance expense increased $4.1 million or 9.7 percent over 1992 due to scheduled maintenance of production facilities. The 1992 maintenance expense was down $3.5 million or 7.7 percent from 1991 due to a decrease in scheduled maintenance. Federal income taxes increased $0.7 million primarily due to a corporate federal income tax rate increase from 34 percent to 35 percent effective January 1993. Taxes other than income taxes increased $2.3 million in 1993, an increase of 6.1 percent over the 1992 expense II-142 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report primarily due to increases in property taxes and gross receipt taxes. Taxes other than income taxes decreased $4.5 million, or 10.5 percent in 1992 compared to 1991 due primarily to the Company discontinuing the collection of franchise fees for two Florida counties which was partially offset by an increase in gross receipt taxes. Changes in franchise fee collections and gross receipt taxes had no impact on earnings. Interest expense decreased $3.2 million or 8.1 percent from the 1992 level and 1992 interest expense decreased $5.6 million or 12.5 percent from 1991. The decrease in both years is primarily attributable to refinancing some of the Company's higher cost securities. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its cost of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on a number of factors. It is expected that higher operating costs and carrying charges on increased investment in plant, if not offset by proportionate increases in operating revenues (either by periodic rate increases or increases in sales), will adversely affect future earnings. Growth in energy sales will be subject to a number of factors, including the volume of sales to neighboring utilities, energy conservation practiced by customers, the elasticity of demand, customer growth, weather, competition, and the rate of economic growth in the service area. In addition to the traditional factors discussed above, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Company is preparing to meet the challenges of a major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access the Company's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for the Company's large industrial and commercial customers and sell excess energy generation to the Company or other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, its ability to retain large industrial and commercial customers, and obtain new long-term contracts for energy sales outside the Company's service area, could be limited, and this could significantly erode earnings. The future effect of cogeneration and small-power production facilities cannot be fully determined at this time, but may be adverse. One effect of cogeneration which the Company has experienced is the loss of its largest industrial customer, Monsanto, in August of 1993. The loss of the Monsanto load reduced revenues, and will result in a reduction in net income of approximately $3 million in the first twelve months. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts that have a return on common equity of 13.75 percent or greater, and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters". II-143 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Also, recently enacted legislation that provides for recovery of prudent environmental compliance costs is discussed in Note 3 to the financial statements under "Environmental Cost Recovery." The Company filed a notice with the Florida Public Service Commission (FPSC) of its intent to obtain rate relief in February 1993. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case. The stipulation also allowed the Company to retain, for the next four years, its existing method for calculating accruals for future power plant dismantlement costs. The existing method provides a more even allocation of expenses over the life of the plants and results in an avoided increase in expenses of about $6 million annually over the next four years when compared to the FPSC method. The stipulation also provided for the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. After the February 1993 filing date, interest rates continued to remain low, resulting in lower cost of capital. Also, the Florida legislature adopted legislation which allows utilities to petition the FPSC for recovery of environmental costs through an adjustment clause if these costs are not being recovered in base rates. See Note 3 to the financial statements under "Environmental Cost Recovery" for further details. The combination of the circumstances discussed above, placed the Company in a better position to manage its finances without an increase in base rates while still providing a fair return for the Company's investors. Consequently, the Company agreed, as a part of this stipulation, to cancel the filing of the rate case. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, which resulted in a decrease in earnings of $0.3 million. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company does not have any investments that qualify for FASB Statement No. 115 treatment. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition during 1993 were gross property additions of $79 million. Funds for these additions were provided by internal sources. The Company continued to refinance higher cost securities to lower the Company's cost of capital. See "Financing Activities" below and the Statements of Cash Flows for further details. On January 1, 1993, the Company changed its method of calculating the accruals for postretirement benefits other than pensions and its method of accounting for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. FINANCING ACTIVITIES As mentioned above, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring higher-cost issues in 1993. The Company sold $75 million of first mortgage bonds and, through public authorities, $53.4 million of pollution control revenue bonds, issued $35 million of preferred stock, and obtained $25 million with a long-term bank note. Retirements, including maturities during 1993, totaled $88.8 million of first mortgage bonds, $40.7 million of pollution control revenue bonds, and $21.1 million of preferred stock. (See the Statements of Cash Flows for further details.) II-144 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Composite financing rates for the years 1991 through 1993 as of year end were as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's gross property additions, including those amounts related to environmental compliance, are budgeted at $200 million for the three years beginning 1994 ($77 million in 1994, $55 million in 1995, and $68 million in 1996). The estimates of property additions for the three-year period include $25 million committed to meeting the requirements of the Clean Air Act, the cost of which is expected to be recovered through the ECR clause which is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Actual construction costs may vary from this estimate because of factors such as the granting of timely and adequate rate increases; changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The Company does not have any baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. Significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $86 million will be required by the end of 1996 in connection with maturities of long-term debt and preferred stock subject to mandatory redemption. Also, the Company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million for The Southern Company including $34 million for Gulf Power Company through 1995. II-145 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company including approximately $30 million to $40 million for Gulf Power Company. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. Following adoption of legislation in April of 1992, allowing electric utilities in Florida to seek FPSC approval of their Clean Air Act Compliance Plans, the Company filed its petition for approval. The Commission approved the Company's plan for Phase I compliance, deferring until a later date approval of its Phase II Plan. An average increase of up to 4 percent in annual revenue requirements from Gulf Power Company customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. The Florida Legislature recently adopted legislation that allows a utility to petition the FPSC for recovery of prudent environmental compliance costs through an ECR clause without lengthy regulatory full revenue requirements rate proceedings. The legislation is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Gulf Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. II-146 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of Gulf Power Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect Gulf Power Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. COAL STOCKPILE DECREASES To reduce the working capital invested in the coal stockpile inventory, the Company implemented a coal stockpile reduction program in 1992. The Company's actual year end inventory at December 31, 1993 was $20.7 million which is considerably lower than the desired level of $31.4 million. This situation exists because a limited supply of coal was available at competitive prices primarily due to the United Mine Workers strike from July to December 1993. In addition, barge transportation was stranded due to floods in the Midwest. As a result of these circumstances, management chose to allow the existing coal inventory to decline until coal prices stabilized. Current market conditions indicate that substantial coal supplies at competitive prices are now available. Therefore, the Company plans to increase purchases and return the coal stockpile inventory to the desired level by the end of the third quarter, 1994. SOURCES OF CAPITAL At December 31, 1993, the Company had $5.6 million of cash and cash equivalents to meet its short-term cash needs. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations; the sale of additional first mortgage bonds, pollution control bonds, and preferred stock; and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficient to permit, at present interest and preferred dividend levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-147 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-148 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-149 BALANCE SHEETS At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-150 BALANCE SHEETS (continued) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-151 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report II-152 STATEMENTS OF CAPITALIZATION (CONTINUED) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-153 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-154 NOTES TO FINANCIAL STATEMENTS At December 31, 1993, 1992 and 1991 Gulf Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: GENERAL Gulf Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services, Inc. (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear) and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company is also subject to regulation by the FERC and the Florida Public Service Commission (FPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by these commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company's electric rates include provisions to periodically adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. The FPSC has also approved the recovery of purchased power capacity costs, energy conservation costs, and environmental compliance costs in cost recovery clauses that are similar to the method used to recover fuel costs. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily using composite straight-line rates which approximated 3.8 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. The Company is included in the consolidated federal income tax return of The Southern Company. II-155 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of certain new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of plant through a higher rate base and higher depreciation expense. The FPSC-approved composite rate used to calculate AFUDC was 7.27 percent effective on July 1, 1993 and 8.03 percent for the first half of 1993, and for 1992, and 1991. AFUDC amounts for 1993, 1992, and 1991 were $966 thousand, $60 thousand, and $149 thousand, respectively. The increase in 1993 is due to an increase in construction projects at Plant Daniel. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The Company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. The amount was $4.0 million and $3.8 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 84 percent of the 1993 deferred vacation cost II-156 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report will be expensed and the balance will be charged to construction. PROVISION FOR INJURIES AND DAMAGES The Company is subject to claims and suits arising in the ordinary course of business. As permitted by regulatory authorities, the Company is providing for the uninsured costs of injuries and damages by charges to income amounting to $1.2 million annually. The expense of settling claims is charged to the provision to the extent available. The accumulated provision of $2.2 million and $2.5 million at December 31, 1993 and 1992, respectively, is included in miscellaneous current liabilities in the accompanying Balance Sheets. PROVISION FOR PROPERTY DAMAGE Due to a significant increase in the cost of traditional insurance, effective in 1993, the Company became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provides for the estimated cost of uninsured property damage by charges to income amounting to $1.2 million annually. At December 31, 1993 and 1992, the accumulated provision for property damage amounted to $10.5 million and $9.7 million, respectively. The expense of repairing such damage as occurs from time to time is charged to the provision to the extent it is available. 2. RETIREMENT BENEFITS: PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension trust fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Prior to the adoption of Statement No. 106, Gulf Power Company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $3.9 million, $3.1 million, and $2.7 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. II-157 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $4.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $543 thousand. Components of the plans' net cost are shown below: Of the above net pension amounts, $(601) thousand in 1993, $3 thousand in 1992, and $518 thousand in 1991, were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance amounts recorded in 1993, $3.0 million was recorded in operating expenses, and the remainder was recorded in construction and other accounts. II-158 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 3. LITIGATION AND REGULATORY MATTERS: COAL BARGE TRANSPORTATION SUIT On August 19, 1993, a complaint against the Company and Southern Company Services, an affiliate, was filed in federal district court in Ohio by two companies with which the Company had contracted for the transportation by barge for certain of the Company's coal supplies. The complaint alleges breach of the contract by the Company and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on the Company's financial statements. FPSC APPROVES STIPULATION In February 1993, the Company filed a notice with the FPSC of its intent to obtain rate relief. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case and to allow the Company to retain for the next four years its existing method for calculating accruals for future power plant dismantlement costs. The stipulation also required the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. See Management's Discussion and Analysis under "Future Earnings Potential" for further details of circumstances that contributed to the company canceling the rate case. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. RECOVERY OF CONTRACT BUYOUT COSTS In July 1990, the Company filed a request for waiver of FERC's fuel adjustment charge regulation to permit recovery of coal contract buyout costs from wholesale customers. On April 4, 1991, the FERC issued an order granting recovery of the buyout costs from wholesale customers from July 19, 1990, forward, but denying retroactive recovery of the buyout costs from January 1, 1987 through July 18, 1990. The Company's request for rehearing was denied by the FERC. The Company refunded $2.7 million (including interest) in June 1991 to its wholesale customers. On July 31, 1991, the Company filed a petition for review of the FERC's decision to the U.S. Court of Appeals for the District of Columbia Circuit. On January 22, 1993, the Court vacated the Commission's order, finding FERC's denial of the Company's request for a retroactive waiver to be arbitrary and capricious. The Court remanded the matter to FERC for consideration consistent with its opinion. Management expects that the commission will ultimately allow the Company to recover the amount refunded plus interest. Accordingly, the Company recorded the reversal of the $2.7 million refund to income in 1993. ENVIRONMENTAL COST RECOVERY In April 1993, the Florida Legislature adopted legislation for an Environmental Cost Recovery (ECR) clause, which allows a utility to petition the FPSC for recovery of all prudent environmental compliance costs that are not being recovered through base rates or any other rate-adjustment clause. Such environmental costs include operation and maintenance expense, depreciation, and a return on invested capital. II-159 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report On January 12, 1994, the FPSC approved the Company's petition under the ECR clause for recovery of environmental costs that were projected to be incurred from July 1993 through September 1994. The order allows the recovery from customers of such costs amounting to $7.8 million during the period, February through September 1994. Thereafter, recovery under ECR will be determined semi-annually and will include a true-up of the prior period and a projection of the ensuing six-month period. In December 1993, the Company recorded $2.6 million as additional revenue for the portion of costs incurred during 1993. 4. CONSTRUCTION PROGRAM: The Company is engaged in a continuous construction program, the cost of which is currently estimated to total $77 million in 1994, $55 million in 1995, and $68 million in 1996. These estimates include AFUDC of approximately $0.7 million, $0.3 million, and $0.2 million, in 1994, 1995, and 1996, respectively. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. 5. FINANCING AND COMMITMENTS: GENERAL Current projections indicate that funds required for construction and other purposes, including compliance with environmental regulations will be derived primarily from internal sources. Requirements not met from internal sources will be financed from the sale of additional first mortgage bonds, preferred stock, and capital contributions from The Southern Company. In addition, the Company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and redemptions of higher-cost securities. Because of the attractiveness of current short term interest rates, the Company may maintain a higher level of short term indebtedness than has historically been true. At December 31, 1993, the Company had $49 million of lines of credit with banks of which $6.1 million was committed to cover checks presented for payment. These credit arrangements are subject to renewal June 1 of each year. In connection with these committed lines of credit, the Company has agreed to pay certain fees and/or maintain compensating balances with the banks. The compensating balances, which represent substantially all the cash of the Company except for daily working funds and like items, are not legally restricted from withdrawal. In addition, the Company has bid-loan facilities with eight major money center banks that total $180 million, of which, none was committed at December 31, 1993. ASSETS SUBJECT TO LIEN The Company's mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $1.4 billion at December 31, 1993. Additional commitments will be required in the future to supply the Company's fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 to terminate two long-term contracts for the supply of coal to Plant Daniel, which is jointly owned by the Company and Mississippi Power, an operating affiliate. The Company's portion of II-160 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report this payment was some $60 million. This amount is being amortized to expense on a per ton basis over a nine-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $18 million at December 31, 1993. In 1988, the Company made an advance payment of $60 million to another coal supplier under an arrangement to lower the cost of future coal purchased under an existing contract. This amount is being amortized to expense on a per ton basis over a ten-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $36 million at December 31, 1993. Also, in 1993 the Company made a payment of $16.4 million to a coal supplier under an arrangement to suspend the purchase of coal under an existing contract for one year. This amount is being amortized to expense on a per ton basis over a one year period. The remaining unamortized amount, which is included in current assets, was $11 million at December 31, 1993. The amortization of these payments is being recovered through the fuel cost recovery clause discussed under "Revenues and Fuel Costs" in Note 1. LEASE AGREEMENT In 1989, the Company entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Mississippi Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million in 1992 and $1.3 million in 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option, after three years from the date of the original contract, to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, the Company has the option to renew the lease. 6. JOINT OWNERSHIP AGREEMENTS: The Company and Mississippi Power jointly own Plant Daniel, a steam-electric generating plant, located in Jackson County, Mississippi. In accordance with an operating agreement, Mississippi Power acts as the Company's agent with respect to the construction, operation, and maintenance of the plant. The Company and Georgia Power jointly own Plant Scherer Unit No. 3, a steam-electric generating plant, located near Forsyth, Georgia. In accordance with an operating agreement, Georgia Power acts as the Company's agent with respect to the construction, operation, and maintenance of the unit. The Company's pro rata share of expenses related to both plants is included in the corresponding operating expense accounts in the Statements of Income. At December 31, 1993, the Company's percentage ownership and its amount of investment in these jointly owned facilities were as follows: (1) Includes net plant acquisition adjustment. (2) Total megawatt nameplate capacity: Plant Scherer Unit No. 3: 818 Plant Daniel: 1,000 II-161 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL The Company and the other operating affiliates of The Southern Company have contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Certain of these agreements are non-firm and are based on the capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, the capacity revenues from these sales primarily affect profitability. The Company's capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC) by the Southern electric system. In 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end 1994. Capacity and energy sales under these long-term non-firm power sales agreements are made from available power pool capacity, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is currently being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA), and the City of Tallahassee, Florida. Under these agreements, 209 megawatts of net dependable capacity were sold by the Company during 1993, and sales will remain at that approximate level until the expiration of the contracts in 2010, unless reduced by FPC, FP&L and JEA after 1999. Capacity and energy sales to FP&L, the Company's largest single customer, provided revenues of $39.5 million in 1993, $46.2 million in 1992, and $42.1 million in 1991, or 6.8 percent, 8.1 percent, and 7.5 percent of operating revenues, respectively. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, the subsidiaries of The Southern Company entered into a settlement agreement with Gulf States Utilities Company (Gulf States) that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received - less the amounts previously included in income - the Company recorded increases in net income of approximately $0.6 million in 1992 and $12.7 million in 1991. In 1993, the Company sold all of its remaining Gulf States common stock received in the settlement, resulting in a gain of $2.3 million after tax. 8. INCOME TAXES: Effective January 1, 1993, Gulf Power Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $31.3 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $76.9 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-162 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $2.3 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: Gulf Power Company and the other subsidiaries of The Southern Company file a consolidated federal tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-163 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 9. LONG-TERM DEBT: POLLUTION CONTROL OBLIGATIONS Obligations incurred in connection with the sale by public authorities of tax-exempt pollution control revenue bonds are as follows: * Sinking fund requirement applicable to the 6 percent pollution control bonds is $100 thousand for 1994 with increasing increments thereafter through 2005, with the remaining balance due in 2006. With respect to the collateralized pollution control revenue bonds, the Company has authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. OTHER LONG-TERM DEBT Long-term debt also includes $17.5 million for the Company's portion of notes payable issued in connection with the termination of Plant Daniel coal contracts (see Note 5 for information on fuel commitments). The notes bear interest at 8.25 percent with the principal being amortized through 1995. Also included in long-term debt is a 30-month note payable for $25 million which was obtained to refinance higher cost securities. The principal is due in June 1996 and bears interest at 4.69 percent which is payable quarterly beginning March 1994. The estimated annual maturities of the notes payable through 1996 are as follows: $8.4 million in 1994, $9.1 million in 1995, and $25 million in 1996. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirement and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash, reacquiring bonds, or by pledging additional property equal to 1 and 2/3 times the requirement. In 1994, $12 million of 4 5/8 percent First Mortgage Bonds due October 1, 1994 and $15 million of 6 percent First Mortgage Bonds due June 1, 1996 are scheduled to be redeemed. II-164 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 11. COMMON STOCK DIVIDEND RESTRICTIONS: The Company's first mortgage bond indenture contains various common stock dividend restrictions which remain in effect as long as the bonds are outstanding. At December 31, 1993, $101 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the mortgage indenture. The Company's charter limits cash dividends on common stock to 50 percent of net income available for such stock during a prior period if the capitalization ratio is below 20 percent and to 75 percent of such net income if such ratio is 20 percent or more but less than 25 percent. The capitalization ratio is defined as the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend. At December 31, 1993, the ratio was 44.4 percent. 12. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate changes, among other factors. II-165 SELECTED FINANCIAL AND OPERATING DATA Gulf Power Company 1993 Annual Report II-166 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-167 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-168 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-169 STATEMENTS OF INCOME Gulf Power Company II-170 STATEMENTS OF INCOME Gulf Power Company II-171 STATEMENTS OF CASH FLOWS Gulf Power Company II-172 STATEMENTS OF CASH FLOWS Gulf Power Company II-173 BALANCE SHEETS Gulf Power Company II-174 BALANCE SHEETS Gulf Power Company II-175 BALANCE SHEETS Gulf Power Company II-176 BALANCE SHEETS Gulf Power Company II-177 GULF POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK (1) Subject to mandatory redemption of 5% annually on or before February 1. II-178 GULF POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-179 MISSISSIPPI POWER COMPANY FINANCIAL SECTION II-180 MANAGEMENT'S REPORT Mississippi Power Company 1993 Annual Report The management of Mississippi Power Company has prepared--and is responsible for--the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist, however, in any system of internal control, based upon a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting control maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Mississippi Power Company in conformity with generally accepted accounting principles. /s/ David M. Ratcliffe -------------------------------------------------- David M. Ratcliffe President and Chief Executive Officer /s/ Thomas A. Fanning -------------------------------------------------- Thomas A. Fanning Vice President and Chief Financial Officer II-181 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF MISSISSIPPI POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Mississippi Power Company (a Mississippi corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-190 through II-206) referred to above present fairly, in all material respects, the financial position of Mississippi Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, Mississippi Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16 , 1994 II-182 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Mississippi Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Mississippi Power Company's net income after dividends on preferred stock for 1993 totaled $42.4 million, an increase of $5.6 million over the prior year. This improvement is attributable primarily to increased energy sales and retail rate increases. A retail rate increase under the Company's Performance Evaluation Plan (PEP-1A) of $6.4 million annually became effective in July 1993. Under the Environmental Compliance Overview Plan (ECO Plan) retail rates increased by $2.6 million annually effective April 1993. A comparison of 1992 to 1991 - excluding the events occurring in 1991 discussed below - would reflect a 1992 increase in earnings of $4.9 million or 15.5 percent. The Company's financial performance in 1991 reflected the after-tax operating and disposal losses of $11.9 million recorded by the Company's former merchandise subsidiary. These losses were partially offset by a $2.6 million positive impact on earnings from the settlement of the contract dispute with Gulf States Utilities Company (Gulf States). REVENUES The following table summarizes the factors impacting operating revenues for the past three years: *Includes the effect of the retail rate increase approved under the ECO Plan. Retail revenues of $368 million in 1993 increased 9.0 percent over the prior year, compared with an increase of 2.2 percent for 1992 and a decrease of 1.5 percent in 1991. The increase in retail revenues for 1993 was a result of growth in energy sales and customers, the favorable impact of weather, and retail rate increases. Changes in base rates reflect rate changes made under the PEP plans and the ECO Plan as approved by the Mississippi Public Service Commission (MPSC). The increase in revenues for the recovery of fuel costs for 1993 reversed two years of decline. Under the fuel cost recovery provision, recorded fuel revenues are equal to recorded fuel expenses, including the fuel component and the operation and maintenance component of purchased energy. Therefore, changes in recoverable fuel expenses are offset with corresponding changes in fuel revenues and have no effect on net income. II-183 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Included in sales for resale to non-affiliates are revenues from rural electric cooperative associations and municipalities located in southeastern Mississippi. Energy sales to these customers in 1993 increased 9.0 percent over the prior year with the related revenues rising 14.1 percent. The customer demand experienced by these utilities is determined by factors very similar to Mississippi Power's. Sales for resale to non-affiliated non-territorial utilities are primarily under long-term contracts consisting of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Capacity revenues for Mississippi Power increased in 1993 and 1992 due to a change in the allocation of transmission capacity revenues throughout the Southern electric system. Most of the Company's capacity revenues are derived from transmission charges. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. The increase in other operating revenues for 1993 was due to increased rents collected from microwave equipment use and the transmission of non-associated companies' electricity. Below is a breakdown of kilowatt-hour sales for 1993 and the percent change for the last three years: Total retail energy sales in 1993 increased compared to the previous year, due primarily to weather influences and the improvement in the economy. The increase in commercial energy sales also reflects the impact of recently established casinos within the Company's service area. Industrial sales increased in 1992 as a result of new contracts with two large industrial customers. The decrease in energy sales for resale to non-affiliates is predominantly due to reductions in unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale to non-affiliates. Sales for resale to non-affiliates are influenced by those utilities' own customer demand, plant availability, and the cost of their predominant fuels -- oil and natural gas. EXPENSES Total operating expenses for 1993 were higher than the previous year because of higher production expenses, which reflects increased demand, an increase in the federal income tax rate, and higher employee-related costs. (See Note 2 to the financial statements for information regarding employee and retiree benefits.) Additionally, included in other operation expenses are increased costs associated with environmental remediation of a Southern electric system research facility. Expenses in 1992 were lower than 1991, excluding the Gulf States settlement, primarily because of lower production expenses stemming from decreased demand. II-184 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Fuel costs constitute the single largest expense for Mississippi Power. These costs increased in 1993 due to an 11.0 percent increase in generation, which reflects higher demand. Fuel expenses in 1992, compared to 1991, were lower because of less generation and the negotiation of new coal contracts. Generation decreased primarily because of the availability of lower cost generation elsewhere within the Southern electric system. Purchased power consists primarily of energy purchases from the affiliates of the Southern electric system. Purchased power transactions (both sales and purchases) among Mississippi Power and its affiliates will vary from period to period depending on demand and the availability and variable production cost at each generating unit in the Southern electric system. Taxes other than income taxes increased in 1993 because of higher ad valorem taxes, which are property based, and municipal franchise taxes, which are revenue based. The decline in 1992 was attributable to lower franchise taxes. Income tax expense in 1993 increased because of the enactment of a higher corporate income tax rate retroactive to January 1, 1993, coupled with higher earnings. The change in income taxes for 1992 and 1991 reflected the change in operating income. EFFECTS OF INFLATION Mississippi Power is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical costs does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from regulatory matters to growth in energy sales. Expenses are subject to constant review and cost control programs. Among the efforts to control costs are utilizing employees more effectively through a functionalization program for the Southern electric system, redesigning compensation and benefit packages, and re- engineering work processes. Mississippi Power is also maximizing the utility of invested capital and minimizing the need for capital by refinancing, decreasing the average fuel stockpile, raising generating plant availability and efficiency, and curbing the construction budget. Operating revenues will be affected by any changes in rates under the PEP-2, the Company's revised performance based ratemaking plan. The PEP plans have proved to be a stabilizing force on electric rates, with only moderate changes in rates taking place. The ECO Plan, approved by the MPSC in 1992, provides for recovery of costs associated with environmental projects approved by the MPSC, most of which are required to comply with Clean Air Act Amendments of 1990 regulations. The ECO Plan is operated independently of PEP-2. The FERC regulates wholesale rate schedules and power sales contracts that Mississippi Power has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. Also, pending before the FERC is the Company's request for a $3.6 million wholesale rate increase. Further discussion of the PEP plans, the ECO Plan, and proceedings before the FERC is made in Note 3 to the financial statements herein. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in Mississippi Power's service area. However, the Energy II-185 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive of IPPs to build cogeneration plants for a utility's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. Mississippi Power is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. If Mississippi Power does not remain a low-cost producer and provider of quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, which could significantly reduce earnings. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, Mississippi Power adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. In January 1994, Mississippi Power adopted the new rules, with no material effect on the financial statements. On January 1, 1993, Mississippi Power changed its methods of accounting for postretirement benefits other than pensions and income taxes. See Notes 2 and 9 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal changes in Mississippi Power's financial condition during 1993 were gross property additions of $140 million to utility plant, a significant lowering of cost of capital through refinancings, and the resolution of PEP and ratepayer litigation. Funding for gross property additions came primarily from capital contributions from The Southern Company, earnings and other operating cash flows. The Statements of Cash Flows provide additional details. FINANCING ACTIVITY Mississippi Power continued to lower its financing costs in 1993 by issuing new debt and equity securities and retiring high- cost issues. The Company sold $132 million of first mortgage bonds, preferred stock and, through public authorities, pollution control revenue bonds. Retirements, including maturities during 1993, totaled some $101 million of such securities. (See the Statements of Cash Flows for further details.) Composite financing rates for the years 1991 through 1993 as of year-end were as follows: II-186 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report CAPITAL STRUCTURE At year-end 1993, the Company's ratio of common equity to total capitalization was 49.8 percent, compared to 47.3 percent in 1992 and 44.4 percent in 1991. The increase in the ratio in 1993 can be attributed primarily to the receipt of $30 million of capital contributions from The Southern Company. CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $256 million ($96 million in 1994, $62 million in 1995, and $98 million in 1996). The major emphasis within the construction program will be on complying with Clean Air Act regulations, completion of a 78-megawatt combustion turbine, and upgrading existing facilities. The estimates for property additions for the three-year period include $39 million committed to meeting the requirements of Clean Air Act regulations. Revisions may be necessary because of factors such as revised load projections, the availability and cost of capital, and changes in environmental regulations. OTHER CAPITAL REQUIREMENTS In addition to the funds required for the Company's construction program, approximately $51 million will be required by the end of 1996 for present sinking fund requirements and maturities of long-term debt. Mississippi Power plans to continue, when economically feasible, to retire high-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act Amendments of 1990 (Clean Air Act) were signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on Mississippi Power and the other operating companies of The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10 thousand megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing more slowly than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which Mississippi Power's portion is approximately $60 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance for The Southern Company could require total construction expenditures ranging from approximately $450 million to $800 million, II-187 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report of which Mississippi Power's portion is approximately $25 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover The Southern Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. Mississippi Power's ECO Plan is designed to allow recovery of costs of compliance with the Clean Air Act, as well as other environmental statutes and regulations. The MPSC reviews environmental projects and the Company's environmental policy through the ECO Plan. Under the ECO Plan, any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. Mississippi Power's management believes that the ECO Plan will provide for recovery of the Clean Air Act costs. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standard could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provisions of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the II-188 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $70 million of committed credit in revolving credit agreements and also had $21 million of committed short-term credit lines. The $40 million of notes payable outstanding at year end 1993 were apart from the committed credit facilities. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations will be derived from operations, the sale of additional first mortgage bonds, pollution control obligations, and preferred stock, and the receipt of additional capital contributions from The Southern Company. Mississippi Power is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest rate levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-189 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-190 STATEMENTS OF CASH FLOWS For the Years ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-191 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-192 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report II-193 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-194 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-195 NOTES TO FINANCIAL STATEMENTS Mississippi Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Mississippi Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Contracts among the companies--dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power--are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. Mississippi Power is also subject to regulation by the FERC and the Mississippi Public Service Commission (MPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. The 1991 financial statements of the Company included the accounts of Electric City Merchandise Company, Inc. (Electric City), which discontinued operations in 1991. All significant intercompany transactions were eliminated in consolidation. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES Mississippi Power accrues revenues for service rendered but unbilled at the end of each fiscal period. The Company's retail and wholesale rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power. Retail rates also include provisions to adjust billings for fluctuations in costs for ad valorem taxes. Revenues are adjusted for differences between the recoverable fuel and ad valorem expenses and the amounts actually recovered in current rates. DEPRECIATION Depreciation of the original cost of depreciable utility plant in service is provided by using composite straight-line rates which approximated 3.1 percent in 1993 and 3.3 percent in 1992 and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES Mississippi Power provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 to the financial statements for additional information about Statement No. 109. II-196 NOTES (continued) Mississippi Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used to capitalize the cost of funds devoted to construction were 6.8 percent in 1993, 8.2 percent in 1992, and 9.8 percent in 1991. AFUDC (net of income taxes), as a percent of net income after dividends on preferred stock, was 3.5 percent in 1993, 2.7 percent in 1992, and 4.8 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. This cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repair, and replacement of minor items of property is charged to maintenance expense except for the maintenance of coal cars and a portion of the railway track maintenance, which are charged to fuel stock. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair value of investment securities was based on listed closing market prices. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when used or installed. VACATION PAY Mississippi Power's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. Such amounts were $4.8 million and $4.7 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 80 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. II-197 NOTES (continued) Mississippi Power Company 1993 Annual Report PROVISION FOR PROPERTY DAMAGE Due to the significant increase in the cost of traditional insurance, effective in 1993, Mississippi Power became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provided for the cost of storm, fire and other uninsured casualty damage by charges to income of $1.5 million in 1993, 1992, and 1991. The cost of repairing damage resulting from such events that individually exceed $50 thousand is charged to the accumulated provision to the extent it is available. As of December 31, 1993, the accumulated provision amounted to $10.5 million. Regulatory treatment by the MPSC allows a maximum accumulated provision of $10.9 million. DISCONTINUED OPERATIONS Electric City began operating as a subsidiary of Mississippi Power in October 1987 and was formally dissolved as of December 31, 1991. Under an agreement reached in October 1991, a portion of Electric City's assets, including inventory and fixed assets, was sold to a concern independent of Mississippi Power. The remaining assets and liabilities, which were not material, were transferred to the Company. The impact of Electric City on Mississippi Power's consolidated earnings in 1991 consisted of (a) a pretax operating loss of $10.2 million ($6.4 million after income taxes) and (b) the pretax loss of $8.7 million ($5.5 million after income taxes) resulting from the disposal of Electric City. 2. RETIREMENT BENEFITS: PENSION PLAN Mississippi Power has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS Mississippi Power also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, Mississippi Power recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the Company in 1992 and 1991 were $3.6 million and $3.0 million, respectively. II-198 NOTES (continued) Mississippi Power Company 1993 Annual Report STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $6.4 million and the aggregate of the service and interest cost components of the net retiree medical cost by $722 thousand. Components of the plans' net cost are shown below: II-199 NOTES (continued) Mississippi Power Company 1993 Annual Report Of the above net pension amounts recorded, ($170 thousand) in 1993, $269 thousand in 1992, and $576 thousand in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $3.9 million was charged to operating expense and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS: RETAIL RATE ADJUSTMENT PLANS Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986. During 1993, all matters related to the original PEP case were finally resolved when the Supreme Court of Mississippi granted a joint motion to dismiss pending appeals. Also in 1993, the MPSC ordered Mississippi Power to review and propose changes to the plan that would reduce the impact of rate changes on the customer and provide incentives for Mississippi Power to keep customer prices low. In response, Mississippi Power filed a revised plan and, on January 4, 1994, the MPSC approved PEP-2. The revised plan includes a mechanism for sharing rate adjustments based on the Company's ability to maintain low rates for customers and on the Company's performance as measured by three performance indicators that emphasize those factors which most directly impact the customers. PEP-2 provides for semiannual evaluations of Mississippi's performance-based return on investment, rather than on common equity as previously calculated. As in previous plans, any change in rates is limited to 2 percent of retail revenues per evaluation period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. ENVIRONMENTAL COMPLIANCE OVERVIEW PLAN The MPSC approved Mississippi Power's ECO Plan in 1992. The plan establishes procedures to facilitate the MPSC's overview of the Company's environmental strategy and provides for recovery of costs associated with environmental projects approved by the MPSC. Under the ECO Plan any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. The ECO Plan resulted in an annual retail rate increase of $2.6 million effective April 1993. FERC REVIEWS EQUITY RETURNS AND OTHER REGULATORY MATTERS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts, including the Company's Transmission Facilities Agreement (TFA) discussed in Note 8 under "Lease Agreements." Any changes in rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, an administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on Mississippi Power's financial statements. In 1988, the Company and its operating affiliates filed with the FERC a contract governing the pricing and other aspects of power transactions among the companies. In 1989, the FERC ordered hearings on the contract and made revenues collected under the contract subject to refund. In 1992, the II-200 NOTES (continued) Mississippi Power Company 1993 Annual Report FERC ruled that certain production costs under the contract had not been properly classified and ordered that the contract be revised and that refunds be made. Under reconsideration, the FERC determined that refunds were not necessary and ordered that its mandated changes in computing certain expenses under the system interchange contract become effective in August 1993. The changes mandated by the FERC will not materially affect the Company's net income. WHOLESALE RATE FILING On September 1, 1993, Mississippi Power filed a $3.6 million wholesale rate increase request with the FERC. Prior to this filing, the Company conferred and negotiated a settlement with all of its wholesale all requirements customers, who have executed a Settlement Agreement and Certificates of Concurrence to be included in this filing with the FERC. The Company is awaiting a response from the FERC. RETAIL RATEPAYERS' SUITS CONCLUDED In 1989, three retail ratepayers of the Company filed a civil complaint in the U.S. District Court for the Southern District of Mississippi against Mississippi Power and other parties. The complaint alleged that Mississippi Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated to be at least $10 million, plus treble and punitive damages, on behalf of all retail ratepayers of the Company for alleged violations of the federal Racketeer Influenced and Corrupt Organizations Act, federal and state antitrust laws, other federal and state statutes, and common law fraud. Mississippi Power also was named as a defendant, together with other parties in a similar civil action filed in the U.S. District Court for the Northern District of Florida. The defendants' motions for dismissal were granted by the courts, resolving these suits. 4. CONSTRUCTION PROGRAM: Mississippi Power is engaged in continuous construction programs, the costs of which are currently estimated to total some $96 million in 1994, $62 million in 1995, and $98 million in 1996. These estimates include AFUDC of $1.6 million in 1994, $1.6 million in 1995, and $2.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the construction of a combustion turbine generation unit of 78 megawatts was completed in February 1994. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act and other environmental matters. 5. FINANCING AND COMMITMENTS: FINANCING Mississippi Power's construction program is expected to be financed from internal and other sources, such as the issuance of additional long-term debt and preferred stock and the receipt of capital contributions from The Southern Company. The amounts of first mortgage bonds and preferred stock which can be issued in the future will be contingent upon market conditions, adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis under "Sources of Capital" for information regarding the Company's coverage requirements. At December 31, 1993, Mississippi Power had committed credit agreements (360 day committed lines) with banks for $21 million. Additionally, Mississippi Power had $70 million of unused committed credit agreements in the form of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. As of December 31, 1993, Mississippi Power had $40 million in short-term bank borrowings all of which were made apart from committed credit arrangements. II-201 NOTES (continued) Mississippi Power Company 1993 Annual Report ASSETS SUBJECT TO LIEN Mississippi Power's mortgage indenture dated as of September 1, 1941, as amended and supplemented, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, Mississippi Power has entered into various long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum production levels, and other financial commitments. Total estimated obligations were approximately $243 million at December 31, 1993. Additional commitments for fuel will be required in the future to supply the Company's fuel needs. In order to take advantage of lower cost coal supplies, agreements were reached in December 1986 to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Mississippi Power and Gulf Power, an operating affiliate. The Company's portion of this payment was about $60 million. In accordance with the ratemaking treatment, the cost to terminate the contracts is being amortized through 1995 to match costs with savings achieved. The remaining unamortized amount of Mississippi Power's share of principal payments to the suppliers including the current portion totaled $18 million at December 31, 1993. 6. JOINT OWNERSHIP AGREEMENTS: Mississippi Power and Alabama Power own as tenants in common Greene County Electric Generating Plant (coal) located in Alabama; and Mississippi Power and Gulf Power own as tenants in common Daniel Electric Generating Plant (coal) located in Mississippi. At December 31, 1993, Mississippi Power's percentage ownership and investment in these jointly owned facilities were as follows: Mississippi Power's share of plant operating expenses is included in the corresponding operating expenses in the Statements of Income. 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL Mississippi Power and the other operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Some of these agreements (unit power sales) are firm commitments and pertain to capacity related to specific generating units. Mississippi Power's participation in firm production capacity unit power sales ended in January 1989. However, the Company continues to participate in transmission and energy sales under the unit power sales agreements. The other agreements (other long-term sales) are non-firm commitments and are based on capacity of the system in general. Because the energy is generally sold at variable costs under these agreements, only revenues from capacity sales affect profitability. Off-system capacity revenues for the Company have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 by the Southern electric system to Florida Power Corporation. In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-202 NOTES (continued) Mississippi Power Company 1993 Annual Report GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts previously included in income -- Mississippi Power recorded an increase in net income of approximately $2.6 million in 1991. 8. LEASE AGREEMENTS: In 1984, Mississippi Power and Gulf States entered into a forty-year transmission facilities agreement whereby Gulf States began paying a use fee to the Company covering all expenses relative to ownership and operation and maintenance of a 500 kV line, including amortization of its original $57 million cost. In 1993, 1992, and 1991 the use fees collected under the agreement, net of related expenses, amounted to $3.9 million, $3.9 million and $4.0 million, respectively, and are included with other income, net, in the Statements of Income. For other information see Note 3 under "FERC Reviews Equity Returns and Other Regulatory Matters." In 1989, Mississippi Power entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Gulf Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million for 1992 and $1.3 million for 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and in 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option after three years to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, Mississippi Power has the option to renew the lease. 9. INCOME TAXES: Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $48 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-203 NOTES (continued) Mississippi Power Company 1993 Annual Report Details of the federal and state income tax provisions are shown below: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: In 1989, under order of the MPSC, Mississippi Power began amortizing deferred income taxes not covered by the Internal Revenue Service normalization requirements, that had been recorded at rates higher than those specified by the current statutory income tax rules. This amortization occurred over a 60-month period, the effect of which was a reduction of income tax expense of approximately $2.7 million per year. At December 31, 1993, this tax rate differential was fully amortized. Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $1.5 million in 1993, $1.4 million in 1992 and $1.5 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. II-204 NOTES (continued) Mississippi Power Company 1993 Annual Report The total provision for income taxes as a percentage of pre-tax income and the differences between those effective rates and the statutory federal tax rates were as follows: Mississippi Power and its affiliates file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. OTHER LONG-TERM DEBT: Details of other long-term debt are as follows: Pollution control obligations represent installment or lease purchases of pollution control facilities financed by application of funds derived from sales by public authorities of tax-exempt revenue bonds. Mississippi Power has authenticated and delivered to the Trustee a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under these agreements. The 5.8% Series of pollution control obligations has a cash sinking fund requirement of $10 thousand annually through 1997 and $20 thousand in 1998. At December 31, 1993, under "Other Property and Investments" approximately $6 million related to the 6.20% Series of Pollution Control Obligations remains available for completion of certain solid waste disposal facilities. The 8.25 percent notes payable relate to the termination of two coal contracts. See Note 5 under "Fuel Commitments" for information on these coal contracts. The annual estimated maturities of total notes payable are $8.8 million in 1994 and $10.8 million in 1995. II-205 NOTES (continued) Mississippi Power Company 1993 Annual Report 11. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement fund requirement is one percent of each outstanding series authenticated under the indenture of Mississippi Power prior to January 1 of each year, other than first mortgage bonds issued as collateral security for certain pollution control obligations. The requirement must be satisfied by June 1 of each year by depositing cash or reacquiring bonds, or by pledging additional property equal to 166-2/3 percent of such requirement. 12. COMMON STOCK DIVIDEND RESTRICTIONS: Mississippi Power's first mortgage bond indenture and the Articles of Incorporation contain various common stock dividend restrictions. At December 31, 1993, $86 million of retained earnings was restricted against the payment of cash dividends on common stock under the most restrictive terms of the mortgage indenture or Articles of Incorporation. 13. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: Mississippi Power's business is influenced by seasonal weather conditions and the timing of rate changes. II-206 SELECTED FINANCIAL AND OPERATING DATA Mississippi Power Company 1993 Annual Report II-207 II-208 II-209 II-210 STATEMENTS OF INCOME Mississippi Power Company II-211 STATEMENTS OF INCOME Mississippi Power Company II-212 STATEMENTS OF CASH FLOWS Mississippi Power Company II-213 STATEMENTS OF CASH FLOWS Mississippi Power Company II-214 BALANCE SHEETS Mississippi Power Company II-215 BALANCE SHEETS Mississippi Power Company II-216 BALANCE SHEETS Mississippi Power Company II-217 BALANCE SHEETS Mississippi Power Company II-218 MISSISSIPPI POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-219 MISSISSIPPI POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-220 SAVANNAH ELECTRIC AND POWER COMPANY FINANCIAL SECTION II-221 MANAGEMENT'S REPORT Savannah Electric and Power Company 1993 Annual Report The management of Savannah Electric and Power Company has prepared -- and is responsible for -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Savannah Electric and Power Company in conformity with generally accepted accounting principles. /s/ Arthur M. Gignilliat, Jr. /s/ K. R. Willis - -------------------------------- ------------------------------------- Arthur M. Gignilliat, Jr. K. R. Willis President Vice-President and Chief Executive Officer Treasurer and Chief Financial Officer II-222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF SAVANNAH ELECTRIC AND POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Savannah Electric and Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-231 through II-244) referred to above present fairly, in all material respects, the financial position of Savannah Electric and Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia, February 16, 1994 II-223 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Savannah Electric and Power Company 1993 Annual Report RESULTS OF OPERATIONS Earnings Savannah Electric and Power Company's net income after dividends on preferred stock for 1993 totaled $21.5 million, representing a $1.0 million (4.6 percent) increase from the prior year. The revenue impact of an increase in retail energy sales due to exceptionally hot summer weather was partially offset by the implementation of a work force reduction program which resulted in a one-time charge to operating expenses of approximately $4.5 million. In 1992, earnings were $20.5 million, representing a $3.5 million (14.6 percent) decrease from the prior year. This decrease resulted primarily from increases in maintenance and administrative and general expenses, partially offset by a 4.6 percent increase in retail operating revenues. Operating revenues increased despite the negative impact of a $2.8 million annual reduction in retail base rates effective in June 1992, and mild weather. REVENUES Total revenues for 1993 were $218.4 million, reflecting a 10.5 percent increase over 1992, primarily due to an increase in retail energy sales. The following table summarizes the factors impacting operating revenues compared to the prior year for the 1991-1993 period: Total retail revenues increased 11.5 percent in 1993, compared to a 4.6 percent increase in 1992. The increase in 1993 retail revenues attributable to growth in both retail customers and average use per customer was enhanced by exceptionally hot weather during the summer. The substantial increase in fuel cost recovery and other revenues reflects increases in net generation and the unit cost of purchased power. The increase in 1992 retail revenues resulted from growth in both retail customers and average use per customer, but was substantially offset by mild weather and the June 1992 base rate reduction. II-224 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Under the Company's fuel cost recovery provisions, fuel revenues equal fuel expense, including the fuel and capacity components of purchased energy, and have no effect on earnings. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Sales to affiliated companies within the Southern electric system vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have little impact on earnings. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The increases in energy sales in 1993 and 1992 continue to reflect a growing customer base, an increase in average energy sales per customer, and improved economic conditions in the Company's service area. Sales were enhanced in 1993 by temperature extremes in the summer months and in December. EXPENSES Total operating expenses for 1993 increased $20.3 million (12.4 percent) over the prior year. This increase includes a $10.8 million increase in fuel expense, and an $8.7 million increase in other operation expenses. Fuel expenses increased primarily because of higher generation due to extremely hot weather and higher cost fuel sources. In 1992 an increase in purchased power reflected a 15.4 percent decrease in generation compared to 1991. Despite the decrease in generation, total 1992 fuel expenses were substantially unchanged from the prior year reflecting generation from higher cost fuel sources. The increase in other operation expenses reflects a $4.5 million cost associated with a one-time charge related to a work force reduction program. The Company also recognized higher employee benefits costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information on these new rules. In 1992, the increase in other operation expenses was primarily a result of increases in outside services and administrative and general expenses, which reflected higher employee training and benefits expenses. Total interest expense on long-term debt was reduced by 5.4 percent in 1992, as the Company refinanced higher-cost debt. II-225 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The mix of energy supply is determined primarily by system load, the unit cost of fuel consumed and the availability of units. The amount and sources of energy supply and the average cost of fuel per net kilowatt-hour generated and purchased power were as follows: EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will depend upon growth in energy sales, which is subject to a number of factors. Traditionally, these factors included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network to sell electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. The Company is preparing now to meet the challenge of these major changes in the traditional business practices of selling electricity. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been initiated by the Company and are a significant part of integrated resource planning. Customers can receive cash incentives for participating in these programs in addition to reducing their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the Company. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects, in conjunction with the precertification approval process for such projects by the Georgia Public Service Commission (GPSC), will II-226 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report diminish the possible exposure to prudency disallowances and the resulting impact on earnings. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." Rates to retail customers served by the Company are regulated by the GPSC. In May 1992, the Company requested, and subsequently received, approval by the GPSC to reduce annual base revenues by $2.8 million, effective June 1992. The reduction includes a base rate reduction of approximately $2.5 million spread among all classes of retail customers. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers. As part of this rate settlement, it was informally agreed that the Company's earned rate of return on common equity should be 12.95 percent. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be implemented by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115, supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules January 1, 1994, with no material effect on the financial statements. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 7 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal change in the Company's financial condition in 1993 was additions of $73 million to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. See Statements of Cash Flows for additional information. CAPITAL STRUCTURE As of December 31, 1993, the Company's capital structure consisted of 45.3 percent common equity, 10.3 percent preferred stock and 44.4 percent long-term debt, excluding amounts due within one year. The Company's long-term financial objective for capitalization ratios is to maintain a capital structure of common equity at 45 percent, preferred stock at 10 percent and debt at 45 percent. Maturities and retirements of long-term debt were $4 million in 1993, $53 million in 1992 and $23 million in 1991. In November 1993, the Company issued 1,400,000 shares of 6.64 percent series preferred stock. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent series preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. The composite interest rates for the years 1991 through 1993 as of year-end were as follows: II-227 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The Company's current securities ratings are as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $98 million ($33 million in 1994, $32 million in 1995, and $33 million in 1996). Actual construction costs may vary from this estimate because of such factors as changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment and materials; and the cost of capital. The largest project during this period is the addition of two 80 megawatt combustion turbine units, to be placed into service in 1994. The estimated cost of this project is $61 million. The Company is also constructing six combustion turbine units for Georgia Power Company. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $5.9 million will be needed by the end of 1996 for present sinking fund requirements and maturities. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the new law -- will have a significant impact on the Company and other subsidiaries of the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this would require some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the Company's portion is approximately $2 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I and increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 through 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million of which the Company's portion is expected to be approximately $25 million. However, the full impact of II-228 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 5 percent in annual revenue requirements from customers could be necessary to fully recover the Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any - -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matters, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes--coal ash and other utility wastes--as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Savannah Electric and Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and will recognize in the financial statements any costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act, the Comprehensive Environmental Response, Compensation, and Liability Act, and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $3.9 million of cash and $14.5 million of unused credit arrangements with banks to meet its short-term cash needs. The Company had $3 million of short-term bank borrowings at December 31, 1993. In January 1994, the Company renegotiated a two-year revolving credit arrangement with four of its II-229 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report existing banks for a total credit line of $20 million. The primary purpose of this additional credit is to provide interim funding for the Company's combustion turbine construction program. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations and the sale of additional first mortgage bonds and preferred stock and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-230 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-231 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-232 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-233 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-234 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-235 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-236 NOTES TO FINANCIAL STATEMENTS Savannah Electric and Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Savannah Electric and Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company also is subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the GPSC. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The Company's electric rates include provisions to adjust billings for fluctuations in capacity and the energy components of purchased power costs. Revenues include the actual cost of fuel and purchased power incurred. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 2.9 percent in 1993 and 3.2 percent in 1992, and 1991. The decrease in 1993 reflects the Company's implementation of new depreciation rates approved by the GPSC. These new rates provide for a timely recovery of the investments in the Company's depreciable properties. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company, which is included in the consolidated federal income tax return filed by The Southern Company, provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 7 for additional information about Statement No. 109. II-237 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the Company to calculate AFUDC were 8.77 percent in 1993, 11.27 percent in 1992, and 11.38 percent in 1991. UTILITY PLANT Utility plant is stated at original cost, which includes materials, labor, minor items of property, appropriate administrative and general costs, payroll-related costs such as taxes, pensions and other benefits and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, items for which the carrying amount does not approximate fair value must be disclosed. At December 31, 1993, the fair value of long-term debt was $164 million and the carrying amount was $154 million. The fair value of long-term debt was $117 million and the carrying amount was $109 million at December 31, 1992. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. 2. RETIREMENT BENEFITS PENSION PLANS The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits under this plan reflect the employee's years of service, age at retirement and average compensation for the three years immediately preceding retirement. The Company uses the projected unit credit actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and debt securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-238 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Consistent with regulatory treatment, the Company recognized these costs on a cash basis as payments were made in 1992 and 1991. The total costs of such benefits recognized by the Company amounted to $375 thousand in 1992 and $487 thousand in 1991. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statements Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown for 1993 only because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: In accordance with Statement No. 87, an additional liability related to under-funded accumulated benefit obligations was recognized at December 31, 1993. A corresponding net-of-tax charge of $2.1 million was recognized as a separate component of Common Stock Equity in the Statements of Capitalization. The assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $1.7 million and the aggregate of the service and interest cost components of the net retiree medical cost by $0.2 million. II-239 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Components of the plans' net costs are shown below: Of the above net pension amounts, $2.0 million in 1993, $1.7 million in 1992 and $1.5 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Net postretirement medical and life insurance costs of $1.8 million in 1993 were charged to operating expenses. The Company has a supplemental retirement plan for certain executive employees. The plan is unfunded and payable from the general funds of the Company. The Company has purchased life insurance on participating executives, and plans to use these policies to satisfy this obligation. Benefit costs associated with this plan for 1993, 1992 and 1991 were $980 thousand, $316 thousand and $338 thousand, respectively. The 1993 benefit costs reflect a one-time expense related to employees who were part of the work force reduction program. WORK FORCE REDUCTION PROGRAM The Company has incurred additional costs for a one-time charge related to the implementation of a work force reduction program. In 1993, $4.5 million was charged to operating expenses and $0.6 million was charged to other income (expense). 3. REGULATORY MATTERS RATE MATTERS In May 1992, the Company filed for, and subsequently received, GPSC approval to implement new base rates designed to decrease base operating revenues by $2.8 million annually. The reduction included a base rate reduction of approximately $2.5 million spread among all classes of customers, effective June 1992. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers in August 1992. 4. CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program, currently estimated to total $33 million in 1994, $32 million in 1995 and $33 million in 1996. The estimates include AFUDC of $1.6 million in 1994, $0.6 million in 1995 and $0.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include: changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing cost of labor, equipment and materials; and cost of capital. The construction of two combustion turbine peaking units totaling 160 megawatts is planned to be completed in mid 1994. The Company is also constructing six combustion turbine peaking units owned by Georgia Power Company. The construction is to be completed in 1996. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. II-240 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 5. FINANCING AND COMMITMENTS GENERAL To the extent possible, the Company's construction program is expected to be financed from internal sources and from the issuance of additional long-term debt and preferred stock and capital contributions from The Southern Company. Should the Company be unable to obtain funds from these sources, the Company would have to use short-term indebtedness or other alternative, and possibly costlier, means of financing. The amounts of long-term debt and preferred stock that can be issued in the future will be contingent on market conditions, the maintenance of adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis for information regarding the Company's earnings coverage requirements. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with four banks totaled $14.5 million, and expire at various times during 1994. The Company has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitments fees based on the unused portions of the commitments. In connection with all other lines of credit, the Company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the Company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. ASSETS SUBJECT TO LIEN As amended and supplemented, the Company's Indenture of Mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. OPERATING LEASES The Company has rental agreements with various terms and expiration dates. Rental expenses totaled $1.5 million, $1.5 million, and $1.4 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated future minimum lease payments for non-cancelable operating leases were as follows: 6. LONG-TERM POWER SALES AGREEMENTS The operating subsidiaries of The Southern Company, including the Company, have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to the capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The Company's portion of capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-241 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $26 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $0.7 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the effective income tax rate to the statutory tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-242 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 8. CUMULATIVE PREFERRED STOCK In November 1993, the Company issued 1,400,000 shares of 6.64 percent Series Preferred stock which has redemption provisions of $26.66 per share plus accrued dividends if on or prior to November 1, 1998, and at $25 per share plus accrued dividends thereafter. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent Series Preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. Cumulative preferred stock dividends are preferential to the payment of dividends on common stock. 9. LONG-TERM DEBT The Company's Indenture related to its First Mortgage Bonds is unlimited as to the authorized amount of bonds which may be issued, provided that required property additions, earnings and other provisions of such Indenture are met. On February 19, 1993, the Company refunded its $4.1 million, 6.25 percent Series Pollution Control Bonds, due 1998 with $4.1 million of variable rate Series Pollution Control Bonds due 2016. In 1994, there is a first mortgage bond maturity of $3.7 million. The sinking fund requirements of first mortgage bonds are being satisfied by certification of property additions. See Note 10 "Long-Term Debt Due Within One Year" for details. Details of other long-term debt are as follows: Sinking fund requirements and /or maturities through 1998 applicable to long-term debt are as follows: $4.5 million in 1994; $0.7 million in 1995; $0.7 million in 1996; $0.1 million in 1997 and no requirement is needed for 1998. Assets acquired under capital leases are recorded as utility plant in service and the related obligation is classified as other long-term debt. Leases are capitalized at the net present value of the future lease payments. However, for ratemaking purposes, these obligations are treated as operating leases, and as such, lease payments are charged to expense as incurred. The Company leases combustion turbine generating equipment under a non-cancelable lease expiring in 1995, with renewal options extending until 2010. The Company also leases a portion of its transportation fleet. Under the terms of these leases, the Company is responsible for taxes, insurance and other expenses. II-243 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund/sinking fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 1 2/3 times the requirements. 11. COMMON STOCK DIVIDEND RESTRICTIONS The Company's Charter and Indentures contain certain limitations on the payment of cash dividends on the preferred and common stocks. At December 31, 1993, approximately $55 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the Mortgage Indenture. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows (in thousands): The Company's business is influenced by seasonal weather conditions, a seasonal rate structure and the timing of rate changes, among other factors. II-244 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report Note: NR = Not Rated II-245 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report II-246 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-247 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-248 STATEMENTS OF INCOME Savannah Electric and Power Company * Tax-free common stock/bond exchange II-249 STATEMENTS OF INCOME Savannah Electric and Power Company II-250 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-251 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-252 BALANCE SHEETS Savannah Electric and Power Company II-253 BALANCE SHEETS Savannah Electric and Power Company II-254 BALANCE SHEETS Savannah Electric and Power Company II-255 BALANCE SHEETS Savannah Electric and Power Company II-256 SAVANNAH ELECTRIC AND POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-257 SAVANNAH ELECTRIC AND POWER COMPANY SECURITIES RETIRED DURING 1993 POLLUTION CONTROL BONDS II-258 PART III Items 10, 11, 12 and 13 for SOUTHERN are incorporated by reference to ELECTION OF DIRECTORS in SOUTHERN's definitive Proxy Statement relating to the 1994 annual meeting of stockholders. Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS ALABAMA (a) (1) Identification of directors of ALABAMA. ELMER B. HARRIS (1) President and Chief Executive Officer of ALABAMA Age 54 Served as Director since 3-1-89. BILL M. GUTHRIE Executive Vice President of ALABAMA Age 60 Served as Director since 12-16-88 EDWARD L. ADDISON (2) Age 63 Served as Director since 11-1-83 WHIT ARMSTRONG (2) Age 46 Served as Director since 9-24-82 PHILIP E. AUSTIN (2) Age 52 Served as Director since 1-25-91 MARGARET A. CARPENTER (2) Age 69 Served as Director since 2-26-93 PETER V. GREGERSON, SR. (2) Age 65 Served as Director since 10-22-93 CRAWFORD T. JOHNSON, III (2) Age 68 Served as Director since 4-18-69 CARL E. JONES, JR. (2) Age 53 Served as Director since 4-22-88 WALLACE D. MALONE, JR. (2) Age 57 Served as Director since 6-22-90 WILLIAM V. MUSE (2) Age 54 Served as Director since 2-26-93 JOHN T. PORTER (2) Age 62 Served as Director since 10-22-93 GERALD H. POWELL (2) Age 67 Served as Director since 2-28-86 ROBERT D. POWERS (2) Age 43 Served as Director since 1-24-92 JOHN W. ROUSE (2) Age 56 Served as Director since 4-22-88 WILLIAM J. RUSHTON, III (2) Age 64 Served as Director Since 9-18-70 JAMES H. SANFORD (2) Age 49 Served as Director since 8-1-83 JOHN C. WEBB, IV (2) Age 51 Served as Director since 4-22-77 LOUIS J. WILLIE (2) Age 70 Served as Director since 3-23-84 JOHN W. WOODS (2) Age 62 Served as Director since 4-20-73 (1) Previously served as Director of ALABAMA from 1980 to 1985. (2) No position other than Director. Each of the above is currently a director of ALABAMA, serving a term running from the last annual meeting of ALABAMA's stockholder (April 23, 1993) for III-1 meeting of ALABAMA's stockholder (April 23, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for the individuals elected in October 1993. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of ALABAMA acting solely in their capacities as such. (b)(1) Identification of executive officers of ALABAMA. ELMER B. HARRIS (1) President, Chief Executive Officer and Director Age 54 Served as Executive Officer since 3-1-89 BANKS H. FARRIS Senior Vice President Age 59 Served as Executive Officer since 12-3-91 WILLIAM B. HUTCHINS, III Senior Vice President and Chief Financial Officer Age 50 Served as Executive Officer since 12-3-91 T. HAROLD JONES Senior Vice President Age 63 Served as Executive Officer since 12-1-91 CHARLES D. MCCRARY Senior Vice President Age 42 Served as Executive Officer since 1-1-91 (1) Previously served as executive officer of ALABAMA from 1979 to 1985. Each of the above is currently an executive officer of ALABAMA, serving a term running from the last annual meeting of the directors (April 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of ALABAMA acting solely in their capacities as such. (c)(1) Identification of certain significant employees. None. (d)(1) Family relationships. None. (e)(1) Business experience. ELMER B. HARRIS - Elected in 1989; Chief Executive Officer. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. Director of SOUTHERN and AmSouth Bancorporation. BILL M. GUTHRIE - Elected in 1988; also served since 1991 as Chief Production Officer of SOUTHERN system and Executive Vice President and Chief Production Officer of SCS; Vice President of SOUTHERN, GULF, MISSISSIPPI and SAVANNAH and Executive Vice President of GEORGIA. Responsible primarily for providing overall management of materials management, fuel services, operating and planning services, fossil, hydro and bulk power operations of the Southern electric system. EDWARD L. ADDISON - Elected in 1983; President of SOUTHERN from 1983 until elected Chairman of the Board in 1994. Director of SOUTHERN, GEORGIA, Phelps Dodge Corporation, Protective Life Corporation, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia and CSX Corporation. WHIT ARMSTRONG - President, Chairman and Chief Executive Officer of The Citizens Bank, Enterprise, Alabama. Also, President and Chairman of the Board of Enterprise Capital Corporation, Inc. PHILIP E. AUSTIN - Chancellor, The University of Alabama System. Previously President and Chancellor of Colorado State University. MARGARET A. CARPENTER - President, Compos-it, Inc. (typographics), Montgomery, Alabama. PETER V. GREGERSON, SR. - Chairman Emeritus of Gregerson's Foods, Inc. (retail groceries), Gadsden, Alabama. Director of AmSouth Bank of Gadsden, Alabama. III-2 CRAWFORD T. JOHNSON, III - Chairman of Coca-Cola Bottling Company United, Inc., Birmingham, Alabama. Director of Protective Life Corporation, AmSouth Bancorporation and Russell Corporation. CARL E. JONES, JR. - Chairman and Chief Executive Officer of First Alabama Bank, Mobile, Alabama. WALLACE D. MALONE, JR. - Chairman and Chief Executive Officer of SouthTrust Corporation, bank holding company, Birmingham, Alabama. WILLIAM V. MUSE - President and Chief Executive Officer of Auburn University. He previously served as President of the University of Akron from 1984 to 1992. JOHN T. PORTER - Pastor of Sixth Avenue Baptist Church, Birmingham, Alabama. Director of Citizen Federal Bank. GERALD H. POWELL - President, Dixie Clay Company of Alabama, Inc. (refractory clay producer), Jacksonville, Alabama. ROBERT D. POWERS - President, The Eufaula Agency, Inc. (real estate and insurance), Eufaula, Alabama. JOHN W. ROUSE - President and Chief Executive Officer of Southern Research Institute (non-profit research institute), Birmingham, Alabama. Director of Protective Life Corporation. WILLIAM J. RUSHTON, III - Chairman of the Board, Protective Life Corporation (insurance holding company), Birmingham, Alabama. Director of SOUTHERN and AmSouth Bancorporation. JAMES H. SANFORD - President, HOME Place Farms Inc. (diversified farmers and ginners), Prattville, Alabama. JOHN C. WEBB, IV - President, Webb Lumber Company, Inc. (wholesale lumber), Demopolis, Alabama. LOUIS J. WILLIE - Chairman of the Board and President of Booker T. Washington Insurance Co. Director of SOUTHERN. JOHN W. WOODS - Chairman and Chief Executive Officer, AmSouth Bancorporation (multi-bank holding company), Birmingham, Alabama. Director of Protective Life Corporation. BANKS H. FARRIS - Elected in 1991; responsible primarily for providing the overall management of the Human Resources, Information Resources, Power Delivery and Marketing Departments and the six geographic divisions. He previously served as Vice President - Human Resources from 1989 to 1991 and Division Vice President from 1985 to 1989. WILLIAM B. HUTCHINS, III - Elected in 1991; Chief Financial Officer, responsible primarily for providing the overall management of accounting and financial planning activities. He previously served as Vice President and Treasurer from 1983 to 1991. T. HAROLD JONES - Elected in 1991; responsible primarily for providing the overall management of the Fossil Generation, Hydro Generation, Power Generation Services and Fuels Departments. He previously served as Vice President - Fossil Generation from 1986 to 1991. CHARLES D. MCCRARY - Elected in 1991; responsible for the External Relations Department, Operating Services and Corporate Services. Also, assumes responsibility for financial matters while Mr. Hutchins is on medical leave. He previously served as Vice President of Administrative Services - Nuclear of SCS from 1988 to 1991. (f)(1) Involvement in certain legal proceedings. None. III-3 GEORGIA (a)(2) Identification of directors of GEORGIA. H. ALLEN FRANKLIN President and Chief Executive Officer. Age 49 Served as Director since 1-1-94. WARREN Y. JOBE Executive Vice President, Treasurer and Chief Financial Officer. Age 53 Served as Director since 8-1-82 EDWARD L. ADDISON (1) Age 63 Served as Director since 11-1-83 BENNETT A. BROWN (1) Age 64 Served as Director since 5-15-80 WILLIAM P. COPENHAVER (1) Age 69 Served as Director since 6-18-86 A. W. DAHLBERG (1) Age 53 Served as Director since 6-1-88 WILLIAM A. FICKLING, JR. (1) Age 61 Served as Director since 4-18-73 L. G. HARDMAN, III (1) Age 54 Served as Director since 6-25-79 JAMES R. LIENTZ, JR. (1) Age 50 Served as Director since 7-1-93 WILLIAM A. PARKER, JR. (1) Age 66 Served as Director since 5-19-65 G. JOSEPH PRENDERGAST (1) Age 48 Served as Director since 1-20-93 HERMAN J. RUSSELL (1) AGE 63 Served as Director since 5-18-88 GLORIA M. SHATTO (1) Age 62 Served as Director since 2-20-80 ROBERT STRICKLAND (1) Age 66 Served as Director since 11-21-79 WILLIAM JERRY VEREEN (1) Age 53 Served as Director since 5-18-88 THOMAS R. WILLIAMS (1) Age 65 Served as Director since 3-17-82 (1) No position other than Director. Each of the above is currently a director of GEORGIA, serving a term running from the last annual meeting of GEORGIA's stockholder (May 19, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except Messrs. Franklin and Lientz. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GEORGIA acting solely in their capacities as such. (b)(2) Identification of executive officers of GEORGIA. H. ALLEN FRANKLIN President, Chief Executive Officer and Director Age 49 Served as Executive Officer since 1-1-94 WARREN Y. JOBE Executive Vice President, Treasurer, Chief Financial Officer and Director Age 53 Served as Executive Officer since 5-19-82 III-4 DWIGHT H. EVANS Executive Vice President - External Affairs Age 45 Served as Executive Officer since 4-19-89 GENE R. HODGES Executive Vice President - Customer Operations Age 55 Served as Executive Officer since 11-19-86 KERRY E. ADAMS Senior Vice President - Fossil and Hydro Power Age 49 Served as Executive Officer since 5-1-89 WAYNE T. DAHLKE Senior Vice President - Power Delivery Age 53 Served as Executive Officer since 4-19-89 JAMES K. DAVIS Senior Vice President - Corporate Relations Age 53 Served as Executive Officer since 10-1-93 ROBERT H. HAUBEIN Senior Vice President - Administrative Services Age 54 Served as Executive Officer since 2-19-92 GALE E. KLAPPA Senior Vice President - Marketing Age 43 Served as Executive Officer since 2-19-92 FRED D. WILLIAMS Senior Vice President - Bulk Power Markets Age 49 Served as Executive Officer since 11-18-92 Each of the above is currently an executive officer of GEORGIA, serving a term running from the last annual meeting of the directors (May 19,1993) for one year until the next annual meeting or until his successor is elected and qualified, except Messrs. Franklin and Davis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GEORGIA acting solely in their capacities as such. (c)(2) Identification of certain significant employees. None. (d)(2) Family relationships. None. (e)(2) Business experience. H. ALLEN FRANKLIN - President and Chief Executive Officer since January 1994. He previously served as President and Chief Executive Officer of SCS from 1988 through 1993. Director of SOUTHERN and SouthTrust Bank. WARREN Y. JOBE - Executive Vice President and Chief Financial Officer since 1982 and Treasurer since 1992. Responsible for financial and accounting operations and planning, internal auditing, procurement, corporate secretary and treasury operations. EDWARD L. ADDISON - President of SOUTHERN from 1983 until his election as Chairman of Board in 1994. Director of SOUTHERN, ALABAMA, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia, Phelps Dodge Corporation, Protective Life Corporation and CSX Corporation. BENNETT A. BROWN - Retired from serving as Chairman of the Board of NationsBank on December 31, 1992. Previously Chairman of the Board and Chief Executive Officer of C&S/Sovran Corporation. Director of Confederation Life Insurance Company. WILLIAM P. COPENHAVER - Director, Arcadian Fertilizer, L.P. (agricultural and industrial chemicals). Director of SOUTHERN and Georgia Bank & Trust Company. A. W. DAHLBERG - President of SOUTHERN effective in 1994. He previously served as President and Chief Executive Officer of GEORGIA from 1988 through 1993. Director of SOUTHERN, Trust Company Bank, Trust Company of Georgia, Protective Life Corporation and Equifax, Inc. WILLIAM A. FICKLING, JR. - Chairman of the Board, Mulberry Street Investment Company, Macon, Georgia, and Co-chairman of Beech Street Corporation (insurance). III-5 L. G. HARDMAN, III - Chairman of the Board of First National Bank of Commerce, Georgia and Chairman of the Board and Chief Executive Officer of First Commerce Bancorp. Chairman of the Board, President and Treasurer of Harmony Grove Mills, Inc. (real estate investments). Director of SOUTHERN. JAMES R. LIENTZ, JR. - President of NationsBank of Georgia since 1993. He previously served as President and Chief Executive Officer of former Citizens & Southern Bank of South Carolina (now NationsBank) from 1990 to 1993, and from 1987 to 1990, he was head of Corporate Bank Group of NationsBank of Georgia, N.A. WILLIAM A. PARKER, JR. - Chairman of the Board, Cherokee Investment Company, Inc. (private investments), Atlanta, Georgia. Director of SOUTHERN, Genuine Parts Company, Life Insurance Company of Georgia, First Union Real Estate Investment Trust, Atlantic Realty Company, ING North America Insurance Company, Post Properties, Inc. and Haverty Furniture Companies, Inc. G. JOSEPH PRENDERGAST - President and Chief Executive Officer, Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. since 1993. From 1988 to 1993, he served as Executive Vice President of Wachovia Corporation and President of Wachovia Corporate Services, Inc. HERMAN J. RUSSELL - Chairman of the Board and Chief Executive Officer, H. J. Russell & Company (construction), Atlanta, Georgia. Chairman of the Board, Citizens Trust Bank, and Citizens Bancshares Corporation Atlanta, Georgia. Director of Wachovia Corporation. GLORIA M. SHATTO - President, Berry College, Mount Berry, Georgia. Director of SOUTHERN, Becton Dickinson & Company, Kmart Corporation and Texas Instruments, Inc. ROBERT STRICKLAND - Retired Chairman of the Board and Chief Executive Officer of SunTrust Banks, Inc. Director of Georgia US Corporation, Equifax, Inc., Life Insurance Company of Georgia, Oxford Industries, Inc. and The Investment Centre. WILLIAM JERRY VEREEN - President and Chief Executive Officer of Riverside Manufacturing Company (manufacture and sale of uniforms), Moultrie, Georgia. Director of Gerber Garment Technology, Inc. and Textile Clothing Technology Corp. THOMAS R. WILLIAMS - President of The Wales Group, Inc. (investments) Atlanta, Georgia. Director of ConAgra, Inc., BellSouth Corporation, National Life Insurance Company of Vermont, AppleSouth, Inc., and American Software, Inc. DWIGHT H. EVANS - Executive Vice President - External Affairs since 1989. Senior Vice President - Public Affairs from 1988 to 1989. GENE R. HODGES - Executive Vice President - Customer Operations since 1992. Senior Vice President - Region/Land Operations from 1990 to 1992. Senior Vice President - Division Operations from 1986 to 1990. KERRY E. ADAMS - Senior Vice President - Fossil and Hydro Power since 1989. WAYNE T. DAHLKE - Senior Vice President - Power Delivery since February 1992. Senior Vice President - Marketing from 1989 to 1992. JAMES K. DAVIS - Senior Vice President - Corporate Relations since October 1993. Vice President of Corporate Relations from 1988 to 1993. ROBERT H. HAUBEIN - Senior Vice President - Administrative Services since 1992. Vice President - Northern Region from 1990 to 1992. Division Vice President of ALABAMA from 1985 to 1990. GALE E. KLAPPA - Senior Vice President - Marketing since 1992. Vice President - - Public Relations of SCS from 1981 to 1992. FRED D. WILLIAMS - Senior Vice President - Bulk Markets since 1992. Vice President - Bulk Power Markets from 1984 to 1992. (f)(2) Involvement in certain legal proceedings. None. III-6 GULF (a)(3) Identification of directors of GULF. D. L. MCCRARY (1) Chairman of the Board and Chief Executive Officer Age 64 Served as Director since 4-28-83 TRAVIS J. BOWDEN President Age 55 Served as Director since 2-1-94 PAUL J. DENICOLA (2) Age 45 Served as Director since 4-19-91 REED BELL, SR., M.D. (2) Age 67 Served as Director since 1-17-86 FRED C. DONOVAN, SR. (2) Age 53 Served as Director since 1-18-91 W. D. HULL, JR. (2) Age 61 Served as Director since 10-14-83 C. W. RUCKEL (2) Age 66 Served as Director since 4-20-62 J. K. TANNEHILL (2) Age 60 Served as Director since 7-19-85 (1) Retires May 1, 1994. (2) No position other than Director. Each of the above is currently a director of GULF, serving a term running from the last annual meeting of GULF's stockholder (June 29, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for Mr. Bowden. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GULF acting solely in their capacities as such. (b)(3) Identification of executive officers of GULF. D. L. MCCRARY Chairman of the Board and Chief Executive Officer Age 64 Served as Executive Officer since 5-1-83 TRAVIS J. BOWDEN President Age 55 Served as Executive Officer since 2-1-94 F. M. FISHER, JR. Vice President - Employee and External Relations Age 45 Served as Executive Officer since 5-19-89 JOHN E. HODGES, JR. Vice President - Customer Operations Age 50 Served as Executive Officer since 5-19-89 G. EDISON HOLLAND, JR. Vice President and Corporate Counsel Age 41 Served as Executive Officer since 4-25-92 EARL B. PARSONS, JR. Vice President - Power Generation and Transmission Age 55 Served as Executive Officer since 4-14-78 A. E. SCARBROUGH Vice President - Finance Age 57 Served as Executive Officer since 9-21-77 Each of the above is currently an executive officer of GULF, serving a term running from the last annual meeting of the directors (July 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except for Mr. Bowden. III-7 There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GULF acting solely in their capacities as such. (c)(3) Identification of certain significant employees. None. (d)(3) Family relationships. None. (e)(3) Business experience. D. L. MCCRARY - Elected Chairman of the Board effective February 1994. He previously served as President and Chief Executive Officer from 1983 to 1994; responsible primarily for formation of overall corporate policy. TRAVIS J. BOWDEN - Elected President effective February 1994 and, upon Mr. McCrary's retirement May 1994, Chief Executive Officer. He previously served as Executive Vice President of ALABAMA from 1985 to 1994. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 through 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, MISSISSIPPI and SAVANNAH. REED BELL, SR., M.D. - Medical Doctor and since 1989, employee of the State of Florida. He serves as Medical Director of Children's Medical Services, District 1. He previously served as Medical Director of the Escambia County Public Health Unit until July 1992. He also previously maintained a private medical practice and served as Medical Director of Children's Medical Services from 1988 to 1989. FRED C. DONOVAN, SR. - President of Baskerville - Donovan, Inc., Pensacola, Florida, an architectural and engineering firm. Director of Baptist Health Care, Inc. W. D. HULL, JR. - Vice Chairman of the Sun Bank/West Florida, Panama City, Florida. He previously served as President and Chief Executive Officer and Director of the Sun Commercial Bank, Panama City, Florida from 1987 to 1992. C. W. RUCKEL - Chairman of the Board of The Vanguard Bank and Trust Company, Valparaiso, Florida. President and owner of Ruckel Properties, Inc., Valparaiso, Florida. J. K. TANNEHILL - President and Chief Executive Officer of Tannehill International Industries, Lynn Haven, Florida. He previously served as President and Chief Executive Officer of Stock Equipment Company, Chagrin Falls, Ohio, until 1991. Director of Sun Bank/West Florida, Panama City, Florida. F. M. FISHER, JR. - Elected Vice President - Employee and External Relations in 1989. He previously served as General Manager of Central Division from 1988 to 1989. JOHN E. HODGES, JR. - Elected Vice President - Customer Operations in 1989. He previously served as General Manager of Western Division from 1986 to 1989. G. EDISON HOLLAND, JR. - Elected Vice President and Corporate Counsel in 1992; responsible for all legal matters associated with GULF and serves as compliance officer. Also served, since 1982, as a partner in the law firm, Beggs & Lane. EARL B. PARSONS, JR. - Elected Vice President - Power Generation and Transmission in 1989; responsible for generation and transmission of electrical energy. He previously served as Vice President - Electric Operations from 1978 to 1989. A. E. SCARBROUGH - Elected Vice President - Finance in 1980; responsible for all accounting and financial services of GULF. (f)(3) Involvement in certain legal proceedings. None. III-8 MISSISSIPPI (a)(4) Identification of directors of MISSISSIPPI. DAVID M. RATCLIFFE President and Chief Executive Officer Age 45 Served as Director since 4-24-91 PAUL J. DENICOLA (1) Age 45 Served as Director since 5-1-89 EDWIN E. DOWNER (1) Age 62 Served as Director since 4-24-84 ROBERT S. GADDIS (1) Age 62 Served as Director since 1-21-86 WALTER H. HURT, III (1) Age 58 Served as Director since 4-6-82 AUBREY K. LUCAS (1) Age 59 Served as Director since 4-24-84 EARL D. MCLEAN, JR. (1) Age 68 Served as Director since 10-21-78 GERALD J. ST. Pe (1) Age 54 Served as Director since 1-21-86 LEO W. SEAL, JR. (1) Age 69 Served as Director since 4-4-67 N. EUGENE WARR (1) Age 58 Served as Director since 1-21-86 (1) No position other than Director. Each of the above is currently a director of MISSISSIPPI, serving a term running from the last annual meeting of MISSISSIPPI's stockholder (April 6, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he or she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of MISSISSIPPI acting solely in their capacities as such. (b)(4) Identification of executive officers of MISSISSIPPI. DAVID M. RATCLIFFE President, Chief Executive Officer and Director Age 45 Served as Executive Officer since 4-24-91 H. E. BLAKESLEE Vice President - Customer Services and Marketing Age 53 Served as Executive Officer since 1-25-84 THOMAS A. FANNING Vice President and Chief Financial Officer Age 37 Served as Executive Officer since 4-1-92 DON E. MASON Vice President - External Affairs and Corporate Services Age 52 Served as Executive Officer since 7-27-83 Each of the above is currently an executive officer of MISSISSIPPI, serving a term running from the last annual meeting of the directors (April 28, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of MISSISSIPPI acting solely in their capacities as such. (c)(4) Identification of certain significant employees. None. (d)(4) Family relationships. None. (e)(4) Business experience. III-9 DAVID M. RATCLIFFE - President and Chief Executive Officer since 1991. He previously served as Executive Vice President of SCS from 1989 to 1991 and Vice President of SCS from 1985 to 1989. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, SAVANNAH and GULF. EDWIN E. DOWNER - Business consultant specializing in economic analysis, management controls and procedural studies since 1990. President and Chief Executive Officer, Unifirst Bank for Savings, F.A., Midland Division, Meridian, Mississippi from 1985 to 1990. ROBERT S. GADDIS - President of the Trustmark National Bank - Laurel, Mississippi. WALTER H. HURT, III - President and Director of NPC Inc. (Investments). Vicar, All Saints Church, Inverness, Mississippi, and St. Thomas Church, Belzoni, Mississippi. Retired newspaper editor and publisher. AUBREY K. LUCAS - President of the University of Southern Mississippi, Hattiesburg, Mississippi. EARL D. MCLEAN, JR. - Co-owner of the T. C. Griffith Insurance Agency, Inc. (insurance and real estate), Columbia, Mississippi. Director of SOUTHERN. GERALD J. ST. Pe - President of Ingalls Shipbuilding and Corporate Vice President of Litton Industries, Inc. since 1985. Director of Merchants and Marine Bank, Pascagoula, Mississippi. LEO W. SEAL, JR. - Chairman of the Board and Chief Executive Officer of Hancock Bank, Gulfport, Mississippi, and Chairman of the Board of Harrison Life Insurance Company. Director of Hancock Bank and Bank of Wiggins. N. EUGENE WARR - Retailer (Biloxi and Gulfport, Mississippi.) Chairman of the Board of First Jefferson Corporation and the Jefferson Bank of Biloxi, Mississippi. H. E. BLAKESLEE - Elected Vice President in 1984. Primarily responsible for rate design, economic analysis and revenue forecasting, economic development, marketing and district operations. THOMAS A. FANNING - Elected Vice President in 1992; responsible primarily for accounting, treasury, finance, information resources and risk management. He previously served as Treasurer of SEI from 1986 to 1992 and Director of Corporate Finance of SCS from 1988 to 1992. DON E. MASON - Elected Vice President in 1983. Primarily responsible for the external affairs functions, including governmental and regulatory affairs, corporate communications, security, materials and general services, as well as the human resources function. (f)(4) Involvement in certain legal proceedings. None. SAVANNAH (a)(5) Identification of directors of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President and Chief Executive Officer Age 61 Served as Director since 8-31-82 HELEN QUATTLEBAUM ARTLEY (1) Age 66 Served as Director since 5-17-77 PAUL J. DENICOLA (1) Age 45 Served as Director since 3-14-91 BRIAN R. FOSTER (1) Age 44 Served as Director since 5-16-89 WALTER D. GNANN (1) Age 58 Served as Director since 5-17-83 JOHN M. MCINTOSH (1) Age 69 Served as Director since 2-27-68 III-10 ROBERT B. MILLER, III (1) Age 48 Served as Director since 5-17-83 JAMES M. PIETTE (1) Age 69 Served as Director since 6-12-73 ARNOLD M. TENEBAUM (1) Age 57 Served as Director since 5-17-77 FREDERICK F. WILLIAMS, JR. (1) Age 66 Served as Director since 7-2-75 (1) No Position other than Director. Each of the above is currently a director of SAVANNAH, serving a term running from the last annual meeting of SAVANNAH's stockholder (May 18, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of SAVANNAH acting solely in their capacities as such. (b)(5) Identification of executive officers of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President, Chief Executive Officer and Director Age 61 Served as Executive Officer since 2-15-72 W. MILES GREER Vice President - Marketing and Customer Services Age 50 Served as Executive Officer since 11-20-85 LARRY M. PORTER Vice President - Operations Age 49 Served as Executive Officer since 7-1-91 KIRBY R. WILLIS Vice President, Treasurer and Chief Financial Officer Age 42 Served as Executive Officer since 1-1-94 Each of the above is currently an executive officer of SAVANNAH, serving a term running from the last annual meeting of the directors (May 18, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except Mr. Willis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of SAVANNAH acting solely in their capacities as such. (c)(5) Identification of certain significant employees. None. (d)(5) Family relationships. None. (e)(5) Business experience. ARTHUR M. GIGNILLIAT, JR. - Elected President and Chief Executive Officer in 1985. Director of Savannah Foods and Industries, Inc. HELEN QUATTLEBAUM ARTLEY - Homemaker and Civic Worker. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, GULF and MISSISSIPPI. BRIAN R. FOSTER - President of NationsBank of Georgia, N.A., in Savannah since 1988. WALTER D. GNANN - President of Walt's TV, Appliance and Furniture Co., Inc., Springfield, Georgia. Past Chairman of the Development Authority of Effingham County, Georgia. III-11 JOHN M. MCINTOSH - Chairman of the Executive Committee, SAVANNAH; retired Chairman of the Board of Directors and Chief Executive Officer, SAVANNAH from 1974 to 1984. Director of SOUTHERN. ROBERT B. MILLER, III - President of American Builders of Savannah. JAMES M. PIETTE - Vice President - Special Projects, Union Camp Corporation, since 1989. Retired Vice Chairman, Board of Directors, Union Camp Corporation from 1987 to 1989. ARNOLD M. TENENBAUM - President of Chatham Steel Corporation. Director of First Union National Bank of Georgia and Savannah Foods and Industries, Inc. FREDERICK F. WILLIAMS, JR. - Retired Partner and Consultant, Hilb, Rogal and Hamilton Employee Benefits, Incorporated (Insurance Brokers), formerly Jones, Hill & Mercer. W. MILES GREER - Vice President - Marketing and Customer Services effective January 1994. Formerly served as Vice President - Economic Development and Corporate Services from 1989 through 1993 and Vice President - Economic Development and Governmental Affairs from 1985 to 1989. LARRY M. PORTER - Vice President - Operations since 1991. Responsible for managing the areas of fuel procurement, power production, transmission and distribution, engineering and system operation. Previously he served as Assistant Plant Manager of GEORGIA's Plant Scherer from 1984 to 1991. KIRBY R. WILLIS - Vice President, Treasurer and Chief Financial Officer effective January 1994. Responsible for all financial activities, Information Resources, Human Resources, Corporate Services, and Environmental Affairs and Safety. He previously served as Treasurer, Controller and Assistant Secretary from 1991 to 1993 and Treasurer and Secretary from 1987 to 1991. (f)(5) Involvement in certain legal proceedings. None. III-12 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (A) SUMMARY COMPENSATION TABLES. The following tables set forth information concerning the Chief Executive Officer and the four most highly compensated executive officers for each of the operating affiliates (ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH), serving as of December 31, 1993 whose total annual salary and bonus exceeded $100,000. No information is provided for any person for any year in which such person did not serve as an executive officer of the operating affiliate. The number of SOUTHERN common shares do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. KEY TERMS used in this Item will have the following meanings:- AME........... ABOVE-MARKET EARNINGS ON DEFERRED COMPENSATION ESP........... EMPLOYEE SAVINGS PLAN ESOP.......... EMPLOYEE STOCK OWNERSHIP PLAN SBP........... SUPPLEMENTAL BENEFIT PLAN VBP........... VEHICLE BUYOUT PROGRAM ALABAMA SUMMARY COMPENSATION TABLE III-13 ALABAMA SUMMARY COMPENSATION TABLE (CONTINUED) (1) Tax reimbursement by ALABAMA and certain personal benefits, including membership fee of $28,402 for Mr. Jones in 1992. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) ALABAMA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans), and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- E. B. Harris $6,746 $1,709 $12,933 $18,000 T. J. Bowden 8,369 1,709 3,193 18,000 B. H. Farris 7,193 1,499 726 18,000 T. H. Jones 6,908 1,331 754 5,100 W. B. Hutchins, III 6,746 1,400 671 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective January 31, 1994, Mr. Bowden resigned to become president of GULF. III-14 GEORGIA SUMMARY COMPENSATION TABLE (1) Due to the pay schedules at GEORGIA, 1992 salary reflects one additional pay period compared with 1991. (2) Tax reimbursement by GEORGIA on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (3) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (4) GEORGIA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- A. W. Dahlberg $6,746 $1,709 $18,092 $18,000 D. H. Evans 8,592 1,709 1,218 18,000 W. Y. Jobe 7,667 1,709 1,882 18,000 G. R. Hodges 7,349 1,620 3,660 18,000 K. E. Adams 7,204 1,634 1,462 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (5) Effective December 31, 1993, Mr. Dahlberg resigned to become president of SOUTHERN. III-15 GULF SUMMARY COMPENSATION TABLE (1) Tax reimbursement by GULF on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) GULF contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- D. L. McCrary $9,300 $1,709 $6,057 $ 2,788 G. E. Holland, Jr. 4,652 - - 16,363 E. B. Parsons, Jr 6,948 1,709 410 16,363 A. E. Scarbrough 6,746 1,338 282 16,363 J. E. Hodges, Jr. 6,651 1,313 - 16,363 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Employee and executive officer of GULF since April 25, 1992. Not eligible to participate in the Long-Term Incentive Plan until January 1, 1993. (5) "All Other Compensation" previously reported as $4,149 for Mr. Holland in the Form 10-K for the year ended December 31, 1992, should have been $0 since Mr. Holland was not yet eligible to participate in ESP and ESOP. III-16 MISSISSIPPI SUMMARY COMPENSATION TABLE (1) Tax reimbursement by MISSISSIPPI on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) MISSISSIPPI contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- David M. Ratcliffe $7,895 $1,709 $2,774 $5,509 R. G. Dawson 6,746 1,252 - 7,045 H. E. Blakeslee 6,843 1,355 - 7,452 D. E. Mason 6,671 1,286 - 7,452 T. A. Fanning 5,520 1,019 - 8,116 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective March 1, 1994, Mr. Dawson resigned to become a vice president of SEI. (5) Benefits under MISSISSIPPI's VBP for 1992 in the amounts of $13,169 and $12,425 to Messrs. Dawson and Fanning, respectively, previously reported in the Form 10-K for the year ended December 31, 1992, under the "Other Annual Compensation" column have been moved to the "All Other Compensation" column. III-17 SAVANNAH SUMMARY COMPENSATION TABLE (1) Tax reimbursement by SAVANNAH on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) SAVANNAH contributions to the ESP, under Section 401(k) of the Internal Revenue Code, ESOP, AME and payments under a VBP for the following:- Name ESP ESOP AME VBP - ---- --- ---- --- --- A. M. Gignilliat $6,746 $3,092 $7,479 $14,195 E. O. Veale 6,163 2,359 5,702 - L. M. Porter 4,943 1,774 658 14,195 W. M. Greer 5,045 1,764 877 14,195 J. L. Rayburn 2,284 1,650 1,911 14,195 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Retired effective December 31, 1993. (5) Not eligible for Long-term Incentive Payout until January 1, 1994. (6) Resigned effective December 31, 1993. III-18 STOCK OPTION GRANTS IN 1993 (B) STOCK OPTION GRANTS. The following table sets forth all stock option grants to the named executive officers of each operating subsidiary during the year ending December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-19 STOCK OPTION GRANTS IN 1993 (1) Grants were made on July 19, 1993, and vest 25% per year on the anniversary date of the grant. Grants fully vest upon termination incident to death, disability, or retirement. The exercise price is the average of the high and low fair market value of SOUTHERN's common stock on the date granted. In accordance with the terms of the Executive Stock Plan, Mr. Jones' unexercised options expire on April 1, 1998, three years after his normal retirement date; Mr. McCrary's unexercised options expire on May 1, 1997, three years after his normal retirement date; and Mr. Gignilliat's unexercised options expire on September 3, 2000, three years after his normal retirement date. (2) A total of 179,746 stock options were granted in 1993 to key executives participating in SOUTHERN's Executive Stock Plan. (3) Based on the Black-Scholes option valuation model. The actual value, if any, an executive officer may realize ultimately depends on the market value of SOUTHERN's common stock at a future date. This valuation is provided pursuant to SEC disclosure rules and there is no assurance that the value realized will be at or near the value estimated by the Black-Scholes model. Assumptions used to calculate this value: price volatility - 12.45%; risk-free rate of return - 5.81%; dividend yield - 5.37%; and time to exercise - ten years. III-20 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (C) AGGREGATED STOCK OPTION EXERCISES. The following table sets forth information concerning options exercised during the year ending December 31, 1993, by the named executive officers and the value of unexercised options held by them as of December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-21 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (1) This represents the excess of the fair market value of SOUTHERN's common stock of $44.125 per share, as of December 31, 1993, above the exercise price of the options. One column reports the "value" of options that are vested and therefore could be exercised; the other "value" of options that are not vested and therefore could not be exercised as of December 31, 1993. (2) The "Value Realized" is ordinary income, before taxes, and represents the amount equal to the excess of the fair market value of the shares at the time of exercise over the exercise price. III-22 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 (D) LONG-TERM INCENTIVE PLANS. The following table sets forth the long-term incentive plan awards made to the named executive officers for the performance period January 1, 1993 through December 31, 1996. See next page for footnotes. III-23 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 III-24 PENSION PLAN TABLE (e)(1) The following table sets forth the estimated combined annual pension benefits under the pension and supplemental defined benefit plans in effect during 1993 for ALABAMA, GEORGIA, GULF and MISSISSIPPI. Employee compensation covered by the pension and supplemental benefit plans for pension purposes is limited to the average of the highest three of the final 10 years' base salary and wages (reported under column titled "Salary" in the Summary Compensation Tables on pages III-13 through III-18). The amounts shown in the table were calculated according to the final average pay formula and are based on a single life annuity without reduction for joint and survivor annuities (although married employees are required to have their pension benefits paid in one of various joint and survivor annuity forms, unless the employee elects otherwise with the spouse's consent) or computation of the Social Security offset which would apply in most cases. This offset amounts to one-half of the estimated Social Security benefit (primary insurance amount) in excess of $3,000 per year times the number of years of accredited service, divided by the total possible years of accredited service to normal retirement age. As of December 31, 1993, the applicable compensation levels and years of accredited service are presented in the following tables: III-25 SAVANNAH has in effect a qualified, trusteed, noncontributory, defined benefit pension plan which provides pension benefits to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. The plan provides pension benefits under a formula which includes each participant's years of service with the Southern system and average annual earnings of the highest three of the final ten years of service with the Southern system preceding retirement. Plan benefits are reduced by a portion of the benefits participants are entitled to receive under Social Security. The plan provides for reduced early retirement benefits at age 55 and a pension for the surviving spouse equal to one-half of the deceased retiree's pension. The following table sets forth the estimated annual pension benefits under the pension plan in effect during 1993 which are payable by SAVANNAH to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. (1)The number of accredited years of service includes ten years credited to Mr. Holland pursuant to a supplemental pension agreement. III-26 As of December 31, 1993, the applicable compensation levels and years of accredited service is presented in the following table: (e)(2) DEFERRED COMPENSATION PLAN; SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN. SAVANNAH has in effect a voluntary deferred compensation plan for certain executive employees pursuant to which such employees may defer a portion of their respective annual salaries. In addition, SAVANNAH has a supplemental executive retirement plan for certain of its executive employees which became effective January 1, 1984. The deferred compensation plan is designed to provide supplemental retirement or survivor benefit payments. The supplemental executive retirement plan is also designed to provide retiring executives of SAVANNAH with a supplemental retirement benefit, which, in conjunction with social security and benefits under SAVANNAH's qualified pension plan, will equal 70 percent of the highest three of the final ten years average annual compensation (including deferrals under the deferred compensation plan). Both of these plans are unfunded and the liability is payable from general funds of SAVANNAH. The deferred compensation plan became effective December 1, 1983, and all of SAVANNAH's executive officers are participating in the plan. In addition, all executives are participating in the supplemental executive retirement plan. In order to provide for its liabilities under the deferred compensation plan and the supplemental executive retirement plan, SAVANNAH has purchased life insurance on participating executive employees in actuarially determined amounts which, based upon assumptions as to mortality experience, policy dividends, tax effects, and other factors which, if realized, along with compensation deferred by employees and the death benefits payable to (1) The plan benefits are subject to the maximum benefit limitations set forth in Section 415 of the Internal Revenue Code. III-27 SAVANNAH, are expected to cover all such insurance premium payments, and all benefit payments to participants, plus a factor for the cost of funds of SAVANNAH. (f) COMPENSATION OF DIRECTORS. (1) Standard Arrangements. The following table presents compensation paid to the directors, during 1993 for service as a member of the board of directors and any board committee(s), except that employee directors received no fees or compensation for service as a member of the board of directors or any board committee. All or a portion of these fees may be deferred until membership on the board is terminated. ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH also provide retirement benefits to non-employee directors who are credited with a minimum of 60 months of service on the board of directors of one or more system companies, under the Outside Directors Pension Plan. Eligible directors are entitled to benefits under the Plan upon retirement from the board on the retirement date designated in the respective companies by-laws. The annual benefit payable ranges from 75 to 100 percent of the annual retainer fee in effect on the date of retirement, based upon length of service. Payments continue for the greater of the lifetime of the participant or 10 years. (2) Other Arrangements. No director received other compensation for services as a director during the year ending December 31, 1993 in addition to or in lieu of that specified by the standard arrangements specified above. (1) Committee Chairmen receive an additional $500 per year fee. (2) Established for period September 15, 1993 through May 31, 1994. (3) Chairman of Executive Committee receives an additional $3,000 per month fee. III-28 (g) EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL ARRANGEMENTS. None. (h) REPORT ON REPRICING OF OPTIONS. None. (i) ADDITIONAL INFORMATION WITH RESPECT TO COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISION. ALABAMA Elmer B. Harris serves on the Compensation Committee of AmSouth Bancorporation. John W. Woods, a director of ALABAMA is an executive officer of AmSouth Bancorporation. GULF Messrs. Paul J. DeNicola and Douglas L. McCrary are ex officio members of its Compensation Committee. III-29 ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. SOUTHERN is the beneficial owner of 100% of the outstanding common stock of registrants ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH. (B) SECURITY OWNERSHIP OF MANAGEMENT. The following table shows the number of shares of SOUTHERN common stock and operating subsidiary preferred stock owned by the directors, nominees and executive officers as of December 31, 1993. It is based on information furnished by the directors, nominees and executive officers. The shares owned by all directors, nominees and executive officers as a group constitute less than one percent of the total number of shares of the respective classes outstanding on December 31, 1993. The number of SOUTHERN common shares shown do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN'S board of directors in January, 1994. III-30 III-31 III-32 III-33 (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security (i.e., the power to dispose of, or to direct the disposition of, a security). (2) The shares shown include shares of common stock of which certain directors and executive officers have the right to acquire beneficial ownership within 60 days pursuant to the Executive Stock Plan, as follows: Mr. Addison, 86,357 shares; Mr. Blakeslee, 660 shares; Mr. Bowden, 5,763 shares; Mr. Dahlberg, 4,278 shares; Mr. Farris, 863 shares; Mr. Gignilliat, 8,556 shares; Mr. Guthrie 15,720 shares; Mr. Harris, 14,215 shares; Mr. Haubein, 835 shares; Mr. Hodges, 5,429 shares; Mr. Holland, 698 shares; Mr. Hutchins, 706 shares; Mr. Jones, 848 shares; Mr. Klappa, 671 shares, Mr. C. D. McCrary, 691 shares; Mr. D. L. McCrary, 9,668 shares; and Mr. Ratcliffe, 5,643 shares. Also included are shares of SOUTHERN common stock held by the spouses of the following directors: Mr. Addison, 670 shares; Mr. Copenhaver, 350 shares; Mr. Harris, 155 shares; Mr. Parker, 22 shares; and Dr. Shatto, 5,067 shares. III-34 (C) CHANGES IN CONTROL. The operating affiliates know of no arrangements which may at a subsequent date result in any change in control. GEORGIA'S Mr. Russell failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MISSISSIPPI'S Messrs. McLean, Jr., Hurt and Seal, Jr. each failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. SAVANNAH'S Mr. Gnann failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MR. DENICOLA, a director of GULF, MISSISSIPPI and SAVANNAH, failed to file on a timely basis a single report, disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. III-35 ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALABAMA (a) Transactions with management and others. During 1993, ALABAMA, in the ordinary course of business, paid premiums amounting to approximately $400,000 for various types of insurance policies purchased from Protective Life Insurance Company, a subsidiary of Protective Life Corporation, a company in which Mr. William J. Rushton, III, a director of ALABAMA, owns an interest and of which he serves as Chairman. The firm of Inzer, Stivender, Haney & Johnson, P.A., performed certain legal services for ALABAMA during 1993. Mr. James C. Inzer, Jr., partner in this firm, is also a director of ALABAMA. ALABAMA purchased automobiles and parts in the amount of approximately $200,000 from companies in which Mr. Blount, a director of ALABAMA, owns 85% interests. ALABAMA purchased electrical supplies in the amount of approximately $200,000 from L & K Electric Supply Company, Ltd. during 1993. Mr. Willie, director of ALABAMA and SOUTHERN, owns an interest in and serves as president of this firm. ALABAMA believes that these transactions have been on terms representing competitive market prices that are no less favorable than those available from others. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GEORGIA (a) Transactions with management and others. In 1993, GEORGIA was indebted in a maximum amount of $105 million to Wachovia Bank and its affiliates, of which G. Joseph Prendergast serves as President and Chief Executive Officer of Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. In 1993, GEORGIA was indebted in a maximum amount of $285 million to NationsBank and its affiliates of which Mr. James R. Lientz, Jr. serves as President of NationsBank of Georgia. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GULF (a) Transactions with management and others. The firm of Beggs & Lane, P.A. serves as local counsel for GULF and received from GULF approximately $800,000 for services rendered. Mr. G. Edison Holland, Jr. is a partner in the firm and also serves as Vice President and Corporate Counsel of GULF. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. MISSISSIPPI (a) Certain business relationships. During 1993, MISSISSIPPI was indebted in a maximum amount of $12.4 million to Hancock Bank, of which Leo W. Seal, Jr. serves as Chairman of the Board and Chief Executive Officer. (b) Certain business relationships. None. (c) Indebtedness of management. None. III-36 (d) Transactions with promoters. None. SAVANNAH (a) Transactions with management and others. Mr. Tenenbaum is a Director of First Union national Bank of Georgia, and Mr. Foster is President of NationsBank of Georgia, N.A., in Savannah. During 1993, these banks furnished a number of regular banking services in the ordinary course of business to SAVANNAH. SAVANNAH intends to maintain normal banking relations with all of the aforesaid banks in the future. (b) Certain business relationships. (c) Indebtedness of management. None. (d) Transactions with promoters. None. III-37 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 on this Form 10-K: (1) Financial Statements: Reports of Independent Public Accountants on the financial statements for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. The financial statements filed as a part of this report for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. (2) Financial Statement Schedules: Reports of Independent Public Accountants as to Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are included herein on pages IV-12 through IV-17. Financial Statement Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Index to the Financial Statement Schedules at page S-1. (3) Exhibits: Exhibits for SOUTHERN, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Exhibit Index at page E-1. (b) Reports on Form 8-K: During the fourth quarter of 1993 the registrants filed Current Reports on Form 8-K as follows: ALABAMA filed Forms 8-K dated October 27, 1993, and November 16, 1993, to facilitate security sales. GEORGIA filed a Form 8-K dated October 20, 1993, to facilitate a security sale. GULF filed a Form 8-K dated November 3, 1993, to facilitate a security sale. SAVANNAH filed a Form 8-K dated November 9, 1993, to facilitate a security sale. IV-1 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 SOUTHERN COMPANY By Edward L. Addison, Chairman By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Edward L. Addison Chairman of the Board (Principal Executive Officer) W. L. Westbrook Financial Vice President (Principal Financial and Accounting Officer) Directors: W. P. Copenhaver John M. McIntosh. A. W. Dahlberg Earl D. McLean, Jr. Paul J. DeNicola William A. Parker Jack Edwards William J. Rushton, III H. Allen Franklin Gloria M. Shatto L. G. Hardman, III Herbert Stockham Elmer B. Harris Louis J. Willie By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. ALABAMA POWER COMPANY By Elmer B. Harris, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Elmer B. Harris President, Chief Executive Officer and Director (Principal Executive Officer) Charles D. McCrary Senior Vice President (Principal Financial Officer) David L. Whitson Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison William V. Muse Whit Armstrong John T. Porter Philip E. Austin Gerald H. Powell Margaret A. Carpenter Robert D. Powers Peter V. Gregerson, Sr. John W. Rouse Bill M. Guthrie James H. Sanford Crawford T. Johnson, III John Cox Webb, IV Carl E. Jones, Jr. Louis J. Willie Wallace D. Malone, Jr. John W. Woods By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-2 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. GEORGIA POWER COMPANY By H. Allen Franklin, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. H. Allen Franklin President, Chief Executive Officer and Director (Principal Executive Officer) Warren Y. Jobe Executive Vice President, Treasurer, Chief Financial Officer and Director (Principal Financial Officer) C. B. Harreld Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison G. Joseph Prendergast Bennett A. Brown Herman J. Russell William P. Copenhaver Gloria M. Shatto A. W. Dahlberg Robert Strickland William A. Fickling, Jr. William Jerry Vereen L. G. Hardman, III Thomas R. Williams James R. Lientz, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. GULF POWER COMPANY By D. L. McCrary, Chairman of the Board By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. D. L. McCrary Chairman of the Board and Chief Executive Officer (Principal Executive Officer) A. E. Scarbrough Vice President - Finance (Principal Financial and Accounting Officer) Directors: Reed Bell Travis J. Bowden Paul J. DeNicola Fred C. Donovan W. D. Hull, Jr. C. W. Ruckel J. K. Tannehill By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25,1994 IV-3 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 COMPANY By David M. Ratcliffe, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. David M. Ratcliffe President, Chief Executive Officer and Director (Principal Executive Officer) Thomas A. Fanning Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Paul J. DeNicola Edwin E. Downer Robert S. Gaddis Walter H. Hurt, III Aubrey K. Lucas Earl D. McLean, Jr. Gerald J. St. Pe' Leo W. Seal, Jr. N. Eugene Warr By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. SAVANNAH ELECTRIC AND POWER COMPANY By Arthur M. Gignilliat, Jr., President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Arthur M. Gignilliat, Jr. President, Chief Executive Officer and Director (Principal Executive Officer) Kirby R. Willis Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Helen Q. Artley Paul J. DeNicola Brian R. Foster Walter D. Gnann John M. McIntosh Robert B. Miller, III James M. Piette Arnold M. Tenenbaum Frederick F. Williams, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-4 EXHIBIT 21. SUBSIDIARIES OF THE REGISTRANTS. (1) Owned by Alabama Power Company. (2) Owned by Georgia Power Company. (3) Owned by SEI Holdings, Inc. (4) 94% owned jointly by Asociados de Electricidad, S. A. (14%) and SEI Holdings, Inc. (80%) (5) 59% owned by SEI y Asociados de Argentina, S. A. (6) Owned by SEI Holdings III, Inc. (7) 36% owned by SEI Chile, S. A. (8) Owned by SEI Holdings IV, Inc. (9) Owned jointly by Inversores de Electricidad, S. A. (15%) and SEI Bahamas Argentina I, Inc. (85%) (10) Owned by Southern Electric Bahamas Holdings, Ltd. (11) 50% owned by Southern Electric Bahamas, Ltd. (12) Owned equally by Alabama Power Company and Georgia Power Company. (13) Owned by Southern Electric International, Inc. (14) Owned by Southern Electric Wholesale Generators, Inc. IV-5 ARTHUR ANDERSEN & CO. Exhibit 23(a) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of The Southern Company and its subsidiaries and the related financial statement schedules, included in this Form 10-K, into The Southern Company's previously filed Registration Statement File Nos. 2-78617, 33-3546, 33-23152, 33-30171, 33-23153 and 33-51433. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-6 ARTHUR ANDERSEN & CO. Exhibit 23(b) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Alabama Power Company and the related financial statement schedules, included in this Form 10-K, into Alabama Power Company's previously filed Registration Statement File No. 33-49653. /s/ Arthur Andersen & Co. Birmingham, Alabama March 25, 1994 IV-7 ARTHUR ANDERSEN & CO. Exhibit 23(c) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Georgia Power Company and the related financial statement schedules, included in this Form 10-K, into Georgia Power Company's previously filed Registration Statement File No. 33-49661. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-8 ARTHUR ANDERSEN & CO. Exhibit 23(d) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Gulf Power Company and the related financial statement schedules, included in this Form 10-K, into Gulf Power Company's previously filed Registration Statement File No. 33-50165. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-9 ARTHUR ANDERSEN & CO. Exhibit 23(e) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Mississippi Power Company and the related financial statement schedules, included in this Form 10-K, into Mississippi Power Company's previously filed Registration Statement File Nos. 33-49320 and 33-49649. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-10 ARTHUR ANDERSEN & CO. Exhibit 23(f) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Savannah Electric and Power Company and the related financial statement schedules, included in this Form 10-K, into Savannah Electric and Power Company's previously filed Registration Statement File Nos. 33-45757 and 33-52509. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-11 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To The Southern Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of The Southern Company and its subsidiaries included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the consolidated financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to The Southern Company's consolidated financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to The Southern Company and its subsidiaries (pages S-2 and S-3, S-11 through S-14, S-35 through S-37, S-53, and S-59) are the responsibility of The Southern 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 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-12 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Alabama Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Alabama Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Alabama Power Company (pages S-4, S-15 through S-18, S-38 through S-40, S-54, and S-60) are the responsibility of Alabama Power 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. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 IV-13 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Georgia Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Georgia Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding the recoverability of Georgia Power Company's investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to Georgia Power Company's financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Georgia Power Company (pages S-5, S-19 through S-22, S-41 through S-43, S-55, and S-61) are the responsibility of Georgia Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-14 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Gulf Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Gulf Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Gulf Power Company (pages S-6, S-23 through S-26, S-44 through S-46, S-56, and S-62) are the responsibility of Gulf Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-15 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Mississippi Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Mississippi Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Mississippi Power Company (pages S-7 and S-8, S-27 through S-30, S-47 through S-49, S-57, and S-63) are the responsibility of Mississippi Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-16 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Savannah Electric and Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Savannah Electric and Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Savannah Electric and Power Company (pages S-9 and S-10, S-31 through S-34, S-50 through S-52, S-58, and S-64) are the responsibility of Savannah Electric and Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-17 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules I through XIV not listed above are omitted as not applicable or not required. Columns omitted from schedules filed have been omitted because the information is not applicable or not required. S-1 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) See Summary of Transactions and Notes on Page S-3 S-2 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of retirements to acquisition adjustments. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. (NOTE 1) OTHER CHANGES INCLUDE THE FOLLOWING (STATED IN THOUSANDS OF DOLLARS) S-3 ALABAMA POWER COMPANY SCHEDULE V -- UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements below include non-depreciable plant retirements. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes include a reduction to utility plant of $61,960,000 for the partial sale of Miller Steam Plant in 1992. S-4 GEORGIA POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of Plant Scherer acquisition adjustment retired for sales in 1991 and 1993. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes for 1993, include an increase to plant of $46,473,000 for the taxes applicable to capitalized AFUDC debt. S-5 GULF POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances 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. S-6 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-8. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-7 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31,1993 (STATED IN THOUSANDS OF DOLLARS) S-8 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-10. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-9 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) S-10 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-11 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-12 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-13 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-14 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-15 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-16 ALABAMA POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-17 ALABAMA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-18 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-19 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-20 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-21 GEORGIA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-22 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-23 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-24 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-25 GULF POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-26 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-27 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-28 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-29 MISSISSIPPI POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PL FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-30 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-31 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-32 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-33 SAVANNAH ELECTRIC AND POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-34 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (3) See Note 1 to SOUTHERN's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (4) Represents additional funding to reserve. (5) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-35 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. (4) Capitalized. S-36 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 8 to SOUTHERN's financial statements in Item 8 herein for a description of the Gulf States settlement. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (4) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-37 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------ Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-38 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further Information. S-39 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) See Note 7 to the financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-40 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-41 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-42 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Note: (1) See Note 3 to GEORGIA's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible accounts was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. S-43 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-44 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - -------------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-45 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 7 to GULF's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-46 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-47 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ------------------ Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-48 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in thousands of Dollars) - ----------------- Notes: (1) See Note 7 to MISSISSIPPI's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-49 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-50 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ---------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-51 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-52 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end. (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) This note payable is an obligation of SEI and does not include borrowings from SOUTHERN. (4) See Note 5 to SOUTHERN's financial statements in Item 8 herein for details regarding SOUTHERN's and its subsidiaries lines of credit and general terms of commitment agreements. S-53 ALABAMA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992, 1991 (Stated in Thousands of Dollars) - ----------------- Notes: (1) At month-end. (2) Average based on daily borrowings during the period (averages and rates quoted on an actual day year basis). (3) ALABAMA also issued commercial paper during 1993, although none was outstanding at year-end. The data shown reflects the issuance of commercial paper. (4) See Note 5 to ALABAMA's financial statements in Item 8 herein for details regarding ALABAMA's lines of credit. S-54 GEORGIA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - -------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 8 to GEORGIA's financial statements in Item 8 herein for details regarding GEORGIA's lines of credit and general terms of its commitment agreements. S-55 GULF POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to GULF's financial statements in Item 8 herein for a description of this short-term indebtedness. (4) See Note 5 to GULF's financial statements in Item 8 herein for details regarding GULF's lines of credit and general terms of its commitment agreements. S-56 MISSISSIPPI POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to MISSISSIPPI's financial statements in Item 8 herein for details regarding MISSISSIPPI's lines of credit and general terms of its commitment agreements. S-57 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to SAVANNAH's financial statements in Item 8 herein for details regarding SAVANNAH's lines of credit and general terms of its commitment agreements. S-58 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-59 ALABAMA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-60 GEORGIA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-61 GULF POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-62 MISSISSIPPI POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-63 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-64 EXHIBIT INDEX The following exhibits indicated by an asterisk preceding the exhibit number are filed herewith. The balance of the exhibits have heretofore been filed with the SEC, respectively, as the exhibits and in the file numbers indicated and are incorporated herein by reference. Reference is made to a duplicate list of exhibits being filed as a part of this Form 10-K, which list, prepared in accordance with Item 601 of Regulation S-K of the SEC, immediately precedes the exhibits being physically filed with this Form 10-K. (3) ARTICLES OF INCORPORATION AND BY-LAWS SOUTHERN (a) 1 - Composite Certificate of Incorporation of SOUTHERN, reflecting all amendments to date. (Designated in Registration No. 33-3546 as Exhibit 4(a), in Certificate of Notification, File No. 70-7341, as Exhibit A and in Certificate of Notification, File No. 70-8181, as Exhibit A.) (a) 2 - By-laws of SOUTHERN as amended effective October 21, 1991, and as presently in effect. (Designated in Form U-1, File No. 70-8181 as Exhibit A-2.) ALABAMA (b) 1 - Charter of ALABAMA and amendments thereto through November 19, 1993. (Designated in Registration Nos. 2-59634 as Exhibit 2(b), 2-60209 as Exhibit 2(c), 2-60484 as Exhibit 2(b), 2-70838 as Exhibit 4(a)-2, 2-85987 as Exhibit 4(a)-2, 33-25539 as Exhibit 4(a)-2, 33-43917 as Exhibit 4(a)-2, in Form 8-K dated February 5, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated July 8, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated October 27, 1993, File No. 1-3164, as Exhibits 4(a) and 4(b) and in Form 8-K dated November 16, 1993, File No. 1-3164, as Exhibit 4(a).) (b) 2 - By-laws of ALABAMA as amended effective April 24, 1992, and as presently in effect. (Designated in Registration No. 33-48885 as Exhibit 4(c).) GEORGIA (c) 1 - Charter of GEORGIA and amendments thereto through October 25, 1993. (Designated in Registration Nos. 2-63392 as Exhibit 2(a)-2, 2-78913 as Exhibits 4(a)-(2) and 4(a)-(3), 2-93039 as Exhibit 4(a)-(2), 2-96810 as Exhibit 4(a)-2, 33-141 as Exhibit 4(a)-(2), 33-1359 as Exhibit 4(a)(2), 33-5405 as Exhibit 4(b)(2), 33-14367 as Exhibits 4(b)-(2) and 4(b)-(3), 33-22504 as Exhibits 4(b)-(2), 4(b)-(3) and 4(b)-(4), in GEORGIA's Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibits 4(a)(2) and 4(a)(3), in Registration No. 33-48895 as Exhibits 4(b)-(2) and 4(b)-(3), in Form 8-K dated December 10, 1992, File No. 1-6468 as Exhibit 4(b), in Form 8-K dated June 17, 1993, File No. 1-6468, as Exhibit 4(b) and in Form 8-K dated October 20, 1993, File No. 1-6468, as Exhibit 4(b).) E-1 (c) 2 - By-laws of GEORGIA as amended effective July 18, 1990, and as presently in effect. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No.1-6468, as Exhibit 3.) GULF (d) 1 - Restated Articles of Incorporation of GULF and amendments thereto through November 8, 1993. (Designated in Registration No. 33-43739 as Exhibit 4(b)-1, in Form 8-K dated January 15, 1992, File No. 0-2429, as Exhibit 1(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(b)-2, in Form 8-K dated September 22, 1993, File No. 0-2429, as Exhibit 4 and in Form 8-K dated November 3, 1993, File No. 0-2429, as Exhibit 4.) *(d) 2 - By-laws of GULF as amended effective February 25, 1994, and as presently in effect. MISSISSIPPI (e) 1 - Articles of incorporation of MISSISSIPPI, articles of merger of Mississippi Power Company (a Maine corporation) into MISSISSIPPI and articles of amendment to the articles of incorporation of MISSISSIPPI through August 19, 1993. (Designated in Registration No. 2-71540 as Exhibit 4(a)-1, in Form U5S for 1987, File No. 30-222-2, as Exhibit B-10, in Registration No. 33-49320 as Exhibit 4(b)-(1), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibits 4(b)-2 and 4(b)-3, in Form 8-K dated August 4, 1993, File No. 0-6849, as Exhibit 4(b)-3 and in Form 8-K dated August 18, 1993, File No. 0-6849, as Exhibit 4(b)-3.) (e) 2 - By-laws of MISSISSIPPI as amended effective August 22, 1989, and as presently in effect. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1989, as Exhibit 3(b).) SAVANNAH (f) 1 - Charter of SAVANNAH and amendments thereto through November 10, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(b)-(1), 33-45757 as Exhibit 4(b)-(2) and in Form 8-K dated November 9, 1993, File No. 1-5072, as Exhibit 4(b).) *(f) 2 - By-laws of SAVANNAH as amended effective February 16, 1994, and as presently in effect. (4) INSTRUMENTS DESCRIBING RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES ALABAMA (b) - Indenture dated as of January 1, 1942, between ALABAMA and Chemical Bank, as Trustee, and indentures supplemental thereto through that dated as of January 1, 1994. (Designated in Registration Nos. 2-59843 as Exhibit 2(a)-2, 2-60484 as Exhibits 2(a)-3 and 2(a)-4, 2-60716 as Exhibit 2(c), 2-67574 as E-2 Exhibit 2(c), 2-68687 as Exhibit 2(c), 2-69599 as Exhibit 4(a)-2, 2-71364 as Exhibit 4(a)-2, 2- 73727 as Exhibit 4(a)-2, 33-5079 as Exhibit 4(a)-2, 33-17083 as Exhibit 4(a)-2, 33-22090 as Exhibit 4(a)-2, in ALABAMA's Form 10-K for the year ended December 31, 1990, File No. 1-3164, as Exhibit 4(c), in Registration Nos. 33-43917 as Exhibit 4(a)-2, 33-45492 as Exhibit 4(a)-2, 33- 48885 as Exhibit 4(a)-2, 33-48917 as Exhibit 4(a)-2, in Form 8-K dated January 20, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Form 8-K dated February 17, 1993, File No.1-3436, as Exhibit 4(a)-3, in Form 8-K dated March 10, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Certificate of Notification, File No. 70-8069, as Exhibits A and B, in Form 8-K dated June 24, 1993, File No. 1- 3436, as Exhibit 4, in Certificate of Notification, File No. 70-8069, as Exhibit A, in Form 8-K dated November 16, 1993, File No. 1-3436, as Exhibit 4(b) and in Certificate of Notification, File No. 70-8069, as Exhibits A and B.) GEORGIA (d) - Indenture dated as of March 1, 1941, between GEORGIA and Chemical Bank, as Trustee, and indentures supplemental thereto dated as of March 1, 1941, March 3, 1941 (3 indentures), March 6, 1941 (139 indentures), March 1, 1946 (88 indentures) and December 1, 1947, through January 1, 1994. (Designated in Registration Nos. 2-4663 as Exhibits B-3 and B-3(a), 2-7299 as Exhibit 7(a)-2, 2- 61116 as Exhibit 2(a)-3 and 2(a)-4, 2-62488 as Exhibit 2(a)-3, 2-63393 as Exhibit 2(a)-4, 2-63705 as Exhibit 2(a)-3, 2-68973 as Exhibit 2(a)-3, 2-70679 as Exhibit 4(a)-(2), 2-72324 as Exhibit 4(a)-2, 2-73987 as Exhibit 4(a)-(2), 2-77941 as Exhibits 4(a)-(2) and 4(a)-(3), 2-79336 as Exhibit 4(a)-(2), 2-81303 as Exhibit 4(a)-(2), 2-90105 as Exhibit 4(a)-(2), 33-5405 as Exhibit 4(a)-(2), 33-14367 as Exhibits 4(a)-(2) and 4(a)-(3), 33-22504 as Exhibits 4(a)-(2), 4(a)-(3) and 4(a)-(4), 33-32420 as Exhibit 4(a)-(2), 33-35683 as Exhibit 4(a)-(2), in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 4(a)(3), in Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibit 4(a)(5), in Registration No. 33-48895 as Exhibit 4(a)-(2), in Form 8-K dated August 26, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-K dated September 9, 1992, File No. 1-6468, as Exhibits 4(a)-(3) and 4(a)-(4), in Form 8-K dated September 23, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-A dated October 12, 1992, as Exhibit 2(b), in Form 8-K dated January 27, 1993, File No. 1-6468, as Exhibit 4(a)-(3), in Registration No. 33-49661 as Exhibit 4(a)-(2), in Form 8-K dated July 26, 1993, File No. 1-6468, as Exhibit 4, in Certificate of Notification, File No. 70-7832, as Exhibit M and in Certificate of Notification, File No. 70-7832, as Exhibit C.) GULF (e) - Indenture dated as of September 1, 1941, between GULF and The Chase Manhattan Bank (National Association) and The Citizens & Peoples National Bank of Pensacola, as Trustees, and indentures supplemental thereto through E-3 November 1, 1993. (Designated in Registration Nos. 2-4833 as Exhibit B-3, 2-62319 as Exhibit 2(a)-3, 2-63765 as Exhibit 2(a)-3, 2-66260 as Exhibit 2(a)-3, 33-2809 as Exhibit 4(a)-2, 33-43739 as Exhibit 4(a)-2, in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 4(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(a)-3, in Registration No. 33-50165 as Exhibit 4(a)-2, in Form 8-K dated July 12, 1993, File No. 0-2429, as Exhibit 4 and in Certificate of Notification, File No. 70-8229, as Exhibit A.) MISSISSIPPI (f) - Indenture dated as of September 1, 1941, between MISSISSIPPI and Morgan Guaranty Trust Company of New York, as Trustee, and indentures supplemental thereto through November 1, 1993. (Designated in Registration Nos. 2-4834 as Exhibit B-3, 2-62965 as Exhibit 2(b)-2, 2-66845 as Exhibit 2(b)-2, 2-71537 as Exhibit 4(a)-(2), 33-5414 as Exhibit 4(a)-(2), 33-39833 as Exhibit 4(a)-2, in MISSISSIPPI's Form 10-K for the year ended December 31, 1991, File No. 0-6849, as Exhibit 4(b), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibit 4(a)-2, in Second Certificate of Notification, File No. 70-7941, as Exhibit I, in MISSISSIPPI's Form 8-K dated February 26, 1993, File No. 0-6849, as Exhibit 4(a)-2, in Certificate of Notification, File No. 70-8127, as Exhibit A, in Form 8-K dated June 22, 1993, File No. 0-6849, as Exhibit 1 and in Certificate of Notification, File No. 70-8127, as Exhibit A.) SAVANNAH (g) - Indenture dated as of March 1, 1945, between SAVANNAH and NationsBank of Georgia, National Association, as Trustee, and indentures supplemental thereto through July 1, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(a)-(1), 33-41496 as Exhibit 4(a)-(2), 33-45757 as Exhibit 4(a)-(2), in SAVANNAH's Form 10-K for the year ended December 31, 1991, File No. 1-5072, as Exhibit 4(b), in Form 8-K dated July 8, 1992, File No. 1-5072, as Exhibit 4(a)-3, in Registration No. 33-50587 as Exhibit 4(a)-(2) and in Form 8-K dated July 22, 1993, File No. 1-5072, as Exhibit 4.) (10) MATERIAL CONTRACTS SOUTHERN (a) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(a) and in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(3).) (a) 2 - Service contract dated as of July 17, 1981, between SCS and SEI. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(2).) E-4 (a) 3 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1987, File No. 1-5072, as Exhibit 10-p.) (a) 4 - Service contract dated as of January 15, 1991, between SCS and Southern Nuclear. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1991, File No. 1-3526, as Exhibit 10(a)(4).) (a) 5 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(b).) (a) 6 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. (Designated in Registration No. 2-59634 as Exhibit 5(c) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(d)(2).) (a) 7 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Registration No. 2-61116 as Exhibit 5(d).) (a) 8 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(1).) (a) 9 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(3).) (a) 10 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(g).) (a) 11 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit A.) (a) 12 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit B.) (a) 13 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(1).) E-5 (a) 14 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-1 and in Form 8-K for January 1977, File No. 1-6468, as Exhibit (B)(3).) (a) 16 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-2.) (a) 17 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1983, File No. 1-6468, as Exhibit 10(k)(4).) (a) 18 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 19 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 20 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(8).) (a) 21 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 22 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(3).) (a) 23 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(7).) (a) 24 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-3, in SOUTHERN's Form 10-K for the year ended December 31, 1987, File E-6 No. 1-3526, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, File No. 1-3526, as Exhibit 10(n)(2).) (a) 25 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-4 and in SOUTHERN's Form 10-K for the year ended December 31, 1987, File No. 1-3526, as Exhibit 10(o)(4).) (a) 26 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. (Designated in Form U-1, File No. 70-6481, as Exhibit B-1.) (a) 27 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-2.) (a) 28 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-4, in SOUTHERN's Form 10-K for the year ended December 31, 1987, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, as Exhibit 10(n)(2).) (a) 29 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-5.) (a) 30 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-1.) (a) 31 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-2.) (a) 32 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(c)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(r)(3).) (a) 33 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in GEORGIA's Form 10-K for the year E-7 ended December 31, 1982, File No. 1-6468, as Exhibit 10(s)(2), in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(r)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468 as Exhibit 10(s)(2).) (a) 34 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(d).) (a) 35 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(e).) (a) 36 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(f).) (a) 37 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(x).) (a) 38 - The Southern Company Executive Stock Plan For the Southern Electric System and the First Amendment thereto. (Designated in Registration No. 33-30171 as Exhibit 4(c).) (a) 39 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(1).) (a) 40 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(m).) (a) 41 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(x).) (a) 42 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(y).) E-8 (a) 43 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-1.) (a) 44 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-2.) (a) 45 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(f), in MISSISSIPPI's Form 10-K for the year ended December 31, 1982, File No. 0-6849, as Exhibit 10(f)(2) and in MISSISSIPPI's Form 10-K for the year ended December 31, 1983, File No. 0-6849, as Exhibit 10(f)(3).) (a) 46 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. (Designated in Form U-1, File No. 70-7738, as Exhibit A-5 and in Form U-1, File No. 70-7937, as A-5(b).) (a) 47 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(cc).) (a) 48 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(dd).) *(a) 49 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. (a) 50 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(ff).) (a) 51 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(gg).) (a) 52 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(hh).) E-9 (a) 53 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1992, File No. 1-3526, as Exhibit 10(a)53.) *(a) 54 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. *(a) 55 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. *(a) 56 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. *(a) 57 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 58 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 59 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. ALABAMA (b) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. (Designated in Registration No. 2-59843 as Exhibit 2(a)-8.) (b) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (b) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (b) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (b) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. E-10 (b) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2, dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (b) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)34 herein. (b) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)35 herein. (b) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)36 herein. (b) 10 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (b) 11 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)39 herein. (b) 12 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)40 herein. (b) 13 - Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Certificate of Notification, File No. 70-7212, as Exhibit B.) (b) 14 - 1991 Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Form U-1, File No. 70- 7873, as Exhibit B-1.) (b) 15 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)43 herein. (b) 16 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)44 herein. (b) 17 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. E-11 (b) 18 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. GEORGIA (c) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. See Exhibit 10(b)1 herein. (c) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIP PI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (c) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (c) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (c) 5 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)7 herein. (c) 6 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)8 herein. (c) 7 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)9 herein. (c) 8 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. See Exhibit 10(a)10 herein. (c) 9 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a) 11 herein. (c) 10 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a)12 herein. (c) 11 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)13 herein. (c) 12 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)14 herein. E-12 (c) 13 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)15 herein. (c) 14 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)16 herein. (c) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. See Exhibit 10(a)17 herein. (c) 16 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)18 herein. (c) 17 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)19 herein. (c) 18 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. See Exhibit 10(a)20 herein. (c) 19 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)21 herein. (c) 20 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)22 herein. (c) 21 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)23 herein. (c) 22 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)24 herein. (c) 23 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)25 herein. (c) 24 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. See Exhibit 10(a)26 herein. (c) 25 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. See Exhibit 10(a)27 herein. E-13 (c) 26 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (c) 27 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (c) 28 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a) 30 herein. (c) 29 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a)31 herein. (c) 30 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (c) 31 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (c) 32 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (c) 33 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (c) 34 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (c) 35 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. *(c) 36 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. See Exhibit 10(a) 59 herein. (c) 37 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. E-14 (c) 38 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (c) 39 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)41 herein. (c) 40 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)42 herein. (c) 41 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (c) 42 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)47 herein. (c) 43 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)48 herein. *(c) 44 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. See Exhibit 10(a)49 herein. (c) 45 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)50 herein. (c) 46 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. See Exhibit 10(a)51 herein. (c) 47 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. See Exhibit 10(a)52 herein. *(c) 48 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. See Exhibit 10(a)54 herein. *(a) 49 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. See Exhibit 10(a)55 herein. *(c) 50 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. See Exhibit 10(a)56 herein. E-15 *(c) 51 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)57 herein. *(c) 52 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)58 herein. GULF (d) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (d) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (d) 3 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (d) 4 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (d) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (d) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (d) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (d) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (d) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-16 (d) 10 - Agreement between GULF and AEC, effective August 1, 1985. (Designated in GULF's Form 10-K for the year ended December 31, 1985, File No. 0-2429, as Exhibit 10(g).) (d) 11 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (d) 12 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (d) 13 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. MISSISSIPPI (e) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (e) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (e) 3 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (e) 4 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984, and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (e) 5 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (e) 6 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (e) 7 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-17 (e) 8 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (e) 9 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (e) 10 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (e) 11 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. See Exhibit 10(a)45 herein. (e) 12 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (e) 13 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. SAVANNAH (f) 1 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. See Exhibit 10(a)3 herein. (f) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (f) 3 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (f) 4 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (f) 5 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (f) 6 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. E-18 (f) 7 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (f) 8 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. *(f) 9 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a) 57 herein. *(f) 10 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated December 15, 1992. See Exhibit 10(a)58 herein. (21) *SUBSIDIARIES OF REGISTRANTS - Contained herein at page IV-5. (23) CONSENTS OF EXPERTS AND COUNSEL SOUTHERN *(a) - The consent of Arthur Andersen & Co. is contained herein at page IV-6. ALABAMA *(b) - The consent of Arthur Andersen & Co. is contained herein at page IV-7. GEORGIA *(c) - The consent of Arthur Andersen & Co. is contained herein at page IV-8. GULF *(d) - The consent of Arthur Andersen & Co. is contained herein at page IV-9. MISSISSIPPI *(e) - The consent of Arthur Andersen & Co. is contained herein at page IV-10. SAVANNAH *(f) - The consent of Arthur Andersen & Co. is contained herein at page IV-11. E-19 (24) POWERS OF ATTORNEY AND RESOLUTIONS SOUTHERN *(a) - Power of Attorney and resolution. ALABAMA *(b) - Power of Attorney and resolution. GEORGIA *(c) - Power of Attorney and resolution. GULF *(d) - Power of Attorney and resolution. MISSISSIPPI *(e) - Power of Attorney and resolution. SAVANNAH *(f) - Power of Attorney and resolution. E-20

91882_1993.txt

91882_1993

1993

91882

ITEM 1. BUSINESS THE COMPANY Organization The Company, a wholly owned subsidiary of SCANA, is a South Carolina corporation organized in 1924 and has its principal executive office at 1426 Main Street, Columbia, South Carolina 29201, telephone number (803) 748-3000. The Company had 4,166 full-time, permanent employees as of December 31, 1993 as compared to 4,168 full-time, permanent employees as of December 31, 1992. SCANA, a South Carolina corporation, was organized in 1984 and is a public utility holding company within the meaning of PUHCA but is presently exempt from registration under such Act. SCANA holds all of the issued and outstanding common stock of the Company. (See Note 1A of Notes to Consolidated Financial Statements.) Industry Segments and Service Area The Company is a regulated public utility engaged in the generation, transmission, distribution and sale of electricity and in the purchase and sale, primarily at retail, of natural gas in South Carolina. The Company also renders urban bus service in the metropolitan areas of Columbia and Charleston, South Carolina. The Company's business is seasonal in that, generally, sales of electricity are higher during the summer and winter months because of air-conditioning and heating requirements, and sales of natural gas are greater in the winter months due to its use for heating requirements. The Company's electric service area extends into 24 counties covering more than 15,000 square miles in the central, southern and southwestern portions of South Carolina. The service area for natural gas encompasses all or part of 29 of the 46 counties in South Carolina and covers more than 19,000 square miles. Total estimated population of the counties representing the Company's combined service area is approximately 2.3 million. The predominant industries in the territories served by the Company include: synthetic fibers; chemicals and allied products; fiberglass and fiberglass products; paper and wood products; metal fabrication; stone, clay and sand mining and processing; and various textile-related products. Information with respect to industry segments for the years ended December 31, 1993, 1992 and 1991 is contained in Note 11 of Notes to Consolidated Financial Statements and all such information is incorporated herein by reference. CAPITAL REQUIREMENTS AND FINANCING PROGRAM Capital Requirements The cash requirements of the Company arise primarily from its operational needs and its construction program. During 1994 the Company is expected to meet its capital requirements principally through internally generated funds (approximately 32% excluding dividends), the issuance and sale of debt securities and additional equity contributions from SCANA. Short-term liquidity is expected to be provided by issuance of commercial paper. The timing and amount of such sales and the type of securities to be sold will depend upon market conditions and other factors. The Company recovers the costs of providing services through rates charged to customers. Rates for regulated services are based on historical costs. As inflation occurs and the Company expands its construction program it is necessary to seek increases in rates, and on June 7, 1993 the PSC issued an order granting the Company a 7.4% annual increase, based on a test year, in retail electric rates to be implemented in two phases of $42.0 million annually effective June 1993 and $18.5 million annually effective June 1994. The Company's future financial position and results of operations will be affected by its ability to obtain adequate and timely rate relief. (See "Regulation.") The Company's estimates of its cash requirements for construction and nuclear fuel expenditures, which are subject to continuing review and adjustment, for 1994 and the four-year period 1995-1998 as now scheduled are as follows: Type of Facilities 1994 1995-1998 (Thousands of Dollars) Electric Plant: Generation. . . . . . . . . . . . . . . . $245,039 $ 539,180 Transmission. . . . . . . . . . . . . . . 21,230 94,177 Distribution. . . . . . . . . . . . . . . 58,178 295,523 Other . . . . . . . . . . . . . . . . . . 12,815 42,975 Nuclear Fuel. . . . . . . . . . . . . . . . 28,064 84,770 Gas . . . . . . . . . . . . . . . . . . . . 15,814 62,276 Transit . . . . . . . . . . . . . . . . . . 422 749 Common. . . . . . . . . . . . . . . . . . . 30,650 54,715 Nonutility . . . . . . . . . . . . . . . . 139 545 Total . . . . . . . . . . . . . . $412,351 $1,174,910 The above estimates exclude AFC. Construction The Company's cost estimates for its construction program for the periods 1994 and 1995-1998 shown in the above table include costs of the projects described below. The Company entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 with commercial operation expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. The steam generators at Summer Station will be replaced during the 1994 regularly scheduled refueling outage. In January 1994 the Company, acting on behalf of itself and the PSA (as co- owners of the 885 Megawatt Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential by agreement of the parties and order of the court. The Company had filed an action in May 1990 against Westinghouse in the U. S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. During 1993 the Company expended approximately $20 million as part of a program to extend the operating lives of certain generating facilities. Additional improvements under the program to be made during 1994 are estimated to cost approximately $17 million. Financing Program The Company's First and Refunding Mortgage Bond Indenture, dated April 1, 1945 (Old Mortgage), contains provisions prohibiting the issuance of additional bonds thereunder (Class A Bonds) unless net earnings (as therein defined) for 12 consecutive months out of the 15 months prior to the month of issuance is at least twice the annual interest requirements on all Class A Bonds to be outstanding (Bond Ratio). For the year ended December 31, 1993 the Bond Ratio was 3.70. The issuance of additional Class A Bonds is restricted also to an additional principal amount equal to 60% of unfunded net property additions (which unfunded net property additions totaled approximately $219.9 million at December 31, 1993), Class A Bonds issued on the basis of retirements of Class A Bonds (which retirement credits totaled $10.9 million at December 31, 1993), and Class A Bonds issued on the basis of cash on deposit with the Trustee. The Company has placed a new bond indenture (New Mortgage) dated April 1, 1993 on substantially all of its electric properties under which its future mortgage-backed debt (New Bonds) will be issued. New Bonds are expected to be issued under the New Mortgage on the basis of a like principal amount of Class A Bonds issued under the Old Mortgage, which have been deposited with the Trustee of the New Mortgage (of which $157 million were available for such purpose as of December 31, 1993), until such time as all presently outstanding Class A Bonds are retired. Thereafter, New Bonds will be issuable on the basis of property additions in a principal amount equal to 70% of the original cost of electric and common plant properties (compared to 60% of value for Class A Bonds under the Old Mortgage), cash deposited with the Trustee, and retirement of New Bonds. New Bonds will be issuable under the New Mortgage only if adjusted net earnings (as therein defined) for 12 consecutive months out of the 18 months immediately preceding the month of issuance are at least twice the annual interest requirements on all outstanding bonds (including Class A Bonds) and New Bonds to be outstanding (New Bond Ratio). For the year ended December 31, 1993 the New Bond Ratio was 5.0. On April 29, 1993 the Securities and Exchange Commission declared effective a registration statement for the issuance of up to $700 million of New Bonds. The following series, aggregating $600 million, have been issued under such registration statement: On June 9, 1993, $100 million, 7 5/8% Series due June 1, 2023 to repay short-term borrowings in a like amount. On July 1, 1993, $100 million, 6% Series due June 15, 2000, and $150 million, 7 1/8% Series due June 15, 2013, and on July 20, 1993, $150 million, 7 1/2% Series due June 15, 2023, to redeem, on July 20, 1993, $382,035,000 of First and Refunding Mortgage Bonds maturing between 1999 and 2017 and bearing interest at rates between 8% and 9 7/8% per annum. On December 20, 1993. $100 million, 6 1/4% Series due December 15, 2003 to repay short-term borrowings in a like amount. On June 1, 1993 the Company redeemed the following amounts of First and Refunding Mortgage Bonds: $35 million, 10 1/8% Series due 2009 and $13 million, 9 7/8% Series due 2009. Without the consent of at least a majority of the total voting power of the Company's preferred stock, the Company may not issue or assume any unsecured indebtedness if, after such issue or assumption, the total principal amount of all such unsecured indebtedness would exceed 10% of the aggregate principal amount of all of the Company's secured indebtedness and capital and surplus; provided, however, that no such consent shall be required to enter into agreements for payment of principal, interest and premium for securities issued for pollution control purposes. Pursuant to Section 204 of the Federal Power Act, the Company must obtain FERC authority to issue short-term indebted- ness. The FERC has authorized the Company to issue up to $200 million of unsecured promissory notes or commercial paper with maturity dates of 12 months or less but not later than December 31, 1995. The Company has $127.0 million authorized and unused lines of credit at December 31, 1993. SCE&G's Restated Articles of Incorporation prohibit issuance of additional shares of preferred stock without consent of the preferred stockholders unless net earnings (as defined therein) for the 12 consecutive months immediately preceding the month of issuance is at least one and one-half times the aggregate of all interest charges and preferred stock dividend requirements (Preferred Stock Ratio). For the year ended December 31, 1993 the Preferred Stock Ratio was 2.52. The ratio of earnings to fixed charges (SEC Method) was 3.57, 2.73, 3.32, 3.33 and 3.04 for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. Additional Capital Requirements In addition to the Company's capital requirements for 1994 described above, approximately $5.0 million will be required for refunding and retiring outstanding securities and obligations. For the years 1995-1998, the Company has an aggregate of $149.4 million of long-term debt maturing (including approximately $43.9 million for sinking fund requirements, of which $43.5 million may be satisfied by deposit and cancellation of bonds issued upon the basis of property additions or bond retirement credits) and $9.9 million of purchase or sinking fund requirements for preferred stock. Actual 1994 expenditures may vary from the estimates set forth above due to factors such as inflation, economic conditions, regulation, legislation, rates of load growth, environmental protection standards and the cost and availability of capital. Fuel Financing Agreements The Company has assigned to Fuel Company all of its rights and interests in its various contracts relating to the acquisition and ownership of nuclear and fossil fuel. To finance nuclear and fossil fuel inventories, Fuel Company issues, from time to time, its promissory notes with maturities of less than 270 days ("Commercial Paper"). The issuance of Commercial Paper is supported by an irrevocable revolving credit agreement which expires July 31, 1996 and is guaranteed by the Company. Accordingly, the amounts outstanding have been included in long- term debt. The credit agreement provides for a maximum amount of $75 million that may be outstanding at any time. At December 31, 1993 Commercial Paper outstanding for nuclear and fossil fuel inventories was approximately $36.8 million at a weighted average interest rate of 3.47%. Such fuel inventories and fuel-related assets and liabilities are included in the Company's financial statements. (See Notes 1 and 4 of Notes to Consolidated Financial Statements.) ELECTRIC OPERATIONS Electric Sales In 1993 residential sales of electricity accounted for 43% of electric sales revenues; commercial sales 29%; industrial sales 21%; sales for resale 4%; and all other 3%. KWH sales by classification for the years ended December 31, 1993 and 1992 are presented below: Sales KWH % Classification 1993 1992 Change (thousands) Residential 5,650,759 5,155,886 9.50 Commercial 4,844,422 4,538,862 6.73 Industrial 4,887,250 4,684,072 4.34 Sale for resale 1,005,968 946,357 6.30 Other 500,937 476,064 5.22 Total Territorial 16,889,336 15,801,241 6.89 Interchange 198,059 77,046 157.07 Total 17,087,395 15,878,287 7.61 The Company furnishes electricity for resale to three municipalities, three investor-owned utilities, two electric cooperatives and one public power authority. Such sales for resale accounted for 4% of total electric sales revenues in 1993. An addition of 6,973 electric customers to 468,901 total customers contributed to an all-time peak demand record of 3,557 on July 29, 1993. The previous years' record of 3,380 MW was set July 13, 1992. Electric Interconnections The Company purchases all of the electric generation of Williams Station, owned by GENCO, under a Unit Power Sales Agreement which has been approved by the FERC. The Company's transmission system is part of the interconnected grid extending over a large part of the southern and eastern portion of the nation. The Company, Virginia Power Company, Duke Power Company, Carolina Power & Light Company, Yadkin, Incorporated and PSA are members of the Virginia- Carolinas Reliability Group, one of the several geographic divisions within the Southeastern Electric Reliability Council which provides for coordinated planning for reliability among bulk power systems in the Southeast. The Company is also interconnected with Georgia Power Company, Savannah Electric & Power Company, Oglethorpe Power Corporation and Southeastern Power Administration's Clark Hill Project. Fuel Costs The following table sets forth the average cost of nuclear fuel and coal and the weighted average cost of all fuels (including oil and natural gas) used by the Company and GENCO for the years 1991-1993. 1991 1992 1993 Nuclear: Per million BTU $ .57 $ .52 $ .47 Coal: Company: Per ton $41.61 $40.00 $39.95 Per million BTU 1.63 1.56 1.55 GENCO: Per ton $42.12 $41.82 $41.64 Per million BTU 1.64 1.63 1.62 Weighted Average Cost of All Fuels: Per million BTU $ 1.38 $ 1.27 $ 1.33 The fuel costs shown above exclude the effects of a PSC approved offsetting of fuel costs through the application of credits carried on the Company's books as a result of a 1980 settlement of certain litigation. Fuel Supply The following table shows the sources and approximate percentages of total KWH generation (including Williams Station) by each category of fuel for the years 1991-1993 and the estimates for 1994 and 1995. Percent of Total KWH Generated Actual Estimated 1991 1992 1993 1994 1995 Coal 68% 65% 72% 77% 69% Nuclear 21 29 22 17 26 Hydro 5 5 5 5 5 Natural Gas & Oil 6 1 1 1 - 100% 100% 100% 100% 100% Coal is currently used at all four of the Company's major fossil fuel-fired plants and GENCO's Williams Station. Unit train deliveries are used at all of these plants. On December 31, 1993 the Company had approximately a 73-day supply of coal in inventory and GENCO had approximately a 56-day supply. The supply of coal is obtained through contracts and purchases on the spot market. Spot market purchases are expected to continue for coal requirements in excess of those provided by the Company's existing contracts. Contracts for the purchase of coal represent the following percentages of estimated requirements for 1994 (approximately 5.3 million tons, including requirements of Williams Station) and expire at the dates indicated (giving effect to the Company's potential to exercise renewal options): Range of % of Final No. of Tons % of 1994 Sulfur Content Expiration Renegotiation Per Year Requirement per Contract Date (1) Date (1) 966,664 18.2 up to 1.55 02/28/2001 02/28/1995 360,000 6.8 1.00 - 1.80 12/31/2002 12/31/1996 134,000 2.5 1.10 - 2.00 03/31/1996 03/31/1994 120,000 2.3 1.10 - 1.60 04/30/1996 04/30/1994 972,000 18.3 up to 1.50 12/31/2002 12/31/1996 192,832 3.6 0.80 - 1.50 06/30/2000 06/30/1994 2,745,496 51.7 (1) Contract extensions beyond the stated renegotiation date to the final expiration date are subject to mutual agreement on price, terms, quantity and quality. All of the above contracts, except the contracts expiring in March 1994 and April 1994 which have firm prices, are subject to periodic price adjustments based on changes in indices published by the U. S. Department of Labor. Coal purchased in December 1993 had an average sulfur content of 1.17%, which permitted the Company to comply with existing environmental regulations. The Company believes that its operations are in substantial compliance with all existing regulations relating to the discharge of sulfur dioxide. The Company has not been advised by officials of DHEC that any more stringent sulfur content requirements for existing plants are contemplated. However, the Company will be required to meet the more stringent emissions standards established by the Clean Air Act (see "Environmental Control Matters"). The Company currently has adequate supplies of uranium under contract to manufacture nuclear fuel for Summer Station through 1996. The following table summarizes all contract commitments for the stages of nuclear fuel assemblies: Commitment Contractor Regions(1) Term Uranium NUEXCO Trading Corporation 11 1994 Uranium Energy Resources of Australia 9-13 1990-1996 Uranium Everest Minerals 9-13 1990-1996 Conversion Sequoyah Fuel Corp. 8-12 1989-1995 Enrichment DOE (2) Through 2022 Fabrication Westinghouse 1-21 1982-2009 Reprocessing None (1) A region represents approximately one-third to one-half of the nuclear core in the reactor at any one time. Region no. 10 was loaded in 1993 and region no. 11 will be loaded in 1994. (2) The contract with the DOE is a "requirements" type contract whereby the DOE supplies total enrichment requirements for the unit through the year 2022, as specified by its then current schedule. The Company has on-site spent fuel storage capability until at least 2008 and expects to be able to expand its storage capacity over the life of Summer Station to accommodate the spent fuel output for the life of the plant through rod consolidation, dry cask storage or other technology as it becomes available. In addition, there is sufficient on-site storage capacity over the life of Summer Station to permit storage of the entire reactor core in the event that complete unloading should become desirable or necessary for any reason. (See "Nuclear Fuel Disposal" under "Environmental Control Matters" for information regarding the contract with the DOE for disposal of spent fuel.) GAS OPERATIONS Gas Sales In 1993 residential sales accounted for 36% of gas sales revenues; commercial sales 26%; industrial sales 17% and transportation gas 21%. Dekatherm sales by classification for the years ended December 31, 1993 and 1992 are presented below: SALES DEKATHERMS % CLASSIFICATION 1993 1992 CHANGE Residential 12,009,444 11,286,088 6.4 Commercial 8,842,728 9,029,256 (2.1) Industrial 5,881,309 5,334,117 10.3 Transportation gas 6,993,817 5,906,697 18.4 Total 33,727,298 31,556,158 6.9 During 1993 the Company added 2,696 customers, increasing its total customers to 221,278. The Company purchases all of its natural gas from Pipeline Corporation. The demand for gas is affected by conservation, the weather, the price relationship between gas and alternative fuels and other factors. The deregulation of natural gas prices at the wellhead which took place on January 1, 1985 and the changes in the prices of natural gas that have occurred under Federal regulation have resulted in the development of a spot market for natural gas in the producing areas of the country. Pipeline Corporation has been successful in purchasing lower cost natural gas in the spot market and arranging for its transportation to South Carolina. On April 8, 1992, the FERC promulgated its Order No. 636, which is intended to deregulate the markets for interstate sales of natural gas by requiring that pipelines provide transportation services that are equal in quality for all gas supplies whether the customer purchases gas from the pipeline or another supplier. The impact of this order on the Company will be primarily through changes affecting its supplier, Pipeline Corporation, which, while operating wholly within the state of South Carolina, is served by two interstate pipelines. To reduce dependence on imported oil, NEPA imposes purchase requirements for alternate fuel vehicles for federal, state, municipal and private fleets which increase over a period of years. The Company expects these requirements for alternate fuel vehicles to develop business opportunities for the sale of compressed natural gas as fuel for vehicles, but it cannot predict the extent of this new market. Gas Cost and Supply Pipeline Corporation purchases natural gas under contracts with producers, brokers and interstate pipelines. The gas is brought to South Carolina through contracts with both Southern Natural and Transco. The volume of gas which Pipeline Corporation is entitled to transport through these contracts on a firm basis is shown below: Maximum Daily Supplier Contract Demand Capacity (MCF) Southern Natural Firm Transportation 160,000 Transco Firm Transportation 29,900 Total 189,900 Under a contract with Pipeline Corporation, the Company's maximum daily contract demand is 184,000 MCF. The contract allows the Company to receive amounts in excess of this demand based on availability. The average cost per MCF of natural gas purchased from Pipeline Corporation was approximately $3.81 in 1993 compared to $3.65 in 1992. To meet the requirements of the Company and its high priority natural gas customers during periods of maximum demand, Pipeline Corporation supplements its supplies of natural gas from two LNG plants. The LNG storage tanks are capable of storing the liquefied equivalent of 1,900,000 MCF of natural gas, of which approximately 1,450,000 MCF were in storage at December 31, 1993. On peak days the LNG plants can regasify up to 150,000 MCF per day. Additionally, Pipeline Corporation had contracted for 6,398,035 MCF of natural gas storage space on December 31, 1993, of which 4,880,484 MCF were in storage at such date. Propane air peak shaving facilities located in the Company's service area can supply an additional 137,400 MCF per day. The Company believes that Pipeline Corporation's current supplies under contract and spot market purchase of natural gas are adequate to meet existing customer demands for service and to accommodate growth. Curtailment Plans The FERC has established allocation priorities applicable to firm and interruptible capacities on interstate pipeline companies to their customers which require Southern Natural and Transco to allocate capacity to Pipeline Corporation. The FERC allocation priorities are not applicable to deliveries by the Company to its customers, which are governed by a separate curtailment plan approved by the PSC. REGULATION General The Company is subject to the jurisdiction of the PSC as to retail electric, gas and transit rates, service, accounting, issuance of securities (other than short-term promissory notes) and other matters. The Company is subject to regulatory jurisdiction under the Federal Power Act, administered by the FERC and the DOE, in the transmission of electric energy in interstate commerce and in the sale of electric energy at wholesale for resale, as well as with respect to licensed hydroelectric projects and certain other matters, including accounting and the issuance of short-term promissory notes. National Energy Policy Act of 1992 Congress has passed NEPA, the principal thrust of which is to create a more competitive wholesale power supply market by creating "exempt wholesale generators" (EWGs) designated by the FERC, which are independent power producers (IPPs) whose owners will not become holding companies under PUHCA. Upon application of a wholesaler of electric energy, the FERC may order an electric utility that owns transmission facilities used for wholesale sales of electric energy to provide transmission service (including any enlargement of transmission capacity needed to provide the service) to the applicant. Charges for transmission service must be "just and reasonable" and a utility is entitled to recover "all legitimate, verifiable economic costs" incurred in connection with any transmission service so ordered. The FERC may not order such service where it (1) would "unreasonably impair the continued reliability of electric wheeling" judged by reference to "consistently applied regional or national reliability standards, guidelines or criteria;" (2) would result in "retail wheeling;" or (3) would conflict with state laws governing retail marketing areas of electric utilities. Electric utilities, including exempt and non-exempt holding companies, may own and operate EWGs subject to advance approval by state utility commissions, which are given access to books and records of the EWG and its affiliates to the extent that such a commission requires access to perform its regulatory duties. It allows both registered and exempt utility holding companies to acquire interests in foreign utility companies engaged in the generation, transmission or distribution of electricity or the retail distribution of gas, where a state commission has certified that it has the ability to protect the utility's retail ratepayers against adverse investments in foreign utilities by affiliates of public utilities that such commissions regulate. State Commissions must consider rate making changes and other regulatory reform to ensure that electric utilities' investments in energy efficiency and demand side management programs are at least as profitable as investing in new generating capacity. FERC has issued a Notice of Proposed Rule Making to develop regulations under NEPA concerning EWGs and electric transmission service. NEPA also has provisions concerning nuclear power, alternate fuel vehicles, minimum efficiency standards, integrated resource planning, demand side management incentives, a variety of energy research projects relating to environmental measures, electric and magnetic fields, hydroelectric projects, and global warming. It authorizes one step licensing for nuclear power plants and requires EPA to issue standards for the Yucca Mountain repository site for nuclear waste (see "Nuclear Fuel Disposal" under "Environmental Control Matters"). To reduce dependence on imported oil, NEPA imposes purchase requirements for alternate fuel vehicles for federal, state, municipal and private fleets which increase over a period of years (see "Gas Operations"). In the opinion of the Company, it will be able to meet successfully the challenges of an altered business climate for electric and gas utilities and natural gas businesses. Neither the application of NEPA or FERC Order No. 636 nor the development of an EWG industry, new markets and obligations for transmission services for wholesale sales of electricity, nor deregulated interstate natural gas markets is expected to have a material adverse impact on the results of its operations, its financial position or its business prospects. Federal Energy Regulatory Commission Pursuant to Section 204 of the Federal Power Act, the Company must obtain FERC authority to issue short-term indebtedness. The FERC has authorized the Company to issue up to $200 million of unsecured promissory notes or commercial paper with maturity dates of 12 months or less but not later than December 31, 1995. The Company holds licenses under the Federal Water Power Act or the Federal Power Act with respect to all its hydroelectric projects. The expiration dates of the licenses covering the projects are as follows: Neal Shoals (5,000 KW capability) and Stevens Creek (9,000 KW capability) 1993; Columbia (10,000 KW capability) 2000; Saluda Project (206,000 KW capability) 2007; and Parr Shoals (14,000 KW capability) and Fairfield Pumped Storage Project (512,000 KW capability) 2020. Pursuant to the provisions of the Federal Power Act as amended by the Electric Consumers Protection Act of 1986, applications for new licenses were filed on December 30, 1991. No competing applications were filed. The Neal Shoals license application was accepted for filing by the FERC on September 30, 1992 and the Stevens Creek application was accepted September 15, 1993. FERC has issued Notices of Authorization for Continued Project Operation for both projects until FERC has acted on SCE&G's applications for new licenses. FERC has announced its intentions to perform a Multiple-project Environmental Assessment for Neal Shoals and a Multiple-project Environmental Impact Statement for Stevens Creek. At the termination of a license under the Federal Power Act, the United States Government may take over the project covered thereby, or the FERC may extend the license or issue a license to another applicant. If the United States takes over a project or the FERC issues a license to another applicant, the original licensee shall be paid its net investment in the project (not to exceed fair value) plus severance damages. Nuclear Regulatory Commission The Company is subject to regulation by the NRC with respect to the ownership and operation of Summer Station. The NRC's jurisdiction encompasses broad supervisory and regulatory powers over the construction and operation of nuclear reactors, including matters of health and safety, antitrust considerations and environmental impact. The NRC conducts semiannual reviews that identify plants that have demonstrated an excellent level of safety performance. Summer Station was recognized in both 1993 reviews as one of the top nuclear plants in the country. In addition, the Federal Emergency Management Agency is responsible for the review, in conjunction with the NRC, of certain aspects of emergency planning relating to the operation of nuclear plants. *Reflects a rate reduction of $3.7 million on January 4, 1993 (see discussion below) and excludes impact of rate reduction of $7.7 million on January 3, 1990 which corresponds to $7.7 million reduction in cost-of-service resulting from NRC approval of extension of Summer Station's operating life to 40 years. ** As modified On June 7, 1993 the PSC issued an order on the Company's pending electric rate proceeding allowing an authorized return on common equity of 11.5%, resulting in a 7.4% annual increase in retail electric rates, or a projected $60.5 million annually based on a test year. These rates are to be implemented in two phases over a two-year period: phase one, effective June 1993, producing $42.0 million annually, and phase two, effective June 1994, producing $18.5 million annually, based on a test year. The Company's request, as modified, had proposed a return on equity of 12.05% and had projected annual increases of $53.0 million and $19.0 million for phases one and two, respectively. On September 14, 1992 the PSC issued an order granting the Company a $.25 increase in transit fares from $.50 to $.75 in both Columbia and Charleston, South Carolina; however, the PSC also required $.40 fares for low income customers and denied the Company's request to reduce the number of routes and frequency of service. The new rates were placed into effect on October 5, 1992. The Company has appealed the PSC's order to the Circuit Court. During oral arguments in February 1994 the Circuit Court retained jurisdiction and remanded the decision to the PSC for the limited purpose of answering questions concerning the applicable regulatory principles used by the PSC in determining these transit rates. Since November 1, 1991 the Company's gas rate schedules for its residential, small commercial and small industrial customers have included a weather normalization adjustment (WNA). The WNA minimizes fluctuations in gas revenues due to abnormal weather conditions and has been approved through November 1994 subject to an annual review by the PSC. The PSC order was based on a return on common equity of 12.25%. The WNA became effective the first billing cycle in December 1991. In May 1989 the PSC approved a volumetric and direct billing method for Pipeline Corporation to recover take-or-pay costs incurred from its interstate pipeline suppliers pursuant to FERC-approved final and non-appealable settlements. In December 1992 the Supreme Court approved Pipeline Corporation's full recovery of the take-or-pay charges imposed by its suppliers and treatment of these charges as a cost of gas. However, the Supreme Court declared the PSC-approved "purchase deficiency" methodology for recovery of these costs to be unlawful retroactive ratemaking and remanded the docket to the PSC to reconsider its recovery methodology. The Company believes that the elimination of the purchase deficiency method of recovery will affect the timing for recovery of take-or-pay charges and shift the allocations among Pipeline Corporation's customers (including the Company) but that all such charges should be ultimately recovered. The Supreme Court decision establishes a principle of law that will provide a basis for full recovery by the Company, as well as Pipeline Corporation, of these costs. On July 3, 1989 the PSC granted the Company approximately $21.9 million of a requested $27.2 million annual increase in retail electric revenues based upon an allowed return on common equity of 13.25%. The Consumer Advocate appealed the decision to the Supreme Court which, on August 31, 1992, found that the evidence in the record of that case did not support a return on common equity higher than 13.0% and remanded to the PSC a portion of its July 1989 order for a determination of the proper return on common equity consistent with the Supreme Court's opinion. On January 19, 1993 the PSC issued an order allowing a return on common equity of 13.0%, approving a refund based on the difference in rates created by the difference between the 13.0% and the 13.25% return on common equity and making other non-material adjustments to the calculation of cost-of-service. The total refund before interest and income taxes, was approximately $14.6 million and was charged against 1992 "Electric Revenues." The refund plus interest was made during 1993. On November 28, 1989 the PSC granted the Company an increase in firm retail natural gas rates, effective November 30, 1989, designed to increase annual revenues by $10.1 million, or 89.5% out of the requested increase of approximately $11.3 million. In its order the PSC authorized a 12.75% return on common equity. The Consumer Advocate appealed to the Supreme Court which on August 31, 1992 remanded the order to the PSC for redetermination of the proper amount of litigation expenses to include in the test period. In January 1993 the PSC reduced the amount of litigation expense and ordered a refund totaling approximately $163,000 which was charged against 1992 "Gas Revenues." The refund was made during 1993. Fuel Cost Recovery Procedures The PSC has established a fuel recovery procedure which determines the fuel component in the Company's retail electric base rates semiannually based on projected fuel costs for the ensuing six-month period, adjusted for any overcollection or undercollection from the preceding six-month period. The Company has the right to request a formal proceeding at any time should circumstances dictate such a review. In the April 1993 semiannual review of the fuel cost component of electric rates, the PSC voted to reduce the rate from 13.5 mills per KWH to 13.0 mills per KWH, a monthly decrease of $.50 for an average customer using 1,000 KWH a month. This reduction coincided with the retail electric rate case effective June 1993. For the October 1993 review the PSC voted to continue the rate of 13.0 mills per KWH. The Company's gas rate schedules and contracts include mechanisms which allow it to recover from its customers changes in the actual cost of gas. The Company's firm gas rates allow for the recovery of a fixed cost of gas, based on projections, as established by the PSC in annual gas cost and gas purchase practice hearings. Any differences between actual and projected gas costs are deferred and included when projecting gas costs during the next annual gas cost recovery hearing. In the October 1993 review the PSC authorized an increase in the base cost of gas from 41.963 cents per therm to 47.100 cents per therm which resulted in a monthly increase of $5.14 (including applicable taxes) based on an average of 100 therms per month on a residential bill during the heating season. In July 1990 the PSC initiated proceedings for a generic hearing on the Industrial Sales Program Rider (ISPR) for the Company and Pipeline Corporation. The PSC issued an order dated December 20, 1991 approving a Stipulation and Agreement signed in December 1991 by all parties involved which retained the ISPR with modifications to Pipeline Corporation's gas cost mechanisms. ENVIRONMENTAL CONTROL MATTERS General Federal and state authorities have imposed environmental control requirements relating primarily to air emissions, wastewater discharges and solid, toxic and hazardous waste management. The Company is attempting to ensure that its operations meet applicable environmental regulations and standards. It is difficult to forecast the ultimate effect of environmental quality regulations upon the existing and proposed operations. Moreover, developments in these and other areas may require that equipment and facilities be modified, supplemented or replaced. Capital Expenditures In the years 1991 through 1993, capital expenditures for environmental control amounted to approximately $73.6 million. In addition, approximately $7.4 million, $5.7 million and $4.8 million of environmental control expenditures were made during 1993, 1992 and 1991, respectively, which were included in "Other operation" and "Maintenance" expenses. It is not possible to estimate all future costs for environmental purposes, but forecasts for minimum capitalized expenditures are $40.3 million for 1994 and $252.1 million for the four-year period 1995 through 1998. These expenditures are included in the Company's construction program. Air Quality Control The Federal Clean Air Act of 1970 (the "1970 Act") requires that electric generating plants comply with primary and secondary ambient air quality standards with respect to certain air pollutants including particulates, sulfur oxides and nitrogen oxides and imposes economic penalties for noncompliance. This Act was amended with the passage of the Clean Air Act Amendments of 1990. Currently, the Company uses a variety of methods to comply with the State Implementation Plan (developed pursuant to the 1970 Act), including the use of low sulfur fuel, fuel switching, reduction of load during periods when compliance cannot be met at full power, maintenance and improvement of existing electrostatic precipitators and the installation of new baghouses. The Company and GENCO have been able to purchase sufficient fuel meeting current sulfur standards for all of their plants. With respect to sulfur dioxide emissions, none of the Company's electric generating plants is included among the Phase I plants listed in the Clean Air Act Amendments of 1990 with a compliance date of January 1, 1995. Both companies will, however, be affected by Phase II requirements which have a compliance date of January 1, 2000. The companies undertook a study in 1992 to determine the most cost effective mix of control options to meet the requirements of the Clean Air Act. Such a control strategy will most likely result in requiring the Company to utilize a combination of the following alternatives to meet its compliance requirements: (1) burn lower sulfur coal, (2) burn natural gas, (3) retrofit at least one coal-fired electric generating unit with a scrubber to remove sulfur dioxide and (4) purchase sulfur dioxide emission allowances to the extent necessary. In addition, the Company will install on most of its coal-fired units low nitrogen oxide burners to reduce nitrogen oxide emissions. The Company currently estimates that, excluding GENCO, air emissions control equipment will require capital expenditures of $190 million over the 1994-1998 period to retrofit existing facilities and an increased operation and maintenance cost of $22 million per year. Total capital expenditures required to meet compliance requirements through the year 2003 are anticipated to be approximately $211 million. Water Quality Control The Federal Clean Water Act, as amended, provides for the imposition of effluent limitations that require various levels of treatment for each wastewater discharge. Under this Act, compliance with applicable limitations is achieved under a national permit program. Discharge permits have been issued for all and renewed for nearly all of the Company's generating units. Commensurate with renewal of these permits has been implementation of a more rigorous control program on behalf of the permitting agency. The facilities have been developing compliance plans to meet the additional parameters of control and compliance has involved updating wastewater treatment technologies. Amendments to the Clean Water Act proposed recently in Congress include several provisions which could prove costly to the Company. These include limitations to mixing zones and the implementation of technology- based standards. Superfund Act and Environmental Assessment Program As described in Note 1L of Notes to Consolidated Financial Statements, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated, an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date ($19.6 million) for site assessments and cleanup relate primarily to regulated operations; such amounts have been deferred and are being amortized and recovered through rates over a ten-year period. Estimates to date include, among other things, the costs estimated to be associated with the matters discussed in the following paragraphs. The Company and SCANA each own two decommissioned manufactured gas plant sites which contain residues of by-product chemicals. The Company and SCANA have each maintained an active review of their respective sites to monitor the nature and extent of the residual contamination. In September 1992 the EPA notified the Company, the City of Charleston and the Charleston Housing Authority of their potential liability for the investigation and cleanup of the Calhoun Park Area Site in Charleston, South Carolina. This site originally encompassed approximately 18 acres and included properties which were the locations for industrial operations, including a wood preserving (creosote) plant and one of the Company's decommissioned manufactured gas plants. The original scope of this investigation has been expanded to approximately 30 acres including adjacent properties owned by the National Park Service and the City of Charleston, and private properties. The site has not been placed on the National Priority List, but may be added before cleanup is initiated. The potentially responsible parties (PRP) have agreed with the EPA to participate in an innovative approach to site investigation and cleanup called "Superfund Accelerated Cleanup Model," allowing the pre-cleanup site investigations process to be compressed significantly. The PRPs have negotiated an administrative order by consent for the conduct of a Remedial Investigation/Feasibility Study (RI/FS) and a corresponding Scope of Work. Actual field work began November 1, 1993 after final approval and authorization was granted by EPA. The Company is also working with the City of Charleston to investigate potential contamination from the manufactured gas plant at the city's aquarium site. During 1993 the Company settled its obligations at the Yellow Water Road Superfund Site near Jacksonville, Florida, the Spencer Transformer and Equipment Site in West Virginia and Elliott's Auto Parts in Benton, Arkansas. No further expenses are anticipated for these sites. The Company has been listed as a PRP and has recorded liabilities, which are not considered material, for the Macon- Dockery waste disposal site near Rockingham, North Carolina, the Aqua-Tech Environmental, Inc. site in Greer, South Carolina and a landfill owned by Lexington County in South Carolina. Solid Waste Control The South Carolina Solid Waste Policy and Management Act of 1991 requires promulgation of regulations addressing specified subjects, one of which affects the management of industrial solid waste. This regulation will establish minimum criteria for industrial landfills as mandated under the Act. The proposed regulation, if adopted as a final regulation in its present form, could significantly impact the Company's engineering, design and operation of existing and future ash management facilities. Potential cost impacts could be substantial. Nuclear Fuel Disposal The Nuclear Waste Policy Act of 1982 (the "1982 Act") requires that the Federal Government make available by 1998 a permanent repository for high-level radioactive waste and spent nuclear fuel and imposes a fee of 1.0 mill per KWH of net nuclear generation after April 7, 1983. Payments, which began in 1983, are subject to change and will extend through the operating life of Summer Station. The Company entered into a contract with the DOE on June 29, 1983, providing for permanent disposal of its spent nuclear fuel by the DOE. The DOE presently estimates that the permanent storage facility will not be available until 2010. The Company has on-site spent fuel storage capability until at least 2008 and expects to be able to expand its storage capacity over the life of Summer Station to accommodate the spent fuel output for the life of the plant through rod consolidation, dry cask storage or other technology as it becomes available. The 1982 Act also imposes on utilities the primary responsibility for storage of their spent nuclear fuel until the repository is available. (See "Fuel Supply" under "Electric Operations" for a discussion of spent fuel storage facilities at Summer Station.) OTHER MATTERS With regard to the Company's insurance coverage for Summer Station, reference is made to Note 10B of Notes to Consolidated Financial Statements, which is incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES Reference is made to Schedule V - Property Plant and Equipment, pages 54 through 59, for information concerning investments in utility plant and nonutility property. The Company's bond indentures, securing the First and Refunding Mortgage Bonds and First Mortgage Bonds issued thereunder, constitute direct mortgage liens on substantially all of its property. ELECTRIC The following table gives information with respect to the Company's electric generating facilities. Net Generating Present Year Capability Facility Fuel Capability Location In-Service (KW)(1) Steam Urquhart Coal/Gas Beech Island, SC 1953 250,000 McMeekin Coal/Gas Irmo, SC 1958 252,000 Canadys Coal/Gas Canadys, SC 1962 430,000 Wateree Coal Eastover, SC 1970 700,000 Summer (2) Nuclear Parr, SC 1984 590,000 Gas Turbines Burton Gas/Oil Burton, SC 1961 28,500 Faber Place Gas Charleston, SC 1961 9,500 Hardeeville Oil Hardeeville, SC 1968 14,000 Canadys Gas/Oil Canadys, SC 1968 14,000 Urquhart Gas/Oil Beech Island, SC 1969 26,000 Coit Gas/Oil Columbia, SC 1969 30,000 Parr (3) Gas/Oil Parr, SC 1970 60,000 Williams (4) Gas/Oil Goose Creek, SC 1972 49,000 Hagood Gas/Oil Charleston, SC 1991 95,000 Hydro Neal Shoals Carlisle, SC 1905 5,000 Parr Shoals Parr, SC 1914 14,000 Stevens Creek Martinez, GA 1914 9,000 Columbia Columbia, SC 1927 10,000 Saluda Irmo, SC 1930 206,000 Pumped Storage Fairfield Parr, SC 1978 512,000 Total (5) 3,304,000 (1) Summer rating. (2) Represents the Company's two-thirds portion of the Summer Station. (3) Two of the four Parr gas turbines are leased and have a net capability of 34,000 KW. This lease expires on June 29, 1996. (4) The two gas turbines at Williams are leased and have a net capability of 49,000 KW. This lease expires on June 29, 1997. (5) Excludes Williams Station. The Company owns 424 substations having an aggregate transformer capacity of 18,624,780 KVA. The transmission system consists of 3,033 miles of lines and the distribution system consists of 15,186 pole miles of overhead lines and 3,006 trench miles of underground lines. GAS Natural Gas The Company's gas system consists of approximately 6,179 miles of three-inch equivalent distribution pipelines and approximately 10,085 miles of distribution mains and related service facilities. The gas system acquired by SCANA is operated by the Company and consists of approximately 450 miles of three-inch equivalent distribution pipelines and approximately 778 miles of distribution mains and related service facilities. Effective January 1, 1994 the assets and liabilities of such gas system were transferred from SCANA to the Company. Propane The Company has propane air peak shaving facilities which can supplement the supply of natural gas by gasifying propane to yield the equivalent of 102,000 MCF per day of natural gas. TRANSIT The Company owns 93 motor coaches which operate on a route system of 285 miles. ITEM 3. ITEM 3. LEGAL PROCEEDINGS For information regarding legal proceedings, see ITEM 1., "BUSINESS," and Note 10 of Notes to Consolidated Financial Statements appearing in ITEM 8., "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." 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 STOCK AND RELATED SECURITY HOLDER MATTERS All of the Company's common stock is owned by SCANA and therefore there is no market for such stock. During 1993 and 1992 the Company paid $108.6 million and $96.6 million, respectively, in cash dividends to SCANA. The Restated Articles of Incorporation of the Company and the Indenture underlying its First and Refunding Mortgage Bonds contain provisions that may limit the payment of cash dividends on common stock. In addition, with respect to hydroelectric projects, the Federal Power Act may require the appropriation of a portion of the earnings therefrom. At December 31, 1993 approximately $10.6 million of retained earnings were restricted as to payment of cash dividends on common stock. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES The cash requirements of the Company arise primarily from its operational needs and its construction program. The ability of the Company to replace existing plant investment, as well as to expand to meet future demands for electricity and gas, will depend upon its ability to attract the necessary financial capital on reasonable terms. The Company recovers the costs of providing services through rates charged to customers. Rates for regulated services are based on historical costs. As customer growth and inflation occur and the Company expands its construction program it is necessary to seek increases in rates. As a result the Company's future financial position and results of operations will be affected by its ability to obtain adequate and timely rate relief. Due to continuing customer growth, the Company entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 with commercial operation expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. Until the completion of the new plant, the Company is contracting for additional capacity as necessary to ensure that the energy demands of its customers can be met. As discussed in Note 2A of Notes to Consolidated Financial Statements on June 7, 1993 the PSC issued an order granting the Company a 7.4% annual increase in retail electric rates to be implemented in two phases of $42.0 million annually effective June 1993 and $18.5 million annually effective June 1994. The estimated primary cash requirements for 1994, excluding requirements for fuel liabilities and short-term borrowings, and the actual primary cash requirements for 1993 are as follows: 1994 1993 (Thousands of Dollars) Property additions and construction expenditures, excluding allowance for funds used during construction (AFC) $384,287 $280,910 Nuclear fuel expenditures 28,064 7,177 Maturing obligations, redemptions and sinking and purchase fund requirements 5,024 3,700 Total $417,375 $291,787 Approximately 20.0% of total cash requirements (excluding dividends) was provided from internal sources in 1993 as compared to 49.2% in 1992. The Company's First and Refunding Mortgage Bond Indenture, dated April 1, 1945 (Old Mortgage), contains provisions prohibiting the issuance of additional bonds thereunder (Class A Bonds) unless net earnings (as therein defined) for 12 consecutive months out of the 15 months prior to the month of issuance is at least twice the annual interest requirements on all Class A Bonds to be outstanding (Bond Ratio). For the year ended December 31, 1993 the Bond Ratio was 3.70. The issuance of additional Class A Bonds is restricted also to an additional principal amount equal to 60% of unfunded net property additions (which unfunded net property additions totaled approximately $219.9 million at December 31, 1993), Class A Bonds issued on the basis of retirements of Class A Bonds (which retirement credits totaled $10.9 million at December 31, 1993) and Class A Bonds issued on the basis of cash on deposit with the Trustee. The Company has placed a new bond indenture (New Mortgage) dated April 1, 1993 on substantially all of its electric properties under which its future mortgage-backed debt (New Bonds) will be issued. New Bonds are expected to be issued under the New Mortgage on the basis of a like principal amount of Class A Bonds issued under the Old Mortgage which have been deposited with the Trustee of the New Mortgage (of which $157 million were available for such purpose as of December 31, 1993), until such time as all presently outstanding Class A Bonds are retired. Thereafter, New Bonds will be issuable on the basis of property additions in a principal amount equal to 70% of the original cost of electric and common plant properties (compared to 60% of value for Class A Bonds under the Old Mortgage), cash deposited with the Trustee, and retirement of New Bonds. New Bonds will be issuable under the New Mortgage only if adjusted net earnings (as therein defined) for 12 consecutive months out of the 18 months immediately preceding the month of issuance are at least twice the annual interest requirements on all outstanding bonds (including Class A Bonds) and New Bonds to be outstanding (New Bond Ratio). For the year ended December 31, 1993 the New Bond Ratio was 5.0. On April 29, 1993 the Securities and Exchange Commission declared effective a registration statement for the issuance of up to $700 million of New Bonds. The following series, aggregating $600 million, have been issued under such registration statement: On June 9, 1993, $100 million, 7 5/8% Series due June 1, 2023 to repay short-term borrowings in a like amount. On July 1, 1993, $100 million, 6% Series due June 15, 2000, and $150 million, 7 1/8% Series due June 15, 2013, and on July 20, 1993, $150 million, 7 1/2% Series due June 15, 2023, to redeem, on July 20, 1993, $382,035,000 of First and Refunding Mortgage Bonds maturing between 1999 and 2017 and bearing interest at rates between 8% and 9 7/8% per annum. On December 20, 1993, $100 million, 6 1/4% Series due December 15, 2003 to repay short-term borrowings in a like amount. On June 1, 1993 the Company redeemed the following amounts of First and Refunding Mortgage Bonds: $35 million, 10 1/8% Series due 2009 and $13 million, 9 7/8% Series due 2009. Without the consent of at least a majority of the total voting power of the Company's preferred stock, the Company may not issue or assume any unsecured indebtedness if, after such issue or assumption, the total principal amount of all such unsecured indebtedness would exceed 10% of the aggregate principal amount of all of the Company's secured indebtedness and capital and surplus; provided, however, that no such consent shall be required to enter into agreements for payment of principal, interest and premium for securities issued for pollution control purposes. Pursuant to Section 204 of the Federal Power Act, the Company must obtain FERC authority to issue short-term indebtedness. The FERC ha authorized the Company to issue up to $200 million of unsecured promissory notes or commercial paper with maturity dates of 12 months or less but not later than December 31, 1995. The Company has $127.0 million authorized and unused lines of credit at December 31, 1993. In addition, the Company has a credit agreement for a maximum of $75 million to finance nuclear and fossil fuel inventories, with $38.2 million available at December 31, 1993. The Company's Restated Articles of Incorporation prohibit issuance of additional shares of preferred stock without consent of the preferred stockholders unless net earnings (as defined therein) for the 12 consecutive months immediately preceding the month of issuance is at least one and one-half times the aggregate of all interest charges and preferred stock dividend requirements (Preferred Stock Ratio). For the year ended December 31, 1993 the Preferred Stock Ratio was 2.52. The Company anticipates that its 1994 cash requirements of $417.4 million will be met primarily through internally generated funds (approximately 32% excluding dividends), the sales of additional securities, additional equity contributions from SCANA and the incurrence of additional short-term and long-term indebtedness. The timing and amount of such financing will depend upon market conditions and other factors. Actual 1994 expenditures may vary from the estimates set forth above due to factors such as inflation and economic conditions, regulation and legislation, rates of load growth, environmental protection standards and the cost and availability of capital. The Company expects that it has or can obtain adequate sources of financing to meet its projected cash requirements. Environmental Matters The Clean Air Act requires electric utilities to reduce substantially emissions of sulfur dioxide and nitrogen oxide by the year 2000. These requirements are being phased in over two periods. The first phase has a compliance date of January 1, 1995 and the second, January 1, 2000. The Company meets all requirements of Phase I and therefore will not have to implement changes until compliance with Phase II requirements is necessary. The Company then will most likely meet its compliance requirements through the burning of natural gas and/or lower sulfur coal, the addition of scrubbers to coal-fired generating units, and the purchase of sulfur dioxide emission allowances. Low nitrogen oxide burners will be installed to reduce nitrogen oxide emissions. The Company is continuing to refine a detailed compliance plan that must be filed with the EPA by January 1, 1996. The Company currently estimates that, excluding GENCO, air emissions control equipment will require capital expenditures of $190 million over the 1994-1998 period to retrofit existing facilities and an increased operation and maintenance cost of $22 million per year. Total capital expenditures required to meet compliance requirements through the year 2003 are anticipated to be approximately $211 million. The South Carolina Solid Waste Policy and Management Act of 1991 requires promulgation of regulations addressing specified subjects, one of which affects the management of industrial solid waste. This regulation will establish minimum criteria for industrial landfills as mandated under the Act. The proposed regulation, if adopted as a final regulation in its present form, could significantly impact the Company's engineering, design and operation of existing and future ash management facilities. Potential cost impacts could be substantial. As described in Note 1L of Notes to Consolidated Financial Statements, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated, an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date ($19.6 million) for site assessments and cleanup of regulated operations have been deferred and are being amortized and recovered through rates over a ten year period. Estimates to date include, among other things, the costs estimated to be associated with the matters discussed in the following paragraphs. The Company and SCANA each own two decommissioned manufactured gas plant sites which contain residues of by-product chemicals. The Company and SCANA have each maintained an active review of their respective sites to monitor the nature and extent of the residual contamination. In September 1992 the EPA notified the Company, the City of Charleston and the Charleston Housing Authority of their potential liability for the investigation and cleanup of the Calhoun Park Area Site in Charleston, South Carolina. This site originally encompassed approximately 18 acres and included properties which were the locations for industrial operations, including a wood preserving (creosote) plant and one of the Company's decommissioned manufactured gas plants. The original scope of this investigation has been expanded to approximately 30 acres including adjacent properties owned by the National Park Service and the City of Charleston, and private properties. The site has not been placed on the National Priority List, but may be added before cleanup is initiated. The potentially responsible parties (PRP) have agreed with the EPA to participate in an innovative approach to site investigation and cleanup called "Superfund Accelerated Cleanup Model," allowing the pre- cleanup site investigations process to be compressed significantly. The PRPs have negotiated an administrative order by consent for the conduct of a Remedial Investigation/Feasibility Study (RI/FS) and a corresponding Scope of Work. Actual field work began November 1, 1993 after final approval and authorization was granted by EPA. The Company is also working with the City of Charleston to investigate potential contamination from the manufactured gas plant at the city's aquarium site. During 1993 the Company settled its obligations at the Yellow Water Road Superfund Site near Jacksonville, Florida, the Spencer Transformer and Equipment Site in West Virginia and Elliott's Auto Parts in Benton, Arkansas. No further expenses are anticipated for these sites. The Company has been listed as a PRP and has recorded liabilities, which are not considered material, for the Macon- Dockery waste disposal site near Rockingham, North Carolina, the Aqua-Tech Environmental, Inc. site in Greer, South Carolina and a landfill owned by Lexington County in South Carolina. Litigation In January 1994 the Company, acting on behalf of itself and the PSA (as co-owners of Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential by agreement of the parties and order of the court. The Company had filed an action in May 1990 against Westinghouse in the U. S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. Regulatory Matters On June 7, 1993 the PSC issued an order on the Company's pending electric rate proceeding allowing an authorized return on common equity of 11.5%, resulting in a 7.4% annual increase in retail electric rates, or a projected $60.5 million annually on a test year basis. These rates are to be implemented in two phases over a two-year period: phase one, effective June 1993, producing $42.0 million annually, and phase two, effective June 1994, producing $18.5 million annually, on a test year basis. The Company's operations are likely to be impacted by NEPA and FERC Order 636. NEPA is designed to create a more competitive wholesale power supply market by creating "exempt wholesale generators" and allowing for the potential requirement that a utility owning transmission facilities provide transmission access to wholesalers. Order No. 636 is intended to deregulate the markets for interstate sales of natural gas by requiring that pipelines provide transportation services that are equal in quality for all gas suppliers whether the customer purchases gas from the pipeline or another supplier. In the opinion of the Company, it will be able to meet successfully the challenges of these altered business climates. Other In November 1992 the Financial Accounting Standards Board issued Statement No. 112 "Employers' Accounting for Postemployment Benefits." The Statement, which is effective for calendar year 1994, establishes certain conditions for the recognition of costs of benefits to former employees after employment but before retirement. The Statement requires recognition of the obligation to provide postemployment benefits if such obligation is attributable to services previously rendered, the obligation relates to rights which vest, payment of the benefits is probable and the amount of such benefits can be reasonably estimated. The Company does not anticipate that application of this Statement will have a significant impact on results of operations or financial position. RESULTS OF OPERATIONS Overview Net income and the percent increase (decrease) from the previous year for the years 1993, 1992 and 1991 were as follows: 1993 1992 1991 Net income $145,968 $102,163 $122,836 Percent increase (decrease) in net income 42.9% (16.8%) 1.7% 1993 Net income increased for 1993 primarily due to an increase in the electric margin which more than offset increases in other operating expenses. 1992 Net income for 1992 decreased from 1991 primarily due to the recording of an $11.1 million (after interest and income taxes) reserve against earnings related to the August 31, 1992 retail electric rate ruling from the South Carolina Supreme Court (see Note 2E of Notes to Consolidated Financial Statements) and as a result of increased non-fuel operating expenses and interest charges. The Company's financial statements include AFC. AFC is a utility accounting practice whereby a portion of the cost of both equity and borrowed funds used to finance construction (which is shown on the balance sheet as construction work in progress) is capitalized. Both an equity and debt portion of AFC are included in nonoperating income as noncash items which have the effect of increasing reported net income. AFC represented approximately 5.6% of income before income taxes in 1993, 5.5% in 1992 and 3.7% in 1991. Electric Operations Electric sales margins for 1993, 1992 and 1991 were as follows: 1993 1992 1991 (Millions of Dollars) Electric revenues $940.2 $844.5 $867.7 Provision for rate refunds .3 (14.6) - Net Electric operating revenues 940.5 829.9 867.7 Less: Fuel used in electric generation 164.2 161.7 160.6 Purchased power 111.1 80.4 102.1 Margin $665.2 $587.8 $605.0 1993 The increase in electric sales margin from 1992 to 1993 is primarily a result of increased residential and commercial KWH sales due to weather and customer growth, an increase in retail electric rates beginning in June 1993, and a $14.6 million reserve recorded in 1992 as discussed below. 1992 The 1992 electric sales margin decreased from 1991 primarily due to the recording of a $14.6 million reserve, before interest and income taxes, related to the August 31, 1992 ruling from the Supreme Court (see Note 2E of Notes to Consolidated Financial Statements) and a $1.9 million billing-related litigation settlement included in 1991 electric operating revenues. Increases (decreases) in megawatt hour (MWH) sales volume by classes are presented in the following table: Increase (Decrease) From Prior Year Volume (MWH) Classification 1993 1992 Residential 494,874 2,380 Commercial 305,560 37,749 Industrial 203,178 49,248 Sale for Resale (excluding interchange) 59,611 12,945 Other 24,873 (3,116) Total territorial 1,088,096 99,206 Interchange 121,013 16,558 Total 1,209,109 115,764 Warmer weather and an increase in the number of electric customers contributed to an all-time peak demand record of 3,557 MW (including Williams Station) on July 29, 1993. The previous year's record of 3,380 MW was set on July 13, 1992. Gas Operations Gas sales margins for 1993, 1992 and 1991 were as follows: 1993 1992 1991 (Millions of Dollars) Gas revenues $174.0 $160.8 $150.8 Less: Gas purchased for resale 107.7 95.8 93.2 Margin $ 66.3 $ 65.0 $ 57.6 1993 The 1993 gas sales margin increased from 1992 primarily as a result of increases in higher margin residential and regular commercial sales. 1992 The 1992 gas sales margin increased from 1991 primarily due to recoveries of $4.2 million allowed under a weather normalization adjustment, increases in residential usage due to unseasonably cool weather during May 1992, and increased transportation volumes. Increases (decreases) in dekatherm (DT) sales volume by classes are presented in the following table: Increase (Decrease) From Prior Year Volume (DT) Classification 1993 1992 Residential 723,356 1,303,673 Commercial (186,529) 22,188 Industrial 547,193 (424,657) Total 1,084,020 901,204 Other Operating Expenses and Taxes Increases (decreases) in other operating expenses, including taxes, are presented in the following table: Increase (Decrease) From Prior Year Classification 1993 1992 (Millions of Dollars) Other operation and maintenance $ 8.1 $11.5 Depreciation and amortization 4.2 5.4 Income taxes 29.9 (17.2) Other taxes (.2) 4.7 Total $42.0 $ 4.4 1993 Other operation and maintenance expenses increased for 1993 primarily due to the implementation of Financial Accounting Standards Board Statement No. 106 (See Note 1J of Notes to Consolidated Financial Statements) pursuant to the June 1993 PSC electric rate order and the amortization of environmental expenses. The depreciation and amortization increase reflects additions to plant in service. The increase in income taxes corresponds to the increase in the corporate tax rate from 34% to 35% retroactive to January 1, 1993. 1992 Other operation and maintenance expenses increased for 1992 primarily due to increases in administrative and general expense, increase in nuclear regulatory fees, and nuclear and transmission system maintenance. The increase in depreciation and amortization expense reflects additions to plant in service. The decrease in income tax expense is primarily related to the tax impact of the rate refund (see Note 2E of Notes to Consolidated Financial Statements) and to other decreases in income. The increase in other taxes is primarily due to higher property taxes caused by property additions and increased millage rates. In addition to the above, other taxes increased due to increases in state license fees. Interest Expense 1993 Interest expense, excluding the debt component of AFC, decreased approximately $1.8 million primarily due to the redemption of First and Refunding Mortgage Bonds and the issuance of First Mortgage Bonds at lower interest rates and the 1992 interest on the provision for rate refund which were partially offset by interest on an adjustment for the 1987-1988 income tax audit. 1992 Interest expense increased approximately $5.7 million in 1992 compared to 1991 due to the issuances of the $145 million and $155 million of First and Refunding Mortgage Bonds on July 24, 1991 and August 29, 1991, respectively, which more than offset the decreases in interest expense resulting from the repayment of debt and lower interest rates on remaining debt and interest of $3.1 million accrued on the provision for rate refund (see Note 2E of Notes to Consolidated Financial Statements). ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Independent Auditor's Report....................................... 29 Consolidated Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992... 30 Consolidated Statements of Income and Retained Earnings for the years ended December 31, 1993, 1992 and 1991............. 32 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991............................. 33 Consolidated Statements of Capitalization as of December 31, 1993 and 1992................................... 34 Notes to Consolidated Financial Statements..................... 36 Supplemental Financial Statement Schedules: Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991................. 54 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991....................... 57 Supplemental financial statement 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 consolidated financial statements or in the notes thereto. INDEPENDENT AUDITOR'S REPORT South Carolina Electric & Gas Company: We have audited the accompanying Consolidated Balance Sheets and Statements of Capitalization of South Carolina Electric & Gas Company (Company) as of December 31, 1993 and 1992 and the related Consolidated Statements of Income and Retained Earnings and of 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 on page 28. 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 financial position of the 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, 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 Columbia, South Carolina February 7, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: A. Organization and Principles of Consolidation The Company, a public utility, is a South Carolina corporation organized in 1924 and a wholly owned subsidiary of SCANA Corporation (SCANA), a South Carolina holding company. The accompanying Consolidated Financial Statements include the accounts of the Company and South Carolina Fuel Company, Inc. (Fuel Company) (see Note 1M). Intercompany balances and transactions between the Company and Fuel Company have been eliminated in consolidation. Affiliated Transactions The Company has entered into agreements with certain affiliates to purchase gas for resale to its distribution customers and to purchase electric energy. The Company purchases all of its natural gas requirements from South Carolina Pipeline Corporation (Pipeline Corporation) and at December 31, 1993 and 1992 the Company had approximately $15.1 million and $15.2 million, respectively, payable to Pipeline Corporation for such gas purchases. The Company purchases all of the electric generation of Williams Station, which is owned by South Carolina Generating Company, Inc. (GENCO), under a unit power sales agreement. At December 31, 1993 and 1992 the Company had approximately $7.5 million and $4.5 million, respectively, payable to GENCO for unit power purchases. Such unit power purchases, which are included in "Purchased power," amounted to approximately $98.1 million, $73.1 million and $92.3 million in 1993, 1992 and 1991, respectively. Total interest income (based on market interest rates) associated with the Company's advances to affiliated companies was approximately $129,000, $231,000 and $141,000 in 1993, 1992 and 1991. Included in "Other interest expense" for 1993, 1992 and 1991 is approximately $29,000, $16,000 and $830,000, respectively, relating to advances from affiliated companies. Intercompany interest is calculated at market rates. B. System of Accounts The accounting records of the Company are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and as adopted by The Public Service Commission of South Carolina (PSC). C. Utility Plant Utility plant is stated substantially at original cost. The costs of additions, renewals and betterments to utility plant, including direct labor, material and indirect charges for engineering, supervision and an allowance for funds used during construction, are added to utility plant accounts. The original cost of utility property retired or otherwise disposed of is removed from utility plant accounts and generally charged, along with the cost of removal, less salvage, to accumulated depreciation. The costs of repairs, replacements and renewals of items of property determined to be less than a unit of property are charged to maintenance expense. The Company, operator of the V. C. Summer Nuclear Station (Summer Station), and The South Carolina Public Service Authority (PSA) are joint owners of the 885 MW Summer Station in the proportions of two-thirds and one-third, respectively. The parties share the operating costs and energy output of the plant in these proportions. Each party, however, provides its own financing. Plant in service related to the Company's portion of Summer Station was approximately $920.2 million and $916.0 million as of December 31, 1993 and 1992, respectively. Accumulated depreciation associated with the Company's share of Summer Station was approximately $285.3 million and $262.2 million as of December 31, 1993 and 1992, respectively. The Company's share of the direct expenses associated with operating Summer Station is included in "Other operation" and "Maintenance" expenses. D. Allowance for Funds Used During Construction Allowance for funds used during construction (AFC), a noncash item, reflects the period cost of capital devoted to plant under construction. This accounting practice results in the inclusion, as a component of construction cost, of the costs of debt and equity capital dedicated to construction investment. AFC is included in rate base investment and depreciated as a component of plant cost in establishing rates for utility services. The Company has calculated AFC using rates of 9.4%, 9.4% and 9.8% for 1993, 1992 and 1991, respectively. These rates do not exceed the maximum allowable rate as calculated under FERC Order No. 561. Interest on nuclear fuel in process is capitalized at the actual interest amount. E. Deferred Return on Plant Investment Commencing July 1, 1987, as approved by a PSC order on that date, the Company ceased the deferral of carrying costs associated with 400 MW of electric generating capacity previously removed from rate base and began amortizing the accumulated deferred carrying costs on a straight-line basis over a ten-year period. Amortization of deferred carrying costs, included in "Depreciation and amortization," was approximately $4.2 million for each of 1993, 1992 and 1991. F. Revenue Recognition Customers' meters are read and bills are rendered on a monthly cycle basis. Base revenue is recorded during the accounting period in which the meters are read. Fuel costs for electric generation are collected through the fuel component in retail electric rates. The fuel component contained in electric rates is established by the PSC during semiannual fuel cost hearings. Any difference between actual fuel cost and that contained in the fuel component is deferred and included when determining the fuel cost component during the next semiannual fuel cost hearing. At December 31, 1993 and 1992 the Company had overcollected through the electric fuel clause component approximately $9.2 million and $17.7 million, respectively, which are included in "Deferred Credits - Other." Customers subject to the gas cost adjustment clause are billed based on a fixed cost of gas determined by the PSC during annual gas cost recovery hearings. Any difference between actual gas cost and that contained in the rates is deferred and included when establishing gas costs during the next annual gas cost recovery hearing. At December 31, 1993 and 1992 the Company had undercollected through the gas cost recovery procedure approximately $11.0 million and $5.7 million, respectively, which are included in "Deferred Debits - Other." G. Depreciation and Amortization Provisions for depreciation are recorded using the straight- line method for financial reporting purposes and are based on the estimated service lives of the various classes of property. The composite weighted average depreciation rates were 2.97%, 3.00%, and 2.97% for 1993, 1992 and 1991, respectively. Nuclear fuel amortization, which is included in "Fuel used in electric generation" and is recovered through the fuel cost component of the Company's rates, is recorded using the units-of- production method. Provisions for amortization of nuclear fuel include amounts necessary to satisfy obligations to the United States Department of Energy under a contract for disposal of spent nuclear fuel. H. Nuclear Decommissioning Decommissioning of Summer Station is presently projected to commence in the year 2022 when the operating license expires. The expenditures (on a before-tax basis) related to the Company's share of decommissioning activities are currently estimated (in 2022 dollars, assuming an annual 4.5% rate of inflation) to be approximately $545.3 million including partial reclamation costs. The Company is providing for its share of estimated decommissioning costs over the life of Summer Station. The Company collected through rates $2.5 million and $1.6 million in 1993 and 1992, respectively. The amounts collected are deposited in an external trust fund in compliance with the financial assurance requirements of the NRC. Management intends for the fund, including earnings thereon, to provide for all eventual decommissioning expenditures on an after-tax basis. In addition, pursuant to the National Energy Policy Act passed by Congress in 1992, the Company has recorded a liability for its estimated share of amounts required by the U. S. Department of Energy for its decommissioning fund. SCE&G will recover the costs associated with this liability, totaling $4.6 million at December 31, 1993, through the fuel cost component of its rates; accordingly, these amounts have been deferred and are included in "Deferred Debits-Other" and "Long-Term Debt, Net." I. Income Taxes The Company is included in the consolidated Federal and State income tax returns filed by SCANA. Income taxes are allocated to the Company based on its contribution to consolidated taxable income. The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," effective January 1, 1993. Prior years' financial statements have not been restated. Deferred tax assets and liabilities were adjusted from the amounts recorded at December 31, 1992 under prior standards to the amounts required at January 1, 1993 under Statement No. 109 at currently enacted income tax rates. The adjustments were charged or credited to regulatory assets or liabilities if the Company expects to recover the resulting additional income tax expense from, or pass through the resulting reductions in income tax expense to, customers of the Company; otherwise they were charged or credited to income tax expense. The cumulative effect of adopting Statement No. 109 on retained earnings as of January 1, 1993, as well as the effect of adoption on net income for the year ended December 31, 1993, was not material. The combined effect of adopting Statement No. 109 and adjusting deferred tax assets and liabilities for the change in 1993 of the corporate Federal income tax rate from 34% to 35% resulted in balances of $97.0 million in regulatory assets (included in "Deferred Debits- Other") and $56.6 million in regulatory liabilities (included in "Deferred Credits-Other"). In accordance with Statement No. 109, deferred tax assets and liabilities are recorded for the tax effect of temporary differences between the book and tax basis of assets and liabilities at currently enacted tax rates. Deferred tax assets and liabilities are adjusted for changes in such rates through charges or credits to regulatory assets or liabilities if they are expected to be recovered from, or passed through to, customers; otherwise, they are charged or credited to income tax expense. Prior to the adoption of Statement No. 109 on January 1, 1993, the Company recorded a deferred income tax provision on all material timing differences between the inclusion of items in pretax financial income and taxable income each year, except for those which were expected to be passed through to, or collected from, customers. Accumulated deferred income taxes were generally not adjusted for changes in enacted tax rates. J. Pension Expense The Company participates in SCANA's noncontributory defined benefit pension plan, which covers all permanent Company employees. Benefits are based on years of accredited service and the employee's average annual base earnings received during the last three years of employment. SCANA's policy has been to fund pension costs accrued to the extent permitted by the applicable Federal income tax regulations as determined by an independent actuary. Net periodic pension cost, as determined by an independent actuary, for the years ended December 31, 1993, 1992 and 1991 included the following components: The change in the annual discount rate used to determine benefit obligations from 8.0% to 7.25% as of December 31, 1993 increased the projected benefit obligation and reduced the unrecognized net gain by approximately $4.1 million. In addition to pension benefits, the Company provides certain health care and life insurance benefits to active and retired employees. On January 1, 1993 the Company adopted Statement No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions." This Statement requires that the cost of postretirement benefits other than pensions be accrued during the years the employees render the service necessary to be eligible for the applicable benefits. The Company previously expensed these benefits, which are primarily health care, as claims were incurred. The accumulated obligation for these benefits at January 1, 1993 was approximately $68 million (transition liability) and the annualized increase in expenses (net of payments to current retirees), including the amortization of the transition liability over approximately 20 years as provided for by the Statement, is approximately $4.7 million. In its June 1993 electric rate order (see Note 2A) the PSC approved the inclusion in rates of the portion of increased expenses related to electric operations. Such expenses had been deferred through May 31, 1993 pursuant to a December 10, 1992 accounting directive allowing deferral pending consideration of recovery in future rate proceedings. For the year ended December 31, 1993 the Company expensed approximately $4.3 million, net of payments to current retirees. Net periodic postretirement benefit cost, as determined by an independent actuary for the year ended December 31, 1993 included the following components (thousands of dollars): The effect of a one-percentage-point increase in the assumed health care cost trend rate for each future year on the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993 and the accumulated postretirement benefit obligation as of December 31, 1993 would be to increase such amounts by $60,000 and $1.7 million, respectively. K. Debt Premium, Discount and Expense, Unamortized Loss on Reacquired Debt Long-term debt premium, discount and expense are being amortized as components of "Interest on long-term debt, net" over the terms of the respective debt issues. Gains or losses on reacquired debt that is refinanced are deferred and amortized over the term of the replacement debt. L. Environmental The Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date for site assessments and cleanup relate primarily to regulated operations; such amounts have been deferred and are being amortized and recovered through rates over a ten-year period. Such amounts totaled $19.6 million and $18.3 million at December 31, 1993 and 1992, respectively, and are included in "Deferred Debits-Other." M. Fuel Inventory Nuclear fuel and fossil fuel inventories are purchased and financed by Fuel Company under a contract which requires the Company to reimburse Fuel Company for all costs and expenses relating to the ownership and financing of fuel inventories. Accordingly, such fuel inventories and fuel-related assets and liabilities are included in the Company's consolidated financial statements (see Note 4). N. Postemployment Benefits In November 1992 the Financial Accounting Standards Board issued Statement No. 112 "Employers' Accounting for Postemployment Benefits." The Statement, which is effective for calendar year 1994, establishes certain conditions for the recognition of costs of benefits to former employees after employment but before retirement. The Statement requires recognition of the obligation to provide postemployment benefits if such obligation is attributable to services previously rendered, the obligation relates to rights which vest, payment of the benefits is probable, and the amount of such benefits can be reasonably estimated. The Company does not anticipate that application of this Statement will have a significant impact on results of operations or financial position. O. Temporary Cash Investments The Company considers temporary cash investments having original maturities of three months or less to be cash equivalents. Temporary cash investments are generally in the form of commercial paper, certificates of deposit and repurchase agreements. P. Reclassifications Certain amounts from prior periods have been reclassified to conform with the 1993 presentation. 2. RATE MATTERS: A. On June 7, 1993 the PSC issued an order on the Company's pending electric rate proceeding allowing an authorized return on common equity of 11.5%, resulting in a 7.4% annual increase in retail electric rates, or a projected $60.5 million annually based on a test year. These rates are to be implemented in two phases over a two-year period: phase one, effective June 1993, producing $42.0 million annually, and phase two, effective June 1994, producing $18.5 million annually, based on a test year. B. On September 14, 1992 the PSC issued an order granting the Company a $.25 increase in transit fares from $.50 to $.75 in both Columbia and Charleston, South Carolina; however, the PSC also required $.40 fares for low income customers and denied the Company's request to reduce the number of routes and frequency of service. The new rates were placed into effect on October 5, 1992. The Company has appealed the PSC's order to the Circuit Court. During oral arguments in February 1994 the Circuit Court retained jurisdiction and remanded the decision to the PSC for the limited purpose of answering questions concerning the applicable regulatory principles used by the PSC in determining these transit rates. C. Since November 1, 1991 the Company's gas rate schedules for its residential, small commercial and small industrial customers have included a weather normalization adjustment. The WNA minimizes fluctuations in gas revenues due to abnormal weather conditions and has been approved through November 1994 subject to an annual review by the PSC. The PSC order was based on a return on common equity of 12.25%. The PSC also approved the WNA for SCANA's directly owned natural gas distribution system which is operated by the Company. The WNA became effective the first billing cycle in December 1991. D. In May 1989 the PSC approved a volumetric and direct billing method for Pipeline Corporation to recover take-or-pay costs incurred from its interstate pipeline suppliers pursuant to FERC-approved final and non-appealable settlements. In December 1992 the Supreme Court approved Pipeline Corporation's full recovery of the take-or-pay charges imposed by its suppliers and treatment of these charges as a cost of gas. However, the Supreme Court declared the PSC-approved "purchase deficiency" methodology for recovery of these costs to be unlawful retroactive ratemaking and remanded the docket to the PSC to reconsider its recovery methodology. The Company believes that the elimination of the purchase deficiency method of recovery will affect the timing for recovery of take-or-pay charges and shift the allocations among Pipeline Corporation's customers (including the Company) but that all such charges should be ultimately recovered. The Supreme Court decision establishes a principle of law that will provide a basis for full recovery by the Company, as well as Pipeline Corporation, of these costs. E. On July 3, 1989 the PSC granted the Company approximately $21.9 million of a requested $27.2 million annual increase in retail electric revenues based upon an allowed return on common equity of 13.25%. The Consumer Advocate appealed the decision to the Supreme Court which, on August 31, 1992, found that the evidence in the record of that case did not support a return on common equity higher than 13.0% and remanded to the PSC a portion of its July 1989 order for a determination of the proper return on common equity consistent with the Supreme Court's opinion. On January 19, 1993 the PSC issued an order allowing a return on common equity of 13.0%, approving a refund based on the difference in rates created by the difference between the 13.0% and the 13.25% return on common equity and making other non- material adjustments to the calculation of cost-of-service. The total refund, before interest and income taxes, was approximately $14.6 million, and was charged against 1992 "Electric Revenues." The refund plus interest was made during 1993. F. On November 28, 1989 the PSC granted the Company an increase in firm retail natural gas rates, effective November 30, 1989, designed to increase annual revenues by $10.1 million, or 89.5% out of the requested increase of approximately $11.3 million. In its order the PSC authorized a 12.75% return on common equity. The Consumer Advocate appealed to the Supreme Court which on August 31, 1992 remanded the order to the PSC for redetermination of the proper amount of litigation expenses to include in the test period. In January 1993 the PSC reduced the amount of litigation expense and ordered a refund totaling approximately $163,000 which was charged against 1992 "Gas Revenues." The refund was made during 1993. 3. LONG-TERM DEBT: The annual amounts of long-term debt maturities, including amounts due under nuclear and fossil fuel agreements (see Note 4), and sinking fund requirements for the years 1994 through 1998 are summarized as follows: Year Amount Year Amount (Thousands of Dollars) 1994 $13,719 1997 $26,345 1995 28,943 1998 31,325 1996 64,146 Approximately $10.9 million of the current portion of long- term debt for 1993 may be satisfied by either deposit and cancellation of bonds issued upon the basis of property additions or bond retirement credits, or by deposit of cash with the Trustee. During 1993 certain issues of the Company's First and Refunding Mortgage Bonds were redeemed and replaced with First Mortgage Bonds. Pipeline Corporation's two principal gas suppliers have incurred liabilities to gas producers under take-or-pay provisions of gas supply contracts. The FERC has accepted filings allowing these pipeline suppliers to recover portions of such take-or-pay liabilities from their customers, including Pipeline Corporation, through volumetric surcharges in gas rates and through direct billings. The Company's liability to Pipeline Corporation for its proportionate share of take-or-pay costs was approximately $1.6 million at December 31, 1993 which is included in Accounts Payable - Affiliated Companies. The Company is paying this amount plus interest (9.4%) to Pipeline Corporation over a five- year period which began June 1989. The Company recovers these costs from its customers through the purchased gas adjustment (PGA) provisions in its rates. The Company's take-or-pay liability to Pipeline Corporation will likely be increased due to the Supreme Court decision dated December 14, 1992 (see Note 2D). The Company anticipates that any such increase will be recovered through the PGA. Certain outstanding long-term debt of an affiliated company (approximately $35.9 million at December 31, 1993 and 1992 respectively) is guaranteed by the Company. Substantially all utility plant and fuel inventories are pledged as collateral in connection with long-term debt. 4. FUEL FINANCINGS: Nuclear and fossil fuel inventories are financed through the issuance of short-term commercial paper. These short-term borrowings are supported by an irrevocable revolving credit agreement which expires July 31, 1996. Accordingly, the amounts outstanding have been included in long-term debt. The credit agreement provides for a maximum amount of $75 million that may be outstanding at any time. Commercial paper outstanding totaled $36.8 million and $55.7 million at December 31, 1993 and 1992 at weighted average interest rates of 3.47% and 3.81%, respectively. 5. STOCKHOLDERS' INVESTMENT (Including Preferred Stock Not Subject to Purchase or Sinking Funds): The changes in "Stockholders' Investment" (Including Preferred Stock Not Subject to Purchase or Sinking Funds) during 1993, 1992 and 1991 are summarized as follows: Common Preferred Thousands Shares Shares of Dollars Balance December 31, 1990 40,296,147 322,877 $847,400 Changes in Retained Earnings: Net Income 122,836 Cash Dividends Declared: Preferred Stock (at stated rates) (6,706) Common Stock (97,000) Other 2 Balance December 31, 1991 40,296,147 322,877 866,532 Changes in Retained Earnings: Net Income 102,163 Cash Dividends Declared: Preferred Stock (at stated rates) (6,474) Common Stock (99,291) Equity Contributions from Parent 126,838 Balance December 31, 1992 40,296,147 322,877 989,768 Changes in Retained Earnings: Net Income 145,968 Cash Dividends Declared: Preferred Stock (at stated rates) (6,217) Common Stock (110,300) Equity Contributions from Parent 58,142 Balance December 31, 1993 40,296,147 322,877 $1,077,361 The Restated Articles of Incorporation of the Company and the Indenture underlying its First and Refunding Mortgage Bonds contain provisions that may limit the payment of cash dividends on common stock. In addition, with respect to hydroelectric projects, the Federal Power Act may require the appropriation of a portion of the earnings therefrom. At December 31, 1993 approximately $10.6 million of retained earnings were restricted as to payment of cash dividends on common stock. 6. PREFERRED STOCK (Subject to Purchase or Sinking Funds): The call premium of the respective series of preferred stock in no case exceeds the amount of the annual dividend. Retirements under sinking fund requirements are at par values. At any time when dividends have not been paid in full or declared and set apart for payment on all series of preferred stock, the Company may not redeem any shares of preferred stock (unless all shares of preferred stock then outstanding are redeemed) or purchase or otherwise acquire for value any shares of preferred stock except in accordance with an offer made to all holders of preferred stock. The Company may not redeem any shares of preferred stock (unless all shares of preferred stock then outstanding are redeemed) or purchase or otherwise acquire for value any shares of preferred stock (except out of monies set aside as purchase funds or sinking funds for one or more series of preferred stock) at any time when it is in default under the provisions of the purchase fund or sinking fund for any series of preferred stock. The aggregate annual amounts of purchase fund or sinking fund requirements for preferred stock for the years 1994 through 1998 are summarized as follows: Year Amount Year Amount (Thousands of Dollars) 1994 $2,504 1997 $2,440 1995 2,515 1998 2,440 1996 2,482 The changes in "Total Preferred Stock (Subject to Purchase or Sinking Funds)" during 1993, 1992 and 1991 are summarized as follows: Number Thousands of Shares of Dollars Balance December 31, 1990 1,050,201 $ 64,460 Shares Redeemed: $100 par value (628) (63) $50 par value (51,169) (2,559) Balance December 31, 1991 998,404 61,838 Shares Redeemed: $100 par value (6,098) (610) $50 par value (51,777) (2,589) Balance December 31, 1992 940,529 58,639 Shares Redeemed: $100 par value (7,374) (737) $50 par value (51,187) (2,558) Balance December 31, 1993 881,968 $ 55,344 7. INCOME TAXES: Total income tax expense for 1993, 1992 and 1991 is as follows: 1993 1992 1991 (Thousands of Dollars) Current taxes: Federal $60,577 $62,147 $36,594 State 6,822 7,852 4,833 Total current taxes 67,399 69,999 41,427 Deferred taxes, net: Federal 12,197 (16,274) 25,212 State 4,387 (322) 4,469 Total deferred taxes 16,584 (16,596) 29,681 Investment tax credits: Amortization of amounts deferred (credit) (3,245) (3,245) (3,245) Total income tax expense $80,738 $50,158 $67,863 Total income taxes differ from amounts computed by applying the statutory Federal income tax rate of 35% for 1993 and 34% for 1992 and 1991 to pretax income as follows: The Omnibus Budget Reconciliation Act was signed into law on August 10, 1993, increasing the corporate tax rate from 34% to 35% effective January 1, 1993. This impact of this change on the Company's financial position and results of operation was not material. The tax effects of significant temporary differences comprising the Company's net deferred tax liability of $471.8 million at December 31, 1993 determined in accordance with Statement No. 109 (see Note 1I) are as follows (thousands of dollars): Deferred tax assets: Unamortized investment tax credits $ 52,310 Cycle billing 15,084 Nuclear operations expenses 4,908 Deferred compensation programs 5,265 Other postretirement benefits 1,631 Injuries and damages 724 Other 3,808 Total deferred tax assets 83,730 Deferred tax liabilities: Accelerated depreciation and amortization 526,540 Reacquired debt 7,574 Property taxes 6,068 Pension expense 6,266 Nuclear system maintenance 2,965 Early retirement programs 1,961 Nuclear decontamination fund 1,417 Other 2,732 Total deferred tax liabilities 555,523 Net deferred tax liability $471,793 "Total deferred taxes" charged (credited) to income tax expense result from timing differences in recognition of the following items: 1992 1991 (Thousands of Dollars) Charged (credited) to expense: Accelerated depreciation and amortization $ (5) $22,053 Deferred fuel accounting (2,947) 461 Property taxes 493 1,608 Cycle billing (1,381) 3,608 Nuclear refueling accrual (4,430) 2,052 Electric rate refund (6,571) - Injuries and damages (1,377) - Other, net (378) (101) Total deferred taxes $(16,596) $29,681 The Internal Revenue Service has examined and closed consolidated Federal income tax returns of SCANA Corporation through 1989 and is currently examining SCANA's 1990 and 1991 Federal income tax returns. No adjustments are currently proposed by the examining agent. SCANA does not anticipate that any adjustments which might result from this examination will have a significant impact on the earnings or financial position of the Company. 8. FINANCIAL INSTRUMENTS The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 1993 and 1992 are as follows: The information presented herein is based on pertinent information available to the Company as of December 31, 1993 and 1992. Although the Company is not aware of any factors that would significantly affect the estimated fair value amounts, such financial instruments have not been comprehensively revalued since December 31, 1993, and the current estimated fair value may differ significantly from the estimated fair value at that date. The following methods and assumptions were used to estimate the fair value of the above classes of financial instruments: Cash and temporary cash investments, including commercial paper, repurchase agreements, treasury bills and notes are valued at their carrying amount. Fair values of investments and long-term debt are based on quoted market prices for similar instruments, or for those instruments for which there are no quoted market prices available, fair values are based on net present value calculations. Settlement of long term debt may not be possible or may not be a prudent management decision. Short-term borrowings are valued at their carrying amount. The fair value of preferred stock (subject to purchase or sinking funds) is estimated on the basis of market prices. Potential taxes and other expenses that would be incurred in an actual sale or settlement have not been taken into consideration. 9. SHORT-TERM BORROWINGS: The Company pays fees to banks as compensation for its lines of credit. Commercial paper borrowings are for 270 days or less. Details of lines of credit and short-term borrowings at December 31, 1993, 1992 and 1991 and for the years then ended are as follows: 1993 1992 1991 (Millions of dollars) Authorized lines of credit at year end $127.0 $119.9 $121.7 Unused lines of credit at year-end $127.0 $119.9 $121.7 Short-term borrowings (including commercial paper) during the year: Maximum outstanding $126.0 $ 95.3 $130.4 Average outstanding $ 56.0 $ 40.9 $ 64.5 Weighted daily average interest rates: Bank loans 3.24% 3.49% 7.69% Commercial paper 3.13% 3.69% 6.31% Short-term borrowings outstanding at year-end: Commercial paper $ 1.0 $ - $ - Weighted average interest rate 3.50% - - Bank loans $ - $ - $ - Weighted average interest rate - - - 10. COMMITMENTS AND CONTINGENCIES: A. Construction The Company entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 and commercial operation is expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. Under the Duke/Fluor Daniel contract the Company must make specified monthly minimum payments. These minimum payments do not include amounts for inflation on a portion of the contract which is subject to escalation (approximately 34% of the total contract amount). The aggregate amount of such required minimum payments remaining at December 31, 1993 is as follows (in thousands): 1994 $168,152 1995 59,766 1996 5,603 Total $233,521 Through December 31, 1993 the Company paid $142.0 million under the contract. B. Nuclear Insurance The Price-Anderson Indemnification Act, which deals with the Company's public liability for a nuclear incident, currently establishes the liability limit for third-party claims associated with any nuclear incident at $9.4 billion. Each reactor licensee is currently liable for up to $79.3 million per reactor owned for each nuclear incident occurring at any reactor in the United States, provided that not more than $10 million of the liability per reactor would be assessed per year. The Company's maximum assessment, based on its two-thirds ownership of Summer Station, would not exceed approxi- mately $52.9 million per incident, but not more than $6.7 million per year. The Company currently maintains policies (for itself and on behalf of the PSA) with Nuclear Electric Insurance Limited (NEIL) and American Nuclear Insurers (ANI) providing combined property and decontamination insurance coverage of $1.4 billion for any losses in excess of $500 million pursuant to existing primary coverages (with ANI) on Summer Station. The Company pays annual premiums and, in addition, could be assessed a retroactive premium not to exceed 7 1/2 times its annual premium in the event of property damage loss to any nuclear generating facilities covered by NEIL. Based on the current annual premium, this retroactive premium would not exceed approximately $8.1 million. To the extent that insurable claims for property damage, decontamination, repair and replacement and other costs and expenses arising from a nuclear incident at Summer Station exceed the policy limits of insurance, or to the extent such insurance becomes unavailable in the future, and to the extent that the Company's rates would not recover the cost of any purchased replacement power, the Company will retain the risk of loss as a self-insurer. The Company has no reason to anticipate a serious nuclear incident at Summer Station. If such an incident were to occur, it could have a materially adverse impact on the Company's financial position. C. Litigation In January 1994 the Company, acting on behalf of itself and the PSA (as co-owners of Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential by agreement of the parties and order of the court. The Company had filed an action in May 1990 against Westinghouse in the U. S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. D. Environmental As described in Note 1L, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date for site assessments and cleanup relate primarily to regulated operations; such amounts have been deferred and are being amortized and recovered through rates over a ten-year period. 11. SEGMENT OF BUSINESS INFORMATION: Segment information at December 31, 1993, 1992 and 1991 and for the years then ended is as follows: Electric Gas Transit Total (Thousands of Dollars) Operating revenues $940,547 $174,035 $ 3,851 $1,118,433 Operating expenses, excluding depreciation and amortization 639,808 148,349 9,737 797,894 Depreciation and amortization 91,142 9,903 175 101,220 Total operating expenses 730,950 158,252 9,912 899,114 Operating income (loss) $209,597 $ 15,783 $(6,061) 219,319 Add - Other income, net 6,585 Less - Interest charges 79,936 Net income $ 145,968 Capital expenditures: Identifiable $ 274,408 $ 11,674 $ 604 $ 286,686 Utilized for overall Company operations 13,934 Total $ 300,620 Identifiable assets at December 31, 1993: Utility plant, net $2,445,466 $178,464 $1,673 $2,625,603 Inventories 66,181 2,526 463 69,170 Total $2,511,647 $180,990 $2,136 2,694,773 Assets utilized for overall Company operations 495,166 Total assets $3,189,939 Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 829,938 $160,820 $ 3,623 $ 994,381 Operating expenses, excluding depreciation and amortization 572,234 133,611 9,205 715,050 Depreciation and amortization 87,367 9,534 163 97,064 Total operating expenses 659,601 143,145 9,368 812,114 Operating income (loss) $ 170,337 $ 17,675 $(5,745) 182,267 Add - Other income, net 3,006 Less - Interest charges 83,110 Net income $ 102,163 Capital expenditures: Identifiable $ 223,697 $ 10,409 $ 346 $ 234,452 Utilized for overall Company operations 8,877 Total $ 243,329 Identifiable assets at December 31, 1992: Utility plant, net $2,271,895 $177,309 $ 1,240 $2,450,444 Inventories 68,435 2,967 481 71,883 Total $2,340,330 $180,276 $ 1,721 2,522,327 Assets utilized for overall Company operations 368,626 Total assets $2,890,953 Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 867,685 $ 150,788 $ 3,869 $1,022,342 Operating expenses, excluding depreciation and amortization 596,466 128,529 9,023 734,018 Depreciation and amortization 82,503 8,969 146 91,618 Total operating expenses 678,969 137,498 9,169 825,636 Operating income (loss) $ 188,716 $ 13,290 $ (5,300) 196,706 Add - Other income, net 3,283 Less - Interest charges 77,153 Net income $ 122,836 Capital expenditures: Identifiable $ 191,218 $ 16,029 $ 89 $ 207,336 Utilized for overall Company operations 7,967 Total $ 215,303 Identifiable assets at December 31, 1991: Utility plant, net $2,154,221 $ 176,570 $ 1,073 $2,331,864 Inventories 69,316 2,553 476 72,345 Total $2,223,537 $ 179,123 $ 1,549 2,404,209 Assets utilized for overall Company operations 344,371 Total assets $2,748,580 12. SUPPLEMENTARY INCOME STATEMENT INFORMATION: Maintenance expense (including repairs) and provision for depreciation and amortization of utility plant are shown separately in the accompanying consolidated statements of income, except for amounts charged to clearing and other accounts, which amounts are not significant. Advertising expenses are not material and there were no royalties. Taxes other than income taxes are as follows (amounts for nonutility operations are not significant): December 31, 1993 1992 1991 (Thousands of Dollars) State electric generation tax $ 4,056 $ 4,299 $ 3,638 General property taxes 47,624 47,320 44,567 Special state utility license 1,814 1,965 1,595 Federal social security taxes 8,534 8,113 7,463 State gross receipts tax 2,871 3,427 2,734 Other taxes 462 470 942 Total charged to operating expenses $65,361 $65,594 $60,939 13. QUARTERLY FINANCIAL DATA (UNAUDITED): (Thousands of Dollars) First Second Third Fourth Quarter Quarter Quarter Quarter Annual Total operating revenues $279,241 $244,485 $329,673 $265,034 $1,118,433 Operating income 55,274 38,934 79,363 45,748 219,319 Net Income 36,820 21,327 61,032 26,789 145,968 (Thousands of Dollars) First Second Third Fourth Quarter Quarter Quarter Quarter Annual Total operating revenues $263,576 $222,097 $270,937 $237,771 $994,381 Operating income 49,805 33,452 58,149 40,861 182,267 Net Income 30,055 13,528 36,747 21,833 102,163 DESCRIPTION OF PLANS Incentive Compensation To bring total compensation of officers to market levels, the Company has two incentive plans: Annual Performance Incentive Plan SCANA has annual Performance Incentive Plans for officers of SCANA and its subsidiaries. The plans promote SCANA's pay-for-performance philosophy, as well as its goal of having a meaningful amount of executive pay "at-risk." Through these plans, financial incentives are provided in the form of annual cash bonuses that are paid only when corporate, business unit and individual goals are achieved. Short-term incentive awards are targeted below the median of the market. Executives eligible for these plans are assigned threshold, target and maximum bonus levels as a percentage of salary level. Bonuses earned are based on the level of the preestablished goals achieved. Award payouts may increase to a maximum of 1.5 times target, if Company performance exceeds the goals established. Even if this were to occur, payouts would still be below the market median. Award payouts may decrease, generally to a minimum of one-half the target-level awards, if the Company's performance is below targeted goals. Awards earned based on the achievement of preestablished goals may nonetheless be decreased to zero (as was done in 1992), if the Management Development and Corporate Performance Committee (Performance Committee) in its discretion determines that actual results do not warrant the levels of payouts otherwise earned. The various plans in which officers of SCANA and its subsidiaries participate focus generally on short-term goals affecting profitability, efficiency, quality of service, customer satisfaction and progress toward SCANA's strategic objectives for the Company and its other subsidiaries. New performance categories for officers in the various plans are established annually. Specific performance measures, and their weights, also vary from year to year. For 1993, the specific measures in each plan, and their weights, for the officers included in the Summary Compensation Table on page 66 are described below. The relationship of performance to payouts for the officers in each plan also is discussed. For officers of SCANA, 80% of the total award is based on corporate Earnings Per Share ("EPS") goals. The remaining 20% is tied to the achievement of individual performance goals, and is awarded on a discretionary basis. Specific EPS goals are established that correspond to threshold, target and maximum payouts for the EPS portion of awards. For 1993, SCANA's EPS results were sufficient to result in maximum payouts for that portion of the awards. Individual performance for corporate officers also was determined to be sufficient to result in maximum -level payouts for that portion of the awards. Awards for officers of the Company are based on three performance categories: corporate EPS, numerous corporate and Strategic Business Unit (SBU) financial and productivity goals, and additional SBU strategic initiatives (i.e., activities that focus on improvements in existing operating procedures, quality of service and product, human resources matters, etc.). One-third of the total award is based on results in each performance category. Threshold, target and maximum performance levels are established for each category; payouts will vary based on the actual level of performance achieved. For 1993, the overall Company performance in all three categories was such that payouts exceeded target-level awards, but were less than the maximum awards possible. Although results for the first two performance categories were above target performance levels, results in the strategic initiative category were below that level. Long-Term Performance Share Plan SCANA has a long-term Performance Share Plan for officers of SCANA and its subsidiaries. The long-term Performance Share Plan measures SCANA's Total Shareholder Return ("TSR") relative to a group of peer companies (PSP Peer Group) over a three-year period. The PSP Peer Group includes 97 electric and gas utilities, none of which have annual revenues of less than $100 million. Total Shareholder Return is stock price increase over the three-year period, plus cash dividends paid during the period, divided by stock price as of the beginning of the period. Comparing SCANA's TSR to a large group of other utilities reflects SCANA's recognition that investors could have invested their funds in other utility companies. Comparing SCANA's TSR against the TSR of the PSP Peer Group measures how well SCANA did when compared to others operating in similar interest, tax, economic and regulatory environments. Executives eligible to participate in the Performance Share Plan are assigned target award opportunities based primarily on their salary level. In determining award sizes, levels of responsibilities and competitive practices also are considered. Target awards are established at levels slightly below the median of the market and represent a significant portion of executives "at-risk" compensation. But, to provide additional incentive for executives, and to ensure that executives are only rewarded when shareholders gain, actual payouts may exceed the median of the market when performance is outstanding. For lesser performance, awards will be at or below the market median. Payouts occur when SCANA's TSR is in the top two-thirds of the PSP Peer Group, and vary based on SCANA's ranking against the peer group. Executives earn target payouts at the 50th percentile of three-year performance. Maximum payouts will be made at 1.5 times target when SCANA's TSR is at or above the 75th percentile of the peer group. No payouts will be earned if performance is in the bottom one-third of the peer group. Awards are denominated in shares of SCANA Common Stock and may be paid in either stock or cash or a combination of the two. For the three-year period from 1991 through 1993, SCANA's TSR was at the 79th percentile of the PSP Peer Group. This resulted in payouts in February 1994 at the maximum level possible. The combination of the annual Incentive Plan and the Performance Share Plan provides an opportunity to bring a participant's compensation to market levels. The progressive payout formulas in both plans dictate that above-market pay can be earned only for better-than-average corporate financial performance, and that poor performance will result in below- market pay. The following table shows the target awards made in 1993 for potential payment in 1996 under the long-term Performance Share Plan, and estimated future payouts under that plan at threshold, target and maximum levels. Defined Contribution Plans Under the Savings Plan, most of the Company's employees may contribute up to 15% of their eligible earnings. The Company matches each employee's contribution on a dollar-for-dollar basis up to a maximum of 6% of the participant's eligible earnings as limited by the Internal Revenue Code (IRC). Both Company and employee contributions are invested in SCANA's Common Stock. In addition to the Savings Plan, SCANA has a Supplementary Voluntary Deferral Plan (the "Supplementary Plan") for certain highly compensated employees of the Company and other SCANA subsidiaries. The Supplementary Plan is designed to provide employees whose participation in the Savings Plan is limited by the IRC with the ability to contribute and receive matching contributions in the same percentage as employees generally. However, unlike the Savings Plan where actual shares of SCANA Common Stock are acquired, under the Supplementary Plan the deferred amounts and matches are only accounted for as though shares of common stock had been purchased. Defined Benefit Plans In addition to the qualified Retirement Plan for all employees, the Company has Supplemental Executive Retirement Plans ("SERP") for certain eligible employees, including officers. A SERP is an unfunded plan which provides for benefit payments in addition to those payable under a qualified retirement plan. It maintains uniform application of the Retirement Plan benefit formula and would provide, among other benefits, payment of Retirement Plan formula pension benefits, if any, which exceed those payable under the IRC maximum benefit limitations. The following table illustrates the estimated maximum annual benefits payable upon retirement at normal retirement date under the Retirement Plan and the SERPs. Benefits are computed based on a straight-life annuity with an unreduced 60% surviving spouse benefit. The amounts in this table assume continuation of the primary Social Security benefits in effect at January 1, 1994 and are not subject to any deduction for Social Security or other offset amounts. Pension Plan Table Final Service Years Average Pay 15 20 25 30 35 $125,000 35,130 46,840 58,550 70,260 72,595 150,000 42,630 56,840 71,050 85,260 88,220 175,000 50,130 66,840 83,550 100,260 103,845 200,000 57,630 76,840 96,050 115,260 119,470 225,000 65,130 86,840 108,550 130,260 135,095 250,000 72,630 96,840 121,050 145,260 150,720 300,000 87,630 116,840 146,050 175,260 181,970 350,000 102,630 136,840 171,050 205,260 213,220 400,000 117,630 156,840 196,050 235,260 244,470 450,000 132,630 176,840 221,050 265,260 275,720 500,000 147,630 196,840 246,050 295,260 306,970 The compensation shown in Column (c) of the Summary Compensation Table for the individuals named therein is covered by the Retirement Plan and/or a SERP. Messrs. Gressette, Kenyon, Timmerman, Young and Stedman now have credited service under the Retirement Plan (or its equivalent under the SERP) of 31, 20, 15, 31 and 21 years, respectively. The Company also has a Key Employee Retention Program (the "Key Employee Retention Program") covering officers and certain other executive employees that provides supplemental retirement and/or death benefits for participants. Under the program the Company will pay to each participant for 180 months, upon retirement at or after age 65, a monthly retirement benefit equal to 25% of the average monthly salary of the participant over his final 36 months of employment prior to age 65, or an optional death benefit payable to a participant's designated beneficiary monthly for 180 months, in an amount equal to 35% of the average monthly salary of the participant over his final 36 months of employment prior to age 65. In the event of the participant's death prior to age 65, the Company will pay to the participant's designated beneficiary for 180 months, a monthly benefit equal to 50% of such participant's base monthly salary in effect at death. All of the executive officers named in the Summary Compensation Table above are participating in the Key Employee Retention Program. Estimated annual retirement benefits payable at age 65 based on projected eligible compensation (assuming increases of 4% per year) to the five executive officers named in the Summary Compensation Table are as follows: Mr. Gressette - $106,863; Mr. Kenyon - $126,347; Mr. Timmerman - $105,411; Mr. Young - $56,013; and Mr. Stedman - $66,729. Life Insurance Plans The Company offers its officers and certain other highly- compensated employees an option to choose whole life insurance (the "Whole Life Option") in lieu of the term life insurance provided employees generally. Under this plan, the employee becomes the owner of a policy with a death benefit of between $200,000 and $550,000 depending upon the salary grade of the employee. Termination, Severance and Change of Control Arrangements The Company has a Key Executive Severance Benefit Plan (the "Severance Plan") intended to assure the objective judgment of, and to retain the loyalties of, key executives when the Company is faced with a potential change in control or a change in control by providing a continuation of salary and benefits after a participant's employment is terminated by the Company during a potential change in control, after a change in control without just cause, disability, retirement or death or by the participant for good reason after a change in control. All of the executive officers named in the Summary Compensation Table except Mr. Gressette have been designated as participants in the Severance Plan. When a potential change in control occurs, a participant is obligated to remain with the Company for six months unless his employment is terminated for disability or normal retirement or until a change in control occurs. Upon a change in control resulting in an officer's termination, the Severance Plan provides for guaranteed severance payments equal to three times the annual compensation of the officer plus payments under certain of the Company's incentive and retirement plans. The officer also would receive an additional amount (a "gross-up" payment) for any IRC Section 4999 excess tax or any such other similar tax applicable to the severance payments. In addition, for 36 months after termination, the officer would receive coverage for medical benefits and life insurance so as to provide the same level of benefits previously enjoyed under group plans or individual policy contracts or otherwise as determined by the Executive Committee of the Board of Directors. Such benefits however would be reduced to the extent that the participant receives similar benefits during the period from another employer. In addition to the Severance Plan, in the event of a merger, consolidation or acquisition in which SCANA is not the surviving corporation, target awards under the Performance Share Plan will become immediately payable based on SCANA's shareholder return performance as of the end of the most recently completed calendar year for each performance period as to which the grant of target shares has occurred at least six months previously. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION There are no executive officer-director interlocks where an executive officer of the Company serves on the compensation committee of another company that has an executive officer serving on the Company's Board of Directors. Messrs. Hipp, McMaster, Rhodes and Warren are all members of the Long-Term Compensation Committee which administers the Performance Share Plan. Messrs. Hipp and Rhodes also are members of the Performance Committee which generally handles all other executive compensation matters. Mr. Warren was the Chief Executive Officer of the Company from April 23, 1986 until January 31, 1990. Information with respect to transactions with entities with which Messrs. Hipp, McMaster, Rhodes and Warren are connected are described below. Mr. Gressette, Chairman of the Board and Chief Executive Officer of the Company, is an ex-officio (i.e. nonvoting) member of the Performance Committee. The Performance Committee receives his input on compensation matters concerning executive compensation of other officers but the committee deliberates and makes its decisions without his participation. Mr. Rhodes is the Chairman and Chief Executive Officer of Rhodes Oil Company, Inc. Purchases from Rhodes Oil Company, Inc. totaling $62,500 for fuel oil and gasoline were made during 1993 by the Company. It is anticipated that such purchases will continue in the future. Mr. McMaster is the President and Manager of Winnsboro Petroleum Company. Purchases from Winnsboro Petroleum Company totaling $77,549 for fuel oil and gasoline were made during 1993 by the Company. It is anticipated that such purchases will continue in the future. Mr. Hipp, is the President and Chief Executive Officer of The Liberty Corporation. Mr. Hipp and John A. Warren are Directors of The Liberty Corporation. During 1993 certain of the insurance policies purchased by the Company on the lives of employees were written by Liberty Life Insurance Company, a subsidiary of the Liberty Corporation, and it is expected that this relationship will continue in the future. The total amount paid during 1993 by the Company to Liberty Life Insurance Company was $538,905. COMPENSATION OF DIRECTORS Fees All of the Directors of the Company are also Directors of SCANA. During 1993, directors who are not employees of SCANA or its subsidiaries were each paid $14,500 for services rendered, plus $1,500 for each Board meeting attended and $700 for attendance at a committee meeting which is not held on the same day as a regular meeting of the Board. The fee for attendance at a telephone conference meeting is $150. The fee for attendance at a conference is $500. In addition, Directors are paid, as part of their compensation, travel, lodging and incidental expenses related to attendance at meetings and conferences. Directors who are employees of SCANA or its subsidiaries receive no compensation for serving as directors or attending meetings. Deferral Plan The Company has a plan pursuant to which directors may defer all or a portion of their fees for services rendered and meeting attendance. Interest is earned on the deferred amounts at a rate set by the Performance Committee. During 1993 and currently, the rate is set at the announced prime rate of The South Carolina National Bank. During 1993, the only director participating in the plan was Mr. Rhodes. Interest credited to Mr. Rhodes' deferral account during 1993 was $8,526. Endowment Plan Each director participates in the Directors' Endowment Plan, which provides for the Company to make a tax deductible charitable contribution totaling $500,000 to institutions of higher education nominated by the director. A portion is contributed upon retirement of the director and the remainder upon the director's death. The plan is funded in part through insurance on the lives of the directors. Designated in-state institutions of higher education must be approved by the Chief Executive Officer of SCANA and any out-of-state designation must be approved by the Performance Committee. The designated institutions are reviewed on an annual basis by the Chief Executive Officer to assure compliance with the intent of the program. The plan is intended to reinforce SCANA's commitment to quality higher education and is intended to enhance SCANA's ability to attract and retain qualified board members. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All shares of the Company's Common Stock are held, beneficially and of record, by SCANA Corporation. The table set forth below indicates as of March 10, 1994, the shares of SCANA's Common Stock beneficially owned by each continuing director and nominee, each of the executive officers named in the Summary Compensation Table on page 66, and the directors and executive officers of the Company as a group. SECURITY OWNERSHIP OF MANAGEMENT Name of Beneficial Amount and Nature Name of Beneficial Amount and Nature Owner of Ownership (1) Owner of Ownership (1) B. L. Amick 1,243 W. H. Hipp 1,400 W. B. Bookhart, Jr. 6,884 B. D. Kenyon 4,782 W. T. Cassels, Jr. 1,000 F. C. McMaster 10,288 H. M. Chapman 3,127 Henry Ponder 4,806 J. B. Edwards 2,217 J. B. Rhodes 3,434 E. T. Freeman 1,500 W. B. Timmerman 12,889 L. M. Gressette, Jr. 14,649 E. C. Wall, Jr. 7,000 B. A. Hagood 1,140 John A. Warren 50,823 J. H. Young 5,108 R. W. Stedman 6,474 All directors and executive officers as a group (18 persons) TOTAL 138,764 TOTAL PERCENT OF CLASS 0.3% (1) Includes shares owned by close relatives, the beneficial ownership of which is disclaimed by the director or nominee, as follows: Mr. Amick - 240; Mr. Bookhart - 1,913; Mr. Chapman - 127; Mr. Gressette - 530; Mr. Hagood - 159; Mr. McMaster - 6,365; Mr. Warren - 7,160. Includes shares purchased through December 31, 1993, but not thereafter, by the Trustee under the Savings Plan. The information set forth above as to the security ownership has been furnished to the Company by such persons. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information regarding certain relationships and related transactions, see Item 11., "Compensation Committee Interlocks and Insider Participation." PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Financial Statements and Schedules See Index to Consolidated Financial Statements and Supplementary Data on page 28. Exhibits Filed Exhibits required to be filed with this Annual Report on Form 10-K are listed in the Exhibit Index following the signature page. Certain of such exhibits which have heretofore been filed with the Securities and Exchange Commission and which are designated by reference to their exhibit number in prior filings are hereby incorporated herein by reference and made a part hereof. Reports on Form 8-K The Company filed a report on Form 8-K on January 13, 1994 in response to Item 5, "Other Events" regarding the settlement with Westinghouse Electric Corporation of a lawsuit relating to the steam generators provided to the Company's Summer Station. 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. (REGISTRANT) SOUTH CAROLINA ELECTRIC & GAS COMPANY BY (SIGNATURE) s/Bruce D. Kenyon (NAME AND TITLE) Bruce D. Kenyon, President and Chief Operating Officer DATE February 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 the dates indicated. (i) Principal executive officer: BY (SIGNATURE) s/L. M. Gressette, Jr. (NAME AND TITLE) L. M. Gressette, Jr., Chairman of the Board and Chief Executive Officer and Director DATE February 15, 1994 (ii) Principal financial officer: BY (SIGNATURE) s/W. B. Timmerman (NAME AND TITLE) W. B. Timmerman, Chief Financial Officer DATE February 15, 1994 (iii) Principal accounting officer: BY (SIGNATURE) s/J. E. Addison (NAME AND TITLE) J. E. Addison, Controller DATE February 15, 1994 BY (SIGNATURE) s/B. L. Amick (NAME AND TITLE) B. L. Amick, Director DATE February 15, 1994 BY (SIGNATURE) s/W. B. Bookhart, Jr. (NAME AND TITLE) W. B. Bookhart, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/W. T. Cassels, Jr. (NAME AND TITLE) W. T. Cassels, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/H. M. Chapman (NAME AND TITLE) H. M. Chapman, Director DATE February 15, 1994 BY (SIGNATURE) s/J. B. Edwards (NAME AND TITLE) J. B. Edwards, Director DATE February 15, 1994 BY (SIGNATURE) s/E. T. Freeman (NAME AND TITLE) E. T. Freeman, Director DATE February 15, 1994 BY (SIGNATURE) s/B. A. Hagood (NAME AND TITLE) B. A. Hagood, Director DATE February 15, 1994 BY (SIGNATURE) s/W. Hayne Hipp (NAME AND TITLE) W. Hayne Hipp, Director DATE February 15, 1994 BY (SIGNATURE) s/F. C. McMaster (NAME AND TITLE) F. C. McMaster, Director DATE February 15, 1994 BY (SIGNATURE) s/Henry Ponder (NAME AND TITLE) Henry Ponder, Director DATE February 15, 1994 BY (SIGNATURE) s/J. B. Rhodes (NAME AND TITLE) J. B. Rhodes, Director DATE February 15, 1994 BY (SIGNATURE) s/E. C. Wall, Jr. (NAME AND TITLE) E. C. Wall, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/John A. Warren (NAME AND TITLE) John A. Warren, Director DATE February 15, 1994 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES The cash requirements of the Company arise primarily from its operational needs and its construction program. The ability of the Company to replace existing plant investment, as well as to expand to meet future demands for electricity and gas, will depend upon its ability to attract the necessary financial capital on reasonable terms. The Company recovers the costs of providing services through rates charged to customers. Rates for regulated services are based on historical costs. As customer growth and inflation occur and the Company expands its construction program it is necessary to seek increases in rates. As a result the Company's future financial position and results of operations will be affected by its ability to obtain adequate and timely rate relief. Due to continuing customer growth, the Company entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 with commercial operation expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. Until the completion of the new plant, the Company is contracting for additional capacity as necessary to ensure that the energy demands of its customers can be met. As discussed in Note 2A of Notes to Consolidated Financial Statements on June 7, 1993 the PSC issued an order granting the Company a 7.4% annual increase in retail electric rates to be implemented in two phases of $42.0 million annually effective June 1993 and $18.5 million annually effective June 1994. The estimated primary cash requirements for 1994, excluding requirements for fuel liabilities and short-term borrowings, and the actual primary cash requirements for 1993 are as follows: 1994 1993 (Thousands of Dollars) Property additions and construction expenditures, excluding allowance for funds used during construction (AFC) $384,287 $280,910 Nuclear fuel expenditures 28,064 7,177 Maturing obligations, redemptions and sinking and purchase fund requirements 5,024 3,700 Total $417,375 $291,787 Approximately 20.0% of total cash requirements (excluding dividends) was provided from internal sources in 1993 as compared to 49.2% in 1992. The Company's First and Refunding Mortgage Bond Indenture, dated April 1, 1945 (Old Mortgage), contains provisions prohibiting the issuance of additional bonds thereunder (Class A Bonds) unless net earnings (as therein defined) for 12 consecutive months out of the 15 months prior to the month of issuance is at least twice the annual interest requirements on all Class A Bonds to be outstanding (Bond Ratio). For the year ended December 31, 1993 the Bond Ratio was 3.70. The issuance of additional Class A Bonds is restricted also to an additional principal amount equal to 60% of unfunded net property additions (which unfunded net property additions totaled approximately $219.9 million at December 31, 1993), Class A Bonds issued on the basis of retirements of Class A Bonds (which retirement credits totaled $10.9 million at December 31, 1993) and Class A Bonds issued on the basis of cash on deposit with the Trustee. The Company has placed a new bond indenture (New Mortgage) dated April 1, 1993 on substantially all of its electric properties under which its future mortgage-backed debt (New Bonds) will be issued. New Bonds are expected to be issued under the New Mortgage on the basis of a like principal amount of Class A Bonds issued under the Old Mortgage which have been deposited with the Trustee of the New Mortgage (of which $157 million were available for such purpose as of December 31, 1993), until such time as all presently outstanding Class A Bonds are retired. Thereafter, New Bonds will be issuable on the basis of property additions in a principal amount equal to 70% of the original cost of electric and common plant properties (compared to 60% of value for Class A Bonds under the Old Mortgage), cash deposited with the Trustee, and retirement of New Bonds. New Bonds will be issuable under the New Mortgage only if adjusted net earnings (as therein defined) for 12 consecutive months out of the 18 months immediately preceding the month of issuance are at least twice the annual interest requirements on all outstanding bonds (including Class A Bonds) and New Bonds to be outstanding (New Bond Ratio). For the year ended December 31, 1993 the New Bond Ratio was 5.0. On April 29, 1993 the Securities and Exchange Commission declared effective a registration statement for the issuance of up to $700 million of New Bonds. The following series, aggregating $600 million, have been issued under such registration statement: On June 9, 1993, $100 million, 7 5/8% Series due June 1, 2023 to repay short-term borrowings in a like amount. On July 1, 1993, $100 million, 6% Series due June 15, 2000, and $150 million, 7 1/8% Series due June 15, 2013, and on July 20, 1993, $150 million, 7 1/2% Series due June 15, 2023, to redeem, on July 20, 1993, $382,035,000 of First and Refunding Mortgage Bonds maturing between 1999 and 2017 and bearing interest at rates between 8% and 9 7/8% per annum. On December 20, 1993, $100 million, 6 1/4% Series due December 15, 2003 to repay short-term borrowings in a like amount. On June 1, 1993 the Company redeemed the following amounts of First and Refunding Mortgage Bonds: $35 million, 10 1/8% Series due 2009 and $13 million, 9 7/8% Series due 2009. Without the consent of at least a majority of the total voting power of the Company's preferred stock, the Company may not issue or assume any unsecured indebtedness if, after such issue or assumption, the total principal amount of all such unsecured indebtedness would exceed 10% of the aggregate principal amount of all of the Company's secured indebtedness and capital and surplus; provided, however, that no such consent shall be required to enter into agreements for payment of principal, interest and premium for securities issued for pollution control purposes. Pursuant to Section 204 of the Federal Power Act, the Company must obtain FERC authority to issue short-term indebtedness. The FERC ha authorized the Company to issue up to $200 million of unsecured promissory notes or commercial paper with maturity dates of 12 months or less but not later than December 31, 1995. The Company has $127.0 million authorized and unused lines of credit at December 31, 1993. In addition, the Company has a credit agreement for a maximum of $75 million to finance nuclear and fossil fuel inventories, with $38.2 million available at December 31, 1993. The Company's Restated Articles of Incorporation prohibit issuance of additional shares of preferred stock without consent of the preferred stockholders unless net earnings (as defined therein) for the 12 consecutive months immediately preceding the month of issuance is at least one and one-half times the aggregate of all interest charges and preferred stock dividend requirements (Preferred Stock Ratio). For the year ended December 31, 1993 the Preferred Stock Ratio was 2.52. The Company anticipates that its 1994 cash requirements of $417.4 million will be met primarily through internally generated funds (approximately 32% excluding dividends), the sales of additional securities, additional equity contributions from SCANA and the incurrence of additional short-term and long-term indebtedness. The timing and amount of such financing will depend upon market conditions and other factors. Actual 1994 expenditures may vary from the estimates set forth above due to factors such as inflation and economic conditions, regulation and legislation, rates of load growth, environmental protection standards and the cost and availability of capital. The Company expects that it has or can obtain adequate sources of financing to meet its projected cash requirements. Environmental Matters The Clean Air Act requires electric utilities to reduce substantially emissions of sulfur dioxide and nitrogen oxide by the year 2000. These requirements are being phased in over two periods. The first phase has a compliance date of January 1, 1995 and the second, January 1, 2000. The Company meets all requirements of Phase I and therefore will not have to implement changes until compliance with Phase II requirements is necessary. The Company then will most likely meet its compliance requirements through the burning of natural gas and/or lower sulfur coal, the addition of scrubbers to coal-fired generating units, and the purchase of sulfur dioxide emission allowances. Low nitrogen oxide burners will be installed to reduce nitrogen oxide emissions. The Company is continuing to refine a detailed compliance plan that must be filed with the EPA by January 1, 1996. The Company currently estimates that, excluding GENCO, air emissions control equipment will require capital expenditures of $190 million over the 1994-1998 period to retrofit existing facilities and an increased operation and maintenance cost of $22 million per year. Total capital expenditures required to meet compliance requirements through the year 2003 are anticipated to be approximately $211 million. The South Carolina Solid Waste Policy and Management Act of 1991 requires promulgation of regulations addressing specified subjects, one of which affects the management of industrial solid waste. This regulation will establish minimum criteria for industrial landfills as mandated under the Act. The proposed regulation, if adopted as a final regulation in its present form, could significantly impact the Company's engineering, design and operation of existing and future ash management facilities. Potential cost impacts could be substantial. As described in Note 1L of Notes to Consolidated Financial Statements, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated, an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date ($19.6 million) for site assessments and cleanup of regulated operations have been deferred and are being amortized and recovered through rates over a ten year period. Estimates to date include, among other things, the costs estimated to be associated with the matters discussed in the following paragraphs. The Company and SCANA each own two decommissioned manufactured gas plant sites which contain residues of by-product chemicals. The Company and SCANA have each maintained an active review of their respective sites to monitor the nature and extent of the residual contamination. In September 1992 the EPA notified the Company, the City of Charleston and the Charleston Housing Authority of their potential liability for the investigation and cleanup of the Calhoun Park Area Site in Charleston, South Carolina. This site originally encompassed approximately 18 acres and included properties which were the locations for industrial operations, including a wood preserving (creosote) plant and one of the Company's decommissioned manufactured gas plants. The original scope of this investigation has been expanded to approximately 30 acres including adjacent properties owned by the National Park Service and the City of Charleston, and private properties. The site has not been placed on the National Priority List, but may be added before cleanup is initiated. The potentially responsible parties (PRP) have agreed with the EPA to participate in an innovative approach to site investigation and cleanup called "Superfund Accelerated Cleanup Model," allowing the pre- cleanup site investigations process to be compressed significantly. The PRPs have negotiated an administrative order by consent for the conduct of a Remedial Investigation/Feasibility Study (RI/FS) and a corresponding Scope of Work. Actual field work began November 1, 1993 after final approval and authorization was granted by EPA. The Company is also working with the City of Charleston to investigate potential contamination from the manufactured gas plant at the city's aquarium site. During 1993 the Company settled its obligations at the Yellow Water Road Superfund Site near Jacksonville, Florida, the Spencer Transformer and Equipment Site in West Virginia and Elliott's Auto Parts in Benton, Arkansas. No further expenses are anticipated for these sites. The Company has been listed as a PRP and has recorded liabilities, which are not considered material, for the Macon- Dockery waste disposal site near Rockingham, North Carolina, the Aqua-Tech Environmental, Inc. site in Greer, South Carolina and a landfill owned by Lexington County in South Carolina. Litigation In January 1994 the Company, acting on behalf of itself and the PSA (as co-owners of Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential by agreement of the parties and order of the court. The Company had filed an action in May 1990 against Westinghouse in the U. S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. Regulatory Matters On June 7, 1993 the PSC issued an order on the Company's pending electric rate proceeding allowing an authorized return on common equity of 11.5%, resulting in a 7.4% annual increase in retail electric rates, or a projected $60.5 million annually on a test year basis. These rates are to be implemented in two phases over a two-year period: phase one, effective June 1993, producing $42.0 million annually, and phase two, effective June 1994, producing $18.5 million annually, on a test year basis. The Company's operations are likely to be impacted by NEPA and FERC Order 636. NEPA is designed to create a more competitive wholesale power supply market by creating "exempt wholesale generators" and allowing for the potential requirement that a utility owning transmission facilities provide transmission access to wholesalers. Order No. 636 is intended to deregulate the markets for interstate sales of natural gas by requiring that pipelines provide transportation services that are equal in quality for all gas suppliers whether the customer purchases gas from the pipeline or another supplier. In the opinion of the Company, it will be able to meet successfully the challenges of these altered business climates. Other In November 1992 the Financial Accounting Standards Board issued Statement No. 112 "Employers' Accounting for Postemployment Benefits." The Statement, which is effective for calendar year 1994, establishes certain conditions for the recognition of costs of benefits to former employees after employment but before retirement. The Statement requires recognition of the obligation to provide postemployment benefits if such obligation is attributable to services previously rendered, the obligation relates to rights which vest, payment of the benefits is probable and the amount of such benefits can be reasonably estimated. The Company does not anticipate that application of this Statement will have a significant impact on results of operations or financial position. RESULTS OF OPERATIONS Overview Net income and the percent increase (decrease) from the previous year for the years 1993, 1992 and 1991 were as follows: 1993 1992 1991 Net income $145,968 $102,163 $122,836 Percent increase (decrease) in net income 42.9% (16.8%) 1.7% 1993 Net income increased for 1993 primarily due to an increase in the electric margin which more than offset increases in other operating expenses. 1992 Net income for 1992 decreased from 1991 primarily due to the recording of an $11.1 million (after interest and income taxes) reserve against earnings related to the August 31, 1992 retail electric rate ruling from the South Carolina Supreme Court (see Note 2E of Notes to Consolidated Financial Statements) and as a result of increased non-fuel operating expenses and interest charges. The Company's financial statements include AFC. AFC is a utility accounting practice whereby a portion of the cost of both equity and borrowed funds used to finance construction (which is shown on the balance sheet as construction work in progress) is capitalized. Both an equity and debt portion of AFC are included in nonoperating income as noncash items which have the effect of increasing reported net income. AFC represented approximately 5.6% of income before income taxes in 1993, 5.5% in 1992 and 3.7% in 1991. Electric Operations Electric sales margins for 1993, 1992 and 1991 were as follows: 1993 1992 1991 (Millions of Dollars) Electric revenues $940.2 $844.5 $867.7 Provision for rate refunds .3 (14.6) - Net Electric operating revenues 940.5 829.9 867.7 Less: Fuel used in electric generation 164.2 161.7 160.6 Purchased power 111.1 80.4 102.1 Margin $665.2 $587.8 $605.0 1993 The increase in electric sales margin from 1992 to 1993 is primarily a result of increased residential and commercial KWH sales due to weather and customer growth, an increase in retail electric rates beginning in June 1993, and a $14.6 million reserve recorded in 1992 as discussed below. 1992 The 1992 electric sales margin decreased from 1991 primarily due to the recording of a $14.6 million reserve, before interest and income taxes, related to the August 31, 1992 ruling from the Supreme Court (see Note 2E of Notes to Consolidated Financial Statements) and a $1.9 million billing-related litigation settlement included in 1991 electric operating revenues. Increases (decreases) in megawatt hour (MWH) sales volume by classes are presented in the following table: Increase (Decrease) From Prior Year Volume (MWH) Classification 1993 1992 Residential 494,874 2,380 Commercial 305,560 37,749 Industrial 203,178 49,248 Sale for Resale (excluding interchange) 59,611 12,945 Other 24,873 (3,116) Total territorial 1,088,096 99,206 Interchange 121,013 16,558 Total 1,209,109 115,764 Warmer weather and an increase in the number of electric customers contributed to an all-time peak demand record of 3,557 MW (including Williams Station) on July 29, 1993. The previous year's record of 3,380 MW was set on July 13, 1992. Gas Operations Gas sales margins for 1993, 1992 and 1991 were as follows: 1993 1992 1991 (Millions of Dollars) Gas revenues $174.0 $160.8 $150.8 Less: Gas purchased for resale 107.7 95.8 93.2 Margin $ 66.3 $ 65.0 $ 57.6 1993 The 1993 gas sales margin increased from 1992 primarily as a result of increases in higher margin residential and regular commercial sales. 1992 The 1992 gas sales margin increased from 1991 primarily due to recoveries of $4.2 million allowed under a weather normalization adjustment, increases in residential usage due to unseasonably cool weather during May 1992, and increased transportation volumes. Increases (decreases) in dekatherm (DT) sales volume by classes are presented in the following table: Increase (Decrease) From Prior Year Volume (DT) Classification 1993 1992 Residential 723,356 1,303,673 Commercial (186,529) 22,188 Industrial 547,193 (424,657) Total 1,084,020 901,204 Other Operating Expenses and Taxes Increases (decreases) in other operating expenses, including taxes, are presented in the following table: Increase (Decrease) From Prior Year Classification 1993 1992 (Millions of Dollars) Other operation and maintenance $ 8.1 $11.5 Depreciation and amortization 4.2 5.4 Income taxes 29.9 (17.2) Other taxes (.2) 4.7 Total $42.0 $ 4.4 1993 Other operation and maintenance expenses increased for 1993 primarily due to the implementation of Financial Accounting Standards Board Statement No. 106 (See Note 1J of Notes to Consolidated Financial Statements) pursuant to the June 1993 PSC electric rate order and the amortization of environmental expenses. The depreciation and amortization increase reflects additions to plant in service. The increase in income taxes corresponds to the increase in the corporate tax rate from 34% to 35% retroactive to January 1, 1993. 1992 Other operation and maintenance expenses increased for 1992 primarily due to increases in administrative and general expense, increase in nuclear regulatory fees, and nuclear and transmission system maintenance. The increase in depreciation and amortization expense reflects additions to plant in service. The decrease in income tax expense is primarily related to the tax impact of the rate refund (see Note 2E of Notes to Consolidated Financial Statements) and to other decreases in income. The increase in other taxes is primarily due to higher property taxes caused by property additions and increased millage rates. In addition to the above, other taxes increased due to increases in state license fees. Interest Expense 1993 Interest expense, excluding the debt component of AFC, decreased approximately $1.8 million primarily due to the redemption of First and Refunding Mortgage Bonds and the issuance of First Mortgage Bonds at lower interest rates and the 1992 interest on the provision for rate refund which were partially offset by interest on an adjustment for the 1987-1988 income tax audit. 1992 Interest expense increased approximately $5.7 million in 1992 compared to 1991 due to the issuances of the $145 million and $155 million of First and Refunding Mortgage Bonds on July 24, 1991 and August 29, 1991, respectively, which more than offset the decreases in interest expense resulting from the repayment of debt and lower interest rates on remaining debt and interest of $3.1 million accrued on the provision for rate refund (see Note 2E of Notes to Consolidated Financial Statements). ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Independent Auditor's Report....................................... 29 Consolidated Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992... 30 Consolidated Statements of Income and Retained Earnings for the years ended December 31, 1993, 1992 and 1991............. 32 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991............................. 33 Consolidated Statements of Capitalization as of December 31, 1993 and 1992................................... 34 Notes to Consolidated Financial Statements..................... 36 Supplemental Financial Statement Schedules: Schedule V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991................. 54 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991....................... 57 Supplemental financial statement 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 consolidated financial statements or in the notes thereto. INDEPENDENT AUDITOR'S REPORT South Carolina Electric & Gas Company: We have audited the accompanying Consolidated Balance Sheets and Statements of Capitalization of South Carolina Electric & Gas Company (Company) as of December 31, 1993 and 1992 and the related Consolidated Statements of Income and Retained Earnings and of 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 on page 28. 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 financial position of the 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, 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 Columbia, South Carolina February 7, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: A. Organization and Principles of Consolidation The Company, a public utility, is a South Carolina corporation organized in 1924 and a wholly owned subsidiary of SCANA Corporation (SCANA), a South Carolina holding company. The accompanying Consolidated Financial Statements include the accounts of the Company and South Carolina Fuel Company, Inc. (Fuel Company) (see Note 1M). Intercompany balances and transactions between the Company and Fuel Company have been eliminated in consolidation. Affiliated Transactions The Company has entered into agreements with certain affiliates to purchase gas for resale to its distribution customers and to purchase electric energy. The Company purchases all of its natural gas requirements from South Carolina Pipeline Corporation (Pipeline Corporation) and at December 31, 1993 and 1992 the Company had approximately $15.1 million and $15.2 million, respectively, payable to Pipeline Corporation for such gas purchases. The Company purchases all of the electric generation of Williams Station, which is owned by South Carolina Generating Company, Inc. (GENCO), under a unit power sales agreement. At December 31, 1993 and 1992 the Company had approximately $7.5 million and $4.5 million, respectively, payable to GENCO for unit power purchases. Such unit power purchases, which are included in "Purchased power," amounted to approximately $98.1 million, $73.1 million and $92.3 million in 1993, 1992 and 1991, respectively. Total interest income (based on market interest rates) associated with the Company's advances to affiliated companies was approximately $129,000, $231,000 and $141,000 in 1993, 1992 and 1991. Included in "Other interest expense" for 1993, 1992 and 1991 is approximately $29,000, $16,000 and $830,000, respectively, relating to advances from affiliated companies. Intercompany interest is calculated at market rates. B. System of Accounts The accounting records of the Company are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and as adopted by The Public Service Commission of South Carolina (PSC). C. Utility Plant Utility plant is stated substantially at original cost. The costs of additions, renewals and betterments to utility plant, including direct labor, material and indirect charges for engineering, supervision and an allowance for funds used during construction, are added to utility plant accounts. The original cost of utility property retired or otherwise disposed of is removed from utility plant accounts and generally charged, along with the cost of removal, less salvage, to accumulated depreciation. The costs of repairs, replacements and renewals of items of property determined to be less than a unit of property are charged to maintenance expense. The Company, operator of the V. C. Summer Nuclear Station (Summer Station), and The South Carolina Public Service Authority (PSA) are joint owners of the 885 MW Summer Station in the proportions of two-thirds and one-third, respectively. The parties share the operating costs and energy output of the plant in these proportions. Each party, however, provides its own financing. Plant in service related to the Company's portion of Summer Station was approximately $920.2 million and $916.0 million as of December 31, 1993 and 1992, respectively. Accumulated depreciation associated with the Company's share of Summer Station was approximately $285.3 million and $262.2 million as of December 31, 1993 and 1992, respectively. The Company's share of the direct expenses associated with operating Summer Station is included in "Other operation" and "Maintenance" expenses. D. Allowance for Funds Used During Construction Allowance for funds used during construction (AFC), a noncash item, reflects the period cost of capital devoted to plant under construction. This accounting practice results in the inclusion, as a component of construction cost, of the costs of debt and equity capital dedicated to construction investment. AFC is included in rate base investment and depreciated as a component of plant cost in establishing rates for utility services. The Company has calculated AFC using rates of 9.4%, 9.4% and 9.8% for 1993, 1992 and 1991, respectively. These rates do not exceed the maximum allowable rate as calculated under FERC Order No. 561. Interest on nuclear fuel in process is capitalized at the actual interest amount. E. Deferred Return on Plant Investment Commencing July 1, 1987, as approved by a PSC order on that date, the Company ceased the deferral of carrying costs associated with 400 MW of electric generating capacity previously removed from rate base and began amortizing the accumulated deferred carrying costs on a straight-line basis over a ten-year period. Amortization of deferred carrying costs, included in "Depreciation and amortization," was approximately $4.2 million for each of 1993, 1992 and 1991. F. Revenue Recognition Customers' meters are read and bills are rendered on a monthly cycle basis. Base revenue is recorded during the accounting period in which the meters are read. Fuel costs for electric generation are collected through the fuel component in retail electric rates. The fuel component contained in electric rates is established by the PSC during semiannual fuel cost hearings. Any difference between actual fuel cost and that contained in the fuel component is deferred and included when determining the fuel cost component during the next semiannual fuel cost hearing. At December 31, 1993 and 1992 the Company had overcollected through the electric fuel clause component approximately $9.2 million and $17.7 million, respectively, which are included in "Deferred Credits - Other." Customers subject to the gas cost adjustment clause are billed based on a fixed cost of gas determined by the PSC during annual gas cost recovery hearings. Any difference between actual gas cost and that contained in the rates is deferred and included when establishing gas costs during the next annual gas cost recovery hearing. At December 31, 1993 and 1992 the Company had undercollected through the gas cost recovery procedure approximately $11.0 million and $5.7 million, respectively, which are included in "Deferred Debits - Other." G. Depreciation and Amortization Provisions for depreciation are recorded using the straight- line method for financial reporting purposes and are based on the estimated service lives of the various classes of property. The composite weighted average depreciation rates were 2.97%, 3.00%, and 2.97% for 1993, 1992 and 1991, respectively. Nuclear fuel amortization, which is included in "Fuel used in electric generation" and is recovered through the fuel cost component of the Company's rates, is recorded using the units-of- production method. Provisions for amortization of nuclear fuel include amounts necessary to satisfy obligations to the United States Department of Energy under a contract for disposal of spent nuclear fuel. H. Nuclear Decommissioning Decommissioning of Summer Station is presently projected to commence in the year 2022 when the operating license expires. The expenditures (on a before-tax basis) related to the Company's share of decommissioning activities are currently estimated (in 2022 dollars, assuming an annual 4.5% rate of inflation) to be approximately $545.3 million including partial reclamation costs. The Company is providing for its share of estimated decommissioning costs over the life of Summer Station. The Company collected through rates $2.5 million and $1.6 million in 1993 and 1992, respectively. The amounts collected are deposited in an external trust fund in compliance with the financial assurance requirements of the NRC. Management intends for the fund, including earnings thereon, to provide for all eventual decommissioning expenditures on an after-tax basis. In addition, pursuant to the National Energy Policy Act passed by Congress in 1992, the Company has recorded a liability for its estimated share of amounts required by the U. S. Department of Energy for its decommissioning fund. SCE&G will recover the costs associated with this liability, totaling $4.6 million at December 31, 1993, through the fuel cost component of its rates; accordingly, these amounts have been deferred and are included in "Deferred Debits-Other" and "Long-Term Debt, Net." I. Income Taxes The Company is included in the consolidated Federal and State income tax returns filed by SCANA. Income taxes are allocated to the Company based on its contribution to consolidated taxable income. The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," effective January 1, 1993. Prior years' financial statements have not been restated. Deferred tax assets and liabilities were adjusted from the amounts recorded at December 31, 1992 under prior standards to the amounts required at January 1, 1993 under Statement No. 109 at currently enacted income tax rates. The adjustments were charged or credited to regulatory assets or liabilities if the Company expects to recover the resulting additional income tax expense from, or pass through the resulting reductions in income tax expense to, customers of the Company; otherwise they were charged or credited to income tax expense. The cumulative effect of adopting Statement No. 109 on retained earnings as of January 1, 1993, as well as the effect of adoption on net income for the year ended December 31, 1993, was not material. The combined effect of adopting Statement No. 109 and adjusting deferred tax assets and liabilities for the change in 1993 of the corporate Federal income tax rate from 34% to 35% resulted in balances of $97.0 million in regulatory assets (included in "Deferred Debits- Other") and $56.6 million in regulatory liabilities (included in "Deferred Credits-Other"). In accordance with Statement No. 109, deferred tax assets and liabilities are recorded for the tax effect of temporary differences between the book and tax basis of assets and liabilities at currently enacted tax rates. Deferred tax assets and liabilities are adjusted for changes in such rates through charges or credits to regulatory assets or liabilities if they are expected to be recovered from, or passed through to, customers; otherwise, they are charged or credited to income tax expense. Prior to the adoption of Statement No. 109 on January 1, 1993, the Company recorded a deferred income tax provision on all material timing differences between the inclusion of items in pretax financial income and taxable income each year, except for those which were expected to be passed through to, or collected from, customers. Accumulated deferred income taxes were generally not adjusted for changes in enacted tax rates. J. Pension Expense The Company participates in SCANA's noncontributory defined benefit pension plan, which covers all permanent Company employees. Benefits are based on years of accredited service and the employee's average annual base earnings received during the last three years of employment. SCANA's policy has been to fund pension costs accrued to the extent permitted by the applicable Federal income tax regulations as determined by an independent actuary. Net periodic pension cost, as determined by an independent actuary, for the years ended December 31, 1993, 1992 and 1991 included the following components: The change in the annual discount rate used to determine benefit obligations from 8.0% to 7.25% as of December 31, 1993 increased the projected benefit obligation and reduced the unrecognized net gain by approximately $4.1 million. In addition to pension benefits, the Company provides certain health care and life insurance benefits to active and retired employees. On January 1, 1993 the Company adopted Statement No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions." This Statement requires that the cost of postretirement benefits other than pensions be accrued during the years the employees render the service necessary to be eligible for the applicable benefits. The Company previously expensed these benefits, which are primarily health care, as claims were incurred. The accumulated obligation for these benefits at January 1, 1993 was approximately $68 million (transition liability) and the annualized increase in expenses (net of payments to current retirees), including the amortization of the transition liability over approximately 20 years as provided for by the Statement, is approximately $4.7 million. In its June 1993 electric rate order (see Note 2A) the PSC approved the inclusion in rates of the portion of increased expenses related to electric operations. Such expenses had been deferred through May 31, 1993 pursuant to a December 10, 1992 accounting directive allowing deferral pending consideration of recovery in future rate proceedings. For the year ended December 31, 1993 the Company expensed approximately $4.3 million, net of payments to current retirees. Net periodic postretirement benefit cost, as determined by an independent actuary for the year ended December 31, 1993 included the following components (thousands of dollars): The effect of a one-percentage-point increase in the assumed health care cost trend rate for each future year on the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993 and the accumulated postretirement benefit obligation as of December 31, 1993 would be to increase such amounts by $60,000 and $1.7 million, respectively. K. Debt Premium, Discount and Expense, Unamortized Loss on Reacquired Debt Long-term debt premium, discount and expense are being amortized as components of "Interest on long-term debt, net" over the terms of the respective debt issues. Gains or losses on reacquired debt that is refinanced are deferred and amortized over the term of the replacement debt. L. Environmental The Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date for site assessments and cleanup relate primarily to regulated operations; such amounts have been deferred and are being amortized and recovered through rates over a ten-year period. Such amounts totaled $19.6 million and $18.3 million at December 31, 1993 and 1992, respectively, and are included in "Deferred Debits-Other." M. Fuel Inventory Nuclear fuel and fossil fuel inventories are purchased and financed by Fuel Company under a contract which requires the Company to reimburse Fuel Company for all costs and expenses relating to the ownership and financing of fuel inventories. Accordingly, such fuel inventories and fuel-related assets and liabilities are included in the Company's consolidated financial statements (see Note 4). N. Postemployment Benefits In November 1992 the Financial Accounting Standards Board issued Statement No. 112 "Employers' Accounting for Postemployment Benefits." The Statement, which is effective for calendar year 1994, establishes certain conditions for the recognition of costs of benefits to former employees after employment but before retirement. The Statement requires recognition of the obligation to provide postemployment benefits if such obligation is attributable to services previously rendered, the obligation relates to rights which vest, payment of the benefits is probable, and the amount of such benefits can be reasonably estimated. The Company does not anticipate that application of this Statement will have a significant impact on results of operations or financial position. O. Temporary Cash Investments The Company considers temporary cash investments having original maturities of three months or less to be cash equivalents. Temporary cash investments are generally in the form of commercial paper, certificates of deposit and repurchase agreements. P. Reclassifications Certain amounts from prior periods have been reclassified to conform with the 1993 presentation. 2. RATE MATTERS: A. On June 7, 1993 the PSC issued an order on the Company's pending electric rate proceeding allowing an authorized return on common equity of 11.5%, resulting in a 7.4% annual increase in retail electric rates, or a projected $60.5 million annually based on a test year. These rates are to be implemented in two phases over a two-year period: phase one, effective June 1993, producing $42.0 million annually, and phase two, effective June 1994, producing $18.5 million annually, based on a test year. B. On September 14, 1992 the PSC issued an order granting the Company a $.25 increase in transit fares from $.50 to $.75 in both Columbia and Charleston, South Carolina; however, the PSC also required $.40 fares for low income customers and denied the Company's request to reduce the number of routes and frequency of service. The new rates were placed into effect on October 5, 1992. The Company has appealed the PSC's order to the Circuit Court. During oral arguments in February 1994 the Circuit Court retained jurisdiction and remanded the decision to the PSC for the limited purpose of answering questions concerning the applicable regulatory principles used by the PSC in determining these transit rates. C. Since November 1, 1991 the Company's gas rate schedules for its residential, small commercial and small industrial customers have included a weather normalization adjustment. The WNA minimizes fluctuations in gas revenues due to abnormal weather conditions and has been approved through November 1994 subject to an annual review by the PSC. The PSC order was based on a return on common equity of 12.25%. The PSC also approved the WNA for SCANA's directly owned natural gas distribution system which is operated by the Company. The WNA became effective the first billing cycle in December 1991. D. In May 1989 the PSC approved a volumetric and direct billing method for Pipeline Corporation to recover take-or-pay costs incurred from its interstate pipeline suppliers pursuant to FERC-approved final and non-appealable settlements. In December 1992 the Supreme Court approved Pipeline Corporation's full recovery of the take-or-pay charges imposed by its suppliers and treatment of these charges as a cost of gas. However, the Supreme Court declared the PSC-approved "purchase deficiency" methodology for recovery of these costs to be unlawful retroactive ratemaking and remanded the docket to the PSC to reconsider its recovery methodology. The Company believes that the elimination of the purchase deficiency method of recovery will affect the timing for recovery of take-or-pay charges and shift the allocations among Pipeline Corporation's customers (including the Company) but that all such charges should be ultimately recovered. The Supreme Court decision establishes a principle of law that will provide a basis for full recovery by the Company, as well as Pipeline Corporation, of these costs. E. On July 3, 1989 the PSC granted the Company approximately $21.9 million of a requested $27.2 million annual increase in retail electric revenues based upon an allowed return on common equity of 13.25%. The Consumer Advocate appealed the decision to the Supreme Court which, on August 31, 1992, found that the evidence in the record of that case did not support a return on common equity higher than 13.0% and remanded to the PSC a portion of its July 1989 order for a determination of the proper return on common equity consistent with the Supreme Court's opinion. On January 19, 1993 the PSC issued an order allowing a return on common equity of 13.0%, approving a refund based on the difference in rates created by the difference between the 13.0% and the 13.25% return on common equity and making other non- material adjustments to the calculation of cost-of-service. The total refund, before interest and income taxes, was approximately $14.6 million, and was charged against 1992 "Electric Revenues." The refund plus interest was made during 1993. F. On November 28, 1989 the PSC granted the Company an increase in firm retail natural gas rates, effective November 30, 1989, designed to increase annual revenues by $10.1 million, or 89.5% out of the requested increase of approximately $11.3 million. In its order the PSC authorized a 12.75% return on common equity. The Consumer Advocate appealed to the Supreme Court which on August 31, 1992 remanded the order to the PSC for redetermination of the proper amount of litigation expenses to include in the test period. In January 1993 the PSC reduced the amount of litigation expense and ordered a refund totaling approximately $163,000 which was charged against 1992 "Gas Revenues." The refund was made during 1993. 3. LONG-TERM DEBT: The annual amounts of long-term debt maturities, including amounts due under nuclear and fossil fuel agreements (see Note 4), and sinking fund requirements for the years 1994 through 1998 are summarized as follows: Year Amount Year Amount (Thousands of Dollars) 1994 $13,719 1997 $26,345 1995 28,943 1998 31,325 1996 64,146 Approximately $10.9 million of the current portion of long- term debt for 1993 may be satisfied by either deposit and cancellation of bonds issued upon the basis of property additions or bond retirement credits, or by deposit of cash with the Trustee. During 1993 certain issues of the Company's First and Refunding Mortgage Bonds were redeemed and replaced with First Mortgage Bonds. Pipeline Corporation's two principal gas suppliers have incurred liabilities to gas producers under take-or-pay provisions of gas supply contracts. The FERC has accepted filings allowing these pipeline suppliers to recover portions of such take-or-pay liabilities from their customers, including Pipeline Corporation, through volumetric surcharges in gas rates and through direct billings. The Company's liability to Pipeline Corporation for its proportionate share of take-or-pay costs was approximately $1.6 million at December 31, 1993 which is included in Accounts Payable - Affiliated Companies. The Company is paying this amount plus interest (9.4%) to Pipeline Corporation over a five- year period which began June 1989. The Company recovers these costs from its customers through the purchased gas adjustment (PGA) provisions in its rates. The Company's take-or-pay liability to Pipeline Corporation will likely be increased due to the Supreme Court decision dated December 14, 1992 (see Note 2D). The Company anticipates that any such increase will be recovered through the PGA. Certain outstanding long-term debt of an affiliated company (approximately $35.9 million at December 31, 1993 and 1992 respectively) is guaranteed by the Company. Substantially all utility plant and fuel inventories are pledged as collateral in connection with long-term debt. 4. FUEL FINANCINGS: Nuclear and fossil fuel inventories are financed through the issuance of short-term commercial paper. These short-term borrowings are supported by an irrevocable revolving credit agreement which expires July 31, 1996. Accordingly, the amounts outstanding have been included in long-term debt. The credit agreement provides for a maximum amount of $75 million that may be outstanding at any time. Commercial paper outstanding totaled $36.8 million and $55.7 million at December 31, 1993 and 1992 at weighted average interest rates of 3.47% and 3.81%, respectively. 5. STOCKHOLDERS' INVESTMENT (Including Preferred Stock Not Subject to Purchase or Sinking Funds): The changes in "Stockholders' Investment" (Including Preferred Stock Not Subject to Purchase or Sinking Funds) during 1993, 1992 and 1991 are summarized as follows: Common Preferred Thousands Shares Shares of Dollars Balance December 31, 1990 40,296,147 322,877 $847,400 Changes in Retained Earnings: Net Income 122,836 Cash Dividends Declared: Preferred Stock (at stated rates) (6,706) Common Stock (97,000) Other 2 Balance December 31, 1991 40,296,147 322,877 866,532 Changes in Retained Earnings: Net Income 102,163 Cash Dividends Declared: Preferred Stock (at stated rates) (6,474) Common Stock (99,291) Equity Contributions from Parent 126,838 Balance December 31, 1992 40,296,147 322,877 989,768 Changes in Retained Earnings: Net Income 145,968 Cash Dividends Declared: Preferred Stock (at stated rates) (6,217) Common Stock (110,300) Equity Contributions from Parent 58,142 Balance December 31, 1993 40,296,147 322,877 $1,077,361 The Restated Articles of Incorporation of the Company and the Indenture underlying its First and Refunding Mortgage Bonds contain provisions that may limit the payment of cash dividends on common stock. In addition, with respect to hydroelectric projects, the Federal Power Act may require the appropriation of a portion of the earnings therefrom. At December 31, 1993 approximately $10.6 million of retained earnings were restricted as to payment of cash dividends on common stock. 6. PREFERRED STOCK (Subject to Purchase or Sinking Funds): The call premium of the respective series of preferred stock in no case exceeds the amount of the annual dividend. Retirements under sinking fund requirements are at par values. At any time when dividends have not been paid in full or declared and set apart for payment on all series of preferred stock, the Company may not redeem any shares of preferred stock (unless all shares of preferred stock then outstanding are redeemed) or purchase or otherwise acquire for value any shares of preferred stock except in accordance with an offer made to all holders of preferred stock. The Company may not redeem any shares of preferred stock (unless all shares of preferred stock then outstanding are redeemed) or purchase or otherwise acquire for value any shares of preferred stock (except out of monies set aside as purchase funds or sinking funds for one or more series of preferred stock) at any time when it is in default under the provisions of the purchase fund or sinking fund for any series of preferred stock. The aggregate annual amounts of purchase fund or sinking fund requirements for preferred stock for the years 1994 through 1998 are summarized as follows: Year Amount Year Amount (Thousands of Dollars) 1994 $2,504 1997 $2,440 1995 2,515 1998 2,440 1996 2,482 The changes in "Total Preferred Stock (Subject to Purchase or Sinking Funds)" during 1993, 1992 and 1991 are summarized as follows: Number Thousands of Shares of Dollars Balance December 31, 1990 1,050,201 $ 64,460 Shares Redeemed: $100 par value (628) (63) $50 par value (51,169) (2,559) Balance December 31, 1991 998,404 61,838 Shares Redeemed: $100 par value (6,098) (610) $50 par value (51,777) (2,589) Balance December 31, 1992 940,529 58,639 Shares Redeemed: $100 par value (7,374) (737) $50 par value (51,187) (2,558) Balance December 31, 1993 881,968 $ 55,344 7. INCOME TAXES: Total income tax expense for 1993, 1992 and 1991 is as follows: 1993 1992 1991 (Thousands of Dollars) Current taxes: Federal $60,577 $62,147 $36,594 State 6,822 7,852 4,833 Total current taxes 67,399 69,999 41,427 Deferred taxes, net: Federal 12,197 (16,274) 25,212 State 4,387 (322) 4,469 Total deferred taxes 16,584 (16,596) 29,681 Investment tax credits: Amortization of amounts deferred (credit) (3,245) (3,245) (3,245) Total income tax expense $80,738 $50,158 $67,863 Total income taxes differ from amounts computed by applying the statutory Federal income tax rate of 35% for 1993 and 34% for 1992 and 1991 to pretax income as follows: The Omnibus Budget Reconciliation Act was signed into law on August 10, 1993, increasing the corporate tax rate from 34% to 35% effective January 1, 1993. This impact of this change on the Company's financial position and results of operation was not material. The tax effects of significant temporary differences comprising the Company's net deferred tax liability of $471.8 million at December 31, 1993 determined in accordance with Statement No. 109 (see Note 1I) are as follows (thousands of dollars): Deferred tax assets: Unamortized investment tax credits $ 52,310 Cycle billing 15,084 Nuclear operations expenses 4,908 Deferred compensation programs 5,265 Other postretirement benefits 1,631 Injuries and damages 724 Other 3,808 Total deferred tax assets 83,730 Deferred tax liabilities: Accelerated depreciation and amortization 526,540 Reacquired debt 7,574 Property taxes 6,068 Pension expense 6,266 Nuclear system maintenance 2,965 Early retirement programs 1,961 Nuclear decontamination fund 1,417 Other 2,732 Total deferred tax liabilities 555,523 Net deferred tax liability $471,793 "Total deferred taxes" charged (credited) to income tax expense result from timing differences in recognition of the following items: 1992 1991 (Thousands of Dollars) Charged (credited) to expense: Accelerated depreciation and amortization $ (5) $22,053 Deferred fuel accounting (2,947) 461 Property taxes 493 1,608 Cycle billing (1,381) 3,608 Nuclear refueling accrual (4,430) 2,052 Electric rate refund (6,571) - Injuries and damages (1,377) - Other, net (378) (101) Total deferred taxes $(16,596) $29,681 The Internal Revenue Service has examined and closed consolidated Federal income tax returns of SCANA Corporation through 1989 and is currently examining SCANA's 1990 and 1991 Federal income tax returns. No adjustments are currently proposed by the examining agent. SCANA does not anticipate that any adjustments which might result from this examination will have a significant impact on the earnings or financial position of the Company. 8. FINANCIAL INSTRUMENTS The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 1993 and 1992 are as follows: The information presented herein is based on pertinent information available to the Company as of December 31, 1993 and 1992. Although the Company is not aware of any factors that would significantly affect the estimated fair value amounts, such financial instruments have not been comprehensively revalued since December 31, 1993, and the current estimated fair value may differ significantly from the estimated fair value at that date. The following methods and assumptions were used to estimate the fair value of the above classes of financial instruments: Cash and temporary cash investments, including commercial paper, repurchase agreements, treasury bills and notes are valued at their carrying amount. Fair values of investments and long-term debt are based on quoted market prices for similar instruments, or for those instruments for which there are no quoted market prices available, fair values are based on net present value calculations. Settlement of long term debt may not be possible or may not be a prudent management decision. Short-term borrowings are valued at their carrying amount. The fair value of preferred stock (subject to purchase or sinking funds) is estimated on the basis of market prices. Potential taxes and other expenses that would be incurred in an actual sale or settlement have not been taken into consideration. 9. SHORT-TERM BORROWINGS: The Company pays fees to banks as compensation for its lines of credit. Commercial paper borrowings are for 270 days or less. Details of lines of credit and short-term borrowings at December 31, 1993, 1992 and 1991 and for the years then ended are as follows: 1993 1992 1991 (Millions of dollars) Authorized lines of credit at year end $127.0 $119.9 $121.7 Unused lines of credit at year-end $127.0 $119.9 $121.7 Short-term borrowings (including commercial paper) during the year: Maximum outstanding $126.0 $ 95.3 $130.4 Average outstanding $ 56.0 $ 40.9 $ 64.5 Weighted daily average interest rates: Bank loans 3.24% 3.49% 7.69% Commercial paper 3.13% 3.69% 6.31% Short-term borrowings outstanding at year-end: Commercial paper $ 1.0 $ - $ - Weighted average interest rate 3.50% - - Bank loans $ - $ - $ - Weighted average interest rate - - - 10. COMMITMENTS AND CONTINGENCIES: A. Construction The Company entered into a contract with Duke/Fluor Daniel in 1991 to design, engineer and build a 385 MW coal-fired electric generating plant near Cope, South Carolina in Orangeburg County. Construction of the plant began in November 1992 and commercial operation is expected in late 1995 or early 1996. The estimated price of the Cope plant, excluding financing costs and AFC but including an allowance for escalation, is $450 million. In addition, the transmission lines for interconnection with the Company's system are expected to cost $26 million. Under the Duke/Fluor Daniel contract the Company must make specified monthly minimum payments. These minimum payments do not include amounts for inflation on a portion of the contract which is subject to escalation (approximately 34% of the total contract amount). The aggregate amount of such required minimum payments remaining at December 31, 1993 is as follows (in thousands): 1994 $168,152 1995 59,766 1996 5,603 Total $233,521 Through December 31, 1993 the Company paid $142.0 million under the contract. B. Nuclear Insurance The Price-Anderson Indemnification Act, which deals with the Company's public liability for a nuclear incident, currently establishes the liability limit for third-party claims associated with any nuclear incident at $9.4 billion. Each reactor licensee is currently liable for up to $79.3 million per reactor owned for each nuclear incident occurring at any reactor in the United States, provided that not more than $10 million of the liability per reactor would be assessed per year. The Company's maximum assessment, based on its two-thirds ownership of Summer Station, would not exceed approxi- mately $52.9 million per incident, but not more than $6.7 million per year. The Company currently maintains policies (for itself and on behalf of the PSA) with Nuclear Electric Insurance Limited (NEIL) and American Nuclear Insurers (ANI) providing combined property and decontamination insurance coverage of $1.4 billion for any losses in excess of $500 million pursuant to existing primary coverages (with ANI) on Summer Station. The Company pays annual premiums and, in addition, could be assessed a retroactive premium not to exceed 7 1/2 times its annual premium in the event of property damage loss to any nuclear generating facilities covered by NEIL. Based on the current annual premium, this retroactive premium would not exceed approximately $8.1 million. To the extent that insurable claims for property damage, decontamination, repair and replacement and other costs and expenses arising from a nuclear incident at Summer Station exceed the policy limits of insurance, or to the extent such insurance becomes unavailable in the future, and to the extent that the Company's rates would not recover the cost of any purchased replacement power, the Company will retain the risk of loss as a self-insurer. The Company has no reason to anticipate a serious nuclear incident at Summer Station. If such an incident were to occur, it could have a materially adverse impact on the Company's financial position. C. Litigation In January 1994 the Company, acting on behalf of itself and the PSA (as co-owners of Summer Station), reached a settlement with Westinghouse Electric Corporation (Westinghouse) resolving a dispute involving steam generators provided by Westinghouse to Summer Station which are defective in design, workmanship and materials. Terms of the settlement are confidential by agreement of the parties and order of the court. The Company had filed an action in May 1990 against Westinghouse in the U. S. District Court for South Carolina; an order dismissing this suit was issued on January 12, 1994. D. Environmental As described in Note 1L, the Company has an environmental assessment program to identify and assess current and former operations sites that could require environmental cleanup. As site assessments are initiated an estimate is made of the amount of expenditures, if any, necessary to investigate and clean up each site. These estimates are refined as additional information becomes available; therefore actual expenditures could significantly differ from the original estimates. Amounts estimated and accrued to date for site assessments and cleanup relate primarily to regulated operations; such amounts have been deferred and are being amortized and recovered through rates over a ten-year period. 11. SEGMENT OF BUSINESS INFORMATION: Segment information at December 31, 1993, 1992 and 1991 and for the years then ended is as follows: Electric Gas Transit Total (Thousands of Dollars) Operating revenues $940,547 $174,035 $ 3,851 $1,118,433 Operating expenses, excluding depreciation and amortization 639,808 148,349 9,737 797,894 Depreciation and amortization 91,142 9,903 175 101,220 Total operating expenses 730,950 158,252 9,912 899,114 Operating income (loss) $209,597 $ 15,783 $(6,061) 219,319 Add - Other income, net 6,585 Less - Interest charges 79,936 Net income $ 145,968 Capital expenditures: Identifiable $ 274,408 $ 11,674 $ 604 $ 286,686 Utilized for overall Company operations 13,934 Total $ 300,620 Identifiable assets at December 31, 1993: Utility plant, net $2,445,466 $178,464 $1,673 $2,625,603 Inventories 66,181 2,526 463 69,170 Total $2,511,647 $180,990 $2,136 2,694,773 Assets utilized for overall Company operations 495,166 Total assets $3,189,939 Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 829,938 $160,820 $ 3,623 $ 994,381 Operating expenses, excluding depreciation and amortization 572,234 133,611 9,205 715,050 Depreciation and amortization 87,367 9,534 163 97,064 Total operating expenses 659,601 143,145 9,368 812,114 Operating income (loss) $ 170,337 $ 17,675 $(5,745) 182,267 Add - Other income, net 3,006 Less - Interest charges 83,110 Net income $ 102,163 Capital expenditures: Identifiable $ 223,697 $ 10,409 $ 346 $ 234,452 Utilized for overall Company operations 8,877 Total $ 243,329 Identifiable assets at December 31, 1992: Utility plant, net $2,271,895 $177,309 $ 1,240 $2,450,444 Inventories 68,435 2,967 481 71,883 Total $2,340,330 $180,276 $ 1,721 2,522,327 Assets utilized for overall Company operations 368,626 Total assets $2,890,953 Electric Gas Transit Total (Thousands of Dollars) Operating revenues $ 867,685 $ 150,788 $ 3,869 $1,022,342 Operating expenses, excluding depreciation and amortization 596,466 128,529 9,023 734,018 Depreciation and amortization 82,503 8,969 146 91,618 Total operating expenses 678,969 137,498 9,169 825,636 Operating income (loss) $ 188,716 $ 13,290 $ (5,300) 196,706 Add - Other income, net 3,283 Less - Interest charges 77,153 Net income $ 122,836 Capital expenditures: Identifiable $ 191,218 $ 16,029 $ 89 $ 207,336 Utilized for overall Company operations 7,967 Total $ 215,303 Identifiable assets at December 31, 1991: Utility plant, net $2,154,221 $ 176,570 $ 1,073 $2,331,864 Inventories 69,316 2,553 476 72,345 Total $2,223,537 $ 179,123 $ 1,549 2,404,209 Assets utilized for overall Company operations 344,371 Total assets $2,748,580 12. SUPPLEMENTARY INCOME STATEMENT INFORMATION: Maintenance expense (including repairs) and provision for depreciation and amortization of utility plant are shown separately in the accompanying consolidated statements of income, except for amounts charged to clearing and other accounts, which amounts are not significant. Advertising expenses are not material and there were no royalties. Taxes other than income taxes are as follows (amounts for nonutility operations are not significant): December 31, 1993 1992 1991 (Thousands of Dollars) State electric generation tax $ 4,056 $ 4,299 $ 3,638 General property taxes 47,624 47,320 44,567 Special state utility license 1,814 1,965 1,595 Federal social security taxes 8,534 8,113 7,463 State gross receipts tax 2,871 3,427 2,734 Other taxes 462 470 942 Total charged to operating expenses $65,361 $65,594 $60,939 13. QUARTERLY FINANCIAL DATA (UNAUDITED): (Thousands of Dollars) First Second Third Fourth Quarter Quarter Quarter Quarter Annual Total operating revenues $279,241 $244,485 $329,673 $265,034 $1,118,433 Operating income 55,274 38,934 79,363 45,748 219,319 Net Income 36,820 21,327 61,032 26,789 145,968 (Thousands of Dollars) First Second Third Fourth Quarter Quarter Quarter Quarter Annual Total operating revenues $263,576 $222,097 $270,937 $237,771 $994,381 Operating income 49,805 33,452 58,149 40,861 182,267 Net Income 30,055 13,528 36,747 21,833 102,163 DESCRIPTION OF PLANS Incentive Compensation To bring total compensation of officers to market levels, the Company has two incentive plans: Annual Performance Incentive Plan SCANA has annual Performance Incentive Plans for officers of SCANA and its subsidiaries. The plans promote SCANA's pay-for-performance philosophy, as well as its goal of having a meaningful amount of executive pay "at-risk." Through these plans, financial incentives are provided in the form of annual cash bonuses that are paid only when corporate, business unit and individual goals are achieved. Short-term incentive awards are targeted below the median of the market. Executives eligible for these plans are assigned threshold, target and maximum bonus levels as a percentage of salary level. Bonuses earned are based on the level of the preestablished goals achieved. Award payouts may increase to a maximum of 1.5 times target, if Company performance exceeds the goals established. Even if this were to occur, payouts would still be below the market median. Award payouts may decrease, generally to a minimum of one-half the target-level awards, if the Company's performance is below targeted goals. Awards earned based on the achievement of preestablished goals may nonetheless be decreased to zero (as was done in 1992), if the Management Development and Corporate Performance Committee (Performance Committee) in its discretion determines that actual results do not warrant the levels of payouts otherwise earned. The various plans in which officers of SCANA and its subsidiaries participate focus generally on short-term goals affecting profitability, efficiency, quality of service, customer satisfaction and progress toward SCANA's strategic objectives for the Company and its other subsidiaries. New performance categories for officers in the various plans are established annually. Specific performance measures, and their weights, also vary from year to year. For 1993, the specific measures in each plan, and their weights, for the officers included in the Summary Compensation Table on page 66 are described below. The relationship of performance to payouts for the officers in each plan also is discussed. For officers of SCANA, 80% of the total award is based on corporate Earnings Per Share ("EPS") goals. The remaining 20% is tied to the achievement of individual performance goals, and is awarded on a discretionary basis. Specific EPS goals are established that correspond to threshold, target and maximum payouts for the EPS portion of awards. For 1993, SCANA's EPS results were sufficient to result in maximum payouts for that portion of the awards. Individual performance for corporate officers also was determined to be sufficient to result in maximum -level payouts for that portion of the awards. Awards for officers of the Company are based on three performance categories: corporate EPS, numerous corporate and Strategic Business Unit (SBU) financial and productivity goals, and additional SBU strategic initiatives (i.e., activities that focus on improvements in existing operating procedures, quality of service and product, human resources matters, etc.). One-third of the total award is based on results in each performance category. Threshold, target and maximum performance levels are established for each category; payouts will vary based on the actual level of performance achieved. For 1993, the overall Company performance in all three categories was such that payouts exceeded target-level awards, but were less than the maximum awards possible. Although results for the first two performance categories were above target performance levels, results in the strategic initiative category were below that level. Long-Term Performance Share Plan SCANA has a long-term Performance Share Plan for officers of SCANA and its subsidiaries. The long-term Performance Share Plan measures SCANA's Total Shareholder Return ("TSR") relative to a group of peer companies (PSP Peer Group) over a three-year period. The PSP Peer Group includes 97 electric and gas utilities, none of which have annual revenues of less than $100 million. Total Shareholder Return is stock price increase over the three-year period, plus cash dividends paid during the period, divided by stock price as of the beginning of the period. Comparing SCANA's TSR to a large group of other utilities reflects SCANA's recognition that investors could have invested their funds in other utility companies. Comparing SCANA's TSR against the TSR of the PSP Peer Group measures how well SCANA did when compared to others operating in similar interest, tax, economic and regulatory environments. Executives eligible to participate in the Performance Share Plan are assigned target award opportunities based primarily on their salary level. In determining award sizes, levels of responsibilities and competitive practices also are considered. Target awards are established at levels slightly below the median of the market and represent a significant portion of executives "at-risk" compensation. But, to provide additional incentive for executives, and to ensure that executives are only rewarded when shareholders gain, actual payouts may exceed the median of the market when performance is outstanding. For lesser performance, awards will be at or below the market median. Payouts occur when SCANA's TSR is in the top two-thirds of the PSP Peer Group, and vary based on SCANA's ranking against the peer group. Executives earn target payouts at the 50th percentile of three-year performance. Maximum payouts will be made at 1.5 times target when SCANA's TSR is at or above the 75th percentile of the peer group. No payouts will be earned if performance is in the bottom one-third of the peer group. Awards are denominated in shares of SCANA Common Stock and may be paid in either stock or cash or a combination of the two. For the three-year period from 1991 through 1993, SCANA's TSR was at the 79th percentile of the PSP Peer Group. This resulted in payouts in February 1994 at the maximum level possible. The combination of the annual Incentive Plan and the Performance Share Plan provides an opportunity to bring a participant's compensation to market levels. The progressive payout formulas in both plans dictate that above-market pay can be earned only for better-than-average corporate financial performance, and that poor performance will result in below- market pay. The following table shows the target awards made in 1993 for potential payment in 1996 under the long-term Performance Share Plan, and estimated future payouts under that plan at threshold, target and maximum levels. Defined Contribution Plans Under the Savings Plan, most of the Company's employees may contribute up to 15% of their eligible earnings. The Company matches each employee's contribution on a dollar-for-dollar basis up to a maximum of 6% of the participant's eligible earnings as limited by the Internal Revenue Code (IRC). Both Company and employee contributions are invested in SCANA's Common Stock. In addition to the Savings Plan, SCANA has a Supplementary Voluntary Deferral Plan (the "Supplementary Plan") for certain highly compensated employees of the Company and other SCANA subsidiaries. The Supplementary Plan is designed to provide employees whose participation in the Savings Plan is limited by the IRC with the ability to contribute and receive matching contributions in the same percentage as employees generally. However, unlike the Savings Plan where actual shares of SCANA Common Stock are acquired, under the Supplementary Plan the deferred amounts and matches are only accounted for as though shares of common stock had been purchased. Defined Benefit Plans In addition to the qualified Retirement Plan for all employees, the Company has Supplemental Executive Retirement Plans ("SERP") for certain eligible employees, including officers. A SERP is an unfunded plan which provides for benefit payments in addition to those payable under a qualified retirement plan. It maintains uniform application of the Retirement Plan benefit formula and would provide, among other benefits, payment of Retirement Plan formula pension benefits, if any, which exceed those payable under the IRC maximum benefit limitations. The following table illustrates the estimated maximum annual benefits payable upon retirement at normal retirement date under the Retirement Plan and the SERPs. Benefits are computed based on a straight-life annuity with an unreduced 60% surviving spouse benefit. The amounts in this table assume continuation of the primary Social Security benefits in effect at January 1, 1994 and are not subject to any deduction for Social Security or other offset amounts. Pension Plan Table Final Service Years Average Pay 15 20 25 30 35 $125,000 35,130 46,840 58,550 70,260 72,595 150,000 42,630 56,840 71,050 85,260 88,220 175,000 50,130 66,840 83,550 100,260 103,845 200,000 57,630 76,840 96,050 115,260 119,470 225,000 65,130 86,840 108,550 130,260 135,095 250,000 72,630 96,840 121,050 145,260 150,720 300,000 87,630 116,840 146,050 175,260 181,970 350,000 102,630 136,840 171,050 205,260 213,220 400,000 117,630 156,840 196,050 235,260 244,470 450,000 132,630 176,840 221,050 265,260 275,720 500,000 147,630 196,840 246,050 295,260 306,970 The compensation shown in Column (c) of the Summary Compensation Table for the individuals named therein is covered by the Retirement Plan and/or a SERP. Messrs. Gressette, Kenyon, Timmerman, Young and Stedman now have credited service under the Retirement Plan (or its equivalent under the SERP) of 31, 20, 15, 31 and 21 years, respectively. The Company also has a Key Employee Retention Program (the "Key Employee Retention Program") covering officers and certain other executive employees that provides supplemental retirement and/or death benefits for participants. Under the program the Company will pay to each participant for 180 months, upon retirement at or after age 65, a monthly retirement benefit equal to 25% of the average monthly salary of the participant over his final 36 months of employment prior to age 65, or an optional death benefit payable to a participant's designated beneficiary monthly for 180 months, in an amount equal to 35% of the average monthly salary of the participant over his final 36 months of employment prior to age 65. In the event of the participant's death prior to age 65, the Company will pay to the participant's designated beneficiary for 180 months, a monthly benefit equal to 50% of such participant's base monthly salary in effect at death. All of the executive officers named in the Summary Compensation Table above are participating in the Key Employee Retention Program. Estimated annual retirement benefits payable at age 65 based on projected eligible compensation (assuming increases of 4% per year) to the five executive officers named in the Summary Compensation Table are as follows: Mr. Gressette - $106,863; Mr. Kenyon - $126,347; Mr. Timmerman - $105,411; Mr. Young - $56,013; and Mr. Stedman - $66,729. Life Insurance Plans The Company offers its officers and certain other highly- compensated employees an option to choose whole life insurance (the "Whole Life Option") in lieu of the term life insurance provided employees generally. Under this plan, the employee becomes the owner of a policy with a death benefit of between $200,000 and $550,000 depending upon the salary grade of the employee. Termination, Severance and Change of Control Arrangements The Company has a Key Executive Severance Benefit Plan (the "Severance Plan") intended to assure the objective judgment of, and to retain the loyalties of, key executives when the Company is faced with a potential change in control or a change in control by providing a continuation of salary and benefits after a participant's employment is terminated by the Company during a potential change in control, after a change in control without just cause, disability, retirement or death or by the participant for good reason after a change in control. All of the executive officers named in the Summary Compensation Table except Mr. Gressette have been designated as participants in the Severance Plan. When a potential change in control occurs, a participant is obligated to remain with the Company for six months unless his employment is terminated for disability or normal retirement or until a change in control occurs. Upon a change in control resulting in an officer's termination, the Severance Plan provides for guaranteed severance payments equal to three times the annual compensation of the officer plus payments under certain of the Company's incentive and retirement plans. The officer also would receive an additional amount (a "gross-up" payment) for any IRC Section 4999 excess tax or any such other similar tax applicable to the severance payments. In addition, for 36 months after termination, the officer would receive coverage for medical benefits and life insurance so as to provide the same level of benefits previously enjoyed under group plans or individual policy contracts or otherwise as determined by the Executive Committee of the Board of Directors. Such benefits however would be reduced to the extent that the participant receives similar benefits during the period from another employer. In addition to the Severance Plan, in the event of a merger, consolidation or acquisition in which SCANA is not the surviving corporation, target awards under the Performance Share Plan will become immediately payable based on SCANA's shareholder return performance as of the end of the most recently completed calendar year for each performance period as to which the grant of target shares has occurred at least six months previously. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION There are no executive officer-director interlocks where an executive officer of the Company serves on the compensation committee of another company that has an executive officer serving on the Company's Board of Directors. Messrs. Hipp, McMaster, Rhodes and Warren are all members of the Long-Term Compensation Committee which administers the Performance Share Plan. Messrs. Hipp and Rhodes also are members of the Performance Committee which generally handles all other executive compensation matters. Mr. Warren was the Chief Executive Officer of the Company from April 23, 1986 until January 31, 1990. Information with respect to transactions with entities with which Messrs. Hipp, McMaster, Rhodes and Warren are connected are described below. Mr. Gressette, Chairman of the Board and Chief Executive Officer of the Company, is an ex-officio (i.e. nonvoting) member of the Performance Committee. The Performance Committee receives his input on compensation matters concerning executive compensation of other officers but the committee deliberates and makes its decisions without his participation. Mr. Rhodes is the Chairman and Chief Executive Officer of Rhodes Oil Company, Inc. Purchases from Rhodes Oil Company, Inc. totaling $62,500 for fuel oil and gasoline were made during 1993 by the Company. It is anticipated that such purchases will continue in the future. Mr. McMaster is the President and Manager of Winnsboro Petroleum Company. Purchases from Winnsboro Petroleum Company totaling $77,549 for fuel oil and gasoline were made during 1993 by the Company. It is anticipated that such purchases will continue in the future. Mr. Hipp, is the President and Chief Executive Officer of The Liberty Corporation. Mr. Hipp and John A. Warren are Directors of The Liberty Corporation. During 1993 certain of the insurance policies purchased by the Company on the lives of employees were written by Liberty Life Insurance Company, a subsidiary of the Liberty Corporation, and it is expected that this relationship will continue in the future. The total amount paid during 1993 by the Company to Liberty Life Insurance Company was $538,905. COMPENSATION OF DIRECTORS Fees All of the Directors of the Company are also Directors of SCANA. During 1993, directors who are not employees of SCANA or its subsidiaries were each paid $14,500 for services rendered, plus $1,500 for each Board meeting attended and $700 for attendance at a committee meeting which is not held on the same day as a regular meeting of the Board. The fee for attendance at a telephone conference meeting is $150. The fee for attendance at a conference is $500. In addition, Directors are paid, as part of their compensation, travel, lodging and incidental expenses related to attendance at meetings and conferences. Directors who are employees of SCANA or its subsidiaries receive no compensation for serving as directors or attending meetings. Deferral Plan The Company has a plan pursuant to which directors may defer all or a portion of their fees for services rendered and meeting attendance. Interest is earned on the deferred amounts at a rate set by the Performance Committee. During 1993 and currently, the rate is set at the announced prime rate of The South Carolina National Bank. During 1993, the only director participating in the plan was Mr. Rhodes. Interest credited to Mr. Rhodes' deferral account during 1993 was $8,526. Endowment Plan Each director participates in the Directors' Endowment Plan, which provides for the Company to make a tax deductible charitable contribution totaling $500,000 to institutions of higher education nominated by the director. A portion is contributed upon retirement of the director and the remainder upon the director's death. The plan is funded in part through insurance on the lives of the directors. Designated in-state institutions of higher education must be approved by the Chief Executive Officer of SCANA and any out-of-state designation must be approved by the Performance Committee. The designated institutions are reviewed on an annual basis by the Chief Executive Officer to assure compliance with the intent of the program. The plan is intended to reinforce SCANA's commitment to quality higher education and is intended to enhance SCANA's ability to attract and retain qualified board members. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All shares of the Company's Common Stock are held, beneficially and of record, by SCANA Corporation. The table set forth below indicates as of March 10, 1994, the shares of SCANA's Common Stock beneficially owned by each continuing director and nominee, each of the executive officers named in the Summary Compensation Table on page 66, and the directors and executive officers of the Company as a group. SECURITY OWNERSHIP OF MANAGEMENT Name of Beneficial Amount and Nature Name of Beneficial Amount and Nature Owner of Ownership (1) Owner of Ownership (1) B. L. Amick 1,243 W. H. Hipp 1,400 W. B. Bookhart, Jr. 6,884 B. D. Kenyon 4,782 W. T. Cassels, Jr. 1,000 F. C. McMaster 10,288 H. M. Chapman 3,127 Henry Ponder 4,806 J. B. Edwards 2,217 J. B. Rhodes 3,434 E. T. Freeman 1,500 W. B. Timmerman 12,889 L. M. Gressette, Jr. 14,649 E. C. Wall, Jr. 7,000 B. A. Hagood 1,140 John A. Warren 50,823 J. H. Young 5,108 R. W. Stedman 6,474 All directors and executive officers as a group (18 persons) TOTAL 138,764 TOTAL PERCENT OF CLASS 0.3% (1) Includes shares owned by close relatives, the beneficial ownership of which is disclaimed by the director or nominee, as follows: Mr. Amick - 240; Mr. Bookhart - 1,913; Mr. Chapman - 127; Mr. Gressette - 530; Mr. Hagood - 159; Mr. McMaster - 6,365; Mr. Warren - 7,160. Includes shares purchased through December 31, 1993, but not thereafter, by the Trustee under the Savings Plan. The information set forth above as to the security ownership has been furnished to the Company by such persons. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information regarding certain relationships and related transactions, see Item 11., "Compensation Committee Interlocks and Insider Participation." PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Financial Statements and Schedules See Index to Consolidated Financial Statements and Supplementary Data on page 28. Exhibits Filed Exhibits required to be filed with this Annual Report on Form 10-K are listed in the Exhibit Index following the signature page. Certain of such exhibits which have heretofore been filed with the Securities and Exchange Commission and which are designated by reference to their exhibit number in prior filings are hereby incorporated herein by reference and made a part hereof. Reports on Form 8-K The Company filed a report on Form 8-K on January 13, 1994 in response to Item 5, "Other Events" regarding the settlement with Westinghouse Electric Corporation of a lawsuit relating to the steam generators provided to the Company's Summer Station. 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. (REGISTRANT) SOUTH CAROLINA ELECTRIC & GAS COMPANY BY (SIGNATURE) s/Bruce D. Kenyon (NAME AND TITLE) Bruce D. Kenyon, President and Chief Operating Officer DATE February 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 the dates indicated. (i) Principal executive officer: BY (SIGNATURE) s/L. M. Gressette, Jr. (NAME AND TITLE) L. M. Gressette, Jr., Chairman of the Board and Chief Executive Officer and Director DATE February 15, 1994 (ii) Principal financial officer: BY (SIGNATURE) s/W. B. Timmerman (NAME AND TITLE) W. B. Timmerman, Chief Financial Officer DATE February 15, 1994 (iii) Principal accounting officer: BY (SIGNATURE) s/J. E. Addison (NAME AND TITLE) J. E. Addison, Controller DATE February 15, 1994 BY (SIGNATURE) s/B. L. Amick (NAME AND TITLE) B. L. Amick, Director DATE February 15, 1994 BY (SIGNATURE) s/W. B. Bookhart, Jr. (NAME AND TITLE) W. B. Bookhart, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/W. T. Cassels, Jr. (NAME AND TITLE) W. T. Cassels, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/H. M. Chapman (NAME AND TITLE) H. M. Chapman, Director DATE February 15, 1994 BY (SIGNATURE) s/J. B. Edwards (NAME AND TITLE) J. B. Edwards, Director DATE February 15, 1994 BY (SIGNATURE) s/E. T. Freeman (NAME AND TITLE) E. T. Freeman, Director DATE February 15, 1994 BY (SIGNATURE) s/B. A. Hagood (NAME AND TITLE) B. A. Hagood, Director DATE February 15, 1994 BY (SIGNATURE) s/W. Hayne Hipp (NAME AND TITLE) W. Hayne Hipp, Director DATE February 15, 1994 BY (SIGNATURE) s/F. C. McMaster (NAME AND TITLE) F. C. McMaster, Director DATE February 15, 1994 BY (SIGNATURE) s/Henry Ponder (NAME AND TITLE) Henry Ponder, Director DATE February 15, 1994 BY (SIGNATURE) s/J. B. Rhodes (NAME AND TITLE) J. B. Rhodes, Director DATE February 15, 1994 BY (SIGNATURE) s/E. C. Wall, Jr. (NAME AND TITLE) E. C. Wall, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/John A. Warren (NAME AND TITLE) John A. Warren, Director DATE February 15, 1994 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All shares of the Company's Common Stock are held, beneficially and of record, by SCANA Corporation. The table set forth below indicates as of March 10, 1994, the shares of SCANA's Common Stock beneficially owned by each continuing director and nominee, each of the executive officers named in the Summary Compensation Table on page 66, and the directors and executive officers of the Company as a group. SECURITY OWNERSHIP OF MANAGEMENT Name of Beneficial Amount and Nature Name of Beneficial Amount and Nature Owner of Ownership (1) Owner of Ownership (1) B. L. Amick 1,243 W. H. Hipp 1,400 W. B. Bookhart, Jr. 6,884 B. D. Kenyon 4,782 W. T. Cassels, Jr. 1,000 F. C. McMaster 10,288 H. M. Chapman 3,127 Henry Ponder 4,806 J. B. Edwards 2,217 J. B. Rhodes 3,434 E. T. Freeman 1,500 W. B. Timmerman 12,889 L. M. Gressette, Jr. 14,649 E. C. Wall, Jr. 7,000 B. A. Hagood 1,140 John A. Warren 50,823 J. H. Young 5,108 R. W. Stedman 6,474 All directors and executive officers as a group (18 persons) TOTAL 138,764 TOTAL PERCENT OF CLASS 0.3% (1) Includes shares owned by close relatives, the beneficial ownership of which is disclaimed by the director or nominee, as follows: Mr. Amick - 240; Mr. Bookhart - 1,913; Mr. Chapman - 127; Mr. Gressette - 530; Mr. Hagood - 159; Mr. McMaster - 6,365; Mr. Warren - 7,160. Includes shares purchased through December 31, 1993, but not thereafter, by the Trustee under the Savings Plan. The information set forth above as to the security ownership has been furnished to the Company by such persons. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information regarding certain relationships and related transactions, see Item 11., "Compensation Committee Interlocks and Insider Participation." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Financial Statements and Schedules See Index to Consolidated Financial Statements and Supplementary Data on page 28. Exhibits Filed Exhibits required to be filed with this Annual Report on Form 10-K are listed in the Exhibit Index following the signature page. Certain of such exhibits which have heretofore been filed with the Securities and Exchange Commission and which are designated by reference to their exhibit number in prior filings are hereby incorporated herein by reference and made a part hereof. Reports on Form 8-K The Company filed a report on Form 8-K on January 13, 1994 in response to Item 5, "Other Events" regarding the settlement with Westinghouse Electric Corporation of a lawsuit relating to the steam generators provided to the Company's Summer Station. 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. (REGISTRANT) SOUTH CAROLINA ELECTRIC & GAS COMPANY BY (SIGNATURE) s/Bruce D. Kenyon (NAME AND TITLE) Bruce D. Kenyon, President and Chief Operating Officer DATE February 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 the dates indicated. (i) Principal executive officer: BY (SIGNATURE) s/L. M. Gressette, Jr. (NAME AND TITLE) L. M. Gressette, Jr., Chairman of the Board and Chief Executive Officer and Director DATE February 15, 1994 (ii) Principal financial officer: BY (SIGNATURE) s/W. B. Timmerman (NAME AND TITLE) W. B. Timmerman, Chief Financial Officer DATE February 15, 1994 (iii) Principal accounting officer: BY (SIGNATURE) s/J. E. Addison (NAME AND TITLE) J. E. Addison, Controller DATE February 15, 1994 BY (SIGNATURE) s/B. L. Amick (NAME AND TITLE) B. L. Amick, Director DATE February 15, 1994 BY (SIGNATURE) s/W. B. Bookhart, Jr. (NAME AND TITLE) W. B. Bookhart, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/W. T. Cassels, Jr. (NAME AND TITLE) W. T. Cassels, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/H. M. Chapman (NAME AND TITLE) H. M. Chapman, Director DATE February 15, 1994 BY (SIGNATURE) s/J. B. Edwards (NAME AND TITLE) J. B. Edwards, Director DATE February 15, 1994 BY (SIGNATURE) s/E. T. Freeman (NAME AND TITLE) E. T. Freeman, Director DATE February 15, 1994 BY (SIGNATURE) s/B. A. Hagood (NAME AND TITLE) B. A. Hagood, Director DATE February 15, 1994 BY (SIGNATURE) s/W. Hayne Hipp (NAME AND TITLE) W. Hayne Hipp, Director DATE February 15, 1994 BY (SIGNATURE) s/F. C. McMaster (NAME AND TITLE) F. C. McMaster, Director DATE February 15, 1994 BY (SIGNATURE) s/Henry Ponder (NAME AND TITLE) Henry Ponder, Director DATE February 15, 1994 BY (SIGNATURE) s/J. B. Rhodes (NAME AND TITLE) J. B. Rhodes, Director DATE February 15, 1994 BY (SIGNATURE) s/E. C. Wall, Jr. (NAME AND TITLE) E. C. Wall, Jr., Director DATE February 15, 1994 BY (SIGNATURE) s/John A. Warren (NAME AND TITLE) John A. Warren, Director DATE February 15, 1994

832427_1993.txt

832427_1993

1993

832427

Item 1. DESCRIPTION OF BUSINESS National Health Laboratories Incorporated (the "Company") was incorporated in Delaware on March 23, 1971 as DCL Health Laboratories Incorporated and adopted its current name on June 3, 1974. The Company's principal executive offices are located at 4225 Executive Square, Suite 800, La Jolla, California 92037, and its telephone number is (619) 550-0600. Until the initial public offering of approximately 5% of the Company's common stock in July 1988, the Company was an indirect wholly owned subsidiary of Revlon Holdings, Inc. ("Revlon"), then known as Revlon, Inc., which, in turn, is an indirect wholly owned subsidiary of Mafco Holdings Inc. ("MAFCO"), a corporation that is 100% owned by Ronald O. Perelman. Following the completion of successive secondary public offerings of the Company's common stock, a self tender offer by the Company and the purchase by the Company of outstanding shares of its common stock, MAFCO's indirect ownership has been reduced to approximately 24%. The Company is one of the leading clinical laboratory companies in the United States. Through a national network of laboratories, the Company offers a broad range of testing services used by the medical profession in the diagnosis, monitoring and treatment of disease. Office-based physicians constitute approximately 90% of the Company's clients. The remainder is comprised primarily of managed care providers, hospitals, clinics, nursing homes and other clinical laboratories. Since its founding, the Company has grown into a network of 17 major laboratories, including a national reference laboratory which performs esoteric testing and tests for the presence of drugs of abuse, 73 sales ports and 662 patient service centers and STAT laboratories, serving customers in 44 states. Recent Developments On March 14, 1994, National Health Laboratories Holdings Inc. ("NHL Holdings"), a newly formed, wholly owned subsidiary of the Company filed a Registration Statement with the Securities and Exchange Commission on Form S-4 under the Securities Act of 1933, as amended, covering the shares of NHL Holdings' common stock to be issued in connection with a proposed corporate reorganization that will create a holding company structure for the Company. Under such proposed corporate reorganization, NHL Holdings, which was specifically formed to effect the reorganization, will become the parent holding company of the Company. All outstanding shares of common stock of the Company will be converted on a share-for-share basis into shares of common stock of NHL Holdings. As a result, the owners of common stock of the Company will become the owners of common stock of NHL Holdings. The Company believes the reorganization will provide a greater ability to take advantage of future growth opportunities and will broaden the alternatives available for future financing. If the proposed corporate reorganization is approved by an affirmative vote of a majority of the outstanding shares of the Company's common stock at the Company's next annual meeting of stockholders, such reorganization is expected to be effected promptly after such approval. The Clinical Laboratory Industry Clinical laboratory tests are used by physicians to diagnose, monitor and treat diseases and other clinical states through the detection of substances in blood or tissue samples and other specimens. Clinical laboratory tests are primarily performed by hospitals in-house, by physicians in their offices or in physician-owned laboratories and by independent laboratory companies like the Company. The Company views the clinical laboratory industry as highly fragmented with many local and regional competitors, including numerous physician and hospital-owned laboratories as well as several large independent laboratory companies. The clinical laboratory industry has experienced rapid consolidation. The Company believes that this consolidation will continue due to pricing pressures, overcapacity, cost burdens on small labs as they strive to meet new regulatory requirements and restrictions on Medicare and Medicaid reimbursement for tests referred by physicians to laboratories in which they have a financial interest. Laboratory Testing Operations and Services The Company has 17 major laboratories, 73 sales ports and 662 patient service centers and STAT laboratories. A "sales port" is a central office which collects specimens in a region for shipment to one of the Company's laboratories for testing. Test results can be printed at a sales port and conveniently delivered to the client. A sales port also is used as a base for sales staff. A "patient service center" is a facility generally maintained by the Company to serve the physicians in a medical professional building. The patient service center collects the specimens as requested by the physician. The specimens are sent, principally through the Company's in-house courier system (and, to a lesser extent, through independent couriers), to one of the Company's major laboratories for testing. Some of the Company's patient service centers have "STAT labs", which are laboratories that have the ability to perform certain routine tests quickly and report results to the physician immediately. The Company processes approximately 116,000 patient specimens on an average day, representing approximately 327,000 separate laboratory tests. Patient specimens are delivered to the Company accompanied by a test request form. These forms are completed by the client, indicating the tests to be performed and providing the necessary billing information. Each specimen and related request form is checked for completeness and then given a unique identification number. The unique identification number assigned to each patient helps to assure that the results are attributed to the correct patient. The test request forms are sent to a data entry terminal where a file is established for each specimen and the necessary testing and billing information entered. Once this information is entered into the system, the tests are performed and the results are entered either manually or through computer interface, depending upon the tests and the type of equipment involved. Most of the Company's computer testing equipment is interfaced with the Company's computer system. Most routine testing is completed by early the next morning, and test results are printed and prepared for distribution by service representatives that day. Some clients have local printer capability and have reports printed out directly in their offices. Clients who request that they be called with a result are so notified in the morning. It is Company procedure to notify the client immediately if at any time in the course of the testing process a life-threatening result is found. The following discussion describes the different types of tests performed by the Company: Routine Clinical Testing. The Company believes that there are approximately 1,300 tests available in the industry today, of which the Company considers approximately 50% routine. The vast majority of the number of tests actually performed by the Company are considered by the Company to be routine. The Company performs all of such routine tests in its own laboratories. A routine test generally is a higher volume, simpler test capable of being performed and reported within 24 hours. The Company performs many routine clinical tests with sophisticated and computerized laboratory testing equipment. These tests provide information used by physicians in determining the existence or absence of disease or abnormalities. The Company performs this core group of routine tests in each of its 17 major regional laboratories for a total of approximately 81,500,000 routine tests annually. Esoteric Clinical Testing. Esoteric tests are specialized laboratory tests performed in cases where information is needed to confirm a diagnosis, or when the physician requires additional information to develop a plan of therapy for a complicated medical case. Esoteric tests are generally more complex tests, requiring more sophisticated technology and more expensive equipment and materials, as well as a higher degree of technical skill to perform. The number of esoteric tests continually increases as new medical discoveries are made. The Company presently considers approximately 650 tests to be esoteric. In March 1989, the Company opened a new, state-of-the-art national reference laboratory in Nashville, Tennessee. This laboratory provides a central location for esoteric testing for all of the Company's major laboratories and their clients. The Company performs approximately 90% of all types of tests considered by the Company to be esoteric at its own facilities, representing approximately 1,950,000 tests annually. With the opening of this facility, the Company has reduced both the types and numbers of esoteric tests that are referred to outside laboratories to be performed. Cytology. Cytology, which involves both routine and esoteric clinical testing, is the examination of cells under a microscope to detect abnormalities in composition, form or structure which are associated with disease. The PAP smear is the most common cytologic test, accounting for approximately 99% of all of the Company's testing in this area. Additional cytology tests are performed on fluid aspirations, bronchial washings and breast fluid smears. The Company performs approximately 3,800,000 PAP smears and other cytologic examinations annually. Anatomical Testing. Routine and esoteric anatomical tests require the examination of a small piece of tissue which either is cut from the body surgically or taken in a biopsy. These tissue specimens are examined by a pathologist both visually and microscopically to detect abnormalities in composition, form or structure which are associated with disease. The Company performs approximately 540,000 anatomical tests annually. Quality Assurance The Company considers the quality of its tests to be of critical importance to its growth and retention of accounts. It has established a comprehensive quality assurance program for all of its laboratories and other facilities designed to help assure accurate and timely test results. All laboratories certified by the Health Care Financing Administration ("HCFA") of the Department of Health and Human Services ("HHS") for participation in the Medicare program and licensed under the Clinical Laboratory Improvement Act of 1967, as amended by the Clinical Laboratory Improvement Amendments of 1988 ("CLIA") must participate in basic quality assurance programs. In addition to the compulsory external inspections and proficiency programs demanded by the regulatory agencies, the Company has adopted a substantial number of additional quality assurance programs. See "-- Governmental and Industry Regulation". Each laboratory is equipped with sophisticated testing equipment which is checked daily in accordance with the Company's preventive maintenance program. In addition, each laboratory is supervised by a medical director who is a physician, assisted by a technical director who meets certain regulatory requirements, and is staffed with medical professionals. The primary role of such professionals is to ensure the accuracy of the Company's tests. The Company employs inspectors with doctorate and masters degrees in biological sciences who visit and inspect each of the laboratories routinely on an unannounced basis. The Company attempts to have such inspections conducted in the same manner as the annual inspections conducted by federal and state government officials. Any deficiencies which appear must be corrected within 30 days. In late 1990, the Company completed a state-of-the-art Technology Center at its headquarters facility in La Jolla, California. The center houses the Company's Quality Assurance Group and enhances its ability to monitor the testing results of the individual laboratories. A computerized network has been established allowing virtual on-line examination of test results and monitoring of the laboratories. The Company also participates in a number of proficiency testing programs which, generally, entail submitting pretested samples to a laboratory to verify the laboratory test results against the known proficiency test value. These proficiency programs are conducted both by the Company on its own and in conjunction with groups such as the College of American Pathologists ("CAP") and state and federal government regulatory agencies. The CAP is an independent non-governmental organization of board certified pathologists which offers an accreditation program to which laboratories can voluntarily subscribe. The CAP accreditation program involves both on-site inspections of the laboratory and participation in the CAP's proficiency testing program for all categories in which the laboratory is accredited by the CAP. A laboratory's receipt of accreditation by the CAP satisfies the Medicare requirement for participation in proficiency testing programs administered by an external source. See "--Governmental and Industry Regulation". Sales, Marketing and Client Service The Company's business strategy also emphasizes sales, marketing and client service which the Company believes have been important factors in its growth. The Company's sales force was slightly reshaped during 1993 to reflect changes in the current marketplace. A new, totally dedicated sales force of 20 people was assembled to better address managed care, an emerging and increasingly important segment of the clinical laboratory customer base. At the beginning of 1993, the Company had contracts with over 300 managed care organizations and insurance companies. During the year, the managed care sales group arranged new contracts with more than 120 additional managed care providers across the country. The Company's hospital sales force was also expanded during 1993. New contracts were signed with over 100 group purchasing or individual hospital organizations which are expected to generate annualized revenues in excess of seven million dollars. The Company continued its support of the sales force's efforts with a variety of marketing and informational brochures. Patient information booklets on commonly ordered chemistry tests and the PAP test were published in both English and Spanish and given to clients for distribution to their patients. A new end stage renal dialysis marketing program was introduced; components included a marketing brochure and a sophisticated data processing program for use in dialysis centers. To support the efforts of the newly formed managed care sales force, the Company developed a unique, proprietary utilization review program geared specifically toward today's managed care client's needs. A managed care capabilities brochure was also prepared to introduce Company sales people to potential new managed care customers. The Company considers it's quality assurance program to be a leader in the industry. To convey this to new and existing clients, a quality assurance brochure was produced to give a detailed explanation of the Company's 19 clinical laboratory and 18 cytology quality assurance programs. Lastly, the Company started a quarterly newsletter called "Horizon" which is directed at the hospital marketplace. After an account is acquired, primary responsibility for the account is turned over to the Company's Client Service Program and its client service coordinators. This group expanded by approximately 20% during 1993, increasing to over 200 individuals. Through these coordinators, the Company continuously monitors and assesses service levels, maintains client relationships and attempts to identify and respond to client needs. Potential New Markets Both the hospital reference and managed care markets present tremendous opportunities for future growth. The impact of health care reform and the current industry consolidation will create many unique situations in both these market segments. The Company plans to continue to expand both sales forces that service these two groups. In addition, the Company intends to target certain niche markets for increased sales penetration during 1994: Clinical Trials, End Stage Renal Dialysis and Nursing Homes. Lastly, several of the acquisitions completed during 1993 opened new geographic markets for the Company's primary target market, office-based physicians. Sales for the Company's national reference laboratory for esoteric testing ("NRL I") increased in 1993 to approximately $65 million from approximately $60 million in 1992. The facility is located in Nashville, Tennessee, and services both the hospital reference and physician office market. Sales of the Company's national reference laboratory for testing for the presence of drugs of abuse ("NRL II") also grew from approximately $3 million in 1992 to approximately $4.3 million in 1993. The Company believes that both these organizations will exhibit continued growth in 1994 and in future years. Information Systems The Company believes the requirement for timely, clearly presented data is paramount to health care organizations' success in the 1990s. A dedicated managed care data system and an enhanced physician office system with field support were two of the many new programs developed by the information systems group in 1993. Plans for 1994 include completion of laboratory hardware/software standardization, final computerization and installation of a cytology and histology data system and developmental work on a new advanced large laboratory system. A new, enhanced billing system to handle the needs of various third party carriers and managed care clients will be installed in all the regional laboratories during the first half of 1994. Additionally, the Company will begin testing and installation of its next generation comprehensive billing system. Further, to improve customer service, a number of the laboratory telephone systems will be replaced or upgraded during 1994. Infectious Waste Certain federal and state laws govern the handling and disposal of infectious and hazardous wastes. Although the Company believes that it is currently in compliance in all material respects with such federal and state laws, failure to comply could subject the Company to fines, criminal penalties and/or other enforcement actions. Customers To date, the Company has focused its marketing efforts primarily on office-based physicians, whose orders account for approximately 90% of its net sales. The remaining 10% of net sales is derived from managed care providers, hospital reference testing, nursing homes, clinics, referrals from other clinical laboratories and other clients. The largest client of the Company accounts for approximately 1.2% of net sales. The Company believes that the loss of any one client would not have a material adverse effect on its financial condition. Payment for the Company's services is made by the patients directly, physicians who in turn bill their patients, or third party payors, including public and private parties such as Medicare, Medicaid and Blue Shield. Employees At December 31, 1993, the Company employed approximately 10,650 people. These include approximately 7,700 full-time employees and approximately 2,950 part-time employees, which represents the equivalent of approximately 8,360 persons full- time. Of the approximately 8,360 full-time equivalent employees, approximately 350 are sales personnel, approximately 7,140 are laboratory and distribution personnel and approximately 870 are administrative and data processing personnel. The Company has no collective bargaining agreements with any unions and believes that its overall relations with its employees are excellent. Governmental and Industry Regulation The clinical laboratory industry is subject to government regulation at the federal, state and local levels. The Company's major laboratories are certified under the federal Medicare program, state Medicaid programs and CLIA. Where applicable, licensure is maintained under the laws of state or local governments that have clinical laboratory regulation programs. In addition, in facilities where radioimmunoassay testing is performed, the facilities are licensed by the federal Nuclear Regulatory Commission and, where applicable, by state nuclear regulatory agencies. Sixteen of the Company's 17 major laboratories are accredited by the CAP. The Chicago regional laboratory, opened January 1, 1994, is currently applying for CAP accreditation. In addition, the Company's STAT laboratories are also certified or licensed, as necessary, under federal, state or local programs. The federal and state certification and licensure programs establish standards for the day-to-day operation of a medical laboratory, including, but not limited to, personnel and quality control. Compliance with such standards is verified by periodic inspections by inspectors employed by the appropriate federal or state regulatory agency. In addition, regulatory authorities require participation in a proficiency testing program provided by an external source which involves actual testing of specimens that have been specifically prepared by the regulatory authority for testing by the laboratory. In 1993, 1992 and 1991, approximately 41%, 42% and 42%, respectively, of the Company's revenues were derived from tests performed for beneficiaries of Medicare and Medicaid programs. Furthermore, the conduct of the Company's other business depends substantially on continued participation in these programs. Under law and regulation, for most of the tests performed for Medicare or Medicaid beneficiaries, the Company must accept reimbursement from Medicare or Medicaid as payment in full. In 1984, Congress adopted legislation establishing a fee schedule reimbursement methodology for testing for out-patients under Medicare. The 1984 legislation reduced the laboratory reimbursement rate by 40%. In 1986, Congress changed the fee schedule reimbursement mechanism by creating national limitation amounts which are the medians of the fee schedule rates for tests subject to the fee schedules. Initially, laboratories were paid 115% of the national limitation amounts. Since 1986, Congress has gradually reduced the percentage of the national limitation amounts that Medicare will pay to 84%. The latest reduction in the national limitation payment amounts (from 88% to 84% effective January 1, 1994) was made as part of the Omnibus Budget Reconciliation Act of 1993 ("OBRA '93") that was enacted into law during 1993. OBRA '93 contains provisions for a further reduction in payments to 80% of the national limitation amounts effective January 1, 1995, followed by an additional reduction to 76% on January 1, 1996. OBRA '93 also eliminated, for 1994 and 1995, the provision for annual fee schedule increases based upon the consumer price index. In addition, state Medicaid programs are prohibited from paying more than the Medicare fee schedule amount for testing for Medicaid beneficiaries. Additional future changes in federal, state or local regulations (or in the interpretation of current regulations) affecting governmental reimbursement for clinical laboratory testing or the methods for choosing laboratories eligible to perform tests could have a material adverse effect on the Company. On January 1, 1993, numerous changes in the Physicians' Current Procedural Terminology ("CPT") were published. The CPT is a coding system that is published by the American Medical Association. It lists descriptive terms and identifying codes for reporting medical and medically related services. The Medicare and Medicaid programs require suppliers, including laboratories, to use the CPT codes when they bill the programs for services performed. HCFA implemented these CPT changes for Medicare and Medicaid on August 1, 1993. The CPT changes have altered the way the Company bills Medicare and Medicaid for some of its services, thereby reducing the reimbursement the Company receives from those programs for some of its services. For example, certain codes for calculations, such as LDL cholesterol were deleted and are no longer a payable service under Medicare and Medicaid. In March 1992, HCFA published proposed regulations to implement the Medicare statute's prohibition (with certain exceptions) against compensation arrangements between physicians and laboratories. The proposed regulations would define remuneration that gives rise to a compensation arrangement as including discounts. If that definition of remuneration were to become effective, it could have an impact on the way the Company prices its services to physicians. However, in August 1993, the referenced Medicare statute was amended by OBRA '93. One of these amendments makes it clear that day-to-day transactions between laboratories and their customers, including but not limited to discounts granted by laboratories to their customers, are not affected by the compensation arrangement provisions of the Medicare statute. Thus, the Company expects the definition of remuneration in HCFA's proposed regulations will be changed to reflect this amendment to the Medicare statute. Currently, these proposed regulations have not been finalized. The Clinton Administration has announced its desire and intention to reform health care in the United States. Some of the proposals that have been discussed include managed competition, global budgeting, price controls and freezes on health care costs. Health care reform could have a material effect on the Company. The Company is unable to predict, however, whether and what type of health care reform legislation will be enacted into law. In November 1990, the Company became aware of a grand jury inquiry relating to its pricing practices being conducted by the United States Attorney for the San Diego area (the Southern District of California) with the assistance of the Office of Inspector General ("OIG") of HHS. On December 18, 1992, the Company announced that it had entered into agreements that concluded the investigation (the "Government Settlement"). The settlement revolved around the government's contention that the Company improperly included its tests for HDL cholesterol and serum ferritin (a measure of iron in the blood) in its basic Health Survey Profile, without clearly offering an alternative profile that did not include these medical tests. The government also contended that, in certain instances, physicians were told that these additional tests would be included in the Health Survey Profile at no extra charge. As a result, the government contended, the Company's marketing activities denied physicians the ability to exercise their judgment as to the medical necessity of these tests. Pursuant to the Government Settlement, the Company pleaded guilty to the charge of presenting two false claims to the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS") and paid a $1 million fine. In connection with pending and threatened civil claims, the Company also agreed to pay $100 million to the federal government, of which $73 million has been paid and $27 million will be paid in quarterly installments through September 30, 1995. Concurrently, the Company settled related Medicaid claims with states that account for over 99.5% of its Medicaid business, and has paid $10.4 million to the settling states. As a result of these settlements, the Company took a one- time pre-tax charge of $136.0 million in the fourth quarter of 1992, which reduced net earnings for the quarter and year ended December 31, 1992 by $80.3 million. Earnings per share for the fourth quarter and year were each reduced by $0.85. The charge covers all estimated costs related to the investigation and the settlement agreements. The Company will continue to receive reimbursements from all government third party reimbursement programs, including Medicare, Medicaid and CHAMPUS, under the settlement agreements. (The Company made changes to requisition forms, pricing and compendia of tests following the settlement. See "Managements' Discussion and Analysis of Financial Condition and Results of Operations".) In September 1993, the Company was served with a subpoena issued by the OIG, which required the Company to provide documents to the OIG concerning its regulatory compliance procedures. The Company has provided documents to the OIG in response to the subpoena. Compliance Program Because of evolving interpretations of regulations and the national debate over health care, compliance with all Medicare, Medicaid and other government-established rules and regulations has become a significant factor throughout the clinical laboratory industry. The Company began the implementation of a new compliance program in late 1992 and early 1993. The objective of the program is to develop aggressive and reliable compliance safeguards. Emphasis is placed on developing training programs for personnel to attempt to assure the strict implementation of all rules and regulations. Further, in-depth reviews of procedures, personnel and facilities are conducted to assure regulatory compliance throughout the Company. Such sharpened focus on regulatory standards and procedures will continue to be an absolute priority for the Company in the future. Competition The clinical laboratory testing business is characterized by intense competition. The Company believes that there are many clinical laboratory companies which provide a broad range of laboratory testing services in the same markets serviced by the Company. Among the Company's national competitors are Allied Clinical Laboratories, Inc., MetPath Inc., Nichols Institute, Roche Biomedical Laboratories, Inc. and SmithKline Beecham Clinical Laboratories, Inc. According to HCFA, there are over 157,000 federally regulated clinical laboratories, of which approximately 6,400 are independent laboratories. The number of regulated clinical laboratories has increased dramatically as a result of the enactment of the Clinical Laboratories Improvement Amendments of 1988 which expanded the definition of laboratories subject to federal regulation. Competition is based primarily on quality, price and the time required to report results. In addition to competition for customers, there is increasing competition for qualified personnel. Item 2. Item 2. PROPERTIES The principal properties of the Company are its leased corporate headquarters located in La Jolla, California and the following major laboratory facilities: Approximate Area Nature of Location (in square feet) Occupancy ------------------- -------------- ----------------------- Phoenix, Arizona 43,024 Lease Expires 2001; 5 year renewal option San Diego, California 37,079 Lease Expires 2000 Denver, Colorado 19,982 Lease Expires 2001; two 5 year renewal options Hollywood, Florida 46,500 Lease Expires 2002; three 5 year renewal options Tampa, Florida 26,600 Lease Expires 2002; one 5 year renewal option Chicago, Illinois 40,065 Lease Expires 2003; two 5 year renewal options Louisville, Kentucky 60,000 Lease Expires 2002; three 5 year renewal options Detroit, Michigan 12,800 Lease Expires 1994 Cranford, New Jersey 36,438 Lease Expires 1995; 5 year renewal option Uniondale, New York 108,000 Lease expires 2007; two 5 year renewal options Winston-Salem, North Carolina 42,500 Lease Expires 2004; one 5 year renewal option NRL I-Nashville, Tennessee 46,313 Lease Expires 2000; two 5 year renewal options NRL II-Nashville, Tennessee 25,640 Lease Expires 2000; two 5 year renewal options Dallas, Texas 27,968 Lease Expires 1994 Houston, Texas 32,368 Lease Expires 1996 San Antonio, Texas 20,660 Lease Expires 1997; two 5 year renewal options Herndon, Virginia 64,172 Lease Expires 2004; 5 year renewal option Seattle, Washington 34,900 Lease Expires 2000; two 5 year renewal options Construction of a new major laboratory facility in Chicago, Illinois was completed in December 1993. The laboratory opened January 1, 1994. Construction of two new laboratories to replace the Company's Detroit, Michigan and Cranford, New Jersey facilities will begin in the first quarter of 1994 and be completed in the third and fourth quarters of 1994, respectively. All of the major laboratory facilities have been built or improved for the single purpose of providing clinical laboratory testing services. The Company believes that these facilities are suitable and adequate and have sufficient production capacity for its currently foreseeable level of operations. The Company believes that if it were to lose the lease on any of the facilities it presently leases, it could find alternate space at competitive market rates and readily relocate its operations to such new locations without material disruption to its operations. Item 3. Item 3. LEGAL PROCEEDINGS The Company is involved in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, based upon the advice of counsel, the ultimate disposition of these matters will not have a material adverse effect on the financial position of the Company. In December 1992, several class actions were filed against the Company and certain of its officers and directors alleging that certain public disclosures made by the Company since February 1990 were false and misleading in that they failed to disclose that a portion of the Company's income was derived from allegedly fraudulent claims and that such non-disclosures rendered the Company's financial statements misleading. These various class actions are pending in the United States District Court for the Southern District of California. The Company believes that the allegations of the complaint that claim wrong doing on behalf of the Company and its officers and directors cannot be supported by the facts or the law and that the Company's disclosures complied with all legal obligations. The Company is defending these lawsuits vigorously. In addition, certain lawsuits have been brought by purported shareholders of the Company, allegedly on the Company's behalf against the Company's directors and certain of its officers, in the Superior Court for the County of San Diego, California. These various claims allege that the Company was damaged by actions of the defendant officers and directors in connection with supervision and control of the practices that led to the guilty plea and civil settlement associated with the Government Settlement. These actions seek no damages against the Company. In November 1993, a class action was filed against the Company and certain of its officers and directors alleging that certain public disclosures made by the Company since December 1992 were false and misleading in that they stated that the Company had taken steps to insure that the Company's sales and marketing practices are compatible with the government's interpretation of current regulations and that they failed to disclose that a portion of the Company's income was derived from allegedly fraudulent claims and that such non-disclosures rendered the Company's financial statements misleading. This class action is pending in the United States District Court for the Southern District of California. The Company believes that the allegations of the complaint that claim wrongdoing on behalf of the Company and its officers and directors cannot be supported by the facts or the law and that the Company's disclosures complied with all legal obligations. On January 5, 1994, a stipulation was entered into whereby the parties have agreed to stay all further activity in this action pending the conclusion of the class actions filed in December 1992. On January 13, 1994, the individual who had commenced a previously reported, purported antitrust class action against the Company in federal district court alleging that he had been billed for unordered tests voluntarily dismissed his action. 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 the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G(3) of Form 10-K, the following is included as an unnumbered Item in Part I of this report in lieu of being included in the definitive proxy statement for the 1994 annual meeting of stockholders. The following table sets forth as of February 23, 1994 the executive officers of the Company. Name Position -------------------------- ---------------------------------- Ronald O. Perelman Chairman of the Board and Director James R. Maher President, Chief Executive Officer and Director David C. Flaugh Senior Executive Vice President and Chief Operating Officer Timothy J. Brodnik Executive Vice President Michael L. Jeub Executive Vice President, Chief Financial Officer and Treasurer Larry L. Leonard, Ph.D. Executive Vice President John F. Markus Executive Vice President and Corporate Compliance Officer James G. Richmond Executive Vice President and General Counsel W. David Slaunwhite, Ph.D. Executive Vice President Bernard E. Statland, M.D., Ph.D Executive Vice President and Chief Executive Officer of National Reference Laboratory Robert E. Whalen Executive Vice President RONALD O. PERELMAN (51) has been Chairman of the Board and Director of the Company since 1988. Mr Perelman has been Chairman of the Board and Chief Executive Officer of MacAndrews & Forbes Holdings Inc. ("M&F Holdings") and MAFCO, for more than the past five years. Mr. Perelman also is Chairman of the Board of Andrews Group Incorporated ("Andrews Group"), Consolidated Cigar Corporation ("Consolidated Cigar"), New World Communications Group, Inc. ("New World Communications"), Mafco Worldwide Corporation ("Mafco Worldwide"), Marvel Entertainment Group, Inc. ("Marvel"), Revlon Consumer Products Corporation ("Revlon Products") and SCI Television, Inc. Mr. Perelman is a director of the following corporations which file reports pursuant to the Securities Exchange Act of 1934: Andrews Group, The Coleman Company, Inc. ("Coleman"), Coleman Holdings Inc., Coleman Worldwide Corporation, Consolidated Cigar, Mafco Worldwide, Marvel, Marvel Holdings Inc. ("Marvel Holdings"), Marvel (Parent) Holdings Inc. ("Marvel Parent"), Marvel III Holdings Inc. ("Marvel III"), Revlon Products, Revlon Worldwide Corporation and SCI Television, Inc. JAMES R. MAHER (44) has been President, Chief Executive Officer and a Director of the Company since December 1992. Mr. Maher was Vice Chairman of The First Boston Corporation from 1990 to 1992 and Managing Director of The First Boston Corporation since 1982. Mr. Maher also is a director of First Brands Corporation. DAVID C. FLAUGH (46) joined the Company in 1970. In 1992 Mr. Flaugh was appointed Chief Operating Officer and Senior Executive Vice President. He was appointed Chief Financial Officer and Treasurer in 1982 and 1988, respectively. From 1991 to 1992, Mr. Flaugh was Vice President-Managing Director. TIMOTHY J. BRODNIK (46) joined the Company in 1971. He was appointed Executive Vice President of the Company in 1993 and was Senior Vice President from 1991 to 1993 and Vice President- Division Manager commencing 1979. Mr. Brodnik oversees the Company's sales operations. MICHAEL L. JEUB (51) joined the Company in 1993 as Executive Vice President, Chief Financial Officer and Treasurer. Previously, Mr. Jeub was President, Chief Operating Officer and Chief Financial Officer of Medical Imaging Centers of America from 1991 to 1993. From 1988 to 1991, Mr. Jeub was a private investor. Prior to 1988, Mr. Jeub held several positions with International Clinical Laboratories, Inc., including Chief Financial Officer and Eastern Division President. LARRY L. LEONARD (52), who holds a Ph.D. degree in microbiology, joined the Company in 1978. He was appointed Executive Vice President of the Company in 1993 and was Senior Vice President from 1991 to 1993 and Vice President-Division Manager commencing 1979. Dr. Leonard oversees major regional laboratories in Arizona, Florida, North Carolina, Texas and Virginia. JOHN F. MARKUS (42) joined the Company in 1990. He was appointed Executive Vice President and Corporate Compliance Officer in 1993 and was Vice President-Managing Director from 1990 to 1993. Previously, Mr. Markus was an attorney in the law firm of Akin, Gump, Strauss, Hauer and Feld in Washington D.C. for more than five years and was a partner in such firm since 1989. JAMES G. RICHMOND (50) joined the Company in 1992 as Executive Vice President and General Counsel. Previously, Mr. Richmond was Managing Partner of the law firm of Coffield, Ungaretti & Harris in Chicago from 1991 to 1992. Prior thereto, he was Special Counsel to the Deputy Attorney General of the United States from 1990 to 1991 and from 1985 to 1991 was United States Attorney for the Northern District of Indiana. W. DAVID SLAUNWHITE, PH.D. (48) joined the Company in 1981. He was appointed Executive Vice President in 1993, was Vice President - Managing Director from 1991 to 1993 and Vice President - Division Manager from 1989 to 1991. Prior to that he held positions of increasing importance with the Company. Dr. Slaunwhite has operational responsibilities for major regional laboratories in California, Colorado, Illinois, Kentucky, Michigan, New Jersey, New York and Washington. BERNARD E. STATLAND, M.D., PH.D. (52) joined the Company in 1990. He was appointed Executive Vice President in 1993 and was Vice President - Managing Director and Chief Executive Officer of the national reference laboratory from 1990 to 1993. Dr. Statland was named a Scientific Advisor on the Company's Board of Consultants in 1989. Prior to joining the Company, he was Director of Pathology and Laboratory Medicine at Methodist Hospital of Indiana for four years and previously held a similar position at Boston University Hospital. ROBERT E. WHALEN (51) joined the Company in 1976. He was named Executive Vice President of the Company in 1993 and was Senior Vice President from 1991 to 1993 and Vice President - Administration commencing 1985. From 1979 to 1985, he was Vice President - Division Manager of the Company. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS On April 24, 1991, the common stock commenced trading on the New York Stock Exchange ("NYSE") under the symbol "NH". Prior to such time, the common stock was quoted on the National Market System of the National Association of Securities Dealers, Inc. Automated Quotation System ("NASDAQ") under the symbol "NHLI". The following table sets forth for the calendar periods indicated the high and low sales prices for the common stock reported on the NYSE Composite Tape, and the cash dividends declared per share of common stock. Dividends Declared High Low Per Share --------------------------------------------------------------- First Quarter 29 1/4 24 1/4 0.07 Second Quarter 25 1/2 18 7/8 0.08 Third Quarter 24 3/8 18 0.08 Fourth Quarter 25 1/8 15 5/8 0.08 First Quarter 18 1/4 12 7/8 0.08 Second Quarter 19 1/2 16 1/8 0.08 Third Quarter 18 1/2 14 1/2 0.08 Fourth Quarter 16 3/8 12 0.08 First Quarter (through February 11, 1994) 15 1/4 13 1/4 On February 16, 1994, there were approximately 625 holders of record of the common stock. The Company has a policy pursuant to which dividends equal to approximately 30% of net earnings are paid quarterly. The declaration and payment of dividends is at the discretion of the Board of Directors of the Company and the amount thereof will be dependent upon the Company's results of operations, financial condition, cash requirements for its business, future prospects and other factors deemed relevant by the Board of Directors. In addition, the Company's five year revolving credit facility entered into in August 1993 (the "Revolving Credit Facility") contains, among other provisions, a covenant prohibiting the declaration or payment of cash dividends to stockholders if, after giving effect to such action, a default (as defined by the terms of the Revolving Credit Facility) shall occur and be continuing. Item 6. Item 6. SELECTED FINANCIAL DATA The selected financial data presented hereinafter as of and for each of the years in the five year period ended December 31, 1993, are derived from consolidated financial statements of the Company, which financial statements have been audited by KPMG Peat Marwick, independent certified public accountants. This data should be read in conjunction with the accompanying notes, the Company's financial statements and the related notes thereto, and "Management's Discussion and Analysis of Financial Condition and Results of Operations", all included elsewhere herein. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company derives approximately 41% of its net sales from tests performed for beneficiaries of Medicare and Medicaid programs. Several changes have been made which impact the reimbursement the Company receives from such programs. On January 1, 1993, numerous changes in the Physicians' Current Procedural Terminology were published which became effective on August 1, 1993. These changes impact the reimbursement the Company receives on some of its services that are billed to the Medicare and Medicaid programs. For example, certain codes for calculations, such as LDL cholesterol were deleted and are no longer a payable service under Medicare and Medicaid. Had such changes been implemented as of January 1, 1993, the Company estimates that 1993 net sales would have been reduced by approximately $7 million. During 1993, provisions were included in OBRA '93 which reduced Medicare reimbursement schedules by lowering payments under the fee schedule methodology from 88% to 84% of the national limitation amounts, effective January 1, 1994. The Company estimates that this change would have decreased 1993 net sales by approximately $10 million had it been implemented as of January 1, 1993. A further reduction in payments to 80% of the national limitation amounts will become effective on January 1, 1995, followed by an additional reduction to 76% on January 1, 1996. OBRA '93 also eliminated, for 1994 and 1995, the provision for annual fee schedule increases based upon the consumer price index. In the latter part of 1993, the Company held discussions with HCFA concerning the reimbursement policy for serum ferritin and HDL cholesterol tests. HCFA expressed concerns that the incidence of orders of these tests by physicians remained too high despite changes in the Company's requisition forms, pricing and compendia of tests instituted after the Company's 1992 settlement. As a result of a HCFA directive to Medicare carriers, the Company began to receive denials of claims submitted in September 1993 for serum ferritin and HDL cholesterol tests ordered by physicians and performed in conjunction with automated chemistry panels. Such denials and related suspended billings reduced the Company's 1993 net sales by approximately $18.6 million. The Company continues to discuss the status of these claims with HCFA. The Company has undertaken actions with regard to HCFA's concerns. The Company has removed the HDL cholesterol and serum ferritin tests from all standard chemistry profiles offered on its test requisition form. These tests may be ordered separately or as part of a custom designed profile where specific authorization is provided by the requesting physician. The Company estimates that the annualized effect of these changes would have been a reduction in net sales of approximately $60 million. A portion of such impact aggregating approximately $18.6 million, as discussed above, was reflected in the Company's 1993 net sales. In March 1992, HCFA published proposed regulations to implement the Medicare statute's prohibition (with certain exceptions) against compensation arrangements between physicians and laboratories. The proposed regulations would define remuneration that gives rise to a compensation arrangement as including discounts. If that definition of remuneration were to become effective, it could have an impact on the way the Company prices its services to physicians. However, in August 1993, the referenced Medicare statute was amended by OBRA '93. One of these amendments makes it clear that day-to-day transactions between laboratories and their customers, including, but not limited to discounts granted by laboratories to their customers, are not affected by the compensation arrangement provisions of the Medicare statute. Thus, the Company expects the definition of remuneration in HCFA's proposed regulations will be changed to reflect this amendment to the Medicare statute. Currently, these proposed regulations have not been finalized. The Clinton Administration has announced its intention and desire to reform health care in the United States. Some of the proposals that have been discussed include managed competition, global budgeting, price controls and freezes on health care costs. Health care reform as well as additional future changes in federal, state or local regulations (or in the interpretation of current regulations) affecting governmental reimbursement for clinical laboratory testing could have a material adverse effect on the Company. The Company is unable to predict, however, whether and what type of legislation will be enacted into law. Due to the effect of numerous changes which are reshaping the clinical laboratory market, including aggressive pricing by many competitors, reduced rates of government reimbursement, pricing pressures generated by managed care providers and the demand for increased service levels, coupled with the decline in utilization of ferritin and HDL tests, the Company expects that its margins will be significantly lower in 1994 than in 1993. Year Ended December 31, 1993 compared with Year Ended December ---------------------------------------------------------------- 31, 1992 -------- Net sales increased by $39.1 million to $760.5 million in 1993, an increase of 5.4% over 1992. Revenues generated by new accounts increased net sales by approximately 12.0%. The acquisition of thirty-four small clinical laboratory companies increased the growth in net sales by approximately 3.5%. In addition, net sales for 1993 increased approximately 2.7% because of the Company's annual price increases (effective in January of 1993). Changes in Medicare's reimbursement policy for LDL tests, coupled with changes in various state Medicaid fee schedules and reimbursement methodologies partially offset the increase in net sales by approximately 1.0%. Medicare's denial of claims for ferritin and HDL tests, which began in September 1993 and continued through December 20, 1993 when the Company introduced new test forms and procedures, and related suspended billings also offset the increase in net sales by approximately 2.6%. Additionally, a decline in the utilization of laboratory services, and, to a lesser extent, severe weather in the first three months of the year further offset the increase in net sales by approximately 7.3%. The Company believes that the decline in utilization was due to fewer patient visits to physicians' offices since the number of tests ordered per patient remained relatively constant. Improved accuracy in estimating the difference between amounts billed and amounts received for services provided under third party payor programs, primarily due to the wider use of specific fee schedules for individual third party carriers, resulted in an increase in the growth in net sales of 1.6%. The aggregate of various other impacts, including discounts granted to meet competitive pressure and movement between payor mix categories, reduced the growth in net sales by approximately 3.5%. Revenues derived from tests performed for beneficiaries of Medicare and Medicaid programs were approximately 41% and 42% of net sales in 1993 and 1992, respectively. The Company actively pursued acquisitions of small clinical laboratory companies during 1993. The laboratory industry is consolidating rapidly as smaller, less efficient organizations are experiencing decreasing profitability in the current health care environment. The purchase of thirty-four small laboratories, primarily in the second half of 1993, increased net sales for the year by approximately $25 million. Had all such acquisitions occurred as of the beginning of 1993, the aggregate contribution to net sales would have been approximately $80.6 million. The Company intends to continue its acquisition program. Cost of sales primarily includes laboratory and distribution costs, a substantial portion of which varies directly with sales. Cost of sales increased to $444.5 million in 1993 from $395.1 million in 1992. As a percentage of net sales, cost of sales increased to 58.4% in 1993 from 54.8% in 1992. Labor costs increased approximately 2.7% of net sales, primarily as a result of an increase in phlebotomy staffing to improve client service and meet competitive demands. Rental of premises also grew approximately 0.3% of net sales due to expanding the number of patient service centers by 50% during 1993. Higher capital spending led to increased depreciation expenses of approximately 0.3% of net sales. Also, several expense categories increased slightly, aggregating approximately 0.3% of net sales. The Company continues to focus on cost savings as part of an ongoing program to improve its cost structure. Internal operating reviews were completed in 15 of the Company's 16 laboratories which were in operation during 1993. In 1994, operating reviews will once again be conducted in all laboratories. The Company believes that the relationship of its expense base to net sales is affected by volume growth, cost control efforts and changing emphasis in various functional areas; therefore, a decrease or increase in any cost as a percentage of net sales in a particular period is not necessarily indicative of a trend. Selling, general and administrative expenses increased to $121.4 million in 1993 from $117.9 million in 1992, an increase of $3.5 million. As a percentage of net sales, selling, general and administrative expenses decreased slightly to 16.0% in 1993 compared with 16.3% in 1992. This was primarily due to a reduction in the provision for doubtful accounts, reflecting improvements in the collection of delinquent accounts, and also a result of reduced spending for the relocation of Company employees and for legal services. These changes more than offset an increase in labor costs related to staffing added during 1993 to improve billing customer service and expand the Company's information systems group. The increase in amortization of intangibles and other assets to $9.1 million in 1993 from $8.3 million in 1992 primarily resulted from the acquisition of several small clinical laboratory companies during 1993. Other gains and expenses include expense reimbursement and termination fees of $21.6 million received in connection with the Company's attempt to purchase Damon Corporation, less related expenses and the write-off of certain bank financing costs aggregating $6.3 million, resulting in a one-time pre-tax gain of $15.3 million. Investment income decreased to $1.2 million in 1993 from $2.2 million in 1992 and interest expense increased to $10.9 million in 1993 from $4.2 million in 1992. During 1993, cash in excess of operating requirements and increased borrowings were used to finance acquisitions of numerous small clinical laboratory companies and to finance purchases by the Company of its common stock. The provision for income taxes as a percentage of earnings before income taxes increased to 41.0% in 1993 from 34.6% in 1992, primarily due to the increase in the U.S. corporate tax rates and a result of a higher effective rate for state income taxes. Year Ended December 31, 1992 compared with Year Ended December -------------------------------------------------------------- 31, 1991 -------- Net sales increased by $117.5 million to $721.4 million in 1992, an increase of 19.5% over 1991. Approximately 15.3% of the increase was due to revenues generated by new accounts. In addition, net sales for 1992 increased approximately 4.2% because of the Company's annual price increases (effective in January of 1992). A net increase in Medicare fee schedules contributed approximately 0.6% to the increase in net sales, whereas changes in various state Medicaid fee schedules and reimbursement methodologies reduced the growth in net sales by approximately 0.6%. Revenues derived from tests performed for beneficiaries of Medicare and Medicaid programs were approximately 42% of net sales in both 1992 and 1991. Cost of sales primarily includes laboratory and distribution costs, a substantial portion of which varies directly with sales. Cost of sales increased to $395.1 million in 1992 from $332.5 million in 1991, although as a percentage of net sales, cost of sales decreased slightly to 54.8% in 1992 from 55.1% in 1991. This improvement was primarily attributable to laboratory supply cost decreases of approximately 0.2% of net sales due to cost control efforts, negotiation of favorable national supply contracts and implementation of the initial phase of a new inventory control system. Distribution expenses (which are incurred to deliver specimens from the physician's office to the laboratory) decreased approximately 0.5% of net sales, primarily due to favorable automobile lease rates. Additionally, labor costs increased approximately 0.5% of net sales, mainly as a result of higher employee benefit costs. Also, cost reduction efforts and operational efficiencies resulted in a slight decrease in several expense categories aggregating approximately 0.1% of net sales. Selling, general and administrative expenses increased to $117.9 million in 1992 from $97.9 million in 1991, an increase of $20.0 million. As a percentage of net sales, selling, general and administrative expenses increased slightly to 16.3% in 1992 compared with 16.2% in 1991. This was primarily due to a moderately higher provision for doubtful accounts as a percent of net sales due to the uncertain national economy. Amortization of intangibles and other assets increased $0.6 million to $8.3 million in 1992, primarily due to amortization of debt issuance costs associated with the revolving credit facility in existence during the year. In the fourth quarter of 1992, the Company took a one-time charge of $136.0 million to cover all estimated costs related to agreements that concluded a government investigation that primarily revolved around the government's contention that the Company improperly received reimbursement for tests for HDL cholesterol and serum ferritin (a measure of iron in the blood) included in its basic Health Survey Profile. The one-time charge reduced net earnings and earnings per share for the quarter and year ended December 31, 1992 by $80.3 million and $0.85, respectively. The Company will continue to receive reimbursements from all government third party reimbursement programs, including Medicare, Medicaid and CHAMPUS, under the settlement agreements. Investment income decreased to $2.2 million in 1992 from $3.6 million in 1991 and interest expense increased to $4.2 million in 1992 from $0.1 million in 1991. Both of these changes are directly related to the purchase of 4,808,000 shares of the Company's outstanding common stock in January 1992 pursuant to a tender offer. Such purchase was financed by approximately $25.8 million in cash on hand and $100.0 million borrowed under a revolving credit facility in existence at that time. Also, in April and October 1992, the Company prepaid $15.0 million and $10.0 million, respectively, of the outstanding balance of such revolving credit facility. The provision for income taxes as a percentage of earnings before income taxes decreased to 34.6% in 1992 from 38.6% in 1991, primarily due to a lower effective rate for state income taxes. Liquidity and Capital Resources The Company has generated cash flow in excess of its operating requirements in each of the three past fiscal years. Cash from operations was $57.2 million, $102.4 million and $135.3 million for the years ended December 31, 1993, 1992 and 1991, respectively. Of these amounts, cash used for capital expenditures was $33.6 million, $34.9 million and $25.4 million for the years ended December 31, 1993, 1992 and 1991, respectively. The Company expects capital expenditures to be approximately $30.0 million to $40.0 million in 1994 to accommodate expected growth, to further automate laboratory processes and improve efficiency. During 1993, the Company acquired thirty-four clinical laboratory companies in various locations of the United States for an aggregate amount of $78.2 million in cash plus $28.7 million of liabilities, comprised primarily of future contractual and contingent payments. Such future payments are expected to be funded with cash generated from operations. These laboratories, on an annual basis, are expected to generate approximately $80.6 million in net sales. During 1992, the Company acquired five clinical laboratories for a total of $2.3 million in cash plus $0.7 million of liabilities were assumed. In 1991, three laboratory companies were purchased for $1.2 million in cash plus $5.3 million of liabilities were assumed. It is the Company's intention to continue its acquisition program, although there can be no assurance that the Company will be able to acquire additional laboratories on terms the Company believes to be competitively advantageous. On August 27, 1993, the Company entered into the unsecured Revolving Credit Facility with Citicorp USA, Inc. as agent for a group of banks. The Revolving Credit Facility provides that the Company may borrow up to $350.0 million in order to refinance existing indebtedness; to finance repurchases from time to time by the Company of its common stock; to finance certain acquisitions; and to provide for the general corporate purposes of the Company. The Revolving Credit Facility matures on September 1, 1998, with commitment reductions of $50.0 million on September 1, 1996 and September 1, 1997. The terms and conditions of the Revolving Credit Facility contain, among other provisions, requirements for maintaining a defined level of stockholders' equity, various financial ratios, certain restrictions on repurchases by the Company of its common stock and certain restrictions on acquisitions made outside the Company's ordinary course of business. Interest rates are determined at the time of borrowing and are based on London Interbank Offered Rates plus 1% per annum, or other alternative rates. On September 1, 1993, the Company borrowed $139.0 million under the Revolving Credit Facility to permanently repay all amounts outstanding under revolving credit facilities in existence on such date. Net additional borrowings during 1993 aggregated $139.0 million and were used to finance acquisitions of several clinical laboratory companies and to finance repurchases by the Company of its common stock. In March 1993 and in June 1992, the Company announced plans to purchase from time to time up to 10 million and 2 million shares of its outstanding common stock, respectively, in the open market. Pursuant to these plans, during 1993 and 1992, the Company purchased 9,485,800 and 310,000 such shares, respectively, for an aggregate amount of $154.2 million and $6.1 million, respectively. In January 1992, pursuant to a self tender offer, the Company purchased 4,808,000 of its outstanding shares of common stock for $26 per share in cash, or $125.8 million. The purchase was financed by $25.8 million of cash on hand and $100.0 million borrowed under a revolving credit facility in existence at that time. Pursuant to the Government Settlement, a total of $55.8 million was paid for settlement and other expenses during 1993, including aggregate cash payments of $38.0 million made to the federal government. The remaining amount due the federal government, $27.0 million, is being paid in quarterly installments through September 1995, which installments are expected to be paid with cash generated from operations. During 1992, the Company paid $47.1 million for settlement and related expenses, including $35.0 million to the federal government and $10.4 million to state Medicaid programs. During 1991, the Company guaranteed a $9.0 million, 5 year loan to a third party for construction of a new laboratory to replace one of the Company's existing facilities. Following its completion in November 1992, the building was leased to the Company by this third party. Under the terms of this guarantee, as modified, the Company is required to maintain 105% of the outstanding loan balance including any overdue interest as collateral in a custody account established and maintained at the lending institution. As of December 31, 1993, 1992 and 1991, the Company had placed $9.5 million, $10.3 million and $11.3 million, respectively, of investments in the custody account. Impact of Statement of Financial Accounting Standards No. 115 -- Accounting for Certain Investments in Debt and Equity Securities SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities", was issued in May 1993 and addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. SFAS No. 115 requires the Company to adopt this statement in 1994. The Company does not anticipate that the adoption of SFAS No. 115 will have a material impact on its financial position or results of operations as the Company's investments in such securities are expected to be classified as trading securities, and, as such, their carrying values are considered representative of their fair values. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the Index on Page of the Financial Report included herein. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III The information required by Part III, Items 10 through 13, of Form 10-K is incorporated by reference from the registrant's definitive proxy statement for its 1994 annual meeting of stockholders, which is to be filed pursuant to Regulation 14A not later than April 30, 1994. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K List of documents filed as part of this Report: (1) Consolidated Financial Statements and Independent Auditors' Report included herein: See Index on page (2) Financial Statement Schedules: See Index on page All other schedules are omitted as they are inapplicable or the required information is furnished in the Consolidated Financial Statements or notes thereto. (3) Index to and List of Exhibits (a) Exhibits:* Exhibits 10.6 through 10.43 are management contracts. 3.1 - Restated Certificate of Incorporation of the Company (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1988 filed with the Commission on March 31, 1989, File No. 1-10740** (the "1988 10-K")). 3.2 - By-laws of the Company (incorporated herein by reference to the Company's 1988 10-K). 10.1 - Laboratory Agreement dated February 4, 1983 between the Company and Humana of Texas, Inc. d/b/a/ Medical City Dallas Hospital (incorporated herein by reference to the Company's Registration Statement on Form S-1 filed with the Commission on May 5, 1988, File No. 33-21708 (the "1988 S-1")). 10.2 - National Health Laboratories Incorporated Employees' Savings and Investment Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991 filed with the Commission on February 13, 1992, File No. 1- 10740** (the "1991 10-K")). 10.3 - National Health Laboratories Incorporated Employees' Retirement Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 filed with the Commission on March 26, 1993, File No. 1-10740 (the "1992 10-K")). 10.4 - National Health Laboratories Incorporated Pension Equalization Plan (incorporated herein by reference to the 1992 10-K). 10.5 - Settlement Agreement dated December 18, 1992 be- tween the Company and the United States of America (incorporated herein by reference to the 1992 10-K). 10.6 - Employment Agreement dated December 21, 1992 be- tween the Company and James R. Maher (incorporated herein by reference to the 1992 10-K). 10.7 - Employment Agreement dated May 1, 1991 between the Company and Robert Whalen (incorporated herein by reference to the 1991 10-K). 10.8 - Amendment to Employment Agreement dated June 6, 1991 between the Company and Robert Whalen (incorporated herein by reference to the 1991 10-K). 10.9 - Amendment to Employment Agreement dated January 1, 1993 between the Company and Robert Whalen (incorporated herein by reference to the 1992 10-K). 10.10* - Amendment to Employment Agreement dated January 1, 1994 between the Company and Robert Whalen. 10.11* - Amendment to Employment Agreement dated March 1, 1994 between the Company and Robert Whalen. 10.12 - Employment Agreement dated May 1, 1991 between the Company and Larry L. Leonard (incorporated herein by reference to the 1991 10-K). 10.13 - Amendment to Employment Agreement dated June 6, 1991 between the Company and Larry L. Leonard (incorporated herein by reference to the 1991 10-K). 10.14 - Amendment to Employment Agreement dated January 1, 1993 between the Company and Larry L. Leonard (incorporated herein by reference to the 1992 10-K). 10.15* - Amendment to Employment Agreement dated January 1, 1994 between the Company and Larry L. Leonard. 10.16* - Amendment to Employment Agreement dated March 1, 1994 between the Company and Larry L. Leonard. 10.17 - Employment Agreement dated May 1, 1991 between the Company and Timothy Brodnik (incorporated herein by reference to the 1991 10-K). 10.18 - Amendment to Employment Agreement dated June 6, 1991 between the Company and Timothy Brodnik (incorporated herein by reference to the 1991 10-K). 10.19 - Amendment to Employment Agreement dated January 1, 1993 between the Company and Timothy Brodnik (incorporated herein by reference to the 1992 10-K). 10.20* - Amendment to Employment Agreement dated January 1, 1994 between the Company and Timothy Brodnik. 10.21* - Amendment to Employment Agreement dated March 1, 1994 between the Company and Timothy Brodnik. 10.22 - Employment Agreement dated December 31, 1990 between the Company and Bernard E. Statland (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 filed with the Commission on March 14, 1991, File No. 1-10740** (the "1990 10-K")). 10.23 - Amendment to Employment Agreement dated April 1, 1991 between the Company and Bernard E. Statland (incorporated herein by reference to the 1991 10-K). 10.24 - Amendment to Employment Agreement dated June 6, 1991 between the Company and Bernard E. Statland (incorporated herein by reference to the 1991 10-K). 10.25 - Amendment to Employment Agreement dated January 1, 1993 between the Company and Bernard E. Statland (incorporated herein by reference to the 1992 10-K). 10.26 - Employment Agreement dated January 1, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1990 10-K). 10.27 - Amendment to Employment Agreement dated April 1, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1991 10-K). 10.28 - Amendment to Employment Agreement dated June 6, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1991 10-K). 10.29 - Amendment to Employment Agreement dated January 1, 1993 between the Company and David C. Flaugh (incorporated herein by reference to the 1992 10-K). 10.30 - Employment Agreement dated January 1, 1991 between the Company and W. David Slaunwhite (incorporated herein by reference to the 1990 - 10-K). 10.31 - Amendment to Employment Agreement dated April 1, 1991 between the Company and David Slaunwhite (incorporated herein by reference to the 1991 10-K). 10.32 - Amendment to Employment Agreement dated June 6, 1991 between the Company and David Slaunwhite (incorporated herein by reference to the 1991 10-K). 10.33 - Amendment to Employment Agreement dated January 1, 1993 between the Company and W. David Slaunwhite (incorporated herein by reference to the 1992 10-K). 10.34* - Amendment to Employment Agreement dated January 1, 1994 between the Company and W. David Slaunwhite. 10.35* - Amendment to Employment Agreement dated March 1, 1994 between the Company and W. David Slaunwhite. 10.36 - Employment Agreement dated January 1, 1991 between the Company and John Markus (incorporated herein by reference to the 1990 10-K). 10.37 - Amendment to Employment Agreement dated April 1, 1991 between the Company and John Markus (incorporated herein by reference to the 1991 10-K). 10.38 - Amendment to Employment Agreement dated June 6, 1991 between the Company and John Markus (incorporated herein by reference to the 1991 10-K). 10.39 - Amendment to Employment Agreement dated January 1, 1993 between the Company and John F. Markus (incorporated herein by reference to the 1992 10-K). 10.40* - Amendment to Employment Agreement dated January 1, 1994 between the Company and John F. Markus. 10.41* - Amendment to Employment Agreement dated March 1, 1994 between the Company and John F. Markus. 10.42 - Employment Agreement dated October 1, 1992 between the Company and James G. Richmond (incorporated herein by reference to the 1992 10-K). 10.43 - Employment Agreement dated July 6, 1993 between the Company and Michael L. Jeub (incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 filed with the Commission on August 9, 1993, File No. 1-10740 (the "1993 Second Quarter 10-Q")). 10.44 - Services Agreement (incorporated herein by reference to Amendment No. 1 to the 1988 S-1). 10.45 - Tax Allocation Agreement dated as of June 26, 1990 between MacAndrews & Forbes Holdings Inc., Revlon Group Incorporated, New Revlon Holdings Inc. and the subsidiaries of Revlon set forth on Schedule A thereto (incorporated herein by reference to the Company's Registration Statement on Form S-1 (No. 33-35782) filed with the Commission on July 9, 1990 (the "1990 S- 1")). 10.46 - National Health Laboratories 1988 Stock Option Plan, as amended (incorporated herein by reference to the 1990 S-1). 10.47 - Revolving Credit Agreement dated as of August 27, 1993 among National Health Laboratories Incorporated, Citicorp USA, Inc., as agent and arranger, and the group of lenders specified therein (incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 filed with the Commission on November 15, 1993, File No. 1- 10740 (the "1993 Third Quarter 10-Q")). 10.48 - Loan Agreement dated August 1, 1991 among National Health Laboratories Incorporated, Frequency Property Corp. and Swiss Bank Corporation, New York Branch (incorporated herein by reference to the 1991 10-K). 24.1* - Consent of KPMG Peat Marwick. 25.1* - Power of Attorney of Ronald O. Perelman. 25.2* - Power of Attorney of James R. Maher. 25.3* - Power of Attorney of Saul J. Farber, M.D. 25.4* - Power of Attorney of Howard Gittis. 25.5* - Power of Attorney of Ann Dibble Jordan. 25.6* - Power of Attorney of David J. Mahoney. 25.7* - Power of Attorney of Paul A. Marks, M.D. 25.8* - Power of Attorney of Linda Gosden Robinson. 25.9* - Power of Attorney of Samuel O. Thier, M.D. 25.10* - Power of Attorney of David C. Flaugh. 28.1 - Form of Collateral Agency Agreement (Bank Obligations) (incorporated herein by reference to Amendment No. 1 to the 1990 S-1 filed with the Commission on July 27, 1990, File No. 33-35785). ______________ * Filed herewith. ** Previously filed under File No. 0-17031 which has been corrected to File No. 1-10740. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. NATIONAL HEALTH LABORATORIES INCORPORATED Registrant By:/s/ JAMES R. MAHER ------------------------------------ James R. Maher President and Chief Executive Officer By:/s/ MICHAEL L. JEUB ------------------------------------ Michael L. Jeub Executive Vice President, Chief Financial Officer and Treasurer (Principal Accounting Officer) Dated: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on March 25, 1994 in the capacities indicated. Signature Title ------------------------ -------- /s/ RONALD O. PERELMAN* Director ------------------------ (Ronald O. Perelman) /s/ JAMES R. MAHER* Director ------------------------ (James R. Maher) /s/ SAUL J. FARBER, M.D.* Director ------------------------ (Saul J. Farber, M.D.) /s/ HOWARD GITTIS* Director ------------------------ (Howard Gittis) /s/ ANN DIBBLE JORDAN* Director ------------------------ (Ann Dibble Jordan) /s/ DAVID J. MAHONEY* Director ------------------------ (David J. Mahoney) /s/ PAUL A. MARKS, M.D.* Director ------------------------ (Paul A. Marks, M.D.) /s/ LINDA GOSDEN ROBINSON* Director ------------------------ (Linda Gosden Robinson) /s/ SAMUEL O. THIER, M.D.* Director ------------------------- (Samuel O. Thier, M.D.) ______________________ * David C. Flaugh, by his signing his name hereto, does hereby sign this report on behalf of the directors of the Registrant after whose typed names asterisks appear, pursuant to powers of attorney duly executed by such directors and filed with the Securities and Exchange Commission. By:/s/ DAVID C. FLAUGH -------------------- David C. Flaugh Attorney-in-fact NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES AND SCHEDULES --------------------------------------------------------------- Page ---- Independent Auditors' Report . . . . . . . . . . . . . . Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992 . . . . . . . . . . . . . Consolidated Statements of Earnings 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 . . . . . . Financial Statement Schedule: VIII - Valuation and Qualifying Accounts . . . . . . . INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders National Health Laboratories Incorporated: We have audited the consolidated financial statements of National Health Laboratories Incorporated 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 schedule as listed in the accompanying index. These consolidated financial statements and 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 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 National Health Laboratories Incorporated 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 financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK San Diego, California February 10, 1994 NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Millions) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation: The consolidated financial statements include the accounts of National Health Laboratories Incorporated (the "Company") and its subsidiaries after elimination of all material intercompany accounts and transactions. Until May 7, 1991, the Company was a direct majority-owned subsidiary of National Health Care Group, Inc. ("NHCG") which is a wholly-owned subsidiary of Revlon Holdings, Inc. ("Revlon"), then known as Revlon, Inc., and MacAndrews & Forbes Holdings Inc. ("MacAndrews & Forbes"). MacAndrews & Forbes is wholly-owned by Mafco Holdings Inc. ("MAFCO"). As a result of an initial public offering in July 1988 (the "Public Offering") and subsequent secondary public offerings in August 1990, May 1991 and February 1992, the Company's self tender offer in January 1992 and the purchase by the Company of outstanding shares of its common stock, MAFCO's indirect ownership has been reduced to approximately 24%. Cash Equivalents: Cash equivalents (primarily investments in money market funds, time deposits and commercial paper which have maturities of three months or less at the date of purchase) are carried at cost which approximates market. Property, Plant and Equipment: Property, plant and equipment is recorded at cost. The cost of properties held under capital leases is equal to the lower of the net present value of the minimum lease payments or the fair value of the leased property at the inception of the lease. Depreciation and amortization expense is computed on all classes of assets based on their estimated useful lives, as indicated below, using principally the straight-line method. Years ----- Buildings and building improvements 40 Machinery and equipment 3-10 Furniture and fixtures 8 Leasehold improvements and assets held under capital leases are amortized over the shorter of their estimated lives or the period of the related leases. Expenditures for repairs and maintenance charged against earnings in 1993, 1992 and 1991 were $10.8, $10.7 and $10.6, respectively. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) Intangibles: Intangibles, consisting of goodwill, net of amortization, of $203.4 and $168.9 at December 31, 1993 and 1992, respectively, and other intangibles (i.e., customer lists, non-compete agreements and rights to names), net of amortization, of $78.1 and $19.4 at December 31, 1993 and 1992, respectively, are being amortized on a straight-line basis over a period of 40 years and 3-40 years, respectively. Total accumulated amortization for goodwill and other intangibles aggregated $46.4 and $39.2 at December 31, 1993 and 1992, respectively. The Company assesses the recoverability of intangible assets by determining whether the amortization of the intangibles' balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operations. The amount of goodwill impairment, if any, is measured based on projected undiscounted future operating cash flows. Fair Value of Financial Instruments: Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments", requires that fair values be disclosed for most of the Company's financial instruments. The carrying amount of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and the revolving credit facility are considered to be representative of their respective fair values. Concentration of Credit Risk: Concentrations of credit risk with respect to accounts receivable are limited due to the diversity of the Company's clients as well as their dispersion across many different geographic regions. Revenue Recognition: Sales are recognized on the accrual basis at the time test results are reported, which approximates when services are provided. Services are provided to certain patients covered by various third-party payor programs including the Medicare and Medicaid programs. Billings for services under third-party payor programs are included in sales net of allowances for differences between the amounts billed and estimated program payment amounts. Adjustments to the estimated payment amounts based on final settlement with the programs are recorded upon settlement. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) Income Taxes: In conjunction with the Public Offering, the Company became a party to a tax allocation agreement with Revlon effective July 14, 1988. Pursuant thereto, the Company made payments to Revlon in amounts equal to the amounts the Company would have paid had it filed a separate federal income tax return. Effective January 1, 1990, Revlon and Revlon's domestic subsidiaries entered into a new tax allocation arrangement under which the federal income tax provision and related liability of the Company was computed as if it filed its own separate return, except that the following items were not taken into account: (i) the effect of timing differences and (ii) any gain recognized on the sale of any asset not in the ordinary course of business. As a result of the reduction of NHCG's ownership interest in the Company on May 7, 1991, the Company is no longer a member of the MAFCO consolidated tax group. For periods subsequent to May 7, 1991, the Company has filed its own separate federal, state and local income tax returns. Pursuant to the deferred method under APB Opinion 11, which was applied in 1991 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 in which the item originated. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement 109"). Statement 109 required 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. 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 January 1, 1992, the Company adopted Statement 109. The cumulative effect of the change in the method of accounting for income taxes was not material and is therefore not presented separately in the accompanying consolidated statements of earnings. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) Earnings per Common Share: For the years ended December 31, 1993, 1992 and 1991, earnings per common share is calculated based on the weighted average number of shares outstanding during each year (89,438,764, 94,468,022 and 99,095,524 shares, respectively). Reclassifications: Certain amounts in the prior years' financial statements have been reclassified to conform with the 1993 presentation. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) 2. ACCOUNTS RECEIVABLE, NET December 31, December 31, 1993 1992 ----------- ----------- Gross accounts receivable $ 170.0 $ 155.8 Less contractual allowances and allowance for doubtful accounts (51.0) (72.9) ------- ------- $ 119.0 $ 82.9 ======= ======= 3. PROPERTY, PLANT AND EQUIPMENT, NET December 31, December 31, 1993 1992 ----------- ----------- Land $ 0.4 $ 0.2 Buildings and building improvements 1.9 1.7 Machinery and equipment 117.9 90.8 Leasehold improvements 27.2 23.3 Furniture and fixtures 14.5 10.4 Buildings under capital leases 9.6 9.6 ------- ------- 171.5 136.0 Less accumulated depreciation and amortization (71.4) (51.5) ------- ------- $ 100.1 $ 84.5 ======= ======= 4. ACCRUED EXPENSES AND OTHER December 31, December 31, 1993 1992 ----------- ----------- Employee compensation and benefits $ 27.9 $ 29.2 Taxes other than federal taxes on income 7.5 3.0 Deferred acquisition related payments 11.4 3.0 Other 8.8 5.4 ------- ------- $ 55.6 $ 40.6 ======= ======= 5. OTHER LIABILITIES December 31, December 31, 1993 1992 ----------- ----------- Deferred acquisition related payments $ 15.4 $ 1.6 Other 6.1 3.1 ------- ------- $ 21.5 $ 4.7 ======= ======= NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) 6. GOVERNMENT SETTLEMENT In November 1990, the Company became aware of a grand jury inquiry relating to its pricing practices being conducted by the United States Attorney for the San Diego area (the Southern District of California) with the assistance of the Office of Inspector General. On December 18, 1992, the Company announced that it had entered into agreements that concluded the investigation (the "Government Settlement"). As a result of this settlement, the Company took a one-time pre-tax charge of $136.0 in the fourth quarter of 1992. The charge covered all estimated costs related to the investigation and the settlement agreements. At December 31, 1993 and 1992, the remaining liability for settlement and related expenses totalled $33.1 and $88.9, respectively, and is reflected in the accompanying consolidated balance sheets under the captions "Accrued Settlement Expenses". 7. REVOLVING CREDIT FACILITY On August 27, 1993, the Company entered into an unsecured revolving credit facility (the "Revolving Credit Facility") with Citicorp USA, Inc. as agent for a group of banks. The Revolving Credit Facility provides that the Company may borrow up to $350.0 in order to refinance existing indebtedness; to finance repurchases from time to time by the Company of its common stock; to finance certain acquisitions; and to provide for the general corporate purposes of the Company. The Revolving Credit Facility matures on September 1, 1998, with commitment reductions of $50.0 on September 1, 1996 and September 1, 1997. The terms and conditions of the Revolving Credit Facility contain, among other provisions, requirements for maintaining a defined level of stockholders' equity, various financial ratios, certain restrictions on repurchases by the Company of its common stock and certain restrictions on acquisitions made outside the Company's ordinary course of business. Interest rates are determined at the time of borrowing and are based on London Interbank Offered Rates plus 1% per annum, or other alternative rates. On September 1, 1993, the Company borrowed $139.0 under the Revolving Credit Facility to permanently repay all amounts outstanding under revolving credit facilities in existence on such date. Net additional borrowings during 1993 aggregated $139.0 and were used to finance acquisitions of several clinical laboratory companies and to finance repurchases by the Company of its common stock. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share data) 8. STOCKHOLDERS' EQUITY In March 1993 and in June 1992, the Company announced plans to purchase from time to time up to 10 million and 2 million shares of its outstanding common stock, respectively, in the open market. Pursuant to these plans, during 1993 and 1992, the Company purchased 9,485,800 and 310,000 such shares, respectively, for an aggregate amount of $154.2 million and $6.1 million, respectively. In January 1992, pursuant to a self tender offer, the Company purchased 4,808,000 of its outstanding shares of common stock for $26 per share in cash, or $125.8 million. The purchase was financed by $25.8 million of cash on hand and $100.0 million borrowed under a revolving credit facility in existence at that time. 9. INCOME TAXES As discussed in Note 1, the Company adopted Statement 109 effective January 1, 1992. The cumulative effect of the change in the method of accounting for income taxes was not material and is therefore not presented separately in the accompanying consolidated statements of earnings. The provisions for income taxes in the accompanying consolidated statements of earnings consist of the following: Years ended December 31, 1993 1992 1991 ------ ------ ------- Current: Federal $48.9 $52.3 $57.3 State and local 10.4 9.0 10.9 ------ ----- ------ 59.3 61.3 68.2 ------ ----- ------ Deferred: Federal 14.9 (32.3) (2.8) State and local 4.2 (7.5) -- ------ ------ ------ 19.1 (39.8) (2.8) ------ ------ ------ $78.4 $21.5 $65.4 ====== ====== ===== The effective tax rates on earnings before income taxes is reconciled to statutory federal income tax rates as follows: Years ended December 31, 1993 1992 1991 ----- ----- ----- Statutory federal rate 35.0% 34.0% 34.0% State and local income taxes, net of federal income tax benefit 4.9 1.5 4.3 Other 1.1 (0.9) 0.3 ----- ------ ----- Effective rate 41.0% 34.6% 38.6% ===== ====== ===== NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) The significant components of deferred income tax expense are as follows: Years ended December 31, 1993 1992 1991 ------ ------ ------ Settlement and related expense $22.2 $(34.8) $ -- Reserve for doubtful accounts 0.4 (2.1) 1.1 Other (3.5) (2.9) (3.9) ------ ------ ------ $19.1 ($39.8) ($2.8) ====== ====== ====== 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 as follows: December 31, 1993 1992 ----- ----- Deferred tax assets: Settlement and related expenses, principally due to accrual for financial reporting purposes $13.2 $34.9 Accounts receivable, principally due to allowance for doubtful accounts 5.5 5.9 Self insurance reserves, principally due to accrual for financial reporting purposes 0.9 1.7 Compensated absences, principally due to accrual for financial reporting purposes 2.0 1.4 Other 6.6 1.8 ----- ----- Total gross deferred tax assets 28.2 45.7 ----- ----- Deferred tax liabilities: Intangible assets, principally due to differences in amortization (3.7) (3.7) Property, plant and equipment, principally due to differences in depreciation (4.3) (3.9) Other (1.7) (0.6) ----- ------ Total gross deferred tax liabilities (9.7) (8.2) ----- ------ Net deferred tax asset $18.5 $37.5 ===== ====== No valuation allowance for deferred tax assets was established as of January 1, 1992; similarly, a valuation allowance was also deemed unnecessary at December 31, 1993 and 1992. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share data) 10. STOCK OPTIONS In 1988, the Company adopted the 1988 Stock Option Plan, reserving 2,000,000 shares of common stock for issuance pursuant to options and stock appreciation rights that may be granted under the plan. The Stock Option Plan was amended in 1990 to limit the number of options to be issued under the Stock Option Plan to 550,000 in the aggregate (including all options previously granted). In 1991, the number of shares authorized for issuance under the Stock Option Plan was increased to an aggregate of 2,550,000. The following table summarizes grants of non-qualified options made by the Company to officers and key employees. For each grant, the exercise price was equivalent to the fair market price per share on the date of grant. Also, for each grant, one-third of the shares of common stock subject to such options vested on the date of grant and one-third vests on each of the first and second anniversaries of such date, subject to their earlier expiration or termination. Exercise Date Options Price Date of of Grant Granted per Share Expiration ------------- ------- --------- ---------------- February 1989 240,000 $ 7.750 February 8, 1999 July 1990 100,000 13.500 July 9, 2000 October 1991 500,000 20.250 October 8, 2001 October 1992 25,000 20.000 October 2, 2002 December 1992 300,000 16.625 December 21, 2002 January 1993 775,000 16.625 January 18, 2003 July 1993 43,500 17.875 July 6, 2003 NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share data) Changes during 1991, 1992 and 1993 in options outstanding under the plan were as follows: Number Exercise Price of Options per Option ---------- ----------------- Outstanding at January 1, 1991 263,400 $ 7.750 - $13.500 Granted 500,000 $20.250 Exercised (123,830) $ 7.750 - $20.250 Canceled or expired (1,670) $ 7.750 --------- Outstanding at December 31, 1991 637,900 $ 7.750 - $20.250 Granted 325,000 $16.625 - $20.000 Exercised (30,662) $ 7.750 - $20.250 Canceled or expired (39,334) $13.500 - $20.250 --------- Outstanding at December 31, 1992 892,904 $ 7.750 - $20.250 Granted 818,500 $16.625 - $17.875 Exercised (33,400) $ 7.750 Canceled or expired (111,170) $ 7.750 - $20.250 --------- Outstanding at December 31, 1993 1,566,834 $ 7.750 - $20.250 ========= Exercisable at December 31, 1993 920,501 $ 7.750 - $20.250 ========= 11. INTERCOMPANY TRANSACTIONS Pursuant to a services agreement between Revlon and the Company, Revlon provided, in years prior to 1992, the Company with certain finance, insurance, legal, employee benefit and administrative services. Revlon charged the Company $0.5 in 1991 for such services, based on the estimated actual cost incurred by Revlon in providing such services. In addition, the services agreement provided that the Company would pay Revlon all costs associated with the participation of Company employees in any pension (see Note 13), health, savings or other employee benefit plans of Revlon. These costs were $9.6 in 1991. Also, Revlon charged the Company $0.2 in 1991 for direct computer services provided to certain of the Company's laboratories. In addition, Revlon passed through to the Company certain direct costs for (i) self-insured retentions, deductibles and co-insurance under insurance policies maintained by Revlon for the Company totalling $2.6 in 1991; (ii) rental of vehicles owned by third parties used by the Company in its business totalling $4.1 in 1991; and (iii) other direct costs, such as bank service fees, totalling $0.7 for 1991. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) From July 1990 to July 1991, Revlon invested the Company's excess cash in a segregated account in the Company's name. Commencing July 1991, the Company established a separate in-house cash management function. Interest income earned on excess cash invested for the Company by Revlon was $1.6 in 1991. 12. COMMITMENTS AND CONTINGENCIES The Company is involved in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, based upon the advice of counsel, the ultimate disposition of these matters will not have a material adverse effect on the financial position of the Company. In December 1992, several class actions were filed against the Company and certain of its officers and directors alleging that certain public disclosures made by the Company since February 1990 were false and misleading in that they failed to disclose that a portion of the Company's income was derived from allegedly fraudulent claims and that such non-disclosures rendered the Company's financial statements misleading. These various class actions are pending in the United States District Court for the Southern District of California. The Company believes that the allegations of the complaint that claim wrongdoing on behalf of the Company and its officers and directors cannot be supported by the facts or the law and that the Company's disclosures complied with all legal obligations. The Company is defending these lawsuits vigorously. In addition, certain lawsuits have been brought by purported shareholders of the Company, allegedly on the Company's behalf against the Company's directors and certain of its officers, in the Superior Court for the County of San Diego, California. These various claims allege that the Company was damaged by actions of the defendant officers and directors in connection with supervision and control of the practices that led to the guilty plea and civil settlement associated with the Government Settlement. These actions seek no damages against the Company. In November 1993, a class action was filed against the Company and certain of its officers and directors alleging that certain public disclosures made by the Company since December 1992 were false and misleading in that they stated that the Company had taken steps to insure that the Company's sales and marketing practices are compatible with the government's interpretation of current regulations and that they failed to disclose that a portion of the Company's income was derived from allegedly fraudulent claims and that such non-disclosures rendered the Company's financial statements misleading. This class action is pending in the United States District Court for the Southern District of California. The Company believes that the allegations of the complaint that claim wrongdoing on behalf of the Company and its officers and directors NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) cannot be supported by the facts or the law and that the Company's disclosures complied with all legal obligations. On January 5, 1994, a stipulation was entered into whereby the parties have agreed to stay all further activity in this action pending the conclusion of the class actions filed in December 1992. During 1991, the Company guaranteed a $9.0, 5 year loan to a third party for construction of a new laboratory to replace one of the Company's existing facilities. Following its completion in November of 1992, the building was leased to the Company by this third party. Such transaction is treated as a capital lease for financial reporting purposes. The associated lease term continues for a period of 15 years, expiring in 2007. Under the terms of this guarantee, as modified, the Company is required to maintain 105% of the outstanding loan balance including any overdue interest as collateral in a custody account established and maintained at the lending institution. As of December 31, 1993 and 1992, the Company had placed $9.5 and $10.3, respectively, of investments in the custody account. Such investments are included under the caption "Other assets, net" in the accompanying consolidated balance sheets. The Company does not anticipate incurring any loss as a result of this loan guarantee due to protection provided by the terms of the lease. Accordingly, the Company, if required to repay the loan upon default of the borrower (and ultimate lessor), is entitled to a rent abatement equivalent to the amount of repayment made by the Company on the borrower's behalf, plus interest thereon at a rate equal to 2% over the prime rate. For all insurance coverages prior to May 7, 1991, the Company paid Revlon a predetermined amount each year, based upon the Company's historical loss experience and other relevant factors, in respect of the Company's share of the self-insured risks and risks insured by outside insurance carriers, in each case applicable to Revlon and its subsidiaries. Regardless of the Company's and Revlon's actual loss experience, the Company will not be required to pay Revlon amounts in excess of the Company's predetermined share of such liability for losses incurred before May 7, 1991. Under the Company's present insurance programs, coverage is obtained for catastrophic exposures as well as those risks required to be insured by law or contract. The Company is responsible for the uninsured portion of losses occurring on or after May 7, 1991 related primarily to general, product and vehicle liability and workers' compensation. The self-insured retentions are on a per occurrence basis without any aggregate annual limit. Provisions for losses expected under these programs are recorded based upon the Company's estimates of the aggregated liability of claims incurred. At December 31, 1993 and 1992, the Company had provided letters of credit aggregating approximately $3.7 and $3.3, respectively, in connection with certain insurance programs. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) Future minimum rental commitments for leases with noncancelable terms of one year or more from December 31, 1993 are as follows: Operating Capital --------- ------- 1994 $13.7 $ 1.2 1995 10.8 1.2 1996 8.6 1.3 1997 7.2 1.4 1998 5.3 1.5 Thereafter 13.9 18.4 ----- ----- Total minimum lease payments 59.5 25.0 Less amount representing interest -- 15.3 ----- ----- Total minimum operating lease payments and present value of minimum capital lease payments $59.5 $ 9.7 ===== ===== Rental expense, which includes rent for real estate, equipment and automobiles under operating leases, amounted to $29.9, $27.0 and $25.6 for the years ended December 31, 1993, 1992 and 1991, respectively. 13. RETIREMENT PLANS Effective January 1, 1992, the Company separated its retirement plans from certain of Revlon's plans, in which the Company had been participating. The Company's plans provide benefits substantially identical to those provided under Revlon's plans. Substantially all employees of the Company are covered by a defined benefit retirement plan (the "Plan"). The benefits to be paid under the Plan are based on years of credited service and average final compensation. For the years ended December 31, 1993 and 1992, pension costs are determined actuarially. For the year ended December 31, 1991, the pension expense reflected in the accompanying consolidated statements of earnings represented an allocation by Revlon of $2.3. Such allocated amount was intended to approximate the Company's pension expense for the year. Under the requirements of Statement of Financial Accounting Standards No. 87, "Employers Accounting for Pensions", the Company has recorded an additional minimum pension liability representing the excess accumulated benefit obligation over plan assets at December 31, 1993. A corresponding amount was recognized as an intangible asset to the extent of unrecognized prior service cost, with the balance recorded as a separate reduction of stockholders' equity. The Company recorded an additional liability of $3.0, an NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) intangible asset of $0.6, and a reduction of stockholders' equity of $2.4. The components of net periodic pension cost are summarized as follows: Years ended December 31, -------------- 1993 1992 ----- ----- Service cost $ 3.7 $ 2.9 Interest cost 2.6 2.0 Actual return on plan assets (1.3) (1.0) Net amortization and deferral 0.4 0.5 ----- ----- Net periodic pension cost $ 5.4 $ 4.4 ===== ===== The status of the Plan follows: December 31, ------------- 1993 1992 ----- ----- Actuarial present value of benefit obligations: Vested benefits $25.0 $17.0 Non-vested benefits 4.0 2.7 ----- ----- Accumulated benefit obligation 29.0 19.7 Effect of projected future salary increases 13.9 9.8 ----- ----- Projected benefit obligation 42.9 29.5 Fair value of plan assets 24.2 15.8 ----- ----- Unfunded projected benefit obligation (18.7) (13.7) Unrecognized prior service cost 0.5 0.8 Unrecognized net loss 16.3 8.9 Unrecognized net transaction (asset) obligation -- -- Additional minimum liability (3.0) -- ----- ----- Accrued pension cost ($4.9) ($4.0) ===== ===== NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share amounts) Assumptions used in the accounting for the Plan were: 1993 1992 ---- ---- Weighted average discount rate 7.0% 8.0% Weighted average rate of increase in future compensation levels 5.5% 5.5% Weighted average expected long-term rate of return 9.0% 9.0% 14. ACQUISITIONS During 1993, the Company acquired thirty-four clinical laboratory companies for an aggregate purchase price of $106.9. During 1992 and 1991, the Company acquired five and three laboratories, respectively, for an aggregate purchase price of $3.0 and $6.5, respectively. The acquisitions were accounted for as purchase transactions. The excess of cost over the fair value of net tangible assets acquired during 1993, 1992 and 1991 was $100.1, $3.0 and $6.4, respectively, which is included under the caption "Intangible assets, net" in the accompanying consolidated balance sheets. The consolidated statements of earnings reflect the results of operations of these purchased businesses from their dates of acquisition. 15. DIVIDENDS On December 21, 1992, the Company declared a quarterly dividend in the aggregate amount of approximately $7.6 ($0.08 per share), which was paid on January 26, 1993 to holders of record of common stock at the close of business on January 5, 1993. Such dividend was paid entirely with cash on hand. On December 15, 1993, the Company declared a quarterly dividend in the aggregate amount of approximately $6.8 ($0.08 per share), which was paid on January 25, 1994 to holders of record of common stock at the close of business on January 4, 1994. Such dividend was paid entirely with cash on hand. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share amounts) 16. QUARTERLY DATA (UNAUDITED) The following is a summary of unaudited quarterly data: Year ended December 31, 1993 ------------------------------------------ 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Total ------------------------------------------ Net sales $199.8 $197.0 $194.8 $168.9 $760.5 Gross profit 90.7 89.2 85.2 50.9 316.0 Net earnings 33.6 33.2 38.2 7.7 112.7 Earnings per common share 0.36 0.37 0.43 0.10 1.26 Year ended December 31, 1992 ------------------------------------------ 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Total ------------------------------------------ Net sales $176.4 $181.1 $183.6 $180.3 $721.4 Gross profit 79.9 83.5 82.6 80.3 326.3 Net earnings 29.7 31.4 30.1 (50.6) 40.6 Earnings per common share 0.31 0.33 0.32 (0.53) 0.43 Expense reimbursement and termination fees received in connection with the Company's attempt to purchase Damon Corporation, less related expenses and the write-off of certain bank financing costs, resulted in a one-time pre-tax gain of $15.3 in the third quarter of 1993. Medicare's denial of claims for ferritin and HDL tests, which began in September 1993 and continued through December 20, 1993 when the Company introduced new test forms and procedures, and related suspended billings reduced net sales and gross profit by $18.6 in the fourth quarter of 1993. The Company took a one-time pre-tax charge of $136.0 in the fourth quarter of 1992 as a result of the Government Settlement. The charge covered all estimated costs related to the investigation and the settlement agreements. INDEX TO EXHIBITS Exhibit No. ----------- Exhibits 10.6 through 10.43 are management contracts. 3.1 Restated Certificate of Incorporation of the Company (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1988 filed with the Commission on March 31, 1989, File No. 1-10740** (the "1988 10-K")). 3.2 By-laws of the Company (incorporated herein by reference to the Company's 1988 10-K). 10.1 Laboratory Agreement dated February 4, 1983 between the Company and Humana of Texas, Inc. d/b/a/ Medical City Dallas Hospital (incorporated herein by reference to the Company's Registration Statement on Form S-1 filed with the Commission on May 5, 1988, File No. 33-21708 (the "1988 S-1")). 10.2 National Health Laboratories Incorporated Employees' Savings and Investment Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991 filed with the Commission on February 13, 1992, File No. 1-10740** (the "1991 10-K")). 10.3 National Health Laboratories Incorporated Employees' Retirement Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 filed with the Commission on March 26, 1993, File No. 1-10740 (the "1992 10-K")). 10.4 National Health Laboratories Incorporated Pension Equalization Plan (incorporated herein by reference to the 1992 10-K). 10.5 Settlement Agreement dated December 18, 1992 between the Company and the United States of America (incorporated herein by reference to the 1992 10-K). 10.6 Employment Agreement dated December 21, 1992 between the Company and James R. Maher (incorporated herein by reference to the 1992 10-K). INDEX TO EXHIBITS Exhibit No. ---------- 10.7 Employment Agreement dated May 1, 1991 between the Company and Robert Whalen (incorporated herein by reference to the 1991 10-K). 10.8 Amendment to Employment Agreement dated June 6, 1991 between the Company and Robert Whalen (incorporated herein by reference to the 1991 10-K). 10.9 Amendment to Employment Agreement dated January 1, 1993 between the Company and Robert Whalen (incorporated herein by reference to the 1992 10-K). 10.10* Amendment to Employment Agreement dated January 1, 1994 between the Company and Robert Whalen. 10.11* Amendment to Employment Agreement dated March 1, 1994 between the Company and Robert Whalen. 10.12 Employment Agreement dated May 1, 1991 between the Company and Larry L. Leonard (incorporated herein by reference to the 1991 10-K). 10.13 Amendment to Employment Agreement dated June 6, 1991 between the Company and Larry L. Leonard (incorporated herein by reference to the 1991 10-K). 10.14 Amendment to Employment Agreement dated January 1, 1993 between the Company and Larry L. Leonard (incorporated herein by reference to the 1992 10-K). 10.15* Amendment to Employment Agreement dated January 1, 1994 between the Company and Larry L. Leonard. 10.16* Amendment to Employment Agreement dated March 1, 1994 between the Company and Larry L. Leonard. 10.17 Employment Agreement dated May 1, 1991 between the Company and Timothy Brodnik (incorporated herein by reference to the 1991 10-K). 10.18 Amendment to Employment Agreement dated June 6, 1991 between the Company and Timothy Brodnik (incorporated herein by reference to the 1991 10-K). INDEX TO EXHIBITS Exhibit No. ----------- 10.19 Amendment to Employment Agreement dated January 1, 1993 between the Company and Timothy Brodnik (incorporated herein by reference to the 1992 10-K). 10.20* Amendment to Employment Agreement dated January 1, 1994 between the Company and Timothy Brodnik. 10.21* Amendment to Employment Agreement dated March 1, 1994 between the Company and Timothy Brodnik. 10.22 Employment Agreement dated December 31, 1990 between the Company and Bernard E. Statland (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 filed with the Commission on March 14, 1991, File No. 1- 10740** (the "1990 10-K")). 10.23 Amendment to Employment Agreement dated April 1, 1991 between the Company and Bernard E. Statland (incorporated herein by reference to the 1991 10-K). 10.24 Amendment to Employment Agreement dated June 6, 1991 between the Company and Bernard E. Statland (incorporated herein by reference to the 1991 10-K). 10.25 Amendment to Employment Agreement dated January 1, 1993 between the Company and Bernard E. Statland (incorporated herein by reference to the 1992 10-K). 10.26 Employment Agreement dated January 1, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1990 10-K). 10.27 Amendment to Employment Agreement dated April 1, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1991 10-K). 10.28 Amendment to Employment Agreement dated June 6, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1991 10-K). 10.29 Amendment to Employment Agreement dated January 1, 1993 between the Company and David C. Flaugh (incorporated herein by reference to the 1992 10-K). INDEX TO EXHIBITS Exhibit No. ----------- 10.30 Employment Agreement dated January 1, 1991 between the Company and W. David Slaunwhite (incorporated herein by reference to the 1990 10-K). 10.31 Amendment to Employment Agreement dated April 1, 1991 between the Company and David Slaunwhite (incorporated herein by reference to the 1991 10-K). 10.32 Amendment to Employment Agreement dated June 6, 1991 between the Company and David Slaunwhite (incorporated herein by reference to the 1991 10-K). 10.33 Amendment to Employment Agreement dated January 1, 1993 between the Company and W. David Slaunwhite (incorporated herein by reference to the 1992 10-K). 10.34* Amendment to Employment Agreement dated January 1, 1994 between the Company and W. David Slaunwhite. 10.35* Amendment to Employment Agreement dated March 1, 1994 between the Company and W. David Slaunwhite. 10.36 Employment Agreement dated January 1, 1991 between the Company and John Markus (incorporated herein by reference to the 1990 10-K). 10.37 Amendment to Employment Agreement dated April 1, 1991 between the Company and John Markus (incorporated herein by reference to the 1991 10-K). 10.38 Amendment to Employment Agreement dated June 6, 1991 between the Company and John Markus (incorporated herein by reference to the 1991 10-K). 10.39 Amendment to Employment Agreement dated January 1, 1993 between the Company and John F. Markus (incorporated herein by reference to the 1992 10-K). 10.40* Amendment to Employment Agreement dated January 1, 1994 between the Company and John F. Markus. 10.41* Amendment to Employment Agreement dated March 1, 1994 between the Company and John F. Markus. INDEX TO EXHIBITS Exhibit No. ---------- 10.42 Employment Agreement dated October 1, 1992 between the Company and James G. Richmond (incorporated herein by reference to the 1992 10-K). 10.43 Employment Agreement dated July 6, 1993 between the Company and Michael L. Jeub (incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 filed with the Commission on August 9, 1993, File No. 1-10740 (the "1993 Second Quarter 10-Q")). 10.44 Services Agreement (incorporated herein by reference to Amendment No. 1 to the 1988 S-1). 10.45 Tax Allocation Agreement dated as of June 26, 1990 between MacAndrews & Forbes Holdings Inc., Revlon Group Incorporated, New Revlon Holdings Inc. and the subsidiaries of Revlon set forth on Schedule A thereto (incorporated herein by reference to the Company's Registration Statement on Form S-1 (No. 33- 35782) filed with the Commission on July 9, 1990 (the "1990 S-1")). 10.46 National Health Laboratories 1988 Stock Option Plan, as amended (incorporated herein by reference to the 1990 S-1). 10.47 Revolving Credit Agreement dated as of August 27, 1993 among National Health Laboratories Incorporated, Citicorp USA, Inc. as agent and arranger, and the group of lenders specified therein (incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 filed with the Commission on November 15, 1993, File No. 1-10740 (the "1993 Third Quarter 10-Q")). 10.48 Loan Agreement dated August 1, 1991 among National Health Laboratories Incorporated, Frequency Property Corp. and Swiss Bank Corporation, New York Branch (incorporated herein by reference to the 1991 10-K). INDEX TO EXHIBITS Exhibit No. ----------- 24.1* Consent of KPMG Peat Marwick. 25.1* Power of Attorney of Ronald O. Perelman. 25.2* Power of Attorney of James R. Maher. 25.3* Power of Attorney of Saul J. Farber, M.D. 25.4* Power of Attorney of Howard Gittis. 25.5* Power of Attorney of Ann Dibble Jordan. 25.6* Power of Attorney of David J. Mahoney. 25.7* Power of Attorney of Paul A. Marks, M.D. 25.8* Power of Attorney of Linda Gosden Robinson. 25.9* Power of Attorney of Samuel O. Thier, M.D. 25.10* Power of Attorney of David C. Flaugh. 28.1 Form of Collateral Agency Agreement (Bank Obligations) (incorporated herein by reference to Amendment No. 1 to the 1990 S-1 filed with the Commission on July 27, 1990, File No. 33-35785). ______________ * Filed herewith. ** Previously filed under File No. 0-17031 which has been corrected to File No. 1-10740.

825313_1993.txt

825313_1993

1993

825313

ITEM 1. BUSINESS General The Partnership was formed in 1987 to succeed to the business of ACMC which began providing investment management services in 1971. On April 21, 1988 the business and substantially all of the operating assets of ACMC were conveyed to the Partnership in exchange for a 1% general partnership interest in the Partnership and 30,868,182 Units (adjusted to reflect the Partnership's two for one Unit split effective February 22, 1993). In December 1991 ACMC transferred its 1% general partnership interest in the Partnership to Alliance. On February 10, 1993 the Partnership declared a two for one Unit split payable to Unitholders of record on February 22, 1993. All Unit and per Unit amounts in this Annual Report on Form 10-K have been adjusted where necessary to reflect the Unit split. In July 1992 AXA acquired 49% of the issued and outstanding shares of the capital stock of ECI. ECI is a public company with shares traded on the New York Stock Exchange, Inc. ("NYSE"). ECI owns all of the shares of Equitable. AXA is a member of a group of companies ("AXA Group") that is the second largest insurance group in France and one of the largest insurance groups in Europe. Principally engaged in property and casualty insurance and life insurance in Europe and elsewhere in the world, the AXA Group is also involved in real estate operations and certain other financial services, including mutual fund management, lease financing services and brokerage services. Based on information provided by AXA, as of December 31, 1993, 42.7% of the voting shares (representing 54.8% of the voting power) of AXA were owned by Midi Participations, a French corporation that is a holding company. The voting shares of Midi Participations are in turn owned 60% by Finaxa, a French corporation that is a holding company, and 40% by subsidiaries of Assicurazioni Generali S.p.A., an Italian corporation ("Generali") (one of which, Belgica Insurance Holdings S.A., a Belgian corporation, owned 34.2%). As of December 31, 1993, 62.4% of the voting shares (representing 71.5% of the voting power) of Finaxa were owned by five French mutual insurance companies ("Mutuelles AXA") one of which, AXA Assurance I.A.R.D. Mutuelle, owned 31.6% of the voting shares (representing 45.5% of the voting power), and 27.1% of the voting shares (representing 19.7% of the voting power) of Finaxa were owned by Compagnie Financiere de Paribas, a French financial institution engaged in banking and related activities ("Paribas"). Including the shares owned by Midi Participations, as of December 31, 1993, the Mutuelles AXA directly or indirectly owned 51.7% of the voting shares (representing 64.2% of the voting power) of AXA. In addition, certain subsidiaries of AXA own 0.3% of the shares of AXA which may not be voted. Acting as a group, the Mutuelles AXA control AXA, Midi Participations and Finaxa. The Mutuelles AXA have approximately 1.5 million policyholders. On July 22, 1993 the business and substantially all of the assets of Equitable Capital Management Corporation ("ECMC") were transferred to the Partnership. The Partnership assumed substantially all of ECMC's liabilities and issued 12,500,000 Units (consisting of 12,400,000 Units and a newly created Class A Limited Partnership Interest convertible initially into 100,000 Units). The Partnership issued 11,800,000 of the Units and the Class A Limited Partnership Interest to ECMC. ECMC may receive additional Units valued at up to $25 million under a formula based on contingent incentive fees received by the Partnership prior to April 1, 1998. The remaining 600,000 Units were issued to certain ECMC employees at a substantial discount from market value. In addition, ACMC purchased 2,380,952 Units for $50 million in cash. ECMC and ACMC are wholly-owned subsidiaries of Equitable. As a result of this transaction Equitable's direct and indirect percentage ownership interest in the Units increased to approximately 63%. The transaction was accounted for in a manner similar to the pooling of interests method. Accordingly, all financial data for all periods presented, except as specifically stated herein, has been restated to include the results of operations of ECMC. On March 7, 1994 the Partnership acquired the business of Shields Asset Management, Incorporated ("Shields") and its wholly-owned subsidiary, Regent Investor Services Incorporated ("Regent") for a purchase price of $70 million in cash. Shields and Regent are investment managers with client assets under management aggregating approximately $8 billion as of December 31, 1993. Shields' clients consist primarily of collectively bargained multiemployer retirement plan accounts. Regent's clients are primarily smaller retirement plan accounts and "wrap-fee" accounts of individuals maintained with third-party broker-dealers with whom Regent has entered into agreements under which Regent is one of several investment managers who may be selected by the client. In addition the Partnership issued 645,160 new Units to key employees of Shields and Regent in connection with their entering into long term employment agreements. The Partnership, one of the nation's largest investment advisers, provides diversified investment management services both to institutional clients and, through various investment vehicles, to individual investors. The Partnership's institutional account management business consists primarily of the active management of equity and fixed income accounts. The Partnership's institutional clients include corporate and public employee pension funds, the general and separate accounts of Equitable and its insurance company subsidiaries, endowment funds, and other domestic and foreign institutions. The Partnership's individual investor services, which developed as a diversification of its institutional investment management business, consist of the management, distribution and servicing of mutual funds and cash management products, including money market funds and deposit accounts. The following tables provide a summary of assets under management and associated revenues: ASSETS UNDER MANAGEMENT (in millions) REVENUES (in thousands) Institutional Account Management The Partnership provides investment management services to institutional clients. As of December 31, 1991, 1992, and 1993 institutional accounts (other than investment companies and deposit accounts) represented approximately 72%, 71%, and 68% respectively, of the total assets under management by the Partnership. The fees earned from the management of those accounts represented approximately 44%, 39% and 38% of the Partnership's revenues for 1991, 1992 and 1993, respectively. INSTITUTIONAL ACCOUNT ASSETS UNDER MANAGEMENT (in millions) REVENUES FROM INSTITUTIONAL ACCOUNT MANAGEMENT (in thousands) Investment Management Services The Partnership's institutional account management business consists primarily of the active management of equity accounts, balanced (equity and fixed income) accounts and fixed income accounts. The Partnership also provides active management for venture capital portfolios, and international (non-U.S.) and global (including U.S.) equity, balanced and fixed income portfolios. The Partnership provides "passive" management services for equity, fixed income and international accounts. As of December 31, 1993 the Partnership's accounts were managed by 81 portfolio managers with an average of 16 years of experience in the industry and 10 years of experience with the Partnership. EQUITY AND BALANCED ACCOUNTS. The Partnership's equity and balanced accounts contributed approximately 20%, 21% and 20% of the Partnership's total revenues for 1991, 1992 and 1993, respectively. Assets under management relating to active equity and balanced accounts grew from approximately $19.7 billion as of December 31, 1988 to approximately $33.9 billion as of December 31, 1993. The Partnership has had a distinct and consistent style of equity investing that has remained essentially unchanged since its inception. The Partnership does not emphasize market timing as an investment tool but instead emphasizes long-term trends and objectives, generally remaining fully invested. The Partnership's strategy is to invest in the securities of companies experiencing growing earnings momentum. Consequently, the Partnership's client portfolios tend to include growth stocks. The result of these investment characteristics is that the Partnership's client portfolios tend to have, as compared to the average of companies comprising the Standard & Poor's Index of 500 Stocks ("S&P 500"), a greater market price volatility, a lower average yield, and a higher average price-earnings ratio. The Partnership's principal method of securities evaluation is through fundamental analysis undertaken by its internal staff of full-time research analysts, supplemented by research undertaken by the Partnership's portfolio managers. The Partnership holds frequent investment strategy meetings in which senior management, portfolio managers and analysts establish the Partnership's firmwide investment strategy, including asset classes and mix, investment themes, and industry concentrations. The Partnership's portfolio managers then construct and maintain portfolios that adhere to each client's guidelines and conform to the Partnership's current investment strategy. The Partnership's balanced accounts consist of an equity component and a fixed income component. Typically, from 50% to 75% of a balanced account is managed in the same manner as a separate equity account, while the remaining fixed income component is oriented toward capital preservation and income generation. FIXED INCOME ACCOUNTS. The Partnership's fixed income accounts contributed approximately 20%, 15% and 14% of the Partnership's total revenues for 1991, 1992 and 1993, respectively. Assets under management relating to active fixed income accounts decreased from approximately $30.9 billion as of December 31, 1988 to approximately $30.8 billion as of December 31, 1993. The Partnership's fixed income management services include conventional actively managed bond portfolios in which portfolio maturity structures, market sector concentrations and other characteristics are actively shifted in anticipation of market changes. The fixed income services also include managing portfolios investing in foreign government securities and other foreign debt securities of high quality and short duration, utilizing currency cross hedging to manage currency risk. Sector concentrations and other portfolio characteristics are heavily committed to areas that the Partnership's portfolio managers believe have the best investment values. The Partnership also manages portfolios that are confined to investment in specialized areas of the fixed income markets, such as mortgage-backed securities and high yield bonds. Alliance Corporate Finance Group Incorporated ("ACFG"), a wholly-owned subsidiary of the Partnership, manages investments in private mezzanine financings and private investment limited partnerships. Private mezzanine financings are investments in the subordinated debt and/or preferred stock portion of leveraged transactions (such as leveraged buy-outs, leveraged acquisitions and leveraged recapitalizations). Such investments may be coupled with a contingent interest component or investment in an equity participation, which provide the potential for capital appreciation. ACFG uses a network of investment banks, commercial banks, other financial institutions and issuers to generate investment opportunities in the private placement market. This network permits ACFG to seek to manage risk through high selectivity and diversification strategies. ACFG also seeks to mitigate risk through an ongoing program of monitoring the performance of the companies in its portfolios. In addition, ACFG maintains a separate Investment Recovery Group responsible for maximizing the recovery of clients' investments in troubled companies. ACFG manages two private investment funds designed for institutional investors, with an aggregate of approximately $986 million under management as of December 31, 1993. As of that date, Equitable and its insurance company subsidiaries had investments of approximately $329 million in these funds. The Partnership manages two collateralized bond obligation funds whose pool of collateral debt securities consist primarily of privately-placed, fixed rate corporate debt securities acquired from Equitable and its affiliates. As of December 31, 1993 these funds had approximately $768 million under management. As of that date, Equitable and its insurance company subsidiaries had investments of approximately $374 million in these funds. ACFG also manages two limited partnerships regulated as business development companies under the Investment Company Act of 1940 ("Investment Company Act") which invest primarily in private mezzanine financings. As of December 31, 1993 these funds had net assets of approximately $377 million. OTHER SERVICES. The Partnership's strategy in passive portfolio management is to provide customized portfolios to meet specialized client needs, such as a portfolio fitted to an index of small-capitalization stocks. In addition, the Partnership offers domestic and international indexation strategies, such as portfolios designed to match the performance characteristics of the S&P 500 and the Morgan Stanley Capital International Indices. The Partnership also offers a variety of structured fixed income portfolio applications, including immuniza- tion (designed to produce a compound rate of return over a specified time, irrespective of interest rate movements), dedication (designed to produce specific cash flows at specific times to fund known liabilities) and indexation (designed to replicate the return of a specified market index or benchmark). A subsidiary of the Partnership is the manager of four passive U.K. unit trusts which invest in small capitalization common stocks on a global basis. As of December 31, 1993, the Partnership managed approximately $13.0 billion in passive portfolios. Subsidiaries of the Partnership maintain offices in London, England and Tokyo, Japan which provide international and global investment management and advisory services to institutional and other clients, and in Melbourne, Australia and Vancouver, Canada, Toronto, Canada and Singapore which market investment management services. Clients The approximately 940 institutional accounts (other than investment companies) for which the Partnership acts as investment manager include corporate employee benefit plans, public employee retirement systems, the general and separate accounts of Equitable and its insurance company subsidiaries, endowment funds, foundations, foreign governments and financial and other institutions. Generally, the minimum size for a new separately managed account is $10 million. The general and separate accounts of Equitable and its insurance company subsidiaries are the Partnership's largest institutional clients. As of December 31, 1993 these accounts, excluding investments made by these accounts in The Hudson River Trust (See "Individual Investor Services - The Hudson River Trust"), represented approximately 22.1% of total assets under management by the Partnership and approximately 12.4% of the Partnership's annual revenues for 1993. Prior to the acquisition of the business and substantially all of the assets of ECMC during 1993, corporate employee benefit plans ("corporate plans") constituted the largest segment of the Partnership's institutional clients. As of December 31, 1993, corporate plan accounts represented approximately 17% of total assets under management by the Partnership. Assets under management for other tax-exempt accounts, including public employee benefit funds organized by government agencies and municipalities, endowments, foundations and multi-em- ployer employee benefit plans, represented approximately 28% of total assets under management as of December 31, 1993. The following table lists the Partnership's ten largest institutional clients, ranked in order of size of total assets under management as of December 31, 1993. Since the Partnership's fee schedules vary based on the type of account, the table does not reflect the ten largest revenue generating clients. Client or Sponsoring Employer Type of Account - ----------------------------- --------------- Equitable and its insurance company subsidiaries . . . . . . . . . . . . Equity, Fixed Income, Passive A Foreign Government Central Bank. . . . . . . Equity, Global Equity, Fixed Income, Global Fixed Income North Carolina Retirement System . . . . . . . Passive Equity, Equity, Global Equity BellSouth Corporation. . . . . . . . . . . . . Passive Equity State Board of Administration of Florida . . . Equity, Fixed Income Ford Motor Company . . . . . . . . . . . . . . Equity, Venture Capital Boeing Company . . . . . . . . . . . . . . . . Equity, Balanced Ontario Municipal Employees Retirement System . . . . . . . . . . . . . Passive Equity National Westminster Bancorp, Inc. . . . . . . Equity, Fixed Income Wyoming Retirement System. . . . . . . . . . . Balanced As of December 31, 1993 these institutional clients accounted for approximately 43.0% of the Partnership's total assets under management. No single institutional client other than Equitable and its insurance company subsidiaries accounted for more than approximately 1.1% of the Partnership's total revenues for the year ended December 31, 1993. Since its inception, the Partnership has experienced periods when it gained significant numbers of new accounts or amounts of assets under management and periods when it lost significant accounts or assets under management. These fluctuations result from, among other things, the relative attractiveness of the Partnership's investment style or level of performance under prevailing market conditions, changes in the investment patterns of clients that dictate a shift in assets under management and other circumstances such as changes in the management or control of a client. Investment Management Agreements and Fees The Partnership's institutional accounts are managed pursuant to a written investment management agreement between the client and the Partnership, which usually is terminable at any time or upon relatively short notice by either party. In general, the Partnership's contracts may not be assigned without the consent of the client. In providing investment management services to institutional clients, the Partnership is principally compensated on the basis of fees calculated as a percentage of assets under management. Fees are generally billed quarterly and are calculated on the net asset value of an account at the beginning or end of a quarter or on the average of such values during the quarter. As a result, fluctuations in the amount or value of assets under management are reflected in revenues from management fees within two calendar quarters. Management fees paid on equity and balanced accounts are generally charged in accordance with a fee schedule that ranges from 0.75% (for the first $10 million in assets) to 0.25% (for assets over $60 million) per annum of assets under management. Fees for the management of fixed income portfolios generally are charged in accordance with lower fee schedules, while fees for passive equity portfolios typically are even lower. With respect to approximately 6.1% of assets under management, including certain of the portfolios of the clients listed in the table listing the Partnership's ten largest institutional clients, the Partnership charges performance-based fees, which consist of a relatively low base fee plus an additional fee based on a percentage of assets if invest- ment performance for the account exceeds certain benchmarks. No assurance can be given that such fee arrangements will not become more common in the investment management industry. Utilization of such fee arrangements by the Partnership on a broader basis could create greater fluctuations in the Partnership's revenues. ACFG's fees for corporate finance activities generally involve the payment of a base management fee ranging from 0.10% to 1.00% of assets under management per annum. In some cases ACFG receives incentive fees generally equivalent to 20% of any gains in excess of a specified hurdle rate. In connection with the investment advisory services provided to the general and separate accounts of Equitable and its insurance company subsidiaries the Partnership provides ancillary accounting, valuation, reporting, treasury and other services for regulatory purposes. Marketing The Partnership's institutional products are marketed by marketing specialists assisted by portfolio managers. These marketing specialists solicit business on a full-time basis for the entire range of the Partnership's institutional account management services. Regional office personnel, including investment managers, participate directly in attracting business for their particular office and products. In addition, marketing specialists are dedicated to public retirement systems. Individual Investor Services The Partnership (i) manages and sponsors a broad range of open-end and closed-end mutual funds other than The Hudson River Trust ("Alliance Mutual Funds"), (ii) manages The Hudson River Trust which is the funding vehicle for the variable annuity insurance and variable life insurance products offered by Equitable and its insurance company subsidiaries, and (iii) provides cash management services (money market funds and federally insured deposit accounts) that are marketed to individual investors through broker-dealers and other financial intermediaries. The assets comprising all Alliance Mutual Funds, The Hudson River Trust and deposit accounts on December 31, 1993 amounted to approximately $37.4 billion held in more than 1,500,000 investor accounts. The assets of the Alliance Mutual Funds and The Hudson River Trust are managed by the same investment professionals who manage the Partnership's institutional client accounts. REVENUES FROM INDIVIDUAL INVESTOR SERVICES (in thousands) Alliance Mutual Funds The Partnership has been managing mutual funds since 1971. Since then, the Partnership has sponsored open-end load mutual funds, closed-end mutual funds and offshore mutual funds. On December 31, 1993 the assets in the Alliance Mutual Funds totalled approximately $22.0 billion. Additional funds are under development. The Hudson River Trust The Hudson River Trust is the funding vehicle for the variable annuity insurance and variable life insurance products offered by Equitable and its insurance company subsidiaries. On December 31, 1993 the assets of the various portfolios of The Hudson River Trust were as follows: DISTRIBUTION. The Alliance Mutual Funds are distributed to individual investors through national and regional broker-dealers, insurance sales representatives, banks and other financial intermediaries. Alliance Fund Distributors, Inc. ("AFD"), a registered broker-dealer and a wholly-owned subsidiary of the Partnership, serves as the principal underwriter and distributor of the Alliance Mutual Funds registered under the Investment Company Act of 1940 as "open-end" investment companies ("U.S. Funds") and serves as the placing or distribution agent of the Alliance Mutual Funds not registered under the Investment Company Act ("Offshore Funds"). 63 sales representatives devote their time exclusively to promoting the sale of Alliance Mutual Fund shares by financial intermediaries. Many of the financial intermediaries that sell shares of Alliance Mutual Funds also offer shares of funds not managed by the Partnership and, in some cases, offer shares managed by their own affiliates. During 1993 the Partnership expanded its mutual fund distribution system (the "System") to include a third distribution option. The System permits open- end Alliance Mutual Funds to offer investors the option of purchasing shares (a) subject to a conventional front-end sales charge ("Class A Shares"), (b) without a front-end sales charge but subject to a contingent deferred sales charge payable by shareholders ("CDSC") and higher distribution fees and transfer agent costs payable by the Funds ("Class B Shares") or (c) without either a front-end sales charge or the CDSC but with higher distribution fees payable by the funds ("Class C Shares"). If a shareholder purchases Class A Shares, AFD compensates the financial intermediary distributing the Fund from a portion of the front-end sales charge paid by the shareholder at the time of each sale. If a shareholder purchases Class B Shares, AFD does not collect a front-end sales charge even though AFD is obligated to compensate the financial intermediary at the time of each sale. Payments made to financial intermediaries during 1993 in connection with the System, net of CDSC received, totalled approximately $75.3 million. Management of the Partnership believes AFD will recover the payments made to financial intermediaries from the higher distribution fees and CDSC it receives over periods not exceeding 5 1/2 years. If a shareholder purchases Class C Shares, AFD does not collect a front-end sales charge or CDSC and does not compensate the financial intermediary at the time of sales but the entire amount of the distribution fees attributable to Class C Shares is paid to the financial intermediary. The rules of the National Association of Securities Dealers, Inc. effectively limit the aggregate of all front-end, deferred and asset-based sales charges paid to AFD with respect to any class of its shares by each open-end Alliance Mutual fund to 6.25% of cumulative gross sales of shares of that class, plus interest at the prime rate plus 1% per annum. The open-end U.S. Funds and Offshore Funds have entered into agreements with AFD, under which AFD is paid a distribution services fee. The Partnership uses borrowings and its own resources to finance distribution of open-end Alliance Mutual Fund shares. The selling and distribution agreements between AFD and the financial intermediaries that distribute Alliance Mutual Funds are terminable by either party upon notice (generally of not more than sixty days) and do not obligate the financial intermediary to sell any specific amount of fund shares. A small amount of mutual fund sales is made directly by AFD, in which case AFD retains the entire sales charge paid. During 1993 the ten largest dealers with which AFD had selling agreements were responsible for 72% of the total sales of Alliance Mutual Funds. Equico Securities, Inc. ("Equico"), a wholly-owned subsidiary of Equitable that utilizes members of Equitable's insurance agency sales force as its registered representatives, has entered into a selected dealer agreement with AFD and since 1986 has been responsible for a significant portion of total open-end mutual fund sales (8% in 1993). Equico is under no obligation to sell a specific amount of fund shares and also sells shares of mutual funds sponsored by organizations unaffiliated with Equitable. Subsidiaries of Merrill Lynch & Co., Inc. (collectively "Merrill Lynch") were responsible for approximately 26%, 21% and 35% of Alliance Mutual Fund sales in 1991, 1992 and 1993, respectively. Merrill Lynch is not under any obligation to sell a specific amount of Alliance Mutual Fund shares and also sells shares of mutual funds which it sponsors and which are sponsored by unaffiliated organizations. No other dealer or agent has in any year since 1988 accounted for more than 10% of the sales of open-end Alliance Mutual Funds. Based on market data reported by the Investment Company Institute (December 1993), the Partnership's market share in the U.S. mutual fund industry is 1.32% of total industry assets and the Partnership accounted for 2.69% of total open-end and closed-end fund sales force-derived industry sales in the U.S. during 1993. While the performance of the Alliance Mutual Funds is a factor in the sale of their shares, there are other factors contributing to success in the mutual fund management business that are not present in the institutional account management business. These factors include the level and quality of shareholder services (see "Shareholder and Administration Services" below) and the amounts and types of distribution assistance and administrative services payments. The Partnership believes that its compensation programs with dealers and distributors are competitive with others in the industry. Under current interpretations of the Glass-Steagall Act and other laws and regulations governing depository institutions, banks and certain of their affiliates generally are permitted to act as agent for their customers in connection with the purchase of mutual fund shares and to receive as compensation a portion of the sales charges paid with respect to such purchases. During 1993, banks and their affiliates accounted for approximately 19.7% of the sales of shares of open-end Alliance Mutual Funds. INVESTMENT MANAGEMENT AGREEMENTS AND FEES. Management fees from the Alliance Mutual Funds and The Hudson River Trust vary between .35% and 1.20% per annum of average net assets. As certain of the U.S. Funds have grown, fee schedules have been revised to provide lower incremental fees above certain levels. Fees paid by the U.S. Funds and The Hudson River Trust are fixed annually by negotiation between the Partnership and the board of directors or trustees of each U.S. Fund and The Hudson River Trust, including a majority of the disinterested directors or trustees. Changes in the fees must be approved by the shareholders of each U.S. Fund and The Hudson River Trust. In general, the investment management agreements of the U.S. Funds and The Hudson River Trust provide for termination at any time upon 60 days notice. Investment management fees paid by Alliance Short-Term Multi-Market Trust represented approximately 9%, 10% and 5% of the Partnership's aggregate investment advisory fees in 1991, 1992 and 1993, respectively. Under each investment management agreement with a U.S. Fund, the Partnership provides the U.S. Fund with investment management services, office space and order placement facilities and pays all compensation of directors or trustees and officers of the U.S. Fund who are affiliated persons of the Partnership. Each U.S. Fund pays all of its other expenses. If the expenses of a U.S. Fund exceed an expense limit established under the securities laws of any state in which shares of that U.S. Fund are qualified for sale or as prescribed in the U.S. Fund's investment management agreement, the Partnership absorbs such excess through a reduction in the advisory fee. Currently, the Partnership believes that California is the only state to impose such a limit. The expense ratios for the U.S. Funds during their most recent fiscal year ranged from 0.97% to 2.69%. In connection with newly organized U.S. Funds, the Partnership may also agree to reduce its fee or bear certain expenses to limit a fund's expenses during an initial period of operations. The Partnership does not expect, however, that state expense or voluntary limits, at current fee and expense levels, will have a significant effect on the results of its operations. Cash Management Services The Partnership provides individual cash management services through a product line comprising twelve money market fund portfolios and two types of brokered money market deposit accounts. Assets in these products as of December 31, 1993 totalled approximately $8.1 billion. The Partnership also offers a managed assets program, which provides customers of participating broker-dealers with a Visa Card, access to automated teller machines and check writing privileges. The program is linked to the customer's chosen Alliance money market fund. The program serves to enhance relationships with broker-dealers and to attract and retain investments in the Alliance money market funds, as well as to generate fee income. Under its investment management agreement with each money market fund, the Partnership is paid an investment management fee equal to 0.50% per annum of the fund's average net assets except for ACM Institutional Reserves which pays a fee between 0.20% and 0.45% of its average net assets. In the case of Alliance Capital Reserves, the fee is payable at lesser rates with respect to average net assets in excess of $1.25 billion. For its distribution and account maintenance services rendered in connection with the sale of money market deposit accounts, the Partnership receives fees from the participating banks that are based on outstanding account balances. Because the money market deposit account programs involve no investment management functions to be performed by the Partnership, the Partnership's costs of maintaining the account programs are less, on a relative basis, than its costs of managing the funds. More than 95% of the assets invested in the Partnership's cash management programs are attributable to regional broker-dealers and other financial intermediaries, with the remainder coming directly from the public. Through active sales efforts, the Partnership has been able to increase the number of financial intermediaries that feature the Alliance line. On December 31, 1993 more than 400 financial intermediaries offered Alliance cash management services. The Partnership's money market fund market share (not including deposit products), as computed based on market data reported by the Investment Company Institute (November 1993), has increased from .82% of total money market fund industry assets at the end of 1987 to 1.33% at November 30, 1993. The Partnership makes payments to financial intermediaries for distribution assistance and shareholder servicing and administration. The Alliance money market funds pay fees to the Partnership at annual rates of up to 0.25% of average daily net assets pursuant to "Rule 12b-1" distribution plans. Such payments are supplemented by the Partnership in making payments to intermediaries under the distribution assistance and shareholder servicing and administration program. During 1993 such supplemental payments totalled $22.1 million ($19.6 million in 1992). Nine employees of the Partnership devote their time exclusively to marketing the Partnership's cash management services. A principal risk to the Partnership's cash management services business is the acquisition of its participating intermediaries by companies that are competitors or that plan to enter the cash management services business. As of December 31, 1993 the five largest participating intermediaries were responsible for assets aggregating approximately $4.2 billion, or 51% of the Alliance cash management services total. Donaldson, Lufkin & Jenrette Securities Corporation ("DLJ Securities Corporation"), a subsidiary of Equitable, was one of these intermediaries. Many of the financial intermediaries whose customers utilize the Partnership's cash management services are broker-dealers whose customer accounts are carried, and whose securities transactions are cleared and settled, by the Pershing Division ("Pershing") of DLJ Securities Corporation. Pursuant to an agreement between Pershing and the Partnership, Pershing recommends to certain of its correspondent firms the use of Alliance money market funds and other cash management products. In return, Pershing is allocated a portion of the revenues derived by the Partnership from sales through such Pershing correspondents. During 1993 these payments to Pershing amounted to approxi- mately $2.9 million. As of December 31, 1993 DLJ Securities Corporation and these Pershing correspondents were responsible for approximately 38% of Alliance's total cash management assets. Pershing may terminate its agreement with the Partnership on 180 days' notice. If the agreement were terminated, Pershing would be under no obligation to recommend or in any way assist in the sale of Alliance cash management products and would be free to recommend or assist in the sale of competitive products. The Alliance money market funds are investment companies registered under the Investment Company Act and are managed under the supervision of boards of directors or trustees, which include disinterested directors or trustees who must approve investment management agreements and certain other matters. The investment management agreements between the money market funds and the Partnership provide for an expense limitation of 1% per annum or less of average daily net assets. See "Alliance Mutual Funds." Shareholder and Administration Services Alliance Fund Services, Inc. ("AFS"), a wholly-owned subsidiary of the Partnership, provides registrar, dividend disbursing and transfer-agency related services for each U.S. Fund and provides servicing for each U.S. Fund's shareholder accounts. As of December 31, 1993 AFS employed approximately 257 people. AFS operates out of offices in Secaucus, New Jersey. Under each servicing agreement AFS receives a monthly fee. Each servicing agreement must be approved annually by the relevant U.S. Fund's board of directors or trustees, including a majority of the disinterested directors or trustees, and may be terminated by either party without penalty upon 60 days' notice. Alliance International Fund Services S.A. ("AIFS"), a wholly-owned subsidiary of the Partnership, is the registrar and transfer agent of substantially all of the Offshore Funds. As of December 31, 1993 AIFS employed approximately 4 people. AIFS operates out of its offices in Luxembourg. AIFS receives a monthly fee for its registrar and transfer agency services. Each agreement between AIFS and an Offshore Fund may be terminated by either party upon 60 days' notice. The Partnership expects to continue to devote substantial resources to shareholder servicing because of its importance in competing for assets invested in mutual funds and cash management services. In addition, under most U.S. Fund investment management agreements, the U.S. Funds are authorized to utilize Partnership personnel to perform legal, clerical and accounting services not required to be provided by the Partnership. The payments therefore must be specifically approved in advance by the U.S. Fund's board of directors or trustees. Currently, the Partnership and AFS are accruing revenues for providing clerical and accounting services to such U.S. Funds at the rate of approximately $7.0 million per year. Competition The financial services industry is highly competitive and new entrants are continually attracted to it. No one or small number of competitors is dominant in the industry. The Partnership is subject to substantial competition in all aspects of its business. Pension fund, institutional and corporate assets are managed by investment management firms, broker-dealers, banks and insurance companies. Many of these financial institutions have substantially greater resources than the Partnership. The Partnership competes with other providers of institutional investment products and services primarily on the basis of the range of investment products offered, the investment performance of such products and the services provided to clients. Based on an annual survey conducted by PENSIONS & INVESTMENTS, as of January 1, 1993, prior to the acquisition of the business and assets of ECMC, the Partnership was ranked 10th out of 851 managers based on tax-exempt assets under management, 6th out of the 25 largest managers of active U.S. assets invested abroad, 5th out of the 25 largest managers of international index assets, 6th out of the 25 largest managers of domestic equity index funds and 10th out of the 25 largest managers of mortgage-backed securities. Many of the firms competing with the Partnership for institutional clients also offer mutual fund shares and cash management services to individual investors. Competitiveness in this area is chiefly a function of the range of mutual funds and cash management services offered, investment performance, the quality in servicing customer accounts and the capacity to provide financial incentives to intermediaries through distribution assistance and administrative services payments funded by "Rule 12b-1" distribution plans and the manager's own resources. Custody and Brokerage Neither the Partnership nor its subsidiaries maintains custody of client funds or securities, which is maintained by client-designated banks, trust companies, brokerage firms or other custodians. Custody of the assets of Alliance Mutual Funds, The Hudson River Trust and money market funds is main- tained by custodian banks and central securities depositories. The Partnership generally has the discretion to select the brokers with whom orders for the purchase or sale of securities for client accounts are placed for execution. These brokers include those that have correspondent clearing arrangements with Pershing. Broker-dealers affiliated with Equitable are used to effect transactions for client accounts only if the use of the broker-dealers has been specifically authorized or directed by the client. Regulation The Partnership, ACFG and Alliance are investment advisers registered under the Investment Advisers Act of 1940. Each U.S. Fund is registered with the Securities and Exchange Commission ("SEC") under the Investment Company Act and the shares of most are qualified for sale in all states in the United States and the District of Columbia, except for Funds offered only to residents of a particular state. AFS is registered with the SEC as a transfer agent and AFD is registered with the SEC as a broker-dealer. AFD is subject to minimum net capital requirements ($4.6 million at December 31, 1993) imposed by the SEC on registered broker-dealers and had aggregate regulatory net capital of $5.9 million at December 31, 1993. The relationships of Equitable and its insurance company subsidiaries with the Partnership are subject to applicable provisions of the New York Insurance Law and regulations. Certain of the investment advisory agreements and ancillary administrative service agreements between Equitable and the insurance company subsidiaries and the Partnership are subject to disapproval by the New York Superintendent of Insurance within a prescribed notice period. Under the New York Insurance Law and regulations, the terms of these agreements are to be fair and equitable, charges or fees for services performed are to be reasonable, and certain other standards must be met. Fees must be determined either with reference to fees charged to other clients for similar services or, in certain cases, which include the ancillary service agreements, based on cost reimbursement. The Partnership's assets under management and its revenues derived from the general accounts of Equitable and its insurance company subsidiaries are directly affected by the investment policies for the general accounts. Among the numerous factors influencing general account investment policies are regulatory factors, such as (i) laws and regulations that require diversification of the investment portfolios and limit the amount of investments in certain investment categories such as below investment grade fixed maturities, equity real estate and equity interests, (ii) statutory investment valuation reserves, and (iii) risk-based capital guidelines for life insurance companies approved by the National Association of Insurance Commissioners for implementation beginning with the 1993 statutory financial statements. Equitable is generally following a strategy of directing new general account investments into investment grade securities and reducing its portfolio of below investment grade fixed maturities and currently has a policy of not investing substantial new funds in equity interests. This has the effect of shifting general account assets managed by the Partnership into categories having lower management fees. All aspects of the Partnership's business are subject to various federal and state laws and regulations and to the laws in the foreign countries in which the Partnership's subsidiaries conduct business. These laws and regulations are primarily intended to benefit clients and fund shareholders and generally grant supervisory agencies broad administrative powers, including the power to limit or restrict the carrying on of business for failure to comply with such laws and regulations. In such event, the possible sanctions which may be imposed include the suspension of individual employees, limitations on engaging in business for specific periods, the revocation of the registration as an investment adviser, censures and fines. Employees As of December 31, 1993 the Partnership and its subsidiaries employed 1,284 full-time employees, including 147 investment professionals, of whom 81 are portfolio managers, 58 are securities analysts, and 8 are order placement specialists. The average period of employment of these professionals with the Partnership is approximately 8 years and their average investment experience is approximately 14 years. The Partnership considers its employee relations to be good. Service Marks The Partnership has registered a number of service marks with the U.S. Patent and Trademark Office, including an "A" design logo and the combination of such logo and the words "Alliance" and "Alliance Capital". Each of these service marks was registered in 1986 and has a duration of 20 years from the date of registration (which is automatically renewable) provided the mark continues to be used during that time. ITEM 2. ITEM 2. PROPERTIES The Partnership's principal executive offices at 1345 Avenue of the Americas, New York, New York are occupied pursuant to a lease which extends until 2009. The Partnership currently occupies approximately 186,000 square feet at this location and will lease approximately 15,500 square feet of additional space at this location during 1994. The Partnership also occupies approximately 51,200 square feet at 1285 Avenue of the Americas, New York, New York and approximately 80,000 square feet at 135 West 50th Street, New York, New York under leases expiring in 2001 and 1998, respectively. The Partnership and its subsidiaries, AFD and AFS, occupy approximately 67,000 square feet of space in Secaucus, New Jersey pursuant to a lease which extends until 2003. The Partnership leases substantially all of the furniture and office equipment at the New York and New Jersey offices. The Partnership also leases space in California, Minnesota and Ohio, and its subsidiaries lease space in London, England, Tokyo, Japan, Melbourne, Australia, Vancouver, Canada, Toronto, Canada, Luxembourg and Singapore. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On July 22, 1993 substantially all of the assets of ECMC were transferred to the Partnership and certain of its wholly-owned subsidiaries pursuant to the Amended and Restated Transfer Agreement dated as of February 23, 1993, as amended and restated on May 28, 1993 ("Transfer Agreement"), among the Partnership, ECMC and Equitable Investment Corporation ("EIC"), a wholly-owned subsidiary of Equitable, in exchange for (i) 11,800,000 newly-issued Limited Partnership Interests which were immediately exchanged for 11,800,000 Units, (ii) a newly created Class A Limited Partnership Interest convertible initially into 100,000 Units, and (iii) the assumption by the Partnership and certain of its subsidiaries of certain liabilities of ECMC. The number of Units into which the Class A Limited Partnership Interest is convertible may increase based on the receipt of future contingent incentive fee income. The transfer of such assets and assumption of such liabilities are referred to herein as the "Transfer". On or about June 8, 1993 a lawsuit was filed in the United States District Court of the Southern District of New York by the owner of an annuity contract issued by Equitable against ECMC, the Partnership, Equitable and The Hudson River Trust (PAUL D. WEXLER V. EQUITABLE CAPITAL MANAGEMENT CORPORATION, ET AL.). The Hudson River Trust is the funding vehicle for the variable annuity insurance and variable life insurance products offered by Equitable and The Equitable Variable Life Insurance Company. As of December 31, 1993 the Partnership managed approximately $7.2 billion in net assets invested in The Hudson River Trust. The lawsuit purports to be brought individually and derivatively on behalf of The Hudson River Trust which is an investment company with multiple portfolios registered under the Investment Company Act. The complaint alleges that the transfer to the Partnership of the investment advisory agreement for The Hudson River Trust imposes an unfair burden on The Hudson River Trust under Section 15(f) of the Investment Company Act. The complaint also appears to allege that the fees charged to The Hudson River Trust under the investment advisory agreement constitute excessive compensation for advisory services under Section 36(b) of the Investment Company Act. The complaint seeks a judgment declaring the Transfer to be null and void and terminating the investment advisory agreement between the Partnership and The Hudson River Trust. The complaint also seeks (apparently in the alternative) payment to The Hudson River Trust of certain amounts paid by the Partnership to ECMC pursuant to the Transfer Agreement and payment to The Hudson River Trust of the value of certain compensation arrangements entered into between the Partnership and certain employees of ECMC. On April 23, 1993 the shareholders of each of the portfolios constituting The Hudson River Trust voted to approve the new investment advisory agreement relating to each of the portfolios between the Partnership and The Hudson River Trust. The Partnership believes that the lawsuit is without merit and will vigorously defend against it. EIC has agreed to bear any legal and other costs of the Partnership relating to the defense or settlement of the lawsuit. In addition, since the investment advisory relationship with The Hudson River Trust was an important factor in the Partnership's decision to enter into the Transfer Agreement, ECMC, EIC and the Partnership have agreed in principle that ECMC or EIC will make a cash contribution to the Partnership in order to reflect lost value to the Partnership attributable to any loss in revenue resulting from a settlement of the lawsuit or a final, non-appealable judgment in favor of the plaintiff. In addition, if such a settlement or final, non-appealable judgment results in the termination of the Partnership's relationship with The Hudson River Trust, ECMC and EIC have agreed in principle that such cash contribution will also reflect any costs incurred by the Partnership relating to the termination of such relationship. Neither ECMC nor EIC will receive any Limited Partnership Interest or Units in return for such cash contribution. On February 18, 1994 the Court ordered the complaint dismissed. Plaintiff has filed an appeal. 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. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market for the Units The Units are traded on the New York Stock Exchange ("NYSE"). The high and low sales prices on the NYSE during each quarter of the Partnership's two most recent fiscal years were as follows: On February 10, 1993 the Partnership declared a two for one Unit split payable to Unitholders of record on February 22, 1993. The high and low sales prices above have been adjusted where necessary to reflect the Unit split. On March 14, 1994 the closing price of the Units on the NYSE was $25.125. As of March 14, 1994 there were approximately 1,461 Unitholders of record. Cash Distributions The Partnership distributes on a quarterly basis all of its Available Cash Flow (as defined in the Partnership Agreement). During its two most recent fiscal years the Partnership made the following distributions of Available Cash Flow: On February 10, 1993 the Partnership declared a two for one Unit split payable to Unitholders of record on February 22, 1993. The cash distribution per Unit amounts above have been adjusted where necessary to reflect the Unit split. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data which appears on page 43 of the Alliance Capital Management L.P. 1993 Annual Report to Unitholders is incorporated by reference in this Annual Report on Form 10-K. 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 44 through 52 of the Alliance Capital Management L.P. 1993 Annual Report to Unitholders is incorporated by reference in this Annual Report on Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of Alliance Capital Management L.P. and subsidiaries and the report thereon by KPMG Peat Marwick which appear on pages 53 through 69 of the Alliance Capital Management L.P. 1993 Annual Report to Unitholders are incorporated by reference in this Annual Report on Form 10-K. The financial statement schedule required by Regulation S-X is filed under 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 General Partner The Partnership's activities are managed and controlled by Alliance as General Partner and Unitholders do not have any rights to manage or control the Partnership. The General Partner has agreed that it will conduct no active business other than managing the Partnership, although it may make certain investments for its own account. The General Partner does not receive any compensation from the Partnership for services rendered to the Partnership as General Partner. The General Partner holds a 1% general partnership interest in the Partnership. As of March 14, 1994 ACMC and ECMC, affiliates of the General Partner, held 45,371,500 Units (including 100,000 Units issuable upon conversion of the Class A Limited Partnership Interest). The General Partner is reimbursed by the Partnership for all expenses incurred by it in carrying out its activities as General Partner, including compensation paid by the General Partner to its directors and officers (to the extent such persons are not compensated directly as employees of the Partnership) and the cost of directors and officers liability insurance obtained by the General Partner. The General Partner was not reimbursed for any such expenses in 1993 except for directors' fees. Directors and Executive Officers of the General Partner The directors and executive officers of the General Partner are as follows: Name Age Position ---- --- -------- Dave H. Williams 61 Chairman of the Board, Chief Executive Officer and Director James M. Benson 47 Director Bruce W. Calvert 47 Director, Vice Chairman and Chief Investment Officer John D. Carifa 49 Director, President, Chief Operating Officer and Chief Financial Officer Henri de Castries 39 Director Christophe Dupont-Madinier 42 Director Alfred Harrison 56 Director and Vice Chairman Jean-Pierre Hellebuyck 46 Director Benjamin D. Holloway 69 Director Henri Hottinguer 59 Director Richard H. Jenrette 64 Director Joseph J. Melone 63 Director Brian S. O'Neil 41 Director Frank Savage 55 Director Peter G. Smith 52 Director Madelon DeVoe Talley 62 Director Reba W. Williams 57 Director David R. Brewer, Jr. 48 Senior Vice President and General Counsel Robert H. Joseph, Jr. 46 Senior Vice President-Finance and Chief Accounting Officer Mr. Williams joined Alliance in 1977 and has been the Chairman of the Board and Chief Executive Officer since that time. He was elected a director of Equitable on March 21, 1991 and was elected to the ECI Board of Directors in July of 1992. ECI is a parent of the Partnership. Mr. Williams is the husband of Reba W. Williams. Mr. Benson was elected a Director of Alliance in October 1993. He has been Senior Executive Vice President of ECI and President and Chief Operating Officer of Equitable since March 1994. He was a Senior Vice President of Equitable from March 1993 until March 1994. From January 1984 to March of 1993 he was President of Management Compensation Group. Mr. Benson is also a Director of Equitable, The Association for Advanced Underwriting, Health Plans, Inc., the California Special Olympics, The Joffrey Ballet and The African Wildlife Foundation. Equitable is a parent of the Partnership. Mr. Calvert joined Alliance in 1973 as an equity portfolio manager and was elected Vice Chairman and Chief Investment Officer on May 3, 1993. From 1986 to 1993 he was an Executive Vice President and from 1981 to 1986 he was a Senior Vice President. He was elected a director of Alliance in 1992. Mr. Carifa joined Alliance in 1971 and was elected President and Chief Operating Officer on May 3, 1993. He has been the Chief Financial Officer since 1973. He was an Executive Vice President from 1986 to 1993 and he was a Senior Vice President from 1980 to 1986. He was elected a director of Alliance in 1992. Mr. de Castries was elected a Director of Alliance in October 1993. He has been Executive Vice President of AXA since 1993, previously serving as General Secretary of AXA from 1991 to 1993 and Central Director of Finances from 1989 to 1991. Mr. de Castries is Chairman of Compagnie Financiere de Paris, AXA Banque, Banque d'Orsay, Cecico Financement and Maeschaert Rouusselle. He also is a Director of Ateliers de Construction du Nord de la France, Cecico Location, Orsay Arbitrage, Financiere 78, France Telecom, La Paternelle Monegasque (Monaco), Equitable, Donaldson Lufkin & Jenrette, Inc. ("DLJ") and Equitable Real Estate Investment Management, Inc. Additionally, Mr. de Castries serves as a Representative of Compagnie Financiere de Paris on the Boards of Banque Eurofin and AXA Credit; AXA on the Boards of Investissement Finance et Developpement - I.F.D. and AXA Asset Management; and AXA Assurances Iard on the Board of Colisee Development. AXA and Equitable are parents of the Partnership. Mr. DuPont-Madinier was elected a Director of Alliance in October 1992. He has been the Manager of AXA, International Division, since 1988. Mr. Dupont- Madinier is also director of Anglo Canada General Insurance Company, AXA Insurance Canada, AXA Assurances Canada, AXA Equity & Law UK, DLJ, Equitable Real Estate Investment Management and the chairman and director of AXA Insurance U.K. AXA is a parent of the Partnership. Mr. Harrison joined Alliance in 1978 and was elected Vice Chairman on May 3, 1993. Mr. Harrison is in charge of the Partnership's Minneapolis office and is a senior portfolio manager. He was an Executive Vice President from 1986 to 1993 and a Senior Vice President from 1978 to 1986. He was a director from 1978 to 1987 and from February 23, 1988 until July 27, 1988. He was elected a director of Alliance in 1992. Mr. Hellebuyck was elected a director of Alliance in October 1992. He has been the Chief Investment Officer of AXA since 1986. Mr. Hellebuyck is also a director of AXA Reassurance France, AXA Reinsurance UK Plc, AXA Reinsurance Company, Equity & Law Plc, Equity & Law Investment Managers Ltd., Equity & Law Fondsmanagement GmbH, Europhenix Management Company and Societe Des Bourses Francaises. AXA is a parent of the Partnership. Mr. Holloway was elected a director of Alliance in November 1987. He is a consultant to Tishman/Speyer, Edward J. Debartolo and The Continental Companies. From September 1988 until his retirement in March 1990, Mr. Holloway was a Vice Chairman of Equitable. He served as an Executive Vice President of Equitable from 1979 until 1988. Prior to his retirement he served as a director and officer of various Equitable subsidiaries and Mr. Holloway was also a director of DLJ until March 1990. Mr. Holloway is a director of Rockefeller Center Properties, Inc, Chairman of Duke University Management Corporation, the Cathedral of St. John the Divine Building and Conservation Fund and Touro National Heritage Trust and a Trustee of the Cathedral of St. John the Divine, Duke University and the American Academy in Rome (Emeritus). Mr. Hottinguer was elected a director of Alliance in October 1992. He has been a partner of Hottinguer & Company since 1968. Mr. Hottinguer is also a President/General Director of Banque Hottinguer and Societe Financiere Pour Le Financement De Bureaux Et D'usines - Sofibus, a Vice President, General Director and Administrator of Financiere Hottinguer, a Vice President/Administrator of AXA International, an Administrator of Investissement Hottinguer S.A., AXA, AXA Assurances IARD, UNI Europe Assurances, ALPHA Assurances VIE and FINAXA, and the Controller of Didot Bottin, Caisee d'Escompte Du Midi and Financiere Provence de Participations - F.P.P. He serves as a General Director of Intercom and Sofides, he is a Permanent Representative of La Banque Hottinguer aupres de I.F.D., La Banque Hottinguer aupres de AXIVA, AXA aupres d'AXA Millesimes and Cie Financiere SGTE au sein de la Societe Schneider S.A., is the Associate Gerant of Hottinguer & Cie, and is a Vice President of Gaspee. In addition, he is the Chairman of the Board of Hottinguer Brothers and Co., Inc., a Director of the Helvetia Fund Inc. and DLJ, the President/Counsel of AXA Belgium and AXA Industry S.A., the Administrator of Hestia Fund, ECU Invest, and Hottinguer Gestion and is a Member of Council of Surveillance d'EMBA N.V. AXA is a parent of the Partnership. Mr. Jenrette was a director of Alliance from 1971 to 1985 and was reelected a director in November 1987. He is Chairman of the Board of Directors and Chief Executive Officer of ECI and Chairman of the Executive Committee of the Board of Directors of Equitable. He was Chairman of the Board of Directors of Equitable from July 1987 until March 1994 and has been a Director of Equitable since 1985 and Chairman, President and Chief Executive Officer of EIC since September 1988. He was Chief Investment Officer of Equitable from July 1986 until March 1991. Mr. Jenrette is also a director of Advanced Micro Devices and the New York Historical Society, Chairman of Historic Hudson Valley and Federal Hall Memorial Associates, a Trustee of Rockefeller Foundation and the University of North Carolina and a member of the Visiting Committee of the American Wing, Metropolitan Museum of Art and the Governor's Council on Hudson River Greenway. ECI and Equitable are parents of the Partnership. Mr. Melone was elected a director of Alliance in January 1991. He is President and Chief Operating Officer of ECI and has been Chairman and Chief Executive Officer of Equitable since March 1994. He was President and Chief Executive Officer of Equitable from 1991 until March 1994. From 1984 to 1990, he was President of The Prudential Insurance Company of America. ECI and Equitable are parents of the Partnership. Mr. O'Neil was elected a Director of Alliance in October 1993. He joined Equitable in 1988, serving as a Senior Vice President from February 1989 to April 1992 and was elected Executive Vice President and Chief Investment Officer in April 1992. In addition, Mr. O'Neil is President and Director of FHJV Holdings, Inc., Vice President and Director of The Equitable Variable Life Insurance Company, and Director of Equitable Real Estate Investment Management as well as The Equitable Foundation. Equitable is a parent of the Partnership. Mr. Savage was elected a Director of Alliance in May 1993. He has been Chairman of ACFG, a subsidiary of the Partnership, since July 1993. Prior to this, he was with ECMC, serving as Vice Chairman from June 1989 to April 1992, and Chairman from April 1992 to July 1993. In addition, Mr. Savage is a Director of Lockheed Corporation and ARCO Chemical Corporation. Mr. Smith was elected a Director of Alliance in July 1993. He has been a Managing Director of AXA Equity and Law, a subsidiary of AXA, since January 1991. Mr. Smith was also an Investment Manager with Equity and Law Life Assurance Society plc. from 1983 to 1991. AXA is a parent of the Partnership. Ms. Talley was elected a Director of Alliance in October 1993. She was with Melhado Flynn from January 1987 to December 1989. Ms. Talley is a Governor of the National Association of Securities Dealers, Vice Chairman of the Board of W.P. Carey & Co. as well as a trustee of Smith Barney-Shearson's TRAK, Advisor Fund and Equity & Income Funds. In addition she serves as Director of Corporate Property Associates, Series 10-1 W.P. Carey Real Estate Limited Partnerships, Biocraft Labs, Schroeders Asian Growth Fund, the New York State Industrial Development Board, the New York State Common Retirement Fund and Global Asset Management Funds, Inc. Ms. Williams was elected a Director of Alliance in October 1993. She is currently the Director of Special Projects of the Partnership. She serves on the boards of the India Liberalisation Fund, The Spain Fund, The Austria Fund, The Visiting Committee for Prints and Illustrated Books, The Board of The Spanish Institute (and its Art Advisory Committee), The Wolfsonian Foundation and The Exhibition Committee of The Equitable Gallery. Ms. Williams is the wife of Dave H. Williams. Mr. Brewer joined Alliance in 1987 and has been Senior Vice President and General Counsel since 1991. From 1987 until 1990 Mr. Brewer was Vice President and Assistant General Counsel of Alliance. Mr. Joseph joined Alliance in 1984 and has been Senior Vice President- Finance and Chief Accounting Officer since January 1994. He was Senior Vice President and Controller from 1989 until January 1994. From 1986 until 1989 Mr. Joseph was Vice President and Controller of Alliance and from 1984 to 1986 Mr. Joseph was a Vice President and the Controller of AFS, a subsidiary of the Partnership. Certain executive officers of Alliance are also directors or trustees and officers of various Alliance Mutual Funds and The Hudson River Trust and are directors and officers of certain of the Partnership's subsidiaries. Under the terms of the Standstill Agreement dated as of July 18, 1991, as amended ("Standstill Agreement"), among ECI, Equitable and AXA, AXA or the Voting Trustees are entitled to nominate 49% of the members of the Board of Directors of the General Partner. See "Item 12. Security Ownership of Certain Beneficial Owners and Management - Principal Security Holders". All directors of the General Partner hold office until the next annual meeting of the stockholder of the General Partner and until their successors are elected and qualified. All officers serve at the discretion of the General Partner's Board of Directors. The General Partner has an Audit Committee composed of its independent directors Mr. Holloway and Ms. Talley. The Audit Committee reports to the Board of Directors with respect to the selection and terms of engagement of the Partnership's independent auditors and reviews various matters relating to the Partnership's accounting and auditing policies and procedures. The Audit Committee held four meetings in 1993. The General Partner has a Board Compensation Committee composed of Messrs. Williams, Holloway and Jenrette. The Board Compensation Committee is responsible for compensation and compensation related matters, including, but not limited to, exclusive responsibility and authority for determining bonuses, contributions and awards under most employee incentive plans or arrangements, amending or terminating such plans or arrangements or any welfare benefit plan or arrangement or adopting any new incentive, fringe benefit or welfare benefit plan or arrangement. The Board Compensation Committee consults with a Management Compensation Committee consisting of Messrs. Williams, Calvert, Carifa and Harrison with respect to matters within its authority. The General Partner pays directors who are not employees of the Partnership, Equitable or any affiliate of Equitable an annual retainer of $18,000 plus $1,000 per meeting attended of the Board of Directors and $500 per meeting of a committee of the Board of Directors not held in conjunction with a Board of Directors meeting. Other directors are not entitled to any additional compensation from the General Partner for their services as directors. The Board of Directors meets quarterly. Section 16(a) of the Securities Exchange Act of 1934 requires the General Partner's directors and executive officers, and persons who own more than 10% of the Units, to file with the SEC and NYSE initial reports of ownership and reports of changes in ownership of Units. To the best of the Partnership's knowledge, during the year ended December 31, 1993 all Section 16(a) filing requirements applicable to its executive officers, directors and 10% beneficial owners were complied with, except that initial reports of beneficial ownership on Form 3 were not filed on a timely basis on behalf of Mr. de Castries, Mr. Smith and Ms. Talley, directors of the General Partner, following their elections in 1993. None of them owned any Units then and none has acquired any Units. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following Summary Compensation Table sets forth all plan and non-plan compensation awarded to, earned by or paid to the Chairman of the Board and each of the four most highly compensated executive officers of the General Partner at the end of 1993: On February 10, 1993 the Partnership declared a two-for-one Unit Split payable to Unitholders of record on February 22, 1993. All Unit amounts in Item 11 have been adjusted to reflect the Unit Split. Compensation Agreements with Certain Executive Officers In connection with the transfer of ACMC's business to the Partnership on April 21, 1988 Messrs. Williams, Harrison, Carifa and Calvert entered into employment agreements with the Partnership. Each of these agreements provides for a base salary and bonus eligibility. The agreements with Messrs. Williams, Harrison, Carifa and Calvert expire on April 21, 1994, 1994, 1996 and 1996, respectively. The base salaries of Messrs. Williams, Harrison, Carifa, Calvert and Joseph are currently $225,000, $200,000, $200,000, $200,000 and $140,000 respectively. Each of these agreements provides that the employee will not engage in competitive practices with the Partnership, Alliance or its affiliates for the term of the agreement unless his employment is terminated by the Partnership other than for cause (as defined below), in which case the nature of the non-compete obligation is significantly relaxed and the term is shortened to the lesser of six months or the remaining employment term. Each of the agreements also restricts the disclosure of confidential information and extends broad indemnification rights, including all of the rights of an "indemnified person" under the Partnership Agreement. The employment agreements provide that the Partnership may terminate employment for any reason, provided that if employment is terminated by the Partnership without cause (as defined), the employee will be entitled to receive his base salary under the agreement for the remaining term thereof and the benefits otherwise provided under the employee benefit plans in which he participates. If employment is terminated by the Partnership for cause or by reason of an employee's death or disability (based on a finding by the Board of Directors of the General Partner that the employee is physically or mentally incapacitated and has been unable for a period of six months to perform his duties by reason of that incapacity), the employee will not be entitled to receive any further salary beyond that payable for services to the date of termination. Cause is defined to include an employee's continuing willful failure to perform his duties, his gross negligence or malfeasance in the performance of his duties, his breach of a confidentiality or non-compete obligation, his commission of a felony, and various acts on the employee's part by reason of which the Board of Directors of the General Partner determines that the employee's continued employment would be seriously detrimental to the Partnership. Messrs. Williams, Harrison, Carifa and Calvert may terminate their respective employment agreements if their duties, status or title are changed to a lesser level or rank than that in effect on December 31, 1987. In such event, the terminating employee is treated as if the Partnership had terminated his employment other than for cause. The employment agreements provide for discretionary bonus eligibility. Bonus amounts are fixed by the Board Compensation Committee after receiving recommendations from the Management Compensation Committee. The aggregate amount available for bonuses and contributions and awards under various employee plans to all employees is based on the annual adjusted consolidated net operating earnings of the Partnership. In connection with Equitable's 1985 acquisition of DLJ, the former parent of ACMC, ACMC entered into employment agreements with Messrs. Williams, Harrison, Carifa and Calvert. Each agreement provided for deferred compensation payable in stated monthly amounts for ten years commencing at age 65, or earlier in a reduced amount in the event of disability or death, if the individual involved so elects. The right to receive such deferred compensation is vested. Assuming payments commence at age 65, the annual amount of deferred compensation payable for ten years to Messrs. Williams, Harrison, Carifa and Calvert is $378,900, $328,332, $522,036 and $434,612, respectively. While the Partnership assumed responsibility for payment of these deferred compensation obligations, ACMC and Alliance are required, subject to certain limitations, to make capital contributions to the Partnership in an amount equal to the payments, and ACMC is also obligated to the employees for the payments. ACMC's obligations to make capital contributions to the Partnership are guaranteed, subject to certain limitations, by EIC, the parent of Alliance. Employee Benefit Plans UNIT ACQUISITIONS. In 1988 the executive officers named in the Summary Compensation Table ("Named Executive Officers") acquired from ACMC, pursuant to Restricted Limited Partnership Units Acquisition Agreements ("Restricted Units Agreements"), an aggregate of 5,048,172 Restricted Units. Messrs. Williams, Harrison, Carifa, Calvert and Joseph acquired 1,583,756, 1,583,756, 929,868, 928,638 and 22,154 Restricted Units, respectively. The cost of the Restricted Units was either $0.50 or $1.00 per Restricted Unit. The price for the Restricted Units was paid either by a reduction of the Named Executive Officer's unvested account balance under the Partners Plan, in cash, or a combination thereof. Each Named Executive Officer has the right to vote his Restricted Units and to receive Partnership distributions made on the Restricted Units. All Restricted Units become nonforfeitable, i.e., vest, over periods of employment ending April 21, 1994 and in certain other situations as described below. 1,170,963, 1,170,963, 1,170,962 and 1,163,570 of the Restricted Units issued to the Named Executive Officers vested on April 21, 1990, April 21, 1991, April 21, 1992 and April 21, 1993, respectively. The remaining 371,714 unvested Restricted Units will vest on April 21, 1994. Unvested Restricted Units are not transferable. Cessation of employment with the Partnership during the vesting period will result in the automatic and immediate forfeiture to ACMC (or its designated affiliate) of unvested Restricted Units unless employment ceases as a result of the Named Executive Officer's disability (as defined), death or termination by the Partnership without cause (as defined). Under the definition of cause a resignation caused by reason of the Partnership's changing his duties, status or title to a lesser level or rank than that in effect on December 31, 1987, will result in the full vesting of the Restricted Units issued to Messrs. Williams, Harrison, Carifa and Calvert. Disability and cause for this purpose are defined in the same manner as in the employment agreements discussed above. See "Compensation Agreements with Named Executive Officers." 395,936, 395,936, 185,972, and 185,726 of the Restricted Units acquired by Messrs. Williams, Harrison, Carifa and Calvert, respectively, vested on April 21, 1993. The fair market value of these Restricted Units on the date of vesting is included in column (i) of the Summary Compensation Table. UNIT OPTION PLAN. Pursuant to the Partnership's Unit Option Plan key employees of the Partnership and its subsidiaries, other than Messrs. Williams, Harrison, Carifa and Calvert, may be granted options to purchase up to 4,923,076 Units. Options may be granted only to employees who the Board Compensation Committee of the General Partner, which administers the Plan, after obtaining recommendations from the Management Compensation Committee, determines materially contribute, or are expected to materially contribute, to the growth and profitability of the Partnership's business. The number of options to be granted to any employee is to be determined in the discretion of the Board Compensation Committee. Options may be granted with terms of up to ten years, and an employee's right to exercise each option will vest at a rate no faster than 20% per year commencing on the first anniversary of the date of grant. Each option will have an exercise price no less than the fair market value of the Units subject to option at the time the option is granted, payable in cash. Generally, options may only be exercisable while the optionee is employed by the Partnership. Options may not be granted under the Unit Option Plan after ten years from its adoption. During 1993 none of the Named Executive Officers were granted or awarded options under the Unit Option Plan by the Partnership or exercised any options granted under the Unit Option Plan. As of December 31, 1993 Mr. Joseph held options to purchase 70,000 Units. Options to purchase 38,000 of the Units are currently exercisable. As of December 31, 1993 the aggregate dollar value of Mr. Joseph's exercisable and unexercisable in-the-money options were $732,000 and $528,313, respectively. 1993 UNIT OPTION PLAN. Pursuant to the Partnership's 1993 Unit Option Plan key employees of the Partnership and its subsidiaries may be granted options to purchase Units. The aggregate number of Units that may be the subject of options granted or awarded under the 1993 Unit Option Plan, the Unit Bonus Plan and the Century Club Plan may not exceed 3,200,000 Units ("Overall Limitation"). In addition the maximum aggregate number of Units that may be the subject of options granted or awarded under the 1993 Unit Option Plan, the Unit Bonus Plan and the Century Club Plan in any of the years ended July 22, 1994, 1995, 1996 and 1997 may not exceed 800,000 Units ("Annual Limitation"). The maximum number of Units that may otherwise be the subject of options granted under the 1993 Unit Option Plan may be increased by the number of Units tendered to the Partnership by employees in payment of either the exercise price or withholding tax liabilities. Options may be granted only to employees who a committee of the General Partner consisting of Messrs. Jenrette and Holloway, which administers the Plan, after obtaining recommendations from the Management Compensation Committee, determines materially contribute, or are expected to materially contribute, to the growth and profitability of the Partnership's business. The number of options to be granted to any employee is to be determined in the discretion of the Board Compensation Committee. Options may be granted with terms of up to ten years, and an employee's right to exercise each option will vest at a rate no faster than 20% per year commencing on the first anniversary of the date of grant. Each option will have an exercise price no less than the fair market value of the Units subject to the option at the time the option is granted, payable in cash. Generally, options may only be exercisable while the optionee is employed by the Partnership or one of its subsidiaries. Options may not be granted under the 1993 Unit Option Plan after ten years from its adoption. None of the Named Executive Officers has been granted or awarded options under the 1993 Unit Option Plan. PROFIT SHARING PLAN. The Partnership maintains a qualified defined contribution profit sharing plan covering most employees of the Partnership who have attained age 21 and completed one year of service. Annual contributions are determined by the Board of Directors in its sole discretion and are allocated among participants who are employed by a participating employer on the last business day of the calendar year involved by crediting each participant with the same proportion of the contribution as the participant's base compensation bears to the total base compensation of all participants. The plan provides for a 401(k) salary reduction election under which the Partnership may match a participant's election to reduce up to 5% of base salary. A partici- pant's interest in the plan is 100% vested after the participant has completed three years of service although account balances deriving from salary reductions are 100% vested at all times. The Partnership's contributions under the plan for a given year may not exceed 15% of the aggregate compensation paid to all participants for that year. Contributions to a participant's plan account (including contributions made by a participant) for a particular year may not exceed 25% of the participant's compensation for that year or $30,000, whichever is less. The amount of the benefits ultimately distributed to an employee is dependent on the investment performance of the employee's account under the plan. Distribution of vested account balances under the plan is made upon termination of employment either in a lump sum or in installments for a specific period of years. If a participant dies prior to termination of his employment, the entire value of his account is paid to the participant's beneficiary. For 1993, vested contributions to the plan for the accounts of Messrs. Williams, Harrison, Carifa, Calvert and Joseph were $26,250, $25,000, $25,000, $25,000 and $19,450, respectively. These amounts are included in column (i) of the Summary Compensation Table. PROFIT SHARING PLAN FOR FORMER ECMC EMPLOYEES. The Partnership maintains a qualified defined contribution profit sharing plan covering most former ECMC employees with vesting and benefit contribution allocation methods substantially equivalent to the profit sharing plan maintained by ECMC prior to the acquisition. The plan provides for a 401(k) salary reduction election under which a participant may reduce up to 12% of compensation and the Partnership must match the first 2 1/2% of compensation so reduced in 1993 and 1994. A participant's entire interest in the plan is 100% vested at all times. The Partnership's contributions under the plan for a given year may not exceed 15% of the aggregate compensation paid to all participants for that year. Contributions to a participant's plan account (including contributions made by a participant) for a particular year may not exceed 25% of the participant's base compensation for that year or $30,000, whichever is less. The amount of the benefits ultimately distributed to an employee is dependent on the investment performance of the employee's account under the plan. Distribution of vested account balances under the plan is made upon termination of employment either in a lump sum or in installments for a specific period of years. If a participant dies prior to termination of his employment, the entire value of his account is paid to the participant's beneficiary. None of the Named Executive Officers is a participant in this plan. RETIREMENT PLAN. The Partnership maintains a qualified, non-contributory, defined benefit retirement plan covering most employees of the Partnership who have completed one year of service and attained age 21. Employer contributions are determined by application of actuarial methods and assumptions to reflect the cost of benefits under the plan. Each participant's benefits are determined under a formula which takes into account years of credited service, the participant's average compensation over prescribed periods and Social Security covered compensation. The maximum annual benefit payable under the plan may not exceed the lesser of $100,000 or 100% of a participant's average aggregate compensation for the three consecutive years in which he received the highest aggregate compensation from the Partnership or such lower limit as may be imposed by the Internal Revenue Code on certain participants by reason of their coverage under another qualified plan maintained by the Partnership. A participant is fully vested after the completion of five years of service. The plan generally provides for payments to or on behalf of each vested employee upon such employee's retirement at the normal retirement age provided under the plan or later, although provision is made for payment of early retirement benefits on an actuarially reduced basis. Normal retirement age under the plan is 65. Death benefits are payable to the surviving spouse of an employee who dies with a vested benefit under the plan. The table below sets forth with respect to the retirement plan the estimated annual straight life annuity benefits payable upon retirement at normal retirement age for employees with the remuneration and years of service indicated. Assuming they are employed by the Partnership until age 65, the credited years of service under the plan for Messrs. Williams, Harrison, Carifa, Calvert and Joseph would be 20, 24, 40, 38 and 28, respectively. Compensation on which plan benefits are based includes only base compensation and not bonuses, incentive compensation, profit-sharing plan contributions or deferred compensation. The compensation for calculation of plan benefits for these five individuals for 1993 is $225,000, $200,000, $200,000, $200,000 and $129,673, respectively. UNIT BONUS PLAN. Pursuant to the Partnership's Unit Bonus Plan the Board Compensation Committee may award Units to key employees of the Partnership and its subsidiaries in lieu of all or a portion of the cash bonus that they would otherwise receive. The aggregate number of Units that may be the subject of awards or grants under the Unit Bonus Plan, the 1993 Unit Option Plan and the Century Club Plan may not exceed the Overall Limitations and the maximum aggregate number of Units that may be the subject of awards or grants under the Unit Bonus Plan, the 1993 Unit Option Plan and the Century Club Plan in any of the years ended July 22, 1994, 1995, 1996 and 1997 may not exceed the Annual Limitation. Units that may otherwise be awarded under the Unit Bonus Plan may be increased by the number of Units tendered to the Partnership in payment of withholding tax liabilities in respect of Unit Bonus Plan awards. Units awarded under the Unit Bonus Plan may be vested or unvested (i.e., subject to forfeiture) at the time of award. Unvested Units will vest or become nonforfeitable in accordance with the conditions specified by the Board Compensation Committee at the time of award. None of the Named Executive Officers has been awarded Units under the Unit Bonus Plan. CENTURY CLUB PLAN. Pursuant to the Partnership's Century Club Plan up to 200,000 Units may be awarded to employees of AFD or another subsidiary of the Partnership who attain certain sales targets or sales criteria determined by the Century Club Committee which consists of Messrs. John D. Carifa and Michael Laughlin, President and Executive Vice President of the General Partner, respectively. The maximum aggregate number of Units that may be awarded under the Century Club Plan, the 1993 Unit Option Plan and the Unit Bonus Plan may not exceed the Overall Limitation and the maximum aggregate number of Units that may be awarded under the Century Club Plan, the 1993 Unit Option Plan and the Unit Bonus Plan in any of the years ended July 22, 1994, 1995, 1996 and 1997 may not exceed that Annual Limitation. Units awarded under the Century Club Plan may be vested or unvested (i.e., subject to the forfeiture) at the time of award. Unvested Units will vest or become nonforfeitable in accordance with the conditions specified by the Century Club Committee at the time of award. None of the Named Executive Officers has been awarded Units under the Century Club Plan. PARTNERS PLAN. Since 1983 a nonqualified, unfunded deferred compensation program known as the Partners Plan has been maintained under which certain key employees received incentive awards pursuant to a formula set each year by the Management Compensation Committee. No awards have been or will be made under the Partners Plan for any year after 1987. All awards are fully vested. Unless accelerated, award account balances generally are distributed upon resignation, retirement, disability or death. The Board of Directors of the General Partner has the right to accelerate vesting and make distributions of up to 90% of a participant's account balance if the key employee agrees to extend the term of his employment for a period of at least one year. Until distributed, the awards are credited with interest based on prevailing market rates plus, for the years prior to 1989, a premium if the Partnership's earnings growth rate exceeded certain levels. Interest credited during 1993 for the accounts of Messrs. Williams, Harrison, Carifa and Calvert was $7,323, $3,115, $2,863, and $2,526 respectively. These amounts are included in column (i) of the Summary Compensation Table. This amount is included in column (h) of the Summary Compensation Table. CAPITAL ACCUMULATION PLAN. Since 1985 a nonqualified, unfunded deferred compensation program known as the Capital Accumulation Plan has been maintained to provide retirement benefits for key employees and their beneficiaries which supplement their benefits under the Retirement Plan described above. Under this plan, at the end of 1985, 1986 and 1987, awards were made for each participant, selected on the basis of performance by the Management Compensation Committee, equal to a percentage of the participant's base salary and the participant's discretionary bonus for the year. The amount awarded was credited to the participant's account on the Partnership's books to which interest is thereafter credited, until distributed or forfeited, based on prevailing market rates. A participant's account balance vests based on the participant's years in the plan with no vesting for zero to four years of participation, 30% vesting after five to seven years with gradually increased vesting thereafter ranging to 87% after 35 years of participation and 100% vesting at age 65 or death. Upon termination of employment other than by reason of permanent disability or death, the participant's vested account balance is to be paid out in ten equal annual installments. In the event of permanent disability, the participant is to receive the higher of the vested balance at the time of disability or 50% of the total balance at the time of disability, in either case payable in ten equal annual installments. In the event of death, the participant's beneficiary is to receive the higher of (i) the participant's account balance paid in ten equal annual installments together with interest or (ii) annually 50% of the participant's total cash compensation for the year prior to the year of the participant's death payable until the participant would have attained age 65, but in no event for less than ten years. While the Partnership is responsible for the payment of all obligations under the plan, ACMC and Alliance are required, subject to certain limitations, to make capital contributions to the Partnership in an amount equal to the payments. ACMC's obligations are guaranteed, subject to certain limitations, by EIC. No additional awards will be made under this plan, but employees will continue to vest in their existing account balances and to be credited with interest at prevailing market rates on these balances. A participant's total cash compensation for 1987 increased by 5% per year, compounded annually, will be considered his total cash compensation for purposes of determining the amount of any death benefits payable in respect of the participant. The Board of Directors of the General Partner intends to cancel this plan if tax legislation is enacted which adversely affects certain benefits derived by ACMC from insurance on the lives of certain of the Partnership's employees purchased in connection with the plan. If the plan is cancelled, the Board of Directors of the General Partner may, at its option, either pay each participant his then vested account balance or continue to maintain the account balances for vesting and distribution as described above as if the plan had not terminated, provided that in such event no death benefit based on a participant's total cash compensation will be paid. The plan account balances which became vested during 1993 for the accounts of Messrs. Williams, Harrison, Carifa and Calvert were $30,011, $29,916, $17,658 and $18,423, respectively. These amounts are included in column (i) of the Summary Compensation Table. DEFERRAL PLAN. Under this plan, certain employees of the Partnership may elect to defer for at least one year the receipt of base or bonus compensation otherwise payable in a given year to January 31 of the year selected. Interest is credited at prevailing market rates on the amounts deferred under this plan until paid. In certain cases, 10% of a deferred amount is subject to forfeiture if the employee's employment terminates prior to the January 31 payment date for any reason other than death or disability. There was no compensation deferred from 1993 to a subsequent year for the Named Executive Officers. During 1993 there were no payments of previously deferred compensation to or interest credited on amounts deferred by any of the Named Executive Officers. DLJ PLANS. Prior to Equitable's 1985 acquisition of DLJ, certain employees of the Partnership participated in various DLJ employee benefit plans and arrangements. Since the acquisition, no employer contributions or awards have been made, nor in the future are any employer contributions or awards to be made, under these plans or arrangements for any employee of the Partnership. No deferral of compensation earned by any such employee for services rendered since the acquisition has been permitted under any such plan or arrangement. The Partnership has no liability for and will not bear the cost of any benefits under these plans and arrangements. In 1983, DLJ adopted an Executive Supplemental Retirement Program under which certain employees of the Partnership deferred a portion of their 1983 compensation in return for which DLJ agreed to pay each of them a specified annual retirement benefit for 15 years beginning at age 65. Benefits are based upon the participant's age and the amount deferred and are calculated to yield an approximate 12.5% annual compound return. In the event of the participant's disability or death, an equal or lesser amount is to be paid to the participant or his beneficiary. After age 55, participants the sum of whose age and years of service equals 80 may elect to have their benefits begin in an actuarially reduced amount before age 65. DLJ has funded its obligation under the Program through the purchase of life insurance policies. The following table shows as to the Named Executive Officers who are participants in the Plan the estimated annual retirement benefit payable at age 65. Each of these individuals is fully vested in the applicable benefit. Estimated Annual Name Retirement Benefit ---- ------------------ Dave H. Williams $ 41,825 Alfred Harrison 50,246 John D. Carifa 114,597 Bruce W. Calvert 145,036 ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Principal Security Holders The Partnership has no information that any person beneficially owns more than 5% of the outstanding Units except (i) ACMC and ECMC wholly-owned subsidiaries of ECI, and (ii) as reported on Schedule 13D, filed with the SEC by AXA and certain of its affiliates pursuant to the Securities Exchange Act of 1934. The following table and notes have been prepared in reliance upon such filing for the nature of ownership and an explanation of overlapping ownership. (1) For insurance regulatory purposes the shares of capital stock of ECI beneficially owned by AXA have been deposited into a voting trust which has an initial term of 10 years ("Voting Trust"). The Voting Trustees, who must be members of AXA's Conseil d'Administration (the body analogous to a U.S. corporation's board of directors), are Claude Bebear, Patrice Garnier and Henri de Clermont-Tonnerre. The Voting Trustees have agreed to exercise their voting rights to protect the legitimate economic interests of AXA, but with a view to ensuring that certain of the indirect minority shareholders of ECI do not exercise control over ECI or certain of its insurance subsidiaries. See "Item 1. Business-General". (2) The Voting Trustees may be deemed to be beneficial owners of all Units beneficially owned by AXA. In addition, the Mutuelles AXA, as a group, and each of Finaxa and Midi Participations may be deemed to be beneficial owners of all Units beneficially owned by AXA. By reason of the fact that the Voting Trustees are members of AXA's Conseil d'Administration and by virtue of the provisions of the Voting Trust Agreement, AXA may be deemed to have shared voting power with respect to the Units. Subject to the restrictions on the disposition of shares of the capital stock of ECI in the Standstill Agreement, AXA has the power to dispose or direct the disposition of all shares of the capital stock of ECI deposited in the Voting Trust. By reason of their relationship with AXA, the Mutuelles AXA, as a group, and each of Finaxa and Midi Participations may be deemed to share the power to vote or to direct the vote and to dispose or to direct the disposition of all the Units beneficially owned by AXA. The address of each of AXA, Midi Participations, Finaxa and the Voting Trustees is 23 Avenue Matignon, Paris, France. The addresses of the Mutuelles AXA are as follows: The address of each of AXA Assurances I.A.R.D. Mutuelle and AXA Assurances Vie Mutuelle is La Grande Arche, Paroi Nord, Paris La Defense, France; the address of each of Alpha Assurances Vie Mutuelle and Alpha Assurances I.A.R.D. Mutuelle is 100-101 Terrasse Boieldieu, Paris La Defense, France; and the address of Uni Europe Assurance Mutuelle is 24 Rue Drouot, Paris, France. See "Item 1. Business-General". (3) By reason of their relationship, AXA, the Voting Trustees, ECI, Equitable, ACMC, ECMC, the Mutuelles AXA, Finaxa and Midi Participations may be deemed to share the power to vote or to direct the vote or to dispose or direct the disposition of the 45,371,500 Units. (4) Includes 100,000 Units which are issuable upon conversion of the Class A Limited Partnership Interest. Management The following table shows, as of March 14, 1994, the beneficial ownership of Units by each director and each Named Executive Officer of the General Partner who owns more than 1% of the outstanding Units and by all directors and executive officers of the General Partner as a group: The Partnership has no information that any director of the General Partner, any Named Executive Officer or the directors and executive officers of the General Partner as a group beneficially own any class of equity securities of any of the Partnership's parents or subsidiaries other than directors' qualifying shares except that (i) Mr. Williams has been granted options to purchase 100,000 shares of the common stock of ECI, (ii) Mr. Benson has been granted options to purchase 250,000 shares of the common stock of ECI, (iii) Mr. Calvert has been granted options to purchase 50,000 shares of the common stock of ECI, (iv) Mr. Carifa has been granted options to purchase 50,000 shares of the common stock of ECI, (v) Mr. de Castries has been granted options to purchase 15,000 shares of AXA, (vi) Mr. Dupont-Madinier has been granted options to purchase 7,938 AXA shares, (vii) Mr. Hellebuyck owns 1,125 shares of AXA and has been granted options to purchase 1,500 shares of AXA, (viii) Mr. Hottinguer owns 1,621 shares of AXA and 1,840 shares of Finaxa, (ix) Mr. Jenrette owns 85 shares of the common stock of ECI and has been granted options to purchase 600,000 shares of the common stock of ECI, (x) Mr. Melone owns 182 shares of the common stock of ECI and has been granted options to purchase 400,000 shares of the common stock of ECI, (xi) Mr. O'Neil owns 27 shares of the common stock of ECI and has been granted options to purchase 100,000 shares of the common stock of ECI, (xii) Mr. Savage owns 136 shares of the common stock of ECI, and (xiii) Mr. Smith has been granted options to purchase 1,000 shares of AXA. The General Partner makes all decisions relating to the management of the Partnership. The General Partner has agreed that it will conduct no business other than managing the Partnership, although it may make certain investments for its own account. Conflicts of interest, however, could arise between the General Partner and the Unitholders. Section 17-403(b) of the Delaware Revised Uniform Limited Partnership Act (the "Delaware Act") states that, except as provided in the Delaware Act or the partnership agreement, a general partner of a limited partnership has the same liabilities to the partnership and to the limited partners as a general partner in a partnership without limited partners. While, under Delaware law, a general partner of a limited partnership is liable as a fiduciary to the other partners, the Agreement of Limited Partnership of Alliance Capital Management L.P. (As Amended and Restated)("Partnership Agreement") sets forth a more limited standard of liability for the General Partner. The Partnership Agreement provides that the General Partner is not liable for monetary damages to the Partnership for errors in judgment or for breach of fiduciary duty (including breach of any duty of care or loyalty), unless it is established that the General Partner's action or failure to act involved an act or omission undertaken with deliberate intent to cause injury to the Partnership, with reckless disregard for the best interests of the Partnership or with actual bad faith on the part of the General Partner, or constituted actual fraud. Whenever the Partnership Agreement provides that the General Partner is permitted or required to make a decision (i) in its "discretion," the General Partner is entitled to consider only such interests and factors as it desires and has no duty or obligation to consider any interest of or other factors affecting the Partnership or any Unitholder or (ii) in its "good faith" or under another express standard, the General Partner will act under that express standard and will not be subject to any other or different standard imposed by the Partnership Agreement or applicable law. In addition, the Partnership Agreement grants broad rights of indemnification to the General Partner and its directors and affiliates and authorizes the Partnership to enter into indemnification agreements with the directors, officers, partners, employees and agents of the Partnership and its affiliates. The Partnership has granted broad rights of indemnification to officers of the General Partner and employees of the Partnership. In addition, the Partnership assumed indemnification obligations previously extended by Alliance to its directors, officers and employees. The foregoing indemnification provisions are not exclusive, and the Partnership is authorized to enter into additional indemnification arrangements. The Partnership has obtained directors and officers liability insurance. The Partnership Agreement also allows transactions between the Partnership and the General Partner or its affiliates if the transactions are on terms determined by the General Partner to be comparable to (or more favorable to the Partnership than) those that would prevail with any unaffiliated party. The Partnership Agreement provides that those transactions are deemed to meet that standard if such transactions are approved by a majority of those directors of the General Partner who are not directors, officers or employees of any affiliate of the General Partner (other than the Partnership and its subsidiar- ies) or, if in the reasonable and good faith judgment of the General Partner, the transactions are on terms substantially comparable to (or more favorable to the Partnership than) those that would prevail in a transaction with an unaffiliated party. The Partnership Agreement expressly permits all affiliates of the General Partner (including Equitable and its other subsidiaries) to compete, directly or indirectly, with the Partnership, to engage in any business or other activity and to exploit any opportunity, including those that may be available to the Partnership. Equitable and some of its subsidiaries currently compete with the Partnership. See "Item 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Competition AXA, Equitable and certain of their direct and indirect subsidiaries provide financial services, some of which are competitive with those offered by the Partnership. The Partnership Agreement specifically allows Equitable and its subsidiaries (other than the General Partner) to compete with the Partnership and to exploit opportunities that may be available to the Partnership. Equitable and certain of its subsidiaries have substantially greater financial resources than the Partnership or the General Partner. Financial Services The Partnership Agreement permits Equitable and its affiliates to provide services to the Partnership on terms comparable to (or more favorable to the Partnership than) those that would prevail in a transaction with an unaffiliated third party. The Partnership believes that its arrangements with Equitable and its affiliates are at least as favorable to the Partnership as could be obtained from an unaffiliated third party, based on its knowledge of and inquiry with respect to comparable arrangements with or between unaffiliated third parties. The Partnership acts as the investment manager for the general and separate accounts of Equitable and its insurance company subsidiaries pursuant to investment advisory agreements. During 1993 the Partnership received approximately $55.4 million in fees pursuant to these agreements. In connection with the services provided under these agreements the Partnership provides ancillary accounting, valuation, reporting, treasury and other services for regulatory purposes under service agreements. During 1993 the Partnership received approximately $6.8 million in fees pursuant to these agreements. Equitable provides certain legal and other services to the Partnership relating to certain insurance and other regulatory aspects of the general and separate accounts of Equitable and its insurance company subsidiaries. During 1993 the Partnership paid approximately $1.4 million to Equitable for these services. During 1993 the Partnership paid Equitable approximately $8.3 million for certain services provided with respect to the marketing of the variable annuity insurance and variable life insurance products for which The Hudson River Trust is the funding vehicle. A life insurance subsidiary of Equitable has issued to ACMC life insurance policies on certain employees of the Partnership, the costs of which are to be borne by ACMC without reimbursement by the Partnership. During 1993 ACMC paid approximately $5.7 million in insurance premiums on these policies. The Partnership and its employees are covered by various policies maintained by Equitable and its other subsidiaries. The amount of premiums for these group policies paid by the Partnership to Equitable was approximately $.2 million for 1993. The Partnership provides investment management services to certain employee benefit plans of Equitable and DLJ. Advisory fees from these accounts totalled approximately $2.9 million for 1993 including $1.8 million from the separate accounts of Equitable. Equico was the Partnership's second largest distributor of load mutual funds in 1993 for which it received sales concessions from the Partnership on sales of $475 million. In 1993 Equico also distributed certain of the Partnership's cash management products. Equico received distribution payments totalling $3.0 million in 1993 for these services. DLJ Securities Corporation and Pershing distribute certain Alliance Mutual Funds and cash management products and receive sales concessions and distribution payments. In addition, the Partnership and Pershing have an agreement pursuant to which Pershing recommends to certain of its correspondent firms the use of Alliance cash management products for which Pershing is allo- cated a portion of the revenues derived by the Partnership from sales through the Pershing correspondents. Amounts paid by the Partnership to DLJ Securities Corporation, Pershing and Wood Struthers & Winthrop Management Corp., a subsidiary of DLJ, in connection with the above distribution services were $10.7 million in 1993. DLJ and its subsidiaries also provide the Partnership with brokerage and various other services, including clearing, investment banking, research, data processing and administrative services. Brokerage, the expense of which is borne by the Partnership's clients, aggregated approximately $0.1 million for 1993. During 1993, the Partnership paid $.2 million to DLJ and its subsidiaries for all such other services. Prior to the Partnership's acquisition of ECMC, during 1993 ECMC reimbursed Equitable in the amount of $9.9 million for rent and the use of certain services and facilities. ECMC also paid Equitable $1.9 million pursuant to a tax sharing arrangement. Subsequent to the Partnership's acquisition of ECMC during 1993 the Partnership reimbursed Equitable in the amount of $1.6 million for rent and the use of certain services and facilities. Other Transactions During 1993 the Partnership paid certain legal and other expenses incurred by Equitable and its insurance company subsidiaries relating to the general and separate accounts of Equitable and such subsidiaries for which it has been or will be fully reimbursed by Equitable. The largest amount of such indebtedness outstanding during 1993 was $1.2 million which represents the amount outstanding on December 31, 1993. Equitable and its affiliates are not obligated to provide funds to the Partnership, except for ACMC's and the General Partner's obligation to fund certain of the Partnership's deferred compensation and employee benefit plan obligations referred to under "Compensation Agreements with Named Executive Officers" and "Capital Accumulation Plan". The Partnership Agreement permits Equitable and its affiliates to lend funds to the Partnership at the lender's cost of funds. ACMC and the General Partner are obligated, subject to certain limitations, to make capital contributions to the Partnership in an amount equal to the payments the Partnership is required to make as deferred compensation under the employment agreements entered into in connection with Equitable's 1985 acquisition of DLJ, as well as obligations of the Partnership to various employees and their beneficiaries under the Partnership's Capital Accumulation Plan. In 1993, ACMC made capital contributions to the Partnership of $.7 million. ACMC's obligations to make these contributions are guaranteed by EIC subject to certain limitations. All tax deductions with respect to these obligations, to the extent funded by ACMC, Alliance or EIC, will be allocated to ACMC or Alliance. Reba W. Williams, the wife of Dave H. Williams, was employed by the Partnership during 1993 and received compensation in the amount of $102,000. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K (a) The following is a list of the documents filed as a part of this annual report on Form 10-K: Other schedules are omitted because they are not applicable, or the required information is set forth in the financial statements or notes thereto. (b) REPORTS ON FORM 8-K. A report on Form 8-K dated November 17, 1993 was filed during the last quarter of 1993 reporting that the Partnership had entered into an Asset Purchase Agreement dated November 16, 1993 with Shields Asset Management, Incorporated ("Shields"), Regent Investor Services Incorporated ("Regent"), Furman Selz Holding Corporation and Xerox Financial Services, Inc. to acquire the business and substantially all of the assets of Shields and Regent. (c) Exhibits. The following exhibits required to be filed by Item 601 of Regulation S-K are filed herewith or, in the case of Exhibits 10.54, 10.55, 10.56, 10.57, 10.58 and 13.5, incorporated by reference herein: EXHIBIT DESCRIPTION 10.54 Amended and Restated Transfer Agreement among Alliance Capital Management L.P., Equitable Capital Management Corporation and Equitable Investment Corporation dated as of February 23, 1993 as amended and restated on May 28, 1993 (1) 10.55 Asset Purchase Agreement among Alliance Capital Management L.P., Shields Asset Management, Incorporated, Regent Investor Services Incorporated, Furman Selz Holding Corporation and Xerox Financial Services, Inc. dated November 16, 1993 (2) 10.56 Alliance Capital Management L.P. 1993 Unit Option Plan (3) 10.57 Alliance Capital Management L.P. Unit Bonus Plan (3) 10.58 Alliance Capital Management L.P. Century Club Plan (3) 13.5 Alliance Capital Management L.P. 1993 Annual Report to Unitholders (pages 43 through 69) 21.1 Subsidiaries of the Registrant 23.1 Consent of KPMG Peat Marwick 24.32 Power of Attorney by James M. Benson 24.33 Power of Attorney by Henri de Castries 24.34 Power of Attorney by Christophe Dupont-Madinier 24.35 Power of Attorney by Jean-Pierre Hellebuyck 24.36 Power of Attorney by Benjamin D. Holloway 24.37 Power of Attorney by Henri Hottinguer 24.38 Power of Attorney by Richard H. Jenrette 24.39 Power of Attorney by Joseph J. Melone 24.40 Power of Attorney by Brian S. O'Neil 24.41 Power of Attorney by Peter G. Smith 24.42 Power of Attorney by Madelon DeVoe Talley (1) Filed as an Exhibit to the Registrant's Form 8-K dated August 10, 1993. (2) Filed as an Exhibit to the Registrant's Form 8-K dated November 17, 1993. (3) Filed as an Exhibit to the Registrant's Registration Statement on Form S-8 (File No. 33-65932) filed with the Securities and Exchange Commission on July 12, 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. Alliance Capital Management L.P. By: Alliance Capital Management Corporation, General Partner Date: March 28, 1994 By: /s/Dave H. Williams ---------------------------- Dave H. Williams Chairman 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. Date: March 28, 1994 /s/John D. Carifa ---------------------------- John D. Carifa President, Chief Operating Officer and Chief Financial Officer Date: March 28, 1994 /s/Robert H. Joseph, Jr. ---------------------------- Robert H. Joseph, Jr. Senior Vice President and Chief Accounting Officer Directors /s/Dave H. Williams * - ---------------------------- ---------------------------- Dave H. Williams Benjamin D. Holloway Chairman and Director Director * * - ---------------------------- ---------------------------- James M. Benson Henri Hottinguer Director Director /s/Bruce W. Calvert * - ---------------------------- ---------------------------- Bruce W. Calvert Richard H. Jenrette Director Director /s/John D. Carifa * - ---------------------------- ---------------------------- John D. Carifa Joseph J. Melone Director Director * * - ---------------------------- ---------------------------- Henri de Castries Brian S. O'Neil Director Director * /s/Frank Savage - ---------------------------- ---------------------------- Christophe Dupont-Madinier Frank Savage Director Director /s/Alfred Harrison * - ---------------------------- ---------------------------- Alfred Harrison Peter Smith Director Director * * - ---------------------------- ---------------------------- Jean-Pierre Hellebuyck Madelon DeVoe Talley Director Director *By/s/David R. Brewer, Jr. /s/Reba W. Williams - ---------------------------- ----------------------------- David R. Brewer, Jr. Reba W. Williams (Attorney-in-Fact) Director Alliance Capital Management L.P. Schedule I - Marketable Securities December 31, 1993 Independent Auditors' Report The General Partner and Unitholders Alliance Capital Management L.P. Under date of January 27, 1994, except as to Note 12, which is as of March 7, 1994, we reported on the consolidated statements of financial condition of Alliance Capital Management L.P. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in partners' capital, and cash flows for the years ended December 31, 1993, 1992 and 1991, as contained in the 1993 Annual Report to Unitholders. These consolidated finan- cial 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 schedule as listed in the accompanying index (page 34). This financial statement schedule is the responsibility of Alliance Capital Management Corporation, General Partner. Our responsibility is to express an opinion on this financial statement schedule based on our 1993 audit. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK New York, New York January 27, 1994, except as to Note 12, which is as of March 7, 1994

30875_1993.txt

30875_1993

1993

30875

ITEM 1. BUSINESS The Company was incorporated in Delaware in 1964. The Company designs, develops and produces advanced electronic systems and products, primarily for sale in defense related markets, and provides various related technical services. The Company's largest business segments are the design, development and production of reconnaissance and surveillance systems and command, control and communications systems which represented approximately 80% of the Company's sales in 1993. The Company also designs, develops and manufactures intelligence collection and processing systems, which through reconnaissance and surveillance activities collect radio frequency signals and images, process that data, correlate it with other information ("fusion"), and communicate the information to users including various decision makers, such as battlefield tactical commanders and the National Command Authority. In addition, the Company produces navigation and control systems, and performs aircraft maintenance and modification and other services. Approximately 89% of the Company's sales in 1993 were made under contracts with the U.S. Government or to prime contractors with the U.S. Government and approximately 9% were to international customers (principally governments). A substantial portion of the Company's business is conducted under contracts which carry governmental security classifications, many of which prohibit the disclosure of any of the information concerning the nature of the work being done. The sales and operating profits of the Company's business segments for the three years ending December 31, 1993, are set forth in tables at page 39 of this Annual Report on Form 10-K. The backlog believed to be firm at December 31, 1993 was $2,133 million compared to $2,320 million at December 31, 1992. Approximately 87% of the backlog is represented by contracts with the U.S. Government and prime contractors, excluding foreign military sales contracted directly with the U.S. Government. The backlog figures consist of the sales value of U.S. Government contracts and subcontracts which have been contractually documented and for which funds have been authorized by the procuring agency and contracting authority, and the aggregate sales price of firm orders for undelivered nongovernment business. Approximately 70% of the backlog at December 31, 1993 is expected to result in sales during 1994, and the remainder is expected to result in sales in subsequent years. No single contract accounts for more than 10% of the Company's backlog. RECONNAISSANCE AND SURVEILLANCE The Company believes that it is a leader in design, development and integration of sophisticated reconnaissance and surveillance systems. These systems include signal intelligence systems (i.e., communications and electronic intelligence systems), intrusion detection systems, electronic support measures and automated, remotely controlled reconnaissance systems. A wholly owned subsidiary of the Company, Engineering Research Associates, Inc., headquartered in Vienna, Virginia ("ERA"), designs and develops high frequency surveillance systems. Another wholly owned subsidiary, HRB Systems, Inc., ("HRB") headquartered in State College, Pennsylvania, designs and develops signal collection, processing and analysis systems, which complement the Company's activities in the intelligence and reconnaissance systems market. Strategic reconnaissance and surveillance systems produced by the Company utilize technically advanced sensors, receivers, electro-optical devices, processing equipment, computers and display and communications devices which detect, locate and analyze hostile electromagnetic signals and other data. These systems provide information as to the location and sources of such signals and the functions, operating characteristics and intentions of such sources. The systems consist of various electronic components and other materials manufactured by the Company and others, which are integrated to perform functions specified by customers. Many systems are integrated using complex interconnection and processing equipment such as mini-computers and micro-processors together with related software. These versatile systems are adaptable to meet evolving needs such as arms-control verification, drug interdiction and improved submarine detection. As an example, one program calls for the design, development and production of a transportable ground station integrating multi-sensor processing and dissemination of strategic and tactical imagery. It will provide, for the first time, near real-time imagery intelligence to tactical commanders. Each system will be specifically tailored to the particular branch of the service to which it is assigned and to the commander's unique needs. The Company has developed reconnaissance and surveillance systems which operate in all environments. The Company's activities in the field of airborne reconnaissance and surveillance systems also involve the modification of aircraft, the installation of the systems, flight testing and technical support and maintenance service for the systems. An advanced version of the EGRETT aircraft, developed as a reconnaissance and surveillance platform for the German Air Force, can carry a variety of payloads including signal intelligence, imagery and environment sensors and communications devices. In January 1993, the Company was notified by the German government that it does not plan to proceed with the GAFECS program, which was the principal user of the EGRETT aircraft. The loss of this program adversely impacted the Company's short-term international business goals, however, the Company believes that there are other government and commercial applications for the aircraft, such as special operations and anti-terrorist support, drug interdiction, search and rescue, communications relay, environmental sensing and monitoring, geophysical surveys and scientific experiments. The Company generally engages in the design, development and production of reconnaissance and surveillance systems under a number of separate contracts, each of which involves relatively few units of production. COMMAND, CONTROL AND COMMUNICATIONS The Company develops and produces a broad range of systems and products for instantaneous communication via line-of-sight, satellites or integrated networks. These systems receive information that is gathered by advanced electronic means and conventional measures such as radar, photo reconnaissance and radio. The information is then transmitted to data processing systems and is displayed in a command center in a form which can readily be used to command and control forces and to monitor rapidly changing strategic and tactical events. These systems include communications (both analog and digital), large scale data processing, software, data link terminals, antennas and display equipment. The Commanders Tactical Terminal is a joint service, interoperable system using airborne relays to disseminate and receive intelligence information to widely dispersed field units on a near real-time basis. The Company is developing a high-priority survivable communications integration system for the U.S. Space Command. It uses microwave, satellite, land lines, fiber optics, sensors and processors to provide secure and accurate communications between U.S. early warning stations and The North American Air Defense Command ("NORAD") in Colorado Springs. The Company produces a transportable, interoperable and self-contained signal intelligence system called Celtic, which provides a readily reconfigurable system to support signal acquisition or a combination of signal acquisition and direction finding. Celtic is one of the fundamental building blocks E-Systems is using to expand in the international marketplace. The Company produces a Multi-mission UHF Satcom Transceiver ("MUST"), a full duplex radio, which combines state-of-the-art modem and transceiver functions into a single unit. As the smallest airborne demand assured multiple access and interoperable radio available today, the MUST transceiver supplies upgrades while simplifying existing communication systems. E-Systems has also developed key components of the Government Emergency Telecommunications Service ("GETS"). This service allows priority status for officials and emergency support personnel to establish communication over public telephone networks in times of crisis. E-Systems also designed and furnishes the Data Distribution System, a key element of the United States Navy's Cooperative Engagement Capability, which provides a highly reliable secure data communication link to distribute real time sensor information for ship defense. Threat tracking information is shared interactively between all ships and aircraft in the same battle group. An outgrowth of the Company's command, control and communications business segment has been the development of complex, computer-based digital data storage systems for easy information retrieval and rapid transmission to the users. The Company's EMASS-R- Data Storage and Retrieval System is being marketed to energy exploration companies, which have extremely large geological databases to maintain and access, and to other non-defense Government customers with huge databases. The Company also produces mobile command and control facilities which can be airlifted anywhere in a worldwide command mission area. These shelters are self-contained command centers for the control of airlift operations from tactical airfields which have no other communications facilities in place. They provide secure line-of-sight or satellite data and voice communications. These systems were used during the Iraq-Kuwait war in the Middle East. NAVIGATION AND CONTROLS The Company develops and manufactures automatic control products for aircraft, missile steering and tracking systems, and aircraft navigation aids. Substantially all Boeing commercial jet aircraft, including the 757 and 767 aircraft, flown by domestic and international airlines are equipped with flight controls designed and manufactured by the Company. Flight controls are sold to manufacturers as original equipment and to airlines as replacements. The Company also produces an automatic pilot module for the Boeing 737 and 757. The Company's flight control systems provide the pilot with computer measured responses to stress on aircraft control surfaces or perform other precision control functions. The Company manufactures portable tactical air navigation systems for military use to assist pilots in landing at remote or unimproved locations. AIRCRAFT MAINTENANCE AND MODIFICATION AND OTHER SERVICES The Company provides maintenance, repair and modification services for commercial, executive and military aircraft of all types. Other similar work by the Company involves U.S. Air Force aircraft which are regularly returned to the Company for maintenance and systems updating. In addition, the Company maintains field teams for servicing and operational support throughout the world. The Company also has designed and installed a number of executive or head-of-state custom interiors in various types of aircraft. The Company and a wholly owned subsidiary, Serv-Air, Inc., performs special services such as facilities operations, logistics and support, electronics repair, computer based training and simulation systems and base management and support services at various military installations in both the continental United States and worldwide. The Company provides worldwide technical and logistics support for the United States Air Force fleet of KC-10 aircraft used for in-flight refueling and cargo transport. Logistics support includes an on-line computerized inventory management system, which supports material procurement, inventory control and specialized repair and overhaul activity for more than 10,000 line items. Serv-Air also provides base support to four major U.S. Army Commands, maintaining infrastructure, utilities and services equivalent to those required in a large city. Primary functions include facility engineering, utility systems operation and repair, equipment and vehicle maintenance, audio visual services, supply and inventory control, housing management, transportation and various administrative efforts. At a Government facility in Lexington, Kentucky, Serv-Air converts crash damaged Apache helicopters into training devices. The Company also provides contract field teams on call to modify, maintain or repair aircraft, watercraft, vehicles and heavy support equipment for the U.S. military forces anywhere in the world. Operating from 17 fixed sites and additional remote sites, E-Systems maintains a fleet of 150 aircraft for the U.S. Customs Service. These aircraft are equipped with sophisticated airborne avionics sensor systems, including downward and forward looking infrared sensors. The Company also performs work for the Federal Aviation Administration on its flight inspection fleet of aircraft used to verify the accuracy and integrity of the country's en route flight guidance system and approach and takeoff airport guidance and control. The Company has a contract to modify four Lear Jet Model 60 aircraft and a Challenger 601-3R aircraft for the Federal Aviation Administration in connection with this program. NON-TRADITIONAL BUSINESS As the defense budget declines, the Company is devoting many of its resources and competencies into systems suited for non-defense Government and commercial customers using leading edge technologies developed for the Department of Defense. Although none of the current programs contribute a significant amount of sales or profits to the Company, the management believes that some of these projects will lead to business areas of which may offer growth potential and make contributions to earnings within the not too distant future. Examples of the initiatives throughout the Company include the harnessing of surveillance technology developed for the Department of Defense into products which can provide nondisruptive means to detect traffic incidents and to estimate traffic volume and flow rates. This system, developed in part with a Government grant, is designed to reduce congestion on the public highways and is expected to be part of a national intelligent vehicle highway plan. Another product aimed at the transportation industry is Accutrans, which uses existing technology to develop a real time system for fleet management, location and status of mass transit vehicles. Another system, Vista Flight Net, enhances weather and flight information for the Federal Aviation Administration's Flight Service Stations, making current and accurate information more readily available to the general aviation pilot. Several of the Company's divisions are working on initiatives in the medical and health care industry. The Company's PACS systems (Picture Archiving and Communications System) is the core element of a comprehensive image management and communications system within a major medical center. The Company is performing contracts involving large data handling capabilities to apply this knowledge to the Federal Student Loan program. Designed to detect and locate those who default on student loans, the system provides support for the United States Health, Education and Welfare Department. The emergence of the so-called "Information Highway", and its opportunities for massive data exchange, is leading to demands for increased levels of integrity and privacy in data systems. E-Systems has a family of products called TeleSecurity-TM- which build on defense security communications systems and have been developed as inexpensive and superior wide area network security systems which control remote access to protected resources. The Company's INFOSEC systems offers a completely secure information storage and retrieval system to protect both Government and civilian sensitive data. INFOSEC automates information processing through consolidation of data systems using media encryptors and encrypted compact discs. GOVERNMENT CONTRACTS Companies engaged primarily in supplying defense related equipment to the Government are subject to certain business risks unique to that industry. Among these are dependence on Government appropriations, changing policies and regulations, complexity of design and rapidly changing technologies and possible cost overruns. Since the Government usually awards or funds contracts for only one year at a time, the Company's business depends primarily upon such relatively short-term contracts, the periodic exercise by the Government of contract options and annual funding of continuing contracts. Approximately 47% of the Company's current Government contracts are firm, fixed price contracts accounting for approximately $1.0 billion. Under this type of contract, the price paid to the Company is not subject to adjustment by reason of the costs incurred by the Company in the performance of the contract, except for costs incurred due to contract changes ordered by the Government. Multi-year fixed price contracts normally allow for price revision based on U.S. Government price indices. The Company incurs significant work-in-process costs in the performance of United States Government contracts. However, the Company is usually entitled to invoice the U.S. Government for monthly progress payments on fixed price contracts and twice-monthly on some cost reimbursable contracts. The Government recently reduced the progress payment rate on fixed price contracts from 85% to 75%, increasing the Company's working capital requirements. The Company does not normally acquire inventory in advance of contract award, and the Company does not maintain significant stocks of finished products for sale. Government progress payments affect the amount of working capital necessary for the Company to finance work-in-process costs in the performance of these contracts. The Government does not recognize interest or other costs associated with the use of capital and, therefore, progress payment reductions may have adverse effects on the Company's profitability. The Company also performs work for the Government under cost reimbursable and incentive type contracts. Cost reimbursable contracts provide for reimbursement of costs incurred, to the extent such costs are allowable under Government regulations, plus a fee. Under incentive type contracts, the amount of profit or fee realized varies with the attainment of incentive goals such as costs incurred, delivery schedule, quality and other criteria. Fixed price contracts normally carry a higher profit rate than cost reimbursable and incentive type contracts to compensate for higher business risk. In addition, government law and regulation provides that certain types of costs may not be included in either the directly-billed cost or the indirect overheads for which the government is responsible. Many of these so-called "unallowable" costs include ordinary costs of doing business in a commercial context. These costs must be borne out of the pretax profit of the corporation and, thus, tend to reduce margins on government work. The so called "unallowable costs", which are not recoverable as a cost of business on Government contracts, although they are ordinary and necessary costs of doing business in the commercial context, are spelled out in Government acquisition regulations which do not permit contractors to bill the Government directly or indirectly for specified kinds of costs on Government cost reimbursement contracts, and do not allow these costs to be included in the bidding and pricing structure of negotiated fixed price contracts. The allowability or unallowability of such costs and other similar costs are covered in detail in the Federal Acquisition Regulations. Examples of such unallowable costs, including costs which are generally regarded as ordinary and necessary business expenses are: Public relations and advertising costs; contributions to local civil defense funds and projects; donations; business entertainment; independent research and development costs and bid and proposal costs over a negotiated ceiling; insurance costs to protect from the cost of correcting defects in material and workmanship; interest on borrowings and other financial costs, including costs associated with raising capital; lobbying; organizational costs including pursuit of mergers and acquisitions; patent and intellectual property costs not specifically required by contract; reconversion costs; employee relocation costs (with exceptions); travel and per diem costs in excess of those reimbursed to government employees and certain legal fees. Any Government contract may be terminated for the convenience of the Government at any time the Government believes that such termination would be in its best interests. Under contracts terminated for the convenience of the Government, the Company is entitled to receive payments for its allowable costs and, in general, a proportionate share of its fee or profit for the work actually performed. Recognition of profits is based upon estimates of final performance, which may change as contracts progress. Work may be performed prior to formal authorization or adjustment of contract price for increased work scope, change orders and other funding adjustments. Because of the complexity of Government contracts and applicable regulations, contract disputes with the Government occur in the ordinary course of the Company's business. The resolution of such disputes may affect the profitability of the Company in performing these contracts. The Company believes that adequate provision has been made in its financial statements for these and other normal uncertainties incident to its Government business. Changes to procurement regulations in recent years, as well as the Government's drive against "fraud, waste and abuse" in defense procurement systems have increased the complexity and cost of doing business with the Government. Some of these changes have redefined the ability to recover various standard business costs which the Government will not allow, in whole or in part, as the cost of doing business on Government contracts. Other legal and regulatory practices have increased the number of auditors, inspectors general and investigators to the point that the Company, like every other major Government contractor, is the constant subject of audits, investigations and inquiries concerning various aspects of its business practices. One pending investigation resulted in subpoenas by the Government for a large number of documents, and Government interviews of a large number of current and former employees. The Company believes that this investigation, which has been ongoing for over three years, is currently dormant. The Company is unaware that the investigation produced credible evidence of material wrongdoing by it or its employees and, therefore, believes that charges or claims will not be brought against it or its employees arising from this investigation. The Company regards charges of violation of government procurement regulations as extremely serious and recognizes that such charges could have a material adverse effect on the Company. If the Company is determined to be in noncompliance with any of the applicable laws and regulations, the possibility exists of penalties and debarment or suspension from receiving additional Government contracts. INTERNATIONAL SALES The distribution of the Company's international sales is shown on the table set forth on Page 38 of the Company's 1993 Consolidated Financial Statements included herein. These sales are primarily export sales. Reconnaissance and surveillance systems, high altitude platforms and ground-based transportable aircraft navigation systems are the principal source of international sales revenues of the Company. Since most of the Company's export sales involve technologically advanced products, services and expertise, U.S. export control regulations limit the type of products and services that may be offered and the countries and governments to which sales may be made. Consequently, the Company's international sales may be adversely affected by changes in U.S. Government export policy. In addition, the Company's international sales are subject to risks inherent in foreign commerce, including currency fluctuations and devaluations, changes in foreign governments and their policies, differences in foreign laws and difficulties in negotiating and litigating with foreign sovereigns. The Company believes that it has mitigated certain of these risks by obtaining letters of credit and advance payments and by denominating contracts in U.S. dollars where possible. COMPETITION With the recent end of the "Cold War" and prospects of substantial reductions in defense budgets for the procurement of military systems and equipment, the Company expects that its niche business in the reconnaissance, surveillance and intelligence market will probably be funded at a level which is less drastically cut than other elements of the defense budget. Therefore, the Company expects that its business will become even more attractive to competitors. The Company faces intense competition with respect to all of its products and services. Competition is heightened by "competitive advocates" required of each Department of Defense procurement office, whose jobs are to see that new and renewal contracts are subjected to increased competition. Many of the Company's significant competitors are, or are controlled by, companies which are larger and have substantially greater financial resources than the Company. The Company also competes with small companies operating within a particular business segment. Sales are made principally through competitive proposals in response to requests for bids from U.S. Government agencies and prime contractors. The principal competitive factors are price, technology, service and ability to perform. The Company's business consists largely of projects which involve the production of a relatively small number of units. Due to the diversity and specialized nature of the products produced and the governmental security restrictions applicable to many of the Company's activities, the Company cannot determine its market position in significant areas of its business. However, the Company believes that it is one of the leading manufacturers of reconnaissance and surveillance systems. RESEARCH AND DEVELOPMENT Research and development and the Company's technological expertise have been important factors in the Company's growth. A substantial portion of the Company's business consists of research and development oriented products conducted under cost reimbursable contracts, many of which also result in the production of prototype hardware and systems. It is not possible to estimate separately the value of the research and development portion of these contracts as compared to the preproduction and prototype portion. In 1993, the Company spent approximately $53.2 million on product research, design and development related to U.S. Government contracts (in addition to the activities described in the above paragraph). This compares to approximately $53.9 million in 1992 and $51.4 million in 1991 and includes research, development and engineering and costs incurred to submit bids and proposals for the Company's highly technical products and services to its customers. Most of the expenditures during these periods were recovered by the Company pursuant to independent research and development agreements negotiated with the U.S. Government. These agreements generally provide that the research and development costs up to specified ceiling limits and for specified efforts may be included in the overhead expense charged to certain Government contracts and recovered as part of the contract price. RAW MATERIALS The Company's products require a wide variety of components and materials. The Company has multiple external sources for most of the components and materials it uses in production and produces certain components and materials internally. Although the Company has experienced shortages and long lead times for certain components and materials, such shortages and long lead times have not had a material effect on the Company's business, and the Company believes that the sources and availability of its raw materials are adequate. ENVIRONMENTAL PROTECTION Federal environmental regulation of the electronics manufacturing industry is effected primarily through the Environmental Protection Agency ("EPA"). Regulations promulgated and proposed by the EPA, as well as state and local authorities, contain detailed provisions governing the types and amounts of waste generated from the electronic manufacturing process and the manner of disposal of such waste. Federal "Superfund" legislation mandates the clean-up of toxic waste sites, which may include sites used by the Company and others in the electronics manufacturing industry. See "Item 3. Legal Proceedings, ENVIRONMENTAL MATTERS". EMPLOYEES At December 31, 1993, the Company employed approximately 16,700 persons, approximately 42% of whom are engineers, scientists and highly skilled technicians. Approximately 1,900 of the Company's employees are covered by collective bargaining agreements with various unions. The Company considers its employee relations to be good. PATENTS, TRADEMARKS AND LICENSES The Company is a high technology company and, as such, is a holder of numerous patents. In addition, the Company is a party to various license agreements and has registered trademarks for a number of its products. None of the business segments of the Company are materially dependent upon patents, licenses, or trademarks. ITEM 2. ITEM 2. PROPERTIES. The Company occupies buildings which contain approximately 7,053,000 square feet of floor space. Approximately 1,860,000 square feet are owned by the Company and the remaining 5,195,000 square feet are leased. Approximately 37,000 square feet of space are leased (or subleased) to non-affiliated persons. The principal plants and offices are located as follows: The plant located at Greenville, Texas, is held under a lease, which expires as of October 1, 2017. A portion of the Garland, Texas, facilities of the Company is held under a lease which expires June 1, 2001, with options to renew for seven successive five-year periods. The Falls Church, Virginia, facility is held under a lease which expires in December 2005, with an option to renew for an additional five-year period. The plant located at Salt Lake City, Utah, is held under a lease which expires in October 1994, with options to renew the lease for three successive five-year periods. The facilities located at State College, Pennsylvania are held under various leases expiring from June 1992 to December 2005 with options to renew, ranging from ten years to multiple five-year periods. All real property and buildings are suitable for the Company's business and are generally fully utilized. The plants, machinery and equipment owned and leased by the Company are well maintained and suitable for its operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ENVIRONMENTAL MATTERS ORANGE COUNTY, FLORIDA. An administrative proceeding was instituted in 1984 by the EPA and the Florida Department of Environmental Regulation against approximately 150 entities, including the Company, for disposal of hazardous waste at the City Chemical Company, Inc. hazardous waste recycling plant in Orange County, Florida. The extent of the Company's contribution of hazardous waste to that plant is estimated at 6.55% of the total waste deposited at the site. In conjunction with other Potentially Responsible Parties ("PRP's"), the Company had conducted a Remedial Investigation/Feasibility Study to define the parameters of needed remedial action. Based upon that study, a Record of Decision was issued by the EPA on March 29, 1990. That decision estimates the capital cost of the selected remedial measure at $1,516,725. Estimated operations and maintenance expenditures over a ten year period at the site are approximately $3,000,000. The EPA entered into a settlement agreement with the Company and approximately 130 other PRP's to finance the remedial program. A Consent Decree to effect that program was entered at the U.S. District Court for the Middle District of Florida on December 9, 1991. The design of the remedial program was completed in 1992. A contract for implementation of that design was awarded on January 20, 1993 with construction completion expected in mid-1994. Since the date of the initial Consent Decree, a substantial number of PRP's have exercised their right to buy-out of their liability at this site by paying a substantial premium above their volumetric contribution. As a result of those payments, no payment by the Company has been required to implement the construction of the remedial program; however, at the 80% construction completion point, the EPA will demand, pursuant to the Consent Decree, that the PRP's replenish the trust account by funding it to 120% of the initial program cost estimate. This will require the Company to make a payment of approximately $165,000 in 1994. The trust account will be used for annual operations and maintenance expenditures. Overruns will be funded at approximately 11% by the Company. The Company estimates total liability to the EPA at this site at approximately $400,000. The Company will also be responsible for a portion of the state's environmental response costs based upon its volumetric share of waste sent to the site. Liability for repayment of the state expenditures is estimated at approximately $100,000. SIMPSONVILLE, SOUTH CAROLINA. An Administrative Proceeding was instituted in 1987 by the EPA against the Company, along with other entities, for environmental response costs at the Golden Strip Septic Tank National Priority List (NPL) Site in Simpsonville, South Carolina. The EPA alleges that the Company and its predecessor corporation, LTV, disposed of hazardous waste at this site at various times prior to 1975. Documents relating to these allegations have been destroyed due to the significant lapse of time between the cessation of operations of the Golden Strip Site in 1975 and the notification to the Company from the EPA in 1987. The Company and other potentially Responsible Parties formed a group to conduct a Remedial Investigation/Feasibility Study. That study developed and analyzed several alternative remedial programs. A Record of Decision was executed by the EPA on September 12, 1991 selecting a remedial program estimated to cost approximately $4,000,000 with recurring annual operations and maintenance costs of approximately $75,000. A Consent Decree negotiated between the EPA and the PRP's was lodged in October, 1992. That Decree approves and authorizes implementation of the remedial program selected by the EPA. The environmental consulting firm of RMT, Inc. has completed a detailed design for the selected remedy. The design is currently awaiting EPA approval prior to implementation. The four major PRP's have executed an agreement allocating liability for the remedial costs. Under the terms of the agreement, the Company is responsible for 19.25% of remedial program costs. Two additional companies will participate to the extent of their very limited resources. The 1994 aggregate expenditures for the site are estimated at $1,500,000 with the Company's share being approximately $290,000. The Company's total liability for construction of the remedial program is estimated at approximately $886,000. SALT LAKE CITY, UTAH. The Company entered into a Stipulated Consent Agreement with the State of Utah, Division of Solid and Hazardous Waste on May 16, 1991 based upon preliminary data which indicated that soil and groundwater contamination existed immediately adjacent to a former underground storage tank located at the Montek Division. The Company has identified the lateral extent of the contamination and has proposed a remedial program consisting of limited soil removal and a groundwater pump and treat system. The remedial program is awaiting approval from the State of Utah. Remedial costs for this program are not expected to exceed $950,000 over a three year period. Neither the anticipated costs to be incurred by the Company to clean-up the sites where the Company has been named a "Potentially Responsible Party", the aggregate of those costs, nor the aggregate of all costs to be incurred to clean-up soil and groundwater contamination are expected to have a material adverse effect on the Company's financial condition. The Company is engaged in an industry which uses relatively insignificant quantities and varieties of hazardous chemicals. However, the current state of the law provides for liability without fault for companies dealing with hazardous waste materials. The federal courts have held that a single company may be held liable for the entire clean-up costs at a given site. Therefore, the Company may be sued for the total cost of cleaning up any of the sites where the Company's waste has been deposited. Should the Government institute such an action, the Company will vigorously oppose any attempt to impose liability beyond its volumetric share of waste sent to the site. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages, offices held and other information with respect to each of the executive officers of the Company as of February 25, 1994 are as follows: Each of the executive officers has been employed as indicated in the table above for more than five years except as may be indicated below: E. GENE KEIFFER -- Mr. Keiffer is Chairman of the Board having been elected to that position on April 25, 1989. He had served as Chief Executive Officer from April 25, 1989 to January 26, 1994. Previously he served as Senior Vice President and Group Executive Officer since November 1, 1983. A. LOWELL LAWSON -- Mr. Lawson was elected Chief Executive Officer on January 26, 1994. He has held the position of President since April 25, 1989. Previously he served as Executive Vice President from April 21, 1987 to April 25, 1989 and Senior Vice President and Group Executive since November 1, 1983. TERRY W. HEIL -- Dr. Heil was elected Senior Vice President effective October 12, 1988. Prior to joining the Company at that time, Dr. Heil had been executive vice president of the Defense Electronics Group of the Singer Corporation since 1986 and had held other senior executive positions with Singer for more than five years previous. PETER A. MARINO -- From July 1991 until October 1991, Mr. Marino was executive vice president and chief operating officer of Fairchild Corporation. From September 1989 to July 1991, Mr. Marino was president and chief operating officer of Fairchild Industries, Inc. a high-technology company engaged in spacecraft and space subsystems, military avionics, defense communications, telecommunications, aerospace fasteners and capital equipment for the plastics molding industry. Between October 1988 and September 1989, he was senior vice president of Fairchild Industries, Inc. From October 1986 to September 1988, Mr. Marino was, first, executive vice president and then, president and chief operating officer of Lockheed Electronics Company, Inc. and a vice president of the parent, Lockheed Corporation. Prior to that time, Mr. Marino had been with the United States Central Intelligence Agency from 1970 to 1986, serving in various technical and managerial positions. BRIAN D. CULLEN -- Mr. Cullen served as Vice President of the Company from April 27, 1987 to January 26, 1994. J. ROBERT COLLINS -- Dr. Collins was vice president of business development of the Garland Division, Garland, Texas, from March 16, 1992 to September 22, 1993 when he was elected to his current position. Prior to that, he was division vice president of the Garland Division from May 20, 1985 to March 16, 1992. ART HOBBS -- Prior to his current position, Mr. Hobbs was the vice president of human resources of the Greenville Division, Greenville, Texas, the largest operating division of the Company. He had served in such capacity since 1982, having previously been director of employee relations for three years. JAMES J. REILLY -- Mr. Reilly was director of Financial Controls from April 14, 1989 to August 10, 1989. Before joining the Company, he was Group Controller for the Pullman Company, which is engaged in the production of aerospace and electronic and material components, since 1987. From 1978 to 1987 he was Vice President-Finance for Loral Electronics Systems Division. MARSHALL D. WILLIAMSON -- From February 1, 1993 until being elected to his current position, Mr. Williamson was vice president and assistant general manager of the Garland Division, Garland, Texas. He served as vice president of the Garland Division from May 20, 1985 until February 1, 1993 previously having held various managerial positions since joining the Company in 1975. 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 and London Stock Exchanges and principally traded in those markets. The table below shows the high and low closing prices of the Company's common stock on the New York Stock Exchange, as reported in the WALL STREET JOURNAL, and the cash dividends declared per share for each quarter during the past two years. HOLDERS OF RECORD: At March 4, 1994, there were 10,386 holders of record of the Company's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FIVE-YEAR SUMMARY OF OPERATIONS AND FINANCIAL CONDITION YEAR ENDED DECEMBER 31, 1993 (IN THOUSANDS EXCEPT PER SHARE DATA) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SOURCES OF LIQUIDITY AND CAPITAL RESOURCES -- Net working capital increased $83 million from the prior year-end to $581 million. Net cash provided by operating activities was $96 million for 1993 compared to $123 million for 1992. This change was primarily due to collections of accounts receivable. Cash and cash equivalents at the beginning of the year and funds provided by operations were used to finance capital expenditures of $52 million, pay dividends of $36 million and pay-off $52 million in long-term debt and installment lease obligations. The ratio of total debt to equity was .04 at December 31, 1993 which is down from the total debt to equity ratio of .16 at December 31, 1992. This decrease is due to the $50 million pay-off of the five year, fixed rate Senior Notes in August 1993. The ratio of current assets to current liabilities was 4.4 at December 31, 1993 compared to 3.0 at December 31, 1992. Excluding the effect of adoption of Statement of Financial Accounting Standards (SFAS) No. 106 in 1992, return on equity increased from 15 percent in 1992 to 17 percent in 1993. The Government recently reduced the progress payment rate on fixed-price contracts from 85 percent to 75 percent. This change will increase requirements for working capital. Current financing agreements provide lines of credit up to $350 million of which $24 million was borrowed at December 31, 1993. Management believes these lines of credit and internally generated funds will be more than adequate to meet increased working capital requirements, capital expansion projects, dividend payments to shareholders and satisfy payment of the Company's maturing debt obligations. In the first quarter of 1993, the Company made the decision to fund a portion of the recurring costs associated with retiree health care benefits. To do so, the Company established a 401(h) account, which is a part of the E-Systems Salaried Retirement Plan, and a 501(c)(9) trust known as a voluntary employees' beneficiary association (VEBA). Funding the retiree health care costs will make them allowable under government contracts and deductible under Internal Revenue Service regulations, thereby, minimizing future profit impact. BUSINESS ENVIRONMENT -- The ongoing and dramatic geopolitical changes occurring in the United States and throughout the world continue to result in changes in the requirements and priorities established by Congress and the administration. Defense spending continues to decline with FY 1994 authorization at $262 billion and an administration target of $200 billion by the end of the decade. The total intelligence budget is expected to remain approximately flat over the next several years. Our customer environment is also changing with a continuing re-evaluation of roles and missions, pressure to reduce spending and a push to combine common functions within the various departments and agencies. There continues to be a large number of political and military pressure points throughout the world. The two currently dominating are the Bosnian conflict in Eastern Europe and the uncertainty that exists in the former Soviet Union. The number and diversity of conflicts or potential conflicts, coupled with decreasing forces, makes the intelligence function more important than ever. The company believes there will be a continuing need for precision weapon systems, expert command and control capabilities, and the collection and distribution of precise and timely intelligence information. As a leader in the design, development, deployment and operation of sophisticated information- oriented collection, analysis, monitoring and dissemination systems, the company is well-positioned to respond to these needs. We are also applying our technical and business strengths to markets which are outside our traditional business. This is evidenced by contract awards from the Department of Education for the development and operation of the national data base for student loans and grants and the FAA for the flight inspection aircraft program. The total value of this FAA contract including options exercisable through FY 1996 is approximately $400 million. These programs combined with increasing market acceptance of our EMASS-R- information storage and retrieval products and our continuing push into medical image processing and information are expected to provide a larger non-traditional business base for the company within the next several years. In January 1993, the company was notified by the German government that it does not plan on proceeding with the GAFECS reconnaissance and surveillance program at this time. Though the loss of this program will have an impact on the company's short-term international business goals, we believe there are opportunities in the international arena which will sustain the growth of our international business. With the above mentioned geopolitical changes, the international market for our products and systems is taking on a new look. Governments who previously depended on the United States and/or NATO to provide Command, Control and Communications, surveillance and analysis functions are now faced with providing these capabilities. As a result we are presently seeing opportunities in several countries and have booked projects in some. We believe that this trend, along with our increasing EMASS-R- penetration, will continue to yield a growing international component of our business base. The company is a developer and producer of high technology electronic systems and services, consisting principally of systems design, integration, hardware modification and development for the United States government or other prime government contractors. The company's business base consists of both cost-type and fixed price contracts with 60 percent being cost-type. The profitability of cost-type contracts is contingent upon several factors: customer's evaluation of performance on contracts, costs actually incurred, delivery schedule, quality and incentive or award fee arrangements. Given this determination of profitability, contract costs and related margins are not readily explainable in typical manufacturing terms. Also, due to the nature of the products or services provided by the company, many contracts are highly sensitive and classified under relevant U.S. Government regulations. 1993 COMPARED TO 1992 NET SALES. Net sales for 1993 totaled $2,097 million compared to $2,095 million in 1992. Net sales in the Reconnaissance and Surveillance product segment decreased 9 percent to $1,260 million. The decline is attributable to the absence of the German reconnaissance and surveillance program which was canceled in January of 1993. COSTS AND EXPENSES. Operating profits increased 6 percent in 1993. This increase was primarily due to increased sales in the Aircraft Maintenance & Modification and Other Services product segment and improved margins in the Command, Control & Communications product segment. Operating profits for the Reconnaissance and Surveillance product segment were $111 million, down $3 million when compared to the same period in 1992. Operating profits in the Command, Control and Communications product segment increased $4 million, or 20 percent, to $27 million in 1993. Operating profits in the Aircraft Maintenance & Modification and Other Services product segment were $23 million, up 28 percent, or $5 million in 1993. Other income totaled $10.8 million for 1993 compared to $3.8 million for the same period in 1992. This increase was primarily due to interest associated with a one-time gain from a favorable tax settlement coupled with an increase in capital gains earned on the Company's Supplemental Executive Retirement Plan investments. INCOME. Excluding the cumulative effect of adopting SFAS 106 in 1992, net income increased 12 percent in 1993 to $121 million compared to $109 million in 1992. This increase was due to improved margins discussed above. 1992 COMPARED TO 1991 NET SALES. Net sales from operations increased 5 percent, or $104 million, in 1992. This increase was primarily due to increased deliveries in the Reconnaissance and Surveillance and Aircraft Maintenance & Modification and Other Services product segments. Net sales in the Reconnaissance and Surveillance segment totaled $1,379 million for the year ended December 31, 1992, up 7 percent, or $89 million, from $1,290 million in the comparable period in 1991. Net sales in the Aircraft Maintenance & Modification and Other Services product segment increased $28 million or 10 percent in 1992. COSTS AND EXPENSES. Excluding the effect of adopting SFAS 106, operating profits increased 12 percent in 1992. This increase was primarily the result of increased sales in the Reconnaissance and Surveillance segment and improved margins due to production efficiencies in the Command, Control & Communications product segment. Operating profits for the Reconnaissance and Surveillance product segment were $114 million, up $6 million when compared to the same period in 1991. Operating profits in the Command, Control and Communication product segment increased $3 million, or 14 percent, to $22 million in 1992. Higher than anticipated costs resulted in a decrease in operating profits in the Aircraft Maintenance & Modification and Other Services product segment. Operating profits in this product segment decreased from $23 million in 1991 to $18 million for the year ended December 31, 1992. LOSS. Excluding the effect of adopting SFAS 106, net income increased 10 percent for the year ended December 31, 1992. Adoption of the new accounting standard required recognition of a non-recurring charge of $179 million which resulted in a loss of $69 million for the year. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The index to Consolidated Financial Statements and Financial Statement Schedule is found on page 21. The Company's Financial Statements, Notes to Consolidated Financial Statements and Financial Statement Schedule follow the index. 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 The information required by this item is set forth in the Company's proxy statement dated March 25, 1994 at pages 4 through 7 in the section entitled "Election of Directors," and is incorporated herein by reference. Reference is made to the section entitled "Executive Officers of the Registrant" under Part I. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is set forth in the Company's proxy statement, dated March 25, 1994, at pages 8 through 17, under the sections entitled "Executive Compensation, Salaried Retirement Plan, Supplemental Executive Retirement Plan and Employment Agreements," and is 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 under "Principal Stockholders" on pages 2 and 3 of the Company's proxy statement dated March 25, 1994, and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Inapplicable. 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 2. Financial Statement Schedule The financial statements and the financial statement schedule filed as a part of this report are listed in the "Index to Consolidated Financial Statements and Financial Statement Schedule" on page 21. The index, statements and schedule are incorporated herein by reference. 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. 3. Exhibits required by Item 601 of Regulation S-K. A list of the exhibits required by Item 601 of Regulation S-K and filed as part of this report is set forth in the Index to Exhibits on pages 41 and 42, which immediately precedes such exhibits. (b) Reports on Form 8-K. No reports on Form 8-K were filed for the three months 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. E-SYSTEMS, INC. /s/ A. LOWELL LAWSON -------------------------------------- A. Lowell Lawson DIRECTOR, CHIEF EXECUTIVE OFFICER AND PRESIDENT 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 date indicated. E-SYSTEMS, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE REPORT OF INDEPENDENT AUDITORS Stockholders and Board of Directors of E-Systems, Inc. We have audited the consolidated balance sheets of E-Systems, Inc. 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 three years in the period ended December 31, 1993. Our audits also included the financial statement schedule listed in the index at Item 14(a). These financial statements and schedule are the responsibility of the Company'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 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 E-Systems, 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 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. As discussed in Note J to the consolidated financial statements, in 1992 the company changed its method of accounting for retiree health care and life insurance benefits in accordance with FASB Statement No. 106. ERNST & YOUNG Dallas, Texas January 27, 1994 E-SYSTEMS, INC. AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED OPERATIONS THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS, EXCEPT PER SHARE DATA) See "Notes to Consolidated Financial Statements." E-SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) ASSETS See "Notes to Consolidated Financial Statements." E-SYSTEMS, INC. AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) See "Notes to Consolidated Financial Statements." E-SYSTEMS, INC. AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED STOCKHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) See "Notes to Consolidated Financial Statements." E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 NOTE A -- SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION -- The accounts of all subsidiaries have been included in the consolidated financial statements. All significant intercompany accounts and transactions have been eliminated. REVENUE AND PROFIT DETERMINATION -- Sales and costs of sales (including general and administrative expenses) on fixed-price contracts are generally recorded when units are delivered, based on the profit rates anticipated on the contracts at completion. Sales and costs of sales on long-term, small quantity, high unit value fixed-price contracts, and sales (costs and fees) on cost reimbursable contracts are recorded under the percentage-of-completion method of accounting as costs (including general and administrative expenses) are incurred. Profits expected to be realized on contracts are based on estimates of total sales value and costs at completion. These estimates are reviewed and revised periodically throughout the lives of the contracts and adjustments to profits resulting from such revisions are made cumulative to the date of change. Amounts in excess of agreed upon contract price for customer-caused delays, errors in specification and design, unapproved change orders or other causes of unanticipated additional costs are recognized in contract value if it is probable that the claim will result in additional revenue and the amount can be reasonably estimated (SEE NOTE C). Losses on contracts are recorded in full as they are identified. FIXED-PRICE CONTRACTS AND RAW MATERIALS -- Costs incurred in advance of contractual coverage receive an allocated portion of general and administrative expenses and are valued at the lower of cost incurred or market. Raw materials and purchased parts are valued at average cost not in excess of market. PROPERTY, PLANT AND EQUIPMENT -- Property, plant and equipment are stated at cost. Capitalized leases are recorded at the present value of the net fixed minimum lease commitments (SEE NOTE H). Provisions for depreciation are computed on both accelerated and straight-line methods using rates calculated to amortize the cost of the assets over their estimated useful lives and include amortization of capitalized leases. Leasehold improvements are amortized over the life of the lease and renewal options which are expected to be exercised. The company's policy is to remove the amounts related to fully-depreciated assets from the financial records. EARNINGS PER SHARE -- Earnings per share are computed based on the sum of the average outstanding common shares and common equivalent shares (1993 -- 34,041,000; 1992 -- 32,941,000; 1991 -- 32,723,000). Common equivalent shares assume the exercise of all dilutive stock options. Primary and fully diluted earnings per share are essentially the same. STATEMENT OF CASH FLOWS -- The company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. COSTS IN EXCESS OF NET ASSETS ACQUIRED -- The costs in excess of net assets acquired (goodwill) are being amortized using the straight-line method over a period of 20 to 40 years. Accumulated amortization was $6,557,000 and $4,580,000 at December 31, 1993 and 1992, respectively. FINANCIAL INSTRUMENTS AND RISK CONCENTRATION -- Financial instruments which potentially subject the company to concentrations of credit risk consist of cash equivalents, billed accounts receivable and unreimbursed costs and fees under cost-plus-fee contracts. The company's cash equivalents consist principally of U.S. Government securities and Eurodollar accounts with high credit quality financial institutions. Generally, the investments mature within 90 days and therefore are subject to minimal risk. Billed accounts receivable and unreimbursed costs and fees under cost-plus-fee contracts result primarily from contracts with the U.S. Government or prime contractors with the U.S. E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE A -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Government and some international customers (principally governments). Contracts involving the U.S. Government do not require collateral or other security. The company conducts ongoing credit evaluations of domestic non-U.S. Government customers and generally does not require collateral or other security from these customers. The company generally requires international customers to furnish letters of credit or make advance payments in amounts sufficient to limit the company's credit risk to a minimal level. Historically, the company has not incurred any significant credit-related losses. RECLASSIFICATIONS -- Certain prior year amounts have been reclassified to conform to the current year presentation. NOTE B -- RECEIVABLES Accounts Receivable and Unreimbursed Costs and Fees Under Cost-Plus-Fee Contracts by major classification are as follows: Accrued recoverable costs and profits and accrued costs and fees under customer contracts represent revenue earned under the percentage-of-completion method but not yet billable under the terms of the contracts. These amounts are billable based on the terms of the contract which include shipments of the product, achievement of milestones or completion of the contract. Substantially all of the accrued recoverable costs and profits and accrued costs and fees at December 31, 1993 are to be billed during 1994. Offset against accrued recoverable costs and profits are unliquidated progress payments of $470,604,000 for 1993 and $549,950,000 for 1992. E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE C -- FIXED-PRICE CONTRACTS Cost elements included in Fixed-Price Contracts in Progress are as follows: Substantially all of the costs incurred in advance of negotiated contracts at December 31, 1993 are expected to receive firm contractual coverage in 1994. NOTE D -- DEBT The company's long-term debt at December 31 is summarized as follows: As of December 31, 1993, the maturities of long-term debt were as follows: The company has two lines of credit dated October 21, 1992, with total credit available of $250 million. One credit agreement in the amount of $150 million terminates October 19, 1995, and the other agreement in the amount of $100 million terminates October 14, 1994 and contains a provision for a one-year extension. These agreements, with a group of eight banks, provide for a floating interest rate based upon competitive bids from the member banks and repayment terms negotiated at the time of each borrowing. The credit agreement in the amount of $150 million provides for a facility fee of .15 percent of the committed amount, and the credit agreement in the amount of $100 million provides for a facility of .125 percent of the committed amount. The company had no borrowings under either line in 1993. The company has total lines of credit available under short-term borrowing agreements of $100 million of which none and $19,533,000 were borrowed at December 31, 1993 and 1992, respectively. The lines of credit provide for interest at each bank's offered rate at the date of the advance. E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE D -- DEBT (CONTINUED) Borrowings under the ESOP line of credit were used to purchase the company's common stock for contribution to the company's Employee Stock Ownership Plan. The company's various debt agreements require, among other things, that the Company maintain a specified current ratio, debt to equity ratio, and tangible net worth. Under the most restrictive of these covenants, the company has unrestricted retained earnings of $169,996,000 at December 31, 1993. The company made interest payments in 1993, 1992, and 1991, respectively, of $7,027,000, $6,817,000, and $7,880,000. NOTE E -- INCOME TAXES During 1992, the company adopted FASB Statement No. 109 "Accounting for Income Taxes." The adoption had no material impact on the company's financial statements. A reconciliation of the provision for taxes on income to the U.S. statutory rate follows: Deferred income taxes result primarily from the use of accelerated methods of depreciation for tax purposes, pension income not currently taxable and safe harbor leasing transactions offset by accrued employee and retiree benefits which are not deductible until paid. E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE E -- INCOME TAXES (CONTINUED) The tax effects of the significant temporary differences which comprise the deferred tax assets and liabilities at December 31, 1993 and 1992 are as follows: A valuation allowance has not been recorded for the deferred federal income tax benefits as the company believes it will generate sufficient taxable income in the future to realize all of the recorded benefits. Included in operating costs and expenses are state income taxes of $6,688,000, $6,575,000, and $2,700,000 in 1993, 1992 and 1991, respectively. The company made federal income tax payments in 1993, 1992, and 1991, respectively, of $55,450,000, $62,027,000, and $43,250,000. NOTE F -- ACCRUED LIABILITIES NOTE G -- STOCKHOLDERS EQUITY At December 31, 1993, there were 50,000,000 authorized shares of common stock and 185,000 shares of authorized but undesignated preferred stock, par value $20. E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE G -- STOCKHOLDERS EQUITY (CONTINUED) Stock option plans, which include both "nonqualified" and incentive stock options, provide for options to be granted to key employees at prices equal to, greater than or less than market value at the date of grant and for terms not to exceed ten years. The options outstanding under the plan expire at various dates through 2003. Information on stock options is summarized as follows: NOTE H -- LEASE COMMITMENTS Certain plant facilities are leased under agreements expiring at various dates through 2017. Substantially all of the leases for plant facilities may be renewed for up to seven years after the initial term of the lease. The capitalized value of leases amounted to $17,461,000 and $25,568,000 at December 31, 1993 and 1992, respectively, and net book value amounted to approximately $9,765,000 and $11,352,000 at December 31, 1993 and 1992, respectively. E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE H -- LEASE COMMITMENTS (CONTINUED) Future minimum payments as of December 31, 1993 under the capital leases and noncancelable operating leases with initial or remaining terms of one year or more follow: Lease expense on plant facilities, machinery and equipment amounted to $18,890,000, $22,616,000 and $24,015,000 in 1993, 1992, and 1991, respectively. NOTE I -- EMPLOYEE BENEFITS The company has several noncontributory defined benefit pension plans covering substantially all employees. Plans covering salaried and non-union employees provide pension benefits that are based on the highest consecutive 60 months of an employee's compensation. Plans covering employees governed by collective bargaining agreements generally provide pension benefits of stated amounts for each year of service and provide for supplemental benefits for employees who retire with 20 years of service before age 62. The company's funding policy for all plans is to make annual contributions generally equal to the amounts accrued for pension expense, up to the maximum amount that can be deducted for federal income tax purposes. A summary of the components of net periodic expense for the company's defined benefit plans and SERP follows: E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE I -- EMPLOYEE BENEFITS (CONTINUED) The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheets for the company's defined benefit pension plans, excluding the SERP: Approximately 52 percent of the defined benefit plans' assets at December 31, 1993 are invested in mutual funds, commercial paper, common stocks and other assets, and 48 percent of the plans' assets are invested in real estate. The market value of the common stock of the company held by the plans was $63,960,000 at December 31, 1993. The company also sponsors a Supplemental Executive Retirement Program (SERP), which is a nonqualified plan that provides certain officers with defined pension benefits in excess of limits imposed by federal tax laws. The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheets for the company's SERP: E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE I -- EMPLOYEE BENEFITS (CONTINUED) The company has established a trust to fund the payment of pension benefits under the SERP. Trust assets totaled $42,134,000 and $38,497,000 at December 31, 1993 and 1992, respectively, and are included in Deferred Charges and Other in the Consolidated Balance Sheets. The assets of the Trust are invested at the discretion of the outside trustee, and at December 31, 1993, consisted primarily of listed common stock, convertible securities and fixed-income investments. Marketable equity securities held by the Trust are carried at the lower of aggregate cost or market. Income and expenses of the Trust are included in the company's consolidated income and expenses. At December 31, 1993, the outside trustee estimates the market value of the trust assets to be $46,119,000. The Trust became irrevocable in 1988 subject only to the claims of creditors in the event of insolvency of the company. 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," effective for fiscal years beginning after December 15, 1993. The company plans to adopt the Statement in 1994, and it is not expected to have a material impact on the company's financial position or results of operations. The company has an Employee Stock Ownership Plan (ESOP) which includes substantially all employees. The ESOP provides for voluntary annual contributions by the company in amounts determined by the Board of Directors. The contributions may be in cash, common stock, securities or other property. The annual contributions are to be at least sufficient to discharge any current obligations of the Employee Stock Ownership Trust. The Employee Stock Ownership Trust borrows funds at various times to purchase common stock of the company for subsequent distribution to the employees over a defined period in accordance with the Employee Stock Ownership Plan. The repayment of the loans is guaranteed by the company; however, at December 31, 1993 and 1992, there were no such obligations outstanding. Contributions to the Trust for 1993, 1992, and 1991 were $11,709,000, $13,045,000 and $12,072,000, respectively. Three of the company's subsidiaries sponsor separate 401K savings plans. The plans provide for voluntary annual contributions by the company at the discretion of management. The company contributed $4,202,000, $2,480,000, and $2,217,000 to the plans in 1993, 1992 and 1991, respectively. During 1987, the Board of Directors approved a retirement policy for its outside directors which provides for post retirement remuneration and death benefits. The expense of the plan is being amortized over the anticipated remaining terms of the directors. NOTE J -- RETIREE HEALTH CARE AND LIFE INSURANCE BENEFITS The company also provides certain health care and life insurance benefits for its retired employees. Employees retiring from the company between the ages of 55 and 65 with at least 10 years of service or who age vest under the E-Systems, Inc. Salaried Retirement Plan are eligible for these benefits. Election to participate must be made as of the date of retirement, and the retiree may elect to cover qualifying dependents. If the retiree elects no medical coverage, it may not be added at a later date. Prior to 1992, the costs for providing retiree health care and life insurance benefits were recognized as an expense as claims were paid. In 1992, the company began to recognize the projected future cost of providing postretirement benefits, such as health care and life insurance, as an expense during the employee's vesting service. Upon implementation of this change, the company immediately recognized the January 1, 1992 accumulated postretirement benefit obligation (APBO) of $270.5 million. E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE J -- RETIREE HEALTH CARE AND LIFE INSURANCE BENEFITS (CONTINUED) A summary of the components of net periodic retiree health care and life insurance benefits cost follows: The cost shown in 1992 for retiree health care and life insurance benefits is $16,856,000 higher than it would have been had the change in accounting not been made in 1992. Annual costs for 1991 are not restated. The company has begun contributing to a Voluntary Employees' Beneficiary Association trust and a 401(h) trust that will be used to partially fund health care benefits for retirees. The company is funding benefits to the extent contributions are tax-deductible, which under current legislation is limited. In general, retiree health care benefits are paid as covered expenses are incurred. Plan assets consist of listed mutual funds, and the expected long-term rate of return on plan assets is 9 percent. The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheets for the company's retiree health care and life insurance plans: The health care cost trend rates, used to calculate both net periodic cost and the APBO, are as follows: E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE J -- RETIREE HEALTH CARE AND LIFE INSURANCE BENEFITS (CONTINUED) Increasing the assumed health care cost trend rates by one percentage point in each year would increase the APBO as of December 31, 1993 by $22,428,000 and net periodic benefit cost for the year ended December 31, 1993 by $2,516,000. In November 1992, the Financial Accounting Standards Board issued Statement No. 112, "Employers Accounting for Postemployment Benefits." This statement is effective for fiscal years beginning after December 15, 1993. The company plans to adopt the Statement in 1994, and it is not expected to have a material impact on the company's financial position or results of operations. NOTE K -- COMMITMENTS AND CONTINGENCIES Changes to procurement regulations in recent years, as well as the Government's drive against "fraud, waste and abuse" in defense procurement systems have increased the complexity and cost of doing business with the Government. Some of these changes have redefined the ability to recover various standard business costs which the Government will not allow, in whole or in part, as the cost of doing business on Government contracts. Other legal and regulatory practices have increased the number of auditors, inspectors general and investigators to the point that the company, like every other major Government contractor, is the constant subject of audits, investigations and inquiries concerning various aspects of its business practices. One pending investigation resulted in subpoenas by the Government for a large number of documents and government interviews of a large number of current and former employees. The company believes that this investigation, which has been ongoing for over three years, is currently dormant. The company is unaware that the investigation produced credible evidence of material wrongdoing by it or its employees and, therefore, believes that charges or claims will not be brought against it or its employees arising from this investigation. The company regards charges of violation of government procurement regulations as extremely serious and recognizes that such charges could have a material adverse effect on the company. If the company is determined to be in noncompliance with any of the applicable laws and regulations, the possibility exists of penalties and debarment or suspension from receiving additional Government contracts. The company is involved in other disagreements which are in the ordinary course of the company's business activities that are not expected to have a material adverse effect on the company's financial position. In addition, the company is involved in certain environmental matters with governmental agencies, and pending or threatened lawsuits and claims of current and former employees alleging various age, race, sex and disability discrimination or retaliatory discharge. Management believes that the impact of the above matters, if any, on the company's financial condition will not be material. NOTE L -- OPERATIONS BY PRODUCT CATEGORY The company has four significant product segments. The Reconnaissance and Surveillance category includes strategic systems for intelligence, reconnaissance and surveillance applications and tactical systems relating to electronic countermeasures and jamming and deception devices. The Command, Control and Communications category includes communications equipment and command and control systems which process data for ready analysis and decision making. In the Navigation and Controls category, automatic control products for aircraft, missile steering and tracking systems, and aircraft navigation aids are developed and manufactured. The company provides maintenance, repair and modification services for aircraft of all types and other maintenance services E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE L -- OPERATIONS BY PRODUCT CATEGORY (CONTINUED) through its Aircraft Maintenance and Modification and Other Services category. Product category information is reported herein by product type since each category involves several divisions. There are no sales between product categories. Identifiable assets by product category include both assets specifically identified with those operations and an allocable share of jointly used assets. Corporate assets consist primarily of cash, deferred federal income taxes, miscellaneous receivables, investments and fixed assets. Sales to the United States Government from all categories amounted to $1,865,069,000, $1,867,043,000, and $1,774,288,000, in 1993, 1992 and 1991, respectively. International sales which are primarily export sales to foreign governments and from all categories are summarized by geographic area as follows: E-SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE L -- OPERATIONS BY PRODUCT CATEGORY (CONTINUED) Financial information by product category (in thousands) is summarized as follows: SCHEDULE IX E-SYSTEMS, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS INDEX OF EXHIBITS SECURITIES EXCHANGE ACT OF 1934

821020_1993.txt

821020_1993

1993

821020

ITEM 1. BUSINESS. 1.(A) GENERAL Heritage Media Corporation (the "Company", "Heritage", or "HMC"), through its ACTMEDIA, Inc. ("ACTMEDIA") subsidiary, is the world's largest independent provider of in-store marketing products and services, primarily to consumer packaged goods manufacturers with products in supermarkets and drug stores. Heritage also owns and operates six network-affiliated television stations and fourteen radio stations in seven major markets. ACTMEDIA offers advertisers a broad assortment of in-store advertising and promotional products which can be purchased separately or integrated to produce a cohesive in-store marketing program for a given product. ACTMEDIA's products and services include print advertisements on shopping carts, aisle directories and shelf facings, promotional products such as cooperative coupon and sampling programs, on-shelf electronic couponing, customized in-store demonstrations and merchandising, and audio in-store advertising. ACTMEDIA's in-store marketing business is part of the alternative media industry, which has grown rapidly at a time when advertising expenditure growth rates on traditional marketing have slowed. ACTMEDIA's revenues have grown from $116 million in 1989 to $216 million in 1993, a compounded annual growth rate of 17%. ACTMEDIA is the only in-store marketing participant with a full-time field management staff supervising its own national field service organization (up to approximately 15,000 available part-time employees). ACTMEDIA delivers its products and services in over 24,000 supermarkets and 12,000 drug stores. Heritage's principal strategy and goal for its in-store marketing business is to develop new in-store products or product enhancements, to pursue in-store opportunities in additional markets outside the U.S., to expand in-store marketing services to new classes of stores and to increase the utilization of its existing in-store products particularly the Instant Coupon Machine and its audio in-store product. The Company's strategy for its television broadcasting business is to emphasize obtaining local advertising revenues through market segmentation, focusing on local news programming and tightly controlling operating expenses. Heritage's strategy for its radio broadcasting business is to focus on the acquisition of underperforming stations and to improve their operations. 1.(B) BUSINESS SEGMENT INFORMATION The business segment information required by this item is set forth in Note 11 of Notes to Consolidated Financial Statements of Heritage, included herein. 1.(C) DESCRIPTION OF THE BUSINESS IN-STORE MARKETING Alternative media augments mass media advertising by reinforcing advertising and promotional messages to consumers where they congregate and, in the case of in-store marketing, where purchase decisions are made. The advent of the alternative media industry was prompted by the realization that traditional mass media vehicles (television, radio, and print advertisements) were becoming less effective due to changes in the profile of a typical shopper and his or her shopping patterns and to the proliferation of types of media used to communicate to the shopping public. Changing shopping patterns have led to shorter supermarket visits, usually without shopping lists, and declining brand loyalty. Industry sources estimate that a significant percentage (ranging from 40% to 66%) of brand purchase decisions are made in the supermarket. Economic trends also support the continued growth of in-store marketing because this medium is inexpensive in comparison to other marketing alternatives such as television, radio and traditional print advertisements. In-store marketing is based upon the foundation that the store is the only place where the product, the manufacturer's message and the consumer with an intent to buy all converge. In-store marketing products and services thus allow advertisers to communicate with consumers at or near the point-of-purchase before, or as, purchasing decisions are made. PRODUCTS AND SERVICES ACTMEDIA offers advertisers a broad assortment of in-store advertising and promotional products which can be purchased separately or integrated under the Company's "store domination" concept to produce a cohesive in-store marketing presentation for a given product or brand. ACTMEDIA's products and services include print advertising products, such as advertisements on shopping carts, aisle directories and shelf facings; promotional products, such as cooperative coupon and sampling programs; on-shelf electronic couponing; audio in-store advertising; and customized in-store demonstrations and merchandising. By linking sight, sound and one-on-one selling, ACTMEDIA provides its clients with an effective means to reach the consumer at the point-of-purchase. INSTANT COUPON MACHINE. The Instant Coupon Machine ("ICM"), which was developed by ACTMEDIA, is an electronic coupon dispenser that is mounted on shelf channels under or near featured products. Through independent market research sponsored by the Company, the ICM was shown to increase brand switching substantially and to encourage first-time purchases of featured products. In market testing, coupons featured in ACTMEDIA's ICM achieved an average redemption rate of 17%, versus reported redemption rates of approximately 2% for coupons in free-standing inserts, approximately 4% for coupons sent to consumers in direct mailings and less than 1% for run of press coupons. The Company's test results also indicated that unit sales increased an average of 35% over four weeks for products using the ICM. In addition to its high redemption rate, test marketing indicated that the ICM would generate significant unplanned purchases; approximately 56% of purchases made with coupons from the ICM were unplanned in 1992. In 1993 this rate had grown to 62%. The Company believes that the ICM is also effective in reaching shoppers who do not normally use coupons; in market tests approximately 47% of consumers who redeemed a coupon from the ICM stated that they never use or only occasionally use a coupon. The ICM holds 500 coupons and is marketed to advertisers on a category-exclusive basis at the shelf. The ICM is sold in four-week cycles. National rollout of the ICM commenced in February 1992. By the end of 1993 the ICM was available in approximately 8,700 grocery stores and 5,700 drug stores. In January 1992, the Company was granted a patent with respect to certain design features of the ICM. RETAILERS' CHOICE. ACTMEDIA's Retailers' Choice program provides cooperative in-store coupon and sampling programs for groups of advertisers, generally five times per year. Under these programs, ACTMEDIA's representatives distribute coupons, samples and premiums inside the entrance of approximately 12,500 stores nationwide. Up to 16.5 million co-op coupon booklets and up to 16.5 million solo coupons and samples are distributed directly to shopping customers per event. In addition, product awareness is reinforced through the placement of featured products on a free-standing Retailer's Choice display. Market tests indicate that these events typically result in 40% of coupon redeemers being new brand users or switchers. Of the Retailers' Choice coupons redeemed, research by the Company indicates approximately 18% are generally redeemed in the first day of an event, which contrasts positively to free-standing insert coupon rates of redemption. IMPACT. Impact is the nation's leading in-store supermarket demonstration program, offering advertisers complete turnkey service for their in-store events. Customized events, such as tastings, premiums, samplings and demonstrations, are conducted in up to 24,000 stores nationwide. All demonstrations are monitored every day by full-time and part-time supervisors at an average ratio of one supervisor to 15 demonstrators. Impact's regular part-time staff of demonstrators, who implement the programs, maintain a consistent professional appearance (with matching aprons and materials). Special display units are utilized in the programs and programs are sold on a store-day basis. Events are generally conducted at the front of the store but can be located elsewhere. Category exclusivity is offered by store chains on event days. CARTS. ACTMEDIA's 8" by 10", four-color advertisements, mounted in plastic frames on the inside and outside of shopping carts, offer advertisers continuous storewide category-exclusive advertising delivery of a print advertisement. Because the shopping cart ads circulate around the entire store with the shopper, these advertisements are an effective tool for advertisers to reinforce their messages. Shopping cart advertisements are available in approximately 8,000 supermarkets nationwide, offering coverage of approximately 80 areas of dominant influence ("ADI"). Shopping cart advertisements are sold in four-week cycles to a maximum of twelve advertisers per cycle and, according to a study by Simmons Research, reach store locations visited by more than 90 million shoppers per cycle. According to studies by Audits & Surveys, Inc. ("A&S") conducted from 1973 to 1993, the use of shopping cart advertisements increased average unit sales for the products advertised by approximately 10% in stores where they were utilized. AISLEVISION. AisleVision features 28" by 18" four-color advertisement posters inserted in stores' overhead aisle directory signs. The large size of AisleVision draws attention to the supermarket aisle in which the product is stocked and has the added benefit of being frequently used by shoppers during their shopping trips. ACTMEDIA's AisleVision is sold in approximately 7,000 stores nationwide, offering category-exclusive coverage of approximately 170 ADI's. AisleVision is sold in four-week cycles to a maximum of 18 advertisers per cycle. Studies conducted by A&S from 1985 to 1993 reported that the use of AisleVision increased average unit sales for the products advertised by approximately 8%. An enhancement, AisleAction, allows the manufacturer to include motion on the directory sign, enhancing shopper awareness of the sign. SHELFTALK/SHELFTAKE-ONE. ShelfTalk features advertisements placed in plastic frames mounted on supermarket or drug store shelves near its featured product. ShelfTake-One includes rebate offers or recipe ideas which consumers may remove from the plastic frame at the site of the featured product. These four-color, 5 1/4" by 4" ads placed perpendicular to the shelf and facing in both directions are an effective means of bringing attention to a product at the shelf level and reinforcing advertising messages at the point-of-purchase. ShelfTalk and ShelfTake-One are sold in approximately 10,000 supermarkets, offering coverage of approximately 180 ADI's, and in approximately 5,500 drug stores, covering approximately 160 ADI's. ShelfTalk and ShelfTake-One are sold in four week cycles on a category-exclusive basis at the shelf. Studies conducted by A&S from 1985 to 1993 reported that ShelfTalk resulted in an approximately 5% average unit sales gain for the products advertised in grocery stores and an approximately 11% average unit sales gain for the products advertised in drug stores. ACTRADIO. ACTRADIO, formerly POP (Point of Purchase) Radio, is the nation's largest advertiser-supported, in-store radio network. ACTRADIO delivers its in-store audio advertising in conjunction with music entertainment services provided by the nation's leading business music providers. Retailers participating in the ACTRADIO network generally receive a share of revenues from the sale of advertising time. At December 31, 1993 there were 7,555 chain supermarkets, 7,395 chain drug stores and 770 Toys 'R' Us/Kids 'R' Us toy and children clothing stores totaling 15,720 stores comprising the total network. ACTRADIO delivers over 800 million advertising impressions over a four week period reaching 68% of adults an average of 6.5 times according to recent Simmons data. This massive reach and frequency makes ACTRADIO an attractive alternative to traditional broadcast, published, or direct mail advertising. Advertisers can extend their message at the point of sale at a fraction of the CPM (cost per thousand) of traditional media. In addition to its advertising value, A&S studies from 1987 through 1992 show that ACTRADIO delivers an average sales gain of 9% with a brand sell ad, and over 20% when a promotional tag or price tag is added. Research conducted in 1992 also indicated that 94% of all shoppers are attentive to the brand sell commercials, and that over half of all shoppers claim it has a positive effect in their purchase choices. ACTRADIO sells advertising time to manufacturers in units of 15 second, 20 second, and 30 second commercials each hour with feature tagging available as an option. ACTRADIO is sold in four week cycles comprising a minimum of 336 broadcasting hours and is available on a national, regional or chain specific basis. Advertisers may run their existing broadcast advertisements or ACTRADIO will produce commercials for them. Each hour of customized programming for retailers includes 48 minutes of music (with a wide choice of formats), 10 minutes of advertising and two minutes of airtime provided to retailers for their own promotional messages. In 1993 ACTRADIO terminated its Joint Operating Agreement ("JOA") with MUZAK and entered into new marketing alliances with leading in-store music providers A.E.I., Muzak, and Broadcast International to create the largest in-store satellite delivered radio network in the United States. The alliances designate ACTRADIO as the music providers' exclusive national advertising agent for a select group of retailers which includes most of the leading national supermarket and drug chains. A similar arrangement with Digital Music Express ("DMX") is expected to be finalized in the near future in conjunction with the launch of DMX/DBS satellite music service. ACTRADIO and the music providers will jointly upgrade and expand the in-store satellite delivery systems across the entire network. As of December 31, 1993, over 40% of the network was satellite delivered, with the balance of the network being delivered via tape equipment. ACTRADIO anticipates the entire satellite network to be completed by the end of 1994 targeting an expanded store base of nearly 24,000 stores. The new name, ACTRADIO Network, adopted in January 1994 more closely aligns the in-store audio product with the wide array of other in-store marketing products and services offered by ACTMEDIA. FREEZERVISION. ACTMEDIA's FreezerVision offers advertisers a means to reinforce its advertising messages at the upright freezercase. FreezerVision is a triangle-shaped print advertisement, mounted in a plastic frame, on the outside of the glass freezercase door. FreezerVision offers highly visible, category-exclusive advertising coverage. FreezerVision is sold in four-week cycles and national retail sales of FreezerVision began in the fourth quarter of 1992. FreezerVision was available in approximately 2,000 supermarkets by the end of 1993. SELECT. In 1991, the Company also offers Select, a service which utilizes ACTMEDIA's part-time field force to perform in-store merchandising tasks for manufacturers. These tasks have included on-pack couponing and stickering, distribution checks and installation of point-of-purchase materials. IN-STORE NETWORK ACTMEDIA's in-store network delivers its products and services in over 24,000 supermarkets and 12,000 drug stores across the country, a network substantially larger than that of any other in-store marketing company. By contracting to purchase the Company's in-store advertising and promotional products, advertisers gain access to up to approximately 200 of the nation's 214 ADI's covering over 70% of the households in the United States. ACTMEDIA currently has contracts with approximately 300 store chains. ACTMEDIA's store contracts generally grant it the exclusive right to provide its customers with those in-store advertising services which are contractually specified. The contracts are of various durations, generally extending from three to five years and provide for a revenue-sharing arrangement with the stores. ACTMEDIA's store contract renewals are staggered and many of its relationships have been maintained for almost two decades. ACTMEDIA's advertising and promotional programs are executed through one of the nation's largest independent in-store distribution and service organizations, although certain chains require the Company to utilize their own employees. ACTMEDIA believes the training, supervision and size of its field service staff (approximately 300 full-time managers and up to approximately 15,000 available part-time employees) provide it with a significant competitive advantage as its competitors generally do not have a comparable field service staff. The Company is attempting to expand its in-store products to additional classes of trade, such as club stores, discount stores, mass merchandisers and convenience stores. CUSTOMER BASE ACTMEDIA's customer base includes approximately 250 companies and 700 brands. This customer base includes the 25 largest advertisers of consumer packaged goods. In 1993, the Company's largest customers included the following: During 1993, Procter & Gamble was the Company's most significant customer. The loss of this customer would materially and adversely affect the Company. ACTMEDIA's sales organization markets its services to consumer packaged goods brand managers, promotion managers and their advertising agencies. ACTMEDIA's sales force consists of approximately 40 representatives, who are compensated on a salary-plus-commission basis. In addition to its sales force for its base products, ACTRADIO has established a separate sales force. Sales representatives stress the benefits of in-store marketing services, including: (i) the exclusivity afforded advertisers for a specific merchandise category, a feature generally unavailable in television, radio, magazine or newspaper advertising; (ii) increases in sales volume; (iii) the ability to reach customers at the point-of-purchase where industry sources estimate that a significant number (ranging from 40% to 66%) of all brand buying decisions are made; and (iv) ACTMEDIA's ability to reach a significant number of consumers at costs per thousand that are significantly less than comparable television or print advertising. INTERNATIONAL OPERATIONS AND INVESTMENTS The Company has set the establishment of a significant business presence outside of the United States as an important priority for ACTMEDIA. The majority of the Company's advertisers are large, multinational companies for whom the use of in-store marketing products in overseas markets is expected to be a logical extension of their advertising and promotional budgets. In November 1990, the Company acquired one of Canada's largest in-store marketing companies (now renamed ACTMEDIA Canada), which primarily operated an in-store cart advertising program. In August 1991, ACTMEDIA Canada acquired a Canadian company whose services include in-store demonstrations, merchandising and information collection. The combination of these two companies has enabled ACTMEDIA to attain a significant market position in Canada comparable to ACTMEDIA's U.S. market position. In January 1992, the Company formed a joint venture named ACTMEDIA Europe in which it has a 65% interest and H. L. van Loon (of Amsterdam, The Netherlands) has a 35% interest. ACTMEDIA Europe simultaneously acquired Media Meervoud, N.V., a Dutch in-store marketing company engaged in both cart advertising and promotions, of which Mr. van Loon was the principal shareholder. During 1993, ACTMEDIA Asia was launched in a joint venture with Omnilink of Singapore. In February 1994, ACTMEDIA acquired in-store marketing companies in Australia and New Zealand. In addition to analyzing international acquisition opportunities in other countries, ACTMEDIA has commenced a program to license its name and train licensees in the methods of conducting in-store operations in countries where the in-store industry is too small for a direct ACTMEDIA presence. Although ACTMEDIA has presently entered into four such license agreements (covering Israel, Turkey, South Africa and Venezuela), revenues from licensed operations were not material in 1993. International sales in 1993 accounted for $17.7 million (approximately 8%) of the In-store revenues. DEVELOPMENT ACTMEDIA is actively pursuing, testing, and developing new product and new business opportunities. Growth opportunities exist in several areas including expanding ACTMEDIA's sampling and demonstration businesses outside the store as well as in-store through the marketing of non-packaged goods. Introducing ACTMEDIA's products into mass merchandisers and convenience store classes of trade remains a key focus area. ACTMEDIA is also pursuing in-store merchandising opportunities through leveraging its national field service organization. International in-store acquisitions continue to be evaluated as vehicles to introduce ACTMEDIA's products worldwide. COMPETITION The advertising and promotion industries are characterized by intense competition. ACTMEDIA competes directly with other point-of-purchase advertisers and coupon/sampling/distribution/demonstration companies and indirectly with all other media in the supply of local and national advertising and promotion services, including cable television, television, radio, magazines, outdoor advertising and newspapers. Also, certain store chains offer limited advertising and promotional products and services. The Company believes that the principal competitive factors affecting its in-store marketing business are the cost of its services and the ability to demonstrate the cost effectiveness of its services as well as the comprehensive scope, coverage and quality of the services provided. There are relatively few barriers to entry particularly at the local level for suppliers of many different types of marketing (including packaged goods manufacturers, advertising agencies, retailers or other companies). However, the development of a nationwide capacity to supply advertising or promotional programs would require sufficient field service personnel to distribute and service comparable advertising or promotional programs, and substantial time and effort could be required to obtain the comprehensive store relationships, contracts and execution systems developed by ACTMEDIA over the years. Although the Company believes that ACTMEDIA is the largest provider of in-store marketing services, other companies (some of which are affiliated with large companies) offer similar services. Moreover, the in-store marketing environment is characterized by rapid technological change, and future technological developments (if and when cost effective) may affect competition. BROADCASTING Heritage owns and operates six network-affiliated television stations (plus one affiliate licensed as a satellite station but operated as a partial stand-alone station), three AM/FM combination radio stations, two stand-alone FM radio stations, and two AM/FM/FM combination radio stations. TELEVISION The Television Group owns six network-affiliated television stations. The following table sets forth selected information relating to the television stations owned by Heritage: Heritage operates its television stations in accordance with a cost-benefit strategy that stresses primarily revenue and cash flow generation and secondarily audience share and ratings. The objective of this strategy is to deliver acceptable profit margins while maintaining a balance between the large programming investment usually required to maintain a number one ranking (with its resultant adverse effect on profit margins), and the unfavorable impact on revenues that results from lower audience ratings. Components of the Company's operating strategy include management's emphasis on obtaining local advertising revenues by market segmentation, which provides a competitive advertising advantage, focusing on local news programming and tightly controlling operating expenses. By emphasizing advertising sales from local businesses, the Company's stations produce a higher percentage of local business (approximately 63% local and 37% national) than the national average. The following table sets forth certain historical net revenue and direct expense information for Heritage's television stations. This information does not reflect any corporate, television group, or nonrecurring expenses, interest expense, or income taxes. The primary costs involved in owning and operating stations are salaries, programming, news expense, depreciation and amortization and commissions for advertising. Television station revenues are primarily derived from local/regional and national advertising and to a lesser extent network compensation, with a small percentage of revenue sometimes obtained from studio rental and programming-related activities. The majority of national and local/regional advertising contracts are short-term, generally running for only a few weeks. WEAR-TV, the ABC affiliate in Pensacola, is the only network affiliated station in the Pensacola-Mobile market which is physically located in Florida and benefits from the market's growth which comes primarily from Florida. In 1993, the station's newscast obtained the market's number one rating and the station began constructing a new studio facility in Pensacola which is scheduled for completion in March 1994. The Television Group's station in Plattsburgh/Burlington, WPTZ-TV, an NBC affiliate, also provides NBC programming to southern Quebec, including Montreal. Additionally, WPTZ-TV operates WNNE-TV, a satellite station serving portions of New Hampshire and Vermont, which allows advertisers to selectively air their messages over WPTZ-TV's entire market or segments of the market. WCHS-TV, an ABC affiliate, is the only network affiliate based in the capital city of Charleston, within the Charleston and Huntington market. The Company acquired KOKH-TV in Oklahoma City, Oklahoma on August 15, 1991 and sold its KAUT-TV station in the same market to a non-commercial licensee (while transferring KAUT's FOX network affiliation to KOKH). The acquisition of KOKH-TV has been very successful. The improved channel position, signal strength, elimination of a commercial station in the market, and the emergence of the Fox network have contributed to the significant revenue increase since the acquisition. In South Dakota, the Company operates two stations, KEVN-TV in Rapid City and KDLT-TV in Sioux Falls, both NBC affiliates. Three of the Company's stations, WEAR-TV, WPTZ-TV and WCHS-TV, which represent 73% of the operating income from Heritage's television operations, have developed specific market segmentation strategies based on their status as the sole network affiliate in one geographic area of a hyphenated market. This geographic advantage enables these stations to build strong local identities and leading positions in local news programming in their portions of these hyphenated markets. In addition, WPTZ-TV and KEVN-TV, both VHF stations, have a transmission advantage in their market areas compared to certain other network affiliates, but KDLT-TV suffers from a signal disadvantage because of the location of its tower. The Company has shaped its sales efforts around two central beliefs: (1) that national advertising spots and a station's relations with its clients are based on ratings, while the sales of local spots depends to a greater extent on the station's local sales force and their relations with clients and (2) that the local advertising segment is the fastest growing advertising segment. As a result of these beliefs, Heritage's stations generally maintain a larger, more experienced sales force but a smaller general staff than its competitors. The strength of the stations' sales forces and their orientation toward generating local advertising revenue have resulted in 63% of the stations' revenues being derived from local sources, against an industry average estimated at approximately 50%. RADIO The Radio Group owns and operates five AM and nine FM radio stations (including two FM "duopolies") in seven of the top 50 markets -- Seattle, WA; St. Louis, MO; Cincinnati, OH; Portland, OR; Milwaukee, WI; Kansas City, MO; and Rochester, NY. The following table sets forth certain information regarding Heritage's radio stations: The Company's strategy is to identify and acquire underperforming radio stations or groups and effect management and operational changes to increase their profitability. Implementation of this strategy typically involves the following four-step process: (1) instituting operational improvements, usually including a change in management personnel and additional capital investments when appropriate; (2) creating increases in audience ratings through programming and promotional changes; (3) improving revenue as a result of the turnaround process; and (4) increasing cash flow. Heritage radio stations strive to be top-rated in their programming formats, and universally program a mass appeal music format directed at a target audience of 25-to-54 year-olds. Presently, seven of the Company's nine FM stations are format leaders in their markets. In addition, Heritage stations are number one ranked among all stations in three of the Company's seven radio markets. The Federal Communications Commission ("FCC") limits radio ownership both in the number of stations commonly owned, operated, or controlled in any one market, and in total. In late 1992, the FCC relaxed its rules to increase the number of stations one entity can own in one market if certain requirements are met. This new combination is commonly known as a "duopoly". The Company acquired two FM stations in 1993 that created "duopolies". On July 22, 1993 it acquired WKLX-FM in Rochester, New York. Effective January 1, 1994, the Company acquired WEZW-FM in the Milwaukee market. Before the Heritage acquisition, the licensees of WKLX-FM and WEZW-FM maintained independent control over and complete responsibility for programming and operations of their respective stations. Heritage assumed management responsibilities (subject to certain FCC restrictions) pursuant to "Local Marketing Agreements" ("LMA's") approximately two months prior to the respective closing dates, and the financial results of the stations were consolidated beginning May 19, 1993, for WKLX, and November 1, 1993, for WEZW. WKLX programs an "oldies" format, similar to the Company's FM stations in Portland and Rochester. WEZW has a soft adult contemporary format that is complementary to that of the Company's WMYX in that market. Heritage announced on January 10, 1994 that it has agreed to acquire radio station KRJY-FM in St. Louis, MO. Heritage currently owns and operates WRTH-AM and WIL-FM in the St. Louis market. This acquisition, the Company's third "duopoly", received approval by the FCC in early March. The Company's acquisition and operating strategies have enabled its radio group to increase earnings before interest, taxes, depreciation and amortization ("EBITDA") from $.1 million in 1987, its first full year, to $9.4 million in 1993. The following table sets forth certain net revenue and direct expense information for Heritage's radio stations including the stations acquired in 1992 and 1993 and excluding a Los Angeles station sold in March 1991. This information does not reflect any corporate, radio group, or nonrecurring expenses, interest expense or income taxes. Also included in the 1993 financial results (but not included in the table above) are revenues of $419,000 and EBITDA of $174,700, from November, 1993, for WEZW-FM under the terms of an LMA Agreement. Each of Heritage's FM facilities is of the highest class of service permitted by the FCC (B or C) with comprehensive signal coverage of its markets. The AM stations operate as full-time facilities on regional or clear channels. COMPETITION The Company's television and radio stations compete for advertising revenues with other media companies in their respective markets, as well as with other advertising media, such as newspapers, magazines, outdoor advertising, local cable systems, direct mail and alternative media. Some competitors are part of larger companies with substantially greater financial resources than Heritage. Competition in the broadcasting industry occurs primarily in individual markets. Generally, a television broadcasting station in one market does not compete with stations in other market areas. Heritage's television stations are located in highly competitive markets. While the pattern of competition in the radio broadcasting industry is basically the same, it is not uncommon for radio stations outside of the market area to place a signal of sufficient strength within that area to gain a share of the audience. In addition to the element of management experience, factors that are material to competitive position include authorized power, assigned frequency, network affiliation, audience characteristics and local program acceptance, as well as strength of local competition. The broadcasting industry is continuously faced with technological change and innovation, the possible rise of popularity of competing entertainment and communications media, changes in labor conditions and governmental restrictions or actions of federal regulatory bodies, including the FCC and the Federal Trade Commission ("FTC"), any of which could possibly have a material effect on Heritage's operations and results. In recent years broadcast television stations have faced increasing competition from the other sources of television service, primarily cable television, and the ratings have reflected a decline in the viewing audience. These other sources can increase competition for a broadcasting station by bringing into its market distant broadcasting signals not otherwise available to the station's audience and also serving as a distribution system for non-broadcast programming. Programming is now being distributed to cable television systems by both terrestrial microwave systems and by satellite. Other sources of competition include home entertainment systems (including television game devices, video cassette recorder and playback systems and video discs), multi-point distribution systems, multichannel multi-point distribution systems and satellite master antenna television systems. Heritage's television stations will face competition from direct broadcast satellite services which transmit programming directly to homes equipped with special receiving antennas or to cable television systems for transmission to their subscribers. The likely entry of telephone companies into the video programming distribution business could increase the competition the Company's television stations face from other distributors of audio and video programming. The broadcasting industry is continuously faced with technological change and innovations, which could possibly have a material effect on the Company's broadcast operations and results. Commercial television broadcasting may face future competition from interactive video and data services that may provide two-way interaction with commercial video programming, along with information and data services that may be delivered by commercial television stations, cable television, direct broadcast satellites, multi-point distribution systems, multichannel multi-point distribution systems, or other future video delivery systems. FEDERAL REGULATION OF BROADCASTING Television and radio broadcasting are subject to the jurisdiction of the FCC, which acts under authority granted by the Communications Act of 1934, as amended (the "Communications Act"). The Communications Act prohibits radio or television broadcasting except in accordance with a license issued by the FCC. The Communications Act also empowers the FCC, among other things, to issue, renew, modify or revoke broadcasting licenses, to determine the location of stations, to regulate the equipment used by stations, to adopt such regulations as may be necessary to carry out the provisions of the Communications Act and to impose penalties for violation of such regulations. The following is a brief summary of certain provisions of the Communications Act and specific FCC regulations and policies. RENEWAL. Broadcasting licenses are issued for a maximum term of up to five years in the case of television stations and up to seven years in the case of radio stations, and are renewable upon application. In determining whether to renew a broadcast license, the FCC has authority to evaluate the licensee's compliance with the provisions of the Communications Act and the FCC's rules and policies. The FCC licenses for each of Heritage's radio and television stations expire at different times between April 1, 1994 and June 1, 1998. Applications to renew the licenses for stations WPTZ-TV, Plattsburgh, NY; and WNNE-TV, Hartford, VT are presently pending before the FCC. The Communications Act authorizes the filing of petitions to deny any license renewal applications during certain periods of time following the filing of renewal applications. Petitions to deny can be used by interested parties, including members of the public, to raise issues concerning a renewal applicant's qualifications. If a substantial and material question of fact concerning a renewal application is raised by the interested party, the FCC will hold an evidentiary hearing on the application. In recent years, there have been a number of petitions to deny filed against broadcast renewal applications challenging the licensee's compliance with the Commission's equal employment opportunity requirements. At the time the application is made for renewal of a broadcasting license, a person may file a competing application of authority to operate the station and replace the incumbent licensee. If a competing application is filed against a renewal application, the FCC is required to hold an evidentiary hearing on the renewal application. In the evidentiary hearing, the FCC recognizes a renewal expectancy for an incumbent licensee that has provided meritorious or substantial service to the audience located in its community of license during the preceding license term. In the vast majority of cases, broadcast licenses are renewed by the FCC even where there are petitions to deny or competing applications filed against broadcast license renewal applications. ACQUISITIONS OR SALES. The Communications Act prohibits the assignment of a license or the transfer of control of a licensee without the prior approval of the FCC. Applications to the FCC for such assignments or transfers are subject to petitions to deny by interested parties and are granted by the FCC only upon a finding that such action will serve the public interest, convenience and necessity. In determining whether to grant such applications, the FCC has authority to evaluate the same types of matters that it considers in evaluating a broadcast license renewal application. In the vast majority of cases where petitions to deny are filed against assignment or transfer applications, the applications are granted and the petitions are denied. On April 5, 1992, several local branches of the NAACP ("NAACP") filed a petition to deny with the FCC against Stations WRTH-AM and WIL-FM; Stations WBBF-AM and WBEE-FM; Stations KULL-AM and KRPM-FM; Stations WEMP-AM and WMYX-FM; and Station WEAR-TV (the"Licensees"), with respect to applications seeking FCC consent to permit James M. Hoak, Chairman of the Board of the Company, to relinquish "control" of the Company upon the conversion of all of Mr. Hoak's shares of Class B Common Stock into Class A Common Stock. On July 16, 1993, the NAACP's petition to deny was denied and the transfer of control applications for the Licensees were granted. On July 21, 1993, the transfer of control of the Licensees was consummated. On September 1, 1993, a petition for reconsideration ("Reconsideration Petition") was filed by the NAACP against the transfer of control applications for the Licensees. In the Reconsideration Petition, the NAACP alleges that the FCC erred in granting the transfer of control applications for the Licensees by summarily rejecting the NAACP's statistical evidence of discrimination without a rational explanation and failing to conduct the type of investigation required. The Company is vigorously opposing the NAACP allegations. While the Company cannot predict the outcome of this matter, the Company believes that the FCC's prior action approving the transfer of control for all of the Company's stations will be affirmed by the FCC without any conditions that will have a material adverse effect on the Company. OWNERSHIP RESTRICTIONS. Under the Communications Act, broadcast licenses may not be held by or transferred or assigned to an alien, a foreign entity, or any corporation of which any officer or director is an alien or of which more than one-fifth of the capital stock of record is owned or voted by aliens. In addition, the Communications Act provides that no broadcast license may be held by any corporation directly or indirectly controlled by any other corporation of which any officer or more than one-fourth of its directors are aliens, or of which more than one-fourth of the capital stock of record is owned or voted by aliens, if the FCC finds the public interest will be served by the refusal to grant such license. The FCC's local "multiple ownership" rules prohibit the grant of a license for a television station to any party if such party owns or has an ownership interest in another television station whose signal covers a portion of the same market served by the station owned, operated or controlled by such party. These rules prohibit the ownership of more than two AM and two FM stations in markets with 15 or more stations (provided that the combined audience share does not exceed 25 percent) and prohibit the ownership of more than three radio stations, no more than two of which are in the same service area, in markets with 14 or fewer stations (provided that the station owned in combination represents less than 50 percent of the stations in that market). In addition, the FCC's local multiple ownership rules prohibit station acquisitions that would result in the ownership interests in a radio and a television station in the same market. However, waivers can be obtained from the FCC for radio and television combinations upon an appropriate showing of good cause or if the stations are failing stations or are located in the top 25 markets where at least 30 separately owned or operated broadcast licensees remain after the proposed combination. The FCC's national television multiple ownership rules generally prohibit an individual or entity, that is not minority controlled, from having an ownership interest in more than 12 television station licenses. The national radio multiple ownership rules permit ownership of up to 18 AM and 18 FM radio stations with an automatic increase to 20 AM and 20 FM stations beginning in September 1994. The FCC's cross ownership rules prohibit radio and/or television licensees from acquiring new ownership interests in daily newspapers published in the same markets served by their broadcast stations; and television licensees may not own cable television systems in communities within the service contours of their television stations. In applying the FCC's multiple and cross ownership rules, the licensee will also have attributed to it any media interests of officers, directors and shareholders who own 5% or more of the licensee's voting stock, except that certain institutional investors who exert no control or influence over a licensee may own up to 10% of such outstanding voting stock before attribution results. These FCC rules do not require any changes in Heritage's present television and radio operations. REGULATORY CHANGES. Legislation was enacted recently by Congress called the Cable Television Consumer Protection and Competition Act of 1992 (the "Act") which imposes certain regulatory requirements on the operation of cable television systems. The Act provides television stations with the right to control the use of their signals on cable television systems. Each television station was required to elect prior to June 17, 1993 whether it wanted to avail itself of must-carry rights or, alternatively, to assert retransmission rights. If a television station elected to exercise its authority to grant retransmission consent, cable systems are required to obtain consent of that television station for the use of its signal and could be required to pay the television station by October 6, 1993 for such use. The Company believed that the preservation and continued cable carriage of the station's signal was more important than any potential negotiated consideration, and prior to the October 6 deadline elected must-carry for all its stations except the Fox affiliate, which successfully negotiated cable retransmission consents in association with the Fox Television Network. These elections remain in effect until October 1, 1996 when the stations again elect. The Act further requires mandatory cable carriage of all qualified local television stations not exercising their retransmission rights. Several challenges to the constitutionality of these requirements have been filed in Federal court including a challenge to the constitutionality of the must carry rights which is pending before the Supreme Court. The Company cannot predict the outcome of such challenges or the effect that the Act will have on the business of the Company if the constitutionality of the requirements is upheld. Legislation has been introduced from time to time which would amend the Communications Act in various respects and the FCC from time to time considers new regulations or amendments to its existing regulations. In addition, a number of proposals for regulatory changes are pending before the FCC and Congress. Such matters include proposals pending before the FCC to relax the rules governing the common ownership of television stations locally and nationally, to authorize a new type of wireless cable system, to authorize digital audio broadcasting and to authorize advanced (high definition) television systems. Certain of these changes will increase operating costs and/or increase the number of competing broadcast stations. Last year, the House and Senate passed campaign reform bills which reduce the rates that a television station can charge for advertising time sold to legally qualified candidates for public office. Differences between the two bills must be reconciled by a joint House and Senate Conference Committee before such legislation can be enacted. Adoption of such legislation could have a negative impact on a television station's revenues and cash flow during primary and general election periods. Heritage cannot predict whether such changes will be adopted or, if adopted, the effect that any such changes would have on the business of Heritage. EMPLOYEES Heritage and its subsidiaries employ approximately 1,300 full-time and up to 15,000 available part-time employees. Of this total, ACTMEDIA employs approximately 600 full-time and up to approximately 15,000 available part-time personnel. Substantially all of ACTMEDIA's part-time personnel are in field service staff. None of the In-store Marketing Group's employees are represented by a collective bargaining unit. Heritage's broadcast subsidiaries currently employ approximately 700 persons of whom 33 employees are represented by unions. The Company believes that it has a good relationship with its employees. ITEM 2. ITEM 2. PROPERTIES. Heritage's headquarters are located in Dallas, Texas. The lease agreement for the 8,202 square feet of office space in Dallas expires October 31, 1996. ACTMEDIA leases office facilities with an aggregate of approximately 65,000 square feet in Norwalk, Connecticut and 8,100 square feet in Des Plaines, Illinois with leases expiring in 2000 and 1998, respectively, and 41 field offices with an aggregate of approximately 84,000 square feet pursuant to leases with terms of three years or less. ACTRADIO leases approximately 5,800 square feet of space for its operations in New York City, New York pursuant to a lease expiring in 1995. The types of properties required to support each of Heritage's broadcast stations include offices, studios, transmitter sites and antenna sites. A station's studios are generally housed with its offices in downtown or business districts. Heritage's television stations own approximately 88 total acres in 8 locations upon which buildings with approximately 93,600 square feet of office and studio space are located. The stations own and lease approximately 148 and 11 acres, respectively, upon which the tower or transmitters are located. Heritage's radio stations own three AM transmitter sites totaling 58 acres. The stations lease approximately 50,000 square feet in seven locations upon which office and studio space is located. The stations also lease tower space at six locations totaling 31 acres. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Heritage is subject to litigation in the ordinary course of business. It is not subject to any such legal proceedings which management believes are likely to result in any material losses being incurred. 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. Shares of the Company's Class A Common Stock have been listed on the American Stock Exchange ("AMEX") under the symbol "HTG" since 1988. No other class of Heritage's common equity is currently publicly traded. The following table sets forth the high and low closing prices of the Class A Common Stock for each quarterly period within the two most recent fiscal years on the AMEX. All share prices have been adjusted to give effect to a four-for-one reverse split of the Company's Class A Common Stock on March 30, 1992. On March 8, 1994 the last reported sale price of the Company's Class A Common Stock was $18.00 per share. At March 8, 1994 there were approximately 1,000 record holders of Class A Common Stock. Heritage has never paid cash dividends on shares of any class of its common stock. Heritage presently intends to retain its funds to support the growth of its business or to repay indebtedness or for other general corporate purposes and therefore does not anticipate paying cash dividends on shares of any class of its common stock in the foreseeable future. Additionally, the various financing agreements to which either Heritage or one or more of its subsidiaries is a party may effectively prohibit or sharply impact upon Heritage's ability to pay dividends. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capitalization and Liquidity." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. (In thousands, except per share data) Set forth below is selected consolidated financial data with respect to the Company for the years ended December 31, 1993, 1992, 1991, 1990, and 1989, which were derived from the audited consolidated financial statements of the Company. This data as of December 31, 1993 and 1992 and for each of the years in the three year period ended December 31, 1993 should be read in conjunction with the audited consolidated financial statements of the Company and its subsidiaries and the related notes thereto included elsewhere herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL The Company's net revenues increased from $222.4 million in 1991 to $291.2 million in 1993, and its operating income increased from $22.3 million to $35.5 million over the same period. This growth is primarily attributable to growth from existing operations within the Company's in-store marketing and broadcast businesses complemented by the acquisition of certain in-store and broadcast properties. The Company reported net losses of $15.0 million and $18.6 million and net earnings of $.5 million for the years ended December 31, 1991, 1992 and 1993, respectively. The operating results before extraordinary items improved from a $19.3 million loss in 1991 to earnings of $77,000 in 1993. In August 1991, the Company purchased KOKH-TV, an independent television station serving Oklahoma City and simultaneously sold and donated its KAUT-TV station assets in this market to a non-commercial educational licensee. The Company retained its rights to broadcast programming provided by the FOX Broadcasting Company network over KOKH-TV. Also in August 1991, ACTMEDIA Canada acquired BLS Retail Resource Group, a Canadian in-store marketing company. On January 2, 1992, the Company acquired 65% of Media Meervoud, a Netherlands in-store marketing company ("MMV"). On June 1, 1992 the Company completed the acquisition of the broadcast assets of radio stations KCFX-FM and WOFX-FM. Also, during 1992, the Company wrote off its investment in Supermarket Visions, Ltd., a U.K. marketing company ("SVL"), as SVL ceased operations. On July 22, 1993 the Company completed the acquisition of the broadcast assets of radio station WKLX-FM. Heritage programmed and marketed the station under an LMA from May 19, 1993 to the completion of the acquisition. On October 25, 1993 the Company agreed to acquire radio station WEZW-FM. Heritage programmed and marketed the station under an LMA with the current owner from such date to the completion of the acquisition on January 1, 1994. The operating results of these stations, effective with the LMAs, are included in the consolidated financial statements. Due to the numerous acquisitions and dispositions, the results of operations from year to year are not comparable. See Note 2 of Notes to Consolidated Financial Statements for additional information concerning the Company's acquisitions, dispositions, and related transactions. RESULTS OF OPERATIONS: 1993 COMPARED TO 1992 Consolidated net revenues of $291.2 million represented a 16% increase over the 1992 revenues of $250.9 million. Cost of services of $151.1 million increased 10% in 1993 compared to 1992 due primarily to the increase in net revenues. Operating income of $35.5 million in 1993 exceeded the comparable 1992 period by 26%. The loss per share was $.29 versus $1.76 in 1992. The improvement in the Company's operating results for the 1993 period primarily reflects revenue growth from the Instant Coupon Machine by the In-store Marketing Group, increased local Television and Radio Group advertising revenues and positive contributions from the Radio acquisitions. The loss per share in 1993 was lower than 1992 due principally to $7.4 million of additional operating income, $6 million lower interest expense and increased average shares outstanding. The 1993 period included a $3 million nonrecurring charge for POP Radio, a $1.7 million writedown of Television broadcast program rights and a $.4 million extraordinary gain on the early extinguishment of debt. The 1992 period included a $3.3 million writeoff of the SVL investment and $3.6 million of extraordinary losses, net, recognized as a result of the Company's 1992 refinancing activities. All comparisons, unless otherwise noted, are for the year ended December 31, 1993 as compared to the comparable 1992 period. IN-STORE MARKETING. The In-store Marketing Group contributed $216.3 million of revenues in 1993, an increase of 16% compared to $186.4 million in 1992. The success of the ICM was a major contributor to this growth. The ICM generated $63 million of revenues in 1993, its first full year of operation, which tripled the $21 million level in 1992. Retailers' Choice (cooperative promotion program) revenues increased by 16%, primarily as a result of management's decision to increase the number of programs compared to 1992. Revenues generated per program registered a small decrease from $3.6 million in 1992 to $3.5 million in 1993. The International operations produced an additional $.5 million of revenues in 1993 to a total of $17.7 million. The International operations were impacted by the world-wide recession, particularly in Canada. Advertising revenues in 1993 declined 10% compared to 1992 reflecting the continuing trend toward promotion and the shift to ICM and away from the shelf-talk product. Total Impact revenues declined by 16% to $53 million in 1993. The number of programs has continued to decline from 141 in 1991 to 133 in 1992 and 108 in 1993. The demonstration business has also seen increased competition which has adversely affected pricing. Net revenues of the POP Radio product increased to $6.6 million in 1993 from $6.0 million in 1992. In 1993 the Company announced that POP Radio was terminating the MUZAK Joint Operating Agreement, forming marketing alliances with three large music network providers to accelerate the conversion to satellite delivery and expanding its in-store audio network by approximately 9,000 stores. As a result of launching this new program, the Company recorded a one-time nonrecurring charge of $3 million in the fourth quarter of 1993 reflecting the costs of closing a tape machine servicing center ($1.1 million), the write-off of obsolete delivery equipment ($1.5 million), and provisions for other costs ($.4 million). These actions will reduce the on-going operating costs and long-term capital requirements for POP Radio, and increase the size and quality of the in-store audio network. In-store Marketing operating income of $22.4 million increased by 36% from $16.4 million in the 1992 period due primarily to the increased 1993 revenues, store operations efficiencies, and reduced POP Radio losses. The operating margin increased to 12% in 1993, excluding the $3 million POP Radio charge, compared to 9% in 1992. The In-store Marketing Group contributed 74% of the Company's revenues and 63% of operating income in 1993, and it is expected that this group will contribute a higher percentage of the Company's revenues and operating income in 1994. TELEVISION. The Television Group generated $41.5 million of revenues in 1993, a 5% increase compared to $39.7 million in 1992. The Television Bureau of Advertising Time Sales Survey reported that industry-wide gross local revenues increased by 4.4% and national revenues were up 1% compared to 1992. The Television Group's local revenues increased 13% and national revenues improved 9% compared to the 1992 period. This favorable performance was substantially offset by the decline of political advertising from $2.3 million in 1992 to $.1 million in 1993. The revenue improvement was produced by the Oklahoma City and Pensacola stations. Pensacola benefited from local revenue growth of 9% and national revenue growth of 19%. The Oklahoma City station (KOKH-TV) generated revenues of $7.3 million in 1993 compared to $6.3 million in 1992 primarily as a result of a 21% increase in local revenues. The continuing emergence of the FOX network and the success of targeting programming to the age 18-49 audience has favorably impacted KOKH-TV's ratings. The group's 1993 results included a $1.7 million writedown of the carrying value of the rights to two television broadcast programs at two stations. Operating income of $12.4 million, excluding the writedown, increased by 9% compared to 1992 primarily as a result of higher revenues. The operating margin improved from 29% in 1992 to 30% in 1993 excluding the writedown. RADIO. Net revenues of the Radio Group increased by 35% from $24.7 million in 1992 to $33.4 million in 1993 as all of the Company's stations experienced increased revenues. The radio stations acquired in June 1992 contributed $3 million of the increase and the 1993 acquisitions contributed $1.5 million of revenues. Revenues for the stations owned for all of both periods increased 21% primarily as a result of improved station ratings. The St. Louis stations improved revenues from $4.9 million to $7 million in 1993 primarily due to the achievement by the FM station of the number one ranking in the market. Operating income grew from $3.3 million in 1992 to $6 million in 1993 primarily as a result of the improved revenues by the stations owned for all of both periods and an additional $.2 million contributed by the acquired stations. CORPORATE EXPENSES. Corporate expenses in 1993 of $3.6 million increased compared to $2.9 million in 1992 due primarily to increased investor relations activities and performance related compensation payments. OTHER OPERATING EXPENSES. As noted above, the 1993 period included a $1.7 million writedown of television program rights as a result of management's assessment of their realizable value (based upon projected future utilization of the programs) and the $3 million POP Radio nonrecurring expense. In-store new product development expenses were approximately $.8 million in 1992 and $1.1 million in 1993. DEPRECIATION AND AMORTIZATION. Depreciation and amortization of $28.2 million in 1993 increased by 8% compared to $26.1 million in 1992. The majority of the increase was due to higher depreciation associated with the capital expenditures to support the growth of Instant Coupon Machine revenues. INTEREST EXPENSE. Interest expense consists of the following: Deferred interest represents accretion of an 8% subordinated note and 13 1/2% subordinated debentures. The decrease in the deferred interest is primarily a result of the retirement of these debt instruments in 1992. The decrease in the current interest from 1992 to 1993 is due to lower debt levels and interest rates. OTHER EXPENSES. Included in the 1992 results of operations is a $3.3 million non-cash charge to reflect the net writeoff of the carrying value of SVL. NET INCOME (LOSS). Primarily as a result of an additional $12 million of operating income (excluding writedowns and nonrecurring charges) and $6 million lower interest expense, the Company improved its operating results from an $18.6 million loss in 1992 to $.5 million earnings in 1993. The loss per share in 1993 is due to the preferred dividend payments and settlement rights accretion. RESULTS OF OPERATIONS: 1992 COMPARED TO 1991 Consolidated net revenues of $250.9 million represented a 13% increase over the 1991 revenues of $222.4 million. Cost of services of $137.6 million increased 10% in 1992 compared to 1991 due to the increase in net revenues. Operating income of $28.1 million in 1992 exceeded the comparable 1991 period by 26%. The loss per share was $1.76 versus $1.97 in 1991. The year reflected a strengthening of advertiser spending compared to 1991 and political advertising revenues which were not material in 1991. The improvement in the Company's operating results for the 1992 period primarily reflects increased revenues from the successful launch of the Instant Coupon Machine by the In-store Marketing Group, $2.8 million of political advertising revenues, and improved advertising revenues. The loss per share in 1992 was lower than 1991 due principally to $5.8 million of additional operating income, $1.2 million lower interest expense and increased average shares outstanding. However, the write-off of the SVL investment and the extraordinary losses, net, recognized as a result of the Company's 1992 refinancing activities moderated the improvement. All comparisons, unless otherwise noted, are for the year ended December 31, 1992 as compared to the comparable 1991 period. IN-STORE MARKETING. The In-store Marketing Group contributed $186.4 million of revenues in 1992, an increase of 9%, compared to $171.1 million in 1991. The success of the national launch of the ICM in 1992 generated approximately $21 million of additional revenues. The International operations produced an additional $6.7 million of revenues in 1992 including $4.3 million of revenues attributed to a full year of the BLS Retail Resource Group acquired in August 1991 and MMV which contributed $3.3 million of revenues in 1992. Advertising revenues in 1992 were level with 1991 as a 53% increase in cart advertising revenues was offset by the shift to ICM and away from the shelf-talk product. Impact promotional services included 133 programs in 1992 versus 141 in 1991, a decrease of 6%, which decreased the number of days serviced by 10%. Total Impact revenues declined by 5%. Retailers' Choice (cooperative promotion program) revenues declined by 23%, partly as a result of management's decision to reduce the number of programs and also due to the packaged goods manufacturers' budget cutbacks. The revenues generated per program decreased from $3.9 million in 1991 to $3.6 million in 1992, a 7% decline. Net sales of the POP Radio product decreased to $6.0 million in 1992 from $8.9 million in 1991 and $20.2 million in 1990. In 1992 the following actions were taken to improve POP Radio: hiring a president to manage Pop Radio as a separate organization, continuing the upgrading of the technology to satellite delivery, improving the service, and negotiating with Muzak to take on the servicing aspects of the network. POP Radio hired several dedicated sales representatives and signed up regional representative firms to address markets that have not been penetrated by ACTMEDIA sales people. Operating income of $16.4 million increased by 11% from $14.8 million in the 1991 period due primarily to the increased 1992 revenues noted above. The operating margins were relatively level with 1991 as they were impacted by lower revenues from POP Radio and the lower margins generated by the emerging International operations. The In-store Marketing Group contributed 74% of the revenues and 58% of operating income in 1992. TELEVISION. The Television Group generated $39.7 million of revenues in 1992, a 12% increase compared to $35.3 million in 1991. The Television Bureau of Advertising Time Sales Survey reported that industry-wide gross local revenues and national revenues for 1992 increased by 6% compared to 1991. The Company's television group local revenues increased 11% and national revenues improved 11% compared to the 1991 period. Also, the Company's 1992 results included $2.3 million of political advertising versus $.3 million in 1991. The revenue improvement was produced primarily at the Oklahoma City, Plattsburgh/Hanover and Pensacola stations. Pensacola's 1991 results were impacted by the gulf war and by the major cutback by automobile advertisers. Plattsburgh also was impacted by the gulf war and the recession in New England and Canada. The Oklahoma City station generated revenues of $6.3 million in 1992 compared to $5 million in 1991 primarily as a result of the acquisition/ disposition and consolidation of the market in August 1991 and the emergence of the Fox network. Operating income of $11.4 million increased by 28% compared to 1991 primarily as a result of higher revenues. The operating margin improved from 25% in 1991 to 29% in 1992. RADIO. Net revenues of the Radio Group increased by 56% from $15.9 million in 1991 to $24.7 million in 1992. The radio stations acquired in June 1992 contributed $5.7 million of revenues. Revenues for the stations owned for all of both periods increased 20% primarily as a result of improved station ratings. Political revenues contributed $.5 million to the 1992 increase. Operating income grew from $1.3 million in 1991 to $3.3 million in 1992 primarily as a result of the improved revenues and $.2 million contributed by the acquired stations. CORPORATE EXPENSES. Corporate expenses in 1992 of $2.9 million increased by 11% compared to 1991 due primarily to the executive search fees for the POP Radio president and compensation consulting fees. OTHER OPERATING EXPENSES. Included in the 1991 period is a writedown of $.5 million of television program rights as a result of management's assessment of their realizable value (based upon projected future utilization of the programs). In-store new product development expenses were approximately $.8 million in 1992 and $.7 million in 1991. DEPRECIATION AND AMORTIZATION. Depreciation and amortization of $26.1 million in 1992 increased by 17% compared to $22.3 million in 1991. The majority of the increase was due to higher depreciation associated with the capital expenditures for the Instant Coupon Machine national launch and the Muzak equipment purchased in early 1992. INTEREST EXPENSE. Interest expense consists of the following: Deferred interest represents accretion of an 8% subordinated note and 13 1/2% subordinated debentures. The decrease in the deferred and increase in current interest is primarily a result of the retirement of these debt instruments in 1992. OTHER EXPENSES. Included in the 1992 results of operations is a $3.3 million non-cash charge to reflect the net write off of the carrying value of SVL. Included in the 1991 results is a $1.3 million non-cash charge for SVL which was based upon the Company's assessment of the impairment in such carrying value as a result of operating losses incurred by such company. Other expenses in 1991 also included a loss of $4.1 million in connection with the August 1991 disposition of station KAUT and non-cash income of $3.75 million related to the settlement of a pre-acquisition liability of ACTMEDIA. NET LOSS. Primarily as a result of the substantial interest expense (both current and deferred) of $37.5 million and $38.6 million in 1992 and 1991, respectively, relating to debt incurred in connection with the Company's acquisitions, the depreciation and amortization charges (relating primarily to goodwill and other intangibles which had a balance of $373.4 million at December 31, 1992), and the extraordinary loss of $3.6 million in 1992 associated with debt retirements, the Company reported net losses of $18.6 million and $15 million in 1992 and 1991, respectively. SEASONALITY AND INFLATION The advertising revenues of the Company vary over the calendar year, with the fourth quarter reflecting the highest revenues for the year. Stronger fourth quarter results are due in part to In-store having one extra 4-week cycle in the fourth quarter, increased retail advertising in the fall in preparation for the holiday season, and political advertising for broadcasting in election years. The slowdown in retail sales following the holiday season accounts for the relatively weaker results generally experienced in the first quarter. The Company believes inflation generally has had little effect on its results. CAPITALIZATION AND LIQUIDITY At December 31, 1993, the Company, through its Heritage Media Services, Inc. subsidiary ("HMSI"), had a $130 million bank credit facility (the "Credit Agreement"). HMSI is the Company's subsidiary which owns ACTMEDIA and the Company's broadcasting properties. The credit facility was comprised of an $80 million term loan which begins to amortize on December 31, 1994, and a $50 million reducing revolving credit facility which begins to decrease on December 31, 1994. At December 31, 1993, $80 million of the term loan facility and $30.5 million of the revolving credit facility were outstanding. At December 31, 1993, $19.5 million of additional borrowings were available under the Credit Agreement. Effective February 9, 1994, the revolving credit facility was increased to $75 million, thereby providing an additional $25 million availability under the Credit Agreement. The Credit Agreement includes a number of financial and other covenants, including the maintenance of certain operating and financial ratios and limitations on or prohibitions of dividends, indebtedness, liens, capital expenditures, asset sales and certain other items. Loans under the Credit Agreement are guaranteed by the Company and HMSI's domestic subsidiaries and are secured by a pledge of the capital stock of HMSI and its domestic subsidiaries. On June 22, 1992, HMSI issued $150 million of 11% senior secured notes (the "Senior Notes") due June 15, 2002. Interest on the Senior Notes is payable semi-annually. The Senior Notes rank on a parity with the obligations under HMSI's Credit Agreement, are guaranteed by the Company and HMSI's domestic subsidiaries and are secured by a pledge of capital stock of HMSI and its domestic subsidiaries. The Senior Notes include a number of financial and other covenants. On October 1, 1992 the Company issued $50 million of 11% senior subordinated notes (the "Subordinated Notes") due October 1, 2002. Interest on the Subordinated Notes is payable semi-annually. The Subordinated Notes are subordinate in right of payment to the prior payment in full of the Credit Agreement and the Senior Notes. In mid-1989, the Company issued approximately $7.55 million in equity settlement rights (the "Rights") (7.55 million Rights) in connection with the financing of the ACTMEDIA acquisition. At the time of issuance these Rights entitled the holders to approximately 18% of the fair market value of the business, properties and assets of ACTMEDIA as a going concern ("Net Equity") as determined in 1994 or 1996 in accordance with put/call features of the Rights purchase agreement. Depending on the circumstances under which the Rights are retired, the Company can pay this value in common stock or cash or subordinated notes convertible into common stock. To the extent such amount is paid in common stock, the valuation is required to be increased by 4%. At December 31, 1993, the amount of ACTMEDIA's indebtedness (substantially all of which is intercompany indebtedness) was approximately $160 million. During the past four years the Company acquired 1.6 million of the Rights at an average price of approximately $2.72 per Right in privately negotiated transactions, thereby reducing the outstanding Rights to 5.9 million or 14.1% of the Net Equity. The Rights mature seven years from the date of issuance (March 19, 1996), but they may be redeemed at the option of the holder ("put options") or the Company ("call options") at certain specified times during the period that they are outstanding. The initial put and call options become available in 1994. On or after April 19, 1994 (but prior to May 19, 1994), the Company is required to select an independent appraiser to determine the Net Equity. Upon completion of the appraisal process, the holders of the Rights will be notified of the appraised valuation of the Net Equity and the resultant valuation of the Rights. For a period of 30 days following such notification, the holders of the Rights may exercise a put option at such valuation. Also during that period, the Company may exercise a call option at such valuation. The put options may be paid in cash or, at the option of the Company, in Class A or Class C common stock, a combination of cash and common stock or, in certain circumstances, in subordinated notes convertible into common stock. The call options are to be paid in cash unless such payment would create an "adverse contractual effect" (defined generally as default under, or conflict with, agreements relating to the Company's indebtedness) for the Company, in which event, the Company may utilize the same payment process as described for the put option. To the extent that neither the put nor the call options are exercised prior to maturity date of the Rights, the Company is required to exercise a call option on that date under the terms set forth above, utilizing a valuation determined by an independent appraiser. To the extent the options are paid in cash, the Company will utilize cash provided by operations and/or borrowings against the Credit Agreement. The Rights were initially recorded at their estimated fair value at the date of issuance which approximated $7,550,000. From time to time the Company estimates the Net Equity and the resultant estimate of the value of the Rights. To the extent that such estimate of value exceeds the carrying value, such excess is being accreted by the interest method to accumulated deficit over the appropriate accounting period. At December 31, 1993, the carrying value was $19,514,000. The Company intends to increase this carrying value through additional accretion, to approximately $25,000,000 by June 30, 1994. The Company will continue to accrete the carrying value of the Rights to their estimated value until they are liquidated under one of the options discussed above. If, as a result of the independent appraisal process described above, a valuation is determined that is above or below the accreted carrying value, the Company will reflect such value through adjustment to the carrying value and to the accumulated deficit at June 30, 1994. Any such increase in the valuation would reduce the Company's net income per share or increase the net loss per share and any such decrease in the valuation would increase the Company's net income per share or reduce the net loss per share for the six months ending June 30, 1994, and, if the puts or calls are exercised, would similarly affect the amount of common stock to be issued (if the price were paid in common stock) or the indebtedness to be incurred (if the price were paid in cash). Based upon the foregoing debt and settlement right obligations, the Company is currently highly leveraged, and it is expected to continue to have a high level of debt for the foreseeable future. As of December 31, 1993, the Company had indebtedness (long-term debt, including current installments and notes payable) of approximately $315.0 million and stockholders' equity of approximately $86.6 million, and accordingly, a consolidated debt-to-equity ratio of 3.6 to 1. As a result of its leverage and in order to repay existing indebtedness, the Company will be required to generate substantial operating cash flow, refinance its indebtedness, make asset sales or effect some combination of the foregoing. The ability of the Company to meet these requirements will depend on, among other things, prevailing economic conditions and financial, business and other factors, some of which are beyond the control of the Company. Further, being primarily a holding company of operating companies through HMSI, the Company's ability to repay its indebtedness incurred at the parent company level will be limited by restrictions on the ability of HMSI under the Credit Agreement and the Senior Notes to declare and pay dividends to the Company. Under the credit agreement, at December 31, 1993, the total amount of dividends that could be paid by HMSI to the Company was $22.6 million. As a result of an amendment to the credit agreement dated February 9, the total amount of available dividends was increased to $50 million, if such dividends are required for the purchase or redemption of settlement rights. Under the Senior Note Indenture, at December 31, 1993, the total amount of dividends that could be paid by HMSI to the Company was $43.3 million. Such dividends are not permitted if, as a result of such payments, a default would occur under either the credit agreement or the Senior Note Indenture. As a result of the foregoing restrictions, consolidated net assets of HMSI totaling $136.3 million at December 31, 1993 are not available to the Company to pay dividends or repay debt. On February 1, 1994, the holders of all of the Company's Series B and Series C Convertible Preferred Stock converted their 161,945 preferred shares into 429,609 Class A common shares and 693,560 Class C common shares at the rate of 6.94 common shares for each preferred share thereby increasing the Company's common shares outstanding to 17.5 million and eliminating the Company's annual preferred dividend obligation of $1.8 million. The Company has focused its growth strategy on acquiring media and other communications-related properties it believes have the potential for long-term appreciation and aggressively managing the operations of these properties to improve their operating results. The Company has historically used cash flows from financing activities to fund its acquisitions and investments while the operations are expected to generate cash flow sufficient to fund their ongoing expenditure requirements. Cash flows provided by operating activities increased to $40.9 million in 1993 from $17.1 million in 1992. The improvement is primarily attributable to an additional $14 million of EBITDA, a $4 million decrease in interest payments in 1993 and improved receivables collections. In 1992 cash flows provided by operating activities decreased by $4.1 million compared to 1991 due to higher interest payments and receivable levels. In 1993 significant uses of cash in investing and financing activities included the following: $9.1 million for the retirement of debt and other liabilities, $2.8 million for purchase of settlement rights, $5.1 million for acquisitions and investments, and $18.5 million for capital expenditures. In 1992, cash flows from financing activities included $42.1 million of net proceeds from the issuance of additional Class A common stock. These proceeds were used primarily to fund the $30 million cash component of the Company's 8% subordinated note retirement and to fund the $7.9 million acquisition of the Kansas City and Cincinnati radio stations. Cash flows used for capital expenditures in investing activities during 1992 were generated by cash flows from operating activities. In 1991, cash flows from financing activities and cash flows used in investing activities reflect increased bank borrowings and proceeds from the issuance of the Series B and Series C Preferred Stock. The preferred stock proceeds were utilized, along with the proceeds from the sale of KDAY-AM, to purchase a portion of HMI's 13.5% debentures at a gain and to fund the cash component of the KOKH-TV and BLS Retail Resource Group acquisitions. Capital expenditures increased from $15.5 million in 1992 to $18.5 million in 1993. This increase was due primarily to the purchase of additional Instant Coupon Machines. Also, the Company completed two nonrecurring projects: the upgrade of the management information systems of the In-store Group and the construction of new broadcast facilities for the Pensacola television station. Capital requirements related to acquisitions for 1994 are expected to include approximately $2 million for the In-store Marketing Group's Australia and New Zealand acquisitions (completed in February 1994), $5 million for the Milwaukee radio station (completed in January 1994), and $7.2 million for the St. Louis radio station scheduled to close in March 1994. As a part of the commitment to the new marketing alliances, the Company made payments totaling $.8 million in 1993 and is expecting to make payments of $4 million in 1994 representing the Company's share of the cost of the network upgrade. These payments are for exclusive marketing rights which are amortized over the term of the retail chain agreements (five years). These requirements will be provided by funds generated from operations. NEW ACCOUNTING PRONOUNCEMENTS The Company does not presently provide post-retirement or post-employment benefits, as defined in FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and No. 112, "Employers' Accounting for Postemployment Benefits." Accordingly, these Statements will not impact the Company's consolidated financial statements. In addition, adoption of FASB Statement No. 114, "Accounting by Creditors for Impairment of a Loan", which is effective for financial statements for fiscal years beginning after December 15, 1994, is not anticipated to have a material effect on the Company's consolidated financial statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of Heritage Media Corporation and Subsidiaries as of December 31, 1993 and 1992 and for the years ended December 31, 1993, 1992 and 1991 are included on pages through herein. 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. Certain information in response to this item is incorporated by reference to the disclosure contained under the heading "Directors and Executive Officers" in the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Certain information in response to this item is incorporated by reference to the disclosure contained under the heading "Directors and Executive Officers" in the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information in response to this item is incorporated by reference to the disclosure contained under the headings "Principal Stockholders" and "Directors and Executive Officers" in the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information in response to this item is incorporated by reference to the disclosure contained under the heading "Directors and Executive Officers" in the 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: Financial Statements to this form are listed in the "Index to Consolidated Financial Statements" at page. (2) Schedules: Financial statement schedules to this form are listed in the "Index to Consolidated Financial Statements" at page herein. (3) Exhibits: See "Exhibit Index" included herein. Registrant agrees to furnish, upon the request of the Commission, a copy of all constituent instruments defining the rights of holders of long-term debt of Registrant and its consolidated subsidiaries. (b) Reports on Form 8-K. None. HERITAGE MEDIA CORPORATION INDEX TO EXHIBITS 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 8, 1994. HERITAGE MEDIA CORPORATION By _______/s/_DAVID N. WALTHALL_______ David N. Walthall 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 the registrant and in the capacities and on the dates indicated. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS All other schedules have been omitted because the required information is inapplicable, immaterial or is presented in the financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Heritage Media Corporation: We have audited the consolidated financial statements of Heritage Media 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 Heritage Media 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 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 Dallas, Texas February 25, 1994 HERITAGE MEDIA CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS) ASSETS See accompanying notes to consolidated financial statements. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS, EXCEPT SHARE INFORMATION) See accompanying notes to consolidated financial statements. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) See accompanying notes to consolidated financial statements. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) See accompanying notes to consolidated financial statements. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Heritage Media Corporation ("HMC" or "the Company") was incorporated on August 7, 1987 and began operations on August 11, 1987. The Company, through Heritage Media Services, Inc. ("HMSI"), a wholly-owned subsidiary, operates in three segments -- in-store marketing and television and radio broadcasting. The Company's in-store marketing operations are conducted in the United States, Canada and The Netherlands. Broadcasting operations are conducted in the United States. Aggregate assets and revenues of the Company's foreign operations comprise less than 10% of the Company's total assets and revenues. (A) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and all of its subsidiaries. All significant itercompany transactions and accounts have been eliminated in consolidation. (B) ACQUISITIONS, GOODWILL AND OTHER INTANGIBLES The cost of acquired companies is allocated first to identifiable assets and liabilities based on estimated fair market values. The excess of cost over identifiable assets and liabilities is recorded as goodwill and amortized over a period of 40 years. Costs allocated to identifiable intangible assets are amortized over the remaining life of the asset as determined by underlying contract terms or independent appraisals. Useful lives of license agreements and other intangibles are 25 and 4-10 years, respectively. Goodwill and other intangibles at December 31, 1993 and 1992 are summarized as follows (thousands of dollars): The Company continually reevaluates the propriety of the carrying amount of goodwill and other intangibles as well as the related amortization period to determine whether current events and circumstances warrant adjustments to the carrying values and/or revised estimates of useful lives. This evaluation is based on the Company's projection of the undiscounted operating income before depreciation, amortization, nonrecurring charges and interest for each of the Company's operating segments over the remaining lives of the amortization periods of related goodwill and intangible assets. The projections are based on the historical trend line of actual results since the commencement of operations in the respective segment and adjusted for expected changes in operating results. To the extent such projections indicate that the undiscounted operating income (as defined above) is not expected to be adequate to recover the carrying amounts of related intangibles, such carrying amounts are written down by charges to expense. At this time, the Company believes that no significant impairment of the goodwill and other intangibles has occurred and that no reduction of the estimated useful lives is warranted. (C) CASH EQUIVALENTS For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (D) INVENTORY Inventory consists of display devices used in the Company's in-store marketing programs. Such amounts are stated at the lower of average cost or market. (E) PROPERTY AND EQUIPMENT Property and equipment is recorded at cost. Depreciation is provided by the straight-line method over the estimated useful lives of the assets. The useful lives of the Company's property and equipment at December 31, 1993 are summarized as follows: The Company continually reevaluates the propriety of the carrying amount of property and equipment and the estimated useful lives used for depreciation. As a result, the Company prospectively changed its estimates of the useful lives of certain in-store marketing and broadcasting equipment during 1992. These changes resulted in additional depreciation expense and net loss per share of approximately $1,100,000 and $.08, respectively, for the year ended December 31, 1992. During the year ended December 31, 1993, the Company recorded a writedown of in-store marketing equipment of $1,685,000 in connection with certain changes in the Company's in-store radio marketing delivery system (see note 8). (F) BROADCAST PROGRAM RIGHTS Broadcast program rights are recorded as assets and liabilities when the programs are available for telecasting. The assets are carried at the lower of cost or estimated net realizable value and are classified as current or noncurrent based upon the expected use of the programs in succeeding years. The contract liabilities are classified as current or noncurrent in accordance with contract payment terms. Costs are charged to operations by the straight-line method over the contract period. The Company continually reevaluates the propriety of the carrying amounts of broadcast program rights assets to determine if circumstances warrant adjustments to the carrying values. As a result, the Company recorded writedowns of program rights of $1,678,000 and $490,000 during the years ended December 31, 1993 and 1991, respectively. The estimated fair value of broadcast program rights liabilities do not differ significantly from their carrying amounts at December 31, 1993 and 1992. (G) DEFERRED FINANCE COSTS Deferred finance costs are recorded at cost and are amortized using the interest method over the period of the related debt agreement. (H) DISCOUNTS ON LONG-TERM DEBT The original discounts on certain notes payable are being accreted over the term of the notes by charges to interest expense using the interest method. (I) REVENUES Revenues from in-store marketing are derived primarily from providing advertising space, promotion and production services in retail stores and by selling advertising time to national advertisers HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) on an in-store music entertainment network. Revenues from in-store marketing are recognized over the contract period of the related advertising program and those from advertisements on the in-store music network are recognized when the commercial is aired. Television and radio broadcasting revenues are primarily derived from local, regional and national advertising and network compensation. Advertising revenues are recognized upon the airing of commercials, while network revenues are recognized monthly as earned. Revenues are presented net of advertising agency and national sales representatives' commissions. (J) BARTER TRANSACTIONS The Company exchanges unsold advertising time for products and services. These transactions are reported at the estimated fair market value of the product or service received. Barter revenues are recorded when the commercials are broadcast and barter expenses are recorded when merchandise or services are used. If merchandise or services are received prior to the broadcast of a commercial, a liability is recorded. Likewise, a receivable is recorded if a commercial is broadcast before the goods or services are received. Barter amounts are not significant to the Company's consolidated financial statements. (K) LOSS PER SHARE The net loss per common share is computed by dividing net income (loss), adjusted for accretion and premium or discount on retirement of the settlement rights and dividends on preferred stock for applicable years, by the weighted average number of Class A and Class C common shares, and one-half of the weighted average number of Class B common shares, outstanding during each year, after giving retroactive effect to a one-for-four reverse stock split in March 1992 (note 6). Common stock purchase options, preferred stock and settlement rights have been excluded from the computation as their effect is antidilutive. Following is a reconciliation of net loss to net loss applicable to common stock for the years ended December 31, 1993, 1992 and 1991: Assuming the conversion of all outstanding preferred shares into Class A and C common shares (see note 6) had occurred on January 1, 1993, pro forma loss per common share before extraordinary item and pro forma net loss per common share for the year ended December 31, 1993 would have been $.19 and $.17, respectively. (L) INCOME TAXES During 1992 and 1991, deferred income taxes are provided for the effects of items reported for tax purposes in periods different from those used for financial reporting purposes in accordance with Accounting Principles Board Opinion No. 11. In February 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Application of SFAS 109, which is required for fiscal years beginning after December 15, 1993, required the Company to change, effective January 1, 1993, from the deferred method to the asset and liability method of HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) accounting for income taxes. Under the asset and liability method, deferred income taxes are provided by applying enacted statutory rates in effect at the balance sheet date to differences between the book and tax bases of assets and liabilities. The resulting deferred tax liabilities, and assets in some cases, are adjusted to reflect changes in tax laws or rates as they occur. The Company implemented the provisions of SFAS 109 in the first quarter of 1993 without restating prior years' financial statements. This change did not have a significant effect on the Company's consolidated financial statements. (M) FOREIGN CURRENCY TRANSLATION For foreign operations, the balance sheet accounts are translated at the current year-end exchange rate and income statement items are translated at the average exchange rate for the year. Resulting translation adjustments are presented as a separate component of stockholders' equity. Foreign transaction exchange gains and losses are recognized as income or expense; such amounts were not material in 1993, 1992 or 1991. (N) RECLASSIFICATIONS Certain reclassifications have been made in the prior years' consolidated financial statements to conform to the 1993 presentation. (2) ACQUISITIONS AND DISPOSITIONS In December 1990, the Company began investing in Supermarket Visions, Ltd. ("SVL"), an in-store marketing company operating in the United Kingdom. Cash investments in SVL preferred stock and advances totaled $994,000 and $344,000 during 1992 and 1991, respectively. During 1992 and 1991, the Company recorded $2,162,000 and $1,300,000 of writedowns of the carrying amount of the Company's investment in SVL. Also during 1992, the Company recorded additional costs of $1,098,000 incurred during the shutdown of SVL. SVL ceased operations in September 1992 and was liquidated in the fourth quarter of 1992. All such writedowns and shutdown costs are included in other expense, net for the respective years. On March 26, 1991, the Company sold a radio station for $5,066,000 cash. The book value of the station was written down to approximately $5,000,000 at December 31, 1990 based on estimated sale proceeds. A gain of approximately $66,000 representing a partial recovery of previous writedowns is reflected in other expense, net in the consolidated statement of operations for the year ended December 31, 1991. On August 15, 1991, the Company sold certain assets of a television station for $1,485,000. The Company also donated certain assets of the station to a charitable organization. The loss on sale and the charitable donation totaled $4,071,000 and is reflected in other expense, net in the consolidated statement of operations for the year ended December 31, 1991. Sale proceeds consisted of $285,000 cash and a note receivable of $1,200,000. Concurrently, the Company purchased a television station in the same market for $7,007,000. The purchase was financed with cash from operations of $2,059,000, a $4,623,000 note payable and 25,000 shares of the Company's Class A common stock with a fair market value of $13 per share. On August 15, 1991, the Company purchased a Canadian in-store marketing company for $3,711,000 consisting of an initial cash payment of $2,252,000 and an obligation for a minimum contingent payment, based on earnings through 1994, of $1,459,000 payable over three years. If the acquired company attains certain predetermined earnings goals, the Company may be obligated to make an additional payment not to exceed $1,053,000 in July 1994. Such payment, to the extent made, will be recognized as additional goodwill. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) ACQUISITIONS AND DISPOSITIONS (CONTINUED) On October 18, 1991, the Company entered into a joint venture agreement to purchase in-store marketing companies in Europe for an initial investment of $511,000. In April 1992, the Company invested an additional $2.2 million in the joint venture which concurrently acquired a 65% interest in an in-store marketing company in The Netherlands. On February 28, 1992, the Company amended its Joint Operating Agreement with Muzak Limited Partnership whereby the Company purchased various in-store marketing assets for a purchase price of $5,000,000. Consideration paid by the Company consisted of $850,000 cash and a $4,150,000 note payable due in fluctuating quarterly installments with the balance due on January 31, 1999. On June 1, 1992, the Company purchased the assets of two radio stations for cash of $7,895,000. On July 22, 1993, the Company purchased the assets of a radio station for cash of $4,918,000. The Company began operating the station on May 14, 1993 under a time brokerage agreement. On January 6, 1994, the Company purchased the assets of a radio station for cash of $5,600,000. As of December 31, 1993, the Company had made escrow deposits of $560,000 relating to this acquisition, reducing its remaining purchase commitment to $5,040,000. The Company began operating the station on October 25, 1993 under a time brokerage agreement. On January 10, 1994, the Company agreed to purchase the assets of a radio station for $7,200,000. Completion of the purchase is pending the consent of the Federal Communications Commission ("FCC"). During 1991, the Company recognized noncash income of $3,750,000 related to the settlement of a preacquisition liability of Actmedia, Inc. ("Actmedia"), an in-store marketing subsidiary of the Company. Such amount is included in other expense, net in the accompanying consolidated statement of operations. During 1993, the Company reached a settlement with the Internal Revenue Service ("IRS") in regards to certain preacquisition tax liabilities of Actmedia. The Company had previously recorded federal tax liability purchase reserves of approximately $3,900,000. As a result of the settlement, the Company paid approximately $800,000 to the IRS and reversed the remaining reserves to goodwill. The acquisitions discussed above were recognized in the consolidated financial statements as follows (thousands of dollars): The following summary presents unaudited pro forma consolidated results of operations for the Company and its subsidiaries assuming (a) the acquisitions and dispositions of (i) the radio stations acquired during 1993 and 1992, (ii) The Netherlands in-store marketing company acquired during 1992, and (iii) the United Kingdom in-store marketing company disposed of in 1992 and (b) the HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) ACQUISITIONS AND DISPOSITIONS (CONTINUED) refinancing transactions discussed in note 4, the 1993 and 1992 settlement rights purchases discussed in note 5 and the conversion of preferred stock discussed in note 6 had occurred at the beginning of the respective periods (thousands of dollars, except per share information): The pro forma amounts assume that the financing requirements of the acquisitions were met by the use of funds from the offering of common stock completed in 1992 and the actual debt issuances incurred in connection with the in-store marketing company and radio station acquisitions and the purchase of settlement rights, assuming that all such financings were completed at the beginning of the respective periods. The pro forma amounts are not necessarily indicative of what the results would actually have been if the transactions had been consummated earlier and are not intended to be an indication of operating results expected to be achieved in the future. (3) ACCRUED EXPENSES Accrued expenses at December 31, 1993 and 1992 are summarized as follows: (4) LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 is summarized as follows: (a) On June 22, 1992, HMSI issued $150 million of 11% Senior Secured Notes ("the Senior Notes") due June 15, 2002. The Senior Notes are redeemable, in whole or in part, at HMSI's option at any time on or after June 15, 1997, at amounts decreasing from 105.5% to 100% of par on June 15, 1999. The Senior Notes rank on a parity with the obligations of HMSI under its credit agreement, are guaranteed by HMC and HMSI's domestic subsidiaries and are secured by a pledge of capital HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) LONG-TERM DEBT (CONTINUED) stock of HMSI and its domestic subsidiaries. The fair market value of the Senior Notes based on quoted market rates is $164,250,000 and $153,000,000 at December 31, 1993 and 1992, respectively. (b) In conjunction with the issuance of the Senior Notes, HMSI entered into a credit agreement with a group of banks providing for an $80 million term loan and a reducing revolving credit facility of up to $50 million (increased to $75 million effective February 9, 1994). Quarterly principal payments under the credit agreement commence on December 31, 1994 and continue until June 1999. At December 31, 1993, $19.5 million of additional borrowings were available under the credit agreement. HMSI pays an annual commitment fee equal to 0.5% of the unadvanced portion of the credit agreement. Loans under the credit agreement bear interest at rates based on the agent bank's base rate, a Eurodollar rate or a CD rate plus a margin depending on HMSI's ratio of consolidated total debt to operating cash flow (as defined). At December 31, 1993, the weighted average interest rate was 4.98% under the Eurodollar option. The loans under the credit agreement are secured by the stock of substantially all subsidiaries of the Company and by the assets of HMSI, Actmedia and certain other subsidiaries. The initial borrowings under the credit agreement, together with proceeds obtained from the issuance of the Senior Notes were used to prepay balances outstanding under HMSI's previous credit agreement. HMSI recognized an extraordinary loss of $2,242,000 on this refinancing. As the credit agreement bears interest at current market rates, its carrying amount approximates its fair market value at December 31, 1993 and 1992. (c) On August 11, 1987, the Company issued a $75 million, 8% subordinated note due July 31, 1994. Interest on this note was deferred and payable at maturity. The note was discounted for financial statement purposes by $24.6 million using a 14% interest rate. On April 15, 1992, the Company retired the 8% subordinated note with an accreted balance of $95,384,000 through the payment of $30,000,000 of cash obtained from the issuance of Class A common stock (note 6), the issuance of 1,335,721 shares of Class C common stock at $9.75 per share and the issuance of a new $50 million, 12% subordinated note ("the New Note"). The $30,000,000 payment is included in the amounts disclosed as cash paid for interest in the statement of cash flows for the year ended December 31, 1992. As a result of this transaction, the Company recognized an extraordinary gain of approximately $2,360,000. On October 1, 1992, the Company retired the New Note through the issuance of $50 million of 11% Senior Subordinated Notes ("the Notes") due October 1, 2002. The Notes are redeemable, in whole or in part, at the Company's option at any time on or after October 1, 1997, at amounts decreasing from 105.5% to 100% of par at October 1, 1999. The Notes are subordinated to the Senior Notes, HMSI's credit agreement and all other indebtedness of the Company and its subsidiaries. The Company recognized an extraordinary loss of $1,526,000 on this refinancing. The fair market value of the Notes based on quoted market rates is $54,500,000 and $47,375,000 at December 31, 1993 and 1992, respectively. (d) Other debt bears interest at varying rates and consists primarily of notes payable, capital lease obligations and industrial development revenue bonds due in varying amounts through 1999. On August 11, 1987, Heritage Media, Inc. ("HMI"), a wholly-owned subsidiary of the Company, issued $74.1 million of subordinated original issue discount debentures in a private placement. During 1992 and 1991, the Company extinguished outstanding HMI debentures with face amounts of $37,183,000 and $23,517,000, respectively, prior to scheduled maturity. These extinguishments resulted in extraordinary losses of $2,186,000 in 1992 and extraordinary gains of $4,320,000 in 1991. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) LONG-TERM DEBT (CONTINUED) On July 14, 1993, the Company retired a subordinated note payable prior to the scheduled maturity with a face value of $3,235,000 by a cash payment of $2,800,000. As a result of this transaction, the Company recognized an extraordinary gain of approximately $435,000. The loan agreements described above require the Company and/or its subsidiaries to comply with various financial and other covenants, including the maintenance of certain operating and financial ratios and they contain substantial limitations on, or prohibitions of, dividends, additional indebtedness, liens, capital expenditures, asset sales and certain other items. The Company is currently highly leveraged, and it is expected to continue to have a high level of debt for the foreseeable future. As a result of its leverage and in order to repay existing indebtedness, the Company will be required to generate substantial operating cash flow, refinance its indebtedness, make asset sales or effect some combination of the foregoing. The ability of the Company to meet these requirements will depend on, among other things, prevailing economic conditions and financial, business and other factors, some of which are beyond the control of the Company. Further, being primarily a holding company of operating companies through HMSI, the Company's ability to repay its indebtedness incurred at the parent company level will be limited by restrictions on the ability of HMSI under the credit agreement to declare and pay dividends to the Company. Under the credit agreement, at December 31, 1993, the total amount of dividends that could be paid by HMSI to the Company was $22,600,000. As a result of an amendment to the credit agreement dated February 9, 1994, the total amount of such dividends was increased to $50,000,000, if such dividends are required for the purchase or redemption of settlement rights (note 5). Under the Senior Note Indenture, at December 31, 1993, the total amount of dividends that could be paid by HMSI to the Company was $43,300,000. Such dividends are not permitted if, as a result of such payments, a default would occur under either the credit agreement or the Senior Note Indenture. As a result of the foregoing restrictions, consolidated net assets of HMSI (note 12) totaling approximately $136,300,000 at December 31, 1993 are not available to the Company to pay dividends or repay debt. Aggregate annual maturities of long-term debt for the years ending December 31, 1994 through 1998 are $2,076,000; $8,290,000; $14,668,000; $28,140,000; and $32,544,000, respectively. Interest expense for the years ended December 31, 1993, 1992 and 1991 is summarized as follows: (5) SETTLEMENT RIGHTS Approximately 7,553,000 settlement rights were originally issued in connection with the Actmedia acquisition in 1989. These rights originally entitled the holders to receive cash or Class A or Class C common stock having a value equal to approximately 18% of the fair market value of the business, properties and assets of Actmedia as a going concern ("Net Equity") at specified future dates. At December 31, 1993, the amount of Actmedia's indebtedness (substantially all of which is intercompany indebtedness) was approximately $160,000,000. Through a series of private transactions, the Company has purchased 1,631,000 settlement rights during the past four years for an HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (5) SETTLEMENT RIGHTS (CONTINUED) aggregate purchase price of $4,434,000 (at an average cost of $2.72 per right). As a result of these purchases, at December 31, 1993, there were approximately 5,922,000 settlement rights outstanding representing approximately 14.1% of Actmedia's Net Equity. The settlement rights mature seven years from the date of issuance (March 19, 1996), but they may be redeemed at the option of the holder ("put options") or the Company ("call options") at certain specified times during the period that they are outstanding. The initial put and call options become exercisable in 1994. On or after April 19, 1994 (but prior to May 19, 1994), the Company will select an independent appraiser to determine the fair market value of the Net Equity of Actmedia. Upon completion of the appraisal process, the holders of the settlement rights will be notified of the appraised valuation of the Net Equity and the resultant valuation of the settlement rights. For a period of 30 days following such notification, the holders of the settlement rights may exercise a put option, or the Company may exercise a call option, at such valuation. The put options may be paid in cash or, at the option of the Company, in Class A or Class C common stock, a combination of cash and common stock or, in certain circumstances, in subordinated notes convertible into common stock. The call options are to be paid in cash unless such payment would create adverse financial consequences for the Company, in which event the Company may utilize the same payment process as described for the put option. To the extent that neither the put nor the call options are exercised prior to maturity of the settlement rights, the Company is required to exercise a call option on that date under the terms set forth above, utilizing a valuation determined by an independent appraiser. The settlement rights were initially recorded at their estimated fair value at the date of issuance which approximated $7,553,000. From time to time the Company estimates the value of Actmedia Net Equity and the resultant estimate of the value of the settlement rights. To the extent that such estimate of value exceeds the carrying value, such excess is being accreted by the interest method to accumulated deficit over the appropriate accounting period. At December 31, 1993, the aggregate carrying value was $19,514,000. The Company intends to increase this carrying value, through additional accretion, to approximately $25,000,000 by June 30, 1994 and will continue to accrete the carrying value of the settlement rights to their estimated value until they are liquidated under one of the options discussed above. If, as a result of the independent appraisal process described above, a valuation is determined that is above or below the accreted carrying value, the Company will reflect such value through adjustment to the carrying value and to the accumulated deficit on June 30, 1994. (6) STOCKHOLDERS' EQUITY Each share of Class A common stock is entitled to one vote. Class C common shares generally are nonvoting; however, Class A and Class C common shares each may vote as a class on certain matters affecting their rights or preferences or as otherwise provided under Iowa law. Any dividends which are declared on any class of common stock must also be declared at an equivalent rate on the other classes of common stock. Class C common stock can be converted, at the holder's option, at any time, into Class A shares. On March 30, 1992, the common shareholders approved a one-for-four reverse split of the Company's common stock. All per share information and numbers of shares in the accompanying consolidated financial statements and notes thereto have been retroactively restated to reflect the results of this split. Additionally, the shareholders approved the elimination of the Class B common stock effective upon the conversion of each share of Class B common stock to one-half share of Class A common stock. During 1992, 400,000 shares of Class B common stock were converted to Class A HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (6) STOCKHOLDERS' EQUITY (CONTINUED) common stock and the 1,600,000 shares of Class B common stock outstanding at December 31, 1992 were converted to Class A common stock upon approval by the FCC on July 20, 1993. Thereafter, the authorization of Class B Common Stock was eliminated from the Company's charter. On April 23, 1992, the Company issued 4,500,000 shares of Class A common stock in a public offering at $10 per share for net proceeds of $41,892,000. The Company used $30,000,000 of the proceeds to retire the $75 million, 8% subordinated note due July 31, 1994 (note 4). Remaining proceeds were used to reduce outstanding borowings under the Company's credit agreement. The Company has authorized 60,000,000 shares of preferred stock which can be issued in series with varying preferences and conversion features as determined by the Company's Board of Directors. In February 1992, the Company issued 22,117 shares of Series B preferred stock and 139,828 shares of Series C preferred stock at $100 per share. The shares were issued in exchange for cash of $14,778,000 and $1,416,900 of outstanding HMI debentures. The Company incurred issuance costs of $196,000 on this transaction. Each share of preferred stock accrues cumulative dividends at an annual rate of $11 per share, payable quarterly. Unpaid dividends accrue an amount equal to 11% per annum. At December 31, 1993, there were no dividends in arrears on the preferred stock. Each share of Series B preferred stock is convertible at the option of the holder into 6.9356 shares of Class A common stock. Each share of Series C preferred stock is convertible at the option of the holder into 6.9356 shares of Class A or Class C common stock. The liquidation preference is $100 per share plus accrued dividends. On February 1, 1994, the Company redeemed all outstanding shares of preferred stock by the issuance of 429,609 shares of Class A and 693,560 shares of Class C common stock. Also, on February 1, 1994, the holder of approximately 2.2 million shares of Class C common stock indicated its intention to convert the Class C shares into Class A shares and exercise its rights to require the Company to register the Class A shares in a secondary public offering. The offering is expected to occur in the first half of 1994. (7) EMPLOYEE BENEFIT PLANS The Company has a nonqualified employee incentive stock option plan under which options to purchase a total of 1,500,000 shares of the Company's Class A common stock may be granted to key employees, officers and directors. The purchase price may not be less than market value at the date of grant without approval of the Board of Directors. The options granted under such plan are exercisable beginning two years from date of grant and expire ten years from date of grant. On July 15, 1992, the Board of Directors approved, and the Company implemented, an option exchange program whereby Company employees, officers and directors were provided an opportunity to exchange existing options for new options on a reduced number of shares. The exercise price of the new options was $7.50 which represented the market price of the Company's Class A common stock on July 14, 1992. Vesting positions were not affected by the exchange. Under this program, 541,479 options issued prior to July 15, 1992 were exchanged for 288,136 new options. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (7) EMPLOYEE BENEFIT PLANS (CONTINUED) Following is a summary of activity in the option plan and agreements discussed above for the years ended December 31, 1991, 1992 and 1993: At December 31, 1993, 238,143 options outstanding under the option plan and agreements discussed above were exercisable and 582,103 shares were available for grant. The Company has a Retirement Savings Plan ("the Plan") whereby participants may contribute portions of their annual compensation to the Plan and certain contributions may be made at the discretion of the Company based on criteria set forth in the Plan agreement. Participants are generally 100% vested in Company contributions after five years of employment with the Company. For the years ended December 31, 1993, 1992 and 1991, Company expenses under the Plan were approximately $809,000, $501,000 and $250,000, respectively. The Company has a Stock Appreciation Rights Plan ("the SAR Plan") under the terms of which certain Actmedia employees may be granted a total of 250,000 stock appreciation units. The units entitle the holders, in the aggregate, to receive an amount equal to 2.5% of the increase, as defined, in the net value of Actmedia from the date of grant to December 31, 1994. At December 31, 1993, approximately 224,000 stock appreciation units were outstanding. Participants vest in such units over a five-year period and the cost of the SAR Plan is being charged to expense over the vesting period. For the years ended December 31, 1993, 1992 and 1991, compensation expense accrued under the SAR Plan was $500,000, $550,000 and $350,000, respectively. The Company does not provide post-employment or post-retirement benefits. (8) OTHER NONRECURRING COSTS In 1993, the Company made the decision to upgrade its existing in-store marketing radio network to a satellite-based delivery system. As a result, certain personnel and facilities utilized by the former HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (8) OTHER NONRECURRING COSTS (CONTINUED) tape-based system will no longer be needed in the Company's operations. During the fourth quarter of 1993, the Company recorded a provision for the following writedowns and costs in connection with the change (thousands of dollars): The system upgrades began in October 1993 and are expected to continue through 1994. As of December 31, 1993, the Company had incurred or paid approximately $2,000,000 of the costs set forth above. The Company is also expected to incur capital costs of approximately $4,000,000 in 1994 in connection with the system upgrades. Such costs will be amortized over the five-year term of the related exclusive marketing rights agreements. (9) INCOME TAXES As discussed in note 1, the Company adopted SFAS 109 as of January 1, 1993. As a result of this change in accounting for income taxes, the Company recorded deferred tax assets (net of a valuation allowance of $26,908,000) and corresponding deferred tax liabilities of $7,319,000 on January 1, 1993. Total income tax expense for the years ended December 31, 1993, 1992 and 1991 of $2,944,000, $1,580,000 and $446,000, respectively, was allocated entirely to continuing operations and consisted primarily of current state income taxes. Income tax expense (benefit) differed from the amounts computed by applying the statutory U.S. federal income tax rates to income (loss) before income taxes and extraordinary items as a result of the following (thousands of dollars): HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (9) INCOME TAXES (CONTINUED) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 1993 are presented below (thousands of dollars): Deferred tax assets and liabilities are computed by applying the U.S. federal income tax rates in effect to the gross amounts of temporary differences and other tax attributes, such as net operating loss and capital loss carryforwards. Deferred tax assets and liabilities relating to state income taxes are not material. The Company expects the net deferred tax assets at December 31, 1993 to be realized as a result of the reversal during the carryforward period of existing taxable temporary differences giving rise to deferred tax liabilities. At December 31, 1993, the Company has net operating loss carryforwards for federal income tax purposes of approximately $56,300,000 which are available to offset future taxable income, if any, through 2007. Additionally, the Company has restricted net operating loss carryforwards of approximately $12,845,000 that can only be used to offset future taxable income, if any, of certain subsidiaries of the Company, through 2005. The Company has capital loss carryforwards of approximately $7,200,000 which are available to offset future capital gains, if any, through 1997. (10) COMMITMENTS AND CONTINGENCIES (A) LEASES AND CONTRACTS The Company and its subsidiaries lease certain real property, transportation and other equipment under noncancellable operating leases expiring at various dates through 1999. The Company also has long-term contractual obligations to two major broadcast ratings firms that provide monthly ratings services. Minimum commitments under all noncancellable leases and contracts for the years ending December 31, 1994 through 1998 are approximately $7,668,000, $7,068,000, $6,227,000, $3,664,000 and $2,913,000, respectively. Lease, rental and contractual expense payments for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $7,907,000, $5,423,000 and $5,469,000, respectively. (B) BROADCAST PROGRAM RIGHTS The Company has entered into contracts for broadcast program rights that expire at various dates during the next five years. Contracts totaling approximately $1,966,000 relate to programs which are not currently available for use and, therefore, are not reflected as assets or liabilities in the HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (10) COMMITMENTS AND CONTINGENCIES (CONTINUED) accompanying consolidated balance sheet at December 31, 1993. The aggregate minimum payments under contracts for programs currently available (those included on the consolidated balance sheet at December 31, 1993) and programs not currently available (those not included on the consolidated balance sheet at December 31, 1993) are approximately $2,581,000, $1,542,000, $510,000, $540,000 and $441,000 for the years ending December 31, 1994 through 1998, respectively. The Company entered into contracts for broadcast program rights of approximately $2,084,000, $2,181,000 and $2,314,000 during the years ended December 31, 1993, 1992 and 1991, respectively. (C) GUARANTEED STORE COMMISSIONS The Company has contractual obligations with certain supermarket chains for terms of a year or more to pay minimum store commission guarantees to these chains in connection with the chains' participation in one or more of the Company's advertising programs. Revenues derived from the Company's advertising programs are normally adequate to generate store commissions which exceed the minimum guarantees and such commission amounts are charged to operations as incurred. To the extent, however, that the store commissions generated by advertising programs are not expected to be sufficient to cover the minimum guarantees, a provision for the difference is charged to operations at the time such determination is made. Future minimum store commission guarantees for the years ending December 31, 1994 through 1998 are approximately $1,451,000, $670,000, $158,000, $129,000, and $54,000, respectively. (D) LITIGATION The Company is a party to lawsuits which are generally incidental to its business. Management of the Company does not believe the resolution of such matters will have a significant effect on its financial position or results of operations. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (11) SEGMENT INFORMATION Information relating to the Company's business segments as of and for the years ended December 31, 1993, 1992 and 1991 is as follows: (a) Includes nonrecurring expenses of $3,000,000 relating to the shut-down of certain in-store marketing facilities. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (11) SEGMENT INFORMATION (CONTINUED) (b) Includes writedowns of program rights of $1,678,000 and $490,000 in 1993 and 1991, respectively. (c) Includes amounts relating to fixed assets obtained in acquisitions, fixed asset additions from barter agreements, and translation adjustments of $1,270,000, $6,567,000 and $5,640,000 in 1993, 1992 and 1991, respectively. In 1993, one customer in the in-store marketing segment accounted for 10% of the Company's net revenues for the year, and in 1992 and 1991 one customer in each year accounted for 11% of the Company's net revenues. (12) SUMMARIZED FINANCIAL DATA OF HMSI Following is summarized financial information for HMSI, the issuer of the Senior Notes and the obligor on credit agreement borrowings (note 4). The Senior Notes and such borrowings are fully and unconditionally guaranteed by the Company and the subsidiaries of HMSI, other than subsidiaries organized outside the United States. Financial information of the guarantors is not presented as the guarantors will be jointly and severally liable on the Senior Notes and the aggregate net assets, earnings and equity of the guarantors are substantially equivalent to the net assets, earnings and equity of the Company and its subsidiaries. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (13) QUARTERLY FINANCIAL DATA (UNAUDITED) Gross profit represents net revenues less cost of services. Operating income is defined as net revenue less cost of services; selling, general and administrative expenses; depreciation and amortization; writedown of program rights; product development costs and other nonrecurring charges. Actmedia reports its operations on a 13-cycle basis whereby the results of operations of three, four-week periods are reported in each of the first three quarters of the fiscal year and four, four-week periods are reported in the fourth quarter of the fiscal year. Extraordinary gains and losses during 1993 and 1992 relate to early extinguishments of debt. Results of the fourth quarter of 1993 include $3,000,000 of nonrecurring charges relating to the upgrade of the Company's in-store marketing radio network. Results for the third quarter of 1992 include $2,700,000 of writedowns of the carrying amount of the Company's investment in SVL. Additional 1992 writedowns of such carrying amount totaling $560,000 did not have a significant impact on the financial results of the quarter in which they were recognized. SCHEDULE III HERITAGE MEDIA CORPORATION FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS) ASSETS See accompanying notes to condensed financial information. SCHEDULE III (CONTINUED) HERITAGE MEDIA CORPORATION FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) See accompanying notes to condensed financial information. SCHEDULE III (CONTINUED) HERITAGE MEDIA CORPORATION FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) See accompanying notes to condensed financial information. HERITAGE MEDIA CORPORATION NOTES TO CONDENSED FINANCIAL INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (1) GENERAL The accompanying condensed financial information of Heritage Media Corporation ("Registrant" or the "Company") should be read in conjunction with the consolidated financial statements of the Registrant included in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. Heritage Media Corporation is primarily a holding company; however, the Company also owned one television station until August 1991 (see note 2). (2) ACQUISITIONS AND DISPOSITIONS In December 1990, the Company began investing in Supermarket Visions, Ltd. ("SVL"), an in-store marketing company operating in the United Kingdom. Cash investments in SVL preferred stock and advances totaled $994,000 and $344,000 during 1992 and 1991, respectively. During 1991 and 1992, the Company recorded $1,300,000 and $2,162,000 of writedowns of the carrying amount of the Company's investment in SVL. Also during 1992, the Company recorded additional costs of $1,098,000 incurred during the shutdown of SVL. SVL ceased operations in September 1992 and was liquidated in the fourth quarter of 1992. All such writedowns and shutdown costs are included in other expense, net for the respective years. On August 15, 1991, the Company sold certain assets of a television station with a total book value of $5,556,000 for $1,485,000. The loss on sale of $4,071,000 is reflected in other expense, net in the consolidated statement of operations for the year ended December 31, 1991. Sale proceeds consisted of $285,000 cash and a note receivable of $1,200,000. Concurrently, the Company purchased a television station in the same market for $7,007,000. The purchase was financed with cash from operations of $2,059,000, the $4,623,000 note payable and 25,000 shares of the Company's Class A common stock at $13 per share. On October 18, 1991, the Company entered into a joint venture agreement to purchase in-store marketing companies in Europe for an initial investment of $511,000. In April 1992, the Company paid $2.2 million to acquire a 65% interest in an in-store marketing company in The Netherlands. On February 28, 1992, the Company amended its Joint Operating Agreement with Muzak Limited Partnership whereby the Company purchased various in-store marketing assets for a purchase price of $5,000,000. Consideration paid by the Company consisted of $850,000 cash and a $4,150,000 note payable due in fluctuating quarterly installments with the balance due on January 31, 1999. (3) LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 is summarized as follows: On August 11, 1987, the Company issued a $75 million, 8% subordinated note due July 31, 1994. Interest on this note was deferred and payable at maturity. The note was discounted for financial statement purposes by $24.6 million using a 14% interest rate. On April 15, 1992, the Company retired the 8% subordinated note with an accreted balance of $95,384,000 through the payment of HERITAGE MEDIA CORPORATION NOTES TO CONDENSED FINANCIAL INFORMATION (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (3) LONG-TERM DEBT (CONTINUED) $30,000,000 of cash obtained from the issuance of Class A common stock (note 5), the issuance of 1,335,721 shares of Class C common stock at $9.75 per share and the issuance of a new $50 million, 12% subordinated note ("the New Note"). As a result of this transaction, the Company recognized an extraordinary gain of approximately $2,360,000. On October 1, 1992, the Company retired the New Note through the issuance of $50 million of 11% Senior Subordinated Notes ("the Notes") due October 1, 2002. The Notes are redeemable, in whole or in part, at the Company's option at any time on or after October 1, 1997, at amounts decreasing from 105.5% to 100% of par at October 1, 1999. The Notes are subordinated to all other indebtedness of the Company and its subsidiaries except that the Notes are senior to a $4,623,000 note payable dated August 15, 1991 issued in connection with the acquisition of a television station (note 2). The Company recognized an extraordinary loss of $1,526,000 on this refinancing. Debt agreements of the Company's subsidiaries prohibit or limit their ability to pay dividends to the Company. However, these agreements permit the payment of dividends sufficient to meet the Company's obligations under the Notes. SCHEDULE V HERITAGE MEDIA CORPORATION AND SUBSIDIARIES PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE VI HERITAGE MEDIA CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE VIII HERITAGE MEDIA CORPORATION AND SUBSIDIARIES ALLOWANCE FOR DOUBTFUL ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE X HERITAGE MEDIA CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS)

846972_1993.txt

846972_1993

1993

846972

Item 1. Business Adience, Inc. ("Adience," and together with its subsidiaries, the "Company") is engaged in the manufacture, sale, installation and maintenance of specialty refractory products through its Heat Technology Division. Refractory products, which are made primarily from fireclays and minerals such as bauxities and aluminas, are used in virtually every industrial process requiring heating or containment at a high temperature of a solid, liquid or gas. Iron and steel producers use Adience's products in various types of iron and steel making furnaces, in coke ovens and in iron and steel handling and finishing operations. Adience also provides installation and maintenance services in connection with its specialty refractory products to the steel, aluminum, glass, petrochemical and other non-ferrous industries. See "Operations of Adience" below. The Company is also engaged, through its 80.3%-owned subsidiary, Information Display Technology, Inc. ("IDT"), in the manufacture, sale and installation of writing, projection and other visual display surfaces; customer cabinetry, work station and conference center casework; and architectural composite panels for building exteriors. See "Operations of Information Display Technology" below. The "Industry Segment Data" note to the Company's consolidated financial statements contained in Item 8 sets forth historical information concerning the net revenues and operating profit by, and identifiable assets attributable to, each of the Company's segments. Operations of Adience Adience's Heat Technology Division consists of four refractory units: BMI, J.H. France, Findlay and Furnco. Through BMI and J.H. France (acquired in 1985 and 1987, respectively), the Heat Technology Division engages in the manufacture, sale, installation and maintenance of specialty unformed refractory products and bricks, which must be replaced, in many cases, as often as several times a day. Refractory products are ceramic materials used as insulation on surfaces that are exposed to high temperatures, such as from contact with molten metals or steam. Through Findlay (acquired in 1989), the Heat Technology Division manufactures and sells specialty refractory block used in the production of glass and glass products. Through Furnco, the Heat Technology Division is engaged in the rebuilding, repair and maintenance of coke ovens. Adience has elected to focus on the specialty material sector, rather than the commodity sector, of the refractory industry and estimates that it is one of the largest producers of specialty refractory products for ironmaking applications. See "Refractory Products and Services" below. Adience's wholly-owned subsidiary, Adience Canada, Inc. ("Adience Canada"), owns and operates its own headquarters and refractory manufacturing facility in Ontario, Canada, from where it markets Adience's full range of products throughout Canada. Background of Adience Adience was incorporated in the State of Delaware in 1985 for the purpose of acquiring BMI, Inc. ("BMI"), a private company principally engaged in the refractory and information display product businesses. From 1986 through 1990, Adience made a number of acquisitions in these and other lines of business. In 1991, Adience determined to streamline and consolidate its overall business by disposing of operations outside its core refractory and information display product businesses and by selling unprofitable operations within such core businesses. In its refractory business, certain Texas operations, which were part of the original BMI, were sold in May 1991. In July 1991, Adience sold its heating and ventilation duct connector business, which was also part of the original BMI operation. In August 1991, Adience sold its Utah electrical and construction contracting business, originally acquired in 1990. In November 1991, Adience sold its Entec operations (engineering and construction of heat exchange devices), which were acquired in June 1988. In 1992, Adience sold its Geotec operations (caisson design and construction and environmental testing services) and Hotworks operations (preheating services to refractory maintenance companies), which were acquired in September 1988 and July 1990, respectively. In 1993, Adience sold its Los Angeles operations. In the information display product area, Adience's 80.3%-owned subsidiary, IDT, sold its "EHB" operations (catalog sales for the office market) in February 1992, which had been acquired in 1986. In 1993, IDT sold its Kensington Lighting operation. See "Operations of Information Display Technology" below. On February 22, 1993, Adience filed a prepackaged plan of reorganization (the "Prepackaged Plan") under Chapter 11 of the Bankruptcy Code, which was confirmed by the United States Bankruptcy Court for the Western District of Pennsylvania on May 4, 1993 and consummated on June 30, 1993. The filing was precipitated by a combination of firstly, an overall decline in the demand for refractory products and services in 1991 and 1992 caused by a decrease in the production of refractory using industries in the United States, particularly steel, and secondly, losses from discontinued operations. The Prepackaged Plan reduced the long-term debt of Adience by exchanging $66 million aggregate principal amount of 15% Senior Subordinated Reset Notes for $49 million aggregate principal amount of new 11% Notes, plus common stock representing 55% of the outstanding common stock of Adience. IDT does not guarantee the 11% Senior Secured Notes issued by Adience under the reorganization plan and IDT did not itself file a plan of reorganization under Chapter 11 of the Bankruptcy Code. IDT is a guarantor of Adience's loan from Congress Financial Corporation (see Liquidity and Sources of Capital). After emerging from the reorganization proceeding, Adience adopted fresh start reporting in accordance with AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." The application of fresh start reporting is set forth in greater detail in the Notes to Adience's Consolidated Financial Statements. Refractory Products and Services The Heat Technology Division primarily manufactures unformed refractory materials. Through its J.H. France operation, the Division also manufactures specialty refractory brick and through the Findlay operation, specialty refractory block. Adience does not focus on the commodity brick market, which are primarily standard pre-formed bricks, and instead focuses on specialty refractory products which are custom designed and often shaped on site to customer requirements. The largest consumer of Adience's refractory products and services is the basic iron and steel industry, followed by the aluminum, glass, petrochemical, cement and cogeneration industries. Adience's products and services are used principally in the production of iron. Adience also performs refractory product installation services on coke ovens. Because of the high temperatures involved in the transportation of molten iron, the coking of coal in coke ovens and the melting or transportation of other non-ferrous materials, the equipment employed in such processes must have linings made of refractory products. These linings deteriorate and must be repaired frequently or replaced as part of regular plant maintenance. In addition to linings, Adience also manufactures blast furnace taphole plugs made from refractory materials. These plugs must be replaced eight to 12 times during a typical full production day. Adience is a major supplier in the United States of such blast furnace taphole plugs, according to internal market data. To expand the scope and value of its services, Adience also provides general plant maintenance services related to refractory products either in specific areas or plant-wide. From 1985 through 1990, Adience experienced significant growth in demand for its specialty refractory products and services. This resulted largely from increasing reliance by the steel industry during this period on the services of outside contractors such as Adience for plant-wide maintenance work, due in part to the lower labor costs maintained by outside contractors. Additionally, steel producers sought to avoid the high overhead associated with carrying the trained personnel and specialized equipment needed for this work. In 1991, Adience experienced a significant decline in demand for its specialty refractory products and services. This resulted primarily from the most serious downturn in the steel industry since the early 1980's coupled with contraction in non-steel industries served by Adience. In the steel industry, one effect of the downturn was increased pressure from the steelworkers union to retain refractory installation work which in the past had been performed by Adience. With the reduction in such work, Adience has been more dependent upon refractory materials sales, which are more price competitive. Manufacturing The manufacturing process for specialty refractory products involves the mixing and kiln firing of various raw materials, particularly fireclays and minerals such as bauxites and aluminas. Adience operates seven refractory product manufacturing plants located near major industrial centers in the United States and Canada. Predominantly all of the refractory products sold by Adience are manufactured in its own plants. Adience custom designs the refractory products it manufactures for specific applications. To better serve the Canadian market, a refractory manufacturing plant was built in Canada by BMI in 1981, and is currently owned and operated by Adience Canada. In November 1989, Adience acquired all of the stock of Cardinal Refractories, Inc. which was engaged in the building, maintenance and repair of refractory-consuming facilities in Canada. In January 1991, Cardinal Refractories, Inc. was merged into Adience Canada. Raw Materials Adience utilizes more than one hundred different raw materials which come from a variety of sources, the majority of which are obtained within the United States. Some of the more important raw materials are alumina, including high purity alumina, bauxite and brown fused alumina; silicon carbide; calcium aluminate cements; and clays. The number of sources of supply varies with each raw material. Adience management believes that it is not dependent in its manufacturing processes on any one source of supply, such that discontinuation of production by any one supplier would seriously jeopardize Adience's competitive position. Installation and Maintenance Adience installs and maintains linings made of specialty refractory products by one of the following processes: guniting, grouting, pumping, ramming, casting of unformed materials and laying of brick. "Guniting" is a process by which granulated refractory products are mixed with water and applied to surfaces through the use of a pneumatic spray gun. In the related process known as "grouting," refractory material is applied to a furnace lining through apertures in the furnace wall without interrupting the normal operation of the furnace. Guniting and grouting are relatively inexpensive methods for maintaining a brick refractory lining and thereby avoiding a major rebuild which involves a substantial capital outlay and lengthy downtime for the furnace. The guniting installation technique requires highly skilled crews and specialized equipment. In the "pumping" process, the refractory product is pumped directly into the refractory lining and cast in a removable mold. In the "ramming" process, a refractory lining is installed on a surface by applying the refractory product to the surface with a pneumatic hammer and in the "casting" process, the refractory lining is cast in a mold and subsequently installed on the surface being lined. The ability to react quickly to customer requests for products or installation and maintenance services is particularly important in the refractory industry because of the extremely high cost of manufacturing downtime. Consequently, the Company maintains refractory service facilities located near its major customers in the United States and Canada. Each facility contains guniting and other equipment required for the installation of refractory products. In addition, each facility is staffed with the supervisory personnel and skilled crews required for specialty refractory applications. All other personnel required for installation projects are hired on an as-needed basis from readily available local union labor pools. These persons are maintained on Adience's payroll only for the duration of each job. The Findlay unit's products are used to line furnaces, troughs, runways and other surfaces exposed to molten glass or the molten tin used in the "float glass" method of production. In the "float glass" method of production, molten glass is poured from the furnace onto a layer of molten tin. The molten glass "floats" on top of the molten tin along specially prepared runways. By controlling the temperature and the rate of flow of the molten glass, the manufacturer is able to achieve the desired thickness of the glass. All of Findlay's products are custom manufactured according to customer specifications. Findlay's products are distinguished by their resistance to corrosion. These product characteristics are particularly important in the glass industry where, unlike the steel industry, certain refractory products are designed to last for up to ten years. Sales and Markets The principal markets for products sold by Adience's Heat Technology Division are the iron and steel, aluminum, glass, petrochemical, cement and cogeneration industries. The iron and steel industry has historically been the major consumer of Adience's refractory products and services, and of products produced by the refractory industry generally. For the six month periods ended December 31 and June 30, 1993 and the fiscal year ended December 31, 1992, direct sales to the iron and steel industry accounted for approximately 52%, 58% and 54%, respectively, of the Heat Technology Division's total revenues. Adience also sells its refractory products to other refractory contractors and buys refractory products produced by other manufacturers in performing its contracting services. Adience also performs specialty refractory product installation and service for the glass, aluminum, petrochemical, cement and cogeneration industries. Each industry is a large consumer of refractory products and services. Many of the competitors in such markets are entities against which Adience already competes in the steel industry. Adience's Findlay unit is among the leading manufacturers in the United States of specialty refractory products used in the glass industry, based on internal market share data. Findlay's customers include major glass producers such as PPG Industries and Corning Glass Works. Findlay markets and sells its products worldwide. Marketing to the steel industry is conducted by an employed sales force working out of sales offices located strategically near major steelmaking centers. Each salesperson is assigned to particular steelmaking facilities, and each handles the full range of Adience products and services. Marketing to customers in the non-steel industries is handled by a sales force working out of sales offices located throughout the country. The refractory products and services sales force is compensated through a base salary plus incentive bonuses based on performance. Within the steel industry, Adience's principal customers have traditionally been the largest companies in the industry. The three largest customers, USX Corp., Bethlehem Steel Corporation and LTV Steel Co., together accounted for approximately 25% and 29% of the Heat Technology Division's revenues for the six month periods ended December 31 and June 30, 1993, respectively, and 26% of such revenues for the fiscal year ended December 31, 1992. USX Corp. alone accounted for approximately 10% of the Division's revenues for the six month periods ended December 31 and June 30, 1993 and the fiscal year ended December 31, 1992. Each of the other companies accounted for less than 10% of the Division's revenues during such periods. Competition In the production of refractory materials, Adience competes with a number of companies, including North American Refractories Co., Indresco Inc., A.P. Green Industries, Inc., National Refractories Co. and Premier Refractories & Chemicals, Inc., some of which are substantially larger than Adience and all of which produce a full line of refractory products, with an emphasis on commodity brick production. Adience has elected to focus on the specialty material sector, rather than the commodity sector, of the refractory industry and estimates that it is one of the largest producers of specialty refractory products for ironmaking applications. Adience's primary competitors in the installation of refractory products are in-house employees of steel companies and also regional refractory service contractors which, unlike Adience, do not engage in the production of the materials. The major refractory producers typically contract with these regional companies to install the product, or the customers install the product in-house. Competition is based primarily on service, price and product performance. Adience believes that it provides an added advantage to its customers due to its ability to produce, install and maintain its refractory products. Research and Development Constant revisions to industry processes and chemistries require changes in refractory products to meet customer demand. Adience maintains fully staffed research and development facilities for improving existing refractory products and installation methods, as well as developing new products for existing and new markets. Research and development expenditures for the Heat Technology Division were approximately $541,000, $541,000 and $1,200,000 for the six month periods ended December 31 and June 30, 1993 and the fiscal year ended December 31, 1992, respectively. Backlog The Heat Technology Division operates on releases from blanket orders and, therefore, does not have a significant amount of backlog orders, except in the case of its Findlay operations which had $2.3 million and $3.1 million in backlog at December 31, 1993 and 1992, respectively. Generally, Adience's customers place orders on the basis of their short-range needs for which sales are made out of inventory or manufactured just in time. Operations of Information Display Technology IDT manufactures and sells custom-designed and engineered writing and projection surfaces (such as chalkboards and markerboards) for instruction and communication; custom cabinets for health care facilities, offices and institutions; modular partitions; and exterior architectural building panels. IDT has its own nationwide marketing network that enables it to market its products to schools, hospitals and offices throughout the country. In certain product areas, IDT operates under the trade name "Greensteel." IDT has achieved its current position in the specialized markets it serves due largely to its integrated approach to customer needs. In many cases, IDT performs a full range of services, including the custom design, production, installation and maintenance of its products. IDT believes that this integrated approach, which many of its competitors do not provide, enhances its responsiveness to customer needs. This approach, which allows the customer to obtain a full line of products and services from a single source, better enables IDT to establish an ongoing relationship with its customers to provide for their future requirements. Competition in IDT's markets is based largely on product quality, responsiveness, reliability and price. Most of the products of IDT are sold in connection with new facility construction or renovation. Such products are generally sold as part of a bid process conducted through architects and general contractors working with IDT's salespeople, and are custom-made to specifications. Successful marketing of these products is dependent upon the maintenance of a strong relationship with architects and general contractors, particularly in the education and health care construction fields. IDT has been advised by its customers that its products have achieved general recognition as quality products. IDT is a publicly-owned corporation whose shares are traded on the American Stock Exchange. Adience owns 10,692,165 shares of IDT's common stock, representing approximately 80.3% of the outstanding shares. On March 29, 1994, the closing sale price of IDT's common stock was $0.8125 per share. Background of IDT IDT was incorporated in the State of New York in May 1987 under the name RT Acquisition Associates, Inc. ("RT") for the purpose of serving as a vehicle for the acquisition of an operating business. Effective April 1, 1990, IDT acquired substantially all of the assets and assumed certain of the liabilities of the Information Display Division of Adience in exchange for 21,100,000 newly-issued shares of IDT's common stock and a convertible note (the "Convertible Note") in the principal amount of $2,500,000, convertible into IDT's common stock at $2.00 per share. In November 1990, IDT prepaid the Convertible Note in full at a price of $2,485,000. Upon the consummation of such acquisition (the "Acquisition"), Adience became the owner of approximately 80.1% of IDT's common stock. In July 1990, RT changed its name to Information Display Technology, Inc. In July 1990, IDT's shareholders approved a one-for-two reverse stock split (the "Reverse Stock Split") pursuant to which 26,350,000 issued and outstanding shares of IDT's common stock (including the 21,100,000 shares issued to Adience pursuant to the Acquisition) were changed into 13,175,000 shares of "new" IDT common stock, on the basis of one "new" share for each two "old" shares. The conversion price for the Convertible Note was automatically changed to $4.00 per share In October 1990, IDT purchased substantially all of the assets of Adience's Kensington Lighting Division in exchange for 142,165 shares of IDT's Common Stock at which time Adience became the owner of approximately 80.3% of IDT's common stock. In November 1990, IDT prepaid the Convertible Note in full for a price of $2,485,000. Substantially all of the assets of the Kensington Lighting Division were sold in 1993. Products IDT manufactures custom-made systems incorporating chalkboards, markerboards, tackboards and bulletin boards. IDT manufactures porcelain and masonite chalkboards which are sold in new construction or as replacements for traditional slate or glass blackboards. Porcelain products are manufactured at IDT's Alliance, Ohio plant, where porcelain is fused to sheet steel in electric furnaces. The porcelain-enameled product is then shipped to one of four other IDT production facilities for fabrication into chalkboards. Porcelain chalkboards, which are available in a range of colors, are virtually unbreakable and maintenance free, and are warranted by IDT to retain their original writing and erasing qualities under normal usage and wear. As a result of these product qualities and the reduced availability of slate for chalkboard production, IDT believes that porcelain chalkboards currently account for approximately 75% of all chalkboard sales in the United States. IDT's chalkboards, markerboards, building panels and cabinetry are typically sold together as a package to finish wall surfaces in school rooms and offices. These products are generally manufactured at one or more of IDT's five production and fabrication facilities and are generally sold together as part of a package to end-users through one sales force operating out of IDT's sales offices. In addition to chalkboards, IDT manufactures dry-marker boards, which are high-gloss porcelain enameled boards on which the user writes with a dry felt-tip marker. IDT also manufactures a variety of other information display surfaces for educational and health care facilities, such as tackboards and pegboards. Unlike most of its competitors, IDT installs as well as manufactures its information display surfaces. IDT designs, engineers and installs manual and motorized information display systems for educational and office use, using combinations of chalkboards, markerboards and other surfaces. IDT manufactures architectural building panels at its porcelain enameling plant using a fusing process similar to that used to manufacture chalkboards and markerboards. Porcelain panels are used for movable dividing walls, store fronts, window walls, window replacements, and the complete "cladding" (the application of a protective covering to the outside surface) of older buildings. Such panels are laminated to an insulation backing to achieve energy conservation. Panels are also manufactured with finishes other than porcelain enamel. Non-porcelain aluminum panels are used in a variety of lightweight architectural applications. IDT manufactures and installs cabinetry in wood or plastic laminate for hospitals, schools, laboratories and industry. The products are manufactured in a variety of surfaces with resistance to heat and chemicals. In addition, IDT manufactures and installs indoor and outdoor display cases. Sales and Markets Most of IDT's products are sold as part of a bid process conducted through architects and general contractors working with IDT's sales staff. Warranties made by IDT with respect to IDT's products and services are consistent with industry standards, except for the lifetime warranty on the writing surface of its porcelain chalkboards, which is in excess of industry standards. IDT markets its products through a sales staff of 25 persons, most of whom work on a commission basis. IDT maintains 13 sales offices in a number of states (see "Properties"). As stated above, IDT's products are generally sold as part of a package to finish wall surfaces in school rooms and offices. While most of the products incorporated into such packages are manufactured by IDT, some components are purchased from other suppliers and distributed by IDT as part of the package. In this way, IDT acts as a distributor for certain related products which it does not manufacture to the extent necessary to complement sale and installation of its own products. Sales of its own products accounted for approximately 52% and 63% of the revenues of IDT in 1993 and 1992, respectively. In 1993, sales to educational institutions and health care facilities accounted for a majority of IDT's revenues. Most of IDT's business is concentrated in the eastern half of the United States and IDT believes that it is the dominant supplier in the Northeast. In order to focus on its core business, IDT has begun to implement a business plan which, among other things, is designed to reduce construction activity and reduce the resale of products manufactured by others. IDT has also sold its Kensington Lighting operation. Raw Materials The porcelain coatings used by IDT are currently produced to its specifications by a single supplier so as to maintain consistent color and quality standards; however, alternative sources of supply are available. IDT has never experienced any difficulty with the quantity or quality of product from its porcelain coatings supplier. All other raw materials are readily available from a variety of sources. Competition IDT competes with a variety of companies which manufacture chalkboards, institutional cabinetry and modular partitions. The competitors are typically privately owned. A number of regional companies manufacture architectural building panels which compete with those produced by IDT, but none has a significant market share. IDT has attained its competitive position primarily as a result of design quality and reliability, both with respect to product and installation. Seasonality IDT's business is seasonal and most of its sales and pre-tax profits occur in the third quarter of the year. This occurs primarily as a result of increased business activity in the summer months when schools are closed and construction activity increases. IDT typically incurs a loss in the first quarter of each year. Backlog At December 31, 1993, total backlog for IDT was approximately $21,300,000, as compared with approximately $27,900,000 as of December 31, 1992. Management expects that all of the backlog will be filled in its next fiscal year. The reduction in the backlog is due to one large project being completed during 1993. IDT believes that its order backlog represents only a portion of the net sales revenue anticipated by IDT in any given fiscal year. Employees of the Company Adience currently employs approximately 800 people in the Heat Technology Division (including Adience Canada) and 32 people in its general and administrative staff. The number of individuals employed in the Heat Technology Division does not reflect members of the building trades, who are hired by Adience as required. Some employees at the South Webster, Ohio plant (approximately 30 persons) are members of the United Steelworkers Union. Some employees at the Smithville, Ontario plant (approximately 10 persons) are members of the Aluminum, Brick and Glassworkers Union. Employees at the Canon City, Colorado plant (approximately 15 persons) are members of the Oil, Chemical and Atomic Workers Union. The current labor contracts at these plants expire in July 1995, July 1994 and October 1995, respectively. All three plants are operated by the Heat Technology Division. Approximately 125 employees at the J.H. France plant in Snow Shoe, Pennsylvania are represented by the Aluminum, Brick and Glassworkers Union under a contract that expires in July 1998. The majority (approximately 60 persons) of the employees at Findlay are represented by the Aluminum, Brick and Glassworkers of America and are working under a labor agreement which expires in August 1994. Of the remaining full-time employees at Adience (approximately 590 persons), approximately 290 are union members who are not covered by collective bargaining agreements. The remaining employees of Adience (approximately 300 persons) are not unionized. IDT currently employs approximately 380 people. About 125 employees at the Dixonville, Pennsylvania plant are members of the Carpenters Union, with the current labor contract expiring in January 1995. Of IDT's remaining employees, approximately 70 persons are union members not covered by collective bargaining agreements. Management considers relations with employees at Adience, IDT and Adience Canada to be good. Patents and Trademarks The Company holds a number of patents and trademarks covering various products and processes relating to its Heat Technology Division and IDT. The Company believes the "Greensteel" trademark is important to IDT, but otherwise its patents and trademarks are not of material importance in terms of the Company's total business. Regulation The Company's manufacturing operations are subject to numerous federal, state and local laws and regulations relating to the storage, handling, emission, transportation and discharge of materials. From time to time, the Company experiences on-site inspections by environmental regulatory authorities who may impose penalties or require remedial actions. Compliance with these laws has not been a material cost to the Company and has not had a material effect upon the capital expenditures, earnings or competitive position of the Company. A violation of such laws or regulations, however, even if inadvertent, could have an adverse impact on the operations of the Company. As more fully described under "BUSINESS -- Legal Proceedings," in February 1992, IDT was cited by the Ohio Environmental Protection Agency (the "Ohio EPA") for violations of Ohio's hazardous waste regulations, including speculative accumulation of waste and illegal disposal of hazardous waste on the site of its Alliance, Ohio facility. IDT had $1,106,000 accrued at December 31, 1992 for the clean-up of this site. In December 1993, IDT and Adience signed a consent order with the Ohio EPA and Ohio Attorney General which required IDT and Adience to pay to the State of Ohio a civil penalty of $200,000 (of which IDT paid $175,000 and Adience paid $25,000). In addition, the consent order requires the payment of stipulated penalties of up to $1,000 per day for failure to satisfy certain requirements of the consent order including milestones in the closure plan. IDT expects that the work to be conducted under the closure plan will be substantially completed in 1994, subject to IDT receiving all necessary approvals from the Ohio EPA. At December 31, 1993, environmental accruals amounted to $783,000 which represents management's reasonable estimate of the amounts remaining to be incurred in this matter, including the costs of effecting the closure plan, bonding and insurance costs, penalties and legal and consultants' fees. Since 1991, Adience and IDT have together paid $341,000 (excluding the civil penalty) for the environmental clean-up related to the Alliance facility. Under the acquisition agreement pursuant to which IDT acquired the property from Adience, Adience represented and warranted that, except as otherwise disclosed to IDT, no hazardous material has been stored or disposed of on the property. No disclosure of storage or disposal of hazardous material on the site was made, accordingly, Adience is required to indemnify IDT for any losses in excess of $250,000. IDT has notified Adience that it is claiming the right to indemnification for all costs in excess of $250,000 incurred by IDT in this matter, and has received assurance that Adience will honor such claim. Adience has reimbursed IDT $196,000; if Adience is financially unable to honor its remaining obligation, such costs would be borne by IDT. Insurance The Company maintains insurance with respect to its properties and operations in such form, in such amounts and with such insurers as is customary in the businesses in which the Company is engaged. Management believes that the amount and form of its insurance coverage is adequate at the present time. Item 2. Item 2. Properties Adience owns its 15,600 square foot headquarters in Pittsburgh, Pennsylvania along with approximately 37,000 square feet of contiguous commercial space. Adience also owns 14 of its facilities. Substantially all of the real property owned by Adience is subject to liens. Management believes that all of its facilities are well-maintained, in good condition and adequate for its present business. At present and anticipated levels of utilization, Adience's production facilities have sufficient capacity to meet demand for Adience's products. In October 1993, Adience committed to purchase a new plant facility which it currently leases in Altoona, Pennsylvania to expand current production of a specific line of refractory product. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- Results of Operations." Heat Technology Division. Adience owns plants at the following locations: The plants located in both Farber, Missouri and South Rockwood, Michigan have been idled and future capital expenditures deferred due to a decline in orders. Adience's lost production capacity has been replaced by its other manufacturing plants. In addition, Adience owns or leases construction yards, sales facilities and other facilities in the following locations: IDT. IDT owns five of its facilities. Real estate owned by IDT is not subject to mortgage. Management believes that all of its facilities are well-maintained, in good condition and adequate for its present business. IDT's production facilities are currently utilized to the extent of one production shift per day. At such level of utilization, IDT's production facilities have sufficient capacity to meet demand for IDT's products. IDT owns or leases production and fabrication facilities at the following locations: IDT also leases sales offices at the following locations: Corona, California; Fraser, Michigan; Millersburg, Ohio; Lakewood, New Jersey; Buffalo, New York; Deer Park, New York; Portland, Oregon; and Lorton, Virginia. Item 3. Item 3. Legal Proceedings Ohio Environmental Matter. In February 1992, IDT was cited by the Ohio Environmental Protection Agency (the "Ohio EPA") for violations of Ohio's hazardous waste regulations including speculative accumulation of waste and illegal disposal of hazardous waste on the site of its Alliance, Ohio facility. IDT has $1,106,000 accrued at December 31, 1992 for the clean-up of this site. In December 1993, IDT and Adience signed a consent order with the Ohio EPA and Ohio Attorney General which required IDT and Adience to pay to the State of Ohio a civil penalty of $200,000 (of which IDT paid $175,000 and Adience paid $25,000). In addition, the consent order requires the payment of stipulated penalties of up to $1,000 per day for failure to satisfy certain requirements of the consent order including milestones in the closure plan. IDT expects that the work to be conducted under the closure plan will be substantially completed in 1994, subject to IDT receiving all necessary approvals from the Ohio EPA. At December 31, 1993, environmental accruals amounted to $783,000, which represents management's reasonable estimate of the amounts remaining to be incurred in the resolution of this matter, including the costs of effecting the closure plan, bonding and insurance costs, penalties and legal and consultants' fees. Since 1991, Adience and IDT have together paid $341,000 (excluding the civil penalty) for the environmental cleanup related to the Alliance facility.. Under the acquisition agreement pursuant to which IDT acquired the property from Adience in 1990, Adience represented and warranted that, except as otherwise disclosed to IDT, no hazardous material had been stored or disposed of on such property. No disclosure of storage or disposal of hazardous material on the site was made, accordingly, Adience is required to indemnify IDT for any losses in excess of $250,000. IDT has notified Adience that it is claiming the right to indemnification for all costs in excess of $250,000 incurred by IDT in this matter, and has received assurance that Adience will honor such claim. Adience has reimbursed IDT $196,000; if Adience is financially unable to honor its remaining obligation, such costs would be borne by IDT. Resolution of Asbestos Litigation. The Company's J.H. France unit, which was merged into Adience in December 1991, has been named as a party in approximately 8,000 pending lawsuits filed in eight jurisdictions principally by employees and former employees of certain customers of J.H. France, alleging that a single product, a plastic insulating cement manufactured more than 20 years ago by J.H. France, caused asbestosis or silicosis in such persons. Such lawsuits typically involve multiple defendants and seek monetary damages ranging from $20,000 each, which is the minimal jurisdictional requirement for personal injury cases in a majority of such state courts, to $1,000,000 each. J.H. France and its insurance carriers have historically settled these lawsuits typically for an average amount per case of less than the minimum amount stated. Punitive damages have also been claimed in some cases. In addition to the lawsuits against J.H. France, Adience has been named a party in approximately 250 pending lawsuits filed in the States of Pennsylvania, Ohio, Michigan and West Virginia, principally by employees and former employees of certain customers of the Company alleging that products produced by the Company caused silicosis, not asbestosis, in such persons. The majority of such lawsuits involve multiple defendants and seek unstated monetary damages in excess of $20,000 each, which is the minimal jurisdictional requirement for personal injury cases in a majority of such state courts, to $1,000,000 each. Adience and its insurance carriers have historically settled these lawsuits for an average amount per case of less than the minimum amount stated. All such claims and all costs of defense for these cases are covered by insurance. The insurance companies which had issued policies covering the J.H. France cases had asserted that each insurance company was only responsible for a pro rata share of the liability in these cases, based upon the number of years for which the carriers provided coverage during the period of the exposure, development and manifestation of each plaintiff's asbestosis or silicosis. In June 1993, the Supreme Court of Pennsylvania held that the insurance policies covering the claims in these J.H. France cases covered liabilities and defense costs up to the amounts of the limits of the respective policies, without regard to the period of time said policies were in effect. As a result of this judicial determination and based upon the Company's experience in obtaining dismissals or settlements in closed cases, the Company anticipates, although no assurance can be given, that the expected costs and liabilities in all pending cases will be adequately covered by insurance. The Company believes that the aggregate limits on the insurance policies in effect exceed the potential liabilities and defense costs which will be incurred in the 8,000 J.H. France cases and the other 250 cases for which the scope of coverage has never been an issue. Other Legal Actions. The Company has been engaged in various other legal actions and claims arising in the ordinary course of business. Management believes that, after discussions with internal and external legal counsel, the ultimate outcome of such litigations and claims will not have a material adverse effect on the Company's consolidated financial position. For information regarding Adience's proceedings under Chapter 11, see "BUSINESS -- Background of Adience". Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders of the Company during the fiscal quarter ended December 31, 1993. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters On January 27, 1994, the Company's Registration Statement on Form S-1 was declared effective by the Securities and Exchange Commission. Pursuant to the Registration Statement, all of the Company's outstanding shares of Common Stock were registered. There currently is no established public trading market for the Common Stock and, accordingly, market prices are not available. Adience has not to date filed any application to list the Common Stock on any stock market or exchange. If a substantial number of Adience's stockholders seek to sell their shares of Common Stock in the public market, the market price of the Common Stock could be adversely affected. Since its inception, Adience has paid only one dividend, in September 1990, of $.10 per share ($1,000,000 in the aggregate). Under the terms of Adience's financing agreement with Congress Financial Corporation and the indenture under which its New Senior Secured Notes were issued, Adience at present is prohibited from declaring or paying any dividends on account of any shares of any class of its capital stock. As a result of this prohibition, it is unlikely that Adience will pay any dividend on its Common Stock in the foreseeable future. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- Liquidity and Sources of Capital; Financing Agreements." As of March 29, 1994, the Company had 152 holders of record of its Common Stock (excluding beneficial owners of shares held of record by nominees). Item 6. Item 6. Selected Consolidated Financial Data The selected consolidated financial statement data presented below for periods subsequent to June 30, 1993 give effect to the consummation of the Prepackaged Plan and to the application of fresh-start reporting by the Company as of that date in accordance with the American Institute of Certified Public Accountants' Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." Accordingly, periods through June 30, 1993 have been designated "Pre-emergence," and periods subsequent to June 30, 1993 have been designated "Post-emergence." Selected financial consolidated balance sheet and income statement data of the pre-emergence periods are not comparable to those of the post-emergence periods and a line has been drawn in the tables to separate the post-emergence financial data from the pre-emergence financial data. The following table presents selected (i) historical consolidated financial data of the Company (pre-emergence) for each of the four fiscal years in the period ended December 31, 1992 and the six-month period ended June 30, 1993, (ii) historical consolidated financial data of the Company (post-emergence) for the six-month period ended December 31, 1993, and (iii) pro forma consolidated income statement data for the fiscal year ended December 31, 1993. The pro forma data (i) eliminate the effect of non-recurring transactions resulting from the Reorganization included in the results of the Company, (ii) adjust pre-emergence results of the Company to reflect the assumed implementation of fresh-start reporting as of January 1, 1993 for income statement purposes, and (iii) assume the exchange of $65,975,000 aggregate principal amount of Old Subordinated Notes for $48,628,625 aggregate principal amount of New Senior Secured Notes and the issuance of 10,000,000 shares of Common Stock pursuant to the Prepackaged Plan as of January 1, 1993. The information below should be read in conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS," the Company's Consolidated Financial Statements, including the notes thereto, and other information contained elsewhere herein. The historical consolidated financial data presented below for each of the three fiscal years in the period ended December 31, 1991 have been derived from the Company's Consolidated Financial Statements, which were audited by Ernst & Young, independent accountants. Ernst & Young's report on the consolidated financial statements for the year ended December 31, 1991, which appears elsewhere herein, includes a description of uncertainties that might have led to the Company's inability to continue as a going concern. The historical consolidated financial data for the six months ended December 31 and June 30, 1993 and the fiscal year ended December 31, 1992 have been derived from the Company's Consolidated Financial Statements, which were audited by Price Waterhouse, independent accountants. The data should be read in conjunction with the consolidated financial statements, related notes and other financial data included elsewhere herein. (1) Adience's management believes the per share amounts are not meaningful prior to June 30, 1993 due to the Reorganization. (2) Pro forma balance sheet information is not presented since the historical balance sheet data as of December 31, 1993 includes the effects of the Prepackaged Plan and the implementation of fresh-start-reporting. (3) On February 10, 1989, Adience's Board of Directors authorized an amendment to Aidence's Certificate of Incorporation to increase the authorized number of shares of common stock from 200 shares, no par value, to 20,000,000 shares, par value $0.15 per share, and a 100,000-for-1 stock split. On September 30, 1990, Adience's Board of Directors declared a $.10 per share cash dividend. No dividends were declared on Adience's common stock for any other period covered. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reorganization and Fresh-Start Reporting Adience, Inc. has experienced continued losses from continuing operations (before reorganization items) both pre- and post-emergence under Chapter 11. In addition, a write down of reorganization value in excess of amounts allocable to identifiable assets has been recorded at December 31, 1993, based on management's belief that a permanent impairment of this asset now exists. The Company is currently seeking to replace and improve the terms of its line of credit financing agreement with Congress Financial Corporation (Congress) which expires June 30, 1994. The continued viability of the Company is dependent upon, among other factors, the ability to generate sufficient cash from operations, financing, or other sources that will meet ongoing obligations over a sustained period. Management has prepared detailed operating and financial plans which combine multifunctional resources as teams to respond better to customer needs, make an investment in product and service opportunities expected to produce a significantly greater return on investment, continue a cost control program begun in 1993, and assume refinancing of the line of credit arrangement on improved terms. Management believes that the successful implementation of this plan will enable the Company to continue as a going concern for a reasonable period. There can be no assurance however, that such activities will achieve the intended improvement in results of operations or financial position. On February 22, 1993, Adience and the unofficial committee of noteholders of Adience filed a prepackaged plan of reorganization (the "Prepackaged Plan") under Chapter 11 of the United States Bankruptcy Code (the "Reorganization"). The Prepackaged Plan was confirmed by the United States Bankruptcy Court for the Western District of Pennsylvania on May 4, 1993 and consummated on June 30, 1993. The filing was precipitated by a combination of an overall decline in the demand for refractory products and service during 1991 and 1992 caused by a decrease in the production of refractory-using industries in the United States, particularly steel, and losses from discontinued operations. The primary purposes of the Prepackaged Plan were to reduce Adience's debt service requirements and overall indebtedness, to realign its capital structure and to provide Adience with greater liquidity. Neither IDT nor Adience Canada, Inc. filed a plan of reorganization. The Prepackaged Plan provided for a restructuring of Adience's capital structure and allowed the holders of $65,975,000 aggregate principal amount of Adience's Senior Subordinated Reset Notes ("Old Subordinated Notes") to exchange them for $48,628,625 aggregate principal amount of new 11% Senior Secured Notes ("New Senior Notes") due June 15, 2002, plus common stock representing 55% of the outstanding common stock of Adience. The Prepackaged Plan also included forgiveness of outstanding interest totaling approximately $8,800,000. The value of the cash and securities distributed was $17,480,000 less than the allowed claims; the resultant gain was recorded as an extraordinary gain. In connection with the Reorganization described above, Adience applied the provisions of the American Institute of Certified Public Accountants' Statement of Position No. 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7") as of June 30, 1993. The Company's basis of accounting for financial reporting purposes changed as a result of applying SOP 90-7. Specifically, SOP 90-7 required the adjustment of the Company's assets and liabilities to reflect a reorganization value generally approximating the fair value of the Company as a going concern on an unleveraged basis, the elimination of its accumulated deficit, and adjustments to its capital structure to reflect consummation of the Prepackaged Plan. Accordingly, the results of operations after June 30, 1993 are not comparable to the results of the operations prior to such date, and the results of operations for the six months ended June 30, 1993 and the six months ended December 31, 1993 have not been aggregated. Further, the financial position of the Company after June 30, 1993 is not comparable to its financial position at any date prior thereto. Results of Operations Fiscal Year ended December 31, 1993 Compared to Fiscal Year ended December 31, The following table summarizes the Company's consolidated results of operations for 1993 and 1992 and provides a consistent basis for further discussion and analysis of those results. (1) For further discussion, see Note 1 to Consolidated Financial Statements. Excluding the effects of reorganization items, the pre-emergence and post-emergence loss of $4.7 million and 13.6 million, respectively, decreased by $5.7 million from 1992, reflecting primarily a reduction in selling, general and administrative expenses of $2.8 million and a decrease in interest expense of $7.3 million, offset partially by a net increase in depreciation and amortization expense of $7.2 million. Included in the net increase in amortization expense for 1993 is the fourth quarter write down of the Company's reorganization value in excess of amounts allocable to identifiable assets. The amount written down was based on management's comparison of actual cash flows for the post-emergence period through December 31, 1993 with the projected cash flows used to arrive at the reorganization value at June 30, 1993. This charge increased the post-emergence loss by $8 million or $.80 per share. Additional losses from previously discontinued operations and disposals amounted to $400,000 and $84,000 for the pre-emergence and post-emergence periods, respectively, and $5.3 million in 1992. Management's decision to discontinue these operations was made after concluding that these businesses no longer fit Adience's long-term growth plans. Net revenues by industry segment for 1993 and 1992 were as follows: During the Reorganization period, which initially began in December 1992, Adience operated under strict payment terms with many of its suppliers, thereby experiencing higher costs. Increased competition in the refractory product sector prohibited the Company from passing along to customers increases in the costs of some important raw materials. As a result, sales opportunities were lost due to Adience's inability to compete on price and offer extended payment terms. In addition, the necessity of management's concentration of efforts on the Reorganization resulted in a loss of business in certain primary steel markets. During 1993, steel producers generally operated at levels close to capacity. However, Adience's restructuring under the supervision of the Bankruptcy Court did not enable the Heat Technology division to capitalize on these favorable economic conditions in the first half of 1993. The Company reacted to the sales decline during the first half of 1993 by taking several significant steps which, due to timing, only modestly impacted 1993 results. The primary steps included the election of a new Board of Directors and the appointment of a new Chief Executive Officer. The problems experienced in the past are being addressed by the new Board and executive management. As a result, new incentive plans are being implemented for the sales force and a realignment of duties is being accomplished within the internal operations of the Company. The Heat Technology division has also expanded its research and development programs through the hiring of seven new ceramic engineers during 1993. A management focus for 1994 is customer service and product quality. Teams of sales and service representatives have been established to respond to customer needs within the various industries that are supplied or serviced with refractory product. Net revenues for the Heat Technology division increased by 23% for the six month period ended December 31, 1993 compared to the six month period ended June 30, 1993. Net revenues for IDT remained consistent with prior year's net revenues. Included in 1993 and 1992 revenues is one large project with incremental revenues of $4.7 million and $2 million, respectively. Excluding this project, net revenues declined $3 million or 6.4% during 1993 within this segment. This decline is attributable to management's efforts to reduce the number of contracts which require the use of purchased rather than manufactured product because the former generate lower gross margins. The Heat Technology Division's cost of revenues amounted to 80.9% and 87.6% of net revenues for the pre-emergence and post-emergence periods respectively, compared with 83.5% for the year ended December 31, 1992. The increase in the Heat Technology Division's cost of revenues as a percentage of net revenues during the post-emergence period was primarily due to negative variances in the refractory production facilities due to a decline in volume (caused by a decrease in material shipments as opposed to construction activity) and the reduced ability to cover overhead costs. The decrease in direct material sales for the Heat Technology Division which caused these negative variances has been partially offset by the increase in construction revenues during the post-emergence period. Additional depreciation expense on buildings and machinery and equipment written up as a result of fresh start reporting (approximately $500,000) and the write-up of inventory values on June 30, 1993 (approximately $1,287,000) through the application of SOP 90-7, accounted for 3.7% of the increase in cost of revenues during the post-emergence period. Going forward, cost of revenues as a percentage of net revenues is expected to remain close to post-emergence levels due to the impact of additional depreciation expense on buildings and machinery and equipment written up as a result of fresh start reporting. (See Notes to Consolidated Financial Statements for further details). IDT's gross margins increased $300,000 to 18.1% of revenues during 1993. During the first quarter of 1993, IDT won a decision by the order of the Board of Finance and Revenue of Pennsylvania, relating to a reassessment of use tax on casework sold during the period February 1988 through September 1990. As a result, an adjustment to decrease cost of revenues by $438,000 was recorded during 1993 resulting from the reversal of the provision relating to this contingency. IDT's Kensington division, which was sold during the fourth quarter of 1993, contributed to the overall gross margin by $378,000 and $385,000 for the years ended December 31, 1993 and 1992, respectively. IDT's gross margin percentage excluding the Kensington division, the 1993 sales tax adjustment and the one large project, which recognized a loss of $290,000 during 1993, would have been 9% higher than 1992. The improvement in gross margin results principally from significant charges incurred in 1992 related to project cost overruns. The project cost overruns of approximately $600,000 were due to weaknesses in sales and project management in specific territories. Controls have been established during 1993 to minimize these types of overruns. For the pre and post-emergence periods in 1993, selling, general and administrative expenses of the Company amounted to 21.5% and 16.6% of net revenues respectively, compared with 21% for the year ended December 31, 1992. The increase in selling, general and administrative expenses during the pre-emergence period is attributable to the low level of sales during the same period. The major component in the overall decrease in 1993 over 1992 related to insurance expense. Adience was self-insured from November 1988 to June 1992 for workers' compensation and general liability. For this period, Adience is responsible for the first $250,000 of losses per occurrence. A loss calculation is performed at the end of each policy year summarizing incurred losses, paid losses and the outstanding reserve. Based upon this calculation and an estimate for potential changes in reserves and for new claims, Adience recorded an additional $2.3 million in insurance expense during the fourth quarter of 1992. In addition, the reduction in selling, general and administrative expenses is due to significant charges of approximately $1.1 million incurred in 1992 related to clean-up activities and other costs associated with the environmental issue at one of IDT's facilities. These activities were accounted for in 1992 and did not have a significant impact on operating costs in 1993. Other income (expense) for the pre-emergence period in 1993 includes retroactive health insurance premium refunds of approximately $215,000 for the Company's medical self-insurance program for the period September 1991 to February 1992. In addition, during June 1993, the Supreme Court of Pennsylvania held that the insurance policies covering these asbestosis and silicosis claims covered liabilities and defense costs up to the amounts of the limits of the respective policies, without regard to the period of time said policies were in effect. As a result of this judicial determination, the court awarded a refund to J.H. France for its pro rata share of the funds paid in these cases or $265,000. Also included in other income (expense) for the post-emergence period in 1993 is the $220,000 loss on the sale of the Heat Technology Division's Los Angeles operations and the $94,000 loss on the sale of IDT's Kensington division. Both sales were recorded during December 1993. Fiscal Year ended December 31, 1992 Compared to Fiscal Year ended December 31, The following table sets forth as a percentage of net revenues certain items appearing in the Company's consolidated financial statements. Percentage of Net Revenues During 1992, a decline in the demand for refractory products and services caused by a decrease in the production of refractory-using industries in the United States, particularly steel, precipitated the decline in revenues. Compounding the decline in demand for refractory products and services during 1992 was the effect of the Prepackaged Plan which increased customer apprehension. Net revenues for the Heat Technology Division's top ten customers declined by $3,500,000 in 1992. The contributing factors in this revenue decline were customer plant closings and major construction projects which were performed in 1991 and not repeated during 1992. IDT's revenues declined by $10,900,000 from 1991. IDT's primary market depends on the construction or refurbishing of educational buildings which, according to industry statistics, reported a 12% decline in capital expenditures in 1992. Industry reports attributed the decline to unusually conservative state and municipal budgets rather than a result of a permanent decline in demand. IDT's major market in the eastern portion of the United States declined, according to industry reports, by approximately 20%. IDT's revenues from this market segment suffered a corresponding percentage decline, which in turn accounted for 70% of IDT's total decrease in net revenues. In addition, the sale of EHB, one of IDT's divisions, in the first quarter accounted for 3% of the decrease in net revenues. The Heat Technology Division's cost of revenues declined by 8% to 84% of net revenues, compared with 83% in 1991. Included in cost of revenues for 1992 was a $1,100,000 write-down of property, plant and equipment for a facility which was anticipated to close during 1993. IDT's cost of revenues declined in line with the reduction in net revenues. However, project cost overruns in excess of $600,000 and enhanced pricing pressures caused by the market also resulted in the increase in cost of revenues as a percentage of net revenues to 83% compared with 79% in 1991. The project cost overruns were due to weaknesses in sales and project management in specific territories. Management controls have been established by IDT to minimize these types of overruns by the creation of centralized estimating and project management departments which are responsible for the preparation of costs estimates and ongoing cost management of all IDT projects. The increase in selling, general and administrative expenses for the Heat Technology Division reflects an adjustment to the workers' compensation and general liability insurance accrual accounts during the fourth quarter of 1992. Adience is self-insured for workers' compensation and general liability coverage for claims incurred during the period November 1988 to June 1992 for the first $250,000 of losses per occurrence. A loss calculation is performed at the end of each policy year summarizing incurred losses, paid losses and the outstanding reserve plus an estimate for potential changes in reserves and for new claims. Based upon this calculation, Adience recorded an additional $2,300,000 in insurance expense during the fourth quarter of 1992, representing Adience's portion of the outstanding reserves. In addition, as more fully described in the Notes to the Company's Consolidated Financial Statements, Adience agreed to indemnify IDT for any losses in excess of $250,000 resulting from the environmental issue at one of IDT's facilities. As a result of this indemnification, Adience recorded a $1,052,000 environmental liability which represents Adience's portion of IDT's liability for environmental issues. IDT's selling, general and administrative expenses decreased as a result of reduced sales commission expense on lower gross margin dollars. Included in reorganization items was the Company's settlement with its principal shareholder and his son as a result of Adience's Prepackaged Plan under Chapter 11 of the Bankruptcy Code. In addition, professional fees incurred as a result of the restructuring have also been segregated for presentation purposes. Liquidity and Sources of Capital As described above, the Company's financial position at December 31, 1993 as presented in its Consolidated Financial Statements reflects fresh start reporting and the amount of New Senior Notes negotiated under the Prepackaged Plan. Consequently, it is not comparable to prior periods and comparisons normally discussed under this heading would not be meaningful. The following comments on operating cash flows, capital expenditures, working capital and liquidity are considered to be relevant in evaluating the Company's present financial position. The Company's principal sources of liquidity are cash from operations, cash on hand, and certain credit facilities available to the Company. The Prepackaged Plan included forgiveness of accrued interest totaling approximately $8.8 million and the value of the New Senior Secured Notes, cash and securities distributed was $17.5 million less than the allowed claims. Management of the Company believes that cash on hand and funds from operations, together with borrowings under credit facilities described below, will be sufficient to cover its working capital, capital expenditure and debt service requirements through 1994. The Company is actively seeking an increase in its credit line through its current lender or different financing resources. The Company expects average borrowings in 1994 to exceed those of 1993. The Company intends to seek further to strengthen its financial position and increase its financial flexibility and may from time to time consider possible additional transactions, including other capital market transactions. Net cash flows provided by operating activities totaled $1.0 million and $1.2 million for the six months ended December 31 and June 30, 1993, respectively. Included in net cash flows provided by operating activities is $4.3 million received during the six months ended June 30, 1993, which relates to a federal tax refund for net operating loss carrybacks. The Company has exhausted any future refunds for net operating loss carrybacks. As discussed previously, the Company benefited as a result of the Reorganization from a forgiveness of interest on the Old Subordinated Notes during the six months ended June 30, 1993. Future cash flows from operations will no longer receive such benefit. In addition, Adience's restructuring under Chapter 11 of the Bankruptcy Code had forced Adience to comply with stricter payment terms from major vendors beginning in 1992. During the current year, however, these stricter payment terms were suspended and accounts payable and accrued expenses increased by $2,469,000 during the six months ended June 30, 1993. Capital expenditures used $1.7 million of funds through December 31, 1993. During 1993, Adience committed to purchase a new plant facility to expand current production of a specific product line. The estimated total cost of this facility and the necessary capital expenditures for machinery and equipment will be $1.5 million and is expected to be partially financed through the Pennsylvania Industrial Development Authority. It is anticipated that necessary capital expenditures in future years will not exceed depreciation expense but will represent a material use of operating funds. Adience and IDT together had $5,293,000 and $1,762,000 in available credit as of December 31, 1993 and February 28, 1994, respectively, under its short-term borrowing arrangement with Congress Financial Corporation ("Congress"). Short-term liquidity is dependent, in large part, on general economic conditions and the effect of those conditions on the steel industry. Due to the cyclical nature of the steel business and considering current trends and industry forecasts, it appears the recent period of low steel demand has ended. The Company's level of material shipments decreased by 29% during 1993, but construction activity remained relatively strong during the same period. It is anticipated that although construction activity will decline during the first half of 1994, material shipments are expected to increase during the same period. Financing Agreements. On the consummation date of the plan of reorganization, June 30, 1993, Adience entered into a financing agreement with Congress for the twelve month period ending June 30, 1994. Under this agreement, Adience may request loan advances not to exceed the lesser of $12 million or available collateral (80% of eligible accounts receivable less than 90 days plus 30% of raw material and finished goods inventory). The loan is collateralized by accounts receivable, inventory, fixed assets, intangible assets and Adience's shares of IDT. In addition, IDT guaranteed the Adience line of credit and pledged its own accounts receivable, inventory and equipment. The interest rate on the loan is 2.5% over the prime rate (effective rate of 8.5% at December 31, 1993). At December 31, 1993 and February 28, 1994, Adience had borrowed $8,007,000 and $11,595,000, respectively, under the credit facility. Letters of credit issued under the facility totaled $1 million at December 31, 1993, which reduced the availability under the financing arrangement in a like amount. IDT also renewed its financing agreement with Congress through June 30, 1994. Under this agreement, IDT may request loan advances not to exceed the lesser of $3 million or available collateral (80% of eligible accounts receivable less than 90 days plus 30% of raw material and finished goods inventory). The loan is collateralized by accounts receivable, inventory and fixed assets. Adience has guaranteed IDT's debt to Congress. The interest rate on the loan is 2.5% over the prime rate. At December 31, 1993 and at February 28, 1994, no amounts were outstanding under this agreement. Letters of credit issued under the facility totaled $700,000 at December 31, 1993, which reduced the availability under the financing arrangement in a like amount. Both Adience and IDT pay commitment fees on the unused portion of their credit facilities. Under the terms of the financing agreements, both companies are required to maintain minimum levels of net worth of $1,500,000 and working capital of $12,000,000. The agreements additionally contain other restrictive covenants applicable to Adience and its subsidiaries which, among other things, limit (i) the incurrence of additional indebtedness, (ii) the granting of liens, (iii) the making of loans, investments and guaranties, (iv) transactions with affiliates, (v) the payment of dividends and other distributions, (vi) the making of annual capital expenditures, and (vii) the disposition of real property. The following is a summary of certain of these covenants: Indebtedness. Adience may not, and may not permit any subsidiary to, create, incur, assume or permit to exist, contingently or otherwise, any indebtedness, except (a) indebtedness to Congress, (b) indebtedness consisting of unsecured current liabilities incurred in the ordinary course of its business which are not more than 90 days past due, (c) indebtedness incurred in the ordinary course of its business secured only by permitted liens (e.g., purchase money mortgages), (d) indebtedness other than for borrowed money, which is and remains contingent and unmatured, (e) indebtedness pursuant to the New Senior Notes, and (f) indebtedness to or from Adience's subsidiaries. Limitation on Liens. Adience may not, and may not permit any subsidiary to, create or suffer to exist any mortgage, pledge, security interest, lien, encumbrance, defect in title or restriction upon the use of their real or personal properties, whether now owned or hereafter acquired, except (a) the liens or security interest in favor of Congress, (b) tax, mechanics and other like statutory liens arising in the ordinary course of Adience's or its subsidiaries' respective businesses, (c) purchase money mortgages or other purchase money liens or security interest upon any specific fixed assets hereafter acquired, and (d) existing liens. Loans, Investments, Guaranties. Adience may not, and may not permit any subsidiary to, directly or indirectly, make any loans or advance money or property to any person, or invest in (by capital contribution or otherwise) or purchase or repurchase the stock or indebtedness or all or a substantial part of the assets or property of any person, or guarantee, assume, endorse, or otherwise be or become responsible for (directly or indirectly) the indebtedness, performance, obligations or dividends of any person or agree to do any of the foregoing, except (a) intercompany loans from and to Adience and its subsidiaries; (b) guarantees by any subsidiary of Adience with respect to the obligations in favor of Congress and guarantees by Adience and any subsidiary of Adience with respect to the obligations in favor of Congress and guarantees by Adience and any subsidiary of Adience with respect to the obligations of IDT in favor of Congress; (c) the endorsement of instruments for collection or deposit in the ordinary course of business; and (d) after written notice thereof to Congress, investments in the following instruments, which shall be pledged and delivered to Congress upon Congress' request, (i) marketable obligations issued or guaranteed by the United States of America or an instrumentality or agency thereof, maturing not more than one (1) year after the date of acquisition thereof, (ii) certificates of deposit or other obligations maturing not more than one (1) year after the date of acquisition thereof issued by any bank or trust company organized under the laws of and located in the United States of America or any state thereof and having capital, surplus and undivided profits of at least $100,000,000, and (iii) open market commercial paper with a maturity not in excess of two hundred seventy (270) days from the date of acquisition thereof which have the highest credit rating by either Standard & Poor's Corporation or Moody's Investors Service, Inc. Transactions with Affiliates. Adience may not, and may not permit any subsidiary to, directly or indirectly (a) purchase, acquire or lease any property or receive any services from, or sell, transfer or lease any property or services to, any affiliate of Adience, except for any such transactions between Adience and Adience's subsidiaries and except for such transactions on prices and terms no less favorable than would have been obtained in an arm's length transaction with a non-affiliated person; or (b) make any payment of management or other fees or of the principal amount of or interest on any indebtedness owing to any shareholder, officer, director or affiliate of Adience, except, that Adience and any subsidiary may make such payments to Adience or a subsidiary, as the case may be, when due. Dividends. Adience may not, and may not permit any subsidiary to, directly or indirectly, during any fiscal year, declare or pay any dividends on account of any shares of any class of capital stock of Adience or its subsidiary now or hereafter outstanding, or set aside or otherwise deposit or invest any sums for such purpose, or redeem, retire, defease, purchase or otherwise acquire any shares of any class of capital stock (or set aside or otherwise deposit or invest any sums for such purpose) for any consideration other than stock or apply or set apart any sums, or make any other distribution (by reduction of capital or otherwise) in respect of any such shares or agree to do any of the foregoing, except, that, dividends may be declared and paid to Adience by its subsidiaries on any class of capital stock or any other interest in, or measured by its profit, owned by Adience or any subsidiary of Adience, in each case out of legally available funds therefore and otherwise in accordance with applicable law. Capital Expenditures. (a) Adience may not, and may not permit any subsidiary to, in the aggregate for all of them, directly or indirectly, expend or commit to expend, capital expenditures in excess of $6,500,000 in any fiscal year of Adience, excluding capital expenditures paid under existing leases; and (b) Adience may not, directly or indirectly, expend or commit to expend, capital expenditures in excess of $4,000,000 in any fiscal year of Adience, excluding capital expenditures paid under existing leases. IDT is subject to a capital expenditure limit of $2,500,000 in any fiscal year, excluding capital expenditures paid under existing leases. Real Property. Adience may not, and may not, permit any subsidiary to sell, lease (as lessor) transfer, or otherwise dispose of any of its or their, as the case may be, real property or any interest therein. As of December 31, 1993, Adience and IDT were in compliance with the covenants of their respective agreements. Adience's ability to continue to comply with such conditions is dependent upon Adience's ability to achieve specified levels of sales, profitable operations and borrowing availability. Waivers or amendments may be required in the future. Inability to achieve compliance could affect Adience's access to further borrowings or require it to secure additional capital by other means. Both Adience and IDT anticipate that the financing agreements with Congress will be renewed at June 30, 1994 or, alternatively, both companies will be able to secure financing from other sources. However, no commitment letters have been requested or received. Long-term liquidity is dependent upon the Company's ability to operate profitably and generate cash flow following favorable changes made to its capital structure and the restructuring of its management structure. Adience's New Senior Notes are due in June 2002, and may not be redeemed at the option of Adience prior to December 15, 1997. Adience has not yet formulated plans to meet these long-term debt requirements. The Indenture under which the New Senior Notes were issued contains restrictive covenants similar to those included in the financing agreements with Congress, and additionally limits the use of cash proceeds from the sale of Adience's assets. The Indenture provides that Adience may not make any asset sale outside of the ordinary course of business unless (i) such asset sale is for fair value and (ii) at least 50% of the consideration therefor received by Adience is in the form of cash and/or cash equivalents. In the case of the sale by Adience of all or substantially all of the stock of IDT or any other asset for which the gross cash proceeds exceed $2 million, Adience is required, within 180 days after the receipt of the net cash proceeds of such asset sale, to make an offer to repurchase the New Senior Notes at a price equal to 100% of the principal amount of the New Senior Notes plus accrued interest thereon. In addition, a default on the Congress financing agreement will result in a default under the Indenture. Both internal and external factors are material to the Company's long-term liquidity. External factors include general economic conditions, the performance of the steel industry and spending by public school systems. Long- term liquidity is dependent upon the Company's ability to control costs during periods of low demand so as to sustain positive cash flow from operations. The Company, even after the Reorganization, continues to operate with a significant amount of interest-bearing debt. Should additional financing be needed, the Company's access to new sources of capital or the amount of available and unused lines of bank credit may be limited. As more fully described under "BUSINESS -- Legal Proceedings," in February 1992, IDT was cited by the Ohio Environmental Protection Agency (the "Ohio EPA") for violations of Ohio's hazardous waste regulations, including speculative accumulation of waste and illegal disposal of hazardous waste on the site of its Alliance, Ohio Facility. IDT had $1,106,000 accrued at December 31, 1992 for the clean-up of this site. In December 1993, IDT and Adience signed a consent order with the Ohio EPA and Ohio Attorney General which required IDT and Adience to pay to the State of Ohio a civil penalty of $200,000 (of which IDT paid $175,000 and Adience paid $25,000). In addition, the consent order requires the payment of stipulated penalties of up to $1,000 per day for failure to satisfy certain requirements of the consent order including milestones in the closure plan. IDT expects that the work to be conducted under the closure plan will be substantially completed in 1994, subject to IDT receiving all necessary approvals from the Ohio EPA. At December 31, 1993, environmental accruals amounted to $783,000 which represents management's reasonable estimate of the amounts remaining to be incurred in this matter, including the costs of effecting the closure plan, bonding and insurance costs, penalties and legal and consultants' fees. Since 1991, Adience and IDT have together paid $341,000 (excluding the civil penalty) for the environmental clean-up related to the Alliance facility. Under the acquisition agreement pursuant to which IDT acquired the property from Adience, Adience represented and warranted that, except as otherwise disclosed to IDT, no hazardous material has been stored or disposed of on the property. No disclosure of storage or disposal of hazardous material on the site was made, accordingly, Adience is required to indemnify IDT for any losses in excess of $250,000. IDT has notified Adience that it is claiming the right to indemnification for all costs in excess of $250,000 incurred by IDT in this matter, and has received assurance that Adience will honor such claim. Adience has reimbursed IDT $196,000; if Adience is financially unable to honor its remaining obligation, such costs would be borne by IDT. Item 8. Item 8. Financial Statements and Supplementary Data The following financial statements and related report and supplementary data are filed as part of this annual report. REPORT OF INDEPENDENT ACCOUNTANTS - POST-EMERGENCE CONSOLIDATED FINANCIAL STATEMENTS To the Board of Directors and Shareholders of Adience, Inc. In our opinion, the accompanying consolidated financial statements listed in the Index appearing under Item 14(a)(1) and (2) on Page 58 present fairly, in all material respects, the financial position of Adience, Inc., and its subsidiaries (Adience) at December 31, 1993, and the results of their operations and their cash flows for the six months ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of Adience's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these financial 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 audit provides a reasonable basis for the opinion expressed above. As discussed in Note 1 to the consolidated financial statements, the Adience Plan of Reorganization was confirmed on May 4, 1993, and was consummated on June 30, 1993. Adience has accounted for the reorganization in accordance with the American Institute of Certified Public Accountants Statement of Position 90-7 "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code." Accordingly, Adience's assets and liabilities as of June 30, 1993, were restated by management, with the assistance of independent advisors, to their reorganized value, which approximated their fair value at the date of reorganization. The financial statements subsequent to the emergence from Chapter 11 have been prepared using a different basis of accounting and therefore, are not comparable to the pre-emergence consolidated financial statements. As discussed in Notes 1 and 6, the Adience line of credit financing agreement expires June 30, 1994. Management expects that financing agreements with the lender will be renewed, or alternatively, that financing will be secured from other sources. PRICE WATERHOUSE Pittsburgh, Pennsylvania March 28, 1994 REPORT OF INDEPENDENT ACCOUNTANTS - PRE-EMERGENCE CONSOLIDATED FINANCIAL STATEMENTS To the Board of Directors and Shareholders of Adience, Inc. In our opinion, the accompanying consolidated financial statements listed in the Index appearing under Item 14(a)(1) and (2) on Page 58 present fairly, in all material respects the financial position of Adience, Inc., and its subsidiaries (Adience) at December 31, 1992, and the results of their operations and their cash flows for the six months ended June 30, 1993, and for the year ended December 31, 1992, in conformity with generally accepted accounting principles. These financial statements are the responsibility of Adience's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial 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. The financial statements of Adience for the year ended December 31, 1991, were audited by other independent accountants whose report dated April 9, 1992, included an explanatory paragraph as to Adience's ability to continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Adience Plan of Reorganization was confirmed on May 4, 1993, and was consummated on June 30, 1993. Adience has accounted for the reorganization in accordance with American Institute of Certified Public Accountants Statement of Position 90-7 "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code." Accordingly, Adience's assets and liabilities as of June 30, 1993, were restated by management, with the assistance of independent advisors, to their reorganized value, which approximated their fair value at the date of reorganization. PRICE WATERHOUSE Pittsburgh, Pennsylvania March 28, 1994 ERNST & YOUNG ONE OXFORD CENTRE PITTSBURGH, PA 15219 412-644-7800 REPORT OF INDEPENDENT AUDITORS Board of Directors Adience, Inc. We have audited the accompanying consolidated statements of income, cash flows, and shareholders' equity (deficit) of Adience, Inc. (Adience) and subsidiaries for the year ended December 31, 1991. These financial statements are the responsibility of Adience'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 consolidated results of operations and cash flows of Adience and subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. The accompanying financial statements have been prepared assuming that Adience will continue as a going concern. As discussed in Notes 1 and 7 to the financial statements, it is unlikely that Adience will be able to generate sufficient cash from operations to enable it to meet its debt obligations in June 1992. This condition raises substantial doubt about Adience's ability to continue as a going concern. Management's plans to mitigate these matters are also described in Notes 1 and 7. The 1991 financial statements do not include any adjustments that might result from the outcome of this uncertainty. ERNST & YOUNG April 9, 1992 29A ADIENCE, INC. CONSOLIDATED BALANCE SHEETS (In Thousands of Dollars, Except Share Data) The accompanying notes are an integral part of these financial statements. ADIENCE, INC CONSOLIDATED STATEMENTS OF OPERATIONS (In Thousands of Dollars, Except Per Share Data) * Earnings per common share are not meaningful prior to June 30,1993 due to the reorganization - see Note 1. The accompanying notes are an integral part of these financial statements. ADIENCE, INC CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars) See Note 1 for significant non-cash transactions not reflected above. The accompanying notes are an integral part of these financial statements. ADIENCE, INC CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT) (In Thousands of Dollars, Except Per Share Data) The accompanying notes are an integral part of these financial statements. ADIENCE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (Dollar Amounts in Thousands, Except Share Data, Unless Otherwise Noted) 1. Basis of Presentation and Company Reorganization Adience, Inc. ("Adience" or "Company") has experienced continued losses from continuing operations (before reorganization items) both pre- and post-emergence under Chapter 11. In addition, a write down of reorganization value in excess of amounts allocable to identifiable assets has been recorded at December 31, 1993, based on management's belief that a permanent impairment of this asset now exists. The Company is currently seeking to replace and improve the terms of its line of credit financing agreement with Congress Financial Corporation (Congress) which expires June 30, 1994. The continued viability of the Company is dependent upon, among other factors, the ability to generate sufficient cash from operations, financing, or other sources that will meet ongoing obligations over a sustained period. Management has prepared detailed operating and financial plans which combine multifunctional resources as teams to respond better to customer needs, make an investment in product and service opportunities expected to produce a significantly greater return on investment, continue a cost control program begun in 1993, and assume refinancing of the line of credit arrangement on improved terms. Management believes that the successful implementation of this plan will enable the Company to continue as a going concern for a reasonable period. There can be no assurance however, that such activities will achieve the intended improvement in results of operations or financial position. A Prepackaged Plan of Reorganization under Chapter 11 of the Bankruptcy Code (the "Prepackaged Plan") was filed by Adience and the Unofficial Committee of Noteholders of Adience on February 22, 1993. The Prepackaged Plan was confirmed by the United States Bankruptcy Court for the Western District of Pennsylvania on May 4, 1993 and consummated on June 30, 1993. The Prepackaged Plan provided for a restructuring of Adience's capital structure and allowed the holders of $66 million aggregate principal amount of Adience's 15% Senior Subordinated Reset Notes ("Old Reset Notes") to exchange them for $49 million aggregate principal amount of new 11% Senior Secured Notes ("New Secured Notes") due June 15, 2002, plus common stock representing 55% of the outstanding common stock of Adience. The Prepackaged Plan included forgiveness of the accrued interest totaling approximately $8.8 million. The value of the cash and securities distributed was $17.5 million less than the allowed claims; the resultant gain is recorded as an extraordinary gain. Neither Adience Canada, a wholly-owned subsidiary, or Information Display Technology, Inc. (IDT), a majority-owned subsidiary of Adience, guarantee the new 11% Notes issued by Adience under the reorganization plan. The new Notes are secured by a lien on all the assets of Adience, including the stock of IDT. Adience Canada and IDT did not file plans of reorganization. The sum of allowed claims plus post petition liabilities exceeded the reorganization value of the assets of Adience immediately before the date of consummation. Also, the Company experienced a change in control as pre- reorganization holders of common stock received less than 50% of the new common stock issued pursuant to the Prepackaged Plan. AICPA SOP 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code ("SOP 90-7"), requires that under these circumstances, a new reporting entity is created and assets and liabilities should be recorded at their fair values. This accounting treatment is referred to as "fresh start reporting". The Company's basis of accounting for financial reporting purposes changed on June 30, 1993 as a result of applying SOP 90-7. Specifically, application of SOP 90-7 required the adjustment of the Company's assets and liabilities to reflect a reorganization value generally approximating the fair value of the Company as a going concern on an unleveraged basis, the elimination of its retained deficit, and adjustments to its capital structure to reflect consummation of the Prepackaged Plan. Fresh start reporting has not been adopted by Adience Canada and IDT. Adience has applied SOP 90-7 in preparing its consolidated balance sheet as of June 30, 1993. The balance sheet became the opening balance sheet for Adience, Inc., as reorganized, on July 1, 1993. Since the December 31, 1993 consolidated balance sheet has been prepared as if it is a new reporting entity, a solid black line has been shown to separate it from prior year information since it is not prepared on a comparable basis. The consolidated statements of operations and cash flows after June 30, 1993 are not comparable to the respective financial statements prior to such date, and the consolidated results of operations for the six months ended June 30, 1993 and the six months ended December 31, 1993 have therefore not been aggregated. Reorganization value at the June 30, 1993 consummation date was determined by management with the assistance of independent advisors. The methodology employed involved estimation of enterprise value (i.e., the market value of the Company's debt and shareholders' equity), taking into account a discounted cash flow analysis, as well as the capitalization of earnings and cash flow approaches. The discounted cash flow analysis was based on five-year cash flow projections prepared by management. The five-year cash flow projections were based on estimates and assumptions about circumstances and events that have not yet taken place. Such estimates and assumptions are inherently subject to significant economic and competitive uncertainties and contingencies beyond the control of the corporation, including, but not limited to, those with respect to the future courses of the Company's business activity. Accordingly, there will usually be differences between projections and actual results because events and circumstances frequently do not occur as expected; and those differences may be material. The assumptions included: a rate of sales growth of approximately 2.5% per annum in excess of the anticipated rate of inflation; selling, general and administrative expenses, after adjustment for non-recurring items, increase in line with the rate of sales growth; operating profit margins for each of the five years are approximately equal to one half of the average annual operating profit margins achieved during the most recent profitable period of 1988-1990; and effective tax rates of 33%. At June 30, 1993, the adjustment to record confirmation of the plan of $23 million was allocated to assets and liabilities as follows: Current assets and liabilities were recorded at fair value. Property, plant and equipment was recorded at reorganization value, which approximated fair value in continued use, based on an independent appraisal. In addition, under SOP 90-7, the long-term debt was recorded at present values on June 30, 1993. The resulting unamortized discount is being accreted to interest expense over the term of the New Secured Notes (See Note 7). Based on the allocation of equity value in conformity with SOP 90-7, the portion of the equity value which was not attributed to specific tangible or identifiable intangible assets of the reorganized Company of $18,329 was reported as "reorganization value in excess of amounts allocable to identifiable assets". This value was initially being amortized on a straight line basis in equal annual amounts over 9 years. On a quarterly basis, management will continue to evaluate the recoverability of the unamortized portion of the reorganization value in excess of amounts allocable to identifiable assets by comparing actual cash flows with the projected cash flows used to arrive at the reorganization value. Should a material difference exist, management will then consider whether the assumptions made in the preparation of the projected cash flows are still reasonable. If management is of the opinion that new projected cash flows are required and that a permanent impairment of the remaining reorganization value has occurred, a reduction of some or all of the unamortized value will be immediately recognized. In the fourth quarter of 1993, the Company recorded a charge of $8 million to reduce the recorded reorganization value in excess of amounts allocable to identifiable assets based on management's comparison of actual cash flows post- emergence through December 31, 1993, with the projected cash flows used to arrive at the reorganization value. This comparison resulted in the preparation of new cash flow projections, which in turn led the Company to the conclusion that permanent impairment of the reorganization value has occurred and that an immediate reduction of approximately 50% of the remaining unamortized value needs to be recognized. This special charge increased the net loss for the six months ended December 31, 1993 by $8 million or $.80 per share. At December 31, 1993, accumulated amortization was approximately $9,011. The effect of the plan of reorganization and the adoption of the provisions of SOP 90-7 in the Company's consolidated balance sheet as of June 30, 1993 was as follows: The following entries record the provisions of the Plan and the adoption of fresh start reporting: 2. Summary of Significant Accounting Policies Consolidation The consolidated financial statements include the accounts of Adience, Adience Canada and IDT. All material intercompany accounts and transactions have been eliminated from the consolidated financial statements. Cash Flow Reporting Cash and cash equivalents include all highly liquid investments with a maturity of three months or less. Inventories Inventories are stated at the lower of cost or market with cost determined on the first-in, first-out (FIFO) basis. Inventories consist primarily of raw materials of $7,512 and $9,264, work-in-process of $2,374 and $3,311 and finished goods of $8,764 and $6,993 at December 31, 1993 and 1992, respectively. Revenue Recognition Approximately 59% of the six months ended December 31, 1993, 49% of the six months ended June 30, 1993, 55% of 1992 and 26% of 1991 revenues were recorded on the percentage of completion method of accounting, measured on the basis of costs incurred to estimated total costs which approximates contract performance to date. Provisions for losses on uncompleted contracts are made if it is determined that a contract will ultimately result in a loss. Substantially all remaining revenue is comprised of direct product shipments to customers and short duration refractory material sales, installation and maintenance work, which are recorded as revenue when shipped and/or installed. Property, Plant and Equipment Property, plant and equipment was stated at cost. In conjunction with the adoption of fresh start reporting, all property, plant and equipment was adjusted to reflect reorganization value, which approximates fair value in continued use, based on an independent appraisal. Improvements to existing equipment that materially extend the life of properties are capitalized as incurred. Expenditures for normal maintenance and repairs are charged to expense as incurred and amounted to $2,469 for the six months ended December 31, 1993, $2,167 for the six months ended June 30, 1993, $4,401 in 1992 and $4,033 in 1991. Depreciation expense is computed using both accelerated and straight-line methods based upon the estimated useful lives of the respective assets. Amortization of assets under capital leases is included in depreciation expense. Goodwill Goodwill resulting from acquisitions accounted for on the purchase method of accounting, was being amortized over 15 to 40 years on the straight-line method. Goodwill relating to domestic acquisitions was written off in conjunction with fresh start reporting. Remaining goodwill will be amortized over 15 years. Reorganization Value in Excess of Amounts Allocable to Identifiable Assets Reorganization value in excess of amounts allocable to identifiable assets is amortized on a straight-line basis over its estimated useful life (see Note 1). Income Taxes Deferred income taxes are recorded to reflect certain items of income and expense recognized in different periods for financial reporting and tax purposes. Adience accounts for income taxes in accordance with the liability method. In 1992 Adience adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which requires an asset and liability approach in accounting for income taxes. Prior to 1992, Adience applied the provisions of SFAS No. 96. There was no cumulative effect for this change in accounting principle as of January 1, 1992. However, as of December 31, 1993 and 1992, a deferred asset was recognized and an offsetting valuation reserve has been established for carryforwards not meeting the "more likely than not" criterion under SFAS No. 109. Reclassifications Certain items in the December 31, 1992 and 1991 financial statements have been reclassified and restated to conform with changes in classification adopted and required in 1993. Earnings Per Common Share Earnings per common share is computed by dividing income or loss by the weighted average number of shares outstanding. Earnings per share for pre-emergence periods is not presented since such information is not comparable with post- emergence earnings per share. 3. Pro Forma Results of Operations (Unaudited) The following consolidating pro forma statement of operations reflects the financial results of the Company as if the reorganization had been effective January 1, 1993: ADIENCE, INC. CONSOLIDATING PRO FORMA STATEMENT OF OPERATIONS (1) Reflects a six month impact of additional depreciation expense resulting from the write-up of property, plant and equipment and the reduction of goodwill amortization which was written off in conjunction with fresh start reporting. (2) Interest expense on reorganized long-term debt. (3) Elimination of the effect of non-recurring reorganization items on operations. 4. Contracts In Progress The status of contract costs on uncompleted construction contracts was as follows: Accounts receivable at December 31, 1993 and 1992 include amounts billed but not yet paid by customers under retainage provisions of approximately $2,989 and $3,338, respectively. Such amounts are generally due within one year. 5. Other Assets Included in other assets are the following: 6. Lines of Credit On the consummation date of the plan of reorganization, June 30, 1993, Adience entered into a financing agreement with Congress, through the twelve month period ending June 30, 1994. Under this agreement, Adience may request loan advances not to exceed the lesser of $12 million or available collateral (80% of eligible accounts receivable less than 90 days plus 30% of raw material and finished goods inventory). The loan is collateralized by accounts receivable, inventory, fixed assets, intangible assets and Adience's shares of IDT. In addition, IDT has guaranteed the Adience line of credit and has pledged as collateral its own accounts receivable, inventory and equipment. The interest rate on the loan is 2.5% over the prime rate (effective rate of 8.5% at December 31, 1993). At December 31, 1993, Adience had borrowed $8,007 under the credit facility. In addition, IDT entered into a financing agreement with Congress, which was also subsequently renewed through June 30, 1994. Under this agreement, IDT may request loan advances not to exceed the lesser of $3 million or available collateral (80% of eligible accounts receivable less than 90 days plus 30% of raw material and finished goods inventory). The loan is collateralized by accounts receivable, inventory and fixed assets. Adience guarantees IDT's debt to Congress. The interest rate on the loan is 2.5% over the prime rate. At December 31, 1993, there were no borrowings outstanding under this agreement. Both Adience and IDT pay commitment fees on the unused portion of their credit facility of 0.5%. Under the terms of the financing agreements, both companies are required to maintain certain financial ratios and meet other financial conditions. The agreements do not allow the companies to incur certain additional indebtedness, pay cash dividends, make certain investments, advances or loans and limits annual capital expenditures. As of December 31, 1993, Adience and IDT were in compliance with the covenants of their respective agreements. Adience's ability to continue to comply with such conditions is dependent upon Adience's ability to achieve specified levels of sales, profitable operations and borrowing availability. Waivers or amendments may be required in the future to ensure compliance. Inability to achieve compliance could affect Adience's access to further borrowings or require it to secure additional capital by other means. Both companies anticipate the financing agreements with Congress will be renewed at June 30, 1994 or, alternatively, both companies will be able to secure financing from other sources. However, no commitment letters have been requested or received. 7. Long-Term Obligations and Liabilities Subject to Compromise Long-term obligations consisted of the following: In connection with the Plan of Reorganization, $49,079 of New Senior Secured Notes with an annual interest rate of 11% were issued under an indenture agreement dated as of June 30, 1993. The New Secured Notes are redeemable at the option of Adience after December 15, 1997. The New Secured Notes are not guaranteed by the subsidiaries of Adience. The New Secured Notes are secured by a lien on all the assets of Adience, including the stock of IDT. Adience, on a consolidated basis, has agreed to certain restrictive covenants which are ordinary to such financings including, among other things, limitations on additional indebtedness, limitations on asset sales and restrictions on the payment of dividends. Principal maturities of long-term obligations are as follows: Property, plant and equipment at December 31, 1993 and 1992 includes equipment, automobiles and trucks under capital leases with a net book value of $1,642 and $1,387, respectively. During the six months ended December 31 and June 30 1993, and the years ended 1992 and 1991 Adience incurred capital lease obligations of $309, $119, $565 and $1,241, respectively. 8. Operating Leases Adience leases certain buildings, machinery, and equipment under both short- and long-term lease arrangements. Future minimum lease commitments under non- cancelable operating leases are not significant. Rental expense relating to such leases was approximately $1.2 million for the six months ended December 31, 1993, $1.0 million for the six months ended June 30, 1993, $2.0 million in 1992 and $4.8 million in 1991. 9. Discontinued Operations During 1992, the Company's Geotec operation was sold for approximately $1.1 million in cash and $1.2 million in notes receivable, after concluding that Geotec's operations no longer fit Adience's long-term growth plans. In addition, the Company's Hotworks division, which provided preheating services to refractory maintenance companies, was sold during 1992 for $1.2 million in cash. During the six months ended December 31, 1993 and June 30, 1993, adjustments to the previously reported loss were made on these sales of approximately $84 and $400, respectively, which has been reflected as an additional loss on the disposal of discontinued operations in the consolidated statements of operations. In November 1991, Adience sold its wholly owned subsidiary, Energy Technology, Inc. (Entec), for approximately $6.5 million. In addition, during 1991, Adience sold certain assets and all of the businesses of its Texas operations (Texops), Chemsteel, Inc., and Ward Duct Connectors, Inc. During 1992, an adjustment to the previously reported gain was made on these sales of approximately $1.1 million, which has been reflected as an additional loss on disposal of discontinued operations in the consolidated statement of operations. The operating results of the discontinued operations are shown separately in the accompanying consolidated statements of operations. Prior year's statements of operations and related footnotes have been restated for comparative purposes. Net revenues of discontinued operations were $13,180 and $65,232 in 1992 and 1991, respectively. 10. Related Party Transactions Note receivable from the principal shareholder of Adience (current portion included in "Prepaid expenses, deposits and other"; 1993--$515; long-term portion included in "Other assets"; 1993--$669 and 1992--$1,116) is payable in semi-annual installments of principal and interest based on an amortization period of five years, with all remaining amounts outstanding due and payable on December 31, 1997. In connection with the plan of reorganization, Adience entered into a new multi- year agreement, to be effective as of October 1, 1992, with the principal shareholder and a severance compensation agreement with his son for a period of seven and five years, respectively. The present value of these payments has been reflected in "Reorganization items-other" and total approximately $4.8 million for the year ended December 31, 1992. 11. Research and Development Expense Adience incurred research and development expense of $541, $541, $1,191 and $1,660 for the six months ended December 31 and June 30, 1993 and years ended December 31, 1992 and 1991, respectively, which amounts have been included in cost of revenues. 12. Income Taxes (Loss) income from continuing operations before income taxes, minority interest in subsidiary and extraordinary item consisted of: Federal, foreign, and state income taxes (benefits) from continuing operations consisted of the following: The effective income tax rate from continuing operations varied from the statutory federal income tax (benefit) rate as follows: Deferred tax liabilities (assets) are comprised of the following at December 31: SFAS 109 requires a valuation allowance when it is "more likely than not that some portion or all of the deferred tax assets will not be realized." It further states that "forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years." The ultimate realization of this deferred income tax asset depends on the Company's ability to generate sufficient taxable income in the future. While the Company believes that the deferred income tax asset will be fully or partially realized by future operating results, losses in recent years and a desire to be conservative make it appropriate to record a valuation allowance. As of December 31, 1993, Adience has a net operating loss carryforward for domestic federal income tax purposes of approximately $13,000 which will expire in 2007 and 2008. Minimum tax and foreign tax credits of $945 are also available to offset federal income tax liabilities to the extent that regular tax exceeds tentative minimum tax in subsequent years. Upon consummation of the plan of reorganization, Adience had an ownership change, as defined by Section 382 of the Internal Revenue Code, which may limit Adience's ability to utilize the pre-ownership change portion of its net operating loss and/or credit. In addition under the provisions of SOP 90-7, subsequent utilization of net operating loss carryforwards will be reflected as an adjustment to reorganization value in excess of amounts allocable to identifiable assets or paid-in capital. An examination of Adience's consolidated U.S. income tax returns for 1988 through 1990 is currently underway. Any resulting adjustments for those years will impact Adience's net operating loss carryforwards. 13. Employee Benefits Employee Stock Ownership Plan During 1989, Adience established an Employee Stock Ownership Plan (ESOP) for most salaried and certain hourly U.S. employees who meet minimum age and service requirements. To fund the ESOP, Adience borrowed $2.5 million repayable over five years in equal quarterly payments plus interest. Proceeds of this borrowing were loaned to the ESOP on the same terms and used by the ESOP, along with cash contributions from Adience, to purchase 646,875 shares of Adience's common stock from its principal shareholder during 1990 and 1989. Effective June 30, 1993 all shares held by the ESOP were allocated to the ESOP participants' accounts. On July 1, 1993, the Company suspended any future recognition of expense related to the ESOP. Accordingly, the Company has no intention at this time to issue more shares of its common stock to the ESOP. Contributions to the ESOP charged to expense for the six months ended December 31 and June 30, 1993 and the years ended 1992 and 1991 amounted to $0, $470, $863 and $918, respectively. Contributions by Adience to the ESOP were used to make loan interest and principal payments. With each principal and interest payment, a portion of the common stock was allocated to participating employees. During 1991, Adience repaid the outstanding balance on the ESOP note. Interest expense on the ESOP borrowings amounted to approximately $81 for 1991. Other Employee Benefit Plans During 1992, Adience initiated a 401(k) Savings Plan. This plan covers substantially all non-bargaining employees, including those employed by IDT, who meet minimum age and service requirements. The Company matches employee contributions of up to 8 percent of compensation at a rate of 25 percent. Amounts charged against income totaled $79 for the six months ended December 31, 1993, $84 for the six months ended June 30, 1993 and $105 for the year ended December 31, 1992. Adience and subsidiaries maintain various defined benefit pension plans covering substantially all hourly employees. The plans provide pension benefits based on the employee's years of service or the average salary for a specific number of years of service. Adience's funding policy is to make annual contributions to the extent deductible for federal income tax purposes. Plan assets and projected benefit obligations for service to date for Adience's defined benefit pension plans aggregated approximately $7,466 and $6,220, respectively, at December 31, 1993. The comparable amounts at December 31, 1992 were $6,980 (assets) and $5,573 (obligations). The components of net periodic pension cost for the six months ended December 31 and June 30, 1993 and the years ended December 31, 1992 and 1991 are not material to the consolidated financial statements. Certain union employees of Adience and subsidiaries are covered by multi- employer defined benefit retirement plans. Expense relating to these plans amounted to $828, $632, $1,037 and $1,421 for the six months ended December 31, 1993 and June 30, 1993 and the years ended December 31, 1992 and 1991, respectively. In December 1990, the Financial Accounting Standards Board issued SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106), that requires that the projected future cost of providing postretirement benefits, such as health care and life insurance, be recognized as an expense as employees render service instead of when the benefits are paid. The Company currently provides only life insurance benefits to certain of its hourly and salaried employees on a fully insured basis. Adoption of SFAS No. 106 did not have a material impact on the Company's consolidated financial statements. In November 1992, the Financial Accounting Standards Board issued new rules that require that the projected future cost of providing postemployment benefits be recognized as an expense as employees render service instead of when the benefits are paid. The Company believes its accrual for postemployment benefits (workers' compensation) is adequate. 14. Commitments and Contingencies At December 31, 1993, Adience had $1,700 in irrevocable standby letters of credit outstanding, not reflected in the accompanying consolidated financial statements, as guarantees in force for various insurance policies, performance and bid bonds. These instruments are usually for a period of one year or the duration of the contract. The letters of credit reduce Adience's availability under the Congress credit facility. In February 1992, IDT was cited by the Ohio Environmental Protection Agency (the "Ohio EPA") for violations of Ohio's hazardous waste regulations, including speculative accumulation of waste and illegal disposal of hazardous waste on the site of its Alliance, Ohio facility. IDT had $1,106 accrued at December 31, 1992 for the clean up of this site. In December 1993, IDT and Adience signed a consent order with the Ohio EPA and Ohio Attorney General which required IDT and Adience to pay to the State of Ohio a civil penalty of $200 (of which IDT paid $175 and Adience paid $25). In addition, the consent order requires the payment of stipulated penalties of up to $1 per day for failure to satisfy certain requirements of the consent order including milestones in the closure plan. IDT expects that the work to be conducted under the closure plan will be substantially completed in 1994, subject to IDT receiving all necessary approvals from the Ohio EPA. At December 31, 1993, environmental accruals amounted to $783 which represents management's reasonable estimate of the amounts remaining to be incurred in this matter, including the costs of effecting the closure plan, bonding and insurance costs, penalties and legal and consultants' fees. Since 1991, Adience and IDT have together paid $341 (excluding the civil penalty) for the environmental clean-up related to the Alliance facility. Under the acquisition agreement pursuant to which IDT acquired the property from Adience, Adience represented and warranted that, except as otherwise disclosed to IDT, no hazardous material has been stored or disposed of on the property. No disclosure of storage or disposal of hazardous material on the site was made, accordingly, Adience is required to indemnify IDT for any losses in excess of $250. IDT has notified Adience that it is claiming the right to indemnification for all costs in excess of $250 incurred by IDT in this matter, and has received assurance that Adience will honor such claim. Adience has reimbursed IDT $196; if Adience is financially unable to honor its remaining obligation, such costs would be borne by IDT. Adience is also engaged in various other legal actions arising in the ordinary course of business. Management believes after discussions with internal and external counsel that the ultimate outcome of the proceedings will not have a material adverse effect on Adience's consolidated financial position. 15. Industry Segment Data Adience operates in two principal industries-heat technology and through IDT's information display products. All operations in a third industry, the industrial services and products division, were divested by the end of 1992. The heat technology division is engaged in the production, installation, and maintenance of specialty refractory products, principally for the ferrous and nonferrous metal industries, throughout the United States and Canada. The information display segment manufactures and installs writing and projection surfaces, custom cabinets, and external architectural building panels. The information display segment's primary markets are educational facilities and healthcare institutions. The 1991 income statement related data has been restated to reflect continuing operations. See Note 9. Substantially all revenues (91% in 1993) are recorded by domestic operations with the balance by Canadian operations. Intersegment revenues are accounted for at prices comparable to unaffiliated customer sales. Operating (loss) profit is total revenues less operating expenses, excluding interest. Adience performs certain management and administrative services for IDT. The fee paid by IDT for these services has been charged at the rate of $300 per annum in 1993 and $135 per annum in 1992 and 1991. Corporate assets consist primarily of notes receivable, property, plant and equipment and reorganization value in excess of amounts allocable to identifiable assets. Adience's products are sold and revenues are derived from companies in diversified industries. Credit is extended to customers based upon an evaluation of the customers' financial condition and generally collateral is not required. At December 31, 1993 and 1992, accounts receivable from customers in the steel and steel-related industries total approximately $9,548 and $9,521, respectively. Credit losses relating to customers in the steel and steel- related industries have been within management's expectations. Note 16 - Quarterly Data and Fourth Quarter Adjustments (Unaudited) The following table sets forth selected highlights for each of the fiscal quarters during the six months ended June 30 and December 31, 1993 and the year ended December 31, 1992: Net earnings (loss) per common share for the fourth quarter of 1993 included a special charge of $8 million for write-down of the Company's reorganization value in excess of amounts allocable to identifiable assets and a $314 loss on the sale of two divisions. Excluding these adjustments, net earnings (loss) per common share for the fourth quarter was $(0.38). Net loss for the fourth quarter of 1992 included a charge of $5.8 million related to the Company's impending restructuring under the Prepackaged Plan and a $2.3 million charge for insurance expense related to the Company's self- insurance programs for workers' compensation and general liability coverage. Additionally, fourth quarter results were reduced by a pre-tax charge for business divestitures of $2.4 million, a $1.2 million write-down in the value of property, plant and equipment and a $1.1 million charge for the environmental issue at one of the Company's facilities. Excluding these special items, the net loss for the fourth quarter and the year was $9.4 million and $17.1 million, respectively. * Earnings per common share are not meaningful prior to June 30, 1993 due to the reorganization - see Note 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 Information concerning the directors and executive officers of the Company required by this item is incorporated by reference to the material appearing under the heading "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of its Shareholders. Item 11. Item 11. Executive Compensation Information required by this item is incorporated by reference to the material appearing under the heading "Executive Compensation" in the Company's Proxy Statement for the 1994 Annual Meeting of its Shareholders, except for Compensation Committee Report and Performance Graph set forth therein, which are not deemed incorporated herein and shall not be deemed filed for purposes of this report. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information required by this item is incorporated by reference to the material appearing under the heading "Principal Shareholders" in the Company's Proxy Statement for the 1994 Annual Meeting of its Shareholders. Item 13. Item 13. Certain Relationships and Related Transactions Information required by this item is incorporated by reference to the material appearing under the heading "Certain Transactions" in the Company's Proxy Statement for the 1994 Annual Meeting of its Shareholders. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K The financial statements, financial statement schedules and exhibits listed below are filed as part of this annual report: (a)(1) Financial Statements: The consolidated financial statements of the Company and its subsidiaries, including a list of such financial statements, are contained in Item 8 of this annual report, and the index thereto is hereby incorporated by reference. (a)(2) Financial Statement Schedules: All other Financial Statement Schedules are omitted either because they are not applicable or are not material, or the information required therein is contained in the consolidated financial statements or notes thereto set forth in Item 8 hereto. (a)(3) Exhibits: Exhibit No. Description 2.1 Plan of Reorganization, as Further Modified, dated May 4, 1993 filed as Exhibit 2.1 to Registration Statement No. 33-72024 (the Registration Statement) and incorporated by reference. 3.1 Restated Certificate of Incorporation of Adience, Inc. filed as Exhibit 3.1 to the Registration Statement and incorporated by reference. 3.2 By-laws of Adience, Inc., filed as Exhibit 3.2 to the Registration Statement incorporated by reference. 4.1 Specimen Common Stock Certificate, filed as Exhibit 4.1 to the Registration Statement incorporated by reference. 4.2 Indenture, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, filed as Exhibit 4.2 to the Registration Statement incorporated by reference. 4.3 Specimen Form of Senior Secured Note, filed as Exhibit 4.3 to the Registration Statement incorporated by reference. 10.1 Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Congress Financial Corporation and Adience, Inc. filed as Exhibit 10.1 to the Registration Statement incorporated by reference. 10.2 Covenant Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.2 to the Registration Statement incorporated by reference. 10.3 Restatement and Acknowledgment, dated June 30, 1993, among Adience, Inc., Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.3 to the Registration Statement incorporated by reference. 10.4 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.4 to the Registration Statement incorporated by reference. 10.5 Trade Financing Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1003, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.5 to the Registration Statement incorporated by reference. 10.6 Amendment to Trademark Collateral Assignment and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.6 to the Registration Statement incorporated by reference. 10.7 Amendment to Patent Collateral Assignment and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.7 to the Registration Statement incorporated by reference. 10.8 Pledge and Security Agreement, dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.8 to the Registration Statement incorporated by reference. 10.9 Guarantee and Waiver, dated June 30, 1993, by Information Display Technology, Inc. to Congress Financial Corporation, filed as Exhibit 10.9 to the Registration Statement incorporated by reference. 10.10 Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Congress Financial Corporation and Information Display Technology, Inc., filed as Exhibit 10.9 to the Registration Statement incorporated by reference. 10.11 Covenant Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.11 to the Registration Statement incorporated by reference. 10.12 Restatement and Acknowledgment, dated June 30, 1993, among Information Display Technology, Inc., Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.12 to the Registration Statement incorporated by reference. 10.13 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.13 to the Registration Statement incorporated by reference. 10.14 Trade Financing Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.14 to the Registration Statement incorporated by reference. 10.15 Amendment to Trademark Collateral Assignment and Security Agreement, dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.15 to the Registration Statement incorporated by reference. 10.16 Guarantee and Waiver, dated June 30, 1993, by Adience, Inc. to Congress Financial Corporation, filed as Exhibit 10.16 to the Registration Statement incorporated by reference. 10.17 Amendment to Open-End Mortgage and Security Agreement, dated as of June 30, 1993, between Congress Financial Corporation and Adience, Inc., filed as Exhibit 10.17 to the Registration Statement incorporated by reference. 10.18 Security Agreement, dated June 30, 1993, between Congress Financial Corporation and Adience Canada, Inc., filed as Exhibit 10.18 to the Registration Statement incorporated by reference. 10.19 Guarantee, dated June 30, 1993, by Adience Canada, Inc. to Congress Financial Corporation, filed as Exhibit 10.19 to the Registration Statement incorporated by reference. 10.20 Security Agreement, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.20 to the Registration Statement incorporated by reference. 10.21 Trademark Collateral Assignment and Security Agreement, dated June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.21 to the Registration Statement incorporated by reference. 10.22 Patent Collateral Assignment and Security Agreement, dated June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.22 to the Registration Statement incorporated by reference. 10.23 Pledge and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.23 to the Registration Statement incorporated by reference. 10.24 Employment Agreement, dated as of February 25, 1992, between Willard M. Bellows and Adience, Inc., filed as Exhibit 10.24 to the Registration Statement incorporated by reference. 10.25 Employment Agreement, dated as of February 25, 1992, between Stephen M. Grimshaw and Adience, Inc., filed as Exhibit 10.25 to the Registration Statement incorporated by reference. 10.26 Employment Agreement, dated as of February 25, 1992, between Charles C. Torie and Adience, Inc., filed as Exhibit 10.26 to the Registration Statement incorporated by reference. 10.27 Profit Sharing Plan of Adience, Inc., filed as Exhibit 10.27 to the Registration Statement incorporated by reference. 10.28 Employees Stock Ownership Plan of Adience, Inc., filed as Exhibit 10.28 to the Registration Statement incorporated by reference. 24.1 Consent of Ernst & Young. The Company agrees to furnish to the Commission upon request copies of all instruments defining the rights of holders of long-term debt of the Company and its subsidiaries which are not filed as a part of this annual report. (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 Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ADIENCE, INC. By: /s/ Fletcher L. Byrom -------------------------- Fletcher L. Byrom Chairman of the Board of Directors and Chief Executive Officer 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 Company in the capacities indicated as of March 29, 1994: /s/ Harry Holiday, Jr. - ------------------------------ ------------------------------ Harry Holiday, Jr. Herbert T. Kerr Director Director /s/ James B. Upchurch - ------------------------------ ------------------------------ James B. Upchurch James H. McConomy Director Director /s/ A. Stanley West - ------------------------------ ------------------------------ A. Stanley West Gregory D. Curtis Director Director /s/ Stephen M. Grimshaw /s/ Fletcher L. Byrom - ------------------------------ ------------------------------ Stephen M. Grimshaw Fletcher L. Byrom Vice President-Finance and Treasurer Director (Principal Financial Officer (Principal Executive Officer) and Principal Accounting Officer) EXHIBITS TO FORM 10-K ADIENCE, INC. ADIENCE, INC. FORM 10-K FOR FISCAL YEAR ENDED DECEMBER 31, 1991 EXHIBIT LIST The following exhibits are required to be filed with this annual report on Form 10-K. Exhibits are incorporated herein by reference to other documents pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, as amended, as indicated in the list. Exhibits not incorporated herein by reference follow the list. The page numbers where each such exhibit may be found under the Commission's sequential numbering system are also indicated. Exhibit No. Description - ----------- ----------- 2.1 Plan of Reorganization, as Further Modified, dated May 4, 1993 filed as Exhibit 2.1 to Registration Statement No. 33-72024 (the Registration Statement) and incorporated by reference. 3.1 Restated Certificate of Incorporation of Adience, Inc. filed as Exhibit 3.1 to the Registration Statement and incorporated by reference. 3.2 By-laws of Adience, Inc., filed as Exhibit 3.2 to the Registration Statement incorporated by reference. 4.1 Specimen Common Stock Certificate, filed as Exhibit 4.1 to the Registration Statement incorporated by reference. 4.2 Indenture, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, filed as Exhibit 4.2 to the Registration Statement incorporated by reference. 4.3 Specimen Form of Senior Secured Note, filed as Exhibit 4.3 to the Registration Statement incorporated by reference. 10.1 Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Congress Financial Corporation and Adience, Inc. filed as Exhibit 10.1 to the Registration Statement incorporated by reference. 10.2 Covenant Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.2 to the Registration Statement incorporated by reference. 10.3 Restatement and Acknowledgment, dated June 30, 1993, among Adience, Inc., Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.3 to the Registration Statement incorporated by reference. 10.4 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.4 to the Registration Statement incorporated by reference. 10.5 Trade Financing Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.5 to the Registration Statement incorporated by reference. 10.6 Amendment to Trademark Collateral Assignment and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.6 to the Registration Statement incorporated by reference. 10.7 Amendment to Patent Collateral Assignment and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.7 to the Registration Statement incorporated by reference. 10.8 Pledge and Security Agreement, dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.8 to the Registration Statement incorporated by reference. 10.9 Guarantee and Waiver, dated June 30, 1993, by Information Display Technology, Inc. to Congress Financial Corporation, filed as Exhibit 10.9 to the Registration Statement incorporated by reference. 10.10 Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Congress Financial Corporation and Information Display Technology, Inc., filed as Exhibit 10.9 to the Registration Statement incorporated by reference. 10.11 Covenant Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.11 to the Registration Statement incorporated by reference. 10.12 Restatement and Acknowledgment, dated June 30, 1993, among Information Display Technology, Inc., Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.12 to the Registration Statement incorporated by reference. 10.13 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.13 to the Registration Statement incorporated by reference. 10.14 Trade Financing Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.14 to the Registration Statement incorporated by reference. 10.15 Amendment to Trademark Collateral Assignment and Security Agreement, dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.15 to the Registration Statement incorporated by reference. 10.16 Guarantee and Waiver, dated June 30, 1993, by Adience, Inc. to Congress Financial Corporation, filed as Exhibit 10.16 to the Registration Statement incorporated by reference. 10.17 Amendment to Open-End Mortgage and Security Agreement, dated as of June 30, 1993, between Congress Financial Corporation and Adience, Inc., filed as Exhibit 10.17 to the Registration Statement incorporated by reference. 10.18 Security Agreement, dated June 30, 1993, between Congress Financial Corporation and Adience Canada, Inc., filed as Exhibit 10.18 to the Registration Statement incorporated by reference. 10.19 Guarantee, dated June 30, 1993, by Adience Canada, Inc. to Congress Financial Corporation, filed as Exhibit 10.19 to the Registration Statement incorporated by reference. 10.20 Security Agreement, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.20 to the Registration Statement incorporated by reference. 10.21 Trademark Collateral Assignment and Security Agreement, dated June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.21 to the Registration Statement incorporated by reference. 10.22 Patent Collateral Assignment and Security Agreement, dated June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.22 to the Registration Statement incorporated by reference. 10.23 Pledge and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.23 to the Registration Statement incorporated by reference. 10.24 Employment Agreement, dated as of February 25, 1992, between Willard M. Bellows and Adience, Inc., filed as Exhibit 10.24 to the Registration Statement incorporated by reference. 10.25 Employment Agreement, dated as of February 25, 1992, between Stephen M. Grimshaw and Adience, Inc., filed as Exhibit 10.25 to the Registration Statement incorporated by reference. 10.26 Employment Agreement, dated as of February 25, 1992, between Charles C. Torie and Adience, Inc., filed as Exhibit 10.26 to the Registration Statement incorporated by reference. 10.27 Profit Sharing Plan of Adience, Inc., filed as Exhibit 10.27 to the Registration Statement incorporated by reference. 10.28 Employees Stock Ownership Plan of Adience, Inc., filed as Exhibit 10.28 to the Registration Statement incorporated by reference. 24.1 Consent of Ernst & Young. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, AND EMPLOYEES OTHER THAN RELATED PARTIES ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) As part of the Prepackaged Plan of Reorganization, Adience agreed to enter into a new multi-year agreement, to be effective as of October 1, 1992, with Herbert T. Kerr in substitution for Mr. Kerr's existing employment agreements with Adience and IDT. The Kerr agreement, which is still being negotiated, calls for semi-annual payments of principal and interest at the annual prime rate on loans previously made to Mr. Kerr by Adience in the aggregate principal amount of approximately $880,000. Interest on the principal amount of such loans that accrued from the date of the making of these loans through December 31, 1992 has been added to the principal of such loans. Mr. Kerr's payment obligations were to begin on June 30, 1993. Beginning with January 15, 1994, payments due have been offset against Adience's obligation under Mr. Kerr's new multi-year agreement, pending the completion of the Kerr agreement. See Schedule IV for details regarding Adience's indebtedness to Mr. Kerr. (2) Up to $34,000 of this note was payable annually on or before April 30 of each year if certain conditions in Mr. Suddarth's employment agreement were met. Mr. Suddarth's employment agreement was terminated during October 1992, and any amounts due Mr. Suddarth under his employment agreement were offset against the Note. (3) Note was written off in accordance with the settlement reached for the termination of Mr. Ward's employment agreement during 1991. (4) Note does not bear interest. (5) Note is collateralized by accounts receivable of the debtor. The payment terms of the note have been renegotiated so that monthly payments of $25,211 are to be made beginning with February 1, 1994. SCHEDULE IV - INDEBTEDNESS OF AND TO RELATED PARTIES - NOT CURRENT ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) As part of the Prepackaged Plan of Reorganization, Adience agreed to enter into a new multi-year agreement, to be effective as of October 1, 1992, with Herbert T. Kerr in substitution for Mr. Kerr's existing employment agreements with Adience and IDT. The Kerr agreement, which is still being negotiated, is to provide for annual compensation of $750,000 plus certain other items of non-cash compensation, and for certain rights upon termination. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT ADIENCE, INC. (THOUSANDS OF DOLLARS) (1) As discussed in Note 1 to the consolidated financial statements, in conjunction with the adoption of fresh start reporting, all property, plant and equipment was adjusted to fair value on a continued use basis, based on an independent appraisal. (2) Adjustment to book basis for write-down of buildings and machinery and equipment for a facility which was anticipated to close during 1993. (3) Depreciation expense is computed using both accelerated and straight-line methods based upon the estimated useful lives of the respective assets. Amortization of assets under capital leases is included in depreciation expense. (4) Reclassification. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) As discussed in Note 1 to the consolidated financial statements, in conjunction with the adoption of fresh start reporting, all property, plant and equipment was adjusted to fair value on a continued use basis, based on an independent appraisal. (2) Adjustment to book basis for write-down of buildings and machinery and equipment for a facility which was anticipated to close during 1993. (3) Depreciation expense is computed using both accelerated and straight-line methods based upon the estimated useful lives of the respective assets. Amortization of assets under capital leases is included in depreciation expense. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) Uncollectible accounts written off, net of recoveries. (2) Payments made related to the Ohio EPA Consent Order (see Note 14 to the Consolidated Financial Statements). SCHEDULE IX - SHORT-TERM BORROWINGS ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) Under the Company's current revolving credit agreement, it can borrow up to a maximum of $15,000,000. Any borrowings are collateralized by fixed assets, accounts receivable and inventory. The present credit facility has a June 30,1994 termination dale. The former revolving credit agreement had a maximum limit of $25,000,000 and was secured by accounts receivable and inventory. It was terminated December 19, 1991. (2) The average amount outstanding during the period was computed by dividing the total month-end outstanding principal balances by 12 or 6. (3) The weighted average interest rate during the period was computed by dividing the actual interest expense for short-term borrowings by the average short-term debt outstanding. (4) At December 31 and June 30,1993 and December 31, 1992 outstanding checks of approximately $1,178,000, $2,184,000 and $1,338,000, respectively, were reclassed to the balance sheet caption "Revolving lines of credit".

96966_1993.txt

96966_1993

1993

96966

ITEM 1. BUSINESS Telephone and Data Systems, Inc. (the "Company" or "TDS"), is a diversified telecommunications service company with local telephone, cellular telephone and radio paging operations. At December 31, 1993, the Company operated 94 telephone subsidiaries serving 356,200 access lines in rural and suburban areas; owned or had the right to acquire cellular interests representing approximately 23.7 million population equivalents and offered cellular telephone service through 116 majority-owned markets with 261,000 cellular telephones in service; and offered radio paging and related services with 460,900 pagers in service. The Company's business development strategy is to expand its existing operations through internal growth and acquisitions and to explore and develop other telecommunications businesses that management believes will utilize the Company's expertise in customer-based telecommunications services. For the year ended December 31, 1993, telephone operations provided 45.4% of the Company's consolidated revenues and all of its earnings; cellular operations provided 41.9% of the Company's consolidated revenues; and paging operations provided 12.7% of the Company's consolidated revenues. The Company conducts substantially all of its telephone operations through its wholly owned subsidiary, TDS Telecommunications Corporation ("TDS Telecom"). TDS Telecom is expanding through the selective acquisition of local exchange telephone companies serving rural and suburban areas and by offering additional lines of telecommunications products and services to existing customers. TDS Telecom has acquired 29 telephone companies since the beginning of 1989. These acquisitions added 59,600 access lines during this five-year period, while internal growth added 57,000 lines. The Company conducts substantially all of its cellular operations through its majority-owned subsidiary, United States Cellular Corporation (AMEX symbol "USM"), which is engaged through subsidiaries and joint ventures primarily in the development and operation of and the acquisition of interests in cellular markets. The Company has had voting control of USM since USM's incorporation. TDS owned an aggregate of 59,548,450 shares of common stock of USM at December 31, 1993, representing over 85% of the combined total of USM's outstanding Common and Series A Common Shares and over 97% of their combined voting power. Assuming USM's Common Shares are issued in all instances in which USM has the choice to issue its Common Shares or other consideration and assuming all other issuances of USM's common stock to TDS and third parties for completed and pending acquisitions and redemptions of USM Preferred Stock and TDS Preferred Shares had been completed at December 31, 1993, TDS would have owned approximately 79.5% of the total outstanding common stock of USM and controlled over 95% of the combined voting power of both classes of its common stock. In the event TDS's ownership of USM falls below 80% of the total value of all of the outstanding shares of USM's stock, TDS and USM would be deconsolidated for federal income tax purposes. TDS and USM 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 USM's Common Shares in connection with certain acquisitions. USM owns, operates, invests in and has the right to acquire interests in cellular telephone systems representing approximately 23.7 million population equivalents in 205 markets in 37 states. USM owns a controlling interest in and manages cellular systems serving 116 markets ("consolidated markets") and has the right to acquire a controlling interest in and manage cellular systems serving 16 additional markets. All but two of these markets are operational. USM owns or has the right to acquire minority interests (without the right to acquire a controlling interest) and manage cellular systems in 12 operational markets and owns non-controlling interests in and does not manage 61 other operational markets. Since the beginning of 1989, the number of cellular customers in USM's consolidated markets has increased from 13,600 to 261,000. The Company conducts substantially all of its radio paging operations through its 82.5%-owned subsidiary, American Paging, Inc. (AMEX symbol "APP"). APP offers radio paging and related services through its subsidiaries. Since the beginning of 1989, the number of pagers in service increased from 127,600 to 460,900 at December 31, 1993, primarily from internal growth. The Company was incorporated in Iowa in 1968. The Company's executive offices are located at 30 North LaSalle Street, Chicago, Illinois 60602. Its telephone number is 312-630-1900. Unless the context indicates otherwise: (i) references to "TDS" or the "Company" refer to Telephone and Data Systems, Inc., and its subsidiaries; (ii) references to "USM" refer to United States Cellular Corporation and its subsidiaries; (iii) references to "APP" refer to American Paging, Inc. and its subsidiaries; (iv) 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; (v) references to "RSA" refer to the Rural Service Area, as used by the FCC in designating non-MSA cellular market areas; (vi) references to cellular "markets" or "systems" refer to MSAs, RSAs or both; and (vii) 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 Each of the diversified telecommunications operations of TDS conducted by its local telephone, cellular telephone and radio paging subsidiaries is subject to FCC and state regulation. The licenses held by these subsidiaries which are granted by the FCC for the use of radio frequencies are an important component of the overall value of the assets of TDS. As discussed here, recent Congressional legislation and related FCC regulatory proceedings may have significant impact on some or all of its diversified telecommunications 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 and PMRS service. The Company anticipates that a substantial portion of 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. The Company believes that competitive bidding for licenses in any market could increase the cost of entry into that market to the extent of prevailing market prices for such licenses. The Company also believes that it has the financial resources to be a strong competitor for licensing in those markets in which it elects to compete, that the competitive bidding process should not materially increase the Company's aggregate cost of entering new markets and should result in more efficient granting of licenses than at present thereby permitting the winning bidder to commence service to customers promptly pursuant to such licenses. 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 each area of the Company's diversified telecommunications 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. It is expected that the new wireless services will be both complementary services and competitive alternatives to current cellular and landline telephone services. 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 and its subsidiaries. There can be no assurance that the Company will not be adversely affected by such technological developments. TELEPHONE OPERATIONS The Company's telephone operations are conducted through TDS Telecom and its 94 telephone subsidiaries. These telephone companies, ranging in size from less than 500 to more than 40,000 access lines, serve 356,200 access lines in 29 states. The Company provides modern, high-quality local and long-distance telephone service. Local service is provided by the Company's operating telephone subsidiaries. Long-distance or toll service is provided through connections with long-distance carriers, primarily AT&T Communications, Inc. ("AT&T"), and the Regional Bell Operating Companies ("RBOCs"). The Company anticipates that it will need to make arrangements with AT&T, the RBOCs and other large companies in order to offer certain software-intensive services such as information gateway services. There is no assurance that the Company will be able to obtain such arrangements or that such arrangements, if obtained, will be on terms favorable to the Company. Future growth in telephone operations is expected to be derived from the acquisition of additional telephone companies, from providing service to new or presently unserved establishments, from business expansion in the areas served by the Company, from upgrading existing customers to higher grades of service, from increased usage of the network through both local and long-distance calling and from providing additional services made possible by advances in technology. The following table summarizes certain information regarding the Company's telephone operations. TELEPHONE ACQUISITIONS TDS pursues an active program of acquiring operating telephone companies. Since January 1, 1989, TDS has acquired 29 telephone companies serving a total of 59,600 access lines for an aggregate consideration totalling $160.2 million. The consideration consisted of $61.9 million in cash and notes, 116,000 Preferred Shares and 2.5 million Common Shares of the Company. At December 31, 1993, the Company had agreements, awaiting regulatory or other approvals, to acquire two telephone companies which serve 17,600 access lines and which own minority cellular interests representing approximately 90,000 population equivalents. These acquisitions are expected to be completed for an aggregate consideration of approximately $53.2 million, consisting of approximately 1.1 million Common Shares of the Company. The Company continually evaluates acquisition opportunities. Telephone holding companies and others actively compete for the acquisition of telephone companies and such acquisitions are subject to the consent or approval of regulatory agencies in most states and, in some cases, to federal waivers that may affect the form of regulation or amount of interstate cost recovery of acquired telephone exchanges. While management believes that it will be successful in making additional acquisitions, there can be no assurance that the Company will be able to negotiate additional acquisitions on terms acceptable to it or that regulatory approvals, where required, will be received. The Company maintains shelf registration of its Common Shares and Preferred Shares under the Securities Act of 1933 for issuance specifically in connection with acquisitions. It is the Company's policy to preserve, insofar as possible, the local management of each telephone company it acquires. The Company provides the telephone subsidiaries with centralized purchasing and general management and other services, at cost plus a reasonable rate of return on invested capital. These services afford the subsidiaries expertise in the following areas: finance, accounting and treasury services; marketing; customer service; traffic; engineering and construction; accounting and customer billing; rate administration; credit and collection; and the development of administrative and procedural practices. CONSTRUCTION AND DEVELOPMENT PROGRAM The Company's policy is to upgrade plant and equipment in presently owned and newly acquired telephone subsidiaries pursuant to an ongoing construction and development program. The Company makes major plant additions to upgrade service and replace existing facilities, and provides for routine plant additions. The program also allows the Company to enhance service and revenues and reduce costs by taking advantage of technological developments in the telecommunications industry. During 1993 the Company began replacing older switches with state-of-the-art 5ESS switches manufactured by AT&T. In 1994 the Company will continue to bring the advanced calling services of the AT&T 5ESS and Siemens Stromberg-Carlson EWSD to more of its customers by adding 14 additional host units. The Company's overall plan is to bring advanced calling services to all customers by the year 2000. The Company has converted facilities serving 96% of its access lines to digital switching technology and is installing high-capacity fiber optic cable facilities where appropriate and cost-effective. At December 31, 1993, the Company had approximately 1,900 route miles of fiber optic cable in service. Gross additions to plant and equipment were $82.2 million in 1993, $67.4 million in 1992, $67.9 million in 1991, $70.3 million in 1990 and $57.6 million in 1989. The Company estimates that gross additions for major construction projects and routine plant additions will total approximately $110 million in 1994, exclusive of pending acquisitions. The Company plans to continue financing its telephone construction program using internally generated cash supplemented by long-term financing from federal government programs. FEDERAL FINANCING AND HIGH COST SUPPORT PROGRAMS The Company's primary sources of long-term financing for additions to telephone plant and equipment have been the Rural Electrification Administration ("REA"), the Rural Telephone Bank ("RTB") and the Federal Financing Bank ("FFB"), agencies of the United States of America. The REA has made primarily 35-year loans to telephone companies since 1949, at interest rates of 2% and 5%, for the purpose of improving telephone service in rural areas. The REA is authorized to make hardship loans at a 5% interest rate and cost of money loans at a rate not greater than 7%. The RTB, established in 1971, makes loans at interest rates based on its average cost of money (6.05% and 6.35% for its fiscal year ended September 30, 1993), and in some cases makes loans concurrently with REA loans. In addition, the REA guarantees loans made to telephone companies by the FFB at the federal cost of money (6.414% for a 35-year note at December 31, 1993). Substantially all of the Company's telephone plant is pledged or is subject to mortgages to secure obligations of the operating telephone companies to the REA, RTB and FFB. The amount of dividends on common stock that may be paid by the operating telephone companies is limited by certain financial requirements set forth in the mortgages. Of the $306.2 million of underlying retained earnings of the telephone subsidiaries at December 31, 1993, $79.1 million was available for the payment of dividends on the subsidiaries' common stock. At December 31, 1993, the Company's operating telephone companies had unadvanced loan commitments under the REA, RTB and FFB loan programs aggregating approximately $93.9 million, at a weighted average annual interest rate of 6.1%, to finance specific construction activities in 1994 and future years. These loan commitments are generally issued for five-year periods and may be extended under certain circumstances. The Company's operating telephone companies have made applications for additional loans from the REA, RTB and FFB, and intend to make further applications as their needs arise. There is no assurance that these applications will be accepted or what the terms or interest rates of any future loan commitments will be. If funds were unavailable through the REA, RTB and FFB programs in the future and the subsidiaries were to borrow from conventional lenders at market rates, their cost of new loans might increase significantly. In that event, the Company would expect to seek higher local service rates to cover higher interest expense in order to maintain a reasonable balance between service to customers and local service rates. A number of the telephone subsidiaries recover a proportion of their costs via interstate support mechanisms. Reevaluation and probable modification of those mechanisms is expected. The interstate Universal Service Fund has been capped and indexed as an interim measure pending regulatory proceedings. Bills in Congress propose to widen the base of providers contributing to support for universal service but could involve development of new mechanisms and eligibility criteria. There is no assurance that cost recovery through direct and indirect interstate mechanisms will remain at current levels. Some telephone subsidiaries are in states where support and rate structures are under reevaluation or have been changed. There is no assurance that the states will continue to provide for cost recovery from current sources. The Company would expect to seek higher local service rates to recover costs for which current interstate or intrastate recovery may become unavailable. REGULATION Operating telephone companies are regulated by state regulatory agencies with respect to local rates, intrastate intra-LATA (Local Access Transport Area) toll rates, intrastate access charges billed to intrastate interexchange carriers, service areas, service standards, accounting and related matters. In a number of states, construction plans and borrowings and certain other financial transactions are also subject to regulatory approval. The switch replacement program discussed above will require some regulatory approval. The Company has sought and will continue to seek appropriate increases in local and other service rates and changes in rate structures to achieve reasonable rates and earnings. The FCC regulates interstate toll rates, interstate access charges paid by interexchange carriers to local exchange carriers and other matters relating to interstate telephone service. The FCC also regulates the use of radio frequencies in telephone operations. The Company's telephone subsidiaries participate in the National Exchange Carrier Association ("NECA") common line and traffic sensitive tariffs and participate in the access revenue pools administered by NECA for interstate services. Where applicable, the Company's subsidiaries also participate in intrastate access tariffs and toll-pooling arrangements approved by state regulatory authorities for intrastate intra-and inter-LATA services. Such interstate and intrastate arrangements are intended to compensate LECs, such as the Company's operating telephone companies, for the costs, including a fair rate of return, of facilities furnished in originating and terminating interstate and intrastate long-distance services. Various aspects of federal and state telephone regulation have, in recent years, been subject to re-examination and ongoing modification. In several states, toll revenue pooling arrangements that are the source of substantial revenues to local exchange companies are being replaced with access-charge-based arrangements. Access charges are typically priced to result in revenue flows similar to those realized in the toll-pooling process. To the extent they are not, the Company may seek adjustments in other rates. On September 19, 1990, the FCC approved a mandatory price cap plan on interstate access rates for the seven RBOCs and GTE, leaving the plan optional for all other local telephone operating companies. This follows a March 16, 1989 FCC decision allowing price cap regulation for AT&T's interstate services. The price cap approach differs from traditional rate-of-return regulation by focusing primarily on the prices of communications services. The intention of price cap regulation is to focus on productivity and the approved plan for telephone operating companies allows for the sharing with its customers of profits achieved by increasing productivity. Alternatives to rate-of-return regulation have also been adopted or proposed primarily for the RBOCs in some of the states in which the Company's operating subsidiaries do business. On May 13, 1993, the FCC approved an alternative regulation plan for small and mid-sized telephone operating companies not electing price caps. This plan intends to reduce regulatory filing burdens under a form of modified rate-of-return. The Company's telephone subsidiaries have not elected the new FCC plan for 1994 and will remain in the NECA pools for this period. Since approximately one-third of the Company's telephone subsidiaries serve high-cost areas, important cost support mechanisms associated with the NECA pooling process would be lost if the Company elected either of the alternatives to rate-of-return regulation. On November 5, 1993, NECA filed with the FCC a Petition for Rulemaking proposing rule revisions to allow incentive settlement options within the NECA pools. The settlement options are designed to provide companies wishing to remain in the NECA pools with incentives similar to those previously adopted by the FCC but only available to non-NECA participants. Management has been involved in providing comments on this plan and continues to evaluate opportunities under all forms of regulation. COMPETITION As a result of a series of FCC, court and state regulatory agencies' decisions, competition has been introduced in certain sectors of the telephone industry, including interstate and intrastate toll, special access services and customer premises equipment. Landline facilities-based competition in intrastate intra-LATA markets is currently prohibited in some of the various states where the Company provides service. On September 17, 1992, the FCC took a step toward introducing competition in the local exchange access business by ordering that competitive access providers, interexchange carriers and others have the right to directly interconnect facilities in the central offices of tier one telephone companies for the provision of interstate special access services. A related proceeding adjusted the interstate transport rate structure to reflect the policy of promoting interstate access competition. The intent of these orders and other related FCC decisions is to allow interstate special access competition with telephone companies and provide telephone companies with increased pricing flexibility, allowing them to compete on fair terms with the new entrants. On August 3, 1993, the FCC adopted a framework parallel to their special access interconnection rules for interstate switched access transport services. Less than one percent of the Company's consolidated revenues are derived from special access transport services and less than seven percent are derived from switched access transport services. Further, the rules do not apply to the Company's telephone subsidiaries, but could lead to changes in other FCC rules and policies that affect the way certain services are priced. Bills are pending in both Houses of Congress that propose to open local exchange and other telecommunications services to competition and apply expanded interconnection requirements to some or all local exchange telephone companies. Technological developments in cellular telephone, digital microwave, coaxial cable, fiber optics and other wireless and wired technologies may further permit the development of alternatives to traditional landline service. The Company and many other members of the local exchange carrier industry are seeking to maintain a strong universally affordable public telecommunications network through regulatory policies and programs that are sensitive to the needs of small communities and rural areas serviced by many of the Company's telephone subsidiaries. Certain providers and users of toll service may seek to bypass the LEC's switching services and local distribution facilities, particularly if services are not strategically priced. There are three primary ways which users of toll service may bypass the Company's switching services. First, users may construct and operate or lease facilities to transmit their traffic to an interexchange carrier. Second, certain interexchange carriers provide services which allow users to divert their traffic from the LEC's usage-sensitive services to their flat-rate services. Third, users may choose to use cellular telephone service to bypass the LEC's switching services. The Company's telephone subsidiaries have experienced only a small loss of traffic to such bypass. The Company and the exchange carrier industry are seeking to address bypass by advocating flexible pricing, including reduced pricing of access and toll services, where appropriate. The FCC released other significant orders and proposed rulemakings during 1992 and 1993 which are intended to further promote competition in video and voice communications and which may provide the Company with increased communications opportunities. On August 14, 1992, the FCC issued a "video dialtone" order permitting telephone companies greater participation in the video marketplace. Video dialtone enables telephone companies to provide network distribution platforms, various ancillary services such as billing and collections, and enhanced gateway services on behalf of video programmers. The FCC also tentatively concluded that the CATV rural exemption should be increased from its current population ceiling for communities in the service areas of 2,500 to 10,000. The rural exemption sets a population benchmark defining areas where a telephone company can directly provide cable TV service to its telephone customers. In addition, the FCC has authorized cellular telephone and other technologies as discussed above under "Regulatory Developments" which may be competitive with traditional telephone operations as well as provide new business opportunities. The Company actively monitors these proceedings seeking to protect its interests, and continues to evaluate new business opportunities that arise out of these regulatory decisions. The Clinton Administration has made its intentions known, through Vice President Gore, to develop a national communications policy, backed by legislation. The policy will be directed toward creation of a broadband interactive National Information Infrastructure. The administration has advocated legislation based on five principles: to encourage private investment, to provide and protect competition, to provide open access to the network, to take action to avoid creating a society of information "haves" and "have nots" and to encourage flexible and responsive governmental action. Because of the legislation proposed by leadership in each house of Congress and the Administration's initiatives, the Company expects that there eventually may be open entry in nearly every aspect of communications. On the other hand, Vice President Gore and certain House and Senate bills suggest that all participants should contribute to universal service and intend, to varying degrees, that geographic location should not determine who has access to an advanced infrastructure. The Company believes high-cost funds and similar cost-averaging methods should continue to be employed to ensure that advanced services reach rural areas. It plans to compete by providing high-quality advanced voice, video, data and image services. CELLULAR TELEPHONE OPERATIONS THE CELLULAR TELEPHONE INDUSTRY 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. USM 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 USM 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 USM, 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 USM'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. USM 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. CERTAIN CONSIDERATIONS REGARDING CELLULAR TELEPHONE OPERATIONS A significant portion of the aggregate market value of TDS's Common Shares is represented by the market value of TDS's interest in USM. Since its inception in 1983, USM 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. USM has experienced operating losses and net losses in all but a few quarters since its inception. USM 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 USM's operations. See "Legal Proceedings - -- La Star Application" for a discussion of certain FCC proceedings which have suspended the Company's and USM's licensing authority in a Wisconsin market pending the outcome of an FCC hearing. The number of population equivalents represented by USM'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 USM'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. USM 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 guidelines 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 telephones, it is anticipated that all cellular telephones currently marketed and in use will comply with those standards. CELLULAR OPERATIONS USM 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 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." USM 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. USM's 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 USM's market clusters or may be sold for cash or other consideration. CELLULAR SYSTEMS DEVELOPMENT ACQUISITIONS. During the last three years, USM has aggressively expanded its size, particularly in markets which share adjacency, through an ongoing acquisition program aimed at strengthening USM'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. The Company has nearly tripled its population equivalents from approximately 8.4 million at December 31, 1988, to approximately 23.7 million at December 31, 1993. Similarly, markets managed or to be managed by USM 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 USM manages or expects to manage, compared to 62% at December 31, 1988. USM 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. USM 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 USM continues to evaluate the disposition of interests which are not essential to its corporate development strategy. USM, or TDS for the benefit of USM, will ordinarily make acquisitions using securities or cash or by exchanging cellular interests it already owns. There is no assurance that USM 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 USM. USM, or TDS for the benefit of USM, has negotiated acquisitions of cellular interests from third parties primarily in consideration for USM's Common Shares or TDS's Common or Preferred Shares. Cellular interests acquired by TDS are generally assigned to USM. At that time, USM 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 USM'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 USM'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, USM 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 minority interests representing approximately 3.8 million population equivalents for an aggregate consideration of $281.9 million. The consideration consisted of 6.1 million TDS Common Shares, 157,000 USM Common Shares, $19.5 million in cash, 29,000 shares of subsidiary preferred stock which are exchangeable into 73,000 TDS Common Shares, and the obligation to deliver approximately 140,000 USM Common Shares to third parties in 1994. USM reimbursed TDS for TDS securities issued and cash paid in the acquisitions through an increase in the debt to TDS under the Revolving Credit Agreement of $101.5 million and the issuance to TDS of 5.5 million USM Common Shares. PENDING ACQUISITIONS. At December 31, 1993, TDS and/or USM 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, TDS and/or USM will issue approximately 2.4 million TDS Common Shares, all of which are expected to be issued in 1994, and 49,000 USM Common Shares, and will pay approximately $6.2 million in cash. Any interests acquired by TDS in these transactions are expected to be assigned to USM and at that time, USM will reimburse TDS for TDS's consideration delivered and costs incurred in such acquisitions in the form of USM Common Shares or increases in the balance under the Revolving Credit Agreement. 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 pursuant to these agreements are included in the table on pages 15 to 18. TDS and USM maintain shelf registration of their respective Common Shares and Preferred Shares under the Securities Act of 1933 for issuance specifically in connection with acquisitions. CELLULAR INTERESTS AND CLUSTERS USM operates clusters of adjacent cellular systems, enabling its customers to benefit from a larger service area than otherwise possible. USM's strategy was initially implemented by filing for licenses to operate cellular systems in MSAs. Following the MSA lotteries and settlements, USM acquired interests in certain additional MSAs through purchases. USM has acquired substantial additional population equivalents through the purchase of interests in RSAs. USM 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. USM anticipates that clustering markets will expand its cellular service areas and provide certain economies in its capital and operating costs. In areas where USM 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. USM's market clusters have grown rapidly. At December 31, 1993, approximately 87%, or 17.7 million, of USM's managed population equivalents were in contiguous markets within market clusters. Additionally, 92% of USM's managed markets were adjacent to another USM-managed market at that time. USM anticipates continuing to pursue strategic acquisitions and trades in order to complement its developing market clusters. USM has also acquired minority interests in markets where it already owns, or has the right to acquire, a majority interest. From time to time, USM may consider trading or selling some of its cellular interests which do not fit well with its long-term strategies. USM 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 USM's population equivalents were in markets that USM manages or expects to manage. At that date, approximately 95% of USM's managed population equivalents were in markets where cellular service has been initiated and where USM is currently operating the system. The following table summarizes the growth in USM's population equivalents in recent years and the development status of these population equivalents. The following section details USM'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 USM operates or anticipates operating. USM's market clusters show the areas in which USM 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 USM and TDS owned or had the right to acquire pursuant to definitive agreements as of December 31, 1993. SYSTEM DESIGN AND CONSTRUCTION. USM 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 USM personnel or independent engineering firms. USM'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, USM has selected high capacity with service-upgraded digital cellular switching systems that are capable of serving multiple markets via a single MTSO. USM's cellular systems are designed to facilitate the installation of equipment which will permit microwave interconnection between the MTSO and each cell site. USM has implemented such microwave interconnection in most of the cellular systems it manages. In other systems in which USM 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. USM 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 USM'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, incuding GTE, US West, Ameritech, BellSouth, Centennial Cellular Corp., Southwestern Bell, McCaw Cellular Communications, Inc., Vanguard Cellular Systems, Inc. and others. Additionally, USM 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 USM to interface with other national networks. During 1994, USM 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. USM believes that currently available technologies will allow sufficient capacity on USM'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. USM, 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, USM 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 USM 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 USM's marketing plan is designed to capitalize on its clustering strategy and to increase revenue by growing USM'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 USM. Most of USM's operations market cellular service under the "United States Cellular"-TM- name and service mark. USM'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. USM'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. USM plans to follow the same marketing program in the other systems it expects to manage. USM 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 USM's goal to respond to customers' concerns and to correct reported service deficiencies within 24 hours of notification. USM has established local service centers in order to repair and maintain most major brands of user equipment. USM has relied primarily on its own direct and retail sales channels to obtain customers for the cellular markets it manages. USM 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. USM 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 USM. USM's agents are in the business of selling cellular telephones, cellular service packages and other related products to customers. USM's dealers include car stereo companies and other companies whose customers are also potential cellular customers. USM's retailers include car dealers, major appliance dealers, office supply dealers and mass merchants. USM 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. USM plans to open more locations in 1994 to further its presence in the local markets. USM also actively pursues national retail accounts which may potentially yield new customer additions in multiple markets. The national account effort is expected to enable USM 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 USM's markets. Upon the sale of a cellular telephone by one of these national distributors, USM receives, often exclusively within the territories served, the resulting cellular customer. In recognition of the needs of these national accounts, USM initiated a centralized customer support program. This program allows for customer activation during peak retail business hours (weekends and evenings) when USM's local office might otherwise be closed. USM 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 USM'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 USM. USM attempts to select the advertising and promotion media that are most appealing to the targeted groups of potential customers in each local market. USM utilizes local advertising media and public relations activities and establishes programs to enhance public awareness of USM, such as providing telephones and service for public events and emergency uses. CUSTOMERS AND SYSTEM USAGE USM data for 1993 indicate that 52% of USM'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 USM'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. USM'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 USM'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 USM'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. USM 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 USM which allows a customer to place or receive a call in a cellular service area away from the customer's home market area. USM 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 USM's systems in the other carriers' systems. Also, a customer of a participating system roaming (i.e. travelling) in a USM market where this arrangement is in effect is able to automatically make and receive calls on USM's system. The charge for this service is typically at premium rates and is billed by USM to the customer's home system, which then bills the customer. USM has entered into agreements with other cellular carriers to transfer roaming usage at agreed-upon rates. In some instances, based on competitive factors, USM may charge a lower amount to its customers than the amount actually charged to USM 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 USM's managed operations. The following table summarizes, by cluster, the total population, USM's customer units and penetration for USM'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. USM 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. USM 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 USM to improve its service by promptly assisting customers who experience equipment problems. USM negotiates volume discounts from its cellular telephone suppliers. USM 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 USM. USM also cooperates with cellular equipment manufacturers in local advertising and promotion of cellular equipment. PRODUCTS AND SERVICES USM's customers are able to choose from a variety of packaged pricing plans which are designed to fit different calling patterns. USM'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 USM include wide-area call delivery, call forwarding, call waiting, three-way calling and no-answer transfer. USM 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 USM'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 USM's licensing authority in a Wisconsin market pending the outcome of an FCC hearing. USM 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, USM 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. USM'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 USM 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. USM 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 USM'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 USM has an interest have financial resources which are substantially greater than those of USM 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. USM 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 USM'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. RADIO PAGING OPERATIONS WIRELESS MESSAGING INDUSTRY Paging is a wireless messaging technology which uses an assigned radio frequency to contact a paging customer within a geographic service area. Pagers are small, lightweight, easy-to-use, battery-operated devices which receive messages by the broadcast of a radio signal. To contact a customer, a message is initiated by placing a telephone call to the customer's pager number. The telephone call is received by a computerized paging switch which generates a signal sent to microprocessor-controlled radio transmitters within the service area. The transmitters broadcast a digital or analog signal that is received by the pager and delivered as a tone, voice, numeric or alphanumeric text message. The paging industry started in 1949 when the FCC set aside certain radio frequencies for exclusive use in providing one-way mobile communications services. Until the 1980s, the industry was highly fragmented with a large number of small, local firms. During that decade, acquisitions of many firms by regional telephone companies greatly consolidated the industry. While it is estimated that by late 1993 more than 500 licensed paging companies remained in the United States, most providing local service in a single market, the ten largest companies served more than 47% of all pager units, with no single provider serving more than 16% of the United States marketplace. The FCC has recently allocated certain radio spectrum channels designated for Advanced Messaging Services ("AMS"), which are also known as Narrowband PCS. These frequency channels, which are anticipated to be auctioned by the FCC in 1994, will accommodate a wide array of emerging wireless technologies and ancillary communications services to both individuals and businesses. As a potential AMS provider, APP is exploring the potential to offer acknowledgment paging, two-way data services, wireless E-mail, location services and the transmission of voice messages and high-resolution graphics. Additional innovations in technology combined with further reduced costs of equipment are expected to continue to broaden the potential market size for paging services and support the industry's rapid growth rate. Management also believes that future developments in the wireless communications industry will produce additional consolidations of smaller operators with larger, multi-market paging companies. APP provides one-way wireless messaging services in the United States with operations concentrated in Florida and in the Mid-Atlantic and Midwest regions. APP has experienced strong growth in the number of pagers in service, increasing from 161,600 at the end of 1989 to 460,900 at year-end 1993, a compound annual growth rate of 30.0% The following table summarizes certain information about APP's operations. COMPANY STRATEGY APP has authorizations for more than 500 transmitter sites on Private Carrier Paging ("PCP") channel 929.3375 MHz in 47 states. Under recently adopted changes in FCC rules, APP has requested exclusive use of this channel throughout the United States. Other companies also hold authorizations for PCP channels and are expected to request exclusive use of PCP channels for systems serving nationwide, regional or local service areas. APP believes this license will enable APP to offer competitive regional and nationwide messaging services and is building certain systems required to utilize and retain its exclusive license. In addition, APP has applied for SMR licenses in several markets, including certain markets it presently serves. These licenses would allow APP to offer a broad range of innovative mobile data services, including one-and two-way messaging, high-resolution graphics, wireless E-mail, and facsimile. Since the FCC classifies APP as a wireline carrier as a result of its relationship with TDS, APP must receive a waiver from the FCC to obtain such licenses. APP is unable to predict whether it will receive such a waiver from the FCC. In the event APP is unable to obtain the SMR licenses, APP believes that it would be able to provide such mobile data services in the pertinent markets though the use of other frequencies for which FCC licenses must be obtained but where no such waiver would be required. APP has recently entered into a joint venture with NEXUS Telecommunications Systems of Israel Ltd. ("NEXUS") to develop proprietary wireless technologies. As part of this arrangement, APP has the exclusive right to market two-way lower-speed data messaging, vehicle location, and inventory management services using patented spread spectrum technology in the western hemisphere. Management believes its alliance with NEXUS has the potential to result in advanced two-way messaging services for current and future customers. APP also expects to have access to two-way messaging service technology offered by other manufacturers. Both wireless and wireline carriers will compete to offer services on America's "information highway" -- the electronic marketplace which will provide consumers and businesses with access to a wide array of data and other services. Paging traditionally provides high-quality service at the lowest price and cost of any wireless service. TDS believes that the wireless messaging industry, including APP's wireless network, will be an important part of the information highway and will permit APP to compete successfully as a provider of information services. One of the many potentials of this network is the ability, through alliances with other firms, to provide customers with a shopping list of specialized information services. For example, APP's customers could receive E-mail messages, news or sports headlines, stock quotes, or morning wake-up calls that also provide the weather forecast. APP's substantial base of loyal customers, modern wireless network infrastructure and well-trained sales force position APP to continue transitioning customers to higher-value, more profitable products and services. Many of the services discussed above can be provided with little or no significant additional capital investment. APP anticipates that marketing expenses will be minimized by selling such services through existing distribution channels and incorporating these services into existing advertising and promotional campaigns. Incremental operational expenses are expected to be minimized by using existing support functions such as APP's customer service and technical staffs to service these new customers. Services which may require additional capacity, such as E-mail, will require higher-speed networks to support the customer base. This, in turn, may require more transmitter sites, more complex communication switches, and other enhancements to APP's infrastructure. Also, additional capital spending may be required to secure the necessary radio spectrum in the auctions the FCC will hold in the future which will allow APP to offer two-way communication, and to expand its one-way capacity. Many of the services such as information services are currently offered in several of APP's operations. The time-frame for new two-way services is projected to be mid-1995, but there can be no assurance at this early stage of development of such services that APP will be willing or able to invest in some or all of such services or that, if implemented, such services will be commercially successful. PAGING OPERATIONS APP provides local, wide-area, regional, and nationwide paging services to customers through its operations centers. It offers local and regional paging coverage throughout Florida, in the Midwest (Illinois, Indiana, Kentucky, Minnesota, Missouri and Wisconsin) and the Mid-Atlantic (Maryland, Pennsylvania, Virginia, and Washington, D.C.) regions, and in the states of Oklahoma, Texas, Arizona and Utah. Nationwide paging is offered through APP's alliance with a nonaffiliated service provider. APP currently provides four types of pagers in all of its markets: digital display, alphanumeric text display, voice and tone. A digital display pager permits a caller to transmit to the customer a numeric message that may consist of a telephone number, an account number or coded information. It has the memory to store several numeric messages that can be recalled by the customer when desired. Alphanumeric text display service allows customers to receive, store, and display full text messages of between 80 and 160 characters, which are sent from either a data entry device or an operator. In the case of voice service, the notification is followed by a brief voice message. A tone pager notifies the customer that a message has been received by emitting an audible beep, displaying a flashing light or vibrating. Since 1986, APP has made a limited number of selective acquisitions of paging companies which had been providing service in the same areas as APP, or in areas adjacent to APP's service areas. In 1991, APP exchanged approximately 22,000 customers in its California, Connecticut, and Rhode Island subsidiaries for 27,000 customers in Florida, where APP already had existing paging operations. In total, APP has added 30,700 net customers through acquisitions since 1986. As the industry continues to consolidate, APP expects to evaluate and may purchase attractive acquisition opportunities on an ongoing basis. MARKETING STRATEGY APP generates its revenues from (i) service usage billed primarily on a flat-rate basis, (ii) pager rentals, (iii) pager warranties, maintenance contracts and repair, (iv) loss protection, (v) voice mail usage on a flat rate or measured service basis, (vi) activation fees, (vii) the sale of new and used pagers, (viii) the sale of pager accessories and (ix) service usage of value-added services such as text dispatching, second telephone numbers or group calls. Service to end users is provided directly by APP in most cases. APP markets its services directly, through its sales force complemented by customer service representatives, and indirectly, through third-party resellers, agents and retailers. APP's sales force and customer service representatives have the responsibility to ensure that all customers and prospects as well as resellers, agents and retailers understand APP's significant competitive advantages: reliable wireless network, wide-area coverage, value-priced selection of pagers and services, and responsive sales and customer service staff. APP offers its services to third-party resellers and retailers under marketing agreements. APP offers resellers paging airtime in bulk quantities at wholesale rates. Resellers then sell APP's airtime to end users at a markup. Agents, on the other hand, refer customers directly to APP. Retail outlets sell the pagers to the customers and the customers then purchase the services from APP. Resellers and retailers may also sell services of other wireless communications companies which may compete with APP. APP seeks to develop long-term and cooperative relationships with its resellers, agents and retailers. APP's cost of obtaining customer units through resellers is substantially less than the cost of obtaining customer units through direct sales or retail distribution channels. Resellers incur the cost to acquire customers as well as to service pagers and to bill and collect revenues from the customer. They also assume the cost of the paging unit for those who rent rather than purchase. COMPETITION APP faces significant competition in all of its markets. Many of APP's competitors, which include local, regional and national paging companies and certain regional telephone companies, possess greater financial, technical and other resources than APP. Moreover, certain competitors in the paging business offer wider coverage in certain geographic areas than does APP and certain competitors follow a low-price discounting strategy to expand market share. If any of such companies were to devote additional resources to the paging business or increase competitive pressure in APP's markets, APP's results of operations could be adversely affected. A number of technologies, including cellular, broadband and narrowband PCS, SMR and others, are competitive forms of technology used in, or projected to be used for, wireless one-way and two-way communications. Cellular telephone technology provides an alternative communications system for customers who are frequently away from fixed-wire communications systems (i.e., ordinary telephones). APP believes that paging will remain one of the lowest-cost forms of wireless messaging due to the low-cost infrastructure associated with paging systems, as well as advances in technology that will provide for reduced paging costs. 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 paging services currently offered by APP. There can be no assurance that APP would not be adversely affected by such technology changes. GOVERNMENT REGULATION APP's message paging operations are subject to regulation by the FCC under the Communications Act. Currently, paging services are offered primarily over radio frequencies that the FCC has allocated for either common carriage (licensees are known as radio common carriers ("RCC")) or private carriage (licensees are known as private carrier paging operators ("PCP")). An RCC license is an exclusive license to a specific radio frequency in a particular locality or region and the licensee is regulated as a common carrier. A PCP license may be designated by the FCC as exclusive or non-exclusive, and may be subject to frequency sharing and coordination procedures. These procedures are designed to avoid interference with the operation of communications by other carriers using the same frequency. PCP licensees are private carriers, not subject to common carrier regulation. The FCC has granted APP licenses to use the radio frequencies required to conduct its paging operations and these licenses define the technical parameters under which APP is authorized to use those frequencies. APP primarily provides paging services directly to customers over its own transmission facilities, and is currently regulated as an RCC for some of its current services. APP also holds PCP licenses. The FCC licenses granted to APP are issued for up to ten years in the case of RCC licenses and five years in the case of PCP licenses, at the end of which time renewal applications must be approved by the FCC. Most of APP's current licenses expire between 1997 and 2001. FCC renewals are generally granted as long as APP is in compliance with FCC regulations. Although APP is unaware of any circumstances which would prevent the approval of any pending or future renewal applications, no assurance can be given that APP's licenses will be renewed by the FCC in the future. Moreover, although revocation and involuntary modification of licenses are extraordinary regulatory measures, the FCC has the authority to restrict the operation of licensed facilities or revoke or modify licenses. No license of APP has ever been revoked or modified involuntarily. See "Legal Proceedings--La Star Application" for a discussion of certain FCC proceedings which have suspended the Company's and USM's licensing authority in a Wisconsin market pending the outcome of an FCC hearing. The Communications Act requires licensees such as APP to obtain prior approval from the FCC for the assignment or transfer of control of any construction permit or station license, or any rights thereunder. The Communications Act also requires prior approval by the FCC of acquisitions of other paging companies by APP. The FCC has approved all transfers of control for which APP has sought approval. APP also routinely applies for FCC authority to use frequencies, modify the technical parameters of existing licenses, expand its service territory and provide new services. Although there can be no assurance that any future requests for approval or applications filed by APP will be approved or acted upon in a timely manner by the FCC, or that the FCC will grant the relief requested, subject to the forthcoming rules for competitive bidding, APP has no reason to believe that any such requests, applications or relief will not be approved or granted. OTHER SUBSIDIARIES Subsidiaries of the Company provide engineering and technical management consulting services (American Communications Consultants, Inc.); data processing and related services (TDS Computing Services, Inc.); graphic communications services (Suttle Press, Inc.); and telemessaging services (Integrated Communications Services, Inc.). EMPLOYEES The Company enjoys satisfactory employee relations. As of December 31, 1993, 4,343 persons were employed by the Company, 91 of whom are represented by unions. - -------------------------------------------------------------------------------- ITEM 2. ITEM 2. PROPERTIES The property of TDS consists principally of telephone lines, central office equipment, telephone instruments and related equipment, and land and buildings related to telephone operations; switching and cell site equipment related to cellular telephone operations; and radio pagers and transmitting equipment related to radio paging operations. As of December 31, 1993, TDS's gross property, plant and equipment of approximately $1.3 billion consisted of the following: "Telephone lines" consists primarily of buried cable and also includes aerial cable, poles, and wire. "Central office equipment" consists of switching equipment, carrier equipment, and related facilities. "Telephone instruments and related equipment" consists of equipment located on the subscribers' premises and includes private branch exchanges. "Land and buildings" consists of land owned in fee simple and improvements thereto. "Miscellaneous" consists of tools, furnishings, fixtures, motor vehicles, work equipment, and plant held for future use. "Plant under construction" includes property of the foregoing categories which had not been placed in service because it was still under construction. The plant and equipment of TDS is maintained in good operating condition and is suitable and adequate for the Company's business operations. The properties of the operating telephone subsidiaries and most of the tangible assets of the cellular subsidiaries are subject to the lien of the mortgages securing the funded debt of such companies. The Company owns substantially all of its central office buildings, local administrative buildings, warehouses, and storage facilities used in its telephone operations and leases most of its offices and transmitter sites used in its cellular and paging businesses. All of the Company's telephone lines and cell and transmitter sites are located either on private or public property. Locations on private land are by virtue of easements or other arrangements. - -------------------------------------------------------------------------------- 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 landline or cellular telephone markets. The more significant proceedings involving the Company are described in the following paragraphs. LA STAR APPLICATION. Star Cellular Telephone Company, Inc. ("Star Cellular"), an indirect, wholly owned subsidiary of USM, 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 USM 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 [USM] 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 USM 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 USM 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 USM 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 USM 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 security 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 sections entitled "TDS Stock and Dividend Information" and "Market Price per Common Share by Quarter." - -------------------------------------------------------------------------------- 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 Income," "Consolidated Statements of Cash Flows," "Consolidated Balance Sheets," "Consolidated Statements of Common Stockholders' Equity," "Notes to Consolidated Financial Statements," "Consolidated Quarterly Income Information (Unaudited)," and "Report of Independent Public Accountants." - -------------------------------------------------------------------------------- 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 Exhibit 99.1 sections entitled "Election of Directors" and "Executive Officers." ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from Exhibit 99.1 section entitled "Executive Compensation." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from Exhibit 99.1 sections entitled "Security Ownership of Management" and "Principal Shareholders." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from Exhibit 99.1 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 (2) Schedules (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. TDS filed a Report on Form 8-K dated October 18, 1993, which described certain completed and pending acquisitions. The Report filed the financial statements of several companies which were acquired or which became pending in 1993 and unaudited consolidated pro forma financial statements reflecting the effects of the completed and pending acquisitions. TDS filed a Form 8-K dated November 17, 1993, which discussed the completion of a rights offering by United States Cellular Corporation. The Form 8-K included a press release by United States Cellular Corporation as an exhibit. 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 Telephone and Data Systems, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Telephone and Data Systems, Inc. and Subsidiaries Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 8, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the change in the method of accounting for cellular sales commissions, with respect to the change in the method of accounting for postretirement benefits other than pensions and with respect to the change in the method of accounting for income taxes as discussed in Note 1, Note 1 and Note 2, respectively, of the Notes to Consolidated Financial Statements; and an explanatory paragraph calling attention to certain litigation as discussed in Note 14 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 8, 1994 - -------------------------------------------------------------------------------- SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- Telephone and Data Systems, Inc. (Parent) BALANCE SHEETS ASSETS - -------------------------------------------------------------------------------- The Notes to Consolidated Financial Statements, included in the Annual Report, are an integral part of these statements. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- Telephone and Data Systems, Inc. (Parent) BALANCE SHEETS LIABILITIES AND STOCKHOLDERS' EQUITY - -------------------------------------------------------------------------------- The Notes to Consolidated Financial Statements, included in the Annual Report, are an integral part of these statements. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- Telephone and Data Systems, Inc. (Parent) STATEMENTS OF INCOME - -------------------------------------------------------------------------------- The Notes to Consolidated Financial Statements, included in the Annual Report, are an integral part of these statements. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- Telephone and Data Systems, Inc. (Parent) STATEMENTS OF CASH FLOWS - -------------------------------------------------------------------------------- The Notes to Consolidated Financial Statements, included in the Annual Report, are an integral part of these statements. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- DEPRECIATION Depreciation is provided for book purposes using the straight-line method. Composite depreciation rates, as applied to the average cost of depreciable property, were 7.3% for telephone, 10.5% for cellular telephone, 17.4% for radio paging, and 12.9% for other property. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- DEPRECIATION Depreciation is provided for book purposes using the straight-line method. Composite depreciation rates, as applied to the average cost of depreciable property, were 7.2% for telephone, 10.5% for cellular telephone, 17.2% for radio paging, and 12.8% for other property. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- DEPRECIATION Depreciation is provided for book purposes using the straight-line method. Composite depreciation rates, as applied to the average cost of depreciable property, were 6.7% for telephone, 10.4% for cellular telephone, 17.1% for radio paging, and 10.1% for other property. SCHEDULE VI--RESERVE FOR DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- The depreciation charged to costs and expenses for "Other" is included in "Other income, net" in the Consolidated Statements of Income. SCHEDULE VI--RESERVE FOR DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- The depreciation charged to costs and expenses for "Other" is included in "Other income, net" in the Consolidated Statements of Income. SCHEDULE VI--RESERVE FOR DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- The depreciation charged to costs and expenses for "Other" is included in "Other income, net" in the Consolidated Statements of Income. TELEPHONE AND DATA SYSTEMS, INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS - -------------------------------------------------------------------------------- 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 minority 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 TELEPHONE AND DATA SYSTEMS, INC.: 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 50 through 54. 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 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, 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. 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 - -------------------------------------------------------------------------------- [LOGO] TELEPHONE AND DATA SYSTEMS, INC. 30 North LaSalle Street Chicago, Illinois 60602 312/630-1900

100880_1993.txt

100880_1993

1993

100880

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 inprecise 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, Union Oil's share of any liability is likely to be relatively small. Settlements and costs incurred in those matters that have been previously 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. Union Oil'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. Unocal Corporation, 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 PART II ITEM 5 ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS All of Union Oil's outstanding common stock is owned by Unocal. Accordingly, there is no established public trading market for Union Oil's stock. The company declared dividends to Unocal totaling $227 million in 1993, $176 million in 1992 and $156 million in 1991. 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 CONSOLIDATED RESULTS Union Oil's net earnings for 1993 were $214 million, compared with $221 million in 1992 and $75 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 $348 million in 1993, $235 million in 1992 and $119 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 $1,104 million in 1993, $1,150 million in 1992 and $1,036 million in 1991. Cash generated from operations was up $301 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 $357 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 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 Union Oil'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. Union Oil 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 Union Oil'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, the company 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. Union Oil 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 Union Oil is a member. The company's refining and marketing operations will continue to focus on improving refining efficiencies and strengthening its Western marketing. Union Oil 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 Union Oil'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. Union Oil 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, Union Oil believes that, as of December 31, 1993, its systems of internal controls over financial reporting met those criteria. Union Oil's Accounting, Auditing and Ethics Committee, consisting solely of directors who are not employees of Union Oil, 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 Unocal's stockholder's); 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 BOARD OF DIRECTORS OF UNION OIL COMPANY OF CALIFORNIA: We have audited the accompanying consolidated balance sheet of Union Oil Company of California and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, cash flows and Shareholder's 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 Union Oil Company of California'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 28 through 48 of this Annual Report on Form 10-K, present fairly, in all material respects, the consolidated financial position of Union Oil Company of California 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, Union Oil Company of California 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 UNION OIL COMPANY OF CALIFORNIA See Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEET UNION OIL COMPANY OF CALIFORNIA The company follows the successful efforts method of accounting for its oil and gas activities. See Notes to Consolidated Financial Statements. CONSOLIDATED CASH FLOWS UNION OIL COMPANY OF CALIFORNIA See Notes to Consolidated Financial Statements. CONSOLIDATED SHAREHOLDER'S EQUITY UNION OIL COMPANY OF CALIFORNIA 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 Union Oil Company of California (Union Oil) and its consolidated subsidiaries will be referred to as the company. Union Oil is a wholly owned subsidiary of Unocal Corporation (Unocal or the Parent). 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 shareholders' 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 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. The effect on the balance sheet was to increase properties, deferred income taxes and shareholders' 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: The consolidated balance sheet at December 31 includes the following: *Includes $45 million for estimated future remediation costs for properties divested in 1993. NOTE 7 - EXCISE, PROPERTY AND OTHER OPERATING TAXES 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 Union Oil files a consolidated federal income tax return with the Parent, which includes essentially all U.S. subsidiaries. All income taxes are included in the accounts of Union Oil and its 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). 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). 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 shareholders' 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 Union Oil'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- 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 18 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 Union Oil's share is five percent. BUSINESS SEGMENT DATA BUSINESS SEGMENT DATA (CONTINUED) (a) Includes asset write-downs as described in the footnotes (e) and (f) on the previous page. 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. 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. REVENUE DATA ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE: None ---------------------------- 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 25 of this Annual Report on Form 10-K (2) Financial Statement Schedules: See Item 8 on page 25 of this Annual Report on Form 10-K (3) Exhibits The Exhibit Index on page 60 of this Annual Report on Form 10-K lists the exhibits that are filed as part of this report. (b) Two reports on Form 8-K were filed: (1) Filed December 8, 1993, Union Oil announced the May 1, 1994, retirement of Richard J. Stegemeier, the Chief Executive Officer of the company. (2) 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. 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. UNION OIL COMPANY OF CALIFORNIA (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. UNION OIL COMPANY OF CALIFORNIA 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. UNION OIL COMPANY OF CALIFORNIA 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. UNION OIL COMPANY OF CALIFORNIA 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. UNION OIL COMPANY OF CALIFORNIA AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (MILLIONS OF DOLLARS) -------------------------------- (a) Represents receivables written off, net of recoveries, reinstatements, and losses sustained. UNION OIL COMPANY OF CALIFORNIA EXHIBIT INDEX Exhibit 3.1 Certificate of Incorporation of Union Oil (incorporated by reference to Exhibit 3 to Union Oil's Annual Report on Form 10-K for the year ended December 31, 1988, File No. 1-554). Exhibit 3.2 Bylaws of Union Oil (incorporated by reference to Exhibit 3 to Union Oil's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-8483. Amendments to bylaws to be effective on and after April 25, 1994 are incorporated by reference to Union Oil's Current Report on Form 8-K, dated March 2, 1994, File No. 1-554). Exhibit 4 Instruments Defining the Rights of Security Holders, Including Indentures. The following Exhibits 10.1 through 10.7 are compensatory plans or agreements required to be filed by Item 601 (b) (10) (iii) (A) of Regulation S-K. Exhibit 10.1 The Management Incentive Program (incorporated by reference to Unocal Corporation's Registration Statement on Form S-8, File No. 33-43231, filed October 8, 1991). Exhibit 10.2 The Long-Term Incentive Plan of 1985 (incorporated by reference to Unocal Corporation's Registration Statement on Form S-8, File No. 2-93452, filed September 28, 1984). Exhibit 10.3 Supplemental Retirement Plan for Key Management Personnel, as amended and effective January 1, 1989 (incorporated by reference to Exhibit 10.3 to Union Oil's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-554). Exhibit 10.4 Other Compensatory Arrangements (incorporated by reference to Exhibit 10.4 to Union Oil's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-554). Exhibit 10.5 Directors' Restricted Stock Plan of 1991 (incorporated by reference to Exhibit B to Unocal's Proxy Statement for its 1991 Annual Meeting of Shareholders, File No. 1-8483). Exhibit 10.6 Form of Indemnity Agreement between Union Oil and each of its directors (incorporated by reference to Exhibit A to Unocal's Proxy Statement for its 1987 Annual Meeting of Shareholders, File No. 1-8483). Exhibit 10.7 Consulting Agreement, dated April 26, 1993, between Union Oil Company of California, dba Unocal, and Claude S. Brinegar. Exhibit 12 Computation of Ratio of Earnings to Fixed Charges Exhibit 23 Consent of Coopers & Lybrand

810765_1993.txt

810765_1993

1993

810765

Item 1. Business. - ------ -------- GENERAL. Consolidated Rail Corporation ("the Company") is a ------- Pennsylvania corporation incorporated on February 10, 1976 to acquire, pursuant to the Regional Rail Reorganization Act of 1973, the rail properties of many of the railroads in the northeast and midwest region of the United States that had gone bankrupt during the early 1970's, the largest of which was the Penn Central Transportation Company. Pursuant to the Conrail Privatization Act, the United States Government sold 85% of the Company's common stock in a public offering on March 26, 1987. The remaining 15% of the Company's common stock, which was then held in connection with an employee stock ownership plan, was distributed to then present and former employees or their beneficiaries in 1987. On July 1, 1993, pursuant to an Agreement and Plan of Merger approved by the shareholders of the Company on May 26, 1993, each share of the Company's common stock that was issued and outstanding or held in the treasury, and each share of the Company's outstanding preferred stock, all of which were held by the Non- union Employee Stock Ownership Plan (the "ESOP"), were automatically converted into one share of the common stock and preferred stock, respectively, of Conrail Inc., a Pennsylvania corporation incorporated on February 12, 1993. On July 1, 1993, Conrail Inc. became the publicly held entity and holding company of the Company, which remains Conrail Inc.'s only significant subsidiary and primary asset. RAIL OPERATIONS. The Company provides freight transportation --------------- services within the northeast and midwest United States. The Company interchanges freight with other United States and Canadian railroads for transport to destinations within and outside the Company's service region. The Company operates no significant line of business other than the freight railroad business and does not provide common carrier passenger or commuter train service. The Company serves a heavily industrial region that is marked by dense population centers which constitute a substantial market for consumer durable and non-durable goods, and a market for raw materials used in manufacturing and by electric utilities. The Company's traffic levels are substantially affected by its ability to compete with trucks and other railroads, the economic strength of the industries and metropolitan areas that produce and consume the freight the Company hauls, and the traffic generated by the Company's connecting railroads. The Company remains dependent on non-bulk traffic, which tends to generate higher revenues than bulk commodities, but also involves higher costs and is more vulnerable to truck competition. The Company's significant freight commodity groups include chemicals and related products, coal, intermodal, automotive parts and finished vehicles, metals and related products, food and grain products, and forest products. In late 1993, the Company announced the reorganization of its Marketing and Sales and Operating Departments into four service networks: Intermodal Service, Automotive Service, Unit Trains Service and Core Service. The Unit Trains network will handle coal and ore traffic, with the remaining commodities, other than automobiles and intermodal, to be handled by the Core network. Effective in 1994, each of these groups controls the integrated planning, pricing and operating functions that will enable them to tailor services, develop products and make capital investments directed toward the special requirements of their respective customers. GOVERNMENT REGULATION. The Company is subject to --------------------- environmental, safety and other regulations generally applicable to all businesses, and its rail operations are also regulated by the Interstate Commerce Commission ("ICC"), the Federal Railroad Administration ("FRA"), state Departments of Transportation and some state and local regulatory agencies. The ICC has jurisdiction over, among other things, rates charged for certain traffic movements, service levels, freight car rents, and issuance or guarantee of railroad securities. It also has jurisdiction over the situations and terms under which one railroad may gain access to another railroad's traffic or facilities, extension or abandonment of rail lines, consolidation, merger, or acquisition of control of rail common carriers and of other carriers by rail common carriers and labor protection provisions in connection with the foregoing. Federal regulation of rates and services has been reduced. The ICC has deregulated rates for intermodal traffic, most boxcar traffic and, most recently, a series of miscellaneous commodities, including steel and automobiles. In addition, railroads are free to negotiate contracts with shippers setting rates, service standards and the terms for movements of other kinds of traffic. As a result, railroads have greater flexibility in adjusting rates and services to meet revenue needs and competitive conditions. The FRA has jurisdiction over safety and railroad equipment standards. The Company's operations are also subject to a variety of governmental laws and regulations relating to the protection of the environment. In addition to being involved as a potentially responsible party at numerous Superfund sites (see Item 3 - "Legal Proceedings"), the Company is subject to increasing regulation of its transportation and handling of certain hazardous and non- hazardous commodities and waste, which has resulted in additional administrative and operating costs. See Note 12 to the Consolidated Financial Statements elsewhere in this Annual Report. Item 2. Item 2. Properties. - ------ ---------- As of December 31, 1993, the Company (excluding its subsidiaries) maintained 20,109 miles of track including track for crossovers, turnouts, second main, other main, passing and switch track, on its 11,831 mile route system. Of total route miles, 9,961 are owned, 56 are leased or operated under contract and 1,814 are operated under trackage rights, including approximately 300 miles operated pursuant to an easement over Amtrak's Northeast Corridor. As of December 31, 1993, virtually all track over which at least 10 million gross tons moved annually (6,276 track miles) was heavy-weight rail of at least 127 pounds per yard, and approximately 98% of such track had continuous welded rail. Continuous welded rail reduces track maintenance costs and, in general, permits trains to travel at higher speeds. As of December 31, 1993, the Company had 9,412 miles of continuous welded rail on track it maintained. As of December 31, 1993, all of the 5,647 track miles maintained for fast freight traffic had a maximum operating speed of 50 MPH or more, and 33% had a maximum operating speed of at least 70 MPH. As of December 31, 1993, approximately 96% of the track over which at least 10 million gross tons moved annually was governed by automatic signal systems. In all, as of December 31, 1993, 7,610 miles of track were controlled by automatic signal systems. The Company owns (or uses subject to capitalized leases) 2,187 locomotives with an average age of 16.6 years and 60,017 freight cars of various types (including 17,595 freight cars under operating leases) with an average age of 21.0 years. Item 3. Item 3. Legal Proceedings. - ------ ----------------- Occupational Disease Litigation. The Company has been named ------------------------------- as a defendant in lawsuits filed pursuant to the provisions of the Federal Employers' Liability Act ("FELA") by persons alleging (1) personal injury or death caused by exposure to asbestos in connection with railroad employment; (2) complete or partial loss of hearing caused by exposure to excessive noise in the course of railroad employment; and (3) repetitive motion injury in connection with railroad employment. As of December 31, 1993, the Company is a defendant in 694 pending asbestosis suits, 1,262 pending hearing loss suits and 16 pending repetitive motion injury suits, and had notice of 609 potential asbestosis claims, 4,746 potential hearing loss claims and 1,049 potential repetitive motion injury claims. The Company expects to be named as a defendant in a significant number of occupational disease cases in the future. Structure and Crossing Removal Disputes in Connection With ---------------------------------------------------------- Lines Abandoned Under NERSA. The Company may be responsible, in - --------------------------- whole or in part, for the costs of removal of several hundred overhead and underpass crossings located on railroad lines it has abandoned under the Northeast Rail Service Act of 1981 ("NERSA") (and, in some instances, responsible for the removal of the lines of railroad themselves as well as appurtenant structures). The Company's liability for the removal of such lines, crossings and structures will be determined on a case-by-case basis. Some states have imposed upon the Company the obligation to remove certain crossings. In 1989, an organization of interests that own property under and adjacent to the Company's elevated West 30th Street rail line running along the west side of lower Manhattan filed a petition with the ICC seeking to force the Company to abandon the line and finance its removal, which could cost in excess of $30 million. The ICC voted in January 1992 to grant the property owners' petition, subject to the owners posting a bond indemnifying the Company for any demolition costs exceeding $7 million. The property owners have refused to post the bond. The parties have appealed to the United States Court of Appeals for the District of Columbia. Withdrawal from RCAF Master Tariff. The Rail Cost Adjustment ---------------------------------- Factor ("RCAF") is an index of rail costs issued by the ICC according to which railroads may adjust their regulated rates for inflation and cost increases free of regulatory interference. In March 1989, the ICC decided to offset the quarterly RCAF by the entirety of the average rail industry productivity gain, in a proceeding previously disclosed by the Company in its quarterly report on Form 10-Q for the period ended June 30, 1992 ("Productivity Adjustment to Cost Recovery Process"). On January 1, 1990, the Company ceased applying RCAF increases to its regulated rates, by ending its participation in the RCAF master tariff. Effective July 1, 1990, the Company published a series of independent rate increases approximately equal to its increases in costs as reflected by the RCAF. The Company's action was contested, but was upheld by the ICC. Since July 1, 1990, the Company has continued to make independent selective increases to its regulated rates. These regulated rates will continue to be subject to individual challenge to the extent the levels of the increases exceed those previously permitted pursuant to the RCAF and no other statutory provisions bar ICC jurisdiction. In January 1991, the ICC commenced a proceeding at the request of a shippers' organization to clarify the legal effect of the Company's (and other railroads') withdrawal from the RCAF master tariff, including the shippers' assertion that railroads thereby lose protection from challenge for rates previously adjusted under these procedures. In April 1991, the Company individually opposed and participated in the rail industry's opposition to the petition. A decision is awaited. Engelhart v. Consolidated Rail Corp. In connection with the ----------------------------------- Special Voluntary Retirement Program offered to certain employees in late 1989 and early 1990, the Company used surplus funds in its overfunded Supplemental Pension Plan ("Plan") to fund certain aspects of that program. In December 1992, certain former employees of the Company brought suit challenging the use of surplus Plan funds (i) to pay administrative Plan expenses previously paid by the Company, (ii) to fund the Special Voluntary Retirement Program, and (iii) to pay life insurance and medical insurance premiums of former employees as improper and unlawful, and alleging that employees who have made contributions to the Plan or its predecessor plans are entitled to share in the surplus assets of the Plan. In August 1993, the federal district court granted the Company's Motion to Dismiss the majority of counts in the complaint, but declined to dismiss the issue of the Company's use of Plan assets to pay administrative expenses of the Plan, which are estimated to be approximately $25 million as of December 31, 1993. However, the Company believes that the use of surplus Plan assets for this purpose is lawful and proper. The Company intends to use surplus Plan assets in a similar manner in connection with its 1994 early retirement program. Environmental Litigation. The Company is subject to various ------------------------ federal, state and local laws and regulations regarding environmental matters. In certain instances, the Company has received notices of violations of such laws and regulations and either has taken or plans to take appropriate steps to address the problems cited or to contest the allegations of violation. As of December 31, 1993, the Company had received inquiries from governmental agencies or had been identified, together with other companies, as a potentially responsible party for cleanup and/or removal costs due to its status as an alleged transporter, generator or property owner at 114 locations throughout the country. However, the Company, through its own investigations and assessments, believes it may have some potential responsibility at only 54 of these sites. The significant environmental proceedings, including Superfund sites, are discussed below. United States v. Southeastern Pennsylvania Transportation --------------------------------------------------------- Authority ("SEPTA"), National Railroad Passenger Corporation - ------------------------------------------------------------ ("Amtrak"), and Consolidated Rail Corp. In March 1986, the United - -------------------------------------- States Environmental Protection Agency ("EPA") filed an action in the United States District Court for the Eastern District of Pennsylvania for cost recovery, injunctive relief, and a declaratory judgment against the Company, Southeastern Pennsylvania Transportation Authority ("SEPTA") and National Railroad Passenger Corp. ("Amtrak") under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA" or "Superfund Law"), as amended. In 1990, the Pennsylvania Department of Environmental Resources intervened as a plaintiff. Suit is based on the release or threatened release at the Paoli Railroad Yard, Paoli, Chester County, Pennsylvania, of polychlorinated biphenyls ("PCBs"), a listed hazardous substance under CERCLA. The Company is sued in its capacity as the operator of the rail yard from April 1, 1976 through December 31, 1982, under an agreement with SEPTA to provide commuter rail service. In March 1992, Penn Central brought suit before the Special Court arguing that the terms of the transfer of its properties to the Company did not contemplate environmental liability for conditions existing at the time of the transfer. The Special Court has determined it has jurisdiction to hear the matter. In February 1993, Penn Central petitioned the district court to stay all proceedings with respect to it pending the outcome of the proceeding before the Special Court. The EPA has responded by filing a petition to stay the district court proceeding in its entirety pending resolution of the Special Court proceeding. Motions and cross-motions for summary judgment by the parties are pending. Pursuant to a series of partial preliminary consent decrees, defendants have performed a series of cleanup actions both on and off-site and have conducted a Remedial Investigation/Feasibility Study ("RI/FS"). As of December 31, 1993, the cost of the RI/FS and of the interim cleanup measures performed by the three defendants is approximately $9 million. Those costs have been shared equally among the three defendants but are subject to reallocation. All work done to date has been performed subject to a denial of liability and without waiving any defense to the governmental claim for cleanup costs or other relief. On September 16, 1992, the EPA issued a Special Notice Letter to the Company, SEPTA, Amtrak and Penn Central Corporation requesting the parties to provide, within 60 days, a good-faith offer to perform all necessary remediation of the Paoli rail yard site, as well as reimbursement of approximately $2.6 million in past response costs of the EPA. The EPA estimates that its remediation plan as set forth in its Record of Decision will cost approximately $28 million. On November 16, 1992, the parties submitted an offer to pay a portion of the estimated cost of the remediation action selected by the EPA. On January 8, 1993, the EPA rejected the parties' offer on several bases, including that the proposal addressed only a portion of the EPA's recommended remedy for the site. The EPA may now issue an administrative order directing any party to carry out its remediation plan, subject to treble damages and daily penalties for failure to comply without sufficient cause. The estimated cost of the Company's portion of the parties' proposed remedy was included in the 1991 special charge and subsequent adjustments to accruals. United States v. Consolidated Rail Corp. The EPA has --------------------------------------- listed the Company's Elkhart Yard in Indiana on the National Priorities List. The EPA contends that chemicals have migrated from the yard and contaminated drinking wells in the area. On February 14, 1990, the EPA filed a civil action against the Company in the U.S. District Court for the Northern District of Indiana seeking recovery of approximately $345,000 for costs incurred in protecting the water supply. In addition, the EPA seeks a declaratory judgment against the Company for all future costs incurred in responding to the release or threatened release of hazardous substances from the site. The Company believes it is not the sole source and may not be a contributing source to the contamination alleged by the EPA. The Company filed a third-party action joining Penn Central as a defendant, to which Penn Central has responded by filing a declaratory judgment action in Special Court. (See previous discussion regarding the Special Court under "United States v. SEPTA, et al"). On July 7, 1992, the EPA issued an order requiring the Company and Penn Central to implement the interim remedy set forth in the Record of Decision. The Company is performing the interim remedy in compliance with the EPA order and is simultaneously in litigation with the EPA over the implementation of the remedy. Penn Central has declined to participate. The estimated cost of remediation was included in the Company's 1991 special charge and subsequent adjustments to accruals. United States v. Consolidated Rail Corp., et al. The Company ----------------------------------------------- has been identified as the fifth largest generator of waste oil at the Berks Associates Superfund site in Douglasville, Pennsylvania. In addition, the Company has become aware that it and its predecessor, Penn Central, owned a small portion of land that was leased to the operator of the Berks site. As such, the Company's liability could increase due to its questionable status as both an owner and a generator. In August 1991, the EPA issued an administrative order against the Company and thirty-five other entities mandating the implementation of an approximately $2 million partial remedy and filed a complaint in the U.S. District Court for the recovery of approximately $8 million in costs incurred by the government. The parties have negotiated an administrative order with the EPA and have filed an answer to the civil action. A group of potentially responsible parties (including the Company) undertook compliance with the administrative order. The Company and the 35 other defendants have filed a third-party complaint against approximately 630 entities seeking contribution for the costs of the remedy and government costs. The Company, along with other defendants, is negotiating a settlement with the EPA. On June 30, 1993, the EPA issued another administrative order against the Company and 33 other entities, mandating the remediation of the southern portion of the site. The effective date of the order has been delayed in light of the negotiations. The most expensive aspect of the remediation of the site is the clean-up of Source Area 2, which the government estimates at between $45 and $55 million. This Source Area was closed prior to the Company's incorporation, and therefore the Company has maintained that it is not liable for the cost of remediating Source Area 2. United States v. Consolidated Rail Corp., et al. The Company ----------------------------------------------- is a potentially responsible party ("PRP"), along with more than 50 other parties, in the United Scrap Lead federal Superfund action in Troy, Ohio, where substantial quantities of batteries were disposed of over a period of several years. The EPA sued the Company and nine other parties in August 1991 in the Southern District of Ohio for the recovery of approximately $2 million in past costs. The Company and other PRP's have commissioned treatability studies. The court has imposed a stay to discuss whether this matter can be settled. The parties are negotiating over the nature of the remediation to be undertaken at the site. Commonwealth of Massachusetts v. Consolidated Rail Corp. On ------------------------------------------------------- April 21, 1992, the Massachusetts Attorney General filed suit in Superior Court of Massachusetts alleging the Company's violation of the Massachusetts Clean Air Act and its implementing regulations by allowing diesel engines to idle unnecessarily and/or in excess of thirty minutes. On May 4, 1992, the court entered a preliminary injunction, the terms of which are substantially consistent with the Company's existing idling policy. The Attorney General subsequently filed a complaint alleging the Company's violation of the preliminary injunction. On February 2, 1993, the parties entered into a partial settlement agreement; however, the Attorney General has alleged that the Company has failed to comply with certain provisions of the settlement. United States v. Consolidated Rail Corp., The Monongahela --------------------------------------------------------- Railway Company, et al. On September 30, 1992, Region VIII of the - ---------------------- EPA filed an administrative action for civil penalties against the Company and its former wholly-owned subsidiary, The Monongahela Railway Company (now merged into the Company), under the Toxic Substances Control Act for allegedly improper handling of a shipment of PCB contaminated soil. The other railroads in the movement and the shipper were served with similar complaints. The Company is currently negotiating with EPA. New York State Department of Environmental Conservation Order ------------------------------------------------------------- On Consent. On February 18, 1993, the New York State Department of - ---------- Environmental Conservation ("NYSDEC") served the Company with a draft Order on Consent requiring the payment of fines in connection with its inspection of Selkirk Yard. The Order also seeks compensation for the hiring of three full-time NYSDEC employees to monitor the Company's compliance at Selkirk and two other rail yards in New York. The Company is negotiating the terms of the Order with NYSDEC. Conway Yard, Pittsburgh. In 1991, the Company received ----------------------- Notices of Violation ("NOV") from the Pennsylvania Department of Environmental Resources ("PADER") alleging violations of the Clean Streams Act for discharges of oil into the Ohio River. In September 1993, PADER sent to the Company a draft Consent Order and Agreement requiring a comprehensive site remediation for soil, ground water, surface waters and sediments at the Conway rail yard and requiring the payment of an undisclosed amount of civil fines in connection with violations at the yard, including continuing ground water contamination. The Company and PADER are negotiating the extent of the investigation and remediation to be undertaken at the yard. Other. In addition to the above proceedings, the Company has ----- been named in various legal proceedings arising out of its activities as an employer and as an operator of a freight railroad, including personal injury actions brought by its employees under FELA, as well as administrative proceedings with and investigation by government agencies. In view of the inherent difficulty of predicting the outcome of legal proceedings, particularly in certain matters described above in which substantial damages are or may be sought, the Company cannot state what the eventual outcomes of such legal proceedings will be. Certain of these matters, if determined adversely to the Company, could result in the imposition of substantial damage awards against, or increased costs to, the Company that could have a material adverse effect on the Company's results of operations and financial position. The Company's management believes, however, based on current knowledge, that such legal proceedings will not have a material adverse effect on the Company's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------ --------------------------------------------------- Information omitted in accordance with General Instruction J(2)(c). PART II Item 5. Item 5. Market for Registrant's Common Equity - ------ ------------------------------------- and Related Stockholder Matters. ------------------------------- All of the common stock of the Company is held by Conrail Inc. Accordingly, there is no market for the Company's common stock. Item 6. Item 6. Selected Financial Data. - ------ ----------------------- Information omitted in accordance with General Instruction J(2)(a). Item 7. Item 7. Management's Discussion and Analysis of Financial - ------ ------------------------------------------------- Condition and Results of Operations. ----------------------------------- See General Instruction J (2)(a). Results of Operations - --------------------- 1993 Compared with 1992 Net income for 1993 was $164 million compared with 1992 net income of $282 million. The decrease in net income is attributable primarily to the following unusual or one-time charges in 1993: one-time after tax charges of $70 million for adoption of required changes in accounting for income taxes and postretirement benefits other than pensions; the reserve for intercompany receivables related to the planned disposition of Concord Resources Group, Inc., ("Concord") a subsidiary of Conrail Inc., $58 million (net of estimated income tax benefits of $31 million); and the one-time effects on deferred taxes of the increase in the 1993 federal corporate income tax rate, $34 million (see Notes 1, 3, 7 and 8 to the Consolidated Financial Statements elsewhere in this Annual Report). Absent these charges, the Company's net income for 1993 would have been $326 million. Operating revenues (primarily freight line haul revenues, but also including switching, demurrage and incidental revenues) increased $93 million, or 2.8%, from $3,345 million in 1992 to $3,438 million in 1993. A 5.0% increase in traffic volume, as measured in units (freight cars and intermodal trailers and containers), primarily as the result of improvement in the economy and growth in the Company's market share, resulted in a $160 million increase in revenues that was partially offset by a 1.6% decrease in average revenue per unit which reduced revenues $54 million. The decline in average revenue per unit is attributable to decreases in average rates which reduced revenue by $62 million, partially offset by a favorable mix of traffic which increased revenues $8 million. Traffic volume increases occurred in the following freight commodity groups: automotive parts and finished vehicles, 13.4%; intermodal, 11.2%; forest products, 6.5%; chemicals and related products, 6.4%; metals and related products, 5.1%; and food and grain products, 3.6%. Coal traffic decreased 9.2%. Switching, demurrage and incidental revenues decreased $13 million. Operating expenses increased $34 million, or 1.2%, from $2,811 million in 1992 to $2,845 million in 1993. The following table sets forth the operating expenses for the two years: Compensation and benefits costs decreased $9 million, or 0.7%, with relatively stable employment levels. The decrease is attributable primarily to a decrease in payroll taxes, partially offset by increases in fringe benefit costs and increased wage rates. Compensation and benefits as a percent of revenues was 35.7% in 1993 compared with 37.0% in 1992. The increase of $15 million, or 5.2%, in equipment rents reflects the effects of new operating leases for equipment and the increase in traffic volume, partially offset by improvement in equipment utilization. Depreciation and amortization expense decreased $13 million, or 4.4%, primarily due to lower depreciation rates for locomotives and freight cars as a result of a depreciation study required by the Interstate Commerce Commission. Other operating expenses increased $38 million, or 7.8%, primarily due to increases in property and corporate taxes, increases in write-downs of uncollectible accounts, and a reduction in 1992 due to reducing accruals related to a 1991 special charge with no corresponding reduction in 1993. The Company's operating ratio (operating expenses as a percent of revenues) was 82.8% for 1993 compared with 84.0% for 1992. The reserve for intercompany receivables of $89 million relates to advances made to Concord. Other income, net, (representing interest and rental income, property sales and other non-operating items, net) increased $16 million, or 16.3%, from $98 million in 1992 to $114 million in 1993, principally due to higher gains from property sales and increased equity income as a result of higher net income of the Company's affiliated companies. Liquidity and Capital Resources - ------------------------------- The Company's cas and cash equivalents decreased $14 million, from $40 million at December 31, 1992 to $26 million at December 31, 1993. Cash generated from operations, and borrowings are the Company's principal sources of liquidity and are used primarily for capital expenditures, debt service, and dividends. Operating activities provided cash of $495 million in 1993, compared with $496 million in 1992 and $570 million in 1991. Issuance of long-term debt provided cash of $485 million in 1993. The principal uses of cash in 1993 were for property and equipment acquisitions, $566 million, payment of long-term debt including capital lease and equipment obligations, $195 million, and the net repayment of commercial paper, $48 million. Through June 30, 1993, at which time the Company's common stock was converted to Conrail Inc. common stock, $32 million was used for the repurchase of common stock. The Company also paid $142 million in cash dividends on common and preferred stock, including $87 million to Conrail Inc. during the last six months of 1993. A working capital (current assets less current liabilities) deficiency of $29 million existed at December 31, 1993, compared with a deficiency of $489 million at December 31, 1992. The decrease in the deficiency is attributable primarily to the increase of $57 million in accounts receivable; the recording of $218 million of current deferred tax assets as a result of adopting SFAS 109 (see Note 7 to the Consolidated Financial Statements elsewhere in this Annual Report); and reductions in short-term borrowings, $48 million, current maturities of long-term debt, $61 million, and accrued and other current liabilities, $86 million. Management believes that the Company's financial position allows it sufficient access to credit sources on investment grade terms, and, if necessary, additional intermediate or long-term debt could be issued for working capital requirements. During 1993, the Company issued an additional $114 million of commercial paper and repaid $162 million. Of the remaining $179 million outstanding at December 31, 1993, $100 million is classified as long-term debt since it is expected to be refinanced through subsequent issuances of commercial paper and is supported by a long-term credit facility. In February 1993, the Company issued $94 million of Pass Through Certificates to finance the acquisition of equipment. Of these certificates, $54 million are direct obligations of the Company and are secured by the acquired equipment. The remaining $40 million of certificates were issued to finance equipment which the Company will utilize under a capital lease, and while such certificates are not direct obligations of or guaranteed by the Company, the amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. The Company issued $79 million of medium-term notes during the first quarter of 1993 under a shelf registration statement filed in April 1990. In May 1993, the Company sold $250 million of 7 7/8% Debentures due 2043 under the same shelf registration statement. During 1993, the Company redeemed $85 million of medium-term notes that were issued in 1988 and 1989. In June 1993, Conrail Inc. and the Company filed a new shelf registration statement on Form S-3 which will enable the Company to issue up to $500 million in debt securities or Conrail Inc. to issue up to $500 million in convertible debt or equity securities. The Company issued approximately $63 million of 1993 Equipment Trust Certificates, Series A, in September 1993, under this registration statement. The certificates were used to finance approximately 80% of the cost of certain rebuilt and new freight cars, which the Company will utilize under an operating lease. Although the certificates are not direct obligations of, or guaranteed by the Company, the amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. In November 1993, the Company issued $102 million of 1993 Equipment Trust Certificates, Series B, to finance approximately 85% of the cost of 80 new locomotives. These certificates are direct obligations of the Company and were not issued pursuant to the 1993 shelf registration statement. During the third quarter of 1993, the Company reached a settlement with the Internal Revenue Service related to the audit of the Company's consolidated federal income tax returns for the fiscal years 1987 through 1989. Under the settlement, the Company paid $51 million, including interest (see Note 7 to the Consolidated Financial Statements elsewhere in this Annual Report). Capital Expenditures - -------------------- Capital expenditures totalled $650 million, $491 million and $398 million in 1993, 1992 and 1991, respectively. Of these capital expenditures, the Company directly financed $232 million in 1993, $13 million in 1992, and $76 million in 1991 through private third-party financing. In addition, the proceeds of notes and debentures sold in those years, $329 million, $80 million, and $30 million, respectively, were available to fund capital expenditures. Capital expenditures for 1993, $650 million, exceeded planned expenditures by $100 million principally due to the accelerated acquisition of locomotives originally expected to be acquired in 1994. Capital expenditures for 1994 are expected to be approximately $490 million. Item 8. Item 8. Financial Statements and Supplementary Data - ------ ------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS The Stockholder and Board of Directors Consolidated Rail Corporation We have audited the consolidated financial statements and financial statement schedules of Consolidated Rail Corporation and subsidiaries listed in Item 14(a) 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 Consolidated Rail Corporation 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 1 to the consolidated financial statements, the Company changed its methods for accounting for income taxes and postretirement benefits other than pensions in 1993. COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania January 24, 1994 See accompanying notes. See accompanying notes. See accompanying notes. See accompanying notes. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies ------------------------------------------ Industry -------- Consolidated Rail Corporation (the "Company"), operates a freight railroad system in the Northeast-Midwest quadrant of the United States and the Province of Quebec. Principles of Consolidation --------------------------- The consolidated financial statements include the Company and majority-owned subsidiaries. Investments in 20% to 50% owned companies are accounted for by the equity method. Cash Equivalents ---------------- Cash equivalents consist of commercial paper, certificates of deposit and other liquid securities purchased with a maturity of three months or less, and are stated at cost which approximates market value. Material and Supplies --------------------- Material and supplies consist mainly of fuel oil and items for maintenance of property and equipment, and are valued at the lower of cost, principally weighted average, or market. Property and Equipment ---------------------- Property and equipment are recorded at cost. Depreciation is provided using the composite straight-line method. The cost (net of salvage) of depreciable property retired or replaced in the ordinary course of business is charged to accumulated depreciation and no gain or loss is recognized. Revenue Recognition ------------------- Revenue is recognized proportionally as a shipment moves on the the Company's system from origin to destination. Earnings Per Share ------------------ Earnings per share amounts are not presented for 1993 as the Company became a wholly owned subsidiary of Conrail Inc. on July 1, 1993 (Note 2). For 1992 and 1991, primary earnings (loss) per share are based on net income (loss) adjusted for the effects of preferred dividends net of income tax benefits, divided by the weighted average number of shares outstanding during the period including the dilutive effect of stock options. Fully diluted earnings (loss) per share assume conversion of Series A ESOP Convertible Junior Preferred Stock ("ESOP Stock") into common stock unless they are antidilutive as they were in 1991. Net income amounts CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) applicable to fully diluted earnings per share in 1992 have been adjusted by the increase, net of income tax benefits, in ESOP-related expenses assuming conversion of all ESOP Stock to common stock. The weighted average number of shares of common stock outstanding during each of the two years ended December 31, 1992 are as follows: 1992 1991 ---------- ---------- Primary weighted average shares 81,743,648 81,883,970 Fully diluted weighted average shares 91,856,193 81,883,970 Ratio of Earnings to Fixed Charges ---------------------------------- Earnings used in computing the ratio of earnings to fixed charges represent income before income taxes plus fixed charges, less equity in undistributed earnings of 20% to 50% owned companies. Fixed charges represent interest expense together with interest capitalized and a portion of rent under long-term operating leases representative of an interest factor. In 1991, when the Company recorded a special charge (Note 10), earnings were insufficient to cover fixed charges. New Accounting Standards ------------------------ Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106") (Note 8) and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") (Note 7). As a result, the Company recorded cumulative after tax charges of $22 million and $48 million for SFAS 106 and SFAS 109, respectively. In November 1992, the Financial Accounting Standards Board issued a standard (SFAS 112) related to accounting for postemployment benefits, which is effective January 1994. This standard requires employers to recognize their obligation to provide salary continuation, supplemental unemployment benefits, and other benefits provided after employment but before retirement when certain conditions are met. The Company has determined that this standard would not have a material effect on its financial statements. 2. Corporate Reorganization and Presentation ----------------------------------------- In May 1993, the shareholders of the Company approved a plan for the adoption of a holding company structure. Under the Plan, each share of the Company's common stock which was CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) issued and outstanding or held in the treasury of the Company, and each share of the Company's preferred stock, all of which were held by the Non-union Employee Stock Ownership Plan (the "ESOP"), were automatically converted into one share of common stock and one share of preferred stock, respectively, of a newly created holding company, Conrail Inc. on July 1, 1993. As a result, effective July 1, 1993, Conrail Inc. became the publicly held entity and the Company became a wholly-owned subsidiary of Conrail Inc. The promissory note receivable, plus accrued interest, which the Company received in 1990 from the ESOP in exchange for its preferred shares remained with the Company and is recorded in the stockholder's equity section of its balance sheet. As part of the establishment of the holding company, a wholly- owned subsidiary of the Company was transferred to Conrail Inc. The financial position and results of operations of this subsidiary are not material to the accompanying consolidated financial statements. In 1992, the Company's Board of Directors authorized a two-for- one common stock split which was effected in the form of a common stock dividend. An amount equal to the par value of the common shares issued was transferred from additional paid- in capital to the common stock account. In addition, a stock dividend on the ESOP Stock in the amount of one share of ESOP Stock for each share of ESOP Stock outstanding was also distributed. All references in the financial statements with regard to the number of shares, and related dividends and per share amounts for both common stock (including treasury shares) and ESOP Stock have been restated to reflect the stock split. Stock compensation and other plans that provide for the issuance of common stock, ESOP Stock, or an amount equivalent to their respective fair market values, have also been amended to reflect the stock split. 3. Related Party Transactions -------------------------- The Company engages in various transactions with Conrail Inc. The Company funds the cash requirements of Conrail Inc., primarily through cash dividends, which in 1993 totalled $87 million (excluding $44 million paid to shareholders prior to July 1, 1993). The Company is obligated to pay a management fee to Conrail Inc. equal to the amount of preferred dividends declared by the holding company in connection with the ESOP which totalled $11 million in 1993 and is recorded in "Other income, net" on the consolidated statement of income (Notes 8 CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) and 11). Advances between the two companies accrue interest at the Federal Reserve Bank's 30-day average interest rate. The resulting interest income and interest expense on advances to and from Conrail Inc. were immaterial to the Company's financial statements. A summary of the Company's transactions with Conrail Inc. are as follows: (In Millions) Short-term receivable $ 9 Short-term payable 21 In September 1993, the Company recorded a reserve of $89 million relating to advances made to Concord Resources Group, Inc. ("Concord"), a subsidiary of Conrail Inc. 4. Property and Equipment ---------------------- The Company acquired equipment and incurred related long-term debt under various capital leases of $75 million in 1993, $13 million in 1992, and $76 million in 1991. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 5. Accrued and Other Current Liabilities ------------------------------------- 6. Long-Term Debt -------------- Long-term debt outstanding, including the weighted average interest rates at December 31, 1993, is composed of the following: Using current market prices when available, or a valuation based on the yield to maturity of comparable debt instruments having similar characteristics, credit rating and maturity, the total fair value of the Company's long-term debt, including the current portion, but excluding capital leases, is $1,782 million in 1993 and $1,310 million in 1992, compared with carrying values of $1,544 million and $1,200 million in 1993 and 1992, respectively. The Company's noncancelable long-term leases generally include options to purchase at fair value and to extend the terms. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Capital leases have been discounted at rates which average 8.3% and are collateralized by assets with a net book value of $439 million at December 31, 1993. Minimum commitments, exclusive of executory costs borne by the Company, are: Operating lease rent expense was $88 million in 1993, $71 million in 1992, and $50 million in 1991. The Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission in April 1990 for $1.25 billion of debt securities. In May 1993, the Company issued $250 million of 7 7/8% Debentures Due 2043, and has $11 million remaining to be issued under this shelf registration at December 31, 1993. In June 1993, the Company and Conrail Inc. filed a new shelf registration statement on Form S-3 which will enable the Company to issue up to $500 million in debt securities or Conrail Inc. to issue up to $500 million in convertible debt or equity securities. In February 1993, the Company issued $94 million of Pass Through Certificates, Series 1993-A1 and 1993-A2 to finance the acquisition of equipment. The Series 1993-A1 certificates, $41 million, have an interest rate of 5.71%, and Series 1993-A2 certificates, $53 million, have an interest rate of 6.86%. Certificates issued in the amount of $54 million are direct obligations of the Company and are secured by the acquired equipment. The remaining certificates, $40 million, were issued to finance equipment which the Company will utilize under a capital lease, and while such certificates are not direct obligations of, or guaranteed by the Company, the amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) In September 1993, the Company issued approximately $63 million of 5.98% 1993 Equipment Trust Certificates, Series A, due 2013, pursuant to the 1993 registration statement. The certificates were used to finance approximately 80% of the cost of certain rebuilt and new freight cars, which the Company will utilize under an operating lease. Although the certificates are not direct obligations of, or guaranteed by the Company, amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. In November 1993, the Company issued $102 million of 1993 Equipment Trust Certificates, Series B, with interest rates ranging from 3.57% to 5.90%, maturing annually from 1994 through 2008. These certificates are obligations of the Company issued for the purchase of locomotives which will serve as collateral for the obligations. Equipment and other obligations mature in 1994 through 2013 and are collateralized by assets with a net book value of $200 million at December 31, 1993. Maturities of long-term debt other than capital leases and commercial paper are $74 million in 1994, $62 million in 1995, $95 million in 1996, $10 million in 1997, $40 million in 1998, and $1,163 million in total from 1999 through 2043. The Company had $179 million of commercial paper outstanding at December 31, 1993. Of the total amount outstanding, $100 million is classified as long-term since it is expected to be refinanced through subsequent issuances of commercial paper and is supported by the long-term credit facility mentioned below. The Company maintains a $300 million uncollateralized revolving credit facility with a group of banks under which no borrowings were outstanding at December 31, 1993. The credit facility, which expires in 1995, requires interest to be paid on borrowings at rates based on various defined short-term market rates and an annual maximum fee of .1% of the facility amount. The credit facility contains, among other conditions, restrictive covenants relating to leverage ratio, debt, and consolidated tangible net worth. Interest payments were $164 million in 1993, $162 million in 1992, and $167 million in 1991. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 7. Income Taxes ------------ The provisions for (benefits from) income taxes are composed of the following: Effective January 1, 1993, the Company adopted the provisions of SFAS 109 which requires a liability approach for measuring deferred tax assets and liabilities based on differences between the financial statement and tax bases of assets and liabilities at each balance sheet date using enacted tax rates in effect when those differences are expected to reverse. As a result, the Company recorded a cumulative adjustment of $48 million. The primary effects of the adoption of this standard on the balance sheet were the recording of a current deferred tax asset of $147 million with a corresponding increase in the long-term deferred income tax liability and the net deferred income tax liabilities related to the cumulative accounting adjustment for the adoption of SFAS 109 and SFAS 106 (Note 8). Prior years' financial statements have not been restated to apply the provisions of the new standard. In conjunction with the public sale in 1987 of the 85% of the Company's common stock owned by the U.S. Government, federal legislation was enacted which resulted in a reduction of the tax basis of certain of the Company's assets, particularly property and equipment, thereby substantially decreasing tax depreciation deductions and increasing future federal income tax payments. Also, net operating loss and investment tax CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) credit carryforwards were cancelled. As a result of the sale- related transactions, a special income tax obligation was recorded in 1987 based on an estimated effective federal and state income tax rate of 37.0%. As a result of the increase in the federal corporate income tax rate from 34% to 35% enacted August 10, 1993, and effective January 1, 1993, income tax expense for 1993 was increased by $38 million, of which $34 million related to the effects of adjusting deferred income taxes and the special income tax obligation for the rate increase. The Company and its subsidiaries will be included in the consolidated federal income tax return filed by Conrail Inc. for periods subsequent to July 1, 1993. The consolidated federal income tax expense or benefit will be allocated to the Company and its subsidiaries as though the Company filed a separate consolidated tax return. During the third quarter of 1993, the Company reached a settlement with the Internal Revenue Service related to the audit of the Company's consolidated federal income tax returns for the fiscal years 1987 through 1989. Under the settlement, the Company paid $51 million, including interest, all of which had been previously provided for in prior years resulting in no income statement effect in 1993. Federal and state income tax payments were $39 million in 1993 (excluding tax settlement), $31 million in 1992, and $45 million in 1991. Significant components of the Company's special income tax obligation and deferred income tax liabilities and (assets) as of December 31, 1993 are as follows: CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The tax effects of each source of deferred income taxes and special income tax obligation (disclosure for 1993 is not required nor applicable under SFAS 109)are as follows: 1992 1991 ----- ----- (In Millions) Deferred taxes Tax depreciation over book $ 84 $ 130 Other property transactions 80 61 Casualty, wage and other accruals 78 (152) Alternative minimum tax (40) (58) Other 6 (6) ----- ----- $208 $ (25) ===== ===== Special income tax obligation Reduced tax basis depreciation (31) (35) Other property transactions (27) (134) ---- ----- $(58) $(169) ==== ===== CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) As of December 31, 1993, the Company has approximately $77 million of alternative minimum tax credits available to offset future U.S. federal income taxes on an indefinite carryforward basis. Deferred income taxes and the special income tax obligation for 1991 include reductions of $159 million and $113 million, respectively, related to the 1991 Special Charge (Note 10). Reconciliations of the U.S. statutory tax rates with the effective tax rates follow: 1993 1992 1991 ----- ----- ------ Statutory tax rate 35.0% 34.0% (34.0)% State income taxes, net of federal benefit 5.1 3.9 (3.5) Effect of federal tax increase on deferred taxes 7.7 Other (0.9) .8 (.7) ----- ----- ----- Effective tax rate 46.9% 38.7% (38.2)% ===== ===== ===== 8. Employee Benefits ----------------- Pension Plans ------------- The Company and certain subsidiaries maintain defined benefit pension plans which are noncontributory for all non- union employees and generally contributory for participating union employees. Benefits are based primarily on credited years of service and the level of compensation near retirement. Funding is based on the minimum amount required by the Employee Retirement Income Security Act of 1974. Pension credits include the following components: CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The funded status of the pension plans and the amounts reflected in the balance sheets are as follows: The assumed weighted average discount rates used in 1993 and in 1992 are 7.25% and 8.0%, respectively, and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation as of December 31, 1993 and 1992 is 6.0%. The expected long-term rate of return on plan assets (primarily equity securities) in 1993 and 1992 is 9.0%. Savings Plans ------------- The Company and certain subsidiaries also provide 401(k) savings plans for union and non-union employees. Under the Non-union ESOP, 100% of employee contributions are matched in the form of Conrail Inc. ESOP Stock (Note 2) for the first 6% of a participating employee's base pay. Under the union employee plan, employee contributions are not matched by the Company. Savings plan expense, including Non-union ESOP expense, was $5 million in 1993 and $4 million in 1992 and 1991. In connection with the Non-union ESOP, the Company issued 9,979,562 of the authorized 10 million shares of its ESOP Stock to the Non-union ESOP in exchange for a 20 year promissory note with interest at 9.55% from the Non-union ESOP in the principal amount of $288 million. In addition, unearned ESOP compensation of $288 million was recognized as a charge to stockholders' equity coincident with the Non- union ESOP's issuance of its $288 million promissory note to the Company. The debt of the Non-union ESOP was recorded by the Company and offset against the promissory note from the Non-union ESOP. Prior to the corporate reorganization CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (Note 2), unearned ESOP compensation was charged to expense as shares of ESOP Stock were allocated to participants. An amount equivalent to the preferred dividends declared on the ESOP Stock partially offset compensation and interest expense related to the Non-union ESOP. In conjunction with the formation of the holding company on July 1, 1993 (Note 2), each share of the Company's preferred stock, all of which were held by the Non-union ESOP, was automatically converted into one share of preferred stock of Conrail Inc. and the debt of the Non-union ESOP and the unearned ESOP compensation accounts were transferred to Conrail Inc. The promissory note receivable from the Non- union ESOP plus the accrued interest were reclassified by the Company to the stockholder's equity section of its balance sheet. Unearned ESOP compensation is now amortized and charged to the Company by Conrail Inc. as shares of ESOP Stock are allocated to participants. An amount equivalent to the preferred dividends declared on the ESOP Stock proportionally offsets compensation expense of the Company and interest expense of Conrail Inc. related to the Non-union ESOP. Conrail Inc. makes dividend payments at a rate of 7.51% on the ESOP Stock and Consolidated Rail Corporation makes additional contributions in an aggregate amount sufficient to enable the Non-union ESOP to make the required interest and principal payments on its note. Interest expense incurred by the Non-union ESOP on its debt to the Company before the corporate reorganization on July 1, 1993 (Note 2) was $15 million in 1993, and $28 million in 1992 and 1991. Compensation expense related to the Non-union ESOP was $10 million in 1993, $9 million in 1992, and $8 million in 1991. Preferred dividends paid to the Non-union ESOP by the Company prior to the corporate reorganization (Note 2) were $11 million in 1993, and $21 million in 1992 and 1991. The Company received debt service payments from the Non-union ESOP of $26 million in 1993, and $21 million in 1992 and 1991. Postretirement Benefits Other Than Pensions ------------------------------------------- The Company provides health and life insurance benefits to certain eligible retired non-union employees. Certain non- union employees are eligible for retiree medical benefits, while substantially all non-union employees are eligible for retiree life insurance benefits. Generally, company-provided health care benefits terminate when covered individuals reach age 65. Retiree medical benefits are funded by a combination of CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Company and retiree contributions. The cost of medical benefits provided by the Company as self-insurer was previously recognized as claims and administrative expenses were paid. Retiree life insurance benefits are provided by insurance companies whose premiums are based on claims paid during the year and the cost of such benefits was previously recognized as the annual insurance premium. The expense of providing both non-union retiree medical and life insurance benefits for 1992 and 1991 was $5 million and $2 million, respectively. Retiree life insurance plan assets consist of a retiree life insurance reserve held in the Company's group life insurance policy. There are no plan assets for the retiree health benefits plan. Effective January 1, 1993, the Company adopted SFAS 106, which requires that the cost of retiree benefits other than pensions be accrued during the period of employment rather than when benefits are paid. The Company elected the immediate recognition method allowed under the statement and accordingly recorded a cumulative, one-time charge of $22 million (net of tax benefits of $14 million). This accrual was in addition to the remaining balance of $21 million which had been accrued for postretirement health benefits for employees who participated in the Company's 1989 non-union voluntary retirement program. The accumulated postretirement obligation at January 1, 1993 was $41 million for the medical plan and $21 million for the life insurance plan. Plan assets attributed to the life insurance plan at January 1, 1993 totalled $5 million. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The following sets forth the plan's funded status reconciled with amounts reported in the Company's balance sheet at December 31, 1993: An 11.5 percent rate of increase in per capita costs of covered health care benefits was assumed for 1994, gradually decreasing to 6 percent by the year 2008. 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 $4 million and would have an immaterial effect on the service cost and interest cost components of net periodic postretirement benefit cost for 1993. A discount rate of 7.0% was used to determine the accumulated postretirement benefit obligations for both the medical and life insurance plans. The assumed rate of compensation increase is 5.0%. 9. Capital Stock ------------- The Company is authorized to issue 25 million shares of preferred stock with no par value. The Board of Directors has the authority to divide the preferred stock into series and to determine the rights and preferences of each. As a result of the holding company structure that became effective on July 1, 1993 (Note 2), each share of the Company's common stock which was issued and outstanding or held in the treasury of the Company, was automatically converted into one share of Conrail Inc. common stock. Subsequent to July 1, 1993, the Company had 100 shares of common stock outstanding, all held by Conrail Inc. All of CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) the long-term incentive plans of the Company were amended to reflect the use of Conrail Inc.'s common stock. The activity and status of treasury stock follow: 1993 1992 1991 --------- --------- ------- Shares, beginning of year 3,690,002 546,400 Acquired 611,182 3,143,602 546,400 Reclassified as authorized but unissued (43,800) Corporate reorganization (Note 2) (4,257,384) --------- --------- ------- Shares, end of year - 3,690,002 546,400 Conrail Inc.'s 1987 Long-Term Incentive Plan (the "1987 Incentive Plan") authorizes the granting to the Company's officers and key employees of up to 4 million shares of Conrail Inc. common stock through stock options, stock appreciation rights, and awards of restricted or performance shares. A stock option is exercisable for a specified term commencing after grant at a price not less than the fair market value of the stock on the date of grant. The 1987 Incentive Plan also provides for the granting of Conrail Inc. stock to employees, contingent on either a specified period of employment or achievement of certain financial or performance goals. Conrail Inc.'s 1991 Long-Term Incentive Plan (the "1991 Incentive Plan") authorizes the granting to the Company's officers and key employees of up to 3.2 million shares of Conrail Inc. common stock, through stock options, stock appreciation rights and awards of restricted or performance shares. As of December 31, 1993, Conrail Inc. had granted 169,005 shares of restricted stock under the incentive plans. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The activity and status of stock options under the incentive plans follow: Non-qualified Stock Options -------------------------------- Option Price Shares Per Share Under Option ----------------- ------------ Balance, January 1, 1991 $14.000 - $25.065 3,271,920 Granted $24.530 - $36.595 339,400 Exercised $14.000 - $25.065 (1,361,922) Cancelled $14.000 - $25.065 (83,718) --------- Balance, December 31, 1991 $14.000 - $36.595 2,165,680 Granted $42.625 - $45.125 1,383,600 Exercised $14.000 - $25.063 (674,652) Cancelled $42.625 (3,750) --------- Balance, December 31, 1992 $14.000 - $45.125 2,870,878 Granted $49.375 - $60.500 73,027 Exercised $14.000 - $53.875 (928,822) Cancelled $31.813 - $45.125 (48,762) --------- Balance, December 31, 1993 $14.000 - $60.500 1,966,321 ========= Exercisable, December 31, 1993 $14.000 - $53.875 995,827 ========= Available for future grants December 31, 1992 1,792,726 ========= December 31, 1993 1,698,036 ========= 10.1991 Special Charge ------------------- In 1991, the Company recorded in operating expenses a special charge totalling $719 million which was composed of $362 million for disposition of certain under-utilized rail lines and other facilities, $212 million for labor settlements primarily representing certain expected costs associated with a new labor agreement that reduced the size of train crews, $57 million for certain environmental clean up costs, and $88 million for legal matters including settlement of the Amtrak collision with the Company at Chase, Maryland in January 1987. The 1991 special charge reduced net income by $447 million, and without the special charge net income would have been $240 million ($2.73 and $2.48 per share, primary and fully diluted, respectively). CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 11.Other Income, Net ----------------- 1993 1992 1991 ---- ----- ---- (In Millions) Interest income $ 40 $ 40 $ 48 Rental income 56 60 53 Property sales, net 20 6 9 Management fee (11) Other, net 9 (8) (3) ---- ---- ---- $114 $ 98 $107 ==== ==== ==== 12.Commitments and Contingencies ----------------------------- Non-union Voluntary Retirement Program -------------------------------------- On December 15, 1993, the Board of Directors approved a voluntary early retirement program for eligible members of its non-union workforce. The eligible employees have until February 28, 1994 to elect to retire under the program, and based on the results of a similar program completed in 1990, the cost of the program is expected to have a material effect on the income statement for the first quarter of 1994. The transaction will not significantly affect the Company's cash position as approximately 85% of the cost will be paid from the Company's overfunded pension plan (Note 8). Environmental ------------- The Company is subject to various federal, state and local laws and regulations regarding environmental matters. The Company is a party to various proceedings brought by both regulatory agencies and private parties under federal, state and local laws, including Superfund laws, and has also been named as a potentially responsible party in many governmental investigations and actions for the cleanup and removal of hazardous substances due to its alleged involvement as either a transporter, generator or property owner. Due to the number of parties involved at many of these sites, the wide range of costs of possible remediation alternatives, the changing technology and the length of time over which these matters develop, it is often not possible to estimate the Company's liability for the costs associated with the assessment and remediation of contaminated sites. Although the Company's operating results and liquidity could be significantly affected in any quarterly or annual reporting period if it were held principally liable in certain of these actions, at December 31, 1993, the Company had accrued $77 million, an CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) amount it believes is sufficient to cover the probable liability and remediation costs that will be incurred at Superfund sites and other sites based on known information and using various estimating techniques. The Company believes the ultimate liability for these matters will not materially affect its consolidated financial condition. The Environmental Quality Department of the Company is charged with promoting the Company's compliance with laws and regulations affecting the environment and instituting environmentally sound operating practices. The department monitors the status of the sites where the Company is alleged to have liability and continually reviews the information available and assesses the adequacy of the recorded liability. Other Contingencies ------------------- The Company is involved in various legal actions, principally relating to occupational health claims, personal injuries, casualties, property damage and loss and damage. The Company has recorded liabilities on its balance sheet for amounts sufficient to cover the expected payments for such actions. At December 31, 1993 these liabilities are presented net of estimated insurance recoveries of approximately $80 million. The Company may be contingently liable for approximately $102 million at December 31, 1993 under indemnification provisions related to sales of tax benefits. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 13. Condensed Quarterly Data (Unaudited) ------------------------------------ Due to the formation of the holding company (Note 2), earnings, dividends, and market price per share amounts are not presented for periods subsequent to July 1, 1993. Effective January 1, 1993, the Company adopted SFAS 106 and SFAS 109, related to the accounting for postretirement benefits other than pensions and income taxes, respectively. As a result, the Company recorded cumulative after tax charges totalling $74 million in the first quarter of 1993. The cumulative after tax charges were reduced to $70 million as a result of the transfer of a wholly owned subsidiary to Conrail Inc. (Notes 1, 7 and 8). In September 1993, the Company recorded a reserve of $89 million relating to advances made to Concord Resources Group, Inc., a subsidiary of Conrail Inc. Also, in the third quarter, as a result of the increase in the federal corporate income tax rate enacted August 10, 1993 and effective January 1, 1993, income tax expense for the third quarter of 1993, includes a charge of $36 million, primarily related to the adjustment of deferred taxes and the special income tax obligation as required by SFAS 109 (Note 7). Item 9. Item 9. Changes in and Disagreements with Accountants - ------- ---------------------------------------------- on Accounting and Financial Disclosure. -------------------------------------- Previously reported in the Company's Current Report on Form 8-K, filed February 18, 1994. PART III Item 10. Item 10. Directors and Executive Officers - ------- -------------------------------- of the Registrant. ----------------- Information Omitted in Accordance with General Instruction J(2)(c). Item 11. Item 11. Executive Compensation. - ------- ---------------------- Information Omitted in Accordance with General Instruction J(2)(c). Item 12. Item 12. Security Ownership of Certain Beneficial - ------- ---------------------------------------- Owners and Management. --------------------- Information Omitted in Accordance with General Instruction J(2)(c). Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- Information Omitted in Accordance with General 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: 1. Financial Statements: Page ---- Report of Independent Accountants..................... 15 Consolidated Statements of Income for each of the three years in the period ended December 31, 1993... 16 Consolidated Balance Sheets at December 31, 1993 and 1992 ........................................... 17 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 1993...................... 18 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 .................................. 19 Notes to Consolidated Financial Statements............ 20 2. Financial Statement Schedules: The following financial statement schedules should be read in connection with the financial statements listed in Item 14(a)1 above. Index to Financial Statement Schedules -------------------------------------- Page ---- Schedule V - Property, Plant and Equipment...... S-1 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment.............. S-2 Schedule VIII - Valuation and Qualifying Accounts.. S-3 Schedule X - Supplementary Income Statement Information...................... S-4 Schedules other than those listed above are omitted for reasons that they are not required, are not applicable, or the information is included in the financial statements or related notes. 3. Exhibits: Exhibit No. ---------- 2 Agreement and Plan of Merger among Consolidated Rail Corporation, Conrail Inc. and Conrail Subsidiary Corporation, dated as of February 17, 1993, filed as Appendix A to the Proxy Statement of the Registrant, dated April 16, 1993 and incorporated herein by reference. 3.1 Amended and Restated Articles of Incorporation of the Registrant as amended through December 31, 1992, filed as Exhibit 3.1 to the Registrant's Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 3.2 By-Laws of the Registrant, as amended through December 31, 1993. 4.1 Articles of Incorporation of the Registrant filed as Exhibit 3.1 to the Registrant's Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 4.2 Form of Certificate of Common Stock, par value $1.00 per share, of the Registrant, filed as Exhibit 4.7 to the Registrant's Registration Statement on Form S-8 (No. 33-19155) and incorporated herein by reference. 4.3 Form of Indenture between the Registrant and The First National Bank of Chicago, as Trustee, with respect to the issuance of up to $1.25 billion aggregate principal amount of the Registrant's debt securities, filed as Exhibit 4 to the Registrant's Registration Statement on Form S-3 (Registration No. 33-34040) and incorporated herein by reference. In accordance with Item 601(b)(4)(iii) of Regulation S-K, copies of instruments of the Registrant with respect to the rights of holders of certain long-term debt are not filed herewith, or incorporated by reference, but will be furnished to the Commission upon request. 10.1 Second Amended and Restated Northeast Corridor Freight Operating Agreement dated October 1, 1986 between National Railroad Passenger Corporation and Consolidated Rail Corporation, filed as Exhibit 10.1 to the Registrant's Registration Statement on Form S- 1 (Registration No. 33-11995) and incorporated herein by reference. 10.2 Letter agreements dated September 30, 1982 and July 19, 1986 between Consolidated Rail Corporation and The Penn Central Corporation, filed as Exhibit 10.5 to the Registrant's Registration Statement on Form S- 1 (Registration No. 33-11995) and incorporated herein by reference. 10.3 Letter agreement dated March 16, 1988 between Consoli dated Rail Corporation and Penn Central Corporation relating to hearing loss litigation, filed as Exhibit 19.1 to the Registrant's Quarterly Report on Form 10- Q for the quarter ended March 31, 1988 and incorporated herein by reference. Management Compensation Plans and Contracts ------------------------------------------- 10.4 Retirement Plan for Non-employee Directors as amended February 21, 1990, filed as Exhibit 10.10 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 and incorporated herein by reference. 11 Statement of earnings (loss) per share computations. 12 Computation of the ratio of earnings to fixed charges. 23 Consent of Independent Accountants. 24 Each of the officers and directors signing this Annual Report on Form 10-K has signed a power of attorney, contained on page 44 hereof, with respect to amendments to this Annual Report. (b) Reports on Form 8-K. Current Report on Form 8-K dated October 7, 1993, filed in connection with the Registrant's issuance of $63,156,000 of 5.98% 1993-A Equipment Trust Certificates Due 2013 pursuant to its current Registration Statement on Form S-3 (No. 33-64670). (c) Exhibits. The Exhibits required by Item 601 of Regulation S-K as listed in Item 14(a)3 are filed herewith or incorporated herein by reference. (d) Financial Statement Schedules. Financial statement schedules and separate financial state ments specified by this Item are included in Item 14(a)2 or are otherwise omitted for reasons that they are not required or are not applicable. POWER OF ATTORNEY ----------------- Each person whose signature appears below under "SIGNATURES" here by authorizes H. William Brown and Bruce B. Wilson, or either of them, to execute in the name of each such person, and to file, any amendment to this report and hereby appoints H. William Brown and Bruce B. Wil son, 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 Securi ties Exchange Act 1934, Consolidated Rail Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CONSOLIDATED RAIL CORPORATION. Date: March 16, 1994 By James A. Hagen ----------------------------- James A. Hagen 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 16th day of March, 1994, by the following persons on behalf of Consolidated Rail Corporation and in the capacities indicated. Signature Title - --------- ----- James A. Hagen Chairman, President and Chief - -------------- Executive Officer and James A. Hagen (Principal Executive Officer) Director H. William Brown Senior Vice President - Finance - ---------------- and Administration H. William Brown (Principal Financial Officer) John A. McKelvey Vice President - Controller - ---------------- (Principal Accounting Officer) John A. McKelvey H. Furlong Baldwin Director - ------------------ H. Furlong Baldwin Claude S. Brinegar Director - ------------------ Claude S. Brinegar Daniel B. Burke Director - --------------- Daniel B. Burke Kathleen Foley Feldstein Director - ------------------------ Kathleen Foley Feldstein Roger S. Hillas Director - --------------- Roger S. Hillas E. Bradley Jones Director - ---------------- E. Bradley Jones David B. Lewis Director - -------------- David B. Lewis John C. Marous Director - -------------- John C. Marous William G. Milliken Director - ------------------- William G. Milliken Raymond T. Schuler Director - ------------------ Raymond T. Schuler David H. Swanson Director - ---------------- David H. Swanson E-1 EXHIBIT INDEX Page Number in SEC Sequential Numbering Exhibit No. System - ----------- --------------------- 3.2 By-laws of the Registrant, as amended through December 31, 1993 11 Statement of earnings (loss) per share computations 12 Computation of the ratio of earnings to fixed charges 23 Consent of Independent Accountants Exhibits 2, 3.1, 4.1, 4.2, 4.3, 10.1, 10.2, 10.3 and 10.4 are incorporated herein by reference. Powers of attorney with respect to amendments to this Annual Report are contained on page 44.

216539_1993.txt

216539_1993

1993

216539

Item 1. Business General For a general description of the Company's business, see Business in Brief on page 4 of the 1993 Annual Report to Stockholders, which is incorporated herein by reference. The Company employs approximately 7,300 people on a full or part-time basis. The Company's businesses are somewhat cyclical; the second and fourth quarters are typically stronger than the first and third quarters. Industry Segments The Company is engaged in three significant industry segments. For financial information concerning these segments and for information concerning the Company's foreign operations see pages 18, 31, 32, 50 and 51 of the 1993 Annual Report to Stockholders, which are incorporated herein by reference. Supplemental information concerning each of the Company's significant industry segments is included below. Newspaper Publishing Business See pages 6, 8, 10 and 48 of the 1993 Annual Report to Stockholders which are incorporated herein by reference for a description of the business done and principal products produced by the Company in its newspaper publishing business. The primary raw material used by the Company in its newspaper operations is newsprint, which is purchased from various Canadian and United States sources, including Garden State Paper Company, Inc., a wholly owned subsidiary of the Company, and Southeast Paper Manufacturing Co., in which the Company owns a one- third equity interest. The newspaper operations of the Company consumed approximately 123,000 tons of newsprint in 1993. Management of the Company believes that newsprint inventory and sources of supply under existing arrangements will be adequate in 1994. All of the Company's newspapers compete for circulation and advertising with other newspapers published nationally and in nearby cities and towns and for advertising with magazines, radio, television and other promotional media. All of the newspapers compete for circulation principally on the basis of performance, service and price. Since 1985, the Company has owned a 40% interest in Garden State Newspapers, Inc., (GSN) a company established to acquire and operate medium-sized daily newspapers throughout the United States. The Company's 1991 operations include a loss of $78.7 million ($78.3 million after-tax; $3.01 per share) from GSN which largely resulted from GSN management's decision to write down the carrying value of certain assets, mostly intangibles, in light of depressed market conditions. The 1991 loss reduced the Company's investment in GSN to zero. Although GSN's net income for the twelve months ended September 30, 1992, was $12 million, such net income was due entirely to a nonrecurring gain from the sale of a newspaper property, net of operating losses. Consequently, in 1992 the Company did not recognize any equity in GSN's 1992 net income, nor has it since, because it is unlikely to realize any dividends or cash distributions from GSN operations. Subsequent to December 26, 1993, GSN failed to redeem the Series A and Series C Preferred Stock that previously had been issued to the Company and which was mandatorily redeemable on January 1, 1994. However, the Company has signed a Letter Agreement (Agreement) with GSN and a GSN affiliate whereby it has agreed to a process through which it would sell its 40% common equity interest in GSN, along with its GSN Series A and Series C Preferred Stock, for approximately $62.7 million. Under the terms of the Agreement, the Company would simultaneously exchange its GSN Series B Preferred Stock for the 9% Preferred Stock of Denver Newspapers, Inc., currently owned by GSN. The Company would continue to hold a warrant to purchase 40% of the common equity of Denver Newspapers, Inc. The Agreement, which will terminate if the contemplated transactions have not occurred by April 29, 1994 (unless extended by mutual agreement of the parties), is subject to various conditions, including the buyer's ability to arrange financing. Consequently, there is no assurance that the transactions will be consummated and, in light of these contingencies, the Company continues to evaluate its options. Television Business See pages 12, 14 and 16 of the 1993 Annual Report to Stockholders which are incorporated herein by reference for a description of the business done by the Company in its television business. The television broadcasting and cable television operations of the Company are subject to the jurisdiction of the Federal Communications Commission (FCC) pursuant to the Communications Act of 1934, as amended (the Act). The Act provides, among other things, that television broadcasts may be made only by persons licensed by the FCC. The Company's television stations operate under such licenses. The Act authorizes the FCC to grant or modify licenses on a determination that the "public convenience, interest, or necessity" will be served thereby, and to revoke licenses for violations of the Act, the terms of the license, or for certain other reasons. Licenses may also be revoked by court order or by the FCC if a licensee is found guilty of violations of certain provisions of the antitrust laws. The maximum term for which the FCC may grant a broadcasting license for a television station is five years, and renewals for periods of not more than five years may be made by the FCC upon considerations similar to those that govern the granting of original licenses. The licenses of WFLA-TV in Tampa and WJKS-TV in Jacksonville were most recently renewed in January 1992, and for WCBD-TV in Charleston in November 1991, and will expire on February 1, 1997, and December 1, 1996, respectively. FCC rules prohibit further acquisitions which would result in the common ownership of a daily newspaper and a television station in the same market. The rules do not apply retroactively to require divestiture of station WFLA-TV which is under common ownership with the Company's Tampa newspaper. The FCC has jurisdiction over and has adopted a regulatory program concerning the cable television industry. The FCC's regulations currently mandate blackout protection of certain local stations' network programs and certain sports programs and govern cable television engineering standards, registration and reporting obligations, and other matters, including rules which require the blackout of certain syndicated programs owned by television stations. In 1992, Congress passed, effective December 4, 1992, the Cable Television Consumer Protection and Competition Act of 1992 (Cable Act). It contains some provisions that are self-effectuating in that they do not require further FCC action and other provisions that require the FCC to adopt rules for their implementation. Examples of the former are provisions that prohibit cable systems from ownership of certain competitive multichannel video distribution services, a prohibition on franchise authorities awarding exclusive franchises, guidelines for awarding franchises and a provision which generally prohibits a cable operator from selling or otherwise transferring ownership in a cable system within 36 months following acquisition or initial construction of the system. Examples of provisions which required the FCC to adopt rules for their implementation include mandatory cable carriage of local television stations, a requirement that some television stations consent to carriage of their signals (retransmission consent), rate regulation, in-home wiring, new equal employment opportunity reporting requirements, consumer protection and customer service requirements, provisions prohibiting a cable operator from requiring purchase of particular program packages (tiers), other than the basic service tier, in order to purchase premium program services, and restrictions on indecent programming on access channels. Several of the provisions and the implementing rules may require changes in the Company's operations, but it is impossible to predict with certainty the extent of any future adverse impact on the systems of some or all of these new requirements. Also in 1992, in its video dialtone ruling, the FCC authorized telephone companies to transmit video programming for programmer- customers on a common carrier basis without having to obtain a municipal cable franchise. On February 22, 1994, the FCC announced the adoption of further rules intended to govern rates which cable operators may charge subscribers. Although the specific rules have not yet been published, the Company's preliminary evaluation of the general provisions indicates that the effect will not be material to the Company. Cable rates are subject to local franchise authority and FCC review, and further rate regulation is possible. In addition, many of the rules and regulations described above, particularly those implementing the Cable Act, are the subject of appeals which are pending in court. In addition to regulation by the FCC, cable television systems are also subject to extensive regulation by franchising authorities, and must file semi- annual Statements of Account and copyright royalty payments with the Copyright Office of the United States. The information contained in the preceding discussion does not purport to be a complete summary of all the provisions of the Act, the Cable Act or of the rules and regulations of the FCC thereunder, or of pending proposals for other regulation of broadcasting and related activities. The Company has cable television franchises to operate its existing systems in portions of Fairfax County, Virginia, and adjoining cities and towns, and in Fredericksburg, Virginia, and portions of Spotsylvania and Stafford Counties, Virginia. At December 26, 1993, the Company's cable television systems served approximately 220,000 subscribers on a subscriber payment basis. The primary source of revenues for WFLA-TV, WJKS-TV, and WCBD-TV is the sale of time to national and local advertisers. Since each of the stations is network affiliated, additional revenue is derived from the network programming carried by each. Expiration dates of the network contracts for WFLA-TV-NBC, WJKS-TV-ABC and WCBD-TV-ABC are April 1995, April 1994 and July 1995, respectively. The Company's television stations are in competition for audience and advertising revenues with other television and radio stations and cable television systems as well as magazines, newspapers and other promotional media. A number of cable television systems which operate generally on a subscriber payment basis are in business in the Company's broadcasting markets and compete for audience by importing out-of-market television signals or by originating programming. The Company's cable television systems have substantially the same competition as its television stations. The television stations and cable television systems compete for audience on the basis of program content and quality of reception, and for advertising revenues on the basis of price, share of market and performance. Reference is made to page 49 of the 1993 Annual Report to Stockholders which is incorporated herein by reference for market share and other information regarding the Company's television stations. Newsprint Paper Manufacturing Business For a description of the business done, principal products produced and sources and availability of raw materials used by the Company in its newsprint paper manufacturing business, see pages 16 and 18 of the 1993 Annual Report to Stockholders, which are incorporated herein by reference. In addition to its Garden State Paper Company, Inc., (Garden State) mill in Garfield, New Jersey, the Company owns a 33 1/3% interest in the Southeast Paper Manufacturing Co. newsprint mill in Dublin, Georgia, which licenses and utilizes the Garden State process, a proprietary de-inking technology for the production of 100 percent recycled newsprint from recovered used newspapers. The Company earns royalties and fees pursuant to a contract with this venture, in addition to its share of operating results. The Company also owns a 49% interest in a Mexican newsprint mill near San Luis Potosi, Mexico, from which the Company receives option fees based on production. Under the terms of the Company's Option Agreement with this affiliate, the Company will continue to receive such fees through October 15, 1994. Unless some other form of divestiture is agreed to, on that date the affiliate's majority owner is expected to exercise its option to buy the Company's capital stock investment in the affiliate for $3.6 million, after which no further fees would be paid to the Company. Garden State owns certain United States patent rights and also has obtained patents in various foreign countries. Although these have been of value, their loss would not materially affect the conduct of its business as the Company has developed substantial proprietary knowledge related to its manufacturing process which enhances its competitive position. Garden State competes with approximately twenty Canadian and American companies in selling newsprint, its sole product, to newspaper publishers. Distribution from the Garden State mill is primarily by truck transportation. Competition is based principally on price, quality of product, and service, although the percentage of recovered fiber contained in manufactured newsprint is becoming increasingly important to newspaper publishers to meet various existing and proposed state and federal standards. Item 2. Item 2. Properties The Company's headquarters and Richmond Newspapers, Inc., are located in Richmond, Virginia, in five adjacent buildings. In addition, Richmond Newspapers, Inc., completed and placed in service, on June 1, 1992, a 428,000 square foot production and distribution facility, located on an 86 acre site in Hanover County, Virginia, near Richmond. The Tampa, Florida, newspapers are published in a single unit production plant and office building located on a six acre tract in that city. The Winston-Salem, North Carolina, newspapers are also published in a single unit plant, although a new 140,000 square foot production and distribution facility, scheduled for completion in mid-1994, is currently under construction on a 12 acre site located near the present facility. All of the foregoing properties are Company-owned. Television facilities for WFLA-TV Tampa, Florida, WJKS-TV Jacksonville, Florida, and WCBD-TV Charleston, South Carolina, are located on land owned by the Company in and around these respective cities. Media General Cable of Fairfax County, Inc., a subsidiary of the Company, has headquarters located in one building owned by the Company in Chantilly, Virginia, and two head-ends located in Fairfax County, Virginia, one on property owned by the Company and adjacent to its production studio and one on leased property. In addition, Fairfax Cable leases an operations center for its service maintenance fleet in Springfield, Virginia. The cable system includes a home subscriber network and a separate institutional network. Newsprint production facilities of Garden State consist of a mill in Garfield, New Jersey, housing two paper-making machines adjacent to a power plant which supplies it with steam and electric power. Both the mill and the power plant are owned by Garden State. Garden State also owns or leases substantial storage facilities for waste paper in the general vicinity of the newsprint mill. Item 3. Item 3. Legal Proceedings Certain of the Company's subsidiaries have been identified as potentially responsible parties, along with many other businesses unrelated to the Company, in connection with the alleged soil and/or groundwater contamination at a former commercial waste disposal site, a former industrial drum recycling location and a former waste oil recycling location. With respect to these matters, these subsidiaries have contributed, or may in the future be asked to contribute, to the costs of site assessment and cleanup. In addition, the Company and one of its subsidiaries are currently involved in environmental assessment and remediation projects at one facility formerly owned, and one facility currently owned. While the ultimate costs of the foregoing matters are not presently determinable, based on information currently available, management believes such costs will not be material to the Company's financial position or results of operations. 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 1993. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Reference is made to page 47 of the 1993 Annual Report to Stockholders which is incorporated herein by reference for information required by this item. Item 6. Item 6. Selected Financial Data Reference is made to Note 5 on pages 31 through 32, and to pages 50 and 51 of the 1993 Annual Report to Stockholders which are incorporated herein by reference for information required by this item. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to pages 40 through 46 of the 1993 Annual Report to Stockholders which are incorporated herein by reference for information required by this item. Item 8. Item 8. Financial Statements and Supplementary Data Consolidated financial statements of the Company as of December 26, 1993, and December 27, 1992, and for the fiscal years ended December 26, 1993, December 27, 1992, and December 29, 1991, and the report of independent auditors thereon, as well as the Company's unaudited quarterly financial data for the fiscal years ended December 26, 1993, and December 27, 1992, are incorporated herein by reference from the 1993 Annual Report to Stockholders pages 23 through 39 and page 47. 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 herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders on May 20, 1994, except as to certain information regarding executive officers included in Part I. Matters regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 are incorporated by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders on May 20, 1994. Item 11. Item 11. Executive Compensation Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders on May 20, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders on May 20, 1994. Item 13. Item 13. Certain Relationships and Related Transactions Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders on May 20, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)1. and 2. The financial statements and schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this annual report. 3.Exhibits The exhibits listed in the accompanying index to exhibits are filed as part of this annual report. (b)Reports on Form 8-K None Index to Financial Statements and Financial Statement Schedules - Item 14(a) Annual Report Form to 10-K Stockholders Media General, Inc. (Registrant) Report of independent auditors 9 39 Consolidated statements of operations for the fiscal years ended December 26, 1993, December 27, 1992, and December 29, 1991 23 Consolidated balance sheets at December 26, 1993, and December 27, 1992 24-25 Consolidated statements of stockholders' equity for the fiscal years ended December 26, 1993, December 27, 1992, and December 29, 1991 26 Consolidated statements of cash flows for the fiscal years ended December 26, 1993, December 27, 1992, and December 29, 1991 27 Notes to consolidated financial statements 28-38 Schedules: V - Property, plant and equipment 10 VI - Accumulated depreciation and amortization of property, plant and equipment 11 VIII - Valuation and qualifying accounts and reserves 12-13 X - Supplementary income statement information 14 Schedules other than those listed above are omitted since they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. The consolidated financial statements of Media General, Inc., listed in the above index which are included in the Annual Report to Stockholders of Media General, Inc., for the fiscal year ended December 26, 1993, are incorporated herein by reference. With the exception of the pages listed in the above index and the information incorporated by reference included in Part I, II, and IV, the 1993 Annual Report to Stockholders is not deemed filed as part of this report. CONSENT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Media General, Inc. We consent to the incorporation by reference in this Annual Report (Form 10-K) of Media General, Inc., of our report dated January 25, 1994, included in the 1993 Annual Report to Stockholders of Media General, Inc. Our audits also included the financial statement schedules of Media General, Inc., listed in Item 14(a). 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. We also consent to the incorporation by reference in (a) the Registration Statement (Form S-8 No. 2-56905) pertaining to the 1971 Unqualified Stock Option Plan and the 1976 Qualified and Non-Qualified Stock Option Plans of Media General, Inc.; (b) the Registration Statement (Form S-8 No. 33-29478) pertaining to the Media General, Inc., Employees Thrift Plan; (c) the Registration Statement (Form S-8 No. 33-23698) pertaining to the 1987 Non-Qualified Stock Option Plan of Media General, Inc.; (d) the Registration Statement (Form S-3 No. 33-26853) pertaining to the Media General, Inc., Automatic Dividend Reinvestment and Stock Purchase Plan and (e) the Registration Statement (Form S- 8 No. 33-52472) pertaining to the 1987 Non-Qualified Stock Option Plan of Media General, Inc., amended and restated May 17, 1991, and in the Prospectus related to each, of our report dated January 25, 1994, with respect to the consolidated financial statements of Media General, Inc., incorporated herein by reference, and our report included in the preceding paragraph with respect to the financial statement schedules of Media General, Inc., included in this Annual Report (Form 10-K) of Media General, Inc., for the fiscal year ended December 26, 1993. ERNST & YOUNG Richmond, Virginia March 22, 1994 Index to Exhibits Exhibit Number Description 2 Letter Agreement dated March 16, 1994, by and among Media General, Inc., Affiliated Newspaper Investment Company, and Garden State Newspapers, Inc. 3(i) The Amended and Restated Articles of Incorporation of Media General, Inc., incorporated by reference to Exhibit 3.1 of Form 10-K for the fiscal year ended December 31, 1989. 3(ii) Bylaws of Media General, Inc., amended as of May 31, 1993. 10.1 1971 Unqualified Stock Option Plan, incorporated by reference to Exhibit 1 to Post-Effective Amendment No. 2 to Registration Statement No. 2-38001. 10.2 Amendment to the 1971 Unqualified Stock Option Plan adopted February, 1974, incorporated by reference to Exhibit 1 to Post-Effective Amendment No. 6 of Registration Statement No. 2-38001. 10.3 Amendment to the 1971 Unqualified Stock Option Plan adopted July 29, 1983, incorporated by reference to Exhibit 10.3 of Form 10-K for the fiscal year ended December 31, 1983. 10.4 Form of Option granted under the 1971 Unqualified Stock Option Plan prior to February, 1974, incorporated by reference to Exhibit 2 to Post-Effective Amendment No. 2 of Registration Statement No. 2-38001. 10.5 Form of Option granted under the 1971 Unqualified Stock Option Plan subsequent to February, 1974, incorporated by reference to Exhibit 2 to Post-Effective Amendment No. 6 of Registration Statement No. 2-38001. 10.6 Addendum dated January, 1984, to Form of Option granted under the 1971 Unqualified Stock Option Plan, incorporated by reference to Exhibit 10.7 of Form 10-K for the fiscal year ended December 31, 1983. 10.7 Addendum dated June 19, 1992, to Form of Option granted under the 1971 Unqualified Stock Option Plan, incorporated by reference to Exhibit 10.7 of Form 10-K for the fiscal year ended December 27, 1992. 10.8 The 1976 Non-Qualified Stock Option Plan, incorporated by reference to Exhibit 1.2 to Registration Statement 2-56905. 10.9 Amendment to the 1976 Non-Qualified Stock Option Plan adopted July 29, 1983, incorporated by reference to Exhibit 10.9 of Form 10-K for the fiscal year ended December 31, 1983. 10.10 Amendment to the 1976 Non-Qualified Stock Option Plan adopted June 19, 1992, incorporated by reference to Exhibit 10.10 of Form 10-K for the fiscal year ended December 27, 1992. 10.11 Form of Option granted under the 1976 Non-Qualified Stock Option Plan, incorporated by reference to Exhibit 2.2 of Registration Statement 2- 56905. 10.12 Amendment to the 1976 Non-Qualified Stock Option Plan, dated December 9, 1978, incorporated by reference to Exhibit 1 to Post-Effective Amendment No. 3 of Registration Statement 2-56905. 10.13 Additional Form of Option to be granted under the 1976 Non-Qualified Stock Option Plan, incorporated by reference to Exhibit 2 to Post- Effective Amendment No. 3 Registration Statement 2-56905. 10.14 Addendum dated January, 1984, to Form of Option granted under the 1976 Non-Qualified Stock Option Plan, incorporated by reference to Exhibit 10.13 of Form 10-K for the fiscal year ended December 31, 1983. 10.15 Addendum dated June 19, 1992, to Form of Option granted under the 1976 Non-Qualified Stock Option Plan, incorporated by reference to Exhibit 10.15 of Form 10-K for the fiscal year ended December 27, 1992. 10.16 The 1987 Non-Qualified Stock Option Plan adopted May 15, 1987, and as amended on August 21, 1987, incorporated by reference to Exhibit 10.14 of Form 10-K for the fiscal year ended December 31, 1987. 10.17 The Media General, Inc., Restricted Stock Plan adopted May 17, 1991, incorporated by reference to Exhibit 10.1 of Form 10-Q for the quarter ended June 30, 1991. 10.18 Amendment to the 1987 Non-Qualified Stock Option Plan, adopted May 17, 1991, incorporated by reference to Exhibit 10.2 of Form 10-Q for the quarter ended June 30, 1991. 10.19 Amendment to the 1987 Non-Qualified Stock Option Plan adopted June 19, 1992, incorporated by reference to Exhibit 10.19 of Form 10-K for the fiscal year ended December 27, 1992. 10.20 Addendum dated June 19, 1992, to Form of Option granted under the 1987 Non-Qualified Stock Option Plan, incorporated by reference to Exhibit 10.20 of Form 10-K for the fiscal year ended December 27, 1992. 10.21 Media General, Inc., Executive Death Benefit Plan effective January 1, 1991, incorporated by reference to Exhibit 10.17 of Form 10-K for the fiscal year ended December 29, 1991. 10.22 Amendment to the Media General, Inc., Executive Death Benefit Plan dated July 24, 1991, incorporated by reference to Exhibit 10.18 of Form 10-K for the fiscal year ended December 29, 1991. 10.23 1984 Outside Directors Retirement Agreement, incorporated by reference to Exhibit 10.16 of Form 10-K for the fiscal year ended December 31, 1984. 10.24 Employment Agreement between Media General, Inc., and D. Tennant Bryan, dated January 1, 1973, incorporated by reference to Exhibit 10.9 of Form 8 dated August 3, 1981. 10.25 Amendment dated September 24, 1981, to Employment Agreement between Media General, Inc., and D. Tennant Bryan dated January 1, 1973, incorporated by reference to Exhibit 10 of Form 10-Q for the quarter ended September 30, 1981. 10.26 Shareholders Agreement, dated May 28, 1987, between Mary Tennant Bryan, Florence Bryan Wisner, J. Stewart Bryan III, and D. Tennant Bryan and J. Stewart Bryan III as Trustees under D. Tennant Bryan Media Trust, and Media General, Inc., incorporated by reference to Exhibit 10.50 of Form 10-K for the fiscal year ended December 31, 1987. 10.27 Amended and Restated Redemption Agreement between Media General, Inc., and D. Tennant Bryan, dated January 29, 1988, incorporated by reference to Exhibit 10.20 of Form 10-K for the fiscal year ended December 31, 1987. 10.28 Employment Contract between Media General, Inc., and Alan S. Donnahoe, dated January 1, 1977, incorporated by reference to Exhibit 10.15 of Form 8 dated August 3, 1981. 10.29 Amendment, dated March 22, 1979, to Employment Contract between Media General, Inc., and Alan S. Donnahoe, dated January 1, 1977, incorporated by reference to Exhibit 10.16 of Form 8 dated August 3, 1981. 10.30 Amendment, dated January 1, 1982, to Employment Contract between Media General, Inc., and Alan S. Donnahoe, dated January 1, 1977, incorporated by reference to Exhibit 10.23 of Form 10-K for the fiscal year ended December 31, 1981. 10.31 Amendment, dated December 1, 1984, to Employment Contract between Media General, Inc., and Alan S. Donnahoe, dated January 1, 1977, incorporated by reference to Exhibit 10.22 of Form 10-K for the fiscal year ended December 31, 1984. 10.32 Amendment, dated December 1, 1989, to Employment Contract between Media General, Inc., and Alan S. Donnahoe, dated January 1, 1977, incorporated by reference to Exhibit 10.25 of Form 10-K for the fiscal year ended December 31, 1989. 10.33 Consulting Agreement between Media General, Inc., and James S. Evans, dated January 1, 1992, incorporated by reference to Exhibit 10.29 of Form 10-K for the fiscal year ended December 29, 1991. 10.34 Media General, Inc., Supplemental Thrift Plan dated July 15, 1987, incorporated by reference to Exhibit 10.27 of Form 10-K for the fiscal year ended December 31, 1989. 10.35 Amended and Restated Media General, Inc., Executive Supplemental Retirement Plan adopted as of January 1, 1991, incorporated by reference to Exhibit 10.32 of Form 10-K for the fiscal year ended December 29, 1991. 10.36 Deferred Income Plan for Selected Key Executives of Media General, Inc., and form of Deferred Compensation Agreement thereunder dated as of December 1, 1984, incorporated by reference to Exhibit 10.29 of Form 10-K for the fiscal year ended December 31, 1989. 10.37 Amended and Restated Deferred Compensation Agreement between Media General, Inc., and James S. Evans, incorporated by reference to Exhibit 10.30 of Form 10-K for the fiscal year ended December 31, 1989. 10.38 Media General, Inc., Management Performance Award Program, adopted November 16, 1990, and effective January 1, 1991, incorporated by reference to Exhibit 10.35 of Form 10-K for the fiscal year ended December 29, 1991. 10.39 Media General, Inc., Deferred Compensation Plan dated March 28, 1991, effective July 1, 1991, incorporated by reference to Exhibit 10.38 of Form 10-K for the fiscal year ended December 29, 1991. 10.40 Media General, Inc., ERISA Excess Benefits Plan effective January 1, 1991, incorporated by reference to Exhibit 10.39 of Form 10-K for the fiscal year ended December 29, 1991. 10.41 Employment Contract between Media General, Inc., and Basil Snider, Jr., dated March 18, 1994 10.42 Amended and Restated Partnership Agreement, dated November 1, 1987, by and among Virginia Paper Manufacturing Corp., KR Newsprint Company, Inc., and CEI Newsprint, Inc., incorporated by reference to Exhibit 10.31 of Form 10-K for the fiscal year ended December 31, 1987. 10.43 Amended and Restated License Agreement, dated November 1, 1987, by and among Media General, Inc., Garden State Paper Company, Inc., and Southeast Paper Manufacturing Co., incorporated by reference to Exhibit 10.32 of Form 10-K for the fiscal year ended December 31, 1987. 10.44 Amended and Restated Umbrella Agreement, dated November 1, 1987, by and among Media General, Inc., Knight-Ridder, Inc., and Cox Enterprises, Inc., incorporated by reference to Exhibit 10.34 of Form 10-K for the fiscal year ended December 31, 1987. 10.45 Amended Newsprint Purchase Contract, dated November 1, 1987, by and among Southeast Paper Manufacturing Co., Media General, Inc., Knight- Ridder, Inc., and Cox Enterprises, Inc., incorporated by reference to Exhibit 10.35 of Form 10-K for the fiscal year ended December 31, 1987. 10.46 Television affiliations agreement, dated March 22, 1989, between WFLA-TV and National Broadcasting Company, Inc., incorporated by reference to Exhibit 10.32 of Form 10-K for the fiscal year ended December 31, 1988. 10.47 Amendments, dated May 27, 1993, to television affiliations agreement, between WFLA-TV and National Broadcasting Company, Inc., dated March 22, 1989. 10.48 Franchise Agreements, dated September 30, 1982, between Media General, Inc., Media General Cable of Fairfax County, Inc., and Fairfax County, Virginia, as amended January 30, 1984, incorporated by reference to Exhibit 10.32 of Form 10-K for the fiscal year ended December 31, 1983. 10.49 Agreement dated March 14, 1988, between Media General Cable of Fairfax County, Inc., and Warner Cable Communications of Reston, Inc., partially assigning Franchise Agreements dated September 30, 1982, incorporated by reference to Exhibit 10.34 of Form 10-K for the fiscal year ended December 31, 1988. 10.50 Cable Television Franchise Ordinance of the Town of Herndon, Virginia, accepted January 24, 1984, by Media General, Inc., and Media General Cable of Fairfax County, Inc., incorporated by reference to Exhibit 10.33 of Form 10-K for the fiscal year ended December 31, 1983. 10.51 Franchise Agreement, dated June 14, 1983, between Media General, Inc., Media General Cable of Fairfax County, Inc., and the City of Fairfax, Virginia, incorporated by reference to Exhibit 10.34 of Form 10-K for the fiscal year ended December 31, 1983. 10.52 Franchise Agreement, dated April 9, 1983, between Media General Cable of Fairfax County, Inc., and the Town of Vienna, Virginia, incorporated by reference to Exhibit 10.35 of Form 10-K for the fiscal year ended December 31, 1983. 10.53 Franchise Agreement, dated July 12, 1983, between Media General Cable of Fairfax County, Inc., Media General, Inc., and the City of Falls Church, Virginia, incorporated by reference to Exhibit 10.36 of Form 10-K for the fiscal year ended December 31, 1983. 10.54 Garden State Newspapers, Inc., Second Amended and Restated Stock Purchase and Shareholders' Agreement dated as of March 31, 1990, incorporated by reference to Exhibit 10.45 of Form 10-K for the fiscal year ended December 31, 1990. 13 Media General, Inc., Annual Report to Stockholders for the fiscal year ended December 26, 1993. 21 List of subsidiaries of the registrant. 23 Consent of Ernst & Young, independent auditors. Note: Exhibits 10.1-10.41 are management contracts or compensatory plans, contracts or arrangements. 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. MEDIA GENERAL, INC. Date: March 17, 1994 By /s/ J. Stewart Bryan III --------------------------------------------- J. Stewart Bryan III, Chairman, 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. Signature Title Date /s/ D. Tennant Bryan Chairman of the Executive March 17, 1994 - ----------------------------- D. Tennant Bryan Committee and Director /s/ James S. Evans Vice Chairman and Director March 17, 1994 - ----------------------------- James S. Evans /s/ Marshall N. Morton Senior Vice President and March 17, 1994 - ----------------------------- Marshall N. Morton Chief Financial Officer /s/ Stephen Y. Dickinson Controller March 17, 1994 - ----------------------------- Stephen Y. Dickinson /s/ Robert P. Black Director March 17, 1994 - ----------------------------- Robert P. Black /s/ Charles A. Davis Director March 17, 1994 - ----------------------------- Charles A. Davis /s/ A. S. Donnahoe Director March 17, 1994 - ----------------------------- A. S. Donnahoe /s/ Robert V. Hatcher, Jr. Director March 17, 1994 - ----------------------------- Robert V. Hatcher, Jr. /s/ John G. Medlin, Jr. Director March 17, 1994 - ----------------------------- John G. Medlin, Jr. /s/ Henry L. Valentine, II Director March 17, 1994 - ----------------------------- Henry L. Valentine, II

850033_1993.txt

850033_1993

1993

850033

ITEM 1. BUSINESS DESCRIPTION OF THE TRUST BP Prudhoe Bay Royalty Trust (the "Trust"), a grantor trust, was created as a Delaware business trust. The Trust has been established by The Standard Oil Company ("Standard Oil") and is administered by The Bank of New York, as trustee (collectively with the co-trustee located in Delaware, the "Trustee"), pursuant to the BP Prudhoe Bay Royalty Trust Agreement dated February 28, 1989 by and among Standard Oil, BP Exploration (Alaska) Inc. (the "Company") and the Trustee (the "Trust Agreement"). The Company and Standard Oil are indirect, wholly owned subsidiaries of The British Petroleum Company p.l.c. ("BP"). The Trustee's offices are located at 101 Barclay Street, New York, New York 10286 and its telephone number is (212) 815-5092. Upon creation of the Trust, the Trust acquired an overriding royalty interest (the "Royalty Interest"), which entitles the Trust to a Per Barrel Royalty, as defined herein, on 16.4246% of the first 90,000 barrels of the average actual daily net production of oil and condensate per quarter (the "Royalty Production") from the Company's working interest in the Prudhoe Bay Unit (the "PBU"). The Royalty Interest was conveyed to Standard Oil pursuant to the terms of an Overriding Royalty Conveyance dated February 27, 1989 (the "Overriding Conveyance") and from Standard Oil to the Trust by a Trust Conveyance dated February 28, 1989 (the "Trust Conveyance"). The Overriding Conveyance and the Trust Conveyance are herein collectively referred to as the "Conveyance". The Royalty Interest is free of any exploration and development expenditures. The Trust is a passive entity, and the Trustee has been given only such powers as are necessary for the collection and distribution of revenues from the Royalty Interest and the payment of Trust liabilities and expenses. The Trust has been formed under the Delaware Trust Act, which entitles holders of the Units of Beneficial Interest (the "Trust Units") to the same limitation of personal liability as stockholders of a corporation are afforded under Delaware law. The Trust Units evidence undivided interests in the Trust and are listed on the New York Stock Exchange under the ticker symbol "BPT". The Trust Units are not an interest in or obligation of the Company, Standard Oil or BP. The ultimate value of the Royalty Interest will be dependent on the Royalty Production and the Per Barrel Royalty for each day. The "Per Barrel Royalty" for any day will equal the per barrel price of West Texas Intermediate crude oil, less scheduled chargeable costs, as adjusted, and production taxes. See "Description of the Royalty Interest." In certain circumstances, the Royalty Interest provided for a minimum royalty payment of $8.92 per barrel of Royalty Production, if any, from the PBU for each quarter through September 30, 1991; for all quarters thereafter there is no minimum royalty payment. Pursuant to a Support Agreement among BP, the Company, Standard Oil and the Trust, BP has guaranteed the performance by the Company of its payment obligations with respect to the Royalty Interest. The only assets of the Trust are (i) the Royalty Interest assigned to the Trust and, (ii) from time to time, cash reserves and cash equivalents being held by the Trustee for distribution. Subject to compliance with certain conditions, additional royalty interests may be assigned to the Trust. See "Description of the Trust Units and the Trust Agreement- Additional Conveyances." The value of the Trust Units is substantially dependent upon estimates of proved reserves, production and the value of oil. Estimates of proved reserves are inherently imprecise and subjective and are revised over time as additional data becomes available. Such revisions may often be substantial. See "Report of Miller and Lents, Ltd.", independent petroleum consultants, included herein. The Company shares control of the operation of the PBU with the other working interest owners, and has no obligation to continue production from the PBU or to maintain production at any level and may interrupt or discontinue production at any time. In addition, the operation of the PBU is subject to normal operating hazards incident to the production and transportation of oil in Alaska. In the event of damage to the PBU which is covered by insurance, the Company has no obligation to use insurance proceeds to repair such damage and may elect to retain such proceeds and close damaged areas to production. The financial statements of the Trust contained in this Annual Report on Form 10-K include information regarding amounts distributed to Trust Unit holders with respect to 1993, 1992, and 1991. This Annual Report also includes information with respect to 1993 production and production in past periods. Amounts distributed with respect to 1993, 1992, and 1991, production in 1993 and in the past, and the most recent estimates of proved reserves attributable to the Trust are not indicative of amounts to be distributed in the future. The following information is subject to the detailed provisions of the Trust Agreement, the Overriding Conveyance, and the Trust Conveyance. The provisions governing the Trust are complex and extensive, and no attempt has been made below to describe all of such provisions. The following is a general description of the basic framework of the Trust and reference is made to the Trust Agreement for detailed provisions concerning the Trust. DESCRIPTION OF THE TRUST UNITS AND THE TRUST AGREEMENT CREATION AND ORGANIZATION OF THE TRUST The Trust holds the Royalty Interest pursuant to the terms of the Trust Agreement and the Conveyance, subject to the laws of the States of Alaska and Delaware. The beneficial interest in the Trust created by the Trust Agreement is divided into equal undivided portions called Trust Units. See the discussion below under "Trust Units". The Bank of New York (Delaware) has been appointed co-trustee in order to satisfy certain requirements of the Delaware Trust Act, but The Bank of New York alone is able to exercise the rights and powers granted to the Trustee in the Trust Agreement. ASSETS OF THE TRUST The Royalty Interest is the only asset of the Trust, other than cash being held for the payment of expenses and liabilities and for distribution to the holders of Trust Units. See "Duties and Limited Powers of Trustee". LIABILITY OF THE TRUST Because of the passive nature of the Trust's assets and the restrictions on the power of the Trustee to incur obligations, it is anticipated that the only liabilities the Trust will incur will be those for routine administrative expenses, such as Trustee's fees, and accounting, legal and other professional fees. However, if a court were to hold that the Trust is an association taxable as a corporation, as more fully discussed in "Certain Tax Considerations-Federal Income Tax- Classification of the Trust", the Trust would incur substantial income tax liabilities in addition to its other expenses. In addition, if the Trust were required to make allocations of income and deductions other than on a quarterly basis, the administrative expenses of the Trust might increase. See "Certain Tax Considerations-Federal Income Tax-Taxation of Trust Unit Holders". The administrative fees and expenses of the Trust for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 were approximately $555,000, $415,000, $415,000, $460,000 and $170,000, respectively, including fees paid by the Trust to accountants, petroleum consultants and counsel. Future administrative fees and expenses will depend, among other things, on the number of Trust Unit holders and the fees of accountants, petroleum consultants, counsel and other experts, if any, engaged by the Trust. DUTIES AND LIMITED POWERS OF TRUSTEE The duties of the Trustee are as specified in the Trust Agreement and by the laws of the State of Delaware. The basic function of the Trustee is to collect income from the Royalty Interest, to pay out of the Trust's income and assets all expenses, charges and obligations and to pay available cash to holders of Trust Units. The Trustee may establish a cash reserve for the payment of material liabilities of the Trust which may become due, if the Trustee has determined that it is not practical to pay such liabilities on subsequent Quarterly Record Dates (as defined below) out of funds anticipated to be available on such dates and that, in the absence of such reserve, the trust estate is subject to the risk of loss or diminution in value or The Bank of New York is subject to the risk of personal liability for such liabilities, provided that, except in certain limited circumstances, it has received an opinion of counsel to the effect that the establishment and maintenance of such reserve will not adversely affect the classification of the Trust as a "grantor trust" for federal income tax purposes or cause the income from the Trust to be treated as unrelated business taxable income for federal income tax purposes. The Trustee is obligated, subject to certain conditions, to borrow funds required to pay liabilities of the Trust, if they become due, and pledge or otherwise encumber the Trust's assets, if it determines that the cash on hand is insufficient to pay such liabilities and that it is not practical to pay such liabilities on subsequent Quarterly Record Dates out of funds anticipated to be available on such dates, provided that, except in certain limited circumstances, it has received an opinion of counsel to the effect described above. Borrowings must be repaid in full before any further distributions are made to holders of Trust Units. All distributable cash of the Trust will be distributed on a quarterly basis. To date, and until certain requirements of the Trust Agreement are met concerning the status of the assets of the Trust for purposes of certain Department of Labor regulations, all distributions to Trust Unit holders must be made as soon as practicable and the Trustee must hold cash received uninvested pending such distribution. The Trustee is required to invest any cash being held by it for distribution on the next distribution date or being held by it as a reserve for liabilities in U.S. Obligations or, if U.S. Obligations having a maturity date on the next distribution date are not available, repurchase agreements with banks, including The Bank of New York, secured by U.S. Obligations and meeting certain specified requirements. Any U.S. Obligation or any such repurchase agreement must mature on the next distribution date or on the due date of the liability with respect to which the reserve is established, if known, and subject to certain exceptions, will be held to maturity. The Trustee is required, in certain circumstances, to invest the cash being held by it in an overnight time deposit with a bank, including The Bank of New York. Amounts being held by the Trustee after the date fixed for distribution of assets upon termination of the Trust, however, must be held uninvested. The Trust Agreement grants the Trustee only such rights and powers as are necessary to achieve the purposes of the Trust. The Trust Agreement prohibits the Trust from engaging in any business, commercial or, with certain exceptions, investment activity of any kind and from using any portion of the assets of the Trust to acquire any oil and gas lease, royalty or other mineral interest. The Trustee may sell Trust properties only as authorized by a vote of the holders of Trust Units, or when necessary, to provide for the payment of specific liabilities of the Trust then due (if, among other things, the Trustee determines that it is not practicable to submit such sale to a vote of the holders of Trust Units, and it receives an opinion of counsel to the effect that such sale will not adversely affect the classification of the Trust as a "grantor trust" for federal income tax purposes), or upon termination of the Trust. Pledges or other encumbrances to secure borrowings are permitted without a vote of holders of Trust Units if the Trustee determines such action is advisable. Any sale of Trust properties must be for cash unless otherwise authorized by the holders of Trust Units, and the Trustee is obligated to distribute the available net proceeds of any such sale to the holders of Trust Units after establishing reserves for liabilities of the Trust. LIABILITIES OF TRUSTEE Except in the circumstances described below, in which the Company will indemnify the Trustee and The Bank of New York in its individual capacity, the Trustee and The Bank of New York in its individual capacity will be indemnified out of the assets of the Trust for any liability, expense, claim, damage or other loss incurred by it in the performance of its duties unless such loss results from its negligence, bad faith, or fraud or from its expenses in carrying out such duties exceeding the compensation and reimbursement it is entitled to under the Trust Agreement. The Trustee and The Bank of New York in its individual capacity will be indemnified by the Company for liabilities to the extent described above (a) whenever the assets of the Trust are insufficient or not permitted by applicable law to provide such indemnity and (b) after the termination of the Trust, to the extent that the Trustee did not have knowledge or should not have reasonably known of a potential claim against the Trustee for which a reserve could have been established and used to satisfy such claim prior to the final distribution of assets of the Trust upon its termination. In no event will the Trustee be deemed to have acted negligently, fraudulently or in bad faith if it takes or suffers action in good faith in reliance upon and in accordance with the written advice of counsel or other experts. The Trustee is not entitled to indemnification from the holders of Trust Units except in certain limited circumstances related to the replacement of mutilated, destroyed, lost or stolen certificates. In addition, the Company has agreed to indemnify and hold the Trustee and the Trust harmless from certain liabilities under the federal securities laws. RESIGNATION OR REMOVAL OF TRUSTEE The Trustee may resign at any time or be removed with or without cause by the holders of a majority of the outstanding Trust Units. Its successor must be a corporation organized and doing business under the laws of the United States, any state thereof or the District of Columbia authorized under such laws to exercise trust powers, or a national banking association domiciled in the United States, in either case having a combined capital, surplus and undivided profits of at least $50,000,000 and subject to supervision or examination by federal or state authorities. Unless the Trust already has a trustee that is a resident of or has a principal office in the State of Delaware, then any successor trustee will be such a resident or have such a principal office. No resignation or removal of the Trustee shall become effective until a successor trustee shall have accepted such appointment. DURATION OF TRUST The Trust is irrevocable and the Company has no power to terminate the Trust or, except with respect to certain corrective amendments agreed to by the Trustee, to alter or amend the terms of the Trust Agreement. The Trust will terminate upon the first to occur of the following events or times: (a) upon a vote of holders of not less than 70% of the outstanding Trust Units, on or prior to December 31, 2010, in accordance with the procedures described under "Voting Rights of Holders of Trust Units" below, or (b) after December 31, 2010 either (i) at such time as the net revenues from the Royalty Interest for two successive years commencing after 2010 are less than $1,000,000 per year, unless the net revenues during such period have been materially and adversely affected by an event constituting force majeure, or (ii) upon a vote of holders of not less than 60% of the outstanding Trust Units. Upon the dissolution of the Trust, the Trustee will continue to act in such capacity until completion of the winding up of the affairs of the Trust. Upon termination of the Trust, the Trustee will sell Trust properties in one or more sales for cash, unless holders representing 70% of the Trust Units outstanding (60% if the decision to terminate the Trust is made after December 31, 2010) authorize the sale for a specified non-cash consideration in which event the Trustee may, but is not obligated to, consummate such non-cash sale, but only if the Trustee shall have received a ruling from the Internal Revenue Service (the "IRS") or an opinion of counsel to the effect that such non-cash sale will not adversely affect the classification of the Trust as a grantor trust for federal income tax purposes or cause the income from the Trust to be treated as unrelated business taxable income for federal income tax purposes. Prior to such sale the Trustee will obtain an opinion of an investment banking firm or other entity qualified to give such opinion as to the fair market value of the assets of the Trust on the day of termination of the Trust. The Trustee will effect any such sale pursuant to procedures or material terms and conditions approved by the vote of holders of 70% of the outstanding Trust Units (60% if the sale is made after December 31, 2010) in accordance with the procedures described under "Voting Rights of Holders of Trust Units" below, unless the Trustee determines that it is not practicable to submit such procedures or terms to a vote of the holders of Trust Units, and the sale is effected at a price which is at least equal to the fair market value of the trust estate as set forth in the opinion mentioned above and pursuant to terms and conditions deemed commercially reasonable by the investment banking firm or other entity rendering such opinion. Upon dissolution of the Trust, the Company will have an option to purchase the Royalty Interest at a price equal to the greater of (i) the fair market value of the trust estate as set forth in the opinion mentioned above, or (ii) the number of then outstanding Trust Units multiplied by (a) the closing price of Trust Units on the day of termination of the Trust on the stock exchange on which the Trust Units are listed, or (b) if the Trust Units are not listed on any stock exchange but are traded in the over-the counter market, the closing bid price on the day of termination of the Trust as quoted on the National Market System of the National Association of Securities Dealers Automated Quotation System. If the Trust Units are neither listed nor traded in the over-the-counter market, the price will be the fair market value of the trust estate as set forth in the opinion mentioned above. After satisfying all existing liabilities and establishing adequate reserves for the payment of contingent liabilities, the Trustee will distribute all available proceeds to the holders of Trust Units on the date specified in a notice given by the Trustee, which date will be no later than 10 days after delivery of such notice. The Trustee cannot predict what amount it will be able to receive for the Trust's assets if the Trust terminates or the expenses which the Trust may incur in attempting to sell the assets. VOTING RIGHTS OF HOLDERS OF TRUST UNITS Although holders of Trust Units possess certain voting rights, their voting rights are not comparable to those of shareholders of a corporation. For example, there is no requirement for annual meetings of holders of Trust Units or annual or other periodic reelection of the Trustee. Meetings of holders of Trust Units may be called by the Trustee at any time at its discretion and must be called by the Trustee at the written request of holders of not less than 25% of the then outstanding Trust Units or at the request of the Company or as may be required by law or applicable regulation. The presence of a majority of the outstanding Trust Units is necessary to constitute a quorum, and holders may vote in person or by proxy. Notice of any meeting of holders of Trust Units must be given not more than 60 nor fewer than 10 days prior to the date of such meeting. The notice must state the purpose or purposes of the meeting and no other matter may be presented or acted upon at the meeting. The Trust Agreement may be amended without a vote of the holders of Trust Units to cure an ambiguity, to correct or supplement any provision of the Trust Agreement that may be inconsistent with any other such provision or to make any other provision with respect to matters arising under the Trust Agreement that do not adversely affect the holders of Trust Units. The Trust Agreement may also be amended with the approval of a majority of the outstanding Trust Units at any duly called meeting of holders of Trust Units. However, no such amendment may alter the relative rights of Trust Unit holders unless approved by the affirmative vote of 100% of the holders of Trust Units and by the Trustee or reduce or delay the distributions to the holders of Trust Units or effect certain other changes unless approved by the affirmative vote of 80% of the holders of Trust Units and by the Trustee. No amendment will be effective until the Trustee has received a ruling from the IRS or an opinion of counsel to the effect that such modification will not adversely affect the classification of the Trust as a "grantor trust" for federal income tax purposes or cause the income from the Trust to be treated as unrelated business taxable income for federal income tax purposes. Removal of the Trustee will require the affirmative vote of the holders of a majority of the Trust Units represented at a duly called meeting of the holders of Trust Units. A successor trustee may be appointed by the holders of Trust Units at such meeting. If the Trustee has given notice of its intention to resign, a successor trustee will be appointed by the Company. The sale of all or any part of the Royalty Interest must be authorized by the affirmative vote of the holders of 70% of the outstanding Trust Units (60% if such sale is to be effected after December 31, 2010), provided that if such sale is effected in order to provide for the payment of specific liabilities of the Trust then due and involves a part, but not all or substantially all, of the assets of the Trust, such sale may be approved by the affirmative vote of holders of a majority of the outstanding Trust Units. However, subject to certain conditions, the Trustee may, without a vote of the holders of Trust Units, sell all or any part of the Trust assets if necessary to provide for the payment of specific liabilities of the Trust then due or upon termination of the Trust. The Trust can be terminated by the holders of Trust Units only if the termination is approved by the holders of 70% of the Trust Units (on or prior to December 31, 2010) or of 60% of the Trust Units (after December 31, 2010). The Trust may also be terminated after December 31, 2010 if the net revenues from the Royalty Interest for two successive years commencing after 2010 are less than $1,000,000 per year, unless the net revenues have been materially and adversely affected by an event constituting force majeure. The Company and Standard Oil will vote or cause to be voted any Trust Units held of record or beneficially by the Company, Standard Oil or any affiliate of either of them in the same proportion as the Trust Units voted by other holders of Trust Units at such meeting. TRUST UNITS Each Trust Unit represents an equal undivided share of beneficial interest in the Trust. Trust Units are evidenced by transferable certificates issued by the Trustee. If at any time there is assigned to the Trust an Additional Royalty Interest, the beneficial interest in the Trust will thereafter be considered to be divided into a number of Trust Units equal to the sum of the number of Trust Units existing prior to such assignment and the number of Trust Units created upon such assignment. The Trust Units will not represent an interest in or obligation of the Company, Standard Oil or any of their respective affiliates. Except in the limited circumstances described under "Additional Conveyances" each Trust Unit will entitle its holder to the same rights as the holder of any other Trust Unit, and the Trust will have no other authorized or outstanding class of equity securities. There are 21,400,000 Trust Units outstanding. DISTRIBUTIONS OF INCOME The Company will pay the Trust amounts due pursuant to the Royalty Interest on a quarterly basis on the fifteenth day after the end of each calendar quarter (or, if such day is not a business day, on the next succeeding business day) unless due to applicable law or stock exchange rules a different payment day is required. Distributions of Trust income are currently made as soon as practicable after receipt of such amounts by the Trustee. After certain requirements of the Trust Agreement concerning the status of the assets of the Trust under certain Department of Labor regulations are met, distributions of Trust income will be made on the fifth day (or if such day is not a business day, on the next succeeding business day) after the Trustee's receipt in same day finally collected funds of amounts to be received on a Quarterly Record Date for each Quarter (defined below) in each year during the term of the Trust. Such distribution will be made to the person in whose name the Trust Unit (or any predecessor Trust Unit) is registered at the close of business on the immediately preceding January 15, April 15, July 15, or October 15 (or, if such day is not a business day, on the next succeeding business day), as the case may be, unless the Trustee determines that a different date is required to comply with applicable law or stock exchange rules (each a "Quarterly Record Date"). A "Quarter", for purposes of the Trust Agreement, is a period of approximately three months beginning on the day after a Quarterly Record Date and continuing through and including the next succeeding Quarterly Record Date. The aggregate quarterly distribution of income (the "Quarterly Income Amount") will be the excess of (i) revenues from the Royalty Interest plus any decrease in cash reserves previously established for estimated liabilities and any other cash receipts of the Trust over (ii) the expenses and payments of liabilities of the Trust plus any net increase in cash reserves for estimated liabilities. If prior to the end of a Quarter the Trustee makes a determination of the Quarterly Income Amount which it anticipates will be distributed to holders of Trust Units on the Quarterly Record Date for such Quarter, based on notice provided to the Trustee by the Company, and the Quarterly Income Amount is not equal to the amount so determined due to late payment, the Trustee will treat such amounts when received as if they were received on such Quarterly Record Date. Payment of the respective pro rata portion of the aggregate quarterly distribution of income to each holder of Trust Units will be made by check mailed to each such holder, provided that holders of Trust Units may arrange for payments of $100,000 or more to be made by wire transfer in immediately available funds. TRANSFERS The Trustee acts as registrar and transfer agent for the Trust Units. Subject to the limitations set forth below and to the limitation described under "Additional Conveyances" below, Trust Units may be transferred by surrender of the certificates duly endorsed, or accompanied by a written instrument of transfer, in form satisfactory to the Trustee, duly executed by the holder of the Trust Unit or his attorney duly authorized in writing. No service charge will be made for any registration of transfer of Trust Units, but the Trustee may require the payment of a sum sufficient to cover any tax or other governmental charge that may be imposed in connection with any registration of transfer. Until a transfer is made in accordance with the regulations prescribed by the Trustee, the Trustee may conclusively treat as the owner of any Trust Unit, for all purposes, the holder shown by its records (except in the event of a purchase by the Company or a designee thereof of Trust Units subject to the Trustee's right of redemption, as described under "Possible Divestiture of Trust Units" below). Any transfer of a Trust Unit will vest in the transferee all rights of the transferor at the date of transfer, except that the transfer of a Trust Unit after the Quarterly Record Date for distribution will not transfer the right of the transferor to such distribution. The Trustee is specifically authorized to rely upon the application of Article 8 of the Uniform Commercial Code, the Uniform Act for Simplification of Fiduciary Security Transfers and other statutes and rules with respect to the transfer of securities, each as adopted and then in force in the State of Delaware, as to all matters affecting title, ownership, warranty or transfer of certificates and the Trust Units represented thereby. MUTILATED, DESTROYED, LOST OR STOLEN CERTIFICATES If a mutilated certificate is surrendered to the Trustee, the Trustee will execute and deliver in exchange therefor a new certificate. If there shall be delivered to the Trustee evidence of the destruction, loss or theft of a certificate and such security or indemnity as may be required to hold the Trust and the Trustee harmless, then, in the absence of notice to the Trustee that such certificate has been acquired by a bona fide purchaser, the Trustee will execute and deliver, in lieu of any such lost, stolen or destroyed certificate, a new certificate. In connection with the issuance of any new certificates, the Trustee may require the payment of a sum sufficient to cover any tax or other governmental charge that may be imposed in relation thereto and any other expenses (including fees and expenses of the Trustee) in connection therewith. REPORTS TO HOLDERS OF TRUST UNITS As promptly as practicable following the end of each calendar year, but no later than 90 days thereafter, the Trustee will mail to each person who was a holder of record at any time during such calendar year a report containing sufficient information to enable holders of Trust Units to make all calculations necessary for federal and Alaska income tax purposes, including the calculation of any depletion or other deduction which may be available to them for such calendar year. As promptly as practicable following the end of each Quarter, but no later than 60 days following the end of such Quarter, during the term of the Trust, the Trustee will mail a report for such Quarter showing in reasonable detail on a cash basis the assets and liabilities, receipts and disbursements and income and expenses of the Trust and the Royalty Production for such Quarter to holders of Trust Units of record on the last Quarterly Record Date immediately preceding the mailing thereof. Within 90 days following the end of each calendar year, the Trustee will mail an annual report containing (a) audited financial statements of the Trust, (b) a statement as to whether or not all fees and expenses of the Trustee were calculated and paid in accordance with the Trust Agreement, (c) such information as the Trustee deems appropriate from a letter of the independent public accountants engaged by the Trustee as to compliance with certain terms of the Conveyance and any Additional Conveyances and computation of the amounts payable to the Trust in respect of the Royalty Interest, (d) a letter of the independent petroleum engineers engaged by the Trust setting forth a summary of such firm's determinations regarding the Company's methods, procedures and estimates referred to in the Conveyance concerning proved reserves and other related matters, and (e) a copy of the latest annual report with respect to the Trust Units filed with the Securities and Exchange Commission (the "Commission") or information furnished to the Trustee pursuant to the Conveyance, to holders of Trust Units of record on the last Quarterly Record Date immediately preceding the mailing thereof. The Trustee will mail to holders of Trust Units any other reports or statements required to be provided to Trust Unit holders by applicable law or governmental regulations or by the requirements of any stock exchange on which the Trust Units may be listed. In the Trust Agreement, holders of Trust Units have waived the right to seek or secure any portion or distribution of the Royalty Interest or any other asset of the Trust or any accounting during the term of the Trust or during any period of liquidation and winding up. LIABILITY OF HOLDERS OF TRUST UNITS The Trust Agreement provides that the holders of Trust Units will, to the full extent permitted by Delaware law, be entitled to the same limitation of personal liability extended to stockholders of private corporations for profit under Delaware law. POSSIBLE DIVESTITURE OF TRUST UNITS The Trust Agreement imposes no restrictions on nationality or other status of the persons or other entities which are eligible to hold Trust Units. However, the Trust Agreement provides that if at any time the Trust or the Trustee is named a party in any judicial or administrative proceeding seeking the cancellation or forfeiture of any property in which the Trust has an interest because of the nationality, or any other status, of any one or more holders the following procedures will be applicable: (i) The Trustee will give written notice of the existence of such proceedings to each holder whose nationality or other status is an issue in the proceeding. The notice will contain a reasonable summary of such proceeding and will constitute a demand to each such holder that he dispose of his Trust Units within 30 days to a party not of the nationality or other status at issue in the proceeding described in the notice. (ii) If any holder fails to dispose of his Trust Units in accordance with such notice, the Trustee shall have the right to redeem and shall redeem at any time during the 90-day period following the termination of the 30-day period specified in the notice, any Trust Unit not so transferred for a cash price per unit equal to the closing price of the Trust Units on the stock exchange on which the Trust Units are then listed or, in the absence of any such listing, the closing bid price on the National Market System of the National Association of Securities Dealers Automatic Quotation System if the Trust Units are so quoted or, if not, the mean between the closing bid and asked prices for the Trust Units in the over-the-counter market, in either case as of the last business day prior to the expiration of the 30-day period stated in the notice. If the Trust Units are neither listed nor traded in the over-the-counter market, the price will be the fair market value of the Trust Units as determined by a recognized firm of investment bankers or other competent advisor or expert. (iii) The Trustee will cancel any Trust Unit redeemed by the Trustee in accordance with the foregoing procedures. (iv) The Trustee may, in its sole discretion, cause the Trust to borrow any amount required to redeem the Trust Units. If the purchase of Trust Units from an ineligible holder by the Trustee would result in a non-exempt prohibited transaction" under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), or under the Internal Revenue Code of 1986, as amended (the "Code"), the Trust Units subject to the Trustee's right of redemption will be purchased by the Company or a designee thereof, at the above-described purchase price. ADDITIONAL CONVEYANCES Additional royalty interests ("Additional Royalty Interests") identical in all respects to the initial Royalty Interest except for the identity of the parties (other than the Trust) (provided that the entity which will make payments to the Trust under any Additional Royalty Interest is the same entity making payments to the Trust under the initial Conveyance), the effective date (which must be on the first day of a calendar quarter and must be the date of delivery thereof to the Trustee) and the percentage set forth in the definition of Royalty Production in the related additional conveyance, may be assigned by the Company or an affiliate thereof to the Trust from time to time, through the execution of additional conveyances (each an "Additional Conveyance"). In consideration of the grant of an Additional Royalty Interest, the Trustee will issue to the order of the Company or such affiliate, a number of Trust Units, not to exceed a total of 18,600,000 additional Trust Units, equal to (i) the product of (a) the percentage set forth in the definition of Royalty Production in the related Additional Conveyance and (b) 21,400,000, (ii) divided by 16.4246%. In connection with such issuance, the recipients of such Trust Units and their transferees will not be treated as holders of Trust Units of record entitled to distributions with respect to the Quarterly Income Amount for the Quarterly Record Date which occurs during the month in which such Additional Conveyance is effective and will not be entitled to transfer such Trust Units (other than to the Company or one of its affiliates) on or prior to such Quarterly Record Date, and the certificates representing such Trust Units will prominently so state. The acceptance by the Trustee of any such assignment will be subject to the conditions that the Trustee shall have received a ruling from the IRS to the effect that neither the existence nor the exercise of the right to assign the Additional Royalty Interest or the power to accept such assignment will adversely affect the classification of the Trust as a "grantor trust" for federal income tax purposes, and rulings from the IRS or an opinion of counsel to the effect that such assignment will not cause the income from the Trust to be treated as unrelated business taxable income for federal income tax purposes, or the holders of Trust Units to recognize income, gain or loss attributable to the Royalty Interest as a result of such assignment, except to the extent of any gain or loss attributable to any cash received by the Trust in connection with such assignment. In addition, the Trustee will require that the Company or its affiliate contribute a cash reserve computed by reference to the value of the cash reserve for future liabilities existing on the date the Additional Conveyance is effective. The Trustee will invest any cash so contributed as described under "Duties and Limited Powers of Trustee" above, and will distribute the cash so contributed and any interest earned thereon to holders of Trust Units of record on the Quarterly Record Date which occurs during the month in which the related Additional Conveyance becomes effective, except to holders of Trust Units issued upon the assignment of the Additional Conveyance. Any Additional Royalty Interest assigned to the Trust will constitute a part of the trust estate and, to the extent permitted by law, will be treated by the Trustee, together with the initial Royalty Interest and all other Additional Royalty Interests previously assigned to the Trust, as constituting one Royalty Interest held for the benefit of all holders of Trust Units. DESCRIPTION OF THE ROYALTY INTEREST The Trust property consists of a Royalty Interest entitling the Trust to a Per Barrel Royalty on 16.4246% of the first 90,000 barrels of the average actual daily net production of oil and condensate per quarter (the "Royalty Production") from the Company's working interest in the PBU. There are 21,400,000 Trust Units outstanding. If additional Trust Units are issued, the Royalty Interest percentage will be increased proportionately. The net production referred to herein pertains only to the Ivishak and PESS formations collectively known as the Prudhoe Bay (Permo-Triassic) Reservoir, and does not pertain to the Lisburne and Endicott formations. The Company's average daily net production from its working interest in the PBU during 1993 was approximately 417,700 barrels of oil and condensate. As is true of net profits royalty interests generally, the Royalty Interest is a property right under applicable principles of Alaska law which burdens production, but there is no other security interest in the reserves or production revenues to which the Royalty Interest is entitled. The royalty payable to the Trust under the Royalty Interest is the product of the Royalty Production and the Per Barrel Royalty for each day. PER BARREL ROYALTY The Per Barrel Royalty in effect for any day will equal the WTI Price for such day less the sum of (i) the product of the Chargeable Costs and the Cost Adjustment Factor and (ii) Production Taxes. WTI PRICE The "WTI Price" for any trading day means (i) the latest price (expressed in dollars per barrel) for West Texas Intermediate crude oil of standard quality having a specific gravity of 40 degrees API for delivery at Cushing, Oklahoma ("West Texas Crude"), quoted for such trading day by the Dow Jones International Petroleum Report (which is published in The Wall Street Journal) or if the Dow Jones International Petroleum Report does not publish such quotes, then such price as quoted by Reuters, or if Reuters does not publish such quotes, then such price as quoted in Platt's Oilgram Price Report, or (ii) if for any reason such publications do not publish such price, then the WTI Price will mean, until (i) is again applicable, the simple average of the daily mean prices (expressed in dollars per barrel) quoted for West Texas Crude by one major oil company, one petroleum broker and petroleum trading company, in each case unaffiliated with BP. Such major oil company, petroleum broker and petroleum trading company must have substantial U.S. operations and will be designated by the Company from time to time in an officer's certificate delivered to the Trustee. In the event that prices for West Texas Crude are not quoted so as to permit the calculation of the WTI Price, "West Texas Crude," for the purposes of calculating the WTI Price first for (i) and then (ii) above, will mean such other light sweet domestic crude oil of standard quality as is designated by the Company in an officer's certificate delivered to the Trustee and approved by the Trustee in the exercise of its reasonable judgment, with appropriate allowance for transportation costs to the Gulf Coast (or other appropriate location) to equilibrate such price to the WTI Price. The WTI Price for any day which is not a trading day will be the WTI Price for the next preceding day which is a trading day. CHARGEABLE COSTS The "Chargeable Costs" per barrel of Royalty Production were $4.50 per barrel through December 31, 1991, $6.00 per barrel from January 1, 1992 through December 31, 1992, $6.75 per barrel from January 1, 1993 through December 31, 1993 and will be the amount set forth in the following table opposite the calendar year stated: Chargeable Costs are multiplied by the Cost Adjustment Factor as defined below. Chargeable Costs will be reduced up to a maximum of $1.20 per barrel in any given year subsequent to 1995 based on the following tests of the Company's additions of Proved Reserves to Current Reserves. Current Reserves are defined as the Company's Proved Reserves of crude oil and condensate as of December 31, 1987 (2035.6 million stock tank barrels ("STB")) and before taking into account any production therefrom and before any reduction that may result from the creation of the Trust. (a) If, by December 31, 1995, 100,000,000 or more STB of Proved Reserves have not been added to Current Reserves, then for each year 1996 through 2000, inclusive, Chargeable Costs as set forth in the table above shall be reduced, as of January 1 in each such year, by an amount equal to the lesser of (A) $1.20 or (B) the product of $1.20 and a fraction, the numerator of which shall be the difference between 100,000,000 STB of Proved Reserves and the actual number of STB of Proved Reserves so added to Current Reserves from January 1, 1988 through December 31, 1995 and the denominator of which shall be 100,000,000 STB of Proved Reserves. The Company added approximately 42,000,000 STB to Proved Reserves during 1988, approximately 45,500,000 STB during 1989, approximately 24,000,000 STB during 1990, approximately 116,000,000 STB during 1991, approximately 144,000,000 STB during 1992 and approximately 206,000,000 STB during 1993. (b) If between January 1, 1996 and December 31, 2000 an additional 200,000,000 STB of Proved Reserves (that is, 200,000,000 STB of Proved Reserves in addition to the 100,000,000 STB of Proved Reserves that are referred to in (a)) have not been added to Current Reserves, then for each year from 2001 through 2005, inclusive, Chargeable Costs as set forth in the table above shall be reduced, as of January 1 in each such year, by an amount equal to the lesser of (A) $1.20 or (B) the product of $1.20 and a fraction, the numerator of which shall be the difference between (1) 200,000,000 STB of Proved Reserves and (2) the sum of (i) the actual number of STB of Proved Reserves so added to Current Reserves from January 1, 1996 through December 31, 2000 plus (ii) the excess, if any, of the number of STB of Proved Reserves so added to Current Reserves from January 1, 1988 through December 31, 1995 over 100,000,000 STB of Proved Reserves (provided that the sum of (i) and (ii) shall not exceed 200,000,000 STB of Proved Reserves) and the denominator of which shall be 200,000,000 STB of Proved Reserves. (c) The tests set forth in (i) and (ii) below will be utilized to calculate the reduction, if any, in Chargeable Costs for the year 2006 and each year thereafter. If the calculation under one of such tests produces a reduction in Chargeable Costs but the calculation under the other test does not, the calculation that produces the reduction shall apply. In applying the tests below, it is the intention of the Company that test (i) allow as a credit toward the 400,000,000 STB of Proved Reserves that must be added to Current Reserves during the period set forth in such test an amount equal to the excess, if any, of the number of STB of Proved Reserves added to Current Reserves prior to December 31, 2000 over 300,000,000 STB of Proved Reserves while test (ii) sets a level of only 100,000,000 STB of Proved Reserves that must be added to Current Reserves during the period set forth in such test, but does not allow a credit for additions of STB of Proved Reserves accrued prior to December 31, 2000. (i) If, between January 1, 2001 and December 31, 2005, an additional 400,000,000 STB of Proved Reserves (that is, 400,000,000 STB of Proved Reserves in addition to the 100,000,000 STB of Proved Reserves that are referred to in (a) and the 200,000,000 STB of Proved Reserves that are referred to in (b)) have not been added to Current Reserves, then for the year 2006 and each year thereafter Chargeable Costs as set forth in the table above shall be reduced, as of January 1 of each such year, by an amount equal to the lesser of (A) $1.20 or (B) the product of $1.20 and a fraction, the numerator of which shall be the difference between (1) 400,000,000 STB of Proved Reserves and (2) the sum of (x) the actual number of STB of Proved Reserves so added to Current Reserves from January 1, 2001 through December 31, 2010 plus (y) the excess, if any, of the number of STB of Proved Reserves so added to Current Reserves from January 1, 1988 through December 31, 2000 over 300,000,000 STB of Proved Reserves (provided that the sum of (x) and (y) shall not exceed 400,000,000 STB of Proved Reserves) and the denominator of which shall be 400,000,000 STB of Proved Reserves. (ii) If, between January 1, 2001 and December 31, 2005, an additional 100,000,000 STB of Proved Reserves (that is, 100,000,000 STB of Proved Reserves in addition to any and all STB of Proved Reserves that are added to Current Reserves prior to January 1, 2001) have not been added to Current Reserves, then for the year 2006 and each year thereafter, Chargeable Costs as set forth in the table above shall be reduced, as of January 1 of each such year, by an amount equal to the lesser of (A) $1.20 or (B) the product of $1.20 and a fraction, the numerator of which shall be the difference between 100,000,000 STB of Proved Reserves and the number of STB of Proved Reserves added to Current Reserves from January 1, 2001 through December 31, 2005 and the denominator of which shall be 100,000,000 STB of Proved Reserves. COST ADJUSTMENT FACTOR The "Cost Adjustment Factor" is the ratio of (1) the Consumer Price Index ("CPI") published for the most recently past February, May, August or November, as the case may be, to (2)121.1 (the Consumer Price Index for January 1989); provided, however, that (a) if for any calendar quarter the average WTI Price is $18.00 or less, then in such event the Cost Adjustment Factor for such quarter shall be the Cost Adjustment Factor for the immediately preceding quarter, and (b) the Cost Adjustment Factor for any calendar quarter in which the average WTI Price exceeds $18.00, after a calendar quarter during which the average WTI Price is equal to or less than $18.00, and for each following calendar quarter in which the average WTI Price is greater than $18.00, shall be the product of (x) the Cost Adjustment Factor for the most recently past calendar quarter in which the average WTI Price is equal to or less than $18.00 and (y) a fraction, the numerator of which shall be the Consumer Price Index published for the most recently past February, May, August or November, as the case may be, and the denominator of which shall be the Consumer Price Index published for the most recently past February, May, August or November during a quarter in which the average WTI Price is equal to or less than $18.00. The Consumer Price Index is the U.S. Consumer Price Index, all items and all urban consumers, U.S. city average, 1982-84 equals 100, as first published, without seasonal adjustment, by the Bureau of Labor Statistics, Department of Labor, without regard to subsequent revisions or corrections by such Bureau. PRODUCTION TAXES "Production Taxes" are the sum of any severance taxes, excise taxes (including windfall profit tax, if any), sales taxes, value added taxes or other similar or direct taxes imposed upon the reserves or production, delivery or sale of Royalty Production. For this purpose, such taxes will be computed at defined statutory rates. In the case of taxes based upon wellhead or field value, the Overriding Conveyance provides that the WTI Price less the product of $4.50 and the Cost Adjustment factor will be deemed to be the wellhead or field value. At the present time, the Production Taxes payable with respect to the Royalty Production are the Alaska Oil and Gas Properties Production Tax ("Alaska Production Tax") and the Alaska Oil and Gas Conservation Tax ("Alaska Conservation Tax"). For the purposes of the Royalty Interest, the Alaska Production Tax will be computed without regard to the "economic limit factor", if any, as the greater of the "percentage of value amount" (based on the statutory rate and the wellhead value as defined above) and the "cents per barrel amount" as such terms are used with respect to such tax. As of the date of this report, the statutory rate for the purpose of calculating the "percentage of value amount" is 15%, and the Alaska Conservation Tax is a tax of $0.004 per barrel of net production. A surcharge to the Alaska Production Tax increased Production Taxes by $0.05 per barrel of net production effective July 1, 1989. ROYALTY PRODUCTION The Royalty Production for each day in a calendar quarter will be 16.4246% of the first 90,000 barrels of the average of the Company's actual daily net production of oil and condensate for such quarter as produced from the company's oil rim and gas cap participation as of February 28, 1989 or as modified thereafter by any redetermination provided under the terms of the Prudhoe Bay Unit Operating Agreement and the Prudhoe Bay Unit Agreement. The Royalty Production will be based upon oil produced from the oil rim and condensate produced from the gas cap, but not upon gas production or natural gas liquids production. The Company's actual average daily net production of oil and condensate for any calendar quarter will be the total production of oil and condensate for such quarter, net of the State of Alaska royalty, divided by the number of days in such quarter. CALCULATION OF ROYALTY AMOUNT The Royalty Interest for each calendar quarter is the sum of the product of each day in such quarter of (i) the Royalty Production and (ii) the Per Barrel Royalty; provided that the payment under the Royalty Interest for any calendar quarter will not be (1) less than zero or (2) more than the aggregate value of the total production of oil and condensate from the Company's current working interest in the PBU for such calendar quarter, net of the State of Alaska royalty and less the value of any applicable payments made to affiliates of the Company. MINIMUM ROYALTY The Royalty Interest provided for a Minimum Per Barrel Royalty for the period from February 28, 1989 to September 30, 1991 of $8.92 per barrel (the "Minimum Per Barrel Royalty"); for all periods thereafter there is no Minimum Per Barrel Royalty. The "Average Per Barrel Royalty" for each of the first three calendar quarters of 1991 was the average of the Per Barrel Royalty for each of the days in such quarter and in the three preceding quarters. During 1989, 1990, and 1991 through and including October 15, 1991, the Trust's distributions were based on the Average Per Barrel Royalty and not on the Minimum Per Barrel Royalty. POTENTIAL CONFLICTS OF INTEREST BETWEEN THE COMPANY AND TRUST The interests of the Company and the Trust with respect to the PBU could at times be different. In particular, because the Per Barrel Royalty will be based on the WTI Price and Chargeable Costs rather than the Company's actual price realized and actual costs, the actual per barrel profit received by the Company on the Royalty Production could differ from the Per Barrel Royalty to be paid to the Trust. It is possible, for example, that the relationship between the Company's actual per barrel revenues and costs could be such that the Company may determine to interrupt or discontinue production in whole or in part even though a Per Barrel Royalty may otherwise have been payable to the Trust pursuant to the Royalty Interest. This potential conflict of interest could affect the royalties paid to Trust Unit holders, although the Company will be subject to the terms of the Prudhoe Bay Unit Operating Agreement. Holders of Trust Units will have certain voting rights with respect to the administration of the Trust, but will have no voting rights with respect to, and no control over, any operating matters related to the PBU. The Company will retain the sole right to control all matters relating to its working interest in the PBU, subject to the terms of the Prudhoe Bay Unit Operating Agreement. DESCRIPTION OF THE BP SUPPORT AGREEMENT BP has agreed pursuant to the terms of a Support Agreement, dated February 28, 1989, among BP, the Company, Standard Oil and the Trust (the "Support Agreement"), to provide financial support to the Company in meeting its payment obligations under the Royalty Interest. Within 30 days of notice to BP pursuant to Article XI of the Trust Agreement, BP will ensure that the Company is in a position to perform its payment obligations under the Royalty Interest and to satisfy its payment obligations to the Trust under the Trust Agreement (including, without limitation, the obligation to make payments as indemnification), including, without limitation, contributing to the Company such funds as are necessary to make such payments. BP's obligations under the Support Agreement are unconditional and directly enforceable by Trust Unit holders. Except as described below, no assignment, sale, transfer, conveyance, mortgage or pledge or other disposition of the Royalty Interest will relieve BP of its obligations under the Support Agreement. Neither BP nor the Company may transfer or assign its rights or obligations under the Support Agreement without the prior written consent of the Trust, except that BP can arrange for its obligations under the Support Agreement to be performed by any affiliate of BP, provided that BP remains responsible for ensuring that such obligations are performed in a timely manner. The Company may sell or transfer all or part of its working interest in the PBU, although such a transfer will not relieve BP of its responsibility to ensure that the Company's payment obligations with respect to the Royalty Interest and under the Trust Agreement and the Conveyance are performed. BP will be released from its obligation under the Support Agreement upon the sale or transfer of all or substantially all of the Company's working interest in the PBU if the transferee is of Equivalent Financial Standing and unconditionally agrees to assume and be bound by BP's obligation under the Support Agreement in a writing in form and substance reasonably satisfactory to the Trustee. A transferee of "Equivalent Financial Standing" is defined in the Support Agreement as an entity having a rating assigned to outstanding unsecured, unsupported long term debt from Moody's Investors Service of at least A3 or from Standard & Poor's Corporation of at least A- or an equivalent rating from at least one nationally-recognized statistical rating organization (after giving effect to the sale or transfer to such entity of all or substantially all of the Company's working interest in the PBU and the assumption by such entity of all of the Company's obligations under the Conveyance and of all BP's obligations under the Support Agreement). DESCRIPTION OF THE PROPERTY BACKGROUND The Prudhoe Bay field (the "Field") is located on the North Slope of Alaska, 250 miles north of the Arctic Circle and 650 miles north of Anchorage. The Field extends approximately 12 miles by 27 miles and contains nearly 150,000 productive acres. The Field, which was discovered in 1968 by BP and others, has been in production since 1977 and during 1989, 1990, 1991, 1992 and 1993, produced on average 1.4 million, 1.3 million, 1.3 million, 1.2 million and 1.1 million barrels of oil and condensate per day, respectively. The Field is the largest producing field in North America. As of January 1, 1994, approximately 8.30 billion STB of oil and condensate had been produced from the Field. The Company estimates that production will decline at an average rate of approximately 10% per year. Field development is well advanced with approximately $16 billion gross capital spent and a total of about 1,200 wells drilled. Other large fields located in the same area include the Kuparuk, Endicott, and Lisburne fields. Production from those fields is not included in the Royalty Interest. Since several oil companies hold acreage within the Field, the PBU was established to optimize Field development. The Prudhoe Bay Unit Operating Agreement specifies the allocation of production and costs to PBU owners. The Company and a subsidiary of the Atlantic Richfield Company ("Arco") are the two Field operators. Other Field owners include affiliates of Exxon Corporation ("Exxon"), Mobil Corporation ("Mobil"), Phillips Petroleum Company ("Phillips") and Chevron Corporation ("Chevron"). GEOLOGY The principal hydrocarbon accumulations at Prudhoe Bay are in the Ivishak sandstone of the Sadlerochit Group at a depth of approximately 8,700 feet below sea level. The Ivishak is overlain by four minor reservoirs of varying extent which are designated the Put River, Eileen, Sag River and Shublik (collectively, "PESS") formations. Underlying the Sadlerochit Group are the oil-bearing Lisburne and Endicott formations. The net production referred to herein pertains only to the Ivishak and PESS formations, collectively known as the Prudhoe Bay (PermoTriassic) Reservoir, and does not pertain to the Lisburne and Endicott formations. The Ivishak sandstone was deposited some 250 million years ago during the Permian and Triassic geologic ages. The sediments in the Ivishak are composed of sandstones, conglomerate and shales which were deposited by a massive braided river/delta system that flowed from an ancient mountain system to the north. Oil was trapped in the Ivishak by a combination of structural and stratigraphic trapping mechanisms. Gross reservoir thickness is 550 feet, with a maximum oil column thickness of 425 feet. The original oil column is bounded on the top by a gas-oil contact, originally at 8,575 feet below sea level across the main field, and on the bottom by an oil-water contact at approximately 9,000 feet below sea level. A layer of heavy oil/tar overlays the oil-water contact in the main field and has an average thickness of around 40 feet. HYDROCARBONS IN PLACE The reservoir contained approximately 22 billion STB of original oil in place, of which approximately 19 billion STB were in the light oil column. The light oil in the reservoir is a medium grade, low sulfur crude with an average specific gravity of 27 degrees API. Original gas in place was approximately 46 trillion standard cubic feet ("TSCF") (equivalent to approximately 8 billion barrels of oil on a BTU basis), with 30 TSCF in the gas cap and 16 TSCF solution gas. The gas cap gas has an average specific gravity of 0.85 and is composed of 70 to 80% methane, 10 to 20% carbon dioxide and the remainder ethane and heavier components. The gas cap composition is such that, upon surfacing, a liquid hydrocarbon phase, known as condensate, is formed. The interests of the Trust Unit holders are based upon oil produced from the oil rim and condensate produced from the gas cap, but not upon gas production (which is currently uneconomic) or natural gas liquids production stripped from gas produced. PRUDHOE BAY UNIT OPERATION AND OWNERSHIP Since several companies hold acreage within the Field's limits, a unit was established to ensure optimum development of the Field. The Prudhoe Bay Unit, which became effective on April 1, 1977, divided the Field into two operating areas. The Company is the operator of the Western Operating Area ("WOA") and Arco Alaska Inc. is the operator of the Eastern Operating Area ("EOA"). Oil and condensate production comes from both the WOA and EOA. The Prudhoe Bay Unit Operating Agreement specifies the allocation of production and costs to the working interest owners. The Prudhoe Bay Unit Operating Agreement also defines operator responsibilities and voting requirements and is unusual in its establishment of separate participating areas for the gas cap and oil rim. The Prudhoe Bay Unit ownership by participating area is summarized in the following table: OIL RIM REDETERMINATION The Prudhoe Bay Unit Operating Agreement, which was entered into in 1977, required a final redetermination of participating interests in the oil rim, based upon improved technical knowledge of the reservoir as a result of Field operations. In 1982, the Company, Arco and Exxon (the three major interest owners holding a total of approximately 94% of the oil rim) reached an agreement regarding final redetermination of participating interests in the Field. In October 1982, Exxon initiated arbitration proceedings regarding final redetermination of participating interests in the oil rim. As a result of the arbitration proceedings, which were concluded in 1985, the Company's participating interest in the oil reservoir was 50.68%. At the current maximum allowable production rate, this resulted in the Company's interest becoming 655,200 net barrels of oil per day ("BOPD"). Also to adjust its share of cumulative total production since the inception of commercial production, the Company overlifted about 13,500 net BOPD for a two-year period ending in August, 1987. After the arbitration award, MPC challenged the award through litigation. Mobil, Phillips and Chevron agreed in principle in October 1990 to end their challenge to the 1985 arbitration on their participating area interest in exchange for a cash settlement from BP, ARCO and Exxon. This settlement became effective on completion of a definitive binding agreement between all PBU owners, known as the Issues Resolution Agreement ("IRA"). The Company has advised the Trustee that the IRA addresses, among other things, final determination of the Original Condensate Reserve ("OCR"), agreement on allocation of the OCR over time, agreement on an additional gas handling expansion project (GHX-2), extension of an existing Enhanced Oil Recovery ("EOR") project to the end of field life and the establishment of a plan of additional development. The IRA is an agreement among the owners of the Prudhoe Bay Unit which is designed to promote cooperation, reduce conflicts, increase efficiency of operations, and resolve a number of issues that were previously subject to negotiation, arbitration, or litigation among the Unit owners. The Company has advised that final approval of the IRA has now been obtained from all Unit owners. The Company has further advised that the OCR was finally determined to be 1,175 million stock tank barrels ("STB") for the Prudhoe Bay Unit, and that this OCR determination resulted in a reallocation of approximately 500 million STB of crude oil reserves to condensate reserves, for the Prudhoe Bay Unit. The Company has also advised that because BP owns 50.68% of the crude oil and 13.84% of the condensate, this OCR settlement alone results in a BP net reserve reduction. The Company has advised the Trustee, however, that the establishment of the OCR at this level when combined with the other elements of the agreement described above should result in no significant change to BP's net reserves, and that the changes agreed to by the Prudhoe Bay Unit owners, including the attendant increased production, are expected to have limited impact on the point at which the company's net production of oil and condensate would fall below 90,000 barrels per day. PRODUCTION AND RESERVES Production began on June 19, 1977, with the completion of the Trans Alaska Pipeline System ("TAPS"). Initially 750,000 BOPD was the TAPS limit, but after start-up, pipeline capacity was increased and in November 1979 a production rate of 1.5 million BOPD was achieved. As of January 1, 1994, there were about 969 producing oil wells, 35 gas reinjection wells, 57 water injection wells and 100 water and miscible gas injection wells in the Field, In terms of individual well performance, oil production rates range from 100 to 8,000 BOPD. Currently, the average well production rate is about 1,000 BOPD. The Company's share of the hydrocarbon liquids production from the Field includes oil, condensate and natural gas liquids. Using the production allocation procedures from the Prudhoe Bay Unit Operating Agreement, the Field's production and the Company's 1993 share of oil and condensate (net of State of Alaska royalty) was as follows: The Company's net proved remaining reserves of oil and condensate in the PBU as of December 31, 1993 were 1,452,900,000 STB. This current estimate of reserves is based upon various assumptions, including a reasonable estimate of the allocation of hydrocarbon liquids between oil and condensate pursuant to the procedures of the Prudhoe Bay Unit Operating Agreement. The Company anticipates that its net production from its current proved reserves will exceed 90,000 barrels per day until the year 2010. The Company also projects continued economic production thereafter, at a declining rate, until the year 2030; however, for the economic conditions and reserve estimates as of December 31, 1993 the Per Barrel Royalty will be zero following the year 2001. Unless 700 million STB are added to proved reserves from the inception of the Trust to year-end 2005 and 100 million STB of reserves are added between 2001 and 2005, Chargeable Costs will be reduced beyond 2005 (see CHARGEABLE COSTS). The Company has added and anticipates adding to its proved reserves. The WTI Price was $14.15 per barrel on December 31, 1993 compared to $19.50 per barrel on December 31, 1992. Based on the higher oil price and the gross reserves projections made for the reservoir as of December 31, 1992, royalty payments to the Trust were then calculated to continue through the year 2010, or nine years longer than the date calculated using the oil price and gross reserves projections as of December 31, 1993. The Company estimates that, if prices and costs had not changed from year-end 1992 to year-end 1993, royalty payments to the Trust would have been projected to continue through the year 2010. See Report of Miller and Lents, Ltd., Independent Petroleum Consultants, below. MILLER AND LENTS, LTD. OIL AND GAS CONSULTANTS TWENTY-SEVENTH FLOOR 1100 LOUISIANA HOUSTON, TEXAS 77002-5216 Telephone 713 651-9455 Telefax 713 654-9914 Cable "MILLENT" February 25, 1994 The Bank of New York Trustee, BP Prudhoe Bay Royalty Trust 101 Barclay Street 21 W New York, New York 10286 Re: Estimates of Proved Reserves, Future Annual Production Rates, And Future Net Revenues for the BP Prudhoe Bay Royalty Trust Gentlemen: This letter report is a summary of those investigations performed in accordance with our engagement by you for the purposes described in Section 4.8(d) of the Overriding Royalty Conveyance dated February 27, 1989, between BP Exploration (Alaska), Inc., and The Standard Oil Company. The investigations included reviews of the estimates of Proved Reserves and annual production rate forecasts of oil and condensate made by BP Exploration (Alaska), Inc. (the Company) attributable to the BP Prudhoe Bay Royalty Trust (the Trust) from the Company's net interests in the Prudhoe Bay (Permo-Triassic) Reservoir (the Reservoir) and of the Company's calculations of Estimated Future Net Revenues and Present Value of Estimated Future Net Revenues that result from the Proved Reserves attributable to the Trust, all as of December 31, 1993. The estimates and calculations reviewed are summarized in the report prepared by the Company for the Trust and transmitted with a cover letter dated February 17, 1994, addressed to Ms. Marie Trimboli of The Bank of New York and signed by Mr. V. W. Holt. Reviews were also performed of (1) the Company's procedures for estimating and documenting Proved Reserves, (2) the Company's estimates of in-place reservoir volumes, (3) the Company's estimates of recovery factors and production profiles for the various areas, pay zones, projects, and recovery processes that are included in the Company's estimates of Proved Reserves, (4) the Company's production strategy and procedures for implementing that strategy, (5) the sufficiency of the data available for making estimates of Proved Reserves and MILLER AND LENTS, LTD. production profiles, and (6) pertinent provisions of the Prudhoe Bay Unit Operating Agreement (PBUOA), the Issues Resolution Agreement (IRA), the Overriding Royalty Conveyance, the Trust conveyance, the BP Prudhoe Bay Royalty Trust Agreement, and other related documents referenced in the Form Registration Statement filed with the Securities and Exchange Commission on August 7, 1989, by the Company. Proved Reserves were estimated by the Company in accordance with the definitions contained in Securities and Exchange Commission Regulation S-X, Rule 4-10(a). Estimated Future Net Revenues and Present Value of Estimated Future Net Revenues are not intended and should not be interpreted to represent fair market values for the estimated reserves. The Prudhoe Bay (Permo-Triassic) Reservoir is defined in the PBUOA. The Prudhoe Bay Unit is an oil and gas unit situated on the North Slope of Alaska in which the Company's interests in the Reservoir have been unitized for the production of oil and gas. The Trust is entitled to a royalty payment on 16.4246 percent of the first 90,000 barrels of the actual average daily net production of oil and condensate for each calendar quarter from the working interest of the Company in the Prudhoe Bay Unit. The payment amount depends upon the Per Barrel Royalty which in turn depends upon the West Texas Intermediate Price (WTI Price), the Chargeable Costs, the Cost Adjustment Factor, and Production Taxes, all of which are defined in the Overriding Royalty Conveyance. "Barrel" as used herein means Stock Tank Barrel as defined in the Overriding Royalty Conveyance. Our reviews do not constitute independent estimates of the reserves and annual production rate forecasts for the areas, pay zones, projects, and recovery processes examined. We relied solely upon the accuracy and completeness of information provided by the Company with respect to pertinent ownership interests and various other historical, accounting, engineering, and geological data. As a result of our reviews, based on the foregoing, we conclude that: 1. A large body of basic data and detailed analyses is available and was used by the Company in making its estimates. In our judgment, the quantity and quality of currently available data on reservoir boundaries, original fluid contacts, and reservoir rock and fluid properties are sufficient to indicate that any future revisions to the estimates of total original in-place volumes would be minor. Furthermore, the data and analyses on recovery factors and future production rates are sufficient to support the Company's Proved Reserves estimates. 2. The methods and procedures employed by the Company to accumulate and evaluate the necessary information and to estimate, document and reconcile reserves, annual production rate forecasts, and future net revenues are effective and are in accordance with generally accepted geological and engineering practice in the petroleum industry. MILLER AND LENTS, LTD. 3. Based on our limited independent tests of the Company's computations of reserves, production flowstreams, and future net revenues, such computations were performed in accordance with the methods and procedures described to us by the Company. 4. The estimated net remaining Proved Reserves attributable to the Trust as of December 31, 1993, of 43.2 million barrels of oil and condensate are, in the aggregate, reasonable. Of this estimate, all 43.2 million barrels are Proved Developed Reserves. 5. Utilizing the specified procedures outlined in Securities and Exchange Commission Regulation S-X Rule 4-10(k)(6), the Company calculated that as of December 31, 1993, production of the Proved Reserves will result in Estimated Future Net Revenues of $84 million and Present Value of Estimated Future Net Revenues of $65 million to the Trust. Those estimates are reasonable. 6. The Company's estimate that, as of December 31, 1993, 578.1 million barrels of Proved Reserves have been added to Current Reserves (before taking into account any production therefrom) is reasonable. Current Reserves are defined in the Overriding Royalty Conveyance as the Company's net Proved Reserves as of December 31, 1987, which were 2,035.6 million barrels. Net additions to Proved Reserves after December 31, 1987, affect the Chargeable Costs that are used to calculate the Per Barrel Royalty paid to the Trust. 7. Based on the Company's current plan of operation and development and on the existing economic environment, the Company's current estimate that its net production of Proved Reserves of oil and condensate from the Reservoir will continue at an average rate exceeding 90,000 barrels per day until the year 2010 is reasonable. As long as the Per Barrel Royalty has a positive value, average daily production attributable to the Trust will remain constant until the Company's net production falls below 90,000 barrels per day; thereafter, production attributable to the Trust will decline as the Company's production declines. However, the Per Barrel Royalty will not have a positive value if the WTI Price is less than the sum of the per barrel Chargeable Costs and per barrel Production Taxes, appropriately adjusted in accordance with the Overriding Royalty Conveyance. Under such circumstances, average daily production attributable to the Trust will have no value to the Trust and can be considered to be zero regardless of the Company's net production level. 8. Based on the WTI Price of $14.15 per barrel prevailing at December 31, 1993, current Production Taxes, and the Chargeable Costs adjusted as prescribed by the Overriding Royalty Conveyance, the Company's projection that royalty payments to the Trust will continue through the year 2001 is reasonable. The MILLER AND LENTS, LTD. Company expects continued economic production from the Reservoir at a declining rate through the year 2030; however, for the economic conditions and reserve estimates as of December 31, 1993, the Per Barrel Royalty will be zero following the year 2001. Therefore, no reserves are currently included for the Trust after that date. 9. Although the Company's estimates of gross ultimate Proved Reserves for the Reservoir increased from year-end 1992 to year- end 1993, the projections of Proved Reserves and Estimated Future Net Revenues attributable to the Trust decreased significantly, primarily because the WTI Price was $14.15 per barrel on December 31, 1993 compared to $19.50 per barrel on December 31, 1992. Based on the higher oil price and the gross reserves projections made for the Reservoir as of December 31, 1992, royalty payments to the Trust were calculated to continue through the year 2010 or nine years longer than the date calculated using the oil price and gross reserves projections as of December 31, 1993. The estimated reserves, economic life, and future revenues attributable to the Trust may change significantly in the future, even if expected Reservoir performance does not change, as a result of changes in prescribed variables and predetermined calculations that must be made for the Trust using such variables. 10. The Company estimates that, if prices and costs had not changed from year-end 1992 to year-end 1993, (a) Proved Reserves attributable to the Trust at December 31, 1993, would have been 91.7 million barrels, and (b) royalty payments to the Trust would have been projected to continue through the year 2010. Those estimates are reasonable. Estimates of ultimate and remaining reserves and production scheduling depend upon assumptions regarding expansion or implementation of alternative projects or development programs and upon strategies for production optimization. The Company has continual reservoir management, surveillance, and planning efforts dedicated to (1) gathering new information, (2) improving the accuracy of its reserves and production capacity estimates, (3) recognizing and exploiting new opportunities, (4) anticipating potential problems and taking corrective actions, and (5) identifying, selecting, and implementing optimum recovery program and cost reduction alternatives. Given this significant effort and ever-changing economic conditions, estimates of reserves and production profiles will change periodically. The Company's current estimates of Proved Reserves include only those projects or development programs which it deems highly certain to be expanded or implemented, given current economic and regulatory conditions. Future projects, development programs, or offtake strategies different from those assumed in the current estimates may change future estimates and affect actual recoveries. However, because several complementary and MILLER AND LENTS, LTD. alternative projects are being considered for recovery of the remaining oil in the Reservoir, a decision not to implement a currently planned project may allow scope expansion or implementation of another project, thereby increasing the overall likelihood of recovering the reserves. Future production rates from the Reservoir will be controlled by facilities limitations and upsets, well downtime, and the effectiveness of programs to optimize production and costs. The Company currently expects continued economic production from the Reservoir at a declining rate through the year 2030. Additional drilling, workovers, facilities modifications, new recovery projects, and programs for production enhancement and optimization are expected to mitigate but not eliminate the anticipated future decline in gross oil and condensate production capacity. In making its future production rate forecasts, the Company provided for normal downtime and planned facilities upsets. Although allowances for unplanned upsets are also considered in its estimates, the Company's studies and this review do not provide for any impediments to crude oil production as a consequence of major disruptions. In making its projections of future net revenues, the Company assumed that the conservation surcharge, amounting to $0.05 per barrel of production, which was imposed by the State of Alaska effective July 1, 1989, will continue indefinitely. The purpose of the surcharge is to provide funds that might be used by the state for spill containment and clean-up in the event of future discharges of oil or other hazardous substances. Provisions for periodic suspension of the surcharge under certain prescribed circumstances are included in the legislation. Under current economic conditions, gas from the Alaskan North Slope, except for minor volumes, cannot be marketed commercially. Oil and condensate recoveries from the Reservoir are expected to be greater as a result of continued reinjection of produced gas than if major volumes of produced gas were being sold. No major gas sale is assumed in the Company's current estimates. If major gas sales are determined to be economically viable in the future, the Company estimates that such sales would not actually commence until eight to ten years after such a determination. In the event that major gas sales are initiated, ultimate oil and condensate recoveries may be reduced from the current estimates unless recovery projects other than those included in the current estimates are implemented. Large volumes of natural gas liquids are likely to be produced from the Reservoir and marketed in the future whether or not major gas sales become viable. Natural gas liquids reserves are not included in the estimates cited herein. The Trust is not entitled to royalty payments from production or sales of natural gas or of natural gas liquids. The evaluations presented in this report, with the exceptions of those parameters specified by others, reflect our informed judgments based on accepted standards of professional investigation but are subject to those MILLER AND LENTS, LTD. generally recognized uncertainties associated with interpretation of geological, geophysical, and engineering information. Government policies and market conditions different from those employed in this study or disruption of existing transportation routes or facilities may cause the total quantity of oil or condensate to be recovered, actual production rates, prices received, or operating and capital costs to vary from those presented in this report. Miller and Lents, Ltd., is an independent oil and gas consulting firm. None of the principals of this firm have any financial interests in the Company or its parent or any related companies or in the Trust. Our fee is not contingent upon the results of our work or report, and we have not performed other services for the Company or the Trust that would affect our objectivity. Very truly yours, MILLER AND LENTS, LTD. By /s/ R. W. Frazier ----------------- R. W. Frazier Vice President RWF/psh Estimates of proved reserves are inherently imprecise and subjective and are revised over time as additional data becomes available. Such revisions may often be substantial. Information regarding estimates of proved reserves attributable to the combined interests of the Company and the Trust were based on Company prepared reserve estimates. The reserves attributable to the Trust are only a part of the overall above stated reserves. There is no precise method of allocating estimates of physical quantities of reserve volumes between the Company and the Trust, since the Royalty Interest is not a working interest and the Trust does not own and is not entitled to receive any specific volume of reserves from the Field. Reserve volumes attributable to the Trust were estimated by allocating to the Trust its share of estimated future production from the Field, based on the WTI Prices on December 31, 1993 ($14.15 per barrel), December 31, 1992 ($19.50 per barrel), December 31, 1991 ($19.10 per barrel), and December 31, 1990 ($28.45 per barrel). Because the reserve volumes attributable to the Trust are estimated using an allocation of reserve volumes based on estimated future production, the current WTI Price, no future movement in the CPI, and no future additions by the Company of Proved Reserves to Current Reserves, a change in the timing of estimated production, a change in the WTI Price, future movement in the CPI, or future additions by the Company of Proved Reserves to Current Reserves will result in a change in the Trust's estimated reserve volumes. Therefore, the estimated reserve volumes attributable to the Trust will vary if different production estimates and prices are used. See "Financial Statements" and the Note 5 thereto. As set forth in Note 5 to the Financial Statements, estimated net proved reserves allocable to the Trust as of December 31, 1993, December 31, 1992, and December 31, 1991 were 43,193,000 barrels, 94,306,000 barrels, and 98,141,000 barrels, respectively. The decrease from December 31, 1992 to December 31, 1993, and from December 31, 1991 to December 31, 1992, reflects the excess of production over additions and changes in timing of production. The decrease from December 31, 1992 to December 31, 1993 also reflects the decrease in the WTI Price from $19.50 per barrel on December 31, 1992 to $14.15 per barrel on December 31, 1993. Proved developed reserves allocable to the Trust as of December 31, 1993, December 31, 1992, and December 31, 1991 were 43,193,000 barrels, 79,420,000 barrels, and 86,116,000 barrels, respectively. The Company is under no obligation to make investments in development projects which would add additional non-proved resources to proved reserves and cannot make such investments without the concurrence of the PBU working interest owners. However, several such investments which would augment Prudhoe Bay projects are already in process. These include additional drilling, waterflood expansions and miscible injection continuation/ expansion projects. Other possible investments could include expanded gas cycling, miscible/waterflood infill drilling, miscible injection supply increases to peripheral areas, chemical flooding, heavy oil tar recovery and development of the smaller reservoirs. While there is no assurance that the PBU working interest owners will make any such investments, they do regularly assess the technical and economic attractiveness of implementing further projects to increase PBU proved reserves. As noted above, the Company's reserve estimates and production assumptions and projections are predicated upon a reasonable estimate of hydrocarbon allocation between oil and condensate. The Company's share of Prudhoe Bay production is the sum of 50.68% of the gross oil production and 13.84% of the gross condensate production from the Field. Oil and condensate are physically produced in a commingled stream of hydrocarbon liquids. The allocation of hydrocarbon liquids between the oil and condensate from the Field is a theoretical calculation performed in accordance with procedures specified in the Prudhoe Bay Unit Operating Agreement. Due to the differences in percentages between oil and condensate, the Company's overall share of oil and condensate production will vary over time according to the proportions of hydrocarbon liquid being allocated as condensate or as oil under the Prudhoe Bay Unit Operating Agreement allocation procedures. Under the terms of the IRA effective October 4, 1990 the present allocation procedures will be adjusted in 1995 to generally allocate condensate in a manner which approximates the anticipated decline in the production of oil until the agreed condensate reserve of 1.175 billion STB has been allocated to the Working Interest Owners. The Company believes this is a reasonable estimate of hydrocarbon allocation between oil and condensate. The occurrence of major gas sales could accelerate the time at which the Company's net production would fall below 90,000 barrels per day, due to the consequent decline in reservoir pressure. In the event of changes in the Company's current assumptions, oil and condensate recoveries may be reduced from the current estimates, unless recovery projects other than those included in the current estimates are implemented. RESERVOIR MANAGEMENT The Prudhoe Bay Field is a complex, combination-drive reservoir, with widely varying reservoir properties. Reservoir management involves directing Field activities and projects to maximize the economic value of Field reserves. Several different oil recovery mechanisms are currently active in the Field, including pressure depletion, gravity drainage/gas cap expansion, waterflooding and miscible gas flooding. Separate yet integrated reservoir management strategies have been developed for the areas impacted by each of these recovery processes. TRANSPORTATION OF PRUDHOE BAY OIL Production from the Field is carried to Pump Station 1, which is the starting point for TAPS, through two 34-inch diameter transit lines, one from each half of the Field. At Pump Station 1, Alyeska Pipeline Service Company, the pipeline operator, meters the oil and pumps it south to Valdez where it is either loaded onto marine tankers or stored temporarily. It takes the oil about six days to make the trip in the 48-inch diameter pipeline. During 1989, analysis of data gathered by newly developed corrosion monitoring pigs revealed areas of corrosion previously undetected on TAPS. All of the corrosion found during 1989 was clustered largely in 13.5 miles, or less than 2%, of the pipeline length. In 1989, analysis of data gathered by sophisticated corrosion monitoring pigs identified previously undetected corrosion on TAPS. An innovative approach enabled an 8.5 mile section of pipe to be replaced in 1991 without disrupting shipments from the terminal to Valdez. In 1992, instead of being replaced, a two mile section near Chandalar received specific repairs. This and other developments have cut the cost of repairs on the main line. Pump station piping corrosion costs have also been reduced significantly. The State of Alaska filed protests to the 1990, 1991, 1992, 1993 and 1994 TAPS tariffs, seeking to exclude corrosion costs from the tariffs charged to ship oil through TAPS. The State of Alaska and the other parties have agreed to continue attempts to resolve the dispute among themselves. Additional protests were filed by the State of Alaska in 1994 challenging the inclusion of certain public affairs and other expenses in such tariffs. HISTORICAL PRODUCTION OF OIL AND CONDENSATE The following table sets forth information concerning the production of oil and condensate for the periods indicated. The amounts listed are the Company's share of production, net of royalties to the State of Alaska. INDUSTRY CONDITIONS The production of oil and gas in Alaska is affected by many state and federal regulations with respect to allowable rates of production, marketing, environmental matters and pricing. Future regulations could change allowable rates of production or the manner in which oil and gas operations may be lawfully conducted. In general, the Company's oil and gas activities are subject to laws and regulations relating to environmental quality and pollution control. The Company believes that the equipment and facilities currently being used in its operations generally comply with the applicable legislation and regulations. During the past few years, numerous environmental laws and regulations have taken effect at the federal, state and local levels. Oil and gas operations are subject to extensive federal and state regulation and to interruption or termination by governmental authorities due to ecological and other considerations. Although the existence of legislation and regulation has had no material adverse effect on the Company's current method of operations, existing and future legislation and regulations could result in the Company experiencing delays and uncertainties in commencing projects. The ultimate impact of such legislation and regulations cannot generally be predicted. Oil prices are subject to international supply and demand. Political developments (especially in the Middle East) and the outcome of meetings of OPEC can particularly affect world oil supply and oil prices. CERTAIN TAX CONSIDERATIONS The following is a summary of the principal tax consequences to the Trust Unit holders resulting from the ownership and disposition of Trust Units. The laws or regulations affecting these matters are subject to change by future legislation or regulations or new interpretations by the IRS, state taxing authorities or the courts, which could adversely affect Trust Unit holders. In addition, there may be differences of opinion as to the applicability or interpretation of present tax laws or regulations. BP and the Trust have not requested from the IRS any rulings on the tax treatment described below, and no assurance can be given that such tax treatment will be available. Taxpayers are urged to consult their tax advisors on the application of the following discussion to their specific circumstances. EMPLOYEES The Trust has no employees. Administrative functions of the Trust are performed by the Trustee. FEDERAL INCOME TAX CLASSIFICATION OF THE TRUST The Trust files its federal tax return as a "grantor trust" rather than as "an association taxable as a corporation." If the Trust were determined to be an association taxable as a corporation, it would be treated as an entity taxable as a corporation on the taxable income from the Royalty Interest, the Trust Unit holders would be treated as shareholders, and distributions to Trust Unit holders would not be deductible in computing the Trust's tax liability as an association. The following discussion is based on the legal conclusion that the Trust will be classified as a grantor trust under current law. TAXATION OF THE TRUST A grantor trust is not subject to tax, and its beneficiaries (the Trust Unit holders in the case of the Trust) are considered for tax purposes to own its income and corpus. A grantor trust files an information return reporting all items of income or deduction. The Trust, therefore, will pay no federal income tax, but will file an information return. TAXATION OF TRUST UNIT HOLDERS The income of the Trust will be deemed to have been received or accrued by the Trust Unit holders at the time such income is received or accrued by the Trust and not when distributed by the Trust. Income will be recognized by a Trust Unit holder consistent with its method of accounting and without regard to the accounting period or method employed by the Trust. The Trust will make quarterly distributions to Trust Unit holders of record on each Quarterly Record Date. See "Description of the Trust Units and the Trust Agreement--Distributions of Income." The terms of the Trust Agreement as described above, seek to assure to the extent practicable that taxable income attributable to such distributions will be reported by the Trust Unit holder who receives such distributions, assuming that such holder is the owner of record on the Quarterly Record Date. In certain circumstances, however, a Trust Unit holder may be required to report taxable income attributable to its Trust Units, but the Trust Unit 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 used to establish such reserve or to repay such loan must be reported by the Trust Unit holder, even though such income is not distributed to the Trust Unit holder. The Trust intends to allocate income and deductions to Trust Unit holders based on record ownership at Quarterly Record Dates. It is unknown whether the IRS will accept such 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. It is anticipated that each Trust Unit holder will be entitled to a deduction for cost depletion and certain other deductions for state and local taxes imposed upon the Trust or a Trust Unit holder and administrative expenses of the Trust. A Trust Unit holder's deduction for cost depletion in any year will be calculated by multiplying the holder's adjusted tax basis in the Trust Units (generally its cost less prior depletion deductions) by Royalty Production during the year and dividing that product by the sum of Royalty Production during the year and estimated remaining Royalty Production as of the end of the year. Trust Unit holders acquiring units on or after October 12, 1990 are possibly permitted to utilize percentage depletion with respect to such Units. Percentage depletion is based on the Trust Unit holders gross income from the Trust rather than on his adjusted basis in his Units. Any deduction for cost depletion or percentage depletion allowable to a Trust Unit holder will reduce its adjusted basis in its Trust Units for purposes of computing subsequent depletion or gain or loss on any subsequent disposition of Trust Units. Each Trust Unit holder must maintain records of its adjusted basis in the Trust Units, make adjustments for depletion deductions to such basis, and use such basis for the computation of gain or loss on the disposition of the Trust Units. TAXATION OF NONRESIDENT ALIEN INDIVIDUALS, PARTNERSHIPS AND FOREIGN CORPORATIONS Generally, nonresident alien individuals, partnerships and foreign corporations (i.e., Foreign persons) are subject to a tax of 30 percent on gross income from sources within the U.S. that are not from a U.S. trade or business. Income from the Trust is considered income which is not effectively connected with a U.S. trade or business. As a result, Foreign persons would be subject to a 30 percent tax on their gross income from the Trust, without deductions. Usually such tax is to be withheld at the source of payment by the withholding agent. However, if there is a treaty in effect between the U.S. and the country of residence of the foreign person, such treaty may reduce the rate of withholding. A holder of Trust Units who is a Foreign person may make an election pursuant to Internal Revenue Code Section 871 (d) or 882(d), or pursuant to any similar provisions of applicable treaties, to treat the income (which constitutes income from real property) from the Trust as income which is effectively connected with a U.S. trade or business. If this election is made such a holder of Trust Units will not be subject of withholding but will, however, be taxed on such income in the same manner as a U.S. person (i.e. U.S. individual, partnership or corporation). As a result, such holder of Trust Units will be taxed on his net income as opposed to his gross income from the Trust. Also, under such an election, any gain or loss upon the disposition of a Trust Unit will be deemed to be connected with a U.S. trade or business and taxed in the manner described above. If a Foreign person owns a greater than 5 percent interest in the Trust, that interest is a U.S. real property interest as provided under Internal Revenue Code Section 897. Gain on disposition of that interest will be taxed as if the holder of Trust Units were a U.S. person. In addition, Foreign persons subject to Internal Revenue Code Section 897 who are nonresident alien individuals will be subject to a minimum tax of 21 percent on the lesser of: 1. the individual's alternative minimum taxable income for the taxable year, or 2. the net gain from the disposal of the Trust Unit. Gain or loss on the disposition is determined by subtracting the adjusted basis of the Trust Units from the proceeds received. If the Foreign person is a corporation which made an election under Internal Revenue Code Section 882(d), the corporation would also be subject to a 30 percent tax under Internal Revenue Code Section 884. This tax is imposed on U.S. branch profits of a foreign corporation that are not reinvested in the U.S. trade or business. This tax is in addition to the tax on effectively connected income. The branch profits tax may be either reduced or eliminated by treaty. SALE OF TRUST UNITS Generally, a Trust Unit holder will realize gain or loss on the sale or exchange of his Trust Units measured by the difference between the amount realized on the sale or exchange and his adjusted basis for such Trust Units. Gain on the sale of Trust Units by a holder that is not a dealer with respect to such Trust Units will be treated as ordinary income to the extent of any depletion deductions taken by such holder and the balance, if any, of the gain will be treated as capital gain. BACKUP WITHHOLDING A payor must withhold 31 percent of any reportable payment if the payee fails to furnish his taxpayer identification number ("TIN") to the payor in the required manner or if the Secretary of the Treasury notifies the payor that the TIN furnished by the payee is incorrect. A Unit holder will avoid backup withholding by furnishing his correct TIN to the Trustee in the form required by law. REPORTS The Trustee will furnish the Trust Unit holders of record quarterly and annual reports described above under "Description of the Trust Units and the Trust Agreement-Reports to Holders of Trust Units" in order to permit computation of tax liability by the Trust Unit holders. STATE INCOME TAXES Unit holders may be required to report their share of income from the Trust to their state of residence or commercial domicile. However, only corporate Unit holders will need to report their share of income to the State of Alaska. Alaska does not impose an income tax on individuals or estates and trusts. Corporate Unit holders should be advised that all Trust income is Alaska source income and should be reported accordingly. ITEM 2. ITEM 2. PROPERTIES Reference is made to "Item I.- Business" for the information required by this item. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Not applicable. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF UNIT HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR TRUST UNITS As of March 18, 1994, there were 2,181 registered holders of Trust Units. Future payments of cash distributions are dependent on such factors as the prevailing WTI Price, the relationship of the rate of change in the WTI Price to the rate of change in the Consumer Price Index, the Chargeable Costs, the rates of Production Taxes prevailing from time to time, and the actual production from the PBU. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Reference is made to "Item 1. - Report of Miller and Lents, Ltd., Independent Petroleum Consultants" of this Annual Report on Form 10-K. The following table presents in summary form selected financial information regarding the Trust. ITEM 1. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION The Trust is a passive entity with the Trustee having only such powers as are necessary for the collection and distribution of revenues from the Royalty Interest, the payment of Trust liabilities and expenses and the protection of the Royalty Interest. All royalty payments received by the Trustee are distributed, net of Trust expenses, to Trust Unit holders. Accordingly, a discussion of liquidity or capital resources is not applicable. RESULTS OF OPERATIONS Payments to the Trust with respect to the Royalty Interest are generally payable on the fifteenth day after the end of the calendar quarter (or the next succeeding business day if such fifteenth day is not a business day) in an amount equal to the per barrel WTI Price for each day during the calendar quarter less the sum of (i) the product of the per barrel Chargeable Costs and the Cost Adjustment Factor (such product hereinafter referred to as "Adjusted Chargeable Costs") and (ii) the per barrel Production Taxes, multiplied by the Royalty Production. ACTUAL RESULTS During 1993 the Trust received payments with respect to the Royalty Interest in the aggregate amount of $51,727,000 and made distributions to Unit holders in the aggregate amount of $51,173,000. The payment with respect to the Royalty Interest for the calendar quarter ended December 31, 1993, which was paid to the Trust on January 18, 1994, was $9,172,000. The following table sets forth with respect to each calendar quarter the average WTI price, the per barrel Chargeable Costs, the Cost Adjustment Factor, the per barrel Adjusted Chargeable Costs, the per barrel Production Taxes, and the Per Barrel Royalty. As discussed above in Part I "Industry Conditions" the production of oil and gas in Alaska is affected by many state and federal regulations. Existing and future legislation and regulations could result in the Company's experiencing delays and uncertainties, although the ultimate impact cannot generally be predicted. Per barrel royalty payments will also remain subject to oil prices, to the WTI Price, to Chargeable Costs, which increase in accordance with the schedule contained above under "Description of the Royalty Interest-Chargeable Costs", to the Cost Adjustment Factor, which is based on CPI, and to Production Taxes which increased by $.05 effective July 1, 1989. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. BP PRUDHOE BAY ROYALTY TRUST Page Independent Auditors' Report ................................. 46 Statements of Assets, Liabilities and Trust Corpus as of December 31, 1993 and 1992.............................. 47 Statements of Cash Earnings and Distributions for the years ended December 31, 1993, 1992 and 1991.............. 48 Statements of Changes in Trust Corpus for the years ended December 31,1993, 1992 and 1991......................... 49 Notes to Financial Statements................................. 50 INDEPENDENT AUDITORS' REPORT ---------------------------- Trustee and Holders of Trust Units of BP Prudhoe Bay Royalty Trust: We have audited the accompanying statements of assets, liabilities and Trust Corpus of BP Prudhoe Bay Royalty Trust as of December 31, 1993 and 1992, and the related statements of cash earnings and distributions and changes in Trust Corpus for each of the years in the three-year period ended December 31, 1993. 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 to the financial statements, these financial statements have been prepared on a modified 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 referred to above present fairly, in all material respects, the assets, liabilities and Trust Corpus of BP Prudhoe Bay Royalty Trust as of December 31, 1993 and 1992, and its cash earnings and distributions and its changes in Trust Corpus for each of the years in the three-year period ended December 31, 1993 on the basis of accounting described in note 2. KPMG Peat Marwick New York, New York March 14, 1994 BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements December 31, 1993, 1992 and 1991 (1) FORMATION OF THE TRUST AND ORGANIZATION BP Prudhoe Bay Royalty Trust (the "Trust") was formed pursuant to a Trust Agreement dated February 28, 1989 among The Standard Oil Company ("Standard Oil"), BP Exploration (Alaska) Inc. (the "Company"), The Bank of New York and a co-trustee (collectively, the "Trustee"). Standard Oil and the Company are indirect wholly owned subsidiaries of the British Petroleum Company p.l.c. ("BP"). On February 28, 1989, Standard Oil conveyed a royalty interest (the "Royalty Interest") to the Trust. The Trust was formed for the sole purpose of owning and administering the Royalty Interest. The Royalty Interest represents the right to receive, effective February 28, 1989, a per barrel royalty (the "Per Barrel Royalty") on 16.4246% of the lesser of (a) the first 90,000 barrels of the average actual daily net production of oil and condensate per quarter or (b) the average actual daily net production of oil and condensate per quarter from the Company's working interest in the Prudhoe Bay Field (the "Field") located on the North Slope of Alaska. Trust Unit holders will remain subject at all times to the risk that production will be interrupted or discontinued or fall, on average, below 90,000 barrels per day in any quarter. BP has guaranteed the performance by the Company of its payment obligations with respect to the Royalty Interest. The co-trustees of the Trust are The Bank of New York, a New York corporation authorized to do a banking business, and The Bank of New York (Delaware), a Delaware banking corporation. The Bank of New York (Delaware) serves as co-trustee in order to satisfy certain requirements of the Delaware Trust Act. The Bank of New York alone is able to exercise the rights and powers granted to the Trustee in the Trust Agreement. The Per Barrel Royalty in effect for any day is equal to the price of West Texas Intermediate crude oil (the "WTI Price") for that day less scheduled Chargeable Costs (adjusted in certain situations for inflation) and Production Taxes (based on statutory rates then in existence). During the period from February 28, 1989 (date of formation) to September 30, 1991, the Royalty Interest provided for a minimum royalty in certain situations. For years subsequent to 1995, Chargeable Costs will be reduced up to a maximum amount of $1.20 per barrel in each year if additions to the Field's proved reserved from January 1, 1988 do not meet certain specific levels. The Trust is passive, with the Trustee having only such powers as are necessary for the collection and distribution of revenues, the payment of Trust liabilities and the protection of the Royalty (Continued) - 50 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements Interest. The Trustee is obligated to establish cash reserves and, subject to certain conditions, is obligated to borrow funds to pay liabilities of the Trust when they become due. The Trustee may sell Trust properties only (a) as authorized by a vote of the Trust Unit holders, (b) when necessary to provide for the payment of specific liabilities of the Trust then due (subject to certain conditions) or (c) upon termination of the Trust. Each Trust Unit issued and outstanding represents an equal undivided share of beneficial interest in the Trust. Royalty payments are received by the Trust and distributed to Trust Unit holders, net of Trust expenses, in the month succeeding the end of each calendar quarter. The Trust will terminate upon the first to occur of the following events: (a) On or prior to December 31, 2010: upon a vote of Trust Unit holders of not less than 70% of the outstanding Trust Units. (b) After December 31, 2010: (i) upon a vote of Trust Unit holders of not less than 60% of the outstanding Trust Units, or (ii) at such time the net revenues from the Royalty Interest for two successive years commencing after 2010 are less than $1,000,000 per year (unless the net revenues during such period are materially and adversely affected by certain events). (2) BASIS OF ACCOUNTING The financial statements of the Trust are prepared on a modified cash basis and reflect the Trust's assets, liabilities and Trust Corpus and the earnings and distributions as follows: (a) Revenues are recorded when received (generally within 15 days of the end of the preceding quarter) and distributions to Trust Unit holders are recorded when paid. (b) Trust expenses (which include accounting, engineering, legal, and other professional fees, trustees' fees and out- of-pocket expenses) are recorded when incurred. (c) Amortization of the Royalty Interest is calculated based on the units-of-production attributable to the Trust over the production of estimated proved reserves attributable to the Trust at the beginning of the fiscal year (approximately 94,306,000, 98,141,000 and 121,500,000 barrels, respectively, were used to calculate the amortization of the Royalty Interest for the years ended December 31, 1993, 1992 and 1991, respectively), is charged directly to the Trust Corpus, and does not affect cash earnings. The rate for amortization per net equivalent barrel of oil was $5.67, $5.45 and $4.40 for the years ended December 31, 1993, 1992 and 1991, respectively. The remaining unamortized balance of the net overriding Royalty Interest at December 31, 1993 (Continued) - 51 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements is not necessarily indicative of the fair market value of the interest held by the Trust. While these statements differ from financial statements prepared in accordance with generally accepted accounting principles, the cash basis of reporting revenues and distributions is considered to be the most meaningful because quarterly distributions to the Unit holders are based on net cash receipts. The accompanying modified cash basis financial statements contain all adjustments necessary to present fairly the assets, liabilities and Trust Corpus of the Trust as of December 31, 1993 and 1992 and its cash earnings and distributions and changes in Trust Corpus for each of the years in the three-year period ended December 31, 1993. The conveyance of the Royalty Interest by Standard Oil to the Trust was accounted for as a purchase transaction. On February 28, 1989, Standard Oil sold 13,360,000 Trust Units to a group of institutional investors for $334 million in a private placement. For financial reporting purposes, the Trust's management valued the remaining Trust Units owned by Standard Oil (8,040,000 units) at a per unit value equivalent to the amount paid by the investors in the private placement. (3) INCOME TAXES The Trust files its federal tax return as a grantor trust subject to the provisions of subpart E of Part I of Subchapter J of the Internal Revenue Code of 1986, as amended, rather than an association taxable as a corporation. The Unit holders are treated as the owners of Trust income and Corpus, and the entire taxable income of the Trust will be reported by the Unit holders on their respective tax returns. (Continued) - 52 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements If the Trust were determined to be an association taxable as a corporation, it would be treated as an entity taxable as a corporation on the taxable income from the Royalty Interest, the Trust Unit holders would be treated as shareholders, and distributions to Trust Unit holders would not be deductible in computing the Trust's tax liability as an association. (4) SUMMARY OF QUARTERLY RESULTS (UNAUDITED) (5) SUPPLEMENTAL RESERVE INFORMATION AND STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOW RELATING TO PROVED RESERVES (UNAUDITED) Pursuant to Statement of Financial Accounting Standards No. 69 - "Disclosures About Oil and Gas Producing Activities" ("FASB 69"), the Trust is required to include in its financial statements supplementary information regarding estimates of quantities of proved reserves attributable to the Trust and future net cash flows. Estimates of proved reserves are inherently imprecise and subjective and are revised over time as additional data becomes available. Such revisions may often be substantial. Information regarding estimates of proved reserves attributable to the combined (Continued) - 53 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements interests of the Company and the Trust were based on Company-prepared reserve estimates. The Company's reserve estimates are believed to be reasonable and consistent with presently known physical data concerning the size and character of the Field. There is no precise method of allocating estimates of physical quantities of reserve volumes between the Company and the Trust, since the Royalty Interest is not a working interest and the Trust does not own and is not entitled to receive any specific volume of reserves from the Field. Reserve volumes attributable to the Trust were estimated by allocating to the Trust its share of estimated future production from the Field, based on the WTI Price on December 31, 1993 ($14.15 per barrel), December 31, 1992 ($19.50 per barrel) and December 31, 1991 ($19.10 per barrel). Because the reserve volumes attributable to the Trust are estimated using an allocation of reserve volumes based on estimated future production and on the current WTI Price, a change in the timing of estimated production or a change in the WTI price will result in a change in the Trust's estimated reserve volumes. Therefore, the estimated reserve volumes attributable to the Trust will vary if different production estimates and prices are used. In addition to production estimates and prices, reserve volumes attributable to the Trust are affected by the amount of Chargeable Costs that will be deducted in determining the Per Barrel Royalty. The Royalty Interest includes a provision under which, in years subsequent to 1995, if additions to the Field's proved reserves from January 1, 1988 do not meet certain specified levels, Chargeable Costs will be reduced up to a maximum amount of $1.20 per barrel in each year. Under the provisions of FASB 69, no consideration can be given to reserves not considered proved at the present time. Accordingly, in estimating the reserve volumes attributable to the Trust, Chargeable Costs were reduced by the maximum amount in years subsequent to 1995, after considering the amount of reserves that have been added to the Field's proved reserves from January 1, 1988. Net proved reserves of oil and condensate attributable to the Trust as of December 31, 1993, 1992 and 1991 based on the Company's latest reserve estimate at such time, the WTI Prices on December 31, 1993, 1992 and 1991 and a reduction in Chargeable Costs in years subsequent to 1995, were estimated to be 43, 94 and 98 million barrels, respectively (of which 43, 79 and 86 million barrels, respectively, are proved developed). The standardized measure of discounted future net cash flow relating to proved reserves disclosure required by FASB 69 assigns monetary amounts to proved reserves based on current prices. This discounted future net cash flow should not be construed as the current market value of the Royalty Interest. A market valuation determination would include, among other things, anticipated price increases and the value of additional reserves not considered proved at the present time or reserves that may be produced after the (Continued) - 54 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements currently anticipated end of field life. At December 31, 1993, 1992 and 1991 the standardized measure of discounted future net cash flow relating to proved reserves attributable to the Trust (estimated in accordance with the provisions of FASB 69), based on the WTI Prices on those dates of $14.15, $19.50 and $19.10, respectively, were as follows (in thousands): (Continued) - 55 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements The following are the principal sources of the change in the standardized measure of discounted future net cash flows (in thousands): (Continued) - 56 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements (Continued) - 57 - ITEM 9. CHANGES IN ACCOUNTANTS The Trust dismissed Ernst & Whinney as its independent accountants on June 15, 1989 and, as of the same date, engaged KPMG Peat Marwick as independent accountants. A Form Registration Statement (Registration No. 33-27923) filed by BP, the Company, and Standard Oil contained a single financial statement of the Trust audited by Ernst & Whinney, namely, a Statement of Assets and Trust corpus as of February 28,1989. The report of Ernst & Whinney on the Statement of Assets and Trust corpus contained in Registration Statement No. 33-27923 did not contain an adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. During the period from February 28, 1989 through June 15, 1989 there were no disagreements with Ernst & Whinney on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of Ernst & Whinney would have caused them to make reference thereto in their report on the Statement of Assets and Trust corpus as of February 28, 1989. During the period from February 28, 1989 through June 15, 1989, there were no reportable events (as defined in Regulation S-K Item 304(a)(1)(v)) with Ernst & Whinney. Ernst & Whinney has furnished the Trust with a copy of a letter addressed to the Securities and Exchange Commission stating that it agreed with the above statements. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The Trust has no directors or executive officers. The Trustee has only such rights and powers as are necessary to achieve the purposes of the Trust. ITEM 11. EXECUTIVE COMPENSATION Not applicable. ITEM 12. UNIT OWNERSHIP (a) Unit Ownership of Certain Beneficial Owners. As of March 18, 1994 the Trustee does not know of any person beneficially owning 5% or more of the Trust Units except based on filings with the Securities and Exchange Commission dated as of December 31, 1993, which filings set forth the following: Name No. of Units Percentage J.P. Morgan & Co., Inc. 2,391,300(1) 11.1 23 Wall Street New York, N.Y. 10007 Prudential Insurance Company of America 3,001,600(1) 14 3 Gateway Center Newark, N.J. 07102 (1) Amount known to be Units with respect to which beneficial owner has the right to acquire beneficial ownership: None. (b) Unit Ownerships of Management Neither the Company, Standard Oil, nor BP owns any Units. Neither The Bank of New York, as Trustee, or in its individual capacity, nor The Bank of New York (Delaware), as co-trustee, or in its individual capacity, owns any Units. (c) Change in Control The Trustee knows of no arrangement, including the pledge of Units, the operation of which may at a subsequent date result in a change in control of the Trust. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not Applicable. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) FINANCIAL STATEMENTS The following financial statements of the Trust are included in Part II, Item 8: Page Statements of Assets, Liabilities and Trust Corpus as of December 31, 1993 and 1992 ............................... 47 Statements of Cash Earnings and Distributions for the years ended December 31, 1993, 1992, and 1991 ........................ 48 Statements of Changes in Trust Corpus for the years ended December 31, 1993, 1992, and 1991 ........................ 49 Notes to Financial Statements .................................. 50 Independent Auditors' Report ................................... 46 (b) FINANCIAL STATEMENT SCHEDULES All financial statement schedules have been omitted because they are either not applicable, not required or the information is set forth in the financial statements or notes thereto. (c) EXHIBITS 4. Form of Trust Agreement (incorporated by reference to Exhibit 6 to the Form 8-A Registration Statement of BP Prudhoe Bay Royalty Trust, Commission File No. 1-10243). 10.1 Form of Trust Conveyance dated February 28, 1989 (incorporated by reference to Exhibit 6 to the Form 8-A Registration Statement of BP Prudhoe Bay Royalty Trust, Commission File No. 1-10243). 10.2 Form of Overriding Royalty Conveyance dated February 27, 1989 (incorporated by reference to Exhibit 6 to the Form 8-A Registration Statement of BP Prudhoe Bay Royalty Trust, Commission File No. 1-10243). 16. Letter of Ernst & Whinney dated June 15, 1989 re change in certifying accountant (incorporated by reference to Exhibit 16 to Form 8-K Current Report of BP Prudhoe Bay Royalty Trust, Commission File No. 1-10243). 23. Consent of Expert - (See Exhibit 23.1 attached hereto). 27. Financial Data Schedule - (See Exhibit 27.1 attached hereto). ALL OTHER EXHIBITS HAVE BEEN OMITTED BECAUSE THEY ARE EITHER NOT APPLICABLE OR NOT REQUIRED. (d) REPORTS ON FORM 8-K No reports on Form 8-K were filed with the Securities and Exchange Commission by the Trust during the quarter ending in December 31, 1993. SIGNATURE 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. BP PRUDHOE BAY ROYALTY TRUST THE BANK OF NEW YORK, as Trustee By: /s/ Walter Gitlin ----------------- Walter Gitlin Vice President March 29, 1994 The Registrant, BP Prudhoe Bay Royalty Trust, has no principal executive officer, principal financial officer, board of directors or persons performing similar functions. Accordingly, no additional signatures are available and none have been provided. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. BP PRUDHOE BAY ROYALTY TRUST Page Independent Auditors' Report ................................. 46 Statements of Assets, Liabilities and Trust Corpus as of December 31, 1993 and 1992.............................. 47 Statements of Cash Earnings and Distributions for the years ended December 31, 1993, 1992 and 1991.............. 48 Statements of Changes in Trust Corpus for the years ended December 31,1993, 1992 and 1991......................... 49 Notes to Financial Statements................................. 50 INDEPENDENT AUDITORS' REPORT ---------------------------- Trustee and Holders of Trust Units of BP Prudhoe Bay Royalty Trust: We have audited the accompanying statements of assets, liabilities and Trust Corpus of BP Prudhoe Bay Royalty Trust as of December 31, 1993 and 1992, and the related statements of cash earnings and distributions and changes in Trust Corpus for each of the years in the three-year period ended December 31, 1993. 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 to the financial statements, these financial statements have been prepared on a modified 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 referred to above present fairly, in all material respects, the assets, liabilities and Trust Corpus of BP Prudhoe Bay Royalty Trust as of December 31, 1993 and 1992, and its cash earnings and distributions and its changes in Trust Corpus for each of the years in the three-year period ended December 31, 1993 on the basis of accounting described in note 2. KPMG Peat Marwick New York, New York March 14, 1994 BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements December 31, 1993, 1992 and 1991 (1) FORMATION OF THE TRUST AND ORGANIZATION BP Prudhoe Bay Royalty Trust (the "Trust") was formed pursuant to a Trust Agreement dated February 28, 1989 among The Standard Oil Company ("Standard Oil"), BP Exploration (Alaska) Inc. (the "Company"), The Bank of New York and a co-trustee (collectively, the "Trustee"). Standard Oil and the Company are indirect wholly owned subsidiaries of the British Petroleum Company p.l.c. ("BP"). On February 28, 1989, Standard Oil conveyed a royalty interest (the "Royalty Interest") to the Trust. The Trust was formed for the sole purpose of owning and administering the Royalty Interest. The Royalty Interest represents the right to receive, effective February 28, 1989, a per barrel royalty (the "Per Barrel Royalty") on 16.4246% of the lesser of (a) the first 90,000 barrels of the average actual daily net production of oil and condensate per quarter or (b) the average actual daily net production of oil and condensate per quarter from the Company's working interest in the Prudhoe Bay Field (the "Field") located on the North Slope of Alaska. Trust Unit holders will remain subject at all times to the risk that production will be interrupted or discontinued or fall, on average, below 90,000 barrels per day in any quarter. BP has guaranteed the performance by the Company of its payment obligations with respect to the Royalty Interest. The co-trustees of the Trust are The Bank of New York, a New York corporation authorized to do a banking business, and The Bank of New York (Delaware), a Delaware banking corporation. The Bank of New York (Delaware) serves as co-trustee in order to satisfy certain requirements of the Delaware Trust Act. The Bank of New York alone is able to exercise the rights and powers granted to the Trustee in the Trust Agreement. The Per Barrel Royalty in effect for any day is equal to the price of West Texas Intermediate crude oil (the "WTI Price") for that day less scheduled Chargeable Costs (adjusted in certain situations for inflation) and Production Taxes (based on statutory rates then in existence). During the period from February 28, 1989 (date of formation) to September 30, 1991, the Royalty Interest provided for a minimum royalty in certain situations. For years subsequent to 1995, Chargeable Costs will be reduced up to a maximum amount of $1.20 per barrel in each year if additions to the Field's proved reserved from January 1, 1988 do not meet certain specific levels. The Trust is passive, with the Trustee having only such powers as are necessary for the collection and distribution of revenues, the payment of Trust liabilities and the protection of the Royalty (Continued) - 50 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements Interest. The Trustee is obligated to establish cash reserves and, subject to certain conditions, is obligated to borrow funds to pay liabilities of the Trust when they become due. The Trustee may sell Trust properties only (a) as authorized by a vote of the Trust Unit holders, (b) when necessary to provide for the payment of specific liabilities of the Trust then due (subject to certain conditions) or (c) upon termination of the Trust. Each Trust Unit issued and outstanding represents an equal undivided share of beneficial interest in the Trust. Royalty payments are received by the Trust and distributed to Trust Unit holders, net of Trust expenses, in the month succeeding the end of each calendar quarter. The Trust will terminate upon the first to occur of the following events: (a) On or prior to December 31, 2010: upon a vote of Trust Unit holders of not less than 70% of the outstanding Trust Units. (b) After December 31, 2010: (i) upon a vote of Trust Unit holders of not less than 60% of the outstanding Trust Units, or (ii) at such time the net revenues from the Royalty Interest for two successive years commencing after 2010 are less than $1,000,000 per year (unless the net revenues during such period are materially and adversely affected by certain events). (2) BASIS OF ACCOUNTING The financial statements of the Trust are prepared on a modified cash basis and reflect the Trust's assets, liabilities and Trust Corpus and the earnings and distributions as follows: (a) Revenues are recorded when received (generally within 15 days of the end of the preceding quarter) and distributions to Trust Unit holders are recorded when paid. (b) Trust expenses (which include accounting, engineering, legal, and other professional fees, trustees' fees and out- of-pocket expenses) are recorded when incurred. (c) Amortization of the Royalty Interest is calculated based on the units-of-production attributable to the Trust over the production of estimated proved reserves attributable to the Trust at the beginning of the fiscal year (approximately 94,306,000, 98,141,000 and 121,500,000 barrels, respectively, were used to calculate the amortization of the Royalty Interest for the years ended December 31, 1993, 1992 and 1991, respectively), is charged directly to the Trust Corpus, and does not affect cash earnings. The rate for amortization per net equivalent barrel of oil was $5.67, $5.45 and $4.40 for the years ended December 31, 1993, 1992 and 1991, respectively. The remaining unamortized balance of the net overriding Royalty Interest at December 31, 1993 (Continued) - 51 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements is not necessarily indicative of the fair market value of the interest held by the Trust. While these statements differ from financial statements prepared in accordance with generally accepted accounting principles, the cash basis of reporting revenues and distributions is considered to be the most meaningful because quarterly distributions to the Unit holders are based on net cash receipts. The accompanying modified cash basis financial statements contain all adjustments necessary to present fairly the assets, liabilities and Trust Corpus of the Trust as of December 31, 1993 and 1992 and its cash earnings and distributions and changes in Trust Corpus for each of the years in the three-year period ended December 31, 1993. The conveyance of the Royalty Interest by Standard Oil to the Trust was accounted for as a purchase transaction. On February 28, 1989, Standard Oil sold 13,360,000 Trust Units to a group of institutional investors for $334 million in a private placement. For financial reporting purposes, the Trust's management valued the remaining Trust Units owned by Standard Oil (8,040,000 units) at a per unit value equivalent to the amount paid by the investors in the private placement. (3) INCOME TAXES The Trust files its federal tax return as a grantor trust subject to the provisions of subpart E of Part I of Subchapter J of the Internal Revenue Code of 1986, as amended, rather than an association taxable as a corporation. The Unit holders are treated as the owners of Trust income and Corpus, and the entire taxable income of the Trust will be reported by the Unit holders on their respective tax returns. (Continued) - 52 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements If the Trust were determined to be an association taxable as a corporation, it would be treated as an entity taxable as a corporation on the taxable income from the Royalty Interest, the Trust Unit holders would be treated as shareholders, and distributions to Trust Unit holders would not be deductible in computing the Trust's tax liability as an association. (4) SUMMARY OF QUARTERLY RESULTS (UNAUDITED) (5) SUPPLEMENTAL RESERVE INFORMATION AND STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOW RELATING TO PROVED RESERVES (UNAUDITED) Pursuant to Statement of Financial Accounting Standards No. 69 - "Disclosures About Oil and Gas Producing Activities" ("FASB 69"), the Trust is required to include in its financial statements supplementary information regarding estimates of quantities of proved reserves attributable to the Trust and future net cash flows. Estimates of proved reserves are inherently imprecise and subjective and are revised over time as additional data becomes available. Such revisions may often be substantial. Information regarding estimates of proved reserves attributable to the combined (Continued) - 53 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements interests of the Company and the Trust were based on Company-prepared reserve estimates. The Company's reserve estimates are believed to be reasonable and consistent with presently known physical data concerning the size and character of the Field. There is no precise method of allocating estimates of physical quantities of reserve volumes between the Company and the Trust, since the Royalty Interest is not a working interest and the Trust does not own and is not entitled to receive any specific volume of reserves from the Field. Reserve volumes attributable to the Trust were estimated by allocating to the Trust its share of estimated future production from the Field, based on the WTI Price on December 31, 1993 ($14.15 per barrel), December 31, 1992 ($19.50 per barrel) and December 31, 1991 ($19.10 per barrel). Because the reserve volumes attributable to the Trust are estimated using an allocation of reserve volumes based on estimated future production and on the current WTI Price, a change in the timing of estimated production or a change in the WTI price will result in a change in the Trust's estimated reserve volumes. Therefore, the estimated reserve volumes attributable to the Trust will vary if different production estimates and prices are used. In addition to production estimates and prices, reserve volumes attributable to the Trust are affected by the amount of Chargeable Costs that will be deducted in determining the Per Barrel Royalty. The Royalty Interest includes a provision under which, in years subsequent to 1995, if additions to the Field's proved reserves from January 1, 1988 do not meet certain specified levels, Chargeable Costs will be reduced up to a maximum amount of $1.20 per barrel in each year. Under the provisions of FASB 69, no consideration can be given to reserves not considered proved at the present time. Accordingly, in estimating the reserve volumes attributable to the Trust, Chargeable Costs were reduced by the maximum amount in years subsequent to 1995, after considering the amount of reserves that have been added to the Field's proved reserves from January 1, 1988. Net proved reserves of oil and condensate attributable to the Trust as of December 31, 1993, 1992 and 1991 based on the Company's latest reserve estimate at such time, the WTI Prices on December 31, 1993, 1992 and 1991 and a reduction in Chargeable Costs in years subsequent to 1995, were estimated to be 43, 94 and 98 million barrels, respectively (of which 43, 79 and 86 million barrels, respectively, are proved developed). The standardized measure of discounted future net cash flow relating to proved reserves disclosure required by FASB 69 assigns monetary amounts to proved reserves based on current prices. This discounted future net cash flow should not be construed as the current market value of the Royalty Interest. A market valuation determination would include, among other things, anticipated price increases and the value of additional reserves not considered proved at the present time or reserves that may be produced after the (Continued) - 54 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements currently anticipated end of field life. At December 31, 1993, 1992 and 1991 the standardized measure of discounted future net cash flow relating to proved reserves attributable to the Trust (estimated in accordance with the provisions of FASB 69), based on the WTI Prices on those dates of $14.15, $19.50 and $19.10, respectively, were as follows (in thousands): (Continued) - 55 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements The following are the principal sources of the change in the standardized measure of discounted future net cash flows (in thousands): (Continued) - 56 - BP PRUDHOE BAY ROYALTY TRUST Notes to Financial Statements (Continued) - 57 - ITEM 9. ITEM 9. CHANGES IN ACCOUNTANTS The Trust dismissed Ernst & Whinney as its independent accountants on June 15, 1989 and, as of the same date, engaged KPMG Peat Marwick as independent accountants. A Form Registration Statement (Registration No. 33-27923) filed by BP, the Company, and Standard Oil contained a single financial statement of the Trust audited by Ernst & Whinney, namely, a Statement of Assets and Trust corpus as of February 28,1989. The report of Ernst & Whinney on the Statement of Assets and Trust corpus contained in Registration Statement No. 33-27923 did not contain an adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. During the period from February 28, 1989 through June 15, 1989 there were no disagreements with Ernst & Whinney on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of Ernst & Whinney would have caused them to make reference thereto in their report on the Statement of Assets and Trust corpus as of February 28, 1989. During the period from February 28, 1989 through June 15, 1989, there were no reportable events (as defined in Regulation S-K Item 304(a)(1)(v)) with Ernst & Whinney. Ernst & Whinney has furnished the Trust with a copy of a letter addressed to the Securities and Exchange Commission stating that it agreed with the above statements. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The Trust has no directors or executive officers. The Trustee has only such rights and powers as are necessary to achieve the purposes of the Trust. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Not applicable. ITEM 12. ITEM 12. UNIT OWNERSHIP (a) Unit Ownership of Certain Beneficial Owners. As of March 18, 1994 the Trustee does not know of any person beneficially owning 5% or more of the Trust Units except based on filings with the Securities and Exchange Commission dated as of December 31, 1993, which filings set forth the following: Name No. of Units Percentage J.P. Morgan & Co., Inc. 2,391,300(1) 11.1 23 Wall Street New York, N.Y. 10007 Prudential Insurance Company of America 3,001,600(1) 14 3 Gateway Center Newark, N.J. 07102 (1) Amount known to be Units with respect to which beneficial owner has the right to acquire beneficial ownership: None. (b) Unit Ownerships of Management Neither the Company, Standard Oil, nor BP owns any Units. Neither The Bank of New York, as Trustee, or in its individual capacity, nor The Bank of New York (Delaware), as co-trustee, or in its individual capacity, owns any Units. (c) Change in Control The Trustee knows of no arrangement, including the pledge of Units, the operation of which may at a subsequent date result in a change in control of the Trust. 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) FINANCIAL STATEMENTS The following financial statements of the Trust are included in Part II, Item 8: Page Statements of Assets, Liabilities and Trust Corpus as of December 31, 1993 and 1992 ............................... 47 Statements of Cash Earnings and Distributions for the years ended December 31, 1993, 1992, and 1991 ........................ 48 Statements of Changes in Trust Corpus for the years ended December 31, 1993, 1992, and 1991 ........................ 49 Notes to Financial Statements .................................. 50 Independent Auditors' Report ................................... 46 (b) FINANCIAL STATEMENT SCHEDULES All financial statement schedules have been omitted because they are either not applicable, not required or the information is set forth in the financial statements or notes thereto. (c) EXHIBITS 4. Form of Trust Agreement (incorporated by reference to Exhibit 6 to the Form 8-A Registration Statement of BP Prudhoe Bay Royalty Trust, Commission File No. 1-10243). 10.1 Form of Trust Conveyance dated February 28, 1989 (incorporated by reference to Exhibit 6 to the Form 8-A Registration Statement of BP Prudhoe Bay Royalty Trust, Commission File No. 1-10243). 10.2 Form of Overriding Royalty Conveyance dated February 27, 1989 (incorporated by reference to Exhibit 6 to the Form 8-A Registration Statement of BP Prudhoe Bay Royalty Trust, Commission File No. 1-10243). 16. Letter of Ernst & Whinney dated June 15, 1989 re change in certifying accountant (incorporated by reference to Exhibit 16 to Form 8-K Current Report of BP Prudhoe Bay Royalty Trust, Commission File No. 1-10243). 23. Consent of Expert - (See Exhibit 23.1 attached hereto). 27. Financial Data Schedule - (See Exhibit 27.1 attached hereto). ALL OTHER EXHIBITS HAVE BEEN OMITTED BECAUSE THEY ARE EITHER NOT APPLICABLE OR NOT REQUIRED. (d) REPORTS ON FORM 8-K No reports on Form 8-K were filed with the Securities and Exchange Commission by the Trust during the quarter ending in December 31, 1993. SIGNATURE 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. BP PRUDHOE BAY ROYALTY TRUST THE BANK OF NEW YORK, as Trustee By: /s/ Walter Gitlin ----------------- Walter Gitlin Vice President March 29, 1994 The Registrant, BP Prudhoe Bay Royalty Trust, has no principal executive officer, principal financial officer, board of directors or persons performing similar functions. Accordingly, no additional signatures are available and none have been provided.

36966_1993.txt

36966_1993

1993

36966

ITEM 1 BUSINESS General. First Tennessee National Corporation (the "Corporation") is a Tennessee corporation incorporated in 1968 and registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. At December 31, 1993, the Corporation had total assets of $9.6 billion and ranked first in terms of total assets among Tennessee-headquartered bank holding companies and ranked in the top 65 nationally. Through its principal subsidiary, First Tennessee Bank National Association (the "Bank"), and its other banking and banking-related subsidiaries, the Corporation provides a broad range of financial services. The Corporation derives substantially all of its consolidated total pre-tax operating income and consolidated revenues from the banking business. As a bank holding company, the Corporation coordinates the financial resources of the consolidated enterprise and maintains systems of financial, operational and administrative control that allows coordination of selected policies and activities. The Corporation assesses the Bank and its subsidiaries for services they receive on a formula basis it believes to be reasonable. The Bank is a national banking association with principal offices in Memphis, Tennessee. It received its charter in 1864 and operates primarily on a regional basis. During 1993 it generated gross revenue of approximately $841 million and contributed 96.1% of consolidated net income from continuing operations. At December 31, 1993, the Bank had $9.4 billion in total assets, $7.0 billion in total deposits, and $5.8 billion in net loans. Within the State of Tennessee on December 31, 1993, it ranked first among banks in terms of total assets and deposits. Nationally, it ranked in the top 100 in terms of total assets and deposits as of December 31, 1993. On December 31, 1993, the Corporation's subsidiary banks had 214 banking locations in 20 Tennessee counties, including all of the major metropolitan areas of the state, and 4 banking locations in Mississippi. An element of the Corporation's business strategy is to seek acquisitions that would enhance long-term shareholder value. The Corporation has an acquisitions department charged with this responsibility which is constantly reviewing and developing opportunities to achieve this element of the Corporation's strategy. The Corporation significantly expanded its mortgage banking operations at the end of 1993. On October 1, 1993, the Bank acquired Maryland National Mortgage Corporation, Baltimore, Maryland ("MNMC") and its wholly-owned subsidiary, Atlantic Coast Mortgage Company, in a transaction accounted for as a purchase. At the time of acquisition, MNMC had total assets of approximately $538 million and a mortgage servicing portfolio of approximately $4.0 billion. On January 4, 1994, the Corporation acquired SNMC Management Corporation, the parent of Sunbelt National Mortgage Corporation, Dallas, Texas ("SNMC") in a transaction accounted for as a pooling-of-interests. SNMC became a subsidiary of the Bank at the close of the transaction. At the time of the acquisition, SNMC had total assets of approximately $451 million and a mortgage servicing portfolio of approximately $6.0 billion. The Corporation provides the following services through its subsidiaries: . general banking services for consumers, small businesses, corporations, financial institutions, and governments . bond division-primarily sales and underwriting of bank-eligible securities and mortgage loans and advisory services to other financial institutions . mortgage banking services . trust, fiduciary, and agency services . a nationwide check clearing service . merchant credit card and automated teller machine transaction processing . discount brokerage, brokerage, venture capital, equipment finance and credit life insurance services . investment and financial advisory services . mutual fund sales as agent . check processing software and systems. All of the Corporation's subsidiaries are listed in Exhibit 21. The Bank has filed notice with the Comptroller of the Currency as a government securities broker/dealer. The bond division of the Bank is registered with the Securities and Exchange Commission ("SEC") as a municipal securities dealer with offices in Memphis and Knoxville, Tennessee; Mobile, Alabama; and Overland Park, Kansas. The subsidiary banks are supervised and regulated as described below. First Tennessee Investment Management, Inc., is registered with the SEC as an investment adviser. Hickory Venture Capital Corporation is licensed as a Small Business Investment Company. First Tennessee Brokerage, Inc. is registered with the SEC as a broker-dealer. Expenditures for research and development activities were not material for the years 1991, 1992 or 1993. Neither the Corporation nor any of its significant subsidiaries is dependent upon a single customer or very few customers. At December 31, 1993, the Corporation and its subsidiaries had approximately 5,653 full-time-equivalent employees, not including contract labor for certain services, such as guard and house-keeping. Supervision and Regulation. The Corporation is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "BHCA"), and is registered with the Board of Governors of the Federal Reserve System (the "Board"). The Corporation is required to file with the Board annual and quarterly reports and such additional information as the Board may require pursuant to the Act. The Board may also make examinations of the Corporation and its subsidiaries. The following summary of the Act and of the other acts described herein is qualified in its entirety by express reference to each of the particular acts and the applicable rules and regulations thereunder. GENERAL As a bank holding company, the Corporation is subject to the regulation and supervision of the Board under the BHCA. Under the BHCA, bank holding companies may not in general directly or indirectly acquire the ownership or control of more than 5% of the voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. The BHCA also restricts the types of activities in which a bank holding company and its subsidiaries may engage. Generally, activities are limited to banking and activities found by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. In addition, the BHCA generally prohibits, subject to certain limited exceptions, the Federal Reserve Board from approving an application by a bank holding company to acquire shares of a bank or bank holding company located outside the acquiror's principal state of operations unless such an acquisition is specifically authorized by statute in the state in which the bank or bank holding company whose shares are to be acquired is located. Tennessee has adopted legislation that authorizes nationwide interstate bank acquisitions, subject to certain state law reciprocity requirements, including the filing of an application with and approval of the Tennessee Commissioner of Financial Institutions. The Tennessee Bank Structure Act of 1974 prohibits a bank holding company from acquiring any bank in Tennessee if the banks that it controls hold 16 1/2% or more of the total deposits in individual, partnership and corporate demand and other transaction accounts, savings accounts and time deposits in all federally insured financial institutions in Tennessee, subject to certain limitations and exclusions. As of December 31, 1993, the Corporation estimates that its subsidiary banks (the "Subsidiary Banks") held approximately 12% of such deposits. Also, under this act, no bank holding company may acquire any bank in operation for less than five years or begin a de novo bank in any county in Tennessee with a population, in 1970, of 200,000 or less, subject to certain exceptions. Under Tennessee law, branch banking is permitted in any county in the state. The Subsidiary Banks are subject to supervision and examination by applicable federal and state banking agencies. The Bank is a national banking association subject to regulation and supervision by the Comptroller of the Currency (the "Comptroller") as its primary federal regulator, as is First Tennessee Bank National Association Mississippi, which is headquartered in Southaven, Mississippi. The remaining Subsidiary Bank, Peoples and Union Bank, is a Tennessee state-chartered bank that is not a member of the Federal Reserve System, and therefore is subject to the regulations of and supervision by the Federal Deposit Insurance Corporation (the "FDIC") as its primary federal regulator, as well as state banking authorities. In addition all of the Subsidiary Banks are insured by, and subject to regulation by, the FDIC. The Subsidiary Banks are subject to various requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon and limitations on the types of investments that may be made, activities that may be engaged in, and the types of services that may be offered. Various consumer laws and regulations also affect the operations of the Subsidiary Banks. In addition to the impact of such 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. PAYMENT OF DIVIDENDS The Corporation is a legal entity separate and distinct from its banking and other subsidiaries. The principal source of cash flow of the Corporation, including cash flow to pay dividends on its stock or principal (premium, if any) and interest on debt securities, is dividends from the Subsidiary Banks. There are statutory and regulatory limitations on the payment of dividends by the Subsidiary Banks to the Corporation, as well as by the Corporation to its shareholders. Each Subsidiary Bank that is a national bank is required by federal law to obtain the prior approval of the Comptroller for the payment of dividends if the total of all dividends declared by the board of directors of such Subsidiary Bank in any year will exceed the total of (i) its net profits (as defined and interpreted by regulation) for that year plus (ii) the retained net profits (as defined and interpreted by regulation) for the preceding two years, less any required transfers to surplus. A national bank also can pay dividends only to the extent that retained net profits (including the portion transferred to surplus) exceed bad debts (as defined by regulation). State-chartered banks are subject to varying restrictions on the payment of dividends under applicable state laws. With respect to Peoples and Union Bank, Tennessee law imposes dividend restrictions substantially similar to those imposed under federal law on national banks, as described above. If, in the opinion of the applicable federal bank regulatory authority, a depository institution or a holding company is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution or holding company, could include the payment of dividends), such authority may require that such institution or holding company cease and desist from such practice. The federal banking agencies have indicated that paying dividends that deplete a depository institution's or holding company's capital base to an inadequate level would be such an unsafe and unsound banking practice. Moreover, the Federal Reserve Board, the Comptroller and the FDIC have issued policy statements which provide that bank holding companies and insured depository institutions generally should only pay dividends out of current operating earnings. In addition, under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), a FDIC-insured depository institution may not make any capital distributions (including the payment of dividends) or pay any management fees to its holding company or pay any dividend if it is undercapitalized or if such payment would cause it to become undercapitalized. See "--FDICIA." At December 31, 1993, under dividend restrictions imposed under applicable federal and state laws, the Subsidiary Banks, without obtaining regulatory approval, could legally declare aggregate dividends of approximately $168.2 million. The payment of dividends by the Corporation and the Subsidiary Banks may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. TRANSACTIONS WITH AFFILIATES There are various legal restrictions on the extent to which the Corporation and its nonbank subsidiaries can borrow or otherwise obtain credit from the Subsidiary Banks. There are also legal restrictions on the Subsidiary Banks' purchases of or investments in the securities of and purchases of assets from the Corporation and its nonbank subsidiaries, a Subsidiary Bank's loans or extensions of credit to third parties collateralized by the securities or obligations of the Corporation and its nonbank subsidiaries, the issuance of guaranties, acceptances and letters of credit on behalf of the Corporation and its nonbank subsidiaries, and certain bank transactions with the Corporation and its nonbank subsidiaries, or with respect to which the Corporation and its nonbank subsidiaries act as agent, participate or have a financial interest. Subject to certain limited exceptions, a Subsidiary Bank (including for purposes of this paragraph all subsidiaries of such Subsidiary Bank) may not extend credit to the Corporation or to any other affiliate (other than another Subsidiary Bank and certain exempted affiliates) in an amount which exceeds 10% of the Subsidiary Bank's capital stock and surplus and may not extend credit in the aggregate to all such affiliates in an amount which exceeds 20% of its capital stock and surplus. Further, there are legal requirements as to the type, amount and quality of collateral which must secure such extensions of credit by these banks to the Corporation or to such other affiliates. Also, extensions of credit and other transactions between a Subsidiary Bank and the Corporation or such other affiliates must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to such Subsidiary Bank as those prevailing at the time for comparable transactions with non-affiliated companies. Also, the Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. CAPITAL ADEQUACY The Federal Reserve Board has adopted risk-based capital guidelines for bank holding companies. The minimum guideline for the ratio of total capital ("Total Capital") to risk-weighted assets (including certain off-balance-sheet items, such as standby letters of credit) is 8%. At least half of the Total Capital must be composed of common stock, minority interests in the equity accounts of consolidated subsidiaries, noncumulative perpetual preferred stock and a limited amount of cumulative perpetual preferred stock, less goodwill and other intangible assets, subject to certain exceptions ("Tier 1 Capital"). The remainder may consist of qualifying subordinated debt, certain types of mandatory convertible securities and perpetual debt, other preferred stock and a limited amount of loan loss reserves. At December 31, 1993, the Corporation's consolidated Tier 1 Capital and Total Capital ratios were 9.60% and 12.14%, respectively. In addition, the Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to average assets, less goodwill and other intangible assets, subject to certain exceptions (the "Leverage Ratio"), of 3% for bank holding companies that meet certain specific criteria, including having the highest regulatory rating. All other bank holding companies generally are required to maintain a Leverage Ratio of at least 3%, plus an additional cushion of at least 100 to 200 basis points. The Corporation's Leverage Ratio at December 31, 1993 was 6.55%. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the Federal Reserve Board has indicated that it will consider a "tangible Tier 1 Capital leverage ratio" (deducting all intangibles) and other indicia of capital strength in evaluating proposals for expansion or new activities. Each of the Subsidiary Banks is subject to risk-based and leverage capital requirements similar to those described above adopted by the Comptroller or the FDIC, as the case may be. The Corporation believes that each of the Subsidiary Banks was in compliance with applicable minimum capital requirements as of December 31, 1993. Neither the Corporation nor any of the Subsidiary Banks has been advised by any federal banking agency of any specific minimum Leverage Ratio requirement applicable to it. Failure to meet capital guidelines could subject a bank to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC, to certain restrictions on its business and, in certain situations, the appointment of a conservator or receiver. See "--FDICIA." All of the federal banking agencies have proposed regulations that would add an additional risk-based capital requirement based upon the amount of an institution's exposure to interest rate risk. HOLDING COMPANY STRUCTURE AND SUPPORT OF SUBSIDIARY BANKS Because the Corporation is a holding company, its right to participate in the assets of any subsidiary upon the latter's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors (including depositors in the case of the Subsidiary Banks) except to the extent that the Corporation may itself be a creditor with recognized claims against the subsidiary. In addition, depositors of a bank, and the FDIC as their subrogee, would be entitled to priority over other creditors in the event of liquidation of a bank subsidiary. Under Federal Reserve Board policy, the Corporation is expected to act as a source of financial strength to, and commit resources to support, each of the Subsidiary Banks. This support may be required at times when, absent such Federal Reserve Board policy, the Corporation may not be inclined to provide it. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary 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 will be assumed by the bankruptcy trustee and entitled to a priority of payment. CROSS-GUARANTEE LIABILITY Under the Federal Deposit Insurance Act (the "FDIA"), 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 any 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. The FDIC's claim for damages is superior to claims of shareholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institution. The Subsidiary Banks are subject to these cross-guarantee provisions. As a result, any loss suffered by the FDIC in respect of any of the Subsidiary Banks would likely result in assertion of the cross-guarantee provisions, the assessment of such estimated losses against the Corporation's other Subsidiary Banks and a potential loss of the Corporation's investment in such other Subsidiary Banks. FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which was enacted on December 19, 1991, substantially revised the depository institution regulatory and funding provisions of the FDIA and made revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking regulators to take "prompt corrective action" in respect of FDIC-insured depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Under applicable regulations, an FDIC-insured depository institution is defined to be well capitalized if it maintains a Leverage ratio of at least 5%, a risk adjusted Tier 1 Capital Ratio of at least 6% and a Total Capital Ratio of at least 10% and is not subject to a directive, order or written agreement to meet and maintain specific capital levels. An insured depository institution is defined to be adequately capitalized if it meets all of its minimum capital requirements as described above. An insured depository institution will be considered undercapitalized if it fails to meet any minimum required measure, significantly undercapitalized if it has a Total Risk-Based Capital Ratio of less than 6%, a Tier 1 Risk-Based Capital Ratio of less than 3% or a Leverage Ratio of less than 3% and critically undercapitalized if it fails to maintain a level of tangible equity equal to at least 2% of total assets. An insured depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. The capital-based prompt corrective action provisions of FDICIA and their implementing regulations apply to FDIC-insured depository institutions and are not directly applicable to holding companies which control such institutions. However, the Federal Reserve Board has indicated that, in regulating bank holding companies, it will take appropriate action at the holding company level based on an assessment of the supervisory actions imposed upon subsidiary depository institutions pursuant to such provisions and regulations. FDICIA generally prohibits an FDIC-insured depository institution from making any capital distribution (including payment of dividends) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. A depository institution's holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the depository institution's assets at the time it becomes undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan for the plan to be accepted by the applicable federal regulatory authority. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator, generally within 90 days of the date on which they become critically undercapitalized. The Corporation believes that at December 31, 1993 all of the Subsidiary Banks were well capitalized under the criteria discussed above. Various other legislation, including proposals to revise the bank regulatory system and to limit the investments that a depository institution may make with insured funds, is from time to time introduced in Congress. See the "Effect of Governmental Policies" subsection. BROKERED DEPOSITS AND "PASS-THROUGH" INSURANCE The FDIC has adopted regulations under FDICIA governing the receipt of brokered deposits and pass-through insurance. Under the regulations, a bank cannot accept or rollover or renew brokered deposits unless (i) it is well capitalized or (ii) it is adequately capitalized and receives a waiver from the FDIC. A bank that cannot receive brokered deposits also cannot offer "pass-through" insurance on certain employee benefit accounts. Whether or not it has obtained such a waiver, an adequately capitalized bank may not pay an interest rate on any deposits in excess of 75 basis points over certain prevailing market rates specified by regulation. There are no such restrictions on a bank that is well capitalized. Because it believes that all the Subsidiary Banks were well capitalized as of December 31, 1993, the Corporation believes the brokered deposits regulation will have no present effect on the funding or liquidity of any of the Subsidiary Banks. FDIC INSURANCE PREMIUMS The Subsidiary Banks are required to pay semiannual FDIC deposit insurance assessments. As required by FDICIA, the FDIC adopted a risk-based premium schedule which has increased the assessment rates for most FDIC-insured depository institutions. Under the new schedule, the premiums initially range from $.23 to $.31 for every $100 of deposits. Each financial institution is assigned to one of three capital groups -- well capitalized, adequately capitalized or undercapitalized -- and further assigned to one of three subgroups within a capital group, on the basis of supervisory evaluations by the institution's primary federal and, if applicable, state supervisors and other information relevant to the institution's financial condition and the risk posed to the applicable FDIC deposit insurance fund. The actual assessment rate applicable to a particular institution will, therefore, depend in part upon the risk assessment classification so assigned to the institution by the FDIC. The FDIC is authorized by federal law to raise insurance premiums in certain circumstances. Any increase in premiums would have an adverse effect on the Subsidiary Banks' and the Corporation's earnings. Under the FDIA, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe and 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 a federal bank regulatory agency. DEPOSITOR PREFERENCE The Omnibus Budget Reconciliation Act of 1993 provides that deposits and certain claims for administrative expenses and employee compensation against an insured depository institution would be afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the "liquidation or other resolution" of such an institution by any receiver. Competition. The Corporation and its subsidiaries face substantial competition in all aspects of the businesses in which they engage from national and state banks located in Tennessee and large out- of-state banks as well as from savings and loan associations, credit unions, other financial institutions, consumer finance companies, trust companies, investment counseling firms, money market mutual funds, insurance companies, securities firms, mortgage banking companies and others. For information on the competitive position of the Corporation and the Bank, refer to page 1. Also, refer to the subsections entitled "Supervision and Regulation" and "Effect of Governmental Policies," both of which are relevant to an analysis of the Corporation's competitors. Due to the intense competition in the financial industry, the Corporation makes no representation that its competitive position has remained constant, nor can it predict whether its position will change in the future. Sources and Availability of Funds. Specific reference is made to the Consolidated Financial Review section, including the subsections entitled "Deposits" and "Liquidity," contained in the Corporation's 1993 Annual Report to Shareholders (the "1993 Annual Report"), which is specifically incorporated herein by reference, along with all of the tables and graphs in the 1993 Annual Report, which are identified separately in response to Item 7 of Part II of this Form 10-K, which are incorporated herein by reference. As permitted by SEC rules, attached to this Form 10-K as Exhibit 13 are only those sections of the 1993 Annual Report that have been incorporated by reference into this Form 10-K. Interest Ceiling. The maximum rates that can be charged by lenders are governed by specific state and federal laws. Most loans made by the Corporation's banking subsidiaries are subject to the limits contained in Tennessee's general usury law (the "Usury Law") or the Industrial Loan and Thrift Companies Act (the "Industrial Loan Act"), with certain categories of loans subject to other state and federal laws. The Usury Law provides for a maximum rate of interest which is the lesser of 4% above the average prime loan rate published by the Board of Governors of the Federal Reserve System or 24% per annum. The Industrial Loan Act generally provides for a maximum rate of 24% per annum plus certain additional loan charges. In addition, state statutory interest rate ceilings on most first mortgage loans on residential real estate are preempted by federal law. Also, Tennessee law permits interest on credit card balances not to exceed 21% per annum plus certain fees established by contract. Effect of Governmental Policies. The Bank is affected by the policies of regulatory authorities, including the Federal Reserve System and the Comptroller. An important function of the Federal Reserve System is to regulate the national money supply. Among the instruments of monetary policy used by the Federal Reserve are: purchases and sales of U.S. Government securities in the marketplace; changes in the discount rate, which is the rate any depository institution must pay to borrow from the Federal Reserve; and changes in the reserve requirements of depository institutions. These instruments are effective in influencing economic and monetary growth, interest rate levels and inflation. The monetary policies of the Federal Reserve System and other governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Because of changing conditions in the national economy and in the money market, as well as the result of actions by monetary and fiscal authorities, it is not possible to predict with certainty future changes in interest rates, deposit levels, loan demand or the business and earnings of the Corporation and the Bank or whether the changing economic conditions will have a positive or negative effect on operations and earnings. Bills are pending before the United States Congress and the Tennessee General Assembly which could affect the business of the Corporation and its subsidiaries, and there are indications that other similar bills may be introduced in the future. It cannot be predicted whether or in what form any of these proposals will be adopted or the extent to which the business of the Corporation and its subsidiaries may be affected thereby. Statistical Information Required by Guide 3. The statistical information required to be displayed under Item I pursuant to Guide 3, "Statistical Disclosure by Bank Holding Companies," of the Exchange Act Industry Guides is incorporated herein by reference to the Consolidated Financial Statements and the notes thereto and the Consolidated Financial Review Section in the 1993 Annual Report along with all of the tables and graphs identified in response to Item 7 of Part II of this Form 10-K; certain information not contained in the Annual Report, but required by Guide 3, is contained in the tables on the immediately following pages: FIRST TENNESSEE NATIONAL CORPORATION ADDITIONAL GUIDE 3 STATISTICAL INFORMATION BALANCES AT DECEMBER 31 (Thousands) (Unaudited) FOREIGN OUTSTANDINGS AT DECEMBER 31 MATURITIES OF SHORT-TERM PURCHASED FUNDS AT DECEMBER 31, 1993 ITEM 2 ITEM 2 PROPERTIES The Corporation has no properties that it considers materially important to its financial statements. ITEM 3 ITEM 3 LEGAL PROCEEDINGS The Corporation is a party to no material pending legal proceedings the nature of which are required to be disclosed pursuant to the Instructions contained in the Form of this Report. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted during the fourth quarter of this fiscal year to a vote of security holders, through the solicitation of proxies or otherwise. ITEM 4A EXECUTIVE OFFICERS OF REGISTRANT The following is a list of executive officers of the Corporation as of March 1, 1994. Officers are elected for a term of one year and until their successors are elected and qualified. Each of the executive officers has been employed by the Corporation or its subsidiaries during each of the last five years. Mr. Terry was President of the Corporation prior to August 1991. Mr. Horn was Vice Chairman of the Bank from August 1991 through January 1993. Prior to August 1991, Mr. Horn was Executive Vice President of the Bank and Manager of its Bond Division. Mr. Glass was Executive Vice President of the Bank and Tennessee Banking Group Manager prior to January 1993. Mr. Kelley was Executive Vice President of the Bank and Corporate Services Group Manager prior to January of 1993. Mr. Keen was Controller of the Bank prior to January 1993. Prior to October 1990, Mr. Johnson was a Senior Vice President of the Corporation and the Bank. Prior to October 1989, Mr. Vezina was a Senior Vice President of the Corporation and the Bank. PART II ITEM 5 ITEM 5 MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Corporation's common stock, $2.50 par value, trades over-the-counter on the National Association of Securities Dealers Automated Quotation System -- National Market System under the symbol FTEN. As of December 31, 1993, there were 7,893 shareholders of record of the Corporation's common stock. Generally, quarterly dividend payments are made on the first day of January, April, July and October. The Corporation has declared the following respective quarterly dividends per share during each quarter, commencing with first quarter 1992: $.28, $.28, $.28, $.36, $.36, $.36, $.36, and $.42. Additional information called for by this Item is incorporated herein by reference to the Summary of Quarterly Financial Information Table, the Selected Financial Data Table, Note 16 to the Consolidated Financial Statements, and the Liquidity subsection of the Consolidated Financial Review section in the 1993 Annual Report and to The Payment of Dividends subsection contained in Item 1 of Part I of this Form 10-K, which is incorporated herein by reference. ITEM 6 ITEM 6 SELECTED FINANCIAL DATA The information called for by this Item is incorporated herein by reference to Selected Financial Data Table in the 1993 Annual Report. ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information called for by this Item is incorporated herein by reference to Consolidated Financial Review Section in the 1993 Annual Report and the following tables and graphs in the 1993 Annual Report: GRAPHS: - ------- Return on Average Equity Return on Average Assets Earnings Per Share Earnings Trend Net Interest Margin and Spread Profitability Per Employee Earning Asset Mix as a Percentage of Average Assets Average Loan Composition Deposits and Other Interest-Bearing Liabilities as a Percentage of Average Assets Net Charge-Offs Nonperforming Loans Nonperforming Assets to Total Loans Cumulative Changes in Nonaccrual Loans and Other Real Estate since Year-End 1988 (Quarterly) Cumulative Changes in Classified Assets Since Year-End 1988 (Quarterly) TABLES: - ------- Analysis of Changes in Net Interest Income Analysis of Noninterest Income and Noninterest Expense Summary of Quarterly Financial Information Rate Sensitivity Analysis at December 31, 1993 Maturities of Investment Securities at December 31, 1993 Maturities of Loans at December 31, 1993 Consumer Loans by Product at December 31 Regulatory Capital at December 31 Net Loans and Foreclosed Real Estate at December 31 FTBNA Loans Secured by Real Estate at December 31 Analysis of Allowance for Loan Losses Changes in Nonperforming Assets at December 31 Nonperforming Assets at December 31 Selected Financial Data Credit Ratings at December 31,1993 Net-Charge Offs as a Percentage of Average Loans, Net of Unearned Income Obligations of States and Municipalities by Quality Rating at December 31, 1993 Consolidated Average Balance Sheet and Related Yields and Rates ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by this Item is incorporated herein by reference to Consolidated Financial Statements and the notes there to and to the Summary of Quarterly Financial Information Table. ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The information called for by this Item is inapplicable. PART III ITEM 10 ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by this Item as it relates to directors and nominees for director of the Corporation is incorporated herein by reference to the "Election of Directors" section of the Corporation's Proxy Statement to be mailed to shareholders in connection with the Corporation's Annual Meeting of Shareholders scheduled for April 19, 1994, (the "1994 Proxy Statement"), which will be filed by amendment to this Form 10-K, pursuant to General Instruction G(3) to such form. The information required by this Item as it relates to executive officers of the Corporation is incorporated herein by reference to Item 4A in Part I of this Report. The information required by this Item as it relates to compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated herein by reference to the "Compliance with Section 16(a) of the Exchange Act" Section of the 1994 Proxy Statement. ITEM 11 ITEM 11 EXECUTIVE COMPENSATION The information called for by this Item is incorporated herein by reference to the "Executive Compensation" section of the 1994 Proxy Statement (excluding the Board Compensation Committee Report and the Total Shareholder Return Performance Graph). ITEM 12 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by this Item is incorporated herein by reference to the Stock Ownership Table and the two paragraphs preceding the table in the 1994 Proxy Statement. The Corporation is unaware of any arrangements which may result in a change in control of the Corporation. ITEM 13 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by this Item is incorporated herein by reference to the "Certain Relationships and Related Transactions" section of the 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: Financial Statements: The consolidated financial statements of the Corporation, and the notes thereto, for the three years ended December 31, 1993, in the 1993 Annual Report, are incorporated herein by reference. The Report of Independent Public Accountants, in the 1993 Annual Report, is incorporated herein by reference. The report of the other auditors referenced in the Report of Independent Public Accountants, attached hereto as Exhibit 99(b), is incorporated herein by reference. Financial Statement Schedules: Not applicable. Exhibits: (2) Stock Purchase Agreement dated as of August 19, 1993, by and between the Bank and MNC Financial, Inc. (3)(i) Restated Charter of the Corporation, as amended, attached as Exhibit 3(a) to Corporation's 1991 Annual Report on Form 10-K and incorporated herein by reference. (3)(ii) Bylaws of the Corporation, as amended. (4)(a) Shareholder Protection Rights Agreement, dated as of 9-7-89 between the Corporation and First Tennessee Bank National Association, as Rights Agent, including as Exhibit A the forms of Rights Certificate and of Election to Exercise and as Exhibit B the form of Charter Amendment designating a series of Participating Preferred Stock of the Corporation with terms as specified, attached as an exhibit to the Corporation's Registration Statement on Form 8-A filed 9-8-89, and incorporated herein by reference. (4)(b) Indenture, dated as of 6-1-87, between the Corporation and Security Pacific National Trust Company (New York), Trustee, attached as an exhibit to the Corporation's Annual Report on Form 10-K for the year ended 12-31-91, and incorporated herein by reference. (4)(c) The Corporation and certain of its consolidated subsidiaries have outstanding certain long-term debt. See Note 13 in the Corporation's 1993 Annual Report to Shareholders. None of such debt exceeds 10% of the total assets of the Corporation and its consolidated subsidiaries. Thus, copies of constituent instruments defining the rights of holders of such debt are not required to be included as exhibits. The Corporation agrees to furnish copies of such instruments to the Securities and Exchange Commission upon request. *(1O)(a) Management Incentive Plan, as amended.(1) *(1O)(b) 1983 Restricted Stock Incentive Plan, as amended.(1) *(1O)(c) 1989 Restricted Stock Incentive Plan, as amended.(1) *(1O)(d) 1992 Restricted Stock Incentive Plan.(1) *(10)(e) 1984 Stock Option Plan, as amended.(1) *(1O)(f) 1990 Stock Option Plan, as amended.(1) *(1O)(g) Survivor Benefits Plan, as amended.(1) *(1O)(h) Directors and Executives Deferred Compensation Plan, as amended.(1) *(1O)(i) Pension Restoration Plan.(2) *(1O)(j) Director Deferral Agreements with Schedule.(2) *(10)(k) Severance Agreements dated 12-15-92 with schedule.(2) (11) Statement re: computation of per share earnings. (13) The portions of the 1993 Annual Report to Shareholders which have been incorporated by reference into this Form 10-K. (21) Subsidiaries of the Corporation. (24) Power of Attorney (99)(a) Annual Report on Form ll-K for the Corporation's Savings Plan and Trust, for fiscal year ended 12- 31-93, as authorized by SEC Rule 15d-21 (to be filed as an amendment to Form lO-K). (99)(b) Report of other auditors. *Exhibits marked with an "*" represent management contract or compensatory plan or arrangement required to be filed as an exhibit. (1) These documents are incorporated herein by reference to the exhibit with the corresponding number contained in the Corporation's 1992 Annual Report on Form 10-K. (2) These documents are incorporated herein by reference to exhibits 10(j), 10(k), and 10(l), respectively, contained in the Corporation's 1992 Annual Report on Form 10-K. (b) A report on Form 8-K was filed on October 18, 1993 (with a date of report of October 1, 1993), disclosing under Item 2 ("Acquisition or Disposition of Assets") the closing of the acquisition of MNMC by the Bank. The report contained audited MNMC consolidated financial statements of financial condition as of 12-31-92 and 12-31-91, and statements of income, statements of changes in stockholders' equity, and statements of cash flows, each for the years ended 12-31-92 and 12-31-91 and contained FTNC pro forma combined condensed statement of condition as of 6-30-93, statements of income for the six months ended 6-30-93 and statements of income for the year ended 12-31-92. 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 7th day of March, 1994. FIRST TENNESSEE NATIONAL CORPORATION By: James F. Keen ------------------------------------- James F. Keen, Senior Vice President and 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. EXHIBIT INDEX *Exhibits marked with an "*" represent management contract or compensatory plan or arrangement required to be filed as an exhibit. (1) These documents are incorporated herein by reference to the exhibit with the corresponding number contained in the Corporation's 1992 Annual Report on Form 10-K. (2) These documents are incorporated herein by reference to exhibits 10(j), 10(k), and 10(l), respectively, contained in the Corporation's 1992 Annual Report on Form 10-K.

856716_1993.txt

856716_1993

1993

856716

ITEM 3. LEGAL PROCEEDINGS Toca On March 4, 1993, the Company filed a complaint against Warren Petroleum Company, Arco Oil & Gas Co., Conoco Inc., Trident NGL, Inc. and other owners of the Yscloskey Gas Plant located in Louisiana (the "Owners") in the United States District Court for the Eastern District of Louisiana, alleging various violations by the defendants of the federal anti-trust laws in connection with a Hydrocarbon Fractionation Agreement at its Toca plant between the Company and the Owners of the Yscloskey plant. The Company also filed a companion state-court action involving the same parties in Civil District Court for the Parish of Orleans, State of Louisiana, which the defendants removed to United States District Court for the Eastern District of Louisiana. The Company and Warren Petroleum Company (in its capacity as the designated Operator for the Yscloskey Plant) have recently negotiated a new Hydrocarbon Fractionation Agreement, which has been executed by substantially all of the Owners of the Yscloskey Plant. The new 15-year agreement provides for a reduced fractionation fee of 9.25% and eliminates the uncertainty regarding uneconomic performance of the Yscloskey plant. The Company anticipates dismissing the various complaints with prejudice. Edgewood On January 16, 1991, problems at the Company's Edgewood Plant relating to both equipment that removes hydrogen sulfide from unprocessed natural gas and the monitoring equipment owned by the purchaser of the residue gas, Enserch Corporation, doing business as Lone Star Gas Company ("Lone Star"), allowed residue gas containing hydrogen sulfide to enter Lone Star's transmission line supplying residue gas to Emory, Texas. The Company has been named as a co-defendant, along with Lone Star, in the following complaints relating to the incident: Gary Prather, et al. v. Enserch ------------------------------- Corporation, et al., filed March 15, 1993, Barbara Rogers, et al., v. Enserch ------------------- ---------------------------------- Corporation, et al. filed March 16, 1993, Judy Silvey, et al. v. Enserch, et ------------------- ---------------------------------- al., filed May 13, 1993, Floyd Rogers, et al. v. Enserch, et al., filed May --- --------------------------------------- 14, 1993, Blair Schamlain, et al. v. Enserch, et al., filed May 25, 1993, ------------------------------------------ Betty Adair v. Enserch, et al., filed on July 14, 1993, Doris Hass v. Enserch ------------------------------ --------------------- Corporation, et al., filed on December 17, 1993, Allie Ruth Harris v. Enserch ------------------- ---------------------------- Corporation, et al., filed on December 17, 1993, Sandra Parker, et al. v ------------------- ----------------------- Enserch Corporation, et al., filed on January 13, 1994, and Carma Brumit v. --------------------------- --------------- Enserch, et al., filed on January 18, 1994. --------------- All the cases have been filed in the District Court, Rains County, Texas, 354th Judicial District, and make similar claims, asserting, among other things, that the defendants breached an implied warranty of merchantability, falsely represented that the residue gas was safe, were negligent and are liable under a strict liability theory. The plaintiffs have alleged a variety of respiratory and neurological illnesses and are seeking treble damages, exemplary damages and attorneys' fees. Prior to the filing of the complaints, the Company received demand letters from the plaintiffs that sought, in the aggregate, approximately $36 million. Damages claimed in the lawsuits are in excess of $13.5 million. The Company believes that it has meritorious defenses to the claims and intends to defend vigorously against any such claims. The Company is currently conducting extensive pre-trial discovery. The underwriters of the Company's general liability insurance policy have indicated preliminarily that such policy appears to cover the types of claims that have been asserted, subject to their right to deny coverage based upon, among other things, final determination of causation and the exact nature of the damages. Granger On December 6, 1993, Green River Gathering Company ("Green River") and Mountain Gas filed a complaint against Washington Energy Exploration, Inc. ("Washington Energy") in District Court in Arapahoe County, Colorado seeking the payment of certain outstanding receivables from Washington Energy and a declaratory judgment that the gathering agreement between Washington Energy and Green River is in full force and effect. Mountain Gas is a wholly-owned subsidiary of the Company and Green River is a partnership owned by the Company and Mountain Gas. Washington Energy is the operator of wells producing approximately 33% of the natural gas transported through the Green River Gathering system to Mountain Gas' Granger facility. On December 27, 1993, Washington Energy filed an answer, counterclaim, crossclaim and request for trial by jury, denying the substance of the allegations and asserting certain affirmative defenses. Washington Energy has also made certain counterclaims seeking monetary damages relating to Green River's performance under the gathering agreement and under a processing agreement between the parties, along with a declaratory judgment that both agreements have been terminated. In addition, Washington Energy has made a crossclaim against two unaffiliated entities, each of which owned a portion of Green River during a portion of the period in question. The Company believes that Green River is in compliance with the gathering agreement and the processing agreement and that both are in full force and effect. The Company believes that it has meritorious defenses to the counterclaims and intends to defend vigorously against any such claims. The Company is currently conducting extensive pre-trial discovery. Katy Commencing in March 1993 and continuing through July 1993, Western Gas Resources Storage, Inc. ("Storage"), a wholly-owned subsidiary of the Company, filed a total of 165 condemnation actions in the County Court at Law No. 1 and No. 2 of Fort Bend County, Texas to obtain certain storage rights and rights- of-way relating to its Katy Gas Storage Facility. The County Court appointed panels of Special Commissioners that have awarded compensation to the owners whose rights were condemned. Certain of the land and mineral owners are seeking in County Court a declaration that Storage does not possess the right to condemn, or, in the alternative, that they should be awarded more compensation than previously awarded by the Special Commissioners. The Company believes that the outcome of such proceedings will not materially affect operation of the Katy Gas Storage Facility. The likelihood of any particular result, however, cannot be determined because the condemnation law under which the proceedings are being brought has never been interpreted by the courts. Woods/Moncrief In February 1994, the United States Appeals Court for the Tenth Circuit affirmed a district court judgment against the Company in the amount of $2.9 million, including interest, in Western Gas Processors Ltd. v. Woods Petroleum ---------------------------------------------- Corporation and W.A. Moncrief, Jr., d/b/a Moncrief Oil Company, which related -------------------------------------------------------------- to claims by certain producers that they had been underpaid. The Company has taken a charge to litigation reserves in the year ended December 31, 1993, in the amount of $2.4 million, as a result of the appellate court decision. The Company will not take any further action. 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 quarter ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS As of March 1, 1994, there were 25,703,829 shares of Common Stock outstanding held by 490 holders of record. The Common Stock is traded on the New York Stock Exchange under the symbol "WGR". The following table sets forth quarterly high and low closing sales prices as reported by the NYSE Composite Tape for the quarterly periods indicated. The Company paid annual dividends on the Common Stock aggregating $.20 per share during the years ended December 31, 1993 and 1992. The Company has declared a dividend of $.05 per share of common stock for the quarter ending March 31, 1994 to holders of record as of such date. Declarations of dividends are within the discretion of the Board of Directors and are dependent upon various factors, including the earnings, cash flow, capital requirements and financial condition of the Company. In addition, the Company's ability to pay dividends is restricted by certain covenants in its credit facilities including a prohibition on declaring or paying dividends that exceed, in the aggregate, the sum of $25 million plus 50% of the Company's consolidated net income earned after March 31, 1993 plus 50% of the cumulative net proceeds received from the sale of any equity securities sold after March 31, 1993. At December 31, 1993, this threshold amounted to $39 million, or $106 million subsequent to the issuance of 2,760,000 shares of $2.625 Convertible Preferred Stock in February 1994. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The following table sets forth selected consolidated financial and operating data for the Company. Certain prior year amounts have been reclassified to conform to the presentation used in 1993. The data for the three years ended December 31, 1993 should be read in conjunction with the Company's Consolidated Financial Statements included elsewhere in this document. The selected consolidated financial data for the two years ended December 31, 1990 is derived from the Company's historical Consolidated Financial Statements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." ($000s, except per share amounts and operating data): ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis relates to factors which have affected the consolidated financial condition and results of operations of the Company for the three years ended December 31, 1993. Certain prior year amounts have been reclassified to conform to the presentation used in 1993. Reference should also be made to the Company's Consolidated Financial Statements and related Notes thereto and the Selected Consolidated Financial and Operating Data included elsewhere in this document. Results of Operations Year ended December 31, 1993 compared to year ended December 31, 1992. Net income decreased $1.6 million and net cash provided by operating activities increased $7.9 million for the year ended December 31, 1993 compared to the same period in 1992. Revenues from the sale of residue gas increased $284.1 million for the year ended December 31, 1993 compared to the same period in 1992 due to an increase in residue gas prices of $.30 per Mcf and an increase in sales volumes of 315 MMcf per day. Of this volume increase, 246 MMcf per day is attributable to an increase in the sale of residue gas purchased from third parties, in part due to the acquisition of Citizens. The remaining volume increase is the result of increased production volumes at the Company's facilities, primarily due to the Mountain Gas and Black Lake acquisitions as well as new well hookups at the Midkiff/Benedum and Giddings facilities. Revenues from the sale of NGLs increased $43.7 million for the year ended December 31, 1993 compared to the same period in 1992 due to an increase in NGL sales volumes of 545 MGal per day which was somewhat offset by a $.01 per gallon decrease in the price of NGLs. Of the volume increase, 377 MGal per day is attributable to an increase in the sale of NGLs purchased from third parties. The remaining volume increase is the result of increased production volumes at the Company's facilities, primarily due to the Mountain Gas and Black Lake acquisitions as well as new well hookups at the Midkiff/Benedum and Giddings facilities. Other revenues increased approximately $1 million for the year ended December 31, 1993 compared to the same period in 1992 due to the termination of certain hedging transactions and interest rate swap agreements in 1993 which resulted in an increase of approximately $5.5 million compared to the same period in 1992. This increase was offset by the sale in 1992 of a 20% undivided interest in the Midkiff/Benedum gas processing plants to the major producer in the area of the plant for a pre-tax gain of approximately $4.5 million. Historically, product purchases as a percentage of residue gas and NGL sales from the Company's plant production approximated 70%. Product purchases as a percentage of residue gas and NGL sales from third-party purchases is substantially higher than the historical percentage and approximates 95%. The increase in the Company's combined percentage is primarily due to a significantly larger increase in the sales volume of products purchased from third parties compared to the sales volume sold from the Company's facilities. As a result, total product purchases as a percentage of residue gas and NGL sales increased approximately 6.3% to 81.5% for the year ended December 31, 1993 compared to the same period in 1992. Plant operating expense increased $7.3 million for the year ended December 31, 1993 compared to the same period in 1992 primarily due to the Mountain Gas and Black Lake acquisitions and an increase in repair and maintenance charges incurred at facilities acquired from UTP. Selling and administrative expense increased $4.2 million as a result of higher payroll and benefit charges and professional fees resulting from the Company's growing operations and its preparation for the Katy Gas Storage Facility, a litigation reserve established for the Woods/Moncrief lawsuit and franchise taxes resulting from the Company's expansion into states which do not charge income taxes, somewhat offset by increased overhead capitalized to the Company's construction projects. In 1993, overhead capitalized to the Company's construction projects increased approximately $3.3 million when compared to the same period in 1992. Amounts capitalized to such projects in 1994 are expected to decline due to the completion of several major projects and fewer projects currently under construction by the Company. Depreciation, depletion and amortization expense increased $17.5 million for the year ended December 31, 1993 compared to the same period in 1992 is primarily due to the Mountain Gas and Black Lake acquisitions. In January 1994, the Katy Gas Storage Facility commenced operations and, as a result, depreciation, depletion and amortization expense associated with the Katy Gas Storage Facility will be approximately $3.0 million per year. Interest expense increased $2.5 million for the year ended December 31, 1993 compared to the same period in 1992 due to higher average long-term debt outstanding. In 1993, interest incurred and capitalized during the construction period of new projects increased approximately $2.8 million when compared to the same period in 1992. Amounts capitalized to such projects in 1994 are expected to decline due to the completion of several major projects and fewer projects currently under construction by the Company. This increase will be more than offset by a reduction in interest expense related to the application of the net proceeds of $133.5 million from the sale of 2,760,000 shares of $2.625 Convertible Preferred Stock in February 1994 against the Company's Revolving Credit Facility. In 1993, the corporate income tax rate was increased from 34% to 35%. This rate increase resulted in an increase in deferred income taxes of approximately $2.1 million for the year ended December 31, 1993. Year ended December 31, 1992 compared to year ended December 31, 1991. Net income and net cash provided by operating activities increased $18.8 million and $58.5 million, respectively, for the year ended December 31, 1992 compared to the same period in 1991. Average gas prices increased $.13 per Mcf and average NGL prices decreased $.04 per gallon for the year ended December 31, 1992 compared to the same period in 1991, while average gas sales increased 132 MMcf per day and average NGL sales increased 1,303 MGal per day. Revenues from the sale of residue gas and NGLs increased $99.3 million and $140.0 million, respectively, for the year ended December 31, 1992 compared to the same period in 1991. These increases were primarily the result of increased production from Company facilities due to the acquisition of 12 plants from UTP in November 1991 and an increase in the sale of products purchased from third parties. Other revenues increased $6.0 million, primarily as a result of a $4.5 million gain on the sale of a 20% interest in the Midkiff and Benedum facilities in the fourth quarter of 1992. Product purchases as a percentage of residue gas and NGL sales increased 1.3% to 75.2% in 1992 compared to 1991. Product purchases as a percentage of residue gas and NGL sales of production from the Company's facilities is approximately 70%. Increasing the historical percentage are purchases of third party products which typically have a lower profit margin. The increase in plant operating expense for the year ended December 31, 1992 compared to the same period in 1991 was primarily due to the acquisition of the UTP facilities. Selling and administrative expense increased $8.7 million for the year ended December 31, 1992 compared to the same period in 1991 primarily due to higher salary and benefit costs, insurance and other administrative expenses related to the Company's acquisition of the UTP facilities. In addition, selling and administrative expenses increased as a result of additional franchise taxes due to increased operations in Texas and increased costs related to the Company's ongoing evaluation of potential acquisitions. The increase in depreciation expense for the year ended December 31, 1992 compared to the same period in 1991 was primarily due to the acquisition of the UTP facilities. Effective January 1, 1992, the Company reviewed the economic useful lives of its plant assets. As a result of this review, the lives of certain of these assets were changed to reflect more closely their remaining economic useful lives. The effect of this change was not material to the results of operations for the year ended December 31, 1992. The decrease in interest expense for the year ended December 31, 1992 compared to the same period in 1991 was due to lower bank rates on variable rate borrowings and lower average long-term debt outstanding. The decrease in the provision for income taxes as a percentage of income before taxes resulted from a reduction in the deferred income tax rate as prescribed by SFAS No. 109. Liquidity and Capital Resources The Company's sources of liquidity and capital resources historically have been net cash provided by operating activities, funds available under its financing facilities and proceeds from offerings of equity securities. In the past, these sources have been sufficient to meet the needs and finance the growth of the Company's business. Net cash provided by operating activities has been primarily affected by product prices, the Company's success in increasing the number and efficiency of its facilities and the volumes of natural gas processed by such facilities and the margin on third party residue gas purchased for resale. The Company's continued growth will be dependent upon success in the areas of additions to dedicated plant reserves, acquisitions, new project development and marketing. In the three years ended December 31, 1993, the Company's total sources of funds aggregated $823.9 million and was comprised of net cash provided by operating activities of $233.4 million, net borrowings under its credit agreement of $426.7 million, net proceeds received from the exercise of common stock options of $1.3 million, net proceeds from the issuance of the $2.28 Cumulative Preferred Stock of $33.4 million, net proceeds from the issuance of the 7.25% Convertible Preferred Stock of $38.2 million, net proceeds from the issuance of Common Stock of $71.3 million and net proceeds received from the disposition of property and equipment of $19.6 million. During the same period, the Company's use of such funds aggregated $819.5 million which were used primarily to make capital investments of $793.9 million, to pay dividends to holders of Common Stock of $12.3 million, to pay dividends to holders of 7.25% Convertible Preferred Stock and $2.28 Cumulative Preferred Stock of $9.1 million and to make distributions to minority interest holders in predecessor company of $4.2 million. On November 12, 1993, the Registration on Form S-3 (Registration No. 33-66516) was declared effective. The Registration provides for the sale of up to $200 million of debt securities and preferred stock and up to 4 million shares of common stock. On February 28, 1994, the Company sold, pursuant to the Registration, 2,760,000 shares of $2.625 Convertible Preferred Stock for net proceeds of $133.5 million, which have been used to repay a portion of the debt incurred under the Company's Revolving Credit facility in the Mountain Gas and Black Lake acquisitions. The Company has been successful overall in replacing production with new reserves. However, volumes of natural gas dedicated to some of the Company's plants have declined during recent years because additions to dedicated plant reserves have not fully offset production. In 1993, excluding reserves acquired in the Mountain Gas and Black Lake acquisitions and including reserves associated with Westana, the Company connected new reserves to its gathering systems replacing 118% of 1993 production. On a Company-wide basis, dedicated reserves, including certain proved undeveloped properties, totaled approximately 1.95 Tcf at December 31, 1993. An additional source of liquidity to the Company is volumes of residue gas and NGLs in storage facilities. The Company stores volumes of residue gas and NGLs primarily to assure an adequate supply for long-term sales contracts and for resale during periods when prices are favorable. At December 31, 1993, the Company held in storage approximately 17.3 million gallons of NGLs at an average cost of $.30 per gallon and 7.9 Bcf of residue gas at an average cost of $1.97 per Mcf ($1.81 per MMbtu). From time to time, the Company contracts on the futures market for the purchase and/or sale of stored residue gas and NGL products as a hedge against price changes. At December 31, 1993, 296 net contracts (10,000 MMbtus per contract) for the sale of residue gas in February 1994 through March 1995 at prices ranging from $1.87 per Mcf to $2.56 per Mcf were outstanding. At December 31, 1993, no such contracts for NGLs were outstanding. Capital Investment Program Between January 1, 1991 and December 31, 1993, the Company expended approximately $793.9 million on new projects and currently has authorized an additional $94.0 million for 1994. For the year ended December 31, 1993, the Company expended $491.4 million on the Mountain Gas and Black Lake acquisitions, the construction of the Katy Gas Storage Facility, connection of new reserves, acquire consolidating assets for existing systems and upgrades to existing and newly acquired facilities. For the year ended December 31, 1992, the Company expended a total of $68.4 million on the Katy Gas Storage Facility, the acquisition of gathering systems connecting new reserves to existing systems and upgrades to newly acquired facilities. For the year ended December 31, 1991, the Company expended a total of $234.1 million for the acquisition, construction and development of various facilities, including the UTP, Edgewood and Midkiff systems and the Reno Junction Isomerization facility, and the acquisition of producing gas wells. The Company financed the UTP acquisition by the private placement of $40 million of Convertible Preferred Stock with an institutional investor and with $100 million of long- term debt from its existing bank group. This long-term debt was subsequently reduced with the net proceeds of $71.3 million received from a common stock offering in November 1991. The Company has completed the construction of the Katy Gas Storage Facility. Lease acquisition and construction costs incurred through December 31, 1993, including pad gas, approximate $90 million and excludes capitalized pre-operating costs. The Katy Gas Storage Facility commenced operations in January 1994. The complex consists of a partially depleted natural gas reservoir with over 17 Bcf of working gas and the capability to deliver up to 400 MMcf/D of natural gas as well as a pipeline header system currently connecting seven pipelines with the capability to connect six additional pipelines. In order to maintain the volumes of natural gas dedicated to or processed by the Company's existing facilities, future capital expenditures for gathering systems needed to connect new reserves, acquire consolidating assets and to maintain existing facilities are anticipated to be approximately $25 million to $30 million per year. The availability of new reserves at existing facilities is somewhat affected by the price of crude oil or natural gas (depending on whether the natural gas is associated gas or gas well gas) which in turn stimulates new drilling at higher price levels. The Company anticipates spending an additional $64 million to $69 million on other capital projects. Depending on the timing of the Company's future projects, it may be required to seek additional sources of capital. The Company's ability to secure such capital is restricted by its credit facilities, although it may request additional borrowing capacity from the banks, seek waivers from the banks to permit it to borrow funds from third parties, seek replacement credit facilities from other lenders or issue additional equity securities. While the Company believes that it would be able to secure additional financing, if required, no assurance can be given that it will be able to do so or as to the terms of any such financing. Financing Facilities Revolving Credit Facility. In August 1993, the Company renegotiated a Revolving Credit Facility with its agent bank, and in September 1993 the agent bank completed the syndication of the facility with seven additional banks. The Company's variable rate Revolving Credit Facility provides for a maximum borrowing of $400 million, of which $345 million was outstanding at December 31, 1993, and, if not renewed, on August 31, 1996 any outstanding balance thereunder converts to a four-year term during which such balance will be repaid in equal quarterly installments. At the Company's option, the Revolving Credit Facility bears interest at certain spreads over the Eurodollar rate or at the agent bank's prime rate. The interest rate spreads were adjusted based on the Company's earnings ratio (earnings before interest and taxes divided by interest expense). At December 31, 1993, the spread was 1.0% for the Eurodollar rate resulting in an interest rate of 4.13% at December 31, 1993. The Company will pay a commitment fee on the unused commitment of .25% if the earnings ratio is greater than or equal to 4.5 to 1.0 or .375% if the ratio is less than 4.5 to 1.0. For the year ended December 31, 1993, the Company's earnings ratio was approximately 4.4 to 1.0. Term Loan Facility. The Company also has a Term Loan Facility with four banks for $50 million which bears interest at 9.87%. Payments on the Term Loan Facility of $25 million, $12.5 million and $12.5 million are due in September 1995, 1996 and 1997, respectively. The Company's Revolving Credit and Term Loan Facilities are subject to certain mandatory prepayment terms. If funded debt under these facilities exceeds four times the sum of the Company's last four quarters' cash flow (as defined in the agreement), the overage must be repaid in no more than six monthly payments commencing 90 days from notification. This mandatory prepayment threshold will be reduced to 3.75 to 1.00 at December 31, 1994 and 3.50 to 1.00 at December 31, 1995. The Term Loan Facility and Revolving Credit Facility are unsecured. The Company is required to maintain a current ratio of at least 1.0 to 1.0, a tangible net worth of at least $247 million, a debt to capitalization ratio of no more than 65% through March 31, 1994, 60% from April 1, 1994 through October 31, 1995 and 55% thereafter and an earnings ratio of not less than 2.0 to 1.0. The Company is prohibited from declaring or paying dividends that exceed the sum of $25 million plus 50% of consolidated net income earned after March 31, 1993 plus 50% of the cumulative net proceeds received from the sale of any equity securities sold after March 31, 1993. At December 31, 1993, this threshold amounted to $39 million, or $106 million subsequent to the issuance of the 2,760,000 shares of $2.625 Convertible Preferred Stock in February 1994. The Company generally utilizes excess daily funds to reduce any outstanding revolving credit balances to minimize interest expense and intends to continue such practice. Master Shelf Agreement. In December 1991, the Company entered into a Master Shelf Agreement (the "Master Shelf") with The Prudential Insurance Company of America ("Prudential") pursuant to which Prudential agreed to quote, from time-to-time, an interest rate at which Prudential or its nominee would be willing to purchase up to $100 million of the Company's senior promissory notes (the "Senior Notes"). Any such Senior Notes must mature in no more than 12 years, with an average life not in excess of 10 years, and will be unsecured. On October 27, 1992, the Company sold $25 million of 7.51% Senior Notes due 2000 and $25 million of 7.99% Senior Notes due 2003. Principal payments on the $50 million of Senior Notes of $8.3 million will be due on October 27 of each year from 1998 through 2003. On September 22, 1993, the Company sold $25 million of 6.77% Senior Notes due in a single payment on September 22, 2003 and on December 27, 1993, the Company sold $25 million of 7.23% Senior Notes due in a single payment on December 27, 2003. The Master Shelf contains certain financial covenants which conform with those contained in the Revolving Credit Facility. In July 1993, Prudential and the Company amended the Master Shelf to provide for an additional $50 million of borrowing capacity (for a total borrowing capacity of $150 million) and to extend the term of the Master Shelf to October 31, 1995. Senior Notes. On April 28, 1993 the Company sold $50 million of 7.65% Senior Notes due 2003 to a group of insurance companies led by Connecticut General Life Insurance Company. Principal payments on the $50 million of Senior Notes of $7.1 million will be due on April 30th of each year from 1997 through 2002 with any remaining principal and interest outstanding due on April 30, 2003. The Senior Notes contain certain financial covenants which conform with those contained in the Revolving Credit Facility. Covenant Compliance. At December 31, 1993, the Company was in compliance with or has obtained necessary waivers related to all of its debt covenants. Interest Rate Swap Agreements. From time to time, the Company enters into interest rate swap agreements to manage exposure to changes in interest rates. The transactions generally involve the exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amounts. In 1993, the Company terminated certain interest rate swap agreements, totaling $175 million of notional principal amount, resulting in a pre-tax gain of approximately $3.6 million. The Company believes that the amounts available to be borrowed under the Revolving Credit Facility and the Master Shelf together with cash provided from operations, will provide it with sufficient financing to connect new reserves, maintain its existing facilities and complete its current capital improvement projects. The Company also believes that cash provided from operations will be sufficient to meet its debt service and preferred stock dividend requirements. Miscellaneous The construction and operation of the Company's gathering lines, plants and other facilities used for the gathering, transporting, processing, treating or storing of residue gas and NGLs are subject to federal, state and local environmental laws and regulations, including those that can impose obligations to clean up hazardous substances at the Company's facilities or at facilities to which the Company sends wastes for disposal. In most instances, the applicable regulatory requirements relate to water and air pollution control or solid waste management procedures. The Company believes that it is in substantial compliance with applicable material environmental laws and regulations. Environmental regulation can increase the cost of planning, designing, constructing and operating the Company's facilities. The Company believes that the costs for compliance with current environmental laws and regulations have not and will not have a material effect on the Company's results of operation. In 1990, the Congress enacted the Clean Air Act Amendments of 1990 (the "Clean Air Act") which impose more stringent standards on emissions of certain pollutants and require the permitting of certain existing air emissions sources. Many of the regulations have not been promulgated and until their promulgation, the Company cannot make a final assessment of the impact of the Clean Air Act. However, based upon its preliminary review of the proposed regulations, the Company does not anticipate that compliance with the Clean Air Act will require any material capital expenditures, although it will increase permitting costs in 1994 and 1995 and may increase certain operating costs on an on-going basis. The Company does not believe that such cost increases will have a material effect on the Company's results of operations, but cannot rule out that possibility. The Company believes that it is reasonably likely that the trend in environmental legislation and regulation will continue to be towards stricter standards. The Company is unaware of future environmental standards that are reasonably likely to be adopted that will have a material effect on the Company's results of operations. The Company is in the process of cleaning up certain releases of non-hazardous substances at facilities that it operates. In addition, the former owner of certain facilities that the Company acquired in 1992 is conducting cleanups at those facilities pursuant to contractual obligations. The Company's expenditures for environmental evaluation and remediation at existing facilities have not been significant in relation to the results of operations of the Company and totaled approximately $1.4 million for the year ended December 31, 1993. For the year ended December 31, 1993, the Company paid an aggregate of approximately $565,000 in air emissions fees to the states in which it operated. Although the Company anticipates that such air emissions fees will increase over time, the Company does not believe that such increases will have a material effect on the Company's results of operations. The Company employs six environmental engineers to monitor environmental compliance and potential liabilities at its facilities. Prior to consummating any major acquisition, the Company's environmental engineers perform audits on the facilities to be acquired. In addition, on an on-going basis, the environmental engineers perform informal environmental assessments of the Company's existing facilities. To date, the Company has not found any material environmental noncompliance or cleanup liabilities, the costs of which would reasonably be expected to have, in the aggregate, a material effect on the Company's results of operations. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Western Gas Resources, Inc.'s Consolidated Financial Statements as of December 31, 1993 and 1992 and for the three years ended December 31, 1993: REPORT OF MANAGEMENT The financial statements and other financial information included in this Annual Report on Form 10-K are the responsibility of management. The financial statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances and include amounts that are based on management's informed judgments and estimates. Management relies on the Company's system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that transactions are properly recorded and executed in accordance with management's authorization. The concept of reasonable assurance is based on the recognition that there are inherent limitations in all systems of internal accounting control and that the cost of such systems should not exceed the benefits to be derived. The internal accounting controls in place during the periods presented are considered adequate to provide such assurance. The Company's financial statements are audited by Price Waterhouse, independent accountants. Their report states that they have conducted their audit in accordance with generally accepted auditing standards. These standards include an evaluation of the system of internal accounting controls for the purpose of establishing the scope of audit testing necessary to allow them to render an independent professional opinion on the fairness of the Company's financial statements. The Audit Committee of the Board of Directors, composed solely of directors who are not employees of the Company, reviews the Company's financial reporting and accounting practices. The Audit Committee meets periodically with the independent accountants and management to review the work of each and to ensure that each is properly discharging its responsibilities. Signature Title --------- ----- /s/ BILL M. SANDERSON ------------------------- Bill M. Sanderson President, Chief Operating Officer and Director /s/ WILLIAM J. KRYSIAK ------------------------- William J. Krysiak Vice President - Controller (Principal Financial and Accounting Officer) REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Board of Directors and Stockholders of Western Gas Resources, Inc. In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of cash flows, of operations, and of changes in stockholders' equity present fairly, in all material respects, the financial position of Western Gas Resources, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their cash flows and their operations 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 Denver, Colorado February 25, 1994 WESTERN GAS RESOURCES, INC. CONSOLIDATED BALANCE SHEET ($000s) - Continued on following page - WESTERN GAS RESOURCES, INC. CONSOLIDATED BALANCE SHEET ($000s, except share amounts) - Continued from previous page - The accompanying notes are an integral part of the consolidated financial statements. WESTERN GAS RESOURCES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS ($000s) - Continued on following page - WESTERN GAS RESOURCES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS ($000s) - Continued from previous page - The accompanying notes are an integral part of the consolidated financial statements. WESTERN GAS RESOURCES, INC. CONSOLIDATED STATEMENT OF OPERATIONS ($000s, except share and per share amounts) The accompanying notes are an integral part of the consolidated financial statements. WESTERN GAS RESOURCES, INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY ($000s, except share amounts) The accompanying notes are an integral part of the consolidated financial statements. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION, ACCOUNTING POLICIES AND OTHER MATTERS ------------------------------------------------------------- Western Gas Resources, Inc., a Delaware corporation, is an independent gas gatherer and processor with operations in major oil and gas-producing basins in the Rocky Mountain, Gulf Coast and Southwestern regions of the United States. Western Gas Resources, Inc. owns and operates natural gas gathering, processing and storage facilities and markets and transports natural gas and natural gas liquids ("NGLs"). Western Gas Resources, Inc. was formed in October 1989 to acquire a majority interest in Western Gas Processors, Ltd. (the "Partnership") and to assume the duties of WGP Company, the general partner of the Partnership. The Partnership had been a Colorado limited partnership formed in 1977 to engage in the gathering and processing of natural gas. The reorganization was accomplished in December 1989 through an exchange for common stock of partnership units held by the former general partners of WGP Company (the "Principal Stockholders") and an initial public offering of Western Gas Resources, Inc. common stock. At December 31, 1990, Western Gas Resources, Inc. held a 51.8% partnership interest in the Partnership and the Principal Stockholders owned 65.7% of Western Gas Resources, Inc.'s common stock and a 40.2% direct interest in the Partnership. The remaining 8.0% of the interest in the Partnership was owned by public holders of the Partnership's $1.80 cumulative participating preference units ("PPUs") (including 7.8% of the PPUs held by the Principal Stockholders). On May 1, 1991, a further restructuring of the Partnership and Western Gas Resources, Inc. (together with its predecessor, WGP Company, collectively, the "Company") was approved by a vote of the security holders. As a result of the affirmative vote on the restructuring, the Partnership prepaid the remaining preference distributions to the PPU holders in the second quarter of 1991 and the Company acquired all of the remaining limited partner units in exchange for 10.2 million shares of newly issued common stock of the Company, all of the Partnership's assets were transferred to the Company by operation of law as a result of the merger, the Company directly owned all assets and was subject to all obligations of the Partnership, and the Partnership ceased to exist. The combinations described above were reorganizations of entities under common control and have been accounted for at historical cost in a manner similar to poolings of interests. The Company has restated all historical financial information to reflect the restructuring. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In October 1991, the Company issued 400,000 shares of 7.25% cumulative perpetual convertible preferred stock ("7.25% Convertible Preferred Stock") with a liquidation preference of $100 per share to an institutional investor. In November 1991, the Company issued 4,115,000 shares of common stock at a public offering price of $18.375 per share. In November 1992, the Company issued 1,400,000 shares of $2.28 cumulative preferred stock ("$2.28 Cumulative Preferred Stock"), with a liquidation preference of $25 per share, at a public offering price of $25 per share. On November 12, 1993, the Company's registration statement filed with the Securities and Exchange Commission (the "Registration") on Form S-3 (Registration No. 33-66516) was declared effective. The Registration provides for the sale of up to $200 million of debt securities and preferred stock and up to 4 million shares of common stock. On February 17, 1994, the Company filed a Prospectus Supplement under the Registration for the sale of 2,760,000 shares of $2.625 cumulative convertible preferred stock ("$2.625 Convertible Preferred Stock"). On February 25, 1994 the Company closed the offering providing for net proceeds of $133.5 million. Significant Business Acquisitions and Dispositions Mountain Gas On July 29, 1993, effective January 1, 1993, the Company acquired the stock of Mountain Gas Resources, Inc. ("Mountain Gas") from Morgan Stanley Leveraged Equity Fund II, L.P. for total consideration of approximately $168.2 million, including the payment of certain transaction costs and the assumption and repayment of $35 million of long-term debt of Mountain Gas. Mountain Gas owns the Red Desert and Granger facilities, both located near the Company's Lincoln Road gas processing plant and gathering system. The 22% interest in the Granger facility previously not owned by Mountain Gas was purchased by the Company in two separate transactions in November and December 1993 for an aggregate of $27.7 million. At the date of acquisition, the Red Desert facility consisted of a cryogenic plant and the Granger plant consisted of a refrigeration unit and a cryogenic unit. In December 1993, the Company completed construction of an additional cryogenic processing plant at Granger, at a total cost of $15.2 million. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In December 1993, a fire at the Granger facility's NGL tank farm required the facility to be shut down for one week. The new cryogenic processing plant as well as the smaller existing cryogenic unit were also damaged. Gas throughput at the facility has since reached levels experienced before the fire, and the Company expects it to be fully operational in May 1994 when the construction of a new tank farm and repairs to the cryogenic units are expected to be completed. The Company believes that insurance will cover, subject to certain deductibles, substantially all of the costs related to rebuilding the NGL tank farm and the other affected facilities, the interruption of business and third-party claims, if any. Black Lake On September 27, 1993, effective January 1, 1993, the Company purchased Black Lake gas processing plant and related reserves ("Black Lake") from Nerco Oil & Gas, Inc. ("Nerco") for approximately $136.2 million. The acquisition includes a 68.9% working interest in the Black Lake field in Louisiana and a gas processing plant. The purchase also includes 50% of the stock of Black Lake Pipeline Company, which owns a 240 mile liquids pipeline extending from Cotton Valley, Louisiana to Mont Belvieu, Texas and transports NGLs for Black Lake and three unaffiliated gas processing plants. Pro forma condensed results of operations for the years ended December 31, 1993 and 1992 give effect to the acquisition and financing of Mountain Gas and Black Lake and the issuance and sale by the Company of 2,760,000 shares of $2.625 Convertible Preferred Stock assuming that each transaction occurred on January 1 for each year presented below. The pro forma results have been prepared for comparative purposes only and are not indicative of the results of operations which actually would have resulted had the acquisitions occurred on the dates indicated, or which may result in the future (in $000s). WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Westana Joint Venture Effective August 1, 1993, the Company formed Westana Gathering Company ("Westana"), a general partnership, with Panhandle Eastern Pipe Line Corporation ("PEPL"). Westana provides gas gathering and processing services in the Anadarko Basin in Oklahoma and markets residue gas and NGLs for producers connected to its system. The Company is the principal operator with each partner holding a 50% ownership interest. The Company contributed its Chester gas processing plant and gathering system, with a net book value of $13.8 million, to Westana. Westana also operates PEPL's 400 mile gathering system, which will be contributed to Westana, after abandonment approval by the FERC. The Company is committed to provide an additional partnership contribution of $8.3 million, of which $4.8 million was contributed through December 31, 1993, for necessary modifications to the gathering system. This contribution will be recouped by the Company through preferential partnership distributions. UTP System On November 1, 1991, the Company purchased the gas processing division of Union Texas Products Corporation, a subsidiary of Union Texas Petroleum Holdings, Inc. (collectively referred to as the "UTP system"). The total consideration was $142.7 million. The acquisition included 12 plants in Texas, Oklahoma and Louisiana. Edgewood System Effective January 1, 1991, the Company purchased the Edgewood Gas Processing Plant and a majority interest in the related production (collectively called the "Edgewood system") from Amoco Production Company for $36 million. The Edgewood system includes a gas processing plant and a sulfur recovery unit. Effective July 1, 1991, the Company also acquired an approximate 80% working interest in three producing gas wells in the Fruitvale field behind the Edgewood plant. Midkiff/Benedum System Effective October 1, 1992, the Company sold a 20% undivided interest (which interest may increase based upon future expansion of the plants to accommodate increased gas volumes) in the Midkiff and Benedum gas processing plants to the major producer in the area of the plant for $22 million, or an increase to net income of $2.9 million, or $.11 per share of common stock. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Accounting Policies The significant accounting policies followed by the Company and the Company's wholly-owned subsidiaries are presented here to assist the reader in evaluating the financial information contained herein. The Company's accounting policies are in accordance with generally accepted accounting principles. Principles of Consolidation The consolidated financial statements include the accounts of the Company and the Company's wholly-owned subsidiaries. All material intercompany transactions have been eliminated in consolidation. The Company's interest in certain investments is accounted for by the equity method. Revenue Recognition Revenue for sales or services is recognized at the time the gas or NGLs are sold or at the time the service is performed. Reclassification Certain prior years' amounts in the consolidated financial statements and related notes have been reclassified to conform to the presentation used in 1993. Earnings Per Share of Common Stock Earnings per share of common stock is computed by dividing the net income available to shares of common stock by the weighted average number of shares of common stock outstanding. Net income available to shares of common stock is net income less dividends declared on the 7.25% Convertible Preferred Stock and $2.28 Cumulative Preferred Stock. The computation of fully diluted earnings per share of common stock for the years ended December 31, 1993 and 1992 was antidilutive, therefore, only primary earnings per share of common stock is presented. Inventories Product inventory includes $15.5 million and $11.6 million of residue gas and $5.2 million and $5.4 million of NGLs at December 31, 1993 and 1992, respectively. Prior to 1992, the cost of residue gas and NGL inventories was determined by the weighted average cost and the first-in, first-out WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) (FIFO) methods, respectively, on a location by location basis. Effective January 1, 1992, the Company changed its method of accounting for NGL inventories to the last-in, first-out (LIFO) method. The effect of this change was not material to the Company's results of operations for the year ended December 31, 1992. Inventories are valued at the lower of cost or net realizable value. At December 31, 1991, NGL inventories were written down to reflect market value, resulting in a $1.4 million reduction in inventory value and a related charge to earnings. Property and Equipment Depreciation is provided using the straight-line method based on the estimated useful life of each facility which ranges from three to 45 years. Useful lives are determined based on the shorter of the life of the equipment or the reserves serviced by the equipment. The cost of certain gas purchase contracts is amortized using the units-of-production method. Effective January 1, 1992, the Company reviewed the economic useful lives of its plant assets. As a result of this review, the lives of certain of these assets were changed to reflect more closely their remaining economic useful lives. The effect of this change was not material to the results of operations for the year ended December 31, 1992. The Company follows the successful efforts method of accounting for oil and gas exploration and production activities. Acquisition costs, development costs and successful exploration costs are capitalized. Exploratory dry hole costs, lease rentals and geological and geophysical costs are charged to expense as incurred. If the undiscounted future net revenue of all proved developed properties does not exceed the net book value of such properties, a charge for impairment would be made against income of the period affected. Upon surrender of undeveloped properties, the original cost is charged against income. Producing properties and related equipment are depleted and depreciated by the units-of-production method based on estimated proved developed reserves of oil and gas. Interest incurred during the construction period of new projects is capitalized and amortized over the life of the associated assets. Such capitalized interest was $4.9 million, $2.1 million and $1.3 million, respectively, for the three years ended December 31, 1993. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Income Taxes In the fourth quarter of 1992, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", retroactive to January 1, 1992. SFAS No. 109 requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in the financial statements or income tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference 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 differences are expected to reverse. Adoption of SFAS No. 109 did not have a material effect on the Company's results of operations for the year ended December 31, 1992. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. Deferred income taxes 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. A pro forma provision for income taxes has been provided in the financial statements of the Company for the year ended December 31, 1991 for comparability to its taxable status after the restructuring. Prior to the restructuring, the Predecessor Company was not subject to Federal income tax since the tax effects of its activities accrued to its partners. Futures Contracts The Company, from time to time, enters into futures contracts to hedge against a portion of the price risk associated with residue gas and NGLs. Changes in the market value of futures contracts are accounted for as additions to or reductions in inventory. Gains and losses resulting from changes in the market value of futures contracts are recognized when the related inventory is sold. At December 31, 1993, 296 such contracts (net) (10,000 MMbtus per contract) for the sale of residue gas in February 1994 through March 1995 at prices ranging from $1.87 per Mcf to $2.56 per Mcf were outstanding. At December 31, 1993, no such contracts for NGLs were outstanding. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Interest Rate Swap Agreements The Company has entered into various interest rate swap agreements to manage exposure to changes in interest rates. The transactions generally involve the exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amounts. At December 31, 1993 and 1992, the total notional principal amount of outstanding interest rate swap agreements was $50 million. In addition to the financial risk that will vary during the life of these swap agreements in relation to the maturity of the underlying debt and market interest rates, the Company is subject to credit risk exposure from nonperformance of the counterparties to the swap agreements. Cash and Cash Equivalents Cash and cash equivalents includes all cash balances and highly liquid investments with a maturity of three months or less. Supplementary Cash Flow Information Interest paid was $16.4 million, $12.5 million and $12.9 million, respectively, for the three years ended December 31, 1993. Income taxes paid were $10.2 million, $12.5 million and $6.6 million, respectively, for the three years ended December 31, 1993. Payments for business acquisitions during the year ended December 31, 1993 include the following payments for working capital and other liabilities assumed (in $000s): NOTE 2-RELATED PARTIES The Company purchases a significant portion of the Williston Gas Company ("Williston") and Westana production for resale to unrelated third parties. Such purchases from Williston included in the Consolidated Statement of Operations were $8.6 million, $4.0 million and $7.4 million, respectively, for the three years ended WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) December 31, 1993. Purchases from Westana totaled $5.3 million for the year ended December 31, 1993. The Company performs various operational and administrative functions for Williston and Westana and allocates the actual expenses incurred in performing the services to each Company. Such charges for Williston totaled $2.4 million, $3.2 million, and $4.0 million, respectively, for the three years ended December 31, 1993. Charges to Westana totaled $933,000 for the year ended December 31, 1993. During the year ended December 31, 1990, an officer and director of the Company borrowed $748,000 from the Company for the purpose of exercising options to purchase 294,524 shares of common stock in the Company. Interest is accrued at a rate equal to the interest rate paid by the Company on its Revolving Credit Facility and is payable annually on December 31 during the term of the note with all unpaid principal and accrued interest due and payable on January 1, 1996. The note is secured by the common stock and is accounted for as a reduction of stockholders' equity. The Company has entered into agreements committing the Company to loan to certain key employees an amount sufficient to exercise their options as each portion of their options vests under the Key Employees' Incentive Stock Option Plan and the Employee Option Plan. The Company will forgive the loan and accrued interest if the employee has been continuously employed by the Company for periods specified under the agreements. As of December 31, 1993 and 1992 loans totaling $1.2 million and $730,000, respectively, were outstanding to key employees under these programs. The loans are secured by the common stock and are accounted for as a reduction of stockholders' equity. NOTE 3-LONG-TERM DEBT The following summarizes the consolidated long-term debt at the dates indicated (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Financing Facilities Revolving Credit Facility. In August 1993, the Company renegotiated a Revolving Credit Facility with its agent bank, and in September 1993 the agent bank completed the syndication of the facility with seven additional banks. The Company's variable rate Revolving Credit Facility provides for a maximum borrowing of $400 million, of which $345 million was outstanding at December 31, 1993, and, if not renewed, on August 31, 1996 any outstanding balance thereunder converts to a four-year term during which such balance will be repaid in equal quarterly installments. At the Company's option, the Revolving Credit Facility bears interest at certain spreads over the Eurodollar rate or at the agent bank's prime rate. The interest rate spreads were adjusted based on the Company's earnings ratio (earnings before interest and taxes divided by interest expense). At December 31, 1993, the spread was 1.0% for the Eurodollar rate resulting in an interest rate of 4.13% at December 31, 1993. Term Loan Facility. The Company also has a Term Loan Facility with four banks for $50 million which bears interest at 9.87%. Payments on the Term Loan Facility of $25 million, $12.5 million and $12.5 million are due in September 1995, 1996 and 1997, respectively. The Company will pay a commitment fee on the unused commitment of .25% if the earnings ratio is greater than or equal to 4.5 to 1.0 or .375% if the ratio is less than 4.5 to 1.0. For the year ended December 31, 1993, the Company's earnings ratio was approximately 4.4 to 1.0. The Company's Revolving Credit and Term Loan Facilities are subject to certain mandatory prepayment terms. If funded debt under these facilities exceeds four times the sum of the Company's last four quarters' cash flow (as defined in the agreement), the overage must be repaid in no more than six monthly payments commencing 90 days from notification. This mandatory prepayment threshold will be reduced to 3.75 to 1.00 at December 31, 1994 and 3.50 to 1.00 at December 31, 1995. The Term Loan Facility and Revolving Credit Facility are unsecured. The Company is required to maintain a current ratio of at least 1.0 to 1.0, a tangible net worth of at least $247 million, a debt to capitalization ratio of no more than 65% through March 31, 1994, 60% from April 1, 1994 through October 31, 1995 and 55% thereafter and an earnings ratio of not less than 2.0 to 1.0. The Company is prohibited from declaring or paying dividends that exceed the sum WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) of $25 million plus 50% of consolidated net income earned after March 31, 1993 plus 50% of the cumulative net proceeds received from the sale of any equity securities sold after March 31, 1993. The Company generally utilizes excess daily funds to reduce any outstanding revolving credit balances to minimize interest expense and intends to continue such practice. Master Shelf Agreement. In December 1991, the Company entered into a Master Shelf Agreement (the "Master Shelf") with The Prudential Insurance Company of America ("Prudential") pursuant to which Prudential agreed to quote, from time-to-time, an interest rate at which Prudential or its nominee would be willing to purchase up to $100 million of the Company's senior promissory notes (the "Senior Notes"). Any such Senior Notes must mature in no more than 12 years, with an average life not in excess of 10 years, and will be unsecured. On October 27, 1992, the Company sold $25 million of 7.51% Senior Notes due 2000 and $25 million of 7.99% Senior Notes due 2003. Principal payments on the $50 million of Senior Notes of $8.3 million will be due on October 27 of each year from 1998 through 2003. On September 22, 1993, the Company sold $25 million of 6.77% Senior Notes due in a single payment on September 22, 2003 and on December 27, 1993, the Company sold $25 million of 7.23% Senior Notes due in a single payment on December 27, 2003. The Master Shelf contains certain financial covenants which conform with those contained in the Revolving Credit Facility. In July 1993, Prudential and the Company amended the Master Shelf to provide for an additional $50 million of borrowing capacity (for a total borrowing capacity of $150 million) and to extend the term of the Master Shelf to October 31, 1995. Senior Notes. On April 28, 1993 the Company sold $50 million of 7.65% Senior Notes due 2003 to a group of insurance companies led by Connecticut General Life Insurance Company. Principal payments on the $50 million of Senior Notes of $7.1 million will be due on April 30th of each year from 1997 through 2002 with any remaining principal and interest outstanding due on April 30, 2003. The Senior Notes contain certain financial covenants which conform with those contained in the Revolving Credit Facility. Covenant Compliance. At December 31, 1993, the Company was in compliance with or has obtained necessary waivers related to all of its debt covenants. Interest Rate Swap Agreements. From time to time, the Company enters into interest rate swap agreements to manage exposure to changes in interest rates. The transactions generally involve the WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amounts. Approximate future maturities of long-term debt are as follows (in $000s): NOTE 4-INCOME TAXES The provisions for income taxes for the years ended December 31, 1993 and 1992 and the pro forma provision for income taxes for the year ended December 31, 1991 are comprised of (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Temporary differences and carryforwards which give rise to the deferred tax liability at December 31, 1993 and 1992 are as follows (in $000s): During the year ended December 31, 1991, deferred income taxes principally were provided for significant timing differences in the recognition of revenue and expenses for tax and financial statement purposes. These items principally consisted of the excess of tax depreciation, depletion and amortization over that deducted for financial reporting purposes. The differences between the provision for income taxes at the statutory rate and the actual provision for income taxes are summarized as follows (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5-COMMITMENTS AND CONTINGENT LIABILITIES Toca On March 4, 1993, the Company filed a complaint against Warren Petroleum Company, Arco Oil & Gas Co., Conoco Inc., Trident NGL, Inc. and other owners of the Yscloskey Gas Plant located in Louisiana (the "Owners") in the United States District Court for the Eastern District of Louisiana, alleging various violations by the defendants of the federal anti-trust laws in connection with a Hydrocarbon Fractionation Agreement at its Toca plant between the Company and the Owners of the Yscloskey plant. The Company also filed a companion state-court action involving the same parties in Civil District Court for the Parish of Orleans, State of Louisiana, which the defendants removed to United States District Court for the Eastern District of Louisiana. The Company and Warren Petroleum Company (in its capacity as the designated Operator for the Yscloskey Plant) have recently negotiated a new Hydrocarbon Fractionation Agreement, which has been executed by substantially all of the Owners of the Yscloskey Plant. The new 15-year agreement provides for a reduced fractionation fee of 9.25% and eliminates the uncertainty regarding uneconomic performance of the Yscloskey plant. The Company anticipates dismissing the various complaints with prejudice. Edgewood On January 16, 1991, problems at the Company's Edgewood Plant relating to both equipment that removes hydrogen sulfide from unprocessed natural gas and the monitoring equipment owned by the purchaser of the residue gas, Enserch Corporation, doing business as Lone Star Gas Company ("Lone Star"), allowed residue gas containing hydrogen sulfide to enter Lone Star's transmission line supplying residue gas to Emory, Texas. The Company has been named as a co-defendant, along with Lone Star, in the following complaints relating to the incident: Gary Prather, et al. v. Enserch ------------------------------- Corporation, et al., filed March 15, 1993, Barbara Rogers, et al., v. Enserch ------------------- ---------------------------------- Corporation, et al. filed March 16, 1993, Judy Silvey, et al. v. Enserch, et ------------------- ---------------------------------- al., filed May 13, 1993, Floyd Rogers, et al. v. Enserch, et al., filed May --- --------------------------------------- 14, 1993, Blair Schamlain, et al. v. Enserch, et al., filed May 25, 1993, ------------------------------------------ Betty Adair v. Enserch, et al., filed on July 14, 1993, Doris Hass v. Enserch ------------------------------ --------------------- Corporation, et al., filed on December 17, 1993, Allie Ruth Harris v. Enserch ------------------- ---------------------------- Corporation, et al., filed on December 17, 1993, Sandra Parker, et al. v ------------------- ----------------------- Enserch Corporation, et al., filed on --------------------------- WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) January 13, 1994, and Carma Brumit v. Enserch, et al., filed on January 18, ------------------------------- 1994. All the cases have been filed in the District Court, Rains County, Texas, 354th Judicial District, and make similar claims, asserting, among other things, that the defendants breached an implied warranty of merchantability, falsely represented that the residue gas was safe, were negligent and are liable under a strict liability theory. The plaintiffs have alleged a variety of respiratory and neurological illnesses and are seeking treble damages, exemplary damages and attorneys' fees. Prior to the filing of the complaints, the Company received demand letters from the plaintiffs that sought, in the aggregate, approximately $36 million. Damages claimed in the lawsuits are in excess of $13.5 million. The Company believes that it has meritorious defenses to the claims and intends to defend vigorously against any such claims. The Company is currently conducting extensive pre-trial discovery. The underwriters of the Company's general liability insurance policy have indicated preliminarily that such policy appears to cover the types of claims that have been asserted, subject to their right to deny coverage based upon, among other things, final determination of causation and the exact nature of the damages. Granger On December 6, 1993, Green River Gathering Company ("Green River") and Mountain Gas filed a complaint against Washington Energy Exploration, Inc. ("Washington Energy") in District Court in Arapahoe County, Colorado seeking the payment of certain outstanding receivables from Washington Energy and a declaratory judgment that the gathering agreement between Washington Energy and Green River is in full force and effect. Mountain Gas is a wholly-owned subsidiary of the Company and Green River is a partnership owned by the Company and Mountain Gas. Washington Energy is the operator of wells producing approximately 33% of the natural gas transported through the Green River Gathering system to Mountain Gas' Granger facility. On December 27, 1993, Washington Energy filed an answer, counterclaim, crossclaim and request for trial by jury, denying the substance of the allegations and asserting certain affirmative defenses. Washington Energy has also made certain counterclaims seeking monetary damages relating to Green River's performance under the gathering agreement and under a processing agreement between the parties, along with a declaratory judgment that both WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) agreements have been terminated. In addition, Washington Energy has made a crossclaim against two unaffiliated entities, each of which owned a portion of Green River during a portion of the period in question. The Company believes that Green River is in compliance with the gathering agreement and the processing agreement and that both are in full force and effect. The Company believes that it has meritorious defenses to the counterclaims and intends to defend vigorously against any such claims. The Company is currently conducting extensive pre-trial discovery. Katy Commencing in March 1993 and continuing through July 1993, Western Gas Resources Storage, Inc. ("Storage"), a wholly-owned subsidiary of the Company, filed a total of 165 condemnation actions in the County Court at Law No. 1 and No. 2 of Fort Bend County, Texas to obtain certain storage rights and rights- of-way relating to its Katy Gas Storage Facility. The County Court appointed panels of Special Commissioners that have awarded compensation to the owners whose rights were condemned. Certain of the land and mineral owners are seeking in County Court a declaration that Storage does not possess the right to condemn, or, in the alternative, that they should be awarded more compensation than previously awarded by the Special Commissioners. The Company believes that the outcome of such proceedings will not materially affect operation of the Katy Gas Storage Facility. The likelihood of any particular result, however, cannot be determined because the condemnation law under which the proceedings are being brought has never been interpreted by the courts. Woods/Moncrief In February 1994, the United States Appeals Court for the Tenth Circuit affirmed a district court judgment against the Company in the amount of $2.9 million, including interest, in Western Gas Processors Ltd. v. Woods Petroleum ---------------------------------------------- Corporation and W.A. Moncrief, Jr., d/b/a Moncrief Oil Company, which related -------------------------------------------------------------- to claims by certain producers that they had been underpaid. The Company has taken a charge to litigation reserves in the year ended December 31, 1993, in the amount of $2.4 million, as a result of the appellate court decision. The Company will not take any further action. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 6-EMPLOYEE BENEFIT PLANS A discretionary profit sharing plan exists for all Company employees meeting certain service requirements. The Company makes annual contributions to the plan as determined by the Board of Directors. Contributions are made to bank trust funds administered by an independent investment manager. Contributions were $2.2 million, $2.0 million and $1.4 million, respectively, in the three years ended December 31, 1993. The Board of Directors of the Company has adopted a Key Employees' Incentive Stock Option Plan and a Non-Employee Director Stock Option Plan that authorize the granting of options to purchase 250,000 and 20,000 common shares of the Company, respectively. The Board of Directors has granted options to purchase 240,000 common shares to certain officers and 15,000 common shares to three non-employee directors of the Company, at exercise prices ranging from $10.71 to $34.00. Each of these options became exercisable as to 25% of the shares covered by it on the later of January 1, 1992, or one year from the date of grant, subject to the continuation of the optionee's relationship with the Company, and became exercisable as to an additional 25% of the covered shares on each subsequent January 1 through 1995 or on the later of each subsequent date of grant anniversary, subject to the same condition. The Company has entered into agreements committing the Company to loan certain key employees an amount sufficient to exercise their options as each portion of their options vests. The Company will forgive the loan and accrued interest if the employee has been continuously employed by the Company for four years after the date of the loan. In April 1987, the Partnership adopted an employee option plan that authorizes granting options to employees to purchase 430,000 common units in the Partnership. Pursuant to the Restructuring, the Company assumed the Partnership's obligation under the Employee option plan. The plan was amended upon the Restructuring to allow each holder of existing options to exercise such options and acquire one share of common stock for each common unit they were originally entitled to purchase. The exercise price and all other terms and conditions for the exercise of such options issued under the amended plan were the same as under the plan, except that the Restructuring accelerated the time after which certain options may be exercised. Through December 31, 1993 and 1992, the Board of Directors has granted options under the plan to purchase shares of common stock at $5.40 per share to approximately 355 and 350 employees, respectively. As of December 31, 1993 and 1992, approximately 415,000 and 390,000 options were vested and WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) approximately 325,000 and 240,000 options for common shares had been exercised, respectively. In February 1994, the Board of Directors retroactively approved, adopted and ratified approximately 53,000 options which were granted to employees in excess of the 430,000 options originally authorized. No more options may be granted under this plan. Options may be exercised only at the rate of 20% of the common shares subject to such option for each year of continuous service by the optionee commencing from the later of July 2, 1987 or the optionee's employment commencement date. The Company has entered into agreements committing the Company to loan to certain key employees an amount sufficient to exercise their options, provided that the Company will not loan in excess of 25% of the total amount available to the employee in any one year. The Company will forgive any loan and accrued interest on July 2, 1997, if the employee is then employed by the Company. As of December 31, 1993 and 1992, loans related to 162,998 and 98,297 options, totaling $1.2 million and $730,000, were extended under these terms. The 1993 Stock Option Plan (the "1993 Plan") became effective on May 24, 1993 after approval by the Company's stockholders. The 1993 Plan is intended to be an incentive stock option plan in accordance with the provisions of Section 422 of the Internal Revenue Code of 1986, as amended. The Company has reserved 1,000,000 shares of Common Stock for issuance upon exercise of options under the 1993 Plan. The 1993 Plan will terminate on the earlier of March 28, 2003 or the date on which all options granted under the 1993 Plan have been exercised in full. The Board of Directors of the Company will determine and designate from time to time those employees of the Company to whom options are to be granted. If any option terminates or expires prior to being exercised, the shares relating to such option shall be released and may be subject to reissuance pursuant to a new option. The Board of Directors has the right to, among other things, fix the price, terms and conditions for the grant or exercise of any option. The purchase price of the stock under each option shall be the fair market value of the stock at the time such option is granted. Options granted will vest 20% a year after the date of grant. The employee must exercise the option within five years of the date each portion vests. If an employee's employment with the Company terminates, the employee may, within the 60 day period immediately following such termination of employment, but in no event later than the expiration date specified in the Option Agreement, exercise any options that have vested as of the date of such WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) termination. If employment terminates by reason of death or disability, the employee (in the event of disability) or the person or persons to whom rights under the option shall pass by will or by the applicable laws of decent and distribution (in the event of death), shall be entitled to exercise 100% of the options granted regardless of the employee's years of service; provided however, that no such option may be exercised after 180 days from the date of death or termination of employment with the Company as a result of disability. Through December 31, 1993, the Board of Directors has granted approximately 384,000 options at exercise prices ranging from $28.25 to $35.50 per share of common stock to approximately 455 employees. No options granted under the 1993 Plan have vested. NOTE 7 - SUPPLEMENTAL INFORMATION ON OIL AND GAS PRODUCING ACTIVITIES (UNAUDITED): Costs The following tables set forth capitalized costs at December 31, 1993 and costs incurred for oil and gas producing activities for the year ended December 31, 1993 (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Results of Operations The results of operations for oil and gas producing activities, excluding corporate overhead and interest costs, for the year ended December 31, 1993 are as follows (in $000s): Reserve Quantity Information Reserve estimates are subject to numerous uncertainties inherent in the estimation of quantities of proved reserves and in the projection of future rates of production and the timing of development expenditures. The accuracy of such estimates is a function of the quality of available data and of engineering and geological interpretation and judgement. Results of subsequent drilling, testing and production may cause either upward or downward revisions of previous estimates. Further, the volumes considered to be commercially recoverable fluctuate with changes in prices and operating costs. Reserve estimates, by their nature, are generally less precise than other financial statement disclosures. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table sets forth information for the year ended December 31, 1993 with respect to changes in the Company's proved reserves, all of which are in the United States. The Company has no significant undeveloped reserves. (*) Primarily represents acquisition of Black Lake oil and gas properties on September 27, 1993, from Nerco. Standardized Measures of Discounted Future Net Cash Flows Estimated discounted future net cash flows and changes therein were determined in accordance with SFAS No. 69. Certain information concerning the assumptions used in computing the valuation of proved reserves and their inherent limitations are discussed below. The Company believes such information is essential for a proper understanding and assessment of the data presented. Future cash inflows are computed by applying year-end prices of oil and gas relating to the Company's proven reserves to the year-end quantities of those reserves. Future price changes are considered only to the extent provided by contractual arrangements in existence at year-end. The assumptions used to compute estimated future net revenues do not necessarily reflect the Company's expectations of actual revenues or costs, nor their present worth. In addition, variations from the expected production rate also could result directly or indirectly from factors outside of the Company's control, such as unintentional delays in development, changes in prices or regulatory controls. The reserve valuation further assumes that all reserves will be disposed of by production. However, if reserves are sold in place additional economic considerations could also affect the amount of cash eventually realized. WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Future development and production costs are computed by estimating the expenditures to be incurred in developing and producing the proved oil and gas reserves at the end of the year, based on year-end costs and assuming continuation of existing economic conditions. Future income tax expenses are computed by applying the appropriate year-end statutory tax rates, with consideration of future tax rates already legislated, to the future pretax net cash flows relating to the Company's proved oil and gas reserves. Permanent differences in oil and gas related tax credits and allowances are recognized. An annual discount rate of 10% was used to reflect the timing of the future net cash flows relating to proved oil and gas reserves. Information with respect to the Company's estimated discounted future cash flows from its oil and gas properties for the year ended December 31, 1993 is as follows (in $000s): WESTERN GAS RESOURCES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Principal changes in the Company's estimated discounted future net cash flows for the year ended December 31, 1993 are as follows (in $000s): NOTE 8 - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED): The following summarizes certain quarterly results of operations (in $000s, except per share amounts): *Excludes selling and administrative, interest and income tax expenses. 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 Pursuant to instruction G(3) to Form 10-K, Items 10, 11, 12 and 13 are omitted because the Company will file a definitive proxy statement (the "Proxy Statement") pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later than 120 days after the close of the fiscal year. The information required by such Items will be included in the definitive proxy statement to be so filed for the Company's annual meeting of stockholders scheduled for May 11, 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 part of this report: (1) Financial Statements: Reference is made to the listing on page 34 for a list of all financial statements filed as a part of this report. (2) Financial Statement Schedules: All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because they are not applicable. (3) Exhibits: 2.1 Agreement for the Sale and Purchase of Assets dated as of May 1, 1990 between Parker Gas Companies, Inc. and its subsidiaries and Western Gas Processors, Ltd. (Filed as exhibit 2.1 to Western Gas Resources, Inc.'s Form 10-Q for the quarter ended March 31, 1990 and incorporated herein by reference). 2.2 Agreement for Sale and Purchase of Assets concerning the Treating Business of Parker Gas Treating Company, dated May 24, 1990 (Filed as exhibit 2.6 to Western Gas Processors, Ltd.'s Form 10-Q for the quarter ended June 30, 1990 and incorporated herein by reference). 2.3 Addendum and Agreement concerning the Treating Agreement and Giddings Agreement (Filed as exhibit 2.6 to Western Gas Processors, Ltd.'s Form 10-Q for the quarter ended June 30, 1990 and incorporated herein by reference). 2.4 Agreement for the Sale and Purchase of Assets dated as of November 2, 1990 between Giddings, Ltd. and Western Gas Processors, Ltd. (Filed as exhibit 10.26 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 2.5 Letter of intent for the Sale and Purchase of Assets dated as of September 24, 1990 between Amoco Production Company and Western Gas Processors, Ltd. (Filed as exhibit 10.27 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33- 39588 dated March 27, 1991 and incorporated herein by reference). 2.6 Purchase and sale agreement by and between Amoco Production Company and Western Gas Processors, Ltd. dated as of January 7, 1991 (Filed as exhibit 10.28 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 2.7 Amendment to purchase and sale agreement by and between Amoco Production Company and Western Gas Processors, Ltd. dated February 13, 1991 (Filed as exhibit 10.29 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 2.8 Second amendment to purchase and sale agreement by and between Amoco Production Company and Western Gas Processors, Ltd. dated February 11, 1991 (Filed as exhibit 10.30 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33- 39588 dated March 27, 1991 and incorporated herein by reference). 3.1 Certificate of Incorporation of Western Gas Resources, Inc. (Filed as exhibit 3.1 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-31604 and incorporated herein by reference). 3.2 Certificate of Amendment to the Certificate of Incorporation of Western Gas Resources, Inc. (Filed as exhibit 3.2 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-31604 and incorporated herein by reference). 3.3 Bylaws of Western Gas Resources, Inc. (Filed as exhibit 3.3 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-31604 and incorporated herein by reference). 3.4 Assistant Secretary's Certificate regarding amendment to bylaws of Western Gas Resources, Inc. (Filed as exhibit 3.4 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 3.5 Certificate of Designation of 7.25% Cumulative Senior Perpetual Convertible Preferred Stock of the Company (Filed as exhibit 3.5 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 3.6 Certificate of Designation of $2.28 Cumulative Preferred Stock of the Company. (Filed as exhibit 3.6 to Western Gas Resources, Inc.'s Registration Statement of Form S-1, Registration No. 33- 53786 dated November 12, 1992 and incorporated herein by reference). 3.7 Amendments of the By-Laws of Western Gas Resources, Inc. as adopted by the Board of Directors on December 13, 1993. (See page 89). 4.1 Subscription Agreements between the respective Founders and Western Gas Resources, Inc. regarding such Founders' initial subscription for shares of common stock (Filed as exhibit 10.31 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 4.2 Commitment letter between DLJ Bridge Finance, L.P., and the Company dated September 16, 1991 (Filed as exhibit 4.1 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 4.3 Amendment No. 1 to Registration Rights Agreement as of May 1, 1991 between Western Gas Resources, Inc., Bill Sanderson, WGP, Inc., Dean Phillips, Inc., Heetco, Inc. NV, Sauvage Gas Company and Sauvage Gas Service, Inc. (Filed as exhibit 4.2 to Western Gas Resources, Inc.'s Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference). 10.1 Amended and Restated Agreement of Limited Partnership of the Partnership dated June 1, 1987 (Filed as exhibit 10.1 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 , dated March 27, 1991 and incorporated herein by reference). 10.2 Transfer Restriction Agreement between Western Gas Resources, Inc. and Western Gas Processors, Ltd. (Filed as exhibit 10.4 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.3 Reinvestment Agreement among Western Gas Processors, Ltd., Western Gas Resources, Inc., WGP, Inc., Heetco, Inc. NV, Dean Phillips, Inc., Sauvage Gas Company and Sauvage Gas Service, Inc. (Filed as exhibit 10.5 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.4 Fifth Restated Loan Agreement dated as of September 21, 1988 between Western Gas Processors, Ltd., and NCNB Texas National Bank (Filed as exhibit 4.8 to Western Gas Processors, Ltd.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1988 and incorporated herein by reference). 10.5 First Amendment to Fifth Restated Loan Agreement dated as of February 7, 1989 between Western Gas Processors, Ltd. and NCNB Texas National Bank (Filed as exhibit 4.9 to Western Gas Processors, Ltd.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1988 and incorporated herein by reference). 10.6 Second Amendment to Fifth Restated Loan Agreement dated as of October 20, 1989 between Western Gas Processors, Ltd. and NCNB Texas National Bank (Filed as exhibit 10.6 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-31604 and incorporated herein by reference). 10.7 Restated Profit-Sharing Plan and Trust Agreement of Western Gas Resources, Inc. (Filed as exhibit 10.8 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33- 39588 dated March 27, 1991 and incorporated herein by reference). 10.8 Employees Common Units Option Plan of Western Gas Processors, Ltd. (Filed as exhibit 10.9 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.9 Amendment to Employees Common Units Option Plan of Western Gas Processors, Ltd. (Filed as exhibit 10.10 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.10 Western Gas Resources, Inc. Non-Employee Director Stock Option Plan (Filed as exhibit 10.12 Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.11 Western Gas Resources, Inc. Key Employees' Incentive Stock Option Plan (Filed as exhibit 10.13 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.12 Registration Rights Agreement among Western Gas Resources, Inc., WGP, Inc., Heetco, Inc., NV, Dean Phillips, Inc., Sauvage Gas Company and Sauvage Gas Service, Inc. (Filed as exhibit 10.14 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.13 Agreement of Sale Concerning the Midkiff Plant and Spraberry Gathering System (without exhibits) dated as of May 12, 1989 between El Paso Natural Gas Company and Western Gas Processors, Ltd. (Filed as exhibit 10.13 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, filed December 8, 1989, Registration No. 33- 31604 and incorporated herein by reference). 10.14 Interim Operating Agreement for the Midkiff system (Filed as exhibit 10.14 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, filed December 8, 1989, Registration No. 33-31604 and incorporated herein by reference). 10.15 Amendment Number One to the Amended and Restated Agreement of Limited Partnership of Western Gas Processors, Ltd. dated as of December 4, 1989 (Filed as exhibit 10.2 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.16 Guaranty of Western Gas Resources, Inc. in favor of NCNB Texas National Bank (Filed as exhibit 10.17 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.17 Form of Agreement to be Bound of Western Gas Resources, Inc. (Filed as exhibit 10.18 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.18 Assumption Agreement of Western Gas Resources, Inc. (Filed as exhibit 10.19 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.19 Distribution Reinvestment Plan of Western Gas Processors, Ltd. (Filed as exhibit 10.19 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, filed December 8, 1989, Registration No. 33-31604 and incorporated herein by reference). 10.20 Second Amendment to Amended and Restated Agreement of Limited Partnership of Western Gas Processors, Ltd. (Filed as exhibit 10.3 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.21 Sixth Restated Loan Agreement dated as September 26, 1990 between Western Gas Processors, Ltd. and NCNB Texas National Bank (Filed as exhibit 10.6 to Western Gas Resources, Inc.'s Registration Statement on Form S-4 dated March 27, 1991 and incorporated herein by reference). 10.22 First Amendment to Sixth Restated Loan Agreement dated as of October 26, 1990 between Western Gas Processors, Ltd. and NCNB Texas National Bank (Filed as exhibit 10.7 to Western Gas Resources, Inc.'s Registration Statement on Form S-4, Registration No. 33-39588 dated March 27, 1991 and incorporated herein by reference). 10.23 Loan Agreement dated as of May 1, 1991 between the Company and NCNB Texas National Bank as Agent and Certain Banks as Lenders (Filed as exhibit 10.1 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.24 First Amendment to Loan Agreement dated as of August 12, 1991 by and among the Company and NCNB Texas National Bank and Various Lenders (Filed as exhibit 10.2 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.25 Second Amendment and First Restatement of Western Gas Processors, Ltd. Employees' Common Units Option Plan (Filed as exhibit 10.6 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.26 Agreement to provide loans to exercise key employees' common stock options (Filed as exhibit 10.26 to Western Gas Resources, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference). 10.27 Agreement to provide loans to exercise employees' common stock options (Filed as exhibit 10.27 to Western Gas Resources, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference). 10.28 Agreement and Plan of Restructuring among the Company, the Partnership and the Founders (Filed as exhibit 10.10 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.29 Asset Purchase Agreement among Union Texas Petroleum Holdings, Inc., Union Texas Products Corporation and the Company dated September 17, 1991 (without exhibits) (Filed as exhibit 10.11 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.30 Stock Purchase Agreement dated October 23, 1991 between the Company and The 1818 Fund, L.P. (Filed as exhibit 10.19 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.31 Registration Rights Agreement dated October 23, 1991 between the Company and The 1818 Fund, L.P. (Filed as exhibit 10.20 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.32 First Restated Loan Agreement dated as of October 31, 1991 by and among the Company and NCNB Texas National Bank as Agent and NCNB Texas National Bank and Bankers Trust Company as Co-Managers of the Acquisition Loan and Certain Banks as Lenders (Filed as exhibit 10.21 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.33 First Restated Loan Agreement (Inventory) dated as of October 31, 1991 by and among the Company and NCNB Texas National Bank as Agent and Certain Banks as Lenders (Filed as exhibit 10.22 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-43077 dated November 14, 1991 and incorporated herein by reference). 10.34 First Amendment to First Restated Loan Agreement dated December 23, 1991 by and among the Company and NCNB Texas National Bank as Agent and NCNB Texas National Bank and Bankers Trust Company as Co- Managers (Filed as exhibit 10.34 to Western Gas Resources, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and incorporated herein by reference). 10.35 Loan Agreement dated as of May 1, 1991 between Western Gas Resources, Inc. and NCNB Texas National Bank (Filed as exhibit 10.27 to Western Gas Resources, Inc.'s Form 10-Q for the quarter ended June 30, 1991 and incorporated herein by reference). 10.36 Letter Agreement dated June 10, 1992 amending the Stock Purchase Agreement dated October 23, 1991 between the Company and the 1818 Fund, L.P. (Filed as exhibit 10.36 to Western Gas Resources, Inc.'s Form 10-Q for the quarter ended June 30, 1992 and incorporated herein by reference). 10.37 Second Restated Loan Agreement dated as of October 20, 1992 by and among the Company and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (Filed as exhibit 10.21 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-53786 dated November 12, 1992 and incorporated herein by reference). 10.38 Second Restated Loan Agreement (Inventory) dated as of October 20, 1992 by and among the Company and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (Filed as exhibit 10.22 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-53786 dated November 12, 1992 and incorporated herein by reference). 10.39 $100,000,000 Senior Notes Master Shelf Agreement dated as of December 19, 1991 by and between the Company and the Prudential Insurance Company of America (Filed as exhibit 10.23 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-53786 dated November 12, 1992 and incorporated herein by reference). 10.40 Letter Amendment No. 1 dated October 22, 1992 to $100,000,000 Senior Notes Master Shelf Agreement (Filed as exhibit 10.40 to Western Gas Resources, Inc's Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.41 Asset Purchase Agreement (without exhibits) dated October 21, 1992 between the Company and Parker & Parsley Gas Processing Co. (Filed as exhibit 10.25 to Western Gas Resources, Inc.'s Registration Statement on Form S-1, Registration No. 33-53786 dated November 12, 1992 and incorporated herein by reference) 10.42 Consulting Agreement dated as of January 1, 1993 by and between the Company and Walter L. Stonehocker (Filed as exhibit 10.42 to Western Gas Resources Inc.'s Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.43 Consulting Agreement dated as of January 1, 1993 by and between the Company and Ward Sauvage (Filed as exhibit 10.43 to Western Gas Resources Inc.'s Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.44 Consulting Agreement dated as of January 1, 1993 by and between the Company and Dean Phillips (Filed as exhibit 10.44 to Western Gas Resources Inc.'s Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). 10.45 Stock Purchase Agreement (without exhibits) dated March 30, 1993 by and between the Company and The Morgan Stanley Leveraged Equity Fund II, L.P. (Filed as exhibit 10.45 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.46 Amendment No. 1 (without exhibits) to Stock Purchase Agreement dated as of March 30, 1993 by and between the Company and The Morgan Stanley Leveraged Equity Fund II, L.P. (Filed as exhibit 10.46 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.47 $150,000,000 Amended and Restated Master Shelf Agreement (without exhibits) effective as of July 22, 1993 by and between the Company and Prudential Insurance Company of America (Filed as exhibit 10.47 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.48 Note Purchase Agreement (without exhibits) dated as of April 1, 1993 by and between the Company and the Purchasers for $50,000,000, 7.65% Senior Notes Due April 30, 2003 (Filed as exhibit 10.48 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.49 $15,000,000 Credit Agreement dated July 30, 1993 by and between the Company and NationsBank of Texas, N.A. (Filed as exhibit 10.49 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.50 General Partnership Agreement (without exhibits), dated August 10, 1993 for Westana Gathering Company by and between Western Gas Resources - Oklahoma, Inc. (a subsidiary of the Company) and Panhandle Gathering Company (Filed as exhibit 10.50 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.51 Amendment to General Partnership Agreement dated August 10, 1993 by and between Western Gas Resources - Oklahoma, Inc. (a subsidiary of the Company) and Panhandle Gathering Company (Filed as exhibit 10.51 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.52 Operating and Maintenance Agreement (without exhibits) dated August 10, 1993 by and between Western Gas Resources - Oklahoma, Inc. (a subsidiary of the Company) and Panhandle Gathering Company (Filed as exhibit 10.52 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.53 Amendment to Operating and Maintenance Agreement dated August 10, 1993 by and between Western Gas Resources -Oklahoma, Inc. (a subsidiary of the Company) and Panhandle Gathering Company (Filed as exhibit 10.53 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.54 Interim Agreement (without exhibits) dated August 10, 1993 by and between Westana Gathering Company and Panhandle Eastern Pipe Line Company (Filed as exhibit 10.54 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.55 Amendment to Interim Agreement dated August 10, 1993 by and between Westana Gathering Company and Panhandle Eastern Pipe Line Company (Filed as exhibit 10.55 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.56 Pipeline Operating Agreement (without exhibits) dated August 10, 1993 by and between Westana Gathering Company and Panhandle Eastern Pipe Line Company (Filed as exhibit 10.56 to Western Gas Resources Inc.'s Form 10-Q for the six months ended June 30, 1993 and incorporated herein by reference). 10.57 $400,000,000 Loan Agreement (Revolver) (without exhibits) dated as of August 31, 1993 among the Company and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (Filed as exhibit 10.57 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.58 Third Restated Loan Agreement (Term) (without exhibits) dated as of August 31, 1993 among the Company and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (Filed as exhibit 10.58 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.59 Letter Amendment No. 1 to the Amended and Restated Master Shelf Agreement effective as of June 30, 1993 by and between the Company and Prudential Insurance Company of America (Filed as exhibit 10.59 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.60 Asset Purchase Agreement (without exhibits) dated July 18, 1993 by and between the Company and Nerco Oil & Gas, Inc. (Filed as exhibit 10.60 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.61 Amendment No. 1 to Note Purchase Agreement dated as of August 31, 1993 by and among the Company and the Purchasers (Filed as exhibit 10.61 to Western Gas Resources Inc.'s Form 10-Q for the nine months ended September 30, 1993 and incorporated herein by reference). 10.62 First Amendment to Stock Purchase Agreement, amending the Stock Purchase Agreement dated October 23, 1991 between Western Gas Resources, Inc. and the 1818 Fund, L.P. (See page 92). 10.63 First Amendment to Loan Agreement (Revolver) as of December 31, 1993 among Western Gas Resources, Inc. and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (See page 96). 10.64 First Amendment to Third Restated Loan Agreement (Term) as of December 31, 1993 among Western Gas Resources, Inc. and NationsBank of Texas, N.A. as Agent and Certain Banks as Lenders (See page 107). 11.1 Statement regarding computation of per share earnings (See page 116) 21.1 List of Subsidiaries of Western Gas Resources, Inc. (See page 118). 23.1 Consent of Price Waterhouse, independent accountants (See page 120). (b) Reports on Form 8-K: None. (c) Exhibits required by Item 601 of Regulation S-K. See (a) (3) above. (d) Financial statement schedules required by Regulation S-X. See (a) (2) above. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Stockholders of Western Gas Resources, Inc. Our audits of the Consolidated Financial Statements referred to in our report dated February 25, 1994 appearing on page 36 also included an audit of the Financial Statement Schedules listed in Item 14(a) 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 Denver, Colorado February 25, 1994 SCHEDULE II WESTERN GAS RESOURCES, INC. NOTES RECEIVABLE FROM RELATED PARTIES ($000s) - Continued on following page - SCHEDULE II WESTERN GAS RESOURCES, INC. NOTES RECEIVABLE FROM RELATED PARTIES ($000s, except share amounts) - Continued from previous page - (1) In July 1990, the Company loaned Mr. Sanderson $748 to purchase 294,524 shares of the Company's common stock. Interest is accrued at a rate equal to that paid by the Company on its Revolving Credit Facility, which was 4.1%, 4.4% and 5.9% at December 31, 1993, 1992, and 1991, respectively. Interest is payable annually on December 31 during the term of the note with all unpaid principal and accrued interest due and payable on January 1, 1996. The note is secured by the common stock and is accounted for as a reduction of stockholders' equity. (2) In 1991, the Company entered into agreements committing the Company to loan to certain key employees an amount sufficient to exercise their options, provided that the Company will not loan in excess of 25% of the total amount available to the employee in one year. The Company will forgive the loan and accrued interest on July 2, 1997,if the employee is then employed by the Company or four years after the date of the loan, depending on the option exercised. The interest on each loan is based on the Applicable Federal Rate on the date the loan is made. SCHEDULE V WESTERN GAS RESOURCES, INC. PROPERTY AND EQUIPMENT ($000s) -Continued on following page - SCHEDULE V WESTERN GAS RESOURCES, INC. PROPERTY AND EQUIPMENT ($000s) - Continued from previous page - (1) Additions for the year ended December 31, 1993 include Black Lake, Mountain Gas, Citizens, Sand Wash, Olympic Pipeline, Rocker B and other small acquisitions totaling $338,900. Additionally, construction projects at existing facilities totaled $140,800, including $74,400 for the Katy Gas Storage Facility, $15,700 for acquired construction in progress, $13,900 for improvements to the Midkiff/Benedum facility, $5,800 for improvements to the Chaney Dell/Lamont facility, $9,800 for improvements to the acquired Mountain Gas Plants, $12,200 for improvements to Giddings and $8,900 for miscellaneous projects. (2) Additions for the year ended December 31, 1992 include the Wakita, Manchester, Burro and other small acquisitions totaling $11,000. Additionally, construction projects at existing facilities totaled $60,000, including $24,000 on the Katy storage facility, $11,000 for improvements to plants acquired in the UTP acquisition, $10,000 for improvements to the Giddings Plant, $5,000 for improvements to the Midkiff Plant, $4,000 for improvements to the Hilight Plant and $6,000 for miscellaneous projects. (3) Sales or retirements for the year ended December 31, 1992 includes the sale of a 20% undivided interest in the Midkiff and Benedum gas processing plants for approximately $22,000. (4) Additions for the year ended December 31, 1991 include the UTP, Edgewood and Fruitvale acquisitions totalling $190,000. Additionally, construction projects at existing facilities totaled approximately $36,000, including $16,000 for the butane isomerization unit, $6,000 for improvements to the Midkiff plant, $2,000 for improvements to the Giddings plant, $3,000 for the acquisition of the Company's headquarters and $9,000 for miscellaneous projects. SCHEDULE VI WESTERN GAS RESOURCES, INC. ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY AND EQUIPMENT ($000s) - Continued on following page - SCHEDULE VI WESTERN GAS RESOURCES, INC. ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY AND EQUIPMENT ($000s) - Continued from previous page - (1) Depreciation is provided using the straight-line method based on estimated useful lives ranging from three to forty-five years. (2) Total depreciation and amortization expense for the three years ended December 31, 1993, 1992 and 1991, as presented on the Consolidated Statement of Operations, includes amortization expense of $5,787, $1,630 and $1,641, respectively. SCHEDULE X WESTERN GAS RESOURCES, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION ($000s) Consent of Independent Accountants We hereby consent to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 (No.33-66516) and in the Registration Statement on Form S-8 (No. 33-67834) of Western Gas Resources, Inc. of our report dated February 25, 1994 appearing on page 36 of this Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page 79 of this Form 10-K. PRICE WATERHOUSE Denver, Colorado March 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, in the City of Denver, State of Colorado on March 14, 1994. WESTERN GAS RESOURCES, INC. --------------------------- (Registrant) By: /s/ BRION G. WISE ----------------------- Brion G. Wise 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. /s/ BRION G. WISE Chairman of the Board, March 14, 1994 - ------------------------ Chief Executive Officer Brion G. Wise and Director /s/ BILL M. SANDERSON President, Chief March 14, 1994 - ------------------------ Operating Officer and Bill M. Sanderson Director /s/ WALTER L. STONEHOCKER Vice Chairman of the Board March 14, 1994 - ------------------------ and Director Walter L. Stonehocker /s/ RICHARD B. ROBINSON Director March 14, 1994 - ------------------------ Richard B. Robinson Director March 14, 1994 - ------------------------ Dean Phillips Director March 14, 1994 - ------------------------ Ward Sauvage Director March 14, 1994 - ------------------------ James A. Senty /s/ WALTER F. IMHOFF Director March 14, 1994 - ------------------------ Walter F. Imhoff Director March 14, 1994 - ------------------------ Walter W. Grist /s/ WILLIAM J. KRYSIAK Vice President - Controller March 14, 1994 - ------------------------ (Principal Financial and William J. Krysiak Accounting Officer)

49071_1993.txt

49071_1993

1993

49071

ITEM 1. BUSINESS GENERAL Humana Inc. is a Delaware corporation organized in 1961. Its principal executive offices are located at 500 West Main Street, Louisville, Kentucky 40202, and its telephone number at that address is (502) 580-1000. As used herein, the term "the Company" includes Humana Inc. and its subsidiaries. On March 1, 1993, the Company separated its acute-care hospital and managed care health plan businesses into two independent publicly-held companies (the "Spinoff"). The Spinoff was effected through the distribution to Humana stockholders of record as of the close of business on March 1, 1993, of all of the outstanding shares of common stock of a new hospital company, Galen Health Care, Inc. ("Galen"). Galen was subsequently merged, through an unrelated transaction, with a subsidiary of Columbia Healthcare Corporation (now Columbia/HCA Healthcare Corporation) ("Columbia") and, therefore, became a wholly-owned subsidiary of Columbia. The Company continues to operate the managed care health plan business. In conjunction with the Spinoff, the Company changed its fiscal year end from August 31 to December 31. Since 1983, the Company has offered managed health care products which integrate financing and management with the delivery of health care services through a network of providers who share financial risk or who have incentives to deliver cost-effective medical services. These products are marketed primarily through health maintenance organizations ("HMOs") and preferred provider organizations ("PPOs") that encourage, and in most HMO products require, use of contracting providers. HMOs and PPOs also control health care costs by various other means, including the use of utilization controls such as pre-admission approval for hospital inpatient services and pre-authorization of outpatient surgical procedures. The HMO and PPO products of the Company are primarily marketed to employer and other groups ("Commercial") and Medicare-eligible individuals. The products marketed to Medicare-eligible individuals are either HMO products that provide health care services which include all Medicare benefits, and in certain circumstances, additional health care services that are not included in Medicare benefits ("Medicare risk") or indemnity insurance policies that supplement Medicare benefits ("Medicare supplement"). Since 1983, the growth in the Company's HMO business has been primarily attributable to acquisitions, while the growth in its PPO business has been exclusively from internally produced sales. COMMERCIAL PRODUCTS HMOs An HMO provides prepaid health care services to its members through primary care and specialty physicians employed by the HMO at facilities owned by the HMO, or through a network of independent primary care and specialty physicians and other health care providers who contract with the HMO or the primary care physician to furnish such services. Primary care physicians include internists, family practitioners and pediatricians. Generally, access to specialty physicians and other health care providers must be approved by the member's primary care physician. These other health care providers include, among others, hospitals, nursing homes, home health agencies, pharmacies, mental health and substance abuse centers, diagnostic centers, optometrists, outpatient surgery centers, dentists, urgent care centers, and durable medical equipment suppliers. Because access to these other health care providers must be approved by the primary care physician, the HMO product is the most restrictive form of managed care. At December 31, 1993, the Company owned and operated ten HMOs, which contract with approximately 27,400 physicians (including approximately 5,900 primary care physicians) and 480 hospitals. In addition, the Company has approximately 1,300 contracts with other providers to provide services to HMO members. The Company also employed approximately 450 physicians in its HMOs. An HMO member pays a monthly fee which generally covers, with minimal co-payments, health care services received or approved by the member's primary care physician. For the year ended December 31, 1993, Commercial HMO premium revenues totaled approximately $1.4 billion or 43 percent of the Company's premium revenues of $3.1 billion. Approximately $168 million of the Company's premium revenues for the year ended December 31, 1993, were derived from contracts with the United States Office of Personnel Management ("OPM") under which the Company provides health care benefits to approximately 122,700 federal civilian employees and their dependents. Pursuant to these contracts, payments made by OPM may be retrospectively adjusted downward by OPM if an audit discloses that a comparable product was offered by the Company to a similarly sized subscriber group using a rating formula which resulted in a lower premium rate than that offered to OPM. PPOs PPO products include many elements of managed health care. In a PPO, the enrollee is encouraged, through financial incentives, to use preferred health care providers which have contracted with the PPO to provide services at favorable rates. PPOs are also similar to traditional health insurance because they provide an enrollee with the freedom to choose a physician or other health care provider. At December 31, 1993, approximately 24,300 physicians and 480 hospitals contracted with the Company to provide services to PPO enrollees. In addition, the Company has approximately 1,300 contracts with other providers to provide services to PPO enrollees. For the year ended December 31, 1993, premium revenues from Commercial PPOs totaled $357 million or 11 percent of the Company's premium revenues of $3.1 billion. MEDICARE PRODUCTS Medicare is a federal program that provides persons age 65 and over and some disabled persons certain hospital and medical insurance benefits, which include hospitalization benefits for up to 90 days per incident of illness plus a lifetime reserve aggregating 60 days. Each Medicare eligible individual is entitled to receive inpatient hospital care (Part A) without the payment of any premium, but is required to pay a premium to the federal government, which is annually adjusted, to be eligible for physician and other services (Part B). Even though participating in both Part A and Part B of Medicare, beneficiaries are still required to pay certain deductible and co-insurance amounts. They may, if they choose, supplement their Medicare coverage by purchasing policies which pay these deductibles and co-insurance amounts. Many of these policies also cover other services (such as prescription drugs) which are not included in Medicare coverage. These policies are known as Medicare supplement policies. Certain managed care companies which operate HMOs contract with the federal government's Health Care Financing Administration ("HCFA") to provide medical benefits to Medicare-eligible individuals residing in the geographic areas in which their HMOs operate in exchange for a fixed monthly payment from HCFA per enrollee. Individuals who elect to participate in these Medicare risk programs are relieved of the obligation to pay some or all of the deductible or co-insurance amounts but are required to use exclusively the services provided by the HMO. Other than the Part B premium paid by the enrollee to the Medicare program, the enrollee does not pay the HMO a premium for these services except where the benefits provided by the HMO exceed the benefits provided by the Medicare program. Medicare Risk As discussed above, a Medicare risk product involves a contract between an HMO and HCFA pursuant to which HCFA makes a fixed monthly payment to the HMO on behalf of each Medicare-eligible individual who chooses to enroll for coverage by the HMO. Enrollment may be terminated by the member upon 30 days' notice. The fixed monthly payment is determined and adjusted annually by HCFA, and takes into account, among other things, the cost of providing medical care in the geographic area where the member resides. The Company markets a variety of Medicare risk HMO products. All of these products provide an enrolled individual with all of the benefits covered by the Medicare program but relieve the enrolled individual of the obligation to pay deductibles and co-insurance that would otherwise apply. Some of these products also provide additional benefits not covered by Medicare, such as vision and dental care services and prescription drugs. Where competitive conditions permit, the Company also charges a premium to members (in addition to the payment from HCFA) for some of the Medicare risk products. At December 31, 1993, approximately 73,300 members in nine markets were paying premiums which totaled $51 million for the year ended December 31, 1993. The Company provides Medicare risk services under seven contracts with HCFA ("HCFA Contracts") in 10 markets. At December 31, 1993, HCFA Contracts covered approximately 270,800 Medicare risk members for which the Company received HCFA revenues of approximately $1.2 billion or 40 percent of the Company's premium revenues for the year ended December 31, 1993, of $3.1 billion. At December 31, 1993, one such HCFA Contract covered approximately 210,000 members in Florida. For the year ended December 31, 1993, this Florida HCFA Contract accounted for $1 billion or 80 percent of the Company's HCFA revenues of approximately $1.2 billion or 32 percent of the Company's total premium revenues. Each HCFA Contract is renewed each December 31 unless HCFA or the Company terminates it upon at least 90 days' notice prior thereto. Management believes termination of the HCFA Contract covering the members in Florida would have a material adverse effect on the Company's revenues, profitability and business prospects. Moreover, changes in the Medicare risk program, such as reduction in payments by HCFA or mandated increases in benefits without corresponding increases in payments, could also have a material adverse effect on the Company's revenues, profitability and business prospects. Effective January 1, 1994, payments under the Company's HCFA Contracts increased by an average of approximately 3 percent. Although annual increases have varied significantly, increases have averaged approximately 7 percent over the last five years, including the increase of January 1994. Medicare Supplement The Company's Medicare supplement product is an insurance policy which pays for hospital deductibles, co-payments and co-insurance for which the Medicare program participant is responsible. Under the terms of existing Medicare supplement policies, the Company may not reduce or cancel the benefits contracted for by policyholders. These policies are annually renewable by the insured at the Company's prevailing rates, which may increase subject to approval by appropriate state insurance regulators. At December 31, 1993, the Company provided Medicare supplement benefits to approximately 153,600 members. Premium revenues derived from this product for the year ended December 31, 1993, totaled $132 million. PROVIDER ARRANGEMENTS The Company's HMOs contract with individual or groups of primary care physicians, generally for an actuarially determined, fixed, per-member-per-month fee called a "capitation" payment. These contracts typically obligate primary care physicians to provide or arrange for the provision of all covered health care services to HMO members, including health care services provided by specialty physicians and other health care providers. The capitation payment does not vary with the nature or extent of health care services arranged for or provided to the member and is generally designed to shift all or part of the HMO's financial risk to the primary care physician. However, the degree to which the Company shifts its risk varies by provider. The Company remains financially responsible for the provision of or payment for such health care services if a primary care physician fails to perform his or her obligations under the contract. The Company also employs 450 physicians in markets where it operates staff model HMOs. The Company is directly responsible for all health care services provided by these employed physicians. In order to control costs, improve quality and create comprehensive networks, the Company also contracts with medical specialists and other providers to which a primary care physician may refer a member. Typically, payments by the Company to these specialists and other providers reduce the ultimate payment that otherwise would be made to a primary care physician. The Company's HMOs and PPOs contract for hospital services generally under a per diem payment arrangement for inpatient hospital services and a discounted fee-for-service payment arrangement for outpatient services. The Company's PPOs contract on a per diem or discounted basis with other health care providers. Many of the physicians who contract with the Company's HMOs also contract with its PPOs to provide services to enrollees at discounted fees. In addition, in a number of markets the Company's PPOs contract with physicians who have not contracted with its HMOs. Physician participation in the Company's HMOs and PPOs is conditioned upon meeting its HMOs' and PPOs' requirements concerning the physician's professional qualifications. Effective with the consummation of the Spinoff, the Company entered into a three-year operating agreement with Galen whereby the Company will use the services of Galen's hospitals guaranteeing certain minimum utilization levels. The rate increases charged for such services are defined under the terms of the agreement. Commercial rate increases are limited to the lesser of the increase in the hospital Consumer Price Index or the Company's premium rate increases, less 1 percent. The Medicare risk rate increases are equal to the percentage adjustment in HCFA's market specific hospital payment rate to the Company. During the year ended December 31, 1993, 16 percent of the Company's total medical costs were incurred in Galen's hospitals. MARKETING Individuals become members of the Company's Commercial HMOs and PPOs through their employer or other groups which typically offer employees or members a selection of health care products, pay for all or part of the premiums and make payroll deductions for any premiums payable by the employees. The Company attempts to become an employer's or group's exclusive source of health care benefits by offering HMO and PPO products that provide cost-effective quality care consistent with the health care needs and expectations of the employees or members. The Company uses various methods to market its Commercial and Medicare products, including television, radio, telemarketing and mailings. At December 31, 1993, the Company used approximately 2,000 independent licensed brokers and agents and 160 licensed employees to sell its Commercial products. Many employer groups are represented by insurance brokers and consultants who assist these groups in the design and purchase of health care products. The Company generally pays brokers a commission based on premiums, with commissions varying by market and premium volume. At December 31, 1993, approximately 260 independent licensed brokers and 430 employed sales representatives, who are each paid a salary and/or per member commission, marketed the Company's Medicare products. The following table lists the Company's Commercial, Medicare risk and Medicare supplement membership at December 31, 1993, by market and product: - --------------- (1) Includes Dade, Broward and Palm Beach counties. The Company acquired an HMO in Washington, D.C., with approximately 125,000 members for $55 million on February 28, 1994. The Company's 25 largest group contracts at December 31, 1993, accounted for approximately 33 percent of total Commercial membership. No one group contract accounted for as much as 5 percent of the Company's Commercial product premium revenues; however, certain employer groups accounted for a significant percentage of Commercial insurance premiums in some markets. The loss of one or more of these contracts in a particular market could have a material adverse effect on the Company's operations in that market. CONTROL OF HEALTH CARE COSTS The focal point for cost control in the Company's HMOs is the primary care physician, whether employed or under contract, who provides services and controls utilization of services by directing or approving hospitalization and referrals to specialists and other health care providers. Cost control in the Company's PPOs is achieved through obtaining discounts from participating health care providers. With respect to both HMO and PPO products, cost control is further achieved through use of a utilization review system managed by the Company designed to reduce unnecessary hospital admissions and lengths of stay and unnecessary or inappropriate medical procedures. New technologies (which typically require substantial expenditures), inflation, increasing hospital costs and numerous other external factors may adversely affect the ability of the Company to control health care costs in the future. RISK MANAGEMENT Through the use of internally developed underwriting criteria, the Company determines the risk it is willing to assume and the amount of premium to charge for its Commercial products. Employer and other groups must meet the Company's underwriting standards in order to qualify to contract with the Company for coverage. Underwriting techniques are not employed in connection with Medicare risk HMO products because of HCFA regulations that require the Company to accept all eligible Medicare applicants regardless of their health or prior medical history. COMPETITION The health care benefit industry is highly competitive and contracts for the sale of Commercial products are generally bid or renewed annually. The Company's competitors vary by local market and include Blue Cross/Blue Shield (including HMOs and PPOs owned by Blue Cross/Blue Shield plans), national insurance companies and other HMOs and PPOs. Many of the Company's competitors have larger enrollments in local markets or greater financial resources. The Company's ability to sell its products and to retain customers is influenced by such factors as benefits, pricing, contract terms, number and quality of participating physicians and other health care providers, utilization review, claims processing and administrative efficiency. GOVERNMENT REGULATION Of the Company's 13 licensed HMO subsidiaries, six are qualified under the Federal Health Maintenance Organization Act of 1973, as amended. Four of these six subsidiaries are parties to HCFA Contracts to provide Medicare risk HMO products in 10 markets. An HMO which is federally qualified may require employers with more than 25 employees that offer health insurance benefits to include federally qualified HMO products as an option available to their employees. To obtain federal qualification, an HMO must meet certain requirements, including conformance with financial criteria, a standard method of rate setting, a comprehensive benefit package, and prohibition of medical underwriting of individuals. In certain markets, and for certain products, the Company operates HMOs that are not federally qualified because this provides greater flexibility with respect to product design and pricing than is possible for federally qualified HMOs. HCFA audits Medicare risk HMOs at least biannually and may perform other reviews more frequently to determine compliance with federal regulations and contractual obligations. These audits include review of the HMOs' administration and management (including management information and data collection systems), fiscal stability, utilization management and incentive arrangements, health services delivery, quality assurance, marketing, enrollment activity, claims processing and complaint systems. HCFA regulations require quarterly and annual submission of financial statements and restrict the number of Medicare risk enrollees to no more than the HMO's Commercial enrollment in a specified service area. HCFA regulations also require independent review of medical records and quality of care, review and approval by HCFA of all advertising, marketing and communication materials, and independent review of all denied claims and service complaints which are not resolved in favor of a member. Laws in each of the states in which the Company operates its HMOs and PPOs regulate its operations, including the scope of benefits, rate formula, delivery systems, utilization review procedures, quality assurance, enrollment requirements, claim payments, marketing and advertising. The PPO products offered by the Company are sold under insurance licenses issued by the applicable state insurance regulators. The Company's HMOs and PPOs are required to be in compliance with certain minimum capital requirements. These requirements must be satisfied by investing in approved investments that generally cannot be used for other purposes. Under state laws, the Company's HMOs and PPOs are audited by state departments of insurance for financial and contractual compliance, and its HMOs are audited for compliance with health services standards by respective state departments of health. Management believes that the Company is in substantial compliance with all governmental laws and regulations affecting its business. NATIONAL HEALTH CARE REFORM Congress is in the process of evaluating a number of legislative proposals that would effect major changes in the United States health care system. Among the proposals under consideration are government imposed cost controls, measures to increase the availability of group health insurance coverage to employees, and the creation of statewide health alliances that would cover individuals and families not enrolled in large employer health plans. Legislative reform is not anticipated before the latter part of 1994 and implementation of any reform package could take several additional years. In general, managed care is being considered as a means by which health care costs may be reduced. Although management believes the Company is well positioned to take advantage of the opportunities which will be afforded by national health care reform, it is not possible to predict the final form these proposals will take or the affect these proposals may have on the Company's operations. STATE HEALTH CARE REFORM During 1993, the State of Florida adopted health care reform legislation which, among other things, established a mechanism through which small employers and self-employed individuals may acquire health care coverage through state chartered non-profit entities known as Community Health Purchasing Alliances (CHPAs). It is intended the CHPAs will also be used to acquire insurance for state employees and Medicaid beneficiaries in the future. The legislation divides the state into 11 geographic areas and establishes a separate CHPA in each area. Humana intends to offer products in each of these geographic areas. In order to sell health care coverage to CHPA membership, an entity must register as an Accountable Health Partnership (AHP). An AHP may be either an insurer or an HMO and must specify in which geographic areas it wishes to offer its product. There are other requirements relating to organization, grievance procedures, terminations and product offerings for AHPs. Applicable Company HMOs and PPOs are in the process of registering as AHPs. Certain other states in which the Company operates are also actively pursuing health care reform; however, at this time it is not possible to predict the ultimate impact on the Company's operations. OTHER RELATED PRODUCTS The Company offers administrative services to employers who self-insure their employee health benefits. At December 31, 1993, the Company provided claims processing, utilization review and other administrative services to 40 self-insured employer groups, for approximately 63,700 employees and employee dependents. For the year ended December 31, 1993, revenues from these services totaled approximately $5 million. The Company operates a prescription drug management service which administers drug benefit programs for various HMOs and PPOs, including those of the Company. For the year ended December 31, 1993, prescription drug management service revenues from third-party customers totaled approximately $3 million. On June 30, 1993, the Company acquired the operations of a dental services company which provides dental products to employer groups, HMOs and PPOs, including those of the Company. Since the acquisition, dental service revenues from third-party customers totaled approximately $2 million. On March 3, 1994, the Company acquired a minority interest in a mental health HMO, which will provide services to the Company's members in certain markets as well as to third-party customers. OTHER BUSINESSES Hospital The Company operates a 170-bed hospital in Lexington, Kentucky, which was contributed to the Company by Galen in connection with the Spinoff. The hospital provides care primarily to members of the Company's managed care plans in Lexington. The Company is currently reviewing alternatives for the ultimate sale or third-party management of the hospital. Captive Insurance Company The Company insures substantially all professional liability risks through a wholly-owned subsidiary (the "Captive Subsidiary") which was incorporated in January 1993 in the State of Vermont. Previous to the Captive Subsidiary beginning operations in February 1993, professional liability risks were insured by a subsidiary of Galen. In connection with the Spinoff, the Captive Subsidiary and the Galen subsidiary entered into a loss portfolio reinsurance agreement whereby the Captive Subsidiary will indemnify the Galen subsidiary, subject to aggregate limits, against all liabilities incurred by the Galen subsidiary related to the professional liability risks of the Company prior to September 1, 1993. Centralized Management Services Centralized management services are provided to each health plan from the Company's headquarters. These services include management information systems, financing, personnel, development, accounting, legal advice, public relations, marketing, insurance, purchasing, risk management, actuarial, underwriting and claims processing. EMPLOYEES As of December 31, 1993, the Company and its subsidiaries had approximately 8,800 full-time employees. ITEM 2. ITEM 2. PROPERTIES The Company owns its principal executive office, which is located in the Humana Building, 500 West Main Street, Louisville, Kentucky 40202. The Company provides medical services in medical centers owned or leased ranging in size from approximately 1,200 to 80,000 square feet. The Company's administrative market offices are generally leased, with square footage ranging from 1,000 to 75,000. The following chart lists the location of properties used in the operation of the Company at December 31, 1993: In addition, the Company owns buildings in Louisville, Kentucky, and San Antonio, Texas, and leases a facility in Jacksonville, Florida, which are used for customer service and claims processing. The Louisville facility also performs enrollment processing and other corporate functions. The Company also owns a hospital and medical office building in Lexington, Kentucky. ITEM 3. ITEM 3. LEGAL PROCEEDINGS 1. A class action law suit styled Mary Forsyth, et al v. Humana Inc., et al, Case #CV-5-89-249-PMP(L.R.L.), was filed on March 29, 1989, in the United States District Court for the District of Nevada (the "Forsyth" case). The claims asserted by plaintiffs included an ERISA count seeking $49,440,000 of damages plus approximately $15,396,000 of interest, a RICO count seeking $103,562,165 of damages (before trebling) plus approximately $31,800,000 of interest, and an antitrust count for an unspecified amount of damages which appears to be similar to those sought in the RICO count. Despite allegations made by the plaintiffs, the Company considered the substance of these claims to be a dispute concerning the calculation of health insurance benefits and believed the claimed damages were greatly in excess of any possible recovery even if plaintiffs were successful on every claim asserted. On July 21, 1993, summary judgment was entered in favor of the Company on all counts, although the court granted the co-payer class until August 24, 1993, to file a third amended complaint in which its members could seek to recover the difference between their co-insurance payments and what those payments would have been if co-insurance obligations of the co-payer class had originally been based on the discounted payments made by Humana Health Insurance Company of Nevada to Sunrise Hospital and Medical Center, Las Vegas, Nevada, (now owned by Columbia). On August 24, 1993, a third amended complaint styled Marietta Cade, et al vs. Humana Health Insurance of Nevada, Inc., et al was filed seeking damages as described above. On January 28, 1994, summary judgment was entered in favor of plaintiffs on this third amended complaint. A subsequent hearing will ascertain the amount of damages suffered by the co-payer class. The Company believes the final resolution of this litigation will not have a material adverse effect on its operations or financial position. 2. On April 22, 1993, an alleged stockholder of the Company filed a purported shareholder derivative action in the Court of Chancery of the State of Delaware, County of New Castle, styled Lewis v. Austen, et al, Civil Action No. 12937. The action was purportedly brought on behalf of the Company and Galen against all of the directors of both companies at the time of the Spinoff alleging, among other things, that the defendants had improperly amended the Company's existing stock option plans in connection with the Spinoff. The plaintiff claims that the amendment to the stock option plans constituted a waste of corporate assets to the extent that employees of each company received options in the stock of the other company. (The challenged amendment to the plan was approved by the Company's stockholders at the 1993 Annual Meeting of Stockholders.) The plaintiff requests, among other things, an injunction prohibiting the exercise of Galen (now Columbia) stock options by the Company's personnel and the exercise of Company stock options by Galen (now Columbia) personnel and an award of damages. On June 14, 1993, the defendants filed a motion to dismiss the plaintiff's complaint. That motion is still pending. The Company believes that the complaint is without merit. Damages for claims for personal injuries and medical benefit denials are usual in the Company's business. Personal injury claims are covered by insurance from the Captive Subsidiary and excess carriers, except to the extent that claimants seek punitive damages, which may not be covered by insurance if awarded. Punitive damages generally are not paid where claims are settled and generally are awarded only where there has been a willful act or omission to act. The Company does not believe that any pending actions will have a material adverse effect on its consolidated financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE COMPANY Set forth below are names and ages of all of the current executive officers of the Company as of March 1, 1994, their positions, date of election to such position and the date first elected an officer of the Company: - --------------- (1) Elected an officer of a predecessor corporation in 1961. (2) Mr. Murray was appointed Controller of the Company at the time of the Spinoff, previous to which he served in the capacity of Vice President and Controller -- Health Plans since August 1990 and Controller -- Health Care Division since October 1989. From October 1985 to October 1989, he was a Certified Public Accountant with Coopers & Lybrand. Executive officers are elected annually by the Company's Board of Directors and serve until their successors are elected or until resignation or removal. There are no family relationships among any of the directors or executive officers of the Company, except that Mr. Jones is the father of David A. Jones, Jr., a director of the Company. Except for Mr. Murray, all of the above-named executive officers have been employees of the Company for more than five years. PART II Information for Items 5 through 8 of this Report which appears in the 1993 Annual Report to Stockholders as indicated on the following table is incorporated by reference 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 The information required by this Item other than the information set forth in Part I under the Section entitled "EXECUTIVE OFFICERS OF THE COMPANY", is herein incorporated by reference from the Registrant's Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 1994, appearing under the caption "ELECTION OF DIRECTORS OF THE COMPANY FOR 1994" on pages 3 through 6 of the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is herein incorporated by reference from the Registrant's Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 1994, appearing under the caption "EXECUTIVE COMPENSATION OF THE COMPANY" on pages 9 through 15 of the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is herein incorporated by reference from the Registrant's Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on May 26, 1994, appearing under the caption "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS OF COMPANY COMMON STOCK" on pages 6 through 8 of the Proxy Statement. 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 (3) Exhibits: - --------------- * Exhibits 10(a) through and including 10(u) are compensatory plans or management contracts. (b) Reports on Form 8-K: No reports on Form 8-K were filed by the Company during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. HUMANA INC. By: /s/ W. ROGER DRURY ------------------------------------ W. Roger Drury Chief Financial Officer 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 Company and in the capacities and on the dates indicated. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders Humana Inc. We have audited the consolidated financial statements and the financial statement schedules of Humana Inc. as listed in Item 14(a) 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 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 Humana Inc. as of December 31, 1993, and 1992, and the consolidated results of operations and cash flows for the years ended December 31, 1993, December 31, 1992, August 31, 1992, and August 31, 1991, and for the four-month period ended December 31, 1992, 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, Humana Inc. adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", effective September 1, 1991, and the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", effective December 31, 1993. COOPERS & LYBRAND Louisville, Kentucky January 31, 1994 HUMANA INC. SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AUGUST 31, 1992, AND AUGUST 31, 1991, AND THE FOUR MONTHS ENDED DECEMBER 31, 1992 (DOLLARS IN THOUSANDS) - --------------- (a) Noninterest bearing ; collateralized by deed of trust on personal residence; payable either in periodic installments or upon termination of employment, sale of residence or default on any collateral instrument having priority over Humana Inc.'s deed of trust. (b) Bears interest at the rate of three percent; collateralized by second mortgage on personal residence; payable upon sale of residence, termination of employment or default on any other financing arrangement which is secured by a mortgage on the residence. HUMANA INC. SCHEDULE III -- PARENT COMPANY FINANCIAL INFORMATION(A) CONDENSED BALANCE SHEET DECEMBER 31, 1993 AND 1992 (DOLLARS IN MILLIONS) - --------------- (a) Parent company financial information has been derived from the consolidated financial statements of the Company and excludes the accounts of all operating subsidiaries. This information should be read in conjunction with the consolidated financial statements of the Company. (b) In the normal course of business the parent company indemnifies certain of its subsidiaries for their health plan obligations. HUMANA INC. SCHEDULE III -- PARENT COMPANY FINANCIAL INFORMATION(A) CONDENSED STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AUGUST 31, 1992, AND AUGUST 31, 1991, AND THE FOUR MONTHS ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) - --------------- (a) Parent company financial information has been derived from the consolidated financial statements of the Company and excludes the accounts of all operating subsidiaries. This information should be read in conjunction with the consolidated financial statements of the Company. HUMANA INC. SCHEDULE III -- PARENT COMPANY FINANCIAL INFORMATION(A) CONDENSED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AUGUST 31, 1992, AND AUGUST 31, 1991, AND THE FOUR MONTHS ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) - --------------- (a) Parent company financial information has been derived from the consolidated financial statements of the Company and excludes the accounts of all operating subsidiaries. This information should be read in conjunction with the consolidated financial statements of the Company. HUMANA INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AUGUST 31, 1992, AND AUGUST 31, 1991, AND THE FOUR MONTHS ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) Exhibit Index - --------------- * Exhibits 10(a) through and including 10(u) are compensatory plans or management contracts.

351616_1993.txt

351616_1993

1993

351616

Item 1. Business ONE VALLEY BANCORP OF WEST VIRGINIA, INC. The Board of Directors of One Valley Bank, National Association, formerly Kanawha Valley Bank, National Association ("One Valley Bank"), caused One Valley Bancorp of West Virginia, Inc. ("One Valley"), a West Virginia corporation, to be formed, through a corporate reorganization, as a single bank holding company holding all of the common stock of One Valley Bank. On September 4, 1981, the effective date of the reorganization, the shareholders of One Valley Bank exchanged their shares of Kanawha Valley Bank common stock for shares of One Valley common stock, $10 par value ("One Valley Common Stock"), and became shareholders of One Valley, and One Valley Bank became a wholly-owned subsidiary of One Valley. As of December 31, 1993, One Valley owned eight operating banking subsidiaries (the "Existing Banking Subsidiaries") including: One Valley Bank, National Association; One Valley Bank of Huntington, Inc.; One Valley Bank of Mercer County, Inc.; One Valley Bank of Martinsburg, National Association; One Valley Bank of Oak Hill, Inc.; One Valley Bank of Ronceverte, National Association; One Valley Bank of Morgantown, Inc.; and One Valley Bank of Summersville, Inc. In addition, One Valley owns 100% of the outstanding stock of One Valley Services, Inc., which, until December, 1993, provided data processing services to the Banking Subsidiaries and other non affiliated banks, and 100% of the outstanding stock of One Valley Square, Inc., a Texas corporation, which owns the office building in which One Valley Bank and One Valley are located. (All of these subsidiaries, including the Existing Banking Subsidiaries, are collectively referred to as the "Subsidiaries".) One Valley's principal activities consist of owning and supervising its Subsidiaries. At December 31, 1993, One Valley had consolidated assets of $2,774,359,000, deposits of $2,328,644,000, and shareholders' equity of $242,590,000. One Valley has, from time to time, engaged in merger or acquisition discussions with other banks and financial institutions both within and outside of West Virginia, and it is anticipated that such discussions will continue in the future. RECENT DEVELOPMENTS On January 28, 1994, One Valley consummated its merger with Mountaineer Bankshares of W.Va., Inc., and as a result acquired ownership of 100% of the outstanding stock of the following seven banking subsidiaries: Old National Bank, Martinsburg; The Empire National Bank of Clarksburg; City National Bank of Fairmont; The Bank of Wadestown, Fairview; Mercantile Banking & Trust Company, Moundsville; The Bank of Cameron, Inc.; and The Sunshine Bank of Wheeling (the "New Banking Subsidiaries") (the Existing Banking Subsidiaries and the New Banking Subsidiaries are collectively referred to as the "Banking Subsidiaries"). The resulting company has total assets of more than $3,500,000,000 and total deposits of $2,900,000,000 making it the largest bank holding company in the State of West Virginia. Except as specifically noted, the information set forth in this Annual Report on Form 10-K includes all of the Banking Subsidiaries. In September 1993, M & I Data Services, Inc., of Milwaukee, Wisconsin, began providing data processing services for the Existing Banking Subsidiaries. It is anticipated that the New Banking Subsidiaries will use data processing services from M & I Data Services, Inc., beginning in 1995. The information set forth in the section captioned "Acquisition Activity" on page 7 of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. HISTORY OF THE BANKING SUBSIDIARIES One Valley Bank, the principal Banking Subsidiary of One Valley, was incorporated in 1867 as a state bank under the laws of West Virginia, with the name "The Kanawha Valley Bank". On February 10, 1975, Kanawha Valley Bank converted from a state bank to a national banking association, and on September 1, 1987, adopted its present corporate name. The other Banking Subsidiaries were incorporated or chartered as state or national banks in the years indicated in the chart below. In September 1987, all Existing Banking Subsidiaries adopted a common corporate identity utilizing "One Valley Bank." Those name changes were undertaken primarily to promote a single corporate image for One Valley's diverse banking operations. Year in Currently Name Which Organized Chartered As One Valley Bank of 1892 National Martinsburg One Valley Bank of 1911 State Morgantown Year in Currently Name Which Organized Chartered As One Valley Bank of 1906 State Mercer County One Valley Bank of 1904 State Oak Hill One Valley Bank of 1956 State Huntington One Valley Bank of 1900 National Ronceverte One Valley Bank of 1910 State Summersville One Valley Bank-East, 1865 National (formerly Old National Bank) The Empire National Bank of 1903 National Clarksburg One Valley Bank of Marion 1939 National County, National Association (formerly City National Bank of Fairmont) The Bank of Wadestown 1905 State Mercantile Banking & Trust 1903 State Company The Bank of Cameron, Inc. 1903 State The Sunshine Bank of Wheeling 1965 State OPERATIONS OF THE BANKING SUBSIDIARIES Following consummation of the Mountaineer merger, and in conjunction with an orderly transition in each market, One Valley will undertake certain inter- company transactions among the Banking Subsidiaries to simplify its organizational structure. During the first half of 1994, the two banks in Martinsburg will be merged, and One Valley will operate one subsidiary bank (with branch offices) in each of the Fairmont, Martinsburg, Clarksburg and Moundsville areas. Applications seeking approval of these transactions have been filed with the appropriate regulatory agencies. All offices formerly operated by Mountaineer will be operated under the title "One Valley Bank." The Banking Subsidiaries offer all services traditionally offered by full-service commercial banks, including commercial and individual demand and time deposit accounts, commercial and individual loans, credit card (MasterCard and Visa) and drive-in banking services. In addition, One Valley Bank is active in correspondent banking services. Trust services are offered on a statewide basis. No material portion of any of the Banking Subsidiaries' deposits has been obtained from a single or small group of customers, and the loss of any one customer's deposits or a small group of customers' deposits would not have a material adverse effect on the business of any of the Banking Subsidiaries. Although the market areas of several of the Banking Subsidiaries encompass a portion of the coal fields located in southern West Virginia, an area of the State which has been economically depressed, the coal-related loans in the loan portfolios of the Existing Banking Subsidiaries constitute less than 5% of One Valley's total loans outstanding. Ten of the 22 counties within One Valley's market areas rank among the State's top ten counties in household income, and the Banking Subsidiaries generally serve the stronger economic areas of the State. The Banking Subsidiaries also offer services to customers at various locations within their service areas by use of automated teller machines ("ATMs"). The ATMs allow customers to make deposits and withdrawals at convenient locations. Customers may also borrow against their revolving lines of credit at those locations. Customers of any Banking Subsidiary may conduct transactions at any One Valley ATM and, by means of the OWL/MAC system, a regional ATM system, through the CIRRUS ATM network, can conduct ATM transactions nationwide. Customers of any of the Banking Subsidiaries may also make deposits or withdrawals at any of One Valley's 80 statewide main office and branch locations. As of March 1, 1994, One Valley and its Subsidiaries had approximately 2013 full time equivalent employees. LEGISLATION The 1980s was a period of significant legislative change in West Virginia for banks and bank holding companies. During the 1980s, West Virginia converted from a unit banking state to permit unlimited branch banking and the interstate acquisition of banks and bank holding companies on a reciprocal basis. State-wide unlimited branch banking commenced on and after January 1, 1987. Interstate banking activities became permissible on January 1, 1988. The entry by out-of-state bank holding companies is permitted only by the acquisition of an existing institution which has operated for two years prior to acquisition, but not by the chartering and acquisition of de novo banks in West Virginia by out- of-state bank holding companies or the establishment of branch banks across state lines (either de novo or by acquisition or merger). West Virginia also allows reciprocal interstate acquisitions by thrift institutions such as savings and loan holding companies, savings and loan associations, savings banks, and building and loan associations. Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), enacted in 1989, One Valley is subject to provisions which among other things create a so-called "cross guarantee" liability on the part of insured depository institutions which are "commonly controlled." This liability permits the Federal Deposit Insurance Corporation ("FDIC"), as receiver of a failed insured depository institution, to assert claims against other commonly controlled insured depository institutions for losses suffered or reasonably anticipated to be suffered by the FDIC with respect to such failed depository institution. FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991 In December 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which substantially revises the bank regulatory and funding provisions of the Federal Deposit Insurance Act and makes revisions to several other federal banking statutes. Among other things, FDICIA requires federal bank regulatory authorities to take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. For these purposes, FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The Office of the Comptroller of the Currency ("OCC") and the Office of Thrift Supervision ("OTS") have adopted regulations to implement the prompt corrective action provisions of FDICIA. Among other things, the regulations define the relevant capital measures for the five capital categories. An institution is deemed to be "well capitalized" if it has a total risk-based capital ratio of 10% or greater, Tier 1 risk-based capital ratio of 6% or greater and a Tier 1 leverage ratio of 5% or greater and is not subject to a regulatory order, agreement or directive to meet and maintain a specific capital level for any capital measure. An institution is deemed to be "adequately capitalized" if it has a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and, generally, a Tier 1 leverage ratio of 4% or greater and the institution does not meet the definition of a "well capitalized" institution. An institution that does not meet one or more of the "adequately capitalized" tests is deemed to be "undercapitalized". If the institution has a total risk-based capital ratio that is less than 6%, a Tier 1 risk-based capital ratio that is less than 3%, or a leverage ratio that is less than 3%, it is deemed to be "significantly undercapitalized". Finally, an institution is deemed to be "critically undercapitalized" if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2%. "Undercapitalized" institutions are subject to growth limitations and are required to submit a capital restoration plan. If an "undercapitalized" institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. "Significantly undercapitalized" institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. "Critically undercapitalized" institutions may not, beginning 60 days after becoming "critically undercapitalized" make any payment of principal or interest on their subordinated debt. In addition, "critically undercapitalized" institutions are subject to appointment of a receiver or conservator. Under FDICIA, a depository institution that is not "well capitalized" is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market. Each of One Valley's Banking Subsidiaries currently meet the FDIC's definition of a "well capitalized" institution for purposes of accepting brokered deposits. For the purposes of the brokered deposit rules, a bank is defined to be "well capitalized" if it maintains a ratio of Tier 1 capital to risk-adjusted assets of at least 6%, a ratio of total capital to risk-adjusted assets of at least 10% and a Tier 1 leverage ratio of at least 5% and is not otherwise in a "troubled condition" as specified by its appropriate federal regulatory agency. FDICIA directs that each federal banking agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly- traded shares and such other standards as the agency deems appropriate. In December, 1993, the FDIC adopted final rules to implement these provisions of FDICIA. The rules set forth general standards to be observed, but in most instances do not specify operating or managerial procedures to be followed. The Board of Governors of the Federal Reserve System ("Board of Govenors") and the OCC are in the process of issuing rules implementing various aspects of FDICIA. At this time, One Valley believes that the rules will not have a material adverse effect on its operations. FDICIA also contains a variety of other provisions that may affect the operations of One Valley's Banking Subsidiaries, including new reporting requirements, revised regulatory standards for real estate lending, "truth in savings" provisions and the requirement that a depository institution give 90 days' prior notice to customers and regulatory authorities before closing any branch. In addition to FDICIA, there have been a number of legislative and regulatory proposals designed to strengthen the federal deposit insurance system and to improve the overall financial stability of the United States banking system. These include proposals to increase capital requirements above presently published guidelines, to place assessments on depository institutions to increase funds available to the FDIC and to allow national banks to branch on an interstate basis. It is impossible to predict whether or in what form these proposals may be adopted in the future and, if adopted, what their effect would be on One Valley. It is likewise impossible to predict what the competitive effect will be as a result of action by the OTS allowing certain thrift institutions to engage in interstate branching on a nationwide basis. COMPETITION Vigorous competition exists in all areas where One Valley and the Banking Subsidiaries are engaged in business. The primary market areas served by the Banking Subsidiaries are generally defined as West Virginia and certain adjoining areas in Kentucky, Maryland, Ohio, Pennsylvania and Virginia. For most of the services which the Banking Subsidiaries perform, they compete with commercial banks as well as other financial institutions. For instance, savings banks, savings and loan associations, credit unions, stock brokers, and issuers of commercial paper and money market funds actively compete for funds and for various types of loans. In addition, insurance companies, investment counseling firms and other business firms and individuals offer personal and corporate trust and investment counseling services. The opening of branch banks within One Valley's market areas has increased competition for the Banking Subsidiaries. Although the bank legislation has provided an opportunity for One Valley to acquire banking subsidiaries in other attractive banking areas of the State, it will likely result in increased competition for One Valley in its market areas, and, with reciprocal interstate banking, One Valley faces additional competition in efforts to acquire other subsidiaries throughout West Virginia and in neighboring states. Until 1993, the various banks and bank-holding companies operating in West Virginia were predominantly owned by shareholders in West Virginia and were financed by operations arising principally in West Virginia. During 1993, Banc One Corp., the seventh largest bank holding company in the United States, consummated its acquisition of Key Centurion Bancshares Inc., and Huntington Bankshares Incorporated consummated its acquisitions of Commerce Banc Corporation and CB&T Financial Corp. It is anticipated that other large out-of-state banks will, over time, expand their operations into West Virginia. While One Valley believes that it can compete effectively with out-of-state banks, One Valley will face larger competitors which have access to increased capital resources and which have relatively sophisticated bank holding companies and marketing structures in place. As of December 31, 1993, there were 18 multi-bank holding companies and 32 one-bank holding companies in the State of West Virginia registered with the Federal Reserve System and the West Virginia Board of Banking and Financial Institutions ("Board of Banking"). These holding companies are headquartered in various West Virginia cities and control banks throughout the State of West Virginia, including banks which compete with the Banking Subsidiaries in their market areas. One Valley has actively competed with some of these bank holding companies to acquire its Banking Subsidiaries. SUPERVISION AND REGULATION One Valley is a bank holding company within the provisions of the Bank Holding Company Act of 1956, is registered as such, and is subject to supervision by the Board of Governors. The Bank Holding Company Act requires One Valley to secure the prior approval of the Board of Governors before One Valley acquires ownership or control of more than five percent (5%) of the voting shares or substantially all of the assets of any institution, including another bank. As a bank holding company, One Valley is required to file with the Board of Governors an annual report and such additional information as the Board of Governors may require pursuant to the Bank Holding Company Act. The Board of Governors may also make examinations of One Valley and of the Banking Subsidiaries. Furthermore, under Section 106 of the 1970 Amendments to the Bank Holding Company Act and the regulations of the Board of Governors, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or any provision of credit, sale or lease of property or furnishing of services. In addition, the Banking Subsidiaries are subject to certain restrictions under federal law that limit the transfer of funds by the Banking Subsidiaries to One Valley and its nonbanking subsidiaries, whether in the form of loans, other extensions of credit, investments or asset purchases. Such transfers by any Banking Subsidiaries to One Valley or any nonbanking subsidiary are limited in amount to 10% of such Banking Subsidiary's capital and surplus and, with respect to One Valley and all nonbanking subsidiaries, to an aggregate of 20% of such Banking Subsidiary's capital and surplus. Furthermore, such loans and extensions of credit are required to be secured in specified amounts and must be fully collateralized. One Valley is required to register annually with the Commissioner of Banking of West Virginia ("Commissioner") and to pay a registration fee to the Commissioner based on the total amount of bank deposits in banks with respect to which One Valley is a bank holding company. Although legislation allows the Commissioner to prescribe the registration fee, it limits the fee to ten dollars per million dollars of deposits rounded off to the nearest million dollars. One Valley is also subject to regulation and supervision by the Commissioner. One Valley is required to secure the approval of the West Virginia Board of Banking before acquiring ownership or control of more than five percent of the voting shares or substantially all of the assets of any institution, including another bank. West Virginia banking law prohibits any West Virginia or non- West Virginia bank or bank holding company from acquiring shares of a bank if the acquisition would cause the combined deposits of all banks in the State of West Virginia, with respect to which it is a bank holding company, to exceed 20% of the total deposits of all depository institutions in the State of West Virginia. The total deposits of the Banking Subsidiaries upon consummation of the Mountaineer merger, were approximately 15.5% of the total deposits in the State of West Virginia. BANKING SUBSIDIARIES The Banking Subsidiaries are subject to FDIC deposit insurance assessments. The FDIC set an assessment rate for the Bank Insurance Fund ("BIF") of 0.23% which became effective on July 1, 1991. Because of decreases in the reserves of the BIF due to the increased number of bank failures in recent years, it is possible that BIF insurance assessments will be increased, and it is also possible that there may be a special additional assessment. A large special assessment could have an adverse impact on One Valley's results of operations. The information set forth in paragraph number seven in the subsection captioned "Income Statement Analysis - Non-Interest Income and Expense" on page 21 of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. The operations of the Banking Subsidiaries are subject to federal and state statutes, which apply to national and state banks. The operations of the Banking Subsidiaries may also be subject to regulations of the OCC, the Board of Governors, the Board of Banking and the FDIC. The primary supervisory authority of One Valley's national Banking Subsidiaries is the OCC while the primary supervisory authority of its state chartered Banking Subsidiaries is the Commissioner. These two authorities regularly examine such areas as reserves, loans, investments, management practices and other aspects of the operations of the Banking Subsidiaries. One Valley's nationally chartered Banking Subsidiaries are chartered under the laws of the United States and, as such, are member banks of the Federal Reserve System. Its state chartered Banking Subsidiaries are non-member banks of the Federal Reserve except for One Valley Bank of Summersville, which is a member bank. The regulation and examination of One Valley and its Banking Subsidiaries are designed primarily for the protection of depositors and not One Valley or its shareholders. CAPITAL REQUIREMENTS The Board of Governors has issued risk-based capital guidelines for bank holding companies, including One Valley. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures into explicit account in assessing capital adequacy, and minimizes disincentives to holding liquid, low-risk assets. Under the guidelines and related policies, bank holding companies must maintain capital sufficient to meet both a risk-based asset ratio test and leverage ratio test on a consolidated basis. The risk- based ratio is determined by allocating assets and specified off- balance sheet commitments into four weighted categories, with higher levels of capital being required for categories perceived as representing greater risk. The leverage ratio is determined by relating core capital (as described below) to total assets adjusted as specified in the guidelines. All of One Valley's Banking Subsidiaries are subject to substantially similar capital requirements adopted by applicable regulatory agencies. Generally, under the applicable guidelines, the financial institution's capital is divided into two tiers. "Tier 1", or core capital, includes common equity, noncumulative perpetual preferred stock (excluding auction rate issues) and minority interests in equity accounts or consolidated subsidiaries, less goodwill. Bank holding companies, however, may include cumulative perpetual preferred stock in their Tier 1 capital, up to a limit of 25% of such Tier 1 capital. "Tier 2", or supplementary capital, includes, among other things, cumulative and limited-life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan losses, subject to certain limitations, less required deductions. "Total capital" is the sum of Tier 1 and Tier 2 capital. Financial institutions are required to maintain a risk-based ratio of 8%, of which 4% must be Tier 1 capital. The appropriate regulatory authority may set higher capital requirements when an institution's particular circumstances warrant. Financial institutions that meet certain specified criteria, including excellent asset quality, high liquidity, low interest rate exposure and the highest regulatory rating, are required to maintain a minimum leverage ratio of 3%. Financial institutions not meeting these criteria are required to maintain a leverage ratio which exceeds 3% by a cushion of at least to 200 basis points. The guidelines also provide that financial institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the Board of Governors' guidelines indicate that the Board of Governors will continue to consider a "tangible Tier 1 leverage ratio" in evaluating proposals for expansion or new activities. The tangible Tier 1 leverage ratio is the ratio of an institution's Tier 1 capital, less all intangibles, to total assets, less all intangibles. Failure to meet applicable capital guidelines could subject the financial institution to a variety of enforcement remedies available to the federal regulatory authorities, including limitations on the ability to pay dividends, the issuance by the regulatory authority of a capital directive to increase capital and the termination of deposit insurance by the FDIC, as well as to the measures described under FDICIA as applicable to undercapitalized institutions. As of December 31, 1993, the Tier 1 risk-based ratio, total risk-based ratio and total assets leverage ratio for One Valley were as follows: Regulatory Requirement One Valley Tier 1 Risk-Based Ratio 4.00% 12.69% Total Risk-Based Ratio 8.00% 13.94% Total Assets Leverage Ratio 3.00% 8.57% As of December 31, 1993 all of One Valley's Banking Subsidiaries had capital in excess of all applicable requirements. The Board of Governors, as well as the FDIC, the OCC and the OTS, have adopted changes to their risk-based and leverage ratio requirements that require that all intangible assets, with certain exceptions, be deducted from Tier 1 capital. Under the Board of Governors' rules, the only types of intangible assets that may be included in (i.e., not deducted from) a bank holding company's capital are readily marketable purchased mortgage servicing rights ("PMSRs") and purchased credit card relationships ("PCCRs"), provided that, in the aggregate, that total amount of PMSRs and PCCRs included in capital does not exceed 50% of Tier 1 capital. PCCRs are subject to a separate sublimate of 25% of Tier 1 capital. The amount of PMSRs and PCCRs that a bank holding company may include in its capital is limited to the lesser of (i) 90% of such assets' fair market value (as determined under the guidelines), or (ii) 100% of such assets' book value, each determined quarterly. Identifiable intangible assets (i.e., intangible assets other than goodwill) other than PMSRs and PCCRs, including core deposit intangibles, acquired on or before February 19, 1992 (the date the Board of Governors issued its original proposal for public comment), generally will not be deducted from capital for supervisory purposes, although they will continue to be deducted for purposes of evaluating applications filed by bank holding companies. GOVERNMENTAL POLICIES In addition to the effect of general economic conditions, the earnings and future business activities of the Banking Subsidiaries, both members and non- members of the Federal Reserve, are affected by the fiscal and monetary policies of the federal government and its agencies, particularly the Board of Governors. The Board of Governors regulates the national money supply in order to mitigate recessionary and inflationary pressures. The techniques used by the Board of Governors include setting the reserve requirements of member banks, establishing the discount rate on member bank borrowings and conducting open market operations in United States government securities to exercise control over the supply of money and credit. Although it is difficult to assess the impact on One Valley of the change from the Bush administration to the Clinton administration, during 1993 there was an increase in corporate taxes, and in the future there may be increased costs for medical and other employee benefits, and a possible change in the regulatory climate for financial institutions. The policies of the Board of Governors have a direct and indirect effect on the amount of bank loans and deposits, and the interest rates charged and paid thereon. While the impact of current economic problems and the policies of the Board of Governors and other regulatory authorities designed to deal with these economic problems upon the future business and earnings of the Banking Subsidiaries cannot be accurately predicted, those policies can materially affect the revenues and income of the Banking Subsidiaries. The information set forth in paragraph number seven in the subsection captioned "Income Statement Analysis - Non-Interest Income and Expense" on page 21 of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. STATISTICAL DISCLOSURE BY BANK HOLDING COMPANIES Statistical disclosures required by bank holding companies are included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" set forth on pages 5 through 22 of One Valley's 1993 Annual Report to Shareholders for the fiscal year ended December 31, 1993. That information is incorporated herein by reference. Item 2. Item 2. Properties ONE VALLEY AND ONE VALLEY BANK One Valley Bank owns the site of One Valley Bank's current banking quarters, One Valley Square in the City of Charleston, West Virginia. This property is leased by One Valley Bank to One Valley Square, Inc. One Valley Square, Inc., constructed a fifteen story (plus basement) office building on the site, and One Valley Bank leases a portion of the basement and seven floors of One Valley Square for its operations, consisting of approximately 130,000 square feet. In addition, One Valley Bank subleases a portion of the seventh floor to others. One Valley also conducts its operations from the space leased by One Valley Bank in One Valley Square. The remaining space is leased to various other tenants. Upon expiration of the land lease, all improvements will revert to the owner of the land. One Valley Bank also conducts operations at its operations center, also located in Charleston, and at 23 branch locations throughout Kanawha, Putnam, Jackson, and Wood Counties. OTHER AFFILIATE BANKS The properties owned or leased by the other Banking Subsidiaries consist generally of fourteen main bank offices, related drive-in facilities, 42 branch offices and such other properties as are necessary to house related support activities of those banks. All of the properties of the Banking Subsidiaries are suitable and adequate for their current operations and are generally being fully utilized. Item 3. Item 3. Legal Proceedings Various legal proceedings are presently pending to which the Banking Subsidiaries are parties; however, these proceedings are ordinary routine litigation incidental to the business of the Banking Subsidiaries. There are no material legal proceedings pending or threatened against One Valley or its Subsidiaries. Item 4. Item 4. Submission of Matters to a Vote of Security Holders At a Special Meeting held on December 8, 1993, the shareholders of One Valley approved an Agreement and Plan of Merger whereby Mountaineer Bankshares of W.Va., Inc., was merged with and into One Valley. The terms and conditions of that Agreement and merger were fully described in One Valley's Registration Statement on Form S-4, Registration No. 33-50729, Filed October 22, 1993. At the Special Meeting that Agreement was approved as follows: FOR AGAINST ABSTAIN 10,332,995 (80.1%) 48,732 (.33%) 133,418 (1.03%) Item 4A. Executive Officers of the Registrant The executive officers of One Valley are: Name Age Banking Experience and Qualifications Robert F. Baronner 67 1991 to Present, Chairman of the Board, One Valley. 1971 to 1991, One Valley Bank. Previously, President and Chief Executive Officer, One Valley. J. Holmes Morrison 53 1967 to present, One Valley Bank. Vice President and Trust Officer, 1970; Senior Vice President and Senior Trust Officer, 1978; Executive Vice President, 1982; President and Chief Operating Officer, 1985; President and Chief Executive Officer, 1988; Chairman of the Board, 1991. Vice President, One Valley, 1982; Senior Vice President, One Valley, 1984; Executive Vice President, One Valley, 1990; President and Chief Executive Officer, One Valley, 1991. Phyllis H. Arnold 45 1973-1979, One Valley Bank. Credit Officer, 1974-1977; Vice President, 1977- 1979. West Virginia State Banking Commissioner, 1979-1983. Executive Vice President, One Valley Bank, 1988; President and Chief Executive Officer, One Valley Bank, 1991; Executive Vice President, One Valley, 1994. Frederick H. Belden, Jr. 55 1968 to present, One Valley Bank. Senior Vice President and Senior Trust Officer, 1982; Executive Vice President, 1986. Executive Vice President, One Valley, 1994. James L. Whytsell 54 1959 to present, One Valley Bank. Senior Vice President, 1977; Executive Vice President, 1986. Senior Vice President, One Valley, 1986. Data Processing. Laurance G. Jones 47 1969 to present, One Valley Bank. Controller, 1971; Vice President, Controller and Treasurer, 1979; Senior Vice President, 1980; Executive Vice President, 1992. Treasurer, One Valley, 1981; Treasurer and Chief Financial Officer, One Valley, 1984; Executive Vice President, One Valley, 1994. Finance and Accounting. Brent D. Robinson 46 1978 to 1994, Mountaineer Bankshares, Inc. and its predecessors. Executive Vice President, One Valley, 1994. James A. Winter 41 1975 to present, One Valley Bank. Vice President, Controller and Assistant Treasurer, 1982. Senior Vice President, 1991; Vice President and Chief Accounting Officer, One Valley, 1989. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters During 1993, One Valley Common Stock was traded over the counter by Merrill Lynch, Pierce, Fenner & Smith, Inc.; Keefe, Bruyette & Woods, Inc.; Robinson-Humphrey Co. Inc.; Legg, Mason, Wood, Walker, Inc.; Wheat First Securities, Inc.; Rothschild, Inc.; Herzog, Heine, Geduld, Inc.; Mayer & Schweitzer, Inc.; McDonald & Company Sec., Inc.; and Sandler O'Neill & Partners. At March 8, 1994, the total number of holders of One Valley Common Stock was approximately 8,700, including shareholders of record and shares held in nominee name. The information set forth in paragraphs number two and three in the subsection captioned "Balance Sheet Analysis-Capital Resources" on page 17 of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. Notes N and Q of Notes to the Consolidated Financial Statements appearing at pages 38 and 39 of One Valley's 1993 Annual Report to Shareholders are incorporated herein by reference. Table 1 "Six-Year Selected Financial Summary" on page five of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 6. Item 6. Selected Financial Data Table 1 "Six-Year Selected Financial Summary" on page five of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information contained on pages 5 through 22 of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data The information contained on pages 24 through 39 of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. See Item 14 for additional information regarding the financial statements. 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 set forth in the sections captioned "Election of Directors", "Management Nominees to the Board of One Valley", "Directors Continuing to Serve Unexpired Terms," and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" on pages 2 through 6 and page 19 of One Valley's definitive Proxy Statement dated March 23, 1994, is incorporated herein by reference. Reference is also made to the information concerning One Valley's executive officers provided in Part I, Item 4A, of this report. Item 11. Item 11. Executive Compensation The information set forth in the sections captioned "Executive Compensation", "Change of Control Agreements", and "Compensation of Directors" on pages 12 through 15 and page 19 of One Valley's definitive Proxy Statement dated March 23, 1994, is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information set forth in the sections captioned "Principal Holders of Voting Securities" and "Ownership of Securities by Directors, Nominees and Officers" on pages 8 through 11 of One Valley's definitive Proxy Statement dated March 23, 1994, is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions The information set forth in the sections captioned "Certain Transactions with Directors and Officers and Their Associates" and "Compensation Committee Interlocks and Insider Participation" on page 19 of One Valley's definitive Proxy Statement dated March 23, 1994, and Note E of the Notes to the Consolidated Financial Statements appearing at page 31 of One Valley's 1993 Annual Report to Shareholders is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 1993 Annual Report to Shareholders Index Page(s) (a) 1. Financial Statements Consolidated Financial Statements of One Valley Bancorp of West Virginia, Inc. incorporated by reference in Part II, Item 8 of this report. Consolidated Balance Sheets at 24 December 31, 1993 and 1992 Consolidated Statements of Income 25 for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Share- 26 holders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows 27 for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial 28-39 Statements Report of Independent Auditors 23 (a) 2. Financial Statement Schedules All schedules are omitted, as the required information is inapplicable or the information is presented in the Consolidated Financial Statements or related notes thereto. (a) 3. Exhibits required to be Filed by Item 601 of Page(s) Regulation S-K and Item 14(c) of Form 10-K Form 10-K See Index to Exhibits (b) Reports on Form 8-K: None. (c) Exhibits See Item 14(a)3 above. (d) Financial Statement Schedules See Item 14(a)2 above. 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. ONE VALLEY BANCORP OF WEST VIRGINIA, INC. By: /s/ J. Holmes Morrison J. Holmes Morrison, President and Chief Executive Officer March 16, 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 as of the date indicated. Signature Title Date /s/ Phyllis H. Arnold Director March 16, 1994 PHYLLIS H. ARNOLD /s/ Charles M. Avampato Director March 16, 1994 CHARLES M. AVAMPATO /s/ Robert F. Baronner Chairman of the Board March 15, 1994 ROBERT F. BARONNER /s/ James K. Brown Director March 16, 1994 JAMES K. BROWN /s/ John T. Chambers Director March 16, 1994 JOHN T. CHAMBERS /s/ Nelle Ratrie Chilton Director March 16, 1994 NELLE RATRIE CHILTON /s/ Ray M. Evans, Jr. Director March 16, 1994 RAY M. EVANS, JR. /s/ James Gabriel Director March 16, 1994 JAMES GABRIEL /s/ Phillip H. Goodwin Director March 16, 1994 PHILLIP H. GOODWIN /s/ Thomas E. Goodwin Director March 16, 1994 THOMAS E. GOODWIN /s/ Cecil B. Highland, Jr. Director March 16, 1994 CECIL B. HIGHLAND, JR. /s/ Laurance G. Jones Treasurer and Chief March 16, 1994 LAURANCE G. JONES Financial Officer (Principal Financial Officer) /s/ Robert E. Kamm, Jr. Director March 16, 1994 ROBERT E. KAMM, JR. /s/ David E. Lowe Director March 16, 1994 DAVID E. LOWE /s/ John D. Lynch Director March 16, 1994 JOHN D. LYNCH /s/ Edward H. Maier Director March 15, 1994 EDWARD H. MAIER /s/ J. Holmes Morrison Chief Executive Officer, March 16, 1994 J. HOLMES MORRISON Director and President /s/ Charles R. Neighborgall, III Director March 16, 1994 CHARLES R. NEIGHBORGALL, III /s/ Robert O. Orders, Sr. Director March 16, 1994 ROBERT O. ORDERS, SR. /s/ John L. D. Payne Director March 15, 1994 JOHN L. D. PAYNE /s/ Angus E. Peyton Director March 15, 1994 ANGUS E. PEYTON /s/ Lacy I. Rice, Jr. Director March 16, 1994 LACY I. RICE, JR. /s/ James W. Thompson Director March 16, 1994 JAMES W. THOMPSON /s/ J. Lee Van Metre, Jr. Director March 15, 1994 J. LEE VAN METRE, JR. /s/ Richard B. Walker Director March 16, 1994 RICHARD B. WALKER /s/ H. Bernard Wehrle, III Director March 15, 1994 H. BERNARD WEHRLE, III Director March , 1994 JOHN H. WICK, III /s/ Thomas D. Wilkerson Director March 16, 1994 THOMAS D. WILKERSON /s/ James A. Winter Vice President and Chief March 16, 1994 JAMES A. WINTER Accounting Officer (Principal Accounting Officer) INDEX TO EXHIBITS Exhibit No. Description: (3) Articles of Incorporation and Bylaws Exhibit 3.1 Articles of Incorporation of One Valley, filed as part of One Valley's 1981 Annual Report on Form 10-K and incorporated herein by reference. Exhibit 3.2 Articles of Amendment of One Valley dated July 17, 1981, filed as part of One Valley's 1981 Annual Report on Form 10- K and incorporated herein by reference. Exhibit 3.3 Articles of Amendment of One Valley dated December 3, 1982, filed as part of One Valley's 1982 Annual Report on Form 10-K and incorporated herein by reference. Exhibit 3.4 Articles of Amendment of One Valley dated May 6, 1986, filed as part of One Valley's Registration Statement on Form S-4, Registration No. 33-5737, May 15, 1986, and incorporated herein by reference. Exhibit 3.5 Articles of Amendment of One Valley dated May 19, 1988, filed as part of One Valley's 1992 Annual Report on Form 10- K and incorporated herein by reference. Exhibit 3.6 Articles of Amendment of One Valley dated May 26, 1993, filed as part of One Valley's Registration Statement on Form S-4, Registration No. 33-50729, October 22, 1993, and incorporated herein by reference. Exhibit 3.7 Amendments to the Bylaws of One Valley dated June 20, 1990, and a complete copy of One Valley's Bylaws as amended, filed as part of One Valley's 1990 Annual Report on Form 10-K and incorporated herein by reference. (10) Material Contracts. Exhibit 10.1 Indemnity Agreement between Resolution Trust Corporation and One Valley, filed as part of One Valley's Registration Statement on Form S-2, Registration No. 33- 43384, October 22, 1991, and incorporated herein by reference. Executive Compensation Plans and Arrangements. Exhibit 10.2 Agreement dated as of May 7, 1985, between One Valley and Thomas E. Goodwin, filed as part of One Valley's Registration Statement on Form S-4, Registration No. 2- 99417, August 5, 1985, and incorporated herein by reference. Exhibit 10.3 Form of Change of Control Agreement between One Valley and 7 of its Executive Officers, dated as of January 1, 1987, filed as part of One Valley's 1986 Annual Report on Form 10-K and incorporated herein by reference. Exhibit 10.4 One Valley Bancorp of West Virginia, Inc., 1983 Incentive Stock Option Plan, as amended, filed as Exhibit No. 4 to One Valley's Registration Statement on Form S-8, Registration No. 33-3570, July 2, 1990, and incorporated herein by reference. Exhibit 10.5 One Valley Bancorp of West Virginia, Inc., 1993 Incentive Stock Option Plan, filed as part of One Valley's Definitive Proxy Statement, Registration No. 0-10042, and incorporated herein by reference. Exhibit 10.6 One Valley Bancorp of West Virginia, Inc., Management Incentive Compensation Plan, as amended February, 1990, filed as part of One Valley's 1992 Annual Report on Form 10- K and incorporated herein by reference. Exhibit 10.7 One Valley Bancorp of West Virginia, Inc., Supplemental Benefit Plan, as amended April, 1990, filed as part of One Valley's 1992 Annual Report on Form 10-K and incorporated herein by reference. (11) Computation of Earnings Per Share -- found at page 31 herein. (12) Statement Re Computation of Ratios -- found at page 32 herein. (13) 1993 Annual Report to Security Holders -- found at page 33 herein. (21) Consent of Ernst & Young -- found at page 82 herein. (23) Subsidiaries of Registrant -- found at page 81 herein. (99) Proxy Statement for the 1993 Annual Meeting of One Valley -- found at page 83 herein. **************************************************************************** APPENDIX On Page 2 of Exhibit 13 a photo of J. Holmes Morrison appears in the upper right corner where indicated. On Page 3 of Exhibit 13 a bar graph appears where indicated. The plot points are listed as follows: Net Income and Dividends Per Share 1988 1989 1990 1991 1992 1993 Net Income $1.33 $1.48 $1.75 $1.93 $2.29 $2.52 Dividends $0.50 $0.56 $0.59 $0.62 $0.70 $0.84 On Page 4 of Exhibit 13 two bar graphs appear where indicated. The plot points for both are listed as follows: Return on Average Assets 1988 1989 1990 1991 1992 1993 0.91% 0.90% 1.00% 0.99% 1.10% 1.19% Return on Average Equity 1988 1989 1990 1991 1992 1993 11.54% 12.02% 13.15% 13.14% 13.92% 13.98 On page 9 of Exhibit 13 the Average Earning Assets bar chart appears where indicated. It will be sent under cover of Form SE. On Page 11 of Exhibit 13 the Total Loans bar chart appears where indicated. It will be sent under cover of Form SE. On Page 12 of Exhibit 13 the Non-performing Assets and Loans 90 Days Past Due bar chart and the Provision for Loan Losses and Net Charge-Offs bar chart appears where indicated. It will be sent under cover of Form SE. On Page 16 of Exhibit 13 the Average Deposits bar chart appears where indicated. It will be sent under cover of Form SE. On Page 18 of Exhibit 13 the Net Interest Margin line graph appears where indicated. It will be sent under cover of Form SE. On Page 19 of Exhibit 13 the Net Interest Income line graph appears where indicated. It will be sent under cover of Form SE. On Page 21 of Exhibit 13 the Net Overhead Ratio line graph appears where indicated.It will be sent under cover of Form SE. On Page 18 of Exhibit 99 the Performance Graph appears where noted. The plot points are listed in the table below that point. On Page 43 of Exhibit 13 a photo appears on the left hand side of the page. The people pictured in the photo are listed in the text on that page. On Page 44 of Exhibit 13 a photo appears in the center of the page. The people pictured in the photo are listed in the text on that page. On the Back Cover of Exhibit 13 the One Valley Bancorp logo appears where indicated.

789575_1993.txt

789575_1993

1993

789575

Item 1. Business - ----------------- Grenada Sunburst System Corporation (the "Registrant") is a multi-bank holding company headquartered in Grenada, Mississippi. The Registrant was organized under the laws of the state of Delaware on May 20, 1986. The Registrant has two major subsidiaries: Sunburst Bank, Mississippi, and Sunburst Bank, Louisiana. Sunburst Bank, Mississippi, organized in 1890, and Sunburst Bank, Louisiana, acquired in May 1988 (collectively the "Banks"), had approximately $1,952 million and $509 million, respectively, in total assets as of December 31, 1993. The Registrant is engaged in a general commercial banking business, conducting operations in 124 locations in 59 communities in Mississippi and Louisiana. The Banks accept demand deposits and various types of interest bearing transaction and time deposit accounts and utilize funds from such activities to make loans and other investments. In addition, through the Registrant's subsidiary, Sunburst Financial Group, Inc., the Registrant offers full-service brokerage to its customers. The Banks offer a wide range of fiduciary services through their trust divisions, and mortgage services through Sunburst Mortgage Corporation as well as other financial services to their customers. The Registrant has expanded its operations through de novo branch banking and acquisition of banks in Mississippi and Louisiana. Each branch office of the Banks does business under the name "Sunburst Bank". At December 31, 1993 the Registrant had 1,657 full-time equivalent employees. Sunburst Bank, Mississippi is incorporated under the laws of the State of Mississippi, and as such, is subject to regulation by the Department of Banking and Consumer Finance for the State of Mississippi. Sunburst Bank, Louisiana is incorporated under the laws of the State of Louisiana and is subject to regulation by the Office of Financial Institutions for the State of Louisiana. The Registrant is registered as a bank holding company with the Board of Governors of the Federal Reserve System and is governed by its applicable laws and regulations as a bank holding company. The Banks' deposits are insured by the FDIC, and, therefore, both banks are subject to the regulations of the Federal Deposit Insurance Act and to examination by that corporation. XXX BEGIN PAGE 3 HERE XXX EXECUTIVE OFFICERS OF THE REGISTRANT When Name Position Held with the Registrant Age Elected - --------------------------------------------------------------------------- R.E. Kennington, II Chairman of the Board 61 1986 J. T. Boone President & Chief Executive 43 1988 Officer D. L. Holland Chief Financial Officer & 50 1986 Treasurer A. J. Huff President & Chief Operating 51 1990 Officer, Sunburst Bank, LA Don W. Ayres Senior Executive Vice President, 48 1991 Sunburst Bank, MS J. Daniel Garrick, III Senior Executive Vice President, 44 1990 Sunburst Bank, MS Frank W. Smith, Jr. Senior Executive Vice President, 40 1990 Sunburst Bank, MS James L. Brown Regional Executive, Northeast 46 1987 Region, Sunburst Bank, MS Thomas H. Carroll, Jr. Regional Executive, Northwest 54 1987 Region, Sunburst Bank, MS E. Jackson Garner Regional Executive, Central 48 1989 Region, Sunburst Bank, MS Todd Mixon Regional Executive, Southern 44 1990 Region, Sunburst Bank, MS James A. Baker Executive Vice President, 49 1991 Asset Quality Group Jerry A. Pegg Executive Vice President, 50 1990 Corporate Administration There are no family relationships between any of the executive officers of the Registrant. XXX BEGIN PAGE 4 HERE XXX R. E. Kennington, II, served as Chief Executive Officer of the Registrant from 1986 to 1992, as Chairman of the Board and Chief Executive Officer of Sunburst Bank, Mississippi, for the period from 1981 to 1989, and as Chairman of Sunburst Bank, Louisiana for 1988 and 1989. Mr. Boone served as Chief Operating Officer of the Registrant from 1990 to 1992, Chief Executive Officer for Sunburst Bank, Louisiana for the years 1988 and 1989 and as Executive Vice President of Sunburst Bank, Mississippi for the six years prior to that. Mr. Huff served as President of the Laurel, MS branch of Sunburst Bank, MS prior to 1990. Mr. Ayres was hired October 9, 1991. Mr. Garrick served as Executive Vice President of Personnel for Sunburst Bank, MS prior to 1990. Mr. Smith served as Executive Vice President of Investments for Sunburst Bank, MS prior to 1990. Mr. Garner served as Executive Vice President for Grenada Sunburst System Corporation prior to 1989. Mr. Mixon served as Senior Vice President of the Commercial Lending Group for Sunburst Bank, MS prior to 1990. Mr. Pegg served as Senior Vice President for Sunburst Bank, MS prior to 1990. Item 2. Item 2. Properties - ------------------ The administrative office of the Registrant is presently located in a modern two story glass, steel, and concrete building owned by the Registrant and located in Grenada, Mississippi. Sunburst Bank, Mississippi operates 124 banking locations, the majority of which are owned premises. Sunburst Bank, Louisiana operates from its main offices in Baton Rouge, Louisiana and has 15 full service offices, one drive-in facility and one operations center. Ten of the offices are owned by the Bank, while seven are leased. Sunburst Financial Group, Inc. operates four offices in Mississippi: one modern, leased building in Jackson, Mississippi which is the main office location, one owned building in Grenada, one owned building in Hattiesburg, and one owned building in Meridian. Sunburst Bank's wholly owned subsidiary, Rapid Finance, Inc. operates 13 consumer lending offices in Mississippi, all of which are leased. All buildings are of either brick masonry or glass, steel, and concrete construction. All buildings have been constructed or remodeled in the last 10 to 15 years and are considered adequate for current and future banking needs. Item 3. Item 3. Legal Proceedings - -------------------------- Various claims and lawsuits, incidental to the ordinary course of business, are pending against the Registrant and its subsidiaries. In the opinion of management, after consultation with legal counsel, resolution of these matters is not expected to have a material effect on the consolidated financial statements. 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 the year ended December 31, 1993. XXX BEGIN PAGE 5 HERE XXX PART II Item 5. Item 5. Market for Registrant's Common Stock and Related Stockholder Matters - ----------------------------------------------------------------------------- The information under the caption "Stock Information" on page 57 and Note 13 of Notes to Consolidated Financial Statements on page 30 of Exhibit 13.1 attached hereto is incorporated herein by reference. Item 6. Item 6. Selected Financial Data - -------------------------------- The information under the caption "Selected Consolidated Financial Information" on page 37 of Exhibit 13.1 attached hereto is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and - ----------------------------------------------------------------------------- Results of Operations --------------------- The information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 39 thru 64 of Exhibit 13.1 attached hereto is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data - ---------------------------------------------------- The following consolidated financial statements of the Registrant and its subsidiaries, the report of independent certified public accountants thereon, and the quarterly data (unaudited) appearing at the pages set forth below in Exhibit 13.1 attached hereto are incorporated herein by reference. Consolidated Balance Sheets Page 11 Consolidated Statements of Income Page 12 Consolidated Statements of Changes in Stockholders' Equity Page 13 Consolidated Statements of Cash Flows Page 14 Notes to Consolidated Financial Statements Pages 15 - 35 Independent Auditor's Report Page 36 Summary of Quarterly Results of Operations (Unaudited) Page 38 Item 9. Item 9. Disagreements on Accounting and Financial Disclosures - -------------------------------------------------------------- There have been no disagreements with the Registrant's independent accountants and auditors on any matter of accounting principles or financial statement disclosure. XXX BEGIN PAGE 6 HERE XXX PART III Item 10. Item 10. Directors and Executive Officers of Registrant - -------------------------------------------------------- Information concerning the directors and nominees of the Registrant appears on pages 3 and 4 of the Registrant's definitive Proxy Statement dated March 18, 1994, and is incorporated herein by reference except for the following information: J. H. Tabb, formerly a director of the Registrant, passed away on March 25, 1994. Information concerning executive officers of the Registrant is presented in Part I hereof. Item 11. Item 11. Executive Compensation - -------------------------------- Information concerning the remuneration of officers and directors of the Registrant and transactions with such persons appears on pages 5-11 of the Registrant's definitive Proxy Statement dated March 18, 1994, and is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - ------------------------------------------------------------------------ Information concerning the security ownership of certain beneficial owners and directors and officers of the Registrant appears on pages 2, 3 and 4 of the Registrant's definitive Proxy Statement dated March 18, 1994, and is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------- Not applicable XXX BEGIN PAGE 7 HERE XXX PART IV Item 14: Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K - ------------------------------------------------------------------------- (a) 1. Financial Statements - See Item 8 above 2. Financial Statement Schedules - All schedules applicable to the Registrant are included in Item 8 above, in the financial statements or related notes thereto 3. Exhibits: 3.1 Certificate of Incorporation (filed as Exhibit (3.1) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference) 3.2 Bylaws, as amended (filed as Exhibit (3.2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) *10.1 Equity Share Bonus Plan and Participation Agreement, as amended (filed as Exhibit (10.1) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) *10.2 Deferred Compensation Agreement (filed as Exhibit (10.2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) *10.3 Management Incentive Compensation Plan (filed as Exhibit (10.3) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) *10.4 Form of Executive Employment Contracts (filed as Exhibit (10.4) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) 10.5 Agreement to Merge with Commercial National Bank, Baton Rouge, LA dated September 28, 1989 (filed as Exhibit A of the Registrant's Registration Statement on Form S-4 (Reg. No. 33-31627) and incorporated herein by reference) 10.6 Purchase and Assumption Agreement among Eastover Bank for Savings, the Registrant and Sunburst Bank, Mississippi dated July 22, 1992 (filed as Appendix H of the Registrant's Registration Statement on Form S-4 (Reg. No. 33-53170) and incorporated herein by reference) 13.1 Portions of the Grenada Sunburst System Corporation 1993 Annual Report (filed herewith) 21.1 Subsidiaries of the Registrant (filed herewith) 23.1 Consent of Independent Auditors (filed herewith) ----------------------------------------------------------------- * Management contract or compensatory plan or agreement identified hereby pursuant to Item 14(a)3. (b) No reports were filed on Form 8-K during the quarter ending December 31, 1993. XXX BEGIN PAGE 8 HERE XXX 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. Grenada Sunburst System Corporation ----------------------------------- BY: /s/Daniel L. Holland Chief Financial Officer and Treasurer -------------------- (Principal Financial and Accounting Daniel L. Holland Officer) 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 Date Capacity --------- ---- -------- /s/James T. Boone March 30, 1994 President and Chief - -------------------- Executive Officer James T. Boone (Principal Executive Officer) /s/Daniel L. Holland March 30, 1994 Chief Financial Officer - -------------------- and Treasurer (Principal Daniel L. Holland Financial and Accounting Officer) XXX BEGIN PAGE 9 HERE XXX 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 their capacity as Director on March 30, 1994. /s/James T. Boone /s/E. Hayes Branscome - --------------------------- --------------------------- Boone, James T. Branscome, E. Hayes /s/J. Russell Flowers /s/John T. Keeton - --------------------------- --------------------------- Flowers, J. Russell Keeton, John T. /s/Robert E. Kennington, II /s/J. M. Robertson, Jr. - --------------------------- --------------------------- Kennington, II, Robert E. Robertson, Jr., J. M. /s/Milton J. Womack - --------------------------- Womack, Milton J. XXX BEGIN PAGE 10 HERE XXX EXHIBIT INDEX ------------- Item 14(a)3. Exhibits Page - --------------------- ---- 3.1 Certificate of Incorporation (filed as Exhibit (3.1) to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated herein by reference)......N/A 3.2 Bylaws, as amended (filed as Exhibit (3.2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference).........N/A *10.1 Equity Share Bonus Plan and Participation Agreement, as amended (filed as Exhibit (10.1) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference)...........................N/A *10.2 Deferred Compensation Agreement (filed as Exhibit (10.2) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference).........N/A *10.3 Management Incentive Compensation Plan (filed as Exhibit (10.3) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference)......................................................N/A *10.4 Form of Executive Employment Contracts (filed as Exhibit (10.4) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference)......................................................N/A 10.5 Agreement to Merge with Commercial National Bank, Baton Rouge, LA dated September 28, 1989 (filed as Exhibit A of the Registrant's Registration Statement on Form S-4 (Reg. No. 33-31627) and incorporated herein by reference).................N/A 10.6 Purchase and Assumption Agreement among Eastover Bank for Savings, the Registrant and Sunburst Bank, Mississippi dated July 22, 1992 (filed as Appendix H of the Registrant's Registration Statement on Form S-4 (Reg. No. 33-53170) and incorporated herein by reference)...............................N/A 13.1 Portions of the Grenada Sunburst System Corporation 1993 Annual Report (filed herewith)...................................11 21.1 Subsidiaries of the Registrant (filed herewith)..................65 23.1 Consent of Independent Auditors (filed herewith).................66 ----------------------------------------------------------------------- * Management contract or compensatory plan or agreement identified hereby pursuant to Item 14(a)3. (b) No reports were filed on Form 8-K during the quarter ending December 31, 1993.

104938_1993.txt

104938_1993

1993

104938

ITEM 1. BUSINESS. GENERAL WMX Technologies, Inc. (formerly named Waste Management, Inc.) is a leading international provider of environmental, engineering and construction, industrial and related services. Unless the context indicates to the contrary, as used in this report the terms "Company" and "WMX Technologies" refer to WMX Technologies, Inc. and its subsidiaries. Through Waste Management, Inc. (formerly named Waste Management of North America, Inc.), a wholly owned subsidiary of the Company (referred to herein, together with its subsidiaries and certain affiliated companies providing solid waste management and related services, as "Waste Management" or "WMI"), the Company provides integrated solid waste management services in North America to commercial, industrial, municipal and residential customers, as well as to other waste management companies. These services consist of solid waste collection, transfer, resource recovery and disposal services. As part of these services, the Company is engaged in providing, through its Recycle America(R) and Recycle Canada(R) programs, paper, glass, plastic and metal recycling services to commercial and industrial operations and curbside recycling services for such materials to residences; in removing methane gas from sanitary landfill facilities for use in electricity generation; and in providing medical and infectious waste management services to hospitals and other health care and related facilities. In addition, through WMI the Company provides street sweeping and parking lot cleaning services, portable fencing and power pole services and Port-O-Let(R) portable sanitation services to municipalities and commercial customers. Chemical Waste Management, Inc., an approximately 79%-owned subsidiary of the Company (referred to herein, together with its subsidiaries other than Rust (as defined below), as "CWM"), is a leading provider of hazardous waste management services in the United States. Its chemical waste management services, including transportation, treatment, resource recovery and disposal, are furnished to commercial and industrial customers, as well as to other waste management companies and to governmental entities. CWM also furnishes radioactive waste management services, primarily to electric utilities and governmental entities. Wheelabrator Technologies Inc., an approximately 55%-owned subsidiary of the Company (referred to herein, together with its subsidiaries, as "WTI"), provides a wide array of environmental products and services in North America and abroad. WTI's clean energy group is a leading developer of facilities and systems for, and provider of services to, the trash-to-energy, energy, and independent power markets. Through the clean energy group, WTI develops, arranges financing for, operates and owns facilities that dispose of trash and other waste materials in an environmentally acceptable manner by recycling it into energy in the form of electricity and steam. WTI's clean water group is principally involved in the design, manufacture and operation of facilities and systems used to purify water, to treat municipal and industrial wastewater, to treat and manage biosolids resulting from the treatment of wastewater by converting them into useful fertilizers, and to recycle organic wastes into compost material useable for horticultural and agricultural purposes. The clean water group also designs and manufactures various products and systems used in water and wastewater treatment facilities and industrial facilities, precision profile wire screens for use in groundwater wells and other industrial applications, and certain other industrial equipment. WTI's clean air group designs, fabricates and installs technologically advanced air pollution emission control and measurement systems and equipment, including systems which remove pollutants from the emissions of WTI's trash-to-energy facilities as well as power plants and other industrial facilities. Rust International Inc., a subsidiary owned approximately 56% by CWM and 40% by WTI (referred to herein, together with its subsidiaries, as "Rust"), furnishes engineering, construction, environmental and infrastructure consulting, hazardous substance remediation and a variety of other on-site industrial and related services primarily to clients in government and in the chemical, petrochemical, nuclear, energy, utility, pulp and paper, manufacturing, environmental services and other industries. Printed on recycled paper LOGO The Company provides comprehensive waste management and related services internationally, primarily through Waste Management International plc, a subsidiary owned 56% by the Company, 12% by Rust and 12% by WTI (referred to herein, together with its subsidiaries, as "Waste Management International"). Waste Management International provides a wide range of solid and hazardous waste management services (or has interests in projects or companies providing such services) in various countries in Europe and in Argentina, Australia, Brunei, Hong Kong, Indonesia, Malaysia, New Zealand, Singapore and Taiwan. On January 1, 1993, CWM and WTI formed Rust and acquired 58% and 42%, respectively, of Rust's outstanding shares. Rust was created to serve the engineering, construction, environmental and infrastructure consulting, hazardous substance remediation and on-site industrial and related services markets, which the managements of CWM, WTI and The Brand Companies, Inc. (referred to herein as "Brand") believed could be served more effectively by organizing the Company's several business units serving those markets into a single integrated company. WTI contributed primarily its engineering and construction and environmental and infrastructure consulting services businesses and its recently formed international engineering unit based in London. CWM contributed primarily its hazardous substance remediation services business, its approximately 56% ownership interest in Brand, and its 12% ownership interest in Waste Management International. On May 7, 1993, Brand was merged into a subsidiary of Rust, and shares of Brand (other than those owned by Rust or exchanged for cash in the merger) were converted into shares of Rust. As a result of such merger, Brand is now a wholly owned subsidiary of Rust. The Company also owns an approximately 28% interest in ServiceMaster Consumer Services L.P., a provider of lawn care, pest control and other consumer services. The remaining ownership interest is held indirectly by ServiceMaster Limited Partnership. Through the end of 1992, the Company categorized its operations into four industry segments-solid waste management and related services; hazardous waste management and related services; energy, environmental and industrial projects and systems; and international waste management and related services (consisting of comprehensive waste management and related services provided outside the United States, Canada and Mexico). Beginning in 1993, the Company categorized the operations of Rust, which was formed from businesses contributed by CWM and WTI, as a fifth industry segment--engineering, construction, industrial and related services--and modified the name of its energy, environmental and industrial projects and systems segment to "trash-to- energy, water treatment, air quality and related services." The following table shows the respective revenues of these segments for the Company's last three years, presented as if the above-described Rust transaction had occurred prior to the periods presented: For information relating to expenses and identifiable assets attributable to the Company's different industry segments, see Note 10 to the Company's Consolidated Financial Statements filed as an exhibit to this report and incorporated by reference herein. For interim periods, the revenues and net income of certain of the Company's businesses may fluctuate for a number of reasons, including there being for some businesses less activity during the winter months. Regulatory or technological developments relating to the environment may require companies engaged in environmental services businesses, including the Company, to modify, supplement or replace equipment and facilities at costs which may be substantial. Because certain of the businesses in which the Company is engaged are intrinsically connected with the protection of the environment and the potential discharge of materials into the environment, a material portion of the Company's capital expenditures is, directly or indirectly, related to such items. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" set forth on pages 32 to 39 of the Company's 1993 Annual Report to Stockholders (which discussion is filed as an exhibit to this report and incorporated by reference herein) for a review of property and equipment expenditures by the Company for the last three years. The Company does not expect such expenditures, which are incurred in the ordinary course of business, to have a materially adverse impact on its and its subsidiaries' combined earnings or its or its subsidiaries' competitive position in the foreseeable future because the Company's businesses are based upon compliance with environmental laws and regulations and its services are priced accordingly. Although the Company strives to conduct its operations in compliance with applicable laws and regulations, the Company believes that in the existing climate of heightened legal, political and citizen awareness and concerns, companies in the environmental services industry, including the Company, will be faced, in the normal course of operating their businesses, with fines and penalties and the need to expend funds for remedial work and related activities with respect to waste treatment, disposal and trash-to-energy facilities. Where the Company concludes that it is probable that a liability has been incurred, a provision is made in the Company's financial statements for the Company's best estimate of the liability based on management's judgment and experience, information available from regulatory agencies and the number, financial resources and relative degree of responsibility of other potentially responsible parties who are jointly and severally liable for remediation of a specific site, as well as the typical allocation of costs among such parties. If a range of possible outcomes is estimated and no amount within the range appears to be a better estimate than any other, then the Company provides for the minimum amount within the range, in accordance with generally accepted accounting principles. Such estimates are subsequently revised, as necessary, as additional information becomes available. While the Company does not anticipate that the amount of any such revision will have a material adverse effect on the Company's operations or financial condition, the measurement of environmental liabilities is inherently difficult and the possibility remains that technological, regulatory or enforcement developments, the results of environmental studies, or other factors could materially alter this expectation at any time. Such matters could have a material adverse impact on earnings for one or more fiscal quarters or years. While in general the Company's environmental services businesses have benefited substantially from increased governmental regulation, the environmental services industry itself has become subject to extensive and evolving regulation by federal, state, local and foreign authorities. Due to the complexity of regulation of the industry and to public pressure, implementation of existing and future laws, regulations or initiatives by different levels of government may be inconsistent and difficult to foresee. The Company makes a continuing effort to anticipate regulatory, political and legal developments that might affect its operations but is not always able to do so. The Company cannot predict the extent to which any legislation or regulation that may be enacted or enforced in the future may affect its operations. The Company was incorporated in Delaware in 1968 and subsequently succeeded to certain businesses owned by its organizers and others. The Company's common stock is listed on the New York Stock Exchange under the trading symbol "WMX" and is also listed on the Frankfurt Stock Exchange, the London Stock Exchange, the Chicago Stock Exchange and the Swiss Stock Exchanges in Basle, Zurich and Geneva. Unless the context indicates to the contrary, all statistical and financial information under Item 1 and Item 2 ITEM 2. PROPERTIES. The principal property and equipment of the Company consists of land (primarily disposal sites), buildings and waste treatment or processing facilities (other than disposal sites), and vehicles and equipment, which as of December 31, 1993 represented approximately 18%, 6% and 30%, respectively, of the Company's and its subsidiaries' total consolidated assets. The Company believes that its vehicles, equipment and operating properties are well maintained and suitable for its current operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" filed as an exhibit to this report and incorporated by reference herein for a discussion of property and equipment expenditures by the Company for the last three years and the capital budget for 1994. The Company's subsidiaries lease numerous office and operating facilities throughout the world. For the year ended December 31, 1993, aggregate annual rental payments on real estate leased by the Company and its subsidiaries approximated $117,296,000. The principal fixed assets of Waste Management consist of vehicles and equipment (which include, among other items, approximately 18,200 collection and transfer vehicles, 1,453,000 containers and 18,000 stationary compactors in the United States and Canada). WMI owns or leases real property in most states and Canadian provinces in which it is doing business. At December 31, 1993, 105 solid waste disposal facilities, aggregating approximately 65,700 total acres including approximately 15,745 permitted acres, were owned by Waste Management in the United States and Canada and 28 facilities, aggregating approximately 11,640 total acres including approximately 6,530 permitted acres, were leased from parties not affiliated with Waste Management under leases expiring from 1994 to 2085. The principal fixed assets of CWM (excluding Rust) consist of its network of transportation, treatment, storage and disposal facilities and its fleet of transportation vehicles. At December 31, 1993, CWM owned or leased in the United States a total of 20 treatment, resource recovery or disposal facilities. At such date, CWM's chemical waste facilities with secure land disposal sites aggregated approximately 10,500 acres, including approximately 3,050 permitted acres. CWM believes that, at current rates of utilization, the permitted and other potentially useable acres included in such total have sufficient capacity to enable CWM to conduct secure land disposal operations for more than 30 years, although not all of CWM's facilities have such capacity. The principal property and equipment of Rust consist of Rust's headquarters buildings, vehicles, equipment and scaffolding inventory, which as of December 31, 1993 represented approximately 20% of Rust's total consolidated assets. The principal fixed assets utilized in Rust's operations at December 31, 1993 consisted of vehicles and equipment (which included, among other items, air monitoring equipment, decontamination trailers, mobile laboratory trailers, vacuum trucks, office trailers, pieces of heavy excavating machinery, mobile waste treatment units and scaffolding inventory). Rust believes that its vehicles, equipment and scaffolding inventory are well maintained and suitable for its current operations. Rust leases numerous office, warehouse and equipment and scaffolding yard facilities in various locations throughout the United States. WTI currently owns, operates or leases 14 trash-to-energy facilities, five cogeneration and small power production facilities, two coal handling facilities, three biosolids drying and pelletizing facilities and various other manufacturing, office and warehouse facilities. Facilities leased or operated (but not owned) by WTI are under leases or agreements having terms expiring from the years 1996 to 2011, subject to renewal options in certain cases. The principal property and equipment of Waste Management International consist of land (primarily disposal sites), buildings and other waste treatment or processing facilities (other than disposal sites), vehicles and equipment. Waste Management International believes that its vehicles, equipment, and operating properties are well maintained and suitable for its current operations, although, due to its many recent acquisitions, vehicles are not standardized. The principal fixed assets utilized in Waste Management International's collection services operations at December 31, 1993 consisted of vehicles and equipment (which included, among other items, approximately 6,300 collection, transportation, and other route vehicles and approximately 280 pieces of landfill and other heavy equipment), approximately 270,000 containers, and approximately 2,300 stationary compactors. In addition, Waste Management International owns approximately 690 pieces of hazardous waste equipment, consisting predominately of containers and collection vehicles. The principal fixed assets utilized in Waste Management International's treatment and disposal services operations at December 31, 1993 consisted of (i) 16 solid waste landfills, aggregating approximately 1,200 total acres including approximately 1,060 permitted acres, owned by Waste Management International, (ii) 14 solid waste landfills, aggregating approximately 890 total acres including approximately 860 permitted acres, leased from parties not affiliated with Waste Management International under leases expiring from 1995 to 2015, (iii) seven secure hazardous waste landfills owned or leased by Waste Management International aggregating approximately 830 acres including approximately 520 permitted acres, and (iv) owned, operated or leased trash-to- energy facilities, other treatment, storage, or disposal facilities and various other manufacturing, office and warehouse facilities. Waste Management International also operates 20 other solid waste landfills. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Some of the businesses in which the Company is engaged are intrinsically connected with the protection of the environment and the potential for the unintended or unpermitted discharge of materials into the environment. In the ordinary course of conducting its business activities, the Company becomes involved in judicial and administrative proceedings involving governmental authorities at the federal, state and local level including, in certain instances, proceedings instituted by citizens or local governmental authorities seeking to overturn governmental action where governmental officials or agencies are named as defendants together with the Company or one or more of its subsidiaries, or both. In the majority of the situations where proceedings are commenced by governmental authorities, the matters involved relate to alleged technical violations of licenses or permits pursuant to which the Company operates or is seeking to operate or laws or regulations to which its operations are subject or are the result of different interpretations of the applicable requirements. From time to time the Company pays fines or penalties in environmental proceedings relating primarily to waste treatment, storage or disposal facilities. At December 31, 1993, CWM and its subsidiaries (other than Rust) were involved in three governmental proceedings (other than those described below) and WTI and Rust were each involved in one such proceeding where it is believed that sanctions involved in each instance may exceed $100,000. On November 12, 1993, the Supreme Court of the State of Louisiana denied CWM's application for a writ of review of an opinion of the Louisiana First Circuit Court of Appeal affirming an administrative order that imposed a fine of approximately $262,000 for certain incidents occurring in 1987 and 1988 at CWM's Lake Charles, Louisiana facility, including alleged unpermitted storage of waste and alleged failures to mark the accumulation date on two containers, to remove or overpack waste from a container in poor condition, to keep hazardous waste containers closed, to properly design and operate the containment system in a fuels loading and unloading area, to provide an adequate number of warning signs, and to take certain actions to prevent fires. On December 30, 1993, a subsidiary of CWM entered into a stipulation of settlement with the New Jersey Department of Environmental Protection and Energy in connection with certain matters occurring in 1992 and 1993 at CWM's Newark, New Jersey facility, including alleged failures to follow required procedures for rejecting hazardous wastes, to comply with certain requirements for managing incompatible wastes and to prepare a manifest before transporting certain waste, and the alleged shipment of waste to an unauthorized facility. CWM's subsidiary agreed to pay civil penalties aggregating approximately $218,000. In settling these matters, CWM's subsidiary did not admit violations of law. The Company or certain of its subsidiaries have been identified as potentially responsible parties in a number of governmental investigations and actions relating to waste disposal facilities which may be subject to remedial action under Superfund. The majority of these proceedings are based on allegations that certain subsidiaries of the Company (or their predecessors) transported hazardous substances to the facilities in question, often prior to acquisition of such subsidiaries by the Company. Such proceedings arising under Superfund typically involve numerous waste generators and other waste transportation and disposal companies and seek to allocate or recover costs associated with site investigation and cleanup, which costs could be substantial. As of December 31, 1993, the Company or its subsidiaries had been notified that they are potentially responsible parties in connection with 104 locations listed on the Superfund National Priority List ("NPL"). Of the 104 NPL sites at which claims have been made against the Company, 19 are sites which the Company has come to own over time. All of the NPL sites owned by the Company were initially sited by others as land disposal facilities. At each of the 19 owned facilities, the Company is working in conjunction with the government to characterize or to remediate identified site problems. In addition, at these 19 facilities the Company has either agreed with other legally liable parties on an arrangement for sharing the costs of remediation or is pursuing resolution of an allocation formula. The 85 NPL sites at which claims have been made against the Company and which are not owned by the Company are at different procedural stages under Superfund. At some, the Company's liability is well defined as a consequence of a governmental decision as to the appropriate remedy and an agreement among liable parties as to the share each will pay for implementing that remedy. At others, where no remedy has been selected or the liable parties have been unable to agree on an appropriate allocation, the Company's future costs are substantially uncertain. The Company periodically reviews its role, if any, with respect to each such location, giving consideration to the nature of the Company's alleged connection to the location (e.g., owner, operator, transporter or generator), the extent of the Company's alleged connection to the location (e.g., amount and nature of waste hauled to the location, number of years of site operation by the Company or other relevant factors), the accuracy and strength of evidence connecting the Company to the location, the number, connection and financial ability of other named and unnamed potentially responsible parties at the location, and the nature and estimated cost of the likely remedy. Where the Company concludes that it is probable that a liability has been incurred, a provision is made in the Company's financial statements for the Company's best estimate of the liability based on management's judgment and experience, information available from regulatory agencies and the number, financial resources and relative degree of responsibility of other potentially responsible parties who are jointly and severally liable for remediation of a specific site, as well as the typical allocation of costs among such parties. If a range of possible outcomes is estimated and no amount within the range appears to be a better estimate than any other, then the Company provides for the minimum amount within the range, in accordance with generally accepted accounting principles. Sites subject to state action under state laws similar to the federal Superfund statute are treated by the Company in the same way as NPL sites. The Company's estimates are subsequently revised, as deemed necessary, as additional information becomes available. While the Company does not anticipate that the amount of any such revisions will have a material adverse effect on the Company's operations or financial condition, the measurement of environmental liabilities is inherently difficult and the possibility remains that technological, regulatory or enforcement developments, the results of environmental studies, or other factors could materially alter this expectation at any time. Such matters could have a material adverse impact on financial condition or earnings for one or more fiscal quarters or years. The Company and certain of its subsidiaries are currently involved in civil litigation and governmental proceedings relating to the conduct of their business. While the outcome of any particular lawsuit or governmental investigation cannot be predicted with certainty, the Company believes that these matters will not have a material adverse effect on its results of operations or financial condition. On September 17, 1993, H. Peter Kriendler, a stockholder of CWM, filed suit in the U. S. District Court for the Northern District of Illinois, Eastern Division, alleging that CWM had violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Two similar suits were filed in that Court on September 30, 1993 and October 13, 1993, and on October 29, 1993 the Court and the parties agreed to consolidate them with the first action. These lawsuits allege that CWM violated federal securities laws by engaging in misrepresentations of, or failures to disclose, material information concerning primarily (i) alleged overvaluation of certain of CWM's assets, principally its incineration facilities, (ii) alleged overstatement of CWM's earnings for 1992 and the first quarter of 1993 due to failure to write down the value of such assets and other matters and (iii) the alleged existence of certain adverse hazardous waste treatment and disposal industry conditions and trends. The lawsuits also allege, among other things, liability on the part of the Company for the above-described alleged violations. The lawsuits seek to represent a class of persons consisting of all purchasers of CWM's common stock during the period of February 4, 1993 through September 3, 1993 and to recover compensation for damages allegedly suffered by such class due to the above- described alleged violations. The Company and CWM believe that they have meritorious defenses to these lawsuits and intend to contest the lawsuits vigorously. In an examination of WTI's federal income tax returns for the period 1986- 1988, the Internal Revenue Service (the "IRS") in January 1993 proposed a significant adjustment related to the 1988 sale of a former subsidiary, which WTI disputed. Under a tax sharing agreement between WTI and a predecessor of WTI, WTI is indemnified by the predecessor for the full amount of any liability assessed with regard to this issue by the IRS. In March 1994, WTI and the IRS filed a Stipulation of Settlement with the U.S. Tax Court which resolved the dispute. WTI believes that the predecessor will be able to meet its indemnification obligation in respect of the agreed tax liability. The Company has brought suit against a substantial number of insurance carriers in an action entitled Waste Management, Inc. et al. v. The Admiral Insurance Company, et al. pending in the Superior court in Hudson County, New Jersey. In this action the Company is seeking a declaratory judgment that environmental liabilities asserted against the Company or its subsidiaries, or that may be asserted in the future, are covered by insurance policies purchased by the Company or its subsidiaries. The Company is also seeking to recover defense costs and other damages incurred as a result of the assertion of environmental liabilities against the Company or its subsidiaries for events occurring over at least the last 25 years at approximately 130 sites and the defendant insurance carriers' denial of coverage of such liabilities. The defendants have denied liability to the Company and have asserted various defenses, including that environmental liabilities of the type for which the Company is seeking relief are not risks covered by the insurance policies in question. The defendants have indicated that they intend to contest these claims vigorously. Discovery is currently underway in this proceeding and is expected to continue for several years. No trial date has been set. The Company is unable at this time to predict the outcome of this proceeding. No amounts have been recognized in the Company's financial statements for any potential recoveries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to the Company's security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below are the names and ages of the Company's executive officers (as defined by regulations of the Securities and Exchange Commission), the positions they hold with the Company and summaries of their business experience. Executive officers are elected by the Board of Directors and serve at the discretion of the Board. J. Steven Bergerson, age 51, has been Senior Vice President-Law and Compliance, since August 1992. He has been a Vice President of the Company since 1984 and was General Counsel of the Company from 1974 until August 1992. Mr. Bergerson has been employed by the Company since 1973. Dean L. Buntrock, age 62, has been a director of the Company and has served as Chairman of the Board and Chief Executive Officer of the Company since 1968. From September 1980 to November 1984, he also served as President. Since May 1993, Mr. Buntrock has also been Chairman of the Board of CWM, a position he previously held from 1986 to September 1991. Mr. Buntrock is also a director of WTI, Rust, Waste Management International, Boston Chicken, Inc., Stone Container Corporation and First Chicago Corporation. Herbert A. Getz, age 38, has been a Vice President of the Company since May 1990 and General Counsel since August 1992. He has also been Secretary of the Company since January 1988. He also served as Assistant General Counsel of the Company from December 1985 until August 1992. Mr. Getz has also held the offices of Vice President, General Counsel and Secretary at WMI from April 1989 until December 1993, and has been Vice President and Secretary of Rust since January 1993. He served as Vice President, Secretary and General Counsel at WTI from November 1990 until May 1993. He is a director of NSC. Mr. Getz commenced employment with the Company in 1983. Thomas C. Hau, age 58, has been a Vice President and the Controller and Principal Accounting Officer of the Company since he commenced employment with the Company in September 1990. From 1971 until his employment by the Company, Mr. Hau was a partner of Arthur Andersen & Co. James E. Koenig, age 46, has been a Senior Vice President of the Company since May 1992, Treasurer of the Company since 1986 and its Chief Financial Officer since 1989. Mr. Koenig first became a Vice President of the Company in 1986. From 1984 to 1986, Mr. Koenig was Staff Vice President and Assistant to the Chief Financial Officer of the Company. Mr. Koenig has been employed by the Company since 1977. Mr. Koenig also served as Vice President, Chief Financial Officer and Treasurer of WTI from November 1990 to May 1993. He also serves as a director of WTI, Waste Management International, Rust and CWM. Phillip B. Rooney, age 49, has served as a director of the Company since 1981 and as its President and Chief Operating Officer since November 1984. Since January 1994, he has also served as Chairman of the Board and Chief Executive Officer of WMI. Mr. Rooney commenced employment with the Company in 1969 and first became an officer of the Company in 1971. Since November 1990, he has served as Chairman of the Board and Chief Executive Officer of WTI, and since January 1993 he has served as Chairman of the Board of Rust. Mr. Rooney is also a director of CWM, Waste Management International, Rust, WTI, Illinois Tool Works, Inc., Caremark International Inc., Urban Shopping Centers, Inc., and ServiceMaster Management Corporation, the general partner of ServiceMaster Limited Partnership. Donald A. Wallgren, age 52, has been Vice President and Chief Environmental Officer of the Company since January 1994. From 1993 to January 1994, Mr. Wallgren was Vice President--Environmental Management of the Company's former corporate service subsidiary, WMX Technology and Services, Inc. He held the same position at the Company from 1992 to 1993 and at WMI from 1989 to May 1990. From 1990 to 1992 he served as Vice President--Recycling, Development and Environmental Management of WMI. Mr. Wallgren has been employed by the Company since 1979. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is traded on the New York Stock Exchange and the Chicago Stock Exchange under the symbol "WMX." The following table sets forth by quarter for the last two years the high and low sale prices of the Company's common stock on the New York Stock Exchange Composite Tape as reported by the Dow Jones News Retrieval Service, and the dividends declared by the Board of Directors of the Company on its common stock. At March 23, 1994, the Company had approximately 71,250 stockholders of record. Due in part to the high level of public awareness of the business in which the Company is engaged, regulatory enforcement proceedings or other unfavorable developments involving the Company's operations or facilities, including those in the ordinary course of business, may be expected to engender substantial publicity which could from time to time have an adverse impact upon the market price for the Company's common stock. In September 1990, WMX Technologies announced its authorization to purchase up to 25,000,000 shares of its common stock from time to time over the following 24-month period in the open market or in privately negotiated transactions. This program has been extended through September 1996. During 1992, the Company purchased approximately 7.6 million shares of its common stock under this program. During 1993, the Company purchased approximately 8.4 million shares of its common stock under this program. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following selected consolidated financial information for each of the five years in the period ended December 31, 1993 is derived from the Company's Consolidated Financial Statements, which have been audited by Arthur Andersen & Co., independent public accountants, whose report thereon is incorporated by reference in this report. The information below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's Consolidated Financial Statements, and the related Notes, and the other financial information which are filed as exhibits to this report and incorporated herein by reference. - -------- /1/The results for 1989 include a non-taxable gain of $70,826,000 resulting from the public offering of 5,000,000 shares of common stock of CWM in October 1989 and special charges of $112,000,000 before tax. /2/The results for 1990 include an extraordinary charge of $24,547,000, or $.05 per share, representing the Company's percentage interest in the writedown by WTI of WTI's investment in the stock of The Henley Group, Inc. and Henley Properties Inc. to market value. /3/The results for 1991 include a special charge of $296,000,000, before tax and minority interest, primarily to reflect then current estimates of the environmental remediation liabilities at waste disposal sites previously used or operated by the Company and its subsidiaries or their predecessors. See Note 11 to the Company's Consolidated Financial Statements. /4/The results for 1992 include a non-taxable gain of $240,000,000 (before minority interest) resulting from the initial public offering of Waste Management International; special charges of $219,900,000, before tax and minority interest, primarily related to writedowns of the Company's medical waste business, CWM incinerators in Chicago, Illinois and Tijuana, Mexico and Brand's investment in its asbestos abatement business and certain restructuring costs incurred by Brand and CWM related to the formation of Rust, and one time after-tax charges aggregating $71,139,000, or $.14 per share, related to the cumulative effect of adopting two new accounting standards. See Notes 1, 9 and 11 to the Company's Consolidated Financial Statements. /5/The results for 1993 include a non-taxable gain of $15,109,000 relating to the issuance of shares by Rust, as well as the Company's share of a special asset revaluation and restructuring charge of $550,000,000, before tax and minority interest, recorded by CWM related primarily to a revaluation of CWM's thermal treatment business, and a provision of approximately $14,000,000 to adjust deferred income taxes resulting from the 1993 tax law change. See Notes 1 and 11 to the Company's Consolidated Financial Statements. /6/Certain amounts have been restated to conform to 1993 classifications. Reference is made to the ratio of earnings to fixed charges for each of the years ended December 31, 1989, 1990, 1991, 1992 and 1993, as set forth in Exhibit 12 to this report, which ratios are incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations set forth on pages 32 to 39 of the Company's 1993 Annual Report to Stockholders (the "Annual Report"), which discussion is filed as an exhibit to this report and incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. (a) The Consolidated Balance Sheets as of December 31, 1992 and 1993, Consolidated Statements of Income, Cash Flows and Stockholders' Equity for each of the years in the three-year period ended December 31, 1993 and Notes to Consolidated Financial Statements set forth on pages 40 to 58 of the Annual Report are filed as an exhibit to this report and incorporated herein by reference. (b) Selected Quarterly Financial Data (Unaudited) is set forth in Note 13 to the Consolidated Financial Statements referred to in Item 8(a) above and 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 in the 12 paragraphs under the caption "Election of Directors" beginning on page 1 of the Company's proxy statement for the annual meeting scheduled for May 13, 1994 (the "Proxy Statement") for a description of the directors of the Company, which paragraphs are incorporated herein by reference. Information concerning the executive officers of the Company is set forth above under "Executive Officers of the Registrant." ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Reference is made to the information set forth under the caption "Compensation" on pages 11 through 19 of the Proxy Statement, 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, including the tables and the footnotes thereto, set forth under the caption "Securities Ownership of Management" on pages 4 through 10 of the Proxy Statement, for certain information respecting ownership of common stock of the Company, CWM, WTI, Waste Management International and Rust, which information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Reference is made to the first paragraph on page 18 and the paragraph under the caption "Compensation Committee Interlocks and Insider Participation" on page 19 of the Proxy Statement and the information set forth under the caption "Certain Transactions" beginning on page 25 of the Proxy Statement for certain information with respect to certain relationships and related transactions, which paragraphs are incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial Statements, Schedules and Exhibits. I. Financial Statements--filed as an exhibit hereto and incorporated herein by reference. (i) Consolidated Statements of Income for the years ended December 31, 1991, 1992 and 1993; (ii) Consolidated Balance Sheets--December 31, 1992 and 1993; (iii) Consolidated Statements of Cash Flows for the years ended December 31, 1991, 1992 and 1993; (iv) Consolidated Statements of Stockholders' Equity for the three years ended December 31, 1993; (v) Notes to Consolidated Financial Statements; and (vi) Report of Independent Public Accountants. II. Schedules. (i) Schedule II--Amounts Receivable from Officers and Employees; (ii) Schedule V--Property and Equipment; (iii) Schedule VI--Accumulated Depreciation and Amortization of Property and Equipment; (iv) Schedule VIII--Reserves; (v) Schedule IX--Short-term Borrowings; (vi) Schedule X--Supplementary Income Statement Information; and (vii) Report of Independent Public Accountants on Schedules. All other schedules have been omitted since the required information is not significant or is included in the financial statements or the notes thereto, or is not applicable. III. Exhibits. The exhibits to this report are listed in the Exhibit Index elsewhere herein. Included in the exhibits listed therein are the following exhibits which constitute management contracts or compensatory plans or arrangements/1/: - -------- /1/In the case of reference to documents filed under the Securities Exchange Act of 1934, the registrant's file number under that Act is 1-7327, Chemical Waste Management, Inc.'s file number under that Act is 1-9253 and Wheelabrator Technologies Inc.'s file number under that Act is 0-14246. (b) Reports on Form 8-K. The registrant did not file any reports on Form 8-K during the fiscal quarter ended December 31, 1993. WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE II--AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE II--AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE II--AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE II--AMOUNTS RECEIVABLE FROM OFFICERS AND EMPLOYEES (CONCLUDED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The Company's general policy is not to advance monies to officers or employees except for relocation or temporary situations. It has, however, adopted a policy of making interest-free loans available to employees whose exercise of non-qualified stock options results in ordinary income to them in excess of $10,000 at the time of such exercise. These receivables are due on or before April 15 of the year following such exercise (extended to November 30, 1992 for loans made by the Company and CWM in 1991 and to May 31, 1993 for loans made by the Company and CWM in 1992). Sufficient shares are withheld from the shares issued to the debtor to fully secure the loan at the time it is made. In addition, certain receivables included above were owed by officers or employees of acquired companies at the time of acquisition by the Company. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE V--PROPERTY AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (A) Effect of foreign currency translation not material in 1991. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (A) Effect of foreign currency translation not material in 1991. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE VIII--RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (A)Reserves of companies accounted for as purchases. (B)Effect of foreign currency translation not material in 1991. (C)Includes reserves for doubtful long-term notes receivable. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE IX--SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (A) Average is computed using daily balances. (B) Weighted average rate is computed by dividing interest expense applicable to commercial paper by the weighted average amount outstanding during the year. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- WMX TECHNOLOGIES, INC. AND SUBSIDIARIES FINANCIAL STATEMENT SCHEDULES ($000'S OMITTED) SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- During 1991, 1992 and 1993 maintenance and repairs charged to costs and expenses in the Consolidated Statements of Income were as follows: - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To WMX Technologies, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in the WMX Technologies, Inc. (formerly Waste Management, Inc.) Annual Report to Stockholders for 1993 filed as an exhibit to and incorporated by reference in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules included on pages 40 through 48 of this Form 10-K 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. ARTHUR ANDERSEN & CO. Chicago, Illinois, February 16, 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 IN OAK BROOK, ILLINOIS ON THE 29TH DAY OF MARCH 1994. WMX TECHNOLOGIES, INC. /s/ Dean L. Buntrock, By___________________________________ Dean L. Buntrock, 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 DATE INDICATED. WMX TECHNOLOGIES, INC. EXHIBIT INDEX - -------- *In the case of incorporation by reference to documents filed under the Securities Exchange Act of 1934, the registrant's file number under that Act is 1-7327, Chemical Waste Management, Inc.'s file number under that Act is 1-9253 and Wheelabrator Technologies Inc.'s file number under that Act is 0-14246. EX-1 - -------- *In the case of incorporation by reference to documents filed under the Securities Exchange Act of 1934, the registrant's file number under that Act is 1-7327, Chemical Waste Management, Inc.'s file number under that Act is 1-9253 and Wheelabrator Technologies Inc.'s file number under that Act is 0-14246. EX-2 - -------- *In the case of incorporation by reference to documents filed under the Securities Exchange Act of 1934, the registrant's file number under that Act is 1-7327, Chemical Waste Management, Inc.'s file number under that Act is 1-9253 and Wheelabrator Technologies Inc.'s file number under that Act is 0-14246. EX-3 - -------- *In the case of incorporation by reference to documents filed under the Securities Exchange Act of 1934, the registrant's file number under that Act is 1-7327, Chemical Waste Management, Inc.'s file number under that Act is 1-9253 and Wheelabrator Technologies Inc.'s file number under that Act is 0-14246. EX-4 - -------- *In the case of incorporation by reference to documents filed under the Securities Exchange Act of 1934, the registrant's file number under that Act is 1-7327, Chemical Waste Management, Inc.'s file number under that Act is 1-9253 and Wheelabrator Technologies Inc.'s file number under that Act is 0-14246. EX-5

811669_1993.txt

811669_1993

1993

811669

ITEM 1 -- BUSINESS GENERAL UST Inc. was formed on December 23, 1986 as a Delaware corporation. Pursuant to a reorganization approved by stockholders at the 1987 Annual Meeting, United States Tobacco Company (originally incorporated in 1911) became a wholly owned subsidiary of UST Inc. on May 5, 1987. UST Inc., through its subsidiaries (collectively "Registrant" unless the context otherwise requires), is engaged in manufacturing, importing and selling consumer products in the following industry segments: Tobacco Products: Registrant's primary activities are manufacturing and selling smokeless tobacco (snuff and chewing tobacco) and importing and selling other tobacco products. Wine: Registrant produces and sells wine. Other: Registrant produces or imports and sells certain other products such as smokers' accessories and operates certain commercial agricultural properties. The international and video entertainment operations as well as certain miscellaneous businesses are included in this segment. INDUSTRY SEGMENT DATA Registrant hereby incorporates by reference the Consolidated Industry Segment Data pertaining to the years 1991 through 1993 set forth on page 28 of its Annual Report to stockholders for the fiscal year ended December 31, 1993 ("Annual Report"), which page is included as Exhibit 13.1. TOBACCO PRODUCTS PRINCIPAL PRODUCTS Registrant's principal smokeless tobacco products and brand names are as follows: Moist -- COPENHAGEN, SKOAL LONG CUT, SKOAL, SKOAL BANDITS Dry -- BRUTON, CC, RED SEAL Chewing -- WB CUT It has been claimed that the use of tobacco products may be harmful to health. To the best of Registrant's knowledge, unresolved controversy continues to exist among scientists concerning the claims made about tobacco and health. In 1986, federal legislation was enacted regulating smokeless tobacco products by, inter alia, requiring health warning notices on smokeless tobacco packages and advertising and prohibiting the advertising of smokeless tobacco products on electronic media. A federal excise tax was imposed in 1986, which was increased in 1991 and 1993. The Health Security Act announced by the Clinton Administration in 1993 seeks, inter alia, a significant federal excise tax increase on moist smokeless and other tobacco products. Also, in recent years, proposals have been made at the federal level for additional regulation of tobacco products including, inter alia, the requirement of additional warning notices, the disallowance of advertising and promotion expenses as deductions under federal tax law, a significant increase of federal excise taxes, a ban or further restriction of all advertising and promotion, regulation of environmental tobacco smoke and increased regulation by new or existing federal agencies. Substantially similar proposals will likely be considered in 1994. In 1993, various state and local governments continued the regulation of tobacco products, including, inter alia, the imposition of significantly higher taxes, sampling and advertising bans or restrictions, regulation of environmental tobacco smoke, negative advertising campaigns and packaging regulations. Additional state and local legislative and regulatory actions will likely be considered in 1994. Registrant is unable to assess the future effects these various actions may have on the sale of its tobacco products. RAW MATERIALS Except as noted below, raw materials essential to Registrant's business are generally purchased in domestic markets under competitive conditions. In 1993, Registrant increased its purchases of dark fired, burley and dark air cured tobaccos ("tobacco") primarily from domestic sources. Although there was a slight increase in foreign purchases in 1993, purchases from foreign suppliers, as a percentage of total tobacco purchased, declined. Such foreign suppliers were located in Canada, Italy and Mexico. Various factors, including a failure of domestic tobacco production to continue to increase, may require Registrant to purchase additional amounts of tobacco from foreign sources in order to meet future requirements. Tobaccos used in the manufacture of smokeless tobacco products must be processed and aged by Registrant for a period of two to three years prior to their use. Registrant or its suppliers purchase certain flavoring components used in Registrant's tobacco products from European sources. At the present time, Registrant has no reason to believe that its future raw material requirements for its tobacco products will not be satisfied. However, the continuing availability and the cost of tobacco from both domestic and foreign sources is dependent upon a variety of factors which cannot be predicted, including weather, growing conditions, disease, local planting decisions, overall market demands and other factors. LICENSE AND DISTRIBUTION ARRANGEMENTS Registrant is a party to license and distribution arrangements that relate to imported pipe tobacco and imported cigarette products, which have been entered into in the ordinary course of Registrant's business, none of which is material to the Tobacco segment. WORKING CAPITAL The principal portion of Registrant's operating cash requirements relates to its need to maintain significant inventories of leaf tobacco, primarily for manufacturing of smokeless tobacco products, and its need to age and cure certain of these tobaccos for periods of up to three years prior to use. CUSTOMERS Registrant sells tobacco products throughout the United States principally to chain stores and tobacco and grocery wholesalers. Approximately 25% of Registrant's gross sales of tobacco products are made to five customers, one of which accounts for more than 10% of such sales. Registrant has maintained satisfactory relationships with these customers for many years. COMPETITIVE CONDITIONS The tobacco manufacturing industry in the United States is composed of at least five domestic companies larger than Registrant and many smaller ones. The larger companies concentrate on the manufacture and sale of cigarettes; one also manufactures and sells smokeless tobacco products. Registrant is a well established and major factor in the smokeless tobacco sector of the overall tobacco market. Consequently, Registrant competes actively with both larger and smaller companies in the sale of its tobacco products. Registrant's principal methods of competition with its tobacco products include quality, advertising, promotion, sampling, price, product recognition and distribution. WINE Registrant is an established producer of premium varietal and blended wines. CHATEAU STE. MICHELLE and COLUMBIA CREST varietal table wines and DOMAINE STE. MICHELLE sparkling wine are produced by Registrant in the state of Washington and sold throughout the United States. Registrant also produces and sells two California premium wines under the labels of VILLA MT. EDEN and CONN CREEK. Approximately 48% of Registrant's wine sales are made to ten distributors, no one of which accounts for more than 20% of total wine sales. Substantially all wines are sold through state-licensed distributors with whom Registrant maintains satisfactory relationships. It has been claimed that the use of alcohol beverages may be harmful to health. To the best of Registrant's knowledge, unresolved controversy continues to exist among scientists concerning the claims made about alcohol beverages and health. In 1988, federal legislation was enacted regulating alcohol beverages by requiring health warning notices on alcohol beverages. Effective in 1991, the federal excise tax on wine was increased from $.17 a gallon to $1.07 a gallon for those manufacturers that produce more than 250,000 gallons a year, such as Registrant. In recent years at the federal level, proposals were made for additional regulation of alcohol beverages including, inter alia, an excise tax increase, modification of the required health warning notices and the regulation of labeling, advertising and packaging. Substantially similar proposals will likely be considered in 1994. Also in recent years, increased regulation of alcohol beverages by various states included, inter alia, the imposition of higher taxes, the requirement of health warning notices and the regulation of advertising and packaging. Additional state and local legislative and regulatory actions affecting the marketing of alcohol beverages will likely be considered during 1994. Registrant is unable to assess the future effects these regulatory and other actions may have on the sale of its wines. Registrant uses grapes harvested from its own vineyards, as well as grapes purchased from independent growers located primarily in Washington State. Total grape harvest yields experienced by Registrant and throughout Washington State in 1993 were significantly higher than the prior year and continue to be adequate to meet requirements for premium varietal wines. From time to time adverse weather conditions have significantly affected grape harvests from Washington State. Should any vineyards be destroyed as a result of such conditions, new vineyards generally require five to six years to provide full yields. At the present time, Registrant has no reason to believe that its future raw material requirements for its wine products will not be satisfied. Registrant's principal competition comes from many larger, well established national companies, as well as smaller wine producers. Registrant's principal methods of competition include quality, price, consumer and trade wine tastings, competitive wine judging and advertising. Registrant is a minor factor in the total nationwide business of producing wines. Registrant concentrates its sales efforts on premium varietal table wines and sparkling wines. The future of Registrant's wine business will be dependent on sales, price and volume growth for premium varietal wines, the success of new products and adequate grape harvest yields from Washington State. OTHER Included in this segment for 1993 were cigarette papers, pipes, smokers' accessories, the international operation, video entertainment, agricultural properties and a majority interest in a company that develops and markets equipment used in filmmaking. None of the above, singly, constitutes a material portion of Registrant's operations. Registrant sold its distribution rights to cigarette papers and related products on March 31, 1993. ADDITIONAL BUSINESS INFORMATION CUSTOMERS In 1993 sales to McLane Co. Inc., a national distributor, exceeded 10% of Registrant's consolidated revenue. ENVIRONMENTAL REGULATIONS Registrant does not believe that compliance with federal, state and local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment will have a material effect upon the capital expenditures, earnings or competitive position of Registrant. NUMBER OF EMPLOYEES Registrant's average number of employees during 1993 was 3,724. TRADEMARKS Registrant sells consumer products under a large number of trademarks. All of the more important trademarks either have been registered or applications therefor are pending with the United States Patent and Trademark Office. SEASONAL BUSINESS No material portion of the business of any industry segment of Registrant is seasonal. ORDERS Backlog of orders is not a material factor in any industry segment of Registrant. ITEM 2 ITEM 2 -- PROPERTIES Set forth below is information concerning principal facilities and real properties of Registrant. Such principal properties in Registrant's industry segments were utilized only in connection with Registrant's business operations. Registrant believes that the above properties at December 31, 1993 were suitable and adequate for the purposes for which they were used, and were operated at satisfactory levels of capacity. Registrant is producing moist smokeless tobacco products at both its Franklin Park and Nashville plants where the combined installed capacity was planned to meet larger future demand for these products. While current capacity exceeds current sales, utilization would increase if market demand increases. All principal properties are owned in fee by Registrant. ITEM 3 ITEM 3 -- LEGAL PROCEEDINGS Registrant was named in an amended complaint filed on January 17, 1992, in an action against the major cigarette companies and others entitled Norma R. Broin, et al. v. Philip Morris Companies, Inc. et al. (Case No.: 91-49738 CA (22), Circuit Court, 11th Judicial Circuit, Dade County, Florida) seeking five billion dollars in punitive damages and unspecified compensatory damages. The action purportedly is brought on behalf of flight attendants who have allegedly sustained physical, psychological and emotional injuries as a result of exposure to environmental tobacco smoke on airplanes. On May 19, 1992, the Court dismissed the class action allegations in plaintiffs' amended complaint. Plaintiffs filed a notice of appeal from the Court's dismissal on June 17, 1992 and this appeal has not been decided. Registrant has had only limited involvement with cigarettes. Prior to 1985, Registrant manufactured some cigarette products which had a de minimis market share, and Registrant is indemnified for the small volume of imported cigarettes which it currently distributes. Registrant believes that the action is without merit, intends to defend it vigorously and does not believe it will result in any material liability to Registrant. ITEM 4 ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT Prior to May 5, 1987, all titles of officers set forth below relate to offices held in United States Tobacco Company. Pursuant to instruction 3 to Item 401(b) of Regulation S-K, the name, office, age and business experience of each executive officer of Registrant as of March 1, 1994 is set forth below: None of the executive officers of Registrant has any family relationship to any other executive officer or director of Registrant. After election, all executive officers serve until the next annual organization meeting of the Board of Directors and until their successors are elected and qualified. All of the Executive Officers of Registrant have been employed continuously by it for more than five years except for Mr. Barrett. Mr. Barrett has served as Executive Vice President since October 7, 1991. He also has served as President of UST Enterprises Inc. since July 1, 1991. Mr. Barrett served as Senior Vice President from January 1, 1991 to October 6, 1991, and served as a member of the Board of Directors from July 27, 1989 through December 13, 1990. Mr. Barrett served as President of Barrett Consultants, a public and government relations firm which he founded in 1980. Mr. Barrett has been employed by Registrant since January 1, 1991. Mr. Bucchignano has served as Executive Vice President and Chief Financial Officer since October 7, 1991. Mr. Bucchignano served as Senior Vice President and Controller from September 27, 1990 to October 6, 1991, and as Controller from August 1, 1987 to September 26, 1990. Mr. Bucchignano has been employed by Registrant since December 10, 1984. Mr. Chapin has served as Executive Vice President and General Counsel since September 25, 1991. Mr. Chapin served as Senior Vice President and General Counsel from January 1, 1981 to September 24, 1991. Mr. Chapin has been employed by Registrant since March 1, 1975. Mr. Gierer has served as Chairman of the Board and Chief Executive Officer since December 1, 1993 and has served as President since September 27, 1990. Mr. Gierer also served as Chief Operating Officer from September 27, 1990 to November 30, 1993 and as Executive Vice President and Chief Financial Officer from February 17, 1988 to September 26, 1990. Mr. Gierer has been employed by Registrant since March 16, 1978. Mr. Peter has served as Executive Vice President since October 29, 1990. He also has served as President of UST International Inc. since January 1, 1993. Mr. Peter served as Senior Vice President from July 27, 1989 to October 28, 1990 and as Vice President from June 23, 1988 to July 26, 1989. Mr. Peter has been employed by Registrant since February 1, 1988. Mr. Taddeo has served as Executive Vice President and President of United States Tobacco Company since September 27, 1990. Mr. Taddeo also served as Senior Vice President of United States Tobacco Company from June 23, 1988 to September 26, 1990. Mr. Taddeo has been employed by Registrant since March 29, 1982. PART II ITEM 5 ITEM 5 -- MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Registrant hereby incorporates the information with respect to the market for its common stock, $.50 par value ("Common Stock"), and related security holder matters set forth on page 27 of its Annual Report, which page is included herein as Exhibit 13.2. Registrant's Common Stock is listed on the New York Stock Exchange and the Pacific Stock Exchange. As of March 1, 1994, there were approximately 13,621 stockholders of record of its Common Stock. ITEM 6 ITEM 6 -- SELECTED FINANCIAL DATA Registrant hereby incorporates by reference the Consolidated Selected Financial Data set forth on pages 46 and 47 of its Annual Report, which pages are included herein as Exhibit 13.3. ITEM 7 ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Registrant hereby incorporates by reference the Management's Discussion and Analysis of Results of Operations and Financial Condition set forth on pages 19-27 of its Annual Report, which pages are included herein as Exhibit 13.4. ITEM 8 ITEM 8 -- FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Registrant hereby incorporates by reference the information contained in the financial statements, including the notes thereto, set forth on pages 28-43 and 45 of its Annual Report, which pages are included herein as Exhibit 13.5. 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 Registrant hereby incorporates by reference the information with respect to the names, ages and business histories of the directors of Registrant which is contained in Table I and the accompanying text set forth under the caption "Election of Directors" in its Notice of 1994 Annual Meeting and Proxy Statement. Information concerning executive officers of Registrant is set forth above following Item 4 of this Report. ITEM 11 ITEM 11 -- EXECUTIVE COMPENSATION Registrant hereby incorporates by reference the information with respect to executive compensation which is contained in Tables II through V (including the notes thereto) and the accompanying text set forth under the caption "Compensation of Executive Officers" in its Notice of 1994 Annual Meeting and Proxy Statement. ITEM 12 ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Registrant hereby incorporates by reference the information with respect to the security ownership of management which is contained in Table I and the accompanying text set forth under the caption "Election of Directors" in its Notice of 1994 Annual Meeting and Proxy Statement. ITEM 13 ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Registrant hereby incorporates by reference certain transactions with directors and information with respect to indebtedness of management which is contained in Table VI and the accompanying text set forth under the caption "Compensation of Executive Officers" in its Notice of 1994 Annual Meeting and Proxy Statement. 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) and (2) The financial statements of Registrant included in this Report are set forth on pages - hereof. (3) The following exhibits are filed by Registrant pursuant to Item 601 of Regulation S-K: (b) No current reports on Form 8-K were filed during the fourth quarter of Registrant's most recent fiscal year. * Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of this Report. SIGNATURE PAGE PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. UST INC. Date: February 16, 1994 By: VINCENT A. GIERER, JR. ------------------------------- VINCENT A. GIERER, JR. CHAIRMAN OF THE BOARD, CHIEF EXECUTIVE OFFICER AND 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 REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. ITEM 14 (a) (1) AND (2) UST AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Registrant, included in the annual report of Registrant to its stockholders for the year ended December 31, 1993, are incorporated by reference in Item 8: Consolidated Statement of Financial Position -- December 31, 1993 and Consolidated Statement of Earnings -- Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Stockholders' Equity -- Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows -- Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements The following consolidated financial statement schedules 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. UST AND SUBSIDIARIES SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UST AND SUBSIDIARIES SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES -- (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UST AND SUBSIDIARIES SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES -- (CONTINUED) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (A) Amounts represent notes arising from installment purchases of common stock under Registrant's Stock Option Plans which carry interest rates ranging from approximately 4% to approximately 9%, provide for payment over periods of up to ten years and are secured by the common stock purchased. UST AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (A) Reclassified on the Consolidated Statement of Financial Position to land, buildings and machinery and equipment. (B) Additions principally relate to the completion of aircraft, new equipment for the wine operations and the Nashville, Franklin Park and Hopkinsville plants, renovation of facilities, and normal replacement of existing manufacturing equipment and motor vehicles. (C) Transfers to property accounts are included in Column C. (D) The annual provisions for depreciation have been computed principally in accordance with the following rates: UST AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT -- (CONTINUED) YEAR ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (A) Reclassified on the Consolidated Statement of Financial Position to buildings and machinery and equipment. (B) Additions principally relate to new equipment for the wine operations and the Nashville and Franklin Park plants, renovation of facilities, and normal replacement for existing manufacturing equipment and motor vehicles. (C) Retirements include $7.1 million for aircraft. (D) Net increase in account, primarily the partial cost of unfinished aircraft. Transfers to property accounts are included in Column C. (E) The annual provisions for depreciation have been computed principally in accordance with the following rates: UST AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT -- (CONTINUED) YEAR ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (A) Reclassified on the Consolidated Statement of Financial Position to buildings and machinery and equipment. (B) Additions principally relate to the completion of aircraft, new equipment for the wine operations and the Nashville and Franklin Park plants, vineyard development, renovation of facilities, and normal replacement for existing manufacturing equipment and motor vehicles. (C) Increase in account represents consolidation of Camera Platforms International, Inc. (D) Net decrease in account, primarily the reclassification of the cost of completed aircraft. Transfers to property accounts are included in Column C. (E) The annual provisions for depreciation have been computed principally in accordance with the following rates: UST AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UST AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT -- (CONTINUED) YEAR ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UST AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT -- (CONTINUED) YEAR ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UST AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- (A) Commercial paper generally matures within 90 days from date of issuance with no provision for extensions of its maturity. Amounts in 1993 are higher than in previous years due to an arbitrage program. (B) Notes payable represent borrowings under lines of credit arrangements. In January 1994, Registrant converted this $40 million loan into a revolving credit and term loan agreement and this amount was classified as long-term debt at December 31, 1993. (See Notes to Consolidated Financial Statements -- Revolving Credit and Term Loan Agreement and Short-Term Lines of Credit.) (C) Represents maximum amount outstanding at any time during the period. (D) The average amount outstanding during the period was computed by dividing the total of the monthly average outstanding principal balances by twelve. (E) The weighted average interest rate during the period was computed by dividing the actual interest expense by the average short-term debt outstanding. UST AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Other items have been omitted as each one did not exceed one percent of revenues. EXHIBIT INDEX * Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of this Report.

29332_1993.txt

29332_1993

1993

29332

ITEM 1. BUSINESS GENERAL An integral part of the Company's strategy during the past two years has been to restructure its operations and expand into floorcovering. Today, the Company operates in two business segments - Textile products and Floorcovering - with approximately half of its sales in each segment. Prior to the acquisitions of Carriage and Masland in 1993, the Company's single line of business, textile products, included the Company's Candlewick carpet yarn operations. With the expansion into the floorcovering business, the Company's carpet yarn operations are now included in the floorcovering segment. Financial information relating to the Company's business segments have been restated for all periods presented and are set forth in Note (O) to the Company's consolidated financial statements. TEXTILES TEXTILE INDUSTRY - The domestic textile industry manufactures products for a variety of end uses, including home furnishings (domestics, drapery and upholstery), industrial products, transportation applications and apparel. The industry, which encompasses yarn preparation, fabric formation and product distribution, is structured with various degrees of vertical integration, depending upon the particular products involved. The textile industry is made up of a great number of companies, none of which are believed to have sales that comprise as much as 10% of the total market. The domestic apparel market, which includes a substantial portion of the customers for the Company's products, is continually faced with competition from imports; however, management believes that implementation of the North American Free Trade Agreement may increase demand for domestic textile products by continuing to encourage utilization of such products by non-domestic cut and sew operations. Additionally, management believes consumer buying patterns continue to be influenced by mass merchandisers and retailers emphasizing price competition for value-added products. The domestic textile industry also services the home furnishing and other industries in a number of applications which are impacted by housing sales as well as by domestic automotive production levels. THE COMPANY'S TEXTILE PRODUCTS - The Company manufactures and markets yarns, threads and knit fabrics from a variety of natural and man-made fibers. Textile products are primarily sold to manufacturers of apparel, domestics, drapery and upholstery, hosiery, industrial fabrics, transportation and other industries. The Company produces a wide variety of products, with a significant focus on high-end value added products. Although the textile products business is organized into three business groups, substantial sales and customer overlap exists among the groups. Textile products are focused on narrow groups of products, related by manufacturing processes, performance qualities and end uses. No group of such products individually accounts for as much as 10% of Dixie's consolidated revenues for 1993, 1992 or 1991 and no customer's volume exceeded 10 percent of the Company's total sales for 1993. The Company's Yarn Group ("Yarn Group") is comprised of the Natural and Dyed Yarn Group and the Synthetics Yarn Group. Products produced and marketed through these groups include ring spun, open end and air jet single and plied yarns which are sold to manufacturers of premium-price apparel, high-end home furnishings, and industrial products. A portion of the yarn produced by the yarn spinning facilities is further processed by the Company's mercerizing and package dyeing facilities. Cotton is the primary fiber for both natural, and mercerized and package dyed markets served. Other markets served include products manufactured from man-made (synthetics) fibers, many of which are high technology fibers that impart strength, heat resistance, stretch and/or characteristics relating to comfort and insulation properties. Natural, dyed and synthetic yarns are marketed through a combination of salaried sales force and, to a lesser extent, commissioned sales agents. The Company's Industrial Sewing Thread Group ("Threads USA") is one of three major domestic manufacturers and marketers of industrial sewing thread, with a full line of products that includes cotton, spun polyester, corespun and filament threads. Thread products are sold directly by the Company's sales personnel through an extensive regional warehouse network as well as to independent wholesale jobbers. The Company's Knit Fabric Group ("Caro Knit") knits, dyes and finishes 100 percent cotton circular knit fabrics for apparel and industrial markets. A majority of the yarn used for the production of the knit fabric is supplied by the Company's yarn facilities. Knit products are sold primarily by its own salaried sales force. The Company's sales order backlog position in its textile products business was approximately $79,000,000 on December 25, 1993 compared to approximately $102,000,000 on December 26, 1992. All of these orders can reasonably be expected to be filled within the 1994 fiscal year. Although the competition faced by the Company's textile business varies depending on the markets involved, a substantial portion of the Company's products in the Company's domestic textile products business is faced with competition from imports. The Company owns a number of patents used in its textile business, and patent protection is sought as a matter of course when machinery or process improvements are made that are considered patentable. However, in the opinion of the Company, its textile operations are not materially dependent upon patents and patent applications. FLOORCOVERING THE CARPET INDUSTRY - The carpet industry is composed of approximately 100 manufacturers of which the top 5 account for over 50% of total sales in the industry. The industry has two primary markets, residential and commercial, with the residential market making up the largest portion of industry's sales. A substantial portion of industry shipments is made in response to replacement demand. The residential market consists of broadloom carpets, rugs and bathmats in a broad range of styles, colors, textures and yarns. The carpet industry also manufactures carpet for the automotive, recreational vehicle and recreational boat industries. The carpet industry is highly competitive with competition principally from 100 domestic manufacturers of carpets and rugs. Carpet manufacturers also face competition from the hard surface floorcovering industry. The principal methods of competition within the carpet industry are quality, style, price and service. THE COMPANY'S FLOORCOVERING BUSINESS - The Company's floorcovering business manufactures and markets carpet yarns and floorcovering products for specialty markets through Candlewick Yarns ("Candlewick"), Carriage Industries, Inc. ("Carriage") and Masland Carpet, Inc. ("Masland"). Candlewick is one of the world's largest independent carpet yarn manufacturers. Its customers include end-use product manufacturers in the bath rug, automotive and broadloom carpet markets. Candlewick is a producer of premier yarns for floorcovering applications. It competes through product quality and innovation. Its product development center and relationships with fiber suppliers have been developed to provide customers a means to evaluate yarn and fiber variations. Candlewick has a significant share of the bath rug yarn market due to the breadth of its product line, service capabilities, quality and history of innovation. Products of Candlewick are marketed through its own salaried sales force. Carriage is a vertically integrated carpet manufacturer serving specialized markets. Its highly diversified markets include: original equipment manufacturers of manufactured housing, recreational vehicles, and small boats; the exposition/trade show market; contract/residential market; and the home center/needlebond market. Carriage's manufacturing operations include yarn extrusion, yarn processing,tufting, needlebonding, dyeing, finishing and finished product transportation through its own trucking fleet. Its product line is marketed by a staff of salaried sales personnel and to a lesser extent commission sales representatives. Carriage competes only in selected portions of the floorcovering market. Competition is based not only on price, but also on quality of goods, customer service and reputation for reliability. The Company has developed a broad array of specialized products of varying styles, widths, colors and backing. Rapid, just-in-time delivery of customer orders is an important part of the Company's customer service program. The Company controls delivery of its products through its trucking fleet of 68 tractor-trailers and utilization of regional distribution centers for finished goods. Masland markets broadloom products for specification by the architectural and design communities and residential carpet and designer rugs to a select group in interior design showrooms and high-end specialty retailers. Each of the markets served require quality, service, innovation in styling and product design. Competition within its business is based primarily on quality, service and styling, with price becoming an increasingly important factor, particularly in the Company's contract business. The Company's sales order backlog position in its floorcovering business was approximately $37,000,000 on December 25, 1993 compared to approximately $24,000,000 on December 26, 1992. All of these orders can reasonably be expected to be filled within the 1994 fiscal year. The Company's floorcovering business owns a variety of trademarks under which its products, particularly those sold by Masland, are marketed. While such trademarks are important to Masland's business, there is no one trademark, other than the name Masland itself, which is of material importance to the segment. There was no single class of products exceeding 10 percent of the Company's sales volume for 1993, 1992 or 1991 and no customer's volume exceeded 10 percent of the Company's total sales for 1993. SEASONALITY Within the varied markets serviced by the Company, there are a number of seasonal production cycles, but the Company's business as a whole is not considered to be significantly affected by seasonal factors. Correspondingly, there appear to be no material impacts on working capital relating to seasonality or other business dynamics. ENVIRONMENTAL While compliance with current federal, state and local provisions regulating the discharge of material into the environment may require additional expenditures by the Company, these expenditures are not expected to have a material effect on capital expenditures, earnings or the competitive position of the Company. RAW MATERIALS The Company obtains natural and synthetic raw materials from a number of domestic suppliers. Cotton fiber is purchased at market rates from numerous cotton merchants and directly from cotton growing cooperatives under short-term supply contracts at costs which are significant factors in the Company's pricing of its products. Man-made fibers are purchased from major chemical suppliers. Although the Company's procurement of raw materials is subject to variations in price and availability due to agricultural and other market conditions and in the price of petroleum used to produce man-made fibers, the Company believes that its sources of raw materials are adequate and that it is not materially dependent on any single supplier. UTILITIES The Company uses electricity as its principal energy source, with oil or natural gas used in some facilities for finishing operations as well as heating. During the past five years the Company has not experienced any material problems in obtaining electricity, natural gas or oil at anticipated prices. Nevertheless, energy shortages of extended duration could have an adverse effect on the Company's operations. The Company had approximately 7,300 associates as of the end of fiscal 1993. ITEM 2. ITEM 2. PROPERTIES The following table lists the Company's facilities according to location, type of operation and approximate total floor space as of March 11, 1994. Approximate Location Type of Operation Square Feet CORPORATE Administrative: Chattanooga, TN Administrative 41,000 TEXTILE PRODUCTS Administrative: Gastonia, NC Administrative 61,000 Warehousing: Gastonia, NC (2 locations) Warehousing 88,000 Sales Branch Warehouses (4 locations) Warehousing 54,000 Total Warehousing 142,000 Manufacturing: Chattanooga, TN Yarn Spinning 440,000 Mebane, NC Yarn Spinning 99,000 Ranlo, NC Yarn Spinning 482,000 Saxapahaw, NC Yarn Spinning 264,000 Tarboro, NC Yarn Spinning 340,000 Chattanooga, TN Package Yarn Dyeing, Bleaching and Mercerizing 276,000 Tryon, NC Bleaching and Mercerizing 63,000 Gastonia, NC Thread Yarn Dyeing and Finishing 530,000 Arroyo, Puerto Rico Thread Yarn Dyeing and Finishing 22,000 Gastonia, NC Thread Yarn Spinning 445,000 Jefferson, SC Knitting, and Fabric Dyeing and Finishing 274,000 Newton, NC Yarn Spinning and Knitting 252,000 Total Manufacturing 3,487,000 FLOORCOVERING Administrative: Dalton, GA Administrative 13,000 Calhoun, GA Administrative 60,000 Mobile, AL(2) Administrative 20,000 Total Administrative 93,000 Warehousing: Ringgold, GA Warehousing 119,000 Manufacturing: Lemoore, CA Tufted Yarn Spinning 322,000 Ringgold, GA Tufted Yarn Spinning 290,000 Roanoke, AL (1) Tufted Yarn Spinning 190,000 Calhoun, GA Carpet Manufacturing 1,016,000 Chatsworth, GA Carpet Manufacturing 24,000 Atmore, AL Carpet Manufacturing 262,000 Mobile, AL(2) Rug Manufacturing, Distribution 400,000 Total Manufacturing 2,504,000 Total 6,447,000 ITEM 2. PROPERTIES - CONTINUED (1) This property is currently leased. Under the provisions of the Roanoke, AL lease, the Company is acquiring title to the property over the term of the lease, which is expected to terminate in 2004. (2) This property is currently leased. Under the provision of the Mobile, AL lease, the Company will acquire the property at the end of the lease. In addition to the facilities listed above, the Company owns or leases various administrative, storage, warehouse and office spaces. In the opinion of the Company, its manufacturing facilities are well maintained and the machinery is efficient and competitive. Operations at each plant generally vary between 120 hours and 168 hours per week. There are no material encumbrances on any of the Company's operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings to which the Company or its subsidiaries are a party or of which any of its property is the subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted during the fourth quarter of 1993 to a vote of the shareholders. Pursuant to instruction G of Form 10-K the following is included as an unnumbered item to Part I. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages, positions and offices held by the executive officers of the registrant as of March 11, 1994, are listed below along with their business experience during the past five years. Name, Age Business Experience During and Position Past Five Years Daniel K. Frierson, 52 Director since 1973, Chairman of Chairman of the Board, President the Board since 1987 and Chief and Chief Executive Officer, Executive Officer since 1980. Director, Member of Executive Director of the American National Committee Bank & Trust Co.. Brother of Paul K. Frierson Phil Barlow, 45 Corporate Vice President and Corporate Vice President and President of Carriage Industries, President, Carriage Industries, Inc. Inc. since 1993. Vice President of Sales and Marketing, Carriage, 1988- 1993. Director of Sales and Marketing, Carriage, 1986 - 1988. David C. Clarke, 36 Corporate Vice President and Corporate Vice President and President, Threads USA since President, Threads USA February, 1994. Executive Vice President of Sales, Threads USA, from September, 1992 to February, 1994. Vice President of Direct Sales, Threads USA, from November, 1991 to September, 1992. Director of Direct Sales, Threads USA, from February, 1991 to November, 1991. Director of Sales, American Thread Company, from 1989 - 1991. C. Pat Driver, 53 Corporate Vice President and Corporate Vice President and President, Synthetic Yarn Group President, Synthetic Yarns since June, 1992. Corporate Vice President and President, Dixie Yarns Group, from 1989 to June, 1992. President, Carpet Yarns, Group (Candlewick), 1983 - 1989. EXECUTIVE OFFICERS OF THE REGISTRANT -- CONT. Name, Age Business Experience During and Position Past Five Years Paul K. Frierson, 56 Director since 1988. Corporate Corporate Vice President and Vice President and President, President, Candlewick Yarns, Carpet Yarns Group (Candlewick) Director since 1989. Executive Vice President of Candlewick from 1984 - 1989. Director of Nationsbank/Chattanooga. Brother of Daniel K. Frierson. Charles P. McCamy, 40 Corporate Vice President and Corporate Vice President and President, Caro Knit Group President, Caro Knit since December, 1992. Vice President of Manufacturing, Caro Knit Group, from January, 1991 to December, 1992. Vice President of Manufacturing, Great American Knitting Mills, 1989 - 1990. George B. Smith, 53 Corporate Vice President and Corporate Vice President President, Natural and Dyed Yarn and President, Natural and Dyed Yarns Group since August, 1993. President Natural Yarn Group from October, 1992 to August, 1993. Self-employed (Consulting and Commission Sales) June, 1990 to November, 1992. Corporate Vice President, Avondale Mills, Inc., 1986 - 1990. President, Avondale Yarn Division, 1989 - 1990. President, Avondale Fabric Division, 1986-1989. John Sturdy, 64 Corporate Vice President and Corporate Vice President President, Masland Carpets, Inc., and President, Masland Carpets, Inc. 1993. President & Chief Executive Officer, Masland Carpets, Inc., 1991 - 1993. President & Chief Operating Officer, The Harbinger Company, Inc., subsidiary of Horizon Industries, Inc. 1984 - 1991. W. Derek Davis, 43 Corporate Vice President of Human Corporate Vice President - Resources since January, 1991. Human Resources Corporate Employee Relations Director, 1990 - 1991. Employee Relations Director, Dixie Yarns Group and Carpet Yarns Group (Candlewick), 1988 - 1990. EXECUTIVE OFFICERS OF THE REGISTRANT -- CONT. Name, Age Business Experience During and Position Past Five Years Jon Faulkner, 34 Corporate Vice President of Corporate Vice President - Administration since 1993. Director Administration of Management Information Systems, 1990 - 1993. Manager of Warehouses and Distribution, Threads USA, 1989 - 1990. Gary Harmon, 48 Treasurer since 1993. Treasurer Director of Tax and Financial Planning, 1985 - 1993. D. Eugene Lasater, 43 Controller since 1988 Controller Starr T. Klein, 51 Secretary since November, 1992. Secretary Assistant Secretary, 1987 - 1992. The executive officers of the registrant are elected annually by the Board of Directors at its first meeting held after each annual meeting of the Company's shareholders. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS The Company's Common Stock trades on the over-the-counter National Market System with the NASDAQ symbol DXYN. No market exists for the Company's Class B Common Stock. As of March 11, 1994, the total number of record holders of the Company's Common Stock was approximately 6,200 and the total number of holders of the Company's Class B Common Stock was 19. Management of the Company estimates that there are approximately 4,700 shareholders who hold the Company's Common Stock in nominee names. Dividends and Price Range of Common Stock for the four quarterly periods in the years ended December 25, 1993 and December 26, 1992 are as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with the related consolidated financial statements and notes thereto included under Items 8, 14(a) (1) and (2) and 14 (d) of the report on Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION GENERAL An integral part of the Company's strategy has been to restructure its textile operations and expand into floorcovering. Today, the Company operates in two business segments - Textile products and Floorcovering - with approximately half of its sales in each segment. Restructuring - During the latter part of 1991, the Company accrued the estimated cost to restructure its operations of approximately $28.3 million ($18.3 million after-tax) and began implementation of a plan to reduce costs in its operations by consolidating manufacturing facilities and expanding to seven- day scheduled operations. Cost of the restructuring incurred through 1993, consisted of approximately $13.5 million to write-down certain assets to estimated fair market value, approximately $3.2 million for severance payments and approximately $11.1 million for other direct costs of the restructuring. Five smaller manufacturing facilities were closed and one was sold. Production and equipment from the discontinued facilities were consolidated into larger, more efficient units and virtually every textile and carpet yarn facility was impacted by the restructuring. Disruptions associated with product and machinery changes had a negative impact on operating profits, particularly in 1993. Substantially all of the planned changes have been completed; however, additional costs are anticipated in 1994 until operations reach planned efficiency levels. Expansion into floorcovering - The carpet industry has been consolidating for a number of years and the Company intends to participate in the industry's consolidation by acquiring carpet companies that serve specialty markets. The acquisition of Carriage Industries, Inc. was completed on March 12, 1993 and Masland Carpets, Inc. was acquired on July 9, 1993. Both Carriage and Masland produce floorcovering products for specialty markets. Carriage is a vertically integrated manufacturer of specialized floorcovering for the manufactured housing, recreational vehicle and small boat industries, the exposition/trade show market, the contract/residential market, and the home center/needlebond market. Masland manufactures high-end residential and contract commercial carpet and designer rugs for interior designers, architects and specialty retailers. RESULTS OF OPERATIONS 1993 Compared with 1992 - Sales for the year ended December 25, 1993 increased approximately 27%. The increase in 1993 sales is attributable to the Company's floorcovering business, which now includes the Company's carpet yarn manufacturing operations and subsequent to their 1993 acquisitions, the operations of Carriage Industries, Inc. and Masland Carpets, Inc.. The dollar volume of sales of the Company's textile products declined 4.5% in 1993, although unit volume increased. The decline in sales of textile products is attributable to weak retail apparel markets and the sale of a dyed yarn facility in the first quarter of 1993. Net income was $4.5 million, or $.41 per share, in 1993 compared with $5.5 million, or $.62 per share, in 1992. Operating income for 1993 was 9.2% of sales in the Company's floorcovering business and .5% of sales for textile products, compared with 6.4% and 4.4%, respectively, in 1992. In addition to the 1993 acquisitions, floorcovering enjoyed strong growth and favorable conditions in the markets it serves throughout 1993. The decrease in operating profits for textile products in 1993 is principally due to weak demand for apparel products and raw material price increases that could not be passed along to customers resulting in price and margin erosion, particularly in the third and fourth quarters of 1993. Disruptions associated with production and operating consolidations have had a negative impact on profits of the Company's textile business. The increase in gross profits and selling, general and administrative expenses as a percent of sales in 1993 reflects the traditional higher margins and higher selling and product distribution costs associated with the specialized floorcovering markets serviced by Carriage and Masland. The increase in other income in 1993 is principally the result of approximately $1.8 million of storm insurance proceeds and gains from assets disposals. Interest expense increased in 1993 due to the higher levels of debt. The Company's effective income tax rate differs from the statutory income tax rates due primarily to nondeductible amortization of intangible assets. Also in 1993, a non-cash income tax charge of approximately $.5 million, or $.04 per share, resulted from the effect of the increase in the statutory federal income tax rate on deferred income taxes established in prior years. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and changed its method of accounting for income taxes to the liability method. In connection with the change in method of accounting, financial statements for periods subsequent to 1986 were restated as if the new method had been in effect during those periods. The effect of the change was to decrease 1992 net income by approximately $.2 million, or $.03 per share, and increase the 1991 net loss by approximately $.2 million, or $.02 per share. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires, under certain conditions, the adoption of accrual accounting for postemployment benefits no later than 1994. The Company sponsors no such plans and the new standard is not expected to affect the Company's financial statements. 1992 Compared with 1991 - Dollar sales decreased in 1992 although unit volume increased. The decrease in dollar volume of sales was attributable to the Company's textile products business, which declined in 1992 due to the effect of adverse economic conditions in high-end markets and a greater portion of unit sales consisting of lower priced products. Operating profits, excluding the effect of the restructuring charge in 1991, increased in both the Company's floorcovering and textile products segments increased as a result of reductions in raw materials costs, manufacturing costs, and selling, general and administrative expenses. Interest expense decreased in 1992 due to lower interest rates. The Company's effective income tax rate differs from the statutory income tax rate due primarily to nondeductible amortization of intangible assets. Net income for 1991 was negatively impacted by an $18.3 million after-tax charge to record the estimated cost of product and facility consolidations associated with the planned restructuring of operations and a $1.5 million after-tax charge for the cumulative effect of the change in method of accounting for postretirement benefits other than pensions when Statement of Financial Accounting Standards No. 106 was adopted. LIQUIDITY AND CAPITAL RESOURCES During the three year period ended December 25, 1993, funds generated from operating activities totaled $117.2 million and funds raised through additional long-term debt amounted to $56.4 million. These cash flows funded the Company's operations, capital expenditures, and cash used in business acquisitions. Funds generated from operating activities (including $45 million from the sale of accounts receivables) were $60.2 million in 1993 and were supplemented by $16.5 million of additional senior indebtedness and $9.2 million (exclusive of insurance proceeds) from the disposal of assets. These funds financed, among other things, $38.8 million of capital expenditures (exclusive of storm and fire related expenditures), the retirement of $36.3 million of debt and expenses related to acquisitions, and dividend payments. On March 13, 1993 a severe winter storm damaged a substantial portion of Carriage's manufacturing facilities, and in August 1993, a fire destroyed Bretlin's Chatsworth, Georgia needlebond facility. Carriage and Bretlin have substantially completed the rebuilding of their damaged facilities. Expenditures to replace or repair damaged facilities, costs, and certain losses associated with the storm and fire were approximately $33.5 million in 1993. Both losses were covered by insurance. Through the end of 1993, insurance reimbursements of approximately $28.1 million had been received. Although the insurance recovery for the storm and fire damage has not been concluded, coverage continues to appear adequate. Capital expenditures were approximately 128% of depreciation and amortization expenses during the three year period ended December 25, 1993 and were directed toward upgrading equipment, improving quality, and providing for greater production efficiency and flexibility. Capital expenditures for 1994 are expected to be below the level of depreciation and amortization expenses and will be concentrated in the Company's floorcovering business. The Company acquired approximately 46% of the outstanding common stock of Carriage Industries, Inc. in 1992 for $27.4 million cash and acquired Carriage's remaining, publicly-held shares on March 12, 1993 in exchange for approximately 2.5 million shares of the Company Common Stock, options to purchase approximately .1 million shares of the Company's Common Stock, and approximately $.7 million cash. On July 9, 1993, the assets of Masland Carpets, Inc. were acquired in exchange for approximately 1.0 million shares of the Company's Common Stock, $1.1 million cash, and the assumption of approximately $.8 million of debt. The holders of the shares issued in the Masland acquisition have the right, after two years, to put the shares to the Company at a price of approximately $18 per share. In October 1993, the Company entered into a seven-year agreement to sell an undivided interest in a revolving pool of its trade accounts receivable. At December 25, 1993, a $45,000,000 interest had been sold under this agreement, and the sale is reflected as a reduction of accounts receivable. The cost of this program are based upon rating agencies' assessment of the quality of the receivables pool and the purchasers' level of investment and are fixed at 6.08% per annum plus administrative fees typical in such transactions. In addition, the Company is generally responsible for credit losses associated with sold receivables. At December 25, 1993, the Company's debt structure consisted of $44.8 million of convertible subordinated debentures, $ 50.0 million of subordinated notes, and $86.5 million of senior indebtedness, principally under a revolving credit and term loan agreement. The convertible subordinated debentures require mandatory sinking fund payments beginning in 1998. Payments are not required under the Company's subordinated notes until 2000. The revolving credit and term loan agreement provides revolving credit up to $125.0 million until September 30, 1995, at which time the outstanding balance, at the Company's election, may be converted into a term loan payable in semi-annual installments over five years. At year-end, the available unused borrowing capacity under the agreement was approximately $38.5 million. The Company's future liquidity requirements are expected to consist primarily of capital expenditures, seasonal working capital requirements, and funds necessary to finance the Company's expansion in the floorcovering business. These liquidity requirements are expected to be financed from operating cash flows, existing credit arrangements, issuance of capital stock, and public or private debt. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The supplementary financial information as required by Item 302 of Regulation S-K is included in PART II, ITEM 5 of this report and the remaining response is included in a separate section 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 section entitled "Information about Nominees for Directors" in the Proxy Statement of the registrant for the annual meeting of shareholders to be held May 5, 1994 is incorporated herein by reference. Information regarding the executive officers of the registrant is presented in Part I of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The section entitled "Executive Compensation Information" in the Proxy Statement of the registrant for the annual meeting of shareholders to be held May 5, 1994 is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The section entitled "Principal Shareholders", as well as the beneficial ownership table (and accompanying notes) from the section entitled "Information About Nominees for Directors" in the Proxy Statement of the registrant for the annual meeting of shareholders to be held May 5, 1994 is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The section entitled "Certain Transactions Between the Company and Directors and Officers" in the Proxy Statement of the registrant for the annual meeting of shareholders to be held May 5, 1994 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)-- The response to this portion of Item 14 is submitted as a separate section of this report. (3) Listing of Exhibits: (i) Exhibits Incorporated by Reference: (3a) Restated Charter of Dixie Yarns, Inc. (3b) Amended and Restated By-Laws of Dixie Yarns, Inc. (4a) Second Amended and Restated Revolving Credit and Term Loan Agreement dated January 31, 1992 by and among Dixie Yarns, Inc., and Trust Company Bank, NationsBank of North Carolina, N.A. and Chemical Bank. (4b) Loan Agreement dated February 6, 1990, between Dixie Yarn, Inc. and New York Life Insurance Company and New York Life Insurance and Annuity Corporation. (4c) Form of Indenture, Dated May 15, 1987 between Dixie Yarns, Inc. and Morgan Guaranty Trust Company of New York as trustee. (4d) Revolving Credit Loan Agreement dated as of September 16, 1991 by and among Ti-Caro, Inc. and Trust Company Bank, individually and as Agent, NCNB National Bank and Chemical Bank. (4e) First Amendment to Revolving Credit Loan Agreement dated as of August 19, 1992 by and among Ti-Caro, Inc., T-C Threads, Inc. and Trust Company Bank, individually and as agent, NCNB National Bank, and Chemical Bank. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - CONTINUED (3) Listing of Exhibits: (10a) Dixie Yarns, Inc. 1983 Incentive Stock Option Plan. (10b) Dixie Yarns, Inc. Incentive Stock Plan. (10c) Dixie Yarns, Inc. Nonqualified Defined Contribution Plan. (10d) Dixie Yarns, Inc. Nonqualified Employee Savings Plan. (10e) Dixie Yarns, Inc. Incentive Compensation Plan. (10f) Asset Transfer and Restructuring Agreement dated July 19, 1993, by and among Dixie Yarns, Inc., Masland Carpets, Inc., individual management investors of Masland Carpets, Inc., The Prudential Insurance Company of America and Pruco Life Insurance Company (10g) Assignment and Bill of Sale dated July 9, 1993, by and between Dixie Yarns, Inc. and Masland Carpets, Inc. (10h) Assignment and Assumption Agreement dated July 9, 1993, by and between Dixie Yarns, Inc. and Masland Carpets, Inc. (10i) Stock Rights and Restrictions Agreement dated July 9, 1993, by and among Dixie Yarns, Inc., Masland Carpets, Inc., The Prudential Insurance Company of America and Pruco Life Insurance Company of America. (10j) Pooling and Servicing Agreement dated as of October 15, 1993, among Dixie Yarns, Inc., Dixie Funding, Inc. and NationsBank of Virginia, N.A. (as Trustee). (10k) Annex X - Definitions, to Pooling and Servicing Agreement dated as of October 15, 1993, among Dixie Yarns, Inc., Dixie Funding, Inc. and NationsBank of Virginia, N.A. (as Trustee). (10l) Series 1993-1 Supplement, dated as of October 15, 1993, to Pooling and Servicing Agreement dated as of October 15, 1993, among Dixie Yarns, Inc., Dixie Funding Inc. and NationsBank of Virginia, N.A. (as Trustee). (10m) Certificate Purchase Agreement dated October 15, 1993, among Dixie Yarns, Inc., Dixie Funding, Inc. and New York Life Insurance and Annuity Corporation. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - CONTINUED (3) Listing of Exhibits --Continued (10n) Certificate Purchase Agreement dated October 15, 1993, among Dixie Yarns, Inc., Dixie Funding, Inc. and John Alden Life Insurance Company. (10o) Certificate Purchase Agreement dated October 15, 1993, among Dixie Yarns, Inc., Dixie Funding, Inc. and John Alden Life Insurance Company of New York. (10p) Certificate Purchase Agreement dated October 15, 1993, among Dixie Yarns, Inc., Dixie Funding, Inc. and Keyport Life Insurance Company. (10q) Executive Severance Agreement dated as of September 8, 1988 as amended. (ii) Exhibits filed with this report: (4f) First Amendment, dated August 25, 1993 to Second Amended and Restated Revolving Credit and Term Loan Agreement dated January 31, 1992, by and among Dixie Yarns, Inc. and Trust Company Bank, NationsBank of North Carolina, N.A. and Chemical Bank. (11) Statement Re: Computation of Earnings Per Share. (21) Subsidiaries of the Registrant. (23) Consent of Ernst & Young. (b) Reports on Form 8-K--The following reports on Form 8-K have been filed by the registrant during the last quarter of the period covered by this report: Current Report on Form 8-K, dated October 15, 1993 reporting the sale of an undivided interest in a revolving pool of its trade accounts receivable. (c) Exhibits--The response to this portion of Item 14 is submitted as a separate section of this report. See Item 14 (a) (3) (ii) above. (d) Financial Statement Schedules--The response to this portion of Item 14 is submitted as a separate section 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. DIXIE YARNS, INC. March 24, 1994 BY: /s/DANIEL K. FRIERSON Daniel K. Frierson, 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. Chairman of the Board, President, Director and /s/DANIEL K. FRIERSON Chief Executive Officer March 24, 1994 Daniel K. Frierson Corporate Vice-President, President of the Candlewick /s/PAUL K. FRIERSON Group and Director March 24, 1994 Paul K. Frierson /s/D. EUGENE LASATER Controller March 24, 1994 D. Eugene Lasater /s/GARY A. HARMON Treasurer March 24, 1994 Gary A. Harmon /s/PAUL K. BROCK Director March 24, 1994 Paul K. Brock SIGNATURES -- CONTINUED /s/LOVIC A. BROOKS, JR. Director March 24, 1994 Lovic A. Brooks, Jr. /s/J. FRANK HARRISON, JR. Director March 24, 1994 J. Frank Harrison, Jr. /s/JAMES H. MARTIN, JR. Director March 24, 1994 James H. Martin, Jr. /s/PETER L. SMITH Director March 24, 1994 Peter L. Smith /s/JOSEPH T. SPENCE, JR. Director March 24, 1994 Joseph T. Spence, Jr. /s/ROBERT J. SUDDERTH, JR. Director March 24, 1994 Robert J. Sudderth, Jr. ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14 (a)(1) AND (2) AND ITEM 14(d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENTS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 25, 1993 DIXIE YARNS, INC. CHATTANOOGA, TENNESSEE FORM 10-K--ITEM 14(a)(1) and (2) DIXIE YARNS, INC. AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Dixie Yarns, Inc. and subsidiaries are included in Item 8: Report of Independent Auditors Consolidated balance sheets--December 25, 1993 and December 26, 1992 Consolidated statements of income(loss)--Years ended December 25, 1993, December 26, 1992, and December 28, 1991 Consolidated statements of cash flows--Years ended December 25, 1993, December 26, 1992, and December 28, 1991. Consolidated statements of stockholders' equity--Years ended December 25, 1993, December 26, 1992, December 28, 1991 The following consolidated financial statement schedules of Dixie Yarns, Inc. and subsidiaries are included in Item 14(d): Schedule V--Property, plant and equipment Schedule VI--Accumulated depreciation, depletion, and amortization of property, plant and equipment Schedule VIII--Valuation and qualifying account 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, or the information is otherwise shown in the financial statements or notes thereto, and therefore have been omitted. Report of Independent Auditors Board of Directors Dixie Yarns, Inc. We have audited the accompanying consolidated balance sheets of Dixie Yarns, Inc. and subsidiaries as of December 25, 1993 and December 26, 1992, and the related consolidated statements of income (loss), stockholders' equity, and cash flows for each of the three years in the period ended December 25, 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 Dixie Yarns, Inc. and subsidiaries at December 25, 1993 and December 26, 1992, and the consolidated results of its operations and cash flows for each of the three years in the period ended December 25, 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 (H) to the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes. ERNST & YOUNG Chattanooga, Tennessee February 17, 1994 See notes to consolidated financial statements. DIXIE YARNS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts of Dixie Yarns, Inc. and its wholly-owned subsidiaries (the "Company"). Significant intercompany accounts and transactions have been eliminated in consolidation. Cash Equivalents: Highly liquid investments with original maturities of three months or less when purchased are reported as cash equivalents. Credit and Market Risk: The Company sells products primarily to manufacturers located throughout the United States who produce products for a wide variety of end users. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. An allowance for doubtful accounts is maintained at a level which management believes is sufficient to cover potential credit losses. The Company invests its excess cash in short- term investments and has not experienced any losses on those investments. Inventories: Substantially all inventories are stated at cost determined by the last-in, first-out (LIFO) method, which is less than market. Inventories are summarized as follows: 1993 1992 At current cost: Raw materials $ 25,274,771 $ 19,619,417 Work-in-process 24,602,923 15,662,366 Finished goods 62,664,139 41,338,244 Supplies, repair parts and other 9,792,498 10,329,674 122,334,331 86,949,701 Excess of current cost over LIFO value (16,524,443) (19,863,374) $105,809,888 $67,086,327 During 1993 and 1992, the reduction of certain inventory quantities resulted in liquidations of LIFO inventory quantities carried at lower costs prevailing in prior years. The effect of these reductions was to increase net income by approximately $350,000 ($.03 per share) and $506,000 ($.06 per share) for 1993 and 1992, respectively. Property, Plant and Equipment: Provision for depreciation and amortization of property, plant and equipment has been computed using the straight-line method for financial reporting purposes and in accordance with the applicable statutory recovery methods for tax purposes. Depreciation and amortization of property, plant and equipment for financial reporting purposes totaled $29,245,367 in 1993, $23,712,953 in 1992, and $22,847,307 in 1991. When events occur that change the extent or manner in which long-lived assets are used, such as a restructuring of the Company's operations, evidence of physical defects, or technological obsolescence, such impaired assets are written down to their estimated fair market value. If such assets are permanently taken out of service, they are no longer depreciated. DIXIE YARNS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Intangible Assets: The excess of the purchase price over the fair market value of identifiable net assets acquired in business combinations is being amortized using the straight-line method over 40 years. The carrying value of goodwill will be reviewed if the facts and circumstances suggest that it may be impaired. Impairment will be measured, and goodwill reduced, for any deficiency of estimated cash flows during the amortization period related to the business acquired. Income Taxes: The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," in 1993. See Note (H). Earnings per Share: Primary earnings per common and common equivalent share is computed using the weighted average number of shares of Common Stock outstanding and includes the effects of Class B Common Stock and the potentially dilutive effects of the exercise of stock options and the put option. Fully-diluted earnings per share reflects the maximum potential dilution of per share earnings which would have occurred assuming the exercise of stock options, the put option, and the conversion of subordinated debentures into shares of Common Stock. For 1993, 1992 and 1991, the additional dilution computed was less than 3%. Revenue recognition: The Company recognizes revenue at the time title passes to the customer. Postemployment Benefits: The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Postemployment Benefits," which requires, under certain conditions, the adoption of accrual accounting for postemployment benefits no later than 1994. The Company sponsors no such plans and the new standard is not expected to affect the Company's financial statements. Reclassifications: In order to conform to the 1993 presentation, certain operating group expenses for 1992 and 1991 which had previously been reported as cost of sales, were reclassified to selling, general and administrative expenses in the accompanying consolidated statements of income (loss). In addition, corporate expenses have been segregated from selling, general and administrative expenses. NOTE B - BUSINESS COMBINATIONS On September 4, 1992, the Company acquired approximately 46% of the outstanding shares of Carriage Industries, Inc. ("Carriage") for $27,400,446 cash ($13.25 per share plus expenses) and on March 12, 1993 acquired the remaining shares of Carriage. The Company issued 2,472,884 shares of its Common Stock, options to purchase 83,044 shares of its Common Stock, and approximately $661,000 cash in exchange for the remaining shares and options for shares of Carriage. The acquisition was accounted for as a purchase effective March 12, 1993, and accordingly, the results of operations and accounts of Carriage subsequent to March 12, 1993 are included in the Company's consolidated financial statements. The total purchase price of $63,685,083 (the Company's initial cash investment in Carriage, expenses of the acquisition, and the estimated fair value of the Company's Common Stock and options exchanged) was allocated to the net tangible assets of Carriage based on the estimated fair market values of the assets acquired. As required by the purchase method of accounting, the excess amount of the purchase price over the fair market value of Carriage's net tangible assets was recorded as an intangible asset and is being amortized using the straight-line method over 40 years. On July 9, 1993, the Company acquired the operating assets and liabilities of Masland Carpets, Inc. ("Masland") in exchange for 1,029,446 shares of the Company's Common Stock, approximately $1,100,000 cash, and the assumption of $750,000 of debt. The Common Stock was issued subject to an agreement which provides certain registration rights respecting the Common Stock, as well as the right, after two years, to put the shares to the Company at a price of $18.06 per share (reduced by dividends paid). The acquisition was accounted for as a purchase effective July 9, 1993, and accordingly, the results of operations and accounts of Masland subsequent to July 9, 1993 are included in the Company's consolidated financial statements. The total purchase price of $19,622,192 (cash paid, expenses of the acquisition, and estimated fair value of the Company's Common Stock issued subject to put option) was allocated to the net tangible assets of Masland based on the estimated fair market values of the assets acquired. A summary of net assets acquired is as follows: Carriage Masland Current assets $ 49,865,747 $ 16,316,797 Property, plant and equipment 53,440,710 11,748,152 Other assets 4,618,971 76,181 Current liabilities (26,802,995) (7,072,437) Long-term debt (27,222,687) (450,000) Other liabilities and deferred taxes (12,326,472) (1,553,215) Intangible asset 21,699,203 --- Net Assets Acquired Excluding Cash 63,272,477 19,065,478 Cash 412,606 556,714 Net Assets Acquired $63,685,083 $19,622,192 The following unaudited pro forma summary presents the consolidated results of operations as if the acquisitions of Carriage and Masland had occurred at the beginning of each period presented after giving effect to certain adjustments, including amortization of cost in excess of net tangible assets acquired, interest expense on debt to finance the acquisitions and related income taxes. The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results that would have occurred had the acquisitions occurred at the beginning of the periods presented or of results which may occur in the future. 1993 1992 Net sales $641,950,000 $637,680,000 Income from continuing operations 6,218,000 8,628,000 Net income (1) 6,218,000 4,099,000 Per common and common equivalent share: Income from continuing operations .49 .67 Net income (1) .49 .32 (1) Net income for the fiscal year ended December 26, 1992 includes losses of $3,537,000 after taxes ($.28 per share) on operations of and disposal of a Carriage segment held for sale and a loss of $992,000 after taxes ($.08 per share) to record the cumulative effect of the adoption of Statement of Financial Accounting Standards No. 106,"Employers Accounting for Postretirement Benefits Other than Pensions" by Masland. Prior to the merger, the Company's initial investment in Carriage was accounted for by the equity method. Accordingly, net income for 1993 and 1992 includes the Company's proportionate share of Carriage's earnings for periods prior to the merger of approximately $320,000 and $538,000 after taxes, respectively. Condensed unaudited historical financial information of Carriage at and for the twelve months ended December 27, 1992 and December 29, 1991 is summarized as follows: 1992 1991 Income statement information: Net sales $133,363,000 $105,976,000 Gross profit 36,096,000 24,936,000 Income from continuing operations 4,697,000 726,000 Net income 1,160,000 974,000 Balance sheet information: Current assets 41,920,000 --- Non-current assets 44,827,000 --- Current liabilities 18,811,000 --- Non-current liabilities 33,617,000 --- NOTE C --SALE OF ACCOUNTS RECEIVABLE In October 1993, the Company entered into a seven-year agreement to sell an undivided interest in a revolving pool of its trade accounts receivable. At December 25, 1993, a $45,000,000 interest had been sold under this agreement, reflected as a reduction of accounts receivable in the accompanying consolidated balance sheets. The costs of this program, which were approximately $570,000 in 1993, are based upon rating agencies' assessment of the quality of the receivables pool and the purchasers' level of investment and are fixed at 6.08% per annum plus administrative fees typical in such transactions. These costs are included in other expense. The Company maintains allowances for doubtful accounts at a level which management believes is sufficient to cover potential credit losses relating to trade accounts receivable, including receivables sold. NOTE D--ACCRUED EXPENSES Accrued expenses consists of the following: 1993 1992 Compensation and benefits $ 11,775,625 $ 9,156,692 Interest expense 2,632,072 2,486,885 Restructuring expense 487,376 3,641,046 Other 11,623,356 5,725,462 $ 26,518,429 $21,010,085 NOTE E--LONG-TERM DEBT AND CREDIT ARRANGEMENTS Long-term debt consists of the following: 1993 1992 Senior Debt: Credit line borrowings $ 86,500,000 $ 70,000,000 Other 1,596,700 23,800 88,096,700 70,023,800 Less current portion 446,829 1,300 87,649,871 70,022,500 Subordinated notes 50,000,000 50,000,000 Convertible subordinated debentures 44,782,000 44,782,000 $182,431,871 $164,804,500 The Company's revolving credit and term loan agreement provides for borrowings of up to $125,000,000 until September 30, 1995, at which time the outstanding balance, at the Company's election, may be converted into a term loan payable in semi-annual installments over five years. The Company may select from several interest rate options which effectively allow for borrowings at rates equal to or lower than the lender's prime rate. A commitment fee of 1/4% per annum is payable on the average daily unused balance of the revolving credit line. At December 25, 1993, the Company's unused borrowing capacity under the arrangement was approximately $38,500,000. The Company's subordinated notes are unsecured, bear interest of 9.96% payable semiannually, and are due in semiannual installments $2,381,000 beginning February 1, 2000. The convertible subordinated debentures bear interest of 7% payable semiannually and are due 2012. The debentures are convertible by the holder into shares of Common Stock of the Company at an effective conversion price of $32.20 per share, subject to adjustment under certain circumstances. The debentures are redeemable at the Company's option through May 15, 1997, in whole or in part, at prices ranging from 102.8% to 100.7% of their principal amount. Subsequent to that date the debentures may be redeemed at 100% of their principal amount. Mandatory sinking fund payments commencing May 15, 1998, will retire $2,500,000 principal amount of the debenture annually and approximately 70% of the debentures prior to maturity. The debentures are subordinated in right of payment to all other indebtedness of the Company. During 1991, the Company repurchased $2,218,000 face value of the debentures resulting in an extraordinary after-tax gain of $451,706 ($.05 per share). The Company's long-term debt and credit arrangements include restrictions relating to minimum net worth, debt to capital ratio, and other financial ratios. The agreements also limit the amount of cash dividends that may be paid. Retained earnings available for payment of dividends amounted to approximately $978,000 at December 25, 1993. Approximate maturities of long-term debt for each of the five years succeeding December 25, 1993, assuming conversion of amounts outstanding under the revolving credit arrangement to a term loan as discussed above, are $447,000 in 1994, $459,000 in 1995, $16,471,000 in 1996 $16,317,000 in 1997, and $18,818,000 in 1998. Interest payments in 1993, 1992, and 1991 were approximately $12,662,000, $11,077,000, and $11,947,000, respectively. NOTE F--FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts and estimated fair values of the Company's financial instruments are as follows: 1993 1992 Carrying Fair Carrying Fair Amount Value Amount Value Cash and cash equivalents $ 4,047,459 $ 4,047,459 $ 1,425,985 $ 1,425,985 Long-term debt (including current portion) 182,878,700 178,974,000 164,805,800 157,893,000 Common Stock, subject to put option 18,177,958 18,177,958 --- --- The carrying amounts of cash and cash equivalents approximate fair values due to the short-term maturity of these instruments. The fair values of the Company's long-term debt were estimated using discounted cash flow analysis based on incremental borrowing rates for similar types of borrowing arrangements and quoted market rates for public debt. The fair value of the Company's Common Stock, subject to put option, was based on current interest rates, future cash flows, and the quoted market prices of the Company's Common Stock. NOTE G--CAPITAL STOCK Holders of Class B Common Stock have the right to twenty votes per share on matters that are submitted to Shareholders for approval and to dividends in an amount not greater than dividends declared and paid on Common Stock. Class B Common Stock is restricted as to transferability; however, the Class B Common Stock may be converted into Common Stock on a one share for one share basis. The Company's Charter authorizes 200,000,000 shares of Class C Common Stock, $3 par value per share, and 16,000,000 shares of Preferred Stock. No shares of Class C Common Stock or Preferred Stock have been issued. Also see Note (B) NOTE H--INCOME TAXES In 1993, the Company adopted Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes," which requires the liability method of accounting for income taxes. The Company restated financial statements for periods subsequent to December 26, 1986, to reflect application of the new method. The effect of the change was to decrease income from continuing operations and net income for 1992 by approximately $200,000 ($.03 per share) and increase the loss from continuing operations and net loss for 1991 by approximately $200,000 ($.02 per share). The provision (benefit) for income tax on income (loss) from continuing operations consist of the following: 1993 1992 1991 Current Deferred Current Deferred Current Deferred Federal $ 21,000 $3,490,000 $1,209,000 $1,879,953 $492,000 $(11,501,838) State 547,000 278,000 248,000 143,235 205,000 (1,051,597) $ 568,000 $3,768,000 $1,457,000 $2,023,188 $697,000 $(12,553,435) Deferred income taxes reflects the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the tax bases of those assets and liabilities. Significant components of the Company's deferred tax liabilities and assets are as follows: Deferred Tax Liabilities 1993 1992 Property, plant and equipment $52,792,000 $41,419,000 Inventories 8,634,000 7,018,000 Other 404,000 1,235,000 Total deferred tax liabilities 61,830,000 49,672,000 Deferred Tax Assets Post-retirement benefits 4,073,000 95,000 Other employee benefits 3,925,000 3,169,000 Alternative minimum tax 3,361,000 1,871,000 Allowances for bad debts, claims and discounts 2,727,000 1,983,000 Restructuring 730,000 5,765,000 Other 1,737,000 810,000 Valuation reserve --- --- Total deferred tax assets 16,553,000 13,693,000 Net deferred tax liabilities $45,277,000 $35,979,000 Differences between the provision (benefit) for income taxes and the amount computed by applying the statutory federal income tax rate to income (loss) from continuing operations are reconciled as follows: 1993 1992 1991 Statutory rate applied to income (loss) from continuing operations $3,157,000 $ 3,042,000 $(12,721,000) Plus state income taxes net of federal tax provision (benefit) 536,000 258,000 (559,000) 3,693,000 3,300,000 $(13,280,000) Increase(decrease) attributable to: Non deductible amortization of intangible assets resulting from business combinations 559,000 423,000 423,000 (Gain) loss accounted for on equity method (96,000) (153,000) 1,457,000 Effect of Federal tax rate increase on deferred income taxes 500,000 --- --- Other items (320,000) (89,812) (456,435) 643,000 180,188 1,423,565 Total tax provision (benefit) $4,336,000 $3,480,188 $(11,856,435) Income tax payments, net of tax refunds received, in 1993, 1992, and 1991 were approximately $2,079,000, $1,024,000, and $5,066,000, respectively. NOTE I--RESTRUCTURING AND PLANT CLOSING COSTS In the fourth quarter of 1991, the Company developed and began implementation of a plan to restructure the Company's manufacturing facilities and support services areas and accrued associated costs of $28,276,000 ($18,271,000 or $2.08 per share after taxes). The plan included, among other things, production and machinery consolidations into fewer facilities, information systems conversions and personnel reductions. As of the end of 1993, the restructuring was substantially complete. Total costs incurred through 1993 consisted of approximately $13,533,000 to write- down certain assets to estimated fair market value, approximately $3,156,000 for severance payments, and approximately $11,100,000 for other direct costs, including product consolidations, equipment relocation, systems conversions, and other related expenses. NOTE J--STOCK PLANS The Company's 1990 Incentive Stock Plan reserves 770,000 shares of Common Stock for sale or award to key associates under stock options, stock appreciation rights, restricted stock performance grants, or other awards. Outstanding options are exercisable at a cumulative rate of 25% to 33 1/3% per year after the second year from the date the options are granted. Options outstanding were granted at prices at or above market price on the date of grant and include grants under the 1983 Incentive Stock Plan, under which no further options may be granted. At December 25, 1993, options to purchase 126,662 shares were exercisable under these plans. A summary of the option activity under the 1990 and 1983 Incentive Stock Plans is as follows: Number of Option Price Shares Per Share Outstanding at December 29, 1990 423,874 $ 4.58 - $33.83 Granted 35,000 13.00 - 13.50 Exercised (19,650) 4.58 - 6.42 Cancelled (56,600) 5.83 - 14.00 Outstanding at December 28, 1991 382,624 4.58 - 33.83 Granted 254,000 10.75 - 11.00 Exercised (27,800) 4.58 - 5.83 Cancelled (68,412) 10.75 - 33.83 Outstanding at December 26, 1992 540,412 5.83 - 30.75 Granted 197,000 12.50 - 15.25 Exercised (22,100) 5.83 Cancelled (87,400) 10.75 - 30.75 Outstanding at December 25, 1993 627,912 $10.75 - $30.75 The Company also has a stock purchase plan which authorizes 108,000 shares of Common Stock for purchase by supervisory associates at the market price prevailing at the time of purchase. At December 25, 1993, 65,940 shares remained available for issue. Shares sold under this plan are held in escrow until paid for and are subject to repurchase agreements which give the Company the right of first refusal at the prevailing market price. Numbers of shares sold under the plan were 12,700 in 1993, 1,800 in 1992, and 3,300 in 1991. The Company issued options for the purchase of 83,044 shares of Common Stock, which were immediately exercisable at prices ranging from $3.19 - $5.27 per share, in connection with the acquisition of Carriage. During 1993, options for 10,699 shares were exercised at prices ranging from $3.43 - $4.29 per share. At December 25, 1993, options for 72,345 shares at prices ranging from $3.19 - $5.27 per share remain exercisable. NOTE K--PENSION PLANS The Company has defined benefit and defined contribution pension plans which cover essentially all associates. Benefits for associates participating in the defined benefit plans are based on years of service and compensation during the period of participation. Plan assets consist primarily of cash equivalents and publicly traded stocks and bonds. The Company's practice is to fund defined benefit plans in accordance with minimum requirements of the Employee Retirement Income Security Act of 1974. Contributions and costs of the defined contribution plans are based on several factors including a percentage of each participant's compensation, the operating performance of the Company, and matching of participant contributions by the Company. Participants in the Company's largest defined benefit plan became eligible participants in a newly established 401(k) defined contribution plan effective in 1994. All accrued benefits under the defined benefit plan became fully vested and were frozen as of December 24, 1993. A portion of the liability of the defined benefit plan was settled through lump sum payments to electing associates. Losses incurred as a result of these settlements and the curtailment described above totaled $768,680 and $358,626 during 1993 and 1992, respectively. Settlement losses of $196,580 included in the 1993 amount were a direct result of the Company's restructuring plan and were charged to the restructuring reserve established in 1991. The net periodic pension cost included the following components: 1993 1992 1991 Defined benefit plans: Service cost $ 1,315,353 $ 1,446,829 $ 1,522,052 Interest cost 1,625,217 1,841,940 2,000,193 Actual return on plan assets (1,326,794) (1,227,989) (5,022,036) Other Components 153,850 (1,056,697) 2,777,701 1,767,626 1,004,083 1,277,910 Defined contribution plans 410,559 --- --- Net periodic pension expense $ 2,178,185 $ 1,004,083 $ 1,277,910 The following table sets forth the funded status of the Company's defined benefit retirement plans and related amounts included in the Company's consolidated balance sheets: 1993 1992 Actuarial present value of benefit obligations: Vested benefits $24,092,792 $14,753,954 Nonvested benefits 1,336 1,284,875 Accumulated benefit obligations $24,094,128 $16,038,829 Plan assets at fair value $16,138,289 $18,540,107 Projected benefit obligation (24,094,128) (17,902,255) Projected benefit obligation (in excess of) or less than plan assets (7,955,839) 637,852 Unrecognized net loss 8,764,390 2,918,403 Remaining unrecognized net transition asset (462,761) (995,762) Adjustment to recognize minimum liability (8,301,629) --- Pension related (liability) asset included in the consolidated balance sheets $(7,955,839) $ 2,560,493 In accordance with the provisions of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions," the Company has recorded an additional minimum liability at December 25, 1993 representing the excess of the accumulated benefit obligation over the fair value of plan assets and accrued pension costs. This additional liability reduced stockholders' equity by $4,981,943 (net of income tax benefit of $3,319,686). The increased liability in 1993 results primarily from decreasing the assumed discount rate used in determining the projected benefit obligation from 8.5% to 7.13%. The weighted average discount rate used in determining the projected benefit obligation was 7.13% for 1993, 8.5% for 1992, and 9% for 1991. There was no increase in future compensation levels assumed for 1993 (due to the freezing of benefits), and a 4% and 5% rate of increase was used for 1992 and 1991, respectively. The assumed long-term rate of return on plan assets was 8.5% for 1993 and 1992, and 9% for 1991. NOTE L--POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company and one of its subsidiaries provided medical, dental and life insurance coverage for retirees under postretirement benefit plans. The parent company provides medical and dental benefits until age 65 to early retirees who have met specified age and service requirements. It pays a portion of these costs for participants who retired prior to 1992 and also pays a portion of the life insurance premiums for a certain group of retirees. No new retirees may become eligible for the life insurance benefits. For measurement purposes, a 12% annual rate of increase in the per capita claims cost for the medical and dental plans was used for 1993, 1992, and 1991. The discount rate used to determine the accumulated postretirement benefit obligations was 7.5% for 1993, 8.5% for 1992, and 9% for 1991. During 1993, the Company settled a portion of its postretirement benefit obligation under the life insurance plan through the payment of lump- sum distributions made to beneficiaries of insured participants. Losses incurred as a result of these settlements totaled $73,049. A subsidiary also provides medical, dental and life insurance plans for all retired associates who have completed required service and age requirements. The subsidiary pays the full cost of these benefits for associates who retired prior to June 1992. Eligible retirees after this date pay a portion of these benefits at the equivalent rates under COBRA. The weighted-average annual assumed rates of increase in the per capita cost of covered medical and dental benefits is 15% and 12% in 1993 for pre-65 and post-65 benefits, respectively, gradually declining to 6% in 2005, and remaining at that level thereafter. The accumulated postretirement benefit obligations were determined using an 8% weighted average discount rate. The components of net periodic postretirement benefit cost are as follows: 1993 1992 1991 Medical Life Medical Life Medical Life and Dental Insurance and Dental Insurance and Dental Insurance Plans Plans Plans Plans Plans Plans Interest cost $107,295 $102,863 $103,719 $63,318 $112,076 $80,964 Service cost 17,766 1,641 --- --- --- --- Amortization of net loss --- 8,942 --- --- --- --- Settlement losses --- 73,049 --- --- --- --- Net periodic postretirement benefit cost $125,061 $186,495 $103,719 $63,318 $112,076 $80,964 The following table sets forth the funded status of the Company's defined benefit retirement plans and related amounts included in the Company's consolidated balance sheets: 1993 1992 Life Life Medical Insurance Medical Insurance Plans Plans Plans Plans Accumulated postretirement benefit obligations: Retirees $(1,564,521) $(1,400,126) $(865,400) $(1,141,876) Active participants (476,711) (69,941) --- --- (2,041,232) (1,470,067) (865,400) (1,141,876) Plan assets --- --- --- --- Accumulated postretirement benefit obligation in excess of plan assets (2,041,232) (1,470,067) (865,400) (1,141,876) Unrecognized net actuarial loss due to past experience different from assumptions made 151,957 431,861 --- 318,645 Accrued postretirement benefit liability included in the consolidated balance sheet $(1,889,275) $(1,038,206) $(865,400) $ (823,231) The assumed rate used to measure the per capita claims cost can have a significant effect on the amounts reported. Increasing the assumed rate by one percentage point in each year would increase the accumulated postretirement benefit obligation and net periodic postretirement benefit cost by approximately $170,000 and $14,000, respectively. NOTE M --STORM AND FIRE DAMAGE On March 13, 1993, a severe winter storm substantially damaged Carriage's manufacturing facilities, including machinery. On August 4, 1993, a fire destroyed Carriage's Bretlin needlebond facility. Both losses were covered by insurance and the total insurance benefits recognized during 1993 were $33,500,000, including approximately $5,400,000 accrued as a receivable. The Company spent approximately $17,900,000 in 1993 to replace and repair capital assets which had been destroyed or damaged. Insurance proceeds in excess of the net book value of destroyed assets and the repair costs of damaged assets were approximately $13,400,000 and are reflected in the financial statements as other income ($1,800,000) and a reduction to cost of sales ($11,600,000) to offset extra expenses and losses incurred as a result of the storm and fire. The insurance claims have not been concluded. NOTE N--COMMITMENTS The Company had outstanding commitments for purchases of machinery and equipment of approximately $11,686,000 at December 25, 1993. NOTE O --INDUSTRY SEGMENT INFORMATION The Company operates in two industry segments: textile products and floorcovering. Textile products include yarns, industrial sewing threads and knit fabrics. Floorcovering includes carpet for manufactured housing, recreational vehicles, high-end residential and commercial markets, rugs and yarns. Prior to the acquisitions of Carriage and Masland in 1993, the Company's single line of business, textile products, included the Company's Candlewick sales yarn operations serving the broadloom and rug manufacturing markets. With the expansion into production and sales of finished floorcovering products through the Carriage and Masland acquisitions, the operations of Candlewick are now included in the floorcovering segment. Accordingly, a restatement of the Company's financial information, by segment, is reflected for the periods presented in the consolidated financial statements. (dollar amounts in thousands) Net Sales Operating Profit(Loss)(1) 1993 1992 1991 1993 1992 1991 Business Segments Textile products $332,059 $347,802 $370,825 $ 1,629 $15,352 $(14,631) Floorcovering 263,899 123,107 122,273 24,424 7,913 1,416 Intersegment elimination (1,357) (1,077) (1,146) --- --- --- Total $594,601 $469,832 $491,952 26,053 23,265 (13,215) Interest expense 12,773 10,824 12,180 Corporate expenses 5,159 5,600 11,448 Other income (expense)-net(1) 899 2,107 (571) Income (loss) before income taxes $ 9,020 $ 8,948 $(37,414) Identifiable Capital Assets at Year End Expenditures 1993 1992 1991 1993 1992 1991 Business Segments Textile products $306,076 $310,594 $311,039 $27,504 $24,072 $34,109 Floorcovering 181,663 73,973 47,332 10,316 1,854 3,475 Corporate 8,840 12,513 14,436 1,005 398 722 Total $496,579 $397,080 $372,807 $38,825 $26,324 $38,306 Depreciation and Amortization 1993 1992 1991 Business Segments Textile products $20,531 $19,851 $18,109 Floorcovering 8,051 3,189 3,312 Corporate 663 673 1,426 Total $29,245 $23,713 $22,847 (1) Net gains (losses) included in operating profit (loss) on a segment basis but classified in "other income (expense) - net" in the Company's Consolidated Statements of Income (Loss) are as follows: 1993 - $1,741; 1992 - $(1,851); 1991-$(920). Operating loss for 1991 includes restructuring costs as follows: Textile products - $23,306; Floorcovering - $ 1,222; Corporate - $3,748. SCHEDULE X-SUPPLEMENTARY INCOME STATEMENT INFORMATION DIXIE YARNS, INC. AND SUBSIDIARIES COL. A COL. B ITEM Charged to Costs and Expenses Year Ended December 25, December 26, December 28, 1993 1992 1991 Maintenance and repairs $27,010,840 $23,209,089 $24,945,876 Amounts for depreciation and amortization of intangible assets, preoperating costs and similar deferrals; taxes, other than payroll and income taxes; royalties and advertising costs are not presented as such amounts are less than 1% of total sales and revenues. ANNUAL REPORT ON FORM 10-K ITEM 14 (c) EXHIBITS YEAR ENDED DECEMBER 25, 1993 DIXIE YARNS, INC. CHATTANOOGA, TENNESSEE Exhibit Index EXHIBIT NO. EXHIBIT DESCRIPTION INCORPORATION BY REFERENCE (3a) Restated Charter of Dixie Incorporated by reference to Yarns, Inc. Exhibit (3a) to Dixie's Annual Report on Form 10-K for the year ended December 30, 1989.* (3b) Amended and Restated By- Incorporated by reference to Laws of Dixie Yarns, Inc. Exhibits (3b) and (3c) to Dixie's Annual Report on Form 10-K for the year ended December 29, 1990.* (4a) Second Amended and Restated Incorporated by reference to Revolving Credit and Term Exhibit (4a) to Dixie's Annual Loan Agreement, dated Report on Form 10-K for the January 31, 1992, by and year ended December 28, 1991.* among Dixie Yarns, Inc. and Trust Company Bank, NationsBank of North Carolina, N.A. and Chemical Bank. (4b) Loan Agreement, dated Incorporated by reference to February 6, 1990 between Exhibit (4d) to Dixie's Annual Dixie Yarns, Inc. and New Report on Form 10-K for the York Life Insurance Company year ended December 30, 1989.* and New York Life Annuity Corporation. (4c) Form of Indenture, dated Incorporated by reference to May 15, 1987 between Dixie Exhibit 4.2 to Amendment No. 1 Yarns, Inc. and Morgan of Dixie's Registration Guaranty Trust Company of Statement No. 33-140 78 on Form New York as Trustee. S-3, dated May 19, 1987. * Commission File No. 0-2585 Exhibit Index - Continued EXHIBIT NO. EXHIBIT DESCRIPTION INCORPORATION BY REFERENCE (4d) Revolving Credit Loan Incorporated by reference to Agreement dated as of Exhibit (4d) to Dixie's Annual September 16, 1991 by Report on Form 10-K for the and among Ti-Caro, Inc. and year ended December 28, 1991.* Trust Company Bank, individually and as agent, NCNB National Bank, and Chemical Bank. (4e) First Amendment to Revolving Incorporated by reference to Credit Loan Agreement dated Exhibit 4(e) to Dixie's Annual as of August 19, 1992 by and Report on form 10-K for the among Ti-Caro, Inc., T-C year ended December 26, 1992.* Threads, Inc. and Trust Company Bank, individually and as agent, NCNB National Bank, and Chemical Bank. (4f) First Amendment, dated Filed herewith August 25, 1993 to Second Amended and Restated Revolving Credit and Term Loan Agreement dated January 31, 1992, by and among Dixie Yarns, Inc. and Trust Company Bank, NationsBank of North Carolina, N.A. and Chemical Bank. (10a) Dixie Yarns, Inc. 1983 Incorporated by reference to Incentive Stock Option Exhibit (10c) to Dixie's Annual Plan. Report on Form 10-K for the year ended December 28, 1985.* (10b) Dixie Yarns, Inc. Incentive Incorporated by reference to Stock Plan. Exhibit (10) to Dixie's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990.* (10c) Dixie Yarns, Inc. Nonquali- Incorporated by reference to fied Defined Contribution Exhibit (10c) to Dixie's Annual Plan. Report on form 10-K for the year ended December 26, 1992.* (10d) Dixie Yarns, Inc. Nonquali- Incorporated by reference to fied Employee Savings Plan. Exhibit (10d) to Dixie's Annual Report on form 10-K for the year ended December 26, 1992.* * Commission File No. 0-2585 Exhibit Index - Continued EXHIBIT NO. EXHIBIT DESCRIPTION INCORPORATION BY REFERENCE (10e) Dixie Yarns, Inc. Incentive Incorporated by reference to Compensation Plan. Exhibit (10e) to Dixie's Annual Report on form 10-K for the year ended December 26, 1992.* (10f) Asset Transfer and Restruc- Incorporated by reference to turing Agreement dated Exhibit (2a) to Dixie's Current July 9, 1993, by and among Report on Form 8-K dated Dixie Yarns, Inc., Masland July 9, 1993.* Carpets, Inc., individual management investors of Masland Carpets, Inc., The Prudential Insurance Company of America and Pruco Life Insurance Company. (10g) Assignment and Bill of Sale Incorporated by reference to dated July 9, 1993, by and Exhibit (2b) to Dixie's Current between Dixie Yarns, Inc. Report on Form 8-K dated July 9, and Masland Carpets, Inc. 1993.* (10h) Assignment and Assumption Incorporated by reference to Agreement dated July 9, 1993, Exhibit (2c) to Dixie's Current by and between Dixie Yarns, Report on Form 8-K dated July 9, Inc. and Masland Carpets, 1993.* Inc. (10i) Stock Rights and Restrictions Incorporated by reference to Agreement dated July 9, 1993, Exhibit (2d) to Dixie's Current by and among Dixie Yarns, Report on Form 8-K dated July 9, Inc., Masland Carpets, Inc., 1993.* The Prudential Insurance Company of America and Pruco Life Insurance Company. (10j) Pooling and Servicing Incorporated by reference to Agreement dated as of Exhibit (2a) to Dixie's October 15, 1993, among Current Report on Form 8-K Dixie Yarns, Inc., Dixie dated October 15, 1993.* Funding, Inc. and NationsBank of Virginia, N.A. (as Trustee). * Commission File No. 0-2585 Exhibit Index - Continued EXHIBIT NO. EXHIBIT DESCRIPTION INCORPORATION BY REFERENCE (10k) Annex X - Definitions, to Incorporated by reference to Pooling and Servicing Exhibit (2b) to Dixie's Agreement dated as of Current Report on Form 8-K October 15, 1993, among dated October 15, 1993.* Dixie Yarns, Inc., Dixie Funding, Inc. and NationsBank of Virginia, N.A. (as Trustee). (10l) Series 1993-1 Supplement, Incorporated by reference to dated as of October 15, Exhibit (2c) to Dixie's 1993, to Pooling and Current Report on Form 8-K Servicing Agreement dated as dated October 15, 1993.* of October 15, 1993, among Dixie Yarns, Inc., Dixie Funding, Inc. and NationsBank of Virginia, N.A. (as Trustee). (10m) Certificate Purchase Incorporated by reference to Agreement dated October 15, Exhibit (2d) to Dixie's 1993, among Dixie Yarns, Current Report on Form 8-K Inc., Dixie Funding, Inc. dated October 15, 1993.* and New York Life Insurance and Annuity Corporation. (10n) Certificate Purchase Incorporated by reference to Agreement dated October 15, Exhibit (2e) to Dixie's 1993, among Dixie Yarns, Current Report on Form 8-K Inc., Dixie Funding, Inc. dated October 15, 1993.* and John Alden Life Insurance Company. (10o) Certificate Purchase Incorporated by reference to Agreement dated October 15, Exhibit (2f) to Dixie's 1993, among Dixie Yarns, Current Report on Form 8-K Inc., Dixie Funding, Inc. dated October 15, 1993.* and John Alden Life Insurance Company of New York. (10p) Certificate Purchase Incorporated by reference to Agreement dated October 15, Exhibit (2g) to Dixie's 1993, among Dixie Yarns, Current Report on Form 8-K Inc., Dixie Funding, Inc. dated October 15, 1993.* and Keyport Life Insurance Company. * Commission File No. 0-2585 Exhibit Index - Continued EXHIBIT NO. EXHIBIT DESCRIPTION INCORPORATION BY REFERENCE (10q) Executive Severance Incorporated by reference to Agreement dated as of Exhibit (19) to Dixie's Quarterly September 8, 1988 as Report on Form 10-Q for the amended. quarter ended March 27,1993.* (11) Statement re: Computation Filed herewith. of Earnings Per Share. (21) Subsidiaries of the Filed herewith. Registrant. (23) Consent of Ernst & Young. Filed herewith. *Commission File No. 0-2585

88128_1993.txt

88128_1993

1993

88128

Item 3. Legal Proceedings. In December 1993, a Consent Decree was entered in the U. S. District Court in Jacksonville, Florida to settle claims of Federal Clean Water Act violations alleged against CSXT. The Consent Decree resolves a civil enforcement action initiated in June, 1992, by the U.S. Environmental Protection Agency with respect to alleged violations by CSXT of permit discharge limitations at five rail yard waste water treatment facilities in Florida and North Carolina. The settlement called for a civil penalty of $3 million, which has been paid by CSXT, as well as the establishment of an escrow account in the amount of $4 million to fund certain environmentally beneficial projects. See Note 12 to the Consolidated Financial Statements, Contingent Liabilities and Long-Term Operating Agreements, on pages 32 and 33. - 6 - Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Information omitted in accordance with General Instruction J(2)(c). PART II Item 5. Item 5. Market for Registrant's Common Stock and Related Stockholder Matters. There is no market for CSXT's common stock as CSXT is a wholly- owned subsidiary of CSX. During the years 1993, 1992 and 1991, CSXT paid dividends on its common stock aggregating $28 million, $74 million and $120 million, respectively. Item 6. Item 6. Selected Financial Data. Information omitted in accordance with General Instruction J(2)(a). However, included as part of "Management's Narrative Analysis and Results of Operations" on page 35 is various selected financial and statistical information. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Information omitted in accordance with General Instruction J(2)(a). However, in compliance with said Instruction, see "Management's Narrative Analysis and Results of Operations" on pages 35 through 41. Item 8. Item 8. Financial Statements and Supplementary Data. The consolidated financial statements of CSXT and notes thereto required in response to this item are included herein (refer to Index to Financial Statements on page 10). Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. - 7 - PART III Item 10. Item 10. Directors, Executive Officers, Promoters and Control Persons of the Registrant. Information omitted in accordance with General Instruction J(2)(c). Item 11. Item 11. Executive Compensation. Information omitted in accordance with General Instruction J(2)(c). Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Information omitted in accordance with General Instruction J(2)(c). Item 13. Item 13. Certain Relationships and Related Transactions. Information omitted in accordance with General Instruction J(2)(c). PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements. See Index to Financial Statements on page 10. 2. Financial Statement Schedules. None. 3. Exhibits. (3.1) Articles of Incorporation, as amended, incorporated herein by reference to Registrant's report on Form 10-K for the year ended December 31, 1987. (3.2) By-laws of the Registrant, incorporated herein by reference to Registrant's report on Form 10-K for the year ended December 31, 1992. (b) Reports on Form 8-K. None. - 8 - 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 11th day of March, 1994. CSX TRANSPORTATION, INC. /s/ GREGORY R. WEBER ------------------------------ Gregory R. Weber (Principal 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. Signatures Title - ----------------------- ------------------------------------- /s/ John W. Snow Chairman of the Board and Director - ----------------- John W. Snow* /s/ Alvin R. Carpenter President and Chief Executive Officer - ----------------------- (Principal Executive Officer) and Alvin R. Carpenter* Director /s/ Jerry R. Davis Executive Vice-President and Chief - ------------------- Operating Officer and Director Jerry R. Davis* /s/ Mark G. Aron Director - ----------------- Mark G. Aron* /s/ James Ermer Director - ---------------- James Ermer* /s/ Paul R. Goodwin Senior Vice President - Finance - -------------------- (Principal Finance Officer) Paul R. Goodwin* /s/ PATRICIA J. AFTOORA - ----------------------- *Patricia J. Aftoora (Attorney-in-Fact) March 11, 1994 - 9 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES Index to Consolidated Financial Statements Page ---- Report of Independent Auditors 11 CSX Transportation, Inc. and Subsidiaries: Consolidated Financial Statements and Notes to Consolidated Financial Statements Submitted Herewith: Consolidated Statement of Earnings - Years Ended December 31, 1993, 1992 and 1991 12 Consolidated Statement of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 13 Consolidated Statement of Financial Position - December 31, 1993 and 1992 15 Consolidated Statement of Retained Earnings - Years Ended December 31, 1993, 1992 and 1991 16 Notes to Consolidated Financial Statements 17 All schedules are omitted because of the absence of the conditions under which they are required or because the required information is set forth in the financial statements or related notes thereto. - 10 - REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS --------------------------------------------- To the Shareholder and Board of Directors of CSX Transportation, Inc. We have audited the accompanying consolidated statement of financial position of CSX Transportation, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings 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 (appearing on pages 12-34) present fairly, in all material respects, the consolidated financial position of CSX Transportation, 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. As discussed in Notes 1 and 11 to the consolidated financial statements, CSXT changed its method of accounting for post-retirement benefits other than pensions in 1991. /s/ ERNST & YOUNG ----------------- Ernst & Young Richmond, Virginia January 28, 1994 - 11 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS (Millions of Dollars) Year Ended December 31, -------------------------------- 1993 1992 1991 ------- ------- ------- OPERATING REVENUE Merchandise $ 2,909 $ 2,770 $ 2,634 Coal 1,363 1,565 1,573 Other 108 99 129 ------- ------- ------- Transportation 4,380 4,434 4,336 Non-Transportation 64 74 88 ------- ------- ------- Total 4,444 4,508 4,424 ------- ------- ------- OPERATING EXPENSE Labor and Fringe Benefits 1,809 1,830 1,849 Materials, Supplies and Other 1,011 973 1,026 Equipment Rent 387 383 376 Depreciation 371 354 344 Fuel 253 262 271 Productivity Charge --- 664 647 ------- ------- ------- Transportation 3,831 4,466 4,513 Non-Transportation 22 20 20 ------- ------- ------- Total 3,853 4,486 4,533 ------- ------- ------- OPERATING INCOME (LOSS) 591 22 (109) Other Income 11 1 20 Interest Expense 60 73 87 ------- ------- ------- EARNINGS (LOSS) BEFORE INCOME TAXES 542 (50) (176) Income Tax Expense (Benefit) 234 (33) (71) ------- ------- ------- EARNINGS (LOSS) BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING 308 (17) (105) Cumulative Effect on Years Prior to 1991 of Change in Accounting for Post- retirement Benefits Other than Pensions --- --- (159) ------- ------- ------- NET EARNINGS (LOSS) $ 308 $ (17) $ (264) ======= ======= ======= See accompanying Notes to Consolidated Financial Statements. - 12 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Millions of Dollars) Year Ended December 31, -------------------------- 1993 1992 1991 ------- ------- ------- OPERATING ACTIVITIES Net Earnings (Loss) $ 308 $ (17) $ (264) Adjustments to Reconcile Earnings (Loss) to Cash Provided Depreciation 371 354 344 Deferred Income Taxes (Benefits) 183 (52) (152) Productivity Charge - Provision --- 664 647 - Payments (245) (353) (72) Cumulative Effect of Change in Accounting --- --- 159 Proceeds from Real Estate Sales 28 41 41 Gain on Sale of Investments (26) --- (39) Gain on Sale of South Florida Track (20) (7) (7) Gain from Disposition of Properties (25) (38) (32) Other Operating Activities 12 (31) (38) Changes in Operating Assets and Liabilities Accounts Receivable 27 30 60 Sale of Accounts Receivable-Net 6 200 --- Materials and Supplies (4) 10 43 Other Current Assets 22 20 (9) Accounts Payable and Other Current Liabilities (7) (96) (156) ------- ------- ------- Cash Provided by Operating Activities 630 725 525 ------- ------- ------- INVESTING ACTIVITIES Property Additions (569) (539) (563) Proceeds from Sale-Leaseback Transactions --- --- 117 Acquisition and Reconstruction Costs for Sale-Leaseback Transactions --- --- (80) Proceeds from Property Dispositions 36 41 53 Proceeds from Sale of Investments 26 --- 106 Proceeds from Sale of South Florida Track 26 10 9 Other Investing Activities 3 (18) (37) ------- ------- ------- Cash Used by Investing Activities (478) (506) (395) ------- ------- ------- - 13 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS, CONTINUED (Millions of Dollars) Year Ended December 31, -------------------------- 1993 1992 1991 ------- ------- ------- FINANCING ACTIVITIES Long-Term Debt Issued 80 148 79 Long-Term Debt Repaid (160) (213) (135) Cash Dividends Paid (28) (74) (120) Affiliated Company Activity (18) (123) 82 Other Financing Activities (2) 4 8 ------- ------- ------- Cash Used by Financing Activities (128) (258) (86) ------- ------- ------- CASH AND CASH EQUIVALENTS Increase (Decrease) in Cash and Cash Equivalents 24 (39) 44 Cash and Cash Equivalents at Beginning of Year 248 287 243 ------- ------- ------- Cash and Cash Equivalents at End of Year $ 272 $ 248 $ 287 ======= ======= ======= See accompanying Notes to Consolidated Financial Statements. - 14 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF FINANCIAL POSITION (Millions of Dollars) December 31, --------------------- 1993 1992 ------ ------ ASSETS Current Assets Cash and Cash Equivalents $ 272 $ 248 Accounts and Notes Receivable 98 83 Materials and Supplies 116 112 Deferred Income Taxes 103 --- Other Current Assets 43 63 ------ ------ Total Current Assets 632 506 ------ ------ Properties and Other Assets Properties-Net 8,631 8,463 Affiliates and Other Companies 155 169 Other Assets 235 337 ------ ------ Total Properties and Other Assets 9,021 8,969 ------ ------ Total Assets $9,653 $9,475 ====== ====== LIABILITIES Current Liabilities Accounts Payable and Other Current Liabilities $1,111 $1,280 Current Maturities of Long-Term Debt 87 114 Due to Parent Company 40 43 ------ ------ Total Current Liabilities 1,238 1,437 ------ ------ Long-Term Debt 593 646 ------ ------ Due to Parent Company 69 86 ------ ------ Deferred Income Taxes 1,937 1,649 ------ ------ Long-Term Liabilities and Deferred Gains 1,631 1,754 ------ ------ SHAREHOLDER'S EQUITY Common Stock, $20 Par Value; Authorized 10,000,000 Shares; 9,061,038 Shares Issued and Outstanding 181 181 Other Capital 1,047 1,047 Retained Earnings 2,957 2,675 ------ ------ Total Shareholder's Equity 4,185 3,903 ------ ------ Total Liabilities and Shareholder's Equity $9,653 $9,475 ====== ====== See accompanying Notes to Consolidated Financial Statements. - 15 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF RETAINED EARNINGS (Millions of Dollars) 1993 1992 1991 ------ ------ ------ BALANCE - JANUARY 1 $2,675 $2,764 $3,152 Net Earnings (Loss) 308 (17) (264) Dividends - Common (28) (74) (120) Minimum Pension Liability Adjustments and Other 2 2 (4) ------ ------ ------ BALANCE - DECEMBER 31 $2,957 $2,675 $2,764 ====== ====== ====== See accompanying Notes to Consolidated Financial Statements. - 16 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (All Tables in Millions of Dollars) NOTE 1. SIGNIFICANT ACCOUNTING POLICIES. Principles of Consolidation The Consolidated Financial Statements reflect the results of operations, cash flows and financial position of CSXT and its majority-owned subsidiaries as a single entity. All significant intercompany accounts and transactions have been eliminated. CSXT is a wholly-owned subsidiary of CSX Corporation (CSX). Investments in companies that are not majority-owned are carried at either cost or equity, depending on the extent of control. Cash and Cash Equivalents Cash and cash equivalents primarily represent amounts due from CSX for CSXT's participation in the CSX cash management plan and are net of outstanding checks which are funded daily as presented for payment. Accounts Receivable CSXT has an ongoing agreement to sell without recourse, on a revolving basis each month, an undivided percentage ownership interest in all freight accounts receivable to CSX Trade Receivable Corporation (CTRC), a wholly-owned subsidiary of CSX. At December 31, 1993 and 1992, accounts receivable sold under this agreement totaled $556 million and $600 million, respectively. In addition, CSXT has an agreement to sell with recourse on a monthly basis, an undivided ownership interest in all miscellaneous accounts receivable to a financial institution. At December 31, 1993, accounts receivable sold under this agreement totaled $50 million. Materials and Supplies Materials and supplies are carried at average cost. - 17 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 1. SIGNIFICANT ACCOUNTING POLICIES, Continued Properties Properties are carried principally at cost. Provisions for depreciation are based on estimated useful service lives of seven to 42 years, computed primarily on the straight-line composite method. Under this method, gains and losses on ordinary dispositions are recorded to accumulated depreciation. Post-retirement Benefits Other Than Pensions CSXT has adopted SFAS No. 106, "Employers' Accounting for Post-retirement Benefits Other than Pensions." Under the accrual method specified by SFAS No. 106, the total future cost of providing other post-retirement employment benefits (OPEBs) is estimated and recognized as expense over the employees' requisite service period. Fair Values of Financial Instruments The following methods and assumptions were used by CSXT in estimating fair values for financial instruments as required by SFAS No. 107, "Disclosures about Fair Value of Financial Instruments": Current Assets and Current Liabilities The carrying amounts reported in the statement of financial position for current assets and current liabilities qualifying as financial instruments approximate their fair values. Long-Term Debt The fair values of CSXT's long-term debt have been based upon market quotations for similar debt instruments or have been estimated using discounted cash flow analyses based upon CSXT's current incremental borrowing rates for similar types of borrowing arrangements. Currently, CSXT has no short-term debt arrangements. CSXT's remaining financial instruments at December 31, 1993, are not significant. Environmental Costs Environmental costs that relate to current operations are expensed or capitalized as appropriate. Expenditures that relate to remediating an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. Liabilities are recorded when CSXT's responsibility for environmental remedial efforts is deemed probable, and the costs can be reasonably estimated. Generally, the timing of these accruals coincides with the completion of a feasibility study or CSXT's commitment to a formal plan of action. The recorded liabilities for estimated future environmental costs at December 31, 1993, 1992 and 1991, were $131 million, $77 million and $81 million, respectively. - 18 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 1. SIGNIFICANT ACCOUNTING POLICIES, Continued Common Stock and Other Capital There have been no changes in common stock during the last three years. Prior Year Data Certain prior-year data have been reclassified to conform to the 1993 presentation. NOTE 2. PRODUCTIVITY CHARGES. In the fourth quarter of 1991, CSXT recorded a pretax charge to provide for the estimated costs of implementing work force reductions, improvements in productivity and other cost reductions. The charge amounted to $647 million on a pretax basis and reduced 1991 net earnings by $409 million. In the second quarter of 1992, CSXT recorded a charge principally to recognize the estimated additional costs of buying out certain trip-based compensation elements paid to train crew employees. The additional pretax charge amounted to $664 million and reduced net earnings for 1992 by $427 million. The $1.3 billion in combined charges includes $1.2 billion for reductions from three to two member train crews and for buying out productivity funds and short-crew allowances. CSXT has reached labor agreements across virtually all of its rail system allowing it to operate trains with two-member crews. The estimated cost based on the ratified labor agreements with the United Transportation Union members is approximately 93% of the amount initially provided. As of December 31, 1993, payments totaling $518 million have been recorded as a reduction of the aggregate liabilities for the productivity charges. The remaining liability consists of $604 million for employee separations and associated costs and $189 million for claims, litigation and other negotiated settlements. - 19 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 3. SUPPLEMENTAL STATEMENT OF EARNINGS FINANCIAL DATA. 1993 1992 1991 ------ ------ ------ Maintenance and Repair Expense $987 $994 $1,015 ==== ==== ====== Selling, General and Administrative Expense (a) $802 $673 $ 687 ==== ==== ====== Taxes Other Than Income and Payroll Taxes $ 79 $ 75 $ 68 ==== ==== ====== (a) Selling, general and administrative expense during 1993 increased $129 million over 1992 primarily due to an increase in the management service fee charged by CSX and increases in certain employee related incentive costs. NOTE 4. OTHER INCOME (EXPENSE). 1993 1992 1991 ---- ---- ---- Interest Income - Other $ 16 $ 18 $ 21 - CSX 12 9 9 Gain on Sale of RF&P Corporation Stock (a) --- --- 39 Gain on Sale of Investment 26 --- --- Gain on Sale of South Florida Track (b) 20 7 7 Fees on Sale of Accounts Receivable (44) (17) (32) Miscellaneous (19) (16) (24) ---- ---- ---- Total $ 11 $ 1 $ 20 ==== ==== ==== (a) In a series of transactions consummated in October 1991, CSXT exchanged its 6.8 million shares of RF&P Corporation (RF&P) stock for the rail assets of RF&P and $106 million in cash. These transactions resulted in a pretax gain of $39 million, before associated minority interest expense of $5 million. (b) In May 1988, CSXT sold approximately 80 miles of track and right of way in Broward, Dade and Palm Beach counties to the state of Florida for $264 million. The sale, which is being recognized on the installment basis, resulted in cash proceeds of $75 million, a pretax gain of $59 million and an after-tax gain of $37 million. The remaining proceeds of $189 million, which were received in the form of an installment mortgage note, are subject to annual legislative appropriations. The deferred installment gain of $148 million will be recognized each year through 1997 as scheduled payments are received. At December 31, 1993 and 1992, the long-term portion of the mortgage note receivable totaled $102 and $130 million, respectively, and was included in other assets in the consolidated statement of financial position. - 20 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 5. INCOME TAXES. Effective January 1, 1993, CSXT adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." SFAS No. 109 superseded SFAS No. 96, "Accounting for Income Taxes," which CSXT adopted effective January 1, 1987. SFAS No. 109 requires that deferred income tax assets and liabilities be classified as current or non-current based upon the classification of the related asset or liability for financial reporting. Net earnings for 1993 were not impacted by the adoption of SFAS No. 109. As permitted under the new rules, prior-year financial statements have not been restated. Income tax expense (benefit) information is as follows: 1993 1992 1991 ------- ------- ------- Current Federal $ 47 $ 17 $ 66 State and Foreign 4 2 15 ---- ---- ---- Total Current 51 19 81 ---- ---- ---- Deferred Federal 166 (48) (122) State 17 (4) (30) ---- ---- ---- Total Deferred 183 (52) (152) ---- ---- ---- Total Expense (Benefit) $234 $(33) $(71) ==== ==== ==== Income tax expense (benefit) reconciled to the tax computed at statutory rate is as follows: 1993 1992 1991 ----------- ----------- ----------- Tax at Statutory Rates $190 35 % $(17) (34)% $(60) (34)% State Income Taxes 13 2 (2) (4) (10) (6) Prior Years' Income Taxes (15) (3) (10) (20) (10) (6) Increase in Statutory Rate (a) 46 9 --- -- --- -- Other --- -- (4) (9) 9 6 ---- -- ---- -- ---- -- Total Expense (Benefit) $234 43 % $(33) (67)% $(71) (40)% ==== == ==== == ==== == (a) CSXT revised its annual effective tax rate in 1993 to reflect the change in the federal statutory rate from 34 to 35 percent. The effect of this change was to increase deferred income tax expense by $46 million related to applying the newly enacted statutory income tax rate to deferred tax balances as of January 1, 1993. - 21 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 5. INCOME TAXES, Continued The significant components of deferred tax assets and liabilities after considering the adoption of SFAS No. 109 include: December 31, January 1, 1993 1993 ------ ------ Deferred Tax Assets Productivity Charge $ 289 $ 356 Employee Benefit Plans 167 143 Investment Tax Credits 100 126 Alternative Minimum Tax Credits 168 148 Other 215 206 ------ ------ Total 939 979 ------ ------ Deferred Tax Liabilities Accelerated Depreciation 2,556 2,455 Other 217 173 ------ ------ Total 2,773 2,628 ------ ------ Net Deferred Tax Liabilities $1,834 $1,649 ====== ====== CSXT and its subsidiaries are included in the consolidated federal income tax return filed by CSX. The consolidated federal income tax expense or benefit is allocated to CSXT and its subsidiaries as though CSXT had filed a separate consolidated return. Federal income tax payments to CSX and payments to state taxing authorities during 1993, 1992 and 1991 totaled $80 million, $56 million and $58 million, respectively. At December 31, 1993 and 1992, investment tax credits of approximately $100 million and $126 million and alternative minimum tax credits of $168 million and $148 million, respectively, are being carried forward for separate tax return purposes and have been recognized for financial reporting purposes as a reduction of the deferred tax liability. Investment tax credits are accounted for under the flow-through method. The earliest carryforwards of investment tax credits begin to expire in 1997. Examinations of the federal income tax returns of CSX and its principal subsidiaries have been completed through 1987. Returns for 1988-1990 are currently under examination. Management believes adequate provision has been made for any adjustments that might be assessed. - 22 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 6. RELATED PARTIES. Cash and cash equivalents at December 31, 1993 and 1992, includes $336 million and $310 million, respectively, representing amounts due from CSX for CSXT's participation in the CSX cash management plan. Under this plan, excess cash is advanced to CSX for investment and CSX makes cash funds available to its subsidiaries as needed for use in their operations. CSX is committed to repay all amounts due on demand should circumstances require. The companies are charged for borrowings or compensated for investments based on returns earned by the plan portfolio. Effective December 18, 1992, CSXT entered into an agreement with CTRC to sell, on a revolving basis, without recourse, all existing accounts receivable to CTRC. In October, 1993, this agreement was amended to sell only freight accounts receivable to CTRC. As of December 31, 1993 and 1992, CSXT had sold $556 million and $600 million, respectively, of accounts receivable to CTRC. CSXT has formal long-term borrowings from CSX which mature from 1994 to 2012 and total $86 million at December 31, 1993, and $106 million at December 31, 1992. Maturities during the next five years aggregate $17 million in 1994, $17 million in 1995, $7 million in 1996, $7 million in 1997 and $7 million in 1998. Fixed interest rates range from 9% to 10% per annum and are based on the market rates in effect when the respective borrowings were placed. Interest expense on borrowings from CSX was $9 million, $11 million and $15 million in 1993, 1992 and 1991, respectively. In 1989, CSXT's pension plan for salaried employees was merged with the CSX Corporation Plan, and all assets of CSXT's plan were transferred to the CSX merged plan. Since the plans were merged, CSX has allocated to CSXT a portion of the net pension expense for the CSX Corporation Plan based on CSXT's relative level of participation in the merged plan which considers the assets and personnel previously in the CSXT plan. The allocated expense from the CSX Corporation Plan amounted to $32 million in 1993, $23 million in 1992 and $32 million in 1991. Included in Materials, Supplies and Other expense are amounts related to a management service fee charged by CSX, data processing related charges from CSX Technology, Inc., and the reimbursement, under an operating agreement, from CSX Intermodal, Inc. (CSXI), for costs incurred by CSXT related to intermodal operations. CSX Technology and CSXI are wholly-owned subsidiaries of CSX. Materials, Supplies and Other expense includes net expense of $214 million, $128 million and $183 million in 1993, 1992 and 1991, respectively, relating to the above arrangements. The $86 million increase from 1993 to 1992 was predominately the result of an increase in the management fee charged by CSX and a one-time intercompany transfer to CSXI in 1992. In 1991, CSXT entered into an operating lease agreement with CSXI for 3,400 rebuilt coal gondola cars. The cars, which were previously owned and rebuilt by CSXT, were sold to CSXI for $117 million which resulted in no gain. These cars are presently being leased by CSXT through March 2006. In addition, CSXT is leasing 65 locomotives from CSXI pursuant to a pre-existing operating - 23 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 6. RELATED PARTIES, Continued lease agreement acquired by CSXI from a third party at year-end 1992. These locomotives are being leased by CSXT through May 2008. The minimum lease payments for the locomotives and coal gondola cars discussed above are approximately $18 million annually. These lease payments are included in the minimum lease payments as discussed in Note 12. In 1988, CSXT participated with Sea-Land Service, Inc. (Sea-Land), a wholly-owned subsidiary of CSX, in four sale-leaseback arrangements. Under these arrangements, Sea-Land sold equipment to a third party and CSXT leased the equipment and assigned the lease to Sea-Land. Sea-Land is obligated for all lease payments and other associated equipment expenses. If Sea-Land defaults on its obligations, CSXT would assume the asset lease rights and obligations of $174 million at December 31, 1993, under the arrangements. CSX purchases futures and options contracts as a partial hedge against fluctuations in fuel oil prices on behalf of CSXT and other CSX subsidiaries. Gains and losses on contracts to hedge fuel oil commitments are deferred and accounted for as a part of the commitment transaction. When recognized, these gains and losses are recorded by the subsidiary. During 1993 and 1991, CSXT recognized $2 million and $3 million, respectively, in net losses with 1992 yielding a slight gain associated with these fuel hedges. The counterparties to certain futures and options contracts consist of a large number of major financial institutions. Through CSX, the positions and the credit ratings of these counterparties are continually monitored, and the amount of agreements or contracts entered into with any one party are limited. While the company may be exposed to credit losses in the event of non-performance by counterparties, it does not currently anticipate losses. NOTE 7. ACCOUNTS PAYABLE AND OTHER CURRENT LIABILITIES. December 31, ---------------------- 1993 1992 ------ ------ Trade Accounts Payable $ 457 $ 457 Labor and Fringe Benefits(a) 337 543 Interest, Taxes and Other 180 144 Casualty Reserves 137 136 ------ ------ Total $1,111 $1,280 ====== ====== (a) Labor and Fringe Benefits includes separation liabilities of $26 million for 1993 and $225 million for 1992. - 24 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 8. PROPERTIES. Balance Balance at Beginning Retirements Other at End of Year Additions and Sales Changes of Year ------------ --------- ----------- ------- ------- - ---- Property: Transportation Road $ 9,074 $ 323 $380 $ 9 $ 9,026 Equipment 3,567 243 199 4 3,615 ------- ------ ---- ---- ------- 12,641 566 579 13 12,641 Non-transportation 61 3 2 1 63 ------- ------ ---- ---- ------- Total $12,702 $ 569 $581 $ 14 $12,704 ======= ====== ==== ==== ======= Accumulated Depreciation: Transportation Road $ 2,781 $ 209 $373 $--- $ 2,617 Equipment 1,453 162 163 --- 1,452 ------- ------ ---- ---- ------- 4,234 371 536 --- 4,069 Non-transportation 5 --- 1 --- 4 ------- ------ ---- ---- ------- Total $ 4,239 $ 371 $537 $--- $ 4,073 ======= ====== ==== ==== ======= Properties - December 31, 1993 $ 8,631 ======= - 25 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 8. PROPERTIES, Continued Balance Balance at Beginning Retirements Other at End of Year Additions and Sales Changes of Year ------------ --------- ----------- ------- ------- - ---- Property: Transportation Road $ 9,003 $ 313 $ 211 $(31) $9,074 Equipment 3,618 226 268 (9) 3,567 ------- ------ ----- ---- ------- 12,621 539 479 (40) 12,641 Non-transportation 63 --- 1 (1) 61 ------- ------ ----- ---- ------- Total $12,684 $ 539 $ 480 $(41) $12,702 ======= ====== ===== ==== ======= Accumulated Depreciation: Transportation Road $ 2,787 $ 205 $ 208 $ (3) $ 2,781 Equipment 1,527 149 223 --- 1,453 ------- ------ ----- ---- ------- 4,314 354 431 (3) 4,234 Non-transportation 5 1 --- (1) 5 ------- ------ ----- ---- ------- Total $ 4,319 $ 355 $ 431 $ (4) $ 4,239 ======= ====== ===== ==== ======= Properties - December 31, 1992 $ 8,463 ======= - 26 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 9. CASUALTY AND OTHER RESERVES, SEPARATION LIABILITIES AND DEFERRED GAINS. Long-term liabilities and deferred gains totaled $1.6 billion and $1.8 billion in 1993 and 1992, respectively, and include casualty reserves; deferred gains; pension and other post-retirement obligations; productivity/restructuring charge liabilities; and other liabilities. Activity relating to casualty reserves, separation liabilities and deferred gains is as follows: Deferred Gains --------------------------- Casualty Separation Sale-Leaseback Installment Reserves(a) Liabilities(a) Transactions(c) Sale(d) ----------- ------------ --------------- ----------- Balance 12/31/91 $ 354 $ 655 $ 84 $ 129 Charged to Expense and Other Additions 237 644 (1) --- Payments and Other Reductions (222) (382)(b) (6) (7) ----- ----- ----- ----- Balance 12/31/92 369 917 77 122 Charged to Expense and Other Additions 189 --- --- --- Payments and Other Reductions (179) (295)(b) (6) (20) ----- ----- ----- ----- Balance 12/31/93 $ 379 $ 622 $ 71 $ 102 ===== ===== ===== ===== (a) Balances include current portion of casualty reserves and separation liabilities, respectively, of $136 million and $225 million at December 31, 1992 and $137 million and $26 million at December 31, 1993. (b) Includes reallocation of $95 million in 1993 and $62 million in 1992 to litigation claims and other negotiated settlements. (c) Deferred gains on sale-leaseback transactions are being amortized over periods not exceeding 21 years. (d) A portion of the deferred gain on South Florida Track installment sale will be recognized each year through 1997 as scheduled payments are received. - 27 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 10. LONG-TERM DEBT. December 31, Type Average ---------------------- (Maturity Dates) Interest Rates 1993 1992 - ----------------- -------------- ------ ------ Equipment Obligations (1994-2008) 9% $ 417 $ 437 Mortgage Bonds (1995-2003) 4% 84 137 Other Obligations (1994-2021) 6% 179 186 ------ ------ Total 8% 680 760 Less Debt Due Within One Year 87 114 ------ ------ Total Long-Term Debt $ 593 $ 646 ====== ====== The estimated fair value of long-term debt at December 31, 1993 and 1992, is as follows: Fair Value of Total Debt 1993 1992 ------------------------ Equipment Obligations $453 $476 Mortgage Bonds 69 115 Other Obligations 192 194 ---- ---- Total $714 $785 ==== ==== In March 1993, CSXT issued $74 million of Series A Equipment Trust Certificates. The certificates will mature in 15 annual installments from 1994 through 2008. CSXT has long-term debt maturities during the next five years aggregating $87 million in 1994, $85 million in 1995, $64 million in 1996, $45 million in 1997 and $41 million in 1998. Substantially all of the properties and certain other assets of CSXT and its subsidiaries are pledged as security for various long-term debt issues. Interest payments, including the amounts on CSX borrowings totaled $74 million, $85 million and $93 million, respectively, for 1993, 1992 and 1991. These payments are net of capitalized interest, which was approximately $7 million for each of the three years. - 28 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 11. EMPLOYEE BENEFIT PLANS. Pension Plans CSX and its subsidiaries, including CSXT, have defined benefit pension plans principally for salaried employees. The plans provide for eligible employees to receive benefits primarily based on years of service 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. See Note 6 for the allocated pension expense from the CSX Corporation Plan. Savings Plans CSXT has established savings plans for virtually all full-time salaried employees and certain employees covered by collective bargaining units of CSXT and subsidiary companies. CSXT matches 50% of each salaried employee's contribution, which is limited to 6% of the employee's earnings. CSXT contributes fixed amounts for each participating employee covered by a collective bargaining agreement. Expense for these plans was $22 million for each of the years 1993, 1992 and 1991. Other Post-Retirement Benefit Plans In addition to the CSX defined benefit pension plans, CSXT participates in two defined benefit post-retirement plans along with CSX and other affiliates which cover most full-time salaried employees. One plan provides medical benefits and another provides life insurance benefits. The post-retirement health care plan is contributory, with retiree contributions adjusted annually, and contains other cost-sharing features such as deductibles and coinsurance. The accounting for the health care plan anticipates future cost-sharing changes to the written plan that are consistent with the company's expressed intent to increase the retiree contribution rate annually for the expected medical inflation rate for that year. The life insurance plan is non- contributory. Effective January 1, 1991, CSXT adopted SFAS No. 106. The effect of adopting the new guidelines had a minimal impact on 1991 results, as the net periodic post-retirement benefit expense of $28 million approximated the expense under the prior method of accounting for the above defined benefit plans, which was on a pay-as-you-go basis. Net earnings for 1991 were decreased by $159 million (net of related income tax benefit of $96 million), by the cumulative effect of the change in accounting related to years prior to 1991, which were not restated. The SFAS No. 106 calculations shown below were prepared for CSXT as if it was participating in such plans on a stand-alone basis. Therefore, although CSXT participates along with CSX and other affiliates in these two plans, a separate measurement of the funding status and benefit expense attributable to its participation in the plans was determined and recognized by CSXT on this basis. - 29 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 11. EMPLOYEE BENEFIT PLANS, Continued Other Post-Retirement Benefit Plans, Continued The company's current policy is to fund the cost of the post- retirement health care and life insurance benefits on a pay-as-you-go basis, as in prior years. The following table shows the two plans' combined status reconciled with the amounts recognized in CSXT's statement of financial position: Life Medical Insurance Plan Plan 1993 1992 1993 1992 ---- ---- ---- ---- Accumulated Post-Retirement Benefit Obligation: Retirees $154 $125 $67 $62 Fully Eligible Active Participants 13 13 2 2 Other Active Participants 20 16 2 1 ---- ---- --- --- Accumulated Post-Retirement Benefit Obligation 187 154 71 65 Unrecognized Prior Service Cost 17 21 4 4 Unrecognized Net Loss (40) (10) (10) (3) ---- ---- --- --- Net Post-Retirement Benefit Obligation $164 $165 $65 $66 ==== ==== === === Net periodic post-retirement benefit expense for 1993, 1992 and 1991 is as follows: Life Medical Insurance Plan Plan 1993 1992 1991 1993 1992 1991 ---- ---- ---- ---- ---- ---- Service Cost $ 4 $ 4 $ 5 $1 $1 $1 Interest Cost 12 13 16 5 6 6 Amortization of Prior Service Cost (Benefit) (4) (2) -- - - - Unrecognized Net Gain (2) -- -- - - - --- --- --- -- -- -- Net Periodic Post-Retirement Benefit Expense $10 $15 $21 $6 $7 $7 === === === == == == The weighted-average annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) for the medical plan is 11.5% for 1993-1994 and is assumed to decrease gradually to 5.5% in 2005 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the - 30 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 11. EMPLOYEE BENEFIT PLANS, Continued Other Post-Retirement Benefit Plans, Continued assumed health care cost trend rates by one percentage point in each year would increase the accumulated post-retirement benefit obligation for the medical plan as of December 31, 1993 by 9%, and the aggregate of the service and interest cost components of net periodic post-retirement benefit expense for 1993 by $2 million. The weighted-average discount rate used in determining the accumulated post-retirement benefit obligation was 7.25% and 8.25% at December 31, 1993 and 1992, respectively. Post-employment Benefits Effective January 1, 1994, the company will adopt SFAS No. 112 "Employers' Accounting for Post-employment Benefits." This statement requires that certain benefits provided to former or inactive employees, after employment but before retirement, such as workers' compensation and disability benefits, be accrued if attributable to employees' service already rendered. The financial impact of adopting SFAS No. 112 is not expected to be significant. Other Plans Under collective bargaining agreements, the company participates in a number of union-sponsored, multi-employer benefit plans. Payments to these plans are made as part of aggregate assessments generally based on hours worked, tonnage moved or a combination thereof. The administrators of the multi- employer plans generally allocate funds received from participating companies to various health and welfare benefit plans and pension plans. Current information regarding such allocations has not been provided by the administrators. Total contributions of $139 million, $125 million and $150 million were made to these plans in 1993, 1992 and 1991, respectively. Certain officers and key employees of CSXT participate in stock purchase performance and award plans of CSX. CSXT is allocated its share of any cost to participate in these plans. NOTE 12. SUMMARY OF COMMITMENTS AND CONTINGENCIES. Lease Commitments CSXT leases equipment under agreements with terms up to 21 years. Non-cancelable, long-term leases generally include provisions for maintenance, options to purchase at fair value and to extend the terms. At December 31, 1993, minimum equipment rentals under non-cancelable operating leases totaled approximately $180 million for 1994, $165 million for 1995, $161 million for 1996, $165 million for 1997, $167 million for 1998 and $1.6 billion thereafter. - 31 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 12. SUMMARY OF COMMITMENTS AND CONTINGENCIES, Continued Lease Commitments, Continued Rent expense on equipment operating leases, including net daily rental charges on railroad operating equipment of $214 million, $204 million and $182 million in 1993, 1992 and 1991, respectively, amounted to $387 million in 1993, $383 million in 1992 and $376 million in 1991. Deferred gains arising from sale-leaseback transactions are being amortized over periods not exceeding 21 years and have reduced rent expense by $6 million in 1993, $6 million in 1992 and $5 million in 1991. Purchase Commitment CSXT entered into an agreement to purchase 300 locomotives from GE Transportation Systems, a unit of General Electric Co. This large single order will cover CSXT's normal locomotive replacement needs over the next four years. This purchase agreement will introduce alternating current traction technology to CSXT's locomotive fleet. CSXT will take delivery of 50 direct current and 30 alternating current locomotives in 1994, and the remaining 220 alternating current units will be delivered during 1995-1997. Contingent Liabilities and Long-Term Operating Agreements CSXT and its subsidiaries are contingently liable individually and jointly with others principally as guarantors of long-term debt and obligations, primarily related to leased properties, joint ventures and joint facilities. These contingent obligations amounted to approximately $199 million at December 31, 1993. CSXT has various long-term railroad operating agreements that allow for exclusive operating rights over various railroad lines. Under these agreements, CSXT is obligated to pay usage fees of approximately $10 million annually. The terms of these agreements range from 30 to 40 years. CSXT is a party to various proceedings brought both by private parties and regulatory agencies related to environmental issues. CSXT has been identified as a potentially responsible party in a number of governmental investigations and actions relating to environmentally impaired sites that are or may be subject to remedial action under the Federal Superfund Statute ("Superfund") or corresponding state statutes. The majority of these proceedings are based on allegations that CSXT, or its railroad predecessors, sent hazardous substances to the facilities in question for disposal. Such proceedings arising under Superfund typically involve numerous other waste generators and disposal companies and seek to allocate or recover costs associated with site investigation and cleanup, which could be substantial. The assessment of the required response and remedial costs associated with these sites is extremely complex. Among the variables that management must assess are imprecise and changing remedial cost estimates and continually evolving governmental standards. - 32 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 12. SUMMARY OF COMMITMENTS AND CONTINGENCIES, Continued Contingent Liabilities and Long-Term Operating Agreements, Continued CSXT frequently reviews its role, if any, with respect to each such location, giving consideration to the nature of CSXT's alleged connection to the location (e.g., generator, owner or operator), the extent of CSXT's alleged connection (e.g., volume of waste sent to the location and other relevant factors), the accuracy and strength of evidence connecting CSXT to the location, and the number, connection and financial position of other named and unnamed potentially responsible parties at the location. Further, CSXT periodically reviews its exposure in all non-Superfund environmental proceedings with which it is involved. Based upon such reviews and updates of the sites with which it is involved, CSXT has recorded, and periodically reviews for adequacy, reserves to cover estimated contingent future environmental costs with respect to such sites. Liabilities are recorded for environmental matters in accordance with CSXT's accounting policy described in Note 1. CSXT does not currently possess sufficient information to reasonably estimate the amounts of additional liabilities, if any, on some sites until completion of future environmental studies. Such additional liabilities could be significant to future consolidated results of operations and cash flows. Based upon information currently available, however, CSXT believes that its environmental reserves are adequate to accomplish remedial actions to comply with present laws and regulations. Legal Proceedings A number of legal actions, other than environmental, are pending against CSXT in which claims are made in substantial amounts. While the ultimate results of environmental investigations, lawsuits and claims involving CSXT cannot be predicted with certainty, management does not currently expect that these matters will have a material adverse effect on the consolidated financial position, results of operations and cash flows of the company. In December 1993, a Consent Decree was entered in the U. S. District Court in Jacksonville, Florida to settle claims of Federal Clean Water Act violations alleged against CSXT. The Consent Decree resolves a civil enforcement action initiated in June, 1992, by the U.S. Environmental Protection Agency with respect to alleged violations by CSXT of permit discharge limitations at five rail yard waste water treatment facilities in Florida and North Carolina. The settlement called for a civil penalty of $3 million, which has been paid by CSXT, as well as the establishment of an escrow account in the amount of $4 million to fund certain environmentally beneficial projects. - 33 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED NOTE 13. QUARTERLY DATA (Unaudited). ----------------------------------------- 1st 2nd 3rd(a) 4th(b) ------ ------ ------ ------ Operating Revenue $1,094 $1,134 $1,081 $1,135 Operating Income 105 172 123 191 Net Earnings 56 131 19 102 ----------------------------------------- 1st 2nd(c) 3rd 4th ------ ------ ------ ------ Operating Revenue $1,123 $1,123 $1,104 $1,158 Operating Income (Loss) 125 (498) 149 246 Net Earnings (Loss) 65 (322) 80 160 ----------------------------------------- 1st(d) 2nd 3rd 4th(e)(f) ------ ------ ------ ------ Operating Revenue $1,059 $1,079 $1,130 $1,156 Operating Income (Loss) 111 137 150 (507) Earnings (Loss) before Cumulative Effect of Change in Accounting 57 74 78 (314) (a) CSXT revised its estimated annual effective tax rate in the third quarter of 1993 to reflect the change in the federal statutory rate from 34 to 35 percent. The effect of this change was to increase income tax expense for the third quarter of 1993 by $50 million. Of this amount, $46 million, related to applying the newly enacted statutory income tax rate to deferred tax balances as of January 1, 1993. (b) The quarterly results were affected by certain adjustments, including credits of $12 million for favorable experience on health and welfare benefits. Other adjustments were not significant to the operating results for the quarter. (c) Includes impact of $664 million pretax productivity charge, $427 million after tax. (d) The first quarter 1991 results exclude the cumulative effect of the accounting change for years prior to 1991 that decreased net earnings $159 million. The effect of adopting SFAS No. 106 on 1991 operating income was not significant and was included in the results of the fourth quarter. The first-, second- and third-quarter 1991 results were not restated. (e) Includes impact of $647 million pretax productivity charge, $409 million after tax. (f) Includes pretax gain of $39 million, before associated minority interest expense of $5 million, on the sale of the stock of RF&P Corporation. - 34 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES MANAGEMENT'S NARRATIVE ANALYSIS AND RESULTS OF OPERATIONS (Millions of Dollars) The following information should be read in conjunction with all other items in this report including "Business", "Properties" and "Financial Statements and Supplementary Data." Selected Financial & Statistical Information -------------------------------------------- 1993 1992(a) 1991(b)(c)1990 1989 ------- ------ ----- ------ ------ Selected Earnings Data: Operating Revenue $4,444 $4,508 $4,424 $4,551 $4,470 Operating Expense 3,853 3,822 3,886 3,929 3,876 Productivity/Restructuring Charge --- 664 647 --- --- ------ ------ ------ ------ ------ Operating Income (Loss) 591 22 (109) 622 594 Other Income 11 1 20 --- 29 Interest Expense 60 73 87 111 146 Income Tax Expense (Benefit) Productivity/Restructuring Charge --- (237) (238) --- --- Other 234 204 167 164 173 Cumulative Effect of Change in Accounting --- --- (159) --- --- ------ ------ ------ ------ ------ Net Earnings (Loss) $ 308 $ (17) $ (264) $ 347 $ 304 ====== ====== ====== ====== ====== Selected Cash Flow Data: Cash Provided by Operating Activities $ 630 $ 725 $ 525 $ 814 $ 881 Cash Used by Investing Activities $ (478) $ (506) $ (395) $ (394) $ (296) Cash Used by Financing Activities $ (128) $ (258) $ (86) $ (364) $ (461) Selected Financial Position Data: Cash and Cash Equivalents $ 272 $ 248 $ 287 $ 243 $ 187 Working Capital (Deficit) $ (606) $ (931) $ (773) $ (707) $ (590) Total Assets $9,653 $9,475 $9,629 $9,510 $9,357 Long-Term Debt $ 593 $ 646 $ 639 $ 742 $ 874 Due to Parent Company: Long-Term Advances $ 69 $ 86 $ 178 $ 157 $ 198 Shareholder's Equity $4,185 $3,903 $3,992 $4,368 $4,103 (a) Includes impact of $664 million pretax productivity charge, $427 million after tax. (b) Includes impact of $647 million pretax productivity charge, $409 million after tax. (c) Net earnings for 1991 were decreased by $159 million by the cumulative effect of the change in accounting related to the adoption of SFAS No. 106. - 35 - CSX TRANSPORTATION, INC. AND SUBSIDIARIES MANAGEMENT'S NARRATIVE ANALYSIS AND RESULTS OF OPERATIONS Results of Operations --------------------- CSXT met the challenges of a prolonged U.S. coal strike and sharp decline in its export coal markets in 1993 by continuing to lower the cost of its operations while increasing its focus on merchandise markets. Despite a $202 million decline in coal revenue, this dual emphasis allowed CSXT to earn operating income of $591 million, $95 million below 1992's comparable $686 million. Operating income rose 10% compared with 1991 earnings of $538 million on a like basis. These comparisons exclude productivity charges of $664 million and $647 million in 1992 and 1991, respectively, associated with labor reductions. Including these charges, the rail unit recorded operating income of $22 million in 1992 and an operating loss of $109 million in 1991. Transportation operating revenue was $4.38 billion, a 1% decline from $4.43 billion a year earlier, but a slight increase from 1991's revenue of $4.34 billion. The decrease in 1993 was caused by a 13% decline in coal revenue, the largest source of CSXT revenue. Coal revenue also was 13% lower than 1991's level. Total coal originated by CSXT was 144.1 million tons in 1993, 11% and 13% below levels originated in 1992 and 1991, respectively. CSXT COMMODITIES BY CARLOADS AND REVENUE Market Share (a) Carloads Revenue (Percent) (Thousands) (Millions of Dollars) --------- -------------------- ---------------------- 1993 1993 1992 1991 1993 1992 1991 ---- ----- ----- ----- ----- ------ ------ Automotive 27 326 288 265 $ 461 $ 413 $ 367 Chemicals 40 371 356 347 652 619 587 Minerals 36 374 345 327 332 310 290 Food and Consumer 34 166 161 164 196 196 201 Agricultural Products 30 284 264 262 327 297 295 Metals 22 258 225 199 243 219 200 Forest Products 30 435 441 439 442 448 425 Phosphates and Fertilizer 70 423 457 475 256 268 269 Coal 40 1,566 1,760 1,816 1,363 1,565 1,573 ----- ----- ----- ----- ------ ------ Total Freight Revenue 4,203 4,297 4,294 4,272 4,335 4,207 ===== ===== ===== Other Revenue 108 99 129 ------ ------ ------ Total Transportation Operating Revenue $4,380 $4,434 $4,336 ====== ====== ====== (a) Market share is defined as CSXT carloads vs. carloads handled by all major Eastern railroads. Weakened demand for U.S. coal from the European Community nations and Japan, due to lower levels of economic growth, continued foreign government - 36 - subsidies and intensified foreign competition, caused CSXT's export coal shipments to decline significantly from the prior two years. In addition, both domestic and export shipments were negatively affected by selective coal strikes against eastern coal operators, which diminished shipments during nine months of 1993. While CSXT anticipates only a slight recovery in the export coal market, the company does expect notably higher carloadings of coal to utilities since the strikes ended in December 1993. CSXT merchandise volume and revenue jumped 4% and 5% from 1992's levels and 6% and 10% from 1991's results, respectively, to 2.6 million carloads and $2.9 billion in revenue. The gains reflected expansion in the domestic economy and improved conditions in key industries served by CSXT. With U.S. auto producers enjoying large gains in market share and increased demand from consumers, CSXT's automotive traffic led the growth in merchandise carloadings and revenue. CSXT also recorded large gains in metals, due to surging scrap demand from U.S. mini-mill steel producers. Minerals traffic advanced due to renewed activity in construction and highway projects. CSXT's agriculture volumes and revenues moved well beyond prior-year levels, benefiting from export of 1992's bumper grain crop through late summer 1993 and continued expansion in the southeastern poultry and feed grain businesses throughout the year. The strengthening economy and higher level of auto production contributed to a sizeable increase in chemical traffic. With foreign demand for U.S.-mined phosphates remaining depressed, phosphate and fertilizer carloadings declined further. The forest products market also was off slightly from 1992 and 1991 levels as a result of excess paper production during 1992. CSXT anticipates modest improvement in merchandise traffic volume and revenue for 1994, reflecting continued expansion of the U.S. economy. Also, while no marked improvement is forecast in export phosphate demand, increased shipments of fertilizer products to the U.S. Midwest is expected as farmers replenish fields following last year's flooding. CSXT transportation operating expense was $3.8 billion, an increase of 1% from comparable 1992 expense and a decline of 1% from 1991 expense, excluding the previously mentioned productivity charges. Labor expense continued to decline, to $1.81 billion, from a level of $1.83 billion and $1.85 billion in 1992 and 1991, respectively, despite the negative impact of a greater number of crew starts associated with moving a larger proportion of merchandise traffic. The 1993 expense includes a 3% wage increase awarded to most contract employees mid-year and also reflects a decrease in employment levels due to implementation of two-member crews and continued personnel reductions. A 4% wage increase is scheduled for mid-1994. CSXT expects to continue to decrease the size of its work force over the next few years. CSXT estimated the average size of its train crews for through, local and yard trains to be 2.7 members at year-end. CSXT plans to lower its average crew size for all trains to 2.3 over the next few years through implementation of smaller yard and local crews as contemplated by the 1992 and 1991 productivity charges. - 37 - Materials, supplies and other expense, which includes the cost of maintenance, information services, management fees from CSX and personal injuries, increased 4% over 1992 and decreased 1% from 1991 levels. The 1993 increase over 1992 was primarily the result of increased management fees from CSX, partially offset by CSXT's intensive Performance Improvement Team (PIT) program and the company's ongoing commitment to safety. CSXT's PIT process has been responsible for marked reductions in the expense base of CSXT operations over the past two years and is expected to contribute additional savings in 1994 and 1995. While shrinking expenses, this program also has led to significant improvements in reliability, performance and efficiency. Major strides have been made in locomotive and freight car maintenance and repair, information technology, contract labor scheduling and purchasing among other areas of rail activity. Specifically, through PIT initiatives, CSXT reduced expenses by $147 million and $116 million in 1993 and 1992, respectively. Further savings of over $100 million each year are targeted for 1994 and 1995. Fuel expense fell to $253 million from $262 million and $271 million in 1992 and 1991, respectively. Fuel consumption decreased from levels in earlier years, reflecting the level of operation and increased fuel efficiency. In 1993, CSXT locomotives consumed 1.33 gallons of diesel fuel per thousand gross ton miles, compared with 1.37 gallons in the prior year and 1.4 gallons in 1991. CSXT diesel fuel averaged 64 cents per gallon vs. 65 cents in 1992 and 68 cents in 1991, net of the CSX hedging program. Building and equipment rent expense increased slightly from earlier years. Depreciation expense increased slightly from earlier years as new equipment was purchased and deployed in the business. With continued effort throughout CSXT to lower its expense base, the company anticipates only a slight increase in total operating expense for 1994, assuming modest improvements in traffic levels and no unusual operating conditions. Property additions for 1993 totaled $569 million, compared with $539 million and $563 million for the years 1992 and 1991, respectively. Included in the 1993 total was $323 million for roadway improvements, including 400 miles of rail that were installed or replaced. CSXT added a total of 75 new, fuel-efficient locomotives to its fleet during the year at a cost of $101 million, bringing the total fleet to 2,810 locomotives compared with 2,965 and 3,123 for year-end 1992 and 1991, respectively. At year-end 1993, the average age of the locomotive fleet was 14.3 years, reflecting the retirement of 230 older units from service. CSXT's car fleet benefited from $73 million in new capital. Additional capital was spent on terminals, technology and other equipment. For 1994, CSXT projects an increase of approximately 10% in its capital additions program. As in past years, the largest share of the total will be directed to track and roadway improvements. - 38 - Property Additions --------------------- (Millions of Dollars) Property Additions 1993 1992 1991 - ------------------ ---- ---- ---- Merchandise Cars $ 68 $ 45 $ 43 Coal Cars 5 4 10 ---- ---- ---- Total Freight Cars 73 49 53 ---- ---- ---- Locomotives 120 134 168 Roadway 323 306 327 Other Equipment and Properties 53 50 15 ---- ---- ---- Total Property Additions $569 $539 $563 ==== ==== ==== CSXT has embarked on a four-year program to acquire 300 locomotives, with 80 of these to be delivered in 1994. Included will be 50 Dash-9-44CW direct current (DC) powered and 250 alternating current (AC) locomotives, 197 of these at 4,400 horsepower and 53 at 6,000 horsepower. The first of the AC units will be delivered in mid-1994. This new technological breakthrough for the railroad industry will allow CSXT to replace an average of two units in its existing fleet with each new unit. Remaining capital in the 1994 budget has been earmarked for car acquisitions, technology and a rail-barge venture to transfer freight between CSXT's rail territory in the southeastern United States and ports along Mexico's eastern coast. - 39 - Financial Condition Liquidity and Capital Resources ------------------------------- Cash provided by operating activities totaled $630 million, a decrease of $95 million from 1992 and an increase of $105 million from 1991. Cash provided by operating activities included an increase of $6 million for 1993, an increase of $200 million for 1992 and a decrease of $75 million for 1991, relating to the amount of accounts receivable sold. In addition, cash provided by operating activities included payments for productivity and restructuring charges of $245 million, $353 million and $72 million for 1993, 1992 and 1991, respectively. Excluding the effect of the sale of receivables and the productivity charge payments, cash provided by operating activities would have been $869 million in 1993, $878 million in 1992 and $672 million in 1991. Cash used by investing activities was $478 million which was $28 million lower than the $506 million used in 1992 and $83 million higher than the $395 million used in 1991. Proceeds from the sale of RF&P Corporation stock of $106 million in 1991 resulted in lower overall uses of cash in 1991 as compared to 1993 and 1992. Property additions of $569 million in 1993 increased $30 million from $539 million in 1992, and $6 million from $563 million in 1991. In the late 1980's, the company launched a major roadway, equipment and locomotive improvement program. Completion of this program has allowed a return to a normalized capital budget that assures the required level of routine maintenance, customer service and safe operation. Sale-leaseback transactions provided net cash of $37 million in 1991. These transactions were focused primarily on improving the rail car fleet. There were no sale-leaseback transactions in 1993 and 1992. Cash used by financing activities decreased to $128 million in 1993 from $258 million in 1992 and increased from $86 million in 1991. The 1993 decrease in cash used was primarily the result of lower repayments of public and affiliated company debt. Cash and cash equivalents increased $24 million during 1993 to a level of $272 million versus $248 million at the end of 1992 and decreased $15 million over the 1991 level of $287 million. Working capital increased by $325 million to a year-end deficit of $606 million in 1993, compared to $931 million in 1992 and $773 million in 1991. A working capital deficit is not unusual for CSXT and does not indicate a lack of liquidity. CSXT maintains adequate current assets to satisfy current liabilities when they are due and has sufficient financial resource capacity, primarily from access to advances from CSX, to manage its day-to-day cash requirements. Environmental concerns have drawn considerable attention. CSXT, like many American companies today, faces the challenge of dealing with this issue and is addressing its environmental responsibilities and managing the related expenditures. Environmental management is an important part of CSXT's strategic planning, which includes promotion of policies and procedures that emphasize environmental awareness throughout the company. - 40 - The following financial ratios, exclusive of the cumulative effect of the change in accounting in 1991, are measures of the condition of CSXT and its subsidiaries as of year end: 1993 1992 1991 ---- ---- ---- Current Ratio .5 .4 .5 Debt-to-Total Capitalization Ratio 13.7% 15.8% 16.4% Return on Assets 3.2% (0.2)% (1.1)% Return on Equity 7.4% (0.4)% (2.5)% Ratio of Earnings to Fixed Charges 4.8X 0.6X N/A Excluding the impacts of the 1992 and 1991 productivity charges, the measures would have been as follows: 1993 1992 1991 ---- ---- ---- Current Ratio .5 .4 .5 Debt-to-Total Capitalization Ratio 13.7% 14.5% 15.2% Return on Assets 3.2% 4.3% 3.2% Return on Equity 7.4% 9.5% 6.7% Ratio of Earnings to Fixed Charges 4.8X 4.6X 3.6X - 41 -

277821_1993.txt

277821_1993

1993

277821

ITEM 1. BUSINESS. GENERAL DEVELOPMENT OF THE COMPANY'S BUSINESS National Education Corporation (the "Company") provides training and education to individuals, businesses and governments. The Company was originally incorporated in California in 1954 and reincorporated in Delaware in 1972. Its business is conducted through four operating entities: ICS Learning Systems, Inc. ("ICS"), Steck-Vaughn Publishing Corporation ("Steck-Vaughn"), National Education Centers, Inc. ("Education Centers") and National Education Training Group, Inc. ("NETG"). During 1993, the Company took substantive measures to turn around the operations at NETG and Education Centers. As a result, the Company's operating performance improved in the fourth quarter of 1993 as compared to the fourth quarter of 1992. This improvement reflects the substantial investments the Company made in product development and marketing at NETG. Overall for 1993, the Company reported a net loss of $9.6 million, compared to net income of $515,000 in 1992. The 1993 loss includes a third quarter $32.9 million pretax write-off for the closure of 14 schools at Education Centers, as well as a write-down of certain intangible assets at NETG. The loss was partially offset by a one-time gain of $21.3 million on the initial public offering of Steck-Vaughn shares. In 1993, ICS achieved a 12.2% increase in revenues and a 13.8% increase in operating income. These results are directly related to a 28,692, or 10.1%, increase in enrollments resulting partially from an expanded telesales operation that improved the conversion of prospective students into enrollments, additional advertising spending and new product introductions. ICS' computer and related training is the company's fastest growing product line and has achieved compound annual growth since 1988 of over 30% in revenue and enrollments. ICS has a total of 14 courses that include an IBM compatible computer as part of a total training package. Also during 1993, ICS introduced the following five new courses: Home Inspector, Real Estate Appraiser, Medical Transcriptionist, Child Psychology and DeskTop Publishing and Design. Based on statistics compiled by the National Home Study Council ("NHSC"), the United States Department of Education recognized accrediting body for independent study schools, ICS continues as the industry leader in generating new enrollments. During 1993, more than 35,000 students enrolled in ICS' high school diploma program and more than 27,000 students enrolled in ICS' eleven two-year associate degree programs in business and technology. An additional 250,000 students worldwide pursued courses in other ICS career and hobby-related areas. ICS acquired the Industrial Print business unit from sister subsidiary NETG in 1993. This unit was combined with the English Language Institute, which was acquired in 1992 and renamed ICS Learning Systems, Business and Industrial Training Division. Through renewed marketing efforts, including an expanded sales force and a streamlined course catalog and database marketing system, this unit markets over 1,000 individual courses and 10,000 hours of education and training. More than 2,000 businesses in America use ICS products to train their workforce. ICS Online, which ICS established in 1993, is an electronic campus which is featured on the fastest growing online service in the United States, America Online ("AOL"). ICS was one of the first home study schools to establish this service and currently offers the following online services through links between personal computers: ICS Library, ICS Bookstore, Electronic Bulletin Board, Online Classroom, Online Enrollment, plus the hundreds of features available on the AOL service. Steck-Vaughn completed an initial public offering of 2,668,000 shares of its common stock at $12.00 per share in July 1993, generating approximately $29,775,000 of net proceeds. This initial public offering represents approximately 18% of the stock of the Company's Steck-Vaughn subsidiary. The net proceeds were reduced by expenses of $1,074,000 that were incurred in connection with the initial public offering. On April 1, 1993, Steck-Vaughn declared a $19,999,000 dividend payable to the Company. The dividend and certain intercompany balances were later paid from proceeds from the offering. During 1993, Steck-Vaughn continued its growth with increases in revenues and operating income of 17.8% and 8.0% respectively, with revenue increases outpacing industry averages. The fastest growing segment of Steck-Vaughn was its library division, which continued to introduce a significant number of new titles in 1993. Overall growth was attributable to continued new product introductions, an expanded selling organization and intense marketing efforts. Steck-Vaughn maintained its aggressive product development effort and produced many new titles in all of the market areas it serves. More than 230 new products were released in 1993. In April 1993, Steck-Vaughn paid approximately $5.4 million to acquire THE MAGNETIC WAY(TM) product line from Creative Edge, Inc. THE MAGNETIC WAY(TM) product line, consisting of magnetic boards and overlays, can be integrated with Steck-Vaughn's print products or marketed as a stand-alone teaching tool. This innovative product line increases Steck-Vaughn's presence in the English as a Second Language market. Due to the rapidly expanding number of products offered, Steck-Vaughn reorganized its sales force effective January 2, 1994. During 1993, each salesperson was responsible for the whole product range, which included elementary, high school, library and adult education markets. Beginning in 1994, the sales force will be segmented into two groups. One group will focus on the elementary, junior high school and library markets, while the other group will focus on the high school and adult education markets. This reorganization will allow the two groups to focus their expertise, time and energy in a more productive way. Education Centers is one of the largest operators of private postsecondary schools in the United States. In 1993, it became more difficult for students at a number of locations, especially in urban areas, to obtain access to federally guaranteed student loans. Certain provisions of the Higher Education Act of 1992, as well as the recent Omnibus Budget Reconciliation Act, caused some lenders to terminate participation in federally guaranteed student loan programs. These difficulties prompted Education Centers to restructure its operations. Anticipating that decreased access to funding would result in further operating losses in some of its schools for the year ending December 31, 1993 and future years, Education Centers elected to cease new student enrollments at 15 of its 48 schools. Education Centers' revenues of $133.2 million decreased $23.9 million or 15.2% from revenues of $157.0 million in 1992. Operating losses before unusual items of $5.5 million compared to operating income before unusual items of $10.8 million in 1992. During the third quarter of 1993, Education Centers restructured its operations and ceased new student enrollments at 14 of its schools, while allowing existing students to complete their educational programs at the schools. As a result, Education Centers recorded an unusual charge of $23.6 million, which included a write-down of assets and estimated costs of closing 14 schools. In February 1993, NETG reorganized its structure to stabilize and reposition the operations for turnaround. NEC named Robert Soto as its new president and it strengthened its management team by adding new vice presidents in product development, marketing and sales. The company directed much of its effort toward developing training courses in areas that are significantly growing in demand, such as client/server computer, business process reengineering, desktop computing, and management and professional development. NETG also restructured its United States sales operations, expanded its marketing activities, and made significant expansions of product development capabilities. Additionally, the company completed the sale of its Canadian operations to a subsidiary of SHL Systemhouse Inc., who will become the distributor of NETG products in Canada. NETG's 1993 revenues of $68.3 million decreased $14.3 million, or 17.3% from revenues of $82.6 million in 1992. In 1993, operating losses of $26.0 million before unusual items increased $4.1 million from losses of $21.9 million in 1992. During the third quarter of 1993, NETG recorded an unusual charge of $9.2 million that resulted from the write-down of certain acquired intangible assets. The decrease in revenues and the increase in operating losses at NETG primarily resulted from a lower contract backlog at the beginning of the year and the transfer of the Industrial Print operation to ICS effective January 1, 1993. Additionally, operating losses increased due to an increase of $3.0 million in product development expenditures, or 29% over the prior year. DESCRIPTION OF BUSINESS BY INDUSTRY SEGMENT Revenues and operating income (loss) by industry segment for the past three years are as follows: ICS Learning Systems, Inc. General. The company provides training and education to consumers and companies under the following names: ICS Learning Systems, English Language Institute, International Correspondence Schools, North American Correspondence Schools, and the ICS Center for Degree Studies (collectively referred to as "ICS"). ICS offers more than 50 independent study courses in the United States and more than 100 courses abroad in disciplines ranging from high school completion requirements through occupational training and associate technology degree programs in business and engineering. Curricula and Product Development. Curricula are carefully designed to reflect the most important trends in employment opportunities and consumer interest. New courses introduced during 1993 include Home Inspector, Real Estate Appraiser, Medical Transcriptionist, Child Psychology and DeskTop Publishing and Design. In addition, a major project to convert all existing print-based products to an electronic format continued in 1993 and was complemented by the installation of a digital data network to facilitate online editing, filing and retrieval, and transfer of products. This format also facilitates the transfer of documents directly to high technology printers in digital format, which will eventually allow ICS to reduce inventory requirements, virtually eliminate any material obsolescence, and position the company to move product electronically via any digital transfer mechanism. Traditionally, all independent study courses have been structured around "graded lessons" in which the student receives one section of instructional material at a time, which must be completed before proceeding to the next section. Courses are designed to be completed by the typical student in periods ranging from 12 to 24 months, depending on the course selected. A computerized student information/testing system permits students, through touch-tone telephones or voice response, to obtain immediate testing and feedback on test results. Over 90% of the 1.5 million exams graded by ICS during 1993 were graded electronically by either the information/testing system via telephone or by electronic scanner. With improved technology, the cost of grading an exam is at an all-time low while the speed of correcting an exam and turnaround to the student have never been faster. ICS utilizes a voice activated computer record access system that allows students to obtain key information from their records, 24 hours a day, without operator assistance. These services are a direct result of a published commitment to 100% customer satisfaction. Tuition for ICS' independent study courses ranges from approximately $400 to $2,300. Students generally pay a portion of the tuition upon enrollment and the balance on a monthly basis. ICS estimates that students complete an average of approximately 40% to 65% of lessons, depending on the course. The company's accounting treatment recognizes independent study contract revenues when cash is received, but only to the extent that such cash can be retained under existing refund policies of the National Home Study Council ("NHSC") and applicable state law. ICS is not dependent on financial aid from the federal government. ICS has recently established a domestic telesales department by which in-bound telephone inquiries are answered by its in-house telesales staff. These telesales professionals seek to enroll students over the telephone without needing to send the customer ICS' traditional sales literature. During the past two years, new telesales departments have been established in Canada, the United Kingdom and Australia. Telesales improved the number of prospective students converted into enrollments and, accordingly, contributed to the 10.1% increase in enrollments at ICS. During 1993, ICS created ICS Online, which is an electronic campus now available on America Online. Through this electronic campus, ICS offers real-time instruction, and ICS students can query their instructors, learn from other students, and discuss their lessons with each other. To accommodate future growth, ICS acquired a warehouse during September 1993. The warehouse consists of 82,000 square feet and is located on approximately 31 acres of land in Ransom, Pennsylvania. Advertising and Marketing. ICS markets its independent study courses throughout its United States and international operations utilizing direct response advertising through print, television media and direct mail marketing. Telemarketing is also used in the United States, Canada, United Kingdom, and Australia. During 1993, ICS began using its computer driven predictive dialing system in its United States-based operation to dial back automatically individuals who have previously requested information from ICS. Live operators then speak directly to the consumer about enrolling in the program. This process has improved telemarketing productivity. Also during 1993, ICS increased its handling of inbound marketing calls by establishing more inbound lines directly to the ICS Marketing Call Center. All of ICS' independent study courses in the United States are accredited by the NHSC. ICS also offers courses in many other English- speaking countries throughout the world. During 1993, ICS enrolled students from more than 150 different countries. With the 1993 transfer of NETG's Industrial Print operation to ICS, which ICS combined with the English Language Institute acquired in 1992 and renamed ICS Learning Systems, Business and Industrial Training Division, ICS intends to pursue independent study training opportunities with business and government agencies. ICS has renewed its marketing and sales efforts by expanding its sales force, streamlining its catalog and offering more courses in an effort to expand this division's customer base. Competition. The independent study industry is highly competitive. The company faces direct competition from United States and foreign independent study providers and indirect competition from community colleges, vocational and technical schools, two-year colleges and universities, and, to a lesser extent, governmental entities and other "distance learning" companies and schools, including electronic universities. In recent years, technological changes have increased the variety of choices available to students in selecting the type of education and the manner in which it is delivered, thereby increasing the entities with which ICS competes for student enrollment. Overall, the Company believes that ICS' competitive position is good. Steck-Vaughn Publishing Corporation General. Steck-Vaughn is one of the country's largest publishers of supplemental educational materials and offers educators a broad range of quality products that address educational needs from early childhood through adulthood. The term "supplemental materials" generally refers to softcover, curriculum-based books, workbooks and other support materials that are used in conjunction with or instead of traditional hardcover "basal" textbooks. Steck-Vaughn also publishes reference and nonfiction products for school and public libraries, as well as bookstores. Sales and Marketing. Steck-Vaughn markets all of its products through multiple distribution channels, including a national sales and telesales organization and has an established reputation for meeting the needs of its broad-based markets. Additionally, Steck-Vaughn has a distributor organization which services public libraries, trade outlets, and other nontraditional school markets. Steck-Vaughn has begun to establish a presence in foreign markets where English language curriculum and library products are in demand. Steck-Vaughn's customer service group emphasizes prompt and accurate delivery of published materials. Steck-Vaughn expanded and realigned its sales force, effective January 2, 1994, into two segments. One group will concentrate on the elementary and junior high schools and school and public libraries, and the other group will focus on the high school and adult education markets. This reorganization of what was previously a smaller group calling on all Steck-Vaughn markets will allow the two groups to focus their expertise, time and energy in a more productive way. Product Development. During the past three years, Steck-Vaughn has increased significantly the number of new educational materials created primarily for use in elementary and secondary schools. In 1991, Steck-Vaughn augmented its development of library titles with the addition of the Raintree product line, a highly respected library publisher in the children's library market. Steck-Vaughn has also responded to growing areas of adult education with the introduction of new publications for adult basic education and adult literacy. In 1990 and again in 1993, Steck-Vaughn was awarded the exclusive distribution rights of the Official Practice Test of the GED Testing Service of the American Council for Education. In April 1993, Steck-Vaughn acquired THE MAGNETIC WAY(TM) product line from Creative Edge, Inc. The product line consists of magnetized boards with metallic coated visual overlays. These products are used by teachers and students to build hands-on displays paralleling curriculum topics for social studies, language arts, reading and science. Twelve comprehensive learning packages, which sell for $200-$450 each, are currently available for use with the magnetized board which sells for approximately $85. Steck-Vaughn also introduced a lower-priced, smaller set of similar products in the fall of 1993. Competition. There are many companies that compete with Steck-Vaughn in the educational publishing field. No single company is dominant in the industry segments for which Steck-Vaughn publishes. Overall, the Company believes that Steck-Vaughn's competitive position is good and that growth has occurred due to new products and increased sales and market penetration. National Education Centers, Inc. General. Education Centers operates 33 postsecondary career schools in urban and suburban locations in 16 states. In addition, Education Centers is in the process of closing 15 schools, which are in various stages of teaching existing students until the schools close. The schools provide training for entry-level occupations in five major disciplines: Medical, Electronics, Business, Automotive, and Aviation. Most schools offer multiple curricula, but no school offers every discipline. Hands-on training using labs and some media-based delivery methodologies form the basic curriculum philosophy. Programs ranging in length from 8 to 36 months are offered to individual students as well as government agencies with a training mandate and organizations having employee training needs that are met by Education Centers' curricula. Curricula. The occupations for which Education Centers offers training programs include medical and dental assistants, electronics technicians, computer-aided drafters, computer programmers, commercial artists, aviation mechanics, broadcast technicians, secretaries, personal computer specialists, ophthalmic technicians, automotive mechanics and pilots, among others. Certain schools offer Bachelor degrees in Interior Design and Electronics Engineering Technology. Tuition for the programs ranges from $4,000 to $25,000 depending on length of course and subject matter. Tuition for government and industry training engagements varies from contract to contract as a function of contract training hours. All courses offered by Education Centers were developed internally or with the assistance of consultants. The development process begins with the establishment of criterion-referenced learning objectives based on achieving skills-based competencies demanded by employers. These objectives drive the development of lesson plans for instructors to follow. Specific test-bank items are then prepared to ensure students master the subject matter. Education Centers has emphasized a modular, nonsequential curriculum design structure for newer programs. The modular design enables Education Centers to start students more frequently and reduce costs due to increased efficiencies. National focus group meetings and surveys conducted in 1993 have provided input from employers that will result in a number of initiatives, including major modifications to the electronics and allied health curricula. Also, program opportunities were identified in computerized accounting and secretarial areas. While these two curricula are not new to Education Centers' program directory, they will be considered for new development with a high-technology focus in 1994. An approach emphasizing individual product lines has been incorporated into the curriculum development and maintenance process which will better integrate the various facets of the business. Job Placement. Over the past three years Education Centers has placed almost 32,500 graduates in jobs. Education Centers maintains placement personnel in each school, has fully computerized its job placement tracking system, and has initiated communication and training programs to achieve its placement goals. To ensure fair value to its student clients, Education Centers has increased its focus from simply graduating students to placing and verifying that graduates are experiencing initial success in their positions for at least three months. Education Centers continues to monitor the overall placement rate as an indicator of progress. Completion. Completion is recognized as one of the critical measures of Education Centers' success. The completion rate for 1993 was 59.5%, with significantly better rates in short-term programs. Higher entrance standards, greater focus on each student's commitment at enrollment, enhanced curricula, greater focus on career development skills, better placement information, and increased involvement with placement staff are several initiatives being implemented to increase completion, as well as placement rates. Financial Aid. Education Centers assists its students in assessing their eligibility for financial aid and in procuring available financial aid. Federal and state financial aid represented approximately 85 percent of Education Centers' revenues and approximately 32 percent of consolidated revenues in 1993. Grant programs, principally the Pell grant, entitle certain students to receive funds for tuition and other educational expenses, based on financial need. These grants may be available to students with family incomes of less than $25,000 per year, and historically many students of Education Centers qualified for these grants. There is no assurance that future governmental programs providing financial assistance to Education Centers' students will remain available at levels which have existed in prior fiscal years. Certain provisions of the Higher Education Act of 1992, as well as the recent Omnibus Budget Reconciliation Act, caused some lenders to terminate participation in federally guaranteed loan programs. Students' access to government financial aid programs has become more restricted due to an increasing number of lenders and guarantors declining to serve vocational schools with shorter-term programs or higher default rates. To alleviate the problem, during the third quarter of 1993, Education Centers ceased enrollments at 14 schools and initiated a program to provide internal financing to Education Centers' students. (For more detailed information regarding discussion of financial aid, see the "Liquidity and Capital Resources" section starting on page 21 of the Company's 1993 Annual Report to Stockholders.) Education Centers has instituted a student loan default reduction program which includes information from the Default Management Manual prepared and distributed by the Career College Association. Education Centers has also incorporated information from the Department of Education Default Reduction Initiative federal regulations issued June 5, 1989, into its default program, plus additional default reduction strategies of its own. Additionally, most of Education Centers' schools use an outside consulting group to contact former students who are reported as delinquent in federal loan repayments to provide information and assistance in avoiding a default on their loans. Education Centers anticipates that its current default programs will reduce the number of future student loan defaults. Accreditation. All schools operated by Education Centers are accredited. Of the 33 schools currently enrolling students, 28 are accredited by the Accrediting Commission of Career Schools and Colleges of Technology (formerly known as the Accrediting Commission for Trade and Technical Schools), and five are accredited by the Accrediting Council for Independent Colleges and Schools, formerly known as the Accrediting Commission for Independent Colleges and Schools. Each school voluntarily undergoes periodic accrediting evaluations by teams of qualified examiners. Advertising and Marketing. Education Centers markets its courses to individual students, organizations, and governmental agencies. It utilizes various direct response advertising media including television, direct mail, and newspapers. In addition, Education Centers offers 90 partial-tuition scholarships to high school students in markets where its schools are located and utilizes Education Centers' employees to give public service presentations at these high schools. For organizations and government entities, Education Centers maintains a staff to make sales calls and prepare proposals based on training needs analyses and/or the existing government request for proposal process. Competition. Education Centers encounters active competition in the marketing of vocational and technical training programs from junior colleges and other public institutions, military training programs, and other proprietary schools. The nature and degree of competition largely depend on the courses being offered by Education Centers' locations and the geographical proximity of competing schools. Competitors may vary substantially in the treatment of course subject matter, the amount of tuition or other fees charged, the duration of the course, and the job placement success rate. Overall, the Company believes Education Centers' competitive position is satisfactory. National Education Training Group, Inc. General. Established in the late 1960s, NETG specializes in providing multimedia products to educate, train and transfer skills to corporate and government employees, with specific emphasis on information systems training. Headquartered in Naperville, Illinois, NETG course offerings range from hands-on, skill-based training to courses that build awareness or provide a theoretical understanding of current business developments. Markets, Products and Delivery Media. NETG offers education and training in the areas of information technologies, enterprise systems, desktop computing, management and professional development, and manufacturing and industrial skills. Because each training audience has its own specific needs, NETG has subdivided its curricula into five primary product lines: Desktop Computing. Today's business environment has generated an overwhelming demand for end-user business applications and desktop system training. In response to this demand, NETG has harnessed the enormous potential of current technologies, such as compact disc-read only memory ("CD-ROM"), the 486-based workstation, and sophisticated training and work support system. The end-user courses are built around specific business case scenarios that allow participants to learn relevant skills quickly and immediately apply those skills to their jobs. Information Technologies (Client/Server Computing and Enterprise Systems Product Lines). NETG has a long history of supporting information systems training. Today the course offerings reflect the varied and changing nature of information systems and include topics on a wide range of technologies such as client/server, object-oriented technologies, networking, and open systems technologies. Management and Professional Development. NETG offers effective, relevant management and professional development training that can help organizations meet their business needs and objectives. The courses emphasize productivity and performance issues. They provide the means for improving personal, management and business skills that are essential to developing highly productive and professional employees. Manufacturing and Industrial Skills. Today's manufacturing and industrial organizations are concerned with reducing costs, reducing risks of accidents, complying with regulations and creating an overall healthy work environment. NETG is committed to providing workers with the most accurate, comprehensive and up-to-date training solutions available. The NETG course library features approximately 1,000 courses on a variety of media including: 1) Videotape: Each video course is a training package comprised of one or more videotaped instructional sessions, audio sessions, and associated textual materials, including comprehensive student and coordinator guides. Groups of related video courses in a specified curriculum are taken as needed by the student to develop various job-related skills either at a task level or at a complete topical level. 2) Local Area Network ("LAN"): Organizations are interconnecting more and more personal computers and workstations via LANs to enable individuals to share information and communicate effectively. Training applications conveniently residing on LANs enable individuals to select from a variety of courses for use on their desktop systems. A number of NETG's computer-based products are available for use on LANs, including the SKILL BUILDER(R) courses. 3) Interactive Video Instruction ("IVI"): Many of NETG's courses are available through interactive delivery media, interactive videodiscs and computer diskettes in conjunction with related textual materials and guides. IVI combines the interactivity and control of the personal computer with video, sound and graphics. 4) Computer-Based Training ("CBT"): CBT products use a computer to deliver interactive instruction, drill and practice, simulation and remedial training. Training programs in NETG's mainframe CBT library include information processing skills training, end-user computing and fourth generation languages, and other subjects related to the application of information technologies. Customers can distribute CBT through worldwide networks because the CBT is stored on a mainframe computer and the training may be accessed simultaneously by students in multiple locations. 5) Compact Disc-Read Only Memory ("CD-ROM"): CD-ROM formatted products are interactive and targeted to meet the growing demands of desktop training. NETG's SKILL BUILDER(R) Series offers a unique architecture which provides a method of learning an application program in which different learning paths may be utilized. The digital mass storage capability inherent in CD-ROM creates lower delivery costs and facilitates updating or customizing the content. 6) Instructor-Led Training ("ILT"): NETG's ILT Group provides a network of skilled instructors to conduct courses in data processing, end user computing, human resource development and manufacturing. NETG's instructor-led programs offer tested course materials developed by training experts within each field. Course content is regularly updated to incorporate the latest technological advances. This selection of delivery options allows greater flexibility in designing training programs that are customized to specific resources. Each of these media offer particular strengths that are brought into play by the requirements of individual training programs. Course Production and Acquisition. NETG has significantly increased its investment in product development to expand course offerings in the emerging technology areas of client/server computing, networking, object-oriented technologies, business reengineering, desktop computing, management and professional development, and manufacturing and industrial skills. NETG is providing high quality learning solutions that effectively and efficiently deliver a direct learning payoff to the participant. All NETG courses are designed to introduce the topic, state the purpose, present the subject matter, and provide examples and practice exercises. NETG's new educational instruction system allows an individual to select from three types of content: informational, conceptual and skills-based training: Informational Courses - build awareness about the particular course topic. The student will acquire a high-level understanding of the subjects covered. These courses are primarily descriptive, and their technical content is lower than the other two course types. Conceptual Courses - provide the student with a theoretical understanding of the topic. After completing the course, the student will have an analytical perspective of the subjects covered. Skills-Based Courses - teach proficiency in a topic. After completing these courses, the student will have a practical knowledge of the subject. Acquisitions/Corporate Partners. NETG is actively acquiring products and technology through strategic alliances and co-development agreements with leading software vendors and training organizations that offer expertise on advanced technologies, desktop computing and management and professional development skills. These choices are driven by customer requests and current market trends. As part of a commitment to quality standards, topics are selected and produced with leading subject matter experts, industry authorities and top educators in each subject area. By aligning itself with leading training developers and industry experts on the most sought after topics in today's business environment, NETG can provide its customers with timely and relevant training and education solutions that provide the proficiency and competency organizations are seeking. NETG corporate business partners include: Andersen Consulting Hands On Learning Individual Software Intelecom Intelligent Communications MicroVideo Learning Systems Novell, Inc. Open Systems Training Video Publishing House Wave Technologies Wilson Learning Xebec Multi-Media Solutions Customized Services. NETG-Spectrum in Bedford, Massachusetts, is the consulting and custom development division of NETG. Spectrum specializes in helping companies use the power of multimedia technology to improve the knowledge, skills and performance of people. Spectrum's high quality, practical solutions have supported strategic change and achieved significant business results such as reduced costs, increased sales, enhanced customer satisfaction, decreased turnover, increased span of control and improved timeliness of information. For over a decade, Spectrum has provided a full scope of services in the design of multimedia performance systems, including consulting, instructional systems design, media production and implementation services. Spectrum uses a full range of delivery media and systems encompassing interactive video, desktop multimedia, workshops, print and video. After determining the optimal choice of media and methods to solve the problem and reach the audience, Spectrum serves as the learning system's integrator to ensure improved performance and results. Distribution, Service, Marketing and Sales. NETG is an international organization with 74 offices and production and distribution centers worldwide. The corporate headquarters are in suburban Chicago, Illinois, and international headquarters are in London, England. The company has approximately 600 employees. Wholly owned subsidiaries are located in the United Kingdom, Netherlands, Germany and Austria. NETG Service System. NETG's Product Support Center, located in Naperville, Illinois, provides customers with toll-free technical assistance, answers to software and hardware questions, and assistance in the installation and ongoing use of courseware products. Support analysts are available to address inquiries 24 hours a day, seven days a week. Customers may also log and track inquiries through a bulletin board. In addition to toll-free product support, NETG also provides toll-free customer service for order placement and product descriptions, including course profiles, prerequisites, target audience descriptions, and details on specific components of courses. NETG also conducts progress reviews which measure and evaluate the success of a training program, as well as an inventory tracking system that details which courses were received, installed and returned. Additional services available to customers include: consultative training needs analysis to help customers identify all performance improvement opportunities; training management workshops that provide training administration techniques; and custom training product design and development services to modify existing courses or develop new fully customized courses. NETG Sales Organization and Distribution Channels. NETG's revenues are primarily generated from customer contracts. Customers typically sign annual agreements based on the amount of training they would expect to require in a twelve-month period. Contracts range from approximately $2,000 to over $1,000,000. NETG has a staff of telemarketing and telesales representatives in the United States, and a separate telesales staff in Europe. The telesales groups offer the same products as the direct sales force, but focus their efforts toward companies with revenues between $100 - 200 million. The sales cycles average two to four months and the average contract is $3,000. NETG's products are also available through local distributors or agents in Argentina, Australia, Bolivia, Brazil, Canada, Denmark, Ecuador, Egypt, Finland, France, Ghana, Hong Kong, India, Iran, Israel, Korea, Malaysia, New Zealand, Nigeria, Norway, Peru, Russia, Saudi Arabia, Singapore, Spain, Sweden, Taiwan, Turkey, the United Arab Emirates, and Venezuela. Competition. The Company believes the total training market in North America is in excess of $45 billion annually for industry and government, and that NETG is one of the largest multimedia training companies in this very large, highly fragmented and competitive market. Most training needs are satisfied by instructor-led training. NETG faces active competition from existing or potential client internal training operations, vendor-supplied training operations, other independent training companies offering instructor-led or multimedia training, universities and community college systems. NETG competes in the training market on the basis of: quality and instructional effectiveness of its training programs; quantity, thoroughness and timeliness of its training programs; price; ability to deliver course material in a timely manner; and client services. Overall, the Company believes that its competitive position is good. Major competitors include CBT Systems, SRA and COMSELL, among others. Foreign Operations The following table shows consolidated net revenues of the Company in foreign countries for 1993, 1992 and 1991: Consolidated operating results are reported in United States dollars. Because the foreign subsidiaries of the Company conduct operations in the currencies of the countries in which they are based, all financial statements of the foreign subsidiaries must be translated into United States dollars. As the value of the United States dollar increases or decreases relative to these foreign currencies, the United States dollar value of items on the financial statements of the foreign subsidiaries is reduced or increased, respectively. Therefore, changes in dollar sales of the foreign subsidiaries from year to year are not necessarily indicative of changes in actual revenues recorded in local currency. Financial information about foreign and domestic operations is described in Note 13, page 33 of the Company's 1993 Annual Report to Stockholders, which Note is hereby incorporated by reference in this Annual Report on Form 10-K. The Company's ability to continue operations outside of the Unites States or maintain the profitability of such operations is to some extent subject to control and regulation by the United States government and foreign governments. The Company's foreign operations are primarily located in the United Kingdom, Canada, Australia and Germany, which historically have controlled and regulated businesses in the same manner as the United States. Research and Development The amount spent during 1993, 1992 and 1991 on Company-sponsored research and development activities was approximately $24 million, $20 million, and $18 million, respectively. In 1993, the Company continued to invest in research and development to ensure new product availability for future revenue generation. The Company spends substantial sums primarily in the development of new products at NETG and Steck-Vaughn, and curricula for ICS and Education Centers. Seasonality of the Business Most of Steck-Vaughn's sales are made in the third quarter of the year because most of its customers purchase products in anticipation of classes commencing in the fall. ICS' business is moderately seasonal with more students studying during the latter part of the year. The Education Centers' business is moderately seasonal due to the inclination of its students to commence classes in the fall. NETG's business is seasonal due to the sales cycle from contracts expiring in the latter half of the year. There is no customer to whom sales are made in an amount that exceeds two percent or more of the Company's consolidated annual net revenues. Additional Information Unearned future tuition income for Education Centers and ICS, which represents amounts estimated to be recognized as revenue in subsequent years as services and courseware are provided, is described in Note 10, page 32 of the Company's 1993 Annual Report to Stockholders, which Note is hereby incorporated by reference in this Annual Report on Form 10-K. Financial information about industry segments is described in Note 13, page 33 of the Company's 1993 Annual Report to Stockholders, which Note is hereby incorporated by reference in this Annual Report on Form 10-K. Compliance with federal, state or local provisions concerning the discharge of materials into the environment or otherwise relating to the protection of the environment have no material effect on the Company's capital expenditures, earnings or competitive position. The Company employed approximately 4,200 persons as of January 31, 1994. Executive Officers of the Company The following table provides information regarding executive officers of the Company, including their ages as of March 1, 1994: ITEM 2. ITEM 2. PROPERTIES. (a) The Company's corporate headquarters are located in leased facilities aggregating 40,000 square feet in Irvine, California. (b) The Company owns real property consisting of approximately 2.2 acres of land with a 22,000 square foot building in Nutley, New Jersey, for a National Education Center. (c) The Company owns an 180,000 square foot building on 15 acres of land and 80,000 square feet of buildings on leased land in Tulsa, Oklahoma, for a National Education Center. (d) The Company owns real property in Scranton, Pennsylvania, for the principal offices of ICS. This building consists of 120,000 square feet of space on 14.3 acres of land. (e) The Company owns an 82,000 square foot building on approximately 31 acres of land in Ransom, Pennsylvania for an ICS warehouse. (f) The Company owns the land and building serving as the warehouse for Steck-Vaughn Company. The building, located in Austin, Texas on approximately 13 acres of land, contains 101,000 square feet of space. (g) The Company owns 28,200 square feet of buildings on approximately 4.7 acres of land in Little Rock, Arkansas, for a National Education Center. (h) The Company owns 22,000 square feet of buildings on approximately 4.8 acres of land in West Des Moines, Iowa, for a National Education Center. (i) The Company owns 60,000 square feet of buildings on approximately 3.1 acres of land in Blairsville, Pennsylvania, for a National Education Center. (j) The Company owns 10,000 square feet of buildings on approximately .5 acres of land in Minneapolis, Minnesota, for a National Education Center. (k) The Company has approximately 130 leases for its operating units and offices, including the following: National Education Centers, Inc.'s headquarters in Irvine, California - approximately 24,000 square feet; National Education Training Group, Inc.'s headquarters in Naperville, Illinois - approximately 30,000 square feet; Steck-Vaughn Company's headquarters in Austin, Texas - approximately 31,000 square feet; and Spectrum's headquarters in Bedford, Massachusetts - approximately 52,500 square feet. Overall, the Company's properties are suitable and adequate for the Company's needs. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is a party to litigation matters and claims which are routine in the course of its operations and, while the results of litigation and claims cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a materially adverse effect on the Company's consolidated financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of the Company's stockholders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The markets on which the Company's Common Stock is traded and the high and low sales prices of the Company's Common Stock during each quarter for the last two years, appears on page 37 of the Company's 1993 Annual Report to Stockholders, which information is hereby incorporated by reference in this Annual Report on Form 10-K. No cash dividends have been declared or paid on the Company's Common Stock during 1993 or 1992. The Company has no present intent to pay cash dividends. The Company's Credit Agreement with its lending institutions restricts the payment of cash dividends. Approximate Number of Equity Security Holders: The number of record holders is based upon the actual number of holders registered on the stock transfer books for the Company at such date and does not include holders of shares in "street names" or persons, partnerships, associations, corporations or other entities identified in security position listings maintained by depository trust companies. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following financial information for the years 1989 through 1993 included in the Company's 1993 Annual Report to Stockholders is incorporated by reference in this Annual Report on Form 10-K: Five-Year Financial Highlights, page 18. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following information included in the Company's 1993 Annual Report to Stockholders is incorporated by reference in this Annual Report on Form 10-K: Management's Discussion and Analysis, pages 19 through 23. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The following financial statements and the supplementary financial information included in the Company's 1993 Annual Report to Stockholders are incorporated by reference in this Annual Report on Form 10-K: The consolidated financial statements of the Company, pages 24 through 27 together with the report of Price Waterhouse, dated February 4, 1994 pertaining to the consolidated financial statements as of December 31, 1993 and 1992, and for the three years ended December 31, 1993, page 35. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. The Company has no information to report in response to this item. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY. (a) The information required by Item 10 with respect to the directors of the Company is incorporated herein by reference from the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders which will be mailed to stockholders and filed with the Securities and Exchange Commission on or about March 28, 1994. (b) The information required by Item 10 with respect to executive officers of the Company is furnished in a separate item captioned "Executive Officers of the Company" and included in Part I of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required by Item 11 is incorporated herein by reference from the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders which will be mailed to stockholders and filed with the Securities and Exchange Commission on or about March 28, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by Item 12 is incorporated herein by reference from the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders which will be mailed to stockholders and filed with the Securities and Exchange Commission on or about March 28, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Item 13 is incorporated herein by reference from the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders which will be mailed to stockholders and filed with the Securities and Exchange Commission on or about March 28, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. * Incorporated by reference from the indicated pages of the Company's 1993 Annual Report to Stockholders. **All other financial statement schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (3) Exhibits: See Exhibit Index. (b) No reports on Form 8-K were filed during the fourth quarter of 1993. NATIONAL EDUCATION CORPORATION REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of National Education Corporation Our audits of the consolidated financial statements referred to in our report dated February 4, 1994 appearing on page 35 of the 1993 Annual Report to Stockholders of National Education Corporation (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) 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 Costa Mesa, California February 4, 1994 NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES At December 31, 1993 (dollars in thousands) NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (dollars in thousands) (A) This amount primarily represents the write-off of intangible assets in connection with previous acquisitions for the Company's National Education Training Group of $9,232,000 and National Education Centers of $2,766,000. NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM AND BANK BORROWINGS (dollars in thousands) No short-term or bank borrowings were outstanding during the twelve month period ended December 31, 1992 and 1993. (A) - The average amount outstanding during the period was computed by dividing the total of the daily principal balances by 365. (B) - The weighted average interest rate during the period was computed by dividing the total interest expense by the weighted average principal amounts of borrowings. (C) - These amounts exclude the portion of domestic bank debt which was refinanced by the issuance of the $20,000,000 senior subordinated convertible debentures in February 1991. NATIONAL EDUCATION CORPORATION AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY CONSOLIDATED INCOME STATEMENT INFORMATION (dollars in thousands) Taxes other than income and payroll taxes are not presented as the amounts are less than one percent of total revenues. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. NATIONAL EDUCATION CORPORATION Date By /s/ JEROME W. CWIERTNIA March 16, 1994 - -------------------------------------- Jerome W. Cwiertnia 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 Company and in the capacities and on the dates indicated. Date By /s/ JEROME W. CWIERTNIA March 16, 1994 - -------------------------------------- Jerome W. Cwiertnia, Director, President and Chief Executive Officer (Principal Executive Officer) By /s/ KEITH K. OGATA March 16, 1994 - -------------------------------------- Keith K. Ogata, Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) By /s/ CHRISTINE A. GATTENIO March 16, 1994 - -------------------------------------- Christine A. Gattenio, Vice President and Corporate Controller (Principal Accounting Officer) Date By: /s/ RICHARD C. BLUM March 10, 1994 - --------------------------------------------- Richard C. Blum, Director By: /s/ DAVID BONDERMAN March 14, 1994 - --------------------------------------------- David Bonderman, Director By: /s/ LEONARD W. JAFFE March 11, 1994 - --------------------------------------------- Leonard W. Jaffe, Director By: /s/ DAVID C. JONES March 10, 1994 - --------------------------------------------- David C. Jones, Director By: /s/ MICHAEL R. KLEIN March 10, 1994 - --------------------------------------------- Michael R. Klein, Director By: /s/ PAUL B. MACCREADY March 11, 1994 - --------------------------------------------- Paul B. MacCready, Director By: /s/ FREDERIC V. MALEK March 10, 1994 - --------------------------------------------- Frederic V. Malek, Director By: /s/ JOHN J. MCNAUGHTON March 9, 1994 - --------------------------------------------- John J. McNaughton, Director By: /s/ HAROLD SEGAL March 10, 1994 - --------------------------------------------- Harold Segal, Director By: /s/ WILLIAM D. WALSH March 10, 1994 - --------------------------------------------- William D. Walsh, Director INDEX TO EXHIBITS (Item 14(a)) * incorporated by reference from a previously filed document (1) Incorporated by reference to Exhibit (19)-2 filed with the Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1987. (2) Incorporated by reference to Exhibit 10 filed with the Form 10-Q Quarterly Report for the quarterly period ended June 30, 1990. (3) Incorporated by reference to Exhibit 10.1 filed with the Annual Report on Form 10-K for the year ended December 31, 1992, filed March 22, 1993. (4) Incorporated by reference to Exhibit 10(b) filed with Registration Statement on Form S-8 (No. 2-86904), filed October 3, 1983. (5) Incorporated by reference to Exhibit 15 filed with Registration Statement on Form S-8 (No. 2-71650), filed April 7, 1981. (6) Incorporated by reference to Exhibit D filed with the 1983 Proxy Statement dated April 25, 1983, for the annual meeting dated May 19, 1983. (7) Incorporated by reference to Exhibit 10.15 filed with the Annual Report on Form 10-K for the year ended December 31, 1987, filed March 30, 1988. (8) Incorporated by reference to Exhibit 10.17 filed with the Annual Report on Form 10-K for the year ended December 31, 1990, filed April 1, 1991. (9) Incorporated by reference to Exhibit "A" filed with the 1990 Proxy Statement, filed April 2, 1990. (10) Incorporated by reference to Exhibit "A" filed with the 1991 Proxy Statement, filed April 1, 1991. (11) Incorporated by reference to Exhibit 4.1 filed with Form 8-K Current Report, dated October 29, 1986, filed October 30, 1986. (12) Incorporated by reference to Exhibit 4 filed with the Annual Report on Form 10-K for the year ended December 31, 1987, filed March 30, 1988. (13) Incorporated by reference to Exhibit 4.2 filed with Amendment No. 1 to Registration Statement on Form S-3 (No. 33-5552), filed May 16, 1986. (14) Incorporated by reference to Exhibit 4 filed with the Form 10-Q Quarterly Report for the quarterly period ended June 30, 1990. (15) Incorporated by reference to Exhibit 4 filed with Form 8-K Current Report, dated February 20, 1991, filed February 27, 1991. (16) Incorporated by reference to Exhibit 10.17 filed with the Annual Report on Form 10-K for the year ended December 31, 1991, filed April 1, 1992. (17) Incorporated by reference to Exhibit 10.18 filed with the Annual Report on Form 10-K for the year ended December 31, 1991, filed April 1, 1992. (18) Incorporated by reference to Exhibit 10.19 filed with the Annual Report on Form 10-K for the year ended December 31, 1991, filed April 1, 1992. (19) Incorporated by reference to Exhibit 10.8 filed with Amendment No. 1 to the Steck-Vaughn Publishing Corporation Registration Statement on Form S-1, File No. 33-62334, filed June 17, 1993. (20) Incorporated by reference to Exhibit 10.9 filed with Amendment No. 1 to the Steck-Vaughn Publishing Corporation Registration Statement on Form S-1, File No. 33-62334, filed June 17, 1993. (21) Incorporated by reference to Exhibit 10.13 filed with the Steck-Vaughn Publishing Corporation Registration Statement on Form S-1, File No. 33-62334, filed May 7, 1993. (22) Filed herewith.

18672_1993.txt

18672_1993

1993

18672

ITEM 1. BUSINESS GENERAL Central Louisiana Electric Company, Inc. (the Company) was incorporated in 1934 under the laws of the State of Louisiana and is engaged principally in the generation, transmission, distribution and sale of electric energy to approximately 213,000 customers in 63 communities and contiguous rural areas in a 14,000 square mile region in the State of Louisiana. At December 31, 1993 the Company employed 1,224 persons. The Company's mailing address is P. O. Box 5000, Pineville, Louisiana 71361-5000, and its telephone number is (318) 484-7400. ELECTRIC OPERATIONS POWER GENERATION The Company operates and either owns or has an ownership interest in four steam electric generating stations. The Company is the sole owner of the Coughlin Power Station, the Teche Power Station and Rodemacher Power Station Unit 1. The Company owns a 50% interest in Dolet Hills Power Station Unit 1 (Dolet Hills Unit 1), and a 30% interest in Rodemacher Power Station Unit 2 (Rodemacher Unit 2). At December 31, 1993, the Company's aggregate electric generating capacity at the four stations was 1,686,000 kilowatts. The following table sets forth certain information with respect to the Company's generating facilities. FUEL The following table sets forth, for the periods indicated, the percentages of power generated from various fuels at the Company's electric generating plants, the cost of fuel per kilowatt hour (KWH) attributable to each such fuel and the weighted average fuel cost per KWH. For information with respect to the Company's ability to pass through changes in costs of generating fuel to its customers, see "Regulatory and Environmental Matters - Rates" hereunder. Gas Supply During 1993 the Company purchased a total of 28,083 billion British thermal units (MMMBtu) of natural gas for the generation of electricity. The annual and average per-day quantities of gas purchased by the Company from each supplier is shown in the table below. Effective January 1, 1992 the Company entered into a new contract with Arkla General Supply Company (AGS), a division of Arkla Energy Marketing Company which is a subsidiary of Arkla, Inc., for the sale of natural gas to be delivered to the Company's four power stations. The contract provides for a firm gas supply through the year 2000 in quantities sufficient to meet the Company's internal system requirements and contains options designed to enable the Company to manage the natural gas component of its total fuel costs. Concurrently with the signing of the gas supply contract, AGS entered into a contract with Louisiana Intrastate Gas Corporation (LIG), which at the time was a wholly owned subsidiary of Arkla, Inc., for the transportation of the gas purchased from AGS. Under the terms of the gas supply contract, AGS incurs the cost of transporting gas via LIG's pipelines to the Company's power stations. The gas supply contract with AGS allows the Company to select in advance, on an annual basis, how the Company will meet its internal system requirements for gas. One option allows the purchase of gas exclusively from AGS with transportation provided by LIG. Another option allows supply needs to be met with gas purchased from AGS and third party gas suppliers and transported by others or by LIG. The Company may continue to purchase gas under a prior contract with LL&E Gas Marketing, Inc. (described in further detail below) without such purchases being considered as purchases from a third party supplier, unless the Company has elected to purchase gas from third party suppliers. The contract with AGS contains pricing mechanisms for gas purchased thereunder which are intended to approximate current market prices at the time of purchase and are designed to be competitive with prices paid by other Louisiana utility companies. In addition to standard contractual termination provisions, the contract may be terminated by either party, subject to acceptance by the other party, if the price calculated according to the contract is determined to be unacceptable. If notice of termination is given because of pricing, the contract will remain in effect for a period of twelve months, and LIG will remain obligated to transport replacement gas for an additional eighteen months. The contract with AGS also contains minimum and maximum supply obligations which are based upon the Company's seasonal generation requirements and are dependent upon which option is selected by the Company. The supply obligations under either option may be increased if the Company's solid-fuel generating units are unavailable due to scheduled or unscheduled maintenance outages or for other reasons. The Company is obligated to purchase certain quantities of gas from AGS on an annual basis. A minimum or base quantity of 20,000 MMMBtu of gas must be purchased during a year, adjusted by plus or minus 10% at the option of the Company each year, if all gas is purchased from AGS. A minimum of 25,000 MMMBtu must be purchased during a year if any gas is purchased from third party suppliers. In 1993 the base quantity of gas to be purchased under the AGS contract was 20,000 MMMBtu. During 1993 the Company purchased a base quantity of 20,045 MMMBtu of gas, including gas purchased on behalf of Southwestern Electric Power Company (SWEPCO), joint owner of Dolet Hills Unit 1, and Louisiana Energy and Power Authority (LEPA) and Lafayette Public Power Authority (LPPA), joint owners of Rodemacher Unit 2. During 1993 the Company did not purchase any gas from third party suppliers under the terms of the contract with AGS. During 1993 the Company entered into a separate contract with LIG for the sale and transportation of natural gas to the Company's power stations. A total of 6,040 MMMBtu of "spot" and surplus gas was purchased from LIG during 1993 under an interim sale and transportation agreement. Gas purchased under the LIG contract is not considered to be purchases from third parties under the gas supply contract between the Company and AGS. The contract with LIG provides for the purchase of spot gas for the Company's internal system requirements when the price of such gas is less than that of energy purchases from other utilities and provides for the purchase of surplus gas, if and when it is available, for energy sales to other utilities. The Company has a separate contract with LIG which provides for the transportation of gas purchased by the Company from third party suppliers or under circumstances where AGS fails to meet its contract obligations. The Company has contracted with LL&E Gas Marketing, Inc., an affiliate of Louisiana Land & Exploration Company, for the purchase of up to 5 MMMBtu of gas per day on a month-to-month basis, subject to termination by either party. The purchase price of the gas is based on a monthly index plus a markup and transportation fee. Purchased gas is transported via the intrastate pipeline system owned and operated by LIG. The Company has never incurred a liability for any gas not taken under the take-or-pay provisions of its gas supply agreements. Although natural gas has been relatively plentiful in recent years, supplies available to the Company and other consumers are vulnerable to disruption due to weather conditions, transportation disruption, price changes and other events. Large boiler-fuel users of natural gas, including electric utilities, generally have the lowest priority among gas users in the event pipeline suppliers are forced to curtail deliveries due to inadequate supplies. Thus, supplies of natural gas may become unavailable from time to time, or prices may increase rapidly in response to temporary supply disruptions. Such events may require the Company to shift its gas- fired generation to alternative fuel sources such as fuel oil to the extent it has the capability to burn those alternative fuels. Currently, the Company anticipates that its alternative fuel capability, combined with its solid-fuel generating resources, are adequate to meet fuel needs during any temporary interruption of gas supplies. Coal and Lignite Supply Under the terms of a contract with Kerr-McGee Coal Corporation (Kerr-McGee), the supplier of coal used in Rodemacher Unit 2, the Company has agreed to purchase approximately 12.8 million tons of low- sulfur coal over a 25 year period which began in 1982. The Company estimates that this supply of coal will be sufficient to meet its share of the fuel requirements of Rodemacher Unit 2 during the same period. The price of coal under the contract is a base price per ton plus a "total escalation charge" to reflect changes in certain indices specified in the contract. The contract also provides for adjustment of the price based on the heating value of coal delivered. After purchasing a given annual quantity of base coal, the Company has the right to purchase coal from third parties in the spot market, and Kerr-McGee has the right to meet the terms of the proposed purchase if it chooses to do so. The coal supplied by Kerr- McGee is surface-mined in Wyoming and transported to the Rodemacher Unit 2 site by railroad in unit trains which are leased by the Company pursuant to various long-term leases. The Company has contracted with rail carriers for the transportation of the coal. Although it is possible that the supply of coal could be curtailed because of rail transportation interruptions, the Company has not experienced any significant interruptions in the past. During 1993 the Company purchased 670,845 tons of coal from Kerr-McGee, including 160,847 tons of spot coal. As of December 31, 1993 the cumulative total of coal purchased by the Company since the inception of this contract, which is subject to the 12.8 million ton contract amount, was approximately 6.1 million tons. At December 31, 1993 the Company's coal inventory at Rodemacher Unit 2 was approximately 75,000 tons (about a 34-day supply). Lignite is used as fuel for Dolet Hills Unit 1. The Company and SWEPCO, a co-owner of the unit, have entered into agreements pursuant to which each acquired an undivided 50% interest in the other's leased and owned lignite reserves in northwestern Louisiana. Prior to the commencement of mining operations in 1985, the estimated recoverable lignite reserves from such holdings within the lignite surface mine permit boundary totaled approximately 150 million tons. It is estimated that Dolet Hills Unit 1 will require approximately 75 million tons of lignite for 30 years of operation. The Company and SWEPCO have entered into an agreement with the Dolet Hills Mining Venture for the mining and delivery of lignite required to meet the fuel needs of the unit. No significant delivery disruptions have been experienced since mining operations began, and the Company does not expect any disruptions in the future. The price of lignite delivered pursuant to the agreement is a base price per ton, subject to escalation based on certain inflation indices, plus specified "pass-through" costs. The agreement terminates 25 years after initial operation of the unit, but may be extended up to an additional 20 years at the option of the Company and SWEPCO. During 1993 approximately 2.6 million tons of lignite were mined, bringing the cumulative total of lignite mined since mining operations began to approximately 21.8 million tons as of December 31, 1993. In order to provide an additional source of lignite for Dolet Hills Unit 1, in 1988 the Company entered into a contract with Phillips Coal Company (Phillips) for the purchase of approximately 3.5 million tons of lignite over the life of the contract. Deliveries began during 1989, and the contract will expire on January 1, 2005. The contract was amended in 1988 and assigned by Phillips to Red River Mining Co., a joint venture of the North American Coal Corp. and Phillips. The contract was also amended in 1989 to increase the maximum amount to be delivered during the life of the contract to 3.7 million tons and to increase the maximum amount to be delivered during any year to 430,000 tons. Of this volume, the Company will receive 94.14%, and SWEPCO will receive 5.86%. The minimum annual purchase requirement is 200,000 tons. The price of lignite under the contract is a base price per MMMBtu, subject to escalation, plus certain pass-through costs. The contract may be terminated, subject to penalty provisions, at the option of the Company at any time after January 1, 1995, with 60 days' written advance notice to Red River Mining Co. During 1993 the Company and SWEPCO purchased a total of 460,099 tons of lignite from Red River Mining Co. Of this amount, 205,001 tons were purchased under the base contract, bringing the cumulative total of lignite purchased under this contract as of December 31, 1993 to approximately 1.3 million tons. The remaining 255,098 tons were purchased as spot lignite under two separate amendments negotiated during 1992 and 1993. The spot lignite is purchased at a base price which is escalated in proportion to the escalation in Dolet Hills Mining Ventures' price. Purchases under these amendments are not applicable to the 3.7 million ton contract obligation. The amount of lignite used by the Company during 1993 from both mining sources was approximately 1.5 million tons. The continuous supply of lignite from the mining sources may be subject to interruption due to adverse weather conditions or other factors which may disrupt mining operations. At December 31, 1993 the Company's lignite inventory was approximately 346,000 tons (about a 60-day supply). Oil Supply The Company has been able to obtain oil supplies by spot purchases as needed. Rodemacher Power Station has oil storage capacity of 762,000 barrels (approximately a 75-day supply), and the other generating stations have oil storage capacity aggregating 319,000 barrels (approximately a 20-day supply). The Company burned only 88 barrels of oil as a fuel source in 1993. POWER PURCHASES The Company purchases electric energy from neighboring utilities when the price of the energy purchased is less than the cost to the Company of generating such energy from its own facilities. Additionally, the Company has a long-term contract under which it purchases a small percentage of its total energy requirements from a hydroelectric generating plant. During 1993 the Company purchased 1,321 million KWH of electricity, or approximately 18% of its total energy requirements. SALES The Company is a "public utility" engaged principally in the generation, transmission, distribution and sale of electricity solely within Louisiana. For further information regarding the Company's generating stations and its transmission and distribution facilities, see "Power Generation" above and "Properties" in Item 2. ITEM 2. PROPERTIES All of the Company's electric generating stations and all other operating properties are located in the State of Louisiana. The Company considers all of its properties to be well maintained, in good operating condition and suitable for their intended purposes. ELECTRIC GENERATING STATIONS As of December 31, 1993, the Company either owned or had an ownership interest in four steam electric generating stations with a combined electric generating capacity of 1,686,000 kilowatts. For additional information regarding the Company's generating facilities, see "Power Generation" under the caption "Electric Operations" in Item 1. SUBSTATIONS As of December 31, 1993, the Company owned 77 transmission and 306 distribution substations. ELECTRIC LINES On December 31, 1993 the Company's transmission system consisted of approximately 67 circuit miles of 500 kilovolt (kV) lines; 450 circuit miles of 230 Kv lines; 646 circuit miles of 138 Kv lines; and 15 circuit miles of 69 Kv lines. The Company's distribution system consisted of approximately 1,950 circuit miles of 34.5 kV lines and 9,962 circuit miles of other lines. GENERAL PROPERTIES The Company owns various properties which include a seven-story headquarters office building, division offices, a central warehouse, service centers, telecommunications equipment and other facilities owned for general purposes. TITLE The Company's electric generating plants and certain other principal properties are owned in fee. Electric transmission and distribution lines are located either on private rights-of-way or along streets or highways by public consent. Substantially all of the Company's property, plant and equipment is subject to liens securing obligations of the Company under an Indenture of Mortgage, none of which impairs the use of such properties in the operation of its business. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not aware of any legal proceeding to which it is a party which would have a material adverse effect on its financial condition or competitive position. For a discussion of various legal proceedings or regulatory matters involving the Company, see "Regulatory and Environmental Matters" in Item 1. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The names of the executive officers of the Company, their positions held, five-year employment history, ages and years of service as of December 31, 1993 are presented below. Executive officers are appointed annually to serve for the ensuing year or until their successors have been appointed. CURRENT POSITION AND FIVE-YEAR NAME OF EXECUTIVE OFFICER EMPLOYMENT HISTORY Gregory L. Nesbitt........ President and Chief Executive Officer since April 1993; President and Chief Operating Officer from April 1992 to April 1993; Executive Vice President and Chief Operating Officer from July 1991 to April 1992; Executive Vice President from January 1988 to July 1991. (Age 55; 13 years of service) Robert L. Duncan.......... Vice President-Customer Operations since July 1984. (Age 51; 28 years of service) David M. Eppler........... Vice President-Finance since October 1993; Vice President and Treasurer from July 1987 to October 1993. (Age 43; 12 years of service) Leonard G. Fontenot....... Vice President-Power Supply and Energy Transmission since April 1986. (Age 56; 31 years of service) Catherine C. Scheffler.... Vice President-Human Resources since October 1993; General Manager-Human Resources from August 1993 to October 1993; Administrator-Compensation from May 1991 to August 1993; Vice President at Rapides Bank and Trust Company from December 1987 to April 1991. (Age 38; 2 years of service) David K. Warner........... Vice President-Administrative Services since April 1988. (Age 43; 13 years of service) John L. Baltes, Jr........ Controller since April 1989; Manager- Accounting Services from June 1988 to April 1989. (Age 47; 12 years of service) Michael P. Prudhomme...... Secretary-Treasurer since January 1994; Secretary from October 1993 to January 1994; Vice President-Customer Services from May 1985 to October 1993. (Age 50; 24 years of service) John E. Carroll........... Assistant Secretary since October 1993; Administrator-Benefits from February 1991 to October 1993; Supervisor- Compensation from October 1987 to February 1991. (Age 34; 9 years of service) 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 (NYSE) and the Pacific Stock Exchange. The following table sets forth high and low sales prices for the Company's common stock as reported on the NYSE Composite Transactions Tape and dividends paid per share during each calendar quarter of 1993 and 1992. Subject to the prior rights of the holders of the respective series of the Company's preferred stock, such dividends as determined by the Board of Directors of the Company may be declared and paid on the common stock from time to time out of funds legally available therefor. The provisions of the Company's charter applicable to preferred stock and certain provisions contained in the debt instruments of the Company under certain circumstances restrict the amount of retained earnings available for the payment of dividends by the Company. The most restrictive covenant requires that common shareholders' equity be not less than 30% of total capitalization, including short-term debt. At December 31, 1993 approximately $129,000,000 of retained earnings was not restricted. On January 21, 1994 the Board of Directors of the Company declared a quarterly dividend of $.355 per share which was paid on February 15, 1994, to common shareholders of record on January 31, 1994. The Company currently expects that dividends of a comparable amount on its common stock will continue to be paid in the future. As of February 22, 1994 there were 12,992 holders of record of the Company's common stock, and the closing price of the Company's common stock as reported on the NYSE Composite Transactions Tape was $22.25 per share. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain selected financial data for the respective periods presented and should be read in conjunction with the Consolidated Financial Statements and the related Notes thereto set forth on pages 20 through 33 in the 1993 Annual Report to Shareholders, which information is filed as Exhibit 13 to this report and incorporated into Item 8 herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth on pages 14 through 18 under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's Annual Report to Shareholders for the year ended December 31, 1993, furnished to the Securities and Exchange Commission pursuant to Rule 14a - 3(b) under the Securities Exchange Act of 1934 (1993 Annual Report to Shareholders), is incorporated herein by reference; such information is filed as Exhibit 13 to this report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information set forth on pages 20 through 33 in the 1993 Annual Report to Shareholders is incorporated herein by reference; such information is filed as 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 The information set forth under the subcaption "Directors" under the caption "Election of Directors" in the Company's definitive Proxy Statement dated March 9, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 (1994 Proxy Statement), is incorporated herein by reference. See also "Executive Officers of the Registrant" on pages 16 and 17 of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information set forth under the subcaption "Organization and Compensation of the Board of Directors" under the caption "Election of Directors" and under the caption "Executive Compensation" in the 1994 Proxy Statement (excluding the information required by paragraphs (i), (k) and (l) of Item 402 of Regulation S-K) is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the caption "Security Ownership of Directors and Management" and under the caption "Security Ownership of Certain Beneficial Owners" in the 1994 Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the subcaption "Compensation Committee Interlocks and Insider Participation" under the caption "Election of Directors" in the 1994 Proxy Statement is incorporated herein by reference. Page> 14(a)(3) List of Exhibits The Exhibits designated by an asterisk are filed herewith. The Exhibits not so designated have been previously filed with the Securities and Exchange Commission, and are incorporated herein by reference. The Exhibits designated by two asterisks are management contracts and compensatory plans and arrangements required to be filed as Exhibits to 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. CENTRAL LOUISIANA ELECTRIC COMPANY, INC. (Registrant) By /s/ GREGORY L. NESBITT (Gregory L. Nesbitt, President and Chief Executive Officer) 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 /s/ GREGORY L. NESBITT (Gregory L. Nesbitt) President, and Chief March 30, 1994 Executive Officer (Principal Executive Officer) /s/ DAVID M. EPPLER (David M. Eppler) Vice President March 30, 1994 (Principal Financial Officer) /s/ JOHN L. BALTES, JR. (John L. Baltes, Jr.) Controller (Principal March 30, 1994 Accounting Officer) SHERIAN G. CADORIA J. PATRICK GARRETT F. BEN JAMES, JR. HUGH J. KELLY WILLIAM A. LOCKWOOD Directors* A. DELOACH MARTIN, JR. ROBERT T. RATCLIFF EDWARD D. SIMMONS ERNEST L. WILLIAMSON *By /s/ DAVID M. EPPLER (David M. Eppler, as Attorney-in-Fact) March 30, 1994

831964_1993.txt

831964_1993

1993

831964

ITEM 3. LEGAL PROCEEDINGS The Company recently settled litigation with Diamond M concerning various matters relating to the sale and bareboat charter of 3 offshore drilling rigs. Legal proceedings were instituted by the Company on August 29, 1991, and were consolidated with related legal proceedings subsequently instituted by Diamond M in the United States District Court, Southern District of Texas, Houston Division. In May, 1989, the Company sold 3 rigs to Diamond M for $22 million, $15 million of which was payable in cash, and $7 million of which was payable pursuant to three-year promissory notes. Simultaneously with the sale, the Company bareboat chartered the rigs from Diamond M for a two-year period, with charter hire payment dates pursuant to the charters coinciding with principal and interest payment dates pursuant to the notes. In the litigation, Diamond M alleged that the Company failed to properly maintain and repair the rigs during the terms of the charters, that the rigs were not in compliance with certain specified classifications and conditions at redelivery upon expiration of the respective charters, and that as a result, Diamond M incurred substantial costs to improve the conditions of the rigs. Diamond M also claimed the right to receive additional charter hire attributable to the period during which its repairs and improvements to the rigs were performed. In June, 1993, a partial summary judgment awarded the Company $1.8 million, together with interest and attorney's fees, for the notes payable by Diamond M to the Company, offset by certain charter hire payments due Diamond M. Following a trial in February, 1994, a judgment was entered in the United States District Court, Southern District of Texas, Houston Division. The judgment awarded Diamond M $3.5 million, plus court costs, offset by the partial summary judgment of $1.8 million. The Company paid Diamond M $1.7 million in February, 1994 as a final settlement of all disputed issues. See Note 13 of Notes to Consolidated Financial Statements. The Company is also party to a number of lawsuits which are ordinary, routine litigation incidental to the Company's business, the outcome of which, individually or in the aggregate, is not expected to have a material adverse effect on the Company's financial condition or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company did not hold a meeting of stockholders or otherwise submit any matter to a vote of stockholders in the fourth quarter of 1993. 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 NASDAQ National Market System under the symbol "CLDR." The following table sets forth the range of high and low closing sale prices per share of Common Stock as reported by NASDAQ for the periods indicated. On March 3, 1994, the closing sale price of the Company's Common Stock, as reported by the NASDAQ, was $11 3/4 per share. On that date, there were 2,173 holders of record of the Company's Common Stock. The Company has never paid cash dividends on its Common Stock, and it is not anticipated that cash dividends will be paid to holders of Common Stock in the foreseeable future. Under the Company's credit agreement with INCC, the Company is restricted from declaring, making, or paying any cash dividend on any class of capital stock except for the quarterly dividend applicable to the Company's Preferred Stock. The Company's $2.3125 Convertible Exchangeable Preferred Stock ("Preferred Stock") is also traded on the NASDAQ National Market System under the symbol "CLDRP." The following table sets forth the range of high and low closing sale prices per share of Preferred Stock as reported by NASDAQ for the periods indicated. On March 3, 1994, the closing sale price of the Company's Preferred Stock, as reported by NASDAQ, was $26 3/4 per share. On that date, there were 50 holders of record of the Company's Preferred Stock. Holders of shares of Preferred Stock are entitled to receive, when, as, and if declared by the Board of Directors out of funds of the Company legally available therefor, cash dividends at an annual rate of $2.3125 per share, payable quarterly on March 15, June 15, September 15 and December 15 in each year, except that if any such date is a Saturday, Sunday or legal holiday, such dividend is payable on the next day that is not a Saturday, Sunday or legal holiday. Dividends are cumulative and are payable to holders of record as they appear on the stock books of the Company on such record dates as are fixed by the Board of Directors. Cash dividends paid on each of the quarterly dividend dates in 1993, 1992 and 1991 were $665,000. The Preferred Stock is also convertible into shares of Common Stock at the rate of 1.89394 shares of Common Stock for each share of Preferred Stock and is subject to redemption at the option of the Company at varying prices depending on the date called for redemption. Under the credit agreement with INCC, the Company is restricted from redeeming the Preferred Stock unless such redemption is mandatory. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain selected consolidated financial information of the Company. The amounts as of and for each of the five years in the period ended December 31, 1993, have been derived from audited consolidated financial statements of the Company. This information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto included elsewhere herein. The selected consolidated financial data provided below are not necessarily indicative of the future results of operations or financial performance of the Company. - --------------- (1) Includes litigation settlement and expenses of $3.7 million in 1993 and gains of $5.0 million and $5.5 million on disposition of assets in 1992 and 1989, respectively. (2) The Company has not paid any cash dividends on its Common Stock. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Activity in the contract drilling industry and related oil service businesses has been severely depressed since 1982 due to volatility in oil and natural gas prices. These conditions have resulted in an oversupply of drilling equipment, decreased rig utilization, declining dayrates and intense competition for drilling contracts. The financial condition and results of operations of the Company and other drilling contractors have suffered, as demand for their services is primarily dependent upon the level of spending by oil and gas companies for exploration, development and production activities. The Company has endeavored to mitigate the effect of these depressed market conditions by diversifying its scope of operations beyond the traditional domestic daywork contract drilling market. To achieve its strategic objective, the Company established separate but related lines of business in turnkey drilling and MOPU operations, and pursued foreign drilling and production opportunities. Each of the Company's business segments will continue to be affected, however, by the unsettled energy markets, which are influenced by a variety of factors, including general economic conditions, the extent of worldwide oil and gas production and demand therefor, government regulations, and environmental concerns. RESULTS OF OPERATIONS Year 1993 Versus 1992 The Company recognized net income, before preferred dividends, of $3.6 million in 1993 compared to net income of $3.0 million in 1992. The 1993 results include litigation settlement and expenses of $3.7 million, or $0.82 per share. Excluding this charge in 1993, the Company would have reported net income of $7.3 million, or $1.03 per common share. The 1992 results included a $1.5 million writedown in the carrying value of oil and gas properties and a $4.7 million gain on the disposition of one of the Company's MOPUs due to its constructive total loss in Hurricane Andrew. Excluding these amounts in 1992, the Company would have reported a net loss of $.2 million, or $0.86 per common share. Operating income increased $7.2 million from 1992 to 1993. The improvement in operating income was primarily due to increased MOPU operating income of $7.1 million, increased foreign daywork drilling operating income of $1.7 million, and decreased domestic daywork drilling operating losses of $.4 million, offset in part by reduced turnkey drilling operating income of $1.1 million, increased oil and gas operating losses of $.5 million, and increased corporate overhead of $.4 million. Daywork Drilling Domestic daywork drilling revenues decreased $4.3 million from $5.5 million in 1992 to $1.2 million in 1993. The decrease was primarily due to the stacking of the majority of the Company's domestic land rigs in 1993 and the sale, effective January 1, 1993, of the Company's 4 inland posted barge drilling rigs together with rights to certain oil and gas production proceeds. Domestic daywork drilling operating losses decreased by $.4 million from $2.8 million in 1992 to $2.4 million in 1993. Costs savings resulting from the sale of the 4 inland posted barge drilling rigs were partially offset by costs associated with stacking the Company's domestic land rigs and the sale, effective January 1, 1993, of rights to certain oil and gas production proceeds. Three of the Company's 4 domestic land drilling rigs will operate in Venezuela during 1994. One of the Company's land drilling rigs was mobilized to Venezuela in 1994 and began drilling operations for Corpoven for a three-year term. Two other domestic land drilling rigs will begin drilling operations in 1994 in Venezuela to drill turnkey wells awarded the Company by Corpoven. Foreign daywork drilling revenues decreased $.5 million from $21.5 million in 1992 to $21.0 million in 1993. Foreign daywork drilling operating income increased $1.7 million during the same period. The increase in operating income was primarily due to reduced labor costs and repair and maintenance expenses, offset in part by decreased revenues during 1993 when compared to 1992. Foreign operating results reflect decreased revenues primarily due to reduced cost flow-throughs billed to the operators and devaluation of the Venezuelan Bolivar. The contracts for the Company's 2 jack-up drilling rigs operating in Venezuela expire on March 9, 1994 and March 15, 1994, respectively. The Company is currently in the process of renegotiating the contracts. No assurance can be given that the contracts will be renewed, and if renewed, at rates comparable to those received in 1993. Contracts on the 2 land drilling rigs working in eastern Venezuela expire in September, 1995. Turnkey Drilling Turnkey drilling revenues decreased $20.0 million from $37.0 million in 1992 to $17.0 million in 1993. Twelve turnkey contracts were completed during 1992 compared to 6 turnkey contracts completed in 1993, 2 of which related to CNCTI and were accounted for under the equity method in the Company's Consolidated Financial Statements. See Note 5 of Notes to Consolidated Financial Statements. Turnkey drilling operating income decreased $1.1 million in 1993 when compared to 1992, primarily due to fewer completed contracts in 1993. The Company anticipates improved turnkey drilling operating results in 1994 due to the award of approximately $50 million in international turnkey contracts to be drilled in 1994 and 1995. The Company was awarded 2 packages with 3 turnkey wells in each package to be drilled for Corpoven with estimated revenues of approximately $36 million. The Company will mobilize 2 of its idle domestic land drilling rigs to Venezuela to work on these projects. In addition, CNCTI, a joint venture in which the Company holds a one-third ownership percentage, was awarded 2 drilling packages by PEMEX for the drilling of a total of 4 wells. The Company has mobilized an idle jack-up drilling rig to the Bay of Tampico, Mexico in the first quarter of 1994 to drill 2 of the 4 wells. The 2 packages are expected to generate $42 million in revenues to CNCTI. MOPU Operations MOPU revenues increased $12.5 million from $9.2 million in 1992 to $21.7 million in 1993. MOPU operating income increased $7.1 million in 1993. The Company's MOPUs contributed greater income in 1993 due to 3 MOPU units working in Venezuela during all of 1993 while the 3 units worked only part of 1992. In addition, the Company's mobile offshore supply unit operated in the Bay of Campeche, Mexico during most of 1993 and none in 1992, and a new MOPU began working during the third quarter of 1993. Partially offsetting these increased revenues and operating income was the loss of income from the MARLIN NO. 3, which was destroyed in a hurricane on August 25, 1992. The MARLIN NO. 3 contributed revenues of $.8 million and operating income of $.4 million in 1992. Each of the 3 MOPUs working in Venezuela has an initial contract term of two years, subject to certain buyout options which, if exercised, could have a material adverse effect on the Company's future results of operations. See "Liquidity and Capital Resources." Oil and Gas Oil and gas revenues increased $1.0 million from $3.7 million in 1992 to $4.7 million in 1993, primarily due to increased natural gas production and pricing. Operating losses from oil and gas exploration activities increased $.5 million during the same period. Increased depreciation, depletion and amortization more than offset the revenue increases. Average daily natural gas production volumes increased to 4,522 Mcf per day in 1993 from 3,363 Mcf per day in 1992. Oil and condensate production decreased from 163 barrels per day in 1992 to 121 barrels per day in 1993. Average product pricing received in 1993 was $2.31 per Mcf of gas and $18.39 per barrel of oil and condensate compared to $2.08 per Mcf and $18.65 per barrel in 1992. Corporate Overhead Corporate overhead increased $.4 million from $4.5 million during 1992 to $4.9 million in 1993. The increase was primarily due to higher costs of certain employee benefits. Other Income (Expense) The Company recognized $3.9 million of other expense in 1993 compared to $2.7 million of other income in 1992. The $6.6 million decrease was primarily due to a litigation settlement and expenses of $3.7 million in 1993, decreased gains on disposition of assets of $2.9 million and increased income taxes of $.7 million, offset in part by increased interest income of $.7 million. See "Liquidity and Capital Resources" for a discussion of the Diamond M litigation settlement and expenses. The net decrease in gains on disposition of assets was primarily related to the $4.7 million gain recorded in 1992 related to the disposition of one of the Company's MOPUs as a result of its constructive total loss in Hurricane Andrew, offset in part by net gains on assets disposed of in 1993. The Company recorded income taxes of $.7 million in 1993 in anticipation of alternative minimum taxes in the United States and certain foreign taxes. The increase in interest income was primarily due to interest on notes receivable issued in connection with the sale of the 4 inland posted barge drilling rigs together with rights to certain oil and gas production proceeds effective January 1, 1993. Year 1992 Versus 1991 The Company recognized net income, before preferred dividends, of $3.0 million in 1992 compared to a net loss of $3.9 million in 1991. The improvement of $6.9 million was due to a $4.8 million increase in MOPU operating income, a $3.2 million reduction in domestic daywork drilling operating losses, a $2.7 million increase in the recognition of other income and reduced oil and gas operating losses of $2.3 million. These improvements were offset in part by a $3.9 million reduction in turnkey drilling operating income, reduced foreign daywork drilling operating income of $2.0 million and increased corporate overhead of $.2 million. Daywork Drilling Domestic daywork drilling revenues decreased $10.4 million from $15.9 million in 1991 to $5.5 million in 1992. The decrease in domestic daywork drilling revenues was attributable to the movement of 2 land rigs to Venezuela, the return to the owner of 3 leased offshore drilling rigs under long-term charter, and the stacking of the Company's 4 barge rigs. Domestic daywork drilling operating losses were reduced by $3.2 million from $6.0 million in 1991 to $2.8 million in 1992. The reduced operating loss was primarily attributable to cost savings associated with barge rig operations and the return to the owner of 3 leased offshore drilling rigs. Foreign daywork drilling revenues increased $2.4 million from $19.1 million in 1991 to $21.5 million in 1992. Foreign daywork drilling operating income decreased $2.0 million during the same period. The increased foreign daywork drilling revenues reflect the contribution during 1992 of the 2 land rigs contracted to work in Venezuela, the impact of less downtime experienced in 1992 when compared to 1991, and cost flow-throughs to the operators. Foreign daywork drilling operating results decreased due to increased jack-up rig repair and maintenance expenses, contract rate reductions associated with the renewal of contracts on the Company's 2 jack-up drilling rigs operating in Lake Maracaibo, Venezuela, effective July 15, 1992 and August 9, 1992, and devaluation of the Venezuelan Bolivar. Each of the jack-up contracts were renewed in January and February, 1993 for one year terms at increased dayrates from that received during the second half of 1992, and were subsequently extended to March 9, 1994 and March 15, 1994, respectively. The Company is currently negotiating renewals of these contracts. Contracts on the 2 land drilling rigs working in eastern Venezuela expired in June, 1993, and were renewed for a period of two years, three months. Turnkey Drilling Turnkey drilling revenues decreased $7.4 million from $44.4 million in 1991 to $37.0 million in 1992. Nine turnkey contracts were completed during 1991 with average revenues of $4.9 million compared to 12 turnkey contracts completed in 1992 with average revenues of $3.1 million. Turnkey drilling operating income decreased $3.9 million in 1992 when compared to 1991. The decrease in turnkey drilling operating income resulted primarily from lower margins on completed contracts. The decrease in average revenue per contract and lower margins on completed contracts in 1992 is primarily due to offshore wells contracted in 1992 at lower average revenues when compared to the offshore wells drilled in 1991. MOPU Operations MOPU revenues increased $7.0 million from $2.2 million in 1991 to $9.2 million in 1992. MOPU operating income increased $4.8 million in 1992. The Company's MOPUs contributed greater income due to the delivery into Venezuela of the LANGLEY on May 8, 1992 and the FRANKLIN and FORRESTAL on September 26, 1992, partially offset by the loss of income from the MARLIN NO. 3. Each of the MOPUs working in Venezuela has an initial contract term of two years, subject to certain buyout options. One of the Company's MOPUs, the MARLIN NO. 3, was declared a constructive total loss on September 2, 1992, as a result of hurricane damage sustained on August 25, 1992. The MARLIN NO. 3 contributed revenues of $.8 million and $1.3 million and operating income of $.4 million and $1.0 million in 1992 and 1991, respectively. Oil and Gas Oil and gas revenues increased $.8 million from $2.9 million in 1991 to $3.7 million in 1992 due primarily to increased natural gas production and pricing. The Company's oil and gas exploration and production activities reflect an operating loss of $1.8 million in 1992, which was an improvement of $2.3 million over the 1991 operating loss of $4.1 million. Average daily natural gas production volumes increased to 3,363 Mcf per day in 1992 from 2,530 Mcf per day in 1991. Oil and condensate production decreased from 181 barrels per day in 1991 to 163 barrels per day in 1992. Average product pricing received in 1992 was $2.08 per Mcf of gas and $18.65 per barrel of oil and condensate compared to $1.66 per Mcf and $19.40 per barrel in 1991. The reduced operating loss was attributable to a $1.5 million writedown in the carrying value of oil and gas properties in 1992 compared to a $4.0 million writedown in 1991 due to a decline in reserve values. Corporate Overhead Corporate overhead increased $.2 million from $4.3 million during 1991 to $4.5 million in 1992. The increase was primarily due to higher costs of certain employee benefits, primarily group medical insurance, increased amortization of restricted stock and other increased expenses. Other Income (Expense) The Company recognized $2.7 million of other income in 1992 compared to $.1 million of other income in 1991. The change resulted from a $3.6 million increase in gains on disposition of assets due principally to the receipt of insurance proceeds associated with the constructive total loss of the MARLIN NO. 3, partially offset by lower interest income, slightly higher interest expense and an increase in other net expenses. The net increase in interest expense resulted from an increase in interest expense associated with the Company's Venezuelan MOPU project, due to interest no longer being capitalized following completion of construction, partially offset by the elimination of interest expense on a capital lease which expired in January 1992 and lower average interest rates on the revolving line of credit. The increase in other net expenses is primarily attributable to reserves established for potentially uncollectible accounts receivable. LIQUIDITY AND CAPITAL RESOURCES The Company's cash and cash equivalents decreased $5.1 million from $15.7 million at December 31, 1992 to $10.6 million at December 31, 1993. The decrease resulted from $12.7 million used to fund capital expenditures and $17.9 million used to make payments on borrowings and preferred stock dividends, partially offset by $17.2 million provided by operating activities and $8.3 million of proceeds received from the sale of the 4 barge drilling rigs, certain oil and gas production payment proceeds, and other excess property and equipment. Cash provided by operating activities of $17.2 million included $7.8 million used for working capital and other requirements, primarily to fund the Company's foreign daywork drilling and turnkey drilling operations. Accounts receivable decreased from December 31, 1992 to December 31, 1993 due primarily to the timing of customer payments. Partially offsetting this decrease in trade receivables was a $1.9 million increase in other receivables due primarily to increased insurance claims. In addition, cash was used to reduce accounts payable and accrued expenses by $3.8 million. Cash was used during 1993 to fund $12.7 million of capital expenditures, consisting of $9.5 million related to MOPU projects, $1.6 million in oil and gas exploration and development expenditures, $1.1 million for drill pipe to be used in the Company's Venezuelan drilling operations, and $.5 million of other expenditures. During the fourth quarter of 1992, the Company acquired 5 jack-up drilling rigs at a cost of $6.0 million, with plans to convert them to MOPUs. The conversion of the first unit, which replaced the MARLIN NO. 3, cost approximately $4.2 million and was funded by a portion of the insurance proceeds received in connection with the constructive total loss of MARLIN NO. 3 in 1992. The unit commenced operations on July 19, 1993 and is currently contracted to Union Pacific Resources Company. The second of the 5 rigs acquired has been converted to a MOPU at a cost of $4.5 million. The cost of this unit was funded by a portion of the proceeds received from the sale of 1,500,000 shares of Common Stock of the Company which was completed during October, 1992. This MOPU is currently being marketed. No assurance can be given that the Company will be able to secure a contract for the operation of the second unit. One of the acquired rigs is currently being used as a mobile offshore supply unit to facilitate the Company's joint venture turnkey drilling operations in Mexico. The Company has mobilized another of the acquired rigs into Mexico where it will be used in turnkey drilling operations in the Bay of Tampico, Mexico. The Company presently expects to bareboat charter the other unit to a third party for use as a workover rig in the U.S. Gulf of Mexico. Charter hire payments commenced September, 1992 with respect to the first of 3 MOPUs contracted to work in Venezuela. Charter hire payments commenced in February, 1993 on the other 2 MOPUs working in Venezuela. Eighty-five percent (85%) of the cash flow attributable to the contracts for the Company's 3 MOPUs working in Venezuela is dedicated to debt repayment under the contracts and loan agreements relating to such MOPUs, and the remaining 15% was deposited by the charterer into a restricted joint account until a $1.0 million balance was attained on June 4, 1993. Construction costs for refurbishment and conversion of the 3 MOPUs contracted to work in Venezuela exceeded the original budget. In accordance with the terms of an agreement between the Company and the charterer of the MOPUs, the charterer paid these excess costs as they became due and payable. The Company reached an agreement with the charterer during the third quarter of 1993 whereby the Company paid the charterer approximately $.8 million in satisfaction of all cost overruns and the charterer paid all outstanding construction and mobilization receivables. Additionally, the restricted joint account was terminated. Each of the 3 MOPUs working in Venezuela has an initial contract term of two years expiring in 1994, subject to certain buyout options. The buyout options can be exercised at any time during the contract term. The loss of future operating income associated with these units, should the buyout options be exercised or contract renewals not be obtained, could have a material adverse effect on the Company's future results of operations. Because the Company now believes there is a reasonable likelihood that the buyout options on 2 of the units will be exercised in 1994, the Company has elected to defer income recognition prospectively on these 2 units to the extent of potential losses that could occur upon exercise of the options. At December 31, 1993, the Company had provided $.6 million of reserves to offset potential losses on the units if the buyout options were to be exercised on 2 of the units. The Company expects to defer additional income recognition in the amounts of $1.6 million, $1.8 million, and $1.8 million, respectively, during the first 3 quarters of 1994. Approximately 62% of the Company's revenues and a substantial portion of its operating income were sourced from its Venezuelan operations in 1993. These operations are subject to customary political and foreign currency risks in addition to operational risks. The Company has attempted to reduce these risks through insurance and the structure of its Venezuelan contracts. In conjunction with the return to Diamond M of 3 offshore drilling rigs under long-term charters, a dispute existed as to whether or not the Company complied with the terms of the charters regarding maintenance and repair of the rigs during the charter period, as well as the condition of the rigs upon redelivery. Diamond M withheld payment of $1.7 million in notes payable by Diamond M to the Company, representing a part of the purchase price for the subject rigs. Diamond M also claimed additional damages associated with repairs to the drilling rigs. In June 1993, a partial summary judgment awarded the Company $1.8 million, together with interest and attorney's fees, for the notes payable by Diamond M to the Company, offset by certain charter hire payments due Diamond M. Following a trial in February, 1994, a judgment was entered in the United States District Court, Southern District of Texas, Houston Division. The judgment awarded Diamond M $3.5 million, plus court costs, offset by the partial summary judgment of $1.8 million. The Company paid Diamond M $1.7 million in February, 1994, as a final settlement of all disputed issues. See "Legal Proceedings" and Note 13 of Notes to Consolidated Financial Statements. The Company's credit agreement with INCC provides for a $10.0 million working capital line of credit facility which matures January 1, 1995 and a $30.0 million term loan which matures January 1, 1995. As of December 31, 1993, the outstanding balance of the Company's term loan with INCC was $13.1 million. The Company has $10.0 million currently available under the working capital line of credit facility. The Company executed a commitment letter to amend the terms of the credit facility to increase the amount available to $20.0 million, subject to certain borrowing base limitations, and extend the maturity date to January 1, 1996. See Note 14 of Notes to Consolidated Financial Statements. The ability of the Company to fund working capital, capital expenditures, debt service and dividends in excess of cash on hand will be dependent upon the success of the Company's domestic and foreign operations. To the extent that internal sources are insufficient to meet those cash requirements, the Company can draw on its available credit facility or seek other debt or equity financing; however, the Company can give no assurance that such other debt or equity financing would be available on terms acceptable to the Company. In any case, the satisfaction of long-term capital requirements will depend upon successful implementation by the Company of its business strategy and future results of operations. Management believes it has successfully implemented the strategy to achieve results of operations commensurate with its immediate and near-term liquidity requirements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and supplementary data of the Company appear on pages 31 through 55 hereof and are incorporated by reference into this Item 8. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no changes in or disagreements with the Company's accountants regarding accounting principles or practices for financial statement disclosures. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth under the captions "Election of Directors" and "Executive Officers" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders, which is to be filed with the Securities and Exchange Commission (the "Commission"), describes the directors and executive officers of the Company and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information set forth under the caption "Executive Officers -- Compensation" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders, which is to be filed with the Commission, sets forth information regarding management compensation and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under captions "Principal Shareholders" and "Election of Directors -- Security Ownership of Management" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders, which is to be filed with the Commission, describes the security ownership of certain beneficial owners and management and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Certain Transactions" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders, which is to be filed with the Commission, sets forth information regarding certain relationships and related transactions and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements (1) and (2) Financial Statements and Schedules See "Index to Consolidated Financial Statements and Schedules" on Page 29. (3) Exhibits. See Exhibit Index on pages 61 to 64 The management contracts and compensatory plans or arrangements required to be filed as Exhibits to this report are as follows: (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. March 4, 1994 CLIFFS DRILLING COMPANY By: /s/ DOUGLAS E. SWANSON ----------------------------- Douglas E. Swanson President & Director PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. FORM 10-K ITEM 14A (1) AND (2) INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Schedules: For Each of the Three Years in the Period Ended December 31, 1993: All other schedules for which provision is made in the applicable rules and regulations of the Securities and Exchange Commission have been omitted as the schedules are not required under the related instructions, are not applicable or the information required thereby is set forth in the Consolidated Financial Statements or the Notes thereto. REPORT OF INDEPENDENT AUDITORS SHAREHOLDERS AND BOARD OF DIRECTORS CLIFFS DRILLING COMPANY We have audited the accompanying consolidated balance sheets of Cliffs Drilling Company 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. 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 Cliffs Drilling Company 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. ERNST & YOUNG Houston, Texas February 23, 1994 CLIFFS DRILLING COMPANY CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying notes to consolidated financial statements. CLIFFS DRILLING COMPANY CONSOLIDATED BALANCE SHEETS See accompanying notes to consolidated financial statements. CLIFFS DRILLING COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. CLIFFS DRILLING COMPANY CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY See accompanying notes to consolidated financial statements. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Corporate Structure On June 21, 1988, Cliffs Drilling Company (the "Company") became a separate publicly-owned company as a result of the spin-off of the Company to shareholders of Cleveland-Cliffs Inc ("Cleveland"). These statements include the activities of the Company's wholly-owned subsidi-aries, Cliffs Oil and Gas Company ("COGC") and Cliffs Drilling International, Inc. ("International"), the Company's Venezuelan activities, which are organized as a foreign branch, and the Company's one-third ( 1/3) interest in a joint venture in Mexico which was organized to perform turnkey drilling services. Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Activities of the Venezuelan branch are also recorded in the accounts of the Company. Certain foreign turnkey drilling operations conducted through International have been consolidated based upon the Company's pro rata ownership. The Company's interest in the operations of Cliffs Neddrill Central Turnkey International, a joint venture consisting of Cliffs Drilling International, Inc., a wholly-owned subsidiary of the Company, Neddrill Turnkey Drilling B.V. and Perforadora Central, S.A. de C.V. ("CNCTI") has been accounted for under the equity method. All significant intercompany transactions and balances are eliminated in consolidation. Cash and Cash Equivalents The Company's policy is to invest cash in short-term investments. Uninvested cash balances are kept at minimum levels. Investments are valued at cost, which approximates market. The Company considers all highly liquid investments with a maturity date of three months or less when purchased to be cash equivalents. Inventories Inventories, consisting principally of tubular goods consumed in turnkey drilling operations, and spare drilling parts, are carried at cost, specific identification method. Drilling Contracts in Progress The Company recognizes revenues and expenses related to its turnkey drilling contracts when all terms and conditions of the contract have been fulfilled. Consequently, the costs related to in progress turnkey drilling contracts are deferred as drilling contracts in progress until the contract is completed and revenue is realized. The amount of drilling contracts in progress is dependent on the volume of contracts, the duration of the contract at the end of the reporting period and the contract amount. Provision for losses on incomplete contracts is made when such losses are anticipated. Revenue Recognition The Company recognizes revenues from its daywork drilling and MOPU operations based upon the contracted daily rate multiplied by the number of operating days in the period. Turnkey drilling contract revenues are recognized when all terms and conditions of the contract have been fulfilled. The Company recognizes oil and gas revenue from its interests in producing wells based upon the sales method. Each of the 3 MOPUs working in Venezuela has an initial contract term of two years expiring in 1994, subject to certain buyout options. The buyout options can be exercised at any time during the CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) contract term. Because the Company now believes there is a reasonable likelihood that the buyout options on 2 of the units will be exercised in 1994, the Company defers income recognition on these 2 units to the extent of potential losses that could occur upon exercise of the options. The deferral of income recognition is reflected as "Contract Termination Provision" in the Consolidated Statements of Operations and in "Deferred Income" in the Consolidated Balance Sheets. Property and Equipment Property and equipment are carried at original cost or at adjusted net realizable value, as applicable. Certain leases have been capitalized and the leased assets have been included in property and equipment. Major renewals and betterments are capitalized in the property accounts, while the cost of repairs and maintenance is charged to operating expenses in the period incurred. The Company records expenditures made on significant projects as construction in progress ("CIP") until the assets are ready for their intended use. No depreciation expense is recorded on amounts included in CIP. Interest on funds borrowed for construction of qualifying assets is capitalized during the construction period. Amortization of capitalized interest is included in depreciation, depletion and amortization in the Consolidated Statements of Operations. Cost and accumulated depreciation are removed from the accounts when assets are sold or retired and the resulting gains or losses are included in the Consolidated Statements of Operations. Depreciation of property and equipment is provided on the straight-line basis at rates based upon expected useful lives of the various classes of assets. Amortization of capital leases is included in depreciation, depletion and amortization in the Consolidated Statements of Operations. Costs related to the exploration and development of oil and gas properties are accounted for under the "Successful Efforts" method of accounting. Lease acquisition costs related to oil, gas and mineral properties are capitalized when incurred. The acquisition costs of unproved properties, which are individually significant, are assessed on a property-by-property basis and a loss is recognized by provision of a valuation allowance when the assessment indicates an impairment in value. Exploration costs, excluding exploratory wells, are charged to expense as incurred. Costs of drilling exploratory wells are capitalized pending determination as to whether the wells have proved reserves which justify commercial development. If commercial reserves are not found, the drilling costs are charged to dry hole expense. Tangible and intangible drilling costs applicable to productive exploratory wells and to the development of oil and gas reserves are capitalized. The cost of productive leaseholds is amortized by field on the unit of production basis by applying the ratio of produced oil and gas to estimated proved reserves. Lease and well equipment and other intangible drilling costs associated with productive wells are amortized based on proved developed reserves. The carrying value of proved oil and gas properties is limited to the undiscounted future net revenue from proved reserves, adjusted for income taxes, on a company-wide basis. Income Taxes The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards (SFAS) No. 109 "Accounting for Income Taxes". Deferred income taxes are provided on CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) items recognized in different periods for financial and tax reporting purposes. See Note 7 of Notes to Consolidated Financial Statements. Earnings (Loss) Per Share Primary earnings (loss) per share computations are based on net income (loss) less dividends on the Company's $2.3125 Convertible Exchangeable Preferred Stock (the "Preferred Stock"), divided by the average number of common shares and equivalents outstanding during the respective years. Common stock equivalents include the number of shares issuable upon exercise of stock options, less the number of shares that could have been repurchased with the exercise proceeds using the treasury stock method. The Preferred Stock is not included in the primary earnings (loss) per share computation as it is not a common stock equivalent. Fully diluted earnings per common share computations are made after the assumption of conversion of the preferred stock when the effect of such conversion is dilutive. Foreign Currency Translation The U.S. dollar is the functional currency for all of the Company's operations. Foreign currency gains and losses are included in the Consolidated Statements of Operations during the period incurred. Foreign currency losses for 1993, 1992 and 1991 amounted to $443,000, $132,000 and $112,000, respectively, and are included in "Other, net" in the Consolidated Statements of Operations. Concentration of Credit Risk The market for the Company's services is the oil and gas industry, and the Company's customers consist primarily of integrated and government-owned international oil companies and independent oil and gas producers. Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of trade receivables. The Company has in place insurance to cover certain exposure in its foreign operations and provides allowances for potential credit losses, when necessary. Accordingly, management considers such credit risk to be limited. Change in Presentation Certain financial statement items have been reclassified in prior years to make them conform with the current year presentation. 2. PROCEEDS-OF-PRODUCTION DRILLING PROGRAM, OTHER RECEIVABLES, AND NOTES AND OTHER RECEIVABLES -- LONG TERM The Company entered into a proceeds-of-production drilling program in 1986 to drill and/or complete 25 oil and gas wells. The revenues due under this arrangement were paid to the Company through an assignment of the proceeds of production generated from the wells drilled. In addition, the Company entered into separate agreements with other industry companies to provide goods and services and were paid in a like manner from the proceeds received by the Company. The revenues and costs associated with the services supplied directly by the Company, including handling fees and interest income, were deferred, resulting in income to be recognized in future periods. Revenues and expenses were recognized in amounts equal to the portion of the cash payments applicable to directly supplied services until all the Company's costs were recovered in the fourth quarter of 1989. During the years 1993, 1992, and 1991, net income of $0, $1,380,000, and $1,240,000 respectively, was recognized from the proceeds-of-production drilling program. At December 31, CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 1993 and 1992, amounts due the Company of $0 and $1,288,000, respectively, were included in "Other Receivables" for the current portion and amounts of $0 and $3,060,000, respectively, were included in "Notes and Other Receivables -- Long-Term" for the noncurrent portion based upon the estimates of future proceeds of production prepared by the Company's independent petroleum consultants. At December 31, 1993 and 1992, amounts of $0 and $1,533,000, respectively, were included in "Deferred Income." Outstanding accounts receivable earned interest at the prime rate plus 2%. On one of the program wells drilled, an alleged failure of the casing provided by one of the industry companies ("Vendor") led the Company to, at the direction of the operator, withhold proceeds due under the assignment agreement pending legal determination of responsibility for the casing failure and remedial costs. The dispute among the Company, the Vendor and the operator regarding the alleged casing failure was referred to the American Arbitration Association for settlement as provided in the agreement. The proceedings before the panel failed to provide sufficient evidence to prove that the Vendor was responsible for the alleged casing failure. On November 12, 1991, an award totaling $1,740,000 was granted the Vendor by the arbitration panel, which represented the amounts previously withheld plus accrued interest and legal fees. The award was paid by the Company on December 16, 1991, and was recoverable, along with the Company's legal fees of $131,000, from the proceeds of production generated from the program wells drilled. Effective January 1, 1993, the Company sold its interest in the proceeds-of-production drilling program together with its 4 inland posted barge drilling rigs, and paid the remaining industry companies for their interests in the production. Other Receivables are summarized as follows: Notes and Other Receivables -- Long Term are summarized as follows: 3. PROPERTY AND EQUIPMENT Effective January 1, 1993, the Company sold its 4 inland posted barge drilling rigs and rights to certain oil and gas production payment proceeds to Cerrito Investment Corporation for an aggregate sales price of $13,500,000, consisting of $5,000,000 in cash and $8,500,000 in notes. The first note has a face amount of $1,000,000, bears interest at the base rate on corporate loans as quoted CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) by the Wall Street Journal, and is due on or before December 31, 1995. Interest is due and payable semi-annually and commenced June 30, 1993. The second note has a face amount of $7,500,000, bears interest at the base rate on corporate loans as quoted by the Wall Street Journal plus one and one-half (1-1/2%), and matures on January 1, 1998. Principal and interest on the $7,500,000 note is payable on a monthly basis solely from the proceeds of the oil and gas production payment which secures the note. No net gain or loss on the sale was recorded for financial reporting purposes. During the fourth quarter of 1992, the Company purchased 5 jack-up drilling rigs for $6,000,000 in cash. The Company has converted 2 of the 5 rigs to MOPUs, converted one to a mobile offshore supply unit for use in the Bay of Campeche, Mexico, mobilized one unit to the Bay of Tampico, Mexico in February, 1994, to drill turnkey wells, and presently expects to bareboat charter the other unit to a third party for use as a workover rig in the U.S. Gulf of Mexico. On October 31, 1991, the Company purchased 3 jack-up drilling rigs from Chiles Offshore Corporation ("Chiles") for $15,500,000 in cash. The Company completed the process of refurbishing and converting the rigs for operation as portable compression units in Lake Maracaibo, Venezuela in 1992. The 3 units were contracted to Dresser-Rand Company ("Dresser-Rand") and mobilized to Venezuela. Expenditures made in 1991 to acquire and modify the rigs, in addition to the associated financing costs, were included in CIP until the units became operational. No interest was capitalized during the year ended December 31, 1993. Total interest capitalized during the years ended December 31, 1992 and 1991 was $1,278,000 and $248,000, respectively. Costs to mobilize the rigs to Venezuela were reimbursed to the Company by Dresser-Rand. Capital leases related to 3 land drilling rigs expired in January, 1992, resulting in the release of the lessors' security interests in such rigs. A capital lease related to an inland posted barge rig expired in July, 1990. The Company exercised its purchase option on the barge and its associated drill pipe for $2,101,841. The rig was sold effective January 1, 1993. 4. DIAMOND M TRANSACTION On May 24, 1989, the Company sold 2 jack-up rigs and a semisubmersible rig to Diamond Offshore Company ("Diamond M"), formerly known as Loews San Antonio Hotel Corporation, for a purchase price of $22,000,000 consisting of $15,000,000 in cash and three promissory notes totaling $7,000,000. Each promissory note was for a term of three years, had an interest rate of 10% per annum and was guaranteed by Loews Corporation, the parent of Diamond M. In connection with the sale, the Company entered into bareboat charters with Diamond M at competitive rates for the 3 rigs for a period of two years from the effective date of the sale. Principal and interest payments by Diamond M to the Company were structured to minimize cash outflow during the charter period. A gain of $10,300,000 was recorded on the sale of the 3 rigs to Diamond M, $4,500,000 of which was recognized in 1989 and $5,800,000 of which was deferred and amortized to income over the charter hire period (1989-1991). In conjunction with the return of the 3 rigs under the terms of the respective bareboat charters with Diamond M, a dispute arose between the Company and Diamond M over the amounts payable pursuant to the promissory notes executed by Diamond M and the Company, among other matters. This dispute was settled in February, 1994, with a payment to Diamond M of $1,700,000. See Note 13 of Notes to Consolidated Financial Statements. 5. OTHER ASSETS CNCTI was awarded a contract for one of 4 turnkey bid packages to drill 4 turnkey wells in the Bay of Campeche, Mexico. Drilling operations commenced in February, 1993. Two turnkey contracts CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) were completed in 1993 and were accounted for by the Company under the equity method. Equity in earnings of CNCTI of $602,000 is included in the Consolidated Statements of Operations as "Revenues" for the year ended December 31, 1993. The Company's investment in CNCTI of $1,852,000 is included in the Consolidated Balance Sheets under the caption "Other Assets" at December 31, 1993. The following information summarizes the unaudited Statements of Operations and Balance Sheets of CNCTI: 6. NOTES PAYABLE In conjunction with the acquisition of 3 jack-up rigs from Chiles and the related Dresser-Rand contracts, the Company entered into an interim financing agreement with NMB Postbank Groep N.V., now known as Internationale Nederlanden (U.S.) Capital Corporation ("INCC"), on October 31, 1991. The interim financing provided $20,000,000 in available funding for the purchase, construction, modification, mobilization and interest carry on the 3 jack-up rigs ("Term Loan") and $10,000,000 in a working capital credit facility. On December 16, 1991, a permanent facility replaced the interim agreement and increased the amount available under the Term Loan to $30,000,000. For the $30,000,000 Term Loan, the Company paid a fee equal to two percent (2%) of the facility. Advances to the Company bear interest at either two percent (2%) per annum plus the greater of the prevailing Federal Funds Rate plus one-half percent ( 1/2%) or INCC's prime rate; or at the adjusted LIBOR rate plus three and three-quarters percent (3 3/4%) per annum during the period prior to commencement of payments on all three charters from Dresser-Rand, ("Mobilization Period") and, thereafter, at one percent (1%) per annum plus the greater of the prevailing Federal Funds Rate plus one-half percent ( 1/2%) or INCC's prime rate; or at the adjusted LIBOR rate plus CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) two and three-quarters percent (2 3/4%) per annum. The applicable lending rate under the Term Loan was approximately six and three-eighths percent (6 3/8%) per annum at December 31, 1993. The Term Loan matures on January 1, 1995. All advances to the Company from the $10,000,000 working capital credit facility bear interest at one and one-half percent (1 1/2%) per annum plus the greater of the prevailing Federal Funds Rate plus one-half percent ( 1/2%) or INCC's prime rate; or at the adjusted LIBOR rate plus three and one-quarter percent (3 1/4%) per annum. The Company is also obligated to pay INCC (i) a commitment fee equal to one-half percent ( 1/2%) per annum on the average daily unadvanced portion of the commitments and (ii) a letter of credit fee of two percent (2%) per annum on the average daily undrawn and unexpired amount of each letter of credit during the period that sum remains outstanding. The working capital credit facility expires January 1, 1995. At December 31, 1993, the Company had outstanding borrowings amounting to $13,108,000 of the $30,000,000 available under the Term Loan and $0 of the $10,000,000 available under the working capital credit facility. Eighty-five percent (85%) of the cash flow attributable to the contracts for the Company's 3 MOPUs working in Venezuela is dedicated to debt repayment under the contracts and loan agreements relating to such MOPUs. The carrying amount of the Company's notes payable approximates fair market value. See Note 14 of Notes to Consolidated Financial Statements. The notes are secured by accounts receivable, certain oil and gas properties, and a first preferred fleet mortgage on a majority of the Company's rig inventory. In addition, both notes are secured by an assignment of the revenues due under the contract with Dresser-Rand. Under the First Restated Credit Agreement with INCC, as amended, the Company is required to comply with various covenants including, but not limited to, the maintenance of various financial ratios, and is restricted from declaring, making, or paying any dividends on the Common Stock. Interest payments on all indebtedness amounted to $1,536,000, $2,623,000 and $894,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Of the totals, $751,000 related to capital leases for the year ended December 31, 1991. 7. INCOME TAXES The Company has incurred net operating losses in prior years resulting in tax net operating loss carryforwards. Of the total carryforwards available, $17,959,000 was utilized during 1993 to offset taxable income for the year. At December 31, 1993, remaining net operating loss carryforwards are $7,684,000 for regular tax purposes. The Company also has a percentage depletion carryover to 1994 of $506,000 and a charitable contribution carryover to 1994 of $24,000. The majority of these amounts have been realized in the financial statements as a reduction of deferred taxes. In addition, the Company has $2,353,000 of unused investment tax credit carryforwards at December 31, 1993. These carryforwards are available for use by the Company through the following expiration dates: - --------------- (1) The investment tax credits reflect the 35% reduction required by the Tax Reform Act of 1986. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company provided for $475,000 of U.S. federal income taxes for the year ended December 31, 1993, due to the alternative minimum tax provisions of the Internal Revenue Code. In addition, the Company provided for $210,000 of Mexican taxes, which are available for credit in the U.S. through 1998. The Company recognized no deferred tax assets or liabilities at December 31, 1993 or 1992, because the tax effects of operating loss carryforwards are offset by the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and for income tax purposes and the valuation allowance applied to deferred tax assets. The significant components of deferred tax assets and liabilities are as follows: For financial reporting purposes, income (loss) before income taxes includes the following components: CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Significant components of the provision for income taxes attributable to continuing operations are as follows: The reconciliation of income tax attributable to continuing operations computed at the U.S. federal statutory tax rates to income tax expense is: Income tax payments amounted to $658,000 for the year ended December 31, 1993. No income tax payments were made during the years ended December 31, 1992 and 1991. 8. TAX LEASES The Company contracted for the construction of 2 jack-up drilling rigs in the period 1980-1982 at a cost of $65,575,000. For tax purposes, both rigs were sold in 1982 to third parties under lease back terms pursuant to Section 168(f)(8) of the Internal Revenue Code ("Safe Harbor Lease"). Cleveland received a payment in the aggregate of $16,685,000 which represented the investment tax credit and depreciable benefits attributable to the rigs. The interest income and principal due the Company from the third parties is equal to the lease payments by the Company to the third parties throughout the lease term. The future net tax deductions associated with the Safe Harbor Leases are $2,950,000, $3,732,000, $4,644,000 and $5,117,000 for the years 1994, 1995, 1996, and 1997, respectively. 9. DEFINED CONTRIBUTION PLAN The Company has a defined contribution plan ("401(k) Plan"). Under the 401(k) Plan, an employee who has reached age 21 and completed one year of service is eligible to participate in the plan through contributions that range in one percent multiples up to 16% of salary, with a 1993 dollar maximum of $8,994. In addition, the Company contributes (or "matches") on behalf of each participant an amount equal to 100% of the portion of each participant's contribution which does not exceed 6% of the participant's annual salary. Employer contributions for certain highly compensated CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) employees may be further limited through the operation of the non-discrimination requirements found in Sections 401(k) and 401(m) of the Internal Revenue Code. Employee contributions can be invested in any or all of 3 funds in multiples of 25%. Employer contributions are invested in the Company's Common Stock. Employee contributions are 100% vested and non-forfeitable. Employer contributions are subject to a graded vesting schedule, with participants becoming fully vested upon completion of 5 years participation in the plan. Distributions from the 401(k) Plan are made upon retirement, death, disability or separation of service. Participants may borrow up to one-half ( 1/2) of their vested interest in the plan, limited to a maximum of $50,000. Contributions to the 401(k) Plan and earnings on contributions are not included in a participant's gross income until distributed to the participant. Contributions to the 401(k) Plan by the Company were $233,000, $266,000, and $393,000 for the years 1993, 1992, and 1991, respectively. 10. LONG-TERM OBLIGATIONS UNDER CAPITAL LEASES Maturities of obligations under capital leases at December 31, 1991 were $2,682,000. The interest portion of the obligation was $240,000 for the year. The final payment under the capital lease obligation was made on January 2, 1992. Interest expense related to the capital leases incurred during 1991 was $572,000. 11. CAPITAL STOCK Changes in the number of issued and outstanding shares of the Company's Common Stock are summarized as follows: The Company has an Incentive Equity Plan under which stock options, stock appreciation rights, restricted and deferred stock awards relating to the Company's Common Stock may be awarded to officers, directors and key employees. The Company's Incentive Equity Plan is designed to attract and reward key executive personnel. The stock options granted under this plan expire not more than 10 years from the date of grant. At December 31, 1993, the following options were outstanding and exercisable: CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Options for 1,500 shares were exercised during 1993 while no options were exercised in 1992 or 1991, respectively. The Company's Board of Directors has awarded restricted stock to key executives as follows: Restrictions on the 1988 award lapse with respect to 20% of the entire award after one year and after each of the succeeding 4 years. Restrictions lapse with respect to 25% of the entire award after one year and after each of the succeeding 3 years. Expense related to amortization of the restricted stock was $120,000, $442,000, and $274,000 for the years 1993, 1992, and 1991, respectively. Deferred compensation expense relative to non-vested shares of restricted stock, measured by the market value of the stock on the date of grant, is being amortized on a straight-line basis over the restriction period. The unamortized deferred compensation expense, which has been deducted from equity in the Consolidated Balance Sheets, amounted to $103,000 and $150,000 at December 31, 1993 and 1992, respectively. Effective December 31, 1992, the Company's Board of Directors awarded restricted stock for 17,500 shares of Common Stock to certain key executives. The price paid for the shares of the restricted stock was $13.25 per share. The Company extended full-recourse, interest-bearing loans to the key executives in the aggregate amount of $232,000. The promissory notes bear interest at seven and one-half percent (7 1/2%) per annum payable quarterly as it accrues on the last day of March, June, September and December until the notes are due on December 31, 1997. Additional shares of deferred stock will be awarded on December 31, 1997 if certain performance criteria are attained by the Company. Compensation expense related to the deferred stock awards will be accrued in future years if it becomes probable the Company performance criteria will be met. No such compensation expense was accrued during the year ended December 31, 1993. 12. REDEEMABLE PREFERRED STOCK On September 27, 1988, the Company completed a public offering of $28,750,000 of $2.3125 Convertible Exchangeable Preferred Stock ("Preferred Stock") which is traded in the over-the-counter market and quoted on the NASDAQ National Market System under the symbol "CLDRP". The Preferred Stock is redeemable at the option of the Company, in whole or in part, at $26.16 per share if redeemed prior to September 15, 1994, and at prices decreasing ratably annually to $25 per share from and after September 15, 1998, plus accrued and unpaid dividends to the redemption date. Any such non-mandatory redemption would be subject to INCC approval according to the terms of the First Restated Credit Agreement. Dividends on the Preferred Stock are cumulative from the date of first issuance and are payable quarterly commencing December 15, 1988 at the rate of $2.3125 per share per annum. Pursuant to the First Restated Credit Agreement, dividends on Preferred Stock cannot exceed the current dividend rate per share without the consent of INCC. In case of the voluntary or involuntary liquidation, dissolution or winding up of the Company, holders of shares of Preferred Stock are entitled to receive a liquidation preference of $25 per share CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) plus an amount equal to any accrued but unpaid dividends to the payment date. The Preferred Stock is also exchangeable in whole, but not in part, at the option of the Company on any dividend payment date subsequent to September 15, 1990, for nine and one-quarter percent (9 1/4%) Convertible Subordinated Debentures due 2013. The Preferred Stock is convertible into Common Stock of the Company at the initial conversion rate of 1.89394 shares of Common Stock for each share of Preferred Stock, subject to adjustment under certain circumstances. The Preferred Stock has no voting rights except as described below or as required by law. The holders of the Preferred Stock have no voting rights to elect directors except when dividends on the Preferred Stock or on any outstanding shares of parity dividend stock have not been paid in the aggregate amount equal to at least six quarterly dividends on such shares. The holders of the Preferred Stock will then be entitled to elect two additional directors to the Board, at any meeting of the shareholders of the Company at which directors are to be elected held during the period such dividends remain in arrears. The voting rights, as well as the term of office of all directors so elected, shall terminate when all such dividends accrued and in default have been paid in full or set apart for payment. In addition, so long as any Preferred Stock is outstanding, the Company shall not, without the affirmative vote or consent of the holders of sixty-six and two-thirds percent (66 2/3%) of all outstanding shares of Preferred Stock voting separately as a class, (i) amend, alter or repeal any provision of the Certificate of Incorporation or the By-Laws of the Company so as to adversely affect the relative rights, preferences, qualifications, limitations or restrictions of the Preferred Stock, (ii) authorize, issue or increase the authorized amount of any class or series of stock, or any security convertible into stock of such class or series, ranking senior to the Preferred Stock as to dividends or upon liquidation, dissolution or winding up of the Company or (iii) effect any reclassification of the Preferred Stock. The affirmative vote or consent of the holders of a majority of the Preferred Stock, voting or consenting separately as a class, is required to (a) authorize any sale, lease or conveyance of all or substantially all of the assets of the Company, or (b) approve any merger, consolidation or compulsory share exchange to which the Company is a party, unless (i) the terms of such merger, consolidation or compulsory share exchange do not provide for a change in the terms of the Preferred Stock and (ii) the Preferred Stock is on a parity with or prior to (in respect of dividends and upon liquidation, dissolution or winding up) any other class or series of capital stock authorized by the surviving corporation, other than any class or series of stock of the Company ranking senior to the Preferred Stock either as to dividends or upon liquidation, dissolution or winding up of the Company and previously authorized with the consent of the holders of Preferred Stock. In the event (i) any person becomes the beneficial owner of more than fifty percent (50%) of the Common Stock or the Company is a party to a business combination, including a merger or consolidation or the sale of all or substantially all of its assets, and (ii) either (a) as a result of such acquisition of shares of Common Stock or business combination, the Preferred Stock thereafter is not convertible into Common Stock of the Company or of the ultimate parent of the Company, which Common Stock is traded on the New York Stock Exchange, the American Stock Exchange or the NASDAQ National Market System, or (b) all or substantially all of the consideration paid in such share acquisition or business combination does not consist of Common Stock of the ultimate parent of the Company, which Common Stock is traded on the New York Stock Exchange, the American Stock Exchange or the NASDAQ National Market System, then each holder of Preferred Stock shall have the option to require the Company to redeem all the Preferred Stock owned by such holder at $25 per share plus accrued and unpaid dividends to the redemption date. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) On October 20, 1992, the staff of the Securities and Exchange Commission (the "Commission") advised the Company of a change in the staff's previous interpretation of a Commission rule regarding the classification of the Company's Preferred Stock as Shareholders' Equity. Accordingly, the Preferred Stock is not presented as a component of Shareholders' Equity. 13. COMMITMENTS AND CONTINGENT LIABILITIES The Company leases its headquarters office, office equipment and other items under operating leases expiring at various dates during the next five years. Management expects that, in the normal course of business, leases that expire will be renewed or replaced by other leases. Total rent expense under operating leases was $656,000, $576,000, and $536,000, for the years ended 1993, 1992 and 1991, respectively. Minimum future obligations under non-cancelable operating leases at December 31, 1993 for the following five years are $724,000, $525,000, $506,000, $514,000 and $544,000, respectively, and $1,248,000 thereafter. In conjunction with the spin-off of the Company from Cleveland, the Company and Cleveland and certain of their subsidiaries entered into a Reorganization and Distribution Agreement (the "Distribution Agreement"). The Distribution Agreement provides, among other things, that the guarantee obligations of Cleveland under the following financing arrangement will continue after the Distribution until the underlying obligations of the Company are satisfied: (i) the Company's lease financing of 3 land rigs with a balance at the Distribution of approximately $8,400,000 which expired in 1992, (ii) the Company's lease financing of one inland posted barge rig with a balance at the Distribution of approximately $2,000,000 which expired in 1990, and (iii) 2 tax benefit transfer lease transactions involving 2 of the Company's offshore jack-up rigs, under which Cleveland guarantees, among other things, the Company's obligations to indemnify the tax lessors against loss of tax benefits thereunder throughout the lease terms ending in 1992 and 1997. Pursuant to the Distribution Agreement, the Company granted to Cleveland a first preferred ship mortgage on BARGE NO. 3 to secure Cleveland's rights to repayment of any amounts that may be paid by Cleveland under either of the guaranties referred to in the foregoing clauses (i) and (ii). Subsequent to the purchase by the Company of BARGE NO. 1 on July 20, 1990 and the final land rig lease payment on January 2, 1992, Cleveland released the first preferred ship mortgage on BARGE NO. 3 effective March 9, 1992. All 4 of the Company's inland posted barge rigs were sold effective January 1, 1993. See Note 3 of Notes to Consolidated Financial Statements. In conjunction with the return to Diamond M of 3 offshore drilling rigs under long-term charters, a dispute existed as to whether or not the Company complied with the terms of the charters regarding maintenance and repair of the rigs during the charter period, as well as the condition of the rigs upon redelivery. Diamond M withheld payment of $1,700,000 in notes payable to the Company, representing a part of the purchase price for the subject rigs. Diamond M also claimed additional damages associated with repairs to the drilling rigs. In June, 1993, a partial summary judgment awarded the Company $1,800,000, together with interest and attorney's fees, for the notes payable owed by Diamond M to the Company, offset by certain charter hire payments due Diamond M. Following a trial in February, 1994, a judgment was entered in the United States District Court, Southern District of Texas, Houston Division. The judgment awarded Diamond M $3,500,000, plus court costs, offset by the partial summary judgment of $1,800,000. The Company paid Diamond M $1,700,000 in February, 1994, as a final settlement of all disputed issues. The Company has other contingent liabilities resulting from litigation, claims and commitments incidental to the ordinary course of business. Management believes that the probable resolution of such contingencies will not materially affect the financial position or results of operations of the Company. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 14. SUBSEQUENT EVENTS The Company executed a commitment letter with INCC to amend the terms of the working capital credit facility. The $10,000,000 working capital credit facility will be converted to a $20,000,000 revolving line of credit subject to certain borrowing base limitations. The revolving line of credit will mature on January 1, 1996. 15. BUSINESS SEGMENTS During the three years ended December 31, 1993, the Company conducted the following business activities: Daywork Drilling -- domestic and foreign drilling of oil and gas wells on a dayrate basis for major and independent oil and gas companies on land, inland waters and offshore. Turnkey Drilling -- domestic and foreign drilling of oil and gas wells on a turnkey basis for major and independent oil and gas companies on land, inland waters and offshore. MOPU Operations -- domestic and foreign operation of mobile offshore production units on a dayrate basis for major and independent oil and gas companies. Oil and Gas -- domestic exploration, development and production of hydrocarbon reserves. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) There were intersegment sales for the year ended December 31, 1993 of $147,000 compared to $3,082,000 and $2,353,000 for the years ended December 31, 1992 and 1991, respectively. Such intersegment sales were accounted for at prices comparable to unaffiliated customer sales. Identifiable assets by industry segment include assets directly identified with those operations. The Company derived a significant amount of its revenues from a few customers in each of the three years ended December 31, 1993. The following table summarizes information with respect to these major customers. 16. DISTRIBUTION OF EARNINGS AND ASSETS The following table sets forth financial information with respect to the Company and its subsidiaries on a consolidated basis by geographical area. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 17. QUARTERLY FINANCIAL DATA (UNAUDITED) Quarterly operating results for years ended December 31, 1993, 1992, and 1991 are summarized as follows: - --------------- (1) Fourth quarter 1993 results include a charge of $3,703,000 related to the Diamond M litigation settlement and expenses. (2) Fourth quarter 1992 results include a $1,500,000 writedown in the carrying value of oil and gas properties. (3) Net Income (Loss) per share for the year ended December 31, 1992 differs from the summation of the individual quarters within that year due to the impact of the public offering of Common Stock completed during the fourth quarter of 1992. (4) Fourth quarter 1991 results include a $4,000,000 writedown in the carrying value of oil and gas properties. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 18. SUPPLEMENTAL INFORMATION ON OIL AND GAS OPERATIONS (UNAUDITED) COGC conducts exploration and production activities in conjunction with the marketing of the Company's contract drilling services. This approach is referred to as the contract drilling support ("CDS") program. Under this program, COGC participates as a working interest owner in oil and gas exploration activities when it directly or indirectly results in the award of a drilling contract. In order to provide funding for the Company's share of development and completion costs of the CDS wells in which the Company has acquired or will acquire a working interest, the Company entered into an Exploration and Development Agreement (the "Development Agreement"), effective as of May 25, 1988, with Mosbacher Offshore, Inc. ("Mosbacher"). Under the terms of the Development Agreement, the Company generally pays the lease acquisition costs and the costs to casing point attributable to the interest it acquired in the initial test well drilled on a property. Subject to maximum funding limits discussed below and the elections of the other working interest owners in the wells with respect to particular operations and certain other contingencies, Mosbacher pays the costs incurred after the casing point of initial test wells (the "completion costs"), the drilling and completion costs of subsequent wells located on the property interest upon which the initial test well was drilled (the "development costs"), and the platform production facility and pipeline costs (the "joint facilities costs") incurred with respect to all wells located on the property interests. Each party owns a working interest in the test well based upon the amount of costs borne by each. With respect to property interests other than the initial test wells, Mosbacher owns all the working interest and the Company owns net profits interests. Should Mosbacher recoup its total costs borne with respect to all of its property interests ("payout"), the Company's net profits interest percentage would increase. However, the Company currently does not believe that payout will occur under the Development Agreement. Under certain circumstances, the Company's net profits interest converts to a working or cost bearing interest in all the property interest. At December 31, 1993, Mosbacher had expended $4,590,000 of completion costs on initial test wells and $16,993,000 in development and joint facilities costs. The obligation of Mosbacher to fund completion costs expired on February 15, 1992; however, Mosbacher will continue to be obligated to fund development and joint facilities costs up to the $25,000,000 limit on properties included under the Development Agreement. Approximately 24%, 19%, and 37% of the future net revenues at December 31, 1993, 1992 and 1991, respectively, were subject to the Development Agreement. A $1,500,000 writedown in the carrying value of oil and gas properties was recorded during the year ended December 31, 1992 due to a decline in estimated future net revenues, caused principally by downward revisions of reserve quantities. A $4,000,000 writedown in the carrying value of oil and gas properties was recorded during the year ended December 31, 1991 due to a decline in estimated future net revenues, caused principally by a decrease in the value of reserves associated with the Development Agreement and lower product prices. The decrease in the Development Agreement value was due principally to a delay in the expected occurrence of payout in the development drilling program due to an increase in the level of third party investment, coupled with a decrease in the estimated proved reserves. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The aggregate capitalized costs related to the Company's oil and gas exploration and production activities are summarized in the following table: Costs incurred in oil and gas property acquisition, exploration and development activities are summarized as follows: The results of operations for oil and gas exploration and production activities are summarized as follows: - --------------- (1) Includes $63,000, $158,000, and $79,000 attributable to a net profits interest for the years ended December 31, 1993, 1992, and 1991, respectively. CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Net quantities of proved reserves, all of which are located in the United States are summarized in the following table: The standardized measure of discounted future net cash flows and major components of that calculation relating to proved oil and gas reserves at December 31, 1993, 1992 and 1991 are as follows: The standardized measure of discounted future net cash flows from production of proved reserves was developed as follows: 1. Estimates were made of quantities of proved reserves and the future periods in which they are expected to be produced based on year-end economic conditions. 2. The estimated future gross revenues of proved reserves were priced on the basis of year-end prices. 3. The future gross revenue streams were reduced by estimated future costs to develop and to produce the proved reserves, based on year-end cost estimates. Future income taxes have not been included due to the effect of net operating loss carryforwards. The standardized measure of discounted future net cash flows does not purport to present the fair market value of the Company's oil and gas reserves. A market value determination would include, among other things, anticipated future changes in oil and gas prices and production and development costs; the value of additional estimated reserves, not considered proved at present, CLIFFS DRILLING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) which may be recovered as a result of further exploration and development activities; and other business risks. The standardized measure of discounted future net cash flows as of December 31, 1993 was calculated using prices in effect at December 31, 1993, which averaged $12.86 per Bbl of oil and $2.42 per Mcf of natural gas. The following are principal sources of changes in the standardized measure of discounted net cash flows: SCHEDULE V CLIFFS DRILLING COMPANY PROPERTY AND EQUIPMENT FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 (IN THOUSANDS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VI CLIFFS DRILLING COMPANY ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY AND EQUIPMENT FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 (IN THOUSANDS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VIII CLIFFS DRILLING COMPANY VALUATION AND QUALIFYING ACCOUNTS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 (IN THOUSANDS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE IX CLIFFS DRILLING COMPANY SHORT-TERM BORROWINGS FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 (IN THOUSANDS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- Notes: (1) Interest expressed as rate per annum. (2) Calculated by taking the amount of borrowings outstanding multiplied by the number of days outstanding divided by the number of days in the year. (3) Calculated as total interest expense on the credit agreement divided by the weighted average amount of principal outstanding. SCHEDULE X CLIFFS DRILLING COMPANY SUPPLEMENTARY STATEMENTS OF OPERATIONS INFORMATION FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 (IN THOUSANDS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EXHIBIT INDEX - --------------- * Filed herewith All other exhibits 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.

737291_1993.txt

737291_1993

1993

737291

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-XIV (the "Partnership"), is a limited partnership formed in late 1983 and currently governed by the Revised Uniform Limited Partnership Act of the State of Illinois to invest in improved income-producing commercial and residential real property. On June 4, 1984, 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 assignee interests therein) ("Interests") pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (No. 2-88687). A total of 401,048.66 Interests were sold to the public at $1,000 per Interest. The holders of 226,632.06 Interests were admitted to the Partnership in 1984; the holders of 174,416.6 Interests were admitted to the Partnership in 1985. The offering closed July 15, 1985. No Limited Partner has made any additional capital contribution after such date. 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 estate 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, 2034. 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 certain of the joint venture partners) 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 set forth in the table set forth in Item 2 ITEM 2. PROPERTIES The Partnership 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 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On June 4, 1984, the Partnership commenced an offering of $250,000,000 (subject to increase by up to $250,000,000) pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. All Interests were subscribed and issued between June 4, 1984 and July 15, 1985 pursuant to the public offering from which the Partnership received gross proceeds of $401,053,660. After deducting selling expenses and other offering costs, the Partnership had approximately $351,747,000 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 for working capital. A portion of such proceeds was 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 $2,831,000. Such funds and short- term investments of approximately $16,190,375 are available for distributions to partners and working capital requirements including the Partnership's potential funding obligations at the Louis Joliet Mall, Louisiana Tower and Wilshire Bundy Plaza related to renovation costs, releasing costs and underlying mortgage obligations, the Partnership's share of legal costs currently being incurred related to the lawsuit against the former manager and one of the unaffiliated venture partners of the 900 Third Avenue venture and the cash operating deficits currently being incurred at the Mariners Pointe Apartments. The Partnership and its consolidated ventures have currently budgeted in 1994 approximately $5,676,000 for tenant improvements 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 approximately $7,611,000. Actual amounts expended 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 and distributions to partners is dependent upon net cash generated by the Partnership's investment properties and the sale or refinancing of such investments. Due to the above situations and the property specific concerns discussed below, the Partnership suspended distributions beginning with the fourth quarter 1991 distribution payable in February 1992. As of December 31, 1993, the current portion of the long-term indebtedness of the Partnership and its consolidated ventures was approximately $28,107,000, including the entire indebtedness encumbering Mariner's Pointe Apartments, Brittany Downs Apartments - Phase II and the Partnership's interest in the Wells Fargo South Tower office building. Reference is made to Notes 4(a) and 4(b). Gateway Tower The Gateway Tower property was operating at a significant deficit due to higher than originally expected leasing costs and lower than originally expected rental rates achieved on leasing. During 1990, the joint venture partner ceased making the required capital contributions necessary to make the quarterly guaranteed payments to the Partnership and the debt service payments. During the first quarter of 1991, the lender served the joint venture with a notice of default and filed a lawsuit to realize on its security and take title to the property. On December 30, 1992, the lender concluded proceedings to realize on its security and took title to the property resulting in the Partnership no longer having an ownership interest in the property. The Partnership received no cash proceeds from the transfer of ownership interest; it did, however, recognize a gain for financial reporting and Federal income tax purposes during 1992 of $7,130,438 and $14,604,506, respectively. The joint venture partner's funding obligation was secured by a guarantee from an affiliated entity of the joint venture partner. After careful review of the joint venture partner and its affiliate's financial condition, the Partnership has determined that they do not have the ability to satisfy any of their financial obligations under the joint venture agreement. Therefore, the Partnership has decided to forego any further attempts to recover amounts due from them as a result of their defaults. 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, 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 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 internal rate of return per 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 or refinancing as discussed below, there are funds remaining in this escrow, after payment 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 re 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(e). 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. Reference is made to note 3(g). Brittany Downs Apartments - Phase I and II In June 1993, the Partnership refinanced the Brittany Downs Apartments Phase I $7,090,000 mortgage loan resulting in a reduction of the effective interest rate on the loan from 8.0% per annum to 6.2% per annum. Brittany Downs Apartments Phase II does not produce sufficient cash flow to cover its required debt service payments and, consequently, the Partnership has been paying a reduced amount of debt service since November 1990. As a result, the Partnership was negotiating with the RTC to obtain a loan modification to reduce the property's required debt service payments. During the fourth quarter 1992, the RTC sold the Phase II mortgage loans. The new underlying lender has placed the Partnership in default for failure to pay the required debt service. Accordingly, the balances of the Phase II first mortgage note, the second mortgage note, and related accrued interest have been classified as current liabilities in the accompanying consolidated financial statements at December 31, 1993 and December 31, 1992. Based on the notice of default, the total amount of interest in arrears on the existing mortgage notes for Brittany Downs Apartment Phase II in the principal amount of $8,566,458 as of December 31, 1993, equals $1,101,800. The Partnership is currently in negotiations with the new lender regardin for sale with Phase I. Because the two Phases currently operate in tandem, the Partnership believes the two Phases together would have a greater individual market value than if marketed for sale independently. If the Partnership is not successful in its discussions with the new Phase II lender, the Partnership has decided, based upon an analysis of current and anticipated market conditions and the probability of large future cash deficits, not to commit additional funds to the Phase II property. This would result in the Partnership no longer having an ownership interest in the Phase II property and could result in gain for financial reporting and Federal income tax purposes to the Partnership with no distributable proceeds from the disposition. The Partnership, however, may still consider marketing the Phase I property for sale in the near future. JMB/NYC At the 2 Broadway building, occupancy increased slightly to 30% during the fourth quarter 1993, up from 29% in the previous quarter. The Downtown Manhattan office leasing market remains depressed due to the significant supply of, and the relatively weak demand for, tenant space. As previously reported, Merrill Lynch, Pierce, Fenner & Smith, Incorporated's lease of approximately 497,000 square feet of space (31% of the building's total space) expired in August 1993. A majority of the remaining tenant roster at the property includes several major financial services companies whose leases expire in 1994. Most of these companies maintain back office support operations in the building which can be easily consolidated or moved. The Bear Stearns Co.'s lease of approximately 186,000 square feet of space (12% of the building's total space), which expires in April 1994, is not expected to be renewed. In addition to the competition for tenants in the Downtown Manhattan market from other buildings in the area, there is ever increasing competition from less expensive alternatives to Manhattan, such as locations in New Jersey and Brooklyn, which are also experiencing high vacancy levels. Rental rates in the Downtown market continue to be at depressed levels and this can be expected to continue while the large amount of vacant space is gradually absorbed. Little, if any, new construction is planned for Downtown over the next few years. It is expected that 2 Broadway will continue to be adversely affected by a high vacancy rate and the low effective rental rates achieved upon releasing of space under existing leases which expire over the next few years. In addition, the property is in need of a major renovation in order to compete in the office leasing market. However, there are currently no plans for a renovation because of the potential sale of the property discussed below and because the effective rents that could be obtained under current market conditions may not be sufficient to justify the costs of the renovation. Occupancy at 1290 Avenue of the Americas increased to 98%, up from 95% in the previous quarter primarily due to Prudential Bache Securities, Inc. occupying 25,158 square feet. The Midtown Manhattan office leasing market remains very competitive. It is expected that the property will continue to be adversely affected by low effective rental rates achieved upon releasing of space covered by existing leases which expire over the next couple years and may be adversely affected by an increased vacancy rate over the next few years. Negotiations are currently being conducted with certain tenants who in the aggregate occupy in excess of 300,000 square feet for the renewal of their leases that expire in 1994 and 1995. John Blair & Co. ("Blair"), a major lessee at 1290 Avenue of the Americas (leased space approximates 253,000 square feet or 13% of the building), has filed for Chapter XI bankruptcy. Because much of the Blair space is subleased, the 1290 venture is collecting approximately 70% of the monthly rent due under the leases from the subtenants. There is uncertainty regarding the collection of the balance of the monthly rents from Blair. Accordingly, a provision for doubtful accounts related to rents and other receivables and accrued rents receivable aggregating $7,659,366 has been recorded at December 31, 1993 in the accompanying combined financial statements related to this tenant. Occupancy at 237 Park Avenue decreased slightly to 98% in the fourth quarter of 1993, down from 99% in the previous quarter. It is expected that the property will be adversely affected by the low effective rental rates achieved upon releasing of existing leases which expire ov years and may be adversely affected by an increased vacancy rate over the next few years. JMB/NYC has had a dispute with the unaffiliated venture partners who are affiliates (hereinafter sometimes referred to as the "Olympia & York affiliates") of Olympia and York Developments, Ltd. (hereinafter sometimes referred to as "O & Y") over the calculation of the effective interest rate with reference to the first mortgage loan, which covers all three properties, for the purpose of determining JMB/NYC's deficit funding obligation commencing in 1992, as described more fully in Note 3(c) of Notes to Financial Statements. Under JMB/NYC's interpretation of the calculation of the effective rate of interest, 2 Broadway operated at a deficit for the year ended December 31, 1993. During the first quarter of 1993, an agreement was reached between JMB/NYC and the Olympia & York affiliates which rescinded the default notices previously received by JMB/NYC and eliminated any alleged operating deficit funding obligation of JMB/NYC for the period January 1, 1992 through June 30, 1993. Accordingly, during this period, JMB/NYC recorded interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum), which is the interest rate on the underlying first mortgage loan. Under the terms of this agreement, during this period, the amount of capital contributions that the Olympia & York affiliates and JMB/NYC would have been required to make to the Joint Ventures, as if the first mortgage loan bore interest at a rate of 12.75% per annum (the Olympia & York affiliates' interpretation), became a priority distribution level to the Olympia & York affiliates from the Joint Ventures' annual cash flow or net sale or refinancing proceeds. The agreement also entitles the Olympia & York affiliates to a 7% per annum return on such unpaid priority distribution level amount. It was also agreed that during this period, the excess available operating cash flow after the payment of the priority distribution level discussed above from any of the Three Joint Ventures will be advanced in the form of loans to pay operating deficits and/or unpaid priority distribution level amounts of any of the other Three Joint Ventures. Such loans will bear a market rate of interest, have a final maturity of ten years from the date when made and will be repayable only out of first available annual cash flow or net sale or refinancing proceeds. The agreement also provides that except as specifically agreed otherwise, the parties each reserves all rights and claims with respect to each of the Three Joint Ventures and each of the partners thereof, including, without limitation, the interpretation of or rights under each of the joint venture partnership agreements for the Three Joint Ventures. The agreement expired on June 30, 1993. Effective July 1, 1993, JMB/NYC is recording interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate plus any excess operating cash flow after capital costs of the Three Joint Ventures, such sum not to be less than 7% nor exceed a 12-3/4% per annum interest rate. The Olympia & York affiliates dispute this calculation and contend that the 12-3/4% per annum fixed rate applies. JMB/NYC continues to seek, among other things, a restructuring of the joint venture agreements or otherwise to reach an acceptable understanding regarding its long-term funding obligations. If JMB/NYC is unable to achieve this, based upon current and anticipated market conditions mentioned above, JMB/NYC may decide not to commit any additional amounts to 2 Broadway and 1290 Avenue of the Americas, which could, under certain circumstances, result in the loss of the interest in the related ventures. The loss of an interest in a particular venture could, under certain circumstances, permit an acceleration of the maturity of the related Purchase Note (each Purchase Note is secured by JMB/NYC's interest in the related venture). The failure to repay a Purchase Note could, under certain circumstances, constitute a default that would permit an immediate acceleration of the maturity of the Purchase Notes for the other ventures. In such event, JMB/NYC may decide not to repay, or may not have sufficient funds to repay, any of the Purchase Notes and accrued interest thereon. This could result in JMB/NYC no longer having an interest in any of the related ventures, which in that event would result in substantial net gain for financial reporting and Federal income tax purposes to JMB/NYC (and through JMB/NYC and the Partnership, to the Limited Partners) with no distributable proceeds. In addition, under certain circumstances as more fully discussed in Note 2, JMB/NYC may be required to make additional capital contributions to certain of the Joint Ventures in deficit restoration obligation associated with a deficit balance in its capital account, and the Partnership could be required to bear a share of such capital contributions obligation. If JMB/NYC is successful in its negotiations to restructure the Three Joint Ventures agreements and retains an interest in one or more of these investment properties, there would nevertheless need to be a significant improvement in current market and property operating conditions (including a major renovation of the 2 Broadway building) resulting in a significant increase in value of the properties before JMB/NYC would receive any share of future net sale or refinancing proceeds. The Joint Ventures that own the 2 Broadway building and land have no plans for a renovation of the property because of the potential sale of the property discussed below and because the effective rents that could be obtained under the current office market conditions may not be sufficient to justify the costs of the renovation. Given the current market and property operating conditions, it is likely that the property would sell at a price significantly lower than the allocated portion of the underlying debt. The first mortgage lender and JMB/NYC would need to approve any sale of this property. The O&Y affiliates have informed JMB/NYC that they have now received a written proposal for the sale of 2 Broadway for a net purchase price of $15 million. The first mortgage lender has preliminarily agreed to the concept of a sale of the building but has not approved the terms of any proposed offer for purchase. Accordingly, a sale pursuant to the proposal received by the O&Y affiliates would be subject to, among other things, the approval of the first mortgage lender as well as JMB/NYC. While there can be no assurance that a sale would occur pursuant to such proposal or any other proposal, if this proposal were to be accepted by or consented to by all required parties and the sale completed pursuant thereto, and if discussions with the O&Y affiliates relating to the proposal were finalized to allocate the unpaid first mortgage indebtedness currently allocated to 2 Broadway to 237 Park and 1290 Avenue of the Americas after completion of the sale, then the 2 Broadway Joint Ventures would incur a significant loss for financial reporting purposes. Accordingly, a provision for value impairment has been recorded for financial reporting purposes for $192,627,560, net of the non-recourse portion of the Purchase Notes including related accrued interest related to the 2 Broadway Joint Venture interests that are payable by JMB/NYC to the O&Y affiliates in the amount of $46,646,810. The provision for value impairment has been allocated $136,534,366 and $56,093,194 to the O&Y affiliates and JMB/NYC, respectively. Such provision has been allocated to the partners to reflect their respective ownership percentages before the effect of the non- recourse promissory notes including related accrued interest. The provision for value impairment is not a loss recognizable for Federal income tax purposes. O & Y and certain of its affiliates have been involved in bankruptcy proceedings in the United States and Canada and similar proceedings in England. The Olympia & York affiliates have not been directly involved in these proceedings. During the quarter ended March 31, 1993, O & Y emerged from bankruptcy protection in the Canadian proceedings. In addition, a reorganization of the company's United States operations has been completed, and affiliates of O & Y are in the process of renegotiating or restructuring a number of loans affecting various properties in the United States in which they have an interest. The Partnership is unable to assess and cannot presently determine to what extent these events may adversely affect the willingness and ability of the Olympia & York affiliates either to meet their own obligations to the Joint Ventures and JMB/NYC or otherwise reach an understanding with JMB/NYC regarding any funding obligation of JMB/NYC. However, the financial difficulties of O&Y and its affiliates may be adversely affecting the Three Joint Ventures' efforts to restructure the mortgage loan and to re-lease vacant space in the building. During the fourth quarter of 1992, the Joint Ventures received a notice from the first mortgage lender alleging a default for failure to meet certain reporting requirements of the Olympia & York affiliates contained in the first mortgage loan documents. No monetary default has been alleged. The Olympia & York affiliates have responded to the lender that the Joint Ventures are not in default. JMB/NYC is unable to determine if the Join default. Accordingly, the balance of the first mortgage loan has been classified as a current liability in the accompanying combined financial statements at December 31, 1992 and 1993. There have not been any further notices from the first mortgage lender. However, the Olympia & York affiliates, on behalf of the Three Joint Ventures, continue to negotiate with representatives of the lender (consisting of a steering committee of holders of notes evidencing the mortgage loan) to restructure certain terms of the existing mortgage loan in order to provide for, among other things, a fixed rate of interest on the loan during the remaining loan term until maturity. In conjunction with the negotiations, the Olympia & York affiliates reached an agreement with the first mortgage lender whereby effective January 1, 1993, the Olympia & York affiliates are limited to taking distributions of $250,000 on a monthly basis from the Three Joint Ventures reserving the remaining excess cash flow in a separate interest-bearing account to be used exclusively to meet the obligations of the Three Joint Ventures as approved by the lender. There is no assurance that a restructuring of the loan will be obtained. Interest on the first mortgage loan is calculated based upon a variable rate related to the short-term U.S. Treasury obligation rate, subject to a minimum rate on the loan of 7% per annum. A significant increase in the short-term U.S. Treasury obligation rate could result in increased interest payable on the first mortgage loan by the Three Joint Ventures. 1090 Vermont Avenue Building During the year, occupancy of this office building increased to 99%, up from 90% at the end of 1992 due to Delphi International occupying 12,396 square feet (approximately 9% of the building's leasable space) in February 1993. Through 1993, the Partnership and joint venture partners have contributed a total of $4,076,000 ($2,038,000 by the Partnership) to the joint venture to cover releasing costs and costs of a lobby renovation. The Partnership and joint venture partner had agreed that the contributions made to the joint venture would be repaid along with a return thereon out of first available proceeds from property operations, sale or refinancing. During the fourth quarter, the joint venture finalized a refinancing of the existing mortgage loan with a new loan in the amount of $17,750,000. The refinancing resulted in net proceeds of approximately $2,259,000 for the joint venture. Of such proceeds, $1,785,560 (of which the Partnership's share was $889,064) was distributed to the venture partners in December 1993 as a partial return of the additional capital contributed. The remaining proceeds are being retained by the joint venture as working capital. The new loan provides for interest only monthly payments for the entire ten-year term. The interest rate for the first five years is 8.01% per annum. The fixed interest rate thereafter until maturity will be 2.8% per annum over the five year Treasury rate at the beginning of such five-year period. In addition to providing refinancing proceeds to the joint venture, the debt service payments due under the new loan are significantly lower than the payments due under the prior loan. Consequently, the property is expected to produce cash flow for the joint venture in 1994. The joint venture negotiated an early lease termination agreement with a major tenant that vacated its space (24,308 square feet) in early 1992. The joint venture terminated the lease (which was to expire in February 1996) for a fee of approximately $1.5 million and entered into a direct lease with the subtenant, which occupies a substantial portion of the former major tenant's space (18,482 square feet). Such fee was used by the joint venture in 1992 to help cover releasing costs and costs of the lobby renovation. Old Orchard Shopping Center On September 2, 1993, effective August 30, 1993, Orchard Associates (in which the Partnership and an affiliated partnership sponsored by the Corporate General Partner each have a 50% interest) sold its interest in the Old Orchard shopping center (reference is made to Note 3(b)). The Partnership is currently retaining its share of the net proceeds from the sale for working capital purposes. Scottsdale Financial Centers I and II On October 1, 1993, the RTC sold the mortgage note underlying Scottsdale Financial Center II and the Partnership simultaneously transferred title to the purchaser of the note. On December 17, 1993, the Partnership relinquished its ownership interest in Scottsdale Financial Center I in a similar transaction. As more fully described in Item 3, Legal Proceedings, a judicial hearing was held in early 1991 concerning, among other things, an alleged default by the Partnership on the mortgage loans secured by the Scottsdale Financial Center I and II investment properties. The judge issued an order rendering the Partnership's rights of offset unenforceable against the RTC acting as receiver of the lender. The court entered a judgment pursuant to this order in February 1992. However, per the judgment, the Partnership was not required to return the guaranteed payments received from the manager since acquisition of the properties, which totalled approximately $1,900,000 for both properties. Both the Partnership and the RTC had filed a notice of appeal from the judgment order of the court. During the appeal process, the RTC was entitled to obtain title to the properties and cash reserves on hand. Accordingly, during the second quarter of 1992, the RTC withdrew the cash reserves on hand at the properties. During the quarter ended March 31, 1993, the Partnership reached an agreement with the RTC for the settlement of the disputes through a dismissal of their respective appeals. In April 1993, in accordance with the settlement, the Partnership returned $320,000, which represented certain amounts (plus interest thereon) which were withdrawn from the property operating accounts subsequent to the date of the alleged default by the Partnership and set aside in a segregated interest bearing account. However, the Partnership was not required to return the $1.9 million of guaranteed payments it had previously received. As a result of the transfers of title discussed above, the Partnership recognized a gain of $18,382,769 and $7,920,092 in 1993 for financial reporting and Federal income tax purposes, respectively, without any corresponding distributable proceeds. Yerba Buena West Office Building In June 1992, the joint venture transferred title to the property to the lender in return for an opportunity to share in future sale or refinancing proceeds above certain specified levels. In connection with the San Francisco earthquake experienced on October 17, 1989, the Yerba Buena office building incurred some structural and cosmetic damage which was repaired. Five tenants (approximately 54% of the building) vacated the building and withheld substantially all of their rent (commencing at various times) since November 1989. The joint venture concluded not to pursue legal recourse against said tenants based on, among other things, the costs of pursuing its remedies, competing demands on the joint venture's (or its partners') resources and the prospects of any material return to the joint venture in light of these events. Reference is made to Note 3(i). Based upon the conditions at Yerba Buena, the joint venture had not made the debt service payments to the underlying lender, commencing with the January 1990 payment. The Partnership and affiliated partners had decided, based upon an analysis of current market conditions and the probability of large future cash deficits, not to fund future joint venture cash deficits. The joint venture was unable to negotiate a loan modification whereby the joint venture retained ownership of the property. In order for the joint venture to share in future 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. In addition, during a certain period of time, the joint venture will have a right of first opportunity to purchase the property if the lender chooses to sell. An affiliate of the Partnership's Corporate General Partner continues to manage and lease the property for the lender. As a result of to the lender as discussed above, the Partnership no longer has an ownership interest in the property and recognized a gain of $1,653,454 and $1,117,418 in 1992 for financial reporting and Federal income tax purposes, respectively, with no corresponding distributable proceeds. Wilshire Bundy Plaza Occupancy at the Wilshire Bundy Plaza decreased to 87% during 1993, down from 91% in the previous year. The building experienced only minor cosmetic damage as a result of the January 1994 earthquake in southern California. From 1993 through 1996, approximately 60% of the building's square feet under tenant leases expires. Dun & Bradstreet (60,500 square feet or approximately 21% of the building's leasable space) and Bozell, Jacobs, Kenyan & Eckhardt (51,000 square feet or approximately 18% of the building's leasable space) have informed the Partnership that they will not be renewing their leases which expire in March 1995 and May 1996, respectively. In addition, several tenants have approached the Partnership seeking space and/or rent reductions. The Partnership is working with its existing tenants and aggressively seeking replacement tenants for current and future vacant space. The West Los Angeles office market (competitive market for the building) is extremely competitive with a current vacancy rate of approximately 20%. While office building development in this market is virtually at a standstill, the Partnership does not expect a significant improvement in the competitive market conditions for several years. As a result of these market conditions, it is expected that in 1994 and for several years beyond, the property will not generate enough cash flow to cover the required debt service on the underlying mortgage loan due to high releasing costs expected to be incurred and lower anticipated effective rental rates expected to be achieved in connection with releasing of the space under current leases that expires. The building may also experience increased vacancy during the releasing period. The Partnership has commenced discussions with the existing lender for a possible debt modification on its mortgage loan which matures April 1996 in order to reduce its debt service and cover its releasing costs over the next several years. If the Partnership is unsuccessful in obtaining such modification, it may decide not to commit additional amounts to the property, which could result in a disposition of the property and a recognition of gain for financial reporting and Federal income tax purposes with no distributable proceeds. 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 had 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 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. Louis Joliet Mall Occupancy of this mall decreased to 82% during 1993 from 91% in the previous year due primarily to the loss of Hermans Sporting Goods (11,850 square feet) which filed for bankruptcy during 1993. Subsequent to the end of the year, Osco (12,407 square feet), pursuant to early termination provisions contained in its lease, terminated its lease and vacated the center reducing occupancy to 77%. During the third quarter of 1993, Al Baskin Co. (19,960 square feet or approximately 7% of the mall space) informed the Partnership that even though its lease does not contain provisions allowing it to terminate its lease, it believed it had the right and intended to terminate its lease effective December 31, 1993 (original lease expiration of December 31, 2003). In response, during the quarter, the Partnership filed an anticipatory breach lawsuit against the tenant in order to prevent the tenant from vacating its space and cease paying rent to the Partnership. The Partnership and tenant have entered into a temporary agreement under which the tenant will continue to operate its store and pay rent through June 30, 1994. The Partnership believes the tenant's position is without merit and intends to enforce the original terms of the lease. Plans are being finalized for an enhancement program for the center to be undertaken in 1994 at a cost of approximately $2,500,000. The enhancement program costs are expected to be funded from the property's operating cash flow and the Partnership's working capital reserve. The owner of Carson Pirie Scott, P.A. Bergner & Co. Holding Company, filed for protection under Chapter 11 of the United States Bankruptcy Code in October 1991. However, Carson Pirie Scott, which owns its store, has continued to operate since this filing and has affirmed its obligation to continue operations in the future in accordance with existing agreements related to the center. Louisiana Tower Occupancy at Louisiana Tower decreased to 90% during 1993, down from 92% in the prior year. The property is operating at a small deficit as a result of the 1990 debt restructuring as more fully discussed in Note 4(b). The Partnership is negotiating with the existing lender for a possible restructuring and/or extension of the existing modified loan. The existing modification period expires and the loan matures in January 1995. The Partnership has decided that it will not commit any significant amounts of capital to this property due to the fact that the recovery of such amounts would be unlikely. Therefore, if the Partnership is unsuccessful in obtaining an acceptable restructuring and/or extension of the loan, the likely result would be the Partnership no longer having an ownership interest in the property. In such event, the Partnership would recognize a loss for Federal income tax purposes and a gain for financial reporting purposes. There can be no assurances that the Partnership will receive a restructuring and/or extension of the loan from the existing lender. Mariners Pointe Apartments Occupancy at the Mariners Pointe Apartments increased to 90% during 1993, up from 87% in the prior year. As a result of certain capital improvement projects, the property operated at a small deficit in 1992. Under the terms of the joint venture agreement, the joint venture partner was obligated to contribute 22.3% of such deficit. The Partnership had made a request for capital from the joint venture partner for its share of the 1992 deficit. The joint venture partner's obligation to make the capita by its interest in the joint venture as well as personal guarantees by certain of its principals. The joint venture partner has not made the required contribution, however the Partnership is currently negotiating with the joint venture partner to obtain its interest in the joint venture and receive certain amounts in satisfaction of its funding obligation. The mortgage loan secured by this property is scheduled to mature October 1, 1994. In this regard, the Partnership is considering its alternatives including a loan extension, refinancing and/or possible sale of the property. There can be no assurance that the Partnership will collect the amounts due from the joint venture partner in satisfaction of its funding obligation or that the Partnership will be able to refinance or extend its existing mortgage loan when it matures. General To the extent that additional payments related to certain properties are required or if properties do not produce adequate amounts of cash to meet their needs, the Partnership may utilize the working capital which it maintains and/or pursue outside financing sources. However, based upon current market conditions, the Partnership may decide not to, or may not be able to, commit additional funds to certain of its investment properties. This would result in the Partnership no longer having an ownership interest in such property, and generally would result in taxable income to the Partnership with no corresponding distributable proceeds. The Partnership's and the ventures' mortgage obligations are all non-recourse. Therefore, the Partnership and its ventures are not personally obligated to pay mortgage indebtedness. There are certain risks and uncertainties 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 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. Therefore, the Partnership is carefully scrutinizing the appropriateness of any discretionary expenditures, particularly in relation to the amount of working capital it has available. 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. 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 the potential for some recovery of its investments. Also, 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 the Partnership expects to distribute from sale proceeds some portion of the Limited Partners' original capital, 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 even though the Partnership would not be able to return a substantial amount of the Limited Partners' original capital from such sales or other dispositions. RESULTS OF OPERATIONS At December 31, 1993, 1992 and 1991, the Partnership owned twelve, fifteen and seventeen investment properties, respectively, all of which were operating. The aggregate increase in the balances of cash and cash equivalents and short term investments at December 31, 1993 as compared to the balances at December 31, 1992 is primarily due to receipt and investment of the Partnership's share of proceeds from the sale of the interest in Old Orchard Shopping Center as well as distribution to the Partnership of its proportionate share of cash flow from the Wells Fargo Center South Tower, the receipt of scheduled amounts due per the settlement agreement with the Turtle Creek joint venture partner and its principals, and the Partnership's share of proceeds from the refinancing of the 1090 Vermont Avenue office building. The decrease in restricted funds at December 31, 1993 as compared to December 31, 1992 is primarily due to the annual remittance on March 31 to the lender of net cash flow generated by the Louisiana Tower as debt service pursuant to the agreement signed in November 1990 as more fully described in Note 4(b), the RTC's withdrawal of the cash reserves on hand (approximately $925,000) at Scottsdale Financial Center II and the Partnership's April 1993 payment of $320,000 to the RTC in accordance with the settlement related to Scottsdale Financial Centers I and II as more fully described in Note 6. The decrease in interest, rents and other receivables, land, buildings and improvements, deferred expenses, accrued interest and accounts payable at December 31, 1993 as compared to December 31, 1992 is due primarily to the disposition of the Scottsdale Financial Centers I and II during 1993 (Note 6) and the disbursement of approximately $2,300,000 of letter of credit proceeds to the lender of the Scottsdale Financial Centers I and II for payment towards accrued interest. The decrease in the current portion of long-term debt at December 31, 1993 as compared to December 31, 1992 is primarily due to the disposition of the Scottsdale Financial Centers I and II and their underlying debt (all of which was classified as current at December 31, 1992) during 1993, partially offset by the debt relating to the Mariner's Pointe Apartments and the Partnership's interest in the Wells Fargo Center which mature in 1994. The increase in due to affiliates at December 31, 1993 as compared to December 31, 1992 is due to the Partnership's paid-in capital obligation to Carlyle Investors, Inc. and Carlyle Managers, Inc., of which the Partnership is a 20% Shareholder (see Note 3(c)). The decrease in the balance of long-term debt less current portion at December 31, 1993 as compared to the balance at December 31, 1992 is primarily due to the debt relating to the Mariner's Pointe Apartments and the Partnership's interest in the Wells Fargo Center which mature in 1994. The decrease in rental income for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 is primarily due to the disposition of the Scottsdale Financial Centers I and II during 1993, lower occupancy at the Wilshire Bundy Plaza, Louis Joliet Mall and Louisiana Tower during 1993, offset partially by higher effective rental rates achieved at the Brittany Downs Apartments Phase I and II during 1993 and the collection of tenant settlements and lease termination fees at Wilshire Bundy Plaza in 1993. The decrease in rental income for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is primarily due to the lease termination of a major tenant at Scottsdale Financial Center I in September 1991 and lease turnover at the Wilshire Bundy Plaza during 1991 and 1992 which resulted in a reduction in operating cost recoveries, partially offset by rental escalations and receipt of lease termination fees at the Louisiana Tower and the Louis Joliet Mall of approximately $486,000 and $200,000, respectively, and the achievement of higher rental rates at the Brittany Downs Apartments-Phases I and II during 1992. Interest income decreased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 primarily due to a decrease in the average balance of U.S. government obligations in 1993 due to contributions by the Partnership of its proportionate share for the releasing costs at 1090 Vermont during the first quarter of 1993 and the Partnership's funding of its share of capital costs at Old Orchard in 1992 and 1993. The decrease in interest income for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is primarily due to a decrease in the average balance of U.S. Government obligations in 1992 due to the contributions by the Partnership of its proportionate share of capital costs at Old Orchard and the payment of the required debt service on the promissory note secured by the Wells Fargo South Tower in 1992 and due to the lower interest rates earned on such U.S. Government obligations in 1992. Other income decreased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and increased for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 as a result of the terms of the Turtle Creek settlement agreement with the venture partner and its principals, as more fully discussed in Note 3(h). The decrease in mortgage and other interest for the twelve months ended December 31, 1993 and the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is primarily due to the recording of additional interest expense in 1991, per the judgement entered in February 1992, for a certain period (June 1990 to December 1991) of the dispute involving the Scottsdale Financial Centers I and II which were disposed of in 1993, partially offset by the accrual of additional interest expense in 1993 relating to the default on the debt underlying the Brittany Downs Apartments - Phase II. Depreciation decreased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and December 31, 1991 primarily due to the Partnership recording a $9,548,085 provision for value impairment at Wilshire Bundy Plaza at June 30, 1992 which reduced the net carrying value of the property, as more fully discussed in Note 1. The decrease in property operating expenses for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is primarily due to the 1991 recognition of previously unaccrued management compensation costs for the period 1985 to 1991 related to the Louis Joliet Mall, all of which were paid as of December 31, 1991. The provision for (recovery of) doubtful accounts decreased for the twelve months ended December 31, 1993 as compared to December 31, 1992 primarily due to the collection and settlement in 1993 of accounts receivable of two tenants at the Wilshire Bundy Plaza who were significantly past due as of December 31, 1992. The provision for doubtful accounts for the twelve months ended December 1, 1992 is primarily attributable to the uncertainty of collectibility of amounts due from certain tenants at the Wilshire Bundy Plaza. The recovery of doubtful accounts for the twelve months ended December 31, 1991 was attributable to proceeds to be received relating to a letter of credit at the Scottsdale Financial Center II, which had been deemed uncollectible in 1990. This recovery income was offset by additional interest expense recorded at the Scottsdale Financial Centers I and II in 1991. Amortization of deferred expenses increased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 primarily due to an increase in leasing activity at certain of the Partnership's investment properties and the amortization of the related lease commissions. The decrease in management fees to the Corporate General Partner for the twelve months ended December 31, 1993 and December 31, 1992 as compared to the twelve months ended December 31, 1991 is due to a decrease in distributions effective with the February 1991 payment and the suspension of distributions effective with the February 1992 payment, a portion of which is its management fee. The increase in the Partnership's share of loss from unconsolidated ventures and the related increase in the Partnership's aggregate deficit investment in unconsolidated ventures, at equity, for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 is due primarily to (i) the sale of the Partnership's interest in the Old Orchard Shopping Center, (ii) a $67,479,870 provision for value impairment recorded in 1993 for Wells Fargo-IBM Tower due to the uncertainty of the venture's ability to recover its net carrying value, (iii) a $192,627,560 provision for value impairment recorded in 1993 for 2 Broadway due to the potential sale of the property at a sales price significantly below its net carrying value, (iv) an $11,946,285 provision for doubtful accounts recorded by JMB/NYC due to the uncertainty of collectibilty of amounts due from the Olympia & York affiliates to the Three Joint Ventures, (v) an $11,551,049 provision for doubtful accounts recorded by JMB/NYC due to the uncertainty of collectibility of amounts due from tenants at the Three Joint Ventures' real estate investment properties, and (vi) increased aggregate interest accrued with reference to the Three Joint Ventures' mortgage loan commencing July 1, 1993 as a result of the expiration of the agreement with the Olympia & York affiliates. Reference is made to Note 3. The decrease in the Partnership's share of the loss from operations of unconsolidated ventures for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 and the related increase in investment in unconsolidated venture, at equity is primarily due to (i) the change in profit and loss allocation from 1991 to 1992 pursuant to JMB/NYC's venture agreements, as more fully described in Note 3(c) of Notes to Consolidated Financial Statements, (ii) the collection in 1992 of $6,069,444 of a total $13,340,601 bankruptcy claim against Drexel Burnham Lambert, a former tenant of the 2 Broadway Building and (iii) the reduced aggregate interest accrued on the joint ventures' mortgage loan commencing in 1992 based upon the interest accrual determined by JMB/NYC, and its unaffiliated venture partners as more fully described in Note 3(c) of Notes to Consolidated Financial Statements. The gain from disposition of unconsolidated venture for the year ended December 31, 1993 is due to the sale of the Partnership's interest in the Old Orchard Shopping Center. The gain from sale or disposition of investment properties for the year ended December 31, 1993 is due to the transfer of the title to the property to the lender of the Scottsdale Financial Centers I and II. The gain from disposition of unconsolidated ventures for the year ended December 31, 1992 is due to the transfer of title to the property to the lender of the Yerba Buena West Office Building in June 1992 and due to the lender realizing upon its security in the Gateway Plaza Office Building in December 1992 as more fully described in Notes 3(d) and 3(i). Reference is made to Note 1 regarding provisions for value impairment of $51,423,084 in 1992 for 1290 Avenue of the Americas. In accordance with the terms of the respective venture agreements, all of such provision has been allocated to the unaffiliated venture partners. 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 increased expenses may be offset by amounts recovered from tenants as many of the long-term leases at the Partnership's commercial properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, the effect on operating earnings generally will depend upon the extent to which the properties are 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 if rental rates and replacement costs of properties increase. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV (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 -------- Consolidated Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIV 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, 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 Combined Supplementary Income Statement Information X Combined Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the combined financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV: We have audited the consolidated financial statements of Carlyle Real Estate Limited Partnership - XIV, a limited partnership, (the 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 the Partnership 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 discussed in Note 3(c) to the consolidated financial statements, the Partnership and its affiliated partners in JMB/NYC Office Building Associates, L.P. (JMB/NYC) are in dispute with the unaffiliated partners in the real estate ventures over the calculation of the effective interest rate with reference to the first mortgage loan, which covers all the real estate owned through JMB/NYC's joint ventures. The Partnership and its affiliated partners in JMB/NYC believe that, for purposes of calculating cash flow deficits and for financial reporting purposes, the joint venture agreements for JMB/NYC's real estate joint ventures require interest to be computed at an effective rate of 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum) plus any excess monthly Net Cash Flow of the real estate owned through JMB/NYC's joint ventures, such sum not to exceed 12- 3/4% per annum. The unaffiliated partners in the real estate joint ventures contend that a 12-3/4% per annum interest rate applies. The Partnership's share of disputed interest aggregated $4,771,000 at December 31, 1993. The ultimate outcome of the dispute cannot presently be determined. Accordingly, the Partnership's share of the disputed interest has not been included in the Partnership's share of operations of unconsolidated ventures for 1993. In addition, as described in Notes 3, 4 and 6 of the notes to the consolidated financial statements, the Partnership is in dispute or negotiations with various lenders and venture partners in connection with certain of its investment properties. Further, as described in such notes, a number of mortgage loans secured by the Partnership's or its venture's investment properties mature in 1994 or 1995. The Partnership has commenced or intends (Continued) to commence discussions with the mortgage lenders in order to extend and/or modify such loans. Such disputes, negotiations and discussions could result, under certain circumstances, in the Partnership no longer having an ownership interest in these investment properties. The ultimate outcome of these disputes, negotiations and discussions cannot presently be determined. The consolidated financial statements do not include any adjustments that might result from these uncertainties. KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Five year maturities of long-term debt are as follows: 1994 . . . . . . . . . $ 28,107,327 1995 . . . . . . . . . 35,345,888 1996 . . . . . . . . . 41,638,702 1997 . . . . . . . . . 683,184 1998 . . . . . . . . . 11,208,234 ============ 1993 1992 -------------- -------------- Current assets . . . . . . . . . . $ 41,432,795 32,615,070 Current liabilities (including $923,041,198 and $931,654,790, respectively, of debt in default at December 31, 1993 and December 31, 1992) (note 3) . . . (1,246,476,073) (981,968,018) -------------- -------------- Working capital (deficit). . . (1,205,043,278) (949,352,948) -------------- -------------- Investment properties, net . . . . 1,096,520,780 1,468,814,241 Other assets . . . . . . . . . . . 107,336,751 116,852,987 Other liabilities. . . . . . . . . (115,020,293) (101,622,430) Long-term debt . . . . . . . . . . (126,882,022) (427,013,408) -------------- -------------- Partners' capital. . . . . . . $ (243,088,062) (107,678,442) ============== ============== Represented by: Invested capital . . . . . . . . $1,073,795,691 1,068,543,310 Cumulative distributions . . . . (249,692,383) (200,912,694) Cumulative losses. . . . . . . . (1,067,191,370) (759,952,174) -------------- -------------- $ (243,088,062) (107,678,442) ============== ============== Total income . . . . . . . . . . . $ 287,330,325 335,268,295 ============== ============== Expenses applicable to operating loss . . . . . . . . . . . . . . $ 594,569,521 385,874,659 ============== ============== Net loss . . . . . . . . . . . . . $ (307,239,196) (50,606,364) ============== ============== KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV CERTAIN UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes of auditors during 1992 or 1993. 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 - XIV EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 8-18, 68-71, A-7 to A-12 and A-14 to A-20 of Prospectus of the Partnership dated June 4, 1984 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 3-C. Assignment Agreement by and among the Partnership, the General Partners and the Initial Limited Partners is filed herewith Yes 4-A. - 4-D. Long-Term Debt Documents are hereby incorporated herein by reference Yes 4-E - Long-term debt documents relating to the refinancing of the first mortgage loan secured by the 1090 Vermont Office Building in Washington, D.C. No 10-A - 10-G. Acquisition Documents are hereby incorporated herein by reference Yes 10-H. Agreement dated March 25, 1993 between JMB/NYC and the Olympia & York affiliates Yes 10-I. Settlement Agreement dated March 12, 1993 between the Resolution Trust Corporation and Carlyle-XIV Yes 10-J. Agreement of Limited Partnership of Carlyle-XIV Associates, L.P. Yes 10-K. Second Amended and Restated Articles of Partnership of JMB/NYC Office Building Associates No 10-L. Documents relating to the sale by the Partnership of its interest in the Old Orchard Venture Yes 10-M. Amended and Restated Certificate of Incorporation of Carlyle-XIV Managers, Inc. (known as Carlyle Managers, Inc.) No 10-N. Amended and Restated Certificate of Incorporation of Carlyle-XIII Managers, Inc. (known as Carlyle Investors, Inc.) No CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV EXHIBIT INDEX - CONTINUED DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 10-O. $1,200,000 demand note between Carlyle-XIV Associates, L.P. and Carlyle Managers, Inc. No 10-P. $1,200,000 demand note between Carlyle-XIV Associates, L.P. and Carlyle Investors, Inc. No 21. List of Subsidiaries No 24. Powers of Attorney No 99-A. The Partnership's Report on Form 8-K for October 1, 1993 Yes 1090 Vermont Ave NOTE Date of Note: November 1, 1993 Principal Amount: $17,750,000.00 Maturity Date: December 1, 2003 Interest Rate: shall mean % per annum for the period beginning with the Funding Date (as defined below) and continuing until the first day of the month following the month in which the fifth anniversary of the Funding Date occurs (the "Reset Date") and shall mean 2.80% per annum in excess of the "Treasury Yield" (as defined below) for the period beginning on the Reset Date and continuing until this Note has been repaid in full, in each case to be computed on the basis of a 360-day year consisting of twelve 30-day months. FOR VALUE RECEIVED, the undersigned ("Maker") does hereby covenant and promise to pay to the order of CBA Conduit, Inc., a Delaware corporation, or its successors or assigns (collectively, "Payee") the Principal Amount together with interest thereon at the Interest Rate and all other amounts due hereunder, all as hereinafter provided. Payments of interest shall be due on January 1, 1994, being the first day of the first month following the date (the "Funding Date") the proceeds of this Note are disbursed by Payee, and on the first day of each month thereafter until this Note is paid in full, and shall be remitted to Payee at the address designated by Payee in a notice to be delivered to Maker in accordance with the notice provisions contained in the Mortgage (as defined below), or at such other place as Payee may subsequently designate to Maker in writing from time to time, in legal tender of the United States. Notwithstanding the foregoing, in the event Maker defaults in its obligation to make any payment due hereunder beyond any applicable grace period provided in the Mortgage (as defined below), for any reason whatsoever, the full amount outstanding hereunder including, without limitation, all accrued and unpaid interest) shall bear interest at a per annum rate of interest equal to the Interest Rate then in effect plus 5%, but in no event to exceed the maximum rate allowed by law (the "Default Rate") until all amounts due and payable hereunder have been paid in full. A late payment premium of 5% of any interest payment (or of any principal payment payable as set forth below) shall also be due with respect to any payment made more than 10 days after the due date thereof. The Principal Amount, or such other amount which is outstanding hereunder, shall be due and payable in legal tender of the United States on the Maturity Date or an earlier date upon acceleration or otherwise in accordance with the terms of the Mortgage (as defined below). This Note is secured by, among other things, (a) a mortgage or deed of trust (the "Mortgage") of property located as indicated below, which Mortgage specifies various defaults upon the happening of which and the expiration of the applicable cure period, if any, under the Mortgage, all sums owing on this Note may, at Payee's option, be declared immediately due and payable and (b) a certain Cash Reserve Agreement (the "Cash Reserve Agreement") between Maker and Payee. For purposes of this Note the term "Treasury Yield" shall mean the average yield for the week prior to the 60th day prior to the Reset Date as reported in H.15(519) or the applicable successor publication, for Treasury Constant Maturities having a maturity of five (5) years. In the event there is no yield reported for Treasury Constant Maturities having a maturity of five (5) years for the week prior to the 60th day prior to the Reset Date, the Treasury Yield will be derived by linear interpolation from the yields reported for Treasury obligations having the next longer and next shorter maturities than the 5 year maturity, as reported in H.15(519) or the applicable successor publication. Payee covenants and agrees by its acceptance of this Note that, provided (i) Maker has fully satisfied in a timely manner the annual financial reporting requirements set forth in the Mortgage and (ii) no default exists hereunder or Event of Default (as defined in the Mortgage) exists under the Mortgage, Payee shall remit to Maker, no more than once per year during the term of this Note, on the first day of the thirteenth (13th) month following the Funding Date, and subject to the satisfaction of such reporting requirements in subsequent years, on the first day of that same month in subsequent years during the term of this Note, an amount equal to .05% of the Principal Amount then outstanding at the time Maker satisfies such requirements. Maker agrees that it shall be bound by any agreement extending the time or modifying the above terms of payment, made by Payee and the owner or owners of the property affected by the Mortgage, whether with or without notice to Maker, and Maker shall continue liable to pay the amount due hereunder, but with interest at a rate no greater than the Interest Rate, according to the terms of any such agreement of extension or modification. This Note may not be changed orally, but only by an agreement in writing, signed by the party against whom enforcement of any waiver, change, modification or discharge is sought. Should the indebtedness represented by this Note or any part thereof be collected at law or in equity, or in bankruptcy, receivership or any other court proceedings (whether at the trial or appellate level), or should this Note be placed in the hands of attorneys for collection upon default, Maker agrees to pay, in addition to the principal, premium and interest due and payable hereon, all costs of collection or attempting to collect this Note, including reasonable attorneys' fees and expenses. All parties to this Note, whether Maker, principal, surety, guarantor or endorser, hereby waive presentment for payment, demand, protest, notice of protest and notice of dishonor. Anything herein to the contrary notwithstanding, the obligations of Maker under this Note and the Mortgage shall be subject to the limitation that payments of interest shall not be required to the extent that receipt of any such payment by Payee would be contrary to provisions of law applicable to Payee limiting the maximum rate of interest that may be charged or collected by Payee. Notwithstanding the foregoing, if for any reason any payment by Maker results in Maker's having paid any interest in excess of that permitted by law, then it is Maker's and Payee's express intent that all excess amounts theretofore collected by the holder of this Note be credited to the then outstanding principal balance hereof (or, if this Note has been paid in full, refunded to Maker), and the provisions of this Note and all documents securing payment of this Note shall immediately be deemed reformed and the amounts thereafter collectible hereunder and thereunder reduced, without necessity of execution of any new document, so as to comply with applicable law, but so as to permit the recovery of the fullest amount otherwise called for hereunder and thereunder. It is further agreed that, without limitation of the foregoing, all calculations of the rate of interest contracted for, charged or received under this Note and under such other documents securing payment of this Note or which are interpreted for the purpose of determining whether such rate would exceed the maximum lawful rate, shall be made, to the extent permitted by the law of the District of Columbia, by amortizing, prorating, allocating and spreading during the full stated term of this Note, all interest contracted for, charged or received from Maker or otherwise by the holder of this Note. On or about the 60th day prior to the Reset Date (such 60th day prior to the Reset Date is hereinafter referred to as the "Initial Prepayment Date"), Payee shall notify Maker of the Interest Rate to be effective beginning on the Reset Date (except that the failure to so notify Maker shall not affect Maker's obligation to make payments hereunder at such new Interest Rate). Prior to the Initial Prepayment Date, Maker shall not have the right to prepay this Note in whole or in part except as expressly provided in Sections 2.09(j) and 2.15(f) of the Mortgage and clause (I) of each of Sections 2.09(f), 2.09(h), 2.15(b) and 2.15(d) of the Mortgage with respect to the application of certain insurance and condemnation proceeds. Maker shall, however, have the right to prepay this Note beginning on the Initial Prepayment Date provided, however, that any such payment made during the month in which the Initial Prepayment Date falls shall not be applied against this Note until the final business day of such month, and on the final business day of each month thereafter (each such final business day of such months a "Permitted Prepayment Day") in whole or in part. Partial prepayments shall, however, only be permitted in connection with either (a) the application of insurance or condemnation proceeds as provided by Section 2.09 or 2.15 of the Mortgage, (b) the application of any Principal Reduction Amount (as defined and under the conditions set forth in the Mortgage) or (c) the application of any amounts deposited into the Cash Reserve (as defined and under the conditions set forth in the Cash Reserve Agreement). Any prepayment shall be conditioned upon written notice thereof given to Payee in accordance with the notice provisions set forth in the Mortgage at least 60 days prior to the Permitted Prepayment Day to be fixed therein for prepayment, provided, however, that in the case of a prepayment under clause (a), (b) or (c) above, only thirty (30) days notice shall be required, and in all cases upon the payment of (i) all accrued interest on the amount prepaid (and all late charges and other sums that may be payable hereunder or under the Mortgage including, without limitation any Early Prepayment Interest (as defined below)) and (ii) to the extent required by the terms hereof or of the Mortgage, a Prepayment Premium (as defined below) or Yield Maintenance Amount (as defined below), as applicable, calculated as set forth below. Maker acknowledges that in certain events certain payments of principal, interest and other amounts due under the terms of the Mortgage will, pursuant to the terms of the Mortgage, be deposited into the Cash Reserve to be held and applied in accordance with the terms of the Cash Reserve Agreement. Maker further acknowledges and agrees that the terms and provisions of the Mortgage and the Cash Reserve and Security Agreement shall control with respect to the application of such payments and that any payment of principal, interest or other amount required by the terms of the Mortgage to be deposited into the Cash Reserve shall not be deemed a payment of this Note until such time as such funds are actually applied against this Note in accordance with the terms of the Cash Reserve and Security Agreement. In the event of any full or partial prepayment of this Note, whether such prepayment is mandatory or voluntary on the part of Maker or due to an acceleration of the Maturity Date resulting from a default under this Note, the Mortgage or any other document delivered by Maker in connection with the loan evidenced hereby (each of the Note, the Mortgage and such other documents are hereinafter sometimes referred to as a "Loan Document") or a prepayment resulting from a determination pursuant to the terms of the Mortgage that certain insurance or condemnation proceeds are to be applied toward prepayment of this Note, or from the application of all or any portion of the Cash Reserve in accordance with the Cash Reserve Agreement, or otherwise, a Prepayment Premium, in the case of payments received by Payee following the Reset Date and a Yield Maintenance Amount in the case of payments received by Payee prior to the Initial Prepayment Date shall, except as set forth in the paragraph immediately following the Prepayment Premium Schedule set forth below, be added to the indebtedness due hereunder and shall be immediately due and payable at the time of such prepayment. Any Yield Maintenance Amount due to Payee shall be calculated by Payee as set forth below under the Yield Maintenance Schedule and any Prepayment Premium due to Payee shall be calculated by Payee as set forth below under the Prepayment Premium Schedule: YIELD MAINTENANCE SCHEDULE The "Yield Maintenance Amount" shall be equal to the greater of (x) one percent (l%) of the amount to be prepaid or (y) an amount calculated in accordance with the following formula: A. Payee shall determine the average yield (to be determined as of the date seven (7) days prior to the date of payment or required payment of such amount) available on Treasury Constant Maturities maturing nearest the Reset Date of this Note as reported in H.15(519) or the applicable successor publication (the "Government Yield"); B. from the then existing interest rate hereunder, Payee shall-subtract the Government Yield (the resulting difference, if positive, the "Positive Spread") (if the resulting number is negative, the calculation in this subparagraph B shall not be applicable and the Yield Maintenance Amount shall be as stated in clause (x) above); C. Payee shall divide the Positive Spread by 12 and multiply the quotient so obtained by the amount of such payment or required payment to determine the "Monthly Interest Shortfall"; and D. Payee shall determine the present value on the date of prepayment of the Monthly Interest Shortfall for each full and partial month remaining until the Reset Date by discounting each Monthly Interest Shortfall at the Government Yield divided by twelve and find the sum of such present values, which sum shall be the amount due, under this clause (y). PREPAYMENT PREMIUM SCHEDULE The "Prepayment Premium" shall be equal to the product of the corresponding percentage set forth below based upon the date of the prepayment multiplied by the amount to be prepaid hereunder: Date of Prepayment Premium Year 1 following Reset Date 5% of principal prepaid Year 2 following Reset Date 4% of principal prepaid Year 3 following Reset Date 3% of principal prepaid Year 4 following Reset Date 2% of principal prepaid First ten (10) months of Year 5 l% of principal prepaid following Reset Date A Prepayment Premium or Yield Maintenance Amount, as applicable, calculated in accordance with the terms of the immediately preceding paragraph shall be due and payable in the case of any prepayment (which shall not include any payment deposited into the Cash Reserve except as and to the extent such amounts are actually applied against this Note in accordance with the terms of the Cash Reserve Agreement) except (i) a prepayment pursuant to Section 2.09(j) or Section 2.15(f) of the Mortgage, (ii) a prepayment made during the period beginning on the Initial Prepayment Date and ending on the Reset Date or (iii) a prepayment made during the period covering the final sixty (60) days immediately prior to the Maturity Date of this Note. In addition to all other amounts due hereunder or under the Mortgage, Maker shall pay to Payee, in connection with any prepayment of this Note, and without implying Payee's consent to any prepayment prohibited by the terms hereof, interest ("Early Prepayment Interest") at the then current interest rate on the amount so prepaid from the date Payee receives such payment as prepayment under this Note (without regard to the date such payment is deposited in the Cash Reserve or actually applied against the indebtedness) through and including the last calendar day of the month in which Payee receives such prepayment. Maker acknowledges that pursuant to the terms of Section 7.06(b) of the Mortgage, in certain events the lien of the Mortgage shall be released by Payee prior to the repayment in full of this Note whereupon this Note shall be secured by, among other things, the Cash Reserve Agreement and the Cash Reserve held by Payee Pursuant thereto. Notwithstanding any other provision herein or in the Mortgage or any other Loan Document contained, neither Maker, any present or future constituent partner in or agent of Maker, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Maker, shall be personally liable, directly or indirectly, under or in connection with this Note or the Mortgage or any other Loan Document, or any instrument or certificate securing or otherwise executed in connection with this Note or the Mortgage or any other Loan Document, or any amendments or modifications to any of the foregoing made at any time or times, heretofore or hereafter; the recourse of the Payee and each of its successors and assignees under or in connection with this Note, the Deed of Trust, any other Loan Document and such instruments and certificates, and any such amendments or modifications, shall be limited to Maker's interest in the Mortgaged Property (as defined in the Mortgage) and such other collateral, if any, as may now or hereafter be given to secure any payment required to be made under this Note or under the Mortgage or any other Loan Document or for the performance of any of the covenants or warranties contained herein or therein only, and Payee hereby waives any such personal liability; provided, however, that the foregoing provisions of this paragraph shall not (i) constitute a waiver of any obligation evidenced by this Note or contained in the Mortgage or any other Loan Document, (ii) limit the right of Payee to name Maker as a party defendant in any action or suit for judicial or non-judicial foreclosure and sale or any other action or suit under the Mortgage or any other Loan Document so long as no judgment in the nature of a deficiency judgment shall be enforced against Maker except to the extent of the Mortgaged Property or such other collateral, (iii) affect in any way the validity or enforceability of any guaranty (whether of payment and/or performance), any indemnity provision contained in Sections 2.17, 2.24, 6.06, 7.11 or 7.19 of the Mortgage in favor of the trustee thereunder and/or Payee or any indemnity agreement given to Payee in the Environmental Indemnification Agreement of even date herewith by and between Maker and Payee (the "Environmental Indemnification Agreement") or in Section 5.2 of the Assignment of Rents and Leases of even date herewith by and between Maker and Payee (the "Assignment of Rents and Leases"), except that the liability of Carlyle (as defined below) only (but not of Maker or of The John Akridge Company (in its capacity as a general partner of Maker)) under any indemnity provision contained in Sections 2.17, 2.24, 6.06, 7.11 or 7.19 of the Mortgage in favor of the trustee thereunder or the Payee or any indemnity agreement given to Payee in Section 5.2 of the Assignment of Rents and Leases (collectively, such indemnity provisions and agreement are hereinafter sometimes referred to as the "Specified Indemnities") shall be limited as provided in the second succeeding paragraph hereof or (iv) constitute a waiver by Payee of any rights to reimbursement for actual, or out-of-pocket, losses, costs or expenses, or any other remedy at law or in equity, against Maker by reason of (1) gross negligence, willful misconduct, intentional misrepresentations or fraudulent acts or omissions, (2) willful misapplication of any insurance proceeds, condemnation awards or tenant security deposits, or of any rental or other income which was required by the Mortgage or other Loan Documents to be paid or applied in a specified manner, arising, in any such case, with respect to the Mortgaged Property, (3) Maker's entry into, modification of, or termination of any lease of any part of the Mortgaged Property, if the Mortgage requires such consent to be obtained by Maker, (4) failure to pay premiums for insurance covering environmental risks or (5) the material inaccuracy of any information contained in rent rolls delivered to Payee on or prior to the date hereof in connection with Payee's underwriting of the Loan evidenced hereby or delivered to Payee pursuant to Section 2.16 of the Mortgage or pursuant to any other Loan Document and relied upon by Payee in making any determination under Section 2.32 of the Mortgage with respect to the Debt Service Coverage Ratio (as such term is used in Section 2.32 of the Mortgage) for the loan evidenced hereby. Notwithstanding anything contained in clause (iii) of this paragraph, so long as Payee's rights to pursue Maker and other parties who are not related to Maker or Maker's partners or principals are not in any way prejudiced or impaired thereby and any costs that Payee may incur by refraining from pursuing Maker that are not paid in advance by Maker are not in Payee's reasonable judgment material, Payee shall seek to obtain reimbursement pursuant to any valid insurance policy covering environmental Dental risks and maintained by Maker (or for which the Maker pays a portion of the premiums) pursuant to the terms of the Mortgage, to the extent such reimbursement shall be available to Payee, before it seeks to obtain satisfaction with respect to any loss or damage it may sustain with respect to environmental matters from the personal assets (other than any assets that may constitute collateral for the loan evidenced hereby) of Maker or any general partner of Maker. For the purposes of this Note, "Carlyle" shall mean, collectively, (i) Carlyle Real Estate Limited Partnership - XIV and (ii) JMB Realty Corporation ("JMB") or any JMB Approved Transferee (as defined in the Mortgage) if JMB or such JMB Approved Transferee acquires all or any part of Carlyle Real Estate Limited Partnership - XIV's partnership interest in Maker. Notwithstanding anything to the contrary in this Note or the Mortgage or in any other Loan Document (including, without limitation, (i) the preceding paragraph of this Note or the next succeeding paragraph of this Note, (ii) the Environmental Indemnification Agreement and (iii) the Assignment of Rents and Leases), no limited partner of Grantor, no present or future constituent partner in or agent of Carlyle, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Carlyle, nor any present or future shareholder, officer, director, employee or agent of The John Akridge Company, shall be personally liable, directly or indirectly, under or in connection with this Note, the Mortgage or any other Loan Document (including, without limitation, the Environmental Indemnification Agreement and the Assignment of Rents and Leases), or any instrument or certificate securing or otherwise executed in connection with this Note, the Mortgage or any other Loan Document (including, without limitation, the Environmental Indemnification Agreement and the Assignment of Rents and Leases), or any amendments or modifications to any of the foregoing made at any time or times, heretofore or hereafter and Payee and each of its successors and assignees waives and does hereby waive any such personal liability. For purposes of this Note, the Mortgage and each of the other Loan Documents (including, without limitation, the Environmental Indemnification Agreement and Assignment of Rents and Leases) and any such instruments and certificates, and any such amendments or modifications, neither the negative capital account of any constituent partner in Carlyle, nor any obligation of any constituent partner in Carlyle to restore a negative capital account or to contribute capital to Carlyle or to another constituent partner in Carlyle, shall at any time be deemed to be the property or an asset of Carlyle or any such other constituent partner (and neither Payee nor any of its successors or assignees shall have any right to collect, enforce or proceed against or with respect to any such negative capital account or partner's obligation to restore or contribute). Notwithstanding anything to the contrary in this Note or in the Mortgage or in any other Loan Document (including, without limitation, (i) the second preceding paragraph hereof, (ii) the Environmental Indemnification Agreement and (ii) the Assignment of Rents and Leases), the aggregate liability of Carlyle under the Specified Indemnities shall in no event exceed the sum of One Million Dollars ($1,000,000.00), but such limitation shall not: (x) limit the liability of Maker or The John Akridge Company (in its capacity as a general partner of Maker) to Payee and/or the trustee under the Specified Indemnities; (y) limit the liability of Carlyle under any indemnity agreement given to Payee in the Environmental Indemnification Agreement or (z) limit the rights of Payee or the liability of Carlyle under clauses (i), (ii), or (iv) of the second preceding paragraph hereof. Maker hereby expressly and unconditionally waives, in connection with any suit, action or proceeding brought by Payee for collection on this Note, any and every right it may have to (i) injunctive relief, (ii) interpose any counterclaim therein other than any compulsory counterclaim and (iii) have the same consolidated with any other or separate suit, action or proceeding. Nothing herein contained shall prevent or prohibit Maker from instituting or maintaining a separate action against Payee with respect to any asserted claim. This Note and the rights and obligations of the parties hereunder shall in all respects be governed by, and construed and enforced in accordance with, the laws of the District of Columbia (without giving effect to District of Columbia principles of conflicts of law). Maker hereby irrevocably submits to the non-exclusive jurisdiction of any District of Columbia or Federal court sitting in the District of Columbia over any suit, action or proceeding arising out of or relating to this Note, and Maker hereby agrees and consents that, in addition to any methods of service of process provided for under applicable law, all service of process in any such suit, action or proceeding in any District of Columbia or Federal court sitting in the District of Columbia may be made by certified or registered mail, return receipt requested, directed to Maker at the address indicated below, and service so made shall be complete five (5) days after the same shall have been so mailed See District of Columbia Rider to Note attached hereto and incorporated herein by reference. MAKER HEREBY KNOWINGLY, VOLUNTARILY AND INTENTIONALLY WAIVES (TO THE EXTENT PERMITTED BY APPLICABLE LAW) ANY RIGHT IT MAY HAVE TO A TRIAL BY JURY OF ANY DISPUTE ARISING UNDER OR RELATING TO THIS NOTE AND AGREES THAT ANY SUCH DISPUTE SHALL, AT THE OPTION OF PAYEE, BE TRIED BEFORE A JUDGE SITTING WITHOUT A JURY. IN WITNESS WHEREOF, Maker has executed and delivered this Note on the day and year first above written. 1090 VERMONT AVENUE, N.W. ASSOCIATES LIMITED PARTNERSHIP, a District of Columbia limited partnership Attest: By: The John Akridge Company, a Virginia corporation, general partner By: Secretary Name: [CORPORATE SEAL] Title: By: Carlyle Real Estate Limited Partnership - XIV, an Illinois limited partnership, general partner Attest: By:JMB Realty Corporation, a Delaware corporation, general partner By: Secretary Name: [CORPORATE SEAL] Title: Property Location: Address of Maker: 1090 Vermont Avenue, N.W. c/o The John Akridge Company Washington, D.C. 20005 601 Thirteenth Street, N.W. Washington, D.C. 20005 Maker's Initials: AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF CARLYLE-XIII MANAGERS, INC. WHEREAS, this corporation desires to change its name to Carlyle Investors, Inc. NOW, THEREFORE, the Certificate of Incorporation as filed with the Delaware Secretary of State on March 25, 1993 is hereby amended and restated to read as follows: ARTICLE ONE: The name of this corporation is Carlyle Investors, Inc. ARTICLE TWO: The address of its registered office in the State of Delaware is Corporation Trust Center, 1209 Orange Street, in the City of Wilmington, County of New Castle, 19801. The name of its registered agent at such address is The Corporation Trust Company. ARTICLE THREE: The nature of the business or purpose to be conducted or promoted is: to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware. ARTICLE FOUR: The total number of shares of stock which this corporation shall have authority to issue is 1,000 and the par value of each of such shares is One Dollar ($1.00) amounting in the aggregate to One Thousand Dollars ($1,000.00). ARTICLE FIVE: The number of directors constituting the Board of Directors shall be that number as shall be fixed by the by-laws of this Corporation. ARTICLE SIX: The corporation is to have perpetual existence. ARTICLE SEVEN: In furtherance and not in limitation of the powers conferred by statute, the Board of Directors of this corporation is expressly authorized to make, alter or repeal the by-laws of this corporation. ARTICLE EIGHT: Elections of directors need not be by written ballot unless the by-laws of this corporation shall so provide. Meetings of the stockholders may be held within or without the State of Delaware, as the by- laws may provide. The books of this corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the by-laws of this corporation. ARTICLE NINE: The corporation reserves the right to amend, alter, change or repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now and hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. ARTICLE TEN: To the fullest extent permitted by the General Corporation Law of the State of Delaware as it now exists or may hereafter be amended, no director of this corporation shall be liable to this corporation or its stockholders for monetary damages arising from a breach of fiduciary duty owed to this corporation. ARTICLE ELEVEN: This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on March 29, 1993. This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on April 6, 1993. IN WITNESS WHEREOF, the President has signed, and the Secretary has attested, this Amended and Restated Certificate of Incorporation this 6th day of April, 1993. Neil G. Bluhm President ATTEST: Kevin B. Yates Secretary STATE OF ILLINOIS ) ) ss COUNTY OF COOK ) I, the undersigned, a Notary Public in and for said County, in the State aforesaid, DO HEREBY CERTIFY that Kevin B. Yates, the Secretary of Carlyle-XIII Managers, Inc., acknowledged that the statements set forth in the foregoing instrument are true and correct, and that he signed the foregoing instrument as his free and voluntary act for the uses and purposes therein set forth. Subscribed and sworn to before me this 6th day of April, 1993. Mona Sarnoff Notary Public AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF CARLYLE-XIV MANAGERS, INC. WHEREAS, this corporation desires to change its name to Carlyle Managers, Inc. NOW, THEREFORE, the Certificate of Incorporation as filed with the Delaware Secretary of State on March 25, 1993 is hereby amended and restated to read as follows: ARTICLE ONE: The name of this corporation is Carlyle Managers, Inc. ARTICLE TWO: The address of its registered office in the State of Delaware is Corporation Trust Center, 1209 Orange Street, in the City of Wilmington, County of New Castle, 19801. The name of its registered agent at such address is The Corporation Trust Company. ARTICLE THREE: The nature of the business or purpose to be conducted or promoted is: to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware. ARTICLE FOUR: The total number of shares of stock which this corporation shall have authority to issue is 1,000 and the par value of each of such shares is One Dollar ($1.00) amounting in the aggregate to One Thousand Dollars ($1,000.00). ARTICLE FIVE: The number of directors constituting the Board of Directors shall be that number as shall be fixed by the by-laws of this Corporation. ARTICLE SIX: The corporation is to have perpetual existence. ARTICLE SEVEN: In furtherance and not in limitation of the powers conferred by statute, the Board of Directors of this corporation is expressly authorized to make, alter or repeal the by-laws of this corporation. ARTICLE EIGHT: Elections of directors need not be by written ballot unless the by-laws of this corporation shall so provide. Meetings of the stockholders may be held within or without the State of Delaware, as the by- laws may provide. The books of this corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the by-laws of this corporation. ARTICLE NINE: The corporation reserves the right to amend, alter, change or repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now and hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. ARTICLE TEN: To the fullest extent permitted by the General Corporation Law of the State of Delaware as it now exists or may hereafter be amended, no director of this corporation shall be liable to this corporation or its stockholders for monetary damages arising from a breach of fiduciary duty owed to this corporation. This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on April 6, 1993. IN WITNESS WHEREOF, the President has signed, and the Secretary has attested, this Amended and Restated Certificate of Incorporation this 6th day of April, 1993. Neil G. Bluhm President ATTEST: Kevin B. Yates Secretary STATE OF ILLINOIS ) ) ss COUNTY OF COOK ) I, the undersigned, a Notary Public in and for said County, in the State aforesaid, DO HEREBY CERTIFY that Kevin B. Yates, the Secretary of Carlyle-XIV Managers, Inc., acknowledged that the statements set forth in the foregoing instrument are true and correct, and that he signed the foregoing instrument as his free and voluntary act for the uses and purposes therein set forth. Subscribed and sworn to before me this 6th day of April, 1993. Mona Sarnoff Notary Public DEMAND NOTE $1,200,000.00 March 25, 1993 FOR VALUE RECEIVED, the undersigned, Carlyle Real Estate Limited Partnership-XIV, an Illinois limited partnership (hereinafter referred to as "Payor"), hereby promises to pay Carlyle Managers, Inc., a Delaware corporation (hereinafter referred to as "Payee"), on demand the principal sum of $1,200,000.00 (hereinafter referred to as the "Principal Amount"). The Principal Amount shall bear interest at the Alternate Federal Short-Term rate (the "Rate") as of the date hereof, which rate shall change to the Rate then in effect as of every six months from the date hereof (the "Compounding Date"); all interest shall be compounded as of every Compounding Date. Payor may at any time elect to prepay all or any portion of the Principal Amount, together with any accrued but unpaid interest thereon, without premium or penalty. IN WITNESS WHEREOF, Payor has executed this Demand Note this 25th day of March, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIV By: JMB Realty Corporation a Delaware corporation Corporate General Partner By: Neil G. Bluhm President DEMAND NOTE $1,200,000.00 March 25, 1993 FOR VALUE RECEIVED, the undersigned, Carlyle Real Estate Limited Partnership-XIV, an Illinois limited partnership (hereinafter referred to as "Payor"), hereby promises to pay Carlyle Investors, Inc., a Delaware corporation (hereinafter referred to as "Payee"), on demand the principal sum of $1,200,000.00 (hereinafter referred to as the "Principal Amount"). The Principal Amount shall bear interest at the Alternate Federal Short-Term rate (the "Rate") as of the date hereof, which rate shall change to the Rate then in effect as of every six months from the date hereof (the "Compounding Date"); all interest shall be compounded as of every Compounding Date. Payor may at any time elect to prepay all or any portion of the Principal Amount, together with any accrued but unpaid interest thereon, without premium or penalty. IN WITNESS WHEREOF, Payor has executed this Demand Note this 25th day of March, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIV By: JMB Realty Corporation a Delaware corporation Corporate General Partner By: Neil G. Bluhm President 1090 Vermont Avenue This document was prepared by and after recording please return to: Brownstein Zeidman and Lore A Professional Corporation 1401 New York Avenue, N.W. Suite 900 Washington, D.C. 20005 Attention: Kenneth G. Lore, Esq. Loan No. 113 Date: As of November 1, 1993 DEED OF TRUST AND SECURITY AGREEMENT FROM 1090 VERMONT AVENUE, N.W. ASSOCIATES LIMITED PARTNERSHIP Address: c/o The John Akridge Company 601 13th Street, N.W., Suite 300 North Washington, D.C. 20005 TO RANDY ALAN WEISS, TRUSTEE Address: c/o Margolius, Mallios, Davis, Rider & Tomar 1828 L Street, N.W., Suite 500 Washington, D.C. 20036 For the Benefit of CBA CONDUIT, INC. a Delaware corporation having its principal office at Suite 103, Financial Centre, 695 East Main Street, Stamford, Connecticut 06901 Note Amount: $17,750,000.00 THIS DEED OF TRUST AND SECURITY AGREEMENT (hereinafter called "Deed of Trust") is made as of the 1st day of November, 1993, by and among 1090 Vermont Avenue, N.W. Associates Limited Partnership, a District of Columbia limited partnership, having an address at c/o The John Akridge Company, 601 Thirteenth Street, N.W., Suite 300 North, Washington, D.C. 20005 ("Grantor"), to Randy Alan Weiss, Trustee, having an address at c/o Margolius, Mallios, Davis, Rider & Tomar, 1828 L Street, N.W., Suite 500, Washington, D.C. 20036 ("Trustee"), for the benefit of CBA CONDUIT, INC., a Delaware corporation having an address at Suite 103, Financial Centre, 695 East Main Street, Stamford, Connecticut 06901, and any subsequent holder of the Secured Obligations hereinafter set forth ("Beneficiary"), as more fully hereinafter set forth. W I T N E S S E T H: WHEREAS, Grantor is the owner of the land described in Schedule A annexed hereto and made a part hereof and all other Mortgaged Property (as hereinafter defined); WHEREAS, Beneficiary has loaned to Grantor the principal amount of Seventeen Million Seven Hundred Fifty Thousand and No/lOOs Dollars ($17,750,000.00) (the "Loan") evidenced by a note (the "Note") of even date herewith made by Grantor to Beneficiary in such amount; and WHEREAS, in order to secure the payment of the Note and the payment and performance of certain further obligations hereinafter described, Grantor has duly authorized the execution and delivery of this Deed of Trust. NOW, THEREFORE, the parties hereto hereby agree as follows: CERTAIN DEFINITIONS Grantor, Trustee and Beneficiary agree that, unless the context otherwise specifies or requires, the following terms shall have the meanings herein specified, such definitions to be applicable equally to the singular and the plural forms of such terms. "Actual Expenses", with respect to any period of time, means, subject to the last sentence of this definition, the aggregate amount of all cash expended during such period of time for costs of owning, operating, managing, repairing (other than costs for capital repairs) or maintaining the Mortgaged Property, exclusive, however, of (i) principal and interest payments on the Note, (ii) costs for Restoration eligible for reimbursement from insurance proceeds in accordance herewith, (iii) costs for Work eligible for reimbursement from condemnation award proceeds in accordance herewith, and (iv) depreciation, amortization and other non-cash expenses. For purposes of this definition, insurance premiums, real estate taxes and other costs not generally paid on a monthly basis will be allocated evenly over the entire period for which they were paid or are payable without regard to the actual date of payment. "Affiliate", when used with respect to a specified Person, means a Person that: (a) directly, or indirectly through one or more intermediaries, controls, is controlled by or is under common control with such specified Person; (b) is a director, officer, employee, trustee or general partner of, or directly or indirectly an owner of an equity interest of ten percent (lO%) or more or a beneficiary of a trust owning an equity interest of ten percent (10%) or more in, the Person specified or any Person specified in clause (a) above; or (c) is a member of the immediate family of the Person specified in clause (a) or (b) above. For purposes hereof, the members of a Person's immediate family shall be such Person's parents, grandparents, children, grandchildren, siblings and children of siblings or the spouse of such Person or of any of the foregoing. For purposes of this definition, the term "control" (and any derivative thereof) means the possession, directly or indirectly, of the power to direct or cause the direction of the management and/or policies of a Person, whether through the ownership of voting stock, by contract or otherwise. "Akridge Group" shall mean, collectively, The John Akridge Company, Vermont and L Ltd, John E. Akridge, III, and Sarah B. Akridge, William C. Smith and any bona fide full-time employee of The John Akridge Company which as of the date hereof holds a partnership interest in the Grantor. "Approved Control Party" shall mean either Carlyle Real Estate Limited Partnership - XIV or The John Akridge Company, but shall not include any successor or assign of either. "Bankruptcy Code" shall have the meaning set forth in Section 7.20 hereof "Business Day" shall mean any day other than a Saturday, Sunday or day on which commercial banks in Stamford, Connecticut, Washington, D.C., Chicago, Illinois or New York, New York are authorized or obligated by law or by local proclamation to be closed. "Carlyle" shall mean Carlyle Real Estate Limited Partnership - XIV (and for purposes of Section 7.16 hereof only JMB (as defined below) or any JMB Approved Transferee (as defined below) if JMB or such JMB Approved Transferee acquires all or any part of Carlyle's partnership interest in Grantor), but shall not include any other successor or assign thereof. "Cash Income", with respect to any period of time, means the aggregate amount of all receipts generated from the operation of the Mortgaged Property and actually received in cash or current funds by Grantor during such period of time, including, without limitation, rent and all other amounts paid by tenants and concession income, but excluding (i) capital proceeds, (ii) insurance proceeds other than proceeds of business interruption insurance, (iii) condemnation award proceeds, (iv) security, pet and other deposits prior to their proper application pursuant to the terms of the respective Leases, and (v) any and all items of non-cash income "Cash Reserve" means all amounts now or hereafter deposited with Beneficiary pursuant to the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable, together with interest thereon, less all amounts paid out from the Cash Reserve pursuant to such applicable agreement. "Cash Reserve Agreement" means that certain Cash Reserve Agreement of even date herewith between Grantor and Beneficiary or any similar agreement hereafter entered into between a successor in interest to Grantor and Beneficiary. "Chattels" or "Personal Property" means all fixtures, furnishings, fittings, appliances, apparatus, equipment, building materials and components, machinery and articles of personal property, of whatever kind or nature, including any replacements, proceeds or products thereof and additions thereto, other than (a) personalty leased by Grantor not constituting fixtures and (b) personalty owned by lessees or persons claiming through lessees unless Grantor has rights thereto under the applicable Leases or otherwise, now or at any time hereafter intended to be or actually affixed to, attached to, placed upon, or used in any way in connection with the use, enjoyment, development, occupancy or operation of the Premises, and whether located on or off the Premises. "Collateral" means all of the Mortgaged Property (as hereinafter defined). "Commercially Viable" shall be construed as set forth in Section 7.24 hereof. "Contractors" shall have the meaning set forth in Section 2.09(f)(iii) hereof. "Credit Agencies" shall have the meaning set forth in Section 2.11 hereof "Credit Reports" shall have the meaning set forth in Section 2.11 hereof. "Debt Service Coverage Ratio", with respect to any period of time, means the ratio of the Net Operating Income for such period of time to the aggregate amount of all payments of principal and interest due under the Note for such period of time. "Default Rate" means the "Default Rate" provided in the Note, but in no event to exceed the maximum rate allowed by law. "Environmental Indemnification Agreement" means that certain Environmental Indemnification Agreement of even date herewith executed by Grantor for the benefit of Beneficiary. "Environmental Regulations" shall have the meaning set forth in the Environmental Indemnification Agreement. "ERISA" shall have the meaning set forth in Section 7.19 hereof. "Events of Default" means the events and circumstances described as such in Section 5.01 hereof. "Excess Cash Flow", when used with respect to any period, means the amount, if any, by which all receipts generated from the Mortgaged Property during such period exceed the Required Payments for such period . "First Permitted Prepayment Date" means the 60th day prior to the Reset Date. "Foreign Investment Acts and Regulations" shall have the meaning set forth in Section 7.22 hereof. "Funding Date" means the date on which the proceeds of the Note are disbursed to Grantor. "Governmental Authorities" shall have the meaning set forth in Section 2.20 hereof. "Hard Costs", with respect to any Restoration or work, shall mean the costs for labor and materials included in Restoration or Work, as approved by Beneficiary, exclusive of (a) any developer's overhead, fee or profit of any kind and (b) any contractor's or subcontractor's profit or fee payable to any contractor or subcontractor that is an Affiliate of Grantor, but inclusive of general contractor's overhead in an amount consistent with reasonable local industry standards and a fee or profit payable to any contractor or subcontractor that is not an Affiliate of Grantor in an amount consistent with reasonable local industry standards. "Hazardous Substances" shall have the meaning set forth in the Environmental Indemnification Agreement. "Debt Service Coverage Ratio", with respect to any period of time, means the-ratio of the Net Operating Income for such period of time to the aggregate amount of all payments of principal and interest due under the Note for such period of time. "Default Rate" means the "Default Rate" provided in the Note, but in no event to exceed the maximum rate allowed by law. "Environmental Indemnification Agreement" means that certain Environmental Indemnification Agreement of even date herewith executed by Grantor for the benefit of Beneficiary. "Environmental Regulations" shall have the meaning set forth in the Environmental Indemnification Agreement. "ERISA" shall have the meaning set forth in Section 7.19 hereof. "Events of Default" means the events and circumstances described as such in Section 5.01 hereof. "Excess Cash Flow", when used with respect to any period, means the amount, if any, by which all receipts generated from the Mortgaged Property during such period exceed the Required Payments for such period. "First Permitted Prepayment Date" means the final Business Day of the month prior to the month in which the fifth anniversary of the Funding Date occurs. "Foreign Investment Acts and Regulations" shall have the meaning set forth in Section 7 . 22 hereof "Funding Date" means the date on which the proceeds of the Note are disbursed to Grantor. "Governmental Authorities" shall have the meaning set forth in Section 2.20 hereof. "Hard Costs", with respect to any Restoration or Work, shall mean the costs for labor and materials included in such Restoration or Work, as approved by Beneficiary, exclusive of (a) any developer's overhead, fee or profit of any kind and (b) any contractor's or subcontractor's profit or fee payable to any contractor or subcontractor that is an Affiliate of Grantor, but inclusive of general contractor's overhead in an amount consistent with reasonable local industry standards and a fee or profit payable to any contractor or subcontractor that is not an Affiliate of Grantor in an amount consistent with reasonable local industry standards. "Hazardous Substances" shall have the meaning set forth in the Environmental Indemnification Agreement. "Impositions" shall have the meaning set forth in Section 2.07 hereof. "Improvements" means all structures or buildings, additions thereto and replacements thereof, now or hereafter located upon the Premises, including all plant equipment, apparatus, machinery and fixtures of every kind and nature whatsoever forming part of said structures or buildings. "Insolvent" shall have the meaning set forth in Section 101 (32) of Title XI of the United States Code (the "Bankruptcy Code"). "JMB" shall mean JMB Realty Corporation, a Delaware corporation, but shall not include any successor or assign thereof. "Laws" shall have the meaning set forth in Section 2.20 hereof. "Leases" shall have the meaning set forth in Section 1.01 hereof. "Liens" shall have the meaning set forth in Section 2.01 hereof. "Loan Documents n shall have the meaning set forth in Section 1.01 hereof. "Loan Reserve" shall have the meaning set forth in Section 2.33 hereof. "Maturity Date" shall have the meaning set forth in the Note. "Maximum Amount" shall have the meaning set forth in Section 2.33 hereof. "Monthly Deposit" shall have the meaning set forth in Section 2.33 hereof "Mortgaged Property" shall have the meaning set forth in Section 1.01 hereof. "Net Operating Income", with respect to any period of time, means the amount, if any, by which the Cash Income for such period of time exceeds the Actual Expenses for such period of time, all as determined in a manner reasonably acceptable to Beneficiary. "Notices" shall have the meaning set forth in Section 7.03 hereof. "Obsolete Collateral" shall have the meaning set forth in Section 3.02 hereof. "Orders" shall have the meaning set forth in Section 2.24 hereof. "Permitted Exceptions" means all of the exceptions to title set forth in the title policy or policies issued in respect of this Deed of Trust for the benefit of and accepted by Beneficiary on the Funding Date and any other exception to title to which Beneficiary may hereafter consent, as well as real estate and personal property taxes not yet due and payable or which, although already due and payable, are still permitted by law to be paid without interest or any delinquency charge of any kind. For all purposes of this Deed of Trust, loss of the right to receive a discount for early payment of real property taxes shall not be deemed to constitute interest. "Permitted Investments" means the following: (a) an account that is maintained by a depository institution or trust company incorporated under the laws of the United States of America or any state thereof and subject to supervision and examination by federal or state banking authorities, so long as at all times the commercial paper, certificates of deposit or other short-term debt obligations of such depository institution or trust company have a rating of either not less than A-l by Standard & Poor's or not less than P-l by Moody's; (b) demand and time deposits in, certificates of deposits of, or bankers' acceptances of, in each case maturing in not more than sixty (60) days from the date of purchase, any depository institution or trust company incorporated under the laws of the United States of America or any state thereof and subject to supervision and examination by federal or state banking authorities, so long as at the time of such investment or contractual commitment providing for such investment the commercial paper, certificates of deposit or other short-term debt obligations of such depository institution or trust company have a rating of either not less than A-l by Standard & Poor's or not less than P-l by Moody's; (c) commercial paper having remaining maturities of not more than sixty (60) days of any corporation incorporated under the laws of the United States or any state thereof which on the date of acquisition has been rated either not less than A-l by Standard & Poor's or not less than P-l by Moody's; (d) U.S. Treasury obligations maturing not more than three (3) months from the date of acquisition; (e) repurchase agreements on U. S. Treasury obligations maturing not more than three (3) months from the date of acquisition, provided that the unsecured obligations of the party agreeing to repurchase such obligations are at the time rated either not less than A-l by Standard & Poor's or not less than P-l by Moody's; and (f) other obligations or securities that are approved by Beneficiary and Grantor. "Permitted Transferee" shall have the meaning set forth in Section 2.32 hereof. "Person" means any individual, corporation, association, partnership, business trust, joint stock company, joint venture, trust, estate or other entity or organization of whatever nature. "Premises" means the land described in Schedule A hereto together with all of the easements, rights, privileges, liberties, tenements, hereditaments and appurtenances (including development rights and air rights) thereunto belonging or in any way appertaining, and all of the estate, right, title, interest, claim and demand whatsoever of Grantor therein and in the streets and ways, open or proposed, adjacent thereto, and in and to all strips, gores, vaults, alley ways, sidewalks and passages used in connection therewith, either in law or in equity, in possession or expectancy, now or hereafter acquired, and as used in this Deed of Trust, shall, unless the context otherwise requires, be deemed to include the Improvements. "Principal Reduction Amount" shall have the meaning set forth in Section 2.32 hereof. "Property Impositions" shall have the meaning set forth in Section 2.07 hereof. "Realty Associates" shall mean Realty Associates-XIV, L.P., an Illinois limited partnership. "Rents" shall have the meaning set forth in Section 1.01 hereof. "Reporting Entities n shall have the meaning set forth in Section 7.22 hereof. "Required Payments", when used with respect to any period, means the aggregate of all payments of debt service on the Note, operating expenses, reserves and necessary leasing and capital costs (other than any leasing or capital costs paid with funds released from the Loan Reserve) with respect to the Mortgaged Property that Grantor is obligated to pay during such period in order to satisfy all of the requirements of this Deed of Trust. "Reset Date" means the first day of the first month following the month in which the fifth anniversary of the Funding Date occurs. "Restoration" shall have the meaning set forth in Section 2.09 hereof. "Secured Obligations" shall have the meaning set forth in Section 1 01 hereof "Solvent" means both (a) that the financial condition of Grantor is such that the sum of Grantor's debts is less than the aggregate of, at fair valuation, (i) all of Grantor's property (exclusive of property transferred, concealed or removed with intent to hinder, delay or defraud Grantor's creditors) and (ii) the sum of the excess of the value of each general partner's nonpartnership property (exclusive of property transferred, concealed or removed with intent to hinder, delay or defraud such partner's creditors and certain personal property that would be exempted from the property of the estate of such general partner in a bankruptcy proceeding) over such general partner's nonpartnership debts, and (b) that Grantor is paying its debts as such debts become due, unless such debts are the subject of a bona fide dispute. Nothing contained in this definition shall be construed as an independent pledge by Grantor's general partners of their nonpartnership property. "Transfer" shall have the meaning set forth in Section 2.32 hereof. "Transferee Cash Reserve Agreement" shall have the meaning set forth in Section 2.34 hereof. "Uniform Commercial Code" shall have the meaning set forth in Section 3 01 hereof. "Work" shall have the meaning set forth in Section 2.15 hereof. "Yield Maintenance Amount", when calculated with respect to any amount, shall mean the greater of (x) one percent (1%) of such amount or (y) the result obtained by applying to such amount the following formula: A. determine the average yield (to be determined as of the date seven (7) days prior to the date of payment or required payment of such amount) available on U.S. Government Treasury Constant Maturities securities maturing nearest the Reset Date of the Note as reported in H.15(519) or the applicable successor publication (the "Government Yield"); B. from the then existing interest rate under the Note, subtract the Government Yield (the resulting difference, if positive, the "Positive Spread") (if the resulting number is negative, the calculations in this subparagraph B shall not be applicable and the Yield Maintenance Amount shall be as stated in clause (x) above): C. divide the Positive Spread by 12 and multiply the quotient so obtained by the amount of such payment or required payment to determine the "Monthly Interest Shortfall": and D. determine the present value on the date of such payment or required payment of the Monthly Interest Shortfall for each full and partial month remaining until the Reset Date by discounting each Monthly of each general partner's nonpartnership property (exclusive of property transferred, concealed or removed with intent to hinder, delay or defraud such partner's creditors and certain personal property that would be exempted from the property of the estate of such general partner in a bankruptcy proceeding) over such general partner's nonpartnership debts, and (b) that Grantor is paying its debts as such debts become due, unless such debts are the subject of a bona fide dispute. Nothing contained in this definition shall be construed as an independent pledge by Grantor's general partners of their nonpartnership property. "Transfer" shall have the meaning set forth in Section 2.32 hereof. "Transferee Cash Reserve Agreement" shall have the meaning set forth in Section 2.34 hereof. "Uniform Commercial Code" shall have the meaning set forth in Section 3.01 hereof. "Work" shall have the meaning set forth in Section 2.15 hereof. "Yield Maintenance Amount", when calculated with respect to any amount, shall mean the greater of (x) one percent (l%) of such amount or (y) the result obtained by applying to such amount the following formula: A. determine the average yield (to be determined as of the date seven (7) days prior to the date of payment or required payment of such amount) available on U.S. Government general issue Treasury securities maturing nearest the Reset Date of the Note as reported in H.15(519) or the applicable successor publication (the "Government Yield"); B. from the then existing interest rate under the Note, subtract the Government Yield (the resulting difference, if positive, the "Positive Spread") (if the resulting number is negative, the calculations in this subparagraph B shall not be applicable and the Yield Maintenance Amount shall be as stated in clause (x) above); C. divide the Positive Spread by 12 and multiply the quotient so obtained by the amount of such payment or required payment to determine the "Monthly Interest Shortfall"; and D. determine the present value on the date of such payment or required payment of the Monthly Interest Shortfall for each full and partial month remaining until the Reset Date by discounting each MonthlyInterest Shortfall at the Government Yield divided by twelve and find the sum of such present values, which sum shall be the amount calculated pursuant to this formula. All terms used in this Deed of Trust which are not defined above shall have the respective meanings set forth elsewhere in this Deed of Trust. ARTICLE I GRANT OF MORTGAGED PROPERTY SECTION 1.01 Granting Clause. Grantor, in consideration of the premises and in order to secure the payment of both the principal of and the interest on and any other sums payable pursuant to the Note, this Deed of Trust or any other document or instrument now or hereafter executed and delivered as further security for the indebtedness secured hereby or pursuant to the terms hereof or otherwise in connection with the loan evidenced by the Note and secured by this Deed of Trust (the Note, this Deed of Trust and any and all such other documents and instruments, including without limitation the Cash Reserve Agreement, any Transferee Cash Reserve Agreement, the Environmental Indemnification Agreement and the Assignment of Rents and Leases referred to in Section 4.01 hereof being hereinafter collectively referred to as the "Loan Documents") and the performance and observance of all the provisions of the Loan Documents (all such obligations, as the same may from time to time hereafter be renewed, increased, rearranged, modified, supplemented, restated and extended, other than those set forth in the Environmental Indemnification Agreement, being hereinafter collectively referred to as the "Secured Obligations"), hereby IRREVOCABLY GIVES, GRANTS, BARGAINS, SELLS, WARRANTS, ALIENS, REMISES, RELEASES, CONVEYS, ASSIGNS, TRANSFERS, MORTGAGES, HYPOTHECATES, DEPOSITS, PLEDGES, SETS OVER AND CONFIRMS unto Trustee and Trustee's successors and assigns, IN TRUST, with POW B OF SALE, right of entry and possession for the benefit and security of Beneficiary, all of Grantor's estate, right, title and interest in, to and under any and all of the following described property (the "Mortgaged Property") whether now owned or held or hereafter acquired: (i) the Premises; (ii)the Improvements; (iii)the Chattels; (iv)all (a) rents, issues, profits, receipts, revenues, royalties, contract rights, benefits, license fees, accounts receivable, concession fees, income, charges, rights, benefits and all other payments of any kind arising or issuing from or out of using, leasing, licensing, possessing, operating from, residing in, selling or otherwise enjoying the Premises or the Improvements, including, without limitation, rent, additional rent, minimum rent, percentage rent, parking maintenance charges or fees, tax and insurance contributions, proceeds of sale of electricity, gas, chilled and heated water and other utilities and services, deficiency rents, liquidated damages following default or late payment of rent, premiums payable by any tenant upon the exercise of a cancellation privilege provided for in any Lease and all proceeds payable under any policy of insurance covering loss of rents resulting from untenantability caused by destruction or damage to the Premises or the Improvements, together with any and all rights and claims of any kind which Grantor may have against any tenant under any Lease or any subtenants or occupants of the Premises or the Improvements, (b) cash, letters of credit, securities, security deposits given to secure the performance by tenants of their obligations under their respective Leases to the extent they may be lawfully assigned, and (c) all payments made by tenants on account of operating expenses, operating charges, real estate taxes and other similar items, and (d) other benefits of the Premises and the Improvements or any part thereof (all of the foregoing items described in subclauses (a) through (d) of this clause (iv) being hereinafter referred to collectively as the "Rents"), and all leases, subleases, lettings, licenses, concessions and other occupancy agreements (written or oral, now or hereafter in effect), together with all guaranties, modifications, renewals and extensions thereof, which grant a possessory interest in and to, or the right to use or enjoy all or any portion of the Premises or the Improvements (collectively, the "Leases"), now or hereafter entered into and all right, title and interest of Grantor thereunder, including, without limitation, cash or securities deposited thereunder to secure performance by the tenants of their obligations thereunder, whether such cash or securities are to be held until the expiration of the terms of such Leases or applied to one or more of the installments of rent coming due immediately prior to the expiration of such terms, all subject, however, to the provisions of the Assignment, of Rents and Leases referred to in Section 4.01 hereof; (v) the Cash Reserve, the Loan Reserve and all working capital and other similar accounts (including without limitation reserves for the replacement of Personal Property), and all inventory accounts, accounts receivable, contract rights, general intangibles, chattel paper, instruments, documents, notes, drafts, letters of credit and insurance policies arising from or related to the Premises or the Improvements and including all replacements and substitutions for, and additions to, any of the foregoing, subject, however, to Grantor's right to receive and apply any such accounts described above to be applied in accordance herewith prior to the occurrence of an Event of Default hereunder; (vi) all of Grantor's right, title and interest in, to and under all agreements, contracts, certificates, licenses, permits, warranties, instruments and other documents, now or hereafter entered into, pertaining to the construction, operation, management or sale or other disposition of the Premises or the Improvements; (vii) all unearned premiums accrued or to accrue under all insurance policies for the Premises or the Improvements obtained by Grantor, proceeds of insurance and condemnation awards, subject, however, to the provisions of Sections 2.09 and 2.15 hereof, and all rights of Grantor to refunds of real estate taxes and assessments: (viii) all of Grantor's right, title and interest in and to all trade names, trademarks and service marks now or hereafter used in connection with the Premises or the Improvements or any part thereof, together with good will appurtenant thereto; (ix) all of the books, computer software, records and files of or relating to the Premises or the Improvements now or hereafter maintained by Grantor or for its account; (x) all awards and claims for damages made and to be made for the taking by eminent domain of the whole or any part of the Premises or the Improvements, including without limitation any awards for change of grade of streets, all of which awards Grantor hereby assigns to Beneficiary; (xi) all mineral, water, oil and gas rights and privileges and royalties pertaining to the Premises; and (xii) all proceeds and products of the conversion, voluntary or involuntary, of any of the foregoing into cash or liquidated claims, including without limitation, but subject to the provisions of Sections 2.09 and 2.15 hereof, all judgments, awards of damages and settlements hereafter made resulting from condemnation proceeds or the taking of the Premises or the Improvements or any portion thereof under the power of eminent domain, any proceeds of any policies of insurance maintained with respect to the Premises or the Improvements or proceeds of any sale, option or contract to sell the Premises or the Improvements or any portion thereof, and all rights of Grantor to refunds of real estate taxes and assessments; and Grantor hereby authorizes, directs and empowers Beneficiary, at its option, on behalf of Grantor, or the successors or assigns of Grantor, subject to the provisions of Sections 2.09 and 2.15 hereof, to adjust, compromise, claim, collect and receive such proceeds, to give proper receipts and acquittances therefor, and, after deducting expenses of collection, to apply the net proceeds in the manner hereinafter provided. TO HAVE AND TO HOLD the Mortgaged Property unto Trustee, its successors and assigns forever, FOR THE PURPOSE OF SECURING the Secured Obligations and upon the uses herein set forth, together with all right to possession of the Mortgaged Property after the occurrence of any Event of Default (as hereinafter defined), Grantor hereby RELEASING AND WAIVING all rights under and by virtue of any homestead laws; and Grantor does hereby bind itself, its successors, assigns, executors and administrators to warrant and forever defend all and singular the Mortgaged Property unto Trustee, its successors and assigns against every person whomsoever lawfully claiming or to claim an interest in the same or any part thereof, subject only to the Permitted Exceptions. IN TRUST, to secure the payment to Beneficiary of the Secured Obligations and the performance of all covenants and agreements in the Loan Documents, whereupon this Deed of Trust shall cease and be void and the Mortgaged Property shall be released at the cost of Grantor. ARTICLE II CERTAIN REPRESENTATIONS, WARRANTIES AND COVENANTS OF GRANTOR Grantor hereby represents and warrants where so stated to, and otherwise covenants and agrees with, Beneficiary as follows: SECTION 2.01 Title. Grantor represents and warrants that it has a good and marketable title to an indefeasible fee estate in the Premises and the Improvements subject to no lien, charge or encumbrance other than the Permitted Exceptions; that it owns the Chattels, all Leases and the Rents in respect of the Premises and the Improvements and all other personal property encumbered hereby free and clear of liens and claims of every nature whatsoever, including without limitation liens, pledges, mortgages, mechanics' or materialmen's liens, deeds of trust, security interests, claims, leases, charges, options, rights of first refusal, easements, restrictive covenants, encumbrances and other restrictions, limitations, charges or rights of others of any kind whatsoever (collectively, "Liens") other than the Permitted Exceptions; and that this Deed of Trust is and will remain a valid and enforceable lien on the Mortgaged Property subject only to the permitted Exceptions. Grantor has full power and lawful authority to subject the Mortgaged Property to the lien of this Deed of Trust in the manner and form herein done or intended hereafter to be done and to perform all of the other obligations to be performed by Grantor under the Loan Documents. Grantor will preserve such title, and will forever warrant and defend the same to Trustee and will forever warrant and defend the validity and such priority of the lien hereof against the claims of all persons and parties whomsoever. SECTION 2.02 Further Acts and Assurances. (a) Grantor will, at its sole cost and expense, do, execute, acknowledge and deliver all and every such further acts, deeds, conveyances, deeds of trust, mortgages, assignments, notices of assignment, transfers and assurances as Trustee or Beneficiary shall from time to time require, for the better assuring, conveying, assigning, transferring and confirming unto Trustee the property and rights hereby conveyed or assigned or intended now or hereafter-so to be, or which Grantor may be or may hereafter become bound to convey or assign to Trustee, or for carrying out the intention or facilitating the performance of the terms of this Deed of Trust, or for filing, registering or recording this Deed of Trust and, on demand, will execute and deliver, and hereby authorizes Trustee or Beneficiary to execute and file in Grantor's name one or more financing statements, chattel mortgages or comparable security instruments, to evidence or perfect more effectively Beneficiary's security interest in and the lien hereof upon the Chattels and other personal property encumbered hereby. Grantor hereby grants to each of Trustee and Beneficiary (each of whom may act singly) an irrevocable power of attorney coupled with an interest for such purpose. (b) Grantor will, at its sole cost and expense, do, execute, acknowledge and deliver all and every such acts, information reports, returns and withholding of monies as shall be necessary or appropriate to comply fully, or to cause full compliance, with all applicable information reporting and back-up withholding requirements of the Internal Revenue Code of 1986, as amended (including all regulations promulgated thereunder) in respect of the Premises and the Improvements and all transactions related to the Premises or the Improvements, and will at all times provide Beneficiary with satisfactory evidence of such compliance and notify Beneficiary of the information reported in connection with such compliance. SECTION 2.03 Filing and Recording. (a) Grantor forthwith upon the execution and delivery of this Deed of Trust, and thereafter from time to time, will cause this Deed of Trust and upon request of Beneficiary any other Loan Document creating a lien or evidencing the lien hereof upon the Mortgaged Property or any part thereof and each instrument of further assurance to be filed, registered or recorded in such manner and in such places as may be required by any present or future law in order to publish notice of and fully to protect the lien hereof upon, and the title of Trustee to and the interest of Beneficiary in, the Mortgaged Property. (b) Grantor will pay all filing, registration and recording fees, and all expenses incident to the execution and acknowledgment of this Deed of Trust, any deed of trust supplemental hereto and any other Loan Document (including any security instrument with respect to the Chattels), and any instrument of further assurance, and any expenses (including reasonable attorneys' fees and disbursements) incurred by Beneficiary in connection with the loan secured hereby and as otherwise provided herein, and will pay all federal, state, county and municipal mortgage recording taxes, stamp taxes and other taxes, duties, imposts, assessments and charges arising out of or in connection with the execution and delivery of the Loan Documents, any deed of trust supplemental hereto, any supplemental security instrument with respect to the Chattels or any instrument of further assurance. SECTION 2.04 Payment of Indebtedness. Grantor will (a) punctually pay the Secured Obligations at the time and place and in the manner specified in the Loan Documents, according to the true intent and meaning thereof, all in such coin or currency of the United States of America which at the time of such payment shall be legal tender for the payment of public and private debts and (b) timely, fully and faithfully perform, discharge, observe and comply with each and all of Grantor's obligations to be performed under the Loan Documents. Grantor hereby represents and warrants that, as of the date hereof, there exist no offsets, counterclaims, or defenses against the Secured Obligations. Grantor shall have the privilege of making prepayments on the principal of the Note (in addition to the required payments thereunder) in accordance with the terms, conditions and limitations set forth in the Note but not otherwise. SECTION 2.05 Maintenance of Existence: Compliance with Laws. Grantor, if other than a natural person, will, so long as it is owner of all or part of the Mortgaged Property, do all things necessary to preserve and keep in full force and effect its existence, franchises, rights and privileges as a business or stock corporation, partnership, trust or other entity under the laws of the state of its formation and will comply with all regulations, rules, statutes, orders and decrees of any governmental authority or court applicable to it or to the Mortgaged Property or any part thereof. Grantor now has and shall continue to have the full right, power and authority to operate and lease the Premises and the Improvements, to encumber the Mortgaged Property as provided herein and to perform all of the other obligations to be performed by Grantor under the Loan Documents. SECTION 2.06 After-Acquired Property. All right, title and interest of Grantor in and to all extensions, improvements, betterments, renewals, substitutes and replacements of, and all additions and appurtenances to, the Mortgaged Property, hereafter acquired by, or released to, Grantor or constructed, assembled or placed by Grantor on the Premises, and all conversions of the security constituted thereby, immediately upon such acquisition, release, construction, assembling, placement or conversion, as the case may be, and in each such case, without any further deed of trust, conveyance, assignment or other act by Grantor, shall become subject to the lien of this Deed of Trust as fully and completely, and with the same effect, as though now owned by Grantor and specifically described in the granting clause hereof, but at any and all times Grantor will execute and deliver to Trustee any and all such further assurances, deeds of trust, conveyances or assignments thereof as Trustee or Beneficiary may reasonably require for the purpose of expressly and specifically subjecting the same to the lien of this Deed of Trust. SECTION 2.07 Payment of Impositions. (a) Subject to the provisions of Section 2.26 hereof, Grantor, from time to time when the same shall become due and payable, or to the extent customarily permitted by prudent lenders to be paid by borrowers in the applicable jurisdiction during a grace period thereafter, within such grace period, and before any fine, penalty or interest may be added or imposed for late payments, will pay and discharge all taxes of every kind and nature (including real and personal property taxes and income, franchise, withholding, profits and gross receipts taxes), all general and special assessments, levies, permits, inspection and license fees, all water and sewer rents and charges, vault space rentals and all other governmental and public charges, whether of a like or different nature, any easement fees or charges, imposed upon or assessed against it or the Mortgaged Property or any part thereof or upon the revenues, rents, issues, income and profits of the Mortgaged Property or arising in respect of the occupancy, use, possession or sale or other disposition thereof, and all insurance premiums for insurance required by this Deed of Trust to be maintained by Grantor (collectively, "Impositions"; all Impositions with respect to real property taxes and insurance premiums for insurance required by this Deed of Trust to be maintained by Grantor being hereinafter referred to as "Property Impositions"). If any special assessment is payable in installments without payment of any penalty or premium, other than interest at a non-default rate prior to the due date of such installment, then Grantor may pay the same in installments. Grantor will, upon Beneficiary's request, deliver to Beneficiary receipts evidencing the payment of all Impositions. Grantor shall not claim or demand or be entitled to any credit or credits on account of the Secured Obligations for any part of the Impositions, and no deduction shall otherwise be made or claimed from the taxable value of this Deed of Trust or the Secured Obligations. (b) Grantor shall deposit at the time of each payment of an installment of interest or principal under the Note, an additional amount sufficient to discharge Grantor's obligations to pay any one or more Property Impositions when they become due. The determination of the amount so payable and of the fractional part thereof to be deposited with Beneficiary, so that the aggregate of such deposits shall be sufficient for this purpose, shall be made by Beneficiary. Such amounts shall be held by Beneficiary pursuant to Section 7.14 hereof and applied to the payment of the obligations in respect of which such amounts were deposited or, at Beneficiary's option, to the payment , said obligations in such order or priority as Beneficiary shall determine, on or before the respective dates on which the same or any of them would become delinquent. If one month prior to the due date of any of the aforementioned obligations the amounts then on deposit therefor shall be insufficient for the payment of such obligation in full, Grantor within ten (10) days after demand shall deposit the amount of the deficiency with Beneficiary. Nothing herein contained shall be deemed to affect any right or remedy of Beneficiary under any provisions of this Deed of Trust or of any statute or rule of law to pay any such amount and to add the amount so paid, together with interest thereon at the Default Rate, to the Secured Obligations. SECTION 2.08 Taxes of Trustee and Beneficiary. Grantor will pay all taxes incurred by Beneficiary by reason of Beneficiary's ownership of the Note, this Deed of Trust or any other Loan Document, including without limitation all real estate transfer and like taxes imposed in connection with a transfer of ownership of all or a portion of the Mortgaged Property pursuant to a foreclosure. a deed in lieu of foreclosure or otherwise. Without limiting the generality of the foregoing, if, by the laws of the United States of America, or of any state or municipality having jurisdiction over Beneficiary, Grantor, Trustee or the Premises, any tax is imposed or becomes due in respect of the issuance of the Note or the recording of this Deed of Trust, Grantor shall pay such tax in the manner required by such law. If any law, statute, rule, regulation, order or court decree has the effect of deducting from the value of the Premises or the Improvements for the purpose of taxation any lien thereon, or imposing upon Beneficiary or Trustee the payment of the whole or any part of the taxes required to be paid by Grantor, or changing in any way the laws relating to the taxation of mortgages or deeds of trust or debts secured by mortgages or deeds of trust or the interest of Grantor, Beneficiary or Trustee in the Premises or the Improvements, or the manner of collection of taxes, so as to affect this Deed of Trust, the Secured Obligations or Grantor, Beneficiary or Trustee, then, and in any such event, Grantor, upon demand by Beneficiary, shall pay such taxes, or reimburse Beneficiary therefor on demand, unless Beneficiary determines that such payment or reimbursement by Grantor is unlawful. In such event, the Secured Obligations shall be due and payable within ninety (90) days after written demand by Beneficiary to Grantor, but notwithstanding anything to the contrary contained in the Note, no prepayment penalty shall be due in this limited situation. Notwithstanding the foregoing, Grantor shall not be required to pay any income or franchise taxes imposed on Beneficiary's net income, excepting only such which may be levied against the income of Trustee or Beneficiary as a complete or partial substitute for taxes required to be paid by Grantor pursuant hereto. SECTION 2.09 Insurance; Casualties. (a) Grantor shall effect and maintain, or cause to be maintained, insurance for Grantor and the Mortgaged Property providing at least the following coverages, except to the extent Beneficiary may have heretofore or may hereafter otherwise agree in writing: (i) comprehensive all risk insurance on the Improvements and the Personal Property, including coverage against loss or damage by fire, collapse, lightning, windstorm, tornado, hail, vandalism and malicious mischief, electrical short circuit, sprinkler leakage, water damage, back-up of sewers and drains, bursting water mains, flood or mud slide in compliance with the Flood Disaster Protection Act of 1973, as amended from time to time (if the Land is now, or at any time while the Loan remains outstanding shall be, situated in any area which an appropriate governmental authority designates as a special flood hazard area, Zone A or Zone V), increased cost of construction and value of the undamaged portion of the Improvements and/or Personal Property arising out of physical loss or damage to the covered property by a peril insured against, and against loss or damage by such other, further and additional risks as now are or hereafter may be embraced by the standard extended coverage forms of endorsements, in each case (A) in an amount equal to 100% of their "Full Replacement Cost," which for purposes of this Deed of Trust shall mean actual replacement value (exclusive of costs of excavations, foundations, underground utilities and footings); (B) containing an agreed amount endorsement with respect to the Improvements and Personal Property waiving all co-insurance provisions; (C) containing an endorsement that all covered losses will be paid on a replacement cost basis, which shall mean the actual cost to repair without deduction for depreciation; and (D) providing for no deductible in excess of the lesser of five percent (5%) of the original principal amount of the Note or $100,000. The Full Replacement Cost shall be ascertained upon the date hereof by an appraiser or contractor designated and paid by Grantor and approved by Beneficiary, or by an engineer or appraiser in the regular employ of the insurer; (ii) insurance against loss or damage by earthquake and other sudden and abnormal earth movement (if the Land is now, or at any time while the Loan remains outstanding shall be, situated in any area which is classified as a Major Damage Zone, Zones 3 and 4, by the International Conference of Building Officials) in an amount equal to the probable maximum loss for the Premises, the Improvements and fixtures and equipment, as determined by Beneficiary, plus the cost of debris removal and demolition of the undamaged portion of the Improvements and/or Personal Property; (iii) Commercial General Liability insurance against claims for personal injury or bodily injury including death or property damage occurring upon, in or about the Premises or the Improvements, such insurance to (A) be on the so-called "occurrence" form with a combined single limit and appropriate annual aggregate limitations; (B) afford immediate protection at the date hereof to the limit of not less than $3,000,000 in respect of each personal injury, bodily injury or death to any person, to the limit of not less than $5,000,000 in respect of any one occurrence, and to the limit of not less than $1,000,000 in respect of any one occurrence for property damage; (C) continue at not less than the said limits until required to be changed by Beneficiary in writing by reason of changed economic conditions making such protection inadequate; and (D) cover at least the following hazards: (1) premises and operations; (2) products and completed operations on an "if any" basis; (3) independent contractors; (4) contractual liability covering the indemnities contained in this Deed of Trust and in the Environmental Indemnification Agreement to the extent the same is available; and (5) employee benefit liability; (iv) business interruption insurance or, as the case may be, rental loss insurance, (A) with loss payable to Beneficiary; (B) covering all risks required to be covered by the insurance provided for in subdivision (i) above; (C) containing an extended period of indemnity endorsement which provides that, after the physical loss to the Improvements and Equipment has been repaired, the-continued loss of income will be insured until such income either returns to the same level it was at prior to the loss, or the expiration of twelve (12) months, whichever first occurs, and notwithstanding that the policy may expire prior to the end of such period; (D) agreeing to pay for losses whether the Premises or the Improvements are open to the public or not; (E) covering loss of income during construction and periods of alterations to the extent that physical damage would result in loss of income, whether or not the Premises or the Improvements are occupied or open to the public; and (F) in an amount equal to 100% of the projected gross income from the Premises and the Improvements for a period of one (1) year. The amount of such business interruption insurance shall be determined prior to the date hereof and at least once each year thereafter based on Grantor's reasonable estimate of the gross income from the Premises and the Improvements for the succeeding period selected by Beneficiary. In the event that all or any portion of the Premises or the Improvements shall be damaged or destroyed, Grantor shall and hereby does assign to Beneficiary all claims under the policies of such insurance and all amounts payable thereunder; and all net amounts, when collected by Beneficiary under such policies, shall be held in trust by Beneficiary and shall be applied to the Secured Obligations from time to time due and payable hereunder and under the Note and, so long as there exists no Event of Default hereunder and Beneficiary has not accelerated any of the Secured Obligations, any rental loss insurance proceeds in excess of scheduled debt service payments on the Note for the period for which such insurance proceeds are paid shall be remitted to Grantor; provided, however, that nothing herein contained shall be deemed to relieve Grantor of its obligation to pay any of the Secured Obligations on the respective dates of payment provided for in the Note and hereunder except to the extent such amounts are actually paid out of the proceeds of such business interruption or rental loss insurance; (v) at all times during which construction, structural repairs or alterations are being made with respect to the Improvements (A) owner's contingent or protective liability insurance covering claims not covered by or under the terms or provisions of the above mentioned Commercial General Public Liability insurance policy; and (B) the insurance provided for in subdivision (i) of this paragraph (a) written in a so-called builder's risk completed value form (1) on a non-reporting basis, (2) against all risks insured against pursuant to subdivision (i) of this paragraph (a), and (3) including permission to occupy the Premises and the Improvements and with an agreed amount endorsement waiving co-insurance; (vi) workers' compensation, subject to the statutory limits of the applicable jurisdiction, and employer's liability insurance with a limit of at least $1,000,000.00 per accident or disease per employee, in respect of any work or operations on, about, or in connection with, the Mortgaged Property (if applicable); (vii) comprehensive boiler and machinery insurance, in such amounts as shall be reasonably required by Beneficiary; (viii) environmental impairment liability insurance offered through the ERIC Property Transfer Liability Insurance Policy Form #PTL 10 03 11 92, modified and endorsed in connection with the Loan, providing for a limit of $2,000,000 per discovery and $2,000,000 policy term aggregate or another policy of at least the same coverage with an insurance company approved by Beneficiary, and Grantor hereby acknowledges and agrees to Beneficiary's requirement that the insurance referred to in this clause (viii) shall on the date hereof be in full force and effect and fully paid for a period of not less than five (5) years from the date hereof, and that on or before the expiration of each anniversary of the date hereof such insurance shall be extended for an additional year up to and including the eleventh full year after the Funding Date; and (ix) such other insurance and in such amounts as Beneficiary from time to time may reasonably request against such other insurable hazards which at the time are commonly insured against in respect of property similar to the Mortgaged Property located in or around the region in which the Mortgaged Property is located. All insurance provided for in this Section 2.09 shall be effected under valid and enforceable policies, in such forms and in such amounts, if not specified above, as may from time to time be satisfactory to Beneficiary, issued by financially sound and responsible insurance companies authorized to do business in the jurisdiction where the Premises are located as approved admitted or unadmitted carriers which have been approved by Beneficiary. Prior to the date hereof, and thereafter not less than thirty (30) days prior to the expiration dates of the policies theretofore furnished to Beneficiary pursuant to this Section 2.09, certified original copies of the policies accompanied by evidence satisfactory to Beneficiary of payment of the first installment of the premiums therefor, shall be delivered by Grantor to Beneficiary; provided, however, that in the case of renewal policies, Grantor may furnish Beneficiary with binders therefor to be followed by the original policies when issued. Grantor shall provide Beneficiary with evidence of the full payment for each renewal policy prior to the expiration of the policy being renewed. All policies of insurance provided for or contemplated by this Section 2.09 shall name Beneficiary and Grantor, as the insured or additional insured, as their respective interests may appear, and in the case of property damage insurance, shall contain a so-called New York standard mortgagee clause in favor of Beneficiary providing that the loss thereunder shall be payable to Beneficiary. (b) Grantor shall not take out separate insurance concurrent in form or contributing in the event of loss with that required to be maintained under this Deed of Trust, or any umbrella or blanket liability or casualty policy, unless, in each case, Beneficiary is included thereon as a named insured with loss payable to Beneficiary under a standard mortgagee endorsement of the character above described. Grantor shall immediately notify Beneficiary whenever any such separate, umbrella or blanket insurance is taken out and shall promptly deliver to Beneficiary the policy or policies of such insurance. Any blanket insurance policy shall specifically allocate to the Mortgaged Property the amount of coverage from time to time required hereunder and shall otherwise provide the same protection as would a separate policy insuring only the Mortgaged Property in compliance with the provisions of clause (a) of this Section 2.09. (c) All policies of insurance provided for in clause (a) of this Section 2.09 shall contain clauses or endorsements to the effect that: (i) no act or negligence of Grantor, or anyone acting for Grantor, or of any tenant under any Lease or other occupant or failure to comply with the provisions of any policy which might otherwise result in a forfeiture of such insurance or any part thereof shall in any way affect the validity or enforceability of such insurance insofar as Beneficiary is concerned; (ii)such policies shall not be materially changed (other than to increase the coverage provided thereby), cancelled or nonrenewed without at least 30 days' written notice to Beneficiary and any other party named therein as an insured thereunder; and (iii)Beneficiary shall not be liable for any premiums thereon or subject to any assessments thereunder. (d) Claims under each policy of insurance provided for or contemplated by clause (a) of this Section 2.09 (excluding third party liability, workers compensation and employers liability insurance) in excess of the lesser of (i) $500,000 or (ii) thirty percent (30X) of the then current principal amount of the Note shall be adjusted with the insurers and/or underwriters by Grantor and, if Beneficiary so elects (which election shall be made within thirty (30) days following Beneficiary's receipt of a Notice from Grantor of its right to such election), Beneficiary (provided that, so long as no Event of Default shall then have occurred and be continuing, Beneficiary agrees that it shall not settle any such claims without Grantor's consent (not to be unreasonably withheld, conditioned or delayed), and Grantor shall (subject to Beneficiary's reasonable discretion) be entitled to lead all negotiations with insurers and underwriters in connection with such claims). Any such claims which do not exceed the lesser of (i) $500,000 or (ii) thirty percent (30X) of the then current principal amount of the Note shall, so long as no Event of Default exists hereunder, be adjusted by Grantor. All costs and expenses of collecting or recovering any insurance proceeds under such policies, including without limitation any and all fees of attorneys, appraisers and adjusters, shall be paid by Grantor. (e) In the event of any damage to or destruction of the Premises or the Improvements, Grantor shall, promptly after obtaining knowledge of the occurrence thereof, give notice thereof to Beneficiary and shall, except as set forth in paragraphs (h) and (j) of this Section 2.09 and regardless of the dollar amount of such damage, proceed with reasonable diligence, at Grantor's sole cost and expense, to repair and restore or cause to be repaired or restored the Premises or the Improvements, as the case may be, or the portion thereof so damaged as nearly as practically possible to the condition the same were in immediately prior to such damage. If any Personal Property is damaged or lost as a result of such fire or other casualty, Grantor shall likewise, at its sole cost and expense, whether or not any insurance proceeds are available or adequate for such purpose, replace or cause to be replaced the Personal Property so damaged or lost. In the event that Grantor fails to advance any funds required for the completion of any such repairs or restoration, Beneficiary may, but shall not be obligated to, advance the required funds or any portion thereof, and Grantor shall, on demand, reimburse Beneficiary for all sums advanced and actual expenses incurred by Beneficiary in connection therewith (including without limitation the charges, disbursements and reasonable fees of Beneficiary's counsel), together with interest thereon at the Default Rate from the date each such advance is made or expense paid by Beneficiary to the date of receipt by Beneficiary of reimbursement from Grantor, which amounts and interest shall become part of the Secured Obligations and be secured hereby. All repairs and restoration required to be made by Grantor hereunder shall be performed in material compliance with all Laws and Orders and shall be without any liability or actual expense of any kind to Beneficiary. (f) The proceeds of any insurance policy so received shall be paid directly to Beneficiary and applied in accordance with the provisions of this Section 2.09. Provided the conditions described in clauses (i) - (vii) below have been satisfied and subject to the limitation set forth in the immediately following sentence, such proceeds shall be paid over to Grantor from time to time to reimburse Grantor for the costs of restoration of the Improvements. Provided that (x) there exists no Event of Default hereunder, (y) the cost to restore the Premises and the Improvements, as determined by Beneficiary, does not exceed fifty percent (50%) of the then current principal amount of the Note, and (z) Grantor has notified Beneficiary of its intention to fully restore the Improvements, Beneficiary agrees to apply any such insurance proceeds received by Beneficiary (or a portion thereof if not all the Improvements are to be fully restored), which proceeds shall be held in an interest bearing account until paid or applied, to the reimbursement of Grantor's costs of restoring the Improvements provided the following conditions have been satisfied: (i) Beneficiary or, in the case of subclause (A) of this clause (i) at Beneficiary's option, a qualified independent construction consultant retained by Beneficiary, shall have reasonably determined that (A) the restoration of the Improvements to a Commercially Viable architectural whole of substantially the same use, value and character as immediately prior to such casualty can be completed by the then Maturity Date under and as defined in the Note at a cost which does not exceed the amount of available insurance proceeds, or in the event that such proceeds are determined by Beneficiary or such construction consultant to be inadequate, Beneficiary shall have received from Grantor a cash deposit equal to the excess of said estimated cost of restoration over the amount of available proceeds and (B) there shall be adequate cash flow from the Mortgaged Property together with the proceeds of any loss of rents insurance coverage to pay all debt service on the Note and all operating expenses in respect of the Mortgaged Property as they become due during the course of such restoration; (ii) if the restoration work (the "Restoration") is of a nature such that (x) a prudent owner or developer of real property would engage an architect or engineer to plan, design, implement, coordinate or supervise all or any thereof or (y) the services of an architect or engineer would be required to meet the requirements of local building ordinances or codes or otherwise to comply with Laws, prior to the commencement thereof (other than Restoration to be performed on an emergency basis to protect the Mortgaged Property), (A) an architect or engineer, reasonably approved by Beneficiary, shall be retained by Grantor at Grantor's expense and charged with the supervision of the Restoration and (B) Grantor shall have prepared, submitted to Beneficiary and secured Beneficiary's approval of the plans and specifications for such Restoration, which approval shall not be unreasonably withheld or delayed; (iii) each request for payment by Grantor shall be in form and substance satisfactory to Beneficiary, shall generally be in accordance with customary construction disbursement procedures and limitations, and shall be made on no less than ten (10) days' prior written notice to Beneficiary and shall be accompanied by a certificate to be prepared and executed by the architect or engineer, reasonably approved by Beneficiary, supervising the Restoration (if one is required pursuant to clause (ii) above), otherwise by an officer or general partner of Grantor, as applicable, stating that (A) all of the Restoration completed has been done in substantial compliance with the approved plans and specifications (if any are required pursuant to clause (ii) above), (B) the sum requested by Grantor is justly required to reimburse Grantor for payments by Grantor to the contractors, subcontractors, materialmen, laborers, engineers, architects or other persons (collectively "Contractors") rendering materials or services for the Restoration and shall include a brief description of such services and materials rendered, (C) when added to all sums previously paid out by Grantor with respect to the Restoration, the sum requested does not exceed the cost of the Restoration done as of the date of such certificate less retainage, (D) the amount of insurance proceeds remaining in the hands of Beneficiary, plus any further amounts deposited by Grantor with Beneficiary in connection with the Restoration, will be sufficient to pay for the lien free completion of the Restoration in a good and workmanlike manner in compliance with all applicable Laws and (E) none of the Restoration for which disbursement of proceeds is requested shall have been included in a previous request; (iv) Grantor shall cause to be delivered to Beneficiary appropriate lien waivers from each of the Contractors, with respect to which Grantor is seeking reimbursement or direct payment to such Contractors for Restoration performed by such party in such request for disbursement; (v) any cross-easement agreements and/or reciprocal easement agreements shall be in effect and the benefits contemplated thereunder continuing to inure to the Premises, in Beneficiary's reasonable determination, as are necessary for the continued legal and economic operation of the Premises and the improvements in a Commercially Viable manner; (vi) Beneficiary shall have received such surety bonds, completion guaranties and other assurances as Beneficiary shall reasonably require with respect to the completion of the Restoration; and (vii) no Event of Default shall exist under this Deed of Trust. Provided Grantor has satisfied the conditions in clauses (i) - (vii) above and continues to satisfy such conditions throughout the entire course of the Restoration, Beneficiary shall reimburse Grantor, or, at Beneficiary's option, make payments jointly to Grantor and such Contractors, from time to time as the Restoration progresses, but in no event more than once per calendar month and with a retainage equal to ten percent (lO%) of the portion of each disbursement applicable to Hard Costs, within ten (10) days following satisfaction of the last of such conditions to be satisfied, for costs incurred by Grantor with respect to the Restoration. If any excess proceeds remain after the Restoration is completed and paid for in full out of such proceeds, such excess proceeds shall be retained by Beneficiary and applied as follows: (I) If such excess proceeds shall be received within the first two (2) years following the Funding Date, such excess proceeds shall be applied on the last day of the month in which received to the payment of a portion of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to the sum of (x) interest on the amount of such excess proceeds through and including the last day of the month in which the same shall be received, plus (y) the Yield Maintenance Amount calculated with respect to the amount of such excess proceeds. (II) If such excess proceeds shall be received during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), such excess proceeds shall be deposited in the Cash Reserve when received. In such event and upon such receipt, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to interest on the amount of such excess proceeds through and including the last day of the month in which the First Permitted Prepayment Date occurs which amount will also be deposited in the Cash Reserve when received. (III) If such excess proceeds shall be received at any time after the First Permitted Prepayment Date, such excess proceeds shall be applied on the last day of the month in which received to the payment of a portion of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to the sum of (x) interest on the amount of such excess proceeds through and including the last day of the month in which the same shall be received, plus (y) the applicable prepayment penalty, if any, required pursuant to the Note, calculated with respect to the amount of such excess proceeds. In the event only a portion of the Improvements is to be restored, the allocable portion of the proceeds required for such Restoration, as determined by Beneficiary, shall be applied to such Restoration as contemplated above, with the balance of such proceeds to be retained by Beneficiary and applied in the manner, at the times and in the amounts set forth above in the immediately preceding three (3) paragraphs of this Section 2.09(f). Interest, if any, earned on insurance proceeds while held by Beneficiary shall be added to the amount of such proceeds. If any of the foregoing conditions to the advance of insurance proceeds for Restoration are not satisfied at any time, Beneficiary shall have the option at any time thereafter to apply such insurance proceeds in the manner set forth in paragraph (i) of this Section 2.09; provided, however, that so long as there is no Event of Default hereunder, Beneficiary shall not apply such proceeds without first giving Grantor written notice, after which Grantor shall have thirty (30) days to cure any unsatisfied conditions set forth in clauses (i) - (vi) above; and provided, further, that in the event such unsatisfied condition is susceptible to cure but cannot with due diligence be cured by the payment of money or otherwise within such thirty (30) day period, Grantor shall have such longer period (unless Beneficiary determines that delay in effecting such cure would have a material adverse impact on Beneficiary or the Mortgaged Property), but not to exceed one hundred twenty (120) days, as is required for Grantor to diligently cure such unsatisfied condition, provided that Grantor first notifies Beneficiary of its intention to cure such unsatisfied condition and actually commences the cure of such unsatisfied condition within the initial thirty (30) day period and at all times thereafter diligently prosecutes the cure of such unsatisfied condition with all due diligence to completion. (g) [RESERVED] (h) In the event that (i) Grantor shall determine in its good faith judgment after any casualty, which determination is not disputed in good faith by Beneficiary, that the damage to the Improvements was so extensive as to make restoration and operation thereof not Commercially Viable, or (ii) after any casualty, Grantor fails to undertake or complete the Restoration, but is unable to satisfy Beneficiary that the Restoration is not Commercially Viable in Beneficiary's reasonable judgment, then: (I) If the casualty occurs at any time within the first two (2) years following the Funding Date, all of the Secured Obligations shall become due and payable on the last day of the month in which all insurance proceeds in respect of such casualty are received, and such insurance proceeds shall be paid over to Beneficiary and applied on such last day of the month in payment of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of such month, (C) the Yield Maintenance Amount calculated with respect to the unpaid principal balance of the Note, and (D) all other Secured Obligations, if any, exceeds (y) the amount of such insurance proceeds so and the several amounts described in subclauses (A) through (D) of this clause (I) shall be applied in payment of the respective obligations described in such subclauses. (II)If the casualty occurs at any time during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), such insurance proceeds shall be paid over to Beneficiary and deposited in the Cash Reserve. In such event and upon the receipt of all such insurance proceeds, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of the month in which the First Permitted Prepayment Date occurs, and (C) all other Secured Obligations, if any, exceeds (y) the amount of such insurance proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (C) of this clause (II) shall be deposited in the Cash Reserve, to be used and applied as provided in the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable. (III)If the casualty occurs at any time on or after the First Permitted Prepayment Date, all of the Secured Obligations shall become due and payable on the last day of the month in which all insurance proceeds in respect of such casualty are received, and such insurance proceeds shall be paid over to Beneficiary and applied on such last day of the month in payment of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of such month, (C) the applicable prepayment penalty, if any, required pursuant to the Note, and (D) all other Secured Obligations, if any, exceeds (y) the amount of such insurance proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (D) of this clause (III) shall be applied in payment of the respective obligations described in such subclauses. (i) [Reserved] (j) In the event that (i) Grantor seeks and elects to fully restore the Improvements (or a discrete portion thereof) and makes a good faith showing that the restoration and operation of the Improvements (or such portion thereof) would be Commercially Viable and that Grantor has the resources to reconstruct and operate the Improvements (or such portion thereof) as such, and (ii) Beneficiary nonetheless shall require that insurance proceeds be held for payment of the debt and not made available for restoration after having made a determination in its good faith judgment after any casualty that the damage to the Improvements (or such portion thereof) was so extensive as to make restoration and operation thereof not Commercially Viable, all such insurance proceeds (or, where Grantor's showing and Beneficiary's determination relate to a discrete portion of the Improvements, such portion of such insurance proceeds as Beneficiary shall allocate to the portion of the Improvements not being restored) shall be paid over to Beneficiary and applied in payment of the Secured Obligations, and Grantor shall not be permitted to restore the Improvements (or such portion thereof) so long as this Deed of Trust is in effect, but shall be obligated to prepay the Note (or, in the case of a portion of the improvements, to make a prepayment of a portion of the principal balance of the Note) and obtain a release of this Deed of Trust in accordance with Section 7.06 hereof (or a release of the lien of this Deed of Trust from the discrete portion of the Improvements not being restored and the part of the Land underlying such portion if Beneficiary determines that such partial release is practicable) by paying to Beneficiary (in addition to Beneficiary's receipt of all such proceeds that Beneficiary shall have allocated to the portion of the Improvements not being restored) the following: (I) In the case where Grantor's good faith showing and Beneficiary's determination relate to all of the Improvements, the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of the month in which the amount described in the immediately preceding clause (A) is paid, and (C) all other Secured Obligations, if any, exceeds (y) the amount of insurance proceeds in respect of such casualty received by Beneficiary. Beneficiary shall apply the several amounts described in subclauses (A) through (C) of this clause (I) in payment of the respective obligations described in such subclauses. (II)In the case where Grantor's good faith showing and Beneficiary's determination relate to a discrete portion of the Improvements, interest on the amount of insurance proceeds applied in reduction of the Secured Obligations through and including the last day of the month in which such proceeds shall be so applied. Beneficiary shall apply the amount of such interest in reduction of the Secured Obligations. In the limited situation described in this paragraph (J), no Yield Maintenance Amount and no prepayment premium shall be due and payable. (k) Notwithstanding anything to the contrary contained herein, the application of any insurance proceeds by Beneficiary to the Secured Obligations or the repair or restoration of any part of the Mortgaged Property as provided in this Section 2.09 shall not reduce or excuse in any manner whatsoever Grantor's obligations diligently to repair and restore or cause to be repaired and restored the damaged portion of the Mortgaged Property, to the extent required by Section 2.09(e) hereof. (1) No destruction of or damage to the Mortgaged Property, or any part thereof, by fire or other casualty whatsoever, whether such damage or destruction be partial or total or otherwise, shall relieve Grantor from its liability to pay in full as and when due the Secured Obligations, or from timely, fully and faithfully performing all its other obligations hereunder and under the Loan Documents. No application of insurance proceeds to the reduction of the Secured Obligations shall have the effect of releasing the lien of this Deed of Trust from all or any portion of the Mortgaged Property until and unless all of the Secured Obligations have been paid in full. (m) If the Premises are located in an area which has been identified by the Secretary of the United States Department of Housing and Urban Development as a flood hazard area, Grantor will keep the Improvements covered, until all sums secured hereby have been repaid in full, by flood insurance in an amount at least equal to the full amount of the Note or the maximum limit of coverage available for the Premises under the National Flood Insurance Act of 1968, whichever is less. SECTION 2.10 Advances by Trustee or Beneficiary. If Grantor shall fail to perform any of the covenants contained in this Deed of Trust, Trustee or Beneficiary may, after written notice to Grantor except in the event of an emergency, make advances to perform the same on its behalf, and all sums so advanced shall be a lien upon the Mortgaged Property and shall be secured hereby. Grantor will repay on demand all sums so advanced on its behalf together with interest thereon at the Default Rate. The provisions of this Section 2.10 shall not prevent any default in the observance of any covenant contained in this Deed of Trust from constituting an Event of Default. SECTION 2.11 Books and Records; Financial Information Reporting. (a) Grantor will keep adequate records and books of account of Grantor and the Premises at the principal office of Grantor in accordance with generally accepted accounting principles consistently applied (except the use of cash basis shall be permitted) reflecting all financial transactions of Grantor in respect of the Mortgaged Property and will permit Trustee and Beneficiary, by their agents, accountants and attorneys, upon reasonable prior notice, to visit and inspect the Mortgaged Property and examine its records and books of account, to make copies and extracts thereof and to discuss its affairs, finances and accounts with the officers or general partners, as the case may be, of Grantor, at such reasonable times as may be requested by Trustee or Beneficiary. Promptly upon demand by Beneficiary, but not more frequently than twice in any calendar year with respect to any entity, Grantor, at its cost, shall cause to be delivered to Beneficiary reports established and/or maintained by any rating agency and/or credit verification organization designated by Beneficiary (collectively, the "Credit Agencies") with respect to the credit status and/or financial condition of, and/or history of default with respect to credit transactions by, Grantor, and/or its partners, principals or major shareholders (collectively the "Credit Reports"), and Grantor hereby expressly grants to Beneficiary the right, license and privilege to obtain the Credit Reports directly from the Credit Agencies at Grantor's cost. (b) Grantor will deliver to Beneficiary within one hundred twenty (120) days- after the close of its fiscal year its audited balance sheet and statement of profit, loss and cash flow setting forth in each case, in comparative form, figures for the preceding year certified by a reputable certified public accounting firm. Grantor shall also deliver to Beneficiary within (i) one hundred twenty (120) days after the close of each calendar year an annual operating statement for the Mortgaged Property setting forth, in comparative form, figures for the preceding year and (ii) thirty (30) days after the end of each calendar quarter, quarterly operating statements for the Premises setting forth, in comparative form, figures for the preceding quarter, together with a certified rent roll conforming to the requirements of Section 2.16(f) hereof, in the case of annual operating statements certified by a reputable certified public accounting firm, and in the case of quarterly statements certified by Grantor's chief financial officer. Such annual operating statement for the Mortgaged Property may be in the form of a supplemental schedule to the audited balance sheets and statements of profit, loss and cash flow referred to in the first sentence of this paragraph (b), in which event it must be either covered by and subject to the same certification and audit opinion as are given in connection with such balance sheets and statements or covered by separate certification and audit opinion to the same effect. Throughout the term of this Deed of Trust, Grantor, with reasonable promptness, will deliver to Beneficiary such other information with respect to Grantor or the Mortgaged Property as Beneficiary may reasonably request from time to time. All financial statements of Grantor shall be prepared in accordance with generally accepted accounting principles consistently applied (except the use of cash basis shall be permitted), shall be delivered in duplicate and, in the case of Grantor, shall be accompanied by the certificate of a principal financial or accounting officer or general partner, as the case may be, of Grantor, dated within five (5) days of the delivery of such statements to Beneficiary, stating that such financial statements are true and correct and that he knows of no Event of Default, nor of any event which after notice or lapse of time or both would constitute an Event of Default, which has occurred and is continuing, or, if any such event or Event of Default has occurred and is continuing, specifying the nature and period of existence thereof and what action Grantor has taken or proposes to take with respect thereto, and, except as otherwise specified, stating that Grantor has fulfilled all of its obligations under this Deed of Trust which are required to be fulfilled on or prior to the date of such certificate. SECTION 2.12 Estoppel Certificates. (a) Grantor, within three (3) days upon request in person or within five (5) days upon request by mail, will furnish a written certificate, in recordable form, of the amount due whether for principal or interest on this Deed of Trust and whether any offsets, counterclaims or defenses exist against the indebtedness secured hereby, specifying the nature of any claimed offset, counterclaim or defense in reasonable detail. Such certificate shall also contain a statement that Grantor has no knowledge of the occurrence of any Event of Default nor of any other event, which, with the giving of notice or passage of time, or both, would constitute an Event of Default which has occurred and remains uncured as of the date of such certificate; or, if any such Event of Default or other default has occurred and remains uncured as of the date of such certificate, then such certificate shall contain a statement specifying the nature thereof, the time for which the same has continued and the action which Grantor has taken or proposes to take with respect thereto, and setting forth or describing such additional matters with respect to Grantor or the Mortgaged Property as Beneficiary shall request and such additional information as Beneficiary may reasonably request. Such certificate shall be certified to, and may be relied upon by, such parties as Beneficiary shall direct. (b) From time to time at the request of Grantor in connection with a proposed sale of the Mortgaged Property, but not more frequently than twice in any calendar year, Beneficiary shall execute and deliver to Grantor or Grantor's designee a certificate setting forth (i~ the date of the most recent debt service payment received by Beneficiary, (ii) the unpaid principal balance of the Note, (iii) the interest rate in effect under the Note, (iv) the Maturity Date of the Note and (v) whether or not Beneficiary has formally declared an Event of Default which is still in effect. If Grantor shall request, Beneficiary shall attach to such certificate a list of the principal Loan Documents or, if thereafter specifically requested by Grantor, true and correct copies of the principal Loan Documents, including without limitation any amendments thereof. SECTION 2.13 Maintenance of Mortgaged Property; Waste; Repairs; Alterations. Grantor will not commit any waste on the Premises or make any change in the use of the Premises or the Improvements which will in any way increase the risk of any fire or other hazard arising out of construction or operation. Grantor will, at all times, maintain the Improvements and Chattels in good operating order and condition and will promptly make, from time to time, at Grantor's sole cost and expense, all structural and non-structural, ordinary and extraordinary, foreseen and unforeseen, repairs, renewals, replacements, additions and improvements in connection therewith which are necessary to such end. All such repairs, renewals, replacements, additions and improvements shall be at least substantially equal in quality to the original Improvements. Grantor will continuously manage or cause to be managed (other than during periods of repair after major casualty or substantial condemnation, with respect to the portions of the Mortgaged Property damaged or condemned) the Mortgaged Property in the manner and for the purposes heretofore used. The Improvements shall not be demolished or substantially altered, nor shall any Chattels be removed other than as provided in Section 2.29 hereof. SECTION 2.14 Environmental Matters. The representations and warranties contained in the Environmental Indemnification Agreement are true and correct SECTION 2.15 Condemnation Proceedings. (a) Grantor, immediately upon obtaining knowledge of the institution or pending institution of any proceedings for the condemnation of the Premises or the Improvements or any portion thereof, will notify Trustee and Beneficiary thereof. Trustee and Beneficiary may, at Grantor's cost and expense for reasonable third-party charges, participate in any such proceedings and may be represented therein by counsel of Beneficiary's selection; provided, however, that neither Trustee nor Beneficiary shall have the right to settle any condemnation action without Grantor's consent except if an Event of Default exists hereunder, in which case no such consent shall be required. Grantor from time to time will deliver to Beneficiary all instruments requested by it to permit or facilitate such participation. Grantor shall not make any agreement in lieu of condemnation of the Premises or the Improvements or any portion thereof without the consent of Beneficiary in each instance, which consent shall not be unreasonably withheld or delayed in the case of the taking of any insubstantial portion of the Premises or the Improvements which does not in Beneficiary's good faith judgment materially adversely affect the commercial viability of continued operation of the remainder of the Premises and the Improvements. In the event of such condemnation proceedings, the award or compensation payable is hereby assigned to and shall be paid to Beneficiary. Beneficiary shall be under no obligation to question the amount of any such award or compensation and may accept the same in the amount in which the same shall be paid. Grantor shall have the right, provided there exists no Event of Default hereunder, to pursue, at Grantor's sole cost and expense, any appeal of any condemnation award. Unless otherwise provided in this Section 2.15 Grantor shall, regardless of the extent of the taking, and whether or not any condemnation award proceeds are available therefor, proceed with reasonable diligence, at Grantor's sole cost and expense, to repair and restore or caused to be repaired or restored the remaining portion of the Premises and the Improvements into an architectural and Commercially Viable premises similar (to the greatest extent possible) to the previously existing structure, with such additional improvements as Grantor , subject to Beneficiary's approval, may elect to add. In the event that Grantor fails to advance any funds required for the completion of any such repair or restoration, Beneficiary may, but shall not be obligated to advance the required funds or any portion thereof, and Grantor shall, on demand, reimburse Beneficiary for all sums advanced and actual expenses incurred by Beneficiary in connection therewith (including without limitation the charges, disbursements and reasonable fees of Beneficiary's counsel), together with interest thereon at the Default Rate from the date each such advance is made or expense paid by Beneficiary to the date of receipt by Beneficiary of reimbursement from Grantor, which amounts and interest shall become part of the Secured Obligations and be secured hereby. All repairs and restoration required to be made by Grantor hereunder shall be performed in material compliance with all Laws and Orders and shall be without any liability or actual expense of any kind to Beneficiary. (b) The proceeds of any award or compensation so received shall be paid directly to Beneficiary and applied, regardless of the rate of interest payable on the award by the condemning authority, in accordance with the provisions of this Section 2.15. Provided the conditions described in clauses (i) - (vii) below have been satisfied and subject to the limitations set forth in the immediately following sentence, such proceeds shall be paid over to Grantor or others as and to the extent provided herein for restoration of the remainder of the Premises and the Improvements. Provided that (x) there exists no Event of Default hereunder, (y) no more than fifty percent (50%) of the Premises or the Improvements have been subject to such taking, and (z) Grantor has notified Beneficiary of its intention to fully restore the remainder of the Premises and the Improvements, Beneficiary agrees to apply any such condemnation award proceeds received by Beneficiary (or such portion thereof as may be required), which proceeds shall be held in a Permitted Investment until paid or applied as hereinafter provided, to the costs of restoring the remainder of the Premises and the Improvements, and which proceeds shall be paid over to Grantor from time to time to reimburse Grantor for the costs of restoration of such remainder provided the following conditions have been satisfied: (i) Beneficiary or, in the case of subclause (A) of this clause (i) at Beneficiary's option, a qualified independent construction consultant retained by Beneficiary, shall have reasonably determined that (A) the restoration of the Improvements to a Commercially Viable architectural whole of substantially the same use, value and character as immediately prior to such taking can be completed by the then Maturity Date under and as defined in the Note at a cost which does not exceed the amount of available condemnation award proceeds, or in the event that such proceeds are determined by Beneficiary or such construction consultant to be inadequate, Beneficiary shall have received from Grantor a cash deposit equal to the excess of said estimated cost of restoration over the amount of available proceeds and (B) there shall be adequate cash flow from the Mortgaged Property together with the proceeds of any loss of rents insurance coverage to pay all debt service on the Note and all operating expenses in respect of the Mortgaged Property as they become due during the course of such restoration; (ii) if the restoration work (the "Work") is of a nature such that (x) a prudent owner or developer of real property would engage an architect or engineer to plan, design, implement, coordinate or supervise all or any thereof or (y) the services of an architect or engineer would be required to meet the requirements of local building ordinances or codes or otherwise to comply with Laws, prior to the commencement thereof (other than Work to be performed on an emergency basis to protect the Mortgaged Property), (A) an architect or engineer, reasonably approved by Beneficiary, shall be retained by Grantor at Grantor's expense and charged with the supervision of the Work and (B) Grantor shall have prepared, submitted to Beneficiary and secured Beneficiary's approval of the plans and specifications for such Work, which approval shall not be unreasonably withheld or delayed; (iii) each request for payment by Grantor shall be in form and substance satisfactory to Beneficiary, shall generally be in accordance with customary construction disbursement procedures and limitations, and shall be made on no less than ten (10) days' prior written notice to Beneficiary and shall be accompanied by a certificate to be prepared and executed by the architect or engineer, reasonably approved by Beneficiary, supervising the Work (if one is required pursuant to clause (ii) above), otherwise by an officer or general partner of Grantor, as applicable, stating that (A) all of the Work completed has been done in substantial compliance with the approved plans and specifications (if any are required pursuant to clause (ii) above), (B) the sum requested by Grantor is justly required to reimburse Grantor for payments by Grantor to the contractors and shall include a brief description of such services and materials rendered, (C) when added to all sums previously paid out by Grantor with respect to the Work, the sum requested does not exceed the cost of the Work done as of the date of such certificate less retainage, (D) the amount of condemnation proceeds remaining in the hands of Beneficiary, plus any further amounts deposited by Grantor with Beneficiary in connection with the Work, will be sufficient to pay for the lien- free completion of the Work in a good and workmanlike manner in compliance with all applicable Laws and (E) none of the Work for which disbursement of proceeds is requested shall have been included in a previous request; (iv) Grantor shall cause to be delivered to Beneficiary appropriate lien waivers from each of the Contractors with respect to which Grantor is seeking reimbursement or direct payment to such Contractors for Work performed by such party in such request for disbursement; (v) any cross-easement agreements and/or reciprocal easement agreements shall be in effect and the benefits contemplated thereunder continuing to inure to the Premises and the Improvements, in Beneficiary's reasonable determination, as are necessary for the continued legal and economic operation of the Premises and the Improvements in a Commercially Viable manner; (vi) Beneficiary shall have received such surety bonds, completion guaranties and other assurances as Beneficiary shall reasonably require with respect to the completion of the Work; and (vii) no Event of Default shall exist under this Deed of Trust. Provided Grantor has satisfied the conditions in clauses (i) - (vii) above and continues to satisfy such conditions throughout the entire course of the Work, Beneficiary shall reimburse Grantor, or, at Beneficiary's option, make payments jointly to Grantor and such Contractors, from time to time as the Work progresses, but in no event more than once per calendar month and with a retainage equal to ten percent (10%) of the portion of each disbursement applicable to Hard Costs, within ten (10) days following satisfaction of the last of such conditions to be satisfied, for costs incurred by Grantor with respect to the Work. If any excess proceeds remain after the Work is completed and paid for in full out of such proceeds, such excess proceeds shall be retained by Beneficiary and applied as follows: (I)If such excess proceeds shall be received within the first two (2) years following the Funding Date, such excess proceeds shall be applied on the last day of the month in which received to the payment of a portion of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to the sum of (x) interest on the amount of such excess proceeds through and including the last day of the month in which the same shall be received, plus (y) the Yield Maintenance Amount calculated with respect to the amount of such excess proceeds. (II)If such excess proceeds shall be received during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), such excess proceeds shall be deposited in the Cash Reserve when received. In such event and upon such receipt, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to interest on the amount of such excess proceeds through and including the last day of the month in which the First Permitted Prepayment Date occurs which amount will also be deposited in the Cash Reserve when received. (III)If such excess proceeds shall be received at any time on or after the First Permitted Prepayment Date, such excess proceeds shall be applied on the last day of the month in which received to the payment of a portion of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to the sum of (x) interest on the amount of such excess proceeds through and including the last day of the month in which the same shall be received, plus (y) the applicable prepayment penalty, if any, required pursuant to the Note, calculated with respect to the amount of such excess proceeds. In the event only a portion of the Premises and the Improvements is to be restored, the allocable portion of the proceeds required for such Work, as determined by Beneficiary, shall be applied to such Work as contemplated above, with the balance of such proceeds to be retained by Beneficiary and applied in the manner set forth above in the immediately preceding three (3) paragraphs of this Section 2.15(b). Interest, if any, earned on condemnation award proceeds while held by Beneficiary shall be added to the amount of such proceeds. If any of the foregoing conditions to the advance of condemnation award proceeds for the Work are not satisfied at any time, Beneficiary shall have the option at any time thereafter to apply such condemnation award proceeds, regardless of the rate of interest payable on the award by the condemning authority, in the manner set forth in paragraph (e) of this Section 2.15; provided, however, that so long as there is no Event of Default hereunder, Beneficiary shall not apply such proceeds without first giving Grantor written notice, after which Grantor shall have thirty (30) days to cure any unsatisfied conditions set forth in clauses (i) -(vi) above and provided, further, that in the event such unsatisfied condition is susceptible to cure but cannot with due diligence be cured by the payment of money or otherwise within such thirty (30) day period, Grantor shall have such longer period (unless Beneficiary determines that delay in effecting such cure would have a material adverse impact on Beneficiary or the Mortgaged Property), but not to exceed one hundred twenty (120) days, as is required for Grantor to diligently cure such unsatisfied condition, provided that Grantor first notifies Beneficiary of its intention to cure such unsatisfied condition and actually commences the cure of such unsatisfied condition within the initial thirty (30) day period and at all times thereafter diligently prosecutes the cure of such unsatisfied condition with all due diligence to completion. (c) [RESERVED] (d) In the event that (i) Grantor shall determine in its good faith judgment after any taking of a portion of the Premises or the Improvements, which determination is not disputed in good faith by Beneficiary, that such taking was so extensive as to make continued operation of the remainder thereof not Commercially Viable or (ii) after any taking Grantor fails to undertake or complete the Work, but is unable to satisfy Beneficiary that the Work is not Commercially Viable in Beneficiary's reasonable judgment then: (I)If the taking occurs at any time within the first two (2) years following the Funding Date, all of the Secured Obligations shall become due and payable on the last day of the month in which all condemnation award proceeds in respect of such taking are received, and such condemnation award proceeds shall be paid over to Beneficiary and applied on such last day of the month in payment of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of such month, (C) the Yield Maintenance Amount calculated with respect to the unpaid principal balance of the Note, and (D) all other Secured Obligations, if any, exceeds (y) the amount of such condemnation award proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (D) of this clause (I) shall be applied in payment of the respective obligations described in such subclauses. (II)If the taking occurs at any time during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), such condemnation award proceeds shall be paid over to Beneficiary and deposited in the Cash Reserve. In such event and upon the receipt of all such condemnation award proceeds, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of the month in which the First Permitted Prepayment Date occurs, and (C) all other Secured Obligations, if any, exceeds (y) the amount of such condemnation award proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (C) of this clause (II) shall be deposited in the Cash Reserve, to be used and applied as provided in the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable. (III)If the taking occurs at any time on or after the First Permitted Prepayment Date, all of the Secured Obligations shall become due and payable on the last day of the month in which all condemnation award proceeds in respect of such taking are received, and such condemnation award proceeds shall be paid over to Beneficiary and applied on such last day of the month in payment of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of such month, (C) the applicable prepayment penalty, if any, required pursuant to the Note, and (D) all other Secured Obligations, if any, exceeds (y) the amount of such condemnation award proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (D) of this clause (III) shall be applied in payment of the respective obligations described in such subclauses. (e) [Reserved] (f) In the event that (i) Grantor seeks and elects to fully restore the remaining portion of the Premises and the Improvements (or a discrete part thereof) and makes a good faith showing that the restoration and operation of such remaining portion of the Premises and the Improvements (or such part thereof) would be Commercially Viable and that Grantor has the resources to reconstruct and operate such remaining portion or such part thereof), and (ii) Beneficiary nonetheless shall require that condemnation award proceeds be held for payment of the debt and not made available for such restoration after having made a determination in its good faith judgment after any taking that the taking of a portion of the Premises or the Improvements was so extensive as to make continued operation of the remainder thereof (or of a part of such remainder) not Commercially Viable, all such condemnation award proceeds (or, where Grantor's showing and Beneficiary's determination relate to a discrete part of such remainder, such portion of the condemnation award proceeds as Beneficiary shall allocate to such part of such remainder, as well as such portion of the condemnation award proceeds as Beneficiary shall allocate to the portion of the Premises and the Improvements that shall have been taken) shall be paid over to Beneficiary and applied in payment of the Secured Obligations, and Grantor shall not be permitted to restore the remaining portion of the Premises or the Improvements (or such discrete part thereof) so long as this Deed of Trust is in effect, but shall be obligated to prepay the Note (or, in the case of a part of the remaining portion of the Premises and the Improvements, to make a prepayment of a portion of the principal balance of the Note) and obtain a release of this Deed of Trust in accordance with Section 7.06 hereof (or a release of the lien of this Deed of Trust from the discrete part of the remaining portion of the Premises and the Improvements not being restored if Beneficiary determines that such partial release is practicable by paying to Beneficiary (in addition to Beneficiary's receipt of all such proceeds that Beneficiary shall have allocated to the portion of the Premises and the Improvements not being restored, as well as such portion of the condemnation award proceeds as Beneficiary shall have allocated to the portion of the Premises and the Improvements that shall have been taken) the following: (I)In the case where Grantor's good faith showing and Beneficiary's determination relate to all of the remainder of the Premises and the Improvements, the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of the month in which the amount described in the immediately preceding clause (A) is paid, and (C) all other Secured Obligations, if any, exceeds (y) the amount of condemnation award proceeds in respect of such taking received by Beneficiary. Beneficiary shall apply the several amounts described in subclauses (A) through (C) of this clause (I) in payment of the respective obligations described in such subclauses. (II)In the case where Grantor's good faith showing and Beneficiary's determination relate to a discrete part of the remainder of the Premises and the Improvements, interest on the amount of condemnation award proceeds applied in reduction of the Secured Obligations through and including the last day of the month in which such proceeds shall be so applied in reduction of the Secured Obligations. Beneficiary shall apply the amount of such interest in reduction of the Secured Obligations. In the limited situation described in this paragraph (f), no Yield Maintenance Amount and no prepayment penalty shall be due and payable. (g)Notwithstanding any taking by public or quasi-public authority through eminent domain or otherwise, Grantor agrees to continue to pay all amounts due in respect of the Secured Obligations, which shall not be reduced until any award or payment therefor shall have been actually received by Beneficiary and applied to the discharge of the Secured Obligations. No application of the proceeds of any award for condemnation or payments in lieu thereof to the reduction of the Secured Obligations shall have the effect of releasing the lien of this Deed of Trust from the portion, if any, of the Mortgaged Property not taken until and unless all of the Secured Obligations have been paid in full. (h)In the event of any temporary taking of the Mortgaged Property or any portion thereof in condemnation or by eminent domain, Grantor shall continue to pay all principal, interest and other Secured Obligations when due and payable under the Note and the other Loan Documents whether or not the proceeds of any award for such temporary taking are applied pursuant to the terms of this paragraph (h) to the prepayment of the Note and the payment of the other Secured Obligations. Unless an Event of Default exists hereunder in which case Beneficiary shall be free to apply such proceeds to the Secured Obligations in such order and priority as Beneficiary shall determine, Grantor shall receive the proceeds of such award for a temporary taking; provided, however, that if any award payable to Grantor on account of such taking is made in a lump sum or is payable other than in equal monthly installments over the term of the temporary taking, then, if but only if, no Event of Default exists hereunder, the award shall be paid over to Beneficiary (who shall hold the same in Permitted Investments) and applied by Beneficiary to the payment of each monthly installment of interest and principal due under the Note and all of the other Secured Obligations as and when the same become due and payable. The excess (if any) of such award received by Beneficiary over such monthly installment of interest and other Secured Obligations falling due for the entire period with respect to which such award was paid shall, monthly, be paid to or on behalf of Grantor for use solely in paying, with respect to the Premises and the Improvements, real estate and personal property taxes, insurance premiums, labor charges, repairs, utilities, accounting and legal expenses and other operating expenses; and provided further, that any unapplied portion of such award held by Beneficiary when such taking ceases or expires, or after all of the Secured Obligations shall have been paid in full (whichever first occurs), plus any interest accrued thereon, shall be repaid to Grantor. If while the proceeds of any such award are held by Beneficiary an Event of Default shall have occurred and be continuing, or Beneficiary shall have accelerated the Secured Obligations, Beneficiary may apply such proceeds in reduction of the Secured Obligations in such order and priority as Beneficiary shall determine. (i) Every reference to "condemnation award proceeds" or "proceeds" contained in this Section 2.15 shall be deemed to include payments in lieu thereof in any form. SECTION 2.16 Leases. (a) Grantor will not without Beneficiary's consent (i) execute an assignment of the Rents or any part thereof from the Premises or the Improvements; (ii) except where the lessee is in default thereunder, terminate or consent to the cancellation or surrender of any Lease of the Premises or the Improvements or of any part thereof, now existing or hereafter to be made, having an unexpired term of one (1) year or more, provided, however, that any Lease may be cancelled if either (A) promptly after the cancellation or surrender thereof a new Lease is entered into with a new lessee having a credit standing, in the reasonable judgment of Beneficiary, at least equivalent to that of the lessee whose Lease was cancelled, and which new Lease, taken as a whole, is on not less favorable terms than the terminated or cancelled Lease or (B)(I) no Event of Default exists hereunder, (II) such Lease demises no more than ten percent (10%) of the net rentable area of the Improvements and accounts for no more than ten percent (10%) of the gross rents payable in respect of the Premises and the Improvements, (III) the tenant under such Lease is not an Affiliate of Grantor, and (IV) such termination, cancellation or surrender is at arm's length and is commercially reasonable and compatible with good leasing practices for similar first class properties in the jurisdiction in which the Premises are located and occurs in the ordinary course of Grantor's business as an owner and operator of the Premises and the Improvements; (iii) modify any such Lease so as to shorten the unexpired term thereof or so as to decrease, waive or compromise in any manner the amount of the Rents payable thereunder or materially expand the obligations of the lessor thereunder; provided, however, that Grantor may modify any Lease without Beneficiary's consent so long as (A) the conditions described in subclauses (I), (II) and (III) of clause (ii) above shall have been satisfied and (B) the modification of such Lease is at arms' length and is commercially reasonable and compatible with good leasing practices for similar first class properties in the jurisdiction in which the Premises are located and occurs in the ordinary course of Grantor's business as an owner and operator of the Premises and the Improvements; (iv) accept prepayments of any installments of Rents to become due under such Leases, except prepayments in the nature of security for the performance of the lessees thereunder-; (v) modify, release or terminate any guaranties of any such Lease unless Grantor has the right to modify or terminate such Lease, or (vi) in any other manner impair the value of the Mortgaged Property or the security of this Deed of Trust. In all events, Grantor shall furnish to Beneficiary copies of all Leases hereafter entered into, as well as copies of all documents effecting the modification, release, cancellation, termination, or surrender of any Lease or of any guaranty of any Lease promptly after the execution thereof. Grantor represents and warrants to Beneficiary that no rent has been paid by any person in possession of any portion of the Premises or the Improvements for more than one installment in advance except for prepayments in the nature of security for the performance of the lessees thereunder as set forth on the rent roll heretofore delivered by Grantor to Beneficiary. Beneficiary hereby consents to any termination, cancellation, surrender or modification of any Lease under circumstances that satisfy the requirements of any of sub-clauses (A) and (B) of clause (ii) of this paragraph. No further consent of Beneficiary to any such termination, cancellation or surrender shall be required. (b) Grantor will not execute any Lease of all or a substantial portion of the Premises or the Improvements except for actual occupancy by the lessee thereunder, and will at all times promptly and faithfully perform, or cause to be performed, all of the covenants, conditions and agreements contained in all Leases of the Premises and the Improvements or portions thereof now or hereafter existing, on the part of the lessor thereunder to be kept and performed so as to assure that no lessee at any time has the legal right, as a result of Grantor's non-performance, to withhold any payments of rent required pursuant to its Lease or to terminate such Lease and will at all times do all things necessary to compel performance by the lessee under each Lease of all material obligations, covenants and agreements by such lessee to be performed thereunder. Each and every Lease of the Premises or the Improvements or any portion thereof hereafter executed shall (i) provide for the giving by the lessee of certificates with respect to the status of such Lease, and Grantor shall exercise its right to request such certificates within five (5) days of any demand therefor by Beneficiary, and (ii) grant Beneficiary the right to enter upon and inspect the leased premises pursuant to Section 2.30 hereof. (c) Each Lease of the Premises or the Improvements, or of any part thereof, hereafter executed shall provide that, in the event of the enforcement by Trustee or Beneficiary of the remedies provided for by law or by this Deed of Trust, the lessee thereunder will, upon request of any person succeeding to the interest of Grantor as a result of such enforcement, automatically become the lessee of said successor in interest, without change in the terms or other provisions of such Lease, provided, however, that said successor in interest shall not be (i) bound by any payment of rent or additional rent for more than one (1) month in advance, except prepayments in the nature of security for the performance by said lessee of its obligations under said Lease, (ii) bound by any amendment or modification of the Lease made in violation of Section 2.16(a) hereof without the consent of Beneficiary or such successor-in interest, (iii) liable for any act or omission of any previous lessor (including Grantor), (iv) subject to any offset, defense or counterclaim that such lessee might be entitled to assert against any previous lessor (including Grantor), or (v) liable for any deposit that such lessee may have given to any previous lessor (including Grantor) that has not, as such, been transferred to such successor in interest, unless such consent was not required pursuant to this Section 2.16. Each Lease shall also provide that, upon request by said successor in interest, such lessee shall execute and deliver an instrument or instruments confirming such attornment. (d) Beneficiary shall have the right to approve the form and substance of any and all Leases of the Premises or the Improvements before they are entered into except as set forth below, as well as the proposed standard form lease for the Improvements. Provided that there is no Event of Default hereunder, Grantor shall have the right, without Beneficiary's consent, to enter into Leases of the Improvements which comply with the following requirements: (i) such Lease shall be on the standard form of lease previously approved by Beneficiary for the Mortgaged Property without deviations other than those of a non-material nature; (ii) the term of such Lease, including all extension options, shall not be in excess of five (5) years unless such extension options provide for rent at the prevailing market rate as of the beginning of the option period; (iii) such Lease shall demise, including any expansion options, no more than ten percent (10%) of the net rentable area of the Improvements; (iv) rents payable under such Lease shall be no less than the fair market rent taking into account all aspects of the Lease; (v) such Lease shall be entered into with an arms-length tenant; (vi) the tenant under such Lease is restricted to a use which is compatible and consistent with the uses permitted under other Leases of the Improvements and such tenant's use does not violate an exclusive agreement contained in any other Lease of the Premises or the Improvements or cause such tenant or Lease to be subject to the approval of any other tenant unless such approval has been obtained in writing prior to the execution of such new Lease; and (vii) the terms of such Lease shall be otherwise in conformity with good leasing practices and shall be commercially reasonable for similar first class properties located in the jurisdiction in which the Premises are located. In the event Grantor enters into any Lease pursuant to this paragraph, Grantor shall, promptly following the execution of such Lease, forward to Beneficiary a copy of such Lease together with a mark-up of the approved standard form Lease showing any changes made to such form and a certification that the Lease complies in all respects with the guidelines described in clauses (i)-(vii) above. (e) In the event Grantor submits any proposed new lease, or modification, termination, surrender or cancellation of any existing Lease, to Beneficiary for Beneficiary's approval in accordance with the terms set forth above, Beneficiary shall be deemed to have consented to such proposed new lease, or modification, termination, surrender or cancellation of such existing Lease, as the case may be, if (i) Grantor shall have submitted to Beneficiary an accurate and complete written summary of the business terms relating to such new lease, or modification, termination, surrender or cancellation of any existing Lease, and shall have requested approval thereof by Beneficiary in writing in accordance with the notice provisions set forth in Section 7.03 hereof, (ii) Beneficiary shall have approved such terms or shall not have disapproved the same within ten (10) days after Beneficiary's receipt of such request for approval thereof, (iii) Grantor thereafter shall have submitted such proposed new lease, or modification, termination, surrender or cancellation of any existing Lease, to Beneficiary for Beneficiary's approval in accordance with the notice provisions set forth in Section 7.03 hereof, and (iv) Beneficiary shall not have disapproved the same within five (5) Business Days after Beneficiary's receipt of such request for approval thereof; provided that (x) the request for approval described in clause (i) of this paragraph (e) shall include the statement clearly marked at the top thereof reading as follows: "FAILURE TO RESPOND WITHIN TEN (10) DAYS FROM YOUR RECEIPT OF THIS NOTICE SHALL BE DEEMED YOUR APPROVAL OF THE MATTERS DESCRIBED IN THIS NOTICE", (y) the request approval described in clause (iii) of this paragraph (e) shall include the statement clearly marked at the top thereof reading as follows: "FAILURE TO RESPOND WITHIN FIVE (5) BUSINESS DAYS FROM YOUR RECEIPT OF THIS NOTICE SHALL BE DEEMED YOUR APPROVAL OF THE MATTERS DESCRIBED IN THIS NOTICE", and (z) the proposed new lease, or the modification, termination, surrender or cancellation of such existing Lease, as the case may be, is an arms' length transaction with a Person who is not an Affiliate of Grantor which conforms with good leasing practices and is commercially reasonable for similar first class properties located in the jurisdiction in which the Premises are located. (f) Grantor shall deliver to Beneficiary within thirty (30) days following the end of each calendar quarter during the term of the Loan a schedule of all Leases in effect as of the last day of such calendar quarter, which schedule shall be certified by Grantor and shall include the following: (i) the name of each tenant; (ii) the number of square feet of space affected by each tenant's Lease; (iii) the monthly and annual Rents, including base rent, additional rent, percentage rent, escalations, pass-through charges and any other kind of rent, under each Lease; (iv) the term of each Lease, including any extension and/or purchase options; and (v) the security deposit held under each Lease and the account in which such security deposit is being held, together with copies certified to be true and complete, of such Leases as shall be specified by Beneficiary. SECTION 2.17 Indemnification. Grantor will indemnify and hold Trustee and Beneficiary harmless against any loss or liability, cost or expense, including, without limitation, any judgments, attorney's fees, costs of appeal bonds and printing costs, arising out of or relating to any proceeding instituted by any claimant alleging a violation by Grantor of any applicable lien law. SECTION 2.18 Attorneys' Fees and Costs of Trustee and Beneficiary. Grantor agrees to pay, within ten (10) business days after demand by the Trustee or Beneficiary, all actual expenses incurred by the Trustee or Beneficiary, including without limitation attorneys' charges, disbursements and reasonable fees, in connection with the enforcement by the Trustee or Beneficiary of any of the Note, this Deed of Trust or any of the other Loan Documents or in connection with the performance of Trustee's duties hereunder. SECTION 2.19 Solvency. Grantor and each and every General Partner of Grantor is Solvent, and no bankruptcy, reorganization, insolvency or similar proceeding under any state or federal law with respect to Grantor or any such principal has been initiated. SECTION 2.20 Due Authorization. The execution and delivery of the Loan Documents by Grantor and performance by Grantor of its obligations thereunder have been duly authorized by all necessary corporate and/or partnership action on the part of Grantor and its constituent entities, and do not and will not violate any present or future law or any rule, regulation, ordinance, order, write, injunction or decree of any court or governmental or quasi-governmental body, agency or other instrumentality (collectively, "Governmental Authorities n ) or any other requirement of law applicable to Grantor or the Mortgaged Property (collectively, "Laws"), or result in a breach of any of the terms, conditions or provisions of, or constitute a default under, or (except as created by the Loan Documents) result in the creation or imposition of any lien of any nature whatsoever upon any of the assets of Grantor pursuant to the terms of any mortgage, deed of trust, indenture, agreement or instrument to which Grantor is a party or by which it or any of its properties is bound. All authorizations, consents and approvals of, notices to, registrations or filings with, or other actions in respect of or by any Governmental Authority, required in connection with the execution and delivery of the Loan Documents by the Grantor, and performance by Grantor of its obligations thereunder have been duly obtained, given or taken and are in full force and effect. SECTION 2.21 No Default. No default has occurred and is continuing beyond the expiration of any applicable grace period under any note, loan agreement, indenture or other material agreement or instrument to which Grantor is a party that would constitute an Event of Default hereunder. SECTION 2.22 Single Purpose Entity. Grantor is, and will, during the term of this Deed of Trust, continue to be, a single purpose entity and agrees that it will not hereafter acquire any property other than the Mortgaged Property in any jurisdiction without the consent of Beneficiary. Grantor, or if Grantor consists of more than one entity, each Grantor hereby represents and warrants to, and covenants with, Beneficiary that, until such time as the Secured Obligations shall be paid in full, Grantor or each such Grantor, as the case may be: (a) shall maintain its existence as a limited partnership duly organized, validly existing and in good standing as a limited partnership under the laws of a State of the United States of America and maintain its chief executive office and principal place of business in a State of the United States of America; (b) shall maintain (i) its chief executive office and principal place of business separate and apart from that of each corporate general partner, or, within thirty (30) days after the date hereof, enter into a lease with its corporate general partner for office space for the chief executive office and principal place of business of Grantor on the premises of the chief executive office and principal place of business of such corporate general partner pursuant to a written lease, and (ii) its chief executive office and principal place of business separate and apart from the domicile of each individual general partner; (c) shall maintain business operations that are independent of, and substantial in relation to, those of each general partner, principal and Affiliate and transact a substantial percentage of its business with entities that are separate from those with which each general partner, principal and Affiliate transacts its business, and, without limiting the generality of the foregoing, conduct its business solely in its own name in order not (i) to mislead others as to the entity with which such other party is transacting business or (ii) to suggest that Grantor is responsible for the debts of any general partner, principal or Affiliate; (d) shall characterize each general partner and Affiliate as a separate person or entity in any report, tax return, financial statement, other accounting or business transaction; (e) shall have Grantor authorize all partnership actions to the extent required by its Certificate of Limited Partnership and Limited Partnership Agreement; (f) shall receive fair consideration and reasonably equivalent value in exchange for any conveyance, transfer or obligation to or for the benefit of each general partner; (g) shall maintain record title to the Mortgaged Property in the name of Grantor, and in no event shall title to any of the Mortgaged Property be recorded in the name of any general partner, Affiliate or any other person or entity; (h) shall not make any conveyance or transfer or incur any obligation to or for the benefit of any general partner with any intent to hinder, delay or defraud any creditor of Grantor or of any general partner; (i) shall not make or incur any conveyance, transfer or obligation to or for the benefit of any general partner or Affiliate at any time when it may be Insolvent or as a result of which it may be rendered Insolvent, or engage in any business or transaction with any general partner or Affiliate after which the property remaining with Grantor will be an unreasonably small capital, or make or incur any such conveyance, transfer or obligation to or for the benefit of any general partner or Affiliate if it intends to incur, or believes that it would incur, debts that would be beyond the ability of Grantor to pay as such debts matured; (j) shall not take any action to dissolve and wind up Grantor or file any petition to take advantage of any applicable insolvency, bankruptcy, liquidation or reorganization statute, and shall not make an assignment for the benefit of its creditors or voluntarily suspend payment of any of its obligations prior to the repayment in full of the Secured Obligations and shall take all action necessary to preclude the dissolution and winding up of the Grantor and to obtain the dismissal of any involuntary petition filed under the federal bankruptcy code with respect to Grantor prior to the repayment in full of the Secured Obligations; (k) does not own and shall not own any asset other than (i) the Mortgaged Property, (ii) such incidental personal property necessary for the operation of the Mortgaged Property, and (iii) unencumbered cash or securities; (l) is not engaged and shall not engage in any business or activity other than in connection with the ownership, management or operation of the Property, and any such business transactions with any general partner or Affiliate shall be entered into upon terms and conditions that are intrinsically fair and substantially similar to those that would be available on an arms-length basis with third parties other than an Affiliate; (m) except for trade payables incurred in the ordinary course of business has not incurred and shall not incur any debt, secured or unsecured, direct or contingent (including guaranteeing any obligation), other than (i) the Secured Obligations, (ii) normal short-term obligations to trade creditors that are paid in the normal course of business when due and (iii) for customary advances by a general partner under Grantor's limited partnership agreement that, in the aggregate do not exceed ten percent (lO%) of the appraised value of the Mortgaged Property, or to any Affiliate or any creditor of any general partner or Affiliate; (n) is and shall be Solvent and pay its liabilities from its assets; (o) has done or caused to be done and shall do all things necessary to preserve its existence, shall not, nor shall any partner, limited or general, or shareholder hereof, amend, modify or otherwise change its partnership certificate or partnership agreement; (p) shall conduct and operate its business as presently conducted and operated; (q) does and shall maintain its partnership records, books of account and bank accounts separate and apart from those of its Affiliates, its general partners or any other person or entity; (r) shall maintain adequate capital for the normal obligations reasonably foreseeable in a business of its size and character and in light of its contemplated business transactions; and (s) shall not commingle its funds and other assets with those of any general partner, Affiliate or any other person or entity. SECTION 2.23 [RESERVED] SECTION 2.24 Compliance with Laws and Insurance Requirements. (a) Grantor, at its own sole cost and expense, shall promptly comply with all Laws, with all orders, rules and regulations (collectively, "Orders") of the National and Local Boards of Fire Underwriters or any other body or bodies exercising similar functions, with all restrictions and covenants of record, and with all conditions and requirements necessary to preserve and extend any and all rights, licenses, permits (including without limitation, all zoning variances, special exceptions and nonconforming uses), privileges, franchises and concessions, foreseen or unforeseen, ordinary as well as extraordinary, which may be applicable to the Mortgaged Property or any part thereof, or to the use or manner of use of the Mortgaged Property by the owners, tenants or occupants thereof, or any persons engaged in the operation or maintenance thereof, whether or not any such Laws or Orders shall necessitate structural changes or improvements or interfere with the use or enjoyment of the Mortgaged Property. Grantor shall also procure, pay for and maintain all permits, licenses, approvals and other authorizations, necessary for the operation of its business at the Premises and the lawful use and occupancy of the Premises and the Improvements, or any part thereof, in connection therewith. (b) Grantor shall, at its own sole cost and expense, observe and comply in all material respects with the requirements of the policies of public liability, fire and all other insurance at any time in force with respect to the Mortgaged Property, and Grantor shall, in the event of any violation or attempted violation of the provisions of this Section 2.24 by any occupant of any portion of the Premises or the Improvements, take steps, immediately upon actual knowledge of such violation or attempted violation, to remedy or prevent the same, as the case may be. (c) Grantor shall have the right, after notice to Beneficiary, to contest by appropriate legal proceedings, diligently conducted in good faith, in the name of Grantor, the validity or application of any Laws, Orders or other matters of the nature referred to in this Section 2.24 subject to the following: (i)If by the terms of any such Law or Order, compliance therewith pending the prosecution of any such proceeding may legally be delayed without subjecting Grantor, Trustee or Beneficiary to any liability (other than for the payment or accrual of interest), civil or criminal, for failure so to comply therewith, or (ii)if any lien, charge or civil liability would be incurred by reason of any such delay, the same would not subject the Mortgaged Property or any part thereof to forfeiture, loss or suspension of operations, and Grantor (a) furnishes Trustee and Beneficiary security satisfactory to Beneficiary against any loss or injury by reason of such contest or delay, and (b) prosecutes the contest with due diligence, then Grantor may delay compliance therewith until the final determination of any such proceeding. Grantor covenants that Trustee and Beneficiary shall not suffer or sustain-any liabilities or expenses by reason of any act or thing done or omitted to be done by Grantor pursuant to this paragraph (c) and that Grantor shall indemnify and hold harmless Trustee and Beneficiary from any such liability or expense. SECTION 2.25 Discharge of Liens. Grantor will pay, from time to time when the same shall become due, all lawful claims and demands of mechanics, materialmen, laborers, and others which, if unpaid, might result in, or permit the creation of, a Lien on the Mortgaged Property or any part thereof, or on the revenues, rents, royalties, issues, income and profits arising therefrom and in general will do or cause to be done everything necessary so that the lien hereof shall be fully preserved, at the sole cost and expense of Grantor and without expense to Trustee or Beneficiary. If any such Liens are filed, Grantor will cause the same to be permanently discharged of record by payment or otherwise, unless Grantor shall in good faith and at its own expense, be contesting such Lien or Liens or the validity thereof by appropriate legal proceedings which shall operate to prevent the collection thereof or other realization thereon or the sale or forfeiture of the Mortgaged Property, or any part thereof to satisfy the same; provided that during such contest Grantor shall provide an indemnity bond or other security reasonably satisfactory to Beneficiary to cover the amount of the contested item or items and the amount of the interest and penalties covering the period through which such proceedings may be expected to last, and in any event assuring the discharge of Grantor's obligation hereunder and of any additional charge, penalty or expense arising from or incurred as a result of such contest; and if Grantor shall have posted a bond as security against payment of any such Lien, interest, penalties and other charges related thereto, Beneficiary shall be named as an additional obligee under the bond. Except as provided above, Grantor will not directly or indirectly create, incur or suffer to exist any Lien on the Mortgaged Property or any part thereof (including without limitation any Lien securing the repayment of a loan made to Grantor by any partner(s), shareholder(s), officer(s), director(s) or trustee(s) of Grantor), whether or not junior to the lien of this Deed of Trust, other than the Permitted Exceptions, and as may be permitted by such other documents approved by Beneficiary as may be executed as further security for the Note or in favor of Beneficiary. SECTION 2.26 Contest of Impositions. Nothing in Section 2.07 hereof shall require the payment or discharge of any Imposition so long as Grantor shall in good faith and at its own expense, after giving notice to Beneficiary of its intention to do so, contest the same or the validity thereof by appropriate legal proceedings which shall operate to prevent the collection thereof or other realization thereon and the sale or forfeiture of the Mortgaged Property, or any part thereof, to satisfy the same; provided that during such contest Grantor shall provide security satisfactory to Beneficiary to cover the amount of the contested item or items and the amount of the interest and penalties covering the period through which such proceedings may be expected to last, and, in any event, assuring the discharge of Grantor's obligation hereunder and of any additional charge, penalty or expense arising from or incurred as a result of such contest; and provided further, that if at any time payment of any Imposition shall become necessary to prevent the delivery of a tax deed conveying the Mortgaged Property or any part thereof because of non-payment, then Grantor shall pay the same in sufficient time to prevent the delivery of such tax deed. If Grantor shall have posted a bond as security against payment of any Imposition, interest, penalties and other charges related thereto, Beneficiary shall be named as an additional obligee under the bond. If Grantor fails to prosecute any such contest with due diligence or fails to maintain sufficient funds or security on deposit as hereinabove provided, Beneficiary may, at its option, within ten (10) days following Beneficiary's written notice to Grantor (or such shorter period of time necessary in Beneficiary's opinion to prevent the collection of Impositions or the sale or forfeiture of the Premises or the Improvements or any part thereof or interest therein), apply the monies and liquidate any securities deposited with Beneficiary, in payment of, or on account of, such Impositions, or any portion thereof then unpaid, including all penalties and interest thereon. If the amount of the money and any such security so deposited is insufficient for the payment in full of such Impositions, together with all penalties and interest thereon, Grantor shall forthwith, upon demand, either deposit with Beneficiary a sum that, when added to such funds then on deposit, is sufficient to make such payment in full, or, if Beneficiary has applied funds on deposit on account of such Impositions, restore such deposit to an amount satisfactory to Beneficiary. Provided that Grantor is not then in default hereunder, Beneficiary shall, if so requested in writing by Grantor, after final disposition of such contest and upon Grantor's delivery to Beneficiary of an official bill for such Impositions, apply the money or security so deposited in full payment of such Impositions or that part thereof then unpaid, together with all penalties and interest thereon and return any excess to Grantor, unless Grantor has paid all such Impositions, together with all penalties and interest thereon, and has provided Beneficiary with evidence reasonably satisfactory to Beneficiary of such payment, in which event Beneficiary shall return such money or security to Grantor. All money held by Beneficiary pursuant to this Section 2.26 shall not be held in trust by Beneficiary and shall be held without any allowance of interest thereon. SECTION 2.27 Use of Mortgaged Property. Grantor will maintain, preserve and renew, from time to time, such rights of way, easements, grants, privileges, licenses and franchises as are necessary for the use and operation of the Mortgaged Property in the manner heretofore used and operated, and will not use or operate, or permit the use or operation of, the Mortgaged Property for any other purpose, initiate, join in or consent to any new private restrictive covenant (apart from any Permitted Exception), easement or other public or private restrictions to the use of the Mortgaged Property, without the consent in each instance of Beneficiary. Grantor shall, however, comply in all material respects with all lawful restrictive covenants which may at any time affect the Mortgaged Property and with zoning ordinances and other private and public restrictions as to the use thereof, and Grantor represents and warrants that the Mortgaged Property is in complete compliance with all such restrictive covenants and zoning ordinances and other private and public restrictions affecting the use thereof. Grantor will not cause or maintain any nuisance in, at or on the Mortgaged Property. Grantor will pay or cause to be paid all charges for all public and private utility services, all public and private rail and highway services (if any), all public and private communications services and all sprinkler systems and protective services at any time rendered to, or in connection with, the Mortgaged Property or any part thereof, will comply in all material respects, or use reasonable efforts to cause compliance with, all contracts relating to any such services, and will do all other things required for the maintenance and continuance of all such services. SECTION 2.28 [RESERVED] SECTION 2.29 Maintenance of Personal Property. Grantor shall cause the Improvements to be equipped with the Personal Property, to the extent and in the manner as shall be necessary, appropriate or required for the operation of the Premises and the Improvements. Except where appropriate replacements, free of superior Liens, are immediately made of a value at least equal to the value of the Personal Property being removed, no Personal Property covered hereunder shall be removed from the Premises without the consent of Beneficiary. The Personal Property so disposed of shall be promptly replaced with Personal Property of the same character and of at least equal usefulness and quality. SECTION 2.30 General Right of Entry. Grantor agrees that it will permit Beneficiary and its agents and designees from time to time upon reasonable advance notice (not less than one business day) and during regular business hours (or upon occurrence of any emergency situation, without advance notice and at any time) to enter upon and inspect the Mortgaged Property to determine its compliance with the requirements of this Deed of Trust and the other Loan Documents and to ascertain its condition. SECTION 2.31 Separate Tax Lot. Grantor represents and warrants that the Premises are assessed for real estate tax purposes as a wholly independent tax lot, separate from any adjoining land or improvements not constituting a part of such lot and that the Premises do not include any land or improvements constituting part of a tax lot for property not encumbered by this Deed of Trust. SECTION 2.32 Limitations on Transfer. (a) Grantor hereby covenants and agrees that, except to the extent otherwise permitted herein, it will not, without the consent in each instance of Beneficiary, (i) convey, sell, assign, lease or otherwise transfer any interest of Grantor in the Mortgaged Property or any portion thereof, (ii) pledge, mortgage, hypothecate, place a deed of trust or other Lien on or otherwise encumber Grantor's interest in the Mortgaged Property or any portion thereof, (iii) permit the conveyance, sale, assignment, pledge, mortgage, hypothecation or other transfer or disposition, (except involuntarily by operation of law as the result of the death of a partner) either directly or indirectly or through one or more step transactions or transactions, of interests in Grantor or in the partners, shareholders, principals or trustees of Grantor or in the partners, shareholders, principals or trustees of such partners, shareholders, principals or trustees, or any portion thereof, except that limited partnership interests and non-controlling stock interests in entities other than Grantor may be transferred, or (iv) enter into or permit to be entered into any agreement or arrangement to do any of the foregoing (each of the aforesaid acts referred to in clauses (i) through (iv) above being referred to herein as a "Transfer"). Any conveyance, sale, assignment, lease, pledge, mortgage, hypothecation, encumbrance or transfer deemed to be such by operation of Law shall also be deemed to be a Transfer. Any attempted Transfer in violation of this Section shall be void and of no force or effect. (b) Notwithstanding the foregoing, Beneficiary agrees that it will permit a single Transfer of Grantor's entire interest in the Mortgaged Property to a third party transferee subject to this Deed of Trust, so long as there is no Event of Default hereunder, if (i) such transferee meets underwriting standards of prudent institutional lenders as determined by Beneficiary, is not an Affiliate of Grantor and is a single-purpose entity that complies with the provisions of Section 2.22 hereof, (ii) the Transfer by Grantor to such transferee is made at arms' length, (iii) at the time of such Transfer, Beneficiary reasonably determines that (A) the Debt Service Coverage Ratio for the Loan based on the greater of (x) the interest rate then payable under the Note and (y) 2.80% per annum in excess of the average yield for Treasury Constant Maturities having a maturity of five (5) years, on the basis of yields reported -in H.15(519) or the applicable successor publication in effect for the week prior to the week in which Beneficiary makes such determination, is no less than 1.35:1 and (B) the loan-to-value ratio determined by dividing the then-current principal balance of the Note by the then-value of the Premises and the Improvements then constituting Mortgaged Property is no greater than seventy-five percent (75%) (each of which determinations shall be made by Beneficiary which determinations with respect to loan-to-value ratios , be made, at Beneficiary's option, on the basis of the amount of consideration to be paid by such third party transferee to Grantor or the amount indicated in a current appraisal performed by an appraiser selected by Beneficiary but at the sole cost and expense of Grantor) at the time of such Transfer), (iv) such transferee executes and delivers an assumption agreement with respect to the Note, this Deed of Trust and the other Loan Documents in form and substance satisfactory to Beneficiary, (v) such transferee delivers or causes to be delivered to Beneficiary such opinions of counsel with respect to the assumption and related matters as Beneficiary shall request, (vi) such transferee pays all counsel fees and other reasonable costs to third parties incurred by Beneficiary in connection with the Transfer and assumption, but in no event less than $5,000, (vii) such transferee deposits in the Loan Reserve the full amount required to be deposited therein upon such Transfer as set forth in Section 2.33 hereof, if any, (viii) such Transferee enters into a Transferee Cash Reserve Agreement as set forth in Section 2.34 hereof in a form acceptable to Beneficiary and (ix) Beneficiary acknowledges full compliance with all of the conditions set forth in the immediately preceding clauses (i) - (viii) in a document that is recorded in the same official records in which this Deed of Trust is recorded. In the event that Beneficiary determines that the aforesaid loan-to-value ratio set forth in subclause (B) above is greater than seventy-five percent (75%), or that the Debt Service Coverage Ratio is less than 1.35:1, then, such Transfer will nevertheless be permitted upon compliance with all of the requirements enumerated in all of clauses (i) through (ix) other than subclause (A) or (B), as applicable, of clause (iii) of this subparagraph of this subsection (b) if, in addition thereto, Grantor pays to Beneficiary (A) such amount (the "Principal Reduction Amount") as would be necessary to reduce the unpaid principal balance of the Note to an amount (I) that does not exceed seventy-five percent (75%) of the then value of the Premises and the Improvements then constituting Mortgaged Property as determined by Beneficiary and (II) which, if it were used to reduce the principal balance of the Note would result in a Debt Service Coverage Ratio of at least 1.35:1 for the Loan (as so reduced) and (B) the following: (I)if such Transfer is proposed to be consummated at any time within the first two (2) years following the Funding Date, the Yield Maintenance Amount calculated with respect to the Principal Reduction Amount; (II)if such Transfer is proposed to be consummated at any time within the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), interest on the Principal Reduction Amount through and including the last day of the month in which the First Permitted Prepayment Date occurs; and (III)if such Transfer is proposed to be consummated at any time on or after the First Permitted Prepayment Date, the applicable prepayment penalty, if any, required pursuant to the Note, calculated with respect to the Principal Reduction Amount, plus interest on the Principal Reduction Amount through and including the last day of the month in which the same shall be received. If the Principal Reduction Amount is paid at any time during the first two years following the Funding Date or at any time on or after the First Permitted Prepayment Date, it will be applied in reduction of the Secured Obligations on the last day of the month in which it is paid. If the Principal Reduction Amount is paid at any time during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), it will be deposited, together with the interest thereon paid pursuant to the immediately preceding clause (II), in the Cash Reserve, to be used and applied as provided in the Transferee Cash Reserve Agreement. Any Yield Maintenance Amount or prepayment penalty paid pursuant to this Section 2.32(b) shall be applied in payment of the obligation far which it is paid. Further notwithstanding Section 2.32(a) hereof and the preceding paragraph of this Section 2.32(b), Beneficiary agrees that it will permit a Carlyle Transfer (as defined below) or a JMB Transfer (as defined below), so long as there is no Event of Default hereunder, if (i) the transferee meets underwriting standards of prudent institutional lenders as to credit worthiness, as determined by Beneficiary, (ii) the transferee executes and delivers an assumption agreement with respect to the obligations of the transferor, if any, under the Note, this Deed of Trust and the other Loan Documents in form and substance reasonably satisfactory to Beneficiary, (iii) the transferee delivers or causes to be delivered to Beneficiary such opinions of counsel with respect to the assumption and related matters as Beneficiary shall request, (iv) the transferee pays all counsel fees and other reasonable costs to third parties incurred by Beneficiary in connection with the Transfer, but in no event less than $5,000, (v) the transferee deposits in the Loan Reserve the full amount required to be deposited therein upon such Transfer as set forth in section 2.33 hereof, if any, and (vi) Beneficiary acknowledges full compliance with all of the conditions set forth in the immediately preceding clauses (i) - (v) in a document that is recorded in the same official records in which this Deed of Trust is recorded. Further notwithstanding Section 2.32(a) hereof and the preceding paragraphs of this Section 2.32(b), Beneficiary agrees that it will permit a REIT Transfer (as defined below), so long as there is no Event of Default hereunder, if (i) the transferee meets underwriting standards of prudent institutional lenders as to credit worthiness, as determined by Beneficiary, (ii) at the time of such Transfer, Beneficiary reasonably determines that (A) the Debt Service Coverage Ratio for the Loan based on the greater of (x) the interest rate then payable under the Note and (y) 2.80% per annum in excess of the average yield for Treasury Constant Maturities having a maturity of five (5) years, on the basis of yields reported in H.15(519) or the applicable successor publication in effect for the week prior to the week in which Beneficiary makes such determination, is no less than 1.35:1 and (B) the loan-to-value ratio determined by dividing the then-current principal balance of the Note by the then-value of the Premises and the Improvements then constituting Mortgaged Property is no greater than seventy-five percent (75%) (each of which determinations shall be made by Beneficiary (which determination with respect to loan-to-value ratio shall be made on the basis of the amount indicated in a current appraisal performed by an appraiser selected by Beneficiary but at the sole cost and expense of the transferor) at the time of such Transfer), (iii) the transferee executes and delivers an assumption agreement with respect to the obligations of the transferor, if any, under the Note, this Deed of Trust and the other Loan Documents in form and substance satisfactory to Beneficiary, (iv) the transferee delivers or causes to be delivered to Beneficiary such opinions of counsel with respect to the assumption and related matters as Beneficiary shall request, (v) the transferee pays all counsel fees and other reasonable costs to third parties incurred by Beneficiary in connection with the Transfer, but in no event less than $5,000, (vi) the transferee deposits in the Loan Reserve the full amount required to be deposited therein upon such Transfer as set forth in Section 2.33 hereof, if any, (vii) such Transferee enters into a Transferee Cash Reserve Agreement as set forth in Section 2.34 hereof in a form acceptable to Beneficiary and (viii) Beneficiary acknowledges full compliance with all of the conditions set forth in the immediately preceding clauses (i) - (vii) in a document that is recorded in the same official records in which this Deed of Trust is recorded. In the event that Beneficiary determines that the aforesaid loan-to-value ratio set forth in subclause (B) above is greater than seventy-five percent (75%), or that the Debt Service Coverage Ratio is less than 1.35:1, then, such Transfer will nevertheless be permitted upon compliance with all of the requirements enumerated in all of clauses (i) through (viii) other than subclause (A) or (B), as applicable, of clause (ii) of this subparagraph of this subsection (b) if, in addition thereto, (A) Grantor pays to Beneficiary such amount (the "Principal Reduction Amount") as would be necessary to reduce the unpaid principal balance of the Note to an amount (I) that does not exceed seventy-five percent (75%) of the then value of the Premises and the Improvements then constituting Mortgaged Property as determined by Beneficiary and (II) which, if it were used to reduce the principal balance of the Note would result in a Debt Service Coverage Ratio of at least 1.35:1 for the Loan (as so reduced), and (B) the following: (I)if such Transfer is proposed to be consummated at any time within the first two (2) years following the Funding Date, the Yield Maintenance Amount calculated with respect to the Principal Reduction Amount; (II)if such Transfer is proposed to be consummated at any time within the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), interest on the Principal Reduction Amount through and including the last day of the month in which the First Permitted Prepayment Date occurs; and (III)if such Transfer is proposed to be consummated at any time on or after the First Permitted Prepayment Date, the applicable prepayment penalty, if any, required pursuant to the Note, calculated with respect to the Principal Reduction Amount, plus interest on the Principal Reduction Amount through and including the last day of the month in which the same shall be received. If the Principal Reduction Amount is paid at any time during the first two years following the Funding Date or at any time on or after the First Permitted Prepayment Date, it will be applied in reduction of the Secured Obligations on the last day of the month in which it is paid. If the Principal Reduction Amount is paid at any time during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), it will be deposited, together with the interest thereon paid pursuant to the immediately preceding clause (II), in the Cash Reserve, to be used and applied as provided in the Transferee Cash Reserve Agreement. Any Yield Maintenance Amount or prepayment penalty paid pursuant to this Section 2.32(b) shall be applied in payment of the obligation for which it is paid. For the purposes of this Section 2.32(b), a "Carlyle Transfer" shall mean a single Transfer of all or any part of Carlyle partnership interest in the Grantor to a third party transferee, so long as The John Akridge Company remains a general partner of the Grantor and is or becomes the managing general partner of Grantor and the Akridge Group owns an aggregate of 50% of the general and limited partnership interests in the Grantor. For the purposes of this Section 2.32(b), a "JMB Transfer" shall mean either (i) a single Transfer of all or any part of any partnership interest in Carlyle held by JMB or any JMB Approved Transferee (as defined below) to any person, firm or entity other than JMB or a JMB Approved Transferee or (ii) a single Transfer of any stock in JMB to any person, firm or entity other than to a current shareholder in JMB or a JMB Approved Transferee if such Transfer, either alone or when taken together with any previous Transfers of JMB stock permitted under Section 2.32(d) hereof, would result in a Transfer of a controlling stock interest in JMB, so long as, in either case, The John Akridge Company remains a general partner of the Grantor and is or becomes the managing general partner of Grantor and the Akridge Group owns an aggregate of 50% of the general and limited partnership interests in the Grantor. For the purposes of this Section 2.32(b), a "REIT Transfer" shall mean (i) a single Transfer of up to ninety-nine percent (99%) of the general and limited partnership interests in the Grantor to a publicly traded real estate investment trust ("REIT") or a master limited partnership controlled by a publicly traded REIT (a "Master Limited Partnership"), (ii) a single Transfer of the Grantor's entire interest in the Mortgaged Property to a publicly traded REIT or a Master Limited Partnership, or (iii) the merger of the Grantor into a publicly traded REIT or a Master Limited Partnership. (c) Further notwithstanding the foregoing provisions of this Section 2.32, (i) if the original Grantor is a limited partnership, limited partnership interests in the original Grantor aggregating not more than forty-nine percent (49%) of all partnership interests in the original Grantor may be transferred without Beneficiary's consent, and (ii) if the original Grantor is a corporation, shares of stock in the original Grantor aggregating not more than forty-nine percent (49%) of all the issued and outstanding stock in the original Grantor may be transferred without Beneficiary's consent, (iii) either Carlyle or the Akridge Group may transfer all or any part of its partnership interest in Grantor to the other so long as Beneficiary is given prior written notice of such Transfer and, in the event of such a Transfer to the Akridge Group, after such Transfer, the constituent members of the Akridge Group hold the same types of interests (i.e., general or limited partnership interests) in the Grantor as each holds as of the date hereof and hold such interests in the proportions to one another as each holds as of the date hereof (except that The John Akridge Company and/or John E. Akridge III, may hold proportionately greater interests than they hold as of the date hereof), (iv) Grantor may transfer its interest in the Mortgaged Property (in whole but not in part) to either Carlyle or the Akridge Group or to an entity formed by the Akridge Group so long as Beneficiary is given prior written notice of such Transfer, and, in the event of such a Transfer to an entity formed by the Akridge Group, after such Transfer, the constituent members of the Akridge Group hold the same types of interests (i.e. general or limited partnership interests) in such entity as each holds in the Grantor as of the date hereof and hold such interests in proportions to one another as each holds as of the date hereof (except that The John Akridge Company and/or John E. Akridge III, may hold proportionately greater interests than they hold as of the date hereof). (d) Further notwithstanding the foregoing provisions of this Section 2.32, so long as the constituent members of the Akridge Group hold the same types of interests (i.e., general or limited partnership interests) in the Grantor as each holds as of the date hereof and hold such interests in the same proportions to one another as each holds as of the date hereof (except that The John Akridge Company and/or John E. Akridge III, may hold proportionately greater interests than they hold as of the date hereof): (i) any and all of Realty Associates' partnership interests in Carlyle may be transferred without Beneficiary's consent; (ii) subject to the requirements of Section 2.32(b) above with respect to a JMB Transfer, stock in JMB may be transferred without Beneficiary's consent so long as Beneficiary is given written notice at any time at which an aggregate of ten percent (10%) of the stock in JMB has been transferred since the later of (A) the date hereof and (B) the date of any prior notice of any transfer of JMB stock under this clause or (C) any JMB Transfer; (iii) any and all partnership interests in Realty Associates may be transferred without Beneficiary's consent; (iv) so long as Beneficiary is given prior written notice of such transfer, JMB may, without Beneficiary's consent, transfer all or any part of its partnership interest in Carlyle to any JMB Approved Transferee; and (v) so long as Beneficiary is given prior written notice of such transfer, Carlyle may, without Beneficiary's consent, transfer all or any part of its partnership interest in Grantor to JMB or any JMB Approved Transferee. For the purposes of this Section 2.32(d), a "JMB Approved Transferee" means any one or more of the following: (i) an "affiliate" or subsidiary of JMB or (ii) a general or limited partnership in which JMB or an "affiliate" or subsidiary of JMB is a general partner. As used herein, an affiliate of JMB includes any corporation in which JMB or its shareholders, individually or collectively, own or control, directly or indirectly, more than 50% of the common stock. (e) Any transferee under any Transfer as to which all of the conditions-of this Section 2.32 with respect to such Transfer are satisfied is hereinafter referred to as a "Permitted Transferee". SECTION 2.33 Loan Reserve. (a) Grantor shall pay to Beneficiary on the Funding Date the amount set forth as the Initial Deposit Amount on Schedule B annexed hereto and made a part hereof for deposit into a reserve (the "Loan Reserve") to be used as hereinafter provided. Thereafter, commencing on the first day of the first month after the month in which the Funding Date occurs and on the first day of each subsequent month, Grantor shall deposit into the Loan Reserve an amount equal to the lesser of the amount set forth as the Monthly Deposit Amount (the "Monthly Deposit") on Schedule B or the Excess Cash Flow with respect to the immediately preceding month into the Loan Reserve. Upon any Transfer of Grantor's interest in the Mortgaged Property to a Permitted Transferee in accordance with Section 2.32(b) hereof, the Permitted Transferee shall pay to the Beneficiary, for deposit into the Loan Reserve, that amount, if any, which, when added to the existing balance of the Loan Reserve at the time of the Transfer, will increase the balance of the Loan Reserve to an amount equal to the sum of (i) the Initial Deposit Amount, plus (ii) an amount equal to the product of (A) the Monthly Deposit set forth on Schedule B hereto and (B) the number of months that have elapsed from (and including) the first month after the month in which the Funding Date falls until the first day of the month in which the Transfer occurs; provided, however, that the Permitted Transferee shall in no event be obligated to pay to Beneficiary at the time of the Transfer an amount in excess of the amount which would cause the Loan Reserve balance to exceed the amount of total debt service on the Note for a period of one (1) year. The Loan Reserve shall constitute additional collateral for the Secured Obligations and may be applied by Beneficiary, at its option, following an Event of Default hereunder, to any of the Secured Obligations in such order and priority as Beneficiary shall determine. The parties intend that this Deed of Trust shall constitute a security agreement with respect to the Loan Reserve and all funds deposited therein. Nevertheless, at Beneficiary's request, the Permitted Transferee shall be required to execute and deliver such further instrument as Beneficiary may reasonably require to assure the continuing perfection of its security interest in the Loan Reserve and the funds deposited therein. (b) If Beneficiary at any time reasonably determines that the net cash flow generated by or in respect of the Mortgaged Property during the immediately preceding twelve (12) calendar months is insufficient to pay any or all of the debt service on the Note, operating expenses, or necessary leasing or capital costs with respect to the Mortgaged Property, or if Grantor delivers to Beneficiary financial statements reflecting such insufficiency, together with a budget with respect to the expenditure of funds for any one or more of such purposes and Grantor's certification as to the lack of available funds to cover such expenditures, Beneficiary shall, provided such certification is consistent with such financial statements, from time to time, (i) in response to Grantor's request, but only to the extent of the deficiency as determined by Beneficiary, unless Grantor shall have delivered such financial statements, in which event the extent of such deficiency shall be as reflected in such financial statements, release funds in the Loan Reserve to pay for (x) tenant improvements costs, concessions, leasing commissions and other expenses incurred by Grantor in connection with the leasing and re-leasing of the Improvements, or (y) costs attributable to replacement of or capital repairs to mechanical systems and structural elements of the Improvements and for other capital costs in connection with the maintenance of the Mortgaged Property or to reimburse Grantor for such costs, but, in all events, only to the extent such costs are not otherwise reimbursable to Grantor under Leases, and (ii) either on its own initiative or in response to Grantor's request, release funds in the Loan Reserve, but only to the extent of such deficiency, to pay debt service on the Note. Each request by Grantor for a disbursement of funds in the Loan Reserve shall (A) be accompanied by such reports, invoices, receipts, financial statements and other documentation as Beneficiary may request, (B) be subject to Beneficiary's approval of all such documentation and the absence of any Event of Default under this Deed of Trust, and (C) in the case of Grantor's request for a disbursement in respect of debt service on the Note, evidence satisfactory to Grantor that the use of such funds in respect of debt service on the Note will not materially adversely affect the ability of Grantor to pay for anticipated leasing and capital costs for the next succeeding twelve (12) months. (c) At such time as Beneficiary determines that the balance of the funds in the Loan Reserve is equal to or greater than the amount set forth on Schedule B as the Maximum Amount (the "Maximum Amount"), Grantor's obligation to make Monthly Deposits into the Loan Reserve shall be suspended until such time, if any, as Beneficiary determines that the Loan Reserve has fallen below the Maximum Amount, at which time Grantor shall again be required to make payments to the Loan Reserve on a monthly basis in an amount equal to (x) the Monthly Deposit to the extent disbursements from the Loan Reserve have been made in respect of approved costs other than debt service on the Note and (y) the greater of the Monthly Deposit and the Excess Cash Flow to the extent disbursements from the Loan Reserve have been made in respect of debt service on the Note. To the extent that the cash flow in respect of the Mortgaged Property during any calendar month, after the payment of debt service on the Note, operating expenses and necessary leasing or capital costs approved by Beneficiary with respect to the Mortgaged Property (the "Required Payments") during such month is less than the amount required to be deposited into the Loan Reserve with respect to such month, Grantor's obligation to make such deposit with respect to such month shall be limited to an amount equal to the cash flow in respect of the Mortgaged Property net of the Required Payments (the "Excess Cash Flow") during such month plus an amount equal to all Excess Cash Flow received by Grantor during the immediately preceding twelve (12) months, less such portion thereof as shall already have been deposited in accordance with the requirements of this clause; provided, however, that any shortfall arising from the application of such limitation of the amount required to be deposited into the Loan Reserve with respect to such month shall accrue and be due and payable from the Excess Cash Flow in respect of the Mortgaged Property during each succeeding month until such shortfall has been reduced to zero and Grantor may not use or distribute any of the Excess Cash Flow in respect of the Mortgaged Property for any purpose other than the Required Payments until such shortfall has been reduced to zero. SECTION 2.34 Cash Reserve. (a) Grantor and Beneficiary, simultaneously with the execution of this Deed of Trust, shall enter into the Cash Reserve Agreement establishing the Cash Reserve. Principal Reduction Amounts, payments of prepayment penalties, casualty insurance proceeds, condemnation award proceeds, principal, interest and any other amounts if, and to the extent, required by any of the provisions of this Deed of Trust to be deposited in the Cash Reserve, shall be so deposited from time to time and shall be held and applied as provided in the Cash Reserve Agreement. Any amount held in the Cash Reserve that Beneficiary shall at any time have the right to apply against any of the Secured Obligations, may at any time or from time to time thereafter be released from the Cash Reserve and applied in reduction of any of the Secured Obligations, as provided in the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable. (b) If a Transfer shall occur in accordance with the provisions of Section 2.32 hereof, the Permitted Transferee, as successor in interest to Grantor, shall enter into a cash reserve agreement with Beneficiary substantially in the form of the Cash Reserve Agreement, with such conforming changes as Beneficiary shall require (the "Transferee Cash Reserve Agreement"), which Transferee Cash Reserve Agreement shall provide for the deposit in the Cash Reserve of any Principal Reduction Amount, prepayment penalty, casualty insurance proceeds, condemnation award proceeds, principal, interest and other amount required by any of the provisions of this Deed of Trust to be deposited in the Cash Reserve. Any payment required to be deposited in the Cash Reserve in connection with any such Transfer or at any time thereafter shall be deposited in the Cash Reserve established and maintained pursuant to the Transferee Cash Reserve Agreement. ARTICLE I I I SECURITY AGREMENT SECTION 3.01 Grant of Security Interest. Without limiting any of the other provisions of this Deed of Trust, Grantor, as debtor, expressly GRANTS unto Beneficiary, as secured party, a security interest in all the Mortgaged Property (including both that now and that hereafter existing) to the full extent that any portion of the Mortgaged Property may be subject to the Uniform Commercial Code as enacted in the jurisdiction in which the Premises are located (hereinafter referred to as the "Uniform Commercial Code"). This Deed of Trust is intended to be a security agreement for the purposes of the Uniform Commercial Code. SECTION 3.02 Covenants of Grantor. Grantor covenants and agrees with Beneficiary that: (a) Grantor is and will be the true and lawful owner of the Collateral, subject to no lien charges or encumbrances other than the lien hereof, other liens and encumbrances benefiting Beneficiary and no other party, and liens and encumbrances, if any, expressly permitted by this Deed of Trust or otherwise expressly consented to by Beneficiary. (b) Grantor represents that it is a duly constituted partnership or corporate entity as set forth above with a mailing address and a principal place of business as set forth above. Grantor has no other offices which constitute a principal place of business in the jurisdiction in which its principal place of business, as set forth above, is located, or a principal place of business in any other jurisdiction. (c) The Collateral is to be used by Grantor solely for business purposes. (d) All the Collateral consisting of tangible personal property (other than motor vehicles) will be kept at the Land and, except for Obsolete Collateral (as hereinafter defined), will not be removed therefrom without the consent of Beneficiary. The Collateral may be affixed to the Land or the improvements but will not be affixed to any other real estate. Grantor shall be permitted to sell or otherwise dispose of Collateral that is no longer useful in connection with the operation of the Premises or the Improvements (herein called "Obsolete Collateral"); provided that such Obsolete Collateral has been or is contemporaneously being replaced by Collateral of at least equal value and utility which is subject to the lien hereof with the same priority as with respect to the Obsolete Collateral. (e) The only persons having an interest in the Collateral are Grantor, Beneficiary and holders of interest, if any, expressly permitted hereby or otherwise expressly consented to in writing by Beneficiary . (f) In addition to any other remedies granted in this Deed of Trust to Beneficiary (including specifically, but not limited to, the right to proceed against those portions of the Mortgaged Property which are real property), Beneficiary may, should an Event of Default occur, proceed under the Uniform Commercial Code as to all or any part of the Mortgaged Property which is Collateral, and shall have and may exercise with respect to the Collateral all the rights, remedies, and powers of a secured party under the Uniform Commercial Code, including without limitation the right to take immediate and exclusive possession of the Collateral, or any part thereof, and for that purpose may, so far as Grantor can give authority therefor, with or without judicial process, enter (if this can be done without breach of the peace), upon any place on which the Collateral or any part thereof may be situated and remove the same therefrom (provided that if the Collateral is affixed to real estate, such removal shall be subject to the conditions stated in the Uniform Commercial Code) and the right and power to sell, at one or more public or private sales, or otherwise dispose of, lease, or utilize the Collateral and any part or parts thereof in any manner authorized or permitted under the Uniform Commercial Code after default by a debtor. Beneficiary shall be entitled to hold, maintain, preserve and prepare the Collateral for sale, until disposed of, or may propose to retain the Collateral subject to Grantor's right of redemption in satisfaction of Grantor's obligations, as provided in the Code. Beneficiary may render the Collateral unusable without removal and may dispose of the Collateral on the Premises. Beneficiary may require Grantor to assemble the Collateral and make it available to Beneficiary for its possession at a place in the county where the Premises are situated to be designated by Beneficiary. Beneficiary will give Grantor reasonable notice of the time and place of any public sale of the Collateral or of the time after which any private sale or any other intended disposition thereof is to be made. Without limiting the foregoing, Beneficiary shall have the right upon any such public sale or sales, and, to the extent permitted by law, upon any such private sale and sales, to purchase the whole or any part of the Collateral so sold, free of any right or equity of redemption in Grantor, whether on the Land or elsewhere. Grantor further agrees to allow Beneficiary to use and occupy the Mortgaged Property, without charge, for the purpose of effecting any of Beneficiary's remedies in respect of the Collateral. The net proceeds of any such collection, recovery, receipt, appropriation, realization or sale, after deducting all actual expenses of every kind incurred therein or incidental to the care, safekeeping or otherwise of any or all of the Collateral or in any way relating to the rights of Beneficiary hereunder, including all attorneys' charges, disbursements and reasonable fees, shall be received by Beneficiary and credited against the payment in whole or in part of the indebtedness secured hereby. To the extent permitted by applicable law, Grantor waives all claims, damages and demands against Beneficiary arising out of the repossession, retention or sale of the Collateral, except for claims, damages and demands due to the gross negligence or willful misconduct of Beneficiary in dealing with such Collateral. Grantor agrees that Beneficiary need not give more than ten (10) days' notice of the time and place or any public sale or of the time at which a private sale will take place and that such notice is commercially reasonable notification of such matters. (g) Grantor hereby authorizes Beneficiary to file financing and continuation statements with respect to the Collateral without the signature of Grantor whenever lawful, and Grantor irrevocably constitutes and appoints Beneficiary, acting by any of its officers, to the extent permitted by applicable law, as Grantor's attorney-in-fact to execute and deliver such financing statements and other documents as may be necessary or appropriate to establish and maintain a perfected security interest in the Collateral as security for the Secured Obligations, subject to no other liens or encumbrances, other than liens or encumbrances benefiting Beneficiary and no other party and liens and encumbrances (if any) expressly permitted by this Deed of Trust. The foregoing appointment of Beneficiary as attorney-in-fact for Grantor shall be deemed to be coupled with an interest and shall be irrevocable. Grantor agrees to execute such financing and continuation statements as Beneficiary may reasonably request. (h) Grantor hereby represents and warrants that no financing statement (other than financing statements showing Beneficiary as the sole secured party, or with respect to liens or encumbrances, if any, expressly permitted by this Deed of Trust or otherwise expressly consented to in writing by Beneficiary) covering any of the Collateral or any proceeds thereof is on file in any public office except pursuant hereto; and Grantor will at its own cost and expense, upon demand, furnish to Beneficiary such further information and will execute and deliver to Beneficiary such financing statements and other documents in form reasonably satisfactory to Beneficiary and will do all such acts as Beneficiary may at any time or from time to time reasonably request or as may be necessary or reasonably appropriate to establish and maintain a perfected security interest in the Collateral as security for the Secured Obligations, subject to no other liens or encumbrances, other than liens or encumbrances benefiting Beneficiary and no other party and to liens and encumbrances (if any) expressly permitted by this Deed of Trust; and Grantor will pay the actual expense of filing or recording such financing statements or other documents, and this instrument, in all public offices wherever filing or recording is reasonably deemed by Beneficiary to be desirable. (i) To the extent permitted by applicable law, the security interest created hereby is specifically intended to cover all rents, royalties, issues and profits, and all inventory accounts, accounts receivable and other revenues of the Mortgaged Property. (j) Certain of the Collateral is or will become "fixtures" (as that term is defined in the Uniform Commercial Code) on the Land and Improvements, and this Deed of Trust upon being filed for record in the real estate records of the jurisdiction in which the land is located shall operate also as a financing statement and fixture filing upon such of the Collateral which is or may become fixtures. (k) Any copy of this Deed of Trust which is signed by Grantor or any carbon, photographic or other reproduction of this Deed of Trust may also serve as a financing statement under the Uniform Commercial Code by Grantor, whose address is set forth hereinabove, in favor of Beneficiary, whose address is set forth hereinabove. ARTICLE IV ASSIGNMENT OF RENTS AND LEASES SECTION 4.01 Assignment. Simultaneously with the execution and delivery hereof, Grantor is executing and delivering to and for the benefit of Beneficiary a separate Assignment of Rents and Leases as further security for the payment and performance of the Secured Obligations. ARTICLE V EVENTS OF DEFAULT AND REMEDIES SECTION 5.01 Events of Default. It shall be an event of default ("Event of Default") if one or more of the following shall occur: (a) if (i) default shall be made in the payment of any installment of interest or principal due under the Note when and as the same shall become due and payable, whether at maturity or by acceleration or as part of any payment or prepayment or otherwise, in each case, as in the Note and this Deed of Trust provided and such default shall have continued for a period of ten (10) days or (ii) default shall be made in the payment of any Imposition required by Section 2.07 to be paid and said default shall have continued for a period of twenty (20) days; or (b) if at any time any representation or warranty made or deemed made under any Loan Document or any other document or certificate provided in connection with any Loan-Document or the Secured Obligations shall be proven to have been materially incorrect when made or deemed made, as the case may be; or (c) if Grantor shall suffer or permit any Transfer to occur, either voluntarily or involuntarily, in violation of Section 2.32 hereof, or if any part of the Improvements or any Chattel is intentionally removed or demolished by Grantor other than in accordance with the provisions of Sections 2.29 and 3.02 hereof (the provisions of this clause (c) to apply to each and every such Transfer, removal and demolition, whether or not Beneficiary has waived by its action or inaction its rights with respect to any previous Transfer, removal or demolition); or (d) if default shall be made in the payment of any of the other Secured Obligations, when and as the same shall become due and payable as in the Note and any other Loan Document provided, or in the performance of any of Grantor's other obligations under any of the Loan Documents which performance consists solely of the payment of a sum of money, (i) prior to maturity (whether such maturity occurs by acceleration, lapse of time or otherwise), if such default shall have continued for a period of ten (10) days after notice thereof to Grantor, and (ii) upon maturity (whether such maturity occurs by acceleration, lapse of time or otherwise); or (e) if default shall be made in the due observance or performance of any other covenant, condition or agreement in the Note, this Deed of Trust or any of the other Loan Documents, and such default shall have continued for a period of thirty (30) days after notice thereof shall have been given to Grantor by Beneficiary, or, in the case of such other documents,-such shorter grace period, if any, as may be provided for therein; or, in any case where such default is susceptible to cure but cannot with due diligence be cured by the payment of money or otherwise within such thirty (30) day, or shorter, period, such longer period (unless Beneficiary determines that delay in effecting such cure might have a material adverse impact on Beneficiary) within which Beneficiary determines that such default can reasonably be cured (not to exceed one hundred twenty (120) days) as is required diligently to effect the cure of such default, but only so long as Grantor promptly notifies Beneficiary of its intention to cure and actually commences the cure of such default within such thirty (30) day or shorter period and at all times thereafter prosecutes such cure with all due diligence to completion; or (f) [Reserved]; or (g) if by order of a court of competent jurisdiction, a trustee, receiver, custodian or liquidator of the Mortgaged Property or any part thereof, or of Grantor, shall be appointed and such order shall not be discharged or dismissed within sixty (60) days after such appointment; or (h) if Grantor shall file a petition in bankruptcy or for an arrangement or for reorganization pursuant to the Federal Bankruptcy Code or any similar law, federal or state, or if, by decree of a court of competent jurisdiction, Grantor shall be adjudicated a bankrupt, or be declared insolvent, or shall make an assignment for the benefit of creditors, or shall admit in writing its inability to pay its debts generally as they become due, or shall consent to the appointment of a receiver or receivers of all or any part of its property; or (i) if any of the creditors of Grantor shall file a petition in bankruptcy against Grantor or for reorganization of Grantor pursuant to the Federal Bankruptcy Code or any similar law, federal or state, and if such petition shall not be discharged or dismissed within sixty (60) days after the date on which such petition was filed; or (j) if final judgment for the payment of money in the amount of the lesser of (i) $250,000 or (ii) ten percent (10%) of the original principal amount of the Note or more shall be rendered against Grantor and Grantor shall not discharge the same or cause it to be discharged within sixty (60) days from the entry thereof, or shall not appeal therefrom or from the order, decree or process upon which or pursuant to which said judgment was granted, based or entered, and secure a stay of execution pending such appeal; or (k) if the payment of any tax referred to in Section 2.08 hereof or the payment of any other sum or any of the Secured Obligations by Grantor would result in the violation of applicable usury laws; or (1) if there should occur after the date hereof the passage of any law in-the jurisdiction where the Premises are located deducting from the value of real property for the purpose of taxation any lien or encumbrance thereon or changing in any way the laws for the taxation of deeds of trust or mortgages or debts secured by deeds of trust or mortgages for state or local purposes or the manner of the collection of any such taxes, and imposing a tax, either directly or indirectly, on any Loan Document or the indebtedness secured by this Deed of Trust, and Grantor fails or is otherwise unable to make timely payment therefor; or (m) if there should occur a default which is not cured within the applicable grace period, if any, under any other mortgage or deed of trust of all or part of the Mortgaged Property regardless of whether any such other mortgage or deed of trust is prior or subordinate to this Deed of Trust; it being further agreed by Grantor that an Event of Default hereunder shall constitute an Event of Default under any such other mortgage or deed of trust held by or for Beneficiary; or (n) if a default shall occur under any obligation set forth in any Permitted Exception or any other agreement, contract, instrument or indenture to which the Grantor is a party beyond the period of grace, if any, provided therein, the effect of which entitles any obligee or agreement of such obligation to foreclose upon all or any material portion of the Mortgaged Property, or which otherwise (in Beneficiary's good faith judgment) materially adversely affects the operations of the Improvements or the Grantor; or (o) if Grantor shall abandon all or a portion of the Mortgaged Property. SECTION 5.02 Remedies. Upon the occurrence and during the continuance of any Event of Default, the Trustee, at the option of Beneficiary, or Beneficiary, may: (a) by notice given to Grantor, declare the entire principal of the Note then outstanding (if not then due and payable), and all accrued and unpaid interest thereon, any applicable prepayment premium and all other Secured Obligations, to be due and payable immediately, and upon any such declaration the principal of the Note and said accrued and unpaid interest, prepayment premium and other Secured Obligations shall become and be immediately due and payable, anything in the Note or in this Deed of Trust to the contrary notwithstanding; (b) by themselves, their agents or attorneys, or by a court appointed receiver, enter into and upon all or any part of the Premises and the Improvements, and each and every part thereof, and are each hereby given a right and license and appointed Grantor's attorney-in-fact to do so, and may exclude Grantor, its agents and servants wholly therefrom; and having and holding the same, may use, operate, manage and control the Premises and the Improvements and conduct the business thereof, either personally or by their superintendents, managers, agents, servants, attorneys or receivers. Upon every such entry, Trustee or Beneficiary, at the expense of the Mortgaged Property, from time to time, either by purchase, repairs or construction, may maintain and restore the Mortgaged Property, whereof they shall become possessed as aforesaid; and likewise, from time to time, at the expense of the Mortgaged Property, Trustee or Beneficiary may make all necessary or proper repairs, renewals and replacements and such useful alterations, additions, betterments and improvements thereto and thereon as to Beneficiary may seem advisable and insure the same. In every such case Trustee or Beneficiary shall have the right to manage and operate the Mortgaged Property and to carry on the business thereof and exercise all rights and powers of Grantor with respect thereto either in the name of Grantor, as its attorney-in-fact, coupled with an interest, or otherwise, as Beneficiary shall deem best. Trustee or Beneficiary shall be entitled to collect and receive the Rents and every part thereof, all of which shall for all purposes constitute property of Grantor; and in furtherance of such right Beneficiary may collect the Rents payable under all Leases of the Premises or the Improvements directly from the lessees thereunder upon notice to each such lessee that an Event of Default exists hereunder accompanied by a demand on such lessee for the payment to Beneficiary of all Rents due and to become due under its Lease. Grantor FOR THE BENEFIT OF BENEFICIARY AND EACH SUCH LESSEE hereby covenants and agrees that the lessee shall be under no duty to question the accuracy of Beneficiary's statement of default and shall unequivocally be authorized to pay said Rents to Beneficiary without regard to the truth of Beneficiary's statement of default and notwithstanding notices from Grantor disputing the existence of an Event of Default such that the payment of Rents by the lessee to Beneficiary pursuant to such a demand shall constitute performance in full of the lessee's obligation under the Lease for the payment of Rents by the lessee to Grantor. After deducting the expenses of conducting the business thereof and of all maintenance, repairs, renewals, replacements, alterations, additions, betterments and improvements and amounts necessary to pay for taxes, assessments, insurance and prior or other proper charges upon the Mortgaged Property or any part thereof, as well as just and reasonable compensation for the services of Trustee and Beneficiary and for all attorneys, counsel, agents, clerks, servants and other employees by them engaged and employed, Trustee or Beneficiary, as the case may be, shall apply the moneys arising as aforesaid, first, to the payment of the principal of the Note and the interest thereon, when and as the same shall become payable and second, to the payment of any other Secured Obligations in such order as Beneficiary may elect; and the balance, if any, shall be turned over to Grantor or such other person as may be lawfully entitled thereto; and/or (c) with or without entry, personally or by their agents or attorneys, insofar as applicable: (i) sell the Mortgaged Property, or any part or parts thereof, and all estate, right, title and interest, claim and demand therein, at public auction at such time and place, and upon such terms and conditions as Beneficiary may deem expedient or as may be required or permitted by applicable law, having first given notice prior to the sale of such time, place and terms by publ-ication in one or more newspapers published or having a general circulation in the county or counties of the state in which the Mortgaged Property is located as may be required or permitted by law and by such other methods, if any, as Trustee or Beneficiary may deem desirable or as may be required or permitted by applicable law. In the event of any sale of all or part of the Mortgaged Property under the terms of this Deed of Trust, Grantor shall pay (in addition to taxable costs) a reasonable fee to Trustee which shall be in lieu of all other fees and commissions permitted by statute or custom to be paid, reasonable attorneys' fees and all expenses incurred in obtaining or continuing abstracts of title for the purpose of any such sale; or (ii) institute proceedings for the complete or partial foreclosure of this Deed of Trust; or (iii) take such other steps to protect and enforce their rights whether by action, suit or proceeding in equity or at law for the specific performance of any covenant, condition or agreement in the Note, this Deed of Trust or any other Loan Document, or in aid of the execution of any power herein granted, or for any foreclosure hereunder, or for the enforcement of any other appropriate legal or equitable remedy or otherwise as Trustee or Beneficiary shall elect. SECTION 5.03 Sale. (a) Trustee or Beneficiary may adjourn from time to time any sale by it to be made under or by virtue of this Deed of Trust by announcement at the time and place appointed for such sale or for such adjourned sale or sales; and, except as otherwise provided by any applicable provision of law, Trustee or Beneficiary, as the case may be, without further notice or publication, may make such sale at the time and place to which the same shall be so adjourned. (b) Upon the completion of any sale or sales made by Trustee or Beneficiary, as the case may be, under or by virtue of this Article V, Trustee, or an officer of any court empowered to do so. shall execute and deliver to the accepted purchaser or purchasers a good and sufficient instrument or instruments conveying, assigning and transferring all estate, right, title and interest in and to the property and rights sold. Trustee is hereby appointed the true and lawful attorney irrevocable of Grantor, in its name and stead, to make all necessary conveyances, assignments, transfers and deliveries of the Mortgaged Property and rights so sold and for that purpose Trustee may execute all necessary instruments of conveyance, assignment and transfer, and may substitute one or more persons with like power, Grantor hereby ratifying and confirming all that its said attorney or such substitute or substitutes shall lawfully do by virtue hereof. Nevertheless, Grantor, if requested by Trustee or Beneficiary, shall ratify and confirm any such sale or sales by executing and delivering to Trustee or to such purchaser or purchasers all such instruments as may be advisable, in the judgment of Trustee or Beneficiary, for the purpose, and as may be designated in such request. Any such sale or sales made under or by virtue of this Article V, whether made under the power of sale herein granted or under or by virtue of judicial proceedings or of a judgment or decree of foreclosure and sale, shall operate to divest all the estate, right, title, interest, claim and demand whatsoever, whether at law or in equity, of Grantor in and to the properties and rights so sold, and shall be a perpetual bar both at law and in equity against Grantor and against any and all persons claiming or who may claim the same, or any part thereof from, through or under Grantor. (c) In the event of any sale or sales made under or by virtue of this Article V (whether made under the power of sale herein granted or under or by virtue of judicial proceedings or of a judgment or decree of foreclosure and sale), the entire principal of, and interest on, the Note, if not previously due and payable, any applicable prepayment premium and all other Secured Obligations, immediately thereupon shall, anything in the Note or in this Deed of Trust to the contrary notwithstanding, become due and payable. If an Event of Default shall have occurred, and following the acceleration of maturity as herein provided, a tender of payment by Grantor or an Affiliate of Grantor of the amount then necessary to satisfy all Secured Obligations is made at any time prior to any sale under or by virtue of this Article V, whether under the power of sale herein granted or under or by virtue of judicial proceedings or of a judgment or decree of foreclosure and sale, such tender shall constitute an evasion of the prepayment provisions of the Note, and shall be deemed to be a voluntary prepayment of the principal indebtedness evidenced by the Note and, to the extent permitted by applicable law, such payment shall include any prepayment premium or yield maintenance payment required by the Note. (d) The purchase money proceeds or avails of any sale or sales made under or by virtue of this Article V, together with any other sums which then may be held by Trustee or Beneficiary under this Deed of Trust, whether under the provisions of this Article V or otherwise, shall be applied as follows: First: To the payment of the costs and expenses of such sale, including reasonable compensation to Trustee and Beneficiary, their agents and counsel, and of any judicial proceedings wherein the same may be made, and of all expenses, liabilities and advances made or incurred by Trustee or Beneficiary under this Deed of Trust, together with interest at the Default Rate on all advances made by Trustee or Beneficiary, and of all taxes, assessments or other charges, except any taxes, assessments or other charges subject to which the Mortgaged Property shall have been sold. Second: To the payment of the whole amount then due, owing or unpaid upon the Note for principal and interest, with interest on the unpaid principal at the Default Rate from and after the happening of any Event of Default described in clause (a) of Section 5.01 hereof from the due date of any such payment of principal until the same is paid, and together with any applicable prepayment premium. Third: To the payment of any other Secured Obligations, including all expenses, liabilities and advances made or incurred by Beneficiary under this Deed of Trust or in connection with the enforcement thereof, together with interest at the Default Rate on all such advances and other Secured Obligations. Fourth: To the payment of the surplus, if any, to whomsoever may be lawfully entitled to receive the same. (e) Upon any sale or sales made under or by virtue of this Article V, whether made under the power of sale herein granted or under or by virtue of judicial proceedings or of a judgment or decree of foreclosure and sale, Beneficiary may bid for and acquire the Mortgaged Property or any part thereof and in lieu of paying cash therefor may make settlement for the purchase price by crediting upon the amount of the bid the entire amount payable to Trustee and/or Beneficiary out of the net proceeds of such sale and all expenses of the sale, the cost of the action and any other sums which Trustee or Beneficiary are authorized to deduct under this Deed-of Trust. SECTION 5.04 Recovery of Judgment. (a) In case an Event of Default described in Section 5.01 hereof shall have happened and be continuing, then, upon written demand of Beneficiary, Grantor will pay to Beneficiary the whole amount which then shall have become due and payable on the Note, for principal and interest, any applicable prepayment premium, all of the other Secured Obligations, and after the happening of any Event of Default described in clause (a) of Section 5.01 hereof will also pay to Beneficiary interest at the Default Rate on the then unpaid principal of the Note and all of the other Secured Obligations, and in addition thereto, upon the happening of any Event of Default described in Section 5.01 hereof, Grantor will pay to Beneficiary such further amount as shall be sufficient to cover the costs and expenses of collection, including reasonable compensation to Trustee and Beneficiary, their agents and counsel and any expenses incurred by Trustee or Beneficiary hereunder. In the event Grantor shall fail forthwith to pay such amounts upon such demand, Beneficiary shall be entitled and empowered to institute such action or proceedings at law or in equity as may be advised by its counsel for the collection of the sums so due and unpaid, and may prosecute any such action or proceedings to judgment or final decree, and may, subject to the provisions of Section 7.16 hereof, enforce any such judgment or final decree against Grantor and collect, out of the property of Grantor wherever situated, as well as out of the Mortgaged Property, in any manner provided by law, moneys adjudged or decreed to be payable. (b) Beneficiary shall be entitled to recover judgment as aforesaid either before, after or during the pendency of any proceedings for the enforcement of the provisions of this Deed of Trust; and the right of Beneficiary to recover such judgment shall not be affected by any entry or sale hereunder, or by the exercise of any other right, power or remedy for the enforcement of the provisions of this Deed of Trust, or the foreclosure of the lien hereof; and in the event of a sale of the Mortgaged Property, and of the application of the proceeds of sale, as in this Deed of Trust provided, to the payment of the debt hereby secured, Beneficiary shall be entitled to enforce payment of, and to receive all amounts then remaining due and unpaid upon, the Note, and to enforce payment of all other charges, payments and costs due under this Deed of Trust, and shall be entitled to recover judgment for any portion of the debt remaining unpaid, with interest at the Default Rate. In case of proceedings against Grantor in insolvency or bankruptcy or any proceedings for its reorganization or involving the liquidation of its assets, then Beneficiary shall be entitled to prove the whole amount of principal and interest due upon the Note to the full amount thereof, any applicable prepayment premium and all other Secured Obligations, without deducting therefrom any proceeds obtained from the sale of the whole or any part of the Mortgaged Property, provided, however, that in no case shall Beneficiary receive a greater amount than such principal and interest, prepayment premium and other Secured Obligations from the aggregate amount of the proceeds of the sale of the Mortgaged Property and the distribution from the estate of Grantor. (c) No recovery of any judgment by Beneficiary and no levy of an execution under any judgment upon the Mortgaged Property or upon any other property of Grantor shall affect in any manner or to any extent, the lien of this Deed of Trust upon the Mortgaged Property or any part thereof, or any liens, rights, powers or remedies of Trustee or Beneficiary hereunder, but such liens, rights, powers and remedies of Trustee or Beneficiary shall continue unimpaired as before. (d) Any moneys thus collected by Beneficiary under this Section 5.04 shall be applied by Beneficiary in accordance with the provisions of clause (d) of Section 5.03 hereof. SECTION 5.05 Appointment of Receiver. After the happening of any Event of Default and immediately upon the commencement of any action, suit or other legal proceedings by Trustee or Beneficiary to obtain judgment for the principal of, or interest on, the Note and other Secured Obligations, or of any other nature in aid of the enforcement of the Note or of this Deed of Trust, Grantor will (a) waive the issuance and service of process and enter its voluntary appearance in such action, suit or proceeding and (b) if required by Beneficiary, consent to the appointment of a receiver or receivers of all or part of the Mortgaged Property and of any or all of the Rents in respect thereof. After the happening of any Event of Default and during its continuance, or upon the commencement of any proceedings to foreclose this Deed of Trust or to enforce the specific performance hereof or in aid thereof or upon the commencement of any other judicial proceeding to enforce any right of Trustee or Beneficiary, Trustee or Beneficiary shall be entitled, as a matter of right, if they shall so elect, without the giving of notice to any other party and without regard to the adequacy or inadequacy of any security for the indebtedness secured hereby, forthwith either before or after declaring the unpaid principal of the Note to be due and payable, to the appointment of such a receiver or receivers SECTION 5.06 Right to Possession. Notwithstanding the appointment of any receiver, liquidator or trustee of Grantor, or of any of its property, or of the Mortgaged Property or any part thereof, Trustee and Beneficiary shall be entitled to retain possession and control of all property now or hereafter held under this Deed of Trust. SECTION 5.07 Remedies Cumulative. No remedy herein conferred upon or reserved to Trustee or Beneficiary is intended to be exclusive of any other remedy or remedies, and each and every such remedy shall be cumulative, and shall be in addition to every other remedy given hereunder or under any other Loan Document or now or hereafter existing at law or in equity or by statute. No delay or omission of Trustee or Beneficiary to exercise any right or power accruing upon any Event of Default shall impair any such right or power, or shall be construed to be a waiver of any such Event of Default or any acquiescence therein; and every power and remedy given by this Deed of Trust to Trustee or Beneficiary may be exercised from time to time as often as may be deemed by them expedient. Nothing in this Deed of Trust or in the Note shall affect the obligation of Grantor to pay the principal of, interest on and other amounts due under the Note in the manner and at the time and place therein respectively expressed. SECTION 5.08 Certain Waivers by Grantor. Grantor will not at any time insist upon, or plead, or in any manner whatever claim or take any benefit or advantage of any stay or extension or moratorium law, any exemption from execution or sale of the Mortgaged Property or any part thereof, wherever enacted, now or at any time hereafter in force, which may affect the covenants and terms of performance of this Deed of Trust, nor claim, take or insist upon any benefit or advantage of any law now or hereafter in force providing for the valuation or appraisal of the Mortgaged Property, or any part thereof, prior to any sale or sales thereof which may be made pursuant to any provision herein, or pursuant to the decree, judgment or order of any court of competent jurisdiction; nor, after any such sale or sales, claim or exercise any right under any statute heretofore or hereafter enacted to redeem the property so sold or any part thereof and Grantor hereby expressly waives all benefit or advantage of any such law or laws, and covenants not to hinder, delay or impede the execution of any power herein granted or delegated to Trustee or Beneficiary, but to suffer and permit the execution of every power as though no such law or laws had been made or enacted. Grantor, for itself and all who may claim under it, waives, to the extent that it lawfully may, all right to have the Mortgaged Property marshaled upon any foreclosure hereof. SECTION 5.09 Recovery of Possession. During the continuance of any Event of Default and pending the exercise by Trustee or Beneficiary of their right to exclude Grantor from all or any part of the Premises and the Improvements, Grantor agrees to pay the fair and reasonable rental value for the use and occupancy of the Premises and the Improvements or any portion thereof which are in its possession for such period and, upon default of any such payment, will vacate and surrender possession of the Premises and the Improvements to Trustee or Beneficiary, as the case may be, or to a receiver, if any, and in default thereof may be evicted by any summary action or proceeding for the recovery of possession of premises for non-payment of rent, however designated. SECTION 5.10 Prepayment Premium. Whenever the term "prepayment premium" is used in this Article V, such term shall be deemed to include any prepayment penalty or Yield Maintenance Amount that may be required to be paid pursuant to the Note or the provisions of this Deed of Trust. ARTICLE VI CONCERNING TRUSTEE SECTION 6.01 Endorsement and Execution of Documents. Upon the written request of the Beneficiary, the Trustee shall, without liability or notice to the Grantor, execute, consent to, or join in any instrument or agreement in connection with or necessary to effectuate the purposes of the Loan Documents. The Grantor hereby irrevocably designates the Trustee as its attorneys-in-fact to execute, acknowledge, and deliver, on the Grantor's behalf and in the Grantor's name, all instruments or agreements necessary to implement the provisions of this Deed of Trust or necessary to further perfect the lien created by this Deed of Trust on the Mortgaged Property. This power of attorney shall be deemed to be coupled with an interest, shall be irrevocable and shall survive any disability of the Grantor. SECTION 6.02 Substitution of Trustee. The Beneficiary may, by firing a deed of appointment in the office where this instrument is recorded, appoint additional or replacement trustees and may remove the Trustee, from time to time, without notice to the Grantor or the Trustee and without specifying any reason. SECTION 6.03 Multiple Trustees. If at any time there are multiple Trustees, any Trustee, individually, may exercise all powers granted to the Trustees collectively, without the necessity of the joinder of the other Trustee(s). SECTION 6.04 Terms of Trustee's Acceptance. The Trustee accepts the trust created by this Deed of Trust upon the following terms and conditions. (a) The Trustee may exercise any of its powers through appointment of attorneys-in-fact or agents. (b) The Trustee shall not be liable for any matter or cause arising under this Deed of Trust or in connection therewith except by reason of its own willful misconduct. (c) The Trustee may select and employ legal counsel for the Trustee and Beneficiary, at the expense of Grantor. (d) The Trustee shall be under no obligation to take any action upon any Event of Default unless it is furnished security or indemnity, in form satisfactory to the Trustee, against costs, expenses, and liabilities which may be incurred by the Trustee. (e) The Trustee shall have no duty to take any action except upon written demand of the parties to whom is then owed fifty-one percent (51%) or more of the then outstanding principal balance of the Note. (f) The Trustee may resign upon thirty (30) days written notice to the Beneficiary. SECTION 6.05 Trustee's Reimbursement. Grantor shall reimburse the Trustee for all reasonable disbursements and expenses incurred by reason of this Deed of Trust. SECTION 6.06 Save Harmless Clause. Grantor shall indemnify and save harmless Beneficiary and the Trustee from all costs and expenses, including reasonable attorneys' fees, incurred by them or any of them by reason of this Deed of Trust, in connection with their performance hereunder, the enforcement of the obligations of Grantor hereunder, or the assertion of any rights or the seeking or obtaining of any remedies they may have hereunder, including any legal action to which Beneficiary or the Trustee shall become a party. Any money so paid or expended by Beneficiary or the Trustee shall be due and payable upon demand together with interest at the Default Rate from the date incurred and shall be secured by this Deed of Trust. ARTICLE VII SECTION 7.01 Severability. In the event any one or more of the provisions contained in this Deed of Trust or in the Note shall for any reason be held to be invalid, illegal or unenforceable in any respect, such invalidity, illegality or unenforceability shall not affect any other provision of this Deed of Trust, but this Deed of Trust shall be construed as if such invalid, illegal or unenforceable provision had never been contained herein or therein SECTION 7.02 Amendments, Waivers, Etc. No provision of this Deed of Trust may be changed, waived, discharged or terminated orally or by any other means except an instrument in writing signed by the party against whom enforcement of the change, waiver, discharge or termination is sought. Any agreement hereafter made by Grantor and Beneficiary relating to this Deed of Trust shall be superior to the rights of the holder of-any intervening or subordinate lien or encumbrance. SECTION 7.03 Notices. All notices, demands, consents, approvals and other communications (collectively, "Notices") hereunder shall be in writing and shall be sent by hand, or by telecopy (with a duplicate copy sent by ordinary mail, postage prepaid), or by postage prepaid, certified or registered mail, return receipt requested, or by reputable overnight courier service, postage prepaid, addressed to the party to be notified as set forth below: (a) if to Beneficiary, CBA Conduit, Inc. Financial Center, Suite 103 695 East Main Street Stamford, CT 06901 Attention: Mr. Stanley V. Cheslock Reference: CBA 1993-1 with a copy to: State Street Bank and Trust Co., Trustee C/O GE Capital Asset Management Corp., Servicer P. O. Box 420250 2000 West Loop South, Suite 1300 Houston, TX 77027 Attention: Mr. John Church, Sr. Vice President Reference CBA 1993-1 with a copy to: GE Capital Asset Management Corp. 2001 N. Beauregard Street, Suite 1200 Alexandria, VA 22311 Attention: Helen Kanovsky, Esq. Reference: CBA 1993-1 and with a copy to: Brownstein Zeidman and Lore A Professional Corporation 1401 New York Avenue, N.W. Suite 900 Washington, D.C. 20005 Attention: Kenneth G. Lore, Esq. Reference CBA 1993-1 (b) if to Grantor, 1090 Vermont Avenue N.W. Associates Limited Partnership c/o The John Akridge Company 601 Thirteenth Street, N.W. Suite 300 North Washington, D.C. 20005 with a copy to: Dennis Moyer, Esquire Hogan and Hartson 8300 Greensboro Drive McLean, Virginia 22102 and 1090 Vermont Avenue, N.W. Associates Limited Partnership c/o Carlyle Real Estate Limited Partnership - XIV 900 North Michigan Avenue Chicago, Illinois 60611-1575 Attention: Mr. Robert J. Chapman with a copy to: Pircher, Nichols & Meeks 10100 Santa Monica Boulevard Los Angeles, California 90067 Attention: Real Estate Notices (c) if to Trustee, Randy Alan Weiss, Trustee c/o Margolius, Mallios, Davis, Rider & Tomar 1828 L Street, N.W., Suite 500 Washington, D.C. 20036 Notices shall be deemed given when so delivered by hand or when a legible copy is received by telecopier (with receipt being verified by telephone confirmation), or if mailed, five (5) business days after mailing (or one (1) business day for overnight courier service), with failure to accept delivery constituting delivery for this purpose. Any party hereto may change the addresses for Notices set forth above by giving at least ten (10) days' prior Notice of such change in writing to the other party as aforesaid and otherwise in accordance with the foregoing provisions. SECTION 7.04 Covenants Running With the Land; Successors and Assigns. All of the grants, covenants, terms, provisions and conditions herein shall run with the land and shall apply to, bind and inure to the benefit of, the successors and assigns of Grantor and the successors in trust of Trustee and the endorsees, transferees, successors and assigns of Beneficiary. Notwithstanding the foregoing, it is hereby acknowledged that Grantor's obligations hereunder are personal and may not be assigned by Grantor; any attempted assignment of Grantor's obligations hereunder shall be null and void. SECTION 7.05 Maximum Rate of Interest. Notwithstanding any contrary provision of this Deed of Trust, in no event shall the aggregate of the interest payable hereunder or under the Note or any other Loan Document, or penalties or premiums for late payments, prepayment premiums, loan servicing fees, application fees, commitment fees, "points" or any other amounts, fees or charges which would under any applicable Law be deemed "interest" ever exceed the maximum amount of interest which under any applicable Law could be lawfully charged on the principal balance of the Note from time to time outstanding. In this connection, it is expressly stipulated and agreed that it is the intention of the Trustee and Beneficiary and Grantor in the execution and delivery of the Note, this Deed of Trust and any other Loan Document contractually to limit the maximum amounts charged to, contracted for with, or received from Grantor in connection with the Secured Obligations which would be deemed "interest" under any applicable Law to the maximum non-usurious amount of interest which would be permitted under such Law. In furtherance thereof, it is stipulated and agreed that none of the terms of this Deed of Trust, the Note or any other Loan Document shall ever be construed to create a contract to pay for the use, forbearance or detention of money interest at a rate in excess of the maximum non-usurious interest rate permitted to be charged to, contracted for with, or received from Grantor by the Trustee or Beneficiary under any applicable Law; neither Grantor nor any endorser or other parties now or hereafter becoming liable for the payment of the Secured Obligations shall ever be liable for interest in excess of the maximum non-usurious interest that under any applicable Law could be charged, contracted for or received from Grantor by the Trustee or Beneficiary; and the provisions of this Section shall be deemed to govern the maximum rate and amount of interest which may be paid under the Note, this Deed of Trust and any other Loan Document, and shall control over all other provisions of this Deed of Trust, the Note or any other Loan Document which might be in apparent conflict herewith. Specifically and without limiting the generality of the foregoing, it is expressly provided: (a) If and when any installment of the interest calculated under the Note becomes due and the aggregate amount thereof, when added to the aggregate amount of any other amounts which constitute interest on the indebtedness evidenced thereby and which have been heretofore paid on said indebtedness, would be in excess of the maximum non-usurious amount of interest permitted by any applicable Law, in light of all discounts, payments or prepayments theretofore made on said indebtedness and presuming the Secured Obligations will be paid at their stated maturity date, then the aggregate amount of such interest installment shall be automatically reduced to the maximum sum, if any, which could lawfully be paid as interest on the principal balance of the Note on such date under such circumstances. (b) If under any circumstances the aggregate amounts paid on the Note, this Deed of Trust and any other Loan Document prior to and incident to final payment thereof include any amounts which under any applicable Law would be deemed interest and which would exceed the maximum non-usurious amount of interest which, under any applicable Law, could lawfully have been collected on such indebtedness, Grantor, the Trustee and Beneficiary stipulate that such payment and collection will have been and will be deemed to have been the result of mathematical error on the part of both Grantor and the Trustee or Beneficiary, and the person or entity receiving such excess payment shall promptly refund the amount of such excess (to the extent only of the excess of such interest payments above the maximum non-usurious amounts which could lawfully have been collected and retained under any applicable Law) upon discovery of such error by the person or entity receiving such payment or Notice thereof from the person or entity making such payment; and (c) All amounts paid or agreed to be paid in connection with the Secured Obligations which would under any applicable Law be deemed "interest" shall, to the extent permitted by such Law, be amortized, prorated, allocated and spread throughout the full term of the Note. SECTION 7.06 Release and ReconveYance of this Deed of Trust. (a) Upon payment in full of the Secured Obligations, but only in compliance with the prepayment restrictions and other provisions of the Note, and the written request of Grantor, Beneficiary shall cause Trustee to release and reconvey, without warranty, the Mortgaged Property then held by Trustee under this Deed of Trust to Grantor upon payment by Grantor of any reconveyance costs and charges of Trustee as may be permitted by law. Trustee agrees to execute any releases as may be directed by Beneficiary hereunder. The release and reconveyance shall operate as a reassignment of the rents, income, issues and profits assigned to Beneficiary hereunder and in the Assignment of Rents and Leases. (b) During the third, fourth and fifth years following the Funding Date, but only until the First Permitted Prepayment Date, Grantor shall be entitled to a release and reconveyance of the Mortgaged Property then held by Beneficiary under this Deed of Trust (but not a release of the obligation under the Note), on the last day of any month upon no less than thirty (30) Business Days' notice from Grantor, provided that there does not then exist any Event of Default hereunder, upon Grantor's paying to Beneficiary, as substitute security for the Note in lieu only of this Deed of Trust and the Assignment of Rents and Leases but not any other Collateral, an amount equal to the sum of (i) the unpaid principal balance of the Note, plus (ii) interest on the Note through and including the last day of the month in which the First Permitted Prepayment Date occurs, plus (iii) all other Secured Obligations, if any, and the several amounts described in subclauses (i) through (iii) of this paragraph (b) shall be deposited in the Cash Reserve, to be used and applied as provided in the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable. The amount described in subclause (i) of the immediately preceding sentence shall be paid in the form of cash or U.S. Treasury obligations maturing no later than the First Permitted Prepayment Date; and all other amounts described in the immediately preceding sentence shall be paid in the form of cash. Upon any release and reconveyance pursuant to this paragraph (b), the Note shall not be surrendered or discharged prior to its satisfaction from the proceeds of the amounts paid pursuant to subclause (i) above on the First Permitted Prepayment Date. SECTION 7.07 No Release. Grantor agrees that no other security, now existing or hereafter taken, for the Secured Obligations shall be impaired or affected in any manner by the execution hereof; no security subsequently taken by any holder of the Secured Obligations shall impair or affect in any manner the security given by this Deed of Trust; all security for the payment of the Secured Obligations shall be taken, considered, and held as cumulative; and the taking of additional security shall at no time release or impair any security by endorsement or otherwise previously given. Grantor further agrees that any part of the security herein described may be released without in any way altering, varying, or diminishing the force, effect, or lien of this Deed of Trust, or of any renewal or extension of said lien, and that this Deed of Trust shall continue as a first lien, assignment, and security interest on all the Mortgaged Property not expressly released until all Secured Obligations are fully discharged and paid. SECTION 7.08 Securitization or Other Conveyance of Note. (a) Grantor acknowledges that Beneficiary may desire to securitize the Note or otherwise to sell or convey, by pledge or otherwise, all or a portion of its interest in the Note, the indebtedness evidenced thereby and this Deed of Trust at its option to third parties and that in order to maximize the proceeds of such securitization or other sale or conveyance, it will be necessary for Grantor to provide certain detailed information and to make representations and warranties with respect to the Premises and the Improvements, and the historical servicing and management of the Premises and the Improvements and Grantor's operations and financial condition, which information has not been fully identified on the date hereof. Grantor nevertheless agrees to maintain at all times while this Deed of Trust is in effect and provide upon Beneficiary's request such information as Beneficiary may advise Grantor it has determined is reasonably necessary for Beneficiary to maximize the proceeds of the securitization or other sale or conveyance of the Note, or portions of the Note or interests therein, including but not limited to (a) information required by the Securities and Exchange Commission, state securities agencies or underwriters of the securities; (b) information necessary to make any legal determination or to qualify for favorable treatment under statutes, regulations or case law or for qualification or other favorable treatment under tax, securities, ERISA or applicable state or federal laws; (c) legal opinions of Grantor's counsel and certifications of Grantor's Authorized Representative (including but not limited to so-called "lOb-5" legal opinions and certifications) relating to the Premises and the Improvements, Grantor's compliance with the terms hereof, matters affecting Affiliates of Grantor that have an effect upon the compliance with the terms hereof; (d) audited financial information; and (e) representations and warranties with respect to the Premises, the Improvements and Grantor's operations and financial condition consistent with those made herein. Grantor agrees to consent to, sign or otherwise facilitate the filing of all documents, reports, instruments, statements, notifications and other papers with appropriate regulatory agencies or, if any transaction involves perfection of exemptions from regulatory requirements, to facilitate the claim of any such exemption at Beneficiary's request and to consent to any amendments to this Deed of Trust Beneficiary deems desirable in order to facilitate such securitization, conveyance or financing, so long as such amendment does not materially affect amounts payable and payment terms applicable to Grantor hereunder. Notwithstanding the foregoing, Grantor shall not by the terms of this Section be required to execute as registrant any registration statement for the registration of securities under federal or state law but, upon request, Grantor shall consent to or otherwise cause its accountants, attorneys or other agents to consent to the filing of such expertized portions of any such registration statement as are required under federal or state securities laws, regulations, rules or other directives. Beneficiary agrees to reimburse Grantor for the reasonable out-of-pocket costs of Grantor in connection with the foregoing. Grantor's failure to provide to Beneficiary any information requested by Beneficiary pursuant to this Section shall not constitute a default under this Deed of Trust if and to the extent that Grantor (a) does not in fact have such information, (b) cannot without unreasonable cost or expense (but without regard to any potential liability to Grantor arising from or in connection with any information or materials requested by Beneficiary) procure such information, (c) is not obligated pursuant to any of the provisions of this Deed of Trust other than this Section to maintain or retain such information, and (d) has not previously been advised by Beneficiary to maintain or retain such information for the purposes described in this Section. (b) Grantor recognizes that, in connection with any securitization of the Note, Beneficiary will engage a servicer for the purpose of servicing all of the loans in the securitized pool. Grantor covenants and agrees that it will pay the custodial fees of such servicer in connection with the Cash Reserve and the Loan Reserve and the fees and charges of such servicer in connection with future modifications, if any, of the Loan Documents. SECTION 7.09 No Merger. Unless expressly~ provided otherwise, in the event that ownership of this Deed of Trust and title to the fee and/or leasehold estates in the Premises or the Improvements encumbered hereby shall become vested in the same person or entity, this Deed of Trust shall not merge in said title but shall continue to be and remain a valid and subsisting lien and/or trust deed on said estates in the Premises or the Improvements for the amount secured hereby. SECTION 7.10 [Reserved] SECTION 7.11 Brokerage. Grantor hereby indemnifies and holds harmless the Trustee and Beneficiary against all liability, cost and expense, including without limitation attorneys' charges, disbursements and reasonable fees, incurred in connection with any claims which may be asserted by any broker or finder or similar agent alleging to have dealt with Grantor in any of the transactions contemplated hereby. SECTION 7.12 Effect of Extensions and Amendments. If the payment of the Secured Obligations, or any part thereof, shall be extended or varied, or if any part of the security or guaranties therefor be released, all persons now or at any time hereafter liable therefor, or interested in the Mortgaged Property, shall be held to assent to such extension, variation or release, and their liability, and the lien, and all provisions hereof, shall continue in full force and effect; the right of recourse against all such persons being expressly reserved by the Trustee and Beneficiary, notwithstanding any such extension, variation or release (subject to the express limitations set forth in Section 7.16). Any person, firm or corporation taking a junior deed of trust or other Lien upon the Mortgaged Property or any part thereof or any interest therein (no such junior deed of trust or other Lien in any event being permitted without Beneficiary's consent), shall, without Section to maintain or retain such information, and (d) has not previously been advised by Beneficiary to maintain or retain such information for the purposes described in this Section. (b) Grantor recognizes that, in connection with any securitization of the Note, Beneficiary will engage a servicer for the purpose of servicing all of the loans in the securitized pool. Grantor covenants and agrees that it will pay the custodial fees of such servicer in connection with the Cash Reserve and the Loan Reserve and the fees and charges of such servicer in connection with future modifications, if any, of the Loan Documents. SECTION 7.09 No Merger. Unless expressly provided otherwise, in the event that ownership of this Deed of Trust and title to the fee and/or leasehold estates in the Premises or the Improvements encumbered hereby shall become vested in the same person or entity, this Deed of Trust shall not merge in said title but shall continue to be and remain a valid and subsisting lien and/or trust deed on said estates in the Premises or the Improvements for the amount secured hereby. SECTION 7.10 Grantor's Waivers. Grantor hereby expressly and unconditionally waives, in connection with any foreclosure or similar action or procedure brought by Beneficiary asserting an Event of Default under clause (a) of Section 5.01 of this Deed of Trust, any and every right it may have to (i) injunctive relief, (ii) interpose any counterclaim that is not a compulsory counterclaim therein and (iii) have the same consolidated with any other or separate suit, action or proceeding. Nothing herein contained shall prevent or prohibit Grantor from instituting or maintaining a separate action against Beneficiary with respect to any asserted claim. SECTION 7.11 Brokerage. Grantor hereby indemnifies and holds harmless the Trustee and Beneficiary against all liability, cost and expense, including without limitation attorneys' charges, disbursements and reasonable fees, incurred in connection with any claims which may be asserted by any broker or finder or similar agent alleging to have dealt with Grantor in any of the transactions contemplated hereby. SECTION 7.12 Effect of Extensions and Amendments. If the payment of the Secured Obligations, or any part thereof, shall be extended or varied, or if any part of the security or guaranties therefor be released, all persons now or at any time hereafter liable therefor, or interested in the Mortgaged Property, shall be held to assent to such extension, variation or release, and their liability, and the lien, and all provisions hereof, shall continue in full force and effect; the right of recourse against all such persons being expressly reserved by the Trustee and Beneficiary, notwithstanding any such extension, variation or release (subject to the express limitations set forth in Section 7.16). Any person, firm or corporation taking a junior deed of trust or other Lien upon the Mortgaged Property or any part thereof or any interest therein (no such junior deed of trust or other Lien in any event being permitted without Beneficiary's consent), shall, without waiving any other limitations in this Deed of Trust on such Liens, take the said Lien subject to the rights of the Trustee and Beneficiary to amend, modify, extend or release the Note, this Deed of Trust or any other document or instrument evidencing, securing or guarantying the indebtedness secured hereby, in each case without obtaining the consent of the holder of such junior Lien and without the lien of this Deed of Trust losing its priority over the rights of any such junior Lien. SECTION 7.13 No Joint Venture. Grantor acknowledges that the relationship between the parties is that of mortgagor and mortgagee and that in no event shall the Trustee or Beneficiary be deemed to be a partner or joint venturer with Grantor. Neither Trustee nor Beneficiary shall be deemed to be such a partner or joint venturer by reason of their becoming a mortgagee in possession or exercising any rights pursuant to this Deed of Trust or any other of the Loan Documents. SECTION 7.14 Funds Held in Accounts. (a) Grantor hereby agrees that Trustee and/or Beneficiary shall have no liability for any investment losses or reduction in value which accrue or occur with respect to any amounts held by or on behalf of Trustee or Beneficiary in any accounts hereunder, under the Cash Reserve Agreement, or otherwise, for the benefit or account of Grantor or the Premises (such as, inter alia, insurance proceeds, partial condemnation awards, funds deposited with Beneficiary pursuant to subsection (b) of Section 2.07 hereof, funds deposited in the Loan Reserve pursuant to Section 2.33 hereof and funds deposited in the Cash Reserve pursuant to Sections 2.09, 2.15, 2.32 and 2.34 hereof), so long as such amounts are invested in Permitted Investments maintained for the account or benefit of Grantor (except that interest and/or other income on funds deposited with Beneficiary pursuant to paragraph (b) of Section 2.07 hereof shall not be for the account or benefit of Grantor), and any such losses shall be borne solely by Grantor. In addition, Grantor agrees that all interest and/or other income on all such funds other than funds deposited with Beneficiary pursuant to subsection (b) of Section 2.07 hereof shall for income tax purposes be deemed to belong to Grantor. (b) Nevertheless, Beneficiary shall invest all funds deposited in the Loan Reserve pursuant to Section 2.33 hereof and in the Cash Reserve pursuant to the provisions of this Deed of Trust and as required by the Cash Reserve Agreement or any Transferee Cash Reserve Agreement only in Permitted Investments, and the interest thereon, if and to the extent actually received, less a reasonable administrative fee that may be deducted by Beneficiary to reimburse it for costs of investment and record keeping, shall belong to Grantor and shall be paid to Grantor, except as and to the extent otherwise provided in the Cash Reserve Agreement or any Transferee Cash Reserve Agreement, together with any remaining balance of such funds not expended in accordance with the terms of the Loan Documents, provided no Event of Default hereunder shall have occurred that shall not have been cured, upon payment in full of the Secured Obligations and release and reconveyance of the Mortgaged Property pursuant to Section 7.06 hereof. If an Event of Default shall occur, Beneficiary may, without notice to Grantor, apply any or all of such funds, including interest thereon, to the Secured Obligations or otherwise-as Beneficiary may determine. SECTION 7.15 Governing Law. THIS DEED OF TRUST SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE INTERNAL LAWS OF THE DISTRICT OF COLUMBIA (WITHOUT REGARD TO PRINCIPLES OF CONFLICTS OF LAW) AND ANY APPLICABLE LAWS OF THE UNITED STATES OF AMERICA. Grantor hereby irrevocably submits to the non-exclusive jurisdiction of any state or federal court in such jurisdiction over any suit, action or proceeding arising out of or relating to the Note, this Deed of Trust or any other Loan Document, and Grantor hereby agrees and consents that, in addition to any methods of service of process provided for under applicable law, all service of process in any suit, action or proceeding in any such court may be made by certified or registered mail, return receipt requested, directed to Grantor at its address indicated herein, and service so made shall be complete five (5) days after the same shall have been so mailed. SECTION 7.16 Limitations on Recourse. (a) Notwithstanding anything to the contrary in the Note or in this Deed of Trust or in any other Loan Document, neither Grantor, any present or future constituent partner in or agent of Grantor, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Grantor, shall be personally liable, directly or indirectly, under or in connection with the Note or this Deed of Trust or any other Loan Document, or any instrument or certificate securing or otherwise executed in connection with the Note or this Deed of Trust or any other Loan Document, or any amendments or modifications to any of the foregoing made at any time or times, heretofore or hereafter; the recourse of each of the Trustee and Beneficiary and each of their respective successors and assignees under or in connection with the Note, this Deed of Trust, any other Loan Document and such instruments and certificates, and any such amendments or modifications, shall be limited to Grantor's interest in the Mortgaged Property and such other collateral, if any, as may now or hereafter be given to secure payment of the Secured Obligations only, and Beneficiary and Trustee and each of their respective successors and assignees waives and does hereby waive any such personal liability; provided, however, that the foregoing provisions of this Section shall not (i) constitute a waiver of any obligation evidenced by the Note or contained in this Deed of Trust, (ii) limit the right of the Trustee or Beneficiary to name Grantor as a party defendant in any action or suit for judicial or non-judicial foreclosure and sale or any other action or suit under this Deed of Trust or any other Loan Document so long as no judgment in the nature of a deficiency judgment shall be enforced against Grantor except to the extent of the Mortgaged Property or such other collateral, (iii) affect in any way the validity or enforceability of any guaranty (whether of payment and/or performance), any indemnity provision contained in Sections 2.17, 2.24, 6.06, 7.11 or 7.19 hereof in favor of Trustee or Beneficiary or any indemnity agreement given to Beneficiary in the Environmental Indemnification Agreement or in Section 5.2 of the Assignment of Rents and Leases of even date herewith by and between Grantor and Beneficiary in connection with the loan secured hereby the "Assignment of Rents and Leases"), except that the liability of Carlyle only (but not of Grantor or of The John Akridge Company (in its capacity as a general partner of Grantor)) under any indemnity provision contained in Sections 2.17, 2.24, 6.06, 7.11 or 7.19 hereof in favor of Trustee or Beneficiary or any indemnity agreement given to Beneficiary in Section 5.2 of the Assignment of Rents and Leases (collectively, such indemnity provisions and agreement are hereinafter sometimes referred to as the "Specified Indemnities") shall be limited as provided in Section 7.16(c) hereof, or (iv) constitute a waiver by Beneficiary of any rights to reimbursement for actual, or out-of-pocket, losses, costs or expenses, or any other remedy at law or in equity, against Grantor by reason of (1) gross negligence, willful misconduct, intentional misrepresentations or fraudulent acts or omissions, (2) willful misapplication of any insurance proceeds, condemnation awards or tenant security deposits, or of any rental or other income which was required by this Deed of Trust or other Loan Documents to be paid or applied in a specified manner, arising, in any such case, with respect to the Mortgaged Property, (3) Grantor's entry into, modification of, or termination of, any Lease, without Beneficiary's prior consent, if this Deed of Trust requires such consent to be obtained by Grantor, (4) failure to pay premiums for insurance covering environmental risks, or (5) the material inaccuracy of any information contained in rent rolls delivered to Beneficiary on or prior to the date hereof in connection with Beneficiary's underwriting of the loan secured hereby or delivered to Beneficiary pursuant to Section 2.16 hereof or otherwise and relied upon by Beneficiary in making any determination under Section 2.32 hereof with respect to the Debt Service Coverage Ratio for the loan secured hereby. Notwithstanding anything contained in clause (iii) of this Section 7.16(a), so long as Beneficiary's rights to pursue Grantor are not in any way prejudiced or impaired thereby and any costs that Beneficiary may incur by refraining from pursuing Grantor that are not paid in advance by Grantor are not in Beneficiary's reasonable judgment material, Beneficiary shall seek to obtain reimbursement pursuant to any valid insurance policy covering environmental risks and maintained by Grantor (or for which Grantor pays a portion of the premiums) pursuant to the terms of this Deed of Trust, to the extent such reimbursement shall be available to Beneficiary, before it seeks to obtain satisfaction with respect to any loss or damage it may sustain with respect to environmental matters from the personal assets (other than any assets that may constitute Mortgaged Property) of Grantor or any general partner of Grantor. (b) Notwithstanding anything to the contrary in the Note or in this Deed of Trust or in any other Loan Document (including, without limitation, (i) Sections 7.16(a) and 7.16(c) hereof, (ii) the Environmental Indemnification Agreement and (ii) the Assignment of Rents and Leases), no limited partner of Grantor, no present or future constituent partner in or agent of Carlyle, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Carlyle, nor any present or future shareholder, officer, director, employee or agent of The John Akridge Company shall be personally liable, directly or indirectly, under or in connection with the Note or this Deed of Trust or any other Loan Document (including, without limitation, the Environmental Indemnification Agreement and the Assignment of Rents and Leases), or any instrument or certificate securing or otherwise executed in connection with the Note or this Deed of Trust or any other Loan Document (including, without limitation, the Environmental Indemnification Agreement and the Assignment of Reich holds title to the land underlying 2 Broadway Building (all of these office buildings are in New York, New York); JMB/Piper Jaffray Tower Associates, a general partnership, which is a partner in (i) OB Joint Venture II, a general partnership, which is a partner of 222 South Ninth Street Limited Partnership, a limited partnership, which holds title to the Piper Jaffray Tower office building in Minneapolis, Minnesota, and (ii) OB Joint Venture, a general partnership, which holds title to the land underlying the Piper Jaffray Tower office building; JMB/Piper Jaffray Tower Associates II, a general partnership, which also is a partner in OB Joint Venture, a general partnership, which holds title to the land underlying the Piper Jaffray Tower office building; 900 3rd Avenue Associates, a general partnership, which is a partner of Progress Partners, a general partnership, which holds title to 900 Third Avenue Building located in New York, New York; and Orchard Associates, a general partnership which is a partner of Old Orchard Joint Venture, a general partnership, which holds title to the Old Orchard Shopping Center in Skokie (Chicago), Illinois. Generally, the developer of the property is a partner in the joint ventures, however, the partners in the JMB/NYC Office Building Associates, JMB/Piper Jaffray Tower Associates, JMB/Piper Jaffray Tower Associates II, 900 3rd Avenue Associates and Orchard Associates are affiliates of the General Partners of the Partnership. Reference is made to Notes 3(a), 3(b) and 3(c) for a description of the terms of such joint venture partn- erships. The Partnership is a 40% shareholder in Carlyle Managers, Inc. and a 40% shareholder in Carlyle Investors, Inc. EXHIBIT 21 LIST OF SUBSIDIARIES The Partnership is a partner of the following joint ventures: 1090 Vermont Ave., N.W. Associates Limited Partnership, a limited partnership, which holds title to the 1090 Vermont Avenue Building in Washington, D.C.; Mariners Pointe Associates, a limited partnership, which holds title to the Mariners Pointe Apartments in Stockton, California; Carlyle-XIV Associates, L.P., which is a partner of JMB/NYC Office Building Associates, L.P., a limited partnership, which is a partner in (i) 237 Park Avenue Associates, a general partnership, which holds title to the 237 Park Avenue Building, (ii) 1290 Associates, a general partnership, which holds title to the 1290 Avenue of the Americas Building, (iii) 2 Broadway Associates, a general partnership, which holds title to the 2 Broadway Building and (iv) 2 Broadway Land Company, a general partnership, which holds title to the land underlying 2 Broadway Building (all of these office buildings are in New York, New York); JMB/Piper Jaffray Tower Associates, a general partnership, which is a partner in (i) OB Joint Venture II, a general partnership, which is a partner of 222 South Ninth Street Limited Partnership, a limited partnership, which holds title to the Piper Jaffray Tower office building in Minneapolis, Minnesota, and (ii) OB Joint Venture, a general partnership, which holds title to the land underlying the Piper Jaffray Tower office building; JMB/Piper Jaffray Tower Associates II, a general partnership, which also is a partner in OB Joint Venture, a general partnership, which holds title to the land underlying the Piper Jaffray Tower office building; 900 3rd Avenue Associates, a general partnership, which is a partner of Progress Partners, a general partnership, which holds title to 900 Third Avenue Building located in New York, New York; and Orchard Associates, a general partnership which is a partner of Old Orchard Joint Venture, a general partnership, which holds title to the Old Orchard Shopping Center in Skokie (Chicago), Illinois. Generally, the developer of the property is a partner in the joint ventures, however, the partners in the JMB/NYC Office Building Associates, JMB/Piper Jaffray Tower Associates, JMB/Piper Jaffray Tower Associates II, 900 3rd Avenue Associates and Orchard Associates are affiliates of the General Partners of the Partnership. Reference is made to Notes 3(a), 3(b) and 3(c) for a description of the terms of such joint venture partnerships. The Partnership is a 40% shareholder in Carlyle Managers, Inc. and a 40% shareholder in Carlyle Investors, Inc. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On June 4, 1984, the Partnership commenced an offering of $250,000,000 (subject to increase by up to $250,000,000) pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. All Interests were subscribed and issued between June 4, 1984 and July 15, 1985 pursuant to the public offering from which the Partnership received gross proceeds of $401,053,660. After deducting selling expenses and other offering costs, the Partnership had approximately $351,747,000 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 for working capital. A portion of such proceeds was 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 $2,831,000. Such funds and short- term investments of approximately $16,190,375 are available for distributions to partners and working capital requirements including the Partnership's potential funding obligations at the Louis Joliet Mall, Louisiana Tower and Wilshire Bundy Plaza related to renovation costs, releasing costs and underlying mortgage obligations, the Partnership's share of legal costs currently being incurred related to the lawsuit against the former manager and one of the unaffiliated venture partners of the 900 Third Avenue venture and the cash operating deficits currently being incurred at the Mariners Pointe Apartments. The Partnership and its consolidated ventures have currently budgeted in 1994 approximately $5,676,000 for tenant improvements 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 approximately $7,611,000. Actual amounts expended 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 and distributions to partners is dependent upon net cash generated by the Partnership's investment properties and the sale or refinancing of such investments. Due to the above situations and the property specific concerns discussed below, the Partnership suspended distributions beginning with the fourth quarter 1991 distribution payable in February 1992. As of December 31, 1993, the current portion of the long-term indebtedness of the Partnership and its consolidated ventures was approximately $28,107,000, including the entire indebtedness encumbering Mariner's Pointe Apartments, Brittany Downs Apartments - Phase II and the Partnership's interest in the Wells Fargo South Tower office building. Reference is made to Notes 4(a) and 4(b). Gateway Tower The Gateway Tower property was operating at a significant deficit due to higher than originally expected leasing costs and lower than originally expected rental rates achieved on leasing. During 1990, the joint venture partner ceased making the required capital contributions necessary to make the quarterly guaranteed payments to the Partnership and the debt service payments. During the first quarter of 1991, the lender served the joint venture with a notice of default and filed a lawsuit to realize on its security and take title to the property. On December 30, 1992, the lender concluded proceedings to realize on its security and took title to the property resulting in the Partnership no longer having an ownership interest in the property. The Partnership received no cash proceeds from the transfer of ownership interest; it did, however, recognize a gain for financial reporting and Federal income tax purposes during 1992 of $7,130,438 and $14,604,506, respectively. The joint venture partner's funding obligation was secured by a guarantee from an affiliated entity of the joint venture partner. After careful review of the joint venture partner and its affiliate's financial condition, the Partnership has determined that they do not have the ability to satisfy any of their financial obligations under the joint venture agreement. Therefore, the Partnership has decided to forego any further attempts to recover amounts due from them as a result of their defaults. 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, 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 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 internal rate of return per 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 or refinancing as discussed below, there are funds remaining in this escrow, after payment 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 re 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(e). 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. Reference is made to note 3(g). Brittany Downs Apartments - Phase I and II In June 1993, the Partnership refinanced the Brittany Downs Apartments Phase I $7,090,000 mortgage loan resulting in a reduction of the effective interest rate on the loan from 8.0% per annum to 6.2% per annum. Brittany Downs Apartments Phase II does not produce sufficient cash flow to cover its required debt service payments and, consequently, the Partnership has been paying a reduced amount of debt service since November 1990. As a result, the Partnership was negotiating with the RTC to obtain a loan modification to reduce the property's required debt service payments. During the fourth quarter 1992, the RTC sold the Phase II mortgage loans. The new underlying lender has placed the Partnership in default for failure to pay the required debt service. Accordingly, the balances of the Phase II first mortgage note, the second mortgage note, and related accrued interest have been classified as current liabilities in the accompanying consolidated financial statements at December 31, 1993 and December 31, 1992. Based on the notice of default, the total amount of interest in arrears on the existing mortgage notes for Brittany Downs Apartment Phase II in the principal amount of $8,566,458 as of December 31, 1993, equals $1,101,800. The Partnership is currently in negotiations with the new lender regardin for sale with Phase I. Because the two Phases currently operate in tandem, the Partnership believes the two Phases together would have a greater individual market value than if marketed for sale independently. If the Partnership is not successful in its discussions with the new Phase II lender, the Partnership has decided, based upon an analysis of current and anticipated market conditions and the probability of large future cash deficits, not to commit additional funds to the Phase II property. This would result in the Partnership no longer having an ownership interest in the Phase II property and could result in gain for financial reporting and Federal income tax purposes to the Partnership with no distributable proceeds from the disposition. The Partnership, however, may still consider marketing the Phase I property for sale in the near future. JMB/NYC At the 2 Broadway building, occupancy increased slightly to 30% during the fourth quarter 1993, up from 29% in the previous quarter. The Downtown Manhattan office leasing market remains depressed due to the significant supply of, and the relatively weak demand for, tenant space. As previously reported, Merrill Lynch, Pierce, Fenner & Smith, Incorporated's lease of approximately 497,000 square feet of space (31% of the building's total space) expired in August 1993. A majority of the remaining tenant roster at the property includes several major financial services companies whose leases expire in 1994. Most of these companies maintain back office support operations in the building which can be easily consolidated or moved. The Bear Stearns Co.'s lease of approximately 186,000 square feet of space (12% of the building's total space), which expires in April 1994, is not expected to be renewed. In addition to the competition for tenants in the Downtown Manhattan market from other buildings in the area, there is ever increasing competition from less expensive alternatives to Manhattan, such as locations in New Jersey and Brooklyn, which are also experiencing high vacancy levels. Rental rates in the Downtown market continue to be at depressed levels and this can be expected to continue while the large amount of vacant space is gradually absorbed. Little, if any, new construction is planned for Downtown over the next few years. It is expected that 2 Broadway will continue to be adversely affected by a high vacancy rate and the low effective rental rates achieved upon releasing of space under existing leases which expire over the next few years. In addition, the property is in need of a major renovation in order to compete in the office leasing market. However, there are currently no plans for a renovation because of the potential sale of the property discussed below and because the effective rents that could be obtained under current market conditions may not be sufficient to justify the costs of the renovation. Occupancy at 1290 Avenue of the Americas increased to 98%, up from 95% in the previous quarter primarily due to Prudential Bache Securities, Inc. occupying 25,158 square feet. The Midtown Manhattan office leasing market remains very competitive. It is expected that the property will continue to be adversely affected by low effective rental rates achieved upon releasing of space covered by existing leases which expire over the next couple years and may be adversely affected by an increased vacancy rate over the next few years. Negotiations are currently being conducted with certain tenants who in the aggregate occupy in excess of 300,000 square feet for the renewal of their leases that expire in 1994 and 1995. John Blair & Co. ("Blair"), a major lessee at 1290 Avenue of the Americas (leased space approximates 253,000 square feet or 13% of the building), has filed for Chapter XI bankruptcy. Because much of the Blair space is subleased, the 1290 venture is collecting approximately 70% of the monthly rent due under the leases from the subtenants. There is uncertainty regarding the collection of the balance of the monthly rents from Blair. Accordingly, a provision for doubtful accounts related to rents and other receivables and accrued rents receivable aggregating $7,659,366 has been recorded at December 31, 1993 in the accompanying combined financial statements related to this tenant. Occupancy at 237 Park Avenue decreased slightly to 98% in the fourth quarter of 1993, down from 99% in the previous quarter. It is expected that the property will be adversely affected by the low effective rental rates achieved upon releasing of existing leases which expire ov years and may be adversely affected by an increased vacancy rate over the next few years. JMB/NYC has had a dispute with the unaffiliated venture partners who are affiliates (hereinafter sometimes referred to as the "Olympia & York affiliates") of Olympia and York Developments, Ltd. (hereinafter sometimes referred to as "O & Y") over the calculation of the effective interest rate with reference to the first mortgage loan, which covers all three properties, for the purpose of determining JMB/NYC's deficit funding obligation commencing in 1992, as described more fully in Note 3(c) of Notes to Financial Statements. Under JMB/NYC's interpretation of the calculation of the effective rate of interest, 2 Broadway operated at a deficit for the year ended December 31, 1993. During the first quarter of 1993, an agreement was reached between JMB/NYC and the Olympia & York affiliates which rescinded the default notices previously received by JMB/NYC and eliminated any alleged operating deficit funding obligation of JMB/NYC for the period January 1, 1992 through June 30, 1993. Accordingly, during this period, JMB/NYC recorded interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum), which is the interest rate on the underlying first mortgage loan. Under the terms of this agreement, during this period, the amount of capital contributions that the Olympia & York affiliates and JMB/NYC would have been required to make to the Joint Ventures, as if the first mortgage loan bore interest at a rate of 12.75% per annum (the Olympia & York affiliates' interpretation), became a priority distribution level to the Olympia & York affiliates from the Joint Ventures' annual cash flow or net sale or refinancing proceeds. The agreement also entitles the Olympia & York affiliates to a 7% per annum return on such unpaid priority distribution level amount. It was also agreed that during this period, the excess available operating cash flow after the payment of the priority distribution level discussed above from any of the Three Joint Ventures will be advanced in the form of loans to pay operating deficits and/or unpaid priority distribution level amounts of any of the other Three Joint Ventures. Such loans will bear a market rate of interest, have a final maturity of ten years from the date when made and will be repayable only out of first available annual cash flow or net sale or refinancing proceeds. The agreement also provides that except as specifically agreed otherwise, the parties each reserves all rights and claims with respect to each of the Three Joint Ventures and each of the partners thereof, including, without limitation, the interpretation of or rights under each of the joint venture partnership agreements for the Three Joint Ventures. The agreement expired on June 30, 1993. Effective July 1, 1993, JMB/NYC is recording interest expense at 1-3/4% over the short-term U.S. Treasury obligation rate plus any excess operating cash flow after capital costs of the Three Joint Ventures, such sum not to be less than 7% nor exceed a 12-3/4% per annum interest rate. The Olympia & York affiliates dispute this calculation and contend that the 12-3/4% per annum fixed rate applies. JMB/NYC continues to seek, among other things, a restructuring of the joint venture agreements or otherwise to reach an acceptable understanding regarding its long-term funding obligations. If JMB/NYC is unable to achieve this, based upon current and anticipated market conditions mentioned above, JMB/NYC may decide not to commit any additional amounts to 2 Broadway and 1290 Avenue of the Americas, which could, under certain circumstances, result in the loss of the interest in the related ventures. The loss of an interest in a particular venture could, under certain circumstances, permit an acceleration of the maturity of the related Purchase Note (each Purchase Note is secured by JMB/NYC's interest in the related venture). The failure to repay a Purchase Note could, under certain circumstances, constitute a default that would permit an immediate acceleration of the maturity of the Purchase Notes for the other ventures. In such event, JMB/NYC may decide not to repay, or may not have sufficient funds to repay, any of the Purchase Notes and accrued interest thereon. This could result in JMB/NYC no longer having an interest in any of the related ventures, which in that event would result in substantial net gain for financial reporting and Federal income tax purposes to JMB/NYC (and through JMB/NYC and the Partnership, to the Limited Partners) with no distributable proceeds. In addition, under certain circumstances as more fully discussed in Note 2, JMB/NYC may be required to make additional capital contributions to certain of the Joint Ventures in deficit restoration obligation associated with a deficit balance in its capital account, and the Partnership could be required to bear a share of such capital contributions obligation. If JMB/NYC is successful in its negotiations to restructure the Three Joint Ventures agreements and retains an interest in one or more of these investment properties, there would nevertheless need to be a significant improvement in current market and property operating conditions (including a major renovation of the 2 Broadway building) resulting in a significant increase in value of the properties before JMB/NYC would receive any share of future net sale or refinancing proceeds. The Joint Ventures that own the 2 Broadway building and land have no plans for a renovation of the property because of the potential sale of the property discussed below and because the effective rents that could be obtained under the current office market conditions may not be sufficient to justify the costs of the renovation. Given the current market and property operating conditions, it is likely that the property would sell at a price significantly lower than the allocated portion of the underlying debt. The first mortgage lender and JMB/NYC would need to approve any sale of this property. The O&Y affiliates have informed JMB/NYC that they have now received a written proposal for the sale of 2 Broadway for a net purchase price of $15 million. The first mortgage lender has preliminarily agreed to the concept of a sale of the building but has not approved the terms of any proposed offer for purchase. Accordingly, a sale pursuant to the proposal received by the O&Y affiliates would be subject to, among other things, the approval of the first mortgage lender as well as JMB/NYC. While there can be no assurance that a sale would occur pursuant to such proposal or any other proposal, if this proposal were to be accepted by or consented to by all required parties and the sale completed pursuant thereto, and if discussions with the O&Y affiliates relating to the proposal were finalized to allocate the unpaid first mortgage indebtedness currently allocated to 2 Broadway to 237 Park and 1290 Avenue of the Americas after completion of the sale, then the 2 Broadway Joint Ventures would incur a significant loss for financial reporting purposes. Accordingly, a provision for value impairment has been recorded for financial reporting purposes for $192,627,560, net of the non-recourse portion of the Purchase Notes including related accrued interest related to the 2 Broadway Joint Venture interests that are payable by JMB/NYC to the O&Y affiliates in the amount of $46,646,810. The provision for value impairment has been allocated $136,534,366 and $56,093,194 to the O&Y affiliates and JMB/NYC, respectively. Such provision has been allocated to the partners to reflect their respective ownership percentages before the effect of the non- recourse promissory notes including related accrued interest. The provision for value impairment is not a loss recognizable for Federal income tax purposes. O & Y and certain of its affiliates have been involved in bankruptcy proceedings in the United States and Canada and similar proceedings in England. The Olympia & York affiliates have not been directly involved in these proceedings. During the quarter ended March 31, 1993, O & Y emerged from bankruptcy protection in the Canadian proceedings. In addition, a reorganization of the company's United States operations has been completed, and affiliates of O & Y are in the process of renegotiating or restructuring a number of loans affecting various properties in the United States in which they have an interest. The Partnership is unable to assess and cannot presently determine to what extent these events may adversely affect the willingness and ability of the Olympia & York affiliates either to meet their own obligations to the Joint Ventures and JMB/NYC or otherwise reach an understanding with JMB/NYC regarding any funding obligation of JMB/NYC. However, the financial difficulties of O&Y and its affiliates may be adversely affecting the Three Joint Ventures' efforts to restructure the mortgage loan and to re-lease vacant space in the building. During the fourth quarter of 1992, the Joint Ventures received a notice from the first mortgage lender alleging a default for failure to meet certain reporting requirements of the Olympia & York affiliates contained in the first mortgage loan documents. No monetary default has been alleged. The Olympia & York affiliates have responded to the lender that the Joint Ventures are not in default. JMB/NYC is unable to determine if the Join default. Accordingly, the balance of the first mortgage loan has been classified as a current liability in the accompanying combined financial statements at December 31, 1992 and 1993. There have not been any further notices from the first mortgage lender. However, the Olympia & York affiliates, on behalf of the Three Joint Ventures, continue to negotiate with representatives of the lender (consisting of a steering committee of holders of notes evidencing the mortgage loan) to restructure certain terms of the existing mortgage loan in order to provide for, among other things, a fixed rate of interest on the loan during the remaining loan term until maturity. In conjunction with the negotiations, the Olympia & York affiliates reached an agreement with the first mortgage lender whereby effective January 1, 1993, the Olympia & York affiliates are limited to taking distributions of $250,000 on a monthly basis from the Three Joint Ventures reserving the remaining excess cash flow in a separate interest-bearing account to be used exclusively to meet the obligations of the Three Joint Ventures as approved by the lender. There is no assurance that a restructuring of the loan will be obtained. Interest on the first mortgage loan is calculated based upon a variable rate related to the short-term U.S. Treasury obligation rate, subject to a minimum rate on the loan of 7% per annum. A significant increase in the short-term U.S. Treasury obligation rate could result in increased interest payable on the first mortgage loan by the Three Joint Ventures. 1090 Vermont Avenue Building During the year, occupancy of this office building increased to 99%, up from 90% at the end of 1992 due to Delphi International occupying 12,396 square feet (approximately 9% of the building's leasable space) in February 1993. Through 1993, the Partnership and joint venture partners have contributed a total of $4,076,000 ($2,038,000 by the Partnership) to the joint venture to cover releasing costs and costs of a lobby renovation. The Partnership and joint venture partner had agreed that the contributions made to the joint venture would be repaid along with a return thereon out of first available proceeds from property operations, sale or refinancing. During the fourth quarter, the joint venture finalized a refinancing of the existing mortgage loan with a new loan in the amount of $17,750,000. The refinancing resulted in net proceeds of approximately $2,259,000 for the joint venture. Of such proceeds, $1,785,560 (of which the Partnership's share was $889,064) was distributed to the venture partners in December 1993 as a partial return of the additional capital contributed. The remaining proceeds are being retained by the joint venture as working capital. The new loan provides for interest only monthly payments for the entire ten-year term. The interest rate for the first five years is 8.01% per annum. The fixed interest rate thereafter until maturity will be 2.8% per annum over the five year Treasury rate at the beginning of such five-year period. In addition to providing refinancing proceeds to the joint venture, the debt service payments due under the new loan are significantly lower than the payments due under the prior loan. Consequently, the property is expected to produce cash flow for the joint venture in 1994. The joint venture negotiated an early lease termination agreement with a major tenant that vacated its space (24,308 square feet) in early 1992. The joint venture terminated the lease (which was to expire in February 1996) for a fee of approximately $1.5 million and entered into a direct lease with the subtenant, which occupies a substantial portion of the former major tenant's space (18,482 square feet). Such fee was used by the joint venture in 1992 to help cover releasing costs and costs of the lobby renovation. Old Orchard Shopping Center On September 2, 1993, effective August 30, 1993, Orchard Associates (in which the Partnership and an affiliated partnership sponsored by the Corporate General Partner each have a 50% interest) sold its interest in the Old Orchard shopping center (reference is made to Note 3(b)). The Partnership is currently retaining its share of the net proceeds from the sale for working capital purposes. Scottsdale Financial Centers I and II On October 1, 1993, the RTC sold the mortgage note underlying Scottsdale Financial Center II and the Partnership simultaneously transferred title to the purchaser of the note. On December 17, 1993, the Partnership relinquished its ownership interest in Scottsdale Financial Center I in a similar transaction. As more fully described in Item 3, Legal Proceedings, a judicial hearing was held in early 1991 concerning, among other things, an alleged default by the Partnership on the mortgage loans secured by the Scottsdale Financial Center I and II investment properties. The judge issued an order rendering the Partnership's rights of offset unenforceable against the RTC acting as receiver of the lender. The court entered a judgment pursuant to this order in February 1992. However, per the judgment, the Partnership was not required to return the guaranteed payments received from the manager since acquisition of the properties, which totalled approximately $1,900,000 for both properties. Both the Partnership and the RTC had filed a notice of appeal from the judgment order of the court. During the appeal process, the RTC was entitled to obtain title to the properties and cash reserves on hand. Accordingly, during the second quarter of 1992, the RTC withdrew the cash reserves on hand at the properties. During the quarter ended March 31, 1993, the Partnership reached an agreement with the RTC for the settlement of the disputes through a dismissal of their respective appeals. In April 1993, in accordance with the settlement, the Partnership returned $320,000, which represented certain amounts (plus interest thereon) which were withdrawn from the property operating accounts subsequent to the date of the alleged default by the Partnership and set aside in a segregated interest bearing account. However, the Partnership was not required to return the $1.9 million of guaranteed payments it had previously received. As a result of the transfers of title discussed above, the Partnership recognized a gain of $18,382,769 and $7,920,092 in 1993 for financial reporting and Federal income tax purposes, respectively, without any corresponding distributable proceeds. Yerba Buena West Office Building In June 1992, the joint venture transferred title to the property to the lender in return for an opportunity to share in future sale or refinancing proceeds above certain specified levels. In connection with the San Francisco earthquake experienced on October 17, 1989, the Yerba Buena office building incurred some structural and cosmetic damage which was repaired. Five tenants (approximately 54% of the building) vacated the building and withheld substantially all of their rent (commencing at various times) since November 1989. The joint venture concluded not to pursue legal recourse against said tenants based on, among other things, the costs of pursuing its remedies, competing demands on the joint venture's (or its partners') resources and the prospects of any material return to the joint venture in light of these events. Reference is made to Note 3(i). Based upon the conditions at Yerba Buena, the joint venture had not made the debt service payments to the underlying lender, commencing with the January 1990 payment. The Partnership and affiliated partners had decided, based upon an analysis of current market conditions and the probability of large future cash deficits, not to fund future joint venture cash deficits. The joint venture was unable to negotiate a loan modification whereby the joint venture retained ownership of the property. In order for the joint venture to share in future 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. In addition, during a certain period of time, the joint venture will have a right of first opportunity to purchase the property if the lender chooses to sell. An affiliate of the Partnership's Corporate General Partner continues to manage and lease the property for the lender. As a result of to the lender as discussed above, the Partnership no longer has an ownership interest in the property and recognized a gain of $1,653,454 and $1,117,418 in 1992 for financial reporting and Federal income tax purposes, respectively, with no corresponding distributable proceeds. Wilshire Bundy Plaza Occupancy at the Wilshire Bundy Plaza decreased to 87% during 1993, down from 91% in the previous year. The building experienced only minor cosmetic damage as a result of the January 1994 earthquake in southern California. From 1993 through 1996, approximately 60% of the building's square feet under tenant leases expires. Dun & Bradstreet (60,500 square feet or approximately 21% of the building's leasable space) and Bozell, Jacobs, Kenyan & Eckhardt (51,000 square feet or approximately 18% of the building's leasable space) have informed the Partnership that they will not be renewing their leases which expire in March 1995 and May 1996, respectively. In addition, several tenants have approached the Partnership seeking space and/or rent reductions. The Partnership is working with its existing tenants and aggressively seeking replacement tenants for current and future vacant space. The West Los Angeles office market (competitive market for the building) is extremely competitive with a current vacancy rate of approximately 20%. While office building development in this market is virtually at a standstill, the Partnership does not expect a significant improvement in the competitive market conditions for several years. As a result of these market conditions, it is expected that in 1994 and for several years beyond, the property will not generate enough cash flow to cover the required debt service on the underlying mortgage loan due to high releasing costs expected to be incurred and lower anticipated effective rental rates expected to be achieved in connection with releasing of the space under current leases that expires. The building may also experience increased vacancy during the releasing period. The Partnership has commenced discussions with the existing lender for a possible debt modification on its mortgage loan which matures April 1996 in order to reduce its debt service and cover its releasing costs over the next several years. If the Partnership is unsuccessful in obtaining such modification, it may decide not to commit additional amounts to the property, which could result in a disposition of the property and a recognition of gain for financial reporting and Federal income tax purposes with no distributable proceeds. 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 had 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 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. Louis Joliet Mall Occupancy of this mall decreased to 82% during 1993 from 91% in the previous year due primarily to the loss of Hermans Sporting Goods (11,850 square feet) which filed for bankruptcy during 1993. Subsequent to the end of the year, Osco (12,407 square feet), pursuant to early termination provisions contained in its lease, terminated its lease and vacated the center reducing occupancy to 77%. During the third quarter of 1993, Al Baskin Co. (19,960 square feet or approximately 7% of the mall space) informed the Partnership that even though its lease does not contain provisions allowing it to terminate its lease, it believed it had the right and intended to terminate its lease effective December 31, 1993 (original lease expiration of December 31, 2003). In response, during the quarter, the Partnership filed an anticipatory breach lawsuit against the tenant in order to prevent the tenant from vacating its space and cease paying rent to the Partnership. The Partnership and tenant have entered into a temporary agreement under which the tenant will continue to operate its store and pay rent through June 30, 1994. The Partnership believes the tenant's position is without merit and intends to enforce the original terms of the lease. Plans are being finalized for an enhancement program for the center to be undertaken in 1994 at a cost of approximately $2,500,000. The enhancement program costs are expected to be funded from the property's operating cash flow and the Partnership's working capital reserve. The owner of Carson Pirie Scott, P.A. Bergner & Co. Holding Company, filed for protection under Chapter 11 of the United States Bankruptcy Code in October 1991. However, Carson Pirie Scott, which owns its store, has continued to operate since this filing and has affirmed its obligation to continue operations in the future in accordance with existing agreements related to the center. Louisiana Tower Occupancy at Louisiana Tower decreased to 90% during 1993, down from 92% in the prior year. The property is operating at a small deficit as a result of the 1990 debt restructuring as more fully discussed in Note 4(b). The Partnership is negotiating with the existing lender for a possible restructuring and/or extension of the existing modified loan. The existing modification period expires and the loan matures in January 1995. The Partnership has decided that it will not commit any significant amounts of capital to this property due to the fact that the recovery of such amounts would be unlikely. Therefore, if the Partnership is unsuccessful in obtaining an acceptable restructuring and/or extension of the loan, the likely result would be the Partnership no longer having an ownership interest in the property. In such event, the Partnership would recognize a loss for Federal income tax purposes and a gain for financial reporting purposes. There can be no assurances that the Partnership will receive a restructuring and/or extension of the loan from the existing lender. Mariners Pointe Apartments Occupancy at the Mariners Pointe Apartments increased to 90% during 1993, up from 87% in the prior year. As a result of certain capital improvement projects, the property operated at a small deficit in 1992. Under the terms of the joint venture agreement, the joint venture partner was obligated to contribute 22.3% of such deficit. The Partnership had made a request for capital from the joint venture partner for its share of the 1992 deficit. The joint venture partner's obligation to make the capita by its interest in the joint venture as well as personal guarantees by certain of its principals. The joint venture partner has not made the required contribution, however the Partnership is currently negotiating with the joint venture partner to obtain its interest in the joint venture and receive certain amounts in satisfaction of its funding obligation. The mortgage loan secured by this property is scheduled to mature October 1, 1994. In this regard, the Partnership is considering its alternatives including a loan extension, refinancing and/or possible sale of the property. There can be no assurance that the Partnership will collect the amounts due from the joint venture partner in satisfaction of its funding obligation or that the Partnership will be able to refinance or extend its existing mortgage loan when it matures. General To the extent that additional payments related to certain properties are required or if properties do not produce adequate amounts of cash to meet their needs, the Partnership may utilize the working capital which it maintains and/or pursue outside financing sources. However, based upon current market conditions, the Partnership may decide not to, or may not be able to, commit additional funds to certain of its investment properties. This would result in the Partnership no longer having an ownership interest in such property, and generally would result in taxable income to the Partnership with no corresponding distributable proceeds. The Partnership's and the ventures' mortgage obligations are all non-recourse. Therefore, the Partnership and its ventures are not personally obligated to pay mortgage indebtedness. There are certain risks and uncertainties 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 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. Therefore, the Partnership is carefully scrutinizing the appropriateness of any discretionary expenditures, particularly in relation to the amount of working capital it has available. 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. 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 the potential for some recovery of its investments. Also, 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 the Partnership expects to distribute from sale proceeds some portion of the Limited Partners' original capital, 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 even though the Partnership would not be able to return a substantial amount of the Limited Partners' original capital from such sales or other dispositions. RESULTS OF OPERATIONS At December 31, 1993, 1992 and 1991, the Partnership owned twelve, fifteen and seventeen investment properties, respectively, all of which were operating. The aggregate increase in the balances of cash and cash equivalents and short term investments at December 31, 1993 as compared to the balances at December 31, 1992 is primarily due to receipt and investment of the Partnership's share of proceeds from the sale of the interest in Old Orchard Shopping Center as well as distribution to the Partnership of its proportionate share of cash flow from the Wells Fargo Center South Tower, the receipt of scheduled amounts due per the settlement agreement with the Turtle Creek joint venture partner and its principals, and the Partnership's share of proceeds from the refinancing of the 1090 Vermont Avenue office building. The decrease in restricted funds at December 31, 1993 as compared to December 31, 1992 is primarily due to the annual remittance on March 31 to the lender of net cash flow generated by the Louisiana Tower as debt service pursuant to the agreement signed in November 1990 as more fully described in Note 4(b), the RTC's withdrawal of the cash reserves on hand (approximately $925,000) at Scottsdale Financial Center II and the Partnership's April 1993 payment of $320,000 to the RTC in accordance with the settlement related to Scottsdale Financial Centers I and II as more fully described in Note 6. The decrease in interest, rents and other receivables, land, buildings and improvements, deferred expenses, accrued interest and accounts payable at December 31, 1993 as compared to December 31, 1992 is due primarily to the disposition of the Scottsdale Financial Centers I and II during 1993 (Note 6) and the disbursement of approximately $2,300,000 of letter of credit proceeds to the lender of the Scottsdale Financial Centers I and II for payment towards accrued interest. The decrease in the current portion of long-term debt at December 31, 1993 as compared to December 31, 1992 is primarily due to the disposition of the Scottsdale Financial Centers I and II and their underlying debt (all of which was classified as current at December 31, 1992) during 1993, partially offset by the debt relating to the Mariner's Pointe Apartments and the Partnership's interest in the Wells Fargo Center which mature in 1994. The increase in due to affiliates at December 31, 1993 as compared to December 31, 1992 is due to the Partnership's paid-in capital obligation to Carlyle Investors, Inc. and Carlyle Managers, Inc., of which the Partnership is a 20% Shareholder (see Note 3(c)). The decrease in the balance of long-term debt less current portion at December 31, 1993 as compared to the balance at December 31, 1992 is primarily due to the debt relating to the Mariner's Pointe Apartments and the Partnership's interest in the Wells Fargo Center which mature in 1994. The decrease in rental income for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 is primarily due to the disposition of the Scottsdale Financial Centers I and II during 1993, lower occupancy at the Wilshire Bundy Plaza, Louis Joliet Mall and Louisiana Tower during 1993, offset partially by higher effective rental rates achieved at the Brittany Downs Apartments Phase I and II during 1993 and the collection of tenant settlements and lease termination fees at Wilshire Bundy Plaza in 1993. The decrease in rental income for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is primarily due to the lease termination of a major tenant at Scottsdale Financial Center I in September 1991 and lease turnover at the Wilshire Bundy Plaza during 1991 and 1992 which resulted in a reduction in operating cost recoveries, partially offset by rental escalations and receipt of lease termination fees at the Louisiana Tower and the Louis Joliet Mall of approximately $486,000 and $200,000, respectively, and the achievement of higher rental rates at the Brittany Downs Apartments-Phases I and II during 1992. Interest income decreased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 primarily due to a decrease in the average balance of U.S. government obligations in 1993 due to contributions by the Partnership of its proportionate share for the releasing costs at 1090 Vermont during the first quarter of 1993 and the Partnership's funding of its share of capital costs at Old Orchard in 1992 and 1993. The decrease in interest income for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is primarily due to a decrease in the average balance of U.S. Government obligations in 1992 due to the contributions by the Partnership of its proportionate share of capital costs at Old Orchard and the payment of the required debt service on the promissory note secured by the Wells Fargo South Tower in 1992 and due to the lower interest rates earned on such U.S. Government obligations in 1992. Other income decreased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and increased for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 as a result of the terms of the Turtle Creek settlement agreement with the venture partner and its principals, as more fully discussed in Note 3(h). The decrease in mortgage and other interest for the twelve months ended December 31, 1993 and the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is primarily due to the recording of additional interest expense in 1991, per the judgement entered in February 1992, for a certain period (June 1990 to December 1991) of the dispute involving the Scottsdale Financial Centers I and II which were disposed of in 1993, partially offset by the accrual of additional interest expense in 1993 relating to the default on the debt underlying the Brittany Downs Apartments - Phase II. Depreciation decreased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and December 31, 1991 primarily due to the Partnership recording a $9,548,085 provision for value impairment at Wilshire Bundy Plaza at June 30, 1992 which reduced the net carrying value of the property, as more fully discussed in Note 1. The decrease in property operating expenses for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 is primarily due to the 1991 recognition of previously unaccrued management compensation costs for the period 1985 to 1991 related to the Louis Joliet Mall, all of which were paid as of December 31, 1991. The provision for (recovery of) doubtful accounts decreased for the twelve months ended December 31, 1993 as compared to December 31, 1992 primarily due to the collection and settlement in 1993 of accounts receivable of two tenants at the Wilshire Bundy Plaza who were significantly past due as of December 31, 1992. The provision for doubtful accounts for the twelve months ended December 1, 1992 is primarily attributable to the uncertainty of collectibility of amounts due from certain tenants at the Wilshire Bundy Plaza. The recovery of doubtful accounts for the twelve months ended December 31, 1991 was attributable to proceeds to be received relating to a letter of credit at the Scottsdale Financial Center II, which had been deemed uncollectible in 1990. This recovery income was offset by additional interest expense recorded at the Scottsdale Financial Centers I and II in 1991. Amortization of deferred expenses increased for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 and for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 primarily due to an increase in leasing activity at certain of the Partnership's investment properties and the amortization of the related lease commissions. The decrease in management fees to the Corporate General Partner for the twelve months ended December 31, 1993 and December 31, 1992 as compared to the twelve months ended December 31, 1991 is due to a decrease in distributions effective with the February 1991 payment and the suspension of distributions effective with the February 1992 payment, a portion of which is its management fee. The increase in the Partnership's share of loss from unconsolidated ventures and the related increase in the Partnership's aggregate deficit investment in unconsolidated ventures, at equity, for the twelve months ended December 31, 1993 as compared to the twelve months ended December 31, 1992 is due primarily to (i) the sale of the Partnership's interest in the Old Orchard Shopping Center, (ii) a $67,479,870 provision for value impairment recorded in 1993 for Wells Fargo-IBM Tower due to the uncertainty of the venture's ability to recover its net carrying value, (iii) a $192,627,560 provision for value impairment recorded in 1993 for 2 Broadway due to the potential sale of the property at a sales price significantly below its net carrying value, (iv) an $11,946,285 provision for doubtful accounts recorded by JMB/NYC due to the uncertainty of collectibilty of amounts due from the Olympia & York affiliates to the Three Joint Ventures, (v) an $11,551,049 provision for doubtful accounts recorded by JMB/NYC due to the uncertainty of collectibility of amounts due from tenants at the Three Joint Ventures' real estate investment properties, and (vi) increased aggregate interest accrued with reference to the Three Joint Ventures' mortgage loan commencing July 1, 1993 as a result of the expiration of the agreement with the Olympia & York affiliates. Reference is made to Note 3. The decrease in the Partnership's share of the loss from operations of unconsolidated ventures for the twelve months ended December 31, 1992 as compared to the twelve months ended December 31, 1991 and the related increase in investment in unconsolidated venture, at equity is primarily due to (i) the change in profit and loss allocation from 1991 to 1992 pursuant to JMB/NYC's venture agreements, as more fully described in Note 3(c) of Notes to Consolidated Financial Statements, (ii) the collection in 1992 of $6,069,444 of a total $13,340,601 bankruptcy claim against Drexel Burnham Lambert, a former tenant of the 2 Broadway Building and (iii) the reduced aggregate interest accrued on the joint ventures' mortgage loan commencing in 1992 based upon the interest accrual determined by JMB/NYC, and its unaffiliated venture partners as more fully described in Note 3(c) of Notes to Consolidated Financial Statements. The gain from disposition of unconsolidated venture for the year ended December 31, 1993 is due to the sale of the Partnership's interest in the Old Orchard Shopping Center. The gain from sale or disposition of investment properties for the year ended December 31, 1993 is due to the transfer of the title to the property to the lender of the Scottsdale Financial Centers I and II. The gain from disposition of unconsolidated ventures for the year ended December 31, 1992 is due to the transfer of title to the property to the lender of the Yerba Buena West Office Building in June 1992 and due to the lender realizing upon its security in the Gateway Plaza Office Building in December 1992 as more fully described in Notes 3(d) and 3(i). Reference is made to Note 1 regarding provisions for value impairment of $51,423,084 in 1992 for 1290 Avenue of the Americas. In accordance with the terms of the respective venture agreements, all of such provision has been allocated to the unaffiliated venture partners. 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 increased expenses may be offset by amounts recovered from tenants as many of the long-term leases at the Partnership's commercial properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, the effect on operating earnings generally will depend upon the extent to which the properties are 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 if rental rates and replacement costs of properties increase. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV (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 -------- Consolidated Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIV 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, 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 Combined Supplementary Income Statement Information X Combined Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the combined financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV: We have audited the consolidated financial statements of Carlyle Real Estate Limited Partnership - XIV, a limited partnership, (the 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 the Partnership 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 discussed in Note 3(c) to the consolidated financial statements, the Partnership and its affiliated partners in JMB/NYC Office Building Associates, L.P. (JMB/NYC) are in dispute with the unaffiliated partners in the real estate ventures over the calculation of the effective interest rate with reference to the first mortgage loan, which covers all the real estate owned through JMB/NYC's joint ventures. The Partnership and its affiliated partners in JMB/NYC believe that, for purposes of calculating cash flow deficits and for financial reporting purposes, the joint venture agreements for JMB/NYC's real estate joint ventures require interest to be computed at an effective rate of 1-3/4% over the short-term U.S. Treasury obligation rate (subject to a minimum rate of 7% per annum) plus any excess monthly Net Cash Flow of the real estate owned through JMB/NYC's joint ventures, such sum not to exceed 12- 3/4% per annum. The unaffiliated partners in the real estate joint ventures contend that a 12-3/4% per annum interest rate applies. The Partnership's share of disputed interest aggregated $4,771,000 at December 31, 1993. The ultimate outcome of the dispute cannot presently be determined. Accordingly, the Partnership's share of the disputed interest has not been included in the Partnership's share of operations of unconsolidated ventures for 1993. In addition, as described in Notes 3, 4 and 6 of the notes to the consolidated financial statements, the Partnership is in dispute or negotiations with various lenders and venture partners in connection with certain of its investment properties. Further, as described in such notes, a number of mortgage loans secured by the Partnership's or its venture's investment properties mature in 1994 or 1995. The Partnership has commenced or intends (Continued) to commence discussions with the mortgage lenders in order to extend and/or modify such loans. Such disputes, negotiations and discussions could result, under certain circumstances, in the Partnership no longer having an ownership interest in these investment properties. The ultimate outcome of these disputes, negotiations and discussions cannot presently be determined. The consolidated financial statements do not include any adjustments that might result from these uncertainties. KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Five year maturities of long-term debt are as follows: 1994 . . . . . . . . . $ 28,107,327 1995 . . . . . . . . . 35,345,888 1996 . . . . . . . . . 41,638,702 1997 . . . . . . . . . 683,184 1998 . . . . . . . . . 11,208,234 ============ 1993 1992 -------------- -------------- Current assets . . . . . . . . . . $ 41,432,795 32,615,070 Current liabilities (including $923,041,198 and $931,654,790, respectively, of debt in default at December 31, 1993 and December 31, 1992) (note 3) . . . (1,246,476,073) (981,968,018) -------------- -------------- Working capital (deficit). . . (1,205,043,278) (949,352,948) -------------- -------------- Investment properties, net . . . . 1,096,520,780 1,468,814,241 Other assets . . . . . . . . . . . 107,336,751 116,852,987 Other liabilities. . . . . . . . . (115,020,293) (101,622,430) Long-term debt . . . . . . . . . . (126,882,022) (427,013,408) -------------- -------------- Partners' capital. . . . . . . $ (243,088,062) (107,678,442) ============== ============== Represented by: Invested capital . . . . . . . . $1,073,795,691 1,068,543,310 Cumulative distributions . . . . (249,692,383) (200,912,694) Cumulative losses. . . . . . . . (1,067,191,370) (759,952,174) -------------- -------------- $ (243,088,062) (107,678,442) ============== ============== Total income . . . . . . . . . . . $ 287,330,325 335,268,295 ============== ============== Expenses applicable to operating loss . . . . . . . . . . . . . . $ 594,569,521 385,874,659 ============== ============== Net loss . . . . . . . . . . . . . $ (307,239,196) (50,606,364) ============== ============== KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV CERTAIN UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes of auditors during 1992 or 1993. 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 - XIV EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 8-18, 68-71, A-7 to A-12 and A-14 to A-20 of Prospectus of the Partnership dated June 4, 1984 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 3-C. Assignment Agreement by and among the Partnership, the General Partners and the Initial Limited Partners is filed herewith Yes 4-A. - 4-D. Long-Term Debt Documents are hereby incorporated herein by reference Yes 4-E - Long-term debt documents relating to the refinancing of the first mortgage loan secured by the 1090 Vermont Office Building in Washington, D.C. No 10-A - 10-G. Acquisition Documents are hereby incorporated herein by reference Yes 10-H. Agreement dated March 25, 1993 between JMB/NYC and the Olympia & York affiliates Yes 10-I. Settlement Agreement dated March 12, 1993 between the Resolution Trust Corporation and Carlyle-XIV Yes 10-J. Agreement of Limited Partnership of Carlyle-XIV Associates, L.P. Yes 10-K. Second Amended and Restated Articles of Partnership of JMB/NYC Office Building Associates No 10-L. Documents relating to the sale by the Partnership of its interest in the Old Orchard Venture Yes 10-M. Amended and Restated Certificate of Incorporation of Carlyle-XIV Managers, Inc. (known as Carlyle Managers, Inc.) No 10-N. Amended and Restated Certificate of Incorporation of Carlyle-XIII Managers, Inc. (known as Carlyle Investors, Inc.) No CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XIV EXHIBIT INDEX - CONTINUED DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 10-O. $1,200,000 demand note between Carlyle-XIV Associates, L.P. and Carlyle Managers, Inc. No 10-P. $1,200,000 demand note between Carlyle-XIV Associates, L.P. and Carlyle Investors, Inc. No 21. List of Subsidiaries No 24. Powers of Attorney No 99-A. The Partnership's Report on Form 8-K for October 1, 1993 Yes 1090 Vermont Ave NOTE Date of Note: November 1, 1993 Principal Amount: $17,750,000.00 Maturity Date: December 1, 2003 Interest Rate: shall mean % per annum for the period beginning with the Funding Date (as defined below) and continuing until the first day of the month following the month in which the fifth anniversary of the Funding Date occurs (the "Reset Date") and shall mean 2.80% per annum in excess of the "Treasury Yield" (as defined below) for the period beginning on the Reset Date and continuing until this Note has been repaid in full, in each case to be computed on the basis of a 360-day year consisting of twelve 30-day months. FOR VALUE RECEIVED, the undersigned ("Maker") does hereby covenant and promise to pay to the order of CBA Conduit, Inc., a Delaware corporation, or its successors or assigns (collectively, "Payee") the Principal Amount together with interest thereon at the Interest Rate and all other amounts due hereunder, all as hereinafter provided. Payments of interest shall be due on January 1, 1994, being the first day of the first month following the date (the "Funding Date") the proceeds of this Note are disbursed by Payee, and on the first day of each month thereafter until this Note is paid in full, and shall be remitted to Payee at the address designated by Payee in a notice to be delivered to Maker in accordance with the notice provisions contained in the Mortgage (as defined below), or at such other place as Payee may subsequently designate to Maker in writing from time to time, in legal tender of the United States. Notwithstanding the foregoing, in the event Maker defaults in its obligation to make any payment due hereunder beyond any applicable grace period provided in the Mortgage (as defined below), for any reason whatsoever, the full amount outstanding hereunder including, without limitation, all accrued and unpaid interest) shall bear interest at a per annum rate of interest equal to the Interest Rate then in effect plus 5%, but in no event to exceed the maximum rate allowed by law (the "Default Rate") until all amounts due and payable hereunder have been paid in full. A late payment premium of 5% of any interest payment (or of any principal payment payable as set forth below) shall also be due with respect to any payment made more than 10 days after the due date thereof. The Principal Amount, or such other amount which is outstanding hereunder, shall be due and payable in legal tender of the United States on the Maturity Date or an earlier date upon acceleration or otherwise in accordance with the terms of the Mortgage (as defined below). This Note is secured by, among other things, (a) a mortgage or deed of trust (the "Mortgage") of property located as indicated below, which Mortgage specifies various defaults upon the happening of which and the expiration of the applicable cure period, if any, under the Mortgage, all sums owing on this Note may, at Payee's option, be declared immediately due and payable and (b) a certain Cash Reserve Agreement (the "Cash Reserve Agreement") between Maker and Payee. For purposes of this Note the term "Treasury Yield" shall mean the average yield for the week prior to the 60th day prior to the Reset Date as reported in H.15(519) or the applicable successor publication, for Treasury Constant Maturities having a maturity of five (5) years. In the event there is no yield reported for Treasury Constant Maturities having a maturity of five (5) years for the week prior to the 60th day prior to the Reset Date, the Treasury Yield will be derived by linear interpolation from the yields reported for Treasury obligations having the next longer and next shorter maturities than the 5 year maturity, as reported in H.15(519) or the applicable successor publication. Payee covenants and agrees by its acceptance of this Note that, provided (i) Maker has fully satisfied in a timely manner the annual financial reporting requirements set forth in the Mortgage and (ii) no default exists hereunder or Event of Default (as defined in the Mortgage) exists under the Mortgage, Payee shall remit to Maker, no more than once per year during the term of this Note, on the first day of the thirteenth (13th) month following the Funding Date, and subject to the satisfaction of such reporting requirements in subsequent years, on the first day of that same month in subsequent years during the term of this Note, an amount equal to .05% of the Principal Amount then outstanding at the time Maker satisfies such requirements. Maker agrees that it shall be bound by any agreement extending the time or modifying the above terms of payment, made by Payee and the owner or owners of the property affected by the Mortgage, whether with or without notice to Maker, and Maker shall continue liable to pay the amount due hereunder, but with interest at a rate no greater than the Interest Rate, according to the terms of any such agreement of extension or modification. This Note may not be changed orally, but only by an agreement in writing, signed by the party against whom enforcement of any waiver, change, modification or discharge is sought. Should the indebtedness represented by this Note or any part thereof be collected at law or in equity, or in bankruptcy, receivership or any other court proceedings (whether at the trial or appellate level), or should this Note be placed in the hands of attorneys for collection upon default, Maker agrees to pay, in addition to the principal, premium and interest due and payable hereon, all costs of collection or attempting to collect this Note, including reasonable attorneys' fees and expenses. All parties to this Note, whether Maker, principal, surety, guarantor or endorser, hereby waive presentment for payment, demand, protest, notice of protest and notice of dishonor. Anything herein to the contrary notwithstanding, the obligations of Maker under this Note and the Mortgage shall be subject to the limitation that payments of interest shall not be required to the extent that receipt of any such payment by Payee would be contrary to provisions of law applicable to Payee limiting the maximum rate of interest that may be charged or collected by Payee. Notwithstanding the foregoing, if for any reason any payment by Maker results in Maker's having paid any interest in excess of that permitted by law, then it is Maker's and Payee's express intent that all excess amounts theretofore collected by the holder of this Note be credited to the then outstanding principal balance hereof (or, if this Note has been paid in full, refunded to Maker), and the provisions of this Note and all documents securing payment of this Note shall immediately be deemed reformed and the amounts thereafter collectible hereunder and thereunder reduced, without necessity of execution of any new document, so as to comply with applicable law, but so as to permit the recovery of the fullest amount otherwise called for hereunder and thereunder. It is further agreed that, without limitation of the foregoing, all calculations of the rate of interest contracted for, charged or received under this Note and under such other documents securing payment of this Note or which are interpreted for the purpose of determining whether such rate would exceed the maximum lawful rate, shall be made, to the extent permitted by the law of the District of Columbia, by amortizing, prorating, allocating and spreading during the full stated term of this Note, all interest contracted for, charged or received from Maker or otherwise by the holder of this Note. On or about the 60th day prior to the Reset Date (such 60th day prior to the Reset Date is hereinafter referred to as the "Initial Prepayment Date"), Payee shall notify Maker of the Interest Rate to be effective beginning on the Reset Date (except that the failure to so notify Maker shall not affect Maker's obligation to make payments hereunder at such new Interest Rate). Prior to the Initial Prepayment Date, Maker shall not have the right to prepay this Note in whole or in part except as expressly provided in Sections 2.09(j) and 2.15(f) of the Mortgage and clause (I) of each of Sections 2.09(f), 2.09(h), 2.15(b) and 2.15(d) of the Mortgage with respect to the application of certain insurance and condemnation proceeds. Maker shall, however, have the right to prepay this Note beginning on the Initial Prepayment Date provided, however, that any such payment made during the month in which the Initial Prepayment Date falls shall not be applied against this Note until the final business day of such month, and on the final business day of each month thereafter (each such final business day of such months a "Permitted Prepayment Day") in whole or in part. Partial prepayments shall, however, only be permitted in connection with either (a) the application of insurance or condemnation proceeds as provided by Section 2.09 or 2.15 of the Mortgage, (b) the application of any Principal Reduction Amount (as defined and under the conditions set forth in the Mortgage) or (c) the application of any amounts deposited into the Cash Reserve (as defined and under the conditions set forth in the Cash Reserve Agreement). Any prepayment shall be conditioned upon written notice thereof given to Payee in accordance with the notice provisions set forth in the Mortgage at least 60 days prior to the Permitted Prepayment Day to be fixed therein for prepayment, provided, however, that in the case of a prepayment under clause (a), (b) or (c) above, only thirty (30) days notice shall be required, and in all cases upon the payment of (i) all accrued interest on the amount prepaid (and all late charges and other sums that may be payable hereunder or under the Mortgage including, without limitation any Early Prepayment Interest (as defined below)) and (ii) to the extent required by the terms hereof or of the Mortgage, a Prepayment Premium (as defined below) or Yield Maintenance Amount (as defined below), as applicable, calculated as set forth below. Maker acknowledges that in certain events certain payments of principal, interest and other amounts due under the terms of the Mortgage will, pursuant to the terms of the Mortgage, be deposited into the Cash Reserve to be held and applied in accordance with the terms of the Cash Reserve Agreement. Maker further acknowledges and agrees that the terms and provisions of the Mortgage and the Cash Reserve and Security Agreement shall control with respect to the application of such payments and that any payment of principal, interest or other amount required by the terms of the Mortgage to be deposited into the Cash Reserve shall not be deemed a payment of this Note until such time as such funds are actually applied against this Note in accordance with the terms of the Cash Reserve and Security Agreement. In the event of any full or partial prepayment of this Note, whether such prepayment is mandatory or voluntary on the part of Maker or due to an acceleration of the Maturity Date resulting from a default under this Note, the Mortgage or any other document delivered by Maker in connection with the loan evidenced hereby (each of the Note, the Mortgage and such other documents are hereinafter sometimes referred to as a "Loan Document") or a prepayment resulting from a determination pursuant to the terms of the Mortgage that certain insurance or condemnation proceeds are to be applied toward prepayment of this Note, or from the application of all or any portion of the Cash Reserve in accordance with the Cash Reserve Agreement, or otherwise, a Prepayment Premium, in the case of payments received by Payee following the Reset Date and a Yield Maintenance Amount in the case of payments received by Payee prior to the Initial Prepayment Date shall, except as set forth in the paragraph immediately following the Prepayment Premium Schedule set forth below, be added to the indebtedness due hereunder and shall be immediately due and payable at the time of such prepayment. Any Yield Maintenance Amount due to Payee shall be calculated by Payee as set forth below under the Yield Maintenance Schedule and any Prepayment Premium due to Payee shall be calculated by Payee as set forth below under the Prepayment Premium Schedule: YIELD MAINTENANCE SCHEDULE The "Yield Maintenance Amount" shall be equal to the greater of (x) one percent (l%) of the amount to be prepaid or (y) an amount calculated in accordance with the following formula: A. Payee shall determine the average yield (to be determined as of the date seven (7) days prior to the date of payment or required payment of such amount) available on Treasury Constant Maturities maturing nearest the Reset Date of this Note as reported in H.15(519) or the applicable successor publication (the "Government Yield"); B. from the then existing interest rate hereunder, Payee shall-subtract the Government Yield (the resulting difference, if positive, the "Positive Spread") (if the resulting number is negative, the calculation in this subparagraph B shall not be applicable and the Yield Maintenance Amount shall be as stated in clause (x) above); C. Payee shall divide the Positive Spread by 12 and multiply the quotient so obtained by the amount of such payment or required payment to determine the "Monthly Interest Shortfall"; and D. Payee shall determine the present value on the date of prepayment of the Monthly Interest Shortfall for each full and partial month remaining until the Reset Date by discounting each Monthly Interest Shortfall at the Government Yield divided by twelve and find the sum of such present values, which sum shall be the amount due, under this clause (y). PREPAYMENT PREMIUM SCHEDULE The "Prepayment Premium" shall be equal to the product of the corresponding percentage set forth below based upon the date of the prepayment multiplied by the amount to be prepaid hereunder: Date of Prepayment Premium Year 1 following Reset Date 5% of principal prepaid Year 2 following Reset Date 4% of principal prepaid Year 3 following Reset Date 3% of principal prepaid Year 4 following Reset Date 2% of principal prepaid First ten (10) months of Year 5 l% of principal prepaid following Reset Date A Prepayment Premium or Yield Maintenance Amount, as applicable, calculated in accordance with the terms of the immediately preceding paragraph shall be due and payable in the case of any prepayment (which shall not include any payment deposited into the Cash Reserve except as and to the extent such amounts are actually applied against this Note in accordance with the terms of the Cash Reserve Agreement) except (i) a prepayment pursuant to Section 2.09(j) or Section 2.15(f) of the Mortgage, (ii) a prepayment made during the period beginning on the Initial Prepayment Date and ending on the Reset Date or (iii) a prepayment made during the period covering the final sixty (60) days immediately prior to the Maturity Date of this Note. In addition to all other amounts due hereunder or under the Mortgage, Maker shall pay to Payee, in connection with any prepayment of this Note, and without implying Payee's consent to any prepayment prohibited by the terms hereof, interest ("Early Prepayment Interest") at the then current interest rate on the amount so prepaid from the date Payee receives such payment as prepayment under this Note (without regard to the date such payment is deposited in the Cash Reserve or actually applied against the indebtedness) through and including the last calendar day of the month in which Payee receives such prepayment. Maker acknowledges that pursuant to the terms of Section 7.06(b) of the Mortgage, in certain events the lien of the Mortgage shall be released by Payee prior to the repayment in full of this Note whereupon this Note shall be secured by, among other things, the Cash Reserve Agreement and the Cash Reserve held by Payee Pursuant thereto. Notwithstanding any other provision herein or in the Mortgage or any other Loan Document contained, neither Maker, any present or future constituent partner in or agent of Maker, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Maker, shall be personally liable, directly or indirectly, under or in connection with this Note or the Mortgage or any other Loan Document, or any instrument or certificate securing or otherwise executed in connection with this Note or the Mortgage or any other Loan Document, or any amendments or modifications to any of the foregoing made at any time or times, heretofore or hereafter; the recourse of the Payee and each of its successors and assignees under or in connection with this Note, the Deed of Trust, any other Loan Document and such instruments and certificates, and any such amendments or modifications, shall be limited to Maker's interest in the Mortgaged Property (as defined in the Mortgage) and such other collateral, if any, as may now or hereafter be given to secure any payment required to be made under this Note or under the Mortgage or any other Loan Document or for the performance of any of the covenants or warranties contained herein or therein only, and Payee hereby waives any such personal liability; provided, however, that the foregoing provisions of this paragraph shall not (i) constitute a waiver of any obligation evidenced by this Note or contained in the Mortgage or any other Loan Document, (ii) limit the right of Payee to name Maker as a party defendant in any action or suit for judicial or non-judicial foreclosure and sale or any other action or suit under the Mortgage or any other Loan Document so long as no judgment in the nature of a deficiency judgment shall be enforced against Maker except to the extent of the Mortgaged Property or such other collateral, (iii) affect in any way the validity or enforceability of any guaranty (whether of payment and/or performance), any indemnity provision contained in Sections 2.17, 2.24, 6.06, 7.11 or 7.19 of the Mortgage in favor of the trustee thereunder and/or Payee or any indemnity agreement given to Payee in the Environmental Indemnification Agreement of even date herewith by and between Maker and Payee (the "Environmental Indemnification Agreement") or in Section 5.2 of the Assignment of Rents and Leases of even date herewith by and between Maker and Payee (the "Assignment of Rents and Leases"), except that the liability of Carlyle (as defined below) only (but not of Maker or of The John Akridge Company (in its capacity as a general partner of Maker)) under any indemnity provision contained in Sections 2.17, 2.24, 6.06, 7.11 or 7.19 of the Mortgage in favor of the trustee thereunder or the Payee or any indemnity agreement given to Payee in Section 5.2 of the Assignment of Rents and Leases (collectively, such indemnity provisions and agreement are hereinafter sometimes referred to as the "Specified Indemnities") shall be limited as provided in the second succeeding paragraph hereof or (iv) constitute a waiver by Payee of any rights to reimbursement for actual, or out-of-pocket, losses, costs or expenses, or any other remedy at law or in equity, against Maker by reason of (1) gross negligence, willful misconduct, intentional misrepresentations or fraudulent acts or omissions, (2) willful misapplication of any insurance proceeds, condemnation awards or tenant security deposits, or of any rental or other income which was required by the Mortgage or other Loan Documents to be paid or applied in a specified manner, arising, in any such case, with respect to the Mortgaged Property, (3) Maker's entry into, modification of, or termination of any lease of any part of the Mortgaged Property, if the Mortgage requires such consent to be obtained by Maker, (4) failure to pay premiums for insurance covering environmental risks or (5) the material inaccuracy of any information contained in rent rolls delivered to Payee on or prior to the date hereof in connection with Payee's underwriting of the Loan evidenced hereby or delivered to Payee pursuant to Section 2.16 of the Mortgage or pursuant to any other Loan Document and relied upon by Payee in making any determination under Section 2.32 of the Mortgage with respect to the Debt Service Coverage Ratio (as such term is used in Section 2.32 of the Mortgage) for the loan evidenced hereby. Notwithstanding anything contained in clause (iii) of this paragraph, so long as Payee's rights to pursue Maker and other parties who are not related to Maker or Maker's partners or principals are not in any way prejudiced or impaired thereby and any costs that Payee may incur by refraining from pursuing Maker that are not paid in advance by Maker are not in Payee's reasonable judgment material, Payee shall seek to obtain reimbursement pursuant to any valid insurance policy covering environmental Dental risks and maintained by Maker (or for which the Maker pays a portion of the premiums) pursuant to the terms of the Mortgage, to the extent such reimbursement shall be available to Payee, before it seeks to obtain satisfaction with respect to any loss or damage it may sustain with respect to environmental matters from the personal assets (other than any assets that may constitute collateral for the loan evidenced hereby) of Maker or any general partner of Maker. For the purposes of this Note, "Carlyle" shall mean, collectively, (i) Carlyle Real Estate Limited Partnership - XIV and (ii) JMB Realty Corporation ("JMB") or any JMB Approved Transferee (as defined in the Mortgage) if JMB or such JMB Approved Transferee acquires all or any part of Carlyle Real Estate Limited Partnership - XIV's partnership interest in Maker. Notwithstanding anything to the contrary in this Note or the Mortgage or in any other Loan Document (including, without limitation, (i) the preceding paragraph of this Note or the next succeeding paragraph of this Note, (ii) the Environmental Indemnification Agreement and (iii) the Assignment of Rents and Leases), no limited partner of Grantor, no present or future constituent partner in or agent of Carlyle, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Carlyle, nor any present or future shareholder, officer, director, employee or agent of The John Akridge Company, shall be personally liable, directly or indirectly, under or in connection with this Note, the Mortgage or any other Loan Document (including, without limitation, the Environmental Indemnification Agreement and the Assignment of Rents and Leases), or any instrument or certificate securing or otherwise executed in connection with this Note, the Mortgage or any other Loan Document (including, without limitation, the Environmental Indemnification Agreement and the Assignment of Rents and Leases), or any amendments or modifications to any of the foregoing made at any time or times, heretofore or hereafter and Payee and each of its successors and assignees waives and does hereby waive any such personal liability. For purposes of this Note, the Mortgage and each of the other Loan Documents (including, without limitation, the Environmental Indemnification Agreement and Assignment of Rents and Leases) and any such instruments and certificates, and any such amendments or modifications, neither the negative capital account of any constituent partner in Carlyle, nor any obligation of any constituent partner in Carlyle to restore a negative capital account or to contribute capital to Carlyle or to another constituent partner in Carlyle, shall at any time be deemed to be the property or an asset of Carlyle or any such other constituent partner (and neither Payee nor any of its successors or assignees shall have any right to collect, enforce or proceed against or with respect to any such negative capital account or partner's obligation to restore or contribute). Notwithstanding anything to the contrary in this Note or in the Mortgage or in any other Loan Document (including, without limitation, (i) the second preceding paragraph hereof, (ii) the Environmental Indemnification Agreement and (ii) the Assignment of Rents and Leases), the aggregate liability of Carlyle under the Specified Indemnities shall in no event exceed the sum of One Million Dollars ($1,000,000.00), but such limitation shall not: (x) limit the liability of Maker or The John Akridge Company (in its capacity as a general partner of Maker) to Payee and/or the trustee under the Specified Indemnities; (y) limit the liability of Carlyle under any indemnity agreement given to Payee in the Environmental Indemnification Agreement or (z) limit the rights of Payee or the liability of Carlyle under clauses (i), (ii), or (iv) of the second preceding paragraph hereof. Maker hereby expressly and unconditionally waives, in connection with any suit, action or proceeding brought by Payee for collection on this Note, any and every right it may have to (i) injunctive relief, (ii) interpose any counterclaim therein other than any compulsory counterclaim and (iii) have the same consolidated with any other or separate suit, action or proceeding. Nothing herein contained shall prevent or prohibit Maker from instituting or maintaining a separate action against Payee with respect to any asserted claim. This Note and the rights and obligations of the parties hereunder shall in all respects be governed by, and construed and enforced in accordance with, the laws of the District of Columbia (without giving effect to District of Columbia principles of conflicts of law). Maker hereby irrevocably submits to the non-exclusive jurisdiction of any District of Columbia or Federal court sitting in the District of Columbia over any suit, action or proceeding arising out of or relating to this Note, and Maker hereby agrees and consents that, in addition to any methods of service of process provided for under applicable law, all service of process in any such suit, action or proceeding in any District of Columbia or Federal court sitting in the District of Columbia may be made by certified or registered mail, return receipt requested, directed to Maker at the address indicated below, and service so made shall be complete five (5) days after the same shall have been so mailed See District of Columbia Rider to Note attached hereto and incorporated herein by reference. MAKER HEREBY KNOWINGLY, VOLUNTARILY AND INTENTIONALLY WAIVES (TO THE EXTENT PERMITTED BY APPLICABLE LAW) ANY RIGHT IT MAY HAVE TO A TRIAL BY JURY OF ANY DISPUTE ARISING UNDER OR RELATING TO THIS NOTE AND AGREES THAT ANY SUCH DISPUTE SHALL, AT THE OPTION OF PAYEE, BE TRIED BEFORE A JUDGE SITTING WITHOUT A JURY. IN WITNESS WHEREOF, Maker has executed and delivered this Note on the day and year first above written. 1090 VERMONT AVENUE, N.W. ASSOCIATES LIMITED PARTNERSHIP, a District of Columbia limited partnership Attest: By: The John Akridge Company, a Virginia corporation, general partner By: Secretary Name: [CORPORATE SEAL] Title: By: Carlyle Real Estate Limited Partnership - XIV, an Illinois limited partnership, general partner Attest: By:JMB Realty Corporation, a Delaware corporation, general partner By: Secretary Name: [CORPORATE SEAL] Title: Property Location: Address of Maker: 1090 Vermont Avenue, N.W. c/o The John Akridge Company Washington, D.C. 20005 601 Thirteenth Street, N.W. Washington, D.C. 20005 Maker's Initials: AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF CARLYLE-XIII MANAGERS, INC. WHEREAS, this corporation desires to change its name to Carlyle Investors, Inc. NOW, THEREFORE, the Certificate of Incorporation as filed with the Delaware Secretary of State on March 25, 1993 is hereby amended and restated to read as follows: ARTICLE ONE: The name of this corporation is Carlyle Investors, Inc. ARTICLE TWO: The address of its registered office in the State of Delaware is Corporation Trust Center, 1209 Orange Street, in the City of Wilmington, County of New Castle, 19801. The name of its registered agent at such address is The Corporation Trust Company. ARTICLE THREE: The nature of the business or purpose to be conducted or promoted is: to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware. ARTICLE FOUR: The total number of shares of stock which this corporation shall have authority to issue is 1,000 and the par value of each of such shares is One Dollar ($1.00) amounting in the aggregate to One Thousand Dollars ($1,000.00). ARTICLE FIVE: The number of directors constituting the Board of Directors shall be that number as shall be fixed by the by-laws of this Corporation. ARTICLE SIX: The corporation is to have perpetual existence. ARTICLE SEVEN: In furtherance and not in limitation of the powers conferred by statute, the Board of Directors of this corporation is expressly authorized to make, alter or repeal the by-laws of this corporation. ARTICLE EIGHT: Elections of directors need not be by written ballot unless the by-laws of this corporation shall so provide. Meetings of the stockholders may be held within or without the State of Delaware, as the by- laws may provide. The books of this corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the by-laws of this corporation. ARTICLE NINE: The corporation reserves the right to amend, alter, change or repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now and hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. ARTICLE TEN: To the fullest extent permitted by the General Corporation Law of the State of Delaware as it now exists or may hereafter be amended, no director of this corporation shall be liable to this corporation or its stockholders for monetary damages arising from a breach of fiduciary duty owed to this corporation. ARTICLE ELEVEN: This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on March 29, 1993. This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on April 6, 1993. IN WITNESS WHEREOF, the President has signed, and the Secretary has attested, this Amended and Restated Certificate of Incorporation this 6th day of April, 1993. Neil G. Bluhm President ATTEST: Kevin B. Yates Secretary STATE OF ILLINOIS ) ) ss COUNTY OF COOK ) I, the undersigned, a Notary Public in and for said County, in the State aforesaid, DO HEREBY CERTIFY that Kevin B. Yates, the Secretary of Carlyle-XIII Managers, Inc., acknowledged that the statements set forth in the foregoing instrument are true and correct, and that he signed the foregoing instrument as his free and voluntary act for the uses and purposes therein set forth. Subscribed and sworn to before me this 6th day of April, 1993. Mona Sarnoff Notary Public AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF CARLYLE-XIV MANAGERS, INC. WHEREAS, this corporation desires to change its name to Carlyle Managers, Inc. NOW, THEREFORE, the Certificate of Incorporation as filed with the Delaware Secretary of State on March 25, 1993 is hereby amended and restated to read as follows: ARTICLE ONE: The name of this corporation is Carlyle Managers, Inc. ARTICLE TWO: The address of its registered office in the State of Delaware is Corporation Trust Center, 1209 Orange Street, in the City of Wilmington, County of New Castle, 19801. The name of its registered agent at such address is The Corporation Trust Company. ARTICLE THREE: The nature of the business or purpose to be conducted or promoted is: to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware. ARTICLE FOUR: The total number of shares of stock which this corporation shall have authority to issue is 1,000 and the par value of each of such shares is One Dollar ($1.00) amounting in the aggregate to One Thousand Dollars ($1,000.00). ARTICLE FIVE: The number of directors constituting the Board of Directors shall be that number as shall be fixed by the by-laws of this Corporation. ARTICLE SIX: The corporation is to have perpetual existence. ARTICLE SEVEN: In furtherance and not in limitation of the powers conferred by statute, the Board of Directors of this corporation is expressly authorized to make, alter or repeal the by-laws of this corporation. ARTICLE EIGHT: Elections of directors need not be by written ballot unless the by-laws of this corporation shall so provide. Meetings of the stockholders may be held within or without the State of Delaware, as the by- laws may provide. The books of this corporation may be kept (subject to any provision contained in the statutes) outside the State of Delaware at such place or places as may be designated from time to time by the Board of Directors or in the by-laws of this corporation. ARTICLE NINE: The corporation reserves the right to amend, alter, change or repeal any provision contained in this Amended and Restated Certificate of Incorporation, in the manner now and hereafter prescribed by statute, and all rights conferred upon stockholders herein are granted subject to this reservation. ARTICLE TEN: To the fullest extent permitted by the General Corporation Law of the State of Delaware as it now exists or may hereafter be amended, no director of this corporation shall be liable to this corporation or its stockholders for monetary damages arising from a breach of fiduciary duty owed to this corporation. This Amended and Restated Certificate of Incorporation was duly adopted by the stockholders of this corporation pursuant to Section 242 of the General Corporation Law of Delaware on April 6, 1993. IN WITNESS WHEREOF, the President has signed, and the Secretary has attested, this Amended and Restated Certificate of Incorporation this 6th day of April, 1993. Neil G. Bluhm President ATTEST: Kevin B. Yates Secretary STATE OF ILLINOIS ) ) ss COUNTY OF COOK ) I, the undersigned, a Notary Public in and for said County, in the State aforesaid, DO HEREBY CERTIFY that Kevin B. Yates, the Secretary of Carlyle-XIV Managers, Inc., acknowledged that the statements set forth in the foregoing instrument are true and correct, and that he signed the foregoing instrument as his free and voluntary act for the uses and purposes therein set forth. Subscribed and sworn to before me this 6th day of April, 1993. Mona Sarnoff Notary Public DEMAND NOTE $1,200,000.00 March 25, 1993 FOR VALUE RECEIVED, the undersigned, Carlyle Real Estate Limited Partnership-XIV, an Illinois limited partnership (hereinafter referred to as "Payor"), hereby promises to pay Carlyle Managers, Inc., a Delaware corporation (hereinafter referred to as "Payee"), on demand the principal sum of $1,200,000.00 (hereinafter referred to as the "Principal Amount"). The Principal Amount shall bear interest at the Alternate Federal Short-Term rate (the "Rate") as of the date hereof, which rate shall change to the Rate then in effect as of every six months from the date hereof (the "Compounding Date"); all interest shall be compounded as of every Compounding Date. Payor may at any time elect to prepay all or any portion of the Principal Amount, together with any accrued but unpaid interest thereon, without premium or penalty. IN WITNESS WHEREOF, Payor has executed this Demand Note this 25th day of March, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIV By: JMB Realty Corporation a Delaware corporation Corporate General Partner By: Neil G. Bluhm President DEMAND NOTE $1,200,000.00 March 25, 1993 FOR VALUE RECEIVED, the undersigned, Carlyle Real Estate Limited Partnership-XIV, an Illinois limited partnership (hereinafter referred to as "Payor"), hereby promises to pay Carlyle Investors, Inc., a Delaware corporation (hereinafter referred to as "Payee"), on demand the principal sum of $1,200,000.00 (hereinafter referred to as the "Principal Amount"). The Principal Amount shall bear interest at the Alternate Federal Short-Term rate (the "Rate") as of the date hereof, which rate shall change to the Rate then in effect as of every six months from the date hereof (the "Compounding Date"); all interest shall be compounded as of every Compounding Date. Payor may at any time elect to prepay all or any portion of the Principal Amount, together with any accrued but unpaid interest thereon, without premium or penalty. IN WITNESS WHEREOF, Payor has executed this Demand Note this 25th day of March, 1993. CARLYLE REAL ESTATE LIMITED PARTNERSHIP-XIV By: JMB Realty Corporation a Delaware corporation Corporate General Partner By: Neil G. Bluhm President 1090 Vermont Avenue This document was prepared by and after recording please return to: Brownstein Zeidman and Lore A Professional Corporation 1401 New York Avenue, N.W. Suite 900 Washington, D.C. 20005 Attention: Kenneth G. Lore, Esq. Loan No. 113 Date: As of November 1, 1993 DEED OF TRUST AND SECURITY AGREEMENT FROM 1090 VERMONT AVENUE, N.W. ASSOCIATES LIMITED PARTNERSHIP Address: c/o The John Akridge Company 601 13th Street, N.W., Suite 300 North Washington, D.C. 20005 TO RANDY ALAN WEISS, TRUSTEE Address: c/o Margolius, Mallios, Davis, Rider & Tomar 1828 L Street, N.W., Suite 500 Washington, D.C. 20036 For the Benefit of CBA CONDUIT, INC. a Delaware corporation having its principal office at Suite 103, Financial Centre, 695 East Main Street, Stamford, Connecticut 06901 Note Amount: $17,750,000.00 THIS DEED OF TRUST AND SECURITY AGREEMENT (hereinafter called "Deed of Trust") is made as of the 1st day of November, 1993, by and among 1090 Vermont Avenue, N.W. Associates Limited Partnership, a District of Columbia limited partnership, having an address at c/o The John Akridge Company, 601 Thirteenth Street, N.W., Suite 300 North, Washington, D.C. 20005 ("Grantor"), to Randy Alan Weiss, Trustee, having an address at c/o Margolius, Mallios, Davis, Rider & Tomar, 1828 L Street, N.W., Suite 500, Washington, D.C. 20036 ("Trustee"), for the benefit of CBA CONDUIT, INC., a Delaware corporation having an address at Suite 103, Financial Centre, 695 East Main Street, Stamford, Connecticut 06901, and any subsequent holder of the Secured Obligations hereinafter set forth ("Beneficiary"), as more fully hereinafter set forth. W I T N E S S E T H: WHEREAS, Grantor is the owner of the land described in Schedule A annexed hereto and made a part hereof and all other Mortgaged Property (as hereinafter defined); WHEREAS, Beneficiary has loaned to Grantor the principal amount of Seventeen Million Seven Hundred Fifty Thousand and No/lOOs Dollars ($17,750,000.00) (the "Loan") evidenced by a note (the "Note") of even date herewith made by Grantor to Beneficiary in such amount; and WHEREAS, in order to secure the payment of the Note and the payment and performance of certain further obligations hereinafter described, Grantor has duly authorized the execution and delivery of this Deed of Trust. NOW, THEREFORE, the parties hereto hereby agree as follows: CERTAIN DEFINITIONS Grantor, Trustee and Beneficiary agree that, unless the context otherwise specifies or requires, the following terms shall have the meanings herein specified, such definitions to be applicable equally to the singular and the plural forms of such terms. "Actual Expenses", with respect to any period of time, means, subject to the last sentence of this definition, the aggregate amount of all cash expended during such period of time for costs of owning, operating, managing, repairing (other than costs for capital repairs) or maintaining the Mortgaged Property, exclusive, however, of (i) principal and interest payments on the Note, (ii) costs for Restoration eligible for reimbursement from insurance proceeds in accordance herewith, (iii) costs for Work eligible for reimbursement from condemnation award proceeds in accordance herewith, and (iv) depreciation, amortization and other non-cash expenses. For purposes of this definition, insurance premiums, real estate taxes and other costs not generally paid on a monthly basis will be allocated evenly over the entire period for which they were paid or are payable without regard to the actual date of payment. "Affiliate", when used with respect to a specified Person, means a Person that: (a) directly, or indirectly through one or more intermediaries, controls, is controlled by or is under common control with such specified Person; (b) is a director, officer, employee, trustee or general partner of, or directly or indirectly an owner of an equity interest of ten percent (lO%) or more or a beneficiary of a trust owning an equity interest of ten percent (10%) or more in, the Person specified or any Person specified in clause (a) above; or (c) is a member of the immediate family of the Person specified in clause (a) or (b) above. For purposes hereof, the members of a Person's immediate family shall be such Person's parents, grandparents, children, grandchildren, siblings and children of siblings or the spouse of such Person or of any of the foregoing. For purposes of this definition, the term "control" (and any derivative thereof) means the possession, directly or indirectly, of the power to direct or cause the direction of the management and/or policies of a Person, whether through the ownership of voting stock, by contract or otherwise. "Akridge Group" shall mean, collectively, The John Akridge Company, Vermont and L Ltd, John E. Akridge, III, and Sarah B. Akridge, William C. Smith and any bona fide full-time employee of The John Akridge Company which as of the date hereof holds a partnership interest in the Grantor. "Approved Control Party" shall mean either Carlyle Real Estate Limited Partnership - XIV or The John Akridge Company, but shall not include any successor or assign of either. "Bankruptcy Code" shall have the meaning set forth in Section 7.20 hereof "Business Day" shall mean any day other than a Saturday, Sunday or day on which commercial banks in Stamford, Connecticut, Washington, D.C., Chicago, Illinois or New York, New York are authorized or obligated by law or by local proclamation to be closed. "Carlyle" shall mean Carlyle Real Estate Limited Partnership - XIV (and for purposes of Section 7.16 hereof only JMB (as defined below) or any JMB Approved Transferee (as defined below) if JMB or such JMB Approved Transferee acquires all or any part of Carlyle's partnership interest in Grantor), but shall not include any other successor or assign thereof. "Cash Income", with respect to any period of time, means the aggregate amount of all receipts generated from the operation of the Mortgaged Property and actually received in cash or current funds by Grantor during such period of time, including, without limitation, rent and all other amounts paid by tenants and concession income, but excluding (i) capital proceeds, (ii) insurance proceeds other than proceeds of business interruption insurance, (iii) condemnation award proceeds, (iv) security, pet and other deposits prior to their proper application pursuant to the terms of the respective Leases, and (v) any and all items of non-cash income "Cash Reserve" means all amounts now or hereafter deposited with Beneficiary pursuant to the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable, together with interest thereon, less all amounts paid out from the Cash Reserve pursuant to such applicable agreement. "Cash Reserve Agreement" means that certain Cash Reserve Agreement of even date herewith between Grantor and Beneficiary or any similar agreement hereafter entered into between a successor in interest to Grantor and Beneficiary. "Chattels" or "Personal Property" means all fixtures, furnishings, fittings, appliances, apparatus, equipment, building materials and components, machinery and articles of personal property, of whatever kind or nature, including any replacements, proceeds or products thereof and additions thereto, other than (a) personalty leased by Grantor not constituting fixtures and (b) personalty owned by lessees or persons claiming through lessees unless Grantor has rights thereto under the applicable Leases or otherwise, now or at any time hereafter intended to be or actually affixed to, attached to, placed upon, or used in any way in connection with the use, enjoyment, development, occupancy or operation of the Premises, and whether located on or off the Premises. "Collateral" means all of the Mortgaged Property (as hereinafter defined). "Commercially Viable" shall be construed as set forth in Section 7.24 hereof. "Contractors" shall have the meaning set forth in Section 2.09(f)(iii) hereof. "Credit Agencies" shall have the meaning set forth in Section 2.11 hereof "Credit Reports" shall have the meaning set forth in Section 2.11 hereof. "Debt Service Coverage Ratio", with respect to any period of time, means the ratio of the Net Operating Income for such period of time to the aggregate amount of all payments of principal and interest due under the Note for such period of time. "Default Rate" means the "Default Rate" provided in the Note, but in no event to exceed the maximum rate allowed by law. "Environmental Indemnification Agreement" means that certain Environmental Indemnification Agreement of even date herewith executed by Grantor for the benefit of Beneficiary. "Environmental Regulations" shall have the meaning set forth in the Environmental Indemnification Agreement. "ERISA" shall have the meaning set forth in Section 7.19 hereof. "Events of Default" means the events and circumstances described as such in Section 5.01 hereof. "Excess Cash Flow", when used with respect to any period, means the amount, if any, by which all receipts generated from the Mortgaged Property during such period exceed the Required Payments for such period . "First Permitted Prepayment Date" means the 60th day prior to the Reset Date. "Foreign Investment Acts and Regulations" shall have the meaning set forth in Section 7.22 hereof. "Funding Date" means the date on which the proceeds of the Note are disbursed to Grantor. "Governmental Authorities" shall have the meaning set forth in Section 2.20 hereof. "Hard Costs", with respect to any Restoration or work, shall mean the costs for labor and materials included in Restoration or Work, as approved by Beneficiary, exclusive of (a) any developer's overhead, fee or profit of any kind and (b) any contractor's or subcontractor's profit or fee payable to any contractor or subcontractor that is an Affiliate of Grantor, but inclusive of general contractor's overhead in an amount consistent with reasonable local industry standards and a fee or profit payable to any contractor or subcontractor that is not an Affiliate of Grantor in an amount consistent with reasonable local industry standards. "Hazardous Substances" shall have the meaning set forth in the Environmental Indemnification Agreement. "Debt Service Coverage Ratio", with respect to any period of time, means the-ratio of the Net Operating Income for such period of time to the aggregate amount of all payments of principal and interest due under the Note for such period of time. "Default Rate" means the "Default Rate" provided in the Note, but in no event to exceed the maximum rate allowed by law. "Environmental Indemnification Agreement" means that certain Environmental Indemnification Agreement of even date herewith executed by Grantor for the benefit of Beneficiary. "Environmental Regulations" shall have the meaning set forth in the Environmental Indemnification Agreement. "ERISA" shall have the meaning set forth in Section 7.19 hereof. "Events of Default" means the events and circumstances described as such in Section 5.01 hereof. "Excess Cash Flow", when used with respect to any period, means the amount, if any, by which all receipts generated from the Mortgaged Property during such period exceed the Required Payments for such period. "First Permitted Prepayment Date" means the final Business Day of the month prior to the month in which the fifth anniversary of the Funding Date occurs. "Foreign Investment Acts and Regulations" shall have the meaning set forth in Section 7 . 22 hereof "Funding Date" means the date on which the proceeds of the Note are disbursed to Grantor. "Governmental Authorities" shall have the meaning set forth in Section 2.20 hereof. "Hard Costs", with respect to any Restoration or Work, shall mean the costs for labor and materials included in such Restoration or Work, as approved by Beneficiary, exclusive of (a) any developer's overhead, fee or profit of any kind and (b) any contractor's or subcontractor's profit or fee payable to any contractor or subcontractor that is an Affiliate of Grantor, but inclusive of general contractor's overhead in an amount consistent with reasonable local industry standards and a fee or profit payable to any contractor or subcontractor that is not an Affiliate of Grantor in an amount consistent with reasonable local industry standards. "Hazardous Substances" shall have the meaning set forth in the Environmental Indemnification Agreement. "Impositions" shall have the meaning set forth in Section 2.07 hereof. "Improvements" means all structures or buildings, additions thereto and replacements thereof, now or hereafter located upon the Premises, including all plant equipment, apparatus, machinery and fixtures of every kind and nature whatsoever forming part of said structures or buildings. "Insolvent" shall have the meaning set forth in Section 101 (32) of Title XI of the United States Code (the "Bankruptcy Code"). "JMB" shall mean JMB Realty Corporation, a Delaware corporation, but shall not include any successor or assign thereof. "Laws" shall have the meaning set forth in Section 2.20 hereof. "Leases" shall have the meaning set forth in Section 1.01 hereof. "Liens" shall have the meaning set forth in Section 2.01 hereof. "Loan Documents n shall have the meaning set forth in Section 1.01 hereof. "Loan Reserve" shall have the meaning set forth in Section 2.33 hereof. "Maturity Date" shall have the meaning set forth in the Note. "Maximum Amount" shall have the meaning set forth in Section 2.33 hereof. "Monthly Deposit" shall have the meaning set forth in Section 2.33 hereof "Mortgaged Property" shall have the meaning set forth in Section 1.01 hereof. "Net Operating Income", with respect to any period of time, means the amount, if any, by which the Cash Income for such period of time exceeds the Actual Expenses for such period of time, all as determined in a manner reasonably acceptable to Beneficiary. "Notices" shall have the meaning set forth in Section 7.03 hereof. "Obsolete Collateral" shall have the meaning set forth in Section 3.02 hereof. "Orders" shall have the meaning set forth in Section 2.24 hereof. "Permitted Exceptions" means all of the exceptions to title set forth in the title policy or policies issued in respect of this Deed of Trust for the benefit of and accepted by Beneficiary on the Funding Date and any other exception to title to which Beneficiary may hereafter consent, as well as real estate and personal property taxes not yet due and payable or which, although already due and payable, are still permitted by law to be paid without interest or any delinquency charge of any kind. For all purposes of this Deed of Trust, loss of the right to receive a discount for early payment of real property taxes shall not be deemed to constitute interest. "Permitted Investments" means the following: (a) an account that is maintained by a depository institution or trust company incorporated under the laws of the United States of America or any state thereof and subject to supervision and examination by federal or state banking authorities, so long as at all times the commercial paper, certificates of deposit or other short-term debt obligations of such depository institution or trust company have a rating of either not less than A-l by Standard & Poor's or not less than P-l by Moody's; (b) demand and time deposits in, certificates of deposits of, or bankers' acceptances of, in each case maturing in not more than sixty (60) days from the date of purchase, any depository institution or trust company incorporated under the laws of the United States of America or any state thereof and subject to supervision and examination by federal or state banking authorities, so long as at the time of such investment or contractual commitment providing for such investment the commercial paper, certificates of deposit or other short-term debt obligations of such depository institution or trust company have a rating of either not less than A-l by Standard & Poor's or not less than P-l by Moody's; (c) commercial paper having remaining maturities of not more than sixty (60) days of any corporation incorporated under the laws of the United States or any state thereof which on the date of acquisition has been rated either not less than A-l by Standard & Poor's or not less than P-l by Moody's; (d) U.S. Treasury obligations maturing not more than three (3) months from the date of acquisition; (e) repurchase agreements on U. S. Treasury obligations maturing not more than three (3) months from the date of acquisition, provided that the unsecured obligations of the party agreeing to repurchase such obligations are at the time rated either not less than A-l by Standard & Poor's or not less than P-l by Moody's; and (f) other obligations or securities that are approved by Beneficiary and Grantor. "Permitted Transferee" shall have the meaning set forth in Section 2.32 hereof. "Person" means any individual, corporation, association, partnership, business trust, joint stock company, joint venture, trust, estate or other entity or organization of whatever nature. "Premises" means the land described in Schedule A hereto together with all of the easements, rights, privileges, liberties, tenements, hereditaments and appurtenances (including development rights and air rights) thereunto belonging or in any way appertaining, and all of the estate, right, title, interest, claim and demand whatsoever of Grantor therein and in the streets and ways, open or proposed, adjacent thereto, and in and to all strips, gores, vaults, alley ways, sidewalks and passages used in connection therewith, either in law or in equity, in possession or expectancy, now or hereafter acquired, and as used in this Deed of Trust, shall, unless the context otherwise requires, be deemed to include the Improvements. "Principal Reduction Amount" shall have the meaning set forth in Section 2.32 hereof. "Property Impositions" shall have the meaning set forth in Section 2.07 hereof. "Realty Associates" shall mean Realty Associates-XIV, L.P., an Illinois limited partnership. "Rents" shall have the meaning set forth in Section 1.01 hereof. "Reporting Entities n shall have the meaning set forth in Section 7.22 hereof. "Required Payments", when used with respect to any period, means the aggregate of all payments of debt service on the Note, operating expenses, reserves and necessary leasing and capital costs (other than any leasing or capital costs paid with funds released from the Loan Reserve) with respect to the Mortgaged Property that Grantor is obligated to pay during such period in order to satisfy all of the requirements of this Deed of Trust. "Reset Date" means the first day of the first month following the month in which the fifth anniversary of the Funding Date occurs. "Restoration" shall have the meaning set forth in Section 2.09 hereof. "Secured Obligations" shall have the meaning set forth in Section 1 01 hereof "Solvent" means both (a) that the financial condition of Grantor is such that the sum of Grantor's debts is less than the aggregate of, at fair valuation, (i) all of Grantor's property (exclusive of property transferred, concealed or removed with intent to hinder, delay or defraud Grantor's creditors) and (ii) the sum of the excess of the value of each general partner's nonpartnership property (exclusive of property transferred, concealed or removed with intent to hinder, delay or defraud such partner's creditors and certain personal property that would be exempted from the property of the estate of such general partner in a bankruptcy proceeding) over such general partner's nonpartnership debts, and (b) that Grantor is paying its debts as such debts become due, unless such debts are the subject of a bona fide dispute. Nothing contained in this definition shall be construed as an independent pledge by Grantor's general partners of their nonpartnership property. "Transfer" shall have the meaning set forth in Section 2.32 hereof. "Transferee Cash Reserve Agreement" shall have the meaning set forth in Section 2.34 hereof. "Uniform Commercial Code" shall have the meaning set forth in Section 3 01 hereof. "Work" shall have the meaning set forth in Section 2.15 hereof. "Yield Maintenance Amount", when calculated with respect to any amount, shall mean the greater of (x) one percent (1%) of such amount or (y) the result obtained by applying to such amount the following formula: A. determine the average yield (to be determined as of the date seven (7) days prior to the date of payment or required payment of such amount) available on U.S. Government Treasury Constant Maturities securities maturing nearest the Reset Date of the Note as reported in H.15(519) or the applicable successor publication (the "Government Yield"); B. from the then existing interest rate under the Note, subtract the Government Yield (the resulting difference, if positive, the "Positive Spread") (if the resulting number is negative, the calculations in this subparagraph B shall not be applicable and the Yield Maintenance Amount shall be as stated in clause (x) above): C. divide the Positive Spread by 12 and multiply the quotient so obtained by the amount of such payment or required payment to determine the "Monthly Interest Shortfall": and D. determine the present value on the date of such payment or required payment of the Monthly Interest Shortfall for each full and partial month remaining until the Reset Date by discounting each Monthly of each general partner's nonpartnership property (exclusive of property transferred, concealed or removed with intent to hinder, delay or defraud such partner's creditors and certain personal property that would be exempted from the property of the estate of such general partner in a bankruptcy proceeding) over such general partner's nonpartnership debts, and (b) that Grantor is paying its debts as such debts become due, unless such debts are the subject of a bona fide dispute. Nothing contained in this definition shall be construed as an independent pledge by Grantor's general partners of their nonpartnership property. "Transfer" shall have the meaning set forth in Section 2.32 hereof. "Transferee Cash Reserve Agreement" shall have the meaning set forth in Section 2.34 hereof. "Uniform Commercial Code" shall have the meaning set forth in Section 3.01 hereof. "Work" shall have the meaning set forth in Section 2.15 hereof. "Yield Maintenance Amount", when calculated with respect to any amount, shall mean the greater of (x) one percent (l%) of such amount or (y) the result obtained by applying to such amount the following formula: A. determine the average yield (to be determined as of the date seven (7) days prior to the date of payment or required payment of such amount) available on U.S. Government general issue Treasury securities maturing nearest the Reset Date of the Note as reported in H.15(519) or the applicable successor publication (the "Government Yield"); B. from the then existing interest rate under the Note, subtract the Government Yield (the resulting difference, if positive, the "Positive Spread") (if the resulting number is negative, the calculations in this subparagraph B shall not be applicable and the Yield Maintenance Amount shall be as stated in clause (x) above); C. divide the Positive Spread by 12 and multiply the quotient so obtained by the amount of such payment or required payment to determine the "Monthly Interest Shortfall"; and D. determine the present value on the date of such payment or required payment of the Monthly Interest Shortfall for each full and partial month remaining until the Reset Date by discounting each MonthlyInterest Shortfall at the Government Yield divided by twelve and find the sum of such present values, which sum shall be the amount calculated pursuant to this formula. All terms used in this Deed of Trust which are not defined above shall have the respective meanings set forth elsewhere in this Deed of Trust. ARTICLE I GRANT OF MORTGAGED PROPERTY SECTION 1.01 Granting Clause. Grantor, in consideration of the premises and in order to secure the payment of both the principal of and the interest on and any other sums payable pursuant to the Note, this Deed of Trust or any other document or instrument now or hereafter executed and delivered as further security for the indebtedness secured hereby or pursuant to the terms hereof or otherwise in connection with the loan evidenced by the Note and secured by this Deed of Trust (the Note, this Deed of Trust and any and all such other documents and instruments, including without limitation the Cash Reserve Agreement, any Transferee Cash Reserve Agreement, the Environmental Indemnification Agreement and the Assignment of Rents and Leases referred to in Section 4.01 hereof being hereinafter collectively referred to as the "Loan Documents") and the performance and observance of all the provisions of the Loan Documents (all such obligations, as the same may from time to time hereafter be renewed, increased, rearranged, modified, supplemented, restated and extended, other than those set forth in the Environmental Indemnification Agreement, being hereinafter collectively referred to as the "Secured Obligations"), hereby IRREVOCABLY GIVES, GRANTS, BARGAINS, SELLS, WARRANTS, ALIENS, REMISES, RELEASES, CONVEYS, ASSIGNS, TRANSFERS, MORTGAGES, HYPOTHECATES, DEPOSITS, PLEDGES, SETS OVER AND CONFIRMS unto Trustee and Trustee's successors and assigns, IN TRUST, with POW B OF SALE, right of entry and possession for the benefit and security of Beneficiary, all of Grantor's estate, right, title and interest in, to and under any and all of the following described property (the "Mortgaged Property") whether now owned or held or hereafter acquired: (i) the Premises; (ii)the Improvements; (iii)the Chattels; (iv)all (a) rents, issues, profits, receipts, revenues, royalties, contract rights, benefits, license fees, accounts receivable, concession fees, income, charges, rights, benefits and all other payments of any kind arising or issuing from or out of using, leasing, licensing, possessing, operating from, residing in, selling or otherwise enjoying the Premises or the Improvements, including, without limitation, rent, additional rent, minimum rent, percentage rent, parking maintenance charges or fees, tax and insurance contributions, proceeds of sale of electricity, gas, chilled and heated water and other utilities and services, deficiency rents, liquidated damages following default or late payment of rent, premiums payable by any tenant upon the exercise of a cancellation privilege provided for in any Lease and all proceeds payable under any policy of insurance covering loss of rents resulting from untenantability caused by destruction or damage to the Premises or the Improvements, together with any and all rights and claims of any kind which Grantor may have against any tenant under any Lease or any subtenants or occupants of the Premises or the Improvements, (b) cash, letters of credit, securities, security deposits given to secure the performance by tenants of their obligations under their respective Leases to the extent they may be lawfully assigned, and (c) all payments made by tenants on account of operating expenses, operating charges, real estate taxes and other similar items, and (d) other benefits of the Premises and the Improvements or any part thereof (all of the foregoing items described in subclauses (a) through (d) of this clause (iv) being hereinafter referred to collectively as the "Rents"), and all leases, subleases, lettings, licenses, concessions and other occupancy agreements (written or oral, now or hereafter in effect), together with all guaranties, modifications, renewals and extensions thereof, which grant a possessory interest in and to, or the right to use or enjoy all or any portion of the Premises or the Improvements (collectively, the "Leases"), now or hereafter entered into and all right, title and interest of Grantor thereunder, including, without limitation, cash or securities deposited thereunder to secure performance by the tenants of their obligations thereunder, whether such cash or securities are to be held until the expiration of the terms of such Leases or applied to one or more of the installments of rent coming due immediately prior to the expiration of such terms, all subject, however, to the provisions of the Assignment, of Rents and Leases referred to in Section 4.01 hereof; (v) the Cash Reserve, the Loan Reserve and all working capital and other similar accounts (including without limitation reserves for the replacement of Personal Property), and all inventory accounts, accounts receivable, contract rights, general intangibles, chattel paper, instruments, documents, notes, drafts, letters of credit and insurance policies arising from or related to the Premises or the Improvements and including all replacements and substitutions for, and additions to, any of the foregoing, subject, however, to Grantor's right to receive and apply any such accounts described above to be applied in accordance herewith prior to the occurrence of an Event of Default hereunder; (vi) all of Grantor's right, title and interest in, to and under all agreements, contracts, certificates, licenses, permits, warranties, instruments and other documents, now or hereafter entered into, pertaining to the construction, operation, management or sale or other disposition of the Premises or the Improvements; (vii) all unearned premiums accrued or to accrue under all insurance policies for the Premises or the Improvements obtained by Grantor, proceeds of insurance and condemnation awards, subject, however, to the provisions of Sections 2.09 and 2.15 hereof, and all rights of Grantor to refunds of real estate taxes and assessments: (viii) all of Grantor's right, title and interest in and to all trade names, trademarks and service marks now or hereafter used in connection with the Premises or the Improvements or any part thereof, together with good will appurtenant thereto; (ix) all of the books, computer software, records and files of or relating to the Premises or the Improvements now or hereafter maintained by Grantor or for its account; (x) all awards and claims for damages made and to be made for the taking by eminent domain of the whole or any part of the Premises or the Improvements, including without limitation any awards for change of grade of streets, all of which awards Grantor hereby assigns to Beneficiary; (xi) all mineral, water, oil and gas rights and privileges and royalties pertaining to the Premises; and (xii) all proceeds and products of the conversion, voluntary or involuntary, of any of the foregoing into cash or liquidated claims, including without limitation, but subject to the provisions of Sections 2.09 and 2.15 hereof, all judgments, awards of damages and settlements hereafter made resulting from condemnation proceeds or the taking of the Premises or the Improvements or any portion thereof under the power of eminent domain, any proceeds of any policies of insurance maintained with respect to the Premises or the Improvements or proceeds of any sale, option or contract to sell the Premises or the Improvements or any portion thereof, and all rights of Grantor to refunds of real estate taxes and assessments; and Grantor hereby authorizes, directs and empowers Beneficiary, at its option, on behalf of Grantor, or the successors or assigns of Grantor, subject to the provisions of Sections 2.09 and 2.15 hereof, to adjust, compromise, claim, collect and receive such proceeds, to give proper receipts and acquittances therefor, and, after deducting expenses of collection, to apply the net proceeds in the manner hereinafter provided. TO HAVE AND TO HOLD the Mortgaged Property unto Trustee, its successors and assigns forever, FOR THE PURPOSE OF SECURING the Secured Obligations and upon the uses herein set forth, together with all right to possession of the Mortgaged Property after the occurrence of any Event of Default (as hereinafter defined), Grantor hereby RELEASING AND WAIVING all rights under and by virtue of any homestead laws; and Grantor does hereby bind itself, its successors, assigns, executors and administrators to warrant and forever defend all and singular the Mortgaged Property unto Trustee, its successors and assigns against every person whomsoever lawfully claiming or to claim an interest in the same or any part thereof, subject only to the Permitted Exceptions. IN TRUST, to secure the payment to Beneficiary of the Secured Obligations and the performance of all covenants and agreements in the Loan Documents, whereupon this Deed of Trust shall cease and be void and the Mortgaged Property shall be released at the cost of Grantor. ARTICLE II CERTAIN REPRESENTATIONS, WARRANTIES AND COVENANTS OF GRANTOR Grantor hereby represents and warrants where so stated to, and otherwise covenants and agrees with, Beneficiary as follows: SECTION 2.01 Title. Grantor represents and warrants that it has a good and marketable title to an indefeasible fee estate in the Premises and the Improvements subject to no lien, charge or encumbrance other than the Permitted Exceptions; that it owns the Chattels, all Leases and the Rents in respect of the Premises and the Improvements and all other personal property encumbered hereby free and clear of liens and claims of every nature whatsoever, including without limitation liens, pledges, mortgages, mechanics' or materialmen's liens, deeds of trust, security interests, claims, leases, charges, options, rights of first refusal, easements, restrictive covenants, encumbrances and other restrictions, limitations, charges or rights of others of any kind whatsoever (collectively, "Liens") other than the Permitted Exceptions; and that this Deed of Trust is and will remain a valid and enforceable lien on the Mortgaged Property subject only to the permitted Exceptions. Grantor has full power and lawful authority to subject the Mortgaged Property to the lien of this Deed of Trust in the manner and form herein done or intended hereafter to be done and to perform all of the other obligations to be performed by Grantor under the Loan Documents. Grantor will preserve such title, and will forever warrant and defend the same to Trustee and will forever warrant and defend the validity and such priority of the lien hereof against the claims of all persons and parties whomsoever. SECTION 2.02 Further Acts and Assurances. (a) Grantor will, at its sole cost and expense, do, execute, acknowledge and deliver all and every such further acts, deeds, conveyances, deeds of trust, mortgages, assignments, notices of assignment, transfers and assurances as Trustee or Beneficiary shall from time to time require, for the better assuring, conveying, assigning, transferring and confirming unto Trustee the property and rights hereby conveyed or assigned or intended now or hereafter-so to be, or which Grantor may be or may hereafter become bound to convey or assign to Trustee, or for carrying out the intention or facilitating the performance of the terms of this Deed of Trust, or for filing, registering or recording this Deed of Trust and, on demand, will execute and deliver, and hereby authorizes Trustee or Beneficiary to execute and file in Grantor's name one or more financing statements, chattel mortgages or comparable security instruments, to evidence or perfect more effectively Beneficiary's security interest in and the lien hereof upon the Chattels and other personal property encumbered hereby. Grantor hereby grants to each of Trustee and Beneficiary (each of whom may act singly) an irrevocable power of attorney coupled with an interest for such purpose. (b) Grantor will, at its sole cost and expense, do, execute, acknowledge and deliver all and every such acts, information reports, returns and withholding of monies as shall be necessary or appropriate to comply fully, or to cause full compliance, with all applicable information reporting and back-up withholding requirements of the Internal Revenue Code of 1986, as amended (including all regulations promulgated thereunder) in respect of the Premises and the Improvements and all transactions related to the Premises or the Improvements, and will at all times provide Beneficiary with satisfactory evidence of such compliance and notify Beneficiary of the information reported in connection with such compliance. SECTION 2.03 Filing and Recording. (a) Grantor forthwith upon the execution and delivery of this Deed of Trust, and thereafter from time to time, will cause this Deed of Trust and upon request of Beneficiary any other Loan Document creating a lien or evidencing the lien hereof upon the Mortgaged Property or any part thereof and each instrument of further assurance to be filed, registered or recorded in such manner and in such places as may be required by any present or future law in order to publish notice of and fully to protect the lien hereof upon, and the title of Trustee to and the interest of Beneficiary in, the Mortgaged Property. (b) Grantor will pay all filing, registration and recording fees, and all expenses incident to the execution and acknowledgment of this Deed of Trust, any deed of trust supplemental hereto and any other Loan Document (including any security instrument with respect to the Chattels), and any instrument of further assurance, and any expenses (including reasonable attorneys' fees and disbursements) incurred by Beneficiary in connection with the loan secured hereby and as otherwise provided herein, and will pay all federal, state, county and municipal mortgage recording taxes, stamp taxes and other taxes, duties, imposts, assessments and charges arising out of or in connection with the execution and delivery of the Loan Documents, any deed of trust supplemental hereto, any supplemental security instrument with respect to the Chattels or any instrument of further assurance. SECTION 2.04 Payment of Indebtedness. Grantor will (a) punctually pay the Secured Obligations at the time and place and in the manner specified in the Loan Documents, according to the true intent and meaning thereof, all in such coin or currency of the United States of America which at the time of such payment shall be legal tender for the payment of public and private debts and (b) timely, fully and faithfully perform, discharge, observe and comply with each and all of Grantor's obligations to be performed under the Loan Documents. Grantor hereby represents and warrants that, as of the date hereof, there exist no offsets, counterclaims, or defenses against the Secured Obligations. Grantor shall have the privilege of making prepayments on the principal of the Note (in addition to the required payments thereunder) in accordance with the terms, conditions and limitations set forth in the Note but not otherwise. SECTION 2.05 Maintenance of Existence: Compliance with Laws. Grantor, if other than a natural person, will, so long as it is owner of all or part of the Mortgaged Property, do all things necessary to preserve and keep in full force and effect its existence, franchises, rights and privileges as a business or stock corporation, partnership, trust or other entity under the laws of the state of its formation and will comply with all regulations, rules, statutes, orders and decrees of any governmental authority or court applicable to it or to the Mortgaged Property or any part thereof. Grantor now has and shall continue to have the full right, power and authority to operate and lease the Premises and the Improvements, to encumber the Mortgaged Property as provided herein and to perform all of the other obligations to be performed by Grantor under the Loan Documents. SECTION 2.06 After-Acquired Property. All right, title and interest of Grantor in and to all extensions, improvements, betterments, renewals, substitutes and replacements of, and all additions and appurtenances to, the Mortgaged Property, hereafter acquired by, or released to, Grantor or constructed, assembled or placed by Grantor on the Premises, and all conversions of the security constituted thereby, immediately upon such acquisition, release, construction, assembling, placement or conversion, as the case may be, and in each such case, without any further deed of trust, conveyance, assignment or other act by Grantor, shall become subject to the lien of this Deed of Trust as fully and completely, and with the same effect, as though now owned by Grantor and specifically described in the granting clause hereof, but at any and all times Grantor will execute and deliver to Trustee any and all such further assurances, deeds of trust, conveyances or assignments thereof as Trustee or Beneficiary may reasonably require for the purpose of expressly and specifically subjecting the same to the lien of this Deed of Trust. SECTION 2.07 Payment of Impositions. (a) Subject to the provisions of Section 2.26 hereof, Grantor, from time to time when the same shall become due and payable, or to the extent customarily permitted by prudent lenders to be paid by borrowers in the applicable jurisdiction during a grace period thereafter, within such grace period, and before any fine, penalty or interest may be added or imposed for late payments, will pay and discharge all taxes of every kind and nature (including real and personal property taxes and income, franchise, withholding, profits and gross receipts taxes), all general and special assessments, levies, permits, inspection and license fees, all water and sewer rents and charges, vault space rentals and all other governmental and public charges, whether of a like or different nature, any easement fees or charges, imposed upon or assessed against it or the Mortgaged Property or any part thereof or upon the revenues, rents, issues, income and profits of the Mortgaged Property or arising in respect of the occupancy, use, possession or sale or other disposition thereof, and all insurance premiums for insurance required by this Deed of Trust to be maintained by Grantor (collectively, "Impositions"; all Impositions with respect to real property taxes and insurance premiums for insurance required by this Deed of Trust to be maintained by Grantor being hereinafter referred to as "Property Impositions"). If any special assessment is payable in installments without payment of any penalty or premium, other than interest at a non-default rate prior to the due date of such installment, then Grantor may pay the same in installments. Grantor will, upon Beneficiary's request, deliver to Beneficiary receipts evidencing the payment of all Impositions. Grantor shall not claim or demand or be entitled to any credit or credits on account of the Secured Obligations for any part of the Impositions, and no deduction shall otherwise be made or claimed from the taxable value of this Deed of Trust or the Secured Obligations. (b) Grantor shall deposit at the time of each payment of an installment of interest or principal under the Note, an additional amount sufficient to discharge Grantor's obligations to pay any one or more Property Impositions when they become due. The determination of the amount so payable and of the fractional part thereof to be deposited with Beneficiary, so that the aggregate of such deposits shall be sufficient for this purpose, shall be made by Beneficiary. Such amounts shall be held by Beneficiary pursuant to Section 7.14 hereof and applied to the payment of the obligations in respect of which such amounts were deposited or, at Beneficiary's option, to the payment , said obligations in such order or priority as Beneficiary shall determine, on or before the respective dates on which the same or any of them would become delinquent. If one month prior to the due date of any of the aforementioned obligations the amounts then on deposit therefor shall be insufficient for the payment of such obligation in full, Grantor within ten (10) days after demand shall deposit the amount of the deficiency with Beneficiary. Nothing herein contained shall be deemed to affect any right or remedy of Beneficiary under any provisions of this Deed of Trust or of any statute or rule of law to pay any such amount and to add the amount so paid, together with interest thereon at the Default Rate, to the Secured Obligations. SECTION 2.08 Taxes of Trustee and Beneficiary. Grantor will pay all taxes incurred by Beneficiary by reason of Beneficiary's ownership of the Note, this Deed of Trust or any other Loan Document, including without limitation all real estate transfer and like taxes imposed in connection with a transfer of ownership of all or a portion of the Mortgaged Property pursuant to a foreclosure. a deed in lieu of foreclosure or otherwise. Without limiting the generality of the foregoing, if, by the laws of the United States of America, or of any state or municipality having jurisdiction over Beneficiary, Grantor, Trustee or the Premises, any tax is imposed or becomes due in respect of the issuance of the Note or the recording of this Deed of Trust, Grantor shall pay such tax in the manner required by such law. If any law, statute, rule, regulation, order or court decree has the effect of deducting from the value of the Premises or the Improvements for the purpose of taxation any lien thereon, or imposing upon Beneficiary or Trustee the payment of the whole or any part of the taxes required to be paid by Grantor, or changing in any way the laws relating to the taxation of mortgages or deeds of trust or debts secured by mortgages or deeds of trust or the interest of Grantor, Beneficiary or Trustee in the Premises or the Improvements, or the manner of collection of taxes, so as to affect this Deed of Trust, the Secured Obligations or Grantor, Beneficiary or Trustee, then, and in any such event, Grantor, upon demand by Beneficiary, shall pay such taxes, or reimburse Beneficiary therefor on demand, unless Beneficiary determines that such payment or reimbursement by Grantor is unlawful. In such event, the Secured Obligations shall be due and payable within ninety (90) days after written demand by Beneficiary to Grantor, but notwithstanding anything to the contrary contained in the Note, no prepayment penalty shall be due in this limited situation. Notwithstanding the foregoing, Grantor shall not be required to pay any income or franchise taxes imposed on Beneficiary's net income, excepting only such which may be levied against the income of Trustee or Beneficiary as a complete or partial substitute for taxes required to be paid by Grantor pursuant hereto. SECTION 2.09 Insurance; Casualties. (a) Grantor shall effect and maintain, or cause to be maintained, insurance for Grantor and the Mortgaged Property providing at least the following coverages, except to the extent Beneficiary may have heretofore or may hereafter otherwise agree in writing: (i) comprehensive all risk insurance on the Improvements and the Personal Property, including coverage against loss or damage by fire, collapse, lightning, windstorm, tornado, hail, vandalism and malicious mischief, electrical short circuit, sprinkler leakage, water damage, back-up of sewers and drains, bursting water mains, flood or mud slide in compliance with the Flood Disaster Protection Act of 1973, as amended from time to time (if the Land is now, or at any time while the Loan remains outstanding shall be, situated in any area which an appropriate governmental authority designates as a special flood hazard area, Zone A or Zone V), increased cost of construction and value of the undamaged portion of the Improvements and/or Personal Property arising out of physical loss or damage to the covered property by a peril insured against, and against loss or damage by such other, further and additional risks as now are or hereafter may be embraced by the standard extended coverage forms of endorsements, in each case (A) in an amount equal to 100% of their "Full Replacement Cost," which for purposes of this Deed of Trust shall mean actual replacement value (exclusive of costs of excavations, foundations, underground utilities and footings); (B) containing an agreed amount endorsement with respect to the Improvements and Personal Property waiving all co-insurance provisions; (C) containing an endorsement that all covered losses will be paid on a replacement cost basis, which shall mean the actual cost to repair without deduction for depreciation; and (D) providing for no deductible in excess of the lesser of five percent (5%) of the original principal amount of the Note or $100,000. The Full Replacement Cost shall be ascertained upon the date hereof by an appraiser or contractor designated and paid by Grantor and approved by Beneficiary, or by an engineer or appraiser in the regular employ of the insurer; (ii) insurance against loss or damage by earthquake and other sudden and abnormal earth movement (if the Land is now, or at any time while the Loan remains outstanding shall be, situated in any area which is classified as a Major Damage Zone, Zones 3 and 4, by the International Conference of Building Officials) in an amount equal to the probable maximum loss for the Premises, the Improvements and fixtures and equipment, as determined by Beneficiary, plus the cost of debris removal and demolition of the undamaged portion of the Improvements and/or Personal Property; (iii) Commercial General Liability insurance against claims for personal injury or bodily injury including death or property damage occurring upon, in or about the Premises or the Improvements, such insurance to (A) be on the so-called "occurrence" form with a combined single limit and appropriate annual aggregate limitations; (B) afford immediate protection at the date hereof to the limit of not less than $3,000,000 in respect of each personal injury, bodily injury or death to any person, to the limit of not less than $5,000,000 in respect of any one occurrence, and to the limit of not less than $1,000,000 in respect of any one occurrence for property damage; (C) continue at not less than the said limits until required to be changed by Beneficiary in writing by reason of changed economic conditions making such protection inadequate; and (D) cover at least the following hazards: (1) premises and operations; (2) products and completed operations on an "if any" basis; (3) independent contractors; (4) contractual liability covering the indemnities contained in this Deed of Trust and in the Environmental Indemnification Agreement to the extent the same is available; and (5) employee benefit liability; (iv) business interruption insurance or, as the case may be, rental loss insurance, (A) with loss payable to Beneficiary; (B) covering all risks required to be covered by the insurance provided for in subdivision (i) above; (C) containing an extended period of indemnity endorsement which provides that, after the physical loss to the Improvements and Equipment has been repaired, the-continued loss of income will be insured until such income either returns to the same level it was at prior to the loss, or the expiration of twelve (12) months, whichever first occurs, and notwithstanding that the policy may expire prior to the end of such period; (D) agreeing to pay for losses whether the Premises or the Improvements are open to the public or not; (E) covering loss of income during construction and periods of alterations to the extent that physical damage would result in loss of income, whether or not the Premises or the Improvements are occupied or open to the public; and (F) in an amount equal to 100% of the projected gross income from the Premises and the Improvements for a period of one (1) year. The amount of such business interruption insurance shall be determined prior to the date hereof and at least once each year thereafter based on Grantor's reasonable estimate of the gross income from the Premises and the Improvements for the succeeding period selected by Beneficiary. In the event that all or any portion of the Premises or the Improvements shall be damaged or destroyed, Grantor shall and hereby does assign to Beneficiary all claims under the policies of such insurance and all amounts payable thereunder; and all net amounts, when collected by Beneficiary under such policies, shall be held in trust by Beneficiary and shall be applied to the Secured Obligations from time to time due and payable hereunder and under the Note and, so long as there exists no Event of Default hereunder and Beneficiary has not accelerated any of the Secured Obligations, any rental loss insurance proceeds in excess of scheduled debt service payments on the Note for the period for which such insurance proceeds are paid shall be remitted to Grantor; provided, however, that nothing herein contained shall be deemed to relieve Grantor of its obligation to pay any of the Secured Obligations on the respective dates of payment provided for in the Note and hereunder except to the extent such amounts are actually paid out of the proceeds of such business interruption or rental loss insurance; (v) at all times during which construction, structural repairs or alterations are being made with respect to the Improvements (A) owner's contingent or protective liability insurance covering claims not covered by or under the terms or provisions of the above mentioned Commercial General Public Liability insurance policy; and (B) the insurance provided for in subdivision (i) of this paragraph (a) written in a so-called builder's risk completed value form (1) on a non-reporting basis, (2) against all risks insured against pursuant to subdivision (i) of this paragraph (a), and (3) including permission to occupy the Premises and the Improvements and with an agreed amount endorsement waiving co-insurance; (vi) workers' compensation, subject to the statutory limits of the applicable jurisdiction, and employer's liability insurance with a limit of at least $1,000,000.00 per accident or disease per employee, in respect of any work or operations on, about, or in connection with, the Mortgaged Property (if applicable); (vii) comprehensive boiler and machinery insurance, in such amounts as shall be reasonably required by Beneficiary; (viii) environmental impairment liability insurance offered through the ERIC Property Transfer Liability Insurance Policy Form #PTL 10 03 11 92, modified and endorsed in connection with the Loan, providing for a limit of $2,000,000 per discovery and $2,000,000 policy term aggregate or another policy of at least the same coverage with an insurance company approved by Beneficiary, and Grantor hereby acknowledges and agrees to Beneficiary's requirement that the insurance referred to in this clause (viii) shall on the date hereof be in full force and effect and fully paid for a period of not less than five (5) years from the date hereof, and that on or before the expiration of each anniversary of the date hereof such insurance shall be extended for an additional year up to and including the eleventh full year after the Funding Date; and (ix) such other insurance and in such amounts as Beneficiary from time to time may reasonably request against such other insurable hazards which at the time are commonly insured against in respect of property similar to the Mortgaged Property located in or around the region in which the Mortgaged Property is located. All insurance provided for in this Section 2.09 shall be effected under valid and enforceable policies, in such forms and in such amounts, if not specified above, as may from time to time be satisfactory to Beneficiary, issued by financially sound and responsible insurance companies authorized to do business in the jurisdiction where the Premises are located as approved admitted or unadmitted carriers which have been approved by Beneficiary. Prior to the date hereof, and thereafter not less than thirty (30) days prior to the expiration dates of the policies theretofore furnished to Beneficiary pursuant to this Section 2.09, certified original copies of the policies accompanied by evidence satisfactory to Beneficiary of payment of the first installment of the premiums therefor, shall be delivered by Grantor to Beneficiary; provided, however, that in the case of renewal policies, Grantor may furnish Beneficiary with binders therefor to be followed by the original policies when issued. Grantor shall provide Beneficiary with evidence of the full payment for each renewal policy prior to the expiration of the policy being renewed. All policies of insurance provided for or contemplated by this Section 2.09 shall name Beneficiary and Grantor, as the insured or additional insured, as their respective interests may appear, and in the case of property damage insurance, shall contain a so-called New York standard mortgagee clause in favor of Beneficiary providing that the loss thereunder shall be payable to Beneficiary. (b) Grantor shall not take out separate insurance concurrent in form or contributing in the event of loss with that required to be maintained under this Deed of Trust, or any umbrella or blanket liability or casualty policy, unless, in each case, Beneficiary is included thereon as a named insured with loss payable to Beneficiary under a standard mortgagee endorsement of the character above described. Grantor shall immediately notify Beneficiary whenever any such separate, umbrella or blanket insurance is taken out and shall promptly deliver to Beneficiary the policy or policies of such insurance. Any blanket insurance policy shall specifically allocate to the Mortgaged Property the amount of coverage from time to time required hereunder and shall otherwise provide the same protection as would a separate policy insuring only the Mortgaged Property in compliance with the provisions of clause (a) of this Section 2.09. (c) All policies of insurance provided for in clause (a) of this Section 2.09 shall contain clauses or endorsements to the effect that: (i) no act or negligence of Grantor, or anyone acting for Grantor, or of any tenant under any Lease or other occupant or failure to comply with the provisions of any policy which might otherwise result in a forfeiture of such insurance or any part thereof shall in any way affect the validity or enforceability of such insurance insofar as Beneficiary is concerned; (ii)such policies shall not be materially changed (other than to increase the coverage provided thereby), cancelled or nonrenewed without at least 30 days' written notice to Beneficiary and any other party named therein as an insured thereunder; and (iii)Beneficiary shall not be liable for any premiums thereon or subject to any assessments thereunder. (d) Claims under each policy of insurance provided for or contemplated by clause (a) of this Section 2.09 (excluding third party liability, workers compensation and employers liability insurance) in excess of the lesser of (i) $500,000 or (ii) thirty percent (30X) of the then current principal amount of the Note shall be adjusted with the insurers and/or underwriters by Grantor and, if Beneficiary so elects (which election shall be made within thirty (30) days following Beneficiary's receipt of a Notice from Grantor of its right to such election), Beneficiary (provided that, so long as no Event of Default shall then have occurred and be continuing, Beneficiary agrees that it shall not settle any such claims without Grantor's consent (not to be unreasonably withheld, conditioned or delayed), and Grantor shall (subject to Beneficiary's reasonable discretion) be entitled to lead all negotiations with insurers and underwriters in connection with such claims). Any such claims which do not exceed the lesser of (i) $500,000 or (ii) thirty percent (30X) of the then current principal amount of the Note shall, so long as no Event of Default exists hereunder, be adjusted by Grantor. All costs and expenses of collecting or recovering any insurance proceeds under such policies, including without limitation any and all fees of attorneys, appraisers and adjusters, shall be paid by Grantor. (e) In the event of any damage to or destruction of the Premises or the Improvements, Grantor shall, promptly after obtaining knowledge of the occurrence thereof, give notice thereof to Beneficiary and shall, except as set forth in paragraphs (h) and (j) of this Section 2.09 and regardless of the dollar amount of such damage, proceed with reasonable diligence, at Grantor's sole cost and expense, to repair and restore or cause to be repaired or restored the Premises or the Improvements, as the case may be, or the portion thereof so damaged as nearly as practically possible to the condition the same were in immediately prior to such damage. If any Personal Property is damaged or lost as a result of such fire or other casualty, Grantor shall likewise, at its sole cost and expense, whether or not any insurance proceeds are available or adequate for such purpose, replace or cause to be replaced the Personal Property so damaged or lost. In the event that Grantor fails to advance any funds required for the completion of any such repairs or restoration, Beneficiary may, but shall not be obligated to, advance the required funds or any portion thereof, and Grantor shall, on demand, reimburse Beneficiary for all sums advanced and actual expenses incurred by Beneficiary in connection therewith (including without limitation the charges, disbursements and reasonable fees of Beneficiary's counsel), together with interest thereon at the Default Rate from the date each such advance is made or expense paid by Beneficiary to the date of receipt by Beneficiary of reimbursement from Grantor, which amounts and interest shall become part of the Secured Obligations and be secured hereby. All repairs and restoration required to be made by Grantor hereunder shall be performed in material compliance with all Laws and Orders and shall be without any liability or actual expense of any kind to Beneficiary. (f) The proceeds of any insurance policy so received shall be paid directly to Beneficiary and applied in accordance with the provisions of this Section 2.09. Provided the conditions described in clauses (i) - (vii) below have been satisfied and subject to the limitation set forth in the immediately following sentence, such proceeds shall be paid over to Grantor from time to time to reimburse Grantor for the costs of restoration of the Improvements. Provided that (x) there exists no Event of Default hereunder, (y) the cost to restore the Premises and the Improvements, as determined by Beneficiary, does not exceed fifty percent (50%) of the then current principal amount of the Note, and (z) Grantor has notified Beneficiary of its intention to fully restore the Improvements, Beneficiary agrees to apply any such insurance proceeds received by Beneficiary (or a portion thereof if not all the Improvements are to be fully restored), which proceeds shall be held in an interest bearing account until paid or applied, to the reimbursement of Grantor's costs of restoring the Improvements provided the following conditions have been satisfied: (i) Beneficiary or, in the case of subclause (A) of this clause (i) at Beneficiary's option, a qualified independent construction consultant retained by Beneficiary, shall have reasonably determined that (A) the restoration of the Improvements to a Commercially Viable architectural whole of substantially the same use, value and character as immediately prior to such casualty can be completed by the then Maturity Date under and as defined in the Note at a cost which does not exceed the amount of available insurance proceeds, or in the event that such proceeds are determined by Beneficiary or such construction consultant to be inadequate, Beneficiary shall have received from Grantor a cash deposit equal to the excess of said estimated cost of restoration over the amount of available proceeds and (B) there shall be adequate cash flow from the Mortgaged Property together with the proceeds of any loss of rents insurance coverage to pay all debt service on the Note and all operating expenses in respect of the Mortgaged Property as they become due during the course of such restoration; (ii) if the restoration work (the "Restoration") is of a nature such that (x) a prudent owner or developer of real property would engage an architect or engineer to plan, design, implement, coordinate or supervise all or any thereof or (y) the services of an architect or engineer would be required to meet the requirements of local building ordinances or codes or otherwise to comply with Laws, prior to the commencement thereof (other than Restoration to be performed on an emergency basis to protect the Mortgaged Property), (A) an architect or engineer, reasonably approved by Beneficiary, shall be retained by Grantor at Grantor's expense and charged with the supervision of the Restoration and (B) Grantor shall have prepared, submitted to Beneficiary and secured Beneficiary's approval of the plans and specifications for such Restoration, which approval shall not be unreasonably withheld or delayed; (iii) each request for payment by Grantor shall be in form and substance satisfactory to Beneficiary, shall generally be in accordance with customary construction disbursement procedures and limitations, and shall be made on no less than ten (10) days' prior written notice to Beneficiary and shall be accompanied by a certificate to be prepared and executed by the architect or engineer, reasonably approved by Beneficiary, supervising the Restoration (if one is required pursuant to clause (ii) above), otherwise by an officer or general partner of Grantor, as applicable, stating that (A) all of the Restoration completed has been done in substantial compliance with the approved plans and specifications (if any are required pursuant to clause (ii) above), (B) the sum requested by Grantor is justly required to reimburse Grantor for payments by Grantor to the contractors, subcontractors, materialmen, laborers, engineers, architects or other persons (collectively "Contractors") rendering materials or services for the Restoration and shall include a brief description of such services and materials rendered, (C) when added to all sums previously paid out by Grantor with respect to the Restoration, the sum requested does not exceed the cost of the Restoration done as of the date of such certificate less retainage, (D) the amount of insurance proceeds remaining in the hands of Beneficiary, plus any further amounts deposited by Grantor with Beneficiary in connection with the Restoration, will be sufficient to pay for the lien free completion of the Restoration in a good and workmanlike manner in compliance with all applicable Laws and (E) none of the Restoration for which disbursement of proceeds is requested shall have been included in a previous request; (iv) Grantor shall cause to be delivered to Beneficiary appropriate lien waivers from each of the Contractors, with respect to which Grantor is seeking reimbursement or direct payment to such Contractors for Restoration performed by such party in such request for disbursement; (v) any cross-easement agreements and/or reciprocal easement agreements shall be in effect and the benefits contemplated thereunder continuing to inure to the Premises, in Beneficiary's reasonable determination, as are necessary for the continued legal and economic operation of the Premises and the improvements in a Commercially Viable manner; (vi) Beneficiary shall have received such surety bonds, completion guaranties and other assurances as Beneficiary shall reasonably require with respect to the completion of the Restoration; and (vii) no Event of Default shall exist under this Deed of Trust. Provided Grantor has satisfied the conditions in clauses (i) - (vii) above and continues to satisfy such conditions throughout the entire course of the Restoration, Beneficiary shall reimburse Grantor, or, at Beneficiary's option, make payments jointly to Grantor and such Contractors, from time to time as the Restoration progresses, but in no event more than once per calendar month and with a retainage equal to ten percent (lO%) of the portion of each disbursement applicable to Hard Costs, within ten (10) days following satisfaction of the last of such conditions to be satisfied, for costs incurred by Grantor with respect to the Restoration. If any excess proceeds remain after the Restoration is completed and paid for in full out of such proceeds, such excess proceeds shall be retained by Beneficiary and applied as follows: (I) If such excess proceeds shall be received within the first two (2) years following the Funding Date, such excess proceeds shall be applied on the last day of the month in which received to the payment of a portion of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to the sum of (x) interest on the amount of such excess proceeds through and including the last day of the month in which the same shall be received, plus (y) the Yield Maintenance Amount calculated with respect to the amount of such excess proceeds. (II) If such excess proceeds shall be received during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), such excess proceeds shall be deposited in the Cash Reserve when received. In such event and upon such receipt, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to interest on the amount of such excess proceeds through and including the last day of the month in which the First Permitted Prepayment Date occurs which amount will also be deposited in the Cash Reserve when received. (III) If such excess proceeds shall be received at any time after the First Permitted Prepayment Date, such excess proceeds shall be applied on the last day of the month in which received to the payment of a portion of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to the sum of (x) interest on the amount of such excess proceeds through and including the last day of the month in which the same shall be received, plus (y) the applicable prepayment penalty, if any, required pursuant to the Note, calculated with respect to the amount of such excess proceeds. In the event only a portion of the Improvements is to be restored, the allocable portion of the proceeds required for such Restoration, as determined by Beneficiary, shall be applied to such Restoration as contemplated above, with the balance of such proceeds to be retained by Beneficiary and applied in the manner, at the times and in the amounts set forth above in the immediately preceding three (3) paragraphs of this Section 2.09(f). Interest, if any, earned on insurance proceeds while held by Beneficiary shall be added to the amount of such proceeds. If any of the foregoing conditions to the advance of insurance proceeds for Restoration are not satisfied at any time, Beneficiary shall have the option at any time thereafter to apply such insurance proceeds in the manner set forth in paragraph (i) of this Section 2.09; provided, however, that so long as there is no Event of Default hereunder, Beneficiary shall not apply such proceeds without first giving Grantor written notice, after which Grantor shall have thirty (30) days to cure any unsatisfied conditions set forth in clauses (i) - (vi) above; and provided, further, that in the event such unsatisfied condition is susceptible to cure but cannot with due diligence be cured by the payment of money or otherwise within such thirty (30) day period, Grantor shall have such longer period (unless Beneficiary determines that delay in effecting such cure would have a material adverse impact on Beneficiary or the Mortgaged Property), but not to exceed one hundred twenty (120) days, as is required for Grantor to diligently cure such unsatisfied condition, provided that Grantor first notifies Beneficiary of its intention to cure such unsatisfied condition and actually commences the cure of such unsatisfied condition within the initial thirty (30) day period and at all times thereafter diligently prosecutes the cure of such unsatisfied condition with all due diligence to completion. (g) [RESERVED] (h) In the event that (i) Grantor shall determine in its good faith judgment after any casualty, which determination is not disputed in good faith by Beneficiary, that the damage to the Improvements was so extensive as to make restoration and operation thereof not Commercially Viable, or (ii) after any casualty, Grantor fails to undertake or complete the Restoration, but is unable to satisfy Beneficiary that the Restoration is not Commercially Viable in Beneficiary's reasonable judgment, then: (I) If the casualty occurs at any time within the first two (2) years following the Funding Date, all of the Secured Obligations shall become due and payable on the last day of the month in which all insurance proceeds in respect of such casualty are received, and such insurance proceeds shall be paid over to Beneficiary and applied on such last day of the month in payment of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of such month, (C) the Yield Maintenance Amount calculated with respect to the unpaid principal balance of the Note, and (D) all other Secured Obligations, if any, exceeds (y) the amount of such insurance proceeds so and the several amounts described in subclauses (A) through (D) of this clause (I) shall be applied in payment of the respective obligations described in such subclauses. (II)If the casualty occurs at any time during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), such insurance proceeds shall be paid over to Beneficiary and deposited in the Cash Reserve. In such event and upon the receipt of all such insurance proceeds, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of the month in which the First Permitted Prepayment Date occurs, and (C) all other Secured Obligations, if any, exceeds (y) the amount of such insurance proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (C) of this clause (II) shall be deposited in the Cash Reserve, to be used and applied as provided in the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable. (III)If the casualty occurs at any time on or after the First Permitted Prepayment Date, all of the Secured Obligations shall become due and payable on the last day of the month in which all insurance proceeds in respect of such casualty are received, and such insurance proceeds shall be paid over to Beneficiary and applied on such last day of the month in payment of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of such month, (C) the applicable prepayment penalty, if any, required pursuant to the Note, and (D) all other Secured Obligations, if any, exceeds (y) the amount of such insurance proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (D) of this clause (III) shall be applied in payment of the respective obligations described in such subclauses. (i) [Reserved] (j) In the event that (i) Grantor seeks and elects to fully restore the Improvements (or a discrete portion thereof) and makes a good faith showing that the restoration and operation of the Improvements (or such portion thereof) would be Commercially Viable and that Grantor has the resources to reconstruct and operate the Improvements (or such portion thereof) as such, and (ii) Beneficiary nonetheless shall require that insurance proceeds be held for payment of the debt and not made available for restoration after having made a determination in its good faith judgment after any casualty that the damage to the Improvements (or such portion thereof) was so extensive as to make restoration and operation thereof not Commercially Viable, all such insurance proceeds (or, where Grantor's showing and Beneficiary's determination relate to a discrete portion of the Improvements, such portion of such insurance proceeds as Beneficiary shall allocate to the portion of the Improvements not being restored) shall be paid over to Beneficiary and applied in payment of the Secured Obligations, and Grantor shall not be permitted to restore the Improvements (or such portion thereof) so long as this Deed of Trust is in effect, but shall be obligated to prepay the Note (or, in the case of a portion of the improvements, to make a prepayment of a portion of the principal balance of the Note) and obtain a release of this Deed of Trust in accordance with Section 7.06 hereof (or a release of the lien of this Deed of Trust from the discrete portion of the Improvements not being restored and the part of the Land underlying such portion if Beneficiary determines that such partial release is practicable) by paying to Beneficiary (in addition to Beneficiary's receipt of all such proceeds that Beneficiary shall have allocated to the portion of the Improvements not being restored) the following: (I) In the case where Grantor's good faith showing and Beneficiary's determination relate to all of the Improvements, the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of the month in which the amount described in the immediately preceding clause (A) is paid, and (C) all other Secured Obligations, if any, exceeds (y) the amount of insurance proceeds in respect of such casualty received by Beneficiary. Beneficiary shall apply the several amounts described in subclauses (A) through (C) of this clause (I) in payment of the respective obligations described in such subclauses. (II)In the case where Grantor's good faith showing and Beneficiary's determination relate to a discrete portion of the Improvements, interest on the amount of insurance proceeds applied in reduction of the Secured Obligations through and including the last day of the month in which such proceeds shall be so applied. Beneficiary shall apply the amount of such interest in reduction of the Secured Obligations. In the limited situation described in this paragraph (J), no Yield Maintenance Amount and no prepayment premium shall be due and payable. (k) Notwithstanding anything to the contrary contained herein, the application of any insurance proceeds by Beneficiary to the Secured Obligations or the repair or restoration of any part of the Mortgaged Property as provided in this Section 2.09 shall not reduce or excuse in any manner whatsoever Grantor's obligations diligently to repair and restore or cause to be repaired and restored the damaged portion of the Mortgaged Property, to the extent required by Section 2.09(e) hereof. (1) No destruction of or damage to the Mortgaged Property, or any part thereof, by fire or other casualty whatsoever, whether such damage or destruction be partial or total or otherwise, shall relieve Grantor from its liability to pay in full as and when due the Secured Obligations, or from timely, fully and faithfully performing all its other obligations hereunder and under the Loan Documents. No application of insurance proceeds to the reduction of the Secured Obligations shall have the effect of releasing the lien of this Deed of Trust from all or any portion of the Mortgaged Property until and unless all of the Secured Obligations have been paid in full. (m) If the Premises are located in an area which has been identified by the Secretary of the United States Department of Housing and Urban Development as a flood hazard area, Grantor will keep the Improvements covered, until all sums secured hereby have been repaid in full, by flood insurance in an amount at least equal to the full amount of the Note or the maximum limit of coverage available for the Premises under the National Flood Insurance Act of 1968, whichever is less. SECTION 2.10 Advances by Trustee or Beneficiary. If Grantor shall fail to perform any of the covenants contained in this Deed of Trust, Trustee or Beneficiary may, after written notice to Grantor except in the event of an emergency, make advances to perform the same on its behalf, and all sums so advanced shall be a lien upon the Mortgaged Property and shall be secured hereby. Grantor will repay on demand all sums so advanced on its behalf together with interest thereon at the Default Rate. The provisions of this Section 2.10 shall not prevent any default in the observance of any covenant contained in this Deed of Trust from constituting an Event of Default. SECTION 2.11 Books and Records; Financial Information Reporting. (a) Grantor will keep adequate records and books of account of Grantor and the Premises at the principal office of Grantor in accordance with generally accepted accounting principles consistently applied (except the use of cash basis shall be permitted) reflecting all financial transactions of Grantor in respect of the Mortgaged Property and will permit Trustee and Beneficiary, by their agents, accountants and attorneys, upon reasonable prior notice, to visit and inspect the Mortgaged Property and examine its records and books of account, to make copies and extracts thereof and to discuss its affairs, finances and accounts with the officers or general partners, as the case may be, of Grantor, at such reasonable times as may be requested by Trustee or Beneficiary. Promptly upon demand by Beneficiary, but not more frequently than twice in any calendar year with respect to any entity, Grantor, at its cost, shall cause to be delivered to Beneficiary reports established and/or maintained by any rating agency and/or credit verification organization designated by Beneficiary (collectively, the "Credit Agencies") with respect to the credit status and/or financial condition of, and/or history of default with respect to credit transactions by, Grantor, and/or its partners, principals or major shareholders (collectively the "Credit Reports"), and Grantor hereby expressly grants to Beneficiary the right, license and privilege to obtain the Credit Reports directly from the Credit Agencies at Grantor's cost. (b) Grantor will deliver to Beneficiary within one hundred twenty (120) days- after the close of its fiscal year its audited balance sheet and statement of profit, loss and cash flow setting forth in each case, in comparative form, figures for the preceding year certified by a reputable certified public accounting firm. Grantor shall also deliver to Beneficiary within (i) one hundred twenty (120) days after the close of each calendar year an annual operating statement for the Mortgaged Property setting forth, in comparative form, figures for the preceding year and (ii) thirty (30) days after the end of each calendar quarter, quarterly operating statements for the Premises setting forth, in comparative form, figures for the preceding quarter, together with a certified rent roll conforming to the requirements of Section 2.16(f) hereof, in the case of annual operating statements certified by a reputable certified public accounting firm, and in the case of quarterly statements certified by Grantor's chief financial officer. Such annual operating statement for the Mortgaged Property may be in the form of a supplemental schedule to the audited balance sheets and statements of profit, loss and cash flow referred to in the first sentence of this paragraph (b), in which event it must be either covered by and subject to the same certification and audit opinion as are given in connection with such balance sheets and statements or covered by separate certification and audit opinion to the same effect. Throughout the term of this Deed of Trust, Grantor, with reasonable promptness, will deliver to Beneficiary such other information with respect to Grantor or the Mortgaged Property as Beneficiary may reasonably request from time to time. All financial statements of Grantor shall be prepared in accordance with generally accepted accounting principles consistently applied (except the use of cash basis shall be permitted), shall be delivered in duplicate and, in the case of Grantor, shall be accompanied by the certificate of a principal financial or accounting officer or general partner, as the case may be, of Grantor, dated within five (5) days of the delivery of such statements to Beneficiary, stating that such financial statements are true and correct and that he knows of no Event of Default, nor of any event which after notice or lapse of time or both would constitute an Event of Default, which has occurred and is continuing, or, if any such event or Event of Default has occurred and is continuing, specifying the nature and period of existence thereof and what action Grantor has taken or proposes to take with respect thereto, and, except as otherwise specified, stating that Grantor has fulfilled all of its obligations under this Deed of Trust which are required to be fulfilled on or prior to the date of such certificate. SECTION 2.12 Estoppel Certificates. (a) Grantor, within three (3) days upon request in person or within five (5) days upon request by mail, will furnish a written certificate, in recordable form, of the amount due whether for principal or interest on this Deed of Trust and whether any offsets, counterclaims or defenses exist against the indebtedness secured hereby, specifying the nature of any claimed offset, counterclaim or defense in reasonable detail. Such certificate shall also contain a statement that Grantor has no knowledge of the occurrence of any Event of Default nor of any other event, which, with the giving of notice or passage of time, or both, would constitute an Event of Default which has occurred and remains uncured as of the date of such certificate; or, if any such Event of Default or other default has occurred and remains uncured as of the date of such certificate, then such certificate shall contain a statement specifying the nature thereof, the time for which the same has continued and the action which Grantor has taken or proposes to take with respect thereto, and setting forth or describing such additional matters with respect to Grantor or the Mortgaged Property as Beneficiary shall request and such additional information as Beneficiary may reasonably request. Such certificate shall be certified to, and may be relied upon by, such parties as Beneficiary shall direct. (b) From time to time at the request of Grantor in connection with a proposed sale of the Mortgaged Property, but not more frequently than twice in any calendar year, Beneficiary shall execute and deliver to Grantor or Grantor's designee a certificate setting forth (i~ the date of the most recent debt service payment received by Beneficiary, (ii) the unpaid principal balance of the Note, (iii) the interest rate in effect under the Note, (iv) the Maturity Date of the Note and (v) whether or not Beneficiary has formally declared an Event of Default which is still in effect. If Grantor shall request, Beneficiary shall attach to such certificate a list of the principal Loan Documents or, if thereafter specifically requested by Grantor, true and correct copies of the principal Loan Documents, including without limitation any amendments thereof. SECTION 2.13 Maintenance of Mortgaged Property; Waste; Repairs; Alterations. Grantor will not commit any waste on the Premises or make any change in the use of the Premises or the Improvements which will in any way increase the risk of any fire or other hazard arising out of construction or operation. Grantor will, at all times, maintain the Improvements and Chattels in good operating order and condition and will promptly make, from time to time, at Grantor's sole cost and expense, all structural and non-structural, ordinary and extraordinary, foreseen and unforeseen, repairs, renewals, replacements, additions and improvements in connection therewith which are necessary to such end. All such repairs, renewals, replacements, additions and improvements shall be at least substantially equal in quality to the original Improvements. Grantor will continuously manage or cause to be managed (other than during periods of repair after major casualty or substantial condemnation, with respect to the portions of the Mortgaged Property damaged or condemned) the Mortgaged Property in the manner and for the purposes heretofore used. The Improvements shall not be demolished or substantially altered, nor shall any Chattels be removed other than as provided in Section 2.29 hereof. SECTION 2.14 Environmental Matters. The representations and warranties contained in the Environmental Indemnification Agreement are true and correct SECTION 2.15 Condemnation Proceedings. (a) Grantor, immediately upon obtaining knowledge of the institution or pending institution of any proceedings for the condemnation of the Premises or the Improvements or any portion thereof, will notify Trustee and Beneficiary thereof. Trustee and Beneficiary may, at Grantor's cost and expense for reasonable third-party charges, participate in any such proceedings and may be represented therein by counsel of Beneficiary's selection; provided, however, that neither Trustee nor Beneficiary shall have the right to settle any condemnation action without Grantor's consent except if an Event of Default exists hereunder, in which case no such consent shall be required. Grantor from time to time will deliver to Beneficiary all instruments requested by it to permit or facilitate such participation. Grantor shall not make any agreement in lieu of condemnation of the Premises or the Improvements or any portion thereof without the consent of Beneficiary in each instance, which consent shall not be unreasonably withheld or delayed in the case of the taking of any insubstantial portion of the Premises or the Improvements which does not in Beneficiary's good faith judgment materially adversely affect the commercial viability of continued operation of the remainder of the Premises and the Improvements. In the event of such condemnation proceedings, the award or compensation payable is hereby assigned to and shall be paid to Beneficiary. Beneficiary shall be under no obligation to question the amount of any such award or compensation and may accept the same in the amount in which the same shall be paid. Grantor shall have the right, provided there exists no Event of Default hereunder, to pursue, at Grantor's sole cost and expense, any appeal of any condemnation award. Unless otherwise provided in this Section 2.15 Grantor shall, regardless of the extent of the taking, and whether or not any condemnation award proceeds are available therefor, proceed with reasonable diligence, at Grantor's sole cost and expense, to repair and restore or caused to be repaired or restored the remaining portion of the Premises and the Improvements into an architectural and Commercially Viable premises similar (to the greatest extent possible) to the previously existing structure, with such additional improvements as Grantor , subject to Beneficiary's approval, may elect to add. In the event that Grantor fails to advance any funds required for the completion of any such repair or restoration, Beneficiary may, but shall not be obligated to advance the required funds or any portion thereof, and Grantor shall, on demand, reimburse Beneficiary for all sums advanced and actual expenses incurred by Beneficiary in connection therewith (including without limitation the charges, disbursements and reasonable fees of Beneficiary's counsel), together with interest thereon at the Default Rate from the date each such advance is made or expense paid by Beneficiary to the date of receipt by Beneficiary of reimbursement from Grantor, which amounts and interest shall become part of the Secured Obligations and be secured hereby. All repairs and restoration required to be made by Grantor hereunder shall be performed in material compliance with all Laws and Orders and shall be without any liability or actual expense of any kind to Beneficiary. (b) The proceeds of any award or compensation so received shall be paid directly to Beneficiary and applied, regardless of the rate of interest payable on the award by the condemning authority, in accordance with the provisions of this Section 2.15. Provided the conditions described in clauses (i) - (vii) below have been satisfied and subject to the limitations set forth in the immediately following sentence, such proceeds shall be paid over to Grantor or others as and to the extent provided herein for restoration of the remainder of the Premises and the Improvements. Provided that (x) there exists no Event of Default hereunder, (y) no more than fifty percent (50%) of the Premises or the Improvements have been subject to such taking, and (z) Grantor has notified Beneficiary of its intention to fully restore the remainder of the Premises and the Improvements, Beneficiary agrees to apply any such condemnation award proceeds received by Beneficiary (or such portion thereof as may be required), which proceeds shall be held in a Permitted Investment until paid or applied as hereinafter provided, to the costs of restoring the remainder of the Premises and the Improvements, and which proceeds shall be paid over to Grantor from time to time to reimburse Grantor for the costs of restoration of such remainder provided the following conditions have been satisfied: (i) Beneficiary or, in the case of subclause (A) of this clause (i) at Beneficiary's option, a qualified independent construction consultant retained by Beneficiary, shall have reasonably determined that (A) the restoration of the Improvements to a Commercially Viable architectural whole of substantially the same use, value and character as immediately prior to such taking can be completed by the then Maturity Date under and as defined in the Note at a cost which does not exceed the amount of available condemnation award proceeds, or in the event that such proceeds are determined by Beneficiary or such construction consultant to be inadequate, Beneficiary shall have received from Grantor a cash deposit equal to the excess of said estimated cost of restoration over the amount of available proceeds and (B) there shall be adequate cash flow from the Mortgaged Property together with the proceeds of any loss of rents insurance coverage to pay all debt service on the Note and all operating expenses in respect of the Mortgaged Property as they become due during the course of such restoration; (ii) if the restoration work (the "Work") is of a nature such that (x) a prudent owner or developer of real property would engage an architect or engineer to plan, design, implement, coordinate or supervise all or any thereof or (y) the services of an architect or engineer would be required to meet the requirements of local building ordinances or codes or otherwise to comply with Laws, prior to the commencement thereof (other than Work to be performed on an emergency basis to protect the Mortgaged Property), (A) an architect or engineer, reasonably approved by Beneficiary, shall be retained by Grantor at Grantor's expense and charged with the supervision of the Work and (B) Grantor shall have prepared, submitted to Beneficiary and secured Beneficiary's approval of the plans and specifications for such Work, which approval shall not be unreasonably withheld or delayed; (iii) each request for payment by Grantor shall be in form and substance satisfactory to Beneficiary, shall generally be in accordance with customary construction disbursement procedures and limitations, and shall be made on no less than ten (10) days' prior written notice to Beneficiary and shall be accompanied by a certificate to be prepared and executed by the architect or engineer, reasonably approved by Beneficiary, supervising the Work (if one is required pursuant to clause (ii) above), otherwise by an officer or general partner of Grantor, as applicable, stating that (A) all of the Work completed has been done in substantial compliance with the approved plans and specifications (if any are required pursuant to clause (ii) above), (B) the sum requested by Grantor is justly required to reimburse Grantor for payments by Grantor to the contractors and shall include a brief description of such services and materials rendered, (C) when added to all sums previously paid out by Grantor with respect to the Work, the sum requested does not exceed the cost of the Work done as of the date of such certificate less retainage, (D) the amount of condemnation proceeds remaining in the hands of Beneficiary, plus any further amounts deposited by Grantor with Beneficiary in connection with the Work, will be sufficient to pay for the lien- free completion of the Work in a good and workmanlike manner in compliance with all applicable Laws and (E) none of the Work for which disbursement of proceeds is requested shall have been included in a previous request; (iv) Grantor shall cause to be delivered to Beneficiary appropriate lien waivers from each of the Contractors with respect to which Grantor is seeking reimbursement or direct payment to such Contractors for Work performed by such party in such request for disbursement; (v) any cross-easement agreements and/or reciprocal easement agreements shall be in effect and the benefits contemplated thereunder continuing to inure to the Premises and the Improvements, in Beneficiary's reasonable determination, as are necessary for the continued legal and economic operation of the Premises and the Improvements in a Commercially Viable manner; (vi) Beneficiary shall have received such surety bonds, completion guaranties and other assurances as Beneficiary shall reasonably require with respect to the completion of the Work; and (vii) no Event of Default shall exist under this Deed of Trust. Provided Grantor has satisfied the conditions in clauses (i) - (vii) above and continues to satisfy such conditions throughout the entire course of the Work, Beneficiary shall reimburse Grantor, or, at Beneficiary's option, make payments jointly to Grantor and such Contractors, from time to time as the Work progresses, but in no event more than once per calendar month and with a retainage equal to ten percent (10%) of the portion of each disbursement applicable to Hard Costs, within ten (10) days following satisfaction of the last of such conditions to be satisfied, for costs incurred by Grantor with respect to the Work. If any excess proceeds remain after the Work is completed and paid for in full out of such proceeds, such excess proceeds shall be retained by Beneficiary and applied as follows: (I)If such excess proceeds shall be received within the first two (2) years following the Funding Date, such excess proceeds shall be applied on the last day of the month in which received to the payment of a portion of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to the sum of (x) interest on the amount of such excess proceeds through and including the last day of the month in which the same shall be received, plus (y) the Yield Maintenance Amount calculated with respect to the amount of such excess proceeds. (II)If such excess proceeds shall be received during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), such excess proceeds shall be deposited in the Cash Reserve when received. In such event and upon such receipt, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to interest on the amount of such excess proceeds through and including the last day of the month in which the First Permitted Prepayment Date occurs which amount will also be deposited in the Cash Reserve when received. (III)If such excess proceeds shall be received at any time on or after the First Permitted Prepayment Date, such excess proceeds shall be applied on the last day of the month in which received to the payment of a portion of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) an amount equal to the sum of (x) interest on the amount of such excess proceeds through and including the last day of the month in which the same shall be received, plus (y) the applicable prepayment penalty, if any, required pursuant to the Note, calculated with respect to the amount of such excess proceeds. In the event only a portion of the Premises and the Improvements is to be restored, the allocable portion of the proceeds required for such Work, as determined by Beneficiary, shall be applied to such Work as contemplated above, with the balance of such proceeds to be retained by Beneficiary and applied in the manner set forth above in the immediately preceding three (3) paragraphs of this Section 2.15(b). Interest, if any, earned on condemnation award proceeds while held by Beneficiary shall be added to the amount of such proceeds. If any of the foregoing conditions to the advance of condemnation award proceeds for the Work are not satisfied at any time, Beneficiary shall have the option at any time thereafter to apply such condemnation award proceeds, regardless of the rate of interest payable on the award by the condemning authority, in the manner set forth in paragraph (e) of this Section 2.15; provided, however, that so long as there is no Event of Default hereunder, Beneficiary shall not apply such proceeds without first giving Grantor written notice, after which Grantor shall have thirty (30) days to cure any unsatisfied conditions set forth in clauses (i) -(vi) above and provided, further, that in the event such unsatisfied condition is susceptible to cure but cannot with due diligence be cured by the payment of money or otherwise within such thirty (30) day period, Grantor shall have such longer period (unless Beneficiary determines that delay in effecting such cure would have a material adverse impact on Beneficiary or the Mortgaged Property), but not to exceed one hundred twenty (120) days, as is required for Grantor to diligently cure such unsatisfied condition, provided that Grantor first notifies Beneficiary of its intention to cure such unsatisfied condition and actually commences the cure of such unsatisfied condition within the initial thirty (30) day period and at all times thereafter diligently prosecutes the cure of such unsatisfied condition with all due diligence to completion. (c) [RESERVED] (d) In the event that (i) Grantor shall determine in its good faith judgment after any taking of a portion of the Premises or the Improvements, which determination is not disputed in good faith by Beneficiary, that such taking was so extensive as to make continued operation of the remainder thereof not Commercially Viable or (ii) after any taking Grantor fails to undertake or complete the Work, but is unable to satisfy Beneficiary that the Work is not Commercially Viable in Beneficiary's reasonable judgment then: (I)If the taking occurs at any time within the first two (2) years following the Funding Date, all of the Secured Obligations shall become due and payable on the last day of the month in which all condemnation award proceeds in respect of such taking are received, and such condemnation award proceeds shall be paid over to Beneficiary and applied on such last day of the month in payment of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of such month, (C) the Yield Maintenance Amount calculated with respect to the unpaid principal balance of the Note, and (D) all other Secured Obligations, if any, exceeds (y) the amount of such condemnation award proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (D) of this clause (I) shall be applied in payment of the respective obligations described in such subclauses. (II)If the taking occurs at any time during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), such condemnation award proceeds shall be paid over to Beneficiary and deposited in the Cash Reserve. In such event and upon the receipt of all such condemnation award proceeds, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of the month in which the First Permitted Prepayment Date occurs, and (C) all other Secured Obligations, if any, exceeds (y) the amount of such condemnation award proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (C) of this clause (II) shall be deposited in the Cash Reserve, to be used and applied as provided in the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable. (III)If the taking occurs at any time on or after the First Permitted Prepayment Date, all of the Secured Obligations shall become due and payable on the last day of the month in which all condemnation award proceeds in respect of such taking are received, and such condemnation award proceeds shall be paid over to Beneficiary and applied on such last day of the month in payment of the Secured Obligations. In such event and at such time, Grantor shall pay to Beneficiary (in addition to Beneficiary's receipt of all such proceeds) the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of such month, (C) the applicable prepayment penalty, if any, required pursuant to the Note, and (D) all other Secured Obligations, if any, exceeds (y) the amount of such condemnation award proceeds so received by Beneficiary, and the several amounts described in subclauses (A) through (D) of this clause (III) shall be applied in payment of the respective obligations described in such subclauses. (e) [Reserved] (f) In the event that (i) Grantor seeks and elects to fully restore the remaining portion of the Premises and the Improvements (or a discrete part thereof) and makes a good faith showing that the restoration and operation of such remaining portion of the Premises and the Improvements (or such part thereof) would be Commercially Viable and that Grantor has the resources to reconstruct and operate such remaining portion or such part thereof), and (ii) Beneficiary nonetheless shall require that condemnation award proceeds be held for payment of the debt and not made available for such restoration after having made a determination in its good faith judgment after any taking that the taking of a portion of the Premises or the Improvements was so extensive as to make continued operation of the remainder thereof (or of a part of such remainder) not Commercially Viable, all such condemnation award proceeds (or, where Grantor's showing and Beneficiary's determination relate to a discrete part of such remainder, such portion of the condemnation award proceeds as Beneficiary shall allocate to such part of such remainder, as well as such portion of the condemnation award proceeds as Beneficiary shall allocate to the portion of the Premises and the Improvements that shall have been taken) shall be paid over to Beneficiary and applied in payment of the Secured Obligations, and Grantor shall not be permitted to restore the remaining portion of the Premises or the Improvements (or such discrete part thereof) so long as this Deed of Trust is in effect, but shall be obligated to prepay the Note (or, in the case of a part of the remaining portion of the Premises and the Improvements, to make a prepayment of a portion of the principal balance of the Note) and obtain a release of this Deed of Trust in accordance with Section 7.06 hereof (or a release of the lien of this Deed of Trust from the discrete part of the remaining portion of the Premises and the Improvements not being restored if Beneficiary determines that such partial release is practicable by paying to Beneficiary (in addition to Beneficiary's receipt of all such proceeds that Beneficiary shall have allocated to the portion of the Premises and the Improvements not being restored, as well as such portion of the condemnation award proceeds as Beneficiary shall have allocated to the portion of the Premises and the Improvements that shall have been taken) the following: (I)In the case where Grantor's good faith showing and Beneficiary's determination relate to all of the remainder of the Premises and the Improvements, the amount, if any, by which (x) the sum of (A) the unpaid principal balance of the Note, (B) interest on the Note through and including the last day of the month in which the amount described in the immediately preceding clause (A) is paid, and (C) all other Secured Obligations, if any, exceeds (y) the amount of condemnation award proceeds in respect of such taking received by Beneficiary. Beneficiary shall apply the several amounts described in subclauses (A) through (C) of this clause (I) in payment of the respective obligations described in such subclauses. (II)In the case where Grantor's good faith showing and Beneficiary's determination relate to a discrete part of the remainder of the Premises and the Improvements, interest on the amount of condemnation award proceeds applied in reduction of the Secured Obligations through and including the last day of the month in which such proceeds shall be so applied in reduction of the Secured Obligations. Beneficiary shall apply the amount of such interest in reduction of the Secured Obligations. In the limited situation described in this paragraph (f), no Yield Maintenance Amount and no prepayment penalty shall be due and payable. (g)Notwithstanding any taking by public or quasi-public authority through eminent domain or otherwise, Grantor agrees to continue to pay all amounts due in respect of the Secured Obligations, which shall not be reduced until any award or payment therefor shall have been actually received by Beneficiary and applied to the discharge of the Secured Obligations. No application of the proceeds of any award for condemnation or payments in lieu thereof to the reduction of the Secured Obligations shall have the effect of releasing the lien of this Deed of Trust from the portion, if any, of the Mortgaged Property not taken until and unless all of the Secured Obligations have been paid in full. (h)In the event of any temporary taking of the Mortgaged Property or any portion thereof in condemnation or by eminent domain, Grantor shall continue to pay all principal, interest and other Secured Obligations when due and payable under the Note and the other Loan Documents whether or not the proceeds of any award for such temporary taking are applied pursuant to the terms of this paragraph (h) to the prepayment of the Note and the payment of the other Secured Obligations. Unless an Event of Default exists hereunder in which case Beneficiary shall be free to apply such proceeds to the Secured Obligations in such order and priority as Beneficiary shall determine, Grantor shall receive the proceeds of such award for a temporary taking; provided, however, that if any award payable to Grantor on account of such taking is made in a lump sum or is payable other than in equal monthly installments over the term of the temporary taking, then, if but only if, no Event of Default exists hereunder, the award shall be paid over to Beneficiary (who shall hold the same in Permitted Investments) and applied by Beneficiary to the payment of each monthly installment of interest and principal due under the Note and all of the other Secured Obligations as and when the same become due and payable. The excess (if any) of such award received by Beneficiary over such monthly installment of interest and other Secured Obligations falling due for the entire period with respect to which such award was paid shall, monthly, be paid to or on behalf of Grantor for use solely in paying, with respect to the Premises and the Improvements, real estate and personal property taxes, insurance premiums, labor charges, repairs, utilities, accounting and legal expenses and other operating expenses; and provided further, that any unapplied portion of such award held by Beneficiary when such taking ceases or expires, or after all of the Secured Obligations shall have been paid in full (whichever first occurs), plus any interest accrued thereon, shall be repaid to Grantor. If while the proceeds of any such award are held by Beneficiary an Event of Default shall have occurred and be continuing, or Beneficiary shall have accelerated the Secured Obligations, Beneficiary may apply such proceeds in reduction of the Secured Obligations in such order and priority as Beneficiary shall determine. (i) Every reference to "condemnation award proceeds" or "proceeds" contained in this Section 2.15 shall be deemed to include payments in lieu thereof in any form. SECTION 2.16 Leases. (a) Grantor will not without Beneficiary's consent (i) execute an assignment of the Rents or any part thereof from the Premises or the Improvements; (ii) except where the lessee is in default thereunder, terminate or consent to the cancellation or surrender of any Lease of the Premises or the Improvements or of any part thereof, now existing or hereafter to be made, having an unexpired term of one (1) year or more, provided, however, that any Lease may be cancelled if either (A) promptly after the cancellation or surrender thereof a new Lease is entered into with a new lessee having a credit standing, in the reasonable judgment of Beneficiary, at least equivalent to that of the lessee whose Lease was cancelled, and which new Lease, taken as a whole, is on not less favorable terms than the terminated or cancelled Lease or (B)(I) no Event of Default exists hereunder, (II) such Lease demises no more than ten percent (10%) of the net rentable area of the Improvements and accounts for no more than ten percent (10%) of the gross rents payable in respect of the Premises and the Improvements, (III) the tenant under such Lease is not an Affiliate of Grantor, and (IV) such termination, cancellation or surrender is at arm's length and is commercially reasonable and compatible with good leasing practices for similar first class properties in the jurisdiction in which the Premises are located and occurs in the ordinary course of Grantor's business as an owner and operator of the Premises and the Improvements; (iii) modify any such Lease so as to shorten the unexpired term thereof or so as to decrease, waive or compromise in any manner the amount of the Rents payable thereunder or materially expand the obligations of the lessor thereunder; provided, however, that Grantor may modify any Lease without Beneficiary's consent so long as (A) the conditions described in subclauses (I), (II) and (III) of clause (ii) above shall have been satisfied and (B) the modification of such Lease is at arms' length and is commercially reasonable and compatible with good leasing practices for similar first class properties in the jurisdiction in which the Premises are located and occurs in the ordinary course of Grantor's business as an owner and operator of the Premises and the Improvements; (iv) accept prepayments of any installments of Rents to become due under such Leases, except prepayments in the nature of security for the performance of the lessees thereunder-; (v) modify, release or terminate any guaranties of any such Lease unless Grantor has the right to modify or terminate such Lease, or (vi) in any other manner impair the value of the Mortgaged Property or the security of this Deed of Trust. In all events, Grantor shall furnish to Beneficiary copies of all Leases hereafter entered into, as well as copies of all documents effecting the modification, release, cancellation, termination, or surrender of any Lease or of any guaranty of any Lease promptly after the execution thereof. Grantor represents and warrants to Beneficiary that no rent has been paid by any person in possession of any portion of the Premises or the Improvements for more than one installment in advance except for prepayments in the nature of security for the performance of the lessees thereunder as set forth on the rent roll heretofore delivered by Grantor to Beneficiary. Beneficiary hereby consents to any termination, cancellation, surrender or modification of any Lease under circumstances that satisfy the requirements of any of sub-clauses (A) and (B) of clause (ii) of this paragraph. No further consent of Beneficiary to any such termination, cancellation or surrender shall be required. (b) Grantor will not execute any Lease of all or a substantial portion of the Premises or the Improvements except for actual occupancy by the lessee thereunder, and will at all times promptly and faithfully perform, or cause to be performed, all of the covenants, conditions and agreements contained in all Leases of the Premises and the Improvements or portions thereof now or hereafter existing, on the part of the lessor thereunder to be kept and performed so as to assure that no lessee at any time has the legal right, as a result of Grantor's non-performance, to withhold any payments of rent required pursuant to its Lease or to terminate such Lease and will at all times do all things necessary to compel performance by the lessee under each Lease of all material obligations, covenants and agreements by such lessee to be performed thereunder. Each and every Lease of the Premises or the Improvements or any portion thereof hereafter executed shall (i) provide for the giving by the lessee of certificates with respect to the status of such Lease, and Grantor shall exercise its right to request such certificates within five (5) days of any demand therefor by Beneficiary, and (ii) grant Beneficiary the right to enter upon and inspect the leased premises pursuant to Section 2.30 hereof. (c) Each Lease of the Premises or the Improvements, or of any part thereof, hereafter executed shall provide that, in the event of the enforcement by Trustee or Beneficiary of the remedies provided for by law or by this Deed of Trust, the lessee thereunder will, upon request of any person succeeding to the interest of Grantor as a result of such enforcement, automatically become the lessee of said successor in interest, without change in the terms or other provisions of such Lease, provided, however, that said successor in interest shall not be (i) bound by any payment of rent or additional rent for more than one (1) month in advance, except prepayments in the nature of security for the performance by said lessee of its obligations under said Lease, (ii) bound by any amendment or modification of the Lease made in violation of Section 2.16(a) hereof without the consent of Beneficiary or such successor-in interest, (iii) liable for any act or omission of any previous lessor (including Grantor), (iv) subject to any offset, defense or counterclaim that such lessee might be entitled to assert against any previous lessor (including Grantor), or (v) liable for any deposit that such lessee may have given to any previous lessor (including Grantor) that has not, as such, been transferred to such successor in interest, unless such consent was not required pursuant to this Section 2.16. Each Lease shall also provide that, upon request by said successor in interest, such lessee shall execute and deliver an instrument or instruments confirming such attornment. (d) Beneficiary shall have the right to approve the form and substance of any and all Leases of the Premises or the Improvements before they are entered into except as set forth below, as well as the proposed standard form lease for the Improvements. Provided that there is no Event of Default hereunder, Grantor shall have the right, without Beneficiary's consent, to enter into Leases of the Improvements which comply with the following requirements: (i) such Lease shall be on the standard form of lease previously approved by Beneficiary for the Mortgaged Property without deviations other than those of a non-material nature; (ii) the term of such Lease, including all extension options, shall not be in excess of five (5) years unless such extension options provide for rent at the prevailing market rate as of the beginning of the option period; (iii) such Lease shall demise, including any expansion options, no more than ten percent (10%) of the net rentable area of the Improvements; (iv) rents payable under such Lease shall be no less than the fair market rent taking into account all aspects of the Lease; (v) such Lease shall be entered into with an arms-length tenant; (vi) the tenant under such Lease is restricted to a use which is compatible and consistent with the uses permitted under other Leases of the Improvements and such tenant's use does not violate an exclusive agreement contained in any other Lease of the Premises or the Improvements or cause such tenant or Lease to be subject to the approval of any other tenant unless such approval has been obtained in writing prior to the execution of such new Lease; and (vii) the terms of such Lease shall be otherwise in conformity with good leasing practices and shall be commercially reasonable for similar first class properties located in the jurisdiction in which the Premises are located. In the event Grantor enters into any Lease pursuant to this paragraph, Grantor shall, promptly following the execution of such Lease, forward to Beneficiary a copy of such Lease together with a mark-up of the approved standard form Lease showing any changes made to such form and a certification that the Lease complies in all respects with the guidelines described in clauses (i)-(vii) above. (e) In the event Grantor submits any proposed new lease, or modification, termination, surrender or cancellation of any existing Lease, to Beneficiary for Beneficiary's approval in accordance with the terms set forth above, Beneficiary shall be deemed to have consented to such proposed new lease, or modification, termination, surrender or cancellation of such existing Lease, as the case may be, if (i) Grantor shall have submitted to Beneficiary an accurate and complete written summary of the business terms relating to such new lease, or modification, termination, surrender or cancellation of any existing Lease, and shall have requested approval thereof by Beneficiary in writing in accordance with the notice provisions set forth in Section 7.03 hereof, (ii) Beneficiary shall have approved such terms or shall not have disapproved the same within ten (10) days after Beneficiary's receipt of such request for approval thereof, (iii) Grantor thereafter shall have submitted such proposed new lease, or modification, termination, surrender or cancellation of any existing Lease, to Beneficiary for Beneficiary's approval in accordance with the notice provisions set forth in Section 7.03 hereof, and (iv) Beneficiary shall not have disapproved the same within five (5) Business Days after Beneficiary's receipt of such request for approval thereof; provided that (x) the request for approval described in clause (i) of this paragraph (e) shall include the statement clearly marked at the top thereof reading as follows: "FAILURE TO RESPOND WITHIN TEN (10) DAYS FROM YOUR RECEIPT OF THIS NOTICE SHALL BE DEEMED YOUR APPROVAL OF THE MATTERS DESCRIBED IN THIS NOTICE", (y) the request approval described in clause (iii) of this paragraph (e) shall include the statement clearly marked at the top thereof reading as follows: "FAILURE TO RESPOND WITHIN FIVE (5) BUSINESS DAYS FROM YOUR RECEIPT OF THIS NOTICE SHALL BE DEEMED YOUR APPROVAL OF THE MATTERS DESCRIBED IN THIS NOTICE", and (z) the proposed new lease, or the modification, termination, surrender or cancellation of such existing Lease, as the case may be, is an arms' length transaction with a Person who is not an Affiliate of Grantor which conforms with good leasing practices and is commercially reasonable for similar first class properties located in the jurisdiction in which the Premises are located. (f) Grantor shall deliver to Beneficiary within thirty (30) days following the end of each calendar quarter during the term of the Loan a schedule of all Leases in effect as of the last day of such calendar quarter, which schedule shall be certified by Grantor and shall include the following: (i) the name of each tenant; (ii) the number of square feet of space affected by each tenant's Lease; (iii) the monthly and annual Rents, including base rent, additional rent, percentage rent, escalations, pass-through charges and any other kind of rent, under each Lease; (iv) the term of each Lease, including any extension and/or purchase options; and (v) the security deposit held under each Lease and the account in which such security deposit is being held, together with copies certified to be true and complete, of such Leases as shall be specified by Beneficiary. SECTION 2.17 Indemnification. Grantor will indemnify and hold Trustee and Beneficiary harmless against any loss or liability, cost or expense, including, without limitation, any judgments, attorney's fees, costs of appeal bonds and printing costs, arising out of or relating to any proceeding instituted by any claimant alleging a violation by Grantor of any applicable lien law. SECTION 2.18 Attorneys' Fees and Costs of Trustee and Beneficiary. Grantor agrees to pay, within ten (10) business days after demand by the Trustee or Beneficiary, all actual expenses incurred by the Trustee or Beneficiary, including without limitation attorneys' charges, disbursements and reasonable fees, in connection with the enforcement by the Trustee or Beneficiary of any of the Note, this Deed of Trust or any of the other Loan Documents or in connection with the performance of Trustee's duties hereunder. SECTION 2.19 Solvency. Grantor and each and every General Partner of Grantor is Solvent, and no bankruptcy, reorganization, insolvency or similar proceeding under any state or federal law with respect to Grantor or any such principal has been initiated. SECTION 2.20 Due Authorization. The execution and delivery of the Loan Documents by Grantor and performance by Grantor of its obligations thereunder have been duly authorized by all necessary corporate and/or partnership action on the part of Grantor and its constituent entities, and do not and will not violate any present or future law or any rule, regulation, ordinance, order, write, injunction or decree of any court or governmental or quasi-governmental body, agency or other instrumentality (collectively, "Governmental Authorities n ) or any other requirement of law applicable to Grantor or the Mortgaged Property (collectively, "Laws"), or result in a breach of any of the terms, conditions or provisions of, or constitute a default under, or (except as created by the Loan Documents) result in the creation or imposition of any lien of any nature whatsoever upon any of the assets of Grantor pursuant to the terms of any mortgage, deed of trust, indenture, agreement or instrument to which Grantor is a party or by which it or any of its properties is bound. All authorizations, consents and approvals of, notices to, registrations or filings with, or other actions in respect of or by any Governmental Authority, required in connection with the execution and delivery of the Loan Documents by the Grantor, and performance by Grantor of its obligations thereunder have been duly obtained, given or taken and are in full force and effect. SECTION 2.21 No Default. No default has occurred and is continuing beyond the expiration of any applicable grace period under any note, loan agreement, indenture or other material agreement or instrument to which Grantor is a party that would constitute an Event of Default hereunder. SECTION 2.22 Single Purpose Entity. Grantor is, and will, during the term of this Deed of Trust, continue to be, a single purpose entity and agrees that it will not hereafter acquire any property other than the Mortgaged Property in any jurisdiction without the consent of Beneficiary. Grantor, or if Grantor consists of more than one entity, each Grantor hereby represents and warrants to, and covenants with, Beneficiary that, until such time as the Secured Obligations shall be paid in full, Grantor or each such Grantor, as the case may be: (a) shall maintain its existence as a limited partnership duly organized, validly existing and in good standing as a limited partnership under the laws of a State of the United States of America and maintain its chief executive office and principal place of business in a State of the United States of America; (b) shall maintain (i) its chief executive office and principal place of business separate and apart from that of each corporate general partner, or, within thirty (30) days after the date hereof, enter into a lease with its corporate general partner for office space for the chief executive office and principal place of business of Grantor on the premises of the chief executive office and principal place of business of such corporate general partner pursuant to a written lease, and (ii) its chief executive office and principal place of business separate and apart from the domicile of each individual general partner; (c) shall maintain business operations that are independent of, and substantial in relation to, those of each general partner, principal and Affiliate and transact a substantial percentage of its business with entities that are separate from those with which each general partner, principal and Affiliate transacts its business, and, without limiting the generality of the foregoing, conduct its business solely in its own name in order not (i) to mislead others as to the entity with which such other party is transacting business or (ii) to suggest that Grantor is responsible for the debts of any general partner, principal or Affiliate; (d) shall characterize each general partner and Affiliate as a separate person or entity in any report, tax return, financial statement, other accounting or business transaction; (e) shall have Grantor authorize all partnership actions to the extent required by its Certificate of Limited Partnership and Limited Partnership Agreement; (f) shall receive fair consideration and reasonably equivalent value in exchange for any conveyance, transfer or obligation to or for the benefit of each general partner; (g) shall maintain record title to the Mortgaged Property in the name of Grantor, and in no event shall title to any of the Mortgaged Property be recorded in the name of any general partner, Affiliate or any other person or entity; (h) shall not make any conveyance or transfer or incur any obligation to or for the benefit of any general partner with any intent to hinder, delay or defraud any creditor of Grantor or of any general partner; (i) shall not make or incur any conveyance, transfer or obligation to or for the benefit of any general partner or Affiliate at any time when it may be Insolvent or as a result of which it may be rendered Insolvent, or engage in any business or transaction with any general partner or Affiliate after which the property remaining with Grantor will be an unreasonably small capital, or make or incur any such conveyance, transfer or obligation to or for the benefit of any general partner or Affiliate if it intends to incur, or believes that it would incur, debts that would be beyond the ability of Grantor to pay as such debts matured; (j) shall not take any action to dissolve and wind up Grantor or file any petition to take advantage of any applicable insolvency, bankruptcy, liquidation or reorganization statute, and shall not make an assignment for the benefit of its creditors or voluntarily suspend payment of any of its obligations prior to the repayment in full of the Secured Obligations and shall take all action necessary to preclude the dissolution and winding up of the Grantor and to obtain the dismissal of any involuntary petition filed under the federal bankruptcy code with respect to Grantor prior to the repayment in full of the Secured Obligations; (k) does not own and shall not own any asset other than (i) the Mortgaged Property, (ii) such incidental personal property necessary for the operation of the Mortgaged Property, and (iii) unencumbered cash or securities; (l) is not engaged and shall not engage in any business or activity other than in connection with the ownership, management or operation of the Property, and any such business transactions with any general partner or Affiliate shall be entered into upon terms and conditions that are intrinsically fair and substantially similar to those that would be available on an arms-length basis with third parties other than an Affiliate; (m) except for trade payables incurred in the ordinary course of business has not incurred and shall not incur any debt, secured or unsecured, direct or contingent (including guaranteeing any obligation), other than (i) the Secured Obligations, (ii) normal short-term obligations to trade creditors that are paid in the normal course of business when due and (iii) for customary advances by a general partner under Grantor's limited partnership agreement that, in the aggregate do not exceed ten percent (lO%) of the appraised value of the Mortgaged Property, or to any Affiliate or any creditor of any general partner or Affiliate; (n) is and shall be Solvent and pay its liabilities from its assets; (o) has done or caused to be done and shall do all things necessary to preserve its existence, shall not, nor shall any partner, limited or general, or shareholder hereof, amend, modify or otherwise change its partnership certificate or partnership agreement; (p) shall conduct and operate its business as presently conducted and operated; (q) does and shall maintain its partnership records, books of account and bank accounts separate and apart from those of its Affiliates, its general partners or any other person or entity; (r) shall maintain adequate capital for the normal obligations reasonably foreseeable in a business of its size and character and in light of its contemplated business transactions; and (s) shall not commingle its funds and other assets with those of any general partner, Affiliate or any other person or entity. SECTION 2.23 [RESERVED] SECTION 2.24 Compliance with Laws and Insurance Requirements. (a) Grantor, at its own sole cost and expense, shall promptly comply with all Laws, with all orders, rules and regulations (collectively, "Orders") of the National and Local Boards of Fire Underwriters or any other body or bodies exercising similar functions, with all restrictions and covenants of record, and with all conditions and requirements necessary to preserve and extend any and all rights, licenses, permits (including without limitation, all zoning variances, special exceptions and nonconforming uses), privileges, franchises and concessions, foreseen or unforeseen, ordinary as well as extraordinary, which may be applicable to the Mortgaged Property or any part thereof, or to the use or manner of use of the Mortgaged Property by the owners, tenants or occupants thereof, or any persons engaged in the operation or maintenance thereof, whether or not any such Laws or Orders shall necessitate structural changes or improvements or interfere with the use or enjoyment of the Mortgaged Property. Grantor shall also procure, pay for and maintain all permits, licenses, approvals and other authorizations, necessary for the operation of its business at the Premises and the lawful use and occupancy of the Premises and the Improvements, or any part thereof, in connection therewith. (b) Grantor shall, at its own sole cost and expense, observe and comply in all material respects with the requirements of the policies of public liability, fire and all other insurance at any time in force with respect to the Mortgaged Property, and Grantor shall, in the event of any violation or attempted violation of the provisions of this Section 2.24 by any occupant of any portion of the Premises or the Improvements, take steps, immediately upon actual knowledge of such violation or attempted violation, to remedy or prevent the same, as the case may be. (c) Grantor shall have the right, after notice to Beneficiary, to contest by appropriate legal proceedings, diligently conducted in good faith, in the name of Grantor, the validity or application of any Laws, Orders or other matters of the nature referred to in this Section 2.24 subject to the following: (i)If by the terms of any such Law or Order, compliance therewith pending the prosecution of any such proceeding may legally be delayed without subjecting Grantor, Trustee or Beneficiary to any liability (other than for the payment or accrual of interest), civil or criminal, for failure so to comply therewith, or (ii)if any lien, charge or civil liability would be incurred by reason of any such delay, the same would not subject the Mortgaged Property or any part thereof to forfeiture, loss or suspension of operations, and Grantor (a) furnishes Trustee and Beneficiary security satisfactory to Beneficiary against any loss or injury by reason of such contest or delay, and (b) prosecutes the contest with due diligence, then Grantor may delay compliance therewith until the final determination of any such proceeding. Grantor covenants that Trustee and Beneficiary shall not suffer or sustain-any liabilities or expenses by reason of any act or thing done or omitted to be done by Grantor pursuant to this paragraph (c) and that Grantor shall indemnify and hold harmless Trustee and Beneficiary from any such liability or expense. SECTION 2.25 Discharge of Liens. Grantor will pay, from time to time when the same shall become due, all lawful claims and demands of mechanics, materialmen, laborers, and others which, if unpaid, might result in, or permit the creation of, a Lien on the Mortgaged Property or any part thereof, or on the revenues, rents, royalties, issues, income and profits arising therefrom and in general will do or cause to be done everything necessary so that the lien hereof shall be fully preserved, at the sole cost and expense of Grantor and without expense to Trustee or Beneficiary. If any such Liens are filed, Grantor will cause the same to be permanently discharged of record by payment or otherwise, unless Grantor shall in good faith and at its own expense, be contesting such Lien or Liens or the validity thereof by appropriate legal proceedings which shall operate to prevent the collection thereof or other realization thereon or the sale or forfeiture of the Mortgaged Property, or any part thereof to satisfy the same; provided that during such contest Grantor shall provide an indemnity bond or other security reasonably satisfactory to Beneficiary to cover the amount of the contested item or items and the amount of the interest and penalties covering the period through which such proceedings may be expected to last, and in any event assuring the discharge of Grantor's obligation hereunder and of any additional charge, penalty or expense arising from or incurred as a result of such contest; and if Grantor shall have posted a bond as security against payment of any such Lien, interest, penalties and other charges related thereto, Beneficiary shall be named as an additional obligee under the bond. Except as provided above, Grantor will not directly or indirectly create, incur or suffer to exist any Lien on the Mortgaged Property or any part thereof (including without limitation any Lien securing the repayment of a loan made to Grantor by any partner(s), shareholder(s), officer(s), director(s) or trustee(s) of Grantor), whether or not junior to the lien of this Deed of Trust, other than the Permitted Exceptions, and as may be permitted by such other documents approved by Beneficiary as may be executed as further security for the Note or in favor of Beneficiary. SECTION 2.26 Contest of Impositions. Nothing in Section 2.07 hereof shall require the payment or discharge of any Imposition so long as Grantor shall in good faith and at its own expense, after giving notice to Beneficiary of its intention to do so, contest the same or the validity thereof by appropriate legal proceedings which shall operate to prevent the collection thereof or other realization thereon and the sale or forfeiture of the Mortgaged Property, or any part thereof, to satisfy the same; provided that during such contest Grantor shall provide security satisfactory to Beneficiary to cover the amount of the contested item or items and the amount of the interest and penalties covering the period through which such proceedings may be expected to last, and, in any event, assuring the discharge of Grantor's obligation hereunder and of any additional charge, penalty or expense arising from or incurred as a result of such contest; and provided further, that if at any time payment of any Imposition shall become necessary to prevent the delivery of a tax deed conveying the Mortgaged Property or any part thereof because of non-payment, then Grantor shall pay the same in sufficient time to prevent the delivery of such tax deed. If Grantor shall have posted a bond as security against payment of any Imposition, interest, penalties and other charges related thereto, Beneficiary shall be named as an additional obligee under the bond. If Grantor fails to prosecute any such contest with due diligence or fails to maintain sufficient funds or security on deposit as hereinabove provided, Beneficiary may, at its option, within ten (10) days following Beneficiary's written notice to Grantor (or such shorter period of time necessary in Beneficiary's opinion to prevent the collection of Impositions or the sale or forfeiture of the Premises or the Improvements or any part thereof or interest therein), apply the monies and liquidate any securities deposited with Beneficiary, in payment of, or on account of, such Impositions, or any portion thereof then unpaid, including all penalties and interest thereon. If the amount of the money and any such security so deposited is insufficient for the payment in full of such Impositions, together with all penalties and interest thereon, Grantor shall forthwith, upon demand, either deposit with Beneficiary a sum that, when added to such funds then on deposit, is sufficient to make such payment in full, or, if Beneficiary has applied funds on deposit on account of such Impositions, restore such deposit to an amount satisfactory to Beneficiary. Provided that Grantor is not then in default hereunder, Beneficiary shall, if so requested in writing by Grantor, after final disposition of such contest and upon Grantor's delivery to Beneficiary of an official bill for such Impositions, apply the money or security so deposited in full payment of such Impositions or that part thereof then unpaid, together with all penalties and interest thereon and return any excess to Grantor, unless Grantor has paid all such Impositions, together with all penalties and interest thereon, and has provided Beneficiary with evidence reasonably satisfactory to Beneficiary of such payment, in which event Beneficiary shall return such money or security to Grantor. All money held by Beneficiary pursuant to this Section 2.26 shall not be held in trust by Beneficiary and shall be held without any allowance of interest thereon. SECTION 2.27 Use of Mortgaged Property. Grantor will maintain, preserve and renew, from time to time, such rights of way, easements, grants, privileges, licenses and franchises as are necessary for the use and operation of the Mortgaged Property in the manner heretofore used and operated, and will not use or operate, or permit the use or operation of, the Mortgaged Property for any other purpose, initiate, join in or consent to any new private restrictive covenant (apart from any Permitted Exception), easement or other public or private restrictions to the use of the Mortgaged Property, without the consent in each instance of Beneficiary. Grantor shall, however, comply in all material respects with all lawful restrictive covenants which may at any time affect the Mortgaged Property and with zoning ordinances and other private and public restrictions as to the use thereof, and Grantor represents and warrants that the Mortgaged Property is in complete compliance with all such restrictive covenants and zoning ordinances and other private and public restrictions affecting the use thereof. Grantor will not cause or maintain any nuisance in, at or on the Mortgaged Property. Grantor will pay or cause to be paid all charges for all public and private utility services, all public and private rail and highway services (if any), all public and private communications services and all sprinkler systems and protective services at any time rendered to, or in connection with, the Mortgaged Property or any part thereof, will comply in all material respects, or use reasonable efforts to cause compliance with, all contracts relating to any such services, and will do all other things required for the maintenance and continuance of all such services. SECTION 2.28 [RESERVED] SECTION 2.29 Maintenance of Personal Property. Grantor shall cause the Improvements to be equipped with the Personal Property, to the extent and in the manner as shall be necessary, appropriate or required for the operation of the Premises and the Improvements. Except where appropriate replacements, free of superior Liens, are immediately made of a value at least equal to the value of the Personal Property being removed, no Personal Property covered hereunder shall be removed from the Premises without the consent of Beneficiary. The Personal Property so disposed of shall be promptly replaced with Personal Property of the same character and of at least equal usefulness and quality. SECTION 2.30 General Right of Entry. Grantor agrees that it will permit Beneficiary and its agents and designees from time to time upon reasonable advance notice (not less than one business day) and during regular business hours (or upon occurrence of any emergency situation, without advance notice and at any time) to enter upon and inspect the Mortgaged Property to determine its compliance with the requirements of this Deed of Trust and the other Loan Documents and to ascertain its condition. SECTION 2.31 Separate Tax Lot. Grantor represents and warrants that the Premises are assessed for real estate tax purposes as a wholly independent tax lot, separate from any adjoining land or improvements not constituting a part of such lot and that the Premises do not include any land or improvements constituting part of a tax lot for property not encumbered by this Deed of Trust. SECTION 2.32 Limitations on Transfer. (a) Grantor hereby covenants and agrees that, except to the extent otherwise permitted herein, it will not, without the consent in each instance of Beneficiary, (i) convey, sell, assign, lease or otherwise transfer any interest of Grantor in the Mortgaged Property or any portion thereof, (ii) pledge, mortgage, hypothecate, place a deed of trust or other Lien on or otherwise encumber Grantor's interest in the Mortgaged Property or any portion thereof, (iii) permit the conveyance, sale, assignment, pledge, mortgage, hypothecation or other transfer or disposition, (except involuntarily by operation of law as the result of the death of a partner) either directly or indirectly or through one or more step transactions or transactions, of interests in Grantor or in the partners, shareholders, principals or trustees of Grantor or in the partners, shareholders, principals or trustees of such partners, shareholders, principals or trustees, or any portion thereof, except that limited partnership interests and non-controlling stock interests in entities other than Grantor may be transferred, or (iv) enter into or permit to be entered into any agreement or arrangement to do any of the foregoing (each of the aforesaid acts referred to in clauses (i) through (iv) above being referred to herein as a "Transfer"). Any conveyance, sale, assignment, lease, pledge, mortgage, hypothecation, encumbrance or transfer deemed to be such by operation of Law shall also be deemed to be a Transfer. Any attempted Transfer in violation of this Section shall be void and of no force or effect. (b) Notwithstanding the foregoing, Beneficiary agrees that it will permit a single Transfer of Grantor's entire interest in the Mortgaged Property to a third party transferee subject to this Deed of Trust, so long as there is no Event of Default hereunder, if (i) such transferee meets underwriting standards of prudent institutional lenders as determined by Beneficiary, is not an Affiliate of Grantor and is a single-purpose entity that complies with the provisions of Section 2.22 hereof, (ii) the Transfer by Grantor to such transferee is made at arms' length, (iii) at the time of such Transfer, Beneficiary reasonably determines that (A) the Debt Service Coverage Ratio for the Loan based on the greater of (x) the interest rate then payable under the Note and (y) 2.80% per annum in excess of the average yield for Treasury Constant Maturities having a maturity of five (5) years, on the basis of yields reported -in H.15(519) or the applicable successor publication in effect for the week prior to the week in which Beneficiary makes such determination, is no less than 1.35:1 and (B) the loan-to-value ratio determined by dividing the then-current principal balance of the Note by the then-value of the Premises and the Improvements then constituting Mortgaged Property is no greater than seventy-five percent (75%) (each of which determinations shall be made by Beneficiary which determinations with respect to loan-to-value ratios , be made, at Beneficiary's option, on the basis of the amount of consideration to be paid by such third party transferee to Grantor or the amount indicated in a current appraisal performed by an appraiser selected by Beneficiary but at the sole cost and expense of Grantor) at the time of such Transfer), (iv) such transferee executes and delivers an assumption agreement with respect to the Note, this Deed of Trust and the other Loan Documents in form and substance satisfactory to Beneficiary, (v) such transferee delivers or causes to be delivered to Beneficiary such opinions of counsel with respect to the assumption and related matters as Beneficiary shall request, (vi) such transferee pays all counsel fees and other reasonable costs to third parties incurred by Beneficiary in connection with the Transfer and assumption, but in no event less than $5,000, (vii) such transferee deposits in the Loan Reserve the full amount required to be deposited therein upon such Transfer as set forth in Section 2.33 hereof, if any, (viii) such Transferee enters into a Transferee Cash Reserve Agreement as set forth in Section 2.34 hereof in a form acceptable to Beneficiary and (ix) Beneficiary acknowledges full compliance with all of the conditions set forth in the immediately preceding clauses (i) - (viii) in a document that is recorded in the same official records in which this Deed of Trust is recorded. In the event that Beneficiary determines that the aforesaid loan-to-value ratio set forth in subclause (B) above is greater than seventy-five percent (75%), or that the Debt Service Coverage Ratio is less than 1.35:1, then, such Transfer will nevertheless be permitted upon compliance with all of the requirements enumerated in all of clauses (i) through (ix) other than subclause (A) or (B), as applicable, of clause (iii) of this subparagraph of this subsection (b) if, in addition thereto, Grantor pays to Beneficiary (A) such amount (the "Principal Reduction Amount") as would be necessary to reduce the unpaid principal balance of the Note to an amount (I) that does not exceed seventy-five percent (75%) of the then value of the Premises and the Improvements then constituting Mortgaged Property as determined by Beneficiary and (II) which, if it were used to reduce the principal balance of the Note would result in a Debt Service Coverage Ratio of at least 1.35:1 for the Loan (as so reduced) and (B) the following: (I)if such Transfer is proposed to be consummated at any time within the first two (2) years following the Funding Date, the Yield Maintenance Amount calculated with respect to the Principal Reduction Amount; (II)if such Transfer is proposed to be consummated at any time within the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), interest on the Principal Reduction Amount through and including the last day of the month in which the First Permitted Prepayment Date occurs; and (III)if such Transfer is proposed to be consummated at any time on or after the First Permitted Prepayment Date, the applicable prepayment penalty, if any, required pursuant to the Note, calculated with respect to the Principal Reduction Amount, plus interest on the Principal Reduction Amount through and including the last day of the month in which the same shall be received. If the Principal Reduction Amount is paid at any time during the first two years following the Funding Date or at any time on or after the First Permitted Prepayment Date, it will be applied in reduction of the Secured Obligations on the last day of the month in which it is paid. If the Principal Reduction Amount is paid at any time during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), it will be deposited, together with the interest thereon paid pursuant to the immediately preceding clause (II), in the Cash Reserve, to be used and applied as provided in the Transferee Cash Reserve Agreement. Any Yield Maintenance Amount or prepayment penalty paid pursuant to this Section 2.32(b) shall be applied in payment of the obligation far which it is paid. Further notwithstanding Section 2.32(a) hereof and the preceding paragraph of this Section 2.32(b), Beneficiary agrees that it will permit a Carlyle Transfer (as defined below) or a JMB Transfer (as defined below), so long as there is no Event of Default hereunder, if (i) the transferee meets underwriting standards of prudent institutional lenders as to credit worthiness, as determined by Beneficiary, (ii) the transferee executes and delivers an assumption agreement with respect to the obligations of the transferor, if any, under the Note, this Deed of Trust and the other Loan Documents in form and substance reasonably satisfactory to Beneficiary, (iii) the transferee delivers or causes to be delivered to Beneficiary such opinions of counsel with respect to the assumption and related matters as Beneficiary shall request, (iv) the transferee pays all counsel fees and other reasonable costs to third parties incurred by Beneficiary in connection with the Transfer, but in no event less than $5,000, (v) the transferee deposits in the Loan Reserve the full amount required to be deposited therein upon such Transfer as set forth in section 2.33 hereof, if any, and (vi) Beneficiary acknowledges full compliance with all of the conditions set forth in the immediately preceding clauses (i) - (v) in a document that is recorded in the same official records in which this Deed of Trust is recorded. Further notwithstanding Section 2.32(a) hereof and the preceding paragraphs of this Section 2.32(b), Beneficiary agrees that it will permit a REIT Transfer (as defined below), so long as there is no Event of Default hereunder, if (i) the transferee meets underwriting standards of prudent institutional lenders as to credit worthiness, as determined by Beneficiary, (ii) at the time of such Transfer, Beneficiary reasonably determines that (A) the Debt Service Coverage Ratio for the Loan based on the greater of (x) the interest rate then payable under the Note and (y) 2.80% per annum in excess of the average yield for Treasury Constant Maturities having a maturity of five (5) years, on the basis of yields reported in H.15(519) or the applicable successor publication in effect for the week prior to the week in which Beneficiary makes such determination, is no less than 1.35:1 and (B) the loan-to-value ratio determined by dividing the then-current principal balance of the Note by the then-value of the Premises and the Improvements then constituting Mortgaged Property is no greater than seventy-five percent (75%) (each of which determinations shall be made by Beneficiary (which determination with respect to loan-to-value ratio shall be made on the basis of the amount indicated in a current appraisal performed by an appraiser selected by Beneficiary but at the sole cost and expense of the transferor) at the time of such Transfer), (iii) the transferee executes and delivers an assumption agreement with respect to the obligations of the transferor, if any, under the Note, this Deed of Trust and the other Loan Documents in form and substance satisfactory to Beneficiary, (iv) the transferee delivers or causes to be delivered to Beneficiary such opinions of counsel with respect to the assumption and related matters as Beneficiary shall request, (v) the transferee pays all counsel fees and other reasonable costs to third parties incurred by Beneficiary in connection with the Transfer, but in no event less than $5,000, (vi) the transferee deposits in the Loan Reserve the full amount required to be deposited therein upon such Transfer as set forth in Section 2.33 hereof, if any, (vii) such Transferee enters into a Transferee Cash Reserve Agreement as set forth in Section 2.34 hereof in a form acceptable to Beneficiary and (viii) Beneficiary acknowledges full compliance with all of the conditions set forth in the immediately preceding clauses (i) - (vii) in a document that is recorded in the same official records in which this Deed of Trust is recorded. In the event that Beneficiary determines that the aforesaid loan-to-value ratio set forth in subclause (B) above is greater than seventy-five percent (75%), or that the Debt Service Coverage Ratio is less than 1.35:1, then, such Transfer will nevertheless be permitted upon compliance with all of the requirements enumerated in all of clauses (i) through (viii) other than subclause (A) or (B), as applicable, of clause (ii) of this subparagraph of this subsection (b) if, in addition thereto, (A) Grantor pays to Beneficiary such amount (the "Principal Reduction Amount") as would be necessary to reduce the unpaid principal balance of the Note to an amount (I) that does not exceed seventy-five percent (75%) of the then value of the Premises and the Improvements then constituting Mortgaged Property as determined by Beneficiary and (II) which, if it were used to reduce the principal balance of the Note would result in a Debt Service Coverage Ratio of at least 1.35:1 for the Loan (as so reduced), and (B) the following: (I)if such Transfer is proposed to be consummated at any time within the first two (2) years following the Funding Date, the Yield Maintenance Amount calculated with respect to the Principal Reduction Amount; (II)if such Transfer is proposed to be consummated at any time within the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), interest on the Principal Reduction Amount through and including the last day of the month in which the First Permitted Prepayment Date occurs; and (III)if such Transfer is proposed to be consummated at any time on or after the First Permitted Prepayment Date, the applicable prepayment penalty, if any, required pursuant to the Note, calculated with respect to the Principal Reduction Amount, plus interest on the Principal Reduction Amount through and including the last day of the month in which the same shall be received. If the Principal Reduction Amount is paid at any time during the first two years following the Funding Date or at any time on or after the First Permitted Prepayment Date, it will be applied in reduction of the Secured Obligations on the last day of the month in which it is paid. If the Principal Reduction Amount is paid at any time during the third, fourth or fifth year following the Funding Date (but in any event prior to the First Permitted Prepayment Date), it will be deposited, together with the interest thereon paid pursuant to the immediately preceding clause (II), in the Cash Reserve, to be used and applied as provided in the Transferee Cash Reserve Agreement. Any Yield Maintenance Amount or prepayment penalty paid pursuant to this Section 2.32(b) shall be applied in payment of the obligation for which it is paid. For the purposes of this Section 2.32(b), a "Carlyle Transfer" shall mean a single Transfer of all or any part of Carlyle partnership interest in the Grantor to a third party transferee, so long as The John Akridge Company remains a general partner of the Grantor and is or becomes the managing general partner of Grantor and the Akridge Group owns an aggregate of 50% of the general and limited partnership interests in the Grantor. For the purposes of this Section 2.32(b), a "JMB Transfer" shall mean either (i) a single Transfer of all or any part of any partnership interest in Carlyle held by JMB or any JMB Approved Transferee (as defined below) to any person, firm or entity other than JMB or a JMB Approved Transferee or (ii) a single Transfer of any stock in JMB to any person, firm or entity other than to a current shareholder in JMB or a JMB Approved Transferee if such Transfer, either alone or when taken together with any previous Transfers of JMB stock permitted under Section 2.32(d) hereof, would result in a Transfer of a controlling stock interest in JMB, so long as, in either case, The John Akridge Company remains a general partner of the Grantor and is or becomes the managing general partner of Grantor and the Akridge Group owns an aggregate of 50% of the general and limited partnership interests in the Grantor. For the purposes of this Section 2.32(b), a "REIT Transfer" shall mean (i) a single Transfer of up to ninety-nine percent (99%) of the general and limited partnership interests in the Grantor to a publicly traded real estate investment trust ("REIT") or a master limited partnership controlled by a publicly traded REIT (a "Master Limited Partnership"), (ii) a single Transfer of the Grantor's entire interest in the Mortgaged Property to a publicly traded REIT or a Master Limited Partnership, or (iii) the merger of the Grantor into a publicly traded REIT or a Master Limited Partnership. (c) Further notwithstanding the foregoing provisions of this Section 2.32, (i) if the original Grantor is a limited partnership, limited partnership interests in the original Grantor aggregating not more than forty-nine percent (49%) of all partnership interests in the original Grantor may be transferred without Beneficiary's consent, and (ii) if the original Grantor is a corporation, shares of stock in the original Grantor aggregating not more than forty-nine percent (49%) of all the issued and outstanding stock in the original Grantor may be transferred without Beneficiary's consent, (iii) either Carlyle or the Akridge Group may transfer all or any part of its partnership interest in Grantor to the other so long as Beneficiary is given prior written notice of such Transfer and, in the event of such a Transfer to the Akridge Group, after such Transfer, the constituent members of the Akridge Group hold the same types of interests (i.e., general or limited partnership interests) in the Grantor as each holds as of the date hereof and hold such interests in the proportions to one another as each holds as of the date hereof (except that The John Akridge Company and/or John E. Akridge III, may hold proportionately greater interests than they hold as of the date hereof), (iv) Grantor may transfer its interest in the Mortgaged Property (in whole but not in part) to either Carlyle or the Akridge Group or to an entity formed by the Akridge Group so long as Beneficiary is given prior written notice of such Transfer, and, in the event of such a Transfer to an entity formed by the Akridge Group, after such Transfer, the constituent members of the Akridge Group hold the same types of interests (i.e. general or limited partnership interests) in such entity as each holds in the Grantor as of the date hereof and hold such interests in proportions to one another as each holds as of the date hereof (except that The John Akridge Company and/or John E. Akridge III, may hold proportionately greater interests than they hold as of the date hereof). (d) Further notwithstanding the foregoing provisions of this Section 2.32, so long as the constituent members of the Akridge Group hold the same types of interests (i.e., general or limited partnership interests) in the Grantor as each holds as of the date hereof and hold such interests in the same proportions to one another as each holds as of the date hereof (except that The John Akridge Company and/or John E. Akridge III, may hold proportionately greater interests than they hold as of the date hereof): (i) any and all of Realty Associates' partnership interests in Carlyle may be transferred without Beneficiary's consent; (ii) subject to the requirements of Section 2.32(b) above with respect to a JMB Transfer, stock in JMB may be transferred without Beneficiary's consent so long as Beneficiary is given written notice at any time at which an aggregate of ten percent (10%) of the stock in JMB has been transferred since the later of (A) the date hereof and (B) the date of any prior notice of any transfer of JMB stock under this clause or (C) any JMB Transfer; (iii) any and all partnership interests in Realty Associates may be transferred without Beneficiary's consent; (iv) so long as Beneficiary is given prior written notice of such transfer, JMB may, without Beneficiary's consent, transfer all or any part of its partnership interest in Carlyle to any JMB Approved Transferee; and (v) so long as Beneficiary is given prior written notice of such transfer, Carlyle may, without Beneficiary's consent, transfer all or any part of its partnership interest in Grantor to JMB or any JMB Approved Transferee. For the purposes of this Section 2.32(d), a "JMB Approved Transferee" means any one or more of the following: (i) an "affiliate" or subsidiary of JMB or (ii) a general or limited partnership in which JMB or an "affiliate" or subsidiary of JMB is a general partner. As used herein, an affiliate of JMB includes any corporation in which JMB or its shareholders, individually or collectively, own or control, directly or indirectly, more than 50% of the common stock. (e) Any transferee under any Transfer as to which all of the conditions-of this Section 2.32 with respect to such Transfer are satisfied is hereinafter referred to as a "Permitted Transferee". SECTION 2.33 Loan Reserve. (a) Grantor shall pay to Beneficiary on the Funding Date the amount set forth as the Initial Deposit Amount on Schedule B annexed hereto and made a part hereof for deposit into a reserve (the "Loan Reserve") to be used as hereinafter provided. Thereafter, commencing on the first day of the first month after the month in which the Funding Date occurs and on the first day of each subsequent month, Grantor shall deposit into the Loan Reserve an amount equal to the lesser of the amount set forth as the Monthly Deposit Amount (the "Monthly Deposit") on Schedule B or the Excess Cash Flow with respect to the immediately preceding month into the Loan Reserve. Upon any Transfer of Grantor's interest in the Mortgaged Property to a Permitted Transferee in accordance with Section 2.32(b) hereof, the Permitted Transferee shall pay to the Beneficiary, for deposit into the Loan Reserve, that amount, if any, which, when added to the existing balance of the Loan Reserve at the time of the Transfer, will increase the balance of the Loan Reserve to an amount equal to the sum of (i) the Initial Deposit Amount, plus (ii) an amount equal to the product of (A) the Monthly Deposit set forth on Schedule B hereto and (B) the number of months that have elapsed from (and including) the first month after the month in which the Funding Date falls until the first day of the month in which the Transfer occurs; provided, however, that the Permitted Transferee shall in no event be obligated to pay to Beneficiary at the time of the Transfer an amount in excess of the amount which would cause the Loan Reserve balance to exceed the amount of total debt service on the Note for a period of one (1) year. The Loan Reserve shall constitute additional collateral for the Secured Obligations and may be applied by Beneficiary, at its option, following an Event of Default hereunder, to any of the Secured Obligations in such order and priority as Beneficiary shall determine. The parties intend that this Deed of Trust shall constitute a security agreement with respect to the Loan Reserve and all funds deposited therein. Nevertheless, at Beneficiary's request, the Permitted Transferee shall be required to execute and deliver such further instrument as Beneficiary may reasonably require to assure the continuing perfection of its security interest in the Loan Reserve and the funds deposited therein. (b) If Beneficiary at any time reasonably determines that the net cash flow generated by or in respect of the Mortgaged Property during the immediately preceding twelve (12) calendar months is insufficient to pay any or all of the debt service on the Note, operating expenses, or necessary leasing or capital costs with respect to the Mortgaged Property, or if Grantor delivers to Beneficiary financial statements reflecting such insufficiency, together with a budget with respect to the expenditure of funds for any one or more of such purposes and Grantor's certification as to the lack of available funds to cover such expenditures, Beneficiary shall, provided such certification is consistent with such financial statements, from time to time, (i) in response to Grantor's request, but only to the extent of the deficiency as determined by Beneficiary, unless Grantor shall have delivered such financial statements, in which event the extent of such deficiency shall be as reflected in such financial statements, release funds in the Loan Reserve to pay for (x) tenant improvements costs, concessions, leasing commissions and other expenses incurred by Grantor in connection with the leasing and re-leasing of the Improvements, or (y) costs attributable to replacement of or capital repairs to mechanical systems and structural elements of the Improvements and for other capital costs in connection with the maintenance of the Mortgaged Property or to reimburse Grantor for such costs, but, in all events, only to the extent such costs are not otherwise reimbursable to Grantor under Leases, and (ii) either on its own initiative or in response to Grantor's request, release funds in the Loan Reserve, but only to the extent of such deficiency, to pay debt service on the Note. Each request by Grantor for a disbursement of funds in the Loan Reserve shall (A) be accompanied by such reports, invoices, receipts, financial statements and other documentation as Beneficiary may request, (B) be subject to Beneficiary's approval of all such documentation and the absence of any Event of Default under this Deed of Trust, and (C) in the case of Grantor's request for a disbursement in respect of debt service on the Note, evidence satisfactory to Grantor that the use of such funds in respect of debt service on the Note will not materially adversely affect the ability of Grantor to pay for anticipated leasing and capital costs for the next succeeding twelve (12) months. (c) At such time as Beneficiary determines that the balance of the funds in the Loan Reserve is equal to or greater than the amount set forth on Schedule B as the Maximum Amount (the "Maximum Amount"), Grantor's obligation to make Monthly Deposits into the Loan Reserve shall be suspended until such time, if any, as Beneficiary determines that the Loan Reserve has fallen below the Maximum Amount, at which time Grantor shall again be required to make payments to the Loan Reserve on a monthly basis in an amount equal to (x) the Monthly Deposit to the extent disbursements from the Loan Reserve have been made in respect of approved costs other than debt service on the Note and (y) the greater of the Monthly Deposit and the Excess Cash Flow to the extent disbursements from the Loan Reserve have been made in respect of debt service on the Note. To the extent that the cash flow in respect of the Mortgaged Property during any calendar month, after the payment of debt service on the Note, operating expenses and necessary leasing or capital costs approved by Beneficiary with respect to the Mortgaged Property (the "Required Payments") during such month is less than the amount required to be deposited into the Loan Reserve with respect to such month, Grantor's obligation to make such deposit with respect to such month shall be limited to an amount equal to the cash flow in respect of the Mortgaged Property net of the Required Payments (the "Excess Cash Flow") during such month plus an amount equal to all Excess Cash Flow received by Grantor during the immediately preceding twelve (12) months, less such portion thereof as shall already have been deposited in accordance with the requirements of this clause; provided, however, that any shortfall arising from the application of such limitation of the amount required to be deposited into the Loan Reserve with respect to such month shall accrue and be due and payable from the Excess Cash Flow in respect of the Mortgaged Property during each succeeding month until such shortfall has been reduced to zero and Grantor may not use or distribute any of the Excess Cash Flow in respect of the Mortgaged Property for any purpose other than the Required Payments until such shortfall has been reduced to zero. SECTION 2.34 Cash Reserve. (a) Grantor and Beneficiary, simultaneously with the execution of this Deed of Trust, shall enter into the Cash Reserve Agreement establishing the Cash Reserve. Principal Reduction Amounts, payments of prepayment penalties, casualty insurance proceeds, condemnation award proceeds, principal, interest and any other amounts if, and to the extent, required by any of the provisions of this Deed of Trust to be deposited in the Cash Reserve, shall be so deposited from time to time and shall be held and applied as provided in the Cash Reserve Agreement. Any amount held in the Cash Reserve that Beneficiary shall at any time have the right to apply against any of the Secured Obligations, may at any time or from time to time thereafter be released from the Cash Reserve and applied in reduction of any of the Secured Obligations, as provided in the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable. (b) If a Transfer shall occur in accordance with the provisions of Section 2.32 hereof, the Permitted Transferee, as successor in interest to Grantor, shall enter into a cash reserve agreement with Beneficiary substantially in the form of the Cash Reserve Agreement, with such conforming changes as Beneficiary shall require (the "Transferee Cash Reserve Agreement"), which Transferee Cash Reserve Agreement shall provide for the deposit in the Cash Reserve of any Principal Reduction Amount, prepayment penalty, casualty insurance proceeds, condemnation award proceeds, principal, interest and other amount required by any of the provisions of this Deed of Trust to be deposited in the Cash Reserve. Any payment required to be deposited in the Cash Reserve in connection with any such Transfer or at any time thereafter shall be deposited in the Cash Reserve established and maintained pursuant to the Transferee Cash Reserve Agreement. ARTICLE I I I SECURITY AGREMENT SECTION 3.01 Grant of Security Interest. Without limiting any of the other provisions of this Deed of Trust, Grantor, as debtor, expressly GRANTS unto Beneficiary, as secured party, a security interest in all the Mortgaged Property (including both that now and that hereafter existing) to the full extent that any portion of the Mortgaged Property may be subject to the Uniform Commercial Code as enacted in the jurisdiction in which the Premises are located (hereinafter referred to as the "Uniform Commercial Code"). This Deed of Trust is intended to be a security agreement for the purposes of the Uniform Commercial Code. SECTION 3.02 Covenants of Grantor. Grantor covenants and agrees with Beneficiary that: (a) Grantor is and will be the true and lawful owner of the Collateral, subject to no lien charges or encumbrances other than the lien hereof, other liens and encumbrances benefiting Beneficiary and no other party, and liens and encumbrances, if any, expressly permitted by this Deed of Trust or otherwise expressly consented to by Beneficiary. (b) Grantor represents that it is a duly constituted partnership or corporate entity as set forth above with a mailing address and a principal place of business as set forth above. Grantor has no other offices which constitute a principal place of business in the jurisdiction in which its principal place of business, as set forth above, is located, or a principal place of business in any other jurisdiction. (c) The Collateral is to be used by Grantor solely for business purposes. (d) All the Collateral consisting of tangible personal property (other than motor vehicles) will be kept at the Land and, except for Obsolete Collateral (as hereinafter defined), will not be removed therefrom without the consent of Beneficiary. The Collateral may be affixed to the Land or the improvements but will not be affixed to any other real estate. Grantor shall be permitted to sell or otherwise dispose of Collateral that is no longer useful in connection with the operation of the Premises or the Improvements (herein called "Obsolete Collateral"); provided that such Obsolete Collateral has been or is contemporaneously being replaced by Collateral of at least equal value and utility which is subject to the lien hereof with the same priority as with respect to the Obsolete Collateral. (e) The only persons having an interest in the Collateral are Grantor, Beneficiary and holders of interest, if any, expressly permitted hereby or otherwise expressly consented to in writing by Beneficiary . (f) In addition to any other remedies granted in this Deed of Trust to Beneficiary (including specifically, but not limited to, the right to proceed against those portions of the Mortgaged Property which are real property), Beneficiary may, should an Event of Default occur, proceed under the Uniform Commercial Code as to all or any part of the Mortgaged Property which is Collateral, and shall have and may exercise with respect to the Collateral all the rights, remedies, and powers of a secured party under the Uniform Commercial Code, including without limitation the right to take immediate and exclusive possession of the Collateral, or any part thereof, and for that purpose may, so far as Grantor can give authority therefor, with or without judicial process, enter (if this can be done without breach of the peace), upon any place on which the Collateral or any part thereof may be situated and remove the same therefrom (provided that if the Collateral is affixed to real estate, such removal shall be subject to the conditions stated in the Uniform Commercial Code) and the right and power to sell, at one or more public or private sales, or otherwise dispose of, lease, or utilize the Collateral and any part or parts thereof in any manner authorized or permitted under the Uniform Commercial Code after default by a debtor. Beneficiary shall be entitled to hold, maintain, preserve and prepare the Collateral for sale, until disposed of, or may propose to retain the Collateral subject to Grantor's right of redemption in satisfaction of Grantor's obligations, as provided in the Code. Beneficiary may render the Collateral unusable without removal and may dispose of the Collateral on the Premises. Beneficiary may require Grantor to assemble the Collateral and make it available to Beneficiary for its possession at a place in the county where the Premises are situated to be designated by Beneficiary. Beneficiary will give Grantor reasonable notice of the time and place of any public sale of the Collateral or of the time after which any private sale or any other intended disposition thereof is to be made. Without limiting the foregoing, Beneficiary shall have the right upon any such public sale or sales, and, to the extent permitted by law, upon any such private sale and sales, to purchase the whole or any part of the Collateral so sold, free of any right or equity of redemption in Grantor, whether on the Land or elsewhere. Grantor further agrees to allow Beneficiary to use and occupy the Mortgaged Property, without charge, for the purpose of effecting any of Beneficiary's remedies in respect of the Collateral. The net proceeds of any such collection, recovery, receipt, appropriation, realization or sale, after deducting all actual expenses of every kind incurred therein or incidental to the care, safekeeping or otherwise of any or all of the Collateral or in any way relating to the rights of Beneficiary hereunder, including all attorneys' charges, disbursements and reasonable fees, shall be received by Beneficiary and credited against the payment in whole or in part of the indebtedness secured hereby. To the extent permitted by applicable law, Grantor waives all claims, damages and demands against Beneficiary arising out of the repossession, retention or sale of the Collateral, except for claims, damages and demands due to the gross negligence or willful misconduct of Beneficiary in dealing with such Collateral. Grantor agrees that Beneficiary need not give more than ten (10) days' notice of the time and place or any public sale or of the time at which a private sale will take place and that such notice is commercially reasonable notification of such matters. (g) Grantor hereby authorizes Beneficiary to file financing and continuation statements with respect to the Collateral without the signature of Grantor whenever lawful, and Grantor irrevocably constitutes and appoints Beneficiary, acting by any of its officers, to the extent permitted by applicable law, as Grantor's attorney-in-fact to execute and deliver such financing statements and other documents as may be necessary or appropriate to establish and maintain a perfected security interest in the Collateral as security for the Secured Obligations, subject to no other liens or encumbrances, other than liens or encumbrances benefiting Beneficiary and no other party and liens and encumbrances (if any) expressly permitted by this Deed of Trust. The foregoing appointment of Beneficiary as attorney-in-fact for Grantor shall be deemed to be coupled with an interest and shall be irrevocable. Grantor agrees to execute such financing and continuation statements as Beneficiary may reasonably request. (h) Grantor hereby represents and warrants that no financing statement (other than financing statements showing Beneficiary as the sole secured party, or with respect to liens or encumbrances, if any, expressly permitted by this Deed of Trust or otherwise expressly consented to in writing by Beneficiary) covering any of the Collateral or any proceeds thereof is on file in any public office except pursuant hereto; and Grantor will at its own cost and expense, upon demand, furnish to Beneficiary such further information and will execute and deliver to Beneficiary such financing statements and other documents in form reasonably satisfactory to Beneficiary and will do all such acts as Beneficiary may at any time or from time to time reasonably request or as may be necessary or reasonably appropriate to establish and maintain a perfected security interest in the Collateral as security for the Secured Obligations, subject to no other liens or encumbrances, other than liens or encumbrances benefiting Beneficiary and no other party and to liens and encumbrances (if any) expressly permitted by this Deed of Trust; and Grantor will pay the actual expense of filing or recording such financing statements or other documents, and this instrument, in all public offices wherever filing or recording is reasonably deemed by Beneficiary to be desirable. (i) To the extent permitted by applicable law, the security interest created hereby is specifically intended to cover all rents, royalties, issues and profits, and all inventory accounts, accounts receivable and other revenues of the Mortgaged Property. (j) Certain of the Collateral is or will become "fixtures" (as that term is defined in the Uniform Commercial Code) on the Land and Improvements, and this Deed of Trust upon being filed for record in the real estate records of the jurisdiction in which the land is located shall operate also as a financing statement and fixture filing upon such of the Collateral which is or may become fixtures. (k) Any copy of this Deed of Trust which is signed by Grantor or any carbon, photographic or other reproduction of this Deed of Trust may also serve as a financing statement under the Uniform Commercial Code by Grantor, whose address is set forth hereinabove, in favor of Beneficiary, whose address is set forth hereinabove. ARTICLE IV ASSIGNMENT OF RENTS AND LEASES SECTION 4.01 Assignment. Simultaneously with the execution and delivery hereof, Grantor is executing and delivering to and for the benefit of Beneficiary a separate Assignment of Rents and Leases as further security for the payment and performance of the Secured Obligations. ARTICLE V EVENTS OF DEFAULT AND REMEDIES SECTION 5.01 Events of Default. It shall be an event of default ("Event of Default") if one or more of the following shall occur: (a) if (i) default shall be made in the payment of any installment of interest or principal due under the Note when and as the same shall become due and payable, whether at maturity or by acceleration or as part of any payment or prepayment or otherwise, in each case, as in the Note and this Deed of Trust provided and such default shall have continued for a period of ten (10) days or (ii) default shall be made in the payment of any Imposition required by Section 2.07 to be paid and said default shall have continued for a period of twenty (20) days; or (b) if at any time any representation or warranty made or deemed made under any Loan Document or any other document or certificate provided in connection with any Loan-Document or the Secured Obligations shall be proven to have been materially incorrect when made or deemed made, as the case may be; or (c) if Grantor shall suffer or permit any Transfer to occur, either voluntarily or involuntarily, in violation of Section 2.32 hereof, or if any part of the Improvements or any Chattel is intentionally removed or demolished by Grantor other than in accordance with the provisions of Sections 2.29 and 3.02 hereof (the provisions of this clause (c) to apply to each and every such Transfer, removal and demolition, whether or not Beneficiary has waived by its action or inaction its rights with respect to any previous Transfer, removal or demolition); or (d) if default shall be made in the payment of any of the other Secured Obligations, when and as the same shall become due and payable as in the Note and any other Loan Document provided, or in the performance of any of Grantor's other obligations under any of the Loan Documents which performance consists solely of the payment of a sum of money, (i) prior to maturity (whether such maturity occurs by acceleration, lapse of time or otherwise), if such default shall have continued for a period of ten (10) days after notice thereof to Grantor, and (ii) upon maturity (whether such maturity occurs by acceleration, lapse of time or otherwise); or (e) if default shall be made in the due observance or performance of any other covenant, condition or agreement in the Note, this Deed of Trust or any of the other Loan Documents, and such default shall have continued for a period of thirty (30) days after notice thereof shall have been given to Grantor by Beneficiary, or, in the case of such other documents,-such shorter grace period, if any, as may be provided for therein; or, in any case where such default is susceptible to cure but cannot with due diligence be cured by the payment of money or otherwise within such thirty (30) day, or shorter, period, such longer period (unless Beneficiary determines that delay in effecting such cure might have a material adverse impact on Beneficiary) within which Beneficiary determines that such default can reasonably be cured (not to exceed one hundred twenty (120) days) as is required diligently to effect the cure of such default, but only so long as Grantor promptly notifies Beneficiary of its intention to cure and actually commences the cure of such default within such thirty (30) day or shorter period and at all times thereafter prosecutes such cure with all due diligence to completion; or (f) [Reserved]; or (g) if by order of a court of competent jurisdiction, a trustee, receiver, custodian or liquidator of the Mortgaged Property or any part thereof, or of Grantor, shall be appointed and such order shall not be discharged or dismissed within sixty (60) days after such appointment; or (h) if Grantor shall file a petition in bankruptcy or for an arrangement or for reorganization pursuant to the Federal Bankruptcy Code or any similar law, federal or state, or if, by decree of a court of competent jurisdiction, Grantor shall be adjudicated a bankrupt, or be declared insolvent, or shall make an assignment for the benefit of creditors, or shall admit in writing its inability to pay its debts generally as they become due, or shall consent to the appointment of a receiver or receivers of all or any part of its property; or (i) if any of the creditors of Grantor shall file a petition in bankruptcy against Grantor or for reorganization of Grantor pursuant to the Federal Bankruptcy Code or any similar law, federal or state, and if such petition shall not be discharged or dismissed within sixty (60) days after the date on which such petition was filed; or (j) if final judgment for the payment of money in the amount of the lesser of (i) $250,000 or (ii) ten percent (10%) of the original principal amount of the Note or more shall be rendered against Grantor and Grantor shall not discharge the same or cause it to be discharged within sixty (60) days from the entry thereof, or shall not appeal therefrom or from the order, decree or process upon which or pursuant to which said judgment was granted, based or entered, and secure a stay of execution pending such appeal; or (k) if the payment of any tax referred to in Section 2.08 hereof or the payment of any other sum or any of the Secured Obligations by Grantor would result in the violation of applicable usury laws; or (1) if there should occur after the date hereof the passage of any law in-the jurisdiction where the Premises are located deducting from the value of real property for the purpose of taxation any lien or encumbrance thereon or changing in any way the laws for the taxation of deeds of trust or mortgages or debts secured by deeds of trust or mortgages for state or local purposes or the manner of the collection of any such taxes, and imposing a tax, either directly or indirectly, on any Loan Document or the indebtedness secured by this Deed of Trust, and Grantor fails or is otherwise unable to make timely payment therefor; or (m) if there should occur a default which is not cured within the applicable grace period, if any, under any other mortgage or deed of trust of all or part of the Mortgaged Property regardless of whether any such other mortgage or deed of trust is prior or subordinate to this Deed of Trust; it being further agreed by Grantor that an Event of Default hereunder shall constitute an Event of Default under any such other mortgage or deed of trust held by or for Beneficiary; or (n) if a default shall occur under any obligation set forth in any Permitted Exception or any other agreement, contract, instrument or indenture to which the Grantor is a party beyond the period of grace, if any, provided therein, the effect of which entitles any obligee or agreement of such obligation to foreclose upon all or any material portion of the Mortgaged Property, or which otherwise (in Beneficiary's good faith judgment) materially adversely affects the operations of the Improvements or the Grantor; or (o) if Grantor shall abandon all or a portion of the Mortgaged Property. SECTION 5.02 Remedies. Upon the occurrence and during the continuance of any Event of Default, the Trustee, at the option of Beneficiary, or Beneficiary, may: (a) by notice given to Grantor, declare the entire principal of the Note then outstanding (if not then due and payable), and all accrued and unpaid interest thereon, any applicable prepayment premium and all other Secured Obligations, to be due and payable immediately, and upon any such declaration the principal of the Note and said accrued and unpaid interest, prepayment premium and other Secured Obligations shall become and be immediately due and payable, anything in the Note or in this Deed of Trust to the contrary notwithstanding; (b) by themselves, their agents or attorneys, or by a court appointed receiver, enter into and upon all or any part of the Premises and the Improvements, and each and every part thereof, and are each hereby given a right and license and appointed Grantor's attorney-in-fact to do so, and may exclude Grantor, its agents and servants wholly therefrom; and having and holding the same, may use, operate, manage and control the Premises and the Improvements and conduct the business thereof, either personally or by their superintendents, managers, agents, servants, attorneys or receivers. Upon every such entry, Trustee or Beneficiary, at the expense of the Mortgaged Property, from time to time, either by purchase, repairs or construction, may maintain and restore the Mortgaged Property, whereof they shall become possessed as aforesaid; and likewise, from time to time, at the expense of the Mortgaged Property, Trustee or Beneficiary may make all necessary or proper repairs, renewals and replacements and such useful alterations, additions, betterments and improvements thereto and thereon as to Beneficiary may seem advisable and insure the same. In every such case Trustee or Beneficiary shall have the right to manage and operate the Mortgaged Property and to carry on the business thereof and exercise all rights and powers of Grantor with respect thereto either in the name of Grantor, as its attorney-in-fact, coupled with an interest, or otherwise, as Beneficiary shall deem best. Trustee or Beneficiary shall be entitled to collect and receive the Rents and every part thereof, all of which shall for all purposes constitute property of Grantor; and in furtherance of such right Beneficiary may collect the Rents payable under all Leases of the Premises or the Improvements directly from the lessees thereunder upon notice to each such lessee that an Event of Default exists hereunder accompanied by a demand on such lessee for the payment to Beneficiary of all Rents due and to become due under its Lease. Grantor FOR THE BENEFIT OF BENEFICIARY AND EACH SUCH LESSEE hereby covenants and agrees that the lessee shall be under no duty to question the accuracy of Beneficiary's statement of default and shall unequivocally be authorized to pay said Rents to Beneficiary without regard to the truth of Beneficiary's statement of default and notwithstanding notices from Grantor disputing the existence of an Event of Default such that the payment of Rents by the lessee to Beneficiary pursuant to such a demand shall constitute performance in full of the lessee's obligation under the Lease for the payment of Rents by the lessee to Grantor. After deducting the expenses of conducting the business thereof and of all maintenance, repairs, renewals, replacements, alterations, additions, betterments and improvements and amounts necessary to pay for taxes, assessments, insurance and prior or other proper charges upon the Mortgaged Property or any part thereof, as well as just and reasonable compensation for the services of Trustee and Beneficiary and for all attorneys, counsel, agents, clerks, servants and other employees by them engaged and employed, Trustee or Beneficiary, as the case may be, shall apply the moneys arising as aforesaid, first, to the payment of the principal of the Note and the interest thereon, when and as the same shall become payable and second, to the payment of any other Secured Obligations in such order as Beneficiary may elect; and the balance, if any, shall be turned over to Grantor or such other person as may be lawfully entitled thereto; and/or (c) with or without entry, personally or by their agents or attorneys, insofar as applicable: (i) sell the Mortgaged Property, or any part or parts thereof, and all estate, right, title and interest, claim and demand therein, at public auction at such time and place, and upon such terms and conditions as Beneficiary may deem expedient or as may be required or permitted by applicable law, having first given notice prior to the sale of such time, place and terms by publ-ication in one or more newspapers published or having a general circulation in the county or counties of the state in which the Mortgaged Property is located as may be required or permitted by law and by such other methods, if any, as Trustee or Beneficiary may deem desirable or as may be required or permitted by applicable law. In the event of any sale of all or part of the Mortgaged Property under the terms of this Deed of Trust, Grantor shall pay (in addition to taxable costs) a reasonable fee to Trustee which shall be in lieu of all other fees and commissions permitted by statute or custom to be paid, reasonable attorneys' fees and all expenses incurred in obtaining or continuing abstracts of title for the purpose of any such sale; or (ii) institute proceedings for the complete or partial foreclosure of this Deed of Trust; or (iii) take such other steps to protect and enforce their rights whether by action, suit or proceeding in equity or at law for the specific performance of any covenant, condition or agreement in the Note, this Deed of Trust or any other Loan Document, or in aid of the execution of any power herein granted, or for any foreclosure hereunder, or for the enforcement of any other appropriate legal or equitable remedy or otherwise as Trustee or Beneficiary shall elect. SECTION 5.03 Sale. (a) Trustee or Beneficiary may adjourn from time to time any sale by it to be made under or by virtue of this Deed of Trust by announcement at the time and place appointed for such sale or for such adjourned sale or sales; and, except as otherwise provided by any applicable provision of law, Trustee or Beneficiary, as the case may be, without further notice or publication, may make such sale at the time and place to which the same shall be so adjourned. (b) Upon the completion of any sale or sales made by Trustee or Beneficiary, as the case may be, under or by virtue of this Article V, Trustee, or an officer of any court empowered to do so. shall execute and deliver to the accepted purchaser or purchasers a good and sufficient instrument or instruments conveying, assigning and transferring all estate, right, title and interest in and to the property and rights sold. Trustee is hereby appointed the true and lawful attorney irrevocable of Grantor, in its name and stead, to make all necessary conveyances, assignments, transfers and deliveries of the Mortgaged Property and rights so sold and for that purpose Trustee may execute all necessary instruments of conveyance, assignment and transfer, and may substitute one or more persons with like power, Grantor hereby ratifying and confirming all that its said attorney or such substitute or substitutes shall lawfully do by virtue hereof. Nevertheless, Grantor, if requested by Trustee or Beneficiary, shall ratify and confirm any such sale or sales by executing and delivering to Trustee or to such purchaser or purchasers all such instruments as may be advisable, in the judgment of Trustee or Beneficiary, for the purpose, and as may be designated in such request. Any such sale or sales made under or by virtue of this Article V, whether made under the power of sale herein granted or under or by virtue of judicial proceedings or of a judgment or decree of foreclosure and sale, shall operate to divest all the estate, right, title, interest, claim and demand whatsoever, whether at law or in equity, of Grantor in and to the properties and rights so sold, and shall be a perpetual bar both at law and in equity against Grantor and against any and all persons claiming or who may claim the same, or any part thereof from, through or under Grantor. (c) In the event of any sale or sales made under or by virtue of this Article V (whether made under the power of sale herein granted or under or by virtue of judicial proceedings or of a judgment or decree of foreclosure and sale), the entire principal of, and interest on, the Note, if not previously due and payable, any applicable prepayment premium and all other Secured Obligations, immediately thereupon shall, anything in the Note or in this Deed of Trust to the contrary notwithstanding, become due and payable. If an Event of Default shall have occurred, and following the acceleration of maturity as herein provided, a tender of payment by Grantor or an Affiliate of Grantor of the amount then necessary to satisfy all Secured Obligations is made at any time prior to any sale under or by virtue of this Article V, whether under the power of sale herein granted or under or by virtue of judicial proceedings or of a judgment or decree of foreclosure and sale, such tender shall constitute an evasion of the prepayment provisions of the Note, and shall be deemed to be a voluntary prepayment of the principal indebtedness evidenced by the Note and, to the extent permitted by applicable law, such payment shall include any prepayment premium or yield maintenance payment required by the Note. (d) The purchase money proceeds or avails of any sale or sales made under or by virtue of this Article V, together with any other sums which then may be held by Trustee or Beneficiary under this Deed of Trust, whether under the provisions of this Article V or otherwise, shall be applied as follows: First: To the payment of the costs and expenses of such sale, including reasonable compensation to Trustee and Beneficiary, their agents and counsel, and of any judicial proceedings wherein the same may be made, and of all expenses, liabilities and advances made or incurred by Trustee or Beneficiary under this Deed of Trust, together with interest at the Default Rate on all advances made by Trustee or Beneficiary, and of all taxes, assessments or other charges, except any taxes, assessments or other charges subject to which the Mortgaged Property shall have been sold. Second: To the payment of the whole amount then due, owing or unpaid upon the Note for principal and interest, with interest on the unpaid principal at the Default Rate from and after the happening of any Event of Default described in clause (a) of Section 5.01 hereof from the due date of any such payment of principal until the same is paid, and together with any applicable prepayment premium. Third: To the payment of any other Secured Obligations, including all expenses, liabilities and advances made or incurred by Beneficiary under this Deed of Trust or in connection with the enforcement thereof, together with interest at the Default Rate on all such advances and other Secured Obligations. Fourth: To the payment of the surplus, if any, to whomsoever may be lawfully entitled to receive the same. (e) Upon any sale or sales made under or by virtue of this Article V, whether made under the power of sale herein granted or under or by virtue of judicial proceedings or of a judgment or decree of foreclosure and sale, Beneficiary may bid for and acquire the Mortgaged Property or any part thereof and in lieu of paying cash therefor may make settlement for the purchase price by crediting upon the amount of the bid the entire amount payable to Trustee and/or Beneficiary out of the net proceeds of such sale and all expenses of the sale, the cost of the action and any other sums which Trustee or Beneficiary are authorized to deduct under this Deed-of Trust. SECTION 5.04 Recovery of Judgment. (a) In case an Event of Default described in Section 5.01 hereof shall have happened and be continuing, then, upon written demand of Beneficiary, Grantor will pay to Beneficiary the whole amount which then shall have become due and payable on the Note, for principal and interest, any applicable prepayment premium, all of the other Secured Obligations, and after the happening of any Event of Default described in clause (a) of Section 5.01 hereof will also pay to Beneficiary interest at the Default Rate on the then unpaid principal of the Note and all of the other Secured Obligations, and in addition thereto, upon the happening of any Event of Default described in Section 5.01 hereof, Grantor will pay to Beneficiary such further amount as shall be sufficient to cover the costs and expenses of collection, including reasonable compensation to Trustee and Beneficiary, their agents and counsel and any expenses incurred by Trustee or Beneficiary hereunder. In the event Grantor shall fail forthwith to pay such amounts upon such demand, Beneficiary shall be entitled and empowered to institute such action or proceedings at law or in equity as may be advised by its counsel for the collection of the sums so due and unpaid, and may prosecute any such action or proceedings to judgment or final decree, and may, subject to the provisions of Section 7.16 hereof, enforce any such judgment or final decree against Grantor and collect, out of the property of Grantor wherever situated, as well as out of the Mortgaged Property, in any manner provided by law, moneys adjudged or decreed to be payable. (b) Beneficiary shall be entitled to recover judgment as aforesaid either before, after or during the pendency of any proceedings for the enforcement of the provisions of this Deed of Trust; and the right of Beneficiary to recover such judgment shall not be affected by any entry or sale hereunder, or by the exercise of any other right, power or remedy for the enforcement of the provisions of this Deed of Trust, or the foreclosure of the lien hereof; and in the event of a sale of the Mortgaged Property, and of the application of the proceeds of sale, as in this Deed of Trust provided, to the payment of the debt hereby secured, Beneficiary shall be entitled to enforce payment of, and to receive all amounts then remaining due and unpaid upon, the Note, and to enforce payment of all other charges, payments and costs due under this Deed of Trust, and shall be entitled to recover judgment for any portion of the debt remaining unpaid, with interest at the Default Rate. In case of proceedings against Grantor in insolvency or bankruptcy or any proceedings for its reorganization or involving the liquidation of its assets, then Beneficiary shall be entitled to prove the whole amount of principal and interest due upon the Note to the full amount thereof, any applicable prepayment premium and all other Secured Obligations, without deducting therefrom any proceeds obtained from the sale of the whole or any part of the Mortgaged Property, provided, however, that in no case shall Beneficiary receive a greater amount than such principal and interest, prepayment premium and other Secured Obligations from the aggregate amount of the proceeds of the sale of the Mortgaged Property and the distribution from the estate of Grantor. (c) No recovery of any judgment by Beneficiary and no levy of an execution under any judgment upon the Mortgaged Property or upon any other property of Grantor shall affect in any manner or to any extent, the lien of this Deed of Trust upon the Mortgaged Property or any part thereof, or any liens, rights, powers or remedies of Trustee or Beneficiary hereunder, but such liens, rights, powers and remedies of Trustee or Beneficiary shall continue unimpaired as before. (d) Any moneys thus collected by Beneficiary under this Section 5.04 shall be applied by Beneficiary in accordance with the provisions of clause (d) of Section 5.03 hereof. SECTION 5.05 Appointment of Receiver. After the happening of any Event of Default and immediately upon the commencement of any action, suit or other legal proceedings by Trustee or Beneficiary to obtain judgment for the principal of, or interest on, the Note and other Secured Obligations, or of any other nature in aid of the enforcement of the Note or of this Deed of Trust, Grantor will (a) waive the issuance and service of process and enter its voluntary appearance in such action, suit or proceeding and (b) if required by Beneficiary, consent to the appointment of a receiver or receivers of all or part of the Mortgaged Property and of any or all of the Rents in respect thereof. After the happening of any Event of Default and during its continuance, or upon the commencement of any proceedings to foreclose this Deed of Trust or to enforce the specific performance hereof or in aid thereof or upon the commencement of any other judicial proceeding to enforce any right of Trustee or Beneficiary, Trustee or Beneficiary shall be entitled, as a matter of right, if they shall so elect, without the giving of notice to any other party and without regard to the adequacy or inadequacy of any security for the indebtedness secured hereby, forthwith either before or after declaring the unpaid principal of the Note to be due and payable, to the appointment of such a receiver or receivers SECTION 5.06 Right to Possession. Notwithstanding the appointment of any receiver, liquidator or trustee of Grantor, or of any of its property, or of the Mortgaged Property or any part thereof, Trustee and Beneficiary shall be entitled to retain possession and control of all property now or hereafter held under this Deed of Trust. SECTION 5.07 Remedies Cumulative. No remedy herein conferred upon or reserved to Trustee or Beneficiary is intended to be exclusive of any other remedy or remedies, and each and every such remedy shall be cumulative, and shall be in addition to every other remedy given hereunder or under any other Loan Document or now or hereafter existing at law or in equity or by statute. No delay or omission of Trustee or Beneficiary to exercise any right or power accruing upon any Event of Default shall impair any such right or power, or shall be construed to be a waiver of any such Event of Default or any acquiescence therein; and every power and remedy given by this Deed of Trust to Trustee or Beneficiary may be exercised from time to time as often as may be deemed by them expedient. Nothing in this Deed of Trust or in the Note shall affect the obligation of Grantor to pay the principal of, interest on and other amounts due under the Note in the manner and at the time and place therein respectively expressed. SECTION 5.08 Certain Waivers by Grantor. Grantor will not at any time insist upon, or plead, or in any manner whatever claim or take any benefit or advantage of any stay or extension or moratorium law, any exemption from execution or sale of the Mortgaged Property or any part thereof, wherever enacted, now or at any time hereafter in force, which may affect the covenants and terms of performance of this Deed of Trust, nor claim, take or insist upon any benefit or advantage of any law now or hereafter in force providing for the valuation or appraisal of the Mortgaged Property, or any part thereof, prior to any sale or sales thereof which may be made pursuant to any provision herein, or pursuant to the decree, judgment or order of any court of competent jurisdiction; nor, after any such sale or sales, claim or exercise any right under any statute heretofore or hereafter enacted to redeem the property so sold or any part thereof and Grantor hereby expressly waives all benefit or advantage of any such law or laws, and covenants not to hinder, delay or impede the execution of any power herein granted or delegated to Trustee or Beneficiary, but to suffer and permit the execution of every power as though no such law or laws had been made or enacted. Grantor, for itself and all who may claim under it, waives, to the extent that it lawfully may, all right to have the Mortgaged Property marshaled upon any foreclosure hereof. SECTION 5.09 Recovery of Possession. During the continuance of any Event of Default and pending the exercise by Trustee or Beneficiary of their right to exclude Grantor from all or any part of the Premises and the Improvements, Grantor agrees to pay the fair and reasonable rental value for the use and occupancy of the Premises and the Improvements or any portion thereof which are in its possession for such period and, upon default of any such payment, will vacate and surrender possession of the Premises and the Improvements to Trustee or Beneficiary, as the case may be, or to a receiver, if any, and in default thereof may be evicted by any summary action or proceeding for the recovery of possession of premises for non-payment of rent, however designated. SECTION 5.10 Prepayment Premium. Whenever the term "prepayment premium" is used in this Article V, such term shall be deemed to include any prepayment penalty or Yield Maintenance Amount that may be required to be paid pursuant to the Note or the provisions of this Deed of Trust. ARTICLE VI CONCERNING TRUSTEE SECTION 6.01 Endorsement and Execution of Documents. Upon the written request of the Beneficiary, the Trustee shall, without liability or notice to the Grantor, execute, consent to, or join in any instrument or agreement in connection with or necessary to effectuate the purposes of the Loan Documents. The Grantor hereby irrevocably designates the Trustee as its attorneys-in-fact to execute, acknowledge, and deliver, on the Grantor's behalf and in the Grantor's name, all instruments or agreements necessary to implement the provisions of this Deed of Trust or necessary to further perfect the lien created by this Deed of Trust on the Mortgaged Property. This power of attorney shall be deemed to be coupled with an interest, shall be irrevocable and shall survive any disability of the Grantor. SECTION 6.02 Substitution of Trustee. The Beneficiary may, by firing a deed of appointment in the office where this instrument is recorded, appoint additional or replacement trustees and may remove the Trustee, from time to time, without notice to the Grantor or the Trustee and without specifying any reason. SECTION 6.03 Multiple Trustees. If at any time there are multiple Trustees, any Trustee, individually, may exercise all powers granted to the Trustees collectively, without the necessity of the joinder of the other Trustee(s). SECTION 6.04 Terms of Trustee's Acceptance. The Trustee accepts the trust created by this Deed of Trust upon the following terms and conditions. (a) The Trustee may exercise any of its powers through appointment of attorneys-in-fact or agents. (b) The Trustee shall not be liable for any matter or cause arising under this Deed of Trust or in connection therewith except by reason of its own willful misconduct. (c) The Trustee may select and employ legal counsel for the Trustee and Beneficiary, at the expense of Grantor. (d) The Trustee shall be under no obligation to take any action upon any Event of Default unless it is furnished security or indemnity, in form satisfactory to the Trustee, against costs, expenses, and liabilities which may be incurred by the Trustee. (e) The Trustee shall have no duty to take any action except upon written demand of the parties to whom is then owed fifty-one percent (51%) or more of the then outstanding principal balance of the Note. (f) The Trustee may resign upon thirty (30) days written notice to the Beneficiary. SECTION 6.05 Trustee's Reimbursement. Grantor shall reimburse the Trustee for all reasonable disbursements and expenses incurred by reason of this Deed of Trust. SECTION 6.06 Save Harmless Clause. Grantor shall indemnify and save harmless Beneficiary and the Trustee from all costs and expenses, including reasonable attorneys' fees, incurred by them or any of them by reason of this Deed of Trust, in connection with their performance hereunder, the enforcement of the obligations of Grantor hereunder, or the assertion of any rights or the seeking or obtaining of any remedies they may have hereunder, including any legal action to which Beneficiary or the Trustee shall become a party. Any money so paid or expended by Beneficiary or the Trustee shall be due and payable upon demand together with interest at the Default Rate from the date incurred and shall be secured by this Deed of Trust. ARTICLE VII SECTION 7.01 Severability. In the event any one or more of the provisions contained in this Deed of Trust or in the Note shall for any reason be held to be invalid, illegal or unenforceable in any respect, such invalidity, illegality or unenforceability shall not affect any other provision of this Deed of Trust, but this Deed of Trust shall be construed as if such invalid, illegal or unenforceable provision had never been contained herein or therein SECTION 7.02 Amendments, Waivers, Etc. No provision of this Deed of Trust may be changed, waived, discharged or terminated orally or by any other means except an instrument in writing signed by the party against whom enforcement of the change, waiver, discharge or termination is sought. Any agreement hereafter made by Grantor and Beneficiary relating to this Deed of Trust shall be superior to the rights of the holder of-any intervening or subordinate lien or encumbrance. SECTION 7.03 Notices. All notices, demands, consents, approvals and other communications (collectively, "Notices") hereunder shall be in writing and shall be sent by hand, or by telecopy (with a duplicate copy sent by ordinary mail, postage prepaid), or by postage prepaid, certified or registered mail, return receipt requested, or by reputable overnight courier service, postage prepaid, addressed to the party to be notified as set forth below: (a) if to Beneficiary, CBA Conduit, Inc. Financial Center, Suite 103 695 East Main Street Stamford, CT 06901 Attention: Mr. Stanley V. Cheslock Reference: CBA 1993-1 with a copy to: State Street Bank and Trust Co., Trustee C/O GE Capital Asset Management Corp., Servicer P. O. Box 420250 2000 West Loop South, Suite 1300 Houston, TX 77027 Attention: Mr. John Church, Sr. Vice President Reference CBA 1993-1 with a copy to: GE Capital Asset Management Corp. 2001 N. Beauregard Street, Suite 1200 Alexandria, VA 22311 Attention: Helen Kanovsky, Esq. Reference: CBA 1993-1 and with a copy to: Brownstein Zeidman and Lore A Professional Corporation 1401 New York Avenue, N.W. Suite 900 Washington, D.C. 20005 Attention: Kenneth G. Lore, Esq. Reference CBA 1993-1 (b) if to Grantor, 1090 Vermont Avenue N.W. Associates Limited Partnership c/o The John Akridge Company 601 Thirteenth Street, N.W. Suite 300 North Washington, D.C. 20005 with a copy to: Dennis Moyer, Esquire Hogan and Hartson 8300 Greensboro Drive McLean, Virginia 22102 and 1090 Vermont Avenue, N.W. Associates Limited Partnership c/o Carlyle Real Estate Limited Partnership - XIV 900 North Michigan Avenue Chicago, Illinois 60611-1575 Attention: Mr. Robert J. Chapman with a copy to: Pircher, Nichols & Meeks 10100 Santa Monica Boulevard Los Angeles, California 90067 Attention: Real Estate Notices (c) if to Trustee, Randy Alan Weiss, Trustee c/o Margolius, Mallios, Davis, Rider & Tomar 1828 L Street, N.W., Suite 500 Washington, D.C. 20036 Notices shall be deemed given when so delivered by hand or when a legible copy is received by telecopier (with receipt being verified by telephone confirmation), or if mailed, five (5) business days after mailing (or one (1) business day for overnight courier service), with failure to accept delivery constituting delivery for this purpose. Any party hereto may change the addresses for Notices set forth above by giving at least ten (10) days' prior Notice of such change in writing to the other party as aforesaid and otherwise in accordance with the foregoing provisions. SECTION 7.04 Covenants Running With the Land; Successors and Assigns. All of the grants, covenants, terms, provisions and conditions herein shall run with the land and shall apply to, bind and inure to the benefit of, the successors and assigns of Grantor and the successors in trust of Trustee and the endorsees, transferees, successors and assigns of Beneficiary. Notwithstanding the foregoing, it is hereby acknowledged that Grantor's obligations hereunder are personal and may not be assigned by Grantor; any attempted assignment of Grantor's obligations hereunder shall be null and void. SECTION 7.05 Maximum Rate of Interest. Notwithstanding any contrary provision of this Deed of Trust, in no event shall the aggregate of the interest payable hereunder or under the Note or any other Loan Document, or penalties or premiums for late payments, prepayment premiums, loan servicing fees, application fees, commitment fees, "points" or any other amounts, fees or charges which would under any applicable Law be deemed "interest" ever exceed the maximum amount of interest which under any applicable Law could be lawfully charged on the principal balance of the Note from time to time outstanding. In this connection, it is expressly stipulated and agreed that it is the intention of the Trustee and Beneficiary and Grantor in the execution and delivery of the Note, this Deed of Trust and any other Loan Document contractually to limit the maximum amounts charged to, contracted for with, or received from Grantor in connection with the Secured Obligations which would be deemed "interest" under any applicable Law to the maximum non-usurious amount of interest which would be permitted under such Law. In furtherance thereof, it is stipulated and agreed that none of the terms of this Deed of Trust, the Note or any other Loan Document shall ever be construed to create a contract to pay for the use, forbearance or detention of money interest at a rate in excess of the maximum non-usurious interest rate permitted to be charged to, contracted for with, or received from Grantor by the Trustee or Beneficiary under any applicable Law; neither Grantor nor any endorser or other parties now or hereafter becoming liable for the payment of the Secured Obligations shall ever be liable for interest in excess of the maximum non-usurious interest that under any applicable Law could be charged, contracted for or received from Grantor by the Trustee or Beneficiary; and the provisions of this Section shall be deemed to govern the maximum rate and amount of interest which may be paid under the Note, this Deed of Trust and any other Loan Document, and shall control over all other provisions of this Deed of Trust, the Note or any other Loan Document which might be in apparent conflict herewith. Specifically and without limiting the generality of the foregoing, it is expressly provided: (a) If and when any installment of the interest calculated under the Note becomes due and the aggregate amount thereof, when added to the aggregate amount of any other amounts which constitute interest on the indebtedness evidenced thereby and which have been heretofore paid on said indebtedness, would be in excess of the maximum non-usurious amount of interest permitted by any applicable Law, in light of all discounts, payments or prepayments theretofore made on said indebtedness and presuming the Secured Obligations will be paid at their stated maturity date, then the aggregate amount of such interest installment shall be automatically reduced to the maximum sum, if any, which could lawfully be paid as interest on the principal balance of the Note on such date under such circumstances. (b) If under any circumstances the aggregate amounts paid on the Note, this Deed of Trust and any other Loan Document prior to and incident to final payment thereof include any amounts which under any applicable Law would be deemed interest and which would exceed the maximum non-usurious amount of interest which, under any applicable Law, could lawfully have been collected on such indebtedness, Grantor, the Trustee and Beneficiary stipulate that such payment and collection will have been and will be deemed to have been the result of mathematical error on the part of both Grantor and the Trustee or Beneficiary, and the person or entity receiving such excess payment shall promptly refund the amount of such excess (to the extent only of the excess of such interest payments above the maximum non-usurious amounts which could lawfully have been collected and retained under any applicable Law) upon discovery of such error by the person or entity receiving such payment or Notice thereof from the person or entity making such payment; and (c) All amounts paid or agreed to be paid in connection with the Secured Obligations which would under any applicable Law be deemed "interest" shall, to the extent permitted by such Law, be amortized, prorated, allocated and spread throughout the full term of the Note. SECTION 7.06 Release and ReconveYance of this Deed of Trust. (a) Upon payment in full of the Secured Obligations, but only in compliance with the prepayment restrictions and other provisions of the Note, and the written request of Grantor, Beneficiary shall cause Trustee to release and reconvey, without warranty, the Mortgaged Property then held by Trustee under this Deed of Trust to Grantor upon payment by Grantor of any reconveyance costs and charges of Trustee as may be permitted by law. Trustee agrees to execute any releases as may be directed by Beneficiary hereunder. The release and reconveyance shall operate as a reassignment of the rents, income, issues and profits assigned to Beneficiary hereunder and in the Assignment of Rents and Leases. (b) During the third, fourth and fifth years following the Funding Date, but only until the First Permitted Prepayment Date, Grantor shall be entitled to a release and reconveyance of the Mortgaged Property then held by Beneficiary under this Deed of Trust (but not a release of the obligation under the Note), on the last day of any month upon no less than thirty (30) Business Days' notice from Grantor, provided that there does not then exist any Event of Default hereunder, upon Grantor's paying to Beneficiary, as substitute security for the Note in lieu only of this Deed of Trust and the Assignment of Rents and Leases but not any other Collateral, an amount equal to the sum of (i) the unpaid principal balance of the Note, plus (ii) interest on the Note through and including the last day of the month in which the First Permitted Prepayment Date occurs, plus (iii) all other Secured Obligations, if any, and the several amounts described in subclauses (i) through (iii) of this paragraph (b) shall be deposited in the Cash Reserve, to be used and applied as provided in the Cash Reserve Agreement or the Transferee Cash Reserve Agreement, as applicable. The amount described in subclause (i) of the immediately preceding sentence shall be paid in the form of cash or U.S. Treasury obligations maturing no later than the First Permitted Prepayment Date; and all other amounts described in the immediately preceding sentence shall be paid in the form of cash. Upon any release and reconveyance pursuant to this paragraph (b), the Note shall not be surrendered or discharged prior to its satisfaction from the proceeds of the amounts paid pursuant to subclause (i) above on the First Permitted Prepayment Date. SECTION 7.07 No Release. Grantor agrees that no other security, now existing or hereafter taken, for the Secured Obligations shall be impaired or affected in any manner by the execution hereof; no security subsequently taken by any holder of the Secured Obligations shall impair or affect in any manner the security given by this Deed of Trust; all security for the payment of the Secured Obligations shall be taken, considered, and held as cumulative; and the taking of additional security shall at no time release or impair any security by endorsement or otherwise previously given. Grantor further agrees that any part of the security herein described may be released without in any way altering, varying, or diminishing the force, effect, or lien of this Deed of Trust, or of any renewal or extension of said lien, and that this Deed of Trust shall continue as a first lien, assignment, and security interest on all the Mortgaged Property not expressly released until all Secured Obligations are fully discharged and paid. SECTION 7.08 Securitization or Other Conveyance of Note. (a) Grantor acknowledges that Beneficiary may desire to securitize the Note or otherwise to sell or convey, by pledge or otherwise, all or a portion of its interest in the Note, the indebtedness evidenced thereby and this Deed of Trust at its option to third parties and that in order to maximize the proceeds of such securitization or other sale or conveyance, it will be necessary for Grantor to provide certain detailed information and to make representations and warranties with respect to the Premises and the Improvements, and the historical servicing and management of the Premises and the Improvements and Grantor's operations and financial condition, which information has not been fully identified on the date hereof. Grantor nevertheless agrees to maintain at all times while this Deed of Trust is in effect and provide upon Beneficiary's request such information as Beneficiary may advise Grantor it has determined is reasonably necessary for Beneficiary to maximize the proceeds of the securitization or other sale or conveyance of the Note, or portions of the Note or interests therein, including but not limited to (a) information required by the Securities and Exchange Commission, state securities agencies or underwriters of the securities; (b) information necessary to make any legal determination or to qualify for favorable treatment under statutes, regulations or case law or for qualification or other favorable treatment under tax, securities, ERISA or applicable state or federal laws; (c) legal opinions of Grantor's counsel and certifications of Grantor's Authorized Representative (including but not limited to so-called "lOb-5" legal opinions and certifications) relating to the Premises and the Improvements, Grantor's compliance with the terms hereof, matters affecting Affiliates of Grantor that have an effect upon the compliance with the terms hereof; (d) audited financial information; and (e) representations and warranties with respect to the Premises, the Improvements and Grantor's operations and financial condition consistent with those made herein. Grantor agrees to consent to, sign or otherwise facilitate the filing of all documents, reports, instruments, statements, notifications and other papers with appropriate regulatory agencies or, if any transaction involves perfection of exemptions from regulatory requirements, to facilitate the claim of any such exemption at Beneficiary's request and to consent to any amendments to this Deed of Trust Beneficiary deems desirable in order to facilitate such securitization, conveyance or financing, so long as such amendment does not materially affect amounts payable and payment terms applicable to Grantor hereunder. Notwithstanding the foregoing, Grantor shall not by the terms of this Section be required to execute as registrant any registration statement for the registration of securities under federal or state law but, upon request, Grantor shall consent to or otherwise cause its accountants, attorneys or other agents to consent to the filing of such expertized portions of any such registration statement as are required under federal or state securities laws, regulations, rules or other directives. Beneficiary agrees to reimburse Grantor for the reasonable out-of-pocket costs of Grantor in connection with the foregoing. Grantor's failure to provide to Beneficiary any information requested by Beneficiary pursuant to this Section shall not constitute a default under this Deed of Trust if and to the extent that Grantor (a) does not in fact have such information, (b) cannot without unreasonable cost or expense (but without regard to any potential liability to Grantor arising from or in connection with any information or materials requested by Beneficiary) procure such information, (c) is not obligated pursuant to any of the provisions of this Deed of Trust other than this Section to maintain or retain such information, and (d) has not previously been advised by Beneficiary to maintain or retain such information for the purposes described in this Section. (b) Grantor recognizes that, in connection with any securitization of the Note, Beneficiary will engage a servicer for the purpose of servicing all of the loans in the securitized pool. Grantor covenants and agrees that it will pay the custodial fees of such servicer in connection with the Cash Reserve and the Loan Reserve and the fees and charges of such servicer in connection with future modifications, if any, of the Loan Documents. SECTION 7.09 No Merger. Unless expressly~ provided otherwise, in the event that ownership of this Deed of Trust and title to the fee and/or leasehold estates in the Premises or the Improvements encumbered hereby shall become vested in the same person or entity, this Deed of Trust shall not merge in said title but shall continue to be and remain a valid and subsisting lien and/or trust deed on said estates in the Premises or the Improvements for the amount secured hereby. SECTION 7.10 [Reserved] SECTION 7.11 Brokerage. Grantor hereby indemnifies and holds harmless the Trustee and Beneficiary against all liability, cost and expense, including without limitation attorneys' charges, disbursements and reasonable fees, incurred in connection with any claims which may be asserted by any broker or finder or similar agent alleging to have dealt with Grantor in any of the transactions contemplated hereby. SECTION 7.12 Effect of Extensions and Amendments. If the payment of the Secured Obligations, or any part thereof, shall be extended or varied, or if any part of the security or guaranties therefor be released, all persons now or at any time hereafter liable therefor, or interested in the Mortgaged Property, shall be held to assent to such extension, variation or release, and their liability, and the lien, and all provisions hereof, shall continue in full force and effect; the right of recourse against all such persons being expressly reserved by the Trustee and Beneficiary, notwithstanding any such extension, variation or release (subject to the express limitations set forth in Section 7.16). Any person, firm or corporation taking a junior deed of trust or other Lien upon the Mortgaged Property or any part thereof or any interest therein (no such junior deed of trust or other Lien in any event being permitted without Beneficiary's consent), shall, without Section to maintain or retain such information, and (d) has not previously been advised by Beneficiary to maintain or retain such information for the purposes described in this Section. (b) Grantor recognizes that, in connection with any securitization of the Note, Beneficiary will engage a servicer for the purpose of servicing all of the loans in the securitized pool. Grantor covenants and agrees that it will pay the custodial fees of such servicer in connection with the Cash Reserve and the Loan Reserve and the fees and charges of such servicer in connection with future modifications, if any, of the Loan Documents. SECTION 7.09 No Merger. Unless expressly provided otherwise, in the event that ownership of this Deed of Trust and title to the fee and/or leasehold estates in the Premises or the Improvements encumbered hereby shall become vested in the same person or entity, this Deed of Trust shall not merge in said title but shall continue to be and remain a valid and subsisting lien and/or trust deed on said estates in the Premises or the Improvements for the amount secured hereby. SECTION 7.10 Grantor's Waivers. Grantor hereby expressly and unconditionally waives, in connection with any foreclosure or similar action or procedure brought by Beneficiary asserting an Event of Default under clause (a) of Section 5.01 of this Deed of Trust, any and every right it may have to (i) injunctive relief, (ii) interpose any counterclaim that is not a compulsory counterclaim therein and (iii) have the same consolidated with any other or separate suit, action or proceeding. Nothing herein contained shall prevent or prohibit Grantor from instituting or maintaining a separate action against Beneficiary with respect to any asserted claim. SECTION 7.11 Brokerage. Grantor hereby indemnifies and holds harmless the Trustee and Beneficiary against all liability, cost and expense, including without limitation attorneys' charges, disbursements and reasonable fees, incurred in connection with any claims which may be asserted by any broker or finder or similar agent alleging to have dealt with Grantor in any of the transactions contemplated hereby. SECTION 7.12 Effect of Extensions and Amendments. If the payment of the Secured Obligations, or any part thereof, shall be extended or varied, or if any part of the security or guaranties therefor be released, all persons now or at any time hereafter liable therefor, or interested in the Mortgaged Property, shall be held to assent to such extension, variation or release, and their liability, and the lien, and all provisions hereof, shall continue in full force and effect; the right of recourse against all such persons being expressly reserved by the Trustee and Beneficiary, notwithstanding any such extension, variation or release (subject to the express limitations set forth in Section 7.16). Any person, firm or corporation taking a junior deed of trust or other Lien upon the Mortgaged Property or any part thereof or any interest therein (no such junior deed of trust or other Lien in any event being permitted without Beneficiary's consent), shall, without waiving any other limitations in this Deed of Trust on such Liens, take the said Lien subject to the rights of the Trustee and Beneficiary to amend, modify, extend or release the Note, this Deed of Trust or any other document or instrument evidencing, securing or guarantying the indebtedness secured hereby, in each case without obtaining the consent of the holder of such junior Lien and without the lien of this Deed of Trust losing its priority over the rights of any such junior Lien. SECTION 7.13 No Joint Venture. Grantor acknowledges that the relationship between the parties is that of mortgagor and mortgagee and that in no event shall the Trustee or Beneficiary be deemed to be a partner or joint venturer with Grantor. Neither Trustee nor Beneficiary shall be deemed to be such a partner or joint venturer by reason of their becoming a mortgagee in possession or exercising any rights pursuant to this Deed of Trust or any other of the Loan Documents. SECTION 7.14 Funds Held in Accounts. (a) Grantor hereby agrees that Trustee and/or Beneficiary shall have no liability for any investment losses or reduction in value which accrue or occur with respect to any amounts held by or on behalf of Trustee or Beneficiary in any accounts hereunder, under the Cash Reserve Agreement, or otherwise, for the benefit or account of Grantor or the Premises (such as, inter alia, insurance proceeds, partial condemnation awards, funds deposited with Beneficiary pursuant to subsection (b) of Section 2.07 hereof, funds deposited in the Loan Reserve pursuant to Section 2.33 hereof and funds deposited in the Cash Reserve pursuant to Sections 2.09, 2.15, 2.32 and 2.34 hereof), so long as such amounts are invested in Permitted Investments maintained for the account or benefit of Grantor (except that interest and/or other income on funds deposited with Beneficiary pursuant to paragraph (b) of Section 2.07 hereof shall not be for the account or benefit of Grantor), and any such losses shall be borne solely by Grantor. In addition, Grantor agrees that all interest and/or other income on all such funds other than funds deposited with Beneficiary pursuant to subsection (b) of Section 2.07 hereof shall for income tax purposes be deemed to belong to Grantor. (b) Nevertheless, Beneficiary shall invest all funds deposited in the Loan Reserve pursuant to Section 2.33 hereof and in the Cash Reserve pursuant to the provisions of this Deed of Trust and as required by the Cash Reserve Agreement or any Transferee Cash Reserve Agreement only in Permitted Investments, and the interest thereon, if and to the extent actually received, less a reasonable administrative fee that may be deducted by Beneficiary to reimburse it for costs of investment and record keeping, shall belong to Grantor and shall be paid to Grantor, except as and to the extent otherwise provided in the Cash Reserve Agreement or any Transferee Cash Reserve Agreement, together with any remaining balance of such funds not expended in accordance with the terms of the Loan Documents, provided no Event of Default hereunder shall have occurred that shall not have been cured, upon payment in full of the Secured Obligations and release and reconveyance of the Mortgaged Property pursuant to Section 7.06 hereof. If an Event of Default shall occur, Beneficiary may, without notice to Grantor, apply any or all of such funds, including interest thereon, to the Secured Obligations or otherwise-as Beneficiary may determine. SECTION 7.15 Governing Law. THIS DEED OF TRUST SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE INTERNAL LAWS OF THE DISTRICT OF COLUMBIA (WITHOUT REGARD TO PRINCIPLES OF CONFLICTS OF LAW) AND ANY APPLICABLE LAWS OF THE UNITED STATES OF AMERICA. Grantor hereby irrevocably submits to the non-exclusive jurisdiction of any state or federal court in such jurisdiction over any suit, action or proceeding arising out of or relating to the Note, this Deed of Trust or any other Loan Document, and Grantor hereby agrees and consents that, in addition to any methods of service of process provided for under applicable law, all service of process in any suit, action or proceeding in any such court may be made by certified or registered mail, return receipt requested, directed to Grantor at its address indicated herein, and service so made shall be complete five (5) days after the same shall have been so mailed. SECTION 7.16 Limitations on Recourse. (a) Notwithstanding anything to the contrary in the Note or in this Deed of Trust or in any other Loan Document, neither Grantor, any present or future constituent partner in or agent of Grantor, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Grantor, shall be personally liable, directly or indirectly, under or in connection with the Note or this Deed of Trust or any other Loan Document, or any instrument or certificate securing or otherwise executed in connection with the Note or this Deed of Trust or any other Loan Document, or any amendments or modifications to any of the foregoing made at any time or times, heretofore or hereafter; the recourse of each of the Trustee and Beneficiary and each of their respective successors and assignees under or in connection with the Note, this Deed of Trust, any other Loan Document and such instruments and certificates, and any such amendments or modifications, shall be limited to Grantor's interest in the Mortgaged Property and such other collateral, if any, as may now or hereafter be given to secure payment of the Secured Obligations only, and Beneficiary and Trustee and each of their respective successors and assignees waives and does hereby waive any such personal liability; provided, however, that the foregoing provisions of this Section shall not (i) constitute a waiver of any obligation evidenced by the Note or contained in this Deed of Trust, (ii) limit the right of the Trustee or Beneficiary to name Grantor as a party defendant in any action or suit for judicial or non-judicial foreclosure and sale or any other action or suit under this Deed of Trust or any other Loan Document so long as no judgment in the nature of a deficiency judgment shall be enforced against Grantor except to the extent of the Mortgaged Property or such other collateral, (iii) affect in any way the validity or enforceability of any guaranty (whether of payment and/or performance), any indemnity provision contained in Sections 2.17, 2.24, 6.06, 7.11 or 7.19 hereof in favor of Trustee or Beneficiary or any indemnity agreement given to Beneficiary in the Environmental Indemnification Agreement or in Section 5.2 of the Assignment of Rents and Leases of even date herewith by and between Grantor and Beneficiary in connection with the loan secured hereby the "Assignment of Rents and Leases"), except that the liability of Carlyle only (but not of Grantor or of The John Akridge Company (in its capacity as a general partner of Grantor)) under any indemnity provision contained in Sections 2.17, 2.24, 6.06, 7.11 or 7.19 hereof in favor of Trustee or Beneficiary or any indemnity agreement given to Beneficiary in Section 5.2 of the Assignment of Rents and Leases (collectively, such indemnity provisions and agreement are hereinafter sometimes referred to as the "Specified Indemnities") shall be limited as provided in Section 7.16(c) hereof, or (iv) constitute a waiver by Beneficiary of any rights to reimbursement for actual, or out-of-pocket, losses, costs or expenses, or any other remedy at law or in equity, against Grantor by reason of (1) gross negligence, willful misconduct, intentional misrepresentations or fraudulent acts or omissions, (2) willful misapplication of any insurance proceeds, condemnation awards or tenant security deposits, or of any rental or other income which was required by this Deed of Trust or other Loan Documents to be paid or applied in a specified manner, arising, in any such case, with respect to the Mortgaged Property, (3) Grantor's entry into, modification of, or termination of, any Lease, without Beneficiary's prior consent, if this Deed of Trust requires such consent to be obtained by Grantor, (4) failure to pay premiums for insurance covering environmental risks, or (5) the material inaccuracy of any information contained in rent rolls delivered to Beneficiary on or prior to the date hereof in connection with Beneficiary's underwriting of the loan secured hereby or delivered to Beneficiary pursuant to Section 2.16 hereof or otherwise and relied upon by Beneficiary in making any determination under Section 2.32 hereof with respect to the Debt Service Coverage Ratio for the loan secured hereby. Notwithstanding anything contained in clause (iii) of this Section 7.16(a), so long as Beneficiary's rights to pursue Grantor are not in any way prejudiced or impaired thereby and any costs that Beneficiary may incur by refraining from pursuing Grantor that are not paid in advance by Grantor are not in Beneficiary's reasonable judgment material, Beneficiary shall seek to obtain reimbursement pursuant to any valid insurance policy covering environmental risks and maintained by Grantor (or for which Grantor pays a portion of the premiums) pursuant to the terms of this Deed of Trust, to the extent such reimbursement shall be available to Beneficiary, before it seeks to obtain satisfaction with respect to any loss or damage it may sustain with respect to environmental matters from the personal assets (other than any assets that may constitute Mortgaged Property) of Grantor or any general partner of Grantor. (b) Notwithstanding anything to the contrary in the Note or in this Deed of Trust or in any other Loan Document (including, without limitation, (i) Sections 7.16(a) and 7.16(c) hereof, (ii) the Environmental Indemnification Agreement and (ii) the Assignment of Rents and Leases), no limited partner of Grantor, no present or future constituent partner in or agent of Carlyle, nor any shareholder, officer, director, employee, trustee, beneficiary or agent of any corporation or trust that is or becomes a constituent partner in Carlyle, nor any present or future shareholder, officer, director, employee or agent of The John Akridge Company shall be personally liable, directly or indirectly, under or in connection with the Note or this Deed of Trust or any other Loan Document (including, without limitation, the Environmental Indemnification Agreement and the Assignment of Rents and Leases), or any instrument or certificate securing or otherwise executed in connection with the Note or this Deed of Trust or any other Loan Document (including, without limitation, the Environmental Indemnification Agreement and the Assignment of Reich holds title to the land underlying 2 Broadway Building (all of these office buildings are in New York, New York); JMB/Piper Jaffray Tower Associates, a general partnership, which is a partner in (i) OB Joint Venture II, a general partnership, which is a partner of 222 South Ninth Street Limited Partnership, a limited partnership, which holds title to the Piper Jaffray Tower office building in Minneapolis, Minnesota, and (ii) OB Joint Venture, a general partnership, which holds title to the land underlying the Piper Jaffray Tower office building; JMB/Piper Jaffray Tower Associates II, a general partnership, which also is a partner in OB Joint Venture, a general partnership, which holds title to the land underlying the Piper Jaffray Tower office building; 900 3rd Avenue Associates, a general partnership, which is a partner of Progress Partners, a general partnership, which holds title to 900 Third Avenue Building located in New York, New York; and Orchard Associates, a general partnership which is a partner of Old Orchard Joint Venture, a general partnership, which holds title to the Old Orchard Shopping Center in Skokie (Chicago), Illinois. Generally, the developer of the property is a partner in the joint ventures, however, the partners in the JMB/NYC Office Building Associates, JMB/Piper Jaffray Tower Associates, JMB/Piper Jaffray Tower Associates II, 900 3rd Avenue Associates and Orchard Associates are affiliates of the General Partners of the Partnership. Reference is made to Notes 3(a), 3(b) and 3(c) for a description of the terms of such joint venture partn- erships. The Partnership is a 40% shareholder in Carlyle Managers, Inc. and a 40% shareholder in Carlyle Investors, Inc. EXHIBIT 21 LIST OF SUBSIDIARIES The Partnership is a partner of the following joint ventures: 1090 Vermont Ave., N.W. Associates Limited Partnership, a limited partnership, which holds title to the 1090 Vermont Avenue Building in Washington, D.C.; Mariners Pointe Associates, a limited partnership, which holds title to the Mariners Pointe Apartments in Stockton, California; Carlyle-XIV Associates, L.P., which is a partner of JMB/NYC Office Building Associates, L.P., a limited partnership, which is a partner in (i) 237 Park Avenue Associates, a general partnership, which holds title to the 237 Park Avenue Building, (ii) 1290 Associates, a general partnership, which holds title to the 1290 Avenue of the Americas Building, (iii) 2 Broadway Associates, a general partnership, which holds title to the 2 Broadway Building and (iv) 2 Broadway Land Company, a general partnership, which holds title to the land underlying 2 Broadway Building (all of these office buildings are in New York, New York); JMB/Piper Jaffray Tower Associates, a general partnership, which is a partner in (i) OB Joint Venture II, a general partnership, which is a partner of 222 South Ninth Street Limited Partnership, a limited partnership, which holds title to the Piper Jaffray Tower office building in Minneapolis, Minnesota, and (ii) OB Joint Venture, a general partnership, which holds title to the land underlying the Piper Jaffray Tower office building; JMB/Piper Jaffray Tower Associates II, a general partnership, which also is a partner in OB Joint Venture, a general partnership, which holds title to the land underlying the Piper Jaffray Tower office building; 900 3rd Avenue Associates, a general partnership, which is a partner of Progress Partners, a general partnership, which holds title to 900 Third Avenue Building located in New York, New York; and Orchard Associates, a general partnership which is a partner of Old Orchard Joint Venture, a general partnership, which holds title to the Old Orchard Shopping Center in Skokie (Chicago), Illinois. Generally, the developer of the property is a partner in the joint ventures, however, the partners in the JMB/NYC Office Building Associates, JMB/Piper Jaffray Tower Associates, JMB/Piper Jaffray Tower Associates II, 900 3rd Avenue Associates and Orchard Associates are affiliates of the General Partners of the Partnership. Reference is made to Notes 3(a), 3(b) and 3(c) for a description of the terms of such joint venture partnerships. The Partnership is a 40% shareholder in Carlyle Managers, Inc. and a 40% shareholder in Carlyle Investors, Inc.

92244_1993.txt

92244_1993

1993

92244

Item 1. Business GENERAL The Southern New England Telephone Company ("Telephone Company") was incorporated in 1882 under the laws of the State of Connecticut and has its principal executive offices at 227 Church Street, New Haven, Connecticut 06510 (telephone number (203) 771-5200). The Telephone Company is a wholly owned subsidiary of Southern New England Telecommunications Corporation ("Corporation"). The Telephone Company, a local exchange carrier ("LEC"), is engaged in the provision of telecommunications services in the State of Connecticut, most of which are subject to rate regulation. These telecommunications services include (i) local and intrastate toll services, (ii) exchange access service, which links customers' premises equipment ("CPE") to the facilities of other carriers, and (iii) other services such as digital transmission of data and transmission of radio and television programs, packet switched data network and private line services. Through its directory publishing operations, the Telephone Company publishes and distributes telephone directories throughout Connecticut and certain adjacent communities. In 1993, approximately 87% of the Telephone Company's revenues were derived from the rate regulated telecommunication services. The remainder were derived principally from directory publishing operations and activities associated with the provision of facilities and non-access services to interexchange carriers. About 71% of the operating revenues from rate regulated services were attributable to intrastate operations, with the remainder attributable to interstate access services. State Regulatory Matters The Telephone Company, in providing telecommunications services in the State of Connecticut, is subject to regulation by the Connecticut Department of Public Utility Control ("DPUC"), which has jurisdiction with respect to intrastate rates and services, and other matters such as the approval of accounting procedures, the issuance of securities and the setting of depreciation rates on telephone plant utilized in intrastate operations. The DPUC has adopted for intrastate ratemaking purposes accounting and cost allocation rules, similar to those adopted by the Federal Communications Commission ("FCC"), for the separation of costs of regulated from non-regulated activities. State Regulation On May 24, 1993, the DPUC issued a final decision on the capital recovery portion of the November 1992 rate request submitted by the Telephone Company ("Rate Request"). The Telephone Company was granted an increase in the composite intrastate depreciation rate from 5.7% to approximately 7.3%. This equated to an increase in Telephone Company revenue requirement of approximately $40 million annually. The new depreciation rates were implemented effective July 1, 1993. On July 7, 1993, the DPUC issued a final decision ("Final Decision-I") in its three-phase review of the current and future telecommunications requirements of Connecticut and a final decision ("Final Decision-II") in the remainder of the Rate Request docket. The Final Decision-I addressed the issues of (i) competition [see Item 1., "Competition"]; (ii) infrastructure modernization; (iii) rate design and pricing principles; and (iv) regulatory and legislative frameworks. With respect to "rate design and pricing principles," the DPUC stated that the pricing of all services must be more in line with the costs of providing these services. Historically, to provide universal service, basic residential services have been subsidized by other tariffed services, primarily message toll and business services. In regard to the regulatory and legislative framework, the DPUC endorsed the concept of incentive-based regulation as a potentially more effective and efficient regulatory system than the present rate of return regulation. The Final Decision-II authorized a rate of return on the Telephone Company's common equity ("ROE") of 11.65% and an increase in intrastate revenue of $37.5 million effective July 7, 1993. The Telephone Company was authorized previously to earn a 12.75% ROE. On August 13, 1993, the DPUC granted the Telephone Company an additional revenue requirement of $1.9 million to the $37.5 million previously awarded based on a review of certain areas requested by the Telephone Company. The total increase in intrastate revenue of $39.4 million is virtually offset by the approximate $40 million increase in capital recovery. In addition, the Final Decision-II addressed areas of infrastructure modernization and incentive regulation. Under infrastructure modernization, the Final Decision-II supported, but did not mandate, implementation of an infrastructure modernization program. On December 3, 1993, the Telephone Company sought approval from the DPUC to allow the Telephone Company to develop and provide electronic information services ("EIS"), including electronic publishing services. Since 1984, dramatic industry changes in technology, regulation and competition have eliminated any need for such a restriction. For the last three years, AT&T and the Regional Bell Operating Companies ("RBOCs") have been permitted to enter the electronic publishing and information services markets. For the same reasons that the U.S. District Court lifted the ban on information services and electronic publishing services for AT&T and the RBOCs, the Company believes that the DPUC should lift the ban on the Telephone Company offering of EIS. A hearing in this matter is expected in the first half of 1994. State legislation, signed into law effective July 1, 1993, authorized the formation of a task force to study Connecticut's telecommunications infrastructure and policies. Draft legislation, based on the recommendations the task force submitted in February 1994, provides a framework to move forward with a new regulatory model for Connecticut. This model would move telecommunications toward a fully competitive marketplace and provide alternative forms of regulation. Overall, the goals of the draft legislation are to: (i) ensure high-quality and affordable universal telecommunications service for Connecticut customers; (ii) promote effective competition and the development of an advanced infrastructure; and (iii) enhance the efficiency of government, educational, and health care facilities through telecommunications. Intrastate Rates The Final Decision-II established rates designed to achieve the increase in intrastate revenue of $39.4 million. The following major provisions were included in the Final Decision-II: (i) reductions in intrastate toll rates including several toll discount plans; (ii) an increase in basic local exchange rates for residential and business customers to be phased in over a two-year period; (iii) a reduction in the pricing ratio gap between business and residential basic local service over a two-year period: (iv) a $7.00 per month Lifeline credit for low-income residential customer; (v) an increase in local calling service areas for most customers with none being reduced: (vi) an increase in the local coin telephone rate from $.10 to $.25; (vii) an increase in the directory assistance charge from $.24 to $.40 and a decrease in the number of "free" directory assistance calls; and (viii) a late payment charge of 1% monthly effective January 1, 1994. This rate award was implemented on July 9, 1993 through a combination of increases for coin telephone calls, directory assistance calls along with an approximate 15% interim surcharge on the remaining products and services with authorized increases including local exchange. On July 22, 1993, the DPUC issued a supplemental decision reducing the interim surcharge implemented on July 9, 1993 to approximately 8%. The Telephone Company issued credits during August of 1993 to customers who were charged at the higher rate. The 8% surcharge was in effect until October 9, 1993, when the remaining new rates became effective, including an average increase in residential basic local exchange rates of $.32 a month and a slight decrease in average monthly business rates. In addition, residential basic local exchange rates will increase $.31 a month and business rates will decrease an average of $.84 a month beginning in July 1994. At December 31, 1993, the Telephone Company's intrastate ROE was below the authorized 11.65%. Federal Regulatory Matters The Telephone Company is subject to the jurisdiction of the FCC with respect to interstate rates, services, video dial tone, access charges and other matters, including the prescription of a uniform system of accounts and the setting of depreciation rates on plant utilized in interstate operations. The FCC also prescribes the principles and procedures (referred to as "separations procedures") used to separate investments, revenues, expenses, taxes and reserves between the interstate and intrastate jurisdictions. In addition, the FCC has adopted accounting and cost allocation rules for the separation of costs of regulated from non-regulated telecommunications services for interstate ratemaking purposes. Federal Regulation On July 1, 1993, the FCC, in connection with its normal triennial review of depreciation, granted the Telephone Company new depreciation rates retroactive to January 1, 1993. The new rates increased depreciation expense by approximately $11 million in 1993. Under current price cap regulation, however, any changes in depreciation rates cannot be reflected in interstate access rates (see "Interstate Rates," below). On January 19, 1994, the Telephone Company filed suit in the U.S. District Court in New Haven claiming that the Cable Communications Policy Act of 1984 ("Cable Act") violates the Telephone Company's First and Fifth Amendment rights. The Cable Act limits the in-territory provision of cable programming by LECs such as the Telephone Company. The Cable Act currently prohibits LECs from owning more than 5% of any company that provides cable programming in their local service area. Since January 1, 1988, the Telephone Company has utilized an FCC approved, company specific Cost Allocation Manual ("CAM"), which apportions costs between regulated and non-regulated activities, and describes transactions between the Telephone Company and its affiliates. In addition, the FCC requires larger LECs, including the Telephone Company, to undergo an annual independent audit to determine whether the LEC is in compliance with its approved CAM. The Telephone Company has received audit reports for 1988 through 1992 indicating it is in compliance with its CAM, and is currently undergoing an audit for the year 1993. Interstate Rates The Telephone Company elected price cap regulation effective July 1, 1991. Under price cap regulation, which replaces traditional rate of return regulation, prices are no longer tied directly to the costs of providing service, but instead are capped by a formula that includes adjustments for inflation, assumed productivity increases, and "exogenous" factors, such as changes in accounting principles, in FCC cost separation rules, and taxes. The treatment as exogenous of various factors affecting a company's costs is subject to FCC interpretation. By electing price cap regulation, the Telephone Company is provided the opportunity to earn a higher interstate rate of return than that allowed under traditional rate of return regulation. However, price cap regulation presents additional risks since it establishes limits by which the Telephone Company is able to increase rates, even if the Telephone Company's interstate rate of return falls below the authorized rate of return. The Telephone Company is allowed to annually elect a productivity offset factor of 3.3% or 4.3%. Since price cap regulation was elected in July 1991, the Telephone Company has selected the 3.3% productivity factor and does not anticipate changing its election for the next tariff period. Choosing the 3.3% factor, the Telephone Company is allowed to earn up to a 12.25% interstate rate of return annually. Earnings between 12.25% and 16.25% would be shared equally with customers, and earnings over 16.25% would be returned to customers. Any amounts returned to customers would be in the form of prospective rate reductions. In addition, the Telephone Company's ability to achieve or exceed its interstate rate of return will depend, in part, on its ability to meet or exceed the assumed productivity increase. As of December 31, 1993, the Telephone Company's interstate rate of return was below the 12.25% threshold. The Telephone Company filed tariffs under price cap regulation on April 2, 1993 which took effect on July 2, 1993, subject to the FCC's further investigation. The Telephone Company will file its 1994 annual interstate access tariff filing on April 1, 1994 to become effective July 1, 1994. The filing will adjust interstate access rates for an experienced rate of inflation, the FCC's productivity target, and exogenous cost changes, if any. In January 1994, the FCC began its scheduled inquiry into the price cap plan for LECs, to determine whether to revise the current plan to improve its performance in meeting the FCC's objectives. Results of this inquiry are expected in late 1994 or early 1995. In an order released on January 9, 1990, which did not directly apply to the Telephone Company, the FCC established a precedent whereby a customer has a right to recover damages if they can establish that a LEC exceeded its authorized rate of return. The FCC, in a March 1993 order responding to a complaint filed by Sprint Communications Company ("Sprint") alleging overearnings in switched traffic sensitive access charges, affirmed the Telephone Company's right to offset overearnings in one access category with underearnings in another category, and held that the Telephone Company had no liability. Sprint has appealed the order to the U.S. Court of Appeals. Regulated Operations The network access lines provided by the Telephone Company to customers' premises can be interconnected with the access lines of other telephone companies in the United States and with telephone systems in most other countries. The following table sets forth, for the Telephone Company, the number of network access lines in service at the end of each year and the number of intrastate toll and intrastate WATS messages handled for each year: 1993 1992 1991 1990 1989 Network Access Lines in Service 1,964 1,937 1,922 1,904 1,875 (in thousands) Intrastate Toll and WATS Messages 524 526 516 521 523 (in millions) The Telephone Company has been making, and expects to continue to make, significant capital expenditures to meet the demand for regulated telecommunications services and to further improve such services (see discussion of I-SNET in "Competition"). The total gross investment in telephone plant increased from approximately $3.4 billion at December 31, 1988 to approximately $4.0 billion at December 31, 1993, after giving effect to retirements, but before deducting accumulated depreciation at either date. Since 1989, cash expended for capital additions was as follows: Dollars in millions 1993 1992 1991 1990 1989 Cash Expended for Capital Additions $231.6 $269.1 $296.3 $370.0 $338.8 In 1993, the Telephone Company funded its cash expenditures for capital additions entirely through cash flows from operations. In 1994, capital additions are expected to be approximately $230 million. The Telephone Company expects to fund substantially all of its 1994 capital additions through cash flows from operations. The Telephone Company currently accounts for the economic effects of regulation in accordance with the provisions of SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." In the event recoverability of operating costs through rates becomes unlikely or uncertain, whether resulting from competitive effects or specific regulatory actions, SFAS No. 71 would no longer apply. The financial impact of an accounting change, should the Telephone Company no longer qualify for the provisions of SFAS No. 71, would be material. Competition The Telephone Company's regulated operations are subject to competition from companies, carriers and competitive access providers which construct and operate their own communications systems and networks for the provision of services to others. At present, regulation continues to provide for a system of subsidies which prevent the Telephone Company's prices from moving toward the cost of providing the service. The Telephone Company's ability to compete depends to some degree on the action of regulators regarding the pricing of local, toll and network access services, and on the Telephone Company's continuing ability to manage its costs effectively. In the Final Decision-I, the DPUC concluded that currently authorized intrastate competition has not adversely affected either service availability or cost, and that a broadened scope of intrastate competitive participation was prudent and warranted. Accordingly, the DPUC found that 10XXX calling and resale competition were in the public interest and should be allowed beginning July 7, 1993 in accordance with recently enacted State legislation. Using 10XXX calling, customers can use any certified carrier for interexchange calling within Connecticut by dialing 1, 0, and XXX (a three-digit carrier code). Terms and conditions associated with the provision of specialized/ancillary services, including monitoring, reporting and compensation, would no longer apply. Since the issuance of Final Decision-I, several interexchange carriers have filed applications with and received approval from the DPUC to offer 10XXX intrastate long-distance service. In addition, a number of resellers have filed for initial certificates of public convenience and necessity. The Telephone Company anticipates additional applications will be filed. The introduction of competition to intrastate long- distance service and the Telephone Company's reduction in intrastate toll rates will further erode the Telephone Company's intrastate toll revenues. Pursuant to Final Decision-I, the Telephone Company filed on October 1, 1993 its proposed implementation plan for equal access based on customer preference for dual primary interexchange carrier capability (ability to choose one carrier for interstate calling and either the same or a different carrier for intrastate long distance calling). The Telephone Company's position regarding cost recovery remains that interexchange carriers should pay for the direct costs of implementing equal access. Regarding competition for local exchange services, in January 1994, MCI announced plans to construct and operate local communication networks in large markets throughout the United States, including parts of Connecticut in which the Telephone Company operates. These networks would allow MCI to bypass the Telephone Company's facilities and provide services directly to customers. Pending DPUC approval, these services are expected to be available in Connecticut within two to three years. Also in January 1994, the Telephone Company announced that it had reached an agreement to lease part of its existing digital fiber optic ring network in the greater Hartford metropolitan area to MFS Communications, Inc. ("MFS"). This agreement allows MFS to provide services to large business customers on an intraexchange basis and eliminates the need for MFS to construct their own facilities. Teleport Communications Group, another competitive access provider, recently announced plans to provide local telephone links for interstate services to businesses and long distance companies in the Hartford area. In an order adopted in September 1992, the FCC required certain LECs, including the Telephone Company, to offer expanded special access interconnection to all interested parties, permitting competitors to terminate their own transmission facilities in LEC central offices. The Telephone Company filed tariffs which were implemented in June 1993, subject to investigation, and was granted some additional pricing flexibility in light of this increased competition. In August 1993, the FCC adopted rules, which largely mirror the requirements adopted in September 1992 for special access interconnection, requiring certain LECs, including the Telephone Company, to offer expanded interstate switched access interconnection. The Telephone Company tariffs which implemented changes associated with switched access interconnection became effective in February 1994. The Telephone Company has received applications from competitive access providers for special access interconnection in selected central offices of the Telephone Company. The Telephone Company anticipates additional applications for both special and switched access interconnection will be filed. A number of LECs, including the Telephone Company, have appealed the FCC's orders to offer special and switched access interconnection. Oral arguments on the appeal of the special access order were heard in February 1994 with a decision expected later in 1994. The appeal of the switched access order has been delayed pending a decision on the special access appeal. The Telephone Company, expecting to see continued movement toward a fully competitive telecommunications marketplace, both on an interexchange and intraexchange basis, has taken several steps to effectively position itself. On January 13, 1994, the Telephone Company announced its intention to invest $4.5 billion over the next 15 years to build a statewide information superhighway ("I-SNET"). I-SNET will be an interactive multimedia network capable of delivering voice, video and a full range of information and interactive services. The Telephone Company expects I-SNET will reach approximately 500,000 residences and businesses thru 1997. In addition, the Telephone Company has reduced its intrastate toll rates beginning in July 1993 [see Item 1., "Intrastate Rates"], is committed to reducing its cost structure, remains focused on providing quality customer service and has introduced several new services as mentioned below. New Services On March 31, 1993, the Telephone Company together with Sprint announced the introduction of 800 CustomLink Service[SM]. This service allows the Telephone Company to offer its business customers an 800 service enabling them to receive calls from anywhere in the United States as well as international locations. In 1993, the Telephone Company launched the next generation of CentraLink products, CentraLink[SM] 3100. CentraLink 3100 is a central-office based product that allows flexibility to add additional phone lines, locations and features to adapt to customers' changing telecommunications requirements. On October 21, 1993, the FCC approved the Telephone Company's application to construct, operate, own, and maintain facilities to conduct a technology and marketing trial for use in providing video dial tone service in West Hartford, Connecticut. With construction of the fiber optic and coaxial facilities completed, the trial began in early 1994. The trial, offered to approximately 500 customers, provides hundreds of choices of videos. On December 15, 1993, the Telephone Company filed a request with the FCC for an expansion of this trial. The proposal seeks to provide this service to an additional 20,000 customers in other areas of Connecticut. On December 22, 1993, the Telephone Company filed with the DPUC its application to conduct a twenty-four month market trial for Digital Enhancer, an Integrated Services Digital Network offering. Digital Enhancer provides customers with integrated voice and data communications capabilities on a single telephone access line. Digital Enhancer will be offered from specially equipped digital central offices and will require customer-provided terminal equipment to access and use the service. This service will enable customers to reduce their telecommunications costs by reducing wiring requirements, increase productivity through increased data transmission speed, and improve quality of service through reduced data error rates. Directory Publishing The Telephone Company's directory publishing operation remains sensitive to the Connecticut economy. The continuing decline in new business formations and the acceleration of business failures within the State will further suppress advertising growth potential in the near term. The Connecticut advertising marketplace continues to undergo major structural changes and is becoming increasingly more fragmented and competitive. Directory publishing faces potential increased competition from non-traditional services such as desktop publishing, electronic shopping services and the expansion of cable television. Furthermore, additional competition may arise from the RBOCs' ability to now offer information services. The Telephone Company's directory publishing operation will continue to strategically widen its business focus and respond to emerging market opportunities to position itself effectively against this potential competition [see discussion of EIS in Item 1., "State Regulation"]. Employee Relations The Telephone Company employed approximately 9,300 persons at February 28, 1994, of whom approximately 70% are represented by The Connecticut Union of Telephone Workers, Inc. ("CUTW"), an unaffiliated union. In December 1993, the Telephone Company announced a business restructuring program designed to reduce costs and will result in approximately 2,500 employees exiting the business over the next two to three year period including those that began in January 1994 [see Note 10]. Item 2. Item 2. Properties The principal properties of the Telephone Company do not lend themselves to a detailed description by character and location. Of the Telephone Company's investment in telephone plant, property and equipment at December 31, 1993, central office equipment represented 40%; connecting lines not on customers' premises, the majority of which are on or under public roads highways or streets and the remainder on or under private property, represented 37%; land and buildings (occupied principally by central offices) represented 10%; telephone instruments and related wiring and equipment, including private branch exchanges, substantially all of which are on the premises of customers, represented 1%; and other, principally vehicles and general office equipment, represented 12%. Substantially all of the central office equipment installations and administrative offices are located in Connecticut in buildings owned by the Telephone Company situated on land which it owns in fee. Many garages, service centers and some administrative offices are located in rented quarters. The Telephone Company has a significant investment in the properties, facilities and equipment necessary to conduct its business wherein the overwhelming majority of this investment relates to telephone operations. Management believes that the Telephone Company's facilities and equipment are suitable and adequate for the business. As discussed previously, the Telephone Company plans to invest $4.5 billion over the next 15 years to build I-SNET. The Telephone Company plans to support this investment primarily through increased productivity from the new technology deployed, ongoing cost containment initiatives and customer demand for the new services offered. The Telephone Company does not plan to request a rate increase for this investment. Item 3. Item 3. Legal Proceedings The Telephone Company is involved in various claims and lawsuits that arise in the normal conduct of their business. In the opinion of management, upon advice of counsel, these claims will not have a material adverse effect on the Telephone Company. Items 4 through 6. Information required under Items 4 through 6 is omitted pursuant to General Instruction J(2). PART II Item 7. Item 7. Management's Discussion and Analysis of Results of Operations Revenues Total revenues, comprised of local service revenues, intrastate (Connecticut) toll revenues, network access (primarily interstate) revenues, and publishing and other revenues, were $1,442.4 million in 1993 as compared with $1,402.6 million in 1992. Local service revenues, derived from the provision of local exchange, public telephone and local private line services, increased $43.7 million, or 8.4%, in 1993. The increase in 1993 was due primarily to new rates for basic local service implemented in accordance with the 1993 general rate award [see Item 1., "Intrastate Rates"]. A portion of the new rates was implemented on July 9, 1993 with the remainder of the new rates implemented in the form of a temporary surcharge which amounted to approximately $9 million. The temporary surcharge was in effect until October 9, 1993, when the remaining new rates became effective. Revenue from directory assistance and coin telephone increased primarily as a result of the July 9th increase in rates. Also contributing to the increase in local service revenues was an increase in access lines in service and an expansion of the local-calling service area in several exchanges during September of 1993, which resulted in a shift of intrastate toll revenue to local service revenue. Access lines in service grew 1.4% to 1,963,972 at December 31, 1993 from 1,936,577 at December 31, 1992. In addition, growth experienced in subscriptions to premium services, such as a 9.4% increase in Totalphone[SM], also contributed to the increase in local service revenues. In 1993, intrastate toll revenues, which includes revenues from toll and WATS services, decreased $20.1 million, or 5.6%. Of the total decrease in 1993, $12.6 million was due primarily to reductions in intrastate toll rates, including several toll discount plans, which were implemented in accordance with the 1993 general rate award [see Item 1., "Intrastate Rates"]. Toll message volumes grew approximately 2%, but were negatively impacted by the expansion of the local-calling service area in several exchanges as discussed with local service revenues. In addition, WATS revenues (which includes "800" services) decreased $7.4 million due primarily to: lower WATS message volumes; customer migration to lower priced services offered by the Telephone Company in response to competition; and the continued impact of competitive providers on this market. Network access charges are assessed on interexchange carriers and end users as a means for the Telephone Company to recover its costs and earn a return on its investment in facilities that provide access to the local exchange network. In 1993, network access revenues increased $14.3 million or 4.4%. The increase in 1993 was due primarily to an increase in interstate minutes of use of approximately 5%. Partially offsetting the impact of the increase in minutes of use was a decrease in tariff rates implemented on July 2, 1993, in accordance with the Telephone Company's 1993 annual FCC filing under price cap regulation [see Item 1., "Interstate Rates"]. Publishing and other revenues (which includes revenues from (i) directory publishing, (ii) marketing, billing and collection, and other non-access services rendered on behalf of interexchange carriers, and (iii) provision for uncollectible accounts receivable) increased $1.9 million, or 1.0%, in 1993. The provision for uncollectible accounts receivable for the Telephone Company's residence, business and directory customers decreased $4.6 million in 1993. This decrease is due primarily to lower directory publishing uncollectible activity. Revenue from billing and collection services increased $3.6 million. Partially offsetting the impact of these items was a decrease in publishing revenues of $7.1 million, or 3.8%. Publishing revenues, a significant portion of which reflect directory contracts entered into during the prior year, have decreased, as anticipated, due primarily to economic conditions in 1992 having deteriorated from 1991. Due primarily to the economic conditions in Connecticut, management expects that revenues from directory publishing for 1994 as compared with 1993 will continue to decline. Costs and Expenses Total costs and expenses, excluding depreciation, amortization and interest, were $1,183.3 million in 1993 as compared with $833.4 million in 1992. Total costs and expenses in 1993 include a $335.0 million before-tax charge relating to business restructuring as discussed in Note 10 to the financial statements. Excluding the effect of this item as well as depreciation, amortization and interest, total costs and expenses would have been $848.3 million in 1993. The restructuring charge recorded in 1993 by the Telephone Company is part of a restructuring plan announced in December 1993. The total restructuring plan includes costs that will be incurred for work force reductions involving approximately 2,500 employees over the next two to three year period including those that began in January 1994. The charge also includes the incremental costs of analyzing and implementing reengineering solutions; designing and developing new processes and tools to continue the Telephone Company's provision of excellent service; and the training of employees to help them keep pace with the changes the Telephone Company is implementing to streamline its business and meet the changing demands of customers. Operating and maintenance expenses of $790.3 million increased $13.3 million, or 1.7%, in 1993. These costs are composed primarily of: (i) wages and salaries; (ii) pension and other employee-benefit costs; and (iii) other general and administrative expenses. In August of 1992, a new three-year labor contract was ratified by members of the CUTW. CUTW members received an initial 2.0% wage increase on September 20, 1992, 3.0% in October 1993 and will receive an additional increase of 5.0% in October 1994. As part of the new bargaining-unit contract, approximately 525 bargaining-unit employees accepted an early retirement incentive offer, Special Pension Option ("SPO"), with most leaving the Telephone Company by March 19, 1993 and the remainder by September 17, 1993 [see Note 2]. The Telephone Company recorded a before-tax pension gain of $6.0 million in 1993 as a result of the SPO. Wage and salary costs of the Telephone Company increased approximately $3 million, or 1% in 1993. The increase in wage and salary costs in 1993 was primarily a result of wage increases for bargaining-unit employees mentioned previously. In addition, management employees received an average 3.5% salary increase effective April 1992. Partially offsetting these wage increases was a decrease in the Telephone Company's average work force of 2.4%. The average work force was reduced primarily through the SPO partially offset by an increase in employees resulting from the reorganization of an affiliate which occurred in the first quarter of 1993. Cost savings are anticipated to be realized beginning in 1994 as the Telephone Company has begun to implement the first phase of the work force reduction portion of the restructuring plan. The Telephone Company participates in the Corporation's pension and other employee benefit plans and is allocated a portion of these costs based on the relative number of Telephone Company employees to total employees participating in these plans. Its portion of the Corporation's pension and benefit costs was approximately 90% in 1993 and 1992. Pension and other employee benefit costs of the Corporation increased $5.0 million, or 3.0%, in 1993, exclusive of costs related to the voluntary separation offers and amortization of the postretirement benefit transition obligation discussed below. Health care benefit costs remained relatively unchanged in 1993 as a result of cost-containment efforts by the Corporation. As discussed in Note 2, the Corporation has reserved the right to require, beginning on July 1, 1996, all employees who retire after a specified date to share premium costs of health care benefits if these costs exceed certain limits. Beginning in 1994, employees began to share a larger portion of health care benefit costs. Management continues to seek additional means to effectively manage its provision for health care benefits for both active and retired employees consistent with its need to offer employees a competitive benefits package. Effective January 1, 1993, the Telephone Company adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 112, "Employers' Accounting for Postemployment Benefits" [see Note 2]. With the adoption of SFAS No. 106, the Telephone Company elected to defer, in accordance with an FCC accounting order and final decision issued by the DPUC on July 7, 1993, recognition of the accumulated postretirement benefit obligation in excess of the fair value of plan assets ("transition obligation") and amortize it over the average remaining service period of 18.4 years. In 1993, amortization of the transition obligation resulting from the adoption of SFAS No. 106 amounted to $18.5 million and is included in operating and maintenance expenses. SFAS No. 112 requires employers to accrue benefits provided to former or inactive employees after employment but before retirement. For the Telephone Company, these benefits include workers' compensation and disability benefits. The cumulative effect of this accounting change reduced 1993 net income reported in the statement of income by $6.5 million. Partially offsetting these increases was a decrease in agency commissions of $7.0 million. Agency commissions decreased due primarily to an affiliate no longer providing these services for the Telephone Company since their reorganization in the first quarter of 1993. Depreciation and Amortization In 1993, depreciation and amortization expense increased $36.0 million, or 15.7%. The increase in depreciation and amortization was attributable primarily to revised depreciation rate schedules for both intrastate and interstate plant, as approved by the DPUC and FCC, respectively [see Item 1., State and Federal Regulation]. Depreciation expense related to intrastate plant increased approximately $20 million while interstate plant increased approximately $11 million. An increase in the average depreciable telephone plant, property and equipment also contributed to the increase in depreciation and amortization expense. Interest Expense Interest expense decreased $4.4 million, or 6.1%, in 1993. This decrease is due primarily to lower interest rates charged on short-term debt, interest savings from debt refinancings and a decrease in average debt outstanding of approximately $38 million. The debt refinancings completed in December 1993 [see Note 6] are anticipated to save approximately $8 million in interest expense annually. Income Taxes The combined federal and state effective tax rate in 1993 was a benefit of 58.6%. The unusually high effective tax rate in 1993 reflects the benefit of the operating loss coupled with the amortization of investment tax credits and the turn around of temporary deferred income taxes. A reconciliation of this effective tax rate to the statutory tax rate is disclosed in Note 3. Effective January 1, 1993, the Telephone Company adopted SFAS No. 109, "Accounting for Income Taxes" [see Note 3]. Item 8. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholder of The Southern New England Telephone Company: We have audited the accompanying financial statements and the financial statement schedules of The Southern New England Telephone Company listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Telephone 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 The Southern New England Telephone 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. 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 financial statements, the Corporation has changed its method of accounting for postretirement benefits other than pensions, postemployment benefits and income taxes. Hartford, Connecticut COOPERS & LYBRAND January 24, 1994 THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY STATEMENT OF (LOSS) INCOME AND RETAINED EARNINGS Dollars in millions, For the years ended December 31, 1993 1992 1991 Revenues Local service $ 566.7 $ 523.0 $ 509.1 Intrastate toll 339.8 359.9 356.7 Network access 342.8 328.5 316.6 Publishing and other 193.1 191.2 211.2 Total Revenues 1,442.4 1,402.6 1,393.6 Costs and Expenses Operating 467.9 469.2 460.0 Maintenance 322.4 307.8 315.1 Provision for business 335.0 - - restructuring Depreciation and amortization 265.2 229.2 232.3 Property and other taxes 58.0 56.4 55.8 Provision for employee separation benefits - - 33.9 Total Costs and Expenses 1,448.5 1,062.6 1,097.1 Operating (Loss) Income (6.1) 340.0 296.5 Other (expense) income, net (.8) 1.5 2.4 Interest expense 68.0 72.4 75.2 (Loss) Income Before Income Taxes, Extraordinary Charge and Accounting change (74.9) 269.1 223.7 Income taxes (43.9) 108.6 92.8 (Loss) Income Before Extraordinary Charge and Accounting Change (31.0) 160.5 130.9 Extraordinary charge from early extinguishment of debt, net of related taxes of $38.0, $2.0 and $1.7, respectively 44.0 2.7 2.2 Accounting Change - cumulative effect to January 1, 1993 6.5 - - Net (Loss) Income $ (81.5) $ 157.8 $ 128.7 Retained Earnings, Beginning of Period $ 763.7 $ 713.4 $ 671.7 Net (loss) income (81.5) 157.8 128.7 Less: Dividends declared to parent 110.0 107.5 87.0 Retained Earnings, End of Period $ 572.2 $ 763.7 $ 713.4 The accompanying notes are an integral part of these financial statements. THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY BALANCE SHEET Dollars in millions, at December 31, 1993 1992 ASSETS Cash and temporary cash investments $ 214.5 $ 6.4 Accounts receivable, net of allowance for uncollectibles of $20.4 and $18.7, respectively 226.3 241.5 Accounts receivable from affiliates 24.7 26.4 Prepaid publishing 40.5 43.5 Materials and supplies 8.0 10.4 Deferred income taxes, prepaid taxes and other 80.2 26.2 Total Current Assets 594.2 354.4 Land 16.9 16.4 Buildings 375.9 358.7 Central office equipment 1,594.9 1,579.2 Outside plant facilities and equipment 1,601.8 1,547.4 Furniture and office equipment 354.6 331.0 Station equipment and connections 21.7 19.2 Plant under construction 74.0 70.3 Total telephone plant, at cost 4,039.8 3,922.2 Less: Accumulated depreciation 1,429.2 1,301.3 Net Telephone Plant 2,610.6 2,620.9 Deferred charges and other assets 265.7 148.9 Total Assets $3,470.5 $3,124.2 The accompanying notes are an integral part of these financial statements. THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY BALANCE SHEET (Cont.) Dollars in millions, at December 31, 1993 1992 LIABILITIES AND STOCKHOLDER'S EQUITY Accounts payable and accrued expenses $ 180.3 $ 164.2 Short-term borrowings from parent - 72.6 Obligations maturing within one year 240.0 .3 Restructuring charge - current 103.0 - Accrued compensated absences 33.9 33.5 Accounts payable to affiliates 12.4 24.3 Advance billing and customer deposits 41.0 41.5 Other current liabilities 70.4 66.5 Total Current Liabilities 681.0 402.9 Long-term obligations 746.1 760.5 Deferred income taxes 424.2 566.4 Restructuring charge - long-term 232.0 - Unamortized investment tax credits 50.8 61.3 Other liabilities and deferred credits 233.1 38.3 Total Liabilities 2,367.2 1,829.4 Stockholder's Equity Common stock, $12.50 par value; (30,428,596 shares issued and 30,385,900 outstanding at each period end) 380.4 380.4 Proceeds in excess of par value 152.1 152.1 Retained earnings 572.2 763.7 Less: Treasury stock (42,696 shares at each period end) (1.4) (1.4) Total Stockholder's Equity 1,103.3 1,294.8 Total Liabilities and Stockholder's Equity $3,470.5 $3,124.2 The accompanying notes are an integral part of these financial statements. THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY STATEMENT OF CASH FLOWS Dollars in millions, For the years ended December 31, 1993 1992 1991 CASH FLOWS FROM OPERATING ACTIVITIES Consolidated net (loss) income $ (81.5) $ 157.8 $128.7 Adjustments to reconcile consolidated net (loss) income to cash provided by operating activities: Depreciation and amortization 265.2 229.2 232.3 Provision for business restructuring, before tax 335.0 - - Cumulative effect of accounting change, net of tax 6.5 - - Provision for employee separation benefits - - 33.9 Extraordinary charge from early extinguishment of debt, before tax 82.0 4.7 3.9 Provision for uncollectible accounts 24.9 30.0 24.3 Allowance for funds used during construction (1.7) (3.0) (2.4) Operating cash flows from Increase in accounts receivable (11.1) (20.8) (30.1) Decrease (increase) in materials and supplies 2.4 2.3 (1.4) (Decrease) increase in accounts payable (16.7) 1.8 (23.3) (Decrease) increase in deferred income taxes (160.4) 21.9 5.5 Decrease in investment tax credits (10.5) (7.0) (7.0) Net change in other assets and liabilities (11.6) 19.6 1.7 Other, net 12.9 9.1 1.0 Net Cash Provided by Operating Activities 435.4 445.6 367.1 CASH FLOWS FROM INVESTING ACTIVITIES Cash expended for capital additions (231.6) (269.1) (296.3) Other, Net (4.0) .8 (2.6) Net Cash Used by Investing Activities (235.6) (268.3) (298.9) CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from long-term borrowings 420.1 173.8 79.3 Repayments of long-term borrowings (171.5) (258.5) (30.0) Net proceeds (payments) of short- term borrowings from affiliate (72.6) 31.9 (63.5) Cash dividends (105.2) (120.7) (58.0) Amounts placed in trust for debt refinancing (62.1) - - Other, net (.4) (3.3) (.5) Net Cash Provided (Used) by Financing Activities 8.3 (176.8) (72.7) Increase (Decrease) in Cash and Temporary Cash Investments 208.1 .5 (4.5) Cash and temporary cash investments, beginning of year 6.4 5.9 10.4 Cash and temporary cash investments, end of year $214.5 $ 6.4 $ 5.9 The accompanying notes are an integral part of these financial statements. NOTES TO FINANCIAL STATEMENTS NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Southern New England Telephone Company ("Telephone Company") is a wholly owned subsidiary of the Southern New England Telecommunications Corporation ("Corporation"). The accounting policies of the Telephone Company are in conformity with generally accepted accounting principles and conform with accounting prescribed for telephone operating companies by the Federal Communications Commission ("FCC") and the Connecticut Department of Public Utility Control ("DPUC"). Substantially all of the Telephone Company's operations and customer base are located in the State of Connecticut. REVENUE RECOGNITION: Revenues are recognized when earned regardless of the period in which billed. Revenues for directory advertising are recognized over the life of the related directory, normally one year. ACCOUNTING CHANGES: The Telephone Company implemented Statements of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," SFAS No. 112, "Employers' Accounting for Postemployment Benefits" and SFAS No. 109, "Accounting for Income Taxes" effective January 1, 1993. The cumulative effect of the accounting change as of January 1, 1993 resulted in a one-time, non-cash charge which reduced net income reported in the statement of income by $6.5 million for SFAS No. 112. For SFAS No. 106, the Telephone Company elected to amortize the transition obligation over the average remaining service period, therefore a cumulative effect was not recorded. In addition, a cumulative effect was not recorded for the adoption of SFAS No. 109 in compliance with the methods of adoption for regulated entities. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: Regulatory authorities require the Telephone Company to provide for a return on capital invested in certain new telephone plant while under construction by including an allowance for funds used during construction ("AFUDC"), which includes both an interest and equity return component, as an item of income during the construction period and as an addition to the cost of the plant constructed. Such income is not realized in cash currently but will be realized over the service life of the related plant as the resulting higher depreciation expense is recovered in the form of increased revenues. DEPRECIATION AND AMORTIZATION: The provision for depreciation for interstate telephone plant is based on the FCC approved equal life group ("ELG") straight-line depreciation method using a remaining-life formula on a phased-in basis which began in 1982. Vintages of interstate plant in service prior to the phase in of ELG are being depreciated using a composite vintage group method. For intrastate plant, the DPUC approved ELG for 1993 vintages and subsequent periods. Vintages of intrastate plant in service prior to 1993 are being depreciated using a composite vintage group method. Assets acquired under capital leases are generally amortized over the life of the lease using the straight-line method. TRANSACTIONS WITH AFFILIATES: The Telephone Company provides certain services for the Corporation and affiliates. The Telephone Company records substantially all the revenue from such services as a reduction of the cost incurred to provide such services. Amounts billed to affiliates for such services totaled $35.6 million in 1993, $32.4 million in 1992 and $37.4 million in 1991. In addition, the Telephone Company charges affiliates for network services at tariffed rates. These amounts are included in revenue and totaled $9.2 million in 1993, $7.8 million in 1992 and $7.5 million in 1991. The Telephone Company is charged for management functions performed by the Corporation. The cost of these management functions totaled $24.5 million in 1993, $23.3 million in 1992 and $22.5 million in 1991. INCOME TAXES: The Telephone Company is included in the consolidated federal income tax return and, where applicable, combined state income tax returns filed by the Corporation. Effective January 1, 1993, the Telephone Company changed the method of computing income taxes from the deferred method under Accounting Principles Board ("APB") Opinion No. 11 to the liability method with the adoption of SFAS No. 109. Under the liability method, deferred tax assets and liabilities are determined based on all temporary differences between the financial statement and tax bases of assets and liabilities using the currently enacted rates. Additionally, under SFAS No. 109, the Telephone Company may recognize deferred tax assets if it is more likely than not that the benefit will be realized. Depreciation for income tax purposes is generally based upon accelerated methods and shorter lives causing such depreciation to be greater during the early years of plant life than the depreciation charges for such assets reflected in these financial statements. The accumulated net tax effects of these and other temporary differences are recorded as deferred income taxes in the accompanying consolidated balance sheet. Investment tax credits realized in prior years are being amortized as a reduction to income taxes over the life of the related plant that gave rise to the credits. CASH: The Telephone Company records payments made by draft as accounts payable until the banks honoring the drafts have presented them for payment. MATERIALS AND SUPPLIES: Materials and supplies, which are carried at original cost, are primarily for the construction and maintenance of telephone plant. TELEPHONE PLANT: Telephone plant is stated at original cost less accumulated depreciation and includes certain employee- benefit costs and payroll taxes applicable to self-constructed assets. The amounts shown do not purport to represent replacement cost or current market value. The cost of depreciable telephone plant retired, net of removal costs and salvage, is charged to accumulated depreciation. Replacements, renewals and betterments of telephone plant that materially increase an asset's usefulness or remaining life are capitalized. Minor replacements and all repairs and maintenance are charged to expense. DEFERRED CHARGES: Regulatory authorities require or permit the exclusion of certain costs of the Telephone Company from entering into ratemaking when they are incurred. When such costs will be recovered through future rates, the Telephone Company records these costs as deferred charges. NOTE 2: EMPLOYEE BENEFITS SEPARATION OFFERS: As part of the new bargaining-unit contract negotiated in August 1992, pension benefits for bargaining-unit employees were enhanced. Also, as part of the contract, employees electing to retire or terminate their employment between December 15, 1992 and February 16, 1993 were offered an early retirement incentive offer, Special Pension Option ("SPO"). Most employees electing to retire or terminate left the Telephone Company by March 19, 1993, with the remainder having left by September 17, 1993. Approximately 525 employees accepted the early retirement offer. The Telephone Company recorded a before-tax $6.0 million pension gain in 1993 as a result of the SPO. In May 1991, the Corporation announced the 1991 Voluntary Separation Option Plan ("VSOP") for substantially all bargaining-unit employees. Of the total number of Telephone Company bargaining-unit employees, approximately 7% accepted the VSOP and left the Telephone Company by September 1991. In July 1991, the Corporation announced a separation offer, the Voluntary Management Offer ("VMO"), for substantially all management employees with at least one year of service. Of the total number of Telephone Company management employees, approximately 15% accepted the VMO and left the Corporation by December 31, 1991. As a result of these offers, the Telephone Company recorded a before-tax charge of $33.9 million in 1991 consisting of $17.4 million in severance costs and $16.5 million in pension costs. On an after-tax basis, the charge reduced 1991 net income by $19.3 million. PENSION PLANS: The Telephone Company participates in two non- contributory, defined benefit pension plans of the Corporation: one for management employees and one for bargaining-unit employees. Benefits for management employees are based on an adjusted career average pay plan. Benefits for bargaining-unit employees are based on years of service and pay during 1987 to 1991 as well as a cash balance component. Funding of the plans is achieved through irrevocable contributions made to a trust fund. Plan assets consist primarily of listed stocks, corporate and governmental debt, and real estate. The Corporation's policy is to fund pension cost for these plans in conformity with the Employee Retirement Income Security Act of 1974 using the aggregate cost method. For purposes of determining contributions, the assumed investment earnings rate on plan assets was 8.5% in 1993 and declines to 6.0% by 1998. The Telephone Company's portion of the Corporation's pension (income) cost computed using the projected unit credit actuarial method was approximately $(7.7) million, $(2.9) million and $16.6 million for 1993, 1992 and 1991, respectively. The increase in pension income for 1993 is due primarily to the net effect of a settlement gain and charges for special termination benefits associated with the SPO that resulted in a gain of $6.0 million in 1993. Pension expense decreased in 1992 as compared with 1991 due primarily to the absence of the charge for special benefits relating to a management retirement offer in 1991 and an increase in the discount rate from 1990 to 1991. When it is economically feasible to do so, the Corporation amends periodically the benefit formulas under its pension plans. Accordingly, pension cost has been determined in such a manner as to anticipate that modifications to the pension plans would continue in the future. POSTRETIREMENT HEALTH CARE: The Telephone Company participates in the health care benefit plans for retired employees provided by the Corporation. Substantially all of the Telephone Company's employees may become eligible for these benefits if they retire with a service pension. In addition, an employee's spouse and eligible dependents may become eligible for health care benefits. Effective July 1, 1996, all bargaining-unit employees who retire after December 31, 1989 and all management employees who retire after December 31, 1991 may have to share with the Corporation the premium costs of postretirement health care benefits if these costs exceed certain limits. Prior to January 1, 1993, these benefits were recognized as an expense only when paid (referred to as the "pay-as-you-go" method). In 1991, in accordance with a DPUC decision in a rate proceeding, the Telephone Company began to fund the postretirement health care benefits. These costs have been contributed to Voluntary Employees' Beneficiary Association ("VEBA") trusts. The Corporation's funding policy with regard to health care costs has been to contribute an amount equal to the service and interest cost of active employees, subject to tax deductible limits, in order to contain the growth of the unfunded postretirement health care liability. Based on the DPUC's July 7, 1993 general rate award decision, the Corporation contributed additional amounts to the VEBAs in the fourth quarter of 1993. The additional amounts began to fund the accumulated liability. In 1992 and 1991, the pay-as-you- go expense combined with the VEBA contributions amounted to $32.4 million and $25.2 million, respectively. Effective January 1, 1993, the Telephone Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires that employers accrue, during the years an employee renders service, the expected cost, based on actuarial valuations, of health care and other non-pension benefits provided to retirees and their eligible dependents. With the adoption of SFAS No. 106, the Telephone Company elected to defer, in accordance with an FCC accounting order and final decision issued by the DPUC on July 7, 1993, recognition of the accumulated postretirement benefit obligation in excess of the fair value of plan assets ("transition obligation") and amortize it over the average remaining service period of 18.4 years. The Telephone Company's portion of the postretirement benefit cost for 1993, including the amortization of the transition obligation, was approximately $45 million. POSTEMPLOYMENT BENEFITS: Effective January 1, 1993, the Telephone Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This statement requires employers to accrue benefits provided to former or inactive employees after employment but before retirement. These benefits include workers' compensation, disability benefits and health care continuation coverage for a limited period of time after employment. The standard generally requires that these benefits be accrued as earned when the right to the benefits accumulate or vest. The cumulative effect of this accounting change reduced 1993 net income reported in the statement of income by $6.5 million. Health care continuation costs, which do not vest, continue to be paid from company funds and are expensed when paid. NOTE 3: INCOME TAXES Effective January 1, 1993, the Telephone Company adopted SFAS No. 109, "Accounting for Income Taxes." As required under SFAS No. 109, and in accordance with SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation," the Telephone Company has a regulatory asset of $71.0 million (recorded in Deferred charges and other assets) related to the cumulative amount of income taxes on temporary differences previously flowed through to ratepayers. These amounts relate principally to capitalization of certain general overhead, taxes and payroll-related construction costs for financial statement purposes. In addition, the Telephone Company has a regulatory liability of $98.9 million (recorded in Other liabilities and deferred credits) relating to future tax benefits to be flowed back to ratepayers associated with unamortized investment tax credits and decreases in both federal and state statutory tax rates. Both the regulatory asset and liability are recognized over the regulatory lives of the related taxable bases concurrent with the realization in rates, except for the liability related to intrastate excess state tax rates, which in accordance with the DPUC final decision issued on July 7, 1993, will be returned to ratepayers over three years. This method is a more accelerated turnaround than the normal recognition period. Income tax (benefit) expense includes the following components: Dollars in Millions For the Years Ended December 31, 1993 1992 1991 FEDERAL Current $ 77.2 $ 65.2 $ 63.4 Deferred (103.9) 12.9 1.5 Investment tax credits, net (10.5) (7.0) (7.1) Total Federal (37.2) 71.1 57.8 STATE Current 28.6 29.3 29.7 Deferred (35.3) 8.2 5.3 Total State (6.7) 37.5 35.0 Total Income Taxes $(43.9) $108.6 $ 92.8 Deferred income tax (benefit) expense results primarily from temporary differences involving accelerated tax depreciation and shorter tax lives for income tax purposes offset by the 1993 accrual for the restructuring charge, which was deductible for financial statements purposes but not for tax. In August 1993, the federal corporate income tax rate increased from 34.0% to 35.0%, retroactive to January 1, 1993. In addition, the enacted state corporate income tax rate will be gradually reduced from the current 11.5% to 10.0% by January 1, 1998. The net impact of these changes in the enacted tax rates was not material to total income taxes or to net deferred tax liabilities. The effective federal income tax rates varied from the statutory federal rate for the reasons set forth below: For the Years Ended December 31, 1993 1992 1991 Statutory federal rate (35.0)% 34.0% 34.0% a.State income taxes, net of (5.8) 9.2 10.4 federal income tax effect. b.Temporary differences associated with depreciation on certain general overhead, taxes 8.4 1.6 2.1 and payroll-related construction costs and AFUDC. c.Amounts currently included in taxable income for which deferred taxes were provided in (10.7) (2.1) (2.7) prior years at tax rates greater than the statutory tax rate. d.Amortization of investment tax credits over the life of the plant that gave rise to the credits. Such amortization reduced income tax expense for (14.0) (2.6) (3.1) the years 1991 through 1993 by the amounts shown in Note 11. e.Prior years' tax adjustments. (1.1) .3 .9 f.Other differences, net. (.4) - (.1) Effective Rate (58.6)% 40.4% 41.5% Deferred income tax liabilities (assets) are composed of the following at December 31, 1993 (in millions): Tax Effect of Temporary Differences for: Depreciation $ 488.3 Items previously flowed through to ratepayers 71.0 Deferred gross earnings tax 19.1 Restructuring charge (98.6) Unamortized investment tax credits (37.0) Other (18.6) Net Deferred Income Tax Liabilities - Long-Term $ 424.2 NOTE 4: DEFERRED CHARGES In accordance with the regulatory accounting practices described in Note 1, deferred charges include the following costs: (i) the Telephone Company's 1990 final gross earnings tax ("GET") payment, which is being amortized over ten years through 1999; (ii) accrued but unexpensed compensated absences at December 31, 1987, which are being amortized over ten years through December 31, 1997; (iii) debt refinancing costs occurring prior to 1988, which were being amortized over the life of the related new debt until 1993, when they were written off as part of the extraordinary charge related to the early extinguishment of debt [see Note 6], and (iv) expenses incurred prior to April 1, 1988 in connection with modifying the Telephone Company's network to provide customers with equal access to interexchange carriers of their choice, which were amortized over eight years through December 31, 1993. Amortization of these costs is on a straight-line basis. Amounts related to these costs are as follows: In Millions, at December 31, 1993 1992 GET $46.5 $54.2 Compensated Absences $13.3 $16.6 Debt Refinancings - $33.6 Equal Access - $ 2.9 NOTE 5: SHORT-TERM DEBT The Telephone Company has obtained short-term financing through intercompany borrowings from the Corporation, which obtains, when necessary, short-term funds for its subsidiaries as a group. There were no amounts payable to the Corporation for temporary cash needs as of December 31, 1993. As of December 31, 1992 and 1991, the amounts payable to the Corporation totaled $72.6 million and $40.8 million, respectively. Additional information regarding notes payable outstanding during the year is as follows: Dollars in Millions, For the Years Ended December 31, 1993 1992 1991 Average amount outstanding during the year (based on daily amounts) $ 46.8 $ 94.6 $107.6 Weighted average interest rate during the year (based on daily 3.15% 3.81% 6.02% amounts) Maximum amount outstanding at any month's end during the year $107.0 $129.3 $139.2 Weighted average interest rate at - 3.47% 4.76% year end NOTE 6: LONG-TERM OBLIGATIONS The components of long-term obligations at December 31 are as follows: Dollars in Millions Interest 1993 1992 Rates Debentures 4.38% to 5.75% $ 45.0 $ 90.0 8.63% 200.0 200.0 Total Debentures 245.0 290.0 Unsecured notes 6.13% to 7.25% 625.0 180.0 8.70% to 9.63% 120.0 300.0 Total Unsecured Notes 745.0 480.0 Total Long-Term Debt 990.0 770.0 Unamortized discount and (4.0) (9.7) premium, net Capital lease obligations .1 .5 Current portion of long-term (240.0 (.3) obligations Total Long-Term Obligations $746.1 $760.5 Maturities of long-term debt outstanding at December 31, 1993 by type of obligation are as follows (in millions): Unsecured Maturities Debentures Notes Total 1994 $200.0 $ 40.0 $240.0 1995 - - - 1996 - - - 1997 - - - 1998 - - - 1999-2008 45.0 380.0 425.0 2009-2018 - - - Thereafter - 325.0 325.0 Total $245.0 $745.0 $990.0 On September 15, 1993, the Telephone Company called $45.0 million of 5.750% debentures due November 1, 1996. The debentures were redeemed on November 1, 1993. The unamortized costs associated with this redemption did not result in a significant charge to the 1993 consolidated statement of income. On December 8, 1993, the Telephone Company filed a shelf registration statement with the Securities and Exchange Commission ("SEC") to sell up to $540.0 million in medium-term notes. On December 14, 1993, the Telephone Company announced that it would repurchase any and all of its $120.0 million of 9.625% and $100.0 million of 9.600% medium-term notes. The Telephone Company repurchased $166.5 million of these notes and on December 30, 1993, executed an "in-substance defeasance" for the remainder of the medium-term notes not repurchased. Sufficient U.S. Government securities were deposited in an irrevocable trust to cover the outstanding principal, interest and call premium payable February 15, 1995. Pursuant to this registration statement, the Telephone Company sold, on December 21, 1993, with DPUC approval: (i) $200.0 million of 6.125% notes due December 15, 2003 at 99.160 to yield 6.239%; and (ii) $245.0 million of 7.250% notes due December 15, 2033 at 99.300 to yield 7.304%. The proceeds of the $245.0 million issue were used to repurchase the debt issues discussed previously and purchase securities placed in the irrevocable trust established for the "in-substance defeasance." On January 14, 1994, the proceeds of the $200.0 million issue were used to redeem $200.0 million of 8.625% debentures called irrevocably on December 14, 1993. The call premium, unamortized costs, defeasance premiums and tender costs associated with these redemptions have been classified as an extraordinary charge in the 1993 statement of income. The extraordinary charge totaled $44.0 million, net of applicable tax benefits of $38.0 million. On April 2, 1992, the Telephone Company filed a shelf registration statement with the SEC to sell up to $180.0 million in medium-term notes with maturities of up to 25 years. Pursuant to this registration statement, the Telephone Company sold, on August 5, 1992, with DPUC approval, $110.0 million of 7.125% notes due August 1, 2007 at 99.317 to yield 7.200%, and $70.0 million of 7.000% notes due August 1, 2004 at face value. On September 8, 1992, the proceeds from the sale of these medium-term notes were used to redeem $65.0 million of 7.750% debentures due June 1, 2004 and $110.0 million of 8.125% debentures due May 1, 2008, both of which were called on August 6, 1992. The call premium, unamortized debt issuance costs, and unamortized premium associated with the redeemed debentures have been classified as an extraordinary charge in the 1992 income statement. This charge totaled $2.7 million, net of applicable tax benefits of $2.0 million. Pursuant to a shelf registration filed in December 1989 with the SEC to register $300.0 million of debt securities, the Telephone Company sold, with DPUC approval, $80.0 million, the remainder of the shelf registration, of 8.700% unsecured notes in December 1991, which matures on August 15, 2031. The proceeds of the $80.0 million issue were used to redeem $80.0 million of 9.625% debentures called irrevocably on December 20, 1991. Related to this redemption, the call premium and unamortized costs associated with the called debentures have been classified as extraordinary charges in the 1991 statement of income. The extraordinary charge totaled $2.2 million, net of applicable tax benefits of $1.7 million. NOTE 7: LEASE OBLIGATIONS The Telephone Company has entered into both capital and operating leases for facilities and equipment used in its operations. Rental expense under operating leases was $30.3 million, $32.9 million and $32.0 for 1993, 1992 and 1991, respectively. Aggregate future minimum rental commitments under noncancelable leases at December 31, 1993 were as follows (in millions): Operating Year Leases 1994 $ 17.5 1995 17.4 1996 16.2 1997 15.3 1998 14.8 Thereafter 61.6 Total Minimum Lease Payments $142.8 Future minimum lease payments under capital leases as of December 31, 1993 were $.1 million through 1998 and $.3 million thereafter, included in the total $.4 million minimum lease payments is $.3 million, which represents future interest. Included in future minimum rental commitments for operating leases are amounts attributable to leases with affiliates totaling $55.3 million. NOTE 8: DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," requires companies to disclose the fair value of all their financial instruments, including both assets and liabilities. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND TEMPORARY CASH INVESTMENTS: The carrying amount approximates fair value because of the short maturity of those instruments. SHORT-TERM BORROWINGS FROM PARENT: The carrying amount approximates fair value because of the short maturity of those instruments. OBLIGATIONS MATURING WITHIN ONE YEAR: The carrying amount approximates fair value because of the short maturity of those instruments. The fair value of long-term debt called in 1993 and redeemed in 1994 is estimated based on the call price for those issues. LONG-TERM DEBT: The fair value of the Telephone Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Telephone Company for debt of the same remaining maturities. The estimated fair values of the Telephone Company's financial instruments are as follows: 1993 1992 Dollars in Millions, Carry Fair Carrying Fair At December 31, Amount Value Amount Value Cash and temporary cash $214.5 $214.5 $ 6.4 $ 6.4 investments Short-term borrowings from Parent - - (72.6) (72.6) Obligations maturing within one (240.0) (253.9) (.3) (.3) year Long-term debt (746.1) (760.0) (760.5) (791.6) NOTE 9: STOCKHOLDER'S EQUITY COMMON, PREFERRED AND PREFERENCE SHARES The Telephone Company has authorization for 70,000,000 shares of common stock at a par value of $12.50 per share. The Telephone Company also has authorization for 500,000 shares of preferred stock at a par value of $50.00 per share and 50,000,000 shares of preference stock at a par value of $1.00 per share. No shares of preferred or preference stock have been issued pursuant to these authorizations. TREASURY STOCK In February 1984, AT&T returned 42,000 shares of common stock to the Telephone Company without payment. The 42,000 shares, valued at the market price on the date received, represent the original shares, adjusted for stock splits, that were issued in 1884 for licenses provided to the Telephone Company. In addition, the Telephone Company purchased at market price 696 shares of common stock in June 1986 from stockholders dissenting to a reorganization that took effect on July 1, 1986 whereby the Telephone Company became a wholly owned subsidiary of the Corporation. NOTE 10: RESTRUCTURING CHARGE In December 1993, the Telephone Company announced a business restructuring program designed to reduce costs. The program includes costs that will be incurred for work force reductions involving approximately 2,500 employees over the next two to three year period including those that began in January 1994. The charge also includes the incremental costs of analyzing and implementing reengineering solutions; designing and developing new processes and tools to continue the Corporation's provision of excellent service; and the training of employees to help them keep pace with the changes the Corporation is implementing to streamline its business and meet the changing demands of customers. The estimated costs of this restructuring program is $335.0 million and is shown as a separate line item in the statement of income and resulted in an after-tax charge of $192.7 million to operations. Management anticipates that expenditures, net of tax, for the restructuring charge will approximate $55 million in 1994, $75 million in 1995 and $55 million in 1996. These expenditures are expected to be funded from cash flows from operations. As a result of this work force reduction coupled with the election to amortize the transition obligation for postretirement health care benefits, the Telephone Company recognized a curtailment loss of $86 million. The curtailment loss was recorded on the balance sheet as a regulatory asset and is currently being recovered in rates. NOTE 11: SUPPLEMENTAL FINANCIAL INFORMATION Dollars in Millions, For the Years Ended December 31, 1993 1992 1991 Amortization of investment tax $ 10.5 $ 7.0 $ 6.7 credits Property and other taxes Property $ 45.0 $ 43.2 $ 45.8 Other 13.0 13.2 10.0 Total Property and Other Taxes $ 58.0 $ 56.4 $ 55.8 Advertising expense $ 11.2 $ 9.7 $ 11.0 Interest expense Long-term obligations $ 64.4 $ 66.9 $ 66.3 Short-term obligations 1.5 3.6 6.5 Other 2.1 1.9 2.4 Total Interest Expense $ 68.0 $ 72.4 $ 75.2 Interest paid $ 74.0 $ 68.2 $ 75.5 Income taxes paid $ 98.8 $ 87.0 $ 94.5 Dollars in Millions 1993 1992 Other current liabilities Dividends payable $ 22.0 $ 17.7 Interest accrued 17.8 23.8 Postemployment benefits accrued 11.0 - Taxes accrued 1.6 7.6 Other current liabilities 18.0 17.4 Total Other Current Liabilities $ 70.4 $ 66.5 During 1993, 1992 and 1991, revenues earned from providing services to AT&T accounted for approximately 12.3%, 12.1% and 12.9%, respectively, of operating revenues. No other customer accounted for more than 10% of operating revenues. NOTE 12: QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Dollars in Millions 1stQTR 2ndQTR 3rdQTR 4thQTR Total Revenues $353.4 $360.4 $363.2 $365.4 $1,442.4 Operating (Loss) 80.5 86.5 90.4 (263.5)(1) (6.1) Income (Loss) Income Before Extraordinary Charge and Accounting Change 38.7 44.1 45.2 (159.0) (31.0) Extraordinary Charge - - - (44.0) (44.0) Cumulative Effect of Accounting Change (6.5) - - - (6.5) Net (Loss) Income $ 32.2 $ 44.1 $45.2 $(203.0) (81.5) Revenues $348.1 $352.0 $350.4 $352.1 $1,402.6 Operating Income 86.2 82.7 82.1 89.0 340.0 Income Before Extraordinary Charge 40.2 40.3 37.9 42.1 160.5 Extraordinary Charge - - (2.7) - (2.7) Net (Loss) Income $ 40.2 $ 40.3 $35.2 $42.1 $157.8 (1) Includes a before-tax charge of $335.0 million for restructuring which reduced net income $192.7 million. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure No changes in or disagreements with accountants on any matter of accounting or financial disclosure occurred during the period covered by this report. Items 10 through 13. Information required under Items 10 through 13 is omitted pursuant to General Instruction J(2). PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents filed as part of the report: Page (1) Report of Independent Accountants 16 Financial Statements Covered by Report of Independent Accountants Statement of (Loss) Income and Retained Earnings - for the years ended 17 December 31, 1993, 1992 and 1991 Balance Sheet - as of December 31, 1993 18 and 1992 Statement of Cash Flows - for the years ended December 31, 1993, 1992 and 1991 20 Notes to Financial Statements 21 (2) Financial Statement Schedules Covered by Report of Independent Accountants for the three years ended December 31, 1993: V - Telephone Plant 39 VI - Accumulated Depreciation 43 VIII - Valuation and Qualifying Accounts 43 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 applicable. (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number 3a Amended and Restated Certificate of Incorporation of the registrant as filed June 14, 1990 (Exhibit 3a to 1990 Form 10-K dated 3/25/91, File No. 1- 6654). 3b By-Laws of the registrant as amended and restated through May 11, 1988 (Exhibit 3b to 1988 Form 10-K dated 3/23/89, File No. 1-6654). 4 No instrument which defines the rights of holders of long-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. 10(iii)(A)1 SNET Short Term Incentive Plan as amended March 1, 1993 (Exhibit 10(iii)(A)1 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)2 SNET Long Term Incentive Plan as amended March 1, 1993 (Exhibit 10(iii)(A)2 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)3 SNET Financial Counseling Program as amended January 1987 (Exhibit 10-D to Form SE dated 3/23/87-1, File No. 1-9157). 10(iii)(A)4 Group Life Insurance Plan and Accidental Death and Dismemberment Benefits Plan for Outside Directors of SNET as amended July 1, 1986 (Exhibit 10-E to Form SE dated 3/23/87-1, File No. 1-9157). 10(iii)(A)5 SNET Executive Non-Qualified Pension Plan and Excess Benefit Plan as amended November 1, 1991 (Exhibit 10-A to Form SE dated 3/20/92, File No. 1-9157). Amendments dated December 8, 1993 (Exhibit 10(iii)(A)5 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). (3) Exhibits (continued): Exhibit Number 10(iii)(A)6 SNET Management Pension Plan as amended November 1, 1987 (Exhibit 10-C to Form SE dated 3/21/88-1, File No. 1-9157). Amendments dated September 1, 1988 and January 1, 1989 (Exhibit 10-C to Form SE dated 3/21/89, File No. 1-9157). Amendments dated January 1, 1989 through August 6, 1989 (Exhibit 10-B to Form SE dated 3/20/90, File No. 1-9157). Amendments dated June 5, 1991 through September 25, 1991 (Exhibit 10-B to Form SE dated 3/20/92, File No. 1-9157). Amendments dated January 1, 1993 (Exhibit 10(iii)(A)6 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). Amendments dated September 8, 1993 through December 8, 1993 (Exhibit 10(iii)(A)6 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 10(iii)(A)7 SNET Incentive Award Deferral Plan as amended March 1, 1993. (Exhibit 10(iii)(A)7 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)8 SNET Mid-Career Pension Plan as amended November 1, 1991 (Exhibit 10-D to Form SE dated 3/20/92, File No. 1-9157). Amendments dated December 8, 1993 (Exhibit 10(iii)(A)8 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 10(iii)(A)9 SNET Deferred Compensation Plan for Non-Employee Directors as amended January 1, 1993. (Exhibit 10(iii)(A)9 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)10 Change-in-Control Agreements (Exhibit 10-F to Form SE dated 3/15/91, File No. 1-9157). 10(iii)(A)11 SNET 1986 Stock Option Plan as amended March 1, 1993. (Exhibit 10(iii)(A)11 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)12 SNET Retirement and Disability Plan for Non- Employee Directors as amended April 14, 1993 (Exhibit 10(iii)(A)12 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 10(iii)(A)13 SNET Non-Employee Director Stock Plan effective January 1, 1994 (Exhibit 4.4 to Registration Statement No. 33-51055, File No. 1-9157) 10(iii)(A)14 Description of SNET Executive Retirement Savings Plan (Exhibit 10(iii)(A)14 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 12 Computation of Ratio of Earnings to Fixed Charges. 23 Consent of Independent Accountants. (3) Exhibits (continued): Exhibit Number 24a Powers of Attorney. 24b Board of Directors' Resolution. 99a Annual Report on Form 11-K for the plan year ended December 31, 1993 for the SNET Management Retirement Savings Plan will be filed as an amendment prior to June 30, 1994. 99b Annual Report on Form 11-K for the plan year ended December 31, 1993 for the SNET Bargaining Unit Retirement Savings Plan will be filed as an amendment prior to June 30, 1994. (b) Reports on Form 8-K: On November 3, 1993, the Telephone Company filed a report on Form 8-K, dated November 3, 1993, announcing that effective December 1, 1993, Donald R. Shassian, will assume the position of Senior Vice President and Chief Financial Officer of both the Corporation and the Telephone Company. On December 8, 1993, the Telephone Company filed a report on Form 8-K, dated December 8, 1993, announcing charges against fourth quarter earnings totaling $4.08 per common share. These charges include a restructuring charge for reengineering and work force reductions, a refinancing charge and a charge for discontinued operations. On January 25, 1994, the Telephone Company filed a report on Form 8-K, dated January 24, 1994, announcing the Corporation's 1993 financial results. 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 SOUTHERN NEW ENGLAND TELEPHONE COMPANY By /s/ J. A. Sadek J. A. Sadek, Vice President and Comptroller, 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. PRINCIPAL EXECUTIVE OFFICER: D. J. Miglio* Chairman, President, Chief Executive Officer and Director PRINCIPAL FINANCIAL AND ACCOUNTING OFFICERS: D. R. Shassian* Senior Vice President and Chief Financial Officer J. A. Sadek By: /s/ J. A. Sadek Vice President and Comptroller (J. A. Sadek, as attorney- in-fact and on his own behalf) DIRECTORS: F. G. Adams* William F. Andrews* Richard H. Ayers* Zoe Baird* Barry M. Bloom* March 23, 1994 F. J. Connor* William R. Fenoglio* Claire L. Gaudiani* J. R. Greenfield* N. L. Greenman* Worth Loomis* Burton G. Malkiel* Frank R. O'Keefe, Jr.* * by power of attorney Schedule V - Sheet 1 THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY SCHEDULE V--TELEPHONE PLANT (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Balance at Additions Other Balance Year 1993 beginning at cost Retirements changes at end Classification of period -Note(a) -Note(b) - Note(c) of period Land $ 16.4 $ .5 $ - $ - $ 16.9 Buildings 358.7 26.8 9.2 (.4) 375.9 Central Office Equipment 1,579.2 97.2 81.2 (.3) 1,594.9 Station Apparatus 19.2 3.2 .6 (.1) 21.7 Pole Lines 135.6 5.5 2.4 .2 138.9 Cable 1,083.6 50.8 13.6 .1 1,120.9 Underground Conduit 212.3 9.5 .7 (.9) 220.2 Public Telephone Equipment 16.9 4.3 (1.7) - 22.9 Other Communications Equipment 65.8 7.2 1.9 .1 71.2 Furniture and Office Equipment 265.2 36.6 17.5 (.9) 283.4 Vehicles and Other Work Equipment 99.0 7.6 7.5 (.2) 98.9 Total Telephone Plant in Service Note(d) 3,851.9 249.2 132.9 (2.4) 3,965.8 Under Construction 70.3 1.9 - 1.8 74.0 TOTAL TELEPHONE PLANT $3,922.2 $251.1 $132.9 $ (.6) $4,039.8 The notes on Sheet 4 are an integral part of this Schedule. Schedule V - Sheet 2 THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY SCHEDULE V--TELEPHONE PLANT (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Balance at Additions Other Balance Year 1992 beginning at cost Retirements changes at end Classification of period -Note(a) -Note(b) - Note(c) of period Land $ 15.5 $ .8 $ - $ .1 $ 16.4 Buildings 343.9 20.2 4.8 (.6) 358.7 Central Office Equipment 1,532.0 129.4 84.0 1.8 1,579.2 Station Apparatus 14.7 6.0 1.5 - 19.2 Pole Lines 131.3 5.9 1.6 - 135.6 Cable 1,029.8 69.2 15.3 (.1) 1,083.6 Underground Conduit 197.4 15.1 .2 - 212.3 Public Telephone Equipment 19.3 .5 2.9 - 16.9 Other Communications Equipment 63.6 5.9 3.6 (.1) 65.8 Furniture and Office Equipment 248.9 28.0 10.7 (1.0) 265.2 Vehicles and Other Work Equipment 91.5 13.2 5.5 (.2) 99.0 Total Telephone Plant in Service Note(d) 3,687.9 294.2 130.1 (.1) 3,851.9 Under Construction 82.1 (10.9) - (.9) 70.3 TOTAL TELEPHONE PLANT $3,770.0 $283.3 $130.1 $(1.0) $3,922.2 The notes on Sheet 4 are an integral part of this Schedule. Schedule V - Sheet 3 THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY SCHEDULE V--TELEPHONE PLANT (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Balance at Additions Other Balance Year 1991 beginning at cost Retirements changes at end Classification of period -Note(a) -Note(b) - Note(c) of period Land $ 15.5 $ - $ - $ - $ 15.5 Buildings 322.2 23.0 1.3 - 343.9 Central Office Equipment 1,496.6 126.4 91.0 - 1,532.0 Station Apparatus 16.0 1.3 2.6 - 14.7 Pole Lines 124.6 7.7 1.0 - 131.3 Cable 979.3 65.6 15.1 - 1,029.8 Underground Conduit 188.1 9.5 .2 - 197.4 Public Telephone Equipment 18.4 1.0 .1 - 19.3 Other Communications Equipment 59.5 6.3 2.2 - 63.6 Furniture and Office Equipment 239.1 33.0 23.2 - 248.9 Vehicles and Other Work Equipment 82.0 13.8 4.3 - 91.5 Total Telephone Plant in Service Note(d) 3,541.3 287.6 141.0 - 3,687.9 Under Construction 76.0 6.1 - - 82.1 TOTAL TELEPHONE PLANT $3,617.3 $293.7 $141.0 - $3,770.0 The notes on Sheet 4 are an integral part of this Schedule. Schedule V - Sheet 4 Notes to Schedule V (a) Additions shown include (1) the original cost of reused material, which is concurrently credited to Material and Supplies, and (2) an Allowance for Funds Used During Construction. (b) Items of telephone plant when retired, sold or reclassified are deducted from the property accounts at original cost. (c) Represents current year transfers between classifications, and other minor adjustments. (d) For interstate telephone plant, the FCC has approved the equal life group ("ELG") depreciation method using a remaining-life formula on a phased-in basis beginning in 1982. Vintages of interstate plant in service prior to the phase-in of ELG are being depreciated using a composite vintage group method. In addition, the FCC approved the use of straight-line amortization effective January 1, 1987 to recover an interstate reserve deficiency over a five-year period ended December 31, 1993. For intrastate plant, the DPUC approved ELG for 1993 vintages and subsequent periods. Vintages of intrastate plant in service prior to 1993 are being depreciated using a composite vintage group method. For the years 1993, 1992 and 1991, depreciation expense on telephone plant expressed as a percentage of average depreciable plant was 6.8%, 6.1% and 6.4%, respectively. Assets acquired under capital leases are generally amortized over the life of the lease using the straight- line method. THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY SCHEDULE VI--ACCUMULATED DEPRECIATION (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Balance at Additions Balance beginning charged at end of to Retirements Other of Description period expense - Note (a) Changes period Year 1993 $1,301.3 $263.8 $135.9 $ - $1,429.2 Year 1992 1,204.1 227.7 130.5 - 1,301.3 Year 1991 1,117.6 230.9 144.4 - 1,204.1 (a) Includes net salvage. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Additions Balance at Additions Balance beginning charged Charged to at end of to other accounts Deductions of Description period expense - Note (a) - Note (b) period Allowance for Uncollectible Accounts Receivable: Year 1993 $18.7 $ 25.3 $2.3 $25.9 $ 20.4 Year 1992 15.0 30.6 3.6 30.5 18.7 Year 1991 9.5 30.1 3.4 28.0 15.0 Restructuring Charge: Year 1993 $ - $335.0 $ - $ - $335.0 (a) Includes amounts previously written off that were credited directly to this account when recovered and miscellaneous debits and credits. (b) Includes amounts written off as uncollectible. EXHIBIT INDEX Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number 3a Amended and Restated Certificate of Incorporation of the registrant as filed June 14, 1990 (Exhibit 3a to 1990 Form 10-K dated 3/25/91, File No. 1- 6654). 3b By-Laws of the registrant as amended and restated through May 11, 1988 (Exhibit 3b to 1988 Form 10-K dated 3/23/89, File No. 1-6654). 4 No instrument which defines the rights of holders of long-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. 10(iii)(A)1 SNET Short Term Incentive Plan as amended March 1, 1993 (Exhibit 10(iii)(A)1 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)2 SNET Long Term Incentive Plan as amended March 1, 1993 (Exhibit 10(iii)(A)2 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)3 SNET Financial Counseling Program as amended January 1987 (Exhibit 10-D to Form SE dated 3/23/87-1, File No. 1-9157). 10(iii)(A)4 Group Life Insurance Plan and Accidental Death and Dismemberment Benefits Plan for Outside Directors of SNET as amended July 1, 1986 (Exhibit 10-E to Form SE dated 3/23/87-1, File No. 1-9157). 10(iii)(A)5 SNET Executive Non-Qualified Pension Plan and Excess Benefit Plan as amended November 1, 1991 (Exhibit 10-A to Form SE dated 3/20/92, File No. 1-9157). Amendments dated December 8, 1993 (Exhibit 10(iii)(A)5 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 10(iii)(A)6 SNET Management Pension Plan as amended November 1, 1987 (Exhibit 10-C to Form SE dated 3/21/88-1, File No. 1-9157). Amendments dated September 1, 1988 and January 1, 1989 (Exhibit 10-C to Form SE dated 3/21/89, File No. 1-9157). Amendments dated January 1, 1989 through August 6, 1989 (Exhibit 10-B to Form SE dated 3/20/90, File No. 1-9157). Amendments dated June 5, 1991 through September 25, 1991 (Exhibit 10-B to Form SE dated 3/20/92, File No. 1-9157). Amendments dated January 1, 1993 (Exhibit 10(iii)(A)6 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). Amendments dated September 8, 1993 through December 8, 1993 (Exhibit 10(iii)(A)6 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 10(iii)(A)7 SNET Incentive Award Deferral Plan as amended March 1, 1993. (Exhibit 10(iii)(A)7 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)8 SNET Mid-Career Pension Plan as amended November 1, 1991 (Exhibit 10-D to Form SE dated 3/20/92, File No. 1-9157). Amendments dated December 8, 1993 (Exhibit 10(iii)(A)8 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 10(iii)(A)9 SNET Deferred Compensation Plan for Non-Employee Directors as amended January 1, 1993. (Exhibit 10(iii)(A)9 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)10 Change-in-Control Agreements (Exhibit 10-F to Form SE dated 3/15/91, File No. 1-9157). 10(iii)(A)11 SNET 1986 Stock Option Plan as amended March 1, 1993. (Exhibit 10(iii)(A)11 to 1992 Form 10-K dated 3/23/93, File No. 1-6654). 10(iii)(A)12 SNET Retirement and Disability Plan for Non- Employee Directors as amended April 14, 1993 (Exhibit 10(iii)(A)12 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 10(iii)(A)13 SNET Non-Employee Director Stock Plan effective January 1, 1994 (Exhibit 4.4 to Registration Statement No. 33-51055, File No. 1-9157) 10(iii)(A)14 Description of SNET Executive Retirement Savings Plan (Exhibit 10(iii)(A)14 to 1993 Form 10-K dated 3/23/94, File No. 1-9157). 12 Computation of Ratio of Earnings to Fixed Charges. 23 Consent of Independent Accountants. 24a Powers of Attorney. 24b Board of Directors' Resolution. 99a Annual Report on Form 11-K for the plan year ended December 31, 1993 for the SNET Management Retirement Savings Plan will be filed as an amendment prior to June 30, 1994. 99b Annual Report on Form 11-K for the plan year ended December 31, 1993 for the SNET Bargaining Unit Retirement Savings Plan will be filed as an amendment prior to June 30, 1994.

808369_1993.txt

808369_1993

1993

808369

ITEM 1. BUSINESS General. The registrant, ML/EQ Real Estate Portfolio, L.P. (the "Partnership"), is a limited partnership formed on December 2, 1986 under the Revised Uniform Limited Partnership Act of the State of Delaware. The Partnership's two general partners are EREIM Managers Corp., a Delaware corporation (the "Managing General Partner"), and MLH Real Estate Associates Limited Partnership, a Delaware limited partnership (the "Associate General Partner" and, together with the Managing General Partner the "General Partners"). The Managing General Partner is an indirect, wholly-owned subsidiary of The Equitable Life Assurance Society of the United States ("Equitable") and the general partner of the Associate General Partner is an indirect, wholly-owned subsidiary of Merrill Lynch & Co., Inc. ("Merrill Lynch"). The Partnership offered to the public $150,000,000 of Beneficial Assignee Certificates (the "BACs"), which evidence the economic rights attributable to limited partnership interests in the Partnership (the "Interests"), in an offering which commenced in 1987. The offering was made pursuant to a Prospectus dated April 23, 1987, as supplemented by Supplements dated December 29, 1987 (the "December Supplement"), March 3, 1988 (the "March 3 Supplement") and March 17, 1988 (the "March 17 Supplement"), filed with the Securities and Exchange Commission (the "SEC") in connection with a Registration Statement on Form S-11 (No. 33-11064). The Prospectus as supplemented is hereinafter referred to as the "Prospectus." Capitalized terms used in this annual report and that are not defined herein have the same meaning as in the Prospectus. The offering terminated on March 29, 1988. On March 10, 1988, the Partnership's initial investor closing occurred at which time the Partnership received $92,190,120, representing the proceeds from the sale of 4,609,506 BACs. On May 3, 1988, the Partnership's final investor closing occurred at which time the Partnership received $16,294,380, representing the proceeds from the sale of an additional 814,719 BACs. In total, the Partnership realized gross proceeds of $108,484,500 from the public offering, representing the sale of 5,424,225 BACs. Business of the Partnership. The Partnership was formed to invest in a diversified portfolio of properties and mortgage loans and considers its business to represent one industry segment, investment in real property. The Partnership does not segregate revenues by geographic region and such a presentation is not required as it would not be material to an understanding of the Partnership's business taken as a whole. The Partnership has no employees. As expected, following its investor closings, the Partnership contributed the net proceeds of its offering to EML Associates (the "Venture"), a joint venture with EREIM LP Associates, a New York general partnership between Equitable and EREIM LP Corp., a wholly-owned subsidiary of Equitable. The Venture was formed in March 1988. The capital of the Venture was provided approximately 80% by the Partnership and approximately 20% by EREIM LP Associates. The Venture has completed its acquisition of a diversified portfolio of real properties and mortgage loans secured by real properties. Based on acquisition prices, approximately 52% of the Venture's original contributed capital was invested in existing income-producing real properties acquired without permanent mortgage indebtedness (the "Properties"), approximately 25% in zero coupon or similar mortgage notes (the "Zero Notes"), and the balance was invested in fixed-rate first mortgage loans (the Zero Notes and the fixed rate first mortgage loans are hereinafter referred to as the "Mortgage Loans"). The Properties and the properties securing Mortgage Loans include commercial, industrial, residential and warehouse/distribution properties. At December 31, 1993, the Venture owned nine Properties (one of which consists of two adjacent office buildings) purchased at an aggregate cost of approximately $68.1 million. In addition, the Venture owned interests in two Zero Notes representing principal and accrued interest on the dates of acquisition of approximately $33.1 million, and had two remaining fixed-rate first mortgage loans in the aggregate principal amount of $15.5 million. The Partnership accepted an early $10.5 million pay-off in November 1993 of a third fixed-rate first mortgage loan which had an original principal amount of $14 million and which would have matured in 1998. (Amounts identified, in each case, are exclusive of closing costs.) Reference is made to ITEM 2. ITEM 2. PROPERTIES. Set forth below is a brief description of each of the Venture's investments at December 31, 1993 which includes, where applicable, the percentage of space covered by leases which are scheduled to expire in 1994, 1995, and 1996. Reference is made to Notes 3-5 and 9 of the Notes to Consolidated Financial Statements in ITEM 8. FINANCIAL STATEMENTS, the relevant provisions of which are incorporated herein by reference, for additional descriptive information concerning the investments. PROPERTIES PROPERTIES (CONTINUED) ANNUAL AGGREGATE LEASE PAYMENTS (IN DOLLARS)* * Lease payments to be received under noncancelable operating leases in effect as of December 31, 1993. RANGE OF LEASE EXPIRATIONS MAJOR TENANTS The following lists major tenants for certain properties together with percentage of space used: All of the remaining properties are leased in their entirety to their respective tenants. Information concerning tenants occupying Properties not otherwise listed above follows. Properties 1200 Whipple Road is a one-story warehouse/distribution property located in the Hayward-Fremont market area, approximately 25 miles southeast of San Francisco. At December 31, 1993, the property was 100% leased to Permer Control, Inc. under a lease which runs through August 2003. The property is used as a distribution center for the Emporium Capwell and Weinstocks divisions of Carter Hawley Hale Stores, Inc. ("CHH") and is described in the March 17 Supplement, which is included as an exhibit to this annual report and is incorporated herein by reference. As noted in that description, the Permer Control lease is assignable to CHH or a subsidiary thereof at any time during the lease, in which event Permer Control is released from liability. On February 11, 1991, CHH filed for protection from creditors under Chapter 11 of the Federal bankruptcy law. CHH's plan of reorganization was approved by the bankruptcy court on September 14, 1992 and became effective on October 8, 1992. As part of the plan, Zell/Chillmark purchased approximately 85% of CHH's indebtedness which was subsequently exchanged for approximately 75% of CHH's equity. All payments due under the lease to date have been made. Richland Mall is a one-level enclosed mall shopping center located in Richland Township, Pennsylvania. Tenants include Hess Department Store, Clemens Market, Footlocker, Kinney Shoes and Radio Shack. At December 31, 1993, the mall was approximately 97.4% leased with approximately 4,700 square feet vacant as of December 31, 1993. Excluding the two anchor stores, the Mall was 92.6% leased. Leases covering approximately 3.2%, 0.5%, and 22.5% of the space are scheduled to expire in 1994, 1995, and 1996, respectively. Richland Mall is described in the Partnership's Current Report on Form 8-K dated July 19, 1988 (the "July Report"), which is included as an exhibit to this annual report and is incorporated herein by reference. Over the past three years, the general economic recession has severely hampered the property's leasing efforts. During this period Richland Mall suffered from lease expirations as well as cancellations by virtue of tenant bankruptcies. During 1993 the property began to show signs of recovery. Potential retail tenants began to show interest in leasing space again which enabled Management to improve store occupancy. Management continues to aggressively pursue tenants for the remaining vacant space. Wal-Mart Stores, a national discount retailer, has announced that it is planning to locate a new store within 2-1/2 miles of Richland Mall; however, zoning for the proposed shopping center which was to include Wal-Mart was rejected by Richland Township in June 1992. The Partnership cannot predict the extent to which the Wal-Mart project, if completed, would affect Richland Mall. Should Wal-Mart enter the local market, its size and advertising strength will undoubtedly affect the business of the Hess Department Store and other specialty retail stores within Richland Mall. In addition, the Partnership has been advised that as a result of the downturn in retailing generally, and same store sales, specifically, the Hess Department Store chain suffered reduced earnings requiring it to obtain working capital revolver loans from a consortium of lenders (including Equitable) in the first quarter of 1992. These loans were repaid in late 1993. The loans provided Hess with the time needed to restructure and reorganize its operations, which includes selling or closing of stores in certain locations. Although the Managing General Partner has been advised that the Hess Department Store at the Richland Mall is performing positively, there can be no assurance that such store will not be sold or closed prior to the termination of its lease (which is scheduled to expire in 2006). The current competitive leasing environment and weak retail economy create significant obstacles to maintaining the past level of performance of this Property. 16/18 Sentry Park West are two four-story office buildings that together contain approximately 190,616 rentable square feet. Tenants include Martin Marietta (formerly General Electric), The Prudential Insurance Company and Liberty Mutual Insurance Company. Martin Marietta acquired General Electric's defense related operations in the first quarter 1993. At December 31, 1993, the property was approximately 60% leased. Leases covering approximately 18.7%, 9.2%, and 7.4% of the space are scheduled to expire in 1994, 1995, and 1996, respectively. Martin Marietta decided not to renew 70,836 square feet of space under a lease which expired in December 1993. In addition to the reduction of rental revenue until a new tenant is secured, reletting of this space will likely require the Venture to incur expenditures for tenant improvements and leasing commissions in its releasing efforts. The Venture has been building reserves for such a contingency. The 16/18 Sentry Park West Property is described in the Partnership's Current Report on Form 8-K dated December 2, 1988, which is included as an exhibit to this annual report and is incorporated herein by reference. 701 Maple Lane, 733 Maple Lane and 7550 Plaza Court are three one-story office/warehouse buildings located in the Chicago metropolitan area. At December 31, 1993, all of the buildings were 100% leased. Tenants include Triangle Engineered Products, Co., Nema Industries, Inc. and Precise Data Service. One lease comprising 18% of available space is scheduled to expire in 1994. These properties are described in the Partnership's Current Report on Form 8-K dated December 27, 1988 (the "December Report"), which is included as an exhibit to this annual report and is incorporated herein by reference. 1850 Westfork Drive is a one-story warehouse/distribution facility located approximately 15 miles west of the Atlanta central business district. At December 31, 1993 the Property was 100% leased to Treadway Exports Limited. Prior to this, the property was 100% leased to Saab-Scania of America, Inc. ("Saab"), however, as part of an effort to consolidate its parts distribution facilities, Saab vacated the property in January 1991. In late February, 1992, the Venture and Saab entered into an agreement, pursuant to which Saab agreed to pay to the Venture $1,100,000 in return for release from the remaining term of its lease. The Partnership's share of this amount constituted Sale or Financing Proceeds (as defined in the Partnership Agreement) and was distributed to BAC Holders and Limited Partners together with the semi-annual distribution on August 31, 1992. The lease with Treadway commenced on September 1, 1992 and is for an initial term of three years with two renewal options for total of an additional three years. The 1850 Westfork Drive Property is described in the December Report, which is included as an exhibit to this annual report and is incorporated herein by reference. 1345 Doolittle Drive is a one-story warehouse/distribution property located in San Leandro, California approximately one mile south of Oakland International Airport. At December 31, 1993 the property was 93.1% leased to Gruner & Jahr Printing and Publishing, Stericycle, Inc., National Distribution Agency and Jay-N Company. The Venture continues to actively market the remaining vacant space which consists of 22,500 square feet. The Gruner & Jahr lease covering approximately 44% of the rentable square feet was renewed in 1992 for a five year term commencing in August, 1993. The 1345 Doolittle Drive Property is described in the Partnership's Current Report on Form 8-K dated May 18, 1989, which is included as an exhibit to the annual report and is incorporated herein by reference. 800 Hollywood Avenue is a one-story warehouse/office building located in Itasca, Illinois. The building contains 2,500 rentable square feet of office space and 47,837 rentable square feet of warehouse space. The property is 100% leased to Concentric, Inc. through May 31, 1997 at a rate of $3.90 per square foot through May 31, 1994, to $4.00 per square foot for the remainder of the term. This reflects a renewal of the previous lease which otherwise would have expired in January 1994 at a rate of $4.09 per square foot. The lease requires the tenant to pay 100% of real estate taxes, insurance, and certain maintenance costs. The property is used for the production and distribution of automotive parts and the manufacture, sale and distribution of extruded plastics and cast-iron parts. MORTGAGE LOANS MORTGAGE LOANS (CONTINUED) ____________________ * Effective implicit rate, compounded semiannually. These notes are zero coupon notes and provide that borrowers may elect to pay interest currently. However, as expected, all interest payments have been deferred and it is expected that interest payments will continue to be deferred until maturity, subject to the transaction described below. Mortgage Loans Northland and Brookdale Zero Notes are first mortgage notes secured by the Northland and Brookdale Centers, two regional shopping malls located outside Detroit, Michigan and Minneapolis, Minnesota, respectively. The Venture owns a 71.66% interest in each of the Zero Notes under the terms of participation agreements with Equitable. A portion of the interest acquired by the Venture in each of the Notes was contributed by EREIM LP Associates in exchange for its interest in the Venture, and the balance was purchased by the Venture from Equitable. The borrower under the Zero Notes is Equitable Real Estate Shopping Centers, L.P. ("ERESC"), a public limited partnership not affiliated with Equitable. The parent company of the Managing General Partner, Equitable Real Estate Investment Management, Inc, ("EREIM"), serves as an asset manager. The terms of the Zero Notes permit the borrower to defer payment of principal and interest on the Zero Notes until June 30, 1995, and all such payments have been deferred to date. The Zero Notes may each be redeemed at any time at a redemption price of 100% of its accreted amount at maturity. Since the value of the assets securing the Northland Zero Note did not support its carrying value, the Venture has not accrued additional interest on the Northland Zero Note on its books since June 30, 1993. As of December 31, 1993, the Venture recognized a loss of $7,628,000 and reduced the value of the asset on its books from $35,145,363 to $27,517,363 to reflect its carrying value. For additional information concerning the Northland and Brookdale Notes and the Northland and Brookdale Centers, reference is made to the information under "REAL PROPERTY INVESTMENTS -- The Zero Notes" and "REAL PROPERTY INVESTMENTS --Brookdale and Northland Zero Notes" in the Prospectus, "REAL PROPERTY INVESTMENTS -- The Zero Notes" in the March 17 Supplement, and Note 1 to Notes to Financial Statements to the Partnership's Current Report on Form 10-Q for the Quarter ended June 30, 1988, all of which information is included as an exhibit to this annual report and incorporated herein by reference. ERESC is subject to the informational requirements under the Securities Exchange Act of 1934, as amended, and in accordance therewith files reports and other information, including financial statements, with the Securities Exchange Commission under Commission File No. 1-9331. Such reports and other information filed by ERESC can be inspected and copied at the public reference facilities maintained by the SEC in Washington, D.C. and at certain of its Regional Offices, and copies may be obtained from the Public Reference Section of the SEC, Washington, D.C. 20549, at prescribed rates. Brookdale Center is located approximately five miles northwest of the central business district of Minneapolis. At December 31, 1993, Brookdale Center was 83% leased (excluding its anchor stores all of which are in operation). Although one of the anchors, the Carson Pirie and Scott chain, has recently entered bankruptcy, it continues to operate its store in the Brookdale Center and is, to date, fulfilling its lease obligations. Northland Center is a regional shopping mall located approximately 11 miles northwest of the central business district of Detroit. At December 31, 1993, Northland Center was approximately 71% leased (excluding its anchor stores all of which are in operation). One of the anchor stores, Hudson, has notified ERESC that it intends to discontinue operations at the Northland Center. Discussions are underway with Hudson to continue its tenancy. Managment believes that significant capital improvements to the Northland Center are needed to maintain the value and marketability of the Property. ERESC has declined to incur such expenses. On March 25, 1994 Equitable entered into an agreement with ERESC (the "ERESC Agreement") in connection with the Zero Notes, which agreement reflected a letter of intent between the parties dated January 19, 1994. The ERESC Agreement provides Equitable and the Venture, in proportion to their respective interests in the Zero Notes, would (a) accept a deed-in-lieu of foreclosure of the Northland Center effective as of January 1, 1994, (b) pay the owner $6.6 million, which amount is the present value of the anticipated cash flow of the Northland Center for the period from January 1, 1994 through June 30, 1995, the maturity date of the Zero Notes and (c) upon the sale of the Brookdale Center, to an unaffiliated third party, permit the owner to prepay the Zero Note secured by the Brookdale Center at the then accreted amount of such Note, plus a defeasance fee equal to 75% of the sale price in excess of $45,000,000 up to the amount of the defeasance fee provided in the Brookdale Note. The consummation of the transactions is subject to certain conditions, including the following: (a) Hudson agreeing to continue to operate as an anchor at the Northland Center on terms acceptable to the Venture and Equitable, (b) Montgomery Ward entering into agreements to operate as an additional anchor at the Northland Center on terms acceptable to the Venture and Equitable, (c) the Venture's agreement to participate in the transaction, and (d) receipt of approval of ERESC's limited partners to the proposed transaction. Under the terms of the ERESC Agreement, EREIM was terminated as asset manager of the Northland Center and Brookdale Center and EREIM released its right of first offer to purchase the Brookdale Center. Management is currently considering this transaction to determine if it is in the best interest of the Partnership. In connection with its determination the Managing General Partner retained Arthur Andersen & Co. S.C. to analyze the proposed transaction to determine whether it is fair from a financial point of view to the Partnership and the BAC Holders. Such analysis considered the effect of the proposed transaction both with and without the benefit of the Guaranty Agreement. Based upon certain assumptions contained in its report, Arthur Andersen & Co. S.C. has rendered an opinion that such transaction is fair from a financial point of view to the Partnership and to its BAC Holders. Since the consummation of the transaction is dependent upon numerous conditions, most of which are beyond the control of the Partnership, there can be no assurance that this transaction as presently described will be consummated, nor that such transaction, if consummated, will be consummated on the terms described herein. 201 Merritt Seven Loan is a first mortgage loan made jointly by the Venture and Equitable and is secured by an eight-story office building in Norwalk, Connecticut. On November 22, 1993, the Venture received cash of $10.5 million reflecting the Venture's 50% share of a $21 million pay-off on the note. The Venture had a 50% participation interest in a loan made by Equitable to the Second Merritt Seven Joint Venture (borrower). The borrower had approached Equitable and the Venture to renegotiate the terms of the nonrecourse 10-1/4% interest-only loan which bore a maturity date in 1998. In November 1993, it was agreed that borrower would have a six-month option to purchase the loan at an amount not less than the fair market value of the property securing such mortgage loan, as determined by an independent appraisal, but in no event less than $21 million. Adequate reserves had been established by the Partnership during the first and third quarters of 1993 to reflect the diminution of value of the underlying security for such mortgage loan. In receiving $8.4 million, its 80% share of the $10.5 million payment, the Partnership realized the carrying value of the mortgage loan on its books. The Partnership's share of the amount represents Sale or Financing Proceeds (as defined in the Partnership Agreement). To the extent those proceeds were not used to augment reserves with regard to the proposed Northland transaction, a $0.10 per unit distribution characterized as Sale or Financing Proceeds was paid in February 1994 to BAC Holders of record as of December 31, 1993. Management believes that accepting the pay-off was in the best interest of the Partnership, given the prospects for the property in a difficult leasing environment. The 201 Merritt Seven Loan and the property which secures it are described in the Partnership's Current Report on Form 8-K dated September 27, 1988, which is included as an exhibit to this annual report and incorporated herein by reference. Jericho Village Loan is a first mortgage loan secured by an apartment complex in Weston, Massachusetts. Interest-only payments on the loan in the amount of $51,250 are due monthly in arrears during the term of the loan, with the full principal amount of the loan due upon expiration of the term of the loan. The loan may not be prepaid for three years. After the third year, the borrower may prepay the loan in full subject to a prepayment penalty based on a yield maintenance formula, but not less than 2% of the principal balance of the loan. The property which secures the loan consists of 22 free-standing one and two-story apartment buildings, containing a total of 99 apartment units. At December 31, 1993 the property was approximately 98% leased. The Jericho Village Loan and the property which secures it are described in the December Report, which is included as an exhibit to this annual report and incorporated herein by reference. Bank of Delaware Building Loan is a first mortgage loan secured by a 17-story office building in the Wilmington central business district. Interest-only payments on the loan in the amount of $82,135 are due monthly in arrears during the term of the loan, with the full principal amount of the loan due upon expiration of the term of the loan. The loan may not be prepaid for five years. After the fifth year, the borrower may prepay the loan in full subject to a prepayment penalty based on a yield maintenance formula, but not less that 1/2% of the principal balance of the loan. The property which secures the loan contains approximately 314,000 rentable square feet. At December 31, 1993 such property was approximately 67.7% leased. The borrower approached the Venture in November, 1992 regarding the potential restructure of this loan. The borrower referred to significant lease rollover exposure in late 1993 and the resultant capital expenditures potentially necessary to renew or release this space. The lease with DuPont, a major tenant in the building, leasing approximately 27% of the property, expired in December, 1993. The borrower stated in its third quarter 1993 report to its investors that it has been notified that DuPont will not renew any of its space. The report continued to state: "...the Partnership estimates that the costs associated with re-leasing any space which becomes available during the next few years including those costs to remove the remaining asbestos in tenant space, will be substantial. In this regard, the Partnership is carefully analyzing whether or not it is economically wise to allocate additional capital to this building based upon the likelihood of ultimately recovering any additional amounts required to cover these re-leasing costs, asbestos removal costs and other capital improvements which may be required. If it is determined that recovery of such additional amounts is unlikely, the Partnership may decide not to commit any additional amounts to the property beyond those costs which may be required in the future to remove asbestos in the building, which represent a recourse obligation to the Partnership. This would result in the Partnership no longer having an ownership interest in the property.. " No specific terms of a restructure have been discussed with the borrower, nor is it certain that a restructure will occur. Management continues to monitor this situation, especially considering the statement of the borrower that it may not fund expenditures necessary to maintain the building's occupancy. It is Management's belief that the property remains adequate security for the mortgage. Discussions with the borrower are continuing; however, Management is willing to consider foreclosure on this property if it is in the Venture's best interest to do so. In February 1994, the owner of the Bank of Delaware Building defaulted on the Mortgage Loan. At this time Management does not believe that foreclosure, if required, would result in a material loss. The Bank of Delaware Building Loan and the property which secures it are described in the December Report, which is included as an exhibit to this annual report and incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no pending legal proceedings material to the Partnership to which the Partnership, the Venture, any of the Properties, or to the knowledge of the Managing General Partner, the properties that secure the Mortgage Loans are subject. 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 to a vote of BAC Holders. PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCK HOLDER MATTERS. No public trading market for BACs or Interests exists nor is it expected that one will develop. Accordingly, accurate information as to the market value of a BAC at any given date is not available. Effective November 9, 1992, the Partnership was advised that Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S") introduced a new limited partnership secondary service through the Merrill Lynch Limited Partnership Secondary Transaction Department ("LPSTD"). This service assists MLPF&S clients wishing to buy or sell Partnership BACs or interests. The LPSTD has replaced the Merrill Lynch Investor Service, a service which was designed to match interested buyers and sellers of partnership interests, but which had been suspended since September 1991 for transactions involving the Partnership's BACs or Interests. BACs are transferable as provided in Article Seven of the Partnership's Amended and Restated Agreement of Limited Partnership, as amended (the "Partnership Agreement"), which is incorporated by reference herein. Subject to certain restrictions, the General Partners are authorized to impose restrictions on the transfer of BACs or Interests (or take such other action as they deem necessary or appropriate) so that the Partnership is not treated as a "publicly-traded partnership" as defined in Section 7704(b) of the Internal Revenue Code of 1986 (or any similar provision of succeeding law) which could result in adverse tax consequences. See "AMENDMENTS TO PARTNERSHIP AGREEMENT - -- TRANSFER OF INTERESTS" in the March 3 Supplement. The number of BAC Holders at December 31, 1993 was 12,659. The Partnership is a limited partnership and, accordingly, does not pay dividends. It does, however, make distributions of cash to its BAC Holders and General Partners. BAC Holders will be entitled to receive cash distributions, allocations of taxable income and tax loss and guaranty proceeds as provided in Article Four of the Partnership Agreement, which is included as an exhibit to this annual report and incorporated herein by reference. For additional information regarding the Guaranty Agreement, see ITEM 1. BUSINESS. The Partnership has on February 28, 1993, made cash distributions to BAC Holders in the amount of $0.40 per BAC in respect of the fiscal semi-annual period ended December 31, 1992. The Partnership withheld its semi-annual distribution in August 1993 in anticipation of the capital needs of the Partnership. The Partnership made a cash distribution to BAC Holders on February 28, 1994, in the amount of $0.10 per BAC to Holders of record at December 31, 1993. The Partnership reduced the February 1994 distribution to supplement reserves. This distribution constitutes a distribution of Sale or Financing Proceeds derived from a portion of the proceeds from the pay-off of the Second Merritt Seven mortgage loan. Reference is made to ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS for further information regarding cash distributions, which information is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following sets forth a summary of the selected financial data for the Partnership for the years ended December 31, 1989, 1990, 1991, 1992 and 1993: The above selected financial data for the years 1991 through 1993 should be read in conjunction with the financial statements and the related notes appearing elsewhere in this annual report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Liquidity and Capital Resources At December 31, 1993, the Partnership had cash and short-term investments of approximately $3.0 million. Such cash and short-term investments are expected to be utilized for general working capital requirements including, to the extent that scheduled lease expirations occur, shortfalls associated with such lease expirations on the Properties until such time as such leases can be replaced, and for participation with Equitable in the proposed Northland Center transaction. In addition, to the extent that cash distributions from the Partnership's interest in the Venture are insufficient, the payment or reimbursement of fees and expenses to the General Partners and their affiliates will be paid out of such cash and short term investments. Amounts which the Managing General Partner determines are not needed for general working capital requirements will be available for distribution. The Partnership's policy is to maintain adequate cash reserves (taking into consideration reserves of the Venture) to enable it to meet short and long-term requirements. The Partnership's working capital reserves may be increased or decreased, from time to time, depending on the Managing General Partner's determination as to their adequacy. However, working capital reserves may not be decreased below 1% of gross offering proceeds prior to the time that the Partnership enters its liquidation phase. In addition, the Partnership owns an 80% interest in the Venture. At December 31, 1993, the Venture's portfolio was fully invested and included interests in nine real properties and four first mortgage loans on real properties (including the two Zero Notes) representing an aggregate acquisition cost of approximately $116.7 million (exclusive of closing costs). At December 31, 1993, the Venture also had approximately $18.8 million in cash and short-term investments which is intended to be utilized primarily to create reserves to consummate the proposed Northland Center transaction and thereafter to fund capital improvements at the Northland Center, fund capital improvements at the Venture's other Properties and cover general working capital requirements. Remaining funds are available for distribution to Venture partners. All of the Venture's properties were acquired without mortgage indebtedness, and neither the Venture nor the Partnership has incurred any borrowings. All of the Venture's Properties as well as its Mortgage Loans (other than the Zero Notes) are currently producing cash flow to the Venture which, net of expenses of the Venture and the establishment or increase of reserves, is being distributed 80% to the Partnership and 20% to EREIM LP Associates. The Venture's Brookdale Zero Note does not provide current cash flow to the Venture but is accruing interest at an implicit rate of 10.2% per annum. Since the value of the assets securing the Northland Zero Note did not support the carrying value of the such note, the Venture has not accrued additional interest on the Northland Zero Note on its books since June 30, 1993. Under the terms of the Zero Notes, principal and interest in the aggregate amount of $68,227,857 is due in June 1995. If the Northland transaction is consummated, Equitable and the Venture will acquire the property securing the Loan and the Venture's $42,882,504 share will not be received in June 1995. Proceeds are expected to be received at a later date upon the disposition of the Property. Although it was contemplated and disclosed at the time of the Partnership's offering of BACs that all of the Partnership's cash flow for 1990 would be utilized to pay various deferred fees and expenses, cash flow exceeded the amount necessary to fully pay such fees and expenses, enabling the Partnership to make its first distribution of Distributable Cash to BAC Holders in the first quarter of 1991. For 1992 and 1993, the Partnership's distributions received from the Venture totaled $7,176,400, and $3,040,000 respectively. Cash received from tenant-related revenues decreased approximately $1.0 million in comparison to the same period last year. This decrease is due to the $1.1 million payment received pursuant to an agreement between Saab and the Venture regarding the termination of its lease. The Partnership's share of the proceeds were distributed to the BAC Holders and limited partners as Sale or Financing Proceeds as defined in the Partnership Agreement. Distributable Cash from operations will be distributed in accordance with the terms of the Partnership Agreement which in general provide that such amounts will be distributed 95% to the BAC Holders and Limited Partners and 5% to the General Partners with the BAC Holders and limited partners entitled to a non-cumulative preferred 6% simple return on their adjusted capital contribution during each period. The first semi-annual distribution of Distributable Cash reflecting the portion of the Partnership's cash flow that was available for distribution after payment of the fees and expenses referred to above and other Partnership obligations for the period ended December 31, 1990, was also made on February 28, 1991, at the rate of $0.25 per BAC. A semi-annual distribution of Distributable Cash, for the period ended June 30, 1991, was also made on August 30, 1991, at the rate of $0.50 per BAC and another semi-annual distribution of Distributable Cash, for the period ended December 31, 1991 was made on February 28, 1992 at the rate of $0.50 per BAC. In addition, a semi-annual distribution of Distributable Cash, for the period ended June 30, 1992, was made on August 31, 1992, at the rate of $0.50 per BAC, and another semi-annual distribution of Distributable Cash for the period ended December 31, 1992 was made on February 28, 1993 at the rate of $0.40 per BAC. The Partnership withheld the distribution for the semi-annual period that would have been made in August 1993. The determination to withhold such distributions at that time was based upon the then anticipated needs of the Venture to fund capital improvements to the Northland Center in order to preserve the Venture's equity in the Northland Zero Note in addition to other working capital needs of the Venture. The levels of future cash distributions principally will be dependent on the distributions to the Partnership by the Venture, which in turn will be dependent on returns from the Venture's investments and future reserve requirements. It is anticipated that the Partnership will not make distributions of Distributable Cash from operations in 1994 which will equal or exceed the amount distributed in 1993, and such distributions will probably be less. Amounts distributed to BAC Holders fluctuate from time to time based on changes in occupancy, rental and expense rates at the Venture's Properties and other factors. The Partnership has increased its working capital reserves, and reduced distributions of Distributable Cash in connection with its efforts to relet vacant space at certain of its Properties, most significantly at Sentry Park West and the property secured by the Bank of Delaware Mortgage Loan, and future distributions are expected to be reduced by amounts to be contributed by the Partnership in connection with the consummation of the proposed Northland transaction and the renovation of the Northland Center. The Partnership would be required to contribute $3.8 million upon the consummation of the proposed Northland transaction and thereafter contribute approximately $6.7 million towards the renovation of the Northland Center. There can be no assurance that distributions of Distributable Cash from operations will be made at any particular level or at all. As a result of the increase in reserves and the continued accretion of interest on the Brookdale Zero Note, the tax liability of the BAC Holders arising from taxable income allocated to a BAC Holder may substantially exceed the amounts, if any, distributed to such BAC Holder. As discussed, the Partnership's share of Sale or Financing Proceeds in the amount of $0.162 per BAC associated with the termination of the lease with Saab at 1850 Westfork Drive was distributed to BAC Holders and Limited Partners on August 31, 1992. In addition, the Partnership's share of Sale or Financing Proceeds, to the extent the funds were not allocated to increase reserves, in the amount of $0.10 per BAC associated with the pay-off of the 201 Merritt Seven Loan was distributed to BAC Holders and Limited Partners on February, 28, 1994. The amount and timing of distributions from Sale or Financing Proceeds depend upon payments of the Mortgage Loans and maturity schedules, the timing of disposition of Properties as well as the need to allocate such funds to increase reserves. At December 31, 1993, approximately 91.8% of the aggregate rentable square feet of the Venture's Properties was leased. Leases covering approximately 5.2%, 13.8%, and 10.6% of the Properties rentable square feet are scheduled to expire in 1994, 1995, and 1996, respectively. The Properties and the properties that secure the Mortgage Loans will compete for, among other things, desirable tenants with other properties in the areas in which they are located which may include properties owned or managed directly or indirectly by Equitable or its subsidiaries and affiliates. Currently, many areas of the country including some in which one or more of the Properties or properties that secure Mortgage Loans are located are experiencing relatively high vacancy rates and competition which may adversely impact the ability of the Venture and the owners of the properties that secure the Mortgage Loans to retain or attract tenants as leases expire or may adversely affect the level of rents which may be obtained (or increase the levels of concessions that may have to be granted). Some of the tenants have recently experienced serious financial difficulties. See Item 2. PROPERTIES - 1200 Whipple Road and Richland Mall. Management believes that the value of the Venture's equity in the Northland Zero Note, and the value of the underlying asset, is likely to decline if the Northland Center is not upgraded. ERESC has declined to undertake such steps. This led to negotiations between ERESC and Equitable resulting in the ERESC Agreement described under ITEM 2. PROPERTIES - Mortgage Loans. As discussed above, Management is considering whether the proposed Northland transaction is in the best interests of the Partnership. If Hudson agrees to continue to occupy its anchor space and Montgomery Ward agrees to become the fourth anchor, and the renovations are completed as contemplated, Management believes the market value of the Northland Center, and the Venture's interest therein, would be increased from its current value. The expected increase in value of the Northland Center as upgraded over its current market value may be less than the amount that is expected to be contributed towards renovations. Management believes, however, that the increase in the future value of the Northland Center if none of the upgrading actions are undertaken is expected to be significantly greater than the amounts contributed toward the renovations. Management believes that the expected increase in value of Northland Center would be of benefit to the BAC Holders. It would also have the effect of reducing the liability of EREIM LP Associates under the Guarantee Agreement. The Partnership is intended to be self-liquidating in nature, meaning that proceeds from the sale of properties or principal repayments of loans will not be reinvested but instead will be distributed to BAC Holders and partners, subject to certain limitations. Under the terms of the Guaranty Agreement which has been assigned to the Partnership, following the earlier of the sale or other disposition of all of the Properties and Mortgage Loans or the liquidation of the Partnership, EREIM LP Associates has guaranteed to pay an amount which, when added to all distributions from the Partnership to the BAC Holders, will enable the Partnership to provide the BAC Holders with the Minimum Return equal to their Capital Contributions plus a simple annual return equal to 9.75% multiplied by their adjusted capital contributions from time to time calculated from the investor closing at which an investor acquired his BACs, subject to certain limitations. The distribution declared as of December 31, 1993, paid on February 28, 1994, was $542,448 ($0.10 per BAC). This brings the total distributions to BAC Holders and limited partners to $13,083,776. The cumulative minimum return (computed at 9.75% simple return per annum on the limited partners' adjusted capital contributions) less the distributions to date total that portion of guarantee liability payable to date. As of December 31, 1993, the cumulative minimum return resulting from the Guarantee Agreement is $61,129,209. Assuming that the last Property is sold on December 31, 2002, upon the expiration of the Partnership, EREIM LP Associate's maximum liability under the Guarantee Agreement as of December 31, 1993, is $251,496,465. Financial Condition The Partnership's financial statements include the consolidated statements of the Partnership and the Venture, through which the Partnership conducts its business of investment in real property. Although the Partnership was formed in 1986, it did not commence operations until March, 1988, following receipt of the first proceeds of its offering of BACs. Thereafter, utilizing the net proceeds of the Partnership's offering of BACs, the Partnership, through the Venture, began its acquisition of real estate investments. The Partnership substantially completed its acquisition phase in 1989. Total real estate investments decreased in 1993 as compared to 1992 primarily as a result of the pay-off of the 201 Merritt Seven Loan, the $7,628,000 loss recognized on the Northland Zero Note and depreciation. Such decrease is offset somewhat by the increase in the balance of the Zero Notes due to the accretion of interest thereon. Other assets (primarily cash and short-term investments) increased in 1993 as compared to 1992 due to the receipt of the pay-off of the 201 Merritt Seven Loan and Management's decision to withhold the semi-annual distribution that would have been made in August 1993. Total liabilities decreased in 1993 as compared to 1992 primarily due to a reduction in the distributions declared to the limited partners. The Partnership had a net loss of $1,533,890 for the year ended December 31, 1993 as compared to net income of $9,517,222 for the year ended December 31, 1992. The net loss is attributable to the realized loss on the 201 Merritt Seven Loan and the write-down on the Northland Zero Note. Inflation has been at relatively low levels during the periods presented in the financial statements and, as a result, has not had a significant effect on the operations of the Partnership, the Venture or their investments. Although the spread is small, inflation is continuing to exceed the rise in market rental rates at many of the Venture's properties. In fact, at several of the Venture's properties, market rental rates are decreasing. If this trend continues, the increase in real estate operating expenses may exceed increases in rental income. Results of Operations Rental income for 1993 decreased approximately $1.1 million as compared to 1992. As stated above, this change is primarily a result of the receipt of $1.1 million pursuant to an agreement between Saab and the Venture regarding the termination of its lease. Operating expenses increased from 1992 to 1993 primarily due to the loss realized on the pay-off of the 201 Merritt Seven Loan and the loss on write-down of the Northland Zero Note. Rental income increased in 1992 as compared to 1991 as a result of the termination of lease income received from Saab. Real estate operating expenses remained consistent from 1992 to 1991. Interest on short-term investments remained relatively constant between 1992 and 1993. Interest earned on the Zero Notes decreased from 1992 to 1993 due to the non-accrual of interest in June 1993 on the Northland Zero Note. The non-accrual of interest offset an increase in interest attributable to the compounding effect typical of these types of investments for Brookdale for the full year and for Northland during the first half of the year. Interest income on the Zero Notes increased from 1991 to 1992 as a result of the interest compounding effect. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Schedules Not Filed: All schedules except those indicated above have been omitted as the required information is not applicable or the information is shown in the financial statements or notes thereto. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. INDEPENDENT AUDITORS' REPORT ML/EQ REAL ESTATE PORTFOLIO, L.P.: We have audited the accompanying consolidated balance sheets of ML/EQ Real Estate Portfolio L.P. (the "Partnership") as of December 31, 1993 and 1992, and the related consolidated statements of operations, partners' capital, and cash flows for each of the three years ended December 31, 1993, 1992 and 1991. These financial statements and the supplemental schedules discussed below 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, such consolidated financial statements present fairly, in all material respects, the financial position of ML/EQ Real Estate Portfolio, L.P. at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years ended December 31, 1993, 1992 and 1991 in conformity with generally accepted accounting principles. Our audits also comprehended the consolidated supplemental schedules of the Partnership as of December 31, 1993 and for each of the three years ended December 31, 1993, 1992 and 1991. In our opinion, such consolidated supplemental schedules, when considered in relation to the basic consolidated financial statements, present fairly in all material respects the information shown therein. /s/ Deloitte & Touche - --------------------- March 18, 1994 Atlanta, Georgia ML/EQ REAL ESTATE PORTFOLIO, L.P. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 and 1992 See notes to consolidated financial statements. ML/EQ REAL ESTATE PORTFOLIO, L.P. CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See notes to consolidated financial statements. ML/EQ REAL ESTATE PORTFOLIO, L.P. CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See notes to consolidated financial statements. ML/EQ REAL ESTATE PORTFOLIO, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Continued) See notes to consolidated financial statements. ML/EQ REAL ESTATE PORTFOLIO, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SUPPLEMENTAL INFORMATION REGARDING NONCASH INVESTING AND FINANCING ACTIVITIES The partnership accrued $225,000 in capital expenditures that were not paid before December 31, 1993. See notes to consolidated financial statements. ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION ML/EQ Real Estate Portfolio, L.P., a Delaware limited partnership (the "Partnership"), was formed on December 22, 1986. The Partnership was formed to invest in existing income-producing real properties, zero coupon or similar mortgage notes and fixed rate mortgage loans through a joint venture, EML Associates (the "Venture"). The Venture was formed on March 10, 1988 with EREIM LP Associates, an affiliate of the Equitable Life Assurance Society of the United States ("Equitable"). The Partnership owns an 80% interest in the Venture. The Managing General Partner of the Partnership is EREIM Managers Corp., (the "Managing General Partner"), an affiliate of the Equitable, and the Associate General Partner is MLH Real Estate Associates Limited Partnership (the "Associate General Partner"), an affiliate of Merrill Lynch, Hubbard Inc. The initial limited partner is MLH Real Estate Assignor, Inc., an affiliate of Merrill Lynch, Hubbard Inc. The Partnership's Amended and Restated Agreement of Limited Partnership (the "Partnership Agreement") authorized the sale of up to 7,500,000 Beneficial Assignee Certificates ("BACs") at $20 per BAC. The BACs evidence the economic rights attributable to limited partners hip interests in the Partnership. On March 10, 1988, the Partnership's initial investor closing occurred, at which time the Partnership received $92,190,120 representing the proceeds from the sale of 4,609,506 BACs. On May 3, 1988, the Partnership had its second and final investor closing. The Partnership received $16,294,380 representing the proceeds from the sale of an additional 814,719 BACs. Total capital contributions to the Partnership are summarized as follows: 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting The Partnership utilizes the accrual basis of accounting for financial accounting and tax reporting purposes. Principles of Consolidation The consolidated financial statements include the accounts of the Partnership and the Venture. EREIM LP Associates' 20% ownership in the Venture is reflected as a minority interest in the Partnership's consolidated financial statements. All significant intercompany accounts are eliminated in consolidation. Allocation of Partnership Income Partnership net income was allocated 99% to the limited partners as a group and 1% to the general partners until 1990 at which time the Partnership paid the final portion of the acquisition/syndication fees to the general partners. Partnership net income is now allocated 95% to the limited partners as a group and 5% to the general partners, consistent with the provision in the limited partnership agreement for the allocation of distributable cash. ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Rental Properties Rental properties are stated at cost. Cost is allocated between land and buildings based upon preacquisition appraisals of each property. Impairment is determined by calculating the sum of undiscounted future cash flows including the projected future undiscounted net proceeds from sale of the property. In the event such sum is less than the depreciated cost of the property, the property will be recorded on the financial statements at the lower amount. Depreciation Depreciation of buildings and building improvements is provided using the straight-line method over estimated useful lives of forty years. Tenant improvements are amortized using the straight-line method over the life of the related lease. Rental Income Rental income is recognized on a straight-line basis over the terms of the leases. Other Real Estate Assets Other real estate assets represent the fair market value of the underlying collateral of the Northland zero coupon loan receivable and the Bank of Delaware mortgage loan receivable at the date such receivables were considered to be in-substance foreclosures (see Notes 4 and 5). Zero Coupon Mortgage Notes Receivable Zero coupon mortgage notes receivable are carried at their present value which is equal to the discounted principal plus accrued interest. Interest income is recognized ratably over the term of the notes using the constant rate of interest implicit in the notes (Note 4). In 1993, the Partnership recorded a write-down and stopped accruing interest on the Northland zero coupon note since the value of the underlying collateral was less than the carrying value (see Note 4). Mortgage Loans Receivable Mortgage loans receivable are stated at cost (Note 5). Organization and Offering Costs Organization costs incurred in the organization and formation of the Partnership are amortized over five years. Offering costs, including the acquisition/syndication fee payable to the general partners and other offering and issuance costs of the BACs, totaling $11,037,537, were charged against the limited partners' capital in accordance with the provisions of the Partnership Agreement, following the investor closings in 1988. Guaranty Fees Guaranty fees are being recognized as expense over the estimated life of the Partnership through a combination of the amortization of the nonrecurring portion of the fees incurred during the first three years of the Partnership and the expense of the recurring portion of the fees as incurred (Note 7). ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Cash Equivalents Cash equivalents include cash, demand deposits, money market accounts and highly liquid short-term investments purchased with a maturity of three months or less. The short-term investments are stated at cost. Income Taxes No provisions for income taxes have been made since all income and losses are allocated to the partners for inclusion in their respective tax returns. Reclassifications Certain prior year amounts have been reclassified to conform with the 1993 presentation. Fair Value of Financial Instruments Management has reviewed the various assets and liabilities of the Partnership in accordance with the Statement of Financial Accounting Standards No. 107 "Disclosures about Fair Value of Financial Instruments" (which is not applicable to real estate assets). Management has concluded that the fair value of its financial instruments, principally the zero coupon note receivable, the mortgage loan receivables and other real estate assets, approximates the fair market value of the underlying collateral. Considerable judgement is required in developing estimates of fair value and accordingly, the use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The actual market value of the underlying collateral can be determined only by negotiation between parties in an arms length sale transaction. See Note 4 regarding the write-down of the Northland zero coupon mortgage note. 3. RENTAL PROPERTIES As of December 31, 1993, the Partnership's rental properties consisted of the following: ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The costs related to the rental properties are summarized as follows: 4. ZERO COUPON MORTGAGE NOTES RECEIVABLE In 1988, The Venture acquired two zero coupon mortgage notes with fair value (including accrued interest) of $33,053,870, which represents the Venture's 71.66 ownership percentage. Equitable Life Assurance Society of the United States owns the remaining 28.34%. These notes provide financing for Equitable Real Estate Shopping Centers L.P. ("ERESC") and are secured by nonrecourse first mortgages on the two properties owned by ERESC: Brookdale Center and Northland Center. ERESC is not affiliated with the Venture. The notes have an implicit interest rate of 10.2% compounded semiannually with the Venture's portion of the entire amount of principal and accrued interest totaling $68,227,857 due June 1995. The notes provide that the borrowers may elect to pay interest currently; however, it is expected that interest payments will be deferred until maturity. Management discontinued the accrual of interest during the quarter ended June 30, 1993 on the Northland zero coupon mortgage as the accreted value of such mortgage approximates the underlying value. On January 19, 1994, the Equitable entered into a letter of intent with Equitable Real Estate Shopping Centers L.P. (ERESC) to obtain, together with the Venture, Northland Mall from ERESC by means of a surrender of deed in lieu of foreclosure. The letter of intent provides that if the transaction is consummated, ERESC will be released from the existing first mortgage and receive $6,600,000. Such transaction is accounted for as an in-substance foreclosure at December 31, 1993 and is classified as an other real estate asset. The Partnership recognized a loss of $7,628,000 as of December 31, 1993 to record the mall at its fair market value. Such loss includes a $4,730,000 provision in anticipation of a payment to terminate the mortgage to be made at closing during 1994. The unaudited financial position and results of operations of ERESC for fiscal year ended December 31, 1993 are summarized as follows: ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. ZERO COUPON MORTGAGE NOTES RECEIVABLE (CONTINUED) EQUITABLE REAL ESTATE SHOPPING CENTERS L.P. UNAUDITED Summary Statement of Financial Position ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. MORTGAGE LOANS RECEIVABLE In 1988, the Venture and Equitable jointly invested in a $28,000,000 nonrecourse first mortgage loan to Second Merritt Seven Joint Venture, a Connecticut General Partnership. The Venture, Equitable and Second Merritt Seven Joint Venture agreed to a $21,000,000 pay-off of the loan by Second Merritt Seven Joint Venture in the fourth quarter of 1993. The Venture received $10,500,000 for its 50% share of the loan resulting in a realized loss of $3.5 million. Adequate reserves had been established by the Partnership during the first and third quarters of 1993 to reflect the diminution of value of the underlying security for the loan. In receiving $8,400,000, the Partnership's 80% share of the $10,500,000 payment, the Partnership realized the carrying value of the mortgage on its books. Management believes that accepting a pay-off was in the best interest of the Venture, given the prospects for the property in a difficult leasing environment. In 1989, the Venture made a $6,000,000 nonrecourse first mortgage loan to the Wilcon Company. The loan is collateralized by an apartment complex in Weston, Massachusetts. The loan bears interest at 10.25% per annum with interest only of $51,250 due monthly to the maturity date of February 1999. In 1989, the Venture made a $9,500,000 nonrecourse first mortgage loan to Three Hundred Delaware Avenue Associates. This loan is collateralized by a seventeen-story office building in Wilmington, Delaware. The loan bears interest at 10.375% per annum with interest only of $82,135 due monthly to the maturity date of March 1999. Subsequent to year-end, the owner of the Bank of Delaware Building defaulted on the mortgage loan receivable. As such, at year-end, the Partnership accounted for this transaction as an in-substance foreclosure. The mortgage loan receivable was reclassified to other real estate assets at its current fair market value. 6. GUARANTY AGREEMENT EREIM LP Associates has entered into a guaranty agreement with the Venture to provide a minimum return to the Partnership's limited partners on their contributions. The Venture has assigned its rights under the guaranty agreement to the Partnership. The guaranty, if necessary, will be paid ninety days following the earlier of the sale or other disposition of all the properties and mortgage loans and notes or the liquidation of the Partnership. The minimum return will be an amount which, when added to the cumulative distributions to the limited partners, will enable the Partnership to provide the limited partners with a minimum return equal to their capital contributions plus a simple annual return of 9.75% on their adjusted capital contributions, as defined in the Partnership Agreement, calculated from the dates of the investor closings. Adjusted capital contributions are the limited partners' original cash contributions less distributions of guaranty proceeds, sale or financing proceeds, and liquidation proceeds, as defined in the Partnership Agreement. The limited partners' original cash contributions have been adjusted by that portion of distributions paid through December 31, 1993, resulting from cash available to the Partnership as a result of sale or financing proceeds paid to the Venture. The minimum return is subject to reduction in the event that certain taxes, other than local property taxes, are imposed on the Partnership or the Venture, and is also subject to certain other limitations set forth in the prospectus. Based upon the assumption that the last property is sold on December 31, 2002, upon expiration of the term of the Partnership, the maximum liability of EREIM LP Associates to the Venture to fund cash deficits under the guaranty agreement as of December 31, 1993 is limited to $251,496,465, plus the value of EREIM LP Associates. ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. GUARANTY AGREEMENT (Continued) As of December 31, 1993 and 1992, the cumulative minimum return (computed at 9.75% per annum) on ML/EQ's limited partners' capital contributions was $61,129,209 and $50,637,645, respectively. The guarantee amount is the minimum return reduced by the semi-annual distributions of cash to the limited partners of the Partnership, other than cash distributed to the limited partners as a result of sale or financing proceeds, guaranty proceeds, and liquidation proceeds, as defined in the Partnership Agreement. As of December 31, 1993, the cumulative amount of cash distributions paid other than cash distributions paid as a result of sale or financing proceeds was $11,662,621. As of December 31, 1993, the cumulative amount of cash distributions paid as a result of sale or financing proceeds received by the Venture was $878,707. Distributions constituting sale or financing proceeds declared as of December 31, 1993 and paid in February 1994 total $542,448. 7. COMPENSATION AND FEES Acquisition/Syndication Fee The acquisition/syndication fee was paid to the general partners for initial acquisition, management and administrative services to the Partnership. The fee was 8.7% of the proceeds from the offering of BACs, which amounted to $9,438,152 based upon the total number of BACs sold and has been included in the offering costs charged to limited partners' capital. The outstanding balance of this fee was paid to the general partners in August 1990. Venture Supervisory Fee The Venture supervisory fee is payable to the Managing General Partner for supervising the Partnership's investment in the Venture. The fee is payable semiannually in an amount equal to .75% per annum of the Partnership's allocable share of the acquisition price of properties owned by the Venture. For each of the years ended December 31, 1993, 1992 and 1991, the total expense for this fee was $409,710. Mortgage Loan Servicing Fee The mortgage loan servicing fee is payable to the Managing General Partner for servicing mortgage loans owned by the Venture. The fee is payable semiannually in an amount equal to .20% per annum of the outstanding principal amount of the Partnership's allocable share of fixed rate first mortgage loans and .20% per annum of the Partnership's allocable share of the accreted amount of zero coupon mortgage notes at the time of acquisition or contribution to the venture. For each of the years ended December 31, 1993, 1992 and 1991 the total expense for this fee was $100,086. Partnership Administration Fee The partnership administration fee is payable to the Associate General Partner as compensation for providing investor services limited to processing investor information and disseminating Partnership reports and tax information. The fee is payable on a semiannual basis at an annual rate of .15% per annum of the average annual adjusted capital contributions of the offering of BACs. For the years ended December 31, 1993, 1992 and 1991, the total expense for this fee was $161,409, $162,066 and $162,727, respectively. ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. COMPENSATION AND FEES (Continued) Guaranty Fee The guaranty fee is payable to the Venture in consideration of the assignment of the guaranty agreement. The fee was initially paid in six semiannual installments, which commenced on June 30, 1988 and ended on December 31, 1990, at an annual rate of 1.15% of gross proceeds plus .35% of average annual adjusted capital contributions. Subsequent to December 31, 1990, the fee is payable on a semiannual basis at an annual rate of .35% of the average annual adjusted capital contributions of the offering of BACs. The guaranty fee is assigned to EREIM LP Associates. For the years ended December 31, 1993, 1992 and 1991, the total expense for this fee was $644,871, $646,405 and $647,947, respectively. Each of these totals include $268,251 of amortization expense on the nonrecurring portion of the fee. Disposition Fee The disposition fee is payable to the Managing General Partner in the case of a sale of a property. Upon distribution of the proceeds of the sale to the limited partners, the fee is payable in the amount of 1.50% of the aggregate gross proceeds received by the Partnership. The Managing General Partner will not receive any portion of the disposition fee which, when combined with amounts paid to all other entities as real estate brokerage commissions in connection with the sale, exceeds 6% of the aggregate gross sale proceeds. 8. PARTNERSHIP AGREEMENT The general partners are liable for all general obligations of the Partnership to the extent not paid by the Partnership. The limited partners are not liable for the obligations of the Partnership beyond the amount of their contributed capital. After payment of the acquisition/syndication fee to the general partners, which has been charged to the limited partners' capital, distributable cash from operations, less any amounts set aside for Reserves, will be allocated semiannually on the basis of 95% to the BAC holders and limited partners as a group and 5% to the general partners. Distributions to the general partners for any semiannual period will be deferred until the limited partners have received a 6% per annum simple return on their adjusted capital contribution during the period. During 1993, the Partnership declared a distribution in the amount of $542,448 ($0.10 per BAC) which was paid in February 1994. Taxable income and loss will generally be allocated 1% to the general partners and 99% to the limited partners. Distributions from sale or financing proceeds, if applicable during a period, will be distributed on a semiannual basis with priority return given to the limited partners. An exception in the agreement provides that the distribution of sale or financing proceeds may be delayed if the purpose for withholding such a distribution is to supplement cash reserves. Subsequent to a complete return of the limited partners' capital contributions and the receipt of the minimum return by the limited partners, as defined in the Partnership Agreement, sales proceeds will be allocated to the general partners to the extent of any distributable cash that has been deferred, net of disposition fees paid to the Managing General Partner. The balance will be allocated 85% to the limited partners and 15% to the general partners. ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. LEASES Future minimum rentals to be received for the properties under noncancelable operating leases in effect as of December 31, 1993 are as follows: In addition to the minimum lease amounts, certain leases provide for escalation charges to tenants for common area maintenance, real estate taxes and, in the case of retail tenants, rent concessions and percentage rents. The amount of escalation charges, rent concessions and percentage rents included in rental income totaled $1,632,857, $1,811,905 and $1,740,010 for the years ended December 31, 1993, 1992 and 1991, respectively. Information with respect to significant individual leases is as follows: Permer Control, Inc. occupies all (257,500 square feet) of 1200 Whipple Road at a current annual base rent of $807,469 under a lease which expires in August 2003. The lease agreement calls for increases in annual rent to $1,009,340 in September 1993 and $1,261,675 in September 1998. Martin Marietta (formerly General Electric) occupied all (96,386 square feet) of 16 Sentry Park West at an annual base rent of $1,453,512 under a lease which expired in December 1993. Martin Marietta decided not to renew 70,836 square feet of space under the lease. Martin Marietta acquired General Electric's defense related operations in the first quarter of 1993. Liberty Mutual Insurance Group occupies approximately 12.4% (23,685 square feet) of 18 Sentry Park West at an annual base rent of $358,236 under a lease which expires in May 1999. Pursuant to an agreement with Saab-Scania of America, Inc. ("Saab"), the former tenant of 1850 Westfork Drive, in connection with the termination of its lease, Saab paid to the Venture $1.1 million in the first quarter of 1992. This agreement released Saab from the lease obligation at 1850 Westfork Drive, which had been scheduled to terminate in June 1998. The Partnership recognized such proceeds as income in 1992. During the third quarter of 1992, the Westfork Drive property was leased in its entirety to Treadway Exports Limited. This lease is for an initial term of three years at an annual base rent of $219,689 with two renewal options for a total of an additional three years. Gruner & Jahr Printing Company occupies approximately 44.6% (143,852 square feet) of Doolittle Drive at an annual base rent of $477,816. The lease was renewed in 1992 for a five year term commencing in August 1993. The buildings located at 701 Maple Lane, 733 Maple Lane, 7550 Plaza Court are 100% leased as of December 31, 1993. One lease comprising 18% of the available space is scheduled to expire in 1994. ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. TAXABLE NET INCOME AND TAX NET WORTH The following is a reconciliation of the Partnership's financial net income to taxable net income and a reconciliation of partners' capital for financial reporting purposes to net worth on a tax basis. ML/EQ REAL ESTATE PORTFOLIO, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) Quarterly financial data for 1993 and 1992 is summarized as follows: (A) Note: In the fourth quarter, a write-down of $7,628,000 was taken against one of the zero coupon mortgage notes since the value of underlying collateral was less than the carrying value of the mortgage. (a) Acquisition/syndication fees and partnership administration fees. (b) Acquisition/syndication fees, management fees and costs related to the offering including reimbursable legal, accounting and printing costs. (c) Guaranty fees. (d) Equitable Legal Department to reimburse legal expenses incurred in connecti on with the organization and offering of the Partnership and ongoing Partnership operations. SCHEDULE XI ML/EQ REAL ESTATE PORTFOLIO, L.P. CONSOLIDATED SCHEDULE OF REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 SCHEDULE XII ------------ ML/EQ REAL ESTATE PORTFOLIO, L.P. CONSOLIDATED SCHEDULE OF MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 ------------------------------------------------------ Notes: (a) Interest at the imputed rate shown is compounded semi-annually and added to the note balance. (b) None of the loans are subject to any delinquencies. (c) EREIM LP Associates, an affiliate, contributed a total of $26,443,097 of zero coupon mortgage notes to the Venture, including principal plus interest at the contribution date. (d) The aggregate cost for book purposes is equal to the tax basis. (e) Represents the Venture's 71.66% interest in the original face amount of the note excluding compounded interest. (f) Payments of interest only of $51,250 are due monthly until the maturity date of February 1999. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Partnership is a limited partnership and has no directors or officers. For informational purposes, certain information regarding the General Partners and their respective directors and officers is set forth below. Managing General Partner The Managing General Partner is a wholly-owned subsidiary of Equitable Real Estate Investment Management, Inc. ("Equitable Real Estate"). Equitable Real Estate is a wholly-owned subsidiary of Equitable Investment Corporation, which is a wholly-owned subsidiary of Equitable Holding Corporation, which is a wholly-owned subsidiary of Equitable. The names and dates of election of the directors and officers of the Managing General Partner as of March 15, 1994 are as follows: ___________________________________ * Named Director on December 12, 1986. ** Elected Vice President on December 19, 1986. The business experience of the directors and executive officers of the Managing General Partner is set forth below. George R. Puskar has been Chairman and Chief Executive Officer of Equitable Real Estate since August 1988. Before that he was President and Chief Operating Officer of Equitable Real Estate since its formation in 1984. He is also a Vice President of Equitable. Paul J. Dolinoy is a Senior Executive Vice President of Equitable Real Estate in charge of the Institutional Accounts and Portfolio Management area. He is responsible for Equitable Real Estate's corporate, public and union pension fund business and also oversees the development of institutional-grade real estate investment products for individual investors. He is also a Vice President of Equitable. Eugene F. Conway is an Executive Vice President of Equitable Real Estate responsible for institutional accounts/retail markets. He also serves as portfolio manager for approximately $1.8 billion of assets. Prior to becoming an Executive Vice President of Equitable Real Estate in 1989, he was a Senior Vice President since 1986 and a Vice President since 1984. Harry D. Pierandri is a Senior Executive Vice President of Equitable Real Estate responsible for overseeing all of its discretionary portfolio management activities, in addition to overseeing its Capital Markets, Asset Management and Valuation divisions. Prior to becoming a Senior Executive Vice President in 1988, he was an Executive Vice President since 1984. Edward G. Smith is an Executive Vice President of Equitable Real Estate responsible since 1988 for overseeing the $14 billion real estate portfolio of Equitable's General Account. Prior to becoming an Executive Vice President in 1988, he was a Senior Vice President since 1984. From 1986 to 1988 he was responsible for development, management and administration at Equitable Real Estate's home office in Atlanta. Timothy J. Welch is a Senior Executive Vice President of Equitable Real Estate in charge of its New York regional office. Prior to assuming his current responsibilities, he was responsible for Investment Sales and International Marketing. Peter F. Arata is an Executive Vice President and has been Chief Financial Officer of Equitable Real Estate since 1984. Since 1992, he has also been a Director of Equitable Agri-Business, an Equitable Real Estate affiliate, one of the nation's leading agricultural property investment organizations with more than $2 billion in assets under management. From 1990 to 1992, he was Chairman and Chief Executive Officer of Equitable Agri-Business. Tommy V. Clinton is an Executive Vice President of Equitable Real Estate responsible for new mortgage loan origination and mortgage sourcing. Prior to becoming an Executive Vice President in 1988, he was Senior Vice President since 1984. Richard R. Dolson is an Executive Vice President of Equitable Real Estate and is in charge of asset management. Prior to becoming an Executive Vice president in 1988, Mr. Dolson was a Senior Vice President since 1984. B. Stanton Breon joined Equitable Real Estate in 1982 and was elected a Vice President in 1993. He is currently responsible for the management of portfolios aggregating approximately $1 billion of assets. Peter J. Urdanick is Senior Vice President and Treasurer of Equitable Real Estate. Prior to becoming Senior Vice President and Treasurer in 1992, Mr. Urdanick was Vice President and Controller since 1985. He is responsible for its corporate finance department, including its treasury operations. Associate General Partner The general partner of the Associate General Partner is MLH Real Estate Inc., a wholly-owned subsidiary of MLH Group Inc., which is a wholly-owned subsidiary of Merrill Lynch, Hubbard Inc. ("MLH"). MLH is a wholly-owned subsidiary of Merrill Lynch Group, Inc., which is a wholly-owned subsidiary of Merrill Lynch. The names and dates of election of the directors and executive officers of the general partner of the Associate General Partner as of March 15, 1994 are as follows: The business experience of the directors and executive officers of the general partner of the Associate General Partner is set forth below. D. Bruce Brunson joined Merrill Lynch in 1986 and was elected Chairman and Chief Executive Officer of MLH in August 1991. He has been Senior Vice President of Merrill Lynch since 1986. From 1986 to 1990, he served as Treasurer of Merrill Lynch and subsequently he coordinated Merrill Lynch's restructuring activities. James A. Vinson joined MLPF&S, a subsidiary of Merrill Lynch, in 1971 and has been President and Chief Operating Officer of MLH since 1984 and a Director of MLH since 1978. Mr. Vinson has been involved since 1971 in real property acquisitions and structuring the equity financing of limited partnerships formed for the purpose of acquiring properties. Thomas J. Brown joined MLPF&S in 1971 and has been involved since 1972 in real property acquisitions and structuring the equity financing of limited partnerships formed for the purpose of acquiring properties. He has been responsible for real estate management since 1984. Mr. Brown became a director of MLH in 1987 and has been Executive Vice President since 1985. Jack A. Cuneo joined MLPF&S in 1975 and is a Senior Vice President of MLH and Manager of its Real Estate Acquisitions and Dispositions Group. Mr. Cuneo is involved in real property acquisitions and sales. Bruce S. Fenton joined MLH in 1981 and is a Vice President of MLH and Manager of its Product Development and Investor Services Group. Ronald J. Solotruk joined MLH in 1988 and is a Vice President and the Chief Financial Officer of MLH and the Manager of its Financial and Investment Services Group. There is no family relationship among any of the above-listed directors and officers of the Managing General Partner and the general partner of the Associate General Partner. All of the directors have been elected to serve until the next annual meeting of the shareholder of the Managing General Partner or general partner of the Associate General Partner, respectively, or until their successors are elected and qualify. All of the officers have been elected to serve until their successors are elected and qualify. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The General Partners are entitled to receive a share of cash distributions and a share of taxable income or tax loss as provided in Article Four of the Partnership Agreement which is incorporated herein by reference. The General Partners and their affiliates may be paid certain fees and commissions and reimbursed for certain out-of-pocket expenses. Information concerning such fees, commissions and reimbursements is set forth under "Compensation and Fees" in the Prospectus and in Schedule IV and Note 7 to notes to Consolidated Financial Statements in ITEM 8: FINANCIAL STATEMENTS, which is incorporated herein by reference. All of the directors and officers of the Managing General Partner are employees of Equitable or its subsidiaries and are not separately compensated for services provided to the Managing General Partner or, on behalf of the Managing General Partner, to the Partnership. All of the directors and officers of the general partner of the Associate General Partner are employees of Merrill Lynch or its subsidiaries and are not separately compensated for services provided to the Associate General Partner or, on behalf of the Associate General Partner, to the Partnership. The Partnership Agreement indemnifies the General Partners and the Initial Limited Partner against liability for losses resulting from errors in judgment or other action or inaction, whether or not disclosed, if such course of conduct did not constitute negligence or misconduct (see Section 5.7 of the Partnership Agreement which is incorporated herein by reference). As a result of such indemnification provisions, a purchaser of BACs may have a more limited right of legal action than he would have if such provision were not included in the Partnership Agreement. In the opinion of the Securities and Exchange Commission, indemnification for liabilities arising under the Federal Securities laws is against public policy and therefore unenforceable. Indemnification of general partners involves a developing and changing area of the law and since the law relating to the rights of assignees of limited partnership interests, such as BAC Holders, is largely undeveloped, investors who have questions concerning the duties of the General Partners should consult their own counsel. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The Initial Limited Partner, an affiliate of the Associate General Partner, is the record owner of substantially all of the Interests in the Partnership, although it has assigned such Interests to BAC Holders. In its capacity as record owner of the Interests, the Initial Limited Partner has no authority to transact business for, or to participate in the activities and decisions of, the Partnership. Merrill Lynch, Pierce, Fenner & Smith, Incorporated is the record owner of approximately 84% of the BACs, holding such BACs in a nominee capacity and having no beneficial interest in the BACs. Otherwise, there is no person known to the Partnership who owns beneficially or of record more than five percent of the BACs of the Partnership. Neither of the General Partners owns any BACs of the Partnership. The directors and officers of the Managing General Partner and the general partner of the Associate General Partner, as a group, own no BACs. There are no arrangements 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 Not applicable. PART IV. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons in the capacities indicated on March 25,1994. SIGNATURES Pursuant to 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 on the 25th day of March, 1994. ML/EQ REAL ESTATE PORTFOLIO, L.P. EREIM MANAGERS CORP. (Managing General Partner) By: /s/ Eugene F. Conway -------------------- Eugene F. Conway Executive Vice President

29917_1993.txt

29917_1993

1993

29917

ITEM 1. BUSINESS - ----------------- Dow Corning Corporation (Dow Corning or the Company) was incorporated in 1943 by Corning Glass Works (now Corning Incorporated) and The Dow Chemical Company (Dow Chemical) to develop, produce and market silicones. Corning Incorporated provided the basic silicone technology and Dow Chemical supplied the chemical processing and manufacturing know-how. Both companies provided initial key employees. Dow Corning built a new business based on silicone chemistry. The starting point is quartz rock, a form of silica. The silicon-oxygen-silicon polymer chain, the backbone of all silicones, is derived from a series of chemical processes. Various organic groups attached to this polymer chain can modify properties and alter physical form. Regardless of form, most silicones share a combination of properties, including electrical resistance, ability to maintain performance across a broad range of temperatures, resistance to aging, water repellency, lubricating characteristics and relative chemical and physiological inertness. The versatility of silicones has led to a wide variety of applications across a broad spectrum of industries in all major countries. Dow Corning has supplemented its product line with selected silicone modified organic and non-silicone products, including reactive chemicals based upon silicon. In addition to silicone lubricants, Dow Corning makes and sells specialty lubricants based on molybdenum disulfide, principally under the trademark MOLYKOTE(R). Hemlock Semiconductor Corporation, a subsidiary in which Dow Corning has a 63.25% interest, produces polycrystalline silicon which is the basic material for most semiconductor devices. Polycrystalline silicon is also used to manufacture solar cells. Today, Dow Corning manufactures and sells more than 4,500 products to over 45,000 customers throughout the world. No one customer accounts for more than 3% of net sales. Raw Materials - ------------- The principal raw material used in the production of Dow Corning products is elemental silicon, which is produced and sold by a number of U.S. and non-U.S. firms. Dow Corning currently purchases silicon from various domestic and foreign producers. Dow Corning is a party to a number of silicon supply contracts which cover the majority of anticipated annual requirements. Worldwide production capacity is judged to be adequate to meet expected demand and shortages appear unlikely. Therefore, Dow Corning believes that it has adequate sources of supply of silicon. Dow Corning also purchases substantial quantities, and believes it has adequate sources of supply, of methyl alcohol, methyl chloride, and other raw materials required for its manufacturing operations. Although from time to time temporary shortages of particular raw materials may exist, Dow Corning believes that it has adequate sources of raw materials required to maintain its operations. Foreign Operations - ------------------ The foreign operations of Dow Corning, principally in Europe and Asia, are conducted primarily through wholly-owned subsidiaries and involve sales of substantially all Dow Corning products. These products are manufactured either domestically or by one of the Company's foreign subsidiaries. See Note 16 of Notes to Consolidated Financial Statements included in this report for financial information relating to foreign operations. Foreign business is subject to special considerations, including exchange controls, fluctuations in currency values, dividend and payment restrictions, political instability and international credit or financial problems. While these conditions associated with foreign business involve risks different from those associated with domestic business activities, Dow Corning does not regard the overall risks of its foreign operations, on the whole, to be materially greater than those of its operations in the United States. Competition - ----------- Dow Corning is a leader among the various companies which produce silicone products throughout the world. Substantial competition for Dow Corning products both in the United States and abroad comes from other manufacturers of silicone products. In addition, virtually all silicone products compete with non- silicone products in specific applications. The risk of product substitution is common to all Dow Corning products. The principal competitive elements in the sale of Dow Corning products are: product quality and performance, responsive customer service, new product development, cost effectiveness, and application expertise. Research and Development - ------------------------ Since its inception, Dow Corning has been engaged in a continuous program of basic and applied research on silicon-based materials to develop new products and processes, to improve and refine existing products and processes, and to develop new applications for existing products. The Company also provides a wide variety of technical services to its customers. Research and development expenditures totalled (in millions of dollars) $163.9 in 1993, $161.2 in 1992, and $148.7 in 1991. Patents and Licenses - -------------------- Dow Corning consistently applies for United States and foreign patents and owns, directly or indirectly, a substantial number of such patents. The Company is a licensor under a number of patent licenses and technology agreements. While Dow Corning considers its patents and licenses a valuable asset, it does not regard its business as being materially dependent on any single patent or license or any group of related patents or licenses. Protection of the Environment - ----------------------------- Dow Corning has set a goal to reduce within the United States its toxic releases by 80% in 1995 compared to 1987. This goal is consistent with voluntary commitments made by the Company under two programs with the U.S. Environmental Protection Agency - - the 33/50 Voluntary Reduction Program under which the Company has committed to reductions of all of its toxic chemical releases, and the Clean Air Act Early Reduction Credit Program under which the Company has committed to major reductions in methyl chloride releases at its largest U.S. manufacturing facilities. As a member of the Chemical Manufacturers Association, the Company is also committed to and is implementing the codes of management practices specified in Responsible Care(R). Dow Corning expends funds consistent with its commitments to limit the discharge of materials into the environment. It is expected that Dow Corning's pollution control related expenditures will be partially offset through the recovery of raw materials in the pollution control process. These expenditures should not materially affect Dow Corning's earnings or competitive position. The Company records a charge to earnings for environmental matters when it is probable that a liability has been incurred and the Company's costs can be reasonably estimated. For information concerning environmental liabilities, see Note 2 of Notes to Consolidated Financial Statements. Employees - --------- Dow Corning's average employment for 1993 was 8,600 persons. Average employment for 1992, determined on a comparable basis, was 9,000 persons. ITEM 2. ITEM 2. PROPERTIES - ------------------- Dow Corning owns or leases extensive property for use in its business and believes that its properties are in good operating condition and are generally suited for the purposes for which they are presently being used. Principal United States production plants are located in Kentucky, Michigan and North Carolina. Principal foreign manufacturing plants are located in Australia, Belgium, Germany, Japan, South Korea and the United Kingdom. Dow Corning owns substantially all of its manufacturing facilities. Approximately 62% of Dow Corning's aggregate investment in plant and equipment is represented by its United States facilities. Dow Corning owns its executive and corporate offices, which are located near Midland, Michigan, and certain foreign offices. The Company also owns research and development facilities in the United States, Europe and Asia. Domestic and foreign sales offices are primarily in leased facilities. Dow Corning leases most of its computers and communications equipment. For information concerning lease commitments, see Note 15 of Notes to Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - -------------------------- ENVIRONMENTAL MATTERS The Company has agreed to participate in the Toxic Substances Control Act (TSCA) Section 8(e) compliance audit program. The Company expects to pay a civil penalty which will exceed $100,000. While the exact amount of the civil penalty is not yet known, the United States Environmental Protection Agency (EPA) has put a limit of $1 million on any civil penalty to be paid. On September 26, 1991, the EPA filed an administrative complaint against the Company under TSCA alleging that, from 1988 to 1990, the Company had imported a chemical substance that did not appear on the TSCA Inventory of Existing Chemical Substances. EPA proposed a civil penalty of $230,000 for the violations alleged in the complaint, but reduced the amount to $172,500 because the Company had voluntarily disclosed the situation to the EPA immediately upon discovering it. On July 13, 1993, the Company finalized a consent agreement with the EPA. Under this agreement, the Company agreed to pay a civil penalty of $46,000 and complete a supplemental enforcement project at its Carrollton, Kentucky Facility. BREAST IMPLANT LITIGATION Breast Implant Products Liability Purported Class Action Lawsuits - ----------------------------------------------------------------- As of January 20, 1994, the Company had been named, generally as one of several defendants, in 41 purported breast implant products liability class action lawsuits filed on behalf of individuals who claim to have or have had silicone gel breast implants. Of these lawsuits, 30 have been brought in various Federal District Courts, 9 have been brought in various state courts, and 2 have been brought in courts in Canada. Among the Federal District Court class action lawsuits, 20 were filed in the first quarter of 1992, 4 were filed in the second quarter of 1992, 1 was filed in the third quarter of 1992, 2 were filed in the fourth quarter of 1992, 1 was filed in the first quarter of 1993, 1 was filed in the second quarter of 1993, and 1 was filed in the third quarter of 1993. These cases have been filed in the Federal District Courts for the District of Arizona, the Northern District of California (3 cases), the Central District of California, the Southern District of California, the District of Hawaii, the Northern District of Illinois, the Eastern District of Kentucky, the Northern District of Louisiana, the Eastern District of Michigan, the District of Minnesota (2 cases), the Eastern District of New York (2 cases), the Northern District of Ohio (3 cases), the Southern District of Ohio (7 cases), the Eastern District of Pennsylvania, the Western District of Pennsylvania (2 cases), the District of Utah and the Eastern District of Virginia. In the purported class action case filed in the Federal District Court for the Eastern District of Virginia, all proceedings have been stayed and class certification has been denied. All of these federal purported breast implant products liability class action lawsuits have been transferred to the Federal District Court for the Northern District of Alabama for discovery purposes (see "Consolidation of Breast Implant Products Liability Lawsuits" below). In one of the federal class actions filed in the Southern District of Ohio (later transferred to the Northern District of Alabama), a class action was conditionally certified on behalf of all breast implant recipients in the United States (and their spouses). The Federal District Court in Alabama has announced that this certification order will be reconsidered and could be confirmed, modified, or vacated. In the class action filed in the District of Utah, a class certification motion has been denied. In the class action filed in the Eastern District of Michigan, the Court was asked to certify a class action on behalf of breast implant recipients residing outside the United States; this motion was denied, but class certification may be sought again in the future. Among the 9 purported class action lawsuits brought in various state courts, 6 were filed in the first quarter of 1992, 1 was filed in the second quarter of 1992, 1 was filed in the third quarter of 1992, and 1 was filed in the fourth quarter of 1992. These cases have been filed in the following state courts: The Dade County, Florida Eleventh Judicial Circuit Court; the District Court for the Third Judicial District of Utah; the Philadelphia County, Pennsylvania Court of Common Pleas; the Dauphin County, Pennsylvania Court of Common Pleas; the Cook County, Illinois Circuit Court (2 cases); the Marion County, Indiana Superior Court; the Civil District Court for the Parish of Orleans, Louisiana; and the District Court for Douglas County, Nebraska. In 5 of these cases (the 2 cases in the Cook County, Illinois Circuit Court, the case in the District Court for the Third Judicial District of Utah, the case in the Philadelphia County, Pennsylvania Court of Common Pleas and the case in the Dauphin County, Pennsylvania Court of Common Pleas), either the purported class action claims have been dismissed or class certification has been denied. The case filed in Douglas County, Nebraska was removed from state to federal court and was then transferred to the Federal District Court for the Northern District of Alabama; the purported class action claims in this case have been withdrawn. In the case filed in the Civil District Court for the Parish of Orleans, Louisiana, the Court certified a class of women with silicone breast implants who either reside in or received their implants in the State of Louisiana; this order certifying a class action has been upheld on appeal. Three of these state purported class action cases remain active. A purported class action was filed in Ontario, Canada, during the first quarter of 1993 against Dow Corning Canada, Inc., a wholly-owned subsidiary of the Company. The Judge has entered an order certifying a class of breast implant recipients in the Province of Ontario, Canada; the Ontario Court of Appeals has declined to hear an appeal from this class certification order. In the third quarter of 1993, a petition was filed in Montreal, Canada, seeking authorization to institute a class action on behalf of a purported class of breast implant recipients in the Province of Quebec, Canada, against Dow Corning Corporation and Dow Corning Canada, Inc. The court has not yet decided whether to authorize such a class action. The typical alleged factual bases for these lawsuits include allegations that the plaintiffs' breast implants caused specified ailments, including, among other things, autoimmune disease, scleroderma, systemic disorders, joint swelling and chronic fatigue. The Company is sometimes named as the manufacturer of silicone gel breast implants, and other times the Company is named as the supplier of silicone materials to other breast implant manufacturers. Plaintiffs in these cases typically seek relief in the form of monetary damages, often in unspecified amounts, and have also asked for certain types of equitable relief such as requiring the Company to fund the removal of the breast implants of the class members, to fund medical research into any ailments caused by silicone gel breast implants and to fund periodic medical checkups for the class members. The purported federal class action in the Federal District Court for the Eastern District of Pennsylvania claims monetary damages of more than $75,000 for each plaintiff. One of the purported federal class actions in the Federal District Court for the Southern District of Ohio claims monetary damages of more than $50,000 for each plaintiff. One of the purported federal class actions in the Federal District Court for the District of Minnesota claims an unspecified amount of monetary damages, but claims less than $50,000 for each plaintiff on fraud claims. The purported federal class action in the Federal District Court for the Southern District of California claims more than $50,000 for each plaintiff. One of the purported federal class actions in the Federal District Court for the Western District of Pennsylvania claims damages of $50,000 compensatory and $50,000 punitive damages for each plaintiff. Each other purported federal class action specifies monetary damages in an unspecified amount except that they claim the minimal jurisdictional amount. The purported state class action in the Dade County, Florida Eleventh Judicial Circuit Court claims $500,000,000 in punitive damages and unspecified compensatory damages for the class. Each other purported state class action specifies monetary damages in an unspecified amount except that they claim the minimal jurisdictional amounts. The purported class action in Ontario, Canada, claims $80,000 in monetary damages for each named plaintiff and unspecified monetary damages for other members of the purported class. Monetary damages claimed in these cases in the aggregate may be substantial; however, the Company does not consider the monetary damages claimed to be a realistic measure of the Company's ultimate resolution costs. Individual Breast Implant Products Liability Lawsuits - ----------------------------------------------------- As of January 20, 1994, the Company has been named, often along with other defendants, in approximately 11,800 individual breast implant products liability lawsuits filed in federal courts and state courts in many different jurisdictions; many of these cases involve multiple plaintiffs. The typical alleged factual bases for these lawsuits include allegations that the plaintiffs' breast implants caused specified ailments, including, among others, autoimmune disease, scleroderma, systemic disorders, joint swelling and chronic fatigue. The Company is sometimes named as the manufacturer of silicone gel breast implants, and other times the Company is named as the supplier of silicone raw materials to other breast implant manufacturers. Plaintiffs in these cases typically seek relief in the form of monetary damages, often in unspecified amounts. In those individual breast implant cases where management is aware that monetary damages are specified, the amount of monetary damages alleged ranges from approximately $100,000 to approximately $140,000,000. Also, many of these cases only specify as monetary damages an amount in excess of the jurisdictional minimum for the courts in which such cases are filed. Monetary damages claimed in these cases in the aggregate may be substantial; however, the Company does not consider the monetary damages claimed to be a realistic measure of the Company's ultimate resolution costs. Consolidation of Breast Implant Products Liability Lawsuits - ----------------------------------------------------------- Many of these breast implant products liability cases have been or are in the process of being consolidated for purposes of case management in federal and state courts. As previously reported, on June 25, 1992, the Judicial Panel on Multidistrict Litigation in "In Re Silicone Gel Breast Implants Products Liability Litigation" consolidated all federal breast implant cases for discovery purposes in the Federal District Court for the Northern District of Alabama under the multidistrict litigation rules "in order to avoid duplication of discovery, prevent inconsistent pretrial rulings, and preserve the resources of the parties, their counsel and the judiciary." Substantially all federal breast implant cases have been consolidated or are in the process of transfer, or are likely to be transferred, to the Federal District Court for the Northern District of Alabama. A substantial number of breast implant cases originally filed in state courts have been removed to federal court and either have been or are likely to be similarly transferred and consolidated. The Company anticipates that any federal breast implant products liability cases filed after June 25, 1992, as well as some state breast implant cases removed to federal courts, will be transferred to the Federal District Court for the Northern District of Alabama for discovery purposes under the multidistrict litigation rules. In addition, the consolidation of many state breast implant products liability cases has proceeded in many jurisdictions where a substantial number of state breast implant lawsuits have been filed; however, this consolidation of state cases has not occurred in all jurisdictions. As of December 31, 1993, substantially more than half of all breast implant cases were consolidated for pretrial purposes at the federal and state levels. The Company views these case consolidation measures as positive steps toward the management of these various lawsuits and anticipates that current and future breast implant lawsuit consolidations will result in a reduction of litigation defense costs per case. For more information on these matters, see Note 2 of Notes to Consolidated Financial Statements. Settlement Proposed to Resolve Breast Implant Claims - ---------------------------------------------------- On September 9, 1993, the Company announced that representatives of plaintiffs and defendants involved with silicone breast implant litigation have developed a "Statement of Principles for Global Resolution of Breast Implant Claims" (the "Statement of Principles"). The Statement of Principles summarizes a proposed claims based structured resolution of claims arising out of breast implants which have been or could be asserted against various implant manufacturers, suppliers, physicians and hospitals (the "Proposed Settlement"). Under the Proposed Settlement, if implemented, industry participants (the "Funding Participants") would contribute up to $4.75 billion over a period of thirty years to establish several special purpose funds. The Proposed Settlement would define the circumstances under which payments from the funds would be made. The Proposed Settlement includes provisions for (a) class membership and the ability of plaintiffs to opt out of the class, (b) the establishment of defined funds for medical diagnostic/evaluation procedures, explantation, ruptures, compensation for specific diseases and administration, (c) payment terms and timing and (d) claims administration. The Proposed Settlement defines periods during which breast implant plaintiffs may elect not to settle their claims by way of the Proposed Settlement and continue their individual breast implant litigation against manufacturers and other defendants (the "Opt Out Plaintiffs"). In certain circumstances, if any defendant who is a Funding Participant considers the number of Opt Out Plaintiffs maintaining lawsuits against such defendant to be excessive, such defendant may decide to exercise the option to withdraw from participation in the Proposed Settlement. For more information on these matters, see Note 2 of Notes to Consolidated Financial Statements. SECURITIES LAWS AND SHAREHOLDER DERIVATIVE LAWSUITS Securities Laws Purported Class Action Lawsuits - ----------------------------------------------- As of January 20, 1994, the Company and certain of its directors and officers were named, as defendants with others, in two purported securities laws class action lawsuits filed by purchasers of stock of Corning Incorporated (Corning) and The Dow Chemical Company (Dow Chemical). These cases were originally filed as several separate cases in the Federal District Court for the Southern District of New York in the first quarter of 1992; these cases were consolidated in the second quarter of 1992 so that there is one case involving claims on behalf of purchasers of stock of Corning and one case involving claims on behalf of purchasers of stock of Dow Chemical. The plaintiffs in these cases allege, among other things, misrepresentations and omissions of material facts and breach of duty with respect to purchasers of stock of Corning and Dow Chemical relative to the breast implant issue. The relief sought in these cases is monetary damages in unspecified amounts. Motions to dismiss both cases have been filed by all defendants. Shareholder Derivative Lawsuits - ------------------------------- As of January 20, 1994, the Company and/or certain of its directors and officers were named in three shareholder derivative lawsuits filed by shareholders of Corning and Dow Chemical. The plaintiffs in these cases allege various breaches of fiduciary duties claimed to be owed by the defendants relative to the breast implant issue. The relief sought by the shareholders filing these suits on behalf of Dow Chemical and Corning is monetary damages in unspecified amounts. Motions to dismiss these cases have been filed by all defendants. GRAND JURY INVESTIGATION On February 8, 1993, the Company received two federal grand jury subpoenas initiated by the Assistant U.S. Attorney in Baltimore, Maryland, seeking documents and information related to silicone breast implants. The Company has provided information in response to the subpoenas and continues to cooperate with the Assistant U.S. Attorney's requests. LAWSUIT AGAINST INSURANCE CARRIERS On June 30, 1993, the Company filed a complaint, which was subsequently amended, in the Superior Court of California against 99 insurance companies which issued occurrence based products liability insurance policies to the Company from 1962 through 1985 ("Insurers"). The complaint also names as defendants three state insurance guaranty funds. This action (the "California Action") resulted from an inability of some of the Insurers to reach an agreement with the Company on a formula for the allocation among the Insurers of payments of defense and indemnity expenses submitted by the Company related to breast implant products liability lawsuits and claims ("Insurance Allocation Agreement"). The California Action was filed to seek, among other things, a judicial enforcement of the obligations of the Insurers under the relevant insurance policies. On September 10, 1993, several of the Company's insurers filed a complaint against the Company and other insurers for declaratory relief in Wayne County Michigan Circuit Court (the "Michigan Action"). This complaint named additional insurers, particularly the insurers that provided coverage on a claims-made basis subsequent to 1985, and raised issues similar to those described above for determination by the courts. On September 13, 1993, plaintiff insurers in the Michigan Action brought a motion in the California Action for the California Action to be stayed or dismissed in favor of the Michigan Action on the grounds of inconvenient forum. On October 1, 1993, the California Court dismissed the California Action on the grounds of inconvenient forum. In light of this ruling, the Company has elected to litigate the coverage issues on breast implant product liability lawsuits and claims in the Michigan Action. Notwithstanding this litigation, the Company is continuing its negotiations with the Insurers to obtain an Insurance Allocation Agreement as described above. SECURITIES AND EXCHANGE COMMISSION INFORMAL INVESTIGATION The Company received a request, dated July 9, 1993, from the Boston Regional Office of the Securities and Exchange Commission for certain documents and information related to silicone breast implants. The request states that an informal investigation of the Company and its equity owners is being conducted by the Boston Regional Office. On July 30, 1993, the Company responded to this request enclosing the documents and information requested along with related information. The Company will continue to cooperate with the Boston Regional Office. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ Item omitted in accordance with provisions of General Instruction J of Form 10-K. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS - --------------------------------------------------------- The Company's common stock is owned in equal portions by Corning Incorporated and Dow Holdings Inc., a wholly-owned subsidiary of The Dow Chemical Company. None of the Company's common stock has been sold or traded since the Company's inception in 1943. The Company did not pay dividends in 1993. In the first quarter of 1992, the Company paid a dividend of $8.20 per common share. The Company paid a dividend of $6.00 per common share in each of the remaining quarters of 1992. Under the provisions of the Revolving Credit Agreement (which is described in Note 8 of Notes to Consolidated Financial Statements) the Company is subject to certain restrictions as to the payment of dividends. The amount of the restriction is based on a formula which considers, among other things, the income before income taxes for the most recent fiscal year. Based on the computation completed for the year ended December 31, 1993, the Company is restricted from issuing dividends in 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- ITEM 7. ITEM 7. MANAGEMENT'S NARRATIVE ANALYSIS - ---------------------------------------- (all amounts in millions of dollars) Results of Operations - --------------------- 1993 Compared to 1992 --------------------- 1993 net sales increased $88.0 or 4.5% over levels reported for 1992. The increase for 1993 was principally attributable to higher sales volumes, particularly in Asia, offset slightly by lower selling prices, and unfavorable currency effects in Europe. Manufacturing cost of sales, as a percent of net sales, was relatively unchanged for 1993 as compared to 1992. Marketing and administrative expenses, as a percent of net sales, were 19.8% in 1993 compared to 21.0% in 1992. This decrease is attributable to lower freight costs, commissions and allowances. Implant costs of $640.0 in 1993 and $69.0 in 1992 represent provisions for costs associated with breast implant litigation, claims and related matters, as further described in Note 2 of Notes to Consolidated Financial Statements. These costs were reported separately to better identify the Company's profitability from ongoing operations and the financial impact resulting from breast implant litigation. Special items of $40.0 in 1992 relate to provisions for restructuring activities, consisting largely of costs associated with the cessation of manufacturing activities at a subsidiary in Brazil and costs involved in global expense reduction, including elimination of low-priority activities, redeployment of people and reduction in the value of affected facilities. The Company incurred an operating loss in 1993 of $404.1, compared to operating income of $93.1 in 1992. Operating results in both years have been negatively impacted by breast implant related charges of $640.0 in 1993 and $69.0 in 1992. Operating results were also negatively impacted in 1992 due to special items of $40.0 described above. Other income was $15.4 in 1993 compared to other expense of $20.6 in 1992. As a result of the turmoil in European financial markets in September 1992, the Company incurred losses in 1992 related to positions taken in several financial instruments. These losses were generated as the market values of these instruments were sensitive to movements in cross-currency exchange rates and interest rates in certain foreign markets. During September 1992, the Company offset these positions and reduced its exposure to the effects of further instability in the European markets. Implant costs of $640.0 described above were offset by a related tax benefit of $225.0. Excluding the impact of this charge and the related tax benefit, the effective tax rate was 34.0% in 1993 compared to 20.2% in 1992. The higher effective rate in 1993 is due to lower foreign tax credits. During 1992, the Company adopted Statements of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and No. 109, Accounting for Income Taxes. The impact of these changes, as further explained in Notes 11 and 13 of Notes to Consolidated Financial Statements, reduced 1992 net income by $111.9, $100.4 of which represented the cumulative effect of these changes for years prior to 1992. 1992 Compared to 1991 --------------------- 1992 net sales increased $110.3 or 6.0% over levels reported for 1991. The increase for 1992 was principally attributable to higher sales volumes. The effects of currencies strengthening in Europe and Asia have also contributed to this increase. Weak economic conditions in most industrialized countries were the major reasons for low volume growth in 1992. Economic conditions and competitive pressures limited opportunities for price improvements and selling prices were lower in 1992 than in 1991. Manufacturing cost of sales, as a percent of net sales, was 68.7% in 1992 compared to 64.8% for 1991. These increases, in large part, reflect the effects of lower selling prices on products sold and growth in employee costs, the latter partially attributable to effects related to the adoption of Statement of Financial Accounting Standards No. 106 and to increases in staffing levels associated with the operation of new facilities. For 1992, manufacturing costs were also unfavorably affected by higher purchased material costs, faster sales growth in lower margin products and higher depreciation charges. Marketing and administrative expenses, as a percent of net sales, were relatively unchanged for 1992 as compared to 1991. Implant costs of $69.0 in 1992 and $25.0 in 1991 represent provisions for costs associated with discontinued breast implant products, as further described in Note 2 of Notes to Consolidated Financial Statements. These costs were reported separately to better identify the financial impact of the breast implant controversy and the Company's profitability from ongoing operations. Special items of $40.0 in 1992 relate to provisions for restructuring activities, consisting largely of costs associated with the cessation of manufacturing activities at a subsidiary in Brazil and costs involved in global expense reduction, including elimination of low-priority activities, redeployment of people and reduction in the value of affected facilities. Special items of $29.0 in 1991 represent provisions for costs of certain legal contract disputes and recognition of partial impairment in the value of certain foreign assets. Operating income for 1992 was down $105.5 or 53.1% from prior year levels. Results have been negatively impacted by charges relating to the breast implant controversy and restructuring activities, weak economic conditions, competitive pricing pressure and expense growth. Other expense for 1992 increased significantly from levels for 1991. As a result of the turmoil in European financial markets in September 1992, the Company incurred losses related to positions taken in several financial instruments. These losses were generated as the market values of these instruments were sensitive to movements in cross-currency exchange rates and interest rates in certain foreign markets. During September 1992, the Company offset these positions and reduced its exposure to the effects of further instability in the European markets. The Company's use of interest and currency rate derivatives is described in Note 10 of Notes to Consolidated Financial Statements. Interest income was also down slightly from 1991 reflecting lower average invested cash balances and lower interest rates. The effective tax rate in 1992 was 20.2%, compared to 27.9% for 1991. The lower effective rate in 1992 was due to higher levels of foreign tax credit utilization. During 1992, the Company elected to adopt Statements of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and No. 109, Accounting for Income Taxes. The impact of these changes, as further explained in Notes 11 and 13 of Notes to Consolidated Financial Statements, reduced 1992 net income by $111.9, $100.4 of which represented the cumulative effect of these changes for years prior to 1992. Credit Availability - ------------------- During 1993, the Company terminated a revolving credit agreement which was in place at December 31, 1992, and replaced it with a revolving credit agreement with 16 domestic and foreign banks which provides for borrowings on a revolving credit basis until November, 1997 of up to $400.0. At December 31, 1993, there was $150.0 outstanding under this facility. Availability of credit under this facility may be affected by certain debt restrictions and provisions as described in Note 8 of Notes to Consolidated Financial Statements. Additionally, the Company has agreements in place whereby it may sell on an ongoing basis fractional ownership interests in a designated pool of U.S. trade receivables, with limited recourse, in amounts up to $65.0. As of December 31, 1993, the Company had no amounts outstanding under these agreements. Under other agreements, $63.2 of foreign trade receivables had been sold and remained uncollected at December 31, 1993. The Company also has agreements with several banks whereby it may borrow up to $269.5 under short-term lines of credit. The Company pays a fixed service fee for certain of these facilities in lieu of any compensating cash balances. Included in short-term borrowings are amounts outstanding under these facilities at December 31, 1993, of $83.7. The Company has registered with the Securities and Exchange Commission $400.0 of debt securities. As of December 31, 1993, $275.0 of these registered securities had been designated to medium-term note programs with $100.0 issued, and $125.0 had been issued in debentures. During 1993, the Company obtained long-term financing totalling $58.8 ($28.6 of which is denominated in foreign currencies) bearing interest at rates ranging from 4.1% to 11.5% at December 31, 1993 and with maturities ranging from two to five years. Management believes that, in light of the Company's positive operating cash flow, the credit facilities currently in place are adequate to meet the short-term financing needs of the Company. Management also believes that the Company will generate the financial liquidity required to meet ongoing operational needs and to participate in the breast implant litigation settlement currently being negotiated (as described in Note 2 of Notes to Consolidated Financial Statements). This belief is based on, among other things, management's estimate of future operational cash flows, its assessment that recovery of substantial amounts of settlement obligations from its insurance carriers is probable, and its evaluation of current financing arrangements. Inflation - --------- The impact of inflation on the Company's financial position and results of operations has been minimal. The Company expects that future impacts of inflation will be offset by increased prices and productivity gains. Contingencies - ------------- For information regarding contingencies, including a discussion of breast implant litigation and the Company's environmental liabilities, see Note 2 of Notes to Consolidated Financial Statements. Management Changes - ------------------ On June 25, 1993, the Company's Board of Directors elected Richard A. Hazleton, President of the Company, to the additional position of Chief Executive Officer. Keith R. McKennon, formerly Chief Executive Officer, continues as the Chairman of the Board of Directors. On December 10, 1993, the Company's Board of Directors elected John W. Churchfield, formerly the Assistant Chief Financial Officer, to the position of Vice President for Planning and Finance and Chief Financial Officer. Edward Steinhoff, formerly Vice President for Finance and Chief Financial Officer, announced in early 1993 his intention to retire and retired December 31, 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- See the "Index to Financial Statements" which is located in the section entitled "Financial Statements for the Year Ended December 31, 1993" included in this report, as well as the "Report of Independent Accountants." 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 omitted in accordance with provisions of General Instruction J of Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - -------------------------------- Item omitted in accordance with provisions of General Instruction J of Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------- Item omitted in accordance with provisions of General Instruction J of Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------------------------------------------------------- Item omitted in accordance with provisions of General Instruction J of Form 10-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ----------------------------------------------------------------- Documents filed as part of Form 10-K for the year ended December 31, 1993 are as follows: (a) Financial Statements and Financial Statement Schedules: See the "Index to Financial Statements" which is located in the section entitled "Financial Statements for the Year Ended December 31, 1993" included in this report, as well as the "Report of Independent Accountants." (b) Reports on Form 8-K: A report on Form 8-K dated January 14, 1994, was filed in connection with a special charge to reflect the Company's best estimate of the costs of resolving breast implant litigation and related matters. (c) Exhibits: See the "Exhibit Index" which is located on page 52. 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. DOW CORNING CORPORATION Date January 28, 1994 By R. A. Hazleton ---------------- ------------------------ R. A. Hazleton President and Chief Executive Officer Date January 28, 1994 By J. W. Churchfield ---------------- ------------------------ J. W. Churchfield Vice President for Planning and Finance and Chief Financial Officer Date January 28, 1994 By G. P. Callaghan ---------------- ------------------------ G. P. Callaghan Corporate Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons (a majority of the Board of Directors) on behalf of the registrant and in the capacities and on the dates indicated. Date January 28, 1994 By G. E. Anderson ---------------- ------------------------ G. E. Anderson Director, Dow Corning Corporation Date January 28, 1994 By V. C. Campbell ---------------- ------------------------ V. C. Campbell Director, Dow Corning Corporation Date January 28, 1994 By D. A. Duke ---------------- ------------------------ D. A. Duke Director, Dow Corning Corporation Date January 28, 1994 By E. C. Falla ---------------- ------------------------ E. C. Falla Director, Dow Corning Corporation Date January 28, 1994 By R. A. Hazleton ---------------- ------------------------ R. A. Hazleton Director, Dow Corning Corporation Date January 28, 1994 By K. R. McKennon ---------------- ------------------------ K. R. McKennon Director, Dow Corning Corporation Date January 28, 1994 By L. A. Reed ---------------- ------------------------ L. A. Reed Director, Dow Corning Corporation Date January 28, 1994 By D. R. Weyenberg ---------------- ------------------------ D. R. Weyenberg Director, Dow Corning Corporation UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K FOR CORPORATIONS FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1993 DOW CORNING CORPORATION MIDLAND, MICHIGAN 48686-0994 STATEMENT OF MANAGEMENT RESPONSIBILITY FOR ------------------------------------------ FINANCIAL STATEMENTS -------------------- The management of Dow Corning Corporation is responsible for the preparation, presentation and integrity of the consolidated financial statements and other information included in this annual report on Form 10-K. The financial statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts based on management's best estimates and judgments. In meeting its responsibility for the reliability of these financial statements, Dow Corning maintains comprehensive systems of internal accounting control. These systems are designed to provide reasonable assurance at reasonable cost that corporate assets are protected against loss or unauthorized use and that transactions and events are properly recorded. Such systems are reinforced by written policies, selection and training of competent financial personnel, appropriate division of responsibilities and a program of internal audits. The financial statements have been audited by our independent accountants, Price Waterhouse. Their responsibility is to express an independent professional opinion with respect to the consolidated financial statements on the basis of an audit conducted in accordance with generally accepted auditing standards. In addition to the audit performed by the independent accountants, Dow Corning maintains a professional staff of internal auditors whose audit coverage is coordinated with that of the independent accountants. The Board of Directors, through its Audit Committee, is responsible for reviewing and monitoring Dow Corning's financial reporting and accounting practices and recommending annually the appointment of the independent accountants. The Committee, composed of nonmanagement directors, meets periodically with management, the internal auditors and the independent accountants to review and assess the activities of each. Both the independent accountants and the internal auditors meet with the Committee, without management present, to review the results of their audits and their assessment of the adequacy of the system of internal accounting controls and the quality of financial reporting. January 20, 1994 R. A. Hazleton J. W. Churchfield - ------------------------- --------------------------- R. A. Hazleton J. W. Churchfield President and Vice President for Chief Executive Officer Planning and Finance and Chief Financial Officer Suite 3900 Telephone 313 259 0500 200 Renaissance Center Detroit, MI 48243 Price Waterhouse Report of Independent Accountants January 20, 1994 To the Stockholders and Board of Directors of Dow Corning Corporation In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Dow Corning 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 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 2 to the financial statements, the Company is involved in product liability litigation and claims related to breast implants for which it is seeking payment from insurance carriers. The Company has recorded an estimated liability and insurance receivable for these matters based upon all currently available information. As additional facts and circumstances develop in the future, it may be necessary for the Company to revise these estimates. As discussed in Note 6 to the financial statements, the Company changed its method of applying fixed costs to inventory in 1991. In 1992, the Company changed its method of accounting for postretirement benefits other than pensions to conform with Statement of Financial Accounting Standards No. 106 as discussed in Note 11 and its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109 as discussed in Note 13. Price Waterhouse (THIS PAGE INTENTIONALLY BLANK) DOW CORNING CORPORATION ----------------------- ----------------------------- Page ---- Consolidated balance sheets at December 31, 1993 and 1992 23 Consolidated statements of operations and retained earnings for the years ended December 31, 1993, 1992 and 1991 25 Consolidated statements of cash flow for the years ended December 31, 1993, 1992 and 1991 26 Notes to consolidated financial statements 28 Supplementary Data - for the years ended December 31, 1993 and 1992: Quarterly financial information 46 Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: V - Property, plant and equipment 47 VI - Accumulated depreciation and amortization of property, plant and equipment 48 VIII - Valuation and qualifying accounts and reserves 49 IX - Short-term borrowings 50 X - Supplementary income statement information 51 All other supplementary data and financial statement schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or the accompanying notes. DOW CORNING CORPORATION ----------------------- CONSOLIDATED BALANCE SHEETS --------------------------- (in millions of dollars) ASSETS ------ December 31, -------------------- 1993 1992 -------- -------- CURRENT ASSETS: Cash and cash equivalents $ 263.0 $ 8.4 -------- -------- Short-term investments 0.9 - -------- -------- Accounts and notes receivable - Trade (less allowance for doubtful accounts of $8.4 in 1993 and 1992) 318.5 285.9 Other receivables 54.5 53.0 -------- -------- 373.0 338.9 -------- -------- Inventories 285.6 356.1 -------- -------- Other current assets - Deferred income taxes 118.4 90.5 Other 28.3 33.8 -------- -------- 146.7 124.3 -------- -------- Total current assets 1,069.2 827.7 -------- -------- PROPERTY, PLANT AND EQUIPMENT: Land and land improvements 130.9 119.3 Buildings 436.0 413.1 Machinery and equipment 2,011.3 1,906.5 Construction-in-progress 132.5 148.9 -------- -------- 2,710.7 2,587.8 Less - Accumulated depreciation (1,544.6) (1,396.5) -------- -------- 1,166.1 1,191.3 -------- -------- OTHER ASSETS: Implant insurance receivable 663.7 - Deferred income taxes 229.6 31.8 Other 133.7 139.9 -------- -------- 1,027.0 171.7 -------- -------- $3,262.3 $2,190.7 ======== ======== The Notes to Consolidated Financial Statements are an integral part of these financial statements. DOW CORNING CORPORATION ----------------------- CONSOLIDATED BALANCE SHEETS --------------------------- (in millions of dollars except share data) LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ December 31, -------------------- 1993 1992 -------- -------- CURRENT LIABILITIES: Notes payable $ 233.7 $ 160.0 Current portion of long-term debt 33.5 37.7 Trade accounts payable 147.1 124.7 Income taxes payable 18.6 41.1 Accrued payrolls and employee benefits 60.4 54.6 Accrued taxes, other than income taxes 19.6 17.2 Implant reserve 158.7 46.2 Other current liabilities 99.0 87.4 -------- -------- Total current liabilities 770.6 568.9 -------- -------- LONG-TERM DEBT 314.7 298.0 -------- -------- OTHER LONG-TERM LIABILITIES: Implant reserve 1,100.0 - Deferred income taxes 14.6 0.2 Other 311.2 306.3 -------- -------- 1,425.8 306.5 -------- -------- CONTINGENT LIABILITIES (NOTE 2) MINORITY INTEREST IN CONSOLIDATED SUBSIDIARIES 102.8 85.2 -------- -------- STOCKHOLDERS' EQUITY: Common stock, $5 par value - 2,500,000 shares authorized and outstanding 12.5 12.5 Retained earnings 604.3 891.3 Cumulative translation adjustment 31.6 28.3 -------- -------- Stockholders' equity 648.4 932.1 -------- -------- $3,262.3 $2,190.7 ======== ======== The Notes to Consolidated Financial Statements are an integral part of these financial statements. (THIS PAGE INTENTIONALLY BLANK) DOW CORNING CORPORATION ----------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ (in millions of dollars except where noted) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - --------------------------------------------------- Principles of Consolidation - --------------------------- The accompanying consolidated financial statements include the accounts of Dow Corning Corporation and all of its wholly-owned and majority-owned domestic and foreign subsidiaries (the Company). The Company's interests in 20% to 50% owned affiliates are carried on the equity basis and are included in other assets. Intercompany transactions and balances have been eliminated in consolidation. Cash Equivalents and Short-Term Investments - ------------------------------------------- Cash equivalents include all highly liquid investments purchased with an original maturity of ninety days or less. All other temporary investments are classified as short-term investments. The carrying amounts for cash equivalents and short-term investments approximate their fair values. The Company enters into agreements to purchase and resell securities. As of December 31, 1993, there was approximately $243.1 outstanding under these agreements. Of this amount, $208.1 had been purchased from Merrill Lynch Mortgage Capital, Inc. with a weighted average maturity of twelve days, and $35.0 had been purchased from Lehman Commercial Paper, Inc. with a weighted average maturity of eight days. Securities purchased under agreements to resell are included in cash and cash equivalents in the accompanying balance sheet. Inventories - ----------- Inventories are stated at the lower of cost or market. The cost of the majority of inventories is determined using the last-in, first-out (LIFO) method and the remainder is valued using the first-in, first-out (FIFO) method. Property and Depreciation - ------------------------- Property, plant and equipment are carried at cost and are depreciated principally using accelerated methods over estimated useful lives ranging from 10 to 20 years for land improvements, 10 to 45 years for buildings and 3 to 20 years for machinery and equipment. Upon retirement or other disposal, the asset cost and related accumulated depreciation are removed from the accounts and the net amount, less any proceeds, is charged or credited to income. Expenditures for maintenance and repairs are charged against income as incurred. Expenditures which significantly increase asset value or extend useful asset lives are capitalized. The Company follows the policy of capitalizing interest as a component of the cost of capital assets constructed for its own use. Interest capitalized was $12.0 in 1993, $11.8 in 1992, and $11.8 in 1991. NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) - --------------------------------------------------- Intangibles - ----------- Other assets include $27.0 and $32.7 of intangible assets at December 31, 1993 and 1992, respectively, representing the excess of cost over net assets of businesses acquired. These intangible assets are being amortized on a straight-line basis over 10 years. Other identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives. Deferred Investment Grants - -------------------------- Included in other long-term liabilities are deferred investment incentives (grants) which the Company has received related to certain capital expansion projects in Belgium, Canada and the United Kingdom. Such grants are deferred and recognized in income over the service lives of the related assets. At December 31, 1993 and 1992, gross deferred investment incentives were $84.6 and $90.7 with related accumulated amortization of $62.8 and $60.8, respectively. Income Taxes - ------------ The Company adopted the provisions of Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, effective on January 1, 1992. SFAS 109 requires a company to recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in a company's financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference 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 differences are expected to reverse. Research and Development Costs - ------------------------------ Research and development costs are charged to operations when incurred and are included in manufacturing cost of sales. These costs totalled $163.9 in 1993, $161.2 in 1992, and $148.7 in 1991. Currency Translation - -------------------- Assets and liabilities of certain foreign subsidiaries are translated into U.S. dollars at end-of-period exchange rates; translation gains and losses, hedging activity and related tax effects from these subsidiaries are reported as a separate component of stockholders' equity. Assets and liabilities of other foreign subsidiaries are remeasured into U.S. dollars using end-of-period and historical exchange rates; remeasurement gains and losses, hedging activity and related tax effects for these subsidiaries are recognized in the statement of operations. Revenues and expenses for all foreign subsidiaries are translated at average exchange rates during the period. Foreign currency transaction gains and losses are included in current earnings. NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) - --------------------------------------------------- Interest and Currency Rate Derivatives - -------------------------------------- The Company enters into a variety of interest rate and currency swaps, interest rate caps and floors, options and forward exchange contracts in its management of interest rate and foreign currency exposures. The differential to be paid or received on interest rate swaps, including interest rate elements in combined currency and interest rate swaps, interest rate caps and floors is recognized over the life of the agreements as an adjustment to interest expense. Gains and losses on terminated interest rate instruments that were entered into for the purpose of changing the nature of underlying debt obligations are deferred and amortized to income as an adjustment to interest expense. Currency option premiums are amortized over the option period. Gains and losses on purchased currency options that are designated and effective as hedges are deferred and recognized in income in the same period as the hedged transaction. Realized and unrealized gains and losses on currency swaps, including currency elements in combined currency and interest rate swaps, and forward exchange contracts are recognized currently in other income and expense, or, if such contracts are effective as net investment hedges, in stockholders' equity. New Accounting Standards - ------------------------ In November 1992, Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Post-employment Benefits" was issued. The Company will be required to adopt this new method of accounting for benefits paid to former or inactive employees after employment but before retirement no later than 1994. This new standard requires, among other things, that the expected costs of these benefits be recognized when they are earned or become payable when certain conditions are met rather than the current method which recognizes these costs when they are paid. The Company does not expect this standard to materially impact its financial condition or results of operations when it is adopted in 1994. Reclassifications - ----------------- Certain reclassifications of prior year amounts have been made to conform to the presentation adopted in 1993. NOTE 2 - CONTINGENCIES - ---------------------- Breast Implant Business - ----------------------- Prior to January 6, 1992, the Company, directly and through its wholly-owned subsidiary, Dow Corning Wright Corporation, was engaged in the manufacture and sale of silicone gel breast implants. As part of a review process initiated in 1991 by the United States Food and Drug Administration (FDA) of Premarket Approval Applications (PMAA) for silicone gel breast implants, on January 6, 1992, the FDA asked breast implant producers and medical practitioners to voluntarily halt the sale and use of silicone gel breast implants pending further review of the safety and effectiveness of such devices, and the Company complied with the FDA's request and suspended shipments of implants. Subsequently, the Company announced that it would not resume the production or sale of silicone gel breast implants and that it would withdraw its PMAA for silicone gel breast implants from consideration by the FDA. The Company also commenced a program to provide up to $1,200 (in whole dollars) per patient to support medical costs of removing the Company's silicone gel breast implants from women who have a documented medical need to have their implants removed and who cannot afford the procedure. As of January 20, 1994, approximately 2,800 women have made use of this program. NOTE 2 - CONTINGENCIES (Continued) - ---------------------- Since late 1991, there has been considerable publicity associated with the breast implant controversy, and the Company experienced a substantial increase in the number of lawsuits against the Company relating to breast implants. As of January 20, 1994, the Company has been named, often together with other defendants, in approximately 11,800 pending breast implant products liability lawsuits filed by or on behalf of individuals who claim to have or have had silicone gel breast implants. Many of these cases involve multiple plaintiffs. In addition, there were 41 purported breast implant products liability class action lawsuits which had been filed against the Company as of January 20, 1994. It is anticipated that the Company will be named as a defendant in additional breast implant lawsuits in the future. The typical alleged factual bases for these lawsuits include allegations that the plaintiffs' breast implants caused specified ailments, including, among other things, autoimmune disease, scleroderma, systemic disorders, joint swelling and chronic fatigue. The Company is sometimes named as the manufacturer of silicone gel breast implants, and other times the Company is named as the supplier of silicone raw materials to other breast implant manufacturers. Although there are similarities among the cases, there are also differences which can significantly affect the cost of defending and disposing of each case, and many cases are at such a preliminary stage that the Company has not yet been able to obtain information relevant to the evaluation of each case. For these reasons, the amounts involved in prior dispositions of breast implant cases are not necessarily indicative of the amounts that may be required to dispose of such cases in the future. The Company is vigorously defending this litigation asserting, among other defenses, that there is no causal connection between silicone breast implants and the ailments alleged by the plaintiffs in these cases. During 1992 and 1993, consolidation of a substantial number of breast implant lawsuits for pretrial purposes occurred in federal court (U.S. District Court for the Northern District of Alabama) and various state courts where a substantial number of breast implant lawsuits have been filed. As of December 31, 1993, substantially more than half of all breast implant cases have been consolidated for pretrial purposes at the federal and state levels. Discovery is proceeding under the supervision of the courts. The Company anticipates that current and future breast implant lawsuit consolidations will result in a reduction of per case litigation defense costs. On September 9, 1993, the Company announced that representatives of plaintiffs and defendants involved with silicone breast implant litigation have developed a "Statement of Principles for Global Resolution of Breast Implant Claims" (the "Statement of Principles"). The Statement of Principles summarizes a proposed claims based structured resolution of claims arising out of breast implants which have been or could be asserted against various implant manufacturers, suppliers, physicians and hospitals (the "Proposed Settlement"). The Statement of Principles does not constitute an agreement and a number of issues remain to be resolved before a tentative settlement agreement can be reached. A number of specifics of settlement concepts contained in the Statement of Principles continue to be undefined and many uncertainties remain. Various steps must be completed before a settlement can be implemented, including review and support of the Proposed Settlement by the boards of directors, managements and insurance carriers of Funding Participants (as defined below) and review and acceptance of the Proposed Settlement by breast implant plaintiffs and their counsel. In addition, a court supervised fairness review process of the Proposed Settlement must be completed before a final agreement can be implemented. The timetable for the completion of this process is currently undetermined. Once a final agreement is approved by the court, claims can then be validated and administered. NOTE 2 - CONTINGENCIES (Continued) - ---------------------- Under the Proposed Settlement, if implemented, industry participants (the "Funding Participants") would contribute up to $4.75 billion over a period of thirty years to establish several special purpose funds. The specific participants and their respective contributions to this fund are currently under negotiation. The Proposed Settlement, if implemented, would be a claims based structured resolution of claims arising out of silicone breast implants, and would define the circumstances under which payments from the funds would be made. The Proposed Settlement includes provisions for (a) class membership and the ability of plaintiffs to opt out of the class, (b) the establishment of defined funds for medical diagnostic/evaluation procedures, explantation, ruptures, compensation for specific diseases and administration, (c) payment terms and timing and (d) claims administration. The Proposed Settlement defines periods during which breast implant plaintiffs may elect not to settle their claims by way of the Proposed Settlement and continue their individual breast implant litigation against manufacturers and other defendants (the "Opt Out Plaintiffs"). In certain circumstances, if any defendant who is a Funding Participant considers the number of Opt Out Plaintiffs maintaining lawsuits against such defendant to be excessive, such defendant may decide to exercise the option to withdraw from participation in the Proposed Settlement. Management believes that a settlement incorporating concepts underlying the Statement of Principles would be a responsible and cost efficient approach to resolving breast implant litigation against the Company. Management continues to evaluate the Proposed Settlement in that light and believes that it would be viable if, among other things, (a) an acceptable agreement as to allocation of liability under the Proposed Settlement among Funding Participants can be reached, (b) adequate insurance support is provided to Funding Participants by their insurance carriers and (c) substantially all plaintiffs participate in the settlement. The Company continues to negotiate with other potential parties to the Proposed Settlement to reach a tentative settlement agreement similar in concept to the Statement of Principles. Since the announcement of the Statement of Principles, the Company has participated in negotiations with other key Funding Participants to reach an agreement regarding, among other things, the respective contribution of each of these Funding Participants to the settlement fund. These negotiations are currently ongoing and have progressed to a point where the Company believes it has sufficient information to estimate its potential liability for breast implant litigation. Notwithstanding the limited information available regarding most of the claims asserted against the Company and the uncertainties related to the eventual resolution of these claims, the Company has made efforts in the past to reflect anticipated financial consequences to the Company of the breast implant situation. In December 1991, the Company recorded a $25.0 pretax charge associated with the breast implant business to cover implant inventories, dedicated equipment and costs associated with confirming the safety of the product. In the first quarter of 1992, the Company recorded $24.0 of pretax costs related to silicone gel breast implant litigation, claims and related matters. In the second quarter of 1992, the Company recorded a $45.0 pretax charge associated with its discontinued breast implant products. This charge represented management's best estimate at the time of future costs for ongoing research associated with breast implants; continued communication with patients, the medical community and other interested parties; the retrieval of breast implant inventories from the Company's medical customers; and various legal defense matters. NOTE 2 - CONTINGENCIES (Continued) - ---------------------- Based on information developed in settlement negotiations, on January 14, 1994, the Company announced a pretax charge of $640.0 for the fourth quarter of 1993. This charge included the Company's best current estimate of its potential liability for breast implant litigation based on current settlement negotiations, and also included provisions for legal, administrative, and research costs related to breast implants, for a total of $1.24 billion, less expected insurance recoveries of $600.0. The amounts recorded by the Company for the estimated cost of settling breast implant litigation and claims and anticipated insurance reimbursements were determined on a present-value basis using a discount rate of 7.0% over a period of more than 30 years. The estimated liability of $1.24 billion as described above is approximately $2.3 billion on an undiscounted basis. The expected insurance recovery of $600.0 as described above is approximately $1.2 billion on an undiscounted basis. The estimated liability of $1.24 billion described above has been combined with reserves of $18.7 remaining from breast implant related charges recorded prior to 1993. This total liability amount is shown opposite the captions "Implant Reserves" in the accompanying balance sheet. The receivable of $600.0 described above has been combined with a receivable of $63.7 which represents breast implant related payments made prior to December 31, 1993, for which recovery through insurance is anticipated. This receivable is shown opposite the caption "Implant Insurance Receivable" in the accompanying balance sheet. The Company believes that a substantial portion of the indemnity, settlement and defense costs related to breast implant lawsuits and claims will be covered by the Company's products liability insurance subject to deductibles, exclusions, retentions and policy limits. The Company's insurers have reserved and may reserve the right to deny coverage, in whole or in part, due to differing theories regarding, among other things, the applicability of coverage and when coverage may attach. Also, a number of the breast implant lawsuits pending against the Company request punitive damages and compensatory damages arising out of alleged intentional torts. Depending on policy language, applicable law and agreements with carriers, any damages which may be awarded pursuant to such lawsuits may or may not be covered, in whole or in part, by insurance. As of December 31, 1993, the Company had a substantial amount of unexhausted claims-made insurance coverage with respect to lawsuits and claims commencing 1986 and thereafter. For lawsuits and claims involving implant dates prior to 1986, the Company believes substantial coverage exists under a number of primary and excess occurrence policies having various limits. Because the defense and disposition of particular breast implant lawsuits and claims may be covered, in whole or in part, both by the claims-made coverage issued from and after 1986, and one or more of the occurrence policies issued prior to 1986, determination of aggregate insurance coverage depends on, among other things, how defense and indemnity costs are allocated among the various policy periods. Discussions among the Company and its primary insurance carriers have occurred and are continuing with a view toward reaching an agreement as to the allocation of costs of breast implant litigation among the various insurance carriers issuing products liability insurance policies to the Company relative to breast implants and other products. The Company became dissatisfied with the progress being made toward reaching such an agreement. Consequently, the Company commenced a lawsuit against certain of these insurance carriers seeking, among other things, a judicial enforcement of the obligations of the insurance carriers under certain of these insurance policies (for additional information regarding this lawsuit, see Legal Proceedings, Part I, Item 3). Management continues to believe that it is probable that the Company NOTE 2 - CONTINGENCIES (Continued) - ---------------------- will recover from its insurance carriers a substantial amount of breast implant related payments which have been or may be made by the Company. In reaching this belief, the Company has analyzed its insurance policies, considered its history of coverage and insurance reimbursement for these types of claims, and consulted with knowledgeable third parties with significant experience in insurance coverage matters. The amount recorded by the Company as an insurance receivable is substantially less than the amount for which the Company would seek reimbursement if a settlement proceeds. Management believes that the Company will generate the financial liquidity required to meet ongoing operational needs and to participate in the settlement currently being negotiated. This belief is based on, among other things, management's estimate of future operational cash flows, its assessment that recovery of substantial amounts of settlement obligations from its insurance carriers is probable, and its evaluation of current financing arrangements. The Implant Reserves less the Implant Insurance Receivable reflects management's best current estimate of the cost of ultimate resolution of breast implant litigation. As breast implant litigation settlement negotiations continue, additional circumstances may develop which could affect the reliability and precision of the current estimate. Those circumstances include, among other things, development of additional information regarding the allocation of settlement payments among the Funding Participants, any revisions to the timing of those payments, the number and extent of claims not covered by a settlement, the amount and timing of insurance recoveries and the allocation of insurance payments among the Company's insurance carriers, and the possibility of resolution of the litigation through alternatives to a settlement of the type currently proposed. As additional facts and circumstances develop, the estimate may be revised, or provisions may be necessary to reflect any additional costs of resolving breast implant litigation and claims not covered by a settlement. Future charges resulting from any revisions or provisions, if required, could have a material adverse effect on Dow Corning's financial position or results of operations in the period or periods in which such charges are recorded. Environmental Matters - --------------------- The Company has been advised by the United States Environmental Protection Agency (EPA) that the Company, together with others, is a Potentially Responsible Party (PRP) with respect to a portion of the cleanup costs and other related matters involving a number of abandoned hazardous waste disposal facilities. Management believes that there are 12 sites at which the Company may have some liability, although management currently expects to settle the Company's liability for a majority of these sites for de minimis amounts. Based upon preliminary estimates by the EPA or the PRP groups formed with respect to these sites, the aggregate liabilities for all PRPs at these sites at which management currently believes the Company may have more than the de minimis liability is $33.0. Management cannot currently estimate the aggregate liability for all PRPs at those sites at which management expects the Company has a de minimis liability. NOTE 2 - CONTINGENCIES (Continued) - ---------------------- The Company records a charge to earnings for sites when it is probable that a liability has been incurred and the Company's costs can be reasonably estimated. The Company has accrued for its estimated liabilities with respect to these sites; such accrual is substantially less than the estimated aggregate liability for all PRPs at these sites as it reflects the Company's estimated share of total remaining cleanup costs. While there are a number of uncertainties with respect to the Company's estimate of its ultimate liability for cleanup costs at these sites, it is the opinion of the Company that these matters will not materially adversely affect the Company's consolidated financial position or results of operations. This opinion is based upon the number of identified PRPs at each site, the number of such PRPs that are believed by management to be solvent, and the portion of waste sent to the sites for which management believes the Company might be held responsible based on available records. Receivables Sold - ---------------- The Company has sold certain receivables subject to recourse provisions. The Company has agreements in place whereby it may sell on an ongoing basis fractional ownership interests in a designated pool of U.S. trade receivables, with limited recourse, in amounts up to $65.0. As of December 31, 1993, the Company had no amounts outstanding under these agreements. The amount of receivables sold under these agreements which remained uncollected at December 31, 1992 was $49.0. In addition, another $63.2 and $25.1 of receivables had been sold at December 31, 1993 and 1992, respectively, under other agreements. During 1993 and 1992, net proceeds of approximately $74.7 and $73.5, respectively, were received upon the sale of receivables. DOW CORNING FIRE STOP(R) - ------------------------ In May, 1993, the Company began communicating additional information and test results to the owners of buildings which contain DOW CORNING FIRE STOP(R) Intumescent Wrap Strip 2002, recommending that the owners conduct a review with a qualified Fire Protection Engineer to determine whether remedial action is warranted, including possible replacement of the product due to uncertainty about its ability to perform consistently and predictably over time. DOW CORNING FIRE STOP(R) Intumescent Wrap Strip 2002 is a non-silicone, resin-based fire stop product which was installed in buildings as a passive fire protection product. The Company ceased the sale of this product in 1992. The potential liability associated with replacement of this product cannot be estimated at this time. However, management believes that the ultimate resolution of this issue will not have a material adverse effect on the Company's consolidated financial position or results of operations. NOTE 3 - SPECIAL ITEMS - ---------------------- Charges of $40.0 in 1992 relate to provisions for restructuring activities, consisting largely of costs associated with the cessation of manufacturing activities at a subsidiary in Brazil and costs involved in global expense reduction, including elimination of low-priority activities, redeployment of people and reduction in the value of affected facilities. Charges of $29.0 in 1991 represent provisions for costs of certain legal contract disputes and recognition of partial impairment in the value of certain foreign assets. NOTE 4 - SALE OF ASSETS AND ACQUISITIONS - ---------------------------------------- In June 1992, the Company announced its intent to offer for sale its medical device business, which principally included metal orthopedic implant devices and other specialty devices. Subsequent to that decision, management decided to retain most of the specialty device product lines and offer for sale principally the metal orthopedic device business. On July 1, 1993, the Company sold the metal orthopedic device assets for approximately $66.3 in cash. The Company's investment in assets was approximately $70.0, most of which represented current assets. The sale of the metal orthopedic device business did not have a material effect on the Company's consolidated net sales, financial position or results of operations. On July 14, 1992, the Company acquired ARA - Werk Kraemer GmbH (ARA), a German supplier of sealants, polyurethane foam products and related application tools. The purchase price included $18.9 of cash and $19.2 in notes to be paid within one year of the acquisition date. The acquisition was accounted for by the purchase method of accounting, and, accordingly, the purchase price has been allocated to the assets acquired and the liabilities assumed based on their estimated fair values at date of acquisition. The excess of purchase price over estimated fair values of the net assets acquired was $25.6 and has been recorded as goodwill, which will be amortized over 10 years. The operating results of ARA are included in the Company's consolidated results from the acquisition date. Consolidated net sales, net income and related per share amounts for the years ended December 31, 1992 and 1991, respectively, would not have been materially different had this acquisition taken place at the beginning of 1991. On November 2, 1992, the Company acquired for $12.8 an additional 40% interest in Lucky-DC Silicone Co., Ltd. (Lucky-DC), a company in which Dow Corning previously had held a 50.0% interest. In addition, under the terms of the agreement with the partner, Lucky Ltd., the Company will acquire for $3.2 the remaining 10% interest by November 1995, subject to the approval by the Government of South Korea. Consolidated net sales, net income and related per share amounts for the years ended December 31, 1992 and 1991, respectively, would not have been materially different had this acquisition taken place at the beginning of 1991. NOTE 5 - FOREIGN CURRENCY - ------------------------- Following is an analysis of the changes in the cumulative translation adjustment: 1993 1992 1991 ----- ----- ----- Balance, beginning of year $28.3 $66.2 $32.5 Translation adjustments and gains (losses) from certain hedges and intercompany balances (0.2) (37.5) 30.5 Income tax effect of current year activity 3.5 (0.4) 3.2 ----- ----- ----- Balance, end of year $31.6 $28.3 $66.2 ===== ===== ===== Net foreign currency gains (losses) currently recognized in income amounted to $(8.1) in 1993, $(35.2) in 1992, and $11.1 in 1991. In 1991, the Company changed functional currencies of certain subsidiary companies in Europe. This change did not materially impact the Company's consolidated financial position or results of operations. NOTE 6 - INVENTORIES - -------------------- Following is a summary of inventories by costing method at December 31: 1993 1992 ------ ------ Raw material, work-in-process and finished goods: Valued at LIFO $197.0 $224.9 Valued at FIFO 88.6 131.2 ------ ------ $285.6 $356.1 ====== ====== Under the dollar value LIFO method used by the Company, it is impracticable to separate inventory values by classifications. Inventories valued using LIFO at December 31, 1993 and 1992 are stated at approximately $70.9 and $96.1, respectively, less than they would have been if valued at replacement cost. Reduction in LIFO reserves in 1993 did not have a material impact on results of operations. In 1991, the Company changed its method of applying fixed costs to inventory by using actual production volumes as a basis for allocating these costs to inventory rather than practical capacity volumes. Management believes this change will result in a better matching of product costs with related sales in reported operating results. The $16.3 cumulative effect of the change on prior years, net of income taxes of $8.4, is included in net income for 1991. The change also increased inventories, net of an adjustment for LIFO valuation, by $24.7. Except for the cumulative effect, the change did not have a material effect on operating results for the periods presented. NOTE 7 - INVESTMENTS AND LOANS - ------------------------------ At December 31, 1993 and 1992, the carrying amounts for investments of $24.6 and $20.4, respectively, which excludes those investments accounted for on the equity basis, and loans of $10.0 and $15.0, respectively, approximate their fair value. Fair values are determined based on quoted market prices or, if quoted market prices are not available, on market prices of comparable instruments. Investments and loans are included in short-term investments and other assets in the accompanying consolidated balance sheets. NOTE 8 - NOTES PAYABLE AND CREDIT FACILITIES - -------------------------------------------- Notes payable at December 31 consisted of: 1993 1992 ------ ------ Revolving Credit Agreement $150.0 $100.0 Other bank borrowings 83.7 60.0 ------ ------ $233.7 $160.0 ====== ====== NOTE 8 - NOTES PAYABLE AND CREDIT FACILITIES (Continued) - -------------------------------------------- During 1993, the Company terminated a revolving credit agreement which was in place at December 31, 1992, and replaced it with a Revolving Credit Agreement with 16 domestic and foreign banks which provides for borrowings on a revolving credit basis until November, 1997, of up to $400.0. The Company also has agreements with several other banks whereby it may borrow up to $269.5 under short-term lines of credit. The Company pays a fixed service fee for certain of these facilities in lieu of any compensating cash balances. Included in other bank borrowings are amounts outstanding under these other facilities at December 31, 1993 and 1992 of $83.7 and $34.4, respectively. The carrying amounts of the Company's short-term borrowings approximate their fair value. Various debt agreements, the Revolving Credit Agreement included, contain various debt restrictions and provisions relating to property liens, sale and leaseback transactions, debt to tangible capital ratio, and funds flow. In addition, the Revolving Credit Agreement provides creditors the right, subject to a majority vote, to demand payment in the event that uninsured breast implant litigation expenditures and judgments exceed certain limits. A settlement agreement of the type currently being negotiated (as described in Note 2 of Notes to Consolidated Financial Statements) would likely exceed these limits. At December 31, 1993, the Company was in compliance with all debt restrictions and provisions. Under the provisions of the Revolving Credit Agreement, the Company is subject to certain restrictions as to the payment of dividends. The amount of the restriction is based on a formula which considers, among other things, the income before income taxes for the most recent fiscal year. Based on the computation completed for the year ended December 31, 1993, the Company is restricted from issuing dividends in 1994. NOTE 9 - LONG-TERM DEBT - ----------------------- Long-term debt at December 31 consisted of: 1993 1992 ------ ------ 9.625% Sinking Fund Debentures due 2005 $ 4.8 $ 4.8 9.375% Debentures due 2008 75.0 75.0 8.15% Debentures due 2029 50.0 50.0 7.61%-9.50% Medium-term Notes due 1994-2001, 8.68% average rate at December 31, 1993 54.5 80.0 5.76% Term Loans, maturing serially 1994-1999 32.1 37.2 Variable-rate Notes due 1994-1998, 5.39% at December 31, 1993 55.2 35.0 Variable-rate Note, maturing serially 1997-1999, 4.1% at December 31, 1993 20.0 - 3.58%-6.50% Japanese yen Notes due 1994-1998 33.4 33.2 Other obligations due 1994-2001 23.2 20.5 ------ ------ 348.2 335.7 Less - Payments due within one year 33.5 37.7 ------ ------ $314.7 $298.0 ====== ====== NOTE 9 - LONG-TERM DEBT (Continued) - ----------------------- The fair value of the Company's long-term debt was approximately $45.0 higher than book value at December 31, 1993 and $38.0 higher than book value at December 31, 1992. The fair value was based largely on interest rates offered on U.S. Treasury obligations with comparable maturities using discounted cash flow analysis. These rates were not adjusted to reflect the premium that the Company might pay over U.S. Treasury rates. A one percentage point increase in these rates would decrease the fair value by approximately $15.0. The Company has $400.0 of debt securities registered with the Securities and Exchange Commission at December 31, 1993, of which $275.0 had been designated to medium-term note programs and another $125.0 had been issued in debentures. At December 31, 1993, $100.0 had been issued under the medium-term note programs, of which $54.5 was still outstanding. The 9.625% debentures, which mature in 2005, require the Company to make annual sinking fund payments of not less than $2.5 nor more than $5.0 through 2004. The Company held $21.9 of these debentures for redemption requirements as of December 31, 1993. The 9.375% and 8.15% debentures are not redeemable by the Company prior to their maturity; however, the holders of the 8.15% debentures may elect to have all or a portion of their debentures repaid on October 15, 1996, at 100% of the principal amount. Aggregate annual maturities of long-term debt are: $33.5 in 1994, $47.9 in 1995, $24.2 in 1996, $23.4 in 1997, $60.7 in 1998 and $108.5 thereafter. Excluded from such maturities are $50.0 of 8.15% debentures, due in 2029, which are subject to early redemptions at the holders' option in 1996. Cash paid during the year for interest, net of amounts capitalized, was $31.8 in 1993, $20.8 in 1992, and $21.1 in 1991. NOTE 10 - INTEREST AND CURRENCY RATE DERIVATIVES - ------------------------------------------------ The Company utilizes a variety of financial instruments, several with off-balance sheet risks, in its management of current and future interest rate and foreign currency exposures. These financial instruments include interest rate and currency swaps, interest rate caps and floors, options and forward exchange contracts. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of these instruments are used to measure the volume of these agreements and do not represent exposure to credit loss. The notional amounts, book values and fair values of these instruments were: NOTE 10 - INTEREST AND CURRENCY RATE DERIVATIVES (Continued) - ------------------------------------------------ The Company enters into interest rate swaps to exchange fixed and variable rate interest payment obligations without the exchange of the underlying principal amounts in order to manage interest rate exposures. The Company also enters into interest rate caps, floors, and swaptions in order to transfer, modify, or reduce interest rate risk. These instruments are used to hedge the Company's debt portfolio and hedge accounting is used to recognize the differential to be paid or received as an adjustment to interest expense over the life of the agreements. At December 31, 1993, these instruments had a weighted average remaining life of 4.1 years. The Company enters into currency swaps and options and forward exchange contracts to hedge some of its foreign currency exposures. Gains and losses on these contracts are recognized concurrent with the transaction gains and losses from the associated exposures. At December 31, 1993, currency swaps and options had a weighted average remaining life of 2.4 years, and forward exchange contracts had a weighted average remaining life of less than one year. The fair values are estimated based on quoted market prices of comparable instruments adjusted through interpolation where necessary for maturity differences. The book values of these instruments approximate their fair values, except for interest rate instruments which were entered into for the purpose of changing the nature of underlying debt obligations. The risks involved with these instruments have been significantly mitigated by the Company entering into offsetting positions. In the event of default by a counterparty, the risk in these transactions is limited to the cost of replacing the instrument at current market rates. All transactions are with major banks and other substantial financial institutions. Although the Company may be exposed to losses in the event of nonperformance by counterparties and interest and currency rate movements, it does not anticipate significant losses due to these financial arrangements. NOTE 11 - POST EMPLOYMENT BENEFITS - ---------------------------------- The Company maintains defined benefit employee retirement plans covering most domestic and certain foreign employees. The Company also has various defined contribution and savings plans covering certain employees. Plan benefits for defined benefit employee retirement plans are based primarily on years of service and compensation. The Company's funding policy is consistent with national laws and regulations. Plan assets include marketable equity securities, insurance contracts, corporate and government debt securities, real estate and cash. The components of pension expense for the Company's domestic and foreign plans are set forth below. NOTE 11 - POST EMPLOYMENT BENEFITS (Continued) - ---------------------------------- The following table presents reconciliations of defined benefit plans' funded status with amounts recognized in the Company's consolidated balance sheets as part of other assets and other long-term liabilities. Plans with assets exceeding the accumulated benefit obligation (ABO) are segregated by column from plans with ABO exceeding assets. Assets exceed ABO for all domestic plans. The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation for defined benefit plans was 7.3% in 1993 and 8.2% in 1992. The weighted average rate of increase in future compensation levels was determined using an age specific salary scale and was 5.6% in 1993 and 5.7% in 1992. The weighted average expected long-term rate of return on plan assets was 8.6% in 1993 and 8.5% in 1992. In addition to providing pension benefits, the Company, primarily in the United States, provides certain health care and life insurance benefits for most retired employees. In 1992, the Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. The Company elected to immediately recognize the cumulative effect of the change in accounting for postretirement benefits of $176.9 ($116.8 net of income tax benefit) which represents the accumulated postretirement benefit obligation existing at January 1, 1992. In addition, the effect of adopting the new rules increased 1992 net periodic postretirement benefit cost by $17.4 ($11.5 net of income tax benefit). Prior to 1992, the cost of retiree health care and life insurance benefits was recognized as an expense as benefits were incurred. The cost of providing these benefits in the United States was $3.4 in 1991. The cost of providing these benefits to retirees outside the United States was not significant. Net periodic postretirement benefit cost includes the following components: NOTE 11 - POST EMPLOYMENT BENEFITS (Continued) - ---------------------------------- 1993 1992 ----- ----- Service cost $ 6.0 $ 6.6 Interest cost 10.3 15.6 Amortization of negative prior service cost (14.3) - ----- ----- $ 2.0 $22.2 ===== ===== The following table presents the plan's funded status reconciled with amounts recognized in the Company's consolidated balance sheets as part of other long-term liabilities: December 31, December 31, 1993 1992 ------------ ------------ Accumulated postretirement benefit obligation: Retirees $ 55.5 $ 49.1 Fully eligible, active plan participants 52.6 41.3 Other active plan participants 37.7 30.8 ----- ------ 145.8 121.2 Unrecognized negative prior service cost 61.5 76.2 Unrecognized net loss (16.8) (3.1) ----- ------ Accrued postretirement benefit cost $190.5 $194.3 ====== ====== In December 1992, the Company amended its retiree health care benefit plan to require that, beginning in 1994, employees have a certain number of years of service to be eligible for any retiree health care benefit. The retiree health care plan anticipates certain cost-sharing changes that will go into effect in 1995 which limit the annual increase in the Company's share of retiree health care costs. The Company continues to fund benefit costs on a pay-as-you-go basis with the retiree paying a portion of the costs. The health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 11.1% in 1993 and was assumed to decrease gradually to 5.75% in 2005 and remain at that level thereafter. For retirees under age 65, plan features limit the health care cost trend rate assumption to a maximum of 8% for years 1994 and later. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation by 13% and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by 11%. The discount rate used in determining the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 8.25% at December 31, 1992. NOTE 12 - RELATED PARTY TRANSACTIONS - ------------------------------------ The Company purchased raw materials and services totalling $39.4 in 1993, $43.5 in 1992, and $44.4 in 1991 from The Dow Chemical Company and its affiliates. The Company believes that the costs of such purchases were competitive with alternative sources of supply. Other transactions between the Company and related parties were not material. NOTE 13 - INCOME TAXES - ---------------------- The components of income (loss) before income taxes are as follows: 1993 1992 1991 -------- ------- ------ U.S. companies $(516.7) $(20.8) $115.4 Non-U.S. companies 94.7 70.8 93.6 ------- ------ ------ $(422.0) $ 50.0 $209.0 ======= ====== ====== The components of the income tax provision (benefit) are as follows: 1993 1992 1991 -------- ------- ------ Current U.S. federal $ 11.7 $ 2.2 $25.7 U.S. state 2.6 2.5 6.3 Non-U.S. 37.9 59.9 56.6 ------- ----- ----- 52.2 64.6 88.6 ------- ----- ----- Deferred U.S. federal (205.4) (26.7) (16.1) Non-U.S. 2.3 (27.8) (14.2) ------- ----- ----- (203.1) (54.5) (30.3) ------- ----- ----- $(150.9) $10.1 $58.3 ======= ===== ===== The tax effects of the principal temporary differences giving rise to deferred tax assets and liabilities were as follows: December 31, December 31, 1993 1992 ------------ ------------ Implant costs $225.0 $ 15.7 Accrued expenses 62.8 45.8 Postretirement health care and life insurance 63.0 66.0 Basis in inventories 24.8 25.3 Tax credit and net operating loss carry forwards 5.6 22.7 Other 20.9 17.5 ------ ----- 402.1 193.0 Valuation allowance (3.5) (3.5) ------ ----- 398.6 189.5 ------ ----- Property, plant and equipment (60.1) (64.3) Other (5.8) (4.2) ------ ----- (65.9) (68.5) ------ ----- Net deferred tax asset $332.7 $121.0 ====== ====== NOTE 13 - INCOME TAXES (Continued) - ---------------------- At December 31, 1993, income and remittance taxes have not been recorded on $198.7 of undistributed earnings of foreign subsidiaries, either because any taxes on dividends would be offset substantially by foreign tax credits or because the Company intends to indefinitely reinvest those earnings. Cash paid during the year for income taxes, net of refunds received, was $72.5 in 1993, $68.2 in 1992, and $90.9 in 1991. The effective rates of (35.8)% for 1993, 20.2% for 1992, and 27.9% for 1991 differ from the U.S. federal statutory income tax rate in effect during those years for the following reasons: Year ended December 31, 1993 1992 1991 ------ ------ ------ Statutory rate (35.0)% 34.0% 34.0% Foreign taxes, net 0.1 (16.4) (8.0) Foreign sales corporation (0.5) (1.9) (1.7) State income taxes 0.4 3.2 2.0 Other, net (0.8) 1.3 1.6 ----- ----- ---- Effective rate (35.8)% 20.2% 27.9% ===== ==== ==== In the first quarter of 1992, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, which requires an asset and liability approach in the measurement of deferred taxes. Financial statements prior to 1992 have not been restated for this change in accounting principle. The cumulative effect of adopting SFAS 109 as of January 1, 1992, increased 1992 net income by $16.4. Except for the cumulative effect, the change did not have a material effect on operating results for the periods presented. On August 11, 1993, the Revenue Reconciliation Act of 1993 was signed into law. The Act increased the U.S. corporate statutory tax rate from 34% to 35% for years beginning after December 31, 1992, changed the deductibility of certain expenses and extended certain tax credits. The effect of this retroactive increase in the statutory tax rate on 1993 earnings was offset by a gain from the revaluation of net deferred tax assets, and the net impact of these changes did not have a material impact on the Company's effective tax rate for 1993. NOTE 14 - COMMON STOCK - ---------------------- The outstanding shares of the Company's common stock are held in equal portions by Corning Incorporated and Dow Holdings Inc., a wholly-owned subsidiary of The Dow Chemical Company. There were no changes in outstanding shares during 1993, 1992 or 1991. NOTE 15 - COMMITMENTS AND GUARANTEES - ------------------------------------ The Company leases certain real and personal property under agreements which generally require the Company to pay for maintenance, insurance and taxes. Rental expense was $46.2 in 1993, $48.4 in 1992, and $46.9 in 1991. The minimum future rental payments required under noncancellable operating leases at December 31, 1993, in the aggregate are $129.2, including the following amounts due in each of the next five years: 1994 - $33.8, 1995 - $24.4, 1996 - $17.1, 1997 - $15.0, and 1998 - $12.8. At December 31, 1993, the Company had issued financial guarantees with off-balance sheet risk, which total approximately $11.1. These guarantees are issued primarily to support employee housing programs. The Company believes it will not have to perform under these agreements as the likelihood of default by the primary parties is remote. NOTE 16 - INDUSTRY SEGMENT AND FOREIGN OPERATIONS - ------------------------------------------------- The Company's operations are classified as a single industry segment. Financial data by geographic area are presented below: 1993 1992 1991 -------- -------- -------- Net sales to customers: United States $ 830.6 $ 822.6 $ 797.8 Europe 490.9 528.7 476.8 Asia 619.9 500.8 467.4 Other 102.3 103.6 103.4 -------- -------- -------- Net sales $2,043.7 $1,955.7 $1,845.4 ======== ======== ======== Interarea sales: United States $ 219.6 $ 228.3 $ 224.7 Europe 54.7 45.1 42.7 Asia 34.7 25.2 23.6 Other 0.3 1.9 0.6 -------- -------- -------- Total interarea sales $ 309.3 $ 300.5 $ 291.6 ======== ======== ======== Operating profit: United States $ 187.5 $ 143.7 $ 185.6 Europe 57.8 38.1 56.5 Asia 73.3 74.0 70.8 Other and eliminations 7.4 (2.4) 12.5 -------- -------- -------- 326.0 253.4 325.4 General corporate expenses (722.1) (163.4) (116.6) Unallocated income (expense), net (25.9) (40.0) 0.2 -------- -------- -------- Income before income taxes $ (422.0) $ 50.0 $ 209.0 ======== ======== ======== Identifiable assets: United States $1,525.8 $1,297.8 $1,271.4 Europe 460.3 488.9 510.6 Asia 586.2 507.7 466.9 Other and eliminations (253.4) (199.7) (204.2) -------- -------- -------- 2,318.9 2,094.7 2,044.7 Corporate assets 943.4 96.0 75.2 -------- -------- -------- Total assets $3,262.3 $2,190.7 $2,119.9 ======== ======== ======== Interarea sales are made on the basis of arm's length pricing. Operating profit is total sales less certain operating expenses. Special items have been identified principally with the United States and Europe in computing operating profit for each area. General corporate expenses, equity in earnings of associated companies, interest income and expense, certain currency gains (losses), minority interests' share in income, and income taxes have not been reflected in computing operating profit. General corporate expenses include certain research and development costs, corporate administrative personnel and facilities costs not specifically identified with a geographic area, and implant costs. Identifiable assets are those operating assets identified with the operations in each geographic area. Corporate assets are principally cash and cash equivalents, short-term investments, intangible assets, investments accounted for on the equity basis, corporate facilities and implant insurance receivable. DOW CORNING CORPORATION ----------------------- SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION ------------------------------------------------------- YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 -------------------------------------------- (in millions of dollars) Charged to operating costs and expenses for year ended December 31, ------------------------------------ 1993 1992 1991 ---- ---- ---- Depreciation and amortization $197.1 $190.6 $171.5 Maintenance and repairs 88.6 91.3 82.9 Advertising costs 11.7 14.0 15.6 DOW CORNING CORPORATION ----------------------- EXHIBIT INDEX ------------- These exhibits are numbered in accordance with Exhibit Table I of Item 601 of Regulation S-K Exhibit # Description Page Number --------- ----------- ----------- 3.1 Restated Articles of Incorporation 53 of Dow Corning Corporation dated March 25, 1988 3.2 By-Laws of Dow Corning Corporation dated June 25, 1993 66 4 Dow Corning Corporation agrees to furnish the Securities and Exchange Commission upon its request a copy of any instrument which defines the rights of holders of long-term debt of the registrant and all of its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed. 12 Computation of ratio of earnings to fixed charges 102 21 Subsidiaries of the Registrant -- has been omitted in accordance with provisions of General Instruction J of Form 10-K. 23 Consent of Price Waterhouse 103

34879_1993.txt

34879_1993

1993

34879

ITEM 1. BUSINESS Overview - - - -------- Federal-Mogul Corporation (which together with its consolidated subsidiaries is referred to herein as "Federal-Mogul", the "Company" or "Registrant") is a global distributor and manufacturer of a broad range of non-discretionary parts, primarily vehicular components for automobiles, light trucks, heavy duty trucks and farm and construction vehicles and industrial products. Through the Company's worldwide distribution network, Federal-Mogul sells replacement parts in the vehicular aftermarket ("Aftermarket" products). The Company also sells parts to original equipment manufacturers ("OE" products), principally the major automotive manufacturers in the United States and Europe. The Company was incorporated in 1924 under Michigan law to carry on a business begun in 1900. The Company's executive offices are located at 26555 Northwestern Highway, Southfield, Michigan 48034, telephone (810) 354-7700. Vehicular components sold by Federal-Mogul include ball and roller bearings, suspension and steering parts, engine and transmission products, sealing devices, fuel pumps and related systems, and lighting and electrical components. Industrial products sold by the Company include ball and roller bearings, sealing products, and specialized heavy duty fluid-film bearings. Federal-Mogul also manufactures heavy wall bearings and precision forged powdered metal parts. Sales of these products account for the balance of the Company's sales. The following table sets forth the Company's net sales by market segment and geographic region as a percentage of total net sales. Year Ended December 31, -------------------------------------------- 1993 1993 1992 1992 1991 Pro Actual Pro Actual Actual Forma Forma (1) (2) Aftermarket U.S. and Canada. 48% 43% 44% 36% 34% International 18 20 19 19 19 Original Equipment U.S. and Canada 21 23 20 24 23 International 8 8 10 13 13 Other (3) U.S. and Canada 3 3 4 4 6 International 2 3 3 4 4 100% 100% 100% 100% 100% (1) Pro forma for the acquisition of SPX Corporation's automotive aftermarket business ("SPR") in October 1993 as if such acquisition had occurred in January 1, 1993. (2) Pro forma for the acquisition of TRW's automotive aftermarket business ("AAB") in October 1992 as if such acquisition had occurred on January 1, 1992. (3) Sales of these products -- air bearing spindles, heavy wall bearings, and precision forged powdered metal parts -- are accounted for by the Company primarily as OE sales for financial reporting purposes. The Company's air bearing spindles operation was sold in May 1993. Recent Acquisitions - - - ------------------- In line with the Company's strategy to emphasize Aftermarket product sales, the Company recently acquired two distributors of automotive Aftermarket products. The Company acquired AAB in October 1992 for approximately $220 million, and SPR in October 1993 for approximately $140 million (collectively, the "Acquisitions"). Primarily as a result of the Acquisitions, Federal-Mogul increased its Aftermarket combined net sales as a percentage of new sales from 53% in 1991 to 66% for 1993 on a pro forma basis as if SPR had been acquired on January 1, 1993. The Acquisitions have enabled the Company to increase its presence as a distributor of Aftermarket products in North America and Europe, broaden its customer base, increase its product offerings and realize substantial cost savings. SPR Acquisition. SPR, which had 1992 net sales of $163 million, is a distributor of engine and chassis components to the North American aftermarket. The Company believes that the primary strategic benefits of the acquisition of SPR (the "SPR Acquisition") include: Increased Customer Base -- The addition of SPR's customers has increased the Company's customer base. For example, SPR is a major distributor of components to machine shops, a distribution channel in which Federal-Mogul previously did not have a significant presence. Expanded Parts Coverage -- SPR is a major distributor of replacement parts for heavy truck, agricultural and construction equipment vehicles. Prior to the SPR Acquisition, Federal-Mogul had not been a major distributor of parts for these vehicles, the market for which currently represents a significant portion of worldwide replacement parts sales. As result of the SPR Acquisition, the Company is able to offer, for the first time, a complete set of agricultural and heavy truck engine parts in the form of an engine kit. Consolidation of Distribution Systems -- The Company expects to achieve significant cost savings through the consolidation of the distribution systems of the two companies. Federal-Mogul and SPR have duplicate warehouse locations in 34 of the 36 cities served by the two companies in the United States and Canada. The Company intends to combine all of the overlapping facilities in these cities by early 1995. AAB Acquisition. In October 1992, the Company acquired from TRW Inc. the assets of AAB for approximately $220 million (the "AAB Acquisition"). AAB distributed a full line of suspension and steering parts and engine components to the vehicular Aftermarket in North, Central and South America as well as in Europe, Africa and the Middle East. Since the date of the AAB Acquisition, Federal-Mogul has completed the consolidation of the operations of the businesses. The Company believes that it will meet or exceed its projected total annual savings of approximately $21 million during and after 1995, with approximately $15 million of these savings having been realized during 1993 and approximately $20 million to be realized during 1994. Aftermarket - - - ----------- The Company supplies a wide variety of Aftermarket products, including engine and transmission products (engine bearings, pistons, piston rings, valves, camshafts, valve lifters, valvetrain parts, timing components and engine kits, bushings and washers), ball and roller bearings, sealing devices (gaskets and oil seals and other high performance specialty seals), lighting and electrical components, and automotive fuel pumps, water pumps, oil pumps and related systems. The Company also sells steering and suspension parts which include such items as tie rod ends, ball joints, idler and pitman arms, center links, constant velocity parts, rack and pinion assemblies, coil springs, U-joints, engine mounts and alignment products. Federal-Mogul sells Aftermarket products under its own brand names, under brand names for which it has long term licenses such as TRW and Sealed Power, and also packages its products under third-party private brand labels such as NAPA and CARQUEST. The Company's Aftermarket business supplies approximately 150,000 part numbers to almost 10,000 customers, including more than 2,000 customers in North America and Europe added as a result of the Acquisitions. Federal-Mogul's customers are located in more than 90 countries around the world. For 1993, Aftermarket net sales in the United States and Canada represented 69% of total Aftermarket net sales, with net sales outside of the United States and Canada representing 31% of such sales. On a pro forma basis as if the SPR Acquisition had occurred on January 1, 1993, Aftermarket combined net sales in the United States and Canada represented 72% of total Aftermarket combined net sales for 1993. Domestic customers include industrial bearing distributors, distributors of heavy duty vehicular parts, machine shops, retail parts stores and independent warehouse distributors who redistribute products to local parts suppliers called jobbers. Internationally, the Company sells Aftermarket products to jobbers, local retail parts stores and independent warehouse distributors. Aftermarket sales to jobbers and local retail parts stores comprise a larger proportion of total international Aftermarket sales than of total domestic Aftermarket sales. Federal-Mogul's distribution centers in Jacksonville, Alabama; LaGrange, Indiana; Olive Branch, Tennessee; and Maysville, Kentucky (the "Distribution Centers") serve as the hub of the Company's domestic Aftermarket distribution network. Products are shipped from the Distribution Centers to North America service centers. For international sales, products are shipped through a facility in Port Everglades, Florida to seven international regional distribution centers and six Latin American branches. The Distribution Centers apply sophisticated computer technology which allows the Company to better manage its inventory and respond to customer needs. Techniques such as the Company's Reduced Inventory Management System, which was implemented in the fall of 1990, allow customers to reduce their inventories by providing them with the ability to order smaller quantities of products more frequently. This allows customers to increase their return on inventory investment. Original Equipment - - - ------------------ Federal-Mogul supplies original equipment ("OE") customers with a wide variety of parts under a number of well-established brand names, including Federal-Mogul and Glyco engine bearings, National and Mather oil seals, BCA ball bearings, Carter fuel systems and Signal-Stat and Switches electrical components. The Company manufacturers all of the OE products it sells. Customers consist primarily of automotive, heavy duty vehicle and farm and industrial equipment manufacturers. In 1993, pproximately 16% of the Company's net sales were to the three major automotive manufacturers in the United States, with General Motors Corporation ("GM") accounting for approximately 9% of the Company's net sales, Ford Motor Company accounting for approximately 5% of the Company's net sales and Chrysler Corporation accounting for approximately 2% of net sales. In addition, the Company sells OE products to most of the major automotive manufacturers headquartered outside the United States. The Glyco facility in Germany sells OE products to Volkswagen, Daimler-Benz and BMW. The Company also sells Federal-Mogul engine bearings to Renault and Peugeot in France and to Fiat in Italy. In addition, the Company sells a small amount of OE products to certain Japanese manufacturers, including Nissan-Mexico and certain Toyota operations in the United States. Recently, the Company began exporting oil seals to Komatsu in Japan for heavy duty diesel engines. The remaining net sales in 1993 were divided among almost 10,000 customers. Manufactured Products - - - ---------------------- The Company manufactures the following vehicular and industrial components: Engine and Transmission Products -- The Company manufactures engine bearings and other engine and transmission products, including pistons, bushings and washers. Bimetallic engine bearings, bushings and washers are used in automotive, truck, industrial, construction and farm equipment applications. These products are marketed under the brand names of Federal- Mogul, Glyco and Sterling. Ball Bearings -- The Company manufactures ball bearings for use chiefly in farm and construction equipment, trucks, automobiles and some industrial machinery under the brand name BCA. The Company also produces clutch and other specialty type precision ball bearings. Sealing Devices -- The Company manufactures a line of sealing products consisting of oil seals and other specialty seals, including oil bath seals and high performance sealing products. Sealing products are used in the automotive, truck, farm and off-highway construction equipment markets. Sealing devices are also supplied for aircraft, marine, stationary machinery and fuel power equipment. These products are marketed under the brand names of Bruss, Mather, and National. Lighting and Electrical Products -- The Company manufactures lighting and safety components for heavy duty truck applications, and electrical switches, controls and assemblies for vehicular applications. These products are marketed under the brand names of Switches and Signal Stat. The Company focuses on the heavy duty truck market segment where strict government regulations require that all lighting and electrical systems be operational at all times. Fuel Systems -- The Company manufactures a full line of automotive fuel pumps and related systems under the Carter brand name. Other Business - - - -------------- The Company also manufactures: Heavy Wall Bearings -- Braunschweiger Huttenwerk GmbH ("BHW"), an indirect, wholly-owned German subsidiary of the Company, manufacturers heavy wall bearings used primarily for large diesel engines in ships and stationary power plants. The Company also manufactures heavy wall bearings at facilities in Indiana and Brazil. Precision Forged Powdered Metal Parts -- The Company manufactures intricate component parts from compressed metal powders. These parts are used in applications requiring high fatigue strength, such as clutch races for automatic transmissions, engine connecting rods, and engine camshaft lobes. Suppliers - - - --------- Federal-Mogul sells Aftermarket parts manufactured by other manufacturers as well as those produced by the Company and its subsidiaries. The products not manufactured by Federal-Mogul are supplied by over 600 companies. In 1993, no outside supplier of the Company provided products which accounted for more than 10% of the Company's net sales. In connection with the acquisition of AAB, the Company and TRW entered into a Supply Agreement for an initial term of 15 years (the "Supply Period") pursuant to which TRW has agreed to supply to the Company parts manufactured by TRW and distributed by the Company. For the first five years of the Supply Period (the "Exclusive Period"), the Company will be an exclusive distributor of such TRW parts and thereafter will be a nonexclusive distributor for the remaining term of the Supply Agreement, subject to certain exceptions. Both the Exclusive Period and the Supply Period are automatically renewable for one-year periods thereafter, terminable on one year's notice by either party. Employee Relations - - - ------------------ On January 1, 1994, the Company had approximately 14,400 full-time employees of whom 8,800 were employed in the United States. Approximately 55% of the Company's U.S. employees are represented by one of four unions. Approximately 55% of the Company's foreign employees are represented by various unions. Each manufacturing facility of the Company has its own contract with differing expiration dates so no contract expiration date affects more than one facility. The Company believes its labor relations to be good. Research and Development - - - ------------------------- The Company is actively engaged in research and developments to improve existing products and manufacturing processes and to design and develop new products and materials. The development of superior quality control systems is a major focus as well. Each of the Company's operating units is engaged in various engineering and research and development efforts. These efforts are conducted primarily at the Company's four major research centers as well as at several manufacturing locations. Total expenditures for research and development activities were approximately $17.2 million in 1993, $18.2 million in 1992 and $20.3 million in 1991. The reduced research and development expenditures between 1991 and 1993 were in large part due to reduced spending at the Company's Glyco operation in Germany. Environmental Regulations - - - -------------------------- The Company's operations, in common with those of industry generally, are subject to numerous existing and proposed laws and governmental regulations designed to protect the environment, particularly regarding plant wastes and emissions and solid waste disposal. Capital expenditures for property, plant and equipment for environment control activities were not material during 1993 and are not expected to be material in 1994 or 1995. Raw Materials - - - ------------- The Company does not normally experience supply shortages of raw materials. Although shortages may occur occasionally, the Company generally buys from many reliable long-term suppliers and purchases most raw material, purchased parts, components and assemblies from multiple sources. Backlog - - - ------- The majority of the Company's products are not on a backlog status. They are produced from readily available materials and have a relatively short manufacturing cycle. For products supplied by outside suppliers, the Company generally purchases products from more than one source. The Company expects to be capable of handling the anticipated 1994 sales volumes. Patents and Licenses - - - --------------------- The Company has a large number of patents which relate to a wide variety of products and processes, and has pending a substantial number of patent applications. While in the aggregate its patents are of material importance to its business, the Company 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 the business as a whole. Competition - - - ------------ The global vehicular parts business is highly competitive. The Company competes with many of its customers that produce their own components as well as independent manufacturers and distributors of component parts in the United States and abroad. In general, competition for such sales is based on price, product quality, customer service and the breadth of products offered by a given supplier. The Company has attempted to meet these competitive challenges through more efficiently integrating its manufacturing and distribution operations, expanding its product coverage within its core businesses, and expanding its worldwide distribution network. Information About International and Domestic Operations and Export Sales ------------------------------------------------------- The Company has both manufacturing and distribution facilities for its products, principally in the United States, Europe, Latin America, Mexico and Canada. Certain of these products, primarily engine bearings and oil seals, are sold to international original equipment manufacturers and vehicular aftermarket customers. International operations are subject to certain risks inherent in carrying on business abroad, including expropriation and nationalization, currency exchange rate fluctuations and currency controls, and export and import restrictions. The likelihood of such occurrences and their potential effect on the Company vary from country to country and are unpredictable. Aftermarket and original equipment sales by major geographical region were: 1993 1992 1991 (Millions of Dollars) -------------------------------- Aftermarket United States and Canada $ 683.8 $ 460.5 $ 377.4 International 309.1 239.5 205.1 Original Equipment United States and Canada 408.5 357.0 319.9 International 174.1 207.0 196.3 Total Sales $1,575.5 $1,264.0 $1,098.7 Detailed results of operations by geographic area for each of the years ended December 31, 1993, 1992 and 1991 appear in Note 11 to the Consolidated Financial Statements contained in Item 8 of this Report. Executive Officers of the Registrant - - - ------------------------------------ Set forth below are the names, ages (at December 31, 1993), positions and offices held, and a brief account of the business experience during the past five years of each executive officer. D.J. Gormley (54) Chairman of the Board since May, 1990 and President and Chief Executive Officer since May 1989; Chief Operating Officer, February 1988 to May 1989; Executive Vice President, January 1986 to February 1988. Mr. Gormley first became an executive officer in 1980. G.N. Bashara, Jr. (59) Vice President, General Counsel and Secretary since April 1987. Mr. Bashara first became an executive officer in 1987. J.B. Carano (44) Vice President and Controller since December 1992; International Distribution Manager - Port Everglades, Florida, February 1990 to November 1992; Group Controller - Worldwide Aftermarket Operation January 1989 to February 1990. Mr. Carano first became an executive officer in 1992. D.J. Davis (42) Vice President of the Company and Vice President of Chassis Operations since December 1993; Vice President of Ball Bearing Products November 1992 to December 1993; General Manager Ball Bearing Products October 1991 to November 1992; General Manager, Lighting and Electrical Division November 1987 to October 1991. Mr. D. J. Davis first became an executive officer in 1993. J.O. Davis (45) Vice President, Distribution and Logistics, Worldwide Aftermarket Operation since December 1993; General Manager, Lighting and Electrical Division October 1992 to December 1993; Plant Manager, Lighting and Electrical Division January 1989 to October 1991. Mr. J. O. Davis first became an executive officer in 1993. J.M. Eastman (57) Vice President - Employee Relations since January 1980; Mr. Eastman first became an executive officer in 1980. R.F. Egan (47) Vice President of the Company and Vice President of Automotive Sales - Worldwide Aftermarket Operation since December 1993; Vice President of Automotive Sales - Worldwide Aftermarket Operation November 1992 to December 1993; National Sales Manager, Automotive Aftermarket - Worldwide Aftermarket Operation May 1985 to November 1992. Mr. Egan first became an executive officer in 1993. T.J. English (53) Vice President - Information Services since March 1989. Director of Information Services, November 1983 to March 1989; Mr. English first became an executive officer in 1989. C.B. Grant (49) Vice President - Corporate Development since December 1992; Vice President and Controller, May 1988 to December 1992. Mr. Grant first became an executive officer in 1985. S.G. Heim (41) Assistant Secretary and Associate General Counsel since May 1988; Associate Genera Counsel since June 1987; Ms. Heim first became an executive officer in 1988. A.C. Johnson (45) Vice President of the Company and Vice President of Powertrain Operations - Americas since December 1993; Vice President and General Manager of Seal Operations November 1992 to December 1993; General Manager, Oil Seals Operations January 1990 to November 1992; Manager, Worldwide Distribution Center August 1988 to January 1990. Mr. Johnson first became an executive officer in 1993. F.J. Musone (49) Vice President of the Company and President of Worldwide Manufacturing since November 1993; President of Chassis Products Operation January 1989 to November 1993; Vice President and General Manager - Federal-Mogul Service, January 1986 to January 1989. Mr. Musone first became an executive officer in 1986. W.A. Schmelzer (53) Vice President and Group Executive, Engine and Transmission Products - Europe since January 1992; General Manager, Engine and Transmission Products - America April 1987 to December 1991. Mr. Schmelzer first became an executive officer in 1992. W.G. Smith (44) Vice President of the Company and President of Worldwide Aftermarket Operation since January 1989; Vice President and General Manager - North American Aftermarket, February 1988 to January 1989; General Manager North American Aftermarket, August 1987 to February 1988. Mr. Smith first became an executive officer in 1988. M.J. Viola (39) Vice President and Treasurer since December 1992; Director of Corporate Finance, April 1992 to December 1992; Manager - Domestic Planning and Analysis, Chrysler Corporation, March 1991 to April 1992; Manager - Foreign Exchange and Financing Studies, Chrysler Corporation, January 1989 to March 1991; Manager - Corporate Financial Analysis, Chrysler Corporation March 1987 to January 1989. M.E. Welch III (45) Senior Vice President and Chief Financial Officer since December 1991; Assistant Treasurer, Chrysler Corporation, September 1988 to November 1991; General Auditor, Chrysler Corporation, July 1987 to September 1988. Chief Financial Officer, Chrysler Canada Ltd., March 1986 to July 1987. Mr. Welch joined Chrysler in 1982 as corporate accounting manager and served in positions of increasing responsibility in a wide range of areas including banking, audit and international finance, acquiring diverse and comprehensive experience in corporate financial operations. Mr. Welch first became an executive officer of the Company in December of 1991 when he left Chrysler to assume the position of Senior Vice President and Chief Financial Officer with the Company. J.J. Zamoyski (47) Vice President and General Manager Worldwide Aftermarket Operation International since November 1993; General Manager, Worldwide Aftermarket, Distribution and Logistics August 1991 to November 1993; Vice President and General Manager, Distribution and Logistics Operations, March 1990 to August 1991; Vice President - Corporate Development and Assistant Treasurer March 1989 to March 1990; Director of Corporate Development and Assistant Treasurer, May 1988 to March 1989; Mr. Zamoyski first became an executive officer in 1980. Generally, officers of the Company are elected at the time of the Annual Meeting of Shareholders but the Board also elects officers are various times during the year. Each officer holds office until his or her successor is elected or appointed or until his or her resignation or removal. ITEM 2. ITEM 2. PROPERTIES - - - ------------------- The Company conducts its business from its World Headquarters complex in Southfield, Michigan, which is leased pursuant to a sale-lease back arrangement. The principal manufacturing and other materially important physical properties of the Company at December 31, 1993 are listed below. All properties are owned in fee except where otherwise noted. A. Manufacturing Facilities. - - - ------------------------------- # Of Sq. Ft. North American Manufacturing Facilities Facilities @ 12/31/93 - - - --------------------------------------- ---------- ---------- Frankfort, Indiana 1 160,000 Greensburg, Indiana 1 204,845 Leiters Ford, Indiana 1 116,900 Lititz, Pennsylvania 1 275,000 Milan, Michigan 1 83,000 # Of Sq. Ft. North American Manufacturing Facilities Facilities @ 12/31/93 - - - --------------------------------------- ---------- ---------- Van Wert, Ohio 1 222,835 Blacksburg, Virginia 1 190,386 Gallipolis, Ohio 1 125,000 Greenville, Michigan 1 197,070 (2) Lafayette, Tennessee 1 110,400 Logansport, Indiana 1 161,000 (1) Malden, Missouri 1 120,000 Mooresville, Indiana 1 65,934 Plymouth, Michigan 1 15,000 Romulus, Michigan 1 170,000 St. Johns, Michigan 1 266,000 Puebla, Mexico 1 100,572 Juarez, Mexico 1 33,000 Mexico City, Mexico 1 72,210 Mexico City, Mexico 1 192,950 (1) Juarez, Mexico 1 33,000 Summerton, South Carolina 1 110,200 22 3,025,302 # Of Sq. Ft. International Manufacturing Facilities Facilities @ 12/31/93 - - - -------------------------------------- ---------- ---------- Braunschweiger, Germany 1 16,191 Cataguases/MG, Brazil 1 46,600 Cuorgne, Italy 1 114,930 Laplata, Argentina 1 64,691 Orleans, France 1 120,300 Wiesbaden, Germany 1 192,919 (1) Wiesbaden, Germany 2 1,030,822 (1) Walldorf, Germany 1 43,600 (1) San Luis, Argentina 1 6,995 10 1,457,530 Total Manufacturing Facilities 33 4,482,832 (1) This facility is leased by the company and accounted for as an operating lease. The company believes that these leases could be renewed or comparable facilities could be obtained without materially affecting operations. (2) The company has announced plans to close this facility in 1994. Operations are being consolidated into the Logansport plant. B. Aftermarket Warehouses. The Company operates one hundred twenty-six warehouses and distribution centers of which one hundred twenty-one are leased. In addition, two warehouses are financed and leased through the issuance of Industrial Revenue Bonds. Following the acquisition of SPR, the Company announced plans to consolidate duplicative operations and close 34 of these facilities before the end of 1994. C. Retail Properties. The Company leases 6 retail facilities in Australia, 9 facilities in Venezuela and 4 in Chile. All owned and leased properties are suitable, well maintained and equipped for the purposes for which they are used. The Company considers that its facilities are suitable and adequate for the operations involved. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - - - ------------------------- A. The Company is a party to three lawsuits filed in various jurisdictions alleging claims pursuant to the Comprehensive Environmental Response Compensation and Liability Act of 1980 ("CERCLA") or other state or federal environmental laws. In addition the Company has been notified by the Environmental Protection Agency and various state agencies that it may be a potentially responsible party ("PRP") for the cost of cleaning up seven other hazardous waste storage or disposal facilities pursuant to CERCLA and other federal and state environmental laws. PRP designation requires the funding of site investigations and subsequent remedial activities. Although these laws could impose joint and several liability upon each party at any site, the potential exposure is expected to be limited because at all sites other companies, generally including many large, solvent public companies, have been named as PRP's as well as the Company. In addition, the Company has identified six present and former properties at which it may be responsible for resolving certain environmental matters, which the Company is actively seeking to resolve. Although difficult to quantify based on the complexity of the issues and the limited available information, the Company has accrued the estimated costs associated with such matters. Management believes these accruals, which have not been discounted or reduced by any anticipated insurance proceeds, will cover the Company's estimated foreseeable total liability for these sites. The Company is involved in other legal actions arising in the normal course of business. After taking into consideration legal counsel's evaluation of such actions, management is of the opinion that their outcome will not have a significant effect on the Company's consolidated financial statements. B. There were no material legal proceedings which were terminated during the fourth quarter of 1993. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - - - ----------------------------------------------------------- No matter was 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 STOCK HOLDER MATTERS - - - --------------------------------------------------------- The Company's common stock is listed on the New York Stock Exchange under the trading symbol (FMO). The approximate number of shareholders of record of the Company's common stock at December 31, 1993 was 12,374. The following table sets forth the high and low sale price of the Company's common stock as reported on the New York Stock Exchange Composite Transactions Tape for the last two years: 1993 1992 Quarter High Low High Low First $20 1/2 $ 16 1/4 $ 18 1/8 $ 14 7/8 Second 22 17 5/8 20 15 5/8 Third 26 1/4 19 7/8 18 14 1/2 Fourth 29 7/8 23 1/4 18 15 1/4 Quarterly dividends of $.12 per common share were declared during 1993 and 1992. The payment of dividends is subject to the restrictions described in Note 6 to the consolidated financial statements contained in Item 8 of this Report. In February 1994, the Company's Board of Directors declared a quarterly dividend of $.12 per common share. This was the 232nd consecutive quarterly dividend declared by the Company. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA ------------------------------------ SIX YEAR FINANCIAL SUMMARY -------------------------- FEDERAL-MOGUL CORPORATION ------------------------- CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY ----------------------------------------------- FEDERAL-MOGUL CORPORATION ------------------------- ITEM 7. ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS ----------------------------------- FEDERAL-MOGUL CORPORATION ------------------------- Overview - - - -------- Federal-Mogul's core business is providing value added services based on the distribution and manufacture of non-discretionary parts to the global vehicular aftermarket and to vehicular and industrial original equipment manufacturers. The strategic direction of the company is to increase the emphasis on its aftermarket business opportunities, capitalizing on its strength of global distribution and systems logistics to improve customer service. Distribution is focused on markets where the diverse and complex vehicular population complements our broad range of products. On October 26, 1993, the company completed its most recent strategic acquisition in the vehicular aftermarket with the purchase of SPX Corporation's United States and Canadian automotive aftermarket operations, Sealed Power Replacement (SPR). The SPR acquisition further expands the broad base of products and provides additional vendor sourcing opportunities. The consolidation of the two businesses is expected to result in significant cost savings through the elimination of duplicative processes and facilities. Since the date of the acquisition, the newly-acquired business has contributed $26.6 million or 1.7% of the company's total 1993 sales. On a pro forma basis, assuming the acquisition had been completed on January 1, 1993, SPR would have contributed 10% of pro forma combined sales for the year. On October 20, 1992, Federal-Mogul completed the purchase of TRW Inc.'s automotive aftermarket business (AAB). The AAB acquisition was a major step in expanding aftermarket activity through an increased presence as a distributor of replacement parts for European and Japanese manufactured vehicles. In addition, the acquisition expanded the company's engine and chassis product offerings and increased purchasing power with outside suppliers. This acquisition contributed approximately 20% of total company sales in 1993. Throughout 1993, the company sold a number of non-strategic businesses and assets that were no longer consistent with the company's primary focus on vehicular parts for the global aftermarket. These included the sale of Westwind Air Bearings Ltd. and its affiliated operations in the United States and Japan, an equity interest in the Japanese engine bearing manufacturer Taiho Kogyo Co., and an equity interest in a Bermuda-based insurance company. It is the company's plan to divest non-strategic businesses and assets and utilize the proceeds to finance restructuring activities in core businesses, while neutralizing, to the extent possible, the earnings impact. In 1993, gains from the sale of businesses and assets were used to offset restructuring charges for the closing of a fuel systems manufacturing facility and the future consolidation of fuel systems operations in the company's lighting and electrical business. Also, the gain from the sale of idle land in Germany has been reserved for the restructuring of the Glyco engine bearing operations. The net effect of he sale of businesses and assets, and restructuring charges in 1993 was insignificant to the pretax earnings. The company reported 1993 earnings from continuing operations of $40.1 million or $1.13 per share, including a one-time after tax gain of $.07 per share on asset sales net of restructuring charges. Earnings for 1993 improved significantly over 1992 and 1991 due to added margin from the acquired AAB business, as well as the timely rationalization of that business which reduced approximately $15 million in operating expenses. Additionally, improved economic conditions in the North American original equipment markets and increased productivity in domestic manufacturing operations contributed to the earnings improvement. In 1992, the company reported earnings from continuing operations of $4.4 million. Due to the adoption of Statement of Financial AccountiNg Standards Nos. 106 and 112, "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS 106), and "Employers' Accounting for Postemployment Benefits" (SFAS 112), the company incurred a net loss in 1992 of $83.7 million, or $3.94 per share. In 1991, the company incurred a net loss of $3.7 million, or $.31 per share. During 1991, the company sold its fastening systems business that was no longer consistent with the company's strategic direction, resulting in a net gain of $16.2 million. This gain was offset by a restructuring charge of $25 million for process changes to improve operating efficiencies. Excluding the effect of these items, the company would have reported 1991 net earnings of $2 million, or a loss of $.05 per common share after the payment of preferred dividends. The company has made a strategic decision to emphasize and expand the company's global aftermarket business. Management believes that aftermarket sales are less cyclical than original equipment sales, and aftermarket expansion will offer greater potential for long-term growth and higher operating margins. Additionally, the company expects to benefit from improvements in the reduction of manufacturing lead time and other process changes, particularly in European operations. Rationalization Costs of Acquired Businesses - - - -------------------------------------------- A key aspect of the recent acquisitions of SPR and AAB is the opportunity to realize significant savings through consolidation of operations in North America and, to a lesser extent, in Europe. Savings realized in 1993 from the integration of AAB exceeded $15 million and the company estimates increasing annual cost savings by an additional $6 million in 1994. As a result of the SPR integration, the company anticipates cost savings of $12.5 million in 1994, with an incremental $10 million of cost savings thereafter. The company believes by 1995 it will meet or exceed combined annual cost savings of $43 million: $21 million from the integration of AAB and $22 million from the integration of SPR. The components of these savings include eliminating redundancies with sales staff, overlapping warehouses, distribution and administration facilities and consolidating freight. The projected 1994 cost savings from the SPR integration is reflected in the pro forma net earnings data for the combined operations as if the acquisition had been completed at the beginning of 1993 as disclosed in Note 2 to the company's consolidated financial statements for 1993. In order to obtain these anticipated cost savings and achieve the benefit of increased sales volume, the company expects to incur one-time costs of approximately $32 million in connection with the integration of Federal- Mogul and AAB and $26 million in the consolidation of SPR. Of the total rationalization costs, $1 million was expensed for SPR in 1993 and $14 million was expensed for AAB in 1992. The remaining portion of the rationalization costs of $18 million for AAB and $25 million for SPR has been capitalized as goodwill. The rationalization expense was significantly higher in the case of AAB based on the greater number of Federal-Mogul locations impacted by the consolidation. Results of Operations - - - --------------------- Sales - - - ----- The company experienced a sales increase of $311.5 million, or 24.6%, in 1993 and $165.3 million, or 15%, in 1992. Excluding the impact of the SPR acquisition, sales grew 22.5% to $1,549 million in 1993. This increase was largely due to the AAB acquisition in the fourth quarter of 1992. Other factors include increased sales to domestic original equipment customers in nearly every manufactured product line and price increases in aftermarket channels. Aftermarket and original equipment sales by major geographic area were: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Aftermarket: United States and Canada $ 683.8 $ 460.5 $ 377.4 International 309.1 239.5 205.1 Original Equipment: United States and Canada 408.5 357.0 320.1 International 174.1 207.0 196.1 ------- ------- ------- Total sales 1,575.5 $1,264.0 $1,098.7 ------- ------- ------- ------- ------- ------- Sales to aftermarket customers represented 63% of total company sales in 1993. On a pro forma basis, assuming the company acquired SPR on January 1, aftermarket sales would have been 66% of 1993 total sales. Comparatively, aftermarket sales were 55% of 1992 sales and 53% of 1991 sales. SPR contributed $26.6 million, or 3.9%, in aftermarket sales to the United States and Canada in 1993. The company has entered into a long-term trademark agreement making it the exclusive distributor of parts sold under the Sealed Power and Speed-Pro brand names. In addition, United States and Canada aftermarket sales improved $223.3 million primarily due to the increased sales of steering and suspension parts sold under the TRW brand name and an increased market presence in engine parts. Federal-Mogul is the North American automotive aftermarket leader in engine bearings, engine parts, ball and roller bearings, fuel pumps, sealing products and lighting and electrical components. International aftermarket sales increased $69.6 million, or 29% in 1993, largely as a result of the acquisition of AAB European operations, additional market share in Japanese application engine part components and the acquisition of an Australian wholesale and retail business. The company has made modest gains in expanding its retail stores by opening several retail stores in late 1993. In the future, the company intends to expand the number of retail stores it owns and operates in strategic areas throughout the world. United States and Canada original equipment sales increased $51.5 million, or 14.4% in 1993. Stronger automotive and light truck production rates in North America contributed to this growth. Sales growth also continued in the new seal application for bonded pistons in transmissions. United States and Canada original equipment sales improved $36.9 million, or 11.5%, between 1992 and 1991, due to new product programs and a recovering demand for light trucks and automobiles. In 1993, European original equipment sales declined $33 million, $6.5 million of which was due to the divestiture of the Westwind Air Bearing business in May 1993. European automotive and heavy duty vehicle production felt the effects of depressed economic conditions resulting in lower sales volumes and price erosion. In 1992, international original equipment sales increased $10.9 million, or 5.6% due to market penetration in heavy duty engine seals and engine bearings. Operating Margin - - - ---------------- Operating margins improved $40.8 million, or 93.6%, in 1993 and $14.6 million, or 50.3%, in 1992 and were: (Millions of Dollars) 1993 1992 1991 ------ ------ ------ Total operating margin $ 84.4 $ 43.6 $ 29.0 ------ ------ ------ ------ ------ ------ Margin percentage 5.4% 3.4% 2.6% ------ ------ ------ ------ ------ ------ The successful integration of AAB had a favorable earnings impact of more than $15 million in cost savings in 1993, as well as the additional margin generated from incremental AAB sales. SPR contributed $1 million in operating margin in 1993 from slightly more than two months of operations. Worldwide aftermarket pricing actions and productivity in the domestic manufacturing operations also contributed to the improvement. As the economic recovery continues in the United States, auto and light truck build rates are expected to remain strong. The company anticipates that North American earnings will continue to improve in 1994. However, after a more than 20% decline in German original equipment production in 1993, continued weak volume and competitive pricing pressures in 1994 are anticipated. The European engine bearing business is expected to offset these economic conditions somewhat through lead time reductions, process improvements and employment reductions. The recently-signed North American Free Trade Agreement (NAFTA) is expected to foster increased competition in the North American vehicle parts business. It is possible that operating margins in the company's Mexican operations will decrease as a result of this agreement. Although the impact of NAFTA on the company's business is uncertain, the company's Mexican operations are approved suppliers to the three major United States automobile manufacturers, as well as a major supplier to the automotive replacement market. Due to the strategic position of operations in Mexico, management believes that NAFTA will provide certain opportunities for the company after the current economic slowdown in Mexico subsides. There is substantial and continuing pressure from major global automotive companies to reduce costs, including costs associated with outside suppliers such as Federal-Mogul. The company has reduced exposure in this area based on recent acquisitions that have significantly modified the sales mix and reduced sales volatility. However, there can be no assurance that the company will be able to maintain its gross margins on product sales to original equipment manufacturers. The global vehicular parts business is highly competitive. The company competes with many of its customers that produce their own components, as well as independent manufacturers and distributors of component parts in the United States and abroad. In general, competition for such sales is based on price, product quality, customer service and product coverage. The company's strategic response to these competitive challenges is to more efficiently and effectively integrate its distribution and manufacturing operations, consolidate its purchasing requirements and expand its product coverage within its global base of aftermarket and original equipment businesses. Other Income and Expense - - - ------------------------ Net interest expense decreased to $18.3 million in 1993 from $19.3 million in 1992. This was the result of several actions taken to repay and refinance debt. The company sold $40 million in accounts receivable in March 1993, bringing the total accounts receivable securitization to $95 million. In April 1993, 6,250,000 shares of Federal-Mogul common stock were issued. Proceeds from these actions were used to repay the term loan associated with the acquisition of AAB. International currency exchange losses totalled $5.7 million in 1993, compared to $5.8 million in 1992 and $4.8 million in 1991. The effect of the continued devaluation of the Brazilian cruzeiro represents the majority of the foreign exchange losses. When deemed prudent and cost effective, the company uses foreign exchange options and forward exchange contracts to hedge material net foreign exchange transaction exposures. However, the company does not typically hedge translation exposures in countries whose local currency is the functional currency. At December 31, 1993, the company's most significant translation exposures were in German deutsche marks and Mexican pesos. Changes in the exchange rate between the U.S. dollar and these currencies are recorded directly as a component of shareholder's equity. Amortization of intangible assets increased in 1993 to $6.8 million from $2.8 million and $1.6 million in 1992 and 1991, respectively. The amortization of trademark and non-compete agreements and the goodwill associated with the acquisitions of AAB and SPR represent the increase in this expense. SFAS 106 & SFAS 112 - - - ------------------- In 1992, in accordance with Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", the company began accruing the cost of providing future postretirement benefits, such as health care and life insurance, over the related employee's service period. Prior to the adoption, the cost of providing these benefits to retired employees was recognized by the company when payments were made. The company elected to immediately recognize the accumulated postretirement benefit obligation at the date of adoption. The charges to operations were: (Millions of Dollars) 1993 1992 ------ ------ Incremental annual expense $ 6.6 $ 7.6 Income tax benefit (2.4) (2.7) -------- ------- 4.2 4.9 Cumulative effect of accounting change 135.7 Income tax benefit (47.6) ------ 88.1 ------ Net effect of SFAS 106 $ 4.2 $ 93.0 ------- ------ ------- ------ Also in 1992, the company adopted Statement of Financial Accounting Standard No. 112, "Employers' Accounting for Postemployment Benefits", which requires the accrual of future postemployment benefits, when such amounts can be estimated. The impact of adopting this standard on the company's financial position in operating results is not significant. Income Taxes - - - ------------ The company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). At December 31, 1993, the company had deferred tax assets of $106.4 million and deferred tax liabilities of $72.5 million. The company records valuation allowances ($21.0 million at December 31, 1993) for all deferred tax assets, except where management believes it is more likely than not that the tax benefit will be realized. A valuation allowance was not established against deferred tax assets attributable to the company's postretirement benefit obligation and its German net operating loss carryforward. The deferred tax asset for the company's postretirement benefit obligation was $55.3 million at December 31, 1993. The company expects that the tax deduction associated with this obligation will be claimed over a period of 35 to 40 years. The total amount of future taxable income in the United States necessary to realize the asset is approximately $150 million. The company could generate approximately $67 million of taxable income from the execution of tax planning strategies, principally through revoking the company's LIFO election. The company will need to generate the additional taxable income in the United States through future operations in order to fully realize the deferred tax asset for the company's postretirement benefit obligation. The deferred tax asset attributable to the German net operating loss carryforward was $19.0 million at December 31, 1993. The carryforward is not subject to expiration. Sufficient taxable income will be generated through the reversal of existing taxable temporary differences to enable the carryforward to be utilized. Liquidity and Financial Condition - - - --------------------------------- Assets - - - ------ The acquisitions of SPR and AAB in 1993 and 1992, respectively, added the following operating assets at the time of the purchase. (Millions of Dollars) SPR AAB ----- ----- Accounts receivable $ 21 $ 54 Inventories 64 117 Property and equipment 8 12 The additions of the above assets reflects the most significant transactions affecting comparisons of these accounts from year to year. The increase in intangible assets for both 1993 and 1992 represents the cost of long-term non-compete and trademark agreements with SPX and TRW and goodwill of the acquired businesses. Excluding the acquisition of SPR and the accounts receivable securitized in 1993, accounts receivable at December 31, 1993 increased approximately $40 million. This increase results primarily from the overall increase in sales. Inventories decreased by approximately $6 million from December 31, 1992 excluding the impact of SPR. This was achieved during a period where sales increased by more than 20%, demonstrating the continued success of lead time reductions and inventory management programs. Liabilities - - - ----------- In the fourth quarter of 1993, the company renegotiated its revolving credit facility (revolver), increasing the amount available from $150 million to $300 million. The renegotiated revolver immediately lowered interest on borrowings by 75 basis points. Interest on the revolver is based on LIBOR plus a range of 50 to 150 basis points which are charged based on the company's Moody's and S&P bond ratings. At December 31, 1993 the company pays interest on the revolver at LIBOR plus 100 basis points which is a reduction of 150 basis points from the prior year. During 1993, the company drew $245 million against the revolver to repay the $100 million 8 3/8% notes due October 1, 1993 and complete the purchase of SPR. At December 31, 1993, the outstanding balance on the revolver was $245 million. In December 1993, the company filed a shelf registration with the SEC that will allow the company to issue a combination of debt and equity securities up to $300 million over a two year period. In February 1994, the company used the shelf registration to offer 5 million shares of common stock to the public. The underwriters of the offering subsequently exercised an option to cover overallotments resulting in the sale of an additional 750,000 shares. The total sale of 5.75 million common shares generated net proceeds to the company of nearly $191 million. The offering proceeds were used to repay a portion of the company's outstanding debt. During the first quarter of 1994, the Company attained an investment grade status from the Moody's and Standard & Poor's rating agencies, primarily as a result of acts taken to repay and refinance debt in 1993 and early 1994. This should provide improved access to capital markets. To finance the 1992 AAB acquisition, the company used net proceeds of $76.6 million from the issuance of 1,600,000 shares of Series D preferred stock in September 1992 and $125 million of unsecured senior bank financing pursuant to a bank credit agreement maturing September 1998 (the $125 million term loan). During the first half of 1993, the $125 million term loan was repaid with the net proceeds from the sale of $40 million of accounts receivable and $85 million of the $116 million net proceeds from the sale of 6,250,000 shares of the company's common stock in April 1993. The increase in other accrued liabilities represents amounts accrued for the rationalization of the AAB and SPR acquisitions and the restructuring of manufacturing operations at the Glyco and the lighting, electrical and fuel systems businesses. The discount rate used to determine the actuarial present value of domestic postretirement pension, health insurance and life insurance benefits was lowered to 7 1/2% for 1993 from 8 3/4% in 1992. The 7 1/2% discount rate reflects the current expected yield for long-term, high quality investments. The lowered discount rate reduced net pension income from domestic plans by about $.6 million for 1993. Assumptions for expected long-term rates of return on plan assets and future compensation increases were also adjusted for current conditions. The changes in assumptions had an insignificant effect on 1993 operating results and the impact in the future is expected to be minimal. The company also lowered the discount rate on its international plans from 9% in 1992 to 8% in 1993, increasing 1993 pension expense by approximately $.3 million. Combined changes in the discount rate increased the recorded liability for pensions by approximately $20 million at December 31, 1993. The impact of changing the discount rate on the recorded liability for postretirement health care and life insurance benefits was largely offset by better than expected experience, lowering the medical trend rate and changes made to certain plan provisions. Environmental Matters - - - --------------------- The company is a party to three lawsuits filed in various jurisdictions alleging claims pursuant to the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA) or other state or federal environmental laws. In addition, the company has been notified by the Environmental Protection Agency and various state agencies that it may be a potentially responsible party (PRP) for the cost of cleaning up seven other hazardous waste storage or disposal facilities pursuant to CERCLA and other federal and state environmental laws. PRP designation requires the funding of site investigations and subsequent remedial activities. Although these laws could impose joint and several liability upon each party at any site, the potential exposure is expected to be limited because at all sites other companies, generally including many large, solvent public companies, have been named as PRP's. In addition, the company has identified six present and former properties at which it may be responsible for cleaning up certain environmental contamination. The company is actively seeking to resolve these matters. Although difficult to quantify, based on the complexity of the issues, the company has accrued the estimated cost associated with such matters. Management believes these accruals, which have not been discounted or reduced by any anticipated insurance proceeds, will be adequate to cover the company's estimated liability for these sites. Cash Flows - - - ---------- Operating Activities - - - -------------------- The company generated cash of $29.6 million from operations in 1993 compared to $52.7 million and $47.9 million in 1992 and 1991, respectively. These year-to-year changes include net earnings from continuing operations of $40.1 million and $4.4 million in 1993 and 1992, respectively, and a loss of $19.8 million in 1991. The 1993 results were lower than previous years as the company spent approximately $22 million dollars on the integration of AAB. It is the company's belief that cash from operations will continue to be sufficient to meet its ongoing working capital requirements including the requirements for the continued integration of SPR and restructuring of the Glyco and the lighting, electrical and fuel systems operations. Investing Activities - - - -------------------- Other than the purchases of SPR and AAB, the company's principal investing activity in 1993, 1992 and 1991 was the acquisition of property and equipment for its existing operations. Approximately $59 million, $40 million and $44 million of cash in 1993, 1992 and 1991, respectively, was reinvested in productive assets of the company. These investments were made to support the company's long-term objective of improving operating productivity and product mix. These investments were funded in 1993 and 1992 with cash from operating and financing activities. In 1991, investments were funded with proceeds from the sale of the company's fastening systems business. Capital expenditures for 1994 are anticipated to be approximately $55 million, as the company continues to enhance manufacturing capabilities in the United States and Europe. Financing Activities - - - -------------------- As previously noted, the sale of common stock and the securitization of accounts receivable in 1993 helped the company reduce debt associated with the purchase of AAB in 1992. The company borrowed approximately $145 million to finance the acquisition of SPX Corporation's automotive aftermarket operations in 1993 which will be repaid from the proceeds of a common stock offering in early 1994. The issuance of Series D Convertible Exchangeable Preferred Stock, borrowings under short and long-term agreements and proceeds from the accounts receivable securitization contributed an additional $274 million in cash in 1992. Cash of $73 million used for long-term debt repayments in 1992 was $24.6 million less than in 1991, as the earlier year included a large debt reduction with the proceeds from the sale of the company's fastening systems business. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- CONSOLIDATED STATEMENTS OF EARNINGS - - - ----------------------------------- FEDERAL-MOGUL CORPORATION - - - ------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS - - - ------------------------------------- FEDERAL-MOGUL CORPORATION - - - ------------------------- See accompanying Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 1. ACCOUNTING POLICIES ------------------- Principles of Consolidation - The consolidated financial statements include the accounts of Federal-Mogul Corporation and its majority-owned subsidiaries (the company). Intercompany accounts and transactions have been eliminated in consolidation. Cash and Equivalents - The company considers all highly liquid investments with maturities of ninety days or less from the date of purchase to be cash equivalents. Inventories - Inventories are stated at the lower of cost or market. Cost determined by the last-in, first-out (LIFO) method was used for 66% and 62% of the inventory at December 31, 1993 and 1992, respectively. The remaining inventories are costed using the first-in, first-out (FIFO) method. If inventories had been valued at current cost, amounts reported at December 31 would have been increased by $65.3 million in 1993 and $64.7 million in 1992. At December 31, inventories consisted of the following: (Millions of Dollars) 1993 1992 ------ ------ Finished products $279.7 $217.5 Work-in-process 21.3 31.3 Raw materials 21.3 18.6 ----- ----- $322.3 $267.4 ----- ----- ----- ----- Inventory quantity reductions resulting in liquidations of certain LIFO inventory layers and the reduction in international locations using the LIFO method increased net earnings in 1993, 1992, and 1991 by $5.3 million ($.19 per share), $6.9 million ($.31 per share) and $13.5 million ($.60 per share), respectively. Intangible Assets - Intangible assets, which result principally from acquisitions, consist of goodwill, trademark and non-compete agreements, patents and other intangibles and are amortized on a straight-line basis over appropriate periods, generally ranging from 7 to 40 years. Intangible assets reflected in the consolidated balance sheets are net of accumulated amortization of $12.0 million and $6.8 million in 1993 and 1992, respectively. Currency Translation - Exchange adjustments related to international currency transactions and translation adjustments for subsidiaries whose functional currency is the United States dollar (principally those located in highly inflationary economies) are reflected in the consolidated statements of earnings. Translation adjustments of international subsidiaries whose local currency is the functional currency are reflected in the consolidated financial statements as a separate component of shareholders' equity. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 1. ACCOUNTING POLICIES (continued) ------------------- Earnings Per Share - The computation of primary earnings per share is based on the weighted average number of outstanding common shares during the period plus, when their effect is dilutive, common stock equivalents consisting of certain shares subject to stock options. Fully diluted earnings per share additionally assumes the conversion of outstanding Series C ESOP and Series D preferred stock and the contingent issuance of common stock to satisfy the Series C ESOP preferred stock redemption price guarantee. The number of contingent shares used in the fully diluted calculation is based on the market price of the company's common stock on December 31, 1993, and the number of preferred shares held by the Employee Stock Ownership Plan (ESOP) that were allocated to participants' accounts as of December 31 of each of the respective years. Fully diluted earnings per share amounts are not reported as there is an insignificant difference in the 1993 calculation and the effects are anti-dilutive in 1992 and 1991. The primary weighted average number of common and equivalent shares outstanding (in thousands) was 27,342, 22,390, and 22,314 for 1993, 1992 and 1991, respectively. The fully diluted weighted average number of common and equivalent shares outstanding (in thousands) was 33,927 for 1993, 25,552 for 1992 and 24,673 for 1991. Net earnings used in the computation of primary earnings per share are reduced by preferred stock dividend requirements. Net earnings used in the computation of fully diluted earnings per share are reduced by amounts representing the additional after-tax contribution that would be necessary to meet ESOP debt service requirements under an assumed conversion of the Series C ESOP preferred stock. Financial Instruments and Concentrations of Credit Risk - Foreign exchange options and forward contracts on foreign currencies and copper futures are entered into by the company as hedges against the impact of currency and raw material price fluctuations and are not used to engage in speculation. Gains and losses are recognized when these instruments are settled. Financial instruments which potentially subject the company to concentrations of credit risk consist primarily of accounts receivable and cash investments. The company's customer base includes virtually every significant automotive manufacturer and a large number of distributors and installers of automotive replacement parts. However, the company's credit evaluation process, reasonably short collection terms and the geographical dispersion of sales transactions help to mitigate this concentration of credit risk. The company also has cash investment policies that limit the amount of credit exposure to any one financial institution and require placement of investments in financial institutions evaluated as highly credit worthy. Changes in Accounting Method - During the fourth quarter of 1992, the company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), retroactively to 1989. Accordingly, retained earnings at January 1, 1990, were increased by $2.9 million, representing the cumulative effect of the change in the method of accounting for income taxes. The loss from continuing operations for the year ended December 31, 1991 has been restated for the effect of adopting SFAS 109 as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 1. ACCOUNTING POLICIES (continued) ------------------- (Millions of Dollars, Except Per Share Amounts) 1991 -------- As previously reported $(21.0) Effect of adoption of SFAS 109 1.2 ----- As restated $(19.8) ----- ----- Per common share as previously reported $(1.08) Effect of adoption of SFAS 109 .05 ----- Per common share as restated $(1.03) ----- ----- Also in the fourth quarter of 1992, the company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS 106), effective as of January 1, 1992, and restated previously reported 1992 quarterly results. Prior to adoption, the cost of providing health care and life insurance benefits to retired employees was recognized as expense as payments were made. The company recorded a charge of $88.1 million, or $3.93 per common share, net of applicable tax benefits of $47.6 million to reflect the cumulative effect for years prior to 1992 of the change in accounting method. In addition to the cumulative effect, the company's 1993 and 1992 postretirement health care and life insurance costs increased $6.6 million and $7.6 million, respectively, as a result of adopting SFAS 106. Reclassifications - Certain items in the prior year financial statements have been reclassified to conform with the presentation used in 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 2. ACQUISITIONS ------------ On October 26, 1993, the company completed its acquisition of SPX Corporation's United States and Canadian automotive aftermarket operations, Sealed Power Replacement (SPR). The acquisition has been accounted for as a purchase and, accordingly, the total cost of $167 million was allocated to the acquired assets and assumed liabilities based on their estimated fair values as of the acquisition date. The company and SPX Corporation also executed a non-compete agreement and a long-term trademark agreement making Federal-Mogul the sole distributor of engine and chassis parts sold under the Sealed Power and Speed-Pro brand names in North America. Federal-Mogul also acquired the right to use these trademarks throughout the rest of the world. The excess of the consideration paid over the estimated fair value of net assets acquired of $65 million has been recorded as goodwill. The earnings statement includes the operating results of the acquired business from October 26, 1993. On October 20, 1992, the company acquired substantially all of TRW Inc.'s automotive aftermarket business (AAB). The acquisition has been accounted for as a purchase and, accordingly, the total cost of $232 million was allocated to the acquired assets and assumed liabilities based on their estimated fair values as of the acquisition date. The company and TRW Inc. also executed a non-compete agreement and completed a long-term supply contract and a trademark agreement (valued at $48.2 million in the aggregate) making the company the exclusive supplier of TRW-brand engine and chassis parts to the independent automotive aftermarket. The excess of the consideration paid over the estimated fair value of net assets acquired of $34 million has been recorded as goodwill. The consolidated statement of earnings includes the operating results of the acquired business from October 20, 1992. The following unaudited pro forma results of operations for the years ended December 31, 1993 and 1992 assume the described acquisitions occurred as of the beginning of the respective periods, after giving effect to certain adjustments, including amortization of intangible assets, increased interest expense on acquisition debt and related income tax effects, with the SPR acquisition impacting 1993 and the SPR and AAB acquisitions impacting 1992. The pro forma results have been prepared for comparative purposes only and do not purport to indicate the results of operations which would actually have occurred had the combination been in effect on the dates indicated, or which may occur in the future. (Millions of Dollars, Except Per Share Amounts) 1993 1992 ---------- ---------- Net sales $1,705.3 $1,672.0 Earnings from continuing operations 74.3 42.0 Net earnings (loss) 50.2 (62.1) Net earnings (loss) per common share: Primary $ 1.50 $ (3.17) Fully diluted 1.41 (3.17) Operating results for 1993 include a $1 million ($.02 per share) charge and for 1992 a $14 million ($.40 per share) charge to provide for certain aspects of the rationalization of the company's present aftermarket business. This charge includes costs incurred for severance, eliminating redundant company facilities and equipment, and integrating the operations of the acquired businesses. On April 27, 1993, the company's wholly-owned Australian subsidiary, Federal-Mogul Pty. Ltd., acquired the automotive aftermarket business and certain assets of Brown & Dureau Automotive Pty. Limited. The acquisition was accounted for as a purchase and the cost of $5.6 million was allocated to the acquired assets and assumed liabilities. The required rationalization expense was insignificant to total operating results. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 3. SALES OF BUSINESSES AND RELATED MATTERS --------------------------------------- In 1993, the company sold a number of non-strategic businesses and assets, using the proceeds to restructure manufacturing operations to enhance future profitability. On an after-tax basis, a gain of $.07 per share was recorded primarily due to a favorable tax treatment on the sale of Westwind Air Bearings, Ltd. In 1992 and 1991, the effect of similar transactions was a charge to income of $14 million and $25 million, respectively. The pretax gain on the sale of these non-strategic businesses and assets totalled $19.2 million and were offset by restructuring charges amounting to $19.2 million. The significant components of these transactions are: In April 1993, the company sold the assets and business of its subsidiary, Westwind Air Bearings, Ltd. in England and its affiliated operations in the United States and Japan for $16.3 million in cash and a 20% equity position in the new Westwind operating company. The pretax earnings effect was a gain of $5.1 million. In September 1993, the company sold its equity interest in the Japanese engine bearing manufacturer, Taiho Kogyo Co., for $9.3 million. A total of 1,544,400 shares were sold to Taiho's principal shareholders, Toyota Motor Corporation and certain Toyota affiliates. The pretax earnings effect was a gain of $8.8 million. In November 1993, the company sold equity interests in a Bermuda-based insurance company, Corporate Officers and Directors Assurance Holding Ltd. for $5.5 million to ACE Limited. The pretax earnings effect was a gain of $2.7 million. During the second half of 1993, the company recorded special charges relating to the rationalization of manufacturing operations. In November 1993, the company announced the closing of its Lafayette, Tennessee fuel systems plant with a plan to consolidate operations with the Lighting and Electrical Division. A restructuring reserve was recorded for $7 million based on the plan to consolidate these two businesses. The company also announced plans to restructure Glyco manufacturing operations in Germany. A reserve of $8.4 million was recorded to provide for personnel reductions and reengineering of manufacturing facilities. The company also sold idle land for $5 million connected with its Glyco operations, resulting in a pretax gain of $1.5 million. In November 1991, the company sold the net assets and operations of its wholly-owned subsidiary, Huck Manufacturing Company, which constituted all operations of the company's fastening systems segment. Total cash proceeds from the sale were $151.9 million. The sale resulted in a net gain of $16.1 million, including an after-tax operating loss of $.1 million. Sales of $142.2 million and expenses of $141.4 million are excluded from the consolidated statements of earnings under captions applicable to continuing operations. Interest expense of $8.3 million was allocated to discontinued operations to the sum of total consolidated net assets and consolidated debt. During the fourth quarter of 1991, the company recorded a $25 million ($.98 per share) restructuring charge for inventory and equipment valuations, severance, reorganizing certain operations and other costs associated with process changes being implemented throughout the company. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 4. ACCOUNTS RECEIVABLE SECURITIZATION ---------------------------------- In June 1992 and March 1993, the company entered into agreements to sell, on a revolving basis, an undivided interest in a designated pool of accounts receivable. Accordingly, the company irrevocably and without recourse transferred all of its U.S. dollar denominated trade accounts receivable (approximately $182 million at December 31, 1993 and principally representing amounts owed to the company by original equipment and aftermarket customers in the U.S. automotive and related industries) and $7 million Canadian receivables to the Federal-Mogul Trade Receivables Master Trust. The Trust sold investor certificates representing an interest in $55 million and $40 million of trust assets in 1992 and 1993, respectively. The company holds seller certificates representing an interest in the remaining assets of the Trust, which certificates are included with accounts receivable in the company's balance sheet at December 31, 1992. The agreement expires in 1997. The trust agreement requires the company to maintain its interest in the assets of the Trust at a certain calculated participation level which, if not met, requires the company to contribute cash or additional trade accounts receivable in order to satisfy such participation requirement. The company exceeded the required participation level by approximately $46 million and $16 million as of December 31, 1993 and 1992, respectively. All losses, credits or other adjustments on receivables owned by the Trust are deductions from the assets represented by the seller certificates owned by the company. Accordingly, the owners of the investor certificates have no recourse to the company beyond the assets represented by the seller certificates. The company does not generally require collateral for its trade accounts receivable and maintains an allowance ($14.5 million and $8.6 million at December 31, 1993 and 1992, respectively) based upon the expected collectibility of all trade accounts receivable, including receivables sold. Accounts receivable in the 1993 and 1992 consolidated balance sheet exclude $95 million and $55 million, respectively, representing investor certificates sold. The discount related to the sale of receivables under this agreement of $5.3 million in 1993 and $2 million in 1992 have been classified as a reduction of other income. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 5. PROPERTY, PLANT AND EQUIPMENT ----------------------------- Properties are stated at cost, which includes expenditures for additional facilities and those which materially extend the useful lives of existing buildings and equipment. Fully depreciated assets have been eliminated from the accounts. Depreciation is computed principally by the straight-line method for financial reporting purposes and by accelerated methods for income tax purposes. At December 31, property, plant and equipment consisted of the following: (Millions of Dollars) 1993 1992 -------- -------- Land $ 30.8 $ 35.0 Buildings 162.3 151.9 Machinery and equipment 423.4 403.1 ------ ------ 616.5 590.0 Accumulated depreciation (216.7) (199.3) ------ ------ $ 399.8 $ 390.7 ------ ------ ------ ------ The company leases various facilities and equipment under both capital and operating leases. Net assets subject to capital leases are not significant at December 31, 1993. The balance of a deferred gain resulting from the 1988 sale and leaseback of a portion of the corporate headquarters complex was $9.9 million at December 31, 1993. The deferred gain is being amortized over the term of the lease as a reduction of rent expense. Future minimum payments under noncancelable operating leases with initial or remaining terms of more than one year are, in millions: 1994--$16.7; 1995--$16.1; 1996--$14.3; 1997--$13.6; 1998--$10.7 and thereafter--$51.9. Future minimum lease payments have been reduced by approximately $37.6 million for amounts to be received under sublease agreements and the balance of the deferred gain. Total rental expense under operating leases was $21.1 million in 1993, $17.7 million in 1992 and $17.2 million in 1991, exclusive of property taxes, insurance and other occupancy costs generally payable by the company. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 6. DEBT ---- In October 1993, the company renegotiated its revolving credit facility and increased the availability of funds from $150 million to $300 million. The company borrowed $245 million against the facility to finance the acquisition of Sealed Power Replacement and to retire the $100 million 8 3/8% notes which were due October 1, 1993. The outstanding revolver balance matures in October, 1997. The revolver carries a variable interest rate (approximately 4.38% at December 31, 1993). The unused portion of the revolver is subject to a variable commitment fee (.375% as of December 31, 1993). The company has additional established lines of credit with several banks in the maximum amount of $49.1 million. At December 31, 1993 and 1992, borrowings under these lines of credit amounted to $35.7 and $28.1 million, respectively. Long-term debt at December 31 consists of the following: (Millions of Dollars) 1993 1992 -------- -------- Revolver due 1997 $245.0 $ - Term loan due 1998 - 125.0 8 3/8% notes due 1993 - 100.0 Notes payable due 2000 75.0 75.0 ESOP obligation 43.9 48.4 Other 30.7 18.9 ----- ----- 394.6 367.3 Less current maturities included in short-term debt 12.1 16.7 ----- ----- $382.5 $350.6 ----- ----- ----- ----- The notes payable due in 2000 require semi-annual interest payments (approximately 10% as of December 31, 1993) and, commencing December 1994, annual principal payments of $3.4 million (increasing to $16.2 million beginning December 1997). The Employee Stock Ownership Plan (ESOP) obligation represents the unpaid principal balance on an eleven-year loan entered into by the company's ESOP in 1989. Proceeds of the loan were used by the ESOP to purchase the company's Series C ESOP preferred stock. Payment of principal and interest on the notes is unconditionally guaranteed by the company, and therefore the unpaid principal balance of the borrowing is classified as long-term debt. Company contributions and dividends on the preferred shares held by the ESOP are used to meet semi-annual principal and interest obligations. In 1993, the company exercised an option to prepay principal in the amount of $4.5 million on the original ESOP loan, which bears interest at 11.2% per annum. The prepayment is being refinanced with bank debt that carries a variable interest rate based on LIBOR plus 100 basis points (4 1/2% as of December 31, 1993). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 6. DEBT (continued) ---- Certain of the company's debt agreements contain restrictive covenants that, among other matters, require the company to maintain certain financial ratios and minimum levels of working capital and tangible net worth. The revolving credit agreement additionally restricts the payment of common stock cash dividends to the greater of $.135 per common share per quarter or 80% of the company's average net earnings available for common shares, as defined in the agreements, for its four most recent fiscal quarters. The carrying value of the company's debt is not materially different from its fair value, which is estimated using discounted cash flow analysis and the company's current incremental borrowing rates for similar types of arrangements. Aggregate maturities of long-term debt for each of the four years following 1994 are, in millions: 1995--$13.3; 1996--$13.3; 1997--$277.3; and 1998--$27.9. Cash interest paid in 1993, 1992 and 1991 was $26.9 million, $27.1 million and $40.1 million, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 7. CAPITAL STOCK AND PREFERRED SHARE PURCHASE RIGHTS ------------------------------------------------- The company's articles of incorporation authorize 60,000,000 shares of common stock with a stated value of $5, of which 29,497,994 shares, 22,391,154 shares and 22,354,354 shares were outstanding at December 31, 1993, 1992 and 1991, respectively. In April 1993, the company sold 6,250,000 shares of its common stock in a public offering with net proceeds of approximately $116 million that were used to repay a portion of the debt incurred with the 1992 acquisition of AAB. Simultaneously, the company issued 500,000 additional shares, valued at approximately $9.6 million, to contribute to the company's domestic pension plans. The articles of incorporation also authorize 5,000,000 shares of preferred stock. On September 24, 1992, the company completed an $80,000,000 private issue of 1,600,000 shares of its $3.875 Series D convertible exchangeable preferred stock. Sold to institutional investors in a private placement under rule 144A of the Securities Act, each share of stock has a liquidation preference of $50 and is convertible into the company's common stock at a conversion price of $18 per share. The shares are not redeemable prior to September 1996, but they may be exchanged at the company's option for 7.75% convertible subordinated debentures due in 2012. Such debentures would be convertible into the company's common stock at a rate of $50 principal amount for each share of common stock and at the same conversion price as the Series D preferred stock. The company's ESOP covers substantially all domestic salaried employees and allocates Series C ESOP convertible preferred stock to eligible employees based on their contributions to the Salaried Employees' Investment Program and their eligible compensation. The company had 944,016 shares, 954,196 shares and 978,170 shares of Series C ESOP preferred stock outstanding at December 31, 1993, 1992 and 1991, respectively. The company repurchased and retired 10,180 Series C ESOP preferred shares valued at $.7 million during 1993 and 23,974 Series C ESOP preferred shares valued at $1.4 million during 1992, all of which were forfeited by participants upon early withdrawal from the plan. The Series C ESOP preferred stock is convertible into shares of the company's common stock at a rate of two shares of common stock for each share of preferred stock. The Series C ESOP preferred stock may only be issued to a trustee acting on behalf of an employee stock ownership plan or other employee benefit plan of the company. The shares are automatically converted into shares of common stock in the event of any transfer to any person other than the plan trustee. The preferred stock is redeemable, in whole or in part, at the option of the company. The charge to operations for the cost of the ESOP was $4.9 million in 1993, $4.7 million in 1992 and $3.8 million in 1991. The company made cash contributions to the plan of $9.2 million in 1993 and 1992, and $8.3 million in 1991 for debt service, including preferred stock dividends of $4.5 million in 1993, $4.6 million in 1992 and $4.8 million in 1990. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 7. CAPITAL STOCK AND PREFERRED SHARE PURCHASE RIGHTS (continued) ------------------------------------------------- In 1988, the company's Board of Directors authorized the distribution of one Preferred Share Purchase Right for each outstanding share of common stock of the company. Each Right entitles shareholders to buy one-half of one-hundredth of a share of a new series of preferred stock at a price of $70. As distributed, the Preferred Share Purchase Rights trade together with the common stock of the company. They may be exercised or traded separately only after the earlier to occur of: (i) 10 days following a public announcement that a person or group of persons has obtained the right to acquire 10% or more of the outstanding common stock of the company (20% in the case of certain institutional investors), or (ii) 10 business days (or such later date as may be determined by action of the Board of Directors) following the commencement or announcement of an intent to make a tender offer or exchange offer which would result in beneficial ownership by a person or group of persons of 10% of more of the company's outstanding common stock. Additionally, if the company is acquired in a merger or other business combination, each Right will entitle its holder to purchase, at the Right's exercise price, shares of the acquiring company's common stock (or stock of the company if it is the surviving corporation) having a market value of twice the Right's exercise price. The Preferred Share Purchase Rights may be redeemed at the option of the Board of Directors for $.005 per Right at any time before a person or group of persons acquires 10% or more of the company's common stock. The Board may amend the Rights at any time without shareholder approval. The Rights will expire by their terms on November 14, 1998. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 8. INCENTIVE STOCK PLANS --------------------- The company's shareholders adopted stock option plans in 1976 and 1984 and a performance incentive stock plan in 1989. These plans provide generally for awarding restricted shares or granting options to purchase shares of the company's common stock. Restricted shares entitle employees to all the rights of common stock shareholders, subject to certain transfer restrictions or forfeitures. Options entitle employees to purchase shares at an exercise price not less than 100% of the fair market value on the grant date and expire after ten years. Under the plans, options become exercisable ranging from six months to four years as determined by the Board of Directors at the time of grant. At December 31, 1993, 775,010 shares were available for future grants under the plans. The following table summarizes the activity relating to the company's incentive stock plans: Number of Shares Share Price ------------- --------------- (In Millions) Outstanding at January 1, 1991 1.4 $ 9.47 - $26.19 Options granted 1.1 $15.69 - $22.00 Options exercised (.1) $9.47 Options lapsed or cancelled - --- Outstanding at December 31, 1991 2.4 $ 9.47 - $26.19 Options granted .1 $16.44 - $22.00 Options exercised - Options lapsed or cancelled (.1) --- Outstanding at December 31, 1992 2.4 $14.34 - $26.19 Options granted .5 $19.25 - $24.13 Options exercised (.3) $14.34 - $22.69 Options lapsed or cancelled - --- Outstanding at December 31, 1993 2.6 $15.69 - $26.19 --- --- Exercisable at December 31, 1993 1.0 $15.69 - $26.19 --- --- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 9. PENSIONS AND OTHER POSTRETIREMENT BENEFITS ------------------------------------------ The company maintains several defined benefit pension plans which cover substantially all domestic employees. Benefits for domestic salaried employees are based on compensation and years of service, while hourly employees' benefits are primarily based on negotiated rates and years of service. In addition, certain employees in other countries are covered by pension plans. International plans maintained by the company provide benefits based on years of service and compensation. The company's funding policy is consistent with funding requirements of federal and international laws and regulations. Plan assets consist primarily of listed equity securities and fixed income instruments. As of December 31, 1993, plan assets included 444,000 shares of Federal-Mogul common stock valued at approximately $12.9 million. Net periodic pension cost for the company's defined benefit plans in 1993, 1992 and 1991 consist of the following: (Millions of Dollars) U.S. Plans International Plans ---------------------- --------------------- Year Ended December 31, 1993 1992 1991 1993 1992 1991 ------ ------ ------ ------ ------ ----- (Income)/Expense Service cost - benefits earned during the period $ 6.8 $ 5.6 $ 5.9 $ .4 $ .3 $ .4 Interest cost on projected benefit obligation 12.9 12.7 11.7 2.2 2.2 2.2 Actual return on plan assets (29.8) (5.7) (27.8) N/A N/A N/A Net amortization and deferral 7.3 (16.9) 6.7 - - - ---- ---- ---- ---- ---- ---- Net periodic pension cost $(2.8) $(4.3) $(3.5) $ 2.6 $ 2.5 $ 2.6 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 9. PENSIONS AND OTHER POSTRETIREMENT BENEFITS (continued) ------------------------------------------ The following table sets forth the funded status for the company's defined benefit plans at December 31, 1993 and 1992: (Millions of Dollars) International U.S. Plans Plans ------------------------------- -------------- Assets Exceed Accumulated Accumulated Accumulated Benefits Benefits Benefits Exceed Assets Exceed Assets December 31, 1993 1992 1993 1992 1993 1992 ------ ------ ------ ------ ------ ------ Actuarial present value of benefit obligations: Vested benefit obligation $ 79.0 $ 68.9 $ 82.8 $ 58.0 $ 26.7 $ 24.4 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- Accumulated benefit obligation $ 83.1 $ 75.2 $ 97.2 $ 67.3 $ 28.0 $ 25.7 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- Projected benefit obligation $ 84.0 $ 76.3 $ 97.4 $ 67.4 $ 28.1 $ 25.9 Plan assets at fair value 151.1 145.7 78.7 55.5 - - Plan assets in excess of (less than) projected benefit obligation 67.1 69.4 (18.7) (11.9) (28.1) (25.9) Unrecognized net (asset) liability at transition (15.2) (19.1) .6 1.3 - - Unrecognized prior service cost (1.8) (1.1) 10.5 8.1 - - Unrecognized net (gain) loss (15.8) (18.4) 9.2 (1.8) 2.6 (.9) ----- ----- ----- ----- ----- ----- Accrued pension asset (liability) included in the consolidated balance sheet $ 34.3 $ 30.8 $ 1.6 $ (4.3) $(25.5) $(26.8) ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- The assumptions used in computing the above information are as follows: U.S. Plans International Plans ---------------------- ---------------------- 1993 1992 1991 1993 1992 1991 ------ ------ ------ ------ ------ ------ Discount rates 7 1/2% 8 3/4% 9% 8% 9% 9% Rates of increase in compensation levels 4 1/2% 5 1/2% 6 1/2% 5% 5% 5% Expected long-term rates of return on assets 10% 9% 9% N/A N/A N/A NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 9. PENSIONS AND OTHER POSTRETIREMENT BENEFITS (continued) ------------------------------------------ The company's minimum liability adjustment at December 31 was $20.2 million for U.S. plans and $2.5 million for international plans in 1993 and $7.7 million for U.S. plans in 1992. In addition to providing pension benefits, the company provides health care and life insurance benefits for certain domestic retirees covered under company-sponsored benefit plans. Employees who are participants in these plans may become eligible for these benefits if they reach normal retirement age while working for the company. Beginning in 1992, the company is required to accrue the cost of providing post-retirement benefits over the employees' service period. The company's policy is to fund benefit costs as they are provided, with retirees paying a portion of the costs. Periodic postretirement benefit costs were $13.8 million in 1993 and $14.4 million in 1992. The cost of these benefits in 1991, which were previously recognized as expense when paid, amounted to $5.4 million. The components of net periodic postretirement benefit costs are as follows: (Millions of Dollars) Year Ended December 31, 1993 1992 -------- -------- Service Cost $ 2.7 $ 2.7 Interest Cost 11.1 11.7 ---- ---- $13.8 $14.4 ---- ---- ---- ---- The accumulated postretirement benefits obligation (APBO) at December 31, 1993 and 1992 was as follows: (Millions of Dollars) December 31, 1993 1992 -------- -------- Accumulated postretirement benefit obligations: Retirees $ 96.2 $ 90.0 Fully eligible plan participants 15.0 18.7 Other active plan participants 39.5 34.6 Other loss (.8) (.2) ----- ----- $149.9 $143.1 ----- ----- ----- ----- The discount rate used in determining the APBO was 7 1/2% at December 31, 1993 and 8 3/4% at December 31, 1992. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 9. PENSIONS AND OTHER POSTRETIREMENT BENEFITS (continued) ------------------------------------------ The assumed annual health care cost trend used in measuring the APBO approximated 9% in 1993, declining to 8 1/2% in 1994 and to an ultimate annual rate of 5 1/2% estimated to be achieved in 2008. At December 31, 1992, the health care cost trend rate approximated 9 1/2% in 1992, declining to 9% in 1993 to an annual rate of 6% to be achieved in 2007. Increasing the assumed cost trend rate by 1% each year would have increased the APBO by approximately 11% and 10% at December 31, 1993 and 1992, respectively. Aggregate service and interest costs would have increased by approximately 13% and 12% for 1993 and 1992, respectively. In 1991, the company established a retiree health benefits account (as defined in Section 401 of the Internal Revenue Code) within its domestic salaried employees' pension plan. Annually through 1995, the company may elect to transfer excess pension plan assets (subject to defined limitations) to the 401(h) account for purposes of funding current salaried retiree health care costs. The company transferred excess pension plan assets of $3.6 million in 1993, $3.9 million in 1992 and $7.8 million in 1991 ($4.2 million related to 1991 expenses and $3.6 million related to 1990 expenses) to the 401(h) account to fund salaried retiree health care benefits. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 10. INCOME TAXES ------------ Under Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109) adopted by the company in 1992, 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. The components of earnings (loss) from continuing operations before income taxes consisted of the following: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Domestic $ 54.5 $ 7.1 $(22.0) International 3.1 1.9 3.3 ----- ----- ----- $ 57.6 $ 9.0 $(18.7) ----- ----- ----- ----- ----- ----- Significant components of the provision for income taxes attributable to continuing operations are as follows: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Current: Federal $ 16.1 $ 4.1 $ 8.5 State and local 1.9 1.0 .8 International 6.5 5.0 4.2 ----- ----- ----- Total current 24.5 10.1 13.5 Deferred: Federal 5.2 (2.7) (12.5) State and local .1 (.2) (.7) International (12.3) (2.6) .8 ----- ----- ----- Total deferred (7.0) (5.5) (12.4) ----- ----- ----- $ 17.5 $ 4.6 $ 1.1 ----- ----- ----- ----- ----- ----- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 10. INCOME TAXES (continued) ------------ The reconciliation of income tax attributable to continuing operations computed at the United States federal statutory tax rates to income tax expense is: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Tax at U.S. statutory rates $ 20.1 $ 3.0 $ (6.4) Increase (decrease) from: State income taxes 1.3 .6 .5 International earnings subject to varying tax rates and tax effect of losses (.2) 1.3 5.0 Tax effect on sale of business (1.8) Tax effect of rate changes U.S. (1.4) Germany (2.9) Other differences 2.4 (.3) 2.0 ----- ----- ----- $ 17.5 $ 4.6 $ 1.1 ----- ----- ----- ----- ----- ----- In 1993 the company was subject to statutory rate changes both in the United States and in Germany. Income tax expense was decreased by $1.4 million and $2.9 million as a result of applying the newly enacted tax rates to the deferred tax balances as of the beginning of the period in the United States and Germany, respectively. However, the effect of the change in tax rates on the current year's income was to increase income tax expense by $.6 million and $1 million, respectively. As a result, net tax benefits of $.8 million and $1.9 million have been recognized, respectively. The following table summarizes the company's total provision for income taxes: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Continuing operations $ 17.5 $ 4.6 $ 1.1 Cumulative effect of accounting change (47.6) Discontinued operations 2.4 Allocated to equity: Currency translation (3.0) (2.5) Preferred dividends (1.6) (1.7) (1.7) Other (.7) ----- ----- ----- $ 12.9 $(47.9) $ 1.8 ----- ----- ----- ----- ----- ----- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 10. INCOME TAXES (continued) ------------ Significant components of the company's deferred tax liabilities and assets as of December 31 are as follows: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Deferred tax liabilities: Fixed asset basis differences $(60.0) $(67.9) $(69.0) Pension (12.5) (9.4) (8.3) ----- ----- ----- Total deferred tax liabilities (72.5) (77.3) (77.3) Deferred tax assets: Postretirement benefits other than pensions 55.3 51.6 - Special charges .2 11.9 6.0 Other non-deductible expenses 29.3 14.3 24.1 AMT credit carryforwards - 5.6 5.3 Foreign tax credit carryforwards 2.4 7.9 7.7 Net operating loss carryforwards of international subsidiaries 37.6 28.0 17.2 Other, net 2.6 4.3 (2.2) ----- ----- ----- Total deferred tax assets 127.4 123.6 58.1 Valuation allowance for deferred tax assets (21.0) (24.3) (21.2) ----- ----- ----- Net deferred tax assets 106.4 99.3 36.9 ----- ----- ----- $ 33.9 $ 22.0 $(40.4) ----- ----- ----- ----- ----- ----- At December 31, 1993, the company had net operating loss carryforwards in Germany of $46 million that are not subject to expiration. Net operating loss carryforwards of $49.5 million exist at other international subsidiaries subject to various expiration dates. Foreign tax credit carryforwards of $2.4 million will expire in years 1994 through 1998. Valuation allowances have been recognized against the net operating loss carryforwards (other than in Germany) and the foreign tax credit carryforwards. The company is not required to record valuation allowances for deferred tax assets where management believes it is more likely than not that the tax benefit will be realized. Valuation allowances were not established against deferred tax assets attributable to the company's postretirement benefit obligation and the German net operating loss carryforward. The deferred tax asset for the company's postretirement benefit obligation is $55.3 million at December 31, 1993. The total amount of future taxable income in the U.S. necessary to realize the asset is $149.5 million. The company could generate approximately $67 million of taxable income from the execution of reasonable and prudent tax planning strategies, principally through revoking the company's LIFO election. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 10. INCOME TAXES (continued) ------------ In addition to tax planning strategies, the company will need to generate additional taxable income of approximately $82.5 million in the U.S. through future operations in order to fully realize the deferred tax asset for the company's postretirement benefit obligation. Over the past ten years, the company has generated taxable income in the U.S., on average, of approximately $52 million per year. Based on the company's history of taxable income and its projection of future earnings, management believes that it is more likely than not that sufficient taxable income will be generated in the foreseeable future to realize the deferred tax asset. The deferred tax asset attributable to the German net operating loss carryforward is $19 million. Sufficient taxable income will be generated through the reversal of existing taxable temporary differences to enable the carryforward to be utilized. Deferred tax liabilities and assets are recorded in the consolidated balance sheets as follows: (Millions of Dollars) 1993 1992 -------- -------- Assets: Prepaid expenses and income tax benefits $ 19.4 $ 14.6 Business investments and other assets 27.5 34.7 Liabilities: Deferred income taxes (13.0) (27.3) ----- ----- $ 33.9 $ 22.0 ----- ----- ----- ----- Income taxes paid in 1993, 1992 and 1991 were $16.3 million, $10.5 million and $17.5 million, respectively. Undistributed earnings of the company's international subsidiaries amounted to approximately $70 million at December 31, 1993. No taxes have been provided on the $63 million of these earnings which are considered by the company to be permanently reinvested. Upon distribution of these earnings, the company would be subject to U.S. income taxes and foreign withholding taxes. Determining the unrecognized deferred tax liability on the distribution of these earnings is not practicable. However, the company believes the foreign withholding taxes would be insignificant and any United States income tax would be largely offset by foreign tax credits. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 11. OPERATIONS BY INDUSTRY SEGMENT AND GEOGRAPHIC AREA -------------------------------------------------- The company is a global distributor and manufacturer of a broad range of non-discretionary parts, primarily vehicular components for automobiles, light trucks, heavy duty trucks and farm and construction vehicles and industrial products. Through its worldwide distribution network, the company sells replacement parts in the vehicular aftermarket. The company also sells parts to original equipment manufacturers, principally the major automotive manufacturers in the United States and Europe. All of these activities constitute a single business segment. Financial information, summarized by geographic area, is as follows: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Net sales: United States and Canada $1,092.3 $ 817.5 $ 697.5 Europe 270.4 268.3 243.5 Other international 212.8 178.2 157.7 ------- ------- ------- $1,575.5 $1,264.0 $1,098.7 ------- ------- ------- ------- ------- ------- Operating profit: United States and Canada $ 91.0 $ 30.8 $ 18.6 Europe (2.3) (.9) (7.4) Other international 20.0 22.1 11.4 ------- ------- ------- Total operating profit (a) 108.7 52.0 22.6 Corporate expenses and other (24.3) (22.4) (18.6) ------- ------- ------- Operating earnings $ 84.4 $ 29.6 $ 4.0 ------- ------- ------- ------- ------- ------- Identifiable assets: United States and Canada $ 804.5 $ 618.2 $ 451.6 Europe 243.2 290.1 328.9 Other international 244.1 195.4 133.4 ------- ------- ------- $1,291.8 $1,103.7 $ 913.9 ------- ------- ------- ------- ------- ------- (a) Operating profit included special charges of $14 million and $25 million in 1992 and 1991, respectively. Transfers between geographic areas are not significant, and when made, are recorded at prices comparable to normal unaffiliated customer sales. Sales to domestic automotive manufacturers were approximately 16% of net sales in 1993 and included sales to General Motors Corporation of $141.7 million, $115.7 million and $112.2 million in 1993, 1992 and 1991, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 12. LITIGATION ---------- The company is involved in various legal actions arising in the normal course of business. After taking into consideration legal counsel's evaluation of such actions, management is of the opinion that their outcome will not have a significant effect on the company's consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 13. SUBSEQUENT EVENTS ----------------- In December 1993, the company filed a shelf registration with the SEC that permits the issuance of a combination of debt and equity securities up to $300 million over a two year period. In February 1994, the company used the shelf registration to offer 5.75 million shares of common stock to the public, generating net proceeds to the company of nearly $191 million. The offering proceeds were used to repay a portion of the outstanding debt which was principally used to purchase SPR. Had the February 1994 offering occurred on January 1, 1993, primary earnings per share for 1993 would have been unchanged at $1.13. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING - - - --------------------------------------------------- To Our Shareholders: The management of Federal-Mogul has the responsibility for preparing the accompanying financial statements and for their integrity and objectivity. The financial statements were prepared in accordance with generally accepted accounting principles and include amounts based on the best estimates and judgments of management. Management also prepared the other financial information in this report and is responsible for its accuracy and consistency with the financial statements. Federal-Mogul has retained independent auditors, ratified by election of the shareholders, to audit the financial statements. Federal-Mogul maintains a strong system of internal accounting controls supplemented by written policies and procedures, implemented by the careful selection and training of qualified personnel and verified by an extensive internal audit program. These measures, the cost of which is balanced against the benefits that may reasonably be expected therefrom, are designed to prevent significant misuse of company assets or misstatements of financial reports and to assure that business is conducted as directed by management in accordance with all applicable laws and the Federal-Mogul Code of Conduct. The Audit Committee of the Board of Directors, comprised of five outside directors, performs an oversight role related to financial reporting. The Committee periodically meets jointly and separately with the independent auditors, internal auditors and management to review their activities and reports, and to take any action appropriate to their findings. At all times the independent auditors have the opportunity to meet with the Audit Committee, without management representatives present, to discuss matters related to their audit. Dennis J. Gormley Chairman and Chief Executive Officer Martin E. Welch III Senior Vice President Chief Financial Officer James B. Carano Vice President and Controller REPORT OF INDEPENDENT AUDITORS - - - ------------------------------ Shareholders and Board of Directors Federal-Mogul Corporation We have audited the accompanying consolidated balance sheets of Federal-Mogul 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. 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 Federal-Mogul 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. 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. Detroit, Michigan February 8, 1994 QUARTERLY FINANCIAL DATA (UNAUDITED) - - - ------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- Net earnings in the first quarter of 1992 were adversely impacted by $88.1 million ($3.93 per share) representing the cumulative effect of a change in the method of accounting for postretirement benefits other than pensions. Quarterly net earnings and earnings per share for the first three quarters of 1992 have been restated from amounts previously reported. Net earnings in the fourth quarter of 1992 were adversely impacted by a special charge of $.40 per share. Refer to Notes 1 and 2 to the consolidated financial statements for further discussion of these matters. In the fourth quarter of 1992, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), retroactively to 1989. Quarterly net earnings and earnings per share have been restated from amounts previously reported in conjunction with the provisions of SFAS 109. 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 is incorporated by reference from pages 1 through 5 of the company's definitive proxy statement dated March 18, 1994 relating to its 1994 annual meeting of shareholders (the "1994 Proxy") under the heading "Nominees for Election as Directors" except that the information required by Item 10 with respect to executive officers included under Part I of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - - - ---------------------------------- The information required by this item is incorporated by reference from the 1994 Proxy under the headings "Information on Executive Compensation" on pages 9 to 11 and under the heading "Retirement Plans" on page 15 and "Nominees for Election as Directors" on pages 4 and 5 of the Proxy. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - - - -------------------------------------------------------------------------- The information required by this item is incorporated by reference from pages 15 through 18 of the 1994 Proxy under the heading "Information on Securities". 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) The following documents are filed as part of this report: 1. Financial Statements: Financial statements filed as part of this Form 10-K are listed under Part II, Item 8 of this Form 10-K. 2. 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 Financial Statements and Schedules Omitted: Schedules other than those listed above are omitted because they are not required under instructions contained in Regulation S-X or because the information called for is shown in the financial statements and notes thereto. Individual financial statements of subsidiaries of the Company have been omitted as the Company is primarily an operating company and all subsidiaries included in the consolidated financial statements filed, in the aggregate, do not have minority equity interests and/or indebtedness to any person other than the Company or its consolidated subsidiaries in amounts which together exceed 5% of the total assets of the Company as shown by the most recent year-end Consolidated Balance Sheet. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION AND SUBSIDIARIES ------------------------------------------ (In Millions) SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - - - ----------------------------------------------------------- FEDERAL-MOGUL CORPORATION AND SUBSIDIARIES ------------------------------------------ (In Millions) SCHEDULE IX - SHORT-TERM BORROWINGS - - - ----------------------------------- FEDERAL-MOGUL CORPORATION AND SUBSIDIARIES ------------------------------------------ (In Millions, Except Percents) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION - - - ------------------------------------------------------- FEDERAL-MOGUL CORPORATION AND SUBSIDIARIES ------------------------------------------ (In Millions) COLUMN A COLUMN B - - - -------------------------------------- --------------------------------- Item Charged to Costs and Expenses - - - -------------------------------------- --------------------------------- Year Ended December 31 3. Exhibits: 3.1 The Registrant's Second Restated Articles of Incorporation, as amended (filed as Exhibit 3.1 to Registrant's Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference). 3.2 The Registrant's Bylaws, as amended (filed as Exhibit 3.2 to Registrant's Form 10-K for the year ended December 31, 1993, and incorporated herein by reference). 4.2 Rights Agreement ("Rights Agreement") between Registrant and National Bank of Detroit as Rights Agent with Bank of New York as successor Rights Agent (filed as Exhibit 1 to Registrant's Form 8-A Registration Statement dated November 7, 1988, and incorporated herein by reference). 4.3 Amendments dated July 25, 1990, to Rights Agreement (filed as Exhibit 4.5 to the 1990 Second Quarter 10-Q). 4.4 Amendment dated September 23, 1992 to Rights Agreement (filed as Exhibit 4.4 to Registrant's Form 10-K for the year ended December 31, 1993 and incorporated herein by reference). 4.5 Reference is made to Exhibit 3.1 hereto which contains provisions defining the rights of securities holders of the long- term debt securities of the Registrant and any of its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed. Other instruments defining the rights of holders of long-term debt of the Registrant and its subsidiaries have not been filed because in each case the total amount of long-term debt permitted thereunder does not exceed 10% of the Registrant's consolidated assets and the Registrant hereby agrees to furnish such instruments to the Securities and Exchange Commission upon its request. 4.6 Second Amended and Restated Revolving Credit Agreement dated October 19, 1993, among the Company, various banks, and Chemical Bank, as agent (filed as Exhibit 4.6 to Registrant's Registration Statement on Form S-3 No. 33-51265 dated December 3, 1993 and incorporated herein by reference). 10.1 The Registrant's 1976 Stock Option Plan, as last amended November 3, 1988 (filed as Exhibit 10.27 to the 1988 10-K, and incorporated herein by reference). 10.2 The Registrant's 1984 Stock Option Plan as last amended, (filed as Exhibit 10.26 to the 1988 10-K, and incorporated herein by reference). 10.3 The Registrant's 1977 Supplemental Compensation Plan, as amended and restated effective as of January 1, 1986 (refiled as Exhibit 10.3 to the 1993 10-K, and incorporated herein by reference). 10.4 Registrant's Supplemental Compensation Retirement Trust Agreement (filed as Exhibit 10.1 to the 1988 Third Quarter 10-Q and incorporated herein by reference). 10.6 Form of Executive Severance Agreement between the Registrant and certain executive officers, (refiled as Exhibit 10.6 to the 1990 10-K, and incorporated herein by reference). 10.7 Amended and Restated Deferred Compensation Plan for Corporate Directors (refiled as Exhibit 10.7 to the 1990 10-K, and incorporated herein by reference). 10.10 Supplemental Executive Retirement Plan, as amended (refiled as Exhibit 10.10 to the 1992 10-K, and incorporated herein by reference). 10.11 Description of Umbrella Excess Liability Insurance for the Executive Council (refiled as Exhibit 10.11 to the 1990 10- K, and incorporated herein by reference). 10.12 Guaranty and Contingent Purchase Agreement of Federal-Mogul Corporation dated February 15, 1989, between the Registrant and Aetna Life Insurance Company ("Guaranty and Contingent Purchase Agreement" filed as Exhibit 10.28 to the 1988 10-K, and incorporated herein by reference). 10.13 Note Agreement dated February 15, 1989, between the Federal-Mogul Corporation Salaried Employees Stock Ownership Trust and Aetna Life Insurance Company (filed as Exhibit 10.29 to the 1988 10-K, and incorporated herein by reference). 10.14 Federal-Mogul Corporation 1989 Performance Incentive Stock Plan (filed as Exhibit 10.31 to the 1988 10-K, and incorporated herein by reference). 10.15 Supply Agreement dated as of October 19, 1992 between the Company and TRW Inc. (filed as Exhibit 10.15 to the 1992 10-K, and incorporated herein by reference). 10.16 Federal-Mogul Corporation Note Agreement dated December 1, 1990 ("12/1/90 Note Agreement") between the Registrant and various financial institutions listed therein(filed as Exhibit 10.17 to the 1991 10-K, and incorporated herein by reference). 10.17 First Amendment dated as of March 9, 1992 to Note Agreement dated February 15, 1989, between the Federal-Mogul Corporation Salaried Employees Stock Ownership Trust and Aetna Life Insurance Company (filed as Exhibit 10.19 to the Registrant's Quarterly Report on Form 10-Q for the first quarter of 1993, and incorporated herein by reference). 10.18 First Amendment dated as of March 9, 1992 to Guaranty and Contingent Purchase Agreement (filed as Exhibit 10.20 to the Registrant's Quarterly Report on Form 10-Q for the first quarter of 1993, and incorporated herein by reference). 10.19 Pooling and Servicing Agreement dated as of June 1, 1992 ("Pooling and Servicing Agreement") among Federal-Mogul Funding Corporation, as Seller, Federal-Mogul Corporation, as Servicer, and Chemical Bank, as trustee (filed as Exhibit 10.21 to the Registrant's Quarterly Report on Form 10-Q for the second quarter of 1993, and incorporated herein by reference). 10.20 Series 1992-1 Supplement dated as of June 1, 1992 to the Pooling and Servicing Agreement (filed as Exhibit 10.22 to the registrant's Quarter Report on Form 10-Q for the second quarter of 1992, and incorporated herein by reference). 10.21 Receivables Purchase Agreement dated as of June 1, 1992 between the Company and Federal-Mogul Funding Corporation (filed as Exhibit 10.23 to the 1992 Form 10-K, and incorporated herein by reference). 10.22 Second Amendment dated as of October 19, 1992 to Guaranty and Contingent Purchase Agreement (filed as Exhibit 10.24 to the 1992 Form 10-K and incorporated herein by reference). 10.23 First Amendment dated as of December 11, 1992, to 12/1/90 Note Agreement (filed as Exhibit 10.27 to the 1992 Form 10- K, and incorporated herein by reference). 10.24 Series 1993-1 Supplement dated as of March 1, 1993 to the Pooling and Servicing Agreement dated June 1, 1992 among the Company, Federal-Mogul Funding Corporation and Chemical Bank trustee (filed as Exhibit 10.29 to the Form 10-K for the first quarter of 1992 and incorporated herein by reference). 10.25 Amendment to Rights Agreement between Federal-Mogul Corporation and the Bank of New York, (filed as Exhibit 10.30 to the second quarter 1992 Form 10-Q and incorporated herein by reference). 11.1 Statement Re: Computation of Per Share earnings (filed herewith). 21.1 Subsidiaries of the Registrant (filed herewith). 23.1 Consent of Ernst & Young (filed herewith). 24.1 Powers of Attorney (filed herewith). The Company will furnish upon request any exhibit described above upon payment of the Company's reasonable expenses for furnishing such exhibit. (b) Report on Form 8-K: A report on Form 8-K dated November 10, 1993 was filed pursuant to Item 2 by the Company during the fourth quarter of 1993 concerning the Company's acquisition of the automotive aftermarket business of Sealed Power Replacement Division of SPX Corporation ("SPR"). The report was amended by Form 8-K/A dated December 3, 1993 to include financial statements of SPR and pro forma financial statements of SPR and the Company which were unavailable at the time the report was filed. 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, thereto duly authorized. FEDERAL-MOGUL CORPORATION By: (Martin E. Welch III) ------------------------------ Martin E. Welch III Senior Vice President and Chief Financial Officer Dated as of March 25, 1994 Pursuant to the required 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 as of the date(s) indicated. Signature Title (D.J. Gormley)* - - - ------------------------ Chairman of the Board, D. J. Gormley President and Chief Executive Officer (M.E. Welch III) - - - ------------------------ Senior Vice President and M. E. Welch III Chief Financial Officer (Principal Financial Officer) (J.B. Carano) - - - ------------------------ Vice President and Controller J. B. Carano (Principal Accounting Officer) (Thomas F. Russell)* - - - ------------------------ Director Thomas F. Russell (Roderick M. Hills)* - - - ------------------------ Director Roderick M. Hills (John J. Fannon)* - - - ------------------------ Director John J. Fannon (Antonio Madero)* - - - ------------------------ Director Antonio Madero (Walter J. McCarthy, Jr.)* - - - ------------------------ Director Walter J. McCarthy, Jr. (Robert S. Miller, Jr.)* - - - ------------------------ Director Robert S. Miller, Jr. (John C. Pope)* - - - ------------------------ Director John C. Pope (Dr. Hugo Michael Sekyra)* - - - ------------------------ Director Dr. Hugo Michael Sekyra *By: (George N. Bashara, Jr.) ------------------------- George N. Bashara, Jr. Attorney-in-fact Dated as of March 25, 1994

314890_1993.txt

314890_1993

1993

314890

Item 1. BUSINESS (a) General Development of Business WICOR, Inc. (the "Company" or "WICOR") is a diversified holding company with two principal businesses: natural gas distribution and manufacturing of pumps and water processing equipment. Wisconsin Gas Company ("Wisconsin Gas") engages in retail distribution of natural gas. Sta-Rite Industries, Inc. ("Sta-Rite") and SHURflo Pump Manufacturing Co. ("SHURflo") are manufacturers of pumps and water processing equipment. WEXCO of Delaware, Inc. ("WEXCO"), another subsidiary, previously engaged in exploration for and development of oil and natural gas through financial participation with producers. WEXCO sold substantially all of its assets in 1993. The Company is a Wisconsin corporation and maintains its principal executive offices in Milwaukee, Wisconsin. The Company was incorporated in 1980 at which time it acquired all the outstanding common stock of Wisconsin Gas through a merger. WEXCO, formed in 1978 as a subsidiary of Wisconsin Gas, also became a subsidiary of the Company. The Company acquired all of the outstanding common stock of Sta-Rite through a merger in 1982. In 1991, Sta-Rite completed the sale of its Fluid Power Group and its Heating Group. This decision was part of Sta-Rite's long- term strategy to concentrate on its water products operations and pursue opportunities for further growth. In 1991, Sta-Rite purchased the operating assets of Aquality, Inc., a manufacturer of swimming pool accessories. In April 1992, Sta-Rite purchased a majority shareholder interest in Nocchi Pompe S.p.A., a manufacturer of small water pumps and related equipment, located near Pisa, Italy. During 1992, the Company increased its ownership interest in Filtron Technology Corp. to 21%. In July 1993, the Company acquired all of the outstanding stock of SHURflo through a merger. SHURflo is a manufacturer of small pumps for the food service, recreational vehicle, marine, industrial and water purification markets. In November 1993, Sta-Rite acquired Dega Research Pty, a Melbourne, Australia-based manufacturer of pumps, filters and accessories for the pool and spa market. This acquisition made Sta- Rite the largest pool and spa equipment company in Australia, which is the second largest market in the world for these products. The Company (including subsidiaries) has 3,222 full-time equivalent employees. (b) Financial Information About Industry Segments Reference is made to "Financial Review-General Overview" included in Exhibit 13, which is hereby incorporated herein by reference. (c) Narrative Description of Business 1. RETAIL DISTRIBUTION OF NATURAL GAS A. General Wisconsin Gas is the largest natural gas distribution public utility in Wisconsin, where all of its business is conducted. At December 31, 1993, Wisconsin Gas distributed gas to approximately 485,000 residential, commercial and industrial customers in 487 communities throughout Wisconsin with an estimated population of 1,867,000 based on the State of Wisconsin's estimates for 1993. Wisconsin Gas is subject to the jurisdiction of the Public Service Commission of Wisconsin ("PSCW") as to various phases of its operations, including rates, service and issuance of securities. See "Wisconsin Rate and Regulatory Matters." B. Gas Markets and Competition Wisconsin Gas' business is highly seasonal, particularly as to residential and commercial sales for space heating purposes, with a substantial portion of its sales occurring in the winter heating season. Competition in varying degrees exists between natural gas and other forms of energy available to consumers. Most of Wisconsin Gas' large commercial and industrial customers are dual-fuel customers that are equipped to switch between natural gas and alternate fuels. Wisconsin Gas offers transportation services for these customers to enable them to reduce their energy costs and use gas rather than other fuels. Under gas transportation agreements, customers seek to purchase lower-priced spot market gas directly from producers or other sellers and arrange with pipelines and Wisconsin Gas to have the gas transported to their facilities. Wisconsin Gas actively assists customers in buying gas and arranging transportation. Wisconsin Gas also offers gas sales services that are priced to compete with these transportation services. Wisconsin Gas earns the same margin (difference between revenue and cost), whether it sells gas to customers or transports customer-owned gas. The following table sets forth the volumes of natural gas delivered by Wisconsin Gas to its customers. *One therm equals 100,000 BTU's. The volumes shown as transported represent customer-owned gas that was delivered by Wisconsin Gas to its customers. The remaining volumes represent quantities sold to customers by Wisconsin Gas. Wisconsin Gas has taken certain steps in recent years to enable it to compete in an increasingly competitive gas industry. Wisconsin Gas has instituted a service options program which provides customers an array of sales, transportation and related services from which they can choose. The service options program also assists Wisconsin Gas in identifying the peak day and annual gas requirements that Wisconsin Gas is obligated to supply. The service options program thus provides customers with a choice of services that they can select to meet their needs while defining Wisconsin Gas' obligation to obtain and sell gas to customers. In 1993, Wisconsin Gas introduced a gas supply management service aimed at its larger customers. Under this service, Wisconsin Gas manages the customer's gas supply. Gas management service customers are freed from the responsibilities imposed by Federal regulation of dealing with one or more gas suppliers, an interstate pipeline and a utility on a daily basis to order the precise gas supply and capacity necessary to meet their varying daily gas requirements. See "Gas Supply and Pipeline Capacity." In 1993, Wisconsin Gas added more than 14,000 customers, surpassing record totals for the fifth consecutive year. See "Service Area Expansion". Up to 25% of Wisconsin Gas' Milwaukee area annual market requirements can be supplied through the interstate pipelines of either ANR Pipeline Company ("ANR") or Northern Natural Gas Company ("NNG"). This capability enhances competition between ANR and NNG for services to Wisconsin Gas and its customers, and Wisconsin Gas believes that such competition provides overall lower gas costs to all customers than otherwise would exist. Wisconsin Gas' future ability to maintain its present share of the industrial dual-fuel market (the market that has installed capability to use gas or other fuels) depends upon Wisconsin Gas' success in obtaining long-term and short-term supplies of natural gas at marketable prices and its success in arranging or facilitating transportation service for those customers that desire to buy their own gas supplies. Although the dual-fuel market comprises approximately 32% of Wisconsin Gas' annual deliveries, it contributes only about 14% of the company's margin. C. Gas Supply and Pipeline Capacity (1) General In recent years, the natural gas industry has undergone structural changes designed to increase competition. In 1992, the Federal Energy Regulatory Commission ("FERC") issued Order No. 636 which fundamentally restructured the interstate natural gas pipeline industry. Prior to Order No. 636, the pipelines serving Wisconsin Gas were major sellers of gas to Wisconsin Gas. They sold gas on a "bundled" or delivered-to-Wisconsin basis. Under Order No. 636, the pipelines are required to "unbundle" the sale of gas from the related transportation service. Consequently, pipelines may no longer provide the delivered-to-Wisconsin gas sales service. Rather, they must sell gas at or near the point of production in competition with other gas sellers. Under Order No. 636, purchasers such as Wisconsin Gas contract separately with one or more sellers for gas supply and with pipelines for capacity to move the gas to markets or into market area storage for future delivery. In the opinion of management, Order No. 636 will not have a material impact on Wisconsin Gas' earnings. ANR and NNG completed the transition to unbundled service on November 1, 1993. Consequently, Wisconsin Gas has replaced all of its "bundled" pipeline services with "unbundled" firm pipeline transportation and storage services and long-term contracts with producers and marketers for firm gas supply. Thus, 1993 was a transition year in which Wisconsin Gas purchased gas supply and capacity under interim arrangements with pipeline suppliers for much of the year and under the Order No. 636 restructured regime described above for the last two months of the year. The following table sets forth the sources and volumes of gas purchased by Wisconsin Gas and volumes of customer-owned gas transported by Wisconsin Gas. *One therm equals 100,000 BTU's. (2) Pipeline Capacity Interstate pipelines serving Wisconsin originate in three major gas producing areas of North America: the traditional Oklahoma and Texas basins; the Gulf of Mexico off-shore from Texas and Louisiana and the adjacent on-shore producing areas of those states; and western Canada. Wisconsin Gas has contracted for long-term firm capacity on a relatively equal basis from each of these areas. This strategy reflects management's belief that overall supply security is enhanced by geographic diversification of Wisconsin Gas' supply portfolio and that Canada represents an important long-term source of reliable, competitively priced gas. Because of the seasonal variations in gas usage in Wisconsin, Wisconsin Gas has also contracted with ANR and NNG for substantial underground storage capacity, primarily in Michigan. There is no known underground storage capability in Wisconsin. Storage enables Wisconsin Gas to optimize its overall gas supply and capacity costs. In summer, gas in excess of market demand is transported into the storage fields, and in winter, gas is withdrawn from storage and combined with gas purchased in or near the production areas ("flowing gas") to meet the increased winter market demand. As a result, Wisconsin Gas can contract for less pipeline capacity than would otherwise be necessary, and it can purchase gas on a more uniform daily basis from suppliers year-around. Each of these capabilities enables Wisconsin Gas to reduce its overall costs. Wisconsin Gas' firm winter daily transportation and storage capacity entitlements from pipelines under long-term contracts are set forth below. Maximum Daily (Thousands Pipeline of Therms*) ----------------- ------------- ANR Mainline 3,175 Storage 4,996 NNG Mainline 1,226 Storage 145 Viking Mainline 64 ----------- Total 9,606 =========== *One therm equals 100,000 BTU's. (3) Long-Term Gas Supply Wisconsin Gas has long-term firm contracts with approximately 30 gas suppliers for gas produced in each of the three producing areas discussed above. The following table sets forth Wisconsin Gas' winter season maximum daily firm total gas supply. Maximum Daily (Thousands of Therms*) ------------- Domestic flowing gas 2,259 Canadian flowing gas 1,396 Storage withdrawals 5,157 ------------- Total 8,812 ============= *One therm equals 100,000 BTU's. (4) Spot Market Gas Supply Wisconsin Gas expects to continue to make gas purchases in the 30-day spot market as price and other circumstances dictate. Wisconsin Gas has purchased spot market gas since 1985 and has supply relationships with a number of sellers from whom it purchases spot gas. D. Wisconsin Rate and Regulatory Matters (1) Rate Matters Wisconsin Gas is subject to the jurisdiction of the PSCW as to various phases of its operations, including rates, customer service and issuance of securities. Effective November 12, 1993, the PSCW granted Wisconsin Gas a $12.3 million general rate increase. Wisconsin Gas' authorized return on common equity was reduced from 12.75% to 11.8%. The PSCW has implemented a bi-annual rate case process for energy utilities pursuant to which Wisconsin Gas' next rate change would be effective November 1, 1995. In July 1993, Wisconsin Gas filed a proposal to adjust rates up to a ceiling amount. The ceiling amount is based on the latest allowed rates, adjusted annually for inflation and reduced by a predetermined productivity factor. A decision on the proposal is expected in April 1994. Wisconsin Gas is unable to predict whether the PSCW will approve its proposal. Wisconsin Gas' rates contain clauses providing for periodic adjustment, with PSCW approval, to reflect changes in purchased gas costs including the recovery of transition costs passed through by pipeline suppliers. See "Transition Cost Recovery Policy". (2) Transition Cost Recovery Policy Under Order No. 636, interstate pipelines are permitted to recover certain costs incurred in the transition from the bundled sales service to the unbundled Order No. 636 regime. ANR and NNG have filed to recover transition costs. ANR and NNG may file in the future to recover additional transition costs, and Wisconsin Gas will bear a portion of such additional costs approved by the FERC. The PSCW has permitted Wisconsin Gas to recover transition costs from customers through its rates. In the judgment of management, the incurrence of these transition costs will have no material effect on Wisconsin Gas' operations or financial condition under current PSCW policy. See Note 8 to Notes to Consolidated Financial Statements contained in Exhibit 13, which note is hereby incorporated herein by reference. (3) Service Area Expansion In recent years, Wisconsin Gas has increased its efforts to obtain regulatory approvals to extend gas service to previously unserved communities. In 1992, Wisconsin Gas extended service to 30 new communities and added 10,400 customers. In 1993, Wisconsin Gas extended service to 41 new communities and added more than 14,000 customers. E. Employees At December 31, 1993, Wisconsin Gas had 1,353 full-time equivalent active employees. 2. MANUFACTURING OF PUMPS AND WATER PROCESSING EQUIPMENT A. General The Company's manufacturing subsidiaries manufacture pumps and water processing equipment used to pump, control and filter water, and positive displacement pumps and other accessories used for fluid handling in a wide array of specialized applications and markets. Manufacturing and assembly activities are conducted in plants in the United States, United Kingdom, Canada, Germany, Italy, Australia, New Zealand and Russia. B. U.S. Operations Water products include jet, centrifugal, sump, submersible and submersible turbine water pumps, water storage and pressure tanks, filters, and pump and tank systems. These products pump, filter and store water used for drinking, cooking, washing and livestock watering, and are used in private and public swimming pools, spas, "hot tubs", jetted bathtubs, and fountains. The manufacturing businesses produce large higher pressure and capacity water pumps used in agricultural and turf irrigation systems and in a wide variety of commercial, industrial and municipal fluids- handling applications. Small, high performance pumps, and related fluids-handling products, are used in four primary markets: (1) the food service industry, where gas operated pumps are used for pumping soft drinks made from syrups, and electric motor driven pumps are used for water boost and drink dispensing; (2) the recreational vehicle and marine markets, where electric motor driven pumps are used for a variety of applications including pumping potable water in travel trailers, motor homes, camping trailers and boats, and for other applications including marine wash down, bilge and live well pumping; (3) industrial markets, where applications are concentrated in the soil extraction market for use in carpet cleaning machines, agricultural markets for spraying agricultural pesticides and fertilizers, and general industrial applications requiring fluid handling; and (4) the water purification industry, where electric motor driven pumps are used to pressurize reverse osmosis systems and for water transfer. Sales of pumps and water processing equipment are somewhat related to the seasons of the year as well as the level of activity in the housing construction industry and are sensitive to weather, interest rates, discretionary income, and leisure and recreation spending. The markets for most water and industrial products are highly competitive, with price, service and product performance all being important competitive factors. The Company believes it is a leading producer of pumps for private water systems and swimming pools and spas and for the food service and recreational vehicle markets. The Company's centrifugal pumps command a major share of the agricultural and irrigation centrifugal market. The Company also ranks among the larger producers of pool and spa filters and submersible turbine pumps. Major brand names include "STA-RITE", "BERKELEY", "SHURflo", "FLOTEC", "TOWN & COUNTRY", "SWIMQUIP" and "AQUALITY." Domestic pumps and water products are sold and serviced primarily through a network of independent distributors, dealers and manufacturers' representatives serving the well drilling, hardware, plumbing, pump installing, irriga-tion, pool and spa, food service, recreational vehicle, marine, and industrial markets. Sales are also made on a private brand basis to large customers in all water products markets and to original equipment manufacturers. Backlog of orders for pumps and water products is not a significant indicator of future sales. C. International Operations International operations are conducted primarily by international subsidiaries and export operations from the United States. Products are sold to markets in approximately 110 countries on six continents. Foreign manufacturing of products from imported and locally manufactured components is carried out by United Kingdom, German, Canadian, Australian, New Zealand, Italian, and Russian subsidiaries. The products sold in the international markets are similar to those sold in the United States, but in many instances have distinct features required for those markets. Product distribution channels are similar to those for domestic markets. Non-domestic sales, including exports, were 34% of 1993 manufacturing sales. D. Raw Materials and Patents Raw materials essential to the manufacturing operations are available from various established sources in the United States and overseas. The principal raw materials needed for production of the Company's primary lines of products include cast iron, aluminum and bronze castings for pumps; copper and aluminum wire for motors; stainless and carbon sheet steel, bar steel and tubing; plastic resins for injection molded components; and powdered metal components. The manufacturing units also purchase from third party suppliers completely assembled electric motors, plastic molded parts, elastomers for valves and diaphragms, components for electric motors, stamped and die cast metal parts, and hardware and electrical components. Although the manufacturing subsidiaries own a number of patents and hold licenses for manufacturing rights under other patents, no one patent or group of patents is critical to the success of the manufacturing businesses as a whole. E. Employees At December 31, 1993, the manufacturing businesses had 1,869 full time equivalent active employees. 3. EXPLORATION AND DEVELOPMENT OF OIL AND NATURAL GAS WEXCO was formed in 1978, a time of national gas shortages, primarily to develop additional future sources of energy for Wisconsin Gas. WEXCO participated in gas and oil exploration and development activities through financial participation with producers. In 1993, in connection with the Company's strategic decision to focus on its primary businesses, WEXCO sold substantially all of its assets. Item 2. Item 2. PROPERTIES (a) Capital Expenditures The Company's capital expenditures for the year ended December 31, 1993, totaled $51.9 million. Retirements during this period totaled $40.0 million, of which $32.8 million represented the original cost of the WEXCO assets sold. See "Properties - Exploration and Development of Oil and Natural Gas." Except as discussed in "Legal Proceedings", the Company does not expect to make any material capital expenditures for environmental control facilities in 1994. (b) Retail Distribution of Natural Gas Wisconsin Gas owns a distribution system which, on December 31, 1993, included approximately 7,800 miles of distribution and transmission mains, 399,000 services and 488,000 active meters. Wisconsin Gas' distribution system consists almost entirely of plastic and coated steel pipe. Wisconsin Gas also owns its main office building in Milwaukee, office buildings in certain other communities in which it serves, gas regulating and metering sta- tions, peaking facilities and its major service centers, including garage and warehouse facilities. The Milwaukee and other office buildings, the principal service facilities and the gas distribution systems of Wisconsin Gas are owned by it in fee subject to the lien of its Indenture of Mortgage and Deed of Trust, dated as of November 1, 1950, under which its first mortgage bonds are issued, and to permissible encumbrances as therein defined. Where distribution mains and services occupy private property, Wisconsin Gas in some, but not all, instances has obtained consents, permits or easements for such installations from the apparent owners or those in possession, generally without an examination of title. (c) Manufacturing of Pumps and Water Processing Equipment The manufacturing businesses have 12 manufacturing facilities located in California (2), Nebraska, Wisconsin (2), Germany, Italy (2), Australia (2), New Zealand and Russia. These plants contain a total of approximately 790,000 square feet of floor space. These businesses also own or lease seven sales/distribution facilities in the United States, six in Australia, two each in France and England, and one each in Canada and Singapore. (d) Exploration and Development of Oil and Natural Gas In 1993, WEXCO sold substantially all of its assets for approximately their book value of $4.0 million. Item 3. Item 3. LEGAL PROCEEDINGS There are no material legal proceedings pending, other than ordinary routine litigation incidental to the Company's businesses, to which the Company or any of its subsidiaries is a party, except as discussed below. There are no material legal proceedings to which any officer or director of the Company or any of its subsidiaries is a party or has a material interest adverse to the Company. There are no material administrative or judicial proceedings arising under environmental quality or civil rights statutes pending or known to be contemplated by governmental agencies to which the Company or any of its subsidiaries is or would be a party. Sta-Rite has entered into a contract with the Wisconsin Department of Natural Resources ("DNR") to perform and complete the Remedial Investigation/Feasibility Study and Remedial Design/Remedial Action phases of the Federal Superfund environmental process for the Delavan, Wisconsin Municipal Well No. 4, which is located close to one of Sta-Rite's facilities. In 1990 and 1991, Sta-Rite provided reserves to cover the estimated costs under the contract. No additions to reserves were required in 1992 or 1993. Although management believes the amounts reserved will be adequate to effect any necessary remediation, there is a possibility that unexpected additional costs may be incurred. Sta-Rite, along with other generators, has been sued by Waste Management of Wisconsin, Inc. for cleanup costs relating to a landfill near Sta-Rite's former Deerfield operation. Sta-Rite has established reserves to cover reasonable costs associated with this litigation. Sta-Rite has been notified by two environmental groups in California of their intent to pursue litigation against a number of submersible pump manufacturers, including Sta-Rite, for violations of the state's health and safety code (Proposition 65). The Company is in the process of evaluating the claims. Wisconsin Gas has identified two previously owned sites on which it operated manufactured gas plants that are of environmental concern. Such plants ceased operations prior to the mid-1950's. Wisconsin Gas has engaged an environmental consultant to help determine the nature and extent of the contamination at these sites. Based on the test results obtained and the possible remediation alternatives available, the Company has estimated that cleanup costs could range from $22 million to $75 million. As of December 31, 1993, the Company has accrued $40 million for cleanup costs in addition to $1.6 million of costs already incurred. These estimates are based on current undiscounted costs. It should also be noted that the numerous assumptions such as the type and extent of contamination, available remediation techniques, and regulatory requirements which are used in developing these estimates are subject to change as new information becomes available. Any such changes in assumptions could have a significant impact on the potential liability. A formal remediation plan is currently being developed for presentation to the DNR. Following plan approval and pilot studies, remediation will commence. Barring unforeseen delays, expenditures by Wisconsin Gas on this remediation work will commence in 1994 and increase in future years as plan approvals are obtained. Expenditures over the next three years are expected to total approximately $20 million. Although most of the work and costs will be incurred in the first few years of the plan, monitoring of the sites and other necessary actions may last up to 30 years. Wisconsin Gas is pursuing recovery of these costs from insurance carriers. Any amounts not recoverable from insurance carriers will be allowed full recovery in rates, based on recent PSCW orders. Accordingly, the accrual has been offset by a deferred charge to a regulatory asset. Certain related investigation costs incurred to date are currently being recovered in utility rates. However, any incurred costs not yet recovered in rates are not allowed by the PSCW to earn a return. As of December 31, 1993, $1.6 million of such costs have been incurred. In 1992, the owner of a portion of one of the properties on which manufactured gas operations were conducted commenced suit in Federal district court against Wisconsin Gas. The suit, which was settled in 1993, generally sought indemnity and contribution under Federal statutes and alleged that Wisconsin Gas is liable for remediating the environmental conditions found to be caused by any releases of hazardous substances from the gasification activities at the site. Under the settlement, Wisconsin Gas has agreed to indemnify the owner from any remediation costs attributable to the release of hazardous substances from the gasification activities on the site. In the judgment of management, the settlement does not materially change Wisconsin Gas' responsibility as required by Federal or state statutes for remediating the environmental conditions found to be caused by any releases of hazardous substances from the gasification activities at the site, which ceased about 40 years ago, the cost of any remediation actions that may be required, or its ability to recover such costs in its rates or from insurers. Wisconsin Gas also owns a service center that is constructed on a site that was previously owned by the City of Milwaukee and was used by the City as a public dump site. Wisconsin Gas has conducted a site assessment at the request of the DNR and has sent the report of its assessment to the DNR. Management cannot predict whether or not the DNR will require any remediation action, nor the extent or cost of any remediation actions that may be required. In the judgment of management, any remediation costs incurred by Wisconsin Gas will be recoverable from the City of Milwaukee or in Wisconsin Gas' rates. 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 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following sets forth the names, ages, and offices held of the executive officers of the Company. The officers serve one- year terms commencing with their election at the meeting of the Board of Directors following the annual meeting of shareholders in April. Mr. Wardeberg was elected to his current positions effective February 1, 1994. Prior thereto he was President and Chief Operating Officer of the Company and Vice Chairman and Chief Executive Officer of Sta-Rite from 1992 to 1994; Vice Chairman of Wisconsin Gas and SHURflo from 1993 to 1994; and Vice President- Water Systems of Sta-Rite from 1989 to 1992. Prior thereto, he was Vice Chairman and Chief Operating Officer of Whirlpool Corporation. Mr. Schrader was elected Vice President of the Company in 1988 and President and Chief Executive Officer of Wisconsin Gas in 1990. Prior thereto, he served as President and Chief Operating Officer of Wisconsin Gas from 1988 to 1990, Executive Vice President from 1986 to 1988, Vice President and Assistant to the Chairman from 1985 to 1986, and Vice President-Market Services from 1983 to 1985. He held several other positions with Wisconsin Gas from 1978 to 1983. Mr. Donnelly was elected President and Chief Operating Officer of Sta-Rite in 1992. Previously he served as Vice President, Treasurer and Chief Financial Officer of the Company and Wisconsin Gas since 1990. He continues as a Vice President of the Company. Mr. Donnelly joined the Company and Wisconsin Gas in 1987 as Vice President and Treasurer. Prior thereto, he served as Vice President-Finance of Eastern Gas and Fuel Associates from 1984 to 1987 and as Vice President-Finance of Boston Gas Company, a subsidiary of Eastern Gas and Fuel Associates, from 1978 to 1984. Mr. Wenzler was elected Vice President, Treasurer and Chief Financial Officer of the Company and Vice President and Chief Financial Officer of Wisconsin Gas in 1992. Prior thereto, he served as Vice President of the Company and President and Chief Executive Officer of Sta-Rite from 1990 to 1992, President and Chief Operating Officer from 1986 to 1990, Executive Vice President from 1985 to 1986, Vice President-Finance, Secretary and Treasurer from 1984 to 1985, and Vice President-Finance and Treasurer from 1981 to 1984. Mr. Nuernberg was elected Secretary of the Company in 1987 and Vice President-Corporate Relations and Secretary of Wisconsin Gas in 1988. Prior thereto, he served as Vice President-Law and Secretary of Wisconsin Gas from 1983 to 1988 and as Secretary from 1982 to 1983. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock and the associated common stock purchase rights (which do not currently trade independent of the common stock) are traded on the New York Stock Exchange. For information regarding the high and low sales prices for the Company's common stock and dividends paid per share in each quarter of 1993 and 1992, see "Investor Information" included in Exhibit 13, which is hereby incorporated herein by reference. At December 31, 1993, there were 17,091 holders of record of WICOR common stock. The Company's ability to pay dividends is dependent to a great extent on the ability of its subsidiaries to pay dividends. The Wisconsin Business Corporation Law and the indentures and agreements under which debt of the Company and its subsidiaries is outstanding each contain certain restrictions on the payment of dividends on common stock by the Company's subsidiaries. See Note 6 of Notes to Consolidated Financial Statements contained in Exhibit 13, which note is hereby incorporated herein by reference. By order of the PSCW, Wisconsin Gas is generally permitted to pay dividends up to the amount projected in its rate case. Wisconsin Gas may pay dividends in excess of the projected dividend amount so long as payment will not cause its equity ratio to fall below 48.43%. If payment of projected dividends would cause its common equity ratio to fall below 43% of total capitalization (including short-term debt), or if payment of additional dividends would cause its common equity ratio to fall below 48.43%, Wisconsin Gas must obtain PSCW approval to pay such dividends. Wisconsin Gas has projected the payment of $16 million of dividends to the Company during the 12 months ending October 31, 1994. See Note 6 of Notes to Consolidated Financial Statements contained in Exhibit 13, which note is hereby incorporated herein by reference. The PSCW desires Wisconsin Gas to target its common equity level at 43% to 50% of total capitalization. For the year ended December 31, 1993, Wisconsin Gas' average common equity level was 45.16%. In addition, $8.6 million of Sta-Rite net assets at December 31, 1993, plus 50% of Sta-Rite future earnings, are available for dividends to the Company. See Note 6 of Notes to Consolidated Financial Statements contained in Exhibit 13, which note is incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA Reference is made to "Selected Financial Data" included in Exhibit 13, which is hereby incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Reference is made to "Financial Review" included in Exhibit 13, which is hereby incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the WICOR, Inc. consolidated balance sheet and consolidated statement of capitalization as of December 31, 1993 and 1992, and the related consolidated statements of income, common equity and cash flows for each of the three years in the period ended December 31, 1993, together with the report of independent public accountants dated February 11, 1994, all appearing in Exhibit 13, which is hereby incorporated herein by reference. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no change in or disagreement with the Company's independent auditors on any matter of accounting principles or practices or financial statement disclosure required to be reported pursuant to this item. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is made to "Item No. 1: Election of Directors" included in the WICOR proxy statement dated March 10, 1994, which is hereby incorporated herein by reference, for the names, ages, business experience and other information regarding directors and nominees for director of the Company. See "Executive Officers of the Registrant" for information regarding executive officers of the Company. Item 11. Item 11. EXECUTIVE COMPENSATION Reference is made to "Executive Compensation" included in the WICOR proxy statement dated March 10, 1994, which is hereby incorporated herein by reference, for information on compensation of executive officers of the Company; provided, however, that the subsections entitled "Board Compensation Committee Report on Executive Compensation" and "Executive Compensation - Performance Information" shall not be deemed to be incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is made to "Security Ownership of Management" included in the WICOR proxy statement dated March 10, 1994, which is hereby incorporated herein by reference, for information regarding voting securities of the Company beneficially owned by its directors and officers. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is made to "Item No. 1: Election of Directors" included in the WICOR proxy statement dated March 10, 1994, which is hereby incorporated herein by reference, for the information required to be disclosed under this item. 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 on Form 10-K: 1. and 2. All Financial Statements and financial statement schedules. The WICOR, Inc. consolidated balance sheet and statement of capitalization as of December 31, 1993 and 1992, and the related consolidated statements of income, common equity and cash flows for each of the three years in the period ended December 31, 1993, together with the report of independent public accountants dated February 11, 1994, included in Exhibit 13, which is incorporated herein by reference. Financial statement schedules. Schedule III -- Condensed Statements of Income, Retained Earnings and Cash Flows (Parent Company Only) for the Years Ended December 31, 1993, 1992 and 1991; Condensed Balance Sheet (Parent Company Only) as of December 31, 1993 and 1992; Notes to Parent Company Only Financial Statements. Schedule V -- Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991. Schedule VI -- Accumulated Depreciation, Depletion and Amortization 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. Schedule IX -- Short-term Borrowings for the Years Ended December 31, 1993, 1992 and 1991. Schedule X -- Supplementary Income Statement In- formation for the Years Ended December 31, 1993, 1992 and 1991. Financial statement schedules other than those referred to above have been omitted as not applicable or not required. 3. Exhibits 3.1 WICOR, Inc. Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Company's Form 10-K Annual Report for 1992). 3.2 WICOR, Inc. By-laws, as amended (incorporated by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-3 No. 33- 50781). 4.1 Indenture of Mortgage and Deed of Trust dated as of November 1, 1950, between Milwaukee Gas Light Company and Mellon National Bank and Trust Company and D. A. Hazlett, Trustees (incorporated by reference to Exhibit 7-E to Milwaukee Gas Light Company's Registration Statement No. 2-8631). 4.2 Eleventh Supplemental Indenture dated as of February 15, 1982, between Wisconsin Gas Company and Mellon Bank, N.A., and N. R. Smith, Trustees (incorporated by reference to Exhibit 4.5 to Wisconsin Gas Company's Form S- 3 Registration Statement No. 33-43729). 4.3 Bond Purchase Agreement dated December 31, 1981, between Wisconsin Gas Company and Teachers Insurance and Annuity Association of America relating to the issuance and sale of $30,000,000 principal amount of First Mortgage Bonds, Adjustable Rate Series due 2002 (incor- porated by reference to Exhibit 4.6 to Wisconsin Gas Company's Form S-3 Registration Statement No. 33-43729). 4.4 Indenture dated as of September 1, 1990, between Wisconsin Gas Company and First Wisconsin Trust Company, Trustee (incorporated by reference to Exhibit 4.11 to Wisconsin Gas Company's Form S-3 Registration Statement No. 33-36639). 4.5 Officers' Certificate, dated as of November 28, 1990, setting forth the terms of Wisconsin Gas Company's 9-1/8% Notes due 1997 (incorporated by reference to Exhibit 4.1 to Wisconsin Gas Company's Form 8-K Current Report for November, 1990). 4.6 Officers' Certificate, dated as of November 19, 1991, setting forth the terms of Wisconsin Gas Company's 7-1/2% Notes due 1998 (incorporated by reference to Exhibit 4.1 to Wisconsin Gas Company's Form 8-K Current Report for November, 1991). 4.7 Officers' Certificate, dated as of September 15, 1993, setting forth the terms of Wisconsin Gas Company's 6.60% Debentures due 2013 (incorporated by reference to Exhibit 4.1 to Wisconsin Gas Company' Form 8-K Current Report for September, 1993). 4.8 Revolving Credit and Term Loan Agreement, dated as of March 29, 1993, among Wisconsin Gas Company and Citibank, N.A., Firstar Bank Milwaukee, N.A., Harris Trust & Savings Bank, M&I Marshall & Ilsley Bank and Citibank, N.A., as Agent (incorporated by reference to Exhibit 4.2 to the Company's Quarterly Report on Form 10-Q dated as of August 9, 1993). 4.9 Note Agreement dated as of December 1, 1986, among Sta-Rite Industries, Inc., Principal Mutual Life Insurance Company, Aid Association for Lutherans, AAL Employees' Retirement Trust and AAL Savings Plan Trust relating to $12,000,000 Promissory Notes due December 1, 1993 (incorporated by reference to Exhibit 4-Q to the Company's Form 10-K Annual Report for 1986). 4.10 Revolving Credit and Term Loan Agreement, dated as of March 29, 1993, among Sta-Rite Industries, Inc. and Citibank, N.A., Firstar Bank Milwaukee, N.A., Harris Trust & Savings Bank, M&I Marshall & Ilsley Bank and Citibank, N.A., as Agent (incorporated by reference to Exhibit 4.3 to the Company's Quarterly Report on Form 10-Q dated as of August 9, 1993). 4.11 Revolving Credit and Term Loan Agreement, dated as of March 29, 1993, among WICOR, Inc. and Citibank, N.A., Firstar Bank Milwaukee, N.A., Harris Trust & Savings Bank, M&I Marshall & Ilsley Bank and Citibank, N.A., as Agent (incorporated by reference to Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q dated as of August 9, 1993). 4.12 Rights Agreement dated as of August 29, 1989, between WICOR, Inc. and Manufacturers Hanover Trust Company, Rights Agent (incorporated by reference to Exhibit 4 to the Company's Form 8-K current report for August, 1989). 4.13 Loan Agreement, dated as of November 4, 1991, by and among M&I Marshall & Ilsley Bank, Wisconsin Gas Company Employees' Savings Plans Trust and WICOR, Inc. (incorporated by reference to Exhibit 4.16 to the Company's Form 10-K Annual Report for 1991). 4.14 Guaranty, dated as of November 4, 1991, from WICOR, Inc. to and for the benefit of M&I Marshall & Ilsley Bank (incorporated by reference to Exhibit 4.17 to the Company's Form 10-K Annual Report for 1991). Sta-Rite Industries, Inc., a wholly-owned subsidiary of the Registrant, is the obligor under various loan agreements in connection with facilities financed through the issuance of industrial development bonds. The loan agreements and the additional documentation relating to these bond issues are not being filed with this Annual Report on Form 10-K in reliance upon Item 601(b)(4)(iii) of Regulation S-K. Copies of these documents will be furnished to the Securities and Exchange Commission upon request. 10.1 Service Agreement dated as of January 1, 1988, among WICOR, Inc., Wisconsin Gas Company, Sta- Rite Industries, Inc., and WEXCO of Delaware, Inc. (incorporated by reference to Exhibit 10.1 to the Company's Form 10-K Annual Report for 1988). 10.2 Endorsement of SHURflo Pump Manufacturing Co. dated as of July 28, 1993, to Service Agreement among WICOR, Inc., Wisconsin Gas Company, Sta-Rite Industries, Inc., and WEXCO of Delaware, Inc. 10.3# WICOR, Inc. 1987 Stock Option Plan, as amended (incorporated by reference to Exhibit 4.1 to the Company's Form S-8 Registration Statement No. 33-67134). 10.4# Forms of nonstatutory stock option agreement used in connection with the WICOR, Inc. 1987 Stock Option Plan (incorporated by reference to Exhibit 10.20 to the Company's Form 10-K Annual Report for 1991). 10.5# WICOR, Inc. 1992 Director Stock Option Plan, (incorporated by reference to Exhibit 4.1 to the Company's Form S-8 Registration Statement No. 33-67132). 10.6# Form of nonstatutory stock option agreement used in connection with the WICOR, Inc. 1992 Director Stock Option Plan (incorporated by reference to Exhibit 4.2 to the Company's Form S-8 Registration Statement No. 33-67132). 10.7# WICOR, Inc. 1994 Officers' Incentive Compen- sation Plan. 10.8# Wisconsin Gas Company Principal Officers' Supplemental Retirement Income Program. 10.9# Wisconsin Gas Company 1994 Officers' Incentive Compensation Plan. 10.10# Wisconsin Gas Company Officers' Medical Expense Reimbursement Plan (incorporated by reference to Exhibit 10.23 to the Company's Form 10-K Annual Report for 1992). 10.11# Wisconsin Gas Company Group Travel Accident Plan (incorporated by reference to Exhibit 10.24 to the Company's Form 10-K Annual Report for 1992). 10.12# Form of Deferred Compensation Agreements between Wisconsin Gas Company and certain of its executive officers (incorporated by reference to Exhibit 10.30 to the Company's Form 10-K Annual Report for 1990). 10.13# Sta-Rite Industries, Inc. Officers Supple- mental Retirement Income Program (incorporated by reference to Exhibit 10.28 to the Company's Form 10-K Annual Report for 1989). #Indicates a plan under which compensation is paid or payable to directors or executive officers of the Company. 10.14# Sta-Rite Industries, Inc. 1994 Officers' Incentive Compensation Plan. 10.15# Sta-Rite Industries, Inc. Group Travel Accident Plan (incorporated by reference to Exhibit 10.28 to the Company's Form 10-K Annual Report for 1992). 10.16# WICOR, Inc. Retirement Plan for Directors, as amended (incorporated by reference to Exhibit 10.29 to the Company's Form 10-K Annual Report for 1992). "Financial Review" portions of WICOR, Inc. 1993 Annual Report to Shareholders, including: General Overview, Results of Operations, Liquidity and Capital Resources, Report of Independent Public Accountants, Consolidated Statement of Income, Consolidated Balance Sheet, Consolidated Statement of Cash Flows, Consolidated Statement of Capitalization, Consolidated Statement of Common Equity, Quarterly Financial Data (Unaudited), Notes to Consolidated Financial Statements, Selected Financial Data, and Investor Information. 13* "Financial Review" portion of the WICOR, Inc. 1993 Annual Report to Shareholders. 21 Subsidiaries of WICOR, Inc. 23 Consent of independent public accountants. 99 WICOR, Inc. proxy statement dated March 10, 1994. (Except to the extent incorporated by reference, this proxy statement is not deemed "filed" with the Securities and Exchange Commission as part of this Form 10-K.) (b) Reports on Form 8-K. No Form 8-K Current Report was filed during the fourth quarter of 1993. #Indicates a plan under which compensation is paid or payable to directors or executive officers of the 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. WICOR, Inc. Date: March 29, 1994 By JOSEPH P. WENZLER ----------------------------------- Vice President, Treasurer, and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on the succeeding pages by the following persons on behalf of the registrant and in the capacities and on the dates indicated. WICOR, Inc. C. In November 1991, WICOR, Inc. (Parent Company Only) established an Employee Stock Ownership Plan (ESOP) covering non-union employees of Wisconsin Gas. Because the parent company has guaranteed the loan, the unpaid balance is shown as a liability on the balance sheet with a like amount of unearned compensation recorded as a reduction of stockholders' equity. The ESOP trustee is repaying the $10 million loan with dividends paid on the shares of WICOR common stock in the ESOP and with Wisconsin Gas contributions to the ESOP. TO EXHIBITS Page 3.1 WICOR, Inc. Restated Articles of Incorporation, as amended (incorporated by reference) 3.2 WICOR, Inc. By-laws, as amended (incorporated by reference) 4.1 Indenture of Mortgage and Deed of Trust dated as of November 1, 1950, between Milwaukee Gas Light Company and Mellon National Bank and Trust Company and D. A. Hazlett, Trustees (incorporated by reference) 4.2 Eleventh Supplemental Indenture dated as of February 15, 1982, between Wisconsin Gas Company and Mellon Bank, N.A., and N. R. Smith, Trustees (incorporated by reference) 4.3 Bond Purchase Agreement dated December 31, 1981, between Wisconsin Gas Company and Teachers Insurance and Annuity Association of America relating to the issuance and sale of $30,000,000 principal amount of First Mortgage Bonds, Adjustable Rate Series due 2002 (incorporated by reference) 4.4 Indenture dated as of September 1, 1990, between Wisconsin Gas Company and First Wisconsin Trust Company, Trustee (incorporated by reference) 4.5 Officers' Certificate, dated as of November 28, 1990, setting forth the terms of Wisconsin Gas Company's 9- 1/8% Notes due 1997 (incorporated by reference) 4.6 Officers' Certificate, dated as of November 19, 1991, setting forth the terms of Wisconsin Gas Company's 7- 1/2% Notes due 1988 (incorporated by reference) 4.7 Officers' Certificate, dated as of September 15, 1993, setting forth the terms of Wisconsin Gas Company's 6.60% Debentures due 2013 (incorporated by reference) 4.6 Officers' Certificate, dated as of November 19, 1991, setting forth the terms of Wisconsin Gas Company's 7- 1/2% Notes due 1988 (incorporated by reference) 4.8 Revolving Credit and Term Loan Agreement, dated as of March 29, 1993, among Wisconsin Gas Company and Citibank, N.A., Firstar Bank Milwaukee, N.A., Harris Trust Savings Bank, M&I Marshall & Ilsley Bank and Citibank, N.A., as Agent (incorporated by reference) 4.9 Note Agreement dated as of December 1, 1986, among Sta-Rite Industries, Inc., Principal Mutual Life Insurance Company, Aid Association for Lutherans, AAL Employees' Retirement Trust and AAL Savings Plan Trust relating to $12,000,000 Promissory Notes due December 1, 1993 (incorporated by reference) (i) PAGE 4.10 Revolving Credit and Term Loan Agreement, dated as of March 29, 1993, among Sta-Rite Industries, Inc. and Citibank, N.A., Firstar Bank Milwaukee, N.A., Harris Trust Savings Bank, M&I Marshall & Ilsley Bank and Citibank, N.A., as Agent (incorporated by reference) 4.11 Revolving Credit and Term Loan Agreement, dated as of March 29, 1993, among WICOR, Inc. and Citibank, N.A., Firstar Bank Milwaukee, N.A., Harris Trust Savings Bank, M&I Marshall & Ilsley Bank and Citibank, N.A., as Agent (incorporated by reference) 4.12 Rights Agreement dated as of August 29, 1989, between WICOR, Inc. and Manufacturers Hanover Trust Company, Rights Agent (incorporated by reference) 4.13 Loan Agreement, dated as of November 4, 1991, by and among M&I Marshall & Ilsley Bank, Wisconsin Gas Company Employees' Savings Plan Trust and WICOR, Inc. (incorporated by reference) 4.14 Guaranty, dated as of November 4, 1991, from WICOR, Inc. to and for the benefit of M&I Marshall & Ilsley Bank (incorporated by reference) 10.1 Service Agreement dated as of January 1, 1988, among WICOR, Inc., Wisconsin Gas Company, Sta-Rite Industries, Inc., and WEXCO of Delaware, Inc. (incorporated by reference) 10.2* Endorsement of SHURflo Pump Manufacturing Co. dated as of July 28, 1993, to Service Agreement among WICOR, Inc., Wisconsin Gas Company, Sta-Rite Industries, Inc., and WEXCO of Delaware, Inc. 10.3# WICOR, Inc. 1987 Stock Option Plan (incorporated by reference) 10.4# Forms of nonstatutory stock option agreement used in connection with the WICOR, Inc. 1987 Stock Option Plan (incorporated by reference) 10.5# WICOR, Inc. 1992 Director Stock Option Plan (incorporated by reference) 10.6# Form of nonstatutory stock option agreement used in connection with the WICOR, Inc. 1992 Director Stock Option Plan (incorporated by reference) 10.7*# WICOR, Inc. 1994 Officers' Incentive Compensation Plan 10.8*# Wisconsin Gas Company Principal Officers' Supplemental Retirement Income Program *Indicates document filed herewith. # Indicates a plan under which compensation is paid or payable to directors or executive officers of the Company. (ii) PAGE 10.9*# Wisconsin Gas Company 1994 Officers' Incentive Compensation Plan 10.10# Wisconsin Gas Company Officers' Medical Expense Reimbursement Plan (incorporated by reference) 10.11# Wisconsin Gas Company Group Travel Accident Plan (incorporated by reference) 10.12# Form of Deferred Compensation Agreements between Wisconsin Gas Company and certain of its executive officers (incorporated by reference) 10.13# Sta-Rite Industries Officers' Supplemental Retirement Income Program (incorporated by reference) 10.14*# Sta-Rite Industries, Inc. 1994 Officers' Incentive Compensation Plan 10.15# Sta-Rite Industries, Inc. Group Travel Accident Plan (incorporated by reference) 10.16# WICOR, Inc. Retirement Plan for Directors (incorporated by reference) 13* "Financial Review" portions of the WICOR, Inc. 1993 Annual Report to Shareholders 21* Subsidiaries of WICOR, Inc 23* Consent of independent public accountants 99* WICOR, Inc. proxy statement dated March 10, 1994 *Indicates document filed herewith. # Indicates a plan under which compensation is paid or payable to directors or executive officers of the Company. (iii)

847903_1993.txt

847903_1993

1993

847903

ITEM 1. BUSINESS (a) General Development of Business RJR Nabisco Holdings Corp. ("Holdings") was organized as a Delaware corporation in 1988 at the direction of Kohlberg Kravis Roberts & Co., L.P. ("KKR"), a Delaware limited partnership, to effect the acquisition of RJR Nabisco, Inc. ("RJRN"), which was completed on April 28, 1989 (the "Acquisition"). As a result of the Acquisition, RJRN became an indirect, wholly owned subsidiary of Holdings. After a series of holding company mergers completed on December 17, 1992, RJRN became a direct, wholly owned subsidiary of Holdings. The business of Holdings is conducted through RJRN. Holdings and RJRN are referred to herein collectively as the "Registrants". RJRN's operating subsidiaries comprise one of the largest tobacco and food companies in the world. In the United States, the tobacco business is conducted by R. J. Reynolds Tobacco Company ("RJRT"), the second largest manufacturer of cigarettes, and the packaged food business is conducted by the Nabisco Foods Group ("NFG"), the largest manufacturer and marketer of cookies and crackers. Tobacco operations outside the United States are conducted by R. J. Reynolds Tobacco International, Inc. ("Tobacco International") and food operations outside the United States and Canada are conducted by Nabisco International, Inc. ("Nabisco International"). NFG and Nabisco International are sometimes referred to herein collectively as "Nabisco". Together, RJRT's and Tobacco International's tobacco products are sold around the world under a variety of brand names. Nabisco's food products are sold in the United States, Canada, Latin America and certain other international markets. For financial information with respect to RJRN's industry segments, lines of business and operations in various geographic locations, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 15 to the consolidated financial statements, and the related notes thereto, of Holdings and RJRN as of December 31, 1993 and 1992 and for each of the years in the three-year period ended December 31, 1993 (the "Consolidated Financial Statements"). RJRN was incorporated in 1970 and can trace its origins back to the formation of R. J. Reynolds Tobacco Company in 1875. Activities were confined to the tobacco industry until the 1960's, when diversification led to investments in transportation, energy and food. With the acquisition of Del Monte Corporation ("Del Monte") in 1979, RJRN began to concentrate its focus on consumer products. This strategy led to the acquisition of Nabisco Brands, Inc. in 1985. RJRN today conducts its tobacco line of business through RJRT and Tobacco International and its food line of business through NFG and Nabisco International. In recent years the Registrants have completed a number of acquisitions within these lines of business. These included the 1992 acquisitions of (i) the assets of New York Style Bagel Chip Company, Inc., the country's leading producer and marketer of bagel chips and pita chips; (ii) Plush Pippin Corporation, a leading regional supplier of frozen pies to in-store supermarket bakeries; (iii) Stella D'oro Biscuit Co., Inc., a New York based specialty bakery ("Stella D'oro") which manufactures breadsticks, breakfast biscuits, specialty cakes, pastries and snacks; and (iv) the Now & Later confection brand, a fruit chewy taffy product. In 1992, the Registrants also acquired Industrias Alimenticias Maguary S.A., Brazil's largest producer and marketer of packaged fruit-based beverages, Lance S.A. de C.V., one of Mexico's leading biscuit and pasta manufacturers, and six food and pet food businesses in Mexico in exchange for Nabisco International's previous minority interest in a joint venture operating those and other businesses in Mexico. During 1993, Nabisco International acquired a 50% interest in both Royal Brands, S.A. in Spain and Royal Brands Portugal, acquired approximately 95% of Cia. Arturo Field y la Estrella Ltda., S.A. in Peru and increased its equity interest in a partially owned business in Venezuela to 100%. In addition, Tobacco International acquired a 52% interest in a cigarette factory in St. Petersburg, Russia in 1992, and constructed a factory in Turkey and acquired a 70% interest in two cigarette factories in the Ukraine in 1993. On January 4, 1993, the Registrants completed the sale of NFG's ready-to-eat cold cereal business to Kraft General Foods, Inc. and one of its affiliates, for an aggregate cash purchase price of approximately $456 million in cash, prior to post-closing adjustments. NFG acquired the Knox gelatin brand in January 1994 and has contractual arrangements pursuant to which it expects to acquire the remaining 50% of Royal Brands, S.A. and Royal Brands Portugal during 1994. RJRN will continue to assess its businesses to evaluate their consistency with strategic objectives. Although RJRN may acquire and/or divest additional businesses in the future, no decisions have been made with respect to any such acquisitions or divestitures. The Registrants' credit agreement, dated as of December 1, 1991, as amended (the "1991 Credit Agreement") and credit agreement, dated as of April 5, 1993, as amended (the "1993 Credit Agreement", and together with the 1991 Credit Agreement, the "Credit Agreements"), prohibit the sale of all or substantially all or any substantial portion of the businesses of certain subsidiaries of RJRN. (b) Financial Information about Industry Segments During 1993, the Registrants' industry segments were tobacco and food. For information relating to industry segments for the years ended December 31, 1993, 1992 and 1991, see Note 15 to the Consolidated Financial Statements. (c) Narrative Description of Business TOBACCO The tobacco line of business is conducted by RJRT and Tobacco International, which manufacture, distribute and sell cigarettes. Cigarettes are manufactured in the United States by RJRT and in over 30 foreign countries and territories by Tobacco International and subsidiaries or licensees of RJRT and are sold throughout the United States and in more than 160 markets around the world. In 1993, approximately 61% of total tobacco segment net sales (after deducting excise taxes) and approximately 65% of total tobacco segment operating income (before amortization of trademarks and goodwill and the effects of a restructuring expense) were attributable to domestic tobacco operations. DOMESTIC TOBACCO OPERATIONS The domestic tobacco business is conducted by RJRT, which is the second largest cigarette manufacturer in the United States. RJRT's largest selling cigarette brands in the United States include WINSTON, DORAL, SALEM, CAMEL, MONARCH and BEST VALUE. RJRT's other cigarette brands, including VANTAGE, MORE, NOW, STERLING, MAGNA and CENTURY, are marketed to meet a variety of smoker preferences. All RJRT brands are marketed in a variety of styles. Based on data collected for RJRT by an independent market research firm, RJRT had an overall share of retail consumer cigarette sales during 1993 of 29.8%, an increase of approximately one share point from 1992. During 1993, RJRT and the largest domestic cigarette manufacturer, Philip Morris U.S.A., together sold approximately 73% of all cigarettes sold in the United States. A primary long-term objective of RJRT is to increase earnings and cash flow through selective marketing investments in its key brands and continual improvements in its cost structure and operating efficiency. Marketing programs for full-price brands are designed to build brand awareness and add value to the brands in order to retain current adult smokers and attract adult smokers of competitive brands. In 1993, these efforts included expansion of continuity and relationship-building programs such as CAMEL Cash and the WINSTON Winners Club, and the introduction of line extensions such as CAMEL Special Lights and WINSTON Select Lights. RJRT believes it is essential to compete in all segments of the cigarette market, and accordingly offers a range of lower-priced brands including DORAL, MONARCH and BEST VALUE intended to appeal to more cost-conscious adult smokers. For a discussion on competition in the tobacco business, see "Other Matters--Competition" in this Item 1 and "1993 Competitive Activity" under Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations. RJRT's domestic manufacturing facilities, consisting principally of factories and leaf storage facilities, are located in or near Winston-Salem, North Carolina and are owned by RJRT. Cigarette production is conducted at the Tobaccoville cigarette manufacturing plant (approximately two million square feet) and the Whitaker Park cigarette manufacturing complex (approximately one and one-half million square feet). RJRT believes that its cigarette manufacturing facilities are among the most technologically advanced in the United States. RJRT also has significant research and development facilities in Winston-Salem, North Carolina. RJRT's cigarettes are sold in the United States primarily to chain stores, other large retail outlets and through distributors to other retail and wholesale outlets. Except for McLane Company, Inc., which represented approximately 10.9% of RJRT's sales, no RJRT customers accounted for more than 10% of sales for 1993. RJRT distributes its cigarettes primarily to public warehouses located throughout the United States that serve as local distribution centers for RJRT's customers. RJRT's products are sold to adult smokers primarily through retail outlets. RJRT employs a decentralized marketing strategy that permits RJRT's sales force to be more flexible in responding to local market dynamics by designing individual in-store programs to fit varying consumption patterns. RJRT utilizes print media, billboards, point-of-sale displays and other methods of advertising. Since 1971, television and radio advertising of cigarettes has been prohibited in the United States. INTERNATIONAL TOBACCO OPERATIONS Tobacco International operates in over 160 markets around the world. Although overall foreign cigarette sales (excluding China, in which production data indicates an approximate 2% per annum growth rate) have increased at a rate of only 1% per annum in recent years, Tobacco International believes that the American Blend segment, in which Tobacco International primarily competes is growing significantly faster. Although Tobacco International is the second largest of two international cigarette producers that have significant positions in the American Blend segment, its share of sales of this segment is approximately one-third of the share of Philip Morris International Inc., the largest American Blend producer. Tobacco International has strong brand presence in Western Europe and is well established in its other key markets in the Middle East/Africa, Asia and Canada. Tobacco International is aggressively pursuing development opportunities in Eastern Europe and the former Soviet Union. Tobacco International markets over 55 brands of which WINSTON, CAMEL and SALEM, all American Blend cigarettes, are its international leaders. WINSTON, Tobacco International's largest selling international brand, has a significant presence in Puerto Rico and has particular strength in the Western Europe and Middle East/Africa regions. CAMEL is sold in approximately 135 markets worldwide and is Tobacco International's second largest selling international brand. SALEM is the world's largest selling menthol cigarette and has particular strength in Far East markets. Tobacco International also markets a number of local brands in various foreign markets. None of Tobacco International's customers accounted for more than 10% of sales for 1993. Approximately 30% of Tobacco International's cigarette volume for 1993 was manufactured by RJRT in the United States for sale in foreign markets. The remainder was manufactured overseas, principally in owned manufacturing facilities or by licensees or joint ventures. Tobacco International operates two tobacco manufacturing facilities in Germany and one located in each of Canada, Hong Kong, Hungary, Malaysia, Poland, Puerto Rico and Switzerland. Tobacco International opened a factory in the People's Republic of China in 1988 as a part of the first cigarette manufacturing joint venture in that country, and in 1993 constructed a factory in Turkey and acquired a 70% interest in two cigarette factories in the Ukraine. In addition, in 1992, Tobacco International acquired a 52% interest in a cigarette factory in St. Petersburg, Russia. Certain of Tobacco International's foreign operations are subject to local regulations that set import quotas, restrict financing flexibility and affect repatriation of earnings or assets. In recent years, certain trade barriers for cigarettes, particularly in Asia and Eastern Europe, have been liberalized. This may provide opportunities for all international cigarette manufacturers, including Tobacco International, to expand operations in such markets; however, there can be no assurance that the liberalizing trends will be maintained or extended or that Tobacco International will be successful in pursuing such opportunities. RAW MATERIALS In its domestic production of cigarettes, RJRT primarily uses domestic burley and flue cured leaf tobaccos purchased at domestic auction. RJRT also purchases oriental tobaccos, grown primarily in Turkey and Greece, and certain other non-domestic tobaccos. Tobacco International uses a variety of tobacco leaf from both United States and international sources. Tobacco leaf is an agricultural commodity subject in the United States to government production controls and price supports that can affect market prices substantially. The tobacco leaf price support program is subject to Congressional review and may be changed at any time in the future. In addition, Congress enacted legislation during 1993 (the Omnibus Budget Reconciliation Act of 1993), which stipulates that, effective January 1, 1994, financial penalties will be assessed against manufacturers if cigarettes produced in the United States do not contain at least 75% (by weight) domestically grown flue cured and burley tobaccos. Currently RJRT expects that compliance with the content regulation will increase its future raw material costs. RJRT and Tobacco International believe there is a sufficient supply of tobacco in the worldwide tobacco market to satisfy their current production requirements. LEGISLATION AND OTHER MATTERS AFFECTING THE CIGARETTE INDUSTRY The advertising, sale and use of cigarettes has been under attack by government and health officials in the United States and in other countries for many years, principally due to claims that cigarette smoking is harmful to health. This attack has resulted in a number of substantial restrictions on the marketing, advertising and use of cigarettes, diminishing social acceptability of smoking and activities by anti-smoking groups designed to inhibit cigarette sales, the form and content of cigarette advertising and the testing and introduction of new cigarette products. Together with manufacturers' price increases in recent years and substantial increases in state and federal excise taxes on cigarettes, this has had and will likely continue to have an adverse effect on cigarette sales. Cigarettes are subject to substantial excise taxes in the United States and to similar taxes in many foreign markets. In 1990, Congress enacted legislation to increase the federal excise tax per pack of 20 cigarettes to 20 cents from 16 cents on January 1, 1991 and provide for an increase in the federal excise tax on January 1, 1993 to 24 cents. In addition, all states and the District of Columbia impose excise taxes of levels ranging from a low of 2.5 cents to a high of 65 cents per pack on cigarettes, and increases in these state excise taxes could also have an adverse effect on cigarette sales. In 1993, thirteen states and the District of Columbia enacted excise tax increases ranging from less than 2 cents per pack to 41 cents per pack. In addition, the Clinton Administration and members of Congress have introduced bills in Congress that would significantly increase the federal excise tax on cigarettes, eliminate the deductibility of a portion of the cost of tobacco advertising, ban smoking in public buildings and workplaces, add additional health warnings on cigarette packaging and advertising and further restrict the marketing of tobacco products. In January 1993, the U.S. Environmental Protection Agency (the "EPA") released a report on the respiratory effects of environmental tobacco smoke ("ETS") which concludes that ETS is a known human lung carcinogen in adults; and in children causes increased respiratory tract disease and middle ear disorders and increases the severity and frequency of asthma. RJRT has joined other segments of the tobacco and distribution industries in a lawsuit against the EPA seeking a determination that the EPA did not have the statutory authority to regulate ETS, and that, given the current body of scientific evidence and the EPA's failure to follow its own guidelines in making the determination, the EPA's classification of ETS was arbitrary and capricious. In September 1991, the U.S. Occupational Safety and Health Administration ("OSHA") issued a Request for Information relating to indoor air quality, including ETS, in occupational settings. OSHA has announced that it will commence formal rulemaking in 1994. While the Registrants cannot predict the outcome, some form of regulation of smoking in workplaces may result. Legislation imposing various restrictions on public smoking has also been enacted in nineteen states and many local jurisdictions, many employers have initiated programs restricting or eliminating smoking in the workplace and nine states have enacted legislation designating a portion of increased cigarette excise taxes to fund either anti-smoking programs, health care programs or cancer research. Federal law prohibits smoking on all domestic airline flights of six hours duration or less and the U.S. Interstate Commerce Commission has banned smoking on buses transporting passengers inter-state. A number of foreign countries have also taken steps to discourage cigarette smoking, to restrict or prohibit cigarette advertising and promotion and to increase taxes on cigarettes. Such restrictions are, in some cases, more onerous than restrictions imposed in the United States. In June 1988, Canada enacted a ban on cigarette advertising, the constitutionality of which is before the Supreme Court of Canada. On December 11, 1990, RJRN and other U.S. cigarette manufacturers, through The Tobacco Institute, announced a tobacco industry initiative to assist retailers in enforcing minimum age laws on the sale of cigarettes, to support the enactment of state laws requiring the adult supervision of cigarette vending machines in places frequented by minors, to seek the uniform establishment of 18 as the minimum age for the purchase of cigarettes in all states, to distribute informational materials to assist parents in combatting peer pressure on their children to smoke and to limit voluntarily certain cigarette advertising and promotional practices. In 1992, the Alcohol, Drug and Mental Health Act was signed into law. This Act contains a provision, effective January 1, 1994, that requires states to adopt a minimum age of 18 for purchase of tobacco products to receive federal funding for mental health and drug abuse programs. In 1964, the Report of the Advisory Committee to the Surgeon General of the U.S. Public Health Service concluded that cigarette smoking was a health hazard of sufficient importance to warrant appropriate remedial action. Since 1966, federal law has required a warning statement on cigarette packaging. Since 1971, television and radio advertising of cigarettes has been prohibited in the United States. Cigarette advertising in other media in the United States is required to include information with respect to the "tar" and nicotine content of cigarettes, as well as a warning statement. During the past three decades, various legislation affecting the cigarette industry has been enacted. In 1984, Congress enacted the Comprehensive Smoking Education Act (the "Smoking Education Act"). Among other things, the Smoking Education Act: (i) establishes an interagency committee on smoking and health that is charged with carrying out a program to inform the public of any dangers to human health presented by cigarette smoking; (ii) requires a series of four new health warnings to be printed on cigarette packages and advertising on a rotating basis; (iii) increases type size and area of the warning on cigarette advertisements; and (iv) requires that cigarette manufacturers provide annually, on a confidential basis, a list of ingredients used in the manufacture of cigarettes to the Secretary of Health and Human Services. The warnings currently required on cigarette packages and advertisements (other than billboards) are as follows: (i) "Surgeon General's Warning: Smoking Causes Lung Cancer, Heart Disease, Emphysema, And May Complicate Pregnancy"; (ii) "Surgeon General's Warning: Quitting Smoking Now Greatly Reduces Serious Risks To Your Health"; (iii) "Surgeon General's Warning: Smoking By Pregnant Women May Result in Fetal Injury, Premature Birth, and Low Birth Weight"; and (iv) "Surgeon General's Warning: Cigarette Smoke Contains Carbon Monoxide." Similar warnings are required on outdoor billboards. In August 1990, the Fire Safe Cigarette Act of 1990 was enacted, which directed the Consumer Product Safety Commission to conduct and oversee research begun under direction of the Cigarette and Little Cigar Fire Safety Act of 1984 and to assess the practicability of developing a performance standard to reduce cigarette ignition propensity. The Commission presented a final report to Congress in August 1993 describing the results of the research. The Commission concluded that while "it is practicable to develop a performance standard to reduce cigarette ignition propensity, it is unclear that such a standard would effectively address the number of cigarette-ignited fires." The Commission further found that additional work would be required before the actual development of a performance standard. Nevertheless, the Commission reported that a test method developed by the National Institute of Standards and Technology was valid and reliable within reasonable limits and could be suitable for use in a performance standard. Although the Registrants cannot predict whether further legislation on this subject may be enacted, some form of regulation of cigarettes based on their propensity to ignite soft furnishings may result. Since the initial report in 1964, the Secretary of Health, Education and Welfare and the Surgeon General have issued a number of other reports which purport to link cigarette smoking with certain health hazards, including various types of cancer, coronary heart disease and chronic obstructive lung disease. These reports have recommended various governmental measures to reduce the incidence of smoking. In addition to the foregoing, legislation and regulations potentially detrimental to the cigarette industry, generally relating to the taxation of cigarettes and regulation of advertising, labeling, promotion, sale and smoking of cigarettes, have been proposed from time to time at various levels of the federal government. Various Congressional committees and subcommittees have approved legislation in recent years that (i) would subject cigarettes to regulation in various ways under the U.S. Department of Health and Human Services, (ii) would subject cigarettes generally to regulation under the Consumer Products Safety Act, (iii) could increase manufacturers' costs, (iv) would mandate anti-smoking education campaigns or establish anti-smoking programs, (v) would provide additional funding for federal and state anti-smoking activities, (vi) would require a new list of six health warnings on cigarette packages and advertising, expand the number or required size of the warnings and restrict the contents of cigarette advertising and promotional activities, (vii) would provide that neither the provisions of the Federal Cigarette Labeling and Advertising Act, as amended (the "Cigarette Act"), nor the Smoking Education Act should be interpreted to relieve any person from liability under common law or state statutory law and (viii) would permit state and local governments to restrict the sale and distribution of cigarettes and the placement of billboard and transit advertising of tobacco products. It is not possible to determine what additional federal, state or local legislation or regulations relating to smoking or cigarettes will be enacted or to predict any resulting effect thereof on RJRT, Tobacco International or the cigarette industry generally but such legislation or regulations could have an adverse effect on RJRT, Tobacco International or the cigarette industry generally. LITIGATION AFFECTING THE CIGARETTE INDUSTRY Various legal actions, proceedings and claims are pending or may be instituted against RJRT or its affiliates or indemnitees, including those claiming that lung cancer and other diseases have resulted from the use of or exposure to RJRT's tobacco products. During 1993, 16 new actions were filed or served against RJRT and/or its affiliates or indemnitees and 18 such actions were dismissed or otherwise resolved in favor of RJRT and/or its affiliates or indemnitees without trial. A total of 35 such actions in the United States, one in Puerto Rico and one against RJRT's Canadian subsidiary were pending on December 31, 1993. As of February 7, 1994, 35 active cases were pending against RJRT and/or its affiliates or indemnitees, 33 in the United States, one in Puerto Rico and one in Canada. Four of the 33 active cases in the United States involve alleged non-smokers claiming injuries resulting from exposure to environmental tobacco smoke. One of such cases is currently scheduled for trial on September 5, 1994 and if tried, will be the first such case to reach trial. The United States cases are in 15 states and are distributed as follows: eight in Louisiana, eight in Texas, three in Mississippi, two in Indiana, two in New Jersey and one each in Alabama, Florida, Illinois, Kentucky, Maryland, Massachusetts, Minnesota, New York, Oregon and West Virginia. Of the 33 active cases in the United States, 24 are pending in state court and 9 in federal court. One of the active cases is alleged to be a class action on behalf of a purported class of 60,000 individuals. The plaintiffs in these actions seek recovery on a variety of legal theories, including strict liability in tort, design defect, negligence, breach of warranty, failure to warn, fraud, misrepresentation and conspiracy. Punitive damages, often in amounts totalling many millions of dollars, are specifically pleaded in 20 cases in addition to compensatory and other damages. The defenses raised by RJRT and/or its affiliates, where applicable, include preemption by the Cigarette Act of some or all such claims arising after 1969; the lack of any defect in the product; assumption of the risk; comparative fault; lack of proximate cause; and statutes of limitations or repose. Juries have found for plaintiffs in two smoking and health cases, but in one such case, which has been appealed by both parties, no damages were awarded. The jury awarded $400,000 in the other case, Cipollone v. Liggett Group, Inc., et al., which award was overturned on appeal and the case was subsequently dismissed. On June 24, 1992, the United States Supreme Court in Cipollone held that claims that tobacco companies failed to adequately warn of the risks of smoking after 1969 and claims that their advertising and promotional practices undermined the effect of warnings after that date were preempted by the Cigarette Act. The Court also held that claims of breach of express warranty, fraud, misrepresentation and conspiracy were not preempted. The Supreme Court's decision was announced through a plurality opinion, and further definition of how Cipollone will apply to other cases must await rulings in those cases. Certain legislation proposed in recent years in Congress, among other things, would eliminate any such preemptive effect on common law damage actions for personal injuries. RJRT is unable to predict whether such legislation will be enacted, if so, in what form, or whether such legislation would be intended by Congress to apply retroactively. The Supreme Court's Cipollone decision itself, or the passage of such legislation, could increase the number of cases filed against cigarette manufacturers, including RJRT. RJRT understands that a grand jury investigation being conducted in the Eastern District of New York is examining possible violations of criminal law in connection with activities relating to the Council for Tobacco Research-USA, Inc., of which RJRT is a sponsor. RJRT is unable to predict the outcome of this investigation. RJRT recently received a civil investigative demand from the U.S. Department of Justice requesting broad documentary information from RJRT. Although the request appears to focus on tobacco industry activities in connection with product development efforts, it also requests general information concerning contacts with competitors. RJRT is unable to predict the outcome of this investigation. Litigation is subject to many uncertainties, and it is possible that some of the legal actions, proceedings or claims could be decided against RJRT or its affiliates or indemnitees. Determinations of liability or adverse rulings against other cigarette manufacturers that are defendants in similar actions, even if such rulings are not final, could adversely affect the litigation against RJRT and its affiliates or indemnitees and increase the number of such claims. Although it is impossible to predict the outcome of such events or their effect on RJRT, a significant increase in litigation activities could have an adverse effect on RJRT. RJRT believes that it has a number of valid defenses to any such actions, including but not limited to those defenses based on preemption under the Cipollone decision, and RJRT intends to defend vigorously all such actions. FOOD The food line of business conducted by NFG, which comprises the Nabisco Biscuit Company, the LifeSavers Division, the Planters Division, the Specialty Products Company, the Fleischmann's Division, the Food Service Division and Nabisco Brands Ltd, and by Nabisco International. Food products are sold under trademarks owned or licensed by Nabisco and brand recognition is considered essential to their successful marketing. None of Nabisco's customers accounted for more than 10% of sales for 1993. NABISCO FOODS GROUP OPERATIONS Nabisco Biscuit Company. Nabisco Biscuit is the largest manufacturer and marketer in the United States cookie and cracker industry with the nine top selling brands, each of which had annual sales of over $100 million in 1993. Overall, in 1993, Nabisco Biscuit had a 39% share of the domestic cookie industry sales, more than double the share of its closest competitor, and a 55% share of the domestic cracker industry sales, more than three times the share of its closest competitor. Leading Nabisco Biscuit cookie brands include OREO, CHIPS AHOY! and NEWTONS. Leading Nabisco Biscuit cracker brands include RITZ, PREMIUM, WHEAT THINS, NABISCO GRAHAMS and TRISCUIT. OREO and CHIPS AHOY! are the two largest selling cookies in the United States. OREO, the leading sandwich cookie, is Nabisco Biscuit's largest selling cookie brand. CHIPS AHOY! is the leader in the chocolate chip cookie segment with recent line extensions such as CHUNKY CHIPS AHOY! broadening its appeal and adding incremental sales. NEWTONS, the oldest Nabisco Biscuit cookie brand, is the third leading cookie brand in the United States. The introduction of FAT FREE FIG and APPLE NEWTONS in 1992 and the addition of the FAT FREE CRANBERRY, RASPBERRY and STRAWBERRY NEWTONS in 1993 has expanded the appeal of NEWTONS and brought incremental sales to the franchise. Nabisco Biscuit's cracker division is led by RITZ, the largest selling cracker brand in the United States, which accounted for 12% of cracker sales in the United States in 1993. In addition, PREMIUM, the oldest Nabisco Biscuit cracker brand and the leader in the saltine cracker segment, is joined by WHEAT THINS, NABISCO GRAHAMS and TRISCUIT to comprise, along with RITZ, the five largest selling cracker brands in the United States. In 1991, Nabisco Biscuit introduced MR. PHIPPS PRETZEL CHIPS, the first such product of its kind. Nabisco Biscuit expanded the MR. PHIPPS franchise with the introduction of MR. PHIPPS TATER CRISPS in 1992, which deliver salty snack taste with only half the fat of potato chips, and the introduction of MR. PHIPPS TORTILLA CRISPS in 1993. In 1992, Nabisco Biscuit became the leading manufacturer and marketer of no fat/reduced fat cookies and crackers with the introduction of the SNACKWELL'S line. In 1993, the SNACKWELL'S brand recorded over $200 million in sales to become the sixth largest cookie/cracker brand in the United States. In October 1992, Nabisco Biscuit acquired STELLA D'ORO, a leading producer of breadsticks, breakfast biscuits, specialty cakes, pastries and snacks. This line of specialty items gives Nabisco Biscuit an entry to new users and usage occasions, further broadening NFG's cookie and cracker portfolio. Nabisco Biscuit's other cookie and cracker brands, which include NUTTER BUTTER, NILLA WAFERS, BARNUM'S ANIMALS CRACKERS, BETTER CHEDDARS, HARVEST CRISPS, CHICKEN IN A BISKIT, CHEESE NIPS and NEW YORK STYLE BAGEL and PITA CHIPS, compete in consumer niche segments. Many are the first or second largest selling brands in their respective segments. Nabisco Biscuit's products are manufactured in 13 Nabisco Biscuit-owned bakeries and in 16 facilities with which Nabisco Biscuit has production agreements. These facilities are located throughout the United States. Nabisco Biscuit is in the process of implementing plans to modernize certain of its facilities. Nabisco Biscuit also operates a flour mill in Toledo, Ohio, which supplies 85% of its flour needs. Nabisco Biscuit's products are sold to major grocery and other large retail chains through Nabisco Biscuit's direct store delivery system. The system is supported by a distribution network utilizing ten major distribution warehouses and 130 shipping branches where shipments are consolidated for delivery to approximately 111,000 separate delivery points. NFG believes this sophisticated distribution and delivery system provides it with a significant service advantage over its competitors. LifeSavers Division. The LifeSavers Division manufactures and markets hard roll and bite-size candy and gum primarily for sale in the United States. LifeSavers' well-known brands include LIFE SAVERS hard roll and bite-size candy, BREATH SAVERS sugar free mints, BUBBLE YUM bubble gum, CARE*FREE sugarless gum, NOW & LATER fruit chewy taffy and LIFE SAVERS GUMMI SAVERS fruit chewy candy. On the basis of the most recent data available, LIFE SAVERS is the largest selling hard roll candy in the United States, with an approximately 25% share of the hard roll candy category, BREATH SAVERS is the largest selling sugar free breath mint in the United States and BUBBLE YUM is the largest selling chunk bubble gum in the United States. LifeSavers' confectionery products are seasonally strongest during the third and fourth quarters. LifeSavers sells its products in the United States primarily to large retail outlets, chain accounts and to other retail and wholesale outlets. These include grocery stores, drug/mass merchandisers, convenience stores, and food service and military suppliers. The products are distributed from 13 distribution centers located throughout the United States. LifeSavers currently owns and operates three manufacturing facilities for its products, one in Holland, Michigan, one in Brooklyn, New York and the other in Las Piedras, Puerto Rico. Sales, for the LifeSavers Division, as well as the Planters, Specialty Products and Fleischmann's Divisions, are handled through NFG's Sales and Integrated Logistics group, which utilize both direct sales and broker sales organizations. Planters Division. The Planters Division produces and/or markets nuts and snacks largely for sale in the United States, primarily under the PLANTERS trademark. On the basis of the most recent data available, PLANTERS nuts are the clear leader in the packaged nut category, with a market share of more than five times that of its nearest competitor. Planters' products are commodity oriented and are seasonally strongest in the fourth quarter. Planters sells its products in the United States primarily to large retail outlets, chain accounts and to other retail and wholesale outlets. These include grocery stores, drug/mass merchandisers, convenience stores, and food service and military suppliers. The products are distributed from the same 13 distribution centers utilized by the LifeSavers Division. Planters currently owns and operates three manufacturing facilities for its products, all located in the United States. Specialty Products Company. NFG's Specialty Products Company manufacturers and markets a broad range of food products, with sauces and condiments, pet snacks, ethnic foods and hot cereals representing the largest categories. Many of its products are first or second in their product categories. Well-known brand names include A.1. steak sauces, GREY POUPON mustards, MILK-BONE pet snacks, ORTEGA Mexican foods and CREAM OF WHEAT hot cereals. Specialty Products' primary entries in the sauce and condiment segments are A.1. steak sauces, the leading steak sauces, and GREY POUPON mustards, which include the leading Dijon mustard. Specialty Products also markets REGINA wine vinegar, the leader in its segment of the vinegar market. A.1., GREY POUPON and REGINA products are manufactured in one facility. Specialty Products is the leading manufacturer of pet snacks in the United States with MILK-BONE dog biscuits. MILK-BONE products include MILK-BONE ORIGINAL BISCUITS, FLAVOR SNACKS, DOG TREATS, BUTCHER BONES and BUTCHER'S CHOICE. Pet snacks are produced at a single manufacturing facility. Specialty Products produces shelf-stable Mexican foods under its ORTEGA brand name. Specialty Products also participates in the dry mix dessert category with ROYAL gelatins and puddings and the non-dessert gelatin category with KNOX unflavored gelatins and has lines of regional products including COLLEGE INN broths, VERMONT MAID syrup, MY-T-FINE puddings, DAVIS baking powder and BRER RABBIT molasses and syrup. NFG, through its Specialty Products Company, is the second largest manufacturer in the hot cereal category, participating in both the cook-on-stove and mix-in-bowl segments of the category. The Quaker Oats Company, with over 60% of the hot cereal category volume sales, is the most significant participant in the hot cereal category. CREAM OF WHEAT, the leading wheat-based hot cereal, and CREAM OF RICE, participate in the cook-on-stove segment and at least seven varieties of INSTANT CREAM OF WHEAT participate in the mix-in-bowl segment. Hot cereals are manufactured in one facility. Specialty Products sells its products to retail grocery chains through independent brokers and to drug/mass merchandisers and other major retail outlets through a direct salesforce. The products are distributed from the same 13 distribution centers utilized by the LifeSavers Division. Fleischmann's Division. The Fleischmann's Division manufactures and markets various margarines and spreads as well as an egg substitute. Fleischmann's margarine business is the second largest margarine producer in the United States. Fleischmann's currently participates in all three segments of the margarine category, with FLEISCHMANN'S in the premium health segment, BLUE BONNET in the volume segment and MOVE OVER BUTTER in the premium blend segment. Fleischmann's margarines are currently manufactured in three facilities. Fleischmann's is also the market leader in the egg substitute category with EGG BEATERS. Distribution for the Fleischmann's Division is principally direct from plant to stores. Food Service Division. The Food Service Division of NFG sells a variety of specially packaged food products of the other groups of NFG through non-grocery channels, including cookies, crackers, cereals, sauces and condiments for the food service and vending machine industry. The Food Service Division is a leading regional supplier of premium frozen pies to in-store supermarket bakeries, wholesale clubs and food service accounts through the Plush Pippin Corporation. The Food Service Division provides NFG with an additional distribution method for its products. Nabisco Brands Ltd. Nabisco Brands Ltd conducts NFG's Canadian operations through a biscuit division, a grocery division and a food service division. The biscuit division produced nine of the top ten cookies and nine of the top ten crackers in Canada in 1993. Nabisco Brands Ltd's cookie and cracker brands in Canada include OREO, CHIPS AHOY!, FUDGEE-O, PEEK FREANS, DAD'S, DAVID, PREMIUM PLUS, RITZ, TRISCUIT and STONED WHEAT THINS. These products are manufactured in five bakeries in Canada and are sold through a direct store delivery system, utilizing 11 sales offices and distribution centers and a combination of public and private carriers. Nabisco Brands Ltd's grocery division produces and markets canned fruits and vegetables, fruit drinks and pet snacks. The grocery division is the leading canned fruit producer in Canada and is the second largest canned vegetable producer in Canada. Canned fruits and vegetables and fruit drinks are marketed under the DEL MONTE trademark, pursuant to a license from Del Monte, and under the AYLMER trademark. The grocery division also markets MILK-BONE pet snacks and MAGIC baking powder, each leading brands in Canada. Excluding the facility sold in connection with the sale of Nabisco's ready-to eat cold cereal business, the division operated six manufacturing facilities in 1993, five of which are devoted to canned products, principally fruits and vegetables, and one of which produced pet snacks. The grocery division's products are sold directly to retail chains and are distributed through six regional warehouses. Nabisco Brands Ltd's food service division sells a variety of specially packaged food products including cookies, crackers, canned fruits and vegetables as well as condiments to non-grocery outlets. The food service division has its own sales and marketing organization and sources product from Nabisco Brands Ltd's other divisions. NABISCO INTERNATIONAL OPERATIONS Nabisco International is a leading producer of powdered dessert and drink mixes, biscuits, baking powder and other grocery items, industrial yeast and bakery ingredients in many of the 17 Latin American countries in which it has operations. Nabisco International also exports a variety of NFG products to markets in Europe and Asia from the United States. Nabisco International is one of the largest multinational packaged food businesses in Latin America. Nabisco International manufactures and markets yeast, baking powder and bakery ingredients under the FLEISCHMANN'S and ROYAL brands, biscuits and crackers under the NABISCO brand, dessert and drink mixes under the ROYAL brand, processed milk products under the GLORIA brand, and canned fruits and vegetables under the DEL MONTE brand pursuant to a license from Del Monte. Nabisco International's largest market is Brazil, where it operates 15 plants. Nabisco International is the market leader in powdered desserts in most of Latin America, the yeast category in Brazil, biscuits in Peru, Spain, Venezuela and Uruguay, and canned vegetables in Venezuela. Nabisco International also maintains a strong position in the processed milk category in Brazil. During 1993, Nabisco International significantly increased its presence in Europe through the acquisition of a 50% interest in each of Royal Brands S.A. in Spain and Royal Brands Portugal. Nabisco International has contractual arrangements pursuant to which it expects to acquire the remaining 50% of such businesses in 1994. Nabisco International's products in Spain now include biscuits marketed under the ARTIACH and MARBU trademarks, powder dessert mixes marketed under the ROYAL trademark and various other foods, including canned meats and juices. Nabisco International's grocery products are sold to retail outlets through its own sales forces and independent wholesalers and distributors. Industrial yeast and bakery products are sold to the bakery trade through Nabisco International's own sales forces and independent distributors. RAW MATERIALS Various agricultural commodities constitute the principal raw materials used by Nabisco in its food businesses. Other raw materials used by Nabisco are purchased on the commodities market and through supplier contracts. Prices of agricultural commodities tend to fluctuate due to various seasonal, climatic and economic factors, which factors generally also affect Nabisco's competitors. Nabisco believes that the raw materials for its products are in plentiful supply and all are readily available from a variety of independent suppliers. OTHER MATTERS COMPETITION Generally, the markets in which RJRN conducts its businesses are highly competitive, with a number of large participants. Competition is conducted on the basis of brand recognition, brand loyalty and price. For most of RJRN's brands substantial advertising and promotional expenditures are required to maintain or improve a brand's position or to introduce a new brand. With respect to the tobacco industry, anti-smoking groups have undertaken activities designed to inhibit cigarette sales, the form and content of cigarette advertising and the testing and introduction of new cigarette products. Because television and radio advertising for cigarettes is prohibited in the United States and brand loyalty has tended to be higher in the cigarette industry than in other consumer product industries, established cigarette brands in the United States have a competitive advantage. RJRT has repositioned or introduced brands designed to appeal to adult smokers of the largest selling cigarette brand in the United States, but there can be no assurance that such efforts will be successful. In addition, increased selling prices and taxes on cigarettes have resulted in additional price sensitivity of cigarettes at the consumer level and in a proliferation of discounted brands in the growing savings segment of the market. Generally, sales of cigarettes in the savings segment are not as profitable as those in other segments. In April 1993, RJRT's largest competitor announced a shift in strategy designed to gain share of market while sacrificing short-term profits. The competitor's tactics included increased promotional spending and temporary price reductions on its largest cigarette brand, followed several months later by list price reductions on all its full-price and mid-price brands. RJRT defended its major full-price brands during the period of temporary price reductions and, to remain competitive in the marketplace, also reduced list prices on all its full-price and mid-price brands in August 1993. The cost of defensive price promotions and the impact of lower list prices were primarily responsible for the sharp drop in RJRT's 1993 operating company contribution. Although some improvement to the stability of the competitive environment has occurred in the fourth quarter of 1993, RJRT cannot predict if or when any further improvement to the competitive environment will occur or whether such stability will continue. In addition, growth in lower price brands was slowed in the second half of 1993 due to net price reductions on full price brands. RJRT is unable to predict whether this trend will continue. ENVIRONMENTAL MATTERS The U.S. Government and various state and local governments have enacted or adopted laws and regulations concerning protection of the environment. The regulations promulgated by the EPA and other governmental agencies under various statutes have resulted in, and will likely continue to result in, substantial expenditures for pollution control, waste treatment, plant modification and similar activities. Certain subsidiaries of the Registrants have been named "potentially responsible parties" with third parties under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") with respect to approximately fifteen sites. RJRN has been engaged in a continuing program to assure compliance with such laws and regulations. Although it is difficult to identify precisely the portion of capital expenditures or other costs attributable to compliance with environmental laws and the Registrants can not reasonably estimate the cost of resolving the above mentioned CERCLA matters, the Registrants do not expect such expenditures or costs to have a material adverse effect on the financial condition of either of the Registrants. EMPLOYEES At December 31, 1993, the Registrants together with their subsidiaries had approximately 66,500 full time employees. None of RJRT's operations are unionized. Most of the unionized workers at Nabisco's operations are represented under a national contract with the Bakery, Confectionery and Tobacco Workers International Union, which was ratified in August 1992 and which will expire in August 1996. Other unions represent the employees of a number of Nabisco's operations. In addition, several of Tobacco International's operations are unionized. RJRN believes that its relations with its employees and with the unions in which its employees are members are good. (d) Financial Information about Foreign and Domestic Operations and Export Sales For information about foreign and domestic operations and export sales for the years 1991 through 1993, see "Geographic Data" in Note 15 to the Consolidated Financial Statements. ITEM 2. ITEM 2. PROPERTIES For information pertaining to the Registrants' assets by lines of business and geographic areas as of December 31, 1993 and 1992, see Note 15 to the Consolidated Financial Statements. For information on properties, see Item 1. ITEM 3. ITEM 3. LEGAL PROCEEDINGS For information relating to litigation and legal proceedings, see "Other Matters-Environmental Matters" and "Litigation Affecting the Cigarette Industry" contained in Item 1 hereof. ------------------------------ The Registrants believe that the ultimate outcome of all pending litigation and legal proceedings should not have a material adverse effect on either of the Registrants' financial position; however, it is possible that the results of operations or cash flows of the Registrants in a particular quarterly or annual period could be materially affected by the ultimate outcome of certain pending litigation matters. Management is unable to derive a meaningful estimate of the amount or range of such possible loss in any particular quarterly or annual period or in the aggregate. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANTS EXECUTIVE OFFICERS OF HOLDINGS The executive officers of Holdings are Charles M. Harper (Chairman of the Board and Chief Executive Officer), Lawrence R. Ricciardi (President and General Counsel), Eugene R. Croisant (Executive Vice President), Stephen R. Wilson (Executive Vice President and Chief Financial Officer), Robert S. Roath (Senior Vice President and Controller) and John J. Delucca (Senior Vice President and Treasurer). The following table sets forth certain information regarding such officers. EXECUTIVE OFFICERS OF RJRN NOT LISTED ABOVE Set forth below are the names, ages, positions and offices held and a brief account of the business experience during the past five years of each executive officer of RJRN, other than those listed above. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock of Holdings, par value $.01 per share (the "Common Stock"), is listed and traded on the New York Stock Exchange (the "NYSE"). Since completion of the Acquisition there has been no public trading market for the common stock of RJRN. As of January 31, 1994, there were approximately 51,000 record holders of the Common Stock. All of the common stock of RJRN is owned by Holdings. The Common Stock closing price on the NYSE for February 22, 1994 was $7 1/2. The following table sets forth, for the calendar periods indicated, the high and low sales prices per share for the Common Stock on the NYSE Composite Tape, as reported in the Wall Street Journal: Holdings has never paid any cash dividends on shares of the Common Stock. Cash dividends paid by RJRN to Holdings are set forth in the Consolidated Statements of Cash Flows in the Consolidated Financial Statements. The operations of the Registrants are conducted through RJRN's subsidiaries and, therefore, the Registrants are dependent on the earnings and cash flow of RJRN's subsidiaries to satisfy their respective debt obligations and other cash needs. The Credit Agreements, which contain restrictions on the payment of cash dividends or other distributions by Holdings in excess of certain specified amounts, and the indentures relating to certain of RJRN's debt securities, which contain restrictions on the payment of cash dividends or other distributions by RJRN to Holdings in excess of certain specified amounts, or for certain specified purposes, effectively limit the payment of dividends on the Common Stock. In addition, the declaration and payment of dividends is subject to the discretion of the board of directors of Holdings and to certain limitations under Delaware law. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data presented below as of December 31, 1993 and 1992 and for each of the years in the three-year period ended December 31, 1993 for Holdings was derived from the Consolidated Financial Statements, which have been audited by Deloitte & Touche, independent auditors. In addition, the consolidated financial data as of December 31, 1991, 1990 and 1989, for the year ended December 31, 1990 and for the period from February 9, 1989 through December 31, 1989 for Holdings and for the period from January 1, 1989 through February 8, 1989 for RJRN was derived from the consolidated financial statements of Holdings and RJRN as of December 31, 1991, 1990 and 1989, for the year ended December 31, 1990 and for each of the periods within the one-year period ended December 31, 1989, not presented herein, which has been audited by Deloitte & Touche, independent auditors. The data should be read in conjunction with the Consolidated Financial Statements, related notes and other financial information included herein. (Footnotes on following page) (Footnotes for preceding page) - --------------- (1) The 1992 amount includes a gain of $98 million on the sale of Holdings' ready-to-eat cold cereal business. (2) The 1989 amount for Holdings included $237 million of interest expense allocated to discontinued operations. (3) On November 8, 1991, Holdings issued 52,500,000 shares of Series A Conversion Preferred Stock, par value $.01 per share ("Series A Preferred Stock") and sold 210,000,000 $.835 depositary shares (the "Series A Depositary Shares"). Each Series A Depositary Share represents a one-quarter ownership interest in a share of Series A Preferred Stock. Each share of Series A Preferred Stock bears cumulative cash dividends at a rate of $3.34 per annum and is payable quarterly in arrears on the 15th day of each February, May, August and November. Because Series A Preferred Stock mandatorily converts into Common Stock by November 15, 1994, dividends on shares of Series A Preferred Stock are reported similar to common equity dividends. (4) On December 16, 1991, an amendment to the Amended and Restated Certificate of Incorporation of Holdings was filed which deleted the provisions providing for the mandatory redemption of the redeemable preferred stock of Holdings on November 1, 2015. Accordingly, such securities were presented as a component of Holdings' stockholders' equity as of December 31, 1992 and 1991. Such securities were redeemed on December 6, 1993 (see Note 12 to the Consolidated Financial Statements). (5) Holdings' stockholders' equity at December 31 of each year from 1993 to 1989 includes non-cash expenses related to accumulated trademark and goodwill amortization of $3.015 billion, $2.390 billion, $1.774 billion, $1.165 billion and $557 million, respectively. (See Note 13 to the Consolidated Financial Statements.) See Notes to Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RJR Nabisco, Inc.'s ("RJRN") operating subsidiaries comprise one of the largest tobacco and food companies in the world. In the United States, the tobacco business is conducted by R. J. Reynolds Tobacco Company ("RJRT"), the second largest manufacturer of cigarettes, and the packaged food business is conducted by the Nabisco Foods Group ("NFG"), the largest manufacturer and marketer of cookies and crackers. Tobacco operations outside the United States are conducted by R.J. Reynolds Tobacco International, Inc. ("Tobacco International") and food operations outside the United States and Canada are conducted by Nabisco International, Inc. ("Nabisco International"). The following is a discussion and analysis of the consolidated financial condition and results of operations of RJR Nabisco Holdings Corp. ("Holdings"), the parent company of RJRN. The discussion and analysis should be read in connection with the historical financial information included in the Consolidated Financial Statements. RESULTS OF OPERATIONS Summarized financial data for Holdings is as follows: (Footnotes on following page) INDUSTRY SEGMENTS The percentage contributions of each of Holdings' industry segments to net sales and operating company contribution during the last five years were as follows: - --------------- (1) Operating income before amortization of trademarks and goodwill and exclusive of restructuring expenses (RJRT: 1993-$355 million, 1992-$43 million; Tobacco International: 1993-$189 million, 1992-$0; Total Food: 1993-$153 million, 1992-$63 million; Headquarters: 1993-$33 million, 1992- $0) and a 1992 gain ($98 million) on the sale of Holdings' ready-to-eat cold cereal business as discussed below. (2) Contributions by industry segments were computed without effects of Headquarters' expenses. (3) Includes predecessor period January 1, 1989 through February 8, 1989. TOBACCO Holdings' tobacco business is conducted by RJRT and Tobacco International. 1993 vs. 1992. Holdings' worldwide tobacco business experienced continued net sales growth in its international business that was more than offset by a significant sales decline in the domestic business, resulting in reported net sales of $8.08 billion in 1993, a decline of 11% from the 1992 level of $9.03 billion. Operating company contribution for the worldwide tobacco business of $1.84 billion in 1993 declined 31% from the 1992 level of $2.69 billion, reflecting sharp reductions for the domestic business which were partially offset by gains in the international business. Operating income for the worldwide tobacco business in 1993 of $893 million declined 60% from $2.24 billion in 1992, reflecting the lower operating company contribution and a $544 million restructuring expense in 1993 versus a restructuring expense of $43 million in 1992. The 1993 restructuring expense includes expenses to streamline both the domestic and international operations by the reduction of personnel in administration, manufacturing and sales functions, as well as rationalization of manufacturing and office facilities. Net sales for RJRT amounted to $4.95 billion in 1993, a decline of 20% from the 1992 level, reflecting the impact of industry-wide price reductions and price discounting on higher price brands, a higher proportion of sales from lower price brands and an overall volume decline of approximately 3.6%. The 1993 decrease in overall volume resulted from a decline in the full-price segment that more than offset growth in the lower price segment. The growth in lower price brands was slowed in the second half of 1993 by net price reductions on full-price brands. RJRT's operating company contribution was $1.20 billion in 1993, a 43% decline from the 1992 level of $2.11 billion, primarily due to the lower net sales and a higher proportion of sales from the lower margin segment, offset in part by lower operating expenses. RJRT's operating income was $480 million in 1993, a decline of 72% from $1.7 billion in 1992. The decline in operating income reflected the lower RJRT operating company contribution as well as a restructuring expense of $355 million in 1993 which is significantly higher than the $43 million restructuring expense recorded in 1992. Tobacco International recorded net sales of $3.13 billion in 1993, an increase of 9% from the 1992 level, due to higher volume in all regions of business, the expansion of markets through ventures in Eastern Europe and Turkey, contract sales to the Russian Republic, favorable pricing in certain regions and a change in fiscal year end, which more than offset unfavorable currency developments in Western Europe. Tobacco International's operating company contribution rose to $644 million in 1993, an increase of 12% compared to the prior year due to higher volume and pricing which was offset in part by higher operating expenses and to a lesser extent foreign currency developments. Tobacco International's operating income was $413 million for 1993, a decline of 23% from the 1992 level. The decline in operating income reflects a restructuring expense of $189 million in 1993 that more than offset the increase in operating company contribution. 1993 Competitive Activity. During recent years, the lower price segment of the domestic cigarette market has grown significantly and the full price segment has declined. The shifting of smokers of full price brands to lower price brands adversely affects RJRT's earnings since lower price brands are generally less profitable than full price brands. Although the difference in profitability is often substantial, it varies greatly depending on marketing and promotion levels and the terms of sale. Accordingly, RJRT has in recent years experienced substantial increased volume in the lower price segment, but the earnings attributable to these sales have not been sufficient to offset decreased earnings from declining sales of RJRT's full price brands. In April 1993, RJRT's largest competitor announced a shift in strategy designed to gain share of market while sacrificing short-term profits. The competitor's tactics included increased promotional spending and temporary price reductions on its largest cigarette brand, followed several months later by list price reductions on all its full-price and mid-price brands. RJRT defended its major full-price brands during the period of temporary price reductions and, to remain competitive in the marketplace, also reduced list prices on all its full-price and mid-price brands in August 1993. The cost of defensive price promotions and the impact of lower list prices were primarily responsible for the sharp drop in RJRT's 1993 operating company contribution. Currently, the domestic cigarette market has consolidated list prices for cigarettes from four or more tiers into two tiers, with price competition being conducted principally through trade and retail promotion on a brand-by-brand basis. The resulting effects from increased list prices on lower price brands and reduced promotional spending by RJRT on its full price brands have not been sufficient to offset the effect of decreased list prices on RJRT's full price brands. This has resulted in lower aggregate profit margins for RJRT. These depressed margins are expected to continue until such time as the competitive environment improves and operating costs are further reduced. Although some improvement to the stability of the competitive environment has occurred in the fourth quarter of 1993, RJRT cannot predict if or when any further improvement to the competitive environment will occur or whether such stability will continue. In addition, growth in lower price brands was slowed in the second half of 1993 due to net price reductions on full price brands. RJRT is unable to predict whether this trend will continue. RJRT's domestic cigarette volume of non-full price brands as a percentage of total domestic volume was 44% in 1993, 35% in 1992 and 25% in 1991 versus 37%, 30% and 25%, respectively, for the domestic cigarette market. 1993 Governmental Activity. Legislation recently enacted restricts the use of imported tobacco in cigarettes manufactured in the United States and is expected to increase RJRT's future raw material cost. In addition, the Clinton Administration and members of Congress have introduced bills in Congress that would significantly increase the federal excise tax on cigarettes, eliminate the deductibility of a portion of the cost of tobacco advertising, ban smoking in public buildings and workplaces, add additional health warnings on cigarette packaging and advertising and further restrict the marketing of tobacco products. It is not possible to determine what additional federal, state or local legislation or regulations relating to smoking or cigarettes will be enacted or to predict any resulting effect thereof on RJRT, Tobacco International or the cigarette industry generally but such legislation or regulations could have an adverse effect on RJRT, Tobacco International or the cigarette industry generally. 1992 vs. 1991. Net sales for RJRT rose 5% from 1991 to $6.17 billion in 1992 as higher unit selling prices and volume were offset in part by a higher proportion of sales from lower price brands. Overall volume for the 1992 year increased 3% from the prior year as a result of gains in the lower price segment more than offsetting a decline in the full price segment. RJRT's operating company contribution in 1992 was $2.11 billion, a 5% decline from the prior year. The decline in operating company contribution was primarily due to the higher proportion of sales of lower margin brands and higher marketing and selling expenditures, which when combined more than offset the effect of higher unit selling prices and volume. RJRT's operating income of $1.70 billion in 1992 declined 8% from the prior year as a result of the decline in operating company contribution as well as a $43 million charge incurred in connection with a restructuring plan, the purpose of which was to improve productivity by realigning operations in the sales, manufacturing, research and development, and administrative areas. Tobacco International recorded net sales of $2.86 billion in 1992, an increase of 7% from 1991. Excluding contract sales to the Russian Republic, for which there were major shipments in 1991, Tobacco International would have reported an increase in net sales in 1992 of 10%. The sales increase is a result of volume gains in Eastern Europe (where the company made several acquisitions), Asia and the Middle East, favorable currency developments and higher selling prices that more than offset lower volume in Western Europe. Operating company contribution and operating income for 1992 rose 15% and 16%, respectively, from the prior year to $575 million and $537 million. The increase in operating company contribution and operating income was due to higher volume, favorable currency developments and higher selling prices offset in part by a higher proportion of sales in the lower margin segment. For a description of certain litigation affecting RJRT and its affiliates, see Note 11 to the Consolidated Financial Statements. FOOD Holdings' food business is conducted by NFG, which comprises the Nabisco Biscuit Company, the LifeSavers Division, the Planters Division, the Specialty Products Company, the Fleischmann's Division, the Food Service Division and Nabisco Brands Ltd, (collectively the "North American Group") and Nabisco International. 1993 vs. 1992. NFG reported net sales of $7.03 billion in 1993, an increase of 5% from 1992. Excluding the 1992 operating results of the ready-to-eat cold cereal business, which was sold at the end of that year, net sales in 1993 increased 9% from 1992, resulting from higher volume, sales from recently acquired businesses and modest price increases in both the North American Group and Nabisco International. The North American Group volume increase was primarily attributable to the success of new product introductions in the U.S., including the Snackwell's line of low fat/fat free cookies and crackers, Fat Free Newtons, Life Savers Gummi Savers candy and Planters' stand-up bag line of peanuts and snacks. Nabisco International's net sales increased as a result of the 1993 acquisitions in Spain and Peru and higher volume and prices from its Latin American businesses. NFG's operating company contribution of $995 million in 1993 was 5% higher than the 1992 amount. Excluding the 1992 operating results of the ready-to-eat cold cereal business, operating company contribution increased 14%, with the North American Group up 13% and Nabisco International up 18%. The North American Group increase was primarily due to the gain in net sales, savings from productivity programs, and contributions from the recently acquired businesses, offset in part by higher expenses for consumer marketing programs. Nabisco International increased operating company contribution through acquisitions and gains in net sales. NFG's operating income was $624 million in 1993, a decrease of 19% from 1992, as a result of the $153 million restructuring expense in 1993, which was significantly higher than the restructuring expense of $63 million recorded in 1992, that more than offset the gain in operating company contribution. Excluding the 1992 operating results of the ready-to-eat cold cereal business and the related gain on its sale, as well as the restructuring expenses in both 1993 and 1992, NFG's operating income was up 16% as a result of the increase in operating company contribution. The 1993 restructuring expense primarily consists of expenses related to the reorganization and downsizing of manufacturing and sales functions which will reduce personnel costs, both domestically and internationally, in order to improve productivity and, to a lesser extent, the rationalization of facilities. 1992 vs. 1991. NFG reported net sales of $6.71 billion in 1992, an increase of 4% from 1991. The increase primarily results from higher volume and pricing in the Latin American subsidiaries and the addition of recently acquired businesses in Mexico and Brazil. Net sales for the North American Group were relatively flat, as higher unit selling prices and volume in U.S. cookie and selected grocery products, including new products and product varieties, were offset by lower sales in the balance of the food lines as a result of restrained consumer spending. NFG's operating company contribution increased 3% from 1991 to $947 million in 1992 as a result of the increase in net sales in Latin America. Operating company contribution in the North American Group was about even with last year reflecting the modest net sales performance in 1992. Margins in the North America Group were maintained in 1992 as a result of productivity gains offsetting the industry trends toward higher trade promotion spending. NFG's 1992 operating income, which included a restructuring expense of $63 million, as well as a gain of $98 million on the sale of the ready-to-eat cold cereal business, rose 8% from 1991 to $769 million as a result of the increase in 1992 operating company contribution. The $63 million charge was incurred in connection with a restructuring plan, the purpose of which was to reduce costs and improve productivity by realigning sales operations and implementing a voluntary separation program. RESTRUCTURING EXPENSE Holdings recorded a pre-tax restructuring expense of $730 million in the fourth quarter of 1993 ($467 million after-tax) related to a program announced on December 7, 1993. Such restructuring program was undertaken in response to a changing consumer product business environment and is expected to streamline operations and improve profitability. Implementation of the program, although begun in the latter part of 1993, will primarily occur in 1994. Approximately 75% of the restructuring program will require cash outlays which will occur primarily in 1994 and early 1995. As an offset to the cash outlays, Holdings expects annual after-tax cash savings of approximately $250 million. The cost of providing severance pay and benefits for the reduction of approximately 6,000 employees throughout the domestic and international food and tobacco businesses is approximately $400 million of the charge and is primarily a cash expense. The workforce reduction was undertaken in order to establish fundamental changes to the cost structure of the domestic tobacco business in the face of acute competitive activity in that business and to take advantage of cost savings opportunities in other businesses through process efficiency improvements. Legislation enacted during the third quarter of 1993 stipulates that, effective January 1, 1994, financial penalties will be assessed against manufacturers if cigarettes produced in the United States do not contain at least 75% (by weight) of domestically grown flue cured and burly tobaccos. As a result, the domestic and international tobacco businesses accrued approximately $70 million of related restructuring charges resulting from a reassessment of raw material sourcing and production arrangements. In addition, a shift in pricing strategy designed to gain share of market by RJRT's largest competitor has resulted in a redeployment of spending and changes in sales and distribution strategies resulting in a restructuring charge of approximately $80 million primarily related to contract termination costs. Abandonment of leases related to the above changes in the businesses results in approximately $60 million of restructuring charges. The remainder of the charge, approximately $120 million, represents non-cash costs to rationalize and close manufacturing and sales facilities in both the tobacco and food businesses to facilitate cost improvements. INTEREST EXPENSE 1993 vs. 1992. Consolidated interest expense of $1.19 billion in 1993 decreased 17% from 1992, primarily as a result of the refinancings of debt that were completed during 1992 and 1993, lower debt levels from the application of net proceeds from the issuance of preferred stock in 1993 and lower effective interest rates and the impact of declining market interest rates in 1993. 1992 vs. 1991. Consolidated interest expense of $1.43 billion in 1992 decreased 32% from 1991, primarily due to the refinancings completed during 1991 and 1992, lower effective interest rates and the impact of declining market interest rates in 1992. INCOME TAXES Effective January 1, 1993, Holdings and RJRN adopted Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"), Accounting for Income Taxes. SFAS No. 109 superseded Statement of Financial Accounting Standards No. 96, the method of accounting for income taxes previously followed by the Registrants. The adoption of SFAS No. 109 did not have a material impact on the financial statements of either Holdings or RJRN. Holdings' provision for income taxes for 1993 was increased by $96 million as a result of the enactment of certain federal tax legislation during the third quarter of 1993 which increased federal corporate income tax rates to 35% from 34%, retroactively to January 1, 1993. The components of this increase to Holdings' provision for income taxes included an $86 million non-cash charge resulting primarily from the remeasurement of the balance of deferred federal income taxes at the date of enactment of the new federal tax legislation for the change in the income tax rates, and a $10 million charge resulting from the increase in current federal income taxes accrued for the change in the income tax rates and other effects of the new tax legislation. Also during 1993, Holdings' provision for income taxes was decreased by a $108 million credit resulting from a remeasurement of the balance of deferred income taxes for a change in estimate of the basis of certain deferred tax amounts relating primarily to international operations. NET INCOME 1993 vs. 1992. Holdings reported a net loss of $145 million in 1993, a decrease of $444 million from 1992. Included in Holdings' 1993 net loss is an after-tax extraordinary loss of $142 million related to the repurchases of high cost debt during 1993 and an after-tax restructuring expense of $467 million. Excluding the extraordinary loss and restructuring expense recorded in 1993, Holdings would have reported net income of $464 million in 1993. Excluding a similar after-tax extraordinary loss and an after-tax restructuring expense of $477 million and $66 million, respectively, in 1992, as well as a 1992 after-tax gain on the sale of Holdings' ready-to-eat cold cereal business of $30 million, Holdings would have reported net income of $812 million in 1992. The decrease in net income in 1993 from 1992, after such exclusions, is due to the lower operating income offset in part by lower interest expense. 1992 vs. 1991. Holdings' net income of $299 million in 1992 includes an after-tax extraordinary loss of $477 million related to the repurchases of high cost debt during 1992. However, after excluding the extraordinary loss, Holdings would have reported net income of $776 million for 1992, an increase of $408 million over last year, primarily as a result of significantly lower interest expense. Net income in 1991 was reduced by $28 million of net charges included in "Other income (expense), net" as a result of the write-off of $109 million of unamortized debt issuance costs and the recognition of $144 million of unrealized losses from interest rate hedges related to the refinancing of existing credit lines, partially offset by a $225 million credit for a change in estimated postretirement health care liabilities. Holdings' net income (loss) applicable to its common stock for 1993, 1992 and 1991 of $(213) million, $268 million and $195 million, respectively, includes a deduction for preferred stock dividends of $68 million, $31 million and $173 million, respectively. Effective January 1, 1993, RJRN adopted Statement of Financial Accounting Standards No. 112 ("SFAS No. 112"), Employers' Accounting for Postemployment Benefits. Under SFAS No. 112, RJRN is required to accrue the costs for preretirement postemployment benefits provided to former or inactive employees and recognize an obligation for these benefits. The adoption of SFAS No. 112 did not have a material impact on the financial statements of either Holdings or RJRN. LIQUIDITY AND FINANCIAL CONDITION DECEMBER 31, 1993 Holdings continued to generate significant free cash flow in 1993, although at a lower level than in 1992. Free cash flow, which represents cash available for the repayment of debt and certain other corporate purposes before the consideration of any debt and equity financing transactions, acquisition expenditures and divestiture proceeds, was $1.0 billion for 1993 and $1.6 billion for 1992. The lower level of free cash flow for 1993 primarily reflects lower operating company contribution in the domestic tobacco business, higher capital expenditures for tobacco manufacturing facilities in Eastern Europe and Turkey and for Nabisco Biscuit facilities and higher taxes paid, offset in part by lower inventory levels in the domestic tobacco business, higher sales of receivables, and a decrease in interest paid. The components of free cash flow are as follows: - --------------- * Operating cash flow, which is used as an internal measurement for evaluating business performance, includes, in addition to net cash flow from (used in) operating activities as recorded in the Consolidated Statement of Cash Flows, proceeds from the sale of capital assets less capital expenditures, and is adjusted to exclude income taxes paid and items of a financial nature (such as interest paid, interest income, and other miscellaneous financial income or expense items). --------------- In 1993, Holdings and RJRN continued to enter into a series of transactions designed to refinance long-term debt, lower debt levels and lower interest costs, thereby improving the consolidated debt cost and maturity structure. These transactions included the issuance of preferred stock and the repurchase and redemption of certain debt obligations with funds provided from the issuance of debt securities (including medium-term notes), borrowings under Holdings' and RJRN's credit agreement, dated as of December 1, 1991, as amended (the "1991 Credit Agreement"), and free cash flow, as well as RJRN's management of interest rate exposure through swaps, options, caps and other interest rate arrangements. As a result of these transactions and lower market interest rates during 1993, Holdings reduced the effective interest rate on its consolidated long-term debt from 8.7% at December 31, 1992 to 8.4% at December 31, 1993. Future effective interest rates may vary as a result of RJRN's ongoing management of interest rate exposure and changing market interest rates as well as refinancing activities and changes in the ratings assigned to RJRN's debt securities by independent rating agencies. One of Holdings' current financial objectives is to achieve a capitalization ratio of 43% over time. Holdings' capitalization ratio was 44.5% at December 31, 1993. The capitalization ratio, which is intended to measure Holdings' long-term debt (including current maturities) as a percentage of total capital, is calculated by dividing (i) Holdings' long-term debt by (ii) the sum of Holdings' total equity, consolidated long-term debt, deferred income taxes and certain other long-term liabilities. Certain of Holdings' other current financial objectives, which are all based on income before extraordinary items excluding after-tax amortization of trademarks and goodwill and referred to below as cash net income, are to achieve a 20% return on year beginning common stockholders' equity, a 2.7 interest and preferred stock dividend coverage ratio and a trendline average annual earnings per share growth of 15% over time. The 20% return on year beginning common stockholders' equity objective, which is intended to measure the return to Holdings' common equity holders on the net assets employed in the business, is calculated by dividing (i) cash net income (after deducting preferred stock dividends) by (ii) total stockholders' equity at the beginning of the year exclusive of preferred stockholders' equity interest. For purposes of calculating the return on year beginning common stockholders' equity, Series A Preferred Stock and similar convertible preferred stock securities, if any, are considered common equity and the related dividends thereon are considered common dividends. The 2.7 interest and preferred stock dividend coverage ratio objective, which is intended to measure Holdings' ability to service its annual interest and preferred stock dividend payments, is calculated by dividing (i) operating income before amortization of trademarks and goodwill and depreciation by (ii) the sum of cash interest expense and preferred stock dividends. The trendline average annual earnings per share growth of 15% as adjusted for after-tax amortization of trademarks and goodwill, is intended to measure Holdings' ability to achieve a certain level of earnings per share growth over time. At December 31, 1993, Holdings had an outstanding total debt level (notes payable and long-term debt, including current maturities) and a total capital level (total debt and total stockholders' equity) of approximately $12.4 billion and $21.5 billion, respectively, each of which is lower than the corresponding amounts at December 31, 1992. Holdings' ratio of total debt to total stockholders' equity at December 31, 1993 improved to 1.4-to-1 versus 1.7-to-1 at December 31, 1992. RJRN's ratio of total debt to common equity at December 31, 1993 was 1.3-to-1, compared with 1.6-to-1 at December 31, 1992. Total current liabilities and long-term debt of RJRN's subsidiaries was approximately $3.4 billion at December 31, 1993 and 1992. Management believes that the improvement to Holdings' and its subsidiaries' financial structure since 1991 has enhanced its ability to take advantage of opportunities to further improve its capital and/or cost structure. Management expects that it will continue to consider opportunities as they arise. Such opportunities, if pursued, could involve further acquisitions from time to time of substantial amounts of securities of Holdings or its subsidiaries through open market purchases, redemptions, privately negotiated transactions, tender or exchange offers or otherwise and/or the issuance from time to time of additional securities by Holdings or its subsidiaries. Acquisitions of securities at prices above their book value, together with the accelerated amortization of deferred financing fees attributable to the acquired securities, would reduce reported net income, depending upon the extent of such acquisitions. Nonetheless, Holdings' and its subsidiaries' ability to take advantage of such opportunities is subject to restrictions in the 1991 Credit Agreements and Holdings' and RJRN's credit agreement, dated as of April 5, 1993, as amended (the "1993 Credit Agreement", and together with the 1991 Credit Agreement, the "Credit Agreements"), and in certain of their debt indentures. For a discussion of recent developments affecting the tobacco business and the potential effect on RJRT's cash flow, see "Results of Operations--Tobacco." In addition, management currently is reviewing and expects to continue to review various corporate transactions, including, but not limited to, joint ventures, mergers, acquisitions, divestitures, asset swaps, spin-offs and recapitalizations. Although Holdings has discussed and continues to discuss various transactions with third parties, no assurance may be given that any transaction will be announced or completed. It is likely that Holdings' tobacco and food businesses would be separated should certain of the foregoing transactions be consummated. During 1993, RJRN issued $750 million principal amount of 8% Notes due 2000, $500 million principal amount of 8 3/4% Notes due 2005 and $500 million principal amount of 9 1/4% Debentures due 2013. Also during 1993, RJRN issued medium-term notes maturing in the years 1995-1998 having an aggregate initial offering price of approximately $230 million. The net proceeds from the sale of debt securities and the sale of 50,000,000 depositary shares at $25 per share issued in connection with the issuance of Series B Cumulative Preferred Stock have been or will be used for general corporate purposes, which include refinancings of indebtedness, working capital, capital expenditures, acquisitions and repurchases and redemptions of securities. Pending such uses, proceeds may be used to repay indebtedness under RJRN's revolving credit facilities or for short-term liquid investments. A portion of the net proceeds collected from the sale of Holdings' ready-to-eat cold cereal business was used on February 5, 1993 to redeem $216 million principal amount of RJRN's 9 3/8% Sinking Fund Debentures due 2016 at a price of $1,065.63 for each $1,000 principal amount of such debentures, plus accrued and unpaid interest thereon. The 1991 Credit Agreement is a $6.5 billion revolving bank credit facility that provides for the issuance of up to $800 million of irrevocable letters of credit. Availability under the 1991 Credit Agreement is reduced by an amount equal to the stated amount of such letters of credit outstanding, by commercial paper borrowings in excess of $1 billion and by amounts borrowed under such facility. At December 31, 1993, approximately $456 million stated amount of letters of credit was outstanding and $328 million was borrowed under the 1991 Credit Agreement. Accordingly, the amount available under the 1991 Credit Agreement at December 31, 1993 was $5.72 billion. On April 5, 1993, Holdings and RJRN entered into the 1993 Credit Agreement, which matures on April 4, 1994 and provides a back-up line of credit to support commercial paper issuances of up to $1 billion. Availability thereunder is reduced by an amount equal to the aggregate amount of commercial paper outstanding. At December 31, 1993, approximately $913 million of commercial paper was outstanding. Accordingly, $87 million was available under the 1993 Credit Agreement at December 31, 1993. Holdings and RJRN expect to obtain bank consent to extend the maturity date of the 1993 Credit Agreement for an additional 364 days. The aggregate of consolidated indebtedness and interest rate arrangements subject to fluctuating interest rates approximated $5.5 billion at December 31, 1993. This represents an increase of $800 million from the year end 1992 level of $4.7 billion, primarily due to Holdings' on-going management of its interest rate exposure. As a result of the general decline in market interest rates compared with the high interest cost on certain of Holdings' consolidated debt obligations, the estimated fair value amount of Holdings' long-term debt reflected in its Consolidated Balance Sheets at December 31, 1993 and 1992 exceeded the carrying amount (book value) of such debt by approximately $400 million and $1.1 billion, respectively. For additional disclosures concerning the fair value of Holdings' consolidated indebtedness as well as the fair value of its interest rate arrangements at December 31, 1993 and 1992, see Notes 10 and 11 to the Consolidated Financial Statements. Capital expenditures were $615 million, $519 million and $459 million for 1993, 1992 and 1991, respectively. The current level of expenditures planned for 1994 is expected to be approximately $600 million (approximately 60% Food and 40% Tobacco), which will be funded primarily by cash flows from operating activities. Management expects that its capital expenditure program will continue at a level sufficient to support the strategic and operating needs of Holdings' businesses. Holdings has operations in many countries, utilizing 35 functional currencies in its foreign subsidiaries and branches. Significant foreign currency net investments are located in Germany, Canada, Hong Kong, Brazil and Spain. Changes in the strength of these countries' currencies relative to the U.S. dollar result in direct charges or credits to equity for non-hyperinflationary countries and direct charges or credits to the income statement for hyperinflationary countries. Translation gains or losses, resulting from foreign-denominated borrowings that are accounted for as hedges of certain foreign currency net investments, also result in charges or credits to equity. Holdings also has significant exposure to foreign exchange sale and purchase transactions in currencies other than its functional currency. The exposures include the U.S. dollar, German mark, Japanese yen, Swiss franc, Hong Kong dollar, Singapore dollar and cross-rate exposure among the French franc, British pound, Italian lira and the German mark. Holdings manages these exposures to minimize the effects of foreign currency transactions on its cash flows. Certain financing agreements to which Holdings is a party and debt instruments of RJRN directly or indirectly restrict the payment of dividends by Holdings. The Credit Agreements, which contain restrictions on the payment of cash dividends or other distributions by Holdings in excess of certain specified amounts, and the indentures relating to certain of RJRN's debt securities, which contain restrictions on the payment of cash dividends or other distributions by RJRN to Holdings in excess of certain specified amounts, or for certain specified purposes, effectively limit the payment of dividends on the Common Stock. In addition, the declaration and payment of dividends is subject to the discretion of the board of directors of Holdings and to certain limitations under Delaware law. The Credit Agreements and the indentures under which certain debt securities of RJRN have been issued also impose certain operating and financial restrictions on Holdings and its subsidiaries. These restrictions limit the ability of Holdings and its subsidiaries to incur indebtedness, engage in transactions with stockholders and affiliates, create liens, sell certain assets and certain subsidiaries' stock, engage in certain mergers or consolidations and make investments in unrestricted subsidiaries. As a result of the increased competitive conditions in the domestic cigarette market and in order to provide Holdings with additional flexibility under certain financial ratios contained in the Credit Agreements, Holdings obtained an amendment to such Credit Agreements during October 1993. Holdings and RJRN believe that they are currently in compliance with all covenants and restrictions in the Credit Agreements and their other indebtedness. On February 24, 1994, Holdings filed a Registration Statement on Form S-3 for a proposed offering of 300 million depositary shares, each representing a one-tenth ownership interest in a share of a newly created series of Preferred Equity Redemption Cumulative Stock ("PERCS"). Each depositary share would mandatorily convert in three years into one share of Common Stock, subject to adjustment and subject to earlier conversion or redemption under certain circumstances. Any net proceeds of a PERCS offering may be used for general corporate purposes which may include refinancings of indebtedness, working capital, capital expenditures, acquisitions and repurchases or redemptions of securities. In addition, such proceeds may be used to facilitate one or more significant corporate transactions, such as a joint venture, merger, acquisition, divestiture, asset swap, spin-off and/or recapitalization, that would result in the separation of the tobacco and food businesses of Holdings. As of February 24, 1994, the specific uses of proceeds have not been determined. Pending such uses, any proceeds would be used to repay indebtedness under RJRN's revolving credit facilities or for short-term liquid investments. ENVIRONMENTAL MATTERS RJRN has been engaged in a continuing program to assure compliance with U.S. Government and various state and local government laws and regulations concerning the protection of the environment. Certain subsidiaries of the Registrants have been named "potentially responsible parties" with third parties under the Comprehensive Environmental Response, Compensation and Liability Act, ("CERCLA") with respect to approximately fifteen sites. Although it is difficult to identify precisely the portion of capital expenditures or other costs attributable to compliance with environmental laws and the Registrants can not reasonably estimate the cost of resolving the above-mentioned CERCLA matters, the Registrants do not expect such expenditures or costs to have a material adverse effect on the financial condition of either of the Registrants. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Refer to the Index to Financial Statements and Financial Statement Schedules on page 34, for the required information. 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 REGISTRANTS Item 10 is hereby incorporated by reference to Holdings' Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 1994. Reference is also made regarding the executive officers of the Registrants to "Executive Officers of the Registrants" following Item 4 of Part I of this Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Item 11 is hereby incorporated by reference to Holdings' Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Item 12 is hereby incorporated by reference to Holdings' Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Item 13 is hereby incorporated by reference to Holdings' Definitive Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 30, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND 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, in the City of New York, State of New York on February 24, 1994. RJR NABISCO HOLDINGS CORP. By: /s/ CHARLES M. HARPER .................................... (Charles M. Harper) 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 indicated on February 24, 1994. *By: /s/ ROBERT F. SHARPE, JR. ...................................... (Robert F. Sharpe, Jr.) 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, in the City of New York, State of New York on February 24, 1994. RJR NABISCO, INC. By: /s/ CHARLES M. HARPER ...................................... (Charles M. Harper) 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 indicated on February 24, 1994. *By: /s/ ROBERT F. SHARPE, JR. ....................................... (Robert F. Sharpe, Jr.) Attorney-in-Fact INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENT SCHEDULES For the years ended December 31, 1993, 1992 and 1991: All other schedules for which provision is made in the applicable regulations of the Securities and Exchange Commission are omitted because they are not required under the related instructions or are not applicable or the required information is shown in the financial statements or notes thereto. REPORT OF DELOITTE & TOUCHE, INDEPENDENT AUDITORS RJR Nabisco Holdings Corp.: RJR Nabisco, Inc.: We have audited the accompanying consolidated balance sheets of RJR Nabisco Holdings Corp. ("Holdings") and RJR Nabisco, Inc. ("RJRN") as of December 31, 1993 and 1992, and the related consolidated statements of income and retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules of Holdings and RJRN as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993 as listed in the accompanying Index to Financial Statements and Financial Statement Schedules. These financial statements and financial statement schedules are the responsibility of the companies' 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatements. 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 Holdings and RJRN 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, 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 New York, New York February 1, 1994 (except with respect to the subsequent event discussed in Note 17, as to which the date is February 24, 1994) RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. CONSOLIDATED FINANCIAL STATEMENTS The Summary of Significant Accounting Policies below and the notes to consolidated financial statements on pages through are integral parts of the accompanying consolidated financial statements of RJR Nabisco Holdings Corp. ("Holdings") and RJR Nabisco, Inc. ("RJRN" and, collectively with Holdings, the "Registrants") (the "Consolidated Financial Statements"). SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES This Summary of Significant Accounting Policies is presented to assist in understanding the Consolidated Financial Statements included in this report. These policies conform to generally accepted accounting principles. Consolidation Consolidated Financial Statements include the accounts of each Registrant and its subsidiaries. Cash Equivalents Cash equivalents include all short-term, highly liquid investments that are readily convertible to known amounts of cash and so near maturity that they present an insignificant risk of changes in value because of changes in interest rates. Inventories Inventories are stated at the lower of cost or market. Various methods are used for determining cost. The cost of U.S. tobacco inventories is determined principally under the LIFO method. The cost of remaining inventories is determined under the FIFO, specific lot and weighted average methods. In accordance with recognized trade practice, stocks of tobacco, which must be cured for more than one year, are classified as current assets. Depreciation Property, plant and equipment are depreciated principally by the straight-line method. Trademarks and Goodwill Values assigned to trademarks are based on appraisal reports and are amortized on the straight-line method over a 40 year period. Goodwill is also amortized on the straight-line method over a 40 year period. Other Income (Expense), Net Interest income, gains and losses on foreign currency transactions and other financial items are included in "Other income (expense), net". Income Taxes Income taxes are accounted for under the provisions of Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"), Accounting for Income Taxes, and are calculated for each Registrant on a separate return basis. Postretirement Benefits Other Than Pensions Postretirement benefits other than pensions are accounted for under the provisions of Statement of Financial Accounting Standards No. 106 ("SFAS No. 106"), Employers' Accounting for Postretirement Benefits Other Than Pensions. Postemployment Preretirement Benefits Postemployment preretirement benefits are accounted for under the provisions of Statement of Financial Accounting Standards No. 112 ("SFAS No. 112"), Employers' Accounting for Postemployment Benefits. Excise Taxes Excise taxes are excluded from "Net sales" and "Cost of products sold". Reclassifications and Restatements Certain reclassifications have been made to prior years' amounts to conform to the 1993 presentation. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS (DOLLARS IN MILLIONS EXCEPT PER SHARE AMOUNTS) See Notes to Consolidated Financial Statements. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) See Notes to Consolidated Financial Statements. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. CONSOLIDATED BALANCE SHEETS (DOLLARS IN MILLIONS) See Notes to Consolidated Financial Statements. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1--OPERATIONS Net sales and cost of products sold exclude excise taxes of $3.757 billion, $3.560 billion and $3.715 billion for 1993, 1992 and 1991, respectively. Operating income in the fourth quarter of 1993 was reduced by a $730 million restructuring expense for a program initiated at the domestic tobacco operations ($355 million), the international tobacco operations ($189 million), the food operations ($153 million) and Headquarters ($33 million). Such restructuring program was undertaken in response to a changing consumer product business environment and is expected to streamline operations and improve profitability. Implementation of the program, although begun in the latter part of 1993, will primarily occur in 1994. Approximately 75% of the restructuring program will require cash outlays which will occur primarily in 1994 and early 1995. As an offset to the cash outlays, Holdings expects annual after-tax cash savings of approximately $250 million. The cost of providing severance pay and benefits for the reduction of approximately 6,000 employees throughout the domestic and international food and tobacco businesses is approximately $400 million of the charge and is primarily a cash expense. The workforce reduction was undertaken in order to establish fundamental changes to the cost structure of the domestic tobacco business in the face of acute competitive activity in that business and to take advantage of cost savings opportunities in other businesses through process efficiency improvements. Legislation enacted during the third quarter of 1993 stipulates that, effective January 1, 1994, financial penalties will be assessed against manufacturers if cigarettes produced in the United States do not contain at least 75% (by weight) of domestically grown flue cured and burly tobaccos. As a result, the domestic and international tobacco businesses accrued approximately $70 million of related restructuring charges resulting from a reassessment of raw material sourcing and production arrangements. In addition, a shift in pricing strategy designed to gain share of market by RJRT's largest competitor has resulted in a redeployment of spending and changes in sales and distribution strategies resulting in a restructuring charge of approximately $80 million primarily related to contract termination costs. Abandonment of leases related to the above changes in the businesses results in approximately $60 million of restructuring charges. The remainder of the charge, approximately $120 million, represents non-cash costs to rationalize and close manufacturing and sales facilities in both the tobacco and food businesses to facilitate cost improvements. During the fourth quarter of 1992, operating income was reduced by a net charge of $8 million as a result of a $106 million restructuring expense recorded at the tobacco operations ($43 million) and the food operations ($63 million), partially offset by a $98 million gain recognized from the sale of Holdings' ready-to-eat cold cereal business for $456 million in cash, prior to post-closing adjustments. The restructuring expense was incurred in connection with a restructuring plan at the tobacco operations, the purpose of which was to improve productivity by realigning operations in the sales, manufacturing, research and development, and administrative areas and a restructuring plan at the food operations, the purpose of which was to reduce costs and improve productivity by realigning sales operations and implementing a previously announced voluntary separation program. The receivable established at December 31, 1992 for the sale of the ready-to-eat cold cereal business was collected on January 4, 1993, except for certain escrow amounts which were subsequently collected. During the fourth quarter of 1991, net income was reduced by $28 million of net charges included in "Other income (expense), net" as a result of the write-off of $109 million of unamortized debt issuance costs and the recognition of $144 million of unrealized losses from interest rate hedges related RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 1--OPERATIONS--(CONTINUED) to the refinancing of the bank credit agreement of RJR Nabisco Capital Corp. ("Capital") dated as of January 31, 1989 (as amended, the "1989 Credit Agreement") and the repayment of the $2.25 billion bank credit facility (as amended, the "1990 Credit Agreement"), partially offset by a $225 million credit for a change in estimated postretirement health care liabilities. NOTE 2--EARNINGS PER SHARE Earnings per share is based on the weighted average number of shares of common stock and Series A Depositary Shares (hereinafter defined) outstanding during the period and common stock assumed to be outstanding to reflect the effect of dilutive warrants and options. Holdings' other potentially dilutive securities are not included in the earnings per share calculation because the effect of excluding interest and dividends on such securities for the period would exceed the earnings allocable to the common stock into which such securities would be converted. Accordingly, Holdings' earnings per share and fully diluted earnings per share are the same. NOTE 3--INCOME TAXES The provision for income taxes consisted of the following: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--INCOME TAXES--(CONTINUED) The components of the deferred income tax liability disclosed on the Consolidated Balance Sheet at December 31, 1993 included the following: Pre-tax income (loss) before extraordinary item for domestic and foreign operations is shown in the following table: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--INCOME TAXES--(CONTINUED) The differences between the provision for income taxes and income taxes computed at statutory U.S. federal income tax rates are explained as follows: At December 31, 1993, there was $1.242 billion of accumulated and undistributed income of foreign subsidiaries. These earnings are intended by management to be reinvested abroad indefinitely. Accordingly, no applicable U.S. federal deferred income taxes or foreign withholding taxes have been provided nor is a determination of the amount of unrecognized U.S. federal deferred income taxes practicable. At December 31, 1993, Holdings had cumulative minimum tax credit carryforwards for U.S. federal tax purposes of $64 million. Effective January 1, 1993, Holdings and RJRN adopted SFAS No. 109. SFAS No. 109 superseded Statement of Financial Accounting Standards No. 96, the method of accounting for income taxes previously followed by the Registrants. The adoption of SFAS No. 109 did not have a material impact on the financial statements of either Holdings or RJRN. Holdings' provision for income taxes for 1993 was increased by $96 million as a result of the enactment of certain federal tax legislation during the third quarter of 1993 which increased federal corporate income tax rates to 35% from 34%, retroactively to January 1, 1993. The components of this RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3--INCOME TAXES--(CONTINUED) increase to Holdings' provision for income taxes included an $86 million non-cash charge resulting primarily from the remeasurement of the balance of deferred federal income taxes at the date of enactment of the new federal tax legislation for the change in the income tax rates, and a $10 million charge resulting from the increase in current federal income taxes accrued for the change in the income tax rates and other effects of the new tax legislation. Also during 1993, Holdings' provision for income taxes was decreased by a $108 million credit resulting from a remeasurement of the balance of deferred income taxes for a change in estimate of the basis of certain deferred tax amounts relating primarily to international operations. During 1993, $101 million of previously recognized deferred income tax benefits for operating loss carryforwards ($36 million), minimum tax credit carryforwards ($44 million) and other carryforward items ($21 million) were realized for U.S. federal tax purposes. NOTE 4--EXTRAORDINARY ITEM The extinguishments of debt of Holdings and RJRN resulted in the following extraordinary losses: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5--SUPPLEMENTAL CASH FLOWS INFORMATION A reconciliation of net income (loss) to net cash flows from operating activities follows: Cash payments for income taxes and interest were as follows: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5--SUPPLEMENTAL CASH FLOWS INFORMATION--(CONTINUED) Cash equivalents at December 31, 1993 and 1992, valued at cost (which approximates market value), totaled $215 million and $99 million, respectively, and consisted principally of domestic and Eurodollar time deposits and certificates of deposit. At December 31, 1993 and 1992, cash of $62 million and $63 million, respectively, was held in escrow as collateral for letters of credit issued in connection with certain foreign currency debt. On February 7, 1990, RJRN entered into an arrangement in which it agreed to sell for cash substantially all of its domestic trade accounts receivable generated during a five-year period to a financial institution. Pursuant to amendments entered into in 1992, the length of the receivable program was extended an additional year. The accounts receivable have been and will continue to be sold with limited recourse at purchase prices reflecting the rate applicable to the cost to the financial institution of funding its purchases of accounts receivable and certain administrative costs. During 1993, 1992 and 1991, total proceeds of approximately $8.2 billion, $8.5 billion and $8.7 billion, respectively, were received by RJRN in connection with this arrangement. At December 31, 1993 and 1992, the accounts receivable balance has been reduced by approximately $437 million and $352 million, respectively, due to the receivables sold. For information regarding certain non-cash financing activities, see Notes 10 and 12 to the Consolidated Financial Statements. NOTE 6--INVENTORIES The major classes of inventory are shown in the table below: At December 31, 1993 and 1992, approximately $1.4 billion of inventory was valued under the LIFO method. The current cost of LIFO inventories at December 31, 1993 and 1992 was greater than the amount at which these inventories were carried on the Consolidated Balance Sheets by $284 million and $277 million, respectively. For the years ended December 31, 1993, 1992 and 1991, net income was increased by $6 million, $4 million, and $9 million, respectively, as a result of LIFO inventory liquidations. The LIFO liquidations resulted from programs to reduce leaf durations consistent with forecasts of future operating requirements. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7--PROPERTY, PLANT AND EQUIPMENT Components of property, plant and equipment were as follows: NOTE 8--NOTES PAYABLE Notes payable consisted of the following: NOTE 9--ACCRUED LIABILITIES Accrued liabilities consisted of the following: NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE Interest expense consisted of the following: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) Long-term debt consisted of the following: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) - --------------- (1) The payment of debt through December 31, 1998 is due as follows (in millions): 1995--$617; 1996--$465; 1997--$70 and 1998--$1,714. (2) RJRN maintains a revolving credit facility of $6.5 billion of which $6.2 billion was unused at December 31, 1993. At December 31, 1993, availability of the unused portion is reduced by $456 million for the extension of irrevocable letters of credit which support the principal and interest on certain existing foreign debt of RJRN and its subsidiaries. A commitment fee of 1/4% per annum is payable on the unused portion of the facility. (3) RJRN maintains a back-up line of credit to support commercial paper issuances of up to $1 billion. Commercial paper outstanding in excess of $1 billion is supported by the 1991 Credit Agreement. (4) As a result of RJRN's management of its interest rate exposure through swaps, options, caps, and other interest rate arrangements, the effective interest rate on certain debt may differ from that disclosed in the table. ------------------------ During 1991, Holdings entered into the following refinancing transactions: (i) the repayment on March 11, 1991 of the aggregate principal amount outstanding of a subordinated promissory note held by a limited partnership affiliated with Kohlberg Kravis Roberts & Co., L.P. ("KKR") plus accrued and unpaid interest thereon for a total of approximately $468 million in cash from borrowings under the revolving credit portion of the 1989 Credit Agreement, (ii) the issuance by Capital on April 25, 1991 of $1.5 billion principal amount of 10 1/2% Senior Notes due 1998 (the "10 1/2% Senior Notes") (the "Senior Note Offering") and the repayment of a portion of the amount outstanding under the 1990 Credit Agreement with a portion of the net proceeds from the Senior Note Offering equal to approximately $731 million in cash, (iii) the redemption on June 3, 1991 of 100% of the aggregate principal amount of all outstanding Subordinated Exchange Debentures Due 2007 of RJR Nabisco Holdings Group, Inc. ("Group") equal to approximately $1.86 billion plus accrued and unpaid interest thereon to the redemption date with (a) an additional portion of the net proceeds from the Senior Note Offering and (b) the entire net proceeds from the issuance by Holdings on April 18, 1991 of 115,000,000 shares of common stock of Holdings, par value $.01 per share (the "Common Stock") at $11.25 per share, (iv) open market purchases of certain of Capital's debentures totalling approximately $128 million with the remaining net proceeds from the Senior Note Offering, (v) the exchange by Holdings of 3.8 shares of Common Stock for each of the 67,997,769 shares of Cumulative Convertible Preferred Stock (the "Preferred Stock") exchanged pursuant to an exchange offer commenced on November 7, 1991 and completed on December 7, 1991, (vi) the issuance by Holdings on November 8, 1991 of 52,500,000 shares of Series A Conversion Preferred Stock, par value .01 per share ("Series A Preferred Stock") of Holdings and the sale of 210,000,000 $.835 depositary shares ("Series A Depositary RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) Shares") at $10.125 per Series A Depositary Share in connection with such issuance (the "Series A Preferred Stock Offering"), (vii) the repayment of the aggregate amount outstanding under the 1990 Credit Agreement, the repayment of a portion of the amount outstanding under the 1989 Credit Agreement and the redemption of certain notes of RJRN with the net proceeds from the Series A Preferred Stock Offering equal to approximately $2.1 billion and (viii) the repayment by Capital on December 19, 1991 of the aggregate amount outstanding under the working capital facility, revolving credit facility and term loan portions of the 1989 Credit Agreement with approximately $3.3 billion in cash from borrowings under a $6.5 billion bank credit facility (as amended, the "1991 Credit Agreement"). On May 15, 1992, Capital merged with and into its wholly-owned subsidiary, RJRN. As a result of the merger, Group became the direct parent of RJRN and RJRN assumed all of the obligations of Capital under the 1991 Credit Agreement and with respect to the following debt securities: Subordinated Discount Debentures due May 15, 2001 (the "Subordinated Discount Debentures"); 15% Payment-in-Kind Subordinated Debentures due May 15, 2001 (the "15% Subordinated Debentures"); 13 1/2% Subordinated Debentures due May 15, 2001 (the "13 1/2% Subordinated Debentures" and, collectively with the Subordinated Discount Debentures and the 15% Subordinated Debentures, the "Subordinated Debentures"); 10 1/2% Senior Notes; 8.30% Senior Notes due April 15, 1999 (the "8.30% Senior Notes"); and 8.75% Senior Notes due April 15, 2004 (the "8.75% Senior Notes" and, collectively with the 8.30% Senior Notes, the "1992 Senior Notes"). Prior to this merger, RJRN had guaranteed all of Capital's obligations with respect to such indebtedness, and the financial statements of RJRN had reflected such indebtedness and all debt related costs. On December 17, 1992, Group merged with and into its wholly-owned subsidiary, RJRN. Also during 1992, Holdings entered into the following refinancing transactions: (i) the redemption on February 15, 1992 of $250 million principal amount of Capital's Subordinated Floating Rate Notes due 1999 (the "Subordinated Floating Rate Notes") at a price of $1,005 for each $1,000 principal amount of Subordinated Floating Rate Notes plus accrued and unpaid interest thereon, (ii) the early extinguishments by Capital of approximately $1 billion aggregate principal amount of certain of Capital's subordinated debentures in a privately negotiated transaction (the "1992 Capital Debenture Repurchase") for approximately $995 million in cash, consisting of $165 million aggregate principal amount of its 15% Subordinated Debentures, $85 million aggregate principal amount of its 13 1/2% Subordinated Debentures and $750 million aggregate principal amount (approximately $550 million accreted amount) of its Subordinated Discount Debentures, (iii) the issuance by Capital on April 9, 1992 of $600 million principal amount of 8.30% Senior Notes and $600 million principal amount of 8.75% Senior Notes and the application of substantially all of the net proceeds from the issuance of the 1992 Senior Notes to repay a portion of the funds temporarily drawn under the 1991 Credit Agreement for the redemption of the Subordinated Floating Rate Notes and for the 1992 Capital Debenture Repurchase, (iv) the retirement on May 15, 1992 of $225 million aggregate principal amount of Capital's Subordinated Extendible Reset Debentures due May 15, 1991 (the "Subordinated Reset Debentures") at a price of $1,010 for each $1,000 principal amount of Subordinated Reset Debentures plus accrued and unpaid interest thereon with the remaining proceeds available from the 1992 Senior Notes plus temporary borrowings under the 1991 Credit Agreement, which were repaid with proceeds of medium-term notes and (v) the additional repurchases during 1992 for approximately $1.822 billion in cash of certain of RJRN's subordinated debentures consisting of $690 million aggregate principal amount of its 15% Subordinated Debentures, $81 million aggregate principal amount of its 13 1/2% RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) Subordinated Debentures and $941 million aggregate principal amount (approximately $728 million accreted amount) of its Subordinated Discount Debentures. The principal or accreted amount of the debentures in item (v) was refinanced with proceeds of debt securities maturing in the years 1999-2004. The purchase of most of such amount had been temporarily funded with borrowings under the 1991 Credit Agreement. Also during 1992, Holdings repurchased $126 million aggregate principal amount (approximately $209 million including accrued interest) of its Senior Converting Debentures due 2009 (the "Converting Debentures") for $229 million in cash, and RJRN repurchased $229 million aggregate principal amount of various other debentures for $240 million in cash. The funds for the repurchase of Converting Debentures and various other debentures of RJRN and for a portion of the purchase price of the Subordinated Debentures in item (v) were provided from the issuance of medium-term notes maturing in the years 1995-1997, borrowings under the 1991 Credit Agreement and cash flow from operations. During 1993, RJRN repurchased for approximately $1.0 billion in cash certain of its subordinated debentures consisting of $153 million aggregate principal amount of its 15% Subordinated Debentures, $82 million aggregate principal amount of its 13 1/2% Subordinated Debentures and $768 million aggregate principal amount (approximately $671 million accreted amount) of its Subordinated Discount Debentures. The principal or accreted amounts of such debentures was refinanced from proceeds of debt securities maturing after 1998, including debt securities issued during 1993. The purchase of most of such amount had been temporarily funded with borrowings under the 1991 Credit Agreement. The remaining portion of the ESOP participation was repurchased on January 15, 1993 for cash, plus accrued and unpaid interest thereon. Holdings redeemed on May 1, 1993, 100% of the aggregate principal amount of its outstanding Converting Debentures at a price of $1,000 for each $1,000 principal amount of Converting Debentures, plus accrued and unpaid interest thereon, for the period from February 9, 1989 through April 30, 1993, of $937.54 for each $1,000 principal amount of Converting Debentures. During 1993, RJRN issued $750 million principal amount of 8% Notes due 2000, $500 million principal amount of 8 3/4% Notes due 2005 and $500 million principal amount of 9 1/4% Debentures due 2013. Also during 1993, RJRN issued medium-term notes maturing in the years 1995-1998 having an aggregate initial offering price of approximately $230 million. The net proceeds from the sale of debt securities and the Series B Preferred Stock Offering (as hereinafter defined) have been or will be used for general corporate purposes, which include refinancings of indebtedness, working capital, capital expenditures, acquisitions and repurchases and redemptions of securities. Pending such uses, proceeds may be used to repay indebtedness under RJRN's revolving credit facilities or for short-term liquid investments. A portion of the net proceeds collected from the sale of Holdings' ready-to-eat cold cereal business was used on February 5, 1993 to redeem $216 million principal amount of RJRN's 9 3/8% Sinking Fund Debentures due 2016 (the "9 3/8% Debenture") at a price of $1,065.63 for each $1,000 principal amount of 9 3/8% Debentures, plus accrued and unpaid interest thereon. On April 5, 1993, the Registrants entered into a credit agreement (as amended, the "1993 Credit Agreement" and together with the 1991 Credit Agreement, the "Credit Agreements"), which matures on April 4, 1994 and provides a back-up line of credit to support commercial paper issuances of up to $1 billion. Availability thereunder is reduced by an amount equal to the aggregate amount of commercial RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10--LONG-TERM DEBT AND INTEREST EXPENSE--(CONTINUED) paper outstanding. At December 31, 1993, approximately $913 million of commercial paper was outstanding. Accordingly, $87 million was available under the 1993 Credit Agreement at December 31, 1993. Holdings and RJRN expect to obtain bank consent to extend the maturity date of the 1993 Credit Agreement for an additional 364 days. Based on RJRN's intention and ability to continue to refinance, for more than one year, the amount of its commercial paper borrowings outstanding either in the commercial paper market or with additional borrowings under the 1991 Credit Agreement, the commercial paper borrowings have been included under "Long-term debt". As permitted by the governing indenture, RJRN intends to pay in cash the May 15, 1994 interest payment due on its 15% Subordinated Debentures. Accordingly, the interest accrued thereon as of December 31, 1993 has been included in "Accrued liabilities". Certain financing agreements to which Holdings is a party and debt instruments of RJRN directly or indirectly restrict the payment of dividends by Holdings. The Credit Agreements, which contain restrictions on the payment of cash dividends or other distributions by Holdings in excess of certain specified amounts, and the indentures relating to certain of RJRN's debt securities, which contain restrictions on the payment of cash dividends or other distributions by RJRN to Holdings in excess of certain specified amounts, or for certain specified purposes, effectively limit the payment of dividends on the Common Stock. In addition, the declaration and payment of dividends is subject to the discretion of the board of directors of Holdings and to certain limitations under Delaware law. The Credit Agreements and the indentures under which certain debt securities of RJRN have been issued also impose certain operating and financial restrictions on Holdings and its subsidiaries. These restrictions limit the ability of Holdings and its subsidiaries to incur indebtedness, engage in transactions with stockholders and affiliates, create liens, sell certain assets and certain subsidiaries' stock, engage in certain mergers or consolidations and make investments in unrestricted subsidiaries. The estimated fair value of Holdings' consolidated long-term debt as of December 31, 1993 and 1992 was approximately $12.4 billion and $14.9 billion, respectively, based on available market quotes, discounted cash flows and book values, as appropriate. The estimated fair value exceeded the carrying amount of Holdings' long-term debt by approximately $400 million and $1.1 billion at December 31, 1993 and 1992, respectively, as a result of the general decline in market interest rates compared with the higher interest cost on certain of Holdings' debt obligations. Considerable judgment was required in interpreting market data to develop the estimates of fair value. In addition, the use of different market assumptions and/or estimation methodologies may have had a material effect on the estimated fair value amounts. Accordingly, the estimated fair value of Holdings' consolidated long-term debt as of December 31, 1993 and 1992 is not necessarily indicative of the amounts that Holdings could realize in a current market exchange. NOTE 11--COMMITMENTS AND CONTINGENCIES Various legal actions, proceedings and claims are pending or may be instituted against R. J. Reynolds Tobacco Company ("RJRT") or its affiliates or indemnities, including those claiming that lung cancer and other diseases have resulted from the use of or exposure to RJRT's tobacco products. During 1993, 16 new actions were filed or served against RJRT and/or its affiliates or indemnities and 18 such actions were dismissed or otherwise resolved in favor of RJRT and/or its RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 11--COMMITMENTS AND CONTINGENCIES--(CONTINUED) affiliates or indemnities. A total of 35 such actions in the United States, one in Puerto Rico and one against RJRT's Canadian subsidiary were pending on December 31, 1993. As of February 7, 1994, 35 active cases were pending against RJRT and/or its affiliates or indemnities, 33 in the United States, one in Puerto Rico and one in Canada. Four of the 33 active cases in the United States involve alleged non-smokers claiming injuries resulting from exposure to environmental tobacco smoke. One of such cases is currently scheduled for trial on September 5, 1994 and if tried, will be the first such case to reach trial. One of the active cases is alleged to be a class action on behalf of a purported class of 60,000 individuals. The plaintiffs in these actions seek recovery on a variety of legal theories, including strict liability in tort, design defect, negligence, breach of warranty, failure to warn, fraud, misrepresentation and conspiracy. Punitive damages, often in amounts totalling many millions of dollars, are specifically pleaded in 20 cases in addition to compensatory and other damages. The defenses raised by RJRT and/or its affiliates, where applicable, include preemption by the Federal Cigarette Labeling and Advertising Act, as amended (the "Cigarette Act") of some or all such claims arising after 1969; the lack of any defect in the product; assumption of the risk; comparative fault; lack of proximate cause; and statutes of limitations or repose. Juries have found for plaintiffs in two smoking and health cases, but in one such case, which has been appealed by both parties, no damages were awarded. The jury awarded plaintiffs $400,000 in the other such case, Cipollone v. Liggett Group, Inc., et. al., which award was overturned on appeal and the case was subsequently dismissed. On June 24, 1992, the United States Supreme Court in Cipollone held that claims that tobacco companies failed to adequately warn of the risks of smoking after 1969 and claims that their advertising and promotional practices undermined the effect of warnings after that date were preempted by the Cigarette Act. The Court also held that claims of breach of express warranty, fraud, misrepresentation and conspiracy were not preempted. The Supreme Court's decision was announced through a plurality opinion, and further definition of how Cipollone will apply to other cases must await rulings in those cases. Certain legislation proposed in recent years in Congress, among other things, would eliminate any such preemptive effect on common law damage actions for personal injuries. RJRT is unable to predict whether such legislation will be enacted, if so, in what form, or whether such legislation would be intended by Congress to apply retroactively. The Supreme Court's Cipollone decision itself, or the passage of such legislation, could increase the number of cases filed against cigarette manufacturers, including RJRT. RJRT understands that a grand jury investigation being conducted in the Eastern District of New York is examining possible violations of criminal law in connection with activities relating to the Council for Tobacco Research-USA, Inc., of which RJRT is a sponsor. RJRT is unable to predict the outcome of this investigation. RJRT recently received a civil investigative demand from the U.S. Department of Justice requesting broad documentary information from RJRT. Although the request appears to focus on tobacco industry activities in connection with product development efforts, it also requests general information concerning contacts with competitors. RJRT is unable to predict the outcome of this investigation. Litigation is subject to many uncertainties, and it is possible that some of the legal actions, proceedings or claims could be decided against RJRT or its affiliates or indemnities. Determinations of RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 11--COMMITMENTS AND CONTINGENCIES--(CONTINUED) liability or adverse rulings against other cigarette manufacturers that are defendants in similar actions, even if such rulings are not final, could adversely affect the litigation against RJRT and its affiliates or indemnities and increase the number of such claims. Although it is impossible to predict the outcome of such events or their effect on RJRT, a significant increase in litigation activities could have an adverse effect on RJRT. RJRT believes that it has a number of valid defenses to any such actions, including but not limited to those defenses based on preemption under the Cipollone decision, and RJRT intends to defend vigorously all such actions. The Registrants believe that the ultimate outcome of all pending litigation matters should not have a material adverse effect on either of the Registrants' financial position; however, it is possible that the results of operations or cash flows of the Registrants in a particular quarterly or annual period could be materially affected by the ultimate outcome of certain pending litigation matters. Management is unable to derive a meaningful estimate of the amount or range of such possible loss in any particular quarterly or annual period or in the aggregate. COMMITMENTS At December 31, 1993, other commitments totalled approximately $556 million, principally for minimum operating lease commitments, the purchase of machinery and equipment and other contractual arrangements. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT CONCENTRATIONS OF CREDIT RISK Certain financial instruments with off-balance sheet risk have been entered into by the RJRN to manage its interest rate and foreign currency exposures. Interest Rate Arrangements At December 31, 1993 and 1992, RJRN had outstanding interest rate swaps, options, caps and other interest rate arrangements with financial institutions having a total notional principal amount of $5.7 billion and $5.2 billion, respectively. The arrangements at December 31, 1993 mature as follows: 1994--$2.7 billion; 1995--$1.1 billion; 1996--$1.1 billion; 1997--$450 million and 1998 $350 million, respectively. The estimated fair value of these arrangements as of December 31, 1993 and 1992 was favorable by approximately $37 million and unfavorable by approximately $1 million, respectively, based on calculations from independent third parties for similar arrangements. Because interest rate swaps and purchased options and other interest rate arrangements effectively hedge interest rate exposures, the differential to be paid or received is accrued and recognized in interest expense as market interest rates change. If an arrangement is terminated prior to maturity, then the realized gain or loss is recognized over the remaining original life of the agreement if the hedged item remains outstanding, or immediately, if the underlying hedged instrument does not remain outstanding. If the arrangement is not terminated prior to maturity, but the underlying hedged instrument is no longer outstanding, then the unrealized gain or loss on the related interest rate swap, option, cap or other interest rate arrangement is recognized immediately. In addition, for written options and other similar interest rate arrangements that are entered into to manage interest rate exposure, changes in market value of such instruments would result in the current recognition of any related gains or losses. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 11--COMMITMENTS AND CONTINGENCIES--(CONTINUED) Foreign Currency Arrangements At December 31, 1993 and 1992, RJRN had outstanding forward foreign exchange contracts with banks to purchase or sell an aggregate notional principal amount of $476 million and $566 million, respectively. The estimated fair value of these arrangements as of December 31, 1993 and 1992 was favorable by approximately $3 million and $4 million, respectively, based on calculations from independent third parties for similar arrangements. The forward foreign exchange contracts and other hedging arrangements entered into by RJRN generally mature at the time the hedged foreign currency transactions are settled. Gains or losses on forward foreign currency transactions are determined by changes in market rates and are generally included at settlement in the basis of the underlying hedged transaction. To the extent that the foreign currency transaction does not occur, gains and losses are recognized immediately. The above interest rate and foreign currency arrangements entered into by RJRN involve, to varying degrees, elements of market risk as a result of potential changes in future interest and foreign currency exchange rates. To the extent that the financial instruments entered into remain outstanding as effective hedges of existing interest rate and foreign currency exposure, the impact of such potential changes in future interest and foreign currency exchange rates on the financial instruments entered into would offset the related impact on the items being hedged. Also, RJRN may be exposed to credit losses in the event of non-performance by the counterparties to these financial instruments. However, RJRN continually monitors its positions and the credit rating of its counterparties and therefore, does not anticipate any non-performance. There are no significant concentrations of credit risk with any individual counterparties or groups of counterparties as a result of any financial instruments entered into including those financial instruments discussed above. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL The changes in Common Stock and paid-in capital are shown as follows: The changes in stock options are shown as follows: At December 31, 1993, options were exercisable as to 20,018,041 shares, compared with 15,590,909 shares at December 31, 1992, and 11,310,162 shares at December 31, 1991. As of December 31, 1993, options for 66,777,008 shares of Common Stock were available for future grant. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL--(CONTINUED) To provide an incentive to attract and retain key employees responsible for the management and administration of the business affairs of Holdings and its subsidiaries, on June 15, 1989 the board of directors of Holdings adopted the Stock Option Plan for Directors and Key Employees of RJR Holdings Corp. and Subsidiaries (the "Stock Option Plan") pursuant to which options to purchase Common Stock may be granted. On June 16, 1989, the Stock Option Plan was approved by the written consent of the holders of a majority of the Common Stock. Any director or key employee of Holdings or any subsidiary of Holdings is eligible to be granted options under the Stock Option Plan. A maximum of 30,000,000 shares of Common Stock (which may be adjusted in the event of certain capital changes) may be issued under the Stock Option Plan. The options to key employees granted to key employees under the Stock Option Plan generally vest over a five year period and the options granted to directors under the Stock Option Plan are immediately fully vested. The exercise price of such options is generally the fair market value of the Common Stock on the date of grant. On August 1, 1990, the board of directors of Holdings adopted the 1990 Long Term Incentive Plan (the "1990 LTIP") which was approved on such date by the written consent of the holders of a majority of the Common Stock. The 1990 LTIP authorizes grants of incentive awards ("Grants") in the form of "incentive stock options" under Section 422 of the Code, other stock options, stock appreciation rights, restricted stock, purchase stock, dividend equivalent rights, performance units, performance shares or other stock-based grants. Awards under the 1990 LTIP may be granted to key employees of, or other persons having a unique relationship to, Holdings and its subsidiaries. Directors who are not also employees of Holdings and its subsidiaries are ineligible for Grants. A maximum of 105,000,000 shares of Common Stock (which may be adjusted in the event of certain capital changes) may be issued under the 1990 LTIP pursuant to Grants. The 1990 LTIP also limits the amount of shares which may be issued pursuant to "incentive stock options" and the amount of shares subject to Grants which may be issued to any one participant. As of December 31, 1993, purchase stock, stock options other than incentive stock options, restricted stock, performance shares and other stock-based grants have been granted under the 1990 LTIP. The options granted before 1993 under the 1990 LTIP generally will vest over a three year period ending December 31, 1995. Prior to January 1, 1993, such options had vested over a six to eight year period. Options granted in 1993 vest over a three year period beginning from the date of grant. The exercise prices of such options are between $4.50 and $11.56 per share. In connection with the purchase stock grants awarded during 1993, 1992 and 1991, 622,222 shares, 495,000 shares and 2,681,000 shares, respectively, of Common Stock were purchased and options to purchase four shares were granted for every share of such Common Stock purchased. In addition, arrangements were made enabling purchasers to borrow on a secured basis from Holdings the price of the stock purchased, as well as the taxes due on any taxable income recognized in connection with such purchases. The current annual interest rate on such arrangements, which was set in July 1993 at the then applicable federal rate for long-term loans, is 6.37%. These borrowings plus accrued interest and taxes must generally be repaid within two years following termination of active employment. During 1993, 1,484,840 shares of Common Stock were awarded in connection with restricted stock grants. These shares are subject to restrictions that will lapse on December 31, 1994. Performance shares were also granted under the 1990 LTIP during 1993, pursuant to which participants are granted a designated number of performance shares that may be earned over a three year performance period commencing January 1, 1993. Pay outs of awards at the end of the performance period, which are denominated in shares of Common Stock, but which may be paid at Holdings' option in either Common Stock or cash, are currently based on Holdings' cumulative cash-earnings per share during such performance period. During 1993, 3,307,500 performance shares were awarded. The maximum aggregate number of shares of Common Stock that RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL--(CONTINUED) may be paid at the end of the performance period is 4,961,250. Commitments to make other stock-based awards were made in 1993 under the 1990 LTIP to individuals who previously acquired certain purchase stock under the 1990 LTIP. Under this program, such individuals may receive grants of Common Stock or cash at the Company's election on either three or four annual grant dates beginning July 1994 and ending either July 1, 1996 or July 1, 1997. The fair market value of Common Stock to be awarded on each grant date is equal to the excess, if any, of (i) 33% or 25%, respectively, of the maximum amount the individual could have borrowed to acquire purchase stock, over (ii) the then fair market value of the same percentage of such individual's purchase stock. The grant is increased by the amount of presumed borrowing costs and the amount necessary to hold the individual harmless from income taxes due as a result of the grant. No grant will be made on a grant date if, on such grant date, the amount determined under clause (ii) above equals or exceeds the amount determined in clause (i) above. In addition to the shares purchased under the 1990 LTIP, approximately 550,000 shares of Common Stock were sold during 1991 to certain management investors. No such sales occurred in 1992 or 1993. Unlike the shares sold under the 1990 LTIP, a portion of these shares remain subject to significant restrictions on transferability. The Preferred Stock, together with the Series A Preferred Stock, Series B Preferred Stock and ESOP Convertible Preferred Stock, stated value $16.00 per share and par value $.01 per share, of Holdings (the "ESOP Preferred Stock") (150,000,000 aggregate preferred shares authorized at December 31, 1993 and 1992) are senior to the Common Stock as to dividends and preferences in liquidation. On December 6, 1993, the outstanding Preferred Stock was redeemed at a redemption price of $27.0125 per share plus accrued and unpaid dividends thereon. Also during 1993, 123,523 shares of Preferred Stock were converted into 342,976 shares of Common Stock. During 1992, 379 shares of Preferred Stock were converted into 1,051 shares of Common Stock. During 1991, 884 shares of Preferred Stock were converted into 2,450 shares of Common Stock and 67,997,769 shares of Preferred Stock were exchanged for 258,391,523 shares of Common Stock in connection with the December 1991 Exchange Offer. The Preferred Stock, stated value $25 per share at par value $.01 per share, paid cash dividends at a rate of 11.5% of stated value per annum, payable quarterly in arrears commencing January 15, 1991. The Preferred Stock was convertible after May 1, 1991 into shares of Common Stock at a conversion price of $9 of stated value per share of Common Stock. Each Series A Depositary Share represents a one-quarter ownership interest in a share of Series A Preferred Stock of Holdings. Each share of Series A Preferred Stock bears cumulative cash dividends at a rate of $3.34 per annum and is payable quarterly in arrears commencing February 18, 1992. Each share of Series A Preferred Stock will mandatorily convert into four shares of Common Stock by November 15, 1994, subject to adjustment in certain events. In addition, each share of Series A Preferred Stock may be convertible upon the occurrence of certain other events, including the option by Holdings to redeem, in whole or in part, at any time at an initial optional redemption price of $64.82 per share, to be paid in shares of Common Stock, plus accrued and unpaid dividends. The initial optional redemption price declines by $.009218 on each day following the issuance of the Series A Preferred Stock to $55.36 on September 15, 1994 and $54.80 thereafter. Holders of Series A Preferred Stock have voting rights with respect to certain matters submitted to a vote of the holders of the Common RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL--(CONTINUED) Stock. Because Series A Preferred Stock mandatorily converts into Common Stock, dividends on shares of Series A Preferred Stock are reported similar to common equity dividends. On August 18, 1993, Holdings issued 50,000 shares of Series B Cumulative Preferred Stock, par value $.01 per share ("Series B Preferred Stock"), and sold 50,000,000 depositary shares ("Series B Depositary Shares") at $25 per Series B Depositary Share ($1.250 billion) in connection with such issuance (the "Series B Preferred Stock Offering"). Each share of Series B Preferred Stock bears cumulative cash dividends at a rate of $2,312.50 per annum, or $2.3125 per Series B Depositary Share, and is payable quarterly in arrears commencing December 1, 1993. Each Series B Depositary Share represents .001 ownership interest in a share of Series B Preferred Stock of Holdings. At Holdings' option, on or after August 19, 1998, Holdings may redeem shares of the Series B Preferred Stock (and the Depositary will redeem the number of Series B Depositary Shares representing the shares of Series B Preferred Stock) at a redemption price equivalent to $25 per Series B Depositary Share, plus accrued and unpaid dividends thereon. On August 1, 1991, Holdings issued 2,983,904 shares of Common Stock in exchange for certain debentures of RJRN aggregating approximately $32.3 million in principal amount. On April 10, 1991, an employee stock ownership plan established by Holdings borrowed $250 million from Holdings (the "ESOP Loan") to purchase 15,625,000 shares of ESOP Preferred Stock. The ESOP Loan, which was renegotiated in 1993, has a final maturity in 2006 and bears interest at the rate of 8.2% per annum. The ESOP Preferred Stock is convertible as of December 31, 1993 into 15,573,973 shares of Common Stock, subject to adjustment in certain events, and bears cumulative dividends at a rate of 7.8125% of stated value per annum at least until April 10, 1999, payable semi-annually in arrears commencing January 2, 1992, when, as and if declared by the board of directors of Holdings. The ESOP Preferred Stock is redeemable at the option of Holdings, in whole or in part, at any time on or after April 10, 1999, at an initial optional redemption price of $16.250 per share. The initial optional redemption price declines thereafter on an annual basis in the amount of $.125 a year to $16 per share on April 10, 2001, plus accrued and unpaid dividends. Holders of ESOP Preferred Stock have voting rights with respect to certain matters submitted to a vote of the holders of the Common Stock. Effective January 1, 1992, RJRN's matching contributions to eligible employees under its Capital Investment Plan are being made in the form of ESOP Preferred Stock. RJRN's matching contribution obligation in respect of each participating employee is equal to $.50 for every pre-tax dollar contributed by the employee, up to 6% of the employee's pay. The shares of ESOP Preferred Stock are allocated at either the floor value of $16 a share or the fair market value of Common Stock, whichever is higher. During 1993 and 1992, approximately $29 million and $29 million, respectively, was contributed to the ESOP by RJRN or Holdings and approximately $20 million and $24 million, respectively, of ESOP dividends were used to service the ESOP's debt to Holdings. On February 9, 1989, 15,254,238 warrants were issued to purchase 15,254,238 shares of Common Stock. Such warrants were initially exercisable at an exercise price of $5.00 per share, subject to adjustment in certain events, at any time prior to February 9, 1999. On November 8, 1991, the exercise price for the warrants and the number of shares of Common Stock issuable upon exercise thereof were adjusted to $4.9164 and 1.017, respectively. During the third quarter of 1992, Holdings repurchased from a limited partnership of which KKR Associates, an affiliate of KKR, is the sole general partner and certain affiliates of Merrill Lynch & Co., Inc. 6,182,586 warrants of the 15,254,238 warrants issued RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12--CAPITAL STOCK AND PAID-IN CAPITAL--(CONTINUED) on February 9, 1989 for approximately $36 million in cash. During October 1992, Holdings repurchased from the same parties the remaining 9,071,652 warrants for approximately $51 million in cash. Each of these warrants allowed the holder to purchase 1.017 shares of Common Stock for an exercise price of $4.9164 at any time on or prior to February 8, 1999. Warrants to purchase 45,529,024 shares of Common Stock were issued in connection with the sale of the 15% Subordinated Debentures and the Subordinated Discount Debentures. Such warrants were initially exercisable at an exercise price of $0.07 per share, subject to adjustment in certain events, and expired January 31, 1992. On November 8, 1991, the exercise price for the warrants and the number of shares of Common Stock issuable upon exercise thereof were adjusted to $0.0688 and 1.017, respectively. During 1992, 12,370,936 warrants were exercised at $0.0688 per share. During 1991, 29,695,730 warrants were exercised at $0.07 per share and 3,361,323 warrants were exercised at $0.0688 per share. See Note 10 for transactions involving the exchange of capital stock for long-term debt. NOTE 13--RETAINED EARNINGS AND CUMULATIVE TRANSLATION ADJUSTMENTS Retained earnings (accumulated deficit) at December 31, 1993, 1992 and 1991 includes non-cash expenses related to accumulated trademark and goodwill amortization of $3.015 billion, $2.390 billion and $1.774 billion, respectively. The changes in cumulative translation adjustments are shown as follows: NOTE 14--RETIREMENT BENEFITS RJRN sponsors a number of non-contributory defined benefit pension plans covering most U.S. and certain foreign employees. Plans covering regular full-time employees in the tobacco operations as well as the majority of salaried employees in the corporate groups and food operations to provide pension benefits that are based on credits, determined by age, earned throughout an employee's service and final average compensation before retirement. Plan benefits are offered as lump sum or annuity options. Plans covering hourly as well as certain salaried employees in the corporate groups and food operations provide pension benefits that are based on the employee's length of service and final average compensation before retirement. RJRN's policy is to fund the cost of current service benefits and past service cost over periods not exceeding 30 years to the extent that such costs are currently tax deductible. Additionally, RJRN participates in several multi-employer and other defined contribution plans, which provide benefits to certain of RJRN's union employees. Employees in foreign countries who are not RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--RETIREMENT BENEFITS--(CONTINUED) U.S. citizens are covered by various post-employment benefit arrangements, some of which are considered to be defined benefit plans for accounting purposes. A summary of the components of pension expense for RJRN-sponsored plans follows: The principal plans used the following actuarial assumptions for accounting purposes: RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--RETIREMENT BENEFITS--(CONTINUED) The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheets at December 31, 1993 and 1992 for RJRN's defined benefit pension plans. - --------------- (1) Of the net pension liability amounts at December 31, 1993 and 1992, $34 million and $12 million, respectively, were related to qualified plans. At December 31, 1993, approximately 99 percent of the plans' assets were invested in listed stocks and bonds and other highly liquid investments. The balance consisted of various income producing investments. In addition to providing pension benefits, RJRN provides certain health care and life insurance benefits for retired employees and their dependents. Substantially all of its regular full-time employees, including certain employees in foreign countries, may become eligible for those benefits if they reach retirement age while working for RJRN. Effective January 1, 1992, RJRN adopted SFAS No. 106. Under SFAS No. 106, RJRN is required to accrue the costs for retirees' health and other postretirement benefits other than pensions and recognize the unfunded and unrecognized accumulated benefit obligation for these benefits. RJRN had previously accrued a liability for postretirement benefits other RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14--RETIREMENT BENEFITS--(CONTINUED) than pensions and as a result, SFAS No. 106 did not have a material impact on RJRN's financial statements. Net postretirement health and life insurance benefit cost for 1993 consists of the following: Net postretirement health and life insurance benefit costs representing accretion on the liability balance of $89 million was charged to operations for the year ended December 31, 1991. The reduction in expense in 1992 reflects the reduction of recorded liabilities by approximately $225 million at December 31, 1991 as disclosed in Note 1 to the Consolidated Financial Statements. RJRN's postretirement health and life insurance benefit plans currently are not funded. The status of the plans was as follows: The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 8% in 1993, 9% in 1994 and 10.7% in 1995 gradually declining to 6.0% by the year 2002 and remaining at that level thereafter. 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 7% and 8.5%, respectively. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.5% and 8.5% as of December 31, 1993 and 1992, respectively. Effective January 1, 1993, RJRN adopted SFAS No. 112. Under SFAS No. 112, RJRN is required to accrue the costs for preretirement postemployment benefits provided to former or inactive employees and recognize an obligation for these benefits. The adoption of SFAS No. 112 did not have a material impact on the financial statements of either Holdings or RJRN. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 15--SEGMENT INFORMATION Industry Segment Data Holdings classifies its continuing operations into two industry segments which are described in Management's Discussion and Analysis of Financial Condition and Results of Operations, appearing elsewhere herein. Summarized financial information for these operations is shown in the following tables. - --------------- (1) Includes amortization of trademarks and goodwill for Tobacco and Food, respectively, for the year ended December 31, 1993, of $407 million and $218 million; for the year ended December 31, 1992, of $404 million and $212 million and for the year ended December 31, 1991, of $404 million and $205 million. (2) The 1993 and 1992 amounts include the effects of the restructuring expense at Tobacco (1993-- $544 million; 1992--$43 million), Food (1993--$153 million; 1992--$63 million) and Headquarters (1993--$33 million; 1992--$0), as applicable, and the sale of Holdings' ready-to-eat cold cereal business (See Note 1 to the Consolidated Financial Statements). (3) Cash and cash equivalents for the domestic operating companies are included in Headquarters' assets. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 15--SEGMENT INFORMATION--(CONTINUED) Geographic Data The following tables show certain financial information relating to Holdings' continuing operations in various geographic areas. - --------------- (1) Transfers between geographic areas (which consist principally of tobacco transferred principally from the United States to Europe) are generally made at fair market value. (2) The 1993 and 1992 amounts include the effects of the restructuring expense of $730 million and $106 million, respectively, and a gain on the sale of Holdings' ready-to-eat cold cereal business ($98 million) (see Note 1 to the Consolidated Financial Statements). (3) Includes amortization of trademarks and goodwill of $625 million, $616 million and $609 million for the 1993, 1992 and 1991 periods, respectively. RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 16--QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of the quarterly results of operations for Holdings for the quarterly periods of 1993 and 1992: - --------------- (1) Earnings per share is computed independently for each of the periods presented; therefore, the sum of the earnings per share amounts for the quarters may not equal the total for the year. In addition, assuming that the transactions discussed in Notes 10 and 12 to the Consolidated Financial Statements had occurred on January 1, 1993 or January 1, 1992, as applicable, and the net proceeds thereof were used to redeem or to repay outstanding indebtedness, the impact on earnings per share would be anti-dilutive for the reported periods. NOTE 17--SUBSEQUENT EVENT On February 24, 1994, Holdings filed a Registration Statement on Form S-3 for a proposed offering of 300 million depositary shares, each representing a one-tenth ownership interest in a share of a newly created series of Preferred Equity Redemption Cumulative Stock ("PERCS"). Each depositary share would mandatorily convert in three years into one share of Common Stock, subject to adjustment and subject to earlier conversion or redemption under certain circumstances. Any net proceeds of a PERCS offering may be used for general corporate purposes which may include refinancings of indebtedness, working capital, capital expenditures, acquisitions and repurchases or redemptions of securities. In addition, such proceeds may be used to facilitate one or more significant corporate transactions, such as a joint venture, merger, acquisition, divestiture, asset swap, spin-off and/or recapitalization, that would result in the separation of the tobacco and food businesses of Holdings. As of February 24, 1994, the specific uses of proceeds have not been determined. Pending such uses, any proceeds would be used to repay indebtedness under RJRN's revolving credit facilities or for short-term liquid investments. ------------------------------------ SCHEDULE II RJR NABISCO HOLDINGS CORP. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 - --------------- (A) Loan is denominated in a foreign currency. Rate fluctuations are included in the "Amounts Collected" column. The amounts presented represent loans to employees in connection with the 1990 Long Term Incentive Plan. See Note 12 to the Consolidated Financial Statements. S-1 SCHEDULE II RJR NABISCO HOLDINGS CORP. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1992 The amounts presented represent loans to employees in connection with the 1990 Long Term Incentive Plan. See Note 12 to the Consolidated Financial Statements. S-2 SCHEDULE III RJR NABISCO HOLDINGS CORP. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF INCOME AND RETAINED EARNINGS (DOLLARS IN MILLIONS) See Notes to Condensed Financial Information. S-3 SCHEDULE III RJR NABISCO HOLDINGS CORP. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) See Notes to Condensed Financial Information. S-4 SCHEDULE III RJR NABISCO HOLDINGS CORP. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS (DOLLARS IN MILLIONS) See Notes to Condensed Financial Information. S-5 SCHEDULE III RJR NABISCO HOLDINGS CORP. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION NOTE A--SUPPLEMENTAL CASH FLOWS INFORMATION For information regarding certain non-cash financing activities, see Notes 10 and 12 to the Consolidated Financial Statements. NOTE B--LONG-TERM DEBT See Note 10 to the Consolidated Financial Statements for information relating to the Converting Debentures. NOTE C--COMMITMENTS AND CONTINGENCIES Holdings has guaranteed the indebtedness of RJRN under the Credit Agreements and certain debentures. The guaranties are secured by a pledge of the capital stock of RJRN owned by Holdings. For a discussion of certain restrictive covenants associated with these debt obligations, see Note 10 to the Consolidated Financial Statements. For disclosure of additional contingent liabilities, see Note 11 to the Consolidated Financial Statements. S-6 SCHEDULE V RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - --------------- Property, plant and equipment are depreciated principally by the straight-line method. Annual depreciation rates for new assets range principally from 5% to 7% for land improvements; 2% to 33% for buildings and leasehold improvements; and 5% to 33% for machinery and equipment. Correspondingly higher depreciation rates are applicable with respect to assets in service at February 9, 1989, the date of the acquisition by Holdings and its affiliates of RJRN. S-7 SCHEDULE VI RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) S-8 SCHEDULE VIII RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - --------------- (A) Miscellaneous adjustments. (B) Principally charges against the accounts. (C) Excludes valuation allowance accounts for deferred tax assets. S-9 SCHEDULE IX RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - --------------- S-10 SCHEDULE X RJR NABISCO HOLDINGS CORP. RJR NABISCO, INC. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) S-11 EXHIBIT INDEX - --------------- *Filed herewith.

46216_1993.txt

46216_1993

1993

46216

Item 1. Business GTE Hawaiian Telephone Company Incorporated (the Company) (formerly Hawaiian Telephone Company) was incorporated under the laws of the Kingdom of Hawaii in 1883. The Company is a wholly-owned subsidiary of GTE Corporation (GTE) and provides communications services in Hawaii and throughout the Pacific and Asia. The Company owns a majority interest in the Micronesian Telecommunications Corporation (MTC). MTC, which is headquartered on Saipan in the Commonwealth of the Northern Marianas, provides local and international telecommunications services on the islands of Saipan, Tinian and Rota. In addition, the Company has a wholly-owned subsidiary, Hawaiian Tel Insurance Company, which provides auto liability, general liability and workers' compensation insurance to the Company on a direct basis. The Company provides local telephone service on each Island in Hawaii and long distance service between the Islands. InterLATA services between Hawaii and domestic points within the United States are provided by interexchange (long distance) common carriers which connect to the Company's local facilities for call origination and termination. The Company provides interLATA service between Hawaii and international termination points in competition with these carriers. These common carriers are charged fees (access charges) for interconnection to the Company's local facilities. End user business and residential customers are also charged access charges for access to the facilities of the long distance carriers. The Company also earns other revenues by leasing interexchange plant facilities and interexchange carriers, primarily the American Telephone and Telegraph Company (AT&T). The number of access lines served by the Company has grown steadily from 525,808 on January 1, 1989 to 725,029 on December 31, 1993. The Company's principal line of business is providing telecommunication services. These services fall into five major classes: local network, network access, long distance, equipment sales and services and other. Revenues from each of these classes over the last three years are as follows: Years Ended December 31 --------------------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of Dollars) Local Network Services $214,627 $ 203,908 $ 194,973 % of Total Revenues 38% 37% 36% Network Access Services $112,712 $ 107,347 $ 102,304 % of Total Revenues 20% 19% 19% Long Distance Services $106,867 $ 111,254 $ 106,721 % of Total Revenues 19% 20% 20% Equipment Sales and Services $ 95,653 $ 101,948 $ 106,430 % of Total Revenues 17% 18% 19% Other $ 35,030 $ 34,565 $ 35,482 % of Total Revenues 6% 6% 6% At December 31, 1993, the Company had 3,320 employees. The Company has written agreements with the International Brotherhood of Electrical Workers (IBEW) covering substantially all non-management employees. One of the agreements with the IBEW unit expires April 30, 1994 and provides for approximately a 5% general wage increase per annum. The agreement for MTC employees expires July 1, 1995 and provides for general wage increases of 5% per annum for 1994 and 1995. Telephone Competition The Company holds franchises, licenses and permits adequate for the conduct of its business in the territories which it serves. The Company is subject to regulation by the Public Utilities Commission (PUC) of the State of Hawaii as to its intrastate business operations and by the Federal Communications Commission (FCC) as to its interstate and international business operations. Information regarding the Company's activities with the various regulatory agencies and revenue arrangements with other telephone companies can be found in Note 9 of the Company's Annual Report to Shareholder for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. The year was marked by important changes in the U.S. telecommunications industry. Rapid advances in technology, together with government and industry initiatives to eliminate certain legal and regulatory barriers are accelerating and expanding the level of competition and opportunities available to the Company. As a result, the Company faces increasing competition in virtually all aspects of its business. Specialized communications companies have constructed new systems in certain markets to bypass the local-exchange network. Additional competition from interexchange carriers as well as wireless companies continues to evolve for both intrastate and interstate communications. During 1994, the Company will begin implementation of a re-engineering plan that will redesign and streamline processes. Implementation of its re-engineering plan will allow the Company to continue to respond aggressively to these competitive and regulatory developments through reduced costs, improved service quality, competitive prices and new product offerings. Moreover, implementation of this program will position the Company to accelerate delivery of a full array of voice, video and data services. The re-engineering program will be implemented over three years. During the year, the Company continued to introduce new business and consumer services utilizing advanced technology, offering new features and pricing options while at the same time reducing costs and prices. During 1993, the FCC announced its decision to auction licenses during 1994 in 51 major markets and 492 basic trading areas across the United States to encourage the development of a new generation of wireless personal communications services (PCS). These services will both complement and compete with the Company's traditional wireline services. The Company will be permitted to fully participate in the license auctions in areas outside of GTE's existing cellular service areas. Limited participation will be permitted in areas in which GTE has an existing cellular presence. In 1992, the FCC issued a "video dialtone" ruling that allows telephone companies to transmit video signals over their networks. The FCC also recommended that Congress amend the Cable Act of 1984 to permit telephone companies to supply video programming in their service areas. Activity directed toward changing the traditional cost-based rate of return regulatory framework for intrastate and interstate telephone services has continued. Various forms of alternative regulation have been adopted, which provide economic incentives to telephone service providers to improve productivity and provide the foundation for the pricing flexibility necessary to address competitive entry into the markets the Company serves. The GTE Consent Decree, which was issued in connection with the 1983 acquisition of GTE Sprint (since divested) and GTE Spacenet, prohibits GTE's domestic telephone operating subsidiaries from providing long distance service beyond the boundaries of the LATA. However, the Company is permitted to provide services between Hawaii and international points. This prohibition restricts their direct provision of long distance service to relatively short distances. The degree of competition allowed in the intraLATA market is subject to state regulation. However, regulatory constraints on intraLATA competition are gradually being relaxed. In September 1993, the FCC released an order allowing competing carriers to interconnect to the local-exchange network for the purpose of providing switched access transport services. This ruling complements similar interconnect arrangements for private line services ordered during 1992. The order encourages competition for the transport of telecommunications traffic between local exchange carriers' (LECs) switching offices and interexchange carrier locations. In addition, the order allows LECs flexibility in pricing competitive services. These and other actions to eliminate the existing legal and regulatory barriers, together with rapid advances in technology, are facilitating a convergence of the computer, media and telecommunications industries. In addition to allowing new forms of competition, these developments are also creating new opportunities to develop interactive communications networks. The Company supports these initiatives to assure greater competition in telecommunications, provided that overall the changes allow an opportunity for all service providers to participate equally in a competitive marketplace under comparable conditions. Item 2. Item 2. Properties The Company's property consists of network facilities (75%), company facilities (14%), customer premises equipment (2%) and other (9%). From January 1, 1989 to December 31, 1993, the Company made gross property additions of $0.7 billion and property retirements of $0.3 billion. Substantially all of the Company's property is subject to liens securing long-term debt. In the opinion of management, the Company's telephone plant is substantially in good repair. Item 3. Item 3. Legal Proceedings There are no pending legal proceedings, either for or against the Company, which would have a material impact on the Company's financial statements. 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 Market information is omitted since the Company's common stock is wholly-owned by GTE Corporation. Item 6. Item 6. Selected Financial Data Reference is made to the Registrant's Annual Report to Shareholder, page 27, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to the Registrant's Annual Report to Shareholder, pages 23 to 26, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 8. Item 8. Financial Statements and Supplementary Data Reference is made to the Registrant's Annual Report to Shareholder, pages 5 to 21, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. 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 Registrant's Annual Report to Shareholder, pages 5 - 21, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Report of Independent Public Accountants. Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Income for the years ended December 31, 1993-1991. Consolidated Statements of Reinvested Earnings for the years ended December 31, 1993-1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993-1991. Notes to Consolidated Financial Statements. (2) Financial Statement Schedules - Included in Part IV of this report for the years ended December 31, 1993-1991: Page(s) ------- Report of Independent Public Accountants 8 Schedules: V - Property, Plant and Equipment 9-11 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 12 VIII - Valuation and Qualifying Accounts 13 X - Supplementary Income Statement Information 14 Note: Schedules other than those listed above are omitted as not applicable, not required, or the information is included in the financial statements or notes thereto. (3) Exhibits - Included in this report or incorporated by reference. 3.1* Amended Articles of Incorporation and By-laws (Exhibit 3.2 of the 1987 Form 10-K, File No. 2-33059). 4* First Mortgage Indenture dated January 15, 1941 amended to and including amendments through September 27, 1962; Supplemental Indenture File No. 33-57416. 13 Annual Report to Shareholder for the year ended December 31, 1993, filed herein as Exhibit 13. (b) Reports on Form 8-K - No reports on Form 8-K were filed during the fourth quarter of 1993. * Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To GTE Hawaiian Telephone Company Incorporated: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in GTE Hawaiian Telephone Company Incorporated and subsidiaries' annual report to shareholder incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 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 in 1992 as discussed in Note 1 to the consolidated financial statements. Our audit was made for the purpose of forming an opinion on those 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 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. Dallas, Texas January 28, 1994. GTE HAWAIIAN TELEPHONE COMPANY INCORPORATED AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) - --------------------------------------------------------------------------- Column A Column B --------------- ----------------------------------------------- Item Charged to Operating Expenses - --------------------------------------------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Maintenance and repairs $ 119,382 $ 113,031 $ 109,761 =========== =========== =========== Taxes, other than payroll And income, are as follows: Real and personal property $ 917 $ 274 $ 335 State gross receipts 20,735 20,180 20,262 Other 4,883 6,109 6,384 Portion of above taxes charged to plant and other accounts (2,392) (2,320) (1,544) ----------- ----------- ------------ Total $ 24,143 $ 24,243 $ 25,437 =========== =========== ============ 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. GTE HAWAIIAN TELEPHONE COMPANY INCORPORATED ------------------------------------------- (Registrant) LARRY J. SPARROW Date March 21, 1994 By ------------------------------------- LARRY J. SPARROW Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. LARRY J. SPARROW Chairman of the Board, March 21, 1994 - ------------------------ Chief Executive Officer, LARRY J. SPARROW and Director (Principal Executive Officer) WARREN H. HARUKI President and Director March 21, 1994 - ------------------------ WARREN H. HARUKI GERALD K. DINSMORE Senior Vice President - Finance March 21, 1994 - ------------------------ and Planning and Director GERALD K. DINSMORE (Principal Financial Officer) WILLIAM M. EDWARDS Controller March 21, 1994 - ------------------------ (Principal Accounting Officer) WILLIAM M. EDWARDS RICHARD M. CAHILL Director March 21, 1994 - ------------------------ RICHARD M. CAHILL MICHAEL B. ESSTMAN Director March 21, 1994 - ------------------------ MICHAEL B. ESSTMAN KENT B. FOSTER Director March 21, 1994 - ------------------------ KENT B. FOSTER THOMAS W. WHITE Director March 21, 1994 - ------------------------ THOMAS W. WHITE

96638_1993.txt

96638_1993

1993

96638

ITEM 1. BUSINESS. OVERVIEW Advanta Corp. (the "Company") is a highly focused direct marketer of select consumer financial services. The Company primarily originates and services credit cards and mortgage loans. Other businesses include small ticket equipment leasing, credit insurance and deposit products. At year end 1993, assets under management totalled over $6.1 billion. Approximately 75% of total revenues are derived from credit cards marketed through carefully targeted direct mail campaigns. By focusing primarily on the no fee gold card, the Company has successfully grown to one of the ten largest issuers of gold cards. Mortgage services contribute 10% of total revenues with a managed loan portfolio of $1.15 billion. Mortgage loans are originated through a network of branch offices, a direct originations center and an expanding number of correspondent relationships. The Company was incorporated in Delaware in 1974 as Teachers Service Organization, Inc., the successor to a business originally founded in 1951. In January 1988, the Company's name was changed from TSO Financial Corp. to Advanta Corp. The Company's principal executive office is located at Brandywine Corporate Center, 650 Naamans Road, Claymont, Delaware 19703. Its principal operating office is located at Five Horsham Business Center, 300 Welsh Road, Horsham, Pennsylvania 19044-0749. The Company's telephone numbers at its principal executive and operating offices are, respectively, (302) 791-4400 and (215) 657-4000. References to the Company in this Report include its consolidated subsidiaries unless the context otherwise requires. CREDIT CARDS The Company, which has been in the credit card business since 1983, issues gold and standard MasterCard and VISA credit cards nationwide. The Company has built a substantial cardholder base which, as of December 31, 1993, totalled nearly 2.7 million accounts and $3.9 billion in managed receivables. According to industry statistics, the Company is one of the ten largest issuers of gold cards. Both gold and standard accounts undergo the same credit analysis, but gold accounts have higher initial credit limits because of the cardholders' higher incomes. In addition, gold accounts generally offer a wider variety of services to cardholders. The primary method of account acquisition is direct mail solicitation. The Company generally uses credit scoring by independent third parties and a proprietary market segmentation and targeting model to target its mailings to profitable segments of the market. In 1982, the Company acquired Colonial National Bank USA ("Colonial National"). As a national bank, Colonial National has the ability to make loans to consumers without many of the restrictions found in various state usury and licensing laws, to negotiate variable rate loans, to generate funds economically in the form of deposits insured by the Federal Deposit Insurance Corporation ("FDIC"), and to include in its product mix a MasterCard and VISA credit card program. Substantially all of the Company's credit card receivables and bank deposits, and most of its mortgage loan receivables, are held by Colonial National. MasterCard and VISA license banks, such as Colonial National and other financial institutions, to issue credit cards using their trademarks and to utilize their interchange networks. Cardholders may use their cards to make purchases at participating merchants or to obtain cash advances at participating financial institutions. The purchase is submitted to a merchant bank which remits to the merchant the purchase amount less a merchant discount fee, and submits the purchase to the card issuing bank for payment through the interchange system. The card issuing bank receives an interchange fee as compensation for the funding and credit risk that it takes when its customers use its credit card. MasterCard or VISA sets the interchange fee as a percentage of each card transaction (currently approximately 1.4%). The Company generates interest and other income from its credit card business through finance charges assessed on outstanding loans, interchange income, cash advance and other credit card fees, and securitization income as described below. Credit Card income also includes fees paid by credit card customers for product enhancements they may select, and revenues paid to Colonial National by third parties for the right to market their products to the Company's credit card customers. Most of the Company's MasterCard and VISA credit cards carry no annual fee, and those credit cards which do include an annual fee generally have lower fees than those charged by many of the Company's competitors. The Company believes that this characteristic of no or low annual fee credit cards has appealed to consumers, and that the Company's credit cards have also appealed to consumers because of their competitive interest rates, quality service, payment terms and credit lines. While the Company believes that its credit card offers will continue to appeal to consumers for the reasons stated, the Company also notes that competition is increasing in the credit card industry. At the same time, the American people are becoming generally more sophisticated and demanding users of credit. These forces are likely to produce significant changes in the industry; in recent years they have resulted in slower growth and lower yields for the industry, and these trends may continue. The Company is devoting substantial resources to meeting the challenges, and taking advantage of the opportunities, which management sees emerging in the industry. In 1993, this included significant focus on balance transfer initiatives, in which the Company encouraged consumers to transfer account balances they were maintaining with other credit card issuers to a Colonial National account with a lower interest rate. Approximately one-half of the growth in the Company's managed credit card receivables in 1993 resulted from balance transfers. The Company intends to continue exploring new approaches to the credit card market. The interest rates on the majority of the Company's credit card receivables are variable, tied to the prime rate. This helps the Company maintain net interest margins in both rising and declining interest rate environments. As Delaware, Colonial National's state of domicile, does not have a usury ceiling applicable to banks, there is no statutory maximum interest rate that the Company may charge its credit cardholders, nor does Delaware law limit the amount of any annual fees, late charges and other ancillary charges which may be assessed. While the state in which an individual cardholder resides may seek to regulate the annual fees and ancillary charges which Colonial National may charge to that state's residents, the enforceability of such regulation is unclear and is currently the subject of litigation in certain states. At the present time, the only Federal appellate decision addressing this issue held such regulation to be unenforceable. See "Government Regulation--Colonial National." Since 1988, Colonial National has been active in the credit card securitization market, securitizing $1.0 billion of credit card receivables in 1993 and $3.2 billion since 1988. The Company continues to recognize income on a monthly basis from the securitized receivables. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes 1 and 3 of the Notes to Consolidated Financial Statements. Colonial National's securitization program provides a number of benefits: diversifying its funding base, providing liquidity, reducing the bank's regulatory capital requirements, lowering its cost of funds, providing a source of variable rate funding to complement the variable rate credit card portfolio and helping to limit the on-balance sheet growth of Colonial National to not more than 7% per annum. See "Government Regulation--The Company." Furthermore, Colonial National continues to own the credit card accounts and customer relationships, which the Company believes continue to build significant long-term value. While the Company believes that securitization will continue to be a reliable source of funding, there is no assurance that the Company will be able to continue securitizations in amounts or under terms comparable to its securitizations to date. A securitization involves the transfer by the Company of the receivables generated by a pool of credit card accounts to a securitization trust. Certificates issued by the trust and sold to investors represent undivided ownership interests in receivables transferred to the trust. The securitization results in removal of receivables from the Company's balance sheet for financial and regulatory accounting purposes. For tax purposes, the investor certificates are characterized as a collateralized debt financing of the Company. The trust receives finance and other charges paid by the credit card customers and pays a rate of return on a monthly basis to the certificate holders. While in most cases the rate of return paid to investors is variable in order to match the pricing dynamics of the underlying receivables, the Company also uses fixed rate securitizations where appropriate to balance interest rate exposure on its assets and liabilities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset/Liability Management." Credit losses on the securitized receivables are paid from the funds in the trust. The Company continues to service the accounts for a fee, generally two percent per annum of the securitized receivables. Excess funds (defined as finance charges plus miscellaneous fees less interest paid to certificate holders, credit losses and servicing fees) are first retained to build up a reserve fund to a certain level, after which amounts are remitted to the Company. The Company's relationship with its credit card customers is not affected by the securitization. Investors in the trust receive payments of interest only during the first three to four years of the trust. Thereafter, an amortization period (generally between six and ten months) commences, during which the certificate holders are entitled to payment of principal and interest. Acceleration of the commencement of the amortization period (which may occur in limited circumstances) on a securitization would accelerate the Company's funding requirement. Upon full repayment of principal to the certificate holders, whether as a result of normal or accelerated amortization, the trust's lien on the accounts terminates and all related receivables and funds held in the trust, including the reserve fund, are transferred to the Company. MORTGAGE LOANS The Company's subsidiary, Advanta Mortgage Corp. USA ("Advanta Mortgage"), originates and services closed end mortgage loans for itself and for Colonial National's "Advanta Mortgage USA" Division, primarily through a broker network serviced by selected sales locations, a centralized direct origination center, and correspondent relationships. Closed end mortgage loans involve the loan of a fixed amount of funds to a residential borrower repayable over a contractual period of generally fifteen years. The Company does not extend mortgage lines of credit, which involve the extension of a revolving amount of credit to a borrower. Advanta Mortgage and Colonial National also purchase portfolios of mortgage loan receivables. Portfolio acquisitions totalled $6 million in 1991, $32 million in 1992 and $42 million in 1993. Advanta Mortgage and Colonial National operate the Company's mortgage loan business as a mortgage banking enterprise, i.e., they originate or purchase loans and then sell or securitize them, generally retaining servicing rights and the related excess cash flows. Consequently, the mortgage loan receivables on the Company's balance sheet are generally its most recently originated loans being held for sale. Thus, while mortgage loan receivables owned at December 31, 1993 were $91 million, during 1993 the Company originated or purchased $510 million and securitized $608 million of such receivables. At the time the receivables are sold or securitized, the Company recognizes a gain which is included in its mortgage banking income. See Note 1 to the Consolidated Financial Statements. Thus, Advanta Mortgage packages its loans for sale and customarily enters into agreements with the purchasers to continue to service the loans for a fee. Advanta Mortgage also services Colonial National's mortgage loan portfolio, packages Colonial National's mortgage loans for sale, and performs the servicing on loans sold by Colonial National where Colonial National retains the servicing rights and obligations. In addition, Advanta Mortgage performs fee-based servicing on loans originated and owned by unrelated third party mortgage lenders. Therefore, Advanta Mortgage and Colonial National's Advanta Mortgage USA Division have the following basic sources of income: net interest income on loans outstanding pending their sale, gains on sales of loans, loan servicing fees and loan origination fees ("points"). Points are deferred and amortized over the contractual life of a loan, and on sale or securitization of the loan are included in the computation of the gain on sale. Interest income earned on loans prior to their sale or securitization is included in the Company's interest revenues, as detailed in "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Net Interest Income." Advanta Mortgage and Colonial National began securitizing home loans in 1988, when they privately placed with institutional investors $72 million of certificates representing fractional ownership interests in securitization trusts. In February 1991, Advanta Mortgage and Colonial National securitized $108 million of loans in their first publicly offered mortgage securitization transaction and securitized approximately $193 million of additional loans in public offerings during the balance of 1991. They publicly securitized $385 million of loans in 1992, and $608 million in 1993. Securitizations of mortgage loans are similar to credit card securitizations as described above. The Company transfers a specified pool of mortgage loans to a trust which issues certificates representing undivided ownership interests in the loans. The Company acts as servicing agent for the trust, providing customer service and collection efforts, and receives loan servicing fees equal to .5% per annum of the securitized receivables. Finance and other charges paid to the trust are used to pay the investors interest on their certificates and premiums on an insurance contract issued by a third party guaranteeing full repayment of principal and interest to the investors. Excess amounts generally go into a reserve account, and after that account reaches a specified level, are paid to the Company. Credit losses on the securitized loans reduce the amount of these payments to the Company. Significant differences from the Company's credit card securitizations, however, include: (1) while in most cases the credit card securitization certificates pay a variable interest rate (which complements the variable rate pricing on the Company's credit cards), the mortgage securitization certificates generally carry a fixed rate of interest (as generally do each of the mortgage loans held by the trust), and (2) payments to investors in the mortgage loan securitizations include both principal and interest from the outset, since the loans held by the trust are not revolving credit lines. At December 31, 1993, Advanta Mortgage and Colonial National had approximately $91 million of mortgage loan receivables outstanding secured by mortgages on properties located in 30 states plus the District of Columbia. Additionally, as of that date, Advanta Mortgage was servicing approximately $1.1 billion in mortgage loans sold by the Company's subsidiaries, as well as $125 million of "contract servicing" receivables. Contract servicing receivables are not included in the Company's "managed portfolio," as the performance of such loans does not have a material impact on either the Company's net income or its credit risk profile. In contrast, the performance of the managed portfolio, including loans sold by the Company, can materially impact ongoing mortgage banking income. See Note 1 to the Consolidated Financial Statements. In 1993, loan loss and prepayment experience depressed mortgage banking income, resulted in higher charge-off rates and necessitated an increase in off-balance sheet mortgage loan recourse reserves. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - - Provision for Credit Losses" and "-- Credit Risk Management -- Asset Quality." As indicated by these higher off-balance sheet reserves, in 1994 the Company expects to experience a higher relative managed mortgage charge-off rate compared to 1993. A majority of this experience is due to a class of loan which the Company has not actively solicited since 1991, as well as to softening real estate values in certain areas in which the Company operates. Approximately 43% of the managed portfolio is secured by second mortgages and the balance is secured by non-purchase money first mortgages. At December 31, 1993, total mortgage loans managed, and the nonperforming loans included in those totals, are concentrated in the following regions: Geographic concentration carries a risk of increased delinquency and/or loss if an area suffers an economic downturn. Advanta Mortgage monitors economic conditions in those regions through market and trend analyses. A Credit Policy Committee meets through the year to update lending policies based on the results of analyses, which may include abandoning lending activities in economically unstable areas of the country. The Company believes that the concentrations of nonperforming loans reflected in the preceding table are not necessarily reflective of general economic conditions in each region, but rather reflect the credit risk inherent in the different grades of loans originated in each area. The interest rate charged and the maximum loan-to-value ratio permitted with respect to each grade of loans are adjusted to compensate for the credit risk inherent in that loan grade. The Company generally limits the total dollar amount of all loans secured by a property, including both the Company's mortgage loan and any other lender's first mortgage, to between 60% and 80% (depending upon the creditworthiness of the borrower) of the appraised value of the property. The average total loan-to-value ratio is 68% (calculated based upon the appraised values of the properties at the time of origination). However, a substantial depreciation in home values may impair the Company's security for these loans. As a result of substantial refinancing activity by consumers as market interest rates declined, in 1992 over 60% and in 1993 over 70% of the mortgage loans originated by the Company were first lien loans. EQUIPMENT LEASING The Company's leasing subsidiary, Advanta Leasing Corp. ("Advanta Leasing"), engages primarily in non-cancelable financing leases of equipment, including computers, fax machines, copiers and commercial cleaning equipment, primarily to professionals and small businesses. Most of the equipment leased has an initial value of less than $150,000, while the average initial value of leased equipment is approximately $7,000. Costs relating to equipment maintenance, insurance and personal property taxes are the responsibility of the lessee. In October 1991, Advanta Leasing closed its first securitization of lease receivables with a private placement of $74.5 million of certificates and closed a similar transaction in the amount of $53 million in September 1992. In 1993, Advanta Leasing securitized $68 million of lease receivables. Securitization of lease receivables is substantially similar to mortgage loan securitization as described above, except that the servicing fee payable to Advanta Leasing is 1.25% per annum of the securitized lease receivables. Including $138 million of remaining securitized receivables, at December 31, 1993 Advanta Leasing managed a portfolio of $189 million of net lease receivables. The small ticket equipment leasing industry is experiencing change as many smaller companies' funding sources have retrenched. This has provided Advanta Leasing with attractive direct marketing and portfolio acquisition opportunities, as Advanta Leasing's funding capacity remains strong. Consequently, the Company anticipates Advanta Leasing's origination volume increasing in 1994. CREDIT INSURANCE AND CREDIT PROTECTION Through unaffiliated insurance carriers, the Company offers credit life, disability and unemployment insurance to its credit cardholders and credit life insurance and a limited life/disability/unemployment insurance product to its mortgage loan customers. The unaffiliated insurers reinsure 100% of the risk on the credit card credit life, disability and unemployment insurance (but not the mortgage loan credit life insurance) with one or more of the Company's insurance subsidiaries. Such subsidiaries receive reinsurance premiums approximating 94% of the net premiums written. The subsidiaries are obligated to pay all losses and refunds, and to maintain reserve amounts equal to all statutory reserves for the benefit of the unaffiliated insurance carriers. In 1992, the insurance subsidiaries began direct underwriting of the property insurance provided for the Company's equipment leasing customers. The insurance subsidiaries are domiciled in Arizona, and are subject to regulation by the Arizona Department of Insurance and other insurance departments in states where they are licensed. The credit card credit life insurance insures the life of the borrower (and any joint borrower) in an amount equal to the unpaid loan balance and accrued interest (subject to a maximum amount of $5,000) and provides for payment to the lender of the borrower's obligation in the event of death. The credit disability insurance and credit unemployment insurance pay the minimum monthly payments required by the credit card loan with respect to the debt outstanding at the commencement of a period of disability or unemployment, up to a maximum of $5,000. Through Colonial National, the Company offers to some of its credit cardholders in certain states a card enhancement program named Credit Protection PlusR which provides benefits similar to those provided to other customers by the credit life, disability and unemployment insurance coverages offered by the unaffiliated insurance carriers. Colonial National, which insures its excess risk of loss on this product with the Company's insurance subsidiaries, began expanding its offering of Credit Protection PlusR in 1993. DEPOSIT, SAVINGS AND INVESTMENT PRODUCTS The Company offers a range of insured savings and transaction accounts through Colonial National, and offers uninsured investment products through the direct and brokered public sale of its senior and subordinated debt securities. Bank deposit services include demand deposits, money market savings accounts, statement savings accounts, retail certificates of deposit, large denomination certificates of deposit (certificates of $100,000 or more) and individual retirement accounts. During 1993, both the senior debt securities of Advanta Corp. and the senior debt securities and deposits of Colonial National achieved investment-grade ratings from the nationally recognized rating agencies. These ratings have allowed the Company to further diversify its funding sources. In November 1993, the Company filed a shelf registration statement with the Securities and Exchange Commission for $1 billion of senior debt securities, and subsequently sold $150 million of three-year notes in an underwritten transaction as well as $90 million (as of March 1, 1994) of medium-term notes of varying maturities pursuant to its $500 million medium-term note program established under this registration statement. In addition, the Company's subordinated debt securities historically have been and continue to be offered to investors with a variety of maturities (ranging from demand to ten years) and yield options. Further, a wholly-owned subsidiary of the Company, Colonial National Financial Corp. ("CNF"), began taking deposits in the form of certificates of deposit in January 1992. CNF is an FDIC insured industrial loan corporation organized under the laws of the State of Utah. The activities of CNF are not currently material to the Company's business. Consumer deposit business at Colonial National is generated from repeat sales to existing customers and new deposits from individuals attracted by newspaper, direct mail and radio advertisements. Also, Colonial National offers retail certificates of deposit to customers through several nationally recognized broker/dealer firms which offer "Master Certificate of Deposit" programs to banks throughout the nation. Under these programs, the customers of the broker/dealer firms may purchase Colonial National certificates of deposit in $1,000 increments, from $1,000 to $100,000. The award of investment grade ratings to Colonial National's senior debt securities has allowed the bank to acquire additional sources of institutional funds throuogh both deposit and non-deposit products. Together, these various programs provide Colonial National with cost effective sources of funding which are geographically diverse and improve control in managing interest rate sensitivity. Investments in the Company's senior debt securities are marketed primarily to institutional investors through underwritten offerings as well as direct placements pursuant to the Company's medium-term note program. Investments in the Company's subordinated debt securities are generated from newspaper advertisements, from direct mail marketing efforts to existing and prospective investors, and through broker/dealer firms. GOVERNMENT REGULATION THE COMPANY. The Company is not required to register as a bank holding Company under the Bank Holding Company Act of 1956, as amended (the "BHCA"). The Company owns Colonial National, which is a "bank" as defined under the BHCA as amended by the Competitive Equality Banking Act of 1987 ("CEBA"). However, under certain grandfathering provisions of CEBA, the Company is not required to register as a bank holding Company under the BHCA, because Colonial National, which takes demand deposits but does not make commercial loans, did not come within the BHCA's definition of the term "bank" prior to the enactment of CEBA and it complies with certain restrictions set forth in CEBA, such as limiting its activities to those in which it was engaged prior to March 5, 1987 and limiting its growth rate to not more than 7% per annum. Such restrictions also prohibit Colonial National from cross-marketing products or services of an affiliate that are not permissible for bank holding companies under the BHCA. In addition, the Company complies with certain other restrictions set forth in CEBA, such as not acquiring control of more than 5% of the stock or assets of an additional "bank" or "savings association" as defined for these purposes under the BHCA. Consequently, the Company is not subject to examination by the Federal Reserve Board (other than for purposes of assuring continued compliance with the CEBA restrictions referenced in this paragraph). Should the Company or Colonial National cease complying with the restrictions set forth in CEBA, registration as a bank holding Company under the BHCA would be required. Registration as a bank holding Company is not automatic. The Federal Reserve Board may deny an application if it determines that control of a bank by a particular Company will cause undue interference with competition or that such Company lacks the financial or managerial resources to serve as a source of strength to its subsidiary bank. While the Company believes that it meets the Federal Reserve Board's managerial standards and that its ownership of Colonial National has improved the bank's competitiveness, should the Company be required to apply to become a bank holding Company the outcome of any such application cannot be certain. Registration as a bank holding Company would subject the Company and its subsidiaries to inspection and regulation by the Federal Reserve Board. Although the Company has no plans to register as a bank holding Company at this time, the Company believes that registration would not restrict, curtail, or eliminate any of its activities at current levels, except that some portions of the current business operations of the Company's insurance subsidiaries would have to be discontinued, the effects of which would not be material. COLONIAL NATIONAL. The Company conducts substantially all its deposit-taking activities and credit card lending business, as well as a large portion of its mortgage lending business, through Colonial National. Under Federal law, Colonial National may "export" (i.e., charge its customers resident in other states) the finance charges permissible under the law of its state of domicile, Delaware, which state has no usury statute applicable to banks. Consistent with prevailing industry practice, the Company also exports credit card fees (including, for example, annual fees, late charges and fees for exceeding credit limits) permitted under Delaware law. There is no precedent clearly applicable to Colonial National as to the permissibility of exporting such fees. In a case involving this issue (to which the Company was not a party), the United States Court of Appeals for the First Circuit ruled that the Commonwealth of Massachusetts did not have the power to prevent a Delaware state-chartered financial institution from charging Massachusetts residents credit card fees in excess of those allowed under Massachusetts law. The United States Supreme Court declined to consider an appeal of the First Circuit's decision, and so that decision became final in 1992. However, litigation involving this issue has been initiated against other credit card issuers in several states, and it is possible that a contrary decision could be reached in a jurisdiction where the judgment of the First Circuit Court of Appeals is not binding. The Company cannot quantify the impact on its business, as a result of possible loss of fees, penalties or other sanctions, that could result from an adverse determination on this issue in one or more states. Colonial National is subject primarily to regulation and periodic examination by the Office of the Comptroller of the Currency (the "Comptroller"). Such regulation relates to the maintenance of reserves for certain types of deposits, the maintenance of certain financial ratios, transactions with affiliates and a broad range of other banking practices. As a national bank, Colonial National is subject to provisions of federal law which restrict its ability to extend credit to its affiliates or pay dividends to its parent Company. See "Dividends and Transfers of Funds." Colonial National is subject to capital adequacy guidelines approved by the Comptroller. These guidelines make regulatory capital requirements more sensitive to differences in risk profiles among banking organizations and consider off-balance sheet exposures in determining capital adequacy. As of December 31, 1993, the minimum ratio of total capital to risk-weighted assets (including certain off- balance sheet items) was 8%. At least half of the total capital is to be comprised of common equity, retained earnings and a limited amount of non-cumulative perpetual preferred stock ("Tier 1 capital"). The remainder may consist of other preferred stock, certain hybrid debt/equity instruments, a limited amount of term subordinated debt or a limited amount of the reserve for possible credit losses ("Tier 2 capital"). In addition, the Comptroller has also adopted a minimum leverage ratio (Tier 1 capital divided by total average assets) of 3% for national banks that meet certain specified criteria, including that they have the highest regulatory rating. Under this guideline, the minimum leverage ratio would be at least 1 or 2 percentage points higher for national banks that do not have the highest regulatory rating, for national banks undertaking major expansion programs, and for other national banks in certain circumstances. As of December 31, 1993, Colonial National's Tier 1 capital ratio was 7.19%, its combined Tier 1 and Tier 2 capital ratio was 12.06%, and its leverage ratio was 6.03%. Recognizing that the risk-based capital standards address only credit risk (i.e., not interest rate, liquidity, operational or other risks), the Comptroller has indicated that many national banks will be expected to maintain capital in excess of the minimum standards. As indicated above, Colonial National's capital levels currently exceed the minimum standards. To date, the Comptroller has not required Colonial National to maintain capital in excess of the minimum standards. However, there can be no assurance that such a requirement will not be imposed in the future, or if it is, what higher standard will be applicable. In addition, pursuant to certain provisions of the FDIC Improvements Act of 1991 ("FDICIA") and regulations promulgated thereunder, FDIC insured institutions such as Colonial National may only accept brokered deposits without FDIC permission if they meet certain capital standards, and are subject to restrictions with respect to the interest they may pay on deposits unless they are "well-capitalized." To be "well-capitalized," a bank must have a ratio of total capital to risk-weighted assets of not less than 10%, Tier 1 capital to risk-weighted assets of not less than 6%, and a Tier 1 leverage ratio of not less than 5%. Based on the applicable standards under these regulations, Colonial National is currently "well-capitalized," and the Company intends to maintain Colonial National as a "well-capitalized" institution. LENDING AND LEASING ACTIVITIES. The Company's activities as a lender are also subject to regulation under various federal and state laws including the Truth-in-Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, the Electronic Funds Transfer Act, and the Fair Credit Reporting Act. Provisions of those statutes, and related regulations, among other matters, require disclosure to borrowers of finance charges in terms of an annual percentage rate, prohibit certain discriminatory practices in extending credit, and regulate the dissemination and use of information relating to a borrower's creditworthiness. Certain of these statutes and regulations also apply to the Company's leasing activities. In addition, Advanta Mortgage and its subsidiaries are subject to licensure and regulation in various states as mortgage bankers, mortgage brokers, and originators, sellers and servicers of mortgage mortgage loans. DIVIDENDS AND TRANSFERS OF FUNDS. There are various legal limitations on the extent to which Colonial National can finance or otherwise supply funds through dividends, loans or otherwise to the Company and its affiliates. The prior approval of the Comptroller is required if the total of all dividends declared by Colonial National in any calendar year exceeds its net profits (as defined) for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus accounts. In addition, Colonial National may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts. The Comptroller also has authority under the Financial Institutions Supervisory Act to prohibit a national bank from engaging in any unsafe or unsound practice in conducting its business. It is possible, depending upon the financial condition of the bank in question and other factors, that the Comptroller could claim that a dividend payment might under some circumstances be an unsafe or unsound practice. Colonial National is also subject to restrictions under Sections 23A and 23B of the Federal Reserve Act. These restrictions limit the transfer of funds to the Company and certain other affiliates, as defined in that Act, in the form of loans, extensions of credit, investments or purchases of assets, and they require generally that Colonial National's transactions with its affiliates be on terms no less favorable to the bank than comparable transactions with unrelated third parties. These transfers by Colonial National to the Company or any single affiliate are limited in amount to 10% of Colonial National's capital and surplus and transfers to all affiliates are limited in the aggregate to 20% of Colonial National's capital and surplus. Furthermore, such loans and extensions of credit are also subject to various collateral requirements. In addition, in order for the Company to maintain its grandfathered exemption under CEBA, Colonial National may not make any loans to the Company or any of its subsidiaries. The Company's insurance subsidiaries are insurance companies organized under and regulated by Arizona law. Arizona insurance regulations restrict the amount of dividends which an insurance Company may distribute without the prior consent of the Director of Insurance. GENERAL. Because the banking and finance businesses in general are the subject of such extensive regulation at both the state and federal levels, and because numerous legislative and regulatory proposals are advanced each year which, if adopted, could affect the Company's profitability or the manner in which the Company conducts its activities, the Company cannot now predict the extent of the impact of any such new laws or regulations. Various legislative proposals have been introduced in Congress in recent years, including, among others, proposals relating to imposing a statutory cap on credit card interest rates, permitting interstate branching by banks, permitting affiliations between banks and commercial or securities firms, and proposals which would place new restrictions on a lender's ability to utilize pre-screening of consumers' credit reports through credit reporting agencies (credit bureaus) in connection with the lender's direct marketing efforts. It is impossible to determine whether any of these proposals will become law and, if so, what impact they will have on the Company. In September 1992, the Federal Communications Commission established rules implementing the Telephone Consumer Protective Act of 1991 which limits telephone solicitations to residences. Because the statute exempts telemarketing to existing or former customers, it will not materially impact the Company's current business operations. COMPETITION As a marketer of credit products, the Company faces intense competition from numerous providers of financial services. Many of these companies are substantially larger and have more capital and other resources than the Company. Competition among lenders can take many forms including convenience in obtaining a loan, customer service, size of loans, interest rates and other types of finance or service charges, duration of loans, the nature of the risk which the lender is willing to assume and the type of security, if any, required by the lender. Although the Company believes it is generally competitive in most of the geographic areas in which it offers its services, there can be no assurance that its ability to market its services successfully or to obtain an adequate yield on its loans will not be impacted by the nature of the competition that now exists or may develop. In seeking investment funds from the public, the Company faces competition from banks, savings institutions, money market funds, credit unions and a wide variety of private and public entities which sell debt securities, some of which are publicly traded. Many of the competitors are larger and have more capital and other resources than the Company. Competition relates to such matters as rate of return, collateral, insurance or guarantees applicable to the investment (if any), the amount required to be invested, convenience and the cost to and conditions imposed upon the investor in investing and liquidating his investment (including any commissions which must be paid or interest forfeited on funds withdrawn), customer service, service charges, if any, and the taxability of interest. EMPLOYEES As of December 31, 1993, the Company had 1,614 employees, up from 1,327 employees at the end of 1992. The Company believes that it has good relationships with its employees. None of its employees is represented by a collective bargaining unit. ITEM 2. ITEM 2. PROPERTIES. The Company leases an aggregate of approximately 189,000 square feet of office space in six office buildings located in Horsham, Pennsylvania, a Philadelphia suburb, and owns a 95,000 square foot building in Horsham. The Company also leases an aggregate of approximately 75,000 square feet of office space for its Advanta Mortgage offices in California, New Jersey, New York and Maryland, and 41,000 square feet of office space for its Advanta Leasing offices in New Jersey. The Company's principal executive and Colonial National's principal operating offices are currently located in approximately 81,000 square feet of leased space in two office buildings in Delaware. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are no material pending legal proceedings to which the Registrant or any of its subsidiaries is a party or of which any of their property is the subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT Each of the executive officers of the Company listed below was elected by the Board of Directors, to serve at the pleasure of the Board in the capacities indicated. Mr. Alter became Executive Vice President and a director of the Company in 1967. He was elected President and Chief Executive Officer in 1972, and Chairman of the Board of Directors in August 1985. In February 1986, he relinquished the title of President. Mr. Hart joined the Company in March 1994 as Executive Vice Chairman. For the five years prior to that he had been President and Chief Executive Officer of MasterCard International, Inc., a worldwide association of over 29,000 member financial institutions. Prior to joining MasterCard in November 1988, Mr. Hart was Executive Vice President of First Interstate Bancorp, Los Angeles, California. Mr. Greenawalt was elected President and Chief Operating Officer of the Company in November 1987. Prior to joining the Company, Mr. Greenawalt served as President of Transamerica Financial Corp., Los Angeles, California, from May 1986. For the 15 years prior to that, Mr. Greenawalt served in various capacities with Citicorp, including most recently as Chairman and Chief Executive Officer of Citicorp Person-to-Person, Inc., St. Louis, Missouri, and, prior to that, as President and Chief Executive Officer of Citicorp Retail Services, Inc., New York, New York. Mr. Kantor became a Senior Vice President of the Company in April 1986, a director in May 1986, Chief Financial Officer in September 1986 and Executive Vice President in December 1986. In November 1993, he was promoted to the position of Vice Chairman, and he relinquished the title of Chief Financial Officer. Prior to joining the Company, Mr. Kantor was the partner in charge of the Financial Services Division of Arthur Andersen & Co. in Philadelphia, Pennsylvania where he served for more than ten years, and was also the audit partner assigned to the Company's account. Mr. Wesselink joined the Company in November 1993 as Senior Vice President and Chief Financial Officer. Prior to joining the Company, Mr. Wesselink was Vice President and Treasurer of Household International. Previous positions held at Household include Vice President-Director of Research, Group Vice President-Chief Financial Officer of Household Finance Corporation (HFC) and Senior Vice President-Chief Financial Officer of HFC. Mr. Marshall joined the Company in January 1988 and was elected Senior Vice President in February 1988. Prior to joining the Company, from July 1987 he was Chief Operations Officer of a Scudder, Stevens & Clark joint venture. Prior to that, Mr. Marshall served in various capacities at Citibank from 1976. At the time he left Citibank, he was a Senior Vice President of Citicorp Retail Services, managing a major portion of its client relationships. Mr. Riseman came to the Company in June 1992 as Senior Vice President, Administration. He was appointed to his present position in February 1994. Prior to joining the Company, Mr. Riseman had 27 years experience with Citicorp, most recently as Director of Training and Development. Prior to that he held Citicorp positions as Business Manager for the Long Island Region, Head of Policy and Administration for New York's Retail Bank, and Chairman of Citicorp Acceptance Co. which was involved in the financing and leasing of autos and financing of mobile homes. Mr. Lindenberg had been the Chairman of the Board and President of an equipment leasing business, LeaseComm Financial Corporation, from that Company's inception in June 1985 until its purchase by the Company. Following the acquisition, Mr. Lindenberg was elected President and Chief Executive Officer of Advanta Leasing Corp., the successor to LeaseComm. Prior to starting LeaseComm, Mr. Lindenberg had been with First Pennsylvania Bank, Philadelphia, Pennsylvania since 1982, where he had served in various capacities, most recently as Vice President of the national division responsible for that bank's commercial lending activities in leasing and electronics. Mr. Averett came to the Company as Vice President in January 1988. Prior to joining the Company, Mr. Averett worked with Citicorp from 1980 to 1987. Most of this tenure was in a retail credit card division (CRS) holding a wide array of positions from financial analyst to credit cycle manager and eventually Regional Collections Manager. Mr. Beck joined the Company in 1986 as Senior Vice President of Colonial National and was elected Vice President and Treasurer in 1992. Prior to joining the Company, he was Vice President, Fidelity Bank, N.A., responsible for asset/liability planning, as well as for managing a portfolio of investment securities held at the bank. From 1970 through 1980, he served in various treasury and planning capacities for Wilmington Trust Company. Mr. Calamari joined the Company in May 1988. From May 1985 through April 1988, Mr. Calamari served in various capacities in the accounting departments of Chase Manhattan Bank, N.A. and its subsidiaries, culminating in the position of Chief Financial Officer of Chase Manhattan of Maryland. From 1976 until May 1985, Mr. Calamari was an accountant with the public accounting firm of Peat, Marwick, Mitchell in New York. Ms. Dyer joined the Company as Vice President, Marketing in 1992. Prior to joining the Company, she was Vice President and Director of Marketing for the Retail Finance Division of MNC Financial. From 1985 to 1989, she was Director, Product Development and Management at the Student Loan Marketing Association and had previously held marketing management positions with Citicorp in their credit card, mortgage and consumer finance businesses. Mr. Fread joined the Company in 1986 as Director of Internal Audit, and was elected to the office of Vice President, Asset Quality in June 1987. Prior to joining the Company, he was an audit manager for Arthur Andersen & Co. where he was responsible for audit and consulting engagements for a variety of financial service companies. Mr. Fried joined the Company as Vice President, Strategic Planning and Business Development in 1992. Prior to joining the Company, he was Vice President, New Business Development for Chase Manhattan's Direct Response Banking Sector. Prior to that position, Mr. Fried had 11 years of senior level marketing, planning and development experience in the Credit Card, Consumer Branch Banking and Private Label Retail Credit Divisions at Citicorp. Mr. Girman joined the Company as Vice President, Accounting Operations, Policies and Procedures in July 1988, and was elected Vice President, Audit and Control, in April 1991. Prior thereto, Mr. Girman served as Vice President, Management Accounting and Accounting Policies and Procedures for The Chase Manhattan Bank (USA), N.A. from April 1985 until joining the Company. Mr. Hofmann came to the Company as Director of Human Resources in November 1986 and was elected Vice President, Human Resources in March 1987. Prior to joining the Company, he was Manager, Human Resources Planning and Development for Subaru of America, Inc. from October 1984, and Manager, Management and Organization Development for Shared Medical Systems Corporation from March 1981 until October 1984. Mr. Millman joined the Company in September 1989 and was elected Assistant Treasurer in July 1990 and Vice President, Corporate Funds Management in August 1991. In November 1993, he became Chief Financial Officer of the Consumer Financial Services unit. Prior to joining the Company, Mr. Millman served as Director of Financial Planning for Knight Ridder, Inc. from March 1987 to January 1988, and as Chief Financial Officer of Osteotech, Inc. from January 1988 to September 1989. Mr. Perlet joined the Company in November 1987, and was elected as Vice President, Insurance in June 1988. Prior to joining the Company, Mr. Perlet was with Colonial Penn Group, Inc. for 13 years, where he served in a variety of capacities, most recently as Senior Vice President. Mr. Schneyer joined the Company as Associate General Counsel in September 1986 and was elected to the offices of Vice President, Secretary and General Counsel in March 1989. Prior to joining the Company, from October 1983, Mr. Schneyer was an attorney in the Legal Department of Allied-Signal, Inc., Morristown, New Jersey. ADVANTA CORP. AND SUBSIDIARIES PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. At December 31, 1993, the Company had approximately 1,000 and 850 holders of record of Class B and Class A common stock, respectively. ADVANTA CORP. AND SUBSIDIARIES ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. FINANCIAL HIGHLIGHTS ADVANTA CORP. AND SUBSIDIARIES ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Overview Net income for 1993 rose to $76.6 million or $1.92 per share. This reflects increases of 60% and 39%, respectively, from the $48.0 million or $1.38 per share reported in 1992. Net income before extraordinary item was $77.9 million or $1.95 per share, increases of 62% and 41%, respectively, from 1992. Earnings per share for 1993 incorporated a 15% increase in the number of common shares outstanding versus 1992, reflecting an equity offering by the Company in March 1993. Earnings per share for 1992 have been adjusted to reflect an effective three-for-two stock split as a result of the October 15, 1993 stock dividend. Earnings for 1993 increased primarily as a result of a $1.1 billion or 34% increase in average managed receivables, continued improvement in credit quality with the total managed charge-off rate decreasing from 3.4% in 1992 to 2.9% in 1993, and controlled growth in operating expenses. The Company continues to securitize a majority of the growth in its receivables and to report the performance of the securitized receivables as noninterest revenues. Consequently, the 34% increase in average managed receivables resulted in a $62.5 million or 32% increase in noninterest revenues to $255.6 million in 1993, from $193.1 million in 1992. As a result of improved credit quality, the provision for credit losses in 1993 fell to $29.8 million from $47.1 million in 1992. Despite a lower provision, reserve coverage of impaired owned assets was higher at December 31, 1993 compared to a year ago. Disciplined cost management resulted in operating expenses increasing only 27%, while average managed receivables grew 34% and the operating expense ratio fell to 4.1% for 1993 compared to 4.4% in 1992. Net interest income of $72.1 million for 1993 increased $3.4 million or 5% from 1992 as a result of a $170 million increase in average earning asset balances, offset by a 22 basis point drop in the owned net interest margin. The Company is executing a strategy to market a "risk-adjusted" credit card product in which credit cards are issued with lower rates to customers whose credit quality is expected to result in a lower rate of credit losses (the "risk-adjusted" strategy). This strategy resulted in a drop in credit card yields thereby lowering the owned net interest margin. Over the last three years, average managed receivables have grown at a compound annual rate of 34%. This receivable growth has generated higher financial returns, net income and earnings per share. The Company intends to continue pursuing a strategy of receivable growth with a goal of increasing average managed receivables by 30% or more in 1994. Net income for 1992 of $48.0 million or $1.38 per share increased 91% and 72%, respectively, from $25.2 million or $.81 per share in 1991. Earnings increased in 1992 primarily as a result of an $807 million or 34% increase in average managed receivables and a 51 basis point increase in the managed net interest margin. Average securitized assets rose 67% in 1992 increasing noninterest revenues $59.8 million or 45%. The largest single component of noninterest revenues, credit card securitization income, rose $38.3 million or 90% as average securitized credit card receivables increased 85%. The provision for credit losses was down 15% in 1992 compared to 1991 as a result of lower charge-offs and delinquency levels on owned receivables. Operating expenses increased 28% with a 34% increase in average managed receivables, while operating expenses as a percentage of average managed receivables fell to 4.4% in 1992 from 4.6% in 1991. (1)See Note 1 to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES The owned net interest margin fell to 4.85% in 1993 from 5.07% in 1992, due to a 173 basis point decrease in the yield on interest earning assets partially offset by a 151 basis point improvement in the cost of funding those assets. In 1993, the owned net interest margin of 4.85% reflects the benefit of the March 1993 equity offering and increased retained earnings. Credit card, mortgage and lease receivable securitization activity shifts revenues from interest income to noninterest revenues. This ongoing securitization activity reduces the level of higher-yielding receivables on the balance sheet while increasing the quantity of lower-yielding money market assets. While the money market assets are subsequently replaced with new receivables, the active securitization program reduces the average yield of the on-balance sheet portfolio. Net interest income on securitized credit card balances is reflected in credit card securitization income. Net interest income on securitized mortgage loans is reflected in income from mortgage banking activities, and net interest income on securitized lease receivables is reflected in leasing revenues, net. All securitization income is included in noninterest revenues. See Note 1 to Consolidated Financial Statements. Average managed credit card receivables of $3.0 billion for 1993 increased $755 million or 34% from 1992. This increase can be attributed to several successful credit card campaigns which generated approximately 853,000 new accounts and a large volume of balance transfers by card- holders. Owned receivable balances would have been higher in both years had it not been for the securitization of $1.0 billion of credit card receivables in 1993 and $950 million in 1992. The 241 basis point decline in the yield on owned credit card receivables was the result of the Company's "risk-adjusted" strategy and the influence of a predominance of newer, lower-yielding accounts in the owned portfolio. It is anticipated that these accounts will start repricing upwards in 1994. Average managed mortgage loans increased to $1.0 billion in 1993, a 34% increase from $786.3 million in 1992. The average balance of owned mortgage loans de-creased to $154.2 million in 1993 from $185.6 million in 1992 primarily due to the securitization of $608 million of receivables in 1993. Mortgage loan originations of $510 million in 1993 were up $84 million or 20% from 1992. Yields on owned mortgage loans decreased to 9.91% from 11.40% in 1992 reflecting the lower rate environment and a significant increase in the proportion of first lien mortgage loans in the portfolio. Average managed lease receivables of $154.8 million increased $45 million or 42% from 1992. Average owned balances on leases increased $12.7 million during 1993 due to increased originations and portfolio purchases. Yields on owned leases increased from 17.46% in 1992 to 18.70% in 1993 due to a higher amount of late fees. A significant decline in the owned average cost of funds was experienced in 1993 as the cost of funds fell to 5.18% from 6.39% in 1992. The rollover of deposits in a lower rate environment, lower money market rates, and the Company's entrance into funding markets not previously available to them with a newly acquired investment-grade rating were the primary reasons for this decline. Net interest income of $68.7 million in 1992 dropped slightly from $69.3 million in 1991 primarily as a result of a 61 basis point decline in the owned net interest margin. This decline in the owned net interest margin was a result of a 218 basis point decline in yields on interest earning assets partially offset by a 157 basis point improvement in the cost of funding those assets. Offsetting this decline in the owned net interest margin was a $96 million increase in average interest earning asset balances. The following table provides an analysis of both owned and managed interest income and expense data, average balance sheet data, net interest spread (the difference between the yield on interest earning assets and the average rate paid on interest-bearing liabilities), and net interest margin (the difference between the yield on interest earning assets and the average rate paid to fund interest earning assets) for 1991 through 1993. Average owned loan and lease receivables and the related interest revenues exclude deferred origination costs and the amortization thereof (see Note 1 to Consolidated Financial Statements) and include certain loan fees. ADVANTA CORP. AND SUBSIDIARIES INTEREST RATE ANALYSIS ADVANTA CORP. AND SUBSIDIARIES INTEREST VARIANCE ANALYSIS: ON-BALANCE SHEET - - - --------------------------------------------- The following table presents the effects of changes in average volume and interest rates on individual financial statement line items on a tax equivalent basis, excluding the amortization of deferred origination costs and including certain loan fees. Changes not solely due to volume or rate have been allocated on a pro rata basis between volume and rate. The effects on individual financial statement line items are not necessarily indicative of the overall effect on net interest income. (1) Includes income from assets held and available for sale. PROVISION FOR CREDIT LOSSES - - - --------------------------- The provision for credit losses of $29.8 million in 1993 decreased $17.3 million or 37% from $47.1 million in 1992. This decrease can be attributed to lower charge-offs on owned receivables, which on a consolidated basis were 2.4% of average receivables compared to 3.9% in 1992, and to lower levels of impaired assets. The owned impaired asset level fell to $22.5 million at December 31, 1993, from $31.6 million a year ago. Lower delinquency levels helped to strengthen the Company's reserve coverage of impaired assets to 138.6% at December 31, 1993, from 127.4% a year ago. During 1993, the Company transferred $11 million of on-balance sheet unallocated loan loss reserves to increase off-balance sheet mortgage loan recourse reserves, which reserves are netted against excess mortgage servicing rights. The provision for credit losses of $47.1 million in 1992 decreased $8.4 million or 15% from $55.5 million in 1991. This decrease was primarily due to lower charge-offs on owned receivables and lower impaired asset levels. A description of the credit performance of the loan portfolio is set forth under the section entitled "Credit Risk Management." ADVANTA CORP. AND SUBSIDIARIES Noninterest revenues of $255.6 million in 1993 increased $62.5 million or 32% from $193.1 million in 1992. Due to the securitization of credit card receivables, activity from securitized account balances normally reported as net interest income and charge-offs is reported in securitization income and servicing income, both of which are included in noninterest revenues. Credit card securitization income increased 68% to $135.8 million from $80.8 million in 1992 while average securitized credit card receivables increased 46% to $2.1 billion in 1993 from $1.5 billion in the prior year. Securitization income as a percentage of average securitized receivables was 6.4% in 1993 compared with 5.6% for 1992. See Note 1 to Con-solidated Financial Statements for further description of securitization income. Credit card securitization income is the revenue collected on the securitized receivables, including interest, interchange income and certain fees, less the related ex-penses, including interest payments to investors in the trusts, charge-offs, servicing costs and transaction expenses. Credit card servicing income increased to $41.6 million in 1993 from $28.6 million in 1992. Servicing income represents fees paid to the Company for continuing to service accounts which have been securitized. Such fees approximate 2% of securitized receivables. Total interchange income earned represents approximately 1.4% of credit card purchases. The amount of inter-change paid to the securitization trusts ranges from 1% to 2% of securitized balances and is included in credit card securitization income. Interchange income decreased 39% to $18.8 million in 1993 from $30.7 million in 1992 due to a larger proportion of interchange revenues being included in securitization income. Other credit card revenues, which include credit insurance, cash advance fees and other credit card related revenues, were basically flat year-to-year due to an increasing proportion of credit card revenues becoming part of securitization income. Additionally, the amortization of annual fee income on owned credit card receivables previously had been included in other credit card revenues; beginning in 1993, this amoritization is included as a com-ponent of net interest income. During 1993, the Company securitized $608 million of mortgage loans compared to $385 million in 1992. In 1993, increased credit losses on the securitized portfolio decreased income from mortgage banking activities by approximately $14 million. Increased prepayments also de-creased income from mortgage banking activities by $14 million in 1993. Consequently, mortgage banking income of $24.1 million was relatively flat compared with 1992. See Note 1 to Consolidated Financial Statements for a description of mortgage banking income. Noninterest revenues of $193.1 million in 1992 increased $59.7 million or 45% from $133.4 million in 1991 primarily due to increases in credit card securitization and servicing income. ADVANTA CORP. AND SUBSIDIARIES Operating expenses of $174.6 million for 1993 increased $37.0 million or 27% from $137.6 million in 1992, driven by a 34% growth in average managed receivables. The increase in operating expenses can be primarily attrib-uted to: (a) a $13.9 million, or 27%, increase in salaries and employee benefits with a 22% increase in the number of employees from 1992, (b) a $4.9 million increase in marketing expenses as the Company promoted its finan-cial products as well as enhanced its general public visibility, (c) a $3.6 million increase in external processing resulting primarily from a 26% increase in the number of accounts managed year-to-year, (d) a $5.1 million increase in professional fees as the Company invested in long-term planning projects, and (e) an overall increase in credit card related costs due to a 27% increase in the number of accounts managed. Operating expenses of $137.6 million for 1992 were up $29.8 million or 28% from $107.8 million in 1991 while average managed receivables grew 34%. This increase in operating expenses can be primarily attributed to: (a) a $9.0 million, or 21%, increase in salaries and employee benefits with a 23% increase in the number of employees year-to-year, (b) a $5.7 million increase in marketing expenses to market the Company's financial products and enhance its general visibility, (c) a $2.3 million increase in credit card fraud losses, due to the growth in managed credit card receivables and a higher incidence of fraud, and (d) an overall increase in credit card related costs due to a 15% increase in the number of accounts managed. In 1991, credit card fraud losses included $3.9 million related to the acceleration of charge-offs (see discussion in "Asset Quality" on page 30). The operating expense ratio fell to 4.4% in 1992 from 4.6% in 1991. INCOME TAXES The Company's consolidated income tax expense was $45.3 million for 1993, or an effective tax rate of 37%, compared to tax expense of $29.1 million, or 38%, in 1992 and tax expense of $14.2 million, or 36%, in 1991. The decrease in the effective tax rate from 1992 to 1993 resulted from a higher level of tax-free income, while the increase in the effective tax rate from 1991 to 1992 resulted from higher pretax income and less tax-free income year-to-year. ASSET/LIABILITY MANAGEMENT - - - ------------------------------------------------------------------------------- The financial condition of Advanta Corp. is managed with a focus on maintaining high credit quality standards, disci-plined interest rate risk management and prudent levels of leverage and liquidity. INTEREST RATE SENSIVITY Interest rate sensitivity refers to the net interest income volatility resulting from changes in interest rates, product spread variability and mismatches in the repricing intervals between interest-rate-sensitive assets and liabilities. The Company attempts to minimize the impact of market interest rate fluctuations on net interest income and net income by regularly evaluating the risk inherent in its asset and liability structure, including securitized assets. This risk arises from continuous changes in the Company's asset/liability mix, market interest rates, the yield curve, prepayment trends and the timing of cash flows. Computer simulations are used to evaluate net interest income volatility under varying rate, spread and volume projections over monthly time periods of up to two years. In managing its interest rate sensitivity position, the Company periodically securitizes, sells and purchases assets, alters the mix and term structure of its retail and institutional funding base and complements its basic business activities by changing the investment portfolio and short- ADVANTA CORP. AND SUBSIDIARIES term asset positions. The Company has primarily utilized variable rate funding in pricing its credit card securitization transactions in an attempt to match the pricing dynamics of the underlying receivables sold to the trusts. Although credit card receivables are priced at a spread over the prime rate, they generally contain interest rate floors. These floors have the impact of converting the credit card receivables to fixed rate receivables in a low interest rate environment. In instances when a significant portion of credit card receivables are at their floors, the Company may convert part of the underlying funding to a fixed rate by using interest rate hedges, swaps and fixed rate securitizations. In pricing mortgage and lease securitizations, primarily fixed rate fund-ing is used as nearly all of the receivables sold to investors carry a fixed rate. Interest rate fluctuations affect net interest income at virtually all financial institutions. While interest rate volatility does have an effect on net interest income, other factors also contribute significantly to changes in net inter-est income. Specifically, within the credit card portfolio, pricing decisions and customer behavior regarding convenience usage affect the yield on the portfolio. These factors may counteract or exacerbate income changes due to fluc-tuating interest rates. The Company closely monitors interest rate movements, competitor pricing and consumer behavioral changes in its ongoing analysis of net interest income sensitivity. LIQUIDITY, FUNDING, AND CAPITAL RESOURCES The Company's goal is to maintain an adequate level of liquidity, both long- and short-term, through active management of both assets and liabilities. During 1993, the Company, through its subsidiaries, securitized $1.0 billion of credit card receivables, $608 million of mortgage loans and $68 million of lease receivables. Cash generated from these transactions was temporarily invested in short-term, high quality investments at money market rates awaiting redeployment to pay down deposits and to fund future credit card, mortgage loan and lease receivable growth. See Consolidated Statements of Cash Flows for more information regarding liquidity, funding and capital resources. In addition, see Note 5 to Consolidated Financial Statements and Supplemental Schedules thereto for additional information regarding the Company's investment portfolio. Over the last six years, the Company has accessed the securitization market to efficiently support its growth strate-gy. While securitization should continue to be a reliable source of funding for the Company, other funding sources are available and include deposits, subordinated debt, medium-term notes and the ability to sell assets and raise additional equity. At December 31, 1993, the Company was carrying $668 million of loans available for sale. The fair value of such loans was in excess of their carrying value at year end. In connection with managing liquidity and asset/liability management, the Company had $308 million of investments available for sale at December 31, 1993. See Note 18 to Consolidated Financial Statements for fair value disclosures. In August 1993, the Company's principal subsidiary, Colonial National Bank USA ("Colonial National" or the "Bank"), sold $50 million of subordinated notes which had received an investment-grade rating and qualified as Tier 2 capital. The following table details the composition of the deposit base at year end for each of the past five years. ADVANTA CORP. AND SUBSIDIARIES It is expected that deposits will increase slightly in 1994, as the Bank is likely to expand its asset base within the limits permitted under the Competitive Equality Banking Act of 1987 ("CEBA"). As a grandfathered institution under CEBA, the Company must limit the Bank's asset growth to 7% per annum. For the fiscal CEBA year ended September 30, 1993, the Bank's average assets did not exceed the allowable amount and, accordingly, the Bank was in full compliance with CEBA growth limits. Deposits at December 31, 1993 include $38 million of deposits at Colonial National Financial Corp. ("CNF"), a Utah state-chartered, FDIC- insured industrial loan corporation (a wholly-owned subsidiary of the Company). CNF's assets or operations are not currently material to the Company, and the Company does not expect them to become material in the near term. During 1993, the debt securities of Advanta Corp. achieved investment-grade ratings from the nationally recognized rating agencies. These ratings have allowed the Company to further diversify its funding sources. In November 1993, the Company filed a shelf registration statement with the Securities and Exchange Commission for $1 billion of debt securities, and subsequently sold $150 million of three-year notes under this registration statement. The Company also anticipates selling up to an additional $500 million of medium-term notes as needed. In addition, steady building of liquidity and capital in 1993 and 1992 was achieved as a result of $76.5 million of dividends from subsidiaries in 1993 and $40.0 million in 1992, and retained earnings of $69.3 million in 1993 and $44.0 million in 1992. The Board of Directors currently intends to have the Company pay regular quarterly dividends to its shareholders, maintaining a 20% premium on the dividend paid on the Class B shares; however, the Company plans to reinvest the majority of its earnings to support future growth. During 1993, the Company raised $90 million in new equity through a 3.0 million share (pre-split) Class B common stock offering. Proceeds were used to support future growth. Other elements contributed to liquidity at the subsidiary level (other than the Bank) in 1993. Advanta Mortgage Corp. USA ("Advanta Mortgage") had lines of credit totaling $190 million, which, because of other available funding sources, were not renewed when they expired in December 1993. Advanta Leasing Corp. ("Advanta Leasing") also has lines of credit totaling approximately $86 million. While there are no specific capital requirements for Advanta Corp., the Office of the Comptroller of the Currency requires that Colonial National maintain a risk-based capital ratio of at least 8%. Colonial National's risk-based capital ratio of 12.06% at December 31, 1993 was in excess of the required level and, in fact, exceeded the mini-mum required capital level of 10% for designation as a "well capitalized" depository institution. The Company intends to take the necessary actions to maintain Colonial National as a "well capitalized" bank. In addition, the Company is subject to various rate setting rules and capital regulations related to the Advanta Insurance Companies. At December 31, 1993, the Company was in full compliance with these rules and regulations. CAPITAL EXPENDITURES The Company spent $11.3 million for capital expenditures in 1993, primarily for the purchase of a building, improvements to that building and additional space in other build-ings, office and voice communication equipment and furniture and fixtures. This compared to $5.3 million for capital expenditures in 1992 and $4.2 million in 1991. In 1994, the Company anticipates capital expenditures to exceed those of 1993 as its facilities are expanding and the Company is continuing to upgrade its voice and comm-unication systems. In 1994, the Company anticipates that its marketing expenditures will exceed those of 1993 as the Company continues to manage account retention, originate new accounts and develop new consumer products for its customers. CREDIT RISK MANAGEMENT - - - ------------------------------------------------------------------------------- Management regularly reviews the loan portfolio in order to evaluate the adequacy of the reserve for credit losses. The evaluation includes such factors as the inherent credit quality of the loan portfolio, past experience, current eco-nomic conditions, projected credit losses and changes in the composition of the loan portfolio. The reserve for credit losses is maintained for on-balance sheet receivables. The on-balance sheet reserve is intended to cover all credit losses inherent in the owned loan portfolio. With regard to securitized assets, anticipated losses and related recourse reserves are reflected in the calculations of Securitization Income and Amounts Due From Securitizations. Recourse reserves are intended to cover all probable credit losses over the life of the securitized receivables. ADVANTA CORP. AND SUBSIDIARIES The reserve for credit losses on a consolidated basis was $31.2 million, or 2.4% of receivables, at December 31, 1993, down from $40.2 million, or 4.0% of receivables, in 1992. Due to improved credit quality, this reserve level resulted in higher reserve coverage of impaired assets (nonperforming assets and accruing loans past due 90 days or more on credit cards) of 138.6% at December 31, 1993, compared to 127.4% at December 31, 1992. Reserve cover-age of impaired credit card assets was 183.7% at December 31, 1993, down slightly from 187.6% at year end 1992. The reserve for credit losses on a consolidated basis increased to $40.2 million, or 4.0% of receivables, in 1992 up from $36.4 million, or 2.9% of receivables, in 1991. This reserve level and a decrease in impaired assets resulted in higher reserve coverage of impaired assets. ASSET QUALITY Impaired assets include both nonperforming assets (mortgage loans and leases past due 90 days or more, real estate owned, credit card receivables due from cardholders in bankruptcy, and off-lease equipment) and accruing loans past due 90 days or more on credit cards. The carrying values for both real estate owned and equipment held for lease or sale are based on net realizable value after taking into account holding costs and costs of disposition and are reflected in other assets. On the total managed portfolio, impaired assets were $95.1 million, or 1.8% of receivables, at year end 1993 compared to $92.7 million, or 2.5% of receivables, in 1992. Nonperforming assets on the total managed portfolio were $63.6 million, or 1.2% of receivables, compared to $57.8 million, or 1.6%, in 1992. A key credit quality statistic, the 30-plus-day delinquency rate on managed credit cards, dropped to 2.4% from 3.7% a year ago. The total managed charge-off rate for 1993 was 2.9%, compared to 3.4% for 1992. The charge-off rate on managed credit cards was 3.5% for 1993, down from 4.5% for 1992. On the total owned portfolio, impaired assets were $22.5 million, or 1.8% of receivables, in 1993 compared to $31.6 million, or 3.2%, in 1992. Gross interest income that would have been recorded in 1993 and 1992 for owned nonperforming assets, had interest been accrued through-out the year in accordance with the assets' original terms, was approximately $1.5 million and $1.8 million, respectively. The amount of interest on nonperforming assets included in income for 1993 and 1992 was $.3 million and $.5 million, respectively. Past due loans represent accruing loans that are past due 90 days or more as to collection of principal and interest. Credit card receivables, except those on bankrupt, decedent and fraudulent accounts, continue to accrue interest until the time they are charged off at 186 days contractual delinquency. In contrast, all mortgage loans and leases are put on nonaccrual when they become 90 days past due. Owned credit card receivables past due 90 days or more and still accruing interest were $11.0 million or 1.0% of receivables at December 31, 1993, compared to $16.3 million, or 2.2% of receivables, a year ago. Through 1990, when the Company received notice that a credit cardholder had filed a bankruptcy petition or was deceased, the Company established a reserve equal to the full balance of the receivable. The receivable, if not paid, would be charged off in accordance with the Com-pany's normal credit card charge-off policy at 186 days contractual delinquency. Likewise, receivables in accounts identified as fraudulent would be reserved against and written off (as an operating expense) when they became 186 days contractually delinquent. These policies are consistent with many leading competitors in the credit card industry. During 1991, the Company adopted a new policy for the charge-off of bankrupt, decedent and fraudulent credit card accounts. Under the new policy, the Company charges off bankrupt or decedent accounts within 30 days of notification and accounts suspected of being fraudulent after a 90-day investigation period, unless the investigation shows no evidence of fraud. Consequently, in 1991, both newly identified bankrupt, decedent and fraudulent accounts, as well as those previously identified, were written off. The 1991 charge-off rates included in the following tables exclude the effect of this acceleration. With respect to the mortgage loan business, in 1993 the Company continued to face several difficult challenges: softening real estate values, increased prepayments and a higher level of charge-offs. The managed charge-off rate on mortgage loans increased from .8% in 1992 to 1.3% in 1993. The 1993 charge-off amount includes $3.0 million of accelerated charge-offs. The managed mortgage charge-off rate in 1994 is anticipated to stay at a high level. ADVANTA CORP. AND SUBSIDIARIES The following tables provide a summary of reserves, impaired assets, delinquencies and charge-offs for the past five years: (1) Restated, where necessary, to exclude interest advances on the serviced mortgage portfolio to be consistent with presentation of owned portfolio. (2) The 1991 charge-off rates are normalized to exclude the acceleration of the charge-off of bankrupt and decedent accounts related to the adoption of a new credit card charge-off policy in 1991. Including these amounts, the charge-off rates for 1991 were 3.8% and 5.3% on a consolidated-managed and credit card-managed basis, respectively. ADVANTA CORP. AND SUBSIDIARIES (1) The 1991 charge-off rates are normalized to exclude the acceleration of the charge-off of bankrupt and decedent accounts related to the adoption of a new credit card charge-off policy in 1991. Including these amounts, the charge-off rates for 1991 were 4.7% and 5.8% on a consolidated-owned and credit card-ownedbasis, respectively. ADVANTA CORP. AND SUBSIDIARIES ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See Notes to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES CONSOLIDATED INCOME STATEMENTS See Notes to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY See Notes to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES See Notes to Consolidated Financial Statements. ADVANTA CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - - - --------------------------------------------------- PRINCIPLES OF CONSOLIDATION The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and include the accounts of Advanta Corp. (the "Company") and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. RECLASSIFICATION Certain prior-period amounts have been reclassified to conform with current-year classifications. CREDIT CARD ORIGINATION COSTS, SECURITIZATION INCOME AND FEES CREDIT CARD ORIGINATION COSTS The Company accounts for credit card origination costs under Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases" ("SFAS 91"). This accounting standard requires certain loan and lease origination fees and costs to be deferred and amortized over the life of a loan or lease as an adjustment to interest income. Origination costs are defined under this standard to include costs of loan origination associated with transactions with independent third parties and certain costs relating to underwriting activities and preparing and processing loan documents. The Company engages third parties to solicit and originate credit card account relationships. Amounts deferred under these arrangements approximated $29.5 million in 1993, $20.3 million in 1992 and $24.4 million in 1991. For credit card receivables, deferred origination costs have been amortized over 60 months. At the May 20, 1993 meeting of the Emerging Issues Task Force ("EITF") of the Financial Accounting Standards Board, the task force reached a consensus regarding the acquisition of individual credit card accounts from independent third parties (EITF Issue 93-1). The consensus was that credit card accounts acquired individually should be accounted for as originations under SFAS 91 and EITF Issue 92-5. Amounts paid to a third party to acquire indi-vidual credit card accounts should be deferred and netted against the related credit card fee, if any, and the net amount should be amortized on a straight-line basis over the privilege period. If a significant fee is charged, the privilege period is the period that the fee entitles the cardholder to use the card. If there is no significant fee, the privilege period should be one year. In accordance with this recent consensus, direct origi-nation costs incurred related to credit card originations initiated after the May 20, 1993 consensus date are deferred and amortized over 12 months. Costs incurred for originations which were initiated prior to May 20, 1993 will continue to be amortized over a 60 month period. Prior to the EITF Issue 93-1 consensus, it was the Company's practice to write off deferred origination costs related to credit card receivables that have been securitized. This practice had effectively written off credit card origination costs much more quickly than the 60 month period previously utilized. In connection with the prospective adoption of a 12 month amortization period for deferred credit card origination costs, the Company will no longer write off deferred origination costs related to credit card receivables being securitized, as under the EITF Issue 93-1 consensus such costs are not directly associated with the receivables. CREDIT CARD SECURITIZATION INCOME Since 1988, the Company, through its subsidiary Colonial National Bank USA ("Colonial National" or "CNB") has completed 16 credit card securitizations totalling $3.2 billion in receivables. See Note 3 and Note 16. In each transaction, credit card receivables were transferred to a trust and interests in the trust were sold to investors for cash. The Company records excess servicing income on credit card securitizations representing additional cash flow from the receivables initially sold based on the repayment term, including prepayments. Prior to the EITF Issue 93-1 consensus, net gains were not recorded at the time each transaction was completed as excess servicing income was offset by the write off of deferred origination costs and the establishment of recourse reserves. Subsequent to the prospective adoption discussed above, excess servicing income has been recorded at a lower level at the time of each transaction, and is predominantly offset by the establishment of recourse reserves. The lower level of excess servicing income corresponds with the discontinuance of ADVANTA CORP. AND SUBSIDIARIES deferred origination cost write-offs upon securitization of receivables as discussed above. During the "revolving period" of each trust, income is recorded based on additional cash flows from the new receivables which are sold to the trusts on a continual basis to replenish the investors' interest in trust receivables which have been repaid by the credit cardholders. CREDIT CARD FEES Annual fees on credit cards are deferred and amortized on a straight-line basis over the fiscal year of the account. The changes relating to origination costs and securitization income, as discussed above, in the aggregate did not have a material effect on the Company's 1993 financial statements. MORTGAGE LOAN ORIGINATION FEES The Company generally charges origination fees ("points") for mortgage loans where permitted under state law. Origi-nation fees are deferred and amortized over the contractual life of the loan. However, upon the sale or securitization of the loans, the unamortized portion of such fees is recognized and included in the computation of the gain on sale. LOAN AND LEASE RECEIVABLES AVAILABLE FOR SALE Loan and lease receivables available for sale represent receivables that the Company generally intends to sell or securitize within the next six months. These assets are reported at the lower of cost or fair market value. INVESTMENTS HELD TO MATURITY Investments held to maturity include those investments that the Company has the positive intent and ability to hold to maturity. These investments are reported at cost, adjusted for amortization of premiums or accretions of discounts. INVESTMENTS AVAILABLE FOR SALE Investments available for sale include securities that the Company sells from time to time to provide liquidity and in response to changes in the market. In 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). This statement requires that debt and equity securities classified as Available for Sale be reported at market value. This Statement is effective for fiscal years beginning after December 15, 1993, although a company may elect earlier adoption as of the end of a fiscal year for which annual statements have not been previously issued. The Company has elected to adopt this statement as of December 31, 1993, and as such, these securities are recorded at market value at that date. Unrealized holding gains and losses on these securities are reported as a separate component of stockholders' equity and included in retained earnings. These securities are reported at the lower of cost or market value at December 31, 1992. The market value was $202,708 at December 31, 1992. FORWARD CONTRACTS A short sale of U.S. Treasury securities for forward settlement involves an agreement between two parties to sell Treasury securities at a specified future date and at a speci-fied future price. The Company periodically sells U.S. Treasury securities short for forward settlement for the purpose of hedging the pricing of anticipated mortgage loan securitizations. Gains or losses are deferred and included in the measurement of the dollar basis of the assets sold. The contractual amounts of forward contracts at December 31, 1993 and 1992 were $72 million and $165 million, respectively. FINANCIAL FUTURES A financial future is a contract to take or make delivery of the underlying financial instrument at a specified price at a future date. The Company periodically sells financial futures contracts expressly for the purpose of managing and reducing interest rate risk specifically related to the reset of one-month LIBOR on outstanding credit card securitiza-tions. Gains or losses are included in securitization income. At December 31, 1993 and 1992, there were no futures contracts outstanding. INTEREST RATE SWAPS An interest rate swap is a contract between two counter-parties to exchange interest payments on a specified notion-al amount at agreed upon rates. The Company enters into these agreements for the primary purpose of managing its interest rate risk. At December 31, 1993, the Company had $500 million notional amount of interest rate swap agreements fixed at a 4.95% weighted average rate and $150 million notional amount of floating rate swaps priced at one-month LIBOR. The fixed rate contracts mature throughout 1994 and the floating rate contracts mature in 1996. INCOME FROM MORTGAGE BANKING ACTIVITIES The Company, through its subsidiaries, sells mortgage loans through both secondary market securitizations and whole loan sales, typically with servicing retained. Income is ADVANTA CORP. AND SUBSIDIARIES recognized at the time of sale approximately equal to the present value of the anticipated future cash flows resulting from the retained yield adjusted for an assumed prepayment rate, net of any anticipated charge-offs, and allowing for a normal servicing fee. Changes in the anticipated future cash flows, as well as the receipt of cash flows which differ from those projected, affect the recognition of current and future mortgage banking income. Also included in this income is any difference between the net sales proceeds and the carrying value of the mortgage loans sold at the time of the transaction. See Note 3 and Note 16. The carrying value includes deferred loan origination fees and costs which in-clude certain fees and costs related to acquiring and pro-cessing a loan held for resale. These deferred origination fees and costs are netted against income from mortgage banking activities when the loans are sold. Mortgage banking income also includes loan servicing fees equal to .5% of the outstanding balance of securitized loans and, beginning in 1992, loan servicing fees on mortgage loan portfolios which were never owned by the Company ("contract servicing"). INCOME FROM LEASE SECURITIZATIONS The Company, through its subsidiaries, sells equipment lease receivables through secondary market securitizations. Income is recorded at the time of sale approximately equal to the present value of the anticipated future cash flows net of anticipated charge-offs, partially offset by deferred initial direct costs, transaction expenses and estimated credit losses under certain recourse requirements of the trust. Also included in income is the difference between the net sales proceeds and the carrying amount of the receivables sold. Subsequent to the initial sale, securitization income is recorded in proportion to the actual cash flows received from the trusts. INSURANCE Insurance premiums, net of commissions on credit life, disability and unemployment policies on credit cards, are earned monthly based upon the outstanding balance of the underlying receivables. The cost of acquiring new rein-surance is deferred and amortized over the reinsurance period in order to match the expense with the anticipated premium revenue. Insurance claim reserves are based on estimated settlement amounts for both reported and incurred but not reported losses. CREDIT LOSSES During 1991, the Company adopted a new charge-off policy related to bankrupt, decedent and fraudulent credit card accounts. Under the previous policy, whenever the Company received notification that a credit cardholder had filed a bankruptcy petition or was deceased, a reserve was established equal to the full balance of the receivable. The receivable, if not paid, would be charged off at 186 days contractual delinquency. Likewise, receivables in accounts identified as fraudulent would be reserved against and written off (as an operating expense) when they became 186 days contractually delinquent. Under the policy adopted in 1991, bankrupt and decedent accounts are written off within 30 days of notification, and accounts suspected of being fraudulent are written off after a 90 day investigation period, unless the investigation shows no evidence of fraud. During the 1991 transition period, both newly identified bankrupt, decedent and fraudulent accounts, as well as those previously identified, were written off. PREMISES AND EQUIPMENT Premises, equipment, computers and software are stated at cost less accumulated depreciation and amortization. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. Repairs and maintenance are charged to expense as incurred. GOODWILL Goodwill, representing the cost of investments in subsidiaries and affiliated companies in excess of net assets acquired at acquisition, is being amortized on a straight-line basis over 25 years. INCOME TAXES Effective January 1, 1993, the Company implemented the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") with no material effect on the financial statements. SFAS 109 utilizes the liability method and deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of the enacted tax laws. Prior to the implementation of SFAS 109, the Company accounted for income taxes using Accounting Principles Board Opinion No. 11. EARNINGS PER SHARE Earnings per common share are computed by dividing net earnings after preferred stock dividends by the average number of shares of common stock and common stock equivalents outstanding during each year. The outstanding preferred stock is not a common stock equivalent. Earnings ADVANTA CORP. AND SUBSIDIARIES per share in 1992 and 1991 have been adjusted to reflect the effective three-for-two stock split as a result of the October 15, 1993 stock dividend. See Note 7. CASH FLOW REPORTING For purposes of reporting cash flows, cash includes cash on hand and amounts due from banks. Cash paid during 1993, 1992 and 1991 for interest was $78.8 million, $94.4 million and $107.7 million, respectively. Cash paid for taxes during these periods was $30.0 million, $17.7 million and $8.7 million, respectively. (A) Includes credit card receivables available for sale of $564 million and $250 million in 1993 and 1992, respectively. (B) Includes mortgage loan receivables available for sale of $74.6 million and $190.5 million in 1993 and 1992, respectively. (C) Includes lease receivables available for sale of $28.6 million and $31.5 million in 1993 and 1992, respectively, and is net of unearned income of $11.9 million and $10.8 million in 1993 and 1992, respectively, and also includes residual interest for both years. (D) Includes approximately $.6 million and $1.7 million in 1993 and 1992, respectively, related to loan and lease receivables available for sale. Receivables serviced for others consisted of the following items: The geographic concentration of managed receivables was as follows: In the normal course of business, the Company makes commitments to extend credit to its credit card customers. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any conditions established in the contract. The Company does not require collateral to support this financial commitment. At December 31, 1993 and 1992, the Company had $16.0 billion and $11.7 billion, respectively, of commitments to extend credit outstanding for which there is potential credit risk. The Company believes that its customers' utilization of these lines of credit will continue to be substantially less than the amount of the commitments, as has been the Company's experience to date. At December 31, 1993 and 1992, out-standing managed credit card receivables represented 24% and 23%, respectively, of outstanding commitments. ADVANTA CORP. AND SUBSIDIARIES NOTE 3. CREDIT CARD, MORTGAGE LOAN AND EQUIPMENT LEASE SECURITIZATIONS - - - --------------------------------------- Colonial National has completed 16 sales of credit card receivables through asset-backed securitizations aggregating $3.2 billion. In each transaction, credit card receivables were transferred to a trust which issued certificates representing ownership interests in the trust to institutional investors. Colonial National retained a participation interest in each trust, reflecting the excess of the total amount of receivables transferred to the trust over the portion represented by certificates sold to investors. The retained participation interests in the credit card trusts were $371.8 million and $393.5 million at December 31, 1993 and 1992, respectively. Although Colonial National continues to service the underlying credit card accounts and maintain the customer relationships, these transactions are treated as sales for financial reporting purposes to the extent of the investors' interests in the trusts. According-ly, the associated receivables are not reflected on the balance sheet. Colonial National is subject to certain recourse provi-sions in connection with these securitizations. At December 31, 1993 and 1992, Colonial National had reserves of $96.4 million and $108.8 million, respectively, related to these recourse provisions. These reserves are netted against the excess servicing-credit card securitization. See Note 16. At December 31, 1993, the Company had amounts receivable from credit card securitizations, which include the related interest-bearing deposits, excess servicing and other amounts related to securitization of $191.0 million, $104.7 million of which was subject to liens by the providers of the credit enhancement facilities for the individual securitizations. At December 31, 1992, the amounts receivable and amounts subject to lien were $192.0 million and $106.5 million, respectively. Through December 31, 1993, the Company had sold, through securitizations and whole loan sales, approximately $1.7 billion of mortgage loan receivables which sales are subject to certain recourse provisions. The Company had reserves of $32.1 million and $10.1 million at year end 1993 and 1992, respectively, related to these recourse provisions which are netted against the excess mortgage servicing rights. See Note 16. At December 31, 1993, the Company had amounts receivable from mortgage loan sales and securitizations of $102.8 million, $39.7 million of which was subject to liens. At December 31, 1992, the amounts receivable and amounts subject to lien were $82.0 million and $32.8 million, respectively. Through December 31, 1993, the Company had securitized approximately $196 million of equipment lease receiv-ables which are subject to certain recourse provisions. The asset-backed certificates carry a fixed rate to investors. There were reserves of $5.3 million and $3.1 million at year end 1993 and 1992, respectively, related to these recourse provisions which are netted against the excess servicing-lease securitizations. See Note 16. The Company had accounts receivable from lease securitizations of $9.7 million at year end 1993 and $4.0 million at year end 1992, of which $5.9 million and $1.7 million, respectively, were subject to liens by the providers of the credit enhancement facility. Total interest in residuals for lease assets sold was $9.6 million and $7.7 million at December 31, 1993 and 1992, respectively, and is also subject to recourse provisions. NOTE 4. RESERVE FOR CREDIT LOSSES - - - -------------------------------------- The reserve for credit losses for lending and leasing transactions is established to reflect losses anticipated from delinquencies that have already occurred. Any adjustments to the reserves are reported in the Income Statements in the periods they become known. During 1993, the Company used $11 million of its on-balance sheet unallocated reserves to increase its off-balance sheet mortgage loan recourse reserves, which are a component of excess mortgage servicing rights. In 1992, the Company used $3.3 million of its on-balance sheet unallocated reserves to increase its off-balance sheet mortgage loan recourse reserves. ADVANTA CORP. AND SUBSIDIARIES The following table displays five years of reserve history: ADVANTA CORP. AND SUBSIDIARIES At December 31, 1993, investment securities with a book value of $17,473 were pledged as collateral for swap and hedge transactions. At December 31, 1991, investment securities with a book value of $101,847 were pledged as collateral for repurchase transactions. There were no investment securities pledged as collateral at December 31, 1992. At December 31, 1993, 1992 and 1991, investment securities with a book value of $7,927, $9,147 and $8,748, respectively, were deposited with insurance regu-latory authorities to meet statutory requirements or held by a trustee for the benefit of primary insurance carriers. At December 31, 1993, $806 of net unrealized gains on securities was included in investments available for sale. During 1993, the net change in unrealized gains on available for sale securities included as a separate component of stockholders' equity was $563. Maturity of investments available for sale at December 31, 1993: Proceeds from sales of available for sale securities during 1993 were $841,000. Gross gains of $3,430 and losses of $888 were realized on these sales. Proceeds during 1992 were $353,000. Gross gains of $2,414 and losses of $427 were realized on these sales. Proceeds during 1991 were $147,000. Gross gains of $1,085 and losses of $508 were realized on these sales. The specific identification method was the basis on which cost was determined in computing realized gains and losses. Equity securities primarily includes FRB, FHLB and FNMA stock that the Company is required to hold. The annual maturities of long-term debt at December 31, 1993 for the years ending December 31 are as follows: $70.4 million in 1995; $180.7 million in 1996; $51.4 million in 1997; $10.4 million in 1998; and $55.5 million thereafter. The average interest cost of the Company's debt during 1993, 1992 and 1991 was 7.59%, 9.01% and 10.27%, respectively. NOTE 7. STOCK DIVIDENDS - - - ------------------------------------ On April 24, 1992, the Company's shareholders approved a dual class stock plan pursuant to which the Company's Common Stock was reclassified as Class A Common Stock and a new class of non-voting stock, Class B Common Stock, was authorized. Promptly following shareholder approval, the Board of Directors declared a dividend of one share of Class B Common Stock on each outstanding share of Class A Common Stock to shareholders of record as of April 24, 1992, which dividend was paid on May 5, 1992. ADVANTA CORP. AND SUBSIDIARIES On September 23, 1993, the Board of Directors approved a three-for-two stock split in the form of a 50% stock dividend on both the Class A and Class B Common Stock to shareholders of record as of October 4, 1993, which dividend was paid on October 15, 1993. All share and per share amounts have been adjusted to reflect the three-for-two stock split as a result of the stock dividend. The balance sheet presentation of stockholders' equity for prior years and earnings per share for the years ended December 31, 1992 and 1991, have been adjusted to reflect the impact of this dividend, as if it had already occurred at such respective dates. The Class A Preferred Stock is entitled to 1/2 vote per share and a non-cumulative dividend of $140 per share per year, which must be paid prior to any dividend on the common stock. Dividends were declared on the Class A Preferred Stock for the first time in 1989 and have continued through 1993 as the Company paid dividends on its common stock. The redemption price of the Class A Preferred Stock is equivalent to the par value. NOTE 9. ISSUANCE OF COMMON STOCK - - - ------------------------------------ On March 24, 1993, in a public offering, the Company sold 2,575,000 shares (pre-split) of Class B Common Stock. Proceeds from the offering, net of the underwriting discount, were $77.5 million. On April 21, 1993, the underwriters of the offering purchased an additional 450,000 shares (pre-split) of Class B Common Stock, pursuant to the overallotment option granted to them by the Company. This brought the Company's total proceeds of the offering, net of related expenses, to approximately $90 million. The Company used the proceeds of the offering for general corporate purposes, including to finance the growth of its subsidiaries. NOTE 10. EXTRAORDINARY ITEM - - - ------------------------------------ In April of 1993, the Company repurchased the remaining $33.2 million of its 12 3/4% Senior Subordinated Debentures at a price equal to 104% of par. This transaction resulted in an extraordinary loss of $1.3 million (net of a tax benefit of $.7 million) or $.03 per share for the year ended December 31, 1993. Current tax payable includes earnings of certain subsidiaries which are not included in the consolidated federal income tax return. In 1993 and 1992, the tax provision includes $2.0 million and $6.5 million of direct entries to equity accounts, respectively. ADVANTA CORP. AND SUBSIDIARIES In 1991, the Company's consolidated tax return reflects alternative minimum taxes payable. The reconciliation of the statutory federal income tax to the consolidated tax expense is as follows: Deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of the enacted tax laws. The net deferred tax liability is comprised of the following: The Company did not record any valuation allowances against deferred tax assets at December 31, 1993. The tax effect of significant temporary differences representing deferred tax assets and liabilities is as follows: NOTE 12. BENEFIT PLANS - - - ---------------------------------- In 1991, the Company adopted the Advanta Management Incentive Plan With Stock Election II ("AMIPWISE II"), which plan was designed to provide incentives to participating employees to remain in the employ of the Company and devote themselves to its success. Under the plan, employees eligible to participate in the Advanta Management Incentive Plan (a bonus program) were given the opportunity to elect to take portions of their anticipated or "target" bonus payments for 1993, 1994 and 1995 in the form of restricted shares of common stock. To the extent such elections were made, restricted shares were issued to the employees, with the number of shares granted to each employee determined by dividing the amount of future bonus payments the employee had elected to receive in stock by the market price of the stock on February 7, 1991 ($4.75). The restricted shares are subject to forfeiture should the employee terminate employment with the Company prior to vesting. Restricted shares vest 10 years from the date of grant, but vesting was and will be accelerated annually with respect to one-third of an employee's restricted shares, to the extent that the employee and the Company met or meet their respective performance goals for each of 1993, 1994 and 1995. When newly eligible employees elect to participate in AMIPWISE II, the number of restricted shares issued to them with respect to their "target" bonus payments for the relevant years is determined based on the average market price of the stock for the 90 days prior to eligibility. Under the plan, 1,062,009 shares of restricted stock have been issued, of which 283,130 shares were vested as the result of 1993 performance bonus awards. ADVANTA CORP. AND SUBSIDIARIES In 1992, the Company implemented a plan similar to AMIPWISE II, for key employees below the management level, under which eligible employees were awarded shares of restricted Class B common stock with respect to "target" bonus payments for 1992, 1993, 1994 and 1995. The num-ber of shares issued to them with respect to their "target" bonus payments for the relevant years was determined based on the average market price of the stock for the year ended December 31, 1991 ($7.07). Under this plan, a total of 83,853 restricted shares of Class B common stock have been issued, of which 35,531 shares have vested as the result of 1992 and 1993 bonus awards. In 1993, the Company adopted a plan substantially similar to AMIPWISE II ("AMIPWISE III") under which elections were made to take "target" bonus payments for 1996, 1997 and 1998 in shares of Class B common stock. The number of shares was determined using the market price of the stock on the election date ($17.00). Under this plan, 386,304 shares of restricted Class B common stock have been issued. At December 31, 1993, a total of 1,229,829 shares issued under these plans and under the predecessor plan to AMIPWISE II (with respect to which employees made elections with respect to "target" bonuses for 1990, 1991 and 1992) were subject to restrictions and were included in the number of shares outstanding. These shares are considered common stock equivalents in the calculation of earnings per share. Deferred compensation of $11.0 million and $5.1 million related to these plans is reflected as a reduction of equity at December 31, 1993 and 1992, respectively. The Company has an Employee Stock Purchase Plan which allows employees and directors to purchase Advanta common stock at a 15% discount from the market price without paying brokerage fees. The Company reports this 15% discount as compensation expense. During 1993, shares were issued under the plan from unissued stock at the average market price on the day of purchase. Effective with the stock dividend on May 5, 1992, only Class B shares are issued for this plan. The Company has two Stock Option Plans which together authorize the grant to employees and directors, of options to purchase an aggregate of 7,425,000 shares of common stock. In connection with the implementation of the dual class stock plan described in Note 7, each option granted prior to the May 5, 1992 stock dividend was converted into two options, each covering an equal number of Class A common shares and Class B common shares as were covered by the original option, and each with an exercise price per share equal to one-half the original exercise price. In connection with the October 15, 1993 stock dividend, the number of options and the exercise price of each option were modified to reflect the three-for-two stock split. Although under these plans options issued after the May 5, 1992 dividend date may be for either Class A or Class B common stock, the Company presently intends only to issue options to purchase Class B common stock. Beginning in 1992, options generally vest over a four-year period, and expire 10 years after the date of grant. Shares available for future grant aggregated 2,051,508 at December 31, 1993, and 2,629,209 at December 31, 1992. Transactions under the plans for the two years ended December 31, 1993, were as follows: The Company also has outstanding, options to purchase 718,500 shares of common stock at a price range of $1.52 to $11.00 per share, which were not issued pursuant to either of the predecessor plans and generally vest over a three-year period. At December 31, 1993, 1,547,115 of the 3,039,000 out-standing options issued under the Stock Options Plans had vested and 709,500 of the 718,500 issued outside the Plans had vested. The Company has a tax-deferred employee savings plan which provides employees savings and investment opportunities, including the ability to invest in the Company's common stock. The employee savings plan provides for discretionary Company contributions equal to a portion of the first 5% of an employee's compensation contributed to the plan. For the three years ended December 31, 1993, 1992 and 1991, the Company contributions equalled 100% of the first 5% of participating employees' compensation contributed to the plan. The expense for this plan totalled ADVANTA CORP. AND SUBSIDIARIES $1,189, $882 and $753 in 1993, 1992 and 1991, respectively. At December 31, 1993, 133,018 of the 337,500 shares of common stock reserved for issuance under the employee savings plan had been purchased by the plan from the Company at the market price on each purchase date. All other shares purchased by the plan for the three years ended December 31, 1993, 1992 and 1991 were purchased on the open market. NOTE 13. COMMITMENTS AND CONTINGENCIES - - - -------------------------------------------- The Company leases office space in several states under leases accounted for as operating leases. Total rent expense for all of the Company's locations for the years ended December 31, 1993, 1992 and 1991 was $4.8 million, $3.5 million and $3.1 million, respectively. The future minimum lease payments of all non-cancellable operating leases are as follows: In January 1994, the Company hired a new senior executive and agreed to the following compensation arrangement. In addition to a base salary, the executive received 200,000 restricted shares of Class B common stock and an option to purchase 100,000 shares of Class B common stock at $27.75 per share. The restricted shares, which as of the date of the grant had a market value of $5.6 million, will vest at the rate of 25% per annum for four years, and the options will become exercisable at the same rate. Should the executive leave the Company's employ before four years have passed, these benefits will vest upon the departure, except in certain limited circumstances. The executive is also to receive a guaranteed one-time bonus of $525, other annual benefits and perquisites estimated at $250, and will also be eligible to receive annual bonuses under AMIPWISE II and AMIPWISE III (see Note 12). NOTE 14. OTHER BORROWINGS - - - --------------------------------- The Company had lines of credit and term funding arrangements of $63.5 million at December 31, 1993, which were collateralized by lease receivables, as well as equipment under operating lease. At December 31, 1992, the Company had lines of credit and term funding arrangements of $208.7 million which were collateralized by lease receivables and mortgage loans. These facilities carry variable interest rates which range from 1 1/4 % above LIBOR to 1 1/4% above the prime rate. There is a quarterly facility fee of 1/4 to 1/2 of 1% of the average unused portion on the lines of credit. The composition of other borrowings was as follows: The following table displays information related to selected types of short-term borrowings: ADVANTA CORP. AND SUBSIDIARIES The weighted average interest rates were calculated by dividing the interest expense for the period for such borrowings by the average amount outstanding during the period. (A) Represents initial deposits and subsequent excess collections up to the required amount on each of the credit card, mortgage and leasing securitizations. (A) Carried at the lower of cost or fair market value. ADVANTA CORP. AND SUBSIDIARIES NOTE 17. CASH, DIVIDEND AND LOAN RESTRICTIONS - - - ------------------------------------------------- In the normal course of business, the Company and its subsidiaries enter into agreements, or are subject to regulatory requirements, that result in cash, debt and dividend restrictions. At December 31, 1992, Advanta Leasing had $6.3 million of cash related to its securitizations which is restric-ted as to its use. This cash represents the initial deposits and subsequent excess collections up to the required amount on each of the equipment lease-backed securitizations. In 1993, this amount is included in interest-bearing deposits. The Federal Reserve Act imposes various legal limitations on the extent to which banks that are members of the Federal Reserve System can finance or otherwise supply funds to certain of their affiliates. In particular, Colonial National is subject to certain restrictions on any extensions of credit to, or other covered transactions, such as certain purchases of assets, with the Company or its affiliates. Such restrictions prevent Colonial National from lending to the Company and its affiliates unless such extensions of credit are secured by U.S. Government obligations or other specified collateral. Further, such secured extensions of credit by Colonial National are limited in amount: (a) as to the Company or any such affiliate, to 10 percent of Colonial National's capital and surplus, and (b) as to the Com-pany and all such affiliates in the aggregate, to 20 percent of Colonial National's capital and surplus. Under certain grandfathering provisions of the Competitive Equality Banking Act of 1987, the Company is not required to register as a bank holding company under the Bank Holding Company Act of 1956, as amended (the "BHCA"), so long as the Company and Colonial National continue to comply with certain restrictions on their activities. With respect to Colonial National, these restric-tions include limiting the scope of its activities to those in which it was engaged prior to March 5, 1987. Since Colonial National was not making commercial loans at that time, it must continue to refrain from making commercial loans--which would include any loans to the Company or any of its subsidiaries--in order for the Company to maintain its grandfathered exemption under the BHCA. The Company has no present plans to register as a bank holding company under the BHCA. Colonial National is subject to various legal limitations on the amount of dividends that can be paid to its parent, Advanta Corp. Colonial National is eligible to declare a dividend provided that it is not greater than the current year's net profits plus net profits of the preceding two years, as defined. During 1993, Colonial National paid $75.0 million of dividends to Advanta Corp., while $30.5 million of dividends were paid during 1992. The Office of the Comptroller of the Currency requires that Colonial National maintain a risk-based capital ratio of at least 8%. Colonial National's risk-based capital ratio of 12.06% at December 31, 1993 was in excess of the required level and exceeded the minimum required capital level of 10% for designation as a "well capitalized" depository institution. ADVANTA CORP. AND SUBSIDIARIES NOTE 18. FAIR VALUE OF FINANCIAL INSTRUMENTS - - - ------------------------------------------------ The estimated fair values of the Company's financial instruments are as follows: The above values do not necessarily reflect the premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular instrument. In addition, these values, derived from the methods and assumptions described below, do not consider the potential income taxes or other expenses that would be incurred on an actual sale of an asset or settlement of a liability. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value. CASH, FEDERAL FUNDS SOLD AND INTEREST-BEARING DEPOSITS For these short-term instruments, the carrying amount is a reasonable estimate of the fair value. INVESTMENTS For investment securities held to maturity and those available for sale, fair values are based on quoted market prices, dealer quotes or estimated using quoted market prices for similar securities. LOANS, NET OF RESERVE FOR CREDIT LOSSES For credit card receivables and mortgage loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value for credit card receivables and mortgage loans also includes the estimated value of the portion of the interest payments and fees which are not sold with the securities backed by these types of loans. The value of the retained interest payments (i.e., excess servicing) is estimated by discounting the future cash flows, adjusted for prepayments, net of anticipated charge-offs and allowing for the value of the servicing. The value of direct finance lease receivables and other loans are estimated based on the market prices of similar receivables with similar characteristics. EXCESS SERVICING-CREDIT CARD AND MORTGAGE SERVICING RIGHTS The fair values of excess mortgage servicing rights and credit card excess servicing rights are estimated by dis-counting the future cash flows at rates which management believes to be reasonable. However, because there is no active market for these financial instruments, management ADVANTA CORP. AND SUBSIDIARIES has no basis to determine whether the fair values presented above would be indicative of the value negotiated in an actual sale. The future cash flows used to estimate the fair values of these financial instruments are adjusted for prepayments, net of anticipated charge-offs under recourse provisions, and allow for the value of servicing. DEMAND AND SAVINGS DEPOSITS The fair value of demand deposits, savings accounts, and money market deposits is the amount payable on demand at the reporting date. This fair value does not include the benefit that results from the low cost of funding provided by these deposits compared to the cost of borrowing funds in the market. TIME DEPOSITS AND DEBT The fair value of fixed-maturity certificates of deposit and notes are estimated using the rates currently offered for deposits and notes of similar remaining maturities. SENIOR SUBORDINATED DEBENTURES The fair value of the senior subordinated debentures is based on dealer quotations. OTHER BORROWINGS The other borrowings are all at variable interest rates and therefore the carrying value approximates a reasonable estimate of the fair value. INTEREST RATE SWAPS AND FORWARD CONTRACTS The fair value of interest rate swaps and forward contracts (used for hedging purposes) is the estimated amount that the Company would pay to terminate the agreement at the reporting date, taking into account current interest rates and the current creditworthiness of the counterparty. CUSTOMER RELATIONSHIPS (BOTH ON- AND OFF-BALANCE SHEET) The fair value of the credit card relationships, which are not financial instruments, is estimated using a credit card valuation model which considers the value of the existing receivables together with the value of new receivables and the associated fees generated from existing cardholders over the remaining life of the portfolio. COMMITMENTS TO EXTEND CREDIT Although the Company had $12.1 billion of unused commitments to extend credit, there is no market value associated with these financial instruments, as any fees charged are consistent with the fees charged by other companies at the reporting date to enter into similar agreements. NOTE 19. CALCULATION OF EARNINGS PER COMMON SHARE - - - -------------------------------------------------------- The following table shows the calculation of earnings per common share for the years ended December 31, 1993, 1992 and 1991: ADVANTA CORP. AND SUBSIDIARIES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders of Advanta Corp.: We have audited the accompanying consolidated balance sheets of Advanta Corp. (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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Advanta Corp. 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. /S/ ARTHUR ANDERSEN & CO. ------------------------- Philadelphia, PA January 25, 1994 REPORT OF MANAGEMENT ON RESPONSIBILITY FOR FINANCIAL REPORTING To the Stockholders of Advanta Corp.: The management of Advanta Corp. and its subsidiaries is responsible for the preparation, content, integrity and objectivity of the financial statements contained in this Annual Report. These financial statements have been pre-pared in accordance with generally accepted accounting principles and as such, must, by necessity, include amounts based upon estimates and judgments made by management. The other financial information in the Annual Report was also prepared by management and is consistent with the financial statements. Management maintains a system of internal controls that provides reasonable assurance as to the integrity and reliability of the financial statements. This control system includes: (l) organizational and budgetary arrangements which provide reasonable assurance that errors or irregularities would be detected promptly, (2) careful selection of personnel and communications programs aimed at assuring that policies and standards are understood by employees, (3) a program of internal audits, and (4) continuing review and evaluation of the control program itself. The financial statements in this Annual Report have been audited by Arthur Andersen & Co., independent public accountants. Their audits were conducted in accordance with generally accepted auditing standards and considered the Company's system of internal controls to the extent they deemed necessary to determine the nature, timing and extent of their audit tests. Their report is printed herewith. ADVANTA CORP. AND SUBSIDIARIES QUARTERLY DATA (UNAUDITED) ADVANTA CORP. AND SUBSIDIARIES SUPPLEMENTAL SCHEDULES Allocation of Reserve for Credit Losses COMPOSITION OF GROSS RECEIVABLES (A) Yield computed on a taxable equivalent basis using a statutory rate of 35% in 1993. ADVANTA CORP. AND SUBSIDIARIES SUPPLEMENTAL SCHEDULES MATURITY OF TIME DEPOSITS OF $100,000 OR MORE 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 text of the Proxy Statement under the caption "Election of Directors" and the last paragraph under the caption "Security Ownership of Management" are hereby incorporated herein by reference, as is the text in Part I of this Report under the caption, "Executive Officers of the Registrant". Graeme K. Howard, Jr., age 61, who has served as a director of the Company since 1985, will not stand for re-election when his term expires in May 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The text of the Proxy Statement under the captions "Executive Compensation" and "Committees, Meetings and Compensation of the Board of Directors" are hereby incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The text of the Proxy Statement under the captions, "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" are hereby incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The text of the third paragraph under the caption "Election of Directors -- Nominees for Election for a Term Expiring in 1997" in the Proxy Statement is hereby incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. The following Financial Statements, Schedules, and Other Information of the Registrant and its subsidiaries are included in this Form 10-K: (a) (1) Financial Statements 1. Consolidated Balance Sheets at December 31, 1993 and 1992. 2. Consolidated Income Statements for each of the three years for the period ended December 31, 1993. 3. Consolidated Statements of Changes in Stockholders' Equity for each of the three years for the period ended December 31, 1993. 4. Consolidated Statements of Cash Flows for each of the three years for the period ended December 31, 1993. 5. Notes to Consolidated Financial Statements. (a) (2) Schedules 1. Schedule I -- Marketable Securities. 2. Schedule III -- Condensed Financial Information of Registrant 3. Schedule VIII -- Valuation and Qualifying Accounts. 4. Schedule IX -- Short-Term Borrowings. 5. Report of Independent Public Accountants on Supplemental Schedules. Other statements and schedules are not being presented either because they are not required or the information required by such statements and schedules is presented elsewhere in the financial statements. (a) (3) Exhibits. 3-a Restated Certificate of Incorporation of Registrant, as amended (incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988 and Exhibit 3 to the Company's Quarterly Report on Form 10- Q for the period ended March 31, 1992). 3-b By-Laws of the Registrant, as amended (incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989). 4-a* Trust Indenture dated April 22, 1981 between Registrant and CoreStates Bank, N.A. (formerly, The Philadelphia National Bank), as Trustee, including Form of Debenture. 4-b Specimen of Class A Common Stock Certificate and specimen of Class B Common Stock Certificate (incorporated by reference to Exhibit 1 of the Registrant's Amendment No. 1 to Form 8 and Exhibit 1 to Registrant's Form 8-A, respectively, both dated April 22, 1992). 4-c Trust Indenture dated as of November 15, 1993 between the Registrant and The Chase Manhattan Bank (National Association), as Trustee (incorporated by reference to Exhibit 4 of the Registrant's Registration Statement on Form S-3 (No. 33-50883), filed November 2, 1993. 9 Inapplicable. 10-a Registrant's Stock Option Plan, as amended (incorporated by reference to Exhibit 10-b to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989).** 10-b Advanta Corp. 1992 Stock Option Plan (incorporated by reference to Exhibit 10-t to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993). 10-c Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of May 1, 1991 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No. 33-40368), filed with Amendment No.1 thereto on May 21, 1991) 10-d Registrant's Advanta Management Incentive Plan (incorporated by reference to Exhibit 10-n to the Registrant's Registration Statement on Form S-2, Registration No.33-39343, filed March 8, 1991).** 10-e* Application for membership in VISA U.S.A. Inc. and Membership Agreement executed by Colonial National Bank USA on March 25, 1983. 10-f* Application for membership in MasterCard International, Inc. and Card Member License Agreement executed by Colonial National Bank USA on March 25, 1983. 10-g* Indenture of Trust dated May 11, 1984 between Linda M. Ominsky, as settlor, and Dennis Alter, as trustee. 10-g(i) Agreement dated October 20, 1992 among Dennis Alter, as Trustee of the trust established by the Indenture of Trust filed as Exhibit 10-g (the "Indenture"), Dennis Alter in his individual capacity, Linda A. Ominsky, and Michael Stolper, which Agreement modifies the Indenture (incorporated by reference to Exhibit 10-g(i) to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993). 10-h Agreement dated as of January 21, 1994 betweenn the Registrant and Alex W. "Pete" Hart (filed herewith).** 10-i Advanta Management Incentive Plan with Stock Election (incorporated by reference to Exhibit 4-c to Amendment No. 1 to the Registrant's Registration Statement on Form S-8 (No. 33-33350) filed February 21, 1990).** 10-j Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of August 1, 1990 (incorporated by reference to Exhibit 4 to the Registrant's Report on Form 8-K filed September 11, 1990). 10-k Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of November 15, 1990 (incorporated by reference to Exhibit 4 to the Registrant's Report on Form 8-K filed November 30, 1990). 10-l Registrant's Advanta Management Incentive Plan With Stock Election II (incorporated by reference to Exhibit 10-o to the Registrant's Registration Statement on Form S-2, Registration No. 33-39343, filed March 8, 1991).** 10-m Pooling and Servicing Agreement between Colonial National Bank USA and Banker's Trust Company, as Trustee, dated as of September 1, 1991 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No.33- 42682), filed with Amendment No. 1 thereto on September 23, 1991). 10-n Pooling and Servicing Agreement between Colonial National Bank USA and Banker's Trust Company, as Trustee, dated as of February 1, 1992 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No.33- 45306), filed with Amendment No.1 thereto on February 3, 1992). 10-o Amended and Restated Master Pooling and Servicing Agreement between Colonial National Bank USA and Chemical Bank, as Trustee, dated as of April 1, 1992 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No. 33-49602), filed with Amendment No. 1 thereto on August 19, 1992). 10-p Advanta Management Incentive Plan with Stock Election III (incorporated by reference to Exhibit 10-s to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993).** 10-q Life Insurance Benefit for Certain Key Executives and Directors (incorporated by reference to Exhibit 10-u to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993).** 10-r $122.5 Million 364-day Unsecured Revolving Credit Agreement dated as of March 24, 1994 among the Registrant, Mellon Bank, N.A. as Agent and the several bank parties thereto (filed herewith). 10-s $122.5 Million 3-year Unsecured Revolving Credit Agreement dated as of March 24, 1994 among the Registrant, Mellon Bank, N.A. as Agent and the several bank parties thereto (filed herewith). 11 Inapplicable. 12 Inapplicable. 13 Inapplicable. 16 Inapplicable. 18 Inapplicable. 21. Subsidiaries of the Registrant (filed herewith). 22 Inapplicable. 23 Consent of independent public accountants (filed herewith). 24 Powers of Attorney of Messrs. Bellis, Botel, Braemer, Brenner, Dunkelberg and Naples (filed herewith). 28 Inapplicable. 99 Inapplicable. _________ *Incorporated by reference to the Exhibit with corresponding number constituting part of the Registrant's Registration Statement on Form S-2 (No. 33-00071), filed on September 4, 1985. **Management contract or compensatory plan or arrangement. (b) Reports on Form 8-K 1. A Report Form 8-K was filed by the Registrant on October 25, 1993 regarding consolidated earnings of the Registrant and its subsidiaries for the fiscal quarter ended September 30, 1993. Summary earnings and balance sheet information as of that date were filed with such report. 2. A Report Form 8-K was filed by the Registrant on December 3, 1993 regarding the commencement of the Registrant's $500,000,000 medium-term note program. No financial statements were filed with such Report. 3. A Report Form 8-K was filed by the Registrant on January 20, 1994 regarding consolidated earnings for the Registrant and its subsidiaries for the fiscal quarter ended and fiscal year ended December 31, 1993. Summary earnings and balance sheet information as of that date were filed with such 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. ADVANTA Corp. Dated: March 28, 1994 By: /S/ Dennis Alter ------------------- Dennis Alter, 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 indicated on the 28th day of March, 1994. FINANCIAL SCHEDULES AND INDEPENDENT PUBLIC ACCOUNTANTS' REPORT THEREON Schedule I ADVANTA CORP. & SUBSIDIARIES Marketable Securities December 31, 1993 (Dollars in thousands) ADVANTA CORP. & SUBSIDIARIES December 31, 1993 Schedule III - Condensed Financial Information of Registrant Parent Company Only CONDENSED BALANCE SHEETS (Dollars in thousands) Schedule III (cont'd) Parent Company Only CONDENSED STATEMENT OF INCOME (Dollars in thousands) Schedule III (Cont'd) Parent Company Only Statement of Cash Flows Schedule VIII ADVANTA Corp. & Subsidiaries Valuation & Qualifying Accounts ($000's) (1) Amounts netted against securitization income. (2) Includes $11.0MM transferred from on-balance sheet unallocated reserves. (3) Relates to net charge-offs. (4) Includes $3.3MM transferred from on-balance sheet unallocated reserves. Schedule IX ADVANTA CORP. & SUBSIDIARIES Short-Term Borrowings ($000's) [ARTHUR ANDERSEN LETTERHEAD] REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To Advanta Corp.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The supplemental schedules 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 stataments. 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. Philadelphia, PA January 25, 1994 EXHIBIT INDEX 3-a Restated Certificate of Incorporation of Registrant, as amended (incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988 and Exhibit 3 to the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1992). 3-b By-Laws of the Registrant, as amended (incorporated by reference to Exhibit 3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989). 4-a* Trust Indenture dated April 22, 1981 between Registrant and CoreStates Bank, N.A. (formerly, The Philadelphia National Bank), as Trustee, including Form of Debenture. 4-b Specimen of Class A Common Stock Certificate and specimen of Class B Common Stock Certificate (incorporated by reference to Exhibit 1 of the Registrant's Amendment No. 1 to Form 8 and Exhibit 1 to Registrant's Form 8-A, respectively, both dated April 22, 1992). 4-c Trust Indenture dated as of November 15, 1993 between the Registrant and The Chase Manhattan Bank (National Association), as Trustee (incorporated by reference to Exhibit 4 of the Registrant's Registration Statement on Form S-3 (No. 33-50883), filed November 2, 1993. 9 Inapplicable. 10-a Registrant's Stock Option Plan, as amended (incorporated by reference to Exhibit 10-b to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989).** 10-b Advanta Corp. 1992 Stock Option Plan (incorporated by reference to Exhibit 10-t to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993). 10-c Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of May 1, 1991 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No. 33-40368), filed with Amendment No.1 thereto on May 21, 1991) 10-d Registrant's Advanta Management Incentive Plan (incorporated by reference to Exhibit 10-n to the Registrant's Registration Statement on Form S-2, Registration No.33-39343, filed March 8, 1991).** 10-e* Application for membership in VISA U.S.A. Inc. and Membership Agreement executed by Colonial National Bank USA on March 25, 1983. 10-f* Application for membership in MasterCard International, Inc. and Card Member License Agreement executed by Colonial National Bank USA on March 25, 1983. 10-g* Indenture of Trust dated May 11, 1984 between Linda M. Ominsky, as settlor, and Dennis Alter, as trustee. 10-g(i) Agreement dated October 20, 1992 among Dennis Alter, as Trustee of the trust established by the Indenture of Trust filed as Exhibit 10-g (the "Indenture"), Dennis Alter in his individual capacity, Linda A. Ominsky, and Michael Stolper, which Agreement modifies the Indenture (incorporated by reference to Exhibit 10-g(i) to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993). 10-h Agreement dated as of January 21, 1994 betweenn the Registrant and Alex W. "Pete" Hart (filed herewith).** 10-i Advanta Management Incentive Plan with Stock Election (incorporated by reference to Exhibit 4-c to Amendment No. 1 to the Registrant's Registration Statement on Form S-8 (No. 33-33350) filed February 21, 1990).** 10-j Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of August 1, 1990 (incorporated by reference to Exhibit 4 to the Registrant's Report on Form 8-K filed September 11, 1990). 10-k Pooling and Servicing Agreement between Colonial National Bank USA and Bankers Trust Company, as Trustee, dated as of November 15, 1990 (incorporated by reference to Exhibit 4 to the Registrant's Report on Form 8-K filed November 30, 1990). 10-l Registrant's Advanta Management Incentive Plan With Stock Election II (incorporated by reference to Exhibit 10-o to the Registrant's Registration Statement on Form S-2, Registration No. 33-39343, filed March 8, 1991).** 10-m Pooling and Servicing Agreement between Colonial National Bank USA and Banker's Trust Company, as Trustee, dated as of September 1, 1991 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No.33-42682), filed with Amendment No. 1 thereto on September 23, 1991). 10-n Pooling and Servicing Agreement between Colonial National Bank USA and Banker's Trust Company, as Trustee, dated as of February 1, 1992 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1(No.33-45306), filed with Amendment No.1 thereto on February 3, 1992). 10-o Amended and Restated Master Pooling and Servicing Agreement between Colonial National Bank USA and Chemical Bank, as Trustee, dated as of April 1, 1992 (incorporated by reference to Exhibit 4.1 to Colonial National's Registration Statement on Form S-1 (No. 33-49602), filed with Amendment No. 1 thereto on August 19, 1992). 10-p Advanta Management Incentive Plan with Stock Election III (incorporated by reference to Exhibit 10-s to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993).** 10-q Life Insurance Benefit for Certain Key Executives and Directors (incorporated by reference to Exhibit 10-u to the Registrant's Registration Statement on Form S-3, Registration No. 33-58660, filed February 23, 1993).** 10-r $122.5 Million 364-day Unsecured Revolving Credit Agreement dated as of March 24, 1994 among the Registrant, Mellon Bank, N.A. as Agent and the several bank parties thereto (filed herewith). 10-s $122.5 Million 3-year Unsecured Revolving Credit Agreement dated as of March 24, 1994 among the Registrant, Mellon Bank, N.A. as Agent and the several bank parties thereto (filed herewith). 11 Inapplicable. 12 Inapplicable. 13 Inapplicable. 16 Inapplicable. 18 Inapplicable. 21. Subsidiaries of the Registrant (filed herewith). 22 Inapplicable. 23 Consent of independent public accountants (filed herewith). 24 Powers of Attorney of Messrs. Bellis, Botel, Braemer, Brenner, Dunkelberg and Naples (filed herewith). 28 Inapplicable. 99 Inapplicable. _________ *Incorporated by reference to the Exhibit with corresponding number constituting part of the Registrant's Registration Statement on Form S-2 (No. 33-00071), filed on September 4, 1985. **Management contract or compensatory plan or arrangement.

890539_1993.txt

890539_1993

1993

890539

ITEM 1. BUSINESS Each of the Grantor Trusts, (the "Trusts"), listed below, was formed by GMAC Auto Receivables Corporation (the "Seller") by selling and assigning the receivables and the security interests in the vehicles financed thereby to The First National Bank of Chicago, as Trustee, in exchange for Class A certificates representing an undivided ownership interest that ranges between approximately 91% and 94.5% in each Trust, which were remarketed to the public, and Class B certificates representing an undivided ownership interest that ranges between approximately 5.5% and 9% in each Trust, which were not offered to the public and initially were held by the Seller. The right of the Class B certificateholders to receive distribution of the receivables is subordinated to the rights of the Class A certificateholders. GRANTOR TRUST ------------- GMAC 1990-A GMAC 1991-A GMAC 1991-B GMAC 1991-C GMAC 1992-A GMAC 1992-C GMAC 1992-D GMAC 1992-E GMAC 1992-F GMAC 1992-G GMAC 1993-A GMAC 1993-B _____________________ PART II ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Each of the Grantor Trusts, listed in the table as shown below, was formed by GMAC Auto Receivables Corporation (the "Seller") pursuant to a Pooling and Servicing Agreement between the Seller and The First National Bank of Chicago, as trustee. Each Trust acquired retail finance receivables from the Seller in the aggregate amount as shown below in exchange for certificates representing undivided ownership interests in each Trust. Each Trust's property includes a pool of retail instalment sale contracts secured by new, and in some Trust's used, automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The certificates for each of the following Trusts consist of two classes, entitled Asset Backed certificates, Class A and Asset Backed certificates, Class B. The Class A certificates represent in the aggregate an undivided ownership interest that ranges between approximately 91% and 94.5% of the Trusts and the Class B certificates represent in the aggregate an undivided ownership interest that ranges between approximately 5.5% and 9% of the Trusts. Only the Class A certificates have been remarketed to the public. The Class B certificates have not been offered to the public and initially are being held by the Seller. The rights of the Class B certificateholder to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. Original Aggregate Amount ----------------------------------- Date of Pooling Retail Asset Backed Certificates Grantor and Servicing Finance ------------------------- Trust Agreement Receivables Class A Class B - ------- ----------------- --------- -------- ------- (In millions of dollars) GMAC 1990-A December 20, 1990 $1,162.6 $1,057.9 $104.7 GMAC 1991-A March 14, 1991 891.7 811.4 80.3 GMAC 1991-B September 17, 1991 1,007.4 916.7 90.7 GMAC 1991-C December 16, 1991 1,326.4 1,207.0 119.4 GMAC 1992-A January 30, 1992 2,001.4 1,851.3 150.1 GMAC 1992-C March 26, 1992 1,100.3 1,012.3 88.0 GMAC 1992-D June 4, 1992 1,647.6 1,499.3 148.3 GMAC 1992-E August 20, 1992 1,578.0 1,436.0 142.0 GMAC 1992-F September 29, 1992 1,644.6 1,496.6 148.0 GMAC 1992-G November 19, 1992 1,379.4 1,303.5 75.9 GMAC 1993-A March 24, 1993 1,403.0 1,297.8 105.2 GMAC 1993-B September 16, 1993 1,450.6 1,341.8 108.8 II-1 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (concluded) General Motors Acceptance Corporation, the originator of the retail receivables, continues to service the receivables for each of the aforementioned Grantor Trusts and receives compensation and fees for such services. Investors receive monthly payments of the pro rata portion of principal and interest for each Trust as the receivables are liquidated. ------------------------ II-2 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. CROSS REFERENCE SHEET Caption Page - --------------------------------------------------- ------ GMAC 1990-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-4 Data for the Year Ended December 31, 1993. GMAC 1991-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-9 Data for the Year Ended December 31, 1993. GMAC 1991-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-14 Data for the Year Ended December 31, 1993. GMAC 1991-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-19 Data for the Year Ended December 31, 1993. GMAC 1992-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-24 Data for the Year Ended December 31, 1993. GMAC 1992-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-29 Data for the Year Ended December 31, 1993. GMAC 1992-D Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-34 Data for the Year Ended December 31, 1993. GMAC 1992-E Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-39 Data for the Year Ended December 31, 1993. GMAC 1992-F Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-44 Data for the Year Ended December 31, 1993. GMAC 1992-G Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-49 Data for Year Ended from December 31, 1993. GMAC 1993-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-54 Data for the period from March 24, 1993 to December 31, 1993. GMAC 1993-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-59 Data for period from September 16, 1993 to December 31, 1993. II-3 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1990-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1990-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income 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 that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1990-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for each of the three years in the period ended December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-4 GMAC 1990-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 207.1 459.8 ------- ------- TOTAL ASSETS ........................... 207.1 459.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 207.1 459.8 ------- ------- TOTAL LIABILITIES ...................... 207.1 459.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-5 GMAC 1990-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- Distributable Income $ $ $ Allocable to Principal ............... 252.7 344.1 358.7 Allocable to Interest ............... 27.7 52.9 82.6 ----- ----- ----- Distributable Income ................... 280.4 397.0 441.3 ===== ===== ===== Income Distributed ..................... 280.4 397.0 441.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-6 GMAC 1990-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1990-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 20, 1990, GMAC 1990-A Grantor Trust acquired retail finance receivables aggregating approximately $1,162.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 8.25% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-7 GMAC 1990-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 70.0 9.0 79.0 Second quarter ..................... 69.0 7.5 76.5 Third quarter ...................... 61.8 6.2 68.0 Fourth quarter ..................... 51.9 5.0 56.9 --------- -------- ----- Total ......................... 252.7 27.7 280.4 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 90.4 16.0 106.4 Second quarter ..................... 90.0 14.1 104.1 Third quarter ...................... 86.1 12.3 98.4 Fourth quarter ..................... 77.6 10.5 88.1 --------- -------- ----- Total ......................... 344.1 52.9 397.0 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 86.6 23.4 110.0 Second quarter ..................... 93.2 21.7 114.9 Third quarter ...................... 90.8 19.7 110.5 Fourth quarter ..................... 88.1 17.8 105.9 --------- -------- ----- Total ......................... 358.7 82.6 441.3 ========= ======== ===== II-8 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991. 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 that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-A Grantor Trust at December 31, 1993 and 1992 and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-9 GMAC 1991-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 162.0 370.4 ------- ------- TOTAL ASSETS ........................... 162.0 370.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 162.0 370.4 ------- ------- TOTAL LIABILITIES ...................... 162.0 370.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-10 GMAC 1991-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period March 14, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- $ $ $ Distributable Income Allocable to Principal ................ 208.3 290.7 230.6 Allocable to Interest ................ 21.2 41.2 46.7 ----- ----- ----- Distributable Income .................... 229.5 331.9 277.3 ===== ===== ===== Income Distributed ...................... 229.5 331.9 277.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-11 GMAC 1991-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 14, 1991, GMAC 1991-A Grantor Trust acquired retail finance receivables aggregating approximately $891.7 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 7.90% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-12 GMAC 1991-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 58.0 6.9 64.9 Second quarter ..................... 55.5 5.8 61.3 Third quarter ...................... 50.6 4.7 55.3 Fourth quarter ..................... 44.2 3.8 48.0 --------- -------- ----- Total ......................... 208.3 21.2 229.5 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 78.5 12.5 91.0 Second quarter ..................... 75.1 11.0 86.1 Third quarter ...................... 71.9 9.5 81.4 Fourth quarter ..................... 65.2 8.2 73.4 --------- -------- ----- Total ......................... 290.7 41.2 331.9 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 78.6 17.1 95.7 Third quarter ...................... 76.7 15.6 92.3 Fourth quarter ..................... 75.3 14.0 89.3 --------- -------- ----- Total ......................... 230.6 46.7 277.3 ========= ======== ===== II-13 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-B Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991. 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 that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-B Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-14 GMAC 1991-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 306.4 582.8 ------- ------- TOTAL ASSETS ........................... 306.4 582.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 306.4 582.8 ------- ------- TOTAL LIABILITIES ...................... 306.4 582.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-15 GMAC 1991-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period September 17, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ------ ------ ------ $ $ $ Distributable Income Allocable to Principal ............... 276.3 340.7 83.9 Allocable to Interest ............... 30.4 51.5 16.5 ------ ------ ------ Distributable Income ................... 306.7 392.2 100.4 ====== ====== ====== Income Distributed ..................... 306.7 392.2 100.4 ====== ====== ====== Reference should be made to the Notes to Financial Statements. II-16 GMAC 1991-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 17, 1991, GMAC 1991-B Grantor Trust acquired retail finance receivables aggregating approximately $1,007.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 6.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-17 GMAC 1991-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 72.7 9.4 82.1 Second quarter ..................... 74.8 8.2 83.0 Third quarter ...................... 68.3 7.0 75.3 Fourth quarter ..................... 60.5 5.8 66.3 --------- -------- ----- Total ......................... 276.3 30.4 306.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 87.1 15.1 102.2 Second quarter ..................... 89.5 13.6 103.1 Third quarter ...................... 84.9 12.1 97.0 Fourth quarter ..................... 79.2 10.7 89.9 --------- -------- ----- Total ......................... 340.7 51.5 392.2 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 83.9 16.5 100.4 ========= ======== ===== II-18 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the years then ended. 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 that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the years then ended, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-19 GMAC 1991-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 496.0 874.6 ------- ------- TOTAL ASSETS ........................... 496.0 874.6 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 496.0 874.6 ------- ------- TOTAL LIABILITIES ...................... 496.0 874.6 ======= ======= Reference should be made to the Notes to Financial Statements. II-20 GMAC 1991-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993 and 1992 (in millions of dollars) 1993 1992 -------- -------- $ $ Distributable Income Allocable to Principal ...................... 378.5 451.8 Allocable to Interest ...................... 39.7 63.3 -------- -------- Distributable Income .......................... 418.2 515.1 ======== ======== Income Distributed ............................ 418.2 515.1 ======== ======== Reference should be made to the Notes to Financial Statements. II-21 GMAC 1991-C GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 16, 1991, GMAC 1991-C Grantor Trust acquired retail finance receivables aggregating approximately $1,326.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.70% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-22 GMAC 1991-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 96.7 12.0 108.7 Second quarter ..................... 101.1 10.6 111.7 Third quarter ...................... 95.2 9.2 104.4 Fourth quarter ..................... 85.5 7.9 93.4 --------- -------- ----- Total ......................... 378.5 39.7 418.2 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 120.6 18.3 138.9 Second quarter ..................... 115.3 16.6 131.9 Third quarter ...................... 109.9 15.0 124.9 Fourth quarter ..................... 106.0 13.4 119.4 --------- -------- ----- Total ......................... 451.8 63.3 515.1 ========= ======== ===== II-23 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992. 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 audit. 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. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-24 GMAC 1992-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 370.7 1,052.5 ------- ------- TOTAL ASSETS ...................................... 370.7 1,052.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 370.7 1,052.5 ------- ------- TOTAL LIABILITIES ................................. 370.7 1,052.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-25 GMAC 1992-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 681.7 948.9 Allocable to Interest ...................... 35.4 72.0 ------- ------- Distributable Income .......................... 717.1 1,020.9 ======= ======= Income Distributed ............................ 717.1 1,020.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-26 GMAC 1992-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On January 30, 1992, GMAC 1992-A Grantor Trust acquired retail finance receivables aggregating approximately $2,001.4 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing February 18, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.05% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-27 GMAC 1992-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 206.9 12.4 219.3 Second quarter ..................... 192.5 9.8 202.3 Third quarter ...................... 157.7 7.5 165.2 Fourth quarter ..................... 124.6 5.7 130.3 --------- -------- ----- Total ......................... 681.7 35.4 717.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 171.8 16.5 188.3 Second quarter ..................... 278.3 21.9 300.2 Third quarter ...................... 263.6 18.4 282.0 Fourth quarter ..................... 235.2 15.2 250.4 --------- -------- ------- Total ......................... 948.9 72.0 1,020.9 ========= ======== ======= II-28 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992. 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 audit. 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. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-29 GMAC 1992-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 311.3 716.3 ------- ------- TOTAL ASSETS ...................................... 311.3 716.3 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) .................................. 311.3 716.3 ------- ------- TOTAL LIABILITIES ................................. 311.3 716.3 ======= ======= Reference should be made to the Notes to Financial Statements. II-30 GMAC 1992-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 405.0 384.0 Allocable to Interest ...................... 31.0 41.2 ------- ------- Distributable Income .......................... 436.0 425.2 ======= ======= Income Distributed ............................ 436.0 425.2 ======= ======= Reference should be made to the Notes to Financial Statements. II-31 GMAC 1992-C GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 26, 1992, GMAC 1992-C Grantor Trust acquired retail finance receivables aggregating approximately $1,100.3 million from the Seller in exchange for certificates representing undivided ownership interests of 92% for the Class A certificates and 8% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.95% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-32 GMAC 1992-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 109.2 10.1 119.3 Second quarter ..................... 109.3 8.5 117.8 Third quarter ...................... 99.7 6.9 106.6 Fourth quarter ..................... 86.8 5.5 92.3 --------- -------- ----- Total ......................... 405.0 31.0 436.0 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 133.1 15.7 148.8 Third quarter ...................... 129.8 13.7 143.5 Fourth quarter ..................... 121.1 11.8 132.9 --------- -------- ----- Total ......................... 384.0 41.2 425.2 ========= ======== ===== II-33 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-D Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-D Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992. 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 audit. 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. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-D Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-34 GMAC 1992-D GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 702.0 1,270.4 ------- ------- TOTAL ASSETS ...................................... 702.0 1,270.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 702.0 1,270.4 ------- ------- TOTAL LIABILITIES ................................. 702.0 1,270.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-35 GMAC 1992-D GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period June 4,1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 568.4 377.2 Allocable to Interest ...................... 55.4 48.0 ------ ------ Distributable Income .......................... 623.8 425.2 ====== ====== Income Distributed ............................ 623.8 425.2 ====== ====== Reference should be made to the Notes to Financial Statements. II-36 GMAC 1992-D GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-D Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On June 4, 1992, GMAC 1992-D Grantor Trust acquired retail finance receivables aggregating approximately $1,647.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing June 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.55% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-37 GMAC 1992-D GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 148.6 16.9 165.5 Second quarter ..................... 153.3 14.8 168.1 Third quarter ...................... 140.7 12.8 153.5 Fourth quarter ..................... 125.8 10.9 136.7 --------- -------- ----- Total ......................... 568.4 55.4 623.8 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 50.7 7.6 58.3 Third quarter ...................... 166.9 21.4 188.3 Fourth quarter ..................... 159.6 19.0 178.6 --------- -------- ----- Total ......................... 377.2 48.0 425.2 ========= ======== ===== II-38 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-E Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-E Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992. 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 audit. 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. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-E Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-39 GMAC 1992-E GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 885.4 1,398.0 ------- ------- TOTAL ASSETS ...................................... 885.4 1,398.0 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 885.4 1,398.0 ------- ------- TOTAL LIABILITIES ................................. 885.4 1,398.0 ======= ======= Reference should be made to the Notes to Financial Statements. II-40 GMAC 1992-E GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 512.6 180.0 Allocable to Interest ...................... 55.1 23.9 ------- ------- Distributable Income .......................... 567.7 203.9 ======= ======= Income Distributed ............................ 567.7 203.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-41 GMAC 1992-E GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-E Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On August 20, 1992, GMAC 1992-E Grantor Trust acquired retail finance receivables aggregating approximately $1,578.0 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing September 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-42 GMAC 1992-E GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 128.3 16.1 144.4 Second quarter ..................... 134.8 14.5 149.3 Third quarter ...................... 129.0 13.0 142.0 Fourth quarter ..................... 120.5 11.5 132.0 --------- -------- ----- Total ......................... 512.6 55.1 567.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Third quarter ...................... 46.1 6.2 52.3 Fourth quarter ..................... 133.9 17.7 151.6 --------- -------- ----- Total ......................... 180.0 23.9 203.9 ========= ======== ===== II-43 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-F Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-F Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992. 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 audit. 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. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-F Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-44 GMAC 1992-F GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 908.7 1,492.8 ------- ------- TOTAL ASSETS ...................................... 908.7 1,492.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 908.7 1,492.8 ------- ------- TOTAL LIABILITIES ................................. 908.7 1,492.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-45 GMAC 1992-F GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 584.1 151.8 Allocable to Interest ...................... 55.0 17.9 ------ ------ Distributable Income .......................... 639.1 169.7 ====== ====== Income Distributed ............................ 639.1 169.7 ====== ====== Reference should be made to the Notes to Financial Statements. II-46 GMAC 1992-F GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-F Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 29, 1992, GMAC 1992-F Grantor Trust acquired retail finance receivables aggregating approximately $1,644.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.50% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-47 GMAC 1992-F GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 146.9 16.2 163.1 Second quarter ..................... 151.2 14.6 165.8 Third quarter ...................... 147.3 12.9 160.2 Fourth quarter ..................... 138.7 11.3 150.0 --------- -------- ----- Total ......................... 584.1 55.0 639.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 151.8 17.9 169.7 ========= ======== ===== II-48 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-G Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-G Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992. 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 audit. 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. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-G Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-49 GMAC 1992-G GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 335.3 1,288.5 ------- ------- TOTAL ASSETS ...................................... 335.3 1,288.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 335.3 1,288.5 ------- ------- TOTAL LIABILITIES ................................. 335.3 1,288.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-50 GMAC 1992-G GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 953.1 91.0 Allocable to Interest ...................... 35.2 4.9 ------ ------ Distributable Income .......................... 988.3 95.9 ====== ====== Income Distributed ............................ 988.3 95.9 ====== ====== Reference should be made to the Notes to Financial Statements. II-51 GMAC 1992-G GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-G Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On November 19, 1992, GMAC 1992-G Grantor Trust acquired retail finance receivables aggregating approximately $1,379.4 million from the Seller in exchange for certificates representing undivided ownership interests of 94.5% for the Class A certificates and 5.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing December 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.30% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-52 GMAC 1992-G GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 268.1 12.9 281.0 Second quarter ..................... 258.3 10.0 268.3 Third quarter ...................... 230.4 7.3 237.7 Fourth quarter ..................... 196.3 5.0 201.3 --------- -------- ----- Total ......................... 953.1 35.2 988.3 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 91.0 4.9 95.9 ========= ======== ===== II-53 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-A Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period March 24, 1993 (inception) through 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 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. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-A Grantor Trust at December 31, 1993 and its distributable income and distributions for the period March 24, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-54 GMAC 1993-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 845.9 ------- TOTAL ASSETS ...................................... 845.9 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 845.9 ------- TOTAL LIABILITIES ................................. 845.9 ======= Reference should be made to the Notes to Financial Statements. II-55 GMAC 1993-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period March 24, 1992 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 557.0 Allocable to Interest .................... 35.6 ----- Distributable Income ......................... 592.6 ===== Income Distributed ........................... 592.6 ===== Reference should be made to the Notes to Financial Statements. II-56 GMAC 1993-A GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 24, 1993, GMAC 1993-A Grantor Trust acquired retail finance receivables aggregating approximately $1,403.0 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.15% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-57 GMAC 1993-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 196.7 13.9 210.6 Third quarter ...................... 194.4 11.8 206.2 Fourth quarter ..................... 165.9 9.9 175.8 --------- -------- ----- Total ......................... 557.0 35.6 592.6 ========= ======== ===== II-58 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-B Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period September 16, 1993 (inception) through 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 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. As described in Note 1 to the financial statements, these financial statements are 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, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-B Grantor Trust at December 31, 1993 and its distributable income and distributions for the period September 16, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-59 GMAC 1993-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 1,269.0 ------- TOTAL ASSETS ...................................... 1,269.0 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 1,269.0 ------- TOTAL LIABILITIES ................................. 1,269.0 ======= Reference should be made to the Notes to Financial Statements. II-60 GMAC 1993-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period September 16, 1993 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 181.6 Allocable to Interest .................... 13.9 ----- Distributable Income ......................... 195.5 ===== Income Distributed ........................... 195.5 ===== Reference should be made to the Notes to Financial Statements. II-61 GMAC 1993-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 16, 1993, GMAC 1993-B Grantor Trust acquired retail finance receivables aggregating approximately $1,450.6 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.00% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-62 GMAC 1993-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 181.6 13.9 195.5 ========= ======== ===== II-63 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 Form 10-K. (a) (2) FINANCIAL STATEMENT SCHEDULES. All schedules have been omitted because they are inapplicable or because the information called for is shown in the financial statements or notes thereto. (a) (3) EXHIBITS (Included in Part II of this report). -- GMAC 1990-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-A Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1991-B Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-C Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-C Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1992-D Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-E Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-F Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-G Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1993-A Grantor Trust Financial Statements for the period March 24, 1993 through December 31, 1993. -- GMAC 1993-B Grantor Trust Financial Statements for the period September 16, 1993 through December 31, 1993. (b) REPORTS ON FORM 8-K. No current reports on Form 8-K have been filed by any of the above-mentioned Grantor Trusts during the fourth quarter ended December 31, 1993 ITEMS 2, 3, 4, 5, 6, 9, 10, 11, 12 and 13 are inapplicable and have been omitted. IV-1 SIGNATURE Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Trustee has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. GMAC 1990-A GRANTOR TRUST GMAC 1991-A GRANTOR TRUST GMAC 1991-B GRANTOR TRUST GMAC 1991-C GRANTOR TRUST GMAC 1992-A GRANTOR TRUST GMAC 1992-C GRANTOR TRUST GMAC 1992-D GRANTOR TRUST GMAC 1992-E GRANTOR TRUST GMAC 1992-F GRANTOR TRUST GMAC 1992-G GRANTOR TRUST GMAC 1993-A GRANTOR TRUST GMAC 1993-B GRANTOR TRUST The First National Bank of Chicago (Trustee) s\ Steven M. Wagner ---------------------------------- (Steven M. Wagner, Vice President) Date: March 30, 1994 -------------- IV-2

790159_1993.txt

790159_1993

1993

790159

ITEM 1 -- BUSINESS GENERAL Wheelabrator Technologies Inc. provides a wide array of environmental products and services in North America and abroad through three principal business lines. The Company's energy group ("Wheelabrator Clean Energy") is a leading developer of facilities and systems for, and provider of services to, the trash-to-energy, energy and independent power markets. Through the subsidiaries comprising Wheelabrator Clean Energy, the Company develops, arranges financing for, operates and owns facilities that dispose of trash and other waste materials in an environmentally acceptable manner by recycling it into energy in the form of electricity and steam. The Company's water group ("Wheelabrator Clean Water") is comprised of several subsidiaries principally involved in the design, manufacture and operation of facilities and systems used to purify water, to treat municipal and industrial wastewater, to treat and manage biosolids resulting from the treatment of wastewater by converting them into useful fertilizers, and to recycle organic wastes into compost material useable for horticultural and agricultural purposes. Wheelabrator Clean Water also designs and manufactures various products and systems used in water and wastewater treatment facilities and industrial facilities, precision profile wire screens for use in groundwater wells and other industrial applications, and certain other industrial equipment. The Company's air group ("Wheelabrator Clean Air") designs, fabricates and installs technologically-advanced air pollution emission control and measurement systems and equipment, including systems which remove pollutants from the emissions of the Company's trash-to-energy facilities as well as power plants and other industrial facilities. Through its subsidiaries, Wheelabrator Clean Air also provides technologies and systems designed to treat air streams which contain nitrogen oxide ("NOx") and volatile organic compounds ("VOCs"), the major contributors to the creation of smog. The majority of the businesses of the Company have been managed together as a group since the early 1980s. The Company's predecessor companies and subsidiaries have been active in project development for approximately 20 years, and in related activities since the turn of the century. Unless the context indicates to the contrary, as used in this report, the terms "Company" and "WTI" refer to Wheelabrator Technologies Inc. and its subsidiaries. Unless otherwise indicated, all statistical and financial information under Item 1 and Item 2 ITEM 2 -- PROPERTIES The Company's principal executive offices are located at Liberty Lane, Hampton, New Hampshire 03842. These offices also serve as the headquarters of the Company's Wheelabrator Clean Energy group. The Company believes that its property and equipment are generally well maintained, in good operating condition and adequate for its present needs. The inability to renew any short- term real property lease by the Company or any of its subsidiaries would not have a material adverse effect on its results of operations. WTI regularly upgrades and modernizes facilities and equipment and expands its facilities as necessary. The following tables set forth the Company's principal facility locations in operation or under construction and their use (including those operated by the Company for others under long-term contracts or similar arrangements) as of December 31, 1993. DESCRIPTION OF OWNED, LEASED AND/OR LONG-TERM OPERATED PROJECTS Set forth below is a description of projects in operation or under construction which are owned, leased or operated under long-term operating agreements by WTI subsidiaries, partnerships or joint ventures controlled by WTI subsidiaries. Unless indicated to the contrary below, each project is owned by subsidiaries or affiliates of the Company. While WTI exercises, or will exercise, operating control over each such project, WTI has no ownership interest in certain of the projects. Projects in Operation - --------------------- (1) Westchester Resco is a limited partnership, 75% held by WTI, and 25% held indirectly by John Hancock Mutual Life Insurance Co. as a limited partner. Projects Under Construction KEY: mW--Megawatts DTPD--Dry Tons Per Day TPD--Tons Per Day TPY--Tons Per Year MCF--Thousands of Cubic Feet Non-Project Facilities Set forth below is a list of all of the primary non-project facilities owned by the Company as of December 31, 1993, and each of the principal plants and offices leased by the Company as of that date. Such list does not purport to be a complete list of all of the Company's leased properties. ITEM 3 ITEM 3 -- LEGAL PROCEEDINGS Saugus, Massachusetts Trash-to-Energy Facility On December 4, 1990, a lawsuit was filed against the Company in Essex County Superior Court in the Commonwealth of Massachusetts ("Essex County Court") over the estimated cost of retrofitting certain pollution control equipment at the Company's Saugus, Massachusetts trash-to-energy facility (the "Saugus Facility"), together with the cost of certain modifications to the ash disposal site located adjacent to the Saugus Facility, and the costs associated with operation and maintenance expenses of the Saugus Facility. The lawsuit, brought by thirteen communities whose municipal waste is disposed at the Saugus Facility, sought declaratory judgment, monetary damages and other relief based upon allegations that some of the costs incurred were not properly recoverable under the terms of their respective service agreements with the Company. The lawsuit also named as defendants several of the Company's other subsidiaries. On March 2, 1992, the Company filed a lawsuit in Essex County Court against the plaintiffs in the foregoing action alleging non-payment of costs billed to them pursuant to their respective service agreements for amounts expended by the Company in retrofitting the Saugus Facility. Upon the Company's motion, the parties were ordered to arbitrate the dispute as provided in the various service agreements. The Company and the communities commenced the arbitration in early 1993. The "Arbitrator's Final Award," issued on November 9, 1993, provided that: (i) the Company was not entitled to recover the cost of capital improvements to the ash landfill or to receive incremental operating costs related to such capital improvements; (ii) the Company was entitled to charge the communities their proportionate shares of approximately $54 million of capital improvements to the Saugus Facility (the Company had sought approximately $59 million); and (iii) the Company was entitled to charge the communities their proportionate shares of incremental operating costs resulting from such capital improvements. Following the issuance of the Arbitrator's Final Award, the parties voluntarily dismissed with prejudice the communities' appeal of the order to arbitrate issued in the Company's 1992 lawsuit. These actions conclusively ended all disputes arising out of the retrofit of the Saugus Facility and the adjacent ash disposal site. Regulatory The business in which the Company is engaged is intrinsically connected with the protection of the environment and involves the potential for the discharge of materials into the environment. In the ordinary course of conducting its business activities, the Company becomes involved in judicial and administrative proceedings involving governmental authorities at the federal, state and local level including, in certain instances, proceedings instituted by citizens or local governmental authorities seeking to overturn governmental action in which governmental officials or agencies are named as defendants together with the Company or one or more of its subsidiaries, or both. In the majority of the situations where proceedings are commenced by governmental authorities, the matters involved relate to alleged technical violations of licenses or permits pursuant to which the Company operates or is seeking to operate or laws or regulations to which its operations are subject or are the result of different interpretations of the applicable requirements. At December 31, 1993, the Company was involved in one such proceeding relating to activities at its Westchester, New York trash-to- energy facility. The EPA has alleged that the facility exceeded its emission limits of sulphur dioxide ("SO\\2\\"). The EPA and the Company are negotiating a consent order which is expected to include the installation of a sorbent injection system (to reduce the SO\\2\\ emissions) and sanctions in an amount which may exceed $100,000. Other In January 1993, the Internal Revenue Service ("IRS") completed an examination of the Company's consolidated federal income tax returns for the period 1986-1988. The IRS proposed a significant adjustment related to the 1988 sale of a former subsidiary, which the Company disputed. In March 1994, WTI and the IRS filed a Stipulation of Settlement with the U.S. Tax Court which resolved the treatment of the disputed matter. Although the Company is primarily liable for the amount of the tax due as a result of the settlement (plus interest), under a Tax Sharing Agreement between the Company and a predecessor of the Company now known as Koll Real Estate Group, Inc. ("KREG"), the Company is indemnified by KREG and a former subsidiary of KREG, Abex, Inc. ("Abex"), for the full amount of any liability assessed with regard to this issue by the IRS (subject to the remaining availability of any portion of the Company's $50 million obligation referred to in Note 3 of Notes to Consolidated Financial Statements included elsewhere in this report). Management believes that KREG and Abex will be able to satisfy their indemnification obligations in respect of the agreed tax liability. In addition, there are other routine lawsuits and claims pending against WTI and its subsidiaries incidental to their businesses. In the opinion of the Company's management, the ultimate liability, if any, with respect to the above proceedings and such other lawsuits and claims will not have a material adverse effect on the business and properties of the Company, taken as a whole, or its 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 REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Common Stock is traded on The New York Stock Exchange under the symbol "WTI." The table below sets forth by quarter, for the last two years, the high and low sales prices of the Common Stock on The New York Stock Exchange Composite Tape as reported by The Wall Street Journal (Midwest Edition) and also shows the cash dividends declared per share during such periods: - ------------------ (1) All per share prices and dividends have been adjusted to reflect the two- for-one stock split in the form of a 100% stock dividend distributed in January 1993. ---------------------------------------- The approximate number of holders of record of Common Stock as of March 1, 1994 was 22,600. In January 1993, the Company effected a two-for-one stock split paid in the form of a 100% stock dividend. During 1993, the Board of Directors declared, and the Company paid, total dividends in the amount of $0.08 per share. In May 1993, the Board of Directors announced its intention to thereafter consider the payment of an annual dividend in lieu of quarterly dividends. Future cash dividends will be considered by the Board of Directors based upon the Company's earnings and financial position and such other business considerations as the Board of Directors considers relevant. On March 15, 1994, WTI announced that the Board of Directors had authorized the repurchase of up to 3,800,000 shares of Common Stock from time to time over the following 24-month period in the open market or in privately negotiated transactions. Under a similar program initiated in 1992, WTI repurchased a total of approximately 4,160,000 shares of Common Stock over a period of two years. ITEM 6 ITEM 6 -- SELECTED FINANCIAL DATA The following selected consolidated financial information for each of the five years in the period ended December 31, 1993 is derived from the Company's Consolidated Financial Statements, which have been audited by Arthur Andersen & Co., independent public accountants, whose report thereon is incorporated by reference in this report. The information below should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Company's Consolidated Financial Statements, and the related Notes, and the other financial information which are filed as exhibits to this report and incorporated herein by reference. WHEELABRATOR TECHNOLOGIES INC. AND SUBSIDIARIES CONSOLIDATED SELECTED FINANCIAL DATA (000's omitted except per share amounts) - ---------------------------- . The 1990 loss of $70.2 million, or $0.44 per share, reflects a restructuring charge, an unrealized loss on investments in common stock and the cumulative effect of a change in accounting method. . 1991 net income includes a $47.1 million pretax gain on the sale of certain foreign equity investments. . 1992 income before extraordinary item and accounting changes includes a $47.0 million nontaxable gain relating to the initial public offering of shares by Waste Management International plc. See Note 2 of Notes to Consolidated Financial Statements. . 1992 net income includes one-time charges of $42.2 million relating to the adoption of two new financial accounting standards. See Note 1 of Notes to Consolidated Financial Statements. . Beginning in 1993, the Company no longer consolidates the financial results of certain businesses contributed to form, in part, Rust International Inc. ("Rust"). Revenues from the contributed businesses amounted to approximately $380.4 million, $423.8 million, $397.8 million and $554.7 million in 1989, 1990, 1991 and 1992, respectively. Beginning in 1993, the Company's share of Rust's net income is included in equity in earnings of affiliates. See Note 2 of Notes to Consolidated Financial Statements. . 1993 income includes a $7.7 million nontaxable gain related to issuance of stock by Rust and a $6.5 million increase in the tax provision due to the revaluing of deferred taxes as a result of the August enactment of the Omnibus Budget Reconciliation Act of 1993. See Notes 2 and 3 of Notes to Consolidated Financial Statements. . Share and per share data for all periods reflect the two-for-one stock split effected on January 7, 1993. See Note 1 of Notes to Consolidated Financial Statements. . The increases in weighted average shares outstanding in 1991 and 1992 are primarily due to shares issued in connection with acquisitions. See Note 2 of Notes to Consolidated Financial Statements. . The increases in stockholders' equity at December 31, 1991 and 1992 primarily reflect income for each year and the effect of acquisitions. The increase in stockholders' equity at December 31, 1993 primarily reflects income for the year, the effects of acquisitions and the January 1, 1993 formation of Rust. See Note 2 of Notes to Consolidated Financial Statements. ---------------------------------------------- ITEM 7 ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations set forth on pages 25 through 31 of the Company's 1993 Annual Report to Stockholders (the "Annual Report") which discussion is filed as an exhibit to this report and incorporated herein by reference. ITEM 8 ITEM 8 -- FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (a) The Consolidated Balance Sheets as of December 31, 1992 and 1993, Consolidated Statements of Income, Cash Flows and Changes in Stockholders' Equity for each of the years in the three-year period ended December 31, 1993 and Notes to Consolidated Financial Statements set forth on pages 32 through 53 of the Annual Report are filed as an exhibit to this report and incorporated herein by reference. (b) Selected Quarterly Financial Data (Unaudited) is set forth in Note 10 of the Notes to Consolidated Financial Statements referred to in Item 8(a) above and incorporated herein by reference. (c) Rust International Inc.'s Consolidated Balance Sheets as of December 31, 1992 and 1993, Consolidated Statements of Income, Cash Flows and Changes in Stockholders' Equity for each of the years in the three-year period ended December 31, 1993 and Notes to Consolidated Financial Statements are incorporated herein by reference to pages through of Rust's 1993 annual report on Form 10-K. Rust's file number under the Securities Exchange Act of 1934 is 1-11896. 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 Directors. The information appearing under the caption "Election of Directors" on pages 2 through 4 of the Company's Proxy Statement for the Annual Meeting of Stockholders to be held May 5, 1994 (the "Proxy Statement"), is incorporated herein by reference. Executive Officers. Information with respect to executive officers of WTI is set forth under the caption "Executive Officers of the Registrant" in Item 1 of this report. ITEM 11 ITEM 11 -- EXECUTIVE COMPENSATION Information appearing under the caption "Compensation" on pages 7 through 11 of the Proxy Statement is incorporated herein by reference. ITEM 12 ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information appearing under the caption "Principal Stockholder" on page 2 of the Proxy Statement and under the caption "Securities Ownership of Management" on pages 4 through 6 of the Proxy Statement is incorporated herein by reference. ITEM 13 ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information appearing under the caption "Certain Transactions and Other Matters" on pages 18 through 25 of the Proxy Statement, under the second full paragraph on page 3 of the Proxy Statement and under the first full paragraph on page 4 of the Proxy Statement 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 and supplementary data of the Company are filed as an exhibit hereto and incorporated herein by reference: (i) Consolidated Statements of Income for the years ended December 31, 1991, 1992 and 1993. (ii) Consolidated Balance Sheets as of December 31, 1992 and 1993. (iii) Consolidated Statements of Cash Flows for the years ended December 31, 1991, 1992 and 1993. (iv) Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1991, 1992 and 1993. (v) Notes to Consolidated Financial Statements. (vi) Report of Independent Public Accountants -- Arthur Andersen & Co. Rust International Inc.'s Consolidated Balance Sheets as of December 31, 1992 and 1993, Consolidated Statements of Income, Cash Flows and Changes in Stockholders' Equity for each of the years in the three-year period ended December 31, 1993 and Notes to Consolidated Financial Statements are incorporated herein by reference to pages through of Rust's 1993 annual report on Form 10-K. Rust's file number under the Securities Exchange Act of 1934 is 1-11896. (2) SCHEDULES: The following financial statement schedules of the Company are included in this report: (i) Report of Independent Public Accountants on Schedules--Arthur Andersen & Co. (ii) Schedule II--Amounts Receivable From Officers, Employees and Related Parties. (iii) Schedule V--Property and Equipment. (iv) Schedule VI--Accumulated Depreciation and Amortization of Property and Equipment. Financial statement schedules of Rust International Inc. are incorporated by reference to pages through of Rust's 1993 annual report on Form 10-K. Rust's file number under the Securities Exchange Act of 1934 is 1-11896. All other schedules have been omitted since they are not applicable, not required, or the information is included in the above-referenced financial statements or notes thereto. (3) EXHIBITS: The exhibits to this report are listed in the Exhibit Index contained elsewhere herein. Included in the exhibits listed therein are the following exhibits which constitute management contracts or compensatory plans or arrangements:* (i) Restricted Unit Plan for Non-Employee Directors of the registrant as amended through June 10, 1991 (incorporated by reference to Exhibit 19.03 to the registrant's quarterly report on Form 10-Q for the quarter ended June 30, 1991). (ii) Amendment, dated as of December 6, 1991, to the Restricted Unit Plan for Non-Employee Directors of the registrant (incorporated by reference to Exhibit 19.05 to registrant's 1991 annual report on Form 10-K). (iii) Deferred Director's Fee Plan adopted June 10, 1991 (incorporated by reference to Exhibit 19.02 to the registrant's quarterly report on Form 10-Q for the quarter ended June 30, 1991). - ------------------ * In the case of incorporation by reference to documents filed under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. Exhibits not incorporated by reference are filed with this report. (iv) 1988 Stock Plan for Executive Employees of Old WTI and its subsidiaries ("1988 Stock Plan") (incorporated by reference to Exhibit 28.1 to Amendment No. 1 to the registrant's registration statement on Form S-8, Reg. No. 33-31523). (v) Amendments, dated as of September 7, 1990, to the 1988 Stock Plan (incorporated by reference to Exhibit 19.02 to the registrant's 1990 annual report on Form 10-K). (vi) Amendment, dated as of November 1, 1990, to the 1988 Stock Plan (incorporated by reference to Exhibit 19.04 to the registrant's 1990 annual report on Form 10-K). (vii) Amendment, dated as of December 6, 1991, to the 1988 Stock Plan (incorporated by reference to Exhibit 19.02 to the registrant's 1991 annual report on Form 10-K). (viii) 1986 Stock Plan for Executive Employees of the registrant and its subsidiaries ("1986 Stock Plan") (incorporated by reference to Exhibit 28.2 to Amendment No. 1 to the registrant's registration statement on Form S-8, Reg. No. 33-13720). (ix) Amendment, dated as of November 1, 1990, to the 1986 Stock Plan (incorporated by reference to Exhibit 19.03 to the registrant's 1990 annual report on Form 10-K). (x) Amendment, dated as of December 6, 1991, to the 1986 Stock Plan (incorporated by reference to Exhibit 19.01 to the registrant's 1991 annual report on Form 10-K). (xi) 1991 Performance Unit Plan of the registrant (incorporated by reference to Exhibit 10.48 of the registrant's 1990 annual report on Form 10-K). (xii) Wheelabrator Technologies Inc. Corporate Incentive Bonus Plan (as amended and restated as of March 8, 1993) (incorporated by reference to Exhibit 10.36 to the registrant's 1992 annual report on Form 10- K). (xiii) Wheelabrator Technologies Inc. Corporate Incentive Bonus Plan (as amended and restated as of March 14, 1994). (xiv) Wheelabrator Technologies Inc. Long Term Incentive Plan (as amended and restated as of March 14, 1994). (xv) Retirement Plan for Non-Employee Directors of the registrant (incorporated by reference to Exhibit 10.32 to the registrant's 1988 annual report on Form 10-K). (xvi) Amendment, dated as of September 7, 1990, to the Retirement Plan for Non-Employee Directors of the registrant (incorporated by reference to Exhibit 19.01 to the registrant's 1990 annual report on Form 10- K). (xvii) Amendment, dated June 10, 1991, to the Retirement Plan for Non- Employee Directors of the registrant (incorporated by reference to Exhibit 19.01 to the registrant's quarterly report on Form 10-Q for the quarter ended June 30, 1991). (xviii) 1991 Stock Option Plan for Non-Employee Directors ("1991 Directors Plan") of the registrant adopted June 10, 1991 (incorporated by reference to Exhibit 19.04 to the registrant's quarterly report on Form 10-Q for the quarter ended June 30, 1991). (xix) Amendment to 1991 Directors Plan dated as of December 22, 1993. (xx) 1992 Stock Option Plan of the registrant (incorporated by reference to Exhibit 10.45 to the registrant's 1991 annual report on Form 10- K). (B) REPORTS ON FORM 8-K The Company did not file any reports on Form 8-K 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, in Oak Brook, Illinois on the 29th day of March 1994. WHEELABRATOR TECHNOLOGIES INC. By /s/ PHILLIP B. ROONEY --------------------------------------- PHILLIP B. ROONEY, 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 date indicated. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To the Stockholders and the Board of Directors of Wheelabrator Technologies Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Wheelabrator Technologies Inc.'s annual report to stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated March 17, 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 and postretirement benefits other than pensions as discussed in Note 1 to the financial statements. 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) in this Form 10-K 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. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. New York, New York, March 17, 1994 SCHEDULE II WHEELABRATOR TECHNOLOGIES INC. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES (1) Indebtedness indicated was related to purchases of common stock by participants in the Company's Equity Purchase Program. See Note 6 of Notes to Consolidated Financial Statements for a further description of the Equity Puchase Program. Such indebtedness was represented by nonrecourse promissory notes issued to the Company which were secured by shares of Common Stock of the Company purchased under such program as well as shares of the common stock of WMX issued in connection with the 1990 Merger. The Company will not issue additional shares of Common Stock under the Equity Purchase Program. SCHEDULE II (CONTINUED) (1) Indebtedness indicated was related to purchases of common stock by participants in the Company's Equity Purchase Program. See Note 6 of Notes to Consolidated Financial Statements for a further description of the Equity Puchase Program. Such indebtedness was represented by nonrecourse promissory notes issued to the Company which were secured by shares of Common Stock of the Company purchased under such program as well as shares of the common stock of WMX issued in connection with the 1990 Merger. The Company will not issue additional shares of Common Stock under the Equity Purchase Program. SCHEDULE V WHEELABRATOR TECHNOLOGIES INC. PROPERTY, PLANT AND EQUIPMENT (000'S OMITTED) * Represents the effect of translating foreign balance sheets to U.S. Dollars, finalization of purchase price adjustments, and transfers from construction in progress. In 1992, primarily reflects the impact of the restatement of assets related to business combinations consummated before the adoption of FAS 109 on a gross basis rather than on a net-of-tax basis previously used. In 1993, primarily reflects the impact of the contribution of certain businesses to form, in part, Rust International Inc. See Note 2 of Notes to Consolidated Financial Statements for a further description of the Company's investment in Rust International Inc. SCHEDULE VI WHEELABRATOR TECHNOLOGIES INC. ACCUMULATED DEPRECIATION (000'S OMITTED) - ------------------- * Represents the effect of translating foreign balance sheets to U.S. Dollars and finalization of purchase price adjustments. In 1993, primarily reflects the impact of the contribution of certain businesses to form, in part, Rust International Inc. See Note 2 of Notes to Consolidated Financial Statements for a further description of the Company's investment in Rust International Inc. WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. **This information appears only on the manually signed original of this report. E-1 WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. ** This information appears only on the manually signed original of this report. E-2 WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. **This information appears only on the manually signed original of this report. E-3 WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. **This information appears only on the manually signed original of this report. E-4 WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. **This information appears only on the manually signed original of this report. E-5 WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. **This information appears only on the manually signed original of this report. E-6 WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. **This information appears only on the manually signed original of this report. E-7 WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. **This information appears only on the manually signed original of this report. E-8 WHEELABRATOR TECHNOLOGIES INC. EXHIBIT INDEX - ------------------ * In the case of incorporation by reference to documents filed by the registrant under the Securities Exchange Act of 1934, the registrant's file number under that Act is 0-14246. **This information appears only on the manually signed original of this report. E-9

101829_1993.txt

101829_1993

1993

101829

Item 1. Business History of Business United Technologies Corporation was incorporated in Delaware in 1934. Since 1973, growth has been enhanced by the acquisition of several companies and by internal growth of existing businesses of the Corporation*. In the first quarter of 1988, the Corporation sold its Essex Group. In December 1988, the Corporation purchased a 46 percent equity interest in Sheller-Globe Corporation, and purchased the remaining equity of the company in the fourth quarter of 1989. During 1990, the Corporation sold its interests in several of the Automotive segment's non-core businesses. In January 1994, the Corporation announced that it was planning to sell 40% of the economic interest in its Automotive segment to the public through an initial public offering. See the description of Automotive at pages 11 through 12 of this Report. In February of 1994, the Corporation announced an agreement to sell Norden Systems, Inc., to Westinghouse Electric Corporation, subject to approval of the U.S. Government. Management's Discussion and Analysis of the Corporation's Results of Operations for 1993 compared to 1992, and for 1992 compared to 1991, and its Financial Position at December 31, 1993 and 1992, and Selected Financial Data for each year in the five year period ended December 31, 1993 are set forth on pages 27 through 35 of the Corporation's 1993 Annual Report to Shareowners. Whenever reference is made in this report to specific pages in the 1993 Annual Report to Shareowners, such pages are incorporated herein by reference. Operating Units and Industry Segments The Corporation conducts its business principally through its Pratt & Whitney, Sikorsky, Hamilton Standard, Norden, Carrier, Otis, and UT Automotive units and also the United Technologies Research Center. The operating units of the Corporation conduct their business within five principal industry segments or lines of business--Pratt & Whitney, Flight Systems, Carrier, Otis, and Automotive. Management believes that during 1993 the principal products produced by the major business units within these five segments held in many instances, rankings of either number one or two. The principal products of the operating units reported within each of these industry segments are as follows: Industry Segment Principal Products Pratt & Whitney --Pratt & Whitney engines and parts Flight Systems --Sikorsky helicopters and parts --Hamilton Standard engine controls, environmental systems, propellers and other flight systems --Norden airborne and ground radar and command/control systems --Chemical Systems and USBI rocket boosters and preparation and refurbishment of rocket boosters Carrier --Carrier heating, ventilating, air conditioning, and refrigeration equipment and service Otis --Otis elevators, escalators and service Automotive --Automotive components and systems The Consolidated Summary of Business Segment Financial Data for the years 1991 through 1993 appears on pages 51 through 54 of the Corporation's 1993 Annual Report to Shareowners. _______________ *"Corporation," unless the context otherwise requires, means United Technologies Corporation and its consolidated subsidiaries. PAGE Description of Business by Industry Segment The following description of the Corporation's business by industry segment should be read in conjunction with Management's Discussion and Analysis of Results of Operations and Financial Position appearing in the Corporation's 1993 Annual Report to Shareowners, especially the information contained therein under the headings "Business Environment" and "Restructuring and Other Actions." Pratt & Whitney Pratt & Whitney's business consists almost entirely of revenues* from the sale of aircraft gas turbine engines and spare parts and from the overhaul and repair of engines. Pratt & Whitney products are sold principally to aircraft manufacturers, airlines and other aircraft operators, aircraft leasing companies, and the U.S. and foreign governments. Direct and indirect revenues from sales to the U.S. Government amounted to $1,556 million, or approximately 26 percent, of Pratt & Whitney revenues in 1993. Sales to the Boeing Company and McDonnell Douglas Corporation, consisting primarily of commercial aircraft jet engines, amounted to $1,218 million, or approximately 21 percent, and $452 million, or approximately 8 percent, respectively, of total Pratt & Whitney revenues in 1993. Commercial Aircraft Engines and Parts Pratt & Whitney is one of the world's leading producers of large turbofan (jet) engines and parts for commercial aircraft. During the years 1991 through 1993, the Corporation's total revenues from its commercial engine business were as follows: Year Total Revenues Engines & Parts 1991 $3,778 million 1992 $3,700 million 1993 $3,266 million As of December 31, 1993, Pratt & Whitney jet engines powered approximately 6,600 commercial aircraft for approximately 725 domestic and foreign airlines and other owners and operators. Jet engines currently in production at Pratt & Whitney for installation in commercial aircraft are as follows: Year of Current Commercial First Maximum Current Production Number of Engine Commercial Takeoff Aircraft in which Engines per Designation Service Thrust Installed Aircraft JT8D-200 1980 21,000 lbs. Douglas MD-80** 2 PW2000 1984 41,700 lbs. Boeing 757-200/PF*** 2 PW4000 1987 62,000 lbs. Airbus A310-300*** 2 Airbus A300-600*** 2 Boeing 747-400*** 4 Boeing 767-200/- 2 300*** Douglas MD-11*** 3 IAE V2500 1989 30,000 lbs. Airbus A320/A321**** 2 Douglas MD-90***** 2 _______________ For the definition of "revenues" as used in this report, see Notes to * Consolidated Summary of Business Segment Financial Data at page 54 of the Corporation's 1993 Annual Report to Shareowners. ** Powered exclusively by Pratt & Whitney engines. Powered by competitive as well as Pratt & Whitney engines.*** **** Powered by competitive as well as IAE International Aero Engines AG engines. *****Powered exclusively by IAE International Aero Engines AG engines. PAGE During 1992, International Lease Finance and Shorouk Air announced firm orders for 14 Boeing 757 aircraft, each powered by two PW2000 engines. At December 31, 1993, a total of 14 customers had announced firm orders for 376 Boeing 757 aircraft powered by 752 PW2000 engines, of which 568 engines had been delivered. The PW4000 is operating in airline service today at up to 62,000 pounds of thrust and was certified at 68,000 pounds of thrust for the Airbus A330 in August, 1993, and is scheduled to be certified at 84,000 pounds of thrust for the Boeing 777 in April 1994. The PW4000 engine powers current production McDonnell Douglas MD-11, Boeing 747 and 767, and Airbus A300 and A310 aircraft. During 1990, United Airlines selected the PW4000 as the launch engine on the new Boeing 777 aircraft as part of a $4 billion engine order, the largest in Pratt & Whitney's history. During 1991, All Nippon Airways became the second customer to select the PW4000-powered Boeing 777. In 1993, firm orders for 45 installed PW4000 engines were announced by six customers. At December 31, 1993, 67 customers had ordered a total of 674 aircraft powered by 1,748 PW4000 engines, of which 984 engines had been delivered. Motoren-und Turbinen-Union GmbH (MTU), a subsidiary of Daimler-Benz of Germany, and Pratt & Whitney have agreed that each company will participate with the other in the development, manufacture and marketing of commercial gas turbine engines. Under terms of a general collaboration agreement signed in March 1991, Pratt & Whitney will be the lead company on the PW4084, the growth version of the PW4000 engine intended for the Boeing 777 aircraft. MTU will have a 12.5 percent share of this program. Pratt & Whitney/MTU presently collaborate in the development, manufacture and marketing of the JT8D-200, the PW300 (see the discussion of General Aviation Engines and Parts beginning at page 4 of this Report), the PW2000 and the V2500 commercial gas turbine engines. P&W, GE, SNECMA and MTU are negotiating an agreement under which a European company could be formed to produce small turbofan engines in the range of the 12,000 to 20,000 pound thrust class. IAE International Aero Engines AG (IAE), a corporation whose shareholders consist of Pratt & Whitney, Rolls-Royce plc of England, Japanese Aero Engines Corporation, MTU, and FiatAvio of Italy, is providing the V2500 engine, to cover the range of 18,000 to 30,000 pounds of thrust. Pratt & Whitney has a 30 percent equity share in IAE. At December 31, 1993, 18 customers had placed firm orders for 311 A320 and A321 (a larger capacity derivative of the A320) aircraft to be powered by the V2500 engine. In addition, at December 31, 1993, seven customers had placed firm orders for 101 MD-90s, a two engine aircraft which will be powered exclusively by the V2500. The competitive environment encountered in introducing new airframe/engine combinations into the fleets of individual airlines, and the manner in which Pratt & Whitney and other engine suppliers respond to that environment, are discussed at pages 5 through 7 of this Report. Military Engines and Parts Pratt & Whitney is one of two major suppliers to the U.S. Government of large jet engines and jet engine parts for military aircraft. During the years 1991 through 1993, the Corporation's total revenues from its government engine business were as follows: Year Total Revenues Engines & Parts 1991 $2,062 million 1992 $2,006 million 1993 $1,595 million At December 31, 1993, approximately 16,500 Pratt & Whitney jet engines were in active military inventories of the U.S. and foreign governments. Jet engines currently in production at Pratt & Whitney for installation on military aircraft are as follows: PAGE Current Current Number of Military Year of Maximum Production Engines per Engine First Takeoff Aircraft in Aircraft Designation Operational Thrust which Installed Use 1974 29,000 lbs. Air Force 2 class Air Force 1 1992 41,700 lbs. Air Force C-17 4 Pratt & Whitney competes with General Electric Company (GE) for engine orders for and fighter aircraft. The is produced by McDonnell Douglas Corporation, and the is currently produced by Lockheed Corporation. Since 1982, Pratt & Whitney's engine has been used to fill approximately one-half of the U.S. Air Force's engine orders for these aircraft. The number of engines for these aircraft ordered annually by the Air Force has decreased from 231 engines ordered in 1989 to 12 engines ordered in 1993, all 12 of which have been awarded to GE. The Corporation has been notified by the U.S. Air Force that no further acquisitions are planned at present. During 1993, Pratt & Whitney delivered two engines under a contract with the South Korean Air Force which calls for production and licensed production of a total of 132 engines. Delivery of 18 engines under an program with Taiwan is scheduled for 1994, and current orders call for Pratt & Whitney to sell 166 engines under that program. In March 1993, the Royal Saudi Air Force issued a letter of intent announcing the selection of Pratt & Whitney's-PW-229 to power its fleet, which contemplated the delivery of approximately 154 engines, commencing in 1994. However, in February 1994 Saudi Arabia reached an agreement in principle with the U.S. Government and five U.S. defense contractors to restructure certain payments for military hardware, which included stretching out deliveries of the 72s involved. In January 1994, Israel selected an derivative with the engine for an anticipated procurement of 20 aircraft, with an option to purchase five more, plus an undetermined number of spares. Currently, all orders for the engine, a version of the PW2000 which powers the C-17 airlift aircraft produced by McDonnell Douglas for the U.S. Air Force, are placed directly with Pratt & Whitney by the Air Force. Twenty engines were delivered to the Air Force in 1993, and 35 engines are scheduled for delivery in 1994. Original Air Force plans called for delivery of 120 C-17s; however, management believes that number may be reduced as a result of either or both of U.S. defense budget cuts and possible Air Force procurement of non-military aircraft to fill the C-17's anticipated role. Jet engines under development by Pratt & Whitney are designated the J52-P- 409 and the-PW-100 (formerly PW5000). The J52-P-409 is an improved performance version of the J52-P-408 and J52-P-8 engines and is rated at approximately 12,500 pounds of takeoff thrust. Due to reductions in the U.S. defense budget, management cannot predict with certainty whether this engine will be produced in significant numbers. The was selected to power the Air Force's aircraft under development by the team of Lockheed Corporation and the Boeing Company, and it is a 35,000-pound-thrust class engine. This engine is being developed under an Engineering and Manufacturing Development contract. Also, as a result of reductions in the U.S. defense budget, management cannot predict with certainty when, and in what quantities, production of the will commence. The competitive environment encountered in supplying military jet engines and jet engine parts to the U.S. Government is discussed beginning at page 12 of this Report. General Aviation Engines and Parts Pratt & Whitney is one of the world's leading producers of small gas turbine engines and parts for business and regional/commuter aircraft, and also supplies small turbine engines and parts for military aircraft, for helicopters and as auxiliary power units for large transport aircraft. Small gas turbine engines are manufactured by Pratt & Whitney Canada and consist of the PT6 series of turboprop/turboshaft engines, which produce up to 1,650 shaft-horsepower, the JT15D series of turbofan engines, which produce up to 3,095 pounds of takeoff thrust and the PW100 series, a turboprop engine, which produces up to 2,750 shaft-horsepower. Typical applications are six to PAGE eighty-passenger business and regional airline aircraft, including the Beech King Air and Super King Air series, the Beech Starship I and Piaggio Avanti pusher turboprops, the Beech 1900 airliner and the Beechjet, Cessna Citation II and V and Caravan I and II, de Havilland Dash 8-100 and Dash 8-300, Piper Cheyenne IIIA, Embraer EMB-120, British Aerospace ATP, Fokker 50, Dornier DO 328 and Aerospatiale/Aeritalia ATR-42 and ATR-72 aircraft, and the Bell 212/412 and Sikorsky S-76B helicopters. On December 31, 1993, more than 17,000 PT6, JT15D and PW100 powered aircraft and helicopters were in use in approximately 160 countries and territories. During 1993, two Pratt & Whitney powered contenders for the Air Force Joint Primary Aircraft Training System completed first flight, one with the PT6 and the other with the JT15D. The PT6, JT15D and PW100 were each selected for a new or derivative installation in 1993. The PW300, a 5,000 pound thrust class turbofan engine, has been developed for mid-size business jets under a collaboration agreement with MTU. The engine powers two applications, the Raytheon Corporate Jets Hawker 1000 and the Learjet Model 60, which started production deliveries in 1991 and 1993, respectively. The PW200 series, a new 500 to 800 shaft-horsepower turboshaft engine, is being developed in Canada to power a series of light helicopters. The first model received Canadian Department of Transport certification in 1991 and is installed in the McDonnell Douglas MD Explorer helicopter which achieved first flight in 1992. The PW206B is installed in the Eurocopter EC 135, currently being developed. In September 1993, Pratt & Whitney Canada launched the PW500 program, a new family of turbofan engines in the 2,500-4,000 thrust class aimed at light to medium business jets. An engine supply contract has been signed with a launch customer but no firm orders have yet been received. The PW901A engine is used as the auxiliary power unit for the Boeing 747-400 aircraft. An auxiliary power unit provides aircraft with starting power, electric power, lighting and air conditioning. More than 430 units have now been ordered by Boeing. Other Pratt & Whitney Products Other activities in the Pratt & Whitney Segment include the production of the RL10 liquid hydrogen fuel rocket motor used for upper stage propulsion for the National Aeronautics and Space Administration (NASA) Atlas-Centaur and Titan-Centaur launch vehicles; the supply of contract services for the construction, outfitting and operation of aircraft and aircraft engine maintenance centers for foreign customers; and the overhaul and repair of Pratt & Whitney engines in the U.S. and Canada and in overseas locations. Pratt & Whitney is a participant in the National Aero-space Plane (NASP) team with Rockwell, Rocketdyne, McDonnell Douglas and Lockheed under contract with the U.S. Air Force. The contract for the NASP involves research and concept studies for the X-30 design. Other Pratt & Whitney Segment Information Pratt & Whitney's business is subject to rapid changes in technology; lengthy and costly development cycles; heavy dependence on a small number of products and programs; changes in legislation and in government procurement and other regulations and procurement practices (such as the current Defense Department emphasis on development of prototypes rather than full production of new systems and on upgrading existing systems rather than developing new systems); procurement preferences and policies of some foreign customers which require in-country manufacture through co-production (such as the co-production of the-PW-229 for the South Korean Fighter Program), offset procurement (where in-country purchases are required as a condition to obtaining orders), joint ventures and production sharing (such as exist in the case of the IAE V2500, JT8D, PW300, PW2000 and PW4000 engines), licensing or other arrangements; substantial competition from major domestic manufacturers and from foreign manufacturers whose governments sometimes give them direct and indirect research and development, marketing subsidies and other assistance for their commercial products; and changes in economic, industrial and international conditions. The principal methods of competition in Pratt & Whitney's business are price, product performance, service, delivery schedule and other terms and PAGE conditions of sale, including fleet introductory assistance allowances and performance and operating cost guarantees, and the participation by the Corporation and its finance subsidiaries in customer financing arrangements in connection with sales of commercial jet engines. Fleet introductory allowances are financial incentives offered by the Corporation to airline customers in order to make engine sales which lead, in turn, to the sale of spare parts and services. Pratt & Whitney's major competitors are the aircraft engine businesses of GE and Rolls Royce. (For information regarding the Corporation's finance subsidiaries and commitments to finance or arrange financing for commercial aircraft, see Note 5 of Notes to Financial Statements at page 43 of the Corporation's 1993 Annual Report to Shareowners.) Historically, it was common to new aircraft programs for only one engine to be selected for a given airplane. In those situations, competition between engine manufacturers occurred principally at the time of the selection of the engine for the particular aircraft. That approach still prevails in some situations, including general aviation aircraft, the McDonnell Douglas MD-80, which is powered exclusively by the Pratt & Whitney JT8D engine, and the MD-90, which is powered exclusively by the IAE V2500. In those situations, when the customer chooses an aircraft, there is no choice of engines. The customer must buy the engine originally selected for that aircraft. In the case of commercial aircraft such as the Boeing 747, 757, 767 and 777, the McDonnell Douglas MD-11, and the Airbus Industrie A300, A300-600, A310, A320 and A321, aircraft manufacturers offer their customers a choice of engines, giving rise to substantial competition among engine manufacturers at the time of the sale of aircraft. This competition has become increasingly significant where new commercial airframe/engine combinations are first introduced to the market and into the fleets of individual airlines. Financial incentives granted by engine suppliers, and performance and operating cost guarantees on their part, are frequently important factors in such sales and can be substantial. (For information regarding participation in guarantees of customer financing arrangements granted by Pratt & Whitney and performance and operating cost guarantees, see Notes 1, 5, 12 and 13 of Notes to Financial Statements at pages 41 to 43 and 50, of the Corporation's 1993 Annual Report to Shareowners.) Sales of Pratt & Whitney military engines are adversely affected by declining defense budgets (both in the U.S. and, to some extent, abroad) and the presence of competitors, such as General Electric. Military spare parts sales have been, and will continue to be, adversely affected by the decline in overall procurement by the U.S. Government and, to a lesser extent, by the U. S. Government's policy of increasing its parts purchases from suppliers other than the original equipment manufacturers. The combined impact of these developments is not believed to be material to the Corporation at the present time. The Corporation's sales to the U.S. Government of spare parts for military products, a substantial portion of which are manufactured by the Corporation's suppliers and subcontractors, were approximately $374 million or 6 percent of total Pratt & Whitney revenues in 1993. Pratt & Whitney sales in the U.S. and Canada are made directly to the customer by the Corporation and, to a limited extent, through independent distributors. Other export sales from the U.S. are made with the assistance of an overseas network of sales offices and representatives outside the U.S. Export sales amounted to $2,289 million, or approximately 33 percent, and $2,031 million, or approximately 34 percent, of total Pratt & Whitney revenues in 1992 and 1993, respectively. Pratt & Whitney's revenues associated with manufacturing operations outside the U.S., which consist primarily of small gas turbine engines and parts manufactured in the Corporation's plants near Montreal, Canada, amounted to $1,217 million, or approximately 18 percent, and $1,118 million, or approximately 19 percent, of total Pratt & Whitney revenues in 1992 and 1993, respectively. Such operations are subject to local government regulations as well as to varying political and economic risks. At December 31, 1993, the business backlog in the Pratt & Whitney business amounted to $9,484 million, including $1,600 million under funded contracts and subcontracts with the U.S. Government, as compared to $11,627 million and $1,553 million, respectively, at December 31, 1992. Of the total Pratt & Whitney business backlog at December 31, 1993, approximately $5,133 million is expected to be realized as sales in 1994. Pratt & Whitney's backlog is based on the terms of firm orders received and does not include discounts granted directly to airline and other customers. Beginning in 1992, a number of major domestic PAGE airlines, foreign airlines and other owners and operators expressed their interest in postponing delivery of aircraft on order and, in some cases, existing orders and options for future delivery were canceled. The Corporation has negotiated with United Airlines changes to previously negotiated engine contract terms, including deferral of some engine deliveries. These factors could affect the amount of Pratt & Whitney business backlog which will ultimately be realized as sales. Flight Systems The Corporation's Flight Systems business is conducted through Sikorsky Aircraft, Hamilton Standard, Norden Systems, Chemical Systems, USBI, and International Fuel Cells. Flight Systems products are sold principally to the U.S. Government, airframe and aircraft engine manufacturers, airlines and other aircraft operators, and foreign governments. Direct and indirect revenues from sales to the U.S. Government amounted to $2,416 million, or approximately 62 percent, of total Flight Systems revenues in 1993. Military and Commercial Helicopters Sikorsky is one of the world's leading manufacturers of military and commercial helicopters. Sikorsky is the primary supplier of transport helicopters to the U.S. Army. Sikorsky is currently producing helicopters for a variety of uses including passenger, utility/transport, cargo, anti-submarine warfare, search and rescue, mine countermeasures and heavy-lift operations. In addition to all branches of the U.S. military, Sikorsky supplies helicopters to foreign governments and the worldwide commercial market. Sikorsky's business base also encompasses spare parts for past and current helicopters produced by Sikorsky, and, through the Sikorsky Support Services, Inc. subsidiary of the Corporation, repair and retrofit of helicopters in the U.S. military fleet. Other helicopter manufacturers include Bell Helicopters, Eurocopter, Boeing Helicopters, Agusta and Westland. Current production programs at Sikorsky include the BLACK HAWK medium- transport helicopter for the U.S. Army and derivatives for foreign governments; the SEAHAWK and CV Helo medium-sized helicopters for anti-submarine warfare missions for the U.S. Navy and derivatives for both the U.S. and foreign governments; the HH-60 JAYHAWK medium-range recovery helicopter for the U.S. Coast Guard; the CH-53E SUPER STALLION heavy-lift and MH-53E SEA DRAGON mine counter-measures helicopters for the U.S. Navy and Marine Corps and derivatives for Japan; and the S-76 intermediate-sized helicopter for executive transport and offshore oil platform support. In 1993, seven HH-60J JAYHAWK helicopters were delivered to the U.S. Coast Guard. On the commercial side, 10 of the 11 deliveries of S-76 helicopters in 1993 were made to international customers. Although in 1992 Sikorsky was awarded a U.S. Government contract for 300 BLACK HAWK helicopters through 1997, declining Defense Department budgets are such that Sikorsky's future will be increasingly dependent upon expanding its international position. Typically, these sales are expected to require the development of an in-country co-production program. Sikorsky succeeded in developing such a program in South Korea in 1990 by entering into a contract with Korean Airlines for 81 BLACK HAWK helicopters, 74 of which were to be co- produced. With this contract substantially completed, a supplemental contract was signed on December 31, 1993 for an additional 57 helicopter kits. In December 1992, Sikorsky signed a contract to provide up to 95 BLACK HAWK helicopters to the Turkish Armed Forces. The first 45 aircraft will be produced by Sikorsky. Of these, 40 have been delivered to and accepted by Turkey with the remainder scheduled to be delivered by June 1994. Sikorsky currently is negotiating a contract for the remaining 50 helicopters that are to be co- produced with Turkish industry participation. Sikorsky has been teamed with Boeing Helicopter Company for the Engineering and Manufacturing Development (EMD) of the U.S. Army's next generation light helicopter program, the RAH-66 Comanche. The Boeing/Sikorsky team has been performing under the EMD cost reimbursement contract awarded in 1991. Present requirements call for a minimum of 1,292 aircraft; however, due in part to declining defense budgets, the Department of Defense in early 1992 called for an extension of the development contract and a deferral of Comanche production beyond 1997. The Corporation cannot predict the quantity of aircraft which PAGE ultimately will be built. Based on Department of Defense direction, the Army and Sikorsky in January 1993 completed negotiations of a restructured Demonstration Validation Prototype Program to validate crucial components of the Comanche design. Sikorsky's development of a new S-92 commercial helicopter continues. Other Flight Systems Products Hamilton Standard is a leading domestic producer of a number of Flight Systems products. Major production programs include engine controls, environmental controls, flight controls and propellers for commercial and military aircraft. In addition, Hamilton Standard produces the space suit for the NASA space shuttle astronauts and environmental controls for the shuttle's orbiter. Norden Systems produces airborne, shipboard and ground based radar systems, electronic systems and anti-submarine warfare systems for the U.S. and foreign governments. Current production programs include the limited rate initial production (LRIP) of the AN/APY-3 Joint STARS (Surveillance Target Attack Radar System) for the U.S. Air Force, the AN/APG-76 Multi-Mode Radar System (MMRS) for the Israeli Super Phantom Program, the Airport Surface Detection Equipment (ASDE-3) surface traffic control radar for the Federal Aviation Administration (FAA), the fire control radar for the Multiple Launch Rocket System (MLRS), the AN/SPS-40 and AN/SPS-67 shipboard radars, the AN/SYS sensor fusion system, and the AN/WLR-9 acoustic intercept system which is operational on all U.S. Navy submarines. Development programs include Joint STARS, which was utilized in the Persian Gulf conflict to identify ground targets; a podded version of the MMRS, which will extend the aircraft and customer base of the radar; the Airport Movement Area Safety System (AMASS) which, in conjunction with ASDE-3, will provide the FAA an automatic runway incursion warning system designed to prevent aircraft runway collisions; the EA-6B Advanced Capability Radar (ADVCAP) for the U.S. Navy; and the WYL-1 Acoustic Intercept System, which is an advanced version of the AN/WLR-9. The Chemical Systems Division manufactures and provides launch services for solid rocket propellant boosters producing more than one million pounds of thrust which, when used in pairs, constitute the initial booster stage for the U.S. Air Force's Titan IV launch vehicle as well as for the Martin Marietta Titan III commercial launch vehicle. In addition, Chemical Systems Division produces other propulsion systems, such as shuttle booster separation motors, the Inertial Upper Stage solid rocket motors for the U.S. Air Force and NASA, the third stage rocket motor for the Navy's Trident II Missile, Tomahawk missile boosters and Aegis booster motors for the U.S. Navy, and is currently a qualified supplier of the U.S. Air Force's Minuteman III/Stage III propulsion system. In 1992, Chemical Systems received a contract from Lockheed Space and Missiles Company for the demonstration and validation of the solid propellant rocket, which will power the U.S. Army's Theater High Altitude Area Defense (THAAD) ballistic missile defense system. USBI is under contract with NASA for the Space Shuttle Solid Rocket Boosters and is responsible for the design, assembly, test, launch operations support and refurbishment of the solid rocket boosters. In addition, USBI provides design support to the Shuttle Processing Contractor in the stacking and testing of the Space Shuttle vehicle, and is responsible for the integration of the solid rocket motors with solid rocket boosters. International Fuel Cells Corporation (IFC) develops, manufactures and sells fuel cell systems and fuel cell electric generating power plants to commercial, aerospace and military customers. ONSI Corporation, an IFC subsidiary established with investments by Toshiba Corporation of Japan and Ansaldo S.p.A. of Italy to manufacture, sell and develop future models of stationary, packaged fuel cell power plants of 1,000 kilowatts or less, delivered 25 of its 200- kilowatt PC25_ fuel cell power plants to commercial customers in 1993. Other Flight Systems Segment Information The Flight Systems business is subject to rapid changes in technology; lengthy and costly development cycles; heavy dependence on a small number of products and programs; changes in legislation and in government procurement and other regulations and procurement practices (such as the current Defense PAGE Department emphasis on development of prototypes rather than full production of new systems and on upgrading existing systems rather than developing new systems); declining defense budgets (both in the U.S. and abroad); procurement preferences and policies of some foreign governments which require in-country manufacture through co-production or offset procurement (such as co-production and offset arrangements entered into with the governments of South Korea and Turkey with respect to the sales discussed at page 7 of this Report), licensing or other arrangements; substantial competition from a large number of companies, including competition from major domestic and foreign manufacturers; and changes in economic, industrial and international conditions. The principal methods of competition in the Flight Systems business are price, delivery schedules, product performance, service and other terms and conditions of sale, including participation in the financing of helicopter sales. Sales in the U.S. are usually made directly to the customer by the Corporation. Export sales to Canada from the U.S. are made directly to the customer. All other export sales are made with the assistance of an overseas network of sales offices and representatives outside the U.S. Such export sales amounted to $810 million, or approximately 20 percent, and $1,000 million, or approximately 25 percent, of total Flight Systems revenues in 1992 and 1993, respectively. At December 31, 1993, the Flight Systems business backlog amounted to $4,877 million, including $3,277 million under funded contracts and subcontracts with the U.S. Government, as compared to $5,571 million and $4,026 million, respectively, at December 31, 1992. Of the total Flight Systems business backlog at December 31, 1993, approximately $2,897 million is expected to be realized as sales in 1994. Carrier Carrier is the world's largest manufacturer of heating, ventilating and air conditioning (HVAC) systems and equipment. Carrier also participates in the commercial, industrial and transport refrigeration businesses. During the years 1991 through 1993, the Corporation's total revenues from these businesses were: Total Revenues--HVAC and Refrigeration Year Systems, Equipment and Service 1991 $3,843 million 1992 $4,328 million 1993 $4,480 million Carrier manufactures and sells 15 major global product lines, with over 10,000 different products manufactured. The products manufactured include chillers and airside equipment, commercial unitary systems, residential split systems (cooling only and heat pump), duct-free split systems, window and portable room air conditioners and furnaces. Other Carrier Segment Information Carrier's business is subject to changes in economic, industrial and international conditions, including possible increases in interest rates, which could reduce the demand for HVAC systems and equipment; changes in legislation and in government regulations; changes in technology; decreases in construction starts; and competition from a large number of companies, including other major domestic and foreign manufacturers. The principal methods of competition are delivery schedule, product performance, price, service and other terms and conditions of sale. Carrier's products and services are sold principally to builders and building contractors and owners. Sales are made both directly to the customer and by or through manufacturers' representatives, distributors, dealers, individual wholesalers and retail outlets. In 1992 and 1993, Carrier's revenues associated with operations outside of the U.S. amounted to $2,335 million, or approximately 54 percent, and $2,284 million, or approximately 51 percent, respectively, of total Carrier Segment revenues. International operations are subject to local government regulations (including regulations relating to capital contributions, currency conversion PAGE and repatriation of earnings), as well as to varying political and economic risks. At December 31, 1993, the Carrier business backlog amounted to $780 million, as compared to $685 million at December 31, 1992. Substantially all of the total business backlog at December 31, 1993 is expected to be realized as sales in 1994. Otis Otis is the world's leader in the production, installation and service of elevators and escalators. During the years 1991 through 1993, the Corporation's total revenues from elevators, escalators and services were as follows: Total Revenues-- Elevators, Year Escalators & Services 1991 $4,304 million 1992 $4,512 million 1993 $4,418 million Included in the above amounts are service revenues of $2,379 million, $2,666 million, and $2,636 million, in 1991, 1992 and 1993, respectively. Otis manufactures a wide range of passenger and freight elevators, including geared and hydraulic elevators for medium and low speed passenger and freight applications and gearless elevators for high-speed passenger operations in high rise buildings, and modernizes older elevators and escalators. Otis also produces a broad line of escalators, moving sidewalks, and shuttle systems for horizontal transportation. Otis services a substantial portion of the elevators and escalators which it has sold in the past and also services elevators and escalators of other manufacturers. At December 31, 1993, Otis serviced more than 750,000 elevators and escalators worldwide, the majority of which are under regular service contracts. Otis conducts its business principally through various affiliated companies worldwide. In some cases, consolidated affiliates have significant minority interests. In addition, Otis continues to invest in emerging markets in Central and Eastern Europe and Asia (e.g., Russia, Ukraine, and the People's Republic of China) through the establishment of affiliated companies, with varying amounts of equity participation. Management cannot predict how these markets will progress, but does not believe that any adverse developments in these markets will have a material effect on the Corporation. Other Otis Segment Information Otis' business is subject to changes in economic, industrial and international conditions, including possible increases in interest rates, which could reduce the demand for elevators, escalators and services; changes in legislation and in government regulations; changes in technology; decreases in construction starts; and substantial competition from a large number of companies including other major domestic and foreign manufacturers. The principal methods of competition are price, delivery schedule, product performance, service and other terms and conditions of sale. Otis' products and services are sold principally to builders and building contractors and owners. In 1992 and 1993, revenues associated with operations outside of the U.S. amounted to $3,754 million, or approximately 83 percent, and $3,723 million, or approximately 84 percent, respectively, of total Otis Segment revenues. International operations are subject to local government regulations (including regulations relating to capital contributions, currency conversion and repatriation of earnings), as well as to varying political and economic risks. At December 31, 1993, the Otis business backlog amounted to $2,812 million as compared to $2,868 million at December 31, 1992. Of the total business backlog at December 31, 1993, approximately $2,442 million is expected to be realized as sales in 1994. PAGE Automotive The Corporation's Automotive business is conducted through the Automotive Group. The Automotive Group is a major domestic supplier of wire harness systems, switches, terminals and connectors, steering wheels, instrument panels, consoles, fractional horsepower motors and other automotive components. The Automotive Group also supplies wire harness systems, fractional horsepower motors, steering wheels and other automotive components to customers in Europe and Asia. During 1990, the Corporation sold its interests in (1) the Sealing Systems Division of Sheller-Globe Corporation, a supplier of rubber molded products principally used as weather stripping for automotive windows, with domestic operations in Iowa, Indiana and California and international operations in France and Spain; (2) Diavia S.p.A. and Aura S.r.L., two Italian automotive aftermarket air conditioning system suppliers; (3) Sheller-Ryobi Corporation, an Indiana aluminum die casting manufacturer; and (4) Sheller-Globe Engineered Polymers Corporation, a Minnesota non-automotive plastic components producer. During 1992, the Corporation sold its interest in the Hose, Fittings and Industrial Products Division of United Technologies Automotive, Inc., a supplier of coupled hose assemblies and fittings products and extruded plastic and plastic sheet products, hydraulic valves and machined products to the automotive and commercial marketplace, which had domestic operations in Georgia, Illinois, Indiana, Michigan, North Carolina and Ohio and an international operation in the United Kingdom. On January 19, 1994, the Corporation announced that it was planning to sell 40% of the economic interest of its Automotive segment to the public through an initial public offering of the Class A Common Stock of UT Automotive, Inc. ("UTA"). UTA filed a registration statement on Form S-1 under the Securities Act of 1933 relating to the offering (the "Registration Statement"). The Registration Statement has not yet been declared effective and is subject to amendment. The Corporation currently plans to retain 60% of the economic interest in UTA and will have the ability to elect at least 80% of the board of directors of UTA. Sales to the Automotive Industry Sales to the major domestic automotive manufacturers are made against periodic short-term releases issued by the automotive manufacturers under annual orders for a percentage of the respective manufacturer's requirements for the products ordered. In 1991, sales to the major domestic automotive manufacturers were $1,302 million, or approximately 62 percent, of total Automotive revenues. In 1992, sales to the major domestic automotive manufacturers were $1,554 million, or approximately 65 percent, of total Automotive revenues. In 1993, sales to the major domestic automotive manufacturers were $1,602 million, or approximately 67 percent, of total Automotive revenues. In 1991, sales to Ford Motor Company were $851 million, or approximately 65 percent, of sales to the major domestic automotive manufacturers and approximately 41 percent of total Automotive revenues. In 1992, sales to Ford Motor Company were $991 million, or approximately 64 percent, of sales to the major domestic automotive manufacturers and approximately 42 percent of total Automotive revenues. In 1993, sales to Ford Motor Company were $965 million, or approximately 60 percent, of sales to the major domestic automotive manufacturers and approximately 41 percent of total Automotive revenues. Other Automotive Segment Products The Automotive Group also produces headliners, door trim panels, sun visors, armrests, package trays and other interior trim, acoustical padding, foam products, mirrors, sun visors, thermal and acoustic barriers, horn pads, airbag covers, steering wheels, electronic controls and modules, vehicle entry systems, relays, interior lighting systems, switches and controls for turn signals, headlights, windshield wipers and ignition systems, power window motors, power door lock activators, anti-lock brake system pump motors, vehicle emission air blower motors, and windshield wiper motors and systems. United Technologies Industrial Lasers Division designs, builds and sells worldwide, high-power, continuous-wave CO2 industrial lasers. PAGE Other Automotive Segment Information The Automotive segment's business is subject to changes in economic, industrial and international conditions; increases in interest rates and decreases in the level of automotive production which could reduce the demand for many of the industrial products of the Corporation; changes in the prices of essential raw materials and petroleum-based materials; changes in legislation and in government regulations; changes in technology; and substantial competition from a large number of companies including other major domestic and foreign manufacturers. The principal methods of competition are price, delivery schedule and product performance. Automotive segment sales are made principally to automotive original equipment manufacturers and systems suppliers. Sales are made both directly to the customer and by or through manufacturers' representatives. Original equipment manufacturers throughout the world are outsourcing an increasing share of the design and manufacture of their automotive systems and subsystems. This trend benefits a select group of large, first-tier suppliers that can provide sophisticated design and engineering services, low-cost manufacturing, high product quality, and total systems capabilities on a global basis. To remain competitive in this environment, the ability to consistently deliver, on time, products of ever-increasing quality has become a critical requirement. In 1991, 1992 and 1993, revenues associated with operations outside of the U.S. amounted to $831 million, or approximately 40 percent, $1,062 million, or approximately 45 percent, and $743 million, or approximately 31 percent, respectively, of total Automotive segment revenues. International operations are subject to local government regulations (including regulations relating to currency conversion and repatriation of earnings), as well as to varying political and economic risks. Other Matters Relating to the Corporation's Business as a Whole Research and Development To maintain its competitive position, the Corporation spends substantial amounts of its own funds on research and development. Such expenditures, net of reimbursements from participating suppliers to the Corporation's advanced commercial aircraft engine programs which are charged against income as incurred and relate principally to the Pratt & Whitney business, were $1,137 million or 5 percent of total revenues in 1993, as compared with $1,221 million or 6 percent of total revenues in 1992 and $1,133 million or 5 percent of total revenues in 1991. The Corporation also performs research and development work under contracts funded by the U.S. Government and some other customers. Such contract research and development, which is performed principally in the Pratt & Whitney business and to a lesser extent in the Flight Systems business, amounted to $918 million in 1993, as compared with $1,012 million in 1992 and $750 million in 1991. Contracts, Environmental and Other Matters Contracts with the U.S. Government are subject to termination for the convenience of the government, in which event the Corporation normally would be entitled to reimbursement for its allowable costs incurred plus a reasonable profit. Most of the Corporation's sales are made under fixed-price type contracts; only six percent of the Corporation's total sales for 1993 were made under cost- reimbursement type contracts. Development contracts awarded in 1991 for the RAH-66 Comanche and the Advanced Tactical Fighter engine are on a cost- reimbursement basis. Like many defense contractors, the Corporation has received allegations from the U.S. Government that some contract prices should be reduced because cost or pricing data submitted in negotiation of the contract prices may not have been in conformance with government regulations. The Corporation has made voluntary refunds in those cases it believes appropriate, has settled some allegations, and does not believe that any further price reductions that may be required will have a material effect upon its financial position or results of operations. PAGE The Corporation is now and believes that, in light of the current government contracting environment, it will be the subject of one or more government investigations. See Item 3 Legal Proceedings at page 14 of this report for further discussion. Recent peace initiatives and related changes in Eastern Europe have served to reduce both U.S. and foreign defense spending as a whole. Management does not currently believe that Defense Department budget cutbacks will have a material adverse effect on the profitability of the Corporation, however, due in part to the Corporation's efforts to reduce its reliance on defense contracts. The Corporation purchases substantial quantities of materials, components and supplies from a large number of sources. Like other users in the U.S., the Corporation is largely dependent on foreign sources located in Africa for its requirements of cobalt, and on sources located in Africa, Eastern and Central Europe and the countries of the former U.S.S.R. for its requirements of chromium. The Corporation does not foresee any unavailability of materials or components which will have any material adverse effect on its overall business, or on any of its business segments, in the near term. To alleviate possible longer term effects, the Corporation has a number of ongoing programs which include the expansion of its internal production capacity for precision parts; the development of new vendor sources; the increased use of more readily available materials through material substitutions and the development of new alloys; and conservation of materials through scrap reclamation and new manufacturing processes such as net shape forging. While the Corporation's patents, trademarks, licenses and franchises are cumulatively important to its business, the Corporation does not believe that the loss of any one or group of related patents, trademarks, licenses or franchises would have a material adverse effect on the overall business of the Corporation or on any of its business segments. The Corporation does not anticipate that compliance with federal, state and local provisions relating to the protection of the environment will have a material adverse effect upon its capital expenditures, competitive position, financial position or results of operations. (Environmental matters are the subject of certain of the Legal Proceedings described in Item 3 beginning at page 14 of this Report, and are further addressed in "Management's Discussion and Analysis of Results of Operations and Financial Position" at pages 34 and 35 and Note 13 of Notes to Financial Statements at page 50 of the Corporation's 1993 Annual Report to Shareowners.) Most of the laws governing environmental matters include criminal provisions. If the Corporation were convicted of a violation of the federal Clean Air Act or the Clean Water Act, the facility or facilities involved in the violation would be listed on the Environmental Protection Agency's (EPA) List of Violating Facilities. The listing would continue until the EPA concluded that the cause of the violation had been cured. Any listed facility cannot be used in performing any U.S. Government contract awarded to the Corporation during any period of listing by the EPA. In March 1990, it was announced that the Corporation and MTU, a subsidiary of Daimler-Benz AG (Daimler) had signed a memorandum of understanding concerning future business collaboration between the two companies. In March 1991, a formal agreement was executed providing for expanded cooperation between the parties with respect to commercial and general aviation engine research and development, manufacturing and marketing. See page 3 of this report for further description of this matter. Employees At December 31, 1993, the Corporation's total employment was approximately 168,600, a reduction of approximately 9,400 over the prior year. Item 2. Item 2. Properties The Corporation's fixed assets include the plants and warehouses described below and a substantial quantity of machinery and equipment, most of which is general purpose machinery and equipment using special jigs, tools and fixtures and in many instances having modern automatic control features and special adaptations. The Corporation's plants, warehouses, machinery and equipment are in good operating condition, are well maintained, and substantially all of its PAGE facilities are in regular use. The Corporation considers the present level of fixed assets capitalized as of December 31, 1993, suitable and adequate for the respective industry segment's operations in the current business environment. For a further discussion of management's effort to restructure the Corporation, see "Management's Discussion and Analysis of Results of Operations and Financial Position" appearing in the Corporation's 1993 Annual Report to Shareowners, especially the information contained under the heading "Restructuring and Other Actions". The square footage numbers set forth in the succeeding paragraphs of this Item 2 are approximations. At December 31, 1993, the Corporation operated (a) plants in the U.S. which had 35.7 million square feet, of which 5.7 million square feet were leased; (b) plants outside the U.S. which had 17.9 million square feet, of which 2.4 million square feet were leased; (c) warehouses in the U.S. which had 6.4 million square feet, of which 4.8 million square feet were leased; and (d) warehouses outside the U.S. which had 5.8 million square feet, of which 4.1 million square feet were leased. Pratt & Whitney segment plants are located in six states, Canada, Singapore, the Netherlands and other areas. At December 31, 1993, the U.S. plants operated by the Pratt & Whitney segment had aggregate floor areas of 14.2 million square feet, of which 0.7 million square feet were leased and the plants outside the U.S. had aggregate floor areas of 3.0 million square feet, of which 0.2 million square feet were leased. In the Pratt & Whitney segment, outdoor testing of engines is conducted on 7,100 acres in Palm Beach County, Florida. In addition, the Corporation currently owns and operates airports in East Hartford, Connecticut and Palm Beach County, Florida. Plans have been announced to move the Corporation's East Hartford airport operations to Bradley International Airport in Windsor Locks, Connecticut. Flight Systems plants are located in ten states, Italy and the Federal Republic of Germany. At December 31, 1993, the U.S. plants operated by the Flight Systems segment had aggregate floor areas of 8.8 million square feet, of which 1.9 million square feet were leased, and the plants outside the U.S. had aggregate floor areas of 0.7 million square feet, of which 0.1 million square feet were leased. Flight Systems also operates company-owned helicopter air fields in Bridgeport and Stratford, Connecticut, a company-owned rotary-wing aircraft completion, training and test center in Palm Beach County, Florida and a 5,100 acre outdoor rocket engine test center in Coyote, California. Carrier plants are located in seven states, Europe, Asia, Latin America, Australia and Canada. At December 31, 1993, the U.S. plants had an aggregate floor area of 5.7 million square feet, of which 1.9 million square feet were leased, and the plants outside the U.S. had an aggregate floor area of 4.4 million square feet, of which 0.6 million square feet were leased. Otis plants are located in one state, Europe, Asia and Latin America. At December 31, 1993, the U.S. plants had an aggregate floor area of 0.8 million square feet, of which none was leased, and the plants outside the U.S. had an aggregate floor area of 5.9 million square feet, of which 0.6 million square feet were leased. Automotive segment plants are located in fourteen states, Canada, Mexico, Europe and Asia. At December 31, 1993, the U.S. plants had an aggregate floor area of 5.7 million square feet, of which 1.1 million square feet were leased; and the plants outside the U.S. had an aggregate floor area of 4.0 million square feet, of which 1.0 million square feet were leased. Management believes that the facilities for the production of its products are suitable and adequate for the business conducted therein, are being appropriately utilized in line with experience and have sufficient production capacity for their present intended purposes. Utilization of the facilities varies based on demand for the products. The Corporation continuously reviews its anticipated requirements for facilities and, based on that review, may from time to time acquire additional facilities and/or dispose of existing facilities. Item 3. Item 3. Legal Proceedings In June 1989, Sikorsky Aircraft submitted a voluntary disclosure report to the Department of Defense describing the conditions that gave rise to a $75 million downward adjustment of progress payments in April 1988 and related matters. On May 18, 1989, an employee filed under seal a "qui tam" action under PAGE the Civil False Claims Act in the United States District court for the District of Connecticut (Civil Action No. H-89-323-AHM) based on information that he learned while working on the Corporation's investigation of the matter. The Corporation and the Department of Justice have entered into a settlement agreement whereby the Corporation will pay the Government $150 million for any damage it has suffered. The amount of the settlement has been previously accrued. On June 29, 1992, the Department of Justice filed a Civil False Claims Act complaint in the United States District Court for the District of Connecticut, No. 592CV375, against Sikorsky Aircraft alleging that the government was overcharged by nearly $4 million in connection with the pricing of parts supplied for the reconditioning of the Navy's Sea King helicopter. The Complaint seeks treble damages plus a $10,000 penalty for each false claim submitted. Management believes that resolution of this matter will not have a material adverse effect upon its capital expenditures, competitive position, financial position or results of operations. In November 1991, the Corporation was served with a Department of Defense Inspector General subpoena for records relating to Pratt & Whitney's government contracts accounting practices for aircraft engine parts produced by foreign companies under certain commercial engine collaboration programs. Pratt & Whitney made a voluntary payment of $13,932,000 to the U.S. Government on December 23, 1992. A federal grand jury in the District of Connecticut is investigating this matter. Management believes that resolution of this matter will not have a material adverse effect upon its capital expenditures, competitive position, financial position or results of operations. In March 1992, the Corporation received a subpoena from the Department of Defense Inspector General requesting documents in connection with Pratt & Whitney's sales of goods and services to the Israeli Government. The investigation relates to the activities of former Israeli General Rami Dotan who pleaded guilty in Israel to engaging in corrupt practices in connection with Israeli Air Force procurements involving another engine manufacturer. A federal grand jury in the Southern District of Florida and the Civil Division of the Department of Justice are investigating this matter. A federal grand jury continues to investigate alleged violations of law in connection with marketing helicopters to the Government of the Kingdom of Saudi Arabia. The Corporation has responded to a grand jury subpoena requesting documents in connection with this matter and several current and former employees have been interviewed. A related civil suit filed by a former employee has been settled. Management believes that resolution of this matter will not have a material adverse effect upon its capital expenditures, competitive position, financial position or results of operations. The Corporation believes that, in light of the current government contracting environment, it will be the subject of one or more government investigations in the foreseeable future. If the Corporation or one of its business units were charged with wrongdoing as a result of any of these investigations, the Corporation or one of its business units could be suspended from bidding on or receiving awards of new government contracts pending the completion of legal proceedings. If convicted or found liable, the Corporation could be fined and debarred from new government contracting for a period generally not to exceed three years. Any contracts found to be tainted by fraud could be voided by the Government. In 1991, two complaints, each purporting to commence derivative and class actions by shareholders of the Corporation, were filed in the United States District Court for the District of Connecticut. The suits sought unspecified treble damages as well as other relief. On June 26, 1992, the District Court dismissed these two complaints in their entirety. Plaintiffs filed a consolidated amended complaint on September 23, 1992. The amended complaint, like the original complaints, named nine of the Corporation's directors as defendants and related to the Corporation's conduct of its defense business. Defendants moved to dismiss the complaint, and on February 4, 1994, the District Court dismissed the amended consolidated complaint in its entirety. Various state and federal government authorities have designated the Corporation as a potentially responsible party for liabilities under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) and similar state statutes. Said authorities seek expenditures and damages for contamination due to the release of pollutants into the environment. The PAGE Corporation believes that any payments it may be required to make as a result of these claims will not be material to the business or financial condition of the Corporation. The Corporation has had liability and property insurance in force over its history with a number of insurance companies, and the Corporation has commenced litigation seeking indemnity and defense under these insurance policies. No prediction can be made at this time as to the eventual outcome of this litigation. (For information regarding the matters discussed in this paragraph, see "Environmental Matters" in Management's Discussion and Analysis of Results of Operations and Financial Position at pages 34 and 35 of the Corporation's 1993 Annual Report to Shareowners.) In January 1994, UT Automotive (UTA) received a letter from the Michigan Department of Natural Resources (MDNR) alleging violations of certain provisions of an air permit for its Niles, Michigan facility. MDNR also asserted that these were violations of a Consent Judgment between the MDNR and UTA (Consent Judgment No. 92-1811-CET, Berrien County Circuit Court). It alleged that the VOC emission rates established by the permit were exceeded. UTA is discussing the allegations with MDNR. Management believes that the resolution of this matter, including payments of any fines or penalties, will not have a material adverse effect upon its capital expenditures, competitive position, financial position or results of operations. In July 1992, the Maine Department of Environmental Conservation (MDEC) filed a Consent Agreement and Enforcement Order against the Corporation related to a Pratt & Whitney facility in North Berwick, Maine. On October 27, 1993, the Corporation and MDEC entered into a settlement agreement, under which the Corporation agreed to pay a penalty of $134,200, to improve its hazardous waste management procedures and submit certain reports and studies regarding hazardous waste management to the MDEC. The matter is now concluded. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to security holders for a vote during the fourth quarter ended December 31, 1993. - ----- Executive Officers of the Registrant The executive officers of United Technologies Corporation, together with the offices in United Technologies Corporation presently held by them, their business experience since January 1, 1989, and their ages, are as follows: PAGE Other Business Age Name Title Experience 2/1/94 Since 1/1/89 Norman R. President, UT President, Electrical 51 Bodine Automotive (since Systems & Components; 1992) President, Automotive Products Division, UT Automotive Eugene Buckley President, Sikorsky ------- 63 Aircraft (since 1987) William L. Senior Vice Vice President, Human 51 Bucknall, Jr. President, Human Resources & Resources & Organization, United Organization (since Technologies; Vice 1992) President, Human Resources, Carrier; Corporate Director, Compensation and Benefits; Corporate Director, Salaried Employee Relations Franklyn A. Senior Vice Senior Vice President, 43 Caine President, Planning Controller; Senior Vice and Corporate President, Human Development (since Resources & 1993) Organization; Vice President, Treasurer Mark S. Coran Executive Vice Vice President, 50 President, Controller, United Operations, Pratt & Technologies; Vice Whitney (since 1991) President, Group Finance, Pratt & Whitney Robert F. Chairman (since President and Chief 60 Daniell 1987), Chief Operating Officer (1984- Executive Officer 1992) (since 1986) George David President and Chief Executive Vice President 51 Operating Officer and President, (since 1992) Commercial/Industrial; Senior Vice President, United Technologies; President and Chief Executive Officer, Otis Elevator Thomas J. Fay Senior Vice Senior Vice President, 60 President, Corporate Affairs, Aetna Communications Life & Casualty (since 1990) Frederick C. Vice President, Director, Financial 43 Flynn, Jr. Treasurer (since Programs; Director, 1989) Business Development William S. President, Carrier President, Carrier North 51 Frago Corporation (since American Operations; 1992) Vice President, Worldwide Marketing & Product Management, General Electric Lighting Bruno Grob President, European Executive Vice 44 & Transcontinental President, European & Operations, Otis Transcontinental Elevator (since Operations; President, 1992) Director General, Otis France; Vice President & Regional Manager, North American Operations, Otis Elevator PAGE Other Business Age Name Title Experience 2/1/94 Since 1/1/89 Robert J. Senior Vice Vice President, Science 60 Hermann President Science & & Technology Technology (since 1992) James T. Executive Vice Vice President and 51 Johnson President, General Manager-Everett Pratt & Whitney and Division, Boeing President-Large Commercial Airplane Commercial Engines Group (since 1993) Karl J. Krapek President, Pratt & Chairman, President and 45 Whitney Chief Executive Officer, (since 1992) Carrier Corporation; President and Chief Operating Officer; President, North American Operations, Otis Elevator Frank W. Senior Vice Vice President, Business 63 McAbee, Jr. President, Practices; Vice Environmental and President, Government Business Practices Contracts and Compliance (since 1990) George E. Vice President - Partner - Price 44 Minnich Controller Waterhouse (since 1993) Stephen F. Page Executive Vice Executive Vice President 54 President and Chief and Chief Financial Financial Officer; Vice Officer (since 1993) President Finance & Treasurer, Black & Decker Corporation William F. Paul Senior Vice Senior Vice President, 57 President, Washington Office; Government Affairs Senior Vice President & (since 1991) Executive Vice President, Aerospace/Defense; Senior Vice President, Defense & Space Systems Karl M. Thomas Executive Vice Group Vice President, 57 President, Operations; President, Technical, Pratt & Manufacturing, Pratt & Whitney (since 1991) Whitney William H. Vice President, Vice President and 50 Trachsel Secretary and Deputy Deputy General Counsel General Counsel (since 1993) Jean-Pierre van President, Otis Executive Vice President 59 Rooy Elevator (since and Chief Operating 1991) Officer; President, North American Operations; Senior Vice President, European & Transcontinental Operations, Otis Elevator Irving B. Executive Vice Senior Vice President 48 Yoskowitz President and and General Counsel General Counsel (since 1990) All of the officers serve at the pleasure of the Board of Directors of United Technologies Corporation or the subsidiary designated. PAGE Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters See "Comparative Stock Data" appearing on page 35 of the Corporation's 1993 Annual Report to its Shareowners containing the following data relating to the Corporation's Common Stock: principal market, quarterly high and low sales prices, approximate number of shareowners and frequency and amount of dividends. All such data are incorporated by reference in this Report. Item 6. Item 6. Selected Financial Data See the Five-Year Summary appearing on page 27 of the Corporation's 1993 Annual Report to its Shareowners containing the following data: sales, net income, primary and fully diluted earnings per share, cash dividends on Common Stock, total assets and long-term debt. All such data are incorporated by reference in this Report. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations and Financial Position See "Management's Discussion and Analysis of Results of Operations and Financial Position" appearing on pages 28 through 35 of the Corporation's 1993 Annual Report to its Shareowners; such discussion and analysis is incorporated by reference in this Report. Item 8. Item 8. Financial Statements and Supplementary Data The 1993 and 1992 Balance Sheets, and other financial statements for the years 1993, 1992 and 1991, together with the report thereon of Price Waterhouse dated January 26, 1994, appearing on pages 36 through 54 in the Corporation's 1993 Annual Report to its Shareowners are incorporated by reference in this Report. The 1993 and 1992 Selected Quarterly Financial Data appearing on page 55 in the Corporation's 1993 Annual Report to its Shareowners are incorporated by reference in this Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. Item 10. Item 10. Directors and Executive Officers of the Registrant The information required by Item 10 with respect to directors is incorporated herein by reference from pages 4 through 6 of the Corporation's Proxy Statement for the 1994 Annual Meeting of Shareowners. Information regarding executive officers is contained in Part I of this Report (pages 16 through 18). Item 11. Item 11. Executive Compensation The information required by Item 11 is incorporated herein by reference from pages 8 through 13, and pages 18 through 19 of the Corporation's Proxy Statement for the 1994 Annual Meeting of Shareowners. Such incorporation by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by Item 12 is incorporated herein by reference from pages 7 through 8 of the Corporation's Proxy Statement for the 1994 Annual Meeting of Shareowners. Item 13. Item 13. Certain Relationships and Related Transactions The information required by Item 13 is incorporated herein by reference from page 8 of the Corporation's Proxy Statement for the 1994 Annual Meeting of Shareowners. PAGE Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page No. in Annual Report (a) (1) Financial Statements (incorporated by reference from the 1993 Annual Report to Shareowners): Report of Independent Accountants 36 Consolidated Statement of Operations for the Three Years ended December 37 31, 1993 Consolidated Balance Sheet--December 31, 1993 and 1992 38 Consolidated Statement of Cash Flows for the Three Years ended December 39 31, 1993 Consolidated Statement of Changes in Shareowners' Equity for the Three 40 Years ended December 31, 1993 Notes to Financial Statements 41 Consolidated Summary of Business Segment Financial Data 51 Selected Quarterly Financial Data 55 (Unaudited) Page No. in Form 10-K (2) Financial Statement Schedules: For the three years ended December 31, 1993: Report of Independent Accountants on Financial Statement Schedules S-1 V-- Property, Plant and Equipment S-2 VI-- Accumulated Depreciation and Amortization of Property, Plant and S-3 Equipment VIII-- Valuation and Qualifying Accounts S-4 IX-- Short-Term Borrowings S-5 X-- Supplementary Income Statement S-6 Information Consent of Independent Accountants All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or the notes thereto. (3) Exhibits: (3) (i) Restated Certificate of Incorporation [incorporated by reference to Exhibit (3)(i) to Form 10K for the year ended December 31, 1992] (ii) Bylaws (4) (i) In accordance with Item 601 of Regulation S-K of the Securities and Exchange Commission, the Corporation hereby agrees to furnish upon request to the Commission a copy of each instrument defining the rights of holders of long-term debt of the Corporation and its consolidated subsidiaries and any unconsolidated subsidiaries for which financial statements otherwise would be required to be filed with this annual report on Form 10-K for the year ended December 31, PAGE (10) (i) United Technologies Corporation 1979 Long Term Incentive Plan [incorporated by reference to Exhibit (10)(i) to Form 10K for the year ended December 31, 1992] (ii) United Technologies Corporation Annual Executive Incentive Compensation Plan [incorporated by reference to Exhibit (10)(ii) to Form 10K for the year ended December 31, 1992] (iii) United Technologies Corporation Disability Insurance Benefits for Executive Control Group [incorporated by reference to Exhibit (10)(iii) to Form 10K for the year ended December 31, 1992] (iv) United Technologies Corporation Executive Estate Preservation Program [incorporated by reference to Exhibit (10)(iv) to Form 10K for the year ended December 31, 1992] (v) Pension Preservation Plan [incorporated by reference to Exhibit (10)(v) to Form 10K for the year ended December 31, 1992] (vi) Senior Executive Severance Plan [incorporated by reference to Exhibit (10)(vi) to Form 10K for the year ended December 31, 1992] (vii) United Technologies Corporation Deferred Compensation Plan [incorporated by reference to Exhibit (10)(vii) to Form 10K for the year ended December 31, 1992] (viii) Otis Elevator Company Incentive Compensation Plan [incorporated by reference to Exhibit (10)(viii) to Form 10K for the year ended December 31, 1992] (ix) Directors Retirement Plan [incorporated by reference to Exhibit (10)(ix) to Form 10K for the year ended December 31, 1992] (x) United Technologies Corporation Deferred Compensation Plan for Non-Employee Directors [incorporated by reference to Exhibit (10)(x) to Form 10K for the year ended December 31, 1992] (xi) United Technologies Corporation Long Term Incentive Plan [ incorporated by reference to Exhibit (10)(xi) to Form 10K for the year ended December 31, 1992] (xii) United Technologies Corporation Executive Disability, Income Protection and Standard Separation Agreement Plan [incorporated by reference to Exhibit (10)(xii) to Form 10K for the year ended December 31, 1992] (xiii) United Technologies Corporation Directors' Restricted Stock/Unit Program [incorporated by reference to Exhibit (10)(xiii) to Form 10K for the year ended December 31, 1992] (xiv) United Technologies Corporation Directors' Stock and Deferred Stock Unit Retainer Program (xv) United Technologies Corporation Pension Replacement Plan (11) Statement re Computation of Per Share Earnings (12) Computation of Ratio of Earnings to Fixed Charges (13) Annual Report to Shareowners for year ended December 31, 1993 (except for the pages and information thereof expressly incorporated by reference in this Form 10-K, the Annual Report to Shareowners is provided solely for the information of the Securities and Exchange Commission and is not to be deemed "filed" as part of this Form 10-K) (22) Subsidiaries of the Registrant (25) Powers of Attorney of Howard H. Baker, Jr., Antonia Handler Chayes, Robert F. Daniell, Robert F. Dee, Charles W. Duncan, Jr., Pehr G. Gyllenhammar, Gerald D. Hines, Charles R. Lee, Robert H. Malott, and Jacqueline G. Wexler (b) A report on Form 8-K was filed by the Registrant on January 19, 1994, in response to both Item 5 and Item 7. PAGE 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 TECHNOLOGIES CORPORATION By /s/ Stephen F. Page Date: March 31, 1994 Stephen F. Page, Executive 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 the date set forth above. Signature Title ROBERT F. DANIELL* Chairman and Chief Executive (Robert F. Daniell) Officer; Director /s/ GEORGE DAVID President and Chief Operating (George David) Officer; Director /s/ GEORGE E. MINNICH Vice President Controller; (George E. Minnich) Principal Accounting Officer /s/ STEPHEN F. PAGE Executive Vice President and (Stephen F. Page) Chief Financial Officer HOWARD H. BAKER, JR.* Director (Howard H. Baker, Jr.) ANTONIA HANDLER CHAYES* Director (Antonia Handler Chayes) ROBERT F. DEE* Director (Robert F. Dee) CHARLES W. DUNCAN, JR.* Director (Charles W. Duncan, Jr.) PEHR G. GYLLENHAMMAR* Director (Pehr G. Gyllenhammar) GERALD D. HINES* Director (Gerald D. Hines) CHARLES R. LEE* Director (Charles R. Lee) ROBERT H. MALOTT* Director (Robert H. Malott) JACQUELINE G. WEXLER* Director (Jacqueline G. Wexler) * By William H. Trachsel (WILLIAM H. TRACHSEL, AS ATTORNEY-IN-FACT) PAGE REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of United Technologies Corporation Our audits of the consolidated financial statements referred to in our report dated January 26, 1994 appearing on page 36 of the 1993 Annual Report to Shareowners of United Technologies Corporation (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. Price Waterhouse Hartford, Connecticut January 26, 1994 S-1 PAGE S-2PAGE S-3PAGE SCHEDULE VIII UNITED TECHNOLOGIES CORPORATION AND SUBSIDIARIES Schedule VIII - Valuation and Qualifying Accounts and Reserves Three Years Ended December 31, 1993 (Millions of Dollars) Certain 1992 and 1991 amounts have been restated to conform with 1993 presentation. S-4PAGE S-5PAGE SCHEDULE X UNITED TECHNOLOGIES CORPORATION AND SUBSIDIARIES Schedule X - Supplementary Income Statement Information Three Years Ended December 31, 1993 (Millions of Dollars) Maintenance and Repairs: 1993 . . . . . . . . . . . . . . . . . . . . . . . $ 242 1992 . . . . . . . . . . . . . . . . . . . . . . . 291 1991 . . . . . . . . . . . . . . . . . . . . . . . 284 S-6PAGE CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (Nos. 33-46916, 33- 40163, 33-34320, 33-31514, 33-29687 and 33-6452) and Form S-8 (Nos. 33-45440, 33-11255, 33-26580, 33-26627, 33-28974, 33-51385, and 2-87322) of United Technologies Corporation of our report dated January 26, 1994 appearing on page 36 of the 1993 Annual Report to Shareowners which is incorporated by reference in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears on page S-1 of this Form 10-K. Price Waterhouse Hartford, Connecticut March 29, 1994 PAGE SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 __________________ EXHIBITS FILED with FORM 10 - K ANNUAL REPORT (Fiscal Year ended December 31, 1993) Under The Securities Exchange Act of 1934 ________________ UNITED TECHNOLOGIES CORPORATION PAGE INDEX TO EXHIBITS Exhibit (3)(i) -- Restated Certificate of Incorporation * Exhibit (3)(ii) -- Bylaws Exhibit (10)(i) -- United Technologies Corporation * 1979 Long Term Incentive Plan Exhibit (10)(ii) -- United Technologies Corporation * Annual Executive Incentive Compensation Plan Exhibit (10)(iii) -- United Technologies Corporation * Disability Insurance Benefits for Executive Control Group Exhibit (10)(iv) -- United Technologies Corporation * Executive Estate Preservation Program Exhibit (10)(v) -- Pension Preservation Plan * Exhibit (10)(vi) -- Senior Executive Severance Plan * Exhibit (10)(vii) -- United Technologies Corporation * Deferred Compensation Plan Exhibit -- Otis Elevator Company Incentive (10)(viii) * Compensation Plan Exhibit (10)(ix) -- Directors Retirement Plan * Exhibit (10)(x) -- United Technologies Corporation * Deferred Compensation Plan for Non-Employee Directors Exhibit (10)(xi) -- United Technologies Corporation * Long Term Incentive Plan Exhibit (10)(xii) -- United Technologies Corporation * Executive Disability, Income Protection Plan and Standard Separation Agreement Exhibit -- United Technologies Corporation * (10)(xiii) Directors' Restricted Stock/Unit Program Exhibit (10)(xiv) -- United Technologies Corporation Directors' Stock and Deferred Stock Unit Retainer Program _______________ * Incorporated by reference (see Item 14). PAGE Exhibit (10)(xv) -- United Technologies Corporation Pension Replacement Plan Exhibit (11) -- Statement re Computation of Per Share Earnings Exhibit (12) -- Computation of Ratio of Earnings to Fixed Charges Exhibit (13) -- Annual Report to Shareowners for year ended December 31, 1993 Exhibit (22) -- Subsidiaries of the Registrant Exhibit (25) -- Powers of Attorney of Howard H. Baker, Jr., Antonia Handler Chayes, Robert F. Daniell, Robert F. Dee, Charles W. Duncan, Jr., Pehr G. Gyllenhammar, Gerald D. Hines, Charles R. Lee, Robert H. Malott, and Jacqueline G. Wexler PAGE PAGE

18926_1993.txt

18926_1993

1993

18926

Item 1. Business. Century Telephone Enterprises, Inc. ("Century") is a regional diversified telecommuni-cations company that is primarily engaged in providing traditional telephone services and mobile communications services. For the year ended December 31, 1993, telephone operations and mobile communications operations provided 80% and 20%, respectively, of the consolidated revenues of Century and its subsidiaries (the "Company"). All of the Company's operations are conducted within the continental United States. At December 31, 1993 the Company's telephone subsidiaries operated over 434,000 telephone access lines, primarily in rural, suburban and small urban areas in 14 states, with the largest customer bases located in Wisconsin, Louisiana, Michigan, Ohio and Arkansas. Based on the number of access lines served, the Company is the fifteenth largest local exchange telephone company in the United States. Whenever used herein with respect to the Company, (i) the term "pops" means the population of licensed cellular telephone markets (based on 1993 population estimates of Donnelly Marketing Information Services) multiplied by the Company's proportionate equity interests in the licensed operators thereof, (ii) the term "MSA" means any Metropolitan Statistical Area for which the Federal Communications Commission (the "FCC") has granted a cellular operating license and (iii) the term "RSA" means any Rural Service Area for which the FCC has granted a cellular operating license. Through its cellular operations, including those operations acquired in February 1994, the Company controls approximately 7.1 million pops in 27 MSAs, primarily concentrated in Michigan, Louisiana, Mississippi and Texas, and 32 RSAs, most of which are in Michigan, Louisiana, Arkansas and Wisconsin. The Company is the majority owner and operator in 18 of the MSAs and 13 of the RSAs, which collectively represent 5.5 million pops, and has minority interests in nine other MSAs and 19 other RSAs, which collectively represent 1.6 million pops. Of the Company's 7.1 million pops, approximately 73% are attributable to the Company's MSA interests, with the balance attributable to its RSA interests. Based on the population of the Company's majority-owned and operated MSAs and RSAs, the Company is the fifteenth largest operator of cellular telephone systems in the United States. At December 31, 1993, the Company's majority-owned cellular systems had more than 116,000 cellular subscribers, not including approximately 28,000 subscribers acquired by the Company in connection with its February 1994 acquisition of Celutel, Inc. described further below. The Company also provides paging services to customers residing in Louisiana and Michigan in conjunction with the operation of its cellular systems. The FCC has awarded only two licenses to provide cellular service in each market. During its licensing process, the FCC reserved one license for companies offering local telephone service in the market (the wireline carrier) and one license for entities unaffiliated with the local telephone company (the non- wireline carrier). Each of the MSAs that the Company operated as of December 31, 1993 and all but one of the RSAs operated by the Company are wireline markets. In April 1993 the Company acquired San Marcos Telephone Company, Inc. ("SMTC") and SM Telecorp, Inc., an affiliate of SMTC. As a result of these acquisitions, the Company acquired approximately 22,500 telephone access lines in and around San Marcos, Texas, along with a 35% ownership interest in the Austin, Texas MSA wireline cellular market and a 9.6% interest in the Texas RSA #16 wireline cellular market, together representing approximately 327,000 pops. In September 1993 the Company signed a definitive merger agreement to acquire a local exchange telephone company in Michigan which serves approximately 2,400 access lines and owns approximately 11% (representing approximately 33,000 pops) of a Michigan cellular partnership which holds the wireline licenses for two RSA cellular markets operated by the Company. This transaction is expected to be completed in March 1994. In February 1994 the Company acquired Celutel, Inc. ("Celutel"), which provides cellular mobile telephone services to approximately 28,000 customers in three MSA non-wireline cellular markets in Mississippi and two MSA non-wireline cellular markets in Texas which have a combined population of 1.4 million. Celutel's share of the pops is approximately 1.1 million. The Company is continually evaluating the possibility of acquiring additional telephone access lines and cellular interests in exchange for either cash, securities or both. Although the Company's primary focus will continue to be on acquiring telephone and cellular interests that are proximate to its properties or that serve a customer base large enough for the Company to operate efficiently, other communications interests may also be acquired. Partially as a result of 1993 acquisitions, the Company also provides long distance, operator and interactive services in certain local and regional markets, as well as certain printing and related services. The results of these operations, which are not material individually or in the aggregate, are recorded for financial reporting purposes as other income, net. Century was incorporated under Louisiana law in 1968 to serve as a holding company for several telephone companies acquired over the previous 15 to 20 years. Century's principal executive offices are located at 100 Century Park Drive, Monroe, Louisiana 71203 and its telephone number is (318) 388-9500. As of December 31, 1993, the Company employed approximately 2,800 persons, of which approximately 200 were covered by a collective bargaining agreement. TELEPHONE OPERATIONS The Company is the fifteenth largest local exchange telephone company in the United States, based on the more than 434,000 access lines it served at December 31, 1993. An access line is a single or multi-party circuit between a customer's business or residence and a central switching office. Through its operating telephone subsidiaries, Century provides services to predominately rural, suburban and small urban markets in 14 states, with Wisconsin, Louisiana, Michigan, Ohio and Arkansas accounting for the greatest share of access lines served. Future growth in telephone operations is expected to be derived from (i) acquiring additional telephone companies, (ii) providing service to new customers, (iii) upgrading existing customers to higher grades of service, (iv) increasing network usage and (v) providing additional services made possible by advances in technology. For information on developing competitive trends, see "-Regulation and Competition." The replacement of mechanical switches with digital switches is an important component of the Company's growth strategy because it allows the Company to offer new services (such as call forwarding, conference calling, caller identification, selective call ringing and call waiting) and to thereby increase utilization of existing access lines. In 1993 the Company expanded its list of premium services offered in certain service areas and plans to aggressively market these services in 1994. In addition, with digital switching the Company has been able to construct central electronic monitoring facilities that allow employees to detect operating malfunctions in digital switches and, in many cases, to correct the malfunctions without a site visit by the Company's personnel, thereby reducing maintenance costs. Progress toward increased digital switching of the Company's telephone systems is demonstrated by the change in the number of digitally switched lines as a percentage of total lines, which increased from 19% in 1982 to 93% in 1993. In addition, the Company is installing fiber optic cable in certain areas in which it operates and has provided alternative routing of telephone service over fiber optic cable networks in two of its larger operating areas. Services The Company's telephone subsidiaries derive revenue from providing (i) local telephone services, (ii) network access and long distance services and (iii) other related services. The following table reflects the percentage of total telephone revenues derived from these respective services: 1993 1992 1991 _________________________ Local service 25.4% 26.3 24.9 Network access and long distance 62.3 61.4 61.6 Other 12.3 12.3 13.5 _________________________ 100.0% 100.0 100.0 ========================= Local service revenues are generated by the provision of local exchange telephone services in the Company's franchised service areas. Network access and long distance revenues primarily relate to services provided to interexchange carriers (long distance carriers) in connection with the origination and termination of long distance telephone calls. Substantially all of the Company's interstate network access revenues are derived through pooling arrangements administered by the National Exchange Carrier Association ("NECA"). NECA receives access charges billed by the Company and other participating local exchange carriers ("LECs") to interstate long distance carriers for their use of the participating LECs' local exchange networks to complete long distance calls and subsequently distributes these revenues to such LECs based on cost separations studies or average schedule settlement agreements. The charges billed to the long distance carriers are based on tariffed access rates filed with the FCC by NECA on behalf of the Company and other participating LECs. Interstate revenues as a percentage of total telephone revenues amounted to 32.1%, 31.4% and 31.0% in 1993, 1992 and 1991, respectively. Certain of the Company's intrastate network access revenues are derived through access charges billed by the Company directly to intrastate long distance carriers. Such intrastate network access charges are based on access tariffs which are subject to state regulatory commission approval. Additionally, certain of the Company's telephone subsidiaries' intrastate network access revenues, along with intrastate long distance revenues, are derived through state pooling arrangements and are determined based on cost separation studies or special settlement arrangements. The various intrastate access charges and state pooling arrangements are intended to compensate LECs for the use of their facilities furnished in originating and terminating intrastate long distance telephone calls. Other revenues include revenues related to non-regulated telecommunications equipment and services, billing and collection services for interexchange carriers, network facilities leases and directory revenues. For further information on the regulation of the Company's revenues, see "-Regulation and Competition." Federal Financing Programs Certain of the Company's telephone subsidiaries receive long- term financing from the Rural Electrification Administration ("REA"), the Rural Telephone Bank ("RTB") and the Federal Financing Bank ("FFB"). The REA has made long-term loans to telephone companies since 1949 for the purpose of improving telephone service in rural areas. The REA continues to make new loans at interest rates that range from 5% to 7% based on borrower qualifications and the cost of money to the United States government. The RTB, established in 1971, makes long-term loans at an interest rate based on its average cost of funds as determined by statutory formula (6.35% for the fiscal year ended September 30, 1993), and in some cases makes loans concurrently with REA loans. In addition, the REA guarantees certain loans made to telephone companies by the FFB or other qualified lenders. A significant portion of the Company's telephone plant is pledged or is subject to mortgages to secure obligations of the Company's telephone subsidiaries to the REA, RTB and FFB. The amount of common stock dividends that may be paid by the Company's telephone subsidiaries is limited by certain financial requirements set forth in the mortgages. Certain of the Company's telephone subsidiaries have made applications for additional loans from the REA and RTB and intend to make further applications as needs arise. There is no assurance that these applications will be accepted or that the terms or interest rates of any future loan commitments will remain favorable. Federal budget proposals which could significantly reduce the availability of new loan commitments to the Company's telephone subsidiaries under the REA and RTB programs in future fiscal years were considered in recent years and are expected to continue to be considered. If the Company's telephone subsidiaries are unable to borrow additional funds through the REA and RTB programs and are forced to borrow from conventional lenders at market rates, the Company's cost of new loans might increase. For additional information regarding the Company's financings, see the Company's consolidated financial statements included in Item 8 herein. Regulation and Competition Traditionally, LECs have operated as regulated monopolies. Consequently, the majority of the Company's telephone operations are regulated by various state regulatory agencies (generally called public service commissions or public utility commissions) and by the FCC. Although it is anticipated that regulation will continue for some time, the form or degree of such regulation is unknown. As discussed in greater detail below under "- Developments Affecting Competition," in recent years various aspects of federal and state regulation have been subject to reexamination and ongoing modification. As further indicated below, it is expected that regulation will decrease and competition will increase in the traditionally monopolistic portions of the industry. Regulation of Rates and Related Matters. The FCC regulates the interstate services provided by the Company's telephone subsidiaries. This regulation primarily consists of the regulation of interstate access charges that are billed to interexchange carriers by the Company for use of its local network in connection with the origination and termination of interstate telephone calls. Additionally, the FCC prescribes rules and regulations for telephone companies, including a uniform system of accounts and rules regarding the separation of costs between jurisdictions and, ultimately, between services. Effective January 1, 1991 the FCC adopted price-cap regulation relating to interstate access rates for the regional Bell operating companies and GTE. An annual opportunity to elect price-cap regulation is available for other LECs. Under price- cap regulation, limits imposed on a company's interstate rates will be adjusted periodically to reflect inflation, productivity improvement and changes in certain non-controllable costs. This alternative form of regulation took effect for AT&T's interstate rates on July 1, 1989. In May 1993 the FCC adopted an optional incentive regulatory plan for LECs not subject to price-cap regulation. A LEC electing the optional incentive regulatory plan would, among other things, file tariffs based primarily on historical costs and not be allowed to participate in the relevant NECA pooling arrangements. The Company has not elected price-cap regulation or the incentive regulatory plan, but will continue to reevaluate its options on a periodic basis. Consequently, the Company's telephone subsidiaries' authorized interstate access rate of return is 11.25%, which is the rate established by the FCC for LECs not governed by price-cap regulation or the optional incentive regulatory plan. The local service rates and intrastate access charges of substantially all of the Company's telephone subsidiaries are regulated by state public service commissions. Most of these commissions also (i) regulate the sale and acquisition of LECs, (ii) prescribe depreciation rates and certain accounting procedures and (iii) regulate various other matters, including certain service standards and operating procedures. In certain states, construction and/or financing plans are also subject to regulatory approval. In recent years, Ohio, Michigan, Wisconsin and a limited number of other state legislatures and regulatory commissions have begun to relax the regulation of LECs, including rates and earnings. Other states have announced their intention to study these issues and it is expected that several such states, including states in which the Company operates, may also relax their regulation of LECs. This relaxed regulatory oversight of certain of the Company's telephone operations may permit the Company to offer new and competitive services faster than under the traditional regulatory process. Coincident with these efforts is the introduction of competition into traditionally monopolistic segments of the industry. For a more detailed discussion of these developments, see "-Developments Affecting Competition". Substantially all of the state commissions that have regulatory jurisdiction over the Company's telephone operations have statutory authority to initiate and conduct earnings reviews of the LECs that they regulate. The specific limits of their authority vary depending upon the state and their particular statutory authority with respect to rate of return regulation and authorized returns. As indicated above, several states are moving away from traditional rate of return regulation, which reduces both the incentive and authority that the respective regulatory commissions have with respect to earnings reviews. Century does not currently have any operating telephone company subject to a formal earnings investigation. However, all independent LECs in Louisiana have been the subject of an informal earnings review by the Louisiana Public Service Commission during 1993. There is no assurance that this informal review (or any other future review in Louisiana or any other state) will not lead to future revenue reductions. Moreover, in light of the movement away from traditional rate of return regulation, no assurance can be given that the Company's telephone subsidiaries will continue to earn the same rate of return that they achieved in 1993. Most of the Company's telephone subsidiaries concur with the common line and traffic sensitive tariffs filed by NECA and participate in the access revenue pools administered by NECA for interstate services. All of the Company's telephone subsidiaries' long distance and intrastate network access revenues are based on access charges, cost separation studies or special settlement arrangements. See "-Services." Recently, the FCC and certain state public utility commissions have explored or implemented initiatives to reduce the funding of certain support mechanisms that have traditionally benefited LECs serving small communities and rural areas. In 1993 the eight-year phase-in of the FCC's mandated Universal Service Fund ("USF") was completed. In December 1993 the FCC adopted a provision which places certain limitations, including a cap, on the USF growth rate during 1994 and 1995. The Company anticipates that, subsequent to 1993, revenues from the USF will continue to increase in the near term, but at a lesser percentage rate than that associated with recent prior periods. The FCC has announced that it intends to comprehensively study the USF during 1994 and 1995 to determine if permanent rule changes should be effected. In addition, the Public Service Commission of Wisconsin ("PSCW") has ordered the existing Wisconsin state support fund to be phased-out over one and one-half years beginning July 1, 1993. Certain of the Company's subsidiaries affected by the order have filed requests with the PSCW to receive increased rates and/or compensation which could potentially offset some or all of the amounts that those subsidiaries have been receiving from such support fund. All such additional revenue must be justified based on each subsidiary's financial need as demonstrated by an expedited rate case. Certain long distance carriers have requested the Company to reduce intrastate access tariffed rates for certain of its telephone subsidiaries. Although intrastate access tariffed rates are subject to state regulatory commission approval, there is no assurance that final resolution of these requests will not result in reduced intrastate access revenues. Developments Affecting Competition. Primarily as a result of regulatory and technological changes, competition has been introduced and encouraged in certain sectors of the telephone industry, including interstate and intrastate toll, special access services and customer premise equipment. In 1992 the FCC took a step toward introducing competition in the local exchange access business by ordering that competitive access providers, interexchange carriers and others have the right to directly interconnect facilities to the central offices of certain larger (Tier One) telephone companies for the provision of interstate special transport access services. The intent of this order and other related FCC decisions is to allow interstate special access competition with telephone companies and provide telephone companies with limited pricing flexibility. In a related proceeding the FCC also issued proposals to expand competitive interconnection to LECs' switched access services in the future. Principally as a result of these and other regulatory actions, competition from competitive access providers and others has increased and is expected to continue to increase. Certain states are considering steps that would further introduce competition into the LEC business. Moreover, certain well-established interexchange carriers have publicly announced their desire to enter the LEC business. Although local exchange competition and competitive access are expected to initially affect large urban areas to a greater extent than rural, suburban and small urban areas such as those in which the Company's telephone operations are located, there is no assurance that these developments will not have an adverse effect on the Company in the future. Certain providers and users of toll service may seek to bypass LECs' switching services and local distribution facilities, particularly if services are not strategically priced. There are three primary ways which users of toll service may bypass the Company's switching services. First, users may construct and operate or lease facilities to transmit their traffic to an interexchange carrier. Second, certain interexchange carriers provide services which allow users to divert their traffic from LECs' usage-sensitive services to their flat-rate services. Third, users may choose to use mobile communications services to bypass LECs' switching services. Within the past two years, each of the three largest interexchange carriers in the United States has acquired, or has entered into preliminary or definitive agreements to acquire interests in mobile communications companies, presumably in part to obtain bypass capabilities. Although certain of the Company's telephone subsidiaries have experienced a loss of traffic to such bypass, the impact of such loss on revenues has not been significant. The Company and the exchange carrier industry are seeking to address bypass by adopting flexible pricing of access and toll services where appropriate, although no assurance can be given as to the ultimate outcome of these efforts. As the mobile communications industry matures, the Company anticipates that existing and emerging mobile communications technologies will increasingly compete with traditional LEC services. Technological and regulatory developments in cellular telephone, personal communications services, digital microwave, coaxial cable, fiber optics and other wired and wireless technologies are expected to further permit the development of alternatives to traditional landline services . For further information on these developments, see "Mobile Communications Operations - Regulation and Competition." In connection with the well-publicized convergence of telecommunications, cable, video, computer and other technologies, several large companies have recently announced plans to offer products that would significantly enhance current communications and data transmission services and, in some instances, introduce new two-way video, entertainment, data, consumer and other multimedia services. In particular, several large cable television companies have announced plans that, if successfully implemented, could provide significant competition with LECs' traditional services. Other companies with wireline experience (including electric utilities) are expected to explore opportunities in this market, along with wireless companies and other emerging technology companies. Although the development of new multimedia services is expected to initially have a greater effect on larger urban areas, no assurance can be given as to how the offering of these products or services by others will affect the Company. For information on the effects of these developments on the Company's cellular operations, see "Mobile Communications Operations - Regulation and Competition." Several bills have been filed in the U. S. Congress that have the potential to significantly alter the telecommunications industry and its regulatory framework. Several of these bills are designed to promote local telephone competition and obligate LECs to provide competitors with universal access to their networks and facilities. Several others are designed to remove barriers of entry to several lines of telecommunications businesses, including current barriers that prohibit the regional Bell operating companies and others from providing interstate and intrastate services and that prohibit LECs from providing cable television services. In addition, the Clinton administration and Congress have proposed legislative and regulatory initiatives to promote wireless technologies as part of the development of a national information infrastructure. Although it is currently impossible to assess the ultimate effect of these initiatives, there can be no assurances that those bills, or others that may follow, will not materially affect the Company's telephone or cellular operations. The Company anticipates that the traditional operations of LECs will increasingly be affected by continued technological developments and continued legislative and regulatory initiatives affecting the ability of LECs to provide new services and the ability of cable companies, interexchange carriers, competitive access providers and others to provide competitive LEC services. The Company intends to actively monitor these developments, to observe the effect of emerging competitive trends in initial test markets (which are expected to be large urban areas) and to continue to evaluate new business opportunities that may arise out of future technological, legislative and regulatory developments. MOBILE COMMUNICATIONS OPERATIONS The Company is the fifteenth largest operator of cellular telephone systems in the United States, based on the population of the Company's majority-owned and operated MSAs and RSAs. The number of pops owned by a cellular operator does not represent the number of users of cellular service and is not necessarily indicative of the number of potential subscribers. Rather, this term is frequently used as a basis for comparing the size of cellular system operators. At December 31, 1993, the Company's pops exceeded 5.9 million. Over 1.1 million additional pops were acquired in the February 1994 acquisition of Celutel. Of the approximately 7.1 million pops controlled by the Company, approximately 5.2 million (73%) are applicable to MSAs and approximately 1.9 million (27%) are RSA pops. Cellular Industry The cellular telephone industry has been in existence for just over ten years in the United States. Although the industry is 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 approximately 16 million cellular customers across the United States. Cellular service is now available to substantially all areas of the United States. Cellular mobile telephone technology was developed in response to certain limitations of conventional mobile telephone systems. Compared to such conventional systems, cellular mobile telephone service is capable of high-quality, high-capacity communications to and from vehicle-mounted and hand-held radio telephones. While conventional mobile systems limit the number of people who can utilize the service simultaneously, cellular systems, if properly designed and equipped, are capable of handling thousands of calls at any given time and are capable of providing service to tens of thousands of subscribers in a market. In a cellular telephone system, the licensed service area is subdivided into geographic areas or cells. Each cell has its own transmitter and receiver that communicates by radio signal with cellular telephones located within the cell. Each cell is connected by a telephone circuit or microwave to a Mobile Switching Center ("MSC"), which in turn is connected to the worldwide telephone network. Communications within a cellular system are controlled by the MSC through a transfer process as a cellular telephone user moves from one cell to another. In this process, when the signal strength of a call declines to a predetermined level, the MSC determines if the signal strength from an adjacent cell is greater and, if so, transfers the call to the adjacent cell. Software which facilitates the transfer between adjacent cells of different cellular systems using equipment of different manufacturers has been implemented by the Company in certain markets. Cellular telephone systems have higher subscriber capacity than conventional mobile telephone systems because of the substantial frequency spectrum allocated to these systems by the FCC and because frequencies can be reused throughout the system. Frequency reuse is possible because the transmission power of cell site equipment and mobile units is relatively low. Therefore, signals on the same channel will not interfere with each other if they are transmitted in cells that are sufficiently far apart. Reuse multiplies the capacity of channels available to the system operator and thereby increases the telephone calling capacity. Until recently, substantially all of the radio transmissions of cellular systems were conducted on an analog basis. Technological developments involving the application of digital radio technology may offer certain advantages over analog technologies, including expanding the capacity of mobile communications systems, improving voice transmission quality, permitting the introduction of new services, and otherwise making such systems more efficient, more accessible, more private and eventually less expensive. Providers of certain competitive services are currently incorporating digital technology into their operations, and may be expected to continue to do so in the future. See "-Regulation and Competition-Developments Affecting Competition." In recent years certain cellular carriers have begun to install digital cellular voice transmission facilities in certain larger markets. During 1993 the Company upgraded certain portions of its cellular systems in Louisiana and Michigan to be capable of providing digital service in the future. The Company will continue to monitor the development and implementation of this technology to determine when it will become beneficial for the Company to install digital cellular voice transmission facilities. See "-Regulation and Competition-Developments Affecting Competition." Strategy The Company's business development strategy for its cellular telephone operations is to secure operating control of service areas that are geographically clustered. Clustered cellular systems aid the Company's marketing efforts and provide various operating and service advantages. After giving effect to those operations acquired in February 1994, 51% of the Company's pops in markets operated by the Company were in a single, contiguous cluster of eight MSAs and six RSAs in Michigan; another 19% were in a cluster of four MSAs and seven RSAs in northern and central Louisiana, southern Arkansas and eastern Texas. Another component of the Company's strategy for cellular operations includes capturing revenues from roaming service. Roaming service revenues are derived from calls made in one cellular service area by subscribers from other service areas. Roaming service is made possible by technical standards requiring that cellular telephones be functionally compatible with the cellular systems in all United States market areas. The Company charges premium rates (compared to rates charged to the Company's customers) for roaming service provided to most non-Company customers. The Company's Michigan cellular properties include a significant portion of the interstate highway corridor between Chicago and Detroit, and its Louisiana properties include an east- west interstate highway and a north-south interstate highway which intersect in its Louisiana cellular service area. In connection with its February 1994 acquisition of Celutel, the Company acquired over 84 percent of the Biloxi/Gulfport, Mississippi MSA and over 82% the Pascagoula, Mississippi MSA. The interstate highway between New Orleans, Louisiana and Mobile, Alabama spans these markets. In connection with this acquisition, the Company also acquired over 86% interest in the Jackson, Mississippi MSA; over 77% in the Brownsville, Texas MSA; and over 67% in the McAllen, Texas MSA. Jackson is the state capital and is located in central Mississippi where two interstate highways intersect. The MSAs in Texas are adjacent to Mexico and consist of urban, resort, farm and ranch areas and include two Foreign Trade Zones. Marketing The Company coordinates the marketing strategy for each cellular system in which it has a majority interest. The Company's cellular sales force consists of approximately 60 sales employees and approximately 200 independent agents. Each sales employee and independent agent solicits cellular customers exclusively for the Company. Company sales employees are compensated by salary and commission and independent sales agents are paid commissions. The Company advertises its services through various means, including direct mail, billboard, magazine, radio, television and newspaper advertisements. The Company is a founding partner and participant in a national alliance of 15 leading mobile communications companies which is marketing a national brand of cellular service under the name MobiLink. This cellular alliance offers a customer satisfaction guarantee and certain quality standards. Services, Customers and System Usage There are a number of different types of cellular telephones, all of which are currently compatible with cellular systems nationwide. The Company sells a full range of vehicle-mounted, transportable, and hand-held portable cellular telephones. Features offered in the cellular telephones sold by the Company include hands-free calling, repeat dialing, horn alert and others. 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 typically charges its customers separately for custom-calling features, air time in excess of the packaged amount, and toll calls. Custom-calling features provided by the Company include call-forwarding, call-waiting, three-way calling and no-answer transfer. The Company 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. Cellular customers come from a wide range of occupations. They typically include a large proportion of individuals who work outside of their office, such as employees in the construction, real estate, wholesale and retail distribution businesses, and professionals. More customers are selecting portable and other transportable cellular telephones as these units become more compact and fully featured, as well as more attractively priced. It is anticipated that average revenue per customer will continue to decline as additional non-commercial customers who generate fewer local minutes of use are added as subscribers and as roaming revenues grow more slowly. An added service offered by the Company 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. These agreements offer the Company's customers the opportunity to roam in these systems. These reciprocal agreements automatically pre-register the customers of the Company's system in the other carriers' systems. Also, a customer of a participating non-Company system traveling in a market operated by the Company where this arrangement is in effect is able to automatically make and receive calls on the Company's system. The charge to a non-Company customer 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. Occasionally, the Company will enter into reciprocal agreements with other cellular carriers to settle roaming usage at a rate different from such premium rates. In some instances, based on competitive factors, the Company may charge a lower amount to its customers than the amount actually charged by another cellular carrier for roaming. The Company anticipates that competitive factors may place downward pressures on charging premium roaming rates. For additional information on roaming revenue, see"-Strategy." During 1993, the Company's cellular subsidiaries experienced strong subscriber growth in the fourth quarter, primarily due to increased holiday season sales. According to the Cellular Telecommunications Industry Association, industry-wide cellular sales have been seasonally strong in the fourth quarter for the past several years. The following table summarizes, among other things, certain information about the Company's customers and market penetration (without giving effect to the operations acquired in February 1994): Notes: 1. Represents the number of systems in which the Company owned at least a 50% interest and which it operated. The revenues and expenses of these cellular markets are included in the Company's consolidated revenues and expenses. 2. Represents the approximate number of revenue-generating cellular telephones served by the cellular systems referred to in footnote 1. 3. Computed by dividing the number of customers at the end of the period by the total population of markets in service as estimated by Donnelly Marketing Information Services for the respective years. 4. Represents the total number of systems that the Company operated, including systems in which it does not own a controlling interest. 5. Represents the approximate number of revenue-generating cellular telephones served in all systems that the Company operated, including systems in which it does not own a controlling interest. The Company's Cellular Interests The table below sets forth certain information with respect to the interests in cellular systems that the Company owned or had the right to acquire pursuant to definitive agreements as of December 31, 1993: (1) To the best of the Company's knowledge. (2) Markets not operated by the Company. (3) Represents a non-wireline interest. Certain Considerations Regarding Cellular Telephone Operations The cellular industry has a relatively limited operating history and there continues to be uncertainty regarding its future. Among other factors, there is uncertainty regarding (i) the continued growth in the number of customers, (ii) the usage and pricing of cellular services, particularly as market penetration increases and lower-usage customers subscribe for service, (iii) the number of customers who will terminate service each month, and (iv) the impact of changes in technology, regulation and competition, any of which could have a material adverse effect on the Company. See " - Regulation and Competition." Management believes that a significant portion of the aggregate market value of Century's common stock is represented by the current market value of its cellular interests. There can be no assurance that the market value of its cellular interests will remain at its current level. Management believes that decreases in the market value of such interests could materially decrease the trading price of Century common stock. The market value of cellular interests is frequently determined on the basis of the number of pops controlled by a cellular provider. The population of a particular cellular market, however, does not necessarily bear a direct relationship to the number of subscribers or the revenues that may be realized from the operation of the related cellular system. The future market value of the Company's cellular interests will depend on, among other things, the success of its cellular operations. Paging As part of the Company's strategy of focusing its resources in the cellular and telephone businesses, the Company's Florida paging operations were sold during 1991. The Company continues to provide paging services to customers in Michigan and Louisiana in conjunction with the operation of its majority-owned cellular systems. As of December 31, 1993, the Company had approximately 9,500 pagers in service. Revenue The following table reflects the major revenue categories for the Company's mobile communications operations as a percentage of total mobile communications revenues in 1993, 1992 and 1991. 1993 1992 1991 _________________________ Cellular access fees, toll revenues and equipment sales 80.5% 78.6 72.4 Cellular roaming 14.5 14.3 16.4 Paging services 5.0 7.1 11.2 _________________________ 100.0% 100.0 100.0 ========================= For further information on these revenue categories, see"- Services, Customers and System Usage" and "- Paging." Regulation And Competition The FCC and various state public utility commissions regulate the licensing, construction, operation, interconnection arrangements, sale and acquisition of cellular telephone systems and certain state public utility commissions also regulate certain aspects of pricing by cellular operators. Cellular Licensing Process. The FCC awarded only two licenses to provide cellular service in each market. Each licensee is required to provide service to a designated portion of the area or population in its licensed area as a condition to maintaining that license. Initially, one license was reserved for companies offering local telephone service in the market (the wireline carrier) and one license was available for firms unaffiliated with the local telephone company (the non-wireline carrier). Since mid-1986, the FCC has permitted telephone companies or their affiliates to acquire control of non-wireline licenses in markets in which they do not hold interests in the wireline license. The completion of acquisitions involving the transfer of control of a cellular system requires prior FCC approval and, in certain cases, receipt of other federal and state regulatory approvals. 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 application for approval of the proposed transfer. Initial operating licenses are granted for ten-year periods and are renewable upon application to the FCC for periods of ten years. Licenses may be revoked and license renewal applications denied for cause. There may be competition for licenses upon the expiration of the initial ten-year terms and there is no assurance that any license will be renewed, although the FCC has issued a decision that grants a renewal expectancy during the license renewal period to incumbent licensees that substantially comply with the terms and conditions of their cellular authorizations and the FCC's regulations. The licenses for the MSA markets operated by the Company were initially granted between 1984 and 1987, and licenses for operated RSAs were initially granted between 1989 and 1991. Five years after initial operating licenses are granted, unserved areas within markets previously granted to licensees may be applied for by both wireline and non-wireline entities and by third parties. The FCC has rules that govern the procedures for filing and granting such applications and has established requirements for constructing and operating systems in such areas. The Company has not lost, and does not expect to lose, any significant market areas as a result of not providing service to such areas. In addition to regulation by the FCC, cellular systems are subject to certain Federal Aviation Administration tower height regulations respecting the siting and construction of cellular transmitter towers and antennas. Competition between cellular providers in each market is conducted principally on the basis of services and enhancements offered, the technical quality and coverage of the system, quality and responsiveness of customer service, and price. Competition may be intense. For a listing of the Company's competitors in cellular markets operated by the Company, see "- The Company's Cellular Interests." Under applicable law, the Company is required to permit the reselling of its services. In certain larger markets and in certain market segments, competition from resellers may be significant. There is also competition for agents. Some of the Company's competitors have greater assets and resources than the Company. Developments Affecting Mobile Communications Competition. Continued and rapid technological advances in the communications field, coupled with legislative and regulatory uncertainty, make it impossible to (i) predict the extent of future competition to cellular systems, (ii) determine which emerging technologies pose the most viable alternatives to the Company's cellular operations, or (iii) systematically list each development that may ultimately impact the Company's cellular operations. No assurance can be given that current or future technological advances, or legislative or regulatory changes, will not impact the Company's cellular operations. Several recent FCC initiatives have resulted in the allocation of additional radio spectrum or the issuance of experimental licenses for emerging mobile communications technologies that will or may be competitive with the Company's cellular and telephone operations, including personal communication services ("PCS"). Due to PCS' next generation, high-capacity digital technology (which has been tested under experimental licenses since late 1989), PCS may be able to offer wireless data, image and other advanced wireless services. In late 1993, the FCC proposed rules for auctioning up to seven PCS licenses per market, two of which would entitle the licensees to use 30 megahertz ("MHz") of frequency band each, one of which would entitle the licensee to use 20 MHz, and four of which would entitle the licensees to use 10 MHz each. These rules would divide the United States into 540 licensed markets, none of which would be co-terminus with current cellular markets. Under these rules, the Company will be permitted to freely pursue PCS licenses outside its cellular markets, but will be limited to acquiring only one 10 MHz block in licensed areas where it controls more than a 20% interest in a cellular licensee and serves more than 10% of the population within the PCS licensed area. Auctioning of certain PCS licenses is anticipated to commence in 1994. Due to several pending petitions to reconsider these rules, it is possible that the final rules will be modified. In addition to PCS, users and potential users of cellular systems may find their communication needs satisfied by other current and developing technologies, several of which may enjoy potential operational and service advantages through their use of digital technology. The FCC has recently authorized the licensees of certain specialized mobile radio service ("SMR") systems (which currently are generally used by taxicabs and tow truck operators) to configure their systems so as to operate in a manner similar to cellular systems. The Company believes that SMR systems are operating in a majority of its cellular markets. Certain well- established SMR providers have announced their intention to create a nationwide digital mobile communications system to compete with cellular systems, and in connection therewith have sought and obtained financial and other assistance from various other well- established telecommunication companies. Other similar communication services which have the technical capability to handle mobile telephone calls may provide competition in certain markets, although these services currently lack the subscriber capacity of cellular systems. One-way paging or beeper services that feature voice message and data display as well as tones may be adequate for potential subscribers who do not need to transmit back to the caller. Other two-way mobile services may also be competitive with the Company's services. For example, the second generation of cordless telephone technology ("CT-2") will permit the application of this technology to a public environment. The FCC has taken various actions to authorize mobile satellite systems in which transmissions from mobile units to satellites would augment or replace transmissions to land-based stations. It is anticipated that the first operational satellite- based mobile communications system will serve primarily rural customers in North America. However, other satellite-based systems are being studied and designed, including a worldwide- system backed by an international consortium, and no assurance can be given that such systems will not ultimately be successful in augmenting or replacing land-based cellular systems. As described further under "Telephone Operations - Regulation and Competition," in connection with the well-publicized convergence of telecommunications, cable, video, computer and other technologies, several large companies have recently announced plans to offer products that would significantly enhance current communications and data transmissions services and, in some instances, introduce new services. Although much of the resulting competition is expected to center on wireline services, it is anticipated that these developments may also increase competition in the mobile communications industry. Several wireless data and computer companies are currently developing and, in some instances, marketing small hand-held products that may ultimately provide an additional source of competition for cellular systems, and it is anticipated that this trend will continue. As also described further under "Telephone Operations - Regulation and Competition," several bills have been filed in the U.S. Congress that have the potential to significantly alter the telecommunications industry, including various bills that focus on the mobile communications industry. It is uncertain how PCS, SMR, CT-2, mobile satellites and other emerging technologies will ultimately affect the Company. However, PCS, SMR, CT-2 and mobile satellites are not anticipated to be significant sources of competition in the Company's markets in the near term. Moreover, management believes that equipping its current cellular networks with digital enhancements and applying new microcellular technologies may permit its cellular systems to provide services comparable with the emerging technologies described above, although no assurances can be given that this will happen or that future technological advances or legislative or regulatory changes will not create additional sources of competition. Paging. There is vigorous competition for paging customers in most of the areas served by the Company. Some of the Company's competitors have greater assets and resources than the Company. The paging companies compete on the basis of price, the reliability and strength of their signals, the size of the area served and the customer service they provide. In recent months, certain other companies have reduced prices on nationwide paging services, a development which is not expected to have a substantial impact on the Company's consolidated operations. The FCC has authorized the use of cellular frequencies to provide paging service, creating the potential for new competitors. It is anticipated that all or substantially all of the developments described in the immediately preceding section will affect the Company's paging operations. It is too early to predict the extent to which these developments may affect the Company. OTHER The Company has certain obligations based on federal, state and local laws relating to the protection of the environment. Costs of compliance through 1993 have not been material and the Company currently has no reason to believe that such costs will become material. For additional information concerning the business and properties of the Company, see notes 2, 6, 7 and 12 of Notes to Consolidated Financial Statements set forth in Item 8 elsewhere herein. Item 2. Item 2. Properties. The Company's properties consist principally of (i) telephone lines, central office equipment, telephone instruments and related equipment, and land and building related to telephone operations and (ii) switching and cell site equipment related to cellular telephone operations. As of December 31, 1993, the Company's gross property, plant and equipment of approximately $1.2 billion consisted of the following: Telephone: General support 7.3% Central office equipment 24.0 Information origination/termination equipment 3.1 Cable and wire 43.8 Construction in progress 4.6 Other .9 _____ 83.7 Mobile Communications 9.7 Other 6.6 _____ 100.0% ===== "General support" consists primarily of land, buildings, tools, furnishings, fixtures, motor vehicles and work equipment. "Central office equipment" consists primarily of switching equipment, circuit equipment, and related facilities. "Information origination/termination equipment" consists primarily of premise equipment (private branch exchanges and telephones) for official company use. "Cable and wire" facilities consist primarily of buried cable and aerial cable, poles, wire, conduit and drops. "Construction in progress" includes property of the foregoing categories that has not been placed in service because it is still under construction. The properties of the Company's telephone subsidiaries are subject to mortgages securing the funded debt of such companies. The Company owns substantially all of the central office buildings, local administrative buildings, warehouses, and storage facilities used in its telephone operations. The Company leases most of the offices used in its cellular operations; certain of its transmitter sites are leased while others are owned by the Company. For further information on the location and type of the Company's properties, see the descriptions of the Company's telephone and mobile communications operations in Item 1. Item 3. Item 3. Legal Proceedings. From time to time, the Company is involved in litigation incidental to its business, including administrative hearings of state public utility commissions relating primarily to rate making, tort actions relating to employee claims and occasional grievance hearings before labor regulatory agencies. Currently, there are no material legal proceedings. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Not applicable. Executive Officers of the Registrant Information concerning Executive Officers, set forth at Item 10 in Part III hereof, is incorporated in Part I of this Report by reference. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Century's common stock is listed on the New York Stock Exchange and is traded under the symbol CTL. The following table sets forth the high and low sale prices, along with the quarterly dividends, for each of the quarters indicated: Sale prices __________________ Dividend per High Low common share ____ ___ ____________ 1992: First quarter $ 24-7/8 18-5/8 .0733 Second quarter $ 25-3/8 18-3/8 .0733 Third quarter $ 25 18-5/8 .0733 Fourth quarter $ 28-7/8 22-7/8 .0733 1993: First quarter $ 33-3/8 26 .0775 Second quarter $ 33-1/8 28 .0775 Third quarter $ 31-5/8 27-1/8 .0775 Fourth quarter $ 30-3/8 23-1/4 .0775 Common stock dividends during 1992 and 1993 were paid each quarter. As of February 28, 1994, there were approximately 5,900 stockholders of record of Century's common stock. Item 6. Item 6. Selected Financial Data. The following table presents certain selected consolidated financial data as of and for each of the years ended in the five- year period ended December 31, 1993. Selected Income Statement Data Selected Balance Sheet Data The following table presents certain selected consolidated operating data as of the end of each of the years in the five-year period ended December 31, 1993. See Items 1 and 2 in Part I and notes 4, 8 and 12 of Notes to Consolidated Financial Statements set forth in Item 8 elsewhere herein for additional information. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. RESULTS OF OPERATIONS The 1993 net income of Century Telephone Enterprises, Inc. and subsidiaries (the "Company") increased to $69,004,000 from $44,305,000 during 1992 and $37,419,000 during 1991. Income before the cumulative effect of changes in accounting principles during 1992 was $59,973,000. Fully diluted earnings per share for 1993 increased to $1.32 from $.91 during 1992 and $.79 during 1991. Fully diluted earnings per share in 1992 before the cumulative effect of changes in accounting principles was $1.22. As of January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106 ("SFAS 106"), "Employers' Accounting for Postretirement Benefits Other than Pensions," and Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes." The cumulative effect of the changes in accounting principles related to SFAS 106 and SFAS 109 reduced 1992 net income by $14,755,000 ($.30 per share) and $913,000 ($.01 per share), respectively. The Company is a regional diversified telecommunications company that is primarily engaged in providing traditional telephone services and cellular mobile telephone services. The Company's 1993 operating income was $124,808,000, an increase of $15,180,000 (13.8%) over 1992 operating income of $109,628,000. During 1993 the operating income of the telephone operations and the mobile communications operations increased $11,230,000 (10.8%) and $3,950,000 (66.3%), respectively, compared to the 1992 results of operations. The Company's net operating income during 1991 was $75,087,000. Year ended December 31, 1993 1992 1991 ================================================================== (expressed in thousands, except per share amounts) Operating income (loss) Telephone $ 114,902 103,672 80,039 Mobile Communications 9,906 5,956 (4,952) __________________________________________________________________ 124,808 109,628 75,087 Interest expense (30,149) (27,166) (22,504) Earnings from unconsolidated cellular partnerships 6,626 1,692 697 Gain on sales of assets 1,661 3,985 - Other income, net 3,310 4,433 4,209 Income tax expense (37,252) (32,599) (20,070) __________________________________________________________________ Income before cumulative effect of changes in accounting principles 69,004 59,973 37,419 Cumulative effect of changes in accounting principles - (15,668) - __________________________________________________________________ Net income $ 69,004 44,305 37,419 ================================================================== Fully diluted earnings per share: Income before cumulative effect of changes in accounting principles $ 1.32 1.22 .79 Cumulative effect of changes in accounting principles - (.31) - __________________________________________________________________ Fully diluted earnings per share $ 1.32 .91 .79 ================================================================== The operating income of the telephone segment includes the operations, subsequent to each respective acquisition, of Century Telephone of San Marcos, Inc. ("San Marcos"), acquired in April 1993; Century Telephone of Ohio, Inc. ("Ohio"), acquired in April 1992; and two other local exchange telephone companies collectively with Ohio the "1992 Acquisitions") acquired during the first quarter of 1992. See note 12 for additional information applicable to these acquisitions. The mobile communications operating income (loss) reflects the operations of the cellular partnerships in which the Company has a majority interest. The minority interest partners' share of the income or loss of such partnerships is reflected in other income, net. The Company's share of income or loss from the cellular partnerships in which it has less than a majority interest is reflected in earnings from unconsolidated cellular partnerships. The operating income of the mobile communications segment during 1993 includes the operations of the Alexandria, Louisiana Metropolitan Statistical Area ("MSA") cellular system ("Alexandria"), which was acquired in December 1992. According to published sources, the Company has the second highest ratio of cellular subscribers to telephone access lines among the 20 largest telephone companies in the United States. Accordingly, the Company anticipates that its mobile communications operations will continue to increasingly influence the Company's overall operations as the cellular industry matures. The following chart illustrates this trend: Year ended December 31, 1993 1992 1991 ================================================================== Telephone Operations: Revenues (% of total revenues) 80.4% 82.7 83.5 Operating income (% of total operating income) 92.1% 94.6 106.6 Mobile Communications Operations: Revenues (% of total revenues) 19.6% 17.3 16.5 Operating income (% of total operating income) 7.9% 5.4 (6.6) ================================================================== TELEPHONE OPERATIONS 1993 1992 1991 ================================================================== (expressed in thousands) Revenues Local service $ 88,704 78,108 58,653 Network access and long distance 217,055 182,711 145,279 Other 42,726 36,691 31,864 __________________________________________________________________ 348,485 297,510 235,796 __________________________________________________________________ Expenses Plant operations 80,578 66,878 52,546 Customer operations 32,225 26,242 19,502 Corporate and other 55,605 46,791 39,227 Depreciation and amortization 65,175 53,927 44,482 __________________________________________________________________ 233,583 193,838 155,757 __________________________________________________________________ Operating income $ 114,902 103,672 80,039 ================================================================== Telephone revenues increased $50,975,000 (17.1%) in 1993 and $61,714,000 (26.2%) in 1992. Revenues applicable to San Marcos and Ohio accounted for $15,681,000 and $14,833,000, respectively, of the 1993 increase and revenues applicable to the 1992 Acquisitions accounted for $34,891,000 of the 1992 increase. Amounts recorded as a result of revisions of prior years' revenue settlements were $8,380,000 (exclusive of Ohio), $8,181,000 and $8,206,000 in 1993, 1992 and 1991, respectively. Local Revenues Local service revenues are derived from the provision of local exchange telephone services in the Company's franchised service areas. During 1993 local service revenues increased $2,219,000 and $5,252,000 due to San Marcos and Ohio, respectively. During 1992 such revenues increased $15,670,000 due to the 1992 Acquisitions. Internal access line growth during 1993, 1992 and 1991 was 3.6%, 3.8% and 3.2%, respectively. Network Access and Long Distance Revenues Network access and long distance revenues increased $34,344,000 (18.8%) in 1993 and $37,432,000 (25.8%) in 1992 due to the following factors: 1993 1992 ================================================================== (expressed in thousands) San Marcos acquisition $ 11,279 - 1992 Acquisitions 8,458 13,687 Partial recovery of increased operating expenses through revenue pools in which the Company participates with other telephone companies and return on rate base 7,326 9,931 Increased recovery as a result of additional investment and phase-in of the Federal Communications Commission ("FCC") mandated Universal Service Fund 6,161 7,040 Increased minutes of use 3,444 3,607 Other (2,324) 3,167 __________________________________________________________________ $ 34,344 37,432 ================================================================== Network access and long distance revenues primarily relate to services provided to interexchange carriers (long distance carriers) in connection with the completion of long distance telephone calls. Substantially all of the Company's interstate network access revenues are received through pooling arrangements administered by the National Exchange Carrier Association ("NECA") based on cost separations studies and average schedule settlement agreements. The NECA receives access charges billed by the Company and other participating local exchange carriers to interstate long distance carriers for their use of the local exchange network to complete long distance calls. These charges to the long distance carriers are based on tariffed access rates filed with the FCC by the NECA on behalf of the Company and other participating local exchange telephone companies. Long distance and intrastate network access revenues are based on access rates, cost separations studies or special settlement arrangements with intrastate long distance carriers. In December 1993 the eight-year phase-in of the FCC Universal Service Fund ("USF") was completed. Revenues from the USF increased approximately $6,161,000 during 1993, of which approximately $3,200,000 was the effect of the phase-in. Revenues were unfavorably impacted in the amount of $1,000,000 during 1993 by reductions (which will aggregate approximately $3,500,000 annually upon final phase-in 1994) in the level of certain settlements received from South Central Bell by the Company's Louisiana subsidiaries. Other Revenues Other revenues include revenues related to nonregulated telecommunications equipment and services, billing and collection services for interexchange long distance carriers, network facilities leases and directories. The increases in other revenues during 1993 and 1992 were primarily due to the 1992 Acquisitions and, during 1993, to San Marcos. Expenses Plant operations expenses during 1993 and 1992 increased $13,700,000 (20.5%) and $14,332,000 (27.3%), respectively. Approximately $3,650,000 and $3,455,000 of the 1993 increase were due to San Marcos and Ohio, respectively. Increases in salaries, wages and benefits during 1993 accounted for approximately $2,192,000. The remainder of the 1993 increase was due to increases in other general operating expenses. Approximately $10,269,000 and $1,105,000 of the 1992 increase were due to the 1992 Acquisitions and the SFAS 106 postretirement benefit costs, respectively. The remainder of the 1992 increase was due to increases in salaries and wages and other general operating expenses. Customer operations, corporate expenses and other expenses increased $14,797,000 (20.3%) in 1993 and $14,304,000 (24.4%) in 1992. The operations of San Marcos and Ohio contributed $6,467,000 and $4,532,000, respectively, to the 1993 increase. The 1992 Acquisitions and the SFAS 106 postretirement benefit costs accounted for approximately $11,186,000 and $806,000, respectively, of the 1992 increase. The remainder of the 1993 and 1992 increases included increased operating costs, such as salaries and wages, employee benefits, insurance and operating taxes. Depreciation and amortization increased $11,248,000 (20.9%) and $9,445,000 (21.2%) in 1993 and 1992, respectively. Approximately $5,447,000 of the 1993 increase was due to San Marcos and Ohio. The 1992 Acquisitions accounted for $6,939,000 of the 1992 increase. Depreciation expense included one-time depreciation charges in certain jurisdictions which aggregated $3,336,000 in 1993 (exclusive of San Marcos), $2,938,000 in 1992 (exclusive of the 1992 Acquisitions) and $1,784,000 in 1991. In addition, the Company obtained higher depreciation rates for certain subsidiaries during the last three years. The first-year effects of the higher rates were approximately $1,650,000 in 1993 (exclusive of San Marcos), $700,000 in 1992 (exclusive of the 1992 Acquisitions) and $3,100,000 in 1991. The remaining increases in depreciation and amortization are due to higher levels of plant in service. The composite depreciation rate for telephone properties, including the one-time additional depreciation, was 7.1%, 6.6% and 6.7% for 1993, 1992 and 1991, respectively. See Other Matters for additional information. MOBILE COMMUNICATIONS OPERATIONS 1993 1992 1991 ================================================================== (expressed in thousands) Revenues Cellular Service $ 76,583 54,489 38,923 Equipment 3,930 3,194 2,592 Paging 4,199 4,409 5,216 __________________________________________________________________ 84,712 62,092 46,731 __________________________________________________________________ Expenses General, administrative and customer service 23,872 19,685 18,144 Sales and marketing 19,894 13,167 13,403 Cost of sales and other operating expenses 19,681 14,313 12,378 Depreciation and amortization 11,359 8,971 7,758 __________________________________________________________________ 74,806 56,136 51,683 __________________________________________________________________ Operating income (loss) $ 9,906 5,956 (4,952) ================================================================== Revenues Revenues from cellular operations during 1993 increased to $80,513,000 from $57,683,000 in 1992 and $41,515,000 in 1991. Service revenues include monthly service fees for providing access and airtime to customers, service fees for providing airtime to users roaming through the Company's service areas and toll revenue. Service revenues increased $22,094,000 (40.5%) in 1993 and $15,566,000 (40.0%) in 1992. Increases in access and usage revenues, exclusive of Alexandria, accounted for $14,585,000 of the 1993 increase in service revenues, compared to $12,871,000 during 1992. The increases in access and usage revenues in both years were primarily attributable to increases in the number of cellular customers. Roaming and toll revenues increased $4,120,000 in 1993, exclusive of Alexandria, after increasing $2,281,000 during 1992. The remainder of the 1993 increase in cellular revenues was due substantially to the Alexandria acquisition. Cellular units in service increased to 116,484 as of December 31, 1993 from 73,084 as of December 31, 1992 (which included the December 1992 acquisition of Alexandria) and 51,083 at December 31, 1991. The average monthly service revenue per subscriber declined to $71 in 1993 from $75 in 1992 and 1991, primarily due to the trend that a higher percentage of new subscribers tend to be lower usage customers. The decline in average monthly service revenue per subscriber was also affected by the growth rate of cellular units in service exceeding the growth rate of roaming revenues. The average monthly service revenue per subscriber may further decline as market penetration increases and additional lower usage customers are activated. The Company will continue to attempt to stimulate cellular usage by promoting the availability of certain enhanced services and by increasing coverage areas through the construction of additional cell sites. Expenses General, administrative and customer service expenses increased $4,187,000 (21.3%) and $1,541,000 (8.5%) during 1993 and 1992, respectively. The increases were primarily due to higher billing and other costs due to the increased number of customers and, in 1993, to Alexandria. During 1993 mobile communications sales and marketing expenses increased $6,727,000 (51.1%) primarily due to an increase in commissions paid to agents for selling cellular services to the large volume of new customers. The remaining increase during 1993 was primarily due to an increase in advertising costs and to Alexandria. The Company implemented a new cellular sales commission structure during 1992 which, notwithstanding an increase in agent sales, contributed to the 1.8% decrease in mobile communications sales and marketing expenses in 1992. The increases in cost of sales and other operating expenses in 1993 and 1992 were primarily due to growth in the business, to the development and operation of the Company's Rural Service Area ("RSA") cellular systems and, in 1993, to Alexandria. Sixty-two cell sites were placed in service during 1993 (compared to 21 during 1992 and 24 during 1991) in partnerships in which the Company has a majority interest. In addition, as a result of the December 1992 acquisition of Alexandria, the Company acquired five additional cell sites. The Company operated 158 cell sites at December 31, 1993 in partnerships in which it has a majority interest. Depreciation and amortization increased $2,388,000 (26.6%) in 1993 and $1,213,000 (15.6%) in 1992 primarily due to higher levels of cellular plant in service. See Other Matters for additional information. INTEREST EXPENSE Interest expense increased $2,983,000 (11.0%) during 1993 and $4,662,000 (20.7%) during 1992. Interest expense incurred during 1993 due to an increase in average debt outstanding was substantially offset by the effect of lower average interest rates. Interest expense during 1992 increased primarily due to the issuance of $115,000,000 of 6% convertible debentures during the first quarter of 1992. The debenture interest of approximately $6,200,000 during 1992 was partially offset by reduced interest expense due to lower average interest rates. EARNINGS FROM UNCONSOLIDATED CELLULAR PARTNERSHIPS Earnings from unconsolidated cellular partnerships increased $4,934,000 in 1993 and $995,000 in 1992. The Company's share of income from the partnership interests acquired in the San Marcos acquisition contributed substantially to the 1993 increase. SALES OF ASSETS During 1993 the Company sold a minority investment in a telephone company which resulted in a pre-tax gain of $1,661,000 ($1,080,000 after-tax). During 1992 the Company consummated the sales of two telephone subsidiaries which served approximately 2,000 access lines; its minority interests in an MSA cellular partnership and an RSA cellular partnership; and its 100% interest in an RSA cellular market. The sales prices totaled $12,212,000 and the aggregate pre-tax gain was $3,985,000 ($2,630,000 after-tax). OTHER INCOME, NET Other income, net decreased $1,123,000 (25.3%) primarily because interest income earned during 1993 was less than interest income during 1992. INCOME TAX EXPENSE The effective income tax rate was 35.1%, 35.2% and 34.9% in 1993, 1992 and 1991, respectively. The additional federal income taxes incurred during 1993 as a result of the 1% increase in the statutory federal income tax rate in accordance with the provisions of the Omnibus Budget Reconciliation Act of 1993 (the "Act") was more than offset by the tax benefit applicable to the deductibility of certain intangible assets also provided by the Act. CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES The Company adopted SFAS 106 as of January 1, 1992. SFAS 106 requires that the expected cost of providing postretirement health care and life insurance benefits be accrued during the years an employee renders service to the Company. During 1991 the Company had recognized $1,475,000 of postretirement benefits on the pay-as-you-go basis. The unrecognized obligation existing at the date of initial application of SFAS 106 (the "Transition Obligation") was $27,390,000. In accordance with the provisions of Statement of Financial Accounting Standards No. 71 ("SFAS 71"), "Accounting for the Effects of Certain Types of Regulation," the Company deferred approximately $3,450,000 of the Transition Obligation; such costs are being expensed in connection with recovery through the rate-making process. The remaining $23,940,000, net of tax benefits which aggregated $9,185,000, was reported as the cumulative effect of a change in accounting principle and reduced 1992 fully diluted earnings per share by $.30. The accrual of postretirement benefits during 1992, net of the related toll revenue and 1992 pay-as-you-go costs, decreased income before income taxes and cumulative effect of changes in accounting principles for 1992 by $2,023,000. The Company also adopted SFAS 109 as of January 1, 1992, under which the accounting for income taxes is based on an asset and liability approach rather than the deferred method. The cumulative effect of the change in accounting principle related to SFAS 109 decreased net income for 1992 by $913,000 ($.01 per fully diluted share). In accordance with the provisions of SFAS 71, the Company established a regulatory liability of approximately $47,000,000 relative to the excess deferred income taxes and the regulatory impact thereof. INFLATION The effects of increased costs are mitigated by the ability to recover costs applicable to the Company's regulated telephone operations through the rate-making process. As operating expenses increase in the nonregulated areas, the Company, to the extent permitted by competition, recovers the costs by increasing prices for its services and equipment. While the regulatory process does not consider replacement cost of physical plant, the Company has historically been able to earn a return on any increased cost of its net investment when facilities are replaced. Possible future regulatory changes may alter the Company's ability to recover increased costs in its regulated operations. LIQUIDITY AND CAPITAL RESOURCES The Company relies on cash provided by operations to provide a substantial portion of its cash needs. The Company's telephone operations have historically provided a stable source of cash flow which has helped the Company continue its program of capital improvements. Cash provided by mobile communications operations has increased each year since that segment became cash-flow positive in 1991. Net cash provided by operating activities was $166,754,000, $146,324,000 and $92,884,000 in 1993, 1992 and 1991, respectively. For additional information relative to the telephone operations and mobile communications operations of the Company, see Results of Operations. Although payments for property, plant and equipment during 1993 increased by $64,172,000, net cash used in investing activities during 1993 was approximately the same as 1992 primarily because the amount of cash used in acquisitions during 1993 was approximately $80,083,000 less than in the previous year. Net cash used in investing activities increased $147,910,000 in 1992, primarily due to the 1992 Acquisitions and to an increase of $44,335,000 in payments for property, plant and equipment. Cash provided by financing activities in 1993 was $23,247,000 less than in 1992 primarily because net borrowings, including long-term debt and notes payable, were $20,582,000 less than in 1992. The $36,785,000 increase in notes payable outstanding at December 31, 1993 compared to December 31, 1992 reflects the Company's utilization of borrowings under its short- term credit facilities to take advantage of declining short-term interest rates during 1993. The Company intends to eventually refinance such short-term borrowings with long-term debt. Proceeds from the issuance of debt during 1992 ($100,655,000 more than during 1991) included $115,000,000 from the issuance of 6% convertible debentures in February 1992 to provide the major portion of the purchase price of Ohio. In October 1993 the Company executed a merger agreement with Celutel, Inc., under which Century acquired Celutel for approximately $102,000,000 during the first quarter of 1994. Approximately $51,400,000 of the purchase price was paid in cash, with the remainder being paid through the issuance of 1,900,000 shares of Century common stock. In connection with the acquisition, Century refinanced approximately $41,700,000 of Celutel's debt. Century funded the cash portion of the merger consideration and the debt prepayment from proceeds received from a committed bridge term loan. It is currently anticipated that the bridge term loan will be repaid prior to September 30, 1994 with proceeds from the issuance of long-term debt, the terms and conditions of which have not yet been determined. Based on a review of its financing alternatives, Century does not anticipate any problems in obtaining such financing. Budgeted capital expenditures for 1994 total $142,000,000 for telephone operations, $50,000,000 for mobile communications operations (of which $10,000,000 will be funded by minority interest owners in cellular partnerships operated by the Company) and $4,000,000 for other operations. As of December 31, 1993, Century's telephone subsidiaries had available for use $84,000,000 of commitments for long-term financing from the Rural Electrification Administration ("REA") and the Company had $23,600,000 of undrawn committed bank lines of credit. In addition, approximately $7,000,000 of uncommitted credit facilities were available to the Company at December 31, 1993. Applications for additional long-term financing for Century's telephone subsidiaries have been filed with the REA and are in various stages of processing. The Company has experienced no significant problems in obtaining funds for capital expenditures or other purposes. Stockholders' equity as a percentage of total capitalization was 48.5% and 47.0% at December 31, 1993 and 1992, respectively. ACCOUNTING PRONOUNCEMENT The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 112 ("SFAS 112"), "Employers' Accounting for Postemployment Benefits," in November 1992. SFAS 112 requires the adoption of accrual accounting for workers compensation, disability and other benefits provided after employment but before retirement by requiring accrual of the expected cost when it is probable that a benefit obligation has been incurred and the amount can be reasonably estimated. The Company will be required to adopt SFAS 112 in the first quarter of 1994. Liabilities for postemployment benefits included in the consolidated balance sheet as of December 31, 1993 are not materially different than those required by SFAS 112. OTHER MATTERS In December 1993 the eight-year phase-in of the USF was completed. Revenues from the USF increased approximately $6,161,000 during 1993, of which approximately $3,200,000 reflected the effect of the phase-in. The Company anticipates that, subsequent to 1993, revenues from the USF will continue to increase in the near term, but at a lesser percentage rate than that associated with recent prior periods. In addition, the Public Service Commission of Wisconsin ("PSCW") has ordered that the existing Wisconsin state support fund, from which certain of the Company's subsidiaries received approximately $3,575,000 during 1993 and $3,755,000 during 1992, will be phased-out over one and one-half years beginning July 1, 1993. Certain of the Company's subsidiaries affected by the order have filed requests with the PSCW to receive increased rates and/or compensation which could potentially offset some or all of the amounts that those subsidiaries have been receiving from the existing support fund. All such additional revenue must be justified based on each subsidiary's financial need as demonstrated by an expedited rate case. The Wisconsin State Telephone Association has, among other things, appealed the PSCW's planned phase-out of the support fund. Also, the Louisiana Public Service Commission ("LPSC") is conducting an informal review of the earnings of all independent local exchange telephone companies in Louisiana. It is possible that reviews by state regulatory authorities, such as the informal review being conducted by the LPSC, may result in refunds and/or future reductions in revenues. Revenues are being impacted by reductions (which will aggregate approximately $3,500,000 annually upon completion in the second quarter of 1994 of a one-year phase-in period) in the level of certain settlements received from South Central Bell by the Company's Louisiana subsidiaries. For information on the effect of these reductions on the Company's 1993 operations, see Results of Operations. The telecommunications industry is currently undergoing various regulatory, competitive and technological changes, including the following. First, the FCC and a limited number of state public utility commissions have begun to reduce the regulatory oversight of the earnings and return rates of local exchange carriers ("LEC's"). Coincident with this movement toward reduced regulation is the introduction and encouragement of local exchange competition by the FCC and various state public utility commissions, along with the emergence of certain companies providing competitive access and other services that compete with LEC's services and the announcement by certain well- established interexchange carriers of their desire to enter the LEC business. Second, several recent FCC initiatives have resulted in the allocation of additional frequency spectrum or the issuance of experimental licenses for mobile communications technologies that will or may be competitive with cellular, including personal communications services (for which the FCC intends to begin auctioning operating licenses in 1994) and mobile satellite services. The FCC has also authorized certain specialized mobile radio service licensees to configure their systems so as to operate in a manner similar to cellular systems, and certain of these licensees recently announced their intention to create a nationwide mobile communications system to compete with cellular systems. Third, in connection with the well- publicized convergence of telecommunications, cable, video, computer and other technologies, several large companies have recently announced plans to offer products that would significantly enhance current communications and data transmission services and, in some instances, introduce new two- way video, entertainment, data, consumer and other multimedia services. Local exchange competition and competitive access are expected to initially affect large urban areas to a greater extent than rural, suburban and small urban areas such as those in which the Company's telephone operations are located. The same expectation holds true for emerging competitive wireless technologies and the development of new multimedia services. Therefore, the Company does not believe these developments are likely to materially affect it in the near term. The Company further believes that it may benefit from having the opportunity to observe the effects of these developments in large urban markets in the near term, thereby better preparing it for competition. The Company will continue to monitor the ongoing changes in regulation, competition and technology and consider which developments provide the most favorable opportunities for the Company to pursue. The Company has certain obligations based on federal, state and local laws relating to the protection of the environment. Costs of compliance through 1993 have not been material and the Company currently has no reason to believe that such costs will become material. Item 8. Item 8. Financial Statements and Supplementary Data. Report of Management ____________________ To the Shareholders of Century Telephone Enterprises, Inc.: Management has prepared and is responsible for the Company's consolidated financial statements. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and necessarily include amounts determined using our best judgments and estimates with consideration given to materiality. The Company maintains internal control systems and related policies and procedures designed to provide reasonable assurance that the accounting records accurately reflect business transactions and that the transactions are in accordance with management's authorization. The design, monitoring and revision of the systems of internal control involve, among other things, our judgment with respect to the relative cost and expected benefits of specific control measures. Additionally, the Company maintains an internal auditing function which independently evaluates the effectiveness of internal controls, policies and procedures and formally reports on the adequacy and effectiveness thereof. The Company's consolidated financial statements have been audited by KPMG Peat Marwick, independent certified public accountants, who have expressed their opinion with respect to the fairness of the consolidated financial statements. Their audit was conducted in accordance with generally accepted auditing standards, which includes the consideration of the Company's internal controls to the extent necessary to form an independent opinion on the consolidated financial statements prepared by management. The Audit Committee of the Board of Directors is composed of directors who are not officers or employees of the Company. The Committee meets periodically with the independent certified public accountants, internal auditors and management. This Committee considers the audit scope and discusses internal control, financial and reporting matters. Both the independent and internal auditors have free access to the Committee. R. Stewart Ewing, Jr. Senior Vice President and Chief Financial Officer Independent Auditors' Report ____________________________ The Board of Directors Century Telephone Enterprises, Inc.: We have audited the consolidated financial statements of Century Telephone Enterprises, Inc. and subsidiaries as listed in Item 14a(i). In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in Item 14a(ii). 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 Century Telephone Enterprises, Inc. 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 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 4 and 8 to the consolidated financial statements, the Company adopted the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," and Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in 1992. KPMG PEAT MARWICK Shreveport, Louisiana February 4, 1994 CENTURY TELEPHONE ENTERPRISES, INC. Consolidated Statements of Income Year ended December 31, ================================================================== 1993 1992 1991 __________________________________________________________________ (expressed in thousands, except per share amounts) REVENUES Telephone $348,485 297,510 235,796 Mobile Communications Cellular 80,513 57,683 41,515 Paging 4,199 4,409 5,216 __________________________________________________________________ Total revenues 433,197 359,602 282,527 __________________________________________________________________ EXPENSES Cost of sales and operating expenses 231,855 187,076 155,200 Depreciation and amortization 76,534 62,898 52,240 __________________________________________________________________ Total expenses 308,389 249,974 207,440 __________________________________________________________________ OPERATING INCOME 124,808 109,628 75,087 __________________________________________________________________ OTHER INCOME (EXPENSE) Interest expense (30,149) (27,166) (22,504) Earnings from unconsolidated cellular partnerships 6,626 1,692 697 Gain on sales of assets 1,661 3,985 - Other income, net 3,310 4,433 4,209 __________________________________________________________________ Total other income (expense) (18,552) (17,056) (17,598) __________________________________________________________________ INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES 106,256 92,572 57,489 INCOME TAXES 37,252 32,599 20,070 __________________________________________________________________ INCOME BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES 69,004 59,973 37,419 CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - (15,668) - __________________________________________________________________ NET INCOME $69,004 44,305 37,419 ================================================================== PRIMARY EARNINGS PER SHARE : Income before cumulative effect of changes in accounting principles $ 1.35 1.23 .79 Cumulative effect of changes in accounting principles - (.32) - __________________________________________________________________ PRIMARY EARNINGS PER SHARE $ 1.35 .91 .79 ================================================================== FULLY DILUTED EARNINGS PER SHARE : Income before cumulative effect of changes in accounting principles $ 1.32 1.22 .79 Cumulative effect of changes in accounting principles - (.31) - __________________________________________________________________ FULLY DILUTED EARNINGS PER SHARE $ 1.32 .91 .79 ================================================================== DIVIDENDS PER COMMON SHARE $ .310 .293 .287 ================================================================== See accompanying notes to consolidated financial statements. CENTURY TELEPHONE ENTERPRISES, INC. Consolidated Balance Sheets December 31, =================================================================== 1993 1992 ___________________________________________________________________ (expressed in thousands) ASSETS CURRENT ASSETS Cash and cash equivalents $ 9,777 9,771 Accounts receivable Customers, less allowance for doubtful accounts of $1,473,000 and $960,000 34,438 28,436 Other 21,771 14,111 Materials and supplies, at cost 4,418 4,512 Other 2,068 3,226 ___________________________________________________________________ Total current assets 72,472 60,056 ___________________________________________________________________ PROPERTY, PLANT AND EQUIPMENT Telephone, at original cost 979,449 871,383 Accumulated depreciation (288,479) (280,242) ___________________________________________________________________ 690,970 591,141 ___________________________________________________________________ Mobile Communications, at cost 113,252 71,926 Accumulated depreciation (27,736) (27,613) ___________________________________________________________________ 85,516 44,313 ___________________________________________________________________ Other, at cost 77,737 61,110 Accumulated depreciation (26,447) (20,686) ___________________________________________________________________ 51,290 40,424 ___________________________________________________________________ Net property, plant and equipment 827,776 675,878 ___________________________________________________________________ INVESTMENTS AND OTHER ASSETS Excess cost of net assets acquired, less accumulated amortization of $29,253,000 and $21,975,000 297,158 217,688 Other investments 98,142 67,478 Deferred charges 23,842 19,387 ___________________________________________________________________ Total investments and other assets 419,142 304,553 ___________________________________________________________________ TOTAL ASSETS $1,319,390 1,040,487 =================================================================== See accompanying notes to consolidated financial statements. CENTURY TELEPHONE ENTERPRISES, INC. Consolidated Balance Sheets (continued) December 31, =================================================================== 1993 1992 ___________________________________________________________________ (expressed in thousands) LIABILITIES AND EQUITY CURRENT LIABILITIES Current maturities of long-term debt $ 14,233 9,709 Notes payable to banks 69,200 32,415 Accounts payable 49,506 34,605 Accrued expenses and other current liabilities Taxes 9,327 10,343 Interest 6,476 6,412 Other 21,152 17,012 Advance billings and customer deposits 9,312 10,169 ___________________________________________________________________ Total current liabilities 179,206 120,665 ___________________________________________________________________ LONG-TERM DEBT 460,933 391,944 ___________________________________________________________________ DEFERRED CREDITS AND OTHER LIABILITIES Deferred income taxes 60,122 39,064 Deferred investment tax credits 10,431 11,833 Other 94,930 91,532 ___________________________________________________________________ Total deferred credits and other liabilities 165,483 142,429 ___________________________________________________________________ STOCKHOLDERS' EQUITY Common stock, $1.00 par value, authorized 100,000,000 shares, issued and outstanding 51,294,705 and 48,896,876 shares 51,295 48,897 Paid-in capital 262,294 191,522 Retained earnings 208,945 155,676 Employee Stock Ownership Plan commitment (9,220) (11,100) Preferred stock - non-redeemable 454 454 ___________________________________________________________________ Total stockholders' equity 513,768 385,449 ___________________________________________________________________ TOTAL LIABILITIES AND EQUITY $1,319,390 1,040,487 =================================================================== See accompanying notes to consolidated financial statements. CENTURY TELEPHONE ENTERPRISES, INC. Consolidated Statements of Cash Flows Year ended December 31, ==================================================================== 1993 1992 1991 ____________________________________________________________________ (expressed in thousands) OPERATING ACTIVITIES Net income $69,004 44,305 37,419 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 86,175 70,762 57,306 Cumulative effect of changes in accounting principles - 15,668 - Equity in income of cellular partnerships (7,592) (2,087) (984) Deferred income taxes 6,781 (1,427) (335) Gain on sales of assets (1,661) (3,985) - Changes in current assets and current liabilities: Increase in accounts receivable (7,026) (2,307) (6,440) Increase in accounts payable 11,024 11,694 4,581 Decrease in other current assets and other current liabilities, net 659 10,549 32 Other, net 9,390 3,152 1,305 ____________________________________________________________________ Net cash provided by operating activities 166,754 146,324 92,884 ____________________________________________________________________ INVESTING ACTIVITIES Acquisitions, net of cash acquired (54,916) (134,999) (4,600) Payments for property, plant and equipment (204,229) (140,057) (95,722) Investments in unconsolidated cellular partnerships (3,605) (2,161) (9,098) Proceeds from sales of assets - 5,049 - Purchase of life insurance investment (7,670) (6,160) (6,080) Other, net 3,948 7,166 (7,752) ____________________________________________________________________ Net cash used in investing activities (266,472) (271,162)(123,252) ____________________________________________________________________ FINANCING ACTIVITIES Proceeds from issuance of long-term debt 82,347 157,087 56,432 Payments of long-term debt (9,764) (44,552) (48,685) Notes payable, net 36,785 17,415 6,000 Proceeds from issuance of common stock 3,529 8,776 6,388 Cash dividends paid (15,735) (14,119) (13,388) Other, net 2,562 (1,636) 2,668 ____________________________________________________________________ Net cash provided by financing activities 99,724 122,971 9,415 ____________________________________________________________________ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 6 (1,867) (20,953) ____________________________________________________________________ CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 9,771 11,638 32,591 ____________________________________________________________________ CASH AND CASH EQUIVALENTS AT END OF YEAR $9,777 9,771 11,638 ==================================================================== See accompanying notes to consolidated financial statements. CENTURY TELEPHONE ENTERPRISES, INC. Consolidated Statements of Stockholders' Equity CENTURY TELEPHONE ENTERPRISES, INC. Notes to Consolidated Financial Statements December 31, 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation - The consolidated financial statements of Century Telephone Enterprises, Inc. and subsidiaries (the "Company") include the accounts of Century Telephone Enterprises, Inc. ("Century") and its majority-owned subsidiaries and cellular partnerships. The Company's regulated operations are subject to the provisions of Statement of Financial Accounting Standards No. 71 ("SFAS 71"), "Accounting for the Effects of Certain Types of Regulation." Unaffiliated parties' interests in cellular partnerships which have been consolidated are included in other liabilities at December 31, 1993 and 1992 in the amounts of $10,494,000 and $6,530,000, respectively. Investments in cellular partnerships where the Company does not have a majority partnership interest are accounted for using the equity method of accounting. The Company's share of income from these partnerships was $7,592,000, $2,087,000 and $984,000 in 1993, 1992 and 1991, respectively, and is included in earnings from unconsolidated cellular partnerships. Revenue Recognition - Revenues are recognized when earned. Certain of Century's telephone subsidiaries participate in revenue pools with other telephone companies for interstate revenue and for certain intrastate revenue. Such pools are funded by toll revenue and/or access charges within state jurisdictions and by access charges in the interstate market. Revenue earned through the various pooling processes is initially recorded based on estimates. The Company recorded adjustments, based upon settlements of prior years' revenues for certain subsidiaries, which increased revenues by $9,152,000, $8,181,000 and $8,206,000 in 1993, 1992 and 1991, respectively. Excess Cost of Net Assets Acquired - The excess cost over net assets acquired of substantially all acquisitions accounted for as purchases (goodwill) is being amortized over 40 years. Amortization of $6,215,000, $4,955,000 and $2,886,000 for 1993, 1992 and 1991, respectively, is included in depreciation and amortization. Amortization of goodwill attributable to unconsolidated investments in cellular partnerships was $966,000, $395,000 and $287,000 for 1993, 1992 and 1991, respectively, and is included as a reduction in earnings from unconsolidated cellular partnerships. The carrying value of goodwill is reviewed for impairment whenever events or changes in circumstances indicate that such carrying value may not be recoverable by assessing the recoverability of such carrying value through projected undiscounted future results. Other Investments - The Company's other investments consist of the following: December 31, 1993 1992 ================================================================== (expressed in thousands) Cash surrender value of life insurance, partially pledged $ 38,642 30,446 Investments in unconsolidated cellular partnerships 41,983 23,895 Investments in marketable equity securities, at cost 8,478 7,008 Other 9,039 6,129 __________________________________________________________________ $ 98,142 67,478 ================================================================== Affiliated Transactions - Certain service subsidiaries of Century provide installation and maintenance services, materials and supplies, and managerial, technical and accounting services to subsidiaries. In addition, Century provides and bills management services to all subsidiaries and in certain instances makes interest-bearing advances to finance construction of plant and purchases of equipment. These purchases are recorded in the telephone subsidiaries' accounts at their cost to the extent permitted by regulatory authorities. Intercompany profits on service subsidiaries' sales to regulated affiliates are limited to a reasonable return on investment and have not been eliminated. Intercompany profits on service subsidiaries' sales to nonregulated affiliates have been eliminated. Property, Plant and Equipment - Telephone plant is stated substantially at original cost of construction. Normal retirements of telephone property are charged against accumulated depreciation, along with the costs of removal less salvage, with no gain or loss recognized. Renewals and betterments of plant and equipment are capitalized while repairs, as well as renewals of minor items, are charged to operating expense. Depreciation of telephone properties is provided on the straight-line method, using class or overall composite rates acceptable to the regulatory authorities. Included in 1993, 1992 and 1991 depreciation expense were additional one-time depreciation charges of $3,621,000, $3,854,000 and $1,784,000, respectively. The composite depreciation rate for telephone properties was 7.1%, 6.6% and 6.7% for 1993, 1992 and 1991, respectively. When non-telephone property is sold or retired, a gain or loss is recognized. Depreciation is provided on the straight- line method over estimated service lives ranging from three to thirty years. Depreciation expense was $77,999,000, $64,340,000 and $53,197,000 in 1993, 1992 and 1991, respectively. Income Taxes - Century files a consolidated federal income tax return with its subsidiaries. In February 1992 the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting For Income Taxes." SFAS 109 requires the use of a method under which deferred tax assets and liabilities are established for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases. Effective January 1, 1992, the Company adopted SFAS 109 and reported an unfavorable $913,000 cumulative effect of the change in the method of accounting for income taxes in the 1992 consolidated statement of income. Due to the reduction in corporate federal income tax rates as a result of the Tax Reform Act of 1986, there existed excess deferred income taxes. Pursuant to SFAS 71, a regulatory liability in the amount of approximately $47,000,000 and a corresponding reduction in net deferred income taxes payable were recorded in 1992 relative to the excess deferred income taxes and the regulatory impact thereof. The regulatory liability, net of the related tax impact (approximately $20,300,000 at adoption), is being amortized as a reduction of federal income tax expense over the estimated remaining lives of the assets which generated the deferred taxes. Investment tax credits related to telephone plant have been deferred and amortized as a reduction of federal income tax expense over the estimated useful lives of the assets giving rise to the credits. In accordance with SFAS 109, unamortized deferred investment tax credits are treated as temporary differences. Earnings Per Share - Primary earnings per share amounts are determined on the basis of the weighted average number of common shares and common stock equivalents outstanding during the year. The number of shares used in computing primary earnings per share was 51,206,000 in 1993, 48,500,000 in 1992 and 47,305,000 in 1991. Fully diluted earnings per share amounts give further effect to convertible securities, primarily the debentures, which are not common stock equivalents. The number of shares used in computing fully diluted earnings per share before the cumulative effect of changes in accounting principles was 55,892,000 in 1993, 52,814,000 in 1992 and 47,432,000 in 1991. For the computation of fully diluted earnings per share for 1992, the debentures have been excluded as their inclusion would be anti- dilutive. The number of shares used in computing fully diluted earnings per share was 55,892,000, 48,653,000 and 47,432,000 in 1993, 1992 and 1991, respectively. Cash Equivalents - The Company considers short-term investments with a maturity at date of purchase of three months or less to be cash equivalents. Reclassifications - Certain amounts previously reported for prior years have been reclassified to conform with the 1993 presentation. (2) LONG-TERM DEBT December 31, 1993 1992 ================================================================== (expressed in thousands) Century 6.0% convertible debentures, due 2007 $115,000 115,000 9.8% senior notes - 4,813 9.4% senior notes, due in installments through 2004 69,600 71,200 10.8% notes, due in installments through 2006 1,245 1,529 Notes payable to banks (at money market rates - 3.9%) 81,500 30,000 8.4% Employee Stock Ownership Plan commitment, due in installments through 2000 9,220 11,100 __________________________________________________________________ Total Century 276,565 233,642 __________________________________________________________________ Subsidiaries First mortgage debt 5.9% notes, payable to agencies of the United States government and cooperative lending associations, due in installments through 2026 158,998 126,670 7.2% bonds, due in installments through 2002 11,699 14,505 Other debt 9.0% notes, due in installments through 2020 8,633 8,334 7.6% capital lease obligations, due in installments through 1997 4,271 3,502 Notes payable to bank (at money market rates - 4.1%), due 1995 15,000 15,000 __________________________________________________________________ Total subsidiaries 198,601 168,011 __________________________________________________________________ Total long-term debt 475,166 401,653 __________________________________________________________________ Less current maturities 14,233 9,709 __________________________________________________________________ Long-term debt, excluding current maturities $460,933 391,944 ================================================================== Except for the 6% convertible debentures, each interest rate shown in the preceding table is a weighted average interest rate as of December 31, 1993. The approximate annual debt maturities (including sinking fund requirements) for the five years subsequent to December 31, 1993 are as follows: 1994 - $14,233,000; 1995 - $77,757,000; 1996 - $45,611,000; 1997 - $17,182,000; and 1998 - $16,077,000. In February 1992 Century issued $115,000,000 of 6% convertible debentures. Interest is payable semiannually in August and February. The debentures are convertible into common stock at a conversion price of $25.33 per share and will mature on February 1, 2007 unless previously converted or redeemed. The debentures may be redeemed by Century on or after February 1, 1995. Certain redemptions through a sinking fund are required from 2002 through 2006. Under certain circumstances the debentures are redeemable at the option of the holder. See note 12 for information applicable to the use of the proceeds. The Company's loan agreements contain various restrictions, among which are limitations regarding issuance of additional debt, payment of cash dividends on common and preferred stock, reacquisition of the Company's capital stock and other matters. All of the Company's year-end consolidated retained earnings was available for the payment of cash dividends to stockholders. The transfer of funds from consolidated subsidiaries to Century is also restricted by various loan agreements. Subsidiaries which have loans from government agencies and cooperative lending associations, or have issued first mortgage bonds, generally may not loan or advance any funds to Century, but may pay dividends if certain financial ratios are met. Loan agreements of subsidiaries with other major lenders provide restrictions as to the payment of dividends, but do not formally limit loans and advances to Century. At December 31, 1993, restricted net assets of subsidiaries were $126,528,000 and subsidiaries' retained earnings in excess of amounts restricted by debt covenants were $286,340,000. Substantially all of the telephone property, plant and equipment is pledged to secure the long-term debt of subsidiaries. At December 31, 1993, Century had outstanding $30,500,000 under a $50,000,000 line of credit (two-year revolver, convertible to a five-year term loan) with interest at the rate chosen by the Company based on a number of interest rate options. In addition, Century had $51,000,000 outstanding under a $55,000,000 line of credit (three-year revolving credit facility) with similar interest rate options. Century's telephone subsidiaries had approximately $84,000,000 in commitments for long-term financing from the Rural Electrification Administration available at December 31, 1993. In addition to the $23,500,000 available under the two lines of credit mentioned above, approximately $7,100,000 of additional borrowings, some of which would be classified as current liabilities, were available at December 31, 1993 to the Company through lines of credit with various banks. Interest paid by the Company was $30,085,000, $24,035,000 and $23,407,000 during 1993, 1992 and 1991, respectively. Interest capitalized by the Company during 1993, 1992 and 1991 was $76,000, $547,000 and $91,000, respectively. ESOP Commitment - The Employee Stock Ownership Plan ("ESOP") is partially funded by loans guaranteed by Century. Each loan is to be repaid over a 10-year period with level principal payments throughout its term. The weighted average interest rate of the loans is 8.4% per annum. The unpaid balances of the loans are included in long-term debt. An equivalent amount, representing unearned employee compensation, is reflected as a deduction in stockholders' equity. Both the debt and the amount in stockholders' equity are reduced in equal amounts as the ESOP repays the loans. (3) STOCKHOLDERS' EQUITY Common Stock - At December 31, 1993, unissued shares of Century's common stock were reserved as follows: ================================================================= Conversion of convertible debentures 4,540,000 Stock option plans 2,958,000 Employee stock purchase plan 506,000 Dividend reinvestment plan 409,000 Conversion of convertible preferred stock 122,000 Other employee benefit plans 1,243,000 _________________________________________________________________ 9,778,000 ================================================================= As amended in 1991, Article III of Century's Articles of Incorporation eliminates prospectively the ability of holders to qualify for ten votes per share by providing that only voting shares beneficially owned continuously by the same person since May 30, 1987 will entitle the holder thereof to ten votes per share. All other shares are entitled to one vote per share. Preferred Stock - As of December 31, 1993, Century had authorized 2,000,000 shares of preferred stock, redeemable or non- redeemable. All outstanding non-redeemable preferred stock has a liquidation price equivalent to its par value of $25 per share and is cumulative as to dividends; each series has voting rights. At December 31, 1993 and 1992, there were 18,162 total shares of non-redeemable preferred stock outstanding that were convertible to a total of approximately 122,000 common shares. Stock Split - In November 1992 Century's Board of Directors declared a three-for-two common stock split effected as a 50% stock dividend in December 1992. Per share data for periods prior to December 1992 which are included in this report have been restated to reflect this stock split. An amount equal to the par value of the additional common shares issued pursuant to the stock split was reflected as a transfer from paid-in-capital to common stock on the consolidated financial statements in 1992. Shareholders' Rights Plan - In 1986 the Board of Directors declared a dividend of one preferred stock purchase right for each common share outstanding or that shall become outstanding prior to November 26, 1996. With certain exceptions, if a person or group acquires ownership of 15% or more of Century's common shares or commences a tender or exchange offer which upon consummation would result in ownership of 30% or more of the common shares, each right held by shareholders, other than such person or group, may be exercised to buy at the then-current exercise price of the right (currently $85) the number of shares of Series AA Junior Participating Preferred Stock of Century having a market value equal to two times the exercise price. The rights, which do not have voting rights, expire on November 27, 1996 and may be redeemed by Century at a price of $.05 per right at any time before they become exercisable. If, at any time the rights are exercisable, Century is a party to a merger, reverse merger or other business combination or certain other transactions occur, each right will entitle its holder to purchase at the exercise price of the right a number of shares of common stock of the surviving company having a market value of two times the exercise price of the right. At December 31, 1993, 519,000 shares of Series AA Junior Participating Preferred Stock were reserved for issuance under the Rights Plan. (4) INCOME TAXES As discussed in note 1, the Company adopted SFAS 109 as of January 1, 1992. The cumulative effect of this change in accounting for income taxes resulted in a $913,000 decrease in net income and was included in cumulative effect of changes in accounting principles in the consolidated statement of income for the year ended December 31, 1992. Total income tax expense (benefit) for the years ended December 31, 1993 and 1992 was allocated as follows: 1993 1992 ================================================================= (expressed in thousands) Income before cumulative effect of changes in accounting principles $ 37,252 32,599 Cumulative effect of changes in accounting principles - (8,272) ________________________________________________________________ Net tax expense in the consolidated statement of income 37,252 24,327 Stockholders' equity, primarily for compensation expense for tax purposes in excess of amounts recognized for financial reporting purposes (800) (2,885) _________________________________________________________________ $ 36,452 21,442 ================================================================= Income tax expense attributable to income before cumulative effect of changes in accounting principles is composed of the following: Year ended December 31, 1993 1992 1991 ================================================================= (expressed in thousands) Federal Current $ 26,409 29,100 16,227 Deferred 6,133 (1,742) (335) State Current 4,062 4,926 4,178 Deferred 648 315 - _________________________________________________________________ $ 37,252 32,599 20,070 ================================================================= The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and 1992 were as follows: December 31, 1993 1992 ================================================================= (expressed in thousands) Deferred tax assets: Postretirement benefit cost $ 10,809 10,194 Deferred compensation 2,522 2,246 Regulatory liability 12,011 14,705 Deferred investment tax credits 3,465 3,685 Other employee benefits 3,842 2,228 Other 630 4,817 _________________________________________________________________ Total gross deferred tax assets 33,279 37,875 Less valuation allowance - - _________________________________________________________________ Net deferred tax assets 33,279 37,875 _________________________________________________________________ Deferred tax liabilities: Property, plant and equipment, primarily due to depreciation differences (84,159) (73,598) Deferred intercompany profits (3,236) (2,929) Other (6,006) (412) _________________________________________________________________ Total gross deferred tax liabilities (93,401) (76,939) _________________________________________________________________ Net deferred tax liability $ (60,122) (39,064) ================================================================= A $20,910,000 deferred tax asset and a valuation allowance of a like amount reported at December 31, 1992 have been netted during 1993 based on a refined purchase price allocation. For the year ended December 31, 1991, deferred tax expense resulted from timing differences in the recognition of revenue and expense for tax and financial accounting purposes. The sources of these timing differences and the tax effects of each were as follows: Year ended December 31, 1991 ================================================================= (expressed in thousands) Excess tax depreciation over book depreciation $ 1,636 Employee benefits (949) Removal costs 552 Amortization of investment tax credits (2,225) Amortization of excess deferred federal income taxes (1,147) Other 1,798 _________________________________________________________________ $ (335) ================================================================= The following is a reconciliation from the statutory federal income tax rate to the Company's effective income tax rate: Year ended December 31, 1993 1992 1991 ================================================================= (expressed as a percentage of pre-tax income) Statutory federal income tax rate 35.0% 34.0 34.0 State income taxes, net of federal income tax benefit 2.9 3.7 4.8 Amortization of nondeductible excess cost of net assets acquired 1.2 2.0 1.7 Amortization of investment tax credits (2.0) (2.3) (3.9) Amortization of excess deferred federal income taxes (1.8) (2.6) (2.0) Other, net (.2) .4 .3 _________________________________________________________________ Effective income tax rate 35.1% 35.2 34.9 ================================================================= Income taxes paid by the Company were $37,092,000, $30,518,000 and $19,962,000 during 1993, 1992 and 1991, respectively. (5) STOCK OPTION AND INCENTIVE PROGRAMS Century's 1990 Incentive Compensation Program (the "1990 Program") allows the Board of Directors, through the Compensation Committee, to grant incentives to employees in any one or a combination of the following forms: incentive stock options and non-qualified stock options; stock awards; restricted stock; performance shares; and cash awards. During 1990, 836,904 stock options were granted under the terms of the 1990 Program with an average option price of $21.58 per share. During 1992, 960,639 stock options were granted with an option price of $27.67 per share. Century has reserved 1,873,000 shares of common stock which may be issued under the 1990 Program. One-seventh of the options granted in 1990 were exercisable on the date of grant. An additional one-seventh become exercisable on each of the first six anniversary dates of the date of grant. The dates on which some or all of the last two- sevenths become exercisable are accelerated if specified average market prices of Century's common stock are attained on one or more of the first four anniversary dates of the date of grant. The options granted in 1992 became exercisable in June 1993. The options expire ten years after the date of grant. The Company's 1988 Incentive Compensation Program (the "1988 Program") allows the Board, through the Compensation Committee, to grant incentives to employees in any one or a combination of the following forms: incentive stock options and non-qualified stock options; stock appreciation rights; stock awards; restricted stock; performance shares; and cash awards. Century has reserved 1,085,000 shares of common stock which may be issued under the 1988 Program. The options under the 1988 Program expire ten years after the date of grant. Stock option transactions during 1991, 1992 and 1993 were as follows: Number of Options _________________ 1990 1988 Program Program ================================================================= Balance as of December 31, 1990 836,904 1,391,007 Exercised (average option price per share: $8.85) - (239,283) _________________________________________________________________ Balance as of December 31, 1991 836,904 1,151,724 Exercised (average option price per share: $8.97) - (516,398) Granted (option price per share: $27.67) 960,639 - _________________________________________________________________ Balance as of December 31, 1992 1,797,543 635,326 Exercised (average option price per share: $20.42 and $9.32, respectively) (2,658) (48,462) _________________________________________________________________ Balance as of December 31, 1993 1,794,885 586,864 ================================================================= At December 31, 1993, 1,499,104 and 586,864 shares were issuable under exercisable options granted under the 1990 Program and the 1988 Program, respectively. Option prices range from $8.85 to $27.67. (6) SALES OF ASSETS During 1993 the Company sold a minority investment in a telephone company which resulted in a pre-tax gain of $1,661,000 ($1,080,000 after-tax). During 1992 the Company sold two telephone subsidiaries which served approximately 2,000 access lines; its minority interest in a Metropolitan Statistical Area ("MSA") cellular partnership and its minority interest in a Rural Service Area ("RSA") cellular partnership; and its 100% interest in an RSA cellular market. The sales prices totaled $12,212,000, and the transactions resulted in an aggregate pre-tax gain of $3,985,000 ($2,630,000 after-tax). (7) BUSINESS SEGMENTS The Company currently operates in two principal segments - traditional telephone services and mobile communications services. The Company's telephone customers are located in rural, suburban and small urban communities in 14 states. Approximately 82% of the Company's telephone access lines are in Wisconsin, Ohio, Louisiana, Michigan and Arkansas. The Company's mobile communications customers are located primarily in Louisiana and Michigan. Other accounts receivable are primarily amounts due from various long distance carriers, principally AT&T. Year ended December 31, 1993 1992 1991 ================================================================= (expressed in thousands) Telephone Operations Revenues Local service $ 88,704 78,108 58,653 Network access, long distance and other 259,781 219,402 177,143 _________________________________________________________________ 348,485 297,510 235,796 _________________________________________________________________ Expenses Cost of sales and operating expenses 168,408 139,911 111,275 Depreciation and amortization 65,175 53,927 44,482 _________________________________________________________________ 233,583 193,838 155,757 _________________________________________________________________ Operating income $ 114,902 103,672 80,039 ================================================================= Capital expenditures $ 131,180 108,974 73,913 Identifiable assets $1,027,390 843,356 616,992 ================================================================= Mobile Communications Operations Revenues Cellular $ 80,513 57,683 41,515 Paging 4,199 4,409 5,216 _________________________________________________________________ 84,712 62,092 46,731 _________________________________________________________________ Expenses Cost of sales and operating expenses 63,447 47,165 43,925 Depreciation and amortization 11,359 8,971 7,758 _________________________________________________________________ 74,806 56,136 51,683 _________________________________________________________________ Operating income (loss) $ 9,906 5,956 (4,952) _________________________________________________________________ Capital expenditures $ 56,092 10,904 12,702 Identifiable assets $240,634 148,485 116,293 ================================================================= The effect of the change in accounting principle related to accounting for postretirement benefits reduced 1992 operating income of the telephone operations and mobile communications operations by $1,773,000 and $250,000, respectively. (8) POSTRETIREMENT BENEFITS The Company sponsors a defined benefit health care plan (the "Retiree Plan") that provides postretirement medical, life and dental benefits to substantially all retired full-time employees, exclusive of the bargaining unit employees of Century Telephone of Ohio, Inc. ("Ohio"). The acquisition of Ohio was consummated on April 1, 1992. The employees of Ohio who are covered under a collective bargaining agreement and who meet certain eligibility requirements are provided postretirement medical and life insurance benefits upon retirement under the provisions of a separate plan (the "Ohio Plan" and, together with the Retiree Plan, the "Benefit Plans"). The Company adopted Statement of Financial Accounting Standards No. 106 ("SFAS 106"), "Employers' Accounting for Postretirement Benefits Other Than Pensions," as of January 1, 1992 and elected immediate recognition of the transition obligation. In accordance with the provisions of SFAS 71 the Company deferred $3,450,000 of the $27,390,000 transition obligation as a regulatory asset; such costs are being expensed in connection with recovery through the rate-making process. The remaining $23,940,000, net of tax benefits which aggregated $9,185,000, was reported as the cumulative effect of a change in accounting principles. The effects of adopting SFAS 106 on net income and on income before cumulative effect of changes in accounting principles for the year ended December 31, 1992 were decreases of $16,009,000 and $1,254,000, respectively. Postretirement benefit costs of approximately $1,475,000 for the year ended December 31, 1991, which were recorded on a pay-as- you-go basis, were not restated. Net periodic postretirement benefit cost under the Benefit Plans for 1993 and 1992 included the following components: Year ended December 31, 1993 1992 ================================================================= (expressed in thousands) Service cost $ 1,640 1,040 Interest cost 3,008 2,521 Amortization of unrecognized actuarial losses 365 - Amortization of unrecognized prior service cost 86 - _________________________________________________________________ Net periodic postretirement benefit cost $ 5,099 3,561 ================================================================= The following table sets forth the amounts recognized as liabilities for postretirement benefits in the Company's consolidated balance sheets at December 31, 1993 and 1992. December 31, 1993 1992 ================================================================= (expressed in thousands) Accumulated postretirement benefit obligation: Retirees and retirees' dependents $ 20,451 15,796 Fully eligible active plan participants - 537 Other active plan participants 24,980 16,991 _________________________________________________________________ Accumulated postretirement benefit obligation 45,431 33,324 Plan assets - - Unrecognized prior service cost (1,177) - Unrecognized net loss (6,302) - _________________________________________________________________ Accrued postretirement benefit costs included in other liabilities $ 37,952 33,324 ================================================================= For measurement purposes, an 8% health care cost rate was assumed for 1993 through 1996; the rate was assumed to decrease to 7% thereafter. If the assumed health care cost trend rate had been increased by one percentage point in each year, the accumulated postretirement benefit obligation as of December 31, 1993 would have increased $5,219,000 and the net periodic postretirement benefit cost for the year ended December 31, 1993 would have increased $756,000. The discount rate used in determining the accumulated postretirement benefit obligation as of December 31, 1993 was 7%. The average discount rate used in 1992 was 8.85%. (9) PENSION PLANS Century sponsors an Outside Directors' Retirement Plan and a Supplemental Executive Retirement Plan to provide directors and officers, respectively, with supplemental retirement and disability benefits. In addition, the bargaining unit employees of Ohio, a wholly-owned subsidiary which was acquired April 1, 1992, are provided benefits under a defined benefit pension plan. At December 31, 1993 and 1992, the combined accumulated benefit obligation of the plans, substantially all of which was vested, aggregated $16,321,000 and $15,167,000, respectively. The projected benefit obligation in excess of plan assets was $7,390,000 and $7,229,000, of which $3,371,000 and $3,704,000 was accrued as of December 31, 1993 and 1992, respectively. The net periodic pension cost for 1993, 1992 and 1991 was $1,057,000, $930,000 and $965,000, respectively. Discount rates ranged from 7.0% - 7.25% for 1993 and from 7.0% - 8.3.% for 1992. Century sponsors an Employee Stock Bonus Plan ("ESBP") and an Employee Stock Ownership Plan ("ESOP"). These plans cover most employees with one year of service with the Company and are funded by Company contributions determined annually by the Board of Directors. The Company recorded contributions related to the ESBP in the amount of $1,800,000, $1,120,000 and $540,000 during 1993, 1992 and 1991, respectively. At December 31, 1993, the ESBP owned 4,454,403 shares of Century common stock. The ESOP held 1,882,935 common shares of Century and had outstanding debt of $9,220,000 at December 31, 1993. Interest incurred by the ESOP on its debt was $895,000, $1,052,000 and $1,205,000 in 1993, 1992 and 1991, respectively. As the Company makes annual contributions to the ESOP, these contributions, along with dividends earned on shares held by the ESOP, are used to repay the debt. The Company contributed $2,596,000, $2,427,000 and $2,728,000 during 1993, 1992 and 1991, respectively, to the ESOP. Dividends on ESOP shares used for debt service by the ESOP were $580,000, $560,000 and $554,000 in 1993, 1992 and 1991, respectively. (10) FAIR VALUE OF FINANCIAL INSTRUMENTS Cash and Cash Equivalents, Accounts Receivable, Accounts Payable and Notes Payable to Banks - The carrying amount approximates the fair value due to the short maturity of these instruments. Other Investments - The fair value of the Company's investments in marketable equity securities, based on quoted market prices, was $11,444,000 and $7,230,000 at December 31, 1993 and 1992, respectively. The carrying amount of the cash surrender value of life insurance approximates the fair value. Long-Term Debt - The fair value ($502,826,000 and $399,783,000 at December 31, 1993 and 1992, respectively) of the Company's long- term debt is estimated by discounting the scheduled payment streams to present value based upon rates currently offered to the Company for debt of similar remaining maturities. (11) COMMITMENTS AND CONTINGENCIES Construction expenditures and investments in vehicles, buildings and other work equipment during 1994 are estimated to be $142,000,000 for telephone operations, $50,000,000 for mobile communications operations (of which $10,000,000 will be funded by minority interest owners in cellular partnerships operated by the Company) and $4,000,000 for other operations. The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial position or results of operations. (12) ACQUISITIONS On April 8, 1993, the Company acquired San Marcos Telephone Company, Inc. ("SMTC") in a stock and cash transaction and SM Telecorp, Inc., an affiliate of SMTC, for cash. Subsequent to the acquisitions, the Company changed the names of San Marcos Telephone Company, Inc. and the principal operating subsidiary of SM Telecorp, Inc. to Century Telephone of San Marcos, Inc. and Century Telecommunications, Inc., respectively. The total acquisition price for both companies approximated $100,000,000, the stock portion (approximately $67,000,000) of which was represented by approximately 2,151,000 shares of Century's common stock. As a result of the acquisitions, which were accounted for as purchases, the Company acquired approximately 22,500 telephone access lines in and around San Marcos, Texas, along with a 35% ownership interest in the Austin, Texas MSA wireline cellular market and a 9.6% interest in the Texas RSA #16 wireline cellular market. Approximately $87,000,000 of cost in excess of net assets acquired was recorded as a result of the acquisitions. On April 1, 1992 the Company acquired Central Telephone Company of Ohio ("Central") for $120,000,000 and changed Central's name to Century Telephone of Ohio, Inc. ("Ohio"). Ohio is a local exchange telephone company with approximately 68,100 access lines located in suburbs of Cleveland, Ohio. The net proceeds from the issuance of debentures were used to fund the major portion of the acquisition of Ohio. The acquisition was accounted for as a purchase and approximately $80,000,000 of cost in excess of net assets acquired was recorded. During the first quarter of 1992, the Company purchased Ooltewah-Collegedale Telephone Company ("Ooltewah") and Chatham Telephone Co., Inc. ("Chatham"). Ooltewah provides service to 6,200 customers in suburbs of Chattanooga, Tennessee. Chatham owns a minority interest in a cellular partnership operated by the Company and serves 1,500 telephone customers in north Louisiana. In December 1992 the Company acquired 100% of the Alexandria, Louisiana MSA wireline cellular market ("Alexandria"). The purchase prices of Ooltewah, Chatham and Alexandria aggregated approximately $37,000,000, of which approximately $21,475,000 was paid through the issuance of 978,115 shares of Century's common stock. The following pro forma information represents the consolidated results of operations of the Company as if each 1993 and 1992 acquisition had been combined with the Company as of January 1 of each respective period. Year ended December 31, 1993 1992 =============================================================== (expressed in thousands, except per share amounts) (unaudited) Revenues $438,418 395,033 Income before cumulative effect of changes in accounting principles $69,122 58,324 Net income $69,122 42,656 Fully diluted earnings per share before cumulative effect of changes in accounting principles $ 1.31 1.12 Fully diluted earnings per share $ 1.31 .85 =============================================================== The pro forma information is not necessarily indicative of the operating results that would have occured if each 1993 and 1992 acquisition had been consummated as of January 1 of each respective period, nor is it necessarily indicative of future operating results. The actual results of operations of an acquired company are included in the Company's consolidated financial statements only from the date of acquisition. (13) SUBSEQUENT EVENTS (UNAUDITED) In September 1993 the Company signed a merger agreement whereby it will acquire a local exchange telephone company in Michigan which serves approximately 2,400 access lines and which owns a minority interest of approximately 11% in a cellular partnership operated by the Company. This transaction is expected to be completed in the first quarter of 1994. In October 1993 the Company executed a merger agreement with Celutel, Inc. under which Century acquired Celutel for approximately $102,000,000 during the first quarter of 1994. Approximately $51,400,000 of the purchase price was paid in cash, with the remainder being paid through the issuance of 1,900,000 shares of Century common stock. In connection with the acquisition, Century refinanced approximately $41,700,000 of Celutel's debt. The acquisition was accounted for as a purchase and approximately $138,000,000 of cost in excess of net assets acquired was recorded as a result of the acquisition. Celutel provides cellular service to approximately 28,000 customers in five non-wireline provider systems in MSAs in Mississippi and Texas. CENTURY TELEPHONE ENTERPRISES, INC. Consolidated Quarterly Income Information (unaudited) Fully diluted earnings per share for the fourth quarter of 1993 reflect a decrease of $.04 per share (compared to the fourth quarter of 1992) related to cellular commissions incurred as a result of the significant increase in the number of cellular subscribers activated during December 1993; such decrease was offset by non-recurring favorable income tax adjustments of $.04 per share. Fully diluted earnings per share before cumulative effect of changes in accounting principles for the fourth quarter of 1992 reflect a $.06 per share impact of favorable adjustments to telephone revenues and a $.04 per share impact from gains on the sales of assets. Fully diluted earnings per share before cumulative effect of changes in accounting principles for 1992 have been adjusted to reflect the December 1992 stock split. See note 3 of Notes to Consolidated Financial Statements. Certain amounts previously reported for 1992 have been reclassified to conform with 1993 presentation. 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. Executive Officers The name, age and office(s) held by each of the Registrant's executive officers are shown below. Each of the executive officers listed below serves at the pleasure of the Board of Directors, except Mr. Williams who has entered into an employment agreement with the Registrant effective through May 1996 and from year to year thereafter subject to the right of Mr. Williams or the Company to terminate the employment agreement in accordance with the terms of such agreement. Name Age Office(s) held with Century ____ ___ ___________________________ Clarke M. Williams 72 Chairman of the Board of Directors Glen F. Post, III 41 Vice Chairman of the Board of Directors, President and Chief Executive Officer R. Stewart Ewing, Jr. 42 Senior Vice President and Chief Financial Officer W. Bruce Hanks 39 President - Telecommunications Services Harvey P. Perry 49 Senior Vice President, General Counsel and Secretary Jim D. Reppond 52 President - Telephone Group Each of the Registrant's executive officers has served as an officer of the Registrant or one or more of its subsidiaries in varying capacities for more than the past 5 years. The balance of the information required by Item 10 is incorporated by reference to the Registrant's definitive proxy statement relating to its 1994 annual meeting of stockholders (the "Proxy Statement"), which Proxy Statement will be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. Item 11. Item 11. Executive Compensation. The information required by Item 11 is incorporated by reference to the Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information required by Item 12 is incorporated by reference to the Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. The information required by Item 13 is incorporated by reference to the Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. a. Financial Statements (i) Consolidated Financial Statements: Independent Auditors' Report on Consolidated Financial Statements and Financial Statement Schedules Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets - December 31, 1993 and Consolidated Statements of Cash Flows 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 Notes to Consolidated Financial Statements Consolidated Quarterly Income Information (unaudited) (ii) Schedules:* III Condensed Financial Information of Registrant V Property, Plant and Equipment VI Accumulated Depreciation and Amortization of Property, Plant and Equipment IX Short-Term Borrowings X Supplementary Income Statement Information * Those Schedules not listed above are omitted as not applicable or not required. b. Report on Form 8-K. The following Current Report on Form 8-K was filed during the fourth quarter of 1993: October 8, 1993 _______________ Item 5. Other Events - Execution of definitive agreement and plan of merger pursuant to which Century Telephone Enterprises, Inc. proposes to acquire Celutel, Inc. c. Exhibits: 3(i) Amended and Restated Articles of Incorporation of Registrant, dated December 15, 1988 (incorporated by reference to Exhibit 3.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988), as amended by the Articles of Amendment dated May 2, 1989 (incorporated by reference to Exhibit 4.1 to Registrant's Current Report on Form 8-K dated May 5, 1989), by the Articles of Amendment dated May 17, 1990 (incorporated by reference to Exhibit 4.1 of the Registrant's Post-Effective Amendment No. 2 on Form S-3 dated December 21, 1990, Registration No. 33-17114) and by the Articles of Amendment dated May 30, 1991 (incorporated by reference to Exhibit 3.1 of Registrant's Current Report on Form 8-K dated June 12, 1991). 3(ii) Registrant's Bylaws, as amended through February 22, 1994, included elsewhere herein. 4.1 Loan Agreement, dated January 3, 1990, between Registrant and National Bank of Detroit, First National Bank of Commerce and Bank One, Texas, National Association (incorporated by reference to Exhibit 4.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989) and amendment thereto dated May 15, 1992 incorporated by reference to Exhibit 4.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992) and the second amendment thereto dated March 31,1993 (incorporated by reference to Exhibit 19.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993). 4.2 Note Purchase Agreement, dated September 1, 1989, between Registrant, Teachers Insurance and Annuity Association of America and the Lincoln National Life Insurance Company (incorporated by reference to Exhibit 4.23 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989). 4.3 Agreement, dated November 27, 1977, among Registrant, The Travelers Insurance Company and The Travelers Indemnity Company, and form of Warrant (incorporated by reference to Exhibits 4 and 5 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1977). 4.10 Form of Indenture dated May 1, 1940 among Century Telephone of Wisconsin, Inc. (formerly La Crosse Telephone Corporation) and the First National Bank of Chicago and William K. Stevens (incorporated by reference to Exhibit 4.12 to Registration No. 2-48478). 4.11 Supplemental Indenture No. 12 (incorporated by reference to Exhibit 5.12 to Registration No. 2- 62172) and Supplemental Indentures 13 and 14 (incorporated by reference to Exhibit 5.11 to Registration No. 2-68731), each of which are supplemental indentures to the Form of Indenture dated May 1, 1940 listed above as Exhibit 4.10. 4.12 Amended and Restated Rights Agreement dated as of November 17, 1986 between Century Telephone Enterprises, Inc. and the Rights Agent named therein (incorporated by reference to Exhibit 4.1 to Registrant's Current Report on Form 8-K dated December 20, 1988), the Amendment thereto dated March 26, 1990 (incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990) and the Second Amendment thereto dated February 23, 1993 (incorporated by reference to Exhibit 4.12 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 4.16 Note Purchase Agreement, dated May 6, 1986, among Registrant, Teachers Insurance and Annuity Association of America, Aetna Life Insurance Company, the Aetna Casualty and Surety Company and Lincoln National Pension Insurance Company (incorporated by reference to Exhibit 4.23 to Registration No. 33-5836), Amendatory Agreement dated November 1, 1986 (incorporated by reference to Exhibit 4.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986), amendment thereto dated November 1, 1987 (incorporated by reference to Exhibit 4.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987) and Modification Letter dated September 1, 1989 (incorporated by reference to Exhibit 19.6 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989). 4.21 * The Century Telephone Enterprises, Inc. Stock Bonus Plan, PAYSOP and Trust, as amended and restated September 10, 1987 and amendment thereto dated February 29, 1988 (incorporated by reference to Exhibit 4.21 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987), amendments thereto dated March 21, 1991 and April 15, 1991, (incorporated by reference to Exhibit 4.21 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991), amendment thereto dated March 31, 1992 (incorporated by reference to Exhibit 4.21 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992) and amendments thereto dated June 1, 1993 and June 10, 1993, included elsewhere herein. 4.22 Form of common stock certificate of the Registrant (incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). 4.23 Indenture, dated February 1, 1992, between Registrant and First American Bank and Trust of Louisiana (incorporated by reference to Exhibit 4.23 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 4.24 Revolving Credit Facility Agreement, dated February 7, 1992 between Registrant and NationsBank of Texas, N.A. (incorporated by reference to Exhibit 4.24 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991), amendment thereto dated April 8, 1993 (incorporated by reference to Exhibit 19.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993) and amendment thereto dated July 9, 1993, included elsewhere herein. 4.25 Credit Agreement, dated February 9, 1994 between Registrant, NationsBank of Texas, N.A., Bank One, Texas, N.A., The Bank of Nova Scotia, First National Bank of Commerce and Texas Commerce Bank National Association, included elsewhere herein. 10.1 * Employment Agreement, dated May 24, 1993, by and between Clarke M. Williams and Registrant (incorporated by reference to Exhibit 19.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). 10.2 * Form of employment agreement that the registrant has entered into with each Executive Officer other than Mr. Williams (incorporated by reference to Exhibit 10.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). 10.3 * Registrant's Outside Directors' Retirement Plan, dated November 19, 1984 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985), amendment thereto dated February 21, 1989 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988) and amendment thereto dated May 17, 1991 (incorporated by reference to Exhibit 10.3 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 10.4 * Registrant's Amended and Restated Supplemental Executive Retirement Plan, as amended and restated May 17, 1991 (incorporated by reference to Exhibit 10.4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991) and amendment thereto dated February 24, 1993 (incorporated by reference to Exhibit 10.4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.5 * Registrant's 1983 Restricted Stock Plan, dated February 21, 1984 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985). 10.6 * Registrant's Key Employee Incentive Compensation Plan, dated January 1, 1984 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985). 10.7 * The Century Telephone Enterprises, Inc. Dollars & Sense Plan and Trust, as amended and restated April 1, 1992 (incorporated by reference to Exhibit 10.7 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992) and amendments thereto dated as of January 1, 1993, April 1, 1993, April 9, 1993 and July 1, 1993, included elsewhere herein. 10.8 * Century Telephone Enterprises, Inc. Employee Stock Ownership Plan and Trust, dated March 20, 1987 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986), amendment thereto dated February 29, 1988 (incorporated by reference to Exhibit 10.9 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987), amendments thereto dated March 21, 1991 and April 15, 1991 (incorporated by reference to Exhibit 10.8 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991), amendments thereto dated March 31, 1992 (incorporated by reference to Exhibit 10.8 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992) and amendments thereto dated June 1, 1993 and June 10, 1993, included elsewhere herein. 10.9 * Registrant's 1988 Incentive Compensation Program as amended and restated August 22, 1989 (incorporated by reference to Exhibit 19.8 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989). 10.10 * Form of Stock Option Agreement entered into in 1988 by the Registrant, pursuant to 1988 Incentive Compensation Program, with certain of its officers (incorporated by reference to Exhibit 10.10 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988) and amendment thereto (incorporated by reference to Exhibit 4.6 to Registrant's Registration No. 33-31314). 10.11 * Registrant's 1990 Incentive Compensation Program, dated March 15, 1990 (incorporated by reference to Exhibit 19.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990). 10.12 * Form of Stock Option Agreement entered into in 1990 by the Registrant, pursuant to 1990 Incentive Compensation Program, with certain of its officers (incorporated by reference to Exhibit 19.3 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990). 10.13 * Disability Retirement Agreement, dated July 17, 1990, between Clarke M. Williams, Jr. and Century Telephone Enterprises, Inc. (incorporated by reference to Exhibit 19.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990). 10.15 Agreement and Plan of Merger dated as of September 24, 1992, as amended by Amendment No. 1 thereto, by and among Registrant, San Marcos Telephone Company, Incorporated, SM Telecorp, Inc., SMTC Acquisition Corp. and SMT Acquisition Corp. (incorporated by reference to Exhibit 2 of Registrant's Registration on Form S-4 dated February 3, 1993, Registration No. 33-57838). 10.16 * Registrant's Amended and Restated Salary Continuation (Disability) Plan for Officers, dated November 26, 1991 (incorporated by reference to Exhibit 10.16 of Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 10.17 * Form of Stock Option Agreement entered into in 1992 by the Registrant, pursuant to 1990 Incentive Compensation Program, with certain of its officers and employees (incorporated by reference to Exhibit 10.17 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.18 * Form of Performance Share Agreement Under the 1990 Incentive Compensation Program, entered into in 1993 with certain of its officers and employees (incorporated by reference to Exhibit 28.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993). 10.19 * Form of Restricted Stock Agreement and Performance Share Agreement Under the 1988 Incentive Compensation Program, entered into in 1993 with certain of its officers and employees (incorporated by reference to Exhibit 28.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993). 10.20 Agreement and Plan of Merger dated October 8, 1993, as amended by Amendment No. 1 thereto dated January 5, 1994 by and among Registrant, Celutel Acquisition Corp., Celutel, Inc. and the Principal Stockholders of Celutel, Inc. (incorporated by reference to Appendix I of Registrant's Prospectus forming a part of its Registration Statement No. 33-50791 filed January 12, 1994 pursuant to Rule 424(b)(5)). 11 Computations of Earnings Per Share, included elsewhere herein. 21 Subsidiaries of the Registrant, included elsewhere herein. 23 Independent Auditors' Consent, included elsewhere herein. * 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. CENTURY TELEPHONE ENTERPRISES,INC. Date: March 16, 1994 By: /s/ Clarke M. Williams Clarke M. Williams 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 date indicated. /s/ Clarke M. Williams Chairman of the Board Clarke M. Williams of Directors March 16, 1994 Vice Chairman of the Board of Directors, /s/ Glen F. Post, III President, and Chief Glen F. Post, III Executive Officer March 16, 1994 Senior Vice President /s/ R. Stewart Ewing, Jr. and Chief Financial R. Stewart Ewing, Jr. Officer March 16, 1994 Senior Vice President, /s/ Harvey P. Perry Secretary, General Harvey P. Perry Counsel and Director March 16, 1994 /s/ Jim D. Reppond President - Telephone Jim D. Reppond Group and Director March 16, 1994 Signatures (Continued) /s/ W. Bruce Hanks President - Telecommunications W. Bruce Hanks Services and Director March 16, 1994 /s/ Murray H. Greer Controller (Principal Murray H. Greer Accounting Officer) March 16, 1994 /s/ William R. Boles, Jr. Director William R. Boles, Jr. March 16, 1994 /s/ Ernest Butler, Jr. Director Ernest Butler, Jr. March 16, 1994 /s/ Calvin Czeschin Director Calvin Czeschin March 16, 1994 /s/ James B. Gardner Director James B. Gardner March 16, 1994 /s/ R. L. Hargrove, Jr. Director R. L. Hargrove, Jr. March 16, 1994 /s/ Johnny Hebert Director Johnny Hebert March 16, 1994 /s/ F. Earl Hogan Director F. Earl Hogan March 16, 1994 Signatures (Continued) /s/ Tom S. Lovett Director Tom S. Lovett March 16, 1994 /s/ C. G. Melville Director C. G. Melville March 16, 1994 SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CENTURY TELEPHONE ENTERPRISES, INC. (Parent Company) STATEMENTS OF INCOME SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) CENTURY TELEPHONE ENTERPRISES, INC. (Parent Company) BALANCE SHEETS December 31, _____________________________________________________________________ 1993 1992 _____________________________________________________________________ (expressed in thousands) ASSETS CURRENT ASSETS Cash and cash equivalents $ 5,547 2,570 Receivables from subsidiaries 53,638 46,967 Other receivables 7,330 1,168 Prepayments and other 857 343 _____________________________________________________________________ Total current assets 67,372 51,048 _____________________________________________________________________ PROPERTY, PLANT AND EQUIPMENT Property and equipment 1,192 1,119 Accumulated depreciation (772) (681) _____________________________________________________________________ Net property, plant and equipment 420 438 _____________________________________________________________________ INVESTMENTS AND OTHER ASSETS Investments in subsidiaries (at equity) 771,062 579,579 Receivables from subsidiaries 130,568 124,215 Other investments, at cost 22,368 3,117 Deferred charges 3,788 3,920 _____________________________________________________________________ Total investments and other assets 927,786 710,831 _____________________________________________________________________ TOTAL ASSETS $995,578 762,317 ===================================================================== SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) CENTURY TELEPHONE ENTERPRISES, INC. (Parent Company) BALANCE SHEETS (continued) December 31, ____________________________________________________________________ 1993 1992 ____________________________________________________________________ (expressed in thousands) LIABILITIES AND EQUITY CURRENT LIABILITIES Current maturities of long-term debt $ 4,450 4,027 Notes payable to banks 69,000 32,000 Payables to subsidiaries 93,540 91,469 Accrued interest 5,431 5,098 Other accrued liabilities 3,656 3,500 ____________________________________________________________________ Total current liabilities 176,077 136,094 ____________________________________________________________________ LONG-TERM DEBT 272,115 229,615 ____________________________________________________________________ PAYABLES TO SUBSIDIARIES 25,696 3,919 ____________________________________________________________________ DEFERRED CREDITS AND OTHER LIABILITIES 7,922 7,240 ____________________________________________________________________ STOCKHOLDERS' EQUITY Common stock, $1.00 par value, authorized 100,000,000 shares, issued and outstanding 51,294,705 and 48,896,876 shares 51,295 48,897 Paid-in capital 262,294 191,522 Retained earnings 208,945 155,676 Employee Stock Ownership Plan commitment (9,220) (11,100) Preferred stock - non-redeemable 454 454 ____________________________________________________________________ Total stockholders' equity 513,768 385,449 ____________________________________________________________________ TOTAL LIABILITIES AND EQUITY $995,578 762,317 ==================================================================== SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) CENTURY TELEPHONE ENTERPRISES, INC. (Parent Company) STATEMENTS OF CASH FLOWS SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) CENTURY TELEPHONE ENTERPRISES, INC. (Parent Company) NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (A) LONG-TERM DEBT The approximate annual debt maturities (including sinking fund requirements) for the five years subsequent to December 31, 1993 are as follows: 1994 - $ 4,450,000 1995 - $ 55,481,000 1996 - $ 37,566,000 1997 - $ 7,014,000 1998 - $ 9,817,000 (B) GUARANTEES As of December 31, 1993, Century has guaranteed a promissory note for a subsidiary of $2,889,000, as well as the applicable interest and premium. Century has also guaranteed $1,085,000 in Industrial Development Revenue Bonds originally issued by a subsidiary; such bonds were assumed by the purchaser of the subsidiary's assets. (C) DIVIDENDS FROM SUBSIDIARIES Dividends paid to Century by consolidated subsidiaries were $908,000, $12,030,000 and $28,612,000 during 1993, 1992 and 1991, respectively. (D) INCOME TAXES AND INTEREST PAID Income taxes paid by Century (including amounts reimbursed from subsidiaries) were $31,500,000, $26,500,000 and $16,000,000 during 1993, 1992 and 1991, respectively. Interest paid by Century was $20,870,000, $15,676,000 and $15,379,000 during 1993, 1992 and 1991, respectively. (E) CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES Century adopted Statement of Financial Accounting Standards No. 106 ("SFAS 106"), "Employer's Accounting for Postretirement Benefits Other than Pensions" and Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes", as of January 1, 1992. (F) SUPPLEMENTAL CASH FLOW INFORMATION Century issued common stock in connection with certain acquisitions during 1993, 1992 and 1991. The value at time of issuance of such common stock was approximately $67,000,000, $21,475,000 and $5,355,000, respectively. These amounts represent the non-cash portion of the purchase prices for the acquisitions and are not included on the Statement of Cash Flows. CENTURY TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT For the year ended December 31, 1993 CENTURY TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (continued) For the year ended December 31, 1992 (1) Includes $110,667,000 of assets at the date of acquisition of purchased subsidiaries, net of $5,064,000 of assets at the date of disposition of subsidiaries sold. For additional information see Note 1 of Notes to Consolidated Financial Statements included in Item 8 elsewhere herein. CENTURY TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (continued) For the year ended December 31, 1991 (1) Includes $2,032,000 of assets related to the Florida paging operations which were sold in 1991. For additional information see note 1 of Notes to Consolidated Financial Statements included in Item 8 elsewhere herein. CENTURY TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the year ended December 31, 1993 Depreciation and amortization charged to income - Depreciation, as above $77,999 Amortization of cost of investment in subsidiaries in excess of net assets acquired 7,512 Amortization of extraordinary retirements 664 ______ $86,175 ====== (1) Includes $16,771,000 of accumulated depreciation and amortization at the date of acquisition of purchased subsidiaries. (2) Includes $6,277,000 of accumulated depreciation related to equipment removed from service to be refurbished and/or held for future use. (3) Includes $1,447,000 of accumulated depreciation and amortization at the date of acquisition of purchased subsidiaries. CENTURY TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (continued) For the year ended December 31, 1992 Depreciation and amortization charged to income - Depreciation, as above $64,340 Amortization of cost of investment in subsidiaries in excess of net assets acquired 5,396 Amortization of extraordinary retirements 1,026 _______ $70,762 ======= (1) Includes $43,154,000 of accumulated depreciation and amortization at the date of acquisition of purchased subsidiaries, net of $1,855,000 of accumulated depreciation and amortization at the date of disposition of subsidiaries sold. CENTURY TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (continued) For the year ended December 31, 1991 Depreciation and amortization charged to income - Depreciation, as above $53,197 Amortization of cost of investment in subsidiaries in excess of net assets acquired 3,173 Amortization of extraordinary retirements 936 _______ $57,306 ======= (1) Includes $1,300,000 of accumulated depreciation and amortization related to the Florida paging operations which were sold in 1991. CENTURY TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS For the years ended December 31, 1993, 1992 and 1991 Note 1 ______ Notes payable to banks represent various promissory notes and revolving credit notes. Note 2 ______ Notes payable to banks represent borrowings under promissory notes and a money market revolving credit note. (a) Maximum amount outstanding at any month-end during the period. (b) Average amount outstanding during the period is computed by dividing the total weighted daily balance outstanding by 360. (c) Average interest rate for the year is computed by dividing short-term interest expense by the average short-term debt outstanding. CENTURY TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Year ended December 31, _________________________________________________________________ 1993 1992 1991 _________________________________________________________________ (expressed in thousands) Maintenance and repairs $ 64,401 52,820 43,561 ================================================================= Taxes, other than payroll and income taxes: Property taxes $ 11,629 9,805 6,906 Gross receipts taxes 4,570 4,473 3,326 All other operating taxes 2,525 1,455 1,263 _________________________________________________________________ Taxes charged to costs and expenses $ 18,724 15,733 11,495 ================================================================= Advertising costs $ 4,148 3,459 2,771 ================================================================= All other requirements of this schedule are either immaterial or disclosed in the consolidated financial statements or related notes. CENTURY TELEPHONE ENTERPRISES, INC. INDEX TO EXHIBITS December 31, 1993 Exhibit Number _______ 3(i) Amended and Restated Articles of Incorporation of Registrant, dated December 15, 1988 (incorporated by reference to Exhibit 3.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988), as amended by the Articles of Amendment dated May 2, 1989 (incorporated by reference to Exhibit 4.1 to Registrant's Current Report on Form 8-K dated May 5, 1989), by the Articles of Amendment dated May 17, 1990 (incorporated by reference to Exhibit 4.1 of the Registrant's Post-Effective Amendment No. 2 on Form S-3 dated December 21, 1990, Registration No. 33-17114) and by the Articles of Amendment dated May 30, 1991 (incorporated by reference to Exhibit 3.1 of Registrant's Current Report on Form 8-K dated June 12, 1991). 3(ii) Registrant's Bylaws, as amended through February 22, 1994, included herein. 4.1 Loan Agreement, dated January 3, 1990, between Registrant and National Bank of Detroit, First National Bank of Commerce and Bank One, Texas, National Association (incorporated by reference to Exhibit 4.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989) and amendment thereto dated May 15, 1992 incorporated by reference to Exhibit 4.1 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992) and the second amendment thereto dated March 31,1993 (incorporated by reference to Exhibit 19.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993). 4.2 Note Purchase Agreement, dated September 1, 1989, between Registrant, Teachers Insurance and Annuity Association of America and the Lincoln National Life Insurance Company (incorporated by reference to Exhibit 4.23 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989). 4.3 Agreement, dated November 27, 1977, among Registrant, The Travelers Insurance Company and The Travelers Indemnity Company, and form of Warrant (incorporated by reference to Exhibits 4 and 5 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1977). 4.10 Form of Indenture dated May 1, 1940 among Century Telephone of Wisconsin, Inc. (formerly La Crosse Telephone Corporation) and the First National Bank of Chicago and William K. Stevens (incorporated by reference to Exhibit 4.12 to Registration No. 2-48478). 4.11 Supplemental Indenture No. 12 (incorporated by reference to Exhibit 5.12 to Registration No. 2-62172) and Supplemental Indentures 13 and 14 (incorporated by reference to Exhibit 5.11 to Registration No. 2-68731), each of which are supplemental indentures to the Form of Indenture dated May 1, 1940 listed above as Exhibit 4.10. 4.12 Amended and Restated Rights Agreement dated as of November 17, 1986 between Century Telephone Enterprises, Inc. and the Rights Agent named therein (incorporated by reference to Exhibit 4.1 to Registrant's Current Report on Form 8-K dated December 20, 1988), the Amendment thereto dated March 26, 1990 (incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1990) and the Second Amendment thereto dated February 23, 1993 (incorporated by reference to Exhibit 4.12 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 4.16 Note Purchase Agreement, dated May 6, 1986, among Registrant, Teachers Insurance and Annuity Association of America, Aetna Life Insurance Company, the Aetna Casualty and Surety Company and Lincoln National Pension Insurance Company (incorporated by reference to Exhibit 4.23 to Registration No. 33-5836), Amendatory Agreement dated November 1, 1986 (incorporated by reference to Exhibit 4.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986), amendment thereto dated November 1, 1987 (incorporated by reference to Exhibit 4.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987) and Modification Letter dated September 1, 1989 (incorporated by reference to Exhibit 19.6 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989). 4.21 The Century Telephone Enterprises, Inc. Stock Bonus Plan, PAYSOP and Trust, as amended and restated September 10, 1987 and amendment thereto dated February 29, 1988 (incorporated by reference to Exhibit 4.21 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987), amendments thereto dated March 21, 1991 and April 15, 1991, (incorporated by reference to Exhibit 4.21 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991), amendment thereto dated March 31, 1992 (incorporated by reference to Exhibit 4.21 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992) and amendments thereto dated June 1, 1993 and June 10, 1993, included herein. 4.22 Form of common stock certificate of the Registrant (incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). 4.23 Indenture, dated February 1, 1992, between Registrant and First American Bank and Trust of Louisiana (incorporated by reference to Exhibit 4.23 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 4.24 Revolving Credit Facility Agreement, dated February 7, 1992 between Registrant and NationsBank of Texas, N.A. (incorporated by reference to Exhibit 4.24 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991), amendment thereto dated April 8, 1993 (incorporated by reference to Exhibit 19.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993) and amendment thereto dated July 9, 1993, included herein. 4.25 Credit Agreement, dated February 9, 1994 between Registrant, NationsBank of Texas, N.A., Bank One, Texas, N.A., The Bank of Nova Scotia, First National Bank of Commerce and Texas Commerce Bank National Association, included herein. 10.1 Employment Agreement, dated May 24, 1993, by and between Clarke M. Williams and Registrant (incorporated by reference to Exhibit 19.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). 10.2 Form of employment agreement that the registrant has entered into with each Executive Officer other than Mr. Williams (incorporated by reference to Exhibit 10.2 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990). 10.3 Registrant's Outside Directors' Retirement Plan, dated November 19, 1984 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985), amendment thereto dated February 21, 1989 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988) and amendment thereto dated May 17, 1991 (incorporated by reference to Exhibit 10.3 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 10.4 Registrant's Amended and Restated Supplemental Executive Retirement Plan, as amended and restated May 17, 1991 (incorporated by reference to Exhibit 10.4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991) and amendment thereto dated February 24, 1993 (incorporated by reference to Exhibit 10.4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.5 Registrant's 1983 Restricted Stock Plan, dated February 21, 1984 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985). 10.6 Registrant's Key Employee Incentive Compensation Plan, dated January 1, 1984 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985). 10.7 The Century Telephone Enterprises, Inc. Dollars & Sense Plan and Trust, as amended and restated April 1, 1992 (incorporated by reference to Exhibit 10.7 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992) and amendments thereto dated as of January 1, 1993, April 1, 1993, April 9, 1993 and July 1, 1993, included herein. 10.8 Century Telephone Enterprises, Inc. Employee Stock Ownership Plan and Trust, dated March 20, 1987 (incorporated by reference to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986), amendment thereto dated February 29, 1988 (incorporated by reference to Exhibit 10.9 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987), amendments thereto dated March 21, 1991 and April 15, 1991 (incorporated by reference to Exhibit 10.8 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991), amendments thereto dated March 31, 1992 (incorporated by reference to Exhibit 10.8 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992) and amendments thereto dated June 1, 1993 and June 10, 1993, included herein. 10.9 Registrant's 1988 Incentive Compensation Program as amended and restated August 22, 1989 (incorporated by reference to Exhibit 19.8 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989). 10.10 Form of Stock Option Agreement entered into in 1988 by the Registrant, pursuant to 1988 Incentive Compensation Program, with certain of its officers (incorporated by reference to Exhibit 10.10 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988) and amendment thereto (incorporated by reference to Exhibit 4.6 to Registrant's Registration No. 33-31314). 10.11 Registrant's 1990 Incentive Compensation Program, dated March 15, 1990 (incorporated by reference to Exhibit 19.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990). 10.12 Form of Stock Option Agreement entered into in 1990 by the Registrant, pursuant to 1990 Incentive Compensation Program, with certain of its officers (incorporated by reference to Exhibit 19.3 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990). 10.13 Disability Retirement Agreement, dated July 17, 1990, between Clarke M. Williams, Jr. and Century Telephone Enterprises, Inc. (incorporated by reference to Exhibit 19.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990). 10.15 Agreement and Plan of Merger dated as of September 24, 1992, as amended by Amendment No. 1 thereto, by and among Registrant, San Marcos Telephone Company, Incorporated, SM Telecorp, Inc., SMTC Acquisition Corp. and SMT Acquisition Corp. (incorporated by reference to Exhibit 2 of Registrant's Registration on Form S-4 dated February 3, 1993, Registration No. 33-57838). 10.16 Registrant's Amended and Restated Salary Continuation (Disability) Plan for Officers, dated November 26, 1991 (incorporated by reference to Exhibit 10.16 of Registrant's Annual Report on Form 10-K for the year ended December 31, 1991). 10.17 Form of Stock Option Agreement entered into in 1992 by the Registrant, pursuant to 1990 Incentive Compensation Program, with certain of its officers and employees (incorporated by reference to Exhibit 10.17 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.18 Form of Performance Share Agreement Under the 1990 Incentive Compensation Program, entered into in 1993 with certain of its officers and employees (incorporated by reference to Exhibit 28.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993). 10.19 Form of Restricted Stock Agreement and Performance Share Agreement Under the 1988 Incentive Compensation Program, entered into in 1993 with certain of its officers and employees (incorporated by reference to Exhibit 28.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993). 10.20 Agreement and Plan of Merger dated October 8, 1993, as amended by Amendment No. 1 thereto dated January 5, 1994 by and among Registrant, Celutel Acquisition Corp., Celutel, Inc. and the Principal Stockholders of Celutel, Inc. (incorporated by reference to Appendix I of Registrant's Prospectus forming a part of its Registration Statement No. 33-50791 filed January 12, 1994 pursuant to Rule 424(b)(5)). 11 Computations of Earnings Per Share, included herein. 21 Subsidiaries of the Registrant, included herein. 23 Independent Auditors' Consent, included herein.

751976_1993.txt

751976_1993

1993

751976

ITEM 1. BUSINESS INTRODUCTION The Newhall Land and Farming Company (a California Limited Partnership) ("the Company" or "the Partnership") is engaged in the development of residential, industrial and commercial real estate and in agriculture and is one of California's largest land resource companies. The interests in the Company (other than those held by the general partners) are represented by transferable Depositary Units listed on the New York and Pacific Stock Exchanges under the ticker symbol NHL. The Company was reorganized from a corporation to a limited partnership on January 8, 1985. The predecessor corporation was established in 1883 by the family of Henry Mayo Newhall and the shares of the corporation were listed on the New York Stock Exchange in 1970. The Company's primary business is developing master-planned communities. Since 1965, the Company has been concentrating its resources on developing the new town of Valencia on 10,000 acres of the 37,500-acre Newhall Ranch in accordance with a master plan designed to enhance the value of developed and undeveloped land. Preliminary planning is underway for another master-planned community on the 12,000 acres of the Newhall Ranch remaining in Los Angeles County. In 1993, the Company exercised an option on approximately 700 acres and purchased 160 acres in Scottsdale, Arizona, for a third master-planned community, with options remaining on an additional 1,400 acres. The master plan and zoning for the new planned community, McDowell Mountain Ranch, was approved by the Scottsdale City Council for development of over 4,000 homes and 70 acres of commercial property on a 3,200-acre site. Approximately 900 acres have been dedicated to the City of Scottsdale for open space. Valencia, one of the nation's most valuable landholdings, is located in the Santa Clarita Valley, approximately 30 miles north of downtown Los Angeles and within 10 miles of the San Fernando Valley which has a population of over 1.3 million people. The Company's Newhall Ranch landholdings are bisected by Interstate 5, California's principal north-south freeway, and four major freeways intersect Interstate 5 within ten minutes of Valencia. During the 1960s and 1970s, residential development dominated the activity in Valencia. In the 1980s, industrial development expanded eight-fold and the Santa Clarita Valley was the fastest growing area of unincorporated Los Angeles County. In the 1990s, Valencia is emerging from a residential and industrial suburb of Los Angeles to become the regional center for North Los Angeles County. Regional centers generate long-term increases in land values with the more intensive development of industrial and commercial business parks and shopping centers, along with a broader range of single-family and multi-family residential projects. The Valencia Town Center regional shopping mall, a joint venture with JMB/Urban Valencia Limited Partnership, celebrated its first anniversary in September, 1993. The mall's first phase development includes three department stores, space for 110 mall shops, a food court, two sit-down restaurants and a 10-screen theater complex in 790,000 square feet of space. In future years, it is expected that the shopping center will be expanded to a total of 1.4 million square feet to include six department stores and additional mall space. Valencia Town Center, with no competitive regional shopping center within 20 miles, has become the primary shopping and business hub for the entire Santa Clarita Valley and draws shoppers from the Antelope Valley, eastern Ventura County and northern San Fernando Valley. The Valencia Town Center trade area is estimated to include 350,000 people with an average household income 60% above the national average. A commuter rail line linking the Santa Clarita Valley, home of Valencia, with downtown Los Angeles began operations in October, 1992. The commuter station and parking lot are located about two miles from Valencia Town Center, and within a ten-minute drive for all Valencia residents. Also, the bus system within the Santa Clarita Valley has been expanded, with an entirely new fleet of buses placed in service. Major damage to freeways from the earthquake which struck the San Fernando Valley on January 17, 1994 is restricting traffic between Greater Los Angeles and the Santa Clarita Valley where Valencia is located. Reconstruction is underway and CalTrans has announced it intends to have the Interstate 5 freeway fully repaired by mid-June. For additional discussion, see the "Impact of Earthquake" section of Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. In the late 1980s, the Company adopted the strategy of selling farm properties with little or no potential for development and redeploying the proceeds into real estate operations. As of December 31, 1993, more than 17,000 acres of non-strategic farm land have been sold. The Company plans to market for sale its remaining 14,800 acres of non-strategic farm land during 1994. The Company intends to retain the 37,500-acre Newhall Ranch where development is continuing and the 38,800-acre Suey Ranch where development will be considered in the future. Also, the 14,000-acre New Columbia Ranch will be retained for its substantial surface and underground water supplies. Financial information concerning the Company's business segments appears in Note 11 of the Notes to Consolidated Financial Statements in this Annual Report. At December 31, 1993, the Company employed 263 persons including 18 classified as seasonal/temporary. COMPETITION The sale and leasing of industrial, residential and commercial real estate is highly competitive, with competition from numerous and varied sources. The degree of competition is affected by such factors as the supply of real estate available comparable to that sold and leased by the Company and the level of demand for such real estate. In turn, the level of demand is affected by interest rates and general economic conditions. The Company is not dependent upon any one customer for a significant portion of its revenues. GOVERNMENTAL REGULATION AND ENVIRONMENT The governmental review process through which landholdings must go before real estate projects are approved and can be built by the Company is referred to as the entitlement process. This process has become increasingly complex and projects often require several years to pass through the requirements of various governmental agencies. In developing its projects, the Company must obtain the approval of numerous governmental authorities regulating such matters as permitted land uses, levels of population, density and traffic, and the provision of utility services such as electricity, water and waste disposal. In addition, the Company is also subject to a variety of federal, state and local laws and regulations concerning protection of health and the environment. This governmental regulation affects the types of projects which can be pursued by the Company and increases the cost of development and ownership. The Company devotes substantial financial and managerial resources to complying with these requirements and dealing with this process. To varying degrees, certain permits and approvals will be required to complete the developments currently being undertaken, or planned, by the Company. In addition, the continued effectiveness of permits already granted is subject to factors such as changes in policies, rules and regulations and their interpretation and application. The ability of the Company to obtain necessary approvals and permits for its projects is often beyond the Company's control and could restrict or prevent development of otherwise desirable properties. (See also Item 1 - Community Development) APPRAISAL OF REAL PROPERTY ASSETS Annually, the Company obtains appraisals of substantially all of its real property assets. The independent firm of Buss-Shelger Associates, MAI real estate appraisers, appraised the market value of the Company's real property assets to be $897,100,000 at December 31, 1993. The appraised assets had an aggregate net book value of $242,571,000 at December 31, 1993 and did not include oil and gas assets, water supply systems, cash and cash equivalents and certain other assets. For the purpose of the appraisals, market value was defined as the most probable price in terms of money which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. A significant portion of the appraised real property assets is located on the Newhall Ranch and currently is undeveloped. The appraised value of undeveloped assets reflects the discount or developer's profit necessary to provide a third-party buyer with the incentive to purchase and undertake the risks inherent in the development process. The Company believes that its strategy of selling primarily finished parcels on which the development process is substantially complete, or retaining land for development of building improvements, has enabled the Company to realize the fullest value from its various assets. The Company intends to continue the development of Valencia and the surrounding area. Entitlements and the continuing development of Valencia enhance the appraised value of the Company's land assets. Although raw land increases in value as development opportunities arise, the most significant increases occur when necessary land use entitlements, including zoning and mapping approvals are obtained from city and county governments. The appraised values of the Company's land and income-producing properties in the Valencia master-planned community have increased from $222 million in 1984, the first year independent property appraisals were obtained, to $745 million in 1993, despite declines in recent years. On a per unit basis, the Company's net appraised value has increased from $11.74 to $21.04 over the same period. A summary of appraised values of properties owned for each of the last five years as of December 31 follows (the appraisals were performed by independent appraisers except as noted): Appraised values are judgments. Land and property appraisals are an estimate of value based on the sale of comparably located and zoned real estate or on the present value of income anticipated from commercial properties. There is no assurance that the appraised value of property would be received if any of the assets were sold. Refer to the "Impact of Earthquake" section of Item 7 in this Annual Report for a discussion of the impact of the earthquake which occurred subsequent to the 1993 appraisal. Certain reclassifications within categories have been made to prior periods' amounts to conform to the 1993 presentation, however, prior periods' amounts have not been restated to reflect land sale activity. REAL ESTATE The Company is developing the community of Valencia on the Newhall Ranch in Los Angeles County, California. Valencia's development is based on a master plan with residential and industrial developments forming the basic community structure supported by shopping centers, schools, colleges, hospital and medical facilities, golf courses, professional offices and a range of recreational amenities. A system of landscaped and lighted pedestrian walkways, known as paseos, provide most residents with access to schools, retail, parks and recreation centers avoiding automobile traffic. Since 1967, over 10,000 homes and apartments have been built in Valencia by the Company and others. At the end of 1993, the population of Valencia was estimated to exceed 30,000. The Company also develops and operates a growing portfolio of commercial properties and provides building-ready sites for sale to industrial and commercial developers and users. RESIDENTIAL DEVELOPMENT AND LAND SALES The transition from the Company's internal home construction to the sale of ready-to-build lots to merchant builders was completed in 1993. During the year, a total of 30 of the Company's own homes closed escrow and merchant builders closed escrow on 137 homes. In 1993, the sale of 62 residential lots was completed. At December 31, 1993, four major home builders were constructing homes in Valencia on land purchased from the Company. They include Pardee, a division of Weyerhaeuser; M.J. Brock, a division of Ryland Homes; Warmington and Bramalea. Also completed in 1993, was the sale of 220 acres at the Cowell Ranch to the City of Walnut Creek. The Company has begun to engage national and regional builders in the construction and sale of single and multi-family homes through a variety of joint-venture arrangements. These development partnerships, initiated in 1993, are designed to provide additional profit participation, more rapid residential development, entry into more affordable housing markets and enable innovative builders to obtain financing in today's tight real estate lending environment. The Company's first residential joint venture is with EPAC Communities, Inc., for 65 homes, of which 21 closed escrow in 1993. At December 31, 1993, a total of 83 residential lots in Valencia Northpark, the Company's newest residential community, were in escrow to a merchant builder. The Company's ability to make additional lot sales in 1994 will be dependent upon market conditions, absorption of lots previously sold to builders and completion of necessary land development and infrastructure improvements. There is substantial interest by merchant builders and the Company is negotiating sales contracts for residential lots and superpads in the Company's newest planned community, McDowell Mountain Ranch, in Scottsdale, Arizona. The Company's ability to complete these initial sales is dependent upon finalizing public financings with the City of Scottsdale and completing necessary land and infrastructure improvements. INDUSTRIAL DEVELOPMENT AND LAND SALES The Company develops the infrastructure and provides building-ready sites to developers and users. Valencia's location just 30 minutes from downtown Los Angeles on Interstate 5, California's major north-south freeway, provides an attractive environment for industrial, commercial, service, distribution and entertainment businesses. The Company's first business park, Valencia Industrial Center, is currently home to over 500 companies and employs more than 14,000 people. At December 31, 1993, the Company had over 650 acres entitled industrial land, primarily in the Company's new business park, Valencia Commerce Center. With no competitive large land parcels available in Los Angeles County, these entitlements place the Company in a favorable position as the economy and real estate markets improve. The California real estate recession and the inability of developers to obtain financing continued to inhibit the sale of industrial and commercial land during 1993. Some improvement was seen in the fourth quarter, however, when five parcels closed escrow bringing the total closings to seven for the year. Escrow closings included two parcels in Valencia Auto Center totaling 8.2 acres, two church sites totaling 10.5 acres, a .7-acre commercial lot, 8.5 acres for a distribution center and a 2-acre parcel to the California Department of Transportation. Future industrial land sales will be concentrated in the 1,600-acre Valencia Commerce Center and expansion of the nearly completed Valencia Industrial Center. With Los Angeles County's northward expansion into the Santa Clarita Valley and beyond, the U.S. Postal Service chose Valencia Commerce Center for its new distribution center. The postal center, currently under construction, will bring 1,500 jobs to Valencia and is expected to make the Center particularly attractive to companies involved in mailing operations. At December 31, 1993, no industrial or commercial land sales were in escrow. COMMUNITY DEVELOPMENT The Company has continued to focus financial and management resources on planning and entitlements during the recession in order to ensure an adequate supply of entitled land as the California economy and real estate markets improve. The Company's success in obtaining entitlements in prior years contributed to a 21% decrease in entitlement expenses in 1993. The Company is committed to continuing its entitlements efforts in the future and does not anticipate a further reduction in entitlement expenses in 1994. For additional discussion of community development and the entitlement process, see Item 1 - Governmental Regulation and Environment. Approvals were granted in 1993 for 192 multi-family homes and 22 acres of commercial development in Valencia. At December 31, 1993, the Company had over 5,600 residential lots approved in the Valencia area including 1,600 lots with general plan land use approval. In March, 1993, the master plan and zoning for a new planned community, McDowell Mountain Ranch, were approved by the Scottsdale City Council for development of over 4,000 homes and 70 acres of commercial property. Final plans and environmental factors are subject to review by government agencies before development can proceed. Significant land development and infrastructure improvements remain to be completed before the Company can deliver the majority of approved lots for sale. COMMERCIAL REAL ESTATE DEVELOPMENT The Company develops and operates commercial properties in the Valencia area for the production of income. The Company's growing and diversified commercial portfolio is expected to continue to provide a stable source of income and cash flow throughout economic cycles as well as appreciation in property value. Valencia Town Center regional shopping mall, the Company's largest income property, celebrated its first anniversary in September, 1993. The Center includes over 100 mall shops, three department stores, a food court, a 10-screen theater and two sit-down restaurants in over 790,000 square feet of space. At the end of 1993, tenant space in the center was 94% leased or committed. Castaic Village, the Company's newest neighborhood shopping center which opened in November, 1992, added PayLess Drugstores, the second anchor tenant, and a Burger King in 1993. Construction is complete on 12,800 square feet of retail space in the 130,000-square-foot shopping center and leasing is underway. During 1993, the Company opened a 30,000-square-foot telecommuting center in Valencia Industrial Center. The facility, wired with fiber optic and traditional cabling for voice, video and data transmission, is the largest telecommuting center in California and reflects a number of trends taking place in the work environment. A new program for developing build-to-suit industrial and commercial facilities was launched in 1993 with the signing of an agreement with ITT Corporation to construct a 175,000-square-foot facility on approximately 10 acres in Valencia Commerce Center. ITT will move its Aerospace Controls and Neo-Dyn Operations with 400 employees from their current San Fernando Valley locations. Earlier in the year, the Company entered into a long-term lease agreement to construct a 7,000-square-foot facility for Trader Joe's, a popular specialty food retailer with stores throughout Southern California. Both of these build-to-suit properties are scheduled to be completed in 1994. Valencia Marketplace, a high-volume retail complex or "power center" to be built adjacent to Interstate 5, is in the entitlement process. The 850,000-square-foot facility, a joint venture with Riley/Pearlman/Mitchell, is expected to break ground in 1994 with completion in 1995. Additional future plans include community shopping centers, apartment projects, restaurants, commercial recreational facilities, office buildings and, eventually, additional hotels. The timing for development of future projects will be dictated by market conditions. For a description of the commercial properties, see Item 2 ITEM 2. PROPERTIES LAND Listed below is the location and acreage of properties owned by the Company at December 31, 1993: (1) An additional 1,430 acres are under long-term option. PLANTS AND BUILDINGS Agriculture - Various buildings located on five farming operations in California and office and maintenance buildings located in Dixon, California. Commercial Real Estate - Listed below is the location, square footage and anchor tenants of commercial properties owned by the Company at December 31, 1993. Other commercial properties not shown in the table include various commercial, industrial and restaurant buildings. The commercial properties are leased to 206 tenants, not including apartment complexes. Valencia Water Company - 14 distribution reservoirs, 14 booster pumping stations, approximately 200 miles of pipeline and other utility facilities. All of the commercial real estate properties and the properties of Valencia Water Company are located in and around Valencia, California. All water utility plant and buildings are owned by the Company. A $60 million mortgage is secured by the Portofino, Northglen and Stonecreek apartment complexes, River Oaks and Bouquet community shopping centers, and the Company's headquarters building. For additional information concerning encumbrances against Company properties, refer to Note 8 of the Notes to Consolidated Financial Statements in this Annual Report. For a discussion of the impact of the January 17, 1994 earthquake on the Company's properties, see the "Impact of Earthquake" section of Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in litigation and various claims, including those arising from its ordinary conduct of business. Management is of the opinion that the ultimate liability from this litigation will not materially affect the Company's consolidated financial condition. 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 DEPOSITARY UNITS AND RELATED SECURITY HOLDER MATTERS MARKET PRICE AND DISTRIBUTION DATA The Company's partnership units are traded on the New York and Pacific Stock Exchanges under the ticker symbol NHL and, at December 31, 1993, the Company had approximately 1,800 unitholders of record. The Company has paid uninterrupted quarterly cash distributions since 1936. The declaration of any distribution, and the amount declared, is determined by the Board of Directors, taking into account the Company's earnings, cash requirements, financial condition and prospects. Item 6. Item 6. SELECTED FINANCIAL DATA See notes to consolidated financial statements ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Years ended December 31, 1993, 1992 and 1991 LIQUIDITY AND CAPITAL RESOURCES The Company ended 1993 with $39.6 million in cash and cash equivalents, an increase of $28.8 million for the year. Contributing to the Company's strong cash position was a $30 million seven-year unsecured loan at 6.9% obtained from a major insurance company in December, 1993 and positive cash flow generated by operations. Also during the year, the Company expanded its lines of credit by $31 million to $69 million at December 31, 1993, providing the Company with over $100 million in credit and cash available to fund future operations. No debt was incurred against raw land or land under development in Valencia. Cash flow in 1993 was adequate to maintain quarterly distributions of 10 cents per partnership unit, fund on-going development projects, and end 1993 with no short-term borrowings outstanding. The Company believes its operations and available credit are sufficient to provide the cash required to finance future operations and enable it to take advantage of new development opportunities. There are no material commitments for capital expenditures other than in the ordinary course of business. The Company plans to spend approximately $30 million for capital additions in 1994 primarily for construction of commercial income properties subject to supportive economic and market conditions. Also, the Company is actively searching for additional large landholdings with development potential. At December 31, 1993, no specific land parcels had been identified. OPERATING ACTIVITIES: Cash provided from operating activities during 1993 included the sale of 3,900 acres of farm land and the sale of 220 acres at the Cowell Ranch. These sales were for $12.9 million cash and $2.5 million in notes receivable secured by the properties sold. An increase in inventory expenditures in 1993 was related primarily to land development and infrastructure expenditures for pending and future land sales in the Valencia area. Also, in 1993, approximately 900 acres of land were purchased with long-term seller financing for McDowell Mountain Ranch, a new master-planned community in Scottsdale, Arizona. The Company anticipates an increase in land development and infrastructure activity in 1994 for new Valencia area and McDowell Mountain Ranch residential projects. The Company has been providing financing for residential and other property sales in Valencia due to the difficulty buyers have been encountering in obtaining bank loans. Contracts generally provide that Newhall receive at least 25 percent in cash upon close of escrow, with the balance represented by a note receivable secured by the property sold and due within one year. In 1993, the Company accepted $8.9 million in notes receivable and collected notes receivable of $22.2 million relating to prior land sales. In 1992, the Company accepted $29 million and collected $10.7 million in notes receivable. Deferred revenues of $11.2 million were recognized in 1993 from land sales in prior years. At December 31, 1993, $1.7 million in deferred revenues remained to be recognized in future periods as the Company completes required site development, landscape and amenity work. In 1992, $8.0 million in deferred revenues were recognized from land sales in prior years and, at the end of 1992, $11.6 million remained to be recognized. Recognition of deferred revenues has no impact on the Company's cash position. INVESTING ACTIVITIES: Capital expenditures totaled $9.5 million in 1993 and included $4.6 million of construction costs for Castaic Village, a 130,000-square-foot neighborhood shopping center being developed just north of Valencia. Additional capital expenditures included water utility construction, land preparation for a 175,000-square-foot build-to-suit for ITT Corporation in Valencia Commerce Center, and various improvements to commercial properties. In 1992, capital expenditures totaled $60 million of which $50.4 million were for construction costs and infrastructure improvements for Valencia Town Center, the Company's regional shopping center which opened in September, 1992. Other capital expenditures in 1992, included $3.8 million for the first phase of Castaic Village, and the purchase of the 433-acre Isola Ranch for $2.7 million. In 1991, capital expenditures totaled $29.3 million and included initial construction costs of $13.6 million for Valencia Town Center, purchase of a 50,000-square-foot office building for $6.8 million, purchase of a 15-acre commercial parcel for $3 million, initial land development costs for Castaic Village and purchase of 79 acres of land adjacent to Valencia Commerce Center. FINANCING ACTIVITIES: Four quarterly distributions totaling $14.7 million, or 40 cents per partnership unit, were paid in 1993. In July, 1992, the Board of Directors reduced the quarterly cash distribution to 10 cents per unit from the 20 cents per unit which had been paid since 1989. The Board found it advisable to reduce the cash distribution when it became apparent that cash flow would be inadequate to cover the distribution paid previously and at the same time fund major projects under development, to obtain entitlements for promising new projects, and to continue the planned buildup of the Company's income properties. The declaration of any distribution, and the amount declared, is determined by the Board of Directors, taking into account the Company's earnings, cash requirements, financial condition and prospects. At December 31, 1993, mortgage and other debt totaled $174.2 million, compared to $131.8 million at year-end 1992 and $78.6 million at year-end 1991. The increase in 1993 primarily was from a $30 million unsecured loan from a major insurance company, $13.4 million of land acquisition notes in connection with McDowell Mountain Ranch in Scottsdale, Arizona and $9.5 million additional reimbursement from tax-exempt community facilities bonds relating to Valencia Town Center. In 1992, the increase in mortgage and other debt consisted principally of draws totaling $35.3 million against a $40 million construction loan and $6.1 million reimbursement from tax-exempt community facilities bonds for Valencia Town Center. Upon receipt of the $30 million unsecured loan in December, 1993, $10.5 million of outstanding advances against a revolving-to-term credit line for the Company's wholly-owned public water utility were retired. The Company expects to replace this revolving credit line with a long-term financing during 1994, subject to approval by the California Public Utilities Commission. In 1994, the Company intends to complete additional public financings to assist in funding major infrastructure and land development projects in Valencia and for McDowell Mountain Ranch. RESULTS OF OPERATIONS Revenues and earnings were depressed in 1993 as a result of the lingering recession in Southern California and continuing weakness in real estate markets. The Company's 1993 total earnings were lower principally because results for 1992 included the sale of farm land which contributed $14.5 million, or 39 cents per unit, to earnings. In 1993, the sale of farm land contributed $5.2 million, or 14 cents per unit, to earnings. Also, the sale of 399 residential lots in 1992 impacted the Company's ability to sell additional lots in 1993. Mitigating this decline, the Company's commercial operations posted a 24% improvement in operating income over the prior year and several moderately-sized land parcels closed escrow in 1993. The sale of land to government agencies, which added $39 million to revenues and $16 million to earnings in 1991, did not have a significant impact on results in either 1993 or 1992. A five-year summary of revenues and operating income for each of the Company's major business segments follows: FIVE YEAR SUMMARY RESIDENTIAL HOME AND LAND SALES Transition from the Company's internal home construction to the sale of ready-to-build lots to merchant builders was completed in 1993. A total of 30 of the Company's own homes closed escrow in 1993, compared with 88 in 1992 and 136 in 1991. Because of the impact of the recession and a larger than normal supply of lots in builders' inventories during the past few years, the Company lowered the price of its lots in 1992 to remain competitive. Profit margins in the past two years, as a result, were lower than in prior years. The sale of 62 residential lots to Pardee, a division of Weyerhaeuser, was completed in 1993. A total of 399 residential lots were sold in 1992 to merchant builders and 97 lots in 1991. The 62-lot sale contributed $4.6 million to current year revenues and $541,000 to income under percentage of completion accounting. Lot sales in 1992 and 1991 contributed $32.7 million and $9.0 million to revenues and $3.7 million and $2.2 million to income, respectively, under percentage of completion accounting. Also included in 1993 results is the sale of 220 acres at the Cowell Ranch for $6.0 million which contributed $5.3 million to income. Under percentage of completion accounting, the Company recognized $6.9 million of deferred revenues and $1.2 million of income in 1993 from prior residential lot sales. This compares with deferred revenues of $6.1 million and $995,000, and income of $5.5 million and $774,000 recognized in 1992 and 1991, respectively, as a result of the sale of higher margin residential lots in prior years. During 1993, cash received from prior residential land sale profit participation agreements added $100,000 to revenues and income. This compares to $733,000 received in 1992 and $1.0 million in 1991. The Company does not expect to receive any profit participation related to recent lot sales because of the more competitive market and lower margins being realized by home building companies. The Company is engaging a number of quality builders in the construction and sale of single and multi-family homes in Valencia through various joint venture arrangements. These ventures are intended to increase momentum in the residential segment, maximize land values and enable innovative builders to obtain financing in today's tight real estate lending environment. The Company's financial exposure is managed through strict controls with new starts directly tied to sales performance. These development partnerships are anticipated to provide the Company with several innovative products in the second half of 1994 to meet the demand for affordable housing in Valencia. The Company's first residential joint venture is with EPAC Communities, Inc. for 65 homes. As of December 31, 1993, 21 homes had closed escrow contributing $6.7 million to revenues and $1.0 million to income. Four major home builders are constructing homes in Valencia on land purchased from the Company. They include Pardee, a division of Weyerhaeuser; M.J. Brock, a division of Ryland Homes; Warmington and Bramalea. Merchant builders closed escrow on 137 homes in Valencia in 1993. At December 31, 1993, a total of 83 residential lots in Valencia Northpark, the Company's newest residential community, were in escrow to a merchant builder with closing expected in the first quarter of 1994. In addition, the Company is currently negotiating sales contracts for residential lots and superpads in its McDowell Mountain Ranch project in Scottsdale, Arizona. The Company's ability to make additional lot sales in 1994 will be dependent upon market conditions, absorption of lots previously sold to builders and the completion of necessary land development and infrastructure improvements. INDUSTRIAL AND OTHER SALES The California real estate recession and the inability of developers to obtain financing continued to inhibit the sale of industrial and commercial land during 1993. Some improvement was seen in the fourth quarter, however, when five parcels closed escrow bringing the total closings to seven for the year. During 1993, escrow closings included two parcels in Valencia Auto Center to Magic Ford totaling 8.2 acres, a 6.9-acre site for a church, a 3.6-acre parcel in Northpark for another church site, and a .7 acre commercial lot. Additionally, Weyerhaeuser purchased 8.5 acres for a distribution center, and early in 1993, escrow closed on a 2-acre parcel to the California Department of Transportation. These 1993 sales contributed $10.9 million to revenues and $5.2 million to income. The 1993 results include $4.3 million in revenues and $2.3 million in income recognized under percentage of completion accounting from prior land sales, including the final income recognition on the U.S. Postal Service site. In 1992, two sales of commercial land totaling 4.5 acres closed escrow and contributed $1.3 million to revenues and $940,000 to income under percentage of completion accounting. In addition, $2.0 million in revenues and $1.6 million in income were recognized in 1992 under percentage of completion accounting from the 1990 sale of 62.4 acres in Valencia Commerce Center to the U.S. Postal Service and the 1991 sale of a 5-acre parcel in Valencia Corporate Center to Kaiser Permanente. In 1991, the Postal Service sale contributed $22.8 million to revenues and $9.2 million to income under percentage of completion. Also, in 1991, 44.6 acres were sold to a local high school district for $14.4 million which contributed $5.5 million to income, and the sale of a 4.5- acre site to an elementary school district added $2.0 million to revenues and $1.2 million to income. At December 31, 1993, industrial land inventories totaled over 650 entitled acres. Of course, final plans always are subject to review by governmental agencies before development can proceed, but these entitlements, and the fact that few competitive large land parcels are available in Los Angeles County, place the Company in a favorable position as the economy and real estate markets improve. At December 31, 1993, no industrial or commercial land sales were in escrow. COMMUNITY DEVELOPMENT In March, 1993, the master plan and zoning for a new planned community, McDowell Mountain Ranch, were approved by the Scottsdale City Council for development of over 4,000 homes and 70 acres of commercial property. The Company exercised its first option on approximately 700 acres in November 1993, with options remaining on an additional 1,400 acres. Earlier in 1993, a 160-acre parcel within the project was purchased from the State of Arizona. The balance of the 3,200 acres has been dedicated to the City of Scottsdale for open space. There is substantial interest from merchant builders for the purchase of residential lots. Contract negotiations are on-going and initial sales are anticipated in late 1994. Arizona entered the recession before California and now is experiencing a good recovery and strong market for new homes. Governmental approvals for 192 multi-family homes and 22 acres of commercial development in Valencia were granted in 1993. At December 31, 1993, the Company had over 5,600 residential lots approved in the Valencia area including 1,600 lots with general plan land use approval. Governmental approvals granted in 1992 included 3,300 homes, three community shopping centers and two elementary school sites. In 1991, the County of Los Angeles granted master plan and zoning approvals for the 1,600-acre Valencia Commerce Center as well as subdivision approvals for 340 acres in the center and 100 acres in Valencia Industrial Center. Included in 1992 approvals was final approval from the Los Angeles County Board of Supervisors for the 1,800-home Westridge Golf Course Community. However, following approval, two environmental groups filed a lawsuit challenging the County's approval, their main contention being that the County had improperly permitted a golf course and highway within a significant ecological area. Numerous other environmental deficiencies were also alleged. In September 1993, the trial court ruled that the County had acted properly in regard to the significant ecological area. However, the trial court rescinded all entitlements for the 1,800 homes until such time as the County has demonstrated full compliance with the California Environmental Quality Act and its Development Monitoring System with respect to air quality, schools and libraries. The Company believes that the deficiencies will be cleared in about one year. Final plans and environmental factors are subject to review by governmental agencies before development can proceed. Significant land development work and infrastructure improvements remain to be completed before the Company can deliver the majority of approved lots for sale. Expenses associated with Community Development activities totaled $6.1 million in 1993, a 21% decrease from 1992, primarily as a result of the Company's success in obtaining entitlements during 1992 and prior years. The decline is partially offset by planning and entitlement expenses relating to McDowell Mountain Ranch. In 1992, Community Development expenses totaled $7.8 million, a 26% increase from 1991 expenses of $6.2 million, due to the Company's intensified efforts in obtaining entitlements. The Company is committed to continuing its entitlement efforts in the future and does not anticipate a further reduction in entitlement expenses in 1994. COMMERCIAL OPERATIONS Commercial operations include the Company's portfolio of income- producing properties and the Natural Resources division, consisting of Valencia Water Company, a wholly-owned public water utility, and the Company's energy operations. The primary contributors to increases of 27% in revenues and 24% in income over 1992 results are Valencia Town Center, the Company's regional shopping center which celebrated its first anniversary in September, 1993, and Valencia Water Company, which received approval for a water rate increase of approximately 20% and a drought recovery surcharge from the California Public Utilities Commission. Also contributing to the increases were Valencia Hilton Garden Inn and the new Castaic Village neighborhood shopping center. Tenant space in Valencia Town Center was 94 percent leased or committed at the end of 1993. The Center's first sit-down restaurant, TGI Friday's, opened in October 1993, and the second restaurant, Sisley Italian Kitchen, opened in December. Eddie Bauer, a national sportswear clothing chain, is scheduled to open in February, 1994 and a letter of intent has been received from the Disney Store. The three department stores and most mall shops report sales above expectations. This first phase development consists of 790,000 square feet of space and includes Robinsons-May, JC Penney and Sears department stores, over 100 mall shops, a 10-screen theater and food court, and the two restaurants. Future plans include expanding the shopping center to 1.4 million square feet with three more department stores and additional mall space. Valencia Hilton Garden Inn, a 152-room joint venture hotel, is in its second year of operation and enjoying excellent occupancy rates at almost 80 percent. Castaic Village, the Company's newest neighborhood shopping center located just north of Valencia, opened in November 1992 with Ralphs supermarket as its first tenant. In 1993, Burger King opened in May and PayLess Drugstores, the second anchor tenant, opened in November. Construction is complete on 12,800 square feet of retail space in the 130,000-square-foot center and leasing is currently underway. Revenues and income from the Company's three apartment complexes and River Oaks and Bouquet Center neighborhood shopping centers were slightly higher in 1993 than in 1992 and 1991. At December 31, 1993, Bouquet Center was 100% leased, River Oaks had a vacancy rate of just 1% and vacancies at the apartment complexes averaged 4%. At year-end 1992, vacancies in the apartment complexes averaged 4% and the two neighborhood shopping centers averaged 1%. These vacancy rates were the same at the end of 1991. During 1993, the Company opened a 30,000-square-foot telecommuting center in Valencia Industrial Center. The facility, wired with fiber optic and traditional cabling for voice, video and data transmission, is the largest telecommuting center in California and reflects a number of business trends taking place in the work environment. CareAmerica Health Plans, the building's first tenant, has leased over 5,000 square feet to accommodate its employees who live 25 miles or more from the health insurer's office in Chatsworth, California. Subsequent to the earthquake the facility has been fully leased. Newhall Land has been negotiating with several major companies to develop industrial and commercial real estate projects on a build-to-suit basis. In December 1993, an agreement was signed with ITT Corporation to construct a 175,000-square-foot facility on approximately 10 acres in Valencia Commerce Center. ITT will move its Aerospace Controls and Neo-Dyn Operations with 400 employees from their current San Fernando Valley locations to this new $14 million facility. Earlier in the year, the Company entered into a long-term lease agreement to construct a 7,000-square-foot facility for Trader Joe's, a popular specialty food retailer with stores throughout Southern California. AGRICULTURAL OPERATIONS In 1993, sales of farm land, partially offset by improved citrus prices and higher prices and yields for grapes, resulted in net decreases of 10% in revenues and 16% in income from the prior year. In 1992, agricultural earnings were 32% below the prior year because of the sale of farm properties and a sharp decline in the price of oranges and lemons. Agricultural operations will continue to provide returns from the 37,000-acre Newhall Ranch where development is continuing and the 39,000-acre Suey Ranch where development will be considered in the future. Also, the New Columbia Ranch, which is being retained for its substantial surface and underground water supplies, will continue to be leased to tenants and contribute to agricultural operations. RANCH SALES A total of 3,900 acres of farm land at the Capay/Wheatland, Merced and Meridian ranches was sold in 1993, contributing $9.9 million to revenues and $5.2 million to income. In 1992, the sale of 6,750 acres of farm land at the Wilson, Merced and Meridian ranches contributed $21.7 million to revenues and $14.5 million to income. Sales of 2,989 acres at the Merced Ranch in 1991 added revenues of $3.9 million and income of $2.8 million. The Company plans to market for sale its remaining 14,840 acres of non-strategic farm land during 1994. While these properties had an appraised value of $23.5 million at December 31, 1993, there is no assurance that sales prices will approximate appraised values. At December 1, 1993, no agricultural parcels were in escrow. GENERAL AND ADMINISTRATIVE EXPENSE Reductions in staff and overhead expenditures resulted in a 3% decrease in total general and administrative expenses in 1993, 5% in 1992 and 16% in 1991. Prior year expenses have been reclassified to reflect consolidation of administrative departments in 1993. UNIT OPTIONS FOR MANAGEMENT Fluctuations in the market price of partnership units in connection with appreciation rights of the Company's outstanding non-qualified options accounted for expenses of $250,000 in 1993 and $650,000 in 1991 and an expense recovery of $900,000 in 1992. INTEREST AND OTHER Interest expense increased in 1993 from the prior year due to a construction loan and community facilities bonds for the Valencia Town Center regional mall, and a ranch mortgage obtained in December 1992. Interest income recognized on notes receivable from land sales reduced the overall increase to 5%. The increase in interest expense in 1992 principally was due to construction financing for the regional mall after completion of the project in September 1992, short-term borrowings during the year and bank financing for the Company's wholly-owned water utility. Also, interest income decreased with the repayment of land sale notes. In 1991, a mortgage obtained on a 50,000-square-foot office building and financing for the Company's wholly-owned water utility contributed to a net increase in interest expense. INFLATION AND RELATED FACTORS The Company's business, like most others, is affected by general economic conditions and is impacted significantly by conditions in its real estate markets. Also, fluctuations in interest rates and the availability of financing to land purchases have an important impact on Company performance. The Company believes it is well positioned against any effects of inflation. Historically, during periods of inflation, the Company has been able to increase selling prices of properties to offset rising costs of land development and construction. However, in the past few years, with declining land values in California and a lingering recession, sales prices of Company properties as well as costs have decreased. The commercial income portfolio is substantially protected from inflation since percentage rent clauses in the Company's leases tend to adjust rental receipts for inflation, and the underlying value of commercial properties over the long-term has tended to rise. IMPACT OF EARTHQUAKE The Company's Valencia properties came out of the San Fernando Valley earthquake in good shape. Valencia Town Center, the Company's regional shopping mall, had only minor damage. Other income properties, except for a four-story office building which incurred some structural damage, experienced only minor damage and virtually all were operational the day following the earthquake. While Valencia Water Company lost three of its 14 storage tanks and incurred extensive damage to main lines, service to most of its customers was restored within one week. The Company does carry earthquake insurance which will limit property losses, but it will be some time before a final determination of these losses is made. It is too early to assess the impact this will have on sales of residential, commercial and industrial land by the Company or on appraised values in Valencia. The most important issue facing the Company and community will be the restoration of full access between the Santa Clarita Valley and greater Los Angeles. Caltrans announced it intends to have the Interstate 5 freeway fully repaired by mid-June and all freeways restored by year-end. Metrolink commuter rail service between the Santa Clarita Valley and Los Angeles remained operational following the earthquake, and capacity and usage have been significantly increased on the Santa Clarita line. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT The Board of Directors of Newhall Management Corporation and Partners of The Newhall Land and Farming Company: We have audited the consolidated financial statements of The Newhall Land and Farming Company 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 The Newhall Land and Farming Company 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 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 Los Angeles, California January 19, 1994 CONSOLIDATED STATEMENTS OF INCOME See notes to consolidated financial statements CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF CHANGES IN PARTNER'S CAPITAL See notes to consolidated financial statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 NOTE 1. ORGANIZATION The Newhall Land and Farming Company, a California Limited Partnership ("the Company" or "the Partnership"), was reorganized from a corporation to a limited partnership on January 8, 1985. The general partners of the Company are Newhall Management Limited Partnership, the Managing General Partner, and Newhall General Partnership. Two executive officers and the Managing General Partner are the general partners of Newhall General Partnership. NOTE 2. INDUSTRY SEGMENTS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Company operates in two reportable industry segments: Real Estate - residential land sales and home building, commercial and industrial land sales, and development and operation of commercial property; Agriculture - primarily farming. Information as to identifiable assets, capital expenditures and depreciation for these segments is summarized in Note 11. In 1993, the Company adopted an unclassified balance sheet to better reflect the current and future activities of the Company. Significant accounting policies related to the Company's segments are: REAL ESTATE/RESIDENTIAL HOME BUILDING: Sales of single and multi-family homes are generally for cash and therefore are recognized at the close of escrow. Home buyers are provided with warranties against certain building defects. Estimated warranty cost is provided for in the period in which the sale is recorded. REAL ESTATE/LAND SALES: Sales are recorded at the time escrow is closed provided that: (1) there has been a minimum down payment, ranging from 20% to 25% depending upon the type of property sold, (2) the buyer has met adequate continuing investment criteria, and (3) the Company, as the seller, has no continuing involvement in the property. Where the Company has an obligation to complete certain future development, revenue is deferred in the ratio of the cost of development to be completed to the total cost of the property being sold under percentage of completion accounting. REAL ESTATE/DEVELOPMENT AND OPERATION OF COMMERCIAL PROPERTIES: The Company owns and leases apartments, commercial and industrial buildings, shopping centers and land to tenants. Except for apartments, rents are typically based on the greater of a percentage of the lessee's gross revenues or a minimum rent. Most lease agreements require that the lessee pay all taxes, maintenance, insurance and certain other operating expenses applicable to leased properties. Apartments are rented on a six-month lease and continue on a month-to-month basis thereafter. Valencia Water Company (a California corporation), a wholly-owned subsidiary, is a public water utility subject to regulation by the California Public Utilities Commission. Water utility revenues include amounts billed monthly to customers and an estimated amount of unbilled revenues. Income taxes accounted for under the provisions of SFAS No. 109 are included in operating expenses. In addition to income, funds advanced or contributed to the utility are subject to federal and state income taxes. Accordingly, deferred income taxes are reflected in the consolidated financial statements. REAL ESTATE/COMMUNITY DEVELOPMENT: Preliminary planning and entitlement costs are charged to expense when incurred. After tentative map approval, expenditures for map recordation are charged to the identified project. AGRICULTURE/OPERATIONS: Revenue is recognized as crops are delivered to farm cooperatives and other purchasers. Crops delivered to farm cooperatives are marketed throughout the year after harvest. At the time of delivery, the Company estimates the proceeds to be received from the cooperatives and records these amounts as unbilled receivables. During the year following harvest, the Company records any adjustments of such estimated amounts arising from changing market conditions. Net income for the years ended December 31, 1993, 1992, and 1991 increased approximately $1,075,000, $1,177,000, and $1,253,000, respectively, as a result of such adjustments. Costs incurred during the development stage of orchard and vineyard crops (ranging from three to ten years) are capitalized and amortized over the productive life of the trees or vines. Farming costs which cannot be readily identified with a specific harvested crop or other revenue producing activity are expensed as incurred. Farming inventories include crops in process and harvested crops and are valued at the lower of cost or market, determined on the first-in, first-out method. AGRICULTURE/RANCH SALES: Sales of non-developable farm land occur irregularly and are recognized upon close of escrow provided the criteria as described for real estate land sales are met. OTHER GENERAL ACCOUNTING POLICIES ARE: BASIS OF CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned. All significant intercompany transactions are eliminated. Certain reclassifications have been made to prior periods' amounts to conform to the current year presentation. CASH AND CASH EQUIVALENTS: The Company considers all highly liquid investments with original maturity dates of 90 days or less to be cash equivalents. JOINT VENTURE: The Company uses the equity method to account for an investment in a joint venture which is less than 50% controlled. PROPERTY AND EQUIPMENT: Property is stated at cost, less proceeds from sales of easements and rights of way. Depreciation of property and equipment is provided on a straight-line basis over the estimated useful lives of the various assets without regard to salvage value. Lives used for calculating depreciation are as follows: buildings - 25 to 40 years; equipment - 3 to 10 years; water supply systems, orchards and other - 5 to 75 years. ENVIRONMENTAL MATTERS: Environmental clean-up costs are charged to expense or established reserves and are not capitalized. Generally, reserves are recorded for environmental clean-up costs when remediation efforts are probable and can be reasonably estimated. To date, environmental clean-up costs have not been material. INCOME TAXES: The Company, as a partnership, is not a taxable entity; accordingly, no provision for income taxes has been made in the consolidated financial statements. Partners are taxed on their allocable share of the Company's earnings. Partners' distributive share of the income, gain, loss, deduction and credit of the Company is reportable on their income tax returns. The Revenue Act of 1987 contained provisions which, in some cases, taxes publicly traded partnerships as corporations. Since the Company was in existence on December 17, 1987, it will continue to be treated as a partnership for the 1987 through 1997 taxable years; and, subject to certain qualification requirements, will continue to be treated as a partnership indefinitely thereafter. AMOUNTS PER PARTNERSHIP UNIT: Net income per unit is computed by dividing net income by the weighted average number of units and common unit equivalents (dilutive options) outstanding during the year. The number of units for the computation was 36,790,000, 36,796,000, and 36,831,000, for the years ended December 31, 1993, 1992, and 1991, respectively. NOTE 3. FEDERAL INCOME TAX RESULTS OF THE PARTNERSHIP The Partnership has elected under Section 754 of the Internal Revenue Code to adjust the basis of property upon the purchase of units by investors. For investors who purchase units, this election provides for the reflection of the investor's price of the units in the tax basis of the Partnership's properties. The excess of the purchase price over the monetary assets and liabilities is allocated to real estate assets and results in a new basis which is used to calculate operating expenses for tax purposes. As required by SFAS No. 109, at December 31, 1993, the net tax basis of the Company's assets and liabilities exceeded the Company's financial statement basis of its assets and liabilities by $212,956,000. This excess amount does not reflect the step-up in asset basis allocated to individual partners upon purchase of units subsequent to the formation of the Partnership. The Partnership's tax returns are subject to examination by federal and state taxing authorities. Because many types of transactions are susceptible to varying interpretations under federal and state income tax laws and regulations, the tax basis amounts may be subject to change at a later date upon final determination by the taxing authorities. NOTE 4. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Company's financial instruments are as follows: The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND CASH EQUIVALENTS The carrying amounts approximate the fair values of these instruments due to their short-term nature. NOTES RECEIVABLE FROM LAND SALES The carrying amounts of notes receivable approximate fair value. Generally, these notes have maturities of less than one year from close of escrow and, if applicable, the carrying amount reflects imputed interest to reduce the note receivable to its present value. MORTGAGE AND OTHER DEBT The carrying amount of the Company's debt reflects fair value based on current interest rates available to the Company for comparable debt. See Note 8 for interest rates on outstanding debt. ADVANCES FROM DEVELOPERS FOR UTILITY CONSTRUCTION Generally, advances are refundable to the developer without interest at the rate of 2.5% per year over 40 years. The fair value is estimated as the discounted value (12%) of the future cash flows to be paid on the advances. NOTE 5. COMPOSITION OF CERTAIN FINANCIAL STATEMENT CAPTIONS NOTE 6. COMMERCIAL LEASING OPERATIONS A summary of the historical cost of properties held for lease, which are included in property and equipment, follows: Minimum lease payments to be received under non-cancellable operating leases as of December 31, 1993 are as follows: * This amount does not include contingent rentals which may be received under certain leases based on lessee sales or apartment rentals. Contingent rentals received for the years ended December 31, 1993, 1992, and 1991 were $8,119, $10,927, and $9,256, respectively. NOTE 7. LINES OF CREDIT No borrowings were outstanding against lines of credit at December 31, 1993 or 1992. At December 31, 1993, the Company had available lines of credit totaling $69 million. Revolving lines of credit for general corporate purposes include a $30 million line of credit with Wells Fargo Bank, a $20 million line of credit with Societe Generale, and a $4 million line of credit with Bank of America. Commitment fees range from .125% to .25% per annum of the unused portion. In addition, in 1993 the Company obtained a $15 million revolving credit facility from Morgan Guaranty Trust Company of New York which is restricted to financing development costs of various types of commercial income projects in Valencia. Letters of credit outstanding against available lines of credit totaled $4.2 million and $4.8 million respectively, at December 31, 1993 and 1992. NOTE 8. MORTGAGE AND OTHER DEBT The $60 million financing from Prudential is secured by six of the Company's commercial properties. The terms of the note require monthly payments of interest only through February, 1995 and monthly principal and interest payments of $501,000 thereafter until maturity on March 1, 1999 when a principal balance of approximately $57 million is due. In December 1992, the Company obtained a non-recourse mortgage financing from Prudential for $12 million secured by the 14,000-acre New Columbia Ranch property. The terms of the note call for interest payments on each May 1 and November 1 and annual principal payments of $240,000 until maturity on November 1, 2003. The commercial mortgage was obtained from Bank of America in January 1991 in conjunction with the purchase of a 50,000-square-foot office building in the vicinity of Valencia Town Center. A $1.6 million principal repayment was made on September 1, 1993 in return for a 2.05% rate reduction. The revised terms call for monthly principal and interest payments of $26,000 and a balloon payment of approximately $3.1 million at maturity on February 1, 2001. The Company obtained a $40 million construction loan from Bank of America for the Valencia Town Center regional mall. Terms of the agreement call for interest only payments until maturity on December 30, 1996. Borrowings bear interest as follows, at the election of the borrower: LIBOR plus 1.75% or the bank's reference rate plus .5%. In October 1992, tax-exempt community facilities bonds were issued to finance a portion of the costs of certain public infrastructure improvements located within or in the vicinity of Valencia Town Center, the Company's regional shopping mall which opened in September 1992. The bonds will be repaid over 20 years from special taxes levied on the mall property. The land acquisition notes include a $2 million, 8.75% mortgage payable in annual principal and interest installments of $201,000 until maturity on March 3, 2018, and a $1.3 million, 8% note payable May 31, 1994. Also included, is a $10.1 million note with interest at 8% and semi-annual installments commencing November 30, 1994 until maturity on May 31, 1998. In December 1993, the Company completed a $30 million seven-year unsecured financing. The terms of the notes call for interest payments payable semi-annually and principal payments in equal annual installments commencing upon the third anniversary of the notes. Upon completion of the $30 million financing in December 1993, $10.5 million of outstanding advances against a revolving-to-term credit line for Valencia Water Company were retired. Annual maturities of long-term debt are approximately $3,319,000 in 1994, $9,877,000 in 1995, $50,032,000 in 1996, $10,093,000 in 1997, $7,997,000 in 1998, and $92,839,000 thereafter. CAPITALIZED INTEREST: During 1993, 1992, and 1991, total interest expense incurred amounted to $10,348,000, $7,555,000, and $5,776,000, net of $535,000, $1,100,000, and $695,000, which was capitalized, respectively. NOTE 9. EMPLOYEE BENEFIT PLANS INCENTIVE COMPENSATION PLAN: Under the terms of the Company's Executive Incentive Plan, the Board of Directors may authorize incentive compensation awards to key management personnel of up to five percent of each year's income. The Board of Directors authorized awards of $307,000, $455,000, and $902,000, for the years ended December 31, 1993, 1992, and 1991, respectively. OPTION AND APPRECIATION RIGHTS PLAN: Under the terms of the Company's Option, Appreciation Rights and Restricted Units Plan, non- qualified options or restricted units may be granted at the market price at date of grant. The plan also allows for the granting of tandem appreciation rights or bonus appreciation rights in connection with non-qualified options, which entitle the holder to receive cash or partnership units, or a combination thereof, at a value equal to the excess of the fair market value on the date of exercise over the option price. The following options were granted: 1993 -- 226,200 non-qualified options without appreciation rights; 1992 -- 123,800 non-qualified options without appreciation rights; and 1991 -- 176,600 non-qualified options with appreciation rights. No restricted units were granted in 1993, 1992, or 1991. Fluctuations in the market price of partnership units in connection with appreciation rights on outstanding non-qualified options accounted for an expense recovery of $900,000 in 1992 and a charge to expense of $250,000 and $650,000 in 1993 and 1991, respectively. A summary of changes under the plans follows: At December 31, 1993, 467,150 options were exercisable and 145,300 options were available for future grants. RETIREMENT PLANS: The Retirement Plan is Company funded and is qualified under ERISA. Generally, all employees of the Company and subsidiaries of the Company are eligible for membership in the Retirement Plan after one year of employment and attainment of age 21. Participants' benefits are calculated as 40.5% of the highest average annual earnings up to Social Security covered compensation, plus 60% of average annual earnings in excess of covered compensation, reduced pro rata for years of service less than 30. The Company's contribution to the Retirement Plan is determined by consulting actuaries on the basis of customary actuarial considerations, including total covered payroll of participants, benefits paid, earnings and appreciation in the Retirement Plan funds. The Board of Directors has adopted a Pension Restoration Plan, pursuant to which the Company will pay any difference between the maximum amount payable under ERISA and the amount otherwise payable under the Plan. The Company's funding policy is to contribute no more than the maximum tax deductible amount. Plan assets are invested primarily in equity and fixed income funds. The weighted-average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations were 7 and 5 percent in 1993, and 8 and 6 percent in 1992 and 1991, respectively. The expected long-term rate of return on assets was 9 percent for each of the three years. The Company also has a Supplemental Executive Retirement Plan and a Retirement Plan for Directors. The additional pension cost for these plans was $184,000 in 1993, $208,000 in 1992, and $164,000 in 1991. The following table sets forth the plans' funded status and amounts recognized in the Company's financial statements for the Retirement and the Pension Restoration Plans: EMPLOYEE SAVINGS PLAN: The Company has an Employee Savings Plan which is available to all eligible employees. Certain employee contributions may be supplemented by Company contributions. Company contributions approximated $245,000 during 1993, $298,000 during 1992, and $292,000 during 1991. DEFERRED CASH BONUS PLAN: In February 1991, the Compensation Committee of the Board of Directors awarded deferred bonuses payable January 15, 1999. The amount to be paid is based upon the relative percentage return on the market value of the Company's depositary units compared to the percentage return on the Standard and Poor's 500 Index over a nine-year period. No deferred cash bonuses were earned in 1993, 1992, or 1991, and accordingly, no expense was recorded. OTHER BENEFITS: The Company does not provide postretirement or postemployment benefits other than those plans described above and, as such, there is no unrecorded obligation to be recognized under SFAS Nos. 106 and 112. NOTE 10. COMMITMENTS AND CONTINGENCIES The Company is involved in litigation and various claims, including those arising from its ordinary conduct of business. Management is of the opinion that the ultimate liability from this litigation will not materially affect the Company's consolidated financial condition. The Company believes it has acquired adequate insurance to protect itself against any future material property and casualty losses. In the ordinary course of business, and as part of the entitlement and development process, the Company is required to provide performance bonds to the County of Los Angeles and the City of Santa Clarita to assure completion of certain public facilities. At December 31, 1993, the Company had performance bonds outstanding totaling approximately $124 million. As a significant landowner, developer and holder of commercial properties, there exists the possibility that environmental contamination conditions may exist that would require the Company to take corrective action. The amount of such future latent cost cannot be determined. However, the Company believes such costs will not materially affect the Company's consolidated financial condition. NOTE 11. INDUSTRY SEGMENT INFORMATION NOTE 12. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following is a summary of selected quarterly financial data for 1993 and 1992: NOTE 13. SUBSEQUENT EVENT On January 17, 1994, a major earthquake struck the San Fernando Valley area in close proximity to Valencia where many of the Company's properties are located. While none of the Company's properties sustained major damage, a final determination of the cost to repair the damage cannot be made at this time. The Company carries earthquake insurance which will limit losses and management of the Company believes that uninsured losses will not have a material adverse effect on the financial statements of the Company taken as a whole. 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 Registrant was reorganized from a corporation to a California limited partnership on January 8, 1985. The general partners of the Partnership are Newhall Management Limited Partnership (the Managing General Partner) and Newhall General Partnership. Two executive officers and the Managing General Partner are the general partners of Newhall General Partnership. Newhall Management Corporation and Newhall General Partnership are the general partners of the Managing General Partner. The Managing General Partner, Newhall Management Limited Partnership, has exclusive management and control of the affairs of the Partnership and shares in Partnership income and losses on the basis of the number of Partnership units owned by it. The Managing General Partner of Newhall Management Limited Partnership, Newhall Management Corporation, will make all decisions and take all action deemed by it necessary or appropriate to conduct the business and affairs of Newhall Management Limited Partnership and, therefore, of the Partnership. The duties and responsibilities of directors are carried out by the Board of Directors of the Managing General Partner of the Managing General Partner, Newhall Management Corporation. Each voting shareholder of Newhall Management Corporation is also a director of Newhall Management Corporation and only voting shareholders may be directors of that corporation. Every voting shareholder and director has a number of votes in all matters equal to the number of votes of every other voting shareholder and director. Upon ceasing to be a director, a shareholder may be a nonvoting shareholder for a period of time prior to the repurchase of his or her shares by the Corporation. See further discussion of the shareholders' agreement and voting trust agreement below. The shareholder-directors of Newhall Management Corporation ("Corporation") are as follows: Thomas L. Lee, age 51, was appointed Chairman and Chief Executive Officer of the Corporation upon its formation in November, 1990 and of the former Managing General Partner in 1989. He served as President and Chief Executive Officer of the former Managing General Partner from 1987 to 1989, and as President and Chief Operating Officer from 1985 to 1987. Mr. Lee joined the predecessor corporation in 1970 and has served in various executive capacities. Mr. Lee was elected as a director in 1985. He is a director of First Interstate Bank of California and CalMat, Inc. and Chairman of the Los Angeles Area Chamber of Commerce. James F. Dickason, age 71, was elected as a director of the Corporation upon its formation in November, 1990 and of the former Managing General Partner upon its formation in 1985. He currently serves as Chairman of the Executive Committee. Mr. Dickason served as a director of the predecessor corporation from 1963 to 1985, as Chairman of the Board of Directors and Chief Executive Officer of the former Managing General Partner from 1985 to 1987 and held the same position with the predecessor corporation from 1979 to 1985. Mr. Dickason also served as President of the predecessor corporation from 1971 until 1985. He was the managing partner of Newhall Resources' managing general partner and the managing partner of Newhall Investment Properties' managing general partner from 1983 until their liquidation in 1989 and 1988, respectively. He is also a director of Pacific Enterprises, Southern California Gas Company and the Automobile Club of Southern California. Mr. Dickason is a Trustee of the Southwest Museum and a director of the California Museum of Science and Industry. George C. Dillon, age 71, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1973. He was Chairman of the Board of Directors of Manville Corporation from 1986 until 1990 and Chairman of the Executive Committee from 1990 to 1991. Previously he was Chairman and Chief Executive Officer of Butler Manufacturing Company, where he had served in various executive capacities since 1951. Mr. Dillon is a director of Phelps-Dodge Corporation and Astec Industries, Inc. Peter McBean, age 83, is a rancher and has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1940. Mr. McBean is Trustee Emeritus of the San Francisco Fine Arts Museum, a Life Trustee of the Cate School of Santa Barbara and Grace Cathedral in San Francisco, and an Honorary Trustee of The California Academy of Sciences. He is also a director and President of the McBean Family Foundation and a Trustee of the Alletta Morris McBean Charitable Trust. Paul A. Miller, age 69, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1979. Mr. Miller is Chairman of the Executive Committee and a director of Pacific Enterprises, a holding company for Southern California Gas Company. He is a director of Wells Fargo Bank N.A. and Wells Fargo & Company and a Trustee of Mutual Life Insurance Company of New York and the University of Southern California. Mr. Miller is also a director of the Los Angeles World Affairs Council, and is a member of the Executive Committee of the California Business Round Table. Henry K. Newhall, age 55, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1982. Dr. Newhall is General Manager, Technology, Oronite Additives Division of Chevron Chemical Company. He has served in various managerial and consulting positions with Chevron since 1971. Jane Newhall, age 80, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1960. Miss Newhall, a private investor, is a director of the Henry Mayo Newhall Foundation and a member of the Foundation Board of Donaldina Cameron House. She is a Trustee of Mills College, the San Francisco Theological Seminary, the University Mound Ladies' Home and the Graduate Theological Union. Peter T. Pope, age 59, was elected a director of the Corporation in 1992. Mr. Pope has been Chairman, President and Chief Executive Officer since 1990 and Chairman and Chief Executive Officer since 1971 of Pope & Talbot, Inc. He is a director of Pope Resources, the American Paper Institute, Oregon Independent College Foundation and the World Forestry Center and a trustee of the Medical Research Foundation of Oregon. Carl E. Reichardt, age 62, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1980. Mr. Reichardt is Chairman of the Board of Directors of Wells Fargo & Company and Wells Fargo Bank, N.A. He is also a director of Ford Motor Company, HCA-Hospital Corporation of America, Pacific Gas & Electric Company, The Irvine Company and ConAgra, Inc. Thomas C. Sutton, age 51, was elected a director of the Corporation in November, 1991. He has been Chairman of the Board and Chief Executive Officer since 1990, President and a director from 1987 to 1990 and Executive Vice President from 1984 to 1987 of Pacific Mutual Life Insurance Company. Mr. Sutton is a director of the Association of California Life Insurance Companies, Executive Service Corps of Southern California and the Health Insurance Association of America. He is a trustee of the South Coast Repertory and the Committee for Economic Development. Lawrence R. Tollenaere, age 71, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1972. Mr. Tollenaere is Chairman of the Board of Directors, and until 1993, was the Chief Executive Officer and President of Ameron, Inc., a multi-divisional company producing and marketing products and services for the utility, construction and industrial markets throughout the world. He is Chairman of Gifford-Hill-American, Inc., and Tamco. He is a director of Pacific Mutual Life Insurance Company, The Parsons Corporation and The National Association of Manufacturers. He is past president and a director of The California Club and an honorary board member of The Employers Group. Mr. Tollenaere is a Trustee of the Huntington Library, a fellow of the Society for the Advancement of Management, Emeritus Fellow of Claremount University and Governor of Iowa State University. Edwin Newhall Woods, age 76, is a rancher and has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1950. Mr. Woods is a director of the California Association of Winegrape Growers. Ezra K. Zilkha, age 68, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1977. Since 1956, Mr. Zilkha has been President of Zilkha & Sons, Inc., a private investment company, and from 1993, President of 3555 Investment Holding Company, an investment holding company. From 1979 to 1988, he was president of Zilkha Corporation, a consulting company and from 1984 to 1990 and from 1991 to 1993 he was Chairman of Union Holdings, Inc., an industrial holding company. He is a director of CIGNA Corporation, Cambridge Associates, Chicago Milwaukee Corporation, Fortune Bancorp Inc., and Milwaukee Land Company, the general partner of Heartland Partners, L.P. Mr. Zilkha is Trustee Emeritus of Wesleyan University and a Trustee of the Brookings Institution, Lycee Francais de New York and the French Institute/Alliance Francaise. He is also Chairman of the Board of The International Center for the Disabled. Each of the shareholder-directors may be contacted at the principal executive offices of the Partnership and is a citizen of the United States. Jane Newhall and Edwin Newhall Woods are first cousins. Section 16(a) of the Securities Exchange Act of 1934, as amended, requires Newhall Management Corporation and its officers and directors, the general partners, and persons who own more than ten percent of the Company's partnership units, to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the New York Stock Exchange. The Company assists officers, directors and ten-percent unitholders to file their Section 16(a) reports and retains a copy of the forms filed. Written representations that all required reports have been filed are obtained at the end of each year. Based upon this information, the Company believes that, during the year ended December 31, 1993, all such filing requirements were complied with. The Board of Directors manages and controls the overall business and affairs of the Corporation, of the Managing General Partner, and of the Partnership. The members of the Board of Directors are elected by the shareholder-directors of the Corporation, unless there is a vacancy on the Board in which case the remaining board members may fill the vacancy, without the approval of the limited partners and with each shareholder-director of the Corporation having an equal number of votes. Because the shareholders and directors are the same persons, it is expected that the shareholders will re-elect themselves to serve as directors. It is the current policy of the Corporation that all directors of the Corporation, except for the initial directors of the former Managing General Partner and Mr. Lee, will retire at age 70. If a new director is elected, he or she is required to become a shareholder by purchasing the number of shares determined by the Board of Directors. The Limited Partnership Agreement ("the Partnership Agreement") of the Partnership requires the General Partners to own at least one percent (1%) of the total number of Partnership units outstanding at all times. In order to meet this 1% requirement, the shareholder- directors had originally contributed Partnership units as capital to the former Managing General Partner. The determination as to how many Partnership units each shareholder-director would contribute was based upon the shareholdings of the shareholder-director in the predecessor corporation and his or her ability to contribute such Partnership units in order that the General Partners would own at least 1% of the total number of Partnership units outstanding at all times. Mr. Scott Newhall, a shareholder-director, died on October 26, 1992. In 1993, Newhall Management Corporation purchased his 370 shares of common stock for cash and sold an equivalent number of publicly traded partnership units in the open market. Newhall Management Limited Partnership repurchased its 71,630 limited partnership units in exchange for an equal number of publicly traded partnership units. After giving effect to these transactions, the Managing General Partner owns 372,300 units of the Partnership or 1.0% of the total number of partnership units outstanding. Messrs. Henry Newhall, Woods, and Zilkha each effectively has contributed to the Managing General Partner a total of 72,000 Partnership units. Mr. McBean and Ms. Newhall each effectively has contributed to the Managing General Partner a total of 71,650 Partnership units. Messrs. Dickason, Dillon, Lee, Miller, Reichardt, and Tollenaere each effectively has contributed to the Managing General Partner a total of 2,000 Partnership units. Messrs. Pope and Sutton each effectively has contributed to the Managing General Partner a total of 500 Partnership units. It should be noted that a shareholder-director will receive the same distributions from the Partnership with regard to his or her Partnership units regardless of whether such Partnership units are represented by limited partner interests in Newhall Management Limited Partnership or by general partner interests in Newhall Management Limited Partnership (which in turn are represented by common stock in the Corporation). All Partnership distributions and allocations to the Managing General Partner with respect to the Partnership units held by such Partner will be passed on to each limited partner of the Managing General Partner or shareholder-director of the Corporation as distributions in proportion to the actual number of units or shares beneficially owned by such limited partner or shareholder-director, as the case may be. The shareholder-directors of the Corporation and the Corporation are parties to a shareholders' agreement and a voting trust agreement. These agreements provided for the transfer of all the shares of Newhall Management Corporation to a voting trust, held in the name of the Trustee. The Secretary of Newhall Management Corporation serves as Trustee. In all matters the Trustee will vote all the shares in accordance with the direction of a majority of the shareholder-directors, with each shareholder-director having one vote on each matter (irrespective of the actual number of shares beneficially owned by such person). The shareholders' agreement and the bylaws of the Corporation restrict the ability of a shareholder-director to transfer ownership of shares of the Corporation. Certain events such as failure to own at least one limited partner unit in Newhall Management Limited Partnership, failure to consent to a Subchapter S election under the Internal Revenue Code, failure to re-execute the trust agreement, ceasing to serve as a director, failure of a shareholder-director's spouse to sign any required consent, a material breach by a shareholder-director of the shareholders' agreement or voting trust agreement, a levy upon the shares of a shareholder, or a purported transfer of shares to someone other than a new or existing director upon approval of the Board of Directors, are considered to be repurchase events. Upon such a repurchase event, the shareholder must immediately resign as a director and the shareholder will lose voting rights under the voting trust agreement. Upon the occurrence of a repurchase event, a shareholder's shares will be repurchased by the Corporation or the Corporation may direct their purchase by a successor director. The Corporation has agreed to repurchase for cash equal to the market value of the Partnership units representing such shares (or provide for the purchase of) all shares of a shareholder-director subject to a repurchase event within one year of the repurchase event and to use its best efforts to effect such repurchase (purchase) as soon as possible after the repurchase event. There can be no assurance that the Corporation will be able to find a replacement for a departing shareholder-director who will purchase shares. The shareholders' agreement expires if Newhall Management Corporation ceases to serve as the Managing General Partner of the Managing General Partner of the Partnership, or Newhall Management Limited Partnership ceases to be the Managing General Partner of the Partnership, if all parties to the shareholders' agreement consent to its termination, or with respect to any individual shareholder, upon the repurchase of all the shareholder's shares. The term of the voting trust is limited by laws to 10 years, but a party to the voting trust will be deemed to have resigned as a director of the Corporation and will have to sell his shares, subject to repurchase by the Corporation, unless, at the times provided in the voting trust agreement, the party re-executes and renews the voting trust for the purpose of keeping it continually in effect. The voting trust agreement terminates if Newhall Management Corporation ceases to serve as a general partner of the Managing General Partner of the Partnership, or Newhall Management Limited Partnership ceases to be the Managing General Partner of the Partnership, or with respect to any individual shareholder if a shareholder no longer owns any shares. The shareholder-directors, as limited partners, are also parties to the limited partnership agreement of Newhall Management Limited Partnership. At the present time, they are the only limited partners of Newhall Management Limited Partnership. The limited partnership agreement has restrictions on transfer similar to the shareholders' agreement and provides for repurchase of the limited partnership units of a limited partner upon the occurrence of repurchase events which are similar to those of the shareholders' agreement, including the cessation of being a director by a limited partner in the case of a limited partner who is a director. Upon the occurrence of a repurchase event, Newhall Management Limited Partnership would have one full year to transfer Partnership units representing the limited partner's interest to the limited partner. A limited partner could not compel the return of Partnership units for at least one year from the date a limited partner chooses to obtain return of Partnership units. Even then, Newhall Management Limited Partnership cannot, and cannot be compelled to, distribute Partnership units to the limited partner if Newhall Management Limited Partnership would thereafter own less than 1% of the Partnership's Partnership units. The limited partners, as limited partners, have no voting rights except as expressly set forth in the limited partnership agreement or granted pursuant to law. Such voting privileges include matters such as (i) electing general partners in specified instances, (ii) amending the limited partnership agreement, (iii) dissolving the limited partnership, (iv) electing a general partner to serve as the Managing General Partner, and (v) removing a general partner. Items (ii) and (iii) require the separate concurrence of the Managing General Partner. Persons other than directors of Newhall Management Corporation may serve as limited partners of Newhall Management Limited Partnership and Newhall Management Corporation has the authority pursuant to the limited partnership agreement to cause additional units to be issued. The partnership agreement provides limited instances in which a general partner shall cease to be a general partner. Newhall Management Limited Partnership will dissolve (i) when a general partner ceases to be a general partner (other than by removal) unless there is at least one other general partner or all partners agree in writing to continue the business of the partnership and to admit one or more general partners, (ii) if Newhall Management Limited Partnership becomes insolvent, (iii) upon the disposition of substantially all assets of Newhall Management Limited Partnership, (iv) 90 days after an affirmative vote of the limited partners to dissolve pursuant to the partnership agreement, or (v) upon the occurrence of any event which makes it unlawful for the business of Newhall Management Limited Partnership to be continued. Newhall General Partnership, a California general partnership, is a general partner for the purposes of continuing the business of the Partnership and serving as an interim Managing General Partner if Newhall Management Limited Partnership or its successor ceases to serve as Managing General Partner. So long as Newhall Management Limited Partnership or its successor remains as Managing General Partner, Newhall General Partnership will have no right to take part in the management and control of the affairs of the Partnership. The general partners of Newhall General Partnership are Newhall Management Limited Partnership, the chief executive officer of Newhall Management Corporation and another officer or director of Newhall Management Corporation selected from time to time by the board of directors of Newhall Management Corporation. Thomas L. Lee is the chief executive officer of Newhall Management Corporation and, therefore, is a general partner of Newhall General Partnership. Gary M. Cusumano, President and Chief Operating Officer of Newhall Management Corporation, has been selected by the board of directors of Newhall Management Corporation to be a general partner of Newhall General Partnership. For as long as Newhall Management Limited Partnership serves as a general partner of the Partnership, Newhall Management Limited Partnership shall serve as a general partner of Newhall General Partnership and the individual general partners of Newhall General Partnership shall be the chief executive officer of Newhall Management Corporation and another officer or director selected by the board of directors of Newhall Management Corporation. The managing partner of Newhall General Partnership is the chief executive officer of Newhall Management Corporation and shall have management and control of the ordinary course of day to day business of Newhall General Partnership. Matters outside the ordinary course of the day to day business of Newhall General Partnership shall be decided by a majority vote of the partners except that a unanimous vote will be required to, among other things, admit a new partner (other than the chief executive officer or other officer or director of Newhall Management Corporation). After giving effect to 2-for-1 unit splits on December 20, 1985 and January 29, 1990, each of the partners of Newhall General Partnership have contributed twenty Partnership units to Newhall General Partnership. No additional capital contributions are required. The income, losses and distributions allocated to Newhall General Partnership with respect to the units will be allocated among the partners of Newhall General Partnership in the ratio of the units contributed by each of them. The ability of a partner to withdraw from Newhall General Partnership or to transfer an interest in Newhall General Partnership is limited by the partnership agreement of Newhall General Partnership. Individual partners of Newhall General Partnership may not withdraw except upon appointment of a successor by the board of directors of Newhall Management Corporation. In addition, an individual general partner may not transfer his interest in Newhall General Partnership except with the written consent of Newhall Management Limited Partnership. Newhall Management Limited Partnership, as a general partner of Newhall General Partnership, may not withdraw unless: (i) it no longer serves as a general partner of the Partnership; (ii) Newhall General Partnership no longer serves as a general partner of the Partnership; or (iii) Newhall General Partnership dissolves and its business is not continued. If Newhall Management Limited Partnership no longer serves as a general partner of the Partnership, simultaneously, it will stop serving as a general partner of Newhall General Partnership. Any individual general partner of Newhall General Partnership who is serving as a general partner by virtue of holding an office or position with Newhall Management Corporation, will stop serving as a general partner of Newhall General Partnership if either (i) Newhall Management Limited Partnership is replaced as a general partner of the Partnership, or (ii) Newhall Management Limited Partnership is no longer a general partner of Newhall General Partnership and individual partners are designated pursuant to the partnership agreement. Newhall General Partnership will dissolve when the Partnership is dissolved, liquidated and wound up and any trust or other entity formed for the purpose of liquidating or winding up the Partnership is liquidated and wound up. Newhall General Partnership will dissolve earlier upon: (i) the distribution of substantially all of its property; (ii) the unanimous agreement of its partners; (iii) ceasing to serve as a general partner of the Partnership; or (iv) the occurrence of an event which would make it unlawful to conduct its business. The Partnership Agreement requires the Partnership to pay all of the costs and expenses incurred or accrued by the general partners in connection with the business and affairs of the Partnership as the Managing General Partner in its sole discretion authorizes or approves from time to time. These costs and expenses include overhead and operating expenses, officer, employee, director and general partner compensation and other employee benefits paid by the general partners. Such compensation and benefits may be determined and changed from time to time without the approval of the limited partners. EXECUTIVE OFFICERS OF THE MANAGING GENERAL PARTNER ITEM 11: ITEM 11: EXECUTIVE COMPENSATION The following tables set forth information as to each of the five highest paid Executive Officers and their compensation for services rendered to the Company and its subsidiaries : SUMMARY COMPENSATION TABLE (1) Represents bonus accrued during the current calendar year based on earnings for such period and paid in the subsequent calendar year. (2) Includes general partner fees paid to Mssrs. Lee and Cusumano as general partners of Newhall General Partnership of $28,000 each and director fees paid of $28,000 to Mr. Lee as a director of Newhall Management Corporation and $1,000 to Mr. Cusumano as a director of a wholly-owned subsidiary. (3) The number and value of restricted unit holdings at December 31, 1993 were as follows: 6,400 units valued at $102,400 for Mr. Lee; 4,900 units valued at $78,400 for Mr. Cusumano; 2,400 units valued at $38,400 for Mr. Wilke; and 1,200 units valued at $19,200 for Mr. Dierckman. Restricted units are granted subject to a return right which permits the Company to reacquire all or a portion of the restricted units for no consideration if the grantee terminates employment with the Company. The return right lapses as to twenty-five percent of the granted restricted units after expiration of each two-year period from the date of grant. The lapsing of the return right is accelerated as to an additional twenty-five percent if two-year Company performance goals as set by the Compensation Committee are met. (4) Totals include the following: (1) Company matching contributions to the Employee Savings Plan and Savings Restoration Plan, and (2) long-term disability insurance premium for Mssrs. Lee and Cusumano in 1993 and 1992, and Mr. Wilke in 1992. OPTION/SAR GRANTS IN LAST FISCAL YEAR (1) Non-qualified options without appreciation rights granted at 100% of fair market value on the date of grant. Options are exercisable twenty-five percent at the end of each of the first four years following date of grant and expire ten years after date of grant. In the event of any change of control of the Company, as defined, then each option will immediately become fully exercisable as of the date of the change of control. (2) 5% compound growth results in final unit price of $23.823 10% compound growth results in final unit price of $37.934 (3) The Modified Black-Scholes Options Valuation Model modifies the Black-Scholes formula to include the impact of distributions and to allow option exercise prior to maturity. The 10-year distribution yield of 3.10% was used in the modified model. (4) To normal retirement at age 65 in 1996: 5% compound growth results in potential realizable value of $31,118 10% compound growth results in potential realizable value of $65,354 AGGREGATED OPTIONS/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES (1) Based on the difference in the unit price of $16.00 at December 31, 1993 and the exercise price of the underlying options. EMPLOYEE BENEFIT PLANS The following are descriptions of the principal employee benefit plans of the Company. RETIREMENT PLANS Under the Retirement Plan, participants' benefits are calculated as 40.5% of the average annual compensation of the highest five calendar years of the preceding ten years up to Social Security covered compensation, plus 60% of the average annual compensation in excess of covered compensation, reduced pro rata for years of service less than 30. Under the Pension Restoration Plan, the Company will pay any difference between the ERISA maximum amount payable under the Retirement Plan and the amount otherwise payable, including amounts restricted by the compensation limit. Credited years of service as of December 31, 1993 (to the nearest whole year) and average annual compensation for the highest five years of the last ten years are as follows: 23 years and $450,000 for Mr. Lee, 24 years and $375,000 for Mr. Cusumano, 18 years and $275,000 for Mr. Wilke, 11 years and $240,000 for Mr. Dierckman, and 22 years and $150,000 for Mr. Frye. The following table reflects the estimated annual benefits paid as a single life annuity upon retirement at age 65 under the Retirement Plan and Pension Restoration Plan at various assumed compensation ranges and credited years of service: The Board of Directors has adopted a Supplemental Executive Retirement Plan pursuant to which the Company will pay benefits to specified employees so that such employees' maximum normal retirement benefit under the Retirement Plan and the Pension Restoration Plan will be earned during a period of 20 rather than 30 years of credited service. As of December 31, 1993, Robert D. Wilke and a former officer of the Company were the only participants in the Supplemental Executive Retirement Plan. The following table reflects the estimated annual benefits under the Supplemental Executive Retirement Plan upon retirement at age 65 at various assumed compensation ranges and credited years of service: CHANGE IN CONTROL SEVERANCE PROGRAM The Partnership entered into severance agreements in March 1988 with three executive officers, Thomas L. Lee, Gary M. Cusumano and Robert D. Wilke, under which each such officer is entitled to certain benefits in the event of a "change of control." Under the provisions of the severance agreements, a "change of control" is deemed to have occurred where (i) any "person" (other than a trustee or similar person holding securities under an employee benefit plan of the Partnership, or an entity owned by the Unitholders in substantially the same proportions as their ownership of units) becomes the beneficial owner of 25% or more of the total voting power represented by the Partnership's then outstanding voting securities, (ii) Newhall Management Corporation is removed as Managing General Partner of the Managing General Partner, or (iii) the holders of the voting securities of the Partnership approve a merger or consolidation of the Partnership with any other entity, other than a merger or consolidation which would result in the voting securities of the Partnership outstanding immediately prior thereto continuing to represent (either by remaining standing or by being converted into voting securities of the surviving entity) at least 75% of the total voting power represented by the voting securities of the Partnership or such surviving entity outstanding immediately after such merger or consolidation, or (iv) a plan of complete liquidation of the Partnership is adopted or the holders of the voting securities of the Partnership approve an agreement for the sale or disposition by the Partnership (in one transaction or a series of transactions) of all or substantially all the Partnership's assets. Entitlement to benefits arises if, within two years following a change in control, the officer's employment is terminated or if he elects to terminate his employment following action by the Partnership which results in (i) a reduction in salary or other benefits, (ii) change in location of employment (iii) a change in position, duties, responsibilities or status inconsistent with the officer's prior position or a reduction in responsibilities, duties, or offices as in effect immediately before the change in control, or (iv) the failure of the Partnership to obtain express assumption by any successor of the Partnership's obligations under the severance agreement. Benefits payable under the agreements consist of (i) payment in a single lump sum equal to continuation of monthly payments of base salary for three years, (ii) payment in a single lump sum of three times the average bonus payments for the two fiscal years preceding the change in control, (iii) continuation of participation in insurance and certain other fringe benefits for three years, (iv) immediate vesting of deferred compensation or non-qualified retirement benefits and options and related appreciation rights, (v) immediate lapse of any Partnership rights to the return or repurchase of Units granted pursuant to Units Rights, (vi) a retirement benefit equivalent to the additional benefits that would have accrued under Partnership retirement plans if employment had continued for two years, and (vii) reduction of required service for full retirement benefits from 30 years to 20 years through a non- qualified arrangement. Benefits payable under the agreements are instead of any severance pay benefits under the Partnership's general severance pay policy. The agreements are not contingent upon the officers actively seeking other employment, but provide for some offset of benefits if other employment (other than self-employment) is obtained. For each month of employment (other than self-employment) during the three years following termination of employment with the Partnership, the officer must return to the Partnership the lesser of 1/36 of the salary continuation payment or the compensation received from the new employer for that month. In addition, to the extent the new employer provides the officer with comparable medical, dental, disability or life insurance coverage, such benefits under the severance agreements will terminate. RETIREMENT PLAN FOR DIRECTORS Directors who cease to be directors after at least five years of service on the Board of Directors, will be eligible for retirement benefits under a Retirement Plan for Directors. This Plan covers service only as an outside director. A director who retires as an employee of the Company but continues on the Board is eligible for benefits under this Plan if he or she serves on the Board for at least five years after retirement as an employee. Under the Plan, each eligible director is entitled to an annual retirement benefit equal to the director's annual base retainer plus the Board meeting fees for the number of regular meetings held in the year preceding retirement at the rates in effect at the date of retirement. Quarterly benefit payments will commence after a director ceases to be a director (but not before age 65) and continue for a period equal to the length of the director's service as an outside director or until death, whichever occurs first. COMPENSATION OF THE DIRECTORS The Partnership Agreement provides that the compensation of the general partners and their partners, directors, officers and employees shall be determined by the Managing General Partner. Both the compensation committee and the nominating committee of the Board of Directors of Newhall Management Corporation, the Managing General Partner of Newhall Management Limited Partnership, have been granted authority by the Board of Directors to determine certain compensation issues. Members of the Board receive an annual fee of $22,000 for serving on the Board and non-employee directors receive a fee of $1,000 for each Board or committee meeting attended. Members of the Board of Directors will also receive reimbursement for travel and other expenses related to attendance at meetings of the Board of Directors and of the committees. In addition, the Partnership Agreement requires the Partnership to reimburse the Managing General Partner for any federal or California income taxes imposed upon the Managing General Partner or its Managing General Partner as a result of its activities as Managing General Partner. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Company currently maintains a $30 million unsecured revolving credit facility, and a subsidiary of the Company has a $15 million revolving credit line with Wells Fargo Bank, N.A. (the "Bank"). There were no borrowings outstanding against these credit lines at December 31, 1993. In addition, certain of the Company's employee benefit plans have invested approximately $13 million in Index Funds managed by the Bank and the Bank has extended approximately $2 million in letters of credit to the Company. The Bank is the principal subsidiary of Wells Fargo & Company. Carl E. Reichardt, Chairman of the Board of the Bank and Wells Fargo & Company, is a director of the Managing General Partner of the Managing General Partner. In addition, a director of the Managing General Partner of the Managing General Partner, Paul A. Miller, is also a director of the Bank and Wells Fargo & Company. REPORT OF THE COMPENSATION COMMITTEE OF THE BOARD OF DIRECTORS OF NEWHALL MANAGEMENT CORPORATION COMPENSATION COMMITTEE CHARTER The Compensation Committee is charged with exercising authority with respect to the compensation of all executive officers of the Company and to review management development issues. It has regularly scheduled meetings two times a year, and meets at other times as appropriate. SENIOR MANAGEMENT COMPENSATION PHILOSOPHY The Company believes its success is greatly influenced by the caliber of its employees. The Company's compensation program for senior management is designed to attract, recruit and retain a highly skilled, professional and dedicated work force. In this regard, Newhall Land's senior management compensation program consists of: . Base salary compensation tied to prevailing real estate industry compensation practices. . Annual merit and incentive pay compensation (bonuses) primarily related to the Company's performance for the previous fiscal year. . Long-term incentive compensation in the form of Unit options and restricted Units directly tied to increasing Unitholder value. As it is directly related to corporate performance, this component of compensation can be highly volatile. The Company's objective is for the base salary annual incentive compensation and long-term incentive compensation of senior management over time to approximate the median levels for an industry comparison group consisting primarily of real estate companies with which the Company competes for executive talent. From year-to-year, however, relative compensation levels may vary due largely to variances in individual company performance. In addition, for individual managers, there is also a subjective element relating to his or her success in meeting individual performance goals determined at the beginning of each year. These goals are for the business segment he or she manages including personal goals for increasing Unitholder values through profitability and, most importantly, the value of the Company's landholdings. BASE SALARY COMPENSATION The base salary for each executive officer is determined on the basis of internal comparability considerations and base salary levels in effect for comparable positions at the Company's principal competitors for executive talent. External salary data provided to the Committee by an independent compensation consulting firm indicate that these salaries for 1993 were generally at or below the median level for such companies. Salaries are reviewed on an annual basis, and adjustments to each executive officer's base salary are based upon individual performance and salary adjustments paid by the Company's competitors. ANNUAL MERIT AND INCENTIVE COMPENSATION (BONUSES) Annual cash bonuses under the Company's Incentive Plan are earned by each executive officer primarily on the basis of the Company's earnings in the previous fiscal year. The aggregate amount of such incentive bonuses may not exceed 5% of the Company's net income before deducting the incentive awards. Also considered are comparable industry performance, the accomplishment of individual and Company objectives and an individual's contribution to the Company's business. The bonuses (except for Mr. Lee's own bonus) are recommended by the Company's Chief Executive Officer, Mr. Lee, and approved by the Compensation Committee and the Board of Directors. The aggregate cash bonuses paid for 1993 were $307,000 (or 2.4% of 1993 net income before bonuses), versus $455,000 in 1992, or a 32.5% reduction from 1992 to 1993. This reduction reflects the Company's reduction in earnings from 1992 to 1993 and the fact that Messrs. Lee and Cusumano did not receive cash bonuses in 1994. Each of the five highest paid executive officers received cash bonuses in 1993. The payment of bonuses recognizes significant strategic accomplishments of the Company during the industry downturn, namely successes in obtaining large amounts of entitlements, growth in the portfolio of commercial properties, reduction in overhead costs and the geographic expansion into Arizona. In lieu of cash bonuses, and because of the decrease in the Company's earnings in 1993, Mr. Lee was awarded options for 9,200 Units and Mr. Cusumano was awarded options for 7,500 Units, each option exercisable at $14.75 per Unit, the Company's unit market price on grant date. These option grants, in lieu of cash bonuses, reflect the 1992 bonus cash amounts of Messrs. Lee and Cusumano, reduced to reflect the reduction in the Company's earnings from 1992 to 1993, and increased to reflect the fact that the bonuses were not paid in cash. The options were valued for bonus purposes based upon a Black-Scholes option value of $5.44 per Unit. LONG-TERM INCENTIVE COMPENSATION To encourage growth in the Unitholder value, the equity component of compensation includes Unit options, restricted Units under the Option, Appreciation Rights and Restricted Units Plan adopted by Unitholders in 1988. They are generally granted at mid-year to key management personnel who are in positions to make a substantial contribution to the long-term success of the Company. These Unit awards mature and are expected to grow in value over time and for that reason represent compensation which is attributable to service over a period of up to ten years. This focuses attention on managing the Company from the perspective of an owner with an equity stake in the business. The size of the Unit option grant to each executive officer, based on the aggregate exercise price, generally is set to a multiple of salary which the Committee deems appropriate in order to create a meaningful opportunity for ownership based upon the individual's current position with the Company, but also takes into account comparable awards to individuals in similar positions in the industry as reflected in external surveys and as reported to the Committee by an independent compensation consultant, and the individual's potential for future responsibility and promotion over the option term. CHIEF EXECUTIVE OFFICER COMPENSATION The last increase in the salary of Mr. Lee was in January 1990, to its 1993 annual level of $305,000. Mr. Lee's annual cash incentive bonus was reduced from $120,000 in 1991 to $50,000 in 1992, with no cash bonus in 1993, reflecting the Company's earnings decline. However, the Committee also felt it was necessary to recognize the significant strategic accomplishments of the Company during the industry downturn. This recognition was made in the form of the bonuses, albeit at reduced amounts, with the 1993 bonuses to Messrs. Lee and Cusumano being paid in the form of Unit options. See "Annual Merit and Incentive Compensation (Bonuses)" above. Mr. Lee's long-term incentive compensation was last reviewed in July, 1993. At that time, he was granted 30,000 Unit options, a 50% increase from the 1992 grant, with an exercise price of $14.625, equal to the market value of the Units at that time. The Committee, in determining the number of options to grant Mr. Lee in 1993, considered the following factors, in addition to the Company's earnings decline: Mr. Lee's salary has been frozen since 1990; Mr. Lee's annual incentive bonus awards have been at significantly lower levels each year beginning in 1991; and Mr. Lee's substantial achievements during the downturn in the real estate industry in terms of obtaining large amounts of entitlements, growth in the portfolio of commercial properties, reduction in overhead costs and the Company's geographic expansion into Arizona. SECTION 162 LIMIT Recently enacted Section 162(m) of the Internal Revenue Code ("Section 162") limits federal income tax deductions for compensation paid to the Chief Executive Officer and the four other most highly compensated officers of a public company to $1 million per year, but contains an exception for performance-based compensation that satisfies certain conditions. The Company believes that Unit options granted to its executives will qualify for the performance based-compensation exception to the deduction limit. Because it is unlikely that other compensation to any Company executive would exceed the deduction limit in the near future and final regulations have not been issued under Section 162(m), the Committee has not yet considered whether it will seek to qualify compensation other than options for the performance-based exception or will prohibit the payment of compensation that would exceed the deduction limit. COMPENSATION COMMITTEE MEMBERS The Compensation Committee of the Board of Directors of Newhall Management Corporation is comprised of the following five directors, none of whom is eligible to receive options, appreciation rights or Units under any compensation plan of the Company: George C. Dillon (Chairman) James F. Dickason Peter T. Pope Carl E. Reichardt Lawrence R. Tollenaere ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT DIRECTORS AND OFFICERS The following table sets forth the number of units beneficially owned by each director of Newhall Management Corporation, each of the Company's five highest paid executives and all directors and officers as a group as of December 31, 1993. * Represents less than 0.1% of the securities outstanding. (1) Includes 72,000 units each for Messrs. Henry K. Newhall, Woods and Zilkha, 71,650 units for Mr. McBean and Miss Jane Newhall, 2,000 units each for Messrs. Dickason, Dillon, Miller, Reichardt and Tollenaere and 500 units for Messrs. Sutton and Pope which are held by the Managing General Partner. Includes 2,000 units held by the Managing General Partner and 20 units contributed to Newhall General Partnership in the case of Mr. Lee. Of the total of 372,300 units held by the Managing General Partner beneficially for the directors, 20 units have been contributed to Newhall General Partnership, and of those 20 units, 10 units have been contributed back to the Managing General Partner by Newhall General Partnership. See Item 10 of this Annual Report on Form 10-K for information on a shareholders' agreement, voting trust agreement, and limited partnership agreement relating to these units. (2) Includes 92,375 units which Mr. Cusumano has the right to acquire and 4,900 restricted units which may be returned to the Partnership under certain circumstances pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (3) The Partnership is advised that Mr. Dickason has sole voting and investment power as to 46,020 units held by a trust for which he is a trustee. (4) Includes 43,750 units which Mr. Dierckman has the right to acquire and 1,200 restricted units which may be returned to the Partnership under certain circumstances pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (5) Includes 3,600 units owned by Mr. Dillon's wife. (6) Includes 39,500 units which Mr. Frye has the right to acquire pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (7) Includes 119,375 units which Mr. Lee has the right to acquire and 6,400 restricted units which may be returned to the Partnership under certain circumstances pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (8) The Partnership is advised that Mr. McBean has sole voting and investment power as to 1,106,662 of these units which are owned by him and has shared voting and investment power as to 783,012 units held of record by certain trusts under which he is a co-trustee with Henry K. Newhall and others. (9) The Partnership is advised that Henry K. Newhall has sole voting and investment power as to 80,928 held by trusts for which he is the trustee and beneficiary. Voting and investment power is shared with Peter McBean and others as to 889,940 units held by certain trusts. (10) Mr. Reichardt has sole voting and investment power as to 3,000 units held by trusts for which he is the trustee. (11) Includes 85,250 units which Mr. Wilke has the right to acquire and 3,900 restricted units which may be returned to the Partnership under certain circumstances pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (12) The Partnership is advised that Mr. Woods has sole voting and investment power as to 342,496 of these units owned by him and sole voting and investment power as to 312,208 of these units held of record by a trust under which he is the trustee. Also included are 54,300 units owned by Mr. Woods' wife as to which he disclaims any beneficial ownership. (13) Includes 230,600 units held by Zilkha & Sons, Inc. for which the Partnership is advised that Mr. Zilkha has sole voting and investment power and 30,000 units held by Mr. Zilkha's wife for which he disclaims beneficial ownership. Except as indicated otherwise in the above notes, the specified persons possess sole voting and investment power as to the indicated number of units to the best knowledge of the Company. Certain provisions of the Partnership's Limited Partnership Agreement require the affirmative vote of holders of at least 75% of the Partnership's voting power to approve (i) the removal of any general partner or the election of any general partner as the Partnership's managing general partner; or (ii) certain business combinations and other specified transactions ("Business Combinations") with, or proposed by or on behalf of, persons beneficially owning 10% or more of the Partnership's voting power, unless such Business Combination is either approved by a majority of the present directors of Newhall Management Corporation (or by directors who are nominated by them) or certain price and procedural requirements are satisfied. CERTAIN UNITHOLDERS The following table sets forth the names and addresses and unitholdings of the only persons known to the Partnership to be beneficial owners of more than five percent of the outstanding units of the Partnership as of December 31, 1993. Except as otherwise indicated, such unitholders have sole voting and investment power to the best knowledge of the Partnership. (1) See footnotes (1) and (8) under Directors and Officers. To the best knowledge of the management of the Company, no other person owned beneficially more than five percent of the outstanding units of the Company on that date. With respect to the above information, the Company has relied upon Schedule 13G filings and information received from such persons. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Company currently maintains a $30 million unsecured revolving credit facility, and a subsidiary of the Company has a $15 million revolving credit line with Wells Fargo Bank, N.A. (the "Bank"). There were no borrowings outstanding against these credit lines at December 31, 1993. In addition, certain of the Company's employee benefit plans have invested approximately $13 million in Index Funds managed by the Bank and the Bank has extended approximately $2 million in letters of credit to the Company. The Bank is the principal subsidiary of Wells Fargo & Company. Carl E. Reichardt, Chairman of the Board of the Bank and Wells Fargo & Company, is a director of the Managing General Partner of the Managing General Partner. In addition, a director of the Managing General Partner of the Managing General Partner, Paul A. Miller, is also a director of the Bank and Wells Fargo & Company. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed with this report: 1. Financial Statements - The Consolidated Financial Statements of the Company: Consolidated Statements of Income for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992, Consolidated Statements of Cash Flows for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, Consolidated Statements of Changes in Partners' Capital for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, and Notes to Consolidated Financial Statements. 2. Schedules - Financial Schedules of the Company for the years ended December 31, 1993, December 31, 1992 and December 31, 1991: Property, Plant and Equipment (Schedule V), Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment (Schedule VI), Short-Term Borrowings (Schedule IX), and Supplemental Income Statement Information (Schedule X). 3. Exhibits (listed by numbers corresponding to the Exhibit Table of Item 601 in Regulation S-K): 3(a) The Newhall Land and Farming Company (a California Limited Partnership) Limited Partnership Agreement incorporated by reference to Exhibit 3(e) to Registrant's Registration Statement on Form S-14 filed August 24, 1984. (b) First Amendment to Limited Partnership Agreement of The Newhall Land and Farming Company (a California Limited Partnership). 4 Depositary Receipt for Units of Interest, The Newhall Land and Farming Company (a California Limited Partnership) incorporated by reference to Exhibit 4 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. * 10(a) Option, Appreciation Rights and Restricted Units Plan (First Amendment and Restatement) of The Newhall Land and Farming Company (a California Limited Partnership). * (b) Newhall Executive Incentive Plan incorporated by reference to Exhibit 10(f) to Registrant's Registration Statement on Form S- 14 filed August 24, 1984. * (c) The Newhall Land and Farming Company Employee Savings Plan incorporated by reference to the Company's Registration Statement on Form S-8 dated January 25, 1984. * (d) The Newhall Land and Farming Company Retirement Plan Restatement, Amendments No. 1 through 5, incorporated by reference to Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. * (e) Form of Severance Agreements. (f) Newhall Management Corporation Retirement Plan for Directors (Revised January 16, 1991) incorporated by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990. * (g) The Newhall Land and Farming Company Supplemental Executive Retirement Plan (Restated effective January 15, 1992) incorporated by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. * (h) The Newhall Land and Farming Company Senior Management Survivor Income Plan. (i) Form of Indemnification Agreement between the Partnership and its General Partners and the general partners, partners, shareholders, officers and directors of its General Partners, or of the Managing General Partner of the Managing General Partner, as amended, incorporated by reference to Exhibit 28(g) to the Company's report on Form 8-K filed December 11, 1990. (j) Tax Payment and Tax Benefit Reimbursement Agreement incorporated by reference to Exhibit 28(f) to the Company's report on Form 8-K filed December 11, 1990. * (k) The Newhall Land and Farming Company Deferred Cash Bonus Plan incorporated by reference to Exhibit 10(l) of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. * (l) Form of award issued under The Newhall Land and Farming Company Deferred Cash Bonus Plan incorporated by reference to Exhibit 10(m) of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. * (m) The Newhall Land and Farming Company Employee Savings Restoration Plan (As restated effective January 15, 1992) incorporated by reference to Exhibit 10(n) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. * (n) The Newhall Land and Farming Company Pension Restoration Plan(As restated effective January 15, 1992) incorporated by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (o) Trust Agreement dated January 15, 1992 between the Partnership and Newhall Management Corporation incorporated by reference to Exhibit 10(p)to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. * (p) Amendment No. 4 to The Newhall Land and Farming Company Employee Savings Plan, incorporated by reference to Exhibit 10(q) of the Company's Annual Report on Form 10-K for the year ended December 31, 1992. * (q) Amendments No. 1, No. 2, and No. 3 to The Newhall Land and Farming Company Employee Savings Plan, incorporated by reference to Exhibit 19(a) of the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 11 Computation of earnings per unit. 21 Subsidiaries of the Registrant. 99(a) Articles of Incorporation of Newhall Management Corporation, as amended, incorporated by reference to Exhibit 28(b) to the Company's report on Form 8-K filed December 11, 1990. (b) Bylaws of Newhall Management Corporation incorporated by reference to Exhibit 28(c) to the Company's report on Form 8-K filed December 11, 1990, and Amendment Number 1 dated July 17, 1991 incorporated by reference to Exhibit 28(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (c) Shareholders' Agreement between Newhall Management Corporation, its shareholders and the Newhall Management Corporation Voting Trust incorporated by reference to Exhibit 28(d) to the Company's report on Form 8-K filed December 11, 1990, and Amendment to Shareholders' Agreement dated as of November 20, 1991 incorporated by reference to Exhibit 28(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (d) Voting Trust Agreement between Newhall Management Corporation, the Trustee, and the individual shareholders of Newhall Management Corporation incorporated by reference to Exhibit 28(e) to the Company's report on Form 8-K filed December 11, 1990. (e) Partnership Agreement of Newhall General Partnership incorporated by reference to Exhibit 28(e) to Registrant's Registration Statement on Form S-14 filed August 24, 1984, and the Certificate of Amendment of Partnership Agreement of Newhall General Partnership, dated November 14, 1990 incorporated by reference to Exhibit 28(e) of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. (f) Limited Partnership Agreement of Newhall Management Limited Partnership, incorporated by reference to Exhibit 28(a) to the Company's report on Form 8-K filed December 11, 1990. * The items marked above constitute Executive Compensation Plans and Arrangements. (b) There was no current report on Form 8-K filed with respect to the quarter ended December 31, 1993. 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 NEWHALL LAND AND FARMING COMPANY (a California Limited Partnership) ------------------------------------ Registrant By Newhall Management Limited Partnership, Managing General Partner By Newhall Management Corporation, Managing General Partner Date: March 16, 1994 By / S / THOMAS L. LEE ----------------------------- Thomas L. Lee Chairman 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. Date: March 16, 1994 By / S / THOMAS L. LEE ---------------------------- Thomas L. Lee, Chairman and Chief Executive Officer of Newhall Management Corporation (Principal Executive Officer) Date: March 16, 1994 By / S / ROBERT D. WILKE ---------------------------- Robert D. Wilke, Vice Chairman and Chief Financial Officer of Newhall Management Corporation (Principal Financial Officer) Date: March 16, 1994 By / S / DONALD L. KIMBALL ---------------------------- Donald L. Kimball, Controller of Newhall Management Corporation (Principal Accounting Officer) Directors of Newhall Management Corporation: Date: March 16, 1994 By / S / James F. Dickason ---------------------------- James F. Dickason Date: March 16, 1994 By / S / George C. Dillon ---------------------------- George C. Dillon Date: March 16, 1994 By / S / Thomas L. Lee ---------------------------- Thomas L. Lee Date: March 16, 1994 By ---------------------------- Peter McBean Date: March 16, 1994 By / S / Paul A. Miller ---------------------------- Paul A. Miller Date: March 16, 1994 By / S / Henry K. Newhall ---------------------------- Henry K. Newhall Date: March 16, 1994 By / S / Jane Newhall ---------------------------- Jane Newhall Date: March 16, 1994 By / S / Peter T. Pope ---------------------------- Peter T. Pope Date: March 16, 1994 By / S / Carl E. Reichardt ---------------------------- Carl E. Reichardt Date: March 16, 1994 By / S / Thomas C. Sutton ---------------------------- Thomas C. Sutton Date: March 16, 1994 By ---------------------------- Lawrence R. Tollenaere Date: March 16, 1994 By / S / Edwin Newhall Woods ---------------------------- Edwin Newhall Woods Date: March 16, 1994 By / S / Ezra K. Zilkha ---------------------------- Ezra K. Zilkha S-1 SCHEDULE V THE NEWHALL LAND AND FARMING COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Dollars in thousands) S-2 SCHEDULE VI THE NEWHALL LAND AND FARMING COMPANY ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Dollars in thousands) S-3 SCHEDULE IX THE NEWHALL LAND AND FARMING COMPANY SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Dollars in thousands) The following information relates to the aggregate of short-term borrowings during the years: The average amount outstanding and average interest rate were computed on a daily weighted average basis during the time there were short-term borrowings. S-4 SCHEDULE X THE NEWHALL LAND AND FARMING COMPANY SUPPLEMENTAL INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Dollars in thousands) As to lines omitted, the amounts are less than 1% of total revenues. THE NEWHALL LAND AND FARMING COMPANY INDEX TO EXHIBITS Item 14 (a) 3

850143_1993.txt

850143_1993

1993

850143

ITEM 1. BUSINESS Development and Description of Business --------------------------------------- Information concerning the business of CRI Liquidating REIT, Inc. (the Liquidating Company) is contained in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and in Notes 1 and 5 of the notes to the financial statements of the Liquidating Company contained in Part IV (filed in response to Item 8 hereof), which is incorporated herein by reference. Employees --------- The Liquidating Company has no employees. Services are performed for the Liquidating Company by CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) and agents retained by it. ITEM 2. ITEM 2. PROPERTIES The Liquidating Company does not hold title to any real estate. The Liquidating Company indirectly holds interests in real estate through its equity investment in three Participating Mortgage Investments. These investments were comprised of two components: 85% of the original investment amount was a Mortgage- Backed Security; and 15% of the original investment amount was an uninsured equity contribution to the limited partnership (a Participation) which owns the underlying property. During 1993, the Liquidating Company sold the Mortgage-Backed Securities, but retained its Participations. The aggregate carrying value of these Participations represents less than 1% of the Liquidating Company's total assets as of December 31, 1993 and 1992. Although the Liquidating Company does not own the related real estate, the Federally Insured Mortgages and Mortgage-Backed Securities in which the Liquidating Company has invested are first liens, or are collateralized by first liens, on the respective residential apartment or townhouse complexes. PART I ITEM 3. ITEM 3. LEGAL PROCEEDINGS Reference is made to Note 10 of the notes to the financial statements on page 81 of 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 matters were submitted to the security holders to be voted on during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS (a), (b) and (c) The information required in these sections is included in Selected Financial Data on pages 21 through 24 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Reference is made to Selected Financial Data on pages 21 through 24 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 25 through 39 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. PART II ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to pages 40 through 47 of the 1993 Annual Report to Shareholders for the financial statements of the Liquidating Company, which are incorporated herein by reference. See also Item 14 of this report for information concerning financial statements and financial statement schedules. 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), (b), (c) and (e) The information required by Item 10 (a), (b), (c) and (e) with regard to directors and executive officers of the registrant is incorporated herein by reference to the Liquidating Company's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994. (d) There is no family relationship between any of the foregoing directors and executive officers. (f) Involvement in certain legal proceedings. None. (g) Promoters and control persons. Not applicable. PART III ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to the Liquidating Company's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement and Note 3 of the notes to the financial statements, included in the 1993 Annual Report to Shareholders. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated herein by reference to the Liquidating Company's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with management and others. The Liquidating Company has 5 directors, two of whom are also executive officers. The Liquidating Company's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement and Note 3 of the notes to the financial statements, included in the 1993 Annual Report to Shareholders, which contain a discussion of the amounts, fees and other compensation paid or accrued by the Liquidating Company to the directors and officers and their affiliates, are incorporated herein by reference. (b) Certain business relationships. The Liquidating Company has no business relationship with entities of which the general and limited partners of the Adviser to the Liquidating Company are officers, directors or equity owners other than as set forth in the Liquidating Company's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement, which is incorporated herein by reference. PART III ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Continued (c) Indebtedness of management. None. (d) Transactions with promoters. Not applicable. 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 and 2. Financial Statements and Financial Statement Schedules The following financial statements are incorporated herein by reference in Item 8 from the indicated pages of the 1993 Annual Report to Shareholders: Page Description Number(s) ----------- --------- Balance Sheets as of December 31, 1993 and 1992 41-42 Statements of Income for the years ended December 31, 1993, 1992 and 1991 43-44 Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 45 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 46-47 Notes to financial statements which include the information required to be included in Schedule XII - Mortgage Loans on Real Estate 48-81 The report of the Liquidating Company's independent accountants with respect to the above listed financial statements appears on page 40 of the 1993 Annual Report to Shareholders. All other financial statements and schedules have been omitted since the required information is included in the financial statements or the notes thereto, or is not applica- ble or required. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - Continued (a) 3. Exhibits (listed according to the number assigned in the table in Item 601 of Regulation S-K) Exhibit No. 3 - Articles of incorporation and bylaws. d. Articles of Incorporation of CRI Liquidating Maryland REIT, Inc. (Incorporated by reference from Exhibit 3(d) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). e. Bylaws of CRI Liquidating Maryland REIT, Inc. (Incorporated by reference from Exhibit 3(e) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - Continued f. Agreement and Articles of Merger between CRI Liquidating Maryland REIT, Inc. and CRI Liquidating REIT, Inc. as filed with the Office of the Secretary of the State of Delaware. (Incorporated by reference from Exhibit 3(f) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). g. Agreement and Articles of Merger between CRI Liquidating Maryland REIT, Inc. and CRI Liquidating REIT, Inc. as filed with the State Department of Assessment and Taxation for the State of Maryland. (Incorporated by reference from Exhibit 3(g) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). Exhibit No. 10 - Material contracts. a. Revised Form of Advisory Agreement. (Incorporated by reference from Exhibit No. 10.2 to the Registration Statement). b. Registration Rights Agreement, dated November 27, 1989 between the Registrant and CRI Insured Mortgage Association, Inc. (Incorporated by reference from Exhibit 10(b) to the Annual Report on Form 10-K for 1989). PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - Continued Exhibit No. 13 - Annual Report to security holders, Form 10-Q or Quarterly Report to security holders. a. 1993 Annual Report to Shareholders. Exhibit No. 21 - Other documents or statements to security holders. a. 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits The list of Exhibits required by Item 601 of Regulation S-K is included in Item (a)(3) above. (d) Financial Statement Schedules See Item (a) 1 and 2 above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. CRI LIQUIDATING REIT, INC. January 28, 1994 /s/William B. Dockser ----------------------- ----------------------- DATE William B. Dockser 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: January 28, 1994 /s/H. William Willoughby --------------------------- ------------------------- DATE H. William Willoughby Director, President, Secretary and Chief Financial Officer January 28, 1994 /s/Jay R. Cohen --------------------------- ------------------------- DATE Jay R. Cohen Executive Vice President and Treasurer --------------------------- ------------------------- DATE Garrett G. Carlson Director January 25, 1994 /s/G. Richard Dunnells --------------------------- ------------------------- DATE G. Richard Dunnells Director --------------------------- ------------------------- DATE Robert F. Tardio Director CROSS REFERENCE SHEET The item numbers and captions in Parts II, III and IV hereof and the page and/or pages in the referenced materials where the corresponding information appears are as follows: CROSS REFERENCE SHEET EXHIBIT INDEX CRI LIQUIDATING REIT, INC. ANNUAL REPORT TO SHAREHOLDERS 21 CRI LIQUIDATING REIT, INC. Selected Financial Data The selected statements of income data presented above for the years ended December 31, 1993, 1992 and 1991, and the balance sheet data as of December 31, 1993 and 1992, are derived from and are qualified by reference to the Liquidating Company's financial statements which have been included elsewhere in this Annual Report to Shareholders. The statements of income data for the years ended December 31, 1990 and 1989 and the balance sheet data as of December 31, 1991, 1990 and 1989 are derived from audited financial statements not included in this Annual Report to Shareholders. This data should be read in conjunction with the financial statements and the notes thereto. CRI LIQUIDATING REIT, INC. Selected Financial Data - Continued (a) All financial information for the periods prior to the Merger on November 27, 1989 has been presented in a manner similar to a pooling of interests, which effectively combines the historical results of the CRIIMI Funds. The dividend and net income per share amounts for the year ended December 31, 1989 have been restated based upon the weighted average shares outstanding as if the Merger had been consummated on January 1, 1989. Market Data ----------- On November 28, 1989, the Liquidating Company was listed on the New York Stock Exchange (Symbol CFR). Prior to that date, there was no public market for the Liquidating Company's shares. As of December 31, 1993 and 1992, there were 30,422,711 shares held by approximately 10,000 and 9,500 investors, respectively. The following table sets forth the high and low closing sales prices and the dividends per share for the Liquidating Company shares during the periods indicated: ---------------------------------- Sales Price Dividends Quarter Ended High Low per Share ------------- -------- ------- ---------- March 31, $ 10 $ 9 1/8 $ 0.62 June 30, 10 1/4 9 0.97 September 30, 9 5/8 9 0.21 December 31, 9 3/8 7 7/8 0.98 -------- $ 2.78 ======== CRI LIQUIDATING REIT, INC. Selected Financial Data - Continued ----------------------------------- Sales Price Dividends Quarter Ended High Low per Share ------------- -------- ------- ---------- March 31, $ 12 $ 10 1/2 $ 0.60 June 30, 11 3/8 10 3/8 0.32 September 30, 11 1/2 10 3/8 0.31 December 31, 11 9 1/4 1.17 -------- $ 2.40 ======== MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS --------------------------------------------- General CRI Liquidating REIT, Inc. (the Liquidating Company) is a finite-life, self-liquidating real estate investment trust (REIT) which as of December 31, 1993, owned a portfolio of 63 U.S. government insured and guaranteed mortgage investments secured by multifamily housing complexes located throughout the United States. Mortgage investments in the portfolio are comprised of 61 loans insured pursuant to programs of the U.S. government through the Federal Housing Administration (FHA) (FHA - Insured Loans) and two securities backed by FHA-Insured Loans which have been securitized by private issuers and guaranteed as to timely payment of principal and interest by the Government National Mortgage Association (GNMA and Mortgage-Backed Securities, respectively). As discussed further below, the Liquidating Company does not intend to acquire any additional mortgage investments, except as may be necessary in connection with maintaining its REIT status, and intends to liquidate its portfolio by March 31, 1997. The Liquidating Company was created in November 1989 in connection with the merger (the Merger) of three funds which owned government insured multifamily mortgages (the CRIIMI Funds), all of which were sponsored by C.R.I., Inc. (CRI), a Delaware corporation formed in 1974. At the time of the Merger, the CRIIMI Funds collectively owned 110 government insured multifamily mortgages. The Merger resulted in two new REITs: (i) the Liquidating Company, a finite-life, self-liquidating REIT, and (ii) CRIIMI MAE Inc. (CRIIMI MAE) (formerly CRI Insured Mortgage Association, Inc.) an infinite-life, growth-oriented REIT. Consistent with the original objectives of the CRIIMI Funds, the Liquidating Company intends to continue to liquidate its assets over time and distribute the proceeds to its shareholders. Dividends to shareholders consist of ordinary income, capital gains and return of capital. Shareholders should expect dividends representing ordinary income and the market price of the shares to decrease as the Liquidating Company liquidates its assets and distributes return of capital over time to its shareholders. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- In the Merger, the Liquidating Company acquired the assets of the CRIIMI Funds. Investors in the CRIIMI Funds received, at their option, shares of common stock of either the Liquidating Company or CRIIMI MAE. To allow those investors who chose CRIIMI MAE shares to maintain their interest in the original assets of the CRIIMI Funds, CRIIMI MAE received one share of common stock of the Liquidating Company for each share of CRIIMI MAE issued in the Merger to investors in the CRIIMI Funds. As a result, CRIIMI MAE owned approximately 67% of the Liquidating Company's common stock as of December 31, 1992. Following the sale of approximately 3.1 million of its shares of common stock of the Liquidating Company, in November 1993, CRIIMI MAE reduced its ownership percentage to approximately 57%. The Liquidating Company shares have been trading on the New York Stock Exchange under the trading symbol CFR since November 28, 1989. The Liquidating Company is governed by a Board of Directors which includes the two shareholders of CRI. The Board of Directors has engaged CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) to act in the capacity of adviser to the Liquidating Company. The Adviser's general partner is CRI, and its limited partners include the shareholders of CRI. The Adviser and its affiliates (1) manage the Liquidating Company's assets with the goal of maximizing the returns to shareholders and (2) conduct the day-to-day operations of the Liquidating Company. The Adviser and its affiliates receive fees and expense reimbursements in connection with the administration and operation of the Liquidating Company. The Adviser also acts in a similar capacity for CRIIMI MAE. The Portfolio ------------- The Liquidating Company's portfolio consists of government insured multifamily mortgages. As of December 31, 1993, the Liquidating Company held a total of 63 government insured multifamily mortgages, 61 of which were FHA-Insured Loans and two of which were GNMA Mortgage-Backed Securities. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- As of December 31, 1993, the portfolio consisted of government insured multifamily mortgages with face values ranging from approximately $374,000 to $13.6 million with an average balance of approximately $3.8 million. Coupon rates in the portfolio range from 7.0% to 11.18%. Approximately 70% of the government insured multifamily mortgages have a coupon rate of 7.5%, and the entire portfolio has a weighted average coupon rate of approximately 7.65%. Additionally, the portfolio has a weighted average effective interest rate of approximately 10.03%. Maturities in the portfolio range from approximately 19 to 32 years as of December 31, 1993, with a weighted average remaining term based on face value of approximately 27 years. The Liquidating Company owns government insured multifamily mortgages on properties which were acquired by the predecessor CRIIMI Funds at a discount to face (Discount Mortgage Investments) on the belief that based on economic, market, legal and other factors, such Discount Mortgage Investments might be sold for cash, converted to condominium housing or otherwise disposed of or refinanced in a manner requiring prepayment or permitting other profitable disposition three to twelve years after acquisition by the predecessor CRIIMI Funds. The Liquidating Company also owns near or at par or premium government insured multifamily mortgages (Near Par or Premium Mortgage Investments) on properties which the Adviser does not expect to incur a significant financial statement loss if disposed of, refinanced or otherwise prepaid prior to maturity. On a tax basis, based on current information, including the current interest rate environment, the disposition of any mortgage investment is expected to result in a gain. Government Insurance Programs ----------------------------- The government insured multifamily mortgages in the Liquidating Company's portfolio include: (i) FHA-Insured Loans and (ii) GNMA Mortgage-Backed Securities. FHA is part of the United States Department of Housing and Urban Development (HUD), and FHA- Insured Loans are insured pursuant to Title II of the National Housing Act. Should an FHA-Insured Loan default, the mortgagee is typically entitled to approximately 99% of the face value of the mortgage. GNMA, which is also part of HUD, was federally chartered to provide liquidity in the secondary mortgage market. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- GNMA Mortgage-Backed Securities are guaranteed pursuant to Title III of the National Housing Act. If an issuer of a GNMA Mortgage- Backed Security defaults, GNMA continues to make interest and principal payments until such mortgage is assigned to HUD. In the event of a default of an FHA-Insured Loan underlying a GNMA Mortgage-Backed Security, the issuer or GNMA will make timely payments of principal and interest until such mortgage is assigned to HUD and pay 100% of the GNMA Mortgage-Backed Security's principal balance when such mortgage is assigned to HUD and GNMA receives the insurance proceeds. REIT Status ----------- The Liquidating Company has qualified and intends to continue to qualify as a REIT under Sections 856-860 of the Internal Revenue Code. As a REIT, the Liquidating Company does not pay taxes at the corporate level. Qualification for treatment as a REIT requires the Liquidating Company to meet certain criteria, including certain requirements regarding the nature of its ownership, assets, income and distributions of taxable income. Business Plan ------------- The Liquidating Company intends to dispose of its existing government insured mortgage investments by March 31, 1997 through an orderly liquidation. Consequently, the Adviser to the Liquidating Company developed a business plan which is intended to effect the orderly liquidation of the portfolio by March 31, 1997, which plan of liquidation was approved by the Liquidating Company's Board of Directors. The business plan assumes that the portfolio will be liquidated through a combination of defaults on or prepayments of (Involuntary Dispositions) and sales of (Voluntary Dispositions) government insured multifamily mortgages. During the term of the business plan, the Liquidating Company expects to generate cash flow from scheduled mortgage payments, Involuntary Dispositions, Voluntary Dispositions and interest earned on short-term investments. For the year ended December 31, 1993, the Liquidating Company experienced a 22% disposition rate based on the December 31, 1992 portfolio balance. In each of the next four calendar years, the business plan assumes a total annual disposition rate of approximately 25% of the portfolio as of MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- December 31, 1993. This is based on a relatively equal annual disposition of the portfolio over the remainder of the term of the business plan. The Liquidating Company intends to make Voluntary Dispositions, in addition to any Involuntary Dispositions that occur, if necessary to attempt to achieve such 25% rate and to liquidate the portfolio by March 31, 1997 in an orderly manner. Although the Liquidating Company expects to profitably dispose of its government insured multifamily mortgages, there can be no assurance as to when any insured mortgage will be disposed of by the Liquidating Company or the amount of proceeds the Liquidating Company would receive from any such disposition. The determination of whether and when to dispose of a particular government insured multifamily mortgage will be made by considering a variety of factors, including, without limitation, the market conditions at that time. As of December 31, 1993, the carrying value of the mortgage investments on a tax basis, including Mortgages Held for Disposition, was approximately $173 million; the par value was approximately $236 million; and the fair market value was approximately $243 million. Settlement of Litigation ------------------------ On March 22, 1990, a complaint was filed on behalf of a class comprised of certain former investors of CRI Insured Mortgage Investments III Limited Partnership (CRIIMI III) and CRI Insured Mortgage Investments II, Inc. (CRIIMI II) (the Plaintiffs) in the Circuit Court for Montgomery County, Maryland against the Liquidating Company, CRIIMI MAE, CRI Insured Mortgage Investments Limited Partnership (CRIIMI I) and its general partner, CRIIMI II, CRIIMI III and its general partner, CRI, and Messrs. William B. Dockser, H. William Willoughby and Martin C. Schwartzberg (the Defendants). On November 18, 1993, the Court entered an order granting final approval of a settlement agreement between the Plaintiffs and the Defendants. Under the terms of the settlement, CRIIMI MAE will issue to class members, including certain former investors of CRIIMI I, up to 2,500,000 warrants to purchase shares of its common stock. In addition, the settlement includes a payment of $1,400,000 for settlement administration costs and Plaintiff's attorneys' fees and expenses. Insurance provided $1,150,000 of the $1,400,000 cash payment, with the balance paid by CRIIMI MAE. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- Results of Operations 1993 Versus 1992 ---------------- Total income decreased $2.7 million or 9.7% to $24.6 million for 1993 from $27.3 million for 1992. This decrease was due primarily to a reduction in mortgage investment income partially offset by an increase in other investment income, as discussed below. Mortgage investment income decreased $2.9 million or 11.7% to $21.7 million for 1993 from $24.5 million for 1992. This decrease was principally the result of a reduction in the mortgage base resulting from the disposition of mortgage investments during 1993 and 1992. It is not anticipated that the nature of income from mortgage investments resulting from fixed payments of principal and interest or the expenses related to the ordinary administration of such mortgage investments will differ materially in future years. However, mortgage dispositions will reduce the recurring mortgage income in future periods. Other investment income increased $.8 million or 36.3% to $2.9 million for 1993 from $2.1 million for 1992. This increase was primarily attributable to approximately $133 million in other short-term investments acquired by the Liquidating Company during 1993, all of which were disposed of by December 31, 1993, as compared to approximately $67 million in other short-term investments acquired by the Liquidating Company during 1992, all of which were disposed of by December 31, 1992. Total expenses increased $1.3 million or 32.6% to $5.1 million for 1993 from $3.8 million for 1992. This increase was principally due to an increase in interest expense, professional fees and annual fees paid to the Adviser, as discussed below. Interest expense increased $1.2 million or 132.0% to $2.2 million for 1993 from $1.0 million for 1992. This increase was due primarily to the financing of a total of approximately $116 million in other short-term investments in February and October 1993 through November 1993 at an interest rate of approximately 3.35%, versus approximately $56 million which was financed in July MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- and August 1992 through December 1992 at an interest rate of 4.0% and 3.45%, respectively. Professional fees increased $.3 million or 97.1% to $.5 million for 1993 from $.2 million for 1992. This increase was primarily attributable to an increase in legal fees incurred in connection with the litigation described above. Annual Fees are paid to the Adviser for managing the Liquidating Company portfolio. These fees include a base component equal to a percentage of average invested assets. In addition, fees paid to the Adviser may include a performance based component that is referred to as the deferred component. The deferred component, which is also calculated as a percentage of average invested assets, is computed each quarter but paid (and expensed) only upon meeting certain cumulative performance goals. If these goals are not met, the deferred component accumulates, and may be paid in the future if cumulative goals are met. In addition, certain incentive fees are paid by the Liquidating Company on a current basis if certain performance goals are met. Annual Fees increased approximately $20,000 or 1.6% to $1.2 million for 1993 from $1.2 million for 1992. This increase was primarily due to the payment by the Liquidating Company, in 1993, of the deferred component of the annual fee due to specific performance goals being met, which included the payment of the deferred component for the second half of 1992. Partially offsetting the increase in annual fees for 1993 as compared to 1992 was a reduction in the mortgage base which is a component used in determining the annual fees payable by the Liquidating Company. The mortgage base has been decreasing as the Liquidating Company effects its business plan to liquidate by 1997. Gains on mortgage dispositions increased $2.0 million or 32.7% to $8.1 million in 1993 from $6.1 million in 1992. The gains or losses on mortgage dispositions are based on the number, carrying amounts, and the proceeds of mortgage investments disposed of during the period. The increase in gains was primarily due to the disposition of ten mortgages during 1993, nine of which resulted in gains. This compared to the disposition of three mortgages during 1992, two of which resulted in gains. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- Historical Dispositions ----------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- For financial statement purposes, the Liquidating Company accounted for the Merger of the CRIIMI Funds in a manner similar to the pooling-of-interests method as a result of the common control existing over the Liquidating Company, the CRIIMI Funds and CRIIMI MAE. Accordingly, there was no change in the basis assigned to each of the mortgage investments for financial statement purposes. However, for tax purposes, the Merger was treated as a taxable event resulting in a new basis being assigned to the assets. Specifically, the merger of CRIIMI I into the Liquidating Company resulted in a taxable gain, while the merger of CRIIMI II and CRIIMI III into the Liquidating Company resulted in taxable losses. As a result, the tax bases of the CRIIMI I assets were adjusted slightly upward and the tax bases of the CRIIMI II and CRIIMI III assets were adjusted downward. Consequently, there exists a difference in the bases of the mortgage investments for financial statement and tax purposes. Although one of the mortgage dispositions during 1993 resulted in a loss for financial statement purposes, all of the dispositions resulted in a tax basis gain totalling $14.9 million. The mortgage disposition resulting in a loss for financial statement purposes was the result of the prepayment of a Near Par or Premium Mortgage Investment formerly held by CRIIMI III. Generally, the Involuntary Disposition of Near Par or Premium Mortgage Investments will result in a loss, for financial statement purposes, because the carrying value of the mortgage investment, including acquisition costs, is the same as or slightly more than the insured amount of the mortgage investment. 1992 Versus 1991 ---------------- Total income decreased $4.2 million or 13.5% to $27.3 million in 1992 from $31.5 million in 1991 primarily due to a decrease in mortgage investment income attributable to the reduction in the mortgage base resulting from the mortgage dispositions noted above. Overall, expenses for 1992 increased from 1991 primarily due to interest expense on the financing of other short-term investments. Interest expense was based on the seller financing of 99% of the purchase price of the other short-term investments purchased in July and August 1992 and disposed of in December MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- 1992. The overall increase in expenses was partially offset by a decrease in annual fees, amortization of deferred costs and mortgage servicing fees due to mortgage dispositions, as well as a decrease in professional fees. The decrease in professional fees for 1992 as compared to 1991 was primarily attributable to increased legal fees in 1991 resulting from the litigation described above. Gains from mortgage dispositions of $6.1 million in 1992 increased from $5.2 million in 1991 principally due to the disposition of one mortgage which resulted in the recognition of a gain in 1992 of approximately $6.0 million. During 1992, the Liquidating Company determined that one of its investment in limited partnerships was fully impaired and as a result recognized a loss of $.7 million. Fair Value of Mortgage Investments ----------------------------------- The following estimated fair values of the Liquidating Company's mortgage investments are presented in accordance with generally accepted accounting principles. These estimated fair values, however, do not represent the liquidation value or the market value of the Liquidating Company. As of December 31, 1992, the Liquidating Company's mortgage investments were recorded at amortized cost (excluding Mortgages Held for Disposition which were recorded at the lower of cost or market). In connection with the Liquidating Company's implementation of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115) as of December 31, 1993, the Liquidating Company's Investment in Mortgages, including Mortgages Held for Disposition, are recorded at fair value, as estimated below, as of December 31, 1993. The difference between the amortized cost and the fair value of the mortgage investments represents the net unrealized gains on the Liquidating Company's mortgage investments and is reported as a separate component of shareholders' equity as of December 31, 1993. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- The fair value of the mortgage investments is based on the average of the quoted market prices from three investment banking institutions which trade insured mortgage loans as part of their day-to-day activities. As of December 31, 1993 Amortized Fair Cost Value ------------ ------------ Investment in Mortgages: Discount $166,913,207 $215,866,436 Near par or premium 16,983,594 17,647,797 Mortgages held for disposition 7,849,077 9,581,409 ------------ ------------ $191,745,878 $243,095,642 ============ ============ Liquidity The Liquidating Company closely monitors its cash flow and liquidity position in an effort to ensure that sufficient cash is available for operations and debt service requirements and to continue to qualify as a REIT. The Liquidating Company's cash receipts, which are derived from scheduled payments of outstanding principal of and interest on, and proceeds from the disposition of, mortgage investments held by the Liquidating Company, plus cash receipts from interest on temporary investments and cash received from the Liquidating Company's investment in limited partnerships (Participations), were sufficient for the years 1993, 1992 and 1991 to meet operating, investing, and financing cash requirements. It is anticipated that cash receipts will be sufficient in future years to meet similar cash requirements. Cash flow was also sufficient to provide for the payment of dividends to the shareholders. The Liquidating Company's dividend on an annual basis is comprised of substantially all of its ordinary income, capital gains and return of capital. Because the Liquidating Company is a liquidating entity, a substantial portion of the dividends paid to shareholders represents return of capital. For the years 1993, 1992 and 1991, total cash dividends were $2.78, $2.40 and $3.15 per share, respectively, of which $1.87, $1.45 and $2.07 per share, respectively, represented return MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- of capital for financial statement purposes. For tax purposes, the portion representing a non-taxable dividend for 1993, 1992 and 1991 was $1.61, $1.21 and $1.76, respectively. As of December 31, 1993, there were no material commitments for capital expenditures. Although the mortgage investments yield a fixed monthly mortgage payment once purchased, the cash dividends paid to shareholders may vary during each year due to (1) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly dividends, (2) the reduction in the asset base and monthly mortgage payments due to monthly mortgage payments received or mortgage dispositions, (3) variations in the cash flow received from the Participations, and (4) changes in the Liquidating Company's operating expenses. Mortgage dispositions may increase the return to shareholders for a period, although neither the timing nor the amount can be predicted. Decreases in market interest rates could result in the prepayment of certain mortgage investments. Although decreases in interest rates could increase prepayment levels of mortgages on single-family dwellings, the Liquidating Company's experience with mortgages on multifamily dwellings has been that decreases in interest rates do not necessarily result in increased levels of prepayments primarily due to the fact that most of the Liquidating Company's mortgage investments have coupon rates of approximately 7.5% and also due to lockouts (i.e., prepayment prohibitions), prepayment penalties on existing financing or difficulties in obtaining refinancing. Decreases in occupancy levels, rental rates or value of any property underlying a mortgage investment may result in the mortgagor being unable or unwilling to make required payments on the mortgage and thereby defaulting. Whether by prepayment, sale or assignment, the proceeds of a disposition of a Discount Mortgage Investment are expected to exceed the carrying amount of the mortgage for financial statement purposes, while the proceeds from the disposition of a Near Par or Premium Mortgage Investment may be slightly less than, the same as or slightly more than, the financial statement carrying amount of the mortgage. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- However, the proceeds of any mortgage disposition, based on current information, including the current interest rate environment, is expected to exceed the carrying amount of the mortgage on a tax basis and, therefore, result in a tax gain. Changes in interest rates will affect the proceeds received through Voluntary Dispositions: (i) by increasing the value of the portfolio in the event of decreases in long-term and intermediate- term U.S. Treasury Rates (Treasury Rates) or decreasing the value of the portfolio in the event of increases in Treasury Rates (assuming the interest rate differential between Treasury Rates and the yields on government insured multifamily mortgages remains constant) and (ii) if the Adviser deems appropriate, increasing the pace at which the Liquidating Company liquidates the portfolio in the event of decreases in Treasury Rates or decreasing the pace of such liquidation in the event of increases in Treasury Rates. Borrowing Policy ---------------- Subject to customary business considerations, there is no specific limitation on the amount of debt that the Liquidating Company may incur. The Liquidating Company does not intend to incur any indebtedness, except in connection with the maintenance of its REIT status. Other Short-Term Investments ---------------------------- On January 28, 1993, October 15, 1993 and October 28, 1993, the Liquidating Company entered into investment and financing agreements with Daiwa Securities America, Inc. (Daiwa). These transactions assisted in maintaining the Liquidating Company's REIT status. Pursuant to the terms of these agreements, the Liquidating Company invested in GNMA mortgage-backed securities or certificates backed by FHA-Insured project loans (collectively, the Securities) with unpaid principal balances of approximately $74.7 million, $40.3 million and $11.9 million, respectively, at purchase prices of 104.615%, 106.41% and 100.8%, respectively, of the face values, which earned interest at per annum pass-through coupon rates of 9.1875%, 13.18% and 8.625%, respectively. In MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- addition, Daiwa provided financing for approximately 99% and 86% of the purchase price for the transactions which occurred on January 28, 1993 and October 15, 1993, respectively, at an interest rate of approximately 3.35%. The related debt was non- recourse and fully secured with the Securities which were held by Daiwa in the Liquidating Company's name. The Liquidating Company disposed of these Securities and repaid the related debt by the end of 1993. These investments provided a net interest rate spread (after borrowing costs) of approximately 4%, 3.5% and 3.5%, respectively. Cash Flow --------- Net cash provided by operating activities decreased for 1993 compared to 1992 primarily as a result of a decrease in mortgage investment income due to the reduction in the mortgage base and an increase in interest expense on the financing of other short-term investments, partially offset by the other investment income on the respective securities financed. Net cash provided by operating activities decreased in 1992 as compared to 1991 principally due to the decrease in mortgage investment income due to the smaller mortgage base, partially offset by a decrease in interest receivable and other assets. The decrease in interest receivable and other assets is attributable to the receipt of interest accrued on one mortgage which defaulted in the second half of 1991. Although other investment income increased in 1992 as compared to 1991, it was partially offset by interest expense on the financing of other short-term investments. Net cash provided by investing activities increased for 1993 as compared to 1992. This increase was principally due to an increase in proceeds from mortgage dispositions from approximately $45 million for 1992 to approximately $56 million for 1993. In addition, cash of approximately $6 million was received during 1993 from the sale of HUD debentures as compared to the receipt of $2 million during 1992 from the redemption of HUD debentures. Also contributing to the increase was the receipt of proceeds of approximately $129 million in 1993 from the sale of other short- term investments as compared to approximately $65 million received in 1992, offset by the purchase of other short-term investments of MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued --------------------------------------------- approximately $133 million for 1993 as compared to approximately $67 million for 1992. Net cash provided by investing activities decreased for 1992 as compared to 1991. This decrease was principally due to fewer mortgage dispositions during 1992. Cash of approximately $65 million and approximately $2 million was received during 1992 from the sale of other short-term investments and the redemption of HUD debentures, respectively. However, this was offset by the purchase of other short-term investments in 1992. Net cash used in financing activities increased for 1993 compared to 1992 due to an increase in dividends paid to shareholders attributable to an increase in mortgage dispositions in 1993. This increase was offset by the receipt of proceeds from short-term debt of approximately $116 million for 1993 as compared to $56 million for 1992. This debt was repaid during 1993 and 1992, respectively. Net cash used in financing activities decreased for 1992 compared to 1991 due to a reduction in dividends paid to shareholders. This reduction in dividends was attributable to fewer mortgage dispositions in 1992. Also during 1992, the Liquidating Company financed the acquisition of other short-term investments. This debt was repaid in December 1992. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of CRI Liquidating REIT, Inc. We have audited the accompanying balance sheets of CRI Liquidating REIT, Inc. (the Liquidating Company) as of December 31, 1993 and 1992, and the related statements of income, changes in shareholders' equity and cash flows for the years ended December 31, 1993, 1992 and 1991. These financial statements are the responsibility of the Liquidating 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 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 the Liquidating Company 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. As explained in Note 2 to the financial statements, effective December 31, 1993, the Liquidating Company changed its method of accounting for its investment in mortgages. Arthur Andersen & Co. Washington, D.C. January 21, 1994 CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 1. Organization CRI Liquidating REIT, Inc. (the Liquidating Company) is a finite-life, self-liquidating real estate investment trust (REIT) which as of December 31, 1993, owned a portfolio of 63 U.S. government insured and guaranteed mortgage investments secured by multifamily housing complexes located throughout the United States. Mortgage investments in the portfolio are comprised of 61 loans insured pursuant to programs of the U.S. government through the Federal Housing Administration (FHA) (FHA - Insured Loans) and two securities backed by FHA-Insured Loans which have been securitized by private issuers and guaranteed as to timely payment of principal and interest by the Government National Mortgage Association (GNMA and Mortgage-Backed Securities, respectively). As discussed further below, the Liquidating Company does not intend to acquire any additional mortgage investments, except as may be necessary in connection with maintaining its REIT status, and intends to liquidate its portfolio by March 31, 1997. The Liquidating Company was created in November 1989 in connection with the merger (the Merger) of three funds which owned government insured multifamily mortgages (the CRIIMI Funds), all of which were sponsored by C.R.I., Inc. (CRI), a Delaware corporation formed in 1974. At the time of the Merger, the CRIIMI Funds collectively owned 110 government insured multifamily mortgages. The Merger resulted in two new REITs: (i) the Liquidating Company, a finite-life, self-liquidating REIT, and (ii) CRIIMI MAE Inc. (CRIIMI MAE) (formerly CRI Insured Mortgage Association, Inc.) an infinite-life, growth-oriented REIT. Consistent with the original objectives of the CRIIMI Funds, the Liquidating Company intends to continue to liquidate its assets over time and distribute the proceeds to its shareholders. Dividends to shareholders consist of ordinary income, capital gains and return of capital. Shareholders should expect dividends representing ordinary income and the market price of the shares to decrease as the Liquidating Company liquidates its assets and distributes return of capital over time to its shareholders. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 1. Organization - Continued In the Merger, the Liquidating Company acquired the assets of the CRIIMI Funds. Investors in the CRIIMI Funds received, at their option, shares of common stock of either the Liquidating Company or CRIIMI MAE. To allow those investors who chose CRIIMI MAE shares to maintain their interest in the original assets of the CRIIMI Funds, CRIIMI MAE received one share of common stock of the Liquidating Company for each share of CRIIMI MAE issued in the Merger to investors in the CRIIMI Funds. As a result, CRIIMI MAE owned approximately 67% of the Liquidating Company's common stock as of December 31, 1992. Following the sale of approximately 3.1 million of its shares of common stock of the Liquidating Company, in November 1993, CRIIMI MAE reduced its ownership percentage to approximately 57%. The Liquidating Company shares have been trading on the New York Stock Exchange under the trading symbol CFR since November 28, 1989. The Liquidating Company is governed by a Board of Directors which includes the two shareholders of CRI. The Board of Directors has engaged CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) to act in the capacity of adviser to the Liquidating Company. The Adviser's general partner is CRI, and its limited partners include the shareholders of CRI. The Adviser and its affiliates (1) manage the Liquidating Company's assets with the goal of maximizing the returns to shareholders and (2) conduct the day-to-day operations of the Liquidating Company. The Adviser and its affiliates receive fees and expense reimbursements in connection with the administration and operation of the Liquidating Company (see Note 3). The Adviser also acts in a similar capacity for CRIIMI MAE. Prior to the Merger, the Liquidating Company did not have any assets or liabilities and did not engage in any activities other than those incident to its formation and the Merger. As a result of the common control existing over the Liquidating Company, the CRIIMI Funds and CRIIMI MAE, the Merger was accounted for at historical cost in a manner similar to the pooling-of-interests method. However, for tax purposes, the Merger was treated as a taxable event resulting in a new basis being assigned to the assets. Specifically, the merger of CRI Insured Mortgage CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 1. Organization - Continued Investment Limited Partnership (CRIIMI I) into the Liquidating Company resulted in a taxable gain, while the merger of CRI Insured Mortgage Investments II, Inc. (CRIIMI II) and CRI Insured Mortgage Investments III Limited Partnership (CRIIMI III) into the Liquidating Company resulted in taxable losses. As a result, the tax bases of the CRIIMI I assets were adjusted slightly upward and the tax bases of the CRIIMI II and CRIIMI III assets were adjusted downward. The Liquidating Company intends to dispose of its existing government insured mortgage investments by March 31, 1997 through an orderly liquidation. Consequently, the Adviser to the Liquidating Company developed a business plan which is intended to effect the orderly liquidation of the portfolio by March 31, 1997, which plan of liquidation was approved by the Liquidating Company's Board of Directors. The business plan assumes that the portfolio will be liquidated through a combination of defaults on or prepayments of (Involuntary Dispositions) and sales of (Voluntary Dispositions) government insured multifamily mortgages. During the term of the business plan, the Liquidating Company expects to generate cash flow from scheduled mortgage payments, Involuntary Dispositions, Voluntary Dispositions and interest earned on short-term investments. For the year ended December 31, 1993, the Liquidating Company has experienced a 22% disposition rate based on the December 31, 1992 portfolio balance. In each of the next four calendar years, the business plan assumes a total annual disposition rate of approximately 25% of the portfolio as of December 31, 1993. This is based on a relatively equal annual disposition of the portfolio over the remainder of the term of the business plan. The Liquidating Company intends to make Voluntary Dispositions, in addition to any Involuntary Dispositions that occur, if necessary to attempt to achieve such 25% rate and to liquidate the portfolio by March 31, 1997 in an orderly manner. Although the Liquidating Company expects to profitably dispose of its government insured multifamily mortgages, there can be no assurance as to when any government insured mortgage will be disposed of by the Liquidating Company or the amount of proceeds the Liquidating Company would receive from any such disposition. The determination of whether and when to dispose of a particular CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 1. Organization - Continued government insured multifamily mortgage will be made by considering a variety of factors, including, without limitation, the market conditions at that time. As of December 31, 1993, the carrying value of the mortgage investments on a tax basis, including Mortgages Held for Disposition, was approximately $173 million; the par value was approximately $236 million; and the fair market value was approximately $243 million. The Liquidating Company has qualified and intends to continue to qualify as a REIT under Sections 856-860 of the Internal Revenue Code (the Code). As a REIT, the Liquidating Company does not pay taxes at the corporate level. Qualification for treatment as a REIT requires the Liquidating Company to meet certain criteria, including certain requirements regarding the nature of its ownership, assets, income and distributions of taxable income. 2. Summary of Significant Accounting Policies Method of accounting -------------------- The financial statements of the Liquidating Company are prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Reclassifications ----------------- Certain amounts in the balance sheet as of December 31, 1992 has been reclassified to conform with the 1993 presentation. Cash and cash equivalents ------------------------- Cash and cash equivalents consist of money market funds, time and demand deposits, commercial paper and repurchase agreements with original maturities of three months or less. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies - Continued Statements of cash flows ------------------------ Since the statements of cash flows are intended to reflect only cash receipt and cash payment activity, the statements of cash flows do not reflect investing and financing activities that affect recognized assets and liabilities but do not result in cash receipts or cash payments. Such activity consisted of the following: o In July 1991, the Liquidating Company received $2,334,150 in 12 3/4% United States Department of Housing and Urban Development (HUD) Debentures as proceeds from the disposition of the mortgage investment in Oak Hill Road Apartments. The proceeds from the redemption of the HUD Debentures, including interest, were received in January 1992. Cash payments made for interest during 1993 and 1992 totalled $2,242,347 and $966,679, respectively. There were no cash payments made for interest during 1991. Investment in Mortgages ----------------------- In May 1993, the Financial Accounting Standards Board issued Statement on Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115). This statement requires that most investments in debt and equity securities be classified into one of the following investment categories based upon the circumstances under which such securities might be sold: Held to Maturity, Available for Sale, and Trading. Generally, certain debt securities for which an enterprise has both the ability and intent to hold to maturity should be accounted for using the amortized cost method and all other securities must be recorded at their fair values. This statement, though not required to be adopted until 1994 for the Liquidating Company, has been adopted as of December 31, 1993. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies - Continued The Liquidating Company intends to liquidate its portfolio by March 31, 1997. In order to achieve this objective, the Liquidating Company will sell certain of its mortgage investments in addition to mortgages assigned to HUD. Consequently, the Adviser believes that the securities held by the Liquidating Company fall into the Available for Sale category. As such, as of December 31, 1993, all mortgage investments are recorded at fair value with the net unrealized gains on its investment in mortgages reported as a separate component of shareholders' equity. Subsequent increases or decreases in the fair value of Available for Sale securities shall be included as a separate component of equity. Realized gains and losses for securities classified as Available for Sale will continue to be reported in earnings, as discussed below. Prior to December 31, 1993, the Liquidating Company accounted for its investment in mortgages at amortized cost. The difference between the cost and the unpaid principal balance at the time of purchase is carried as a discount or premium and amortized over the remaining contractual life of the mortgage using the effective interest method. The effective interest method provides a constant yield of income over the term of the mortgage. Mortgage investment income is comprised of amortization of the discount plus the stated mortgage interest payments received or accrued less amortization of the premium. The Liquidating Company's investment in mortgages is comprised of Federally Insured Mortgages (as defined below) and Mortgage-Backed Securities guaranteed by GNMA. Payment of principal and interest on Federally Insured Mortgages is insured by HUD. Payment of principal and interest on Mortgage-Backed Securities is guaranteed by GNMA pursuant to Title 3 of the National Housing Act. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies - Continued At any point in time, the Liquidating Company may be aware of certain mortgages which have been assigned to HUD or for which the servicer has received proceeds from a prepayment. In addition, at certain times the Liquidating Company may have entered into a contract to sell certain mortgages. In these cases, the Liquidating Company will classify these mortgages as Mortgages Held for Disposition. Gains from dispositions of mortgages are recognized upon the receipt of funds or HUD debentures. Losses on dispositions of mortgages are recognized when it becomes probable that a mortgage will be disposed of and that the disposition will result in a loss. Investment in limited partnerships ---------------------------------- The investment in limited partnerships (Participations), which do not carry any GNMA or HUD guarantees, are accounted for under the equity method. Under this method, the Liquidating Company's investment in the Participations is adjusted for the Liquidating Company's share of net earnings or losses and reduced by distributions from the limited partnerships. In addition, mortgage investment income from the mortgages of such limited partnerships, which were sold during 1993, has been reduced and income from the investment in limited partnerships has been increased to the extent the underlying interest expense is included in the Liquidating Company's share of net earnings or losses from the Participations. When received by the Liquidating Company, these interest amounts, as with distributions, reduce the investment in the Participations. Deferred costs -------------- Included in deferred costs are mortgage selection fees, which were paid to the former general partners or adviser to the CRIIMI Funds. These deferred costs are being amortized using the effective interest method on a specific mortgage CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies - Continued basis from the date of the acquisition of the related mortgage to the expected dissolution date of the Liquidating Company (see Note 1). Upon disposition of a mortgage, the related unamortized fee is treated as part of the mortgage investment balance in order to measure the gain or loss on the disposition. Also included in deferred costs are organizational costs which were incurred in connection with the organization of the Liquidating Company and which are amortized using the straight-line method over 60 months beginning as of the Merger consummation date of November 27, 1989. The Liquidating Company's costs incurred in connection with the Merger were expensed upon the consummation of the Merger (see Note 1). Borrowing Policy ---------------- The Liquidating Company's Articles of Incorporation do not limit the amount or percentage of indebtedness which the Liquidating Company may incur. The Liquidating Company does not intend to incur any indebtedness, except in connection with the maintenance of its REIT status. During 1993 and 1992, the Liquidating Company entered into transactions in which it incurred debt in connection with the purchase of government guaranteed mortgage-backed securities and government insured certificates backed by project loans. This debt was nonrecourse and fully secured with the purchased government guaranteed mortgage-backed securities and government insured certificates backed by project loans. As of December 31, 1993 and 1992, the Liquidating Company disposed of these government guaranteed mortgage-backed securities and government insured certificates backed by project loans, and repaid the related debt. Interest expense is based on the seller financing of a portion of the purchase price of the other short-term investments in government guaranteed mortgage-backed CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies - Continued securities and government insured certificates backed by project loans (see Note 7). Income taxes ------------ The Liquidating Company has qualified and intends to continue to qualify as a REIT as defined in the Code and, as such, will not be taxed on that portion of its taxable income which is distributed to shareholders provided that at least 95% of such taxable income is distributed. The Liquidating Company intends to distribute substantially all of its taxable income and, accordingly, no provision for income taxes has been made in the accompanying financial statements. The Liquidating Company, however, may be subject to tax at normal corporate rates on net income or capital gains not distributed. Per share amounts ----------------- Net income, dividends and return of capital per share amounts for 1993, 1992 and 1991 represent net income, dividends and return of capital, respectively, divided by the weighted average equivalent shares outstanding during each year. The per share amounts are based on the weighted average shares outstanding, including shares held for issuance pending presentation of units in the CRIIMI Funds. Common stock ------------ The Liquidating Company has authorized 30,425,901 shares of $.01 par value common stock and issued 30,422,711 shares and 30,421,134 shares as of December 31, 1993 and 1992, respectively. All shares issued are outstanding. The remaining 1,577 shares, as of December 31, 1992, were held for issuance pending presentation of predecessor units and were considered outstanding. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 3. Transactions with Related Parties Below is a summary of the amounts paid or accrued to related parties during the years 1993, 1992 and 1991. These items are described further in the text which follows. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 3. Transactions with Related Parties - Continued The Liquidating Company has entered into an agreement with the Adviser (see Note 1) (the Advisory Agreement) under which the Adviser is obligated to evaluate and negotiate voluntary mortgage dispositions, provide administrative services for the Liquidating Company and conduct the Liquidating Company's day-to-day affairs. The Advisory Agreement is for a term through November 27, 1995. The Advisory Agreement, absent a notice of termination or non-renewal, will be automatically renewed for successive three-year terms. The Advisory Agreement may be terminated solely for cause, as defined in the Advisory Agreement, by the Liquidating Company or the Adviser. Notice of non-renewal must be given at least 180 days prior to the expiration date of the Advisory Agreement. If the Liquidating Company terminates the Advisory Agreement other than for cause, or the Adviser terminates the Advisory Agreement for cause, in addition to compensation otherwise due, the Liquidating Company will be required to pay the Adviser a fee equal to the Annual Fee (as described below) payable for the previous fiscal year. If the Advisory Agreement is not renewed, no termination fee will be payable. Under the Advisory Agreement, the Adviser receives compensation from the Liquidating Company as follows: o An Annual Fee for managing the Liquidating Company's portfolio of mortgages. The Annual Fee is calculated separately for each of the remaining mortgage pools from the former CRIIMI Funds. With respect to CRIIMI I, the Annual Fee will equal 0.75% of Average Invested Assets invested in mortgage investments transferred by CRIIMI I in the Merger, one-third of which will be deferred and paid on a cumulative basis only during such quarters as the Carryover CRIIMI I Target Yield, as discussed below, is achieved on a cumulative basis. Any such deferred CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 3. Transactions with Related Parties - Continued amounts will be paid only out of proceeds of mortgage dispositions attributable to CRIIMI I mortgage investments representing market discount. With respect to CRIIMI II, the Annual Fee will equal 0.75% of Average Invested Assets invested in existing mortgage investments transferred by CRIIMI II in the Merger, one-fourth of which will be deferred and paid on a cumulative basis only during such quarters as the Carryover CRIIMI II Target Yield, as discussed below, is achieved on a cumulative basis. Any such deferred amounts will be paid only out of operating income attributable to CRIIMI II mortgage investments. With respect to CRIIMI III, the Annual Fee will equal 0.25% of Average Invested Assets invested in mortgage investments transferred by CRIIMI III in the Merger. After December 31, 1993, this fee will be reduced to 0.125% for any quarter that the Carryover CRIIMI III Cumulative Annual Fee Yield, as discussed below, is not achieved. The Carryover CRIIMI I Target Yield will be achieved during any quarter that the former CRIIMI I mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 13.33% per annum based on financial statement income. The Carryover CRIIMI II Target Yield will be achieved during any quarter that the former CRIIMI II mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 11.66% per annum based on financial statement income. The Carryover CRIIMI III Cumulative Annual Fee Yield will be achieved during any quarter, commencing after CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 3. Transactions with Related Parties - Continued December 31, 1993, that the former CRIIMI III mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 10.89% per annum based on financial statement income. Detail of the Annual Fees paid for the years 1993, 1992 and 1991 is as follows: CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 3. Transactions with Related Parties - Continued CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 3. Transactions with Related Parties - Continued o The Adviser is also entitled to certain Incentive Fees (the Incentive Fee) in connection with the disposition of certain mortgage investments. Like the Annual Fee, the Incentive Fees are calculated separately with respect to mortgage investments transferred in the Merger by CRIIMI I and CRIIMI II. No Incentive Fees are payable with respect to mortgage investments transferred by CRIIMI III. During any quarter in which either the Carryover CRIIMI I or CRIIMI II Target Yields have been achieved on a cumulative basis and the Adviser has been paid any deferred amounts of the Annual Fee, the Incentive Fee will equal approximately 9.08% of net disposition proceeds representing the financial statement gain on the related CRIIMI I or CRIIMI II mortgage investments disposed of. After the Carryover CRIIMI I Adjusted Contribution or the Carryover CRIIMI II Adjusted Share Capital has been reduced to zero, the Incentive Fee will increase to approximately 9.08% of the net disposition CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 3. Transactions with Related Parties - Continued proceeds from the disposition of CRIIMI I or CRIIMI II mortgage investments, each determined separately. The Carryover CRIIMI I Adjusted Contribution and the Carryover CRIIMI II Adjusted Share Capital equal the aggregate Adjusted Contribution of CRIIMI I investors (initial investment of investors reduced by all amounts distributed to them representing distributions of principal on their original mortgage investments other than distributions of proceeds of mortgage dispositions representing market discount that have been applied to the Target Yield) and the aggregate Share Capital of CRIIMI II investors (initial investment of investors reduced by all amounts distributed to them representing distributions of principal on their original mortgage investments other than distributions of proceeds of mortgage dispositions representing market discount that have been applied to the Target Yield), respectively, as of November 27, 1989, the consummation date of the Merger. Subsequent to November 27, 1989, the Carryover CRIIMI I Adjusted Contribution and the Carryover CRIIMI II Adjusted Share Capital are reduced by all amounts of principal received from their respective former mortgage investments, whether as part of regular mortgage payments or as proceeds of mortgage dispositions, except for proceeds of mortgage dispositions representing market discount that have been applied to the respective Target Yield. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 4. Fair Value of Financial Instruments The following estimated fair values of the Liquidating Company's financial instruments are presented in accordance with generally accepted accounting principles. These estimated fair values, however, do not represent the liquidation value or the market value of the Liquidating Company. As of December 31, 1992, the Liquidating Company's mortgage investments were recorded at amortized cost (excluding Mortgages Held for Disposition which were recorded at the lower of cost or market as discussed in Note 6). In connection with the Liquidating Company's implementation of SFAS 115 as of December 31, 1993 (see Note 2), the Liquidating Company's Investment in Mortgages, including Mortgages Held for Disposition (see Note 6) are recorded at fair value, as estimated below, as of December 31, 1993. The difference between the amortized cost and the fair value of the mortgage investments represents the net unrealized gains on the Liquidating Company's mortgage investment and is reported as a separate component of shareholders' equity as of December 31, 1993. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 4. Fair Value of Financial Instruments - Continued The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Investment in mortgages and mortgages held for disposition ---------------------------------------------------------- The fair value of the mortgage investments and mortgages held for disposition is based on the average of the quoted market prices from three investment banking institutions which trade insured mortgage loans as part of their day-to- day activities. Cash and cash equivalents and accrued interest receivable --------------------------------------------------------- The carrying amount approximates fair value because of the short maturity of these instruments. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 5. Investment in Mortgages As of December 31, 1993, the Liquidating Company owned 63 mortgages. These mortgage investments have a weighted average coupon rate of approximately 7.65%, a weighted average effective interest rate of approximately 10.03%, and a weighted average remaining term based on face value of approximately 27 years. Based on the carrying value as of December 31, 1993, approximately 92% of the 63 mortgage investments were purchased at a discount (Discount Mortgage Investments) and 8% were purchased near or at par or for a premium (Near Par or Premium Mortgage Investments). A discussion of these types of mortgages is as follows: Federally Insured Mortgages --------------------------- The Liquidating Company owns Federally Insured Mortgages on properties which were acquired by the predecessor CRIIMI Funds at a discount to face on the belief that based on economic, market, legal and other factors, such Discount Mortgage Investments might be sold for cash, converted to condominium housing or otherwise disposed of or refinanced in a manner requiring prepayment or permitting other profitable disposition three to twelve years after acquisition by the predecessor CRIIMI Funds. The Liquidating Company also owns near or at par or premium Federally Insured Mortgages on properties which the Adviser does not expect to incur a significant financial statement loss if disposed of, refinanced or otherwise prepaid prior to maturity. On a tax basis, based on current information, including the current interest rate environment, the disposition of any mortgage investment is expected to result in a gain. Mortgage-Backed Securities -------------------------- The Liquidating Company also owns Mortgage-Backed Securities issued by private entities for which the monthly principal and interest payments of the underlying mortgages are guaranteed by GNMA (GNMA Mortgage-Backed Securities) or which are backed by Federally Insured Mortgages. In the CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued original selection of Mortgage-Backed Securities, the properties underlying such securities were evaluated utilizing criteria similar to those employed in selecting the Liquidating Company's Federally Insured Mortgages. Participating Mortgages ----------------------- As of December 31, 1992, the Liquidating Company also owned three Participating Mortgage Investments. Each Participating Mortgage Investment consisted of two components: 85% of the original investment amount was a Mortgage-Backed Security; and 15% of the original investment amount was an uninsured equity contribution to the limited partnership which owns the underlying property. The equity contributions represent a purchase of 50 percent ownership interests in the three limited partnerships and entitle the Liquidating Company to participate in 50 percent of the net available cash flow from operations and/or a portion of the residual value, if any, of the property underlying the GNMA Mortgage-Backed Security. In addition, the Liquidating Company is entitled to an annual return on its Participations. During 1993, the Liquidating Company sold the mortgage investment components of each of its Participating Mortgage Investments but retained the Participation components for all three Participating Mortgage Investments. General ------- The safekeeping and servicing of the mortgage investments (excluding the Participations) is performed by various trustees and servicers under the terms of the Servicing Agreements. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued Descriptions of the mortgage investments owned by the Liquidating Company which exceed approximately 3% of the aggregate carrying value of the total mortgage investments as of December 31, 1993, summarized information regarding other mortgage investments and mortgage investment income earned in 1993, 1992 and 1991, including interest earned on the disposed mortgage investments, are as follows: CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued (A) All mortgages are collateralized by first liens on residential apartment or townhouse complexes which have diverse geographic locations and are Federally Insured Mortgages or Mortgage-Backed Securities issued or sold pursuant to a program of GNMA. Payment of principal and interest on Federally Insured Mortgages is insured by HUD. Payment of the principal and interest on Mortgage-Backed Securities is guaranteed by GNMA pursuant to Title 3 of the National Housing Act. The investment in limited partnerships is not federally insured or guaranteed. (B) Principal and interest are payable at level amounts over the life of the mortgage investment. Total annual debt service payable to the Liquidating Company (excluding principal and interest on the mortgages held for disposition, but including the annual return on one Participation) for the mortgage investments held as of December 31, 1993, is approximately $20.3 million. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued (C) Reconciliations of the carrying amount of the mortgage investments for the years ended December 31, 1993 and 1992 follow: (D) Principal Amount of Loans Subject to Delinquent Principal or Interest is not presented since all required payments with respect to these Federally Insured Mortgages or Mortgage-Backed Securities are current and none of these mortgages are delinquent as of December 31, 1993, except for the mortgages classified as Mortgages Held for Disposition as discussed below in Note 6. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued Historical Dispositions ----------------------- CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 6. Mortgages Held for Disposition As of December 31, 1993 and 1992, the following mortgages were classified as Mortgages Held for Disposition: CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 7. Other Short-term Investments On January 28, 1993, October 15, 1993 and October 28, 1993, the Liquidating Company entered into investment and financing agreements with Daiwa Securities America, Inc. (Daiwa). These transactions assisted in maintaining the Liquidating Company's REIT status. Pursuant to the terms of these agreements, the Liquidating Company invested in GNMA mortgage-backed securities or certificates backed by FHA-Insured project loans (collectively, the Securities) with unpaid principal balances of approximately $74.7 million, $40.3 million and $11.9 million, respectively, at purchase prices of 104.615%, 106.41% and 100.8%, respectively, of the face values, which earned interest at per annum pass-through coupon rates of 9.1875%, 13.18% and 8.625%, respectively. In addition, Daiwa provided financing for approximately 99% and 86% of the purchase price for the transactions which occurred on January 28, 1993 and October 15, 1993, respectively, at an interest rate of approximately 3.35%. The related debt was non- recourse and fully secured with the Securities which were held by Daiwa in the Liquidating Company's name. The Liquidating Company disposed of these Securities and repaid the related debt by the end of 1993. These investments provided a net interest rate spread (after borrowing costs) of approximately 4%, 3.5% and 3.5%, respectively. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 8. Reconciliation of Financial Statement Net Income to Tax Basis Income Reconciliations of the financial statement net income to the tax basis income for the years ended December 31, 1993, 1992 and 1991 are as follows: Differences in the financial statement net income and the tax basis income principally relate to differences in the tax bases of assets and liabilities and their related financial reporting amounts resulting from the Merger and the acquisition of other short-term investments. Such differences relate to investments in mortgages, other short-term investments, and deferred costs. CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 8. Reconciliation of Financial Statement Net Income to Tax Basis Income - Continued As a result of the foregoing, the nature of the dividends for income tax purposes on a per share basis is as follows: 1993 1992 1991 ------ ------ ------ Ordinary income $ .81 $ .86 $ .97 Long-term capital gains .36 .33 .42 Non-taxable dividend 1.61 1.21 1.76 ------ ------ ------ $ 2.78 $ 2.40 $ 3.15 ====== ====== ====== 9. Summary of Quarterly Results of Operations (Unaudited) The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1993, 1992 and 1991: CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 9. Summary of Quarterly Results of Operations (Unaudited) - Continued CRI LIQUIDATING REIT, INC. NOTES TO FINANCIAL STATEMENTS 10. Settlement of Litigation On March 22, 1990, a complaint was filed on behalf of a class comprised of certain former investors of CRIIMI III and CRIIMI II (the Plaintiffs) in the Circuit Court for Montgomery County, Maryland against the Liquidating Company, CRIIMI MAE, CRIIMI I and its general partner, CRIIMI II, CRIIMI III and its general partner, CRI, and Messrs. William B. Dockser, H. William Willoughby and Martin C. Schwartzberg (the Defendants). On November 18, 1993, the Court entered an order granting final approval of a settlement agreement between the Plaintiffs and the Defendants. Under the terms of the settlement, CRIIMI MAE will issue to class members, including certain former investors of CRIIMI I, up to 2,500,000 warrants to purchase shares of its common stock. In addition, the settlement includes a payment of $1,400,000 for settlement administration costs and Plaintiff's attorneys' fees and expenses. Insurance provided $1,150,000 of the $1,400,000 cash payment, with the balance paid by CRIIMI MAE. Directors and Executive Officers -------------------------------- The Annual Report to the Securities and Exchange Commission on Form 10-K is available to Shareholders and may be obtained by writing: Investor Services/CRI Liquidating REIT, Inc. C.R.I., Inc. The CRI Building 11200 Rockville Pike Rockville, Maryland 20852 CRI Liquidating REIT, Inc. shares are traded on the New York Stock Exchange under the symbol CFR.

37637_1993.txt

37637_1993

1993

37637

ITEM 1. BUSINESS THE COMPANY Florida Power Corporation (the "Company") was incorporated in Florida in 1899 and is an operating public utility engaged in the generation, purchase, transmission, distribution and sale of electricity within Florida. The Company became a wholly owned subsidiary of Florida Progress Corporation ("Florida Progress") in March 1982, as a result of a corporate restructuring. All of the Company's common stock is owned by Florida Progress. The Company's preferred stock is owned by non-affiliates. The Company provided electric service during 1993 to an average of 1,214,653 customers in a service area covering about 20,000 square miles in central and northern Florida and along the west coast of the state. The service area includes St. Petersburg and Clearwater as well as the areas surrounding Walt Disney World, Orlando, Ocala and Tallahassee. Of the Company's 1993 electric revenues billed, approximately 56% were derived from residential sales, 24% from commercial sales, 9% from industrial sales, 5% from other retail sales and 6% from wholesale sales. The more important industries in the territory include phosphate mining and processing, electronics manufacturing and design, and citrus and other food processing. Other important commercial activities are tourism, health care, construction and agriculture. The Company's revenues and unit sales, measured in kilowatt hours ("KWH"), vary with the weather. This weather sensitivity results primarily from customers using electricity to heat or cool their residences or places of business. Revenues and KWH sales tend to be higher in summer and winter. See the financial information under the heading "Quarterly Financial Data" which follows the notes to the Company's financial statements for the year ended December 31, 1993 contained herein under Item 8 ("Financial Statements"). FUEL AND PURCHASED POWER GENERAL: The Company's consumption of various types of fuels depends on several factors. The most important factors are the demand for electricity by the Company's customers, the availability of various generating units, the availability and cost of fuel, and the requirements of federal and state regulatory agencies. In 1993, the Company's energy mix was 45% coal, 21% oil, 18% nuclear and 16% purchased power, as compared to 47% coal, 24% oil, 16% nuclear and 13% purchased power for 1992. The Company is permitted to pass the cost of recoverable fuel and purchased power to its customers through fuel adjustment clauses. (See Note 1 to the Financial Statements.) Because of uncertainties in the relevant domestic and international markets, future prices for and the availability of the various fuels discussed in this report cannot be determined. However, the Company believes that its fuel supply contracts, as described below, will be adequate to meet its fuel supply needs. The Company's average fuel costs per million British thermal units ("Btu") for each of the five years ended December 31, 1993, were as follows: 1993 1992 1991 1990 1989 Coal $1.96 $1.97 $2.01 $2.05 $2.06 Oil 2.49 2.53 2.56 3.10 2.65 Nuclear .54 .57 .65 .67 .67 Gas 4.27* 2.54* 1.90 2.15 2.29 Average 1.79 1.86 1.89 2.11 2.10 *Gas accounted for .2% of the Company's fuel mix in 1993 and 1992. OIL AND GAS: Oil is purchased under contracts with several suppliers. The cost of the Company's oil is tied by contract to certain posted or published market prices. These prices are largely influenced by the world market for fuel. At present, management believes that the Company has contracts for an adequate supply of oil for the reasonably foreseeable future. The Company's natural gas is purchased under firm and interruptible transportation contracts. Existing contracts for oil are sufficient to cover the requirements when natural gas is not available through the interruptible contracts. In addition, the Company has signed contracts to transport natural gas through the proposed SunShine Pipeline. (See Item 2 ITEM 2. PROPERTIES The Company believes that its physical properties are adequate to carry on its business as currently conducted. The Company maintains property insurance against loss or damage by fire or other perils to the extent that such property is usually insured. (See Note 10 to the Financial Statements.) Substantially all of the utility plant is pledged as collateral for the Company's first mortgage bonds. GENERATION: In November 1993, the Company added 396 MW of peaking capability to its Intercession City site. As a result of modifications to existing generating units, there was a total capability increase of 561 MW from last year's winter generating capability. As of December 31, 1993, the Company's total net winter generating capability was 7,563 MW. This capability is generated by eighteen steam units at six plant locations with a capability of 4,929 MW and 43 combustion turbine peaking units with a capability of 2,634 MW. The Company's ability to use this generating capability may be adversely impacted by various governmental regulations affecting nuclear operations and other aspects of the Company's business. (See "Regulation and Franchises" and "Environmental Matters" under Item 1 "Business.") Operation of these units may also be substantially curtailed by unanticipated equipment failures or interruption of fuel supplies. The net maximum hourly demand served during 1993 was 6,729 MW on August 5, 1993. The Company met that demand through system generating capability and economy power purchases from neighboring utilities. The Company's existing generating plants (all located in Florida) and their capabilities are as follows: Winter Net Maximum Dependable Primary Location Steam Peaking Capability Plants Fuel (County) MW MW MW - ------ ------- -------- ----- ------- ---------- Crystal River: Citrus Unit #1 Coal 373 - 373 Unit #2 Coal 469 - 469 Unit #3 Uranium 755* - 755 Unit #4 Coal 717 - 717 Unit #5 Coal 717 - 717 ----- ----- 3,031 3,031 Anclote: Pasco Unit #1 Oil 517 - 517 Unit #2 Oil 517 - 517 Bartow Oil Pinellas 449 217 666 Turner Oil Volusia 145 200 345 Intercession City Oil Osceola - 750 750 DeBary Oil Volusia - 786 786 Higgins Oil Pinellas 123 148 271 Bayboro Oil Pinellas - 232 232 Avon Park Oil Highlands - 64 64 Port St. Joe Oil Gulf - 18 18 Rio Pinar Oil Orange - 18 18 Suwannee River Oil Suwannee 147 201 348 ----- ----- ----- 4,929 2,634 7,563 ===== ===== ===== * Represents 90.4% of total plant capability because 9.6% of capability was owned by other parties at December 31, 1993. In January 1994, a 40 MW cogeneration unit located at the University of Florida in Gainesville was put into service. This unit provides steam to the University campus and hospital while generating electricity for the Company's system. Also in January 1994, the Company put two of its oldest power plants, the Higgins and Turner steam units, on extended cold shutdown status. This will increase the overall efficiency of the Company's operation. PLANNED GENERATION: The Company and Georgia Power Company ("Georgia Power") plan to become co-owners of a 165 MW advanced combustion turbine to be located at the Company's Intercession City Peaker site. Upon expected completion in 1996, the Company would operate and maintain the unit for both owners. During the months of June through September, Georgia Power would have the exclusive right to the output of this unit. The Company would have that right for the balance of the year. This transaction would be subject to approval by the Securities and Exchange Commission ("SEC") and the Georgia Public Service Commission. In a separate agreement, the Company has agreed to sell between 150 and 500 MW of summer peaking capacity annually to Georgia Power during the years of 1995 through 1999. Since the Company is a winter-peaking utility and Georgia Power is a summer-peaking utility, this transaction presents unique advantages to both parties. The agreement was accepted for filing by the FERC on March 11, 1994 and is pending approval by the Georgia Public Service Commission. The Company's generation strategy includes continuing efforts to sign similar energy agreements with other utilities. The revenues from these energy sales will help the Company offset some of its annual production costs and better utilize its facilities year-round. In 1992, the FPSC granted the Company a certificate of need to build two gas-fired combined cycle generating units and related facilities. Each unit has a winter rating of 235 MW. They are to be built on a new power plant site in Polk County, Florida, approximately 50 miles east of Tampa. This new site is to be reclaimed from about 8,000 acres of mined-out phosphate land. The first unit is planned to come on line in 1998, with the second unit to follow in 1999. Commencement of construction of these units is contingent on obtaining all regulatory approvals. The Company plans to use natural gas to fuel the first phase of the new energy complex in Polk County. Two Company subsidiaries currently have 30% equity interests in the interstate and intrastate partnerships, respectively, of a gas pipeline project called the SunShine Pipeline. These investments totaled $4.9 million at December 31, 1993. The Company has an option to reduce or eliminate its ownership positions at the end of 1994. The SunShine Pipeline, estimated to cost approximately $600 million, would originate near Pascagoula, Mississippi and would consist of two components: the Sunshine Interstate Pipeline Project and the Sunshine Pipeline Project. The two components of the pipeline together will consist of approximately 600 miles of pipe with a 30-inch diameter main line. The design capacity through-put is anticipated to be approximately 460 million cubic feet per day ("MMcf/d") for the interstate component and approximately 380 MMcf/d for the intrastate component. Each of the components would be owned by a separate general partnership and, in connection therewith, the Company has formed two subsidiary companies: Power Interstate Energy Services Corporation, which is a partner in the interstate partnership, and Power Energy Services Corporation, which is a partner in the intrastate partnership. ANR Pipeline Company, a subsidiary of The Coastal Corporation, owns 40% of each partnership and TransCanada PipeLines Limited owns 30% of each partnership through subsidiary companies. The interstate component of the SunShine Pipeline from Pascagoula to Okaloosa County, Florida would be regulated by the FERC. The intrastate component of the project from Okaloosa County to Polk County, Florida would be regulated by the FPSC. In June 1993, the FPSC approved a determination of need for the intrastate portion of the pipeline. Construction on the pipeline is contingent upon obtaining all regulatory approvals, financing and commitments from customers. (See Note 10 to the Financial Statements.) The Company has signed a separate 25-year contract for the transportation of natural gas through the SunShine Pipeline to the Company's Anclote plant near Tarpon Springs and the Polk County site. The Company has contracted to purchase 120 MMcf/d of capacity through the pipeline beginning in early 1996, and to increase that volume to 210 MMcf/d by 1999 upon completion of the Company's planned generation complex in Polk County. The Company's expansion plan for generation is summarized in the table below: In late December 1993, the FPSC adopted a rule regarding the construction of new power plants in Florida. In general, the rule requires each investor-owned electric utility to engage in a competitive bidding process for the construction of a new generation unless the utility demonstrates on a case by case basis that such a process is not in the best interests of the utility's ratepayers. More specifically, the rule provides that prior to filing a petition for determination of need for an electrical power plant, each investor-owned electric utility shall evaluate supply-side alternatives to its next planned generating unit by issuing a request for proposals. The utility is required to evaluate proposals (which may include non-utility generators, utility generators, turnkey offerings, and other generating supply alternatives) from which a manageable group of potentially viable and cost-effective finalists would be selected. The rule also provides, however, that the FPSC may waive the rule or any part thereof upon a showing that the waiver (a) would likely result in a lower cost supply of electricity to the utility's ratepayers, (b) would increase the reliable supply of electricity to the utility's ratepayers, or (c) is otherwise in the public interest. Although the adoption of this rule could eventually affect the Company's ability to construct its own power plants, the rule is not expected to affect the construction of two gas-fired combined cycle generating units at the Company's site in Polk County, Florida, because as noted above, the FPSC already has granted the Company a certificate of need for these units. NUCLEAR PLANT AND NUCLEAR INSURANCE: Information regarding nuclear plant and nuclear insurance is contained in Note 7 to the Financial Statements. TRANSMISSION AND DISTRIBUTION: As of December 31, 1993, the Company distributed electricity through 329 substations with an installed transformer capacity of 38,711,485 kilovolt amperes ("KVA"). Of this capacity, 26,963,425 KVA is located in transmission substations and 11,748,060 KVA in distribution substations. The Company has 4,454 circuit miles of transmission lines of which 2,560 circuit miles are operated at 500, 230 or 115 kilovolts ("KV") and the balance at 69 KV. The Company has 22,390 circuit miles of distribution lines which operate at various voltages ranging from 2.4 to 25 KV. The Company is preparing to construct a 500 KV transmission line that will run through northwest Hillsborough County and connect the Lake Tarpon substation in Pinellas County to the Kathleen substation in Polk County (the "LTK Line"). The Company received a certification of need for the LTK Line from the FPSC in 1984, a letter from the FDEP in February 1994 indicating that a water quality certification had been issued, and a dredge and fill permit from the U.S. Army Corps of Engineers in March 1994. Through the end of 1993, several lawsuits challenging various aspects of the LTK Line were dismissed with prejudice or were unsuccessful on the merits. In the first quarter 1994, Hillsborough County filed a lawsuit against the FDEP, and other parties initiated two administrative proceedings, that challenge procedures followed in issuing permits or authorizations relating to the LTK Line. Completion of the LTK Line is subject to the successful defense of these and any other legal actions that may seek to halt or delay construction of the LTK Line, and to the completion of condemnation proceedings to acquire various parcels needed for the project. The Company has deferred indefinitely its plans to construct a 250 mile, 500 KV transmission line that would have interconnected bulk power electric systems in Florida and Georgia. Factors contributing to this decision were a slowing in the Company's customer growth rate and uncertainties related to transmission access and pricing. ITEM 3. ITEM 3. LEGAL PROCEEDINGS 1. FERC Docket No. ER93-299. On December 17, 1993, the Company executed settlement agreements related to the coal cost issues in its 1993 wholesale rate case. The parties had previously resolved all cost of service issues and agreed to settlement rates that produced increased annual revenues of $5.9 million, or $2.7 million less than the Company's initially filed rates. The coal issue settlement involves a net cost to the Company of $1.2 million, and includes the customers' agreement to use certain FPSC market pricing mechanisms for FERC fuel adjustment clause purposes. In addition, the settlement resolves all claims regarding the propriety of past coal-related fuel adjustment costs through December 31, 1993. The proposed, unopposed settlement is pending before the FERC, with approval expected in the first quarter of 1994. 2. FERC Docket No. ER94-961-000. On January 24, 1994, the Company reached a settlement in principle with the majority of its wholesale customers in its proposed 1994 rate case. The settlement provides for an annual revenue increase of approximately $10 million compared to 1993 settlement rates pending FERC approval. The agreement was reached utilizing a "pre-filing settlement procedure" under which the Company's rate case filing package was provided to the wholesale customers in advance of filing with FERC, without delaying the eventual effective date of the new rates. The settlement agreement was filed with FERC on February 8, 1994, with settlement rates becoming effective for the customers that are parties to the agreement on March 2, 1994. A decision from the FERC regarding this settlement, and new rates for the minority of customers not party to the agreement, is expected in April 1994. 3. Florida Gas Transmission Company v. Florida Public Service Commission, Florida Supreme Court Case No. 82,171. On July 7, 1993, the FPSC issued a certificate of need to the Sunshine Pipeline Partners, a Florida general partnership, for an intrastate natural gas pipeline from northwest Florida to central Florida. Through a wholly owned subsidiary, Power Energy Services Corporation, the Company holds a 30% equity interest in this general partnership. On August 2, 1993, Florida Gas Transmission Company filed a notice of appeal of the FPSC's action to the Florida Supreme Court on the basis that (i) the law under which the certificate was granted is unconstitutionally vague in its delegation of authority to the FPSC and (ii) the FPSC's final order failed to address matters that the FPSC is statutorily required to address. Briefs have been filed and oral arguments were heard in the case on February 1, 1994. A decision is expected in the first half of 1994. 4. Union Carbide Corporation v. Florida Power & Light Company ("FP&L") and Florida Power Corporation, U.S. District Court for the Middle District of Florida, Tampa Division, Civil Action No. 88-1672-CIV-T-13C. In this suit filed on October 14, 1988, seeking both injunctive relief and damages, Union Carbide Corporation ("Union Carbide") claims that the Company violated provisions of the Sherman and Clayton Antitrust Acts primarily by refusing to provide retail electric service to Union Carbide's plant at Mims, Florida. The Company's records indicate that a territorial agreement has been in effect between it and FP&L for approximately thirty (30) years, pursuant to which it was understood and agreed that the Company would not provide retail electric service in the area in question and that FP&L would provide such service. The Company's records further indicate that its territorial agreement with FP&L was approved by the FPSC pursuant to a clearly articulated policy of the state encouraging such territorial agreements between electric utilities. Accordingly, the Company and FP&L jointly filed a Motion for Summary Judgment on November 22, 1988, contending that there is no dispute as to any material issue of fact in the case, and that the case should therefore be decided in their favor, as a matter of law, based upon the qualification of the approved territorial agreement for the state action exemption to the antitrust laws. Union Carbide filed a Motion for Partial Summary Judgment as to the issue of liability on May 2, 1989. On July 11, 1989, the General Counsel to the FPSC was allowed to appear and file a Memorandum of Law as Amicus Curiae in support of the positions of the Company and FP&L in their Joint Motion for Summary Judgment. On December 8, 1993, the Court denied the Motion for Summary Judgment filed by the Company and FP&L and the Motion for Partial Summary Judgment filed by Union Carbide. The Court found that even though Florida has a clearly articulated State policy of allocating service territories of utilities and the FPSC has provided adequate supervision of the retail service territories of the Company and FP&L, the documentation of the territorial agreement and the FPSC's approval of that agreement, "...gives rise to conflicting interpretations of the intent of [the Company and FP&L and the FPSC] regarding the provision of service in Broward County." The Court construed the intent of the FPSC in approving the territorial agreement to be to "...allocate to each utility that territory on its respective side of the boundary line in which competition is reasonably expected." Union Carbide, FP&L, and the Company all filed Motions for Reconsideration of the Court's Order of December 8, 1993. On January 26, 1994, the Court denied all the Motions for Reconsideration and found that a material issue of fact exists as to "...whether Mims was located in an area to the east of the [territorial] boundary line [between the Company and FP&L] in which competition [between the Company and FP&L] was reasonably foreseeable in the future." This issue had never been raised by any of the parties to the litigation, and was mentioned for the first time in the Court's Order of December 8, 1993. The Company believes that the issue of expected competition in the Mims area at the time the territorial agreement was approved is not material to a proper disposition of the case, and that a summary judgment should be entered in favor of the Company and FP&L on the basis of the Court's findings in their favor on all the critical issues of law in its Order of December 8, 1993. Incident to a status conference in the case on February 1, 1994, Union Carbide requested certification of the case for purposes of taking an appeal. Accordingly, the Court elected to delay permitting any additional discovery or setting the case for trial on the limited issue of material fact it found to exist pending disposition of appeals from the Court's rulings on the motions for summary judgment. The Company and FP&L filed notices of appeal to the U.S. Court of Appeals for the 11th Circuit on February 8, 1994 and the plaintiff filed a notice of cross appeal on February 22, 1994. Also at the status conference on February 1, 1994, Praxair, Inc. to which Union Carbide had previously spun off its plant at Mims, Florida, was substituted for Union Carbide as the plaintiff in their cause, subject to certain reservations. Accordingly, future reports on this case will be under the name of Praxair, Inc. v. FP&L and the Company. 5. Kim S. McDowell and Talesa C. Lloyd v. Florida Power Corporation, United States District Court for the Middle District of Florida, Tampa Division, Case No. 91-1858-CIV-T-23B. On November 3, 1992, counsel for the plaintiffs in this matter filed a motion for leave to file a first amended complaint. The initial pro se action, filed on November 29, 1991, by these two former employees of the Company, raised allegations of sexual discrimination and harassment and sought relief under Title VII of the Civil Rights Act of 1964. The motion asks the court to allow the plaintiffs to amend the initial complaint to add another named plaintiff and to allow the named plaintiffs to represent a class of female employees. The first amended complaint also seeks injunctive relief and compensatory and punitive damages on behalf of the class of all former, present, and future female employees of the Company who have been, are being or will be discriminated against or harassed because of their sex. The Company believes that its exposure in this matter will not be material even if it is unsuccessful in defending against the individual claims of the named representatives. However, it cannot yet be determined whether this case will be certified as a class action or how large the class could become. Certain procedural matters have delayed the handling of this case, and at present seven motions are pending and no trial date has been set. 6. Florida Public Utilities Company v. Florida Power Corporation, Florida Power & Light Company, Atlanta Gas Light Company, and City of Sanford, Florida, United States District Court for the Middle District of Florida, Orlando Division, Civil Action No. 92-115-CIV-ORL-19. On February 7, 1992, the Company was served with a copy of a complaint alleging damages caused by violations of the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA" or "Superfund") and Sections 376.302 and 376.313(3) Florida Statutes, by former owners of a coal gasification plant previously operated at Sanford, Florida. The plaintiff, Florida Public Utilities Company, currently owns the land which includes the former plant site. The complaint states that the FDEP has completed its initial investigation and has determined that hazardous substances have been discharged and/or released at the site of the former gasification plant. The plaintiff alleges that the Company owned and operated the plant from 1944 until 1946 and that the Company is a successor in interest through the merger of the Company with a previous owner of the plant, Sanford Gas Company. On February 3, 1994, the parties to this action submitted a completed contamination assessment report to the FDEP. As of this date, the Company has not received any further communication from the FDEP. The Company anticipates an extended period of negotiation with the FDEP. The lawsuit continues to be stayed pending the results of the FDEP's review. At the present time, the Company does not believe that its share of the costs of cleaning up this site will be material, or that it will have to bear a significantly disproportionate share of those costs. This matter is being reported because liability for the cleanup of certain sites is technically joint and several, and because the extent to which other parties will ultimately share in the cleanup costs at this site is not yet determinable. (See Note 10 to the Financial Statements for further information regarding the potential costs.) 7. Peak Oil Company, Missouri Electric Works, 62nd Street, AKO Bayside, Bluff Electric and Sydney Mine Superfund Sites. The Company has been notified by the EPA that it is or could be a "potentially responsible party" ("PRP") with respect to each of the above Superfund sites. Based upon the information presently available, the Company has no reason to believe that its total liability for the cleanup of these sites will be material or that it will be required to pay a significantly disproportionate share of those costs. However, these matters are being reported because liability for cleanup of certain sites is technically joint and several, and because the extent to which the Company may ultimately have to participate in those cleanup costs is not presently determinable. (See Note 10 to the Financial Statements for further information regarding the potential costs.) 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 All of the Company's common stock is owned by Florida Progress, its corporate parent, and hence there is no market for the stock. For the past three years, the Company has paid quarterly dividends to Florida Progress totaling the amounts shown in the Statements of Shareholders' Equity of the Financial Statements. The Company's Amended Articles of Incorporation, as amended, and its Indenture dated as of January 1, 1944, as supplemented, under which it issues first mortgage bonds, contain provisions restricting dividends in certain circumstances. At December 31, 1993, the Company's ability to pay dividends was not, nor is it expected to be, limited by these restrictions. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (In millions) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Although the electric utility industry is becoming increasingly competitive, the Company believes that it is in a good competitive position. See Item 1 "Business-Competition." The Company is streamlining operations and cutting costs to improve its competitiveness. These actions also are expected to allow the Company to offset other rising costs such as income taxes, environmental expenses and insurance costs. The Company expects to earn its authorized return on equity, while maintaining competitive prices. Through anticipated sales growth and cost control, the Company believes it can wait to file a major retail rate case until its next baseload unit is near completion in 1998. OPERATING RESULTS In 1993, the Company earned $181.5 million, compared with $170.2 million in 1992 and $164.1 million in 1991. Operating revenues were $1.958 billion in 1993, compared with $1.774 billion in 1992 and $1.719 billion in 1991. The increased operating revenues and higher earnings in 1993 were mainly due to the phased-in increases in retail base rates, reflecting the outcome of the Company's 1992 retail rate case. In September 1992, the FPSC granted the Company an annual revenue increase of $85.8 million. The FPSC approved permanent increases in retail base rates of approximately $58 million in November 1992, $9.7 million in April 1993 and $18.1 million in November 1993. (See Note 8 to the Financial Statements.) The retail rates are based on a 12% regulatory return on equity. The Company's allowed retail regulatory return on equity range is 11% to 13%. The Company's retail regulatory return on equity was 12.1% for the year ended December 31, 1993. New revenues were granted in the approved rate increase to allow for the recovery of new investment to support customer growth, increased operations and maintenance costs, and higher depreciation expenses. The rate increase also allows the Company to recover costs for employee benefits in accordance with the new accounting standard for other postretirement benefits that became effective January 1, 1993. The new base rates increased operating revenues by $43.4 million and increased earnings by $10.4 million for 1993, after recording new expenses authorized in the rate case. The FPSC has conducted proceedings to review the authorized return on common equity for other Florida utilities to reflect a lower cost of capital. While some of these proceedings have resulted in a reduction of the authorized return on common equity, the FPSC has not ordered any refunds or lowered customer rates. The Company filed a 1994 wholesale base rate proceeding on February 8, 1994 before the FERC after reaching a settlement in principle with its wholesale customers. The Company is requesting an increase in annual revenues of approximately $10 million to recover costs for new generating facilities and higher purchased power costs. The settlement is expected to be approved by the FERC in the second quarter 1994. In December 1993, the Company executed a settlement agreement with its wholesale customers for $5.7 million in higher annual revenues in its 1993 rate proceeding. The settlement is expected to be approved by the FERC in the first quarter of 1994. The Company reached a settlement with its wholesale customers in its 1992 rate proceeding, which had no significant impact on annual revenues but resulted in a retroactive depreciation adjustment that increased the Company's 1992 fourth quarter earnings by $5.6 million. (See Note 1 to the Financial Statements.) The Company's customer growth rate for 1993 was 2.7%, compared with 2% in 1992. An increase of more than 32,000 customers during 1993 was the principal reason for a 5.3% increase in retail KWH sales for the year. The main reason for the increase in the customer growth rate during 1993 was the Company's acquisition of the Sebring Utilities Commission electrical distribution system. The purchase occurred in April 1993, adding about 12,500 customers to the Company's system. The Company paid $54 million for the system, which included $23.6 million for the book value of the assets and going-concern value of the system. The $30.4 million difference was used to retire Sebring's prior debt and will be repaid to the Company through a transition rate from Sebring customers over a period of 15 years. The Company plans to include the net book value of the assets in its next retail rate case in 1998. In addition to customer growth, the higher energy sales in 1993 were the result of increased average customer usage. During 1993, average residential and commercial customer usage was up by 1.7% and 1.8%, respectively, compared with 1992. The primary reason for the higher average usage was the warmer-than-normal summer weather in the Company's service territory in 1993. Fuel and purchased power costs increased by $49.9 million in 1993, compared with 1992. The increase was primarily due to higher system requirements and increased purchased power costs. The Company has several long-term purchased power commitments with qualifying facilities that will increase its level of purchased power over the next several years. Since the Company recovers substantially all fuel and purchased power costs through fuel and capacity adjustment clauses, and defers any adjustments to the following period, these fluctuations have little impact on net income. (See Note 10 to the Financial Statements with respect to present and possible future impact of these commitments.) Other utility operations and maintenance expenses increased by $64.2 million in 1993. Recoverable energy conservation programs accounted for $32.3 million of the increase. The Company recovers substantially all of its energy conservation program costs through a clause similar to the fuel adjustment clause. Also contributing to the increase were postretirement benefits and the costs associated with an early retirement option announced in late 1993. These increases in other utility operations and maintenance expenses were partially offset by reduced maintenance costs at the Crystal River Nuclear Plant that resulted from the timing of outages. The Company's earnings were lowered by $3.4 million, for the early retirement costs recognized in 1993 and the Company estimates that 1994 earnings will be lower by approximately $8 million. Payroll cost reductions and other lower personnel-related expenses are expected to pay back the expenses being recognized for the early retirement option in less than three years. During 1993, the nuclear unit's capacity factor was 84.5%, which is above the industry average. This capacity factor was achieved despite the plant completing a mid-cycle maintenance outage. The Company's share of the expenses for the 53-day outage totaled $9.7 million. (See Note 7 to the Financial Statements.) Electric utilities have only recently begun the process of decommissioning large nuclear units. Therefore, estimates of decommissioning costs have been based on limited experience. As the industry gains additional experience, estimates of decommissioning costs may increase. (See Note 7 to the Financial Statements.) In November 1992, the U.S. Nuclear Regulatory Commission issued its most recent Systematic Assessment of Licensee Performance report for the nuclear unit. The report gave favorable ratings to the plant in all seven functional areas. The plant received the highest performance rating in three of seven areas and the next to the highest or industry average rating in the remaining four areas. The next performance report for the unit is expected in April 1994. The 1992 retail rate decision included revenues to recover additional depreciation expense, beginning in November 1992, previously ordered by the FPSC. The decision included a provision for fossil plant dismantlement costs. These dismantlement costs totaled $23.9 million in 1993, $18.2 million in 1992 and $16.6 million in 1991. (See Note 1 to the Financial Statements.) The financial return on the Company's common equity was 12.1% in 1993, 12.3% in 1992 and 12.9% in 1991. Although the Company's 1993 return was bolstered by the increase in retail electric rates and the higher energy sales, these increases were offset by higher income taxes, and increased costs for insurance and the early retirement option. The Company has been notified by the EPA that it is or may be a potentially responsible party for the cleanup costs of several contaminated sites. In addition, the Company is a defendant in an action seeking contribution for cleanup costs from the prior owners of a former coal gasification plant site. (See Note 10 to the Financial Statements.) INTEREST EXPENSE AND INFLATION Interest expense was impacted by lower interest rates in both 1992 and 1993, compared with 1991. Interest expense increased in 1993, compared with 1992, despite lower rates, due to higher average debt levels in 1993. Allowance for funds used during construction decreased $3.1 million in 1993, compared with an increase of $9.3 million in 1992. During 1992 and 1993, several major construction projects were completed at the Company, contributing to the 1993 decrease. Even though the inflation rate has been relatively low in recent years, inflation continues to affect the Company by reducing the purchasing power of the dollar and increasing the cost of replacing assets used in the business. This has a negative effect on the Company since regulators do not generally consider this economic loss when utility rates are set. However, such losses are partly offset by the economic gains that result from the repayment of long-term debt with inflated dollars. INCOME TAXES In August, the Omnibus Budget Reconciliation Act of 1993 was signed into law. The major provision of the new tax law affecting the Company is the increase in the maximum corporate income tax rate from 34% to 35%. This 1% increase in the tax rate lowered the Company's 1993 net earnings by $2.8 million (See Note 5 to the Financial Statements.) ACCOUNTING STANDARDS The Company adopted Financial Accounting Standard No. 109, "Accounting for Income Taxes," in 1993. The adoption of the standard did not have an impact on earnings in 1993. (See Note 1 to the Financial Statements.) The Company also adopted Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in 1993. This standard mandates that an employer's obligation for postretirement benefits must be fully accrued by the date employees attain full eligibility to receive these benefits. The Company accrued approximately $18 million in additional annual costs under the new standard in 1993, which was recovered through increased customer base rates. (See Note 6 to the Financial Statements.) The Company will be required to adopt two new financial accounting standards in 1994 - Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and Financial Accounting Standard No. 112, "Employers' Accounting for Postemployment Benefits." The adoption of these standards is not expected to have a material impact on earnings. (See Note 1 to the Financial Statements.) LIQUIDITY AND CAPITAL RESOURCES Cash from operations has been the primary source of capital for the Company over the last five years. The Company's construction expenditures for 1993 totaled $426.4 million, consisting primarily of distribution and production expenditures. The five-year construction program includes planned expenditures of $344 million, $378 million, $325 million, $371 million and $354 million for 1994 through 1998. In December 1991, the FPSC approved the utility's request to construct two gas-fired, combined-cycle generating units in Polk County, Florida. Construction expenditures of $287 million are planned for this new energy complex in the 1994-1998 forecast with most of the expenditures in the later years. The Company plans to use natural gas for the first phase of the new energy complex in Polk County. The Company's subsidiaries currently have 30% equity interests in the interstate and intrastate partnerships of a gas pipeline project. These investments totaled $4.9 million at December 31, 1993. The Company has an option to reduce or eliminate its ownership positions at the end of 1994. (See Note 10 to the Financial Statements.) In a separate agreement, the Company has signed a 25-year contract for the transportation of natural gas to the Company's Anclote plant near Tarpon Springs and the Polk County site through this planned pipeline. The Clean Air Act of 1990 requires electric utility companies to reduce sulfur dioxide emissions in two phases. The Company will not be affected significantly by Phase I, which begins in 1995, and expects to meet Phase II requirements in the year 2000 with minimal capital expenditures. In addition to funding its construction commitments with cash from operations, the Company accesses the capital markets through the issuance of commercial paper, medium-term notes and first mortgage bonds and receives equity from Florida Progress' common stock sales. The Company's goal is to maintain a capital structure consistent with its double A minus credit rating. In 1992, the Company established a $200-million public medium-term note program, providing for the issuance of either fixed or floating interest rate notes, with maturities that may range from nine months to 30 years. The program has approximately $170 million available for future issuance. During 1993, the Company repaid $355.5 million of first mortgage bonds and $45.4 million of medium-term notes. (See Note 2 to the Financial Statements.) The Company's embedded cost of long-term debt declined to 6.8% at December 31, 1993, compared with 7.5% at year-end 1992. During 1992, the Company purchased and redeemed 50,000 shares of its Cumulative Preferred Stock, pursuant to sinking fund provisions. In 1993, the Company redeemed an additional 800,000 shares of its Cumulative Preferred Stock. (See Note 3 to the Financial Statements.) Florida Progress contributed $60 million in 1993, $121.6 million in 1992 and $100 million in 1991 to the Company from the proceeds of Florida Progress' public stock offerings in May 1992 and May 1991 and the Progress Plus Stock Plan. These equity funds were used to reduce outstanding commercial paper and to further strengthen the Company's financial position. The Company has a $400-million commercial paper program that is rated A-1+ by Standard & Poor's and P-1 by Moody's. The Company's interim financing needs are funded primarily through its commercial paper program. The Company has established 364-day and five-year revolving bank credit facilities, both for $200 million, which are used to back up commercial paper. (See Note 2 to the Financial Statements.) ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statements and Supplementary Data Report of Independent Certified Public Accountants Statements of Income for the years ended December 31, 1993, 1992 and 1991 Balance Sheets, December 31, 1993 and 1992 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Quarterly Financial Data (Unaudited) AUDITORS' REPORT To the Board of Directors and Shareholders of Florida Power Corporation: We have audited the balance sheets of Florida Power Corporation 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. In connection with our audits of the financial statements, we also have audited the financial statement schedules as listed in Item 14 herein. 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 Florida Power Corporation 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 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 1 and 6 to the financial statements, in 1993, Florida Power Corporation changed its methods of accounting for income taxes and postretirement benefits other than pensions. /s/KPMG PEAT MARWICK - --------------------- KPMG PEAT MARWICK St. Petersburg, Florida January 24, 1994 FLORIDA POWER CORPORATION Statements of Income - --------------------------------------------------------------------------- For the Years Ended December 31, 1993, 1992 and 1991 (In millions) 1993 1992 1991 OPERATING REVENUES $1,957.6 $1,774.1 $1,718.8 - --------------------------------------------------------------------------- OPERATING EXPENSES: Operation Fuel used in generation 460.8 471.9 498.5 Purchased power 209.5 140.4 104.3 Deferred fuel (11.8) (3.7) 3.8 Other 378.0 310.9 282.0 - --------------------------------------------------------------------------- 1,036.5 919.5 888.6 Maintenance 136.8 139.7 134.8 Depreciation 240.2 209.5 206.3 Taxes, Other Than Income 152.6 138.3 129.3 Income taxes 104.5 97.7 92.8 - --------------------------------------------------------------------------- 1,670.6 1,504.7 1,451.8 - --------------------------------------------------------------------------- OPERATING INCOME 287.0 269.4 267.0 - --------------------------------------------------------------------------- OTHER INCOME AND DEDUCTIONS: Allowance for equity funds used during construction 8.9 10.4 4.0 Miscellaneous other income, net (1.9) (1.0) (0.3) - --------------------------------------------------------------------------- 7.0 9.4 3.7 - --------------------------------------------------------------------------- INTEREST CHARGES: Interest On Long-Term Debt 91.7 84.2 79.1 Other Interest Expense 14.1 16.0 16.1 - --------------------------------------------------------------------------- 105.8 100.2 95.2 Allowance for borrowed funds used during construction (6.7) (8.3) (5.4) - --------------------------------------------------------------------------- 99.1 91.9 89.8 - --------------------------------------------------------------------------- NET INCOME 194.9 186.9 180.9 DIVIDENDS ON PREFERRED STOCK 13.4 16.7 16.8 - --------------------------------------------------------------------------- NET INCOME AFTER DIVIDENDS ON PREFERRED STOCK $181.5 $170.2 $164.1 =========================================================================== The accompanying notes are an integral part of these financial statements. FLORIDA POWER CORPORATION Balance Sheets - -------------------------------------------------------------------------- December 31, 1993 and 1992 (In millions) 1993 1992 ASSETS PROPERTY, PLANT AND EQUIPMENT: Electric utility plant in service and held for future use $5,320.3 $4,853.9 Less: Accumulated depreciation 1,846.2 1,660.8 Accumulated decommissioning for nuclear plant 118.3 102.0 Accumulated dismantlement for fossil plants 68.5 47.1 - -------------------------------------------------------------------------- 3,287.3 3,044.0 Construction work in progress 285.7 333.8 Nuclear fuel, net of amortization of $299.9 in 1993 and $273.6 in 1992 68.4 64.2 - -------------------------------------------------------------------------- 3,641.4 3,442.0 Other property, net 27.7 28.4 - -------------------------------------------------------------------------- 3,669.1 3,470.4 - -------------------------------------------------------------------------- CURRENT ASSETS: Accounts receivable, less reserve of $2.4 in 1993 and $2.6 in 1992 168.2 147.8 Inventories at average cost Fuel 58.9 77.8 Materials and supplies 112.2 103.4 Underrecovery of fuel costs 7.1 4.4 Deferred income taxes 29.2 13.7 Other 5.8 10.4 - -------------------------------------------------------------------------- 381.4 357.5 - -------------------------------------------------------------------------- OTHER ASSETS: Nuclear plant decommissioning fund 107.7 89.8 Unamortized debt expense, being amortized over term of debt 31.6 21.1 Other 69.7 41.8 - -------------------------------------------------------------------------- 209.0 152.7 - -------------------------------------------------------------------------- $4,259.5 $3,980.6 ========================================================================== The accompanying notes are an integral part of these financial statements. FLORIDA POWER CORPORATION Balance Sheets - -------------------------------------------------------------------------- December 31, 1993 and 1992 (In millions) 1993 1992 CAPITALIZATION AND LIABILITIES CAPITALIZATION: Common stock without par value - 60,000,000 shares authorized, 100 shares outstanding $812.9 $752.9 Retained earnings 709.5 692.0 - -------------------------------------------------------------------------- 1,522.4 1,444.9 Cumulative preferred stock: Without sinking funds 113.5 133.5 With sinking funds 35.0 82.5 Long-term debt 1,398.6 1,235.8 - -------------------------------------------------------------------------- 3,069.5 2,896.7 - -------------------------------------------------------------------------- CURRENT LIABILITIES: Accounts payable 106.2 71.0 Accounts payable to associated companies 17.1 25.0 Customer deposits 71.5 69.0 Income taxes payable 24.6 15.5 Accrued other taxes 8.4 8.2 Accrued interest 33.2 30.2 Other 34.2 28.4 - -------------------------------------------------------------------------- 295.2 247.3 Notes payable 125.0 - Current portion of long-term debt 45.9 120.0 Preferred stock sinking fund obligations - 12.5 - -------------------------------------------------------------------------- 466.1 379.8 - -------------------------------------------------------------------------- DEFERRED CREDITS AND OTHER LIABILITIES: Deferred income taxes 472.7 503.3 Unamortized investment tax credits 117.8 126.3 Other 133.4 74.5 - -------------------------------------------------------------------------- 723.9 704.1 - -------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES (Note 10) - -------------------------------------------------------------------------- $4,259.5 $3,980.6 ========================================================================== The accompanying notes are an integral part of these financial statements. FLORIDA POWER CORPORATION Statements of Cash Flow - ----------------------------------------------------------------------------- For the Years Ended December 31, 1993, 1992 and 1991 (In millions) 1993 1992 1991 OPERATING ACTIVITIES: Net income after dividends on preferred stock $181.5 $170.2 $164.1 Adjustments for noncash items: Depreciation & amortization 276.5 243.4 241.9 Deferred income taxes and investment tax credits, net (25.0) 8.6 (35.2) Allowance for equity funds used during construction (8.9) (10.4) (4.0) Changes in working capital: Accounts receivable (18.4) (12.5) 2.9 Inventories 10.1 (21.7) 25.2 Overrecovery (underrecovery) of fuel cost (2.7) (43.8) 46.4 Accounts payable 35.2 9.6 18.6 Accounts payable to associated companies (7.9) 4.4 (6.4) Other 25.1 (5.3) 11.2 Other operating activities 14.2 (4.0) 7.7 - ----------------------------------------------------------------------------- 479.7 338.5 472.4 - ----------------------------------------------------------------------------- INVESTING ACTIVITIES: Construction expenditures (426.4) (472.9) (345.9) Allowance for borrowed funds used during construction (6.7) (8.3) (5.4) Additions to nonutility property (7.6) (12.3) (8.4) Acquisition of electric distribution system (53.9) - - Proceeds from sale of property 6.0 3.8 4.5 Other investing activities (18.4) (14.9) (11.4) - ----------------------------------------------------------------------------- (507.0) (504.6) (366.6) - ----------------------------------------------------------------------------- FINANCING ACTIVITIES: Issuance of long-term debt 385.0 430.1 208.5 Repayment of long-term debt (402.7) (243.2) (173.3) Increase in commercial paper with long-term support 104.0 18.0 78.0 Redemption of preferred stock (80.5) (5.0) - Dividends paid on common stock (163.5) (155.4) (142.1) Equity contributions from parent 60.0 121.6 100.0 Increase (decrease) in short-term debt 125.0 - (178.5) - ----------------------------------------------------------------------------- 27.3 166.1 (107.4) - ----------------------------------------------------------------------------- NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS - - (1.6) Beginning cash and equivalents - - 1.6 - ----------------------------------------------------------------------------- ENDING CASH AND EQUIVALENTS $ - $ - $ - ============================================================================= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the year for: Interest (net of amount capitalized) $93.8 $89.7 $86.7 Income taxes (net of refunds) $120.3 $92.7 $120.8 ============================================================================= The accompanying notes are an integral part of these financial statements. FLORIDA POWER CORPORATION Statements of Shareholders' Equity - --------------------------------------------------------------------------- For the Years Ended December 31, 1993, 1992 AND 1991 (In millions, except share amounts) Cumulative Preferred Stock ----------------- Without With Common Retained Sinking Sinking Stock Earnings Funds Funds - --------------------------------------------------------------------------- Balance, December 31, 1990 $531.3 $655.2 $133.5 $100.0 Net income after dividends on preferred stock 164.1 Capital contribution by parent company 100.0 Cash dividends on common stock (142.1) Preferred stock reclassified to current - 25,000 shares (2.5) - --------------------------------------------------------------------------- Balance, December 31, 1991 631.3 677.2 133.5 97.5 Net income after dividends on preferred stock 170.2 Capital contribution by parent company 121.6 Cash dividends on common stock (155.4) Preferred stock redeemed or reclassified to current - 150,000 shares (15.0) - --------------------------------------------------------------------------- Balance, December 31, 1992 752.9 692.0 133.5 82.5 Net income after dividends on preferred stock 181.5 Capital contribution by parent company 60.0 Cash dividends on common stock (163.5) Preferred stock redeemed - 675,000 shares (0.5) (20.0) (47.5) - --------------------------------------------------------------------------- Balance, December 31, 1993 $812.9 $709.5 $113.5 $35.0 =========================================================================== The accompanying notes are an integral part of these financial statements. FLORIDA POWER CORPORATION NOTES TO FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL - The Company is a public utility engaged in the generation, purchase, transmission, distribution and sale of electric energy primarily within Florida. It is subject to regulation by the FPSC and the FERC. The Company's records comply with the accounting and reporting requirements of these regulatory authorities and generally accepted accounting principles. UTILITY PLANT - Utility plant 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. Substantially all of the utility plant is pledged as collateral for the Company's first mortgage bonds. UTILITY REVENUES, FUEL AND PURCHASED POWER EXPENSES - The Company accrues the non-fuel portion of base revenues for services rendered but unbilled. Revenues include amounts resulting from fuel, purchased power and conservation adjustment clauses, which are designed to permit full recovery of these costs. The adjustment factors are based on projected costs for a six- or 12-month period. Revenues and expenses are adjusted for differences between recoverable fuel, purchased power and conservation costs and amounts included in current rates. The cumulative fuel cost difference is shown on the balance sheet as overrecovery or underrecovery of fuel costs. Any overrecovery or underrecovery of costs, plus an interest factor, is refunded or billed to customers during the subsequent period. The cost of fossil fuel for electric generation is charged to expense as consumed. The cost of nuclear fuel is amortized to fuel expense based on the quantity of heat produced for the generation of electric energy in relation to the quantity of heat expected to be produced over the life of the nuclear fuel core. INCOME TAXES - Financial Accounting Standard No. 109, "Accounting for Income Taxes," was adopted by the Company in the first quarter of 1993. The objective of this standard is to recognize the amount of current and deferred taxes payable and refundable for all events that have been recognized in the financial statements or tax returns based on enacted tax laws at the date of the financial statements. The Company elected to report the cumulative effect of the change in method of accounting for income taxes in 1993. Under the new standard, deferred income taxes are provided on all significant temporary differences between the financial statements and the tax bases of assets and liabilities using presently enacted tax rates. In adopting the standard, the Company recorded a net decrease in deferred tax balances of $57 million which resulted from the reversal of deferred income taxes accrued in prior years at rates in excess of the presently enacted tax rate and the recognition of a temporary difference related to deferred investment tax credits. The decrease to deferred income taxes was partially offset by an increase for temporary differences for which no deferred taxes had been recorded because of prior regulatory practices. Because of regulatory precedent and the Company's intent to recover and settle these amounts in future rates, a corresponding regulatory asset and regulatory liability were recorded and there was no effect on net income. Deferred investment tax credits subject to regulatory accounting practices are amortized to income over the lives of the related properties. DEPRECIATION AND MAINTENANCE - The Company provides for depreciation of the cost of properties over their estimated useful lives primarily on a straight-line basis. The Company's annual provision for depreciation, including a provision for nuclear plant decommissioning costs and fossil plant dismantlement costs, expressed as a percentage of the average balances of depreciable utility plant, was 4.8% for 1993, 4.6% for 1992 and 4.8% for 1991. The Company was authorized by the FPSC to apply new depreciation rates, which resulted in a $37.2-million increase in depreciation expense for 1991. This increase included $16.6 million for fossil plant dismantlement costs. The effect of these new rates on wholesale customers was reversed in connection with the settlement of the Company's 1992 wholesale rate request, resulting in a one-time adjustment of previously recorded depreciation. The reversal increased net income in the fourth quarter of 1992 by $5.6 million, of which $3.1 million was applicable to periods prior to 1992. The 1992 retail rate case included higher fossil plant dismantlement costs, totaling about $24 million annually, beginning in November 1992. In 1993, the Company filed a new depreciation study with the FPSC. The filing includes the results of a site-specific dismantlement study of the Company's fossil generating facilities. If the FPSC approves the Company's recommended change in rates, annual depreciation expense will decrease by $9.7 million on a retail jurisdictional basis, beginning in January 1995. The Company charges maintenance expense with the cost of repairs and minor renewals of property. The plant accounts are charged with the cost of renewals and replacements of property units. Accumulated depreciation is charged with the cost, less the net salvage, of property units retired. ALLOWANCE FOR FUNDS - The allowance for funds used during construction represents the estimated cost of capital funds (equity and debt) applicable to utility plant under construction. Recognition of this item as a cost of utility plant under construction is appropriate because it constitutes an actual cost of construction and, under established regulatory rate practices, the Company is permitted to earn a return on these costs and recover them in the rates charged for utility services while the plant is in service. In 1993, the FPSC reduced the Company's allowance for funds rate to 7.8%, effective July 1, 1993. The revision was prompted by the Company's newly authorized cost of capital. The average rate used in computing the allowance for funds was 7.9% for 1993 and 8% for 1992 and 1991. MARKETABLE SECURITIES AND FINANCIAL INSTRUMENTS - The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Fixed-income securities are carried at amortized cost and other equity securities are stated at the lower aggregate of cost or market value. The Company will be required to adopt Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," in 1994. The standard requires the Company to address the accounting and reporting for investments in debt and equity securities. The standard requires investments to be classified in three categories depending on the Company's intended use. The adoption of this standard is required to be reflected prospectively, and is not expected to have a material impact on 1994 earnings. (2) DEBT The Company's long-term debt at December 31, 1993 and 1992, is scheduled to mature as follows: Interest (In millions) Rate 1993 1992 - ------------------------------------------------------------------------------ First mortgage bonds: Maturing through 1998: 1993(early redemption) 8.48%(b) $ - $ 75.0 1995 4.74%(a) 34.4 34.4 1997 6.13% 16.7 16.7 1998 (early redemption) 7.00% - 20.5 Maturing 1999 through 2003 6.50%(a) 355.0 355.0 Maturing 2006 and 2008 6.88% 80.0 80.0 Maturing 2021 through 2023 7.98%(a) 400.0 300.0 Discount, net of premium, being amortized over term of bonds (7.3) (2.2) - ------------------------------------------------------------------------------ 878.8 879.4 Pollution control financing obligations: Maturing 2014 through 2027 6.59%(a) 240.9 240.9 Notes maturing: 1993-1994 8.41%(a) 45.9 90.0 1995-2008 7.79%(a) 78.9 49.5 Commercial paper, supported by revolver maturing December 31, 1998 3.29%(a) 200.0 96.0 - ------------------------------------------------------------------------------ 1,444.5 1,355.8 Less: Current portion of long-term debt 45.9 120.0 - ------------------------------------------------------------------------------ $1,398.6 $1,235.8 - ------------------------------------------------------------------------------ (a) Weighted average interest rate at December 31, 1993. (b) Weighted average interest rate at the redemption date. The Company has revolving lines of credit totaling $400 million, which are used to support commercial paper. The lines of credit were not drawn on as of December 31, 1993. Interest rate options under line of credit arrangements vary from sub-prime or money market rates to the prime rate. Banks providing lines of credit are compensated through fees. Commitment fees on lines of credit vary between .1 and .175 of 1%. The revolving lines of credit facilities, $200 million each, are for terms of 364 days and five years. In 1993, the 364-day facility was renewed to November 1994 and the five-year facility was extended to December 1998. Based on the duration of the underlying backup credit facilities, $200 million of the outstanding commercial paper at December 31, 1993, and all outstanding commercial paper at December 31, 1992, are classified as long-term debt. In 1993, the Company refunded $355.5 million of its first mortgage bonds, with a weighted average interest rate of 8.13%, which were comprised of seven series originally due to mature from 1998 through 2006. The Company refunded substantially all of these first mortgage bonds using the proceeds from the issuance of four series of first mortgage bonds, with a weighted average interest rate of 6.35%, which are due to mature from 1999 through 2008. In connection with the purchase of the Sebring Utilities Commission electric distribution system in April 1993, the Company issued $30.7 million of 15-year, 6.67% amortizing medium-term notes. The net proceeds were used to repay commercial paper that was issued initially to retire the Sebring Utilities Commission debt. In December 1993, the Company issued $100 million of First Mortgage Bonds, 7% Series due 2023. The proceeds were used for the repayment of commercial paper and for general corporate purposes. The combined aggregate maturities of long-term debt for 1994 through 1998 are $45.9 million, $35.4 million, $30.6 million, $38.0 million and $201.5 million, respectively. In addition, about 17% of the Company's outstanding first mortgage bonds have an annual 1% sinking fund requirement. These requirements, which total $1.8 million annually for 1994 and 1995, $1.3 million annually for 1996 and 1997 and $1 million for 1998, are expected to be satisfied with property additions. (3) PREFERRED AND PREFERENCE STOCK A summary of outstanding Cumulative Preferred Stock of the Company follows: The Company has 4 million shares of authorized Cumulative Preferred Stock, $100 par value, of which 1.5 million shares are outstanding. In addition, the Company has 1 million shares of authorized, but unissued, Preference Stock, $100 par value, and 5 million shares of authorized, but unissued, Cumulative Preferred Stock, without par value. In March 1993, the Company redeemed its $20-million 8.80% series perpetual preferred stock, as well as the 1993 mandatory and optional sinking fund amounts on its 7.08% and 7.84% series preferred stock, totaling $5 million and $20 million, respectively. In December 1993, the Company redeemed the 1994 mandatory and optional sinking fund amounts on the 7.08% and 7.84% series preferred stock, totaling $5 million and $20 million, respectively. In addition, the Company redeemed all the remaining shares of its 7.84% series preferred stock, totaling $10 million, at a redemption price of $101.96. Preferred stock redemption requirements for 1995 through 1998, after giving effect to the above retirements, are $2.5 million annually. (4) FINANCIAL INSTRUMENTS The fair value amounts of the Company's financial instruments have been determined using available market information and valuation methodologies deemed appropriate in the opinion of management. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions may have a material effect on the estimated fair value amounts. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments. NUCLEAR PLANT DECOMMISSIONING FUND - The assets in this fund consist of cash and equivalents, which are valued at their carrying amount, and equity securities and governmental notes and bonds, which are valued at quoted market prices. PREFERRED STOCK OF THE COMPANY WITH SINKING FUNDS - The fair values of the Company's preferred stock subject to mandatory redemption are estimated using discounted cash flow analyses, based on current market rates. DEBT - The carrying amounts of debt with short-term maturities (primarily commercial paper) approximate their fair value. The fair values for debt with fixed interest rates are estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The fair value analysis ignores redemption prices and issuance costs (including underwriting commissions) that would be required to refund existing fixed interest rate debt. In addition, the analysis assumes that all of the debt is currently callable at fair value. The Company had the following financial instruments for which the estimated fair values differ from the carrying values at December 31, 1993 and 1992: (5) INCOME TAXES (In millions) 1993 1992 1991 - ------------------------------------------------------------------------- Components of income tax expense: Payable currently: Federal $110.2 $ 75.4 $108.8 State 19.1 13.6 19.1 - ------------------------------------------------------------------------- 129.3 89.0 127.9 - ------------------------------------------------------------------------- Deferred, net: Federal (13.9) 14.3 (21.7) State (2.6) 2.2 (4.3) - ------------------------------------------------------------------------- (16.5) 16.5 (26.0) - ------------------------------------------------------------------------- Amortization of investment tax credits, net (8.5) (8.0) (9.2) - ------------------------------------------------------------------------- $104.3 $ 97.5 $ 92.7 - ------------------------------------------------------------------------- The principal components of deferred income tax expense for 1992 and 1991 were the underrecovery or overrecovery of fuel costs and the difference between accelerated and straight-line depreciation. The primary differences between the statutory rates and the effective income tax rates are detailed below: 1993 1992 1991 - -------------------------------------------------------------------------- Federal statutory income tax rate 35.0% 34.0% 34.0% State income tax, net of federal income tax benefits 3.6 3.6 3.7 Amortization of investment tax credits (2.8) (2.8) (3.4) Other ( .7) (0.5) (0.4) - -------------------------------------------------------------------------- Effective income tax rates 35.1% 34.3% 33.9% - -------------------------------------------------------------------------- The Omnibus Budget Reconciliation Act of 1993 included various rule changes and increased the maximum corporate income tax rate from 34% to 35%. The impact of the new tax law increased the Company's 1993 income tax expense by $2.8 million. The tax rate change increased the Company's deferred tax balances by $18.3 million with a corresponding net increase to the regulatory asset. The following summarizes the components of deferred tax liabilities and assets at December 31, 1993: (In millions) 1993 - ------------------------------------------------------------------------- Deferred tax liabilities: Difference in tax basis of property, plant and equipment $500.4 Deferred book expenses 13.8 Under/(over) recovery of fuel 2.8 - ------------------------------------------------------------------------- Total deferred tax liabilities $517.0 - ------------------------------------------------------------------------- Deferred tax assets: Accrued book expenses $ 40.5 Unbilled revenues 17.3 Regulatory liability for deferred income taxes 11.9 Other 3.8 - ------------------------------------------------------------------------- Total deferred tax assets $ 73.5 - ------------------------------------------------------------------------- At December 31, 1993, the Company had net non-current deferred tax liabilities of $472.7 million and net current deferred tax assets of $29.2 million. The Company expects the results of future operations will generate sufficient taxable income to allow the utilization of deferred tax assets. (6) RETIREMENT BENEFIT PLANS PENSION BENEFITS -- The Company's parent, Florida Progress, has a non-contributory defined benefit pension plan covering substantially all employees. The benefits are based on length of service, compensation during the highest consecutive 48 of the last 120 months of employment and social security benefits. Prior to January 1, 1992, the compensation portion of the benefit formula was based on the highest consecutive 60 of the last 120 months of employment. The participating companies make annual contributions to the plan based on an actuarial determination and in consideration of tax regulations and funding requirements under federal law. Based on actuarial calculations and the funded status of the pension plan, the Company was not required to contribute to the plan for 1993, 1992 or 1991. Shown below are the components of the net pension cost calculations for those years: (In millions) 1993 1992 1991 - -------------------------------------------------------------------- Service cost $16.3 $18.1 $ 13.9 Interest cost 27.5 25.4 22.4 Actual earnings on plan assets (60.7) (37.3) (91.4) Net amortization and deferral 17.9 (3.1) 58.0 - -------------------------------------------------------------------- Net pension costs 1.0 3.1 2.9 ==================================================================== The Company's costs were as follows: Share of Plans net pension costs .9 3.0 2.7 Regulatory adjustment - (.9) (2.7) - -------------------------------------------------------------------- Net pension cost recognized $ .9 $ 2.1 $ - - -------------------------------------------------------------------- The following summarizes the funded status of the pension plan at December 31, 1993 and 1992: (In millions) 1993 1992 - -------------------------------------------------------------------- Accumulated benefit obligation: Vested $276.0 $229.2 Non-vested 37.9 33.9 - -------------------------------------------------------------------- 313.9 263.1 Effect of projected compensation increases 91.8 96.3 - -------------------------------------------------------------------- Projected benefit obligation 405.7 359.4 Plan assets at market value, primarily listed stocks and bonds 505.0 460.0 - -------------------------------------------------------------------- Plan assets in excess of projected benefit obligation $ 99.3 $100.6 - -------------------------------------------------------------------- Consisting of the following components: Unrecognized transition asset $ 45.3 $ 50.3 Unrecognized prior service cost (10.3) (11.2) Effect of changes in assumptions and difference between actual and estimated experience 64.3 61.5 - -------------------------------------------------------------------- $ 99.3 $100.6 - -------------------------------------------------------------------- The following weighted average actuarial assumptions at January 1 were used in the calculation of pension costs for the following years: 1993 1992 1991 - ------------------------------------------------------------------------------ Discount rate 7.75% 7.25% 8.50% Expected long-term rate of return 9.00% 9.00% 9.00% Rate of compensation increase 5.50% 6.00% 6.00% - ------------------------------------------------------------------------------ The Company used a discount rate of 7.25% and a rate of compensation increase of 5% to calculate the pension plan's 1993 year-end funded status. The change in the discount rate from 7.75% at December 31, 1992 to 7.25% at December 31, 1993, increased the projected benefit obligation by $25.8 million and is expected to increase annual pension costs by $.8 million, beginning in 1994. OTHER POSTRETIREMENT BENEFITS - The Company's parent, Florida Progress, provides certain health care and life insurance benefits for retired employees. Employees become eligible for these benefits when they reach normal retirement age while working for the Company. Prior to 1993, the Company's policy had been to accrue benefits currently payable along with amortization of past service costs of current retirees. The Company had accrued $23.9 million at December 31, 1992, using this method. The Company implemented Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective January 1, 1993. This standard requires that an employer's obligation for postretirement benefits be fully accrued by the date employees attain full eligibility to receive such benefits. The Company's costs for 1993 increased from $5 million to $22.7 million under the new standard and was recovered from customers through retail base rates as discussed in Note 8. The net postretirement benefit cost of the plan for 1993 was: (In millions) 1993 - ----------------------------------------------------------------------- Service cost $ 5.6 Interest cost 11.8 Amortization of unrecognized transition obligation 6.5 - ----------------------------------------------------------------------- $23.9 - ----------------------------------------------------------------------- The Company's share of the plan's postretirement benefit costs were $22.7 million in 1993. The following summarizes the plan's status, reconciled with amounts recognized in Florida Progress' balance sheet at December 31: (In millions) 1993 1992 - ---------------------------------------------------------------------- Accumulated postretirement benefit obligation: Retirees $ 94.3 $ 73.8 Fully eligible active plan participants 2.0 3.6 Other active plan participants 76.2 74.7 - ---------------------------------------------------------------------- 172.5 152.1 - ---------------------------------------------------------------------- Unrecognized transition obligation (120.7) (128.2) Unrecognized net losses (4.4) - - ---------------------------------------------------------------------- Accrued postretirement benefit cost $ 47.4 $ 23.9 - ---------------------------------------------------------------------- The following weighted average actuarial assumptions were used in the calculation of the year-end status of other postretirement benefits: 1993 1992 - ---------------------------------------------------------------------- Discount rate 7.5% 8.0% Rate of compensation increase 5.0% 5.5% Health care cost trend rates: Pre-Medicare 13.00-5.25% 14.50-6.00% Post-Medicare 9.75-5.00% 10.50-5.00% - ---------------------------------------------------------------------- The unrecognized transition obligation is being accrued through 2012. A one-percentage point increase in the assumed health care cost trend rate for each future year would have increased 1993 current service and interest cost by 18.6% and the accumulated postretirement benefit obligation as of December 31, 1993 by 15.1%. The change in the discount rate from 8% at December 31, 1992 to 7.5% at December 31, 1993, increased the projected benefit obligation of the plan by $11.4 million and is expected to increase annual postretirement benefit costs of the plan by $.8 million, beginning in 1994. Due to different retail and wholesale regulatory requirements, the Company plans to make quarterly contributions to an irrevocable external trust fund recently established for wholesale ratemaking, while continuing to accrue postretirement benefit costs to an unfunded reserve for retail ratemaking. EARLY RETIREMENT OPTION - In late 1993, Florida Progress offered an early retirement option to certain employees age 55 or older with at least 20 years of service with the Company. The effective retirement date for those employees accepting the option is February 1, 1994. The Company recognized expenses related to this offer of about $6 million in 1993, which are not included in the postretirement benefit cost table. The Company estimates the related expenses in 1994 will be about $13 million. NEW ACCOUNTING STANDARD - The Company will be required to adopt Financial Accounting Standard No. 112, "Employers' Accounting for Postemployment Benefits," in 1994. The adoption of this standard is not expected to have a material impact on earnings in 1994. (7) NUCLEAR OPERATIONS JOINTLY OWNED PLANT - The following information relates to the Company's 90.4% proportionate share of the Crystal River Nuclear Plant at December 31, 1993: (In millions) 1993 - ------------------------------------------------------------- Utility plant in service $622.7 Construction work in progress 22.8 Unamortized nuclear fuel 68.4 Accumulated depreciation 266.3 Accumulated decommissioning 118.3 - ------------------------------------------------------------- Net capital additions for the Company were $20.1 million in 1993, and depreciation expense, exclusive of nuclear decommissioning, was $26.2 million. Each co-owner provides for its own financing. The Company's share of the asset balances shown previously and operating costs are included in the appropriate consolidated financial statements. Amounts exclude any allocation of costs related to common facilities. DECOMMISSIONING COSTS - The Company's nuclear plant depreciation expenses include a provision for future decommissioning costs that are recoverable through rates charged to customers. The Company is placing amounts collected in an externally managed trust fund. The recovery from customers, plus income earned on the trust fund, is intended to be sufficient to cover the Company's share of the future dismantlement, removal and land restoration costs. The Company has a license to operate the nuclear unit through December 3, 2016, and contemplates decommissioning beginning at that time. In the current site-specific study approved by regulatory authorities, total future decommissioning costs are estimated to be approximately $1.2 billion, which corresponds to $221 million in 1993 dollars. Decommissioning expense, as authorized by the FPSC and the FERC, was $11.9 million for 1993 and 1992 and $11.8 million for 1991. The Company prepared a 1991 site-specific study at the request of the FPSC that estimated decommissioning costs. Those costs, expressed in 1993 dollars, are $307.6 million. The FPSC postponed consideration of that study until 1994. The Company is required to file a new site-specific study with the FPSC in 1994, which will incorporate current cost factors, technology and radiological criteria. The results of that study cannot be reasonably estimated at this time. However, based on prior regulatory treatment, the Company expects to recover any increase in nuclear decommissioning costs through future rates. The NRC issued updated waste burial cost factors in 1993, which are used in the generic NRC formula for estimating decommissioning costs. The Company's 1991 site-specific study contains estimates for decommissioning costs that exceed current NRC minimum requirements. The National Energy Policy Act of 1992 established a fund to pay for the decontamination and decommissioning of nuclear enrichment facilities operated by the DOE. The fund is expected to consist of payments from affected domestic utilities and the federal government. The Company's current annual special assessment, before adjustment for inflation, is $1.4 million. The Company recorded a total estimated liability of $19.5 million at December 31, 1993, with a corresponding regulatory asset. This special assessment is being recovered from utility customers through the fuel adjustment clause. The Financial Accounting Standards Board has issued Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts." Based in part on the issuance of this interpretation, the SEC staff announced it intends to require that estimated nuclear decommissioning costs be shown as a liability in the financial statements, beginning in 1994. The Company currently has recorded the accumulated provisions for nuclear decommissioning costs as a contra asset on the balance sheet. If the SEC staff maintains its position, a liability and a corresponding asset of $307.6 million each would be recorded in 1994 based on available cost estimates. FUEL DISPOSAL COSTS - The Company has entered into a contract with the DOE for the transportation and disposal of spent nuclear fuel. Disposal costs for nuclear fuel consumed are being collected from customers through the fuel adjustment clause at a rate of $.001 per net nuclear kilowatt-hour sold and are paid to the DOE quarterly. The Company currently is storing spent nuclear fuel on site and has sufficient storage capacity in place or under construction for fuel burned through the year 2009. PLANT MAINTENANCE AND REFUELING OUTAGES - The Company accrues a reserve for maintenance and refueling expenses anticipated to be incurred during scheduled nuclear plant outages. A planned 53-day mid-cycle maintenance outage in 1993, cost the Company $9.7 million. A 77-day refueling outage in 1992, resulted in a cost of $30.2 million to the Company. The next planned refueling outage, scheduled for approximately nine weeks beginning in April 1994, presently is estimated to cost $21.4 million. INSURANCE - The Price-Anderson Act currently limits the liability of an owner of a nuclear power plant for a single nuclear incident to $9.4 billion. The Company has purchased the maximum available commercial nuclear liability insurance of $200 million with the balance provided by indemnity agreements prescribed by the NRC. In the event of a nuclear incident at any U.S. nuclear power plant, the Company could be assessed up to $79.3 million per incident, with a maximum assessment of $10 million per year. The Company has never been assessed for a nuclear incident under these indemnity agreements. In addition to this liability insurance, the Company carries extra expense insurance with Nuclear Electric Insurance, Ltd. ("NEIL") to cover the cost of replacement power during any prolonged outage of the nuclear unit. Under this policy, the Company is subject to a retroactive premium assessment of up to $2.7 million in any year in which policy losses exceed accumulated premiums and investment income. (8) RATES AND REGULATION RETAIL RATES - In January 1992, the Company filed a retail base rate increase request of $145.9 million using a regulatory return on equity of 13.6%. The request was based upon a dual-year test period that included 1992 and 1993. In September 1992, the FPSC granted the Company an annual revenue increase of $85.8 million. The new rates provide the Company the opportunity to earn a regulatory return on equity of 12%, with a new allowed range between 11% and 13%. The FPSC granted increases in retail base rates of approximately $58 million in November 1992, $9.7 million in April 1993 and $18.1 million in November 1993. The FPSC also upheld a previously awarded interim increase of $31.2 million. The interim rates and new base rates increased 1992 earnings by $15.4 million. The new base rates increased 1993 earnings by $10.4 million, after recording new expenses authorized in the rate case. WHOLESALE RATES - In December 1993, the Company executed a settlement agreement with its wholesale customers in its 1993 base rate proceeding. The agreement provides for an annual revenue increase of $5.7 million, effective February 1993. The settlement is expected to be approved by the FERC in the first quarter of 1994. In December 1992, the Company reached a settlement agreement with its wholesale customers, which resulted in no significant change in revenues. The 1992 settlement was approved by the FERC and provided for a retroactive change in the Company's depreciation rates to December 1990. (See Note 1.) The Company expects to file a 1994 wholesale base rate proceeding in the first quarter of 1994. The Company will be requesting an increase in revenues of approximately $10 million to recover costs for new generating facilities and higher purchased power costs. If approved by the FERC, the rate increase will go into effect in March 1994. (9) TRANSACTIONS WITH RELATED PARTIES The Company has entered into two coal supply contracts with Electric Fuels to meet substantially all of its coal requirements through 2004. The cost of coal purchased for 1993, 1992, and 1991 was $244.6 million, $261.1 million, and $264.1 million, respectively. The amount payable to Electric Fuels for coal purchases at December 31, 1993 and 1992, was $16.6 million and $23.1 million, respectively. (10) COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM - Substantial commitments have been made in connection with the Company's construction program, which are presently estimated to result in construction expenditures in 1994 of $344 million for electric plant and nuclear fuel. SUNSHINE PIPELINE PROJECT - The Company currently has a 30% equity ownership interest in both an intrastate and an interstate gas pipeline partnership, with an option to reduce or eliminate its interest in December 1994. The cost of the pipeline project is estimated to be approximately $600 million. In 1994, the Company expects to invest $6 million in these partnerships. FUEL AND PURCHASED POWER COMMITMENTS - The Company has entered into various long-term commitments to provide the fossil and nuclear fuel requirements of its generating plants and to reserve pipeline capacity for natural gas. In most cases, such contracts contain provisions for price escalation, minimum purchase levels and other financial commitments. Estimated annual payments, based on current market prices, for the Company's firm commitments for fuel purchases, excluding coal and purchased power, are $3.7 million, $12.9 million, $35.2 million, $36.6 million and $36.1 million for 1994 through 1998, respectively, and $1,150.3 million in total thereafter. Additional commitments will be required in the future to supply the Company's fuel needs. The Company has entered into long-term contracts with The Southern Company for up to 400 megawatts of purchased power annually through 2010, representing 4.7% of the Company's total current system capacity. The Company has an option to lower these purchases to 200 megawatts annually, beginning in 2000 with a three-year notice. The power will be supplied by coal-fired generating units that have a combined capacity of approximately 3,500 megawatts. The entire commitment is guaranteed by The Southern Company's total system, which is approximately 30,000 megawatts. The long-term contracts obligate the Company to pay certain minimum annual amounts representing capacity payments. The estimated annual capacity payments under the contracts will be $49 million in 1994 and then approximately $60 million annually until the contract expires in 2010. The capacity cost of power purchased under these contracts was $38 million in 1993 and $22 million in 1992 and 1991. As of December 31, 1993, the Company had entered into long-term contracts with non-utility generators for 1,117 megawatts of capacity. These contracts have terms ranging from nine to 35 years. In most cases, these contracts account for 100% of the generating capacity of each of the facilities. Of the 1,117 megawatts under contract, 473 megawatts are currently available and the remaining future capacity is a part of the Company's plans for meeting future electricity demand growth. All commitments have been approved by the FPSC. The following table shows the annual capacity payments, and the present value (at 10%) of these payments at December 31, 1993, which the Company expects to incur if all units are brought into service as contracted and meet contracted performance requirements: Capacity Present (In millions) Payments Value - ------------------------------------------------------------------ 1994 $ 84 $ 77 1995 181 150 1996 218 163 1997 235 160 1998 247 154 1999-2025 10,497 2,022 - ----------------------------------------------------------------- Total $11,462 $2,726 - ----------------------------------------------------------------- The capacity cost of power purchased from non-utility generators was $33 million in 1993, $10 million in 1992 and $2 million in 1991. The Company does not plan to increase the level of purchased power it currently has under contract. The Company believes that its current contracts allow for system reliability and help reduce construction expenditures. These contracts could weaken the Company's overall credit ratings. The FPSC allows these capacity payments to be recovered through a capacity cost recovery clause, which is similar to, and works in conjunction with the fuel adjustment clause. INSURANCE COVERAGE - The Company is subject to retroactive premium assessments in connection with its nuclear liability insurance. In addition, the Company currently carries approximately $2.1 billion in nuclear property insurance provided through several different policies. One of these policies, which also is underwritten by NEIL, provides $1.4 billion of excess coverage. Under this policy, the Company is subject to a retroactive premium assessment of up to $6.5 million for the first loss in any policy year in which losses exceed funds available to NEIL. In the event of multiple losses in any policy year, the Company's aggregate retroactive premium could total up to $13.9 million. Effective November 1993, the FPSC authorized the Company to self-insure the Company's transmission and distribution lines against loss due to storm damage and other natural disasters. The Company is accruing $3 million annually to the storm damage reserve and may defer any losses in excess of the reserve. CONTAMINATED SITE CLEANUP - The Company has received notices from the EPA that it is or could be a "potentially responsible party" under the CERCLA and the Superfund Amendment and Reauthorization Act and may be liable, together with others, for the costs of cleaning up several contaminated sites identified by the EPA. In addition, the Company has been named as a defendant in one suit brought against four prior owners of a coal gasification plant site, seeking contributions pursuant to CERCLA and Florida law toward the cost of cleaning up that site and nearby property that may have become contaminated. The best estimates currently available to the Company indicate that its proportionate share of liability for cleaning up the sites range from $.7 million to $1.5 million, and it has reserved $1 million against these potential costs. Liability for such cleanup costs is technically joint and several. However, the Company presently has no reason to believe that it will ultimately have to pay a significantly disproportionate share of the cleanup costs of any of the sites. Although it does not currently contemplate a need to do so, the Company believes that it would have a sound basis for seeking recovery through the ratemaking process in the event it ultimately has to pay a significantly disproportionate share of the costs of cleaning up any contaminated site. It is recognized, however, that no such recovery would be assured. UNION CARBIDE LAWSUIT - The Company and FP&L are co-defendants in an antitrust action brought by Union Carbide, a customer of FP&L, seeking injunctive relief and damages. The suit challenges a long-standing territorial agreement between the two unaffiliated, neighboring utilities, notwithstanding the defendants' contention that the agreement was clearly authorized by state law and approved by the FPSC. The Company believes that the state action exemption from the antitrust laws is applicable to the agreement and its consequent refusal to provide electricity to Union Carbide. Management believes it has a strong defense and intends to vigorously defend against this action. The business of the Company is seasonal in nature and it is management's opinion that comparisons of earnings for the quarters do not give a true indication of overall trends and changes in the Company's operations. As explained in Note 1 to the Financial Statements, the Company recorded an adjustment to depreciation expense in the fourth quarter of 1992, which increased earnings by $5.6 million. 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 R. Mark Bostick, Age 39, Director since 1992 Member - Executive Committee Since January, 1989, Mr. Bostick's principal occupation has been President of COMCAR Industries, Inc., a privately held, diversified transportation company. For more than five years before 1989, Mr. Bostick was Executive Vice President of COMCAR. Mr. Bostick was a director of Mid-State Federal Savings Bank, Ocala, Florida, until December 9, 1993. Stanley A. Brandimore, Age 66, Director since 1982 Member: Compliance Committee Mr. Brandimore retired as an employee of Florida Progress on July 1, 1990. For more than five years prior to his retirement, Mr. Brandimore was Executive Vice President and General Counsel of Florida Progress. Jack B. Critchfield, Age 60, Director 1975 - 1978 and since 1988 Chairman - Executive Committee Since December 1, 1991, Dr. Critchfield's principal occupation has been Chairman of the Board and Chief Executive Officer of Florida Progress. From January 1991 to December 1991, Dr. Critchfield was Chairman, President and Chief Executive Officer; and, from February 1990 to January 1991, he was President and Chief Executive Officer, and from February 1988 to February 1990, he was President and Chief Operating Officer of Florida Progress. From January 1987 to February 1988, Dr. Critchfield was a Group Vice President of Florida Progress and President and Chief Executive Officer of Electric Fuels. From November 1983 to January 1987, he served as Vice President of the Eastern and Ridge Divisions of the Company. Dr. Critchfield is a director of Barnett Banks, Inc., Jacksonville, Florida. Allen J. Keesler, Age 55, Director since 1988 Member - Executive Committee President and Chief Executive Officer of the Company and Group Vice President of Florida Progress. See the following executive officer listing for additional background information. Mr. Keesler is a director of SouthTrust Corporation, Birmingham, Alabama. Richard Korpan, Age 52, Director since 1989 Member - Executive Committee Mr. Korpan joined Florida Progress in June 1989 to become Executive Vice President and Chief Financial Officer and was elected President and Chief Operating Officer effective December 1, 1991. Prior to joining Florida Progress, he was President and Chief Executive Officer of Pacific Diversified Capital Company, a subsidiary that comprises the non-utility operations of San Diego Gas & Electric Company ("SDG&E"). From 1979 to 1986, he held several positions with SDG&E including Senior Vice President and Chief Financial Officer, Group Vice President- Finance, and Treasurer. After practicing law in Colorado, he served in various financial positions at Public Service Company of Colorado before joining SDG&E. Mr. Korpan is a director of SunBank of Tampa Bay. Clarence V. McKee, Esquire, Age 51, Director since 1988 Mr. McKee's principal occupation is Chairman and Chief Executive Officer of McKee Communications, Inc., radio and television property investments, Tampa, Florida. From 1987 to 1992, he served as Chairman and Chief Executive Officer of WTVT Holdings, Inc. He served as Counsel to Pepper & Corazinni, a Washington, D.C. communications law firm, from 1980 until 1987 when he became a co-owner of WTVT Holdings, Inc., licensee of WTVT-TV, Tampa, Florida. He also served two years as a television commentator for the Fox Broadcasting Network. Mr. McKee is a director of Barnett Bank of Tampa and Barnett Banks, Inc., Jacksonville. Joan D. Ruffier, Age 54, Director since 1991 Member - Executive Committee Ms. Ruffier's principal occupation is a general partner of Sunshine Cafes, Orlando, Florida, a food and beverage concession business at major Florida airports. From 1978 to 1982 she served as a management consultant to the National Association of Bank Women. From 1982 to 1986, she practiced public accounting with the firm of Colley, Trumbower & Howell. In 1986, she assumed her present position. Ms. Ruffier is a member of the Administrative Board of Sun Bank, N.A. in Orlando, and the board of the Jacksonville Branch of the Federal Reserve Bank of Atlanta. She also serves on the boards of directors of SunHealth Corporation and Sun Health Enterprises, Inc. of Charlotte, North Carolina. Lee H. Scott, Age 67, Director since 1983 On February 28, 1990, Mr. Scott retired as an employee of Florida Progress. From February 1988 through February 1990, Mr. Scott's principal occupation was Chairman of the Board of the Company and Vice Chairman of the Board of Florida Progress. From April 1986 to February 1988, Mr. Scott was President and Chief Executive Officer of the Company. For more than three years prior to April 1986, Mr. Scott was President and Chief Operating Officer of the Company. From January 1985 to February 1988, Mr. Scott was also a Group Vice President of Florida Progress. Jean Giles Wittner, Age 59, Director since 1977 Member - Compliance Committee Ms. Wittner is President of Wittner & Company, a St. Petersburg, Florida firm involved in real estate management and insurance brokerage and consulting. She previously served as President and Chief Executive Officer of a savings association from 1975 until it was sold on December 31, 1986. She then became President of Wittner Securities, Inc. In November 1989, she became President of Wittner & Company. All of the directors except Mr. Bostick, Mr. Brandimore and Mr. Scott are directors of Florida Progress. Each director holds office until the next Annual Meeting of Shareholders and until the election and qualification of a successor. b) EXECUTIVE OFFICERS OF THE COMPANY Allen J. Keesler, Jr., President and Chief Executive Officer, Age 55 Since February 1988, Mr. Keesler's principal occupation has been President and Chief Executive Officer of the Company and Group Vice President of Florida Progress. For more than three years prior to February 1988, Mr. Keesler was President and Chief Executive Officer of Talquin Corporation ("Talquin"), a former subsidiary of Florida Progress. Mr. Keesler has been a Group Vice President of Florida Progress since January 1986. Maurice H. Phillips, Executive Vice President, Age 55 Since September 1989, Mr. Phillips' principal occupation has been as shown above. For more than three years prior to September 1989, Mr. Phillips was Senior Vice President, Operations of the Company. Dr. Percy M. Beard, Jr., Senior Vice President, Nuclear Operations, Age 57 Since November 1989, Dr. Beard's principal occupation has been as shown above. From December 1981 to November 1989, Dr. Beard held various positions with the Institute of Nuclear Power Operations ("INPO") including, Vice President, Government Relations. INPO, formed in 1979, is a nonprofit organization whose members consist primarily of utilities with nuclear plants either in operation or under construction. John A. Hancock, Senior Vice President, Power Supply, Age 53 Mr. Hancock became Senior Vice President, Energy Supply, effective January 1993. From September 1989, to January 1993, Mr. Hancock was Senior Vice President, Power Operations, of the Company. For more than four years prior to September 1989, Mr. Hancock was Vice President, Fossil Operations, of the Company. Philip C. Henry, Senior Vice President, Energy Delivery, Age 61 Mr. Henry was elected Senior Vice President, Energy Delivery, of the Company effective January 1993. From March 1983 to January 1993, Mr. Henry served as Vice President, Design and Construction, of the Company. Jeffrey R. Heinicka, Senior Vice President and Chief Financial Officer, effective March 1994, Age 40 From April 1993 until appointment to his current position in March 1994, Mr. Heinicka served as Vice President and Treasurer of the Company. In March 1994, Mr. Heinicka was also appointed as Senior Vice President and Chief Financial Officer of Florida Progress where he had served as Vice President and Treasurer since December 1990. From March 1988 until December 1990, he was Vice President, Treasurer and Controller of Electric Fuels. David L. Miller, Senior Vice President, Corporate Services, Age 49 Since January 1993, Mr. Miller's principal occupation has been as shown above. From October 1990 to January 1993, Mr. Miller was Senior Vice President, Administrative Services, of the Company. Prior to that time he served the Company as Vice President, Suncoast Division, from April 1988 to October 1990, South Suncoast Division Manager from October 1987 to April 1988, and as Director of Conservation and Marketing during 1986. Joseph H. Richardson, Senior Vice President, Legal and Administrative Services, and General Counsel, effective October 21, 1993, Age 44 From August 1991 to present, Mr. Richardson served (and will continue to serve concurrently) as Senior Vice President, Corporate Development, of Florida Progress. From May 1990 until September 1993, he was President and Chief Executive Officer of Talquin. From May 1990, to August 1991, Mr. Richardson was Group Vice President, Development Group. From July 1986 to May 1990, he served as Vice President of Talquin. There are no family relationships between any director and/or executive officer of the Company. Each executive officer is elected annually. See Item 11 ITEM 11. EXECUTIVE COMPENSATION COMPENSATION OF DIRECTORS With the exception of Messrs. Bostick, Brandimore and Scott, the compensation for all outside directors of the Company (excluding employees of Florida Progress) is a daily meeting fee of $1,500 for Company Board and committee meetings attended on any one day. Messrs. Bostick, Brandimore and Scott receive these daily meeting fees and $7,500 per year as a retainer fee. Outside directors who serve on the Board of Directors of the Company's parent are paid an annual retainer in the amount of $22,500, plus a fee of $1,500 for attendance at each meeting of the parent's Board of Directors and a per day meeting fee of $1,500 for subsidiary and committee meetings attended on any one day. All or a portion of these fees may be deferred at the discretion of a director. COMPENSATION OF EXECUTIVES The following table contains information with respect to compensation awarded, earned or paid during the years 1991-1993 to (i) the Chief Executive Officer, (ii) the other four most highly compensated executive officers of the Company, and (iii) two additional individuals for whom disclosure would have been provided but for the fact that the individuals were not serving as executive officers at the end of 1993 (collectively (ii) and (iii) referred to as the "Named Executive Officers"). (1) All other annual compensation paid to the Chief Executive Officer and the Named Executive Officers during 1993, other than salary and annual incentive compensation, does not exceed the minimum amounts required to be reported pursuant to Securities and Exchange Commission rules. (2) Company contributions to its Savings Plan on behalf of the Chief Executive Officer and the Named Executive Officers. (3) Represents the dollar value as of February 3, 1994, the date of grant, of shares of Common Stock earned under the 1991-1993 performance cycle of the Florida Progress Corporation Long-Term Incentive Plan ("LTIP"), two-thirds of which are restricted. The total number of shares earned are as follows: Allen J. Keesler, Jr., 6,952 shares; Maurice H. Phillips 3,873 shares; Joseph F. Cronin 2,974 shares; and Joseph H. Richardson 2,524 shares. The vesting schedule for the restricted stock is 50% on January 1, 1995 and 50% on January 1, 1996. Dividends are payable on the restricted Common Stock to the extent and on the same date as dividends are paid on all other shares of Florida Progress Corporation Common Stock. In the event of a change in control of Florida Progress Corporation, all restrictions on all shares of restricted stock shall lapse upon such change in control. (4) Messrs. Cronin and Neiser retired from the Company effective December 31, 1993. Each was relieved of his executive officer responsibilities effective October 1, 1993. The following table contains information with respect to Performance Shares awarded in 1993 to the Chief Executive Officer and each of the Named Executive Officers of the Company for the 1993-1995 performance cycle of the LTIP: (1) The LTIP is a Common Stock based incentive plan for long-term growth and performance of Florida Progress. It was approved by the Florida Progress shareholders in 1990. (2) Performance shares awarded under the Florida Progress LTIP which, upon achievement of performance criteria established by the Compensation Committee of the Board of Directors of Florida Progress, would result in the payout of shares of Florida Progress Common Stock, two-thirds of which would be restricted for periods of time. Payouts of shares of Florida Progress Common Stock are made for achieving returns on equity equal to or exceeding the thresholds established by the Compensation Committee. In the event of a change in control of Florida Progress, 150% of all performance shares awarded under the LTIP and then outstanding would automatically be considered earned and would be paid in shares of unrestricted Florida Progress Common Stock together with shares of unrestricted Florida Progress Common Stock payable for dividend equivalents accrued to the change in control on performance shares awarded for performance cycles starting after December 31, 1992. Also, all restrictions on shares of restricted Florida Progress Common Stock previously granted and then held would terminate. As of December 31, 1993, no restricted Florida Progress Common Stock was held by the Chief Executive Officer or the Named Executive Officers. (3) Awards are earned upon achievement of Florida Progress and/or subsidiary return on equity goals for the three-year performance cycle. PENSION PLAN TABLE The table below illustrates the estimated annual benefits (based on a straight life annuity at age 65) payable under the Florida Progress Retirement Plan and its Nondiscrimination Plan for specified compensation and service levels. The current compensation, i.e., base pay, and the years of credited service that would be used in calculating benefits under the Retirement and Nondiscrimination Plans for the executives named in the summary compensation table are as follows: Mr. Keesler, $383,004 - 31 years of service; Mr. Phillips, $243,628 - 33 years of service; Mr. Kuzma, $220,500 - 3 years of service; Mr. Richardson $200,000 - 17 years of service; Dr. Beard, $191,000 - 4 years of service; Mr. Cronin $225,000 - 29 years of service; and Mr. Neiser $200,436 - 27 years of service. The table below shows estimated Retirement and Nondiscrimination Plans benefits using a direct 40% Social Security offset formula. The estimated total annual regular benefit that a participant in the Florida Progress Supplemental Executive Retirement Plan ("SERP") would be entitled to receive (including those amounts payable under the Retirement and Nondiscrimination Plans and primary Social Security) is equal to the benefit shown in the table above as payable under the Retirement and Nondiscrimination Plans, but calculated as if the SERP participant had 35 years of service. The current compensation that would be used in calculating the benefits for each executive listed in the summary compensation table who is a SERP participant is substantially that reported as salary and bonus in the summary compensation table. The amounts payable under the SERP are reduced by amounts payable under the Retirement and Nondiscrimination Plans and primary Social Security. Benefits may also be paid under the SERP upon early retirement (age 55 with five years of service, but only with the consent of the Florida Progress Compensation Committee for executives with less than 15 years of service), disability, certain terminations of employment within three years after a change in control is deemed to have occurred, and termination after becoming 100% vested (vesting occurs in specified situations after a person otherwise qualifies for early retirement or when the combination of age plus years of service equals 65). These pre-normal retirement benefits are based generally on the accrued benefit earned by a participant as of the date of termination of employment, except that the change-in-control benefit is 100% of the participant's projected normal retirement benefit plus up to two years annual salary and bonus and the disability benefit is based on 70% of the participant's then current earnings. Mr. Keesler is eligible for the foregoing SERP benefits. Messrs. Cronin and Neiser took early retirement pursuant to the "special early retirement" provisions of the SERP, which are distinguished and apart from those mentioned above. Under their arrangements, Mr. Cronin will receive annual retirement benefits of $152,586 until age 62, and $142,435 thereafter, Mr. Neiser $137,283 until age 62, and $127,239 thereafter, with a 50% annual survivor benefit payable to their respective spouses upon their deaths. At least 50% of those benefits are payable pursuant to the SERP with the balance payable under the Retirement and Nondiscrimination Plans. The Company will also pay for life 100% of their Company medical insurance premiums and 75% of their spouse's. Mr. Cronin will also be eligible to receive two-thirds of his 1992-1994 LTIP performance cycle award, if it is earned. Dr. Percy M. Beard is employed as the Company's Senior Vice President, Nuclear Operations, pursuant to an employment agreement with the Company. Under that agreement, the Company shall employ Dr. Beard at a base salary of not less than $150,000 per year through November 1994, subject to his death or resignation. The agreement is automatically extended for additional one-year terms unless either party chooses not to extend it. The agreement accords him credit for prior employment for purposes of certain Company benefits. If Dr. Beard remains employed beyond November 1994, but his employment terminates before he shall be entitled to receive compensation under the Retirement Plan, the Company is obligated to pay him the equivalent of early retirement benefits due employees with less than 25 years of service until the date he is entitled to receive retirement benefits under the Retirement Plan. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT None of the Company's officers or directors owns any shares of the Company's common or preferred stock. The following table sets forth information concerning shares of Florida Progress Common Stock that are held by persons known to the Company to be the beneficial owners of more than 5% of said stock as of December 31, 1993. Number of Shares Percent Name and Address Beneficially Owned(1) of Class - ---------------- --------------------- --------- Savings Plan for Employees of Florida Progress Corporation Trust One Progress Plaza St. Petersburg, Florida 33701 5,079,619(2) 5.69% Franklin Resources, Inc. 777 Mariners Island Blvd. San Mateo, California 94404 4,638,742 5.20% - ----------------------------------------------------------------------------- (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security. Unless otherwise noted, the number of shares held are beneficially owned as of December 31, 1993. (2) The Investment Committee of the Savings Plan for Employees of Florida Progress Corporation shares investment power with participating employees in respect of all such shares. Shares are voted in accordance with instructions of the participating employees to whose accounts such shares are allocated. No votes are cast in respect of shares for which instructions are not received or for shares which are not allocated to a participant's account. The table below sets forth as of December 31, 1993, the number of shares of common stock of Florida Progress Corporation owned by the Company's directors, Chief Executive Officer and Named Executive Officers individually and the directors and executive officers of the Company as a group. Number of Shares Percent of Name Beneficially Owned (1) Class (2) ---- ---------------------- ---------- Stanley A. Brandimore 450 R. M. Bostick 200 Jack B. Critchfield 9,297 Allen J. Keesler, Jr. 20,526 Richard Korpan 2,138 Clarence V. McKee 1,700 Joan D. Ruffier 2,205 Lee H. Scott 19,804 Jean Giles Wittner 7,398 Percy M. Beard, Jr. 476 David R. Kuzma 2,334 Maurice H. Phillips 7,573 Joseph H. Richardson 3,566 Joseph F. Cronin 7,532 Richard W. Neiser 7,624 All 18 directors and executive officers as a group, including those named above 114,737 .13% (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security. (2) Unless otherwise noted, less than 1% per individual. 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, notes to Financial Statements, and report thereon of KPMG Peat Marwick are found in Item 8 "Financial Statements and Supplementary Data" herein. 2. The following Financial Statement Schedules and reports are included herein: V- Electric Plant for the years ended December 31, 1993, 1992 and 1991 VI- Accumulated Depreciation of Electric Plant and Amortization of Nuclear Fuel 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 IX- Short-Term Borrowings 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 The Report of Independent Certified Public Accountants on Financial Statements and Schedules. See index at the beginning of Item 8 "Financial Statements and Supplementary Data". All other schedules are not submitted because they are not applicable or not required or because the required information is included in the financial statements or notes thereto. 3. Exhibits filed herewith: 12 Statement of Computation of Ratios. 23 Consent of Independent Certified Public Accountants to the incorporation by reference of their report on the financial statements into the Company's registration statements on Form S-3 (No. 33-62210) (relating to the Company's first mortgage bond shelf) and Form S-3 (No. 33-50908) (relating to the Company's medium-term note shelf). 4. Exhibits incorporated herein by reference: 3.(a) Amended Articles of Incorporation, as amended, of the Company. (Filed as Exhibit 3(a) to the Company's Form 10-K for the year ended December 31, 1991, as filed with the SEC on March 30, 1992. 3.(b) Bylaws as amended. (Filed as Exhibit (3)(b) to the Company's Form 10-K for the year ended December 31, 1987). 4.(a) Indenture, dated as of January 1, 1944 (the "Indenture"), between the Company and Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, securing the First Mortgage Bonds, 3 3/8% Series Due 1974. (Filed as Exhibit B-18 to the Company's Registration Statement on Form A-2 (No. 2-5293) filed with the SEC on January 24, 1944). 4.(b) Seventh Supplemental Indenture, dated as of July 1, 1956, between the Company and Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, with reference to the modification and amendment of the Indenture and the issuance of the Company's First Mortgage Bonds, 3 7/8% Series Due 1986. (Filed as Exhibit 4(b) to the Company's Registration Statement on Form S-3 (No. 33-16788) filed with the SEC on September 27, 1991). 4.(c) Eighth Supplemental Indenture, dated as of July 1, 1958, between the Company and Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, with reference to the modification and amendment of the Indenture and the issuance of the Company's First Mortgage Bonds, 4 1/8% Series Due 1988. (Filed as Exhibit 4(c) to the Company's Registration Statement on Form S-3 (No. 33-16788) filed with the SEC on September 27, 1991.) 4.(d) Sixteenth Supplemental Indenture, dated as of February 1, 1970, between the Company and Morgan Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, with reference to the modification and amendment of the Indenture. (Filed as Exhibit 4(d) to the Company's Registration Statement on Form S-3 (No. 33-16788) filed with the SEC on September 27, 1991.) 4.(e) Twenty-Ninth Supplemental Indenture dated as of September 1, 1982, between the Company and Morgan Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, with reference to the modification and amendment of the Indenture. (Filed as Exhibit 4(c) to the Company's Registration Statement on Form S-3 (No. 2-79832) filed with the SEC on September 17, 1982.) 10.(a) Florida Progress Supplemental Executive Retirement Plan. (Filed as Exhibit 10(a) to the Florida Progress Form 10-K for the year ended December 31, 1993, as filed with the SEC (File No. 1-8349) on March 30, 1994). * 10.(b) Management Incentive Compensation Plan of Florida Progress Corporation, as amended. (Filed as Exhibit 10(a) to the Florida Progress Form 10-K for the year ended December 31, 1992, as filed with the SEC (File No. 1-8349) on March 31, 1993.) * 10.(c) Florida Progress Corporation Long-Term Incentive Plan, approved by the Florida Progress Shareholders on April 19, 1990. (Filed as Exhibit 10(d) to the Florida Progress Form 10-Q for the quarter ended March 31, 1990, as filed with the SEC (File No. 1-8349) on May 14, 1990). * 10.(d) Amended and Restated General Partnership Agreement of the SunShine Pipeline Partners dated May 5, 1993. (Filed as Exhibit 10(a) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). 10.(e) Amended and Restated General Partnership Agreement of the SunShine Interstate Pipeline Partners dated May 5, 1993. (Filed as Exhibit 10(b) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). 10.(f) Precedent Agreement dated April 8, 1993 between the Company and the SunShine Pipeline Partners covering terms and conditions of service to be provided to the Company by the intrastate component of the SunShine Pipeline. (Filed as Exhibit 10(c) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). 10.(g) Precedent Agreement dated April 8, 1993 between the Company and the SunShine Pipeline Partners covering terms and conditions of service to be provided to the Company by the interstate component of the SunShine Pipeline. (Filed as Exhibit 10(d) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). 10.(h) Letter Agreement dated June 30, 1993 relating to the SunShine Pipeline. (Filed as Exhibit 10(e) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). (Confidential treatment has been granted with respect to a portion of this document - omitted portion filed separately with the SEC). * Exhibit constitutes an executive compensation plan or arrangement. In reliance upon Item 601(b)(4)(iii) of Regulation S-K, certain instruments defining the rights of holders of long-term debt of the Company are not being filed herewith, because the total amount authorized thereunder 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: During the fourth quarter of the year ended December 31, 1993, the Company filed the following reports on Form 8-K: Form 8-K dated October 21, 1993, reporting under Item 5 "Other Events" a press release and related Investor Information Report, each dated October 21, 1993, reporting third quarter 1993 earnings. Form 8-K dated December 1, 1993, reporting under Item 5 "Other Events" a press release dated December 1, 1993 relating to a decision by the Company's parent, Florida Progress, to offer a voluntary early retirement option to about 200 employees, most of whom worked at the Company. Form 8-K dated December 7, 1993, reporting under Item 5 "Other Events" the sale of $100 million first mortgage bonds and filing under Item 7 "Financial Statements and Exhibits" certain related documents. In addition, the Company filed the following report on Form 8-K subsequent to the fourth quarter of 1993: Form 8-K dated January 17, 1994, reporting under Item 5 "Other Events" various press releases and related Investor Information reports, which disclose certain workforce reductions at the Company and Florida Progress' 1993 earnings. 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. FLORIDA POWER CORPORATION March 24, 1994 By: /s/ Allen J. Keesler, Jr. ------------------------- Allen J. Keesler, Jr., 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. Signature Title Date /s/ Jack B. Critchfield Chairman of the March 24, 1994 ------------------------- Board and Director Jack B. Critchfield /s/ Allen J. Keesler, Jr. President, Chief March 24, 1994 ------------------------- Executive Officer Allen J. Keesler, Jr. and Director Principal Executive Officer /s/ Jeffrey R. Heinicka Senior Vice President March 24, 1994 - ------------------------- and Jeffrey R. Heinicka Chief Financial Officer Principal Financial Officer /s/ John Scardino, Jr. Vice President March 24, 1994 - ------------------------- and Controller John Scardino, Jr. Principal Accounting Officer /s/ R. Mark Bostick Director March 24, 1994 - ------------------------- R. Mark Bostick /s/ S. A. Brandimore Director March 24, 1994 - ------------------------- S. A. Brandimore /s/ Richard Korpan Director March 24, 1994 - ------------------------- Richard Korpan /s/ Clarence V. McKee Director March 24, 1994 - ------------------------- Clarence V. McKee /s/ Joan D. Ruffier Director March 24, 1994 - ------------------------- Joan D. Ruffier /s/ Lee H. Scott Director March 24, 1994 - ------------------------- Lee H. Scott /s/ Jean Giles Wittner Director March 24, 1994 - ------------------------- Jean Giles Wittner Note: (1) Retirements charged to accumulated depreciation $22.7 Retirements charged to income and other accounts 0.8 ------- $23.5 ======= Note: (3) See Note 1 to the Financial Statements for a description of the method used to compute the provision for depreciation Note: (1) Retirements charged to accumulated depreciation $61.3 Retirements charged to income and other accounts 3.5 ------- $64.8 ======= Note: (2) See Note 1 to the Financial Statements for a description of the method used to compute the provision for depreciation Note: (1) Retirements charged to accumulated depreciation $56.4 ======= Note: (2) See Note 1 to the Financial Statements for a description of the method used to compute the provision for depreciation (A) Increase due primarily to business acquisitions. (B) Primarily earnings on Nuclear Decommissioning Fund. Note: Deductions are payments of actual expenditures related to the outage. (a) Based on end of period balance. (b) The average interest rate was determined by dividing interest expense on short-term borrowings for the year by average short-term borrowings during the year. (c) The Company is authorized to issue $400 million in commercial paper (C/P) with various maturities up to but not exceeding 270 days. All C/P borrowings are backed up by an equivalent amount of unused bank lines of credit. (d) As of December 31, 1993, 1992 and 1991, $200 million, $96 million and $-0-, respectively, of the C/P borrowings were classified as long-term in the Financial Statements because of the maturity of the underlying backup bank lines of credit. See Note 2 to the Financial Statements. For purposes of this schedule, all C/P borrowings are included in the amounts shown. FLORIDA POWER CORPORATION Schedule X Supplementary Income Statement Information - ---------------------------------------------------------------------------- For the Years Ended December 31, 1993, 1992, and 1991 (In millions) The amounts of depreciation and maintenance, other than those set forth in the statements of income are not significant. Rents, royalties, advertising costs and research and development costs are not significant. Taxes other than income taxes are set forth below: 1993 1992 1991 Property taxes $54.6 $49.7 $46.2 State gross receipts tax 42.6 37.5 32.2 Franchise fees 38.3 34.0 34.8 Payroll and other taxes 25.6 24.9 22.4 - ---------------------------------------------------------------------------- Total 161.1 146.1 135.6 Less amounts not charged to operating expenses 8.5 7.8 6.3 - ---------------------------------------------------------------------------- Charged directly to operating expenses $152.6 $138.3 $129.3 ============================================================================ EXHIBIT INDEX EXHIBIT NUMBER EXHIBIT ------- ------- Exhibits filed herewith: 12 Statement of Computation of Ratios. 23 Consent of Independent Certified Public Accountants to the incorporation by reference of their report on the financial statements into the Company's registration statements on Form S-3 (No. 33-62210) (relating to the Company's first mortgage bond shelf) and Form S-3 (No. 33-50908) (relating to the Company's medium-term note shelf). Exhibits incorporated herein by reference: 3.(a) Amended Articles of Incorporation, as amended, of the Company. (Filed as Exhibit 3(a) to the Company's Form 10-K for the year ended December 31, 1991, as filed with the SEC on March 30, 1992. 3.(b) Bylaws as amended. (Filed as Exhibit (3)(b) to the Company's Form 10-K for the year ended December 31, 1987). 4.(a) Indenture, dated as of January 1, 1944 (the "Indenture"), between the Company and Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, securing the First Mortgage Bonds, 3 3/8% Series Due 1974. (Filed as Exhibit B-18 to the Company's Registration Statement on Form A-2 (No. 2-5293) filed with the SEC on January 24, 1944). 4.(b) Seventh Supplemental Indenture, dated as of July 1, 1956, between the Company and Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, with reference to the modification and amendment of the Indenture and the issuance of the Company's First Mortgage Bonds, 3 7/8% Series Due 1986. (Filed as Exhibit 4(b) to the Company's Registration Statement on Form S-3 (No. 33-16788) filed with the SEC on September 27, 1991). 4.(c) Eighth Supplemental Indenture, dated as of July 1, 1958, between the Company and Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, with reference to the modification and amendment of the Indenture and the issuance of the Company's First Mortgage Bonds, 4 1/8% Series Due 1988. (Filed as Exhibit 4(c) to the Company's Registration Statement on Form S-3 (No. 33-16788) filed with the SEC on September 27, 1991.) 4.(d) Sixteenth Supplemental Indenture, dated as of February 1, 1970, between the Company and Morgan Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, with reference to the modification and amendment of the Indenture. (Filed as Exhibit 4(d) to the Company's Registration Statement on Form S-3 (No. 33-16788) filed with the SEC on September 27, 1991.) 4.(e) Twenty-Ninth Supplemental Indenture dated as of September 1, 1982, between the Company and Morgan Guaranty Trust Company of New York and The Florida National Bank of Jacksonville, as Trustees, with reference to the modification and amendment of the Indenture. (Filed as Exhibit 4(c) to the Company's Registration Statement on Form S-3 (No. 2-79832) filed with the SEC on September 17, 1982.) 10.(a) Florida Progress Supplemental Executive Retirement Plan. (Filed as Exhibit 10(a) to the Florida Progress Form 10-K for the year ended December 31, 1993, as filed with the SEC (File No. 1-8349) on March 30, 1994). 10.(b) Management Incentive Compensation Plan of Florida Progress Corporation, as amended. (Filed as Exhibit 10(a) to the Florida Progress Form 10-K for the year ended December 31, 1992, as filed with the SEC (File No. 1-8349) on March 31, 1993.) 10.(c) Florida Progress Corporation Long-Term Incentive Plan, approved by the Florida Progress Shareholders on April 19, 1990. (Filed as Exhibit 10(d) to the Florida Progress Form 10-Q for the quarter ended March 31, 1990, as filed with the SEC (File No. 1-8349) on May 14, 1990). 10.(d) Amended and Restated General Partnership Agreement of the SunShine Pipeline Partners dated May 5, 1993. (Filed as Exhibit 10(a) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). 10.(e) Amended and Restated General Partnership Agreement of the SunShine Interstate Pipeline Partners dated May 5, 1993. (Filed as Exhibit 10(b) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). 10.(f) Precedent Agreement dated April 8, 1993 between the Company and the SunShine Pipeline Partners covering terms and conditions of service to be provided to the Company by the intrastate component of the SunShine Pipeline. (Filed as Exhibit 10(c) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). 10.(g) Precedent Agreement dated April 8, 1993 between the Company and the SunShine Pipeline Partners covering terms and conditions of service to be provided to the Company by the interstate component of the SunShine Pipeline. (Filed as Exhibit 10(d) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). 10.(h) Letter Agreement dated June 30, 1993 relating to the SunShine Pipeline. (Filed as Exhibit 10(e) to the Company's Form 10-Q for the quarter ended June 30, 1993, as filed with the SEC on August 3, 1993). (Confidential treatment has been granted with respect to a portion of this document - omitted portion filed separately with the SEC).

897729_1993.txt

897729_1993

1993

897729

ITEM 1. BUSINESS. (a) General Development of Business Trump Plaza Associates (the "Partnership") owns and operates the Trump Plaza Hotel and Casino ("Trump Plaza"), a luxury casino hotel located on The Boardwalk in Atlantic City, New Jersey. The Partnership was organized in June 1982 as a general partnership under the laws of the State of New Jersey. Trump Plaza Funding, Inc. (the "Company") was incorporated on March 14, 1986 as a New Jersey corporation and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. The partners in the Partnership are Trump Plaza Holding Associates ("Holding"), which has a 99% interest in the Partnership, and the Company, which has a 1% interest in the Partnership. Donald J. Trump ("Trump"), by virtue of his ownership of the Company, Holding and Trump Plaza Holding Inc. ("Holding Inc."), which owns a 1% partnership interest in Holding, is the beneficial owner of 100% of the equity interest in the Partnership. In 1993, the Partnership, the Company and certain affiliated entities completed a refinancing (the "Refinancing") of their debt and equity interests. The purpose of the Refinancing was (i) to repay, in full, the mortgage indebtedness and certain other indebtedness issued as part of the restructuring (the "Restructuring") of the indebtedness of the Partnership and the Company pursuant to a prepackaged plan of reorganization (the "Plan") under chapter 11 of the Bankruptcy Code of 1978, as amended, effective as of May 29, 1992, (ii) to repurchase the preferred stock interest in Trump Plaza not owned by Trump and (iii) to repay certain personal indebtedness of Trump. The Refinancing On June 25, 1993, the Company consummated the Refinancing, which included (i) the offering (the "Mortgage Note Offering") by the Company of $330 million in aggregate principal amount of its 10-7/8% Mortgage Notes due 2001 (the "Mortgage Notes") and (ii) the offering (the "Units Offering" and, together with the Mortgage Note Offering, the "Offerings") by Holding of 12,000 Units (the "Units") consisting of an aggregate of $60 million in principal amount of 12-1/2% Pay-in-Kind Notes due 2003 (the "PIK Notes") and 12,000 Warrants to acquire an aggregate of $12 million in principal amount of PIK Notes. Each of the Warrants entitles the holder to acquire $1,000 principal amount of PIK Notes for no additional consideration. The partnership agreement of the Partnership was amended and restated to alter certain procedures and to effectuate the consummation of the Offerings. The proceeds of the Units Offering were distributed to Trump. Trump used $35 million of such proceeds to purchase stock of the Company, which used such funds, together with a portion of the proceeds of the Mortgage Note Offering, to redeem the Company's outstanding stock units (the "Stock Units"), each consisting of (i) one share of the Company's 9.34% Participating Cumulative Redeemable Preferred Stock (the "Preferred Stock"), liquidation preference $25 per share, par value $1 per share, and (ii) one share of the Company's common stock (the "Common Stock"), par value $.00001 per share. The remaining $25 million of the proceeds of the Units Offering were distributed to Trump as part of a special distribution (the "Special Distribution"). Trump used the Special Distribution primarily to reduce his personal indebtedness and to satisfy certain property tax obligations with respect to real estate owned by him. Out of the proceeds of the Mortgage Note Offering, $225 million was used to redeem all of the Bonds (as defined below). In connection with the Offerings, the Company formed Holding, a New Jersey general partnership, for the purpose of offering the Units. Trump contributed to Holding his equity ownership interest in the Partnership and became the sole beneficial owner of Holding. The two partners in Holding are Trump and Holding Inc. Holding Inc. acts as the managing general partner of Holding. Holding has no assets other than its equity interest in the Partnership. Also in connection with the Offerings, the Company became the managing general partner of the Partnership as of June 18, 1993 upon its merger with TP/GP Corp., a New Jersey corporation ("TP/GP"), which had been the managing general partner of the Partnership until such date. Holding and the Company, both of which became wholly-owned by Trump upon such merger, became the sole partners of the Partnership. The Mortgage Notes are senior indebtedness of the Company. The Company and the Partnership are subject to restrictions on the incurrence of additional indebtedness. The Mortgage Notes are unconditionally guaranteed by the Partnership. The Guarantee ranks pari passu in right of payment with all existing and future senior indebtedness of the Partnership. The PIK Notes are secured by Holding's equity interest in the Partnership. Holders of the PIK Notes and the Warrants are not creditors of the Partnership and, consequently, have no recourse to the assets of the Partnership if an event of default should occur thereunder. Accordingly, the PIK Notes are structurally subordinated to the indebtedness of the Partnership, including the Mortgage Notes. In the event of a sale of equity interests in Holding or an affiliate thereof which owns any direct or indirect equity interest in Trump Plaza, Holding is required to, or is required to cause such affiliate to, use 35% of the net proceeds of such sale, within 90 days after receipt thereof, to redeem PIK Notes at 100% of the principal amount thereof, if such redemption occurs prior to June 15, 1995. After such date, the redemption price is 108% of the principal amount of the PIK Notes until June 15, 1998, with the redemption price decreasing annually thereafter. The PIK Notes are redeemable at the option of Holding, in whole or in part, at any time on or after June 15, 1998 at the redemption prices set forth therein, together with accrued and unpaid interest to the date of redemption. Upon consummation of the Refinancing (i) Trump became the sole owner record of the Company's outstanding Common Stock, as well as the sole owner of the equity interest of Holding and the Partnership and (ii) the Company redeemed its Stock Units, including the Preferred Stock, and the Bonds (as defined below). As of December 31, 1993, the Company's debt consisted of approximately $330 million principal amount outstanding of its Mortgage Notes and $325,859,000 (net of discount) of mortgage indebtedness. As of December 31, 1993, Holding's debt consisted of approximately $64,252,000 of PIK Notes and $12 million of deferred warrant obligations. As of December 31, 1993, the Partnership's debt consisted of a non-recourse promissory note to the Company in the amount of $325,859,000 (net of discount) and approximately $7.5 million of other indebtedness. The Partnership has unconditionally guaranteed the Mortgage Notes. The Restructuring In 1991, the Partnership began to experience a liquidity problem. Management believes that the Partnership's liquidity problem was attributable, in part, to an overall deterioration in the Atlantic City gaming market, as indicated by reduced rates of casino revenue growth for the industry for the two prior years, aggravated by an economic recession in the Northeast and the Persian Gulf War. Comparatively excessive casino gaming capacity in Atlantic City, due in part to the opening of the Trump Taj Mahal Casino Resort (the "Taj Mahal") in April 1990, may also have contributed to the Partnership's liquidity problem. In order to alleviate its liquidity problem, on May 29, 1992 (the "Effective Date"), the Partnership and the Company restructured their indebtedness pursuant to the Plan. The purpose of the Restructuring was to improve the amortization schedule and extend the maturity of the Partnership's indebtedness by (i) eliminating the sinking fund requirement on the Company's 12-7/8% First Mortgage Bonds, due 1998 (the "Original Bonds"), (ii) extending the maturity and lowering the interest rate on the Original Bonds, (iii) reducing the aggregate principal amount of such indebtedness from $250 million to $225 million, and (iv) eliminating certain other indebtedness by reconstituting such debt in part as Bonds (defined below) and in part as Stock Units. The Restructuring was necessitated by the Partnership's inability to either generate cash flow or obtain additional financing sufficient to make the scheduled sinking fund payment on the Original Bonds. On the Effective Date, the Company, which theretofore had no interest in the Partnership, received a 50% beneficial interest in TP/GP, and the Company and TP/GP were admitted as partners of the Partnership. The Company issued $225 million principal amount of the Company's 12% Mortgage Bonds due 2002 (the "Bonds") and approximately three million Stock Units to certain creditors. Pursuant to the terms of the partnership agreement, the Company was issued the Preferred Stock. TP/GP became the managing general partner of the Partnership, and through its Board of Directors, managed the affairs of the Partnership until its merger into the Company on June 24, 1993. Upon consummation of the Plan, each holder of $1,000 principal amount of Original Bonds and such other indebtedness received (i) $900 principal amount of Bonds, (ii) 12 Stock Units and (iii) certain cash payments. As a result of the Refinancing, the Company redeemed the Stock Units, consisting of the Company's Common Stock and Preferred Stock and Trump became the sole beneficial owner of the Company's Common Stock. The Company also retired the outstanding principal amount and interest on the Bonds. In addition, TP/GP was merged into the Company and the Company became the managing general partner of the Partnership. (b) Financial Information about Industry Segments The Partnership operates in only one industry segment. See the Financial Statements of the Company and the Partnership included elsewhere herein. (c) Narrative Description of Business General The Partnership owns and operates Trump Plaza, a luxury casino hotel located in Atlantic City, New Jersey. Trump Plaza, with its 60,000 square foot casino (presently being expanded to 75,000 square feet by June 1994), first class guest rooms and other luxury amenities, is the only casino hotel in Atlantic City with both a "Four Star" Mobil Travel Guide rating and a "Four Diamond" AAA rating. Management believes that these ratings reflect the high quality amenities and services that Trump Plaza provides to its casino patrons and hotel guests. Trump Plaza is conveniently located on The Boardwalk, at the end of the main highway into Atlantic City and is one of the first casino hotels visible from that approach. Management believes that the central location of Trump Plaza, with its accessibility to "drive in" and "walk in" patrons, is highly advantageous to Trump Plaza. In addition, the Casino Reinvestment Development Authority ("CRDA") is currently overseeing the development of a "tourist corridor" which will link The Boardwalk with downtown Atlantic City and, when completed, will feature an entertainment and retail complex of up to 800,000 square feet. Trump Plaza will be located at the end of the tourist corridor by The Boardwalk. Trump Plaza seeks to attract casino patrons who tend to wager more frequently and in larger denominations than the typical Atlantic City gaming patron (a "high-end" patron). This strategy is accomplished, in part, through the attractiveness of the facility, which is enhanced by routinely attending to the aesthetics of the casino and other public areas in Trump Plaza. In addition, Trump Plaza provides a consistency in the conduct of play of its table games that serious gaming patrons seek. Finally, Trump Plaza offers a broad selection of dining choices (including four gourmet restaurants), headline entertainment, deluxe accommodations and other amenities and services. Facilities and Amenities The casino in Trump Plaza currently offers 86 table games and 1,836 slot machines. After the planned expansion of Trump Plaza, the casino will offer approximately 2,244 slot machines, 86 table games and a keno lounge. In addition to the casino, Trump Plaza consists of a 31-story tower with 557 guest rooms, including 62 suites. The facility also offers 10 restaurants, a 750-seat cabaret theatre, four cocktail lounges, 28,000 square feet of convention, ballroom and meeting room space, a swimming pool, tennis courts and a health spa. A 10-story parking garage, which can accommodate 2,650 cars, is connected to Trump Plaza via an enclosed pedestrian walkway. The entry level of Trump Plaza includes a cocktail lounge, three gift shops, a deli, a coffee shop, an ice cream parlor and a buffet. The casino level houses the casino, a fast food restaurant, an exclusive slot lounge for high-end patrons and a gift shop. There is also an enclosed skywalk which connects Trump Plaza at the casino level with the Atlantic City Convention Center. Trump Plaza's guest rooms are located in a tower which affords most guest rooms a view of the ocean. While rooms are of varying size, a typical guest room consists of approximately 400 square feet. Trump Plaza also features 23 one-bedroom suites, 21 two-bedroom suites and 18 "Super Suites." The Super Suites are located on the top two floors of the tower and offer luxurious accommodations and 24-hour butler and maid service. The Super Suites and certain other suites are located on the "Club Level" which requires guests to use a special elevator key for access, and contains a lounge area (the "Club Level Lounge") that offers 24-hour food and bar facilities. Trump Plaza is connected by an enclosed pedestrian walkway to a 10-story parking garage, which can accommodate approximately 2,650 cars, and contains 13 bus bays, a comfortable lounge, a gift shop and waiting area (the "Transportation Facility"). The Transportation Facility provides patrons with immediate access to the casino, and is located directly off of the main highway into Atlantic City. Business Strategy General. In 1990, the Atlantic City casino industry experienced a significant increase in room capacity and in available casino floor space, due primarily to opening the Taj Mahal, which at the time was wholly-owned by Trump. Management believes that the opening of Taj Mahal had a disproportionately adverse effect on Trump Plaza due to the common use to the "Trump" name. Management believes that results in 1991 were adversely affected by the weakness in the economy throughout the Northeast and the adverse impact on tourism and consumer spending caused by the war in the Middle East. In 1991, the Partnership retained the services of Nicholas L. Ribis as Chief Executive Officer, and Kevin DeSanctis as President and Chief Operating Officer. Mr. DeSanctis resigned from his positions on March 7, 1994. See "Management." Mr. Trump and this new management team implemented a new business strategy, designed to capitalize on Trump Plaza's first-class facilities and improve operating results. Key elements of this strategy consist of redirecting marketing efforts to more profitable patron segments and continually monitoring operations to adapt to, and anticipate, industry trends. A primary element of the new business strategy is to seek to attract patrons who tend to wager more frequently and in larger denominations than the typical Atlantic City gaming customer. Such high-end players typically wager $5 or more per play in slots and $25 or more per play in table games. In order to attract more high-end gaming patrons to Trump Plaza in a cost-effective manner, the Partnership has refocused its marketing efforts. Commencing in 1991, the Partnership substantially curtailed costly "junket" marketing operations which involved attracting groups of patrons to the facility on an entirely complimentary basis (e.g., by providing free air fare, gifts and room accommodations). In the fall of 1992, the Partnership decided to de-emphasize marketing efforts directed at "high roller" patrons from the Far East, who tend to wager $50,000 or more per play in table games. In each case the Partnership determined that the potential benefit derived from these patrons did not outweigh the high costs associated with attracting such players and the resultant volatility in the results of operations of Trump Plaza. This shift in marketing strategy has allowed the Partnership to focus its efforts on attracting the high-end players. Gaming Environment. Trump Plaza also pursues a continuous preventative maintenance program that emphasizes the casino, hotel rooms and public areas in Trump Plaza. These programs are designed to maintain the attractiveness of Trump Plaza to its gaming patrons. Trump Plaza continuously monitors the configuration of the casino floor and the games it offers to patrons with a view towards making changes and improvements. Trump Plaza's casino floor has clear, large signs for the convenience of patrons. As new games have been approved by the Casino Control Commission ("CCC"), the Partnership has integrated such games into its casino operations to the extent it deems appropriate. In recent years, there has been an industry trend towards fewer table games and more slot machines. For the Atlantic City casino industry, revenue from slot machines increased from 54.6% of the industry gaming revenue in 1988 to 67.1% of the industry gaming revenue in 1993. Trump Plaza experienced a similar increase, with slot revenue increasing from 51.2% of gaming revenue in 1988 to 70.2% of the industry gaming revenue in 1993. In response to this trend, Trump Plaza has devoted more of its casino floor space to slot machines. In April 1993, Trump Plaza removed 12 table games from the casino floor and replaced them with 75 slot machines. Moreover, as part of its program to attract high-end slot players, the Partnership created "Fifth Avenue Slots," a partitioned portion of the casino floor that includes approximately 70 slot machines (most of which provide for $5 or more per play), an exclusive lounge for high-end patrons and other amenities. "Comping" Strategy. In order to compete effectively with other Atlantic City casino hotels, the Partnership offers complimentary drinks, meals, room accommodations and/or travel arrangements to its patrons ("complimentaries" or "comps"). Trump Plaza's policy on complimentaries is to provide comps primarily to patrons with a demonstrated propensity to wager at Trump Plaza. Entertainment. Trump Plaza offers headline entertainment, as well as other entertainment and revue shows as part of its strategy to attract high-end and other patrons. In 1993, Trump Plaza entered into Atlantic City exclusive contracts with Kenny Rogers, Anne Murray, Jay Black, Jimmy Roselli, Paul Anka, Regis Philbin & Kathie Lee Gifford, Engelbert and Jerry Vale. Trump Plaza offers headline entertainment weekly during the summer and monthly during the off-season, and also features other entertainment and revue shows. Player Development/Casino Hosts. The Partnership currently employs approximately 24 gaming representatives in New Jersey, New York and other states, as well as several international representatives, to promote Trump Plaza to prospective gaming patrons. Player development personnel host special events, offer incentives and contact patrons directly in an effort to attract high-end table game patrons from the United States, Canada and South America. Trump Plaza's casino hosts assist patrons on the casino floor, make room and dinner reservations and provide general assistance. They also solicit Trump Card (the frequent player slot card) sign-ups in order to increase the Partnership's marketing base. Promotional Activities. The Trump Card, a player identification card, constitutes a key element in Trump Plaza's direct marketing program. Slot machine players are encouraged to register for and utilize their personalized Trump Card to earn various complimentaries based upon their level of play. The Trump Card is inserted during play into a card reader attached to the slot machine for use in computerized rating systems. These computer systems record data about the cardholder, including playing preferences, frequency and denomination of play and the amount of gaming revenues produced. Trump Plaza designs promotional offers, conveyed via direct mail and telemarketing, to patrons expected to provide revenues based upon their historical gaming patterns. Such information is gathered on slot wagering by the Trump Card and on table game wagering by the casino game supervisors. Promotional activities include the mailing of vouchers for complimentary slot play. Trump Plaza also utilizes a special events calendar (e.g., birthday parties, sweepstakes and special competitions) to promote its gaming operations. The Partnership conducts slot machine and table game tournaments in which cash prizes are offered to a select group of players invited to participate in the tournament based upon their tendency to play. Such players tend to play at their own expense during "off-hours" of the tournament. At times, tournament players are also offered special dining and entertainment privileges that encourage them to remain at Trump Plaza. Bus Program. Trump Plaza has a bus program, which transports approximately 2,400 gaming patrons per day during the week and 3,500 per day on the weekends. The Partnership's bus program offers incentives and discounts to certain scheduled and chartered bus customers. Trump Plaza's Transportation Facility contains 13 bus bays and is connected by an enclosed pedestrian walkway to Trump Plaza. The Transportation Facility provides patrons with immediate access to the casino, and contains a comfortable lounge area for patrons waiting for return buses. Credit Policy. Historically, Trump Plaza has extended credit to certain qualified patrons. For the years ended December 31, 1991, 1992 and 1993, credit play as a percentage of total dollars wagered was approximately 29%, 28% and 18%, respectively. As part of the Partnership's new business strategy and in response to the general economic downturn in the Northeast and recent credit experience, Trump Plaza has imposed stricter standards on applications for new or additional credit and has reduced credit to international patrons. Atlantic City Market Gaming in Atlantic City started in May 1978 when the first casino hotel opened for business. Since 1978, gaming in Atlantic City has grown from one casino to 12 casinos as of December 31, 1993, with approximately $3.3 billion of casino industry revenue generated in 1993. Gaming revenue for all Atlantic City casino hotels has increased approximately 2.6%, 5.2%, 1.3%, 7.5% and 2.7% during 1989, 1990, 1991, 1992 and 1993, respectively (in each case as compared to the prior year). See "Competition" below. Atlantic City is near many densely populated metropolitan areas. The primary area served by Atlantic City casino hotels is the corridor that extends from Washington, D.C. to Boston and includes New York City and Philadelphia. Within this primary area, Atlantic City may be reached by automobile or bus. Principal arteries lead into Atlantic City from the metropolitan New York area and from the Baltimore/Washington, D.C. area, both of which are approximately three hours away by automobile. Atlantic City can also be reached by air and rail transportation, although most patrons arrive by automobile or bus. Historically, Atlantic City has suffered from inadequate rail and air transportation. As a result, a majority of Atlantic City gaming patrons travel from the mid-atlantic and northeast regions of the United States by automobile or bus. Rail service to Atlantic City has recently been improved with the introduction of Amtrak express service to and from Philadelphia and New York City. An expansion of the Atlantic City International Airport (located approximately 12 miles from Atlantic City) to handle large airline carriers and large passenger jets was recently completed. Despite the expansion of the Atlantic City International Airport, however, access to Atlantic City by air is still limited by a lack of regularly scheduled flights and by inadequate terminal facilities. The lack of adequate transportation infrastructure has limited the expansion of the Atlantic City gaming industry's geographic patron base and the attractiveness of Atlantic City to major conventions. In February 1993, the State of New Jersey broke ground for a new $250,000,000 Convention Center on a 30.5-acre site adjacent to the Atlantic City Expressway. Targeted for completion in 1996, the new Convention Center will house approximately 500,000 square feet of exhibit space along with 45 meeting rooms totalling nearly 110,000 square feet. The building will include a 1,600-car underground garage and an indoor street linking the Convention Center to the existing Rail Terminal. The new Convention Center has been designed to serve as the centerpiece of Atlantic City's renaissance as a favorable meeting destination. Possible Expansion Sites Management has determined to expand the Partnership's facilities. The purpose of such an expansion is to increase the casino floor space and to add additional gaming units. Any such expansion will require various regulatory approvals, including the approval of the CCC. Furthermore, the Casino Control Act requires that additional guest rooms be put in service within a specified time period after any such casino expansion. As discussed below, the Partnership has planned expansion of its hotel facilities. If the Partnership completed any casino expansion and subsequently did not complete the requisite number of additional guest rooms within the specified time period, the Partnership might have to close all or a portion of the expanded casino in order to comply with regulatory requirements, which could have a material adverse effect on the results of operations and financial condition of the Partnership. Boardwalk Expansion Site. In 1993, the Partnership received the approval of CCC, subject to certain conditions, for the expansion of the Trump Plaza hotel facilities on a 2.0-acre parcel of land located directly across the street from Trump Plaza on the Boardwalk upon which there is located an approximately 361-room hotel, which is closed to the public and is in need of substantial renovation and repair (the "Boardwalk Expansion Site"). In June 1993, Trump and the lender holding mortgage liens on the Boardwalk Expansion Site negotiated the terms of a restructuring of loans of approximately $52.0 million of principal and accrued interest secured by the liens on the Boardwalk Expansion Site. On June 25, 1993, the date the Offerings were consummated, Trump transferred title to the Boardwalk Expansion Site to the lender in exchange for a reduction in Trump's indebtedness to such lender, with a further reduction of Trump's indebtedness if the Partnership assumed the Boardwalk Expansion Site Lease (as defined below). On such date, the lender leased the Boardwalk Expansion Site to Trump (the "Boardwalk Expansion Site Lease") for a term of five years, which expires on June 30, 1998, during which time Trump is obligated to pay the lender $260,000 per month in lease payments. In connection with the Offerings, the Partnership acquired a five- year option (the "Option") to acquire the Boardwalk Expansion Site. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option is dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and would require the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site is dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option. The CCC has required that the Partnership exercise the Option by no later than July 1, 1995. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidation and Capital Resources." Management has determined to build or refurbish rooms at the Boardwalk Expansion Site. When completed, the hotel will have approximately 361 rooms, including a retail space, located on two stories, fronting The Boardwalk. In September 1993, Trump entered into a sublease agreement (the "Time Warner Sublease") with Time Warner Entertainment Company, L.P. ("Time Warner") for a period of ten years with the sublessee's option to renew the sublease for a ten-year period. Under this agreement, Time Warner agreed to sublease the entire first floor of the retail space (approximately 17,000 square feet) located at the Boardwalk Expansion Site for a new Warner Brothers Studio Store. In October 1993, the Partnership assumed Trump's duties and obligations under the Time Warner Sublease. The Time Warner Sublease is subject to certain conditions subsequent; the Partnership believes that it will satisfy all conditions subsequent to that agreement in 1994. Management believes that the store will be a major attraction on The Boardwalk and will increase the flow of patrons through the casino. The remaining portion of the Boardwalk Expansion Site will be used for a new entranceway to Trump Plaza, directly off the Atlantic City Expressway, as well as a public park and parking facilities for Trump Plaza patrons. As a result of such expansion, the Partnership, upon approval by the CCC, will be able to increase Trump Plaza's casino floor space by 30,000 square feet. The Partnership has begun construction at such site (pursuant to rights granted to the Partnership by the lender and the lessee under the Boardwalk Expansion Site Lease) prior to acquiring title thereto pursuant to the Option. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." The Partnership is obligated to either pay a tax to the CRDA of 2.5% of its gross casino revenues or to obtain investment tax credits in an amount equal to 1.25% of its gross casino revenues. In connection with the assumption of the Boardwalk Expansion Site Lease, the Partnership obtained from the CRDA $10.3 million of investment tax credits with respect to the demolition of certain structures on the Boardwalk Expansion Site and the construction of certain improvements on the site. There can be no assurance, however, that such credits would be sufficient to defray a significant portion of the total project costs. Regency Expansion Site. In December 1993, Trump entered into an option agreement to acquire the Trump Regency Hotel ("Trump Regency"). In consideration for the Partnership's making certain payments in connection with the option, Trump agreed that, if the Trump Regency is acquired pursuant to such option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. See "Certain Relationships and Related Transactions -- Trump Regency." Competition Competition in the Atlantic City casino hotel market is intense. Trump Plaza competes primarily with other casinos located in Atlantic City, New Jersey, as well as gaming establishments located on Native American reservations in New York and Connecticut, and also would compete with any other facilities in the northeastern and mid-atlantic regions of the United States at which casino gaming or other forms of wagering may be authorized in the future. To a lesser extent, Trump Plaza faces competition from cruise lines, riverboat gambling, casinos located in Mississippi, Nevada, New Orleans, Puerto Rico, the Bahamas and other locations inside and outside the United States and from other forms of legalized gaming in New Jersey and in its surrounding states such as lotteries, horse racing (including off-track betting), jai alai and dog racing and from illegal wagering of various types. To the extent that legalized gaming becomes more prevalent in New Jersey or other nearby jurisdictions, competition from Native Americans or others would intensify. At present, there are 12 casino hotels located in Atlantic City, including Trump Plaza, all of which compete for patrons. In addition, there are several sites on The Boardwalk and in the Atlantic City Marina area on which casino hotels could be built in the future, although Management is not aware of any present plans to develop such sites. Total Atlantic City gaming revenue has increased over the past four years, although at varying rates. In 1991, six Atlantic City casino hotels reported increases in gaming revenues as compared to 1990, and five reported decreases in gaming revenues (including Trump Plaza). Management believes that the reduced rate of growth in aggregate gaming revenues in Atlantic City since 1987 as compared to prior years was principally due to the weakness in the economy throughout the Northeast and the adverse impact in 1991 of the war in the Middle East on tourism and consumer spending. Although all 12 Atlantic City casinos reported increases in gaming revenues in 1992 as compared to 1991, the Partnership believes that this was due, in part, to the depressed industry conditions in 1991. In 1993, nine casinos experienced increased casino revenues, as compared to 1992, while three casinos (including Trump Plaza) reported decreases. In 1990, the Atlantic City casino industry experienced a significant increase in room capacity and in available casino floor space, including the rooms and floor space made available by the opening of the Taj Mahal, which at the time was wholly-owned by Trump. The effects of such expansion were to increase competition and to contribute to a 1990 decline in gaming revenues per square foot. In 1990, the Atlantic City casino industry experienced a decline in gaming revenues per square foot of 5.0% which trend continued in 1991, although at the reduced rate of 2.9%. However, in 1992 and 1993, the Atlantic City casino industry experienced an increase of 6.9% and 1.4%, respectively in gaming revenues per square foot each as compared to the prior year. Casinos in Atlantic City must be located in approved hotel facilities which offer dining, entertainment and other guest facilities. Competition among casino hotels is based primarily upon promotional allowances, advertising, the attractiveness of the casino area, service, quality and price of rooms, food and beverages, restaurant, convention and parking facilities and entertainment. In order to compete effectively with all other Atlantic City casino hotels, the Partnership offers complimentary drinks, meals, room accommodations and/or travel arrangements to patrons with a demonstrated propensity to wager at Trump Plaza, as well as cash bonuses and other incentives pursuant to approved coupon programs. In 1988, Congress passed the Indian Gaming Regulatory Act ("IGRA"), which requires any state in which casino-style gaming is permitted (even if only for limited charity purposes) to negotiate compacts with federally recognized Native American tribes at the request of such tribes. Under IGRA, Native American tribes enjoy comparative freedom from regulation and taxation of gaming operations, which provides such tribes with an advantage over their competitors, including the Partnership. In 1991, the Mashantucket Pequot Nation opened a casino facility in Ledyard, Connecticut, located in the far eastern portion of such state, an approximately three-hour drive from New York City. In February 1992, the Mashantucket Pequot Nation initiated 24 hour gaming. In January 1993, slot machines were added at such facility, and the facility currently contains over 3,100 slot machines. The Mashantucket Pequot Nation has announced various expansion plans, including its intention to build another casino in Ledyard together with hotels, restaurants and a theme park. Trump, the Partnership and the Other Trump Casinos have recently filed a lawsuit seeking, among other things, a declaration that IGRA is unconstitutional and seeking an injunction against the enforcement of certain provisions of IGRA. The complaint states, among other things, that the Mashantucket Pequot Nation's casino has caused the Partnership substantial economic injury. The complaint states further that any future expansions of existing Native American gaming facilities or new ventures by such persons or others in the northeastern or mid-Atlantic region of the United States would have a further adverse impact on Atlantic City in general and could cause the Partnership further substantial economic injury. A group in New Jersey terming itself the "Ramapough Indians" has applied to the U.S. Department of the Interior to be recognized formally as a Native American tribe, which recognition would permit it to require the State of New Jersey to negotiate a gaming compact under IGRA. On December 3, 1993, however, the Interior Department proposed that such Federal recognition to the Ramapough Indians be denied. Similarly, a group in Cumberland County, New Jersey calling itself the "Nanticoke Lenni Lenape" tribe has filed a notice of intent with the Federal Bureau of Indian Affairs seeking formal recognition as a Native American tribe. Also, it has been reported that a Sussex County, New Jersey businessman has offered to donate land he owns there to the Oklahoma-based Lenape/Delaware Indian Nation which originated in New Jersey and already has Federal tribal status but does not have a reservation in the state. In addition, in July 1993, the Oneida Nation opened a casino featuring 24-hour table gaming, but without slot machines, near Syracuse, New York. Representatives of the St. Regis Mohawk Nation signed a gaming compact with New York State officials for the opening of a casino, without slot machines, in the northern portion of the state close to the Canadian border. The St. Regis Mohawk Nation has announced that it intends to open their casino in the summer of 1994. The Narragansett Native American Nation of Rhode Island has recently won a federal court case, which will require the Governor of Rhode Island to negotiate a casino gaming compact with the Nation. The Mohegan Nation, which is located in Connecticut, received federal recognition in March 1994. Other Native American Nations are seeking federal recognition, land, and negotiation of gaming compacts in New York, Pennsylvania, Connecticut and other nearby states. Legislation permitting other forms of casino gaming has been proposed, from time to time, in various states, including those bordering New Jersey. The Partnership's operations would be adversely affected by such competition, particularly if casino gaming were permitted in jurisdictions near or in New Jersey or other states in the Northeast. In December 1993, the Rhode Island Lottery Commission approved the addition of slot machine games on video terminals at Lincoln Greyhound Park and Newport Jai Alai, where poker and blackjack have been offered for over two years. Currently, casino gaming, other than Native American gaming, is not allowed in other areas of New Jersey or in New York or Pennsylvania. However, the Partnership expects that proposals may be introduced to legalize riverboat or other forms of gaming in Philadelphia and one or more other locations in Pennsylvania. The State of Louisiana recently approved casino gaming in the City of New Orleans, and a developer has been selected. To the extent that legalized gaming becomes more prevalent in New Jersey or other jurisdictions, competition would intensify. In addition, legislation has from time to time been introduced in the New Jersey State Legislature relating to types of state-wide legalized gaming, such as video games with small wagers. To date, no such legislation, which may require a state constitutional amendment, has been enacted. Management is unable to predict whether any such legislation, if enacted, would have a material adverse impact on the business, operations or financial condition of the Partnership. Conflicts of Interest Trump is a 100% beneficial owner of Trump's Castle Casino Resort ("Trump's Castle") subject to certain litigation warrants and a 50% beneficial owner of the Taj Mahal (collectively, the "Other Trump Casinos"), and is the sole beneficial owner of TC/GP, Inc., an entity that as of December 31, 1993 has provided certain services to Trump's Castle; prior thereto, Trump's Castle Management Corp., an entity solely owned by Trump, provided management services to Trump's Castle. Under certain circumstances, Trump could increase his beneficial interest in Taj Mahal to 100%. In addition, Trump has a personal services agreement with the partnership that owns the Taj Mahal pursuant to which he receives substantial compensation based, in part, on the financial results of the Taj Mahal. The Other Trump Casinos compete directly with each other and with other Atlantic City casino hotels, including Trump Plaza. Nicholas L. Ribis, the Chief Executive Officer of the Partnership, is also the chief executive officer of the partnerships that own the Other Trump Casinos. In addition, Messrs. Ribis and Trump serve on the governing bodies of the partnerships that own the Other Trump Casinos. As a result of Trump's interests in three competing Atlantic City casinos and the common chief executive officer, a conflict of interest may be deemed to exist by reason of such persons' access to information and business opportunities possibly useful to any or all of such casinos. No specific procedures have been devised for resolving conflicts of interest confronting, or which may confront, Trump, such persons and the Other Trump Casinos. See "Certain Relationships and Related Transactions." Employees and Labor Relations The Partnership has approximately 3,800 employees of whom approximately 1,100 are covered by collective bargaining agreements. Management believes that its relationships with its employees are satisfactory. All of the Partnership's employees must be licensed or registered under the Casino Control Act. See "Gaming Regulations -- Employees." The Company has no employees. In April 1993, the National Labor Relations board found that the Partnership had violated the National Labor Relations Act (the "NLRA") in the context of a union organizing campaign by table game dealers of the Partnership in association with the Sports Arena and Casino Employees Union Local 137, a/w Laborers' International Union of North America, AFL-CIO ("Local 137"). In connection with such finding, the Partnership was ordered to refrain from interfering with, restraining, or coercing employees in the exercise of the rights guaranteed them by Section 7 of the NLRA, to notify its employees of such rights and to hold an election by secret ballot among its employees, which is anticipated to be held in May 1994, regarding whether they desire to be represented for collective bargaining by Local 137. Seasonality The gaming industry in Atlantic City traditionally has been seasonal, with its strongest performance occurring from May through September, and with December and January showing substantial decreases in activity. Revenues have been significantly higher on Fridays, Saturdays, Sundays and holidays than on other days. Gaming and Other Laws and Regulations The following is only a summary of the applicable provisions of the Casino Control Act and certain other laws and regulations. It does not purport to be a full description thereof and is qualified in its entirety by reference to the Casino Control Act and such other laws and regulations. In general, the Casino Control Act contains detailed provisions concerning, among other things: the granting of casino licenses; the suitability of the approved hotel facility, and the amount of authorized casino space and gaming units permitted therein; the qualification of natural persons and entities related to the casino licensee; the licensing and registration of employees and vendors of casino licensees; rules of the games; the selling and redeeming of gaming chips; the granting and duration of credit and the enforceability of gaming debts; management control procedures, accounting and cash control methods and reports to gaming agencies; security standards; the manufacture and distribution of gaming equipment; equal employment opportunity for employees of casino operators, contractors of casino facilities and others; and advertising, entertainment and alcoholic beverages. Casino Control Commission. The ownership and operation of casino/hotel facilities in Atlantic City are the subject of strict state regulation under the Casino Control Act. The CCC is empowered to regulate a wide spectrum of gaming and non-gaming related activities and to approve the form of ownership and financial structure of not only a casino licensee, but also its entity qualifiers and intermediary and holding companies. Operating Licenses. The Partnership was issued its initial casino license on May 14, 1984. On April 19, 1993, the CCC renewed the Partnership's casino license through March 31, 1995, and on March 15, 1993 approved Trump as a natural person qualifier through May 1995. No assurance can be given that the CCC will renew the casino license or, if it does so, as to the conditions it may impose, if any, with respect thereto. Casino Licensee. No casino hotel facility may operate unless the appropriate license and approvals are obtained from the CCC, which has broad discretion with regard to the issuance, renewal, revocation and suspension of such licenses and approvals, which are non-transferable. The qualification criteria with respect to the holder of a casino license include its financial stability, integrity and responsibility; the integrity and adequacy of its financial resources which bear any relation to the casino project; its good character, honesty and integrity; and the sufficiency of its business ability and casino experience to establish the likelihood of a successful, efficient casino operation. The casino license held by the Partnership is renewable for periods of up to two years. The CCC may reopen licensing hearings at any time, and must reopen a licensing hearing at the request of the New Jersey Division of Gaming Enforcement (the "Division"). To be considered financially stable, a licensee must demonstrate the following ability: to pay winning wagers when due, to achieve a gross operating profit; to pay all local, state and federal taxes when due, to make necessary capital and maintenance expenditures to insure that it has a superior first-class facility, and to pay, exchange, refinance or extend debts which will mature or become due and payable during the license term. In the event a licensee fails to demonstrate financial stability, the CCC may take such action as it deems necessary to fulfill the purposes of the Casino Control Act and protect the public interest, including: issuing conditional licenses, approvals or determinations; establishing an appropriate cure period, imposing reporting requirements; placing restrictions on the transfer of cash or the assumption of liability; requiring reasonable reserves or trust accounts; denying licensure; or appointing a conservator. See "Conservatorship" below. The partnership believes that it has adequate financial resources to meet the financial stability requirements of the CCC for the foreseeable future. Pursuant to the Casino Control Act, CCC Regulations and precedent, no entity may hold a casino license unless each officer, director, principal employee, person who directly or indirectly holds any beneficial interest or ownership in the licensee, each person who in the opinion of the CCC has the ability to control or elect a majority of the board of directors of the licensee (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) and any lender, underwriter, agent or employee of the licensee or other person whom the CCC may consider appropriate, obtains and maintains qualification approval from the CCC. Qualification approval means that such person must, but for residence, individually meet the qualification requirements as a casino key employee. See "Narrative Description of Business -- Gaming and Other Laws and Regulations -- Employees." Pursuant to a condition of its casino license, payments by the Partnership to or for the benefit of any related entity or partner are subject to prior CCC approval; and, if the Partnership's cash position falls below $5.0 million for three consecutive business days, the Partnership must present to the CCC and the Division evidence as to why it should not obtain a working capital facility in an appropriate amount. Control Persons. An entity qualifier or intermediary or holding company, such as Holding, Holding Inc. and the Company, is required to register with the CCC and meet the same basic standards for approval as a casino licensee; provided, however, that the CCC, with the concurrence of the Director of the Division, may waive compliance by a publicly-traded corporate holding company with the requirement that an officer, director, lender, underwriter, agent or employee thereof, or person directly or indirectly holding a beneficial interest or ownership of the securities thereof individually qualify for approval under casino key employee standards so long as the CCC and the Director are, and remain, satisfied that such officer, director, lender, underwriter, agent or employee is not significantly involved in the activities of the casino licensee, or that such security holder does not have the ability to control the publicly-traded corporate holding company or elect one or more of its directors. Persons holding five percent or more of the equity securities of such holding company are presumed to have the ability to control the company or elect one or more of its directors and will, unless this presumption is rebutted, be required to individually qualify. Equity securities are defined as any voting stock or any security similar to or convertible into or carrying a right to acquire any security having a direct or indirect participation in the profits of the issuer. Financial Sources. The CCC may require all financial backers, investors, mortgagees, bond holders and holders of notes or other evidence of indebtedness, either in effect or proposed, which bears any relation to the casino project, publicly traded securities of an entity which holds a casino license or is an entity qualifier, subsidiary or holding company of a casino licensee (a "Regulated Company"), to qualify as financial sources. In the past, the CCC has waived the qualification requirement for holders of less than 15% of a series of publicly traded mortgage bonds so long as the bonds remained widely distributed and freely traded in the public market and the holder had no ability to control the casino licensee. The CCC may require holders of less than 15% of a series of debt to qualify as financial sources even if not active in the management of the issuer or the casino licensee. Institutional Investors. An institutional investor ("Institutional Investor") is defined by the Casino Control Act as any retirement fund administered by a public agency for the exclusive benefit of federal, state or local public employees; investment company registered under the Investment Company Act of 1940; collective investment trust organized by banks under Part Nine of the Rules of the Comptroller of the Currency; closed end investment trust; chartered or licensed life insurance company or property and casualty insurance company; banking and other chartered or licensed lending institution; investment advisor registered under the Investment Advisers Act of 1940; and such other persons as the CCC may determine for reasons consistent with the policies of the Casino Control Act. An Institutional Investor may be granted a waiver by the CCC from financial source or other qualification requirements applicable to a holder of publicly-traded securities, in the absence of a prima facie showing by the Division that there is any cause to believe that the holder may be found unqualified, on the basis of CCC findings that: (i) its holdings were purchased for investment purposes only and, upon request by the CCC, it files a certified statement to the effect that it has no intention of influencing or affecting the affairs of the issuer, the casino licensee or its holding or intermediary companies; provided, however, that the Institutional Investor will be permitted to vote on matters put to the vote of the outstanding security holders; and (ii) if (x) the securities are debt securities of a casino licensee's holding or intermediary companies or another subsidiary company of the casino licensee's holding or intermediary companies which is related in any way to the financing of the casino licensee and represent either (A) 20% or less of the total outstanding debt of the company, or (B) 50% or less of any issue of outstanding debt of the company, (y) the securities are equity securities and represent less than 10% of the equity securities of a casino licensee's holding or intermediary companies, or (z) the securities so held exceed such percentages, upon a showing of good cause. There can be no assurance, however, that the CCC will make such findings or grant such waiver and, in any event, an Institutional Investor may be required to produce for the CCC or the Division upon request, any document or information which bears any relation to such debt or equity securities. Generally, the CCC requires each institutional holder seeking waiver of qualification to execute a certification to the effect that (i) the holder has received the definition of Institutional Investor under the Casino Control Act and believes that it meets the definition of Institutional Investor; (ii) the holder purchased the securities for investment purposes only and holds them in the ordinary course of business; (iii) the holder has no involvement in the business activities of, and no intention of influencing or affecting the affairs of the issuer, the casino licensee or any affiliate; and (iv) if the holder subsequently determines to influence or affect the affairs of the issuer, the casino licensee or any affiliate, it shall provide not less than 30 days' prior notice of such intent and shall file with the CCC an application for qualification before taking any such action. If an Institutional Investor changes its investment intent, or if the CCC finds reasonable cause to believe that it may be found unqualified, the Institutional Investor may take no action with respect to the security holdings, other than to divest itself of such holdings, until it has applied for interim casino authorization (see "Interim Casino Authorization" below) and has executed a trust agreement pursuant to such an application. Ownership and Transfer of Securities. The Casino Control Act imposes certain restrictions upon the issuance, ownership and transfer of securities of a Regulated Company and defines the term "security" to include instruments which evidence a direct or indirect beneficial ownership or creditor interest in a Regulated Company including, but not limited to, mortgages, debentures, security agreements, notes and warrants. Each of the Company and the Partnership are deemed to be a Regulated Company, and instruments evidencing a beneficial ownership or creditor interest therein, including partnership interest, are deemed to be the securities of a Regulated Company. If the CCC finds that a holder of such securities is not qualified under the Casino Control Act, it has the right to take any remedial action it may deem appropriate including the right to force divestiture by such disqualified holder of such securities. In the event that certain disqualified holders fail to divest themselves of such securities, the CCC has the power to revoke or suspend the casino license affiliated with the Regulated Company which issued the securities. If a holder is found unqualified, it is unlawful for the holder (i) to exercise, directly or through any trustee or nominee, any right conferred by such securities, or (ii) to receive any dividends or interest upon such securities or any remuneration, in any form, from its affiliated casino licensee for services rendered or otherwise. With respect to non-publicly-traded securities, the Casino Control Act and CCC regulations require that the corporate charter or partnership agreement of a Regulated Company establish a right in the CCC of prior approval with regard to transfers of securities, shares and other interests and an absolute right in the Regulated Company to repurchase at the market price or the purchase price, whichever is the lesser, any such security, share or other interest in the event that the CCC disapproves a transfer. With respect to publicly-traded securities, such corporate charter or partnership agreement is required to establish that any such securities of the entity are held subject to the condition that, if a holder thereof is found to be disqualified by the CCC, such holder shall dispose of such securities. Interim Casino Authorization. Interim casino authorization is a process which permits a person who enters into a contract to obtain property relating to a casino operation or who obtains publicly-traded securities relating to a casino licensee to close on the contract or own the securities until plenary licensure or qualification. During the period of interim authorization, the property relating to the casino operation or the securities are held in trust. Whenever any person enters into a contract to transfer any property which relates to an ongoing casino operation, including a security of the casino licensee or a holding or intermediary company or entity qualifier, under circumstances which would require that the transferee obtain licensure or be qualified under the Casino Control Act, and that person is not already licensed or qualified, the transferee is required to apply for interim authorization. Furthermore, the closing or settlement date in the contract may not be earlier than the 121st day after the submission of a complete application for licensure or qualification together with a fully executed trust agreement in a form approved by the CCC. If, after the report of the Division and a hearing by the CCC, the CCC grants interim authorization, the property will be subject to a trust. If the CCC denies interim authorization, the contract may not close or settle until the CCC makes a determination on the qualifications of the applicant. If the CCC denies qualification, the contract will be terminated for all purposes and there will be no liability on the part of the transferor. If, as the result of a transfer of publicly traded securities of a licensee, a holding or intermediary company or entity qualifier of a licensee or a financing entity of a licensee, any person is required to qualify under the Casino Control Act, that person is required to file an application for licensure or qualification within 30 days after the CCC determines that qualification is required or declines to waive qualification. The application must include a fully executed trust agreement in a form approved by the CCC or, in the alternative, within 120 days after the CCC determines that qualification is required, the person whose qualification is required must divest such securities as the CCC may require in order to remove the need to qualify. The CCC may grant interim casino authorization where it finds by clear and convincing evidence that: (i) statements of compliance have been issued pursuant to the Casino Control Act; (ii) the casino hotel is an approved hotel in accordance with the Casino Control Act; (iii) the trustee satisfies qualification criteria applicable to key casino employees, except for residency and casino experience; and (iv) interim operation will best serve the interests of the public. When the CCC finds the applicant qualified, the trust will terminate. If the CCC denies qualification to a person who has received interim casino authorization, the trustee is required to endeavor, and is authorized, to sell, assign, convey or otherwise dispose of the property subject to the trust to such persons who are licensed or qualified or shall themselves obtain interim casino authorization. Where a holder of publicly traded securities is required, in applying for qualification as a financial source or qualifier, to transfer such securities to a trust in application for interim casino authorization and the CCC thereafter orders that the trust become operative: (i) during the time the trust is operative, the holder may not participate in the earnings of the casino hotel or receive any return on its investment or debt security holdings; and (ii) after disposition, if any, of the securities by the trustee, proceeds distributed to the unqualified holder may not exceed the lower of their actual cost to the unqualified holder or their value calculated as if the investment had been made on the date the trust became operative. Approved Hotel Facilities. The CCC may permit a licensee, such as the Partnership, to increase its casino space if the licensee agrees to add a prescribed number of qualifying sleeping units within two years after the commencement of gaming operations in the additional casino space. However, if the casino licensee does not fulfill such agreement due to conditions within its control, the licensee will be required to close the additional casino space, or any portion thereof that the CCC determines should be closed. License Fees. The CCC is authorized to establish annual fees for the renewal of casino licenses. The renewal fee is based upon the cost of maintaining control and regulatory activities prescribed by the Casino Control Act, and may not be less than $200,000 for a two-year casino license. Additionally, casino licensees are subject to potential assessments to fund any annual operating deficits incurred by the CCC or the Division. There is also an annual license fee of $500 for each slot machine maintained for use or in use in any casino. Gross Revenue Tax. Each casino licensee is also required to pay an annual tax of 8% on its gross casino revenues. For the years ended December 31, 1992 and 1993, the Partnership's gross revenue tax was approximately $21.0 million and $21.3 million respectively, and its license, investigations, and other fees and assessments totalled approximately $4.7 million and $4.0 million respectively. Investment Alternative Tax Obligations. An investment alternative tax imposed on the gross casino revenues of each licensee in the amount of 2.5% is due and payable on the last day of April following the end of the calendar year. A licensee is obligated to pay the investment alternative tax for a period of 25 years. Estimated payments of the investment alternative tax obligation must be made quarterly in an amount equal to 1.25% of estimated gross revenues for the preceding three-month period. Investment tax credits may be obtained by making qualified investments or by the purchase of bonds issued by the CRDA. CRDA bonds may have terms as long as fifty years and bear interest at below market rates, resulting in a value lower than the face value of such CRDA bonds. For the first ten years of its obligation, the licensee is entitled to an investment tax credit against the investment alternative tax in an amount equal to twice the purchase price of bonds issued to the licensee by the CRDA. Thereafter, the licensee is (i) entitled to an investment tax credit in an amount equal to twice the purchase price of such bonds or twice the amount of its investments authorized in lieu of such bond investments or made in projects designated as eligible by the CRDA and (ii) has the option of entering into a contract with the CRDA to have its tax credit comprised of direct investments in approved eligible projects which may not comprise more than 50% of its eligible tax credit in any one year. From the moneys made available to the CRDA, the CRDA set aside $100,000,000 for investment in hotel development projects in Atlantic City undertaken by a licensee which result in the construction or rehabilitation of at least 200 hotel rooms by December 31, 1996. The CRDA is required to determine the amount each casino licensee may be eligible to receive out of the moneys set aside. Minimum Casino Parking Charges. As of July 1, 1993, each casino licensee was required to impose on and collect from patrons a standard minimum parking charge of at least $2.00 for the use of parking, space for the purpose of parking, garaging or storing motor vehicles in a parking facility owned or leased by a casino licensee or by any person on behalf of a casino licensee. Of the amount collected by the casino licensee, $1.50 will be paid to the New Jersey State Treasurer and paid by the New Jersey State Treasurer into a special fund established and held by the New Jersey State Treasurer for the exclusive use of the CRDA. Amounts in the special fund will be expended by the CRDA for (i) eligible projects in the corridor region of Atlantic City, which projects are related to the improvement of roads, infrastructure, traffic regulation and public safety, and (ii) funding up to 35% of the cost to casino licensee of expanding their hotel facilities to provide additional hotel rooms, which hotel rooms are required to be available upon the opening of the Atlantic City Convention Center and dedicated to convention events. Conservatorship. If, at any time, it is determined that the Partnership, the Company, Holding, Inc. or Holding has violated the Casino Control Act or that any of such entities cannot meet the qualification requirements of the Casino Control Act, such entity could be subject to fines or the suspension or revocation of its license or qualification. If the Partnership's license is suspended for a period in excess of 120 days or revoked or if the CCC fails or refuses to renew such casino license, the CCC could appoint a conservator to operate and dispose of the Partnership's casino hotel facilities. A conservator would be vested with title to all property of the Partnership relating to the casino and the approved hotel subject to valid liens and/or encumbrances. The conservator would be required to act under the direct supervision of the CCC and would be charged with the duty of conserving, preserving and, if permitted, continuing the operation of the casino hotel. During the period of the conservatorship, a former or suspended casino licensee is entitled to a fair rate of return out of net earnings, if any, on the property retained by the conservator. The CCC may also discontinue any conservatorship action and direct the conservator to take such steps as are necessary to effect an orderly transfer of the property of a former or suspended casino licensee. Employees. All employees of the Partnership must be licensed by or registered with the CCC, depending on the nature of the position held. Casino employees are subject to more stringent requirements than non-casino employees and must meet applicable standards pertaining to financial stability, integrity and responsibility, good character, honesty and integrity, business ability and casino experience and New Jersey residency. These requirements have resulted in significant competition among Atlantic City casino operators for the services of qualified employees. Gaming Credit. The Partnership's casino games are conducted on a credit as well as cash basis. Gaming debts arising in Atlantic City in accordance with applicable regulations are enforceable in the courts of the State of New Jersey. The extension of gaming credit is subject to regulations that detail procedures which casinos must follow when granting gaming credit and recording counter checks which have been exchanged, redeemed or consolidated. Control Procedures. Gaming at Trump Plaza is conducted by trained and supervised personnel. The Partnership employs extensive security and internal controls. Security checks are made to determine, among other matters, that job applicants for key positions have had no criminal history or associations. Security controls utilized by the surveillance department include closed circuit video camera to monitor the casino floor and money counting areas. The count of moneys from gaming also is observed daily by representatives of the CCC. Other Laws and Regulations. The United States Department of the Treasury has adopted regulations pursuant to which a casino is required to file a report of each deposit, withdrawal, exchange of currency, gambling tokens or chips, or other payments or transfers by, through, or to such casino which involves a transaction in currency of more than $10,000 per patron per gaming day. Such reports are required to be made on forms prescribed by the Secretary of the Treasury and are filed with the Commissioner of the Internal Revenue Service (the "IRS"). In addition, the Partnership is required to maintain detailed records (including the names, addresses, social security numbers and other information with respect to its gaming customers) dealing with, among other items, the deposit and withdrawal of funds and the maintenance of a line of credit. The Department of the Treasury has recently adopted regulations, scheduled to become effective in December 1994, which will require the Partnership, among other things, to keep records of the name, permanent address and taxpayer identification number (or in the case of a non-resident alien, such person's passport number) of any person engaging in a currency transaction in excess of $3,000. The Partnership is unable to predict what effect, if any, these new reporting obligations will have on gaming practices of certain of its patrons. In the past, the IRS had taken the position that gaming winnings from table games by non-resident aliens was subject to a 30% withholding tax. The IRS, however, subsequently adopted a practice of not collecting such tax. Recently enacted legislation exempts from tax withholding table game winnings by non-resident aliens, unless the Secretary of the Treasury determines by regulation that such collections have become administratively feasible. As the result of an audit conducted by the U.S. Department of Treasury, Office of Financial Enforcement, the Partnership was alleged to have failed to timely file the "Currency Transaction Report by Casino" in connection with 65 individual currency transactions in excess of $10,000 during the period from October 31, 1986 to December 10, 1988. The Partnership paid a fine of $292,500 in connection with these violations. The Partnership has revised its internal control procedures to ensure continued compliance with these regulations. The Partnership is subject to other federal, state and local regulations and, on a periodic basis, must obtain various licenses and permits, including those required to sell alcoholic beverages. Management believes that it has obtained all required licenses and permits to conduct its business. (d) Financial Information About Foreign and Domestic Operations and Export Sales Not applicable. ITEM 2. ITEM 2. PROPERTIES. The Partnership owns and leases several parcels of land in and around Atlantic City, New Jersey, each of which is used in connection with the operation of Trump Plaza and each of which is subject to the liens of the Note Mortgage and Guarantee Mortgage (collectively, the "Mortgages") and certain other liens. The "Note Mortgage" is the mortgage on and related assignments of the assets constituting the real property owned and leased by the Partnership and substantially all of the Partnership's other assets, all of which constitute Trump Plaza and its related properties, which secures the non-recourse promissory note (the"Partnership Note") of the Partnership issued to the Company in exchange for the Company's lending to the Partnership the proceeds of the Mortgage Note Offering. In exchange for the use of such proceeds, the Company has assigned the Note Mortgage and the Partnership Note to the Trustee. The "Guarantee Mortgage" is the mortgage on and related assignments of the assets of the Partnership described above, senior to the lien of the Note Mortgage, which secures the Partnership's non-recourse guarantee (the "Guarantee") of the Mortgage Notes. The Mortgage Note Indenture, the Note Mortgage and the Guarantee Mortgage are herein collectively referred to as the "Mortgage Note Agreements." Casino Parcel. Trump Plaza is located on The Boardwalk in Atlantic City, New Jersey, next to the Atlantic City Convention Center. It occupies the entire city block (approximately 2.38 acres) bounded by The Boardwalk, Mississippi Avenue, Pacific Avenue and Columbia Place (the "Casino Parcel"). The Casino Parcel consists of four tracts of land, one of which is owned by the Partnership and three of which are leased to the Partnership pursuant to three non-renewable Ground Leases, each of which expires on December 31, 2078 (each, a "Ground Lease"). Trump Seashore Associates, Seashore Four Associates and Plaza Hotel Management Company (each, a "Ground Lessor") are the owners/lessors under such Ground Leases (respectively, the "TSA Lease," "SFA Lease" and "PHMC Lease"; the land which is subject to the Ground Leases (which includes Additional Parcel 1, as hereinafter defined) is referred to collectively as the "Leasehold Tracts" and individually as a "Leasehold Tract"). Trump Seashore Associates and Seashore Four Associates are beneficially owned by Trump and are, therefore, affiliates of the Company and the Partnership. On August 1, 1991, as security for indebtedness owed to a third party, Trump Seashore Associates transferred its interest in the TSA Lease to United States Trust Company of New York ("UST"), as trustee for the benefit of such third party creditor. The trust agreement among UST, Trump Seashore Associates and such creditor provides that the trust shall terminate on the earlier of (i) August 1, 2012 or (ii) the date on which such third party creditor certifies to UST that all principal, interest and other sums due and owing from Trump Seashore Associates to such third party creditor have been paid. Trump Seashore Associates is currently negotiating with its third party lender for the extension or refinancing of the indebtedness described above, which debt matured on October 28, 1993. The lender has agreed to forebear from pursuing remedies under such loan through May 28, 1994, while such refinancing negotiations are taking place. The Mortgage Note Agreements provide that, upon such refinancing, the refinancing lender shall consent to the execution of an agreement between TSA and the Partnership providing, among other matters, for certain protections for holders of Mortgage Notes in the event of a default arising under the TSA Lease. While the transfer to UST of Trump Seashore Associates' interest in the TSA Lease was primarily a financing transaction to provide the third-party creditor with a potentially enhanced security interest, because of the transfer of such interest to UST, it is not certain that the TSA Lease would be deemed to be held by an affiliate of the Partnership and, therefore, even if the agreement described above is executed by TSA, the holders of the Mortgage Notes and the PIK Notes may not have the benefit of any such agreement regarding the TSA Lease. The SFA Lease and the PHMC Lease each contain options pursuant to which the Partnership may purchase the Leasehold Tract covered by such Ground Lease at certain times during the term of such Ground Lease under certain circumstances. Upon any refinancing of the mortgage indebtedness which currently encumbers the fee interest in the TSA Lease Leasehold Tract, including any refinancing resulting from the on-going negotiations described above, the TSA Lease will be amended to confirm the existence thereunder of the purchase options, or provide for an additional option grant, in each case substantially similar to those currently set forth in the other Ground Leases. The purchase price pursuant to each option is specified in the applicable Ground Lease. The Ground Leases are "net leases" pursuant to which the Partnership, in addition to the payment of fixed rent, is responsible for all costs and expenses with respect to the use, operation and ownership of the Leasehold Tracts and the improvements now, or which may in the future be, located thereon, including, but not limited to, all maintenance and repair costs, insurance premiums, real estate taxes, assessments and utility charges. The improvements located on the Leasehold Tracts are owned by the Partnership during the terms of the respective Ground Leases and upon the expiration of the term of each Ground Lease (for whatever reason), ownership of such improvements will vest in the Ground Lessor. Subject to the provisions of the Mortgage Note Agreements, the Partnership has the right to improve the Leasehold Tracts, alter, demolish and/or rebuild the improvements constructed thereon, and remove any personal property and movable trade fixtures therefrom. The Ground Leases provide that each Ground Lessor may encumber its fee estate with mortgage liens, but any such fee mortgage will not increase the rent under the applicable Ground Lease and must be subordinate to such Ground Lease. Accordingly, any default by a Ground Lessor under any such fee mortgage (including that mortgage encumbering the TSA Lease parcel, for which refinancing negotiations are on-going) will not result in a termination of the applicable Ground Lease but would permit the fee mortgagee to bring a foreclosure action and succeed to the interests of the Ground Lessor in the fee estate, subject to the Partnership's leasehold estate under such Ground Lease. Each Ground Lease also specifically provides that the Lessor may sell its interest in the applicable Leasehold Tract, but any such sale would be made subject to the Partnership's interest in the applicable Ground Lease. The Mortgages are subject and subordinate to each of the Ground Leases. Accordingly, if a Ground Lease were to be terminated while such Mortgages were outstanding, the lien of the Mortgages would be extinguished as to the applicable Leasehold Tract. The Ground Leases, however, contain certain provisions to protect the Mortgage Note Trustee and the holders of the Mortgage Notes from such an occurrence, including the following: (i) no cancellation, surrender, acceptance of surrender or modification of a Ground Lease is binding on the Mortgage Note Trustee or affects the lien of the Mortgages without the Mortgage Note Trustee's prior written consent, (ii) the Mortgage Note Trustee is entitled to a copy of any notices (including notices of default) sent by a Ground Lessor to the Partnership, has the right to perform any term or condition of the Ground Lease to be performed by the Partnership and can cure any defaults, (iii) if any default is not remedied within the applicable grace period specified in the Ground Lease, then before the Ground Lessor exercises its rights under the Ground Lease or any statute, the Mortgage Note Trustee has an additional period of time within which to cure, or commence the curing of, the default and (iv) upon any termination of a Ground Lease, the Ground Lessor must enter into a new lease, on substantially the same terms as the applicable Ground Lease, with the Mortgage Note Trustee. In the event of a default by the Partnership under a Ground Lease, however, notwithstanding any additional cure period granted to the Mortgage Note Trustee, there can be no assurance that the Mortgage Note Trustee will take action to cure the default, will have sufficient time to cure the default or will otherwise be able to take advantage of such provisions. If the Ground Lease were then terminated and a new lease entered into, the Mortgage Note Trustee would nevertheless remain obligated to cure all pre- existing defaults. If a bankruptcy case is filed by or commenced against a lessor under applicable bankruptcy law, the trustee in bankruptcy in a liquidation or reorganization case under the applicable bankruptcy law, or a debtor-in-possession in a reorganization case under the applicable bankruptcy law, has the right, at its option, to assume or reject the lease of the debtor-lessor (subject, in each case, to court approval). If the lease is assumed, the rights and obligations of the Partnership thereunder, and the rights of the Mortgage Note Trustee as leasehold mortgagee under the Mortgage Note Agreements, would continue in full force and effect. If the lease is rejected, the Partnership would have the right, at its election, either (i) to treat the lease as terminated, in which event the lien of the Mortgages on the leasehold estate created thereby would be extinguished, or (ii) to continue in possession of the land and improvements under the lease for the balance of the term thereof and at the rental set forth therein (with a right to offset against such rent any damages caused by the lessor's failure to thereafter perform its obligations under such lease). The Mortgage Note Agreements provide that if a lease is rejected, the Partnership assigns to the Trustee its rights to elect whether to treat the lease as terminated or to remain in possession of the leased premises. In the case of the Ground Leases, the rejection of a Ground Lease by a trustee in bankruptcy or debtor-lessor (as debtor-in-possession) may result in termination of any options to purchase the fee estate of the debtor-lessor and the Mortgage Note Trustee's option (as leasehold mortgagee), in certain circumstances, to enter into a new lease directly with the lessor. In addition, under an interpretation of New Jersey law, it is possible that a court would regard such options as separate contracts and, therefore, severable from the Ground Lease. In such event, the trustee in bankruptcy or debtor-lessor (as debtor-in-possession) could assume the Ground Lease, while rejecting some or all of such options under the Ground Lease. Parking Parcels. The Partnership owns a parcel of land (the "Garage Parcel") located across the street from the Casino Parcel and along Pacific Avenue in a portion of the block bounded by Pacific Avenue, Mississippi Avenue, Atlantic Avenue and Missouri Avenue. The Partnership has constructed on the Garage Parcel a 10-story parking garage capable of accommodating approximately 2,650 cars and which includes offices and a bus transportation center with bays accommodating up to 13 buses at one time. An enclosed pedestrian walkway from the parking garage accesses Trump Plaza at the casino level. Parking at the parking garage is available to Trump Plaza's guests, as well as to the general public. Two of the tracts comprising a portion of the Garage Parcel are subject to first mortgages on the Partnership's fee interest in such tracts. As of December 31, 1993, such mortgages had approximate outstanding principal balances of $2.7 million and $2.0 million. The Partnership leases, pursuant to the PHMC Lease, a parcel of unimproved land located on the northwest corner of the intersection of Mississippi and Pacific Avenues consisting of approximately 11,800 square feet ("Additional Parcel 1") and owns another unimproved parcel on Mississippi Avenue adjacent to Additional Parcel 1 consisting of approximately 5,750 square feet (the "Bordonaro Parcel"). The Bordonaro Parcel is encumbered by a first mortgage having an outstanding principal balance, as of December 31, 1993, of approximately $150,000. Additionally Parcel 1 and the Bordonaro Parcel are presently paved and used for surface parking. The Partnership also owns five unimproved parcels of land, aggregating approximately 43,300 square feet, and sub leases on an unimproved parcel consisting of approximately 3,125 square feet. All of such parcels are contiguous and are located along Atlantic Avenue, in the same block as the Garage Parcel. They are used for surface parking for employees of Trump Plaza and are not encumbered by any mortgage liens other than those of the Mortgages. Warehouse Parcel. The Partnership owns a warehouse and office facility located in Egg Harbor Township, New Jersey containing approximately 64,000 square feet of space (the "Egg Harbor Parcel"). The Egg Harbor Parcel is encumbered by a first mortgage having an outstanding principal balance, as of December 31, 1993, of approximately $1.6 million. Boardwalk Expansion Site. See "Certain Relationships and Related Transactions -- Boardwalk Expansion Site." Superior Mortgages. The lien securing the indebtedness on the Garage Parcel, the Bordonaro Parcel and the Egg Harbor Parcel (all of such liens are collectively called the "Existing Senior Mortgages") are all senior to the liens of the Mortgages. The principal amount currently secured by such Existing Senior Mortgages as of December 31, 1993 is in the aggregate, $6.4 million. If the Partnership were to default in the payment of the indebtedness secured by any of the Existing Senior Mortgages or default in the performance of any of the other obligations thereunder, and the holder of an Existing Senior Mortgage were to commence a foreclosure action, the debt owed to the holder of such Existing Senior Mortgage, together with the debt owed to the holder of any other Existing Senior Mortgage which is also then being foreclosed, would have to be satisfied before the holders of the Mortgage Notes would realize any proceeds from the sale of the portion of the property encumbered thereby. If the Company and the Partnership default in the payment of the Mortgage Notes or any other obligation under the Mortgages, and the Mortgage Note Trustee elects to foreclose under the Mortgages, the Mortgage Note Trustee will receive the proceeds of the sale of the collateral under the Mortgage Note Indenture (the "Collateral") subject to the rights of the holders of any Existing Senior Mortgages. The purchaser of the Collateral at any such foreclosure sale would take title to the Collateral subject to the extent not foreclosed upon the Existing Senior Mortgages. In addition to the Existing Senior Mortgages, the Partnership may, under certain circumstances, borrow up to $25 million to pay for certain expansion site costs which may be secured by a lien on the expansion site superior to the lien of the Mortgages thereon. The Partnership has financed or leased and from time to time will finance or lease its acquisition of furniture, fixtures and equipment. The lien in favor of any such lender or lessor will be superior to the liens of the Mortgages. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Partnership, its partners, certain members of its former Executive Committee, and certain of its employees, have been involved in various legal proceedings. In general, the Partnership has agreed to indemnify such persons against any and all losses, claims, damages, expenses (including reasonable costs, disbursements and counsel fees) and liabilities (including amounts paid or incurred in satisfaction of settlements, judgments, fines and penalties) incurred by them in said legal proceedings. Such persons and entities are vigorously defending the allegations against them and intend to vigorously contest any future proceedings. Penthouse Litigation On April 3, 1989, BPHC Acquisition, Inc. and BPHC Parking Corp. (collectively, "BPHC") filed a third-party complaint (the "Complaint") against the Partnership and Trump. The Complaint arose in connection with the action entitled Boardwalk Properties, Inc. and Penthouse International Ltd. v. BPHC Acquisition, Inc. and BPHC Parking Corp., which was instituted on March 20, 1989 in the New Jersey Superior Court, Chancery Division, Atlantic County. The suit arose in connection with the conditional sale by Boardwalk Properties, Inc. ("BPI") (or, with respect to certain of the property, BPI's agreement to sell) to Trump of BPI's fee and leasehold interests in (i) an approximately 2.0-acre parcel of land located directly across the street from Trump Plaza upon which there is located an approximately 500 room hotel, which is closed to the public and is in need of substantial renovation (the "Penthouse Site"), (ii) an approximately 4.2-acre parcel of land located on Atlantic Avenue, diagonally across from Trump Plaza's parking garage (the "Columbus Plaza Site") which was then owned by an entity in which 50% of the interests were each owned by BPHC and BPI and (iii) an additional 1,462-square foot parcel of land located within the area of the Penthouse Site (the "Bongiovanni Site"). Prior to BPI entering into its agreement with Trump, BPI had entered into agreements with BPHC which provided, among other things, for the sale to BPHC of the Penthouse Site, as well as BPI's interest in the Columbus Plaza Site, assuming that certain contingencies were satisfied by a certain date. Additionally, by agreement between BPHC and BPI, in the event BPHC failed to close on the Penthouse Site, BPHC would convey to BPI the Bongiovanni Site. Upon BPHC's failure to close on the Penthouse Site, BPI entered into its agreement with Trump pursuant to which it sold the Penthouse Site to Trump and instituted a lawsuit against BPHC for specific performance to compel BPHC to transfer to BPI, BPHC's interest in the Columbus Plaza and Bongiovanni Sites, as provided for in the various agreements between BPHC and BPI and in the agreement between BPI and Trump. The Complaint alleges that the Partnership and/or Trump engaged in the following activities: civil conspiracy, violations of the New Jersey Antitrust Act, violations of the New Jersey RICO statute, malicious interference with contractual relations, malicious interference with prospective economic advantage, inducement to breach a fiduciary duty and malicious abuse of process. The relief sought in the Complaint included, among other things, compensatory damages, punitive damages, treble damages, injunctive relief, the revocation of all of the Partnership's and Trump's casino licenses, the revocation of the Partnership's current Certificate of Partnership, the revocation of any other licenses or permits issued to the Partnership and Trump by the State of New Jersey, and a declaration voiding the conveyance by BPI to Trump of BPI's interest in the Penthouse Site, as well as BPI's and/or Trump's rights to obtain title to the Columbus Plaza Site. The Partnership and Trump filed an answer denying all liability and alleging that all of BPHC's claims are without merit. On November 9, 1990, BPHC filed an application to amend its counterclaims against BPI and the Complaint, which amendment sought to withdraw all of BPHC's affirmative claims for equitable relief and thereby limit such claims to monetary damages. On December 20, 1990, the Superior Court entered an Order permitting BPHC to withdraw its affirmative demands for equitable relief. Trial of the Penthouse litigation was bifurcated into issues of liability and damages, with liability issues to be tried first. On March 25, 1993, after trial on issues of liability, the Superior Court rendered a decision rejecting all of BPHC's claims in the Complaint. On October 13, 1993, the court entered a judgment dismissing with prejudice all claims against Trump and the Partnership. On November 5, 1993 BPHC filed a motion seeking to have this judgment declared interlocutory in nature, rather than final. The Partnership successfully opposed this motion which was denied on November 19, 1993. On November 30, 1993, BPHC filed a notice of appeal to the Appellate Division. On January 19, 1994, BPHC filed a motion in the Appellate Division seeking a determination that the Superior Court had erred in ruling that the judgment as to the Partnership and Trump was final. The Partnership and Trump successfully opposed that motion, which was denied on March 3, 1994. A briefing schedule for the appeal from the final judgment has been set. If that schedule is not subsequently modified, BPHC's brief is due on April 18, 1994, the brief of the Partnership and Trump is due on May 18, 1994 and BPHC's reply brief is due on May 31, 1994. On January 9, 1991, BPHC instituted suit against Trump, the Partnership, BPI, Penthouse International Ltd. and Robert C. Guccione in the United States District Court for the District of New Jersey. This action is virtually identical to the state court action described above. The Partnership and Trump filed an answer denying all liability and alleging that all of BPHC's claims are without merit. In April 1993, the Partnership filed a motion to dismiss certain claims based on the favorable decision in the state court action. In May 1993, the court issued an order to show cause, scheduling a hearing for June 1993 to determine whether certain claims of the plaintiff's amended complaint should be dismissed with prejudice. On July 15, 1993, the court acted favorably on the Partnership's motion and dismissed the action in its entirety. The order of dismissal was appealed to the United States Court of Appeals for the Third Circuit. All briefs have been filed and the appeal is presently scheduled for disposition in April 1994. Other Litigation Various other legal proceedings are now pending against the Partnership. The Partnership considers all such other proceedings to be ordinary litigation incident to the character of its business and not material to its business or financial condition. The majority of such claims are covered by liability insurance (subject to a $250,000 deductible per claim), and the Partnership believes that the resolution of these claims, to the extent not covered by insurance, together with uninsured claims will not, individually or in the aggregate, have a material adverse effect on the financial condition and results of operations of the partnership. The Partnership is also a party to various administrative proceedings involving allegations that it has violated certain provisions of the Casino Control Act. The Partnership believes that the final outcome of these proceedings will not, either individually or in the aggregate, have a material adverse effect on the Partnership or on the ability of the Partnership to otherwise retain or renew any casino or other licenses required under the Casino Control Act for the operation of Trump Plaza. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted by the Registrant to its security holders for a vote during the fourth quarter of 1993. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) There is no established public trading market for the Company's outstanding Common Stock. (b) As of December 31, 1993, Trump was the sole holder of record of the Company's Common Stock. (c) The Company has not paid any cash dividends on its Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. SELECTED FINANCIAL INFORMATION The following table sets forth historical financial information of the Partnership for each of the five years ended December 31, 1993. This information should be read in conjunction with the financial statements of the Partnership and related notes included elsewhere in this Report and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Year Ended December 31, ----------------------- 1989 1990 1991 1992 1993 ---- ---- ---- ---- ---- Statements of Operations Data: (dollars in thousands) Revenues: Gaming . . . . . . . . . . . . $306,009 $276,932 $233,265 $265,448 $264,081 Other. . . . . . . . . . . . . 90,680 87,286 66,411 73,270 69,203 Trump Regency. . . . . . . . . - - 11,547 9,465 - -------- ------- -------- -------- ------- Gross revenues . . . . . . . 396,689 364,218 311,223 348,183 333,284 Promotional allowances 42,551 44,281 31,539 34,865 32,793 -------- ------- -------- -------- ------- Net revenues . . . . . . . . . 354,138 319,937 279,684 313,318 300,491 Costs and expenses: Gaming . . . . . . . . . . . . 177,401 178,356 133,547 146,328 136,895 Other . . . . . . . . . . . . 29,158 26,331 23,404 23,670 24,778 General and administrative 71,533 76,057 69,631 75,459 71,624 Depreciation and amortization. 16,906 16,725 16,193 15,842 17,554 Restructuring costs. . . . . . - - 943 5,177 - Trump Regency . . . . . . . . - 3,359 19,879 11,839 - -------- ------- ------- -------- -------- 294,998 300,828 263,597 278,315 250,851 -------- ------- ------- -------- -------- Income from operations 59,140 19,109 16,087 35,003 49,640 -------- ------- ------- -------- -------- Net interest expense . . . . . . 31,988 33,128 33,363 31,356 39,889 Extraordinary (loss) gain - - - (38,205) 4,120 Net income (loss) (1). . . . . . 24,564 (10,591) (29,230) (35,787) 9,338 Balance Sheet Data: Cash and cash equivalents. . . . $11,627 $10,005 $10,474 $18,802 14,393 Property and equipment - net . . 321,391 316,595 306,834 300,266 293,141 Total assets . . . . . . . . . . 406,950 395,775 378,398 370,349 374,498 Total long-term debt - net (2) 273,411 247,048 33,326 249,723 395,948 Preferred Partnership Interest - - - 58,092 - Total capital. . . . . . . . . . 88,481 83,273 54,043 11,362 (54,710) - -------------- (1) Net loss for the year ended December 31, 1990 includes income of $2.4 million resulting from the settlement of a lawsuit relating to a boxing match. Net loss for the year ended December 31, 1991 includes a $10.9 million charge associated with rejection of the Regency Lease and $4.0 million of costs associated with certain litigation. Net income for 1992 includes $1.5 million of costs associated with certain litigation. Net income for 1993 includes $3.9 million of costs associated with the Boardwalk Expansion Site. (2) Long-term debt of $225 million at December 31, 1991 had been classified as a current liability. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. General The Company was incorporated on March 14, 1986 as a New Jersey Corporation, and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. As part of a prepackaged plan of reorganization under chapter 11 of the U.S. Bankruptcy Code consummated on May 29, 1992, the Company became a partner of the Partnership and issued approximately three million Stock Units, each comprised of one share of Preferred Stock and one share of Common Stock. On June 25, 1993 the Company issued and the Partnership guaranteed $330,000,000 of Mortgage Notes (for net proceeds of $325,687,000) and Holding, issued 12,000 Units consisting of an aggregate of $60,000,000 of PIK Notes, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost. Holding has no other assets or business other than its 99% equity interest in the Partnership. The Company owns the remaining 1% interest in the Partnership. The combined proceeds of the Offerings, together with cash on hand, were used substantially as follows: (i) $225.0 million of such proceeds were used to repay the Partnership's Promissory Note to the Company in the principal amount of $225.0 million, which proceeds were then used by the Company to redeem the Bonds; (ii) $12.0 million was used to repay the Regency Note (see "Item 13. Certain Relationships and Related Transactions -- Trump Regency"); (iii) $40.0 million was distributed to the Company (which used such funds, together with $35.0 million from the Units Offering distributed to Trump and paid to the Company, to redeem its Stock Units); (iv) approximately $17.3 million was used to pay the expenses incurred in connection with the Offerings; and (v) approximately $52.5 million was used to make the Special Distribution to Trump, which was used by Trump primarily to pay certain personal indebtedness. No portion of the net proceeds was retained by Holding, the Company or the Partnership for working capital purposes. The financial information presented below reflects the results of operations of the Partnership. Since the Company and Holding have no business operations other than their interest in the Partnership, their results of operations are not discussed below. Results Of Operations For The Years Ended December 31, 1993 and Gaming revenues were $264.1 million for the year ended December 31, 1993, a decrease of $1.4 million or 0.5% from gaming revenues of $265.4 million in 1992. This decrease in gaming revenues consisted of a reduction in table games revenues, which was partially offset by an increase in slot revenues. These results were impacted by major snow storms during February and March, which severely restricted travel in the region. The decrease in revenues was also attributable, in part, to the revenues derived from "high roller" patrons from the Far East during 1992, which did not recur in 1993, due in part to the decision to de-emphasize marketing efforts directed at "high roller" patrons from the Far East and also to the effects of the adverse economic conditions in that region. Slot revenues were $170.5 million for the year ended December 31, 1993, an increase of $1.0 million or 0.6%, from slot revenues of $169.5 million in 1992. The Partnership elected to discontinue certain progressive slot jackpot programs thereby reversing certain accruals into revenues which had the effect of improving slot revenue by $4.1 million for the year ended December 31, 1992. Excluding the aforementioned adjustment, slot revenues would have resulted in a $5.0 million or 3.0% improvement over 1992. The Partnership believes that its improvement in slot revenues reflects its intensified slot marketing efforts directed towards patrons who tend to wager more per slot play and general growth in the industry. See "Business - -- Business Strategy." Table games revenues were $93.6 million for the year ended December 31, 1993, a decrease of $2.3 million or 2.4% from table games revenues of $95.9 million in 1992. This decrease was primarily due to a reduction in table games drop (i.e., the dollar value of chips purchased) by 9.2% for the year ended December 31, 1993 from 1992, offset by an increase in the table games hold percentage to 14.9% (the percentage of table drop retained by the Partnership) for the year ended December 31, 1993 from 13.9% in 1992. The reduction in table game drop was due to the large dollar amounts wagered during 1992 by certain foreign customers. During the year ended December 31, 1993, gaming credit extended to customers was approximately 18.0% of overall table play. At December 31, 1993, gaming receivables amounted to approximately $16.0 million, with allowances for doubtful gaming receivables of approximately $10.4 million. Other revenues were $69.2 million for the year ended December 31, 1993, a decrease of $4.1 million or 5.6%, from other revenues (excluding revenues from Trump Regency) of $73.3 million in 1992. Other revenues include revenues from rooms, food and beverage and miscellaneous items. The decrease in other revenues primarily reflects a $2.1 million adjustment to the outstanding gaming chip liability in 1992, (this amount had been offset in gaming cost and expenses with a specific reserve provision for casino uncollectible accounts receivable) as well as decreases in food and beverage revenues attendant to reduced levels of gaming activity, and reduced promotional allowances. Promotional allowances were $32.8 million for the year ended December 31, 1993, a decrease of $2.1 million or 5.9%, from promotional allowances of $34.9 million in 1992. This decrease is primarily attributable to a reduction in table gaming activity as well as the Partnership's focusing its marketing efforts during the period towards patrons who tend to wager more frequently and in larger denominations. Gaming costs and expenses were $136.9 million for the year ended December 31, 1993, a decrease of $9.4 million, or 6.4%, from gaming costs and expenses of $146.3 million in 1992. This decrease was primarily due to a $4.8 million decrease in gaming bad debt expense as well as decreased promotional and operating expenses and taxes associated with decreased levels of gaming activity and revenues from 1992. Other costs and expenses were $24.8 million for the year ended December 31, 1993 an increase of $1.1 million or 4.7%, from other costs and expenses of $23.7 million in 1992. General and administrative expenses were $71.6 million for the year ended December 31, 1993, a decrease of $3.8 million, or 5.1%, from general and administrative expenses of $75.5 million in 1992. This decrease resulted primarily from a $2.4 million real estate tax charge resulting from a reassessment by local authorities of prior years' property values incurred during 1992 and overall cost reductions related to cost containment efforts. Income from operations was $49.6 million for the year ended December 31, 1993, an increase of $7.0 million or 16.4% from income from operations (excluding the operations of Trump Regency and before restructuring costs) of $42.6 million for 1992. In addition to the items described above, 1993 costs and expenses were lower as a result of the absence of the Restructuring costs and the expenses associated with the Trump Regency which were incurred in 1992. Net interest expense was $39.9 million for the year ended December 31, 1993, an increase of $8.5 million, or 27.2% from net interest expense of $31.4 million in 1992. This is attributable to the interest expense associated with the Offerings. Other non-operating expenses were $3.9 million for the year ended December 31, 1993, an increase of $2.4 million or 164.9% from non-operating expense of $1.5 million in 1992. This increase is directly attributable to costs associated with the Boardwalk Expansion Site. See "Note 7 to the Financials -- Commitments and Contingent Future Expansions." The Offerings resulted in an extraordinary gain of $4.1 million for the year ended December 31, 1993, which reflects the excess of carrying value of the Regency Hotel obligation over the amount of the settlement payment, net of related prepaid expenses. The Restructuring resulted in an extraordinary loss of $38.2 million for the year ended December 31, 1992 consisting of the effects of stating the Bonds and Preferred Stock issued at fair value and the write off of certain deferred financing charges and costs. Results Of Operations For The Year Ended December 31, 1992 and Gaming revenues were $265.4 million for the year ended December 31, 1992, an increase of $32.1 million, or 13.8%, from gaming revenues of $233.3 million in 1991. This increase in gaming revenues was primarily attributable to an increase in slot revenues which was partially offset by a decline in table game revenues. Slot revenues were $169.5 million for the year ended December 31, 1992, an increase of $35.1 million, or 26.1%, from slot revenues of $134.4 million in 1991. The Partnership believes that its improvement in slot revenues reflects its intensified slot marketing efforts directed towards patrons who tend to wager more per slot play and general growth in the industry. See "Business - Business Strategy". In addition, the Partnership elected to discontinue certain progressive slot jackpot programs, thereby reversing certain accruals into revenues which had the effect of improving slot revenue by $4.1 million for the year ended December 31, 1992. Table game revenues were $95.9 million for the year ended December 31, 1992, a decrease of $3.0 million, or 3.0%, from table game revenues of $98.9 million in 1991. While table game drop (i.e., the dollar value of chips purchased) increased 6.7% for the year ended December 31, 1992 from 1991, the decline in table game revenues was due to a decrease in the table game hold percentage (i.e., the percentage of table game drop retained by the Partnership) to 13.9% for the year ended December 31, 1992 from 15.3% in 1991. The reduction in table game hold percentage was due, in part, to the large dollar amounts wagered by a few patrons, whose individual success at the gaming tables had an impact on the overall table game hold percentage. During the year ended December 31, 1992, gaming credit extended to customers was approximately 27.8% of overall table play. At December 31, 1992, gaming receivables amounted to approximately $20.5 million, with allowances for doubtful gaming receivables of approximately $14.0 million. Other revenues (excluding revenues from Trump Regency) were $73.3 million for the year ended December 31, 1992, an increase of $6.9 million, or 10.4%, from other revenues of $66.4 million in 1991. Other revenues include revenues from rooms, food and beverage and miscellaneous items. This increase in other revenues primarily reflects increases in food and beverage revenues attendant to increased levels of gaming activity. In addition, the Partnership recognized $2.1 million in other revenues during the year ended December 31, 1992 as the result of the cancellation of outstanding chips to offset the debt of a patron who owed in excess of such amounts to the Partnership. The revenue derived from such cancellation, however, was offset by an associated increase in bad debt expense in 1992. Promotional allowances were $34.9 million for the year ended December 31, 1992, an increase of $3.4 million, or 10.8%, from promotional allowances of $31.5 million in 1991. This increase is primarily attributable to the increase in gaming activity during the period. Gaming costs and expenses were $146.3 million for the year ended December 31, 1992, an increase of $12.8 million, or 9.6%, from gaming costs and expenses of $133.5 million in 1991. This increase was primarily due to increased promotional and operating expenses associated with increased slot revenues, increased taxes and increased regulatory expenses. Gaming costs and expenses also increased due to the $2.1 million increase in bad debt expense referred to above. Other costs and expenses were $23.7 million for the year ended December 31, 1992, an increase of $0.3 million, or 1.3%, from other costs and expenses of $23.4 million in 1991. General and administrative expenses were $75.5 million for the year ended December 31, 1992, an increase of $5.9 million, or 8.5%, from general and administrative expenses of $69.6 million in 1991. This increase resulted primarily from a $2.4 million increase in real estate taxes arising from a reassessment by local authorities of prior years property values, as well as increased property insurance and other costs associated with maintaining Trump Plaza. In connection with the Restructuring, the Partnership incurred $5.2 million of non-recurring costs for the year ended December 31, 1992, comprised of professional fees and other costs and expenses of the Restructuring. Pursuant to the terms of the Restructuring, the Partnership ceased operating Trump Regency as of September 30, 1992. For the year ended December 31, 1992, the Partnership realized a net loss of $2.4 million from the operation of Trump Regency, compared to the net loss of $8.3 million in 1991. See "Certain Relationships and Related Transactions." Income from operations (excluding the operations of Trump Regency and before restructuring costs) was $42.6 million for the year ended December 31, 1992, an increase of $17.2 million, or 67.7%, from income from operations of $25.4 million in 1991. Net interest expense was $31.4 million for the year ended December 31, 1992, a decrease of $2.0 million, or 6.0%, from net interest expense of $33.4 million in 1991. The Restructuring resulted in an extraordinary loss of $38.2 million for the year ended December 31, 1992, which reflects a $32.8 million accounting adjustment to carry the Bonds and Preferred Stock issued in the Restructuring on the Partnership's balance sheet at fair market value based upon then current rates of interest. The Partnership also wrote-off certain deferred financing charges and costs of $5.4 million. Net loss was $35.8 million for the year ended December 31, 1992, and increase of $6.6 million, or 22.6%, from the net loss of $29.2 million in 1991. Liquidity and Capital Resources The Partnership. Cash flow from operating activities is the Partnership's principal source of liquidity. For the year ended December 31, 1993, net cash from operating activities was $18.5 million. On June 25, 1993, the date of consummation of the Offerings, the Partnership paid accrued interest on the Bonds. Interest on the Bonds was payable semi-annually on March 15 and September 15, while interest on the Mortgage Notes is payable semi-annually on each June 15 and December 15, commencing December 15, 1993. The decrease of $7.7 million in net cash provided by operating activities as compared to 1992 reflects the aforementioned changes in payments of accrued interest on the Bonds. Capital expenditures of $10.1 million for the year ended December 31, 1993 increased approximately $1.4 million from 1992, and was primarily due to the refurbishment of the casino floor (including new carpeting), the purchase of additional slot machines, the construction of an electronic graphic sign adjacent to the transportation facility and demolition and refurbishing costs associated with the Boardwalk Expansion Site. These expenditures were financed from funds generated from operations. The Boardwalk Expansion (as described below), may require additional borrowings. Capital expenditures for 1992, and 1991 were $8.6 million and $5.5 million, respectively. Previously, the Partnership provided for significant capital expenditures which concentrated on the construction of the Transportation Facility and the renovation of certain restaurants, hotel rooms and the hotel lobby. See "Business -- Facilities and Amenities." At December 31, 1993, the Partnership had a combined working capital deficit totalling $1.5 million, compared to a working capital deficit of $18.2 million at December 31, 1992. In 1993, the Partnership received the approval of the CCC, subject to certain conditions, for the Expansion of its hotel facilities on the Boardwalk Expansion Site upon which there is located an approximately 361-room hotel, which is closed to the public and in need of substantial renovation and repair. On June 25, 1993, the date the Offerings were consummated, Trump transferred title to the Boardwalk Expansion Site to a lender in exchange for a reduction in Trump's indebtedness to such lender in an amount equal to the sum of fair market value of the Boardwalk Expansion Site and all rent payments made to such lender by Trump under the Boardwalk Expansion Site Lease (as defined below). On the date the Offerings were consummated, the lender leased the Boardwalk Expansion Site to Trump for a term of five years, which expires on June 30, 1998, during which time Trump will be obligated to pay the lender $260,000 per month in lease payments. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. In connection with the Offerings, the Partnership acquired a five-year option to purchase the Boardwalk Expansion Site. Until such time as the Option is exercised or expires, the Partnership will be obligated, from and after the date it entered into the Option, to pay the net expenses associated with the Boardwalk Expansion Site, including, without limitation, current real estate taxes (approximately $1.2 million per year based upon current assessed valuation), $66,000 per month until January 1, 1995 in respect of past due taxes and annual lease payments for the portion of the Boardwalk Expansion Site currently leased by the Partnership from a third party, which lease payments were $86,058 for 1993 and $83,500 for 1992, and increase annually based on the consumer price index. In addition, net expenses include the costs of demolishing certain structures situated on the Boardwalk Expansion Site at a cost of approximately $1.5 million, the redemption in November 1993 of $496,000 in tax sale certificates issued to third parties and $100,000 in annual insurance expense. Under the Option, the Partnership has the right to acquire the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until expiration on June 30, 1998. In addition, the Partnership has a right of first refusal upon any proposed sale of all or any portion of the Boardwalk Expansion Site during the term of the Option. Trump, individually, also has been granted by such lender a right of first refusal upon a proposed sale of all or any portion of the Boardwalk Expansion Site. Trump, has agreed with the Partnership that his right of first refusal will be subject to the Partnership's prior exercise of its right of first refusal (with any decision of the Partnership requiring the approval of the Independent Directors of the Company, acting as the managing general partner of the Partnership). Acquisition of the Boardwalk Expansion Site by the Partnership would under certain circumstances (provided there are no events of default under the Boardwalk Expansion Site Lease or the Option and provided that certain other events had not theretofore or do not thereafter occur) discharge Trump's obligation to such lender in full. Under the terms of the Option, if the Partnership defaults in making payments due under the Option, the Partnership would be liable to the lender for the sum of (a) the present value of all remaining payments to be made by the Partnership pursuant to the Option during the term thereof and (b) the cost of demolition of all improvements then located on the Boardwalk Expansion Site. The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option would be dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and requires the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site would be dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option or the right of first refusal requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option or such right. The CCC has required that the Partnership exercise the Option or its right of first refusal therein no later than July 1, 1995. Management has determined to build or refurbish rooms at the Boardwalk Expansion Site. As a result of such expansion, the Partnership will be permitted to increase Trump Plaza's casino floor space by 30,000 square feet. The Partnership plans to add approximately 10,000 square feet in April, 1994 with an additional 5,000 square feet in June, 1994 and 10,000 square feet planned to open in April, 1995. The 5,000 remaining allowable square feet will be added as patron demand warrants. The Partnership has begun construction at such site pursuant to rights granted to the Partnership by the lender under the Boardwalk Expansion Site Lease. Pursuant to the terms of certain personal indebtedness of Trump, the Partnership is restricted from expending more than $15.0 million less any CRDA tax credits for improvements at the Boardwalk Expansion Site prior to such time as it exercises the Option. The Partnership has received approximately $294,000 in CRDA credit as of December 31, 1993. The Partnership's ability to exercise the Option will be restricted by, among other things, the Mortgage Note Indenture, the PIK Note Indenture and the terms of certain indebtedness of Trump, and would require the approval of the CCC. Management does not currently anticipate that it will be in a position to exercise the Option to acquire such site prior to 1995 due, in part, to limitations on its ability to incur additional indebtedness. If the Partnership is unable to finance the purchase price of the Boardwalk Expansion Site pursuant to the Option, any amounts expended with respect to the Boardwalk Expansion Site, including payments under the Option and the Boardwalk Expansion Site lease, if assumed, and any improvements thereon would inure to the benefit of the owner of the Boardwalk Expansion Site and not to the Partnership. In such event, the Partnership might have to close all or a portion of the expanded casino in order to comply with regulatory requirements, which could have a material adverse effect on the results of operations and financial condition of the Partnership. As of December 31, 1993, the Partnership had expended approximately $2.7 million in construction costs related to the Boardwalk Expansion Site. Pursuant to the terms of the Partnership Agreement, prior to amendment on June 25, 1993, the date of the consummation of the Offerings, which eliminated such distribution requirements, the Partnership was required to make certain periodic distributions to the Company and Trump sufficient to pay taxes attributable to distributions received from the Partnership, any amounts required to be paid to directors as fees or pursuant to indemnification obligations, premiums on directors' and officers' liability insurance and other reasonable general and administrative expenses. The Partnership was also required to distribute to the Company, to the extent of cash available therefrom, funds sufficient to enable the Company to pay dividends on, and the redemption price of its Stock Units. For the year ended December 31, 1993, such distributions were approximately $6.3 million. Pursuant to the terms of a Services Agreement with Trump Plaza Management Corp. ("TPM"), a corporation beneficially owned by Trump, in consideration for services provided, the Partnership pays TPM each year an annual fee of $1.0 million in equal monthly installments, and reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement, up to certain amounts. Under this Agreement, approximately $1.2 million was charged to expense for the year ended December 31, 1993. The Mortgage Note Indenture and the PIK Note Indenture restrict the ability of the Partnership to make distributions to its partners, including restrictions relating to the achievement of certain financial ratios. Subject to the satisfaction of these restrictions, the Partnership may make distributions to its partners with respect to their partnership interests. The Company. The Company's sole source of liquidity is, and will be, payments made by the Partnership in respect of the Partnership Note securing the Company's indebtedness, and distributions from the Partnership, if any, in respect of its Partnership interest. Holding. Holding has no business operations other than that associated with holding its partnership interest in the Partnership and as issuer of the PIK Notes and Warrants. Holding's sole source of liquidity is from distributions in respect of its interest in the Partnership. Prior to the Units Offering, Holding did not have any long-term or short-term indebtedness; upon consummation of the Units Offering on June 25, 1993, Holding issued $72.0 million of indebtedness comprised of $60.0 million of PIK Notes and $12.0 million of deferred warrant obligations. Holding's indebtedness will increase upon exercise of the Warrants and upon the issuance of additional PIK Notes in lieu of cash interest paid on the PIK Notes. On December 15, 1993, the Partnership elected to issue in lieu of cash, an additional $3.6 million in PIK Notes to satisfy its semi-annual PIK Note interest obligation. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. An index to the financial statements and required financial statement schedules is set forth at Item 14. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS. Management Prior to the merger of TP/GP into the Company, management of the affairs of the Partnership was vested in TP/GP. As of June 18, 1993, the date of such merger, the Company became the managing partner of the Partnership. As of such date, the Company was granted full authority to do all things deemed necessary or desirable of the operations, business and affairs of the Partnership. As currently constituted, the Board of Directors of the Company consists of Messrs. Trump, Nicholas L. Ribis, Jay Kramer and Don M. Thomas. As currently constituted, the board of directors of Holding Inc. consists of Messrs. Trump, Ribis, Ernest E. East, Kramer and Thomas. In addition, Holding Inc. acts as the managing partner of Holding. Trump is currently the sole beneficial owner of the Partnership, the Company, Holding and Holding Inc. Pursuant to the PIK Notes Indenture and the Mortgage Notes Indenture, the Company and Holding Inc. are each required to have at least two Independent Directors (as such term is defined by the American Stock Exchange, Inc.). The prior approval of the majority of the Company's Independent Directors will be required before the Partnership can engage in certain affiliate transactions. Set forth below, are the names, ages, positions and offices held with the Company, Holding and the Partnership and a brief account of the business experience during the past five years of each member of the Board of Directors and the executive officers of the Company, Holding and the Partnership. Donald J. Trump - Mr. Trump, 47 years old, has been a general partner of the Partnership and a 100% shareholder, director, Chairman of the Board of Directors, President and Treasurer of the Company, the managing general partner of the Partnership. Prior to the consummation of the Offerings, Trump was a 50% shareholder, director, Chairman of the Board of Directors, President and Treasurer of TP/GP. Trump was President and sole director of the Company from May 1986 to May 1992; and Chairman of the executive committee and President of the Partnership from May 1986 to May 1992. Trump has been Chairman of the Board of Partner Representatives of Trump's Castle Associates, the partnership that owns Trump's Castle ("TCA"), since May 1992; and was Chairman of the executive committee of TCA, from June 1985 to May 1992. Trump was Chairman of the executive committee of Trump Taj Mahal Associates, the partnership that owns the Taj Mahal ("TTMA"), from June 1988 to October 1991; and has been Chairman of the board of directors of the managing general partner of TTMA since October 1991; President and sole director of Trump Boardwalk since May 1986; and President of the Trump Organization, which has been in the business, through its affiliates and subsidiaries, of acquiring, developing and managing real estate properties for more than the past five years. Trump was a member of the board of directors of Alexander's Inc. from 1987 to March 1992. Nicholas L. Ribis - Mr. Ribis, 49 years old, has been the Chief Executive Officer of the Partnership since February 1991 and a member of the Executive Committee of the Partnership from April 1991 to May 29, 1992 and was a director and Vice President of TP/GP from May 1992 until its merger into the Company in June 1993. Mr. Ribis serves as the Chairman of the Atlantic City Casino Association. He has also been Chief Executive Officer of TCA and TTMA since March 1991; member of the executive committee of TCA from April 1991 to May 1992; member of the Board of Partner Representatives of TCA since May 1992; member of the executive committee of TTMA from April 1991 to October 1991; and member of the board of directors of the managing general partner of TTMA since October 1991. From January 1980 to January 1991, Mr. Ribis was Senior Partner in, and since February 1991, is Counsel to, the law firm of Ribis, Graham & Curtin, which serves as New Jersey legal counsel to all of the above-named companies, and certain of their affiliated entities, including the Company. Kevin DeSanctis - Mr. DeSanctis, 41 years old, was President of the Company from March 1991 until March 7, 1994 and was Chief Financial Officer of the Company from May to July 1992. Mr. DeSanctis was a director of TP/GP from May 29, 1992 until TP/GP's merger into the Company in June 1993 and has been President and Chief Operating Officer of the Partnership since March 1991. From August 1989 to February 1991, Mr. DeSanctis served as Vice President of Casino Operations of the Mirage Hotel and Casino in Las Vegas, Nevada. Mr. DeSanctis previously served as Vice President of Casino Operations of the Golden Nugget Hotel and Casino from April 1989 to August 1989; Senior Vice President of Casino Operations of Clark Management Company (d/b/a Dunes Hotel/Casino) from January 1988 to April 1989; Senior Vice President/Director of Casino Operations of the Aladdin Hotel & Casino from March 1987 to November 1987; Vice President/Director of Casino Operations of the Flamingo Hilton from January 1986 to February 1987 and in various other positions within the Las Vegas gaming industry prior thereto. William Velardo - Mr. Velardo, 39 years old, has been the acting Chief Operating Officer of the Company since March 7, 1994 and, prior thereto, was Vice President of Casino Operations of the Partnership since May 1991. Mr. Velardo served as an Administrative Assistant of the Partnership from March 1991 until receiving licensure in the position of Vice President of Casino Operations. From November 1989 to March 1991, Mr. Velardo served as Casino Manager at the Mirage Hotel and Casino in Las Vegas. Prior to his position at the Mirage, Mr. Velardo served in a variety of casino management positions for over 13 years, 11 of which were with Caesars Palace and Caesars Tahoe. Ernest E. East - Mr. East, 51 years old, was Secretary of TP/GP from May 1992 until its merger into the Company in June 1993 and has been Secretary of the Company since July 1992; Senior Vice President-Administrative and Corporate Affairs of the Partnership since July 1991; and Senior Vice President- Administrative and Corporate Affairs of TCA and TTMA since July 1991; member of the Board of Partner Representatives of TCA since May 1992; member of the board of directors of the managing general partner of TTMA since October 1991. Mr. East was formerly the Vice President-General Counsel of the Del Webb Corporation from January 1984 through June 1991. Jay Kramer - Mr. Kramer, 76 years old, is an attorney and labor relations specialist. Mr. Kramer was a Commissioner and Chairman of the New York Sate Labor Relations Board from 1954 through 1976, under five governors. Mr. Kramer was a director of TP/GP until its merger into the Company in June 1993 and has been a director of the Company since June 1993. Mr. Kramer served as a member of the Audit Committee of TTMA from July 1990 through October 1991, and as a member of the Audit Committee of TCA and the Partnership from August 1986 through May 1992. In 1981 and 1982, Mr. Kramer served as director, audit committee member and sole stockholder of Claridge Management Corporation, an entity formed to act as the managing general partner of Claridge Casino pending the licensing of the owner of such casino by the CCC. Mr. Kramer has been the impartial chairman (the automatic arbitrator of all disputes) in many industries, including the National Building Trade Congress, the fur industry, the pharmaceuticals industry, the deep sea tanker industry, Three Mile Island and numerous others. Don M. Thomas - Mr. Thomas, 62 years old, has been the Senior Vice President of Corporate Affairs of the Pepsi-Cola Bottling Co. of New York since January 1985. Mr. Thomas was the Acting Chairman, and a Commissioner, of the CRDA from 1985 through 1987, and a Commissioner of the CCC from 1980 through 1984. From 1974 through 1980, Mr. Thomas served as Vice President, General Counsel of the National Urban League. From 1966 through 1974, Mr. Thomas served in various capacities with Chrysler Corporation rising to the level of President-Auto Dealerships. Mr. Thomas was an attorney with American Airlines from 1957 through 1966. Mr. Thomas was a director of TP/GP until its merger into the Company in June 1993 and has been a director of the Company since June 1993. Mr. Thomas is an attorney licensed to practice law in the State of New York. Mitchell G. Etess - Mr. Etess, 36 years old, has been Senior Vice President of Marketing of the Partnership since December 1991 and Advertising Manager and Public Relations Manager of the Partnership's predecessor from December 1988 to December 1991. From January 1988 to December 1988, Mr. Etess was a vice president of the advertising agency of Gordon, Etess & Associates in Pinehurst, North Carolina. Mr. Etess was General Manager of the Holly Inn in Pinehurst, North Carolina from November 1986 to November 1987; Associate Manager of Club Corp. of America in Traverse City, Michigan from May 1986 to November 1986, and Manager of Grossinger's Hotel in New York from February 1985 to November 1985. Francis X. McCarthy, Jr. - Mr. McCarthy, 41 years old, was Vice President of Finance and Accounting of TP/GP from October 1992 until June 1993, the date of TP/GP's merger into the Company, and has been Senior Vice President of Finance and Administration of the Partnership since August 1990; Chief Accounting Officer of the Company since May 1992; Vice President and Chief Financial Officer of the Company since July 1992 and Assistant Treasurer of the Company since March 1991. Mr. McCarthy previously served in a variety of financial positions for Greater-Bay Hotel and Casino, Inc. from June 1980 through August 1990. John P. Burke - Mr. Burke, 46 years old, has been corporate treasurer of the Partnership since October 1991; corporate treasurer of TCA since October 1991; Vice President of The Trump Organization since September 1990; and member of the board of directors of TTMA since October 1991. Mr. Burke was an Executive Vice President and Chief Administrative Officer of Imperial Corporation of America from April 1989 through September 1990. From May 1980 through April 1989, Mr. Burke was Executive Vice President and Chief Financial Officer of Tamco Enterprises, Inc. Robert M. Pickus - Mr. Pickus, 38 years old, has been Vice President and General Counsel of the Partnership since December 1993 and was Senior Vice President and General Counsel of TCA, Secretary of Trump's Castle Funding, Inc. from June 1988 until December 1993 and General Counsel of TCA from June 1985 to June 1988. Mr. Pickus was also Secretary of Trump's Castle Hotel & Casino, Inc., an entity beneficially owned by Trump, from October 1991 until December 1993. Patricia M. Wild - Ms. Wild, 41 years old, was Assistant Secretary of the Company and Vice President and General Counsel of the Partnership from February 1991 until December 1993; Vice President and General Counsel of the Company from July 1992 until December 1993; and Associate General Counsel of the Partnership from May 1989 through January 1991. From December 1986 to April 1989, Ms. Wild served as a Deputy Attorney General on the Environmental Prosecutions Task Force of the New Jersey Department of Law and Public Safety, Division of Criminal Justice. From April 1983 to December 1986, Ms. Wild served as Deputy Attorney General with the New Jersey Division of Gaming Enforcement. All of the persons listed above have been qualified or licensed by the CCC. The employees of the Partnership serve at the pleasure of the Company, the managing general partner of the Partnership, subject to any contractual rights contained in any employment agreement. The officers of the Company serve at the pleasure of the Board of Directors of the Company. The officers of Holding Inc. serve at the pleasure of the board of directors of that company. Donald J. Trump, Nicholas L. Ribis and Ernest E. East served as either executive officers and/or directors of TTMA and its affiliated entities when such parties filed their petition for reorganization under chapter 11 of the Bankruptcy Code on July 17, 1991. The Second Amended Joint Plan of Reorganization of such parties was confirmed on August 28, 1991, and was declared effective on October 4, 1991. Donald J. Trump, Nicholas L. Ribis, Ernest E. East and John P. Burke also served as executive committee members, officers, and/or directors of TCA and its affiliated entities, at the time such parties filed a petition for reorganization under chapter 11 of the Bankruptcy Code on March 9, 1992. The First Amended Joint Plan of Reorganization of such parties was confirmed on May 5, 1992, and declared effective on May 29, 1992. Donald J. Trump, Nicholas L. Ribis, Ernest E. East and John P. Burke served as either executive officers and/or directors of the Partnership and its affiliated entities when such parties filed their petition for reorganization under chapter 11 of the Bankruptcy Code in March 1992. The First Amended Joint Plan of Reorganization of such parties was confirmed on April 30, 1992, and was declared effective on May 29, 1992. Trump was a partner of Plaza Operating Partners Ltd. when it filed a petition for reorganization under chapter 11 of the Bankruptcy Code on November 2, 1992. The plan of reorganization for Plaza Operating Partners Ltd. was confirmed on December 11, 1992 and declared effective in January 1993. John P. Burke was Executive Vice President and Chief Administrative Officer of Imperial Corporation of America ("Imperial"), a thrift holding company whose major subsidiary, Imperial Savings, was seized by the Resolution Trust Corporation in February 1990. Subsequently, in February 1990, Imperial filed a petition for reorganization under chapter 11 of the Bankruptcy Code. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Compensation Holding, the Company and the Partnership do not offer their executive officers stock option or stock appreciation right plans, long-term incentive plans or defined benefit pension plans. The following table sets forth compensation paid or accrued during the years ended December 31, 1993, 1992 and 1991 to the Chief Executive Officer and each of the four most highly compensated executive officers of the Partnership whose cash compensation, including bonuses and deferred compensation, exceeded $100,000 for the year ended December 31, 1993. Executive Officers of the Company do not receive any additional compensation for serving in such capacity. Compensation accrued during one year and paid in another is recorded under the year of accrual. Information relating to long-term compensation is inapplicable and has therefore been omitted from the table. - ----------- (1) Represents the dollar value of annual compensation not properly categorized as salary or bonus, including amounts reimbursed for income taxes and director's fees. Following SEC rules, perquisites and other personal benefits are not included in this table if the aggregate amount of that compensation is the lesser of either $50,000 or 10% of the total of salary and bonus for that officer. (2) Represents vested and unvested contributions made by the Partnership under the Trump Plaza Hotel and Casino Retirement Savings Plan. Funds accumulated for an employee, which consist of a certain percentage of the employee's compensation plus Partnership contributions equalling 50% of the participant's contributions, are retained until termination of employment, attainment of age 59 1/2 or financial hardship, at which time the employee may withdraw his or her vested funds. (3) Mr. Ribis devotes approximately one-third of his professional time to the affairs of the Partnership. Mr. Ribis is also employed as the chief executive officer of the Other Trump Casinos; his compensation from the Other Trump Casinos is not included in the table. (4) Mr. DeSanctis resigned from all of his positions with the Company on March 7, 1994. (5) Mr. Velardo has been serving as acting Chief Operating Officer since March 7, 1994. Employment Agreements The Partnership has an employment agreement with Nicholas L. Ribis pursuant to which Mr. Ribis acts as Chief Executive Officer of the Partnership. The agreement, which expires in September 1996, provides for an annual salary of $550,000. The salary increases by ten percent for each of the second and third years of the agreement. Upon execution of the employment agreement, Mr. Ribis received a $250,000 signing bonus. In the event the Partnership, or any entity which acquires substantially all of the equity interests or assets of the Partnership, proposes to engage in an offering of common shares to the public, the Partnership and Mr. Ribis have agreed to negotiate new compensation arrangements which shall include equity participation for Mr. Ribis. Mr. Ribis is also chief executive officer of TTMA and TCA, the partnerships that own the Other Trump Casinos, and receives compensation from such entities for such services. Mr. Ribis devotes approximately one-third of his professional time to the affairs of the Partnership. All other executive officers of the Partnership, except Messrs. East and Burke, devote substantially all of their time to the business of the Partnership. The Partnership had an employment agreement with Kevin DeSanctis, former President and Chief Operating Officer of Trump Plaza. The agreement was terminated upon the resignation of Mr. DeSanctis. Mr. DeSanctis received $205,000 of salary in 1994. The Partnership has an employment agreement with Ernest E. East, Esq., who is Senior Vice President of Administration and Corporate Affairs of the Partnership. The agreement, which expires in June 1995, provides for an annual salary of $100,000. Mr. East also has similar employment agreements with each of TTMA and TCA. Mr. East devotes approximately one-third of his professional time to the affairs of the Partnership. The Partnership had an employment agreement with William Velardo, who until March 7, 1994 was the Vice President of Casino Operations of the Partnership. That agreement expired on March 12, 1994. The Partnership has not yet negotiated a separate employment agreement with Mr. Velardo, who, as of March 7, 1994, has been the acting Chief Operating Officer of the Company. The Partnership has a severance agreement with Robert M. Pickus, Esq., who is the Vice President/General Counsel of the Partnership. The agreement provides that upon Mr. Pickus' termination other than for cause (as defined in the agreement) or loss of his casino key employee license from CCC, the Partnership will pay Mr. Pickus a severance payment equal to the amount of his salary at its then current rate for a period of one year, which is anticipated to be in excess of $150,000. All of the above agreements provide for discretionary bonuses and/or signing bonuses. Compensation of Directors Each director of the Company, receives an annual fee of $50,000 and $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the Board of Directors of the Company. Each director of TP/GP, other than Trump, received an annual fee of $50,000 and $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the board of directors of TP/GP. In addition, each member of the TP/GP Audit Committee received a fee of $1,500 for each meeting attended. Upon consummation of the PIK Notes Offerings, all members of the board of directors of Holding Inc., other than Trump, received an annual fee of $50,000 and a fee of $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the Board. Such fees were paid to persons who also act as officers or employees of the Partnership. Compensation Committee Interlocks and Insider Participation Holding does not have a compensation committee and its officers serve without separate compensation. In general, the compensation of executive officers of the Partnership is determined by the Board of Directors of the Company, composed of Donald J. Trump, Nicholas L. Ribis, Jay Kramer and Don M. Thomas. The compensation of Nicholas L. Ribis and Kevin DeSanctis is set forth in their employment agreements with the Partnership, pursuant to which the Partnership has delegated the responsibility over certain matters, such as bonuses, to Trump. See "Employment Agreements" above. No officer or employee of Trump Plaza, other than Messrs. Ribis and DeSanctis, who serve on the Board of Directors of the Company, participated in the deliberations of the Board of Directors of the Company concerning executive compensation. Executive officers of the Company do not receive any additional compensation for serving in such capacity. The SEC requires issuers to disclose the existence of any other corporation in which both (i) an executive officer of the registrant serves on the board of directors and/or compensation committee, and (ii) a director of the registrant serves as an executive officer. Messrs. Ribis, East and Burke, executive officers of the Partnership, have served on the board of directors of other entities in which members of the Board of Directors of the Company and TP/GP (namely, Messrs. Trump and Ribis) served and continue to serve as executive officers. Management believes that such relationships have not affected the compensation decisions made by the Board of Directors of the Company and TP/GP in the last fiscal year. Messrs. Ribis, East and Burke serve on the board of directors of Taj Mahal Holding Corp., which holds an indirect equity interest in TTMA, the partnership that owns the Taj Mahal, of which Messrs. Trump and Ribis are executive officers. Such persons also serve on the board of directors of TM/GP Corporation (a subsidiary of Taj Mahal Holding Corp.), the managing general partner of TTMA, of which Messrs. Trump and Ribis are executive officers. Mr. Ribis is compensated by TTMA for his services as its chief executive officer; Mr. East is compensated by TTMA for his services as its vice president. Mr. Ribis also serves on the board of directors of Trump Taj Mahal Realty Corp. ("Taj Realty Corp."), which leases certain real property to TTMA, of which Trump is an executive officer. Trump, however, does not receive any compensation for serving as an executive officer of Taj Realty Corp. Mr. East also serves on the Board of Partner Representatives of TCA, the partnership that owns Trump's Castle, of which Messrs. Trump and Ribis are executive officers. Mr. Ribis receives compensation from TCA for acting as its chief executive officer. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Trump has owned 100% of the Common Stock since June 25, 1993. Trump has sole voting and investment power regarding the Common Stock owned by him. In connection with the PIK Note Offering which was consummated on June 25, 1993, TP/GP was merged with and into the Company, and the Company became the managing general partner of the Partnership. Trump contributed his interest in the Partnership to Holding, which is beneficially-owned by Trump. Since such date, the Company and Holding have been the sole partners in the Partnership. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Although the Partnership has not fully considered all of the areas in which it intends to engage in transactions with affiliates of the partners, it is free to do so, subject to certain restrictions. Payments to affiliates in connection with any such transactions are governed by the provisions of the Mortgage Note Indenture and the PIK Note Indenture which generally require that such transactions be on terms as favorable to the Partnership as would be obtainable from an unaffiliated party, and requires the approval of a majority of the Independent Directors of the Company for certain affiliated transactions. The Partnership has engaged in some limited intercompany transactions with TCA and TTMA. The Partnership utilized TCA's print shop operations (until it closed in February 1991) and utilized its fleet maintenance and limousine services until April 1991. The Partnership paid TCA approximately $317,000 in 1991 and paid to TTMA approximately $1,000, $242,000 and $0 in 1993, 1992 and 1991, respectively, for fleet maintenance and limousine services. In the future the Partnership may be required to make payments to TTMA for the continued use of its limousine bays. Payments made by the Partnership to TCA for services provided by its print shop approximated $4,000 in 1991. The Partnership also has joint property insurance coverage with TCA and TTMA for which the annual premium paid by the Partnership was $251,000 for the twelve months ended May 1993. The Partnership also leases from TTMA certain office facilities located in Pleasantville, New Jersey. In 1993, 1992 and 1991, lease payments by the Partnership to TTMA totalled approximately $30,000, $138,000 and $98,000, respectively, and to TCA (the former owner of such facility) totalled approximately $42,000 in 1991. In 1990, lease payments for such leases to TCA totalled approximately $135,000. Such lease terminated on March 19, 1993, and the Partnership vacated the premises. Through February 1, 1993, the Partnership also leased from Trump approximately 120 parking spaces at the Penthouse Site for approximately $5.50 per parking space per day, with payments under such arrangement for the year ended December 31, 1993 and December 31, 1992 totalling $21,000 and $227,000 respectively. The Partnership also leased portions of its warehouse facility located in Egg Harbor Township, New Jersey to TTMA until 1991. Lease payments by TTMA to the Partnership totalled $46,000 and $23,000 in 1991 and 1990, respectively. The Partnership also leased such warehouse to TCA until January 31, 1994; lease payments by TCA to the Partnership totalled $15,000, $14,000, and $18,000 in 1993, 1992 and 1991, respectively. Until January 1991, Helicopter Air Services, Inc. (d/b/a Trump Air) ("Trump Air"), a Delaware corporation wholly-owned by Trump, provided regularly scheduled helicopter services to the public between New York City and Atlantic City. In addition, the Partnership provided complimentary carriage to certain patrons of Trump Plaza on an Aerospatiale Super Puma helicopter that was operated by Trump Air and owned by another corporation that is wholly-owned by Trump. Trump Air was reimbursed by the Partnership for its actual costs and expenses incurred in rendering helicopter services provided by the Super Puma. All other helicopter services provided by Trump Air to patrons of Trump Plaza were paid for by the Partnership at Trump Air's prevailing ticket rates. In 1990, the Partnership paid Trump Air approximately $231,000 for air services provided to patrons of Trump Plaza. Trump and Trump Boardwalk collectively own 100% of the interests in Seashore Four. Seashore Four is the fee owner of a parcel of land constituting a portion of the Casino Parcel, which it leases to the Partnership pursuant to the SFA Lease, a long-term, triple-net lease. Seashore Four was assigned the lessor's interest in the existing SFA Lease in connection with its acquisition of fee title to such parcel from a non-affiliated third party in November 1983. The SFA Lease was entered into by the Partnership with such third party on an arm's-length basis. The Partnership recorded rental expenses of approximately $900,000, $900,000 and $900,000 in 1993, 1992 and 1991, respectively, concerning rent owed to Seashore Four. Trump and Trump Seashore Associates, Inc. collectively own 100% of the interests in Trump Seashore Associates ("Trump Seashore"). Trump Seashore is the fee owner of a parcel of land constituting a portion of the Casino Parcel, which it leases to the Partnership pursuant to the Trump Seashore Lease, a long-term, triple-net lease. In July 1988, Trump Seashore exercised a $10 million option to purchase the fee title to such parcel from a non-affiliated third party. In connection therewith, Trump Seashore was assigned the lessors' interest in the Trump Seashore Lease, which interest has, however, been transferred to UST. See "Properties." The Partnership paid rental payments to Trump Seashore of approximately $1.0 million, $1.0 million and $1.1 million in 1993, 1992 and 1991, respectively. The Partnership has separately agreed to reimburse Trump for any payments which he may make under (i) a note (the "Harrah's Note") for which Trump and the Partnership are co-makers and which constitutes part of the redemption price for Harrah's Atlantic City, Inc.'s ("HAC") prior interests in the Partnership and Seashore Four, which were redeemed in 1986, pursuant to a Redemption Agreement dated as of March 11, 1986; and (ii) his or Trump Boardwalk's indemnity of HAC under the Redemption Agreement, insofar as it relates to the Partnership. Trump and Trump Boardwalk have agreed to assign to the Partnership any payment either receives pursuant to HAC's and The Promus Companies Incorporated's (HAC's parent corporation) indemnity, insofar as it relates to the Partnership. The Harrah's Note was repaid on May 16, 1993. Prior to the consummation of the Offerings, the board of directors of TP/GP authorized the Partnership to lease, on a per diem basis, certain real property in Florida owned by Trump, known as "Mar-a-lago," to entertain certain patrons of Trump Plaza. To date, the Partnership has not leased Mar-a-lago, and the Partnership currently has no specific plans to lease Mar-a-lago in the future; nevertheless, the Partnership may enter into such arrangements in the future. In May of 1991, the Partnership entered into a lease with Atlantic City Explorers Club of which Hugh B. McCluskey, a former partner of the law firm of Ribis, Graham & Curtin, is President, whereby the Partnership leased certain property in Atlantic City for $60,000.00 per annum. Nicholas L. Ribis, the Chief Executive Officer of the Partnership, is Of Counsel to such law firm. The lease was terminated in January 1993. Trump Regency. In June 1989, Trump Crystal Tower Associates Limited Partnership, a New Jersey limited partnership wholly-owned by Trump, acquired from Elsinore Shore Associates all of the assets constituting the former Atlantis casino hotel, which is located on The Boardwalk adjacent to the Atlantic City Convention Center on the opposite side from Trump Plaza. Prior to such acquisition, all of the Atlantis' gaming operations were discontinued. The facility was renamed the Trump Regency Hotel and leased to the Partnership, which operated it solely as a non-casino hotel. As part of the Restructuring, the lease was terminated and the Partnership issued to Chemical Bank ("Chemical"), the assignee of rents payable under such lease, a promissory note in the original principal amount of $17.5 million (the "Regency Note"). At such time, title to the Trump Regency was transferred by Trump to ACFH Inc. ("ACFH"), a wholly owned subsidiary of Chemical. Since that time, the Trump Regency has been operated by ACFH as a non-casino hotel. The Partnership repaid the Regency Note with a portion of the proceeds of the Offerings. In December 1993, Trump entered into an option agreement (the "Chemical Option Agreement") with Chemical and ACFH. The Chemical Option Agreement grants to Trump an option to purchase (i) the Trump Regency (including the land, improvements and personal property used in the operation of the hotel) and (ii) certain promissory notes made by Trump and/or certain of his affiliates and payable to Chemical (the "Chemical Notes") which are secured by certain real estate assets located in New York, unrelated to Trump Plaza. As of December 31, 1993, the aggregate amount owed by Trump and his affiliates under the Chemical Notes (none of which constitutes an obligation of Plaza Associates) was approximately $65 million. The aggregate purchase price payable for the assets subject to the Chemical Option Agreement is $80 million. Under the terms of the Chemical Option Agreement, $1 million was required to be paid for the option by January 5, 1994. The option expires on May 6, 1994, provided that the option may be extended until June 30, 1994 by the payment of an additional $250,000 on or before that date. The $1 million payment (and the $250,000 payment, if made) may be credited against the $80 million purchase price. The Chemical Option Agreement does not allocate the purchase price among the assets subject to the option or permit the option to be exercised for some, but not all, of such assets. In connection with the execution of the Chemical Option Agreement, Trump agreed with the Partnership that, if Trump is able to acquire the Trump Regency pursuant to the exercise of the option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. Trump further agreed that Trump Plaza would not be required to pay any additional consideration to Trump in connection with any assignment of the option to purchase the Trump Regency to the Partnership. In consideration of the foregoing agreements, the Partnership agreed to make the $1 million option payment to Chemical (subject to refund by Trump if the option is terminated as a result of certain specified events). On January 5, 1994, the Partnership obtained the approval of the CCC to make the $1 million payment, and the payment was made on that date. Boardwalk Expansion Site. On February 2, 1993, the Partnership acquired the Option from Trump to enter into a long-term lease of the Boardwalk Expansion Site, on which the partially constructed Penthouse Hotel is located. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." The portion of the Boardwalk Expansion Site owned by Trump (which constitutes substantially all of the Boardwalk Expansion Site) is encumbered by a mortgage securing a loan with a balance of approximately $52.0 million of principal and accrued interest. In June 1993 Trump and the lender which holds such mortgage negotiated the terms of a restructuring of such loan. In connection with such restructuring Trump transferred title to the property to such lender, on the date the Offerings are consummated, entered into the Boardwalk Expansion Site Lease. The Boardwalk Expansion Site Lease has a term of five years during which time Trump will be obligated to pay the lender $260,000 per month in lease payments. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and the obligation to make some or all of the payments thereunder subject to certain limitations, including regulatory approval and the satisfaction of the conditions set forth in the Mortgage Note Indenture and the PIK Note Indenture. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." In connection with the Offerings, the Partnership acquired the Option to purchase the Boardwalk Expansion Site. Until such time as the Option is exercised or expires, the Partnership will be obligated to pay the net expenses associated with the Boardwalk Expansion Site. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." Under the Option, the Partnership has the right to purchase the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until 1998, in consideration of which the Partnership will pay certain expenses of the Boardwalk Expansion Site, including annual lease payments for the portion of the Boardwalk Expansion Site currently leased by Trump from a third party, which lease payments were $86,058 for 1993 and $83,500 for 1992 and increase annually based on the consumer price index, as well as current real estate taxes (approximately $1.2 million per year based upon current assessed valuation). See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." Acquisition of the Boardwalk Expansion Site by the Partnership would under certain circumstances (provided there are no events of default under the Boardwalk Expansion Site Lease or the Option and provided that certain other events had not theretofore or do not thereafter occur) discharge Trump's obligation to such lender in full. Management believes that the Boardwalk Expansion Site will be useful to the operation of Trump Plaza as the site of the future expansion of the Partnership's hotel operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" and "Business -- Possible Expansion Sites." Services Agreement On June 24, 1993, The Partnership and Trump Plaza Management Corp. ("TPM") entered into an Amended and Restated Services agreement (the "Services Agreement") pursuant to which TPM is required to provide to the Partnership, from time to time when reasonably requested, consulting services on a non-exclusive basis, relating to marketing, advertising, promotional and other similar and related services (the "Services") with respect to the business and operations of the Partnership. In addition, the Services Agreement contains a non-exclusive "license" of the "Trump" name. TPM is not required to devote any prescribed amount of time to the performance of its duties. In consideration for the Services, the Partnership pays TPM an annual fee of $1.0 million in equal monthly installments. In addition to such annual fee, the Partnership reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement. The Partnership paid TPM $1,247,000 and $708,000 in 1993 and 1992, respectively, for the Services. Pursuant to the Services Agreement, the Partnership will agree to hold TPM, its officers, directors and employees harmless from and against any loss arising out of or in connection with the performance of the Services and to hold Trump harmless from and against any loss arising out of the license of the "Trump" name. Indemnification Agreements The directors of the Company and the directors of TP/GP (other than Trump) serving prior to the Offerings have entered into separate indemnification agreements with the Partnership pursuant to which such persons are afforded the full benefits of the indemnification provisions of the Partnership Agreement. The Partnership has also entered into an Indemnification Trust Agreement with an Indemnification Trustee (the "Trust Agreement") pursuant to which the sum $100,000 has been deposited by the Partnership with the Indemnification Trustee for the benefit of the directors of the Company and the Class B Directors of TP/GP serving prior to the Offerings to provide a source for indemnification for such persons if the Partnership, the Company or TP/GP, as the case may be, fails to immediately honor a demand for indemnification by such persons. The Trust Agreement also provides that the directors of the Company and TP/GP (other than Trump) serving prior to the Offerings, under certain circumstances, are entitled to request that the lender under the Working Capital Facility deposit funds with the Indemnification Trustee for distribution to such persons in the event that they are entitled to indemnification for the Company, the Partnership or TP/GP and such indemnity is not provided. Not more than $200,000 per director (or an aggregate of $1.0 million) may be drawn down for such purpose; the Partnership is obligated to repay all such amounts. In connection with the Offerings, the Indemnification Agreements with the directors of the Company and the Class B Directors of TP/GP were amended to provide that (i) the Working Capital Facility would not be terminated or amended in a manner adverse to such directors unless prior thereto there is deposited an additional aggregate amount of $600,000 in the Indemnification Trust Fund for the benefit of such directors, and (ii) the Partnership would maintain directors' and officers' insurance covering such persons during the term of the Indemnification Agreements; provided, however, that if such insurance would not be available on a commercially practicable basis, the Partnership could, in lieu of obtaining such insurance, annually deposit an amount in the Indemnification Trust Fund equal to $500,000 for the benefit of such directors; provided, further, that deposits relating to the failure to obtain such insurance shall not exceed $2.5 million. Since the Working Capital Facility was terminated upon consummation of the Offerings, the Partnership deposited $600,000 in the Indemnification Trust Fund in June 1993. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial Statements. See the Index immediately following the signature page. (b) Reports on Form 8-K. The Registrant did not file any reports on Form 8-K during the last quarter of the year ended December 31, 1993. (c) Exhibits. Exhibit No. Exhibit - ----------- ------- 3.1 Amended and Restated Certificate of Incorporation of the Company. (1) 3.1.1 Form of Second Amended and Restated Certificate of Incorporation of the Company. (8) 3.2 Amended and Restated By-Laws of the Company. (1) 3.3 Amended and Restated Certificate of Incorporation of TP/GP. (1) 3.4 Amended and Restated By-Laws of TP/GP. (1) 3.5 Certificate of Incorporation of Holding Inc. (8) 3.6 By-Laws of Holding. (8) 3.7 Second Amended and Restated Partnership Agreement of the Partnership. (9) 3.8 Partnership Agreement of Holding. (8) 3.8.1 Amendment No. 1 to the Partnership Agreement of Holding. (8) 3.9 Agreement and Plan of Merger between TP/GP and the Company. (8) 4.1 Mortgage Note Indenture, among the Company, as issuer, the Partnership, as guarantor, and the Mortgage Note Trustee, as trustee. (9) 4.2 Indenture of Mortgage, between the Partnership, as Mortgagor, and the Company, as Mortgagee. (9) 4.3 Assignment Agreement between the Company and the Mortgage Note Trustee. (9) 4.4 Assignment of Operating Assets from the Partnership to the Company. (9) 4.5 Assignment of Leases and Rents from the Partnership to the Company. (9) 4.6 Indenture of Mortgage between the Partnership and the Mortgage Note Trustee (the Guarantee Mortgage). (9) 4.7 Assignment of Leases and Rents from the Partnership to the Mortgage Note Trustee. (9) 4.8 Assignment of Operating Assets from the Partnership to the Mortgage Note Trustee. (9) 4.9 Partnership Note. (9) 4.10 Mortgage Note (included in Exhibit 4.1). (9) 4.11 Pledge Agreement of the Company in favor and for the benefit of the Trustee. (9) 4.12 Indenture between Holding, as Issuer, and the PIK Note Trustee, as trustee. (9) 4.13 PIK Note (included in Exhibit 4.12). (9) 4.14 Warrant Agreement. (8) 4.15 Warrant (included in Exhibit 4.14). (8) 4.16 Pledge Agreement of Holding in favor and for the benefit of the PIK Note Trustee. (8) 10.10 Agreement of Lease, dated as of July 1, 1980, by and between SSG Enterprises, as Lessor and Atlantic City Seashore 2, Inc., as Lessee, as SSG Enterprises' interest has been assigned to Seashore Four, and as Atlantic City Seashore 2, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.11 Agreement of Lease, dated July 11, 1980, by and between Plaza Hotel Management Company, as Lessor, and Atlantic City Seashore 3, Inc., as Lessee, as Atlantic City Seashore 3, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.12 Agreement of Lease, dated as of July 1, 1980, by and between Magnum Associates and Magnum Associates II, as Lessor and Atlantic City Seashore 1, Inc., as Lessee, as Atlantic City Seashore 1, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.13-10.15 Intentionally omitted. 10.16 Trump Plaza Hotel and Casino Retirement Savings Plan effective as of November 1, 1986. (2) 10.17-10.20 Intentionally omitted. 10.21 Assignment of Lease, dated as of July 28, 1988, by and between Magnum Associates and Magnum Associates II, as assignor, Trump Seashore Associates, as assignee, and Trump Plaza Associates, as lessee. (5) 10.22-10.23 Intentionally omitted. 10.24 Employment Agreement, dated January 28, 1991, between the Partnership and Kevin DeSanctis. (5) 10.24.1 Amendment to Employment Agreement, dated August 6, 1992, between the Partnership and Kevin DeSanctis. (7) 10.25 Intentionally omitted. 10.26 Employment Agreement, dated as of June 1, 1992 between the Partnership and Ernest E. East. (1) 10.27 Employment Agreement, dated as of March 13, 1991 between the Partnership and William Velardo. (3) 10.28 Option Agreement, dated as of February 2, 1993 between Trump and the Partnership. (3) 10.29 Appraisal of Trump Plaza by Appraisal Group International, dated March 5, 1993. (8) 10.30 Amended and Restated Services Agreement between the Partnership and Trump. (6) 10.31 Working Capital Facility between the Partnership and Belmont Fund, L.P. (1) 10.31.1 Mortgage and Security Agreement of the Partnership in favor of Belmont Fund, L.P. (8) 10.31.2 Assignment of Rents and Leases: by the Partnership to Belmont Fund L.P., dated May 29, 1992. (8) 10.31.3 Assignment of Operating Assets: by the Partnership to Belmont Fund L.P., dated May 29, 1992. (8) 10.32.1 Mortgage: from Donald J. Trump, Nominee to Emil F. Aysseh, Trustee dated January 12, 1983. (8) 10.32.2 Mortgage: from Donald J. Trump, Nominee to Emil F. Aysseh, Trustee dated June 23, 1983. (8) 10.32.3 Mortgage Consolidation, Modification, and Extension Agreement: dated June 23, 1983. (8) 10.32.4 Partial Assignment of Mortgage: (1/3 interest) by Alfred Aysseh to New Canaan Bank Trust Company. (8) 10.32.5 Partial Assignment of Mortgage: (1/3 interest) by New Canaan Bank and Trust Company to Alfred Aysseh. (8) 10.32.6 Assignment of Mortgage: Emil F. Aysseh, Trustee to Community National Bank and Trust Company of New York. (8) 10.32.7 Mortgage Note and Mortgage Modification Agreement: by and between Emil F. Aysseh, Trustee and Donald J. Trump, Nominee dated January 10, 1992. (8) 10.33 Mortgage: from Donald J. Trump, Nominee to Albert Rothenberg and Robert Rothenberg, dated October 3, 1983. (8) 10.34 Mortgage: made by Harrah's Associates to Adeline Bordonaro, dated January 28, 1986. (8) 10.35 Mortgage: made by the Partnership to The Mutual Benefit Life Insurance Company, dated October 5, 1990. (8) 10.35.1 Collateral Assignment of Leases: made by the Partnership to The Mutual Benefit Life Insurance Company, dated October 5, 1990. (8) 10.36 Form of Option between the Partnership and Midlantic Bank. (9) 10.37 Form of Lease between Trump and Midlantic Bank. (8) 10.38 Employment Agreement between the Partnership and Nicholas L. Ribis. 10.39 Severance Agreement between the Parnership and Robert M. Pickus. 25 Power of Attorney of directors and certain officers of the Company (included in signature page). (8) - ------------ (1) Incorporated herein by reference to the Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. (2) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the year ended December 31, 1986. (3) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the year ended December 31, 1992. (4) Incorporated herein by reference to the identically numbered Exhibit in the Company's Registration Statement on Form S-1, Registration No. 33-4604, declared effective on May 9, 1986. (5) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. (6) Previously filed in Holding's Registration Statement on Form S-1, Registration No. 33-58608. (7) Incorporated herein by reference to the Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992. (8) Incorporated herein by reference to the identically numbered Exhibit in the Company's and the Partnership's Registration Statement on Form S-1, Registration No. 33-58602. (9) Incorporated herein by reference to the identically numbered Exhibit in Holding's Registration Statement on Form S-1, Registration No. 33-58608. (d) Financial Statement Schedules. See the Index immediately following the signature page. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Company and registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized, in the City of New York, State of New York, on the 30th day of March, 1994. TRUMP PLAZA HOLDING ASSOCIATES By: Trump Plaza Holding, Inc. Its Managing General Partner ----------------------- By: Donald J. Trump Title: President TRUMP PLAZA FUNDING, INC. ------------------------ By: Donald J. Trump Title: President Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the registrants and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- TRUMP PLAZA FUNDING, INC. By: - ------------------------ Donald J. Trump Principal Executive March 30, 1994 Officer By: - ------------------------ Francis X. McCarthy Jr. Principal Financial March 30, 1994 and Accounting Officer By: - ------------------------ Donald J. Trump Director March 30, 1994 By: - ------------------------ Nicholas L. Ribis Director March 30, 1994 By: - ------------------------ Jay Kramer Director March 30, 1994 By: - ------------------------ Don M. Thomas Director March 30, 1994 TRUMP PLAZA HOLDING ASSOCIATES By: Trump Plaza Holding, Inc. its Managing General Partner By: - ------------------------ Donald J. Trump Chief Executive Officer March 30, 1994 By: - ------------------------ Francis X. McCarthy Jr. Principal Financial March 30, 1994 and Accounting Officer By: - ------------------------ Donald J. Trump Director March 30, 1994 By: - ------------------------ Nicholas L. Ribis Director March 30, 1994 By: - ------------------------ Ernest E. East Director March 30, 1994 By: - ------------------------ Jay Kramer Director March 30, 1994 By: - ------------------------ Don M. Thomas Director March 30, 1994 Reports of Independent Public Accountants......... Balance Sheets of Trump Plaza Funding, Inc. as of December 31, 1993 and 1992................ Statements of Income of Trump Plaza Funding, Inc. for the years ended December 31, 1993, 1992 and 1991................................... Statements of Capital of Trump Plaza Funding, Inc. for the Years Ended December 31, 1993, 1992 and 1991................................... Statements of Cash Flows of Trump Plaza Funding, Inc. for the Years Ended December 31, 1993, 1992 and 1991................................... Report of Independent Public Accountants. Consolidated Balance Sheets of Trump Plaza Holding Associates and Trump Plaza Associates as of December 31, 1993 and 1992...................... Consolidated Statements of Operations of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Capital (Deficit) of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991........................................ Consolidated Statements of Cash Flows of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991. Notes to Financial Statements of Trump Plaza Funding, Inc., Trump Plaza Holding Associates and Trump Plaza Associates.......................... Schedule II Amounts Receivable (Payable) From (To) Related Parties, Underwriters, Promoters, and Employees other than Related Parties.......... V Property and Equipment............................ VI Accumulated Depreciation and Amortization of Property and Equipment.......... VIII Valuation and Qualifying Accounts............... X Supplementary Income Statement Information...... Other Schedules are omitted for the reason that they are not required or are not applicable, or the required information is shown in the consolidated financial statements or notes thereto REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Trump Plaza Funding, Inc.: We have audited the accompanying balance sheets of Trump Plaza Funding, Inc. (a New Jersey corporation) as of December 31, 1993 and 1992, and the related statements of income and retained earnings 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 Trump Plaza Funding, 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. ARTHUR ANDERSEN & CO. Roseland, New Jersey February 18, 1994 TRUMP PLAZA FUNDING, INC. BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS DECEMBER 31, DECEMBER 31, 1993 1992 ----------- ----------- CURRENT ASSETS: Cash $ 2,000 $ 2,000 Mortgage Interest Receivable 1,495,000 7,950,000 Receivable From Partnership 974,000 4,228,000 ----------- ----------- Total current assets 2,471,000 12,180,000 Mortgage Note Receivable 325,859,000 225,000,000 Receivable From Partnership 2,949,000 - Investment in Preferred Partnership Interest - 58,092,000 ----------- ----------- Total assets $331,279,000 $295,272,000 =========== =========== LIABILITIES AND CAPITAL CURRENT LIABILITIES: Accrued Interest Payable $ 1,495,000 $ 7,950,000 Income Taxes Payable 974,000 2,086,000 Dividends Payable - 2,026,000 ----------- ---------- Total current liabilities 2,469,000 12,062,000 10 7/8% Mortgage Bonds, net of discount due 2001 (Notes 1, 2 and 4) 325,859,000 - 12% Mortgage Bonds, due 2002 (Notes 1, 2 and 4) - 225,000,000 Deferred Income Taxes Payable 2,949,000 116,000 ----------- ----------- Total liabilities 331,277,000 237,178,000 ----------- ----------- Commitments and Contingencies (Note 7) Preferred Stock, 3,600,893 authorized, 2,999,580 issued and outstanding in 1992 - 58,092,000 Common Stock, $.00001 par value 3,600,893 authorized, 2,999,580 issued and outstanding in 1992 - - Common Stock, $.01 par value, 1,000 shares authorized, 100 shares issued and outstanding, at December 31, 1993 and none in 1992 - - Additional Paid in Capital 2,000 2,000 Retained Earnings - - ----------- ----------- Total liabilities and capital $331,279,000 $295,272,000 =========== =========== The accompanying notes to financial statements are an integral part of these balance sheets. TRUMP PLAZA FUNDING, INC. STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ----------- ---------- ----------- Interest Income From Partnership $ 32,642,000 $ 27,720,000 $ 30,444,000 Preferred Partnership Investment Income 3,993,000 4,468,000 - Reimbursement for Income Taxes 1,802,000 2,202,000 - Interest Expense (32,642,000) (27,720,000) (30,444,000) Directors' Fees and Related Expenses (497,000) (224,000) - ----------- ----------- ------------ Income Before Provision for Taxes 5,298,000 6,446,000 - Provision for Income Taxes 1,802,000 2,202,000 - ----------- ----------- ------------ Net Income $ 3,496,000 $ 4,244,000 $ - =========== =========== =========== The accompanying notes to financial statements are an integral part of these statements. TRUMP PLAZA FUNDING, INC. STATEMENTS OF CAPITAL FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Common Stock ------------ Additional Number of Paid In Retained Shares Amount Capital Earnings Total --------- -------- ---------- ------------ ---------- Balance, December 31, 1993 200 $ 2,000 $ - $ - $ 2,000 Net Income - - - - - --------- -------- --------- ----------- --------- Balance, December 31, 1991 200 2,000 - - 2,000 Net Income - - - 4,244,000 4,244,000 Accrued dividends on preferred stock - - - (4,126,000) (4,126,000) Preferred Stock Accretion - - - (342,000) (342,000) Capital contribution from Partnership - - - 224,000 224,000 Redemption of stock units upon consummation of offering, effective May 29, 1992 (200) (2,000) - - (2,000) Issuance of stock upon consummation of offering effective May 29, 1992 2,999,580 - 2,000 - 2,000 --------- ------- ---------- --------- ---------- Balance, December 31, 1992 2,999,580 - 2,000 - 2,000 Net Income - - - 3,496,000 3,496,000 Accrued dividends on preferred stock - - - (3,678,000) (3,678,000) Preferred stock accretion - - - (315,000) (315,000) Capital contribution from Partnership - - 40,000,000 497,000 40,497,000 Capital contribution from Donald J. Trump - - 35,000,000 - 35,000,000 Redemption of Preferred Stock - - (75,000,000) - 75,000,000) Redemption of Stock Units upon consummation of offering, effective June 25, 1993 (2,999,580) - - - - Issuance of stock upon consummation of offering, effective June 25, 1993 100 - - - - -------- ------- ----------- -------- --------- Balance, December 31, 1993 100 $ - $ 2,000 $ - $ 2,000 ========= ======== =========== ========= ========== The accompanying notes to financial statements are an integral part of these statements. The accompanying notes to financial statements are an integral part of these statements. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Trump Plaza Holding Associates and Trump Plaza Associates: We have audited the accompanying consolidated balance sheets of Trump Plaza Holding Associates (a New Jersey general partnership) and Trump Plaza Associates ( a New Jersey general partnership) as of December 31, 1993 and 1992, and the related statements of operations, capital and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and the schedules referred to below are the responsibility of the management of Trump Plaza Holding Associates and Trump Plaza Associates. 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 Trump Plaza Holding Associates and Trump Plaza Associates 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. 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 the financial statements and schedules 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 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 basis financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey February 18, 1994 TRUMP PLAZA HOLDING ASSOCIATES AND TRUMP PLAZA ASSOCIATES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 -------- -------- Current Assets: Cash and cash equivalents...................... $14,393,000 $18,802,000 Trade receivables, net of allowance for doubtful accounts of $10,616,000 and $14,402,000, respectively..................... 6,759,000 7,675,000 Accounts receivable, other..................... 198,000 195,000 Due from affiliates, net (Note 9).............. - 91,000 Iventories..................................... 3,566,000 3,068,000 Prepaid expenses and other current assets...... 2,701,000 2,502,000 ------------ ------------ Total current assets...................... 27,617,000 32,333,000 ------------ ------------ Property and Equipment (Note 5): Land and land improvements................... 35,613,000 34,907,000 Buildings and building improvements.......... 295,617,000 293,908,000 Furniture, fixtures and equipment............ 78,173,000 74,622,000 Leasehold improvements....................... 2,404,000 2,378,000 Construction in progress..................... 3,784,000 3,924,000 ------------ ------------ 415,591,000 409,739,000 Less--Accumulated depreciation and amortization................................ (122,450,000) (109,473,000) ------------ ------------ Net property and equipment............... 293,141,000 300,266,000 ------------ ------------ Land Rights, net of accumulated amortization of $3,410,000 and $3,041,000, respectively... 30,058,000 30,428,000 ------------ ------------ Other Assets: Deferred bond issuance costs, net of accumulated amortization of $1,088,000 in 1993 (Note 2)............................ 16,254,000 - Other (Note 8)............................... 7,428,000 7,322,000 ------------ ------------ Total other assets........................ 23,682,000 7,322,000 ------------ ------------ Total assets.............................. $374,498,000 $370,349,000 ============ ============ LIABILITIES AND CAPITAL Current Liabilities: Current maturities of long-term debt (Note 4) $1,633,000 $9,980,000 Accounts payable............................. 6,309,000 7,767,000 Accrued payroll.............................. 5,806,000 4,978,000 Accrued interest payable (Note 4)............ 1,829,000 8,028,000 Due to affiliates, net (Note 9).............. 97,000 - Other accrued expenses....................... 7,109,000 10,475,000 Other current liabilities.................... 5,330,000 5,221,000 Distribution payable to Trump Plaza Funding, Inc................................ 974,000 4,112,000 ------------ ------------ Total current liabilities................. 29,087,000 50,561,000 ------------ ------------ Non-Current Liabilities: Long-term debt, net of current maturities (Notes 2 and 4)............................. 395,948,000 249,723,000 Distribution payable to Trump Plaza Funding, Inc................................ 2,949,000 116,000 Deferred state income taxes.................. 1,224,000 495,000 ------------ ------------ Total noncurrent liabilities.............. 400,121,000 250,334,000 ------------ ------------ Total liabilities......................... 429,208,000 300,895,000 ------------ ------------ Commitments and Contingencies (Notes 5 and 7) Preferred Partnership Interest................. - 58,092,000 ------------ ------------ Capital: Partners' Deficit............................ (78,772,000) (3,362,000) Retained Earnings............................ 24,062,000 14,724,000 ------------ ------------ Total Capital (Deficit)........................ (54,710,000) 11,362,000 ------------ ------------ Total liabilities and capital............. $374,498,000 $370,349,000 ============ ============ The accompanying notes to financial statements are an integral part of these consolidated balance sheets. The accompanying notes to financial statements are an integral part of these consolidated statements. The accompanying notes to financial statements are an integral part of these consolidated statements. The accompanying notes to financial statements are an integral part of these consolidated statements. TRUMP PLAZA FUNDING, INC. AND TRUMP PLAZA HOLDING ASSOCIATES AND TRUMP PLAZA ASSOCIATES NOTES TO FINANCIAL STATEMENTS (1) Organization: ------------- The accompanying financial statements include those of Trump Plaza Funding, Inc. (the "Company"), a New Jersey General Corporation as well as those of Trump Plaza Holding Associates ("Holding"), a New Jersey General Partnership, and its 99% owned subsidiary, Trump Plaza Associates (the "Partnership"), a New Jersey General Partnership, which owns and operates Trump Plaza Hotel and Casino located in Atlantic City, New Jersey. The Company owns the remaining 1% interest in the Partnership. Holding's sole source of liquidity is distributions in respect of its interest in the Partnership. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements of Holding. The minority interest in the Partnership has not been separately reflected in the consolidated financial statements of Holding since it is not material. The Company was incorporated on March 14, 1986 as a New Jersey corporation, and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. As part of a Prepackaged Plan of Reorganization under Chapter 11 of the U.S. Bankruptcy code consummated on May 29, 1992, the Company became a partner of the Partnership and issued approximately three million Stock Units, each comprised of one share of Preferred Stock and one share of Common Stock of the Company. On June 25, 1993, the Stock Units were redeemed with a portion of the proceeds of the Company's 10 7/8% Mortgage Notes due 2001 (the "Mortgage Notes") as well as Holding's Units. See Note 2-Offering of Mortgage Notes and Units. Holding was formed in February, 1993 as a New Jersey general partnership for the purpose of raising funds for the Partnership. On June 25, 1993, Holding completed the sale of 12,000 Units (the "Units"), each Unit consisting of $5,000 principal amount of 12 1/2% Pay-In-Kind Notes, due 2003 (the "PIK Notes"), and one Warrant to acquire $1,000 principal amount of PIK Notes (collectively with the Mortgage Note Offering, the "Offerings"). The PIK Notes and the Warrants are separately transferable. Holding has no other assets or business other than its 99% equity interest in the Partnership. See Note 2-Offering of Mortgage Notes and Units. The Partnership was organized in June 1982 as a New Jersey general partnership. Prior to the date of the consummation of the Offerings, the Partnership's three partners were TP/GP, the managing general partner of the Partnership, the Company and Donald J. Trump ("Trump"). On June 25, 1993, Trump contributed his interest in TP/GP to the Company and TP/GP merged with and into the Company. The Company then became the managing general partner of the Partnership. In addition, Trump contributed his interest in the Partnership to Holding, and the Company and Holding, each of which are wholly owned by Trump, became the sole partners of the Partnership. (2) Offering of Mortgage Notes and Units: ------------------------------------- On June 25, 1993 the Company issued, and the Partnership guaranteed $330,000,000 of Mortgage Notes (for net proceeds of $325,687,000) and Holding issued an aggregate of $60,000,000 of PIK Notes, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost (the "Offerings"). The combined proceeds, together with cash on hand were used substantially as follows: (i) $225.0 million of such proceeds were used to repay the Partnership's promissory note to the Company in the principal amount of $225.0 million, which proceeds were then used by the Company to redeem the 12% Mortgage Bonds, due 2002; (ii) $12.0 million was used to repay the Regency Note (see Note 4); (iii) $40.0 million was distributed to the Company (which used such funds, together with $35.0 million from the Units Offering distributed to Trump and paid to the Company, to redeem its Stock Units); (iv) approximately $17.3 million was used to pay the expenses incurred in connection with the Offerings; (v) approximately $52.5 million was used to make the Special Distribution to Trump which was used by Trump to repay certain personal indebtedness and (vi) to pay accrued interest on the Bonds and accrued dividends on the Preferred Stock. (3) Summary of significant accounting policies: ------------------------------------------- Gaming Revenues and Promotional Allowances - ------------------------------------------ Gaming revenues represent the net win from gaming activities which is the difference between amounts wagered and amounts won by patrons. The retail value of accommodations, food, beverage and other services provided to customers without charge is included in gross revenue and deducted as promotional allowances. The estimated departmental costs of providing such promotional allowance are included in gaming costs and expenses as follows: YEARS ENDED DECEMBER 31, ------------------------ (in thousands) 1993 1992 1991 ---- ---- ---- ROOMS $ 4,190 $ 4,804 $ 4,307 FOOD AND BEVERAGE 14,726 14,982 13,572 OTHER 3,688 3,884 2,802 ------- ------- ------- $22,604 $23,670 $20,681 ====== ====== ====== During 1992, certain Progressive Slot Jackpot Programs were discontinued which resulted in $4,100,000 of related accruals being taken into income. Inventories - ----------- Inventories of provisions and supplies are carried at the lower of cost (weighted average) or market. Property and Equipment - ---------------------- Property and equipment is carried at cost and is depreciated on the straight-line method using rates based on the following estimated useful lives: Buildings and building improvements 40 years Furniture, fixtures and equipment 3-10 years Leasehold improvements 10-40 years Interest associated with borrowings used to finance construction projects has been capitalized and is being amortized over the estimated useful lives of the assets. Land Rights - ----------- Land rights represent the fair value of such rights, at the time of contribution to the Partnership by the Trump Plaza Corporation, an affiliate of the Partnership. These rights are being amortized over the period of the underlying operating leases which extend through 2078. Income Taxes - ------------ The Company, Holding and the Partnership adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"), effective January 1, 1993. Adoption of this new standard did not have a significant impact on the respective statements of financial condition or results of operations. SFAS No. 109 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 difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The accompanying financial statements of the Company include a provision for Federal income taxes, based on distributions from the Partnership relating to the Company's Preferred Stock which was redeemed on June 25, 1993. The Company will be reimbursed for such income taxes by the Partnership. The accompanying consolidated financial statements of Holding and the Partnership do not include a provision for Federal income taxes since any income or losses allocated to its partners are reportable for Federal income tax purposes by the partners. Income Taxes cont. - ------------------ Under the New Jersey Casino Control Commission regulations, the Partnership is required to file a New Jersey corporation business tax return. Accordingly, a provision (benefit) for state income taxes has been reflected in the accompanying consolidated financial statements of Holding and the Partnership. The Partnership's deferred state income taxes result primarily from differences in the timing of reporting depreciation for tax and financial statement purposes. Statements of Cash Flows - ------------------------ For purposes of the statements of cash flows, the Company, Holding and the Partnership consider all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The following supplemental disclosures are made to the statements of cash flows. 1993 1992 1991 ---------- ---------- ---------- Cash paid during the year for interest $41,118,000 $25,310,000 $34,533,000 ========== ========== ========== Cash paid for state and Federal income taxes $ 81,000 $ - $ - ========== ========== ========== Reclassifications - ----------------- Certain reclassifications were made to the 1991 and 1992 consolidated financial statements to present them on a basis consistent with the 1993 classification. (4) Long-Term debt: --------------- Long term debt consists of the following: December 31, December 31, 1993 1992 ------------ ------------ Company: 10 7/8% Mortgage Notes, due 2001 net of unamortized discount of $4,141,000 in 1993 (A) $325,859,000 $ - 12% First Mortgage bonds, due 2002 (A) - 225,000,000 ----------- ----------- $325,859,000 $225,000,000 =========== =========== Holding and the Partnership: Partnership Partnership Note (10 7/8% Mortgage Notes, due 2001 net of unamortized discount of $4,141,000 in 1993) (A) $325,859,000 $ - Partnership Note (12% First Mortgage bonds, due 2002) (A) - 225,000,000 10% note payable to Harrah's Atlantic City, Inc. (C) - 8,471,000 Mortgage notes payable (D) 6,410,000 7,284,000 Regency Hotel Obligation (A) - 17,500,000 Other notes payable 1,060,000 1,448,000 ----------- ----------- 333,329,000 259,703,000 Less - Current maturities 1,633,000 9,980,000 ----------- ----------- 331,696,000 249,723,000 Holding PIK Notes (12 1/2% Notes due 2003 net of discount of $11,310,000 in 1993) (B) 64,252,000 - ----------- ----------- $395,948,000 249,723,000 =========== =========== (4) Long-Term debt cont.: --------------------- (A) On June 25, 1993 the Company issued $330,000,000 principal amount of 10 7/8% Mortgage Notes, due 2001, net of discount of $4,313,000. Net proceeds of the Offering were used to redeem all of the Company's outstanding $225,000,000 principal amount 12% Mortgage Bonds, due 2002 and together with other funds (see (B) Pay-In-Kind Notes) all of the Company's Stock Units, comprised of $75,000,000 liquidation preference participating cumulative redeemable Preferred Stock with associated shares of Common Stock, to repay $17,500,000 principal amount 9.14% Regency Note due 2003 (see Note 6), to make a portion of the Special Distribution and to pay transaction expenses. See Note 2- Offering of Mortgage Notes and Units. The Mortgage Notes mature on June 15, 2001 and are redeemable at any time on or after June 15, 1998, at the option of the Company or the Partnership, in whole or in part, at the principal amount plus a premium which declines ratably each year to zero in the year of maturity. The Mortgage Notes bear interest at the stated rate of 10 7/8% per annum from the date of issuance, payable semi-annually on each June 15 and December 15, commencing December 15, 1993 and are secured by substantially all of the Partnership's assets. The accompanying consolidated financial statements reflect interest expense at the effective interest rate of 11.12% per annum. The Mortgage Note Indenture contains certain covenants limiting the ability of the Partnership to incur indebtedness, including indebtedness secured by liens on Trump Plaza. In addition, the Partnership may, under certain circumstances, incur up to $25.0 million of indebtedness to finance the expansion of its facilities, which indebtedness may be secured by a lien on the Boardwalk Expansion Site (see Note 8 Commitments And Contingencies) senior to the liens of the Note Mortgage and Guarantee Mortgage thereon. The Mortgage Notes represent the senior indebtedness of the Company. The Partnership Note and the Guarantee rank pari passu in right of payment with all existing and future senior indebtedness of the Partnership. The Mortgage Notes, the Partnership Note, the Note Mortgage, the Guarantee and the Guarantee Mortgage are non-recourse to the partners of the Partnership, to the shareholders of the Company and to all other persons and entities (other than the Company and the Partnership), including Trump. Upon an event of default, holders of the Mortgage Notes would have recourse only to the assets of the Company and the Partnership. (B) On June 25, 1993 Holding issued $60,000,000 principal amount of 12 1/2% PIK Notes, due 2003, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost. The Warrants are exercisable following the earlier of certain triggering events or June 15, 1996. The PIK Notes mature on June 15, 2003 and bear interest at the rate of 12 1/2% per annum from the date of issuance, payable semi-annually on each June 15 and December 15, commencing December 15, 1993. At the option of Holding, interest is payable in whole or in part, in cash or, in lieu of cash, through the issuance of additional PIK Notes valued at 100% of their principal amount. The ability of Holding to pay interest in cash on the PIK Notes is entirely dependent on the ability of the Partnership to distribute available cash, as defined, to Holding for such purpose. On December 15, 1993 the Partnership elected to issue, in lieu of cash, an additional $3,562,000 in PIK Notes to satisfy its semi-annual PIK Note interest obligation. The PIK Notes are subordinate to the Company's Mortgage Notes and any other indebtedness of the Partnership and are secured by a pledge of Holding's 99% equity interest in the Partnership. The indenture to which the PIK Notes were issued (the "PIK Note Indenture") contains covenants prohibiting Holding from incurring additional indebtedness and engaging in other activities, and other covenants restricting the activities of the Partnership substantially similar to those set forth in the Mortgage Note Indenture. The PIK Notes and the Warrants are non-recourse to the Partners of Holding, including Trump, and to all other persons and entities (other than Holding). Upon an event of default, holders of PIK Notes or Warrants will have recourse only to the assets of Holding which consist solely of its equity interest in the Partnership. (4) Long-Term debt cont.: --------------------- (C) The entire $8,471,000 principal amount of the 10% note payable was repaid on May 16, 1993. (D) Interest on these notes are payable with interest rates ranging from 10.0% to 11.0%. The notes are due at various dates between 1994 and 1998 and are secured by real property. The aggregate maturities of long-term debt in each of the years subsequent to 1993 are: 1994 $ 1,633,000 1995 2,850,000 1996 542,000 1997 2,012,000 1998 433,000 Thereafter 390,111,000 ------------ $397,581,000 ============ (5) Leases: ------- The Partnership leases property (primarily land), certain parking space, and various equipment under operating leases. Rent expense for the years ended December 31, 1993, 1992, and 1991 was $4,338,000, $4,361,000 and $11,219,000 respectively, of which $2,513,000, $2,127,000 and $8,478,000, respectively, relates to affiliates of the Partnership. Future minimum lease payments under the noncancelable operating leases are as follows: Amounts Relating to Total Affiliates ------------ ------------ 1994 $ 6,220,000 $ 1,900,000 1995 6,445,000 2,125,000 1996 6,670,000 2,350,000 1997 6,670,000 2,350,000 1998 5,110,000 2,350,000 Thereafter 274,183,000 193,600,000 ------------ ------------ $305,298,000 $204,675,000 ============ ============ Certain of these leases contain options to purchase the leased properties at various prices throughout the leased terms. At December 31, 1993, the aggregate option price for these leases was approximately $58,000,000. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses which are included in the above lease commitment amounts. In connection with the Offerings, the Partnership acquired a five-year option to purchase the Boardwalk Expansion Site. Management intends to exercise this option by June 30, 1995. See Note 7-"Commitments and Contingencies Future Expansion." (6) Extraordinary Gain (Loss) and Non-Operating Expense: ---------------------------------------------------- The $4,120,000 excess of the carrying value of the Regency Hotel obligation over the amount of the settlement payment net of related prepaid expenses, has been reported as an extraordinary gain for the year ended December 31, 1993. The extraordinary loss for the year ended December 31, 1992 consists of the effect of stating the Bonds and Preferred Stock issued at fair value as compared to the carrying value of these securities and the write off of certain deferred financing charges and costs. Non-operating expense in 1993 includes $3,873,000 in costs associated with the Boardwalk Expansion Site (see Note 7-Commitments and Contingencies Future Expansion), net of miscellaneous non- operating credits. In 1992 these costs included $1,462,000 of legal expenses relating to the Penthouse litigation, and in 1991 these costs included $3,968,000 of legal expenses incurred in connection with the Penthouse litigation and $10,850,000 for the settlement of the Regency lease. (7) Commitments and Contingencies: ------------------------------ Casino License Renewal - ---------------------- The operation of an Atlantic City hotel and casino is subject to significant regulatory controls which affect virtually all of its operations. Under the New Jersey Casino Control Act (the "Act"), the Partnership is required to maintain certain licenses. In April, 1993, the New Jersey Casino Control Commission ("CCC") renewed the Partnership's license to operate Trump Plaza. This license must be renewed in June, 1995, is not transferable and will include a review of the financial stability of the Partnership. Upon revocation, suspension for more than 120 days, or failure to renew the casino license, the Act provides for the mandatory appointment of a conservator to take possession of the hotel and casino's business and property, subject to all valid liens, claims and encumbrances. Legal Proceedings - ----------------- The Partnership, its Partners, certain members of its former Executive Committee, and certain of its employees, have been involved in various legal proceedings. In general, the Partnership has agreed to indemnify such persons against any and all losses, claims, damages, expenses (including reasonable costs, disbursements and counsel fees) and liabilities (including amounts paid or incurred in satisfaction of settlements, judgements, fines and penalties ) incurred by them in said legal proceedings. Such persons and entities are vigorously defending the allegations against them and intend to vigorously contest any future proceedings. Various other legal proceedings are now pending against the Partnership. The Partnership considers all such other proceedings to be ordinary litigation incident to the character of its business and not material to its business or financial condition. The Partnership believes that the resolution of these claims will not, individually or in the aggregate, have a material adverse effect on its financial condition or results of operations. The Partnership is also a party to various administrative proceedings involving allegations that it has violated certain provisions of the Act. The Partnership believes that the final outcome of these proceedings will not, either individually or in the aggregate, have a material adverse effect on its financial condition, results of operations or on the ability of the Partnership to otherwise retain or renew any casino or other licenses required under the Act for the operation of Trump Plaza. Casino Reinvestment Development - ------------------------------- Authority Obligations --------------------- Pursuant to the provisions of the Act, the Partnership, commencing twelve months after the date of opening of Trump Plaza in May 1984, and continuing for a period of twenty-five years thereafter, must either obtain investment tax credits (as defined in the Casino Control Act), in an amount equivalent to 1.25% of its gross casino revenues, or pay an alternative tax of 2.5% of its gross casino revenues, (as defined in the Casino Control Act). Investment tax credits may be obtained by making qualified investments or by the purchase of bonds at below market interest rates from the Casino Reinvestment Development Authority ("CRDA"). The Partnership is required to make quarterly deposits with the CRDA. In April 1990, the Partnership modified its agreement with the CRDA under which it was required to purchase bonds to satisfy the investment alternative tax. Under the terms of the agreement, the Partnership donated $11,971,000 in deposits previously made to the CRDA for the purchase of CRDA bonds through December 31, 1989, in exchange for satisfaction of an equivalent amount of its prior bond purchase commitments, as well as receiving future tax credits, to be utilized to satisfy substantial portions of the Partnership's future investment alternative tax obligations. The Partnership charged $1,358,000 and $2,493,000 to operations in 1992 and 1991, respectively, which represents amortization of the tax credits discussed above. As of December 31, 1993, no tax credits were available. For the years ended December 31, 1993, 1992 and 1991, the Partnership charged to operations $1,047,000, $645,000 and $219,000, respectively, to give effect to the below market interest rates associated with the CRDA bonds. Concentrations of Credit Risks - ------------------------------ In accordance with casino industry practice, the Partnership extends credit to a limited number of casino patrons, after extensive background checks and investigations of credit worthiness. At December 31, 1993 approximately 31% of the Partnership's casino receivables were from customers whose primary residence is outside the United States with no significant concentration in any one foreign country. Future Expansion - ---------------- In 1993, the Partnership received the approval of the CCC, subject to certain conditions, for the expansion of its hotel facilities (the "Boardwalk Expansion Site"). On June 25, 1993, Trump transferred title to the Boardwalk Expansion Site to a lender in exchange for a reduction in Trump's indebtedness to such lender in an amount equal to the sum of fair market value of the Boardwalk Expansion Site and all rent payments made to such lender by Trump under the Boardwalk Expansion Site Lease. On the date the Offerings were consummated, the lender leased the Boardwalk Expansion Site to Trump ("the Boardwalk Expansion Site Lease") for a term of five years, which expires on June 30, 1998, during which time Donald J. Trump was obligated to pay the lender $260,000 per month in lease payments. See Note 6-"Extraordinary Gain (Loss) and Non-Operating Expense." In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. In connection with the Offerings, the Partnership acquired a five- year option to purchase the Boardwalk Expansion Site (the "Option"). Until such time as the Option is exercised or expires, the Partnership will be obligated, from and after the date it entered into the Option, to pay the net expenses associated with the Boardwalk Expansion Site. During the year ended December 31, 1993 the Partnership incurred $4.4 million of such expenses. Under the Option, the Partnership has the right to acquire the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until expiration on June 30, 1998. The CCC has required that the Partnership exercise the Option for its right of first refusal therein no later than July 1, 1995. If the Partnership defaults in making payments due under the Option, the Partnership would be liable to the lender for the sum of (a) the present value of all remaining payments to be made by the Partnership pursuant to the Option during the term thereof and (b) the cost of demolition of all improvements then located on the Boardwalk Expansion Site. As of December 31, 1993, the Partnership had capitalized approximately $2.7 million in construction costs related to the Boardwalk Expansion Site. The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option would be dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and requires the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site is dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option or such right. The accompanying financial statements do not include any adjustments that may be necessary should the Partnership be unable to exercise the Option. (8) Employee Benefit Plans: ----------------------- The Partnership has a retirement savings plan for its nonunion employees under Section 401(K) of the Internal Revenue Code. Employees are eligible to contribute up to 15% of their earnings to the plan and the Partnership will match 50% of an eligible employee's contributions up to a maximum of 4% of the employee's earnings. The Partnership recorded charges of $765,000, $699,000 and $571,000 for matching contributions for the years ended December 31, 1993, 1992 and 1991, respectively. (9) Transactions with Affiliates: ----------------------------- Due to/from Affiliates - ---------------------- Amounts due to affiliates was $97,000, as of December 31, 1993 and due from affiliates was $91,000 as of December 31,1992. The Partnership leases warehouse facility space to Trump Castle Associates and had formerly leased space to Trump Taj Mahal Associates. Lease payments of $15,000, $14,000 and $18,000 were received from Trump Castle Associates in 1993, 1992 and 1991, respectively, and $46,000 from Trump Taj Mahal Associates in 1991. The Partnership leases office space from Trump Taj Mahal Associates, which terminated on March 19, 1993. Lease payments of $30,000, $138,000 and $98,000 were paid to Trump Taj Mahal Associates in 1993, 1992 and 1991 respectively. Prior to April 1991, the Partnership leased office space from Trump Castle Associates. Lease payments to Trump Castle Associates amounted to $42,000 in 1991. The Partnership paid Trump Castle Associates $317,000 in 1991, and Trump Taj Mahal Associates $1,000 and $242,000 in 1992 and 1991, respectively, for fleet maintenance and limousine services. Additionally, the Partnership paid Trump Castle Associates $4,000 in 1991 for printing services. The Partnership leases two parcels of land under long-term ground leases from Seashore Four Associates and Trump Seashore Associates. In 1993, 1992 and 1991, the Partnership paid $900,000, $900,000 and $900,000, respectively, to Seashore Four Associates, and paid $1,000,000, $1,000,000 and $1,100,000 in 1993, 1992 and 1991, respectively, to Trump Seashore Associates. Services Agreement - ------------------ Pursuant to the terms of a Services Agreement with Trump Plaza Management Corp. ("TPM"), a corporation beneficially owned by Donald J. Trump, in consideration for services provided, the Partnership pays TPM each year an annual fee of $1.0 million in equal monthly installments, and reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement, up to certain amounts. Under this Agreement, approximately $1.2 million and $0.7 million was charged to expense for the years ended December 31, 1993 and 1992, respectively. Advances to Donald J. Trump - --------------------------- In December 1993, Trump entered into an option agreement (the "Chemical Option Agreement") with Chemical Bank ("Chemical") and ACFH Inc. ("ACFH") a wholly owned subsidiary of Chemical. The Chemical Option Agreement grants to Trump an option to purchase (i) the Trump Regency (including the land, improvements and personal property used in the operation of the hotel) and (ii) certain promissory notes made by Trump and/or certain of his affiliates and payable to Chemical (the "Chemical Notes") which are secured by certain real estate assets located in New York, unrelated to the Partnership. The aggregate purchase price payable for the assets subject to the Chemical Option Agreement is $80 million. Under the terms of the Chemical Option Agreement, $1 million was required to be paid for the option by January 5, 1994. The option expires on May 6, 1994, provided that the option may be extended until June 30, 1994 by the payment of an additional $250,000 on or before that date. The $1 million payment (and the $250,000 payment, if made) may be credited against the $80 million purchase price. The Chemical Option Agreement does not allocate the purchase price among the assets subject to the option or permit the option to be exercised for some, but not all, of such assets. In connection with the execution of the Chemical Option Agreement, Trump agreed with the Partnership that, if Trump is able to acquire the Trump Regency pursuant to the exercise of the option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. Trump further agreed that the Partnership would not be required to pay any additional consideration to Trump in connection with any assignment of the option to purchase the Trump Regency. On January 5, 1994, the Partnership obtained the approval of the CCC to make the $1 million payment, and the payment was made on that date. (10) Fair Value of Financial Instruments: ------------------------------------ The carrying amount of the following financial instruments of the Company, Holding and the Partnership approximates fair value, as follows: (a) cash and cash equivalents, accrued interest receivables and payables are based on the short term nature of these financial instruments. (b) CRDA bonds and deposits are based on the allowances to give effect to the below market interest rates. The estimated fair values of other financial instruments are as follows: December 31, 1993 ----------------- Carrying Amount Fair Value --------------- --------------- 12 1/2% PIK Notes $ 64,252,000 $ 68,784,000 10 7/8% Mortgage Notes $325,859,000 $313,500,000 The fair values of the PIK and Mortgage Notes are based on quoted market prices obtained by the Partnership from its investment advisor. There are no quoted market prices for other notes payable and a reasonable estimate could not be made without incurring excessive costs. (A) Represents reclassification of completed capital projects to in-service classifications. SCHEDULE VI (A) Represents reclassification of certain capital projects to appropriate classifications. (B) Includes retirements of $811,000, and $163,000 in 1992, and 1991 respectively. SCHEDULE VIII (A) Write-off of uncollectible accounts. (B) Write-off of allowance applicable to contribution of CRDA deposits.

46738_1993.txt

46738_1993

1993

46738

ITEM 1. BUSINESS Heller Financial, Inc. (the "Company") was incorporated in 1919 under the laws of the State of Delaware and is engaged in various aspects of the commercial finance business. The Company and its consolidated subsidiaries employ approximately 1,400 people. The executive offices of the Company are located at 500 West Monroe Street, Chicago, Illinois 60661 (telephone: (312) 441-7000). Unless the context indicates otherwise, references to the Company include Heller Financial, Inc. and its consolidated subsidiaries. The Company operates in the middle market segment of the commercial finance industry, which generally includes entities in the manufacturing and service sectors with annual sales in the range of $15 million to $200 million and in the real estate sector with property values in the range of $5 million to $40 million. The Company currently provides services in six product categories: (1) corporate financing, (2) real estate financing, (3) current asset management, (4) asset based financing, (5) specialized financing and investments and (6) international factoring and asset based financing. The Company has undertaken a long term program to strengthen its performance by diversifying its lending portfolio and earnings sources, strengthening earnings and asset quality and maintaining capital strength. The portfolio and earnings sources are being diversified by reducing reliance on the corporate financing business and growing the asset based businesses and specialized financing and investment activities. The Company is attempting to strengthen earnings by developing more stable earning streams, reducing the level and volatility of credit quality costs and increasing productivity. Improved asset quality is being pursued through aggressive resolution of problem accounts, more conservative underwriting and reduced transaction and hold sizes. Lastly, the Company is maintaining a strong financial position through moderate leverage, strong reserves and liquidity. CORPORATE FINANCING The Corporate Finance group offers a broad spectrum of services based on the cash flows underlying a client's business. These services include the financing of corporate recapitalizations, refinancings, acquisitions and buy-outs of publicly and privately held entities in a wide variety of industries. Loans are provided on both a term and revolving basis for periods of up to ten years and are predominantly collateralized by senior liens on the borrower's stock or assets or both. Corporate financings may also include some unsecured, subordinated or non-voting equity financing. From time to time the Company sells assignments and participations in its loans. REAL ESTATE FINANCING The Real Estate Financial Services group provides interim financing to owners, investors and developers primarily for the acquisition, refinancing and renovation of commercial and residential income producing properties in a wide range of property types and geographic areas. These loans generally have terms ranging from one to five years and are principally collateralized by first mortgages. The Company also offers a number of financing products including financing for discounted loan portfolio acquisitions, participating junior debt financing to developers of single family and multi-family housing, credit sale- leaseback financing for single tenant properties, credit enhancements for multi-family tax exempt bonds and standby commitments with terms of one to two years. CURRENT ASSET MANAGEMENT The Current Asset Management group primarily offers factoring services to the apparel, textile and home furnishings industries. In return for a commission, the group purchases the client's accounts receivable and provides collection and management information services. Working capital is provided by advancing on a formula basis a percentage of the purchase price of the client's factored accounts receivable prior to the due date. In 1993, the Company was one of the largest factors in the highly competitive United States factoring industry, with volume of $6.4 billion. During 1993, Small Business Finance was established to provide receivables financing products and services to the smaller end of the middle market and Healthcare Financial Services expanded its activities which include working capital financing and medical insurance claims management services. ASSET BASED FINANCING Asset based financing is offered by Vendor Finance, Commercial Equipment Finance, Heller First Capital ("First Capital") and Heller Business Credit ("Business Credit"). Vendor Finance provides leasing and financing of equipment through manufacturer and vendor programs and direct relationships with end users, with individual transactions generally under $500,000. This division supports the machining, graphics, healthcare, communication, plastics and production equipment markets. Commercial Equipment Finance provides financing of general equipment transactions ranging in size from $1 million to $10 million to a diverse group of businesses for expansion, replacement and modernization or refinancing of existing equipment obligations. During 1993, Vendor Finance and Commercial Equipment Finance leases were consolidated in Heller Financial Leasing, a wholly-owned subsidiary of the Company, which was formed to provide additional focus for this growing portfolio. First Capital is a provider of long-term financial products for small businesses under U.S. Small Business Administration loan programs, which guarantee from 70% to 90% of such financings. Loans of up to $1,250,000 are made to small businesses in a wide variety of industries, for working capital, equipment and owner-occupied facilities. The guaranteed portions of these loans are sold in the secondary market, with servicing rights generally retained by First Capital. Business Credit was established as a separate unit during 1993, to rebuild a strong national presence in asset based lending. Its financings are secured by receivables, inventory and property, plant and equipment and are generally used by middle market companies in a variety of industries for working capital, refinancings, restructurings, and acquisitions. In addition to established businesses, clients include high growth and established turnaround companies. SPECIALIZED FINANCING AND INVESTMENTS Specialized financing and investments are originated by four units: Project Investment and Advisory, Equity Capital, Heller Investments and Aircraft Finance. Project Investment and Advisory offers financing to independent power producers and industrial projects in the form of senior and junior secured loans, development loans and industrial project equity investments. Equity Capital and Heller Investments make investments in middle market companies. Equity Capital primarily focuses on established middle market companies, while Heller Investments focuses on companies requiring an operational and financial turnaround. Aircraft Finance offers financing for commercial aircraft through leases or junior secured loans to an operating lessor, with terms ranging from 2 to 10 years. INTERNATIONAL FACTORING AND ASSET BASED FINANCING The Company provides factoring and asset based financing outside the United States through investments in commercial finance companies located in 18 countries in Europe, Asia, Australia and Latin America. These companies, which may be wholly-owned or joint ventures, offer factoring, asset based finance, acquisition finance, leasing, vendor finance and/or trade finance programs to the mid-sized corporate sector. During 1993, the Company established factoring joint ventures in Mexico and Malaysia. OWNERSHIP All of the outstanding common stock of the Company is owned by Heller International Corporation (the "Parent"), a wholly-owned subsidiary of The Fuji Bank, Limited ("Fuji Bank"), headquartered in Tokyo, Japan. Fuji Bank also directly owns 21% of the outstanding shares of Heller International Group, Inc., a consolidated subsidiary of the Company engaged in factoring and asset based financing activities outside the U.S. Fuji Bank is one of the largest banks in the world, with total deposits of approximately $356 billion at September 30, 1993. Management of the Company believes that Fuji Bank's ownership of the Company permits it to compete more effectively in the commercial finance business. For a discussion of the "Keep Well Agreement" between Fuji Bank and the Company, see "Certain Relationships and Related Transactions--Keep Well Agreement with Fuji Bank." SUMMARY OF TOTAL REVENUES, LENDING ASSETS AND INVESTMENTS A summary of total revenues, lending assets and investments by product category is included in the "Portfolio Composition" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations." This summary closely corresponds to a classification by operating unit. In addition, for information about international operations, see Note 16 to the Consolidated Financial Statements. RATES CHARGED; COMPETITION; REGULATION Rates charged by the Company vary depending on the risk and maturity of the loan, competition, current cost of borrowing to the Company and state usury laws and other governmental regulations. The Company's portfolio of receivables primarily earns interest at variable rates. These variable rates float in accordance with various agreed upon reference rates, including the prime or corporate base lending rates, or the London Inter-bank Offered Rate. Competition varies by operating group. In general, the Company is subject to competition from a variety of financial institutions, including commercial finance companies, banks and leasing companies. As a subsidiary of Fuji Bank, the Company is subject to the limitations imposed by the Bank Holding Company Act of 1956, as amended, and related regulations adopted by the Board of Governors of the Federal Reserve System. Those regulations restrict the Company to activities that have been defined as being so closely related to banking as to be incidental thereto and also restrict certain lending activities. The Company's guaranteed loan operations and certain of its equity investment activities are subject to the supervision and regulation of the Small Business Administration. To date, such regulations have not had a material adverse effect on the Company. ITEM 2. ITEM 2. PROPERTIES The Company leases executive offices located at 500 West Monroe Street, Chicago, Illinois 60661 and maintains various offices throughout the United States, Europe, Asia and Australia, all of which are leased premises. For information concerning the Company's lease obligations, see Note 7 to the Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is party to a number of legal proceedings as plaintiff and defendant, all arising in the ordinary course of its business. The Company believes that the amounts, if any, which may ultimately be funded or paid with respect to these matters will not have a materially adverse effect on the financial condition or results of operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were acted upon in the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The outstanding common stock of the Company is owned entirely by the Parent, which is wholly owned by Fuji Bank, and there is no public trading market for the Company's common stock. During 1993 and 1992, no cash dividends were declared on the Company's common stock or NW Preferred Stock, Class B ("NW Preferred Stock"), and all dividends declared on the Cumulative Perpetual Senior Preferred Stock, Series A ("Perpetual Preferred Stock") and the Cumulative Convertible Preferred Stock, Series D ("Convertible Preferred Stock") have been paid through December 31, 1993. The Company is prohibited from paying cash dividends on common stock, NW Preferred Stock, and Convertible Preferred Stock unless full cumulative dividends on all outstanding shares of Perpetual Preferred Stock have been paid. Under the terms of the Convertible Preferred Stock, all of which is owned by the Parent, the Company is prohibited from paying dividends on common stock unless full cumulative dividends on all outstanding shares of the Convertible Preferred Stock have been paid. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table presents information from the Company's consolidated financial statements for the five years ended December 31, 1993, which have been audited by Arthur Andersen & Co., independent public accountants, as indicated in their report included herein. This information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the "Financial Statements and Supplementary Data." - -------- * During 1989, the Company declared and paid $10.7 million of dividends that accumulated from March 30, 1984 to December 31, 1988. ** See Exhibit 12. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS During 1993, the Company's results of operations and financial position improved as earnings and asset quality improved, portfolio diversification increased and balance sheet strength was maintained. Earnings quality improved as operating revenues grew at a faster rate than operating expenses, in part due to strong growth in fees and other income from newer businesses, while credit quality costs decreased from the high level of 1992. Asset quality improved as nonearning assets decreased by 22%. The portfolio became more balanced due to the lower level of corporate financings and growth in asset based financing and specialized financing and investments. Although the Company has made progress in these areas, initiatives to strengthen the earnings quality, diversify assets and improve asset quality will continue through 1994. RESULTS OF OPERATIONS The following table summarizes the Company's operating results for the years ended December 31, 1993, 1992, and 1991. 1993 vs. 1992 The Company achieved record net income available for common stock of $106 million, an increase of $61 million or 139%, before a tax accounting credit recorded in 1992. This increase reflects lower credit quality costs, strong gains on investments and increased fees and other income from newer business initiatives, as well as continued growth in net interest income. These factors more than offset increased spending on new business initiatives and a higher provision for income taxes. Net interest income increased due to the improved funding spreads resulting from the low interest rate environment, coupled with increased turnover in the portfolio. Interest income decreased as a result of lower floating rate indices. While average earning funds employed remained relatively stable, a shift in the composition of the portfolio occurred, as average corporate financings decreased and average asset based and specialized financing and investments increased. Rates charged on 86% of total average earning funds employed were based on floating rate indices such as the average three month London Inter- bank Offered Rate, which decreased to 3.31% from 3.79% in 1992. Interest expense decreased as a result of a reduction in the average borrowing rate to 4.4% from 4.7% in 1992. The effect of the lower average borrowing rate was partially offset by an increase in the costs associated with the extension of the average maturity of the debt portfolio. Fees and other income increased $37 million, principally as a result of strong gains on investments from specialized and corporate financings and increased income from real estate and small business loan activities. Although income of international joint ventures declined primarily as the result of a sale of an interest in a leasing joint venture, overall international operations achieved a $7 million increase in net income, reflecting a lower provision for losses. Operating expenses were higher as spending for diversification efforts increased $14 million in 1993. This increase was partially offset by the benefits of productivity enhancements and expense controls in core businesses. Although the provision for losses declined in 1993, significant progress was made in addressing the risks associated with troubled credits in the corporate financing and real estate portfolios. The Company maintained its reserve levels at 3% of receivables or 99% of nonearning receivables at December 31, 1993, even though the level of problem accounts receded and the performance of new financings over the last three years has remained strong. The 8% effective tax rate reflects the recognition of deferred tax benefits. In 1994, management expects the effective tax rate to approach the statutory tax rate. 1992 vs. 1991 Net income available for common stock in 1992 was $85 million, up 48% over 1991 as the Company benefitted from the adoption of a new accounting standard for income taxes and increases in net interest income and other operating revenues. This level of earnings was accomplished while the Company strengthened its loss reserves and increased spending associated with new business initiatives. Net interest income increased as a 4% growth in average earning funds and reduced costs of carrying nonearning assets more than offset a modest spread compression due to an increase in the average term of the debt portfolio. Rates charged on 87% of total average earning funds employed were based on floating rate indices, such as the average prime rate which decreased to 6.3% in 1992 from 8.5% in 1991. As a result of the lower variable market rates, interest income declined, and interest expense fell as the average borrowing rate was 4.7% compared to 6.7% in 1991. Other revenue sources rose $14 million as a result of improved earnings from unconsolidated joint ventures and continued gains on sales of capital appreciation rights and other non-voting equity investments. Operating expenses remained relatively flat for the year, as reductions in legal and rent expense and the benefits of productivity improvements and expense controls were offset by operating expenses for new business initiatives. Spending for these efforts under the Company's diversification program amounted to $17 million during the year. The provision for losses increased as the Company strengthened its allowance for losses to 3% of receivables to improve coverage ratios and address the risks associated with certain troubled credits in the corporate financing and real estate portfolios. Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," which resulted in the recognition of $41 million of previously unrecognized tax benefits. In addition, the Company recorded an income tax benefit in 1992 compared with a provision in 1991, as a result of the favorable settlement of certain tax audits and recognition of additional deferred tax benefits in excess of the current tax provision. PORTFOLIO COMPOSITION During 1993, the Company continued to make progress in diversifying its assets and sources of income, as corporate financing decreased to 46% of the portfolio and asset based financing continued to increase in amount and as a percentage of the portfolio. The following tables present the lending assets and investments and the total revenues of the Company by product category. The Current Asset Management group lending assets and investments and total revenues are included in the asset based product category. Lending assets include receivables and repossessed assets. Total revenues include interest income, fees and other income and the income of the international joint ventures. Lending Assets and Investments. During 1993, lending assets decreased $362 million while the investment portfolio increased $94 million. The slight decline in lending assets principally reflects the reduction of corporate financings which was caused by increased liquidity and activity in the debt and equity markets. Equipment financings, working capital loans, and higher factoring receivables account for the increase in asset based lending, which the Company will continue to grow as it pursues its diversification program. The increase in investments is primarily attributable to equity interests and other investments related to power project financings and investments in established companies with high growth potential. Concentrations of lending assets of 5% or more, based on the standard industrial classification of the borrower, are as follows: The majority of the lending assets in the department and general merchandise retail stores category is comprised of factored accounts receivable which represent short-term trade receivables from numerous customers. The receivables in the general purpose office buildings and apartments categories represent interim financing for properties principally located in major U.S. cities, with no concentration in any one geographic location. The textile and apparel manufacturing receivables are distributed among 14 borrowers. The general industrial machines classification is distributed among machinery used for many different industrial applications. Total Revenues. The growth in total revenues is primarily attributable to the $37 million increase in fees and other income principally resulting from newer business initiatives in specialized financing and investments, asset based and real estate financings and small business loan activities. This increase largely offsets a $39 million decrease in revenues associated with the reduction in the level of corporate financings and the effect on revenues of the lower level of floating interest rates. PRODUCT CATEGORIES Corporate financing. Due to continuing efforts to strengthen portfolio quality and reduce concentrations, the Company financed transactions with smaller individual balances and lower debt multiples, while it broadened its syndication capabilities. Accordingly, the number of transactions funded during 1993 increased, while the amount of new fundings decreased to $906 million from $1,199 million in the prior year. The reduction in lending assets during 1993 reflects more rapid turnover of the portfolio caused by increased market and portfolio liquidity. Interest income increased, due to the higher level of average real estate funds employed which offset the effects of the lower interest rate environment. Fees and other income increased primarily due to income from newer business initiatives. The increased writedowns taken in 1993 reflects management's efforts to resolve problem real estate accounts, with general purpose office buildings accounting for the majority of the increase. The real estate portfolio was distributed by geographic location and property type as follows: As of December 31, 1993, over 90% of the real estate loans were collateralized by first mortgages. The real estate portfolio is geographically dispersed throughout the United States. Loan portfolios are financings of borrowers engaged in the acquisition of discounted portfolios of residential, commercial and industrial loans. Over the last three years, in an effort to reduce its exposure to general purpose office buildings, the Company has substantially curtailed fundings in this sector. New financings were principally in the loan portfolio acquisition, mobile home park and retail categories. Additionally, certain borrowers in the general purpose office building portfolio converted $122 million of variable rate debt to fixed debt, at market rates, in order to limit exposure to interest rate risk. Asset based financing. Asset based lending assets increased $424 million or 39% and related revenues increased $27 million or 22%, through the expansion of various lending products. The asset based lending portfolio is comprised of factored accounts receivable, equipment loans and leases, working capital financings and other collateralized loans. Factored accounts are short-term trade receivables primarily from department and general merchandise retailers. These accounts, which are purchased from approximately 545 clients, are highly liquid with an average turnover of 51 days, and are managed continuously by evaluating the consolidated exposure from all clients to a particular customer. Credit files are maintained for approximately 210,000 customers in order to control this credit exposure. Equipment loans and leases are managed by Vendor Finance and are often made with recourse to the vendor. Commercial Equipment Finance provides financing of equipment loans and leases that are central to a borrower's operations. Business Credit and First Capital loans are secured by inventory, receivables, property, plant, equipment and real estate. Presented below is summarized information about the asset based portfolio and related revenues. The asset and revenue growth illustrates the emphasis the Company has placed on growing its asset based businesses and diversifying its earnings sources. During 1993, the Company signed an agreement to acquire substantially all of the assets of an insurance premium finance company. The regulatory process could not be completed by the date required under the agreement and, accordingly, the agreement was terminated by the seller. Specialized financing and investments. Specialized financing and investments principally consist of financing of leases of aircraft and related equipment through Aircraft Finance, independent power projects through Project Investment and Advisory and equity investments in middle market companies through Equity Capital and Heller Investments. International lending assets include the assets of the wholly-owned subsidiaries, principally in Australia and Singapore, while the investments in joint ventures consist of the equity investments in 50% or less owned companies in 15 countries in Europe, Asia, and Latin America. International lending assets increased reflecting the higher level of factoring receivables. The higher level of investments in joint ventures reflects 1993 joint venture income, net of distributions. Overall international operations achieved higher net income, as the reduction in joint venture income was more than offset by the reduction in the provision for losses of wholly-owned subsidiaries. Income of international joint ventures represents the Company's share of net income from each joint venture investment. The Company periodically enters into currency exchange contracts to hedge the earnings and net investments in its international joint ventures from exposure to foreign currency fluctuations. CREDIT MANAGEMENT The Company manages credit risk through its underwriting procedures, centralized approval of individual transactions and active portfolio and account management. Underwriting procedures have been developed for each product category which enables the Company to assess a prospective borrower's ability to perform in accordance with established loan terms. These procedures may include reviewing the ability of the business or property to perform in differing economic environments, analyzing cash flows and collateral values, performing financial sensitivity analysis and assessing potential exit strategies. Financing and restructuring transactions over a certain amount are reviewed by an independent corporate credit function and require approval by a centralized credit committee. The Company manages the portfolio by monitoring transaction size and diversification by industry, geographic area and property type. Through these methods, management identifies and limits exposure to unfavorable risks, and seeks favorable financing opportunities. Additionally, a centralized department, independent of operations, periodically reviews the ongoing credit management of the individual portfolios. Examples of recent portfolio management actions include a significant reduction of new financings of general purpose office buildings and media transactions, financing of smaller transactions, and reductions in individual commitment sizes and amounts retained. Loan grading systems are used to monitor the performance of loans by product category. These systems generally consider debt service coverage, the relationship of loan to underlying business or property value, collateral value, industry characteristics, economic trends, principal and interest risk and the value of additional credit enhancements such as guarantees, irrevocable letters of credit and recourse provisions. When problem accounts are identified, specialized professionals with expertise in various industries formulate strategies to accelerate the resolution process. NONEARNING AND TROUBLED ACCOUNT ACTIVITY During 1993, the Company made progress towards improving asset quality by continuing to resolve and write down problem accounts. Accordingly, nonearning assets decreased by $120 million or 22%. Nonearning Assets. Receivables are classified as nonearning when there is significant doubt as to the ability of the debtor to meet current contractual terms as evidenced by loan delinquency, reduction of cash flows, deterioration in the loan to value relationship or other considerations. Nonearning assets decreased $120 million, from 7.2% to 5.9% of total lending assets during 1993, through the aggressive resolution and writedown of problem accounts in the corporate financing and real estate portfolios. The Company is managing risk in new financings through more conservative underwriting practices in corporate and real estate financings and growth in asset based businesses, which are believed to have lower risk characteristics. During 1994, one of the Company's primary goals will be to continue to lower nonearning assets and reduce credit quality costs. The table below presents the nonearning assets by product category. Corporate financing and real estate nonearning assets decreased $98 million and $30 million, respectively, during 1993, reflecting management's concerted efforts to resolve problem accounts. The remaining corporate financing nonearning assets are principally comprised of three accounts which were originated prior to 1990, while the real estate nonearning assets are principally comprised of financings of general purpose office buildings. Allowances for Losses. The allowance for losses on receivables is a general reserve available to absorb losses in the entire portfolio. This allowance is established through direct charges to income and losses are charged to the allowance when all or a portion of a receivable is deemed uncollectible. The allowance is reviewed periodically and adjusted when necessary given the size and loss experience of the overall portfolio, the effect of current economic conditions and the collectibility and workout potential of identified risk accounts. For repossessed assets, if the fair value declines after the time of repossession, a valuation allowance is established to reflect this reduction in value. Delinquent Earning Accounts and Troubled Debt Restructurings. The level of delinquent earning accounts changes between periods based on the timing of payments and the effects of changes in general economic conditions on the Company's borrowers. Delinquent earning accounts decreased primarily reflecting the lower level of new problem accounts in the corporate financing portfolio. At December 31, 1993 and 1992, the Company had $53 million and $57 million of loans, respectively, which are defined as troubled debt restructurings. Loans in the real estate portfolio accounted for $36 million of the current year total and $39 million of the 1992 amount. Writedowns. Total net writedowns increased during 1993 as the increase in real estate net writedowns were partially offset by the $29 million reduction in the level of corporate financing net writedowns. The Company has addressed a substantial portion of the problem accounts. Management believes that writedowns will decrease in 1994 as a result of these actions, coupled with forecasted favorable economic conditions. As a result of management's efforts to resolve problem real estate accounts, the amount of writedowns taken in 1993 increased, with general purpose office buildings accounting for the majority of the increase. Other writedowns represent losses incurred on a construction loan portfolio which was sold in 1991. LIQUIDITY AND CAPITAL RESOURCES During 1993, the Company's financial position continued to strengthen as it lowered its leverage and improved its liquidity through a reduction in commercial paper. The Company was active in the debt market through the issuance of $1,020 million of senior debt during 1993, the proceeds of which were used to retire maturing senior notes and reduce commercial paper obligations. The issuance of the notes, which had maturities ranging from 1995 to 2000, enabled the Company to reduce commercial paper and other short-term borrowings as a percentage of total debt to 33% at December 31, 1993, compared with 39% at December 31, 1992, and 47% at December 31, 1991. The Company extended the average maturity of the debt portfolio including commercial paper from 23 months to 26 months during 1993. The ratio of debt to total stockholders' equity at December 31, 1993, was 4.7X, compared with 5.4X at December 31, 1992 and 6.1X at December 31, 1991. The Company plans to continue to be active in issuing senior debt during 1994, primarily due to the need to replace $808 million of maturing debt, potentially refinance an additional $70 million which is subject to repayment at the option of the holders and support the growth of the asset based and other portfolios. The Company's domestic bank credit arrangements include a $1,344 million three-year credit facility and a $756 million one-year credit facility. These credit arrangements together with $500 million in liquidity support from Fuji Bank under the "Keep Well Agreement," and $494 million available under the factored accounts receivable sale program provide the Company with an aggregate amount of $3,094 million of committed credit and sale facilities. Total committed credit and sale facilities represent 162% of outstanding commercial paper, while total committed credit and sale facilities, excluding the liquidity support under the "Keep Well Agreement," represent 136% of outstanding commercial paper at December 31, 1993. The maturity of the Company's one-year credit facility is extendible every six months at the banks' discretion. The maturity of the three-year credit facility is extendible annually at the banks' discretion. Extensions on these facilities were granted during 1993 and extensions will be requested in 1994. International subsidiaries are funded primarily through committed and uncommitted foreign bank credit facilities totaling $17 million and $77 million, respectively, at December 31, 1993. Net cash provided by operating activities increased 11% in 1993 from the amount provided in 1992, principally reflecting improved profitability of the Company. The cash provided by investing activities was $100 million in 1993 compared with a use of $676 million in 1992. This change in funding activities reflects a significant increase in collections and sales of longer term loans, which more than offset a 13% increase in new business funding. The low net funding requirements enabled the Company to use its cash provided by operations to reduce its debt. The Company seeks to maintain a conservative posture with respect to currency and interest rate risk. The Company has numerous swap agreements with financial institutions of a notional amount which aggregated $3.5 billion at December 31, 1993. The purpose of these agreements is to manage exposure to interest rate and currency exchange rate fluctuations. At December 31, 1993, after the effect of the interest rate swap agreements, variable rate liabilities exceeded variable rate assets by approximately $139 million which represented 2% of total assets. In addition, at December 31, 1993, the Company was a party to $201 million of foreign currency exchange contracts in order to hedge the exposures to foreign currency fluctuations of international earnings and investments. The average interest rates paid by the Company on outstanding indebtedness, after the effect of swap agreements, during the three years ended December 31, 1993, are summarized below. ACCOUNTING DEVELOPMENTS In May 1993, the Financial Accounting Standards Board released Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan," which the Company is required to adopt no later than 1995. SFAS 114 requires impaired loans to be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the value of the collateral if the loan is collateral dependent. The statement also requires changes in the disclosures of impaired loans. The Company does not expect the adoption of this pronouncement to have a material effect on its results of operations or financial position. The future impact is not currently determinable, however, since it will be based on the existing impaired loans as of the date of adoption. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HELLER FINANCIAL, INC. AND SUBSIDIARIES MANAGEMENT REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of Heller Financial, Inc. and its subsidiaries has the responsibility for preparing the accompanying financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles and are not misstated due to material fraud or error. The financial statements include amounts that are based on management's best estimates and judgments. Management also prepared the other information in the December 31, 1993, annual report filed on Form 10- K and is responsible for its accuracy and consistency with the financial statements. The Company's financial statements have been audited by Arthur Andersen & Co., independent public accountants selected by the holder of the common stock. Management has made available to Arthur Andersen & Co. all the Company's financial records and related data, as well as the minutes of the stockholders' and directors' meetings. Furthermore, management believes that all representations made to Arthur Andersen & Co. during its audit were valid and appropriate. Management of the Company has established and maintains a system of internal control that provides reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition, and the prevention and detection of fraudulent financial reporting. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees with significant roles in the financial reporting process and updated as necessary. Management monitors the system of internal control for compliance. The Company maintains an internal auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements. The Company's independent public accountants have developed an overall understanding of our accounting and financial controls and have conducted other tests they consider necessary to support their opinion on the financial statements. Management has considered the internal auditors' and Arthur Andersen & Co.'s recommendations concerning the Company's system of internal control and has taken actions that it believes are cost-effective in the circumstances to respond appropriately to these recommendations. Management believes that, as of December 31, 1993, the Company's system of internal control is adequate to accomplish the objectives discussed above. Management also recognizes its responsibility for fostering a strong ethical climate so that the Company's affairs are conducted according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in the Company's code of ethical business practices, which is publicized throughout the Company. The code of ethical business practices addresses, among other things, the necessity of ensuring open communication within the Company, potential conflicts of interest, compliance with all domestic and foreign laws, including those relating to financial disclosure, and the confidentiality of proprietary information. Michael S. Blum Chairman and Chief Executive Officer Richard J. Almeida Executive Vice President and Chief Financial Officer Anthony O'B. Beirne Senior Vice President and Controller HELLER FINANCIAL, INC. AND SUBSIDIARIES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Heller Financial, Inc.: We have audited the accompanying consolidated balance sheets of HELLER FINANCIAL, INC. (a Delaware corporation) 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 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 Heller Financial, 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 13 to the Consolidated Financial Statements, the Company changed its method of accounting for income taxes, effective January 1, 1992. 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, changes in stockholders' equity and cash flows for each of the two years in the period ended December 31, 1990 (none of which are presented herein), and we have expressed an unqualified opinion on those financial statements. In our opinion, the information set forth in the selected financial data for each of the five years in the period ending December 31, 1993, appearing on page 7 is fairly stated in all material respects in relation to the consolidated financial statements from which it has been derived. ARTHUR ANDERSEN & CO. Chicago, Illinois, January 21, 1994 HELLER FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT FOR INFORMATION ON SHARES) ASSETS The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. HELLER FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. HELLER FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS) - -------- At December 31, 1993, 1992, 1991 and 1990 the Retained Earnings balance includes deferred foreign currency translation adjustments of $(12,588), $(7,337), $985, and $5,983, respectively. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. HELLER FINANCIAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF ACCOUNTING POLICIES Affiliated Group-- All of the common stock of Heller Financial, Inc. (the "Company") is owned by Heller International Corporation (the "Parent"), which is a wholly-owned subsidiary of The Fuji Bank, Limited ("Fuji Bank") of Tokyo, Japan. Basis of Presentation-- The accompanying consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. Investments in affiliated companies owned 50% or less are accounted for by the equity method. The Company does not own less than 20% of any affiliated companies. All intercompany accounts and transactions have been eliminated. Cash and cash equivalents consist of cash deposits maintained in various banks and other short-term investments with original maturities of less than three months. These short-term investments include $50 million of debt securities held to maturity and $62 million of securities available for sale, classified in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which was adopted by the Company as of December 31, 1993. The fair value of cash equivalents approximates the carrying value. Receivables are presented net of unearned income in the consolidated balance sheet and are carried at net realizable value. Income Recognition-- Loan origination and commitment fees as well as certain direct loan origination costs are deferred and amortized to interest income using the effective interest method over the life of the related loan or commitment period. From time to time, the Company sells portions of loans which it originates. Upon sale of a portion of a loan, the Company's recorded investment is allocated between the portion sold and the portion retained based on the relative fair values. Any deferred fees relating to the portion of the loan sold are recognized in income as part of the gain or loss on sale. For loan sales which qualify as syndications, fees received are generally recognized in income, subject to certain yield tests, when the syndication is complete. When the Company receives equity interests and other investments in connection with certain financings, unearned income is recorded in an amount that is equal to the relative fair value of the investment received. The unearned income is amortized to interest income over the contractual life of the related loan using the effective interest method. Increased unearned income resulting from a redemption of certain equity interests and other investments is amortized to fees and other income using the effective interest method over the life of the related loan or commitment period. The valuation of these investments is periodically reviewed and, if the recorded value of an investment is permanently impaired, the investment balance is written down to its newly established value and amortization of any unearned income is suspended. Upon disposition of an investment and retirement of the related loan, the difference between the cash or other consideration received and the book value of the investment is recognized as a gain or loss and recorded in fees and other income. As a commercial finance company, income recognition is reviewed on an account by account basis. Collateral is evaluated regularly, primarily by assessing the current and future cash flow streams from the collateral. Loans are classified as nonearning and all unearned income amortization is suspended when there is significant doubt as to the ability of the debtor to meet current contractual terms. Numerous factors including loan covenant defaults, deteriorating loan- to-value relationships, delinquencies greater than 120 days, the sale of major income generating assets or other major operational or organizational changes may lead to income suspension. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) An account may be restored to earning status either when all delinquent principal and interest has been paid under the original contractual terms or the account has been restructured and has demonstrated both the capacity to service the amended terms of the debt and adequate loan to value coverage. Allowance for Losses-- The allowance for losses on receivables is established through direct charges to income. Losses are charged to the allowance when all or a portion of a receivable is deemed impaired and uncollectible as determined by account management procedures. These procedures include assessing how the borrower is affected by economic and market conditions, evaluating operating performance and reviewing loan-to-value relationships. Management evaluates the general allowance for losses on a quarterly basis. Nonearning assets and all loans with certain loan grading characteristics are reviewed to determine if there is a potential risk of loss under varying scenarios of performance. The estimates of potential loss for these individual loans are aggregated and added to a general reserve requirement, which is based on the total of all other loans in the portfolio. This total reserve requirement is then compared to the existing allowance for losses and adjustments are made, if necessary. Repossessed Assets-- Assets which have been legally or substantively acquired in satisfaction of receivables are carried at fair value and are included in investments and other assets, net of the related valuation allowance. After repossession, operating costs are expensed and cash receipts are applied to the asset balance. Investments-- The Company adopted the provisions of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective December 31, 1993. SFAS No. 115 requires that certain investments be classified as investments held to maturity, trading securities or securities available for sale. Securities which are held to maturity are reported at amortized cost. Trading securities are carried at fair value, with the unrealized gains or losses included in earnings. Securities available for sale are also carried at fair value, with the unrealized gains or losses included in stockholders' equity, net of related taxes. Interest Rate Swap Agreements-- The differential paid or received with respect to the Company's interest rate swap agreements is recognized over the life of the related agreement. Income Taxes-- The Company and its wholly-owned domestic subsidiaries are included in the consolidated United States federal income tax return of the Parent. Heller International Group, Inc. ("International") files a separate United States federal income tax return. The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." According to the provisions of SFAS No. 109, the Company reports income tax expense as if it were a separate taxpayer and records future tax benefits as soon as it is more likely than not that such benefits will be realized. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Benefit Plans-- The Company provides health care benefits for eligible retired employees and their eligible dependents. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" which requires accrual accounting for postretirement health care benefits. The adoption of SFAS No. 106 resulted in a $7.1 million transition obligation which is being amortized prospectively over twenty years. The Company also adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits" effective June 30, 1993, which establishes accounting standards for benefits provided to former or inactive employees after employment but before retirement. The adoption of SFAS No. 112 had no effect on the consolidated financial statements since the Company's accounting practices have been consistent with this accounting standard. Information About Operations by Businesses and Geographic Areas-- The Company and its subsidiaries are engaged principally in furnishing commercial financing to businesses in the United States and to a lesser extent, investing in and operating commercial finance companies throughout the world. Currency Exchange Contracts and Foreign Currency Translation-- The Company periodically enters into currency exchange contracts to hedge its exposure to foreign currency fluctuations from its earnings and net investments in subsidiaries outside the United States. Gains and losses resulting from translation of certain foreign currency financial statements and the related effects of hedges of the net investments in subsidiaries outside the United States are deferred and accumulated in stockholders' equity, net of related taxes, until the investment is sold or substantially liquidated. Net investment hedging gains and losses are also included in stockholders' equity, net of related taxes. 2. LENDING ASSETS Lending assets include receivables and repossessed assets. Diversification of Credit Risk-- Concentrations of lending assets of 5% or more, based on the standard industrial classification of the borrower, are as follows: The majority of the lending assets in the department and general merchandise retail stores category is comprised of factored accounts receivable which represent short-term trade receivables from numerous customers. The receivables in the general purpose office building and apartment categories represent interim HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) financing for properties principally located in major U.S. cities with no concentration in any one geographic location. The textile and apparel manufacturing receivables are distributed among 14 borrowers. The general industrial machines classification is distributed among machinery used for many different industrial applications. The Company provides financing for recapitalizations, refinancings, acquisitions and corporate buy-outs ("corporate financings"), which are generally considered to be highly leveraged transactions by regulatory agencies. As of December 31, 1993, the Company's total corporate financing lending assets amounted to $3,479.0 million, consisting of 164 accounts with an average balance of $21.2 million, to borrowers in a wide variety of industries. Total corporate financing lending assets as of December 31, 1992 were $4,403.2 million and consisted of 169 accounts having an average balance of $26.1 million. The corporate financing portfolio is predominantly collateralized by senior liens on the borrower's stock or assets, or both. The commercial loans consist principally of corporate financing and asset based receivables. The asset based receivables are collateralized by inventory, receivables or fixed assets of the borrowers. The Company's real estate loans are principally collateralized by first mortgages on residential and commercial real estate. The equipment loans and leases are secured by the underlying equipment, and the Company often has recourse to the equipment vendor. Contractual Maturity of Loan Receivables-- The contractual maturities of the Company's receivables at December 31, 1993, which are presented in the table below, should not be regarded as a forecast of cash flows (in millions): Nonearning Assets and Troubled Debt Restructurings-- The Company has loans for which it has ceased to recognize interest and fee income. The following table sets forth information regarding nonearning receivables and repossessed assets. Nonearning assets have decreased $119.9 million, from 7.2% to 5.9% of total lending assets during 1993, through the aggressive resolution and writedown of problem accounts in the corporate financing and real estate portfolios. The remaining corporate financing nonearning assets are principally comprised of three HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) accounts which were originated prior to 1990, while the real estate nonearning assets are principally comprised of general purpose office building financings. Repossessed assets include in-substance repossessions of $50.4 million, $45.4 million and $54.8 million at December 31, 1993, 1992 and 1991, respectively, which were accounted for in the same manner as collateral that had been formally repossessed, even though the Company did not hold legal title. At December 31, 1993 and 1992, the Company had $53.2 million and $56.5 million, respectively, of loans which resulted from troubled debt restructurings. At December 31, 1993, the Company was not committed to lend significant additional funds in connection with troubled debt restructurings. The following table indicates the effect on income if interest on nonearning loans and troubled debt restructurings outstanding at year-end had been recognized at original contractual rates during the year. Allowance for Losses-- The changes in the allowance for losses on receivables and in the valuation allowance on repossessed assets were as follows: Writedowns occurring at the time of repossession are considered writedowns of receivables. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 3. INVESTMENTS AND OTHER ASSETS The following table sets forth a summary of the major components of investments and other assets: Equipment on lease is comprised of aircraft and related equipment. Noncancelable future minimum rental receipts under the leases are $17.9 million, $16.4 million, $14.5 million, $9.8 million and $1.3 million for 1994 through 1998. Investments in unconsolidated joint ventures represent investments in companies in 15 foreign countries. These investments are owned 50% or less by the Company, and offer factoring, asset based finance, acquisition finance, leasing, vendor and/or trade finance programs to the mid-sized corporate sector. Equity interests and other investments as well as investments which are classified as securities available for sale are obtained in connection with certain financings and investing activities of the Company. There were 92 investments recorded at December 31, 1993. In accordance with SFAS No. 115, the Company has classified its marketable equity securities portfolio as securities available for sale. These securities are primarily received in conjunction with corporate financings and are carried at their fair values using the specific identification method. Upon adoption of SFAS No. 115, the Company recognized $13.6 million of gross unrealized gains and $.2 million of gross unrealized losses on these securities, net of $5.4 million of taxes, through stockholders' equity. The Company holds certain foreign investments which are classified as trading securities according to the provisions of SFAS No. 115. Net gains of $.8 million related to these investments were recorded in income for the year ended December 31, 1993. In accordance with the provisions of SFAS No. 109, the Company recorded net deferred tax benefits for which future realization of the benefits is more likely than not to occur. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 4. DEBT Under the terms of existing debt agreements, the Company could have borrowed an additional $6.6 billion at December 31, 1993. Senior Debt-Commercial Paper and Short-Term Borrowings--The table below sets forth information concerning commercial paper. These amounts are computed based on the average daily balances outstanding during the year. The Company issues commercial paper with maturities ranging up to 270 days. In addition, the Company has short-term borrowings of $68.9 million, $54.5 million and $104.0 million at December 31, 1993, 1992 and 1991, respectively, which are used to finance the consolidated international operations. The Company and Fuji Bank are parties to a "Keep Well Agreement," which cannot be terminated by either party prior to December 31, 2000. After December 31, 2000, either Fuji Bank or the Company may terminate the agreement upon 30 business days prior written notice. As long as the Perpetual Preferred Stock is outstanding and held by third parties other than Fuji Bank, the agreement may not be terminated by either party unless the Company has received written certifications from Moody's Investors Services, Inc. and Standard and Poor's Corporation that, upon such termination, the Perpetual Preferred stock will be rated no lower than "a3" and "A-", respectively. The Keep Well Agreement provides that if the Company should lack sufficient cash or credit facilities to meet its commercial paper obligations, Fuji Bank will lend the Company up to $500 million. That loan would be payable on demand and the proceeds from the loan could only be used by the Company to meet its commercial paper obligations. Commitment fees paid by the Company to Fuji Bank under the agreement amounted to $.3 million in 1993, 1992 and 1991. Interest on any loans will be charged at the prime rate of Morgan Guaranty Trust Company of New York plus .25% per annum. No loans have been made by Fuji Bank under this agreement. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) At December 31, 1993, the Company had committed credit and asset sale facilities which totaled $3,094 million. This total includes $2,100 million in bank facilities, $500 million in liquidity support from Fuji Bank as part of the "Keep Well Agreement," and $494 million of additional liquidity available under a factored accounts receivable sale program. The Company enters into swap agreements with various financial institutions as a means of managing its interest rate exposure. At December 31, 1993, these agreements had the effect of converting $1,986 million of fixed rate debt to variable rate debt at a weighted average interest rate of 4.23%. The Company also used swaps to convert $195 million of variable rate debt from one index to another index, resulting in a weighted average interest rate of 3.69% at December 31, 1993. In addition, the Company used swaps to convert $328.2 million from one currency and variable rate to another currency and variable rate resulting in a weighted average interest rate of 3.88% at December 31, 1993. The overall weighted average interest rate paid under these debt swap agreements was 4.14% at December 31, 1993. The interest rates on the variable rate notes are primarily based on indices such as the commercial paper rate published by the Board of Governors of the Federal Reserve System plus .20% to .25%, the U.S. dollar London Inter-bank Offered Rate plus .20% to .95%, and the prime rate less 2.00% to 2.28%. The rates on HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) these notes are adjusted periodically based on changes in the underlying indices. The average interest rates on the variable rate notes at December 31, 1993 and 1992, were 4.07% and 4.54%, respectively. The fixed rate medium-term notes had a weighted average interest rate of 8.94% and 8.91% at December 31, 1993 and 1992, respectively. The $200 million and $128.2 million variable rate notes denominated in Japanese yen which are outstanding as of December 31, 1993, are valued on the basis of fixed exchange rates of 125 and 117 Japanese yen per U.S. dollar, respectively, as a result of cross currency interest rate swap agreements. The scheduled maturities of debt outstanding at December 31, 1993, other than commercial paper and short-term borrowings and excluding unamortized discount, are as follows: Notes totaling $70 million are repayable at the option of the holders prior to the final maturity date are reflected in the table above as maturing at the earliest possible repayment date. Notes redeemable solely at the option of the Company prior to the final maturity date are reflected in the table above as maturing on the final maturity date. 5. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK The Company is a party to several agreements involving financial instruments with off-balance-sheet risk in order to meet the financing needs of its borrowers and to manage its own exposure to interest rate and currency exchange rate fluctuations. These financial instruments, which include loan commitments, letters of credit, guarantees, and various swap and cap agreements, involve elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Company's exposure to credit loss in the event of nonperformance by the other party to loan commitments, letters of credit and guarantees is represented by the contractual amount of those instruments. The Company uses similar credit policies in making commitments and incurring conditional obligations as it does for loans and receivables. These financial instruments and their contract amounts at December 31, 1993 and 1992, are as follows: At December 31, 1993 and 1992, loan commitments represent agreements to provide $1,162.6 million and $1,014.9 million, respectively, of additional financing to existing borrowers, generally contingent upon the borrowers maintaining specific credit standards. In addition, loan commitments include $499.9 million HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) and $173.5 million at December 31, 1993 and 1992, respectively, to provide funding to new borrowers. Commitments to fund new borrowers generally have fixed expiration dates and termination clauses and typically require payment of a fee. The Company evaluates each borrower's creditworthiness on an individual basis and the collateral required varies depending upon the nature of the financing. Since many of the commitments are expected to remain unused, the total commitment amounts do not necessarily represent future cash requirements. For factoring credit guarantees, the Company receives a fee for guaranteeing the collectibility of certain factoring clients' accounts receivable. The Company employs the same credit approval procedures for these services as it does for its traditional factoring services. Under this arrangement, clients generally retain the responsibility for collection and bookkeeping. Losses related to these services have historically been insignificant. Letters of credit and financial guarantees are conditional commitments issued by the Company to guarantee the performance of a borrower to a third party. The credit risk involved in issuing letters of credit and financial guarantees is essentially the same as that involved in extending loans to borrowers and the collateral required is also similar to that involved in the Company's normal lending transactions. The Company is also a party to several agreements involving financial instruments where the contract or notional amounts exceed the potential credit loss. These financial instruments and their contract or notional amounts at December 31, 1993 and 1992, are as follows: Interest rate swap transactions involve the exchange of fixed and floating rate interest payment obligations without the exchange of the underlying principal amounts and are used to manage interest rate exposure. Interest rate caps are used to mitigate the impact of an increase in interest rates. Currency swap transactions involve the exchange of the underlying principal amounts and interest payments and are used to manage the currency risk created by the issuance of debt denominated in a foreign currency. Basis swap transactions involve the exchange of two different floating rate interest payment obligations without the exchange of the underlying principal amounts and are used to manage the basis risk between different floating rate indices. Entering into swap and cap agreements involves the risk of dealing with counterparties and their ability to meet the terms of the contracts. Swap and cap agreements have a credit risk defined by the cost of replacing the instrument if the counterparty defaults. Notional amounts often are used to express the volume of these transactions, but the amount of credit risk is much smaller. The Company manages this risk by establishing minimum credit ratings for counterparties and by limiting the exposure to individual counterparties as measured by the total notional amount and the current replacement cost of existing transactions. Spot and forward currency exchange contracts are used to hedge the Company's exposure to foreign currency fluctuations of international earnings and investments. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Company is party to a receivables purchase agreement with Dynamic Funding Corporation ("Dynamic"). Under this agreement, which expires March 31, 1995, the Company may sell to Dynamic, with limited recourse, an undivided interest of up to $500 million in a designated pool of its factored accounts receivable. As of December 31, 1993 and 1992, the Company had sold $5.7 million and $5.5 million, respectively, of such receivables to Dynamic for cash. As the average maturity of factored accounts receivable is 51 days and the historical loss experience is substantially less than 1%, the Company's recourse exposure is minimal. Dynamic has entered into a standby credit agreement and an operating agreement with Fuji Bank and one of its affiliates. The Company believes the terms of the agreement are similar to those which might apply in any similar arrangement among unaffiliated parties. 6. LEGAL PROCEEDINGS The Company is party to a number of legal proceedings as plaintiff and defendant, all arising in the ordinary course of its business. The Company believes that the amounts, if any, which may ultimately be funded or paid with respect to these matters will not have a materially adverse effect on the financial condition or results of operations of the Company. 7. RENTAL COMMITMENTS The Company and its consolidated subsidiaries have minimum rental commitments under noncancellable operating leases at December 31, 1993, as follows (in millions): The total rent expense, net of rental income from subleases, was $15.3 million, $12.1 million and $14.1 million in 1993, 1992 and 1991, respectively. 8. REDEEMABLE PREFERRED STOCK The Company has authorized the issuance of 100,000 shares of a series of preferred stock designated NW Preferred Stock, Class B (No Par Value) ("NW Preferred Stock"), pursuant to the "Keep Well Agreement" between the Company and Fuji Bank wherein, among other things, Fuji Bank has agreed to purchase NW Preferred Stock in an amount required to maintain the Company's net worth at $500 million. The Company's net worth was $1,253 million at December 31, 1993. If and when issued, dividends will be paid quarterly on NW Preferred Stock at a rate per annum equal to 1% over the three-month London Inter-bank Offered Rate. Subject to certain conditions, NW Preferred Stock will be redeemable at the option of the holder within a specified period of time after the end of a calendar quarter in an aggregate amount not greater than the excess of the net worth of the Company as of the end of such calendar quarter over $500 million and at a redemption price equal to the price paid for such stock plus accumulated dividends. No purchases of NW Preferred Stock have been made by Fuji Bank under this agreement. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 9. PREFERRED STOCK The Company's 5,000,000 shares of 8.125% Perpetual Preferred Stock have a par value of $.01 per share. The Company is prohibited from paying cash dividends on Common Stock or any other preferred stock that ranks, with respect to payment of dividends, equal or junior to the Perpetual Preferred Stock, unless full cumulative dividends on the Perpetual Preferred Stock have been paid. The Perpetual Preferred Stock is not redeemable prior to September 22, 2000. On or after this date, the Perpetual Preferred Stock will be redeemable at the option of the Company, in whole or in part at a redemption price of $25 per share, plus accrued and unpaid dividends. The Perpetual Preferred Stock ranks senior with respect to payments of dividends and liquidation to other outstanding or authorized preferred stock of the Company. During 1993 and 1992, the Company declared and paid $10.1 million and $1.5 million, respectively, of Perpetual Preferred Stock dividends. The Company's Cumulative Convertible Preferred Stock, Series D ("Convertible Preferred Stock") is held by the Parent. The Convertible Preferred Stock has a dividend yield established quarterly at a rate of 1/2% less than the announced prime commercial lending rate of Morgan Guaranty Trust Company of New York, payable quarterly. Under the terms of the Convertible Preferred Stock, the Company is prohibited from paying cash dividends on Common Stock unless full cumulative dividends on all outstanding shares of Convertible Preferred Stock for all past dividend periods have been paid. During 1993, 1992 and 1991, the Company declared and paid $1.4 million, $1.5 million and $2.1 million of dividends, respectively. The Convertible Preferred Stock is convertible into Common Stock of the Company at the conversion price of one share of Common Stock for each 200 shares of Convertible Preferred Stock. Subject to certain conditions, the Convertible Preferred Stock is redeemable at any time at the option of the Company at a redemption price equal to the price paid for such stock plus accumulated dividends. During 1991, the Company retired $275 million of Dutch Auction Rate Transferable Securities and paid $4.4 million of dividends on this stock. 10. DIVIDEND RESTRICTIONS Dividends may legally be paid only out of the Company's surplus, as determined under the provisions of the Delaware General Corporation Law, or net profits for either the current or preceding fiscal year, or both. 11. OPERATING EXPENSES The following table sets forth a summary of the major components of operating expenses and the amount of minority interest in Heller International Group, Inc. income which has been included in operating expenses rather than as a separate caption in the Consolidated Statements of Income due to the immateriality of the amount: The Parent performs services for the Company and charges the Company for the related costs incurred. These charges are reflected in certain of the above captions. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 12. BENEFIT PLANS AND OTHER POST RETIREMENT BENEFITS The Company has various incentive compensation plans and a savings and profit-sharing plan which provide for annual contributions to eligible employees based on the Company's achievement of certain financial objectives and employee achievement of certain job related objectives. In addition, the Company has noncontributory defined benefit pension plans covering substantially all of its domestic employees. Certain foreign employees are covered by contributory or noncontributory defined contribution plans. The Company's policy is to fund, at a minimum, pension contributions as required by the Employee Retirement Income Security Act of 1974. Benefits are based on an employee's years of service and average earnings for the five highest consecutive years of compensation occurring during the last ten years before retirement. The following table summarizes the funded status of the defined benefit pension plans at December 31, 1993 and 1992: At December 31, 1993, the Company reduced the discount rate used to calculate the projected pension benefit obligation to 7.5%, reflecting the change in the interest rate environment. This reduction in the discount rate is expected to increase 1994 pension expense by approximately $1 million. The discount rate reduction had no effect on 1993 pension expense, which was $1.0 million compared to $1.2 million and $.9 million in 1992 and 1991, respectively. The Company also decreased the salary rate assumption from 7% to 6% at December 31, 1993, based on the Company's experience. This rate reduction had no effect on the 1993 pension expense and is expected to reduce 1994 pension expense by $.7 million. The Company also provides health care benefits for eligible retired employees and their eligible dependents. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" which requires accrual accounting for postretirement health care benefits. At December 31, 1993, $6.7 million of the transition obligation remains unamortized. This obligation, under the terms of the amended healthcare plan, was calculated using relevant actuarial assumptions and health care cost trend rates projected at annual rates ranging from 12% in 1993 to 6% in 2002 and thereafter and using a discount rate of 8.5%. The effect of a 1% annual increase in these assumed cost trend rates would increase the accumulated postretirement benefit obligation by approximately $.8 million; while annual service and interest cost components in the aggregate would not be materially affected. Consistent with the reduction in the discount rate for the pension plan, the discount rate used to calculate the accumulated postretirement benefit obligation was reduced to 7.5%, at December 31, 1993. The reduction in the discount rate had no effect on the postretirement benefit expense for 1993 but is expected to increase 1994 expense by less than $.1 million. The net postretirement benefit liability and associated expense were $1.1 million for the year ended December 31, 1993. Postretirement benefit expense was $.3 million for 1992 and 1991, when retiree medical claims were expensed as incurred. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 13. INCOME TAXES The Company accounts for income taxes in accordance with the provisions of SFAS No. 109, "Accounting for Income Taxes". SFAS No. 109 requires the Company to record deferred tax benefits for deductible temporary differences if it is more likely than not that these benefits will be realized and also requires the Company to report income tax expense as if it were a separate taxpayer. In 1992, the Company recognized $41.1 million of previously unrecognized tax benefits and amended the tax allocation agreement with the Parent, to conform to the new accounting standard. In prior years, income taxes provided on a consolidated basis were allocated between the Company and the Parent based on their separate taxable income or loss before state income taxes and carryforwards of net operating losses, tax credits and capital losses. Management believes that it is more likely than not that at December 31, 1993 and 1992, $109.1 million and $65.1 million, respectively, will be realized from the Company's existing deductible temporary differences. These tax benefits are shown net of valuation allowances of $13.5 million and $55.0 million at December 31, 1993 and 1992, respectively. The valuation allowance was reduced in 1993 as a result of management's increased confidence in the deductibility of temporary differences. The provision for income taxes is summarized in the following table: In accordance with the provisions of the current tax allocation agreement, payments of $55.7 million were made to the Parent in 1993 for the Company's estimated current income tax liability. In 1992 and 1991, income taxes paid amounted to $24.2 million and $.2 million, respectively. Included in the above table are amounts relating to International, which files a separate United States federal income tax return. Income taxes paid by International in 1993, 1992 and 1991 amounted to $1.2 million, $.4 million, and $1.7 million, respectively. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) During 1993, the statutory federal income tax rate increased to 35% from 34%, the rate in effect for 1992 and 1991. The reconciliation between the statutory federal income tax provision and the actual effective tax provision for each of the three years ended December 31 is as follows: In 1994, management expects the effective tax rate to approach the statutory tax rate. The significant components of the deferred tax liabilities and assets at December 31, 1993 and 1992 are shown below: Provision has not been made for United States or additional foreign taxes on $85.7 million of undistributed earnings of subsidiaries outside the United States, as those earnings are intended to be reinvested. Such earnings would become taxable upon the sale or liquidation of these international operations or upon the remittance of dividends. Given the availability of foreign tax credits and various tax planning strategies, management believes any tax liability which may ultimately be paid on these earnings would be HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) substantially less than that computed at the statutory federal income tax rate. Upon remittance, certain foreign countries impose withholding taxes that are then available, subject to certain limitations, for use as credits against the Company's U.S. tax liability, if any. The amount of withholding tax that would be payable upon remittance of the entire amount of undistributed earnings would be approximately $10.2 million. During 1993, the Company utilized alternative minimum tax credit carryforwards of $5.1 million, which were available at December 31, 1992, for federal income tax purposes. In addition, the Company utilized its remaining investment tax credits of $13.8 million. The Company had unused foreign tax credit carryforwards of $4.4 million at December 31, 1993. Due to substantial restrictions on the utilization of foreign tax credits imposed by the Tax Reform Act of 1986, the Company may not be able to utilize a significant portion of foreign tax credit carryforwards prior to expiration and, accordingly, the Company has not recorded any deferred tax benefits related to these credits. 14. RELATED PARTIES Services Provided by Fuji Bank and the Parent for the Company. Certain employees of Fuji Bank and the Parent perform managerial, administrative and other related functions for the Company. The Company compensates Fuji Bank and the Parent for these services at a rate which reflects current costs which were $1.8 million and $43.5 million, respectively for 1993, and $1.7 million and $41.0 million for 1992. From time to time, certain subsidiaries of Fuji Bank serve as managers for various offerings of the Company's debt securities. The fees paid by the Company are similar to those the Company would pay an unaffiliated agent in an arms-length transaction. The Fuji Bank and Trust Company acts as registrar and paying agent for various debt issuances by the Company. Services Provided by the Company for Fuji and the Parent. The Company performs services for its affiliates, and charges them for the cost of the work performed. Effective November 1, 1991, Heller Capital Markets Group, Inc. ("CMG"), a wholly-owned subsidiary of the Company, agreed to act as placement agent for the sale of commercial paper issued by the Parent. CMG is compensated based on the face amount of the commercial paper notes sold. CMG received compensation of $.4 million in 1993 and 1992 and $.1 million in 1991, pursuant to this agreement. Management believes the terms of the agreement are similar to those which would apply in any similar arrangement among unaffiliated parties. The Company provides advisory services to Fuji Bank with respect to real estate clients at the request of Fuji Bank. During 1993, 1992 and 1991, the Company charged Fuji Bank approximately $.1 million, $.2 million, and $.3 million respectively, for these services. In the ordinary course of its business, the Company participates in joint financings with certain affiliates of the Company. From time to time the Company guarantees its clients' obligations under letters of credit issued by financial institutions, some of which are affiliates of the Company. The Company believes that these joint financings and letter of credit arrangements with affiliates are on terms similar to those available from unaffiliated financial institutions. The Company has agreements with certain other subsidiaries of the Parent which provide for the Company to receive an annual negotiated fee for servicing assets which have been sold by the Company to the Parent and these affiliates. The Company continues to service these assets and all other direct costs and expenses, including any additional advances made after the date of the agreement, are borne by the subsidiaries of the Parent. The amount of fees for servicing the transferred assets in 1993, 1992 and 1991, was approximately $4.3 million, $4.7 million and $3.5 million, respectively. These amounts are recorded as a reduction of operating expenses in the consolidated statements of income. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Intercompany Receivables and Financial Instruments. The Company is party to a $250 million interest rate swap agreement (the "$250 million agreement") with the Parent which was amended in 1992 and expires July 31, 1995. The Company also entered into a $200 million interest rate swap agreement with the Parent, effective January 13, 1994 which expires December 15, 2000. The purpose of the agreements is to manage the Company's exposure to interest rate fluctuations. Under these agreements, the Company pays interest to the Parent at a variable rate based on the commercial paper rate published by the Board of Governors of the Federal Reserve System and the Parent pays interest to the Company at fixed rates of 5.0% and 5.57%, respectively. The fixed rates were determined based upon the prevailing market rate for such transactions. The $250 million agreement had the effect of reducing the Company's interest expense by $4.6 million in 1993, $6.9 million in 1992 and $5.1 million in 1991. The Company is a party to a $24.7 million interest rate swap agreement with Fuji Bank, New York branch, which became effective in March, 1990 and expires in February, 1995. During 1993, $1.5 million had been paid to Fuji Bank under this agreement. Additionally, the Company entered into cross-currency basis swap agreements with a subsidiary of Fuji Bank, which had the effect of converting debt denominated in Japanese Yen to $148.2 million of U.S. currency. During 1993, $4.2 million had been paid to Fuji Bank under these agreements. At December 31, 1993 and 1992, other assets include net amounts due from affiliates of $31.3 million and $6.8 million, respectively. The amounts are comprised principally of interest bearing demand notes representing amounts due to the Company under the interest rate swap agreement with the Parent, advances, administrative fees and costs charged to other subsidiaries of the Parent. The notes bear interest at rates which approximate the average rates on the Company's commercial paper obligations or short-term bank borrowing rates outstanding during the period. Fuji Bank and one of its subsidiaries provided uncommitted lines of credit to consolidated international subsidiaries totaling $12.9 million and $21.1 million at December 31, 1993 and 1992, respectively. Borrowings under these facilities totaled $8.7 million and $12.7 million at December 31, 1993 and 1992, respectively. In addition, Fuji Bank provides uncommitted lines of credit to certain international joint ventures. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 15. FAIR VALUE DISCLOSURES SFAS No. 107 "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information for certain financial instruments, for which it is practicable to estimate that value. These values must be estimated as there is no well established market for many of the Company's assets and financial instruments. Fair values are based on estimates using present value, property yield, historical rate of return and other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. These assumptions are inherently judgmental and changes in such assumptions could significantly affect fair value calculations. In that regard, the derived fair value estimates may not be substantiated by comparison to independent markets and may not be realized in immediate liquidation of the instrument. The book values and estimated fair market values of the Company's financial instruments at December 31, 1993 and 1992, are as follows: The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments. Carrying values approximate fair values for all financial instruments which are not specifically addressed. Certain variable rate receivables that reprice frequently and have no significant credit risk, fair values were assumed to equal carrying values. All other receivables were pooled by loan type and risk rating. The fair value for these receivables was estimated via discounted cash flow analyses, using interest rates equal to the London Inter-bank Offered Rate or the prime rate offered as of December 31, 1993 and 1992, plus an adjustment for normal spread, credit quality and the remaining terms of the loans. Book and fair values of the trading securities and securities available for sale are based on quoted market prices. The fair values of equity interests and other investments are calculated by first using the Company's business valuation model to determine the estimated value of these investments as of the anticipated exercise date. The business valuation model analyzes the cash flows of the related company and considers values for similar equity investments. The determined value is then discounted back to December 31, 1993 and 1992, using a rate appropriate for returns on equity investments. Although the investments in international joint ventures accounted for by the equity method are not considered financial instruments and as such are not included in the above table, management believes that the fair values of these investments significantly exceed the carrying value of these investments. The fair values of the Company's debt and swap agreements were estimated using discounted cash flow analyses, based on current incremental borrowing and swap rates for arrangements with similar terms and remaining maturities, as quoted by independent financial institutions as of December 31, 1993 and 1992. The fair value of debt is presented net of the fair value of interest rate, cross currency interest rate and basis swap agreements which amounted to a $148.1 million and $83.8 million, respectively, net favorable position as of December 31, 1993 and 1992. The fair values of loan commitments, letters of credit and guarantees are negligible after consideration of the time value of money. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 16. FINANCIAL DATA BY REGION The following table shows certain financial information for the years ended December 31, 1993, 1992 and 1991, attributable to United States and international operations by geographic region. HELLER FINANCIAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 17. SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following financial information for the calendar quarters of 1993, 1992 and 1991, is unaudited. In the opinion of management, all adjustments necessary to present fairly the results of operations for such periods have been included. Net income for the quarter ended March 31, 1992 includes $41.1 million of income for the cumulative effect of the recognition of a deferred tax asset through December 31, 1991, resulting from the adoption of SFAS No. 109, "Accounting for Income Taxes." The provision for losses increased in the quarter ending December 31, 1992, as the Company strengthened its allowance for losses to 3.0% of receivables to improve coverage ratios and to address the risks associated with certain troubled credits in the corporate financing and real estate portfolios. 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 names and ages of all directors and executive officers of the Company as of January 1, 1994, and a biographical summary for each such person, appear in the following pages. No family relationship exists among the persons named below. DIRECTORS EXECUTIVE OFFICERS Each of the officers and directors of the Company are elected at the annual meeting for a term of one year until their successors are duly elected and qualified. An Initial Statement Of Beneficial Ownership Of Securities on Form 3 was filed by: (i) Challis Lowe (elected effective September 7, 1993 as Senior Vice President--Human Resources) on November 17, 1993, (ii) Thomas Jaekel (elected effective October 14, 1993 as President, Real Estate Financial Services Group) on December 3, 1993, and (iii) Minoru Itosaka (elected effective July 23, 1993 as Director), on January 14, 1994. In all filings, there were no reported holdings of the Registrant's equity securities. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following information is furnished as to all plan and non-plan compensation awarded to, earned by, or paid to the Chief Executive Officer of the Company and the four next most highly compensated executive officers of the Company (as determined at December 31, 1993) for services rendered in all capacities to the Company and its subsidiaries during the years ended December 31, 1993, 1992 and 1991. SUMMARY COMPENSATION TABLE (1) (2) ANNUAL COMPENSATION - -------- (1) All numbers are rounded to the nearest whole dollar. (2) Certain executive officers of the Company whose compensation is included above are employed and paid by the Parent. Pursuant to a management agreement between the Company and the Parent, the Company reimburses the Parent for their services. (3) The cash bonus under the management incentive plan for services rendered to the Company and its subsidiaries during the year ended December 31, 1993 was not calculable as of the date of this report. Such amounts will be disclosed in the Company's annual report for the subsequent fiscal year in the appropriate column for the year in which earned. Annual bonus amounts are earned and accrued during the year shown, and paid subsequent to the end of such year. (4) Amounts in the Other Annual Compensation column and in the All Other Compensation column for the year ended December 31, 1991 have been excluded under the transition period provisions of the Securities and Exchange Commission ("SEC") Executive Compensation Disclosure rules which became effective on October 21, 1992. (5) During 1993, the Company had a Long Term Incentive Plan that commenced on January 1, 1992 and terminates on December 31, 1994 ("1992-94 LTIP"), which it had historically considered as a long term compensation plan. The SEC, however, pursuant to its Release 33-7009, dated August 6, 1993, requires that the Company report accrued compensation under the 1992-94 LTIP as annual compensation since accruals are based upon the Company's performance in one year and are not affected by the Company's performance in subsequent years. As a result, the Company is reporting in this column annual accruals under the 1992-94 LTIP. Under the terms of the 1992-94 LTIP, payouts of accruals occur after the termination of the 1992-94 LTIP to officers who are active employees of the Company and participants in the 1992-94 LTIP through its termination date (subject to exceptions in the case of disability, death or retirement). Payouts of accruals under a prior Long Term Incentive Plan that commenced on January 1, 1990 and terminated on December 31, 1992 ("1990-92 LTIP"), were made to the named executive officers in 1992 for the following accruals attributable to 1992 and 1991, respectively: Mr. Blum, $348,750 and $290,000; Mr. Almeida, $95,504 and $90,083; Mr. Lockhart, $81,585 and $77,543; Mr. Vernick, $78,002 and $71,760; and Ms. Martin, $74,189 and $66,867. These payouts were previously reported, in aggregate, as 1992 LTIP Payouts in the Company's 1992 Annual Report on Form 10-K. Perquisites and other personal benefit amounts for each of the named executive officers are omitted since the amounts fall below the minimum level for disclosure. (6) A significant portion of the 1993 and 1992 amounts consists of special payments attributable to the performance of specific business units and investments. (7) Amounts reported reflect the Company's contribution made in the form of a match on amounts deferred by the officer in the Company's Savings and Profit Sharing Plan, that is qualified under Section 501(a) of the Internal Revenue Code. This Plan is available to all employees who work at least 900 hours per year. The Company makes matching contributions equal to 50% of the employee's contribution provided, however, that the Company's contribution will not exceed 2.5% of the employee's base salary. RETIREMENT AND OTHER DEFINED BENEFIT PLANS The Company has a defined benefit retirement income plan (the "Retirement Plan") for the benefit of its employees that is a qualified plan under Section 401 of the Internal Revenue Code of 1986 (the "Code"). Substantially all domestic employees of the Company who have one year of service, including executive officers and directors of the Company, and also certain executive officers and directors of International, participate in the Retirement Plan. Non-employee directors are not eligible for retirement benefits. The Company adopted a Supplemental Executive Retirement Plan ("SERP"), effective October 28, 1987, which provides benefits to all officers at the level of Senior Vice President and above who participate in the Company's LTIP and the Retirement Plan, which are in excess of the limitations imposed by Sections 401(a)(17) and 415 of the Internal Revenue Code, as amended from time to time. Under a defined benefit plan, such as the Company's, contributions are not specifically allocated to individual participants. The table below shows estimated annual retirement benefits for executives in specified remuneration and service classifications. ESTIMATED ANNUAL RETIREMENT BENEFITS In general, remuneration covered by the retirement plan consists of the annual base salary determined before any salary reduction contributions to the Company's Savings and Profit Sharing Plan. The number of years of credited service as of December 31, 1993, and the actual average remuneration for their respective years of credited service with the Company for those individuals listed on the Summary Compensation Table are as follows: Michael S. Blum, $464,050, 7 years 6.5 months, Richard J. Almeida, $240,400, 6 years 5 months, Dennis P. Lockhart, $210,972, 6 years, Mitchell F. Vernick, $188,582, 7 years 4.5 months, and Lauralee E. Martin, $185,667, 7 years 4.5 months. The figures shown in the table above include benefits payable under the SERP as described above. However, the figures shown are prior to offsets for Social Security, Retirement Plan and Company match benefits (under its Savings and Profit Sharing Plan) as specified by the SERP benefit formula. The estimates assume that benefits commence at age 65 under a straight life annuity form. COMPENSATION OF DIRECTORS Directors of the Company are not compensated for provision of services as a director to the Company. EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE OF CONTROL ARRANGEMENTS Michael S. Blum has an employment contract with the Parent which expires on December 31, 1996 and provides that if his employment is terminated by the Parent without cause (as defined in the contract), or if he resigns in response to a significant diminution of his assigned duties and responsibilities by the Parent, he will be entitled to receive full salary and all executive perquisites through the later of December 31, 1996, or the last day of the twelfth month following the month in which his termination occurred (the "Cutoff Date"). He will also receive a pro rata portion of his estimated incentive plan payments for the year of termination and will continue to be covered under certain benefit plans through the Cutoff Date. If Mr. Blum's employment is terminated pursuant to either of the situations described above, he will receive 50% of his full salary from the Cutoff Date until August 30, 1998. In the event that Mr. Blum and the Parent do not reach an agreement regarding the terms of an extension or renewal of his contract, Mr. Blum is entitled to receive full salary until the later of December 31, 1996, or nine months from the date the Parent informs him that it does not intend to extend his employment and thereafter at the rate of 50% of his full salary through August 30, 1998 (subject to reduction for compensation received from another employer). Mr. Blum would also receive coverage under certain benefit plans through August 30, 1998 and perquisites through December 31, 1997. Mitchell Vernick participates in special incentive arrangements with the Company pursuant to which he is eligible to receive payments based upon the performance of specific business units and investments. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Michael S. Blum, Tomohiro Kamio, and Osamu Kita served as members of the Compensation Committee of the Board of Directors of the Company during 1993. Mr. Blum also served as Chairman and Chief Executive Officer of the Company, and its subsidiaries, International and Holdings. In addition, Mr. Blum served as the Chairman of the Board, Chief Executive Officer and President of the Parent and served as a member of the Compensation Committee of the Parent, International, and Holding. Another executive officer of the Parent, Osamu Kita, also served as a member of the Compensation Committee of the Company. As identified below, several directors of the Company also served as executive officers of one or more of the other companies for whom Mr. Blum served as a member of the Compensation Committee of the Board of Directors: Mr. Almeida, Parent, International and Holdings; Mr. Fukabori, Parent; Mr. Litwin, International and Holdings; Mr. Lockhart, Parent, International and Holdings; Mr. Vernick, International and Holdings. No other relationships exist between the directors and executive officers of the Company and the directors and executive officers of the Company's Parent or subsidiaries. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT VOTING SECURITIES The following table sets forth the ownership of all of the outstanding common stock of the Company, as of February 1, 1994: EQUITY SECURITIES All of the outstanding common stock of the Parent is owned by Fuji Bank. As of November 30, 1993, certain directors and executive officers of the Company owned beneficially certain amounts of Fuji Bank's common stock, all as indicated below. In addition, Messrs. Fukabori, Ishikawa, Itosaka, Iwasaki, Kita, Kobayashi, Takano and Yamamoto participate in a Fuji Bank employee stock purchase plan and, as of November 30, 1993, beneficially held a total of approximately 31,808 shares. The aggregate number of shares of Fuji Bank common stock that are beneficially owned by the Company's directors and officers, considered as a group, including those shares held in the Fuji Bank employee stock purchase plan, does not exceed 1% of the outstanding shares of such stock. The following table sets forth the ownership of all outstanding equity securities of the Company, and its subsidiaries, as of February 1, 1994: - -------- (a) The aggregate number of shares of 8 1/8% Cumulative Perpetual Senior Preferred Stock, Series A that were beneficially owned did not exceed 1% of the outstanding shares of such stock. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS KEEP WELL AGREEMENT WITH FUJI BANK The Company entered into a Keep Well Agreement (the "Agreement") with Fuji Bank on April 23, 1983 in order to assist the Company in maintaining its credit rating. The Agreement was amended and supplemented on January 26, 1984, in connection with the consummation of the purchase of the Company by Fuji Bank and has been amended since that date from time to time. The Agreement provides that Fuji Bank will maintain the Company's net worth in an amount equal to $500 million. Accordingly, if the Company should determine, at the close of any month, that its net worth is less than $500 million, then Fuji Bank will purchase, or cause one of its subsidiaries to purchase, shares of the Company's NW Preferred Stock, Class B (No Par Value) ("NW Preferred Stock") in an amount necessary to increase the Company's net worth to $500 million. If and when issued, dividends will be paid quarterly on the NW Preferred Stock at a rate per annum equal to 1% over the three-month London Inter-bank Offered Rate. Such dividends will not be paid during a default in the payment of principal or interest on any of the outstanding indebtedness for money borrowed by the Company. Subject to certain conditions, the NW Preferred Stock will be redeemable at the option of the holder, within a specified period of time after the end of a calendar quarter in an aggregate amount not greater than the excess of net worth of the Company as of the end of such calendar quarter over $500 million. The Agreement further provides that if the Company should lack sufficient cash, other liquid assets or credit facilities to meet its payment obligations on its commercial paper, then Fuji Bank will lend the Company up to $500 million (the "Liquidity Commitment"), payable on demand, which the Company may use only for the purpose of meeting such payment obligations. Any such loan by Fuji Bank to the Company (a "Liquidity Advance" or "Advances") will bear interest at a fluctuating interest rate per annum equal to the announced prime commercial lending rate of Morgan Guaranty Trust Company of New York plus .25% per annum. Each Liquidity Advance will be repayable on demand at any time after the business day following the 29th day after such Advance was made. No repayment of the Liquidity Advance will be made during a period of default in the payment of the Company's senior indebtedness for borrowed money. No Advances or purchases of NW Preferred Stock have been made by Fuji Bank under the Agreement; other infusions of capital in the Company have been made by International. Under the Agreement, the Company has covenanted to maintain, and Fuji Bank has undertaken to assure that the Company will maintain, unused short-term lines of credit and committed credit facilities in an amount approximately equal to 75% of the amount of its commercial paper obligations from time to time outstanding. In addition, under the Agreement, neither Fuji Bank nor any of its subsidiaries can sell, pledge or otherwise dispose of any shares of the Company's Common Stock or permit the Company to issue shares of its Common Stock except to Fuji Bank or a Fuji Bank affiliate. Neither Fuji Bank nor the Company may terminate the Agreement for any reason prior to December 31, 2000. After December 31, 2000 either Fuji Bank or the Company may terminate the Agreement upon 30 business days' prior written notice. So long as the Perpetual Preferred Stock is outstanding and held by third parties other than Fuji Bank, the Agreement may not be terminated by either party unless the Company has received written certifications from Moody's Investors Services, Inc. and Standard and Poor's Corporation that upon termination the Perpetual Preferred Stock will be rated by them no lower than "a3" and "A-", respectively. For these purposes the Preferred Stock will no longer be deemed outstanding at such time as an effective notice of redemption of all of the Preferred Stock shall have been given by the Company and funds sufficient to effectuate such redemption shall have been deposited with the party designated for such purpose in the notice. In addition, any termination of the Keep Well Agreement by the Company must be consented to by Fuji Bank. Any such termination will not relieve the Company of its obligations in respect of any NW Preferred Stock outstanding on the date of termination or the dividends thereon, any amounts owed in respect of Liquidity Advances on the date of termination or the unpaid principal or interest on those Advances or Fuji Bank's fee relating to the Liquidity Commitment. Any such termination will not adversely affect the Company's commercial paper obligations outstanding on the date of termination. The Agreement can be modified or amended by a written agreement of Fuji Bank and the Company. However, no such modification or amendment may change the prohibition against termination before December 31, 2000. Further, no such modification or amendment may adversely affect the Company's then-outstanding commercial paper obligations. Under the Agreement, the Company's commercial paper obligations and any other debt instruments are solely the obligations of the Company. The Agreement is not a guarantee by Fuji Bank of the payment of the Company's commercial paper obligations, indebtedness, liabilities or obligations of any kind. TAX ALLOCATION AGREEMENT Under the terms of the tax allocation agreement between the Parent and its subsidiaries, as amended, each company covered by the agreement calculates its current and deferred income taxes based on its separate company taxable income or loss, utilizing separate company net operating losses, tax credits, capital losses and deferred tax assets or liabilities. CERTAIN TRANSACTIONS WITH THE PARENT AND ITS SUBSIDIARIES Services Provided for the Company. Certain employees of the Parent perform managerial, administrative and other related functions for the Company. During 1993, the Company compensated the Parent $43.5 million for these services. Services Provided by the Company. The Company performs services for its affiliates and charges those companies for the cost of the work performed. Heller Capital Markets Group, Inc. ("CMG"), a wholly-owned subsidiary of the Company, acts as placement agent for the sale of commercial paper issued by the Parent. CMG receives compensation, based upon the face amount of the commercial paper notes sold. For the year ending December 31, 1993, the Parent paid $.4 million to CMG as compensation pursuant to this arrangement. Management believes the terms of this arrangement are similar to those which might apply in any similar arrangement among unaffiliated parties. The Company has agreements with certain subsidiaries of the Parent which provide for the Company to receive an annual negotiated fee for servicing assets which have previously been sold by the Company to the Parent and those affiliates. The Company continues to service these assets and all other direct costs and expenses, including any additional advances made after the date of the agreement, are borne by the subsidiaries of the Parent. In 1993, the amount of fees the Company received for servicing the transferred assets was approximately $4.3 million. These amounts are recorded as a reduction of operating expenses in the consolidated statement of income. Financial Transactions and Instruments. In the ordinary course of its business, the Company participates in joint financings with certain affiliates of the Company. From time to time the Company guarantees its clients' obligations under letters of credit issued by financial institutions, some of which are affiliates of the Company. The Company believes that these joint financings and letter of credit arrangements with affiliates are on terms similar to those available from unaffiliated financial institutions. The Company is a party to a master swap agreement with its Parent. The Company and its Parent have entered into two swap transactions under that agreement. The first is a $250 million swap transaction, which was initially entered into in 1985, and was last amended in 1992, in part, to extend the term through July 31, 1995 ("1985 agreement"). The second was a $200 million swap transaction, which commenced on January 13, 1994 and expires on December 15, 2000 ("1994 agreement"). The purpose of the 1985 and 1994 agreements (collectively the "agreements") is to manage the Company's exposure to interest rate fluctuations. Under the provisions of these agreements, the Company pays interest to the Parent at a variable rate based on the commercial paper rate published by the Board of Governors of the Federal Reserve System and the Parent pays interest to the Company at a fixed rate of 5.0% and 5.57% under the 1985 and 1994 swap agreements, respectively. The fixed rate was determined based upon prevailing market rates for such transactions at the time of such swap. The 1985 agreement had the effect of reducing the Company's interest expense by $4.6 million in 1993. On February 15, 1985, the Company issued to the Parent 1,000 shares of previously subscribed Cumulative Convertible Preferred Stock, Series D (No Par Value) ("Convertible Preferred Stock"), which has a dividend yield established quarterly at the rate of 1/2% under the announced prime commercial lending rate of Morgan Guaranty Trust Company of New York, cumulative from March 30, 1984 and payable quarterly commencing on March 31, 1989. During 1993, the Company declared and paid approximately $1.4 million of dividends on the Convertible Preferred Stock. The Convertible Preferred Stock is convertible into Common Stock of the Company at the conversion price of one share of Common Stock for each 200 shares of Convertible Preferred Stock. Subject to certain conditions, the Convertible Preferred Stock is redeemable, in whole or in part, at any time at the option of the Company at a redemption price equal to the price paid for such stock plus accumulated dividends. Upon voluntary or involuntary liquidation, the holder of the Convertible Preferred Stock is entitled to be paid an amount equal to the price paid for each share plus accumulated dividends. At December 31, 1993, net amounts due from affiliates was $31.3 million. The amounts were comprised principally of interest bearing demand notes representing amounts due to the Company under the interest rate swap agreement with the Parent, advances, administrative fees and costs charged to other subsidiaries of the Parent. The notes bear interest at rates which approximate the average rates on the Company's commercial paper obligations or short-term bank borrowing rates outstanding during the period. CERTAIN OTHER RELATIONSHIPS Services Provided for the Company. Certain employees of Fuji Bank perform managerial, administrative and other related functions for the Company. The Company compensates Fuji Bank for the use of such individuals' services at a rate which reflects current costs to Fuji Bank. In 1993, the Company's cost for such services was approximately $1.8 million. Certain subsidiaries of Fuji Bank serve as managers for various offerings of the Company's debt securities. The fees paid by the Company are similar to those the Company would pay an unaffiliated agent in an arms-length transaction. The Fuji Bank and Trust Company acts as registrar and paying agent for various debt issuances by the Company. Services Provided by the Company. The Company provides advisory services to Fuji Bank real estate clients at the request of Fuji Bank. During 1993, the Company charged Fuji Bank less than $.1 million for these services. Financial Instruments. During March, 1990, the Company entered into a receivables purchase agreement with Dynamic Funding Corporation ("Dynamic"). Under this agreement, which expires March 31, 1995, the Company may sell to Dynamic with limited recourse an undivided interest of up to $500 million in a designated pool of its factored accounts receivable. As of December 31, 1993, the Company had sold a $5.7 million interest to Dynamic for cash. Dynamic has entered into a standby credit agreement and an operating agreement with Fuji Bank and one of its affiliates. The Company is a party to a $24.7 million interest rate swap agreement with Fuji Bank, New York branch, which became effective in March 1990 and expires in February 1995. During 1993, $1.5 million had been paid to Fuji Bank under this Agreement. Additionally, the Company entered into cross-currency basis swap agreements with a subsidiary of Fuji Bank which had the effect of converting debt denominated in Japanese Yen to $148.2 million of U.S. currency. During 1993, $4.2 million had been paid to Fuji Bank under these agreements. Fuji Bank and one of its subsidiaries provided uncommitted lines of credit to consolidated international subsidiaries totaling $12.9 million at December 31, 1993. Borrowings under these facilities totaled $8.7 million at December 31, 1993. In addition, Fuji Bank provides uncommitted lines of credit to certain international joint ventures. 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: Heller Financial, Inc. and Subsidiaries-- Report of Independent Public Accountants--Arthur Andersen & Co. Consolidated Balance Sheets--December 31, 1993 and 1992 Consolidated Statements of Income 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 2. Financial Statement Schedules: Schedule II--Heller Financial, Inc. Amounts Receivable From Employees Other Than Related Parties. All other schedules are omitted because they are not applicable or because the required information appears in the financial statements or the notes thereto. 3. Exhibits: - -------- *Filed herewith. Instruments defining the rights of holders of certain issues of long- term debt of the Company have not been filed as exhibits to this Report because the authorized principal amount of any one of such issues does not exceed 10% of the total assets of the Company. In accordance with paragraph (b)(4)(iii) of Item 601 of Regulation S-K, the Company hereby agrees to furnish to the Securities and Exchange Commission, upon request, a copy of each instrument that defines the rights of holders of the Company's long-term debt. (b) Current Reports on Form 8-K: During the fourth quarter of 1993, the Company filed a Current Report on Form 8-K dated October 31, 1993. On January 28, 1994, the Company filed with the U.S. Securities and Exchange Commission a Current Report on Form 8-K, dated January 27, 1994, to announce the Company's earnings for the year 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, ON THE 7TH DAY OF FEBRUARY, 1994. Heller Financial, Inc. Michael S. Blum By ---------------------------------- Michael S. Blum 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. Michael S. Blum * By----------------------------------- By----------------------------------- Michael S. Blum Mark Kessel (Chairman, Chief Executive (Director) Officer and Director) * * By----------------------------------- By----------------------------------- Tomohiro Kamio Osamu Kita (Director) (Director) Richard J. Almeida * By----------------------------------- By----------------------------------- Richard J. Almeida Michael J. Litwin (Executive Vice President, (Director) Chief Financial Officer and Director) * Anthony O'B. Beirne By----------------------------------- By----------------------------------- Dennis P. Lockhart Anthony O'B. Beirne (Director) (Senior Vice President, Controller and Chief Accounting Officer) * By----------------------------------- By----------------------------------- Lauralee E. Martin Tetsuya Fukabori (Director) (Director) * * By----------------------------------- By----------------------------------- Atsushi Takano Hidetsune Iseki (Director) (Director) * * By----------------------------------- By----------------------------------- Mitchell F. Vernick Hirokazu Ishikawa (Director) (Director) * * By----------------------------------- By----------------------------------- Masashi Yamamoto Tatsuo Iwasaki (Director) (Director) James B. Currie * *By----------------------------------- By----------------------------------- James B. Currie Minoru Itosaka Attorney-in-Fact (Director) February 7, 1994 SCHEDULE II HELLER FINANCIAL, INC. AMOUNTS RECEIVABLE FROM EMPLOYEES OTHER THAN RELATED PARTIES - -------- (a)Bridge loan. (b) The amounts relate to mortgage receivables which are denominated in Singapore dollars. (c) The amount relates to a car loan receivable which is denominated in Singapore dollars. INDEX TO EXHIBITS - -------- *Filed herewith.

69970_1993.txt

69970_1993

1993

69970

Item 12. Security Ownership of Certain Beneficial Owners and Management; and Item 13.

86940_1993.txt

86940_1993

1993

86940

ITEM 1. BUSINESS SOUTHERN was incorporated under the laws of Delaware on November 9, 1945. SOUTHERN is domesticated under the laws of Georgia and is qualified to do business as a foreign corporation under the laws of Alabama. SOUTHERN owns all the outstanding common stock of ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH, each of which is an operating public utility company. ALABAMA and GEORGIA each own 50% of the outstanding common stock of SEGCO. The operating affiliates supply electric service in the states of Alabama, Georgia, Florida, Mississippi and Georgia, respectively, and SEGCO owns generating units at a large electric generating station which supplies power to ALABAMA and GEORGIA. More particular information relating to each of the operating affiliates is as follows: ALABAMA is a corporation organized under the laws of the State of Alabama on November 10, 1927, by the consolidation of a predecessor Alabama Power Company, Gulf Electric Company and Houston Power Company. The predecessor Alabama Power Company had had a continuous existence since its incorporation in 1906. GEORGIA was incorporated under the laws of the State of Georgia on June 26, 1930, and admitted to do business in Alabama on September 15, 1948. GULF is a corporation which was organized under the laws of the State of Maine on November 2, 1925, and admitted to do business in Florida on January 15, 1926, in Mississippi on October 25, 1976 and in Georgia on November 20, 1984. MISSISSIPPI was incorporated under the laws of the State of Mississippi on July 12, 1972, was admitted to do business in Alabama on November 28, 1972, and effective December 21, 1972, by the merger into it of the predecessor Mississippi Power Company, succeeded to the business and properties of the latter company. The predecessor Mississippi Power Company was incorporated under the laws of the State of Maine on November 24, 1924, and was admitted to do business in Mississippi on December 23, 1924, and in Alabama on December 7, 1962. SAVANNAH is a corporation existing under the laws of Georgia; its charter was granted by the Secretary of State on August 5, 1921. SOUTHERN also owns all the outstanding common stock of SEI, Southern Nuclear, SCS (the system service company), and various other subsidiaries related to foreign operations and domestic non-utility operations (see Exhibit 21 herein). At this time, the operations of the other subsidiaries are not material. SEI designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. A further description of SEI's business and organization follows later in this section. Southern Nuclear provides services to the Southern electric system's nuclear plants. SEGCO owns electric generating units with an aggregate capacity of 1,019,680 kilowatts at Plant Gaston on the Coosa River near Wilsonville, Alabama, and ALABAMA and GEORGIA are each entitled to one-half of SEGCO's capacity and energy. ALABAMA acts as SEGCO's agent in the operation of SEGCO's units and furnishes coal to SEGCO as fuel for its units. SEGCO also owns three 230,000 volt transmission lines extending from Plant Gaston to the Georgia state line at which point connection is made with the GEORGIA transmission line system. THE SOUTHERN SYSTEM The transmission facilities of each of the operating affiliates and SEGCO are connected to the respective company's own generating plants and other sources of power and are interconnected with the transmission facilities of the other operating affiliates and SEGCO by means of heavy-duty high voltage lines. (In the case of GEORGIA's integrated transmission system, see Item 1 - BUSINESS - "Territory Served" herein.) Operating contracts covering arrangements in effect with principal neighboring utility systems provide for capacity exchanges, capacity purchases and sales, transfers of economy energy and other similar transactions. Additionally, the operating affiliates have entered into voluntary reliability agreements with the subsidiaries of Entergy Corporation, Florida Electric Power Coordinating Group and TVA and with Carolina Power & Light Company, Duke Power Company, South Carolina Electric & Gas Company and Virginia Electric I-1 and Power Company, each of which provides for the establishment and periodic review of principles and procedures for planning and operation of generation and transmission facilities, maintenance schedules, load retention programs, emergency operations, and other matters affecting the reliability of bulk power supply. The operating affiliates have joined with other utilities in the Southeast (including those referred to above) to form the SERC to augment further the reliability and adequacy of bulk power supply. Through the SERC, the operating affiliates are represented on the National Electric Reliability Council. An intra-system interchange agreement provides for coordinating operations of the power producing facilities of the operating affiliates and SEGCO and the capacities available to such companies from non-affiliated sources and for the pooling of surplus energy available for interchange. Coordinated operation of the entire interconnected system is conducted through a central power supply coordination office maintained by SCS. The available sources of energy are allocated to the operating affiliates to provide the most economical sources of power consistent with good operation. The resulting benefits and savings are apportioned among the operating affiliates. SCS has contracted with each operating affiliate, SEI, various of the other subsidiaries, Southern Nuclear and SEGCO to furnish, at cost and upon request, the following services: general executive and advisory services, power pool operations, general engineering, design engineering, purchasing, accounting and statistical, finance and treasury, taxes, insurance and pensions, corporate, rates, budgeting, public relations, employee relations, systems and procedures and other services with respect to business and operations. SOUTHERN also has a contract with SCS for certain of these specialized services. Southern Nuclear has contracted with ALABAMA to operate its Farley Nuclear Plant, as authorized by amendments to the plant operating licenses. Southern Nuclear also has a contract to provide GEORGIA with technical and other services to support GEORGIA's operation of plants Hatch and Vogtle. Applications are now pending before the NRC for amendments to the Hatch and Vogtle operating licenses which would authorize Southern Nuclear to become the operator. See Item 1 - BUSINESS - "Regulation - Atomic Energy Act of 1954" herein. NEW BUSINESS DEVELOPMENT SOUTHERN continues to consider new business opportunities, particularly those which allow use of the expertise and resources developed through its regulated utility experience. These endeavors began in 1981 and are conducted through SEI and other existing subsidiaries. SEI's primary business focus is international and domestic cogeneration, the independent power market, and the privatization of generation facilities in the international market. SEI currently operates two domestic independent power production projects totaling 225 megawatts and is one-third owner of one of these (which produces 180 megawatts). It has a contract to sell electric energy to Virginia Electric and Power Company from a facility SEI is developing (through subsidiaries) in King George, Virginia. Upon completion, currently planned for 1996, SEI will operate the 220 megawatt coal-fired plant and own 50% of the project. In April 1993, SOUTHERN completed the purchase of a 50% interest in Freeport, an electric utility on the Island of Grand Bahama, for a purchase price of $35.5 million. Freeport has generating capacity of about 112 megawatts. In August 1993, SOUTHERN completed the purchase of a 55% interest in Alicura, an entity that owns the right to use the generation from a 1,000 megawatt hydroelectric generating facility in Argentina, for a net purchase price of approximately $188 million. In December 1993, SOUTHERN completed the purchase of a 35% interest in Edelnor for the purchase price of $73 million. Edelnor is a utility located in Northern Chile that owns and operates a transmission grid and a 96 megawatt generating facility and is building an additional 150 megawatt facility. SEI has continued to render consulting services and market SOUTHERN system expertise in the United States and throughout the world. It contracts with other public utilities, commercial concerns and government agencies for the rendition of services and the licensing of intellectual property. In addition, SEI engages in energy management-related services and activities. These continuing efforts to invest in and develop new business opportunities offer the potential of earning returns which may exceed those of rate-regulated operations. However, because of the absence of any assured return or rate of return, they also involve a higher I-2 degree of risk. SOUTHERN expects to make substantial investments over the period 1994-1996 in these and other new businesses. CERTAIN FACTORS AFFECTING THE INDUSTRY The electric utility industry is expected to become increasingly competitive in the future as a result of the enactment of the Energy Act (see each registrant's "Management's Discussion and Analysis - Future Earnings Potential" in Item 7 herein), deregulation, competing technologies and other factors. In recent years the electric utility industry in general has experienced problems in a number of areas including the uncertain cost of capital needed for construction programs, difficulty in obtaining sufficient return on invested capital and in securing adequate rate increases when required, high costs and other issues associated with compliance with environmental and nuclear regulations, changes in regulatory climate, prudence audits and the effects of inflation and other factors on the costs of operations and construction expenditures. The SOUTHERN system has been experiencing certain of these problems in varying degrees and management is unable to predict the future effect of these or other factors upon its operations and financial condition. CONSTRUCTION PROGRAMS The subsidiary companies of SOUTHERN are engaged in continuous construction programs to accommodate existing and estimated future loads on their respective systems. Construction additions or acquisitions of property during 1994 through 1996 by the operating affiliates, SEGCO, SCS and Southern Nuclear are estimated as follows: (in millions) *Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. Reference is made to Note 4 to the financial statements of each registrant in Item 8 herein for the amounts of AFUDC included in the above estimates. The construction estimates for the period 1994 through 1996 do not include amounts which may be spent by SEI (or the subsidiary(s) created to effect such project(s)) on future power production projects or the projects discussed earlier under "New Business Development." (See also Item 1 - BUSINESS - "Financing Programs" herein.) I-3 Estimated construction costs in 1994 are expected to be apportioned approximately as follows: (in millions) *SCS and Southern Nuclear plan capital additions to general plant in 1994 of $26 million and $1 million, respectively, while SEGCO plans capital additions of $14 million to generating facilities. Does not add due to changes made in subsidiaries' construction budget subsequent to approval of SOUTHERN system construction budget. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing cost of labor, equipment and materials; cost of capital and SEI securing a contract(s) to buy or build additional generating facilities. The operating affiliates do not have any baseload generating plants under construction and current energy demand forecasts do not require any additional baseload generating facilities before 2011. However, within the service area, the construction of combustion turbine peaking units with an aggregate capacity of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. During 1991, the Georgia legislature passed legislation which requires GEORGIA and SAVANNAH each to file an Integrated Resource Plan for approval by the Georgia PSC. Under the plan rules, the Georgia PSC must pre-certify the construction of new power plants. (See Item 1 - BUSINESS - "Rate Matters - Integrated Resource Planning" herein.) See Item 1 - BUSINESS - "Regulation - Environmental Regulation" herein for information with respect to certain existing and proposed environmental requirements and Item 2 ITEM 2. PROPERTIES ELECTRIC PROPERTIES The operating affiliates and SEGCO, at December 31, 1993, operated 33 hydroelectric generating stations, 31 fossil fuel generating stations and three nuclear generating stations. The amounts of capacity owned by each company are shown in the table below. I-18 Notes: (1) Owned by ALABAMA and MISSISSIPPI as tenants in common in the proportions of 60% and 40%, respectively. (2) Excludes the capacity owned by AEC. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) (3) Capacity shown is GEORGIA's or GULF's (Unit 3 only) current portion: 8.4% of Units 1 and 2, 75% (25% for GULF) for Unit 3 and 33.1% for Unit 4 of total plant capacity. See Item 2 - PROPERTIES - "Proposed Sales of Property" and "Jointly-Owned Facilities" herein. (4) Capacity shown is GEORGIA's portion (53.5%) of total plant capacity. (5) Represents 50% of the plant which is owned as tenants in common by GULF and MISSISSIPPI. (6) SEGCO is jointly-owned by ALABAMA and GEORGIA. (See Item 1 - BUSINESS herein.) (7) Capacity shown is GEORGIA's portion (50.1%) of total plant capacity. (8) Capacity shown is GEORGIA's portion (45.7%) of total plant capacity. (9) Generation is dedicated to a single industrial customer. Except as discussed below under "Titles to Property", the principal plants and other important units of the SOUTHERN system are owned in fee by the operating affiliates and SEGCO. It is the opinion of management of each such company that its operating properties are adequately maintained and are substantially in good operating condition. MISSISSIPPI owns a 79-mile length of 500-kilovolt transmission line which is leased to Gulf States. The line, completed in 1984, extends from Plant Daniel to the Louisiana state line. Gulf States is paying a use fee over a forty-year period covering all expenses and the amortization of the original $57 million cost of the line. The all-time maximum demand on the SOUTHERN system was 25,936,900 kilowatts and occurred in July 1993. This amount excludes demand served by generation retained by OPC, MEAG and Dalton and excludes demand associated with power purchased from SEPA by its preference customers. At that time, 27,342,700 kilowatts were supplied by SOUTHERN system generation and 1,405,800 kilowatts (net) were sold to other parties through net purchased and interchanged power. The reserve margin for the Southern electric system at that time was 13.2%. For information on the other registrants' peak demands reference is made to Item 6 - SELECTED FINANCIAL DATA herein. ALABAMA and GEORGIA will incur significant costs in decommissioning their nuclear units at the end of their useful lives. (See Item 1 - BUSINESS - I-19 "Regulation - Atomic Energy Act of 1954" and Note 1 to SOUTHERN's, ALABAMA's and GEORGIA's financial statements in Item 8 herein.) OTHER ELECTRIC GENERATION FACILITIES Through special purpose subsidiaries, SOUTHERN owns a 50% interest in Freeport, a 35% interest in Edelnor, a 55.3% interest Alicura and a 33.3% interest in a co-generation facility in Hawaii. For further discussion of other SEI projects, see Item 1 - BUSINESS - "New Business Development" herein. The generating capacity of these utilities (or facilities) at December 31, 1993, was as follows: * Represents a concession contract that provides SEI with the rights to use the generation. I-20 JOINTLY-OWNED FACILITIES ALABAMA has sold an undivided interest in two units of Plant Miller to AEC. GEORGIA has sold undivided interests in certain generating plants and other related facilities to OPC, MEAG, Dalton, FP&L and JEA. The percentages of ownership resulting from these sales are as follows: ALABAMA and GEORGIA have contracted to operate and maintain the respective units in which each has an interest (other than Rocky Mountain, as described below) as agent for the joint owners. See "Proposed Sales of Property" below for a description of the proposed sale of GEORGIA's remaining unsold ownership interest in Plant Scherer Unit 4. In connection with the joint ownership arrangements for Plant Vogtle, GEORGIA has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy until 1994 for Unit 1 and 1996 for Unit 2 and, with regard to a portion of a 5% interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest. The payments for capacity are required whether any capacity is available. The energy cost is a function of each unit's variable operating costs. Except for the portion of the capacity payments related to the 1987 and 1990 write-offs of Plant Vogtle costs, the cost of such capacity and energy is included in purchased power in the Statements of Income in Item 8 herein. In December 1988, GEORGIA and OPC completed a joint ownership agreement for the Rocky Mountain project under which GEORGIA will retain its present investment in the project and OPC will finance, complete and operate the facility. Upon completion (scheduled for 1995), GEORGIA will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). For purposes of the ownership formula, GEORGIA's investment will be expressed in nominal dollars and OPC's investment will be expressed in constant 1987 dollars. Based on current cost estimates, GEORGIA's final ownership is estimated at approximately 25% of the project at completion. GEORGIA has held preliminary discussions regarding the potential disposition of its remaining interest in the project. PROPOSED SALES OF PROPERTY In 1991 and 1993, GEORGIA completed the first two in a series of four separate transactions to sell Unit 4 of Plant Scherer to FP&L and JEA for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4% of this unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to off-system sales contracts with Gulf States that were suspended in 1988. GEORGIA will continue to operate the unit. I-21 The 1991 and 1993 sales and the remaining transactions are scheduled as follows: Plant Scherer, a jointly owned coal-fired generating plant, has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. TITLES TO PROPERTY The operating affiliates' and SEGCO's interests in the principal plants (other than certain pollution control facilities, one small hydroelectric generating station leased by GEORGIA and the land on which four combustion turbine generators of MISSISSIPPI are located, which is held by easement) and other important units of the respective companies are owned in fee by such companies, subject only to the liens of applicable mortgage indentures (except for SEGCO) and to excepted encumbrances as defined therein. The operating affiliates own the fee interests in certain of their principal plants as tenants in common. (See Item 2 - PROPERTIES - "Jointly-Owned Facilities" herein.) Properties such as electric transmission and distribution lines and steam heating mains are constructed principally on rights-of-way which are maintained under franchise or are held by easement only. A substantial portion of lands submerged by reservoirs is held under flood right easements. In substantially all of its coal reserve lands, SEGCO owns or will own the coal only, with adequate rights for the mining and removal thereof. PROPERTY ADDITIONS AND RETIREMENTS During the period from January 1, 1989, to December 31, 1993, the operating affiliates, SEGCO, and other (i.e. SCS, Southern Nuclear and, beginning in 1993, various of the special purpose subsidiaries) gross property additions and retirements were as follows: (1) Includes approximately $62 million attributable to property sold to AEC in 1992. (2) Includes approximately $480 million attributable to property sold to OPC, FP&L and JEA, but excludes $231 million from the write-off of certain Plant Vogtle costs in 1990. (3) Net of intercompany eliminations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS (1) STEPAK V. CERTAIN SOUTHERN OFFICIALS (U.S. District Court for the Southern District of Georgia) In April 1991, two SOUTHERN stockholders filed a derivative action suit against certain current and former directors and officers of SOUTHERN. The suit alleges violations of RICO by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages, including treble damages pursuant to RICO, in an unspecified amount, which if awarded, would be payable to SOUTHERN. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that the I-22 SOUTHERN board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs appealed the dismissal to the U.S. Court of Appeals for the Eleventh Circuit. (2) JOHNSON V. ALABAMA (Circuit Court of Shelby County, Alabama) In September 1990, two customers of ALABAMA filed a civil complaint in the Circuit Court of Shelby County, Alabama, against ALABAMA seeking to represent all persons who, prior to June 23, 1989, entered into agreements with ALABAMA for the financing of heat pumps and other merchandise purchased from vendors other than ALABAMA. The plaintiffs contended that ALABAMA was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring ALABAMA to refund all payments, principal and interest, made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered ALABAMA to refund or forfeit interest of approximately $10 million because of ALABAMA's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. ALABAMA has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot be determined; however, in management's opinion, the final outcome will not have a material adverse effect on SOUTHERN's or ALABAMA's financial statements. (3) OHIO RIVER COMPANY, ET AL.VS. GULF, ET AL. (U.S. District Court for Southern District of Ohio, Western Division) In 1993, a complaint against GULF and SCS was filed in federal district court in Ohio by two companies with which GULF had contracted for the transportation by barge for certain GULF coal supplies. The complaint alleges breach of the contract by GULF and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on SOUTHERN's or GULF's financial statements. See Item 1 - BUSINESS - "Construction Programs," "Fuel Supply," "Regulation - - Federal Power Act" and "Rate Matters", for a description of certain other administrative and legal proceedings discussed therein. Additionally, each of the operating affiliates and SEI are, in the normal course of business, engaged in litigation or administrative proceedings that include, but are not limited to, acquisition of property, injuries and damages claims, and complaints by present and former employees. In management's opinion these various actions will not have a material adverse effect on any of the registrants' financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-23 EXECUTIVE OFFICERS OF SOUTHERN (Inserted in Part I in accordance with Regulation S-K, Item 401(b), Instruction 3) EDWARD L. ADDISON Chairman and CEO Age 63 Elected in 1983; responsible primarily for the formation of overall corporate policy. He was elected Chairman of SOUTHERN effective January 1994. A. W. DAHLBERG President and Director Age 53 Elected in 1985; President and Chief Executive Officer of GEORGIA from 1988 through 1993. He was elected Executive Vice President of SOUTHERN in 1991. He was elected President of SOUTHERN effective January 1994. PAUL J. DENICOLA Executive Vice President and Director Age 45 Elected in 1989; Executive Vice President of SOUTHERN since 1991. Elected President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 to 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. H. ALLEN FRANKLIN Executive Vice President and Director Age 49 Elected in 1988; President and Chief Executive Officer of SCS from 1988 through 1993 and, beginning 1991, Executive Vice President of SOUTHERN. He was elected President and CEO of GEORGIA effective January 1994. ELMER B. HARRIS Executive Vice President and Director Age 54 Elected in 1989; President and Chief Executive Officer of ALABAMA since 1989 and, beginning 1991, Executive Vice President of SOUTHERN. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. W. L. WESTBROOK Financial Vice President Age 54 Elected in 1986; responsible primarily for all aspects of financing for SOUTHERN. He has served as Executive Vice President of SCS since 1986. BILL M. GUTHRIE Vice President Age 60 Elected in 1991; serves as Chief Production Officer for the SOUTHERN system. Senior Executive Vice President of SCS effective January 1994. He has also served as Executive Vice President of ALABAMA since 1988. Each of the above is currently an officer of SOUTHERN, serving a term running from the last annual meeting of the directors (May 26, 1993) for one year until the next annual meeting or until his successor is elected and qualified. I-24 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The common stock of SOUTHERN is listed and traded on the New York Stock Exchange. The stock is also traded on regional exchanges across the United States. High and low stock prices, per the New York Stock Exchange Composite Tape and as adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994, during each quarter for the past two years were as follows: There is no market for the other registrants' common stock, all of which is owned by SOUTHERN. On February 28, 1994, the closing price of SOUTHERN's common stock was $20-5/8. (b) Number of SOUTHERN's common stockholders at December 31, 1993: 237,105 Each of the other registrants have one common stockholder, SOUTHERN. (c) Common dividends are payable at the discretion of each registrant's board of directors. The common dividends paid by SOUTHERN and the operating affiliates to their stockholder(s) for the past two years were as follows: (in thousands) In January 1994, SOUTHERN's board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. II-1 The dividend paid per share by SOUTHERN was 27.5c. for each quarter of 1992 and 28.5c. for each quarter of 1993. SOUTHERN's common dividend for the first quarter of 1994 was raised to 29.5c. per share. The amount of common dividends that may be paid by the subsidiary registrants is restricted in accordance with their respective first mortgage bond indenture and charter. The amounts of earnings retained in the business and the amounts restricted against the payment of cash dividends on common stock at December 31, 1993, were as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SOUTHERN. Reference is made to information under the heading "Selected Consolidated Financial and Operating Data," contained herein at pages II-38 through II-49. ALABAMA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-78 through II-91. GEORGIA. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-123 through II-137. GULF. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II- 166 through II-179. MISSISSIPPI. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-207 through II-220. SAVANNAH. Reference is made to information under the heading "Selected Financial and Operating Data," contained herein at pages II-245 through II-258. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION SOUTHERN. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-8 through II-15. ALABAMA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-53 through II-58. GEORGIA. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-95 through II-101. GULF. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-141 through II-147. MISSISSIPPI. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-183 through II-189. SAVANNAH. Reference is made to information under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition," contained herein at pages II-224 through II-230. II-2 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO 1993 FINANCIAL STATEMENTS II-3 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-4 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES FINANCIAL SECTION II-5 MANAGEMENT'S REPORT The Southern Company and Subsidiary Companies 1993 Annual Report The management of The Southern Company has prepared -- and is responsible for - -- the consolidated financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of three directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the consolidated financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of The Southern Company and its subsidiaries in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ E. L. Addison /s/ W. L. Westbrook - ------------------------------------ ---------------------------- Edward L. Addison W. L. Westbrook Chairman and Chief Executive Officer Financial Vice President II-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS AND TO THE STOCKHOLDERS OF THE SOUTHERN COMPANY: We have audited the accompanying consolidated balance sheets and consolidated statements of capitalization of The Southern Company (a Delaware corporation) and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, paid-in capital, 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 (pages II-16 through II-37) referred to above present fairly, in all material respects, the financial position of The Southern Company and its subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The Southern Company and Subsidiary Companies 1993 Annual Report RESULTS OF OPERATIONS EARNINGS AND DIVIDENDS The Southern Company's 1993 financial performance exceeded the strong results recorded for 1992, and set several new records. The company's financial strength continued to gain momentum for the third consecutive year. In January 1994, The Southern Company board of directors increased the quarterly dividend rate by 3.5 percent, and approved a two-for-one common stock split in the form of a stock distribution. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. For 1993, The Southern Company's net income of $1.0 billion established a new record high and the company's common stock reached an all-time high closing price during the year of 23 3/8 -- surpassing the record of 19 1/2 set in 1992. Also, return on average common equity reached the highest level since 1986. Earnings reported for 1993 totaled $1,002 million or $1.57 per share, an increase of $49 million or 6 cents per share from the previous year. Both 1993 and 1992 earnings were affected by special non-operating or non-recurring items. After excluding these special items in both years, earnings from operations of the ongoing business of selling electricity were $1,016 million or $1.59 per share, an increase of $77 million or 10 cents per share compared with 1992. The special items that affected 1993 and 1992 earnings were as follows: In 1993, several items -- both positive and negative -- had an impact on earnings, which resulted in a net reduction of $14 million. These items were: (1) The conclusion of a settlement agreement -- discussed later -- with Gulf States Utilities (Gulf States) increased earnings. (2) The second in a series of four separate transactions to sell Plant Scherer Unit 4 to two Florida utilities increased earnings. (3) Environmental clean-up costs incurred at sites located in Alabama and Georgia decreased earnings. (4) Costs associated with a transportation fleet reduction program decreased earnings. The improvements in 1993 earnings resulted primarily from increased retail energy sales and continued emphasis on effective cost controls. The special items that increased 1992 earnings were primarily related to additional settlement provisions from Gulf States, and to gains on the sale of Gulf States common stock received in 1991. Returns on average common equity were 13.43 percent in 1993, 13.42 percent in 1992, and 12.74 percent in 1991. Dividends paid on common stock during 1993 were $1.14 per share or 28 1/2 cents per quarter. During 1992 and 1991, dividends paid per share were $1.10 and $1.07, respectively. In January 1994, The Southern Company board of directors raised the quarterly dividend to 29 1/2 cents per share or an annual rate of $1.18 per share. REVENUES Operating revenues increased in 1993 and 1992 and decreased in 1991 as a result of the following factors: II-8 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Retail revenues of $7.3 billion in 1993 increased 7.4 percent from last year, compared with an increase of 1.6 percent in 1992. Under fuel cost recovery provisions, fuel revenues generally equal fuel expense -- including the fuel component of purchased energy -- and do not affect net income. Sales for resale revenues within the service area were $447 million in 1993, up 9.2 percent from the prior year. This increase resulted primarily from the prolonged hot summer weather, which increased the demand for electricity. Revenues from sales for resale within the service area were $409 million in 1992, down 1.9 percent from the prior year. The decrease resulted from certain municipalities and cooperatives in the service area retaining more of their own generation at facilities jointly owned with Georgia Power. Revenues from sales to utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Capacity revenues decreased in 1993 and 1992 because the amount of capacity under contract declined by some 500 megawatts and 300 megawatts, respectively. In 1994, the contracted capacity will decline another 400 megawatts. Changes in revenues are influenced heavily by the amount of energy sold each year. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The rate of growth in 1993 retail energy sales was the highest since 1986. Residential energy sales registered the highest annual increase in two decades as a result of hotter-than-normal summer weather and the addition of 46,000 new customers. Commercial sales were also affected by the warm summer. Industrial energy sales in 1993 and 1992 showed moderate growth, reflecting a recovery in the business and economic conditions in The Southern Company's service area. Energy sales to retail customers are projected to grow at an average annual rate of 1.7 percent during the period 1994 through 2004. Energy sales for resale outside the service area are predominantly unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale outside the service area. Sales to customers outside the service area have decreased for the third consecutive year primarily as a result of the scheduled decline in megawatts of capacity under contract. In addition, the decline in 1992 and 1991 sales was also influenced by fluctuations in prices for oil and natural gas, the primary fuel sources for utilities with which the company has long-term contracts. When oil and gas prices fall below a certain level, these customers can generate electricity to meet their requirements more economically. However, the fluctuation in these energy sales, excluding the impact of contractual declines, had minimal effect on earnings because The Southern Company is paid for dedicating specific amounts of its generating capacity to these utilities. EXPENSES Total operating expenses of $6.7 billion for 1993 were up 6.5 percent compared with the prior year. The increase was attributable to higher production expenses of $75 million to meet increased energy demands and an additional $50 million in depreciation expenses and property taxes resulting from additional utility plant being placed into service. The transportation fleet reduction program and environmental clean-up costs discussed earlier increased expenses by some $62 million. Also, a $67 million change in deferred Plant Vogtle expenses compared with the amount in 1992 contributed to the rise in total operating expenses. In 1992, total operating expenses of $6.3 billion were at the same level reported for 1991. The costs to produce and deliver electricity in 1992 declined by $165 million primarily as a result of less energy being sold and continued effective cost controls. However, expenses in 1991 were reduced by proceeds from a settlement II-9 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report agreement with Gulf States that more than offset the decline in 1992 expenses when compared with 1991. Deferred expenses related to Plant Vogtle in 1992 increased by $47 million when compared with the prior year. Fuel costs constitute the single largest expense for The Southern Company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. The amount and sources of generation and the average cost of fuel per net kilowatt-hour generated were as follows: Fuel and purchased power expenses of $2.6 billion in 1993 increased 1.3 percent compared with the prior year because of increased energy demands and slightly higher average cost of fuel per net kilowatt-hour generated. Fuel and purchased power costs in 1992 decreased $137 million or 5.0 percent compared with 1991 primarily because 1.1 billion fewer kilowatt-hours were needed to meet customer requirements. Also, the decrease in these costs was attributable to a lower average cost of fuel per net kilowatt-hour generated. Income taxes for 1993 increased $69 million compared with the prior year. The increase is attributable to a number of factors, including a 1 percent increase in the corporate federal income tax rate effective January 1993, the second sale of additional ownership interest in Plant Scherer Unit 4, and the increase in taxable income from operations. For 1992, income taxes rose $11 million or 1.7 percent above the amount reported for 1991. For the fifth consecutive year, total gross interest charges and preferred stock dividends declined from amounts reported in the previous year. The declines are attributable to lower interest rates and significant refinancing activities during the past two years. In 1993, these costs were $831 million - -- down $21 million or 2.3 percent. These costs for 1992 decreased $71 million. As a result of favorable market conditions during 1993, some $3.0 billion of senior securities was issued for the primary purpose of retiring higher-cost debt and preferred stock. EFFECTS OF INFLATION The Southern Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on The Southern Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, Georgia Power could realize an after-tax gain currently estimated to total approximately $20 million. See Note 7 to the financial statements for additional information. In early 1994, Georgia Power and the system service company announced work force reduction programs that are estimated to reduce 1994 earnings by some $55 million. These actions will assist in efforts to control the growth in operating expenses. II-10 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report See Note 4 to the financial statements for information on an uncertainty regarding full recovery of an investment in the Rocky Mountain pumped storage hydroelectric project. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The Southern Company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If The Southern Company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. An important part of the Energy Act was to amend the Public Utility Holding Company Act of 1935 (PUHCA) and allow holding companies to form exempt wholesale generators and foreign utility companies to sell power largely free of regulation under PUHCA. These new entities are able to sell power to affiliates -- under certain restrictions -- and to own and operate power generating facilities in other domestic and international markets. To take advantage of these opportunities, Southern Electric International (Southern Electric) -- founded in 1981 -- is focusing on international and domestic cogeneration, the independent power market, and the privatization of generating facilities in the international market. During 1993, investments of some $315 million were made in entities that own and operate generating facilities in various international markets. In the near term, Southern Electric is expected to have minimal effect on earnings, but the possibility exists that it could be a prime contributor to future earnings growth. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been implemented by some of the system operating companies and are a significant part of integrated resource planning. See Note 3 to the financial statements under "Georgia Power's Demand-Side Conservation Programs" for information concerning the recovery of certain costs. Customers can receive cash incentives for participating in these programs as well as reduce their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the utility. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects in conjunction with precertification approval processes of such projects by the respective state public service commissions in Alabama, Georgia, and Mississippi will diminish the possible exposure to prudency disallowances and the resulting impact on earnings. In addition, Georgia Power has conducted a competitive bidding process for additional peaking capacity needed in 1996 and 1997. To meet expected requirements for 1996, Georgia Power has filed a plan with the state public service commission for certification of a four-year purchase power contract and for an ownership interest in a combustion turbine peaking unit. Rates to retail customers served by the system operating companies are regulated by the respective state public service commissions in Alabama, Florida, Georgia, and Mississippi. Rates for Alabama Power and Mississippi Power are adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that The Southern Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in some of these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." II-11 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, The Southern Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Southern Company adopted the new rules January 1, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The Southern Company's financial condition is now the strongest since the mid-1980s. Record levels of performance were set in 1993 related to earnings, market price of common stock, and energy sold to retail customers. In January 1994, The Southern Company board of directors increased the common stock dividend for the third consecutive year, and approved a two-for-one common stock split in the form of a stock distribution. Another major change in The Southern Company's financial condition was gross property additions of $1.4 billion to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Consolidated Statements of Cash Flows provide additional details. On January 1, 1993, The Southern Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 9 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company achieved a ratio of common equity to total capitalization -- including short-term debt -- of 43.5 percent in 1993, compared with 42.8 percent in 1992 and 41.5 percent in 1991. The company's goal is to maintain the common equity ratio generally within a range of 40 percent to 45 percent. During 1993, the operating companies sold $2.2 billion of first mortgage bonds and, through public authorities, $385 million of pollution control revenue bonds, at a combined weighted interest rate of 6.5 percent. Preferred stock of $426 million was issued at a weighted dividend rate of 5.7 percent. The operating companies continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $2.5 billion during 1993, $2.8 billion during 1992, and $1.0 billion during 1991. Retirements of preferred stock totaled $516 million during 1993, $326 million during 1992, and $125 million during 1991. As a result, the composite interest rate on long-term debt decreased from 9.2 percent at December 31, 1990, to 7.6 percent at December 31, 1993. During this same period, the composite dividend rate on preferred stock declined from 8.5 percent to 6.4 percent. In 1993, The Southern Company raised $205 million from the issuance of new common stock under the Dividend Reinvestment and Stock Purchase Plan (DRIP) and the Employee Savings Plan. At the close of 1993, the company's common stock had a market value of $22.00 per share, compared with a book value of $11.96 per share. The market-to-book value ratio was 184 percent at the end of 1993, compared with 168 percent at year-end 1992 and 156 percent at year-end 1991. CAPITAL REQUIREMENTS FOR CONSTRUCTION The construction program of the operating companies is budgeted at $1.5 billion for 1994, $1.3 billion for 1995, and $1.5 billion for 1996. The total is $4.3 billion for the three years. Actual construction costs may vary from this estimate because of factors such as changes in environmental regulations; changes in existing nuclear plants to meet new regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The operating companies do not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload facilities until well into the future. However, within the II-12 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts of capacity is planned to be completed by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $789 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of long-term debt. Also, the operating subsidiaries plan to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV II-13 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report requirements, on some Georgia Power plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Southern Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL In early 1994, The Southern Company sold -- through a public offering -- common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. Any portion of the common stock required during 1994 for the DRIP and the employee stock plans that is not provided from the issuance of new stock will be acquired on the open market in accordance with the terms of such plans. The operating subsidiaries plan to obtain the funds required for construction and other purposes from sources similar to those used in the past. However, the type and timing of any financings -- if needed -- will depend on market conditions and regulatory approval. II-14 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Completing the sale of Unit 4 of Plant Scherer will provide some $260 million of cash during the years 1994 and 1995. As required by the Nuclear Regulatory Commission, Alabama Power and Georgia Power established external sinking funds for nuclear decommissioning costs. For 1994 through 2000, the combined amount to be funded for both Alabama Power and Georgia Power totals $36 million annually. The cumulative effect of funding over this period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." To meet short-term cash needs and contingencies, the system companies had approximately $178 million of cash and cash equivalents and $1.1 billion of unused credit arrangements with banks at the beginning of 1994. To issue additional first mortgage bonds and preferred stock, the operating companies must comply with certain earnings coverage requirements designated in their mortgage indentures and corporate charters. The ability to issue securities in the future will depend on coverages at that time. The coverage ratios were, at the end of the respective years, as follows: *Savannah Electric's requirement is 2.50. II-15 CONSOLIDATED STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report CONSOLIDATED STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-16 CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-17 CONSOLIDATED STATEMENTS OF BALANCE SHEETS At December 31, 1993, and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-18 CONSOLIDATED BALANCE SHEETS (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these balance sheets. II-19 CONSOLIDATED STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report II-20 CONSOLIDATED STATEMENTS OF CAPITALIZATION (continued) At December 31, 1993 and 1992 The Southern Company and Subsidiary Companies 1993 Annual Report The accompanying notes are an integral part of these statements. II-21 NOTES TO FINANCIAL STATEMENTS The Southern Company and Subsidiary Companies 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Southern Company is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both the company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The operating companies also are subject to regulation by the FERC and their respective state regulatory commissions. The companies follow generally accepted accounting principles and comply with the accounting policies and practices prescribed by their respective commissions. All material intercompany items have been eliminated in consolidation. Consolidated retained earnings at December 31, 1993, include $2.6 billion of undistributed retained earnings of subsidiaries. Certain prior years' data presented in the consolidated financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The operating companies accrue revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The operating companies' electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $137 million in 1993, $132 million in 1992, and $162 million in 1991. Alabama Power and Georgia Power have contracts with the U.S. Department of Energy (DOE) that provide for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2003 at Plant Hatch, into 2009 at Plant Vogtle, and into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. Georgia Power -- based on its ownership interests -- and Alabama Power currently estimate their liability under this law to be approximately $39 million and $46 million, respectively. These obligations are recorded in the Consolidated Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected costs of decommissioning nuclear facilities. II-22 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. Alabama Power and Georgia Power have established external sinking funds to comply with the NRC's regulations. Prior to the enactment of these regulations, Alabama Power and Georgia Power had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. Alabama Power and Georgia Power have filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amounts prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Alabama Power's Plant Farley and Georgia Power's plants Hatch and Vogtle -- based on its ownership interests -- were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a set period of time as approved by the respective state public service commissions. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the Georgia Public Service Commission (GPSC) ordered that the allowed costs of Plant Vogtle, a two-unit nuclear facility of which Georgia Power owns 45.7 percent, be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. Under these plans, Georgia Power deferred financing costs and depreciation expense until the allowed investment was fully reflected in rates as of October 1991. In 1991, the GPSC modified the Plant Vogtle phase-in plan to begin earlier amortization of the costs deferred under the plan. Also, the GPSC levelized capacity buyback expense from co-owners of Plant Vogtle. See Note 3 for additional information regarding Georgia Power's 1991 rate order. Previously, pursuant to two separate interim accounting orders by the GPSC, Georgia Power deferred substantially all operating expenses and financing costs related to Plant Vogtle. Units 1 and 2 began commercial operation in May 1987 and May 1989, respectively. The accounting orders were for the periods from the date of each unit's commercial operation until October 1987 and 1989, respectively. Under phase-in plans and accounting orders from the GPSC, Georgia Power deferred and began amortizing the costs -- recovered through rates -- related to Plant Vogtle as follows: The unrecovered balance above includes approximately $160 million related to the adoption in 1993 of FASB Statement No. 109, Accounting for Income Taxes. See Note 9 for information about Statement No. 109. II-23 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Each GPSC order calls for recovery of deferred costs within 10 years. Also, the orders authorized Georgia Power to impute a return similar to allowance for funds used during construction (AFUDC) on its investment in Plant Vogtle units 1 and 2 after the units began commercial operation. These deferred returns are included in the above amounts, except for the equity component in the case of the Unit 2 accounting order. INCOME TAXES The companies provide deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 for additional information about Statement No. 109. AFUDC AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the companies to calculate AFUDC during the years 1991 through 1993 ranged from a before-income-tax rate of 4.9 percent to 11.4 percent. Deferred income taxes related to capitalized debt cost were $5 million, $4 million, and $7 million in 1993, 1992, and 1991, respectively. After Plant Vogtle units 1 and 2 began commercial operation in 1987 and 1989, respectively, Georgia Power imputed a deferred return similar to AFUDC on its investment in the units under the short-term cost deferrals and phase-in plans, as discussed earlier. AFUDC and the deferred return, net of income tax, as a percent of consolidated net income were 1.7 percent in 1993, 1.8 percent in 1992, and 6.0 percent in 1991. The deferred return was discontinued in October 1991 after the allowed investment in Plant Vogtle was fully reflected in rates. UTILITY PLANT Utility plant is stated at original cost less regulatory disallowances. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Consolidated Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of The Southern Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred II-24 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In 1992, Georgia Power converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that will be amortized as a credit to income over approximately four years. This conversion will not have a material effect on net income. VACATION PAY The operating companies' employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the companies accrue a current liability for earned vacation pay and record a current asset representing the future recoverability of this cost. The amount was $73 million and $70 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 71 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The system companies have defined benefit, trusteed, non-contributory pension plans that cover substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. Primarily, the companies use the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The system companies also provide certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the system companies adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered Georgia Power to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional costs would be expensed in 1993 and the remaining costs would be deferred. An additional one-fifth of the costs would be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The costs deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of regulatory treatment allowed by the operating companies' respective public service commissions, the adoption of Statement No. 106 did not have a material impact on consolidated net income. Prior to 1993, the system companies, except for Georgia Power and Savannah Electric, recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. Consistent with regulatory treatment in these years, Georgia Power and Savannah Electric recognized these costs on a cash basis as payments were made. The total costs of such benefits recognized by system companies in 1992 and 1991 were $42 million and $36 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement II-25 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1 percent would increase the accumulated medical benefit obligation at December 31, 1993, by $129 million and the aggregate of the service and interest cost components of the net retiree medical cost by $14 million. Components of the plans' net cost are shown below: Of the above net pension amounts, pension income of $9 million in 1993 and pension expense of $2 million in 1992 and $11 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $64 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. II-26 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report WORK FORCE REDUCTION PROGRAMS The system companies have incurred additional costs for work force reduction programs. The costs related to these programs were $35 million, $37 million, and $72 million for the years 1993, 1992, and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $19 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected, and this matter is concluded. STOCKHOLDER SUIT In April 1991, two Southern Company stockholders filed a derivative action suit in the U.S. District Court for the Southern District of Georgia against certain current and former directors and officers of The Southern Company. The suit alleges violations of the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) by officers and breaches of fiduciary duty and gross negligence by all defendants resulting from alleged fraudulent accounting for spare parts, illegal political campaign contributions, violations of federal securities laws involving misrepresentations and omissions in SEC filings, and concealment of the foregoing acts. The complaint seeks damages -- including treble damages pursuant to RICO -- in an unspecified amount, which if awarded, would be payable to The Southern Company. The plaintiffs' amended complaint was dismissed by the court in March 1992. The court ruled the plaintiffs had failed to present adequately their allegation that The Southern Company board of directors' refusal of an earlier demand by the plaintiffs was wrongful. The plaintiffs have appealed the dismissal to the U.S. Court of Appeals for the 11th Circuit. ALABAMA POWER HEAT PUMP FINANCING SUIT In September 1990, two customers of Alabama Power filed a civil complaint in the Circuit Court of Shelby County, Alabama, against Alabama Power seeking to represent all persons who, prior to June 23, 1989, entered into agreements with Alabama Power for the financing of heat pumps and other merchandise purchased from vendors other than Alabama Power. The plaintiffs contended that Alabama Power was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring Alabama Power to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June 1993, the court ordered Alabama Power to refund or forfeit interest of approximately $10 million because of Alabama Power's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. Alabama Power has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GULF POWER COAL BARGE TRANSPORTATION SUIT In 1993, a complaint against Gulf Power and the system service company was filed in federal district court in Ohio by two companies with which Gulf Power had contracted for the transportation by barge for certain Gulf Power coal supplies. The complaint alleges breach of the contract by Gulf Power and seeks damages estimated by the plaintiffs to be in excess of $85 million. II-27 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. ALABAMA POWER RATE ADJUSTMENT PROCEDURES In November 1982, the Alabama Public Service Commission (APSC) adopted rates that provide for periodic adjustments based upon Alabama Power's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement -- amounting to some $60 million -- is being amortized to income to offset the rate reduction in accordance with the APSC's rate order. See Note 8 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. GEORGIA POWER'S DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of Georgia Power's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. Georgia Power suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved Georgia Power's request for an accounting order allowing Georgia Power to defer all current unrecovered and future costs related to these programs until the superior court's decision is reversed or until the next general rate case proceedings. An association of industrial customers has filed a petition for review of the accounting order in superior court. Georgia Power's costs related to these conservation programs through 1993 were $60 million, of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. GEORGIA POWER 1991 RATE ORDER; PHASE-IN PLAN MODIFICATIONS Georgia Power received a rate order in 1991 from the GPSC that modified the Plant Vogtle phase-in plans to begin earlier amortization of the costs deferred under the plans. The amortization period began October 1991 -- rather than October 1994 as originally scheduled -- and extends through September 1999. In addition, the GPSC ordered the levelization of capacity buyback expense from the co-owners of Plant Vogtle over a six-year period beginning October 1991. This results in net cost deferrals during the first three years and subsequent amortization of the deferred amounts in the last three years. MISSISSIPPI POWER RETAIL RATE ADJUSTMENT PLAN Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986 with various modifications in 1991 and the latest in 1994. In 1993, the Mississippi Public Service Commission (MPSC) ordered Mississippi Power to review and propose changes that would enhance the plan. Mississippi Power filed a revised plan, and the MPSC approved PEP-2 on January 4, 1994. Under PEP-2, Mississippi Power's rate of return will be measured on retail net investment rather than on common equity, as previously calculated. Also, the number of indicators used to evaluate Mississippi Power's performance was reduced to three with emphasis on price and service to the customer. In addition, PEP-2 provides for the sharing of rate adjustments based on low rates and on the performance rating. The evaluation periods for PEP-2 are semiannual. Any change in rates is limited to 2 percent of retail revenues per period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. II-28 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the company's financial statements. 4. CONSTRUCTION PROGRAM GENERAL The operating companies are engaged in continuous construction programs, currently estimated to total some $1.5 billion in 1994, $1.3 billion in 1995, and $1.5 billion in 1996. These estimates include AFUDC of $34 million in 1994, $41 million in 1995, and $35 million in 1996. The construction programs are subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; changes in existing nuclear plants to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The operating companies do not have any new baseload generating plants under construction. However, within the service area, the construction of combustion turbine peaking units of approximately 1,700 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 was not economically justifiable and reasonable and withheld authorization for Georgia Power to spend funds from approved securities issuances on that project. In 1988, Georgia Power and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 6. However, full recovery of Georgia Power's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event Georgia Power cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off. At December 31, 1993, Georgia Power's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, Georgia Power's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL In early 1994, The Southern Company sold -- through a public offering -- 5.6 million shares of common stock with proceeds totaling $120 million. The company may require additional equity capital during the remainder of 1994. The amount and timing of additional equity capital to be raised in 1994 -- as well as in subsequent years -- will be contingent on The Southern Company's investment opportunities. Equity capital can be provided from any combination of public offerings, private placements, or the company's stock plans. II-29 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report To the extent possible, the operating companies' construction programs are expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The subsidiary companies may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FOREIGN UTILITY OPERATIONS During 1993, The Southern Company made investments of approximately $315 million in utilities that own and operate generating facilities in various foreign markets. The consolidated financial statements reflect these investments in majority-owned subsidiaries on a consolidated basis and other investments on an equity basis. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with banks totaled $1.1 billion, of which approximately $500 million expires at various times during 1994 and 1995; $130 million expires at May 1, 1996; $400 million expires at June 30, 1996; and $70 million expires at December 1, 1996. Georgia Power's revolving credit agreements of $150 million, of which $130 million remained unused as of December 31, 1993, expire May 1, 1996. During the term of these agreements, Georgia Power may convert short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Georgia Power's option. In connection with these credit arrangements, Georgia Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing The Southern Company, Alabama Power, and Georgia Power up to the total credit amount of $400 million. To provide liquidity support to commercial paper programs, $135 million and $165 million of the $400 million available credit are currently dedicated to the exclusive use of Alabama Power and Georgia Power, respectively. During the term of these agreements, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Mississippi Power has $70 million of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Mississippi Power's option. In connection with these credit arrangements, Mississippi Power agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. Savannah Electric has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at Savannah Electric's option. In connection with these credit arrangements, Savannah Electric agrees to pay commitment fees based on the unused portions of the commitments. In connection with all other lines of credit, the companies have the option of paying fees or maintaining compensating balances, which are substantially all the cash of the companies except for daily working funds and similar items. These balances are not legally restricted from withdrawal. In addition, the companies from time to time borrow under uncommitted lines of credit with banks, and in the case of Alabama Power and Georgia Power, through commercial paper programs that have the liquidity support of committed bank credit arrangements. ASSETS SUBJECT TO LIEN The operating companies' mortgages, which secure the first mortgage bonds issued by the companies, constitute a direct first lien on substantially all of the companies' respective fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of the system's generating plants, the subsidiary companies have II-30 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels, and other financial commitments. Total estimated long-term obligations were approximately $15 billion at December 31, 1993. Additional commitments for coal and nuclear fuel will be required in the future to supply the operating companies' fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 for the payment of $121 million to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Gulf Power and Mississippi Power. Also, in March 1988, Gulf Power made an advance payment of $60 million to a coal supplier under an agreement to lower the cost of future coal purchased under an existing contract. These amounts are being amortized to expense. The remaining unamortized amount included in deferred charges at December 31, 1993, was $70 million. OPERATING LEASES The operating companies have entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $11 million, $9 million, and $7 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated minimum rental commitments for noncancelable operating leases were as follows: 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS In 1992, Alabama Power sold an undivided interest in units 1 and 2 of Plant Miller and related facilities to Alabama Electric Cooperative, Inc. Since 1975, Georgia Power has sold undivided interests in plants Vogtle, Hatch, Scherer, and Wansley in varying amounts, together with transmission facilities, to OPC, the Municipal Electric Authority of Georgia (MEAG), and the city of Dalton, Georgia. Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. See Note 7 for additional information concerning these sales. In addition, Georgia Power has entered into a joint ownership agreement with OPC with respect to the Rocky Mountain project, as discussed later. At December 31, 1993, Alabama Power's and Georgia Power's ownership and investment (exclusive of nuclear fuel) in jointly owned facilities with the above entities were as follows: *Estimated ownership at date of completion. Georgia Power and OPC have entered into a joint ownership agreement regarding the 848-megawatt Rocky Mountain pumped storage hydroelectric project. Under the agreement, Georgia Power will retain its present investment in the project and OPC will finance, complete, and operate the facility. Upon completion, Georgia Power will own an undivided interest in the project equal to the proportion its investment bears to the total investment in the project (excluding each party's cost of funds and ad valorem taxes). Based on current cost estimates, Georgia Power's final ownership is estimated at approximately 25 percent of the project at completion. Georgia Power has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. II-31 NOTES (continued) THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES 1993 ANNUAL REPORT Alabama Power and Georgia Power have contracted to operate and maintain the jointly owned facilities -- except for the Rocky Mountain project -- as agents for their respective co-owners. The companies' proportionate share of their plant operating expenses is included in the corresponding operating expenses in the Consolidated Statements of Income. In connection with a joint ownership arrangement at Plant Vogtle, Georgia Power has remaining commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from this plant for periods of up to 10 years following commercial operation (and, with regard to a portion of the 5 percent additional interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for such capacity are required whether any capacity is available. The energy cost of these purchases is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power in the Consolidated Statements of Income. Capacity payments totaled $183 million, $289 million, and $320 million, for 1993, 1992, and 1991, respectively. Projected capacity payments for the next five years are as follows: $132 million in 1994; $77 million in 1995; $70 million in 1996; $59 million in 1997; and $59 million in 1998. Also, a portion of the above capacity payments relates to Plant Vogtle costs that were written off after being disallowed for retail ratemaking purposes. In 1991, the GPSC ordered that the Plant Vogtle capacity buyback expense be levelized over a six-year period. The amounts deferred and not expensed in the year paid totaled $38 million in 1993, $100 million in 1992, and $30 million in 1991. The projected net amount to be deferred in 1994 is $1 million. The projected net amortization of the deferred expense is $49 million in 1995, $62 million in 1996, and $57 million in 1997. 7. PLANNED SALES OF INTEREST IN PLANT SCHERER Georgia Power has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FP&L) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FP&L would eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. The capacity from this unit was previously dedicated to long-term power sales contracts with Gulf States that were suspended in 1988. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Plant Scherer -- a jointly owned coal-fired generating plant -- has four units with a total capacity of 3,272 megawatts. Unit 4 was completed in 1989. See Note 6 for information regarding current plant ownership. 8. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from specific generating plants is currently being sold to FP&L, FPC, JEA, and the city of Tallahassee, Florida. Under these agreements, an average II-32 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report of 1,700 megawatts of capacity is scheduled to be sold during 1994 and 1995. Thereafter, these sales will decline to some 1,600 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts to be refunded to customers and the amounts previously included in income -- The Southern Company recorded an increase in consolidated net income of $114 million, or 18 cents per share, in November 1991. With respect to Alabama Power's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. 9. INCOME TAXES Effective January 1, 1993, The Southern Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on consolidated net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $1.5 billion are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $1.1 billion are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities, are as follows: II-33 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Consolidated Statements of Income. Credits amortized in this manner amounted to $29 million in 1993, $41 million in 1992, and $48 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. COMMON STOCK STOCK DISTRIBUTION In January 1994, The Southern Company board of directors authorized a two-for-one common stock split in the form of a stock distribution for each share held as of February 7, 1994. For all reported common stock data, the number of common shares outstanding and per share amounts for earnings, dividends, and market price have been adjusted to reflect the stock distribution. SHARES RESERVED At December 31, 1993, a total of 24 million shares was reserved for issuance pursuant to the Dividend Reinvestment and Stock Purchase Plan, the Employee Savings Plan, and the Executive Stock Option Plan. EXECUTIVE STOCK OPTION PLAN The Southern Company's Executive Stock Option Plan authorizes the granting of non-qualified stock options to key employees of The Southern Company, including officers. Currently, 34 employees are eligible to participate in the plan. As of December 31, 1993, 38 current and former employees participated in the plan. The maximum number of shares of common stock that may be issued under the Executive Stock Option Plan may not exceed 6 million. The price of options granted to date has been at the fair market value of the shares on the date of grant. Options granted to date become exercisable pro rata over a maximum period of four years from date of grant, such that all options generally are exercisable by 1997. Options outstanding will expire upon termination of the plan, which will occur on December 7, 1997, unless terminated earlier by the board of directors. Stock option activity in 1992 and 1993 is summarized below: II-34 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 11. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: With respect to the collateralized pollution control revenue bonds, the operating companies have authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under installment sale or loan agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. Assets acquired under capital leases are recorded as utility plant in service, and the related obligation is classified as other long-term debt. The net book value of capitalized leases was $217 million and $236 million at December 31, 1993 and 1992, respectively. At December 31, 1993, the composite interest rates for nuclear fuel, buildings, and other were 3.6 percent, 9.7 percent, and 12.0 percent, respectively. Sinking fund requirements and/or serial maturities through 1998 applicable to other long-term debt are as follows: $89 million in 1994; $154 million in 1995; $58 million in 1996; $26 million in 1997; and $7 million in 1998. 12. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 166 2/3 percent of such requirements. II-35 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 13. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, Alabama Power and Georgia Power maintain agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the companies' nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for Alabama Power and Georgia Power -- based on its ownership and buyback interests -- is $159 million and $171 million, respectively, per incident but not more than an aggregate of $20 million and $22 million, respectively, to be paid for each incident in any one year. Alabama Power and Georgia Power are members of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. Alabama Power's and Georgia Power's maximum annual assessments are limited to $14 million and $18 million, respectively, under current policies. Additionally, both companies have policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments under current policies for Alabama Power and Georgia Power for excess property damage would be $16 million and $15 million, respectively. The replacement power assessments are $9 million for Alabama Power and $13 million for Georgia Power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. Alabama Power and Georgia Power participate in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, Alabama Power and Georgia Power could be subject to a maximum total assessment of $6 million and $7 million, respectively. II-36 NOTES (continued) The Southern Company and Subsidiary Companies 1993 Annual Report 14. COMMON STOCK DIVIDEND RESTRICTIONS The income of The Southern Company is derived primarily from equity in earnings of its operating subsidiaries. At December 31, 1993, $1.6 billion of consolidated retained earnings was restricted against the payment by the operating companies of cash dividends on common stock under terms of bond indentures or charters. 15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: *Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. The company's business is influenced by seasonal weather conditions and the timing of rate changes. II-37 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) Note: Common stock data have been adjusted to reflect a two-for-one stock split in the form of a stock distribution for each share held as of February 7, 1994. II-38 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA The Southern Company and Subsidiary Companies 1993 Annual Report (See Note Below) II-39 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-40 SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA (continued) The Southern Company and Subsidiary Companies 1993 Annual Report II-41 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-42 CONSOLIDATED STATEMENTS OF INCOME The Southern Company and Subsidiary Companies II-43 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-44 CONSOLIDATED STATEMENTS OF CASH FLOWS The Southern Company and Subsidiary Companies II-45 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-46 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-47 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-48 CONSOLIDATED BALANCE SHEETS The Southern Company and Subsidiary Companies II-49 ALABAMA POWER COMPANY FINANCIAL SECTION II-50 MANAGEMENT'S REPORT Alabama Power Company 1993 Annual Report The management of Alabama Power Company has prepared -- and is responsible for - -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the company. Limitations exist in any system of internal controls based on a recognition that the cost of the system should not exceed its benefits. The company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The company's system of internal accounting controls is evaluated on an ongoing basis by the company's internal audit staff. The company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Alabama Power Company in conformity with generally accepted accounting principles. /s/ Elmer B. Harris /s/ William B. Hutchins, III - -------------------------- ------------------------------ Elmer B. Harris William B. Hutchins III President Senior Vice President and Chief Executive Officer and Chief Financial Officer II-51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF ALABAMA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Alabama Power Company (an Alabama corporation and wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, 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 (pages II-59 through II-77) referred to above present fairly, in all material respects, the financial position of Alabama Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 II-52 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Alabama Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS The company's 1993 net income after dividends on preferred stock was $346 million, representing a 2.3 percent increase over the prior year. This improvement can be attributed to higher retail energy sales and lower financing costs. Retail energy sales increased 5.1 percent from 1992 levels. This was primarily due to the extreme weather during 1993, especially when compared to the unusually mild weather of 1992. Long-term debt interest expense and preferred stock dividends decreased in 1993 reflecting the continued redemption and refinancing of higher cost debt and preferred stock. These positive factors were partially offset by higher operating costs and a scheduled reduction in capacity sales to non-affiliated utilities. When comparing 1992 earnings with the prior year, it should be noted that 1991 earnings included an unusual item -- the settlement of litigation with Gulf States Utilities Company (Gulf States) that resulted in an after-tax gain of $9 million. A comparison of 1992 to 1991, excluding this unusual item, would reflect a 1992 increase in earnings of $8 million. The return on average common equity for 1993 was 13.9 percent compared to 14.0 percent in 1992, and 14.6 percent in 1991. REVENUES The following table summarizes the principal factors that affected operating revenues for the past three years: Retail revenues of $2.4 billion in 1993 increased $180 million (8.0 percent) over the prior year, compared with no increase in 1992. The extreme weather during 1993 and sales growth contributed to the increase in retail revenues over 1992. Fuel revenues increased substantially during 1993. However, changes in fuel revenues are offset with corresponding changes in recoverable fuel expenses and have no effect on net income. Gains in 1992 retail revenues, due to higher rates and sales growth, were partially offset by lower fuel cost recovery revenues. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: II-53 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report Capacity revenues decreased in 1993 due to a scheduled reduction in capacity dedicated to unit power sales customers for the first five months of the year. The major factor contributing to the increase in capacity revenues in 1992 and 1991 was a new generating unit, Plant Miller Unit 4, that was placed in commercial service in March 1991 and dedicated to unit power sales. This unit's fixed costs are higher than those of the unit it replaced, which previously provided energy to unit power sales customers. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: EXPENSES Total operating expenses of $2.4 billion for 1993 were up 7.0 percent compared with the prior year. The increase was mainly attributable to higher production expenses of $95 million to meet increased energy demands. Total operating expenses for 1992 increased moderately over those recorded in 1991. However, absent the Gulf States settlement, which reduced 1991 operating expenses, total operating expenses would have decreased $6 million. Fuel costs are the single largest expense for the company. The mix of fuel sources for generation of electricity is determined primarily by system load, the unit cost of fuel consumed, and the availability of hydro and nuclear generating units. Fuel expense increases in 1993 represent $83 million of the production expense increase mentioned above. Fuel expense decreased in 1992 as a result of the reduction in the cost of both coal and nuclear fuel, offset somewhat by a small increase in generation. Fuel cost per kilowatt-hour generated was 1.73 cents in 1993, 1.64 cents in 1992 and 1.69 cents in 1991. Purchased power expenses decreased in 1992 primarily due to less purchased energy and a decrease in the price of such energy. Other operation expenses increased 6.0 percent in 1993 following a minimal increase in 1992. The increase in 1993 is primarily the result of environmental cleanup costs, net expenses of a March snowstorm, and the one-time cost of a transportation fleet reduction program, which together totaled $16.1 million. Depreciation and amortization expense increased 3.4 percent in 1993 and 3.5 percent in 1992. This is principally due to continued growth in depreciable plant in service. Taxes other than income taxes increased 4.0 percent in 1993 and 1.4 percent in 1992. These increases were the result of the addition of new facilities and higher revenue-related taxes. The increase in income tax expense of 2.6 percent for 1993 is primarily attributable to a one percent increase in the corporate federal income tax rate effective January 1, 1993. Interest expense and dividends on preferred stock decreased $7.5 million (2.8 percent) and $7.2 million (2.6 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. II - 54 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report EFFECTS OF INFLATION The company is subject to rate regulation that is based on the recovery of historical costs and, therefore is subject to economic losses caused by inflation. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will also depend upon growth in electric sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the company's service area. In addition, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The law also includes provisions to streamline the licensing process for new nuclear plants. The company is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for a utility's large industrial and commercial customers and sell excess energy generation to other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the company does not remain a low-cost producer and provide quality service, the company's retail energy sales growth, as well as any new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Rates to retail customers served by the company are regulated by the Alabama Public Service Commission (APSC). Rates for the company can be adjusted periodically within certain limitations based on earned retail rate of return compared with an allowed return. See Note 3 to the financial statements for information about other regulatory matters. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The company adopted the new rules January 1, 1994, with no material effect on the financial statements. II-55 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report FINANCIAL CONDITION OVERVIEW The company's financial condition remained stable in 1993. Growth in energy sales combined with a significant lowering of the cost of capital, achieved through the refinancing and/or redemption of higher-cost long-term debt and preferred stock contributed to this stability. The company had gross property additions of $436 million in 1993. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. The Statements of Cash Flows provide additional details. On January 1, 1993, the company changed its methods of accounting for postretirement benefits other than pensions, and for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. CAPITAL STRUCTURE The company's ratio of common equity to total capitalization was 47.4 percent in 1993, compared with 47.6 percent in 1992, and 45.4 percent in 1991. In 1993, the company issued $860 million of first mortgage bonds, $158 million of preferred stock and, through public authorities, $144 million of pollution control revenue bonds. The company continued to reduce financing costs by retiring higher-cost bonds and preferred stock. Retirements, including maturities, of bonds totaled $835 million, and preferred stock retirements totaled $207 million. Composite financing rates as of year-end for 1991 through 1993 were as follows: The company's current securities ratings are as follows: CAPITAL REQUIREMENTS Capital expenditures are estimated to be $588 million for 1994, $572 million for 1995, and $531 million for 1996. The total is $1.7 billion for the three years. Actual capital costs may vary from this estimate because of factors such as changes in environmental regulations; changes in the existing nuclear plant to meet new regulations; revised load projections; increasing costs of labor, equipment, and materials; and the cost of capital. The company does not have any baseload generating plants under construction, and current energy demand forecasts do not require any additional baseload generating units until well into the future. However, the construction of combustion turbine peaking units of approximately 720 megawatts of capacity is planned by 1996 to meet increased peak-hour demands. In addition, significant construction of transmission and distribution facilities and upgrading of generating plants will continue. In addition to the funds needed for the capital budget, approximately $80 million will be required by the end of 1996 for present sinking fund requirements, redemptions announced, and maturities of first mortgage bonds. Also, the company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 II-56 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the company's portion is approximately $30 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company, of which the company's portion is approximately $225 million to $350 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in annual revenue requirements from customers could be necessary to fully recover the company's cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard II-57 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Alabama Power Company 1993 Annual Report and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the company could incur costs to clean up properties currently or previously owned. The company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of The Southern Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Southern electric system. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL It is anticipated that the funds required will be derived from sources in form and quantity similar to those used in the past. To issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements designated in its mortgage indenture and corporate charter. The company's coverages are at a level that would permit any necessary amount of security sales at current interest and dividend rates. As required by the Nuclear Regulatory Commission and as ordered by the APSC, the company has established external trust funds for nuclear decommissioning costs. Also, during 1993, the APSC issued a policy statement which will require external funding of postretirement benefits. The cumulative effect of funding these items over a long period will diminish internally funded capital and may require capital from other sources. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Depreciation and Nuclear Decommissioning." II-58 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-59 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-60 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-61 BALANCE SHEETS At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-62 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Alabama Power Company The accompanying notes are an integral part of these statements. II-63 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Alabama Power Company The accompanying notes are an integral part of these statements. II-64 NOTES TO FINANCIAL STATEMENTS Alabama Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The company is a wholly owned subsidiary of The Southern Company which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly-owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services upon request to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The company is also regulated by the FERC and the Alabama Public Service Commission (APSC). The company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The company's electric rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel expense includes the amortization of the cost of nuclear fuel and a charge, based on nuclear generation, for the permanent disposal of spent nuclear fuel. Total charges for nuclear fuel included in fuel expense amounted to $62 million in 1993, $48 million in 1992, and $69 million in 1991. The company has a contract with the U.S. Department of Energy (DOE) that provides for the permanent disposal of spent nuclear fuel, which was scheduled to begin in 1998. However, the actual year this service will begin is uncertain. Sufficient storage capacity currently is available to permit operation into 2012 and 2014 at Plant Farley units 1 and 2, respectively. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund, which is to be funded in part by a special assessment on utilities with nuclear plants. This assessment will be paid over a 15-year period, which began in 1993. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The company currently estimates its liability under this law to be approximately $46 million. This obligation is recognized in the accompanying Balance Sheets. DEPRECIATION AND NUCLEAR DECOMMISSIONING Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates which approximated 3.3 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. Depreciation expense includes an amount for the expected cost of decommissioning nuclear facilities. II-65 NOTES (continued) Alabama Power Company 1993 Annual Report In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external trust fund, a surety method, or prepayment. The company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the company had reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The company has filed plans with the NRC to ensure that -- over time -- the deposits and earnings of the external trust funds will provide the minimum funding amount prescribed by the NRC. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for Plant Farley were as follows: The amount in the internal reserve is being transferred into the external trust funds over the remaining life of the license for Plant Farley as approved by the APSC. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The actual decommissioning costs may vary from the above estimates because of regulatory requirements, changes in technology, and changes in costs of labor, materials, and equipment. INCOME TAXES The company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the company adopted Financial Accounting Standards Board (FASB) Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rate used to determine the amount of allowance, net of deferred income tax, was 6.2 percent in 1991. Such method of computing AFUDC ceased upon the commercial operation of Plant Miller Unit 4 in March 1991. For construction projects begun after 1986, deferral of taxes related to capitalized interest is no longer permitted. For those projects, the composite rate used to determine the amount of allowance was 7.8 percent in 1993, 7.9 percent in 1992, and 8.3 percent in 1991. AFUDC, net of income tax, as a percent of net income after dividends on preferred stock was 1.5 percent in 1993, 1.1 percent in 1992, and 2.0 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs and replacements of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive II-66 NOTES (continued) Alabama Power Company 1993 Annual Report of minor items of property) is charged to utility plant. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the company accrues a current liability for earned vacation pay and records a current asset representing future recoverability of this cost. The amount was $23 million and $22 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 65 percent of the 1993 deferred vacation cost will be expensed and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. However, in December 1993, the APSC issued an accounting policy statement which requires the company to externally fund all postretirement benefits. It is expected that an external funding program will begin in 1994. Effective January 1, 1993, the company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-67 NOTES (continued) Alabama Power Company 1993 Annual Report Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, the company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the company in 1992 and 1991 were $15.2 million and $15.4 million, respectively. Status and Cost of Benefits Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $32.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $3.4 million. II-68 NOTES(continued) Alabama Power Company 1993 Annual Report Components of the plans' net cost are shown below: Of the above net pension amounts, $(8.9) million in 1993, $(5.1) million in 1992, and $0.7 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $22 million was charged to operating expenses and the remainder was charged to construction and other accounts. WORK FORCE REDUCTION PROGRAM The company has incurred additional costs for work force reduction programs. The costs related to these programs were $16.1 million, $13.4 million and $6.7 million for the years 1993, 1992 and 1991, respectively. A portion of the cost of these programs was deferred and is being amortized in accordance with regulatory treatment. The unamortized balance of these costs was $15.3 million at December 31, 1993. 3. LITIGATION AND REGULATORY MATTERS RETAIL RATE ADJUSTMENT PROCEDURES In November 1982, the APSC adopted rates that provide for periodic adjustments based upon the company's earned return on end-of-period retail common equity. The rates also provide for adjustments to recognize the placing of new generating facilities in retail service. Both increases and decreases have been placed into effect since the adoption of these rates. The rate adjustment procedures allow a return on common equity range of 13.0 percent to 14.5 percent and limit increases or decreases in rates to 4 percent in any calendar year. The APSC issued an order in December 1991 that reduced a scheduled 2.03 percent annual increase in rates to 1.03 percent, effective January 1992. The 1 percent reduction will remain in effect through 1994. The rate reduction was designed to refund to retail ratepayers a portion of the benefits from a settled contract dispute with Gulf States Utilities Company (Gulf States). The present value of this portion of the settlement amounting to approximately $60 million is being amortized to revenues to offset the rate reduction in accordance with the APSC's rate order. See Note 7 for additional information concerning the Gulf States settlement. Also in the December 1991 rate order, the APSC reaffirmed its satisfaction with the ratemaking mechanism and stated that it did not foresee any further review or changes in the procedures until after 1994. The ratemaking procedures will remain in effect after 1994 unless the APSC votes to modify or discontinue them. In February 1993, the APSC ordered - at the company's request - a moratorium on rate increases for the first two quarters of 1993, which facilitated the transition of an accounting change. This accounting change permitted the accrual of estimated operation and maintenance expenses related to nuclear refueling outages during the period between outages rather than at the time the expenses are incurred. HEAT PUMP FINANCING SUIT In September 1990, two customers of the company filed a civil complaint in the Circuit Court of Shelby County, Alabama, against the company seeking to represent all II-69 NOTES(continued) Alabama Power Company 1993 Annual Report persons who, prior to June 23, 1989, entered into agreements with the company for the financing of heat pumps and other merchandise purchased from vendors other than the company. The plaintiffs contended that the company was required to obtain a license under the Alabama Consumer Finance Act to engage in the business of making consumer loans. The plaintiffs were seeking an order declaring these agreements null and void and requiring the company to refund all payments -- principal and interest -- made under these agreements. The aggregate amount under these agreements, together with interest paid, currently is estimated to be $40 million. In June, 1993, the court ordered the company to refund or forfeit interest of approximately $10 million because of the company's failure to obtain such license. However, the court's order did not require any refund or forfeiture with respect to any principal payments under the agreements at issue. The company has appealed the court's order to the Supreme Court of Alabama. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material effect on the company's financial statements. 4. CAPITAL BUDGET The company's capital expenditures are currently estimated to total $588 million in 1994, $572 million in 1995 and $531 million in 1996. The estimates include AFUDC of $10 million in 1994, $11 million in 1995 and $12 million in 1996. The estimates for property additions for the three-year period includes $36.5 million committed to meeting the requirements of the Clean Air Act. The capital budget is subject to periodic review and revision, and actual capital cost incurred may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth projections; changes in environmental regulations; changes in the existing nuclear plant to meet new regulatory requirements; increasing costs of labor, equipment, and materials; and cost of capital. At December 31, 1993, significant purchase commitments were outstanding in connection with the construction program. The company does not have any new baseload generating plants under construction. However, the construction of combustion turbine peaking units of approximately 720 megawatts is planned to be completed by 1996. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. 5. FINANCING, INVESTMENT, AND COMMITMENTS GENERAL To the extent possible, the company's construction program is expected to be financed primarily from internal sources. Short-term debt will be utilized when necessary; the amounts available are discussed below. The company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and for redeeming higher-cost securities. FINANCING The ability of the company to finance its capital budget depends on the amount of funds generated internally and the funds it can raise by external financing. The II-70 NOTES(continued) Alabama Power Company 1993 Annual Report company's primary sources of external financing are sales of first mortgage bonds and preferred stock to the public, receipt of additional paid-in capital from The Southern Company, and leasing of nuclear material. In order to issue additional first mortgage bonds and preferred stock, the company must comply with certain earnings coverage requirements contained in its mortgage indenture and corporate charter. The most restrictive of these provisions requires, for the issuance of additional first mortgage bonds, that before-income-tax earnings, as defined, cover pro forma annual interest charges on outstanding first mortgage bonds at least twice; and for the issuance of additional preferred stock, that gross income available for interest cover pro forma annual interest charges and preferred stock dividends at least one and one-half times. These coverages, for first mortgage bonds and for preferred stock for the year ended December 31, 1993, were 5.70 and 2.71, respectively. BANK CREDIT ARRANGEMENTS The company, along with The Southern Company and Georgia Power Company, has entered into agreements with several banks outside the service area to provide $400 million of revolving credit to the companies through June 30, 1996. To provide liquidity support for commercial paper programs, the company and Georgia Power Company have exclusive right to $135 million and $165 million, respectively, of the available credit. The companies have the option of converting the short-term borrowings into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements provide for payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. Additionally, the company maintains committed lines of credit in the amount of $350 million which expire at various times during 1994 and, in certain cases, provide for average annual compensating balances. Because the arrangements are based on an average balance, the company does not consider any of its cash balances to be restricted as of any specific date. Moreover, the company borrows from time to time pursuant to arrangements with banks for uncommitted lines of credit. In connection with all other lines of credit, the company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. At December 31, 1993, the company had regulatory approval to have outstanding up to $450 million of short-term borrowings. ASSETS SUBJECT TO LIEN The company's mortgage, as amended and supplemented, securing the first mortgage bonds issued by the company, constitutes a direct lien on substantially all of the company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations through the year 2013 were approximately $8 billion at December 31, 1993. In addition, a contract with a certain coal contractor requires reimbursement or purchase, at net book value, of the investment in the mine or equipment upon termination of the contract. At December 31, 1993, such net book value was approximately $13 million. Additional commitments for coal and for nuclear fuel will be required in the future to supply the company's fuel needs. 6. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS The company and Georgia Power Company own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,019,680 kilowatts, together with associated transmission facilities. The capacity of these units is sold equally to the company and Georgia Power Company under a contract expiring in 1994 which, in substance, requires payments sufficient to provide for the operating expenses, taxes, interest expense II-71 NOTES(continued) Alabama Power Company 1993 Annual Report and a return on equity, whether or not SEGCO has any capacity and energy available. The company's share of expenses totaled $86 million in 1993, $73 million in 1992 and $82 million in 1991, and is included in "Purchased power from affiliates" in the Statements of Income. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two years' notice. In addition, the company has guaranteed unconditionally the obligation of SEGCO under an installment sale agreement for the purchase of certain pollution control facilities at SEGCO's generating units, pursuant to which $24.5 million principal amount of pollution control revenue bonds are outstanding. Georgia Power Company has agreed to reimburse the company for the pro rata portion of such obligation corresponding to its then proportionate ownership of stock of SEGCO if the company is called upon to make such payment under its guaranty. At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. SEGCO paid dividends totaling $11.3 million in 1993, $12.0 million in 1992, and $4.5 million in 1991, of which one-half of each was paid to the company. SEGCO's net income was $8.3 million, $9.3 million and $9.2 million for 1993, 1992 and 1991, respectively. In June 1992 the company completed the sale of a portion of Plant Miller Units 1 and 2 to Alabama Electric Cooperative, Inc. (AEC). The company's percentage ownership and investment in jointly-owned generating plants at December 31, 1993, follows: (1) Jointly owned with an affiliate, Mississippi Power Company. (2) Jointly owned with AEC. 7. LONG-TERM POWER SALES AGREEMENTS GENERAL The operating subsidiaries of The Southern Company, including the company, have entered into long-term and short-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The company's portion of off-system capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. Unit power from Plant Miller is being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA) and the City of Tallahassee, Florida (Tallahassee). Under these agreements, an average of 1,100 megawatts of capacity is scheduled to be II-72 NOTES(continued) Alabama Power Company 1993 Annual Report sold during 1994. Thereafter, these sales will increase to some 1,200 megawatts and remain at that approximate level -- unless reduced by FP&L, FPC, and JEA for the periods after 1999 -- until the expiration of the contracts in 2010. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. With respect to the company's portion of proceeds received in 1991, see Note 3 concerning the regulatory treatment of amounts being refunded to retail customers over a three-year period. ALABAMA MUNICIPAL ELECTRIC AUTHORITY (AMEA) CAPACITY CONTRACTS In August 1986, the company entered into a firm power purchase contract with AMEA entitling AMEA to scheduled amounts of capacity (to a maximum 100 megawatts) for a period of 15 years commencing September 1, 1986 (1986 Contract). In October 1991, the company entered into a second firm power purchase contract with AMEA entitling AMEA to scheduled amounts of additional capacity (to a maximum 80 megawatts) for a period of 15 years commencing October 1, 1991 (1991 Contract). In both contracts the power will be sold to AMEA for its member municipalities that previously were served directly by the company as wholesale customers. Under the terms of the contracts, the company received payments from AMEA representing the net present value of the revenues associated with the respective capacity entitlements, discounted at effective annual rates of 9.96 percent and 11.19 percent for the 1986 and 1991 Contracts, respectively. These payments are being recognized as operating revenues and the discounts are being amortized to other interest expense as scheduled capacity is made available over the terms of the contracts. In order to secure AMEA's advance payments and the company's performance obligation under the contracts, the company issued and delivered to an escrow agent first mortgage bonds representing the maximum amount of liquidated damages payable by the company in the event of a default under the contracts. No principal or interest is payable on such bonds unless and until a default by the company occurs. As the liquidated damages decline under the contracts, a portion of the bonds equal to the decreases are returned to the company. At December 31, 1993, $153 million of such bonds were held by the escrow agent under the contracts. 8. INCOME TAXES Effective January 1, 1993, the company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $469 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $441 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-73 NOTES (continued) Alabama Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $13 million in 1993, $18 million in 1992, and $16 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-74 NOTES (continued) Alabama Power Company 1993 Annual Report 9. OTHER LONG-TERM DEBT Details of other long-term debt are as follows: Pollution control obligations represent installment purchases of pollution control facilities financed by funds derived from sales by public authorities of revenue bonds. The company is required to make payments sufficient for the authorities to meet principal and interest requirements of such bonds. With respect to $154.5 million of such pollution control obligations, the company has authenticated and delivered to the trustees a like principal amount of first mortgage bonds as security for its obligations under the installment purchase agreements. No principal or interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase agreements. The company has capitalized leased nuclear material and recorded the related lease obligations. The arrangement provides for the payment of interest at varying rates and times dependent on options selected by the company from types of loans available under the arrangement. At the end of 1993 the effective rate of this lease arrangement, including applicable fees, was 3.58 percent. Principal payments are required under the arrangement based on the cost of fuel burned. The company has also capitalized certain office building leases and a street light lease. Monthly principal payments plus interest are required, and at December 31, 1993, the interest rate was 9.5 percent for office buildings and 13.0 percent for street lights. The net book value of capitalized leases included in utility plant in service was $94.7 million and $103.0 million at December 31, 1993 and 1992, respectively. The estimated aggregate annual maturities of other long-term debt through 1998 are as follows: $38.9 million in 1994, $33.3 million in 1995, $18.7 million in 1996, $6.4 million in 1997 and $3.0 million in 1998. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The annual first mortgage bond improvement fund requirement is one percent of the aggregate principal amount of bonds of each series authenticated, so long as a portion of that series is outstanding, and may be satisfied by the deposit of cash and/or reacquired bonds, the certification of unfunded property additions or a combination thereof. The 1994 requirement of $20.1 million was satisfied by the deposit of cash in 1994, which was used for the partial redemption of various series of outstanding bonds. In addition, maturing in 1994 are other long-term debt of $38.9 million consisting primarily of capitalized nuclear fuel obligations. II-75 NOTES (continued) Alabama Power Company 1993 Annual Report 11. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988 (Act), the company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at Plant Farley. The Act limits to $9.4 billion, public liability claims that could arise from a single nuclear incident. Plant Farley is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums which could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment, excluding any applicable state premium taxes, for the company is $159 million per incident but not more than an aggregate of $20 million to be paid for each incident in any one year. The company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The company's maximum annual assessment per incident is limited to $14 million under the current policy. Additionally, the company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional cost that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased cost of replacement power in an amount up to $3.5 million per week (starting 21 weeks after the outage) for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum annual assessments per incident under current policies for the company would be $16 million for excess property damage and $9 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and then, any further remaining proceeds are to be paid either to the company or to its bond trustees as may be appropriate under applicable trust indentures. The company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the company could be subject to a maximum total assessment of $6.4 million. II-76 NOTES (continued) Alabama Power Company 1993 Annual Report 12. COMMON STOCK DIVIDEND RESTRICTIONS The company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $653 million of retained earnings was restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. 13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: The company's business is influenced by seasonal weather conditions and the timing of rate adjustments. II-77 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-78 SELECTED FINANCIAL AND OPERATING DATA Alabama Power Company II-79 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company Notes: (1) Generating capacity and fuel data includes Alabama Power Company's 50% portion of SEGCO. (2) Includes Southeastern Power Administration allotment. * Less than one-tenth of one percent. II-80 SELECTED FINANCIAL AND OPERATING DATA (continued) Alabama Power Company II-81 STATEMENTS OF INCOME Alabama Power Company * Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-82 STATEMENTS OF INCOME Alabama Power Company II-83 STATEMENTS OF CASH FLOWS Alabama Power Company ( ) Denotes use of cash. II-84 STATEMENTS OF CASH FLOWS Alabama Power Company II-85 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-86 BALANCE SHEETS Alabama Power Company II-87 BALANCE SHEETS Alabama Power Company *Includes the effect of recognizing, beginning in 1987, retail service rendered but not yet billed to customers. II-88 BALANCE SHEETS Alabama Power Company II-89 ALABAMA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-90 ALABAMA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS II-91 GEORGIA POWER COMPANY FINANCIAL SECTION II-92 MANAGEMENT'S REPORT Georgia Power Company 1993 Annual Report The management of Georgia Power Company has prepared this annual report and is responsible for the financial statements and related information. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that the books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls based upon the recognition that the cost of the system should not exceed its benefits. The Company believes that its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, which is composed of five directors who are not employees, provides a broad overview of management's financial reporting and control functions. At least three times a year this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal control and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted with a high standard of business ethics. In management's opinion, the financial statements present fairly the financial position, results of operations and cash flows of Georgia Power Company in conformity with generally accepted accounting principles. As discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of regulators regarding recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ H. Allen Franklin /s/ Warren Y. Jobe - --------------------- -------------------------- H. Allen Franklin Warren Y. Jobe President and Chief Executive Vice President, Executive Officer Treasurer and Chief Financial Officer II-93 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GEORGIA POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Georgia Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-102 through II-122) referred to above present fairly, in all material respects, the financial position of Georgia Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. As more fully discussed in Note 4 to the financial statements, an uncertainty exists with respect to the actions of the regulators regarding the recoverability of the Company's investment in the Rocky Mountain pumped storage hydroelectric project. The outcome of this uncertainty cannot be determined until regulatory proceedings are concluded. Accordingly, no provision for any write-down of the costs associated with the Rocky Mountain project resulting from the potential actions of the Georgia Public Service Commission has been made in the accompanying financial statements. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-94 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Georgia Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Georgia Power Company's 1993 earnings totaled $570 million, representing a $49 million (9.5 percent) increase over the prior year. This improvement is primarily a result of higher retail revenues and lower financing costs. Also, during the period, the Company had an $18 million after-tax gain on the sale of a portion of Plant Scherer Unit 4. Higher retail revenues reflect growth in energy sales of 6.1 percent from 1992 levels primarily due to exceptionally hot summer weather during 1993. Interest expense and preferred stock dividends decreased in 1993 due to the redemption and refinancing of higher-cost debt and preferred stock. These positive events were partially offset by higher operating expenses. In comparing 1992 earnings to the prior year, it should be noted that 1991 earnings included two unusual items that significantly affect this comparison. Earnings in 1991 were $89 million higher due to the completion of a settlement agreement with Gulf States Utilities Company (Gulf States) related to power sales contracts. This increase was partially offset by an after-tax charge of $33 million in 1991 for a work force reduction program. A comparison of 1992 to 1991 -- excluding these unusual items -- would reflect a 1992 increase in earnings of $102 million. REVENUES The following table summarizes the factors impacting operating revenues for the 1991-1993 period: Retail revenues of $3.8 billion in 1993 increased $262 million (7.4 percent) over the prior year, compared with an increase of $87 million (2.5 percent) in 1992. The exceptionally hot weather during the summer of 1993 was the primary factor affecting the increase in retail revenues over 1992. The increase in retail revenues for 1992 was a result of higher retail rates and sales growth, partially offset by mild weather and lower fuel revenues. Fuel revenues generally represent the direct recovery of fuel expense, including the fuel component of purchased energy, and do not affect net income. Revenues from demand-side options programs generally represent the direct recovery of program costs. See Note 3 to the financial statements for further information on these programs. Revenues from sales to non-affiliated utilities decreased in both 1993 and 1992. Contractual unit power sales to Florida utilities for 1993 and 1992 are down compared with prior years, primarily due to scheduled reductions that corresponded with the sales to these utilities of portions of Plant Scherer Unit 4 in July 1991 and June II-95 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report 1993. Sales to municipalities and cooperatives increased slightly in 1993 due to the hot summer weather. Generally, these sales have been decreasing as these customers retain more of their own generation at facilities jointly owned with the Company. Revenues from sales to non-affiliated utilities outside the service area under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were as follows: Revenues from sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. Sales to affiliated companies do not have a significant impact on earnings. Changes in revenues are a function of the amount of energy sold each year. Kilowatt-hour (KWH) sales for 1993 and the percent change by year were as follows: The hot summer weather during 1993 contributed primarily to the sales growth in the residential and commercial classes. Continued improvement in economic conditions positively impacted sales growth in the commercial and industrial classes. Residential energy sales growth in 1992 reflected mild weather. Commercial and industrial sales growth in 1992 is attributable to improved economic conditions. The decrease in energy sales to non-affiliated utilities reflects scheduled reductions in contractual power sales. EXPENSES Fuel expense increased 2.3 percent in 1993 due to higher generation, which was partially offset by lower nuclear fuel costs. In 1992, fuel expense decreased 6.9 percent due to lower generation and lower fuel costs. Purchased power expense has decreased significantly since 1991, reflecting declining contractual capacity purchases from the co-owners of plants Vogtle and Scherer. Purchased power expense decreased $88 million in 1993 and $43 million in 1992. The declines in Plant Vogtle contractual capacity purchases did not have a significant impact on earnings in 1993 or 1992 as these costs are being levelized over six years under the terms of the 1991 Georgia Public Service Commission (GPSC) retail rate order. The levelization is reflected in the amortization of deferred Plant Vogtle expenses in the income statements. See Note 3 to the financial statements for additional information. Other Operation and Maintenance (O & M) expenses increased 9.0 percent in 1993 after remaining relatively flat in 1992. The increase in 1993 is primarily the result of environmental remediation costs at various current and former operating sites, the one- time costs of an automotive fleet reduction program and the recognition of higher employee benefit costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information concerning these new rules. Also, during 1993, O & M expenses reflect costs associated with new demand-side option programs. These costs were offset by increases in retail revenues. See Note 3 to the financial statements for additional information on the recovery of demand-side option program costs. Depreciation and amortization expense increased slightly due to additional plant investment. The 1992 decrease is due to the effects of lower depreciation rates effective in October 1991. Taxes other than income taxes increased 7.4 percent in 1993 and 3.8 percent in 1992. II-96 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report These increases reflect higher ad valorem taxes. The 1993 increase also includes higher taxes paid to municipalities as a result of increased sales. Income tax expense increased $62 million in 1993 due primarily to higher earnings and the effect of a one percent increase in the federal tax rate effective January, 1993. Also, the Company incurred $27 million of tax expense in connection with the second in a series of four separate transactions to sell Plant Scherer Unit 4. The sale resulted in an after-tax gain of $18 million. Interest expense and dividends on preferred stock decreased $19 million (4.0 percent) and $49 million (9.3 percent) in 1993 and 1992, respectively. These reductions are due to significant refinancing of long-term debt and preferred stock. The Company refinanced $1.7 billion of securities in both 1993 and 1992. In addition, the Company has retired $544 million of long-term debt with the proceeds from the 1991 and 1993 Plant Scherer Unit 4 sales. Other interest charges in 1993 include interest related to the settlement of an Internal Revenue Service audit. The settlement, in total, did not have an effect on 1993 net income. The Company has deferred certain expenses and recorded a deferred return related to Plant Vogtle under phase-in plans. See Note 3 to the financial statements under "Plant Vogtle Phase-In-Plans" for information regarding the deferral and subsequent amortization of costs related to Plant Vogtle. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize either this economic loss or the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Growth in energy sales is subject to a number of factors which traditionally have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. Assuming normal weather, retail sales growth is projected to be approximately 2 percent annually on average during 1994 through 1996. The scheduled addition of four combustion turbine generating units in 1994, four units in 1995 and one unit in 1996, as well as the Rocky Mountain pumped storage hydroelectric project in 1995, will increase related O & M and depreciation expenses. See Note 4 to the financial statements for information on regulatory uncertainties related to the Rocky Mountain project. The GPSC has certified the construction of the 1994 and 1995 combustion turbine generating units for meeting peak generating needs. In addition, the Company has completed a demonstration competitive bidding process for its supply-side requirements expected for 1996. The Company has filed with the GPSC for certification of a four-year purchase power agreement beginning in 1996, and for construction of a jointly owned combustion turbine to be completed in 1996 to meet these needs. As part of efforts to curtail growth in operating expenses, the Company is reducing its work force through an early-retirement program announced in January 1994. The program resulted in a first quarter 1994 after-tax charge to earnings of $39 million. The program has an expected payback period of approximately two years. Pursuant to an Integrated Resource Plan approved by the GPSC in 1992, the Company has implemented various demand-side option programs and has been authorized by the GPSC to recover associated program costs through rate riders. On October 15, 1993, a superior court judge ruled that recovery of these costs through rate riders is unlawful. The Company has ceased collection of the rate riders and is deferring program costs as ordered by the II-97 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report GPSC pending the final outcome of this matter. See Note 3 to the financial statements for additional information. The Company has completed two in a series of four separate transactions to sell Unit 4 of Plant Scherer to two Florida utilities. The remaining transactions are scheduled to take place in 1994 and 1995. If the sales take place as planned, the Company would realize an additional after-tax gain estimated to total approximately $20 million. See Note 5 to the financial statements for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs cannot be billed to customers. The Clean Air Act is discussed later under "Environmental Issues." The Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition among electric utilities. The law also includes provisions to streamline the licensing process for new nuclear generating plants. The Energy Act marks the beginning of a major change in the traditional business practices of selling electricity. The Energy Act allows Independent Power Producers (IPPs) and other electric suppliers access to a utility's transmission lines to sell their electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. If the Company does not remain a low cost producer and provide quality service, the Company's sales growth could be limited and this could significantly erode earnings. The Company continues to compete with other electric suppliers within the state. In Georgia, most new retail customers with more than 900 kilowatts of connected load may choose their electricity supplier. In addition, the bulk power market has become very competitive as utilities, IPPs and cogenerators seek to supply future capacity needs. Competition can create new business opportunities, but it increases risk and has the potential to adversely affect earnings. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC currently is reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Review of Equity Returns" for additional information. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be adopted by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which will be effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules in January, 1994, with no material effect on the financial statements. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition in 1993 were gross utility plant additions of $674 million and the lowering of the cost of capital achieved through the refinancing or retirement of $1.7 billion of long-term debt and preferred stock. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See Notes 2 and 7 to the financial statements regarding the impact of these changes. The funds needed for gross property additions are currently provided from operations. The Statements of Cash Flows provide additional details. II-98 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report FINANCING ACTIVITIES In 1993, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring or repaying high-cost issues. New issues during 1991 through 1993 totaled $3.0 billion and retirement or repayment of securities totaled $4.2 billion. The retirements included the redemption of $253 million and $291 million in 1993 and 1991, respectively, of first mortgage bonds with the proceeds from the Plant Scherer Unit 4 sales. Composite financing rates for the years 1991 through 1993, as of year-end, were as follows: The Company's current securities ratings are as follows: * Not rated by Duff & Phelps LIQUIDITY AND CAPITAL REQUIREMENTS Cash provided from operations increased by $236 million in 1993, primarily due to higher retail sales, lower interest costs, decreasing capacity purchases from the co-owners of plants Vogtle and Scherer and the receipt of cash payments from Gulf States that completed the settlement of litigation. The Company estimates that construction expenditures for the years 1994 through 1996 will total $688 million, $555 million and $629 million, respectively. The Company will continue to invest in transmission and distribution facilities and enhance existing generating plants. These expenditures also include amounts for nine combustion turbine generating units and equipment that will be required to comply with the provisions of the Clean Air Act. The Company's contractual capacity purchases will decline by $113 million over the next three years. Cash requirements for sinking fund requirements, redemptions announced, and maturities of long-term debt are expected to total $377 million during 1994 through 1996. As a result of requirements by the Nuclear Regulatory Commission, the Company has established external sinking funds for the purpose of funding nuclear decommissioning costs. For 1994 through 1996, the amount to be funded for the Company totals $16 million annually. For additional information concerning nuclear decommissioning costs, see Note 1 to the financial statements under "Nuclear Decommissioning." SOURCES OF CAPITAL The Company expects to meet future capital requirements primarily using funds generated from operations and, if needed, by the issuance of new debt and equity securities, term loans, and short-term borrowings. To meet short-term cash needs and contingencies, the Company had approximately $540 million of unused credit arrangements with banks at the beginning of 1994. See Note 8 to the financial statements for additional information. Completing the remaining two transactions for the sale of Plant Scherer Unit 4 will generate approximately $130 million in both 1994 and in 1995. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's ability to satisfy all coverage requirements is such that it could issue new first mortgage bonds and preferred stock to provide sufficient funds for all anticipated requirements. ENVIRONMENTAL ISSUES In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts II-99 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, Georgia Power's construction expenditures are estimated to total approximately $150 million through 1995. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total Georgia Power construction expenditures ranging from approximately $150 million to $325 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 2 percent in Georgia Power's annual revenue requirements from customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Metropolitan Atlanta is classified as a non-attainment area with regard to the ozone ambient air quality standards. Title I of the Clean Air Act requires the state of Georgia to conduct specific studies and establish new control rules by November 1994 -- affecting sources of nitrogen oxides and volatile organic compounds -- to achieve attainment by 1999. As the required first step, the state has issued rules for the application of reasonably available control technology to reduce nitrogen oxide emissions by May 31, 1995. The results of these new rules require nitrogen oxide controls, above Title IV requirements, on some Company plants. Final attainment rules, based on modeling studies, could require installation of additional controls for nitrogen oxide emissions as early as 1997. Compliance with any new rules could result in significant additional costs. The impact of new rules will depend on the development and implementation of such rules. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a II-100 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Georgia Power Company 1993 Annual Report new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standards will depend on the level chosen for the standards and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the nonhazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either nonhazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. These laws include the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA or Superfund). Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized costs to clean-up known sites in the financial statements. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. II-101 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-102 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-103 BALANCE SHEETS At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-104 STATEMENTS OF CAPITALIZATION AT December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report II-105 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-106 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-107 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Georgia Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-108 NOTES TO FINANCIAL STATEMENTS Georgia Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), and Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Intracompany contracts dealing with jointly owned generating facilities, transmission lines and exchange of electric power are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and each of the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides support services for nuclear power plants in the Southern electric system. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935. Both The Southern Company and its subsidiaries are subject to the regulatory provisions of this act. The Company is also subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective regulatory commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company is authorized by state law and FERC regulations to recover fuel costs and the fuel component of purchased energy costs through fuel cost recovery provisions, which are periodically adjusted to reflect increases or decreases in such costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. Fuel costs were under recovered by $79 million and $4 million at December 31, 1993, and 1992, respectively. These amounts are included in customer accounts receivable on the balance sheets. The fuel cost recovery rate was increased effective December 6, 1993. The cost of nuclear fuel is amortized to fuel expense based on estimated thermal units used to generate electric energy and includes a provision for the disposal of spent fuel. Total charges for nuclear fuel amortized to expense were $75 million in 1993, $84 million in 1992, and $93 million in 1991. The Company has contracted with the U.S. Department of Energy (DOE) for permanent disposal of spent fuel beginning in 1998; however, the actual year this service will begin is uncertain. Pending permanent disposition of the spent fuel, sufficient storage capacity is available at Plant Hatch into 2003 and at Plant Vogtle into 2009. Also, the Energy Policy Act of 1992 required the establishment in 1993 of a Uranium Enrichment Decontamination and Decommissioning Fund which is to be funded, in part, by a special assessment on utilities with nuclear plants. This fund will be used by the DOE for the decontamination and decommissioning of its nuclear fuel enrichment facilities. The law provides that utilities will recover these payments in the same manner as any other fuel expense. The Company -- based on its ownership interest -- estimates its total assessment under this law to be approximately $42 million to be paid over a 15-year period beginning in 1993. This obligation is recognized in the accompanying Balance Sheets and is being recovered through the fuel cost recovery provisions. The remaining liability at December 31, 1993, is $39 million. II-109 NOTES (continued) Georgia Power Company 1993 Annual Report NUCLEAR REFUELING OUTAGE COSTS Prior to 1992, the Company expensed nuclear refueling outage costs as incurred during the outage period. Pursuant to the 1991 GPSC retail rate order, the Company began accounting for these costs on a normalized basis in 1992. Under this method of accounting, refueling outage costs are deferred and subsequently amortized to expense over the operating cycle of each unit, which is normally 18 months. Deferred nuclear outage costs were $17 million and $6 million at December 31, 1993 and 1992, respectively. DEPRECIATION Depreciation is provided on the cost of depreciable utility plant in service and is calculated primarily on the straight-line basis over the estimated composite service life of the property. The composite rate of depreciation was 3.1 percent in 1993 and 1992, and 3.2 percent in 1991. Effective October 1991, the Company adopted lower depreciation rates consistent with the 1991 GPSC retail rate order. When a property unit is retired or otherwise disposed of in the normal course of business, its costs and the costs of removal, less salvage, are charged to the accumulated provision for depreciation. Minor items of property included in the cost of the plant are retired when the related property unit is retired. NUCLEAR DECOMMISSIONING In 1988, the Nuclear Regulatory Commission (NRC) adopted regulations requiring all licensees operating commercial nuclear power reactors to establish a plan for providing, with reasonable assurance, funds for decommissioning. Reasonable assurance may be in the form of an external sinking fund, a surety method, or prepayment. The Company has established external trust funds to comply with the NRC's regulations. Prior to the enactment of these regulations, the Company had internally reserved nuclear decommissioning costs. The NRC's minimum external funding requirements are based on a generic estimate of the cost to decommission the radioactive portions of a nuclear unit based on the size and type of reactor. The estimated cost of decommissioning and the amounts being recovered through rates at December 31, 1993, for the Company's ownership interest in plants Hatch and Vogtle were as follows: The amounts in the internal reserve are being transferred into the external trust fund over a period of approximately nine years as approved by the GPSC in its 1991 retail rate order. The estimates approved by the GPSC for ratemaking exclude costs of non-radiated structures and site contingency costs. The actual decommissioning cost may vary from the above estimates because of regulatory requirements, changes in technology, and increased costs of labor, materials, and equipment. The decommissioning cost estimates are based on prompt dismantlement and removal of the plant from service. The Company expects the GPSC to periodically review and adjust, if necessary, the amounts collected in rates for the anticipated cost of decommissioning. PLANT VOGTLE PHASE-IN PLANS In 1987 and 1989, the GPSC ordered that the costs of Plant Vogtle Units 1 and 2 be phased into rates under plans that meet the requirements of Financial Accounting Standards Board (FASB) Statement No. 92, Accounting for Phase-In Plans. In 1991, the GPSC modified the phase-in plans. In addition, the Company deferred certain Plant Vogtle operating expenses and financing costs under accounting orders issued by the GPSC. See Note 3 for further information. II-110 NOTES (continued) Georgia Power Company 1993 Annual Report INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. See Note 7 to the financial statements for further information. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AND DEFERRED RETURN AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. For the years 1993, 1992 and 1991, the average AFUDC rates were 4.87 percent, 7.16 percent and 9.90 percent, respectively. The reduction in the average AFUDC rate since 1991 reflects the Company's greater use of lower cost short-term debt. The Company also imputed a return on its investment in Plant Vogtle Units 1 and 2 after they began commercial operation, under short-term cost deferrals and phase-in plans as described in Note 3. AFUDC and the Vogtle deferred returns, net of taxes, as a percentage of net income after dividends on preferred stock, amounted to 1.4 percent, 2.1 percent and 9.2 percent for 1993, 1992 and 1991, respectively. UTILITY PLANT Utility plant is stated at original cost with the exception of Plant Vogtle, which is stated at cost less regulatory disallowances. Original cost includes materials; labor; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS All financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below at December 31: The fair values of nuclear decommissioning trusts and investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. In December 1992, the Company converted to the inventory method of accounting for certain emergency spare parts. This conversion resulted in a regulatory liability that is being amortized as credits to income over II-111 NOTES (continued) Georgia Power Company 1993 Annual Report approximately four years. This conversion will not have a material effect on income in any year. VACATION PAY Company employees earn vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. This amount was $42 million at December 31, 1993, and $40 million at December 31, 1992. In 1994, approximately 72 percent of the 1993 deferred vacation costs will be expensed, and the balance will be charged to construction and other accounts. 2. RETIREMENT BENEFITS PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan covering substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the projected unit credit actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. For medical care benefits, a qualified trust has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." In October 1993, the GPSC ordered the Company to phase in the adoption of Statement No. 106 to cost of service over a five-year period, whereby one-fifth of the additional expense was recognized -- approximately $6 million -- in 1993 and the remaining additional expense was deferred. An additional one-fifth of the costs will be expensed each succeeding year until the costs are fully reflected in cost of service in 1997. The cost deferred during the five-year period will be amortized to expense over a 15-year period beginning in 1998. As a result of the regulatory treatment allowed by the GPSC, the adoption of Statement No. 106 did not have a material impact on net income. Prior to 1993, the Company recognized these cost on a cash basis as payments were made. The total costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $56 million, $13 million, and $9 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as II-112 NOTES (continued) Georgia Power Company 1993 Annual Report of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: Weighted average rates used in actuarial calculations: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $68 million and the aggregate of the service and interest cost components of the net retiree medical cost by $7 million. The components of the plans' net costs are shown below: Of net pension costs (income) recorded, $(6) million in 1993 and $5 million in 1991, were recorded to operating expense, with the balance being recorded to construction and other accounts. II-113 NOTES (continued) Georgia Power Company 1993 Annual Report Of the above net postretirement medical and life insurance costs recorded in 1993, $21 million was charged to operating expenses, $21 million was deferred, and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS DEMAND-SIDE CONSERVATION PROGRAMS In October 1993, a Superior Court of Fulton County, Georgia, judge ruled that rate riders previously approved by the GPSC for recovery of the Company's costs incurred in connection with demand-side conservation programs were unlawful. The judge held that the GPSC lacked statutory authority to approve such rate riders except through general rate case proceedings and that those procedures had not been followed. The Company has suspended collection of the demand-side conservation costs and appealed the court's decision to the Georgia Court of Appeals. In December 1993, the GPSC approved the Company's request for an accounting order allowing the Company to defer all current unrecovered and future costs related to these programs until the court's decision is reversed or until the next general rate case proceeding. An association of industrial customers has filed a petition for review of such accounting order in the Superior Court of Fulton County, Georgia. The Company's costs related to these conservation programs through 1993 were $60 million of which $15 million has been collected and the remainder deferred. The estimated costs, assuming no change in the programs certified by the GPSC, are $38 million in 1994 and $40 million in 1995. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on these financial statements. RETAIL RATEPAYERS' SUIT CONCLUDED In March 1993, several retail ratepayers of Georgia Power filed a civil complaint in the Superior Court of Fulton County, Georgia, against Georgia Power, The Southern Company, the system service company, and Arthur Andersen & Co. The complaint alleged that Georgia Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated by the plaintiffs to be in excess of $60 million -- plus treble and punitive damages -- for alleged violations of the Georgia Racketeer Influenced and Corrupt Organizations Act and other state statutes, statutory and common law fraud, and negligence. These state law allegations were substantially the same as those included in a 1989 suit brought in federal district court in Georgia. That suit and similar ones filed in Alabama, Florida, and Mississippi federal courts were subsequently dismissed. The defendants' motions to dismiss the current complaint were granted by the Superior Court of Fulton County, Georgia, in July 1993. In January 1994, the plaintiffs' appeal of the dismissal to the Supreme Court of Georgia was rejected. This matter is now concluded. GULF STATES SETTLEMENT On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received, the Company recorded increases of $3 million in 1992 and $89 million in 1991 net income. FERC REVIEW OF EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power, and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. II-114 NOTES (continued) Georgia Power Company 1993 Annual Report The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. PLANT VOGTLE PHASE-IN PLANS Pursuant to orders from the GPSC, the Company recorded a deferred return under phase-in plans for Plant Vogtle Units 1 and 2 until October 1991 when the allowed investment was fully reflected in rates. In addition, the GPSC issued two separate accounting orders that required the Company to defer substantially all operating and financing costs related to both units until rate orders addressed these costs. These GPSC orders provide for the recovery of deferred costs within 10 years. The GPSC modified the phase-in plans in 1991 to accelerate the recognition of costs previously deferred under the Plant Vogtle Unit 2 phase-in plan and to levelize the remaining Plant Vogtle declining capacity buyback expenses. Under these orders, the Company has deferred and begun amortizing these costs (as recovered through rates) as follows: NUCLEAR PERFORMANCE STANDARDS In October 1989, the GPSC adopted a nuclear performance standard for the Company's nuclear generating units under which the performance of plants Hatch and Vogtle will be evaluated every three years. The performance standard is based on each unit's capacity factor as compared to the average of all U.S. nuclear units operating at a capacity factor of 50% or higher during the three-year period of evaluation. Depending on the performance of the units, the Company could receive a monetary reward or penalty under the performance standards criteria. The first evaluation was conducted in 1993 for performance during the 1990-92 period. During this three-year period, the Company's units performed at an average capacity factor of 81 percent compared to an industry average of approximately 73 percent. Based on these results, the GPSC approved a performance reward of approximately $8.5 million for the Company. This reward is being collected through the retail fuel cost recovery provision and recognized in income over a 36- month period beginning November, 1993. 4. COMMITMENTS AND CONTINGENCIES CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program and currently estimates property additions to be approximately $688 million in 1994, $555 million in 1995 and $629 million in 1996. These estimated additions include AFUDC of $19 million in 1994, $27 million in 1995, and $18 million in 1996. The estimates for property additions for the three-year period include $88 million committed to meeting the requirements of the Clean Air Act. While the Company has no new baseload generating plants under construction, the construction of nine combustion turbine peaking units is planned to be completed by 1996. In addition, significant construction of transmission and distribution facilities, and upgrading and extending the useful life of generating plants will continue. The construction program is subject to periodic review and revision, and actual construction costs may vary from estimates because of numerous factors, including, but not limited to, changes in business conditions, load growth estimates, environmental regulations, and regulatory requirements. II-115 NOTES (continued) Georgia Power Company 1993 Annual Report FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into various long-term commitments for the procurement of fossil and nuclear fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $4.8 billion at December 31, 1993. Additional commitments for coal and for nuclear fuel will be required in the future to supply the Company's fuel needs. OPERATING LEASES The Company has entered into coal rail car rental agreements with various terms and expiration dates. Rental expense totaled $8 million, $7 million, and $5 million for 1993, 1992, and 1991, respectively. Minimum annual rental commitments for noncancellable rail car leases are $9 million annually for years 1994 through 1998, and total approximately $191 million thereafter. ROCKY MOUNTAIN PROJECT STATUS In its 1985 financing order, the GPSC concluded that completion of the Rocky Mountain pumped storage hydroelectric project in 1991 as then planned was not economically justifiable and reasonable and withheld authorization for the Company to spend funds from approved securities issuances on that project. In 1988, the Company and Oglethorpe Power Corporation (OPC) entered into a joint ownership agreement for OPC to assume responsibility for the construction and operation of the project, as discussed in Note 5. The joint ownership agreement significantly reduces the risk of the project being canceled. However, full recovery of the Company's costs depends on the GPSC's treatment of the project's cost and disposition of the project's capacity output. In the event the Company cannot demonstrate to the GPSC the project's economic viability based on current ownership, construction schedule, and costs, then part or all of such costs may have to be written off in accordance with FASB Statement No. 90, Accounting for Abandonments and Disallowed Plant Costs. At December 31, 1993, the Company's investment in the project amounted to approximately $197 million. AFUDC accrued on the Rocky Mountain project has not been credited to income or included in the project cost since December 1985. If accrual of AFUDC is not resumed, the Company's portion of the estimated total plant additions at completion would be approximately $199 million. The plant is currently scheduled to begin commercial operation in 1995. The Company has held preliminary discussions with other parties regarding the potential disposition of its remaining interest in the project. The ultimate outcome of this matter cannot now be determined. NUCLEAR INSURANCE Under the Price-Anderson Amendments Act of 1988, the Company maintains agreements of indemnity with the NRC that, together with private insurance, cover third-party liability arising from any nuclear incident occurring at the Company's nuclear power plants. The act limits to $9.4 billion public liability claims that could arise from a single nuclear incident. Each nuclear plant is insured against this liability to a maximum of $200 million by private insurance, with the remaining coverage provided by a mandatory program of deferred premiums that could be assessed, after a nuclear incident, against all owners of nuclear reactors. A company could be assessed up to $79 million per incident for each licensed reactor it operates but not more than an aggregate of $10 million per incident to be paid in a calendar year for each reactor. Such maximum assessment for the Company -- based on its ownership and buyback interests -- is $171 million per incident but not more than an aggregate of $22 million to be paid for each incident in any one year. The Company is a member of Nuclear Mutual Limited (NML), a mutual insurer established to provide property damage insurance in an amount up to $500 million for members' nuclear generating facilities. The members are subject to a retrospective premium adjustment in the event that losses exceed accumulated reserve funds. The Company's maximum assessment per incident is limited to $18 million under current policies. Additionally, the Company has policies that currently provide decontamination, excess property insurance, and premature decommissioning coverage up to $2.25 billion for losses in excess of the $500 million NML coverage. This excess insurance is provided by Nuclear Electric II-116 NOTES (continued) Georgia Power Company 1993 Annual Report Insurance Limited (NEIL), a mutual insurance company, and American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters. NEIL also covers the additional costs that would be incurred in obtaining replacement power during a prolonged accidental outage at a member's nuclear plant. Members can be insured against increased costs of replacement power in an amount up to $3.5 million per week -- starting 21 weeks after the outage -- for one year and up to $2.3 million per week for the second and third years. Under each of the NEIL policies, members are subject to assessments if losses each year exceed the accumulated funds available to the insurer under that policy. The maximum assessments per incident under the current policies for the Company would be $15 million for excess property damage and $13 million for replacement power. For all on-site property damage insurance policies for commercial nuclear power plants, the NRC requires that the proceeds of such policies issued or renewed on or after April 2, 1991, shall be dedicated first for the sole purpose of placing the reactor in a safe and stable condition after an accident. Any remaining proceeds are to be applied next toward the costs of decontamination and debris removal operations ordered by the NRC, and any further remaining proceeds are to be paid either to the Company or to its bond trustees as may be appropriate under the policies and applicable trust indentures. The Company participates in an insurance program for nuclear workers that provides coverage for worker tort claims filed for bodily injury caused at commercial nuclear power plants. In the event that claims for this insurance exceed the accumulated reserve funds, the Company could be subject to a maximum total assessment of $7 million. 5. FACILITY SALES AND JOINT OWNERSHIP AGREEMENTS Since 1975, the Company has sold undivided interests in plants Hatch, Wansley, Vogtle, and Scherer Units 1 and 2, together with transmission facilities, to OPC, an electric membership generation and transmission corporation; the Municipal Electric Authority of Georgia (MEAG), a public corporation and an instrumentality of the state of Georgia; and the City of Dalton, Georgia. The Company has sold an interest in Plant Scherer Unit 3 to Gulf Power, an affiliate. Additionally, the Company has completed two of four separate transactions to sell Unit 4 of Plant Scherer to Florida Power & Light Company (FPL) and Jacksonville Electric Authority (JEA) for a total price of approximately $806 million, including any gains on these transactions. FPL will eventually own approximately 76.4 percent of the unit, with JEA owning the remainder. Georgia Power will continue to operate the unit. The completed and scheduled remaining transactions are as follows: Except as otherwise noted, the Company has contracted to operate and maintain all jointly owned facilities. The Company includes its proportionate share of plant operating expenses in the corresponding operating expenses in the Statements of Income. As discussed in Note 4, the Company and OPC have a joint ownership arrangement for the Rocky Mountain pumped storage hydroelectric project under which the Company will retain its present investment in the project and OPC will finance and complete the remainder of the project and operate the completed facility. Based on current cost estimates the Company's ownership will be approximately 25% of the project (194 megawatts of capacity) at completion. The Company will own six of eight 80 megawatt combustion turbine generating units and 75% of the related common facilities being jointly constructed with Savannah Electric, an affiliate. The Company's investment in the project at December 31, 1993, was $100 million and is expected to total approximately $182 million when the project is completed. All units are II-117 NOTES (continued) Georgia Power Company 1993 Annual Report expected to be completed by June, 1995. Savannah Electric will operate these units. In connection with the joint ownership arrangements for plants Vogtle and Scherer, the Company has made commitments to purchase declining fractions of OPC's and MEAG's capacity and energy from these units. These commitments are in effect during periods of up to 10 years following commercial operation (and with regard to a portion of a 5 percent interest in Plant Vogtle owned by MEAG, until the latter of the retirement of the plant or the latest stated maturity date of MEAG's bonds issued to finance such ownership interest). The payments for capacity are required whether or not any capacity is available. The energy cost is a function of each unit's variable operating costs. Except as noted below, the cost of such capacity and energy is included in purchased power from non-affiliates in the Company's Statements of Income. Capacity payments totaled $183 million, $289 million and $320 million in 1993, 1992 and 1991, respectively. The Plant Scherer buyback agreements ended in 1993. The current projected Plant Vogtle capacity payments for the next five years are as follows: $132 million in 1994, $77 million in 1995, $70 million in 1996, $59 million in 1997 and $59 million in 1998. Portions of the payments noted above relate to costs in excess of Plant Vogtle's allowed investment for ratemaking purposes. The present value of these portions was written off in 1987 and 1990. Additionally, the Plant Vogtle declining capacity buyback expense is being levelized over a six-year period. See Note 3 for further information. At December 31, 1993, the Company's percentage ownership and investment (exclusive of nuclear fuel) in jointly owned facilities in commercial operation, were as follows: (1) Investment net of write-offs. The Company and an affiliate, Alabama Power, own equally all of the outstanding capital stock of Southern Electric Generating Company (SEGCO), which owns electric generating units with a total rated capacity of 1,020 megawatts, as well as associated transmission facilities. The capacity of the units has been sold equally to the Company and Alabama Power under a contract expiring in 1994, which, in substance, requires payments sufficient to provide for the operating expenses, taxes, debt service and return on investment, whether or not SEGCO has any capacity and energy available. An amended contract has been filed with the FERC with substantially the same provisions, but the term thereof would be extended automatically for two year periods, subject to any party's right to cancel upon two year's notice. The Company's share of expenses included in purchased power from affiliates in the Statements of II-118 NOTES (continued) Georgia Power Company 1993 Annual Report Income, is as follows: At December 31, 1993, the capitalization of SEGCO consisted of $58 million of equity and $84 million of long-term debt on which the annual interest requirement is $3.8 million. 6. LONG-TERM POWER SALES AGREEMENTS The Company and the operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service territory. Certain of these agreements are non-firm and are based on the capacity of the Southern system. Other agreements are firm and pertain to capacity related to specific generating units. Because energy is generally sold at cost under these agreements, it is primarily the capacity revenues that affect the Company's profitability. The capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). This amount decreases to 200 megawatts in 1994 and the contract expires at year-end. Sales under these long-term non-firm power sales agreements are made from available power pool energy, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is being sold to FPL, JEA, and the City of Tallahassee, Florida and beginning in 1994 to FPC. Under these agreements, the Company sold approximately 830 megawatts of capacity in 1993 and is scheduled to sell approximately 403 megawatts of capacity in 1994. Thereafter, these sales will decline to an estimated 157 megawatts by the end of 1996 and will remain at that approximate level through 1999. After 2000, capacity sales will decline to approximately 101 megawatts -- unless reduced by FPL and JEA -- until the expiration of the contracts in 2010. 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $993 million are revenues to be received from customers. These assets are attributable to tax benefits flowed-through to customers in prior years, and taxes applicable to capitalized AFUDC. The related liabilities of $453 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: II-119 NOTES (continued) Georgia Power Company 1993 Annual Report The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax basis, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $19 million in 1993, $19 million in 1992, and $27 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory tax rate to effective income tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 8. CAPITALIZATION COMMON STOCK DIVIDEND RESTRICTIONS The Company's first mortgage bond indenture contains various common stock dividend restrictions that remain in effect as long as the bonds are outstanding. At December 31, 1993, $742 million of retained earnings were restricted against the payment of cash dividends on common stock under terms of the mortgage indenture. Supplemental indentures in connection with future first mortgage bond issues may contain more stringent common stock dividend restrictions than those currently in effect. The Company's charter limits cash dividends on common stock to the lesser of the retained earnings balance or 75 percent of net income available for such stock during a prior period of 12 months if the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend, is below 25 percent, and to 50 percent of such net income if such ratio is less than 20 percent. At December 31, 1993, the ratio as defined was 46.1 percent. II-120 NOTES (continued) Georgia Power Company 1993 Annual Report REMARKETED BONDS In 1992, the Company issued two series of variable rate first mortgage bonds each with principal amounts of $100 million due 2032. The current composite interest rate on the bonds is 6.20 percent and is fixed for the first three years of the issues. POLLUTION CONTROL BONDS The Company has incurred obligations in connection with the sale by public authorities of tax-exempt pollution control and industrial development revenue bonds. The Company has authenticated and delivered to trustees an aggregate of $407.7 million of its first mortgage bonds, which are pledged as security for its obligations under pollution control and industrial development contracts. No interest on these first mortgage bonds is payable unless and until a default occurs on the installment purchase or loan agreements. An aggregate of approximately $1.3 billion of the pollution control and industrial development bonds is secured by a subordinated interest in specific property of the Company. Details of pollution control bonds are as follows: BANK CREDIT ARRANGEMENTS At the beginning of 1994, the Company had unused credit arrangements with banks totaling $540 million, of which $10 million expires June 30, 1994, $130 million expires at May 1, 1996, and $400 million expires at June 30, 1996. The $400 million expiring June 30, 1996, is under revolving credit arrangements with several banks providing the Company, Alabama Power, and The Southern Company up to a total credit amount of $400 million. To provide liquidity support for commercial paper programs and for other short-term cash needs, $165 million and $135 million of the $400 million available credit are currently dedicated for the Company and Alabama Power, respectively. However, the allocations can be changed among the borrowers by notifying the respective banks. During the term of the agreements expiring in 1996, short-term borrowings may be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the companies' option. In addition, these agreements require payment of commitment fees based on the unused portions of the commitments or the maintenance of compensating balances with the banks. The $10 million credit arrangement expiring in 1994 allows borrowings for up to 90 days. Commitment fees are based on the unused portion of the commitment. In addition, the Company borrows under uncommitted lines of credit with banks and through a $150 million commercial paper program that has the liquidity support of committed bank credit arrangements. Average compensating balances held under these committed facilities were not material in 1993. OTHER LONG-TERM DEBT Assets acquired under capital leases are recorded in the Balance Sheets as utility plant in service, and the related obligations are classified as long-term debt. At December 31, 1993, the Company had a capitalized lease obligation for its corporate headquarters building of $88 million with an interest rate of 8.1 percent. Other capitalized lease obligations were $137 thousand with a composite interest rate of 6.8 percent. The maturities of capital lease obligations through 1998 are approximately as follows: $423 thousand in 1994, $309 thousand in 1995, $335 thousand in 1996, $362 thousand in 1997, and $392 thousand in 1998. The lease agreement for the corporate headquarters building provides for payments that are minimal in early years and escalate through the first 21 years of the lease. For ratemaking purposes, the GPSC has treated the lease as an operating lease and has allowed only the lease II-121 NOTES (continued) Georgia Power Company 1993 Annual Report payments in cost of service. The difference between the accrued expense and the lease payments allowed for ratemaking purposes is being deferred as a cost to be recovered in the future as ordered by the GPSC. At December 31, 1993, and 1992, the interest and lease amortization deferred on the Balance Sheets are $47 million and $48 million, respectively. In December 1993, the Company borrowed $37 million through a long-term note due in 1995. ASSETS SUBJECT TO LIEN The Company's mortgage dated as of March 1, 1941, as amended and supplemented, securing the first mortgage bonds issued by the Company, constitutes a direct lien on substantially all of the Company's fixed property and franchises. LONG-TERM DEBT DUE WITHIN ONE YEAR The current portion of the Company's long-term debt is as follows: *Less than .1 million The indenture's first mortgage bond improvement fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash or reacquired bonds, or by pledging additional property equal to 1 2/3 times the requirement. The 1993 and 1992 requirements were met in the first quarter of each year by depositing cash subsequently used to redeem bonds. The 1994 requirement was funded in December 1993. REDEMPTION OF HIGH-COST SECURITIES The Company plans to continue a program of redeeming or replacing high-cost debt and preferred stock in cases where opportunities exist to reduce financing costs. High-cost issues may be repurchased in the open market or called at premiums as specified under terms of the issue. They may also be redeemed at face value to meet improvement fund and sinking fund requirements, to meet replacement provisions of the mortgage, or by use of proceeds from the sale of property pledged under the mortgage. In general, for the first five years a series is outstanding the Company is prohibited from redeeming for improvement fund purposes more than 1 percent annually of the original issue amount. 9. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial information for 1993 and 1992 is as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate increases. II-122 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-123 SELECTED FINANCIAL AND OPERATING DATA Georgia Power Company 1993 Annual Report II-124 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report Note: As of 9/1/91, Georgia Power Company's sales to Oglethorpe Power Company are not included in Peak-Hour Demand * Less than one-tenth of one percent. II-125 SELECTED FINANCIAL AND OPERATING DATA (continued) Georgia Power Company 1993 Annual Report II-126 STATEMENTS OF INCOME Georgia Power Company Note: Reflects major sales of facilities to Jacksonville Electric Authority, Florida Power & Light Company, OPC, MEAG, and Dalton. Increases in net income, after total taxes, from these sales were $18,391,000 in 1993, $14,542,000 in 1991, $6,336,000 in 1990, $3,851,000 in 1987, and $21,250,000 in 1984. II-127 STATEMENTS OF INCOME Georgia Power Company II-128 STATEMENTS OF CASH FLOWS Georgia Power Company ( ) Denotes use of cash. II-129 STATEMENTS OF CASH FLOWS Georgia Power Company II-130 BALANCE SHEETS Georgia Power Company II-131 BALANCE SHEETS Georgia Power Company II-132 BALANCE SHEETS Georgia Power Company II-133 BALANCE SHEETS Georgia Power Company II-134 GEORGIA POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-135 GEORGIA POWER COMPANY OUTSTANDING SECURITIES (Continued) AT DECEMBER 31, 1993 (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. II-136 GEORGIA POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS (1) Issued in exchange for $5.00 preferred outstanding at the time of company formation. * Less than $500. II-137 GULF POWER COMPANY FINANCIAL SECTION II-138 MANAGEMENT'S REPORT Gulf Power Company 1993 Annual Report The management of Gulf Power Company has prepared and is responsible for the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of the directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Gulf Power Company in conformity with generally accepted accounting principles. /s/ D. L. McCrary /s/ A. E. Scarbrough - -------------------------- ------------------------ Douglas L. McCrary Arlan E. Scarbrough Chairman of the Board Vice President - Finance and Chief Executive Officer II-139 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF GULF POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Gulf Power Company (a Maine corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-148 through II-165) referred to above present fairly, in all material respects, the financial position of Gulf Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 8 to the financial statements, effective January 1, 1993, Gulf Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 II-140 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Gulf Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Gulf Power Company's net income after preferred stock dividends was $54.3 million for 1993, a $0.2 million increase over 1992 net income. Earnings reflect a $2.3 million gain on the sale of Gulf States Utilities Company (Gulf States) stock and the reversal of a $1.7 million wholesale rate refund as the result of a court order which is further discussed in Note 3 to the financial statements under "Recovery of Contract Buyout Costs". The company also experienced growth in residential and commercial sales and a decrease in interest expense on long-term debt as a result of security refinancings, offset by higher operation and maintenance expense, and decreased industrial sales reflecting the loss of the Company's largest industrial customer, Monsanto, which began cogeneration in August of 1993. The Company's 1992 net income after dividends on preferred stock decreased $3.7 million compared to the prior year. The 1991 earnings included an after-tax gain of $12.7 million representing the settlement of litigation with Gulf States. See Note 7 to the financial statements under "Gulf States Settlement Completed" for further details. Excluding this settlement from 1991, earnings for 1992 increased $8.4 million -- or approximately -- 18.7 percent over 1991. This improvement was due to increased energy sales; lower interest expense and preferred dividends as a result of security refinancings; and continued emphasis on cost controls. The Company's return on average common equity was 13.29 percent for 1993, a slight decrease from the 13.62 percent return earned in 1992, which was up from the 12.03 percent earned in 1991 (excluding the Gulf States settlement). REVENUES Changes in operating revenues over the last three years are the result of the following factors: * Includes the non-interest portion of the wholesale rate refund reversal discussed in "Earnings." Retail revenues of $471.7 million in 1993 increased $10.2 million or 2.2 percent from last year, compared with an increase of 1.2 percent in 1992 and 4.9 percent in 1991. Revenues increased in the residential and commercial classes primarily due to customer growth, and favorable weather and economic conditions. Revenues in the industrial class declined due to the loss of the Company's largest industrial customer, Monsanto, which began operating its cogeneration facility in August 1993. See "Future Earnings Potential" for further details. The change in base rates for 1993 and 1992 reflects the expiration of a retail rate penalty in September 1992. Sales for resale were $95.4 million in 1993, increasing $1.2 million or 1.3 percent over 1992. Sales to affiliated companies vary from year to year depending on demand and the availability and cost of generating resources at each company. The majority of non-affiliated energy sales arise from long-term contractual agreements. Non-affiliated long-term contracts include capacity and energy components. Capacity revenues reflect the recovery of II-141 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report fixed costs and return on investment. Energy is sold at its variable cost. The capacity and energy components under these long-term contracts were as follows: Beginning in June 1992, all the capacity from the Company's ownership portion of Plant Scherer Unit No. 3 was sold through unit power sales, resulting in increased capacity revenues. In 1993, changes in other operating revenues are primarily due to the recognition of $2.6 million under the Environmental Cost Recovery (ECR) clause which is fully discussed in Note 3 to the financial statements under "Environmental Cost Recovery", which is offset by true-ups of other regulatory cost recovery clauses. The increase in other operating revenues in 1992 was primarily due to true-ups of regulatory cost recovery clauses and the changes in franchise fee collections and Florida gross receipts taxes (discussed under "Expenses") which had no effect on earnings. Energy sales for 1993 and percent changes in sales since 1991 are reported below. Overall retail sales remained relatively flat in 1993. Increases in residential and commercial sales -- reflecting customer growth, favorable weather and an improving economy -- were offset by the decreased sales in the industrial class reflecting the loss of Monsanto. Retail sales increased 3.8 percent in 1992 primarily due to an increase in the number of customers served and a moderately improving economy. Energy sales for resale to non-affiliates increased 2.0 percent and are predominantly unit power sales under long-term contracts to Florida utilities which are discussed above. Energy sales to affiliated companies vary from year to year as mentioned above. EXPENSES Total operating expenses for 1993 increased $16.6 million or 3.5 percent over 1992 primarily due to increased operation and maintenance expenses and higher taxes. Other operation expenses increased $10.9 million or 11.1 percent from the 1992 level. The increase is attributable to additional costs of $7.4 million related to increases in the buyout of coal supply contracts and $1.4 million of environmental clean-up costs. Also, higher employee benefit costs and the costs of an automotive fleet reduction program increased expenses by $2.1 million. Operating expenses for 1992 increased by approximately $16 million over 1991. Excluding the Gulf States settlement, an after-tax reduction of $0.6 million in 1992 and $12.7 million in 1991, 1992 total operating expenses increased $4.3 million or 0.9 percent over 1991. Fuel and purchased power expenses decreased $3.8 million or 1.8 percent from 1992 reflecting the lower cost of fuel. Total 1992 fuel and purchased power increased $1.4 million or 0.7 percent from 1991. Maintenance expense increased $4.1 million or 9.7 percent over 1992 due to scheduled maintenance of production facilities. The 1992 maintenance expense was down $3.5 million or 7.7 percent from 1991 due to a decrease in scheduled maintenance. Federal income taxes increased $0.7 million primarily due to a corporate federal income tax rate increase from 34 percent to 35 percent effective January 1993. Taxes other than income taxes increased $2.3 million in 1993, an increase of 6.1 percent over the 1992 expense II-142 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report primarily due to increases in property taxes and gross receipt taxes. Taxes other than income taxes decreased $4.5 million, or 10.5 percent in 1992 compared to 1991 due primarily to the Company discontinuing the collection of franchise fees for two Florida counties which was partially offset by an increase in gross receipt taxes. Changes in franchise fee collections and gross receipt taxes had no impact on earnings. Interest expense decreased $3.2 million or 8.1 percent from the 1992 level and 1992 interest expense decreased $5.6 million or 12.5 percent from 1991. The decrease in both years is primarily attributable to refinancing some of the Company's higher cost securities. EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its cost of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on a number of factors. It is expected that higher operating costs and carrying charges on increased investment in plant, if not offset by proportionate increases in operating revenues (either by periodic rate increases or increases in sales), will adversely affect future earnings. Growth in energy sales will be subject to a number of factors, including the volume of sales to neighboring utilities, energy conservation practiced by customers, the elasticity of demand, customer growth, weather, competition, and the rate of economic growth in the service area. In addition to the traditional factors discussed above, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Company is preparing to meet the challenges of a major change in the traditional business practices of selling electricity. The Energy Act allows independent power producers (IPPs) to access the Company's transmission network in order to sell electricity to other utilities, and this may enhance the incentive for IPPs to build cogeneration plants for the Company's large industrial and commercial customers and sell excess energy generation to the Company or other utilities. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, its ability to retain large industrial and commercial customers, and obtain new long-term contracts for energy sales outside the Company's service area, could be limited, and this could significantly erode earnings. The future effect of cogeneration and small-power production facilities cannot be fully determined at this time, but may be adverse. One effect of cogeneration which the Company has experienced is the loss of its largest industrial customer, Monsanto, in August of 1993. The loss of the Monsanto load reduced revenues, and will result in a reduction in net income of approximately $3 million in the first twelve months. The Federal Energy Regulatory Commission (FERC) regulates wholesale rate schedules and power sales contracts that the Company has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts that have a return on common equity of 13.75 percent or greater, and may require such returns to be lowered, possibly retroactively. See Note 3 to the financial statements under "FERC Reviews Equity Returns" for additional information. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters". II-143 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Also, recently enacted legislation that provides for recovery of prudent environmental compliance costs is discussed in Note 3 to the financial statements under "Environmental Cost Recovery." The Company filed a notice with the Florida Public Service Commission (FPSC) of its intent to obtain rate relief in February 1993. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case. The stipulation also allowed the Company to retain, for the next four years, its existing method for calculating accruals for future power plant dismantlement costs. The existing method provides a more even allocation of expenses over the life of the plants and results in an avoided increase in expenses of about $6 million annually over the next four years when compared to the FPSC method. The stipulation also provided for the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. After the February 1993 filing date, interest rates continued to remain low, resulting in lower cost of capital. Also, the Florida legislature adopted legislation which allows utilities to petition the FPSC for recovery of environmental costs through an adjustment clause if these costs are not being recovered in base rates. See Note 3 to the financial statements under "Environmental Cost Recovery" for further details. The combination of the circumstances discussed above, placed the Company in a better position to manage its finances without an increase in base rates while still providing a fair return for the Company's investors. Consequently, the Company agreed, as a part of this stipulation, to cancel the filing of the rate case. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, the Company adopted Statement No. 112, which resulted in a decrease in earnings of $0.3 million. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company does not have any investments that qualify for FASB Statement No. 115 treatment. FINANCIAL CONDITION OVERVIEW The principal changes in the Company's financial condition during 1993 were gross property additions of $79 million. Funds for these additions were provided by internal sources. The Company continued to refinance higher cost securities to lower the Company's cost of capital. See "Financing Activities" below and the Statements of Cash Flows for further details. On January 1, 1993, the Company changed its method of calculating the accruals for postretirement benefits other than pensions and its method of accounting for income taxes. See Notes 2 and 8 to the financial statements, regarding the impact of these changes. FINANCING ACTIVITIES As mentioned above, the Company continued to lower its financing costs by issuing new securities and other debt, and retiring higher-cost issues in 1993. The Company sold $75 million of first mortgage bonds and, through public authorities, $53.4 million of pollution control revenue bonds, issued $35 million of preferred stock, and obtained $25 million with a long-term bank note. Retirements, including maturities during 1993, totaled $88.8 million of first mortgage bonds, $40.7 million of pollution control revenue bonds, and $21.1 million of preferred stock. (See the Statements of Cash Flows for further details.) II-144 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Composite financing rates for the years 1991 through 1993 as of year end were as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's gross property additions, including those amounts related to environmental compliance, are budgeted at $200 million for the three years beginning 1994 ($77 million in 1994, $55 million in 1995, and $68 million in 1996). The estimates of property additions for the three-year period include $25 million committed to meeting the requirements of the Clean Air Act, the cost of which is expected to be recovered through the ECR clause which is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Actual construction costs may vary from this estimate because of factors such as the granting of timely and adequate rate increases; changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment, and materials; and the cost of capital. The Company does not have any baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. Significant construction of transmission and distribution facilities and upgrading of generating plants will be continuing. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $86 million will be required by the end of 1996 in connection with maturities of long-term debt and preferred stock subject to mandatory redemption. Also, the Company plans to continue a program to retire higher-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on the Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995 and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million for The Southern Company including $34 million for Gulf Power Company through 1995. II-145 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million for The Southern Company including approximately $30 million to $40 million for Gulf Power Company. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. Following adoption of legislation in April of 1992, allowing electric utilities in Florida to seek FPSC approval of their Clean Air Act Compliance Plans, the Company filed its petition for approval. The Commission approved the Company's plan for Phase I compliance, deferring until a later date approval of its Phase II Plan. An average increase of up to 4 percent in annual revenue requirements from Gulf Power Company customers could be necessary to fully recover the cost of compliance for both Phase I and Phase II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. The Florida Legislature recently adopted legislation that allows a utility to petition the FPSC for recovery of prudent environmental compliance costs through an ECR clause without lengthy regulatory full revenue requirements rate proceedings. The legislation is discussed in Note 3 to the financial statements under "Environmental Cost Recovery". Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Gulf Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. II-146 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Gulf Power Company 1993 Annual Report Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of Gulf Power Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect Gulf Power Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. COAL STOCKPILE DECREASES To reduce the working capital invested in the coal stockpile inventory, the Company implemented a coal stockpile reduction program in 1992. The Company's actual year end inventory at December 31, 1993 was $20.7 million which is considerably lower than the desired level of $31.4 million. This situation exists because a limited supply of coal was available at competitive prices primarily due to the United Mine Workers strike from July to December 1993. In addition, barge transportation was stranded due to floods in the Midwest. As a result of these circumstances, management chose to allow the existing coal inventory to decline until coal prices stabilized. Current market conditions indicate that substantial coal supplies at competitive prices are now available. Therefore, the Company plans to increase purchases and return the coal stockpile inventory to the desired level by the end of the third quarter, 1994. SOURCES OF CAPITAL At December 31, 1993, the Company had $5.6 million of cash and cash equivalents to meet its short-term cash needs. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations; the sale of additional first mortgage bonds, pollution control bonds, and preferred stock; and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficient to permit, at present interest and preferred dividend levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-147 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-148 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-149 BALANCE SHEETS At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-150 BALANCE SHEETS (continued) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-151 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report II-152 STATEMENTS OF CAPITALIZATION (CONTINUED) At December 31, 1993 and 1992 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-153 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 Gulf Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-154 NOTES TO FINANCIAL STATEMENTS At December 31, 1993, 1992 and 1991 Gulf Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: GENERAL Gulf Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services, Inc. (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear) and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company is also subject to regulation by the FERC and the Florida Public Service Commission (FPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by these commissions. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for service rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as fuel is used. The Company's electric rates include provisions to periodically adjust billings for fluctuations in fuel and the energy component of purchased power costs. Revenues are adjusted for differences between recoverable fuel costs and amounts actually recovered in current rates. The FPSC has also approved the recovery of purchased power capacity costs, energy conservation costs, and environmental compliance costs in cost recovery clauses that are similar to the method used to recover fuel costs. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily using composite straight-line rates which approximated 3.8 percent in 1993, 1992, and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 8 for additional information about Statement No. 109. The Company is included in the consolidated federal income tax return of The Southern Company. II-155 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of certain new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of plant through a higher rate base and higher depreciation expense. The FPSC-approved composite rate used to calculate AFUDC was 7.27 percent effective on July 1, 1993 and 8.03 percent for the first half of 1993, and for 1992, and 1991. AFUDC amounts for 1993, 1992, and 1991 were $966 thousand, $60 thousand, and $149 thousand, respectively. The increase in 1993 is due to an increase in construction projects at Plant Daniel. UTILITY PLANT Utility plant is stated at original cost. Original cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair values of investment securities were based on listed closing market prices. The fair values for long-term debt and preferred stock subject to mandatory redemption were based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. VACATION PAY The Company's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. The amount was $4.0 million and $3.8 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 84 percent of the 1993 deferred vacation cost II-156 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report will be expensed and the balance will be charged to construction. PROVISION FOR INJURIES AND DAMAGES The Company is subject to claims and suits arising in the ordinary course of business. As permitted by regulatory authorities, the Company is providing for the uninsured costs of injuries and damages by charges to income amounting to $1.2 million annually. The expense of settling claims is charged to the provision to the extent available. The accumulated provision of $2.2 million and $2.5 million at December 31, 1993 and 1992, respectively, is included in miscellaneous current liabilities in the accompanying Balance Sheets. PROVISION FOR PROPERTY DAMAGE Due to a significant increase in the cost of traditional insurance, effective in 1993, the Company became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provides for the estimated cost of uninsured property damage by charges to income amounting to $1.2 million annually. At December 31, 1993 and 1992, the accumulated provision for property damage amounted to $10.5 million and $9.7 million, respectively. The expense of repairing such damage as occurs from time to time is charged to the provision to the extent it is available. 2. RETIREMENT BENEFITS: PENSION PLAN The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension trust fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Prior to the adoption of Statement No. 106, Gulf Power Company recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The costs of such benefits recognized by the Company in 1993, 1992, and 1991 were $3.9 million, $3.1 million, and $2.7 million, respectively. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. II-157 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $4.8 million and the aggregate of the service and interest cost components of the net retiree medical cost by $543 thousand. Components of the plans' net cost are shown below: Of the above net pension amounts, $(601) thousand in 1993, $3 thousand in 1992, and $518 thousand in 1991, were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance amounts recorded in 1993, $3.0 million was recorded in operating expenses, and the remainder was recorded in construction and other accounts. II-158 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 3. LITIGATION AND REGULATORY MATTERS: COAL BARGE TRANSPORTATION SUIT On August 19, 1993, a complaint against the Company and Southern Company Services, an affiliate, was filed in federal district court in Ohio by two companies with which the Company had contracted for the transportation by barge for certain of the Company's coal supplies. The complaint alleges breach of the contract by the Company and seeks damages estimated by the plaintiffs to be in excess of $85 million. The final outcome of this matter cannot now be determined; however, in management's opinion the final outcome will not have a material adverse effect on the Company's financial statements. FPSC APPROVES STIPULATION In February 1993, the Company filed a notice with the FPSC of its intent to obtain rate relief. On May 4, 1993, the FPSC approved a stipulation between the Company, the Office of Public Counsel, and the Florida Industrial Power Users Group to cancel the filing of the rate case and to allow the Company to retain for the next four years its existing method for calculating accruals for future power plant dismantlement costs. The stipulation also required the reduction of the Company's allowed return on equity midpoint from 12.55 percent to 12.0 percent. See Management's Discussion and Analysis under "Future Earnings Potential" for further details of circumstances that contributed to the company canceling the rate case. FERC REVIEWS EQUITY RETURNS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on common equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts. Any changes in the rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, a FERC administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on the Company's financial statements. RECOVERY OF CONTRACT BUYOUT COSTS In July 1990, the Company filed a request for waiver of FERC's fuel adjustment charge regulation to permit recovery of coal contract buyout costs from wholesale customers. On April 4, 1991, the FERC issued an order granting recovery of the buyout costs from wholesale customers from July 19, 1990, forward, but denying retroactive recovery of the buyout costs from January 1, 1987 through July 18, 1990. The Company's request for rehearing was denied by the FERC. The Company refunded $2.7 million (including interest) in June 1991 to its wholesale customers. On July 31, 1991, the Company filed a petition for review of the FERC's decision to the U.S. Court of Appeals for the District of Columbia Circuit. On January 22, 1993, the Court vacated the Commission's order, finding FERC's denial of the Company's request for a retroactive waiver to be arbitrary and capricious. The Court remanded the matter to FERC for consideration consistent with its opinion. Management expects that the commission will ultimately allow the Company to recover the amount refunded plus interest. Accordingly, the Company recorded the reversal of the $2.7 million refund to income in 1993. ENVIRONMENTAL COST RECOVERY In April 1993, the Florida Legislature adopted legislation for an Environmental Cost Recovery (ECR) clause, which allows a utility to petition the FPSC for recovery of all prudent environmental compliance costs that are not being recovered through base rates or any other rate-adjustment clause. Such environmental costs include operation and maintenance expense, depreciation, and a return on invested capital. II-159 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report On January 12, 1994, the FPSC approved the Company's petition under the ECR clause for recovery of environmental costs that were projected to be incurred from July 1993 through September 1994. The order allows the recovery from customers of such costs amounting to $7.8 million during the period, February through September 1994. Thereafter, recovery under ECR will be determined semi-annually and will include a true-up of the prior period and a projection of the ensuing six-month period. In December 1993, the Company recorded $2.6 million as additional revenue for the portion of costs incurred during 1993. 4. CONSTRUCTION PROGRAM: The Company is engaged in a continuous construction program, the cost of which is currently estimated to total $77 million in 1994, $55 million in 1995, and $68 million in 1996. These estimates include AFUDC of approximately $0.7 million, $0.3 million, and $0.2 million, in 1994, 1995, and 1996, respectively. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the Company plans to construct two 80 megawatt combustion turbine peaking units. The first is scheduled to be completed in 1998, and the second in 1999. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. 5. FINANCING AND COMMITMENTS: GENERAL Current projections indicate that funds required for construction and other purposes, including compliance with environmental regulations will be derived primarily from internal sources. Requirements not met from internal sources will be financed from the sale of additional first mortgage bonds, preferred stock, and capital contributions from The Southern Company. In addition, the Company may issue additional long-term debt and preferred stock primarily for the purposes of debt maturities and redemptions of higher-cost securities. Because of the attractiveness of current short term interest rates, the Company may maintain a higher level of short term indebtedness than has historically been true. At December 31, 1993, the Company had $49 million of lines of credit with banks of which $6.1 million was committed to cover checks presented for payment. These credit arrangements are subject to renewal June 1 of each year. In connection with these committed lines of credit, the Company has agreed to pay certain fees and/or maintain compensating balances with the banks. The compensating balances, which represent substantially all the cash of the Company except for daily working funds and like items, are not legally restricted from withdrawal. In addition, the Company has bid-loan facilities with eight major money center banks that total $180 million, of which, none was committed at December 31, 1993. ASSETS SUBJECT TO LIEN The Company's mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, the Company has entered into long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum purchase levels and other financial commitments. Total estimated long-term obligations were approximately $1.4 billion at December 31, 1993. Additional commitments will be required in the future to supply the Company's fuel needs. To take advantage of lower-cost coal supplies, agreements were reached in 1986 to terminate two long-term contracts for the supply of coal to Plant Daniel, which is jointly owned by the Company and Mississippi Power, an operating affiliate. The Company's portion of II-160 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report this payment was some $60 million. This amount is being amortized to expense on a per ton basis over a nine-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $18 million at December 31, 1993. In 1988, the Company made an advance payment of $60 million to another coal supplier under an arrangement to lower the cost of future coal purchased under an existing contract. This amount is being amortized to expense on a per ton basis over a ten-year period. The remaining unamortized amount included in deferred charges, including the current portion, was $36 million at December 31, 1993. Also, in 1993 the Company made a payment of $16.4 million to a coal supplier under an arrangement to suspend the purchase of coal under an existing contract for one year. This amount is being amortized to expense on a per ton basis over a one year period. The remaining unamortized amount, which is included in current assets, was $11 million at December 31, 1993. The amortization of these payments is being recovered through the fuel cost recovery clause discussed under "Revenues and Fuel Costs" in Note 1. LEASE AGREEMENT In 1989, the Company entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Mississippi Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million in 1992 and $1.3 million in 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option, after three years from the date of the original contract, to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, the Company has the option to renew the lease. 6. JOINT OWNERSHIP AGREEMENTS: The Company and Mississippi Power jointly own Plant Daniel, a steam-electric generating plant, located in Jackson County, Mississippi. In accordance with an operating agreement, Mississippi Power acts as the Company's agent with respect to the construction, operation, and maintenance of the plant. The Company and Georgia Power jointly own Plant Scherer Unit No. 3, a steam-electric generating plant, located near Forsyth, Georgia. In accordance with an operating agreement, Georgia Power acts as the Company's agent with respect to the construction, operation, and maintenance of the unit. The Company's pro rata share of expenses related to both plants is included in the corresponding operating expense accounts in the Statements of Income. At December 31, 1993, the Company's percentage ownership and its amount of investment in these jointly owned facilities were as follows: (1) Includes net plant acquisition adjustment. (2) Total megawatt nameplate capacity: Plant Scherer Unit No. 3: 818 Plant Daniel: 1,000 II-161 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL The Company and the other operating affiliates of The Southern Company have contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Certain of these agreements are non-firm and are based on the capacity of the system in general. Other agreements are firm and pertain to capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, the capacity revenues from these sales primarily affect profitability. The Company's capacity revenues have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 to Florida Power Corporation (FPC) by the Southern electric system. In 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end 1994. Capacity and energy sales under these long-term non-firm power sales agreements are made from available power pool capacity, and the revenues from the sales are shared by the operating affiliates. Unit power from specific generating plants is currently being sold to FPC, Florida Power & Light Company (FP&L), Jacksonville Electric Authority (JEA), and the City of Tallahassee, Florida. Under these agreements, 209 megawatts of net dependable capacity were sold by the Company during 1993, and sales will remain at that approximate level until the expiration of the contracts in 2010, unless reduced by FPC, FP&L and JEA after 1999. Capacity and energy sales to FP&L, the Company's largest single customer, provided revenues of $39.5 million in 1993, $46.2 million in 1992, and $42.1 million in 1991, or 6.8 percent, 8.1 percent, and 7.5 percent of operating revenues, respectively. GULF STATES SETTLEMENT COMPLETED On November 7, 1991, the subsidiaries of The Southern Company entered into a settlement agreement with Gulf States Utilities Company (Gulf States) that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received - less the amounts previously included in income - the Company recorded increases in net income of approximately $0.6 million in 1992 and $12.7 million in 1991. In 1993, the Company sold all of its remaining Gulf States common stock received in the settlement, resulting in a gain of $2.3 million after tax. 8. INCOME TAXES: Effective January 1, 1993, Gulf Power Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $31.3 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $76.9 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and to unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-162 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $2.3 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the federal statutory income tax rate to the effective income tax rate is as follows: Gulf Power Company and the other subsidiaries of The Southern Company file a consolidated federal tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-163 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 9. LONG-TERM DEBT: POLLUTION CONTROL OBLIGATIONS Obligations incurred in connection with the sale by public authorities of tax-exempt pollution control revenue bonds are as follows: * Sinking fund requirement applicable to the 6 percent pollution control bonds is $100 thousand for 1994 with increasing increments thereafter through 2005, with the remaining balance due in 2006. With respect to the collateralized pollution control revenue bonds, the Company has authenticated and delivered to trustees a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under the agreements. OTHER LONG-TERM DEBT Long-term debt also includes $17.5 million for the Company's portion of notes payable issued in connection with the termination of Plant Daniel coal contracts (see Note 5 for information on fuel commitments). The notes bear interest at 8.25 percent with the principal being amortized through 1995. Also included in long-term debt is a 30-month note payable for $25 million which was obtained to refinance higher cost securities. The principal is due in June 1996 and bears interest at 4.69 percent which is payable quarterly beginning March 1994. The estimated annual maturities of the notes payable through 1996 are as follows: $8.4 million in 1994, $9.1 million in 1995, and $25 million in 1996. 10. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirement and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirement amounts to 1 percent of each outstanding series of bonds authenticated under the indenture prior to January 1 of each year, other than those issued to collateralize pollution control obligations. The requirement may be satisfied by depositing cash, reacquiring bonds, or by pledging additional property equal to 1 and 2/3 times the requirement. In 1994, $12 million of 4 5/8 percent First Mortgage Bonds due October 1, 1994 and $15 million of 6 percent First Mortgage Bonds due June 1, 1996 are scheduled to be redeemed. II-164 NOTES (CONTINUED) Gulf Power Company 1993 Annual Report 11. COMMON STOCK DIVIDEND RESTRICTIONS: The Company's first mortgage bond indenture contains various common stock dividend restrictions which remain in effect as long as the bonds are outstanding. At December 31, 1993, $101 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the mortgage indenture. The Company's charter limits cash dividends on common stock to 50 percent of net income available for such stock during a prior period if the capitalization ratio is below 20 percent and to 75 percent of such net income if such ratio is 20 percent or more but less than 25 percent. The capitalization ratio is defined as the ratio of common stock equity to total capitalization, including retained earnings, adjusted to reflect the payment of the proposed dividend. At December 31, 1993, the ratio was 44.4 percent. 12. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: The Company's business is influenced by seasonal weather conditions and the timing of rate changes, among other factors. II-165 SELECTED FINANCIAL AND OPERATING DATA Gulf Power Company 1993 Annual Report II-166 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-167 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-168 SELECTED FINANCIAL AND OPERATING DATA (CONTINUED) Gulf Power Company 1993 Annual Report II-169 STATEMENTS OF INCOME Gulf Power Company II-170 STATEMENTS OF INCOME Gulf Power Company II-171 STATEMENTS OF CASH FLOWS Gulf Power Company II-172 STATEMENTS OF CASH FLOWS Gulf Power Company II-173 BALANCE SHEETS Gulf Power Company II-174 BALANCE SHEETS Gulf Power Company II-175 BALANCE SHEETS Gulf Power Company II-176 BALANCE SHEETS Gulf Power Company II-177 GULF POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK (1) Subject to mandatory redemption of 5% annually on or before February 1. II-178 GULF POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-179 MISSISSIPPI POWER COMPANY FINANCIAL SECTION II-180 MANAGEMENT'S REPORT Mississippi Power Company 1993 Annual Report The management of Mississippi Power Company has prepared--and is responsible for--the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist, however, in any system of internal control, based upon a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting control maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors, and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls, and financial reporting matters. The internal auditors and independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of Mississippi Power Company in conformity with generally accepted accounting principles. /s/ David M. Ratcliffe -------------------------------------------------- David M. Ratcliffe President and Chief Executive Officer /s/ Thomas A. Fanning -------------------------------------------------- Thomas A. Fanning Vice President and Chief Financial Officer II-181 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF MISSISSIPPI POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Mississippi Power Company (a Mississippi corporation and a wholly owned subsidiary of The Southern Company) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-190 through II-206) referred to above present fairly, in all material respects, the financial position of Mississippi Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 9 to the financial statements, effective January 1, 1993, Mississippi Power Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16 , 1994 II-182 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Mississippi Power Company 1993 Annual Report RESULTS OF OPERATIONS EARNINGS Mississippi Power Company's net income after dividends on preferred stock for 1993 totaled $42.4 million, an increase of $5.6 million over the prior year. This improvement is attributable primarily to increased energy sales and retail rate increases. A retail rate increase under the Company's Performance Evaluation Plan (PEP-1A) of $6.4 million annually became effective in July 1993. Under the Environmental Compliance Overview Plan (ECO Plan) retail rates increased by $2.6 million annually effective April 1993. A comparison of 1992 to 1991 - excluding the events occurring in 1991 discussed below - would reflect a 1992 increase in earnings of $4.9 million or 15.5 percent. The Company's financial performance in 1991 reflected the after-tax operating and disposal losses of $11.9 million recorded by the Company's former merchandise subsidiary. These losses were partially offset by a $2.6 million positive impact on earnings from the settlement of the contract dispute with Gulf States Utilities Company (Gulf States). REVENUES The following table summarizes the factors impacting operating revenues for the past three years: *Includes the effect of the retail rate increase approved under the ECO Plan. Retail revenues of $368 million in 1993 increased 9.0 percent over the prior year, compared with an increase of 2.2 percent for 1992 and a decrease of 1.5 percent in 1991. The increase in retail revenues for 1993 was a result of growth in energy sales and customers, the favorable impact of weather, and retail rate increases. Changes in base rates reflect rate changes made under the PEP plans and the ECO Plan as approved by the Mississippi Public Service Commission (MPSC). The increase in revenues for the recovery of fuel costs for 1993 reversed two years of decline. Under the fuel cost recovery provision, recorded fuel revenues are equal to recorded fuel expenses, including the fuel component and the operation and maintenance component of purchased energy. Therefore, changes in recoverable fuel expenses are offset with corresponding changes in fuel revenues and have no effect on net income. II-183 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Included in sales for resale to non-affiliates are revenues from rural electric cooperative associations and municipalities located in southeastern Mississippi. Energy sales to these customers in 1993 increased 9.0 percent over the prior year with the related revenues rising 14.1 percent. The customer demand experienced by these utilities is determined by factors very similar to Mississippi Power's. Sales for resale to non-affiliated non-territorial utilities are primarily under long-term contracts consisting of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Capacity revenues for Mississippi Power increased in 1993 and 1992 due to a change in the allocation of transmission capacity revenues throughout the Southern electric system. Most of the Company's capacity revenues are derived from transmission charges. Sales to affiliated companies within the Southern electric system will vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have no material impact on earnings. The increase in other operating revenues for 1993 was due to increased rents collected from microwave equipment use and the transmission of non-associated companies' electricity. Below is a breakdown of kilowatt-hour sales for 1993 and the percent change for the last three years: Total retail energy sales in 1993 increased compared to the previous year, due primarily to weather influences and the improvement in the economy. The increase in commercial energy sales also reflects the impact of recently established casinos within the Company's service area. Industrial sales increased in 1992 as a result of new contracts with two large industrial customers. The decrease in energy sales for resale to non-affiliates is predominantly due to reductions in unit power sales under long-term contracts to Florida utilities. Economy sales and amounts sold under short-term contracts are also sold for resale to non-affiliates. Sales for resale to non-affiliates are influenced by those utilities' own customer demand, plant availability, and the cost of their predominant fuels -- oil and natural gas. EXPENSES Total operating expenses for 1993 were higher than the previous year because of higher production expenses, which reflects increased demand, an increase in the federal income tax rate, and higher employee-related costs. (See Note 2 to the financial statements for information regarding employee and retiree benefits.) Additionally, included in other operation expenses are increased costs associated with environmental remediation of a Southern electric system research facility. Expenses in 1992 were lower than 1991, excluding the Gulf States settlement, primarily because of lower production expenses stemming from decreased demand. II-184 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Fuel costs constitute the single largest expense for Mississippi Power. These costs increased in 1993 due to an 11.0 percent increase in generation, which reflects higher demand. Fuel expenses in 1992, compared to 1991, were lower because of less generation and the negotiation of new coal contracts. Generation decreased primarily because of the availability of lower cost generation elsewhere within the Southern electric system. Purchased power consists primarily of energy purchases from the affiliates of the Southern electric system. Purchased power transactions (both sales and purchases) among Mississippi Power and its affiliates will vary from period to period depending on demand and the availability and variable production cost at each generating unit in the Southern electric system. Taxes other than income taxes increased in 1993 because of higher ad valorem taxes, which are property based, and municipal franchise taxes, which are revenue based. The decline in 1992 was attributable to lower franchise taxes. Income tax expense in 1993 increased because of the enactment of a higher corporate income tax rate retroactive to January 1, 1993, coupled with higher earnings. The change in income taxes for 1992 and 1991 reflected the change in operating income. EFFECTS OF INFLATION Mississippi Power is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical costs does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations, such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from regulatory matters to growth in energy sales. Expenses are subject to constant review and cost control programs. Among the efforts to control costs are utilizing employees more effectively through a functionalization program for the Southern electric system, redesigning compensation and benefit packages, and re- engineering work processes. Mississippi Power is also maximizing the utility of invested capital and minimizing the need for capital by refinancing, decreasing the average fuel stockpile, raising generating plant availability and efficiency, and curbing the construction budget. Operating revenues will be affected by any changes in rates under the PEP-2, the Company's revised performance based ratemaking plan. The PEP plans have proved to be a stabilizing force on electric rates, with only moderate changes in rates taking place. The ECO Plan, approved by the MPSC in 1992, provides for recovery of costs associated with environmental projects approved by the MPSC, most of which are required to comply with Clean Air Act Amendments of 1990 regulations. The ECO Plan is operated independently of PEP-2. The FERC regulates wholesale rate schedules and power sales contracts that Mississippi Power has with its sales for resale customers. The FERC is currently reviewing the rate of return on common equity included in these schedules and contracts and may require such returns to be lowered, possibly retroactively. Also, pending before the FERC is the Company's request for a $3.6 million wholesale rate increase. Further discussion of the PEP plans, the ECO Plan, and proceedings before the FERC is made in Note 3 to the financial statements herein. Future earnings in the near term will depend upon growth in energy sales, which are subject to a number of factors. Traditionally, these factors have included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in Mississippi Power's service area. However, the Energy II-185 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network in order to sell electricity to other utilities, and this may enhance the incentive of IPPs to build cogeneration plants for a utility's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. Mississippi Power is preparing to meet the challenge of this major change in the traditional business practices of selling electricity. If Mississippi Power does not remain a low-cost producer and provider of quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, which could significantly reduce earnings. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be effective by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. In 1993, Mississippi Power adopted Statement No. 112, with no material effect on the financial statements. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115 supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. In January 1994, Mississippi Power adopted the new rules, with no material effect on the financial statements. On January 1, 1993, Mississippi Power changed its methods of accounting for postretirement benefits other than pensions and income taxes. See Notes 2 and 9 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal changes in Mississippi Power's financial condition during 1993 were gross property additions of $140 million to utility plant, a significant lowering of cost of capital through refinancings, and the resolution of PEP and ratepayer litigation. Funding for gross property additions came primarily from capital contributions from The Southern Company, earnings and other operating cash flows. The Statements of Cash Flows provide additional details. FINANCING ACTIVITY Mississippi Power continued to lower its financing costs in 1993 by issuing new debt and equity securities and retiring high- cost issues. The Company sold $132 million of first mortgage bonds, preferred stock and, through public authorities, pollution control revenue bonds. Retirements, including maturities during 1993, totaled some $101 million of such securities. (See the Statements of Cash Flows for further details.) Composite financing rates for the years 1991 through 1993 as of year-end were as follows: II-186 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report CAPITAL STRUCTURE At year-end 1993, the Company's ratio of common equity to total capitalization was 49.8 percent, compared to 47.3 percent in 1992 and 44.4 percent in 1991. The increase in the ratio in 1993 can be attributed primarily to the receipt of $30 million of capital contributions from The Southern Company. CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $256 million ($96 million in 1994, $62 million in 1995, and $98 million in 1996). The major emphasis within the construction program will be on complying with Clean Air Act regulations, completion of a 78-megawatt combustion turbine, and upgrading existing facilities. The estimates for property additions for the three-year period include $39 million committed to meeting the requirements of Clean Air Act regulations. Revisions may be necessary because of factors such as revised load projections, the availability and cost of capital, and changes in environmental regulations. OTHER CAPITAL REQUIREMENTS In addition to the funds required for the Company's construction program, approximately $51 million will be required by the end of 1996 for present sinking fund requirements and maturities of long-term debt. Mississippi Power plans to continue, when economically feasible, to retire high-cost debt and preferred stock and replace these obligations with lower-cost capital. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act Amendments of 1990 (Clean Air Act) were signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the law -- will have a significant impact on Mississippi Power and the other operating companies of The Southern Company. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10 thousand megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing more slowly than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this has required some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which Mississippi Power's portion is approximately $60 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I, increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 to 2000, compliance for The Southern Company could require total construction expenditures ranging from approximately $450 million to $800 million, II-187 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report of which Mississippi Power's portion is approximately $25 million. However, the full impact of Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An average increase of up to 3 percent in revenue requirements from customers could be necessary to fully recover The Southern Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. Mississippi Power's ECO Plan is designed to allow recovery of costs of compliance with the Clean Air Act, as well as other environmental statutes and regulations. The MPSC reviews environmental projects and the Company's environmental policy through the ECO Plan. Under the ECO Plan, any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. Mississippi Power's management believes that the ECO Plan will provide for recovery of the Clean Air Act costs. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standard could result in significant additional costs. The impact of new standards -- if any -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provisions of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matter, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes -- coal ash and other utility wastes -- as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. The Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and has recognized in the financial statements costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect the Company. The impact of new legislation -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the II-188 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Mississippi Power Company 1993 Annual Report potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $70 million of committed credit in revolving credit agreements and also had $21 million of committed short-term credit lines. The $40 million of notes payable outstanding at year end 1993 were apart from the committed credit facilities. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations will be derived from operations, the sale of additional first mortgage bonds, pollution control obligations, and preferred stock, and the receipt of additional capital contributions from The Southern Company. Mississippi Power is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest rate levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-189 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-190 STATEMENTS OF CASH FLOWS For the Years ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-191 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-192 BALANCE SHEETS At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report II-193 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Mississippi Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-194 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Mississippi Power Company 1993 Annual Report STATEMENTS OF PAID-IN CAPITAL For the Years Ended December 31, 1993, 1992, and 1991 The accompanying notes are an integral part of these statements. II-195 NOTES TO FINANCIAL STATEMENTS Mississippi Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Mississippi Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, Southern Company Services (SCS), Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four southeastern states. Contracts among the companies--dealing with jointly owned generating facilities, interconnecting transmission lines, and the exchange of electric power--are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission. SCS provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns, and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. Mississippi Power is also subject to regulation by the FERC and the Mississippi Public Service Commission (MPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the respective commissions. The 1991 financial statements of the Company included the accounts of Electric City Merchandise Company, Inc. (Electric City), which discontinued operations in 1991. All significant intercompany transactions were eliminated in consolidation. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES Mississippi Power accrues revenues for service rendered but unbilled at the end of each fiscal period. The Company's retail and wholesale rates include provisions to adjust billings for fluctuations in fuel and the energy component of purchased power. Retail rates also include provisions to adjust billings for fluctuations in costs for ad valorem taxes. Revenues are adjusted for differences between the recoverable fuel and ad valorem expenses and the amounts actually recovered in current rates. DEPRECIATION Depreciation of the original cost of depreciable utility plant in service is provided by using composite straight-line rates which approximated 3.1 percent in 1993 and 3.3 percent in 1992 and 1991. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES Mississippi Power provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 9 to the financial statements for additional information about Statement No. 109. II-196 NOTES (continued) Mississippi Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used to capitalize the cost of funds devoted to construction were 6.8 percent in 1993, 8.2 percent in 1992, and 9.8 percent in 1991. AFUDC (net of income taxes), as a percent of net income after dividends on preferred stock, was 3.5 percent in 1993, 2.7 percent in 1992, and 4.8 percent in 1991. UTILITY PLANT Utility plant is stated at original cost. This cost includes: materials; labor; minor items of property; appropriate administrative and general costs; payroll-related costs such as taxes, pensions, and other benefits; and the estimated cost of funds used during construction. The cost of maintenance, repair, and replacement of minor items of property is charged to maintenance expense except for the maintenance of coal cars and a portion of the railway track maintenance, which are charged to fuel stock. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, all financial instruments of the Company -- for which the carrying amount does not approximate fair value -- are shown in the table below as of December 31: The fair value of investment securities was based on listed closing market prices. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when used or installed. VACATION PAY Mississippi Power's employees earn their vacation in one year and take it in the subsequent year. However, for ratemaking purposes, vacation pay is recognized as an allowable expense only when paid. Consistent with this ratemaking treatment, the Company accrues a current liability for earned vacation pay and records a current asset representing the future recoverability of this cost. Such amounts were $4.8 million and $4.7 million at December 31, 1993 and 1992, respectively. In 1994, an estimated 80 percent of the 1993 deferred vacation cost will be expensed, and the balance will be charged to construction and other accounts. II-197 NOTES (continued) Mississippi Power Company 1993 Annual Report PROVISION FOR PROPERTY DAMAGE Due to the significant increase in the cost of traditional insurance, effective in 1993, Mississippi Power became self-insured for the full cost of storm and other damage to its transmission and distribution property. As permitted by regulatory authorities, the Company provided for the cost of storm, fire and other uninsured casualty damage by charges to income of $1.5 million in 1993, 1992, and 1991. The cost of repairing damage resulting from such events that individually exceed $50 thousand is charged to the accumulated provision to the extent it is available. As of December 31, 1993, the accumulated provision amounted to $10.5 million. Regulatory treatment by the MPSC allows a maximum accumulated provision of $10.9 million. DISCONTINUED OPERATIONS Electric City began operating as a subsidiary of Mississippi Power in October 1987 and was formally dissolved as of December 31, 1991. Under an agreement reached in October 1991, a portion of Electric City's assets, including inventory and fixed assets, was sold to a concern independent of Mississippi Power. The remaining assets and liabilities, which were not material, were transferred to the Company. The impact of Electric City on Mississippi Power's consolidated earnings in 1991 consisted of (a) a pretax operating loss of $10.2 million ($6.4 million after income taxes) and (b) the pretax loss of $8.7 million ($5.5 million after income taxes) resulting from the disposal of Electric City. 2. RETIREMENT BENEFITS: PENSION PLAN Mississippi Power has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits are based on the greater of amounts resulting from two different formulas: years of service and final average pay or years of service and a flat-dollar benefit. The Company uses the "entry age normal method with a frozen initial liability" actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and fixed-income securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS Mississippi Power also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Amounts funded are primarily invested in debt and equity securities. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." Because the adoption of Statement No. 106 was reflected in rates, it did not have a material impact on net income. Prior to 1993, Mississippi Power recognized these benefit costs on an accrual basis using the "aggregate cost" actuarial method, which spreads the expected cost of such benefits over the remaining periods of employees' service as a level percentage of payroll costs. The total costs of such benefits recognized by the Company in 1992 and 1991 were $3.6 million and $3.0 million, respectively. II-198 NOTES (continued) Mississippi Power Company 1993 Annual Report STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statement Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown only for 1993 because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the above actuarial calculations were: An additional assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $6.4 million and the aggregate of the service and interest cost components of the net retiree medical cost by $722 thousand. Components of the plans' net cost are shown below: II-199 NOTES (continued) Mississippi Power Company 1993 Annual Report Of the above net pension amounts recorded, ($170 thousand) in 1993, $269 thousand in 1992, and $576 thousand in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Of the above net postretirement medical and life insurance costs recorded in 1993, $3.9 million was charged to operating expense and the remainder was charged to construction and other accounts. 3. LITIGATION AND REGULATORY MATTERS: RETAIL RATE ADJUSTMENT PLANS Mississippi Power's retail base rates have been set under a Performance Evaluation Plan (PEP) since 1986. During 1993, all matters related to the original PEP case were finally resolved when the Supreme Court of Mississippi granted a joint motion to dismiss pending appeals. Also in 1993, the MPSC ordered Mississippi Power to review and propose changes to the plan that would reduce the impact of rate changes on the customer and provide incentives for Mississippi Power to keep customer prices low. In response, Mississippi Power filed a revised plan and, on January 4, 1994, the MPSC approved PEP-2. The revised plan includes a mechanism for sharing rate adjustments based on the Company's ability to maintain low rates for customers and on the Company's performance as measured by three performance indicators that emphasize those factors which most directly impact the customers. PEP-2 provides for semiannual evaluations of Mississippi's performance-based return on investment, rather than on common equity as previously calculated. As in previous plans, any change in rates is limited to 2 percent of retail revenues per evaluation period before a public hearing is required. PEP-2 will remain in effect until the MPSC modifies or terminates the plan. ENVIRONMENTAL COMPLIANCE OVERVIEW PLAN The MPSC approved Mississippi Power's ECO Plan in 1992. The plan establishes procedures to facilitate the MPSC's overview of the Company's environmental strategy and provides for recovery of costs associated with environmental projects approved by the MPSC. Under the ECO Plan any increase in the annual revenue requirement is limited to 2 percent of retail revenues. However, the plan also provides for carryover of any amount over the 2 percent limit into the next year's revenue requirement. The ECO Plan resulted in an annual retail rate increase of $2.6 million effective April 1993. FERC REVIEWS EQUITY RETURNS AND OTHER REGULATORY MATTERS In May 1991, the FERC ordered that hearings be conducted concerning the reasonableness of the Southern electric system's wholesale rate schedules and contracts that have a return on equity of 13.75 percent or greater. The contracts that could be affected by the hearings include substantially all of the transmission, unit power, long-term power and other similar contracts, including the Company's Transmission Facilities Agreement (TFA) discussed in Note 8 under "Lease Agreements." Any changes in rate of return on common equity that may occur as a result of this proceeding would be effective 60 days after a proper notice of the proceeding is published. A notice was published on May 10, 1991. In August 1992, an administrative law judge issued an opinion that changes in rate schedules and contracts were not necessary and that the FERC staff failed to show how any changes were in the public interest. The FERC staff has filed exceptions to the administrative law judge's opinion, and the matter remains pending before the FERC. The final outcome of this matter cannot now be determined; however, in management's opinion, the final outcome will not have a material adverse effect on Mississippi Power's financial statements. In 1988, the Company and its operating affiliates filed with the FERC a contract governing the pricing and other aspects of power transactions among the companies. In 1989, the FERC ordered hearings on the contract and made revenues collected under the contract subject to refund. In 1992, the II-200 NOTES (continued) Mississippi Power Company 1993 Annual Report FERC ruled that certain production costs under the contract had not been properly classified and ordered that the contract be revised and that refunds be made. Under reconsideration, the FERC determined that refunds were not necessary and ordered that its mandated changes in computing certain expenses under the system interchange contract become effective in August 1993. The changes mandated by the FERC will not materially affect the Company's net income. WHOLESALE RATE FILING On September 1, 1993, Mississippi Power filed a $3.6 million wholesale rate increase request with the FERC. Prior to this filing, the Company conferred and negotiated a settlement with all of its wholesale all requirements customers, who have executed a Settlement Agreement and Certificates of Concurrence to be included in this filing with the FERC. The Company is awaiting a response from the FERC. RETAIL RATEPAYERS' SUITS CONCLUDED In 1989, three retail ratepayers of the Company filed a civil complaint in the U.S. District Court for the Southern District of Mississippi against Mississippi Power and other parties. The complaint alleged that Mississippi Power obtained excessive rate increases by improper accounting for spare parts and sought actual damages estimated to be at least $10 million, plus treble and punitive damages, on behalf of all retail ratepayers of the Company for alleged violations of the federal Racketeer Influenced and Corrupt Organizations Act, federal and state antitrust laws, other federal and state statutes, and common law fraud. Mississippi Power also was named as a defendant, together with other parties in a similar civil action filed in the U.S. District Court for the Northern District of Florida. The defendants' motions for dismissal were granted by the courts, resolving these suits. 4. CONSTRUCTION PROGRAM: Mississippi Power is engaged in continuous construction programs, the costs of which are currently estimated to total some $96 million in 1994, $62 million in 1995, and $98 million in 1996. These estimates include AFUDC of $1.6 million in 1994, $1.6 million in 1995, and $2.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing costs of labor, equipment and materials; and cost of capital. The Company does not have any new baseload generating plants under construction. However, the construction of a combustion turbine generation unit of 78 megawatts was completed in February 1994. In addition, significant construction will continue related to transmission and distribution facilities and the upgrading and extension of the useful lives of generating plants. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act and other environmental matters. 5. FINANCING AND COMMITMENTS: FINANCING Mississippi Power's construction program is expected to be financed from internal and other sources, such as the issuance of additional long-term debt and preferred stock and the receipt of capital contributions from The Southern Company. The amounts of first mortgage bonds and preferred stock which can be issued in the future will be contingent upon market conditions, adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis under "Sources of Capital" for information regarding the Company's coverage requirements. At December 31, 1993, Mississippi Power had committed credit agreements (360 day committed lines) with banks for $21 million. Additionally, Mississippi Power had $70 million of unused committed credit agreements in the form of revolving credit agreements expiring December 1, 1996. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitment fees based on the unused portions of the commitments or to maintain compensating balances with the banks. As of December 31, 1993, Mississippi Power had $40 million in short-term bank borrowings all of which were made apart from committed credit arrangements. II-201 NOTES (continued) Mississippi Power Company 1993 Annual Report ASSETS SUBJECT TO LIEN Mississippi Power's mortgage indenture dated as of September 1, 1941, as amended and supplemented, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all the Company's fixed property and franchises. FUEL COMMITMENTS To supply a portion of the fuel requirements of its generating plants, Mississippi Power has entered into various long-term commitments for the procurement of fuel. In most cases, these contracts contain provisions for price escalations, minimum production levels, and other financial commitments. Total estimated obligations were approximately $243 million at December 31, 1993. Additional commitments for fuel will be required in the future to supply the Company's fuel needs. In order to take advantage of lower cost coal supplies, agreements were reached in December 1986 to terminate two contracts for the supply of coal to Plant Daniel, which is jointly owned by Mississippi Power and Gulf Power, an operating affiliate. The Company's portion of this payment was about $60 million. In accordance with the ratemaking treatment, the cost to terminate the contracts is being amortized through 1995 to match costs with savings achieved. The remaining unamortized amount of Mississippi Power's share of principal payments to the suppliers including the current portion totaled $18 million at December 31, 1993. 6. JOINT OWNERSHIP AGREEMENTS: Mississippi Power and Alabama Power own as tenants in common Greene County Electric Generating Plant (coal) located in Alabama; and Mississippi Power and Gulf Power own as tenants in common Daniel Electric Generating Plant (coal) located in Mississippi. At December 31, 1993, Mississippi Power's percentage ownership and investment in these jointly owned facilities were as follows: Mississippi Power's share of plant operating expenses is included in the corresponding operating expenses in the Statements of Income. 7. LONG-TERM POWER SALES AGREEMENTS: GENERAL Mississippi Power and the other operating affiliates of The Southern Company have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside of the system's service area. Some of these agreements (unit power sales) are firm commitments and pertain to capacity related to specific generating units. Mississippi Power's participation in firm production capacity unit power sales ended in January 1989. However, the Company continues to participate in transmission and energy sales under the unit power sales agreements. The other agreements (other long-term sales) are non-firm commitments and are based on capacity of the system in general. Because the energy is generally sold at variable costs under these agreements, only revenues from capacity sales affect profitability. Off-system capacity revenues for the Company have been as follows: Long-term non-firm power of 400 megawatts was sold in 1993 by the Southern electric system to Florida Power Corporation. In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-202 NOTES (continued) Mississippi Power Company 1993 Annual Report GULF STATES SETTLEMENT COMPLETED On November 7, 1991, subsidiaries of The Southern Company entered into a settlement agreement with Gulf States that resolved litigation between the companies that had been pending since 1986 and arose out of a dispute over certain unit power and other long-term power sales contracts. In 1993, all remaining terms and obligations of the settlement agreement were satisfied. Based on the value of the settlement proceeds received -- less the amounts previously included in income -- Mississippi Power recorded an increase in net income of approximately $2.6 million in 1991. 8. LEASE AGREEMENTS: In 1984, Mississippi Power and Gulf States entered into a forty-year transmission facilities agreement whereby Gulf States began paying a use fee to the Company covering all expenses relative to ownership and operation and maintenance of a 500 kV line, including amortization of its original $57 million cost. In 1993, 1992, and 1991 the use fees collected under the agreement, net of related expenses, amounted to $3.9 million, $3.9 million and $4.0 million, respectively, and are included with other income, net, in the Statements of Income. For other information see Note 3 under "FERC Reviews Equity Returns and Other Regulatory Matters." In 1989, Mississippi Power entered into a twenty-two year operating lease agreement for the use of 495 aluminum railcars to transport coal to Plant Daniel. Gulf Power, as joint owner of Plant Daniel, is responsible for one half of the lease costs. The Company's share of the lease is charged to fuel inventory and allocated to fuel expense as the fuel is used. The lease costs charged to inventory were $1.2 million in 1993, $1.2 million for 1992 and $1.3 million for 1991. For the year 1994, the Company's annual lease payment will be $1.2 million. The Company's annual lease payment for 1995 will be $2.4 million and for 1996, 1997, and in 1998 the payment will be $1.2 million. Lease payments after 1998 total approximately $17.4 million. The Company has the option after three years to purchase the railcars at the greater of termination value or fair market value. Additionally, at the end of the lease term, Mississippi Power has the option to renew the lease. 9. INCOME TAXES: Effective January 1, 1993, Mississippi Power adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $48 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. II-203 NOTES (continued) Mississippi Power Company 1993 Annual Report Details of the federal and state income tax provisions are shown below: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: In 1989, under order of the MPSC, Mississippi Power began amortizing deferred income taxes not covered by the Internal Revenue Service normalization requirements, that had been recorded at rates higher than those specified by the current statutory income tax rules. This amortization occurred over a 60-month period, the effect of which was a reduction of income tax expense of approximately $2.7 million per year. At December 31, 1993, this tax rate differential was fully amortized. Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $1.5 million in 1993, $1.4 million in 1992 and $1.5 million in 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. II-204 NOTES (continued) Mississippi Power Company 1993 Annual Report The total provision for income taxes as a percentage of pre-tax income and the differences between those effective rates and the statutory federal tax rates were as follows: Mississippi Power and its affiliates file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. 10. OTHER LONG-TERM DEBT: Details of other long-term debt are as follows: Pollution control obligations represent installment or lease purchases of pollution control facilities financed by application of funds derived from sales by public authorities of tax-exempt revenue bonds. Mississippi Power has authenticated and delivered to the Trustee a like principal amount of first mortgage bonds as security for obligations under collateralized installment agreements. The principal and interest on the first mortgage bonds will be payable only in the event of default under these agreements. The 5.8% Series of pollution control obligations has a cash sinking fund requirement of $10 thousand annually through 1997 and $20 thousand in 1998. At December 31, 1993, under "Other Property and Investments" approximately $6 million related to the 6.20% Series of Pollution Control Obligations remains available for completion of certain solid waste disposal facilities. The 8.25 percent notes payable relate to the termination of two coal contracts. See Note 5 under "Fuel Commitments" for information on these coal contracts. The annual estimated maturities of total notes payable are $8.8 million in 1994 and $10.8 million in 1995. II-205 NOTES (continued) Mississippi Power Company 1993 Annual Report 11. LONG-TERM DEBT DUE WITHIN ONE YEAR: A summary of the improvement fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement fund requirement is one percent of each outstanding series authenticated under the indenture of Mississippi Power prior to January 1 of each year, other than first mortgage bonds issued as collateral security for certain pollution control obligations. The requirement must be satisfied by June 1 of each year by depositing cash or reacquiring bonds, or by pledging additional property equal to 166-2/3 percent of such requirement. 12. COMMON STOCK DIVIDEND RESTRICTIONS: Mississippi Power's first mortgage bond indenture and the Articles of Incorporation contain various common stock dividend restrictions. At December 31, 1993, $86 million of retained earnings was restricted against the payment of cash dividends on common stock under the most restrictive terms of the mortgage indenture or Articles of Incorporation. 13. QUARTERLY FINANCIAL DATA (UNAUDITED): Summarized quarterly financial data for 1993 and 1992 are as follows: Mississippi Power's business is influenced by seasonal weather conditions and the timing of rate changes. II-206 SELECTED FINANCIAL AND OPERATING DATA Mississippi Power Company 1993 Annual Report II-207 II-208 II-209 II-210 STATEMENTS OF INCOME Mississippi Power Company II-211 STATEMENTS OF INCOME Mississippi Power Company II-212 STATEMENTS OF CASH FLOWS Mississippi Power Company II-213 STATEMENTS OF CASH FLOWS Mississippi Power Company II-214 BALANCE SHEETS Mississippi Power Company II-215 BALANCE SHEETS Mississippi Power Company II-216 BALANCE SHEETS Mississippi Power Company II-217 BALANCE SHEETS Mississippi Power Company II-218 MISSISSIPPI POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-219 MISSISSIPPI POWER COMPANY SECURITIES RETIRED DURING 1993 FIRST MORTGAGE BONDS POLLUTION CONTROL BONDS PREFERRED STOCK II-220 SAVANNAH ELECTRIC AND POWER COMPANY FINANCIAL SECTION II-221 MANAGEMENT'S REPORT Savannah Electric and Power Company 1993 Annual Report The management of Savannah Electric and Power Company has prepared -- and is responsible for -- the financial statements and related information included in this report. These statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and necessarily include amounts that are based on the best estimates and judgments of management. Financial information throughout this annual report is consistent with the financial statements. The Company maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that books and records reflect only authorized transactions of the Company. Limitations exist in any system of internal controls, however, based on a recognition that the cost of the system should not exceed its benefits. The Company believes its system of internal accounting controls maintains an appropriate cost/benefit relationship. The Company's system of internal accounting controls is evaluated on an ongoing basis by the Company's internal audit staff. The Company's independent public accountants also consider certain elements of the internal control system in order to determine their auditing procedures for the purpose of expressing an opinion on the financial statements. The audit committee of the board of directors, composed of four directors who are not employees, provides a broad overview of management's financial reporting and control functions. Periodically, this committee meets with management, the internal auditors and the independent public accountants to ensure that these groups are fulfilling their obligations and to discuss auditing, internal controls and financial reporting matters. The internal auditors and the independent public accountants have access to the members of the audit committee at any time. Management believes that its policies and procedures provide reasonable assurance that the Company's operations are conducted according to a high standard of business ethics. In management's opinion, the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows of Savannah Electric and Power Company in conformity with generally accepted accounting principles. /s/ Arthur M. Gignilliat, Jr. /s/ K. R. Willis - -------------------------------- ------------------------------------- Arthur M. Gignilliat, Jr. K. R. Willis President Vice-President and Chief Executive Officer Treasurer and Chief Financial Officer II-222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE BOARD OF DIRECTORS OF SAVANNAH ELECTRIC AND POWER COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Savannah Electric and Power Company (a Georgia corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings, paid-in capital, 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 (pages II-231 through II-244) referred to above present fairly, in all material respects, the financial position of Savannah Electric and Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the periods stated, in conformity with generally accepted accounting principles. As explained in Notes 2 and 7 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. /s/ Arthur Andersen & Co. Atlanta, Georgia, February 16, 1994 II-223 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Savannah Electric and Power Company 1993 Annual Report RESULTS OF OPERATIONS Earnings Savannah Electric and Power Company's net income after dividends on preferred stock for 1993 totaled $21.5 million, representing a $1.0 million (4.6 percent) increase from the prior year. The revenue impact of an increase in retail energy sales due to exceptionally hot summer weather was partially offset by the implementation of a work force reduction program which resulted in a one-time charge to operating expenses of approximately $4.5 million. In 1992, earnings were $20.5 million, representing a $3.5 million (14.6 percent) decrease from the prior year. This decrease resulted primarily from increases in maintenance and administrative and general expenses, partially offset by a 4.6 percent increase in retail operating revenues. Operating revenues increased despite the negative impact of a $2.8 million annual reduction in retail base rates effective in June 1992, and mild weather. REVENUES Total revenues for 1993 were $218.4 million, reflecting a 10.5 percent increase over 1992, primarily due to an increase in retail energy sales. The following table summarizes the factors impacting operating revenues compared to the prior year for the 1991-1993 period: Total retail revenues increased 11.5 percent in 1993, compared to a 4.6 percent increase in 1992. The increase in 1993 retail revenues attributable to growth in both retail customers and average use per customer was enhanced by exceptionally hot weather during the summer. The substantial increase in fuel cost recovery and other revenues reflects increases in net generation and the unit cost of purchased power. The increase in 1992 retail revenues resulted from growth in both retail customers and average use per customer, but was substantially offset by mild weather and the June 1992 base rate reduction. II-224 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Under the Company's fuel cost recovery provisions, fuel revenues equal fuel expense, including the fuel and capacity components of purchased energy, and have no effect on earnings. Revenues from sales to non-affiliated utilities under long-term contracts consist of capacity and energy components. Capacity revenues reflect the recovery of fixed costs and a return on investment under the contracts. Energy is generally sold at variable cost. The capacity and energy components were: Sales to affiliated companies within the Southern electric system vary from year to year depending on demand and the availability and cost of generating resources at each company. These sales have little impact on earnings. Kilowatt-hour sales for 1993 and the percent change by year were as follows: The increases in energy sales in 1993 and 1992 continue to reflect a growing customer base, an increase in average energy sales per customer, and improved economic conditions in the Company's service area. Sales were enhanced in 1993 by temperature extremes in the summer months and in December. EXPENSES Total operating expenses for 1993 increased $20.3 million (12.4 percent) over the prior year. This increase includes a $10.8 million increase in fuel expense, and an $8.7 million increase in other operation expenses. Fuel expenses increased primarily because of higher generation due to extremely hot weather and higher cost fuel sources. In 1992 an increase in purchased power reflected a 15.4 percent decrease in generation compared to 1991. Despite the decrease in generation, total 1992 fuel expenses were substantially unchanged from the prior year reflecting generation from higher cost fuel sources. The increase in other operation expenses reflects a $4.5 million cost associated with a one-time charge related to a work force reduction program. The Company also recognized higher employee benefits costs under new accounting rules adopted in 1993. See Note 2 to the financial statements for additional information on these new rules. In 1992, the increase in other operation expenses was primarily a result of increases in outside services and administrative and general expenses, which reflected higher employee training and benefits expenses. Total interest expense on long-term debt was reduced by 5.4 percent in 1992, as the Company refinanced higher-cost debt. II-225 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The mix of energy supply is determined primarily by system load, the unit cost of fuel consumed and the availability of units. The amount and sources of energy supply and the average cost of fuel per net kilowatt-hour generated and purchased power were as follows: EFFECTS OF INFLATION The Company is subject to rate regulation and income tax laws that are based on the recovery of historical costs. Therefore, inflation creates an economic loss because the Company is recovering its costs of investments in dollars that have less purchasing power. While the inflation rate has been relatively low in recent years, it continues to have an adverse effect on the Company because of the large investment in long-lived utility plant. Conventional accounting for historical cost does not recognize this economic loss nor the partially offsetting gain that arises through financing facilities with fixed-money obligations such as long-term debt and preferred stock. Any recognition of inflation by regulatory authorities is reflected in the rate of return allowed. FUTURE EARNINGS POTENTIAL The results of operations for the past three years are not necessarily indicative of future earnings potential. The level of future earnings depends on numerous factors ranging from growth in energy sales to regulatory matters. Future earnings in the near term will depend upon growth in energy sales, which is subject to a number of factors. Traditionally, these factors included changes in contracts with neighboring utilities, energy conservation practiced by customers, the elasticity of demand, weather, competition, and the rate of economic growth in the Company's service area. However, the Energy Policy Act of 1992 (Energy Act) will have a profound effect on the future of the electric utility industry. The Energy Act promotes energy efficiency, alternative fuel use, and increased competition for electric utilities. The Energy Act allows Independent Power Producers (IPPs) to access a utility's transmission network to sell electricity to other utilities. This may enhance the incentives for IPPs to build cogeneration plants for the Company's large industrial and commercial customers. Although the Energy Act does not require transmission access to retail customers, pressure for legislation to allow retail wheeling will continue. The Company is preparing now to meet the challenge of these major changes in the traditional business practices of selling electricity. If the Company does not remain a low-cost producer and provide quality service, the Company's retail energy sales growth, as well as new long-term contracts for energy sales outside the service area, could be limited, and this could significantly erode earnings. Demand-side options -- programs that enable customers to lower or alter their peak energy requirements -- have been initiated by the Company and are a significant part of integrated resource planning. Customers can receive cash incentives for participating in these programs in addition to reducing their energy requirements. Expansion and increased utilization of these programs will be contingent upon sharing of cost savings between the customers and the Company. Besides promoting energy efficiency, another benefit of these programs could be the ability to defer the need to construct baseload generating facilities further into the future. The ability to defer major construction projects, in conjunction with the precertification approval process for such projects by the Georgia Public Service Commission (GPSC), will II-226 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report diminish the possible exposure to prudency disallowances and the resulting impact on earnings. Compliance costs related to the Clean Air Act Amendments of 1990 (Clean Air Act) could reduce earnings if such costs are not fully recovered. The Clean Air Act is discussed later under "Environmental Matters." Rates to retail customers served by the Company are regulated by the GPSC. In May 1992, the Company requested, and subsequently received, approval by the GPSC to reduce annual base revenues by $2.8 million, effective June 1992. The reduction includes a base rate reduction of approximately $2.5 million spread among all classes of retail customers. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers. As part of this rate settlement, it was informally agreed that the Company's earned rate of return on common equity should be 12.95 percent. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 112, Employers' Accounting for Postemployment Benefits, which must be implemented by 1994. The new standard requires that all types of benefits provided to former or inactive employees and their families prior to retirement be accounted for on an accrual basis. These benefits include salary continuation, severance pay, supplemental unemployment benefits, disability-related benefits, job training, and health and life insurance coverage. The FASB has issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. Statement No. 115, supersedes FASB Statement No. 12, Accounting for Certain Marketable Securities. The Company adopted the new rules January 1, 1994, with no material effect on the financial statements. On January 1, 1993, the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. See notes 2 and 7 to the financial statements regarding the impact of these changes. FINANCIAL CONDITION OVERVIEW The principal change in the Company's financial condition in 1993 was additions of $73 million to utility plant. The majority of funds needed for gross property additions since 1990 have been provided from operating activities, principally from earnings and non-cash charges to income such as depreciation and deferred income taxes. See Statements of Cash Flows for additional information. CAPITAL STRUCTURE As of December 31, 1993, the Company's capital structure consisted of 45.3 percent common equity, 10.3 percent preferred stock and 44.4 percent long-term debt, excluding amounts due within one year. The Company's long-term financial objective for capitalization ratios is to maintain a capital structure of common equity at 45 percent, preferred stock at 10 percent and debt at 45 percent. Maturities and retirements of long-term debt were $4 million in 1993, $53 million in 1992 and $23 million in 1991. In November 1993, the Company issued 1,400,000 shares of 6.64 percent series preferred stock. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent series preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. The composite interest rates for the years 1991 through 1993 as of year-end were as follows: II-227 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report The Company's current securities ratings are as follows: CAPITAL REQUIREMENTS FOR CONSTRUCTION The Company's projected construction expenditures for the next three years total $98 million ($33 million in 1994, $32 million in 1995, and $33 million in 1996). Actual construction costs may vary from this estimate because of such factors as changes in environmental regulations; revised load projections; the cost and efficiency of construction labor, equipment and materials; and the cost of capital. The largest project during this period is the addition of two 80 megawatt combustion turbine units, to be placed into service in 1994. The estimated cost of this project is $61 million. The Company is also constructing six combustion turbine units for Georgia Power Company. OTHER CAPITAL REQUIREMENTS In addition to the funds needed for the construction program, approximately $5.9 million will be needed by the end of 1996 for present sinking fund requirements and maturities. ENVIRONMENTAL MATTERS In November 1990, the Clean Air Act was signed into law. Title IV of the Clean Air Act -- the acid rain compliance provision of the new law -- will have a significant impact on the Company and other subsidiaries of the Southern electric system. Specific reductions in sulfur dioxide and nitrogen oxide emissions from fossil-fired generating plants will be required in two phases. Phase I compliance must be implemented in 1995, and affects eight generating plants -- some 10,000 megawatts of capacity or 35 percent of total capacity -- in the Southern electric system. Phase II compliance is required in 2000, and all fossil-fired generating plants in the Southern electric system will be affected. Beginning in 1995, the Environmental Protection Agency (EPA) will allocate annual sulfur dioxide emission allowances through the newly established allowance trading program. An emission allowance is the authority to emit one ton of sulfur dioxide during a calendar year. The method for allocating allowances is based on the fossil fuel consumed from 1985 through 1987 for each affected generating unit. Emission allowances are transferable and can be bought, sold, or banked and used in the future. The sulfur dioxide emission allowance program is expected to minimize the cost of compliance. The market for emission allowances is developing slower than expected. However, The Southern Company's sulfur dioxide compliance strategy is designed to take advantage of allowances as the market develops. The Southern Company expects to achieve Phase I sulfur dioxide compliance at the eight affected plants by switching to low-sulfur coal, and this would require some equipment upgrades. This compliance strategy is expected to result in unused emission allowances being banked for later use. Additional construction expenditures are required to install equipment for the control of nitrogen oxide emissions at these eight plants. Also, continuous emissions monitoring equipment would be installed on all fossil-fired units. Under this Phase I compliance approach, additional construction expenditures are estimated to total approximately $275 million through 1995 for The Southern Company, of which the Company's portion is approximately $2 million. Phase II compliance costs are expected to be higher because requirements are stricter and all fossil-fired generating plants are affected. For sulfur dioxide compliance, The Southern Company could use emission allowances banked during Phase I and increase fuel switching, install flue gas desulfurization equipment at selected plants, and/or purchase more allowances depending on the price and availability of allowances. Also, in Phase II, equipment to control nitrogen oxide emissions will be installed on additional system fossil-fired plants as required to meet anticipated Phase II limits. Therefore, during the period 1996 through 2000, compliance could require total construction expenditures ranging from approximately $450 million to $800 million of which the Company's portion is expected to be approximately $25 million. However, the full impact of II-228 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report Phase II compliance cannot now be determined with certainty, pending the development of a market for emission allowances, the completion of EPA regulations, and the possibility of new emission reduction technologies. An increase of up to 5 percent in annual revenue requirements from customers could be necessary to fully recover the Company's costs of compliance for both Phase I and II of the Clean Air Act. Compliance costs include construction expenditures, increased costs for switching to low-sulfur coal, and costs related to emission allowances. There can be no assurance that all Clean Air Act costs will be recovered. Title III of the Clean Air Act requires a multi-year EPA study of power plant emissions of hazardous air pollutants. The study will serve as the basis for a decision on whether additional regulatory control of these substances is warranted. Compliance with any new control standards could result in significant additional costs. The impact of new standards -- if any - -- will depend on the development and implementation of applicable regulations. The EPA continues to evaluate the need for a new short-term ambient air quality standard for sulfur dioxide. Preliminary results from an EPA study on the impact of a new standard indicate that a number of plants could be required to install sulfur dioxide controls. These controls would be in addition to the controls already required to meet the acid rain provision of the Clean Air Act. The EPA is expected to take some action on this issue in 1994. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In addition, the EPA is evaluating the need to revise the ambient air quality standards for particulate matters, nitrogen oxides, and ozone. The impact of any new standard will depend on the level chosen for the standard and cannot be determined at this time. In 1994 or 1995, the EPA is expected to issue revised rules on air quality control regulations related to stack height requirements of the Clean Air Act. The full impact of the final rules cannot be determined at this time, pending their development and implementation. In 1993, the EPA issued a ruling confirming the non-hazardous status of coal ash. However, the EPA has until 1998 to classify co-managed utility wastes--coal ash and other utility wastes--as either non-hazardous or hazardous. If the EPA classifies the co-managed wastes as hazardous, then substantial additional costs for the management of such wastes may be required. The full impact of any change in the regulatory status will depend on the subsequent development of co-managed waste requirements. Savannah Electric and Power Company must comply with other environmental laws and regulations that cover the handling and disposal of hazardous waste. Under these various laws and regulations, the Company could incur costs to clean up properties currently or previously owned. The Company conducts studies to determine the extent of any required clean-up costs and will recognize in the financial statements any costs to clean up known sites. Several major pieces of environmental legislation are in the process of being reauthorized or amended by Congress. These include: the Clean Water Act, the Comprehensive Environmental Response, Compensation, and Liability Act, and the Resource Conservation and Recovery Act. Changes to these laws could affect many areas of the Company's operations. The full impact of these requirements cannot be determined at this time, pending the development and implementation of applicable regulations. Compliance with possible new legislation related to global climate change, electromagnetic fields, and other environmental and health concerns could significantly affect The Southern Company. The impact of new legislation - -- if any -- will depend on the subsequent development and implementation of applicable regulations. In addition, the potential for lawsuits alleging damages caused by electromagnetic fields exists. SOURCES OF CAPITAL At December 31, 1993, the Company had $3.9 million of cash and $14.5 million of unused credit arrangements with banks to meet its short-term cash needs. The Company had $3 million of short-term bank borrowings at December 31, 1993. In January 1994, the Company renegotiated a two-year revolving credit arrangement with four of its II-229 MANAGEMENT'S DISCUSSION AND ANALYSIS (continued) Savannah Electric and Power Company 1993 Annual Report existing banks for a total credit line of $20 million. The primary purpose of this additional credit is to provide interim funding for the Company's combustion turbine construction program. It is anticipated that the funds required for construction and other purposes, including compliance with environmental regulations, will be derived from operations and the sale of additional first mortgage bonds and preferred stock and capital contributions from The Southern Company. The Company is required to meet certain coverage requirements specified in its mortgage indenture and corporate charter to issue new first mortgage bonds and preferred stock. The Company's coverage ratios are sufficiently high enough to permit, at present interest levels, any foreseeable security sales. The amount of securities which the Company will be permitted to issue in the future will depend upon market conditions and other factors prevailing at that time. II-230 STATEMENTS OF INCOME For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-231 STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report ( ) Denotes use of cash. The accompanying notes are an integral part of these statements. II-232 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-233 BALANCE SHEETS At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-234 STATEMENTS OF CAPITALIZATION At December 31, 1993 and 1992 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-235 STATEMENTS OF RETAINED EARNINGS For the Years Ended December 31, 1993, 1992, and 1991 Savannah Electric and Power Company 1993 Annual Report The accompanying notes are an integral part of these statements. II-236 NOTES TO FINANCIAL STATEMENTS Savannah Electric and Power Company 1993 Annual Report 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL Savannah Electric and Power Company is a wholly owned subsidiary of The Southern Company, which is the parent company of five operating companies, a system service company, Southern Electric International (Southern Electric), Southern Nuclear Operating Company (Southern Nuclear), and various other subsidiaries related to foreign utility operations and domestic non-utility operations. At this time, the operations of the other subsidiaries are not material. The operating companies (Alabama Power Company, Georgia Power Company, Gulf Power Company, Mississippi Power Company, and Savannah Electric and Power Company) provide electric service in four Southeastern states. Contracts among the companies -- dealing with jointly owned generating facilities, interconnecting transmission lines and the exchange of electric power -- are regulated by the Federal Energy Regulatory Commission (FERC) or the Securities and Exchange Commission (SEC). The system service company provides, at cost, specialized services to The Southern Company and to the subsidiary companies. Southern Electric designs, builds, owns and operates power production facilities and provides a broad range of technical services to industrial companies and utilities in the United States and a number of international markets. Southern Nuclear provides services to The Southern Company's nuclear power plants. The Southern Company is registered as a holding company under the Public Utility Holding Company Act of 1935 (PUHCA). Both The Southern Company and its subsidiaries are subject to the regulatory provisions of the PUHCA. The Company also is subject to regulation by the FERC and the Georgia Public Service Commission (GPSC). The Company follows generally accepted accounting principles and complies with the accounting policies and practices prescribed by the GPSC. Certain prior years' data presented in the financial statements have been reclassified to conform with current year presentation. REVENUES AND FUEL COSTS The Company accrues revenues for services rendered but unbilled at the end of each fiscal period. Fuel costs are expensed as the fuel is used. The Company's electric rates include provisions to adjust billings for fluctuations in capacity and the energy components of purchased power costs. Revenues include the actual cost of fuel and purchased power incurred. DEPRECIATION AND AMORTIZATION Depreciation of the original cost of depreciable utility plant in service is provided primarily by using composite straight-line rates, which approximated 2.9 percent in 1993 and 3.2 percent in 1992, and 1991. The decrease in 1993 reflects the Company's implementation of new depreciation rates approved by the GPSC. These new rates provide for a timely recovery of the investments in the Company's depreciable properties. When property subject to depreciation is retired or otherwise disposed of in the normal course of business, its cost -- together with the cost of removal, less salvage -- is charged to the accumulated provision for depreciation. Minor items of property included in the original cost of the plant are retired when the related property unit is retired. INCOME TAXES The Company, which is included in the consolidated federal income tax return filed by The Southern Company, provides deferred income taxes for all significant income tax temporary differences. Investment tax credits utilized are deferred and amortized to income over the average lives of the related property. In years prior to 1993, income taxes were accounted for and reported under Accounting Principles Board Opinion No. 11. Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. Statement No. 109 required, among other things, conversion to the liability method of accounting for accumulated deferred income taxes. See Note 7 for additional information about Statement No. 109. II-237 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) AFUDC represents the estimated debt and equity costs of capital funds that are necessary to finance the construction of new facilities. While cash is not realized currently from such allowance, it increases the revenue requirement over the service life of the plant through a higher rate base and higher depreciation expense. The composite rates used by the Company to calculate AFUDC were 8.77 percent in 1993, 11.27 percent in 1992, and 11.38 percent in 1991. UTILITY PLANT Utility plant is stated at original cost, which includes materials, labor, minor items of property, appropriate administrative and general costs, payroll-related costs such as taxes, pensions and other benefits and the estimated cost of funds used during construction. The cost of maintenance, repairs, and replacement of minor items of property is charged to maintenance expense. The cost of replacements of property (exclusive of minor items of property) is charged to utility plant. CASH AND CASH EQUIVALENTS For purposes of the Statements of Cash Flows, temporary cash investments are considered cash equivalents. Temporary cash investments are securities with original maturities of 90 days or less. FINANCIAL INSTRUMENTS In accordance with FASB Statement No. 107, Disclosure About Fair Value of Financial Instruments, items for which the carrying amount does not approximate fair value must be disclosed. At December 31, 1993, the fair value of long-term debt was $164 million and the carrying amount was $154 million. The fair value of long-term debt was $117 million and the carrying amount was $109 million at December 31, 1992. The fair value for long-term debt was based on either closing market prices or closing prices of comparable instruments. MATERIALS AND SUPPLIES Generally, materials and supplies include the cost of transmission, distribution, and generating plant materials. Materials are charged to inventory when purchased and then expensed or capitalized to plant, as appropriate, when installed. 2. RETIREMENT BENEFITS PENSION PLANS The Company has a defined benefit, trusteed, non-contributory pension plan that covers substantially all regular employees. Benefits under this plan reflect the employee's years of service, age at retirement and average compensation for the three years immediately preceding retirement. The Company uses the projected unit credit actuarial method for funding purposes, subject to limitations under federal income tax regulations. Amounts funded to the pension fund are primarily invested in equity and debt securities. FASB Statement No. 87, Employers' Accounting for Pensions, requires use of the "projected unit credit" actuarial method for financial reporting purposes. POSTRETIREMENT BENEFITS The Company also provides certain medical care and life insurance benefits for retired employees. Substantially all employees may become eligible for these benefits when they retire. A qualified trust for medical benefits has been established for funding amounts to the extent deductible under federal income tax regulations. Accrued costs of life insurance benefits, other than current cash payments for retirees, currently are not being funded. Effective January 1, 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on a prospective basis. Statement No. 106 requires that medical care and life insurance benefits for retired employees be accounted for on an accrual basis using a specified actuarial method, "benefit/years-of-service." II-238 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Consistent with regulatory treatment, the Company recognized these costs on a cash basis as payments were made in 1992 and 1991. The total costs of such benefits recognized by the Company amounted to $375 thousand in 1992 and $487 thousand in 1991. STATUS AND COST OF BENEFITS Shown in the following tables are actuarial results and assumptions for pension and postretirement medical and life insurance benefits as computed under the requirements of FASB Statements Nos. 87 and 106, respectively. Retiree medical and life insurance information is shown for 1993 only because Statement No. 106 was adopted as of January 1, 1993, on a prospective basis. The funded status of the plans at December 31 was as follows: The weighted average rates assumed in the actuarial calculations were: In accordance with Statement No. 87, an additional liability related to under-funded accumulated benefit obligations was recognized at December 31, 1993. A corresponding net-of-tax charge of $2.1 million was recognized as a separate component of Common Stock Equity in the Statements of Capitalization. The assumption used in measuring the accumulated postretirement medical benefit obligation was a weighted average medical care cost trend rate of 11.3 percent for 1993, decreasing gradually to 6.0 percent through the year 2000 and remaining at that level thereafter. An annual increase in the assumed medical care cost trend rate by 1.0 percent would increase the accumulated medical benefit obligation as of December 31, 1993, by $1.7 million and the aggregate of the service and interest cost components of the net retiree medical cost by $0.2 million. II-239 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report Components of the plans' net costs are shown below: Of the above net pension amounts, $2.0 million in 1993, $1.7 million in 1992 and $1.5 million in 1991 were recorded in operating expenses, and the remainder was recorded in construction and other accounts. Net postretirement medical and life insurance costs of $1.8 million in 1993 were charged to operating expenses. The Company has a supplemental retirement plan for certain executive employees. The plan is unfunded and payable from the general funds of the Company. The Company has purchased life insurance on participating executives, and plans to use these policies to satisfy this obligation. Benefit costs associated with this plan for 1993, 1992 and 1991 were $980 thousand, $316 thousand and $338 thousand, respectively. The 1993 benefit costs reflect a one-time expense related to employees who were part of the work force reduction program. WORK FORCE REDUCTION PROGRAM The Company has incurred additional costs for a one-time charge related to the implementation of a work force reduction program. In 1993, $4.5 million was charged to operating expenses and $0.6 million was charged to other income (expense). 3. REGULATORY MATTERS RATE MATTERS In May 1992, the Company filed for, and subsequently received, GPSC approval to implement new base rates designed to decrease base operating revenues by $2.8 million annually. The reduction included a base rate reduction of approximately $2.5 million spread among all classes of customers, effective June 1992. An additional $0.3 million reduction resulted from the implementation of an experimental, time-of-use rate for certain commercial customers in August 1992. 4. CONSTRUCTION PROGRAM The Company is engaged in a continuous construction program, currently estimated to total $33 million in 1994, $32 million in 1995 and $33 million in 1996. The estimates include AFUDC of $1.6 million in 1994, $0.6 million in 1995 and $0.7 million in 1996. The construction program is subject to periodic review and revision, and actual construction costs may vary from the above estimates because of numerous factors. These factors include: changes in business conditions; revised load growth estimates; changes in environmental regulations; increasing cost of labor, equipment and materials; and cost of capital. The construction of two combustion turbine peaking units totaling 160 megawatts is planned to be completed in mid 1994. The Company is also constructing six combustion turbine peaking units owned by Georgia Power Company. The construction is to be completed in 1996. See Management's Discussion and Analysis under "Environmental Matters" for information on the impact of the Clean Air Act Amendments of 1990 and other environmental matters. II-240 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 5. FINANCING AND COMMITMENTS GENERAL To the extent possible, the Company's construction program is expected to be financed from internal sources and from the issuance of additional long-term debt and preferred stock and capital contributions from The Southern Company. Should the Company be unable to obtain funds from these sources, the Company would have to use short-term indebtedness or other alternative, and possibly costlier, means of financing. The amounts of long-term debt and preferred stock that can be issued in the future will be contingent on market conditions, the maintenance of adequate earnings levels, regulatory authorizations and other factors. See Management's Discussion and Analysis for information regarding the Company's earnings coverage requirements. BANK CREDIT ARRANGEMENTS At the beginning of 1994, unused credit arrangements with four banks totaled $14.5 million, and expire at various times during 1994. The Company has $20 million of revolving credit arrangements expiring December 31, 1995. These agreements allow short-term borrowings to be converted into term loans, payable in 12 equal quarterly installments, with the first installment due at the end of the first calendar quarter after the applicable termination date or at an earlier date at the Company's option. In connection with these credit arrangements, the Company agrees to pay commitments fees based on the unused portions of the commitments. In connection with all other lines of credit, the Company has the option of paying fees or maintaining compensating balances, which are substantially all the cash of the Company except for daily working funds and similar items. These balances are not legally restricted from withdrawal. ASSETS SUBJECT TO LIEN As amended and supplemented, the Company's Indenture of Mortgage, which secures the first mortgage bonds issued by the Company, constitutes a direct first lien on substantially all of the Company's fixed property and franchises. OPERATING LEASES The Company has rental agreements with various terms and expiration dates. Rental expenses totaled $1.5 million, $1.5 million, and $1.4 million for 1993, 1992, and 1991, respectively. At December 31, 1993, estimated future minimum lease payments for non-cancelable operating leases were as follows: 6. LONG-TERM POWER SALES AGREEMENTS The operating subsidiaries of The Southern Company, including the Company, have entered into long-term contractual agreements for the sale of capacity and energy to certain non-affiliated utilities located outside the system's service area. Certain of these agreements are non-firm and are based on capacity of the system in general. Other agreements are firm and pertain to the capacity related to specific generating units. Because the energy is generally sold at cost under these agreements, revenues from capacity sales primarily affect profitability. The Company's portion of capacity revenues has been as follows: Long-term non-firm power of 400 megawatts was sold by the Southern electric system in 1993 to Florida Power Corporation (FPC). In January 1994, this amount decreased to 200 megawatts, and the contract will expire at year-end. II-241 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 7. INCOME TAXES Effective January 1, 1993, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. The adoption of Statement No. 109 resulted in cumulative adjustments that had no material effect on net income. The adoption also resulted in the recording of additional deferred income taxes and related assets and liabilities. The related assets of $25 million are revenues to be received from customers. These assets are attributable to tax benefits flowed through to customers in prior years and to taxes applicable to capitalized AFUDC. The related liabilities of $26 million are revenues to be refunded to customers. These liabilities are attributable to deferred taxes previously recognized at rates higher than current enacted tax law and unamortized investment tax credits. Additionally, deferred income taxes related to accelerated tax depreciation previously shown as a reduction to utility plant were reclassified. Details of the federal and state income tax provisions are as follows: The tax effects of temporary differences between the carrying amounts of assets and liabilities in the financial statements and their respective tax bases, which give rise to deferred tax assets and liabilities are as follows: Deferred investment tax credits are amortized over the life of the related property with such amortization normally applied as a credit to reduce depreciation in the Statements of Income. Credits amortized in this manner amounted to $0.7 million in 1993, 1992 and 1991. At December 31, 1993, all investment tax credits available to reduce federal income taxes payable had been utilized. A reconciliation of the effective income tax rate to the statutory tax rate is as follows: The Southern Company and its subsidiaries file a consolidated federal income tax return. Under a joint consolidated income tax agreement, each company's current and deferred tax expense is computed on a stand-alone basis, and consolidated tax savings are allocated to each company based on its ratio of taxable income to total consolidated taxable income. II-242 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 8. CUMULATIVE PREFERRED STOCK In November 1993, the Company issued 1,400,000 shares of 6.64 percent Series Preferred stock which has redemption provisions of $26.66 per share plus accrued dividends if on or prior to November 1, 1998, and at $25 per share plus accrued dividends thereafter. In December 1993, the Company redeemed all 800,000 shares outstanding of its 9.5 percent Series Preferred stock at the prescribed redemption price of $26.57 plus accrued dividends. Cumulative preferred stock dividends are preferential to the payment of dividends on common stock. 9. LONG-TERM DEBT The Company's Indenture related to its First Mortgage Bonds is unlimited as to the authorized amount of bonds which may be issued, provided that required property additions, earnings and other provisions of such Indenture are met. On February 19, 1993, the Company refunded its $4.1 million, 6.25 percent Series Pollution Control Bonds, due 1998 with $4.1 million of variable rate Series Pollution Control Bonds due 2016. In 1994, there is a first mortgage bond maturity of $3.7 million. The sinking fund requirements of first mortgage bonds are being satisfied by certification of property additions. See Note 10 "Long-Term Debt Due Within One Year" for details. Details of other long-term debt are as follows: Sinking fund requirements and /or maturities through 1998 applicable to long-term debt are as follows: $4.5 million in 1994; $0.7 million in 1995; $0.7 million in 1996; $0.1 million in 1997 and no requirement is needed for 1998. Assets acquired under capital leases are recorded as utility plant in service and the related obligation is classified as other long-term debt. Leases are capitalized at the net present value of the future lease payments. However, for ratemaking purposes, these obligations are treated as operating leases, and as such, lease payments are charged to expense as incurred. The Company leases combustion turbine generating equipment under a non-cancelable lease expiring in 1995, with renewal options extending until 2010. The Company also leases a portion of its transportation fleet. Under the terms of these leases, the Company is responsible for taxes, insurance and other expenses. II-243 NOTES (continued) Savannah Electric and Power Company 1993 Annual Report 10. LONG-TERM DEBT DUE WITHIN ONE YEAR A summary of the improvement fund/sinking fund requirements and scheduled maturities and redemptions of long-term debt due within one year is as follows: The first mortgage bond improvement (sinking) fund requirements amount to 1 percent of each outstanding series of bonds authenticated under the indentures prior to January 1 of each year, other than those issued to collateralize pollution control and other obligations. The requirements may be satisfied by depositing cash or reacquiring bonds, or by pledging additional property equal to 1 2/3 times the requirements. 11. COMMON STOCK DIVIDEND RESTRICTIONS The Company's Charter and Indentures contain certain limitations on the payment of cash dividends on the preferred and common stocks. At December 31, 1993, approximately $55 million of retained earnings was restricted against the payment of cash dividends on common stock under the terms of the Mortgage Indenture. 12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows (in thousands): The Company's business is influenced by seasonal weather conditions, a seasonal rate structure and the timing of rate changes, among other factors. II-244 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report Note: NR = Not Rated II-245 SELECTED FINANCIAL AND OPERATING DATA Savannah Electric and Power Company 1993 Annual Report II-246 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-247 SELECTED FINANCIAL AND OPERATING DATA (continued) Savannah Electric and Power Company 1993 Annual Report II-248 STATEMENTS OF INCOME Savannah Electric and Power Company * Tax-free common stock/bond exchange II-249 STATEMENTS OF INCOME Savannah Electric and Power Company II-250 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-251 STATEMENTS OF CASH FLOWS Savannah Electric and Power Company II-252 BALANCE SHEETS Savannah Electric and Power Company II-253 BALANCE SHEETS Savannah Electric and Power Company II-254 BALANCE SHEETS Savannah Electric and Power Company II-255 BALANCE SHEETS Savannah Electric and Power Company II-256 SAVANNAH ELECTRIC AND POWER COMPANY OUTSTANDING SECURITIES AT DECEMBER 31, 1993 FIRST MORTGAGE BONDS II-257 SAVANNAH ELECTRIC AND POWER COMPANY SECURITIES RETIRED DURING 1993 POLLUTION CONTROL BONDS II-258 PART III Items 10, 11, 12 and 13 for SOUTHERN are incorporated by reference to ELECTION OF DIRECTORS in SOUTHERN's definitive Proxy Statement relating to the 1994 annual meeting of stockholders. Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS ALABAMA (a) (1) Identification of directors of ALABAMA. ELMER B. HARRIS (1) President and Chief Executive Officer of ALABAMA Age 54 Served as Director since 3-1-89. BILL M. GUTHRIE Executive Vice President of ALABAMA Age 60 Served as Director since 12-16-88 EDWARD L. ADDISON (2) Age 63 Served as Director since 11-1-83 WHIT ARMSTRONG (2) Age 46 Served as Director since 9-24-82 PHILIP E. AUSTIN (2) Age 52 Served as Director since 1-25-91 MARGARET A. CARPENTER (2) Age 69 Served as Director since 2-26-93 PETER V. GREGERSON, SR. (2) Age 65 Served as Director since 10-22-93 CRAWFORD T. JOHNSON, III (2) Age 68 Served as Director since 4-18-69 CARL E. JONES, JR. (2) Age 53 Served as Director since 4-22-88 WALLACE D. MALONE, JR. (2) Age 57 Served as Director since 6-22-90 WILLIAM V. MUSE (2) Age 54 Served as Director since 2-26-93 JOHN T. PORTER (2) Age 62 Served as Director since 10-22-93 GERALD H. POWELL (2) Age 67 Served as Director since 2-28-86 ROBERT D. POWERS (2) Age 43 Served as Director since 1-24-92 JOHN W. ROUSE (2) Age 56 Served as Director since 4-22-88 WILLIAM J. RUSHTON, III (2) Age 64 Served as Director Since 9-18-70 JAMES H. SANFORD (2) Age 49 Served as Director since 8-1-83 JOHN C. WEBB, IV (2) Age 51 Served as Director since 4-22-77 LOUIS J. WILLIE (2) Age 70 Served as Director since 3-23-84 JOHN W. WOODS (2) Age 62 Served as Director since 4-20-73 (1) Previously served as Director of ALABAMA from 1980 to 1985. (2) No position other than Director. Each of the above is currently a director of ALABAMA, serving a term running from the last annual meeting of ALABAMA's stockholder (April 23, 1993) for III-1 meeting of ALABAMA's stockholder (April 23, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for the individuals elected in October 1993. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of ALABAMA acting solely in their capacities as such. (b)(1) Identification of executive officers of ALABAMA. ELMER B. HARRIS (1) President, Chief Executive Officer and Director Age 54 Served as Executive Officer since 3-1-89 BANKS H. FARRIS Senior Vice President Age 59 Served as Executive Officer since 12-3-91 WILLIAM B. HUTCHINS, III Senior Vice President and Chief Financial Officer Age 50 Served as Executive Officer since 12-3-91 T. HAROLD JONES Senior Vice President Age 63 Served as Executive Officer since 12-1-91 CHARLES D. MCCRARY Senior Vice President Age 42 Served as Executive Officer since 1-1-91 (1) Previously served as executive officer of ALABAMA from 1979 to 1985. Each of the above is currently an executive officer of ALABAMA, serving a term running from the last annual meeting of the directors (April 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of ALABAMA acting solely in their capacities as such. (c)(1) Identification of certain significant employees. None. (d)(1) Family relationships. None. (e)(1) Business experience. ELMER B. HARRIS - Elected in 1989; Chief Executive Officer. He previously served as Senior Executive Vice President of GEORGIA from 1986 to 1989. Director of SOUTHERN and AmSouth Bancorporation. BILL M. GUTHRIE - Elected in 1988; also served since 1991 as Chief Production Officer of SOUTHERN system and Executive Vice President and Chief Production Officer of SCS; Vice President of SOUTHERN, GULF, MISSISSIPPI and SAVANNAH and Executive Vice President of GEORGIA. Responsible primarily for providing overall management of materials management, fuel services, operating and planning services, fossil, hydro and bulk power operations of the Southern electric system. EDWARD L. ADDISON - Elected in 1983; President of SOUTHERN from 1983 until elected Chairman of the Board in 1994. Director of SOUTHERN, GEORGIA, Phelps Dodge Corporation, Protective Life Corporation, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia and CSX Corporation. WHIT ARMSTRONG - President, Chairman and Chief Executive Officer of The Citizens Bank, Enterprise, Alabama. Also, President and Chairman of the Board of Enterprise Capital Corporation, Inc. PHILIP E. AUSTIN - Chancellor, The University of Alabama System. Previously President and Chancellor of Colorado State University. MARGARET A. CARPENTER - President, Compos-it, Inc. (typographics), Montgomery, Alabama. PETER V. GREGERSON, SR. - Chairman Emeritus of Gregerson's Foods, Inc. (retail groceries), Gadsden, Alabama. Director of AmSouth Bank of Gadsden, Alabama. III-2 CRAWFORD T. JOHNSON, III - Chairman of Coca-Cola Bottling Company United, Inc., Birmingham, Alabama. Director of Protective Life Corporation, AmSouth Bancorporation and Russell Corporation. CARL E. JONES, JR. - Chairman and Chief Executive Officer of First Alabama Bank, Mobile, Alabama. WALLACE D. MALONE, JR. - Chairman and Chief Executive Officer of SouthTrust Corporation, bank holding company, Birmingham, Alabama. WILLIAM V. MUSE - President and Chief Executive Officer of Auburn University. He previously served as President of the University of Akron from 1984 to 1992. JOHN T. PORTER - Pastor of Sixth Avenue Baptist Church, Birmingham, Alabama. Director of Citizen Federal Bank. GERALD H. POWELL - President, Dixie Clay Company of Alabama, Inc. (refractory clay producer), Jacksonville, Alabama. ROBERT D. POWERS - President, The Eufaula Agency, Inc. (real estate and insurance), Eufaula, Alabama. JOHN W. ROUSE - President and Chief Executive Officer of Southern Research Institute (non-profit research institute), Birmingham, Alabama. Director of Protective Life Corporation. WILLIAM J. RUSHTON, III - Chairman of the Board, Protective Life Corporation (insurance holding company), Birmingham, Alabama. Director of SOUTHERN and AmSouth Bancorporation. JAMES H. SANFORD - President, HOME Place Farms Inc. (diversified farmers and ginners), Prattville, Alabama. JOHN C. WEBB, IV - President, Webb Lumber Company, Inc. (wholesale lumber), Demopolis, Alabama. LOUIS J. WILLIE - Chairman of the Board and President of Booker T. Washington Insurance Co. Director of SOUTHERN. JOHN W. WOODS - Chairman and Chief Executive Officer, AmSouth Bancorporation (multi-bank holding company), Birmingham, Alabama. Director of Protective Life Corporation. BANKS H. FARRIS - Elected in 1991; responsible primarily for providing the overall management of the Human Resources, Information Resources, Power Delivery and Marketing Departments and the six geographic divisions. He previously served as Vice President - Human Resources from 1989 to 1991 and Division Vice President from 1985 to 1989. WILLIAM B. HUTCHINS, III - Elected in 1991; Chief Financial Officer, responsible primarily for providing the overall management of accounting and financial planning activities. He previously served as Vice President and Treasurer from 1983 to 1991. T. HAROLD JONES - Elected in 1991; responsible primarily for providing the overall management of the Fossil Generation, Hydro Generation, Power Generation Services and Fuels Departments. He previously served as Vice President - Fossil Generation from 1986 to 1991. CHARLES D. MCCRARY - Elected in 1991; responsible for the External Relations Department, Operating Services and Corporate Services. Also, assumes responsibility for financial matters while Mr. Hutchins is on medical leave. He previously served as Vice President of Administrative Services - Nuclear of SCS from 1988 to 1991. (f)(1) Involvement in certain legal proceedings. None. III-3 GEORGIA (a)(2) Identification of directors of GEORGIA. H. ALLEN FRANKLIN President and Chief Executive Officer. Age 49 Served as Director since 1-1-94. WARREN Y. JOBE Executive Vice President, Treasurer and Chief Financial Officer. Age 53 Served as Director since 8-1-82 EDWARD L. ADDISON (1) Age 63 Served as Director since 11-1-83 BENNETT A. BROWN (1) Age 64 Served as Director since 5-15-80 WILLIAM P. COPENHAVER (1) Age 69 Served as Director since 6-18-86 A. W. DAHLBERG (1) Age 53 Served as Director since 6-1-88 WILLIAM A. FICKLING, JR. (1) Age 61 Served as Director since 4-18-73 L. G. HARDMAN, III (1) Age 54 Served as Director since 6-25-79 JAMES R. LIENTZ, JR. (1) Age 50 Served as Director since 7-1-93 WILLIAM A. PARKER, JR. (1) Age 66 Served as Director since 5-19-65 G. JOSEPH PRENDERGAST (1) Age 48 Served as Director since 1-20-93 HERMAN J. RUSSELL (1) AGE 63 Served as Director since 5-18-88 GLORIA M. SHATTO (1) Age 62 Served as Director since 2-20-80 ROBERT STRICKLAND (1) Age 66 Served as Director since 11-21-79 WILLIAM JERRY VEREEN (1) Age 53 Served as Director since 5-18-88 THOMAS R. WILLIAMS (1) Age 65 Served as Director since 3-17-82 (1) No position other than Director. Each of the above is currently a director of GEORGIA, serving a term running from the last annual meeting of GEORGIA's stockholder (May 19, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except Messrs. Franklin and Lientz. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GEORGIA acting solely in their capacities as such. (b)(2) Identification of executive officers of GEORGIA. H. ALLEN FRANKLIN President, Chief Executive Officer and Director Age 49 Served as Executive Officer since 1-1-94 WARREN Y. JOBE Executive Vice President, Treasurer, Chief Financial Officer and Director Age 53 Served as Executive Officer since 5-19-82 III-4 DWIGHT H. EVANS Executive Vice President - External Affairs Age 45 Served as Executive Officer since 4-19-89 GENE R. HODGES Executive Vice President - Customer Operations Age 55 Served as Executive Officer since 11-19-86 KERRY E. ADAMS Senior Vice President - Fossil and Hydro Power Age 49 Served as Executive Officer since 5-1-89 WAYNE T. DAHLKE Senior Vice President - Power Delivery Age 53 Served as Executive Officer since 4-19-89 JAMES K. DAVIS Senior Vice President - Corporate Relations Age 53 Served as Executive Officer since 10-1-93 ROBERT H. HAUBEIN Senior Vice President - Administrative Services Age 54 Served as Executive Officer since 2-19-92 GALE E. KLAPPA Senior Vice President - Marketing Age 43 Served as Executive Officer since 2-19-92 FRED D. WILLIAMS Senior Vice President - Bulk Power Markets Age 49 Served as Executive Officer since 11-18-92 Each of the above is currently an executive officer of GEORGIA, serving a term running from the last annual meeting of the directors (May 19,1993) for one year until the next annual meeting or until his successor is elected and qualified, except Messrs. Franklin and Davis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GEORGIA acting solely in their capacities as such. (c)(2) Identification of certain significant employees. None. (d)(2) Family relationships. None. (e)(2) Business experience. H. ALLEN FRANKLIN - President and Chief Executive Officer since January 1994. He previously served as President and Chief Executive Officer of SCS from 1988 through 1993. Director of SOUTHERN and SouthTrust Bank. WARREN Y. JOBE - Executive Vice President and Chief Financial Officer since 1982 and Treasurer since 1992. Responsible for financial and accounting operations and planning, internal auditing, procurement, corporate secretary and treasury operations. EDWARD L. ADDISON - President of SOUTHERN from 1983 until his election as Chairman of Board in 1994. Director of SOUTHERN, ALABAMA, Wachovia Bank of Georgia, N.A., Wachovia Corporation of Georgia, Phelps Dodge Corporation, Protective Life Corporation and CSX Corporation. BENNETT A. BROWN - Retired from serving as Chairman of the Board of NationsBank on December 31, 1992. Previously Chairman of the Board and Chief Executive Officer of C&S/Sovran Corporation. Director of Confederation Life Insurance Company. WILLIAM P. COPENHAVER - Director, Arcadian Fertilizer, L.P. (agricultural and industrial chemicals). Director of SOUTHERN and Georgia Bank & Trust Company. A. W. DAHLBERG - President of SOUTHERN effective in 1994. He previously served as President and Chief Executive Officer of GEORGIA from 1988 through 1993. Director of SOUTHERN, Trust Company Bank, Trust Company of Georgia, Protective Life Corporation and Equifax, Inc. WILLIAM A. FICKLING, JR. - Chairman of the Board, Mulberry Street Investment Company, Macon, Georgia, and Co-chairman of Beech Street Corporation (insurance). III-5 L. G. HARDMAN, III - Chairman of the Board of First National Bank of Commerce, Georgia and Chairman of the Board and Chief Executive Officer of First Commerce Bancorp. Chairman of the Board, President and Treasurer of Harmony Grove Mills, Inc. (real estate investments). Director of SOUTHERN. JAMES R. LIENTZ, JR. - President of NationsBank of Georgia since 1993. He previously served as President and Chief Executive Officer of former Citizens & Southern Bank of South Carolina (now NationsBank) from 1990 to 1993, and from 1987 to 1990, he was head of Corporate Bank Group of NationsBank of Georgia, N.A. WILLIAM A. PARKER, JR. - Chairman of the Board, Cherokee Investment Company, Inc. (private investments), Atlanta, Georgia. Director of SOUTHERN, Genuine Parts Company, Life Insurance Company of Georgia, First Union Real Estate Investment Trust, Atlantic Realty Company, ING North America Insurance Company, Post Properties, Inc. and Haverty Furniture Companies, Inc. G. JOSEPH PRENDERGAST - President and Chief Executive Officer, Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. since 1993. From 1988 to 1993, he served as Executive Vice President of Wachovia Corporation and President of Wachovia Corporate Services, Inc. HERMAN J. RUSSELL - Chairman of the Board and Chief Executive Officer, H. J. Russell & Company (construction), Atlanta, Georgia. Chairman of the Board, Citizens Trust Bank, and Citizens Bancshares Corporation Atlanta, Georgia. Director of Wachovia Corporation. GLORIA M. SHATTO - President, Berry College, Mount Berry, Georgia. Director of SOUTHERN, Becton Dickinson & Company, Kmart Corporation and Texas Instruments, Inc. ROBERT STRICKLAND - Retired Chairman of the Board and Chief Executive Officer of SunTrust Banks, Inc. Director of Georgia US Corporation, Equifax, Inc., Life Insurance Company of Georgia, Oxford Industries, Inc. and The Investment Centre. WILLIAM JERRY VEREEN - President and Chief Executive Officer of Riverside Manufacturing Company (manufacture and sale of uniforms), Moultrie, Georgia. Director of Gerber Garment Technology, Inc. and Textile Clothing Technology Corp. THOMAS R. WILLIAMS - President of The Wales Group, Inc. (investments) Atlanta, Georgia. Director of ConAgra, Inc., BellSouth Corporation, National Life Insurance Company of Vermont, AppleSouth, Inc., and American Software, Inc. DWIGHT H. EVANS - Executive Vice President - External Affairs since 1989. Senior Vice President - Public Affairs from 1988 to 1989. GENE R. HODGES - Executive Vice President - Customer Operations since 1992. Senior Vice President - Region/Land Operations from 1990 to 1992. Senior Vice President - Division Operations from 1986 to 1990. KERRY E. ADAMS - Senior Vice President - Fossil and Hydro Power since 1989. WAYNE T. DAHLKE - Senior Vice President - Power Delivery since February 1992. Senior Vice President - Marketing from 1989 to 1992. JAMES K. DAVIS - Senior Vice President - Corporate Relations since October 1993. Vice President of Corporate Relations from 1988 to 1993. ROBERT H. HAUBEIN - Senior Vice President - Administrative Services since 1992. Vice President - Northern Region from 1990 to 1992. Division Vice President of ALABAMA from 1985 to 1990. GALE E. KLAPPA - Senior Vice President - Marketing since 1992. Vice President - - Public Relations of SCS from 1981 to 1992. FRED D. WILLIAMS - Senior Vice President - Bulk Markets since 1992. Vice President - Bulk Power Markets from 1984 to 1992. (f)(2) Involvement in certain legal proceedings. None. III-6 GULF (a)(3) Identification of directors of GULF. D. L. MCCRARY (1) Chairman of the Board and Chief Executive Officer Age 64 Served as Director since 4-28-83 TRAVIS J. BOWDEN President Age 55 Served as Director since 2-1-94 PAUL J. DENICOLA (2) Age 45 Served as Director since 4-19-91 REED BELL, SR., M.D. (2) Age 67 Served as Director since 1-17-86 FRED C. DONOVAN, SR. (2) Age 53 Served as Director since 1-18-91 W. D. HULL, JR. (2) Age 61 Served as Director since 10-14-83 C. W. RUCKEL (2) Age 66 Served as Director since 4-20-62 J. K. TANNEHILL (2) Age 60 Served as Director since 7-19-85 (1) Retires May 1, 1994. (2) No position other than Director. Each of the above is currently a director of GULF, serving a term running from the last annual meeting of GULF's stockholder (June 29, 1993) for one year until the next annual meeting or until a successor is elected and qualified, except for Mr. Bowden. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of GULF acting solely in their capacities as such. (b)(3) Identification of executive officers of GULF. D. L. MCCRARY Chairman of the Board and Chief Executive Officer Age 64 Served as Executive Officer since 5-1-83 TRAVIS J. BOWDEN President Age 55 Served as Executive Officer since 2-1-94 F. M. FISHER, JR. Vice President - Employee and External Relations Age 45 Served as Executive Officer since 5-19-89 JOHN E. HODGES, JR. Vice President - Customer Operations Age 50 Served as Executive Officer since 5-19-89 G. EDISON HOLLAND, JR. Vice President and Corporate Counsel Age 41 Served as Executive Officer since 4-25-92 EARL B. PARSONS, JR. Vice President - Power Generation and Transmission Age 55 Served as Executive Officer since 4-14-78 A. E. SCARBROUGH Vice President - Finance Age 57 Served as Executive Officer since 9-21-77 Each of the above is currently an executive officer of GULF, serving a term running from the last annual meeting of the directors (July 23, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except for Mr. Bowden. III-7 There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of GULF acting solely in their capacities as such. (c)(3) Identification of certain significant employees. None. (d)(3) Family relationships. None. (e)(3) Business experience. D. L. MCCRARY - Elected Chairman of the Board effective February 1994. He previously served as President and Chief Executive Officer from 1983 to 1994; responsible primarily for formation of overall corporate policy. TRAVIS J. BOWDEN - Elected President effective February 1994 and, upon Mr. McCrary's retirement May 1994, Chief Executive Officer. He previously served as Executive Vice President of ALABAMA from 1985 to 1994. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. He previously served as Executive Vice President of SCS from 1991 through 1993 and President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, MISSISSIPPI and SAVANNAH. REED BELL, SR., M.D. - Medical Doctor and since 1989, employee of the State of Florida. He serves as Medical Director of Children's Medical Services, District 1. He previously served as Medical Director of the Escambia County Public Health Unit until July 1992. He also previously maintained a private medical practice and served as Medical Director of Children's Medical Services from 1988 to 1989. FRED C. DONOVAN, SR. - President of Baskerville - Donovan, Inc., Pensacola, Florida, an architectural and engineering firm. Director of Baptist Health Care, Inc. W. D. HULL, JR. - Vice Chairman of the Sun Bank/West Florida, Panama City, Florida. He previously served as President and Chief Executive Officer and Director of the Sun Commercial Bank, Panama City, Florida from 1987 to 1992. C. W. RUCKEL - Chairman of the Board of The Vanguard Bank and Trust Company, Valparaiso, Florida. President and owner of Ruckel Properties, Inc., Valparaiso, Florida. J. K. TANNEHILL - President and Chief Executive Officer of Tannehill International Industries, Lynn Haven, Florida. He previously served as President and Chief Executive Officer of Stock Equipment Company, Chagrin Falls, Ohio, until 1991. Director of Sun Bank/West Florida, Panama City, Florida. F. M. FISHER, JR. - Elected Vice President - Employee and External Relations in 1989. He previously served as General Manager of Central Division from 1988 to 1989. JOHN E. HODGES, JR. - Elected Vice President - Customer Operations in 1989. He previously served as General Manager of Western Division from 1986 to 1989. G. EDISON HOLLAND, JR. - Elected Vice President and Corporate Counsel in 1992; responsible for all legal matters associated with GULF and serves as compliance officer. Also served, since 1982, as a partner in the law firm, Beggs & Lane. EARL B. PARSONS, JR. - Elected Vice President - Power Generation and Transmission in 1989; responsible for generation and transmission of electrical energy. He previously served as Vice President - Electric Operations from 1978 to 1989. A. E. SCARBROUGH - Elected Vice President - Finance in 1980; responsible for all accounting and financial services of GULF. (f)(3) Involvement in certain legal proceedings. None. III-8 MISSISSIPPI (a)(4) Identification of directors of MISSISSIPPI. DAVID M. RATCLIFFE President and Chief Executive Officer Age 45 Served as Director since 4-24-91 PAUL J. DENICOLA (1) Age 45 Served as Director since 5-1-89 EDWIN E. DOWNER (1) Age 62 Served as Director since 4-24-84 ROBERT S. GADDIS (1) Age 62 Served as Director since 1-21-86 WALTER H. HURT, III (1) Age 58 Served as Director since 4-6-82 AUBREY K. LUCAS (1) Age 59 Served as Director since 4-24-84 EARL D. MCLEAN, JR. (1) Age 68 Served as Director since 10-21-78 GERALD J. ST. Pe (1) Age 54 Served as Director since 1-21-86 LEO W. SEAL, JR. (1) Age 69 Served as Director since 4-4-67 N. EUGENE WARR (1) Age 58 Served as Director since 1-21-86 (1) No position other than Director. Each of the above is currently a director of MISSISSIPPI, serving a term running from the last annual meeting of MISSISSIPPI's stockholder (April 6, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he or she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of MISSISSIPPI acting solely in their capacities as such. (b)(4) Identification of executive officers of MISSISSIPPI. DAVID M. RATCLIFFE President, Chief Executive Officer and Director Age 45 Served as Executive Officer since 4-24-91 H. E. BLAKESLEE Vice President - Customer Services and Marketing Age 53 Served as Executive Officer since 1-25-84 THOMAS A. FANNING Vice President and Chief Financial Officer Age 37 Served as Executive Officer since 4-1-92 DON E. MASON Vice President - External Affairs and Corporate Services Age 52 Served as Executive Officer since 7-27-83 Each of the above is currently an executive officer of MISSISSIPPI, serving a term running from the last annual meeting of the directors (April 28, 1993) for one year until the next annual meeting or until his successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of MISSISSIPPI acting solely in their capacities as such. (c)(4) Identification of certain significant employees. None. (d)(4) Family relationships. None. (e)(4) Business experience. III-9 DAVID M. RATCLIFFE - President and Chief Executive Officer since 1991. He previously served as Executive Vice President of SCS from 1989 to 1991 and Vice President of SCS from 1985 to 1989. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, SAVANNAH and GULF. EDWIN E. DOWNER - Business consultant specializing in economic analysis, management controls and procedural studies since 1990. President and Chief Executive Officer, Unifirst Bank for Savings, F.A., Midland Division, Meridian, Mississippi from 1985 to 1990. ROBERT S. GADDIS - President of the Trustmark National Bank - Laurel, Mississippi. WALTER H. HURT, III - President and Director of NPC Inc. (Investments). Vicar, All Saints Church, Inverness, Mississippi, and St. Thomas Church, Belzoni, Mississippi. Retired newspaper editor and publisher. AUBREY K. LUCAS - President of the University of Southern Mississippi, Hattiesburg, Mississippi. EARL D. MCLEAN, JR. - Co-owner of the T. C. Griffith Insurance Agency, Inc. (insurance and real estate), Columbia, Mississippi. Director of SOUTHERN. GERALD J. ST. Pe - President of Ingalls Shipbuilding and Corporate Vice President of Litton Industries, Inc. since 1985. Director of Merchants and Marine Bank, Pascagoula, Mississippi. LEO W. SEAL, JR. - Chairman of the Board and Chief Executive Officer of Hancock Bank, Gulfport, Mississippi, and Chairman of the Board of Harrison Life Insurance Company. Director of Hancock Bank and Bank of Wiggins. N. EUGENE WARR - Retailer (Biloxi and Gulfport, Mississippi.) Chairman of the Board of First Jefferson Corporation and the Jefferson Bank of Biloxi, Mississippi. H. E. BLAKESLEE - Elected Vice President in 1984. Primarily responsible for rate design, economic analysis and revenue forecasting, economic development, marketing and district operations. THOMAS A. FANNING - Elected Vice President in 1992; responsible primarily for accounting, treasury, finance, information resources and risk management. He previously served as Treasurer of SEI from 1986 to 1992 and Director of Corporate Finance of SCS from 1988 to 1992. DON E. MASON - Elected Vice President in 1983. Primarily responsible for the external affairs functions, including governmental and regulatory affairs, corporate communications, security, materials and general services, as well as the human resources function. (f)(4) Involvement in certain legal proceedings. None. SAVANNAH (a)(5) Identification of directors of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President and Chief Executive Officer Age 61 Served as Director since 8-31-82 HELEN QUATTLEBAUM ARTLEY (1) Age 66 Served as Director since 5-17-77 PAUL J. DENICOLA (1) Age 45 Served as Director since 3-14-91 BRIAN R. FOSTER (1) Age 44 Served as Director since 5-16-89 WALTER D. GNANN (1) Age 58 Served as Director since 5-17-83 JOHN M. MCINTOSH (1) Age 69 Served as Director since 2-27-68 III-10 ROBERT B. MILLER, III (1) Age 48 Served as Director since 5-17-83 JAMES M. PIETTE (1) Age 69 Served as Director since 6-12-73 ARNOLD M. TENEBAUM (1) Age 57 Served as Director since 5-17-77 FREDERICK F. WILLIAMS, JR. (1) Age 66 Served as Director since 7-2-75 (1) No Position other than Director. Each of the above is currently a director of SAVANNAH, serving a term running from the last annual meeting of SAVANNAH's stockholder (May 18, 1993) for one year until the next annual meeting or until a successor is elected and qualified. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he/she was or is to be selected as a director or nominee, other than any arrangements or understandings with directors or officers of SAVANNAH acting solely in their capacities as such. (b)(5) Identification of executive officers of SAVANNAH. ARTHUR M. GIGNILLIAT, JR. President, Chief Executive Officer and Director Age 61 Served as Executive Officer since 2-15-72 W. MILES GREER Vice President - Marketing and Customer Services Age 50 Served as Executive Officer since 11-20-85 LARRY M. PORTER Vice President - Operations Age 49 Served as Executive Officer since 7-1-91 KIRBY R. WILLIS Vice President, Treasurer and Chief Financial Officer Age 42 Served as Executive Officer since 1-1-94 Each of the above is currently an executive officer of SAVANNAH, serving a term running from the last annual meeting of the directors (May 18, 1993) for one year until the next annual meeting or until his successor is elected and qualified, except Mr. Willis. There are no arrangements or understandings between any of the individuals listed above and any other person pursuant to which he was or is to be selected as an officer, other than any arrangements or understandings with officers of SAVANNAH acting solely in their capacities as such. (c)(5) Identification of certain significant employees. None. (d)(5) Family relationships. None. (e)(5) Business experience. ARTHUR M. GIGNILLIAT, JR. - Elected President and Chief Executive Officer in 1985. Director of Savannah Foods and Industries, Inc. HELEN QUATTLEBAUM ARTLEY - Homemaker and Civic Worker. PAUL J. DENICOLA - President and Chief Executive Officer of SCS effective January 1994. Executive Vice President of SCS from 1991 through 1993. He previously served as President and Chief Executive Officer of MISSISSIPPI from 1989 to 1991. Director of SOUTHERN, GULF and MISSISSIPPI. BRIAN R. FOSTER - President of NationsBank of Georgia, N.A., in Savannah since 1988. WALTER D. GNANN - President of Walt's TV, Appliance and Furniture Co., Inc., Springfield, Georgia. Past Chairman of the Development Authority of Effingham County, Georgia. III-11 JOHN M. MCINTOSH - Chairman of the Executive Committee, SAVANNAH; retired Chairman of the Board of Directors and Chief Executive Officer, SAVANNAH from 1974 to 1984. Director of SOUTHERN. ROBERT B. MILLER, III - President of American Builders of Savannah. JAMES M. PIETTE - Vice President - Special Projects, Union Camp Corporation, since 1989. Retired Vice Chairman, Board of Directors, Union Camp Corporation from 1987 to 1989. ARNOLD M. TENENBAUM - President of Chatham Steel Corporation. Director of First Union National Bank of Georgia and Savannah Foods and Industries, Inc. FREDERICK F. WILLIAMS, JR. - Retired Partner and Consultant, Hilb, Rogal and Hamilton Employee Benefits, Incorporated (Insurance Brokers), formerly Jones, Hill & Mercer. W. MILES GREER - Vice President - Marketing and Customer Services effective January 1994. Formerly served as Vice President - Economic Development and Corporate Services from 1989 through 1993 and Vice President - Economic Development and Governmental Affairs from 1985 to 1989. LARRY M. PORTER - Vice President - Operations since 1991. Responsible for managing the areas of fuel procurement, power production, transmission and distribution, engineering and system operation. Previously he served as Assistant Plant Manager of GEORGIA's Plant Scherer from 1984 to 1991. KIRBY R. WILLIS - Vice President, Treasurer and Chief Financial Officer effective January 1994. Responsible for all financial activities, Information Resources, Human Resources, Corporate Services, and Environmental Affairs and Safety. He previously served as Treasurer, Controller and Assistant Secretary from 1991 to 1993 and Treasurer and Secretary from 1987 to 1991. (f)(5) Involvement in certain legal proceedings. None. III-12 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (A) SUMMARY COMPENSATION TABLES. The following tables set forth information concerning the Chief Executive Officer and the four most highly compensated executive officers for each of the operating affiliates (ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH), serving as of December 31, 1993 whose total annual salary and bonus exceeded $100,000. No information is provided for any person for any year in which such person did not serve as an executive officer of the operating affiliate. The number of SOUTHERN common shares do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. KEY TERMS used in this Item will have the following meanings:- AME........... ABOVE-MARKET EARNINGS ON DEFERRED COMPENSATION ESP........... EMPLOYEE SAVINGS PLAN ESOP.......... EMPLOYEE STOCK OWNERSHIP PLAN SBP........... SUPPLEMENTAL BENEFIT PLAN VBP........... VEHICLE BUYOUT PROGRAM ALABAMA SUMMARY COMPENSATION TABLE III-13 ALABAMA SUMMARY COMPENSATION TABLE (CONTINUED) (1) Tax reimbursement by ALABAMA and certain personal benefits, including membership fee of $28,402 for Mr. Jones in 1992. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) ALABAMA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans), and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- E. B. Harris $6,746 $1,709 $12,933 $18,000 T. J. Bowden 8,369 1,709 3,193 18,000 B. H. Farris 7,193 1,499 726 18,000 T. H. Jones 6,908 1,331 754 5,100 W. B. Hutchins, III 6,746 1,400 671 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective January 31, 1994, Mr. Bowden resigned to become president of GULF. III-14 GEORGIA SUMMARY COMPENSATION TABLE (1) Due to the pay schedules at GEORGIA, 1992 salary reflects one additional pay period compared with 1991. (2) Tax reimbursement by GEORGIA on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (3) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (4) GEORGIA contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- A. W. Dahlberg $6,746 $1,709 $18,092 $18,000 D. H. Evans 8,592 1,709 1,218 18,000 W. Y. Jobe 7,667 1,709 1,882 18,000 G. R. Hodges 7,349 1,620 3,660 18,000 K. E. Adams 7,204 1,634 1,462 18,000 In accordance with the transition rules of the SEC, information for 1991 is omitted. (5) Effective December 31, 1993, Mr. Dahlberg resigned to become president of SOUTHERN. III-15 GULF SUMMARY COMPENSATION TABLE (1) Tax reimbursement by GULF on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) GULF contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- D. L. McCrary $9,300 $1,709 $6,057 $ 2,788 G. E. Holland, Jr. 4,652 - - 16,363 E. B. Parsons, Jr 6,948 1,709 410 16,363 A. E. Scarbrough 6,746 1,338 282 16,363 J. E. Hodges, Jr. 6,651 1,313 - 16,363 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Employee and executive officer of GULF since April 25, 1992. Not eligible to participate in the Long-Term Incentive Plan until January 1, 1993. (5) "All Other Compensation" previously reported as $4,149 for Mr. Holland in the Form 10-K for the year ended December 31, 1992, should have been $0 since Mr. Holland was not yet eligible to participate in ESP and ESOP. III-16 MISSISSIPPI SUMMARY COMPENSATION TABLE (1) Tax reimbursement by MISSISSIPPI on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) MISSISSIPPI contributions to the ESP, ESOP, non-pension related accruals under the SBP (ERISA excess plan under which accruals are made to offset Internal Revenue Code imposed limitations under the Employee Savings and Stock Ownership Plans) and payments under a VBP for the following:- Name ESP ESOP SBP VBP - ---- --- ---- --- --- David M. Ratcliffe $7,895 $1,709 $2,774 $5,509 R. G. Dawson 6,746 1,252 - 7,045 H. E. Blakeslee 6,843 1,355 - 7,452 D. E. Mason 6,671 1,286 - 7,452 T. A. Fanning 5,520 1,019 - 8,116 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Effective March 1, 1994, Mr. Dawson resigned to become a vice president of SEI. (5) Benefits under MISSISSIPPI's VBP for 1992 in the amounts of $13,169 and $12,425 to Messrs. Dawson and Fanning, respectively, previously reported in the Form 10-K for the year ended December 31, 1992, under the "Other Annual Compensation" column have been moved to the "All Other Compensation" column. III-17 SAVANNAH SUMMARY COMPENSATION TABLE (1) Tax reimbursement by SAVANNAH on certain personal benefits. In accordance with the transition rules of the SEC, information for 1991 is omitted. (2) Payouts made in 1992, 1993 and 1994 for the four-year performance periods ending December 31, 1991, 1992 and 1993, respectively. (3) SAVANNAH contributions to the ESP, under Section 401(k) of the Internal Revenue Code, ESOP, AME and payments under a VBP for the following:- Name ESP ESOP AME VBP - ---- --- ---- --- --- A. M. Gignilliat $6,746 $3,092 $7,479 $14,195 E. O. Veale 6,163 2,359 5,702 - L. M. Porter 4,943 1,774 658 14,195 W. M. Greer 5,045 1,764 877 14,195 J. L. Rayburn 2,284 1,650 1,911 14,195 In accordance with the transition rules of the SEC, information for 1991 is omitted. (4) Retired effective December 31, 1993. (5) Not eligible for Long-term Incentive Payout until January 1, 1994. (6) Resigned effective December 31, 1993. III-18 STOCK OPTION GRANTS IN 1993 (B) STOCK OPTION GRANTS. The following table sets forth all stock option grants to the named executive officers of each operating subsidiary during the year ending December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-19 STOCK OPTION GRANTS IN 1993 (1) Grants were made on July 19, 1993, and vest 25% per year on the anniversary date of the grant. Grants fully vest upon termination incident to death, disability, or retirement. The exercise price is the average of the high and low fair market value of SOUTHERN's common stock on the date granted. In accordance with the terms of the Executive Stock Plan, Mr. Jones' unexercised options expire on April 1, 1998, three years after his normal retirement date; Mr. McCrary's unexercised options expire on May 1, 1997, three years after his normal retirement date; and Mr. Gignilliat's unexercised options expire on September 3, 2000, three years after his normal retirement date. (2) A total of 179,746 stock options were granted in 1993 to key executives participating in SOUTHERN's Executive Stock Plan. (3) Based on the Black-Scholes option valuation model. The actual value, if any, an executive officer may realize ultimately depends on the market value of SOUTHERN's common stock at a future date. This valuation is provided pursuant to SEC disclosure rules and there is no assurance that the value realized will be at or near the value estimated by the Black-Scholes model. Assumptions used to calculate this value: price volatility - 12.45%; risk-free rate of return - 5.81%; dividend yield - 5.37%; and time to exercise - ten years. III-20 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (C) AGGREGATED STOCK OPTION EXERCISES. The following table sets forth information concerning options exercised during the year ending December 31, 1993, by the named executive officers and the value of unexercised options held by them as of December 31, 1993. The number of SOUTHERN common shares shown and the per share exercise price and market price do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN's board of directors in January, 1994. See next page for footnotes. III-21 AGGREGATED STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES (1) This represents the excess of the fair market value of SOUTHERN's common stock of $44.125 per share, as of December 31, 1993, above the exercise price of the options. One column reports the "value" of options that are vested and therefore could be exercised; the other "value" of options that are not vested and therefore could not be exercised as of December 31, 1993. (2) The "Value Realized" is ordinary income, before taxes, and represents the amount equal to the excess of the fair market value of the shares at the time of exercise over the exercise price. III-22 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 (D) LONG-TERM INCENTIVE PLANS. The following table sets forth the long-term incentive plan awards made to the named executive officers for the performance period January 1, 1993 through December 31, 1996. See next page for footnotes. III-23 LONG-TERM INCENTIVE PLANS - AWARDS IN 1993 III-24 PENSION PLAN TABLE (e)(1) The following table sets forth the estimated combined annual pension benefits under the pension and supplemental defined benefit plans in effect during 1993 for ALABAMA, GEORGIA, GULF and MISSISSIPPI. Employee compensation covered by the pension and supplemental benefit plans for pension purposes is limited to the average of the highest three of the final 10 years' base salary and wages (reported under column titled "Salary" in the Summary Compensation Tables on pages III-13 through III-18). The amounts shown in the table were calculated according to the final average pay formula and are based on a single life annuity without reduction for joint and survivor annuities (although married employees are required to have their pension benefits paid in one of various joint and survivor annuity forms, unless the employee elects otherwise with the spouse's consent) or computation of the Social Security offset which would apply in most cases. This offset amounts to one-half of the estimated Social Security benefit (primary insurance amount) in excess of $3,000 per year times the number of years of accredited service, divided by the total possible years of accredited service to normal retirement age. As of December 31, 1993, the applicable compensation levels and years of accredited service are presented in the following tables: III-25 SAVANNAH has in effect a qualified, trusteed, noncontributory, defined benefit pension plan which provides pension benefits to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. The plan provides pension benefits under a formula which includes each participant's years of service with the Southern system and average annual earnings of the highest three of the final ten years of service with the Southern system preceding retirement. Plan benefits are reduced by a portion of the benefits participants are entitled to receive under Social Security. The plan provides for reduced early retirement benefits at age 55 and a pension for the surviving spouse equal to one-half of the deceased retiree's pension. The following table sets forth the estimated annual pension benefits under the pension plan in effect during 1993 which are payable by SAVANNAH to employees upon retirement at the normal retirement age after designated periods of accredited service and at a specified compensation level. (1)The number of accredited years of service includes ten years credited to Mr. Holland pursuant to a supplemental pension agreement. III-26 As of December 31, 1993, the applicable compensation levels and years of accredited service is presented in the following table: (e)(2) DEFERRED COMPENSATION PLAN; SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN. SAVANNAH has in effect a voluntary deferred compensation plan for certain executive employees pursuant to which such employees may defer a portion of their respective annual salaries. In addition, SAVANNAH has a supplemental executive retirement plan for certain of its executive employees which became effective January 1, 1984. The deferred compensation plan is designed to provide supplemental retirement or survivor benefit payments. The supplemental executive retirement plan is also designed to provide retiring executives of SAVANNAH with a supplemental retirement benefit, which, in conjunction with social security and benefits under SAVANNAH's qualified pension plan, will equal 70 percent of the highest three of the final ten years average annual compensation (including deferrals under the deferred compensation plan). Both of these plans are unfunded and the liability is payable from general funds of SAVANNAH. The deferred compensation plan became effective December 1, 1983, and all of SAVANNAH's executive officers are participating in the plan. In addition, all executives are participating in the supplemental executive retirement plan. In order to provide for its liabilities under the deferred compensation plan and the supplemental executive retirement plan, SAVANNAH has purchased life insurance on participating executive employees in actuarially determined amounts which, based upon assumptions as to mortality experience, policy dividends, tax effects, and other factors which, if realized, along with compensation deferred by employees and the death benefits payable to (1) The plan benefits are subject to the maximum benefit limitations set forth in Section 415 of the Internal Revenue Code. III-27 SAVANNAH, are expected to cover all such insurance premium payments, and all benefit payments to participants, plus a factor for the cost of funds of SAVANNAH. (f) COMPENSATION OF DIRECTORS. (1) Standard Arrangements. The following table presents compensation paid to the directors, during 1993 for service as a member of the board of directors and any board committee(s), except that employee directors received no fees or compensation for service as a member of the board of directors or any board committee. All or a portion of these fees may be deferred until membership on the board is terminated. ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH also provide retirement benefits to non-employee directors who are credited with a minimum of 60 months of service on the board of directors of one or more system companies, under the Outside Directors Pension Plan. Eligible directors are entitled to benefits under the Plan upon retirement from the board on the retirement date designated in the respective companies by-laws. The annual benefit payable ranges from 75 to 100 percent of the annual retainer fee in effect on the date of retirement, based upon length of service. Payments continue for the greater of the lifetime of the participant or 10 years. (2) Other Arrangements. No director received other compensation for services as a director during the year ending December 31, 1993 in addition to or in lieu of that specified by the standard arrangements specified above. (1) Committee Chairmen receive an additional $500 per year fee. (2) Established for period September 15, 1993 through May 31, 1994. (3) Chairman of Executive Committee receives an additional $3,000 per month fee. III-28 (g) EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE IN CONTROL ARRANGEMENTS. None. (h) REPORT ON REPRICING OF OPTIONS. None. (i) ADDITIONAL INFORMATION WITH RESPECT TO COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISION. ALABAMA Elmer B. Harris serves on the Compensation Committee of AmSouth Bancorporation. John W. Woods, a director of ALABAMA is an executive officer of AmSouth Bancorporation. GULF Messrs. Paul J. DeNicola and Douglas L. McCrary are ex officio members of its Compensation Committee. III-29 ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. SOUTHERN is the beneficial owner of 100% of the outstanding common stock of registrants ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH. (B) SECURITY OWNERSHIP OF MANAGEMENT. The following table shows the number of shares of SOUTHERN common stock and operating subsidiary preferred stock owned by the directors, nominees and executive officers as of December 31, 1993. It is based on information furnished by the directors, nominees and executive officers. The shares owned by all directors, nominees and executive officers as a group constitute less than one percent of the total number of shares of the respective classes outstanding on December 31, 1993. The number of SOUTHERN common shares shown do not reflect the stock distribution resulting from the two-for-one common stock split approved by SOUTHERN'S board of directors in January, 1994. III-30 III-31 III-32 III-33 (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security and/or investment power with respect to a security (i.e., the power to dispose of, or to direct the disposition of, a security). (2) The shares shown include shares of common stock of which certain directors and executive officers have the right to acquire beneficial ownership within 60 days pursuant to the Executive Stock Plan, as follows: Mr. Addison, 86,357 shares; Mr. Blakeslee, 660 shares; Mr. Bowden, 5,763 shares; Mr. Dahlberg, 4,278 shares; Mr. Farris, 863 shares; Mr. Gignilliat, 8,556 shares; Mr. Guthrie 15,720 shares; Mr. Harris, 14,215 shares; Mr. Haubein, 835 shares; Mr. Hodges, 5,429 shares; Mr. Holland, 698 shares; Mr. Hutchins, 706 shares; Mr. Jones, 848 shares; Mr. Klappa, 671 shares, Mr. C. D. McCrary, 691 shares; Mr. D. L. McCrary, 9,668 shares; and Mr. Ratcliffe, 5,643 shares. Also included are shares of SOUTHERN common stock held by the spouses of the following directors: Mr. Addison, 670 shares; Mr. Copenhaver, 350 shares; Mr. Harris, 155 shares; Mr. Parker, 22 shares; and Dr. Shatto, 5,067 shares. III-34 (C) CHANGES IN CONTROL. The operating affiliates know of no arrangements which may at a subsequent date result in any change in control. GEORGIA'S Mr. Russell failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MISSISSIPPI'S Messrs. McLean, Jr., Hurt and Seal, Jr. each failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. SAVANNAH'S Mr. Gnann failed to file on a timely basis a single report disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. MR. DENICOLA, a director of GULF, MISSISSIPPI and SAVANNAH, failed to file on a timely basis a single report, disclosing one transaction on Form 4 as required by Section 16 of the Securities Exchange Act of 1934. III-35 ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALABAMA (a) Transactions with management and others. During 1993, ALABAMA, in the ordinary course of business, paid premiums amounting to approximately $400,000 for various types of insurance policies purchased from Protective Life Insurance Company, a subsidiary of Protective Life Corporation, a company in which Mr. William J. Rushton, III, a director of ALABAMA, owns an interest and of which he serves as Chairman. The firm of Inzer, Stivender, Haney & Johnson, P.A., performed certain legal services for ALABAMA during 1993. Mr. James C. Inzer, Jr., partner in this firm, is also a director of ALABAMA. ALABAMA purchased automobiles and parts in the amount of approximately $200,000 from companies in which Mr. Blount, a director of ALABAMA, owns 85% interests. ALABAMA purchased electrical supplies in the amount of approximately $200,000 from L & K Electric Supply Company, Ltd. during 1993. Mr. Willie, director of ALABAMA and SOUTHERN, owns an interest in and serves as president of this firm. ALABAMA believes that these transactions have been on terms representing competitive market prices that are no less favorable than those available from others. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GEORGIA (a) Transactions with management and others. In 1993, GEORGIA was indebted in a maximum amount of $105 million to Wachovia Bank and its affiliates, of which G. Joseph Prendergast serves as President and Chief Executive Officer of Wachovia Corporation of Georgia and Wachovia Bank of Georgia, N.A. In 1993, GEORGIA was indebted in a maximum amount of $285 million to NationsBank and its affiliates of which Mr. James R. Lientz, Jr. serves as President of NationsBank of Georgia. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. GULF (a) Transactions with management and others. The firm of Beggs & Lane, P.A. serves as local counsel for GULF and received from GULF approximately $800,000 for services rendered. Mr. G. Edison Holland, Jr. is a partner in the firm and also serves as Vice President and Corporate Counsel of GULF. (b) Certain business relationships. None. (c) Indebtedness of management. None. (d) Transactions with promoters. None. MISSISSIPPI (a) Certain business relationships. During 1993, MISSISSIPPI was indebted in a maximum amount of $12.4 million to Hancock Bank, of which Leo W. Seal, Jr. serves as Chairman of the Board and Chief Executive Officer. (b) Certain business relationships. None. (c) Indebtedness of management. None. III-36 (d) Transactions with promoters. None. SAVANNAH (a) Transactions with management and others. Mr. Tenenbaum is a Director of First Union national Bank of Georgia, and Mr. Foster is President of NationsBank of Georgia, N.A., in Savannah. During 1993, these banks furnished a number of regular banking services in the ordinary course of business to SAVANNAH. SAVANNAH intends to maintain normal banking relations with all of the aforesaid banks in the future. (b) Certain business relationships. (c) Indebtedness of management. None. (d) Transactions with promoters. None. III-37 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 on this Form 10-K: (1) Financial Statements: Reports of Independent Public Accountants on the financial statements for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. The financial statements filed as a part of this report for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed under Item 8 herein. (2) Financial Statement Schedules: Reports of Independent Public Accountants as to Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are included herein on pages IV-12 through IV-17. Financial Statement Schedules for SOUTHERN and Subsidiary Companies, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Index to the Financial Statement Schedules at page S-1. (3) Exhibits: Exhibits for SOUTHERN, ALABAMA, GEORGIA, GULF, MISSISSIPPI and SAVANNAH are listed in the Exhibit Index at page E-1. (b) Reports on Form 8-K: During the fourth quarter of 1993 the registrants filed Current Reports on Form 8-K as follows: ALABAMA filed Forms 8-K dated October 27, 1993, and November 16, 1993, to facilitate security sales. GEORGIA filed a Form 8-K dated October 20, 1993, to facilitate a security sale. GULF filed a Form 8-K dated November 3, 1993, to facilitate a security sale. SAVANNAH filed a Form 8-K dated November 9, 1993, to facilitate a security sale. IV-1 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 SOUTHERN COMPANY By Edward L. Addison, Chairman By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Edward L. Addison Chairman of the Board (Principal Executive Officer) W. L. Westbrook Financial Vice President (Principal Financial and Accounting Officer) Directors: W. P. Copenhaver John M. McIntosh. A. W. Dahlberg Earl D. McLean, Jr. Paul J. DeNicola William A. Parker Jack Edwards William J. Rushton, III H. Allen Franklin Gloria M. Shatto L. G. Hardman, III Herbert Stockham Elmer B. Harris Louis J. Willie By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. ALABAMA POWER COMPANY By Elmer B. Harris, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Elmer B. Harris President, Chief Executive Officer and Director (Principal Executive Officer) Charles D. McCrary Senior Vice President (Principal Financial Officer) David L. Whitson Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison William V. Muse Whit Armstrong John T. Porter Philip E. Austin Gerald H. Powell Margaret A. Carpenter Robert D. Powers Peter V. Gregerson, Sr. John W. Rouse Bill M. Guthrie James H. Sanford Crawford T. Johnson, III John Cox Webb, IV Carl E. Jones, Jr. Louis J. Willie Wallace D. Malone, Jr. John W. Woods By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-2 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. GEORGIA POWER COMPANY By H. Allen Franklin, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. H. Allen Franklin President, Chief Executive Officer and Director (Principal Executive Officer) Warren Y. Jobe Executive Vice President, Treasurer, Chief Financial Officer and Director (Principal Financial Officer) C. B. Harreld Vice President and Comptroller (Principal Accounting Officer) Directors: Edward L. Addison G. Joseph Prendergast Bennett A. Brown Herman J. Russell William P. Copenhaver Gloria M. Shatto A. W. Dahlberg Robert Strickland William A. Fickling, Jr. William Jerry Vereen L. G. Hardman, III Thomas R. Williams James R. Lientz, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. GULF POWER COMPANY By D. L. McCrary, Chairman of the Board By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. D. L. McCrary Chairman of the Board and Chief Executive Officer (Principal Executive Officer) A. E. Scarbrough Vice President - Finance (Principal Financial and Accounting Officer) Directors: Reed Bell Travis J. Bowden Paul J. DeNicola Fred C. Donovan W. D. Hull, Jr. C. W. Ruckel J. K. Tannehill By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25,1994 IV-3 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 COMPANY By David M. Ratcliffe, President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. David M. Ratcliffe President, Chief Executive Officer and Director (Principal Executive Officer) Thomas A. Fanning Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Paul J. DeNicola Edwin E. Downer Robert S. Gaddis Walter H. Hurt, III Aubrey K. Lucas Earl D. McLean, Jr. Gerald J. St. Pe' Leo W. Seal, Jr. N. Eugene Warr By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 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. SAVANNAH ELECTRIC AND POWER COMPANY By Arthur M. Gignilliat, Jr., President By Wayne Boston (Wayne Boston, Attorney-in-fact) 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. 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. Arthur M. Gignilliat, Jr. President, Chief Executive Officer and Director (Principal Executive Officer) Kirby R. Willis Vice President, Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: Helen Q. Artley Paul J. DeNicola Brian R. Foster Walter D. Gnann John M. McIntosh Robert B. Miller, III James M. Piette Arnold M. Tenenbaum Frederick F. Williams, Jr. By Wayne Boston (Wayne Boston, Attorney-in-fact) Date: March 25, 1994 IV-4 EXHIBIT 21. SUBSIDIARIES OF THE REGISTRANTS. (1) Owned by Alabama Power Company. (2) Owned by Georgia Power Company. (3) Owned by SEI Holdings, Inc. (4) 94% owned jointly by Asociados de Electricidad, S. A. (14%) and SEI Holdings, Inc. (80%) (5) 59% owned by SEI y Asociados de Argentina, S. A. (6) Owned by SEI Holdings III, Inc. (7) 36% owned by SEI Chile, S. A. (8) Owned by SEI Holdings IV, Inc. (9) Owned jointly by Inversores de Electricidad, S. A. (15%) and SEI Bahamas Argentina I, Inc. (85%) (10) Owned by Southern Electric Bahamas Holdings, Ltd. (11) 50% owned by Southern Electric Bahamas, Ltd. (12) Owned equally by Alabama Power Company and Georgia Power Company. (13) Owned by Southern Electric International, Inc. (14) Owned by Southern Electric Wholesale Generators, Inc. IV-5 ARTHUR ANDERSEN & CO. Exhibit 23(a) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of The Southern Company and its subsidiaries and the related financial statement schedules, included in this Form 10-K, into The Southern Company's previously filed Registration Statement File Nos. 2-78617, 33-3546, 33-23152, 33-30171, 33-23153 and 33-51433. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-6 ARTHUR ANDERSEN & CO. Exhibit 23(b) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Alabama Power Company and the related financial statement schedules, included in this Form 10-K, into Alabama Power Company's previously filed Registration Statement File No. 33-49653. /s/ Arthur Andersen & Co. Birmingham, Alabama March 25, 1994 IV-7 ARTHUR ANDERSEN & CO. Exhibit 23(c) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Georgia Power Company and the related financial statement schedules, included in this Form 10-K, into Georgia Power Company's previously filed Registration Statement File No. 33-49661. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-8 ARTHUR ANDERSEN & CO. Exhibit 23(d) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Gulf Power Company and the related financial statement schedules, included in this Form 10-K, into Gulf Power Company's previously filed Registration Statement File No. 33-50165. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-9 ARTHUR ANDERSEN & CO. Exhibit 23(e) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Mississippi Power Company and the related financial statement schedules, included in this Form 10-K, into Mississippi Power Company's previously filed Registration Statement File Nos. 33-49320 and 33-49649. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-10 ARTHUR ANDERSEN & CO. Exhibit 23(f) CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 16, 1994 on the financial statements of Savannah Electric and Power Company and the related financial statement schedules, included in this Form 10-K, into Savannah Electric and Power Company's previously filed Registration Statement File Nos. 33-45757 and 33-52509. /s/ Arthur Andersen & Co. Atlanta, Georgia March 25, 1994 IV-11 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To The Southern Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of The Southern Company and its subsidiaries included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the consolidated financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding recoverability of the investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to The Southern Company's consolidated financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to The Southern Company and its subsidiaries (pages S-2 and S-3, S-11 through S-14, S-35 through S-37, S-53, and S-59) are the responsibility of The Southern 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 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-12 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Alabama Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Alabama Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Alabama Power Company (pages S-4, S-15 through S-18, S-38 through S-40, S-54, and S-60) are the responsibility of Alabama Power 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. /s/ Arthur Andersen & Co. Birmingham, Alabama February 16, 1994 IV-13 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Georgia Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Georgia Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our report on the financial statements includes an explanatory paragraph which states that an uncertainty exists with respect to the actions of the regulators regarding the recoverability of Georgia Power Company's investment in the Rocky Mountain pumped storage hydroelectric project, as discussed in Note 4 to Georgia Power Company's financial statements. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Georgia Power Company (pages S-5, S-19 through S-22, S-41 through S-43, S-55, and S-61) are the responsibility of Georgia Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-14 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Gulf Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Gulf Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Gulf Power Company (pages S-6, S-23 through S-26, S-44 through S-46, S-56, and S-62) are the responsibility of Gulf Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-15 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Mississippi Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Mississippi Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Mississippi Power Company (pages S-7 and S-8, S-27 through S-30, S-47 through S-49, S-57, and S-63) are the responsibility of Mississippi Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-16 ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS AS TO SCHEDULES To Savannah Electric and Power Company: We have audited in accordance with generally accepted auditing standards, the financial statements of Savannah Electric and Power Company included in this Form 10-K, and have issued our report thereon dated February 16, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)(2) herein as it relates to Savannah Electric and Power Company (pages S-9 and S-10, S-31 through S-34, S-50 through S-52, S-58, and S-64) are the responsibility of Savannah Electric and Power 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. /s/ Arthur Andersen & Co. Atlanta, Georgia February 16, 1994 IV-17 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules I through XIV not listed above are omitted as not applicable or not required. Columns omitted from schedules filed have been omitted because the information is not applicable or not required. S-1 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) See Summary of Transactions and Notes on Page S-3 S-2 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of retirements to acquisition adjustments. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. (NOTE 1) OTHER CHANGES INCLUDE THE FOLLOWING (STATED IN THOUSANDS OF DOLLARS) S-3 ALABAMA POWER COMPANY SCHEDULE V -- UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements below include non-depreciable plant retirements. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes include a reduction to utility plant of $61,960,000 for the partial sale of Miller Steam Plant in 1992. S-4 GEORGIA POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Retirements include non-depreciable plant retirements and unamortized portions of Plant Scherer acquisition adjustment retired for sales in 1991 and 1993. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Other changes for 1993, include an increase to plant of $46,473,000 for the taxes applicable to capitalized AFUDC debt. S-5 GULF POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991, 1992 and 1993, as summarized below, were each less than 10% of the total balances 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. S-6 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-8. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-7 MISSISSIPPI POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31,1993 (STATED IN THOUSANDS OF DOLLARS) S-8 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES (STATED IN THOUSANDS OF DOLLARS) Total additions and total retirements for 1991 and 1992, as summarized below, were each less than 10% of the total balances as of the respective year-ends. Additions for 1993 were greater than 10% of the year-end balance and, consequently, 1993 is reported in full detail on page S-10. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. S-9 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE V - UTILITY PLANT, INCLUDING INTANGIBLES FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) S-10 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-11 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-12 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-14 S-13 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-14 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-15 ALABAMA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-16 ALABAMA POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-18 S-17 ALABAMA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-18 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-19 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-20 GEORGIA POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-22 S-21 GEORGIA POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-22 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-23 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-24 GULF POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-26 S-25 GULF POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-26 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-27 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-28 MISSISSIPPI POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-30 S-29 MISSISSIPPI POWER COMPANY NOTES TO SCHEDULE VI -ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PL FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-30 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI --ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1993 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-31 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1992 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-32 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEAR ENDED DECEMBER 31, 1991 (STATED IN THOUSANDS OF DOLLARS) See Notes on Page S-34 S-33 SAVANNAH ELECTRIC AND POWER COMPANY NOTES TO SCHEDULE VI -- ACCUMULATED PROVISION FOR DEPRECIATION OF UTILITY PLANT FOR THE YEARS ENDING DECEMBER 31, 1993, 1992 AND 1991 (STATED IN THOUSANDS OF DOLLARS) S-34 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (3) See Note 1 to SOUTHERN's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (4) Represents additional funding to reserve. (5) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-35 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to SOUTHERN's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. (4) Capitalized. S-36 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 8 to SOUTHERN's financial statements in Item 8 herein for a description of the Gulf States settlement. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) Insurance recoveries net of charges to reserve for purposes for which reserve was created. (4) See Note 1 to SOUTHERN's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-37 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - ------------------ Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-38 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to ALABAMA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further Information. S-39 ALABAMA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) See Note 7 to the financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to ALABAMA's financial statements under "Depreciation and Nuclear Decommissioning" in Item 8 herein for further information. S-40 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) Represents additional funding to reserve. (4) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-41 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ----------------------- Notes: (1) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (2) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. (3) See Note 1 to GEORGIA's financial statements under "Revenues and Fuel Costs" in Item 8 herein for further information. S-42 GEORGIA POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Note: (1) See Note 3 to GEORGIA's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible accounts was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. (3) See Note 1 to GEORGIA's financial statements under "Nuclear Decommissioning" in Item 8 herein for further information. S-43 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-44 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - -------------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-45 GULF POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) - ------------------ Notes: (1) See Note 7 to GULF's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-46 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - --------------- Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-47 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ------------------ Note: Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-48 MISSISSIPPI POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in thousands of Dollars) - ----------------- Notes: (1) See Note 7 to MISSISSIPPI's financial statements in Item 8 herein for a description of the Gulf States settlement. The provision for uncollectible was reversed. (2) Represents write-off of accounts considered to be uncollectible, less recoveries of amounts previously written off. S-49 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1993 (Stated in Thousands of Dollars) - -------------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-50 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1992 (Stated in Thousands of Dollars) - ---------------------- Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-51 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEAR ENDED DECEMBER 31, 1991 (Stated in Thousands of Dollars) Note: Represents write-off of accounts receivable considered to be uncollectible, less recoveries of amounts previously written off. S-52 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE IX - SHORT-TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end. (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) This note payable is an obligation of SEI and does not include borrowings from SOUTHERN. (4) See Note 5 to SOUTHERN's financial statements in Item 8 herein for details regarding SOUTHERN's and its subsidiaries lines of credit and general terms of commitment agreements. S-53 ALABAMA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992, 1991 (Stated in Thousands of Dollars) - ----------------- Notes: (1) At month-end. (2) Average based on daily borrowings during the period (averages and rates quoted on an actual day year basis). (3) ALABAMA also issued commercial paper during 1993, although none was outstanding at year-end. The data shown reflects the issuance of commercial paper. (4) See Note 5 to ALABAMA's financial statements in Item 8 herein for details regarding ALABAMA's lines of credit. S-54 GEORGIA POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - -------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 8 to GEORGIA's financial statements in Item 8 herein for details regarding GEORGIA's lines of credit and general terms of its commitment agreements. S-55 GULF POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to GULF's financial statements in Item 8 herein for a description of this short-term indebtedness. (4) See Note 5 to GULF's financial statements in Item 8 herein for details regarding GULF's lines of credit and general terms of its commitment agreements. S-56 MISSISSIPPI POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) - ---------------------- Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to MISSISSIPPI's financial statements in Item 8 herein for details regarding MISSISSIPPI's lines of credit and general terms of its commitment agreements. S-57 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE IX - SHORT -TERM BORROWINGS DECEMBER 31, 1993, 1992 AND 1991 (Stated in Thousands of Dollars) Notes: (1) At month-end (2) Average based on daily borrowings during period (averages and rates quoted on an actual day year basis). (3) See Note 5 to SAVANNAH's financial statements in Item 8 herein for details regarding SAVANNAH's lines of credit and general terms of its commitment agreements. S-58 THE SOUTHERN COMPANY AND SUBSIDIARY COMPANIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-59 ALABAMA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-60 GEORGIA POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-61 GULF POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-62 MISSISSIPPI POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-63 SAVANNAH ELECTRIC AND POWER COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) S-64 EXHIBIT INDEX The following exhibits indicated by an asterisk preceding the exhibit number are filed herewith. The balance of the exhibits have heretofore been filed with the SEC, respectively, as the exhibits and in the file numbers indicated and are incorporated herein by reference. Reference is made to a duplicate list of exhibits being filed as a part of this Form 10-K, which list, prepared in accordance with Item 601 of Regulation S-K of the SEC, immediately precedes the exhibits being physically filed with this Form 10-K. (3) ARTICLES OF INCORPORATION AND BY-LAWS SOUTHERN (a) 1 - Composite Certificate of Incorporation of SOUTHERN, reflecting all amendments to date. (Designated in Registration No. 33-3546 as Exhibit 4(a), in Certificate of Notification, File No. 70-7341, as Exhibit A and in Certificate of Notification, File No. 70-8181, as Exhibit A.) (a) 2 - By-laws of SOUTHERN as amended effective October 21, 1991, and as presently in effect. (Designated in Form U-1, File No. 70-8181 as Exhibit A-2.) ALABAMA (b) 1 - Charter of ALABAMA and amendments thereto through November 19, 1993. (Designated in Registration Nos. 2-59634 as Exhibit 2(b), 2-60209 as Exhibit 2(c), 2-60484 as Exhibit 2(b), 2-70838 as Exhibit 4(a)-2, 2-85987 as Exhibit 4(a)-2, 33-25539 as Exhibit 4(a)-2, 33-43917 as Exhibit 4(a)-2, in Form 8-K dated February 5, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated July 8, 1992, File No. 1-3164, as Exhibit 4(b)-3, in Form 8-K dated October 27, 1993, File No. 1-3164, as Exhibits 4(a) and 4(b) and in Form 8-K dated November 16, 1993, File No. 1-3164, as Exhibit 4(a).) (b) 2 - By-laws of ALABAMA as amended effective April 24, 1992, and as presently in effect. (Designated in Registration No. 33-48885 as Exhibit 4(c).) GEORGIA (c) 1 - Charter of GEORGIA and amendments thereto through October 25, 1993. (Designated in Registration Nos. 2-63392 as Exhibit 2(a)-2, 2-78913 as Exhibits 4(a)-(2) and 4(a)-(3), 2-93039 as Exhibit 4(a)-(2), 2-96810 as Exhibit 4(a)-2, 33-141 as Exhibit 4(a)-(2), 33-1359 as Exhibit 4(a)(2), 33-5405 as Exhibit 4(b)(2), 33-14367 as Exhibits 4(b)-(2) and 4(b)-(3), 33-22504 as Exhibits 4(b)-(2), 4(b)-(3) and 4(b)-(4), in GEORGIA's Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibits 4(a)(2) and 4(a)(3), in Registration No. 33-48895 as Exhibits 4(b)-(2) and 4(b)-(3), in Form 8-K dated December 10, 1992, File No. 1-6468 as Exhibit 4(b), in Form 8-K dated June 17, 1993, File No. 1-6468, as Exhibit 4(b) and in Form 8-K dated October 20, 1993, File No. 1-6468, as Exhibit 4(b).) E-1 (c) 2 - By-laws of GEORGIA as amended effective July 18, 1990, and as presently in effect. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No.1-6468, as Exhibit 3.) GULF (d) 1 - Restated Articles of Incorporation of GULF and amendments thereto through November 8, 1993. (Designated in Registration No. 33-43739 as Exhibit 4(b)-1, in Form 8-K dated January 15, 1992, File No. 0-2429, as Exhibit 1(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(b)-2, in Form 8-K dated September 22, 1993, File No. 0-2429, as Exhibit 4 and in Form 8-K dated November 3, 1993, File No. 0-2429, as Exhibit 4.) *(d) 2 - By-laws of GULF as amended effective February 25, 1994, and as presently in effect. MISSISSIPPI (e) 1 - Articles of incorporation of MISSISSIPPI, articles of merger of Mississippi Power Company (a Maine corporation) into MISSISSIPPI and articles of amendment to the articles of incorporation of MISSISSIPPI through August 19, 1993. (Designated in Registration No. 2-71540 as Exhibit 4(a)-1, in Form U5S for 1987, File No. 30-222-2, as Exhibit B-10, in Registration No. 33-49320 as Exhibit 4(b)-(1), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibits 4(b)-2 and 4(b)-3, in Form 8-K dated August 4, 1993, File No. 0-6849, as Exhibit 4(b)-3 and in Form 8-K dated August 18, 1993, File No. 0-6849, as Exhibit 4(b)-3.) (e) 2 - By-laws of MISSISSIPPI as amended effective August 22, 1989, and as presently in effect. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1989, as Exhibit 3(b).) SAVANNAH (f) 1 - Charter of SAVANNAH and amendments thereto through November 10, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(b)-(1), 33-45757 as Exhibit 4(b)-(2) and in Form 8-K dated November 9, 1993, File No. 1-5072, as Exhibit 4(b).) *(f) 2 - By-laws of SAVANNAH as amended effective February 16, 1994, and as presently in effect. (4) INSTRUMENTS DESCRIBING RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES ALABAMA (b) - Indenture dated as of January 1, 1942, between ALABAMA and Chemical Bank, as Trustee, and indentures supplemental thereto through that dated as of January 1, 1994. (Designated in Registration Nos. 2-59843 as Exhibit 2(a)-2, 2-60484 as Exhibits 2(a)-3 and 2(a)-4, 2-60716 as Exhibit 2(c), 2-67574 as E-2 Exhibit 2(c), 2-68687 as Exhibit 2(c), 2-69599 as Exhibit 4(a)-2, 2-71364 as Exhibit 4(a)-2, 2- 73727 as Exhibit 4(a)-2, 33-5079 as Exhibit 4(a)-2, 33-17083 as Exhibit 4(a)-2, 33-22090 as Exhibit 4(a)-2, in ALABAMA's Form 10-K for the year ended December 31, 1990, File No. 1-3164, as Exhibit 4(c), in Registration Nos. 33-43917 as Exhibit 4(a)-2, 33-45492 as Exhibit 4(a)-2, 33- 48885 as Exhibit 4(a)-2, 33-48917 as Exhibit 4(a)-2, in Form 8-K dated January 20, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Form 8-K dated February 17, 1993, File No.1-3436, as Exhibit 4(a)-3, in Form 8-K dated March 10, 1993, File No. 1-3436, as Exhibit 4(a)-3, in Certificate of Notification, File No. 70-8069, as Exhibits A and B, in Form 8-K dated June 24, 1993, File No. 1- 3436, as Exhibit 4, in Certificate of Notification, File No. 70-8069, as Exhibit A, in Form 8-K dated November 16, 1993, File No. 1-3436, as Exhibit 4(b) and in Certificate of Notification, File No. 70-8069, as Exhibits A and B.) GEORGIA (d) - Indenture dated as of March 1, 1941, between GEORGIA and Chemical Bank, as Trustee, and indentures supplemental thereto dated as of March 1, 1941, March 3, 1941 (3 indentures), March 6, 1941 (139 indentures), March 1, 1946 (88 indentures) and December 1, 1947, through January 1, 1994. (Designated in Registration Nos. 2-4663 as Exhibits B-3 and B-3(a), 2-7299 as Exhibit 7(a)-2, 2- 61116 as Exhibit 2(a)-3 and 2(a)-4, 2-62488 as Exhibit 2(a)-3, 2-63393 as Exhibit 2(a)-4, 2-63705 as Exhibit 2(a)-3, 2-68973 as Exhibit 2(a)-3, 2-70679 as Exhibit 4(a)-(2), 2-72324 as Exhibit 4(a)-2, 2-73987 as Exhibit 4(a)-(2), 2-77941 as Exhibits 4(a)-(2) and 4(a)-(3), 2-79336 as Exhibit 4(a)-(2), 2-81303 as Exhibit 4(a)-(2), 2-90105 as Exhibit 4(a)-(2), 33-5405 as Exhibit 4(a)-(2), 33-14367 as Exhibits 4(a)-(2) and 4(a)-(3), 33-22504 as Exhibits 4(a)-(2), 4(a)-(3) and 4(a)-(4), 33-32420 as Exhibit 4(a)-(2), 33-35683 as Exhibit 4(a)-(2), in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 4(a)(3), in Form 10-K for the year ended December 31, 1991, File No. 1-6468, as Exhibit 4(a)(5), in Registration No. 33-48895 as Exhibit 4(a)-(2), in Form 8-K dated August 26, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-K dated September 9, 1992, File No. 1-6468, as Exhibits 4(a)-(3) and 4(a)-(4), in Form 8-K dated September 23, 1992, File No. 1-6468, as Exhibit 4(a)-(3), in Form 8-A dated October 12, 1992, as Exhibit 2(b), in Form 8-K dated January 27, 1993, File No. 1-6468, as Exhibit 4(a)-(3), in Registration No. 33-49661 as Exhibit 4(a)-(2), in Form 8-K dated July 26, 1993, File No. 1-6468, as Exhibit 4, in Certificate of Notification, File No. 70-7832, as Exhibit M and in Certificate of Notification, File No. 70-7832, as Exhibit C.) GULF (e) - Indenture dated as of September 1, 1941, between GULF and The Chase Manhattan Bank (National Association) and The Citizens & Peoples National Bank of Pensacola, as Trustees, and indentures supplemental thereto through E-3 November 1, 1993. (Designated in Registration Nos. 2-4833 as Exhibit B-3, 2-62319 as Exhibit 2(a)-3, 2-63765 as Exhibit 2(a)-3, 2-66260 as Exhibit 2(a)-3, 33-2809 as Exhibit 4(a)-2, 33-43739 as Exhibit 4(a)-2, in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 4(b), in Form 8-K dated August 18, 1992, File No. 0-2429, as Exhibit 4(a)-3, in Registration No. 33-50165 as Exhibit 4(a)-2, in Form 8-K dated July 12, 1993, File No. 0-2429, as Exhibit 4 and in Certificate of Notification, File No. 70-8229, as Exhibit A.) MISSISSIPPI (f) - Indenture dated as of September 1, 1941, between MISSISSIPPI and Morgan Guaranty Trust Company of New York, as Trustee, and indentures supplemental thereto through November 1, 1993. (Designated in Registration Nos. 2-4834 as Exhibit B-3, 2-62965 as Exhibit 2(b)-2, 2-66845 as Exhibit 2(b)-2, 2-71537 as Exhibit 4(a)-(2), 33-5414 as Exhibit 4(a)-(2), 33-39833 as Exhibit 4(a)-2, in MISSISSIPPI's Form 10-K for the year ended December 31, 1991, File No. 0-6849, as Exhibit 4(b), in Form 8-K dated August 5, 1992, File No. 0-6849, as Exhibit 4(a)-2, in Second Certificate of Notification, File No. 70-7941, as Exhibit I, in MISSISSIPPI's Form 8-K dated February 26, 1993, File No. 0-6849, as Exhibit 4(a)-2, in Certificate of Notification, File No. 70-8127, as Exhibit A, in Form 8-K dated June 22, 1993, File No. 0-6849, as Exhibit 1 and in Certificate of Notification, File No. 70-8127, as Exhibit A.) SAVANNAH (g) - Indenture dated as of March 1, 1945, between SAVANNAH and NationsBank of Georgia, National Association, as Trustee, and indentures supplemental thereto through July 1, 1993. (Designated in Registration Nos. 33-25183 as Exhibit 4(a)-(1), 33-41496 as Exhibit 4(a)-(2), 33-45757 as Exhibit 4(a)-(2), in SAVANNAH's Form 10-K for the year ended December 31, 1991, File No. 1-5072, as Exhibit 4(b), in Form 8-K dated July 8, 1992, File No. 1-5072, as Exhibit 4(a)-3, in Registration No. 33-50587 as Exhibit 4(a)-(2) and in Form 8-K dated July 22, 1993, File No. 1-5072, as Exhibit 4.) (10) MATERIAL CONTRACTS SOUTHERN (a) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(a) and in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(3).) (a) 2 - Service contract dated as of July 17, 1981, between SCS and SEI. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1985, File No. 1-3526, as Exhibit 10(a)(2).) E-4 (a) 3 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1987, File No. 1-5072, as Exhibit 10-p.) (a) 4 - Service contract dated as of January 15, 1991, between SCS and Southern Nuclear. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1991, File No. 1-3526, as Exhibit 10(a)(4).) (a) 5 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(b).) (a) 6 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. (Designated in Registration No. 2-59634 as Exhibit 5(c) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(d)(2).) (a) 7 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Registration No. 2-61116 as Exhibit 5(d).) (a) 8 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(1).) (a) 9 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. (Designated in Form 8-K for January, 1975, File No. 1-6468, as Exhibit (b)(3).) (a) 10 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(g).) (a) 11 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit A.) (a) 12 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. (Designated in Certificate of Notification, File No. 70-5592, as Exhibit B.) (a) 13 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(1).) E-5 (a) 14 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-1 and in Form 8-K for January 1977, File No. 1-6468, as Exhibit (B)(3).) (a) 16 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-5792, as Exhibit B-2.) (a) 17 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1983, File No. 1-6468, as Exhibit 10(k)(4).) (a) 18 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(2).) (a) 19 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 20 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. (Designated in Form 8-K dated as of July 5, 1977, File No. 1-6468, as Exhibit (b)(8).) (a) 21 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. (Designated in Form 8-K for February, 1977, File No. 1-6468, as Exhibit (b)(4).) (a) 22 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(3).) (a) 23 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. (Designated in Form 8-K dated as of June 13, 1977, File No. 1-6468, as Exhibit (b)(7).) (a) 24 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-3, in SOUTHERN's Form 10-K for the year ended December 31, 1987, File E-6 No. 1-3526, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, File No. 1-3526, as Exhibit 10(n)(2).) (a) 25 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-4 and in SOUTHERN's Form 10-K for the year ended December 31, 1987, File No. 1-3526, as Exhibit 10(o)(4).) (a) 26 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. (Designated in Form U-1, File No. 70-6481, as Exhibit B-1.) (a) 27 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. (Designated in Form U-1, File No. 70-6481, as Exhibit B-2.) (a) 28 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-4, in SOUTHERN's Form 10-K for the year ended December 31, 1987, as Exhibit 10(o)(2) and in SOUTHERN's Form 10-K for the year ended December 31, 1989, as Exhibit 10(n)(2).) (a) 29 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. (Designated in Form U-1, File No. 70-6573, as Exhibit B-5.) (a) 30 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-1.) (a) 31 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA, dated as of December 31, 1990. (Designated in Form U-1, File No. 70-7843, as Exhibit B-2.) (a) 32 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(c)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1982, File No. 1-6468, as Exhibit 10(r)(3).) (a) 33 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. (Designated in GEORGIA's Form 10-K for the year E-7 ended December 31, 1982, File No. 1-6468, as Exhibit 10(s)(2), in SOUTHERN's Form 10-K for the year ended December 31, 1984, File No. 1-3526, as Exhibit 10(r)(2) and in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468 as Exhibit 10(s)(2).) (a) 34 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(d).) (a) 35 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(e).) (a) 36 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in SAVANNAH's Form 10-K for the year ended December 31, 1988, File No. 1-5072, as Exhibit 10(f).) (a) 37 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(x).) (a) 38 - The Southern Company Executive Stock Plan For the Southern Electric System and the First Amendment thereto. (Designated in Registration No. 33-30171 as Exhibit 4(c).) (a) 39 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(1).) (a) 40 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. (Designated in GULF's Form 10-K for the year ended December 31, 1991, File No. 0-2429, as Exhibit 10(m).) (a) 41 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(x).) (a) 42 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1988, File No. 1-6468, as Exhibit 10(y).) E-8 (a) 43 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-1.) (a) 44 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. (Designated in Form U-1, File No. 70-7609, as Exhibit B-2.) (a) 45 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. (Designated in MISSISSIPPI's Form 10-K for the year ended December 31, 1981, File No. 0-6849, as Exhibit 10(f), in MISSISSIPPI's Form 10-K for the year ended December 31, 1982, File No. 0-6849, as Exhibit 10(f)(2) and in MISSISSIPPI's Form 10-K for the year ended December 31, 1983, File No. 0-6849, as Exhibit 10(f)(3).) (a) 46 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. (Designated in Form U-1, File No. 70-7738, as Exhibit A-5 and in Form U-1, File No. 70-7937, as A-5(b).) (a) 47 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(cc).) (a) 48 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(dd).) *(a) 49 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. (a) 50 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(ff).) (a) 51 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(gg).) (a) 52 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. (Designated in GEORGIA's Form 10-K for the year ended December 31, 1990, File No. 1-6468, as Exhibit 10(hh).) E-9 (a) 53 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. (Designated in SOUTHERN's Form 10-K for the year ended December 31, 1992, File No. 1-3526, as Exhibit 10(a)53.) *(a) 54 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. *(a) 55 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. *(a) 56 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. *(a) 57 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 58 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. *(a) 59 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. ALABAMA (b) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. (Designated in Registration No. 2-59843 as Exhibit 2(a)-8.) (b) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (b) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (b) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (b) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. E-10 (b) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2, dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (b) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)34 herein. (b) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)35 herein. (b) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)36 herein. (b) 10 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (b) 11 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)39 herein. (b) 12 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)40 herein. (b) 13 - Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Certificate of Notification, File No. 70-7212, as Exhibit B.) (b) 14 - 1991 Firm Power Purchase Contract between ALABAMA and AMEA. (Designated in Form U-1, File No. 70- 7873, as Exhibit B-1.) (b) 15 - Purchase and Ownership Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)43 herein. (b) 16 - Operating Agreement for Joint Ownership Interest in the James H. Miller, Jr. Steam Electric Generating Plant Units One and Two dated November 18, 1988, between ALABAMA and AEC. See Exhibit 10(a)44 herein. (b) 17 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. E-11 (b) 18 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA, MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. GEORGIA (c) 1 - Indenture dated as of June 1, 1959, between SEGCO and Citibank, N.A., as Trustee, and indentures supplemental thereto through December 1, 1962. See Exhibit 10(b)1 herein. (c) 2 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIP PI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (c) 3 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (c) 4 - Agreement dated as of January 27, 1959 and Amendment No. 1 dated as of October 27, 1982, among SEGCO, ALABAMA and GEORGIA. See Exhibit 10(a)6 herein. (c) 5 - Joint Committee Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)7 herein. (c) 6 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)8 herein. (c) 7 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of January 6, 1975, between GEORGIA and OPC. See Exhibit 10(a)9 herein. (c) 8 - Revised and Restated Integrated Transmission System Agreement dated as of November 12, 1990, between GEORGIA and OPC. See Exhibit 10(a)10 herein. (c) 9 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a) 11 herein. (c) 10 - Plant Hal Wansley Operating Agreement dated as of March 26, 1976, between GEORGIA and OPC. See Exhibit 10(a)12 herein. (c) 11 - Edwin I. Hatch Nuclear Plant Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)13 herein. (c) 12 - Edwin I. Hatch Nuclear Plant Operating Agreement dated as of August 27, 1976, between GEORGIA, MEAG and Dalton. See Exhibit 10(a)14 herein. E-12 (c) 13 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase and Ownership Participation Agreement dated as of August 27, 1976 and Amendment No. 1 dated as of January 18, 1977, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)15 herein. (c) 14 - Alvin W. Vogtle Nuclear Units Number One and Two Operating Agreement dated as of August 27, 1976, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)16 herein. (c) 15 - Alvin W. Vogtle Nuclear Units Number One and Two Purchase, Amendment, Assignment and Assumption Agreement dated as of November 16, 1983, between GEORGIA and MEAG. See Exhibit 10(a)17 herein. (c) 16 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)18 herein. (c) 17 - Plant Hal Wansley Operating Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)19 herein. (c) 18 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and Dalton. See Exhibit 10(a)20 herein. (c) 19 - Integrated Transmission System Agreement dated as of August 27, 1976, between GEORGIA and MEAG. See Exhibit 10(a)21 herein. (c) 20 - Plant Hal Wansley Purchase and Ownership Participation Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)22 herein. (c) 21 - Plant Hal Wansley Operating Agreement dated as of April 19, 1977, between GEORGIA and Dalton. See Exhibit 10(a)23 herein. (c) 22 - Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of May 15, 1980, Amendment No. 1 dated as of December 30, 1985, Amendment No. 2 dated as of July 1, 1986 and Amendment No. 3 dated as of August 1, 1988, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)24 herein. (c) 23 - Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of May 15, 1980 and Amendment No. 1 dated as of December 3, 1985, among GEORGIA, OPC, MEAG and Dalton. See Exhibit 10(a)25 herein. (c) 24 - Plant Robert W. Scherer Purchase, Sale and Option Agreement dated as of May 15, 1980, between GEORGIA and MEAG. See Exhibit 10(a)26 herein. (c) 25 - Plant Robert W. Scherer Purchase and Sale Agreement dated as of May 16, 1980, between GEORGIA and Dalton. See Exhibit 10(a)27 herein. E-13 (c) 26 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (c) 27 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (c) 28 - Plant Robert W. Scherer Unit No. Four Amended and Restated Purchase and Ownership Participation Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a) 30 herein. (c) 29 - Plant Robert W. Scherer Unit No. Four Operating Agreement by and among GEORGIA, FP&L and JEA dated as of December 31, 1990. See Exhibit 10(a)31 herein. (c) 30 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (c) 31 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1, dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (c) 32 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (c) 33 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (c) 34 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (c) 35 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. *(c) 36 - Power Purchase Agreement dated as of December 3, 1993 between GEORGIA and FPC. See Exhibit 10(a) 59 herein. (c) 37 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. E-14 (c) 38 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (c) 39 - Rocky Mountain Pumped Storage Hydroelectric Project Ownership Participation Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)41 herein. (c) 40 - Rocky Mountain Pumped Storage Hydroelectric Project Operating Agreement dated November 18, 1988, between OPC and GEORGIA. See Exhibit 10(a)42 herein. (c) 41 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (c) 42 - Block Power Sale Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)47 herein. (c) 43 - Coordination Services Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)48 herein. *(c) 44 - Amended and Restated Nuclear Managing Board Agreement for Plant Hatch and Plant Vogtle among GEORGIA, OPC, MEAG and Dalton dated as of July 1, 1993. See Exhibit 10(a)49 herein. (c) 45 - Integrated Transmission System Agreement, Power Sale and Coordination Umbrella Agreement between GEORGIA and OPC dated as of November 12, 1990. See Exhibit 10(a)50 herein. (c) 46 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and Dalton dated as of December 7, 1990. See Exhibit 10(a)51 herein. (c) 47 - Revised and Restated Integrated Transmission System Agreement between GEORGIA and MEAG dated as of December 7, 1990. See Exhibit 10(a)52 herein. *(c) 48 - Amendment No. 4 to the Plant Robert W. Scherer Units Number One and Two Purchase and Ownership Participation Agreement dated as of December 31, 1990. See Exhibit 10(a)54 herein. *(a) 49 - Amendment No. 2 to the Plant Robert W. Scherer Units Number One and Two Operating Agreement dated as of December 31, 1990. See Exhibit 10(a)55 herein. *(c) 50 - Plant Scherer Managing Board Agreement dated as of December 31, 1990 among GEORGIA, OPC, MEAG, Dalton, GULF, FP&L and JEA. See Exhibit 10(a)56 herein. E-15 *(c) 51 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)57 herein. *(c) 52 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a)58 herein. GULF (d) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated as of September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (d) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (d) 3 - Plant Robert W. Scherer Unit Number Three Purchase and Ownership Participation Agreement dated as of March 1, 1984, Amendment No. 1 dated as of July 1, 1986 and Amendment No. 2 dated as of August 1, 1988, between GEORGIA and GULF. See Exhibit 10(a)28 herein. (d) 4 - Plant Robert W. Scherer Unit Number Three Operating Agreement dated as of March 1, 1984, between GEORGIA and GULF. See Exhibit 10(a)29 herein. (d) 5 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (d) 6 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984 and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (d) 7 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (d) 8 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (d) 9 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-16 (d) 10 - Agreement between GULF and AEC, effective August 1, 1985. (Designated in GULF's Form 10-K for the year ended December 31, 1985, File No. 0-2429, as Exhibit 10(g).) (d) 11 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (d) 12 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (d) 13 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. MISSISSIPPI (e) 1 - Service contracts dated as of January 1, 1984 and Amendment No. 1 dated September 6, 1985, between SCS and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SEGCO and SOUTHERN. See Exhibit 10(a)1 herein. (e) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (e) 3 - Amended and Restated Unit Power Sales Agreement dated February 18, 1982 and Amendment No. 1 dated May 18, 1982, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)32 herein. (e) 4 - Amended and Restated Unit Power Sales Agreement dated May 19, 1982, Amendment No. 1 dated August 30, 1984, and Amendment No. 2 dated October 30, 1987, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI and SCS. See Exhibit 10(a)33 herein. (e) 5 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (e) 6 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (e) 7 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. E-17 (e) 8 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. (e) 9 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (e) 10 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. (e) 11 - Transmission Facilities Agreement dated February 25, 1982, Amendment No. 1 dated May 12, 1982 and Amendment No. 2 dated December 6, 1983, between Gulf States and MISSISSIPPI. See Exhibit 10(a)45 herein. (e) 12 - Form of commitment agreement, Amendment No. 1 and Amendment No. 2 with respect to SOUTHERN, ALABAMA, GEORGIA and MISSISSIPPI revolving credits. See Exhibit 10(a)46 herein. (e) 13 - Long Term Transmission Service Agreement between Entergy Power, Inc. and ALABAMA MISSISSIPPI and SCS. See Exhibit 10(a)53 herein. SAVANNAH (f) 1 - Service contract dated as of March 3, 1988, between SCS and SAVANNAH. See Exhibit 10(a)3 herein. (f) 2 - Interchange contract dated October 28, 1988, effective January 1, 1989, between ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)5 herein. (f) 3 - Unit Power Sales Agreement dated July 19, 1988, between FPC and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 34 herein. (f) 4 - Amended Unit Power Sales Agreement dated July 20, 1988, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 35 herein. (f) 5 - Amended Unit Power Sales Agreement dated August 17, 1988, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 36 herein. (f) 6 - Unit Power Sales Agreement dated December 8, 1990, between Tallahassee and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a)37 herein. E-18 (f) 7 - Transition Energy Agreement dated December 31, 1990, between JEA and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 39 herein. (f) 8 - Transition Energy Agreement dated December 31, 1990, between FP&L and ALABAMA, GEORGIA, GULF, MISSISSIPPI, SAVANNAH and SCS. See Exhibit 10(a) 40 herein. *(f) 9 - Plant McIntosh Combustion Turbine Purchase and Ownership Participation Agreement between GEORGIA and SAVANNAH dated as of December 15, 1992. See Exhibit 10(a) 57 herein. *(f) 10 - Plant McIntosh Combustion Turbine Operating Agreement between GEORGIA and SAVANNAH dated December 15, 1992. See Exhibit 10(a)58 herein. (21) *SUBSIDIARIES OF REGISTRANTS - Contained herein at page IV-5. (23) CONSENTS OF EXPERTS AND COUNSEL SOUTHERN *(a) - The consent of Arthur Andersen & Co. is contained herein at page IV-6. ALABAMA *(b) - The consent of Arthur Andersen & Co. is contained herein at page IV-7. GEORGIA *(c) - The consent of Arthur Andersen & Co. is contained herein at page IV-8. GULF *(d) - The consent of Arthur Andersen & Co. is contained herein at page IV-9. MISSISSIPPI *(e) - The consent of Arthur Andersen & Co. is contained herein at page IV-10. SAVANNAH *(f) - The consent of Arthur Andersen & Co. is contained herein at page IV-11. E-19 (24) POWERS OF ATTORNEY AND RESOLUTIONS SOUTHERN *(a) - Power of Attorney and resolution. ALABAMA *(b) - Power of Attorney and resolution. GEORGIA *(c) - Power of Attorney and resolution. GULF *(d) - Power of Attorney and resolution. MISSISSIPPI *(e) - Power of Attorney and resolution. SAVANNAH *(f) - Power of Attorney and resolution. E-20

64907_1993.txt

64907_1993

1993

64907

ITEM 2. PROPERTIES Mercantile and Mercantile Bank occupy 22 stories of the Mercantile Tower, a 35-story building owned by Mercantile Bank and located at Seventh and Washington Streets in St. Louis, Missouri. Among the other properties owned by Mercantile Bank are a four story, 91,170 usable square foot off-site office building located at 12443 Olive Boulevard, Creve Coeur, Missouri, which houses Mercantile's credit card, mortgage loan, and asset- based lending operations; a four-story, 222,400 usable square foot off-site processing center located at 1005 Convention Plaza in St. Louis, Missouri, which houses most other operational functions of Mercantile; and a four-story building located at 721 Locust Street, St. Louis, Missouri, which has 101,827 square feet of usable office space and houses Mercantile Bank. Mercantile's subsidiaries own and lease other facilities in Missouri, Illinois, Kansas and Iowa. See Note G to the consolidated financial statements included on page 53 in the Annual Report of the Registrant to its Shareholders for the year ended December 31, 1993, which is incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS None ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT See Part III, Item 10. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Information concerning the Common Stock of the Registrant, included on page 66 in the Annual Report of the Registrant to its Shareholders for the year ended December 31, 1993, is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected Financial Data, included as Exhibit 1 on page 12 in the Annual Report of the Registrant to its Shareholders for the year ended December 31, 1993, 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 of Financial Condition and Results of Operations, included on pages 12 through 41 in the Annual Report of the Registrant to its Shareholders for the year ended December 31, 1993, is incorporated herein by reference. Selected Quarterly Financial Data, included as Exhibit 34 on page 41 in the Annual Report of the Registrant to its Shareholders for the year ended December 31, 1993, is incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding directors is contained in "Election of Directors" and "Beneficial Ownership of Stock by Management," included in the Proxy Statement for the 1994 Annual Meeting of Shareholders, which information is incorporated herein by reference. The executive officers were appointed by and serve at the pleasure of the Board of Directors of Mercantile. Each of the officers named above, except Messrs. Heise, Normile and Strickler, serve on the Mercantile Management Executive Committee. Messrs. Jacobsen, Babb, McClure, Heise and Normile have served as executive officers of either Mercantile or Mercantile Bank for the last five years. From 1974 until his start with Mercantile in February 1991, Mr. Adams was employed by the international consulting firm, CRESAP, a Towers Perrin Company, most recently as Vice President/Partner in charge of its financial institutions practice. Mr. Arnold was employed by Harris Trust & Savings Bank for twenty-four years, most recently as Senior Vice President and Deputy Chief Credit Officer, before joining Mercantile in February 1991. Prior to joining Mercantile in April 1992, Mr. Beirise was employed by Continental Bank N.A. for twenty-four years, most recently as Managing Director, Corporate Banking. Mr. Gorman was Executive Vice President and Secretary of UPSA from 1971 through July 1991. From August 1991 through January 1994, he was President and Chief Executive Officer of UPSA. Mr. King served as Chairman of the Board, Chief Executive Officer and President of MidAmerican Corporation from 1989 until January 1993. Prior to 1989, Mr. King held the same positions with MidAmerican Corporation's predecessor, Merchants Bancorporation. Mr. Pierce was employed by Kaiser Aluminum and Chemical Corporation from 1973 until he was hired by Mercantile in October 1989, most recently as Corporate Vice President, Human Resources. Mr. Strickler was the President of Patrick Strickler & Associates from August 1985 through September 1988. From September 1988 until starting with Mercantile in April 1990, Mr. Strickler served as Senior Vice President of Golin-Harris Company. Mr. Bilstrom was a partner in the law firm of Katten Muchin & Zavis from 1983 through May 1990, when he joined Mercantile as General Counsel and Secretary. ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation is contained in "Compensation of Executive Officers," included in the Proxy Statement for the 1994 Annual Meeting of Shareholders, which is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership of certain beneficial owners and management is contained in "Voting Securities and Principal Holders Thereof" and "Beneficial Ownership of Stock by Management," included in the Proxy Statement for the 1994 Annual Meeting of Shareholders, which is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions is contained in "Interest of Management and Others in Certain Transactions" included in the Proxy Statement for the 1994 Annual Meeting of Shareholders, which is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Financial Statements: Incorporated herein by reference, are listed in Item 8

39547_1993.txt

39547_1993

1993

39547

ITEM 1. BUSINESS. The Actava Group Inc. ("Actava" or the "Company") provides high quality, brand-name products through distribution channels to retail markets across the United States. Actava operates in three distinct businesses: photofinishing, lawn and garden equipment and sporting goods. A description of each segment appears below. Actava was organized in 1929 under Pennsylvania law and reincorporated in 1968 under Delaware law. On July 19, 1993, the Company changed its name from Fuqua Industries, Inc. to The Actava Group Inc. Actava's principal executive offices are located at 4900 Georgia-Pacific Center, Atlanta, Georgia 30303 and its telephone number is (404) 658-9000. PHOTOFINISHING Actava owns 51% of the voting stock and 50% of the equity of Qualex Inc. ("Qualex"). Qualex, the largest wholesale photofinishing company in the United States, was created in 1988 through a combination of Actava's photofinishing subsidiary, Colorcraft Corporation, and the United States photofinishing operations of Eastman Kodak Company ("Kodak"). Kodak owns all of the voting stock and equity interest of Qualex not owned by Actava. Both Actava and Kodak have granted to the other a right of first refusal for the purchase of their respective interests in Qualex. Qualex is engaged in the processing of photographic film for consumer use throughout the United States. Qualex primarily processes color film to produce prints and slides, but also processes black and white and movie film. Qualex is a wholesale photofinisher, obtaining over 98% of its sales from independent retailers in 1993. Qualex's business also includes a limited amount of direct sales to consumers through owned and operated retail photographic stores and mail order operations. Qualex offers nonbranded photofinishing products which are sold to major retailers, largely drug, mass merchant and grocery operators, who market these products under their own retail brands. In addition, Qualex offers certain branded photofinishing products, including premium-quality photofinishing through its Kodalux(R) Processing Services ("KPS"). KPS is available to all Qualex customers and is currently offered from ten Qualex processing plants. Kodalux(R) is a Kodak-owned trademark licensed to Qualex under an agreement which expires on April 15, 1997. In addition to color roll processing, KPS includes chrome processing (slides and movies) and ancillary work such as reprints, enlargements and other services. Qualex provides pickup and delivery services for over 41,000 retail stores in all 50 states. These pickup and delivery services are provided by either Qualex-owned vehicles or through third party contract delivery services. Qualex provides 24-hour (next day) processing services, often on a seven-day-a-week basis, to all major metropolitan areas it serves. The film to be processed is picked up throughout the day and then delivered to Qualex's plants for processing. Consequently, Qualex plants perform the majority of their processing work at night. Plants are located as close to customers as possible to minimize the delivery constraints inherent in next-day service. Qualex currently operates 50 plants located in 33 states. The combination of Colorcraft and Kodak initially permitted Qualex to consolidate plants and other distribution systems which serviced overlapping geographic areas. The consolidation of redundant services has allowed and will continue to allow Qualex to enjoy the benefits of economies of scale and cost savings. In early 1987, Colorcraft Corporation entered into long-term arrangements to purchase a significant portion of its photofinishing materials from Kodak. Upon its formation, Qualex assumed these arrangements on substantially the same terms and conditions. Additionally, all of Qualex's photofinishing plants which offer nonbranded products participate in the Kodak Colorwatch(R) photofinishing marketing program and, therefore, use exclusively Kodak consumable materials. As a result of the long-term arrangements and the fact that substantially all of Qualex's plants are on the Kodak Colorwatch(R) program, Qualex purchases substantially all of its photofinishing material from Kodak. SEE "CONSOLIDATED STATEMENTS OF OPERATIONS" IN CONSOLIDATED FINANCIAL STATEMENTS. In addition to its traditional photofinishing services, Qualex also provides microlabs and related maintenance and supplies to customers who desire to offer on-site processing. Because of the continuing development of the microlab, the ultimate level of acceptance by retail stores and consumers cannot be determined. Management believes the new microlabs will allow both Qualex and its retail customers to participate in the well established on-site processing market. SEE ITEM 3. "LEGAL PROCEEDINGS." Qualex has not incurred significant research and development costs. In order to deliver high-quality pictures in a brief period of time at a competitive price, Qualex utilizes high-speed printers, paper processors and other sophisticated equipment which require significant ongoing capital expenditures. Capital expenditures in 1993 were approximately $44 million. Competition in the photofinishing industry is aggressive and is based upon price, quality processing, dependable delivery time and convenience. There are many processors in each market, including mini-labs and microlabs which offer "one-hour" on-site developing. In 1993, Qualex's largest account constituted 11% of its sales volume, its five largest accounts produced approximately 31% of its sales volume and its 10 largest accounts produced approximately 43% of its sales volume. Due to the next day processing nature of the business, there is no material backlog. Actava and Kodak are parties to a Shareholders' Agreement (as amended, the "Qualex Shareholders' Agreement") which sets forth certain rights of and limitations on Actava and Kodak with regard to their Qualex stock. The Qualex Shareholders' Agreement provides that certain decisions regarding Qualex's operations are to be approved by a majority of the members of the Qualex Board of Directors, including at least one of Kodak's representatives on the Board. The declaration of dividends by Qualex merely requires the approval of a majority of the Qualex directors. Actava has control over the distribution of dividends from Qualex because its appointees constitute a majority of the Qualex directors. Upon any change of control of Actava, as defined in the Qualex Shareholders' Agreement ("Qualex Control Event"), the Qualex Shareholders' Agreement provides for changes in the stock ownership and the composition and voting requirements of the Qualex Board of Directors that would eliminate Actava's ability, among other things, unilaterally to cause the declaration of dividends by Qualex. Pursuant to the terms of an amendment to the Qualex Shareholders' Agreement (the "Amendment"), the parties have stipulated that the election of Mr. Charles R. Scott as president and chief executive officer of Actava on February 6, 1991 constituted a Qualex Control Event. Under the terms of the Amendment, Kodak initially waived its Qualex Control Event rights under the Qualex Shareholders' Agreement with respect to such Qualex Control Event, but Kodak reserved the right to withdraw its waiver and enforce such rights on March 1, 1992 or any subsequent March 1, by providing Actava with at least 30 days' prior written notice. Kodak did not withdraw its waiver and seek to enforce its rights as a result of such Qualex Control Event on March 1, 1992, March 1, 1993 or March 1, 1994. Kodak also retained its rights to require the changes permitted by the Qualex Shareholders' Agreement if any other Qualex Control Event occurs. If Kodak in the future elects to enforce its Qualex Control Event rights, Actava would lose the ability to control the declaration of dividends by Qualex, and therefore, any distribution of profits by Qualex. The results of Qualex are consolidated with the results of Actava. In 1993, Qualex accounted for 62% of Actava's consolidated sales. SEE ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." If Actava in the future is deemed to be no longer in control of Qualex, then Actava would cease to consolidate the accounts of Qualex. In that event, Actava would account for its ownership of Qualex using the equity method of accounting. SEE "PHOTOFINISHING TRANSACTION" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. LAWN AND GARDEN EQUIPMENT Actava's Snapper Division manufactures Snapper(R) brand power lawnmowers, lawn tractors, garden tillers, snow throwers, and related parts and accessories and distributes blowers, string trimmers and edgers. The lawnmowers include rear engine riding mowers, front engine riding mowers or lawn tractors, and self-propelled and push-type walk-behind mowers. Snapper also manufactures a line of commercial lawn and turf equipment, a Blackhawk(TM) line of mowers and markets a fertilizer line under the Snapper(R) brand. Snapper products are premium priced, generally selling at retail from $250 to $8,200. They are sold exclusively through 54 independent distributors and to approximately 7,800 dealers throughout the United States. In addition, Snapper products are exported to 27 independent distributors and four company-owned distributors covering 41 foreign countries. Snapper does no private label manufacturing of lawn and garden equipment and does not sell directly to multi-unit retailers or mass merchandisers. While the ultimate consumers generally purchase lawnmowers in the spring and early summer, Snapper sells to its distributors nearly year-round utilizing accounts receivable dating programs, with the greatest volume of production and shipment preceding ultimate consumer purchasing periods. Accounts receivable dating programs establish the due dates for distributor accounts receivable to coincide with the anticipated sales to the ultimate consumer. Therefore, Snapper's cash flow needs are seasonal, with the greatest need for funds being in the first quarter of the year. SEE ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS." Snapper makes available, through General Electric Credit Corporation, a retail customer revolving credit plan which allows consumers to pay for Snapper products in installments. Consumers also receive Snapper credit cards which can be used to purchase additional Snapper products. In addition, Snapper has an agreement with a financial institution which makes available to dealers floor plan financing for Snapper products. This agreement provides financing for dealer inventories and accelerates cash flow to Snapper's distributors and to Snapper. Under the terms of the agreement, a default in payment by one of the dealers on the program is non-recourse by the financial institution to both the distributor and Snapper. However, the distributor is obligated to repurchase any equipment recovered from the dealer and Snapper is obligated to repurchase the recovered equipment if the distributor defaults. Snapper manufactures its products in McDonough, Georgia at facilities totaling approximately 1,000,000 square feet. A substantial portion of the component parts for Snapper products is manufactured by Snapper, excluding engines and tires. During the three years ended December 31, 1993, Snapper has expended an average of $4.9 million per year for research and development. While it holds several design and mechanical patents, Snapper is not dependent upon any one or more patents, nor does it consider that patents play a material role in its business. Snapper does believe, however, that its registered trademark Snapper(R) is an important asset in its business. Snapper walk-behind mowers are subject to Consumer Product Safety Commission safety standards and are designed and manufactured in accordance therewith. The lawn and garden business is highly competitive, with the competition being based upon price, image, quality and service. While no one company dominates the market, Actava believes Snapper is one of the significant manufacturers of lawn and garden products. There are approximately 50 manufacturers in competition with Snapper. Snapper's principal brand name competitors in the sale of power lawnmowers include The Toro Company, Lawn-Boy (a product group of The Toro Company), Sears, Roebuck and Co., Deere & Company, Ariens Company, Honda Corporation, Murray Ohio Manufacturing Co., American Yard Products, Inc. (a subsidiary of AB Electrolux), MTD Products, Inc. and Simplicity Manufacturing, Inc. The Company announced in March 1993 that it had retained Merrill Lynch to assist in exploring alternatives for realizing value from the Company's investment in Snapper. These efforts have not been successful and management believes they have resulted in a substantial distraction for Snapper's management, distributors and dealers. As a result, the Company has suspended its efforts to find alternatives for Snapper and has instructed Snapper's management to devote their full time and attention to improving operating results. At December 31, 1993, Snapper had approximately $122 million in backlog orders believed to be firm as compared to approximately $114 million at December 31, 1992. In 1993, Snapper accounted for 18% of Actava's consolidated sales. SEE ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." SPORTING GOODS The companies which comprise Actava Sports manufacture, import and distribute products for a broad cross section of the sporting goods and leisure time markets. Products are sold under a variety of Actava's own brand names, including DP(R), Hutch(R), Reach(R), Weather-Rite(R) and American Camper(R). Actava also sells exercise equipment under a license for the Body By Jake(R) trademark and various other products under licenses from the National Football League, National Basketball Association, National Hockey League, Major League Baseball, The Walt Disney Company, Inc., Remington Arms Company, Inc. and numerous colleges and universities. In addition, Actava has a nationally distributed line of hosiery and is a licensee for the officially licensed socks of the National Football League, Major League Baseball, Keds(R) and Pro-Keds(R) (copyrights and registered trademarks which are held by third parties) and various colleges and universities. On June 8, 1993, Actava acquired substantially all of the assets of Diversified Products Corporation ("DP"), a fitness and recreation equipment company based in Opelika, Alabama, for a net purchase price consisting of $11,629,500 in cash, the issuance of 1,090,909 shares of the Company's Common Stock valued at $12,000,000 and the assumption or payment of certain liabilities including trade payables and a revolving credit facility. Actava also entered into an agreement which may provide the seller with the right to receive additional payments, or additional shares of Actava Common Stock, depending upon the value of the issued shares over a period of not longer than one year from the purchase. SEE ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." The transaction has been accounted for using the purchase method of accounting; accordingly, the purchased assets and liabilities have been recorded at their estimated fair value at the date of the acquisition. The results of operations of the acquired business have been included in the consolidated financial statements of Actava since the date of acquisition. Approximately 57% of the sales of Actava Sports consists of products manufactured or purchased domestically by Actava. These include hosiery, footballs, uniforms and related equipment. The remaining 43% of sales comes from imported merchandise, including fitness and camping equipment, soccer balls, volleyballs, basketballs, footballs, rainwear and other related sports items. Imported products come from a large number of suppliers, located primarily in the Far East. Analyzed by product lines, camping and outdoor equipment comprised approximately 26% of the Actava Sports sales in 1993, exercise equipment represented 36% and products for team and other recreational activities comprised approximately 38%. International buying is an important part of the Actava Sports operations. Actava World Trade Corporation maintains offices in The People's Republic of China, Taiwan, Hong Kong and South Korea to facilitate purchasing in the Pacific Rim. To the extent the business of Actava Sports is dependent upon imports, factors affecting foreign trade (such as dock and carrier strikes, tariff rates, import and export quotas, currency fluctuations and revaluations, local economic conditions in foreign countries, foreign relations between the United States and other countries and international political and economic situations) are significant in determining the general availability and prices paid by Actava Sports for purchases abroad. Actava Sports has not encountered a shortage of raw materials or finished goods and is generally not dependent upon any sole supplier, although in 1993 DP was adversely affected by delays experienced in receiving electronic components for DP treadmills. SEE ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." Sporting goods are sold by Actava Sports through manufacturers' representatives and directly to mass merchandisers and other retailers. The sporting goods market is highly competitive. Actava Sports does not spend a significant amount of funds for research and development. The trademarks used by Actava Sports in the aggregate are considered to be of material importance, but no single patent or trademark is of material importance to consolidated operations. The loss of certain significant patents or trademarks could have a material effect on the affected individual Actava Sports company. Actava Sports had approximately $34 million in backlog orders believed to be firm as of December 31, 1993 as compared to approximately $19 million at December 31, 1992. This increase is primarily due to the acquisition of DP. In 1993, Actava Sports accounted for 19% of Actava's consolidated sales. SEE ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." ENVIRONMENTAL PROTECTION Actava's manufacturing and processing plants are subject to federal, state and local pollution laws and regulations. Compliance with such laws and regulations has not, and is not expected to, materially affect Actava's competitive position. Actava's capital expenditures for environmental control facilities and incremental operating costs in connection therewith were not material in 1993, and are not expected to be material in future years for compliance relating to facilities owned by Actava in 1993. The Company is involved in various environmental matters including clean-up efforts at landfill or refuse sites and groundwater contamination. The Company's participation in three existing superfund sites has been quantified and its remaining exposure is estimated to be less than $300,000 for all three sites. The Company is participating with the Federal and Ohio Environmental Protection Agencies in initial investigations of a potential environmental contamination site involving a divested subsidiary. DP is also complying with various requirements under a compliance order under the Resource Conservation Recovery Act as administered by the State of Alabama. Upon the acquisition of DP, a reserve of approximately $1.5 million was established for expected clean-up costs. EMPLOYEES At December 31, 1993, Actava, including Qualex, had approximately 11,200 employees, of whom approximately 1,400 were represented by unions under various collective bargaining agreements. In general, Actava believes its employee relations to be good. INDUSTRY SEGMENT DATA Industry Segment Data is included in ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." ITEM 2. ITEM 2. PROPERTIES. The following is a list of Actava's principal properties. Certain of the properties are subject to mortgages securing indebtedness, which, as of December 31, 1993, aggregated approximately $1.8 million, including mortgages on machinery and equipment. SEE "NOTES PAYABLE AND LONG-TERM DEBT" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The management of Actava believes that the above listed facilities are generally adequate and satisfactory for their present usage. In addition, Actava owns or leases miscellaneous real estate, offices and warehouse facilities, machinery and equipment at various locations which are not currently utilized in Actava's current operations and are, or may be, offered for sale or other disposal. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Qualex On February 18, 1994, Photographic Concepts Inc. (PCI), a Florida corporation, sued Qualex in the United States District Court for the Middle District of North Carolina, in a lawsuit captioned Photographic Concepts, Inc. v. Qualex, Inc., Civil Action No. 1:94-CV-00081. PCI's claims arise out of allegations that Qualex entered into and then breached an agreement with PCI relating to the marketing of on-site microlab photofinishing services. During 1993, Qualex's microlab business resulted in $33.3 million in revenues and $7.3 million in gross profits, and Qualex expects such business to increase in the future. PCI alleges, among other things, that Qualex breached an agreement to purchase an interest in PCI, violated a confidentiality agreement with PCI, and misappropriated trade property and other information from PCI. PCI is seeking both monetary and injunctive relief. Qualex is currently gathering the information and documents necessary to file its response to PCI's Complaint. That response must be filed by April 25, 1994. Qualex intends to defend the case vigorously, but the Company is unable to determine the probable impact of the suit at this early stage in the proceeding. Divested Subsidiary On November 30, 1993, a lawsuit was filed by the Department of Justice ("DOJ") against American Seating Company ("American Seating"), a former subsidiary of Actava, in the United States District Court for the Western District of Michigan. The lawsuit is captioned United States v. American Seating Co., Civil Action No. 1:93-CV-956. Pursuant to an asset purchase agreement between Actava and Amseco Acquisition, Inc., dated July 15, 1987, Actava assumed the obligation for certain liabilities incurred by American Seating arising out of litigation or other dispute, involving events occurring on or before June 22, 1987. The DOJ alleges that American Seating failed to disclose certain information relating to its price discount practices that it contends was required in an offer submitted by American Seating to the General Services Administration for possible contracts for sales of systems furniture and related services. The complaint seeks recovery of unspecified single and treble damages, penalties, costs and prejudgment and post-judgment interest. The parties have engaged in settlement discussions but have not agreed on a disposition of the case. A trial, if necessary, has been scheduled for June 1995. Management believes that American Seating has meritorious defenses to the allegations and intends to vigorously defend the action. Since the suit is still in the early stages, management is unable to determine the probable impact of the suit. Because the DOJ has previously asserted damages of approximately $3.5 million, the lawsuit could have a material effect on results of operations and financial condition of the Company, if adversely determined, on a number of disputed issues as to liability, damages and penalties. Shareholder Litigation In 1991, Virginia E. Abrams and Fuqua Industries, Inc. v. J. B. Fuqua, et al., Civil Action No. 11974, was filed in the Delaware Chancery Court. The named defendants are certain current and former members of Actava's Board of Directors and Intermark, Inc., a predecessor of Triton Group Ltd., which currently owns 25.0% of the Company's Common Stock. The Company was named as a nominal defendant. The action is brought derivatively in the right of and on behalf of the Company and was purportedly brought as a class action on behalf of all common stockholders of the Company other than the defendants. The complaint alleges, among other things, a long-standing pattern and practice by the defendants of misusing and abusing their power as directors and insiders of the Company by manipulating the affairs of the Company to the detriment of the Company's past and present stockholders. The complaint seeks (i) monetary damages from the director defendants, including a joint and several judgment for $15.7 million for alleged improper profits obtained by Mr. J. B. Fuqua in connection with the sale of his shares in the Company to Intermark; (ii) injunctive relief against the Company, Intermark and its current directors, including a prohibition against approving or entering into any business combination with Intermark without specified approval; and (iii) costs of suit and attorneys' fees. In 1991, two additional complaints, Behrens and Harris v. Fuqua Industries, Inc., et al., Civil Action No. 11988 and Freberg and Lewis v. Fuqua Industries, Inc., et al., Civil Action No. 11989, were filed in the Delaware Chancery Court by plaintiffs who allege that they are stockholders of the Company. Each of these complaints purport to be brought on behalf of a class of stockholders of the Company other than the named defendants. The named defendants are the Company and certain of its current and former directors. The complaints allege, among other things, that members of the Company's Board of Directors presently contemplate either a sale, a merger or other business combination involving Intermark and the Company or one or more of its subsidiaries or affiliates. The complaints seek costs of suit and attorneys' fees and preliminary and permanent injunctive relief and other equitable remedies, ordering the director defendants to carry out their fiduciary duties to the plaintiffs and other members of the class and to take all appropriate steps to enhance the Company's value as a merger or acquisition candidate. On motion by the defendants in all three class action suits, the Delaware Chancery Court ordered the consolidation of the three suits in re Fuqua Industries, Inc. Shareholder Litigation, Civil Action No. 11974 on May 1, 1991. The action is in the discovery stage and no significant events occurred in regard to these legal proceedings in 1993. Other Litigation Actava is the defendant in various other legal proceedings. Actava is not aware, however, of any other action which, in the opinion of management, would materially and adversely affect liquidity, results of operations or the financial position of Actava. SEE ITEM 1. "ENVIRONMENTAL PROTECTION." ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. EXECUTIVE OFFICERS OF THE REGISTRANT Each of the executive officers of Actava as of the date hereof was elected to serve until the next annual meeting of the Board of Directors of Actava or until his successor is elected and qualified: On February 6, 1991, Mr. Charles R. Scott was elected to the office of president and chief executive officer. Mr. Scott had previously not held an office with Actava although he had been a member of the Board of Directors since January 16, 1989 and served as chairman from July 1, 1989 to February 6, 1991. Prior to being elected as Actava's president and chief executive officer, Mr. Scott served as chairman and chief executive officer of Intermark, Inc., which, through its wholly owned subsidiary, Triton Group Ltd., owned approximately 25.0% of the outstanding shares of Actava's common stock. In 1992, Intermark filed for protection under Chapter 11 of the Bankruptcy Act and was merged into Triton Group Ltd. upon confirmation of its Plan of Reorganization on June 25, 1993. On March 3, 1994, Actava announced that an independent committee of its Board of Directors had been appointed to select a successor to Mr. Scott. On May 30, 1991, Mr. Frederick B. Beilstein was elected to the office of senior vice president-treasurer and chief financial officer. Prior to joining Actava, Mr. Beilstein served as executive vice president and chief financial officer of Edgcomb Metals Company from January 1990 through March 1991. Prior to March 1991, Mr. Beilstein served as senior executive vice president and chief financial officer of Days Inns Corp. and as president of Days Inns Management Company, Inc. Mr. Walter M. Grant was elected to the office of senior vice president and general counsel in July 1993 and to the position of corporate secretary in March 1994. Mr. Grant served as senior vice president and general counsel for the North American operations of Smith & Nephew plc, an international health care company, from October 1991 through June 1993. Prior to October 1991, Mr. Grant served as vice president, general counsel and secretary of Contel Corporation, a telecommunications company. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. Actava's Common Stock is listed and traded on the New York and Pacific Stock Exchanges. The following table summarizes the high and low market prices according to the New York Stock Exchange Composite Tape and cash dividends declared for 1993 and 1992: Actava's debt agreements, including subordinated debt, contain covenants which, among other things, place restrictions upon the amount of dividends it may pay. SEE ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." On March 3, 1994, the Company reported the suspension of the dividend on its Common Stock. SEE ITEM 7. "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." As of March 24, 1994, there were approximately 6,878 holders of record of Common Stock. The last reported sale price of the Common Stock on the composite tape on such date was $7 1/4 per share. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Actava provides high-quality, brand name consumer products through distribution channels to retail markets across the United States. The Company's businesses encompass the broad leisure industry, including photofinishing, fitness equipment and sporting goods, as well as lawn and garden equipment. Actava owns 51% of the voting stock of Qualex, the largest photofinisher in the United States, processing approximately 20% of all color print rolls of film. Qualex also processes black and white and movie film. Qualex is a wholesale photofinisher, obtaining substantially all of its sales from independent retailers in 1993. Qualex's business also includes a limited amount of direct sales to consumers through owned and operated retail photographic stores and mail-order operations. Actava's Snapper Division manufactures Snapper(R) brand power lawnmowers, lawn tractors, garden tillers, snow throwers, and related products, parts and accessories and distributes blowers, string trimmers and edgers. The lawnmowers include rear engine riding mowers, front engine riding mowers or lawn tractors, and walk-behind mowers. Snapper also manufactures a line of commercial lawn and turf equipment and a Blackhawk(TM) line of mowers and markets a fertilizer line under the Snapper(R) brand. Actava Sports companies manufacture, import and distribute products for a broad cross-section of the sporting goods, fitness and leisure markets. Products are sold under a variety of Actava companies' own brand names, as well as under licenses from the National Football League, National Basketball Association, Major League Baseball, The Walt Disney Company, Inc., Remington Arms Company, Inc., The Keds Corporation (Keds(R) and Pro-Keds(R)), Body by Jake Licensing Corporation (Body by Jake(R)), and numerous colleges and universities. Actava's long-range strategy is to maximize stockholder wealth by concentrating its capital resources on its companies which offer the highest potential returns. As a result, the Company continues to analyze its businesses with a view toward enhancing their value through marketing alliances, licensing arrangements and joint ventures, with particular emphasis on cost efficiencies through plant consolidations or product-line expansions or improvements. The following is a discussion of the operating results and financial position of the Company on a consolidated basis and the operating results of each of these business segments. CONSOLIDATED CONTINUING OPERATIONS The Company's consolidated sales for 1993 increased $92.4 million, or 8.0% from 1992 principally because of the acquisition of DP. Gross profit as a percentage of sales for 1993 of 22.9% is a decrease from 29.2% while gross profit dollars decreased by $52.1 million to $283.7 million. This is primarily due to gross profit declines suffered by Snapper and Qualex, but partially offset by an increase in gross profits by Actava Sports companies. The Snapper gross profit decline is primarily attributable to manufacturing problems associated with new product introductions during 1993. In 1992, sales increased $224.1 million, or 24.2%, from 1991, primarily as a result of the resumption of production and shipment to distributors at Snapper, the impact of the acquisitions at Qualex in the fourth quarter of 1991 and the first quarter of 1992 as well as increased market share with certain Qualex customers and the expansion of business with existing customers for each of the companies comprising Actava Sports. The gross profit for 1992 of $335.8 million compared to the gross profit for 1991 of $255.5 million, an increase of $80.3 million. This increase was primarily attributable to the increased production and shipment levels at Snapper for 1992 which resulted in significantly higher sales and absorption of fixed manufacturing costs and the additional gross profit at Qualex attributable to acquisition activities. During 1991, certain inventory quantities at Snapper were reduced, resulting in a liquidation of LIFO inventory quantities which were carried at lower costs prevailing in years prior to 1991 as compared with the cost of 1991 purchases. The effect of this decreased the 1991 net loss by approximately $1.5 million and decreased loss per share of common stock by $.09. Selling, general and administrative expenses, which include provisions for doubtful accounts, decreased by $9.9 million, or 3.8%, to $253.7 million for 1993 in comparison to 1992. The reductions in selling, general and administrative expenses are primarily attributable to cost reductions at Qualex achieved through plant and administrative restructuring and consolidations. Selling, general and administrative expenses, which include provisions for doubtful accounts, increased by $1.7 million in 1992 in comparison to 1991. The 1992 increase is related to the additional costs at Qualex associated with the increased volume of prints processed as well as higher promotional and advertising expenses partially offset by reductions at Snapper due to the curtailment of special promotional programs and the positive impact of other administrative cost savings as a result of plant restructuring and a decrease in unallocated corporate expenses principally because of the downsizing of the corporate staff. In 1993, Actava recorded an operating profit of $26.7 million, compared to an operating profit from 1992 of $72.1 million. The 1993 operating profit includes provisions of $3.2 million for plant relocations and consolidations and an additional $4.0 million for a change in estimate of future warranty costs at Snapper due to increased warranty claims. Also negatively impacting operating profits for 1993 in comparison to 1992 was underutilization of plant capacity and manufacturing inefficiencies at Snapper and DP, lower gross margins on initial product introductions by Snapper, and an increase in corporate expenses of approximately $4.0 million. The corporate expense increase is primarily attributable to additional self-insurance reserves, as well as an increase in insurance administrative expense, and the impact of reduced expense for 1992 due to the reversal in 1992 of certain reserves previously established for settlement of employee agreements and office relocations. The 1992 operating profit of $72.1 million compares to an operating loss of $35.7 million for 1991. The operating loss for 1991 included provisions for plant relocations and consolidations totaling $19.0 million and provisions for the settlement of employee agreements and related costs of $6.8 million. Operating profit for 1991 was adversely affected by production costs at Snapper. Interest expense for 1993 of $43.3 million is an increase of $9.8 million from 1992. This increase is primarily attributable to higher average borrowings at both Qualex and Snapper and the addition of interest associated with DP. The increased borrowing resulted from the Qualex $200 million Senior Note private placement completed in the second quarter of 1992 and the revolving credit facilities established to provide working capital for Snapper and the Actava Sports companies, including DP. These credit lines have substantially reduced subsidiary reliance on Actava for working capital needs. Interest expense for 1992 of $33.5 million is an increase of $9.9 million from 1991. This increase is primarily attributable to higher average borrowings at both Qualex and Snapper. The increased borrowing resulted from the financing required for the acquisitions made by Qualex in the fourth quarter of 1991 and January 1992, borrowings in excess of debt repayments from the Qualex Senior Note private placement, and the revolving credit facilities established in 1992 to provide working capital for Snapper. Other income (net of other deductions) decreased $9.0 million for 1993 when compared to 1992. This is primarily due to a decrease in investment income from lower levels of investment, increases in early payment interest credit expense at Snapper, losses on asset sales at Qualex and an increase of $3.0 million in a valuation allowance for a real estate investment due to an accelerated plan of disposition. Other income (net of other deductions) in 1992 increased $2.6 million in comparison to 1991. This increase is the result of a decrease in early payment interest credit expenses at Snapper, partially offset by reduced investment income due to lower average investment levels and rates of return. During the year, the Company provides for income taxes using anticipated effective annual tax rates for Qualex and for all other company operations. The rates are based on expected operating results for the year and estimated permanent differences between book and taxable income. Due to the recognition of net operating loss benefits to the extent possible through a reduction in deferred income tax liabilities in a prior year, Actava, excluding Qualex, recognizes the benefit of current net operating losses only to the extent of potential refunds from carrybacks. SEE "INCOME TAXES" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The Company has net deferred taxes of approximately $24.3 million composed of deferred tax liabilities of approximately $78.1 million offset by deferred tax assets of approximately $53.8 million. 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. Included in the approximate $53.8 million of deferred tax assets is approximately $16.2 million as recognized by Qualex, which is not included in the Actava consolidated federal income tax return. The remaining approximate $37.6 million of deferred assets have been recognized by Actava due to available income tax carrybacks and the company's determination that available net operating losses should not be allowed to expire, as the tax savings represent significant amounts. The Company plans to implement actions to create sufficient taxable income to utilize the carryover prior to any expiration. In order to implement its tax planning strategy to utilize its tax carryforwards, the Company would pursue the sale of certain corporate assets, including its investment in Qualex. SEE "INCOME TAXES" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The minority interest shown on Actava's Consolidated Statements of Operations represents Kodak's portion of the earnings of Qualex. In accordance with the Shareholders' Agreement, the Company and Kodak are each entitled to 50% of Qualex's net income for income reporting purposes. Although Qualex accounted for 62% of Actava's 1993 revenues and had pre-tax profits of $33.7 million in 1993, only approximately 25% of its pre-tax profits ($8.5 million in 1993) is reported in Actava's consolidated net income due to Qualex's income tax provision at an effective rate of 49% and the 50% minority interest effect. SEE "PHOTOFINISHING TRANSACTION" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. Effective January 1, 1992, Qualex changed its method of accounting for the cost of its proof advertising program to recognize advertising expense as it is incurred rather than at the time of the initial sale to the customer. SEE "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- ACCOUNTING CHANGES -- CHANGE IN ACCOUNTING FOR CERTAIN ADVERTISING COSTS" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". The Company adopted the new method of accounting for income taxes as of January 1, 1993. Statement No. 109 affects the manner and rates at which deferred income taxes are reflected on the balance sheet and the amount of taxes reflected in the statement of operations. The adoption of Statement No. 109 did not result in a material effect on net income for 1993. SEE "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ACCOUNTING CHANGES -- CHANGE IN METHOD OF ACCOUNTING FOR INCOME TAXES" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". Statement No. 106 requires the cost of postretirement benefits to be recognized in the financial statements over an employee's active working career. The Company adopted the new method of accounting for these benefits as of January 1, 1993. The adoption of Statement No. 106 resulted in a charge to net income of $4.4 million and was reported as the cumulative effect of change in accounting principle in the first quarter of 1993. SEE "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- ACCOUNTING CHANGES -- CHANGE IN METHOD OF ACCOUNTING FOR POSTRETIREMENT BENEFITS" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The Company and its subsidiaries provide benefits to former or inactive employees after employment, but before retirement, such as severance benefits, continuation of health care benefits and life insurance coverage. The costs of these are currently accounted for on a pay-as-you-go (cash) basis. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires employers to recognize the obligation to provide these benefits when certain conditions are met. The Company is required to adopt the new method of accounting for these benefits no later than January 1, 1994. The adoption of Statement No. 112 will not have a significant effect on the Company's financial position or results of operations. The Company and its subsidiaries invest in various debt and equity securities. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires certain debt securities to be reported at amortized cost, certain debt and equity securities to be reported at market with current recognition of unrealized gains and losses, and certain debt and equity securities to be reported at market with unrealized gains and losses as a separate component of shareholders' equity. The Company is required to adopt the new method of accounting no later than January 1, 1994. The adoption of Statement No. 115 will not have a significant impact on the Company's financial position or results of operations. As a result of the items described above, Actava reported a net loss in 1993 of $47.6 million in comparison to net income in 1992 of $11.6 million and a net loss in 1991 of $50.8 million, respectively. OPERATING SEGMENTS SEGMENT PERFORMANCE THE ACTAVA GROUP INC. AND SUBSIDIARIES - --------------- (a) Pre-Tax Earnings include the minority interest of Eastman Kodak Company in Qualex Inc. (b) Operating profit represents total sales less costs of products sold and selling, general and administrative expenses including goodwill amortization. There were no significant intersegment sales or transfers. (c) Includes a provision of $4.1 million in 1993, $17.0 million in 1991, $15.7 million in 1990, and $2.9 million in 1989 before tax for the relocation or consolidation of certain photofinishing plants. (d) Includes warranty expense of $4.0 million before tax in 1993 due to a change in accounting estimate and provisions in 1990 of $13.7 million before tax for the consolidation of lawn and garden manufacturing facilities and $4.8 million before tax for the write-off of excess inventory created as a result of the elimination of certain models from lawn and garden product lines. Photofinishing: In 1988, the Company combined its photofinishing operations, with the domestic photofinishing operations of Eastman Kodak Company in a transaction accounted for as a purchase, forming a jointly owned company, Qualex Inc. SEE "PHOTOFINISHING TRANSACTION" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. In October, 1993, Qualex entered into an Agreement of General Partnership with JVQ Capital One, Inc. for the purpose of acquiring, owning, holding, leasing, and selling on-site microlab equipment. In the future, Qualex intends to sell to this partnership qualifying leases of microlab equipment with the result that Qualex will record income upon the sale of the lease rather than over the life of the lease. Qualex will continue to service the equipment under an agreement with the lessee of the equipment and will pay fees for management and leasing services to the parent corporation of JVQ Capital One, Inc., a general partner. Actava, which owns 51% of the voting shares of Qualex, consolidates the accounts of Qualex with its accounts. Kodak's interest in the earnings and equity of Qualex are reflected as minority interest. Photofinishing sales increased $4.4 million or .6% in 1993 as compared to 1992 due primarily to the conversion of former microlab operating leases to salestype financing leases as a result of the expiration of early cancellation periods for certain of such leases. An overall increase in equivalent prints processed from 1992 to 1993 partially offset continued per print price declines. Photofinishing sales increased $121.1 million or 18.6% in 1992 as compared to 1991. Generally, Qualex experienced price declines of 4% to 5% during the 1992 year while sales increased. These price decreases occurred due to the effect of price reductions offered by competitors and the associated demand for similar prices from Qualex customers. The primary reasons for the sales increase were the added print volume resulting from acquisitions finalized in the last quarter of 1991 and in January 1992 (SEE "ACQUISITIONS" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS), and an overall increase in rolls processed through comparable 1991 plants, partially offset by continued price declines. Although sales increased in 1993, per print price continued to decline, resulting in a decrease in gross profit as a percent of sales from 31.3% for 1992 to 28.3% for 1993, with 1992 restated to include route distribution costs as a cost of sales component. Gross profit dollars decreased $22.2 million in 1993 from 1992 levels. Gross profit as a percentage of sales was 31.3% for 1992 and 1991. However, because of the increase in sales, gross profit dollars rose $38.4 million or 18.9% in 1992 in comparison to 1991. The 1991 increase, however, was partially offset by increases in selling, general and administrative expenses. As a result of the additional sales volume, selling expense increased $8.1 million or 16.4% and route pick-up and delivery costs increased by $9.0 million or 14.7% for 1992 in comparison to 1991. In addition, advertising and promotional expenses decreased $1.7 million or 5.5% as a result of an accounting principle change which resulted in the deferral of $3.5 million of advertising expenses to later periods. If the accounting principle for the recognition of certain advertising expenses had not been changed, advertising and promotional expenses would have increased by $1.8 million or 5.8% in 1992. Qualex also incurred increased administrative expenses of $19.3 million or 24.8% for 1992 in comparison to 1991. This increase was primarily due to acquired administrative offices, amortization of intangibles associated with the 1991 and 1992 acquisitions and the increased volume of prints processed, even though the cost per print has decreased. As a result, operating profit before charges for plant relocations and consolidations increased $807,000 in 1993 and $9.6 million in 1992 when compared to respective prior periods. Charges for plant relocations and consolidations of $4.1 million for 1993 and $17.0 million for 1991 were provided, while no provision was made for 1992. This contributed to the increase in operating profit of $26.6 million, or 95%, from 1991 to 1992, and to a decrease in operating profit of $3.3 million, or 6%, from 1992 to 1993. In 1993 and 1991 Qualex recorded charges of $4.1 million and $17.0 million before tax benefits, respectively, primarily for the expenses associated with the relocation and consolidation of certain photofinishing plants and, in 1992, $725,000 for the consolidation of certain marketing and sales and operations functions. During 1992 and 1993, $33.3 million was charged against these reserves for the direct costs associated with plant and administrative relocations and consolidations and the reserve balance available for future charges was $6.8 million at December 31, 1993. As a result of the above factors, Qualex recorded an operating profit of $51.3 million for 1993, a decrease of $3.3 million or 6.0% from 1992. The operating profit for 1992 of $54.6 million was an increase of $26.6 million from 1991. Management anticipates lower pricing trends in the wholesale photofinishing industry to continue in 1994. Qualex will attempt to offset the effects of lower pricing with improved product mix, lower prices for paper and chemicals, the sale of certain microlab leases and continuing consolidations of plant facilities and administrative offices. Lawn and Garden: Snapper's sales to distributors decreased by $23.2 million, or 9.4% for 1993 in comparison to 1992, despite a strong retail sales year for lawn and garden equipment, as Snapper continued to control production to estimated retail sales by reducing production and shipments to distributors in order to decrease retail inventories. Sales for 1993 and 1992 were $225.0 million and $248.2 million, respectively. Gross profit as a percentage of sales decreased to 13.9% for 1993 as compared to 27.5% in 1992. Gross profit in dollars decreased by $37.0 million from $68.2 million to $31.2 million for these same respective periods. These decreases resulted from continuing manufacturing problems such as unfavorable manufacturing variances and cost over-runs for newly introduced products as well as an increase in product related expenses such as warranty. The start-up costs, overall product mix and delays associated with these new products negatively impacted Snapper's cost of sales. In addition, because Snapper's new Blackhawk(TM) line of mowers, which represented sales of approximately $10.9 million in 1993, is a lower price-point and margin product than the Snapper(TM) brand line, per unit gross margin has been lower when compared to last year's margins. Management does not expect sales of Blackhawk(TM) line to be as significant in 1994 as in 1993. A $4.0 million warranty expense was charged to operations in the fourth quarter of 1993 due to recent unanticipated increases in warranty claims. Also, gross profit was lower because of inventory shortages and shut-down costs for a company owned foreign distributor. Snapper's sales to distributors and gross profit increased $89.7 million and $40.2 million or 56.5% and 143.7%, respectively, for 1992 in comparison to 1991. 1991 sales to distributors were purposely reduced as a result of the decision to decrease retail inventories by producing and shipping less product than that sold at retail. Production and shipment to distributors was increased for the 1992 model year. In addition, in 1992 Snapper redesigned and reengineered its product offerings, with particular emphasis on recycling and mulching capability. Because sales were down for 1993, selling, general and administrative expenses, including sales volume related expenses such as co-operative advertising, decreased by 2.5% in comparison to 1992. Income of $849,000 was provided by reducing a reserve for plant relocation and consolidation in recognition of finalizing a plant closing. During 1993, Snapper's management extended the due dates of certain receivables for terms beyond one year and as a result recorded unearned discounts in the amount of approximately $1.8 million as a charge to other expense. The decreased gross profit, partially offset by reduced selling, general and administrative expenses, resulted in an operating loss of $17.1 million at Snapper in 1993 as compared to an operating profit of $17.8 million for 1992. Operating profit decreased $34.9 million in 1993, compared to 1992, because selling, general and administrative expenses remained relatively constant whereas gross profit decreased by $37.0 million. In 1991, Snapper initiated an aggressive retail marketing campaign in order to further accelerate the reduction of inventory. Snapper reduced its expenditures for marketing promotions and advertising campaigns in 1992 in comparison to 1991, concentrating its 1992 programs on the new product offerings with particular emphasis on mulching capabilities as well as quality and service. As a result, selling, general and administrative expenses decreased $28.1 million or 35.8% in 1992, in comparison to 1991. In addition, certain cost reductions were achieved as a result of the 1991 closing of two of the three Snapper manufacturing facilities. Management believes these savings were approximately $10.0 million. As a result of the factors discussed above, Snapper recorded an operating profit of $17.8 million in 1992 in comparison to an operating loss of $50.6 million for 1991. The Company announced in March, 1993, that it had retained Merrill Lynch to assist in exploring alternatives for realizing value from the Company's investment in Snapper. These efforts have not been successful and management believes they have resulted in a substantial distraction for Snapper's management, distributors and dealers. As a result, the Company has suspended its efforts to find alternatives for Snapper and has instructed Snapper's management to devote their full time and attention to improving operating results. On August 9, 1993, the Company announced that a new Chief Executive Officer had been employed for Snapper. Sporting Goods: Sales for Actava Sports increased by $111.2 million, or 85.7% for 1993 when compared to 1992. This increase is primarily due to the acquisition of DP in June, 1993. In addition to the increase resulting from the acquisition, sales increased for other Actava Sports companies during 1993. Gross profit as a percent of sales decreased from 20.1% to 13.8% for 1993 but gross profit in dollars increased by $7.2 million, or 27.4%, from $26.0 million to $33.2 million, when compared to 1992. Selling, general and administrative expenses increased by $10.3 million for 1993 as compared to 1992, from $20.1 million to $30.4 million. This was due to $8.6 million of DP selling, general and administrative expense incurred from the acquisition date to year-end 1993. Operating profit decreased from $5.9 million in 1992 to $2.7 million in 1993. The decrease in operating profit is primarily attributable to DP, which recorded a loss for the six months ended December 31, 1993 due to the cautious retail environment and production problems caused by late delivery of electronic components for treadmill equipment. Actava announced on October 26, 1993, that a new President and Chief Executive Officer had been appointed for DP. Sales for Actava Sports increased $13.2 million or 11.4% in 1992 as compared to 1991. Each of the three subsidiaries that comprised this segment in 1992 had increased net sales in 1992 to their major multi-unit retail customers. The Actava Sports operating profit of $5.9 million for 1992 was an increase of 33.3% from 1991. Operating profit as a percent of net sales was 4.5% and 3.7%, respectively, for 1992 and 1991. In addition, operating profit for 1991 included the impact of provisions for plant consolidations of $500,000 before tax benefits for the costs of consolidating the manufacturing and warehouse facilities of one of the companies in Actava Sports. FINANCIAL POSITION Actava's working capital was $103.4 million at December 31, 1993 as compared to $176.1 million at December 31, 1992. The decrease reflects the loss incurred by the Company for 1993, repayment by Qualex of long-term debt using cash realized through collections and sales of accounts receivable, the payment of certain sinking fund requirements, the use of approximately $11.6 million of cash in the DP acquisition and $23.0 million of additional cash provided to DP. Increases in accounts receivable and increases in inventory are principally financed by borrowings from working capital lines of credit. Cash and short-term investments at Actava, excluding Qualex, decreased by $31.6 million in 1993, to $44.3 million. The primary reasons for this decrease were the cash requirements for the DP acquisition, plus a $15.0 million equity contribution and an $8.0 million working capital advance made by Actava to DP following the acquisition. Increased inventory also contributed to the decrease in cash. At December 31, 1993, approximately $5.0 million of Actava's cash and short-term investments were pledged to secure a Snapper credit line and approximately $20.7 million of cash and short-term investments were pledged to support outstanding letters of credit. Due to the seasonal nature of its businesses, the Company has the greatest need for funds in the first and last quarters of the year. For 1993, consolidated cash flows of $12.9 million were used by operations, investing activities used $25.0 million of cash, and financing activities provided $35.9 million of cash. Cash flow used by operations included depreciation of $44.7 million and amortization of $25.8 million. Investing activities used $25.0 million of cash, including payments for property, plant and equipment (net of disposals) of $39.5 million, payments for purchases of businesses of $9.4 million, representing the acquisition of DP, and net sales of investments of $34.2 million. Financing activities provided $35.9 million during the year with borrowings under short-term bank agreements of $52.3 million, net payments of $311,000 under longterm debt agreements, payments of subordinated debt of $1.8 million, and payments of dividends by Qualex and the Company of $8.6 million and $6.3 million, respectively. Actava's senior long-term debt increased slightly from $220.4 million at December 31, 1992 to $220.9 million at December 31, 1993. This increase is primarily attributable to borrowings by Qualex, partially offset by the termination of capitalized lease obligations for Snapper. Actava's long-term subordinated debt position of $190.6 million at December 31, 1993 is a decrease of $3.0 million from year-end 1992. Subordinated debt is 46.5% of Actava's total long-term debt, including the current portion, with the first significant maturity due in 1996. The Company has a currency swap agreement with a financial institution in order to eliminate exposure to foreign currency exchange rates for its 6% Senior Subordinated Swiss Franc Bonds. A default by the financial institution that is a party to the swap agreement would expose the Company to potential currency exchange risk on the remaining bond interest and principal payments. SEE "SUBORDINATED DEBENTURES" IN NOTES TO FINANCIAL STATEMENTS. On June 8, 1993, the Company acquired substantially all the assets of DP for a net purchase price consisting of $11.6 million in cash, the issuance of 1,090,909 shares of the Company's Common Stock valued at $12 million, and the assumption or payment of certain liabilities including trade payables and a revolving credit facility. SEE "ACQUISITIONS" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The Company also entered into an agreement which may provide the seller with the right to receive additional payments of cash, or additional shares of Company Common Stock, depending upon the value of the issued shares over a period of not longer than one year from the purchase date. The agreement gives the seller the right under certain circumstances, to require the Company to purchase the 1,090,909 shares issued to the seller in connection with the acquisition (the "Acquisition Shares") at a price equal to $11.00 per share. The payment of additional cash or the issuance of additional shares will not increase the cost recorded by Actava for DP, but will affect the manner in which the total purchase price is recorded by Actava. The right of the seller to receive additional payments of cash or additional shares of Company Common Stock becomes exercisable after June 8, 1994. In the event that a registration statement under the Securities Act of 1933, as amended, is in effect with respect to the Acquisition Shares, the Company may require the seller to sell the Acquisition Shares to purchasers other than the Company and pay to the seller the difference between the price received and $11.00 per share. The Company has filed a Registration Statement under the Securities Act of 1933, as amended, with respect to the Acquisition Shares. If the Registration Statement is not declared effective on or before June 8, 1994, the Company will be required to repurchase the Acquisition Shares for $12.0 million in cash. Any such repurchase would violate covenants in the Company's credit and subordinated debt agreements. Actava's debt agreements contain covenants which, among other things, place restrictions upon the amount of stock the Company may repurchase and dividends it may pay. Under the terms of Actava's 6% Senior Subordinated Swiss Franc Bonds due 1996, Actava may not make any cash redemptions (in excess of the aggregate net cash proceeds from the sale of Common Stock) of its Common Stock or declare any cash dividends after September 30, 1985 in excess of $25 million plus (or minus) the net income (or loss) of Actava subsequent to September 30, 1985. As of December 31, 1993 Actava had approximately $3.4 million available for dividends or redemptions pursuant to this covenant. The Qualex credit agreement and the Shareholders' Agreement with Eastman Kodak Company also restrict the amount of net assets of Qualex which may be transferred to the Company or Kodak by dividend or other means. In addition, the DP credit agreement requires that Actava maintain, at all times, an unrestricted cash and short-term investment position of $20 million after September 30, 1994. Non-compliance with this requirement subjects this agreement to termination by the lender upon seventy-five days notice to Actava. In November 1991, the Company entered into a Loan Agreement with its 25.0% stockholder, Triton Group Ltd. ("Triton"), whereby Triton could borrow up to $32.0 million from the Company secured by the stock in the Company owned by Triton (the "Triton Loan"). SEE "TRITON GROUP LTD." IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The Triton Loan Agreement was modified in June 1993, pursuant to the Plan of Reorganization filed by Triton in its Chapter 11 bankruptcy proceeding. The modification reduced the interest rate on the Triton Loan, extended the maturity date from November 1994 to April 1997 and modified the mandatory payment (margin call) provisions and the Stockholder Agreement between Actava and Triton, as described in the Notes to the Consolidated Financial Statements. As modified, the Triton Loan provided for quarterly payments of interest only with no scheduled principal payments due until final maturity in April 1997. In December 1993, Triton and Actava entered into a further amendment to the Loan Agreement pursuant to which Triton made a principal payment of $5.0 million plus accrued interest on the Triton Loan, reducing the loan balance to approximately $26.7 million. In addition, the December 1993 amendment provided for quarterly principal payments of $1.25 million commencing March 31, 1994 and modified the mandatory payment (margin call) provisions of the loan, as described in the Notes to Consolidated Financial Statements. Triton has announced that it is seeking to make arrangements to prepay the remaining balance of approximately $26.7 million due under the Triton Loan and has obtained a bank commitment, subject to certain conditions, that would enable Triton to prepay its obligations in full. Triton has also announced, however, that it may seek to impose additional requirements on Actava as a condition to Triton's repayment of the loan. On December 31, 1993, the Company, excluding its subsidiaries and Snapper, had $9.3 million of unrestricted cash and short-term investments. The Company's subsidiaries, excluding Qualex, had unused borrowing capacity of approximately $36.5 million at December 31, 1993 under credit agreements secured by assets such as accounts receivable and inventory. Such subsidiaries, however, are restricted by financial covenants in their credit agreements from paying the Company more than 70% of their net income as dividends. Qualex is subject to similar restrictions under its credit agreements. In addition, Qualex is subject to the Change of Control provisions in the Shareholders Agreement between the Company and Kodak. These Change of Control provisions could have the effect of eliminating the Company's ability to control the payment of dividends by Qualex. During 1994, the Company will be entitled, under these covenants, to receive approximately $8.8 million in cash dividends from its subsidiaries, including Qualex and Snapper, based on their earnings in 1993 plus an additional dividend of approximately $4.7 million from Qualex pursuant to a waiver of the dividend restrictions by the lender to Qualex. These subsidiary dividends are usually paid in the first three months of the year. The Company uses its existing cash and short-term investments, as well as dividends from its subsidiaries and payments on the Triton Loan, to provide for items such as operating expense payments, debt service, and dividend payments to shareholders. On March 3, 1994, the Company announced it was suspending dividend payments to shareholders, which will result in approximately $6.3 million of cash savings in 1994. The Company, excluding its subsidiaries and Snapper, has debt service payments scheduled in 1994 of approximately $21.3 million, and the Company anticipates that its total cash needs in 1994 will exceed the anticipated amount of additional cash to be received by the Company, including dividends from its subsidiaries. As a result, if the Company does not receive additional cash through either a refinancing, the repayment of the Triton Loan or the realization of value from the sale or partial sale of one of its operating entities, the Company will end 1994 with less unrestricted cash and short-term investments than it held at the end of 1993. The amended credit agreements (SEE "NOTES PAYABLE AND LONG-TERM DEBT" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS), with Snapper and one of the Company's sporting goods subsidiaries contain financial covenants (involving tangible net worth, book net worth and other matters) which the Company must comply with to prevent a default. A default under these credit agreements would have serious adverse consequences, including the elimination of funding for the operations of Snapper and the sporting goods company, as well as the prohibition on payment of any dividends to the Company by these businesses. As a result of the net loss for 1993, it was necessary for the Company to obtain financial covenant amendments from the lenders in order for the Company to be in compliance with these covenants at December 31, 1993. Management expects the Company to remain in compliance with these covenants, as amended, for the first and second quarters of 1994 and thereafter if certain events take place, including increased earnings. Management expects that the Company would continue to be in compliance after the second quarter of 1994 without regard to increased earnings if the $26.7 million Triton Loan is repaid because the Triton Loan is excluded for purposes of determining compliance with certain covenants in the credit agreements. If existing cash, dividends from subsidiaries and payments on the Triton Loan are not sufficient to meet its cash requirements, the Company will seek to generate additional cash by selling or pledging certain assets, and will consider additional options to reduce its cash expenditures. OTHER ITEMS On March 28, 1991, the Qualex Shareholders Agreement between Actava and Eastman Kodak Company was amended. The amendment stipulates that a change of control of Actava, as defined in the Shareholders' Agreement ("Change of Control"), occurred on February 6, 1991. However, in the amendment, Kodak waived its Change of Control rights under the Shareholders' Agreement with respect to the February 6, 1991 Change of Control. Kodak may withdraw its waiver and enforce its rights under the agreement as of each March 1, by providing Actava with 30 days written notice. Kodak did not give the notice required to exercise its Change of Control rights on March 1, 1994. The amendment also provides that the Board of Directors of Qualex would be increased to nine members, comprised of five representatives of Actava, three representatives of Kodak and the chief executive officer of Qualex. Since the formation of Qualex in March, 1988, Actava has consolidated the accounts of Qualex as Actava has a controlling interest in the entity. Actava's controlling interest includes ownership of 51% of the voting securities of Qualex and majority representation on Qualex's Board of Directors. SEE "PHOTOFINISHING TRANSACTION" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. While the March, 1991 amendment does not change Actava's controlling interest in Qualex, if Kodak were to withdraw its waiver, or if an additional Change of Control of Actava were to occur, the Shareholders' Agreement, as amended, provides for the redemption of certain of Qualex's preferred stock, including the voting preferred stock owned by Actava. Upon redemption, Actava would own 50% of the voting securities of Qualex. While Actava's voting stock would be reduced from 51% to 50%, this change would not alter Actava's and Kodak's current equal interest in the equity, earnings and cash dividends of Qualex. In addition, the Board of Directors of Qualex would be composed of 11 members, comprised of five representatives of Actava, five representatives of Kodak and the chief executive officer of Qualex and all actions of the board would require the affirmative vote of at least seven board members. In the event these changes were to occur, Actava may possibly be deemed to no longer control Qualex and Actava would no longer be in a position to unilaterally control, among other things, the declaration of dividends to Actava and Kodak by Qualex as the declaration would require the concurrence of Kodak. If Actava were deemed in the future to no longer be in control of Qualex, Actava would cease to consolidate the accounts of Qualex. In that event, Actava would account for its ownership of Qualex using the equity method of accounting. Such a development would not affect the net income and shareholders' equity of Actava. However, Actava's consolidated total assets, liabilities, sales and costs and expenses would be reduced as they would no longer include specific accounts of Qualex. If Actava had accounted for Qualex using the equity method during all of 1993, Actava's total assets and liabilities at December 31, 1993 would have been $696.4 million and $500.5 million, respectively, and sales and total costs and expenses would have been $465.8 million and $519.0 million, respectively. Actava's manufacturing and processing plants are subject to federal, state and local pollution laws and regulations. Compliance with such laws and regulations has not, and is not expected to, materially affect Actava's competitive position. Actava's capital expenditures for environmental control facilities and incremental operating costs in connection therewith were not material in 1993, and are not expected to be material in future years for compliance in regard to its 1993 facilities. The Company is involved in various environmental matters including clean-up efforts at landfill or refuse sites and groundwater contamination. The Company's participation in three existing superfund sites has been quantified and its remaining exposure is estimated to be less than $300,000 for all three sites. The Company is participating with the Federal and Ohio Environmental Protection Agencies in initial investigations of a potential environmental contamination site involving a divested subsidiary. DP is also complying with various requirements under a compliance order under the Resource Conservation Recovery Act as administered by the State of Alabama. Upon the acquisition of DP, a reserve of approximately $1.5 million was established for expected clean-up costs. OTHER SEGMENT DATA THE ACTAVA GROUP INC. AND SUBSIDIARIES - --------------- (a) Corporate assets consist primarily of short-term investments, land, notes receivable and certain property and equipment. ACCOUNTING PRINCIPLE DEVELOPMENTS The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Actava adopted the new method of accounting for income taxes on January 1, 1993. Statement No. 109 affects the manner and rates at which deferred income taxes are reflected on the balance sheet and therefore, possibly the amount of taxes reflected in the statement of operations. The adoption of Statement No. 109 did not result in a significant impact to net income when reported as the cumulative effect of a change in accounting principle in the first quarter of 1993. SEE "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- INCOME TAXES" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Statement No. 106 requires the cost of postretirement benefits to be recognized in the financial statements over an employee's active working career. Actava adopted the new method of accounting for these benefits on January 1, 1993. The adoption of Statement No. 106 resulted in a $4.4 million charge to net income and was reported as the cumulative effect of a change in accounting principle in the first quarter of 1993. SEE "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- POSTRETIREMENT BENEFITS OTHER THAN PENSIONS" IN NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The Company and its subsidiaries provide benefits to former or inactive employees after employment, but before retirement, such as severance benefits, continuation of health care benefits and life insurance coverage. The costs of these are currently accounted for on a pay-as-you-go (cash) basis. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires employers to recognize the obligation to provide these benefits when certain conditions are met. The Company is required to adopt the new method of accounting for these benefits no later than January 1, 1994. The adoption of Statement No. 112 will not have a significant effect on the Company's financial position or results of operations. The Company and its subsidiaries invest in various debt and equity securities. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires certain debt securities to be reported at amortized cost, certain debt and equity securities to be reported at market with current recognition of unrealized gains and losses, and certain debt and equity securities to be reported at market with unrealized gains and losses as a separate component of shareholders' equity. The Company is required to adopt the new method of accounting no later than January 1, 1994. The adoption of Statement No. 115 will not have a significant impact on the Company's financial position or results of operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required under this item is submitted as a separate section in this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None PART III Incorporated by reference to the Proxy Statement for the 1994 annual meeting of stockholders. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) Financial Statements INDEX OF FINANCIAL STATEMENTS The following consolidated financial statements of The Actava Group Inc. and subsidiaries are included in Item 8: (a)(2) Schedules INDEX OF FINANCIAL STATEMENT SCHEDULES The following consolidated financial statement schedules of The Actava Group Inc. and subsidiaries 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. (a)(3) Listing of Exhibits. - --------------- (b) Reports on Form 8-K filed in the fourth quarter of 1993: None. (c) The response to this portion of Item 14 is submitted as a separate section in this report. (d) The response to this portion of Item 14 is submitted as a separate section in 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. THE ACTAVA GROUP INC. By: /s/ FREDERICK B. BEILSTEIN, III -------------------------------- Frederick B. Beilstein, III Senior Vice President and Chief Financial Officer Dated: March 31, 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 ad in the capacities and on the dates indicated. THE ACTAVA GROUP INC. ANNUAL REPORT ON FORM 10-K ITEM 14(A)(1) AND (2), (C) AND (D) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 FORM 10-K-ITEM 14(A)(1) AND (2) The Actava Group Inc. and Subsidiaries List of Financial Statements and Financial Statement Schedules The following consolidated financial statements of The Actava Group Inc. and subsidiaries are included in Item 8: 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 stockholders' equity -- Years ended December 31, 1993, 1992 and 1991 Notes to consolidated financial statements -- December 31, 1993 The following consolidated financial statement schedules of The Actava Group Inc. and subsidiaries 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. REPORT OF INDEPENDENT AUDITORS To The Stockholders The Actava Group Inc. We have audited the accompanying consolidated balance sheets of The Actava Group Inc. 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 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 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 The Actava Group 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 taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the notes to consolidated financial statements, in 1993 Actava changed its method of accounting for income taxes and postretirement benefits, and in 1992 Actava changed its method of accounting for the cost of its proof advertising program. ERNST & YOUNG Atlanta, Georgia March 3, 1994, except for the Notes Payable and Long-Term Debt Note as to which the date is March 29, 1994 THE ACTAVA GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. THE ACTAVA GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. THE ACTAVA GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. THE ACTAVA GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Actava and its majority-owned subsidiaries. All significant intercompany transactions and accounts have been eliminated in consolidation. Accounting Changes Change in Method of Accounting for Certain Advertising Costs Effective January 1, 1992, Qualex changed its method of accounting for the cost of its proof advertising program to recognize these costs at the time the advertising is placed by the customer. Under the proof advertising program, Qualex reimburses certain advertising costs incurred by its customers up to a percentage of sales to that customer. Qualex previously accrued such costs at the time of the initial sale. Qualex believes that this new method is preferable because it recognizes advertising expense as it is incurred rather than at the time of the initial sale to the customer. The 1992 adjustment of $1,034,000, net of income taxes of $1,437,000 and minority interest of $1,033,000, was included in income for 1992 to apply retroactively the new method. The 1992 adjustment before income taxes and minority interest was $3,504,000. The pro forma amounts presented in the consolidated statements of operations for 1992 and 1991 reflect the effect of the retroactive application of applying the new method and related taxes and minority interest. Change in Method of Accounting for Income Taxes Effective January 1, 1993, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes." Under Statement 109, the liability method is used in accounting for income taxes: 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 presentation of some items, such as depreciation, has changed; however, the cumulative effect of the change in accounting principle on pre-tax income from continuing operations, net income and financial position was not material. Change in Method of Accounting for Postretirement Benefits Effective January 1, 1993, the Company adopted FASB Statement No. 106, "Accounting for Postretirement Benefits Other Than Pensions." The Company and its subsidiaries provide group medical plans and life insurance coverage for certain employees subsequent to retirement. The plans have been funded on a pay-as-you-go (cash) basis. The plans are contributory, with retiree contributions adjusted annually, and contain other cost-sharing features such as deductibles, coinsurance and life-time maximums. The plan accounting anticipates future cost-sharing changes that are consistent with the Company's expressed intent to increase the retiree contribution rate annually for the expected medical trend rate for that year. The Company funds the excess of the cost of benefits under the plans over the participants' contributions as the costs are incurred. The coordination of benefits with medicare uses a supplemental, or exclusion of benefits, approach. As permitted by Statement 106, the Company elected to immediately recognize the effect in the statement of operations for the first quarter of 1993 as a $4,404,000 charge to net income as the cumulative effect of a change in accounting principle. The annual net periodic postretirement benefit expense for 1993 decreased by $38,000 as a result of adopting the new rules. Postretirement benefit expense for 1992 and 1991, THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) recorded on a cash basis, has not been restated. The pro forma amounts presented in the consolidated statements of operations reflect no effect of the retroactive application of applying the new method as it is not material. The assumed health care cost trend rate used to measure the expected cost of benefits covered by the plan for 1993 is 14%. This trend rate is assumed to decrease in 1% decrements to 6% in 2001 and years thereafter. A 7% discount rate per year, compounded annually, was assumed to measure the accumulated postretirement benefit obligation as of December 31, 1993, as compared to 9% for January 1, 1993. A 1% increase in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligations as of December 31, 1993, by 16% and the net periodic postretirement benefit cost by 18%. The following table presents the plans' funded status reconciled with amounts recognized in the Company's consolidated balance sheet: Net periodic postretirement benefit cost includes the following components: Change in Accounting Estimate During 1993, Snapper revised its estimate of accrued product warranty expense to reflect an increase in the amount of future warranty expense to be incurred due to increased warranty claims. This change in accounting estimate resulted in an additional $4,000,000 charge to net income in 1993. Short-Term Investments Short-term investments which are classified as current assets are carried at the lower of aggregate cost or market value. These investments consist of interest bearing obligations and other obligations whose return is based upon market rates of interest. There is no significant concentration of short-term investments in any single issuer. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Marketable equity securities which are classified as long-term investments are carried at the lower of aggregate cost or market value. Marketable debt securities which are classified as long-term investments are carried at cost which approximates market value. Market values for these securities are based on quoted market prices. Interest income is accrued as earned, while dividend income is recorded on the exdividend date. The cost of marketable securities sold is determined on the specific identification method and realized gains and losses are reflected in income. Inventories Inventories of finished goods, work in process and raw materials are stated at the lower of cost or market. The Last-In, First-Out (LIFO) method of determining cost is used for a substantial portion of these inventories. Property, Plant and Equipment Property, plant and equipment are recorded at cost and are depreciated over their expected useful lives. Generally, depreciation is provided on the straight-line method for financial reporting purposes and on accelerated methods for tax purposes. Amortization associated with capitalized leases is included in depreciation expense. Intangibles Intangibles consist of the excess of the purchase price over the net asset of businesses acquired, customer lists and covenants not to compete. Amounts relating to the excess of the purchase price over the net assets of businesses acquired are amortized over a 40-year period using the straight-line method. Amounts relating to customer lists and covenants not to compete are amortized over two to five years or the life of the agreement, respectively. Management continuously evaluates intangible assets to determine that no diminishment in value has occurred. Intangible assets are summarized as follows: Income Taxes Income taxes are provided for all taxable items in the statement of operations regardless of when these items are reported for federal income tax purposes. Actava elects to utilize certain provisions of the federal income tax laws to reduce current taxes payable. Deferred income taxes are provided for temporary differences in recognition of income and expenses for tax and financial reporting purposes. Effective January 1, 1993, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes." Under Statement 109, the liability method is used in accounting for income taxes: 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. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Postemployment Benefits The Company and its subsidiaries provide benefits to former or inactive employees after employment, but before retirement, such as severance benefits, continuation of health care benefits and life insurance coverage. The costs of these are currently accounted for on a pay-as-you-go (cash) basis. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires employers to recognize the obligation to provide these benefits when certain conditions are met. The Company is required to adopt the new method of accounting for these benefits no later than January 1, 1994. The adoption of Statement No. 112 will not have a significant effect on the Company's financial position or results of operations. Certain Investments in Debt and Equity Securities The Company and its subsidiaries invest in various debt and equity securities. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires certain debt securities to be reported at amortized cost, certain debt and equity securities to be reported at market with current recognition of unrealized gains and losses, and certain debt and equity securities to be reported at market with unrealized gains and losses as a separate component of shareholders' equity. The Company is required to adopt the new method of accounting no later than January 1, 1994. The adoption of Statement No. 115 will not have a significant impact on the Company's financial position or results of operations. Earnings Per Share of Common Stock Primary earnings per share are computed by dividing net income (loss) by the average number of common and common equivalent shares outstanding during the year. Common equivalent shares include shares issuable upon the assumed exercise of stock options using the treasury stock method when dilutive. Computations of common equivalent shares are based upon average prices during each period. Fully diluted earnings per share are computed using such average shares adjusted for any additional shares which would result from using end-of-year prices in the above computations, plus the additional shares that would result from the conversion of the 6 1/2% Convertible Subordinated Debentures. Net income (loss) is adjusted by interest (net of income taxes) on the 6 1/2% Convertible Subordinated Debentures. The computation of fully diluted earnings per share is used only when it results in an earnings per share number which is lower than primary earnings per share. Revenue Recognition Sales from the lawn and garden and sporting goods segments are recognized when the products are shipped to their customers. Sales from the photofinishing segment are recognized when the products are delivered to their customer. Index Protection Agreements The Company uses index protection agreements to hedge interest rate risk associated with its borrowings and to hedge the risk or market price fluctuations of commodities bought and sold in the normal course of business. These contracts are accounted for as hedges and any gains or losses are deferred and included in the basis of the underlying transactions. Cash flows from the contracts are accounted for in the same categories as the cash flows from the items being hedged. During 1993, Qualex entered into a $100,000,000 notional amount interest rate swap agreement which expires in 1996. Under the agreement, Qualex pays a variable interest rate based on the London interbank offered rate (LIBOR) and receives a variable amount based on the difference between LIBOR and prime THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) rate. At December 31, 1993, termination of this interest rate swap agreement would require a cash payment by Qualex of $1,158,000 based on market quotes. Qualex also entered into various commodity swaps to provide protection for silver recoveries from photofinishing processes. During 1993 and 1992, Qualex received $835,000 and $12,335,000, respectively, from the termination of such swap agreements. These gains were deferred and are being amortized over the original agreement terms. During 1993 and 1992, $2,928,000 and $1,683,000 of these gains were amortized as reductions of cost of sales while $1,961,000 and $782,000 of gain amortization reduced interest expense in 1993 and 1992, respectively. At December 31, 1993 and 1992, respectively, $7,422,000 and $11,476,000 of these gains were recorded as deferred income. At December 31, 1993, termination of the commodity swap agreements would require cash payments by Qualex of $18,688,000 based on market quotes. Self-Insurance The Company is primarily self-insured for workers' compensation, health, automobile, product and general liability costs. The self-insurance claim liability is determined based on claims filed and an estimate of claims incurred but not yet reported. Reclassifications Certain reclassifications were made in prior years' financial statements to conform to current presentations. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SUPPLEMENTAL CASH FLOW INFORMATION The following tables provide additional information related to the Consolidated Statements of Cash Flows: PHOTOFINISHING TRANSACTION Photofinishing operations are conducted by Qualex Inc., which was formed in March 1988 by the combination of Actava's photofinishing subsidiary with the domestic photofinishing operations of Eastman Kodak Company. While Actava and Kodak currently share Qualex's equity, income and dividends equally, Actava has 51% voting control by virtue of its ownership of 50% of Qualex's common stock and 100% of Qualex's voting preferred stock. Actava also has majority representation on the Qualex Board of Directors, although certain decisions, not including the declaration of dividends, require the concurrence of Kodak's Board representatives. Actava consolidates the accounts of Qualex and presents Kodak's portion of ownership and equity in the income of Qualex as minority interest. The Qualex Shareholders' Agreement between Actava and Eastman Kodak Company stipulates that upon a change of control at Actava certain Qualex preferred stock, including the voting preferred owned by THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Actava, will be redeemed. On March 28, 1991, the Qualex Shareholders' Agreement between Actava and Kodak was amended. The amendment stipulates that a change of control of Actava, as defined in the Shareholders' Agreement, occurred on February 6, 1991. However, in the amendment Kodak waived its change of control rights under the Shareholders' Agreement with respect to the February 6, 1991 change of control. As of March 1, 1992, and each subsequent March 1, Kodak may withdraw its waiver, and enforce its rights under the Agreement by providing Actava with 30 days written notice. At March 3, 1994, Kodak had not provided notice to Actava of an election to withdraw its waiver. The Board of Directors of Qualex was increased from seven to nine members, comprised of five representatives of Actava, three representatives of Kodak and the chief executive officer of Qualex, pursuant to the amendment. Should Kodak withdraw its waiver or if an additional change in control of Actava were to occur and if the Qualex preferred stock were redeemed, Actava would own 50% of the voting securities of Qualex. While Actava's voting stock would be reduced from 51% to 50%, this change would not alter Actava's and Kodak's current equal interest in the equity, earnings and cash dividends of Qualex. In addition, the Board of Directors of Qualex would be composed of 11 members, comprised of five representatives of Actava, five representatives of Kodak and the chief executive officer of Qualex, and all actions of the Board would require the affirmative vote of at least seven board members. In the event these changes were to occur, Actava may possibly be deemed to no longer control Qualex and Actava would no longer be in a position unilaterally to control, among other things, the declaration of dividends to Actava and Kodak by Qualex. If Actava were deemed in the future to no longer be in control of Qualex, Actava would cease to consolidate the accounts of Qualex. In that event, Actava would account for its ownership of Qualex by using the equity method of accounting. Such a development would not affect the net income or shareholders' equity of Actava. However, Actava's consolidated total assets, liabilities, sales and costs and expenses would be reduced as they would no longer include the specific accounts of Qualex. If Actava had accounted for Qualex using the equity method during all of 1993, Actava's total assets and liabilities would have been $696,374,000 and $500,460,000, respectively, and sales and total costs and expenses would have been $465,812,000 and $518,963,000, respectively. ACQUISITIONS On June 8, 1993, the Company acquired substantially all the assets of Diversified Products Corporation ("DP") for a net purchase price consisting of $11,629,500, the issuance of 1,090,909 shares of the Company's Common Stock valued at $12,000,000, and the assumption or payment of certain liabilities including trade payables and a revolving credit facility. The Company also entered into an agreement which may provide the seller the right to additional payments depending upon the value of the issued shares over a period of not longer than one year from the purchase date. The issuance of additional payments of cash or additional shares will not increase the cost to DP; any subsequent issuance will only affect the manner in which the total purchase price is recorded for Actava. This transaction was accounted for using the purchase method of accounting; accordingly, the purchased assets and liabilities have been recorded at their estimated fair value at the date of the acquisition. The purchase price resulted in an excess of costs over net assets acquired of approximately $11,417,000. The results of operations of the acquired business have been included in the consolidated financial statements since the date of acquisition. The following data represents the combined unaudited operating results of Actava on a pro forma basis as if the above transaction had taken place at the beginning of 1992. The pro forma information does not necessarily reflect the results of operations as they would have been had the transaction actually taken place at THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) that time. Adjustments include amounts of depreciation to reflect the fair value and economic lives of property, plant and equipment and amortization of intangible assets: During 1992, Qualex acquired Samiljan Foto, L.P. and certain other photofinishing operations for $21,228,000 and $22,997,000 respectively, including expenses. For one of the businesses in which Qualex purchased a majority interest in 1992, the sellers have the right to require Qualex to purchase the remaining interest, beginning in 1997, at an amount not to exceed $18,000,000. During 1991, Qualex acquired Guardian Photo Inc. and Phototron Corporation for $73,785,000 and $16,137,000, respectively, including expenses. In a concurrent transaction with the acquisition of Phototron Corporation, Actava, Kodak and Qualex settled the litigation brought against them by Phototron Corporation. These transactions were accounted for using the purchase method of accounting, accordingly; the assets and liabilities of the purchased businesses have been recorded at their estimated fair value at the dates of acquisition. The purchase price resulted in an excess of costs over net assets acquired of approximately $23,321,000 and $53,848,000 during 1992 and 1991, respectively, in addition to $19,215,000 and $30,300,000 attributed to customer lists, respectively. The results of operations of the businesses acquired have been included in the consolidated financial statements since the dates of acquisition. The following data represents the combined unaudited operating results of Actava on a pro forma basis as if the 1991 transactions had taken place at the beginning of 1991. Pro forma information for 1992 acquisitions would not be significantly different from the results reported. The pro forma information does not necessarily reflect the results of operations as they would have been had the transaction actually taken place at that time. Adjustments include amounts of depreciation to reflect the fair value and economic lives of property, plant and equipment and amortization of intangible assets. ACCOUNTS AND NOTES RECEIVABLE Receivables from sales of Actava's lawn and garden products amounted to $146,994,000 and $157,605,000 at December 31, 1993 and 1992, respectively. The receivables are primarily due from independent distributors located throughout the United States. Amounts due from distributors are supported by a security interest in the inventory or accounts receivable of the distributors. The receivables generally have extended due dates which correspond to the seasonal nature of the products' retail selling season. Concentrations of credit risk due to the common business of the customers are limited due to the number of customers THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) comprising the customer base and their geographic location. Ongoing credit evaluations of customer's financial condition are performed and reserves for potential credit losses are maintained. Such losses, in the aggregate, have not exceeded management's expectations. Photofinishing sales are made to national, regional and local retailers located throughout the United States, including mass merchants, grocery store chains and drug store chains. Photofinishing receivables, which were $70,744,000 and $76,202,000 at December 31, 1993 and 1992, respectively, are unsecured and generally due within 20 days following the end of each month. Included in accounts receivable at December 31, 1993 and 1992 are $54,711,000 and $47,564,000, respectively, due from national retail chains. Of these amounts, $9,812,000 and $9,465,000 at December 31, 1993 and 1992, respectively, were receivable from one such customer on net sales of $84,297,000 and $86,611,000, respectively. The Company provides an allowance for doubtful accounts equal to the estimated losses expected to be incurred in the collection of accounts receivable. Such losses have consistently been within management's expectations. Receivables from the sale of sporting goods are primarily from mass merchants and sporting goods retailers located throughout the United States. The receivables, which are unsecured, were $71,836,000 and $19,781,000 at December 31, 1993 and 1992, respectively, and are generally due within 30 to 60 days. Of these amounts, $23,362,000, and $4,686,000 are from the same four highest balance customers for December 31, 1993 and 1992, respectively. The companies which comprise the sporting goods group maintain allowances for potential credit losses and such losses, in the aggregate, have not exceeded management's expectations. TRITON GROUP LTD. LOAN At December 31, 1993, the Company had a $26,726,000 million note receivable from Triton Group Ltd. secured by 4,413,598 shares of Actava Common Stock. At December 31, 1992, $31,726,000 was outstanding under the agreement and was secured by 4,338,598 shares of Actava Common Stock. Effective June 25, 1993, the Company and Triton modified the terms of the loan as part of a plan of reorganization filed by Triton under Chapter 11 of the U.S. Bankruptcy Code. The modifications, which became effective June 25, 1993, included: extending the due date of the Loan to April 1, 1997; reducing the interest rate to prime plus 1 1/2% for the first six months following June 25, 1993, to prime plus 2% for the next six months, and to prime plus 2 1/2% for the remainder of the term of the note; revising collateral maintenance (margin call) requirements; and providing for release of collateral under certain circumstances. Under the modified agreements, Actava's right of first refusal with respect to any sale by Triton of its Actava Common stock will continue in effect until the loan is paid off. The Stockholder Agreement was amended to permit Triton to designate two directors (who are not officers or employees of Triton) on an expanded nine-member Board of Directors so long as Triton continues to own 20% or more of Actava's outstanding Common Stock. Triton filed a motion on July 30, 1993, with the United States Bankruptcy Court for the Southern District of California seeking to modify Triton's recently approved Plan of Reorganization. The modifications sought by Triton would have amended or eliminated the collateral maintenance (margin call) provisions that are an integral part of the Amended and Restated Loan Agreement. On August 2, 1993, the Bankruptcy Court entered a temporary restraining order suspending the effectiveness of the margin call provisions until the Court had an opportunity to hear Triton's motion seeking preliminary injunction. The motion seeking a preliminary injunction was heard on August 10, 1993, and was denied. Triton then withdrew its motion to modify its Plan of Reorganization. Therefore, the provisions of the Amended and Restated Loan Agreement continue to remain in effect. On August 19, 1993, the Amended and Restated Loan agreement was amended to allow Triton to satisfy certain margin call requirements by making deposits to a Collateral Deposit Account in lieu of delivering certificates of deposit. The margin call provisions for principal repayments and transfers of shares of Company Common Stock were not amended. On December 7, 1993, the Amended and Restated Loan Agreement was amended, in connection with a $5,000,000 prepayment of principal received on December 7, 1993, to provide for quarterly principal payment installments of $1,250,000 due on the last day of each quarter THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) of each year beginning March 31, 1994, with any unpaid principal and accrued interest due on April 1, 1997. The Agreement was also amended to require 75,000 additional shares of Actava Common Stock to be pledged as collateral and to modify the margin call provisions of the Agreement to provide a $7.50 minimum per share value of Actava Common Stock for purposes of determining the amount of any margin call mandatory payments. These modifications limit the circumstances under which Triton must pledge additional collateral for the loan; however, the 4,413,598 shares of Actava Common Stock owned by Triton will continue to be pledged to secure the loan until the loan is paid in full. At March 3, 1994, the pledged shares had a market value of $30,895,000 as compared to the loan balance of $26,726,000. In the opinion of management, the shares held as collateral are, and will continue to be, sufficient to provide for realization of the loan. INVENTORIES Inventory balances are summarized as follows: Work in process is not considered significant. During 1991, certain inventory quantities were reduced resulting in a liquidation of LIFO inventory quantities which were carried at lower costs prevailing in prior years as compared with the cost of current year purchases. The utilization of this lower cost inventory decreased net loss by approximately $1,487,000 and decreased loss per share of common stock by $.09. LONG-TERM INVESTMENTS Marketable securities are summarized as follows: Net realized gains (losses) on the sale of these securities totaled $(185,000) and $134,000 in 1993 and 1992, respectively, and have been included in the determination of income. At December 31, 1993, the value of marketable equity securities exceeded their cost by $265,000, while at December 31, 1992, unrealized losses on these securities of $201,000 were recorded to a valuation allowance and included in shareholders' equity. The market value of debt securities approximates cost. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) ACCOUNTS PAYABLE, ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accounts payable, accrued expenses and other current liabilities, including $31,392,000 in 1993 and $44,274,000 in 1992 due to Eastman Kodak Company, are summarized as follows: NOTES PAYABLE AND LONG-TERM DEBT Qualex has three separate line of credit agreements for working capital needs. These agreements are $5,000,000 each, for a total of $15,000,000. The Company pays a facility fee of 1/4% per annum on the committed line of credit agreements. At December 31, 1993, $3,200,000 was outstanding under these agreements while no amounts were outstanding at December 31, 1992. Included in Notes Payable at December 31, 1993 and 1992 is $87,359,000 and $58,243,000, respectively, which was outstanding under a three year Finance and Security Agreement which provides working capital to the Snapper division. The Agreement, dated October 23, 1992, is for $75,000,000 (and may be increased under certain circumstances up to $100,000,000 for a specified period of time). Interest is payable at the prime rate plus 3/4% to 1 1/4%, depending upon the prime rate in effect. The Agreement provides for the payment of an annual line fee of $487,500 which is subject to increases in certain circumstances. The loan is principally secured by Snapper assets and certain inventory of Snapper and requires Actava to comply with various restrictive financial covenants. The assets which serve as collateral are determined by reference to the outstanding balance under the credit agreement and the qualification of the assets as collateral is defined in the credit agreement; however, the assets potentially available as collateral are, in the aggregate, $173,068,000. As of March 29, 1994, effective as of December 31, 1993, various provisions of the Agreement, including the financial covenants, were amended. During 1992, in order to provide additional working capital and for general corporate purposes, an Actava Sports subsidiary entered into a three year Loan and Security Agreement with a financial institution to provide up to $35,000,000 of working capital. Interest is payable at the prime rate plus 1 1/4%. The Agreement provides for a facility fee of $350,000. The loan is principally secured by certain receivables and inventory of the subsidiary and requires the subsidiary to comply with various restrictive financial covenants. The assets which serve as collateral are determined by reference to the outstanding balance under the credit agreement and the qualification of the assets as collateral is defined in the credit agreement; however, the assets potentially available as collateral are, in the aggregate, $23,681,000. At December 31, 1993, $1,846,000 was outstanding under the agreement while no amounts were outstanding at December 31, 1992. During 1992, in order to provide additional working capital and for general corporate purposes, an Actava Sports subsidiary entered into a one-year Revolving Loan Agreement with a financial institution to provide up to $6,500,000 for working capital. Interest is payable at the prime rate of the financial institution. The loan is unsecured and requires the subsidiary to comply with various restrictive financial covenants. In August, 1993, the agreement was amended to increase the facility limit to $8,000,000 for a six-month period beginning THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) September 1, 1993, and to extend the term of the agreement until August 31, 1994. At December 31, 1993, $2,700,000 was outstanding under the Agreement while no amounts were outstanding at December 31, 1992. In April 1993, a Revolving Loan and Security Agreement with respect to a revolving credit facility of up to $10,000,000 was entered into by an Actava Sports subsidiary. Interest is payable at the prime rate plus 1%. The agreement provides for a facility fee of $25,000. The loan is principally secured by certain receivables and inventory of the subsidiary and requires the subsidiary to comply with various restrictive financial covenants. The assets which serve as collateral are determined by reference to the outstanding balance under the credit agreement and the qualification of the assets as collateral is defined in the credit agreement; however, the assets potentially available as collateral are, in the aggregate, $12,881,000. At December 31, 1993 and 1992, no amounts were outstanding under the agreement. In December 1993, an Actava Sports subsidiary, DP, entered into a Finance and Security Agreement with two financial institutions in order to provide up to $50,000,000 of working capital under a revolving credit facility. The agreement is secured by certain receivables, inventories, property, plant and equipment, and intangibles, as well as DP's issued and outstanding common stock and requires compliance with various restrictive financial covenants. The assets which serve as collateral are determined by reference to the outstanding balance under the credit agreement and the qualification of the assets as collateral is defined in the credit agreement; however, the assets potentially available as collateral are, in the aggregate, $109,000,000. As of March 29, 1994, effective December 31, 1993, various provisions of the Agreement, including the financial covenants, were amended. Interest is payable at the prime rate plus 1 1/2%. The Agreement provides for an annual facility fee of $375,000. At December 31, 1993, $36,178,000 was outstanding under the agreement. Long-term debt is summarized as follows: Qualex issued through a private placement $200,000,000 of Senior Notes in 1992 with September 1 maturities in 1997, 1999 and 2002 of $60,000,000, $70,000,000 and $70,000,000, respectively, with interest rates of 7.99%, 8.45% and 8.84%, respectively. During 1992, Qualex entered into an unsecured $115,000,000 Revolving Credit Agreement with eight financial institutions which will expire in May 1995. Interest is payable under three rate options which are determined by reference to the prime rate, the London interbank offered rate plus 1/2% to 3/4%, and competitive bids. The Agreement provides for a participation fee of 1/8% and an annual facility fee of 1/4%. At December 31, 1993, $10,000,000 was outstanding under the agreement while no amounts were outstanding at December 31, 1992. The Qualex Credit Agreement and the Shareholders' Agreement with Eastman Kodak Company restrict the amount of net assets of Qualex which may be transferred to Actava by dividend or other means. At December 31, 1993, approximately $166,000,000 of the $194,000,000 representing Actava's share of the net assets of Qualex was restricted under the terms of these agreements. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Collateral for certain of the long-term debt includes real property. Assets pledged as collateral under the borrowings are not material. Maturities of long-term and subordinated debt are $15,142,000 in 1995, $35,172,000 in 1996, $75,783,000 in 1997 and $59,121,000 in 1998. The fair value of Actava's long-term and subordinated debt, including the current portion, at December 31, 1993 is estimated to be approximately $445,000,000 and was estimated at $425,000,000 at December 31, 1992. This estimate is based on a discounted cash flow analysis using Actava's current incremental borrowing rates for similar types of agreements and on quoted market prices for issues which are traded. Actava does not anticipate settlement of long-term debt at fair value and currently does not intend to pay the debt prior to maturity. SUBORDINATED DEBT Subordinated debt is summarized as follows: In 1986 Actava issued 6% Senior Subordinated Swiss Franc Bonds due 1996 for 100,000,000 Swiss francs. Simultaneously, in order to eliminate exposure to fluctuations in the currency exchange rate over the life of the bonds, Actava entered into a currency swap agreement with a financial institution whereby Actava received approximately $48,000,000 in exchange for the Swiss Franc Bond proceeds. As a result of the swap agreement, Actava will, in effect, make its interest and principal bond repayments in U.S. dollars without regard for changes in the currency exchange rate. A default by the counterparty to the swap agreement would expose Actava to potential currency exchange risk on the remaining bond interest and principal payments in that Actava would be required to purchase Swiss francs at current exchange rates rather than at the swap agreement exchange rate. The amount of this potential risk cannot be currently calculated as the principal and interest payments will be made in future years and alternative swap agreements could be entered into by Actava. At December 31, 1993, the swap agreement has an effective exchange rate over its remaining term of .5459 Swiss francs per U.S. dollar while the U.S. dollar equivalent market exchange rate was .6734. After considering the stated interest rate, the cost of the currency swap agreement, taxes and underwriting commissions, the effective cost of the bonds is approximately 11.3%. The fair value of the currency swap as of December 31, 1993 and 1992, was $10,795,000 and $7,242,000, respectively; however, this is subject to change as domestic interest rates and foreign currency markets are determining factors. Actava, at its option, may redeem the Senior Subordinated Swiss Franc Bonds at 101.0% plus accrued interest for one year subsequent to March 6, 1994 and at decreasing amounts thereafter. The Bonds include a covenant which restricts the amount of stockholders' equity available for cash dividends and the cash redemption of capital stock. At December 31, 1993, $3,412,000 was available for these purposes pursuant to this covenant. In 1987 Actava issued $75,000,000 of 6 1/2% Convertible Subordinated Debentures due in 2002 in the Euro-dollar market. The Debentures are convertible into Actava's Common Stock at a conversion price of THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $41 5/8 per share. At Actava's option the Debentures may be redeemed at 101% plus accrued interest prior to August 4, 1994 and at 100% thereafter. The 9 7/8% Senior Subordinated Debentures are redeemable at the option of Actava at 101.555% of the principal amount plus accrued interest if redeemed prior to March 15, 1994, and at decreasing prices thereafter. Mandatory sinking fund payments of $3,000,000 (which Actava may increase to $6,000,000 annually) began in 1982 and are intended to retire, at par plus accrued interest, 75% of the issue prior to maturity. At the option of Actava, the 10% Subordinated Debentures are redeemable, in whole or in part, at the principal amount plus accrued interest. Sinking fund payments of 10% of the outstanding principal amount commenced in 1989; however, Actava receives credit for Debentures redeemed or otherwise acquired in excess of sinking fund payments. CAPITAL STOCK Preferred and Preference Stock There are 5,000,000 authorized shares of Preferred Stock and 1,000,000 authorized shares of Preference Stock, none of which were outstanding or designated as to a particular series at December 31, 1993. Common Stock There are 100,000,000 authorized shares of Common Stock, $1 par value. At December 31, 1993, 1992 and 1991 there were 17,635,186, 16,544,277 and 16,544,027 shares issued and outstanding, respectively, after deducting 5,132,558, 6,223,467 and 6,223,717 treasury shares, respectively. Actava has reserved the shares of Common Stock listed below for possible future issuance: THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Stock Options Actava's stock option plans provide for the issuance of qualified incentive stock options and nonqualified stock options. Incentive stock options may be issued at a per share price not less than the market value of Actava's Common Stock at the date of grant. Nonqualified options may be issued generally at prices and on terms determined by the stock option committee. The following table reflects changes in the incentive stock options issued under these plans: During 1993 nonqualified options for 75,500 shares at $13.75 per share were granted. At December 31, 1993, incentive stock options totaling 64,000 shares were exercisable at prices ranging from $11.875 to $27.875 and nonqualified options totaling 53,875 shares were exercisable at prices ranging from $13.75 to $14.50. There were 591,550 and 696,300 shares under Actava's stock option plans at December 31, 1993 and 1992, respectively, which were available for the granting of additional stock options. PROVISIONS FOR PLANT RELOCATION AND CONSOLIDATION The 1993 and 1991 consolidated provisions for plant relocations and consolidations include $4,096,000 and $17,037,000, respectively, before tax and minority interest for the costs of relocating or consolidating certain of Qualex's photofinishing plants. After tax benefit and minority interest, the Qualex provisions amounted to $1,038,000 and $5,196,000 or $.06 and $.31 per share for 1993 and 1991, respectively. In addition, the 1993 provision includes reductions of $865,000, before and after tax, or $.05 per share, to reserves for consolidating certain lawn and garden facilities and Actava Sports facilities. The 1991 provision also includes $500,000 before tax ($315,000 net of tax or $.02 per share) for consolidating facilities at a sporting goods subsidiary and $1,432,000 before tax ($945,000 net of tax or $.06 per share) for reducing the Actava corporate office facilities. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) OTHER INCOME -- NET Other income net of other (expenses) from continuing operations is summarized as follows: Early payment interest credit expense which is the result of cash payments received by Snapper from distributors prior to receivable due dates is included in net miscellaneous income (expense). The early payment interest credit expense was $4,322,000 for 1993, $2,522,000 for 1992, and $4,348,000 for 1991. INCOME TAXES Income tax expense (benefit) is composed of the following: Income tax expense (benefit) computed by applying federal statutory rates to income (loss) before income taxes is reconciled to the actual income tax expense (benefit) as follows: THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Significant components of deferred tax assets and liabilities at December 31, 1993, are as follows: The components of deferred income tax expense (benefit) for the years ended December 31, 1992 and 1991 are as follows: Actava has a net operating loss carryforward for federal income tax purposes of approximately $86,800,000 at December 31, 1993, which will expire in years 2006 through 2008. Actava has an alternative minimum tax credit carryforward of approximately $8,800,000, which may be carried forward indefinitely, available to offset regular tax in certain circumstances. PENSION PLANS Actava and its subsidiaries have several noncontributory defined benefit and other pension plans which are "qualified" under federal tax law and cover substantially all employees. In addition Actava has a THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) "nonqualified" supplemental retirement plan which provides for the payment of benefits to certain employees in excess of those payable by the qualified plans. Benefits under the qualified and nonqualified plans are based upon the employee's years of service and level of compensation. Actava's funding policy for the qualified plans is to contribute annually such amounts as are necessary to provide assets sufficient to meet the benefits to be paid to the plans' members and to keep the plans actuarially sound. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The components of net periodic pension costs are as follows: Assumptions used in the accounting for the defined benefit plans are as follows: These actuarial assumptions were changed during 1993 for accounting for the defined benefit plans as of December 31, 1993. The change in discount rates from 8.4% for 1992 to 7.2% for 1993 increased projected benefit obligations by approximately 12%. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following tables set forth the funded status and amount recognized in the Consolidated Balance Sheets for Actava's defined benefit pension plans: Substantially all of the plan assets at December 31, 1993 and 1992 are invested in governmental bonds, mutual funds and temporary investments. Some of the Company's subsidiaries also have defined contribution plans which provide for discretionary annual contributions covering substantially all of their employees. Contributions from continuing operations of approximately $5,900,000 in 1993, $7,000,000 in 1992, and $4,800,000 in 1991 were made to these plans. LEASES Actava and its subsidiaries are lessees of warehouses, manufacturing facilities and other properties under numerous noncancelable leases. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Capitalized leased property, which is not significant, is included in property, plant and equipment and other assets. Future minimum payments for the capital leases and noncancelable operating leases with initial or remaining terms of one year or more are summarized as follows: Rental expense charged to continuing operations for all operating leases was $19,729,000, $21,499,000 and $17,720,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Certain noncancelable leases have renewal options for up to 10 years, and generally, related real estate taxes, insurance and maintenance expenses are obligations of Actava. Certain leases have escalation clauses which provide for increases in annual rentals in certain circumstances. LITIGATION On February 18, 1994, Photographic Concepts Inc. ("PCI"), a Florida corporation, sued Qualex in the United States District Court for the Middle District of North Carolina, in a lawsuit captioned Photographic Concepts, Inc. v. Qualex, Inc., Civil Action No. 1:94-CV-00081. PCI's claims arise out of allegations that Qualex entered into and then breached an agreement with PCI relating to the marketing of on-site "microlab" photofinishing services. During 1993, Qualex's microlab business resulted in $33,300,000 in revenues and $7,300,000 in gross profits, and Qualex expects such business to increase in the future. PCI alleges, among other things, that Qualex breached agreement with PCI, and misappropriated trade property and other information from PCI. PCI is seeking both monetary and injunctive relief. Qualex is currently gathering the information and documents necessary to file its response to PCI's Complaint. That response must be filed by April 25, 1994. Qualex intends to defend the case vigorously, but the Company is unable to determine the probable impact of the suit at this early stage in the proceeding. In 1991, three lawsuits were filed against Actava, certain of Actava's current and former directors and Intermark, Inc., which owned approximately 26% of Actava's Common Stock. One complaint alleged, among other things, a long-standing pattern and practice by the defendants of misusing and abusing their power as directors and insiders of Actava by manipulating the affairs of Actava to the detriment of Actava's past and present stockholders. The complaint sought monetary damages from the director defendants, injunctive relief against Actava, Intermark and its current directors, and costs of suit and attorney's fees. The other two complaints alleged, among other things that members of the Actava Board of Directors contemplate either a sale, a merger, or other business combination involving Intermark, Inc. and Actava or one or more of its subsidiaries or affiliates. The complaints sought costs of suit and attorney's fees and preliminary and permanent injunctive relief and other equitable remedies, ordering the director defendants to carry out their fiduciary duties and to take all appropriate steps to enhance Actava's value as a merger/acquisition candidate. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) These three suits were consolidated on May 1, 1991. While these actions are in their preliminary stages, management currently believes the actions will not materially affect the operations or financial position of Actava. Actava is a defendant in various other legal proceedings. However, Actava is not aware of any action which, in the opinion of management, would materially affect the financial position or results of operations of Actava. CONTINGENT LIABILITIES AND COMMITMENTS Actava, on behalf of its Snapper division, has an agreement with a financial institution which makes available to dealers floor plan financing for Snapper products. This agreement provides financing for dealer inventories and accelerates cash flow to Snapper's distributors and to Snapper. Under the terms of the agreement, a default in payment by one of the dealers on the program is non-recourse to both the distributor and to Snapper. However, the distributor is obligated to repurchase any equipment recovered from the dealer and Snapper is obligated to repurchase the recovered equipment if the distributor defaults. At December 31, 1993 and 1992, there was approximately $23,000,000 and $20,000,000, respectively, outstanding under these floor plan financing arrangements. Actava is contingently liable under various guarantees of debt totaling approximately $8,600,000. The debt is primarily Industrial Revenue Bonds which were issued by former subsidiaries to finance their manufacturing facilities and equipment, and is secured by the facilities and equipment. In addition, upon the sale of the subsidiaries, Actava received lending institution guarantees or bank letters of credit to support Actava's contingent obligations. There are no material defaults on the debt agreements. Actava is contingently liable under various real estate leases of former subsidiaries. The total future payments under these leases, including real estate taxes, is estimated to be approximately $9,100,000. The leased properties generally have financially sound subleases. In January 1992, Qualex entered into an agreement whereby it sells an undivided interest in a designated pool of trade accounts receivable on an ongoing basis. The maximum allowable amount of receivables to be sold, initially set at $50,000,000, was increased to $75,000,000 in August 1992. As collections reduce the pool of sold accounts receivable, Qualex sells participating interests in new receivables to bring the amount sold up to the desired level. At December 31, 1993 and 1992, the uncollected balance of receivables sold amounted to $60,000,000 and $30,000,000, respectively. The proceeds are reported as operating cash flows in the statement of cash flows and a reduction of receivables in Qualex's balance sheet. Total proceeds received by Qualex during the year were $519,000,000 for 1993 and $220,000,000 for 1992. There has been no adjustment to the allowance for doubtful accounts because Qualex has retained substantially the same risk of credit loss as if the receivables had not been sold. Qualex pays fees based on the purchaser's level of investment and borrowing costs. During 1993 and 1992, Qualex recorded $2,200,000 and $1,100,000, respectively, of these fees as other expenses. Qualex has a supply contract with Kodak for the purchase of sensitized photographic paper and purchases substantially all of the chemicals used in photoprocessing from Kodak. Qualex also purchases various other production materials and equipment from Kodak. Qualex and DP handle and store various materials in the normal course of business that have been classified as hazardous by various federal, state and local regulatory agencies. As of December 31, 1993, Qualex and DP are continuing to conduct tests at various sites and will perform any necessary cleanup where and to the extent legally required. At those sites where tests have been completed, cleanup costs have been immaterial. The Company may also be liable for remediation of environmental damage relating to businesses previously sold in excess of amounts accrued. At the sites currently being tested, it is management's opinion that cleanup costs will not have a material effect on Actava's financial position or results of operations. THE ACTAVA GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In January 1993, Qualex signed a ten year agreement to purchase its information systems services from an outside agency. Annual service charges under this agreement are approximately $13,000,000. At December 31, 1993, approximately $5,000,000 of Actava's cash and short-term investments were pledged to secure a Snapper credit line and approximately $20,700,000 of cash and short-term investments were pledged to support outstanding letters of credit. SEGMENT INFORMATION A description of Actava's segments is presented in the first four paragraphs of Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." Additional segment information as of and for the three years ended December 31, 1993 is presented in the tables captioned "Segment Performance" and "Other Segment Data" which are included in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." THE ACTAVA GROUP INC. AND SUBSIDIARIES SUMMARY OF QUARTERLY EARNINGS AND DIVIDENDS - --------------- (a) Actava's lawn and garden division estimates certain sales related expenses for the year and charges these expenses to income based upon estimated sales for the year. Sales and expenses for 1993 were different than estimated in the first three quarters. If the expenses had been charged to income based upon actual sales for the year, net loss would have increased in the first and second quarter by $4,500,000 and $7,450,000, respectively, and decreased in the third and fourth quarters by $1,750,000 and $10,200,000, respectively. Sales and expenses for the year were also different in 1992 than estimated in the first three quarters. If the expenses had been charged to income based upon actual sales for the year, net income would have increased in the first and third quarters by $3,500,000 and $700,000, respectively, and decreased in the fourth quarter by $4,200,000. (b) Effective January 1, 1992, Qualex changed its method of accounting for the cost of its proof advertising program to recognize these costs at the time the advertising is placed by the customer. Under the proof advertising program, Qualex reimburses certain advertising costs incurred by its customers up to a percentage of sales to that customer. Qualex previously accrued such costs at the time of the initial sale. Qualex believes that this new method is preferable because it recognizes advertising expense as it is incurred rather than at the time of the initial sale to the customer. Information for the first quarter of 1992, as previously reported, differs from the above amounts as a result of this change. The effects of this change do not have a significant effect on the other quarters. (c) Effective January 1, 1993, Actava adopted FASB Statement No. 106, "Accounting for Postretirement Benefits Other Than Pensions". Actava and its subsidiaries provide group medical plans and life insurance coverage for certain employees subsequent to retirement. In prior years, these benefits had been charged to operations on a pay-as-you-go (cash) basis; effective as of 1993 they are charged to operations on an accrual basis. Information for the first quarter of 1993, as previously reported, differs from the above amounts because the cumulative effect was originally reported net-of-tax. (d) During the fourth quarter of 1993, Actava's lawn and garden division revised its estimate of accrued product warranty expense to reflect an increase in the amount of future warranty cost to be incurred due to increased warranty claims. This change in accounting estimate resulted in an increase in the net loss for the fourth quarter of approximately $4,000,000. (e) During the fourth quarter of 1993, Actava increased its valuation allowance for an investment in a real estate development from $1,425,000 to $4,425,000, due to an accelerated plan for disposition. This change in estimate resulted in an increase in the net loss for the fourth quarter of approximately $3,000,000. SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. THE ACTAVA GROUP INC. ANNUAL REPORT ON FORM 10-K YEAR ENDED DECEMBER 31, 1993 ITEM 14(D) FINANCIAL STATEMENT SCHEDULES S-1 SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES THE ACTAVA GROUP INC. AND SUBSIDIARIES DECEMBER 31, 1993 - --------------- (A) Senior Vice-President, Treasurer and Chief Financial Officer (B) Represents one note receivable in the amount of $117,000, with interest at 6.5%, due June 25, 2001, with interest payable annually, four notes receivable each in the amount of $60,938, with interest at 6.5%, due August 1, 2001, with at least one-half of interest payable annually, and one note receivable in the amount of $16,234, with interest at 6.5%, due August 1, 2002, with at least one-half of interest payable annually. All notes receivable were issued in connection with purchases of The Actava Group Inc. stock. See "Triton Group Ltd. Loan" of Notes to Consolidated Financial Statements for information regarding a note receivable from Triton Group Ltd. S-2 SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF THE ACTAVA GROUP INC. CONDENSED BALANCE SHEETS S-3 SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF THE ACTAVA GROUP INC. -- (CONTINUED) CONDENSED STATEMENTS OF OPERATIONS S-4 SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF THE ACTAVA GROUP INC. -- (CONTINUED) CONDENSED STATEMENTS OF CASH FLOWS S-5 SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF THE ACTAVA GROUP INC. -- (CONTINUED) NOTES TO CONDENSED FINANCIAL STATEMENTS NOTE A -- ACCOUNTING POLICIES In the parent-company-only financial statements, Actava's investment in subsidiaries is stated at cost plus equity in undistributed earnings of subsidiaries since the date of acquisition. Actava's share of net income of its unconsolidated subsidiaries in these financial statements is included in consolidated income using the equity method. Parent-company-only financial statements should be read in conjunction with Actava's consolidated financial statements. NOTE B -- DEBT Long-term debt consisted of the following: Subordinated debt of The Actava Group Inc. is described in "Subordinated Debt" of Notes to Consolidated Financial Statements. Notes payable and long-term debt of The Actava Group Inc. are described in "Notes Payable and Long-Term Debt" of Notes to Consolidated Financial Statements. Maturities of long-term and subordinated debt are $3,764,000 in 1995, $33,849,000 in 1996, $15,171,000 in 1997 and $58,761,000 in 1998. NOTE C -- DIVIDENDS FROM SUBSIDIARIES Cash dividends paid by Qualex Inc. to Actava amounted to $8,614,000 in 1993, $3,886,000 in 1992 and $6,782,000 in 1991. S-6 SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT THE ACTAVA GROUP INC. AND SUBSIDIARIES - --------------- Note A -- Assets acquired in acquisitions of businesses. Note B -- Purchases in the normal course of business. Note C -- Reclassifications and other changes. Note D -- Sale of businesses. Note E -- Reclassification to other assets held for sale. Note F -- The annual provisions for depreciation have been computed principally in accordance with the following ranges of rates: Buildings and improvements 2% to 10% Machinery and equipment 7% to 33% S-7 SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT THE ACTAVA GROUP INC. AND SUBSIDIARIES - --------------- Note A -- Reclassifications and other changes. Note B -- Sale of businesses. Note C -- Reclassification to other assets held for sale. S-8 SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS THE ACTAVA GROUP INC. AND SUBSIDIARIES S-9 SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS -- (CONTINUED) THE ACTAVA GROUP INC. AND SUBSIDIARIES S-10 SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS -- (CONTINUED) THE ACTAVA GROUP INC. AND SUBSIDIARIES - --------------- Note A -- Uncollectible accounts charged off -- net of recoveries. Note B -- Reclassifications and other changes. Note C -- Acquisition of business Note D -- Losses of subsidiaries held for disposition and discontinued operations. Note E -- Costs incurred in consolidation of facilities. Note F -- Costs incurred. S-11 SCHEDULE IX -- SHORT-TERM BORROWINGS THE ACTAVA GROUP INC. AND SUBSIDIARIES - --------------- Note A -- Notes payable to banks represent borrowings under lines of credit arrangements that are reviewed and renewed periodically. Note B -- The average amount outstanding during the period was computed by dividing the total of daily outstanding principal balances by 360, or by the number of days the lines of credit were available. Note C -- The weighted-average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. S-12 SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION THE ACTAVA GROUP INC. AND SUBSIDIARIES Amounts for taxes, other than payroll and income taxes, and royalties are not presented as such amounts are less than 1% of total sales and revenues. S-13 INDEX TO EXHIBITS - --------------- (b) Reports on Form 8-K filed in the fourth quarter of 1993: None. (c) The response to this portion of Item 14 is submitted as a separate section in this report. (d) The response to this portion of Item 14 is submitted as a separate section in this report.

823549_1993.txt

823549_1993

1993

823549

ITEM 1. BUSINESS. Tenneco Inc., a Delaware corporation, is a diversified industrial company conducting all of its operations through its subsidiaries. As used herein, "Tenneco" refers to Tenneco Inc. and its consolidated subsidiaries. The major businesses of Tenneco are the transportation and sale of natural gas; manufacture and sale of farm and construction equipment; manufacture and sale of automotive exhaust system parts, ride control products and brake products; construction and repair of ships; manufacture and sale of packaging materials, cartons, containers and specialty packaging products; and manufacture and sale of phosphorus chemicals and surfactant products. See "Business Strategy". At December 31, 1993, Tenneco had approximately 75,000 employees. CONTRIBUTIONS OF MAJOR BUSINESSES Information concerning Tenneco's principal industry segments and geographic areas is set forth in Note 15 to the Financial Statements of Tenneco Inc. and Consolidated Subsidiaries. The following tables summarize (i) net sales and operating revenues from continuing operations, (ii) income (loss) from continuing operations before interest expense and income taxes and (iii) capital expenditures of the major business groups of Tenneco for the periods indicated. NET SALES AND OPERATING REVENUES FROM CONTINUING OPERATIONS INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INTEREST EXPENSE AND INCOME TAXES - -------- * Includes restructuring charges of $920 million and $461 million related to Farm and construction equipment in 1992 and 1991, respectively, and in 1991 $79 million related to Chemicals and $12 million related to Other. For additional information concerning these charges, see Note 2 to the Financial Statements of Tenneco Inc. and Consolidated Subsidiaries and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." CAPITAL EXPENDITURES FOR CONTINUING OPERATIONS The interest expense and income taxes from continuing operations which are not allocated to the major businesses were as follows: NATURAL GAS PIPELINES AND MARKETING Tenneco is engaged in the interstate and intrastate transportation and marketing of natural gas. Its natural gas operations are conducted by Tenneco Gas Inc. and other subsidiaries of Tenneco Inc. (collectively, "Tenneco Gas"). Historically, interstate pipeline companies served primarily as merchants of natural gas, purchasing gas under long-term contracts with numerous producers and reselling gas to local distribution companies under long-term sales agreements. Interstate pipelines were not required to transport gas for customers who did not purchase the gas from the pipeline company. Commencing in 1984, the Federal Energy Regulatory Commission (the "FERC") issued a series of orders that have resulted in a major restructuring of the natural gas transmission industry and its business practices. This restructuring, coupled with a nationwide excess of deliverable natural gas, resulted in increased competition for markets and decreased prices for natural gas, and dramatically increased the ratio that pipelines' transportation volumes bear to their total throughput. With full implementation of the FERC's Order No. 636 (discussed below under the caption "Federal Regulation"), most interstate pipeline companies now serve primarily as gas transporters rather than gas merchants. During this period, pipeline customers have turned more and more to marketers of natural gas to secure natural gas supplies for them, make transportation arrangements and provide other services. Generally, these gas marketers are not regulated by the FERC and may be affiliates of regulated interstate pipeline companies, subject to certain information-sharing restrictions to prevent unfair competitive advantages. To respond to the changing natural gas industry, Tenneco Gas, through companies that are not subject to regulation by the FERC, has been providing natural gas marketing services since 1984. In addition, Tenneco Gas has started building new business units that are not generally subject to regulation by the FERC and that Tenneco Gas believes have the potential to generate higher returns than its regulated businesses. The principal activities of these business units include development of and participation in international natural gas pipeline and gas-fired power generation projects and of domestic gas-fired power generation projects; establishment of natural gas production financing programs for producers; and the sale of administrative services. INTERSTATE PIPELINE OPERATIONS Tenneco Gas's interstate pipeline operations include the pipeline systems of Tennessee Gas Pipeline Company ("Tennessee"), Midwestern Gas Transmission Company ("Midwestern") and East Tennessee Natural Gas Company ("East Tennessee"), which are engaged in the transportation, storage and, to a limited extent, sale of natural gas primarily to or for other gas transmission or distribution companies for resale. Tennessee's multiple-line system begins in gas-producing regions of Texas and Louisiana, including the continental shelf of the Gulf of Mexico, and extends into the northeastern section of the United States, including the New York City and Boston metropolitan areas. Midwestern's pipeline system extends from Portland, Tennessee, to Chicago, and principally serves the Chicago metropolitan area. East Tennessee's pipeline system serves the states of Tennessee, Virginia and Georgia. At December 31, 1993, Tenneco's interstate gas transmission systems included approximately 16,300 miles of pipeline, gathering lines and sales laterals, together with related facilities that include 91 compressor stations with an aggregate of approximately 1.5 million horsepower. These systems also include underground and above-ground gas storage facilities to permit increased deliveries of gas during peak demand periods. The total design delivery capacity of Tenneco's interstate systems at December 31, 1993, was approximately 4,299 million cubic feet ("MMCF") of gas per day, and approximately 5,605 MMCF on peak demand days, which includes gas withdrawal from storage. Joint Ventures Tenneco also has interests in several joint ventures formed to own and operate interstate pipeline systems. These interests include a 50% interest in Kern River Gas Transmission Company ("Kern River") and a 13.2% interest in Iroquois Gas Transmission Company ("Iroquois"). Kern River, which owns a 904-mile pipeline system extending from Wyoming to California with a design capacity of 700 MMCF of gas per day, completed its second year of operations in 1993. Also in 1993, Kern River implemented Order No. 636 with no adverse effect to the pipeline's normal business flow. The 370-mile Iroquois pipeline began initial operation in late 1991 and became fully operational in January 1992. The pipeline extends from the Canadian border at Waddington, New York, to Long Island, New York, and, with additional compression added in 1993, is designed to deliver (directly or through interconnecting pipelines such as Tennessee) 641 MMCF of gas per day to local distribution companies and electric generation facilities in six states. Gas Sales and Transportation Volumes The following table sets forth the volumes of gas, stated in MMCF, sold and transported by Tenneco's interstate pipeline systems for the periods shown. - -------- * These sales and transportation volumes include all natural gas sold or transported by Tenneco's interstate pipeline companies. The table includes Tenneco's proportionate share of sales and transportation volumes of the joint ventures in which it has interests; of the total volumes shown, 165,728 MMCF was attributable to these joint venture interests in 1993, 125,134 MMCF in 1992, and 118,839 MMCF in 1991. Intercompany deliveries of natural gas have not been eliminated from the table. Federal Regulation Tenneco's interstate natural gas pipeline companies are "natural gas companies" as defined in the Natural Gas Act of 1938, as amended (the "Natural Gas Act"). As such, these companies are subject to the jurisdiction of the Department of Energy, including the FERC. Tenneco's interstate pipeline operations are operated pursuant to certificates of public convenience and necessity issued under the Natural Gas Act and pursuant to the Natural Gas Policy Act of 1978. The FERC regulates the interstate transportation and certain sales of natural gas, including, among other things, rates and charges allowed natural gas companies, extensions and abandonments of facilities and service, rates of depreciation and amortization and the accounting system utilized by the companies. Prior to the FERC's industry restructuring initiatives in the 1980's, Tenneco's interstate pipeline companies operated primarily as merchants, purchasing natural gas under long-term contracts and reselling the gas to customers, again under long-term contracts. With the FERC mandated conversion from a primarily merchant to a primarily transportation business, Tennessee's sales, and hence its purchases of gas for resale, declined precipitously, and Tennessee incurred significant liability to its producers under its long-term gas supply contracts, many of which specified prices at above market levels. On June 25, 1992, the FERC approved a settlement allowing Tennessee to recover from its customers up to $650 million of excess gas supply costs incurred in resolving this liability through July 1, 1992 (including take-or-pay costs and payments to producers to suspend or terminate contracts or to reduce contract prices to market levels). The settlement also allowed Tennessee to place into effect, as of July 1, 1992, a Gas Inventory Charge providing a mechanism for the recovery of these excess gas supply costs until September 1, 1993, the effective date of Tennessee's implementation of Order No. 636. Tennessee charged to operating expenses that portion of excess gas supply costs incurred prior to the implementation of Order No. 636 that it cannot recover from customers. In 1992, the FERC issued Order No. 636 which, together with subsequently issued clarifying Order Nos. 636-A and 636-B (the "FERC Restructuring Orders"), directed a further sweeping restructuring of the interstate gas pipeline industry. The FERC Restructuring Orders required pipelines to: "unbundle" their transportation and storage services from their sales services; increase pipeline customers' flexibility to change receipt and delivery points under transportation contracts and to allow release of capacity under those contracts for use by others; and separate interstate pipeline gas sales organizations from interstate pipeline transportation and storage business units. Under the FERC Restructuring Orders, rates for pipeline transportation and storage generally remain subject to traditional cost-of-service regulation but under a rate design which is relatively insensitive to throughput and hence less sensitive to seasonal variation. Sales of natural gas by interstate pipelines occur pursuant to a blanket sales certificate under which price and other terms of sale are set by market forces. After a series of FERC orders and compliance filings, Tennessee implemented its Order No. 636 tariff commencing on September 1, 1993, restructuring its transportation, storage and sales services. The FERC Restructuring Orders recognized that transition costs, including gas supply realignment costs, may result from this restructuring and provided mechanisms for the full recovery of such qualified costs. Pipelines were encouraged to propose various mechanisms in the restructuring proceedings to reduce transition costs, including assignment of gas supply contracts and phasing in of the conversions of the pipeline sales service. The FERC Restructuring Orders specified that pipelines would be allowed to make special filings to recover many types of transition costs. Tennessee has made multiple filings to begin recovery of certain of the transition costs already paid or obligated to be paid in connection with the FERC Restructuring Orders. Tennessee's filings request authority to: recover, through a monthly surcharge, one-time gas supply realignment costs and certain related costs incurred to date over a twelve-month period; direct-bill customers for unrecovered gas costs over a twelve-month period; and track and recover, through an annual surcharge, upstream transportation costs from customers. The filings were accepted effective September 1, 1993, and made subject to refund pending review. The FERC will review the recovery of the gas supply realignment costs and the direct billing of unrecovered gas costs in hearings set for the fall of 1994. However, Tennessee's filings to recover production costs related to its Bastian Bay facilities have been rejected by the FERC based on the continued use of the gas production from the field; but, the FERC recognized Tennessee's right to file for the recovery of losses upon disposition of these assets. Tennessee will seek judicial review of the FERC actions rejecting recovery of production costs relating to Bastian Bay. Tennessee is confident that the Bastian Bay costs will ultimately be recovered as transition costs directly related to Order No. 636, and no FERC order has questioned the ultimate recoverability of these costs. The total amount of transition costs that will be incurred by Tennessee will depend upon: developments in restructuring proceedings involving Tennessee, its customers and other affected parties; the resolution of pending litigation; and the terms of multiple negotiations with individual suppliers. Until these issues are resolved, Tennessee cannot finally determine the ultimate amount of one-time realignment costs or other related annual costs it will incur, nor the amounts which will be recovered from customers. Tennessee believes that one- time realignment costs will not exceed $700 million; at December 31, 1993, Tennessee had recorded and deferred approximately $120 million of such one-time costs which are recoverable from its customers. Tennessee believes that other related annual costs will not exceed $100 million in 1994, decreasing thereafter over the length of the contracts involved. The FERC Restructuring Orders will undergo judicial review, clarifications and formulation of cost recovery details as the restructuring process proceeds. However, Tennessee believes that it is entitled to full recovery of all transition costs it will incur. Given the fact that the FERC Restructuring Orders contemplate complete recovery by pipelines of qualified transition costs, Tenneco believes that Tennessee's Order No. 636 restructuring (together with the Order No. 636 restructuring of Tenneco's other interstate pipelines) will not have a material effect on Tenneco's consolidated financial position or results of operations. Competition The natural gas pipeline industry is experiencing increasing competition in virtually every aspect of operations, the result of actions by the FERC to strengthen market forces throughout the industry. In a number of key markets, Tenneco's interstate pipelines face competitive pressure from other major pipeline systems, enabling local distribution companies and end users to choose a supplier or switch suppliers based on the short term price of the gas and the cost of transportation. Competition between pipelines is particularly intense in Midwestern's Chicago and Northern Indiana markets, in East Tennessee's Roanoke, Chattanooga and Atlanta markets, and in Tennessee's supply area, Louisiana and Texas. Even in other markets, such as Tennessee's New England market, displacement of load to other pipelines is possible during summer or other low demand seasons. Tenneco Gas pipelines have frequently been required to discount their transportation rates to maintain market share. Gas Supply With full implementation of Order No. 636, Tennessee's firm sales obligations requiring maintenance of long-term gas purchase contracts have declined from over a 1.4 billion dekatherm maximum daily delivery obligation to less than a 200 million dekatherm maximum daily delivery obligation. As discussed above under the caption "Federal Regulation", Tennessee has attempted to reduce its natural gas purchase portfolio in line with these requirements through termination and assignment to third parties. Although Tennessee's requirements for purchased gas are substantially less than prior to its implementation of Order No. 636, Tenneco Gas is pursuing the attachment of gas supplies to, and transportation by others through, Tennessee's system. Current gas supply activities include development of offshore and onshore pipeline gathering projects and utilization of production financing programs to spur exploration and development drilling in areas adjacent to Tennessee's system. GAS MARKETING AND INTRASTATE PIPELINES Subsidiaries of Tenneco Energy Resources Corporation ("TERC") buy and sell natural gas and arrange for shipment of gas purchased and sold. With the implementation of Order No. 636, the volumes of gas that are purchased and sold by gas marketers have increased and competition to serve the increased demand is intense. Consequently, TERC is focused upon improving its ability to serve as a major gas marketer and specifically upon the development of natural gas products and services designed to meet the changing needs of its customers as the natural gas market continues to become more deregulated. Through various intrastate pipeline and gathering subsidiaries, Tenneco is engaged in the intrastate sale and transportation of natural gas in various states. These subsidiaries include Channel Industries Gas Company, Tenngasco Gas Supply Company, Tenneco Gas Gathering Company and Creole Gas Pipeline Corporation. Tenngasco Gas Supply Company also owns an equity interest in Oasis Pipeline Company, which has 1 Bcf of pipeline capacity from central and west Texas. As of December 31, 1993, Tenneco owned or had an equity interest in approximately 2,000 miles of intrastate pipelines and other related facilities. Tenneco's intrastate pipeline systems are subject to the jurisdiction of state regulatory authorities and are subject to the jurisdiction of the FERC but only to a very limited extent. The following table sets forth the volumes of gas, stated in MMCF, sold by subsidiaries of TERC and transported by Tenneco's non-jurisdictional pipelines for the periods indicated: TERC is also engaged in the processing of natural gas, including the processing of gas of third parties, and it also markets natural gas liquids that are extracted from the gas stream. On February 11, 1994, TERC announced the sale of original issue stock to Ruhrgas AG, through a transaction, certain terms of which are to be finalized by February 1995, resulting in dilution of the Company's ownership in that subsidiary from 100% to 80%. At the same time, Tenneco Gas entered into an agreement with the buyer to pursue joint opportunities in the European gas industry. TENNECO VENTURES Tenneco Gas Production Corporation ("TGPC") and Tenneco Ventures Corporation ("Ventures"), subsidiaries of Tennessee, together with certain institutional investors and partners, invest in oil and gas properties by acquiring interests in properties or providing financing to producers for exploration and development. Three institutional investors have agreed to provide up to an aggregate of $65,000,000 to TGPC for investment in oil and gas properties. TGPC selects the properties to be acquired and owns at least a 10% interest in each of the properties. As of December 31, 1993, approximately $25,000,000 of such amount had been used to acquire interests in oil and gas properties. A majority of the gas reserves from these properties should be available for sale through TERC and transportation on the pipeline systems of Tenneco Gas. FARM AND CONSTRUCTION EQUIPMENT Case Corporation and other subsidiaries of Tenneco ("Case") manufacture a full line of farm equipment and light and medium-sized construction equipment. The Case manufacturing activities are presently carried on at seven plants in North America (primarily in the Midwest, not including joint ventures) and nine plants in four foreign countries. At December 31, 1993 Case's products were sold through approximately 150 company-owned retail outlets and approximately 4,100 independently owned dealer outlets in 50 states and throughout the world. The principal customers for Case construction equipment are utility companies and contractors. RESTRUCTURING OF CASE OPERATIONS On March 21, 1993, the Board of Directors of Tenneco Inc. adopted a comprehensive restructuring program for Case (the "Case Restructuring Program") which resulted in a pre-tax charge of $920 million ($843 million after taxes, or $5.85 per average common share), all of which was reflected in the 1992 loss from continuing operations before interest expense and income taxes. Implementation of the Case Restructuring Program was commenced in 1993, and various restructuring actions in the Program were completed in 1993 and others are in process. The Case Restructuring Program is expected to be substantially completed during 1996. The Case Restructuring Program is highly complex, and effectively implementing it continues to be a major undertaking. The specific restructuring measures were based on management's best business judgment under prevailing circumstances and on assumptions which may be revised over time and as circumstances change. Case continues to believe that the successful completion of the Case Restructuring Program will enhance its operating income and pre-tax cash flow over 1992 levels by approximately $200 million annually by 1996. For additional information about Case's restructuring program, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 2 to "Notes to the Financial Statements." OPERATIONS The following were products manufactured by Case in 1993: FARM EQUIPMENT CONSTRUCTION EQUIPMENT -------------- ---------------------- two-wheel and four- excavators wheel drive farm crawler dozers and loaders tractors wheel loaders combines loader/backhoes cotton pickers rough terrain forklifts hay and forage skid steer loaders equipment trenchers soil conditioning equipment crop production equipment implements Case also distributes in North America excavators that are manufactured by a third party. Case manufactures and distributes equipment primarily under the names "Case", "Case IH", "Case Poclain" and "Case International." Case has a 50% interest in a joint venture with Cummins Engine Company, Inc. ("Cummins") to manufacture a line of diesel engines. Case has incorporated engines produced by this joint venture into virtually all of its product lines. Cummins sells to others engines manufactured by the joint venture. The Tenneco Inc. General Employee Benefit Trust holds approximately 8.6% of the outstanding common stock of Cummins. Case Ventures Corporation and Hesston Ventures Corporation, a wholly-owned subsidiary of AGCO Corporation, each own a 50% interest in Hay and Forage Industries, a joint venture which manufactures hay and forage equipment at a plant in Hesston, Kansas. Case and AGCO/Hesston separately market and sell equipment manufactured by the joint venture under the Case and Hesston brand names, respectively, and through their respective distribution systems. The following table sets forth information with respect to sales during the past three years: Case's business is affected by the general level of activity in the agricultural and construction industries, including the rate of worldwide agricultural production and demand, levels of total industry capacity, weather conditions, exchange rates, commodity prices, levels of equipment inventory and prevailing levels of construction. The farm and construction equipment industry is characterized by unrelenting global competition and flat to declining markets. Both United States and international manufacturers of farm and construction equipment compete on a world-wide basis in such markets. AUTOMOTIVE PARTS The principal components of the automotive parts operations of Tenneco are Walker Manufacturing Company, Monroe Auto Equipment Company and Tenneco Brake. WALKER MANUFACTURING COMPANY Walker Manufacturing Company and its affiliates ("Walker") manufacture a variety of automotive exhaust systems and emission control products. In the United States, Walker operates nine manufacturing facilities and seven distribution centers, three of which are located at manufacturing facilities, and also has two research and development facilities. Walker also operates ten manufacturing facilities located in Australia, Canada, the United Kingdom, Mexico, Denmark, Germany, France, Portugal and Sweden. Walker's products are sold to automotive manufacturers for use as original equipment and to wholesalers and retailers for resale as replacement equipment. Sales to the original equipment market are directly dependent on new car sales, and sales to the replacement market are related to the service life of original equipment and to the level of maintenance by individual owners of their automobiles. The service life of exhaust systems has increased in recent years, resulting in a decline in the exhaust replacement rate. The following table sets forth information relating to Walker's sales: In addition to the "Walker" line, Walker manufactures and distributes exhaust systems under a number of other brand names in the United States and foreign countries. MONROE AUTO EQUIPMENT COMPANY Monroe Auto Equipment Company and its affiliates ("Monroe") are engaged principally in the design, manufacture and distribution of ride control products. Monroe ride control products consist of hydraulic shock absorbers, air adjustable shock absorbers, spring assisted shock absorbers, gas charged shock absorbers, struts, replacement cartridges and electronically adjustable suspension systems. Monroe manufactures and markets replacement shock absorbers for virtually all domestic and most foreign makes of automobiles. In addition, Monroe manufactures and markets shock absorbers and struts for use as original equipment on passenger cars and trucks, as well as for other uses. Monroe has five manufacturing facilities in the United States and seven foreign manufacturing operations in Australia, Belgium, Brazil, Canada, the United Kingdom and Spain. The following table sets forth information relating to Monroe's sales: TENNECO BRAKE Tenneco Brake manufactures brake products for sale in the replacement equipment market. Its facilities consist of a plant in Cartersville, Georgia, which produces non-asbestos friction material for car and light truck brakes, and Tenneco Heavy Duty Brake, a Canadian manufacturer of heavy-duty non- asbestos friction brakes. Additionally, Tenneco's Brake-Pro Systems Division operates a distribution network for brake products and provides services to retail installer specialists. The automotive parts operations of Tenneco face intense competition from other manufacturers of automotive equipment. SHIPBUILDING Newport News Shipbuilding and Dry Dock Company ("Newport News"), a Tenneco subsidiary located in Newport News, Virginia, is the largest privately owned shipbuilding company in the United States. Its primary business is constructing nuclear-powered submarines and aircraft carriers for the United States Navy. Newport News also overhauls and repairs Naval and commercial vessels and refuels nuclear-powered ships. Newport News' shipbuilding facilities are located on the James River on approximately 475 acres of property which it owns. At December 31, 1993, the aggregate amount of Newport News' backlog of work to be completed was approximately $3.7 billion (substantially all of which is Navy-related), a decline from the backlog of $4.7 billion as of December 31, 1992. The cuts in naval shipbuilding following the end of the cold war have continued to put pressure on the Newport News backlog. At December 31, 1993, Newport News anticipated that it would complete approximately $1.6 billion of the current backlog by December 31, 1994, and an additional $1.0 billion in 1995. The December 31, 1993, backlog of Newport News included contracts for the construction of two Nimitz class aircraft carriers and five Los Angeles class attack submarines. Also included in that backlog is a contract for the refueling and overhaul of the aircraft carrier Enterprise, and a contract for the conversion of two Sealift ships. The present backlog extends into 1998. Subject to new orders, this existing backlog will decline as two submarines per year, on average, are delivered through 1996, and the aircraft carriers are delivered in 1995 and 1998. Newport News has various other contracts for Naval design work and for industrial projects. As is typical for similar Government contracts, all of Newport News' contracts with the Navy are unilaterally terminable by the Navy at its convenience with compensation for work completed and costs incurred. Newport News is aggressively pursuing new business opportunities and attempting to expand its business base in light of the declining Naval backlog, but there is no assurance that it will be able to do so to a material extent. While the mix of jobs between Naval and commercial work is expected to change somewhat, the U.S. Navy will continue to be the leading customer of the shipyard. The shipyard is actively pursuing the design and construction contract for the next aircraft carrier, CVN 76. Congress has appropriated through the government's fiscal year 1994 $2.1 billion of the $4.5 billion cost of this program (which will include approximately $1.4 billion of work to be performed by other companies). Authorization of the acquisition of CVN 76 by the U.S. Navy and appropriation of the balance of the cost is anticipated subsequent to the government's fiscal year 1994. In addition to working toward authorization of CVN 76, Newport News is pursuing major Naval overhaul and repair work and foreign military sales. A commercial division is pursuing ship repair work and new commercial construction opportunities. However, Newport News has not entered into any contracts for the initial construction of commercial ships since 1974. With respect to all Navy work, Newport News faces intense business pressures in the future because of expected declines in the United States' defense budget and excess ship building and repair capacity in the United States. Due to uncertainties as to future defense spending levels and the allocation of amounts appropriated for such spending to the various defense programs involved, Tenneco is unable to predict the number or timing of subsequent contracts for Naval construction or refueling and overhaul which may be awarded. Newport News reduced its workforce by approximately 7,000 or 25% between December 31, 1990 and December 31, 1993. PACKAGING Packaging Corporation of America and other Tenneco subsidiaries ("PCA") manufacture and sell containerboard, paperboard, corrugated shipping containers, folding cartons, molded fibre products, disposable plastic and aluminum containers and other related products. Its shipping container products are used in the packaging of food, paper products, metal products, rubber and plastics, automotive products and point of purchase displays. Its folding cartons are used in the packaging of soap and detergent, food products and a wide range of other consumer goods. Uses for its molded fibre products include produce and egg packaging, food service items and institutional and consumer disposable dinnerware. Its disposable plastic and aluminum containers are sold to the food service, food processing and related industries. In addition to products bearing the name "Packaging Corporation of America", PCA manufactures and distributes products under the names "EZ POR", "Packaging Company of California", "Revere Foil Containers" "Dahlonega Packaging", "Dixie Container," "Agri-Pak" and "Pressware International." The following table sets forth information with respect to PCA's sales during the past three years: At December 31, 1993, PCA operated 55 shipping container plants, six carton plants and 13 corrugated containerboard and paperboard machines at seven mills. Two of the mills (located in Georgia and Wisconsin), including substantially all of the equipment associated with both mills, are leased from third parties. PCA also has eight molded fibre products plants, one pressed paperboard plant, one lumber plant, five paper stock plants, and 10 disposable plastic and aluminum container plants. PCA's plants are located primarily in the United States. Its foreign plants are located in Great Britain, Spain, Canada, Switzerland and Germany. In the United States, PCA has a 50% ownership interest in a molded fibre distribution company and in a hardwood chip mill. In addition, PCA has a 50% ownership interest in a disposable aluminum product joint venture in Great Britain and a 30% interest in a joint venture in Hungary that owns a paperboard mill and a carton plant. The principal raw materials used by PCA in its mill operations are virgin pulp and reclaimed paper stock. PCA obtains these raw materials from independent logging contractors, from timberlands owned or controlled by it, from operation of its reclaimed paper stock collecting and processing plants and from other sources. At December 31, 1993, PCA owned 188,000 acres of timberland in Alabama, Michigan, Mississippi and Tennessee and leased, managed or had cutting rights on an additional 843,000 acres of timberland in those states and in Florida, Wisconsin and Georgia. During the years 1993, 1992 and 1991, approximately 22%, 18% and 23%, respectively, of the virgin fibre and timber used by PCA in its operations was obtained from timberlands controlled by it. PCA faces intense competition from many other manufacturers and alternative products of others. CHEMICALS Albright & Wilson Limited, a British-based chemical company, and other Tenneco subsidiaries ("Albright & Wilson"), are engaged in the chemical business. Albright & Wilson has four manufacturing facilities in the United Kingdom, four manufacturing facilities in the United States and 23 additional manufacturing facilities in 12 other countries (Canada, Colombia, Australia, Italy, France, Spain and six countries in Asia). In the years 1993, 1992 and 1991, approximately 81%, 84% and 86%, respectively, of Albright & Wilson's sales were made outside the United States. The principal products of Albright & Wilson are phosphorus chemicals and surfactants and a range of specialty chemicals for water management, flame retardants and intermediates for pharmaceuticals and agricultural chemicals. The following table sets forth sales of Albright & Wilson by product lines for the periods indicated: -------- * Sales by Albright & Wilson's pulp chemicals business, which was sold in 1992 have not been included. Albright & Wilson has a 50% interest in a joint venture that owns and operates a purified wet-process phosphoric acid plant in Aurora, North Carolina, which has largely displaced the use of phosphorus as a feedstock for phosphoric acid manufactured by Albright & Wilson in North America. OTHER Tenneco has several wholly-owned finance subsidiaries which purchase interest-bearing and noninterest-bearing trade receivables from its operating subsidiaries. Tenneco Credit Corporation and Tenneco Credit Canada Corp. purchase retail receivables primarily generated by Case Corporation's retail sales with the remainder from other Tenneco operating subsidiaries. Funding for Tenneco Credit Corporation is provided through the private and public debt markets. Funding for Tenneco Credit Canada Corp. is provided through private debt markets. Case Finance Company, Tenneco International Finance Limited and Case Canada Wholesale Finance Corporation purchase wholesale receivables primarily generated by the sale or lease of Case farm and construction equipment to its domestic and foreign dealers. The companies are funded primarily through private debt markets. BUSINESS STRATEGY Since September 1991 the Company has focused on various initiatives and taken steps designed to strengthen its financial results and improve its financial flexibility and thereby generate greater returns to its shareholders. Asset evaluation and redeployment have been and will continue to be important parts of this strategy. The Company continues to study opportunities for the strategic repositioning and restructuring of its operations (including through acquisitions, dispositions, divestitures, spin-offs and joint venture participation, wholly and partially, of various businesses). ENVIRONMENTAL MATTERS Tenneco Inc. estimates that its subsidiaries will make capital expenditures for environmental matters of approximately $90 million in 1994 and such expenditures will range from approximately $180 million to $200 million in the aggregate for the years 1995 through 2005. For information regarding environmental matters see Item 3, "Legal Proceedings--Environmental Proceedings" and "--Potential Superfund Liability", Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations--Environmental Matters" and Note 16 "Commitments and Contingencies" in the "Notes to Financial Statements." See also Note 1 "Summary of Accounting Policies--Environmental Liabilities" in the "Notes to Financial Statements." ITEM 2. ITEM 2. PROPERTIES. Reference is made to Item 1 for a description of Tenneco's properties. Tenneco believes that substantially all of its plants and equipment are, in general, well maintained and in good operating condition. They are considered adequate for present needs and as supplemented by planned construction are expected to remain adequate for the near future. During 1993, certain Case facilities were underutilized in varying degrees as their production capabilities exceeded the market demand for construction and agricultural equipment produced by such facilities. In 1993 Case curtailed production in an effort to further reduce existing inventory levels. For additional information concerning restructuring measures affecting facilities, see Note 2 to the "Notes to Financial Statements." Tenneco Inc. is of the opinion that its subsidiaries have generally satisfactory title to the properties owned and used in their respective businesses, subject to liens for current taxes and easements, restrictions and other liens which do not materially detract from the value of such property or the interests therein or the use of such properties in their businesses. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. (1) Martin Litigation. On November 19, 1993, the Supreme Court of the State of Louisiana denied a writ of certiorari which had the effect of affirming the decision of the Louisiana Court of Appeals holding in the case of Louisiana Intrastate Gas Corporation v. Martin Intrastate Gas Company, originally brought in the 22nd Judicial District Court for St. Tammany Parish, Louisiana, on October 25, 1991. The case involved a dispute between Louisiana Intrastate Gas Corporation ("LIG") and Martin Intrastate Gas Company ("Martin Intrastate"), of which Kenneth G. Martin is President, as to the nature and extent of Martin Intrastate's right to compel LIG to purchase natural gas under a 1978 gas purchase contract entered into by another affiliate of Kenneth G. Martin which subsequently filed for bankruptcy. The seller's rights under the contract were later purportedly assigned to Martin Intrastate. The original party seller was Martin Exploration Company, now a subsidiary of Tennessee. Tenneco's involvement in the case arose from its agreement to retain certain LIG liabilities in connection with its sale of LIG in 1989. In essence, Martin Intrastate originally claimed that it had been validly assigned all of seller's rights under the contract, that the contract was "statewide," covering all available gas that Martin Intrastate owned, controlled or had the right to sell, for its own account or for the account of others, and that the contract provided for a purchase price of about six times the current wellhead price. The Louisiana Court of Appeals held that Martin Exploration Company (the Tennessee subsidiary) holds the rights to sell gas to LIG under the "statewide" gas purchase contract. As a result of the denial of writ, the decision of the Louisiana Court of Appeals is final and nonappealable, and the case has been concluded without a material adverse effect on the financial condition or results of operations of Tenneco Inc. and its consolidated subsidiaries. (2) Environmental Proceedings. Tennessee is a party in proceedings involving federal and state authorities regarding the past use by Tennessee of a lubricant containing polychlorinated biphenyls ("PCBs") in its starting air systems. On January 13, 1992, the United States Environmental Protection Agency ("EPA") filed an administrative complaint alleging that Tennessee violated the Toxic Substances Control Act between 1980 and 1990 by engaging in the unauthorized use and disposal of materials containing PCBs. The complaint addresses PCB-related activity at 26 compressor stations in five states (Alabama, Mississippi, Kentucky, Tennessee and Ohio). A civil penalty of $15,678,000 was sought. Tennessee and the EPA have reached an agreement in principle under which Tennessee will make a specified payment in full settlement of civil penalties under the Toxic Substances Control Act arising from Tennessee's prior use of PCBs at compressor stations throughout its system. This agreement covers 42 Tennessee compressor stations in nine states and five EPA regions. The agreement in principle is contingent upon the completion of Tennessee's negotiations with EPA on the remediation of its compressor stations in Regions IV, V and VI. With respect to the nine stations in Regions II and III, EPA has advised Tennessee that it is deferring to the Pennsylvania and New York environmental agencies to specify the remediation requirements applicable to Tennessee. Tennessee anticipates that it will soon reach an agreement with the Pennsylvania Department of Environmental Resources ("PaDER") and will enter into a consent order on remediation at the Pennsylvania stations (under which Tennessee also agrees to pay a civil penalty and to make a contribution for environmental projects); meanwhile, Tennessee will continue its negotiations with the New York Department of Environmental Conservation on remediation at the New York stations. The agreements with the EPA and PaDER are expected to be entered into in the first quarter of 1994. Tenneco believes that the ultimate resolution of this matter will not have a material adverse effect on the financial condition or results of operations of Tenneco Inc. and its consolidated subsidiaries. See Note 16 to "Notes to Financial Statements" for additional information. In Commonwealth of Kentucky, Natural Resources and Environmental Protection Cabinet v. Tennessee Gas Pipeline Co. (Franklin County Circuit Court, Docket No. 88-C1-1531, November 16, 1988), the Kentucky environmental agency alleges that Tennessee discharged pollutants into the waters of the state without a permit and seeks an injunction against future discharges and a civil penalty. Counsel for Tenneco are unable to express an opinion as to its ultimate outcome. A subsidiary of Tennessee owns a 13.2% general partnership interest in Iroquois Gas Transmission System, L.P. ("Iroquois"), which owns an interstate natural gas pipeline from the Canadian border through the states of New York and Connecticut to Long Island. In early 1992, Iroquois was informed by U.S. Attorney's Offices for the Northern, Southern, and Eastern Districts of New York that a civil investigation had been initiated to determine whether Iroquois committed civil environmental violations during construction of the pipeline. In February 1992, 26 alleged violations were identified to Iroquois in writing. In response, Iroquois denied that such violations had occurred and asserted that all concerns raised by governmental authorities during construction had been fully addressed. Iroquois subsequently was informed that the alleged violations included certain field reports prepared by a Federal/State Inter-Agency Task Force which surveyed the right-of-way in connection with the right-of-way restoration program. Iroquois responded to the appropriate U.S. Attorneys' Offices that none of the matters referenced in field reports issued to date represent violations of any law or governmental authorization. As of March 4, 1994, no formal civil demand in connection with this civil investigation has been made on Iroquois by the federal government. On December 3, 1993, Iroquois received notification from the Enforcement Staff of the Federal Energy Regulatory Commission's Office of the General Counsel ("Enforcement") that Enforcement has commenced a preliminary, non- public investigation concerning Iroquois' construction of certain of its pipeline facilities. That office has requested certain information regarding such construction. In addition, on December 27, 1993, Iroquois received a similar request for information from the Army Corps of Engineers requesting certain information regarding permit compliance in connection with certain aspects of the pipeline's construction. Iroquois is evaluating and responding to these requests for information. No proceedings have been commenced against Iroquois in connection with these agency inquiries. A criminal investigation has been initiated against Iroquois and its environmental consultant by the U.S. Attorneys' Office for the Northern District of New York in conjunction with the U.S. Environmental Protection Agency ("EPA") and the Federal Bureau of Investigation ("FBI"). According to a press release issued by the FBI in June 1992, areas under investigation include possible environmental violations, wire fraud, mail fraud and providing false information or concealment of information from Federal agencies in conjunction with construction of the pipeline. To date, no criminal charges have been filed and the Assistant U.S. Attorney in charge of the investigation has stated that he is not yet ready to meet with Iroquois' attorneys to discuss the specifics of the matter. As a general partner, Tennessee's subsidiary may be jointly and severally liable with the other partners for the liabilities of Iroquois. Tennessee has a contract to provide gas dispatching as well as post-construction field operation and maintenance services for the operator of Iroquois, but Tennessee is not the operator of Iroquois and is not an affiliate of the operator. Moreover, the foregoing proceedings and investigations have not affected pipeline operations. Based upon information available to Tenneco at March 4, 1994 concerning the above investigations and proceedings involving Iroquois, Tenneco believes that neither Tennessee nor any of its subsidiaries is the target of the investigation described above and that the ultimate resolution of these matters will not have a material adverse effect on the financial condition or results of operations of Tenneco Inc. and its consolidated subsidiaries. On August 2, 1993, the Department of Justice filed suit against Packaging Corporation of America ("PCA") in the Federal District Court for the Northern District of Indiana, alleging that wastewater from PCA's molded fibre products plant in Griffith, Indiana interfered with or damaged the Town of Griffith's municipal sewage pumping station on two occasions in 1991 and 1993, resulting in discharges by the Town of untreated wastewater into a river. PCA has denied responsibility for the Town's wastewater discharges. The violations alleged by the Department of Justice could result in the assessment of statutory penalties in excess of $100,000; however, the Company does not believe that its ultimate resolution will have a material adverse effect upon its consolidated financial condition or results of operations. Pryor Foundry, Inc. ("Pryor") has been advised that the EPA may seek to impose a fine upon Pryor in connection with discharges of water by its facility in Pryor, Oklahoma, without the necessary permit. The violations alleged by the EPA could result in the assessment of statutory penalties in excess of $100,000; however, the Company does not believe that its ultimate resolution will have a material adverse effect upon its consolidated financial condition or results of operations. (3) Potential Superfund Liability. At December 31, 1993, Tenneco has been designated as a potentially responsible party in 70 "Superfund" sites. With respect to its pro rata share of the remediation costs of certain sites, Tenneco is fully indemnified by third parties. With respect to certain other sites, Tenneco has sought to resolve its liability through payments to the other potentially responsible parties. For the remaining sites, Tenneco has estimated its share of the remediation costs to be between $12 million and $72 million or 0.4% to 2.3% of the total remediation costs for those sites and has provided reserves that it believes are adequate for such costs. Because the clean-up costs are estimates and are subject to revision as more information becomes available about the extent of remediation required, Tenneco's estimate of its share of remediation costs could change. Moreover, liability under the Comprehensive Environmental Response, Compensation and Liability Act is joint and several, meaning that Tenneco could be required to pay in excess of its pro rata share of remediation costs. Tenneco's understanding of the financial strength of other potentially responsible parties has been considered, where appropriate, in Tenneco's determination of its estimated liability. Tenneco does not believe that the costs associated with its current status as a potentially responsible party in the Superfund sites described above will be material to its financial position or results of operations. For additional information concerning environmental matters, see the caption "Environmental Matters" under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", and the caption "Environmental Matters" under Note 16 to the Financial Statements of Tenneco Inc. and Consolidated Subsidiaries. (4) Grand Jury Investigation. Case Corporation is the subject of a grand jury investigation coordinated by the United States Customs Service and the United States Attorney's offices in Milwaukee, Wisconsin, and Chicago, Illinois, concerning possible mislabeling of parts shipments to Syria and possible improper shipments to Libya and other countries subject to export restrictions. Case is cooperating fully with the investigation. Tenneco cannot predict the outcome of this investigation, but does not believe that it will have a material adverse effect on the financial position or results of operations of Tenneco Inc. and its consolidated subsidiaries. (5) Other Matters. Tenneco Inc. and its subsidiaries are parties to numerous legal proceedings arising from their operations. Tenneco Inc. believes that the outcome of these proceedings, individually and in the aggregate, will have no material effect on Tenneco's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of security holders of Tenneco Inc. during the fourth quarter of the fiscal year ended December 31, 1993. ITEM 4.1 EXECUTIVE OFFICERS OF THE REGISTRANT. Set forth below is a list of the executive officers of Tenneco Inc. at March 1, 1994. Each of such officers has served in the capacities indicated below with Tenneco Inc. (or prior to a corporate reorganization in 1987 with the then publicly held affiliate of Tenneco Inc. which bore the same name) since the dates indicated below: - -------- * Unless otherwise indicated, all offices held are with Tenneco Inc. Each of the executive officers of Tenneco Inc. has been continuously engaged in the business of Tenneco Inc., its subsidiaries, affiliates or predecessor companies during the past five years except that: (i) from 1986 to 1991, Michael H. Walsh was Chairman and Chief Executive Officer of Union Pacific Railroad Company; (ii) from 1986 to 1992, Dana G. Mead was employed by International Paper, last serving in the capacity of Executive Vice President; (iii) Theodore R. Tetzlaff has been a partner in the law firm of Jenner & Block, Chicago, for more than five years; (iv) from 1985 to 1992, Stacy S. Dick was employed by The First Boston Corporation, last serving in the capacity of Managing Director; (v) from 1980 to 1992, John J. Castellani was employed by TRW Inc., last serving in the capacity of Vice President of Government Relations; (vi) from 1988 to 1993, James V. Faulkner, Jr., was employed by USCPI, Inc., last serving in the capacity of Senior Vice President and General Counsel; (vii) from 1988 until his employment by Tenneco in 1992, Barry R. Schuman was employed by Union Pacific Railroad Company, last serving in the capacity of Vice President of Human Resources; (viii) from 1990 until 1992, Arthur H. House served as Vice President, Corporate Communications of Aetna Life & Casualty Company and from 1988 to 1990 as Senior Vice President, Corporate Affairs of Shawmut National Corporation; (ix) from 1975 to 1994, Karen R. Osar was employed by J. P. Morgan & Co., Inc., last serving in the capacity of Managing Director--Corporate Finance Group; (x) from 1983 to 1990, Robert G. Simpson was employed by Kraft Inc. and Philip Morris Management Co., last serving in the capacity of Director of Kraft General Foods Federal Taxes; and (xi) from 1977 to 1993, Paul T. Stecko was employed by International Paper, last serving as Vice President and General Manager of Publications Papers, Bristols and Converting Papers. Tenneco Inc.'s Board of Directors is divided into three classes of directors serving staggered three-year terms, with a minimum of eight directors and a maximum of sixteen directors. At each annual meeting of stockholders, successors to the directors whose terms expire at such meeting are elected. Officers are elected at the annual meeting of directors held immediately following the annual meeting of stockholders. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The outstanding shares of Common Stock, par value $5 per share, of Tenneco Inc. (the "Common Stock") are listed on the New York, Midwest, Pacific, Toronto, London, Paris, Frankfurt, Dusseldorf, Basel, Geneva and Zurich Stock Exchanges. The following table sets forth the high and low sale prices of Common Stock during the periods indicated on the New York Stock Exchange Composite Transactions Tape and dividends paid per share of Common Stock during such periods: The number of holders of Common Stock of record as of February 23, 1994, was approximately 104,000. The declaration of dividends on the Company's capital stock is at the discretion of the Company's Board of Directors. The Board has not adopted a dividend policy as such; subject to legal and contractual restrictions, its decisions regarding dividends are based on all considerations which in its business judgement are relevant at the time, including past and projected earnings, cash flows, economic, business and securities market conditions and anticipated developments concerning Tenneco's business and operations. For additional information concerning the payment of dividends by Tenneco Inc., see "Years 1993 and 1992 --Holding Company Structure and Ability to Pay Dividends" in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." Tenneco's cash flow and the consequent ability of Tenneco Inc. to pay any dividends on the Common Stock is substantially dependent upon Tenneco's earnings and cash flow available after its debt service and the availability of such earnings to Tenneco Inc. by way of dividends, distributions, loans and other advances. The instruments setting forth the rights of the holders of the Preferred Stock and Junior Preferred Stock contain provisions restricting Tenneco Inc.'s right to pay dividends and make other distributions on the Common Stock. Certain of Tenneco Inc.'s subsidiaries have provisions under financing arrangements and an investment agreement which limit the amount of dividends that may be paid by them to Tenneco Inc. At December 31, 1993, such amount was calculated to be $2.6 billion. Tenneco Inc.'s loan agreements do not impose any restrictions on the right to pay dividends, although certain of such agreements impose restrictions on borrowings unless specified levels of consolidated tangible net worth are met at the time. Under applicable corporate law, dividends may be paid by Tenneco Inc. out of "surplus" (as defined under the law) or, if there is not a surplus, out of net profits for the year in which the dividends are declared or the preceding fiscal year. At December 31, 1993, Tenneco Inc. had surplus of at least $1.7 billion for the payment of dividends, and Tenneco Inc. will also be able to pay dividends out of any net profits for the current and prior fiscal year. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. TENNECO INC. AND CONSOLIDATED SUBSIDIARIES SELECTED CONSOLIDATED FINANCIAL INFORMATION (Table continued on next page) (Continued from previous page) - -------- Notes: (a) Includes the disposition of a number of assets and investments including Newport News' Sperry Marine business; several PCA operations; two wholly-owned pipeline companies, Viking Gas Transmission Company and Dean Pipeline Company; and facilities and land of two foreign Farm and construction equipment operations for a gain of $118 million. (b) For Natural gas pipelines, includes a gain of $265 million related to the sale of its natural gas liquids business including its interest in an MTBE plant then under construction. Also, Packaging recorded a gain of $42 million related to the sale of three short-line railroads. (c) Includes restructuring charge of $920 million related to Farm and construction equipment in 1992. Losses in 1992 for the Farm and construction equipment segment before the restructuring charge were $260 million. Of the total $552 million restructuring charge recorded in 1991, $461 million related to Farm and construction equipment, $79 million related to Chemicals and $12 million related to Other. Losses in 1991 for the Farm and construction equipment segment before the restructuring charge were $618 million. (d) Includes after-tax restructuring charge of $843 million, or $5.85 per average common share, and $480 million, or $3.91 per average common share, for 1992 and 1991, respectively. (e) Tenneco elected early adoption of Statement of Financial Accounting Standards ("FAS") No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, for its domestic operations and FAS No. 109, Accounting for Income Taxes. Both standards were adopted effective January 1, 1992, using the cumulative catch-up method. Under FAS No. 106, Tenneco is required to accrue the estimated costs of retiree benefits other than pensions (primarily health care benefits and life insurance) during the employees' active service period. Prior to 1992, Tenneco expensed the cost of these benefits as medical and insurance claims were paid. Tenneco expects to adopt the new standard for its non-U.S. plans in the first quarter of 1995 and estimates that the adoption will reduce pre-tax income by approximately $20 million. The adoption of FAS No. 109 changed Tenneco's method of accounting for income taxes from the deferred method to the liability method. The 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. The 1992 Statements of Income (Loss) include an after-tax charge of $699 million or $4.86 per average common share for the cumulative effect of the accounting changes consisting of $414 million or $2.88 per share for FAS No. 106 and $285 million or $1.98 per share for FAS No. 109. (f) Earnings per share of common stock are based on the average number of shares of common stock and Series A preferred stock (each share of Series A preferred stock represents two shares of common stock) outstanding during each period. Because Series A preferred stock outstanding is included in average common shares outstanding for purposes of computing earnings per share, the preferred dividends paid are not deducted from net income (loss) to determine net income (loss) to common stock. In 1992, 12,000,000 shares of common stock were issued to the Stock Employee Compensation Trust ("SECT"). Shares of common stock issued to a related trust are not considered to be outstanding in the computation of average shares of common stock until the shares are utilized to fund the obligations for which the trust was established. At December 31, 1993, the SECT had utilized 2,479,425 of these shares. Other convertible securities and common stock equivalents outstanding during each of the five years ended December 31, 1993, 1992, 1991, 1990 and 1989 were not materially dilutive. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. YEARS 1993 AND 1992 RESTRUCTURING PROGRAMS-CASE OPERATIONS 1991 Restructuring Program During 1991, Tenneco Inc. (the "Company") identified restructuring measures which resulted in a pre-tax charge of $461 million taken at its farm and construction equipment segment ("Case"). The 1991 restructuring charge was in part attributable to aggressive measures taken in September 1991 to respond to depressed market conditions facing the farm and construction equipment business and to improve Case's performance. The estimated costs for the program included $256 million attributable to the elimination of 7,400 jobs; $93 million for plant closings; and $112 million for the rationalization or discontinuance of farm and construction equipment product lines (including costs associated with dealer discounts, other incentive programs and inventory writedowns to net realizable value). As of December 31, 1993, $63 million of the 1991 restructuring charge remained on the balance sheet as a current liability. Management believes that this balance is adequate to complete the remaining actions required under this plan. While the measures taken at Case since September 1991 under this program resulted in significant improvements in Case's performance, the worldwide farm and construction equipment market continued to deteriorate during 1992, and Tenneco Management and the Board of Directors determined that major structural and strategic changes were necessary in order to strengthen Case's competitive position in the global marketplace and to enhance Case's return to a sustained level of profitability. 1992 Restructuring Program Consequently, on March 21, 1993, the Board of Directors of Tenneco Inc. adopted a comprehensive restructuring program for Case (the "Case Restructuring Program") in order to strengthen Case's competitive position in the global marketplace and to enhance Case's return to a sustained level of profitability. Adoption of the Case Restructuring Program resulted in a pre-tax charge of $920 million ($843 million after tax or $5.85 per average common share), all of which was reflected in the 1992 loss from continuing operations before interest expense and income taxes. This restructuring program is expected to be substantially completed during 1996. The program addresses four fundamental issues which were adversely impacting Case's operating results and the industry at large, which has been characterized by unrelenting global competition and flat to declining markets for agricultural and construction equipment: . Excess Manufacturing Capacity. Continued weakness in markets, from previous historical levels, particularly for worldwide agricultural equipment has led to substantial under utilization of Case's component manufacturing and final assembly capacity. . Overly Integrated Component Production. Case adopted a program to put in place new, more cost effective arrangements for selected components that will reduce investment requirements, provide greater access to industry technology developments and result in lower per unit costs. . Unprofitable, Highly-Proliferated Products. Case believes there are significant advantages to focusing its financial, technical, manufacturing and marketing resources on those products where it has a current or potential leadership position and which collectively provide a solid and sustainable core business. . Marketing and Distribution Inefficiencies. Case's distribution system includes both independent dealers and company-owned stores. Case believes that, in many cases, company-owned stores are not as effective in marketing its products as its independent dealers. Improvements to the parts distribution network are expected to improve efficiency and customer responsiveness. The pre-tax charge included estimates of $441 million attributable to rationalizing production of selected components; $161 million for consolidating and resizing production capacity; $126 million for discontinuing or replacing unprofitable products; and $192 million for privatization of Case-owned retail stores, restructuring the parts distribution network and other associated costs of restructuring. In 1993, the following restructuring actions were implemented and are at various stages of completion: . The Schofield, Wisconsin manufacturing facility, which employed approximately 425 employees, was closed and production was transferred to the Case facilities in Fargo, North Dakota and Burlington, Iowa. . Case closed the Southhaven, Mississippi parts depot which employed approximately 70 employees. Existing parts depots in Atlanta, Georgia and Dallas, Texas will serve customers previously served by the Southhaven facility. During 1992 and 1993, Case outsourced the operations of five regional depots located in North America where Case employed approximately 135 people. All of this was done to further improve the efficiency of the parts distribution network. . Assembly of combine and cotton picker transmissions was relocated from Doncaster, England to Racine, Wisconsin. Final assembly of combines and cotton pickers remains at Case's East Moline, Illinois plant. . The Meltham, England facility, which manufactured gears and other selected components, primarily for discontinued products, was sold. Approximately 90 employees worked at Meltham. . In February 1994, Case sold its foundry in Pryor, Oklahoma to Grede Foundries Inc. Grede Foundries Inc. will continue to supply Case with castings currently produced at the foundry and will retain the approximately 350 employees at this facility. . The sale of Case-owned stores continued. At the end of 1993, Case had approximately 150 company-owned stores as compared to approximately 250 in September 1991. . The Vitry, France facility, which manufactured gear and shaft components, was closed and production was transferred to Case's facility in St. Dizier, France. These components are used primarily in transmissions manufactured at St. Dizier. . Plant rationalizations, designed to streamline operations, improve production flows, and concentrate on core production, progressed at Case's Hamilton, Ontario plant which manufactures planting/seeding and tillage equipment, as well as at Case's East Moline, Illinois plant. . Case announced its intent to cease engine and component production and close the tractor manufacturing facility in Neuss, Germany following termination of production of the current Maxxum tractor models, which is expected to occur by the second quarter of 1996. Case also announced its intent to close the foundry located in Neuss, Germany during the fourth quarter of 1994. The terms and conditions related to the closing of the Neuss facilities are the subject of a compromise of interest and social plan between Case and the Neuss Works Council which was executed during the first quarter of 1994. As of December 31, 1993, Case employed approximately 1,100 people at the Neuss facilities. . Case announced that production of a number of non-core products would be discontinued. In 1993, Case ceased production of the W11B and W14 wheel loaders, the 1085C rubber tire excavator, the "A" family agricultural tractors, as well as a number of agricultural implements. In addition, during 1993, Case ceased supplying its dealers with other non-core products, including the 450C crawler dozer and the 455C crawler loader and the under 40 horsepower series tractors, all of which were manufactured for Case by a third party. As of December 31, 1993, approximately $130 million of the actions necessary to complete the program had been implemented leaving $790 million to be implemented over the next three years. Of the remaining actions to be implemented, $314 million pertain to rationalizing production of selected components; $152 million pertain to consolidating and resizing production capacity; $125 million pertain to discontinuing or replacing unprofitable products; and $199 million pertain to privatization of Case-owned retail stores, restructuring the parts distribution network and other associated costs of restructuring. Total employment was reduced by approximately eight percent during 1993 with an estimated 1,400 jobs eliminated. Case's worldwide production volumes for farm and construction equipment during 1993 were three percent lower than in 1992. Inventories at Case and its dealers decreased by $400 million during 1993 and by $1.9 billion since December 1990. This was largely accomplished by selling $1.9 billion less wholegoods and parts to its dealers than those dealers sold to their customers. Case intends to continue reducing inventories during 1994. The Case Restructuring Program is highly complex, and effectively implementing it continues to be a major undertaking. While Case is committed to successfully completing the program, there can be no assurance that the objectives of the program will be achieved. The specific restructuring measures and associated estimated costs are based on management's best business judgment under prevailing circumstances and on assumptions which may be revised over time and as circumstances change. Case continues to believe that the successful completion of the restructuring program will enhance its operating income and pre-tax cash flow over 1992 levels by approximately $200 million annually by 1996. REVENUES Revenues for 1993 were $13.26 billion, up slightly from $13.14 billion in 1992. An increase in natural gas pipeline revenues, up $679 million or 31 percent, due to higher gas volumes, was offset by decreased revenues in all other divisions except automotive parts where revenues were slightly ahead of 1992. Shipbuilding reported a $404 million or 18 percent decrease in revenues due to a declining backlog as a result of reductions in defense spending. Revenues for farm and construction equipment were down $81 million or two percent primarily due to weak construction and agricultural equipment markets in Europe. Revenues also decreased for packaging, down $36 million or two percent due to lower commodity prices, and for chemicals, down $37 million or four percent compared to 1992. INCOME (LOSS) BEFORE INTEREST EXPENSE AND INCOME TAXES (OPERATING INCOME OR LOSS) Operating income for 1993 was $1,169 million, an improvement of $211 million over 1992, excluding gains of $118 million from 1993 disposition of assets and investments and the 1992 farm and construction equipment restructuring charge of $920 million. In 1992, Tenneco recorded a pre-tax restructuring charge of $920 million ($843 million after tax or $5.85 per average common share) for the farm and construction equipment group. Reference is made to Note 2 "Restructuring Costs" and Note 4 "Discontinued Operations, Disposition of Assets, and Extraordinary Loss" in the "Notes to Financial Statements" for additional information. Natural gas pipelines operating income for 1993 was $411 million compared with $360 million in 1992. Revenues increased to $2,862 million in 1993 from $2,183 million in 1992 due primarily to higher gas volumes as a result of the acquisition in December 1992 of EnTrade Corporation, a natural gas marketing firm. Transportation volumes increased due to a return to normal weather and increased market demand. Partially offsetting these revenue increases were higher gas purchase costs, higher depreciation relating to capital additions placed in service in late 1992 and increased pipeline maintenance expenses. The 1993 operating income includes $31 million in gains on asset sales and $34 million from a favorable rate decision that allows collection from customers of the transition obligation that was established at the time Tenneco adopted Statement of Financial Accounting Standards ("FAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." These gains were partially offset by a reserve of $10 million established for gas costs as well as by litigation settlements related to divested operations and a one-time expense related to a gas inventory charge. In 1992, the Federal Energy Regulatory Commission ("FERC") issued Order Nos. 636, 636-A and 636-B (the "FERC Restructuring Orders"). Taken together, the FERC Restructuring Orders directed a further sweeping restructuring of the interstate gas pipeline industry. The FERC Restructuring Orders required pipelines to: "unbundle" their transportation and storage services from their sales services; increase pipeline customers' flexibility to change receipt and delivery points under transportation contracts and to allow release of capacity under those contracts for use by others; and separate interstate pipeline gas sales organizations from interstate pipeline transportation and storage business units. Under the FERC Restructuring Orders, rates for pipeline transportation and storage generally remain subject to traditional cost-of- service regulation but under a rate design which is relatively insensitive to throughput and hence less sensitive to seasonal variation. Sales of natural gas by interstate pipelines occur pursuant to a blanket sales certificate under which price and other terms of sale are set by market forces. After a series of FERC orders and compliance filings, Tennessee implemented its Order No. 636 tariff commencing on September 1, 1993, restructuring its transportation, storage and sales services. Tennessee has made multiple filings to begin recovery of certain of the transition costs already paid or obligated to be paid in connection with the FERC Restructuring Orders. Given the fact that the FERC Restructuring Orders contemplate complete recovery by pipelines of qualified transition costs, Tenneco believes that Tennessee's Order No. 636 restructuring (together with the Order No. 636 restructuring of Tenneco's other interstate pipelines) will not have a material effect on Tenneco's consolidated financial position or results of operations. Reference is made to Note 9 "Federal Energy Regulatory Commission ("FERC") Regulatory Matters" in "Notes to Financial Statements" for additional information on the FERC Restructuring Orders and other rate-related matters. Farm and construction equipment reported operating income of $82 million in 1993, a $342 million improvement over the $260 million operating loss in 1992, excluding the restructuring charge of $920 million. The $342 million improvement in 1993 results (excluding the restructuring charge) came despite a $81 million drop in revenues compared to the prior year. The decreased revenues were driven by continued weakness in European markets and loss of sales from products discontinued under the Case restructuring programs. Lower worldwide sales volumes in 1993 were more than offset by savings in several critical operating areas. Improved price realization was the major profit driver as Case continued its value-based pricing strategy of lower discounts and higher pricing. The company-wide focus on operating cost reductions and manufacturing performance improvements also contributed to 1993 results. For the year 1993, Case's retail sales of major (100 horsepower or greater) agricultural equipment were up 20 percent, in line with the North American industry. Case also matched the North American construction equipment industry sales gain of 20 percent for the year. Case's sales in its European markets were down 13 percent for the year, the result of continued economic weakness in Europe. The increase in North American sales and a three percent reduction in worldwide production compared to 1992, resulted in a reduction in the inventories of Case and its dealers of $400 million in 1993. In 1994, North American unit sales of farm and construction equipment are expected to be up slightly while European markets are expected to be down compared to 1993. Automotive parts operating income for 1993 declined $15 million to $215 million compared with $230 million in 1992, a 7 percent decrease. Revenues were slightly ahead of 1992. Higher revenues were led by a 15 percent increase in North American original equipment sales relating to Walker exhaust products and Monroe ride control products due to increased new car and light truck production. North American exhaust aftermarket sales were up six percent. Offsetting the increased revenues were lower revenues in European original equipment and aftermarkets due to the continuing recession in Europe and lower sales in the North American ride control aftermarket due to sluggish demand and stiff price competition. Improvements in 1993 operating income from the higher North American original equipment market and aftermarket exhaust revenues, combined with aggressive cost management and quality program initiatives were more than offset by the effects of the weaker North American ride control aftermarket conditions, unfavorable foreign exchange rates and the recessionary conditions in Europe. Shipbuilding's 1993 operating income was $225 million compared with $249 million in 1992. Revenues decreased $404 million or 18 percent in 1993 due to a declining backlog resulting from lower defense spending. The 1993 operating income includes a $15 million gain on the sale of the Sperry Marine business and a $12 million benefit from the recognition of the recovery of a portion of the postretirement benefit costs reserve that was established when FAS No. 106 was adopted in 1992. Excluding the gain on the sale of the Sperry Marine business and the recovery of a portion of the postretirement benefit costs, operating income decreased from 1992 due to the declining backlog. Partially offsetting the lower operating income were the effects of several management initiatives undertaken in 1993 and 1992, which included headcount reductions and organization changes that improved operating efficiencies. The backlog at the shipyard at the end of 1993 was $3.7 billion compared with $4.7 billion at the end of 1992. The 1993 backlog included five Los Angeles class submarines, two Nimitz class aircraft carriers (John C. Stennis and United States), the overhaul and refueling contract for the aircraft carrier Enterprise and the Sealift conversion contract involving two ships. In the absence of new orders, this existing backlog will decline as two submarines per year, on average, are delivered through 1996, and the aircraft carriers are delivered in 1995 and 1998. The Enterprise work will be completed in 1994 and the Sealift conversion ships will be delivered in 1995. Newport News is aggressively pursuing new business opportunities and attempting to expand its business base in light of the declining Naval backlog, but there is no assurance that it will be able to do so to a material extent. While the U.S. Navy will continue to be the leading customer of the shipyard, the mix of jobs between Navy and commercial work is expected to change. The shipyard is actively pursuing design and construction work on the next carrier contract (CVN 76), major overhaul and refueling work and commercial work. Packaging ended the year with $139 million in operating income, down from $221 million in 1992. Revenues decreased only slightly by $36 million or two percent, as higher containerboard volumes were more than offset by lower linerboard prices which fell from an average price of approximately $345 per ton in 1992 to an average price of $295 per ton in 1993. Earnings were depressed by weak linerboard prices in the commodity business where profitability fell from $93 million in 1992 to $19 million in 1993. The specialty businesses ended the year at $120 million in operating income, which included gains from asset sales partially offset by asset realignment costs of $29 million, versus operating income of $128 million for 1992, in spite of extreme pricing pressures in molded fibre and paperboard markets. Offsetting some of the pricing and market conditions were operating cost reductions and favorable purchasing initiatives. Operating income for 1993 for the chemicals segment improved to $78 million from $72 million in 1992. This increase in earnings was due to higher sales volumes and margin improvements from cost reduction and productivity programs partially offset by an unfavorable foreign exchange impact. In local currencies, sales rose by 9 percent, but were more than offset by the movement in European currencies against the U.S. dollar. With the exception of the surfactants business group, whose products go into more economically sensitive merchandise, all segments achieved higher year-over-year operating income. Operating income from the phosphates business group rose 36 percent, and operating income from the specialty chemicals business group increased 63 percent over 1992 levels as both segments were successful in moving downstream into higher-margin products. Chemicals is emphasizing the development of high margin specialty products, such as biocides and flame retardants, where growth prospects are good. Tenneco's other operations reported operating income of $19 million for 1993, compared to a loss of $32 million in 1992. The improvement was primarily attributable to the gain of $39 million from the contribution of Tenneco's investment in Cummins Engine Company of 3.2 million shares of common stock to the Case Corporation Pension Plan for Hourly-Paid Employees ("Case Plan") in December 1993. INTEREST EXPENSE Interest incurred declined $72 million, from $536 million in 1992 to $464 million in 1993, due primarily to lower debt levels from the retirement of $1.0 billion in debt with the proceeds of the April 1993 equity offering. Interest capitalized decreased to $4 million in 1993 from $9 million in 1992 due to lower levels of major capital projects. Finance charges (interest expense related to finance subsidiaries classified as an operating expense) were $254 million in 1993 versus $364 million in 1992. The lower expense was due to lower average debt levels primarily due to the retirement of $1.0 billion of Tenneco's finance subsidiaries' debt with proceeds from the issuance of lower-cost asset backed securities as well as lower interest rates. INCOME TAXES Income tax expense for 1993 was $258 million versus $76 million reported for 1992. The increased tax expense in 1993 was attributable to higher pre-tax income and the increase in the U.S. corporate tax rate from 34 percent to 35 percent. Partially offsetting these increases was a $48 million tax benefit from a tax realignment of Tenneco's operations in Germany and a lower level of unbenefitted foreign losses. Reference is made to Note 10 "Income Taxes" in the "Notes to Financial Statements" for additional information. DISCONTINUED OPERATIONS AND EXTRAORDINARY LOSS Extraordinary loss for 1993 of $25 million, net of tax benefit of $13 million, or 15 cents per average common share, and for 1992 of $12 million, net of tax benefit of $6 million, or 8 cents per average common share, were attributable to redemption premiums related to the prepayment of higher interest-bearing long-term debt. Income from discontinued operations in 1992 of $71 million, net of income tax expense of $46 million, or 50 cents per average common share, was attributable to the sales of Tenneco's minerals and pulp chemicals businesses. The sales of these businesses resulted in a $96 million gain, net of $45 million income tax expense, from the sale of the minerals business, and a $25 million loss from the sale of the pulp chemicals business (no tax effect). Net income for 1992 from minerals operations was $3 million, net of income tax expense of $3 million, and net loss from pulp chemicals operations was $3 million, net of a tax benefit of $2 million. Reference is made to Note 4 "Discontinued Operations, Disposition of Assets, and Extraordinary Loss" in the "Notes to Financial Statements" for additional information regarding the preceding items. EARNINGS (LOSS) PER AVERAGE COMMON SHARE Income from continuing operations for 1993 was $451 million, or $2.59 per average common share after preferred dividends, compared with a loss from continuing operations of $683 million, or $4.85 per average common share after preferred dividends in 1992. Net income to common stock was $412 million, or $2.44 per average common share in 1993 versus a net loss to common stock of $1.34 billion, or $9.29 per average common share in the prior year. Included in the 1993 net income (loss) to common stock was the extraordinary loss of the $25 million or 15 cents per average common share. Included in 1992 net income (loss) to common stock was income from discontinued operations of $71 million, or 50 cents per average common share, the extraordinary loss of $12 million or 8 cents per average common share and the charge of $699 million, or $4.86 per average common share relating to the cumulative effect of changes in accounting principles. The 1992 loss from continuing operations of $4.85 per average common share included an after-tax restructuring charge of $5.85 per average common share. Preferred stock dividends were $14 million for 1993 and $16 million for 1992. Average shares outstanding used for the calculation of earnings per average common share for 1993 were 168.8 million compared to 144.1 million in 1992, excluding the stock employee compensation trust ("SECT") shares described below. The increase was primarily attributable to the 23.5 million shares issued in the April 1993 underwritten public offering and the issuance of treasury shares and SECT shares to employee benefit plans. In November 1992, Tenneco established a SECT to fund a portion of its obligations arising from its various employee compensation and benefit plans. Tenneco issued 12 million shares of treasury stock to the SECT in exchange for a promissory note of $432 million. The SECT has a five-year life during which it will utilize the common stock to satisfy those obligations. The shares of common stock issued to the SECT are not considered to be outstanding in the computation of average shares of common stock until the shares of common stock are utilized to fund the obligations for which the trust was established. In 1993, the SECT issued 2.5 million shares of common stock with a market value of $119 million to fund employee compensation and benefit plans. Reference is made to Note 11 "Common Stock" and to Note 12 "Preferred Stock" in the "Notes to Financial Statements" for additional information. HOLDING COMPANY STRUCTURE AND ABILITY TO PAY DIVIDENDS Tenneco's cash flow and the consequent ability of the Company to pay any dividends is substantially dependent upon Tenneco's earnings and cash flow available after its debt service and the availability of such earnings to the Company by way of dividends, distributions, loans and other advances. Certain of the Company's subsidiaries have provisions under financing arrangements and an investment agreement which limit the amount of their retained earnings available for dividends to the Company. At December 31, 1993, such amount was calculated to be $2.6 billion. The Company's loan agreements do not impose any restrictions on the right to pay dividends, although certain of such agreements impose restrictions on borrowings unless specified levels of consolidated tangible net worth are met at the time. Under applicable corporate law, dividends may be paid by the Company out of "surplus" (as defined under the law) or, if there is not a surplus, out of net profits for the year in which the dividends are declared or the preceding fiscal year. At December 31, 1993, the Company has surplus of at least $1.7 billion for the payment of dividends, and the Company will also be able to pay dividends out of any net profits for the current and prior fiscal year. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities was $1,615 million for the year 1993 compared to $929 million for 1992, an increase of $686 million. Excluding discontinued operations, there was an improvement of $644 million. This improvement was due primarily to higher income from continuing operations and the sale of approximately $1.0 billion of Case retail receivables to limited purpose business trusts, which issued asset backed securities to the public in 1993. Partially offsetting these improvements were increased refunds to customers in final settlement of the collection of take-or-pay costs. This was primarily a timing issue since these funds were recovered in 1992 and disbursed in 1993. The variance of the information reflected in the "Other" category is due primarily to the reserves established in 1992 for restructuring measures. The working capital decrease of $439 million for 1993 was due primarily to the sale of receivables to limited purpose business trusts, which issued asset backed securities to the public. Partially offsetting the decrease is the reduction in taxes payable due to higher state tax payments associated with shipbuilding contract completions and tax deductions associated with the early funding of the Case Plan through the contribution of Tenneco's investment in Cummins Engine Company to the pension plan. Net cash used by investing activities in 1993 was $338 million compared to $105 million of cash provided in 1992. Net proceeds (expenditures) from the sale of discontinued operations were $663 million lower in 1993, primarily due to the sale of Tenneco's minerals and pulp chemicals operations in 1992. This was partially offset by proceeds from the sale of businesses in 1993 of $266 million, primarily the sales of Dean Pipeline Company and Viking Gas Transmission Company, shipbuilding's Sperry Marine business, several packaging operations, and facilities and land of two foreign Case operations. Reference is made to Note 4 "Discontinued Operations, Disposition of Assets, and Extraordinary Loss" in the "Notes to Financial Statements" for additional information on cash provided by these investing activities. Expenditures for plant, property and equipment from continuing operations for 1993 were $587 million compared to $569 million for 1992. Increased expenditures for automotive parts ($30 million), farm and construction equipment ($41 million) and packaging ($27 million) were basically offset by declines for natural gas pipelines ($81 million). See Note 15 "Segment and Geographic Area Information" in the "Notes to Financial Statements" for a complete breakdown of capital expenditures by operating segment. Capitalization totaled $8.99 billion at December 31, 1993, a decrease of $792 million from December 31, 1992. The resulting ratio of total debt to capitalization dropped from 82.8 percent to 67.6 percent. The total debt to capitalization ratio was 64.0 percent including the market value of the SECT shares compared to 78.8 percent at December 1992. The major changes in capitalization were: total debt down $2.02 billion, stockholders' equity up $1.27 billion and preferred stock down $28 million. The increase in stockholders' equity was primarily due to the issuance of 23.5 million shares of common stock in the April 1993 underwritten public offering, the proceeds of which were used to retire debt and redeem variable rate preferred stock. The remaining decrease in debt resulted from the issuance of asset backed securities. Following issuance of the final order by the FERC approving Tennessee's partial settlement of its current rate case, Tennessee will be required to make refunds to its customers related to rates collected since February 1, 1992. Tennessee estimates these refunds will total approximately $400 million and be payable in installments over the second and third quarters of 1994. To minimize the cash flow requirements associated with the implementation of FERC Restructuring Orders, Tenneco plans to utilize various financing arrangements to manage the timing between recovery from pipeline customers and payments for transition costs. The actual cash flows will depend upon negotiations between Tennessee, its customers and suppliers, and developments in the restructuring proceedings with the FERC as the FERC Restructuring Orders undergo clarification and judicial review. Until these issues are resolved, Tennessee cannot finally determine the ultimate amount of one-time realignment costs or other related annual costs it will incur, nor the amounts which will be recovered from customers. Tennessee believes that one-time realignment costs will not exceed $700 million; at December 31, 1993, Tennessee recorded and deferred approximately $120 million of such one-time costs which are recoverable from its customers. Tennessee believes that other related annual costs will not exceed $100 million in 1994, decreasing thereafter over the length of the contracts involved. Changes in the structure of the natural gas industry in an Order No. 636 environment are anticipated to reduce working capital requirements over the next several years. In December 1992, Tenneco Inc. entered into a three-year $1.4 billion credit agreement with banks to replace a $1.8 billion credit agreement which would otherwise have terminated in February 1993. With this credit agreement, Tenneco Inc. and its consolidated subsidiaries had, at December 31, 1993, committed credit agreements with various banks providing for $3.1 billion of borrowing capacity, of which $654 million expire in 1994. As of December 31, 1993, $63 million of borrowings were outstanding under these facilities and the remaining $3.0 billion were available for borrowing. Of the remainder available, $525 million was reserved to cover outstanding commercial paper and similar short- term obligations. The availability of borrowings under Tenneco's credit agreements and facilities is subject to its ability at the time to meet certain conditions specified therein which Tenneco believes it currently meets. These conditions include, among others, compliance with the financial covenants and ratios required by such agreements, the absence of default under such agreements and the continued accuracy of the representations and warranties contained in such agreements (including the absence of any material adverse changes since the specified dates). Based upon Tenneco's estimates of anticipated needs and circumstances of business operations, together with anticipated market conditions, Tenneco expects adequate sources of funds to be available to finance its future operations through internally generated funds, the sale of assets, the use of credit facilities and the issuance of asset backed securities and other long- term securities. Over the past several years, Tenneco has relied on externally generated funds to meet substantial portions of its cash requirements. ENVIRONMENTAL MATTERS In 1988, Tennessee initiated an internal project to identify and deal with the presence of polychlorinated biphenyls ("PCBs") at compressor stations operated by both its interstate and intrastate natural gas pipeline systems. Tenneco recorded a reserve in September 1991, for estimated future environmental expense of $260 million. As of December 31, 1993, $64 million has been charged against the environmental reserve. The remaining reserve of $196 million is reflected on the balance sheet under "Payables--Trade" ($41 million) and "Deferred Credits and Other Liabilities" ($155 million). Tenneco believes that a substantial portion of these costs, which will be expended over the next five to ten years, will be recovered through rates charged to customers of its natural gas pipelines. The estimated costs expected to be recovered, amounting to $230 million, were recorded in 1991 as an asset ($30 million in "Current assets" and $200 million in "Investments and other assets"). The estimated unrecoverable portion, amounting to $30 million, was charged against income and reflected in "Operating expenses" in 1991. Tennessee is currently recovering environmental expenses annually in its rates. A significant portion of these expenses remains subject to review and refund in Tennessee's pending rate case. As of December 31, 1993, the asset balance is $167 million ($37 million in "Current assets" and $130 million in "Investments and other assets"). On January 13, 1992, the United States Environmental Protection Agency ("EPA") filed an administrative complaint alleging that Tennessee violated the Toxic Substances Control Act between 1980 and 1990 by engaging in the unauthorized use and disposal of materials containing PCBs. The complaint addresses PCB-related activity at 26 compressor stations in five states (Alabama, Mississippi, Kentucky, Tennessee and Ohio). A civil penalty of $15,678,000 was sought. Tennessee and the EPA have reached an agreement in principle under which Tennessee will make a specified payment in full settlement of civil penalties under the Toxic Substances Control Act arising from Tennessee's prior use of PCBs at compressor stations throughout its system. This agreement covers 42 Tennessee compressor stations in nine states and five EPA regions. The agreement in principle is contingent upon the completion of Tennessee's negotiations with EPA on the remediation of its compressor stations in Regions IV, V and VI. With respect to the nine stations in Regions II and III, EPA has advised Tennessee that it is deferring to the Pennsylvania and New York environmental agencies to specify the remediation requirements applicable to Tennessee. Tennessee anticipates that it will soon reach an agreement with the Pennsylvania Department of Environmental Resources ("PaDER") and will enter into a consent order on remediation at the Pennsylvania stations (under which Tennessee also agrees to pay a civil penalty and to make a contribution for environmental projects); meanwhile, Tennessee will continue its negotiations with the New York Department of Environmental Conservation on remediation at the New York stations. The agreements with the EPA and PaDER are expected to be entered into in the first quarter of 1994. Tenneco believes that the ultimate resolution of this matter will not have a material adverse effect on the financial condition or results of operations of Tenneco Inc. and its consolidated subsidiaries. See Note 16 to "Notes to Financial Statements" for additional information. In Commonwealth of Kentucky, Natural Resources and Environmental Protection Cabinet v. Tennessee Gas Pipeline Co. (Franklin County Circuit Court, Docket No. 88-C1-1531, November 16, 1988), the Kentucky environmental agency alleges that Tennessee discharged pollutants into the waters of the state without a permit and seeks an injunction against future discharges and a civil penalty. Counsel for Tenneco are unable to express an opinion as to its ultimate outcome. A subsidiary of Tennessee owns a 13.2% general partnership interest in Iroquois Gas Transmission System, L.P. ("Iroquois"), which owns an interstate natural gas pipeline from the Canadian border through the states of New York and Connecticut to Long Island. In early 1992, Iroquois was informed by U.S. Attorney's Offices for the Northern, Southern, and Eastern Districts of New York that a civil investigation had been initiated to determine whether Iroquois committed civil environmental violations during construction of the pipeline. In February 1992, 26 alleged violations were identified to Iroquois in writing. In response, Iroquois denied that such violations had occurred and asserted that all concerns raised by governmental authorities during construction had been fully addressed. Iroquois subsequently was informed that the alleged violations included certain field reports prepared by a Federal/State Inter-Agency Task Force which surveyed the right-of-way in connection with the right-of-way restoration program. Iroquois responded to the appropriate U.S. Attorneys' Offices that none of the matters referenced in field reports issued to date represent violations of any law or governmental authorization. As of March 4, 1994, no formal civil demand in connection with this civil investigation has been made on Iroquois by the federal government. On December 3, 1993, Iroquois received notification from the Enforcement Staff of the Federal Energy Regulatory Commission's Office of the General Counsel ("Enforcement") that Enforcement has commenced a preliminary, non- public investigation concerning Iroquois' construction of certain of its pipeline facilities. That office has requested certain information regarding such construction. In addition, on December 27, 1993, Iroquois received a similar request for information from the Army Corps of Engineers requesting certain information regarding permit compliance in connection with certain aspects of the pipeline's construction. Iroquois is evaluating and responding to these requests for information. No proceedings have been commenced against Iroquois in connection with these agency inquiries. A criminal investigation has been initiated against Iroquois and its environmental consultant by the U.S. Attorneys' Office for the Northern District of New York in conjunction with the U.S. Environmental Protection Agency ("EPA") and the Federal Bureau of Investigation ("FBI"). According to a press release issued by the FBI in June 1992, areas under investigation include possible environmental violations, wire fraud, mail fraud and providing false information or concealment of information from Federal agencies in conjunction with construction of the pipeline. To date, no criminal charges have been filed and the Assistant U.S. Attorney in charge of the investigation has stated that he is not yet ready to meet with Iroquois' attorneys to discuss the specifics of the matter. As a general partner, Tennessee's subsidiary may be jointly and severally liable with the other partners for the liabilities of Iroquois. Tennessee has a contract to provide gas dispatching as well as post-construction field operation and maintenance services for the operator of Iroquois, but Tennessee is not the operator of Iroquois and is not an affiliate of the operator. Moreover, the foregoing proceedings and investigations have not affected pipeline operations. Based upon information available to Tenneco at March 4, 1994 concerning the above investigations and proceedings involving Iroquois, Tenneco believes that neither Tennessee nor any of its subsidiaries is the target of the investigation described above and that the ultimate resolution of these matters will not have a material adverse effect on the financial condition or results of operations of Tenneco Inc. and its consolidated subsidiaries. On August 2, 1993, the Department of Justice filed suit against Packaging Corporation of America ("PCA") in the Federal District Court for the Northern District of Indiana, alleging that wastewater from PCA's molded fibre products plant in Griffith, Indiana interfered with or damaged the Town of Griffith's municipal sewage pumping station on two occasions in 1991 and 1993, resulting in discharges by the Town of untreated wastewater into a river. PCA has denied responsibility for the Town's wastewater discharges. The violations alleged by the Department of Justice could result in the assessment of statutory penalties in excess of $100,000; however, the Company does not believe that its ultimate resolution will have a material adverse effect upon its consolidated financial condition or results of operations. Pryor Foundry, Inc. ("Pryor") has been advised that the EPA may seek to impose a fine upon Pryor in connection with discharges of water by its facility in Pryor, Oklahoma, without the necessary permit. The violations alleged by the EPA could result in the assessment of statutory penalties in excess of $100,000; however, the Company does not believe that its ultimate resolution will have a material adverse effect upon its consolidated financial condition or results of operations. At December 31, 1993, Tenneco has been designated as a potentially responsible party in 70 "Superfund" sites. With respect to its pro rata share of the remediation costs of certain sites, Tenneco is fully indemnified by third parties. With respect to certain other sites, Tenneco has sought to resolve its liability through payments to the other potentially responsible parties. For the remaining sites, Tenneco has estimated its share of the remediation costs to be between $12 million and $72 million or 0.4% to 2.3% of the total remediation costs for those sites and has provided reserves that it believes are adequate for such costs. Because the clean-up costs are estimates and are subject to revision as more information becomes available about the extent of remediation required, Tenneco's estimate of its share of remediation costs could change. Moreover, liability under the Comprehensive Environmental Response, Compensation and Liability Act is joint and several, meaning that Tenneco could be required to pay in excess of its pro rata share of remediation costs. Tenneco's understanding of the financial strength of other potentially responsible parties has been considered, where appropriate, in Tenneco's determination of its estimated liability. Tenneco believes that the costs associated with its current status as a potentially responsible party in the Superfund sites described above will have no material effect on the financial position or results of operations of Tenneco Inc. and its consolidated subsidiaries. OTHER MATTERS In 1992, the FASB issued FAS No. 112 which requires employers to account for postemployment benefits for former or inactive employees after employment but before retirement on the accrual basis rather than the "pay-as-you-go" basis as at present, for fiscal years beginning after December 15, 1993. Tenneco will adopt the new standard as a one-time adjustment in the first quarter of 1994. Implementation of this new accounting method will result in a one-time charge of approximately $39 million, net of income taxes. On February 11, 1994, TERC, a subsidiary of the Company, announced the sale of original issue stock to Ruhrgas AG, through a transaction, certain terms of which are to be finalized by February 1995, resulting in dilution of the Company's ownership in that subsidiary from 100% to 80%. At the same time, Tenneco Gas entered into an agreement with the buyer to pursue joint opportunities in the European gas industry. YEARS 1992 AND 1991 REVENUES Revenues for 1992 were $13.14 billion, down slightly from $13.42 billion in 1991. A decline in farm and construction equipment revenues, down $620 million due to weak construction and agricultural equipment markets, was substantially offset by increased revenues in all other divisions except natural gas pipelines where revenues were even with 1991. Packaging reported a $144 million increase in revenues driven by higher volumes in all segments. Revenues for automotive parts were up $107 million mainly due to increased sales in original equipment markets in North America. Revenues also increased for shipbuilding, up $49 million, and for chemicals, up $35 million compared to 1991. INCOME (LOSS) BEFORE INTEREST EXPENSE AND INCOME TAXES (OPERATING INCOME OR LOSS) Operating loss for 1992, which included the farm and construction equipment restructuring charges of $920 million, was $80 million, an improvement of $67 million over 1991. Excluding the restructuring charges in both periods and 1991 assets sales, operating income increased $742 million from 1991 to 1992. In the 1992 results, Tenneco recorded a comprehensive pre-tax restructuring charge of $920 million ($843 million after taxes or $5.85 per average common share) for the farm and construction equipment group. Included in the 1991 results was a $552 million pre-tax restructuring charge ($480 million after taxes or $3.91 per average common share). Also in 1991, assets were sold that resulted in a pre-tax gain of $307 million. Reference is made to Note 2 "Restructuring Costs" and Note 4 "Discontinued Operations, Disposition of Assets, and Extraordinary Loss" in the "Notes to Financial Statements" for additional information regarding these items. Natural gas pipelines' operating income for 1992 was $360 million compared with $296 million in 1991 (excluding a $265 million pre-tax gain on the fourth quarter 1991 sale of its natural gas liquids business). The 1991 operating income included a $30 million charge taken in the third quarter to cover future environmental costs estimated to be unrecoverable through rates, along with earnings of $19 million related to the natural gas liquids business that was sold. The improved earnings resulted from increased volumes (including those attributable to Kern River), higher rates on the pipeline system of Tennessee and effective cost control programs. Farm and construction equipment reported a 1992 operating loss of $260 million compared with a $618 million loss in 1991 excluding restructuring charges of $920 million and $461 million for 1992 and 1991, respectively. The $358 million improvement in 1992 results (excluding restructuring costs) came despite a $620 million drop in revenues compared to the prior year. The decreased revenues were driven by lower volumes caused by the declining market conditions. The improvement in 1992 results was achieved because of the implementation of a new pricing strategy that resulted in increased operating margins ($250 million) and lower operating costs. Offsetting these improvements were lower earnings caused by the decreased sales volumes and severance costs for health care for early retirees recorded as a result of the adoption of FAS No. 106. Operating income for 1992 for automotive parts reached a record $230 million compared with $175 million in 1991. Both Walker exhaust and Monroe ride control operations achieved record results. Higher revenues, combined with aggressive cost management and an intense focus on cost of quality improvement programs, contributed to the higher 1992 earnings. Shipbuilding's 1992 operating income was $249 million compared with $225 million in 1991. The 11 percent increase in earnings came from improved performance in both the submarine construction and the overhaul businesses. Revenues increased slightly compared to the prior year. The increased earnings reflect the results of several management initiatives undertaken in 1992 which included headcount reductions and organizational changes that improved operating efficiencies, along with a strong focus on operating cost reductions including cost of quality improvement programs. The backlog at the shipyard at the end of 1992 was $4.7 billion compared with $6.6 billion at the end of 1991. Packaging posted operating income of $221 million in 1992, an increase of $124 million over the prior year (excluding a $42 million pre-tax gain from the 1991 sale of three short-line railroads). Revenues increased $144 million or 7 percent, driven by higher volumes in all businesses, without the benefit of linerboard price increases in 1992. All packaging businesses contributed to the record earnings. The improved containerboard earnings were driven by cost reduction programs and increased productivity in primary mills and container plants. Higher performance was achieved in the box business by improved productivity and increased volumes which were up 9 percent, more than twice the industry's 4.4 percent. Operating income for 1992 for chemicals improved to $72 million from $9 million in 1991 (excluding a 1991 restructuring charge of $79 million). This increase in earnings was the direct result of cost reductions and an improved mix of specialty products and productivity programs. Revenues increased $35 million from last year without the benefit of economic recovery in major markets around the world. Tenneco's other operations reported an operating loss of $32 million for 1992, down from a loss of $86 million in 1991 (excluding restructuring charges of $12 million). The improvement was primarily attributable to a 1991 provision of $50 million for settlement of litigation. INTEREST EXPENSE Interest incurred declined $38 million, from $574 million in 1991 to $536 million in 1992, due primarily to lower debt levels. Interest capitalized decreased to $9 million in 1992 from $15 million in 1991 due to lower levels of capital spending. Finance charges (interest expense related to finance subsidiaries classified as an operating expense) were $364 million in 1992 versus $429 million in 1991. The lower expense was due to lower average debt levels combined with lower interest rates. INCOME TAXES Income tax expense for 1992 was $76 million versus a tax benefit of $14 million reported for 1991. This change was driven by lower pre-tax losses in 1992 compared to 1991. The tax expense for 1992 included a benefit of $77 million related to restructuring, whereas 1991 results included a benefit of $72 million. Both 1991 and 1992 included pre-tax foreign operating losses for which no tax benefits were currently available. Such foreign operating losses may be available to offset future income in the respective foreign jurisdictions. DISCONTINUED OPERATIONS AND EXTRAORDINARY LOSS Income from discontinued operations in 1992 of $71 million, net of income tax expense of $46 million, or 50 cents per average common share, was attributable to the sales of Tenneco's minerals and pulp chemicals businesses. The sales of these businesses resulted in a $96 million gain, net of $45 million income tax expense, from the sale of the minerals business, and a $25 million loss from the sale of the pulp chemicals business (no tax effect). Net income for 1992 from minerals operations was $3 million, net of income tax expense of $3 million, and net loss from pulp chemicals operation was $3 million, net of a tax benefit of $2 million. The 1991 loss from discontinued operations of $40 million, net of a tax benefit of $26 million, or 32 cents per average common share, was attributable to a reserve established for litigation and claims primarily related to the 1988 sale of Tenneco's oil and gas businesses totaling $58 million, net of a tax benefit of $31 million, partially offset by net income from operations of the minerals and pulp chemicals businesses during 1991 of $18 million ($12 million for minerals and $6 million for pulp chemicals), net of income tax expense of $5 million ($1 million for minerals and $4 million for pulp chemicals). Extraordinary loss for 1992 of $12 million, net of tax benefit of $6 million, or 8 cents per average common share, was attributable to the redemption premium related to the prepayment of high interest-bearing long-term debt. Reference is made to Note 4 "Discontinued Operations, Disposition of Assets, and Extraordinary Loss" in the "Notes to Financial Statements" for additional information regarding these items. CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES Effective January 1, 1992, Tenneco elected early adoption of FAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, for its domestic operations and FAS No. 109, Accounting for Income Taxes. Both standards were adopted using the cumulative catch-up method. As a result of the adoption of these two statements, the 1992 Statement of Income (Loss) includes an after-tax charge of $699 million, or $4.86 per average common share, for the cumulative effect of the accounting changes consisting of $414 million, or $2.88 per average common share, for FAS No. 106, and $285 million, or $1.98 per average common share, for FAS No. 109. Reference is made to Note 1 in the "Summary of Accounting Policies--Changes in Accounting Principles" for further information. EARNINGS (LOSS) PER AVERAGE COMMON SHARE Loss from continuing operations for 1992 was $683 million, or $4.85 per average common share after preferred dividends, compared with a loss from continuing operations of $692 million, or $5.77 per average common share after preferred dividends in 1991. Net loss to common stock was $1.34 billion, or $9.29 per average common share in 1992 versus a net loss to common stock of $748 million, or $6.09 per average common share in the prior year. Included in 1992 was income from discontinued operations of $71 million, or 50 cents per average common share, the extraordinary loss of $12 million, or 8 cents per average common share, and the charge of $699 million, or $4.86 per average common share relating to the cumulative effect of changes in accounting principles. The 1992 loss from continuing operations of $4.85 per average common share included an after-tax restructuring charge of $5.85 per average common share and the 1991 loss from continuing operations of $5.77 per share included an after-tax restructuring charge of $3.91 per average common share. Loss from discontinued operations in 1991 was $40 million, or 32 cents per average common share. Preferred stock dividends were $16 million for each of the years 1992 and 1991. Average shares outstanding used for the calculation of earnings per average share for 1992 were 144.1 million compared to 122.8 million in 1991. The increase was primarily attributable to the December 1991 issuance of 17.9 million Depositary Shares representing 8.9 million shares of Series A preferred stock. The remaining increase was the result of treasury shares sold in a public offering to fund employee benefit plans in 1992 along with 1.4 million treasury shares issued in December 1991 in a public offering. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities was $929 million for the year 1992 compared to $950 million for 1991, a decrease of $21 million including discontinued operations. Excluding the discontinued operations, there was an improvement of $145 million. This improvement was due primarily to a substantial decrease in long-term notes and receivables partially offset by the tax payment associated with the completion of long-term shipbuilding contracts. The decrease in long-term notes and receivables was due to the sale of $552 million of Case retail receivables through an asset backed securitization in December 1992. The changes in working capital and other were driven by restructuring charges recorded in both 1992 and 1991. For the year 1992 working capital decreased $409 million. This was driven by lower receivables and inventories of farm and construction equipment primarily generated from lower production levels in 1992 compared to 1991. The $596 million of the adjustments included in the "Other" category includes $779 million of restructuring measures, offset by $183 million of miscellaneous non-restructuring items, none of which is significant. The restructuring charge had no impact on cash flows in 1992. The $779 million of adjustments included in the "Other" category is comprised of a $340 million reduction of net property, plant and equipment, a $39 million reduction of intangibles and other assets, a $24 million adjustment to other accounts, and the establishment of a $376 million restructuring reserve included in "Deferred Credits and Other Liabilities" on the Balance Sheet as disclosed in Note 2 to the Financial Statements. Net cash provided by investing activities was $105 million for 1992 compared to cash used of $660 million in 1991. This improvement was due primarily to the proceeds from the sale of Tenneco's minerals and pulp chemical operations, lower capital expenditures ($299 million, which includes $122 million from discontinued operations) and lower expenditures for investments. Expenditures for plant, property and equipment from continuing operations for 1992 were $569 million compared to $746 million for 1991. This reduction affected all divisions and was part of Tenneco's continuing restructuring program initiated in 1991. The major decreases associated with continuing operations were incurred by farm and construction equipment ($44 million), packaging ($30 million) and shipbuilding ($29 million). Capitalization totaled $9.78 billion at year-end 1992 which was down $2.66 billion from year-end 1991. The ratio of total debt to capitalization increased from 74.7 percent to 82.8 percent. The total debt to capitalization ratio at year-end 1992, including the market value of the SECT shares, was 78.8 percent. The major changes in capitalization were a reduction in total debt of $1.19 billion and a decrease in stockholders' equity of $1.44 billion. The decrease in stockholders' equity was primarily due to the Case Restructuring Program and the adoption of the changes in accounting principles. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEX TO FINANCIAL STATEMENTS OF TENNECO INC. AND CONSOLIDATED SUBSIDIARIES [THIS PAGE INTENTIONALLY LEFT BLANK] REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Tenneco Inc.: We have audited the accompanying balance sheets of Tenneco Inc. (a Delaware corporation) and consolidated subsidiaries as of December 31, 1993 and 1992, and the related statements of income (loss), cash flows and changes in stockholders' 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 Tenneco'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 Tenneco Inc. and consolidated subsidiaries as of December 31, 1993 and 1992, and the results of their operations, cash flows and changes in stockholders' equity for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 1 to the financial statements, effective January 1, 1992, Tenneco 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 supplemental schedules listed in the index to Item 14 relating to Tenneco Inc. and consolidated subsidiaries are presented for purposes of complying with the Securities and Exchange Commission's rules and are not 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 of Tenneco Inc. and consolidated subsidiaries taken as a whole. Arthur Andersen & Co. Houston, Texas February 14, 1994 STATEMENTS OF INCOME (LOSS) The accompanying notes to financial statements are an integral part of these statements of income (loss). Reference is made to Note 1 for definitions of "Tenneco Industrial" and "Tenneco Finance." BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. Reference is made to Note 1 for definitions of "Tenneco Industrial" and "Tenneco Finance." STATEMENTS OF CASH FLOWS The accompanying notes to financial statements are an integral part of these statements of cash flows. Reference is made to Note 1 for definitions of "Tenneco Industrial" and "Tenneco Finance." Note: Cash and temporary cash investments include highly liquid investments with maturity of three months or less at date of purchase. STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY The accompanying notes to financial statements are an integral part of these statements of changes in stockholders' equity. NOTES TO FINANCIAL STATEMENTS 1. Summary of Accounting Policies Consolidation and Presentation The financial statements of Tenneco Inc. and consolidated subsidiaries ("Tenneco") include all majority-owned subsidiaries including wholly-owned finance subsidiaries. Companies in which at least a 20% to a 50% voting interest is owned are carried at cost plus equity in undistributed earnings since date of acquisition and cumulative translation adjustments. At December 31, 1993, equity in undistributed earnings (losses) and cumulative translation adjustments amounted to $(57) million and $(10) million, respectively; at December 31, 1992, the corresponding amounts were $(73) million and $(3) million, respectively. The accompanying financial statements also include, on a separate and supplemental basis, the combination of Tenneco's industrial companies and finance companies as follows: Tenneco Industrial-The financial information captioned "Tenneco Industrial" reflects the consolidation of all majority-owned subsidiaries except for the finance subsidiaries. The finance operations have been included using the equity method of accounting whereby the net income and net assets of these companies are reflected, respectively, in the income statement caption, "Equity in net income-Tenneco Finance," and in the balance sheet caption, "Investment in affiliated companies." Tenneco Finance-The financial information captioned "Tenneco Finance" reflects the combination of Tenneco's wholly-owned finance subsidiaries. All significant intercompany transactions, including activity within and between the "Tenneco Industrial" and "Tenneco Finance" business units, have been eliminated. Environmental Liabilities Expenditures for ongoing compliance with environmental regulations that relate to current operations are expensed or capitalized as appropriate. Expenditures that relate to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. Liabilities are recorded when environmental assessments indicate that remedial efforts are probable and the costs can be reasonably estimated. Estimates of the liability are based upon currently available facts, existing technology, and presently enacted laws and regulations taking into consideration the likely effects of inflation and other societal and economic factors. All available evidence is considered including prior experience in remediation of contaminated sites, other companies' clean-up experience, and data released by the Environmental Protection Agency or other organizations. These liabilities are included in the balance sheet at their undiscounted amounts. Recoveries are evaluated separately from the liability and, if appropriate, are recorded separately from the associated liability in the financial statements. For further information on this subject, reference is made to Note 16, "Commitments and Contingencies-Environmental Matters" and to Management's Discussion and Analysis of Financial Condition and Results of Operations. Depreciation and Amortization Depreciation of Tenneco's properties is provided on a straight-line basis in amounts which, in the opinion of management, are adequate to allocate the cost of properties over their estimated useful lives. The excess of investment in subsidiaries over net assets at date of acquisition is being amortized over a 40-year period. Such amortization relative to continuing operations amounted to $16 million, $14 million and $13 million for 1993, 1992 and 1991, respectively, and is included in the income statement caption, "Other income, net." Revenue Recognition Newport News Shipbuilding and Dry Dock Company ("Newport News"), a subsidiary, reports profits on its long-term shipbuilding contracts on the percentage-of-completion method of accounting, determined on the basis of total costs incurred to date to estimated final total costs. Losses on contracts are reported when first estimated. The performance of contracts usually extends over several years, requiring periodic reviews and revisions of estimated final contract prices and costs during the term of the contracts. The effect of these revisions is included in income in the period the revisions are made. Sales by the Farm and construction equipment segment to independent dealers are recorded at the time of shipment to those dealers. Sales through company- owned retail stores are recorded at the time of sale to retail customers. The Farm and construction equipment segment grants certain sales incentives to stimulate sales of the farm and construction equipment products to retail customers. The expense for such incentive programs is recorded at the time of sale. Tenneco's other divisions recognize revenue on the accrual method when title passes to the customer or when the service is performed. Changes in Accounting Principles Tenneco elected early adoption of Statement of Financial Accounting Standards ("FAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," for its domestic operations and FAS No. 109, "Accounting for Income Taxes." Both standards were adopted effective January 1, 1992, using the cumulative catch-up method. Under FAS No. 106, Tenneco is required to accrue the estimated costs of retiree benefits other than pensions (primarily health care benefits and life insurance) during the employees' active service period. Prior to 1992, Tenneco expensed the cost of these benefits as medical and insurance claims were paid. Tenneco expects to adopt the new standard for its non-U.S. plans in the first quarter of 1995 and estimates that the adoption will reduce pre-tax income by approximately $20 million. The adoption of FAS No. 109 changed Tenneco's method of accounting for income taxes from the deferred method to the liability method. The 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. In 1992, Tenneco recorded an after-tax charge of $699 million or $4.86 per average common share for the cumulative effect of the accounting changes consisting of $414 million or $2.88 per share for FAS No. 106 and $285 million or $1.98 per share for FAS No. 109. Reference is made to Note 10, "Income Taxes," and Note 13, "Postretirement and Postemployment Benefits," for further information regarding these changes. Inventories At December 31, 1993 and 1992, inventory by major classification was as follows: Inventories generally are valued at the lower of cost (determined on the "first-in, first-out" or "average" methods) or market based on estimated realizable value. Notes Receivable Short-term notes receivable of $1,359 million and $1,921 million were outstanding at December 31, 1993 and 1992, respectively, of which $1,299 million and $1,853 million, respectively, related to Tenneco Finance. These notes receivable are presented net of unearned finance charges of $96 million and $182 million at December 31, 1993 and 1992, respectively, which related principally to Tenneco Finance. At December 31, 1993 and 1992, unearned finance charges related to long-term notes and other receivables were $139million and $174 million, respectively, which related principally to Tenneco Finance. Allowance for Doubtful Accounts and Notes Receivable At December 31, 1993 and 1992, the allowance for doubtful accounts and notes receivable was $129 million and $119 million, respectively, of which $42 million and $49 million, respectively, related to Tenneco Finance. Restrictions on the Payment of Dividends by Subsidiaries At December 31, 1993, Tennessee Gas Pipeline Company ("Tennessee") and Tenneco Credit Corporation ("TCC"), both wholly-owned consolidated subsidiaries, had retained earnings of $3,150 million and $299 million, respectively, of which $681 million and $129 million, respectively, were contractually restricted as to the payment of dividends. The restrictions for Tennessee are contained in indentures under which certain of its notes and debentures have been issued. The TCC restrictions are contained in the investment agreement between TCC and Tenneco Inc. which was entered into in support of various loan agreements of TCC. Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations for information regarding the payment of dividends by Tenneco Inc. Reclassifications Prior years' financial statements have been reclassified to conform to 1993 presentations. 2. Restructuring Costs During 1991, Tenneco identified restructuring measures which resulted in a pre-tax restructuring charge of $552 million ($480 million after tax or $3.91 per average common share) which was recorded as part of continuing operations. The charge reflected estimated costs of $287 million attributable to an 8,000 personnel reduction program; $122 million to plant closings; and $143 million for the rationalization or discontinuance of farm and construction equipment product lines, including costs associated with dealer discounts, other incentive programs and inventory writedowns to net realizable value. Of the total pre-tax charge, $461 million was taken at Tenneco's Farm and construction equipment segment ("Case"). The 1991 restructuring charge was in part attributable to aggressive measures taken in September 1991 to respond to depressed market conditions facing the farm and construction equipment business and to improve Case's performance. While the measures taken at Case since September 1991 resulted in significant improvement in Case's performance, the worldwide farm and construction equipment market continued to deteriorate during 1992, and Tenneco Management and the Board of Directors determined that major structural and strategic changes were necessary in order to (1) rationalize certain component production operations to reduce the fixed cost portion of the manufacturing process; (2) reduce excess capacity; (3) focus, discontinue or replace unprofitable and noncompetitive product lines; and (4) restructure and refocus product and component parts distribution to strengthen Case's competitive position in the global marketplace. Consequently, on March 21, 1993, the Board of Directors of Tenneco Inc. adopted a comprehensive restructuring program for Case. Adoption of this program resulted in a pre-tax restructuring charge of $920 million ($843 million after tax, or $5.85 per average common share), all of which was reflected in the 1992 loss from continuing operations before interest expense and income taxes. The $920 million pre-tax charge was recorded as a $340 million reduction of net plant, property and equipment, a $55 million reduction of inventory, a $63 million reduction of intangibles and other accounts and a $462 million reserve for the future cost of implementing the various restructuring actions. Of this reserve, $86 million was recorded as a current liability and $376 million was recorded in "Deferred credits and other liabilities." As of December 31, 1993, approximately $130 million of the actions necessary to complete the program had been implemented leaving $790 million to be implemented over the next three years. Of the remaining actions to be implemented, $259 million pertain to plant, property and equipment, $26 million pertain to inventories, $58 million pertain to intangibles and other accounts and $447 million is reflected as a reserve for future costs of implementing other various restructuring actions. Of this reserve, $144 million is recorded as a current liability and $303 million is recorded in "Deferred credits and other liabilities" on the balance sheet as of December 31, 1993. The restructuring actions taken during 1993 are described in detail in Management's Discussion and Analysis of Financial Condition and Results of Operations. In addition, $63 million of the 1991 restructuring charge remained on the balance sheet as a current liability at December 31, 1993. The specific restructuring measures were based on management's best business judgment under prevailing circumstances and on assumptions which may be revised over time and as circumstances change. The estimated costs associated with such measures may require further revision in the future. 3. Acquisitions In January 1991, Georgia-Pacific Corporation ("Georgia-Pacific"), Tenneco and General Electric Capital Corporation ("GECC"), completed the sale by Georgia- Pacific (a) to GECC of the buildings, machinery and equipment at two containerboard mills; (b) to Packaging Corporation of America ("PCA") and other subsidiaries of Tenneco of the land and certain equipment at such mills, 19 corrugated container plants, two short-line railroads that serve the mills, and leasehold interests in approximately 100,000 acres of leased timberlands; and (c) to John Hancock Mutual Life Insurance Company ("John Hancock") and Metropolitan Life Insurance Company ("Metropolitan Life") of approximately 540,000 acres of fee timberlands. The assets purchased by GECC and the timberlands purchased by John Hancock and Metropolitan Life have been leased to PCA. The aggregate price paid to Georgia-Pacific was $727 million. Of that amount, GECC paid $500 million, John Hancock and Metropolitan Life paid $173 million and PCA and other Tenneco subsidiaries paid an aggregate of $54 million. The accompanying financial statements for 1991 include $371 million in net sales from these assets since the date the purchases and lease arrangements were completed. Reference is made to Note 16, "Commitments and Contingencies-Lease Commitments," for further information regarding these lease commitments. 4. Discontinued Operations, Disposition of Assets, and Extraordinary Loss Discontinued Operations During 1992, Tenneco sold its minerals and pulp chemicals operations for proceeds of $500 million and $202 million, respectively. The sales of these discontinued operations resulted in a gain (loss) of $96 million and $(25) million, net of income tax expense of $45 million and $0, respectively. Revenues for the minerals discontinued operations were $55 million for 1992 and $124 million for 1991. Net income was $3 million and $12 million, net of income tax expense of $3 million and $1 million for 1992 and 1991, respectively. Revenues for the pulp chemicals discontinued operations were $54 million and $120 million for 1992 and 1991, respectively. Net income (loss) was $(3) million and $6 million, net of income tax expense (benefit) of $(2) million and $4 million for 1992 and 1991, respectively. The allocation of interest expense to discontinued operations was based on the ratio of net assets of discontinued operations to consolidated net assets plus debt. Interest expense, net of income tax, of $5 million and $10 million was allocated to the minerals operations and $5 million and $7 million was allocated to the pulp chemicals operations for 1992 and 1991, respectively. A loss of $58 million from discontinued operations, net of a $31 million tax benefit, was recorded in 1991 to reflect additional costs estimated to be incurred in connection with the sale of Tenneco's oil and gas businesses in 1988. The costs are primarily attributable to (a) the settlement in December 1991 of litigation instituted by approximately 380 employees of Tenneco's former oil and gas businesses claiming additional compensation and damages as a result of the sale of such businesses; (b) the excess of presently estimated settlement costs of additional claims by the purchasers and others arising out of the sales of such businesses over reserves initially established for such claims; and (c) a July 1991 decision of a federal appellate court refusing to reconsider a ruling that lessors under oil and gas leases are entitled to royalty payments on compression, gathering and other miscellaneous charges collected by natural gas producers pursuant to Federal Energy Regulatory Commission Order No. 94, against which royalty payments Tenneco has agreed to indemnify the purchasers of certain of its oil and gas assets. Disposition of Assets During 1993, Tenneco disposed of a number of assets and investments including its Newport News' Sperry Marine business; several PCA operations; two wholly- owned pipeline companies, Viking Gas Transmission Company and Dean Pipeline Company; and facilities and land of two foreign Case operations. The proceeds from dispositions were $266 million and the pre-tax gain was $118 million. In 1991, Tenneco sold its natural gas liquids business including its interest in an MTBE plant under construction in La Porte, Texas, in a transaction valued at $632 million resulting in a pre-tax gain of $265 million. The terms of the sale included the assumption by the purchaser of costs associated with the construction of the MTBE plant. Also, the Company sold three short-line railroads for a total of $54 million and a pre-tax gain of $42 million. Extraordinary Loss In April 1993, Tenneco Inc. issued 23.5 million shares of common stock for approximately $1.1 billion. The proceeds were used to retire $327 million of short-term debt, $688 million of long-term debt and $14 million of variable rate preferred stock. In November 1993, Tenneco retired DM250 million bonds. The redemption premium related to the retirement of long-term debt resulting from these two transactions ($25 million, net of income tax benefits of $13 million) was recorded as an extraordinary loss. In December 1992, Tenneco deposited cash with a trustee to defease $310 million of its high interest-bearing long-term debt. Accordingly, this amount was excluded from long-term debt on the balance sheet at December 31, 1992. This debt was prepaid in January and February 1993. In November 1992, Tenneco also prepaid $71 million of high interest-bearing long-term debt related to an investment in a partnership. Tenneco recorded an extraordinary loss of $12 million (net of income tax benefits of $6 million) for the redemption premium resulting from these transactions. 5. Foreign Operations At December 31, 1993, 1992 and 1991, and for the years then ended, the results of operations and combined net assets of foreign subsidiaries were as follows: 6. Plant, Property and Equipment, At Cost At December 31, 1993 and 1992, plant, property and equipment, at cost, by major segment was as follows: 7. Long-Term Debt, Short-Term Debt and Financing Arrangements Long-Term Debt A summary of long-term debt outstanding at December 31, 1993, is set forth in the following table: At December 31, 1993, approximately $272 million of gross plant, property and equipment was pledged as collateral to secure $34 million principal amount of long-term debt. The aggregate maturities and sinking fund requirements applicable to the issues outstanding at December 31, 1993, are $686 million, $726 million, $660 million, $788 million and $854 million for 1994, 1995, 1996, 1997 and 1998, respectively. Short-Term Debt Information for the year ended December 31, 1993, regarding short-term debt follows: * Includes borrowings under both committed and uncommitted lines of credit and similar arrangements. Financing Arrangements As of December 31, 1993, Tenneco and its subsidiaries had arranged total lines of credit of $3.3 billion, of which $3.1 billion are committed lines of credit as more fully described below: Notes: (a) The credit facilities generally provide for commitment fees on the unused portion of the total commitment, and most credit facilities also provide for facility fees on the total commitment. (b) Includes borrowings under uncommitted lines of credit and similar arrangements. (c) Of these lines of credit, $100 million is also available to Tenneco Finance; also, $100 million expires in 1994. (d) Of these lines of credit, $654 million expire in 1994. 8. Financial Instruments The estimated fair values of Tenneco's financial instruments at December 31, 1993 and 1992, were as follows: The following methods and assumptions were used to estimate the fair value of financial instruments: Cash and Temporary Cash Investments-Fair value was considered to be the same as the carrying amount. Receivables-Tenneco believes that in the aggregate, the carrying amount of its receivables, both current and non-current, was not materially different from the fair value of those receivables. Customer notes and accounts receivable are concentrated in the Farm and construction equipment segment. At December 31, 1993 and 1992, 75% and 77%, respectively, of total customer receivables related to this business segment. Other Investments-At December 31, 1993, these investments included preferred stock ($17 million) in Steerage Corporation (the acquiror of Newport News' Sperry Marine Business), venture capital investments ($8 million) and several tracts of undeveloped land ($17 million). At December 31, 1992, these investments included Tenneco's share of several partnerships established to develop gas reserves ($41 million), venture capital investments ($12 million) and several tracts of undeveloped land ($18 million). Because of the nature of these investments, it was not practicable to estimate their fair value. Short-Term Debt-Fair value was considered to be the same as the carrying amount. Long-Term Debt-The fair value of fixed-rate long-term debt was based on the market value of debt with similar maturities and interest rates; the carrying amount of floating rate long-term debt was assumed to approximate its fair value. Interest Rate Swaps-The fair value of interest rate swaps was based on the cost that would have been incurred to buy out those swaps in a loss position and the consideration that would have been received to terminate those swaps in a gain position. At December 31, 1993 and 1992, Tenneco was a party to swaps with a notional value of $810 million and $918 million, respectively, which were in a net payable position and $775 million for both years which were in a net receivable position. The differential paid or received on interest rate swap agreements was recognized as an adjustment to interest expense. The counterparties to these interest rate swaps are major international financial institutions. The risk associated with counterparty default on interest rate swaps is measured as the cost of replacing, at the prevailing market rates, those contracts in a gain position. In the event of non- performance by the counterparties, the cost to replace outstanding interest rate swaps at December 31, 1993 and 1992, would not have been material. Foreign Currency Contracts-At December 31, 1993 and 1992, Tenneco had entered into currency/interest rate swaps totaling $133 million and $136 million, respectively. Additionally, at December 31, 1992, Tenneco had a long-term foreign debt obligation of $154 million. These instruments hedge certain translation effects of Tenneco's investment in net assets in certain foreign countries, primarily Great Britain and Germany. Pursuant to these arrangements, Tenneco recognized aggregate after-tax translation gains of $5 million, $30 million and $15 million for 1993, 1992 and 1991, respectively, which have been included in the balance sheet caption "Cumulative translation adjustments." In the normal course of business, Tenneco and its foreign subsidiaries routinely enter into various foreign currency purchase and sale contracts to minimize the transaction effect of exchange rate movements on receivables and payables denominated in foreign currencies. These contracts generally mature in one year or less. At December 31, 1993, Tenneco had net purchase contracts (primarily Belgian Francs, French Francs, Netherlands Guilder, Danish Krone, Italian Lira and Swedish Krona) with a notional value of $308 million and net sale contracts (primarily Canadian Dollar, U.S. Dollar and British Pound) with a notional value of $315 million. At December 31, 1992, Tenneco had net purchase contracts (primarily the U.S. Dollar, Swedish Krona, Netherlands Guilder, Italian Lira, British Pound, Danish Krone and Belgian Franc) with a notional value of $410 million and net sale contracts (primarily the French Franc, Spanish Peseta, German Mark and Canadian Dollar) with a notional value of $403 million. Based on exchange rates at December 31, 1993 and 1992, the cost of replacing these contracts in the event of non-performance by the counterparties would not have been material. Guarantees-At December 31, 1993 and 1992, Tenneco had guaranteed payment and performance of approximately $95 million and $100 million, respectively, primarily with respect to letters of credit and other guarantees supporting various financing and operating activities. 9. Federal Energy Regulatory Commission ("FERC") Regulatory Matters On August 1, 1991, Tennessee filed for a general rate increase. On August 31, 1991, the FERC accepted the filing, suspended its effectiveness for the maximum period of five months pursuant to the normal regulatory process and set the matter for hearing. With minor modifications, Tennessee's proposed rates were placed into effect on February 1, 1992, subject to refund. The rates finally determined under Docket No. RP91-203 will be effective retroactive to February 1, 1992, and will continue until the rates are changed by a filing by Tennessee or pursuant to a subsequent proceeding convened by the FERC. On June 2, 1993, Tennessee filed a Stipulation and Agreement that resolved several significant issues in this rate proceeding and established procedures for resolving the remaining issues, including the recovery of certain environmental expenditures. Tennessee is currently collecting these environmental costs in its rates subject to further review in the rate case and possible refund. Tennessee intends to pursue full recovery of these costs. The Stipulation and Agreement was approved by an initial order of the FERC on October 29, 1993, and Tennessee has recorded a liability which is adequate to cover these refunds. Tennessee anticipates a final order on the Stipulation and Agreement from the FERC in early 1994, pursuant to which Tennessee will disburse agreed-upon refunds. Among the issues confirmed by the Stipulation and Agreement is the ability of Tennessee to collect from customers, on an accrual basis, the costs of providing benefits other than pensions to retirees. These costs were previously collected from customers on a "pay-as-you-go" basis. The Stipulation and Agreement allowed Tennessee to collect over a 20-year period the transition obligation related to postretirement benefit costs. Tennessee had previously expensed these amounts when FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," was adopted in 1992. As a result of this Stipulation and Agreement, Tennessee has established a regulatory asset of $34 million and has included the income effect of this favorable regulatory development in the income statement caption, "Other income, net." On June 25, 1992, the FERC approved a settlement allowing Tennessee to recover from its customers up to $650 million of excess gas supply costs incurred through July 1,1992, in resolving take-or-pay costs and payments to producers to suspend or terminate contracts or to reduce contract prices to market levels. The settlement also allowed Tennessee to place into effect, as of July 1,1992, a Gas Inventory Charge providing a mechanism for the recovery of these excess gas supply costs until September 1, 1993, the effective date of Tennessee's implementation of Order No. 636. Tennessee charged to operating expenses that portion of excess gas supply costs incurred prior to the implementation of Order No. 636 that it cannot recover from customers. On April 8, 1992, the FERC issued Order No. 636 which, together with subsequently issued clarifying Order Nos. 636-A and 636-B (the "FERC Restructuring Orders"), directed a further sweeping restructuring of the interstate gas pipeline industry. The FERC Restructuring Orders required pipelines to: 1) "unbundle" their transportation and storage services from their sales services, 2) increase pipeline customers' flexibility to change receipt and delivery points under transportation contracts and to allow release of capacity under those contracts for use by others and 3) separate interstate pipeline gas sales organizations from interstate pipeline transportation and storage business units. Under the FERC Restructuring Orders, rates for pipeline transportation and storage generally remain subject to traditional cost-of- service regulation but under a rate design which is relatively insensitive to throughput and hence less sensitive to seasonal variation. Sales of natural gas by interstate pipelines occur pursuant to a blanket sales certificate under which price and other terms of sale are set by market forces. After a series of FERC orders and compliance filings, Tennessee implemented its Order No. 636 tariff commencing on September 1, 1993, restructuring its transportation, storage and sales services. The FERC Restructuring Orders recognized that transition costs, including gas supply realignment costs, may result from this restructuring and provided mechanisms for the full recovery of such qualified costs. Pipelines were encouraged to propose various mechanisms in the restructuring proceedings to reduce transition costs, including assignment of gas supply contracts and phasing in of the conversions of the pipeline sales service. The FERC Restructuring Orders specified that pipelines would be allowed to make special filings to recover many types of transition costs. Tennessee has made multiple filings to begin recovery of certain transition costs already paid or obligated to be paid in connection with the FERC Restructuring Orders. Tennessee's filings request authority to: 1) recover, through a monthly surcharge, one-time gas supply realignment costs and certain related costs incurred to date over a twelve-month period, 2) direct-bill customers for unrecovered gas costs over a twelve-month period and 3) track and recover, through an annual surcharge, upstream transportation costs from customers. The filings were accepted effective September 1, 1993, and made subject to refund pending review. Hearings have been instituted to review the recovery of the gas supply realignment costs and the direct billing of unrecovered gas costs. Tennessee's filings to recover production costs related to its Bastian Bay facilities have been rejected by the FERC based on the continued use of the gas production from the field, however, the FERC recognized the ability of Tennessee to file for the recovery of losses upon disposition of these assets. Tennessee will seek appellate review of the FERC actions. Tennessee is confident that the Bastian Bay costs will ultimately be recovered as transition costs directly related to Order No. 636, and no FERC order has questioned the ultimate recoverability of these costs. The total amount of transition costs that will be incurred by Tennessee will depend upon: 1) developments in restructuring proceedings involving Tennessee, its customers and other affected parties, 2) the resolution of pending litigation and 3) the terms of multiple negotiations with individual suppliers. Until these issues are resolved, Tennessee cannot finally determine the ultimate amount of one-time realignment costs or other related annual costs it will incur, nor the amounts which will be recovered from customers. Tennessee believes that one-time realignment costs will not exceed $700 million. At December 31, 1993, Tennessee recorded and deferred approximately $120 million of such one-time costs which are recoverable from its customers. Tennessee believes that other related annual costs will not exceed $100 million in 1994, decreasing thereafter over the length of the contracts involved. The FERC Restructuring Orders will undergo judicial review, clarifications and formulation of cost recovery details as the restructuring process proceeds. However, Tennessee believes that it is entitled to full recovery of all transition costs it will incur. Given the fact that the FERC Restructuring Orders contemplate complete recovery by pipelines of qualified transition costs, Tenneco believes that Tennessee's Order No. 636 restructuring (together with the Order No. 636 restructuring of Tenneco's other interstate pipelines) will not have a material effect on Tenneco's consolidated financial position or results of operations. 10. INCOME TAXES Effective January 1, 1992, Tenneco changed its method of accounting for income taxes from the deferred method to the liability method required by FAS No. 109, "Accounting for Income Taxes" using the cumulative catch-up method. This new standard requires that a deferred tax be recorded to reflect the tax expense (benefit) resulting from the recognition of temporary differences. Temporary differences are differences between the tax basis 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. No provision has been made for U.S. income taxes on unremitted earnings of foreign subsidiaries ($1.07 billion at December 31,1993) since it is the present intention of management to reinvest a major portion of such unremitted earnings in foreign operations. The components of income (loss) from continuing operations before income taxes are as follows: Following is an analysis of the components of consolidated income tax expense (benefit) applicable to continuing operations: In August 1993, the U.S. federal income tax rate was increased from 34% to 35%, retroactive to January 1,1993. For 1992 and 1991, this rate was 34%. Following is a reconciliation of income taxes computed at the U.S. federal income tax rate to the income tax expense (benefit) from continuing operations reflected in the Statements of Income (Loss): The components of Tenneco's net deferred tax liability at December 31, 1993 and 1992, were as follows: As reflected in the table above, Tenneco had potential tax benefits of $236 million and $355 million which were not recognized in the Statements of Income (Loss) at December 31, 1993 and 1992, respectively. These benefits resulted primarily from operating loss carryforwards which are available to reduce future tax liabilities of certain foreign entities. During 1993, $37 million was realized as a result of the consolidation of Tenneco's German operations. The remainder of the change in these tax benefits from 1992 to 1993 resulted from the reduction in deferred tax assets, primarily related to restructuring. At December 31, 1993, Tenneco had operating loss carryforwards of $227 million of which $189 million will carryforward indefinitely while the remaining amounts expire at various dates from 1994 through 1998. Prior to adoption of FAS No. 109, Tenneco recorded deferred federal income tax expense (benefit) based on timing differences in the recognition of revenues and expenses for tax and financial reporting purposes. A description of the differences and the related tax effect on continuing operations are as follows: 11. Common Stock Tenneco Inc. has authorized 350 million shares ($5.00 par value) of common stock, and 173,953,012 and 150,300,224 shares were issued at December 31, 1993 and 1992, respectively. Tenneco transferred 12,000,000 shares of common stock to the Stock Employee Compensation Trust when it was established in November 1992. At December 31, 1993, the Trust held 9,520,575 shares which are included in the issued shares quoted above. Treasury stock held by Tenneco was 4,166,835 and 5,323,912 shares at the respective dates. Equity Offering In April 1993, Tenneco Inc. completed an underwritten public offering of 23.5 million shares of common stock for approximately $1.1 billion. The proceeds were used to retire $327 million of short-term debt, $688 million of long-term debt and $14 million of variable rate preferred stock. Reserved At December 31, 1993, the shares of Tenneco Inc. common stock reserved for issuance were as follows: Stock Plans 1994 Tenneco Inc. Stock Ownership Plan--Subject to stockholder approval in May 1994, Tenneco will adopt the 1994 Tenneco Inc. Stock Ownership Plan effective as of December 8, 1993. This plan provides Tenneco the latitude to grant a variety of awards, such as common stock, stock equivalent units, dividend equivalents, performance units, stock appreciation rights ("SAR's") and stock options, to officers and key employees of the Tenneco companies. The plan requires that options and SAR's be granted at not less than the fair market value of a share of common stock on the grant date. The plan also requires that no award granted shall vest in less than six months after the grant date. The Company intends to reserve 8,400,000 shares of common stock for issuance under this plan, which will terminate December 31, 1998. 1988 Key Employee Restricted Stock Plan--At December 31, 1993, 1,205,029 restricted shares and 101,465 restricted units were outstanding under this plan at an average price of $47.77 per share. These awards generally require, among other things, that the employee remain an employee of Tenneco during the restriction period. This plan will be superseded by the 1994 Tenneco Inc. Stock Ownership Plan. Under another arrangement, 250 shares of restricted stock or restricted units are issued annually to each member of the Board of Directors who is not also an officer of Tenneco. At December 31, 1993, 7,500 restricted shares and no restricted units were outstanding under this program at an average price of $43.92 per share. Options and Stock Appreciation Rights--Tenneco Inc. has granted stock options and stock appreciation rights to key employees. The options and SAR's became exercisable over four years and lapse after ten years from the date of grant. This plan has been terminated. The following table reflects the status and activity for all stock options issued by Tenneco Inc., including those outside the option plan discussed above, for the periods indicated: For the years ended December 31, 1993, 1992 and 1991, compensation expense for these stock plans was not material. Employee Stock Purchase Plan--On June 1, 1992, Tenneco initiated an Employee Stock Purchase Plan. The Plan allows U.S. and Canadian Tenneco employees to purchase Tenneco Inc. common stock at a 15% discount. Each year employees in the plan may purchase shares with a discounted value not to exceed $21,250. Tenneco reserved 5,000,000 shares of treasury stock to be issued through this plan. At December 31, 1993, 659,477 shares had been issued to participants and the remaining treasury shares are held by the Stock Employee Compensation Trust (discussed below) for issuance to employees in this plan. Stock Employee Compensation Trust ("SECT") In November 1992, Tenneco established a SECT to fund a portion of its obligations arising from its various employee compensation and benefit plans. Tenneco issued 12,000,000 shares of treasury stock to the SECT in exchange for a promissory note of $432 million that bears interest at the rate of 7.8% per annum. The SECT has a five-year life during which it will utilize the common stock to satisfy those obligations. At December 31, 1993, 2,479,425 shares had been utilized. Shareholder Rights Plan In 1988, Tenneco Inc. adopted a Shareholder Rights Plan ("the Plan") to deter coercive takeover tactics and to prevent a potential acquiror from gaining control of Tenneco without offering a fair price to all Tenneco Inc. shareholders. Under the Plan, each outstanding share of Tenneco Inc. common stock received one Purchase Right, exercisable at $130, subject to adjustment. In the event a person or group acquires 20% or more of the outstanding Tenneco Inc. common stock other than pursuant to an offer for all shares of such common stock which is fair and in the best interests of Tenneco Inc. and its shareholders, or has in the judgment of the Tenneco Inc. Board of Directors acquired a substantial amount of common stock under certain motives deemed adverse to Tenneco's best interests, each Purchase Right entitles the holder to purchase shares of common stock or other securities of Tenneco Inc. or, under certain circumstances, of the acquiring person, having a value of twice the exercise price. The Purchase Rights, under certain circumstances, are redeemable by Tenneco Inc. at a price of $.02 per Purchase Right. Dividend Reinvestment and Stock Purchase Plan Under the Tenneco Inc. Dividend Reinvestment and Stock Purchase Plan, holders of Tenneco Inc. common stock, $7.40 preferred stock, and $2.80 Depositary Shares may apply their cash dividends and optional cash investments to the purchase of shares of common stock without incurring a brokerage commission or other service charge. Tenneco Inc. also offers participants in the plan a 3% discount on purchases of common stock with their reinvested dividends. Earnings Per Share Earnings per share of common stock are based on the average number of shares of common stock and Series A preferred stock (each share of Series A preferred stock represents two shares of common stock) outstanding during each period. Because Series A preferred stock outstanding is included in average common shares outstanding for purposes of computing earnings per share, the preferred dividends paid are not deducted from net income (loss) to determine net income (loss) to common stock. In 1992, 12,000,000 shares of common stock were issued to the SECT. Shares of common stock issued to a related trust are not considered to be outstanding in the computation of average shares of common stock outstanding until the shares are utilized to fund the obligations for which the trust was established. At December 31, 1993, 2,479,425 shares had been utilized. Other convertible securities and common stock equivalents outstanding during each of the three years ended December 31, 1993, 1992 and 1991, were not materially dilutive. 12. Preferred Stock At December 31, 1993, Tenneco Inc. had authorized 15,000,000 shares of preferred stock. In addition, Tenneco Inc. has an authorized class of stock consisting of 50,000,000 shares of junior preferred stock, without par value, none of which has been issued. Tenneco has reserved 3,500,000 shares of junior preferred stock for the Shareholder Rights Plan. The preferred stock issues outstanding at December 31, 1993, are as follows: In December 1991, Tenneco issued 17,870,350 Depositary Shares, each representing one-half of a share of a new series of cumulative preferred stock designated as Series A preferred stock. This stock ranks prior to Tenneco's junior preferred stock (when and if issued) and common stock. Each share of the Series A preferred stock converts automatically into two shares of common stock on the final conversion date, December 31, 1994, or in connection with certain other events. In addition, Tenneco has the option to call the Series A preferred stock, in whole or in part, at any time or from time to time prior to the final conversion date for conversion into shares of common stock having a value initially equal to $92.70 (equivalent to $46.35 for each Depositary Share), reduced by $0.006624 (equivalent to $0.003312 for each Depositary Share) on each day following the date of issue (computed on the basis of a 360-day year of twelve 30-day months) to and including October 31, 1994, and equal to $85.50 thereafter (equivalent to $42.75 for each Depositary Share), plus an amount in cash equal to accrued and unpaid dividends. The Series A preferred stock pays quarterly dividends on the last day of March, June, September and December at an annual rate of $5.60 per share. The $7.40 and $4.50 preferred stock issues have a mandatory redemption value of $100 per share (an aggregate of $178 million and $208 million at December 31, 1993 and 1992, respectively). Tenneco recorded these preferred stocks at their fair value at the date of original issue (an aggregate of $250 million) and is making periodic accretions of the excess of the redemption value over the fair value at the date of issue. Such accretions are included in the income statement caption, "Preferred stock dividends" as a reduction of net income to arrive at net income (loss) to common stock. During 1993, Tenneco retired the remainder of a variable rate preferred stock issue at the redemption price of $100 per share, or $17 million. The aggregate maturities applicable to preferred stock issues outstanding at December 31, 1993, are $20million for each of the years 1994, 1995, 1996, 1997 and 1998. In 1991, a French subsidiary issued equity securities that will convert into Tenneco Inc. preferred stock in 1996. At December 31, 1993, Tenneco has reserved 1.5 million shares of preferred stock for this purpose. These equity securities are reflected in the balance sheet caption, "Minority interest." Changes in Preferred Stock with Mandatory Redemption Provisions* 13. Postretirement and Postemployment Benefits Postretirement Benefits Tenneco has postretirement health care and life insurance plans which cover substantially all of its domestic employees. For salaried employees, the plans cover employees retiring from Tenneco on or after attaining age 55 who have had at least 10 years service with Tenneco after attaining age 45. The salaried plans were amended during 1993 to reduce the cost of providing future benefits. For hourly employees, the postretirement benefit plans generally cover employees who retire pursuant to one of Tenneco's hourly employee retirement plans. All of these benefits may be subject to deductibles, copayment provisions and other limitations, and Tenneco has reserved the right to change these benefits. Effective January 1, 1992, for its domestic operations, Tenneco adopted FAS No. 106 which requires employers to account for the cost of these postretirement benefits on the accrual basis rather than on the "pay-as-you-go" basis which was Tenneco's previous practice. Tenneco elected to recognize this change in accounting principle on the cumulative catch-up basis. The effect on 1992 income of immediately recognizing the transition obligation was as follows: Tenneco plans to adopt FAS No. 106 for its international operations in the first quarter of 1995. The estimated pre-tax transition obligation for Tenneco's international operations is approximately $20 million. Currently, Tenneco's postretirement benefit plans are not funded. The obligation of the domestic plans reconciles with amounts recognized on the balance sheet at December 31, 1993 and 1992, as follows: The net periodic postretirement benefit costs from continuing operations for the years 1993 and 1992 consist of the following components: A pre-tax loss resulting from curtailments, settlements and special termination benefits under these plans was $0 and $40 million for 1993 and 1992, respectively, which related primarily to restructuring at the Farm and construction equipment segment. The weighted average assumed health care cost trend rate used in determining the 1993 accumulated postretirement benefit obligation was 9% in 1993 declining to 5% in 1997 and remaining at that level thereafter. The weighted average assumed health care cost trend rate used in determining the 1992 accumulated postretirement benefit obligation was 12% in 1992 declining to 5% in 1997 and remaining at that level thereafter. Increasing the assumed health care cost trend rate by one percentage-point in each year would increase the accumulated postretirement benefit obligation as of September 30, 1993, and September 30, 1992, by approximately $47 million and $94 million, respectively, and would increase the aggregate of the service cost and interest cost components of the net postretirement benefit cost for 1993 and 1992 by approximately $10 million and $11 million, respectively. The discount rates (which are based on long-term market rates) used in determining the 1993 and 1992 accumulated postretirement benefit obligations were 7.50% and 8.75%, respectively. Postemployment Benefits Tenneco will adopt FAS No. 112, "Employers' Accounting for Postemployment Benefits," in the first quarter of 1994. This new accounting rule requires employers to account for postemployment benefits for former or inactive employees after employment but before retirement on the accrual basis rather than the "pay-as-you-go" basis as at present. Tenneco has determined that implementation of this new rule will reduce 1994 net income by $39 million which will be reported as the cumulative effect of a change in accounting principle. 14. Pension Plans Tenneco has retirement plans which cover substantially all of its employees. Benefits are based on years of service and, for most salaried employees, on final average compensation. Tenneco's funding policies are to contribute to the plans amounts necessary to satisfy the funding requirements of federal laws and regulations. Plan assets consist principally of listed equity and fixed income securities. The funded status of the plans reconciles with amounts recognized on the balance sheet at December 31, 1993 and 1992, as follows: Note: Assets of one plan may not be utilized to pay benefits of other plans. In December 1993, Tenneco contributed 3.2 million shares of Cummins Engine Company, Inc. stock having a fair market value of $168 million to the Case Corporation Pension Plan for Hourly-Paid Employees ("Case Plan"). In conjunction with this contribution, active Case salaried employees were transferred (with associated assets) from the Tenneco Inc. Retirement Plan to the Case Plan, and Case hourly retirees were transferred (with associated assets) from the Case Plan to the Tenneco Inc. Retirement Plan. These transactions, which are reflected in the disclosure information shown above as of December 31, 1993, resulted in the fair value of the Case Plan assets now exceeding the accumulated benefit obligation. Net pension costs from continuing operations for the years 1993, 1992 and 1991 consist of the following components: Pre-tax gains (losses) resulting from curtailments, settlements and special termination benefits under these plans were $(37) million, $(46) million and $13 million for 1993, 1992 and 1991, respectively, all of which related primarily to restructuring at the Farm and construction equipment segment. The weighted average discount rates (which are based on long-term market rates) used in determining the 1993, 1992 and 1991 actuarial present value of the benefit obligations were 7.6%, 8.9% and 9.2%, respectively. The rate of increase in future compensation was 5.1%, 6.6% and 6.6% for 1993, 1992 and 1991, respectively. The weighted average expected long-term rate of return on plan assets was 9.9%, 10.0% and 10.1% for 1993, 1992 and 1991, respectively. 15. Segment and Geographic Area Information See notes on following page. Notes: (a) Contracts with U.S. government agencies (primarily shipbuilding contracts with the U.S. Navy) accounted for $1.9 billion, $2.4 billion and $2.3 billion for 1993, 1992 and 1991, respectively. (b) Products are transferred between geographic areas on a basis intended to reflect as nearly as possible the "market value" of the products. Tenneco is engaged in the sale of products for export from the United States. Such sales are reflected in the table below: 16. Commitments and Contingencies Capital Commitments Tenneco estimates that expenditures aggregating $700 million will be required after December 31, 1993, to complete facilities and projects authorized at such date, and substantial commitments have been made in connection therewith. Purchase Obligations In connection with the financing commitments of certain joint ventures, Tenneco has entered into unconditional purchase obligations for products and services of $197 million ($152 million on a present value basis). Tenneco's annual obligations under these agreements are $26 million for 1994 and 1995, $25 million for 1996, $23 million for 1997 and $22 million for 1998. Payments under such obligations, including additional purchases in excess of contractual obligations, were $31 million, $33 million and $35 million for the years 1993, 1992 and 1991, respectively. In addition, in connection with the Great Plains coal gasification project (Dakota Gasification Company), Tenneco has contracted to purchase 30% of the output of the plant's original design capacity for a remaining period of 16 years. Lease Commitments Tenneco holds certain of its facilities and equipment under long-term leases. The minimum rental commitments under non-cancelable operating leases with lease terms in excess of one year are $171 million, $150 million, $126 million, $121 million and $118 million for the years 1994, 1995, 1996, 1997 and 1998, respectively, and $1,084 million for subsequent years. Of these amounts, $78 million for each of the years 1994, 1995 and 1996, $81 million for 1997, $89 million for 1998 and $872 million for subsequent years are lease payment commitments to GECC, John Hancock and Metropolitan Life for assets purchased from Georgia-Pacific in January 1991 and leased to Tenneco. Commitments under capital leases were not significant to the accompanying financial statements. Total rental expense for continuing operations for the years 1993, 1992 and 1991, was $207 million, $218 million and $215 million, respectively, including minimum rentals under non-cancelable operating leases of $198 million, $208 million and $206 million for the corresponding periods. Litigation On November 19, 1993, the Supreme Court of the State of Louisiana denied a writ of certiorari which had the effect of affirming the decision of the Louisiana Court of Appeals holding in the case of Louisiana Intrastate Gas Corporation v. Martin Intrastate Gas Company, originally brought in the 22nd Judicial District Court for St. Tammany Parish, Louisiana, on October 25, 1991. The case involved a dispute between Louisiana Intrastate Gas Corporation ("LIG") and Martin Intrastate Gas Company ("Martin Intrastate"), of which Kenneth G. Martin is President, as to the nature and extent of Martin Intrastate's right to compel LIG to purchase natural gas under a 1978 gas purchase contract entered into by another affiliate of Kenneth G. Martin which subsequently filed for bankruptcy. The seller's rights under the contract were later purportedly assigned to Martin Intrastate. The original party seller was Martin Exploration Company, now a subsidiary of Tennessee. Tenneco's involvement in the case arose from its agreement to retain certain LIG liabilities in connection with its sale of LIG in 1989. In essence, Martin Intrastate originally claimed that it had been validly assigned all of seller's rights under the contract, that the contract was "statewide," covering all available gas that Martin Intrastate owned, controlled or had the right to sell, for its own account or for the account of others, and that the contract provided for a purchase price of about six times the current wellhead price. The Louisiana Court of Appeals held that Martin Exploration Company, the Tennessee subsidiary, holds the rights to sell gas to LIG under the "statewide" gas purchase contract. As a result of the denial of writ, the decision of the Louisiana Court of Appeals is final and nonappealable, and the case has been concluded without a material adverse effect on the financial condition or results of operations of Tenneco Inc. and its consolidated subsidiaries. Tenneco Inc. and its subsidiaries are parties to numerous other legal proceedings arising from their operations. Tenneco Inc. believes that the outcome of these proceedings, individually and in the aggregate, will have no material effect on the financial position or results of operations of Tenneco Inc. and its consolidated subsidiaries. Environmental Matters In 1988, Tennessee initiated an internal project to identify and deal with the presence of polychlorinated biphenyls (PCBs) at compressor stations operated by both its interstate and intrastate natural gas pipeline systems. This situation arose as a result of the use of a PCB-containing lubricant, purchased between 1953 and the early 1970's, in air compressors which are used to start the main gas compressor engines (lubricants containing PCBs were not used in the main gas compressor engines themselves). The project was subsequently expanded to include a full screening for the presence of other substances included on the U.S. Environmental Protection Agency List of Hazardous Substances. Tennessee conducted the project with frequent contact with federal and state regulatory agencies, both through informal negotiation and formal entry of consent orders, in order to assure that site characterization efforts met regulatory requirements. At the conclusion of a comprehensive study to estimate remediation costs for its compressor sites and all other sites on Tennessee's interstate and intrastate pipeline systems at which listed substances had been identified, Tenneco recorded a reserve of $260 million for estimated future environmental expenses including: 1) expected remediation expense and associated onsite, offsite and groundwater technical studies, 2) legal fees and 3) settlement of third party and governmental litigation, including civil penalties. Through December 31, 1993, Tenneco has charged $64 million against this environmental reserve. Based upon Tennessee's continuing evaluation and experience to date, Tenneco believes the amount of the reserve is still appropriate. Of the remaining reserve, $41 million has been recorded on the balance sheet under "Payables-trade" and $155 million under "Deferred credits and other liabilities." Tenneco believes that a substantial portion of these costs, which will be expended over the next five to ten years, will be recovered through rates charged to customers of its natural gas pipelines. The estimated costs expected to be recovered, amounting to $230 million, were recorded in 1991 as an asset ($30 million in "Current assets" and $200 million in "Investments and other assets"). The estimated unrecoverable portion, amounting to $30 million, was charged against income and reflected in "Operating expenses" in 1991. Tennessee is currently recovering environmental expenses annually in its rates. A significant portion of these expenses remains subject to review and refund in Tennessee's pending rate case. As of December 31, 1993, the asset balance is $167 million ($37 million in "Current assets" and $130 million in "Investments and other assets"). Tenneco believes that its liability insurance policies in effect during the period in which the environmental issues occurred provide coverage for remediation costs and related claims. In 1991, the Company commenced litigation in a Louisiana state court against 26 of its insurance carriers during this period, seeking recovery of losses which the Company incurred. The issues in dispute involve determining: 1) whether the presence of PCBs and other substances at each compressor station constituted a separate occurrence for purposes of the per-occurrence limits of the policies, 2) the applicability of the pollution exclusions in certain policies issued after 1971, 3) the applicability of provisions which exclude the environmental impacts located solely on the insured's property, 4) whether the term "property damage" in the policies will cover the cost of compliance with governmental clean-up directives, 5) the allocation of costs to the various policies in effect during the period the environmental impact occurred, 6) the applicability of provisions excluding pollution that is "expected or intended" and 7) the adequacy of notice of claims to insurance carriers. This environmental insurance coverage litigation remains pending. Tenneco has completed settlements with five of the defendants' carriers and believes that the likelihood of recovery against the remaining defendant carriers is reasonably possible. While it believes its legal position to be meritorious, Tenneco has not adjusted its environmental reserve to reflect any insurance recoveries. Tenneco has identified other sites in its various operating divisions where environmental remediation expense may be required should there be a change in ownership, operations or applicable regulations. These possibilities cannot be predicted or quantified at this time and accordingly, no provision has been recorded. However, provisions have been made for all instances where it has been determined that the incurrence of any material remedial expense is reasonably possible. 17. QUARTERLY FINANCIAL DATA (UNAUDITED) (a) Represents the redemption premium related to the retirement of long-term debt. (b) Includes a pre-tax restructuring charge of $920 million ($843 million after tax, or $5.85 per average common share). (c) The sum of the quarters does not equal the total of the respective year's earnings per share due to the issuance of additional shares throughout the year. The preceding notes are an integral part of the foregoing financial statements. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. There has been no change in accountants during 1993 or 1992, nor has there been any disagreement on any matter of accounting principles or practices or financial disclosure which in either case is required to be reported pursuant to this Item 9. 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", have been omitted from this report inasmuch as Tenneco Inc. will file with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this report a definitive Proxy Statement for the Annual Meeting of Stockholders of Tenneco Inc. to be held on May 10, 1994, at which meeting the stockholders will vote upon the election of directors. The information under the caption "Election of Directors" in such Proxy Statement is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. FINANCIAL STATEMENTS INCLUDED IN ITEM 8 See "Index to Financial Statements of Tenneco Inc. and Consolidated Subsidiaries" set forth in Item 8, "Financial Statements and Supplementary Data." INDEX TO FINANCIAL STATEMENTS AND SCHEDULES INCLUDED IN ITEM 14 SCHEDULES OMITTED AS NOT REQUIRED OR INAPPLICABLE SCHEDULE II TENNECO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES (THOUSANDS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- Note: Primarily temporary noninterest-bearing home loans. SCHEDULE III SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT TENNECO INC. STATEMENTS OF INCOME (LOSS) (The accompanying notes to financial statements are an integral part of these statements of income (loss).) SCHEDULE III (CONTINUED) SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT TENNECO INC. STATEMENTS OF CASH FLOWS - -------- Note: Cash and temporary cash investments include highly liquid investments with a maturity of three months or less at date of purchase. (The accompanying notes to financial statements are an integral part of these statements of cash flows.) SCHEDULE III (CONTINUED) SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT TENNECO INC. BALANCE SHEETS (The accompanying notes to financial statements are an integral part of these balance sheets.) SCHEDULE III (CONTINUED) SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT TENNECO INC. NOTES TO FINANCIAL STATEMENTS Accounting Policies The financial statements of Tenneco Inc. should be read in conjunction with the financial statements of Tenneco Inc. and Consolidated Subsidiaries presented in this document. Majority-owned subsidiaries and companies in which at least a 20% voting interest is owned are carried at cost plus equity in undistributed earnings since date of acquisition and cumulative translation adjustments. At December 31, 1993, equity in undistributed earnings and cumulative translation adjustments amounted to $3,692 million and $(280) million, respectively; at December 31, 1992, the corresponding amounts were $2,961 million and $(199) million, respectively. Dividends received from companies accounted for on an equity basis amounted to none, $121 million and $10 million for 1993, 1992 and 1991, respectively. Income Taxes Tenneco Inc.'s pre-tax earnings (losses) from continuing operations (excluding equity in net income (loss) from continuing operations of affiliated companies) for the years 1993, 1992 and 1991 are principally domestic. The differences between the U.S. income tax benefit, reflected in the Statements of Income (Loss), of $80 million, $93 million and $104 million for the years 1993, 1992 and 1991 and the income tax expense (benefit), computed at the U.S. federal income tax rates, of $130 million, $(264) million and $(271) million, respectively, consisted principally of the tax effect of equity in net income (loss) from continuing operations of affiliated companies. Long-Term Debt and Current Maturities The aggregate maturities and sinking fund requirements applicable to the long-term debt issues outstanding at December 31, 1993, are $135 million, $10 million, $160 million, $19 million and $774 million for 1994, 1995, 1996, 1997 and 1998, respectively. Financial Instruments Tenneco Inc. has guaranteed the performance of certain subsidiaries pursuant to arrangements under which receivables are factored on a nonrecourse basis with Tenneco Credit Corporation. Also, Tenneco Inc. has agreed to pay to Tenneco Credit Corporation a service charge to the extent necessary so that the earnings of Tenneco Credit Corporation and its consolidated subsidiaries (before fixed charges and income taxes) are not less than 125% of the fixed charges. (The above notes are an integral part of the foregoing financial statements.) SCHEDULE V TENNECO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE V -- PLANT, PROPERTY AND EQUIPMENT (NOTE 1) (MILLIONS) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - ---- Notes: (1) Reference is made to Note 1 to financial statements in Part II for bases of provision for depreciation and amortization. (2) Retirements of plant by the Natural gas pipelines group are recorded at original cost, and retirements of other properties are recorded at cost. (3) Includes acquired companies at date of acquisition (1991 includes $34 million by the Packaging group and $1 million by the Automotive parts group, 1992 includes $11 million by the Natural gas pipelines group and 1993 includes $1 million by the Automotive parts group). (4) Includes FAS No. 52 foreign currency translation changes totaling $(35) million, $(283) million and $(86) million in 1991, 1992 and 1993, respectively. (5) Includes FAS No. 109 accounting principle changes of $70 million in the Farm and construction equipment group and $12 million in the Packaging group. See Note 1 to financial statements in Part II for additional information. (6) Includes amounts charged to restructuring expense of $(340) million in the Farm and construction equipment group. See Note 2 to financial statements in Part II for additional information. SCHEDULE VI TENNECO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT (NOTE 1) (MILLIONS) - ---- Notes: (1) Reference is made to Note 1 to financial statements in Part II for bases of provision for depreciation and amortization. (2) Includes amounts charged to discontinued operations of $24 million for 1991 and $13 million for 1992 in the Chemicals and minerals group. (3) Includes FAS No. 52 foreign currency translation changes totaling $(9) million, $(129) million and $(47) million in 1991, 1992 and 1993, respectively. (4) Includes FAS No. 109 accounting principle changes of $27 million in the Farm and construction equipment group and $2 million in the Packaging group. See Note 1 to financial statements in Part II for additional information. SCHEDULE VIII TENNECO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS (MILLIONS) ============================================================================== - -------- Note: Uncollectible accounts written off, net of recoveries on accounts previously written off. SCHEDULE IX TENNECO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS (NOTE) (MILLIONS) - -------- Note: See Note 7 to the financial statements in Part II for additional information. SCHEDULE X TENNECO INC. AND CONSOLIDATED SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS) ================================================================================ REPORTS ON FORM 8-K During the fourth quarter of the fiscal year ended December 31, 1993, Tenneco Inc. filed with the Securities and Exchange Commission a Current Report on Form 8-K dated November 1, 1993, with respect to the issuing of a press release regarding the medical condition of Mike Walsh, Chairman and Chief Executive Officer of Tenneco Inc. EXHIBITS The following exhibits are filed with Tenneco Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1993, or incorporated therein by reference (exhibits designated by an asterisk were filed with the Report; all other exhibits were incorporated by reference): UNDERTAKING. The undersigned, Tenneco Inc., hereby undertakes pursuant to Regulation S-K, Item 601(b), paragraph (4)(iii), to furnish to the Securities and Exchange Commission upon request all constituent instruments defining the rights of holders of long-term debt of Tenneco Inc. and its consolidated subsidiaries not filed herewith for the reason that the total amount of securities authorized under any of such instruments does not exceed 10% of the total consolidated assets of Tenneco Inc. and its consolidated subsidiaries. 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. Tenneco Inc. Dana G. Mead By___________________________________ President and Chief Executive Officer Date: March 9, 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 T. R. Tetzlaff March 9, 1994 -------------------------------------- Attorney-in-fact - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- EXHIBITS TO FORM 10-K ANNUAL REPORT UNDER THE SECURITIES EXCHANGE ACT OF 1934 FOR TENNECO INC. FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 COMMISSION FILE NO. 1-9864 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INDEX TO EXHIBITS - -------- * Exhibit incorporated by reference.

7383_1993.txt

7383_1993

1993

7383

ITEM 1. BUSINESS General Armco Inc. ("Armco" or the "Company") was incorporated as an Ohio corporation in 1917 as a successor to a New Jersey corporation incorporated in 1899. Armco is the second largest domestic producer of stainless flat-rolled steels and is the largest domestic producer of electrical steels in terms of sales revenues. The Company also produces carbon steels and steel products and tubular steel goods. The Company is a partner in Armco Steel Company, L.P. ("ASC"), a 50%-owned joint venture with Kawasaki Steel Corporation ("Kawasaki") that produces primarily high-strength, low-carbon flat-rolled steel products. Armco is also a partner in North American Stainless ("NAS"), a 50%-owned joint venture with Acerinox S.A. that finishes chrome nickel flat-rolled stainless steel. The Company owns a 50% partnership interest in National-Oilwell, a distributor of oil country tubular goods and a manufacturer of drilling, production and other oil and gas equipment that operates a network of oil field supply stores throughout North America. Armco also provides insurance services through businesses it intends to sell or liquidate. As part of its strategy to focus on Specialty Flat-Rolled Steel, Armco has continued to evaluate the growth potential and profitability of its businesses and investments, and to rationalize or divest those that do not represent a strategic fit or offer growth potential or positive cash flow. In 1992 and 1993, Armco divested or otherwise rationalized several unprofitable or non-strategic operations. In September 1993, Armco sold its joint venture interest in several wire-drawing operations in its Worldwide Grinding Systems segment, and in November 1993, Armco sold the balance of its Worldwide Grinding Systems business. Also in September 1993, Armco sold Armco do Brasil S.A., its Brazilian sheet and strip business, and made a decision to dispose of several other businesses in its Other Steel and Fabricated Products segment, including Miami Industries (which was sold in October 1993), its Tex-Tube Division, its conversion services businesses and Flour City Architectural Metals. On January 28, 1994, Armco signed a letter of intent to sell its ongoing insurance operations to Vik Brothers Insurance, Inc., a privately owned property and casualty insurance holding company. Under the terms of the letter of intent, approximately $70 million would be received at closing and approximately $15 million would be received in three years, the latter payment being subject to a reserve analysis and potential adjustment at that time. As a result of restructuring certain obligations arising from the 1992 merger plan for the runoff companies, the proceeds from the sale have been pledged as security for certain note obligations due to the runoff insurance companies and will be retained in the investment portfolio of the Armco Financial Services Group runoff companies. The transaction is subject to a number of conditions, including a definitive purchase agreement, approval by regulatory authorities and approval of the boards of directors of Armco and the purchaser. In connection with the foregoing actions, Armco recorded in 1993 charges totaling $250.5 million, which included special charges of $165.5 million reflected in operating losses, and an $85.0 million charge reflected as loss on disposal of discontinued operations, which included a $45.0 million charge for expenses and losses in connection with the proposed sale of the ongoing insurance companies and $40.0 million in connection with the sale of the Worldwide Grindings Systems segment. The previously reported initial public offerings of equity and debt, through which ASC would implement its plan to restructure and recapitalize itself, commenced on March 30, 1994, with the underwritten public offerings by the corporate successor to ASC of approximately 17.6 million shares of common stock, at $23.50 per share, and $325 million of senior notes. The sales of the securities and the restructure and recapitalization are scheduled to be completed on April 7, 1994. Under the terms of the plan, the proceeds from the offerings will be used by ASC primarily to reduce its debt and unfunded pension liability, Armco's obligations to make certain cash payments to ASC will be eliminated and Armco will receive approximately 1 million shares, or approximately 4.2%, of the successor corporation's common stock. Business Segments Following the sale in the fourth quarter of 1993 of the business of Armco's former Worldwide Grinding Systems segment, Armco will report its businesses in two segments -- Specialty Flat-Rolled Steel and Other Steel and Fabricated Products. The information on the amounts of revenue, operating results and identifiable assets attributable to each of Armco's business segments set out in Note 9 of the Notes to Financial Statements in Armco's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference herein. Additional information about Armco's business segments and equity investments is set forth in Management's Discussion and Analysis in Armco's Annual Report to Shareholders for the year ended December 31, 1993, which is incorporated by reference herein. Specialty Flat-Rolled Steel Armco's Specialty Flat-Rolled Steel businesses produce and finish stainless and electrical steel sheet and strip and stainless plate. The Specialty Flat-Rolled Steel group is headquartered in Butler, Pennsylvania, with its principal manufacturing plants in Butler and Zanesville, Ohio, where Armco produces flat-rolled stainless and electrical steel sheet and strip products, and in Coshocton, Ohio, where Armco finishes premium quality flat-rolled stainless steel in strip and sheet form. The segment also includes Eastern Stainless Corporation ("Eastern"), an 84%-owned subsidiary located in Baltimore, Maryland, which is a leading domestic producer of stainless steel plate as well as the results of European trading companies that buy and sell steel and manufactured steel products. Armco has a 50% interest in NAS, located in Carrollton, Kentucky, which began customer shipments in mid-1993 and can finish flat-rolled stainless steel in widths up to 60 inches. The NAS interest is accounted for as an equity investment. The specialty steel industry is a relatively small but distinct segment of the overall steel industry that represented approximately 2% of domestic steel tonnage but accounted for approximately 17% of domestic steel revenues in 1993. Specialty steels refer to alloy tool steel, electrical steel and stainless sheet, strip, plate, bar, rod and wire products. Specialty steels differ from basic carbon steel by their metallurgical composition. They are made with a high alloy content, which enables their use in environments that demand exceptional hardness, toughness, strength and resistance to heat, corrosion or abrasion or combinations thereof. Unlike high-volume carbon steel, specialty steel is generally produced in relatively small quantities utilizing special processing techniques designed to meet more exacting specifications and tolerances. Stainless steel, which represents the largest part of the specialty steel market, contains elements such as chromium, nickel and molybdenum that give it the unique qualities of resistance to rust, corrosion and heat; high strength; good wear characteristics; natural attractiveness; and ease of maintenance. Stainless steel is used, among other things, in the automotive, aircraft, and aerospace industries and in the manufacture of food handling, chemical processing, pollution control and medical and health equipment. Electrical steels are iron-silicon alloys and, through special production techniques, possess unique magnetic properties that make them desirable for use as energy efficient core material in such applications as electrical transformers, motors and generators. Since 1975, usage of stainless steel in the United States has more than doubled. Armco expects that the demand for stainless steel will continue to be positively affected by increasing use in the manufacture of consumer durable goods and industrial applications. Per capita stainless steel usage in many highly developed countries significantly exceeds usage per capita in the United States and Armco believes that this is an indication of the growth potential of demand for stainless steel in the United States. In addition, the 1990 amendments to the Clean Air Act have resulted in the increasing use of corrosion-resistant materials in a number of applications for which stainless steel is well suited, including industrial pollution control devices and motor vehicle exhaust systems for use in the United States, where Armco now has the leading market share. Another factor that Armco believes will affect demand positively is the increasing issuance of new car bumper-to-bumper warranties and the use of stainless steel in passenger restraint systems. Stainless steel products generate higher average profit margins than carbon steel products and, depending on the stainless grade, sell at average prices of three to five times those of carbon steel. Armco produces flat-rolled stainless steel and alloy electrical steel sheet and strip products that are used in a diverse range of consumer durables and industrial applications. Since the acquisition of Cyclops, approximately 70% of Armco's sales of Specialty Flat-Rolled Steel has been stainless steel and 30% has been electrical steel. Major markets served are industrial machinery and electrical equipment, automotive, construction and service centers. In the stainless steel market, Armco is the leading domestic producer of chrome grades used primarily in the domestic market for automotive exhaust components. Stainless steel, which formerly was not used in parts of the exhaust system other than the catalytic converter, is now used in the entire exhaust system from manifold to tailpipe by many auto manufacturers. Armco has developed a number of specialty grades for this application, many of which are patented. Armco is also known for its "bright anneal" chrome grade finishes utilized for automotive and appliance trim and other chrome grades used for cutlery, kitchen utensils, scissors and surgical instruments. Specialty chrome nickel grades produced by Armco are used in household cookware, restaurant and food processing equipment and medical equipment. Commodity chrome nickel stainless steel finished by NAS and marketed by Armco is expected to meet anticipated demand from steel service centers and end users who serve the domestic chemical, pulp and paper, construction and food and beverage industries. Other Armco stainless products include functional stainless steel manufactured for automotive, agricultural, heating, air conditioning and other manufacturing uses and Eastern's stainless steel plate, principally in flat plate form, for use in industrial applications where high resistance to heat, stress or corrosion is required. Typical users of stainless steel plate include the chemical processing, pulp and paper, food and beverage, waste treatment, environmental control and textile industries for applications such as tanks, piping and tubing, flue gas scrubbers and heat exchangers. Eastern is also the only domestic producer of diamond-patterned stainless floor plate that is used primarily in decking for ships and chemical plant construction. Armco is the only United States manufacturer of a complete line of flat-rolled electrical steel sheet and strip products and is the sole domestic producer of certain high permeability oriented electrical steels. It is also the only domestic manufacturer utilizing laser scribing technology. In this process, the surface of electrical steel is etched with high-technology lasers which refine the magnetic domains of the steel resulting in superior electrical efficiency. Major electrical product categories are: Regular Grain Oriented ("RGO"), used in the cores of energy-efficient power and distribution transformers; Cold Rolled Non-Oriented ("CRNO"), used for electrical motors and lighting ballasts; and TRAN COR(R)H, which is used in power transformers and is the only high permeability electrical steel made domestically. In 1993, Armco exported approximately 18.7% of its RGO product to Mexico, South America and other international markets. Armco had trade orders in hand for its Specialty Flat-Rolled Steel segment of $154.8 million at December 31, 1993, and $132.7 million at December 31, 1992. The backlog increased in 1993 due to stronger demand and an improving economy. While substantially all of the orders in hand at year-end 1993 are expected to be shipped in 1994, such orders, as is customary in the industry, are subject to modification, extension and cancellation. Armco's specialty steelmaking operations are concentrated in the four contiguous states of Pennsylvania, Ohio, Kentucky and Maryland, which permits cost-efficient materials flow between plants. Armco's Butler, Pennsylvania facility, which is situated on 1,300 acres with 3.2 million square feet of buildings, continuously casts 100% of its steel. At Butler, melting takes place in three 165-ton electric arc furnaces that feed the world's largest (175-ton) argon-oxygen decarburization unit for refining molten metal that, in turn, feeds two double strand continuous casters. The melt capacity at Butler was approximately 850,000 tons by year-end 1993. Butler also operates a hot-strip mill, anneal and pickle units and a fully-automated tandem cold-rolling mill. It also has various intermediate and finishing operations for both stainless and electrical steels. Armco's Zanesville, Ohio plant, with 508,000 square feet of buildings on 88 acres, is a dedicated finishing plant for some of the steel produced at the Butler facility and has a Sendzimer cold-rolling mill, anneal and pickle units, high temperature box anneal and other decarburization and coating units. The world-class finishing plant in Coshocton, Ohio, located on 650 acres, is housed in a 500,000 square-foot plant and has three Sendzimer mills, four anneal and pickle lines, three "bright anneal" lines, two 4-high mills for cold reduction and other processing equipment, including temper rolling, slitting and packaging facilities. Armco's joint venture, NAS, which began customer shipments in mid-1993, is a state-of-the-art stainless steel finishing facility in Carrollton, Kentucky. NAS produces high volume grades of flat-rolled chrome nickel stainless in coils up to 30 tons and in widths up to 60 inches, a product that offers cost and handling savings to customers. The new plant is highly automated, featuring anneal and pickle lines, a Sendzimer cold-rolling mill, and other related equipment using world-class technology. Since Eastern discontinued its melt operations on July 22, 1993, Eastern's operations consist primarily of a hot plate rolling mill and finishing facility in Baltimore, Maryland, with its slab requirements largely being supplied by Armco's Butler facility. Other Steel and Fabricated Products The Other Steel and Fabricated Products segment includes steelmaking, fabricating and processing plants in Pennsylvania and Ohio; a nonresidential construction company; a steel tubing company; and a snowplow manufacturer. The businesses in this segment currently include: -- Carbon steel operations at Mansfield, Ohio, which produce commodity grades of carbon steel sheet, much of which is coated at a dedicated galvanizing facility at Dover, Ohio. Under a plan to spend approximately $100 million at Mansfield to enhance its steel production capability and improve the operating performance of both the Mansfield and Dover, Ohio operations, Armco has begun installing a thin-slab caster and related plant modifications at Mansfield. Installation is expected to be completed in 1995. The caster is designed to produce carbon steels, functional grades of chrome stainless steels and nonoriented grades of electrical steels. The Mansfield plant currently consists of a 1.4 million square-foot facility, with a melt shop with two electric arc furnaces (170-ton and 100-ton), a 100-ton argon-oxygen decarburization unit, a six-stand hot strip mill, a five-stand tandem cold rolling mill and a newly retrofitted Z-mill for chrome stainless finishing. On March 28, 1994, Armco announced its intention to idle the production facilities at its Empire-Detroit carbon steel plant in Mansfield, Ohio and the Dover, Ohio galvanizing plant. The plants are expected to remain idle until the previously announced construction of a $100 million thin-slab caster is completed, which is scheduled for mid-1995. Armco expects to recognize a special charge of up to $20 million in the first quarter of 1994 for the cost of benefits to employees on layoff and other costs of idling the facilities, as well as costs associated with planned permanent work force reductions. -- Douglas Dynamics, which is the largest North American manufacturer of snowplows for four-wheel drive pick-up trucks and utility vehicles. Douglas Dynamics is headquartered in Milwaukee, Wisconsin, has snowplow manufacturing plants in Rockland, Maine and Milwaukee, Wisconsin and sells its snowplows through independent distributors throughout the United States and Canada. -- Sawhill Tubular, which produces steel pipe and tubing, electric welded and mandrel-drawn steel tubing and electric-resistance welded steel pipe at its plant in Pennsylvania. During 1993, Armco divested or decided to dispose of various businesses previously in this segment: -- Armco sold Miami Industries, a steel tubing company, in October 1993, and has also decided to dispose of Tex-Tube, another steel tubing business. As of September 30, 1993, results for both Miami Industries and Tex-Tube are no longer reported as part of the Other Steel and Fabricated Products segment. -- Flour City Architectural Metals, headquartered in Glen Cove, New York, which designs, fabricates and installs custom curtain wall systems in nonresidential commercial and institutional construction. In February 1993, Armco sold part of its nonresidential construction business. As of September 30, 1993, Armco decided to dispose of the remainder of this business and no longer reports the results of its nonresidential construction businesses as part of the Other Steel and Fabricated Products segment. -- Conversion services (remelting, forging, blooming, anneal and pickling and heat treating) provided in plants in Baltimore, Maryland and Bridgeville, Pennsylvania. As of September 30, 1993, Armco decided to dispose of these businesses and no longer reports their results as part of the Other Steel and Fabricated Products segment. This segment also included the business of Armco do Brasil S.A., a fabricating and processing plant in Brazil that processed semi-finished steel. Armco sold this business in September 1993. Armco had trade orders in hand for its Other Steel and Fabricated Products segment of $73.0 million at December 31, 1993. The segment's backlog decreased in 1993 primarily as a result of the 1993 sale or planned divestiture of a number of businesses. While substantially all of the orders in hand at year-end 1993 are expected to be shipped in 1994, such orders, as is customary in these industries, are subject to modification, extension and cancellation. Employees At December 31, 1993, Armco had approximately 6,600 employees in its continuing operations and approximately 2,300 employees in its insurance and discontinued operations. Most of Armco's domestic production and maintenance employees are represented by international, national or independent local unions, although some operations are not unionized. Eastern recently completed two-year agreements with the United Steelworkers of America ("USWA"), the union that represents employees at the Eastern plant in Baltimore, Maryland. Armco also recently completed 36-month and 33-month agreements, respectively, with the local unions at the specialty steel plants in Butler, Pennsylvania and Zanesville, Ohio. In late June, the USWA employees at Armco's Mansfield and Dover, Ohio plants ratified new six-year contracts, which became effective September 1, 1993. Competition Armco's steel products are subject to wide variations in demand because of changes in business conditions. Armco faces intense competition within the domestic steel industry, from foreign steel producers, from manufacturers of products other than steel, including aluminum, ceramics, plastics and glass, and from foreign producers of steel components and products that typically have lower labor costs. In addition, many foreign steel producers are owned, controlled or subsidized by their governments and their decisions with respect to production and sales may be influenced more by political and economic policy considerations than by prevailing market conditions. Some foreign producers of steel and products made of steel have continued to ship into the United States market despite decreasing profit margins or losses. If certain pending trade proceedings ultimately do not provide relief from unfairly traded imports, if other relevant U.S. trade laws are weakened, if world demand for steel declines or if the U.S. dollars strengthens, an increase in the market share of imports may occur and the pricing of the Company's products could be adversely affected. Competition is based primarily on price, with factors such as reliability of supply, service and quality also being important in certain segments. In addition to the other integrated steel producers, competition is presented by the so-called "mini-mills," which generally have smaller, non-unionized work-forces and are free of many of the employer, environmental and other obligations that traditionally have burdened integrated steel producers. Mini-mills also derive certain competitive advantages by utilizing less capital intensive sources of steel production. At least one of these mini-mills is already producing flat-rolled carbon steel products while others have considered doing the same. In future years, mini-mills may provide increased competition in the higher quality, value added product lines now dominated by the integrated carbon steel producers and stainless steel producers. Import penetration for stainless sheet and strip in 1993 and 1992 was 25.2% and 17.8%, respectively, and for stainless plate was 16.0% and 14.5%, respectively. Import penetration of electrical steel was 22.7% and 17.5%, respectively, during such periods. Voluntary steel import restraint agreements ("VRAs"), intended to achieve certain disciplines over market-distortive trade practices in the carbon and specialty steel industries, expired on March 31, 1992. With the expiration of the VRAs, Armco is unable to predict the level of future steel imports. Existing trade laws or current regulations may not be adequate to prevent unfair trading practices and imports may pose increasingly serious problems for the domestic specialty steel industry. This is particularly so if United States trade laws are weakened in the ongoing General Agreement on Tariffs and Trade Uruguay Round or the Multilateral Steel Agreement trade negotiations. At this time, it cannot be predicted with any degree of certainty what the outcome of such negotiations will be. Armco's carbon steel operations at Mansfield, Ohio, may also be adversely affected by the outcome of recent International Trade Commission ("ITC") and United States Department of Commerce ("Commerce Department") rulings on trade cases. On June 30, 1992, the major carbon steelmakers filed 84 trade cases against foreign producers of carbon steel from 21 countries charging them with selling steel below their home market prices and receiving unfair trade subsidies that are illegal under United States trade laws. On August 21, 1992, the ITC made affirmative preliminary determinations in 72 of the cases (affecting 95% of the volume of imports alleged to have been unfairly traded), finding that there was a reasonable indication that the domestic steel industry had been materially injured or was threatened with material injury by the imports in question. On June 22, 1993, the Commerce Department reached a final determination that foreign producers from 12 countries had unfairly benefited from government subsidies and that certain steel producers from 19 countries had unlawfully dumped steel and steel products in the U.S. market. On July 27, 1993, the ITC ruled that foreign producers had not caused injury to the domestic producers of hot-rolled carbon steel, although about one-third of the claims were upheld against foreign cold-rolled producers, and generally all claims against foreign coated carbon steel producers were upheld. This ruling was generally unfavorable for the domestic carbon steel industry, since it partially reversed previously assessed duties on foreign producers. It is too early to assess the effect, if any, that the rulings will have upon future pricing and demand for domestically produced products. The rulings, however, were generally favorable for coated carbon steel products, one of Mansfield's major product lines. Anti-dumping and countervailing duties might be imposed against those imports for which the ITC made a final affirmative injury determination. These duties are designed to offset "dumping" and the advantages of foreign subsidies and create a "level playing field" for domestic producers in the U.S. market. The Company and other U.S. steel producers have appealed certain of the ITC's determinations to the United States Court of International Trade, and foreign steel producers have appealed certain other of the ITC's determinations, as well as certain of the Commerce Department's determinations. During 1993, steel imports increased to 19.5 million tons, versus 17.1 million tons in 1992, an increase of 14.2%. In 1993, imports accounted for 18.8% of U.S apparent steel supply, versus 18.0% in 1992. Armco, Allegheny Ludlum Corporation, the USWA and the independent unions at Armco's plants in Butler, Pennsylvania and Zanesville, Ohio have filed a petition requesting that the U.S. government impose both antidumping and countervailing duties on imports of grain-oriented electrical steel from Italy. In addition, Allegheny Ludlum Corporation and the USWA petitioned the U.S. government to assess antidumping duties on imports of grain-oriented electrical steel from Japan. In October 1993, the ITC issued a preliminary determination of material injury due to subsidized and dumped grain-oriented electrical steel from Italy and dumped grain-oriented electrical steel from Japan. The Commerce Department announced on January 25, 1994, a preliminary CVD (subsidy) margin of 23.14% against Italy. On February 3, 1994, the Commerce Department announced preliminary anti-dumping margins of 5.62% against Italy and 31.08% against Japan. A final ruling by the ITC is anticipated in June of 1994. Specialty steel (stainless sheet and strip, plate, bar, rod and wire, and electrical steels) imports accounted for approximately 26.5% of the domestic market in 1993, 20.8% in 1992, and 18.1% in 1991. Raw Materials and Energy Sources Raw material prices represent a major component of per ton production costs in the specialty steel industry. The principal raw materials used by Armco in the production of specialty steels are iron and steel scrap, chrome and nickel and their ferroalloys, stainless steel scrap, silicon and zinc. These materials are purchased in the open market from various outside sources. Since much of this purchased raw material is not covered by long-term contracts, availability and price are subject to world market conditions. Chrome and nickel and certain other materials in mined alloy form can be acquired only from foreign sources, many of them located in developing countries that may be subject to unstable political and economic conditions that might disrupt supplies or affect the price of these materials. A significant portion of the chrome and nickel requirements, however, is obtained from stainless steel scrap rather than mined alloys. While certain raw materials have been in short supply from time to time, Armco currently is not experiencing and does not anticipate any problems obtaining appropriate materials in amounts sufficient to meet its production needs. Armco also uses large amounts of electricity and natural gas in the manufacture of its products. It is expected that such energy sources will continue to be reasonably available in the foreseeable future. Compliance with amendments to the Clean Air Act, enacted in November 1990, may increase the operating costs of the utilities providing services to Armco's facilities, and in turn may result in increased costs to Armco for utility services. Environmental Matters Armco, in common with other United States manufacturers, is subject to various federal, state and local requirements for environmental controls relating to its operations. Armco has spent substantial amounts in recent years to control air and water pollution to achieve and maintain compliance with applicable environmental requirements. Armco also has spent and will continue to spend substantial amounts for proper waste disposal and for the investigation and cleanup of properties that require remediation as a result of past waste disposal. Statutory and regulatory requirements in this area are continuing to evolve and, accordingly, it is not possible to predict with certainty the type and magnitude of expenditures that will be required in the future. However, Armco has estimated aggregate expenditures of approximately $30.0 million during the three-year period 1993-1995, of which approximately $20.0 million is related to control of air pollution as required by amendments to the Clean Air Act (enacted in November 1990), corresponding state laws and implementing regulations (which amount does not include approximately $7.0 million in estimated capital expenditures related to Armco Worldwide Grindings Systems segment, the business of which was sold in 1993) for capital projects for pollution control in all its domestic and international operations, with the largest expenditures being made in the Specialty Flat-Rolled Steel segment. This projection has been prepared internally and without independent engineering or other assistance and reflects Armco's current analysis of probable required capital projects for pollution control. Expenditures associated with remediation matters for which Armco is one of a number of potentially responsible parties are generally not included. In addition to the direct impact on Armco, the Clean Air Act amendments are expected to increase the operating cost of electrical utilities which rely on fossil fuels and this, in turn, could result in increased costs for utility services of which certain operations of Armco are significant customers. Armco's capital expenditures for pollution control projects amounted to approximately $4.1 million in 1993. During the period 1982 through 1992, Armco's capital expenditures for pollution control projects amounted to approximately $72.6 million (which amounts do not include such expenditures related to Armco Worldwide Grinding Systems segment, the business of which has been reclassified as a discontinued operation). Armco also is a party to a number of administrative proceedings and negotiations with environmental regulatory authorities. Armco believes that the ultimate liability from environmental-related liabilities will not materially affect the consolidated financial position or liquidity of Armco; however, it is possible that due to fluctuations in Armco's operating results, future developments with respect to such matters could have a material effect on the results of future operations or liquidity in interim or annual periods. Under the federal Comprehensive Environmental Response, Compensation and Liability Act, certain analogous state laws, and the federal Resource Conservation and Recovery Act, past disposal of wastes, whether on-site or at other locations, may result in the imposition of cleanup obligations by federal or state regulatory authorities or other potentially responsible parties, even when the wastes were disposed of in accordance with applicable laws and requirements in existence at the time of the disposal. The federal government has asserted that joint and several liability applies to hazardous waste litigation and courts have held that, absent proof that damages are allocable or subject to allocation, joint and several liability will be applied. Armco has been named as a defendant, or identified as a potentially responsible party, in various proceedings wherein the state or federal government or another potentially responsible party seeks reimbursement for or to compel clean-up of hazardous waste sites. Armco has been required to perform or fund such cleanup or participate in cleanup with others at a number of sites at which its facilities or facilities formerly owned by Armco disposed of wastes in the past and may, from time to time, be required to remediate or join with others in the remediation of other locations as these sites are identified by federal and state authorities. Armco and its subsidiaries are also parties to some lawsuits with respect to alleged property damage and personal injury from waste disposal sites. In addition, environmental exit costs with respect to Armco's ongoing businesses (which costs it is Armco's policy not to accrue until a decision is made to dispose of a property) may be incurred if Armco makes a decision to dispose of additional properties. These costs include remediation and closure costs of clean-up such as for soil contamination, closure of waste treatment facilities and monitoring commitments. While Armco believes that the ultimate liability for the environmental remediation matters identified to date, including the clean-up, closure and monitoring of waste sites, will not materially affect its consolidated financial condition or liquidity, the identification of additional sites, increases in remediation costs with respect to identified sites, the failure of other potentially responsible parties to contribute their share of remediation costs, decisions to dispose of additional properties and other changed circumstances may result in increased costs to Armco, which could have a material effect on its financial condition, liquidity and results of operations. Research and Development Armco carries on a broad range of research and development activities aimed at improving its existing products and manufacturing processes and developing new products and processes. Armco's research and development activities are carried out primarily at a central research and technology laboratory located in Middletown, Ohio. This laboratory is engaged in applied materials research related to iron and steel, non-ferrous materials and new materials. In addition, the materials and metallurgy departments at each operating unit develop and implement improvements to products and processes that are directly connected with the activities of such operating unit. Armco spent $12.9 million, $24.0 million and $23.6 million, respectively, on research in each of the three years ended December 31, 1993, 1992 and 1991 (including $3.9 million, $9.4 million and $11.8 million, respectively, funded by affiliates, primarily ASC, in each of such years). Equity and Other Investments Armco's equity and other investments include ASC, NAS (discussed above under "Specialty Flat-Rolled Steel"), Armco Financial Services Group ("AFSG") and National-Oilwell. Armco Steel Company, L.P. ASC is a joint venture limited partnership formed in 1989 by Armco and Kawasaki. With plants located in Middletown, Ohio and Ashland, Kentucky, ASC produces primarily high strength, low carbon flat-rolled steel. These products are supplied to the automotive, appliance and manufacturing markets, as well as to the construction industry and independent steel distributors and service centers. Effective May 13, 1989, substantially all of the assets, properties, business and liabilities of Armco's former Eastern Steel Division were transferred to, or assumed by, ASC, a Delaware limited partnership managed by a general partner corporation equally owned by subsidiaries of Armco and Kawasaki. The previously reported initial public offerings of equity and debt, through which ASC would implement its plan to restructure and recapitalize itself, commenced on March 30, 1994, with the underwritten public offerings by the corporate successor to ASC of approximately 17.6 million shares of common stock, at $23.50 per share, and $325 million of senior notes. The sales of the securities and the restructure and recapitalization are scheduled to be completed on April 7, 1994. Under the terms of the plan, the proceeds from the offerings will be used by ASC primarily to reduce its debt and unfunded pension liability, Armco's obligations to make certain cash payments to ASC will be eliminated and Armco will receive approximately 1 million shares, or approximately 4.2%, of the successor corporation's common stock. The domestic steel industry is highly competitive. Despite significant reductions in raw steel producing capability by major domestic producers over the last decade, the domestic industry continues to be adversely affected by excess world capacity. Over the last decade, extensive downsizings have necessitated costly restructuring charges that, when combined with highly competitive market conditions, have resulted in substantial losses for most domestic integrated steel producers. Carbon steel consumption in the United States has not grown with the overall economy in recent years. Producers of steel products face substantial competition from manufacturers of plastics, aluminum, ceramics, glass, concrete and other materials. While domestic carbon steel producers have taken action to scale back their operations through corporate reorganizations or as a result of bankruptcy proceedings, which actions have resulted in the closing of numerous production facilities, there still exists significant excess capacity in the domestic carbon steel industry. Overall, domestic steel capability utilization (including specialty steels) was approximately 87% during 1993. From time to time industry overcapacity has created an operating environment in which competing producers engaged in significant price discounting in order to maintain or gain market share. A number of major domestic steelmakers now operate under, or have emerged from, bankruptcy protection and have lower operating costs, which permit them to sell their products at lower prices. Further, domestic integrated carbon steel producers (including ASC) have lost market share to domestic mini-mills and low-cost reconstituted mills in recent years as these mills have expanded their product lines to include large-size structural products and certain carbon steel flat-rolled products, including thin cast slabs. Management believes that, before the cost reductions that have been effected in the last six months, ASC's cost per ton of steel was significantly higher than experienced by its domestic and foreign competitors and that its cost per ton is still higher than those of a number of its competitors, particularly the mini-mills. Imports of carbon steel and steel products have had a particularly adverse impact on domestic carbon steel shipments and pricing. High labor costs, including pension, health and other employee benefit obligations, and restrictive work practices are likely to continue to be competitive disadvantages for ASC and other domestic producers. Furthermore, foreign producers frequently have received subsidized financing and many are owned or controlled by foreign governments and base their decisions with respect to steel production and pricing on political and economic policy considerations as well as business factors. As a result of voluntary steel import restraint arrangements negotiated in 1985 between the United States and certain other steel-producing nations, steel imports declined from the levels of the mid-1980's. However, such arrangements expired in March 1992 without being extended or replaced with other import restrictions. Existing trade laws or trade negotiations may not be adequate to prevent unfair trading practices. On June 30, 1992, the major carbon steelmakers filed 84 trade cases against foreign producers of carbon steel from 21 countries charging them with selling steel below their home market prices and receiving unfair trade subsidies that are illegal under United States trade laws. On August 21, 1992, the ITC made affirmative preliminary determinations in 72 of the cases (affecting 95% of the volume of imports alleged to have been unfairly traded), finding that there was a reasonable indication that the domestic steel industry had been materially injured or was threatened with material injury by the imports in question. On June 22, 1993, the Commerce Department reached a final determination that foreign producers from 12 countries had unfairly benefited from government subsidies and that certain steel producers from 19 countries had unlawfully dumped steel and steel products in the U.S. market. On July 27, 1993, the ITC ruled that foreign producers had not caused injury to the domestic producers of hot-rolled carbon steel, although about one-third of the claims were upheld against foreign cold-rolled producers, and generally all claims against foreign coated carbon steel producers were upheld. On November 30, 1992, and January 27, 1993, the Commerce Department assigned preliminary duties on subsidy and dumping cases, respectively. However, on July 27, 1993, the ITC ruled that foreign producers had not caused injury to the domestic producers of hot-rolled carbon steel, although about one-third of the claims were upheld against foreign cold-rolled producers, and generally all claims against foreign coated carbon steel producers were upheld. This ruling was generally unfavorable for the domestic carbon steel industry, since it partially reversed previously assessed duties on foreign producers. It is too early to assess the effect, if any, that the rulings will have upon future pricing and demand for domestically produced products. The automotive industry, directly or indirectly, comprises the most substantial portion of the total sales of ASC. Significant downturns in the domestic automotive industry have had and likely would have a material adverse effect on ASC's profitability. At December 31, 1993, ASC had approximately 6,400 active employees. Most of the production and maintenance employees are represented by national or independent local unions. ASC steelmaking employees at its Ashland, Kentucky, facility are covered under an agreement with the USWA. The contract, which was originally scheduled to expire on July 31, 1993, has been extended to June 1, 1994. ASC coke-making employees at the Ashland facility are covered under an agreement with the Oil, Chemical & Atomic Workers union, which was scheduled to expire on October 1, 1993, but has been extended to May 1, 1994. No predictions can be made as to the results of the renegotiations of these agreements or the possible effects of the renegotiations upon ASC, although the agreement with the USWA covering hourly employees at the Ashland facility establishes procedures for revising its economic terms upon their expiration and contains no-strike clauses that are effective during the negotiation period. The terms of the agreement with the Armco Employees Independent Federation ("AEIF") covering ASC's hourly employees at its Middletown, Ohio facility have been settled though March 1, 1997 pursuant to an arbitrator's decision. On February 15, 1994, the USWA filed a petition with the National Labor Relations Board seeking to represent the hourly employees at the Middletown facility currently represented by the AEIF. If the USWA is elected as the bargaining representative for those employees, it may seek to renegotiate the terms of the existing AEIF agreement covering those employees prior to March 1, 1997. Armco Financial Services Group AFSG currently consists primarily of insurance companies that Armco intends to sell (the "AFSG companies to be sold") and companies that have ceased writing new business and are being liquidated (the "runoff companies"). The AFSG companies to be sold provide multiple-line casualty insurance, including personal and commercial automobile, workers' compensation, homeowners, multiperil, personal and commercial property and general liability insurance and consist primarily of Northwestern National Casualty Company ("NNCC"), Pacific National Insurance Company ("PNIC") and Statesman Insurance Company ("Statesman"). Armco wrote off, in the fourth quarter of 1991, its advances to the AFSG companies to be sold of $170.3 million. Armco estimates that 61% of future claims against the runoff companies will be paid during the period 1993-1997 and that substantially all remaining claims will be paid by the year 2017. While there have been no charges recorded with respect to the runoff companies since 1990, in the future there may be further adverse developments with respect to the runoff companies, which, if not otherwise offset through favorable commutations or other actions, will require additional charges to income. On January 28, 1994, Armco signed a letter of intent to sell its ongoing insurance operations to Vik Brothers Insurance, Inc., a privately owned property and casualty insurance holding company. Under the terms of the letter of intent, approximately $70 million would be received at closing and approximately $15 million would be received in three years, the latter payment being subject to a reserve analysis and potential adjustment at that time. As a result of restructuring certain obligations arising from the 1992 merger plan for the runoff companies, the proceeds from the sale have been pledged as security for certain note obligations due to the runoff insurance companies and will be retained in the investment portfolio of the Armco Financial Services Group runoff companies. The transaction is subject to a number of conditions, including a definitive purchase agreement, approval by regulatory authorities and approval of the boards of directors of Armco and the purchaser. The insurance business is highly competitive. Many of the competitors of the AFSG companies to be sold offer more diversified lines of insurance and have substantially greater financial resources. In addition, the insurance regulators having supervisory authority over Armco's insurance operations retain substantial control over certain corporate transactions, including the sale of the AFSG companies to be sold and the liquidation of the runoff companies. They also have broad powers to interpret statutory accounting requirements and to initiate rehabilitation and liquidation proceedings. The liability for unpaid losses and loss adjustment expenses includes an amount determined from loss reports and individual cases and an amount, based on past experience, for losses incurred but not reported. Such liability is necessarily based on estimates and, while management believes that the amount is fairly stated, the ultimate liability may be in excess of or less than the amount provided. The methods for making such estimates and for establishing the resulting liability are continually reviewed and any adjustments resulting therefrom are reflected in earnings currently. The Company does not discount the liability for unpaid losses and loss adjustment expenses. The AFSG companies to be sold estimate losses for reported claims on an individual case basis. Case reserves are based on experience with a particular type of risk and the available information surrounding each individual claim. Case reserves are reviewed on a regular basis. As additional facts become available, the case reserves are adjusted as necessary. The stability of the case reserving process is monitored through comparison with ultimate settlement. The estimates of losses for incurred but not reported claims (IBNR), as well as additive reserves for reported claims, are developed primarily from an analysis of historical patterns of the development of paid and incurred losses (dollars and claim counts) by accident year for each line of business. Salvage and subrogation estimates are developed from patterns of actual recoveries. Allocated loss adjustment expense reserves are developed from an analysis of historical patterns of the development of paid allocated loss adjustment expenses to incurred losses, by accident year, by line of business. These historical patterns are then applied to projected ultimate losses for each line of business. Unallocated loss adjustment expense reserves are developed utilizing a cost accounting system. The cost accounting system is based on historical costs modified for anticipated changes in operations and selections of alternative costs. Loss and loss adjustment expense reserves are stated at management's estimate of the ultimate cost of settling all incurred but unpaid claims. Loss and loss adjustment expense reserves are not discounted. On October 25, 1990, Northwestern National Holding Company ("NNHC") purchased Statesman. NNHC has accounted for the Statesman acquisition as a purchase and accordingly, the original purchase price was allocated to assets and liabilities based upon their fair value at the date of acquisition. During 1986, Northwestern National Insurance Company was restructured and its principal book of business was transferred to NNCC. As provided by the agreement, NNCC assumed certain liabilities in connection with this book of business. Additionally, NNCC received securities and cash in connection with the transfer. Activity with respect to loss and loss adjustment expense reserves for the last three years is as follows: A reconciliation of the liability for losses and loss adjustment expenses as reported to net of ceded reinsurance follows: The following table reconciles reserves determined in accordance with accounting principles and practices prescribed or permitted by insurance statutory authorities (Statutory reserve) to reserves determined in accordance with generally accepted accounting principles (GAAP reserve) at December 31, as follows: Effective on January 1, 1993 the AFSG companies to be sold adopted a new statutory accounting principle allowing the recognition of salvage and subrogation recoverable in the determination of the statutory reserve for losses and loss expenses. Prior year financial statements have not been restated for the change in accounting principle. Effective on January 1, 1993 the AFSG companies to be sold adopted Statement of Financial Accounting Standards ("SFAS"), SFAS No. 106 and SFAS No. 112 pertaining to postretirement and postemployment benefits. The new accounting principles were adopted for both statutory and GAAP reporting purposes. However, certain differences exist between statutory and GAAP accounting principles that resulted in larger unallocated loss adjustment expense reserves for statutory reporting. The following table presents a calendar year runoff of the reserve for losses and loss adjustment expenses for the years 1984 through 1993. The top line of the table shows the reserve for losses and loss adjustment expenses recorded as of December 31 for each of the indicated years. This reserve represents the estimated amount of losses and loss expenses for claims arising in all years that are unpaid at the balance sheet date, including losses and loss adjustment expenses that had been incurred but not yet reported. Each column shows the reserve amount at the indicated calendar year end and cumulative data on payments and the re-estimated reserves for all accident years making up that calendar year end reserve. The last entry for each calendar year in the lower section of the table represents the incurred loss and loss expense developed, subsequent to the balance sheet date, through 1993. The estimates are increased or decreased as more information concerning the frequency and severity of claims becomes available. The deficiency depicted for a given year is cumulative for that year and all prior years. The following table shows a $40 million deficiency in 1990 and a $29 million deficiency in 1991. The AFSG companies to be sold experienced a significant number of large losses in 1991 and 1990, predominantly in multi-peril and commercial auto. The deficiencies that occurred in 1991 and 1990 are a result of additional unprecedented developments on these large losses. In addition, approximately $17 million of the deficiency for 1990 pertains to additional development and reserve strengthening that occurred on the 1990 and prior accident year loss and loss expense reserves of Statesman Insurance Company, a company acquired in October 1990. The AFSG companies to be sold implemented new reserving procedures to improve the future adequacy of reserve levels. The table reflects the (deficiency) redundancy on loss and loss expense reserves before the impact of the (deficiency) redundancy on loss and loss expense reserves ceded to unaffiliated insurers. The AFSG companies to be sold limits the maximum net loss which can arise from large risks by reinsuring (ceding) certain levels of risks with other reinsurers. The following table shows the deficiency on net loss and loss expense reserves, which is significantly lower than the deficiency in the table above. Significant development on large losses exceeding the AFSG companies to be sold net retention during 1990 and 1991 resulted in a smaller impact on reserve adequacy on a net of reinsurance basis The (deficiency) redundancy computed net of ceded reinsurance is as follows: The tables do not present accident or policy year development data which readers may be more accustomed to analyzing; therefore, analysis of the effect of loss and loss expense reserving on any particular accident year cannot be discerned. The table reflects adjustments to income in each year for all prior years. Conditions and trends that have affected development of the reserve in the past may not occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table. National-Oilwell Armco, through a wholly owned subsidiary, has a 50% partnership interest in National-Oilwell, which was formed in 1987 when Armco and USX Corporation each contributed their oilfield equipment operations to National-Oilwell in exchange for equal interests in the new partnership. National-Oilwell is a distributor of oil country tubular goods and a manufacturer of drilling, production and other oil and gas equipment, and operates a network of oil field supply stores throughout North America through which it distributes products to the oil and gas industries worldwide. National-Oilwell operates in a highly competitive environment. ITEM 2. ITEM 2. PROPERTIES Armco owns and leases property around the world. This property includes manufacturing facilities, offices and undeveloped property. The locations of Armco's principal plants and materially important physical properties are described in ITEM 1. "BUSINESS" and are used by the Specialty Flat-Rolled Steel and Other Steel and Fabricated Products businesses. Armco believes that all its operating facilities are being adequately maintained and are in good operating condition. All of Armco's principal plants and properties are held in fee. Portions of the Houston plant, shut down in 1983, are leased from the Gulf Coast Waste Disposal Authority (Texas). In most instances, Armco has an option to purchase the leased facilities at the end of the lease period. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are various claims pending against Armco and its subsidiaries involving product liability, patent, insurance arrangements, environmental, antitrust, hazardous waste, employee benefits and other matters arising out of the conduct of the business of Armco. Reserve Mining Litigation. On July 17, 1992, Armco was sued in the -------------------------- United States District Court, District of Minnesota, Fifth Division, by a group of former salaried employees of Reserve Mining Company ("Reserve"), a joint venture between a subsidiary of Armco and LTV Corporation that produced iron ore pellets. The complaint alleges that Armco is liable for certain unpaid welfare benefits, including vacation, severance, supplemental layoff, life insurance and health insurance benefits. While Armco cannot determine the possible exposure, if any, from this lawsuit, plaintiffs preliminarily calculated the benefits at about $12 million. On February 17, 1993, the Court dismissed state law, ERISA and fiduciary claims with prejudice and plaintiffs' independent fiduciary claims without prejudice. Plaintiffs filed an amended complaint, in response to which Armco filed a motion to dismiss. On October 22, 1993, the Court granted Armco's motion to dismiss in its entirety. On November 22, 1993, plaintiffs filed a notice of appeal on the February 17 and October 22 decisions. The appeal is currently pending. In August 1992, Armco was sued in the U.S. District Court, District of Minnesota by members of the USWA who declined to participate in the USWA v. Armco settlement. The complaint alleges breaches of the Basic Labor - -------------- Agreement, Supplemental Unemployment Benefit Plan, Insurance Agreement, Pension Agreement and Program of Hospital-Medical Benefits for Pensioners and Surviving Spouses and seeks an unspecified amount of damages. On February 17, 1993, the Court granted Armco's motion to dismiss plaintiffs' state law claims. Plaintiffs' claims based on the labor agreements remain pending. Plaintiffs filed an amended complaint, in response to which Armco filed a motion to dismiss certain claims therein. On October 22, 1993, the Court granted Armco's motion. On November 8, 1993, Armco filed an answer to the allegations in the amended complaint not subject to the motion to dismiss. On May 14, 1993, Armco received a letter from the Pension Benefit Guaranty Corporation ("PBGC") asserting that Armco is liable for certain pension plan obligations of Reserve, a Minnesota general partnership between a subsidiary of Armco and a subsidiary of LTV Corporation. Reserve filed for reorganization under the U.S. Bankruptcy Code on July 16, 1986. In the letter, the PBGC demands payment by Armco of $42.8 million. On May 23, 1993, Armco and the PBGC entered into an agreement, tolling until December 31, 1993 the running of the statute of limitations with respect to the PBGC's claim against Armco and also with respect to any claims Armco may have against the PBGC. The original tolling agreement has been extended to April 29, 1994. While Armco's management believes that it has substantial defenses against these Reserve-related claims, if these creditors and other Reserve creditors are successful in such claims, Armco could become liable for these and other Reserve nondebt obligations in an amount which could be substantial. CRS Litigation. On October 31, 1990, a third-party complaint was served --------------- on Armco in the Circuit Court of Montgomery County, Maryland by the owner of a 6.3 mile potable water tunnel designed by defendant, CRS Sirrine ("CRS") and its predecessor companies, and constructed by Armco and Clevecon Inc. Armco built 3.4 miles of the tunnel; Clevecon built the remaining 2.9 miles. No portion of the tunnel, which was completed in early 1984, has ever been functional. Washington Suburban Sanitary Commission filed suit against CRS seeking damages in the amount of $200 million. CRS filed third-party complaints against Armco and Clevecon seeking damages to the extent of any liability of CRS attributable to Armco's or Clevecon's negligence or negligent misrepresentation in connection with the installation of the potable water tunnel and the third party defendants' alleged defective workmanship in connection with the same. Armco's motion to dismiss or, in the alternative, for summary judgment was denied by the Court. CRS subsequently settled the claims against it by Washington Suburban Sanitary Commission and continued to prosecute its third-party claims against Armco and Clevecon. Oral argument on Armco's re-filed summary judgment motion was held on January 3, 1994. The circuit court denied Armco's summary judgment motion and the case proceeded to trial. On January 28, 1994, a directed verdict was entered by the court in favor of Armco. CRS has filed a notice of appeal of the judgment entered in favor of Armco. Cornerstones Litigation. An action was filed by Cornerstones Municipal ------------------------ Utility District ("Cornerstones") and William St. John, as representative of a class of owners of real property situated within Cornerstones, in the District Court of Harris County, Texas, in July 1989, alleging that Armco Construction Products supplied defective pipe for a sanitary sewer system in three residential subdivisions. The petition sought in excess of $40 million in damages. On May 29, 1991, plaintiffs filed a Third Amended Petition adding Kingsbridge Municipal Utility District ("Kingsbridge") and John Keplinger, as representative of a class of owners of real property situated within Kingsbridge, as additional plaintiffs. The residents of Kingsbridge made similar allegations, sought certification of the class of Kingsbridge homeowners and seek to recover damages for an allegedly faulty sanitary sewer system in four residential subdivisions. The amended petition seeks in excess of $40 million in damages, on behalf of the Kingsbridge and the Cornerstones plaintiffs, which is in excess of the court's jurisdictional limits. On January 13, 1992, the Court granted Armco's Motion for Summary Judgment and dismissed all of the Cornerstones plaintiffs' claims against the defendants on the basis of the statute of limitations. The Cornerstones plaintiffs appealed the decision and, in January 1993, the Appellate Court reversed the dismissal of the Cornerstones action and remanded it to the trial court. In May 1993, the Texas Supreme Court granted Armco's application for leave to appeal the appellate court's decision and heard argument on the matter on September 14, 1993. On November 24, 1993, the Texas Supreme Court reversed the appellate court in favor of Armco, awarding Armco its costs and remanding the case to the appellate court for disposition of unaddressed issues. The Kingsbridge action remains pending and is in discovery. On or about April 3, 1992, Vincent and Linda Adduci and 71 other plaintiffs, owners of real property situated within Cornerstones, filed suit in the District Court of Harris County, Texas, against multiple defendants, including Armco. The suit, similar to the action filed by Cornerstones and William St. John discussed above, alleges damages were sustained as a result of improper design and installation of the sanitary sewer system servicing the subdivision, as well as certain manufacturing and/or design defects of the pipe utilized to construct the sanitary system. The complaint seeks an unspecified amount of damages. On or about September 11, 1992, Harris W. Arthur and other plaintiffs, owners of real property situated within Cornerstones, filed suit in the District Court of Harris County, Texas, against multiple defendants, including Armco. The suit, similar to the action filed by Cornerstones and William St. John and the action filed by Vincent and Linda Adduci and other plaintiffs, alleges damages were sustained as a result of improper design and installation of the sanitary sewer system servicing the subdivision, as well as certain manufacturing and/or design defects of the pipe utilized to construct the sanitary sewer system. The complaint also asserts legal malpractice theories against various counsel for the Municipal Utility District. The complaint seeks an unspecified amount of damages. On March 22, 1993, an action captioned William C. Irons, et al. v. --------------------------- Turner, Collie & Braden, et al. was filed in the District Court of Harris - ------------------------------- County, Texas. This action, which involves approximately 100 additional owners of real property situated within Cornerstones, names multiple defendants, including Armco, and alleges theories of damages similar to those in the Arthur and Adduci matters. The complaint seeks an unspecified amount of - ------- ------ damages. Armco Chile Prodein, S.A. Litigation. On or about November 15, 1991, ------------------------------------- Armco and Armco Chile Prodein, S.A. were sued for damages in the United States District Court for the Southern District of Alabama by a maritime cargo carrier. Plaintiff's claims are based upon allegations of fraud, negligent misrepresentation, negligent interference with contractual relations and wrongful arrest. Plaintiff's allegations arise out of a series of transactions in which it was engaged by Armco Chile Prodein to transport fiberglass reinforced pipe from Jacksonville, Florida to Talcahuano, Chile. Plaintiff made three such shipments of pipe. After discovering damage to the first and second shipments of pipe, which defendants contend was due to negligence by plaintiff, Armco Chile Prodein arrested, pursuant to Chilean law, the vessel which plaintiff utilized to carry the third shipment of pipe. Plaintiff alleges, among other things, that this arrest was wrongful and that the alleged wrongful arrest resulted in such severe damage to plaintiff's business interests and reputation that plaintiff went out of business. Plaintiff's experts claim that the damages suffered by plaintiff range from $38 million to $47 million. Both Armco and Armco Chile Prodein filed motions for summary judgment. On January 25, 1993, the court granted summary judgment discharging Armco and subsequently denied plaintiff's motions for reconsideration of the summary judgment granted to Armco. On April 30, 1993, a jury verdict on plaintiff's wrongful arrest and lost profits claims was rendered in favor of the plaintiff and against Armco Chile Prodein in the amount of $10,500,000. Judgment on the verdict was entered by the Court on May 7, 1993. Thereafter, Armco Chile Prodein filed a motion seeking judgment as a matter of law or, alternatively, for a new trial. On October 12, 1993, finding that the jury's verdict on liability and damages was against the weight of the evidence, the trial court granted the defendant's post-trial motion, entering judgment in favor of Armco Chile Prodein against plaintiff. The court also granted Armco's motion for a conditional new trial in the event the judgment is overturned on appeal. The plaintiff has appealed this ruling to the Federal Circuit Court. Environmental Proceedings. Armco's steelmaking operations have been -------------------------- involved in or subject to a number of consent orders or judgments under local, state or federal environmental laws and regulations which generally require Armco to comply with certain discharge standards and to add certain pollution abatement equipment. Armco continues to be subject to such orders or settlements to the extent that such standards have not been met or the equipment is not installed. In addition, Armco participates directly or indirectly in a number of proceedings challenging various regulations or procedures relating to environmental compliance. Armco becomes involved in such actions when it perceives that the ultimate application of such regulations or procedures could involve significant capital expenditures by Armco or subject Armco to penalties without obtaining a material environmental benefit. In addition, Armco has been named as a defendant in certain litigation wherein the state or federal government or other potentially responsible parties seek reimbursement for or to compel cleanup of hazardous waste sites. Armco has provided information on materials it has deposited at other hazardous waste sites and may be named as a defendant if litigation is commenced with respect to such sites. The federal government has asserted that joint and several liability applies in hazardous waste litigation and courts have held that, absent proof that damages are allocable or subject to allocation, joint and several liability will be applied. The following paragraphs provide information on certain suits and proceedings in which Armco is a participant. On July 31, 1989, the United States filed a civil action in the United States District Court for the Southern District of Texas, Houston Division, under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") for cost recovery and injunctive relief associated with the French Limited Superfund site (the "French Limited Site") near Crosby, Texas. Armco and 84 other defendants were named in the action. Concurrently, the United States government filed a Consent Decree requiring the defendants to reimburse the United States in the amount of $1.3 million, to pay certain future oversight costs and to undertake remedial action at the French Limited Site. The Decree was approved and entered by the court. The defendants estimated that the remedy outlined in the Decree would cost approximately $81 million over a five- to eight-year period. Armco's remaining share of costs, which is fully accrued, is approximately $1.6 million. Armco has been one of four remaining defendants in three class actions filed in the 157th Judicial District, District Court of Harris County, Texas on behalf of about 750 residents near the French Limited Site. These cases were Avalos ------ v. Atlantic Richfield Company, ("ARCO") et al., Curette v. ARCO and Adolph - --------------------------------------------------------------- ------ v. ARCO. In December 1992, the Avalos, Curette, and Adolph plaintiffs accepted - -------- a $1.1 million settlement offer made by Armco and two other defendants, of which Armco's share was $549,270.56. The settlement funds were paid out in 1993 and the court dismissed the action with prejudice. As a condition to settlement, about 300 individuals who were not represented by counsel or who had only recently had counsel appear on their behalf and who did not wish to settle their claims were severed from the Avalos action and transferred to a separate action styled Rosa Ann Barrett, et - ------ -------------------- al. v. ARCO, et al., in the United States District Court for the Southern - --------------------- District of Texas, Houston Division. On December 13, 1993, Rhonda Sills, on behalf of herself and two of her children, sued the same defendants as in the Avalos case. In February, a suit on behalf of Rod Luke Chambers and about 30 - ------ other plaintiffs was filed against the ARCO defendants. These suits are based on the same theories as those asserted in the Avalos case and seek an ------ unspecified amount of damages. Armco believes the Barrett, Sills & Chambers ------------------------- lawsuits are not well-founded and, accordingly, no liability has been recorded at this time. An action styled The United States of America, State of Maryland v. -------------------------------------------------- Azrael, et al. v. Armco Steel Corporation, et al. was filed in the United - ------------------------------------------------- States District Court for the District of Maryland pursuant to Section 107 of CERCLA to recover monies expended by the United States and the State of Maryland in response to a release and threatened release (federal allegation) and an imminent and substantial danger to the public health or welfare presented by the release or substantial threat of release (state allegation) of hazardous substances from a waste disposal site at the intersection of Kane and Lombard Streets in Baltimore, Maryland. Armco was served with a third-party complaint on April 19, 1991. The third-party complaint alleges that Armco arranged for the disposal and/or treatment or arranged with a transporter for transport for disposal or treatment of hazardous waste to the Kane and Lombard site. A determination has not been made as to how much waste, if any, Armco sent to the site. To date, settlement discussions with the third-party plaintiffs have been unsuccessful. On or about September 29, 1989, the United States filed a civil action in the United States District Court for the District of Minnesota under CERCLA for declaratory relief and cost recovery associated with the Arrowhead Refining Superfund site (the "Arrowhead Site") in Hermantown, Minnesota. Armco, Reserve and 13 other defendants are named in the action. The United States Environmental Protection Agency's ("USEPA") current estimated cost to clean up the Arrowhead Site is about $30 million. Armco has joined in the filing of a third-party complaint against approximately 300 third-party defendants. Discovery is in progress. During 1990, USEPA and the State of Minnesota issued several orders directing Armco and several other parties to undertake certain remedial actions or risk substantial penalties for not doing so. In early 1991, Armco joined the Minnesota Arrowhead Site Committee ("MASC"), a group of potentially responsible parties ("PRPs"), and has participated in MASC's implementation of the orders. In addition to its compliance activities, MASC also commissioned studies of alternative technologies to remedy sludge and soil contamination at the Arrowhead Site. USEPA is in the process of amending its Record of Decision to include a more cost effective remedy identified by these studies. Armco will be responsible for about 65% of the MASC groups cleanup costs at the site. On or about October 12, 1989, the United States filed a civil action in the United States District Court of Pennsylvania, Western District, against Armco and ten other defendants under CERCLA for cost recovery associated with the Malitovsky Drum Superfund site in Pittsburgh, Pennsylvania. Armco and the other defendants are alleged to have sent materials to the site. The complaint alleges that costs in excess of $1 million have been expended, and additional costs are being incurred through efforts of the United States to recover monies expended in connection with its response actions. Late in 1992, USEPA and the defendants reached an agreement in principle, under which Armco will pay $118,333.33. A definitive settlement agreement has been negotiated, pending final approval by USEPA. In December 1989, Traverse Bay Area Intermediate School District ("TBA") filed suit in the United States District Court for the Western District of Michigan alleging that Parsons Corporation, the predecessor in interest of Hitco, a former subsidiary of Armco, released hazardous substances which contaminated the plaintiff's property. Armco assumed the defense of Hitco pursuant to the terms of the sale of Hitco. The TBA litigation was dismissed with prejudice on January 4, 1993. Armco and TBA jointly performed a remedial investigation, focused feasibility study and risk assessment on TBA's property and submitted the reports to the Michigan Department of Natural Resources ("MDNR"). On March 24, 1993, MDNR sent Armco and TBA a "Notice of Demand for Payment and Response Action", claiming reimbursement of approximately $1.3 million in past costs plus statutory interest and demanding performance of additional investigation and response activities at the site which are estimated to cost about $600,000. Armco's costs are not expected to exceed $1.45 million in resolving Hitco's share of liability at the site. Armco and TBA are working cooperatively with MDNR to settle the matter. On or about June 29, 1992, Armco was served with a complaint, styled as a class action, filed in the Superior Court of California, County of Los Angeles, by Scott Liuzza and approximately 80 named plaintiffs against Armco and a number of other companies, relating to, among other things, a land reclamation site owned by Armco and recently closed under the supervision and with the approval of the appropriate environmental agencies. The plaintiffs are seeking a recovery in an unstated amount for alleged personal and property damages plus injunctive relief. The court sustained Armco's demurrer to the class action counts of the complaint and in March 1994 dismissed plaintiff's claims for the diminution of property values and personal injury. Discovery is in progress with a cutoff date of April 19, 1994. On July 19, 1993, Armco's subsidiary Flour City Architectural Metals, Inc. (formerly E.G. Smith Construction Products, Inc.) ("Flour City") received a request from USEPA under Section 3007 of the Resource Conservation and Recovery Act ("RCRA") for information as part of an ongoing investigation into Flour City's compliance with a Consent Agreement and Final Order dated October 27, 1988 (the "Consent Order") relating to two inactive waste surface impoundments located at the former E.G. Smith plant in Cambridge, Ohio. On February 11, 1993, Armco sold the Flour City Cambridge, Ohio plant, but retained title to 21.5 acres of the Cambridge facility, including the surface impoundments, and responsibility for compliance with the terms of the Consent Order. Armco has established reserves which it believes will be adequate to cover the required remediation. Armco believes that it is in compliance with the Consent Order. Armco submitted a revised closure plan for this site in September, 1993. On or about July 31, 1990, the State of Connecticut filed an action entitled Leslie Carothers, Commissioner of Environmental Protection v. Cyclops ---------------------------------------------------------------------- Corporation, Detroit Strip Division in the Connecticut State Superior Court, - ----------------------------------- Judicial District of Hartford/New Britain at Hartford, seeking certain penalties and a permanent injunction against Cyclops Corporation to restrain it from discharging wastewater into the waters of the State of Connecticut without a permit. The claim involves a closed facility in Hamden, Connecticut. Although Armco, as successor to Cyclops Corporation, and the State of Connecticut have signed a Consent Order by which Armco agreed to perform certain remedial investigations and activities, the penalty claim in the litigation is still outstanding. Settlement discussions are expected to resolve this matter trial which is scheduled for April 16, 1994. An action styled Tammy Fisher Whalen v. AES, Inc., et al. was filed on ---------------------------------------- March 17, 1993 in the 10th Judicial District, District Court of Galveston County, Texas by Tammy Fisher Whalen on behalf of herself and several other plaintiffs against AES, Inc. and approximately 40 other defendants, including Armco and a number of other major corporations, relating to the McGinnis Waste Disposal Site. Substantially identical actions entitled Elizabeth Ewell, et ------------------- al v. AES, Inc., et al. and Bonnie R. Cannon, et al. v. AES, Inc., et al. - ----------------------- --------------------------------------------- were filed in the same court on May 4, 1993 and June 10, 1993, respectively. In each case, the plaintiffs sought $1 billion in alleged actual damages and $4 billion in punitive damages. Based on Armco's demonstration that no Armco materials went to the McGinnis Site, plaintiffs have moved to dismiss these actions. Whalen and Ewell were dismissed on June 21 and June 25, 1993 ------ ----- respectively. The judge is expected to sign the Cannon dismissal shortly. ------ In September 1992, National Supply Company, Inc., a wholly owned subsidiary of Armco ("National Supply") and a 50% general partner in National-Oilwell, received a letter from USEPA, which asserted that National Supply and/or National-Oilwell is a PRP under CERCLA with respect to the Odessa Drum Company, Inc. Superfund site (the "Odessa Site") located in Odessa, Ector County, Texas. Armco has joined a de minimis PRP group to negotiate a settlement for its liability at this site. Armco believes that any response costs National Supply may bear in connection with the Odessa Site will not be material to Armco. In August 1992, Eastern received a letter from USEPA, which asserted that Eastern is a PRP under CERCLA with respect to the Moyer Landfill Superfund site (the "Moyer Landfill Site") in Collegeville, Pennsylvania. Eastern has responded that it did not send waste or other materials to the Moyer Landfill Site. Eastern understands that a cost recovery action has been instituted in the United States District Court, Eastern District of Pennsylvania, against a substantial number of parties, not including Eastern, which are asserted to have potential liability under CERCLA with respect to the Moyer Landfill Site. No claims against Armco are anticipated. E. G. Smith Construction Products, Inc. ("E. G. Smith"), a subsidiary of Armco, is one of four companies that have been identified by USEPA as PRPs at the Fultz Landfill Superfund site in Byesville, Ohio. USEPA's preliminary estimates for remediation cost is $22 million on a present value basis. The USEPA did not provide an estimate of the waste volume at the site alleged to be that of E. G. Smith. The operators of the landfill have stated that any of E. G. Smith's industrial wastes that are of concern to USEPA were not deposited in the landfill but were transported to another site. USEPA is undertaking cleanup at the site, with the expectation that they can recover such costs from the PRP's. Cyclops received a notice from USEPA that it may be a PRP with respect to the anticipated remediation of contaminated soil on certain property in New Boston, Ohio sold by Cyclops to a third party several years ago. No amount was estimated by USEPA as to the cost of such remediation. Prior to such sale, the salvage contractor hired by the current owner (which was then occupying the property as a tenant of Cyclops) engaged in intentional conduct which directly resulted in contamination. As a part of the sentence imposed upon the contractor in response to his guilty plea to the resulting criminal charges, the contractor agreed to remediate the contaminated condition. Armco currently is reviewing its legal position as to the notice, including the defenses which it may have on the basis of the circumstances of the contamination. The current owner of the property and the contractor have also been notified by USEPA that they may be PRPs. Armco and the current owner have collected $825,000 on a $1 million performance bond which had been obtained to secure the contractor's performance. These funds are being used for remediation and oversight of the clean-up. In July of 1990, Eastern entered into a Consent Order with the Maryland Department of Environment to resolve a complaint alleging various violations of environmental requirements. This Order was followed by a voluntary Consent Judgment on April 17, 1992 and an amendment of the Consent Judgment in August of 1993. Pursuant to the Order and Judgment, Eastern spent a total of $4.5 million in 1991, 1992 and 1993 on various pollution prevention projects. In addition, Eastern paid a $0.3 million penalty and agreed to expend an additional $0.9 million on projects in 1994. Additional expenditures of about $1 million will be necessary if Eastern restarts its melting, grinding and coil processing operations. On July 22, 1993, Armco received a request from the Kansas Department of Health and Environment ("KDHE") for information regarding a former Armco Construction Products Division plant located in Topeka, Kansas and now owned by Contech Construction Products, Inc. ("Contech"). Contech and Armco had previously tried to resolve a claim by Contech concerning all environmental contamination at the Topeka plant. The claim arises under indemnity provisions contained in an agreement dated June 30, 1986 between Armco and Contech, formerly a subsidiary of Armco, under which Armco conveyed the property and other assets to Contech pursuant to a management buyout of Contech. The request was issued pursuant to a Kansas law that has liability provisions similar to CERCLA. Despite several meetings among Armco, Contech and other former owners of allegedly contaminated portions of the plant, the parties have been unable to resolve the dispute. Armco answered KDHE's information request in August 1993. The amount, if any, of potential liability cannot be reasonably estimated. In December 1993, Armco and one other company received a notice of nonbinding preliminary allocation of proportionate responsibility from the Pennsylvania Department of Environmental Resources ("PADER") for the William Taylor Estate site. PADER is seeking a voluntary settlement for the recovery of past and future response costs at the site. The notice alleges disposal of material from three facilities operated by the Sawhill Tubular Division. While cleanup costs cannot be estimated, Armco believes, based on information to date, that the response costs will not be material. On February 2, 1994, the Missouri Department of Natural Resources, ("Missouri DNR") issued a Notice of Violation to GS Technologies, Inc. ("GS Technologies") for failure to obtain permits prior to the construction/modification of ten processes or pieces of equipment. These changes were made before the Kansas City facility was sold to GS Technologies as part of its sale of its Worldwide Grinding Systems in late 1993. Armco is taking the lead in working with Missouri DNR to resolve this issue. It is not expected that any penalties will be material. On February 16, 1994, Missouri DNR and the USEPA jointly issued a Part B permit to the Kansas City facility under RCRA. This permit seeks to require "interim measures" including investigation and potentially, remediation at several areas of the facility. Armco has petitioned for review of most of such permit provisions to the Environmental Appeals Board. These provisions are stayed during pendancy of the appeal. It is expected that preliminary investigation costs may reach $1 million; however, other costs cannot be determined until there is more certainty as to the extent of actual permit requirements. On January 18, 1994, Armco received a 104(e) request for information under CERCLA from USEPA regarding shipments from the former E. G. Smith Division of Cyclops to the Granville Solvents site in Ohio. Armco has responded to the request. Cleanup costs and any Armco liability therefor cannot be determined based on available information. In the opinion of management, the ultimate liability resulting from the claims described in the preceding paragraphs in the "Legal Proceedings" section will not materially affect the consolidated financial position or liquidity of Armco and its subsidiaries; however, it is possible that due to fluctuations in Armco's operating results, future developments with respect to such matters could have a material effect on its financial condition, liquidity and results of operations in future interim or annual periods. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of the security holders of Armco during the fourth quarter of the year ended December 31, 1993. Executive Officers of Armco The executive officers of Armco as of March 1, 1994, were as follows: ________________________ (1) Effective January 1, 1994, Mr. Will was elected Chief Executive Officer. He had previously been President and Chief Operating Officer. (2) Effective March 1, 1994. (3) Effective April 1, 1993. (4) Effective as of March 1, 1994. (5) Effective September 1, 1993, Mr. Hildreth was elected Vice President and Secretary. He had previously been General Counsel since February 1, 1993. (6) Effective September 1, 1993. (7) Effective March 1, 1994. (8) All officers are elected annually by the Board of Directors and hold office until their successors are elected and qualified. Each of the officers named above has held responsible positions with Armco or its subsidiaries during the past five years, with the exceptions of Messrs. Will, Harmer, Leemputte, Visokey and Higbee. Immediately prior to joining Armco, Mr. Will was President and Chief Executive Officer of Cyclops Industries, Inc. (a manufacturer of flat-rolled carbon and stainless steel products). Mr. Harmer was Vice President and Controller of FMC Corporation (a broad-based chemicals and manufacturing company). Mr. Leemputte was project manager for Gemini Consulting (specializing in the development and application of leading edge business concepts and practices). Prior to that, Mr. Leemputte held various accounting positions at FMC Corporation. Mr. Visokey was Vice President, Purchasing and Traffic for LTV Steel Company. Mr. Higbee was President of National-Oilwell. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this item is incorporated herein by reference from page 57 of the Annual Report to Shareholders for the year ended December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA _______________________________ (1) The information in this Item should be read in conjunction with Armco's financial statements and the Notes thereto, which are incorporated by reference in Item 8. (2) In 1993, Armco adopted SFAS 106 and 109 which increased long-term employee benefits and total assets. (3) In April 1992, Armco acquired Cyclops Industries, Inc. (4) Special credits (charges) for the years 1991 through 1993 primarily relate to the shutdown and rationalization of operating facilities. The credit in 1989 is primarily a result of a $109.4 gain on the formation of Armco Steel Company, L.P. from the assets, liabilities and business of the Eastern Steel Division, and a credit for a favorable ruling on certain export commitments, partially offset by corporate restructuring charges. (5) The Class B common stock was issued by Eastern Stainless Corporation prior to Armco's acquisition of this 84%-owned former subsidiary of Cyclops Industries, Inc. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is incorporated herein by reference from pages 19-31 following the caption "Management's Discussion and Analysis" of the Consolidated Financial Statements in the Annual Report to Shareholders for the year ended December 31, 1993. Subsequent Developments On March 28, 1994, Armco announced its intention to idle the production facilities at its Empire-Detroit carbon steel plant in Mansfield, Ohio and the Dover, Ohio galvanizing plant. The plants are expected to remain idle until the previously announced construction of a $100 million thin-slab caster is completed, which is scheduled for mid-1995. Armco expects to recognize a special charge of up to $20 million in the first quarter of 1994 for the cost of benefits to employees on layoff and other costs of idling the facilities, as well as costs associated with planned permanent work force reductions. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is incorporated herein by reference from pages 32-56 of the Annual Report to Shareholders for the year ended December 31, 1993. (Unaudited) Subsequent Developments On March 28, 1994, Armco announced its intention to idle the production facilities at its Empire-Detroit carbon steel plant in Mansfield, Ohio and the Dover, Ohio galvanizing plant. The plants are expected to remain idle until the previously announced construction of a $100 million thin-slab caster is completed, which is scheduled for mid-1995. Armco expects to recognize a special charge of up to $20 million in the first quarter of 1994 for the cost of benefits to employees on layoff and other costs of idling the facilities, as well as costs associated with planned permanent work force reductions. 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 as to executive officers of Armco is contained in Part I of this report under "Executive Officers of Armco" and is incorporated herein by reference. The information required as to directors is incorporated herein by reference from the information set forth under the caption "ELECTION OF DIRECTORS" in the registrant's Proxy Statement for the 1994 Annual Meeting of Shareholders filed with the Securities and Exchange Commission pursuant to Rule 14a-6 of the Securities Exchange Act of 1934, as amended (the "Proxy Statement"). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated herein by reference from the information set forth in the Proxy Statement under the caption "EXECUTIVE COMPENSATION". ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The security ownership in Armco stock of directors, certain executive officers and directors and executive officers as a group and of persons known by Armco to be the beneficial owners of more than five percent of any class of Armco's voting securities is incorporated herein by reference from the information set forth in the Proxy Statement under the caption "MISCELLANEOUS -- Stock Ownership". 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 I. Documents Filed as a Part of this Report ________________ *Incorporated in this annual report on Form 10-K by reference to pages 32-56 of the Annual Report to Shareholders for the year ended December 31, 1993. Financial Statements and Financial Statement Schedules Omitted The financial statements and financial statement schedules for Armco Inc. and Consolidated Subsidiaries, and for Armco Financial Services Group and Armco Steel Company, L.P., other than those listed above, are omitted because of the absence of conditions under which they are required, or because the information is set forth in the notes to financial statements. B. Exhibits The following is an index of the exhibits included in the Form 10-K Annual Report. 3(a). Articles of Incorporation of Armco Inc., as amended as of May 12, 1993(1) 3(b). Regulations of Armco Inc. (2) 4. Armco hereby agrees to furnish to the Securities and Exchange Commission, upon its request, a copy of each instrument defining the rights of holders of long-term debt of Armco and its subsidiaries omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. 10(a). Incentive Compensation Plan (3)* 10(b). Deferred Compensation Plan for Directors (4)* 10(c). 1983 Stock Option Plan (5)* 10(d). Incentive Compensation Plan (6)* 10(e). 1993 Long-Term Incentive Plan of Armco Inc.* (7) 10(f). Severance Agreements (8)* 10(g). 1988 Stock Option Plan (9)* 10(h). 1988 Restricted Stock Plan (9)* 10(i). Executive Supplemental Deferred Compensation Plan Trust (10)* 10(j). Executive Supplemental Deferred Compensation Plan (11)* 10(k). Rights Agreement dated as of June 27, 1986 between Armco Inc. and Harris Trust and Savings Bank, as amended as of June 24, 1988 (13) 10(l). Joint Venture Formation Agreement dated March 24, 1989 (14) 10(m). Incentive Compensation Plan for Key Management (12)* 10(n). Pension Plan for Outside Directors (12)* 10(o). Key Management Severance Policy (15)* 10(p). Armco Inc. 1991 Long-Term Incentive Plan (Armco Inc. Long-Term Incentive Plan Performance Share Plan) (16)* 10(q). Profit Sharing Plan for Armco Advanced Materials Company (17)* 10(r). Minimum Pension Plan (18)* 10(s). Stainless Steel Toll Rolling Services Agreement 10(t). Armco Inc. Noncontributory Pension Plan As Amended and Restated (Effective As of January 1, 1989.)* 10(u). Armco Inc. Retirement and Savings Plan.* 11. Computation of Income (Loss) Per Share 13. Annual Report to Shareholders for the year ended December 31, 1993. (Filed for information only, except for those portions that are specifically incorporated in this Form 10-K Annual Report for the year ended December 31, 1993.) 21. List of subsidiaries of Armco Inc. 23. Independent Auditors' Consent 28. Schedule P - Analysis of Losses and Loss Expenses 99. Description of Armco Capital Stock The annual reports (Form 11-K) for the year ended December 31, 1993 for the Armco Inc. Retirement and Savings Plan and the Armco Inc. Thrift Plan for Hourly Employees will be filed by amendment as exhibits hereto, as permitted under Rule 15d-21. * Management contract or compensatory plan or arrangement required to be filed as an exhibit to the Form 10-K pursuant to Item 14(c) of Form 10-K. ______________________ (1) Incorporated by reference from Exhibit 4.2 to Armco's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (2) Incorporated by reference from Exhibit 3(b) to Armco's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987. (3) Incorporated by reference from Exhibits 10(a) and 10(c) to Armco's Annual Report on Form 10-K for the year ended December 31, 1980. (4) Incorporated by reference from Exhibit 10(f) to Armco's Annual Report on Form 10-K for the year ended December 31, 1981. (5) Incorporated by reference from Exhibit 19 to Armco's Quarterly Report on Form 10-Q for the quarter ended March 31, 1983. (6) Incorporated by reference from Exhibit 10(g) to Armco's Annual Report on Form 10-K for the year ended December 31, 1983. (7) Incorporated by reference from Exhibit 10 to Armco's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (8) Incorporated by reference from Exhibit 10(a) to Armco's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988. (9) Incorporated by reference from Exhibits 10(h) and 10(i) to Armco's Annual Report on Form 10-K for the year ended December 31, 1988. (10) Incorporated by reference from Exhibit 10(b) to Armco's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988. (11) Incorporated by reference from Exhibit 10(c) to Armco's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988. (12) Incorporated by reference from Exhibit 10(l) to Armco's Annual Report on Form 10-K for the year ended December 31, 1989. (13) Incorporated by reference from Exhibit 1 to Armco's Form 8-A dated July 7, 1986 and Exhibit 1.1 to Armco's Form 8 dated July 11, 1988. (14) Incorporated by reference from Exhibit 10 to Armco's Form 8-K dated March 27, 1989. (15) Incorporated by reference from Exhibit 10(p) to Armco's Annual Report on Form 10-K for the year ended December 31, 1990. (16) Incorporated by reference from Exhibit 10(p) to Armco's Annual Report on Form 10-K for the year ended December 31, 1991. (17) Incorporated by reference from Exhibit 10(q) to Armco's Annual Report on Form 10-K for the year ended December 31, 1991. (18) Incorporated by reference from Exhibit 10(r) to Armco's Annual Report on Form 10-K for the year ended December 31, 1991. ______________________ II. Reports on Form 8-K The following reports on Form 8-K were filed by Armco since the Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 was filed: 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 as of March 31, 1994. ARMCO INC. JAMES F. WILL By________________________________ James F. Will 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 indicated as of March 31, 1994. JAMES F. WILL OWEN B. BUTLER By ___________________________________ By _______________________________ James F. Will Owen B. Butler President, Director Chief Executive Officer and Director ROBERT L. PURDUM DAVID A. DUKE By ___________________________________ By _______________________________ Robert L. Purdum David A. Duke Director Director DAVID G. HARMER JOHN C. HALEY By ___________________________________ By _______________________________ David G. Harmer John C. Haley Vice President and Director Chief Financial Officer PETER G. LEEMPUTTE PAUL H. HENSON By ___________________________________ By _______________________________ Peter G. Leemputte Paul H. Henson Controller Director WILLIAM B. BOYD JOHN H. LADISH By ___________________________________ By _______________________________ William B. Boyd John H. Ladish Director Director JOHN J. BURNS, JR. BURNELL R. ROBERTS By ___________________________________ By _______________________________ John J. Burns, Jr. Burnell R. Roberts Director Director INDEPENDENT AUDITORS' REPORT Armco Inc.: We have audited the consolidated financial statements of Armco Inc. and consolidated 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 9, 1994, which report includes an explanatory paragraph for changes in Armco Inc.'s methods of accounting for postretirement benefits other than pensions, income taxes, certain investments in debt and equity securities, and postemployment benefits; 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 consolidated financial statement schedules of Armco Inc. and consolidated subsidiaries, listed in Item 14. These consolidated 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 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. DELOITTE & TOUCHE Pittsburgh, Pennsylvania February 9, 1994 SCHEDULE I ARMCO INC. AND CONSOLIDATED SUBSIDIARIES MARKETABLE SECURITIES--OTHER SECURITY INVESTMENTS (Dollars in Millions) (1) Joint venture partnerships. The investment represents 50% ownership in these businesses. (2) Discontinued business, 100% owned by Armco. (3) Companies accounted for by the equity method; presented at cost plus equity. (4) Investments represent joint venture ownership and/or investments in restricted deposits, advances or assets held for sale, for which there are no quoted market prices. SCHEDULE V ARMCO INC. PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) NOTES: (A) Represents foreign currency translation adjustment and reclassifications. (B) Fair market value of assets of purchased businesses. (C) Recorded value of assets of divested businesses. (D) Prior period amounts above have been restated to reflect the assets and accounts of Armco's Worldwide Grinding Systems businesses as discontinued operations. SCHEDULE VI ARMCO INC. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) NOTES: (A) Represents foreign currency translation adjustment and reclassifications. (B) Recorded value of assets of divested businesses. (C) The rates of depreciation are: land improvements 5%, buildings 2%--5%, and machinery and equipment 5%--33%. (D) Prior period amounts above have been restated to reflect the assets and accounts of Armco's Worldwide Grinding Systems businesses as discontinued operations. SCHEDULE VIII ARMCO INC. AND CONSOLIDATED SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (Dollars in Millions) NOTES: (A) Represents foreign currency translation adjustment and reclassifications. (B) Net balances of consolidated subsidiaries purchased (divested). INDEPENDENT AUDITORS' REPORT Armco Inc.: We have audited the accompanying consolidated balance sheets of Armco Steel Company, L.P. and Subsidiaries (an Investee of Armco Inc.) as of December 31, 1991, 1992 and 1993, and the related consolidated statements of operations and partners' capital (deficit) and cash flows for each of the four years in the period ended December 31, 1993. Our audits also included Financial Statement Schedule V, Property, Plant and Equipment; Schedule VI, Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment; Schedule VIII, Valuation and Qualifying Accounts and Reserves; Schedule IX, Short-term Borrowings; and Schedule X, Supplementary Income Statement Information, of Armco Steel Company, L.P. and subsidiaries (an Investee of Armco Inc.), all for each of the four years in the period ended December 31, 1993. 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 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 Armco Steel Company, L.P. and subsidiaries (an Investee of Armco Inc.) at December 31, 1991, 1992 and 1993, and the results of its operations and its cash flows for each of the four 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 5 to the consolidated financial statements, in 1993 the Company changed its method of accounting for retiree health care and life insurance benefits to conform with Statement of Financial Accounting Standards No. 106 and, retroactively, restated its 1990, 1991 and 1992 financial statements for the change. /s/ Deloitte & Touche Cincinnati, Ohio January 26, 1994 ARMCO STEEL COMPANY, L.P. CONSOLIDATED BALANCE SHEETS December 31, 1991, 1992 and 1993 (dollars in millions) ASSETS See notes to consolidated financial statements. ARMCO STEEL COMPANY, L.P. CONSOLIDATED BALANCE SHEETS December 31, 1991, 1992 and 1993 (dollars in millions) LIABILITIES AND PARTNERS' CAPITAL (DEFICIT) See notes to consolidated financial statements. ARMCO STEEL COMPANY, L.P. CONSOLIDATED STATEMENTS OF OPERATIONS AND PARTNERS' CAPITAL (DEFICIT) For the Years Ended December 31, 1990, 1991, 1992 and 1993 (dollars in millions) See notes to consolidated financial statements. ARMCO STEEL COMPANY, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1990, 1991, 1992 and 1993 (dollars in millions) See notes to consolidated financial statements. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (dollars in millions) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation--Armco Steel Company, L.P. (the "Company") is a limited partnership formed pursuant to an agreement dated March 24, 1989 (the "Joint Venture Agreement") between Armco Inc. ("Armco") and Kawasaki Steel Corporation ("Kawasaki"). The general partner of the Company is AK Steel Corporation (the "General Partner"), formerly AK Management Corporation, a Delaware corporation owned one-half by each of AJV Investments Corp., a Delaware corporation and wholly-owned subsidiary of Armco and KSCA, Incorporated, a Delaware corporation and indirect wholly-owned subsidiary of Kawasaki. The limited partners of the Company are Armco and Kawasaki Steel Investments, Inc., a Delaware corporation and indirect wholly-owned subsidiary of Kawasaki ("KSI"). Under the Joint Venture Agreement, on May 13, 1989, Armco sold certain assets, properties and business of its Eastern Steel Division ("Predecessor") to KSI for $350.0. Simultaneously, KSI contributed the purchased assets, properties and business to the Company in exchange for a 39.5% limited partnership interest. Armco transferred to the Company substantially all of the remaining assets, properties and business of Predecessor and the Company also assumed certain of Armco's liabilities and obligations related to or arising out of Predecessor and its properties, assets and the conduct of Predecessor business for a 59.5% limited partnership interest. On May 14, 1990, KSI made a cash contribution to the Company of $70.0. On May 13, 1991 and October 4, 1991, KSI contributed another $70.0 and $33.8, respectively. The latter contribution was in satisfaction of its obligation to make an additional $35.0 capital contribution on March 15, 1992, without any change in its limited partnership interest. As a result of these contributions, on May 14, 1990, KSI's limited partnership interest increased to 44.5% with a corresponding reduction in Armco's interest and on May 13, 1991, KSI's limited partnership interest increased, and Armco's limited partnership interest decreased, to 49.5%. The General Partner has a 1.0% general partnership interest in the Company. The accompanying consolidated financial statements of the Company include the net assets acquired at formation from Armco and Kawasaki on the basis of Armco's and Kawasaki's historical cost, and the changes in the net assets of the Company subsequent to the formation, and the results of operations, partners' capital (deficit) and the cash flows for the periods since inception on such historical cost basis. Kawasaki's historical cost was based on the purchase price paid on May 13, 1989 by Kawasaki for its 40% interest in the net assets of the Company. Armco's historical cost is based on the book value of net assets contributed on May 13, 1989 by Armco for its 60% interest in the Company, adjusted for changes resulting from the 5% reductions in limited partnership interest effective May 14, 1990 and May 13, 1991. The Company consists of the operations and accounts of the Middletown Works, Ashland Works, Headquarters and ASC Investments, Inc. and its group of wholly-owned subsidiaries, (the "ASCII group"). With plants in Middletown, Ohio, and Ashland, Kentucky, the Company provides coated, high strength, low carbon flat-rolled steels to the automotive, appliance, construction and service center markets primarily in the Midwest. The Company had one major customer that accounted for 23.0%, 27.9%, 23.0% and 22.5% of its net sales in 1990, 1991, 1992 and 1993, respectively. Armco and Kawasaki agreed to share a portion of the 1992 Special Charges and Unusual Items (see Note 8) unequally with Armco being allocated 74.5%, Kawasaki 24.5% and the General Partner 1.0%. On August 31, 1992, the Company acquired a 50% ownership interest in Southwestern Ohio Steel, L.P. (SOS), a joint venture to which substantially all of the businesses of Southwestern Ohio Steel, Inc. and SOS Leveling Company, Inc. were transferred by Armco. The Company's interest in SOS was funded through capital contributions from Kawasaki, in the form of cash of $11.1, and from Armco, in the form of a 25% ownership interest in SOS with an estimated fair value of $11.1. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) Inventories--Inventories are valued at the lower of cost or market. The cost of the majority of inventories is measured on the last in, first out (LIFO) method. Other inventories are measured principally at average cost. Liquidation of LIFO inventory layers caused by certain inventory reductions reduced the net losses in 1992 and 1993 by $2.6 and $10.4, respectively. Investments--The Company has investments in associated companies (joint ventures and an entity that the Company does not control). These investments are accounted for under the equity method. Because these companies are directly integrated in the basic steelmaking facilities, the Company includes its proportionate share of the income (loss) of these associated companies in cost of products sold. Virginia Horn Taconite Company, a member of the ASCII group ("Virginia Horn"), owns a 56% share of Eveleth Expansion Company ("Eveleth"), a company which produces iron ore pellets, which equates to a 35% interest in Eveleth Mines. In connection with such investment, Virginia Horn has certain commitments to Eveleth. Because Virginia Horn does not control Eveleth, the investment is accounted for under the equity method (see Note 7). ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The following are condensed balance sheets of Eveleth at December 31, 1992 and 1993 and condensed statements of Eveleth's operations for the three years in the period ended December 31, 1993. The financial statements are presented on an historical basis and as adjusted to reflect the Company's estimate of net realizable value of the fixed assets of Eveleth. Eveleth Expansion Company (a partnership) Condensed Balance Sheets December 31, 1992 and 1993 (dollars in millions) ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) Eveleth Expansion Company (a partnership) Condensed Statements of Operations For the Years Ended December 31, 1991, 1992 and 1993 (dollars in millions) Notes General -- Eveleth, a partnership, is in the business of mining taconite and producing iron ore pellets for its partners. The partners of Eveleth, and their respective percentage equity interests in Eveleth, are Virginia Horn (56%), Onco Eveleth Company, a wholly-owned subsidiary of Oglebay Norton Company (ONCO) (20.5%) and Ontario Eveleth Company, a wholly-owned subsidiary of Stelco, Inc. (Stelco) (23.5%). Pellet production is allocated for sale to the partners based upon annual agreements. Partnership Funding -- Under the terms of agreements with Eveleth's lenders and among the partners, each partner is obligated to advance a portion of Eveleth's required operating funds, whether or not pellets are produced. Operating advances by each partner are made pursuant to a formula which allocates certain variable costs based on each partner's share of annually agreed-upon pellet production and certain fixed costs based on each partner's percentage interest in Eveleth. Eveleth is dependent for its continued existence upon the annual pellet purchases and ongoing financial support of its partners. Property, Plant and Equipment--Property, plant and equipment and the related depreciation expense included in the Historical--Adjusted amounts are based on the Company's estimate of the net realizable value of such fixed assets. The Historical--Adjusted amounts reflect amounts recorded by the Company for the impairment of fixed assets of $94.2 recorded prior to 1991 and an additional impairment of $42.0 recorded in 1992. The Historical--Adjusted depreciation amounts recorded by the Company represent reductions of depreciation expense for the previously recognized impairment of fixed assets in the Historical--Adjusted financial statements. Debt--Evelth's debt bears inerest of 9.5-10% and matures in 1995. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The Company records its proportionate share of the losses of Eveleth based on Historical--Adjusted amounts. These losses, which are included in the Company's cost of products sold, were $6.5, $16.1, $17.4 and $14.0 in 1990, 1991, 1992 and 1993, respectively. In addition, in 1992 the Company fully impaired its investment in Eveleth to recognize the Company's estimate of the net realizable value of the fixed assets of Eveleth. The Company's recorded share of Eveleth's losses in 1991 and 1992 exceeded its proportionate percentage interest in Eveleth because the Company purchased a larger percentage of Eveleth's annual pellet production relative to its percentage interest and, therefore, under the cost-allocation formula described above, the Company absorbed a higher percentage of the Eveleth costs. The Company's annual cash funding of Eveleth's fixed costs is appproximately $12.0 per year. See Notes 7 and 8. The following is a summary of the net assets of SOS at December 31, 1992 and 1993 and its operating results for the four months ended December 31, 1992 and the year ended December 31, 1993. Property, Plant and Equipment--Steelmaking plant and equipment are depreciated under the straight line method over their estimated lives ranging from 2 to 31 years. Maintenance and repair expenses for 1990, 1991, 1992 and 1993 were $278.5, $267.1, $265.5 and $261.3, respectively. Financial Instruments--The carrying value of the Company's financial instruments does not differ materially from their estimated fair value. Cash Equivalents--Cash equivalents include short-term, highly liquid investments that are readily convertible to known amounts of cash and are of an original maturity of three months or less. 2. INCOME TAXES The ASCII group will file a consolidated federal income tax return for the year ended December 31, 1993. No federal tax will be due for 1993 due to the incurrence of a consolidated 1993 loss. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) Deferred federal income taxes in the accompanying Consolidated Balance Sheets relate to temporary differences of the ASCII group, primarily differences between book and tax carrying values of the group's investments in joint ventures. The ASCII group recorded a consolidated deferred tax benefit of $10.8 in 1992 which represents the net reduction during the year of the group's consolidated deferred tax liability. No deferred tax charge or benefit was recorded in 1993. The ASCII group has consolidated net operating loss (NOL) carryforwards into 1994 of $34.3 under the "regular" tax system ($32.5 under the alternative minimum tax (AMT) system). These NOL's, if unused to offset future consolidated taxable income of the ASCII group, will expire in 2006, 2007 and 2008. In addition, Virginia Horn, one of ASCII's wholly-owned subsidiaries, has available an NOL carryforward into 1994 of $1.5 under the "regular" tax system ($1.7 under the AMT system). This carryforward, if unused to offset future Virginia Horn taxable income, will expire in 2001. However, for federal income tax purposes, the amount of NOL carryforwards arising prior to the Recapitalization (see Note 11) which will annually be available to offset taxable income following the Recapitalization may be restricted by Section 382 of the Internal Revenue Code. As a result, the use of all or a significant portion of these NOL carryforwards may be deferred or disallowed. The ASCII group adopted Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, effective January 1, 1993. The effect of this standard was not material. Other than for the ASCII group, the financial statements do not reflect U.S. federal income tax liabilities because each of the partners' U.S. federal income tax returns will include their appropriate share of the Company's taxable income or loss. 3. NOTES PAYABLE AND LONG-TERM DEBT At December 31, 1993, the Company had agreements that provide credit facilities for borrowings up to $50.0 with a group of banks on a revolving credit basis until May, 1994. At December 31, 1993, $3.8 letters of credit were issued under these facilities. Under the terms of a Security Agreement between the Company and its lenders, these credit facilities and the majority of the Company's long-term debt are secured by a pool of Company assets which includes accounts receivable, inventories, and property, plant and equipment. The terms of the Security Agreement will permit additional financings, which are yet to be negotiated, of up to $254.0 through 1995 to be secured by the pledged assets. At December 31, 1993, the Company also had a $100.0 unsecured term loan, maturing in 1996, with an affiliate of Kawasaki. The Company has incurred interest expense and commitment fees to an affiliate of Kawasaki of $2.1, $2.4, $1.3 and $4.2 during 1990, 1991, 1992 and 1993, respectively, relating to borrowings under the revolving credit agreement and the unsecured term loan. On January 18, 1994, the Company's various lenders signed amendments to the revolving credit agreements and long-term debt agreements to revise certain financial covenants effective as of December 31, 1993. The Company is required to maintain as of December 31, 1993 a minimum tangible net worth of $650.0, a minimum current ratio of 1.0 and a maximum leverage ratio of 1.0, as defined in the agreements. At December 31, 1993, the Company's actual measures under these financial covenants were a tangible net worth of $742.1, a current ratio of 1.76 and a leverage ratio of 0.85. In addition, on January 18, 1994 the Company entered into an agreement with certain of its lenders whereby the maturity of a portion of its debt will be extended to May 31, 1995 in the event that the proposed recapitalization described in Note 11 is not completed by May 1994 (the original maturity date of the debt). Management believes that the Recapitalization will be completed before that date. As a result, $80.0 of debt has been classified as long-term at December 31, 1993. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) At December 31, 1991, 1992 and 1993, the Company's long-term debt, less current maturities, was as follows: - ---------------- (a) Rate fixed in 1992. (b) Debt secured by the No. 1 Electrogalvanizing Line and a $15.0 letter of credit. (c) Debt with extended maturity to May 31, 1995. (d) Unsecured subordinated term loan with an affiliate of Kawasaki. At December 31, 1993, the maturities of long-term debt are as follows: The Company capitalized interest on projects under construction of $12.6, $7.1, $3.5 and $1.2 during 1990, 1991, 1992 and 1993, respectively. 4. OPERATING LEASES Rental expense was $9.7, $11.2, $14.6 and $10.1 for 1990, 1991, 1992 and 1993, respectively. At December 31, 1993, obligations to make future minimum lease payments were as follows: 5. EMPLOYEE AND RETIREE BENEFIT PLANS Pension Plans--The Company provides noncontributory pension benefits to virtually all employees. Benefits are based on years of service and earnings in the highest 60 consecutive months in the last 120 months prior to retirement or a minimum amount per year of service, whichever is higher. The qualified plans are funded in accordance with the minimum funding requirements of the Employee Retirement Income Security Act of 1974, as amended. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The details of the net periodic pension expense for 1990, 1991, 1992 and 1993 are as follows: The funded status of the plans at December 31, 1991, 1992 and 1993, using the assumptions stated below for each period, was as follows: - ----------------- * The change in the discount rate is expected to increase pension expense by $9.1 annually and to have no material effect on funding requirements. The mix of pension assets held at December 31, 1993 was as follows: Of the total accrued pension cost of $110.5, $201.5 and $209.3 at December 31, 1991, 1992, and 1993, respectively, $45.4, $24.9 and $56.6 are included in Other accruals, and $65.1, $176.6 and $152.7 are included in Other liabilities in the accompanying Consolidated Balance Sheets. The 1992 pension disclosures above include the effects on the Company's pension plans of the Special Charges and Unusual Items described in Note 8. The total loss resulting from the related curtailment and special and contractual termination benefits amounted to $105.9. A minimum liability and corresponding intangible asset of $23.2, $25.9 and $35.2 at December 31, 1991, 1992 and 1993, respectively, was recognized for the excess of the accumulated benefit obligation over the total ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) of plan assets and the accrued pension liability. These balances are included in Other liabilities and Other assets, respectively, in the accompanying Consolidated Balance Sheets. In addition, a direct charge to equity of $113.2 was recorded in 1993 primarily as a result of the reduction in the discount rate for pension liabilities from 8.5% to 7.5%. The corresponding credit is included in Other liabilities. Retiree Health Care and Life Insurance Benefits -- In addition to providing pension benefits, the Company provides certain health and life insurance benefits for retirees. Most employees become eligible for these benefits at retirement. The retiree health and life insurance benefits are funded as claims are paid and for 1990, 1991, 1992 and 1993 the Company paid benefits totalling $24.2, $28.1, $29.7 and $32.2, respectively. In December 1993, the Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", retroactive to January 1, 1990. SFAS 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. SFAS No. 106 allows recognition of the cumulative effect of this obligation in the year of the adoption or the amortization of the obligation over a period of up to twenty years. The Company elected to recognize this obligation immediately effective January 1, 1990 and recorded $491.6 as the cumulative effect of this charge. The Company's cash flows are not affected by implementation of this statement, but implementation increased the operating loss by $23.8, $22.2, and $22.9 in 1990, 1991 and 1992, respectively, and decreased the operating profit by $27.0 in 1993. The Company is presently paying for these plans from its general assets as the benefits become payable. The Company does not anticipate funding these benefits in the foreseeable future. In 1990, 1991, 1992 and 1993, the Company recognized $48.0 $50.3, $52.6 and $59.2, respectively, as an expense for postretirement health care and life insurance benefits. A special charge of $56.5 for retiree health care benefits associated with restructuring and a voluntary salary reduction program was taken in the fourth quarter of 1992. (see Note 8). The following table sets forth the plans' funded status, reconciled with amounts recognized in the Company's statement of financial position at December 31, 1991, 1992 and 1993. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) For measurement purposes, health care costs are assumed to increase 10% in 1994 grading down by 1% per year to a constant level of 4.5% annual increase for pre-65 benefits and 7% in 1994 grading down by 1% per year to a constant level of 4.5% annual increase for post-65 benefits. In concluding that health care trend rates will decrease at a rate of 1% per year, the Company has considered future rates of inflation, recent movements toward managed health care programs in negotiated contracts and the trend among larger companies toward the formation of coalitions in an effort to reduce health care costs. The Company is currently finalizing negotiations with health care providers in the Cincinnati- Dayton corridor, a region that includes a significant number of the Company's retirees. In addition, the Company intends to implement similar managed health care programs in other geographic regions containing a concentration of its retirees, and is developing a managed care network for all active and retired salaried and union employees in Ohio. These programs will be in effect in January 1995. The Company has also considered the recent political environment and activities geared towards reducing health care costs and has taken into consideration the level of health care costs in relation to the U.S. Gross National Product (GNP). Despite the assumption that health care trend rates will decrease 1% per year, the combination of assumptions used in the SFAS 106 valuation results in approximately 18% of GNP for health care costs by the year 2000 compared to 14% currently. A one (1) percentage point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of January 1, 1994 by $75.7 and the aggregate of the service cost and interest cost components of net period benefit cost for the year then ended by $6.8. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5% for 1993 and 8.5% for prior years. This 1% reduction in the discount rate associated with a 1% reduction in the ultimate health care trend rate will increase OPEB expense by $0.1. The Company will adopt SFAS 112, Employers' Accounting for Postemployment Benefits, effective January 1, 1993. Adoption of this standard did not have a material effect on the accompanying consolidated financial statements. 6. RELATED PARTY TRANSACTIONS During 1990, 1991, 1992 and 1993, the Company was party to certain transactions with Armco, Kawasaki, and their affiliates. These transactions consisted of charges to and from the Company for various services rendered and received, and are reflected primarily in Selling and administrative expenses in 1990, 1991 and 1992, and in Cost of products sold in 1993 in the accompanying Consolidated Statements of Operations. The following is a summary of such related party services for the periods: Services provided to Armco and affiliates by the Company: ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) Services provided to the Company by Armco, Kawasaki and their affiliates and inventory purchases from Armco: Processing and conversion increased during 1992 and 1993 as the Company provided services to Armco under a long-term toll rolling agreement, which will continue in effect after completion of the proposed Recapitalization (see Note 11). Research and engineering decreased in 1993 due to Armco transferring a portion of their research staff to the Company on April 1, 1993. The cost of this research staff for the nine-months ended December 31, 1993 was $3.8 and was included in Selling and administrative expenses in the Consolidated Statements of Operations and Partners' Capital (Deficit). In 1993, the Company purchased processing services and other materials of $3.6 from SOS. The Company acquired a 50% ownership interest in SOS to which substantially all of the businesses of Southwestern Ohio Steel, Inc. and SOS Leveling Company, Inc. were transferred by Armco. Sales to Armco, Kawasaki and their affiliates were $101.2, $89.8, $85.9 and $36.7 during 1990, 1991, 1992 and 1993, respectively, and sales to SOS were $26.0 for the four months ended December 31, 1992 and $99.5 for 1993. All of these amounts are included in Total Net Sales in the accompanying Consolidated Statements of Operations. Other miscellaneous sales to Armco, Kawasaki and their affiliates were $5.0, $2.5, $1.7 and $0.7 during 1990, 1991, 1992 and 1993, respectively. Under the Joint Venture Agreement, Armco is obligated to indemnify the Company for certain supplemental unemployment benefit payments up to a maximum of $20.0. As a result, the related receivables are included as reductions in Partners' Capital (Deficit) in the accompanying Consolidated Balance Sheets. 7. COMMITMENTS Virginia Horn is committed to fund its percentage share of certain defined fixed costs of Eveleth. Through an agreement with Armco the Company has assumed Armco's obligations relating to Virginia Horn which include a guarantee of Virginia Horn's performance to the other participants of Eveleth Mines. Under agreement with another owner of Eveleth, the Company purchased 300,000 tons of iron ore from this Eveleth partner in 1993 and is expected to purchase at least 250,000 tons per year through 1996. Beginning in the fourth quarter of 1992, Virginia Horn elected not to nominate to purchase equity iron ore pellets from Eveleth. As a result of that decision together with doubts regarding the continued level of support by the Eveleth Mines partners, in light of worldwide excess iron ore capacity and Eveleth Mines' position as a high cost producer, the Company concluded that its ability to recover its investment was doubtful and therefore impaired its investment in Eveleth Mines (see Note 8). However, the Company continues to record its proportionate share of Eveleth's losses, of which approximately $12.0 per year is funded with cash. See Note 10. As of December 31, 1993, the Company had agreed to purchase a total of 1.6 million tons of iron ore pellets from a Brazilian iron ore company through 1998. Under this contract, the Company also has agreed to purchase sinter feed ore requirements. In addition, the Company has agreed to purchase at least 6.5 million tons through 1997 from a North American pellet producer. In June 1993, the Company and Peabody Coal Company ("Peabody") entered into a six-year agreement that superseded a 1984 agreement. The new agreement provides for a fixed market price from February 1994 through February 1996, after which annual price adjustments will be made based on market prices. In addition, Peabody agreed to a price reduction for the remainder of 1993. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The Company has committed to purchase property, plant and equipment (including unexpended amounts relating to projects substantially under way) amounting to approximately $74.8 (including $38.9 of environmental costs of which $24.2 and $14.7 will be spent in 1994 and 1995 respectively) at December 31, 1993. 8. SPECIAL CHARGES AND UNUSUAL ITEMS The special charges and unusual items recorded in 1992 and 1993 are: - -------------- (a) Net of estimated realizable values. In 1992, the Company recorded charges totalling $379.3 relating to restructuring of facilities, workforce reductions and the impairment of its investment in Eveleth. Restructuring of the facilities and workforce reductions resulted from the determination that the Company had redundant assets, excess capacity and excessive operating costs. The impairment of Eveleth followed the Company's conclusion as to its inability to recover its investment (see Note 7). Most of these actions, which were intended to reduce future operating costs, took place following an operations review conducted by the Company's newly appointed management team and were completed in the fourth quarter of 1992. In 1993, the Company continued to review its operations for the purpose of reducing operating costs. In connection with this review, the Company recorded additional charges of $12.6 for restructuring of facilities, and $5.0 for certain legal, litigation and other unusual items which consist of $3.0 that is reserved for litigation payments resulting from the aborted outsourcing of operations in Ashland that were shut down as part of the Ashland restructuring and $2.0 for legal expenses in connection with defending the Company for existing and potential lawsuits relating to the workforce terminations. See Note 10. 9. EXTRAORDINARY ITEM The extraordinary item recorded in 1992 represents the following: "The Coal Industry Retiree Health Benefit Act" requires that health benefits for any pre-1976 retirees who were previously covered by one of two insolvent United Mineworkers multi-employer welfare funds revert to their former employers. Retirees of employers that no longer exist are also assigned to surviving companies using a formula included in the legislation. The Company was required to assume a portion of their benefits and recorded an extraordinary loss of $12.1 of which $1.2 and $0.9 are included in Other accruals and $10.9 and $11.9 in Other liabilities in the accompanying Consolidated Balance Sheets as of December 31, 1992 and 1993, respectively. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) 10. LEGAL, ENVIRONMENTAL MATTERS AND CONTINGENCIES Domestic steel producers, including the Company, are subject to stringent federal, state and local laws and regulations relating to the protection of human health and the environment. The Company has expended, and can be expected to expend in the future, substantial amounts for compliance with these environmental laws and regulations. Capital expenditures for environmental remediation and protection for 1993 totalled $16.4. In addition, the Company made payments for environmental compliance of approximately $38.3 for 1993. The Clean Air Act Amendments of 1990 (the "CAAA" or "Amendments") impose new standards designed to reduce air emissions. The Amendments will directly affect many of the Company's ongoing operations, particularly its coke oven batteries. The Company believes that the costs of complying with the Amendments will not have a material adverse effect on its financial condition, results of operations or cash flows. Federal regulations promulgated pursuant to the Clean Water Act impose categorical pretreatment limits on the concentrations of various constitutions in coke plant wastewaters prior to discharge into publicly owned treatment works ("POTW"). Due to concentrations of ammonia and phenol in excess of these limits at the Middletown Works, the Company, through the Middletown POTW, petitioned the United States Environmental Protection Agency (the "EPA") for "removal credits," a type of compliance exemption, based on the Middletown POTW's satisfactory treatment of the Company's wastewater for ammonia and phenol. The EPA declined to review the Company's application on the grounds that the EPA had failed to promulgate new sludge management rules. As a result of the EPA's refusal, the Company sought and obtained from the Federal District Court for the Southern District of Ohio an injunction prohibiting the EPA from instituting enforcement action against the Company for noncompliance with the pretreatment limitations, pending the EPA's promulgation of the applicable sludge management regulations. Although the Company is unable to predict the outcome of this matter, if the EPA eventually refuses to grant the Company's request for removal credits, the Company could incur additional costs to construct pretreatment facilities at the Middletown Works. The estimated cost of such a facility is in the range of $2.0 to $4.0. The Company believes those costs would not have a material adverse effect on its financial condition, results of operations or cash flows. The Company operates an on-site landfill for the disposal of various sludges and dusts, principally resulting from air and water pollution treatment systems at the Middletown Works. These materials are currently considered non-hazardous wastes. The Company currently intends, subject to approval by the Ohio Environmental Protection Agency (the "Ohio EPA"), to expand the present landfill, which is expected to reach capacity in the next eight to nine years. Based on current projections, the Company estimates that the design and construction of the expansion, which is slated to begin in mid-1994 with an anticipated completion date of January 1, 1996, will cost approximately $6.2 million. If the expansion is not approved by the Ohio EPA, the Company may incur increased disposal costs due to the need for off-site disposal. The Company believes these costs would not have a material adverse effect on its financial condition, results of operations or cash flows. On December 5, 1986, Armco received notification from the EPA advising that it was being considered as a PRP at the Maxey Flats Nuclear Disposal Site near Morehead, Kentucky. Records from the landfill indicated that the Ashland Works had sent approximately 120 cubic feet of material to the site. The Company has been identified as de minimis contributor to the Maxey Flats site, and as a result, anticipates that it will be able to resolve its liability for a nominal amount. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The Company will continue to review its businesses to determine if additional facilities should be closed, written down or otherwise restructured or if its workforce should be further reduced. In this regard, the Company is negotiating with the Eveleth partners concerning the potential closure of, or the Company's exit from, Eveleth. If these negotiations are successfully completed, the closure of, or exit from, Eveleth would be subject to other events, including the approval by the Company's Board of Directors, and could result in a charge of approximately $30.0 million. This amount approximates the Company's proportionate share of the potential shutdown costs arising from the potential closure, which costs primarily represent employee and retiree benefits and contract termination fees. In addition, in the second quarter of 1994 the Company may incur a charge of approximately $65.0 million relating to further reductions of its workforce, subject to approval by the Company's Board of Directors. This charge is expected to be comprised of approximately $50.0 million for pension-related curtailments and $15.0 million for health care related curtailments. Although it is not possible at this time for the Company to determine accurately the amounts of any other special charges that may result from the closure, write down or restructuring of other facilities or from additional workforce reductions, additional special charges could be incurred and may be substantial. The company is also involved in routine litigation, other environmental proceedings, and claims pending with respect to matters arising out of the normal conduct of the business. In management's opinion, the ultimate liability resulting from such claims, individually or in the aggregate, will not materially affect the Company's consolidated financial position, results of operations or cash flows. In June 1990, the Company filed an antitrust action against several companies. Effective February 25, 1992, the Company reached a confidential settlement with three of the four remaining defendants. The settlement reduced 1992 Cost of products sold in the accompanying Consolidated Statements of Operations. The Company is continuing to pursue the claim against the remaining defendant. 11. SUBSEQUENT EVENTS On January 13, 1994, the General Partner approved the filing with the Securities and Exchange Commission of registration statements in connection with a proposed Recapitalization of the Company (the "Recapitalization"). The Company is currently negotiating for the sale of its ownership interest in SOS and another subsidiary of ASCII. No prediction can be made concerning the ultimate outcome of such negotiations which, if successful, would be subject to other events including the approval by the Company's Board of Directors. However, the ultimate sale, if any, will not result in a loss. SCHEDULE V ARMCO STEEL COMPANY, L.P. PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) - -------------- NOTES: (A) Reclass from Lease-rights to Property upon payment of leases. (B) Reclass additional portions of Caster undergoing modification to construction in progress. (C) Transfer of steel processing companies from Armco Inc. (D) Impair and reclass to investments, assets which are to be idled and sold as part of the Company's restructuring plan. SCHEDULE VI ARMCO STEEL COMPANY, L.P. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) - ---------- NOTES: (A) Reclass from Lease-rights to Property upon payment of leases. (B) Impairment of a blast furnace and other equipment. (C) Reclassification of asset groups. (D) Impairment and reclassification to investments, assets which are to be idled and sold as part of the Company's restructuring plan. (E) Generally, depreciation rates on assets are 5% for land improvements and leaseholds, 3-4% for Buildings and 5% for Machinery and equipment. SCHEDULE VIII ARMCO STEEL COMPANY, L.P. VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (Dollars in Millions) - -------------- NOTES: (A) Represents impairment of Virginia Horn Taconite Company's investment in Eveleth Expansion Company. SCHEDULE IX ARMCO STEEL COMPANY, L.P. SHORT-TERM BORROWINGS (Dollars in Millions) - -------------- NOTES: (A) Borrowings from an affiliate, which are payable within one year. (B) Based on daily balances. (C) Based on average rates for two weeks preceding and following year-end. SCHEDULE X ARMCO STEEL COMPANY, L.P. SUPPLEMENTARY INCOME STATEMENT INFORMATION INDEPENDENT AUDITORS' REPORT - ---------------------------- Armco Inc.: We have audited the statement of consolidated net assets of Armco Financial Services Group - Companies to be Sold as of December 31, 1993 and 1992 and the related consolidated statements of operations and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included Financial Statement Schedule I, Summary of Investments - Other than Investments in Related Parties; Schedule III, Condensed Financial Information; Schedule VI, Reinsurance; Schedule VIII, Valuation and Qualifying Accounts; and Schedule X, Supplemental Information Concerning Property-Casualty Insurance Operations. 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 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 Armco Financial Services Group - Companies to be Sold 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, 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. As discussed in Notes 3 and 6 to the consolidated financial statements, effective January 1, 1993 the Company changed its method of accounting for reinsurance contracts and postretirement benefits other than pensions. As discussed in Note 1 to the consolidated financial statements, effective December 31, 1993 the Company changed its method of accounting for investments in debt securities. DELOITTE & TOUCHE Milwaukee, Wisconsin February 25, 1994 ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD STATEMENT OF CONSOLIDATED NET ASSETS AS OF DECEMBER 31, 1993 AND 1992 (Dollars in thousands) See notes to consolidated financial statements. ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD STATEMENT OF CONSOLIDATED OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) See notes to consolidated financial statements. ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD STATEMENT OF CONSOLIDATED CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) (continued) ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) See notes to consolidated financial statements. - ------------------------------------------------------------------------------ ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ---------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Armco Financial Services Group - Companies to be Sold (AFSG - Companies to be Sold or the Company) consists of the net assets of Armco Inc.'s (Armco) insurance companies which Armco intends to sell and which continue underwriting activities. These activities principally represent the transactions of Northwestern National Holding Company, Inc. (NNHC), which is a wholly owned subsidiary of Armco Financial Services Corporation (AFSC), which is a wholly owned subsidiary of Armco and is accounted for by Armco as an investment in net assets using the cost recovery method. NNHC owns 100% of the common and preferred stock of Northwestern National Casualty Company and its wholly owned subsidiary, NN Insurance Company (collectively, NNCC), Pacific National Insurance Company and its wholly owned subsidiary, Pacific Automobile Insurance Company (collectively, PNIC), SICO, Inc. and its wholly owned subsidiary, Statesman Insurance Company and Statesman's wholly owned subsidiary Timeco, Inc. (collectively, SICO) and Certified Finance Corporation (CFC). CFC had not commenced operations as of December 31, 1993. Principles of Consolidation - The consolidated financial statements include --------------------------- the accounts of NNHC and its subsidiaries NNCC, PNIC, SICO and CFC. Significant intercompany accounts and transactions have been eliminated. Business Segment - The Company operates in a single business segment, ---------------- property and casualty insurance. Basis of Presentation - The accompanying financial statements have been --------------------- prepared on the basis of generally accepted accounting principles (GAAP) which vary from statutory reporting practices prescribed or permitted for insurance companies by regulatory authorities (see Note 8). Investments - In May 1993, the Financial Accounting Standards Board (FASB) ----------- issued Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The statement requires fixed maturity investments which are available for sale to be recorded at market value. The Company adopted SFAS No. 115 on December 31, 1993 and reclassified certain investments from the "held to maturity class" into the "available for sale" class on the same date. The financial statement effect of adopting the statement was to increase investments by $13,321,000 and net assets by $13,321,000. Amounts reported in the Statement of Consolidated Cash Flows for 1993 are based on the classification of securities prior to the adoption of SFAS No. 115. Fixed maturity investments include bonds and mortgage-backed securities. Fixed maturity investments which the Company has the positive intent and ability to hold to maturity ("held to maturity") are reported at amortized cost. Fixed maturity investments which are available for sale ("available for sale") are reported at market value as of December 31, 1993 and at the lower of amortized cost or market, determined in the aggregate, as of December 31, 1992. Equity securities are common stocks which are reported at market value. The difference between cost and market value of common stocks, and investments available for sale at December 31, 1993, is reflected as a component of net assets. Short-term investments (cash equivalents) are reported at cost which approximates market value. During 1992, the Company re-evaluated its intentions to hold to maturity all of its bonds and reclassified certain investments as available for sale. Investments classified as available for sale are expected to be held for an indefinite period and may be sold depending on interest rates, cash requirements and other considerations. Because the aggregate market value of these investments exceeded the amortized cost, there was no financial statement effect of this reclassification as of December 31, 1992. Investment income consists primarily of interest which is recognized on an accrual basis. Interest income on mortgage-backed securities is determined on the effective yield method based on scheduled principal payments. Realized capital gains and losses, calculated as the difference between proceeds and book value, are determined by specific identification of the investments sold. Recognition of Premium Revenues - Premiums, net of reinsurance ceded, are ------------------------------- earned on a pro rata basis over the term of the policy. Deferred Policy Acquisition Costs - Policy acquisition costs that vary with --------------------------------- and are directly related to the production of premiums are deferred and amortized over the terms of the policies to which they relate. Amortization for the years ended December 31, 1993, 1992 and 1991 was $46,456,000, $49,912,000 and $56,256,000, respectively. Depreciation - Depreciation on property and equipment is provided primarily ------------ on the straight-line basis over the estimated useful lives of the respective assets. Goodwill - Goodwill, which represents the excess of cost over the fair value -------- of net assets of acquired subsidiaries is amortized on a straight-line basis over periods not exceeding 40 years. Cash Flow - For purposes of reporting cash flows, the Company considers all --------- highly liquid short-term investments purchased with maturities of three months or less to be cash equivalents. Insurance Liabilities - The liability for losses and loss adjustment expenses --------------------- is reported net of a receivable for salvage and subrogation of $7,746,000, $7,523,000 and $7,499,000 at December 31, 1993, 1992 and 1991, respectively. Participating Policy Contracts - Participating business represents ------------------------------ approximately 14%, 13% and 11% of total premiums in force at December 31, 1993, 1992 and 1991, respectively. Participating business is composed entirely of workers' compensation policies. The amount of dividends to be paid on these policies is determined based on the provisions of the individual policies. Dividend expense for the years ended December 31, 1993, 1992 and 1991, was $2,414,000, $2,966,000 and $5,170,000, respectively. 2. INVESTMENTS The amortized cost and market value of the Company's fixed maturity investments as of December 31, 1993 that are designated as held to maturity are as follows: The amortized cost and market value of the Company's fixed maturity investments as of December 31, 1993 that are designated as available for sale are as follows: The amortized cost and market value of the Company's fixed maturity investments as of December 31, 1992 that are designated as held to maturity are as follows: The amortized cost and market value of the Company's fixed maturity investments as of December 31, 1992 that are designated as available for sale are as follows: The amortized cost and market value of the Company's fixed maturity investments 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. Proceeds from fixed maturity investment sales and gross realized gains and losses during 1993 are as follows: Proceeds from sales and maturities of investments during 1992 and 1991 were $267,030,000 and $230,664,000, respectively. Gross gains of $11,060,000 and $5,514,000 and gross losses of $978,000 and $2,985,000 were realized on those sales. At December 31, 1993 and 1992, the Company's fixed maturity investments carried at amortized cost of $52,845,000 and $44,716,000, respectively, were on deposit with regulatory authorities. Total investment income, investment expense and net investment income for the years ended December 31, 1993, 1992 and 1991 were as follows: 3. REINSURANCE ACTIVITY The Company limits the maximum net loss which can arise from large risks or risks in concentrated areas of exposure by reinsuring (ceding) certain levels of risks with other insurers, either on an automatic basis or under general reinsurance contracts known as "treaties" or by negotiation on substantial individual risks. Ceded reinsurance is treated as the risk and liability of the assuming companies. Reinsurance contracts do not relieve the Company from its obligations to policyholders. In the event that reinsuring companies are unable to meet their obligations under the agreements, the Company would continue to have primary liability to policyholders for losses incurred. The Company evaluates the financial condition of its reinsurers and evaluates concentrations of credit risk when determining reinsurance placements. At December 31, 1993 reinsurance receivables of $18,061,000 and prepaid reinsurance premiums of $2,026,000 were associated with a single reinsurer. The Company has never suffered a significant loss due to reinsurers unable to meet their obligations. The following tables summarize amounts related to reinsurance assumed and ceded as of December 31, 1993, 1992 and 1991 and for the years then ended, respectively. Loss and Loss Adjustment Expense (LAE) Activity: (Dollars in Thousands) In December 1992, the FASB issued SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." The statement establishes the conditions required for a contract to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. The Company adopted SFAS No. 113 on January 1, 1993. Prior to the adoption of the new statement, assets and liabilities were reported net of the effects of reinsurance. Subsequent to the adoption of the new statement, ceded reinsurance balances due from unaffiliated insurers are reported separately as assets. Ceded reinsurance balances due from affiliated insurers continue to be reported in liabilities. As permitted by the statement, prior period financial statements have been restated. 4. TRANSACTIONS WITH AFFILIATES The Company has entered into a number of agreements or arrangements with affiliated companies in connection with intercompany services. The net amounts charged (credited) to operations during 1993, 1992 and 1991, were as follows: The net amount due from affiliates at December 31, 1993, which includes fees and assessments paid by the Company on behalf of affiliates, was $803,000. At December 31, 1992, $36,000 was due to affiliates. 5. INCOME TAXES Armco and the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109) effective January 1, 1993. SFAS No. 109 requires an asset and liability approach for financial accounting. Armco accounted for the operating results of the AFSG - Companies to be Sold under the cost recovery method, whereby net income is not recognized until realized through a sale of the business, while net losses are charged against income as incurred. These businesses are now presented as discontinued operations with a portion of the consolidated Armco federal tax provision/benefit being allocated to the Company in accordance with the intraperiod tax allocation provisions of SFAS No. 109. Because Armco is in a consolidated net operating loss position for both financial reporting and federal income tax purposes, no federal income tax provision or benefit was allocated to the Company. Because Armco accounts for the Company as an investment which it intends to sell, the cumulative effect of adopting SFAS No. 109 and the deferred federal tax assets and liabilities applicable to the Company are recorded on the books of Armco, rather than by the Company. The Company and its subsidiaries file state income tax returns in several states on both a separate company and combined basis. A provision (benefit) of $223,000, $(166,000) and $246,000 is reported in the Statement of Consolidated Operations for the years ended December 31, 1993, 1992 and 1991, respectively. The 1993 provision includes a current year state income tax provision of $224,000 and adjustments to prior years state income taxes of $(1,000). The 1992 benefit includes a current year state income tax provision of $27,000 and a refund from prior year state income taxes of $(193,000). The 1991 provision includes a current year state income tax provision of $2,000 and an adjustment to prior years state income taxes of $244,000. 6. PENSION, PROFIT SHARING AND BENEFIT PLANS The Company has a noncontributory, trusteed retirement plan covering substantially all of its employees. Pension costs relating to this retirement plan are computed based on accepted actuarial methods. It is the Company's policy to fund pension costs as they accrue, but, in no event at less than the amount required by, nor more than the maximum amount allowable under, the Employee Retirement Income Security Act of 1974 (ERISA). Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The following table sets forth the retirement plan's funded status and amounts recognized in the financial statements of the Company at December 31, 1993, 1992 and 1991: Net periodic pension benefit for 1993, 1992 and 1991 included the following components: The following assumptions were used in determining the actuarial present value of the projected benefit obligation as of December 31, 1993, 1992 and 1991: The Company, along with other affiliates, has a benefit plan which provides medical and dental benefits for eligible retired employees. Substantially, all employees become eligible for these benefits if they reach normal retirement age while working for the Company. These benefits are funded as claims are paid. In December 1990, the FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The standard requires the accrual of expense for these benefits during the years the employee is actively employed. The Company adopted SFAS No. 106 on January 1, 1993. The cumulative effect of the accounting change resulted in a decrease in 1993 income of $14,000,000. The following table sets forth the benefit plan's funded status and amounts recognized in the balance sheets of the companies participating in the plan as of December 31, 1993. The accrued postretirement benefit liability applicable solely to the Company is $14,633,000 as of December 31, 1993. Net postretirement benefit cost applicable solely to the Company for the year ended December 31, 1993 is $15,174,000. For measurement purposes, an 11.25% annual rate of increase in the per capita cost of covered health care benefits for non-Medicare eligible participants was assumed for 1994 (8.25% used for Medicare eligible participants); the rate was assumed to decrease gradually to 5.25% for all participants by 2000 and remain 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 plan's accumulated postretirement benefit obligation as of December 31, 1993 by $2,866,000, and the aggregate service cost and interest cost components of the plan's net periodic postretirement benefit cost for the year by $446,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation at December 31, 1993 was 7.25%. The Company also has a noncontributory, trusteed profit sharing plan. Annual contributions to the plan (limited to a maximum of 15% of participating salaries) are based upon operating results of the Company. No expense was recorded for the years ended December 31, 1993, 1992 and 1991. The Company provides medical, dental and life insurance benefits to eligible participants on long-term disability, at no cost to the participant. Prior to 1993, the Company expensed these benefits on a pay-as-you-go basis. In December 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This statement requires recognition of an employer's obligation to provide benefits to former and inactive employees after employment but before retirement. The Company adopted SFAS No. 112 in 1993. The cumulative effect of the accounting change, reported on the Statement of Consolidated Operations as a component of other expenses, resulted in a decrease in 1993 income of $715,000. 7. NOTE PAYABLE As partial financing of the SICO acquisition, the Company entered into a $14,000,000 term loan agreement with a local bank. The Company has the option of electing an interest rate tied to the bank's prime or Eurodollar rate. The interest rate on the loan was 5.875%, 5.625% and 7.69% as of December 31, 1993, 1992 and 1991, respectively. The term loan is secured by the stock of SICO. Under the terms of the loan agreement, the Company is required to make principal payments of $700,000 on March 31, 1994 and each quarter end thereafter through December 31, 1994. The loan is subject to various covenants. At December 31, 1993, the lender waived compliance with certain existing covenants and new covenants were negotiated effective January 1, 1994. The new covenants require the Company to maintain tangible shareholder's equity, as defined, of $120 million during fiscal 1994. At December 31, 1993, as defined, tangible shareholder's equity was $138.1 million. In addition, various covenants applicable to the Company's subsidiaries require minimum statutory surplus levels and maximum premiums to surplus ratios. 8. NET ASSETS NNHC depends on dividends from its subsidiaries to service debt and pay expenses. The payment of shareholder dividends by insurance companies without the prior approval of the state insurance regulators is limited to formula amounts based on net investment income, and capital and surplus determined in accordance with statutory accounting principles. At December 31, 1993, approximately $4.2 million of dividends are available without prior regulatory approval. NNCC paid dividends to NNHC of $3,170,000, $3,896,500 and $3,500,000 during the years ended December 31, 1993, 1992 and 1991, respectively In accordance with the terms of an order dated April 10, 1985 of the Insurance Commissioner of the State of California (the Commissioner), PNIC may not pay any dividend or other distribution unless the dividend is approved by the Commissioner. PNIC received approval for and paid dividends to NNHC of $1,000,000 during the year ended December 31, 1992 and $450,000 during the year ended December 31, 1991. SICO paid dividends to NNHC of $1,500,000 during the year ended December 31, 1992. During the year ended December 31, 1991, PNIC redeemed all 500,000 shares of its preferred stock owned by NNHC at the $10 par value. Simultaneous with this redemption, NNHC made a $2,000,000 capital contribution to PNIC and a $3,500,000 contribution to NNCC. This transaction was approved by the Commissioner. The following information has been prepared on the basis of statutory accounting principles which differ from GAAP. The principal differences relate to deferred acquisition costs and assets not admitted for statutory reporting. 9. FAIR VALUES OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of the fair value of financial instruments. In developing the fair value of financial instruments, the Company uses available market quotes and data, provided by external pricing services, as well as valuation methodologies where appropriate. As considerable judgment is required in interpreting market data and performing valuation methodologies, the fair value estimates presented below are not necessarily indicative of the amounts the Company might pay or receive in actual current market transactions. Furthermore, as a number of the Company's significant assets and liabilities are excluded from the provisions of SFAS No. 107, the disclosures below do not reflect the Company's statement of net assets on a fair value basis, nor the fair value of the Company as a whole. The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments: Financial Assets ---------------- Fair values for fixed maturity investments are based on quoted market prices. Equity securities are valued based on quoted market prices. Cash and cash equivalents are highly liquid investments with maturities of less than three months; carrying value approximates fair value. Accrued investment income is valued at carrying value as it is short-term in nature. Insurance premium balances receivable are generally collected on a monthly basis. Due to the short-term nature of these receivables, their carrying value approximates fair value. Financial Liabilities --------------------- The Company's insurance reserves are specifically excluded from the provisions of SFAS No. 107. Other financial liabilities are valued at their carrying value due to their short-term nature. As permitted under SFAS No. 107, other financial liabilities exclude postretirement and postemployment benefit obligations for purposes of this disclosure. The fair value of the Company's note payable is based on current rates offered to the Company for debt of the same remaining maturities. 10. COMMITMENTS The Company leases certain office facilities and equipment under operating leases. Minimum rental commitments under noncancelable leases are as follows: Total rental expense was $2,512,000, $2,291,000 and $2,201,000 in 1993, 1992 and 1991, respectively. 11. LITIGATION The Company is involved in various lawsuits that have arisen from the normal conduct of business. These proceedings are handled by corporate and outside counsel. It is the opinion of management that the outcome of these proceedings will not have a material effect on the Company's financial condition or liquidity; however, it is possible that due to fluctuations in the Company's results, future developments with respect to changes in the ultimate liability could have a material effect on future interim or annual results of operations. 12. SUBSEQUENT EVENTS On January 31, 1994, Armco announced that it had signed a letter of intent to sell Northwestern National Holding Company, Inc. and its subsidiaries to Vik Brothers Insurance, Inc. (Vik), a privately held, Raleigh, North Carolina- based property and casualty insurance holding company. In connection with the proposed transaction, Vik would pay approximately $70 million at the closing and approximately $15 million, reduced by a potential adjustment for adverse experience in the insurance reserves, in three years. The final agreement is subject to a number of conditions, including a definitive purchase agreement, and approvals by regulatory authorities and the boards of directors of both companies. - -------------------------------------------------------------------------------- ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD SCHEDULE I SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES AS OF DECEMBER 31, 1993 (Dollars in thousands) See notes to consolidated financial statements. ARMCO FINANCIAL SERVICES GROUP - SCHEDULE III COMPANIES TO BE SOLD (PARENT ONLY) CONDENSED FINANCIAL INFORMATION CONDENSED STATEMENTS OF NET ASSETS AS OF DECEMBER 31, 1993 AND 1992 (Dollars in thousands) See notes to condensed financial information. ARMCO FINANCIAL SERVICES GROUP - SCHEDULE III COMPANIES TO BE SOLD (PARENT ONLY) CONDENSED FINANCIAL INFORMATION CONDENSED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) See notes to condensed financial information. ARMCO FINANCIAL SERVICES GROUP - SCHEDULE III COMPANIES TO BE SOLD (PARENT ONLY) CONDENSED FINANCIAL INFORMATION CONDENSED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) See notes to condensed financial information. - -------------------------------------------------------------------------------- ARMCO FINANCIAL SERVICES GROUP - SCHEDULE III COMPANIES TO BE SOLD (PARENT ONLY) CONDENSED FINANCIAL INFORMATION NOTES TO CONDENSED FINANCIAL INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. The accompanying condensed financial information should be read in conjunction with the consolidated financial statements of the AFSG - Companies to be Sold. 2. Long-term debt consists of the following: As partial financing of the SICO acquisition, the Company entered into a $14,000,000 term loan agreement with a local bank. The Company has the option of electing an interest rate tied to the bank's prime or Eurodollar rate. The interest rate on the loan was 5.875%, 5.625% and 7.69% as of December 31, 1993, 1992 and 1991, respectively. The term loan is secured by the stock of SICO. Under the terms of the loan agreement, the Company is required to make principal payments of $700,000 on March 31, 1994 and each quarter end thereafter through December 31, 1994. The loan is subject to various covenants. At December 31, 1993, the lender waived compliance with certain existing covenants and new covenants were negotiated effective January 1, 1994. The new covenants require the Company to maintain tangible shareholder's equity, as defined, of $120 million during fiscal 1994. At December 31, 1993, as defined, tangible shareholder's equity was $138.1 million. In addition, various covenants applicable to the Company's subsidiaries require minimum statutory surplus levels and maximum premiums to surplus ratios. 3. NNHC depends on dividends from its subsidiaries to service debt and pay expenses. The payment of shareholder dividends by insurance companies without the prior approval of the state insurance regulators is limited to formula amounts based on net investment income, and capital and surplus determined in accordance with statutory accounting principles. At December 31, 1993, approximately $4.2 million of dividends are available without prior regulatory approval. NNCC paid dividends to NNHC of $3,170,000, $3,896,500 and $3,500,000 during the years ended December 31, 1993, 1992 and 1991 respectively. In accordance with the terms of an order dated April 10, 1985 of the Insurance Commissioner of the State of California (the Commissioner), PNIC may not pay any dividend or other distribution unless the dividend is approved by the Commissioner. PNIC received approval for and paid dividends to NNHC of $1,000,000 during the year ended December 31, 1992 and $450,000 during the year ended December 31, 1991. SICO paid dividends to NNHC of $1,500,000 during the year ended December 31, 1992. During the year ended December 31, 1991, PNIC redeemed all 500,000 shares of its preferred stock owned by NNHC at the $10 par value. Simultaneous with this redemption, NNHC made a $2,000,000 capital contribution to PNIC and a $3,500,000 contribution to NNCC. This transaction was approved by the Commissioner. 4. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The statement requires fixed maturity investments which are available for sale to be recorded at market value. The Company adopted SFAS No. 115 on December 31, 1993. ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD SCHEDULE VI REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD SCHEDULE X SUPPLEMENTAL INFORMATION CONCERNING PROPERTY/CASUALTY INSURANCE OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD DISCLOSURE OF CERTAIN DATA ON LOSS AND LOSS EXPENSE RESERVES The liability for unpaid losses and loss adjustment expenses includes an amount determined from loss reports and individual cases and an amount, based on past experience, for losses incurred but not reported. Such liability is necessarily based on estimates and, while management believes that the amount is fairly stated, the ultimate liability may be in excess of or less than the amount provided. The methods for making such estimates and for establishing the resulting liability are continually reviewed and any adjustments resulting therefrom are reflected in earnings currently. The Company does not discount the liability for unpaid losses and loss adjustment expenses. AFSG companies to be sold estimates losses for reported claims on an individual case basis. Case reserves are based on experience with a particular type of risk and the available information surrounding each individual claim. Case reserves are reviewed on a regular basis. As additional facts become available, the case reserves are adjusted as necessary. The stability of the case reserving process is monitored through comparison with ultimate settlement. The estimates of losses for incurred but not reported claims (IBNR), as well as additive reserves for reported claims, are developed primarily from an analysis of historical patterns of the development of paid and incurred losses (dollars and claim counts) by accident year for each line of business. Salvage and subrogation estimates are developed from patterns of actual recoveries. Allocated loss adjustment expense reserves are developed from an analysis of historical patterns of the development of paid allocated loss adjustment expenses to incurred losses, by accident year, for each line of business. These historical patterns are then applied to projected ultimate losses for each line of business. Unallocated loss adjustment expense reserves are developed utilizing a cost accounting system. The cost accounting system is based on historical costs modified for anticipated changes in operations and selections of alternative costs. In December 1992, the FASB issued SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration contracts." The statement establishes the conditions required for a contract to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. The Company adopted SFAS No. 113 in 1993. Prior to the adoption of the new statement, assets and liabilities were reported net of the effects of reinsurance. Subsequent to the adoption of the new statement, ceded reinsurance balances due from unaffiliated insurers are reported separately as assets. Ceded reinsurance balances due from affiliated insurers continue to be reported in liabilities. As permitted by the statement, prior period financial statements have been restated. Loss and loss adjustment expense reserves are stated at management's estimate of the ultimate cost of settling all incurred but unpaid claims. Loss and loss adjustment expense reserves are not discounted.

792014_1993.txt

792014_1993

1993

792014

Item 1. Business. Introduction INVG Mortgage Securities Corp. (the "Company") is a corporation organized under the laws of the State of Maryland on March 26, 1986. The Company's principal executive offices are located at Meadow Wood Crown Plaza, 1575 Delucchi Lane, Suite 115-20, Reno, Nevada 89502. Its telephone number is (702) 828-5405. The Company holds all of the outstanding common stock of Investors GNMA Mortgage-Backed Securities Trust, Inc. ("Investors GNMA"), and INVG Government Securities Corp. ("INVG Government"). The Company, directly or through its subsidiaries, has historically generated revenues primarily from Collateralized Mortgage Obligation ("CMO") investments whereby the company was engaged in the business of acquiring modified mortgage-backed pass through certificates ("GNMA Certificates") and then issuing and selling bonds (Bonds) backed by the GNMA Certificates. These investments in CMO issuances give the Company the right to the excess cashflows and earnings on the GNMA Certificates over the expenses required on the the Bonds ("CMO Issuance Investments"). The Company has also invested in other similar mortgage related investments wherein the Company has the right to receive the cashflows of a CMO bond offering after debt service payments are made, such as CMO Mortgage Derivative Investments and REMIC Mortgage Derivative Investments, ("Mortgage Derivative Investments"). The Company and its subsidiaries are qualified as real estate investment trusts under the Internal Revenue Code of 1986 as amended (the "Code"). The Company intends to operate in a manner so as to continue to qualify for the tax benefits accorded by Sections 856 to 860 of the Code and thereby not be subject to federal income tax at the corporate level. There can be no assurance, however, that the Company will be able to do so. Among the conditions that the Company must satisfy to obtain such benefits is the requirement that the Company distribute to its shareholders an amount equal to substantially all of its taxable income. See "Federal Income Tax Consequences - Federal Income Taxation of a REIT." Investors GNMA issued $500,000,000 aggregate principal amount of its GNMA-Backed Sequential Pay Bonds Series 1983-1 (the "Series 1983-1 Bonds") on October 25, 1983; $500,000,000 aggregate principal amount of its GNMA- Backed Sequential Pay Bonds, Series 1984-1 (the "Series 1984-1 Bonds") on January 30, 1984; $300,000,000 aggregate principal amount of its GNMA- Backed Sequential Pay Bonds, Series 1984-2 (the "Series 1984-2 Bonds") on April 30, 1984; $250,000,000 aggregate principal amount of its GNMA-Backed Sequential Pay Bonds, Series 1984-3 (the "Series 1984-3 Bonds") on June 29, 1984; $500,000,000 aggregate principal amount of its GNMA-Backed Sequential Pay Bonds, Series 1984-4 (the "Series 1984-4 Bonds") on October 30, 1984 and $300,000,000 aggregate principal amount of its GNMA-Backed Sequential Pay Bonds, Series 1984-5 (The "Series 1984-5 Bonds") on December 27, 1984. No Bonds have been issued by Investors GNMA since December 1984. The Series 1984-5 Bonds were redeemed on May 26, 1992, the Series 1984-1 Bonds were redeemed on January 25, 1993 and the Series 1983-1 Bonds were redeemed on February 25, 1993. (See "Bond Redemptions".) The Company is currently exploring the feasibility of redeeming the remaining three Bond Series. INVG Government was organized by the Company in May 1986. On December 30, 1986, INVG Government commenced operations by issuing $200,369,000 principal amount of its Collateralized Mortgage Obligations, Series A (the "Series A Bonds"). The issuance of the Series A Bonds was financed, in part, by the issuance of 115,000 shares of Series A Participating Preferred Stock (the "Series A Preferred Stock") by the Company to certain institutional investors including one or more pension plans for which Robert E. Greeley, a director of the Company, was investment manager, and including the Boston Safe Deposit and Trust Company, a subsidiary of Shearson Lehman Brothers Inc., for a purchase price of $100 per share. Holders of the Series A Preferred Stock were entitled to receive during 1990, 1989, 1988 and 1987 in the form of dividends or redemption payments 80.01% of the "Series A Net Cash Flow" (as defined in the terms governing the Series A Preferred Stock). The Company made a capital contribution to INVG Government of the full amount of the proceeds received by the Company from the sale of the Series A Preferred Stock. INVG Government used such funds to purchase GNMA Certificates to use as collateral for the Series A Bonds. No Bonds have been issued by INVG Government since December 1986. The Series A Bonds were redeemed on February 1, 1994.. During the fourth quarter of 1990 the Company repurchased all of the shares of the Company's Series A Preferred Stock from the preferred shareholders. This was done in order to give management discretion for the possibility of restructuring the assets. The Company paid $1,232,375 (including expenses) in cash and issued a note with a face value of $1,158,375 in connection with the purchase of the Series A Preferred Stock which had a redemption value of $8,090,400. The note had an interest rate equal to the prime rate plus 2% per annum. The note was redeemed at face value in November, 1991. While the Board of Directors cancelled all issued shares of the Series A Preferred Stock on January 15, 1991, the transaction was reflected in the Company's financial statements as of December 31, 1990. The Series 1983-1 Bonds, the Series 1984-1 Bonds, the Series 1984-2 Bonds, the Series 1984-3 Bonds, the Series 1984-4 Bonds, the Series 1984-5 Bonds and the Series A Bonds are hereinafter collectively referred to as the "Issued Bonds." All of the Issued Bonds, to the extent still outstanding, are collateralized by GNMA Certificates. Future Prospects - ---------------- The Company's Net Interest Margin continues to decline through the process of repayments and prepayments on the mortgages underlying the Company's assets as well as from the redemption of Bond Series. The dramatic decrease in long term interest rates throughout 1992 and 1993 has accelerated the rate of prepayments. Additionally, the Company's asset pool is depleted by normal business expenses and the payment of dividends. The Company has been reinvesting its excess cash flows in Mortgage Derivative Investments which include CMO Residuals and REMIC Residual bonds. To the extent the Company continues to have cash in excess of that required for expenses and dividends, the Company intends to continue to reinvest that excess cash in Mortgage Derivative Investments in order to generate income for distribution to stockholders. Advisory Agreement - ------------------ The principal operating expenses of the Company have been advisory fees for legal, accounting, management and administrative services with respect to the operation of the Company and its subsidiaries. From February 1990 through December 1991, the Company had an advisory agreement with Fulcrum Financial Partners, Inc. ("Fulcrum") with respect to itself and each of its subsidiaries (the Company and its subsidiaries being hereinafter referred to as the "Companies"). As such advisor, Fulcrum was responsible for conducting the day-to-day operations of each of the Companies in connection with policy decisions made by its Board of Directors; and performing such services as were required for disbursing, collecting and investing cash proceeds of each of the Companies, preparing and delivering reports and filings required with respect to each of the Companies and other activities relating to the assets of each of the Companies. Fulcrum received a monthly fee of $15,000 for each month of the year 1991 for its services. Administration Agreement - ------------------------ In December 1991, the Companies entered into a year to year Administration Agreement with TIS Asset Management, Inc. (the "Administrator") to perform corporate administrative services for the Companies. Under this agreement, the Administrator administers the day-to- day operations of the Companies and performs or supervises the performance of such other administrative functions as may be agreed upon by the Administrator and the Board of Directors of each Company, including the establishment and posting of books of original record with their attendant quarterly financial statements and maintenance of appropriate computer services to perform such administrative services. The Administrator prepares reports and forms as required to satisfy the continuous reporting and other requirements of any and all governmental bodies and agencies. The Administrator serves as the Companies' consultant with respect to the formation of investment criteria and policy guidelines for recommendation to the Boards of Directors. Until December 31, 1992, pursuant to the Administration Agreement, the Administrator received a monthly fee of $14,500 and pays the employment expenses of its personnel, computer expenses, rent and other office expenses and overhead. Effective January 1, 1993 this fee was increased to $16,000 per month. Pursuant to the Administration Agreement, the Administrator does not assume responsibility other than to render in good faith the services called for thereunder and is not responsible for any action of the Board of Directors of any of the Companies in following or declining to follow any advice or recommendation of the Administrator. The Administrator, its directors, officers, shareholders and employees are not liable to any Company, any Company's Shareholders or others, except by reason of acts constituting bad faith, willful misfeasance, gross negligence or reckless disregard of its duties. The Companies have agreed to indemnify the Administrator and its Affiliates, shareholders, directors, officers, and employees with respect to all expenses, losses, damages, liabilities, demands, charges and claims of any nature whatsoever in respect of or arising from any acts or omissions performed or omitted by the Administrator in good faith and in accordance with the standard set forth in the Administration Agreement. The foregoing description of the Administration Agreement does not purport to be complete but is merely a summary of the material provisions thereof and is qualified in its entirety by reference to the Administration Agreement which is incorporated by reference in Exhibit 10.3 hereto. Consulting Agreement - -------------------- At the Annual Meeting of Shareholders held on October 26, 1993, a consulting agreement with Page Mill Asset Management was ratified. Under this agreement, which is effective January 1, 1993, the Companies will pay Page Mill a monthly fee of $10,000 plus an incentive management fee. The incentive management fee, determined with respect to the Companies' performance each fiscal year is equal to 25% of the dollar amount, if any, by which the Companies' consolidated taxable income for such fiscal year, before payment of any incentive fee to Page Mill, net operating loss deductions arising from prior periods' losses and special Internal Revenue Code deductions pertaining to real estate investment trusts, plus certain other adjustments in accordance with generally accepted accounting principles, exceeds the amount necessary to provide an annualized return on equity equal to 1% over the average ten-year U.S. Treasury rate for such fiscal year. Under this agreement, the Company has recorded expense in the year ended December 31, 1993 of $120,000 and $774,000 for of the monthly and incentive management fees, respectively. Page Mill Asset Management is 100% owned by Robert E. Greeley, Chairman of the Board and President of the Company. Other Expenses of the Companies - ------------------------------- Other operating expenses include annual fixed fees payable to the trustees (the "Trustees") under the Indentures under which the Bonds are issued. Such fees are calculated at a rate of 0.015% per annum of the Bonds outstanding, except for the trustee fees for the Series A Bonds, which are calculated at a rate of 0.02% per annum of the Series A Bonds outstanding. Only a portion of the trustee fees were accrued in 1993 as certain fees were overpaid in prior years. Annual aggregate legal and accounting fees approximated $150,000. Consulting fees for officers' services and administration approximated $312,000 plus the incentive management fee and annual fees paid to directors approximated $45,000. Other administrative costs of the Company approximates $120,000. Taxable Income and Dividends - ---------------------------- The Companies have each elected to qualify for the tax benefits accorded by Sections 856 to 860 of the Code, and intend to operate in a manner so as to continue to qualify for such benefits in the future and thereby not be subject to federal income tax at the corporate level. There can be no assurance, however, that the Companies will be able to do so. Among the conditions that the Companies must satisfy to obtain such benefits is the requirement that such entities must distribute to their shareholders an amount equal to substantially all of their taxable income. See "Federal Income Tax Consequences - Federal Income Taxation of a REIT". The Company's subsidiary, Investors GNMA, commencing fiscal 1986, changed its method of accruing original issue discount on its Bonds for purposes of reporting taxable income. Due to the adoption of this new method of tax accounting and due to tax losses in recent years, Investors GNMA has net operating loss carryforwards at December 31, 1993 aggregating $14.0 million which may be applied against the taxable income of Investors GNMA in future years commencing in 1994. While Investors GNMA may make distributions to the Company and the Company in turn may make distributions to its shareholders, during the years in which taxable income may be offset by net operating losses and in years in which Investors GNMA or the Company have no taxable income, any distributions during those years will be subject to the discretion of the Board of Directors of such entities and will depend upon the operating capital requirements of the Companies. The taxable income of the Company principally is derived through its subsidiaries from: (1) the Net Interest Margin of the Company, plus non- cash income resulting from the amortization of market discount on the GNMA Certificates and less non-cash amortization of original issue discount on the Bonds, amortization of market premium on the GNMA Certificates and Bond issuance expenses, (2) interest received and earnings on other investments including Mortgage Derivative Investments, less (3) the operating expenses of the Company. The Company's funds available for distribution to its shareholders are primarily derived from: (1) the excess of interest received on the GNMA Certificates collateralizing the Bonds over the interest payments due on the Bonds (such excess constituting the "Interest Margin"); (2) the excess of funds received from selling GNMA Certificates over the costs associated with redeeming the Bonds, plus investment earnings on cash balances and less operating expenses (together with the "Interest Margin," the "Net Interest Margin"); or (3) interest received and earnings from other investments which include investments in Mortgage Derivative Investments such as CMO Residuals, REMIC residual bonds, and other mortgage related investments. If the taxable income of the Company of a subsidiary of the Company for any year exceeds its cash flow for such year, such subsidiary is required to distribute to its shareholder an amount substantially equal to such taxable income in order to preserve its status (and consequently the status of the Company) as a real estate investment trust and, therefore, may be required to distribute a portion of its working capital to its shareholders. The Bond Offerings - ------------------ INVESTORS GNMA. Bonds issued by Investors GNMA are issued pursuant to an Indenture (the "Investors GNMA Indenture") dated as of September 1, 1983 between Investors GNMA and Chemical Bank, as trustee (the "Investors GNMA Trustee"), as supplemented by a supplemental indenture with respect to each series of Bonds. The Investors GNMA Indenture limits the amount of Bonds which can be issued thereunder to $5,000,000,000, and provides that Bonds of any series may be issued thereunder up to the aggregate principal amount authorized from time to time by the Company. The collateral pledged to collateralize each series of Bonds issued by Investors GNMA consists of (i) GNMA Certificates, together with the payments thereon, having the characteristics described below, and (ii) a P&I Account (as defined in the Investors GNMA Indenture) (the "Investors GNMA P&I Account"). The Delivery Date GNMA Principal Balance (as defined in the Investors GNMA Indenture) for each series of Bonds are not less than the aggregate principal amount of the Bonds of such series issued, the lowest pass-through rate on any GNMA Certificate securing any series of Bonds issued by Investors GNMA will equal or exceed the highest interest rate (the "Bond Interest Rate") on the Bonds of any Sequence (as defined below). The difference between the lowest pass-through rate and the highest Bond Interest Rate with respect to any series of Bonds is the "Investors GNMA Minimum Spread" for such series. Scheduled distributions of principal of, and interest on, the GNMA Certificates collateralizing a series are sufficient to pay accrued interest on the Bonds of such series and to amortize the entire principal amount of the Bonds of each sequence by their respective stated maturity date. The Mortgage Certificates for the Bonds of a particular series will collateralize only that series of Bonds. Each series of Bonds issued by Investors GNMA is issuable in sequences ("Sequences"). Each Sequence has its own Bond Interest Rate and stated maturity which is the date on which the Bonds of such Sequence will be fully paid assuming no prepayments of principal are received with respect to the GNMA Certificates securing the Bonds of such series (the "Stated Maturity"). The actual maturity of any Sequence could differ substantially from its Stated Maturity based upon actual prepayment experience of such GNMA Certificates and because certain of the underlying mortgages for a GNMA Certificate may have terms to maturity that are shorter than the stated maturity of such GNMA Certificate. All distributions of principal of, and interest on, the GNMA Certificates held on behalf of Investors GNMA will be remitted to the Investors GNMA Trustee who will deposit such funds in the Investors GNMA P&I Account for the related series of Bonds established under the Investors GNMA Indenture. Each series of Bonds will have a separate Investors GNMA P&I Account. All amounts on deposit in any Investors GNMA P&I Account representing distributions of principal of the GNMA Certificates will be applied on each monthly payment date (a "Monthly Payment Date") to pay principal on the then amortizing Sequence of the related series of Bonds. Each series of Bonds will mature by Sequence, and principal payments of succeeding Sequences will be made only after all Bonds of the immediately preceding Sequence have been paid in full. All amounts on deposit in any Investors GNMA P&I Account representing distributions of interest on the GNMA Certificates will be applied on each Monthly Payment Date to the extent necessary to pay interest on the aggregate principal balance of all the related Sequences of Bonds outstanding on the last day of the month preceding such Monthly Payment Date. All distributions received on the respective GNMA Certificates which are not required to pay principal of, and interest on, the related series of Bonds will be remitted monthly to Investors GNMA. The Indenture for Bonds issued by Investors GNMA provides that the Bonds are not redeemable at the option of Investors GNMA, except that the last maturing Sequence of any series of Bonds may be redeemed at the option of Investors GNMA, in whole but not in part, on any Monthly Payment Date, when the outstanding principal amount of such Sequence declines to 10% or less of the original principal amount of the Bonds of such Sequence at a redemption price equal to the outstanding principal amount thereof, together with interest accrued thereon. INVG GOVERNMENT. Bonds issued by INVG Government are issued pursuant to an Indenture (the "INVG Government Indenture") dated as of December 1, 1986 between INVG Government and Texas Commerce Bank National Association (the "INVG Government Trustee"), as amended, and as supplemented by supplemental indentures (each a "Series Supplement") with respect to each series of Bonds. The INVG Government Indenture does not limit the amount of Bonds which can be issued thereunder, and provides that Bonds of any series may be issued thereunder up to the aggregate principal amount that may be authorized from time to time by INVG Government. The collateral pledged to secure each series of Bonds issued by INVG Government may consist of (i) Mortgage Certificates together with the distributions of principal and interest thereon, (ii) a Collection Account (as defined in the INVG Government Indenture) (the "INVG Government Collection Account") and (iii) other reserve funds and accounts which may be required in order to obtain the desired investment rating on the Bonds (collectively, the "Collateral"). On the closing date for each series of Bonds, the value of the Collateral pledged to secure such Bonds (calculated in accordance with the methodology specified in the INVG Government Indenture) will not be less than the aggregate principal amount of such Bonds. Scheduled distributions of principal of and interest on the Mortgage Certificates collateralizing each series of Bonds are calculated to be sufficient to pay accrued interest on such Bonds and to amortize the entire principal amount of each class of such Bonds by its respective stated maturity date. The Collateral for the Bonds of a particular series will secure only that series. Each series of Bonds issued by INVG Government is issuable in Classes (the "Classes"). Each Class will have its own Bond Interest Rate, which may be a floating interest rate that is redetermined periodically according to a specified index, and its own Stated Maturity, which is the date on which the Bonds of such Class will be fully paid assuming no prepayments of principal are received on the Mortgage Certificates securing such series. Each series of Bonds will mature by Class, and principal payments on the various Classes of Bonds within each series will be made in the order specified in the Series Supplement. The actual maturity of any Class of Bonds could differ substantially from its Stated Maturity based upon the actual prepayment experience of the Mortgage Certificates and because certain of the underlying mortgage loans may have terms-to-maturity that are shorter than the Stated Maturity of the related Mortgage Certificate. No assurance can be given that the actual maturity and effective yield with respect to any Class of Bonds will be comparable to that experienced with respect to any other Class of Bonds within such series or within other series of Bonds issued by INVG Government or any of its affiliates. All distributions of principal of and interest on the Mortgage Certificates pledged to secure a series of Bonds will be remitted to the INVG Government Trustee who will deposit such funds in the INVG Government Collection Account for such series. Each series of Bonds will have a separate INVG Government Collection Account. All amounts on deposit in any INVG Government Collection Account representing distributions of principal of the Mortgage Certificates will be applied on each payment date ("Payment Date") for the related series of Bonds to pay principal on the then- amortizing Class of such series. Amounts on deposit in the INVG Government Collection Account representing distributions of interest on the Mortgage Certificates will be applied on each Payment Date, to the extent necessary to pay interest on the aggregate principal balance of the outstanding Bonds of such Series accrued as of the date prior to such Payment Date specified in the Series Supplement. All amounts remaining in the INVG Government Collection Account for a Series of Bonds which are not applied to the payment of principal of and interest on the Bonds of the related series and the INVG Government Trustee's operating expenses will be remitted to INVG Government. The INVG Government Indenture permits series of Bonds or Classes of Bonds within a series to be redeemed at the option of INVG Government upon the dates or under the circumstances specified in the related Series Supplement. The redemption price paid for such Bonds will be equal to their outstanding principal amount, together with accrued interest thereon to the date specified in the Series Supplement. Bond Redemptions - ---------------- On May 4, 1992, following the consent of the holders of not less than a majority in principal amount of the outstanding bonds, the Board of Directors of the Company and the Trustee approved an amendment to the Indenture for Series 1984-5 GNMA-Backed Sequential pay bonds. This amendment related to the redemption provisions of the Indenture. On May 5, 1992, the Board of Directors resolved to effect a redemption of the Series 1984-5 Bonds and a notice was sent to all of the Bondholders to the effect that the Company, as issuer, was exercising its right of redemption in respect of the Series 1984-5 Bonds pursuant to the Section 11.01 of the Indenture. This redemption was scheduled for the next payment date of May 26, 1992. On May 22, 1992, Chemical Bank, acting as trustee under the indenture, sold the GNMA Certificates securing the Series 1984-5 Bonds, the proceeds of which were used to redeem the bonds on May 26, 1992. The gain to the Company from selling the mortgages was $7,476,302. After accounting for expenses of the transaction, including amortization of discount and deferred bond issuance costs, the extraordinary loss to the Company from the redemption of these bonds was $6,188,203. The net cash received by the Company on this transaction was $1,867,342. On August 24 and November 30, 1992 the Company purchased for $7,197,087 and $3,414,410, respectively, a portion of its Bond Series 1984- 1. These bonds had original face values of $8,000,000 and $5,000,000 and current face values of $5,273,152 and $3,035,032 on their respective purchase dates. The bonds were acquired with $1,754,364 of cash and the remaining $8,857,133 was financed under a reverse repurchase agreement. The Company paid $548,604 principal on the reverse repurchase agreement in 1992, decreasing the outstanding balance to $8,308,529. At December 31, 1992 the interest rate on the reverse repurchase agreement was 5%. This debt is renewed on a month to month basis. For financial accounting purposes, the portion of Bond Series 1984-1 acquired was considered redeemed in 1992. This resulted in $3,387,807 in extraordinary losses from redemption of bonds, which is comprised of $2,303,313 from premium paid for the bonds; $387,272 in unamortized discount; $54,038 in unamortized deferred bond issuance costs and $643,183 in related bond redemption expenses. On December 9, 1992, the Company commenced a tender offer (the "Offer") for all of its outstanding Series 1983-1 Bonds and Series 1984-1 Bonds and a solicitation of consents to amend the provisions of the related Indenture to permit the Company to redeem bonds of these Series not tendered pursuant to the Offer. On January 25, 1993, after giving consideration to the scheduled payments, the Company (i) purchased $46,926,150 aggregate principal amount of the Series 1984-1 Bonds tendered pursuant to the Offer for an aggregate purchase price and consent payment of 111.5%, plus accrued interest to the purchase date, or a total of $52,706,392, and (ii) redeemed the remaining $2,952,592 of Series 1984-1 Bonds for par plus accrued interest to the redemption date. On February 25, 1993, after giving consideration to the scheduled payments, the Company (x) purchased $68,946,187 aggregate principal amount of its Series 1983-1 Bonds tendered pursuant to the Offer for an aggregate purchase price and consent payment of 113.5%, plus accrued interest to the purchase date, or a total of $78,787,507 and (y) redeemed the remaining $458,068 of Series 1983- 1 Bonds for par plus accrued interest to the redemption date. . In 1993 the Company realized a gain of $25,954,618 from selling the GNMA Certificates securing the Series 1983-1 and Series 1984-1 Bonds. After accounting for expenses, including amortization of discounts, the Company realized an extraordinary loss of $24,190,531 from the retirement of the Series 1983-1 and Series 1984-1 Bonds. The net cash the Company received from this series of transactions was $963,542. On January 5, 1994 the Board of Directors of INVG Government authorized an optional redemption of the Series A Bonds on February 1, 1994. On January 24, 1994 the GNMA Certificates securing the Series A Bonds were sold. Issued Bonds - ------------ The following table sets forth certain information with respect to the Issued Bonds to the extent outstanding at December 31, 1993. INVESTMENTS OF THE COMPANY -------------------------- Investment Policies - ------------------- The Company's investment policies and other policies are determined by its Board of directors in accordance with the articles and bylaws of the Company. The objective of the company is to maximize earnings and cashflow for distribution to the shareholder through mortgage related investments. The Company, in its early years, invested in CMO Related Investments through issuance of its own Bonds. Over the last year, the Company has been reinvesting its cashflows from these CMO Related Investments in Mortgage Derivative Investments which are similar in earnings and cashflow nature to its original CMO Related Investments. At all times, the Company intends to make investments in such a manner as to be consistent with the requirements of the Code to qualify as a REIT unless, because of circumstances or changes in the Code (or in the regulations promulgated thereunder), the Company determines that it is no longer in the best interest of the Company to qualify as a REIT. The Company's policies with respect to such activities may be reviewed and modified from time to time by the Company. The investment in Mortgage Derivative Investments and other investments may from time to time cause conflicts to occur between the articles of Investors GNMA and the Indenture under which Investors GNMA's Bonds were issued. Government National Mortgage Association - ---------------------------------------- GNMA is a wholly owned corporate instrumentality of the United States within the United States Department of Housing and Urban Development (the "HUD"). Section 306 (g) of Title III of the National Housing Act of 1934, as amended (the "Housing Act"), authorized GNMA to guaranty the timely payment of the principal of, and interest on, certificates which are based on and backed by a pool of mortgage loans insured by the FHA under the Housing Act, or Title V of the Housing Act of 1949, or guaranteed by the United States Veterans Administration (the "VA") under the Servicemen's Readjustment Act of 1944, as amended or Chapter 37 of Title 38, United States Code or by other eligible mortgage loans. Section 306(g) of the Housing Act provides that "the full faith and credit of the United States is pledged to the payment of all amounts which may be required to be paid under any guaranty under this subsection." In order to meet its obligations under such guarantees, GNMA is authorized, under Section 306(d) of the Housing Act, to borrow from the United States Treasury with no limitations as to amount. GNMA Certificates - ----------------- Each GNMA Certificate is a "fully modified pass-through" mortgage- backed certificate issued under either the GNMA I or the GNMA II program (hereinafter described) and serviced by a mortgage banking company or other financial concern approved by GNMA as a seller-servicer of FHA Loans or VA loans. Although a GNMA certificate does not constitute a liability of, or evidence any right of recovery against, its issuer, the full and timely payment of principal of, and interest on, each GNMA Certificate is guaranteed by GNMA and such guaranty is backed by the full faith and credit of the United States. Each GNMA Certificate will evidence a fractional undivided interest in a pool of FHA Loans and VA Loans and provide for the payment to the registered holder of such GNMA Certificate of fixed monthly payments of principal and interest equal to the aggregate amount of the scheduled monthly principal and interest payments on each FHA or VA Loan, less a servicing and guaranty fee based on the outstanding principal of the FHA or VA Loans underlying the GNMA Certificate and liquidation proceeds in the event of a foreclosure or other disposition of any such FHA or VA Loans. GNMA approves the issuance of each GNMA Certificate in accordance with a guaranty agreement (the "Guaranty Agreement") between GNMA and each issuer-servicer of the GNMA Certificates. Pursuant to its Guaranty Agreement such issuer-servicer is required to advance its own funds in order to make timely payments of all amounts due on the GNMA Certificate even if the payments received by such issuer on the FHA Loans and VA Loans backing the GNMA Certificate are less than the amounts due thereon. The Guaranty Agreement provides that in the event of default by the issuer- servicer, including (i) a failure by the issuer-servicer to make a required payment in accordance with the terms and conditions of such Guaranty Agreement, (ii) an advance by GNMA pursuant to a request to GNMA by the issuer-servicer to make a payment of principal of, or interest on, the GNMA Certificates, or (iii) insolvency of the issuer-servicer, GNMA shall have the right, by letter to the issuer-servicer, to effect the complete extinguishment of the issuer-servicer's interest in the pool of FHA Loans and VA Loans backing the GNMA Certificates, and the FHA Loans and VA Loans shall become the absolute property of GNMA, subject only to the unsatisfied rights of the holders of the GNMA Certificates. In such event, the Guaranty Agreement provides that, on and after the time GNMA directs such a letter of extinguishment to the issuer-servicer, GNMA shall be the successor in all respects to the issuer-servicer in its capacity under the Guaranty Agreement, and shall be subject to all responsibilities, duties and liabilities theretofore placed on the issuer-servicer by the terms and provisions of the Guaranty Agreement. At any time thereafter, however, GNMA may enter into an agreement with any other eligible issuer of GNMA Certificates under which such issuer undertakes and agrees to assume all or any part of such responsibilities, duties and liabilities placed on the original issuer-servicer, provided that no such agreement shall detract from the responsibilities, duties and liabilities of GNMA as guarantor of the GNMA Certificates or otherwise adversely affect the rights of the holders thereof to principal and interest payments on the GNMA Certificates. The issuer of a GNMA Certificate expects that interest and principal payments on the FHA Loans and VA Loans backing each GNMA Certificate will be the source of funds for payments due on such GNMA Certificate. If the issuer is unable to make payments on the GNMA Certificates as they become due, it must promptly notify GNMA and request GNMA to make such payments. In the event no payment is made by the issuer and the issuer fails to notify GNMA and request GNMA to make such payment, the holder of the GNMA Certificate has recourse only against GNMA to obtain such payments. The Trustees, as registered holders of a GNMA Certificate, may proceed directly against GNMA under the terms of the Guaranty Agreement relating to such GNMA Certificate, for any amounts which are not paid when due. GNMA Certificates Collateralizing the Bonds - ------------------------------------------- All of the GNMA Certificates collateralizing the Bonds are registered in the name of the respective Trustee. The Company will not add any GNMA Certificates to, or substitute other GNMA Certificates for, the original GNMA Certificates included in the collateral for each series of Bonds. Other Collateral - ---------------- Although the Company or INVG Government may issue Bonds secured by collateral other than GNMA Certificates, no such Bonds have been issued. FEDERAL INCOME TAX CONSEQUENCES ------------------------------- The Company intends to operate in a manner that will enable it to continue to qualify as a real estate investment trust (a "REIT") under the Code. The discussion below is not intended as a detailed discussion of all applicable Code provisions, the rules and regulations promulgated thereunder, or the administrative and judicial interpretations thereof. In general, if an entity desiring to qualify as a REIT (a "REIT Candidate") satisfies certain tests with respect to the nature of its income, assets, management, and share ownership, and the amount of its distributions, it will qualify as a REIT for federal income tax purposes. As a result, the REIT Candidate generally will not be subject to tax at the corporate level to the extent that it distributes its income to its shareholders. This treatment eliminates most of the "double taxation" (taxation at the corporate level and subsequently at the shareholder level when earnings are distributed) that typically results from the use of corporate investment vehicles. Such qualification, however, depends upon the ability of the Company to meet detailed factual and legal standards in future years. Federal Income Taxation of a REIT - --------------------------------- In any year in which a REIT Candidate qualifies as a REIT, and for which an election to be a real estate investment trust is in effect, it generally will not be subject to federal income tax on that portion of its REIT Taxable Income (as defined below) or capital gain that is distributed to its shareholders. Any such income that is not distributed, however, will be subject to tax at the regular corporate rates. A REIT, moreover, may be subject to special taxes on certain types of income, regardless of distributions to shareholders, and to the corporate minimum tax on certain items of tax preference. The Company, however, does not expect to have income of such types. As a REIT, the Company is required to use the calendar year both for tax purposes and financial reporting purposes. The taxable income of a REIT ("REIT Taxable Income") is generally computed as if it were an ordinary corporation, subject to certain adjustments. Due to the differences, however, between tax accounting rules and generally accepted accounting principles, the REIT Taxable Income of the Company may vary from net income for financial reporting purposes. GROSS INCOME AND ASSET TESTS. In order to qualify as a REIT, a REIT Candidate must satisfy, for each taxable year, various tests with respect to the nature of its gross income and its assets. The three principal income tests are the following: 1. THE 75 PERCENT TEST. At least 75 percent of the gross income (excluding gross income from prohibited transactions) of a REIT Candidate for the taxable year must be derived from certain qualifying real estate related sources, including interest on obligations secured by mortgages on real property, gain from the sale or other disposition of interests in real property and real estate mortgages, dividends from other real estate investment trusts and commitment fees related to mortgage loans. 2. THE 95 PERCENT TEST. In addition to meeting the 75 percent test, at least an additional 20 percent of the gross income of a REIT Candidate for the taxable year must be derived from the items of income that qualify under the 75 percent test, or from certain types of passive investments. Income attributable to dividends from companies other than REITs, interest on obligations not secured by real property, and gains from the sale or disposition of stock or other securities, other than stock or other securities held for sale to customers in the ordinary course of business, will constitute qualified income for purposes of this 95 percent test, but will be non-qualifying income for purposes of the 75 percent test. 3. THE 30 PERCENT TEST. A REIT Candidate must also derive less than 30 percent of its gross income from the sale or other disposition of (i) real property or mortgage loans held for less than four years, other than certain foreclosure property or property involuntarily converted through destruction, condemnation or similar events, (ii) stock or securities held for less than one year, and (iii) property in any prohibited transaction (i.e., sale or other disposition of inventory or property held primarily for sale in the ordinary course of business that is not foreclosure property. In addition, at the end of each quarter of the taxable year of a REIT Candidate, at least 75 percent of the value of such REIT Candidate's assets must be real estate assets (including interests in real property, loans secured by mortgages on real property and shares of other REITS), cash and cash items (including receivables), and certain United States government securities. The balance of a REIT Candidate's assets may be invested without restriction, except that holdings of securities may not exceed 25% of the value of the REIT Candidate's total assets. Moreover, the securities of any one non-governmental issuer must not exceed 5 percent of the value of such REIT Candidate's assets or 10 percent of the outstanding voting securities of that issuer. The securities of another REIT will not be treated as a security of a non-governmental issuer for purposes of the 5 percent and 10 percent asset test. Since the gross income of the Company's subsidiaries will be derived principally from interest and gains with respect to GNMA Certificates and Mortgage Derivative Investments, and since their assets will consist principally of GNMA Certificates and certain United States government securities, such subsidiaries should satisfy the gross income and asset tests during each taxable year or relevant portion thereof. If the Company or either of its subsidiaries should inadvertently fail to meet the 75 percent or 95 percent income tests, loss of real estate investment trust status could be avoided if the relevant corporation pays a tax equal to 100 percent of any excess non-qualifying taxable income. There is no comparable safeguard that could protect against the failure of the Company or its subsidiaries to meet the 30 percent test. THE DISTRIBUTION TEST. The distribution test requires that a REIT distribute to its shareholders in each taxable year an amount equal to at least 95 percent of its REIT Taxable Income (computed before the dividends paid deduction and excluding any net capital gain), subject to various adjustments for income from certain foreclosure property, net losses from inventory type sales and certain penalty taxes. Generally, such distribution must be made in the taxable year, or in the following year if declared before the REIT timely files its tax return for such year and if paid on or before the first regular dividend payment after such declaration. The undistributed amount remains subject to tax at the tax rate then otherwise applicable. If a REIT Candidate fails to meet the 95 percent distribution requirement as a result of an adjustment to its tax returns by the Internal Revenue Service (the "Service) a REIT Candidate may retroactively cure the failure by paying a deficiency dividend (plus a penalty and interest). Due to the nature of the income of the Company's subsidiaries from their assets and deductions in respect of their obligations, under certain circumstances the Company's subsidiaries may generate REIT Taxable Income in excess of cash flow. For example, the maturity and interest rates of the investments of the Company's subsidiaries are not likely to match the exact terms of the maturity and interest rates of the debt securities secured by such assets. Similarly, the Company's subsidiaries may recognize taxable market discount income realized upon the sale, retirement or other disposition of GNMA Certificates purchased at a discount from the stated redemption price at maturity; whereas the proceeds from such disposition may be used to make nondeductible principal payments on debt securities secured by such assets. Also, if the Company's subsidiaries' method of computing original issue discount (as discussed below) delayed its deductions, this could also result in REIT Taxable Income in excess of cash flow. The Company and its subsidiaries intend to monitor closely the interrelationship between REIT Taxable Income and cash flow. It is possible, although unlikely, that the Company and its subsidiaries may decide to terminate their REIT status as a result of any such cash shortfall. THE OWNERSHIP TEST. The share ownership test requires that the REIT Candidate's outstanding shares be held by a minimum of 100 persons for at least, approximately, 92 percent of the days in each taxable year and that no more than 50 percent in value of the shares be owned, actually or constructively, by five or fewer individuals at all times during the second half of each taxable year. For this purpose a pension fund and certain other types of tax-exempt entities are included within the meaning of the term "individual." To evidence compliance with these requirements, a REIT Candidate is required to maintain records that disclose the beneficial ownership of its outstanding shares. In fulfilling its obligation to maintain records, a REIT Candidate must demand written statements each year from the record holders of designated percentages of its shares, which would, inter alia, disclose the actual owners of such shares. ----- ---- Deduction of Bond Original Issue Discount - ----------------------------------------- The Company's subsidiaries' Bonds may have "original issue discount" for federal income tax purposes. The aggregate amount of original issue discount on a Bond, if any, will be the excess of its "stated redemption price at maturity" over its original issue price. The original issue price for a Bond of a particular Sequence is the initial offering price at which the Bonds in that Sequence are sold to the public. The Company's subsidiaries will deduct this original issue discount over the anticipated life of the Bond in computing its REIT Taxable Income. The Company will abide by recently issued Treasury regulations and other available guidance for purposes of computing original issue discount in connection with determining taxable income Original issue discount for federal income tax purposes is computed with respect to bonds, such as the Bonds, which are subject to acceleration due to prepayments on other debt obligations securing such Bonds, by taking into account the anticipated rate of prepayments assumed in pricing the Bonds (the "Prepayment Assumption"). The amount of original issue discount to be deducted by the Company's subsidiaries for an accrual period (generally the period between interest payments or compounding dates) is the excess of the sum of (a) the present value (discounted at the original yield to maturity of the Bond determined with reference to the Prepayment Assumption) of all payments remaining to be made on the Bond as of the close of such period and (b) the principal payments (or any payments made with respect to a bond that does not have qualified periodic interest payments) made during the accrual period, over the "adjusted issue price" of the Bond at the beginning of the accrual period. The adjusted issue price of a Bond is the sum of such Bond's issue price plus prior accruals of original issue discount less total prior payments of principal (or any payments made with respect to a bond that does not have qualified periodic interest payments). For purposes of the present value calculation above, the payments remaining to be made as of the end of the accrual period are determined (i) with regard to all events that have occurred before the close of such accrual period and (ii) assuming that the remaining payments will be made in accordance with the original Prepayment Assumption. Failure to Qualify as a REIT - ---------------------------- If a REIT Candidate fails to qualify for taxation as a REIT in any taxable year, it will be subject to tax (including any applicable minimum tax) on its taxable income at regular corporate rates without any deduction for distributions to shareholders. Unless entitled to relief under specific Code provisions, a REIT Candidate will also be disqualified from treatment as a REIT for the following four taxable years. Failure to qualify for even one year could result in a REIT Candidate incurring substantial indebtedness in order to pay any resulting taxes, thus reducing the amount of cash available for distribution to shareholders. Taxation of United States Shareholders - -------------------------------------- So long as a REIT Candidate qualifies for taxation as a REIT, distributions to shareholders out of current or accumulated earnings and profits will constitute dividends to the shareholders taxable as ordinary income (which will not be eligible for the dividends received deduction for corporations). In the event that a REIT Candidate's total distributions for a taxable year exceed its current and accumulated earnings and profits, a portion of each distribution will be treated first as a return of capital that reduces a shareholder's basis in his shares (but not below zero) and then as realized capital gain (if the shares are held as capital assets) to the extent that such distributions are in excess of adjusted basis. Distributions properly designated by a REIT Candidate as "capital gain dividends" will be taxable to shareholder as long-term capital gain to the extent such dividends do not exceed such REIT Candidate' actual net capital gain for the taxable year, regardless of the length of time for which the shareholder has owned the stock of the REIT. Any loss on the sale or exchange of stock of a REIT will, however, be treated as a long-term capital loss to the extent of any capital gain dividend received on such stock by such shareholder, regardless of the length of such shareholder's holding period. The Company will notify its shareholders after the close of its taxable year of the portions of the distributions that constitute ordinary income, return of capital and capital gain. Shareholders of the Company may not deduct any net operating losses or capital losses of the Company. State and Local Taxes - --------------------- The Company and its shareholders may be subject to state or local taxation in various state or local jurisdictions, including those in which they transact business or reside. As a result, shareholders should consult their own tax advisors for an explanation of how state and local tax laws may affect their investment in the Company. Foreign Investors - ----------------- Distributions on the Common Stock received by a foreign investor which are treated as capital gain by reason of the fact that such distributions exceed the Company's current and accumulated earnings and profits, as calculated for federal income tax purposes for the taxable year of the distribution as well as the investor's adjusted basis in such shares, and gain from the sale of the Company's shares by a foreign person will not be subject to United States taxation, unless such gain is effectively connected with such person's United States trade or business, or in the case of an individual foreign person, such person is present within the United States for more than 182 days in such taxable year (or is otherwise treated as a resident for income tax purposes). Dividends paid to foreign persons, generally, will be subject to United States withholding tax at a rate of 30 percent, or at a lower rate if a stockholder can claim the benefits of a tax treaty. However, distributions of proceeds attributable to the sale or exchange by the Company of United States real property interests are subject to income and withholding taxes pursuant to the Foreign Investment in Real Property Tax Act of 1980. The federal income taxation of foreign persons is a highly complex matter that may be affected by many considerations. Accordingly, prospective purchasers who are foreign persons should consult their own tax advisers regarding the income and withholding tax considerations with respect to their investment in the Company. ITEM 2: ITEM 2: Properties ---------- On November 12, 1993 the Company entered into a two year lease for offices at 433 California Street, San Francisco, California 94104. On January 1, 1993 the Company entered into a month to month lease for offices at Meadow Wood Crown Plaza, 1575 Delucchi Lane, Suite 115-20, Reno, Nevada 89502. The Company has no other physical properties. ITEM 3: ITEM 3: Legal Proceedings ----------------- None. ITEM 4: ITEM 4: Submission of Matters to a Vote of Security Holders --------------------------------------------------- At the annual meeting of shareholders on October 26, 1993, 639,174 or 94.6% of shares entitled to vote were represented in person or by proxy. The following items were submitted for a vote of the security holders and the results were: 1) Election of Robert E. Greeley, Russell Berg and Robert B. Ford as directors. Shares for Robert E. Greeley 609,144 Shares for Russell Berg 608,944 Shares for Robert B. Ford 607,944 2) Ratification of Deloitte & Touche as independent accountantss for the year ending December 31, 1993. Shares for ratification 609,460 Shares against ratification 29,714 Shares abstaining 0 3) Ratification and approval of a consulting agreement with Page Mill Asset Management and the ratification of a prior consulting arrangement with the President of the Corporation. Shares for ratification and approval 461,082 Shares against ratification and approval 43,294 Shares abstaining 134,798 4) Ratification of the renumeration of the directors of the Corporation. Shares for ratification 600,480 Shares against ratification 36,194 Shares abstaining 2,500 5) Approval of an amendment to the Articles of Incorporation of the Corporation to provide for additional classes of the Corporation's securities. Shares for approval 421,196 Shares against approval 90,130 Shares abstaining 127,848 6) Approval of an amendment to the Bylaws of the Corporation to delete a prohibition on the issuance of options or warrants to insiders unless such options or warrants are also offered to the public. Shares for approval 531,450 Shares against approval 102,430 Shares abstaining 5,294 7) Approval of the Corporation's stock option plan. Shares for approval 430,046 Shares against approval 76,830 Shares abstaining 132,298 PART II ITEM 5: ITEM 5: Market for the Registrant's Common Stock and -------------------------------------------- Related Stockholder Matters --------------------------- The Company's common stock is traded in the over-the-counter market and is included in the NASDAQ National Market System (NASDAQ symbol: INVG). As of March 31, 1994 there were approximately 90 common stock recordholders and participants in security position listings. The following table sets forth the range of representative high and low closing prices as reported by NASDAQ. In order to maintain its qualification as a REIT under the Code for any taxable year, the Company, among other things, must distribute as dividends to its stockholders an amount at least equal to (i) 95% of its REIT taxable income (determined before the deduction of dividends paid and excluding any net capital gain) plus (ii) 95% of the excess of its net income from foreclosure property over the tax imposed on such income by the Code less (iii) any excess non-cash income (as determined under the Code). The Company intends that the cash dividends paid each year to its stockholders will equal or exceed the Company's taxable income generated from operations. The following table details the dividends declared and/or paid for the Company's two most recent fiscal years. ITEM 6: ITEM 6: Selected Financial Data ----------------------- The following selected financial data is qualified in its entirety by, and should be read in conjunction with, the financial statements and notes thereto appearing in sections of this Annual Report. The data as of December 31, 1993, 1992 and 1991 and for the years ended December 31, 1993, 1992 and 1991 have been derived from the Company's financial statements which are included elsewhere in this Annual Report on Form 10-K. ITEM 7: ITEM 7: Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations ---------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Net loss for the year ended December 31, 1993 totaled $9,232,283. This compares to net losses of $5,006,252 and $2,250,676 for the years ended December 31, 1992 and 1991, respectively. Results for both 1993 and 1992 included gains from sales of GNMA Certificates and other investments as well as extraordinary losses from the redemption of bonds. 1993 results also include the cumulative effect of change in accounting. . The table below indicates the results of CMO issuance investments: The variance in net loss from year to year is almost entirely attributable to the change in the net interest loss. The elements of the net interest loss are: Net interest margin (interest from GNMA certificates less interest on bonds) declined in 1993 because of the redemptions of Series 1983-1 and 1984-1 and the increased rate of payments (including prepayments) on the principal of the CNMA certificates. Amortization of Discounts and Bond issuance Costs declined in 1993 because of the redemptions. Income from Mortgage Derivative Investments exists only in 1993 as these investments were made only in the last half of 1993. A number of purchases of Mortgage Derivative Investments were financed with short-term debt which accounts for the increase in that area. Expenses of the Company were $1,445,117, $847,143 and $889,012 in the years ended December 31, 1993, 1992 and 1991, respectively. 1993 expenses include an accrual of $774,000 for an incentive management fee as described in Note 12 to the financial statements. Trustee fees declined significantly in 1993 because only a portion of the trustee fees were accrued in 1993 as certain fees were overpaid in prior years. LIQUIDITY AND CAPITAL RESOURCES Cash provided by operating activities of the Company totaled $7,666,406 for the year ended December 31, 1993; $1,240,032 for the year ended December 31, 1993; and $1,625,543 for the year ended December 31, 1991. The Company's cash and cash equivalents increased $1,819,422, $1,559,336 and $490,951 in the three years, respectively. In the year ended December 31, 1993, the Company invested in Mortgage Derivative Investments, net of principal reductions, of $8,380,290 and invested $2,623,891 in other investments. The funds for these purchases were derived from various sources including the excess of principal payments received on the GNMA certificates over the principal payments on the GNMA-Backed Sequential pay bonds ($7,641,887), cash provided by operations ($7,666,406). These amounts were offset by a decrease in short-term debt of $2,361,029 and the increase in cash and cash equivalents of $1,819,422. The Company had total assets of $308.8 million and $533.5 million at December 31, 1992 and 1992, respectively. Of these amounts, $287.5 million and $521.9 million, respectively, were invested in GNMA Certificates which collateralize the bonds. The Company had no capital expenditures during the year ended December 31, 1993. ITEM 8: ITEM 8: Financial Statements and Supplementary Data ------------------------------------------- AND SUPPLEMENTAL SCHEDULES Page ---- Report of Independent Auditors, Deloitte & Touche 22 Consolidated Balance Sheets at December 31, 1993 and December 31, 1992 23 Consolidated Statements of Income (Loss) for the Years Ended December 31, 1993, 1992 and 1991 24 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 25 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 26 Notes to Consolidated Financial Statements 27-36 Supplemental Schedule IX 37 REPORT OF INDEPENDENT AUDITORS To the Board of Directors and Stockholders of INVG Mortgage Securities Corp. We have audited the accompanying consolidated balance sheets of INVG Mortgage Securities Corp.and subsidiary companies as of December 31, 1993, 1992 and 1991, and the related statements of income, changes in stockholders' equity, and cash flows for the three years in the period ended December 31, 1993. Our audits also included the financial statement schedule listed in the Index at Item 8. These financial statements and the 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, such financial statements present fairly, in all material respects, the financial position of the company 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 financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 2, the Company changed its method of accounting for its investments to adopt the provisions of Statement of Financial Accounting Standards No. 115. New York, New York April 13, 1994 INVG MORTGAGE SECURITIES CORP. AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. - Organization INVG Mortgage Securities Corp. (the "Company") was incorporated on March 26, 1986 in the State of Maryland. On May 12, 1986, pursuant to a Merger and Reorganization Agreement approved by the shareholders of Investors GNMA Mortgage-Backed Securities Trust, Inc. ("Investors GNMA"), each outstanding share of Investors GNMA was converted into one share of the Company's common stock, par value $.01 per share. Pursuant to the merger, Investors GNMA became a subsidiary of the Company. On May 12, 1986, the Company formed another subsidiary, INVG Government Securities Corp. ("INVG Government"). The Company holds all of the outstanding common stock of Investors GNMA Mortgage-Backed Securities Trust, Inc. ("Investors GNMA"), and INVG Government Securities Corp. ("INVG Government"). The Company, directly or through its subsidiaries, has historically generated revenues primarily from Collateralized Mortgage Obligation ("CMO") investments whereby the company was engaged in the business of acquiring modified mortgage-backed pass through certificates ("GNMA Certificates") and then issuing and selling bonds (Bonds) backed by the GNMA Certificates. These investments in CMO issuances give the Company the right to the excess cashflows and earnings on the GNMA Certificates over the expenses required on the the Bonds ("CMO Issuance Investments"). The Company has also invested in other similar mortgage related investments wherein the Company has the right to receive the cashflows of a CMO bond offering after debt service payments are made, such as CMO Mortgage Derivative Investments and REMIC Mortgage Derivative Investments, ("Mortgage Derivative Investments"). The Company's investment policies and other policies are determined by its Board of directors in accordance with the articles and bylaws of the Company. The objective of the company is to maximize earnings and cashflow for distribution to the shareholder through mortgage related investments. The Company, in its early years, invested in CMO Related Investments through issuance of its own Bonds. Over the last year, the Company has been reinvesting its cashflows from these CMO Related Investments in Mortgage Derivative Investments which are similar in earnings and cashflow nature to its original CMO Related Investments. At all times, the Company intends to make investments in such a manner as to be consistent with the requirements of the Code to qualify as a REIT unless, because of circumstances or changes in the Code (or in the regulations promulgated thereunder), the Company determines that it is no longer in the best interest of the Company to qualify as a REIT. The Company's policies with respect to such activities may be reviewed and modified from time to time by the Company. The investment in Mortgage Derivative Investments and other investments may from time to time cause conflicts to occur between the articles of Investors GNMA and the Indenture under which Investors GNMA's Bonds were issued. Note 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 balances and transactions have been eliminated. Accounting Change - On December 31, 1993 the Company adopted Statement of Financial Accounting Standards No. 115 ("SFAS 115") - Accounting for Certain Investments in Debt and Equity Securities. In accordance with this new Standard, the Company classified its investments as either available- for-sale or held-to-maturity. The Company has elected to classify its investments in CMO Residuals and REMIC Residuals as available-for-sale while it has elected to classify its investments in GNMA Certificates as held-to-maturity investments. SFAS 115 requires that held-to-maturity investments be accounted for at amortized cost. However, if the fair value, as defined, of the investment declines below the amortized cost basis and the decline is considered to be "other than temporary", the cost basis of the individual asset must be written down to its fair value as the new cost basis. The amount of the write down is included in the Company's current earnings (i.e. accounted for as a realized loss). The decline in fair value is considered to be other than temporary if the cost basis exceeds the related projected cash flow from the investment discounted at a risk-free rate of return. Held-to Maturity. The investment in GNMA Certificates is classified as a held-to-maturity investment. In connection with the fourth quarter adoption of SFAS 115 and consistent with the consensus reached by the Emerging Issues Task Force on Issue No. 93-18, the Company measures other than temporary impairment by comparing the net cash flows from the GNMA Certificates (net of GNMA Bonds principal and interest payments and related trustee expenses) discounted at a risk free rate to the net carrying value of the GNMA Certificates (i.e. net of GNMA Bond liabilities). If such discounted cash flows are less than the net carrying value, the Company records a reserve to reduce the net carrying value to fair value. For purposes of determining fair value, the Company discounts the net cash flows as discussed above using an estimated risk adjusted rate of return. In connection with the adoption of SFAS 115, the Company recorded a charge of $8,530,329 in the fourth quarter representing the cumulative effect of the change in accounting principle. Available-for-Sale. The Company is inot in the business of trading its mortgage-related assets, however, from time to time the Company may sell an asset as part of the Company's efforts to adjust its portfolio composition to reflect changes in economic conditions. Therefore the Company has classified its investments in CMO Residual Interests and REMIC Residual interests as available-for-sale. They are carried at fair value in the financial statements. Unrealized holding gains and losses for available-for-sale investments are excluded from earnings and reported as a net amount in shareholders equity until realized. Available-for-sale investments are also subject to write down whenever the fair value is less than the future projected cash flows discounted at a risk-free rate. None of the Company's available-for-sale investments were subject to write down as of December 31, 1993. Cash Equivalents - Cash equivalents are short-term investments which are readily converted to cash and have original maturities of less than three months. Mortgage Certificates and Collateralized Mortgage Obligation Bonds ("CMOs") - Mortgage certificates and CMO bonds are carried at their outstanding principal balance plus or minus any premium or discount, respectively. Amortization of Deferred Issuance Costs, Premiums and Discounts - Deferred Issuance Costs, premiums and discounts relating to mortgage certificates and GNMA Bonds are amortized to income using the interest method over the stated maturity of the mortgage certificates or bonds. Prepayments are not anticipated. When prepayments occur, a proportionate amount of the related costs, premiums and discounts are recognized in income so that the effective interest rate on the remaining balance continues unchanged. Mortgage Derivative Investments - Mortgage Derivative Investments are accounted for under the Prospective method. Under this method, assets are carried at cost and income is amortized over their estimated lives based on a method which provides a constant yield. At the end of each quarter, the yield over the remaining life of the asset is recalculated based on expected future cash flows using current interest rates and mortgage prepayment speeds. This new yield is then used to calculate the subsequent quarter's income. Management has the intention and the ability to hold all of its real estate investments to term. Under certain extended high interest rate periods, or in the event of extremely high prepayment rates on the collateral, the return on the Company's investment in a mortgage derivative investment could be zero or negative. In the event that the projected return on an investment in a mortgage derivative investment falls below a risk free rate, the Company would be required to write down the investment to its fair value. Income Taxes - The Company has elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended. As a REIT, the Company must distribute annually at least 95% of its taxable income to its shareholders. No provision has been made for income taxes in the accompanying financial statements as the Company will not be subject to income taxes. Over the life of a Mortgage Derivative Investment, total taxable income will equal total financial statement income; however, the timing of income recognition may differ between the two from year to year. Reclassifications - Certain reclassifications have been made to the December 31, 1991 financial statements to conform such financial statements to the December 31, 1992 financial statements. Such reclassifications do not affect net income as reported. Net Income (Loss) Per Share - Net income (loss) per share is based upon the weighted average number of shares of common stock outstanding. Note 3. - GNMA Certificates The GNMA Certificates are being used as collateral for the GNMA-Backed Sequential Pay Bonds (the "Bonds"). Information with respect to such GNMA Certificates is as follows: Note 4. - GNMA-Backed Sequential Pay Bonds The Bonds are collateralized by the GNMA Certificates. Information with respect to such Bonds is as follows: Since principal payments on the Bonds are made by applying all distributions of principal received on the GNMA Certificates (both scheduled payments and prepayments), it is not possible to determine the annual amount of future principal payments. The scheduled principal payments to be made on the Bonds for each of the next five years ending December 31 are as follows: 1994, $9,211,000; 1995, $10,104,000; 1996, $11,086,000; 1997, $12,164,000; 1998, $13,349,000; thereafter $229,692,000. Because the INVG Series A bonds were redeemed in their entirety on February 1, 1994, scheduled principal payments on those bonds have been excluded from the preceeding amounts. The sequence of each series of bonds with the latest stated maturity is redeemable at the option of the Company in whole, but not in part, when the outstanding principal amount of that sequence declines to 10% or less of its original outstanding principal amount at a redemption price equal to the outstanding principal amount thereof, plus accrued interest, except for the Series A Bonds. The Series A Bonds are redeemable at the option of the Company in whole, but not in part, on any payment date after the earlier of July 1, 1996 or the payment date on which the Class A-2 Bonds are paid in full. Interest paid on the Bonds during the years ending December 31, 1993, 1992 and 1991 amounted to $40,504,225, $68,054,797 and $88,306,456, respectively. Note 5. - Redemption of Bond Series 1984-5 On May, 4, 1992, after obtaining the consent of the holders of not less than a majority in principal amount of the outstanding Bonds, the Company and the Trustee amended the redemption provisions of the Indenture governing Series 1984-5. On May 5, 1992, the Board of Directors of Investors GNMA authorized a redemption of the Series 1984-5 Bonds. On that date a notice was sent to all of the Bondholders of such Series to the effect that the Company, as issuer, was exercising its right of redemption with respect to such Bonds pursuant to the Section 11.01 of the Indenture. The redemption was scheduled for the next payment date of May 26, 1992. On May 22, 1992, Chemical Bank, acting as trustee under the Indenture, sold the GNMA Certificates securing the Series 1984-5 Bonds. The proceeds of the sale were used to redeem the Bonds on May 26, 1992. After accounting for expenses of the transaction, including amortization of discount and deferred bond issuance costs, the extraordinary loss to the Company from the redemption of the Bonds was $9,396,000. The net cash the Company received from this series of transactions was $1,867,342. Note 6. - Tender and Redemption of Bond Series 84-1 On August 24 and November 30, 1992 the Company purchased for $7,197,087 and $3,414,410, respectively, $5,273,152 and $3,035,032 aggregate principal amount, respectively, of its outstanding Series 1984-1. These Bonds had original face values of $8,000,000 and $5,000,000, respectively. On December 9, 1992, the Company commenced a tender offer (the "Offer") for all of its outstanding Series 1984-1 Bonds and a solicitation of consents to amend the provisions of the related Indenture to permit the Company to redeem Bonds of such Series not tendered pursuant to the 1984-1 Offer. On January 15, 1993, after obtaining the consent of not less than a majority in principal amount of the outstanding Series 1984-1 Bonds, the Company and the Trustee entered into an amendment to the Indenture which permitted the Company to redeem any Series 1984-1 Bonds not tendered pursuant to the 1984-1 Offer. On January 25, 1993, after giving consideration to the scheduled principal and interest payments, the Company (i) purchased $46,926,150 aggregate principal amount of the Series 1984-1 Bonds tendered pursuant to the Offer for an aggregate purchase price and consent payment of 111.5% of such aggregate principal amount plus accrued interest to the purchase date, or a total of $52,706,392, and (ii) redeemed the remaining $2,952,592 aggregate principal amount of Series 1984-1 Bonds for par plus accrued interest to the redemption date. For financial accounting purposes the Series 1984-1 Bonds that the Company acquired in 1992 were considered redeemed in 1992. As a result, the Company realized an extraordinary loss in 1992 of $3,387,807. In 1993 the Company realized a gain of $11,024,422 from selling the GNMA Certificates securing the Series 1984-1 Bonds. After accounting for expenses, including amortization of discounts, the Company realized in 1993 an extraordinary loss of $8,357,868 from the retirement of the Series 1984- 1 Bonds. The net cash the Company received from this series of transactions was $606,620. Note 7. - Tender and Redemption of Bond Series 83-1 On December 9, 1992, the Company commenced a tender offer (the "Offer") for all of its outstanding Series 1983-1 Bonds and a solicitation of consents to amend the provisions of the related Indenture to permit the Company to redeem Bonds of such Series not tendered pursuant to the 1983-1 Offer. On February 12, 1993, after obtaining the consent of not less than a majority in principal amount of the outstanding Series 1983-1 Bonds, the Company and the Trustee entered into an amendment to the Indenture which permitted the Company to redeem any Series 1983-1 Bonds not tendered pursuant to the 1983-1 Offer. On February 25, 1993, after giving consideration to the scheduled payments, the Company (i) purchased $68,946,187 aggregate principal amount of the Series 1983-1 Bonds tendered pursuant to the 1983-1 Offer for an aggregate purchase price and consent payment of 113.5% of such aggregate principal amount, plus accrued interest to the purchase date, or a total of $78,787,507 and (ii) redeemed the remaining $458,068 of Series 1983-1 Bonds for par plus accrued interest to the redemption date. The Company realized in 1993 a gain of $14,930,196 from selling the GNMA Certificates securing the Series 1983-1 Bonds. After accounting for expenses, including amortization of discounts, the Company realized an extraordinary loss of $15,832,663 from the retirement of the Series 1983-1 Bonds. The net cash the Company received from this series of transactions was $356,922. Note 8. - Subsequent Redemption of Series A Bonds On January 5, 1994 the Board of Directors of the Company authorized an optional redemption of the Series A Bonds on February 1, 1994 pursuant to the call provisions of the Series A Bonds. On January 24, 1994, the GNMA Certificates securing the Series A Bonds were sold. The Company realized a gain of $4,495,000 from the sale of the GNMA Certificates. On February 1, 1994, the Series A Bonds were redeemed at par. After accounting for expenses, including amortization of discounts and premiums, the Company incurred an extraordinary loss of $2,236,000 from the redemption of the Series A Bonds. The net cash the Company received from this series of transactions was $5,010,000. Note 9. - Mortgage Derivative Investments During the year ended December 31, 1993, the Company purchased Mortgage Derivative Investments as shown in the schedule below: Residual Series Merrill Lynch Trust II was redeemed on August 26, 1993 for $5,363,545 resulting in a gain of $1,105,556. Cash receipts from FHLMC REMIC 1332-R and GNMA REMIC 92-G64R exceeded the cost basis of the Mortgage Derivative Investments. This excess of cash over basis is included in interest income from Mortgage Derivative Investments. In accordance with FASB-107, the Company shall disclose the fair value of financial instruments for which it is practicable to estimate that value. The Company has disclosed in Notes 3 and 4 the fair value of the GNMA Certificates and Bonds based on market prices for comparable instruments as of December 31, 1993. However, the Company is unable to sell the GNMA Certificates and therefore realize any gain until the Bonds which are collateralized by the certificates either mature or are called in accordance with the underlying bond indenture. For purposes of determining fair value of the GNMA Certificates, the Company uses the cash flows from GNMA Certificates net of bond interest expenses and related trustee expenses. The Company includes in its net cash flows an assumption of redemption of the Series at the earliest available stated redemption date with an assumed sale of the GNMA Certificates at a current market price. These cash flows are discounted at a fair value rate of 12%. The following table gives the pertinent fair value assumptions used in forecasting the cash flows as of December 31, 1993: The Company computes the estimated fair value of its mortgage derivative investments, including CMO Residuals and REMIC Residuals, by projecting anticipated future cash flows and discounting those cash flows at discount rates established in market transactions for securities having similar characteristics and backed by collateral of similar rate and term. The Company has used available market information as of December 31, 1993 and has concluded that the fair value of the mortgage derivative investments at December 31, 1993 was approximately equal to the carrying value of $9,400,000 as of December 31, 1993. The Company estimated the prospective yield on these investments for the first quarter of 1994 to be approximately 27.6%. Note 10. - Other Investments During the year ended December 31, 1993, the Company purchased other investments as shown in the schedule below: Note 11. - Tax Status The Company has available at December 31, 1993 net operating loss carryforwards aggregating $14.0 million which may be applied against future taxable income of Investors GNMA. Of the $14.0 million of net operating loss carryforward available at December 31, 1993, $3.5 million, $8.1 million, $.8 million, $.8 million, $.4 million and $.4 million expire in the years ending December 31, 2002, 2003, 2004, 2005, 2006 and 2007, respectively. The Company's policy is to comply with the requirements of the Internal Revenue Code that are applicable to real estate investment trusts and to distribute sufficient taxable income to qualify as a REIT. Accordingly, no provision for federal income taxes is required in the Company's financial statements to the extent that sufficient distributions of taxable income have been made to the shareholders for reporting in their respective tax returns. In accordance with Statement of Financial Accounting Standards 109 disclosure requirements, the following differences existed at December 31, 1993 between the tax bases and the reported financial statement amounts of the Company's assets and liabilities (unaudited): Note 12. - Management The Company is managed by the Board of Directors. From February 1990 through December 1991, the day-to-day activities of the Company were managed by Fulcrum Financial Partners ("FFP"), subject to the supervision of the Board of Directors. Under the terms of their agreement, FFP received a monthly management fee of $15,000 which cost is shared by INVG Mortgage and INVG Government Securities Corp.., an affiliate of the Company. Effective in January 1992, the day-to-day Administrative affairs of the Company are managed, subject to the supervision of the Board of Directors, under an Administration Agreement with TIS Asset Management, Inc. This agreement provided for a monthly fee of $16,000 for administrative services to be divided among the affiliated Companies. On August 6, 1993, the directors of the Company approved the 1993 Stock Option Plan (the "Plan"). Under the Plan, stock options of up to 34,000 shares of common stock may be granted. The plan provides for granting of stock options at an option price per share equal to 100 percent of the fair market value on the date of grant. These options have a term of five years and become exercisable ratably over a three year period commencing with the date of grant. During the current year, 17,000 options were granted with an option price of $7.125 per share, none of which were exercised as of December 31. 1993. During 1992, the Company paid to the President, who is also a Director of the Company, an Officer's consulting fee in lieu of a Directors fee. Consulting Agreement - -------------------- At the Annual Meeting of Shareholders held on October 26, 1993, a consulting agreement with Page Mill Asset Management was ratified. Under this agreement, which is effective January 1, 1993, the Companies will pay Page Mill a monthly fee of $10,000 plus an incentive management fee. The incentive management fee, determined with respect to the Companies' performance each fiscal year is equal to 25% of the dollar amount, if any, by which the Companies' consolidated taxable income for such fiscal year, before payment of any incentive fee to Page Mill, net operating loss deductions arising from prior periods' losses and special Internal Revenue Code deductions pertaining to real estate investment trusts, plus certain other adjustments in accordance with generally accepted accounting principles, exceeds the amount necessary to provide an annualized return on equity equal to 1% over the average ten-year U.S. Treasury rate for such fiscal year. Under this agreement, the Company has recorded expense in the year ended December 31, 1993 of $120,000 and $774,000 for the monthly and incentive management fees, respectively. Page Mill Asset Management is 100% owned by Robert E. Greeley, Chairman of the Board and President of the Company. Note 13 - Dividends The Company declared dividends on its common stock of $0.50 per share in 1993 and $0.60 per share in 1992. All of the dividends are taxable as ordinary income. The Company's dividends are not eligible for the dividends received deduction for coprorations. No dividends were paid on the Company's common stock in 1991. Note 14. - Short-term Debt At December 31, 1993 the Company owed $5,947,500 under five repurchase agreements with Kidder, Peabody & Co. These borrowings had initial terms of one month and are renewed on a month-to-month basis. The weighted average interest rate on these borrowings at December 31, 1993 was 3.607%. The debt is collateralized by some of the Company's Mortgage Derivative which have a fair value of $7,405,259. Note 15.- Quarterly Financial Data (Unaudited) ITEM 12: ITEM 12: Security Ownership of Certain Beneficial Owners and Management -------------------------------------------------------------- On March 17, 1993, INVG Government acquired 6,500 shares of the common stock of the Company. On November 10, 1993 and December 3, 1993 INVG Government acquired 1,200 and 1,000 shares, respectively, of the Company. These treasury stock acquisitions cost $55,568 and reduced the number of outstanding shares to 673,575. At March 30, 1994, the common stock, par value $.01 per share, of the Company beneficially owned by security holders holding 5% or more of the outstanding common stock of the Company was as follows: Name of Amount and Nature Beneficial of Beneficial Percent of Owner Address Ownership Class - --------------- ----------------------- ------------------ ---------- Page Mill Asset Meadow Wood Crown Plaza 253,800 Shares (1) 37.68% Management 1575 Delucchi Lane Reno, Nevada 89502 The table below sets forth, as of March 30, 1994, the number of shares of Common Stock beneficially owned by each director of the Company, and by all of the Company's officers and directors as a group, which information as to beneficial ownership is based upon statements furnished to the Company by such persons. ITEM 13: ITEM 13: Certain Relationships and Related Transactions ---------------------------------------------- The Company has entered into a Consulting Agreement with Page Mill Asset Management, 100% of which is owned by Robert E. Greeley, Chairman of the Board and President of the Company. PART IV ITEM 14: ITEM 14: Exhibits, Financial Statements Schedules and Reports on Form 8-K ---------------------------------------------------------------- (a) Documents filed as part of this report: (1) Financial statements of the Company - as listed in the "Index to Financial Statements" included in Part II, Item 8 of this Form 10-K. (2) Financial statement schedules - Schedule IX All financial statement schedules not included have been omitted because of the absence of conditions under which they are required or because the information is given in the consolidated financial statements and notes included in Part II, Item 8 of this Form 10-K. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the last quarter of the year ended December 31, 1993. (c) Exhibits The following exhibits (unless incorporated by reference to another report) are included in a separate volume filed with this report and are identified by the numbers indicated. Exhibit No. Description - ------- ----------- 3.1 Articles of Incorporation of the Company (Incorporated by reference from Exhibit 3.1 to the Company's Form 10-K for the year ended December 31, 1987) 3.2 By-Laws of the Company (Incorporated by reference from Exhibit 3.2 to the Company's Form 10-K for the fiscal year ended December 31, 1986) 4.1 Indenture, between Investors GNMA and Chemical Bank, as trustee (Incorporated by reference from Exhibit 4.1 to Investors GNMA Report on Form 8-K dated January 30, 1984 (File No. 2-85391)) 4.2 Supplement to Indenture for Series 1983-1 Bonds of Investors GNMA (Incorporated by reference from Exhibit 4.2 to the Company's Report on Form 8-K dated January 30, 1984 (File No. 2-85391) 4.3 Supplement to Indenture for Series 1984-1 Bonds of Investors GNMA (Incorporated by reference from Exhibit 4.3 to Investors GNMA Report on Form 8-K dated January 30, 1984 (File No. 2-85391)) 4.4 Supplement to Indenture for Series 1984-2 Bonds of Investors GNMA (Incorporated by reference from Exhibit 4.5 to Investors GNMA Report on Form 8-K dated April 30, 1984 (File No. 2-85391)) 4.5 Supplement to Indenture for Series 1984-3 Bonds of Investors GNMA (Incorporated by reference from Exhibit 4.4 to Investors GNMA Report on Form 10-K for the year ended December 31, 1985 (File No. 2-85391)) 4.6 Supplement to Indenture for Series 1984-4 Bonds of Investors GNMA (Incorporated by reference from Exhibit 4.4 to Investors GNMA Report on Form 10-K for the year ended December 31, 1985 (File No. 2-85391)) 4.7 Supplement to Indenture for Series 1984-5 Bonds of Investors GNMA (Incorporated by reference from Exhibit 4.4 to Investors GNMA Report on Form 10-K for the year ended December 31, 1985 (File No. 2-85391)) 4.8 Pledge Agreement, between Investors GNMA and Chemical Bank (Incorporated by reference from Exhibit 4.4 to Investors GNMA Report on Form 8-K dated January 30, 1984 (File No. 2-85391)) 4.9 Indenture dated as of December 1, 1986 between INVG Government Securities Corp. and Texas Commerce Bank National Association (Incorporated by reference from Exhibit 4.1 to INVG Government Report on Form 10-K for the year ended December 31, 1986) 4.10 Series A Supplement to Indenture dated as of December 30, 1986 between INVG Government Securities Corp. and Texas Commerce Bank National Association (Incorporated by reference from Exhibit 4.2 to INVG Government Report on Form 10-K for the year ended December 31, 1986) 10.1 Management Agreement dated as of May 12, 1986 among the Company, Investors GNMA and INVG Government (Incorporated by reference from Exhibit 10.1 to INVG Government Report on Form 10-K for the year ended December 31, 1987) 10.2 Advisors Agreement dated as of February 14, 1990 among the Company, INVG Government and Investors GNMA (Incorporated by reference from Exhibit 10.2 to the Company's Report on Form 10-K for the year ended December 31, 1989) 10.3 Administration Agreement dated as of December 1, 1991 among the Company, INVG Government and Investors GNMA and TIS Asset Management, Inc. 13.1 The Company's Annual Report to Shareholders for 1993 (Furnished for the information of the Commission and not deemed to be filed except for those portions which are expressly incorporated by reference into this Form 10-K) 22.1 List of Subsidiaries (Incorporated by reference from Exhibit 22.1 to the Company's Report on Form 10-K for the year ended December 31, 1986) 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. INVG MORTGAGE SECURITIES CORP. By: /s/ Robert E. Greeley --------------------------- Robert E. Greeley Chairman of the Board Date: April 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. Signature Date Title - --------- ---- ----- /s/ Robert E. Greeley April 14, 1994 Chairman of The Board, - --------------------- President and Treasurer. Robert E. Greeley (Principal Executive and Financial Officer) /s/ Russell Berg April 14, 1994 Director and Secretary - --------------------- Russell Berg /s/ Robert B. Ford April 14, 1994 Director - --------------------- Robert B. Ford BOARD OF DIRECTORS LEGAL COUNSEL RUSSELL BERG Marron Reid & Sheehy Director, San Francisco, CA Viewpoints International ROBERT B. FORD INDEPENDENT ACCOUNTANTS Independent Real Estate Deloitte & Touche Consultant New York, NY ROBERT E. GREELEY ADMINISTRATOR General Partner, TIS Asset Management, Inc. Cypress Cove Fund L.P. 655 Montgomery Street #800 San Francisco, CA 94111 CUSTODIAN, TRANSFER AGENT AND DIVIDEND PAYING AGENT Harris Trust 110 William Street New York, NY 10038 A copy of the Company's Form 10-K filed with the Securities and Exchange Commission may be obtained without charge by writing to: INVG Mortgage Securities Corp. Meadow Wood Crown Plaza 1575 Delucchi Lane, Suite 115-20 Reno, Nevada 89502

791445_1993.txt

791445_1993

1993

791445

ITEM 1. BUSINESS. (a) General Development of Business Trump Plaza Associates (the "Partnership") owns and operates the Trump Plaza Hotel and Casino ("Trump Plaza"), a luxury casino hotel located on The Boardwalk in Atlantic City, New Jersey. The Partnership was organized in June 1982 as a general partnership under the laws of the State of New Jersey. Trump Plaza Funding, Inc. (the "Company") was incorporated on March 14, 1986 as a New Jersey corporation and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. The partners in the Partnership are Trump Plaza Holding Associates ("Holding"), which has a 99% interest in the Partnership, and the Company, which has a 1% interest in the Partnership. Donald J. Trump ("Trump"), by virtue of his ownership of the Company, Holding and Trump Plaza Holding Inc. ("Holding Inc."), which owns a 1% partnership interest in Holding, is the beneficial owner of 100% of the equity interest in the Partnership. In 1993, the Partnership, the Company and certain affiliated entities completed a refinancing (the "Refinancing") of their debt and equity interests. The purpose of the Refinancing was (i) to repay, in full, the mortgage indebtedness and certain other indebtedness issued as part of the restructuring (the "Restructuring") of the indebtedness of the Partnership and the Company pursuant to a prepackaged plan of reorganization (the "Plan") under chapter 11 of the Bankruptcy Code of 1978, as amended, effective as of May 29, 1992, (ii) to repurchase the preferred stock interest in Trump Plaza not owned by Trump and (iii) to repay certain personal indebtedness of Trump. The Refinancing On June 25, 1993, the Company consummated the Refinancing, which included (i) the offering (the "Mortgage Note Offering") by the Company of $330 million in aggregate principal amount of its 10-7/8% Mortgage Notes due 2001 (the "Mortgage Notes") and (ii) the offering (the "Units Offering" and, together with the Mortgage Note Offering, the "Offerings") by Holding of 12,000 Units (the "Units") consisting of an aggregate of $60 million in principal amount of 12-1/2% Pay-in-Kind Notes due 2003 (the "PIK Notes") and 12,000 Warrants to acquire an aggregate of $12 million in principal amount of PIK Notes. Each of the Warrants entitles the holder to acquire $1,000 principal amount of PIK Notes for no additional consideration. The partnership agreement of the Partnership was amended and restated to alter certain procedures and to effectuate the consummation of the Offerings. The proceeds of the Units Offering were distributed to Trump. Trump used $35 million of such proceeds to purchase stock of the Company, which used such funds, together with a portion of the proceeds of the Mortgage Note Offering, to redeem the Company's outstanding stock units (the "Stock Units"), each consisting of (i) one share of the Company's 9.34% Participating Cumulative Redeemable Preferred Stock (the "Preferred Stock"), liquidation preference $25 per share, par value $1 per share, and (ii) one share of the Company's common stock (the "Common Stock"), par value $.00001 per share. The remaining $25 million of the proceeds of the Units Offering were distributed to Trump as part of a special distribution (the "Special Distribution"). Trump used the Special Distribution primarily to reduce his personal indebtedness and to satisfy certain property tax obligations with respect to real estate owned by him. Out of the proceeds of the Mortgage Note Offering, $225 million was used to redeem all of the Bonds (as defined below). In connection with the Offerings, the Company formed Holding, a New Jersey general partnership, for the purpose of offering the Units. Trump contributed to Holding his equity ownership interest in the Partnership and became the sole beneficial owner of Holding. The two partners in Holding are Trump and Holding Inc. Holding Inc. acts as the managing general partner of Holding. Holding has no assets other than its equity interest in the Partnership. Also in connection with the Offerings, the Company became the managing general partner of the Partnership as of June 18, 1993 upon its merger with TP/GP Corp., a New Jersey corporation ("TP/GP"), which had been the managing general partner of the Partnership until such date. Holding and the Company, both of which became wholly-owned by Trump upon such merger, became the sole partners of the Partnership. The Mortgage Notes are senior indebtedness of the Company. The Company and the Partnership are subject to restrictions on the incurrence of additional indebtedness. The Mortgage Notes are unconditionally guaranteed by the Partnership. The Guarantee ranks pari passu in right of payment with all existing and future senior indebtedness of the Partnership. The PIK Notes are secured by Holding's equity interest in the Partnership. Holders of the PIK Notes and the Warrants are not creditors of the Partnership and, consequently, have no recourse to the assets of the Partnership if an event of default should occur thereunder. Accordingly, the PIK Notes are structurally subordinated to the indebtedness of the Partnership, including the Mortgage Notes. In the event of a sale of equity interests in Holding or an affiliate thereof which owns any direct or indirect equity interest in Trump Plaza, Holding is required to, or is required to cause such affiliate to, use 35% of the net proceeds of such sale, within 90 days after receipt thereof, to redeem PIK Notes at 100% of the principal amount thereof, if such redemption occurs prior to June 15, 1995. After such date, the redemption price is 108% of the principal amount of the PIK Notes until June 15, 1998, with the redemption price decreasing annually thereafter. The PIK Notes are redeemable at the option of Holding, in whole or in part, at any time on or after June 15, 1998 at the redemption prices set forth therein, together with accrued and unpaid interest to the date of redemption. Upon consummation of the Refinancing (i) Trump became the sole owner record of the Company's outstanding Common Stock, as well as the sole owner of the equity interest of Holding and the Partnership and (ii) the Company redeemed its Stock Units, including the Preferred Stock, and the Bonds (as defined below). As of December 31, 1993, the Company's debt consisted of approximately $330 million principal amount outstanding of its Mortgage Notes and $325,859,000 (net of discount) of mortgage indebtedness. As of December 31, 1993, Holding's debt consisted of approximately $64,252,000 of PIK Notes and $12 million of deferred warrant obligations. As of December 31, 1993, the Partnership's debt consisted of a non-recourse promissory note to the Company in the amount of $325,859,000 (net of discount) and approximately $7.5 million of other indebtedness. The Partnership has unconditionally guaranteed the Mortgage Notes. The Restructuring In 1991, the Partnership began to experience a liquidity problem. Management believes that the Partnership's liquidity problem was attributable, in part, to an overall deterioration in the Atlantic City gaming market, as indicated by reduced rates of casino revenue growth for the industry for the two prior years, aggravated by an economic recession in the Northeast and the Persian Gulf War. Comparatively excessive casino gaming capacity in Atlantic City, due in part to the opening of the Trump Taj Mahal Casino Resort (the "Taj Mahal") in April 1990, may also have contributed to the Partnership's liquidity problem. In order to alleviate its liquidity problem, on May 29, 1992 (the "Effective Date"), the Partnership and the Company restructured their indebtedness pursuant to the Plan. The purpose of the Restructuring was to improve the amortization schedule and extend the maturity of the Partnership's indebtedness by (i) eliminating the sinking fund requirement on the Company's 12-7/8% First Mortgage Bonds, due 1998 (the "Original Bonds"), (ii) extending the maturity and lowering the interest rate on the Original Bonds, (iii) reducing the aggregate principal amount of such indebtedness from $250 million to $225 million, and (iv) eliminating certain other indebtedness by reconstituting such debt in part as Bonds (defined below) and in part as Stock Units. The Restructuring was necessitated by the Partnership's inability to either generate cash flow or obtain additional financing sufficient to make the scheduled sinking fund payment on the Original Bonds. On the Effective Date, the Company, which theretofore had no interest in the Partnership, received a 50% beneficial interest in TP/GP, and the Company and TP/GP were admitted as partners of the Partnership. The Company issued $225 million principal amount of the Company's 12% Mortgage Bonds due 2002 (the "Bonds") and approximately three million Stock Units to certain creditors. Pursuant to the terms of the partnership agreement, the Company was issued the Preferred Stock. TP/GP became the managing general partner of the Partnership, and through its Board of Directors, managed the affairs of the Partnership until its merger into the Company on June 24, 1993. Upon consummation of the Plan, each holder of $1,000 principal amount of Original Bonds and such other indebtedness received (i) $900 principal amount of Bonds, (ii) 12 Stock Units and (iii) certain cash payments. As a result of the Refinancing, the Company redeemed the Stock Units, consisting of the Company's Common Stock and Preferred Stock and Trump became the sole beneficial owner of the Company's Common Stock. The Company also retired the outstanding principal amount and interest on the Bonds. In addition, TP/GP was merged into the Company and the Company became the managing general partner of the Partnership. (b) Financial Information about Industry Segments The Partnership operates in only one industry segment. See the Financial Statements of the Company and the Partnership included elsewhere herein. (c) Narrative Description of Business General The Partnership owns and operates Trump Plaza, a luxury casino hotel located in Atlantic City, New Jersey. Trump Plaza, with its 60,000 square foot casino (presently being expanded to 75,000 square feet by June 1994), first class guest rooms and other luxury amenities, is the only casino hotel in Atlantic City with both a "Four Star" Mobil Travel Guide rating and a "Four Diamond" AAA rating. Management believes that these ratings reflect the high quality amenities and services that Trump Plaza provides to its casino patrons and hotel guests. Trump Plaza is conveniently located on The Boardwalk, at the end of the main highway into Atlantic City and is one of the first casino hotels visible from that approach. Management believes that the central location of Trump Plaza, with its accessibility to "drive in" and "walk in" patrons, is highly advantageous to Trump Plaza. In addition, the Casino Reinvestment Development Authority ("CRDA") is currently overseeing the development of a "tourist corridor" which will link The Boardwalk with downtown Atlantic City and, when completed, will feature an entertainment and retail complex of up to 800,000 square feet. Trump Plaza will be located at the end of the tourist corridor by The Boardwalk. Trump Plaza seeks to attract casino patrons who tend to wager more frequently and in larger denominations than the typical Atlantic City gaming patron (a "high-end" patron). This strategy is accomplished, in part, through the attractiveness of the facility, which is enhanced by routinely attending to the aesthetics of the casino and other public areas in Trump Plaza. In addition, Trump Plaza provides a consistency in the conduct of play of its table games that serious gaming patrons seek. Finally, Trump Plaza offers a broad selection of dining choices (including four gourmet restaurants), headline entertainment, deluxe accommodations and other amenities and services. Facilities and Amenities The casino in Trump Plaza currently offers 86 table games and 1,836 slot machines. After the planned expansion of Trump Plaza, the casino will offer approximately 2,244 slot machines, 86 table games and a keno lounge. In addition to the casino, Trump Plaza consists of a 31-story tower with 557 guest rooms, including 62 suites. The facility also offers 10 restaurants, a 750-seat cabaret theatre, four cocktail lounges, 28,000 square feet of convention, ballroom and meeting room space, a swimming pool, tennis courts and a health spa. A 10-story parking garage, which can accommodate 2,650 cars, is connected to Trump Plaza via an enclosed pedestrian walkway. The entry level of Trump Plaza includes a cocktail lounge, three gift shops, a deli, a coffee shop, an ice cream parlor and a buffet. The casino level houses the casino, a fast food restaurant, an exclusive slot lounge for high-end patrons and a gift shop. There is also an enclosed skywalk which connects Trump Plaza at the casino level with the Atlantic City Convention Center. Trump Plaza's guest rooms are located in a tower which affords most guest rooms a view of the ocean. While rooms are of varying size, a typical guest room consists of approximately 400 square feet. Trump Plaza also features 23 one-bedroom suites, 21 two-bedroom suites and 18 "Super Suites." The Super Suites are located on the top two floors of the tower and offer luxurious accommodations and 24-hour butler and maid service. The Super Suites and certain other suites are located on the "Club Level" which requires guests to use a special elevator key for access, and contains a lounge area (the "Club Level Lounge") that offers 24-hour food and bar facilities. Trump Plaza is connected by an enclosed pedestrian walkway to a 10-story parking garage, which can accommodate approximately 2,650 cars, and contains 13 bus bays, a comfortable lounge, a gift shop and waiting area (the "Transportation Facility"). The Transportation Facility provides patrons with immediate access to the casino, and is located directly off of the main highway into Atlantic City. Business Strategy General. In 1990, the Atlantic City casino industry experienced a significant increase in room capacity and in available casino floor space, due primarily to opening the Taj Mahal, which at the time was wholly-owned by Trump. Management believes that the opening of Taj Mahal had a disproportionately adverse effect on Trump Plaza due to the common use to the "Trump" name. Management believes that results in 1991 were adversely affected by the weakness in the economy throughout the Northeast and the adverse impact on tourism and consumer spending caused by the war in the Middle East. In 1991, the Partnership retained the services of Nicholas L. Ribis as Chief Executive Officer, and Kevin DeSanctis as President and Chief Operating Officer. Mr. DeSanctis resigned from his positions on March 7, 1994. See "Management." Mr. Trump and this new management team implemented a new business strategy, designed to capitalize on Trump Plaza's first-class facilities and improve operating results. Key elements of this strategy consist of redirecting marketing efforts to more profitable patron segments and continually monitoring operations to adapt to, and anticipate, industry trends. A primary element of the new business strategy is to seek to attract patrons who tend to wager more frequently and in larger denominations than the typical Atlantic City gaming customer. Such high-end players typically wager $5 or more per play in slots and $25 or more per play in table games. In order to attract more high-end gaming patrons to Trump Plaza in a cost-effective manner, the Partnership has refocused its marketing efforts. Commencing in 1991, the Partnership substantially curtailed costly "junket" marketing operations which involved attracting groups of patrons to the facility on an entirely complimentary basis (e.g., by providing free air fare, gifts and room accommodations). In the fall of 1992, the Partnership decided to de-emphasize marketing efforts directed at "high roller" patrons from the Far East, who tend to wager $50,000 or more per play in table games. In each case the Partnership determined that the potential benefit derived from these patrons did not outweigh the high costs associated with attracting such players and the resultant volatility in the results of operations of Trump Plaza. This shift in marketing strategy has allowed the Partnership to focus its efforts on attracting the high-end players. Gaming Environment. Trump Plaza also pursues a continuous preventative maintenance program that emphasizes the casino, hotel rooms and public areas in Trump Plaza. These programs are designed to maintain the attractiveness of Trump Plaza to its gaming patrons. Trump Plaza continuously monitors the configuration of the casino floor and the games it offers to patrons with a view towards making changes and improvements. Trump Plaza's casino floor has clear, large signs for the convenience of patrons. As new games have been approved by the Casino Control Commission ("CCC"), the Partnership has integrated such games into its casino operations to the extent it deems appropriate. In recent years, there has been an industry trend towards fewer table games and more slot machines. For the Atlantic City casino industry, revenue from slot machines increased from 54.6% of the industry gaming revenue in 1988 to 67.1% of the industry gaming revenue in 1993. Trump Plaza experienced a similar increase, with slot revenue increasing from 51.2% of gaming revenue in 1988 to 70.2% of the industry gaming revenue in 1993. In response to this trend, Trump Plaza has devoted more of its casino floor space to slot machines. In April 1993, Trump Plaza removed 12 table games from the casino floor and replaced them with 75 slot machines. Moreover, as part of its program to attract high-end slot players, the Partnership created "Fifth Avenue Slots," a partitioned portion of the casino floor that includes approximately 70 slot machines (most of which provide for $5 or more per play), an exclusive lounge for high-end patrons and other amenities. "Comping" Strategy. In order to compete effectively with other Atlantic City casino hotels, the Partnership offers complimentary drinks, meals, room accommodations and/or travel arrangements to its patrons ("complimentaries" or "comps"). Trump Plaza's policy on complimentaries is to provide comps primarily to patrons with a demonstrated propensity to wager at Trump Plaza. Entertainment. Trump Plaza offers headline entertainment, as well as other entertainment and revue shows as part of its strategy to attract high-end and other patrons. In 1993, Trump Plaza entered into Atlantic City exclusive contracts with Kenny Rogers, Anne Murray, Jay Black, Jimmy Roselli, Paul Anka, Regis Philbin & Kathie Lee Gifford, Engelbert and Jerry Vale. Trump Plaza offers headline entertainment weekly during the summer and monthly during the off-season, and also features other entertainment and revue shows. Player Development/Casino Hosts. The Partnership currently employs approximately 24 gaming representatives in New Jersey, New York and other states, as well as several international representatives, to promote Trump Plaza to prospective gaming patrons. Player development personnel host special events, offer incentives and contact patrons directly in an effort to attract high-end table game patrons from the United States, Canada and South America. Trump Plaza's casino hosts assist patrons on the casino floor, make room and dinner reservations and provide general assistance. They also solicit Trump Card (the frequent player slot card) sign-ups in order to increase the Partnership's marketing base. Promotional Activities. The Trump Card, a player identification card, constitutes a key element in Trump Plaza's direct marketing program. Slot machine players are encouraged to register for and utilize their personalized Trump Card to earn various complimentaries based upon their level of play. The Trump Card is inserted during play into a card reader attached to the slot machine for use in computerized rating systems. These computer systems record data about the cardholder, including playing preferences, frequency and denomination of play and the amount of gaming revenues produced. Trump Plaza designs promotional offers, conveyed via direct mail and telemarketing, to patrons expected to provide revenues based upon their historical gaming patterns. Such information is gathered on slot wagering by the Trump Card and on table game wagering by the casino game supervisors. Promotional activities include the mailing of vouchers for complimentary slot play. Trump Plaza also utilizes a special events calendar (e.g., birthday parties, sweepstakes and special competitions) to promote its gaming operations. The Partnership conducts slot machine and table game tournaments in which cash prizes are offered to a select group of players invited to participate in the tournament based upon their tendency to play. Such players tend to play at their own expense during "off-hours" of the tournament. At times, tournament players are also offered special dining and entertainment privileges that encourage them to remain at Trump Plaza. Bus Program. Trump Plaza has a bus program, which transports approximately 2,400 gaming patrons per day during the week and 3,500 per day on the weekends. The Partnership's bus program offers incentives and discounts to certain scheduled and chartered bus customers. Trump Plaza's Transportation Facility contains 13 bus bays and is connected by an enclosed pedestrian walkway to Trump Plaza. The Transportation Facility provides patrons with immediate access to the casino, and contains a comfortable lounge area for patrons waiting for return buses. Credit Policy. Historically, Trump Plaza has extended credit to certain qualified patrons. For the years ended December 31, 1991, 1992 and 1993, credit play as a percentage of total dollars wagered was approximately 29%, 28% and 18%, respectively. As part of the Partnership's new business strategy and in response to the general economic downturn in the Northeast and recent credit experience, Trump Plaza has imposed stricter standards on applications for new or additional credit and has reduced credit to international patrons. Atlantic City Market Gaming in Atlantic City started in May 1978 when the first casino hotel opened for business. Since 1978, gaming in Atlantic City has grown from one casino to 12 casinos as of December 31, 1993, with approximately $3.3 billion of casino industry revenue generated in 1993. Gaming revenue for all Atlantic City casino hotels has increased approximately 2.6%, 5.2%, 1.3%, 7.5% and 2.7% during 1989, 1990, 1991, 1992 and 1993, respectively (in each case as compared to the prior year). See "Competition" below. Atlantic City is near many densely populated metropolitan areas. The primary area served by Atlantic City casino hotels is the corridor that extends from Washington, D.C. to Boston and includes New York City and Philadelphia. Within this primary area, Atlantic City may be reached by automobile or bus. Principal arteries lead into Atlantic City from the metropolitan New York area and from the Baltimore/Washington, D.C. area, both of which are approximately three hours away by automobile. Atlantic City can also be reached by air and rail transportation, although most patrons arrive by automobile or bus. Historically, Atlantic City has suffered from inadequate rail and air transportation. As a result, a majority of Atlantic City gaming patrons travel from the mid-atlantic and northeast regions of the United States by automobile or bus. Rail service to Atlantic City has recently been improved with the introduction of Amtrak express service to and from Philadelphia and New York City. An expansion of the Atlantic City International Airport (located approximately 12 miles from Atlantic City) to handle large airline carriers and large passenger jets was recently completed. Despite the expansion of the Atlantic City International Airport, however, access to Atlantic City by air is still limited by a lack of regularly scheduled flights and by inadequate terminal facilities. The lack of adequate transportation infrastructure has limited the expansion of the Atlantic City gaming industry's geographic patron base and the attractiveness of Atlantic City to major conventions. In February 1993, the State of New Jersey broke ground for a new $250,000,000 Convention Center on a 30.5-acre site adjacent to the Atlantic City Expressway. Targeted for completion in 1996, the new Convention Center will house approximately 500,000 square feet of exhibit space along with 45 meeting rooms totalling nearly 110,000 square feet. The building will include a 1,600-car underground garage and an indoor street linking the Convention Center to the existing Rail Terminal. The new Convention Center has been designed to serve as the centerpiece of Atlantic City's renaissance as a favorable meeting destination. Possible Expansion Sites Management has determined to expand the Partnership's facilities. The purpose of such an expansion is to increase the casino floor space and to add additional gaming units. Any such expansion will require various regulatory approvals, including the approval of the CCC. Furthermore, the Casino Control Act requires that additional guest rooms be put in service within a specified time period after any such casino expansion. As discussed below, the Partnership has planned expansion of its hotel facilities. If the Partnership completed any casino expansion and subsequently did not complete the requisite number of additional guest rooms within the specified time period, the Partnership might have to close all or a portion of the expanded casino in order to comply with regulatory requirements, which could have a material adverse effect on the results of operations and financial condition of the Partnership. Boardwalk Expansion Site. In 1993, the Partnership received the approval of CCC, subject to certain conditions, for the expansion of the Trump Plaza hotel facilities on a 2.0-acre parcel of land located directly across the street from Trump Plaza on the Boardwalk upon which there is located an approximately 361-room hotel, which is closed to the public and is in need of substantial renovation and repair (the "Boardwalk Expansion Site"). In June 1993, Trump and the lender holding mortgage liens on the Boardwalk Expansion Site negotiated the terms of a restructuring of loans of approximately $52.0 million of principal and accrued interest secured by the liens on the Boardwalk Expansion Site. On June 25, 1993, the date the Offerings were consummated, Trump transferred title to the Boardwalk Expansion Site to the lender in exchange for a reduction in Trump's indebtedness to such lender, with a further reduction of Trump's indebtedness if the Partnership assumed the Boardwalk Expansion Site Lease (as defined below). On such date, the lender leased the Boardwalk Expansion Site to Trump (the "Boardwalk Expansion Site Lease") for a term of five years, which expires on June 30, 1998, during which time Trump is obligated to pay the lender $260,000 per month in lease payments. In connection with the Offerings, the Partnership acquired a five- year option (the "Option") to acquire the Boardwalk Expansion Site. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option is dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and would require the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site is dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option. The CCC has required that the Partnership exercise the Option by no later than July 1, 1995. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidation and Capital Resources." Management has determined to build or refurbish rooms at the Boardwalk Expansion Site. When completed, the hotel will have approximately 361 rooms, including a retail space, located on two stories, fronting The Boardwalk. In September 1993, Trump entered into a sublease agreement (the "Time Warner Sublease") with Time Warner Entertainment Company, L.P. ("Time Warner") for a period of ten years with the sublessee's option to renew the sublease for a ten-year period. Under this agreement, Time Warner agreed to sublease the entire first floor of the retail space (approximately 17,000 square feet) located at the Boardwalk Expansion Site for a new Warner Brothers Studio Store. In October 1993, the Partnership assumed Trump's duties and obligations under the Time Warner Sublease. The Time Warner Sublease is subject to certain conditions subsequent; the Partnership believes that it will satisfy all conditions subsequent to that agreement in 1994. Management believes that the store will be a major attraction on The Boardwalk and will increase the flow of patrons through the casino. The remaining portion of the Boardwalk Expansion Site will be used for a new entranceway to Trump Plaza, directly off the Atlantic City Expressway, as well as a public park and parking facilities for Trump Plaza patrons. As a result of such expansion, the Partnership, upon approval by the CCC, will be able to increase Trump Plaza's casino floor space by 30,000 square feet. The Partnership has begun construction at such site (pursuant to rights granted to the Partnership by the lender and the lessee under the Boardwalk Expansion Site Lease) prior to acquiring title thereto pursuant to the Option. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." The Partnership is obligated to either pay a tax to the CRDA of 2.5% of its gross casino revenues or to obtain investment tax credits in an amount equal to 1.25% of its gross casino revenues. In connection with the assumption of the Boardwalk Expansion Site Lease, the Partnership obtained from the CRDA $10.3 million of investment tax credits with respect to the demolition of certain structures on the Boardwalk Expansion Site and the construction of certain improvements on the site. There can be no assurance, however, that such credits would be sufficient to defray a significant portion of the total project costs. Regency Expansion Site. In December 1993, Trump entered into an option agreement to acquire the Trump Regency Hotel ("Trump Regency"). In consideration for the Partnership's making certain payments in connection with the option, Trump agreed that, if the Trump Regency is acquired pursuant to such option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. See "Certain Relationships and Related Transactions -- Trump Regency." Competition Competition in the Atlantic City casino hotel market is intense. Trump Plaza competes primarily with other casinos located in Atlantic City, New Jersey, as well as gaming establishments located on Native American reservations in New York and Connecticut, and also would compete with any other facilities in the northeastern and mid-atlantic regions of the United States at which casino gaming or other forms of wagering may be authorized in the future. To a lesser extent, Trump Plaza faces competition from cruise lines, riverboat gambling, casinos located in Mississippi, Nevada, New Orleans, Puerto Rico, the Bahamas and other locations inside and outside the United States and from other forms of legalized gaming in New Jersey and in its surrounding states such as lotteries, horse racing (including off-track betting), jai alai and dog racing and from illegal wagering of various types. To the extent that legalized gaming becomes more prevalent in New Jersey or other nearby jurisdictions, competition from Native Americans or others would intensify. At present, there are 12 casino hotels located in Atlantic City, including Trump Plaza, all of which compete for patrons. In addition, there are several sites on The Boardwalk and in the Atlantic City Marina area on which casino hotels could be built in the future, although Management is not aware of any present plans to develop such sites. Total Atlantic City gaming revenue has increased over the past four years, although at varying rates. In 1991, six Atlantic City casino hotels reported increases in gaming revenues as compared to 1990, and five reported decreases in gaming revenues (including Trump Plaza). Management believes that the reduced rate of growth in aggregate gaming revenues in Atlantic City since 1987 as compared to prior years was principally due to the weakness in the economy throughout the Northeast and the adverse impact in 1991 of the war in the Middle East on tourism and consumer spending. Although all 12 Atlantic City casinos reported increases in gaming revenues in 1992 as compared to 1991, the Partnership believes that this was due, in part, to the depressed industry conditions in 1991. In 1993, nine casinos experienced increased casino revenues, as compared to 1992, while three casinos (including Trump Plaza) reported decreases. In 1990, the Atlantic City casino industry experienced a significant increase in room capacity and in available casino floor space, including the rooms and floor space made available by the opening of the Taj Mahal, which at the time was wholly-owned by Trump. The effects of such expansion were to increase competition and to contribute to a 1990 decline in gaming revenues per square foot. In 1990, the Atlantic City casino industry experienced a decline in gaming revenues per square foot of 5.0% which trend continued in 1991, although at the reduced rate of 2.9%. However, in 1992 and 1993, the Atlantic City casino industry experienced an increase of 6.9% and 1.4%, respectively in gaming revenues per square foot each as compared to the prior year. Casinos in Atlantic City must be located in approved hotel facilities which offer dining, entertainment and other guest facilities. Competition among casino hotels is based primarily upon promotional allowances, advertising, the attractiveness of the casino area, service, quality and price of rooms, food and beverages, restaurant, convention and parking facilities and entertainment. In order to compete effectively with all other Atlantic City casino hotels, the Partnership offers complimentary drinks, meals, room accommodations and/or travel arrangements to patrons with a demonstrated propensity to wager at Trump Plaza, as well as cash bonuses and other incentives pursuant to approved coupon programs. In 1988, Congress passed the Indian Gaming Regulatory Act ("IGRA"), which requires any state in which casino-style gaming is permitted (even if only for limited charity purposes) to negotiate compacts with federally recognized Native American tribes at the request of such tribes. Under IGRA, Native American tribes enjoy comparative freedom from regulation and taxation of gaming operations, which provides such tribes with an advantage over their competitors, including the Partnership. In 1991, the Mashantucket Pequot Nation opened a casino facility in Ledyard, Connecticut, located in the far eastern portion of such state, an approximately three-hour drive from New York City. In February 1992, the Mashantucket Pequot Nation initiated 24 hour gaming. In January 1993, slot machines were added at such facility, and the facility currently contains over 3,100 slot machines. The Mashantucket Pequot Nation has announced various expansion plans, including its intention to build another casino in Ledyard together with hotels, restaurants and a theme park. Trump, the Partnership and the Other Trump Casinos have recently filed a lawsuit seeking, among other things, a declaration that IGRA is unconstitutional and seeking an injunction against the enforcement of certain provisions of IGRA. The complaint states, among other things, that the Mashantucket Pequot Nation's casino has caused the Partnership substantial economic injury. The complaint states further that any future expansions of existing Native American gaming facilities or new ventures by such persons or others in the northeastern or mid-Atlantic region of the United States would have a further adverse impact on Atlantic City in general and could cause the Partnership further substantial economic injury. A group in New Jersey terming itself the "Ramapough Indians" has applied to the U.S. Department of the Interior to be recognized formally as a Native American tribe, which recognition would permit it to require the State of New Jersey to negotiate a gaming compact under IGRA. On December 3, 1993, however, the Interior Department proposed that such Federal recognition to the Ramapough Indians be denied. Similarly, a group in Cumberland County, New Jersey calling itself the "Nanticoke Lenni Lenape" tribe has filed a notice of intent with the Federal Bureau of Indian Affairs seeking formal recognition as a Native American tribe. Also, it has been reported that a Sussex County, New Jersey businessman has offered to donate land he owns there to the Oklahoma-based Lenape/Delaware Indian Nation which originated in New Jersey and already has Federal tribal status but does not have a reservation in the state. In addition, in July 1993, the Oneida Nation opened a casino featuring 24-hour table gaming, but without slot machines, near Syracuse, New York. Representatives of the St. Regis Mohawk Nation signed a gaming compact with New York State officials for the opening of a casino, without slot machines, in the northern portion of the state close to the Canadian border. The St. Regis Mohawk Nation has announced that it intends to open their casino in the summer of 1994. The Narragansett Native American Nation of Rhode Island has recently won a federal court case, which will require the Governor of Rhode Island to negotiate a casino gaming compact with the Nation. The Mohegan Nation, which is located in Connecticut, received federal recognition in March 1994. Other Native American Nations are seeking federal recognition, land, and negotiation of gaming compacts in New York, Pennsylvania, Connecticut and other nearby states. Legislation permitting other forms of casino gaming has been proposed, from time to time, in various states, including those bordering New Jersey. The Partnership's operations would be adversely affected by such competition, particularly if casino gaming were permitted in jurisdictions near or in New Jersey or other states in the Northeast. In December 1993, the Rhode Island Lottery Commission approved the addition of slot machine games on video terminals at Lincoln Greyhound Park and Newport Jai Alai, where poker and blackjack have been offered for over two years. Currently, casino gaming, other than Native American gaming, is not allowed in other areas of New Jersey or in New York or Pennsylvania. However, the Partnership expects that proposals may be introduced to legalize riverboat or other forms of gaming in Philadelphia and one or more other locations in Pennsylvania. The State of Louisiana recently approved casino gaming in the City of New Orleans, and a developer has been selected. To the extent that legalized gaming becomes more prevalent in New Jersey or other jurisdictions, competition would intensify. In addition, legislation has from time to time been introduced in the New Jersey State Legislature relating to types of state-wide legalized gaming, such as video games with small wagers. To date, no such legislation, which may require a state constitutional amendment, has been enacted. Management is unable to predict whether any such legislation, if enacted, would have a material adverse impact on the business, operations or financial condition of the Partnership. Conflicts of Interest Trump is a 100% beneficial owner of Trump's Castle Casino Resort ("Trump's Castle") subject to certain litigation warrants and a 50% beneficial owner of the Taj Mahal (collectively, the "Other Trump Casinos"), and is the sole beneficial owner of TC/GP, Inc., an entity that as of December 31, 1993 has provided certain services to Trump's Castle; prior thereto, Trump's Castle Management Corp., an entity solely owned by Trump, provided management services to Trump's Castle. Under certain circumstances, Trump could increase his beneficial interest in Taj Mahal to 100%. In addition, Trump has a personal services agreement with the partnership that owns the Taj Mahal pursuant to which he receives substantial compensation based, in part, on the financial results of the Taj Mahal. The Other Trump Casinos compete directly with each other and with other Atlantic City casino hotels, including Trump Plaza. Nicholas L. Ribis, the Chief Executive Officer of the Partnership, is also the chief executive officer of the partnerships that own the Other Trump Casinos. In addition, Messrs. Ribis and Trump serve on the governing bodies of the partnerships that own the Other Trump Casinos. As a result of Trump's interests in three competing Atlantic City casinos and the common chief executive officer, a conflict of interest may be deemed to exist by reason of such persons' access to information and business opportunities possibly useful to any or all of such casinos. No specific procedures have been devised for resolving conflicts of interest confronting, or which may confront, Trump, such persons and the Other Trump Casinos. See "Certain Relationships and Related Transactions." Employees and Labor Relations The Partnership has approximately 3,800 employees of whom approximately 1,100 are covered by collective bargaining agreements. Management believes that its relationships with its employees are satisfactory. All of the Partnership's employees must be licensed or registered under the Casino Control Act. See "Gaming Regulations -- Employees." The Company has no employees. In April 1993, the National Labor Relations board found that the Partnership had violated the National Labor Relations Act (the "NLRA") in the context of a union organizing campaign by table game dealers of the Partnership in association with the Sports Arena and Casino Employees Union Local 137, a/w Laborers' International Union of North America, AFL-CIO ("Local 137"). In connection with such finding, the Partnership was ordered to refrain from interfering with, restraining, or coercing employees in the exercise of the rights guaranteed them by Section 7 of the NLRA, to notify its employees of such rights and to hold an election by secret ballot among its employees, which is anticipated to be held in May 1994, regarding whether they desire to be represented for collective bargaining by Local 137. Seasonality The gaming industry in Atlantic City traditionally has been seasonal, with its strongest performance occurring from May through September, and with December and January showing substantial decreases in activity. Revenues have been significantly higher on Fridays, Saturdays, Sundays and holidays than on other days. Gaming and Other Laws and Regulations The following is only a summary of the applicable provisions of the Casino Control Act and certain other laws and regulations. It does not purport to be a full description thereof and is qualified in its entirety by reference to the Casino Control Act and such other laws and regulations. In general, the Casino Control Act contains detailed provisions concerning, among other things: the granting of casino licenses; the suitability of the approved hotel facility, and the amount of authorized casino space and gaming units permitted therein; the qualification of natural persons and entities related to the casino licensee; the licensing and registration of employees and vendors of casino licensees; rules of the games; the selling and redeeming of gaming chips; the granting and duration of credit and the enforceability of gaming debts; management control procedures, accounting and cash control methods and reports to gaming agencies; security standards; the manufacture and distribution of gaming equipment; equal employment opportunity for employees of casino operators, contractors of casino facilities and others; and advertising, entertainment and alcoholic beverages. Casino Control Commission. The ownership and operation of casino/hotel facilities in Atlantic City are the subject of strict state regulation under the Casino Control Act. The CCC is empowered to regulate a wide spectrum of gaming and non-gaming related activities and to approve the form of ownership and financial structure of not only a casino licensee, but also its entity qualifiers and intermediary and holding companies. Operating Licenses. The Partnership was issued its initial casino license on May 14, 1984. On April 19, 1993, the CCC renewed the Partnership's casino license through March 31, 1995, and on March 15, 1993 approved Trump as a natural person qualifier through May 1995. No assurance can be given that the CCC will renew the casino license or, if it does so, as to the conditions it may impose, if any, with respect thereto. Casino Licensee. No casino hotel facility may operate unless the appropriate license and approvals are obtained from the CCC, which has broad discretion with regard to the issuance, renewal, revocation and suspension of such licenses and approvals, which are non-transferable. The qualification criteria with respect to the holder of a casino license include its financial stability, integrity and responsibility; the integrity and adequacy of its financial resources which bear any relation to the casino project; its good character, honesty and integrity; and the sufficiency of its business ability and casino experience to establish the likelihood of a successful, efficient casino operation. The casino license held by the Partnership is renewable for periods of up to two years. The CCC may reopen licensing hearings at any time, and must reopen a licensing hearing at the request of the New Jersey Division of Gaming Enforcement (the "Division"). To be considered financially stable, a licensee must demonstrate the following ability: to pay winning wagers when due, to achieve a gross operating profit; to pay all local, state and federal taxes when due, to make necessary capital and maintenance expenditures to insure that it has a superior first-class facility, and to pay, exchange, refinance or extend debts which will mature or become due and payable during the license term. In the event a licensee fails to demonstrate financial stability, the CCC may take such action as it deems necessary to fulfill the purposes of the Casino Control Act and protect the public interest, including: issuing conditional licenses, approvals or determinations; establishing an appropriate cure period, imposing reporting requirements; placing restrictions on the transfer of cash or the assumption of liability; requiring reasonable reserves or trust accounts; denying licensure; or appointing a conservator. See "Conservatorship" below. The partnership believes that it has adequate financial resources to meet the financial stability requirements of the CCC for the foreseeable future. Pursuant to the Casino Control Act, CCC Regulations and precedent, no entity may hold a casino license unless each officer, director, principal employee, person who directly or indirectly holds any beneficial interest or ownership in the licensee, each person who in the opinion of the CCC has the ability to control or elect a majority of the board of directors of the licensee (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) and any lender, underwriter, agent or employee of the licensee or other person whom the CCC may consider appropriate, obtains and maintains qualification approval from the CCC. Qualification approval means that such person must, but for residence, individually meet the qualification requirements as a casino key employee. See "Narrative Description of Business -- Gaming and Other Laws and Regulations -- Employees." Pursuant to a condition of its casino license, payments by the Partnership to or for the benefit of any related entity or partner are subject to prior CCC approval; and, if the Partnership's cash position falls below $5.0 million for three consecutive business days, the Partnership must present to the CCC and the Division evidence as to why it should not obtain a working capital facility in an appropriate amount. Control Persons. An entity qualifier or intermediary or holding company, such as Holding, Holding Inc. and the Company, is required to register with the CCC and meet the same basic standards for approval as a casino licensee; provided, however, that the CCC, with the concurrence of the Director of the Division, may waive compliance by a publicly-traded corporate holding company with the requirement that an officer, director, lender, underwriter, agent or employee thereof, or person directly or indirectly holding a beneficial interest or ownership of the securities thereof individually qualify for approval under casino key employee standards so long as the CCC and the Director are, and remain, satisfied that such officer, director, lender, underwriter, agent or employee is not significantly involved in the activities of the casino licensee, or that such security holder does not have the ability to control the publicly-traded corporate holding company or elect one or more of its directors. Persons holding five percent or more of the equity securities of such holding company are presumed to have the ability to control the company or elect one or more of its directors and will, unless this presumption is rebutted, be required to individually qualify. Equity securities are defined as any voting stock or any security similar to or convertible into or carrying a right to acquire any security having a direct or indirect participation in the profits of the issuer. Financial Sources. The CCC may require all financial backers, investors, mortgagees, bond holders and holders of notes or other evidence of indebtedness, either in effect or proposed, which bears any relation to the casino project, publicly traded securities of an entity which holds a casino license or is an entity qualifier, subsidiary or holding company of a casino licensee (a "Regulated Company"), to qualify as financial sources. In the past, the CCC has waived the qualification requirement for holders of less than 15% of a series of publicly traded mortgage bonds so long as the bonds remained widely distributed and freely traded in the public market and the holder had no ability to control the casino licensee. The CCC may require holders of less than 15% of a series of debt to qualify as financial sources even if not active in the management of the issuer or the casino licensee. Institutional Investors. An institutional investor ("Institutional Investor") is defined by the Casino Control Act as any retirement fund administered by a public agency for the exclusive benefit of federal, state or local public employees; investment company registered under the Investment Company Act of 1940; collective investment trust organized by banks under Part Nine of the Rules of the Comptroller of the Currency; closed end investment trust; chartered or licensed life insurance company or property and casualty insurance company; banking and other chartered or licensed lending institution; investment advisor registered under the Investment Advisers Act of 1940; and such other persons as the CCC may determine for reasons consistent with the policies of the Casino Control Act. An Institutional Investor may be granted a waiver by the CCC from financial source or other qualification requirements applicable to a holder of publicly-traded securities, in the absence of a prima facie showing by the Division that there is any cause to believe that the holder may be found unqualified, on the basis of CCC findings that: (i) its holdings were purchased for investment purposes only and, upon request by the CCC, it files a certified statement to the effect that it has no intention of influencing or affecting the affairs of the issuer, the casino licensee or its holding or intermediary companies; provided, however, that the Institutional Investor will be permitted to vote on matters put to the vote of the outstanding security holders; and (ii) if (x) the securities are debt securities of a casino licensee's holding or intermediary companies or another subsidiary company of the casino licensee's holding or intermediary companies which is related in any way to the financing of the casino licensee and represent either (A) 20% or less of the total outstanding debt of the company, or (B) 50% or less of any issue of outstanding debt of the company, (y) the securities are equity securities and represent less than 10% of the equity securities of a casino licensee's holding or intermediary companies, or (z) the securities so held exceed such percentages, upon a showing of good cause. There can be no assurance, however, that the CCC will make such findings or grant such waiver and, in any event, an Institutional Investor may be required to produce for the CCC or the Division upon request, any document or information which bears any relation to such debt or equity securities. Generally, the CCC requires each institutional holder seeking waiver of qualification to execute a certification to the effect that (i) the holder has received the definition of Institutional Investor under the Casino Control Act and believes that it meets the definition of Institutional Investor; (ii) the holder purchased the securities for investment purposes only and holds them in the ordinary course of business; (iii) the holder has no involvement in the business activities of, and no intention of influencing or affecting the affairs of the issuer, the casino licensee or any affiliate; and (iv) if the holder subsequently determines to influence or affect the affairs of the issuer, the casino licensee or any affiliate, it shall provide not less than 30 days' prior notice of such intent and shall file with the CCC an application for qualification before taking any such action. If an Institutional Investor changes its investment intent, or if the CCC finds reasonable cause to believe that it may be found unqualified, the Institutional Investor may take no action with respect to the security holdings, other than to divest itself of such holdings, until it has applied for interim casino authorization (see "Interim Casino Authorization" below) and has executed a trust agreement pursuant to such an application. Ownership and Transfer of Securities. The Casino Control Act imposes certain restrictions upon the issuance, ownership and transfer of securities of a Regulated Company and defines the term "security" to include instruments which evidence a direct or indirect beneficial ownership or creditor interest in a Regulated Company including, but not limited to, mortgages, debentures, security agreements, notes and warrants. Each of the Company and the Partnership are deemed to be a Regulated Company, and instruments evidencing a beneficial ownership or creditor interest therein, including partnership interest, are deemed to be the securities of a Regulated Company. If the CCC finds that a holder of such securities is not qualified under the Casino Control Act, it has the right to take any remedial action it may deem appropriate including the right to force divestiture by such disqualified holder of such securities. In the event that certain disqualified holders fail to divest themselves of such securities, the CCC has the power to revoke or suspend the casino license affiliated with the Regulated Company which issued the securities. If a holder is found unqualified, it is unlawful for the holder (i) to exercise, directly or through any trustee or nominee, any right conferred by such securities, or (ii) to receive any dividends or interest upon such securities or any remuneration, in any form, from its affiliated casino licensee for services rendered or otherwise. With respect to non-publicly-traded securities, the Casino Control Act and CCC regulations require that the corporate charter or partnership agreement of a Regulated Company establish a right in the CCC of prior approval with regard to transfers of securities, shares and other interests and an absolute right in the Regulated Company to repurchase at the market price or the purchase price, whichever is the lesser, any such security, share or other interest in the event that the CCC disapproves a transfer. With respect to publicly-traded securities, such corporate charter or partnership agreement is required to establish that any such securities of the entity are held subject to the condition that, if a holder thereof is found to be disqualified by the CCC, such holder shall dispose of such securities. Interim Casino Authorization. Interim casino authorization is a process which permits a person who enters into a contract to obtain property relating to a casino operation or who obtains publicly-traded securities relating to a casino licensee to close on the contract or own the securities until plenary licensure or qualification. During the period of interim authorization, the property relating to the casino operation or the securities are held in trust. Whenever any person enters into a contract to transfer any property which relates to an ongoing casino operation, including a security of the casino licensee or a holding or intermediary company or entity qualifier, under circumstances which would require that the transferee obtain licensure or be qualified under the Casino Control Act, and that person is not already licensed or qualified, the transferee is required to apply for interim authorization. Furthermore, the closing or settlement date in the contract may not be earlier than the 121st day after the submission of a complete application for licensure or qualification together with a fully executed trust agreement in a form approved by the CCC. If, after the report of the Division and a hearing by the CCC, the CCC grants interim authorization, the property will be subject to a trust. If the CCC denies interim authorization, the contract may not close or settle until the CCC makes a determination on the qualifications of the applicant. If the CCC denies qualification, the contract will be terminated for all purposes and there will be no liability on the part of the transferor. If, as the result of a transfer of publicly traded securities of a licensee, a holding or intermediary company or entity qualifier of a licensee or a financing entity of a licensee, any person is required to qualify under the Casino Control Act, that person is required to file an application for licensure or qualification within 30 days after the CCC determines that qualification is required or declines to waive qualification. The application must include a fully executed trust agreement in a form approved by the CCC or, in the alternative, within 120 days after the CCC determines that qualification is required, the person whose qualification is required must divest such securities as the CCC may require in order to remove the need to qualify. The CCC may grant interim casino authorization where it finds by clear and convincing evidence that: (i) statements of compliance have been issued pursuant to the Casino Control Act; (ii) the casino hotel is an approved hotel in accordance with the Casino Control Act; (iii) the trustee satisfies qualification criteria applicable to key casino employees, except for residency and casino experience; and (iv) interim operation will best serve the interests of the public. When the CCC finds the applicant qualified, the trust will terminate. If the CCC denies qualification to a person who has received interim casino authorization, the trustee is required to endeavor, and is authorized, to sell, assign, convey or otherwise dispose of the property subject to the trust to such persons who are licensed or qualified or shall themselves obtain interim casino authorization. Where a holder of publicly traded securities is required, in applying for qualification as a financial source or qualifier, to transfer such securities to a trust in application for interim casino authorization and the CCC thereafter orders that the trust become operative: (i) during the time the trust is operative, the holder may not participate in the earnings of the casino hotel or receive any return on its investment or debt security holdings; and (ii) after disposition, if any, of the securities by the trustee, proceeds distributed to the unqualified holder may not exceed the lower of their actual cost to the unqualified holder or their value calculated as if the investment had been made on the date the trust became operative. Approved Hotel Facilities. The CCC may permit a licensee, such as the Partnership, to increase its casino space if the licensee agrees to add a prescribed number of qualifying sleeping units within two years after the commencement of gaming operations in the additional casino space. However, if the casino licensee does not fulfill such agreement due to conditions within its control, the licensee will be required to close the additional casino space, or any portion thereof that the CCC determines should be closed. License Fees. The CCC is authorized to establish annual fees for the renewal of casino licenses. The renewal fee is based upon the cost of maintaining control and regulatory activities prescribed by the Casino Control Act, and may not be less than $200,000 for a two-year casino license. Additionally, casino licensees are subject to potential assessments to fund any annual operating deficits incurred by the CCC or the Division. There is also an annual license fee of $500 for each slot machine maintained for use or in use in any casino. Gross Revenue Tax. Each casino licensee is also required to pay an annual tax of 8% on its gross casino revenues. For the years ended December 31, 1992 and 1993, the Partnership's gross revenue tax was approximately $21.0 million and $21.3 million respectively, and its license, investigations, and other fees and assessments totalled approximately $4.7 million and $4.0 million respectively. Investment Alternative Tax Obligations. An investment alternative tax imposed on the gross casino revenues of each licensee in the amount of 2.5% is due and payable on the last day of April following the end of the calendar year. A licensee is obligated to pay the investment alternative tax for a period of 25 years. Estimated payments of the investment alternative tax obligation must be made quarterly in an amount equal to 1.25% of estimated gross revenues for the preceding three-month period. Investment tax credits may be obtained by making qualified investments or by the purchase of bonds issued by the CRDA. CRDA bonds may have terms as long as fifty years and bear interest at below market rates, resulting in a value lower than the face value of such CRDA bonds. For the first ten years of its obligation, the licensee is entitled to an investment tax credit against the investment alternative tax in an amount equal to twice the purchase price of bonds issued to the licensee by the CRDA. Thereafter, the licensee is (i) entitled to an investment tax credit in an amount equal to twice the purchase price of such bonds or twice the amount of its investments authorized in lieu of such bond investments or made in projects designated as eligible by the CRDA and (ii) has the option of entering into a contract with the CRDA to have its tax credit comprised of direct investments in approved eligible projects which may not comprise more than 50% of its eligible tax credit in any one year. From the moneys made available to the CRDA, the CRDA set aside $100,000,000 for investment in hotel development projects in Atlantic City undertaken by a licensee which result in the construction or rehabilitation of at least 200 hotel rooms by December 31, 1996. The CRDA is required to determine the amount each casino licensee may be eligible to receive out of the moneys set aside. Minimum Casino Parking Charges. As of July 1, 1993, each casino licensee was required to impose on and collect from patrons a standard minimum parking charge of at least $2.00 for the use of parking, space for the purpose of parking, garaging or storing motor vehicles in a parking facility owned or leased by a casino licensee or by any person on behalf of a casino licensee. Of the amount collected by the casino licensee, $1.50 will be paid to the New Jersey State Treasurer and paid by the New Jersey State Treasurer into a special fund established and held by the New Jersey State Treasurer for the exclusive use of the CRDA. Amounts in the special fund will be expended by the CRDA for (i) eligible projects in the corridor region of Atlantic City, which projects are related to the improvement of roads, infrastructure, traffic regulation and public safety, and (ii) funding up to 35% of the cost to casino licensee of expanding their hotel facilities to provide additional hotel rooms, which hotel rooms are required to be available upon the opening of the Atlantic City Convention Center and dedicated to convention events. Conservatorship. If, at any time, it is determined that the Partnership, the Company, Holding, Inc. or Holding has violated the Casino Control Act or that any of such entities cannot meet the qualification requirements of the Casino Control Act, such entity could be subject to fines or the suspension or revocation of its license or qualification. If the Partnership's license is suspended for a period in excess of 120 days or revoked or if the CCC fails or refuses to renew such casino license, the CCC could appoint a conservator to operate and dispose of the Partnership's casino hotel facilities. A conservator would be vested with title to all property of the Partnership relating to the casino and the approved hotel subject to valid liens and/or encumbrances. The conservator would be required to act under the direct supervision of the CCC and would be charged with the duty of conserving, preserving and, if permitted, continuing the operation of the casino hotel. During the period of the conservatorship, a former or suspended casino licensee is entitled to a fair rate of return out of net earnings, if any, on the property retained by the conservator. The CCC may also discontinue any conservatorship action and direct the conservator to take such steps as are necessary to effect an orderly transfer of the property of a former or suspended casino licensee. Employees. All employees of the Partnership must be licensed by or registered with the CCC, depending on the nature of the position held. Casino employees are subject to more stringent requirements than non-casino employees and must meet applicable standards pertaining to financial stability, integrity and responsibility, good character, honesty and integrity, business ability and casino experience and New Jersey residency. These requirements have resulted in significant competition among Atlantic City casino operators for the services of qualified employees. Gaming Credit. The Partnership's casino games are conducted on a credit as well as cash basis. Gaming debts arising in Atlantic City in accordance with applicable regulations are enforceable in the courts of the State of New Jersey. The extension of gaming credit is subject to regulations that detail procedures which casinos must follow when granting gaming credit and recording counter checks which have been exchanged, redeemed or consolidated. Control Procedures. Gaming at Trump Plaza is conducted by trained and supervised personnel. The Partnership employs extensive security and internal controls. Security checks are made to determine, among other matters, that job applicants for key positions have had no criminal history or associations. Security controls utilized by the surveillance department include closed circuit video camera to monitor the casino floor and money counting areas. The count of moneys from gaming also is observed daily by representatives of the CCC. Other Laws and Regulations. The United States Department of the Treasury has adopted regulations pursuant to which a casino is required to file a report of each deposit, withdrawal, exchange of currency, gambling tokens or chips, or other payments or transfers by, through, or to such casino which involves a transaction in currency of more than $10,000 per patron per gaming day. Such reports are required to be made on forms prescribed by the Secretary of the Treasury and are filed with the Commissioner of the Internal Revenue Service (the "IRS"). In addition, the Partnership is required to maintain detailed records (including the names, addresses, social security numbers and other information with respect to its gaming customers) dealing with, among other items, the deposit and withdrawal of funds and the maintenance of a line of credit. The Department of the Treasury has recently adopted regulations, scheduled to become effective in December 1994, which will require the Partnership, among other things, to keep records of the name, permanent address and taxpayer identification number (or in the case of a non-resident alien, such person's passport number) of any person engaging in a currency transaction in excess of $3,000. The Partnership is unable to predict what effect, if any, these new reporting obligations will have on gaming practices of certain of its patrons. In the past, the IRS had taken the position that gaming winnings from table games by non-resident aliens was subject to a 30% withholding tax. The IRS, however, subsequently adopted a practice of not collecting such tax. Recently enacted legislation exempts from tax withholding table game winnings by non-resident aliens, unless the Secretary of the Treasury determines by regulation that such collections have become administratively feasible. As the result of an audit conducted by the U.S. Department of Treasury, Office of Financial Enforcement, the Partnership was alleged to have failed to timely file the "Currency Transaction Report by Casino" in connection with 65 individual currency transactions in excess of $10,000 during the period from October 31, 1986 to December 10, 1988. The Partnership paid a fine of $292,500 in connection with these violations. The Partnership has revised its internal control procedures to ensure continued compliance with these regulations. The Partnership is subject to other federal, state and local regulations and, on a periodic basis, must obtain various licenses and permits, including those required to sell alcoholic beverages. Management believes that it has obtained all required licenses and permits to conduct its business. (d) Financial Information About Foreign and Domestic Operations and Export Sales Not applicable. ITEM 2. ITEM 2. PROPERTIES. The Partnership owns and leases several parcels of land in and around Atlantic City, New Jersey, each of which is used in connection with the operation of Trump Plaza and each of which is subject to the liens of the Note Mortgage and Guarantee Mortgage (collectively, the "Mortgages") and certain other liens. The "Note Mortgage" is the mortgage on and related assignments of the assets constituting the real property owned and leased by the Partnership and substantially all of the Partnership's other assets, all of which constitute Trump Plaza and its related properties, which secures the non-recourse promissory note (the"Partnership Note") of the Partnership issued to the Company in exchange for the Company's lending to the Partnership the proceeds of the Mortgage Note Offering. In exchange for the use of such proceeds, the Company has assigned the Note Mortgage and the Partnership Note to the Trustee. The "Guarantee Mortgage" is the mortgage on and related assignments of the assets of the Partnership described above, senior to the lien of the Note Mortgage, which secures the Partnership's non-recourse guarantee (the "Guarantee") of the Mortgage Notes. The Mortgage Note Indenture, the Note Mortgage and the Guarantee Mortgage are herein collectively referred to as the "Mortgage Note Agreements." Casino Parcel. Trump Plaza is located on The Boardwalk in Atlantic City, New Jersey, next to the Atlantic City Convention Center. It occupies the entire city block (approximately 2.38 acres) bounded by The Boardwalk, Mississippi Avenue, Pacific Avenue and Columbia Place (the "Casino Parcel"). The Casino Parcel consists of four tracts of land, one of which is owned by the Partnership and three of which are leased to the Partnership pursuant to three non-renewable Ground Leases, each of which expires on December 31, 2078 (each, a "Ground Lease"). Trump Seashore Associates, Seashore Four Associates and Plaza Hotel Management Company (each, a "Ground Lessor") are the owners/lessors under such Ground Leases (respectively, the "TSA Lease," "SFA Lease" and "PHMC Lease"; the land which is subject to the Ground Leases (which includes Additional Parcel 1, as hereinafter defined) is referred to collectively as the "Leasehold Tracts" and individually as a "Leasehold Tract"). Trump Seashore Associates and Seashore Four Associates are beneficially owned by Trump and are, therefore, affiliates of the Company and the Partnership. On August 1, 1991, as security for indebtedness owed to a third party, Trump Seashore Associates transferred its interest in the TSA Lease to United States Trust Company of New York ("UST"), as trustee for the benefit of such third party creditor. The trust agreement among UST, Trump Seashore Associates and such creditor provides that the trust shall terminate on the earlier of (i) August 1, 2012 or (ii) the date on which such third party creditor certifies to UST that all principal, interest and other sums due and owing from Trump Seashore Associates to such third party creditor have been paid. Trump Seashore Associates is currently negotiating with its third party lender for the extension or refinancing of the indebtedness described above, which debt matured on October 28, 1993. The lender has agreed to forebear from pursuing remedies under such loan through May 28, 1994, while such refinancing negotiations are taking place. The Mortgage Note Agreements provide that, upon such refinancing, the refinancing lender shall consent to the execution of an agreement between TSA and the Partnership providing, among other matters, for certain protections for holders of Mortgage Notes in the event of a default arising under the TSA Lease. While the transfer to UST of Trump Seashore Associates' interest in the TSA Lease was primarily a financing transaction to provide the third-party creditor with a potentially enhanced security interest, because of the transfer of such interest to UST, it is not certain that the TSA Lease would be deemed to be held by an affiliate of the Partnership and, therefore, even if the agreement described above is executed by TSA, the holders of the Mortgage Notes and the PIK Notes may not have the benefit of any such agreement regarding the TSA Lease. The SFA Lease and the PHMC Lease each contain options pursuant to which the Partnership may purchase the Leasehold Tract covered by such Ground Lease at certain times during the term of such Ground Lease under certain circumstances. Upon any refinancing of the mortgage indebtedness which currently encumbers the fee interest in the TSA Lease Leasehold Tract, including any refinancing resulting from the on-going negotiations described above, the TSA Lease will be amended to confirm the existence thereunder of the purchase options, or provide for an additional option grant, in each case substantially similar to those currently set forth in the other Ground Leases. The purchase price pursuant to each option is specified in the applicable Ground Lease. The Ground Leases are "net leases" pursuant to which the Partnership, in addition to the payment of fixed rent, is responsible for all costs and expenses with respect to the use, operation and ownership of the Leasehold Tracts and the improvements now, or which may in the future be, located thereon, including, but not limited to, all maintenance and repair costs, insurance premiums, real estate taxes, assessments and utility charges. The improvements located on the Leasehold Tracts are owned by the Partnership during the terms of the respective Ground Leases and upon the expiration of the term of each Ground Lease (for whatever reason), ownership of such improvements will vest in the Ground Lessor. Subject to the provisions of the Mortgage Note Agreements, the Partnership has the right to improve the Leasehold Tracts, alter, demolish and/or rebuild the improvements constructed thereon, and remove any personal property and movable trade fixtures therefrom. The Ground Leases provide that each Ground Lessor may encumber its fee estate with mortgage liens, but any such fee mortgage will not increase the rent under the applicable Ground Lease and must be subordinate to such Ground Lease. Accordingly, any default by a Ground Lessor under any such fee mortgage (including that mortgage encumbering the TSA Lease parcel, for which refinancing negotiations are on-going) will not result in a termination of the applicable Ground Lease but would permit the fee mortgagee to bring a foreclosure action and succeed to the interests of the Ground Lessor in the fee estate, subject to the Partnership's leasehold estate under such Ground Lease. Each Ground Lease also specifically provides that the Lessor may sell its interest in the applicable Leasehold Tract, but any such sale would be made subject to the Partnership's interest in the applicable Ground Lease. The Mortgages are subject and subordinate to each of the Ground Leases. Accordingly, if a Ground Lease were to be terminated while such Mortgages were outstanding, the lien of the Mortgages would be extinguished as to the applicable Leasehold Tract. The Ground Leases, however, contain certain provisions to protect the Mortgage Note Trustee and the holders of the Mortgage Notes from such an occurrence, including the following: (i) no cancellation, surrender, acceptance of surrender or modification of a Ground Lease is binding on the Mortgage Note Trustee or affects the lien of the Mortgages without the Mortgage Note Trustee's prior written consent, (ii) the Mortgage Note Trustee is entitled to a copy of any notices (including notices of default) sent by a Ground Lessor to the Partnership, has the right to perform any term or condition of the Ground Lease to be performed by the Partnership and can cure any defaults, (iii) if any default is not remedied within the applicable grace period specified in the Ground Lease, then before the Ground Lessor exercises its rights under the Ground Lease or any statute, the Mortgage Note Trustee has an additional period of time within which to cure, or commence the curing of, the default and (iv) upon any termination of a Ground Lease, the Ground Lessor must enter into a new lease, on substantially the same terms as the applicable Ground Lease, with the Mortgage Note Trustee. In the event of a default by the Partnership under a Ground Lease, however, notwithstanding any additional cure period granted to the Mortgage Note Trustee, there can be no assurance that the Mortgage Note Trustee will take action to cure the default, will have sufficient time to cure the default or will otherwise be able to take advantage of such provisions. If the Ground Lease were then terminated and a new lease entered into, the Mortgage Note Trustee would nevertheless remain obligated to cure all pre- existing defaults. If a bankruptcy case is filed by or commenced against a lessor under applicable bankruptcy law, the trustee in bankruptcy in a liquidation or reorganization case under the applicable bankruptcy law, or a debtor-in-possession in a reorganization case under the applicable bankruptcy law, has the right, at its option, to assume or reject the lease of the debtor-lessor (subject, in each case, to court approval). If the lease is assumed, the rights and obligations of the Partnership thereunder, and the rights of the Mortgage Note Trustee as leasehold mortgagee under the Mortgage Note Agreements, would continue in full force and effect. If the lease is rejected, the Partnership would have the right, at its election, either (i) to treat the lease as terminated, in which event the lien of the Mortgages on the leasehold estate created thereby would be extinguished, or (ii) to continue in possession of the land and improvements under the lease for the balance of the term thereof and at the rental set forth therein (with a right to offset against such rent any damages caused by the lessor's failure to thereafter perform its obligations under such lease). The Mortgage Note Agreements provide that if a lease is rejected, the Partnership assigns to the Trustee its rights to elect whether to treat the lease as terminated or to remain in possession of the leased premises. In the case of the Ground Leases, the rejection of a Ground Lease by a trustee in bankruptcy or debtor-lessor (as debtor-in-possession) may result in termination of any options to purchase the fee estate of the debtor-lessor and the Mortgage Note Trustee's option (as leasehold mortgagee), in certain circumstances, to enter into a new lease directly with the lessor. In addition, under an interpretation of New Jersey law, it is possible that a court would regard such options as separate contracts and, therefore, severable from the Ground Lease. In such event, the trustee in bankruptcy or debtor-lessor (as debtor-in-possession) could assume the Ground Lease, while rejecting some or all of such options under the Ground Lease. Parking Parcels. The Partnership owns a parcel of land (the "Garage Parcel") located across the street from the Casino Parcel and along Pacific Avenue in a portion of the block bounded by Pacific Avenue, Mississippi Avenue, Atlantic Avenue and Missouri Avenue. The Partnership has constructed on the Garage Parcel a 10-story parking garage capable of accommodating approximately 2,650 cars and which includes offices and a bus transportation center with bays accommodating up to 13 buses at one time. An enclosed pedestrian walkway from the parking garage accesses Trump Plaza at the casino level. Parking at the parking garage is available to Trump Plaza's guests, as well as to the general public. Two of the tracts comprising a portion of the Garage Parcel are subject to first mortgages on the Partnership's fee interest in such tracts. As of December 31, 1993, such mortgages had approximate outstanding principal balances of $2.7 million and $2.0 million. The Partnership leases, pursuant to the PHMC Lease, a parcel of unimproved land located on the northwest corner of the intersection of Mississippi and Pacific Avenues consisting of approximately 11,800 square feet ("Additional Parcel 1") and owns another unimproved parcel on Mississippi Avenue adjacent to Additional Parcel 1 consisting of approximately 5,750 square feet (the "Bordonaro Parcel"). The Bordonaro Parcel is encumbered by a first mortgage having an outstanding principal balance, as of December 31, 1993, of approximately $150,000. Additionally Parcel 1 and the Bordonaro Parcel are presently paved and used for surface parking. The Partnership also owns five unimproved parcels of land, aggregating approximately 43,300 square feet, and sub leases on an unimproved parcel consisting of approximately 3,125 square feet. All of such parcels are contiguous and are located along Atlantic Avenue, in the same block as the Garage Parcel. They are used for surface parking for employees of Trump Plaza and are not encumbered by any mortgage liens other than those of the Mortgages. Warehouse Parcel. The Partnership owns a warehouse and office facility located in Egg Harbor Township, New Jersey containing approximately 64,000 square feet of space (the "Egg Harbor Parcel"). The Egg Harbor Parcel is encumbered by a first mortgage having an outstanding principal balance, as of December 31, 1993, of approximately $1.6 million. Boardwalk Expansion Site. See "Certain Relationships and Related Transactions -- Boardwalk Expansion Site." Superior Mortgages. The lien securing the indebtedness on the Garage Parcel, the Bordonaro Parcel and the Egg Harbor Parcel (all of such liens are collectively called the "Existing Senior Mortgages") are all senior to the liens of the Mortgages. The principal amount currently secured by such Existing Senior Mortgages as of December 31, 1993 is in the aggregate, $6.4 million. If the Partnership were to default in the payment of the indebtedness secured by any of the Existing Senior Mortgages or default in the performance of any of the other obligations thereunder, and the holder of an Existing Senior Mortgage were to commence a foreclosure action, the debt owed to the holder of such Existing Senior Mortgage, together with the debt owed to the holder of any other Existing Senior Mortgage which is also then being foreclosed, would have to be satisfied before the holders of the Mortgage Notes would realize any proceeds from the sale of the portion of the property encumbered thereby. If the Company and the Partnership default in the payment of the Mortgage Notes or any other obligation under the Mortgages, and the Mortgage Note Trustee elects to foreclose under the Mortgages, the Mortgage Note Trustee will receive the proceeds of the sale of the collateral under the Mortgage Note Indenture (the "Collateral") subject to the rights of the holders of any Existing Senior Mortgages. The purchaser of the Collateral at any such foreclosure sale would take title to the Collateral subject to the extent not foreclosed upon the Existing Senior Mortgages. In addition to the Existing Senior Mortgages, the Partnership may, under certain circumstances, borrow up to $25 million to pay for certain expansion site costs which may be secured by a lien on the expansion site superior to the lien of the Mortgages thereon. The Partnership has financed or leased and from time to time will finance or lease its acquisition of furniture, fixtures and equipment. The lien in favor of any such lender or lessor will be superior to the liens of the Mortgages. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Partnership, its partners, certain members of its former Executive Committee, and certain of its employees, have been involved in various legal proceedings. In general, the Partnership has agreed to indemnify such persons against any and all losses, claims, damages, expenses (including reasonable costs, disbursements and counsel fees) and liabilities (including amounts paid or incurred in satisfaction of settlements, judgments, fines and penalties) incurred by them in said legal proceedings. Such persons and entities are vigorously defending the allegations against them and intend to vigorously contest any future proceedings. Penthouse Litigation On April 3, 1989, BPHC Acquisition, Inc. and BPHC Parking Corp. (collectively, "BPHC") filed a third-party complaint (the "Complaint") against the Partnership and Trump. The Complaint arose in connection with the action entitled Boardwalk Properties, Inc. and Penthouse International Ltd. v. BPHC Acquisition, Inc. and BPHC Parking Corp., which was instituted on March 20, 1989 in the New Jersey Superior Court, Chancery Division, Atlantic County. The suit arose in connection with the conditional sale by Boardwalk Properties, Inc. ("BPI") (or, with respect to certain of the property, BPI's agreement to sell) to Trump of BPI's fee and leasehold interests in (i) an approximately 2.0-acre parcel of land located directly across the street from Trump Plaza upon which there is located an approximately 500 room hotel, which is closed to the public and is in need of substantial renovation (the "Penthouse Site"), (ii) an approximately 4.2-acre parcel of land located on Atlantic Avenue, diagonally across from Trump Plaza's parking garage (the "Columbus Plaza Site") which was then owned by an entity in which 50% of the interests were each owned by BPHC and BPI and (iii) an additional 1,462-square foot parcel of land located within the area of the Penthouse Site (the "Bongiovanni Site"). Prior to BPI entering into its agreement with Trump, BPI had entered into agreements with BPHC which provided, among other things, for the sale to BPHC of the Penthouse Site, as well as BPI's interest in the Columbus Plaza Site, assuming that certain contingencies were satisfied by a certain date. Additionally, by agreement between BPHC and BPI, in the event BPHC failed to close on the Penthouse Site, BPHC would convey to BPI the Bongiovanni Site. Upon BPHC's failure to close on the Penthouse Site, BPI entered into its agreement with Trump pursuant to which it sold the Penthouse Site to Trump and instituted a lawsuit against BPHC for specific performance to compel BPHC to transfer to BPI, BPHC's interest in the Columbus Plaza and Bongiovanni Sites, as provided for in the various agreements between BPHC and BPI and in the agreement between BPI and Trump. The Complaint alleges that the Partnership and/or Trump engaged in the following activities: civil conspiracy, violations of the New Jersey Antitrust Act, violations of the New Jersey RICO statute, malicious interference with contractual relations, malicious interference with prospective economic advantage, inducement to breach a fiduciary duty and malicious abuse of process. The relief sought in the Complaint included, among other things, compensatory damages, punitive damages, treble damages, injunctive relief, the revocation of all of the Partnership's and Trump's casino licenses, the revocation of the Partnership's current Certificate of Partnership, the revocation of any other licenses or permits issued to the Partnership and Trump by the State of New Jersey, and a declaration voiding the conveyance by BPI to Trump of BPI's interest in the Penthouse Site, as well as BPI's and/or Trump's rights to obtain title to the Columbus Plaza Site. The Partnership and Trump filed an answer denying all liability and alleging that all of BPHC's claims are without merit. On November 9, 1990, BPHC filed an application to amend its counterclaims against BPI and the Complaint, which amendment sought to withdraw all of BPHC's affirmative claims for equitable relief and thereby limit such claims to monetary damages. On December 20, 1990, the Superior Court entered an Order permitting BPHC to withdraw its affirmative demands for equitable relief. Trial of the Penthouse litigation was bifurcated into issues of liability and damages, with liability issues to be tried first. On March 25, 1993, after trial on issues of liability, the Superior Court rendered a decision rejecting all of BPHC's claims in the Complaint. On October 13, 1993, the court entered a judgment dismissing with prejudice all claims against Trump and the Partnership. On November 5, 1993 BPHC filed a motion seeking to have this judgment declared interlocutory in nature, rather than final. The Partnership successfully opposed this motion which was denied on November 19, 1993. On November 30, 1993, BPHC filed a notice of appeal to the Appellate Division. On January 19, 1994, BPHC filed a motion in the Appellate Division seeking a determination that the Superior Court had erred in ruling that the judgment as to the Partnership and Trump was final. The Partnership and Trump successfully opposed that motion, which was denied on March 3, 1994. A briefing schedule for the appeal from the final judgment has been set. If that schedule is not subsequently modified, BPHC's brief is due on April 18, 1994, the brief of the Partnership and Trump is due on May 18, 1994 and BPHC's reply brief is due on May 31, 1994. On January 9, 1991, BPHC instituted suit against Trump, the Partnership, BPI, Penthouse International Ltd. and Robert C. Guccione in the United States District Court for the District of New Jersey. This action is virtually identical to the state court action described above. The Partnership and Trump filed an answer denying all liability and alleging that all of BPHC's claims are without merit. In April 1993, the Partnership filed a motion to dismiss certain claims based on the favorable decision in the state court action. In May 1993, the court issued an order to show cause, scheduling a hearing for June 1993 to determine whether certain claims of the plaintiff's amended complaint should be dismissed with prejudice. On July 15, 1993, the court acted favorably on the Partnership's motion and dismissed the action in its entirety. The order of dismissal was appealed to the United States Court of Appeals for the Third Circuit. All briefs have been filed and the appeal is presently scheduled for disposition in April 1994. Other Litigation Various other legal proceedings are now pending against the Partnership. The Partnership considers all such other proceedings to be ordinary litigation incident to the character of its business and not material to its business or financial condition. The majority of such claims are covered by liability insurance (subject to a $250,000 deductible per claim), and the Partnership believes that the resolution of these claims, to the extent not covered by insurance, together with uninsured claims will not, individually or in the aggregate, have a material adverse effect on the financial condition and results of operations of the partnership. The Partnership is also a party to various administrative proceedings involving allegations that it has violated certain provisions of the Casino Control Act. The Partnership believes that the final outcome of these proceedings will not, either individually or in the aggregate, have a material adverse effect on the Partnership or on the ability of the Partnership to otherwise retain or renew any casino or other licenses required under the Casino Control Act for the operation of Trump Plaza. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted by the Registrant to its security holders for a vote during the fourth quarter of 1993. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) There is no established public trading market for the Company's outstanding Common Stock. (b) As of December 31, 1993, Trump was the sole holder of record of the Company's Common Stock. (c) The Company has not paid any cash dividends on its Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. SELECTED FINANCIAL INFORMATION The following table sets forth historical financial information of the Partnership for each of the five years ended December 31, 1993. This information should be read in conjunction with the financial statements of the Partnership and related notes included elsewhere in this Report and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Year Ended December 31, ----------------------- 1989 1990 1991 1992 1993 ---- ---- ---- ---- ---- Statements of Operations Data: (dollars in thousands) Revenues: Gaming . . . . . . . . . . . . $306,009 $276,932 $233,265 $265,448 $264,081 Other. . . . . . . . . . . . . 90,680 87,286 66,411 73,270 69,203 Trump Regency. . . . . . . . . - - 11,547 9,465 - -------- ------- -------- -------- ------- Gross revenues . . . . . . . 396,689 364,218 311,223 348,183 333,284 Promotional allowances 42,551 44,281 31,539 34,865 32,793 -------- ------- -------- -------- ------- Net revenues . . . . . . . . . 354,138 319,937 279,684 313,318 300,491 Costs and expenses: Gaming . . . . . . . . . . . . 177,401 178,356 133,547 146,328 136,895 Other . . . . . . . . . . . . 29,158 26,331 23,404 23,670 24,778 General and administrative 71,533 76,057 69,631 75,459 71,624 Depreciation and amortization. 16,906 16,725 16,193 15,842 17,554 Restructuring costs. . . . . . - - 943 5,177 - Trump Regency . . . . . . . . - 3,359 19,879 11,839 - -------- ------- ------- -------- -------- 294,998 300,828 263,597 278,315 250,851 -------- ------- ------- -------- -------- Income from operations 59,140 19,109 16,087 35,003 49,640 -------- ------- ------- -------- -------- Net interest expense . . . . . . 31,988 33,128 33,363 31,356 39,889 Extraordinary (loss) gain - - - (38,205) 4,120 Net income (loss) (1). . . . . . 24,564 (10,591) (29,230) (35,787) 9,338 Balance Sheet Data: Cash and cash equivalents. . . . $11,627 $10,005 $10,474 $18,802 14,393 Property and equipment - net . . 321,391 316,595 306,834 300,266 293,141 Total assets . . . . . . . . . . 406,950 395,775 378,398 370,349 374,498 Total long-term debt - net (2) 273,411 247,048 33,326 249,723 395,948 Preferred Partnership Interest - - - 58,092 - Total capital. . . . . . . . . . 88,481 83,273 54,043 11,362 (54,710) - -------------- (1) Net loss for the year ended December 31, 1990 includes income of $2.4 million resulting from the settlement of a lawsuit relating to a boxing match. Net loss for the year ended December 31, 1991 includes a $10.9 million charge associated with rejection of the Regency Lease and $4.0 million of costs associated with certain litigation. Net income for 1992 includes $1.5 million of costs associated with certain litigation. Net income for 1993 includes $3.9 million of costs associated with the Boardwalk Expansion Site. (2) Long-term debt of $225 million at December 31, 1991 had been classified as a current liability. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. General The Company was incorporated on March 14, 1986 as a New Jersey Corporation, and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. As part of a prepackaged plan of reorganization under chapter 11 of the U.S. Bankruptcy Code consummated on May 29, 1992, the Company became a partner of the Partnership and issued approximately three million Stock Units, each comprised of one share of Preferred Stock and one share of Common Stock. On June 25, 1993 the Company issued and the Partnership guaranteed $330,000,000 of Mortgage Notes (for net proceeds of $325,687,000) and Holding, issued 12,000 Units consisting of an aggregate of $60,000,000 of PIK Notes, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost. Holding has no other assets or business other than its 99% equity interest in the Partnership. The Company owns the remaining 1% interest in the Partnership. The combined proceeds of the Offerings, together with cash on hand, were used substantially as follows: (i) $225.0 million of such proceeds were used to repay the Partnership's Promissory Note to the Company in the principal amount of $225.0 million, which proceeds were then used by the Company to redeem the Bonds; (ii) $12.0 million was used to repay the Regency Note (see "Item 13. Certain Relationships and Related Transactions -- Trump Regency"); (iii) $40.0 million was distributed to the Company (which used such funds, together with $35.0 million from the Units Offering distributed to Trump and paid to the Company, to redeem its Stock Units); (iv) approximately $17.3 million was used to pay the expenses incurred in connection with the Offerings; and (v) approximately $52.5 million was used to make the Special Distribution to Trump, which was used by Trump primarily to pay certain personal indebtedness. No portion of the net proceeds was retained by Holding, the Company or the Partnership for working capital purposes. The financial information presented below reflects the results of operations of the Partnership. Since the Company and Holding have no business operations other than their interest in the Partnership, their results of operations are not discussed below. Results Of Operations For The Years Ended December 31, 1993 and Gaming revenues were $264.1 million for the year ended December 31, 1993, a decrease of $1.4 million or 0.5% from gaming revenues of $265.4 million in 1992. This decrease in gaming revenues consisted of a reduction in table games revenues, which was partially offset by an increase in slot revenues. These results were impacted by major snow storms during February and March, which severely restricted travel in the region. The decrease in revenues was also attributable, in part, to the revenues derived from "high roller" patrons from the Far East during 1992, which did not recur in 1993, due in part to the decision to de-emphasize marketing efforts directed at "high roller" patrons from the Far East and also to the effects of the adverse economic conditions in that region. Slot revenues were $170.5 million for the year ended December 31, 1993, an increase of $1.0 million or 0.6%, from slot revenues of $169.5 million in 1992. The Partnership elected to discontinue certain progressive slot jackpot programs thereby reversing certain accruals into revenues which had the effect of improving slot revenue by $4.1 million for the year ended December 31, 1992. Excluding the aforementioned adjustment, slot revenues would have resulted in a $5.0 million or 3.0% improvement over 1992. The Partnership believes that its improvement in slot revenues reflects its intensified slot marketing efforts directed towards patrons who tend to wager more per slot play and general growth in the industry. See "Business - -- Business Strategy." Table games revenues were $93.6 million for the year ended December 31, 1993, a decrease of $2.3 million or 2.4% from table games revenues of $95.9 million in 1992. This decrease was primarily due to a reduction in table games drop (i.e., the dollar value of chips purchased) by 9.2% for the year ended December 31, 1993 from 1992, offset by an increase in the table games hold percentage to 14.9% (the percentage of table drop retained by the Partnership) for the year ended December 31, 1993 from 13.9% in 1992. The reduction in table game drop was due to the large dollar amounts wagered during 1992 by certain foreign customers. During the year ended December 31, 1993, gaming credit extended to customers was approximately 18.0% of overall table play. At December 31, 1993, gaming receivables amounted to approximately $16.0 million, with allowances for doubtful gaming receivables of approximately $10.4 million. Other revenues were $69.2 million for the year ended December 31, 1993, a decrease of $4.1 million or 5.6%, from other revenues (excluding revenues from Trump Regency) of $73.3 million in 1992. Other revenues include revenues from rooms, food and beverage and miscellaneous items. The decrease in other revenues primarily reflects a $2.1 million adjustment to the outstanding gaming chip liability in 1992, (this amount had been offset in gaming cost and expenses with a specific reserve provision for casino uncollectible accounts receivable) as well as decreases in food and beverage revenues attendant to reduced levels of gaming activity, and reduced promotional allowances. Promotional allowances were $32.8 million for the year ended December 31, 1993, a decrease of $2.1 million or 5.9%, from promotional allowances of $34.9 million in 1992. This decrease is primarily attributable to a reduction in table gaming activity as well as the Partnership's focusing its marketing efforts during the period towards patrons who tend to wager more frequently and in larger denominations. Gaming costs and expenses were $136.9 million for the year ended December 31, 1993, a decrease of $9.4 million, or 6.4%, from gaming costs and expenses of $146.3 million in 1992. This decrease was primarily due to a $4.8 million decrease in gaming bad debt expense as well as decreased promotional and operating expenses and taxes associated with decreased levels of gaming activity and revenues from 1992. Other costs and expenses were $24.8 million for the year ended December 31, 1993 an increase of $1.1 million or 4.7%, from other costs and expenses of $23.7 million in 1992. General and administrative expenses were $71.6 million for the year ended December 31, 1993, a decrease of $3.8 million, or 5.1%, from general and administrative expenses of $75.5 million in 1992. This decrease resulted primarily from a $2.4 million real estate tax charge resulting from a reassessment by local authorities of prior years' property values incurred during 1992 and overall cost reductions related to cost containment efforts. Income from operations was $49.6 million for the year ended December 31, 1993, an increase of $7.0 million or 16.4% from income from operations (excluding the operations of Trump Regency and before restructuring costs) of $42.6 million for 1992. In addition to the items described above, 1993 costs and expenses were lower as a result of the absence of the Restructuring costs and the expenses associated with the Trump Regency which were incurred in 1992. Net interest expense was $39.9 million for the year ended December 31, 1993, an increase of $8.5 million, or 27.2% from net interest expense of $31.4 million in 1992. This is attributable to the interest expense associated with the Offerings. Other non-operating expenses were $3.9 million for the year ended December 31, 1993, an increase of $2.4 million or 164.9% from non-operating expense of $1.5 million in 1992. This increase is directly attributable to costs associated with the Boardwalk Expansion Site. See "Note 7 to the Financials -- Commitments and Contingent Future Expansions." The Offerings resulted in an extraordinary gain of $4.1 million for the year ended December 31, 1993, which reflects the excess of carrying value of the Regency Hotel obligation over the amount of the settlement payment, net of related prepaid expenses. The Restructuring resulted in an extraordinary loss of $38.2 million for the year ended December 31, 1992 consisting of the effects of stating the Bonds and Preferred Stock issued at fair value and the write off of certain deferred financing charges and costs. Results Of Operations For The Year Ended December 31, 1992 and Gaming revenues were $265.4 million for the year ended December 31, 1992, an increase of $32.1 million, or 13.8%, from gaming revenues of $233.3 million in 1991. This increase in gaming revenues was primarily attributable to an increase in slot revenues which was partially offset by a decline in table game revenues. Slot revenues were $169.5 million for the year ended December 31, 1992, an increase of $35.1 million, or 26.1%, from slot revenues of $134.4 million in 1991. The Partnership believes that its improvement in slot revenues reflects its intensified slot marketing efforts directed towards patrons who tend to wager more per slot play and general growth in the industry. See "Business - Business Strategy". In addition, the Partnership elected to discontinue certain progressive slot jackpot programs, thereby reversing certain accruals into revenues which had the effect of improving slot revenue by $4.1 million for the year ended December 31, 1992. Table game revenues were $95.9 million for the year ended December 31, 1992, a decrease of $3.0 million, or 3.0%, from table game revenues of $98.9 million in 1991. While table game drop (i.e., the dollar value of chips purchased) increased 6.7% for the year ended December 31, 1992 from 1991, the decline in table game revenues was due to a decrease in the table game hold percentage (i.e., the percentage of table game drop retained by the Partnership) to 13.9% for the year ended December 31, 1992 from 15.3% in 1991. The reduction in table game hold percentage was due, in part, to the large dollar amounts wagered by a few patrons, whose individual success at the gaming tables had an impact on the overall table game hold percentage. During the year ended December 31, 1992, gaming credit extended to customers was approximately 27.8% of overall table play. At December 31, 1992, gaming receivables amounted to approximately $20.5 million, with allowances for doubtful gaming receivables of approximately $14.0 million. Other revenues (excluding revenues from Trump Regency) were $73.3 million for the year ended December 31, 1992, an increase of $6.9 million, or 10.4%, from other revenues of $66.4 million in 1991. Other revenues include revenues from rooms, food and beverage and miscellaneous items. This increase in other revenues primarily reflects increases in food and beverage revenues attendant to increased levels of gaming activity. In addition, the Partnership recognized $2.1 million in other revenues during the year ended December 31, 1992 as the result of the cancellation of outstanding chips to offset the debt of a patron who owed in excess of such amounts to the Partnership. The revenue derived from such cancellation, however, was offset by an associated increase in bad debt expense in 1992. Promotional allowances were $34.9 million for the year ended December 31, 1992, an increase of $3.4 million, or 10.8%, from promotional allowances of $31.5 million in 1991. This increase is primarily attributable to the increase in gaming activity during the period. Gaming costs and expenses were $146.3 million for the year ended December 31, 1992, an increase of $12.8 million, or 9.6%, from gaming costs and expenses of $133.5 million in 1991. This increase was primarily due to increased promotional and operating expenses associated with increased slot revenues, increased taxes and increased regulatory expenses. Gaming costs and expenses also increased due to the $2.1 million increase in bad debt expense referred to above. Other costs and expenses were $23.7 million for the year ended December 31, 1992, an increase of $0.3 million, or 1.3%, from other costs and expenses of $23.4 million in 1991. General and administrative expenses were $75.5 million for the year ended December 31, 1992, an increase of $5.9 million, or 8.5%, from general and administrative expenses of $69.6 million in 1991. This increase resulted primarily from a $2.4 million increase in real estate taxes arising from a reassessment by local authorities of prior years property values, as well as increased property insurance and other costs associated with maintaining Trump Plaza. In connection with the Restructuring, the Partnership incurred $5.2 million of non-recurring costs for the year ended December 31, 1992, comprised of professional fees and other costs and expenses of the Restructuring. Pursuant to the terms of the Restructuring, the Partnership ceased operating Trump Regency as of September 30, 1992. For the year ended December 31, 1992, the Partnership realized a net loss of $2.4 million from the operation of Trump Regency, compared to the net loss of $8.3 million in 1991. See "Certain Relationships and Related Transactions." Income from operations (excluding the operations of Trump Regency and before restructuring costs) was $42.6 million for the year ended December 31, 1992, an increase of $17.2 million, or 67.7%, from income from operations of $25.4 million in 1991. Net interest expense was $31.4 million for the year ended December 31, 1992, a decrease of $2.0 million, or 6.0%, from net interest expense of $33.4 million in 1991. The Restructuring resulted in an extraordinary loss of $38.2 million for the year ended December 31, 1992, which reflects a $32.8 million accounting adjustment to carry the Bonds and Preferred Stock issued in the Restructuring on the Partnership's balance sheet at fair market value based upon then current rates of interest. The Partnership also wrote-off certain deferred financing charges and costs of $5.4 million. Net loss was $35.8 million for the year ended December 31, 1992, and increase of $6.6 million, or 22.6%, from the net loss of $29.2 million in 1991. Liquidity and Capital Resources The Partnership. Cash flow from operating activities is the Partnership's principal source of liquidity. For the year ended December 31, 1993, net cash from operating activities was $18.5 million. On June 25, 1993, the date of consummation of the Offerings, the Partnership paid accrued interest on the Bonds. Interest on the Bonds was payable semi-annually on March 15 and September 15, while interest on the Mortgage Notes is payable semi-annually on each June 15 and December 15, commencing December 15, 1993. The decrease of $7.7 million in net cash provided by operating activities as compared to 1992 reflects the aforementioned changes in payments of accrued interest on the Bonds. Capital expenditures of $10.1 million for the year ended December 31, 1993 increased approximately $1.4 million from 1992, and was primarily due to the refurbishment of the casino floor (including new carpeting), the purchase of additional slot machines, the construction of an electronic graphic sign adjacent to the transportation facility and demolition and refurbishing costs associated with the Boardwalk Expansion Site. These expenditures were financed from funds generated from operations. The Boardwalk Expansion (as described below), may require additional borrowings. Capital expenditures for 1992, and 1991 were $8.6 million and $5.5 million, respectively. Previously, the Partnership provided for significant capital expenditures which concentrated on the construction of the Transportation Facility and the renovation of certain restaurants, hotel rooms and the hotel lobby. See "Business -- Facilities and Amenities." At December 31, 1993, the Partnership had a combined working capital deficit totalling $1.5 million, compared to a working capital deficit of $18.2 million at December 31, 1992. In 1993, the Partnership received the approval of the CCC, subject to certain conditions, for the Expansion of its hotel facilities on the Boardwalk Expansion Site upon which there is located an approximately 361-room hotel, which is closed to the public and in need of substantial renovation and repair. On June 25, 1993, the date the Offerings were consummated, Trump transferred title to the Boardwalk Expansion Site to a lender in exchange for a reduction in Trump's indebtedness to such lender in an amount equal to the sum of fair market value of the Boardwalk Expansion Site and all rent payments made to such lender by Trump under the Boardwalk Expansion Site Lease (as defined below). On the date the Offerings were consummated, the lender leased the Boardwalk Expansion Site to Trump for a term of five years, which expires on June 30, 1998, during which time Trump will be obligated to pay the lender $260,000 per month in lease payments. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. In connection with the Offerings, the Partnership acquired a five-year option to purchase the Boardwalk Expansion Site. Until such time as the Option is exercised or expires, the Partnership will be obligated, from and after the date it entered into the Option, to pay the net expenses associated with the Boardwalk Expansion Site, including, without limitation, current real estate taxes (approximately $1.2 million per year based upon current assessed valuation), $66,000 per month until January 1, 1995 in respect of past due taxes and annual lease payments for the portion of the Boardwalk Expansion Site currently leased by the Partnership from a third party, which lease payments were $86,058 for 1993 and $83,500 for 1992, and increase annually based on the consumer price index. In addition, net expenses include the costs of demolishing certain structures situated on the Boardwalk Expansion Site at a cost of approximately $1.5 million, the redemption in November 1993 of $496,000 in tax sale certificates issued to third parties and $100,000 in annual insurance expense. Under the Option, the Partnership has the right to acquire the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until expiration on June 30, 1998. In addition, the Partnership has a right of first refusal upon any proposed sale of all or any portion of the Boardwalk Expansion Site during the term of the Option. Trump, individually, also has been granted by such lender a right of first refusal upon a proposed sale of all or any portion of the Boardwalk Expansion Site. Trump, has agreed with the Partnership that his right of first refusal will be subject to the Partnership's prior exercise of its right of first refusal (with any decision of the Partnership requiring the approval of the Independent Directors of the Company, acting as the managing general partner of the Partnership). Acquisition of the Boardwalk Expansion Site by the Partnership would under certain circumstances (provided there are no events of default under the Boardwalk Expansion Site Lease or the Option and provided that certain other events had not theretofore or do not thereafter occur) discharge Trump's obligation to such lender in full. Under the terms of the Option, if the Partnership defaults in making payments due under the Option, the Partnership would be liable to the lender for the sum of (a) the present value of all remaining payments to be made by the Partnership pursuant to the Option during the term thereof and (b) the cost of demolition of all improvements then located on the Boardwalk Expansion Site. The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option would be dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and requires the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site would be dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option or the right of first refusal requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option or such right. The CCC has required that the Partnership exercise the Option or its right of first refusal therein no later than July 1, 1995. Management has determined to build or refurbish rooms at the Boardwalk Expansion Site. As a result of such expansion, the Partnership will be permitted to increase Trump Plaza's casino floor space by 30,000 square feet. The Partnership plans to add approximately 10,000 square feet in April, 1994 with an additional 5,000 square feet in June, 1994 and 10,000 square feet planned to open in April, 1995. The 5,000 remaining allowable square feet will be added as patron demand warrants. The Partnership has begun construction at such site pursuant to rights granted to the Partnership by the lender under the Boardwalk Expansion Site Lease. Pursuant to the terms of certain personal indebtedness of Trump, the Partnership is restricted from expending more than $15.0 million less any CRDA tax credits for improvements at the Boardwalk Expansion Site prior to such time as it exercises the Option. The Partnership has received approximately $294,000 in CRDA credit as of December 31, 1993. The Partnership's ability to exercise the Option will be restricted by, among other things, the Mortgage Note Indenture, the PIK Note Indenture and the terms of certain indebtedness of Trump, and would require the approval of the CCC. Management does not currently anticipate that it will be in a position to exercise the Option to acquire such site prior to 1995 due, in part, to limitations on its ability to incur additional indebtedness. If the Partnership is unable to finance the purchase price of the Boardwalk Expansion Site pursuant to the Option, any amounts expended with respect to the Boardwalk Expansion Site, including payments under the Option and the Boardwalk Expansion Site lease, if assumed, and any improvements thereon would inure to the benefit of the owner of the Boardwalk Expansion Site and not to the Partnership. In such event, the Partnership might have to close all or a portion of the expanded casino in order to comply with regulatory requirements, which could have a material adverse effect on the results of operations and financial condition of the Partnership. As of December 31, 1993, the Partnership had expended approximately $2.7 million in construction costs related to the Boardwalk Expansion Site. Pursuant to the terms of the Partnership Agreement, prior to amendment on June 25, 1993, the date of the consummation of the Offerings, which eliminated such distribution requirements, the Partnership was required to make certain periodic distributions to the Company and Trump sufficient to pay taxes attributable to distributions received from the Partnership, any amounts required to be paid to directors as fees or pursuant to indemnification obligations, premiums on directors' and officers' liability insurance and other reasonable general and administrative expenses. The Partnership was also required to distribute to the Company, to the extent of cash available therefrom, funds sufficient to enable the Company to pay dividends on, and the redemption price of its Stock Units. For the year ended December 31, 1993, such distributions were approximately $6.3 million. Pursuant to the terms of a Services Agreement with Trump Plaza Management Corp. ("TPM"), a corporation beneficially owned by Trump, in consideration for services provided, the Partnership pays TPM each year an annual fee of $1.0 million in equal monthly installments, and reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement, up to certain amounts. Under this Agreement, approximately $1.2 million was charged to expense for the year ended December 31, 1993. The Mortgage Note Indenture and the PIK Note Indenture restrict the ability of the Partnership to make distributions to its partners, including restrictions relating to the achievement of certain financial ratios. Subject to the satisfaction of these restrictions, the Partnership may make distributions to its partners with respect to their partnership interests. The Company. The Company's sole source of liquidity is, and will be, payments made by the Partnership in respect of the Partnership Note securing the Company's indebtedness, and distributions from the Partnership, if any, in respect of its Partnership interest. Holding. Holding has no business operations other than that associated with holding its partnership interest in the Partnership and as issuer of the PIK Notes and Warrants. Holding's sole source of liquidity is from distributions in respect of its interest in the Partnership. Prior to the Units Offering, Holding did not have any long-term or short-term indebtedness; upon consummation of the Units Offering on June 25, 1993, Holding issued $72.0 million of indebtedness comprised of $60.0 million of PIK Notes and $12.0 million of deferred warrant obligations. Holding's indebtedness will increase upon exercise of the Warrants and upon the issuance of additional PIK Notes in lieu of cash interest paid on the PIK Notes. On December 15, 1993, the Partnership elected to issue in lieu of cash, an additional $3.6 million in PIK Notes to satisfy its semi-annual PIK Note interest obligation. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. An index to the financial statements and required financial statement schedules is set forth at Item 14. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS. Management Prior to the merger of TP/GP into the Company, management of the affairs of the Partnership was vested in TP/GP. As of June 18, 1993, the date of such merger, the Company became the managing partner of the Partnership. As of such date, the Company was granted full authority to do all things deemed necessary or desirable of the operations, business and affairs of the Partnership. As currently constituted, the Board of Directors of the Company consists of Messrs. Trump, Nicholas L. Ribis, Jay Kramer and Don M. Thomas. As currently constituted, the board of directors of Holding Inc. consists of Messrs. Trump, Ribis, Ernest E. East, Kramer and Thomas. In addition, Holding Inc. acts as the managing partner of Holding. Trump is currently the sole beneficial owner of the Partnership, the Company, Holding and Holding Inc. Pursuant to the PIK Notes Indenture and the Mortgage Notes Indenture, the Company and Holding Inc. are each required to have at least two Independent Directors (as such term is defined by the American Stock Exchange, Inc.). The prior approval of the majority of the Company's Independent Directors will be required before the Partnership can engage in certain affiliate transactions. Set forth below, are the names, ages, positions and offices held with the Company, Holding and the Partnership and a brief account of the business experience during the past five years of each member of the Board of Directors and the executive officers of the Company, Holding and the Partnership. Donald J. Trump - Mr. Trump, 47 years old, has been a general partner of the Partnership and a 100% shareholder, director, Chairman of the Board of Directors, President and Treasurer of the Company, the managing general partner of the Partnership. Prior to the consummation of the Offerings, Trump was a 50% shareholder, director, Chairman of the Board of Directors, President and Treasurer of TP/GP. Trump was President and sole director of the Company from May 1986 to May 1992; and Chairman of the executive committee and President of the Partnership from May 1986 to May 1992. Trump has been Chairman of the Board of Partner Representatives of Trump's Castle Associates, the partnership that owns Trump's Castle ("TCA"), since May 1992; and was Chairman of the executive committee of TCA, from June 1985 to May 1992. Trump was Chairman of the executive committee of Trump Taj Mahal Associates, the partnership that owns the Taj Mahal ("TTMA"), from June 1988 to October 1991; and has been Chairman of the board of directors of the managing general partner of TTMA since October 1991; President and sole director of Trump Boardwalk since May 1986; and President of the Trump Organization, which has been in the business, through its affiliates and subsidiaries, of acquiring, developing and managing real estate properties for more than the past five years. Trump was a member of the board of directors of Alexander's Inc. from 1987 to March 1992. Nicholas L. Ribis - Mr. Ribis, 49 years old, has been the Chief Executive Officer of the Partnership since February 1991 and a member of the Executive Committee of the Partnership from April 1991 to May 29, 1992 and was a director and Vice President of TP/GP from May 1992 until its merger into the Company in June 1993. Mr. Ribis serves as the Chairman of the Atlantic City Casino Association. He has also been Chief Executive Officer of TCA and TTMA since March 1991; member of the executive committee of TCA from April 1991 to May 1992; member of the Board of Partner Representatives of TCA since May 1992; member of the executive committee of TTMA from April 1991 to October 1991; and member of the board of directors of the managing general partner of TTMA since October 1991. From January 1980 to January 1991, Mr. Ribis was Senior Partner in, and since February 1991, is Counsel to, the law firm of Ribis, Graham & Curtin, which serves as New Jersey legal counsel to all of the above-named companies, and certain of their affiliated entities, including the Company. Kevin DeSanctis - Mr. DeSanctis, 41 years old, was President of the Company from March 1991 until March 7, 1994 and was Chief Financial Officer of the Company from May to July 1992. Mr. DeSanctis was a director of TP/GP from May 29, 1992 until TP/GP's merger into the Company in June 1993 and has been President and Chief Operating Officer of the Partnership since March 1991. From August 1989 to February 1991, Mr. DeSanctis served as Vice President of Casino Operations of the Mirage Hotel and Casino in Las Vegas, Nevada. Mr. DeSanctis previously served as Vice President of Casino Operations of the Golden Nugget Hotel and Casino from April 1989 to August 1989; Senior Vice President of Casino Operations of Clark Management Company (d/b/a Dunes Hotel/Casino) from January 1988 to April 1989; Senior Vice President/Director of Casino Operations of the Aladdin Hotel & Casino from March 1987 to November 1987; Vice President/Director of Casino Operations of the Flamingo Hilton from January 1986 to February 1987 and in various other positions within the Las Vegas gaming industry prior thereto. William Velardo - Mr. Velardo, 39 years old, has been the acting Chief Operating Officer of the Company since March 7, 1994 and, prior thereto, was Vice President of Casino Operations of the Partnership since May 1991. Mr. Velardo served as an Administrative Assistant of the Partnership from March 1991 until receiving licensure in the position of Vice President of Casino Operations. From November 1989 to March 1991, Mr. Velardo served as Casino Manager at the Mirage Hotel and Casino in Las Vegas. Prior to his position at the Mirage, Mr. Velardo served in a variety of casino management positions for over 13 years, 11 of which were with Caesars Palace and Caesars Tahoe. Ernest E. East - Mr. East, 51 years old, was Secretary of TP/GP from May 1992 until its merger into the Company in June 1993 and has been Secretary of the Company since July 1992; Senior Vice President-Administrative and Corporate Affairs of the Partnership since July 1991; and Senior Vice President- Administrative and Corporate Affairs of TCA and TTMA since July 1991; member of the Board of Partner Representatives of TCA since May 1992; member of the board of directors of the managing general partner of TTMA since October 1991. Mr. East was formerly the Vice President-General Counsel of the Del Webb Corporation from January 1984 through June 1991. Jay Kramer - Mr. Kramer, 76 years old, is an attorney and labor relations specialist. Mr. Kramer was a Commissioner and Chairman of the New York Sate Labor Relations Board from 1954 through 1976, under five governors. Mr. Kramer was a director of TP/GP until its merger into the Company in June 1993 and has been a director of the Company since June 1993. Mr. Kramer served as a member of the Audit Committee of TTMA from July 1990 through October 1991, and as a member of the Audit Committee of TCA and the Partnership from August 1986 through May 1992. In 1981 and 1982, Mr. Kramer served as director, audit committee member and sole stockholder of Claridge Management Corporation, an entity formed to act as the managing general partner of Claridge Casino pending the licensing of the owner of such casino by the CCC. Mr. Kramer has been the impartial chairman (the automatic arbitrator of all disputes) in many industries, including the National Building Trade Congress, the fur industry, the pharmaceuticals industry, the deep sea tanker industry, Three Mile Island and numerous others. Don M. Thomas - Mr. Thomas, 62 years old, has been the Senior Vice President of Corporate Affairs of the Pepsi-Cola Bottling Co. of New York since January 1985. Mr. Thomas was the Acting Chairman, and a Commissioner, of the CRDA from 1985 through 1987, and a Commissioner of the CCC from 1980 through 1984. From 1974 through 1980, Mr. Thomas served as Vice President, General Counsel of the National Urban League. From 1966 through 1974, Mr. Thomas served in various capacities with Chrysler Corporation rising to the level of President-Auto Dealerships. Mr. Thomas was an attorney with American Airlines from 1957 through 1966. Mr. Thomas was a director of TP/GP until its merger into the Company in June 1993 and has been a director of the Company since June 1993. Mr. Thomas is an attorney licensed to practice law in the State of New York. Mitchell G. Etess - Mr. Etess, 36 years old, has been Senior Vice President of Marketing of the Partnership since December 1991 and Advertising Manager and Public Relations Manager of the Partnership's predecessor from December 1988 to December 1991. From January 1988 to December 1988, Mr. Etess was a vice president of the advertising agency of Gordon, Etess & Associates in Pinehurst, North Carolina. Mr. Etess was General Manager of the Holly Inn in Pinehurst, North Carolina from November 1986 to November 1987; Associate Manager of Club Corp. of America in Traverse City, Michigan from May 1986 to November 1986, and Manager of Grossinger's Hotel in New York from February 1985 to November 1985. Francis X. McCarthy, Jr. - Mr. McCarthy, 41 years old, was Vice President of Finance and Accounting of TP/GP from October 1992 until June 1993, the date of TP/GP's merger into the Company, and has been Senior Vice President of Finance and Administration of the Partnership since August 1990; Chief Accounting Officer of the Company since May 1992; Vice President and Chief Financial Officer of the Company since July 1992 and Assistant Treasurer of the Company since March 1991. Mr. McCarthy previously served in a variety of financial positions for Greater-Bay Hotel and Casino, Inc. from June 1980 through August 1990. John P. Burke - Mr. Burke, 46 years old, has been corporate treasurer of the Partnership since October 1991; corporate treasurer of TCA since October 1991; Vice President of The Trump Organization since September 1990; and member of the board of directors of TTMA since October 1991. Mr. Burke was an Executive Vice President and Chief Administrative Officer of Imperial Corporation of America from April 1989 through September 1990. From May 1980 through April 1989, Mr. Burke was Executive Vice President and Chief Financial Officer of Tamco Enterprises, Inc. Robert M. Pickus - Mr. Pickus, 38 years old, has been Vice President and General Counsel of the Partnership since December 1993 and was Senior Vice President and General Counsel of TCA, Secretary of Trump's Castle Funding, Inc. from June 1988 until December 1993 and General Counsel of TCA from June 1985 to June 1988. Mr. Pickus was also Secretary of Trump's Castle Hotel & Casino, Inc., an entity beneficially owned by Trump, from October 1991 until December 1993. Patricia M. Wild - Ms. Wild, 41 years old, was Assistant Secretary of the Company and Vice President and General Counsel of the Partnership from February 1991 until December 1993; Vice President and General Counsel of the Company from July 1992 until December 1993; and Associate General Counsel of the Partnership from May 1989 through January 1991. From December 1986 to April 1989, Ms. Wild served as a Deputy Attorney General on the Environmental Prosecutions Task Force of the New Jersey Department of Law and Public Safety, Division of Criminal Justice. From April 1983 to December 1986, Ms. Wild served as Deputy Attorney General with the New Jersey Division of Gaming Enforcement. All of the persons listed above have been qualified or licensed by the CCC. The employees of the Partnership serve at the pleasure of the Company, the managing general partner of the Partnership, subject to any contractual rights contained in any employment agreement. The officers of the Company serve at the pleasure of the Board of Directors of the Company. The officers of Holding Inc. serve at the pleasure of the board of directors of that company. Donald J. Trump, Nicholas L. Ribis and Ernest E. East served as either executive officers and/or directors of TTMA and its affiliated entities when such parties filed their petition for reorganization under chapter 11 of the Bankruptcy Code on July 17, 1991. The Second Amended Joint Plan of Reorganization of such parties was confirmed on August 28, 1991, and was declared effective on October 4, 1991. Donald J. Trump, Nicholas L. Ribis, Ernest E. East and John P. Burke also served as executive committee members, officers, and/or directors of TCA and its affiliated entities, at the time such parties filed a petition for reorganization under chapter 11 of the Bankruptcy Code on March 9, 1992. The First Amended Joint Plan of Reorganization of such parties was confirmed on May 5, 1992, and declared effective on May 29, 1992. Donald J. Trump, Nicholas L. Ribis, Ernest E. East and John P. Burke served as either executive officers and/or directors of the Partnership and its affiliated entities when such parties filed their petition for reorganization under chapter 11 of the Bankruptcy Code in March 1992. The First Amended Joint Plan of Reorganization of such parties was confirmed on April 30, 1992, and was declared effective on May 29, 1992. Trump was a partner of Plaza Operating Partners Ltd. when it filed a petition for reorganization under chapter 11 of the Bankruptcy Code on November 2, 1992. The plan of reorganization for Plaza Operating Partners Ltd. was confirmed on December 11, 1992 and declared effective in January 1993. John P. Burke was Executive Vice President and Chief Administrative Officer of Imperial Corporation of America ("Imperial"), a thrift holding company whose major subsidiary, Imperial Savings, was seized by the Resolution Trust Corporation in February 1990. Subsequently, in February 1990, Imperial filed a petition for reorganization under chapter 11 of the Bankruptcy Code. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Compensation Holding, the Company and the Partnership do not offer their executive officers stock option or stock appreciation right plans, long-term incentive plans or defined benefit pension plans. The following table sets forth compensation paid or accrued during the years ended December 31, 1993, 1992 and 1991 to the Chief Executive Officer and each of the four most highly compensated executive officers of the Partnership whose cash compensation, including bonuses and deferred compensation, exceeded $100,000 for the year ended December 31, 1993. Executive Officers of the Company do not receive any additional compensation for serving in such capacity. Compensation accrued during one year and paid in another is recorded under the year of accrual. Information relating to long-term compensation is inapplicable and has therefore been omitted from the table. - ----------- (1) Represents the dollar value of annual compensation not properly categorized as salary or bonus, including amounts reimbursed for income taxes and director's fees. Following SEC rules, perquisites and other personal benefits are not included in this table if the aggregate amount of that compensation is the lesser of either $50,000 or 10% of the total of salary and bonus for that officer. (2) Represents vested and unvested contributions made by the Partnership under the Trump Plaza Hotel and Casino Retirement Savings Plan. Funds accumulated for an employee, which consist of a certain percentage of the employee's compensation plus Partnership contributions equalling 50% of the participant's contributions, are retained until termination of employment, attainment of age 59 1/2 or financial hardship, at which time the employee may withdraw his or her vested funds. (3) Mr. Ribis devotes approximately one-third of his professional time to the affairs of the Partnership. Mr. Ribis is also employed as the chief executive officer of the Other Trump Casinos; his compensation from the Other Trump Casinos is not included in the table. (4) Mr. DeSanctis resigned from all of his positions with the Company on March 7, 1994. (5) Mr. Velardo has been serving as acting Chief Operating Officer since March 7, 1994. Employment Agreements The Partnership has an employment agreement with Nicholas L. Ribis pursuant to which Mr. Ribis acts as Chief Executive Officer of the Partnership. The agreement, which expires in September 1996, provides for an annual salary of $550,000. The salary increases by ten percent for each of the second and third years of the agreement. Upon execution of the employment agreement, Mr. Ribis received a $250,000 signing bonus. In the event the Partnership, or any entity which acquires substantially all of the equity interests or assets of the Partnership, proposes to engage in an offering of common shares to the public, the Partnership and Mr. Ribis have agreed to negotiate new compensation arrangements which shall include equity participation for Mr. Ribis. Mr. Ribis is also chief executive officer of TTMA and TCA, the partnerships that own the Other Trump Casinos, and receives compensation from such entities for such services. Mr. Ribis devotes approximately one-third of his professional time to the affairs of the Partnership. All other executive officers of the Partnership, except Messrs. East and Burke, devote substantially all of their time to the business of the Partnership. The Partnership had an employment agreement with Kevin DeSanctis, former President and Chief Operating Officer of Trump Plaza. The agreement was terminated upon the resignation of Mr. DeSanctis. Mr. DeSanctis received $205,000 of salary in 1994. The Partnership has an employment agreement with Ernest E. East, Esq., who is Senior Vice President of Administration and Corporate Affairs of the Partnership. The agreement, which expires in June 1995, provides for an annual salary of $100,000. Mr. East also has similar employment agreements with each of TTMA and TCA. Mr. East devotes approximately one-third of his professional time to the affairs of the Partnership. The Partnership had an employment agreement with William Velardo, who until March 7, 1994 was the Vice President of Casino Operations of the Partnership. That agreement expired on March 12, 1994. The Partnership has not yet negotiated a separate employment agreement with Mr. Velardo, who, as of March 7, 1994, has been the acting Chief Operating Officer of the Company. The Partnership has a severance agreement with Robert M. Pickus, Esq., who is the Vice President/General Counsel of the Partnership. The agreement provides that upon Mr. Pickus' termination other than for cause (as defined in the agreement) or loss of his casino key employee license from CCC, the Partnership will pay Mr. Pickus a severance payment equal to the amount of his salary at its then current rate for a period of one year, which is anticipated to be in excess of $150,000. All of the above agreements provide for discretionary bonuses and/or signing bonuses. Compensation of Directors Each director of the Company, receives an annual fee of $50,000 and $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the Board of Directors of the Company. Each director of TP/GP, other than Trump, received an annual fee of $50,000 and $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the board of directors of TP/GP. In addition, each member of the TP/GP Audit Committee received a fee of $1,500 for each meeting attended. Upon consummation of the PIK Notes Offerings, all members of the board of directors of Holding Inc., other than Trump, received an annual fee of $50,000 and a fee of $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the Board. Such fees were paid to persons who also act as officers or employees of the Partnership. Compensation Committee Interlocks and Insider Participation Holding does not have a compensation committee and its officers serve without separate compensation. In general, the compensation of executive officers of the Partnership is determined by the Board of Directors of the Company, composed of Donald J. Trump, Nicholas L. Ribis, Jay Kramer and Don M. Thomas. The compensation of Nicholas L. Ribis and Kevin DeSanctis is set forth in their employment agreements with the Partnership, pursuant to which the Partnership has delegated the responsibility over certain matters, such as bonuses, to Trump. See "Employment Agreements" above. No officer or employee of Trump Plaza, other than Messrs. Ribis and DeSanctis, who serve on the Board of Directors of the Company, participated in the deliberations of the Board of Directors of the Company concerning executive compensation. Executive officers of the Company do not receive any additional compensation for serving in such capacity. The SEC requires issuers to disclose the existence of any other corporation in which both (i) an executive officer of the registrant serves on the board of directors and/or compensation committee, and (ii) a director of the registrant serves as an executive officer. Messrs. Ribis, East and Burke, executive officers of the Partnership, have served on the board of directors of other entities in which members of the Board of Directors of the Company and TP/GP (namely, Messrs. Trump and Ribis) served and continue to serve as executive officers. Management believes that such relationships have not affected the compensation decisions made by the Board of Directors of the Company and TP/GP in the last fiscal year. Messrs. Ribis, East and Burke serve on the board of directors of Taj Mahal Holding Corp., which holds an indirect equity interest in TTMA, the partnership that owns the Taj Mahal, of which Messrs. Trump and Ribis are executive officers. Such persons also serve on the board of directors of TM/GP Corporation (a subsidiary of Taj Mahal Holding Corp.), the managing general partner of TTMA, of which Messrs. Trump and Ribis are executive officers. Mr. Ribis is compensated by TTMA for his services as its chief executive officer; Mr. East is compensated by TTMA for his services as its vice president. Mr. Ribis also serves on the board of directors of Trump Taj Mahal Realty Corp. ("Taj Realty Corp."), which leases certain real property to TTMA, of which Trump is an executive officer. Trump, however, does not receive any compensation for serving as an executive officer of Taj Realty Corp. Mr. East also serves on the Board of Partner Representatives of TCA, the partnership that owns Trump's Castle, of which Messrs. Trump and Ribis are executive officers. Mr. Ribis receives compensation from TCA for acting as its chief executive officer. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Trump has owned 100% of the Common Stock since June 25, 1993. Trump has sole voting and investment power regarding the Common Stock owned by him. In connection with the PIK Note Offering which was consummated on June 25, 1993, TP/GP was merged with and into the Company, and the Company became the managing general partner of the Partnership. Trump contributed his interest in the Partnership to Holding, which is beneficially-owned by Trump. Since such date, the Company and Holding have been the sole partners in the Partnership. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Although the Partnership has not fully considered all of the areas in which it intends to engage in transactions with affiliates of the partners, it is free to do so, subject to certain restrictions. Payments to affiliates in connection with any such transactions are governed by the provisions of the Mortgage Note Indenture and the PIK Note Indenture which generally require that such transactions be on terms as favorable to the Partnership as would be obtainable from an unaffiliated party, and requires the approval of a majority of the Independent Directors of the Company for certain affiliated transactions. The Partnership has engaged in some limited intercompany transactions with TCA and TTMA. The Partnership utilized TCA's print shop operations (until it closed in February 1991) and utilized its fleet maintenance and limousine services until April 1991. The Partnership paid TCA approximately $317,000 in 1991 and paid to TTMA approximately $1,000, $242,000 and $0 in 1993, 1992 and 1991, respectively, for fleet maintenance and limousine services. In the future the Partnership may be required to make payments to TTMA for the continued use of its limousine bays. Payments made by the Partnership to TCA for services provided by its print shop approximated $4,000 in 1991. The Partnership also has joint property insurance coverage with TCA and TTMA for which the annual premium paid by the Partnership was $251,000 for the twelve months ended May 1993. The Partnership also leases from TTMA certain office facilities located in Pleasantville, New Jersey. In 1993, 1992 and 1991, lease payments by the Partnership to TTMA totalled approximately $30,000, $138,000 and $98,000, respectively, and to TCA (the former owner of such facility) totalled approximately $42,000 in 1991. In 1990, lease payments for such leases to TCA totalled approximately $135,000. Such lease terminated on March 19, 1993, and the Partnership vacated the premises. Through February 1, 1993, the Partnership also leased from Trump approximately 120 parking spaces at the Penthouse Site for approximately $5.50 per parking space per day, with payments under such arrangement for the year ended December 31, 1993 and December 31, 1992 totalling $21,000 and $227,000 respectively. The Partnership also leased portions of its warehouse facility located in Egg Harbor Township, New Jersey to TTMA until 1991. Lease payments by TTMA to the Partnership totalled $46,000 and $23,000 in 1991 and 1990, respectively. The Partnership also leased such warehouse to TCA until January 31, 1994; lease payments by TCA to the Partnership totalled $15,000, $14,000, and $18,000 in 1993, 1992 and 1991, respectively. Until January 1991, Helicopter Air Services, Inc. (d/b/a Trump Air) ("Trump Air"), a Delaware corporation wholly-owned by Trump, provided regularly scheduled helicopter services to the public between New York City and Atlantic City. In addition, the Partnership provided complimentary carriage to certain patrons of Trump Plaza on an Aerospatiale Super Puma helicopter that was operated by Trump Air and owned by another corporation that is wholly-owned by Trump. Trump Air was reimbursed by the Partnership for its actual costs and expenses incurred in rendering helicopter services provided by the Super Puma. All other helicopter services provided by Trump Air to patrons of Trump Plaza were paid for by the Partnership at Trump Air's prevailing ticket rates. In 1990, the Partnership paid Trump Air approximately $231,000 for air services provided to patrons of Trump Plaza. Trump and Trump Boardwalk collectively own 100% of the interests in Seashore Four. Seashore Four is the fee owner of a parcel of land constituting a portion of the Casino Parcel, which it leases to the Partnership pursuant to the SFA Lease, a long-term, triple-net lease. Seashore Four was assigned the lessor's interest in the existing SFA Lease in connection with its acquisition of fee title to such parcel from a non-affiliated third party in November 1983. The SFA Lease was entered into by the Partnership with such third party on an arm's-length basis. The Partnership recorded rental expenses of approximately $900,000, $900,000 and $900,000 in 1993, 1992 and 1991, respectively, concerning rent owed to Seashore Four. Trump and Trump Seashore Associates, Inc. collectively own 100% of the interests in Trump Seashore Associates ("Trump Seashore"). Trump Seashore is the fee owner of a parcel of land constituting a portion of the Casino Parcel, which it leases to the Partnership pursuant to the Trump Seashore Lease, a long-term, triple-net lease. In July 1988, Trump Seashore exercised a $10 million option to purchase the fee title to such parcel from a non-affiliated third party. In connection therewith, Trump Seashore was assigned the lessors' interest in the Trump Seashore Lease, which interest has, however, been transferred to UST. See "Properties." The Partnership paid rental payments to Trump Seashore of approximately $1.0 million, $1.0 million and $1.1 million in 1993, 1992 and 1991, respectively. The Partnership has separately agreed to reimburse Trump for any payments which he may make under (i) a note (the "Harrah's Note") for which Trump and the Partnership are co-makers and which constitutes part of the redemption price for Harrah's Atlantic City, Inc.'s ("HAC") prior interests in the Partnership and Seashore Four, which were redeemed in 1986, pursuant to a Redemption Agreement dated as of March 11, 1986; and (ii) his or Trump Boardwalk's indemnity of HAC under the Redemption Agreement, insofar as it relates to the Partnership. Trump and Trump Boardwalk have agreed to assign to the Partnership any payment either receives pursuant to HAC's and The Promus Companies Incorporated's (HAC's parent corporation) indemnity, insofar as it relates to the Partnership. The Harrah's Note was repaid on May 16, 1993. Prior to the consummation of the Offerings, the board of directors of TP/GP authorized the Partnership to lease, on a per diem basis, certain real property in Florida owned by Trump, known as "Mar-a-lago," to entertain certain patrons of Trump Plaza. To date, the Partnership has not leased Mar-a-lago, and the Partnership currently has no specific plans to lease Mar-a-lago in the future; nevertheless, the Partnership may enter into such arrangements in the future. In May of 1991, the Partnership entered into a lease with Atlantic City Explorers Club of which Hugh B. McCluskey, a former partner of the law firm of Ribis, Graham & Curtin, is President, whereby the Partnership leased certain property in Atlantic City for $60,000.00 per annum. Nicholas L. Ribis, the Chief Executive Officer of the Partnership, is Of Counsel to such law firm. The lease was terminated in January 1993. Trump Regency. In June 1989, Trump Crystal Tower Associates Limited Partnership, a New Jersey limited partnership wholly-owned by Trump, acquired from Elsinore Shore Associates all of the assets constituting the former Atlantis casino hotel, which is located on The Boardwalk adjacent to the Atlantic City Convention Center on the opposite side from Trump Plaza. Prior to such acquisition, all of the Atlantis' gaming operations were discontinued. The facility was renamed the Trump Regency Hotel and leased to the Partnership, which operated it solely as a non-casino hotel. As part of the Restructuring, the lease was terminated and the Partnership issued to Chemical Bank ("Chemical"), the assignee of rents payable under such lease, a promissory note in the original principal amount of $17.5 million (the "Regency Note"). At such time, title to the Trump Regency was transferred by Trump to ACFH Inc. ("ACFH"), a wholly owned subsidiary of Chemical. Since that time, the Trump Regency has been operated by ACFH as a non-casino hotel. The Partnership repaid the Regency Note with a portion of the proceeds of the Offerings. In December 1993, Trump entered into an option agreement (the "Chemical Option Agreement") with Chemical and ACFH. The Chemical Option Agreement grants to Trump an option to purchase (i) the Trump Regency (including the land, improvements and personal property used in the operation of the hotel) and (ii) certain promissory notes made by Trump and/or certain of his affiliates and payable to Chemical (the "Chemical Notes") which are secured by certain real estate assets located in New York, unrelated to Trump Plaza. As of December 31, 1993, the aggregate amount owed by Trump and his affiliates under the Chemical Notes (none of which constitutes an obligation of Plaza Associates) was approximately $65 million. The aggregate purchase price payable for the assets subject to the Chemical Option Agreement is $80 million. Under the terms of the Chemical Option Agreement, $1 million was required to be paid for the option by January 5, 1994. The option expires on May 6, 1994, provided that the option may be extended until June 30, 1994 by the payment of an additional $250,000 on or before that date. The $1 million payment (and the $250,000 payment, if made) may be credited against the $80 million purchase price. The Chemical Option Agreement does not allocate the purchase price among the assets subject to the option or permit the option to be exercised for some, but not all, of such assets. In connection with the execution of the Chemical Option Agreement, Trump agreed with the Partnership that, if Trump is able to acquire the Trump Regency pursuant to the exercise of the option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. Trump further agreed that Trump Plaza would not be required to pay any additional consideration to Trump in connection with any assignment of the option to purchase the Trump Regency to the Partnership. In consideration of the foregoing agreements, the Partnership agreed to make the $1 million option payment to Chemical (subject to refund by Trump if the option is terminated as a result of certain specified events). On January 5, 1994, the Partnership obtained the approval of the CCC to make the $1 million payment, and the payment was made on that date. Boardwalk Expansion Site. On February 2, 1993, the Partnership acquired the Option from Trump to enter into a long-term lease of the Boardwalk Expansion Site, on which the partially constructed Penthouse Hotel is located. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." The portion of the Boardwalk Expansion Site owned by Trump (which constitutes substantially all of the Boardwalk Expansion Site) is encumbered by a mortgage securing a loan with a balance of approximately $52.0 million of principal and accrued interest. In June 1993 Trump and the lender which holds such mortgage negotiated the terms of a restructuring of such loan. In connection with such restructuring Trump transferred title to the property to such lender, on the date the Offerings are consummated, entered into the Boardwalk Expansion Site Lease. The Boardwalk Expansion Site Lease has a term of five years during which time Trump will be obligated to pay the lender $260,000 per month in lease payments. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and the obligation to make some or all of the payments thereunder subject to certain limitations, including regulatory approval and the satisfaction of the conditions set forth in the Mortgage Note Indenture and the PIK Note Indenture. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." In connection with the Offerings, the Partnership acquired the Option to purchase the Boardwalk Expansion Site. Until such time as the Option is exercised or expires, the Partnership will be obligated to pay the net expenses associated with the Boardwalk Expansion Site. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." Under the Option, the Partnership has the right to purchase the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until 1998, in consideration of which the Partnership will pay certain expenses of the Boardwalk Expansion Site, including annual lease payments for the portion of the Boardwalk Expansion Site currently leased by Trump from a third party, which lease payments were $86,058 for 1993 and $83,500 for 1992 and increase annually based on the consumer price index, as well as current real estate taxes (approximately $1.2 million per year based upon current assessed valuation). See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." Acquisition of the Boardwalk Expansion Site by the Partnership would under certain circumstances (provided there are no events of default under the Boardwalk Expansion Site Lease or the Option and provided that certain other events had not theretofore or do not thereafter occur) discharge Trump's obligation to such lender in full. Management believes that the Boardwalk Expansion Site will be useful to the operation of Trump Plaza as the site of the future expansion of the Partnership's hotel operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" and "Business -- Possible Expansion Sites." Services Agreement On June 24, 1993, The Partnership and Trump Plaza Management Corp. ("TPM") entered into an Amended and Restated Services agreement (the "Services Agreement") pursuant to which TPM is required to provide to the Partnership, from time to time when reasonably requested, consulting services on a non-exclusive basis, relating to marketing, advertising, promotional and other similar and related services (the "Services") with respect to the business and operations of the Partnership. In addition, the Services Agreement contains a non-exclusive "license" of the "Trump" name. TPM is not required to devote any prescribed amount of time to the performance of its duties. In consideration for the Services, the Partnership pays TPM an annual fee of $1.0 million in equal monthly installments. In addition to such annual fee, the Partnership reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement. The Partnership paid TPM $1,247,000 and $708,000 in 1993 and 1992, respectively, for the Services. Pursuant to the Services Agreement, the Partnership will agree to hold TPM, its officers, directors and employees harmless from and against any loss arising out of or in connection with the performance of the Services and to hold Trump harmless from and against any loss arising out of the license of the "Trump" name. Indemnification Agreements The directors of the Company and the directors of TP/GP (other than Trump) serving prior to the Offerings have entered into separate indemnification agreements with the Partnership pursuant to which such persons are afforded the full benefits of the indemnification provisions of the Partnership Agreement. The Partnership has also entered into an Indemnification Trust Agreement with an Indemnification Trustee (the "Trust Agreement") pursuant to which the sum $100,000 has been deposited by the Partnership with the Indemnification Trustee for the benefit of the directors of the Company and the Class B Directors of TP/GP serving prior to the Offerings to provide a source for indemnification for such persons if the Partnership, the Company or TP/GP, as the case may be, fails to immediately honor a demand for indemnification by such persons. The Trust Agreement also provides that the directors of the Company and TP/GP (other than Trump) serving prior to the Offerings, under certain circumstances, are entitled to request that the lender under the Working Capital Facility deposit funds with the Indemnification Trustee for distribution to such persons in the event that they are entitled to indemnification for the Company, the Partnership or TP/GP and such indemnity is not provided. Not more than $200,000 per director (or an aggregate of $1.0 million) may be drawn down for such purpose; the Partnership is obligated to repay all such amounts. In connection with the Offerings, the Indemnification Agreements with the directors of the Company and the Class B Directors of TP/GP were amended to provide that (i) the Working Capital Facility would not be terminated or amended in a manner adverse to such directors unless prior thereto there is deposited an additional aggregate amount of $600,000 in the Indemnification Trust Fund for the benefit of such directors, and (ii) the Partnership would maintain directors' and officers' insurance covering such persons during the term of the Indemnification Agreements; provided, however, that if such insurance would not be available on a commercially practicable basis, the Partnership could, in lieu of obtaining such insurance, annually deposit an amount in the Indemnification Trust Fund equal to $500,000 for the benefit of such directors; provided, further, that deposits relating to the failure to obtain such insurance shall not exceed $2.5 million. Since the Working Capital Facility was terminated upon consummation of the Offerings, the Partnership deposited $600,000 in the Indemnification Trust Fund in June 1993. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial Statements. See the Index immediately following the signature page. (b) Reports on Form 8-K. The Registrant did not file any reports on Form 8-K during the last quarter of the year ended December 31, 1993. (c) Exhibits. Exhibit No. Exhibit - ----------- ------- 3.1 Amended and Restated Certificate of Incorporation of the Company. (1) 3.1.1 Form of Second Amended and Restated Certificate of Incorporation of the Company. (8) 3.2 Amended and Restated By-Laws of the Company. (1) 3.3 Amended and Restated Certificate of Incorporation of TP/GP. (1) 3.4 Amended and Restated By-Laws of TP/GP. (1) 3.5 Certificate of Incorporation of Holding Inc. (8) 3.6 By-Laws of Holding. (8) 3.7 Second Amended and Restated Partnership Agreement of the Partnership. (9) 3.8 Partnership Agreement of Holding. (8) 3.8.1 Amendment No. 1 to the Partnership Agreement of Holding. (8) 3.9 Agreement and Plan of Merger between TP/GP and the Company. (8) 4.1 Mortgage Note Indenture, among the Company, as issuer, the Partnership, as guarantor, and the Mortgage Note Trustee, as trustee. (9) 4.2 Indenture of Mortgage, between the Partnership, as Mortgagor, and the Company, as Mortgagee. (9) 4.3 Assignment Agreement between the Company and the Mortgage Note Trustee. (9) 4.4 Assignment of Operating Assets from the Partnership to the Company. (9) 4.5 Assignment of Leases and Rents from the Partnership to the Company. (9) 4.6 Indenture of Mortgage between the Partnership and the Mortgage Note Trustee (the Guarantee Mortgage). (9) 4.7 Assignment of Leases and Rents from the Partnership to the Mortgage Note Trustee. (9) 4.8 Assignment of Operating Assets from the Partnership to the Mortgage Note Trustee. (9) 4.9 Partnership Note. (9) 4.10 Mortgage Note (included in Exhibit 4.1). (9) 4.11 Pledge Agreement of the Company in favor and for the benefit of the Trustee. (9) 4.12 Indenture between Holding, as Issuer, and the PIK Note Trustee, as trustee. (9) 4.13 PIK Note (included in Exhibit 4.12). (9) 4.14 Warrant Agreement. (8) 4.15 Warrant (included in Exhibit 4.14). (8) 4.16 Pledge Agreement of Holding in favor and for the benefit of the PIK Note Trustee. (8) 10.10 Agreement of Lease, dated as of July 1, 1980, by and between SSG Enterprises, as Lessor and Atlantic City Seashore 2, Inc., as Lessee, as SSG Enterprises' interest has been assigned to Seashore Four, and as Atlantic City Seashore 2, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.11 Agreement of Lease, dated July 11, 1980, by and between Plaza Hotel Management Company, as Lessor, and Atlantic City Seashore 3, Inc., as Lessee, as Atlantic City Seashore 3, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.12 Agreement of Lease, dated as of July 1, 1980, by and between Magnum Associates and Magnum Associates II, as Lessor and Atlantic City Seashore 1, Inc., as Lessee, as Atlantic City Seashore 1, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.13-10.15 Intentionally omitted. 10.16 Trump Plaza Hotel and Casino Retirement Savings Plan effective as of November 1, 1986. (2) 10.17-10.20 Intentionally omitted. 10.21 Assignment of Lease, dated as of July 28, 1988, by and between Magnum Associates and Magnum Associates II, as assignor, Trump Seashore Associates, as assignee, and Trump Plaza Associates, as lessee. (5) 10.22-10.23 Intentionally omitted. 10.24 Employment Agreement, dated January 28, 1991, between the Partnership and Kevin DeSanctis. (5) 10.24.1 Amendment to Employment Agreement, dated August 6, 1992, between the Partnership and Kevin DeSanctis. (7) 10.25 Intentionally omitted. 10.26 Employment Agreement, dated as of June 1, 1992 between the Partnership and Ernest E. East. (1) 10.27 Employment Agreement, dated as of March 13, 1991 between the Partnership and William Velardo. (3) 10.28 Option Agreement, dated as of February 2, 1993 between Trump and the Partnership. (3) 10.29 Appraisal of Trump Plaza by Appraisal Group International, dated March 5, 1993. (8) 10.30 Amended and Restated Services Agreement between the Partnership and Trump. (6) 10.31 Working Capital Facility between the Partnership and Belmont Fund, L.P. (1) 10.31.1 Mortgage and Security Agreement of the Partnership in favor of Belmont Fund, L.P. (8) 10.31.2 Assignment of Rents and Leases: by the Partnership to Belmont Fund L.P., dated May 29, 1992. (8) 10.31.3 Assignment of Operating Assets: by the Partnership to Belmont Fund L.P., dated May 29, 1992. (8) 10.32.1 Mortgage: from Donald J. Trump, Nominee to Emil F. Aysseh, Trustee dated January 12, 1983. (8) 10.32.2 Mortgage: from Donald J. Trump, Nominee to Emil F. Aysseh, Trustee dated June 23, 1983. (8) 10.32.3 Mortgage Consolidation, Modification, and Extension Agreement: dated June 23, 1983. (8) 10.32.4 Partial Assignment of Mortgage: (1/3 interest) by Alfred Aysseh to New Canaan Bank Trust Company. (8) 10.32.5 Partial Assignment of Mortgage: (1/3 interest) by New Canaan Bank and Trust Company to Alfred Aysseh. (8) 10.32.6 Assignment of Mortgage: Emil F. Aysseh, Trustee to Community National Bank and Trust Company of New York. (8) 10.32.7 Mortgage Note and Mortgage Modification Agreement: by and between Emil F. Aysseh, Trustee and Donald J. Trump, Nominee dated January 10, 1992. (8) 10.33 Mortgage: from Donald J. Trump, Nominee to Albert Rothenberg and Robert Rothenberg, dated October 3, 1983. (8) 10.34 Mortgage: made by Harrah's Associates to Adeline Bordonaro, dated January 28, 1986. (8) 10.35 Mortgage: made by the Partnership to The Mutual Benefit Life Insurance Company, dated October 5, 1990. (8) 10.35.1 Collateral Assignment of Leases: made by the Partnership to The Mutual Benefit Life Insurance Company, dated October 5, 1990. (8) 10.36 Form of Option between the Partnership and Midlantic Bank. (9) 10.37 Form of Lease between Trump and Midlantic Bank. (8) 10.38 Employment Agreement between the Partnership and Nicholas L. Ribis. 10.39 Severance Agreement between the Parnership and Robert M. Pickus. 25 Power of Attorney of directors and certain officers of the Company (included in signature page). (8) - ------------ (1) Incorporated herein by reference to the Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. (2) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the year ended December 31, 1986. (3) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the year ended December 31, 1992. (4) Incorporated herein by reference to the identically numbered Exhibit in the Company's Registration Statement on Form S-1, Registration No. 33-4604, declared effective on May 9, 1986. (5) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. (6) Previously filed in Holding's Registration Statement on Form S-1, Registration No. 33-58608. (7) Incorporated herein by reference to the Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992. (8) Incorporated herein by reference to the identically numbered Exhibit in the Company's and the Partnership's Registration Statement on Form S-1, Registration No. 33-58602. (9) Incorporated herein by reference to the identically numbered Exhibit in Holding's Registration Statement on Form S-1, Registration No. 33-58608. (d) Financial Statement Schedules. See the Index immediately following the signature page. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Company and registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized, in the City of New York, State of New York, on the 30th day of March, 1994. TRUMP PLAZA HOLDING ASSOCIATES By: Trump Plaza Holding, Inc. Its Managing General Partner ----------------------- By: Donald J. Trump Title: President TRUMP PLAZA FUNDING, INC. ------------------------ By: Donald J. Trump Title: President Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the registrants and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- TRUMP PLAZA FUNDING, INC. By: - ------------------------ Donald J. Trump Principal Executive March 30, 1994 Officer By: - ------------------------ Francis X. McCarthy Jr. Principal Financial March 30, 1994 and Accounting Officer By: - ------------------------ Donald J. Trump Director March 30, 1994 By: - ------------------------ Nicholas L. Ribis Director March 30, 1994 By: - ------------------------ Jay Kramer Director March 30, 1994 By: - ------------------------ Don M. Thomas Director March 30, 1994 TRUMP PLAZA HOLDING ASSOCIATES By: Trump Plaza Holding, Inc. its Managing General Partner By: - ------------------------ Donald J. Trump Chief Executive Officer March 30, 1994 By: - ------------------------ Francis X. McCarthy Jr. Principal Financial March 30, 1994 and Accounting Officer By: - ------------------------ Donald J. Trump Director March 30, 1994 By: - ------------------------ Nicholas L. Ribis Director March 30, 1994 By: - ------------------------ Ernest E. East Director March 30, 1994 By: - ------------------------ Jay Kramer Director March 30, 1994 By: - ------------------------ Don M. Thomas Director March 30, 1994 Reports of Independent Public Accountants......... Balance Sheets of Trump Plaza Funding, Inc. as of December 31, 1993 and 1992................ Statements of Income of Trump Plaza Funding, Inc. for the years ended December 31, 1993, 1992 and 1991................................... Statements of Capital of Trump Plaza Funding, Inc. for the Years Ended December 31, 1993, 1992 and 1991................................... Statements of Cash Flows of Trump Plaza Funding, Inc. for the Years Ended December 31, 1993, 1992 and 1991................................... Report of Independent Public Accountants. Consolidated Balance Sheets of Trump Plaza Holding Associates and Trump Plaza Associates as of December 31, 1993 and 1992...................... Consolidated Statements of Operations of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Capital (Deficit) of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991........................................ Consolidated Statements of Cash Flows of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991. Notes to Financial Statements of Trump Plaza Funding, Inc., Trump Plaza Holding Associates and Trump Plaza Associates.......................... Schedule II Amounts Receivable (Payable) From (To) Related Parties, Underwriters, Promoters, and Employees other than Related Parties.......... V Property and Equipment............................ VI Accumulated Depreciation and Amortization of Property and Equipment.......... VIII Valuation and Qualifying Accounts............... X Supplementary Income Statement Information...... Other Schedules are omitted for the reason that they are not required or are not applicable, or the required information is shown in the consolidated financial statements or notes thereto REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Trump Plaza Funding, Inc.: We have audited the accompanying balance sheets of Trump Plaza Funding, Inc. (a New Jersey corporation) as of December 31, 1993 and 1992, and the related statements of income and retained earnings 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 Trump Plaza Funding, 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. ARTHUR ANDERSEN & CO. Roseland, New Jersey February 18, 1994 TRUMP PLAZA FUNDING, INC. BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS DECEMBER 31, DECEMBER 31, 1993 1992 ----------- ----------- CURRENT ASSETS: Cash $ 2,000 $ 2,000 Mortgage Interest Receivable 1,495,000 7,950,000 Receivable From Partnership 974,000 4,228,000 ----------- ----------- Total current assets 2,471,000 12,180,000 Mortgage Note Receivable 325,859,000 225,000,000 Receivable From Partnership 2,949,000 - Investment in Preferred Partnership Interest - 58,092,000 ----------- ----------- Total assets $331,279,000 $295,272,000 =========== =========== LIABILITIES AND CAPITAL CURRENT LIABILITIES: Accrued Interest Payable $ 1,495,000 $ 7,950,000 Income Taxes Payable 974,000 2,086,000 Dividends Payable - 2,026,000 ----------- ---------- Total current liabilities 2,469,000 12,062,000 10 7/8% Mortgage Bonds, net of discount due 2001 (Notes 1, 2 and 4) 325,859,000 - 12% Mortgage Bonds, due 2002 (Notes 1, 2 and 4) - 225,000,000 Deferred Income Taxes Payable 2,949,000 116,000 ----------- ----------- Total liabilities 331,277,000 237,178,000 ----------- ----------- Commitments and Contingencies (Note 7) Preferred Stock, 3,600,893 authorized, 2,999,580 issued and outstanding in 1992 - 58,092,000 Common Stock, $.00001 par value 3,600,893 authorized, 2,999,580 issued and outstanding in 1992 - - Common Stock, $.01 par value, 1,000 shares authorized, 100 shares issued and outstanding, at December 31, 1993 and none in 1992 - - Additional Paid in Capital 2,000 2,000 Retained Earnings - - ----------- ----------- Total liabilities and capital $331,279,000 $295,272,000 =========== =========== The accompanying notes to financial statements are an integral part of these balance sheets. TRUMP PLAZA FUNDING, INC. STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ----------- ---------- ----------- Interest Income From Partnership $ 32,642,000 $ 27,720,000 $ 30,444,000 Preferred Partnership Investment Income 3,993,000 4,468,000 - Reimbursement for Income Taxes 1,802,000 2,202,000 - Interest Expense (32,642,000) (27,720,000) (30,444,000) Directors' Fees and Related Expenses (497,000) (224,000) - ----------- ----------- ------------ Income Before Provision for Taxes 5,298,000 6,446,000 - Provision for Income Taxes 1,802,000 2,202,000 - ----------- ----------- ------------ Net Income $ 3,496,000 $ 4,244,000 $ - =========== =========== =========== The accompanying notes to financial statements are an integral part of these statements. TRUMP PLAZA FUNDING, INC. STATEMENTS OF CAPITAL FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Common Stock ------------ Additional Number of Paid In Retained Shares Amount Capital Earnings Total --------- -------- ---------- ------------ ---------- Balance, December 31, 1993 200 $ 2,000 $ - $ - $ 2,000 Net Income - - - - - --------- -------- --------- ----------- --------- Balance, December 31, 1991 200 2,000 - - 2,000 Net Income - - - 4,244,000 4,244,000 Accrued dividends on preferred stock - - - (4,126,000) (4,126,000) Preferred Stock Accretion - - - (342,000) (342,000) Capital contribution from Partnership - - - 224,000 224,000 Redemption of stock units upon consummation of offering, effective May 29, 1992 (200) (2,000) - - (2,000) Issuance of stock upon consummation of offering effective May 29, 1992 2,999,580 - 2,000 - 2,000 --------- ------- ---------- --------- ---------- Balance, December 31, 1992 2,999,580 - 2,000 - 2,000 Net Income - - - 3,496,000 3,496,000 Accrued dividends on preferred stock - - - (3,678,000) (3,678,000) Preferred stock accretion - - - (315,000) (315,000) Capital contribution from Partnership - - 40,000,000 497,000 40,497,000 Capital contribution from Donald J. Trump - - 35,000,000 - 35,000,000 Redemption of Preferred Stock - - (75,000,000) - 75,000,000) Redemption of Stock Units upon consummation of offering, effective June 25, 1993 (2,999,580) - - - - Issuance of stock upon consummation of offering, effective June 25, 1993 100 - - - - -------- ------- ----------- -------- --------- Balance, December 31, 1993 100 $ - $ 2,000 $ - $ 2,000 ========= ======== =========== ========= ========== The accompanying notes to financial statements are an integral part of these statements. The accompanying notes to financial statements are an integral part of these statements. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Trump Plaza Holding Associates and Trump Plaza Associates: We have audited the accompanying consolidated balance sheets of Trump Plaza Holding Associates (a New Jersey general partnership) and Trump Plaza Associates ( a New Jersey general partnership) as of December 31, 1993 and 1992, and the related statements of operations, capital and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and the schedules referred to below are the responsibility of the management of Trump Plaza Holding Associates and Trump Plaza Associates. 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 Trump Plaza Holding Associates and Trump Plaza Associates 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. 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 the financial statements and schedules 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 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 basis financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey February 18, 1994 TRUMP PLAZA HOLDING ASSOCIATES AND TRUMP PLAZA ASSOCIATES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 -------- -------- Current Assets: Cash and cash equivalents...................... $14,393,000 $18,802,000 Trade receivables, net of allowance for doubtful accounts of $10,616,000 and $14,402,000, respectively..................... 6,759,000 7,675,000 Accounts receivable, other..................... 198,000 195,000 Due from affiliates, net (Note 9).............. - 91,000 Iventories..................................... 3,566,000 3,068,000 Prepaid expenses and other current assets...... 2,701,000 2,502,000 ------------ ------------ Total current assets...................... 27,617,000 32,333,000 ------------ ------------ Property and Equipment (Note 5): Land and land improvements................... 35,613,000 34,907,000 Buildings and building improvements.......... 295,617,000 293,908,000 Furniture, fixtures and equipment............ 78,173,000 74,622,000 Leasehold improvements....................... 2,404,000 2,378,000 Construction in progress..................... 3,784,000 3,924,000 ------------ ------------ 415,591,000 409,739,000 Less--Accumulated depreciation and amortization................................ (122,450,000) (109,473,000) ------------ ------------ Net property and equipment............... 293,141,000 300,266,000 ------------ ------------ Land Rights, net of accumulated amortization of $3,410,000 and $3,041,000, respectively... 30,058,000 30,428,000 ------------ ------------ Other Assets: Deferred bond issuance costs, net of accumulated amortization of $1,088,000 in 1993 (Note 2)............................ 16,254,000 - Other (Note 8)............................... 7,428,000 7,322,000 ------------ ------------ Total other assets........................ 23,682,000 7,322,000 ------------ ------------ Total assets.............................. $374,498,000 $370,349,000 ============ ============ LIABILITIES AND CAPITAL Current Liabilities: Current maturities of long-term debt (Note 4) $1,633,000 $9,980,000 Accounts payable............................. 6,309,000 7,767,000 Accrued payroll.............................. 5,806,000 4,978,000 Accrued interest payable (Note 4)............ 1,829,000 8,028,000 Due to affiliates, net (Note 9).............. 97,000 - Other accrued expenses....................... 7,109,000 10,475,000 Other current liabilities.................... 5,330,000 5,221,000 Distribution payable to Trump Plaza Funding, Inc................................ 974,000 4,112,000 ------------ ------------ Total current liabilities................. 29,087,000 50,561,000 ------------ ------------ Non-Current Liabilities: Long-term debt, net of current maturities (Notes 2 and 4)............................. 395,948,000 249,723,000 Distribution payable to Trump Plaza Funding, Inc................................ 2,949,000 116,000 Deferred state income taxes.................. 1,224,000 495,000 ------------ ------------ Total noncurrent liabilities.............. 400,121,000 250,334,000 ------------ ------------ Total liabilities......................... 429,208,000 300,895,000 ------------ ------------ Commitments and Contingencies (Notes 5 and 7) Preferred Partnership Interest................. - 58,092,000 ------------ ------------ Capital: Partners' Deficit............................ (78,772,000) (3,362,000) Retained Earnings............................ 24,062,000 14,724,000 ------------ ------------ Total Capital (Deficit)........................ (54,710,000) 11,362,000 ------------ ------------ Total liabilities and capital............. $374,498,000 $370,349,000 ============ ============ The accompanying notes to financial statements are an integral part of these consolidated balance sheets. The accompanying notes to financial statements are an integral part of these consolidated statements. The accompanying notes to financial statements are an integral part of these consolidated statements. The accompanying notes to financial statements are an integral part of these consolidated statements. TRUMP PLAZA FUNDING, INC. AND TRUMP PLAZA HOLDING ASSOCIATES AND TRUMP PLAZA ASSOCIATES NOTES TO FINANCIAL STATEMENTS (1) Organization: ------------- The accompanying financial statements include those of Trump Plaza Funding, Inc. (the "Company"), a New Jersey General Corporation as well as those of Trump Plaza Holding Associates ("Holding"), a New Jersey General Partnership, and its 99% owned subsidiary, Trump Plaza Associates (the "Partnership"), a New Jersey General Partnership, which owns and operates Trump Plaza Hotel and Casino located in Atlantic City, New Jersey. The Company owns the remaining 1% interest in the Partnership. Holding's sole source of liquidity is distributions in respect of its interest in the Partnership. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements of Holding. The minority interest in the Partnership has not been separately reflected in the consolidated financial statements of Holding since it is not material. The Company was incorporated on March 14, 1986 as a New Jersey corporation, and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. As part of a Prepackaged Plan of Reorganization under Chapter 11 of the U.S. Bankruptcy code consummated on May 29, 1992, the Company became a partner of the Partnership and issued approximately three million Stock Units, each comprised of one share of Preferred Stock and one share of Common Stock of the Company. On June 25, 1993, the Stock Units were redeemed with a portion of the proceeds of the Company's 10 7/8% Mortgage Notes due 2001 (the "Mortgage Notes") as well as Holding's Units. See Note 2-Offering of Mortgage Notes and Units. Holding was formed in February, 1993 as a New Jersey general partnership for the purpose of raising funds for the Partnership. On June 25, 1993, Holding completed the sale of 12,000 Units (the "Units"), each Unit consisting of $5,000 principal amount of 12 1/2% Pay-In-Kind Notes, due 2003 (the "PIK Notes"), and one Warrant to acquire $1,000 principal amount of PIK Notes (collectively with the Mortgage Note Offering, the "Offerings"). The PIK Notes and the Warrants are separately transferable. Holding has no other assets or business other than its 99% equity interest in the Partnership. See Note 2-Offering of Mortgage Notes and Units. The Partnership was organized in June 1982 as a New Jersey general partnership. Prior to the date of the consummation of the Offerings, the Partnership's three partners were TP/GP, the managing general partner of the Partnership, the Company and Donald J. Trump ("Trump"). On June 25, 1993, Trump contributed his interest in TP/GP to the Company and TP/GP merged with and into the Company. The Company then became the managing general partner of the Partnership. In addition, Trump contributed his interest in the Partnership to Holding, and the Company and Holding, each of which are wholly owned by Trump, became the sole partners of the Partnership. (2) Offering of Mortgage Notes and Units: ------------------------------------- On June 25, 1993 the Company issued, and the Partnership guaranteed $330,000,000 of Mortgage Notes (for net proceeds of $325,687,000) and Holding issued an aggregate of $60,000,000 of PIK Notes, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost (the "Offerings"). The combined proceeds, together with cash on hand were used substantially as follows: (i) $225.0 million of such proceeds were used to repay the Partnership's promissory note to the Company in the principal amount of $225.0 million, which proceeds were then used by the Company to redeem the 12% Mortgage Bonds, due 2002; (ii) $12.0 million was used to repay the Regency Note (see Note 4); (iii) $40.0 million was distributed to the Company (which used such funds, together with $35.0 million from the Units Offering distributed to Trump and paid to the Company, to redeem its Stock Units); (iv) approximately $17.3 million was used to pay the expenses incurred in connection with the Offerings; (v) approximately $52.5 million was used to make the Special Distribution to Trump which was used by Trump to repay certain personal indebtedness and (vi) to pay accrued interest on the Bonds and accrued dividends on the Preferred Stock. (3) Summary of significant accounting policies: ------------------------------------------- Gaming Revenues and Promotional Allowances - ------------------------------------------ Gaming revenues represent the net win from gaming activities which is the difference between amounts wagered and amounts won by patrons. The retail value of accommodations, food, beverage and other services provided to customers without charge is included in gross revenue and deducted as promotional allowances. The estimated departmental costs of providing such promotional allowance are included in gaming costs and expenses as follows: YEARS ENDED DECEMBER 31, ------------------------ (in thousands) 1993 1992 1991 ---- ---- ---- ROOMS $ 4,190 $ 4,804 $ 4,307 FOOD AND BEVERAGE 14,726 14,982 13,572 OTHER 3,688 3,884 2,802 ------- ------- ------- $22,604 $23,670 $20,681 ====== ====== ====== During 1992, certain Progressive Slot Jackpot Programs were discontinued which resulted in $4,100,000 of related accruals being taken into income. Inventories - ----------- Inventories of provisions and supplies are carried at the lower of cost (weighted average) or market. Property and Equipment - ---------------------- Property and equipment is carried at cost and is depreciated on the straight-line method using rates based on the following estimated useful lives: Buildings and building improvements 40 years Furniture, fixtures and equipment 3-10 years Leasehold improvements 10-40 years Interest associated with borrowings used to finance construction projects has been capitalized and is being amortized over the estimated useful lives of the assets. Land Rights - ----------- Land rights represent the fair value of such rights, at the time of contribution to the Partnership by the Trump Plaza Corporation, an affiliate of the Partnership. These rights are being amortized over the period of the underlying operating leases which extend through 2078. Income Taxes - ------------ The Company, Holding and the Partnership adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"), effective January 1, 1993. Adoption of this new standard did not have a significant impact on the respective statements of financial condition or results of operations. SFAS No. 109 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 difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The accompanying financial statements of the Company include a provision for Federal income taxes, based on distributions from the Partnership relating to the Company's Preferred Stock which was redeemed on June 25, 1993. The Company will be reimbursed for such income taxes by the Partnership. The accompanying consolidated financial statements of Holding and the Partnership do not include a provision for Federal income taxes since any income or losses allocated to its partners are reportable for Federal income tax purposes by the partners. Income Taxes cont. - ------------------ Under the New Jersey Casino Control Commission regulations, the Partnership is required to file a New Jersey corporation business tax return. Accordingly, a provision (benefit) for state income taxes has been reflected in the accompanying consolidated financial statements of Holding and the Partnership. The Partnership's deferred state income taxes result primarily from differences in the timing of reporting depreciation for tax and financial statement purposes. Statements of Cash Flows - ------------------------ For purposes of the statements of cash flows, the Company, Holding and the Partnership consider all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The following supplemental disclosures are made to the statements of cash flows. 1993 1992 1991 ---------- ---------- ---------- Cash paid during the year for interest $41,118,000 $25,310,000 $34,533,000 ========== ========== ========== Cash paid for state and Federal income taxes $ 81,000 $ - $ - ========== ========== ========== Reclassifications - ----------------- Certain reclassifications were made to the 1991 and 1992 consolidated financial statements to present them on a basis consistent with the 1993 classification. (4) Long-Term debt: --------------- Long term debt consists of the following: December 31, December 31, 1993 1992 ------------ ------------ Company: 10 7/8% Mortgage Notes, due 2001 net of unamortized discount of $4,141,000 in 1993 (A) $325,859,000 $ - 12% First Mortgage bonds, due 2002 (A) - 225,000,000 ----------- ----------- $325,859,000 $225,000,000 =========== =========== Holding and the Partnership: Partnership Partnership Note (10 7/8% Mortgage Notes, due 2001 net of unamortized discount of $4,141,000 in 1993) (A) $325,859,000 $ - Partnership Note (12% First Mortgage bonds, due 2002) (A) - 225,000,000 10% note payable to Harrah's Atlantic City, Inc. (C) - 8,471,000 Mortgage notes payable (D) 6,410,000 7,284,000 Regency Hotel Obligation (A) - 17,500,000 Other notes payable 1,060,000 1,448,000 ----------- ----------- 333,329,000 259,703,000 Less - Current maturities 1,633,000 9,980,000 ----------- ----------- 331,696,000 249,723,000 Holding PIK Notes (12 1/2% Notes due 2003 net of discount of $11,310,000 in 1993) (B) 64,252,000 - ----------- ----------- $395,948,000 249,723,000 =========== =========== (4) Long-Term debt cont.: --------------------- (A) On June 25, 1993 the Company issued $330,000,000 principal amount of 10 7/8% Mortgage Notes, due 2001, net of discount of $4,313,000. Net proceeds of the Offering were used to redeem all of the Company's outstanding $225,000,000 principal amount 12% Mortgage Bonds, due 2002 and together with other funds (see (B) Pay-In-Kind Notes) all of the Company's Stock Units, comprised of $75,000,000 liquidation preference participating cumulative redeemable Preferred Stock with associated shares of Common Stock, to repay $17,500,000 principal amount 9.14% Regency Note due 2003 (see Note 6), to make a portion of the Special Distribution and to pay transaction expenses. See Note 2- Offering of Mortgage Notes and Units. The Mortgage Notes mature on June 15, 2001 and are redeemable at any time on or after June 15, 1998, at the option of the Company or the Partnership, in whole or in part, at the principal amount plus a premium which declines ratably each year to zero in the year of maturity. The Mortgage Notes bear interest at the stated rate of 10 7/8% per annum from the date of issuance, payable semi-annually on each June 15 and December 15, commencing December 15, 1993 and are secured by substantially all of the Partnership's assets. The accompanying consolidated financial statements reflect interest expense at the effective interest rate of 11.12% per annum. The Mortgage Note Indenture contains certain covenants limiting the ability of the Partnership to incur indebtedness, including indebtedness secured by liens on Trump Plaza. In addition, the Partnership may, under certain circumstances, incur up to $25.0 million of indebtedness to finance the expansion of its facilities, which indebtedness may be secured by a lien on the Boardwalk Expansion Site (see Note 8 Commitments And Contingencies) senior to the liens of the Note Mortgage and Guarantee Mortgage thereon. The Mortgage Notes represent the senior indebtedness of the Company. The Partnership Note and the Guarantee rank pari passu in right of payment with all existing and future senior indebtedness of the Partnership. The Mortgage Notes, the Partnership Note, the Note Mortgage, the Guarantee and the Guarantee Mortgage are non-recourse to the partners of the Partnership, to the shareholders of the Company and to all other persons and entities (other than the Company and the Partnership), including Trump. Upon an event of default, holders of the Mortgage Notes would have recourse only to the assets of the Company and the Partnership. (B) On June 25, 1993 Holding issued $60,000,000 principal amount of 12 1/2% PIK Notes, due 2003, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost. The Warrants are exercisable following the earlier of certain triggering events or June 15, 1996. The PIK Notes mature on June 15, 2003 and bear interest at the rate of 12 1/2% per annum from the date of issuance, payable semi-annually on each June 15 and December 15, commencing December 15, 1993. At the option of Holding, interest is payable in whole or in part, in cash or, in lieu of cash, through the issuance of additional PIK Notes valued at 100% of their principal amount. The ability of Holding to pay interest in cash on the PIK Notes is entirely dependent on the ability of the Partnership to distribute available cash, as defined, to Holding for such purpose. On December 15, 1993 the Partnership elected to issue, in lieu of cash, an additional $3,562,000 in PIK Notes to satisfy its semi-annual PIK Note interest obligation. The PIK Notes are subordinate to the Company's Mortgage Notes and any other indebtedness of the Partnership and are secured by a pledge of Holding's 99% equity interest in the Partnership. The indenture to which the PIK Notes were issued (the "PIK Note Indenture") contains covenants prohibiting Holding from incurring additional indebtedness and engaging in other activities, and other covenants restricting the activities of the Partnership substantially similar to those set forth in the Mortgage Note Indenture. The PIK Notes and the Warrants are non-recourse to the Partners of Holding, including Trump, and to all other persons and entities (other than Holding). Upon an event of default, holders of PIK Notes or Warrants will have recourse only to the assets of Holding which consist solely of its equity interest in the Partnership. (4) Long-Term debt cont.: --------------------- (C) The entire $8,471,000 principal amount of the 10% note payable was repaid on May 16, 1993. (D) Interest on these notes are payable with interest rates ranging from 10.0% to 11.0%. The notes are due at various dates between 1994 and 1998 and are secured by real property. The aggregate maturities of long-term debt in each of the years subsequent to 1993 are: 1994 $ 1,633,000 1995 2,850,000 1996 542,000 1997 2,012,000 1998 433,000 Thereafter 390,111,000 ------------ $397,581,000 ============ (5) Leases: ------- The Partnership leases property (primarily land), certain parking space, and various equipment under operating leases. Rent expense for the years ended December 31, 1993, 1992, and 1991 was $4,338,000, $4,361,000 and $11,219,000 respectively, of which $2,513,000, $2,127,000 and $8,478,000, respectively, relates to affiliates of the Partnership. Future minimum lease payments under the noncancelable operating leases are as follows: Amounts Relating to Total Affiliates ------------ ------------ 1994 $ 6,220,000 $ 1,900,000 1995 6,445,000 2,125,000 1996 6,670,000 2,350,000 1997 6,670,000 2,350,000 1998 5,110,000 2,350,000 Thereafter 274,183,000 193,600,000 ------------ ------------ $305,298,000 $204,675,000 ============ ============ Certain of these leases contain options to purchase the leased properties at various prices throughout the leased terms. At December 31, 1993, the aggregate option price for these leases was approximately $58,000,000. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses which are included in the above lease commitment amounts. In connection with the Offerings, the Partnership acquired a five-year option to purchase the Boardwalk Expansion Site. Management intends to exercise this option by June 30, 1995. See Note 7-"Commitments and Contingencies Future Expansion." (6) Extraordinary Gain (Loss) and Non-Operating Expense: ---------------------------------------------------- The $4,120,000 excess of the carrying value of the Regency Hotel obligation over the amount of the settlement payment net of related prepaid expenses, has been reported as an extraordinary gain for the year ended December 31, 1993. The extraordinary loss for the year ended December 31, 1992 consists of the effect of stating the Bonds and Preferred Stock issued at fair value as compared to the carrying value of these securities and the write off of certain deferred financing charges and costs. Non-operating expense in 1993 includes $3,873,000 in costs associated with the Boardwalk Expansion Site (see Note 7-Commitments and Contingencies Future Expansion), net of miscellaneous non- operating credits. In 1992 these costs included $1,462,000 of legal expenses relating to the Penthouse litigation, and in 1991 these costs included $3,968,000 of legal expenses incurred in connection with the Penthouse litigation and $10,850,000 for the settlement of the Regency lease. (7) Commitments and Contingencies: ------------------------------ Casino License Renewal - ---------------------- The operation of an Atlantic City hotel and casino is subject to significant regulatory controls which affect virtually all of its operations. Under the New Jersey Casino Control Act (the "Act"), the Partnership is required to maintain certain licenses. In April, 1993, the New Jersey Casino Control Commission ("CCC") renewed the Partnership's license to operate Trump Plaza. This license must be renewed in June, 1995, is not transferable and will include a review of the financial stability of the Partnership. Upon revocation, suspension for more than 120 days, or failure to renew the casino license, the Act provides for the mandatory appointment of a conservator to take possession of the hotel and casino's business and property, subject to all valid liens, claims and encumbrances. Legal Proceedings - ----------------- The Partnership, its Partners, certain members of its former Executive Committee, and certain of its employees, have been involved in various legal proceedings. In general, the Partnership has agreed to indemnify such persons against any and all losses, claims, damages, expenses (including reasonable costs, disbursements and counsel fees) and liabilities (including amounts paid or incurred in satisfaction of settlements, judgements, fines and penalties ) incurred by them in said legal proceedings. Such persons and entities are vigorously defending the allegations against them and intend to vigorously contest any future proceedings. Various other legal proceedings are now pending against the Partnership. The Partnership considers all such other proceedings to be ordinary litigation incident to the character of its business and not material to its business or financial condition. The Partnership believes that the resolution of these claims will not, individually or in the aggregate, have a material adverse effect on its financial condition or results of operations. The Partnership is also a party to various administrative proceedings involving allegations that it has violated certain provisions of the Act. The Partnership believes that the final outcome of these proceedings will not, either individually or in the aggregate, have a material adverse effect on its financial condition, results of operations or on the ability of the Partnership to otherwise retain or renew any casino or other licenses required under the Act for the operation of Trump Plaza. Casino Reinvestment Development - ------------------------------- Authority Obligations --------------------- Pursuant to the provisions of the Act, the Partnership, commencing twelve months after the date of opening of Trump Plaza in May 1984, and continuing for a period of twenty-five years thereafter, must either obtain investment tax credits (as defined in the Casino Control Act), in an amount equivalent to 1.25% of its gross casino revenues, or pay an alternative tax of 2.5% of its gross casino revenues, (as defined in the Casino Control Act). Investment tax credits may be obtained by making qualified investments or by the purchase of bonds at below market interest rates from the Casino Reinvestment Development Authority ("CRDA"). The Partnership is required to make quarterly deposits with the CRDA. In April 1990, the Partnership modified its agreement with the CRDA under which it was required to purchase bonds to satisfy the investment alternative tax. Under the terms of the agreement, the Partnership donated $11,971,000 in deposits previously made to the CRDA for the purchase of CRDA bonds through December 31, 1989, in exchange for satisfaction of an equivalent amount of its prior bond purchase commitments, as well as receiving future tax credits, to be utilized to satisfy substantial portions of the Partnership's future investment alternative tax obligations. The Partnership charged $1,358,000 and $2,493,000 to operations in 1992 and 1991, respectively, which represents amortization of the tax credits discussed above. As of December 31, 1993, no tax credits were available. For the years ended December 31, 1993, 1992 and 1991, the Partnership charged to operations $1,047,000, $645,000 and $219,000, respectively, to give effect to the below market interest rates associated with the CRDA bonds. Concentrations of Credit Risks - ------------------------------ In accordance with casino industry practice, the Partnership extends credit to a limited number of casino patrons, after extensive background checks and investigations of credit worthiness. At December 31, 1993 approximately 31% of the Partnership's casino receivables were from customers whose primary residence is outside the United States with no significant concentration in any one foreign country. Future Expansion - ---------------- In 1993, the Partnership received the approval of the CCC, subject to certain conditions, for the expansion of its hotel facilities (the "Boardwalk Expansion Site"). On June 25, 1993, Trump transferred title to the Boardwalk Expansion Site to a lender in exchange for a reduction in Trump's indebtedness to such lender in an amount equal to the sum of fair market value of the Boardwalk Expansion Site and all rent payments made to such lender by Trump under the Boardwalk Expansion Site Lease. On the date the Offerings were consummated, the lender leased the Boardwalk Expansion Site to Trump ("the Boardwalk Expansion Site Lease") for a term of five years, which expires on June 30, 1998, during which time Donald J. Trump was obligated to pay the lender $260,000 per month in lease payments. See Note 6-"Extraordinary Gain (Loss) and Non-Operating Expense." In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. In connection with the Offerings, the Partnership acquired a five- year option to purchase the Boardwalk Expansion Site (the "Option"). Until such time as the Option is exercised or expires, the Partnership will be obligated, from and after the date it entered into the Option, to pay the net expenses associated with the Boardwalk Expansion Site. During the year ended December 31, 1993 the Partnership incurred $4.4 million of such expenses. Under the Option, the Partnership has the right to acquire the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until expiration on June 30, 1998. The CCC has required that the Partnership exercise the Option for its right of first refusal therein no later than July 1, 1995. If the Partnership defaults in making payments due under the Option, the Partnership would be liable to the lender for the sum of (a) the present value of all remaining payments to be made by the Partnership pursuant to the Option during the term thereof and (b) the cost of demolition of all improvements then located on the Boardwalk Expansion Site. As of December 31, 1993, the Partnership had capitalized approximately $2.7 million in construction costs related to the Boardwalk Expansion Site. The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option would be dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and requires the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site is dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option or such right. The accompanying financial statements do not include any adjustments that may be necessary should the Partnership be unable to exercise the Option. (8) Employee Benefit Plans: ----------------------- The Partnership has a retirement savings plan for its nonunion employees under Section 401(K) of the Internal Revenue Code. Employees are eligible to contribute up to 15% of their earnings to the plan and the Partnership will match 50% of an eligible employee's contributions up to a maximum of 4% of the employee's earnings. The Partnership recorded charges of $765,000, $699,000 and $571,000 for matching contributions for the years ended December 31, 1993, 1992 and 1991, respectively. (9) Transactions with Affiliates: ----------------------------- Due to/from Affiliates - ---------------------- Amounts due to affiliates was $97,000, as of December 31, 1993 and due from affiliates was $91,000 as of December 31,1992. The Partnership leases warehouse facility space to Trump Castle Associates and had formerly leased space to Trump Taj Mahal Associates. Lease payments of $15,000, $14,000 and $18,000 were received from Trump Castle Associates in 1993, 1992 and 1991, respectively, and $46,000 from Trump Taj Mahal Associates in 1991. The Partnership leases office space from Trump Taj Mahal Associates, which terminated on March 19, 1993. Lease payments of $30,000, $138,000 and $98,000 were paid to Trump Taj Mahal Associates in 1993, 1992 and 1991 respectively. Prior to April 1991, the Partnership leased office space from Trump Castle Associates. Lease payments to Trump Castle Associates amounted to $42,000 in 1991. The Partnership paid Trump Castle Associates $317,000 in 1991, and Trump Taj Mahal Associates $1,000 and $242,000 in 1992 and 1991, respectively, for fleet maintenance and limousine services. Additionally, the Partnership paid Trump Castle Associates $4,000 in 1991 for printing services. The Partnership leases two parcels of land under long-term ground leases from Seashore Four Associates and Trump Seashore Associates. In 1993, 1992 and 1991, the Partnership paid $900,000, $900,000 and $900,000, respectively, to Seashore Four Associates, and paid $1,000,000, $1,000,000 and $1,100,000 in 1993, 1992 and 1991, respectively, to Trump Seashore Associates. Services Agreement - ------------------ Pursuant to the terms of a Services Agreement with Trump Plaza Management Corp. ("TPM"), a corporation beneficially owned by Donald J. Trump, in consideration for services provided, the Partnership pays TPM each year an annual fee of $1.0 million in equal monthly installments, and reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement, up to certain amounts. Under this Agreement, approximately $1.2 million and $0.7 million was charged to expense for the years ended December 31, 1993 and 1992, respectively. Advances to Donald J. Trump - --------------------------- In December 1993, Trump entered into an option agreement (the "Chemical Option Agreement") with Chemical Bank ("Chemical") and ACFH Inc. ("ACFH") a wholly owned subsidiary of Chemical. The Chemical Option Agreement grants to Trump an option to purchase (i) the Trump Regency (including the land, improvements and personal property used in the operation of the hotel) and (ii) certain promissory notes made by Trump and/or certain of his affiliates and payable to Chemical (the "Chemical Notes") which are secured by certain real estate assets located in New York, unrelated to the Partnership. The aggregate purchase price payable for the assets subject to the Chemical Option Agreement is $80 million. Under the terms of the Chemical Option Agreement, $1 million was required to be paid for the option by January 5, 1994. The option expires on May 6, 1994, provided that the option may be extended until June 30, 1994 by the payment of an additional $250,000 on or before that date. The $1 million payment (and the $250,000 payment, if made) may be credited against the $80 million purchase price. The Chemical Option Agreement does not allocate the purchase price among the assets subject to the option or permit the option to be exercised for some, but not all, of such assets. In connection with the execution of the Chemical Option Agreement, Trump agreed with the Partnership that, if Trump is able to acquire the Trump Regency pursuant to the exercise of the option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. Trump further agreed that the Partnership would not be required to pay any additional consideration to Trump in connection with any assignment of the option to purchase the Trump Regency. On January 5, 1994, the Partnership obtained the approval of the CCC to make the $1 million payment, and the payment was made on that date. (10) Fair Value of Financial Instruments: ------------------------------------ The carrying amount of the following financial instruments of the Company, Holding and the Partnership approximates fair value, as follows: (a) cash and cash equivalents, accrued interest receivables and payables are based on the short term nature of these financial instruments. (b) CRDA bonds and deposits are based on the allowances to give effect to the below market interest rates. The estimated fair values of other financial instruments are as follows: December 31, 1993 ----------------- Carrying Amount Fair Value --------------- --------------- 12 1/2% PIK Notes $ 64,252,000 $ 68,784,000 10 7/8% Mortgage Notes $325,859,000 $313,500,000 The fair values of the PIK and Mortgage Notes are based on quoted market prices obtained by the Partnership from its investment advisor. There are no quoted market prices for other notes payable and a reasonable estimate could not be made without incurring excessive costs. (A) Represents reclassification of completed capital projects to in-service classifications. SCHEDULE VI (A) Represents reclassification of certain capital projects to appropriate classifications. (B) Includes retirements of $811,000, and $163,000 in 1992, and 1991 respectively. SCHEDULE VIII (A) Write-off of uncollectible accounts. (B) Write-off of allowance applicable to contribution of CRDA deposits.

9534_1993.txt

9534_1993

1993

9534

ITEM 1. BUSINESS All references herein to the "Corporation" or "Bandag" refer to Bandag, Incorporated and its subsidiaries unless the context indicates otherwise. Bandag is engaged in the production and sale of precured tread rubber and equipment used by its franchisees for the retreading of tires for trucks, buses, light commercial trucks, industrial equipment, off-the-road equipment and passenger cars. Bandag specializes in a patented cold-bonding retreading process which it introduced to the United States in 1957. The Bandag Method, as it is called, separates the process of vulcanizing the tread rubber from the process of bonding the tread rubber to the tire casing, allowing for optimization of temperature and pressure levels at each stage of the retreading process. Although a Bandag retread is typically sold at a higher unit price than the alternative "hot-capped" process, as well as retreads sold using competitive precured systems, the Bandag product is considered to be superior, resulting in a longer lasting retread and lower user cost per mile. The Corporation and its licensees have 1,325 franchisees worldwide, with 38% located in the United States and 62% internationally. The majority of Bandag's franchisees are independent operators of full service tire distributorships. Bandag's revenues primarily come from the sale of retread material and equipment to its franchisees. Bandag's products compete with new tire sales, as well as retreads produced using other retread processes. The Corporation concentrates its marketing effort on existing franchisees and on expanding their respective market penetration. Due to its strong distribution system, marketing efforts, and leading technology, Bandag, through its independent franchisee network, has been able to maintain the largest market presence in the retreading industry. The Company as a tread rubber supplier to its independent network of franchisees competes in the light and heavy truck tire replacement market. Both new tire manufacturers and tread rubber suppliers compete in this market. While the Company has independent franchisees in over 110 countries, and competes in all of these geographic markets, its largest market is the United States. Truck tires retreaded by the Company's franchisees make up approximately 16% of the U.S. light and heavy truck tire replacement market. The Company's primary competitors are new tire manufacturers such as Goodyear Tire and Rubber Company, Bridgestone Corporation and Groupe Michelin. Goodyear Tire and Rubber Company also competes in the U.S. market as a tread rubber supplier to a combination of company owned and independent retreaders. As a result of a recapitalization of the Corporation approved by the Corporation's shareholders on December 30, 1986, and substantially completed in February 1987, the Carver Family (as hereinafter defined) obtained absolute voting control of the Corporation. As of March 21, 1994 the Carver Family beneficially owned shares of Common Stock and Class B Common Stock constituting 73% of the votes entitled to be cast in the election of directors and other corporate matters. The "Carver Family" is composed of (i) Lucille A. Carver, a director and widow of Roy J. Carver, (ii) the lineal descendants of Roy J. Carver and their spouses, and (iii) certain trusts and other entities for the benefit of the Carver Family members. Description of Business The Corporation's business consists of the franchising of patented processes for the retreading of tires for trucks, buses, light commercial trucks, industrial equipment, off-the-road equipment, and passenger cars, and the production and sale of precured tread rubber and related products used in connection with these processes. The Bandag retreading process can be divided into two steps: (i) manufacturing the tread rubber and (ii) bonding the tread to a tire casing. Bandag manufactures over 500 separate tread designs and sizes, treads specifically designed for various applications, allowing fleet managers to fine-tune their tire program. Bandag tread rubber is vulcanized prior to shipment to its independent franchisees. The Bandag franchisee performs the retreading process of bonding the cured tread to a prepared tire casing. This two-step process allows utilization of the optimum temperature and pressure levels at each step. Lower temperature levels during the bonding process results in a more consistent, higher quality finished retread with less damage to the casing. Bandag has developed a totally integrated retreading system with the raw materials, bonding process and manufacturing equipment specifically designed to work together as a whole. The Corporation also franchises the use of another cold process precured retreading system, the Vakuum Vulk Method, for which the Corporation owns worldwide rights. In connection with the Vakuum Vulk Method, the Corporation currently sells tread rubber, equipment, and supplies to franchisees located in certain European countries. Markets and Distribution The principal market categories for tire retreading are truck and bus, with more than 90% of the tread rubber sold by the Corporation used in the retreading of these tires. Additionally, the Corporation markets tread rubber for the retreading of off-the-road equipment, industrial and light commercial vehicle and passenger car tires; however, historically, sales of tread rubber for these applications have not contributed materially to the Corporation's results of operations. Trucks and Buses Tread rubber, equipment, and supplies for retreading and repairing truck and bus tires are sold primarily to independent franchisees by the Corporation to use the Bandag Method for that purpose. Bandag has 1,325 franchisees throughout North America, Central America, South America, Europe, Africa, Far East, Australia and New Zealand. These franchisees are owned and operated by independent franchisees and corporations, some with multiple franchises and/or locations. Of these franchisees 500 are located in the United States. Additionally, the Corporation has approximately 65 franchisees in Europe who retread tires using the Vakuum Vulk Method. One hundred twenty-three of Bandag's foreign franchisees are franchised by licensees of the Corporation in Australia and India. A limited number of franchisees are trucking companies which operate retread shops essentially for their own needs. A few franchisees also offer "hot-cap" retreading and most sell one or more lines of new tires. The current franchise agreement offered by the Corporation grants the franchisee the non-exclusive retread manufacturing rights to use the Bandag Method for one or more applications and the Bandag trademarks in connection therewith within a specified territory, but the franchisee is free to market Bandag products outside the territory. No initial franchise fee is paid by a franchisee for his franchise. Other Applications The Corporation continues to manufacture and supply to its franchisees a limited amount of tread for Off-the-Road (OTR) tires. The Corporation's program for retreading of industrial tires includes all varieties, solid and pneumatic, and its light commercial vehicle program is directed at the market of light trucks and recreational vehicles. Regulations Various federal and state authorities have adopted safety and other regulations with respect to motor vehicles and components, including tires, and various states and the Federal Trade Commission enforce statutes or regulations imposing obligations on franchisors, primarily a duty to disclose material facts concerning a franchise to prospective franchisees. Management is unaware of any present or proposed regulations or statutes which would have a material adverse effect upon the Corporation's business, but cannot predict what other regulations or statutes might be adopted or what their effect on the Corporation's business might be. Competition The Corporation faces strong competition in the market for replacement truck and bus tires, the principal retreading market which it serves. The competition comes not only from the major manufacturers of new tires, but also from manufacturers of retread- ing materials. Competitors include producers of "camelback", "strip stock", and "slab stock" for "hot-cap" retreading, as well as a number of producers of precured tread rubber. Various methods for bonding precured tread rubber to tire casings are used by competitors. Bandag retreads are often sold at a higher price than tires retreaded by the "hot-cap" process. The Corporation believes that the superior quality and greater mileage of Bandag retreads and expanded service programs to franchisees and end users outweigh any price differential. Bandag franchisees compete with many new tire dealers and retreading operators of varying sizes, which include shops operated by the major new tire manufacturers, large independent retread companies, retreading operations of large trucking companies, and smaller commercial tire dealers. Sources of Supply The Corporation manufactures the precured tread rubber, cushion gum, and related supplies in Corporation-owned manufacturing plants in the United States, Canada, Brazil, Belgium, South Africa, Mexico, Malaysia and New Zealand. The Corporation has a 40% minority interest in its licensee in India. The Corporation also manufactures pressure chambers, tire casing analyzers, buffers, tire builders, tire handling systems, and other items of equipment used in the Bandag and Vakuum Vulk retreading methods. Curing rims, chucks, spreaders, rollers, certain miscellaneous equipment, and various retreading supplies, such as repair patches sold by the Corporation, are purchased from others. The Corporation purchases rubber and other materials for the production of tread rubber and other rubber products from a number of suppliers. The rubber for tread is primarily synthetic and obtained principally from sources which most conveniently serve the respective areas in which the Corporation's plants are located. Although synthetic rubber and other petrochemical products have periodically been in short supply and significant cost fluctuations have been experienced in previous years, the Corporation to date has not experienced any significant difficulty in obtaining an adequate supply of such materials. However, the effect on operations of future shortages will depend upon their duration and severity and cannot presently be forecast. The principal source of natural rubber, used for the Corporation's cushion gum, is the Far East. The supply of natural rubber has historically been adequate for the Corporation's purposes. Natural rubber is a commodity subject to wide price fluctuations as a result of the forces of supply and demand. Synthetic prices have historically been related to the cost of petrochemical feedstocks which are relatively stable. A relationship between natural rubber and synthetic rubber prices exists, but it is by no means exact. Patents The Corporation owns or has licenses for the use of a number of United States and foreign patents covering various elements of the Bandag and Vakuum Vulk Methods. The Corporation has patents covering improved features which began expiring in 1993, and the Corporation has applications pending for additional patents. The Corporation's patent counsel has advised the Corporation that the United States patents are by law presumed valid and that the Corporation does not infringe upon the patent rights of others. While the outcome of litigation can never be predicted with certainty, such counsel has advised the Corporation that, in his opinion, in the event of litigation placing the validity of such patents at issue, the Corporation's United States patent position should remain adequate. The protection afforded the Bandag Method by foreign patents owned by the Corporation, as well as those under which it is licensed, varies among different countries depending mainly upon the extent to which the elements of the Bandag Method are covered, the strength of the patent laws and the degree to which patent rights are upheld by the courts. Patent counsel for the Corporation is of the opinion that its patent position in the foreign countries in which its principal sales are made is adequate and does not infringe upon the rights of others. The Corporation has, however, extended its foreign market penetration to some countries where little or no patent protection exists. The Corporation does not consider that patent protection is the primary factor in its successful retreading operation, but rather, that its proprietary technical "know-how", product quality, franchisee support programs and effective marketing programs are more important to its success. The Corporation has secured registrations for its trademark and service mark BANDAG, as well as other trademarks and service marks, in the United States and most of the other important commercial countries. Other Information The Corporation conducts research and development of new products, primarily in the tire retreading field, and the improvement of materials, equipment, and retreading processes. The cost of this research and development program was approximately $14,715,000 in 1991, $12,612,000 in 1992, and $12,321,000 in 1993. The Company's business has seasonal characteristics which are tied not only to the overall performance of the economy, but more specifically to the level of activity in the trucking industry. Tire demand does, however, lag the seasonality of the trucking industry. The Company's third and fourth quarters have historically been the strongest in terms of sales volume and earnings. As stated in the Company's 13D filed pursuant to the acquisition of the HON Industries common stock, "The shares of Common Stock purchased by Bandag have been acquired for investment purposes. Bandag believes that the Common Stock represents an attractive investment opportunity at this time." The Company continues to believe that HON Industries' common stock is a good, long-term investment consistent with the Company's overall corporate strategy to maximize long term shareholder value. The Company purchased the stock in 1987 and 1988 at a cost of $25.3 million and its market value at the end of 1993 was $69.5 million. The Corporation has sought to comply with all statutory and administrative requirements concerning environmental quality. The Corporation has made and will continue to make necessary capital expenditures for environmental protection. It is not anticipated that such expenditures will materially affect the Corporation's earnings or competitive position. As of December 31, 1993, the Corporation had 2,334 employees. Financial Information about Industry Segments As stated above, the Corporation's continuing operations are conducted in one principal business and, accordingly, the Corporation's financial statements contain information concerning a single industry segment. Revenues of Principal Product Groups The following table sets forth (in millions of dollars), for each of the last three fiscal years, revenues attributable to the Corporation's principal product groups: 1993 1992 1991 Revenues: Tread rubber, cushion gum, and retreading supplies $555.9 $544.9 $524.4 Other products (1) 39.8 51.6 64.9 Corporate (2) 5.4 5.9 4.6 _____ _____ _____ Total $601.1 $602.4 $593.9 (1) Includes retreading equipment, rubber compounds, and the sale of new and retreaded tires and related services. (2) Consists of interest and dividend income. Financial Information about Foreign and Domestic Operations Financial Statement "Operations in Different Geographic Areas and Sales by Principal Products" follows on page 10. Operations in Different Geographic Areas and Sales by Principal Products The Company's operations are conducted in one principal business, which includes the manufacture of precured tread rubber, equipment and supplies for retreading tires. Information concerning the Company's operations by geographic area and sales by principal product for the years ended December 31, 1993, 1992 and 1991 is shown below (in millions): Information concerning operations in different geographic areas: The Company does not have a formal continuous exchange risk hedging program, but selectively hedges transactions which are believed to be subject to unacceptable foreign currency exchange risk. Executive Officers of the Corporation The following table sets forth the names and ages of all executive officers of the Corporation, the period of service of each with the Corporation, positions and offices with the Corporation presently held by each, and the period during which each officer has served in his present office: Period of Present Period in Service with Position or Present Name Age Corporation Office Office Martin G. Carver* 45 15 Yrs. Chairman of the 13 Yrs. Board, Chief Executive Officer and President Lucille A. Carver* 76 36 Yrs. Treasurer 35 Yrs. Gary L. Carlson 43 20 Yrs. Sr. Vice President 1 Mo. and General Manager Eastern Hemisphere Retreading Division (EHRD) Donald F. Chester 58 11 Yrs. Sr. Vice President, 11 Yrs. International Nathaniel L. Derby II 51 22 Yrs. Vice President, 8 Yrs. Engineering Thomas E. Dvorchak 61 23 Yrs. Sr. Vice President 16 Yrs. and Chief Financial Officer Stuart C. Green 52 2 Yrs. Sr. Vice President, 2 Yrs. 7 Mos. Manufacturing 7 Mos. William D. Herd 50 16 Yrs. Sr. Vice President, 4 Yrs. Sales & Marketing Melvin P. Hershey 48 10 Yrs. Vice President, 5 Yrs. Personnel Administration John A. Lodge 51 14 Yrs. Vice President, 2 Yrs. Materials 8 Mos. Dr. Floyd S. Myers 53 12 Yrs. Vice President, 8 Yrs. Technical * Denotes that officer is also a director of the Corporation. Mr. Martin G. Carver was elected Chairman of the Board effective June 23, 1981, Chief Executive Officer effective May 18, 1982, and President effective May 25, 1983. Prior to his present position, Mr. Carver was also Vice Chairman of the Board from January 5, 1981 to June 23, 1981. Mrs. Carver, has, for more than five years, served as a Director and Treasurer of the Corporation. Mr. Carlson joined Bandag in 1974. In 1985 he was appointed to Vice President, Personnel Administration and in 1989 was appointed Vice President, Planning and Development. In November 1993, he was named to his current position of Sr. Vice President and General Manager EHRD. Mr. Chester joined Bandag in 1983 and was elected Senior Vice President, International. From 1969 to 1983, he was employed by the Singer Corporation, serving as President, Singer Mexicana S.A. de C.V. from 1981 to 1983. Mr. Derby joined Bandag in 1971 and was appointed to his present position in 1985 as Vice President, Engineering. Mr. Dvorchak joined Bandag in 1971 and has held his present office since January 1978. Mr. Green joined Bandag in 1991 and was elected Senior Vice President, Manufacturing. From 1981 to that date, he was employed by Nissan Motor Manufacturing Corporation in various management positions in manufacturing, the latest of which was Director, Manufacturing Vehicle Assembly, Component Assembly and Paint Plants, Manufacturing Division. Mr. Herd joined Bandag in 1977 as Canadian Division Manager and was appointed to Vice President, North American Sales in August 1982. He was elected to the position of Senior Vice President, North American Sales in 1983, and in 1990 he was elected to his current office of Senior Vice President, Sales and Marketing. Mr. Hershey joined Bandag in 1983 as Plant Manager and was appointed to Vice President, Marketing in 1986. He was appointed to his present position as Vice President, Personnel Administration in 1989. Mr. Lodge joined Bandag in 1979 as a Systems Analyst. He was promoted to Manager of Domestic Customer Service in 1984; in 1985 he was promoted to the position of Personnel Manager; and in 1988 he became Manager of Management Services. Mr Lodge served as Manager, Materials since 1990 before being appointed to his current position in 1991. Dr. Myers joined Bandag in 1982 as Vice President, Advanced Research and was appointed to his present position as Vice President, Technical in 1985. All of the above-named executive officers are elected annually by the Board of Directors or are appointed by the Chairman of the Board and serve at the pleasure of the Board of Directors, or the Chairman of the Board as the case may be. ITEM 2. ITEM 2. PROPERTIES The general offices of the Corporation are located in a seventeen- year-old, 56,000 square foot leased office building in Muscatine, Iowa. The tread rubber manufacturing plants of the Corporation are located to service principal markets. The Corporation operates fourteen of such plants, six of which are located in the United States, and the remainder in Canada, Belgium, South Africa, Brazil, New Zealand, Mexico, Malaysia and Venezuela. The plants vary in size from 9,600 square feet to 194,000 square feet with the first plant being placed into production during 1959. All of the plants are owned in fee or under lease purchase contracts, except for the plants located in New Zealand, Malaysia and Venezuela, which are under standard lease contracts. Retreading equipment is manufactured at a company-owned plant of approximately 60,000 square feet in Muscatine. In addition, the Corporation owns a research and development center in Muscatine of approximately 58,400 square feet; a 26,000 square foot facility, used primarily for training franchisees and franchisee personnel; and a 26,000 square foot office and warehouse facility. In addition, the Corporation mixes rubber and produces cushion gum at a company-owned 168,000 square foot plant in California. The Company owns its European headquarters office in Belgium and a 129,000 square foot warehouse in the Netherlands. In the opinion of the Corporation, its properties are maintained in good operating condition and the production capacity of its plants is adequate for the near future. Because of the nature of the activities conducted, necessary additions can be made within a reasonable period of time. At December 31, 1993, the net carrying amount of property, plant, and equipment pledged as collateral on other liabilities was approximately $16,047,000. 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. Information concerning cash dividends declared and market prices of the Company's Common Stock and Class A Common Stock for the last three fiscal years is as follows: ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (Cont.) The approximate number of record holders of the Corporation's Common Stock as of March 21, 1994, was 2,029, the number of holders of Class A Common Stock was 1,990 and the number of holders of Class B Common Stock was 351. The Common Stock and Class A Common Stock are traded on the New York Stock Exchange and the Chicago Stock Exchange. There is no established trading market for the Class B Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain Consolidated Selected Financial Data for the periods and as of the dates indicated: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1993-1992 Consolidated net sales were approximately equal with 1992, whereas unit volume increased by 4%. Selling prices were generally stable, except in some European markets, but the U.S. dollar strengthened during 1993 and this had an unfavorable impact on the translated value of the Company's foreign-currency-denominated sales. The Company's seasonal sales pattern, which is closely related to trucking industry activity and shows the highest activity during the third and fourth quarters, was similar to previous years. Because of stable selling prices, domestic unit volume and sales showed 5% and 4% improvements, respectively, over the prior year. Western Europe, while experiencing a relatively small 1% decrease in unit volume, showed a 13% decrease in sales revenue. Contributing factors were the unfavorable impact of currency rates and lower selling prices in some European markets, with the currency rate having the greater impact. Unit volume for the Company's other combined foreign operations improved 7% over the previous year, but sales did not increase accordingly. This again was due to the stronger U.S. dollar and the resulting unfavorable impact when translating foreign-currency-denominated sales at lower rates and, to a lesser extent, due to the discontinuance of sales in certain of the Company's markets. Consolidated net earnings decreased by 5% compared to 1992. The Company's consolidated gross profit margin declined by 2.4 percentage points, but this was partially offset by a 1.5 percentage point decline in total operating expenses as a percent of sales because of generally lower spending in many categories. The Company's decrease in gross margin was primarily due to higher depreciation expense attributable to higher capital spending in recent years and higher overall manufacturing costs in line with generally higher cost levels. Although total domestic revenues increased by 4%, domestic earnings before income taxes was the same as the previous year, with higher product costs only partially offset by decreased operating expenses. The Company's foreign operations comprised 37% and 14% of this year's revenues and earnings before income taxes, respectively. This represented a two percentage point decline as a percent of total revenues and a three percentage point decline as a percent of total earnings before income taxes compared to the previous year. The Western European operation's earnings before income taxes were adversely impacted again this year, decreasing by 60% from the previous year. The earnings decrease was due primarily to the lower translation rate, combined with a five percentage point drop in gross profit margin. The lower gross profit margin was due to higher raw material and manufacturing costs, which the Company absorbed because of strong competitive pressures, and non-recurring inventory valuation adjustments. Earnings before income taxes for the combined other foreign operations decreased 12% from last year primarily due to lower gross margins in Brazil and Canada. Brazil's lower margin was primarily due to a refinement in the methodology used to determine certain manufacturing costs. Canada's lower gross margin was the result of a higher-than-usual amount of finished goods imported from the U.S. this year and the plant being shut down for an extended period in December in order to relocate its finished goods inventory to a distribution center closer to major markets in Southeastern Canada. The Company's effective income tax rate increased from 36.5% in 1992 to 37% in 1993, reflecting the higher federal income tax rates enacted for 1993. This increase in tax rate reduced net earnings by $625,000 and earnings per share by $.02 compared to the prior year. Earnings per share were $.10 lower in 1993, which represents a 3% decrease from the previous year. During the third quarter of 1993, the Company acquired 144,200 shares of its outstanding Common Stock and Class A Common Stock for $6,797,000 at prevailing market prices. There were fewer shares outstanding in 1993 as a result of these purchases. The cumulative current year impact of these purchases and those made in the previous year had a $.02 favorable impact on earnings per share. 1992-1991 Consolidated net sales increased 1% from 1991, which was 4 percentage points less than the unit volume increase due mainly to the impact of discontinuing the sale of custom compounding services to outside customers. Partially offsetting this decrease was the favorable impact of the higher translated value of foreign-currency-denominated sales. Domestic unit volume showed nominal improvement despite the soft North American economy, with foreign markets, in total, showing a slightly better performance than the domestic markets. Consolidated net earnings increased 4% from 1991. The Company's selling price increases were not sufficient to offset the increases in raw material and plant costs during the year, which resulted in a slight drop in gross profit margin. This was offset by a decrease in operating expenses and higher interest income. The decrease in operating expenses resulted primarily from reduced spending for R&D and marketing programs, especially in the United States. R&D spending was lower in 1992 than the previous year because the previous year included heavy spending on the development of the Eclipse System, which is now substantially complete. Earnings from foreign operations represented 17% and 24% of total earnings before taxes in 1992 and 1991, respectively. Net earnings from operations in Western Europe declined by 70% from 1991, even though net sales were 7% higher on a 4% increase in unit volume. The percentage differential between the net sales and volume increases was due primarily to favorable foreign translation rates into U. S. dollars. Net earnings for the year were adversely impacted by a substantial increase in operating expenses and unusually high foreign exchange losses due to devaluations of several European countries' currencies in which sales are denominated. The Company has undertaken a concerted effort to increase market share in Western Europe, and spending related to this effort is primarily responsible for the substantial increase in operating expenses. Net sales for the other combined foreign operations increased 10% over last year, with the operations in Mexico and Brazil accounting for the majority of the increase. Net earnings were 14% higher than last year primarily due to improved gross margins in Brazil and slightly lower operating expenses, as a percentage of net sales. The Company's effective income tax rate decreased from 38% in 1991 to 36.5% in 1992, having a positive impact on net income. Earnings per share before the cumulative effect of changes in accounting methods increased $.13, a 5% increase from 1991. During the year, the Company acquired 451,300 shares of its outstanding Common Stock and Class A Common Stock. These purchases took place during the latter half of the year and, therefore, did not significantly affect the average shares outstanding. The Company adopted, effective January 1, 1992, Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106) and No. 109 "Accounting for Income Taxes" (FAS 109). The cumulative effect of adopting FAS 106 reduced net earnings by $.09 per share. The cumulative effect of adopting FAS 109 increased net earnings by $.08 per share. Adoption of FAS 106 and 109 did not significantly impact operating results for 1992. See Notes D and G for further details. 1991-1990 Consolidated net sales decreased 1% from 1990 due to a combination of lower effective selling prices and flat unit volume. Volume in the United States market was impacted by the depressed economy and the work-off of dealer inventories accumulated late in 1990 during the uncertainty surrounding the Gulf War. The effective selling price was also impacted by the Gulf War as raw material costs rose sharply in late 1990, but dropped back again to previous levels in 1991. Volume in foreign markets, in total, showed a slight increase compared to the previous year. Consolidated net earnings increased 1% from 1990. Lower effective selling prices were offset by lower raw material costs, keeping gross profit margin stable. Operating and other expenses increased only slightly from 1990 as reduced spending on marketing programs offset higher expenses in other categories. The Company's effective income tax rate decreased from 38.5% in 1990 to 38% in 1991, having a positive impact on net income. Earnings per share increased $.11, a 4% increase from 1990. The percentage increase in earnings per share was higher than the increase in net earnings due to fewer average shares outstanding during 1991, as a result of the full year impact of shares acquired in 1990. Impact of Inflation and Changing Prices Although the Company has generally been able to adjust its effective selling prices in response to changes in product costs, during the past two fiscal years the Company's gross profit margin has declined because the Company, due to competitive conditions, has elected not to increase its selling prices in response to increased product costs. Replacement of fixed assets requires a greater investment than the original asset cost due to the impact of increases in the general price level over the useful lives of plant and equipment. This increased capital investment would result in higher depreciation charges affecting both inventories and cost of products sold. However, for new assets, the replacement cost depreciation, calculated on a straight-line basis, is not significantly greater than historical depreciation that has principally been calculated by accelerated methods resulting in higher depreciation charges in the early years of an asset's life. Capital Resources and Liquidity Current assets exceeded current liabilities by $213,599,000 at the end of 1993, while cash and cash equivalents increased by $24,187,000 from December 31, 1992, and totaled $58,004,000 at year-end. The Company invests excess funds over various terms, but only instruments with an original maturity date of over 90 days are classified as investments. The increase in cash flow from operating activities was primarily from higher income taxes payable and reduced inventories. No major changes in working capital requirements are foreseen, except for those normally faced in the growth of the business. The Company funds its capital expenditures from the cash flow generated from operations. During 1993 the Company spent $40,472,000 for capital additions, including a major expansion at its Oxford, North Carolina plant. As of December 31, 1993, the Company had available uncommitted lines of credit totaling $86,000,000 in the United States for working capital purposes. Also, the Company's foreign subsidiaries have approximately $31,000,000 credit and overdraft facilities available to them. From time to time during 1993, the Company's Western Europe subsidiary borrowed funds to supplement its operational cash flow needs or to repay intercompany transactions. The Company's other liabilities totaled $11,039,000, which are 2.6% of the sum of other liabilities and stockholders' equity. The Company has no plans at this time to undertake additional other liabilities of any material amount. During the year, the Company acquired 144,200 shares of its outstanding Common Stock and Class A Common Stock for $6,797,000 at prevailing market prices and paid cash dividends amounting to $18,033,000. The Company generally funds its dividends and stock repurchases from the cash flow generated from its operations, and the Company has historically utilized excess funds to purchase its own shares, believing the acquisition of the Company's stock to be a good investment. In 1993, the Company adopted FAS 115 and recorded the related non-cash effect to the Company's balance sheet. See Note B for further details. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Page Report of Independent Auditors 22 Consolidated Balance Sheets as of December 31, 1993, 1992 and 1991 23 - 24 Consolidated Statements of Earnings for the Years Ended December 31, 1993, 1992 and 1991 25 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 26 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 27 Notes to Consolidated Financial Statements 28 - 36 Report of Independent Auditors Stockholders and Board of Directors Bandag, Incorporated We have audited the accompanying consolidated balance sheets of Bandag, Incorporated and subsidiaries as of December 31, 1993, 1992 and 1991, and the related consolidated statements of changes of stockholders' equity, earnings and cash flows for the years then ended. 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 and 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 Bandag, Incorporated and subsidiaries at 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. 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 B to the consolidated financial statements, as of December 31, 1993, the Company changed its method of accounting for certain investments in debt and equity securities. As discussed in Notes D and G to the consolidated financial statements, in 1992 the Company changed its method of accounting for income taxes and postretirement employee benefits other than pensions. ERNST & YOUNG February 4, 1994 See notes to consolidated financial statements. Consolidated Statements of Earnings See notes to consolidated financial statements See notes to consolidated financial statements. Notes to Consolidated Financial Statements A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts and transactions of all subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. 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 reported in the consolidated balance sheet for cash and cash equivalents approximates its fair value. Accounts Receivable and Concentrations of Credit Risk: Concentrations of credit risk with respect to accounts receivable are limited due to the number of customers the Company has and their geographic dispersion. The Company maintains close working relationships with these customers and performs ongoing credit evaluations of their financial condition. No one customer is large enough to pose a significant financial risk to the Company. The Company maintains an allowance for losses based upon the expected collectibility of accounts receivable. Credit losses have been within management's expectations. Inventories: Inventories are valued at the lower of cost, determined by the last in, first out (LIFO) method, or market. The excess of current cost over the amount stated for inventories valued by the LIFO method amounted to approximately $20,189,000, $18,145,000, and $16,111,000 at December 31, 1993, 1992, and 1991, respectively. Property, Plant, and Equipment: Provisions for depreciation and amortization of plant and equipment are principally computed using declining-balance methods, based upon the estimated useful lives of the various classes of depreciable assets. Foreign Currency Translation: Assets and liabilities of foreign subsidiaries are translated at the current exchange rate and items of income and expense are translated at the average exchange rate for the year. The effects of these translation adjustments as well as gains and losses from certain hedges are reported in a separate component of stockholders' equity. Exchange gains and losses arising from transactions denominated in a currency other than the functional currency of the foreign subsidiary and translation adjustments in countries with highly inflationary economies or in which operations are directly and integrally linked to the Company's U.S. operations are included in income. Research and Development: Expenditures for research and development are expensed as incurred. Revenue Recognition: Sales are recognized when products are shipped to dealers at which time costs associated with the sale are recognized. B. INVESTMENTS 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." As permitted under the Statement, the Company elected to adopt the provisions of the new standard as of December 31, 1993. In accordance with the Statement, prior period financial statements have not been restated to reflect the change in accounting principle. The effect of adopting the Statement increased stockholders' equity $27,693,000 (net of $16,500,000 of deferred tax) to reflect the net unrealized holding gain on securities classified as available-for-sale. Under Statement 115, management determines the appropriate classification of debt securities at the time of purchase and reevaluates such designation as of each balance sheet date. Debt securities are classified as held-to-maturity based upon the positive intent and ability of the Company to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization and accretion is included in investment income. Interest on securities classified as held-to-maturity is included in investment income. Marketable equity securities are classified as available-for-sale. Available-for-sale securities are carried at fair value with the unrealized gains, net of tax, reported in a separate component of stockholders' equity. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in investment income. The cost of securities sold is based on the specific identification method. Dividends on securities classified as available-for-sale are included in investment income. The following is a summary of securities held-to-maturity and available-for-sale: At December 31, 1993, securities held-to-maturity are due in one year or less and include $51,850,000 reported as cash equivalents. Prior to the adoption of Statement 115, investments other than marketable equity securities were carried at cost and include short-term investments with maturities greater than three months when purchased. The carrying amount of such investments approximates its fair value. Marketable equity securities, prior to the adoption of Statement 115, were carried at lower of cost or market value. At December 31, 1992, and 1991, the market value of the investment in marketable equity securities, based on quoted market prices, ($58,327,000, and $47,779,000, respectively) exceeded cost by $33,024,000, and $22,476,000, respectively. C. SHORT-TERM NOTES PAYABLE The carrying amount reported in the consolidated balance sheet of the Company's short- term notes payable approximates its fair value. Total available funds under unused lines of credit and foreign credit and overdraft facilities at December 31, 1993 amounted to $117 million. Interest paid on short-term notes payable and other obligations amounted to $1,529,000, $1,598,000 and $2,421,000 in 1993, 1992, and 1991, respectively. D. INCOME TAXES In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Effective January 1, 1992, the Company adopted the provisions of Statement 109 and changed its method of accounting for income taxes. As permitted by Statement 109, prior-year consolidated financial statements have not been restated to reflect the change in accounting method. The cumulative effect of adopting Statement 109 as of January 1, 1992, was to increase net earnings by $2,215,000 or $.08 per share. Other than the cumulative effect of adoption, Statement 109 did not have a material effect on the remaining quarterly operating results for 1992. 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. Significant components of the Company's deferred tax assets (liabilities) reflecting the net tax effects of temporary differences are summarized as follows: (In thousands) December 31 1993 1992 Obligation to provide postretirement benefits $1,728 $2,242 Marketing programs 8,515 9,994 Accounts receivable valuation allowances 2,690 2,445 Unremitted earnings of foreign subsidiaries (3,886) (4,760) Excess pension funding (2,761) (2,512) Purchased tax benefits Unrealized holding gain on marketable equity securities (16,500) - Other, net 8,724 4,644 _______ ______ Net deferred tax assets (liabilities) ($3,848) $9,431 _______ ______ The components of earnings before income taxes are summarized as follows: Significant components of the provision for income tax expense (credit) attributable to continuing operations under the liability method in 1993 and 1992 and the deferred method in 1991 are summarized as follows: The components of the provision (credit) for deferred income taxes for the year ended December 31, 1991, principally relate to undistributed earnings of certain subsidiaries, provisions for depreciation, and accrued marketing expenses. No timing difference had a tax effect in excess of 5% of the income tax expense computed at the statutory rate. No item, other than state income taxes in 1993, 1992 and 1991, affects the Company's effective income tax rate by an amount which exceeds 5% of the income tax expense computed at the statutory rate. Undistributed earnings of subsidiaries on which deferred income taxes have not been provided are not significant. Income taxes paid amounted to $42,840,000, $56,319,000, and $56,417,000 in 1993, 1992, and 1991, respectively. E. STOCKHOLDERS' EQUITY On May 6, 1992, the Company's stockholders adopted an amendment to the Company's articles of incorporation establishing a new class of common stock, Class A Common Stock, and the Board of Directors authorized a stock dividend whereby one share of Class A Common Stock was distributed for each share of Common Stock and Class B Common Stock outstanding at the close of business on May 27,1992. Class A Common Stock and Class B Common Stock have the same rights regarding dividends and distributions upon liquidation as Common Stock. However, Class A Common Stockholders are not entitled to vote, Class B Common Stockholders are entitled to ten votes for each share held and Common Stockholders are entitled to one vote for each share held. Transfer of shares of Class B Common Stock is substantially restricted and must be converted to Common Stock prior to sale. In certain instances, outstanding shares of Class B Common Stock will be automatically converted to shares of Common Stock. Unless extended for an additional period of five years by the Board of Directors, all then-outstanding shares of Class B Common Stock will be converted to shares of Common Stock on January 16, 2002. Under the terms of the Bandag, Incorporated Restricted Stock Grant Plan, the Company is authorized to grant up to an aggregate of 100,000 shares of Common Stock and 100,000 shares of Class A Common Stock to certain key employees. The Shares granted under the plan will entitle the grantee to all dividends and voting rights; however, such shares will not vest until seven years after the date of grant. If a grantee's employment is terminated prior to the end of the seven-year period for any reason other than death, disability or termination of employment after age 60, the shares will be forfeited and made available for future grants. A grantee who has attained age 60 and employment is then terminated prior to the end of the seven-year vesting period does not forfeit the nonvested shares. During the years ended December 31, 1993, 1992, and 1991, 5,150 shares, 5,500 shares and 2,550 shares of Common Stock, respectively, were granted under the Plan. The resulting charge to net earnings amounted to $495,000, $532,000, and $493,000, in 1993, 1992, and 1991, respectively. At December 31, 1993, 54,325 shares of Common Stock and 64,975 shares of Class A Common Stock are available for grant under the Plan. Under the terms of the Bandag, Incorporated Nonqualified Stock Option Plan, the Company is authorized to grant options to purchase up to 500,000 shares of Common Stock and 500,000 shares of Class A Common Stock to certain key employees. The option price is equal to the market value of the shares on the date of grant. At December 31, 1993, options to purchase 100,000 shares of Common Stock and 100,000 shares of Class A Common Stock are outstanding and exercisable at $23.458 per share for Common Stock options and $22.792 per share for Class A Common Stock options. Options to purchase 20,000 shares of Common Stock and 20,000 shares of Class A Common Stock expire on November 13, 1997, and each of the four anniversaries thereafter. At December 31, 1993, no options granted under this Plan have been exercised and options to purchase 400,000 shares of Common Stock and 400,000 shares of Class A Common Stock are available for grant. No options may be granted after November 13, 1997. Earnings per share amounts are based upon the weighted average number of shares of Common Stock, Class A Common Stock, Class B Common Stock, and common stock equivalents (dilutive stock options) outstanding during each year. The weighted average number of shares assumed outstanding was 27,337,000 in 1993, 27,743,000 in 1992, and 27,842,000 in 1991. These amounts and the related earnings and cash dividend per share information have been adjusted to reflect the 1992 stock dividend on a retroactive basis. F. EMPLOYEE PENSION PLANS The Company sponsors defined-benefit pension plans covering substantially all of its full-time employees in North America. Benefits are based on years of service and, for salaried employees, the employee's average annual compensation for the last five years of employment. The Company's funding policy is to contribute annually the maximum amount that can be deducted for income tax purposes. Contributions are intended to provide for benefits attributed to service to date and those expected to be earned in the future. Aggregate accumulated benefit obligations and projected benefit obligations, as estimated by consulting actuaries, and plan net assets and funded status are as follows: Assumptions used in the determination of the actuarial present value of the projected benefit obligation and net pension cost are as follows: Assets of the plans are principally invested in guaranteed interest contracts and common stock. The pension expense is composed of the following: The Company also sponsors defined-contribution plans, covering substantially all salaried employees in the United States. The annual contributions are made in such amounts as determined by the Company's Board of Directors. Although employees may contribute up to 12% of their annual compensation from the Company, they are generally not required to make contributions in order to participate in the plans. The Company recorded aggregate expense in connection with employee pension plans in the amount of $2,921,000, $2,685,000, and $2,432,000 in 1993, 1992, and 1991, respectively. G. OTHER POSTRETIREMENT EMPLOYEE BENEFITS The Company provides certain medical benefits under its self-insured health benefit plan to certain individuals who retired from employment before January 1, 1993. The program is contributory, with retiree contributions adjusted periodically. The program also contains co-insurance provisions, which result in shared costs between the Company and the retiree. In addition, the company provides post-termination benefit continuation in accordance with the requirements of the Omnibus Budget Reconciliation Act of 1989 ("OBRA"). The Company does not maintain any separate fund to provide postretirement medical obligations. Substantially all employees with the Company on and after January 1, 1993 are covered by the Bandag Security Program, which provides fully vested benefits with only 5 years of service. Benefits under this program are available upon retirement or separation for any other reason and may be used in connection with medical expense or for any other purpose. The periodic cost and benefit obligation information for the Bandag Security Program is reflected in Note F. In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Effective January 1, 1992, the Company adopted the provisions of Statement 106 and, as permitted by the Statement, elected to immediately recognize the transition obligation. The cumulative effect of adopting Statement 106 was to decrease net earnings by approximately $2,435,000 or $.09 per share (net of the related tax effect of approximately $1,400,000 or $.05 per share). Postretirement benefit costs for prior periods have not been restated. Other than the cumulative effect of adoption, Statement 106 did not have a material effect on the remaining quarterly operating results for 1992. The following table sets forth amounts recognized in the Company's consolidated balance sheet: The weighted-average annual assumed rate of increase in the per capita cost of covered benefits is 13% for 1994 and is assumed to decrease gradually to 7% for 2001 and remain at that level thereafter. 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 $569,000, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $114,000. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 6.5% at December 31, 1993 and 1992. Employees in most foreign countries are covered by various postretirement benefit arrangements generally sponsored by the foreign governments. The Company's contributions to foreign plans were not significant in 1993, 1992 and 1991. H. BUSINESS INFORMATION BY GEOGRAPHIC AREA The information regarding operations in different geographic areas is presented on page 10 of this report and is included herein by reference. I. SUMMARY OF UNAUDITED QUARTERLY RESULTS OF OPERATIONS Unaudited quarterly results of operations for the years ended December 31, 1993 and 1992 are summarized as follows: Results for the quarter ended March 31, 1992, have been restated to retroactively reflect the changes in accounting methods described in Notes D and G, which resulted in a decrease in previously reported net earnings of $220,000 or $.01 per share. These changes in accounting methods did not have a material effect on the remaining quarterly operating results for 1992. 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 Item 10 (with respect to the directors of the registrant) is incorporated herein by reference from the registrant's definitive Proxy Statement involving the election of directors filed or to be filed pursuant to Regulation 14A not later than 120 days after December 31, 1993. In accordance with General Instruction G (3) to Form 10-K, the information with respect to executive officers of the Corporation required by Item 10 has been included in Part I hereof. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information called for by Item 11 is incorporated herein by reference from the registrant's definitive Proxy Statement involving the election of directors filed or to be filed pursuant to Regulation 14A not later than 120 days after December 31, 1993. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by Item 12 is incorporated herein by reference from the registrant's definitive Proxy Statement involving the election of directors filed or to be filed pursuant to Regulation 14A not later than 120 days after December 31, 1993. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Item 13 is incorporated herein by reference from the registrant's definitive Proxy Statement involving the election of directors filed or to be filed pursuant to Regulation 14A not later than 120 days after December 31, 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 are included in Part II, Item 8: Page Consolidated Balance Sheets as of December 31, 1993, 1992 and 1991 23 - 24 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 25 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 26 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 27 Notes to Consolidated Financial Statements 28 - 36 (2) Financial Statements Schedules Page Schedule I Marketable securities - other investments. 39 Schedule V Property, plant and equipment. 40 Schedule VI Accumulated depreciation, depletion and amortization of property, plant and equipment. 41 Schedule VIII Valuation and qualifying accounts and reserves. 42 Schedule IX Short-term borrowings. 43 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. Amounts for other items have been omitted as such amounts are less than 1% of total sales and revenues in the respective year. Item 14 (Cont.) (3) Exhibits Exhibit No. Description 3.1 Bylaws: As amended November 13, 1987. (Incorporated by reference to Exhibit No. 3.1 to the Corporation's Form 10-K for the year ended December 31, 1987.) 3.2 Restated Articles of Incorporation, effective December 30, 1986. (Incorporated by reference to Exhibit No. 3.2 to the Corporation's Form 10-K for the year ended December 31, 1992.) 3.3 Articles of Amendment to Bandag, Incorporated's Articles of Incorporation, effective May 6, 1992. (Incorporated by reference to Exhibit No. 3.3 to the Corporation's Form 10-K for the year ended December 31, 1992.) 4 Instruments defining the rights of security holders. (Incorporated by reference to Exhibit Nos. 3.2 and 3.3 to the Corporation's Form 10-K for the year ended December 31, 1992.) The Corporation agrees to furnish copies of its long-term debt agreements to the Commission on request. 10.1 *1984 Bandag, Incorporated Restricted Stock Grant Plan, as amended May 6, 1992. (Incorporated by reference to Exhibit No. 10.1 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.2 U. S. Bandag System Franchise Agreement Truck and Bus Tires. 10.3 Agreement of Lease dated June 27, 1975 and Amendment dated November 14, 1982 by and between Bandag, Incorporated and Macomb Motel, Inc. (Incorporated by reference as Exhibit No. 10.5 to the Corporation's Form 10-K for the year ended December 31, 1985.) 10.4 *Miscellaneous Fringe Benefits for Executives. 10.5 *Nonqualified Stock Option Plan, as amended May 6, 1992. (Incorporated by reference as Exhibit No. 10.6 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.6 *Nonqualified Stock Option Agreement of Martin G. Carver dated November 13, 1987, as amended by an Addendum dated June 12, 1992. (Incorporated by reference as Exhibit No. 10.7 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.7 *Form of Participation Agreement under the 1984 Bandag, Incorporated Restricted Stock Grant Plan. (Incorporated by reference as Exhibit No. 10.8 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.8 *Employment Agreement with Michel Petiot effective January 1, 1994, dated December 20, 1993. 11 Computation of earnings per share. 21 Subsidiaries of Registrant. *Represents a management compensatory plan or arrangement. (b) Reports on Form 8-K: No report on Form 8-K was filed during the last quarter of the period covered by 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. BANDAG, INCORPORATED By /s/ Martin G. Carver Martin G. Carver Chairman of the Board, Chief Executive Officer, President and Director (Principal Executive Officer) 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 and in the capacities and on the dates indicated. By /s/ Stephen A. Keller By /s/ Stanley E. G. Hillman Stephen A. Keller Stanley E. G. Hillman Director Director By ______________________ By /s/ R. Stephen Newman Edgar D. Jannotta R. Stephen Newman Director Director By /s/ James R. Everline By /s/ Martin G. Carver James R. Everline Martin G. Carver Director Chairman of the Board, Chief Executive Officer, President and Director (Principal Executive Officer) By /s/ Thomas E. Dvorchak Thomas E. Dvorchak Senior Vice President and Chief Financial Officer (Chief Accounting Officer) Date: March 29, 1994 EXHIBIT INDEX Exhibit No. Page No. Description 3.1 Bylaws: As amended November 13, 1987. (Incorporated by reference to Exhibit No. 3.1 to the Corporation's Form 10-K for the year ended December 31, 1987.) 3.2 Restated Articles of Incorporation, effective December 30, 1986. (Incorporated by reference to Exhibit No. 3.2 to the Corporation's Form 10-K for the year ended December 31, 1992.) 3.3 Articles of Amendment to Bandag, Incorporated's Articles of Incorporation, effective May 6, 1992. (Incorporated by reference to Exhibit No. 3.3 to the Corporation's Form 10-K for the year ended December 31, 1992.) 4 Instruments defining the rights of Security Holders. (Incorporated by reference to Exhibit Nos. 3.2 and 3.3 to the Corporation's Form 10-K for the year ended December 31, 1992.) The Corporation agrees to furnish copies of its long-term debt agreements to the Commission on request. 10.1 *1984 Bandag, Incorporated Restricted Stock Grant Plan, as amended May 6, 1992. (Incorporated by reference to Exhibit No. 10.1 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.2 50 U. S. Bandag System Franchise Agreement Truck and Bus Tires. 10.3 Agreement of Lease dated June 27, 1975 and Amendment dated November 14, 1982 by and between Bandag, Incorporated and Macomb Motel, Inc. (Incorporated by reference as Exhibit No. 10.5 to the Corporation's Form 10-K for the year ended December 31, 1985.) 10.4 *Miscellaneous Fringe Benefits for Executives. 10.5 *Nonqualified Stock Option Plan, as amended May 6, 1992. (Incorporated by reference as Exhibit No. 10.6 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.6 *Nonqualified Stock Option Agreement of Martin G. Carver dated November 13, 1987, as amended by an Addendum dated June 12, 1992. (Incorporated by reference as Exhibit No. 10.7 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.7 *Form of Participation Agreement under the 1984 Bandag, Incorporated Restricted Stock Grant Plan. (Incorporated by reference as Exhibit No. 10.8 to the Corporation's Form 10-K for the year ended December 31, 1992.) 10.8 68 *Employment Agreement with Michel Petiot effective January 1, 1994, dated December 20, 1993. 11 69 Computation of earnings per share. 21 71 Subsidiaries of Registrant. * Represents a management compensatory plan or arrangement.

813461_1993.txt

813461_1993

1993

813461

ITEM 1 -- BUSINESS GENERAL Westcorp, a California corporation, is a financial services holding company which operates principally through its wholly-owned subsidiary, Western Financial Savings Bank, F.S.B. (the "Bank"). The Bank owns all of the outstanding capital stock of Westcorp Financial Services, Inc. ("Westcorp Financial"), Western Financial Auto Loans, Inc. ("WFAL"), Western Financial Auto Loans 2, Inc. ("WFAL2"), Western Reconveyance Company, Inc., ("Recon"), Westplan Insurance Agency, Inc. ("Westplan"), and Western Consumer Services, Inc. ("WCS"). Westplan owns all the outstanding stock of Westplan Investments ("WI"). WCS owns all the outstanding stock of Westhrift Life Insurance Company ("Westhrift"). Unless otherwise expressly indicated, a reference herein to Westcorp or the Bank shall also be deemed to include a reference to their respective subsidiaries. Westcorp was formed in 1974 as Western Thrift Financial Corporation, the holding company for Western Thrift & Loan Association ("Western Thrift"), a California-licensed thrift and loan association founded in 1972. In 1977, Western Thrift Financial Corporation acquired Amfac Thrift & Loan Association and caused it to be merged with Western Thrift. In March 1986 Western Thrift Financial Corporation changed its name to Westcorp. In May 1986, Westcorp completed its first public offering of 4.5 million shares of common stock. In April 1988, it reincorporated in Delaware as Westcorp, Inc. In September 1990, it reincorporated in California. During 1993, Westcorp completed a common stock offering of 4.3 million shares. In November 1982, Westcorp acquired Evergreen Savings and Loan Association ("Evergreen"), a California-licensed savings and loan association, which became a wholly-owned subsidiary of Westcorp. Evergreen's name was ultimately changed to Western Financial Savings Bank. In June 1992, Western Financial Savings Bank converted to a federal charter and added F.S.B. to its name. Westcorp's business consists primarily of attracting deposits from the public and using such deposits, together with borrowings and other funds, to purchase retail installment sales contracts secured by motor vehicles primarily from new and used car dealers and to originate and purchase loans secured by residential real estate. Westcorp operates 26 retail banking offices, 8 automobile dealer centers, 32 consumer finance offices specializing in motor vehicle finance and 13 mortgage banking offices located throughout California. Westcorp also has 7 consumer finance offices located in Oregon, Nevada and Arizona. Generally, the dealer centers and mortgage banking offices are located in or near the Bank's branch offices. Westcorp's lending activities are conducted primarily in the California marketplace. As of December 31, 1993, Westcorp's loan portfolio totalled approximately $1.6 billion of which approximately 14.8% consisted of outstanding retail installment sales contracts secured by motor vehicles and other consumer loans, and approximately 85.2% consisted of loans secured by real property used primarily for residential purposes. At December 31, 1993, Westcorp also serviced for the benefit of others $1.0 billion of consumer loans and $1.2 billion of real estate loans. Westcorp's revenues are derived principally from interest charged on its loan portfolio, servicing income, and, to a lesser extent, loan fees, insurance revenues and income on other investments. Interest on deposits and borrowings and general and administrative costs are Westcorp's major expense items. The Bank is subject to examination and comprehensive regulation by the Office of Thrift Supervision ("OTS") and the Federal Deposit Insurance Corporation ("FDIC"). It is also a member of the Federal Home Loan Bank of San Francisco ("FHLB"), which is currently one of twelve regional banks for federally insured savings and loan associations and savings banks comprising the Federal Home Loan Bank System ("FHLB System"). The FHLB System is under the supervision of the Federal Housing Finance Board which was created by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"). The Bank is further subject to certain regulations of the Board of Governors of the Federal Reserve System ("FRB") governing reserves required to be maintained against deposits and other matters. Westcorp Financial is further regulated by the California Department of Corporations, the Oregon Department of Insurance and Finance and the Arizona Corporation Commission. LENDING ACTIVITIES General Westcorp's loan portfolio (including loans classified as available for sale) totalled $1.6 billion at December 31, 1993, representing 72% of Westcorp's assets at that date. The loan portfolio consists principally of loans secured by motor vehicles, loans secured by single family or multifamily dwellings ("residential loans") and residential construction loans. Westcorp's strategy is to focus on and expand its well-defined niches in the motor vehicle finance and single family residential real estate lending markets, the two main lines of business that Westcorp has successfully developed in the financial services industry. Westcorp has adopted various measures to protect its loan portfolio from interest rate fluctuations. Such measures include (i) emphasizing short term consumer loans, (ii) originating adjustable-rate mortgages ("ARMs") for residential properties, (iii) originating fixed rate and ARMS residential loans documented for sale in the secondary mortgage market, (iv) funding loans with advances of like maturities from the FHLB, and (v) pooling and selling motor vehicle loans through securitized public offerings. The types of loans which Westcorp may originate are limited by federal statutes and regulations promulgated by the OTS. Westcorp may originate or purchase whole loans or loan participations secured by real estate located throughout the United States. Notwithstanding this nationwide lending authority, over 99% of Westcorp's real estate loan portfolio is secured by real estate located in California. As a federally chartered savings institution, the Bank has authority to make various kinds of secured and unsecured consumer and commercial loans. It has not, however, expanded its lending activities to include credit card accounts or significant amounts of commercial loans and has no plans to do so in the foreseeable future. The following table sets forth selected data relating to the composition of Westcorp's loan portfolio by type of loan, including loans classified as available for sale, as of the dates indicated. Motor Vehicle Loans The Bank and its predecessors and affiliates have underwritten and purchased motor vehicle loans from dealers and made direct motor vehicle loans (i.e., loans on applications submitted by consumers directly to offices of the Bank or Westcorp Financial) since 1973. Motor vehicle loans are currently underwritten through the Bank's motor vehicle dealer centers ("Dealer Centers") or through a Westcorp Financial branch office. Neither the Bank nor Westcorp Financial has minimum or maximum maturity requirements; however, motor vehicle loans of less than three years' maturity or more than six years are seldom purchased due to low customer demand. Each motor vehicle loan is fully amortizing and provides for level payments over the term of the loan with the portion of principal and interest of each level payment determined on the basis of the sum of the digits (also known as the Rule of 78s) or on the simple interest method. At December 31, 1993, approximately 39% of the aggregate outstanding principal amount of motor vehicle loans were advanced by the Bank to finance purchases of new vehicles and approximately 61% were advanced to finance purchases of used vehicles. At December 31, 1992, approximately 43% of the aggregate outstanding principal amount of motor vehicle loans were advanced to finance purchases of new vehicles and approximately 57%, were advanced to finance purchases of used vehicles. Loans originated by Westcorp Financial on average have a higher interest rate than those originated by the Bank since Westcorp Financial's underwriting criteria are not as strict as the Bank's. Therefore, Westcorp Financial's loans generally have a higher percentage of delinquencies. Accordingly, the Bank and Westcorp Financial generally service a different customer base. The Credit Officers at the Dealer Centers purchase motor vehicle loans through franchised new car dealers and selected used car dealers. The Westcorp Financial Branch Manager is responsible for purchasing motor vehicle loans through franchised new car dealers and from used car dealers. The marketing is accomplished by sales managers through personal calls to auto dealerships as well as referrals. Substantially all loans purchased by the Bank are reviewed by Bank employees to insure proper documentation and adherence to underwriting guidelines, and all loans purchased by Westcorp Financial are similarly reviewed by Westcorp Financial employees. Substantially all motor vehicle loans are nonrecourse to the originating dealer. In the case of new car loans, the Bank generally lends to the applicant an amount not to exceed the sum of the dealer's cost, taxes, license fees, service warranty cost and, if applicable, premium for credit life or credit disability insurance, and in some cases, miscellaneous costs. Additional advances over the sum of such costs may be made under certain circumstances based on the creditworthiness of the applicant. For used cars, the amount loaned does not exceed the wholesale "blue book" value for the car plus related expenses and any additional approved advances. For loans made or purchased by Westcorp Financial, dealers are offered a flexible program as to the amount of additional advances on both new and used vehicles, based on the creditworthiness of the applicant, at a higher rate of interest. The Bank regularly sells the motor vehicle loans originated by it and Westcorp Financial in the secondary market and retains the servicing thereon. At December 31, 1993 and 1992, $102 million and $180 million respectively of motor vehicle loans were classified as held for sale. See "Loan Sales and Securitizations". Real Estate Loans GENERAL Westcorp offers three categories of real estate loans on existing improved properties: fixed rate mortgage loans, ARMs with potential negative amortization and ARMs with no negative amortization. Westcorp currently offers fixed rate mortgage loans and ARMs on single family residential properties secured by a first lien with maturities of up to 30 years. Interest rates are adjusted monthly, quarterly, semiannually or annually, at a rate typically equal to 2.25 to 3.0 percentage points above the Cost of Funds Index ("COFI") published by the FHLB, Treasury, the Federal Cost of Funds Index, LIBOR or other generally recognized cost of funds indices, with certain rate caps designed to stimulate greater customer acceptance while maintaining the desired interest rate flexibility. Interest rates and loan fees are determined primarily by competitive conditions and profitability requirements. In 1993, Westcorp generally did not offer ARMs with initial rates below those which would prevail under the foregoing general terms to remain competitive with other lenders in its market area. The interest rates on ARMs may increase or decrease no more than 3.0% to 6.0% over the life of the loans. All ARMs are assumable by qualified buyers at the interest rate then in effect on the loan, but the maximum upward or downward interest rate adjustment over the life of the assumed loan may be changed from 3.0% to 6.0% greater or less than the interest rate at the time of assumption. On ARMs with no negative amortization, the maximum change in interest rate per period may be limited to 2 percentage points or less per annum on some loan programs. On ARMs with negative amortization, the amount of any interest due in excess of the monthly payment is capitalized by adding it to the principal balance of the loan, to be repaid through future monthly payments, resulting in negative amortization of principal. So that the loan amortizes fully over the remaining term to maturity, payments may be adjusted by more than 7.5% at the end of each five-year interval throughout the life of the loan or sooner, if the outstanding loan amount reaches a dollar figure specified in the contract (generally no greater than 125% of the original loan amount). As of December 31, 1993 and 1992, the total amount of negative amortization capitalized to principal totalled $0.2 million and $1.8 million, respectively, which represents less than 1% of the total real estate loan portfolio. At December 31, 1993, Westcorp's real estate loan portfolio, based on dollar value, consisted of 14.1% fixed rate loans, 30.8% ARMs with no negative amortization and 55.1% of ARMs with negative amortization. The total of all fixed rate loans and ARMs having a contractual maturity after 1994 is $152 million and $1.0 billion, respectively. Westcorp believes that its lending strategy of diversification in its loan portfolio among its three types of loans reduces the overall risk exposure to the institution. The following table sets forth information on the amount of fixed rate mortgage loans and ARMs, net of undisbursed loan proceeds, in Westcorp's portfolio at the dates indicated: COMPOSITION OF REAL ESTATE PORTFOLIO Westcorp's primary real estate lending activity is the origination of mortgage loans to enable borrowers to purchase, refinance or improve residential property. Increasingly, loans originated are in turn sold to others through secondary market activities. Westcorp's total real estate loan portfolio (including those classified as held for sale) consisted of the following: Westcorp's portfolio of real estate loans classified as available for sale consists primarily of single family loans totalling $199 million at December 31, 1993 and $62.4 million at December 31, 1992. Single Family Residential Loans. Single family residential loans made by Westcorp are generally under $400,000 in original principal amount but Westcorp may consider making single family residential loans up to $650,000 in original principal amount. Westcorp's single family residential loans consist of 77.7% ARMs and 22.3% fixed rate loans at December 31, 1993. At December 31, 1993, of the total $825 million single family residential loan portfolio, $184 million were fixed rate loans with a weighted average interest rate of 7.8%. Westcorp sells most of the loans originated by it in the secondary market as whole loan transactions through FNMA, FHLMC and other private institutional purchasers, and generally retains the servicing thereon. Westcorp also offers 15 year and 30 year fixed rate conventional loans and loans insured by the Federal Housing Administration ("FHA") or partially guaranteed by the Veterans Administration ("VA"), secured by first liens on single family residences. The general terms of these loans conform to the guidelines established by purchasers of loans in the secondary market. Generally, Westcorp will not advance more than 80.0% of the property's value unless the borrower has private mortgage insurance. On loans for the purchase of owner occupied single family residences, Westcorp may finance up to 95.0% of the market value based on the lesser of the purchase price or appraised value of the property with mandatory private mortgage insurance on loans with loan-to-value ratios that exceed 80.0% at origination insuring the unpaid balance that exceeds 75.0% of the property's value. The cost of this insurance is paid by the borrower during the term of the loan. Residential loans have typically been made for terms of up to 30 years and are amortized on a monthly basis with level payment of principal and interest due each month, subject to periodic adjustment in the case of ARMs. Westcorp regularly reviews its loan policy in light of market conditions and may change its policy in the future. As part of Westcorp's single family residential lending strategy, Westcorp originates both fixed and adjustable rate residential loans secured by second trust deeds. Westcorp offers a second trust deed loan of up to $300,000 with a term from 5 to 15 years at both fixed and adjustable interest rates. These loans amortize on a 15 or 30 year basis and, depending upon the repayment option selected by the borrower, may involve a "balloon" payment at the end of the term. When making such loans, Westcorp requires that it be given notice in the event of a default under the first trust deed to enable it to take appropriate steps to protect its interest. Westcorp offers a loan referred to as the "Western Revolver," which is a secured line of credit typically collateralized by a second trust deed on a single family residence and bearing an adjustable rate of interest based on a market index. At December 31, 1993 the Bank had committed to lend approximately $111 million of such loans, of which $70 million was outstanding. Multifamily Residential Loans. Westcorp is not currently making new multifamily residential loans with the exception of loans to refinance or restructure loans currently in the portfolio or loans to facilitate the disposition of real estate owned. Westcorp may become a more active multifamily lender if and when economic conditions warrant such increased activity. Multifamily lending in the past has consisted of permanent loans secured by multifamily residential properties (generally apartment houses) and were originated by Westcorp both for its own portfolio and for sale to others. Multifamily residential loans made by Westcorp were generally adjustable rate loans under $5.0 million in original principal amount. Westcorp generally has not extended credit above 80.0% of the appraised value of multifamily residences. At December 31, 1993, no multifamily loan exceeded $10 million or .8% of the total real estate loan portfolio. Construction Loans. In the past, Westcorp provided construction loans primarily for multifamily and single family owner occupied residences but currently provides such loans only on single family owner occupied residences. These included (or include with respect to such single family residences) loans for the acquisition and development of unimproved property to be used for residential purposes. At December 31, 1993, Westcorp's construction loans totaled $31.7 million (of which $14.9 million had not been disbursed as of December 31, 1993) or 1.5% of assets. Construction loans generally have adjustable interest rates equal to 2.0 to 3.5 percentage points above a market index, currently the average prime rate of three major banks. Construction loans generally have terms ranging from 12 to 18 months and advances are generally made to cover actual construction costs and include a reserve for paying the stated interest due on the loan. Construction financing is generally considered to involve a higher degree of risk than long term financing secured by improved owner occupied real estate. Accordingly, these loans generally have fees and rates substantially higher than the fees and rates charged for other types of secured real estate loans made by Westcorp. Westcorp's risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development, the estimated construction costs (including interest during construction) and the ability of the borrower to manage the project. At December 31, 1993, Westcorp had no acquisition, development or construction loans on its books. LOAN ORIGINATIONS, SALES AND SECURITIZATIONS Westcorp's origination activity has continued to increase even as on-balance sheet loans have decreased as a result of greater emphasis on loan sales in the secondary market. The following table sets forth the loan origination, purchase and sale activity of Westcorp for the periods indicated. - --------------- (1) Includes motor vehicle loans purchased from motor vehicle dealers. (2) Motor vehicle loans sold to WFAL2 or a grantor trust. (3) Includes scheduled payments, prepayments and charge-offs. Loan originations come from a number of sources, which include the Bank and Westcorp Financial's network of offices. This network consists of the Dealer Centers, the Westcorp Financial Branch offices, the mortgage banking offices, and a network of automobile dealers and mortgage brokers. The Bank regards all of its branches as loan solicitation facilities as well as sources of deposits. Motor vehicle loans held by the Bank and Westcorp Financial have been purchased from approved motor vehicle dealers on a nonrecourse basis or have been originated directly by the Bank and Westcorp Financial. The Bank and Westcorp Financial believe that the creation and maintenance of close personal relationships at the Dealer Center and motor vehicle dealer-branch office level are major factors in promoting the growth and sustaining the quality of its motor vehicle loan portfolio. Most real estate loans are referred from real estate brokers and mortgage brokers. Westcorp hires commissioned loan agents at its mortgage banking offices to originate single family residential loans. The loan agents, whose commissions are based on closed loans, assist walk-in customers as well as serving real estate brokers in the area of each respective branch office. Westcorp is represented in its wholesale real estate lending by salaried employees located at its mortgage banking offices. These employees receive commissions based on the total volume of loans acquired through mortgage brokers. Westcorp has established criteria for the brokers (from whom it will accept loan referrals), and the loan agents endeavor to increase the number of brokers approved by Westcorp for this purpose. Westcorp periodically audits its motor vehicle loans and real estate loans to ensure compliance with its underwriting guidelines. In addition, branch manager bonuses are calculated by a formula of production and branch profitability which takes into consideration delinquencies and loan losses. Bonuses are therefore not only determined by the amount of loans but also by their quality. Between January 1, 1986 and December 31, 1993, Westcorp securitized or sold, in 22 transactions, approximately $3.3 billion of its motor vehicle loans in publicly underwritten securitization transactions in which Westcorp continues to service such loans. All 22 issues were rated "AAA" by S&P and "Aaa" by Moody's, their highest rating categories, as a result of a third party credit enhancement provided by Financial Security Assurance, Inc. ("FSA") or due to the structure of the transaction. On March 11, 1994, Westcorp sold an additional $200 million through a similar transaction. Beginning in 1990, Westcorp began to securitize its motor vehicle loans using an off-balance sheet structure which utilizes a separate grantor trust for each transaction. These securitizations are structured to be treated as sales without recourse, thereby removing the motor vehicle loans sold from Westcorp's balance sheet. Westcorp retains a residual interest in the excess interest (which is recorded as servicing fee income) which represents the excess of the underlying interest rate on the pool of motor vehicle loans sold over the sum of the pass-through rate on the grantor trust securities, credit losses, administrative expenses and contractual servicing fees. Westcorp securitized $777.5 million and $450.0 million of motor vehicle loans using this structure during 1993 and 1992, respectively. Westcorp derives multiple benefits from the grantor trust form of motor vehicle loan securitization, including a stable source of low cost funding, elimination of interest rate risk, enhanced return on assets and improved capital position. In the past, most of the real estate loans originated or purchased by Westcorp have been maintained in its portfolio except for fixed rate conventional, FHA and VA loans, which have historically been originated for sale in the secondary market. In 1993, Westcorp increasingly sold fixed rate loans in the secondary market. In years prior to 1992, Westcorp's real estate loan sales activities were part of its general real estate loan investment strategy. During 1992, these sales activities were segregated into a separate portfolio of real estate loans held for sale and accounted for as a discrete operating activity in accordance with GAAP. Westcorp sold $596.9 million of whole fixed rate conventional loans and $14.4 million of whole FHA and VA fixed rate loans in 1993 compared to $340.8 million and $6.8 million in 1992. Westcorp also sold $192.8 million of ARMs in 1993 compared to $37.2 million in 1992. Prior to 1989, Westcorp purchased ARMs and construction loans in the secondary market. Westcorp anticipates that future growth of its real estate loan portfolio will be accomplished primarily by its origination activities rather than by purchases in the secondary market. INTEREST RATES AND LOAN FEES Interest rates charged on motor vehicle and real estate loans are primarily determined by competitive loan rates offered in the lending area. These rates reflect prevailing levels of interest rates, the availability of lendable funds and the demand for loans. In addition to interest earned on motor vehicle and real estate loans, Westcorp receives loan origination fees for originating real estate loans. Loan origination fees in an amount equal to a percentage of the principal amount of the loans are charged to the borrower for the origination of the loan. Currently, Westcorp receives fees of up to 3.63% on its loans. Westcorp generally does not charge a loan fee for the origination or purchase of motor vehicle loans. Loan origination fees are a volatile source of income varying with the volume and type of loans made and with competitive conditions in the mortgage markets. Loan demand and availability of credit affect these market conditions. SERVICING OF LOANS Additional fees and charges which relate to the servicing of existing motor vehicle and real estate loans include prepayment fees, late charges and fees collected in connection with an assumption of the loan by a different borrower or other loan modifications. As a result of substantial loan sales during the last three years, loan servicing fee income, which included contractual servicing fees and Westcorp's retained residual interest, substantially increased. This increase in servicing fee income represents a partial offset to the decrease in net interest income. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Comparison of Results of Operations -- Net Interest Income." LOAN INSURANCE Each borrower obtaining a motor vehicle loan from the Bank or Westcorp Financial is required to maintain insurance covering physical damage to the financed vehicle. The insurance policy must name the Bank or Westcorp Financial, as applicable, as a loss payee under the policy, and must cover loss and damage due to collision and other risks included in comprehensive coverage. Since borrowers may choose their own insurers to provide the required coverage, the specific terms and conditions of their policies vary within limits prescribed under applicable insurance law and regulations. If a borrower fails to obtain or maintain the required insurance, the Bank or Westcorp Financial, as applicable has the right to obtain such insurance and add the premium for such insurance to the balance due on the loan. A subsidiary of the Bank, Westplan, acts as an independent agent for unaffiliated insurers in providing material damage insurance coverage on motor vehicles securing loans owned by either the Bank or Westcorp Financial. Westcorp requires title insurance, or in some instances lot book insurance, insuring the priority of its liens on loans secured by real property, and may require additional title endorsements to standard policies as necessary to protect its security in the property encumbered. Westcorp requires that fire and extended coverage be maintained in amounts at least equal to the replacement costs of structures and improvements on all properties serving as security for its loans. If the borrower fails to obtain or maintain the required insurance, Westcorp has the right to obtain such insurance and add the premium for such insurance to the balance due on the loan. Westcorp also requires flood insurance on properties that are within areas defined as having a special flood hazard. Private mortgage insurance may be required by regulation, secondary mortgage market saleability or increased risk exposure. In addition, Westcorp offers credit life and credit disability and mortgage life and disability insurance to its loan customers through an independent insurer. Westhrift, an indirect subsidiary of the Bank, is engaged in the business of reinsuring policies for credit life and credit disability coverage underwritten by an independent insurer. As of December 31, 1993 the credit life insurance in force was $47.8 million. ASSET QUALITY Westcorp has established procedures to assist in the effective identification, measurement and rehabilitation of delinquent and other problem loans. An integral part of this process is the Internal Asset Review Department ("IAR"). The IAR is an independent review function established to measure risk within Westcorp's asset portfolio. The IAR reviews and classifies assets as Pass, Special Mention, Substandard, Doubtful or Loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that Westcorp may sustain some loss unless the deficiencies are corrected. Doubtful assets have a higher possibility of loss than substandard assets. Special mention assets are assets not falling in the foregoing categories, but which have weaknesses or potential weaknesses deserving management's close attention. Consumer Loan Quality Westcorp's consumer loan servicing activities are conducted through the Bank and Westcorp Financial. The Bank's consumer loan servicing activities are conducted through its Dealer Centers. Westcorp Financial's servicing activities are conducted by the Westcorp Financial branch that generated the loan. In most cases, delinquencies are cured promptly, but if not, Westcorp reposses and sells the vehicle collateralizing the loan in accordance with the terms of the loan and statutory guidelines. Deficiency balances are charged off against the allowance for loan losses. After charge off, Westcorp pursues collection of deficiency balances subject to applicable law. Total delinquencies and losses increased from 1989 to 1991, which trend was attributable to several factors. The first factor relates to Westcorp's move to new headquarters which was completed in 1990. This resulted in a large turnover in collection personnel in anticipation of the move and the relocation of Westcorp's Southern California servicing activities to Irvine. As a result, prompt follow ups on delinquent loans by personnel were temporarily interrupted. This was followed by conversion onto a new computer system that occurred in the latter part of 1990, creating a need for training on the new system. Total delinquencies and losses decreased during 1993 and 1992 as compared to 1991. Total delinquencies and losses compared to the total amounts of motor vehicle loans outstanding were .90% and 1.79%, 1.12% and 2.05%, and 2.24% and 1.89%, in 1993, 1992 and 1991, respectively. Management attributes such improvement to the completion of its relocation, the substantial conversion to the new computer system (which has resulted in increased employee attention and follow-up on delinquencies) and a change in the charge-off policy requiring the charge-off of loans delinquent 120 days or more rather than 150 days or more. This change may have resulted in slightly lower delinquency figures in 1993 and 1992, in that certain loans not in the process of collection that were delinquent 120 days or more were charged off as compared to prior periods where loans were allowed to go 150 days or more past due prior to charge off. These charged off loans were therefore being carried on the books of Westcorp as delinquent loans for periods of 30 and sometimes 60 days less than in prior reporting periods. This policy was implemented in response to regulatory requirements and was not instituted for the purpose of reducing delinquency. Loss experience was higher in the initial months after the change of policy but there has not been a significant overall change in loss experience over the most recent reporting period as a result of the change. The following tables set forth the delinquency and loss experience of Westcorp related to motor vehicle loans, at the dates indicated. - --------------- (1) The period of delinquency is based on the number of days payments are contractually past due. (2) This amount includes unearned add-on interest. (3) Includes delinquency information for loans sold to grantor trusts but which were originated and are still serviced by Westcorp. - --------------- (1) Includes loan loss information for loans sold to grantor trusts that were originated and are still serviced by Westcorp. Motor vehicle loans are not placed in nonaccrual status since it is Westcorp's policy to charge-off these loans after 120 days past due unless Westcorp can demonstrate that repayment would occur regardless of delinquency status, (i.e., the loan is well secured by collateral and is in the process of collection). Interest continues to accrue on motor vehicle loans until the loan is charged off. At the time a motor vehicle loan is charged off, all accrued but unpaid interest is reversed. Real Estate Loan Quality Real estate loan borrowers are provided a 10 to 15 day period after the date payment is due before a late charge is assessed. Customers receive computer generated notices of delinquencies on the fifteenth and thirtieth day of delinquency as well as telephone calls from employees of Westcorp. If delinquencies on real estate loans are not cured promptly, Westcorp normally records a notice of default in the appropriate county recorder's office. If the default is not cured within three months after a notice of default has been recorded, Westcorp proceeds to sell the property at a trustee's sale after appropriate publication. California law does not generally permit a deficiency judgment against the borrower following a trustee's sale. California law does permit a deficiency judgment in some instances following a judicial foreclosure. Due to the time and expense required for a judicial foreclosure, however, such actions are rarely initiated by lenders in California. If Westcorp acquires title to a security property at a trustee's sale, the property so acquired is thereafter sold and, if deemed necessary, may be financed by a loan on terms more favorable to the borrower than normally offered by Westcorp. At December 31, 1993, Westcorp had $19.2 million of these financing arrangements outstanding compared to $8.3 million at December 31, 1992. The following table sets forth the percentages of the dollar amounts of Westcorp's total real estate portfolio, including loans available for sale, represented by delinquent real estate loans for the past five years. The decrease in real estate delinquencies over 60 days is shown by loan type in the table below: Total real estate delinquencies over 60 days at December 31, 1993 were $23.0 million compared to $49.4 million at December 31, 1992 after increases in each year from 1989 to 1992. California, where substantially all of the collateral for Westcorp's real estate loans is located, has experienced significant downturns in the market values of real estate. Although the region is continuing to experience high levels of unemployment and a continued slump in residential construction and new home sales, Westcorp was able to reduce delinquencies during 1993. Westcorp does not believe that its real estate portfolio was adversely affected by the January 17, 1994 Northridge earthquake in any material respects. The Special Asset Department ("SAD")is responsible for the management, collection and disposition of all loans, including delinquent or nonperforming loans, which have certain characteristics that indicate current or potential credit weaknesses. SAD has prepared action plans with respect to each of these loans. Action plans vary from recommendations to monitor and review for performing loans that are classified only by virtue of delinquent taxes or inadequate debt service ratios to recommendations to foreclose on loans with chronic or acute problems with no other apparent remedy. Westcorp services a pool of multifamily residential loans previously sold by it with an original principal balance of $159.6 million and a current balance at December 31, 1993 of $100.6 million in which the purchaser has recourse against Westcorp up to an amount equal to 20.0% of the total original pool amount. Management has provided an allowance for loan losses which it believes is sufficient to absorb any losses under the recourse provision of this pool. Nonperforming Assets Nonperforming assets (NPA) include (i) loans in Westcorp's portfolio that are contractually past due 90 days or more or performing nonaccrual loans with identified credit deficiencies ("nonperforming loans"), (ii) insubstance foreclosures, (iii) real estate acquired through foreclosure, and (iv) real estate acquired for investment or development that would otherwise be considered insubstance foreclosure. Collectively, nonperforming assets of $75.0 million represented 3.5% of total assets at December 31, 1993 compared to $102.5 million and 4.1%, respectively, at December 31, 1992. Westcorp's nonperforming assets at December 31, 1993 consisted primarily of multifamily and construction loans. In general, the accrual of interest on real estate loans is discontinued when in management's judgment the interest will not be collectible in the normal course of business or when the loan is 90 days or more past due. When a loan is placed on nonaccrual status, interest accrued to date but not collected is reversed. Accordingly, Westcorp does not accrue or recognize interest income on nonperforming loans. Nonperforming loans consisted of the following as of December 31: Nonperforming assets decreased during 1993 to $75.0 million compared to $102.5 at December 31, 1992. At December 31, 1993, NPA included $32.0 million of nonaccrual loans, $20.8 million of insubstance foreclosures, $17.4 million of real estate acquired through foreclosure, and $4.8 million of nonperforming real estate held for development. Assets secured by single family 1-4 unit residences accounted for 37.3% of the total NPA portfolio. The decrease in total NPA is a result of dispositions without corresponding new additions to the NPA portfolio. The migration of nonperforming loans, insubstance foreclosures ("ISF") and real estate owned is shown below. Allowance for Loan Losses Consistent with loan volume, loan sales, losses, nonaccrual loans and other relevant factors, Westcorp maintained its allowance for loan losses at $39.7 million at December 31, 1993 compared with $40.7 million at December 31, 1992. While Westcorp's nonperforming assets are mainly multifamily and construction loans, no single loan or series of such loans predominate. The provision and allowance for loan losses are indicative of loan volumes, loss trends and management's analysis of market conditions. The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses in the loan portfolio. The table below presents summarized data relative to the allowance for loan losses at December 31: The following table sets forth the activity in the allowance for loan losses. Westcorp established an allowance for real estate losses separate from the allowance for loan losses during 1992. The allowance for real estate losses was established to absorb potential losses in the REO portfolio in accordance with generally accepted accounting principles. Changes in the allowance for real estate losses at December 31 were as follows: Prior to 1992, there was no separate allowance for real estate losses as Westcorp had not prior to that time experienced significant REO activity. Westcorp was of the view that the allowance for loan losses was adequate to also cover the few REO properties and limited number of foreclosures Westcorp had theretofore experienced. In 1992, an allowance for real estate losses was created as Westcorp had a sufficient amount of REO activity to require a separate allowance for real estate losses. The allowance for real estate losses was created by charging real estate operations. The allowance for real estate losses was reduced at December 31, 1993 from the level at December 31, 1992, due primarily to charge-offs taken in the first quarter of 1993 related to certain properties for which specific reserves were provided in the fourth quarter of 1992. INVESTMENT AND MORTGAGE BACKED SECURITIES ACTIVITIES Westcorp's investments consist primarily of investment securities and mortgage-backed securities. Both of these portfolios are classified as available for sale and are therefore accounted for at the lower of cost or market. Westcorp, through the Bank's subsidiary, WCS, has also entered into joint ventures for the development and sale to individual buyers of single family residences and the construction or rehabilitation of apartment projects. As a result of the passage of FIRREA and the capital standards therein, management anticipates that WCS's joint venture activities will continue to be reduced. See "Business -- Subsidiaries -- Western Consumer Services, Inc." INVESTMENT SECURITIES ACTIVITIES Westcorp's investment securities portfolio consists primarily of United States Agency and Treasury Securities. This portfolio is maintained primarily for liquidity in accordance with regulatory requirements. The Bank also holds FHLB stock as required by its affiliation with the FHLB System, corporate bonds, and minimal amounts of other investments. The following table sets forth Westcorp's investments at the dates indicated. - --------------- (1) Excludes investment in common stock of subsidiaries. The following table sets forth the stated maturities of Westcorp's investments at December 31, 1993. Mortgage Backed Securities Activities At December 31, 1993 the mortgage backed securities portfolio consisted of various issues as follows: Other participation certificates were issued to fund certain low-income housing programs designed to provide affordable access to the housing market. Westcorp's mortgage-backed securities had maturities at December 31, 1993 of ten years or more, although payments are generally received monthly throughout the life of these securities. These securities had at that date a weighted average interest rate of 5.57%, and had an estimated market value of $95.8 million, as compared to their book value of $94.6 million. FUNDING SOURCES Westcorp employs various sources to fund its operations, including deposits, commercial paper, advances from the FHLB, repurchase agreements, and other borrowings. The sources used vary depending on such factors as rates paid, maturities, and the impact on capital. See "Asset Liability Management" in Management's Discussion and Analysis. DEPOSITS Westcorp attracts both short term and long term deposits from the general public and institutions by offering a variety of accounts and rates. Westcorp offers regular passbook accounts, various money market accounts, fixed interest rate certificates with varying maturities, and individual retirement accounts. Although Westcorp is authorized to offer negotiable order of withdrawal ("NOW") accounts, it has elected not to do so in the belief that its depositors prefer the higher interest rates it can offer on other money market accounts which do not entail the high transaction costs it believes are associated with NOW accounts. Westcorp's deposits are obtained primarily from the areas surrounding its branches in California and a small amount are solicited from areas outside California by employees only at the Bank's headquarters. From time to time in the past, Westcorp obtained brokered deposits when such deposits were an inexpensive source of funds which generally provided a means of matching Westcorp's ARMs to certain of its liabilities. The Board of Directors of Westcorp has authorized Westcorp to hold up to $100.0 million of brokered deposits if such deposits would be an inexpensive source of funds relative to its other sources of funds and are permitted to be held by Westcorp. As of December 31, 1993, Westcorp had no brokered deposits. See further discussion in the section captioned "Supervision and Regulation -- The Bank -- Brokered Deposits." The following table sets forth the amount of Westcorp's deposits by type for the dates indicated. The variety of savings deposits offered by Westcorp has allowed it to remain competitive in obtaining funds and to respond with flexibility to, but without eliminating the threat of, disintermediation (the flow of funds away from depository institutions such as savings and loan associations into direct investment vehicles such as government and corporate securities). In addition, Westcorp, as well as financial institutions generally, has become much more subject to short term fluctuations in deposit flows, as customers have become more interest rate conscious. The ability of Westcorp to attract and maintain deposits and control its cost of funds has been, and will continue to be, significantly affected by money market conditions. Westcorp's average certificate deposits outstanding are summarized below. Westcorp's maturities of certificate accounts greater than or equal to $100,000 are as follows at December 31, 1993: BORROWINGS AND OTHER SOURCES OF FUNDS Westcorp's other sources of funds include issuances of commercial paper, securities sold under agreements to repurchase, advances from the FHLB and other borrowings as well as loan repayments and cash generated from operations. The FHLB System functions in a reserve capacity for savings institutions. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances from the FHLB on security of such stock and on certain residential mortgage loans and other assets. The Bank has been preapproved for advances up to 25% of its assets, based on remaining availability under credit facilities established by the Bank with the FHLB, with 24 hours notice. Such borrowings may be made pursuant to several different programs offered from time to time by the FHLB. Additional funds are available subject to additional collateral and other requirements. Each credit program has its own interest rate, which may be fixed or variable, and range of maturities. The FHLB prescribes the acceptable uses to which advances pursuant to each program may be put, as well as limitations on the sizes of advances and repayment provisions. The Bank also has utilized the FHLB for long term borrowings to fund its lending activities and had borrowed $126 million as of December 31, 1993. At December 31, 1993 the Bank had a total unused line of credit with the FHLB of approximately $203 million. The weighted average interest rate as of December 31, 1993 was 7.58%. The maximum amount of advances outstanding at any month-end was $174 million and $279 million during 1993 and 1992, respectively. The Bank also has a commercial paper facility with a credit line up to $200 million with the FHLB. Savings associations such as the Bank also have authority to borrow from the Federal Reserve Bank (the "FRB") "discount window." FRB regulations require these institutions to exhaust all reasonable alternative sources of funds, including FHLB sources, before borrowing from the FRB. Federal regulations have been promulgated which connect Community Reinvestment Act (the "CRA") performance with access to long term advances from FHLB to member institutions. The Bank does not believe that there will be any adverse effect to it relative to access to this source of funds. The Bank received an "outstanding" in its most recent CRA evaluation, the highest rating available. SUBORDINATED CAPITAL DEBENTURES The Bank issued $125,000,000 of 8.5% Subordinated Capital Debentures due 2003 on June 17, 1993. The Bank subsequently received permission from the OTS to include these debentures in supplementary capital for purposes of determining compliance with risk-based capital requirements. See "Regulatory Capital Requirements" in Supervision and Regulation. As a result, the Bank redeemed its $52 million of outstanding 11% Subordinated Capital Debentures due 1999 on September 10, 1993. This early extinguishment of debt resulted in an extraordinary loss of $1.1 million net of related taxes of $0.8 million. See "Extraordinary Item" in Management's Discussion and Analysis. SUBSIDIARIES General The Bank's subsidiaries are Westcorp Financial, WFAL, WFAL2, Westplan (which in turn owns all of the stock of Westplan Investments), Western Reconveyance and WCS, (which in turn owns all of the stock of Westhrift). Each of such subsidiaries are described in detail below. The operations of a former subsidiary, Westamerica Computer Services, Inc., were merged into the Bank effective September 1, 1993. Westcorp Financial Services, Inc. Westcorp Financial is in the business of consumer finance. Each of its offices are licensed to the extent required by law to conduct business in each respective state. Westcorp Financial initiated operations to serve markets not covered by the Bank. During 1993, Westcorp Financial originated $198.5 million of motor vehicle loans. The loans which Westcorp Financial originates are generally sold to the Bank and are serviced by Westcorp Financial under its license, whether such loans are held by the Bank or sold in securitized offerings. In 1994 Westcorp Financial plans to expand into other states, including Texas. Western Financial Auto Loans, Inc. WFAL is a wholly-owned, limited purpose finance subsidiary of the Bank. WFAL was organized primarily for the purpose of purchasing motor vehicle loans from the Bank and issuing obligations collateralized by such loans and engaging in other asset-backed financing transactions. A total of three such transactions totaling $527.5 million were completed during 1993. On March 11, 1994, an additional $200 million of loans were sold in a similar transaction. Western Financial Auto Loans 2, Inc. WFAL2 is a wholly-owned, limited purpose finance subsidiary of the Bank. WFAL2 was organized primarily for the purpose of purchasing motor vehicle loans from the Bank originated by the Bank and Westcorp Financial, and issuing obligations collateralized by the motor vehicle loans and engaging in other asset-backed financing transactions. Since December 1986, the Bank sold motor vehicle loans with a principal amount of approximately $2.9 billion to WFAL2 in exchange for the net proceeds of ten bond issues totaling $1.2 billion and nine sales to grantor trusts established by WFAL2 in the amount of $1.6 billion. Each bond issuance to date has been paid off in full at or before its respective maturity date. Westplan Insurance Agency, Inc. Westplan was incorporated in California in 1980 and is licensed by the California Insurance Commissioner to transact the business of an insurance agency. It acts as an agent for independent insurers in providing property and casualty insurance coverage on collateral, primarily motor vehicles, securing loans made by the Bank and Westcorp Financial, protection insurance and other noncredit related life and disability programs. In addition, Westplan offers annuities through the branch offices. Westplan's revenues consist of commissions received on policies sold to customers of the Bank and Westcorp Financial. See "Business -- Loan Insurance." Westplan was transferred from Westcorp to the Bank effective March 31, 1993 in compliance with OTS regulations pertaining to insurance agencies. The Bank paid $1.5 million to Westcorp for all the stock of Westplan. In addition, Westplan also holds all outstanding stock of Westplan Investments. Westplan Investments Westplan Investments was incorporated in 1993 as a licensed mutual funds broker dealer in contemplation of selling mutual funds to the general public. Westcorp anticipates that such operations will commence at some time during 1994 although no assurance can be given in this regard. Western Reconveyance Company, Inc. Western Reconveyance is a California corporation which was incorporated in 1979. It acts primarily as the trustee under trust deed loans made by the Bank and Westcorp Financial and is not a significant source of income. Western Reconveyance Company Inc. was transferred from Westcorp to the Bank in 1992. Westcorp received $10,000 from the Bank for the stock of that company. Western Consumer Services, Inc. WCS is a company which conducts real estate development activities primarily in the form of joint ventures. The joint ventures are engaged in construction of residential units for sale, construction of rental units and rehabilitation of rental housing, the latter primarily in low and moderate income neighborhoods. WCS's interest in these projects ranges from 51% to 100% and, in some cases, includes a participating share of the profits realized upon sale. Its asset level at December 31, 1993, was approximately $9.2 million. WCS's investment in real estate totaled $0.5 million at December 31, 1993. Westcorp believes that the joint venture operations were affected by the combination of overall recessionary pressures and slower sales activities beginning in August 1990. Westcorp is continuing its efforts to dispose of assets in this real estate investment category to third parties (other than the Laguna Hills property described below). The Bank transferred its ownership of Laguna Hills Country Plaza, which is the location of its Laguna Hills branch office, to WCS in 1992 which resulted in an increase of $7.8 million of real estate being carried on the books of WCS. This transfer occurred as a result of a determination that this property could not be treated as branch premises for regulatory purposes (based on OTS guidelines) since the Bank did not occupy 25.0% of the premises, consistent with OTS guidelines, and was thus required to divest the property. The Bank is required to hold risk based capital against this asset as it does against other assets which are held in its real estate investment subsidiary. If and when the Bank is able to occupy 25% or more of the premises, it may transfer the property from WCS to the Bank. As a result of the passage of FIRREA, certain of the Bank's investments in and extension of credit to any subsidiary engaged in activities not permissible for a national bank must be deducted from the Bank's capital for purposes of determining compliance with the capital standards pursuant to a phase-in schedule. See "Supervision and Regulation -- Regulatory Capital Requirements." In 1992 an amendment to FIRREA provided for an extension of the phase-in period from July 1, 1994 to June 30, 1996 for investments in or extensions of credit to real estate subsidiaries of the Bank subject to the approval of an application submitted to the OTS. The Bank received approval of its application and its real estate subsidiary investment is now subject to a capital phase-in period that expires on July 1, 1996. In addition, WCS also holds all outstanding stock of Westhrift. Westhrift Life Insurance Company Westhrift, an Arizona corporation, is engaged in the business of reinsuring credit life and credit disability insurance offered to borrowers of the Bank and Westcorp Financial and underwritten by an independent insurer. The credit life insurance policies provide for full payment to the Bank of the insured's financial obligation in the event of the insured's death. The credit disability insurance policies provide for payment to the Bank of an insured's financial obligation during a period of disability resulting from illness or physical injury. In 1987 Westhrift received a Certificate of Authority from the California Insurance Commissioner to conduct insurance business in California. For Arizona statutory purposes, Westhrift's aggregate reserves for credit life and credit disability policies as of December 31, 1993 were $3.7 million, and Westhrift's provision for loss on such policies for the year ended December 31, 1993 was $0.3 million. The aggregate reserves are computed in accordance with commonly accepted actuarial standards consistently applied, and are based on actuarial assumptions which are in accordance with or stronger than those called for in policy provisions. The policies reinsured are underwritten by the independent insurer for no more than the amount that the insured owes to the Bank. Westhrift does not engage in any business except with respect to customers of the Bank and Westcorp Financial. See "Business -- Loan Insurance." COMPETITION Westcorp faces strong competition in its lending activities and, with respect to the Bank, in attracting savings deposits. Westcorp believes it is competitive because it offers a high degree of professionalism and quality in the services it provides through longstanding relationships with borrowers, real estate brokers and motor vehicle dealers. The greatest competition for deposits comes from other savings and loan associations, money market funds, commercial banks, credit unions, thrift and loan associations, corporate and government securities and mutual funds. Many of the nation's largest savings and loan associations and other depository institutions are headquartered or have branches in the areas where Westcorp primarily conducts its business. Westcorp competes for deposits primarily on the basis of interest rates paid and quality of service to its customers. Westcorp does not rely on any individual, group or entity for a material portion of deposits. Although the majority of its deposits are placed by depositors in the geographic areas in which Westcorp's branches are located, some are placed by depositors located in other regions across the United States. Competition in originating real estate loans comes primarily from other savings and loan associations, commercial banks and mortgage bankers. Westcorp competes for mortgage loans principally on the basis of the interest rates and loan fees it charges, the types of loans it originates and the quality of services it provides borrowers. Westcorp believes it offers a high degree of professionalism and quality in the services it provides borrowers and real estate brokers. Westcorp faces strong competition in the purchase of motor vehicle dealer generated motor vehicle loans from commercial banks, motor vehicle manufacturer finance subsidiaries, consumer finance companies and credit unions. Westcorp competes for the purchase of such loans on the basis of price and the level of service provided to the respective dealers. Westcorp also depends for its share of a particular dealer's motor vehicle loans on the promptness with which it can process and approve a motor vehicle loan application submitted by the dealer. Westcorp must also compete with dealer rebate and interest rate subsidy programs offered by motor vehicle manufacturer's finance subsidiaries. SUPERVISION AND REGULATION GENERAL The adoption of FIRREA in 1989 substantially restructured the regulatory framework in which Westcorp and the Bank operate. In December 1991, The Federal Deposit Insurance Corporation Improvement Act ("FDICIA") was enacted. FDICIA requires specified regulatory agencies to adopt regulations having broad application to insured financial institutions such as the Bank. Set forth below is a discussion of the statutory and regulatory framework for Westcorp as affected by FIRREA and FDICIA and the regulations promulgated thereunder. However, to the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable law or regulation or in the policies of various regulatory authorities may have a material effect on the business and prospects of Westcorp and the Bank. WESTCORP The Savings and Loan Holding Company Act Westcorp, by virtue of its ownership of the Bank, is a savings and loan holding company within the meaning of the Home Owners' Loan Act, as amended by FIRREA ("HOLA"). FIRREA transferred, with few changes, the provisions of the Savings and Loan Holding Company Act from the National Housing Act to HOLA. Savings and loan holding companies and their savings association subsidiaries are extensively regulated under federal laws. As a savings and loan holding company registered with the OTS, Westcorp is subject to its regulations, examination and reporting requirements. Westcorp is a "unitary" savings and loan holding company within the meaning of regulations promulgated by the OTS, and as a result Westcorp is virtually unrestricted in the types of business activities in which it may engage, provided the Bank continues to meet the Qualified Thrift Lender test under HOLA. Although Westcorp intends to remain a unitary savings and loan holding company, if it acquires one or more insured institutions and operates them as separate subsidiaries rather than merging them into the Bank, or if certain other circumstances not currently applicable to Westcorp arise, Westcorp would be treated as a "multiple" savings and loan holding company and could cause additional regulatory restrictions to be imposed on Westcorp. Westcorp does not anticipate that those circumstances will arise unless such institutions are acquired pursuant to a supervisory acquisition and the insured subsidiaries meet the Qualified Thrift Lender test. HOLA prohibits a savings and loan holding company, without prior approval of the OTS, from controlling any other savings association or savings and loan holding company. Additionally, FIRREA empowers the OTS to take substantive action when it determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of any particular activity constitutes a serious risk to the financial safety, soundness, or stability of such holding company's subsidiary savings association. Thus, FIRREA confers on the OTS oversight authority for all holding company affiliates, not just the Bank. Specifically, the OTS may, as necessary: (i) limit the payment of dividends by the Bank; (ii) limit transactions between the Bank, the holding company and the subsidiaries or affiliates of either; and (iii) limit any activities of the holding company that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the Bank. Any such limits may be issued in the form of regulations, or a directive having the effect of a cease and desist order. Savings association subsidiaries of a savings and loan holding company are limited by HOLA in the type of activities and investments in which they may participate if the investment and/or activity involves an affiliate. In general, savings association subsidiaries of a savings and loan holding company are subject to Sections 23A and 23B of the Federal Reserve Act ("FRA") in the same manner and to the same extent as if the savings association were a member bank of the Federal Reserve System. Section 23A of the FRA puts certain quantitative limitations on certain transactions between a bank or its subsidiary and an affiliate, including transactions involving (i) loans or extensions of credit to the affiliate; (ii) the purchase of or investment in securities issued by an affiliate; (iii) purchase of certain assets from an affiliate; (iv) the acceptance of securities issued by an affiliate as security for a loan or extension of credit to any person; or (v) the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. Under Section 23B, transactions between a bank or its subsidiary and an affiliate must meet certain qualitative limitations. Such transactions must be on terms at least as favorable to the bank or its subsidiary as transactions with unaffiliated companies. In addition, Section 11 of the HOLA, as amended by FIRREA, also specifically prohibits a savings association subsidiary of the savings and loan holding company from making a loan or extension of credit to an affiliate unless that affiliate is engaged only in activities permitted to bank holding companies under Section 4(c) of the Bank Holding Company Act or from purchasing or investing in the securities of any affiliate (other than a subsidiary of the savings association). The OTS may issue additional restrictions if necessary to protect the safety and soundness of any savings association. The OTS has issued regulations, consistent with the provisions of Sections 23A and 23B, which exclude transactions between a savings association and its subsidiaries from the limitations of those sections, but those regulations also define certain subsidiaries to be affiliates and subject to the requirements of those sections. At the present time, none of the Bank's subsidiaries are within the definition of an affiliate for purposes of those regulations. In addition, amendments made by FIRREA and FDICIA require that savings associations comply with the requirements of FRA Sections 22(g) and 22(h), and Federal Reserve Board ("FRB") Regulation O promulgated thereunder, in the same manner as member banks, with respect to loans to executive officers, directors and principal shareholders. As a matter of policy, the Bank does not make loans to executive officers, directors or principal shareholders. THE BANK California Savings Association Law As a federally chartered institution, the Bank's investments and borrowings, loans, issuance of securities, payments of interest and dividends, establishment of branch offices and all other aspects of its operations are subject to the exclusive jurisdiction of the OTS, to the exclusion of the California Savings Association Law or regulations of the California Savings and Loan Commissioner. Federal Home Loan Bank System The Bank is a member of the FHLB System which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Banks provide a central credit facility for member institutions. The Bank, as a member of the FHLB System, is required to own capital stock in the FHLB in an amount at least equal to the greater of 1.0% of the aggregate outstanding balance of its loans secured by residential real property or 5.0% of the sum of advances outstanding plus committed FHLB commercial paper lines. The Bank is in compliance with this requirement. Since the adoption of FIRREA, the dividends which the Bank has received on its FHLB stock have been significantly reduced as a result of requirements imposed by FIRREA on the FHLB System. Each FHLB is required to transfer a certain portion of its reserves and undivided profits to the Resolution Funding Corporation ("RFC"), the entity established to raise funds to resolve troubled thrifts, to fund a portion of the interest and the principal on RFC bonds and other obligations. Also, each FHLB is required to transfer a percentage of its annual net earnings to the Affordable Housing Program, as defined in FIRREA, which amount is to increase from 6% of the annual net income of each FHLB in 1994 to at least 10% in 1995 and thereafter. Accordingly, it is anticipated that the level of dividends to be received by the Bank from the FHLB will continue to be less than those received prior to the adoption of FIRREA. Insurance of Accounts The FDIC administers two separate deposit insurance funds for financial institutions: (i) the Savings Association Insurance Fund ("SAIF"), which insures the deposits of associations that were insured by the FSLIC prior to the enactment of FIRREA, and (ii) the Bank Insurance Fund ("BIF"), which insures the deposits of institutions that were insured by the FDIC prior to FIRREA. Thus, commencing in 1989 the deposits of the Bank became insured through the SAIF to the maximum amount permitted by law (currently $100,000). During 1993 the Bank was required to pay insurance premiums of $5.0 million. FDICIA requires the FDIC to implement, by January 1, 1994, a risk-based assessment system under which an institution's premiums are based on the FDIC's determination of the relative risk the condition of such institution poses to its insurance fund. In response, the FDIC adopted a transitional rule, effective January 1, 1993, and a final rule, effective January 1, 1994. Under these rules, each insured institution is classified as "well capitalized," "adequately capitalized" or "undercapitalized," using definitions substantially the same as those adopted with respect to the "prompt corrective action" rules adopted by the regulatory agencies under FDICIA. See "Prompt Corrective Regulatory Action." Within each of these classifications, the FDIC has created three risk categories into which an institution may be placed, based upon the supervisory evaluations of the institution's primary federal financial institution regulatory agency and the FDIC. These three categories consist of those institutions deemed financially sound, those with demonstrated weakness that could result in significant deterioration of the institution and risk of loss to the FDIC, and those which pose a substantial probability of loss to the FDIC. Each of these nine assessment categories is assigned an assessment rate ranging from 0.23% to 0.31% of the institutions deposit assessment base. Under these regulations, an institution is precluded from disclosing the risk-based assessment category to which it has been assigned. FIRREA established a five year moratorium on conversions from the SAIF to the BIF. The Resolution Trust Corporation Completion Act ("RTCCA"), enacted on December 17, 1993, extended this moratorium until the date on which the SAIF first meets the reserve ratio designed for it. There are several exceptions to this moratorium. Most importantly, a SAIF member may convert to bank charter if the resulting bank remains a SAIF member during the term of the moratorium. Additionally, conversions to bank charter can take place during the moratorium if (i) it affects only an "insubstantial" portion of an institution's total deposits and is approved by the FDIC; (ii) it results from the acquisition of a troubled institution that is in default or in danger of default and is approved by the FDIC and the Resolution Trust Corporation (the "RTC"); or (iii) it results from a merger or consolidation of a bank and a savings association and is approved by the FDIC or the Office of the Comptroller of the Currency (the "OCC"), as well as by the FRB. The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which could result in termination of the Bank's deposit insurance. Liquidity Requirements Under OTS regulations, the Bank is required to maintain an average daily balance of liquid assets (cash, certain time deposits, bankers' acceptances and specified United States government, state or federal agency obligations and certain corporate debt obligations and commercial paper) equal to at least 5.0% of its average daily balance of net withdrawal accounts and borrowings payable on demand or in one year or less. If at any time the Bank's liquid assets do not at least equal (on an average daily basis for any month) the amount required by these regulations (which requirement may not be set at less than 4.0% nor more than 10.0% of the Bank's net withdrawable accounts plus short term borrowings), the Bank would be subject to various OTS enforcement procedures, including monetary penalties. The Bank must also maintain an average daily balance of short term liquid assets (generally those having maturities of 12 months or less) equal to at least 1.0% of its average daily balance of net withdrawable accounts plus short term debt. At December 31, 1993, the Bank's liquidity and short term liquidity percentages as calculated for the foregoing purposes were 10.3% and 4.7%, respectively. Thus, the Bank was in compliance with these requirements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capital Resources and Liquidity." Brokered Deposits In June 1992, the FDIC issued regulations under FDICIA that provide for differential regulation relating to brokered deposits based on capital adequacy. Institutions are divided into categories of "well capitalized," "adequately capitalized" and "undercapitalized." Only "well capitalized" institutions may continue to accept brokered deposits without restriction. "Adequately capitalized" institutions may accept brokered deposits only if (i) they first obtain a waiver from the FDIC and (ii) the rate of interest paid on such brokered deposits, at the time such funds are accepted, does not "significantly" exceed (defined as more than 75 basis points) (a) the rate paid on deposits of similar maturity in such institution's normal market area for deposits accepted in the institution's normal market area or (b) the "national rate" paid on deposits of comparable maturity for deposits accepted outside the institution's normal market area. For purposes of these regulations, "national rate" means 120% of the current yield on similar maturity U.S. Treasury obligations or, in the case of a deposit at least half of which is uninsured (institutional or wholesale deposits), 130% of such applicable yield. Furthermore, because the term "deposit broker" is defined to include an "adequately capitalized" association which itself solicits deposits by offering rates of interest that are "significantly" higher (defined as more than 75 basis points) than the prevailing rates offered by other insured associations in the offering association's market area, the interest rate limitations applicable to deposits obtained through third party intermediaries will also apply to deposits obtained by the offering association. "Undercapitalized" institutions are prohibited from (i) accepting brokered deposits or (ii) soliciting any deposits by offering rates of interest that are "significantly" higher (defined as more than 75 basis points) than the prevailing rates of interest on insured deposits (i) in such institution's market area or (ii) in the market area in which such deposits would otherwise be accepted. The terms "well capitalized," "adequately capitalized" and "undercapitalized" have the same meanings as under the regulations pertaining to prompt corrective regulatory action described under "Prompt Corrective Regulatory Action." At December 31, 1993, the Bank met the capital requirements of a well capitalized association as defined by the regulation. Nonetheless, the Bank does not currently accept brokered deposits as defined by the regulation. Regulatory Capital Requirements FIRREA includes capital requirements intended to require the owners of savings associations to invest more of their own funds in the associations they control, thus providing a greater incentive for the owners of the associations to limit the risks such associations incur. FIRREA mandated that the OTS promulgate final capital regulations which provide capital standards no less stringent than the capital standards applicable to national banks. Those regulations were adopted by the OTS and became effective on December 7, 1989. Additionally, FIRREA requires that these capital standards contain (i) a leverage limit (core capital) requirement; (ii) a tangible capital requirement; and (iii) a risk-weighted capital requirement. FIRREA requires savings associations to maintain "core capital" in an amount not less than 3.0% of adjusted total assets. Core capital is defined in the OTS capital regulations as including, among other things, (i) common stockholders' equity (including retained earnings); (ii) a certain portion of the association's qualifying supervisory goodwill; (iii) noncumulative perpetual preferred stock and related surplus; and (iv) purchased mortgage servicing rights meeting certain valuation requirements ("PMSRs"). FDIC regulations required that the maximum amount of such PMSRs which can be included in core capital and tangible capital not exceed, in the aggregate, an amount equal to 50% of the institutions core capital. Effective March 4, 1994, qualifying intangibles, including PMSRs and purchased credit card relationships ("PCCRs") may be included in core and tangible capital, up to a maximum of 50% of core capital with PCCRs, however, limited to 25% of core capital. At December 31, 1993 the Bank had no PMSRs or PCCRs. Effective December 31, 1990, the OCC, the principal national bank regulator, amended its capital regulations by requiring a minimum core capital requirement of 3.0% of adjusted total assets for national banks with a composite 1 rating (the highest rating available) under the CAMEL rating system for national banks and substantially higher core capital requirements for lower rated national banks. It is expected that most national banks will be required to maintain core capital of 4.0% to 5.0% under the new regulation. Because FIRREA generally requires that the capital standards applicable to savings institutions be "no less stringent" than those applicable to national banks, there is a high likelihood that the OTS will impose substantially equivalent requirements, and in April 1991, the OTS proposed to modify the 3.0% of adjusted total assets core capital requirement in the same manner. Under the OTS proposal, only savings associations rated composite 1 under the OTS MACRO rating system will be permitted to operate at the regulatory minimum core capital ratio of 3.0%. For all other savings associations, the minimum core capital ratio will be 3.0% plus at least an additional 100 to 200 basis points, which thus will increase the core capital ratio requirement to 4.0% to 5.0% (or more) of adjusted total assets. In determining the amount of additional core capital any savings institution will be required to maintain, the OTS will assess both the quality of risk management systems and the level of overall risk in each individual savings association through the supervisory process on a case-by-case basis. The OTS has not yet issued a final rule. The OTS may currently impose a higher individual minimum capital requirement on a case-by-case basis. During 1993, the Bank was required by an Agreement with the OTS, (the "OTS Agreement") to maintain core capital of 4.5%. At December 31, 1993, the Bank's core capital was 8.6%. The OTS Agreement was terminated by the OTS effective January 25, 1994. See "Agreement with the Office of Thrift Supervision". A savings association must maintain "tangible capital" in an amount not less than 1.5% of adjusted total assets. "Tangible capital" means core capital less any intangible assets (including supervisory goodwill), plus PMSRs and PCCRs to the extent includable in core capital as described above. At December 31, 1993, the Bank's tangible capital was 8.6%. A savings institution's investments in and extensions of credit to a subsidiary engaged in any activities not permissible for national banks ("nonincludable subsidiaries") generally are deducted from the institution's core capital and tangible capital in determining compliance with capital standards. This deduction is not required for investments in and extensions of credit to a subsidiary engaged solely in mortgage banking, to certain subsidiaries which are themselves insured depository institutions or, unless the FDIC determines otherwise in the interests of safety and soundness, to a subsidiary which engages in such impermissible activities solely as agent for its customers. The Bank is required to deduct from its core and tangible capital its investments in WCS and Westplan (both equity and extensions of credit), as the former is engaged in residential real estate activities not permitted to national banks, and the latter is engaged in an insurance agency business not permitted to national banks. The amount of the deduction related to WCS is to be phased-in through June 30, 1996, while the amount of the deduction related to Westplan is not subject to a phase-in period. By letter dated December 29, 1992, the OTS approved the inclusion in the Bank's core and tangible capital of its investment in WCS at the 75% level through June 30, 1994, at the 60% level from July 1, 1994 through June 30, 1995, and at the 40% level from July 1, 1995 through June 30, 1996. After July 1, 1996 the Bank will not be permitted to include any of its remaining investment in WCS in its core or tangible capital. At December 31, 1993 the amount of its investment in WCS excluded from the Bank's core and tangible capital was $5.8 million (25% of the investment in that subsidiary)and the amount of its investment in Westplan excluded from core and tangible capital was $2.2 million (100% of the investment in that subsidiary). As of December 31, 1993, the Bank's core capital was $186.0 million, exceeding the regulatory requirement of the OTS as set by the OTS Agreement by $88.6 million. The Bank's tangible capital at December 31, 1993 was $186.0 million, exceeding the regulatory requirement of the OTS by $153.5 million. The risk-based component of the capital standards requires that an association have total capital equal to 8.0% of risk-weighted assets on and after December 31, 1992. The OTS risk-based capital regulation provides that for assets sold as to which any recourse liability is retained (including on-balance sheet assets related to the assets sold which are at risk) a savings association must hold capital as a part of its risk-based capital requirement equal to the lesser of (i) the amount of that recourse liability or (ii) the risk-weighted capital requirement for assets sold off-balance sheet as though the assets had not been sold. In addition, in the former instance, when calculating the Bank's risk-based capital ratio (a) the value of those on-balance sheet assets which are subject to recourse, to the extent of that recourse liability ("fully-capitalized assets"), is deducted from the Bank's total capital and (b) neither the risk-weighted value of the asset sold off-balance sheet nor the amount of the fully capitalized assets is included in the Bank's total risk-weighted assets. The Bank held $142.2 million of additional risk-based capital at December 31, 1993 as a result of this requirement due to its recourse liability relating to the Bank's grantor trust financings, all of which related to fully capitalized assets. The Bank's risk-based capital ratio at that date was 15.58%. The Bank's total risk-weighted assets are determined by taking the sum of the products obtained by multiplying each of the Bank's assets and certain off-balance sheet items by a designated risk-weight. Before an off-balance sheet item can be assigned a risk-weight, it must be converted to an on-balance sheet credit equivalent amount. Four risk-weight categories now exist for on-balance sheet assets; a fifth category (of 200% risk-weighing) was deleted by the OTS with the reassignment of these assets to the 100% risk-weighted category. The four risk-weighted categories are: CATEGORY 1: Zero percent risk-weight. Includes, among other assets, cash, securities issued by, or backed by the full faith and credit of, the U.S. government including GNMA mortgage-backed securities, notes and obligations issued by either the FSLIC or FDIC and backed by the full faith and credit of the U.S. government, and assets directly and unconditionally guaranteed by the U.S. government or its agencies; CATEGORY 2: Twenty percent risk-weight. Includes, among other assets, cash items in the process of collection, mortgage related securities issued or guaranteed by FNMA or FHLMC, mortgages guaranteed by the VA or FHA, obligations collateralized by securities issued or guaranteed by the U.S. government, privately issued mortgage related securities qualifying as such under the Secondary Mortgage Enhancement Act, stock in the FHLB, and claims or balances due from the FHLB, the FRB or from domestic depository institutions; CATEGORY 3: Fifty percent risk-weight. Includes, among other assets, qualifying mortgage loans (including certain qualifying residential construction loans) and qualifying multifamily mortgage loans, mortgage related securities backed by qualifying mortgage loans; CATEGORY 4: One hundred percent risk-weight. Includes, among other assets, consumer loans (including motor vehicle loans), commercial loans, home equity loans, nonqualifying multifamily mortgage loans, nonqualifying residential construction loans, land loans, investments in fixed assets and premises, and intangible assets including goodwill not deducted from capital and equity investments permissible for both savings associations and national banks. Before a risk-weight category can be applied to a consolidated off-balance sheet item, such item must be converted into a credit-equivalent amount by multiplying its face amount by whichever of four conversion factors is appropriate. There is a (i) 100% conversion of direct credit substitutes, including financial guarantees, financial standby letters of credit, assets sold with recourse (unless the full amount of the recourse retained is less than the amount of capital required by the credit-risk component for the total assets sold, in which case the appropriate credit risk component is the full amount of the recourse) and assets sold under an agreement to repurchase; (ii) a 50.0% conversion factor is applied to transaction-related contingencies, such as performance bonds or performance-based standby letters of credit and the unused portions of nonexempt loan commitments; (iii) a 20.0% conversion of trade-related contingencies, such as commercial letters of credit; (iv) a 0% conversion factor applies to the unused portion of exempt loan commitments (those which are unconditionally cancelable, with each draw treated as a separate potential loan to be evaluated) and unused, unconditionally cancelable retail credit card lines. Interest-rate contracts (e.g. swaps, caps, collars, options and forward rate agreements) have special credit equivalent amounts equal to the sum of their current credit exposure plus their potential credit exposure. The risk-weight category to be applied to such amounts in determining the credit risk component would depend on the obligor, but in no event would be higher than 50.0% risk-weight. As of December 31, 1993, the Bank's total risk-weighted assets equaled $1.9 billion. Total capital, as defined by OTS regulations, is core capital plus supplementary capital (supplementary capital cannot exceed 100% of core capital) less direct equity investments not permissible to national banks (subject to a phase-in schedule), reciprocal holdings of depository institution capital investments, and that portion of land loans and nonresidential construction loans in excess of 80.0% loan-to-value ratio. Supplementary capital is comprised of three elements: (i) permanent capital instruments; (ii) maturing capital instruments; and (iii) general valuation loan and lease loss allowance. During 1993 the Bank sold $125.0 million of its 8.5% Subordinated Capital Debentures, due 2003 (the "8.5% Debentures"), using the proceeds of that offering to redeem all of its outstanding 11% Subordinated Capital Debentures, due 1999 (the "11% Debentures") and for general corporate purposes. Both the 11% Debentures and the 8.5% Debentures are maturing capital instruments as defined by the OTS capital regulations. Those regulations require that as the maturity date of a maturing capital instrument approaches, a specified amount of that instrument must be deducted from total capital each year. Because the 11% Debentures included a sinking fund obligation along with its May 1, 1999 maturity date, the Bank was permitted as of May 1, 1993 to include only $35.1 million of the $52.0 of those debentures outstanding in its total capital. The OTS approved the Bank's application to include the 8.5% Debentures as supplementary capital on August 4, 1993. Following that approval and the subsequent redemption of all of the outstanding 11% Debentures on September 10, 1993, the Bank did include the 8.5% Debentures in its supplementary capital. By the terms of that approval, the amount of the 8.5% Debentures which may be included in supplementary capital may not exceed 40% of the Bank's total capital, and by September 30, 1995, the amount which may be included may not exceed one-third of the Bank's total capital. At December 31, 1993 the $125.0 million of 8.5% Debentures represented 37.5% of the Bank's total capital. Consistent with the OTS capital regulations, the amount of the 8.5% Debentures which may be included as supplementary capital will decrease at the rate of 20% of the amount originally outstanding per year (net of redemptions), commencing on July 1, 1998. The OTS has adopted an interest rate risk component to its capital rules, effective January 1, 1994. The new rule establishes a method for determining an appropriate level of capital to be held by savings associations subject to the supervision of the OTS, such as the Bank, against interest rate risk ("IRR"). The new rule generally provides that if a savings association's IRR, calculated in accordance with the rule, exceeds a specified percentage, the savings association must deduct from its total capital an IRR component when calculating its compliance with the risk-based capital requirement. Specifically, the rule provides that a savings association's IRR is to be determined by the decline in that association's Net Portfolio Value ("NPV") (i.e. the value of the association's assets as determined in accordance with the provisions of the rule) resulting from a 200 basis point change in market interest rates (increase or decrease, whichever results in a lower NPV) divided by the NPV prior to that change. If that result is a decrease of greater than 2%, the association must deduct from its total capital an amount equal to one-half of the decline in its NPV in excess of 2% of its NPV prior to the interest rate change (the "IRR component"). The reduction of an association's total risk-based capital is effective on the first day of the third quarter following the reporting date of the information used to make the required calculations. The rule also contains provisions (i) reducing the IRR component if the association reduces its IRR by the end of the quarter following the reporting date and (ii) permitting the OTS to waive or defer the IRR component on a showing that the association has made meaningful steps to reduce or control its interest rate risk. Westcorp does not believe it will be required to reduce its total capital by an IRR component at July 1, 1994. Any savings association that fails any of the capital requirements is subject to possible enforcement actions by the OTS or the FDIC. Such actions could include a capital directive, a cease and desist order, civil money penalties, the establishment of restrictions on an association's operations and the appointment of a conservator or receiver. The OTS' capital regulation provides that such actions, through enforcement proceedings or otherwise, could require one or more of a variety of corrective actions. The OTS must prohibit asset growth by any institution that is in violation of the foregoing minimum capital requirements, and must require any such institution to comply with a capital directive issued by the OTS. See "Prompt Corrective Regulatory Action". In summary, the Bank exceeded the current minimum requirements for core capital, tangible capital and risk-weighted capital as of December 31, 1993. However, the required deductions from capital for its investments in WCS, Westplan and direct real estate investments in facilities in which the Bank uses less than 25% of the available space in its operations are still being phased-in. The Bank's core, tangible and risk-weighted capital ratios at December 31, 1993, on a fully phased-in basis, would be 7.8%, 7.8% and 14.8%, respectively. Accordingly, the Bank meets all of the fully phased-in capital requirements. Westcorp believes that the Bank will continue to meet all of the fully phased-in requirements when required. Prompt Corrective Regulatory Action FDICIA requires each applicable agency and the FDIC to take prompt corrective action to resolve the problems of insured depository institutions that fall below certain capital ratios. Such action must be accomplished at the least possible long-term cost to the appropriate deposit insurance fund. In connection with such action, each agency must promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the adequacy of its regulatory capital level: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The critically undercapitalized level cannot be set lower than 2% of total assets or higher than 65% of the required minimum leverage capital level. In addition to the various capital levels, FDICIA allows an institution' s primary federal regulatory agency to treat an institution as if it were in the next lower category if that agency (1) determines (after notice and an opportunity for hearing) that the institution is in an unsafe or unsound condition or (2) deems the institution to be engaged in an unsafe or unsound practice. At each successive downward level of capital, institutions are subject to more restrictions and regulators are given less flexibility in deciding how to deal with the bank or thrift. For example, undercapitalized institutions will be subject to asset growth restrictions and will be required to obtain prior approval for acquisitions, branching and engaging in new lines of business. For significantly undercapitalized institutions, the appropriate agency must require the institution to sell shares in order to raise capital, must restrict interest rates offered by the institution, and must restrict transactions with affiliates unless, in each case, the agency determines that such actions would not further the purposes of the prompt corrective action system. In addition, for critically undercapitalized institutions, the agency must require prior agency approval for any transaction outside the ordinary course of business, and the institution must be placed in receivership or conservatorship unless the appropriate agency and FDIC make certain affirmative findings regarding the viability of the institution (which findings must be reviewed every 90 days). FDICIA prohibits any insured institution (regardless of its capitalization category) from making capital distributions to anyone or paying management fees to any persons having control of the institution if after such transaction the institution would be undercapitalized. Any undercapitalized institution must submit an acceptable capital restoration plan to the appropriate agency within 45 days of becoming undercapitalized. A capital restoration plan will be acceptable only if each company having control over an undercapitalized institution guarantees that the institution will comply with the capital restoration plan until the institution has been adequately capitalized on an average during each of four consecutive calendar quarters and provides adequate assurances of performance. The aggregate liability of such guarantee is limited to the lesser of (i) an amount equal to 5% of the institution's total assets at the time the institution became undercapitalized or (ii) the amount which is necessary to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time the institution fails to comply with its capital restoration plan. The OTS, in conjunction with the other federal financial institution regulatory agencies, adopted regulations defining the five categories of capitalization and implementing a framework of supervisory actions, including those described above, applicable to savings institutions in each category. The regulations provide that a savings association will be deemed to be (i) "well capitalized" if it has a total risk-based capital ratio of 10% or greater, a Tier 1 (i.e., core) risk-based capital ratio of 6% or greater, a leverage ratio of 5% or greater and is not subject to any OTS order or directive to meet and maintain a specific capital level for any capital measure; (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8% or greater; has a Tier 1 risk-based capital ratio of 4% or greater and has either (a) a leverage ratio of 4% or greater or (b) a leverage ratio of 3% or greater and is rated composite 1 under the MACRO rating system in the most recent examination of the institution; (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8%, has a Tier 1 risk-based capital ratio that is less than 4%, has a leverage ratio that is less than 4% or, if rated composite 1 under the MACRO rating system in the most recent examination of the institution, has a leverage ratio that is less than 3%; (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6%, a Tier 1 risk-based capital ratio that is less than 3% or a leverage ratio that is less than 3%; and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2%. At December 31, 1993, the Bank met the capital requirements to be considered "well capitalized". Loans to One Borrower Under FIRREA, the loans-to-one borrower limitations for national banks apply to all savings associations in the same manner and to the same extent as they do to national banks. Thus, savings associations generally are not permitted to make loans to a single borrower in excess of 15% to 25% of the savings associations' unimpaired capital and unimpaired surplus (depending upon the type of loan and the collateral provided therefore), except that a savings association 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 $30.0 million or 30% of the savings association's unimpaired capital and unimpaired surplus, provided that the association receives the written approval of the OTS to do so (which approval the Bank has not sought) and certain other conditions are satisfied; or (iii) to finance the sale of real property which it owns as a result of foreclosure, providing that no new funds are advanced. In addition, further restrictions on a savings association's loans-to-one borrower authority may be imposed by the OTS if necessary to protect the safety and soundness of the savings association. At December 31, 1993, 15.0% of the Bank's unimpaired capital and unimpaired surplus for loans-to-one borrower purposes was $51.9 million. The largest amount outstanding at December 31, 1993 to one borrower (and related entities) was $17.5 million. Equity Risk Investment Limitations The Bank generally is not authorized to make equity investments other than investments in subsidiaries. A savings association may not acquire a new subsidiary or engage in a new activity through an existing subsidiary without giving 30 days prior notice to the OTS and the FDIC, and must conduct the activities of the subsidiary in accordance with the regulations and orders of the OTS. Under certain circumstances, the OTS also may order a savings association to divest its interest in, terminate the activities of, or take other corrective measures with respect to, an existing subsidiary. The Bank's aggregate investment in service corporations subsidiaries was $9.9 million as of December 31, 1993. Qualified Thrift Lender Test A Qualified Thrift Lender ("QTL") test was enacted as a part of FIRREA, and was modified by FDICIA. An association that fails to become or remain a QTL must either (i) convert to a bank subject to the banking regulations or (ii) be subject to severe restrictions, including being forbidden to invest in or conduct any activity that is not permissible to both a savings association and a national bank, and certain other restrictions on branching, advances from its Federal Home Loan Bank, and dividends. Effective three years after an association fails to meet its QTL requirements, the association is forbidden from retaining any investment or continuing any activity not permitted for a national bank and must repay promptly all FHLB advances. In addition, companies that control savings associations that fail the QTL test must, within one year of such failure, become a bank holding company subject to the Bank Holding Company Act. Under the existing QTL requirements, a savings association's "qualified thrift investments" must equal not less than 65% of the association's "portfolio assets" measured on a monthly basis, in 9 of every 12 consecutive months. Qualified thrift investments include all loans or mortgage-backed securities held by an association which are secured or relate to domestic residential or manufactured housing, as well as FHLB stock and certain obligations of the FDIC and related entities. Certain other investments are included as qualified thrift investments, but are limited to 20% of an association's portfolio assets, including (i) 50% of residential mortgage loans sold by an association within 90 days of their origination, (ii) investments in subsidiaries which derive at least 80% of their revenue from domestic residential or manufactured housing, (iii) subject to certain limitations, 200% of investments relating to "starter homes" or housing and community facilities in "credit-needy areas", (iv) consumer loans in the aggregate of not more than 10% of portfolio assets, and (v) FHLMC and FNMA stock. Portfolio assets are total assets less goodwill and other intangible assets, the value of the association's facilities and the association's liquid assets maintained to meet its liquidity requirements (but not over 20% of its total assets). At December 31, 1993 the Bank's percentage of qualified thrift investments to portfolio assets was 87.3%. Westcorp anticipates that the Bank will continue to remain a QTL. Dividend Regulations The OTS has adopted regulations limiting the amount of capital distributions a savings association may make. The regulation divides savings associations into three tiers; those which meet all of the fully phased-in capital requirements of the OTS both before and after the proposed distribution (Tier 1 Associations), those which meet all of the current capital requirements both before and after the proposed distribution (Tier 2 Associations), and those which fail to meet one or more of the current capital requirements (Tier 3 Associations). Tier 2 Associations are further divided into two levels, based upon the association's degree of compliance with the risk-based capital standard. A Tier 1 Association may make capital distributions in an amount equal to the greater of (i) 100% of its net income for the current calendar year to the date of capital distribution, plus the amount that would reduce by one-half its "surplus capital ratio" (the amount by which the association's total capital-to-risk-weighted assets ratio exceeds its fully phased-in requirement of 8%) at the beginning of the current calendar year (i.e. at the end of the immediately prior calendar year), or (ii) 75% of its net income over the most recent four-quarter period preceding the quarter in which the capital distribution is to be made. A Tier 2 Association may make capital distributions of up to 75% of its net income over the past four-quarter period. A Tier 3 Association may not make any capital distribution without the prior authorization of the OTS. Although Tier 1 and Tier 2 Associations do not need to obtain prior approval to make a capital distribution which complies with the requirements of the OTS regulation, the savings association must file a notice with the OTS at least 30 days in advance of the date on which the distribution is to be made. The OTS has the authority, under the regulation, to preclude a savings association from making capital distributions, notwithstanding its qualification to do so on the above tests, if the OTS determines that the savings association is in need of more than normal supervision, or if the proposed distribution will constitute an unsafe or unsound practice given the condition of the savings association. In addition, a Tier 1 Association deemed to be in need of more than normal supervision by the OTS may be downgraded to a Tier 2 or Tier 3 Association as a result of such determination. A savings association may also apply to the OTS for approval to make a capital distribution even though it does not meet the above tests, or for an amount which exceeds the amount permitted by the express terms of the regulation. In addition, another OTS regulation pertaining to holding companies requires that the OTS be given a 30 day advance notice before a savings association subsidiary pays a dividend to its holding company. The notice described above can also constitute the notice for this purpose, if so designated. The Bank is a Tier 1 Association. As of the date hereof, under the limitations of the OTS capital distributions regulation, the Bank may pay dividends up to the greater of 100% of its net income since January 1, 1994 plus 50% of its surplus capital or 75% of its net income over the four-quarter period ending December 31, 1993. However, the Bank is also subject to certain limitations on the payment of dividends by the terms of the indenture for its 8.5% Debentures, which limitations are more severe than the OTS capital distribution regulations. Under the most restrictive of those limitations, the greatest capital distribution which the Bank could currently make is $14.7 million. See "Market for Registrant's Common Equity and Related Stockholder Matters -- Dividends." Westcorp did not receive any dividends from the Bank during 1993. The Bank anticipates making quarterly dividend payments to Westcorp during 1994. Community Reinvestment Act The CRA requires financial institutions regulated by the federal financial supervisory agencies to ascertain and help meet the credit needs of their delineated communities, including low-and moderate-income neighborhoods within those communities, consistent with safe and sound banking practices. The CRA was amended by FIRREA. The FIRREA amendments require that the federal financial supervisory agencies evaluate an institution's CRA performance based on a four tiered descriptive rating system, and that these ratings and written evaluations be made public. The four possible ratings are: (i) Outstanding record of meeting community credit needs; (ii) Satisfactory record of meeting community credit needs; (iii) Needs to improve record of meeting community credit needs; and (iv) Substantial noncompliance in meeting community credit needs. Many factors play a role in assessing a financial institution's CRA performance. The institution's regulator must consider its financial capacity and size, legal impediments, local economic conditions and demographics, including the competitive environment in which it operates. The evaluation does not rely on absolute standards and the institutions are not required to perform specific activities or to provide specific amounts or types of credit. The Bank received a CRA audit in 1992, which was made public in 1993. The Bank's rating was "outstanding." An institution in this group, the highest possible under the CRA, has an outstanding record of ascertaining and helping to meet the credit needs of its entire delineated community, including low-and moderate-income neighborhoods, in a manner consistent with its resources and capabilities. Each year, the Bank prepares a CRA statement for public viewing. This document contains the Bank's CRA strategic plan, CRA notice, ascertainment of community credit needs, marketing and types of credit offered and extended, community outreach activities, geographical distribution and record of opening and closing offices, practices intended to discourage discrimination, community development and a file of public comments. The OTS, concurrently with the federal banking regulatory agencies, has proposed to revise the CRA regulations. The proposed procedures are designed to focus on performance rather than process, to promote consistency in assessments, to permit more effective enforcement against institutions with poor performance, and to reduce unnecessary compliance burden while stimulating improved performance. Specifically, the proposed regulations replace the current process-based assessment system with a new evaluation system that would rate institutions based on actual performance in meeting community credit needs. The new system would evaluate the degree to which an institution is providing (i) loans, (ii) branches and other services, and (iii) investments to low and moderate-income areas. The proposed regulations also emphasize the importance of an institution's CRA performance in the corporate application process, and seek to make the regulations more enforceable. The Bank does not believe that its performance, as might be measured by the regulations if they become adopted as proposed will differ materially from its performance under the existing CRA regulations. Classification of Assets The OTS has adopted a classification system for problem assets of insured institutions. Problem assets are classified as "special mention," "substandard," "doubtful" or "loss," depending on the presence of certain characteristics. An asset will be considered "special mention" when assets do not currently expose a savings association to a sufficient degree of risk to warrant classification but possess credit deficiencies or potential weaknesses deserving management's close attention; an asset is "substandard" if it is inadequately protected by the current capital and paying capacity of the obligor or by the collateral pledged, if any. "Substandard" assets exhibit a well-defined weakness or weaknesses, including the "distinct possibility" that the institution will sustain "some loss" if the deficiencies are not corrected or that liquidation would not be timely even if there is little likelihood of loss. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard," with the added characteristic that the weaknesses make "collection or liquidation in full," on the basis of currently existing facts, conditions and values, "highly questionable and improbable." Assets classified as "loss" are those considered "uncollectible" and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Comparison of Results of Operations -- Provision for Loan and Real Estate Losses." Insured institutions are required to classify their own assets and to establish general valuation allowances (reserves) where appropriate. Assets classified as substandard or doubtful may be reviewed by the OTS examiner and valuation allowances may be required to be increased subject to review by the OTS Regional Director. For the portion of assets classified as loss, the OTS permits 100% of the amount classified to be charged off or the establishment of a specific valuation allowance. The OTS has proposed that it revise its current asset classification scheme with regard to special mention assets. The OTS is proposing to remove the specific reference to special mention assets from its asset classification regulation, and instead issue regulatory guidance on this topic that will more closely align its treatment of special mention assets with the Interagency Policy Statement on Credit Availability issued by the four federal banking regulatory agencies and the OTS. Basically, the guidance will clarify the supervisory treatment of special mention assets and emphasize that such assets are not considered adversely classified assets. In addition, the OTS is considering removing the specific description of assets classified as "substandard," "doubtful" and "loss" from the regulatory text and providing such descriptions in guidance, as is the practice of the federal banking regulatory agencies. Westcorp does not anticipate that this proposal, when finalized, will result in any increase in its classified assets. As of December 31, 1993 the Bank had established allowances for loan and real estate losses of $43.2 million. Insurance Operations The insurance subsidiaries of the Bank are subject to regulation and supervision in the jurisdictions in which they do business. The method and extent of such regulation varies, but the insurance laws of most states establish agencies with broad regulatory and supervisory powers. These powers relate primarily to the establishment of solvency standards which must be met and maintained, the licensing of insurers and their agents, the nature and amount of investments, approval of policy forms and rates, and the form and content of required financial statements. The Bank, through its insurance subsidiaries, is also subject to various state laws and regulations covering extraordinary dividends, transactions with insurance subsidiaries and other matters. The Bank is in compliance with these state laws and regulations. Consumer Finance Operations Westcorp Financial has offices in California, Oregon, Nevada and Arizona. As such it is subject to audit and examination by the OTS, the FDIC, the California Department of Corporations, the Oregon Department of Insurance and Finance and the Arizona Corporation Commission. At December 31, 1993, and as of the date hereof, Westcorp Financial is in compliance with the licensing and operation laws and regulations applicable to each of its offices in these states. The Bank does not guarantee nor is the Bank responsible for the activities of Westcorp Financial in any of these states. Investment Powers Pursuant to FDICIA, the OTS and the other federal financial institution regulatory agencies promulgated final rules, which became effective March 19, 1993, pertaining to real estate lending standards. Those standards, entitled Interagency Guidelines for Real Estate Lending Policies, require insured institutions to adopt lending policies consistent with the guidelines, including as to loan portfolio management considerations, underwriting standards and loan administration. In particular, the regulation establishes supervisory loan-to-value ("LTV") limits for real property secured loans. Each insured institution is to set its own policy with respect to LTV, but those LTV limits are not to exceed the LTV limits of the guidelines, except as specifically permitted by the guidelines. Generally, the LTV limits are as follows: for raw land, 65%; for land development, 75%; for construction of 1 to 4 family residential housing, 85%, and 80% for other construction loans; and for improved property, 85%. Loans secured by owner occupied 1 to 4 family residences are not subject to a supervisory LTV limit, except that any such loan with a LTV ratio of greater than 90% at origination requires either private mortgage insurance or other readily marketable collateral. The Bank's LTV standards are consistent with these supervisory limitations. Accounting Requirements FIRREA requires the OTS to establish accounting standards to be applicable to all savings associations for purposes of complying with regulations, except to the extent otherwise specified in the capital standards. Such standards must incorporate generally accepted accounting principles to the same degree as is prescribed by the federal banking agencies for banks or may be more stringent than such requirements. Such standards must be fully implemented by January 1, 1994 and must be phased-in as provided in federal regulations in effect on May 1, 1989. Effective April 1, 1990, the OTS adopted a statement of policy which provides guidance regarding the proper classification of, and accounting for, securities held for investment, sale and trading. Securities held for investment, sale or trading may be differentiated based upon an institution's desire to earn an interest yield (held for investment), to realize a holding gain from assets held for indefinite periods of time (held for sale), or to earn a dealer's spread between the bid and asked prices (held for trading). Critical to the proper classification of an accounting for securities as investments is the intent and ability of an institution to hold the securities until maturity. A positive intent to hold to maturity, not just a current lack of intent to dispose, is necessary for securities acquired to be considered to be held for investment purposes. Securities held for investment purposes may be accounted for at amortized cost while securities held for sale are to be accounted for at lower of cost or market and securities held for trading are to be accounted for at market. The Bank believes that its investment activities have been and will continue to be conducted in accordance with the requirements of OTS policies and generally accepted accounting principles. The Federal Financial Institutions Examination Council determined in August of 1993 that all federal financial institution regulatory agencies must adopt FAS 115, "Accounting for Certain Investments in Debt and Equity Securities," for fiscal years commencing on or after January 1, 1994. Under FAS 115, savings associations will be required to recognize unrealized gains and losses on "available for sale" securities when measuring shareholders' equity. Several issues are under consideration regarding the implementation of FAS 115 by such institutions. The OTS has not yet determined whether to include this equity component in core capital or as a part of supplementary capital. Also to be resolved is how capital shortfalls produced by market movements should be managed from a regulatory standpoint. The OTS is expected to finalize these issues during 1994. While FAS 115 has not yet been adopted, had it been in effect at December 31, 1993 Westcorp would have recognized an increase in shareholders' equity of approximately $1 million. For additional information see Note U to the Consolidated Financial Statements. Annual Examinations FDICIA significantly reduces regulatory discretion by mandating the appropriate federal financial institution regulatory agency to conduct a full scope, on-site examination of each insured depository institutions every twelve months. The Bank's last annual examination ended on December 17, 1993. FDIC Back-up Enforcement Authority The FDIC has the statutory authority under FDICIA to direct an insured institution's principal regulator to take enforcement action, and to take that action itself if the principal regulator fails to act timely, or in an emergency situation. Financial Reporting FDICIA requires insured institutions to submit independently audited annual reports to the FDIC and the appropriate agency. These publicly available reports must include: (i) annual financial statements prepared in accordance with generally accepted accounting principles and such other disclosure requirements as required by the FDIC or the appropriate agency and (ii) a report, signed by the chief executive officer and the chief financial officer or chief accounting officer of the institution which contains statements, attested to by independent auditors, about the adequacy of internal controls and compliance with laws and regulations. Insured institutions such as the Bank are required to monitor these activities through an independent audit committee. FDICIA also directs the FDIC to develop with other appropriate agencies a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practicable, in any balance sheet, financial statement, report of condition or any other report of any insured depository institution. Standards for Safety and Soundness FDICIA requires the federal banking 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) audit underwriting; (iv) interest rate risk exposure; (v) asset growth; and (vi) compensation fees and benefits. The compensation standards would 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. The OTS, in conjunction with the federal banking regulatory agencies, has proposed safety and soundness standards to meet the FDICIA requirements. In general, the proposed standards identify emerging safety and soundness problems and ensure that such action is taken to address those concerns before they pose a risk to the deposit insurance fund. More specifically, the proposed rules establish safety and soundness standards addressing (i) Internal Controls and information systems, (ii) Internal audit system, (iii) Loan documentation, (iv) Credit underwriting, (v) Interest rate exposure, (vi) Asset growth, and (vii) Compensation, fees and benefits. In addition, the agencies have proposed standards specifying (i) Maximum ratio of classified assets to capital and (ii) Minimum earnings sufficient to absorb losses without impairing capital. The OTS determined not to propose a minimum ratio of market value to book value for publicly traded equity securities as such ratio would not be a feasible means to achieve the safety and soundness objectives of Congress in enacting the relevant provisions of FDICIA. Generally, the standards proposed do not call for savings institutions to meet specific numerical goals. The proposed rules require savings institutions to take specific actions or adopt particular policies or practices designed to reduce safety and soundness concerns. However, the proposed regulations do set a maximum ratio of 1.0 for classified assets to total capital plus general valuation reserves otherwise not includable in total capital. If adopted, the Bank's ratio would have been .55% at December 31, 1993. In addition, the minimum earnings requirement proposed is such earnings over the past four quarters (whether positive or negative) which, if repeated over the next four quarters, will not result in the savings association becoming capital deficient as to any minimum capital requirement. In the event the OTS determines that a savings association has failed to satisfy the safety and soundness standards pursuant to the proposed rules, the OTS may, upon requisite notice, require such association to submit a compliance plan that sets forth the steps it will take and the time frame required to correct the deficiency. If the association fails to comply with the OTS request, the OTS may then issue an order, subject to appeal by the association, requiring such association to correct a safety and soundness deficiency or to take or refrain from other actions. RTC Restructuring Act and RTCCA The RTC's ability to serve as receiver for insolvent thrifts was extended from August 9, 1992 to September 30, 1993 by the RTC Restructuring Act. The RTCCA subsequently extended that period to a date between January 1, 1995 and July 1, 1995, as determined by the Chairman of the Thrift Depositor Protection Oversight Board. Furthermore the RTC Restructuring Act and the RTCCA restructure the RTC and provide additional funding to carry out the purposes of the RTC. The RTC Restructuring Act clarifies that certain qualifying loans made for construction of a residence consisting of one to four dwelling units and certain qualifying loans made for the purchase of multifamily rental and homeowner properties secured by a first lien on a residence consisting of more than four dwelling units are to be included in the 50.0% risk-weighted category in calculating an institution's compliance with its risk-based capital requirements. See "Regulatory Capital Requirements." Agreement with the Office of Thrift Supervision On May 14, 1992, the Bank entered into the OTS Agreement. The Bank entered into the OTS Agreement at the request of the OTS, based on the belief of the OTS that certain acts and practices of the Bank required corrective action. Pursuant to the terms of the OTS Agreement the Bank took certain corrective actions, including adding William J. Crawford and Stanley E. Foster to its Board of Directors, reorganized its management information systems department, upgraded its internal audit and control functions and implemented a restructuring of its Internal Asset Review Department. In further compliance with the OTS Agreement the Bank reduced its level of classified assets as a percentage of GAAP capital plus general valuation allowances and enhanced its compliance with the need to maintain separate corporate identities as between itself and its subsidiaries. The OTS determined during its most recent regular examination of the Bank, which concluded on December 17, 1993 that the Bank had substantially complied with the requirements of the OTS Agreement and on January 25, 1994 advised the Bank, in writing, that the OTS Agreement was terminated. Growth Limitations OTS Regulatory Bulletin 3a-1 ("RB 3a-1") prohibits those savings associations subject to its provisions from increasing their total assets from one quarter to the next in excess of an amount equal to the interest credited to their deposits during the quarter without the prior written approval of the institution's Regional Director. The savings associations which are subject to RB 3a-1 are those considered by the OTS as requiring more than normal supervision. As a result of determinations made by the OTS at the Bank's examination completed February 7, 1993, the Bank became subject to RB 3a-1. As a result of determinations made by the OTS at the completion on December 17, 1993 of the Bank's latest examination, the Bank is no longer subject to RB 3a-1. The Bank's activities during 1993 were not adversely affected by its compliance with RB 3a-1. TAXATION Federal Income Tax Provisions Westcorp and its subsidiaries file a calendar tax year consolidated federal income tax return. The Bank is a savings and loan association for federal tax purposes. Savings and loan associations satisfying certain conditions are permitted under the Code to establish reserves for bad debts and to make annual additions to these reserves which qualify as deductions from income. The Bank is permitted to compute its additions to its bad debt reserve on qualifying real property loans using one of the following two methods: (i) the percentage of taxable income method; or (ii) the experience method. Qualifying real property loans are generally loans secured by an interest in real property and nonqualifying loans are all other loans. The deduction with respect to nonqualifying loans must be computed under the experience method. The Bank intends, when permitted, to compute its annual bad debt reserve deduction for qualifying real property loans under the method which permits the Bank to obtain the maximum allowable deduction. Under the experience method, a savings and loan association is permitted to deduct the greater of (i) an amount based on average yearly loan losses over the current and previous five years or (ii) an amount that would increase its reserve to an amount not in excess of the reserve balance at December 31, 1987. Under the percentage of taxable income method, as revised by the Act, the Bank may generally deduct an amount equal to 8% of its taxable income, after deducting (i) shareholder distributions included under section 593 of the Internal Revenue Code, (ii) net gains from sales of stocks or tax exempt obligations, (iii) dividends for which a dividend received deduction was allowed, reduced by 8% of the dividend received deduction, and (iv) the capital gain rate differential portion of the lessor of (a) the tax year's net long-term capital gain or (b) the tax year's net long-term capital gain from the sale of property other than stock sales or sales of tax-exempt obligations, as an addition to its bad debt reserve. This amount is then reduced by any addition to the reserve for nonqualifying loans. In addition, the bad debt deduction under the percentage of taxable income method is allowed only to the extent that it does not exceed the amount necessary to increase the accumulated reserve for qualifying real property loans to 6% of such loans at year end. Finally, the bad debt deduction under the percentage of taxable income method when added to the deduction with respect to nonqualifying loans, is limited to the larger of (i) the amount by which 12% of the total deposits and withdrawable accounts at year end exceeds the sum of surplus, undivided profits and reserves at the beginning of the year or (ii) the reserve amount computed using the experience method. The allowable deduction under the percentage of taxable income method is available only if at least 60% of the total dollar amount of the Bank's assets are qualifying assets. Qualifying assets include, among other things, cash, U.S. government obligations, certificates of deposit, loans secured by an interest in residential real property and loans made for the payment of expenses of a college or university education. As of December 31, 1993, the Bank exceeds the 60.0% requirement for qualifying assets. The net effect of the percentage of taxable income method deduction is that the maximum effective federal income tax rate applicable to a savings and loan association fully able to use this method will be approximately 32.2%, assuming a statutory tax rate of 35%. A savings association, such as the Bank, which files its federal income tax return as part of a consolidated group, is required to reduce proportionately its bad debt deduction (if computed under the percentage of taxable income method) for tax losses attributable to activities on non-savings and loan members of the group that are functionally related to the activities of the savings and loan association member of the group. The Bank does not expect this provision to have a significant impact on its otherwise allowable bad debt deduction. A savings and loan association which utilizes the percentage of taxable income method is subject to recapture taxes on such reserves if it makes certain distributions to stockholders. Dividends may be paid without the imposition of any tax on the Bank to the extent that the amounts paid as dividends do not exceed the Bank's current or accumulated earnings and profits as calculated for federal income tax purposes. Dividends paid in excess of current and accumulated earnings and profits, distributions in redemption of stock and other distributions with respect to stock such as distributions in partial or complete liquidation, are deemed to be made from the bad debt reserve for qualifying real property loans, to the extent that this reserve exceeds the amount that could have been accumulated under the experience method. The amount of tax that would be payable upon any distribution which is treated as having been from the bad debt reserve for qualifying real property loans is also deemed to have been paid from the reserve to the extent thereof. Management does not contemplate using the reserve in a manner that will create taxable income, but assuming a 35% tax rate, distributions to stockholders which are treated as having been made from the bad debt reserve for qualifying real property loans could result in a federal recapture tax which is approximately equal to one-half of the amount of such distributions, unless offset by net operating losses. In addition, certain large savings and loan associations (including the Bank) are required to recapture their existing bad debt reserves in the event that for any taxable year less than 60% of the association's assets are qualifying assets. A savings and loan association is denied any deduction for interest on debt incurred or continued to purchase or carry tax-exempt obligations acquired after August 7, 1986, although an exception is provided for "qualified tax-exempt obligations," which, among other things, must not be issued by an issuer that reasonably anticipates to issue, together with subordinate entities, not more than $10 million of tax-exempt obligations other than private activity bonds during the calendar year. Both bonds qualifying under this exception and certain other bonds acquired after December 31, 1982 and before August 8, 1986, will be permanently subject to the disallowance of 20% of the deduction with respect to interest on indebtedness treated as incurred to purchase or carry tax-exempt bonds. Moreover, Westcorp will be subject to the alternative minimum tax if such tax is larger than the regular federal tax otherwise payable. Generally, alternative minimum taxable income is a taxpayer's regular taxable income, increased by the taxpayer's tax preference items for the year and adjusted by computing certain deductions in a special manner which negates the acceleration of such deductions under the regular federal tax. This amount is then reduced by an exemption amount and is subject to tax at a 20% rate. Alternative minimum tax items generally applicable to savings and loan associations include (i) 100% of the excess of a savings and loan association's bad debt deduction over the amount that would have been allowable under the experience method; (ii) interest on certain private activity tax-exempt bonds issued after August 7, 1986; (iii) an amount equal to 75% of the amount by which a corporation's adjusted current earnings exceed its alternative minimum taxable income (computed without regard to this adjustment or the net operating loss deduction); and (iv) a portion of accelerated depreciation on property owned by and used or leased by Westcorp and its subsidiaries. For alternative minimum tax purposes, net operating losses can offset no more than 90% of alternative minimum taxable income. In addition, for taxable years beginning after December 31, 1986 and before January 1, 1996 Westcorp will be subject to an additional environmental tax of .12% of its alternative minimum taxable income with certain adjustments and exclusions. As of December 31, 1993, Westcorp had no net operating loss carry-forwards. For net operating losses incurred in taxable years beginning after 1986, there is a 3-year carryback and a 15-year carry-forward period. The returns of Westcorp and its subsidiaries and affiliates were examined for the years 1982 and 1983 without material change. The returns of Westcorp for the year 1988 and 1989 are currently under examination. California Franchise Tax Provisions The California franchise tax applicable to the Bank is a variable rate tax. This rate is computed under a formula which is higher than the rate applicable to nonfinancial corporations because it includes an amount "in lieu" of local personal property and business license taxes paid by nonfinancial corporations (but not generally paid by financial institutions such as the Bank). For taxable year 1993, the total tax rate was set at 11.107%. Under California regulations, bad debts may be treated by savings and loan associations in either of two ways, as debts are ascertained to be worthless in whole or in part or by deducting from income a reasonable reserve addition. The Bank utilizes the latter method, the amount being determined by multiplying loans outstanding at the close of the income year by the ratio of total bad debts sustained to the sum of loans outstanding, using annual averages computed over a three-year or six-year forward period, whichever is greater. The Bank and its subsidiaries file separate tax returns using the combined reporting method. The returns of Westcorp and its subsidiaries and affiliates were examined for the years 1984 through 1987. Assessed amounts were paid by the affiliate company. The returns for the years 1988 and 1989 are currently under examination. For additional information regarding the federal and state taxes payable by Westcorp, see Note Q to the Consolidated Financial Statements. EMPLOYEES At December 31, 1993, Westcorp had 1,181 full-time and 37 part-time employees. None of these employees is represented by a collective bargaining unit or union, and Westcorp and its subsidiaries believe they have good relations with their respective personnel. ITEM 2 ITEM 2 -- PROPERTIES As of December 31, 1993, the Bank owns 21 properties in California and leases an additional 44 properties, 2 of which are located in Oregon, 2 in Nevada and 1 in Arizona. WCS owns one property as well. Neither Westcorp, nor any of its other subsidiaries, has any material properties. The executive offices, located at 23 Pasteur Road, Irvine, California are owned by the Bank. The remaining owned and leased properties are used as branch offices, dealer centers, mortgage banking offices, and finance company offices. As of December 31, 1993, the net book value of property and leasehold improvements was approximately $59.7 million. The following table sets forth certain information with respect to offices of Westcorp. - --------------- (1) A mortgage banking office is also located at this address. (2) A dealer center is also located at this address. (3) A Westcorp Financial Services office is also located at this address. (4) Branches are leased from companies controlled by a major stockholder. (5) A branch office is also located at this address. (6) Leased on month to month term. ITEM 3 ITEM 3 -- LEGAL PROCEEDINGS Westcorp is involved as a party to certain legal proceedings incidental to its business. Westcorp believes that the outcome of such proceedings will not have a material effect upon Westcorp's business or financial condition. 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 Price Range by Quarter The common stock of Westcorp began trading in the over-the-counter market on May 5, 1986. On June 17, 1993, Westcorp commenced trading on the New York Stock Exchange (NYSE), identified by the symbol, WES. From January 25, 1988 to June 17, 1993 Westcorp was registered with the American Stock Exchange (AMEX), also identified by the symbol WES. The following table illustrates the high and low sale prices by quarter in 1993 and 1992, as reported by NYSE or AMEX, as applicable, which prices are believed to represent actual transactions: There were approximately 1,000 shareholders of Westcorp common stock at December 31, 1993. The number of shareholders was determined by the number of record holders, including the number of individual participants, in security position listings. Dividends Westcorp paid a $.05 per share cash dividend for each of the four quarters of 1993. Westcorp paid a $.04 per share cash dividend for the first quarter of 1992, and $.05 per share cash dividend for each of the last three quarters of 1992. On February 28, 1994, Westcorp declared a cash dividend of $.075 per share. While Westcorp is not restricted in its ability to pay dividends, the Bank is restricted by regulation and by the indenture relating to the Bank's subordinated debentures as to the amount of funds which can be transferred to Westcorp in the form of dividends. Under the most restrictive of these terms, on December 31, 1993, the maximum dividend the Bank could declare would be $14.7 million. The Bank must notify the OTS of its intent to declare cash dividends 30 days before declaration, and may not pay a dividend or make a loan to Westcorp for any purpose to the extent Westcorp engages in any activity not permitted for a bank holding company. During 1993, the Bank did not pay any dividends to Westcorp. The Bank anticipates making quarterly dividend payments to Westcorp during 1994. ITEM 6 ITEM 6 -- SELECTED FINANCIAL DATA - --------------- (1) Net of unearned discount, and including loans available for sale of $101,724,718 at December 31, 1993. (2) Net of undisbursed loan proceeds, and including loans available for sale of $199,006,560 at December 31, 1993. (3) Includes investments available for sale of $118,001,821 at December 31, 1993. (4) Includes bonds outstanding issued by finance subsidiaries of the Bank, subordinated debentures issued by the Bank which are included as part of risk-based capital and commercial paper issued by the Bank. - --------------- (1) During the third quarter of 1993, the Bank redeemed its 11% Subordinated Capital Debentures due 1999 at a loss. See Note K to the financial statements. (2) Gives effect to 4 1/2 to 1 stock split effective March 14, 1986, the issuance of 5.1 million shares of new common stock in 1986, a 5% stock dividend in 1991 and the issuance of 4.3 million shares of common stock in 1993. ITEM 7 ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSES OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and notes thereto. OVERVIEW Westcorp originated record levels of motor vehicle loans and single family residential loans during 1993 in spite of the continued recessionary environment. Specifically, Westcorp originated consumer and real estate loans of $829 million and $913 million, respectively, during 1993. This compared to $673 million and $598 million, respectively, during 1992, an overall increase of 37% over 1992's record combined origination level of $1.3 billion. Westcorp continued its ongoing program of motor vehicle and real estate loan sales and securitizations. During 1993, Westcorp sold or securitized $778 million of consumer loans and $804 million of real estate loans compared to $450 million and $385 million, respectively, in 1992. Westcorp continued to focus on improving asset quality and experienced a 27% decline in nonperforming assets to $75 million at year-end 1993 compared to $102 million at the end of 1992. Westcorp's capital was also enhanced by completing an offering of 4.3 million shares of common stock and issuing $125 million of subordinated debentures through the Bank. At the end of 1993, Westcorp's equity to assets ratio stood at 9.4% compared to 6.4% at December 31, 1992 and total assets at the end of 1993 totalled $2.2 billion compared to $2.5 billion at the end of 1992. In addition, the Bank's tangible, core, and risk-based capital of 8.6%, 8.6% and 15.6%, respectively, exceeded all regulatory capital requirements. Subsequent to December 31, 1993, the OTS Agreement was also terminated as it was determined by the OTS that the Bank had complied with its terms in all material respects. RESULTS OF OPERATIONS General Westcorp's net income was $12.9 million for the year ended December 31, 1993 compared to $2.3 million for the year ended December 31, 1992 and $21.1 million for the year ended December 31, 1991. The increase in net income for the year ended December 31, 1993 compared to 1992 was primarily attributable to lower provisions for loan and real estate losses and higher loan servicing income, offset by lower net interest income. The decrease in net income in 1992 relative to 1991 was the result of higher provisions for loan and real estate losses combined with lower net interest margins in the real estate portfolio. Provisions for loan and real estate losses were $22.6 million in 1993 compared with $34.3 million and $24.6 million in 1992 and 1991, respectively. Westcorp is continuing to provide loan loss reserves deemed necessary to absorb potential losses in the loan portfolio. Westcorp's loan portfolio decreased 26.0% between 1991 and 1993, from $2.1 billion at December 31, 1991 to $1.9 billion and $1.6 billion at December 31, 1992 and December 31, 1993, respectively. Offsetting this decrease, loans outstanding originated by Westcorp and sold to others with servicing retained increased 85% between 1991 and 1993, to $2.2 billion at December 31, 1993 compared to $1.4 billion and $1.2 billion at December 31, 1992 and 1991, respectively. During 1993, Westcorp generated $35.9 million in loan servicing fees compared to $22.8 million and $8.8 million in 1992 and 1991, respectively. Gains on the sale of such loans increased to $18.6 million in 1993 as compared to $11.8 million and $7.3 million in 1992 and 1991, respectively. NET INTEREST INCOME The net interest income of Westcorp depends upon the difference between the income it receives from its interest-earnings assets and its cost of funds, which difference is, in turn affected significantly by, first, the spread between yields earned by Westcorp on its interest-earning assets and the rates of interest paid by Westcorp on its interest-bearing liabilities (referred to as interest rate spread), second, the relative amounts of Westcorp's interest-earning assets and interest-bearing liabilities and, third, a combination of the first two. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The following table sets forth certain information regarding changes in interest income and interest expense of Westcorp for the periods indicated. For each category of interest earning assets and interest bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in average portfolio volume multiplied by prior period average rate), (ii) changes in rates (change in weighted average interest rate multiplied by prior period average portfolio balance), and (iii) the combined effect of changes in rates and volume (change in weighted average interest rate multiplied by change in average portfolio balance). Net interest income in 1993 was $56.7 million compared with $74.4 million in 1992 and $87.9 million in 1991. The decrease in net interest income resulted from a decrease in both the amount of interest earning assets and a decrease in the interest rate spread in 1993, offset by a decrease in interest bearing liabilities. The decrease in interest earning assets to $1.9 billion for 1993 compared with $2.2 billion for 1992 and $2.4 billion for 1991 is primarily attributable to ongoing consumer and real estate loan sales and increased real estate loan payoffs. The loan sales are part of Westcorp's strategy of securitizing its loans. See "Business--Loan Sales and Securitizations." Increased real estate loan payoffs and mortgage-backed securities reductions during 1993 occurred as borrowers took advantage of low interest rates to refinance home mortgages. The Bank elected to not replace these loans with new portfolio loans, but to concentrate on originating loans for sale. See "Business -- Loan Sales and Securitizations". The decrease in interest bearing liabilities resulted primarily from a decrease in deposits due to a pricing strategy aimed at reducing the deposit base commensurate with the lower asset base. Since 1990, interest rates have generally declined for Westcorp's interest-earning assets. This decline correlates with overall market interest rate decline. Average yield on interest earning assets decreased to 7.82% for the year ended December 31, 1993 from 9.0%, and 10.9% for the years ended 1992 and 1991, respectively. The yield on the real estate portfolio at December 31, 1993 was 7.2% compared to 8.6% and 10.5% for the years ended December 31, 1992 and 1991, respectively. Consumer loan rates, which are less sensitive to market conditions, were 13.3% for the year ended December 31, 1993 compared to 13.2% for the years ended December 31, 1992 and 1991. The decrease in interest income is primarily the result of an increase in nonaccrual and foreclosed loans and consistent decreases in the 11th District Cost of Funds Index ("COFI") during each month of 1993. The continuing deterioration of the California real estate market has led to higher levels of nonaccrual loans and foreclosed assets. Interest income was reduced by $1.2 million in 1993 compared to $8.1 million in 1992 and $2.9 million in 1991. The decrease in COFI was reflected in a decrease in interest earned on interest earning assets, especially for loan rates which were indexed to COFI, and adjustable rate mortgages in particular. These yield declines have been offset to some degree by decreases in interest costs, particularly in the savings deposit portfolio. Westcorp's average cost of funds declined to 5.3% for the year ended December 31, 1993 from 6.1% and 7.7% in the years of 1992 and 1991, respectively. The cost of savings deposits for the year ended December 31, 1993 was 4.8% compared to 5.6% and 7.3% for the years ended December 31, 1992 and 1991, respectively. Other short-term interest costs, such as those for commercial paper have experienced similar reductions. The cost of FHLB advances during this period has not fallen as quickly because FHLB advances are fixed rate and have longer maturities. The cost of debt (including those characterized as public debt offerings) has remained high primarily due to the 11% Debentures of approximately $52.0 million which were outstanding for most of the year. The weighted average interest cost for other public offerings during 1993 was 7.5% compared to 7.9% and 8.9% for 1992 and 1991, respectively. The decreases are chiefly the result of replacing the issuance of on-balance sheet collateralized bonds with sales of consumer loans in the secondary market beginning in late 1990 as well as the issuance of 8.5% Debentures in 1993 replacing the 11% Debentures previously outstanding. The interest rate spread was 2.5% during 1993 compared to 2.9% and 3.2% during 1992 and 1991, respectively. The following tables present the average interest bearing balances, interest, yield on assets, rates on liabilities and the spread between the combined average yields earned on interest earning assets and average rates paid on interest bearing liabilities for the periods indicated. Average balances are determined on a daily basis. - --------------- (1) For the purposes of these computations, nonaccruing loans are included in the average loan amounts outstanding. The following table sets forth the weighted average interest rate on Westcorp's interest earning assets, the weighted average rates paid on Westcorp's interest bearing liabilities and the resultant interest rate spread as of each of the three years ended December 31, 1993, 1992, and 1991. Westcorp's ability to maintain a positive spread during periods of fluctuating interest rates is determined principally by the relative maturities of its interest-earning assets and interest-bearing liabilities, and the relative repricing mechanisms of its interest sensitive assets and liabilities. Synchronizing the repricing of an institution's liabilities and assets to minimize interest rate risk is commonly referred to as "gap management." "Negative gap" occurs when an institution's liabilities reprice more rapidly than its assets and "positive gap" occurs when an institution's assets reprice more rapidly than its liabilities. As a result of Westcorp's practice of matching its rate sensitive liabilities with rate sensitive assets, it had a "positive gap" of 19.4% at December 31, 1993 for assets and liabilities having an interest rate maturity of one year or less and 14.2% for assets and liabilities having an interest rate maturity of three years or less. At December 31, 1993, over 86% of Westcorp's interest earning assets had interest rate maturities of under three years. Westcorp's asset/liability management strategy is to match its loan products against interest-bearing liabilities with similar repricing characteristics and durations. As part of this strategy, Westcorp has continued to originate fixed-rate consumer loans for securitization and sale in the secondary market. These securitizations allow Westcorp to match assets and liabilities and reduce interest rate risk on this portfolio. Westcorp has also continued to sell fixed-rate mortgage loans in the secondary market in response to these market changes. See "Business -- Loan Originations, Sales and Securitizations." Westcorp also manages its exposure to interest rates by originating ARMs and by match funding fixed rate real estate loans with advances from the FHLB. Westcorp has also introduced loan products tied to current market interest indices such as LIBOR, Treasury and the Federal Cost of Funds Index to reduce the exposure associated with loan products tied to the COFI, which is a lagging market index. During 1993, Westcorp maintained a positive interest spread despite fluctuations in general interest rates as a result of the short interest rate maturities of its loan portfolio adjusting almost as frequently as its liabilities to changes in interest rates. Westcorp's ability to maintain a positive gap is significantly affected by changes in interest rates due, among other factors, to (i) the lagging nature of the index on which interest rate adjustments on a large percentage of Westcorp's interest earning assets are based, (ii) the fact that Westcorp's interest earning assets and interest bearing liabilities reprice at different times, (iii) the effect of interest rate caps on its assets, (iv) the fact that interest rates on such assets and liabilities may respond to different economic, market and competitive factors, (v) the fact that sustained high levels of interest rates may adversely affect real estate loans, motor vehicle loans and lending markets in general, and (vi) the fact that sustained low levels of interest rates may increase the difficulty of originating ARMs as well as increase loan prepayments, which prepayments may be reinvested at lower interest rates. The following table illustrates the projected interest rate maturities, based upon certain assumptions regarding the major asset and liability categories of Westcorp at December 31, 1993. Prepayment and decay assumptions for mortgage loans and savings accounts are developed using both industry averages as provided by the OTS and Westcorp's own prepayment experience. For Westcorp's mortgage loans, the prepayment assumptions range from 7% to 29% of loans prepaying per year depending upon the interest rate, type of loan and contractual repricing terms. For passbook and money market deposit accounts Westcorp uses a rate of 14% to 79% decay per year depending upon the characteristics of each type of account. The interest rate sensitivity of Westcorp's assets and liabilities illustrated in the following table could vary substantially if different assumptions were used or actual experience differs from the assumptions set forth. Although Westcorp's investment securities and mortgage-backed securities are classified as available for sale, they are presented in the repricing categories relative to their respective stated maturities adjusted for any appropriate prepayment assumptions. Loans available for sale are presented as repricing within three months based on management's intent relative to these assets. - --------------- (1) Based on contractual maturities adjusted by Westcorp's historical prepayment rate. (2) Based on interest rate repricing adjusted for projected prepayments. (3) Based on assumptions established by the OTS. (4) Based on contractual maturity. (5) The motor vehicle loan collateralized bonds are amortized based on the scheduled payments of the collateral. PROVISIONS FOR LOAN AND REAL ESTATE LOSSES Valuation allowances for estimated losses on loans and real estate are determined by taking into consideration several factors, including, but not limited to, general economic conditions in the markets Westcorp serves, historical losses, delinquency, individual loan reviews and levels of nonperforming loans and assets relative to reserve levels. The allowance for loan losses ("ALL") decreased from $40.7 million at December 31, 1992 to $39.7 million at December 31, 1993. The provision for loan losses totaled $22.6 million during 1993 offset by net charge-offs totaling $23.6 million. This was a decrease in provisions of $11.7 million and $2.0 million compared to 1992 and 1991 respectively. This balance reflects Westcorp's reduction in nonperforming loans during 1993. Westcorp believes that the ALL, which is 124.2% of nonperforming loans, 166.1% of loans past due 60 days or more and 2.55% of total loans, is currently adequate to absorb potential losses in the portfolio. The allowance for real estate losses totaled $3.5 million at December 31, 1993 compared to $20.2 million at December 31, 1992. The allowance for real estate losses decreased $16.7 million during 1993 due primarily to the charge-offs taken in the first quarter of 1993 related to certain properties for which specific reserves were provided in the fourth quarter of 1992. In addition, Westcorp's inventory of real estate (including REO acquired through foreclosure, insubstance foreclosures, and real estate held for investment or development) declined 50.0% to $47.5 compared to $94.9 at December 31, 1992. Furthermore, in addition to general loss reserves, individual properties are written down to estimated current fair value at time of foreclosure. Any additional deterioration in fair value is recorded in a specific reserve on each individual property. Westcorp did not have an allowance or provision related to REO prior to 1992. The table below provides comparative data relative to the allowance for loan and real estate losses for the periods indicated. - --------------- (1) Nonperforming loans, insubstance foreclosures (including real estate investments classified as insubstance foreclosures) and real estate owned. (2) Loans, net of unearned discounts and undisbursed loan proceeds. In the past several years, the national economy has been adversely affected by negative or low rates of economic growth and high unemployment. The effects of the economic downturn have been acute in California, where essentially all of Westcorp's real estate loan portfolio is located. Nonetheless, Westcorp experienced a decrease in delinquencies and nonperforming assets during 1993. Real estate loans past due 60 days or more at December 31, 1993 decreased to $23.0 million or 1.7% of total real estate loans from $49.4 million or 3.1% at year-end 1992. In the same time frame, nonperforming assets decreased 26.8% to $75.0 million from $102.5 million. The decrease has, in part, been the result of loans migrating from delinquent loans to nonperforming loans and, in turn, to ISF or REO. These properties, in turn, have been disposed of by Westcorp's Special Asset Department. The types and migration of nonperforming assets are shown in the tables that follow. Through its Internal Asset Review department, Westcorp has identified and regularly reviews its problem credits as well as potential problem credits. To the extent that the California economy continues to suffer through a severe and protracted downturn, additional loans may begin to experience credit problems. However, the possibility and extent of such an occurrence is impossible to predict at this time. OTHER INCOME Other income consists of income derived from loan servicing fees, loan related fee income such as late charges and extension fees, gains on sales of loans, mortgage-backed securities and investments, insurance agency activity as well as reinsurance of credit life and credit disability, and real estate operations. Other income totaled $73.8 million for the year ended December 31, 1993, compared to $32.9 million and $37.6 million for the years ended December 31, 1992 and 1991, respectively. Loan servicing fees increased to $35.9 million in 1993 from $22.8 million and $8.8 million in 1992 and 1991, respectively. Loans serviced for others, all of which were originated by Westcorp, totaled $2.2 billion at December 31, 1993 compared to $1.4 billion at December 31, 1992 and $1.2 billion at December 31, 1991. Servicing income has continued to increase because of the increased servicing portfolio and larger servicing fee spreads on more recent consumer loan transactions. The following tables indicate the motor vehicle and real estate loan originations and securitizations for each of the years ended December 31, 1993, 1992 and 1991 and the weighted average yield on assets securitized and weighted average off-balance sheet financing costs for motor vehicle securitizations during such periods: - --------------- (1) Includes loans purchased. (2) Represents the weighted average interest rate on securitized transactions. The combined portfolio of loans owned and loans serviced for others generates income from late charges, extension fees, documentation fees, reconveyance fees, and so forth. The increased portfolio, as well as heightened origination activity combined to generate $46.5 million in income during 1993 compared to $32.5 million and $18.2 million in 1992 and 1991, respectively. Gains on the sale of loans, mortgage-backed securities and investment securities increased to $21.1 million in 1993 from $13.3 million and $8.0 million in 1992 and 1991 respectively. In 1993, Westcorp sold $1.6 billion of loans compared to $834.8 million and $851.3 million for the years ended December 31, 1992 and 1991, respectively. Gains increased during the year ended December 31, 1993 over the years ended December 31, 1992 and 1991 due to higher loan sales volumes and more favorable pricing in the secondary market due to the decline in interest rates. Insurance related income for 1993 totalled $7.1 million compared to $5.3 and $5.2 for 1992 and 1991, respectively. This income is generated through various insurance products including credit life and disability policies and annuity sales. Real estate operations reflected a net expense for the year ended December 31, 1993 of $5.9 million compared to net expense of $19.3 million in 1992 and net income of $2.8 million in 1991. The net expense in 1993 and 1992 was primarily attributable to the real estate loss provisions previously discussed as well as the expenses of holding and disposing of REO. Real estate operations includes the management and disposition of real estate acquired through foreclosure and real estate joint ventures constructed for development and sale and real estate joint ventures held as operating units. Interests held by Westcorp in these joint venture projects range from 51% to 100%. Westcorp's investment in real estate joint venture projects declined to $9.2 million at December 31, 1993 compared to $50.3 million at December 31, 1992 and $59.2 million at December 31, 1991. See "Business -- Subsidiaries -- Western Consumer Services, Inc." Losses (before elimination of intercompany expenses) from joint venture operations were $2.0 million in 1993 compared to losses of $1.5 million in 1992 and $1.3 million in 1991. Westcorp intends to continue to reduce its involvement in this type of activity. OTHER EXPENSE Other expenses, which consist of salaries and employee benefits, occupancy, insurance and other miscellaneous expenses increased to $83.6 million in 1993 from $69.4 million in 1992 and $65.3 million in 1991. Other miscellaneous expenses include marketing, telephone, supplies and legal and professional fees. The increases in expenses is related to increased loan servicing portfolios, expansion into other states, higher levels of nonperforming assets and the OTS Agreement reflected in both an increase in personnel and higher personnel costs. In addition, the premium paid to the Savings Association Insurance Fund increased as a result of an increase in premium rates. The ratio of other expenses to average serviced assets was 2.08% in 1993 compared to 1.85% in 1992, and 1.79% in 1991. INCOME TAXES Westcorp's effective tax rate was 43% for the year ended December 31, 1993 compared to 38% for the year ended December 31, 1992 and 41% for the year ended December 31, 1991. On August 10, 1993, the Omnibus Budget Reconciliation act of 1993 was signed into law. Among other things, it provided for a higher federal tax rate of 35% to be paid by Westcorp (previously the tax rate was 34%). This new tax rate was effective beginning January 1, 1993. Approximately $0.3 million has been included in Westcorp's deferred tax asset as a result of this law change. CAPITAL RESOURCES AND LIQUIDITY Westcorp's funds are generated primarily through the operations of the Bank and its subsidiaries. In addition, Westcorp completed a public offering of 4.3 million shares of common stock during 1993. The Bank also completed a $125 million offering of subordinated debentures. The proceeds of these offerings were used to pay off higher cost subordinated debentures, to provide the Bank additional capital under regulatory guidelines, and to generate the capital resources to expand. Westcorp and its subsidiaries have diversified sources of funds generated through its operations. Primary sources of funds include deposits, loan principal and interest payments received, sales of real estate loans and motor vehicle loans, sales of and payments on mortgage-backed securities, and the maturity or sale of investment securities. Prepayments on loans and mortgage-backed securities and deposit inflows and outflows are affected significantly by interest rates, real estate sales activity and general economic conditions. The recent decline in interest rates resulted in substantially higher levels of loan prepayments during 1993 and 1992. It is difficult to predict whether this trend will continue. The decrease in deposits resulted from a pricing strategy designed to reduce the deposit base commensurate with the lower asset base. Other sources of funds include a commercial paper facility totalling $200 million, reverse repurchase agreements and FHLB advances. At December 31, 1993, Westcorp had $125 million of commercial paper outstanding with approximately $75 million still available from this source. FHLB advances outstanding at December 31, 1993 totalled $126 million with approximately $203 million still available under such line. At December 31, 1993, Westcorp had no reverse repurchase agreements. When conditions are favorable, structured finance capital markets are accessed regularly with respect to Westcorp's motor vehicle loans. In 1993, $777.5 million was raised by Westcorp through motor vehicle loan sale transactions using an off-balance sheet grantor trust structure. An additional $200 million were sold on March 11, 1994. In 1992 and 1991, $450 and $725 million, respectively, were raised in similar loan sale transactions. All of those transactions received the highest rating given by Moody's Investors Service, Inc. ("Moody's") and Standard & Poor's Corporation ("S&P") at the time of sale based on the structure of the transaction and credit enhancement provided by Financial Security Assurance Inc. ("FSA"). In each transaction, FSA issued a financial guaranty insurance policy pursuant to which the payment of interest and principal was guaranteed to the holders of the beneficial interests in the related grantor trust. In addition, during 1993, Westcorp sold $804 million of real estate loans as part of its mortgage banking activity. Westcorp will engage in motor vehicle and real estate loan sales when market conditions are appropriate. If Westcorp does not sell such loans it will hold them in its portfolio, relying on its other sources of funds to meet its liquidity needs. Westcorp uses its funds to meet its business needs, which include funding maturing certificates of deposit and savings withdrawals, repaying of borrowings, funding loan and investment commitments and real estate operations, meeting operating expenses, and maintaining minimum regulatory liquidity and capital levels. OTS regulations require the Bank, as a savings association, to maintain a specified level of liquid assets such as cash, and short term U.S. government and other qualifying securities. Such liquid assets must not be less than 5.0% of the Bank's average daily balance of net withdrawable deposit accounts and borrowings payable in one year or less, with short term liquid assets (which generally have a term of less than one year) consisting of not less than 1.0% of that average daily balance amount. For the twelve month periods ended December 31, 1993, 1992 and 1991, such ratios were 10.3%, 5.7% and 6.0%, respectively. EFFECT OF INFLATION AND CHANGING PRICES Unlike many industrial companies, substantially all of the assets and virtually all of the liabilities of Westcorp are monetary in nature. As a result, interest rates have a more significant effect on Westcorp's performance than the general level of inflation. ITEM 8 ITEM 8 -- FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Westcorp's consolidated financial statements begin on page of this report. ITEM 9 ITEM 9 -- CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III Certain information required by Part III is omitted from this report, in that Westcorp will file a definitive proxy statement (the "Proxy Statement") within 120 days after the end of its fiscal year pursuant to Regulation 14A of the Securities Exchange Act of 1934 for its Annual Meeting of Stockholders to be held May 26, 1994 and the information included therein is incorporated herein by reference. ITEM 10 ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding directors appears under the caption "Election of Directors" in the Proxy Statement and is incorporated herein by reference. Information regarding executive officers appears under the caption "Executive Officers Who Are Not Directors" in the Proxy Statement and is incorporated herein by reference. ITEM 11 ITEM 11 -- EXECUTIVE COMPENSATION Information regarding executive compensation appears under the caption "Executive Compensation Summary" in the Proxy Statement and is incorporated herein by reference. ITEM 12 ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership of certain beneficial owners and management appears under the caption "Security Ownership of Management and Certain Stockholders" in the Proxy Statement and is incorporated herein by reference. ITEM 13 ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions appears under the caption "Certain Transactions Between Management and Westcorp or its Subsidiaries" in the Proxy Statement and is incorporated herein by reference. 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 The following consolidated financial statements and report of independent auditors of Westcorp and subsidiaries are included in this Report commencing on page. Report of Independent Auditors Consolidated statements of financial condition -- 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 -- December 31, 1993. (2) FINANCIAL STATEMENT SCHEDULES Schedules to the consolidated financial statements are omitted because the required information is inapplicable or the information is presented in Westcorp's consolidated financial statements or related notes. (3) Exhibits - --------------- * Exhibits previously filed with Westcorp Registration Statement on Form S-4 (File No. 33-34286), filed April 11, 1990 incorporated herein by reference under Exhibit Number indicated. ** Exhibit previously filed with Westcorp Registration Statement on Form S-1 (File No. 33-4295), filed May 2, 1986 incorporated herein by reference under Exhibit Number indicated. *** Exhibit previously filed with Westcorp Registration Statement on Form S-8 (File No. 33-43898), filed December 11, 1991 incorporated herein by reference under the Exhibit Number indicated. **** Exhibit previously filed with Westcorp 10-Q filed May 15, 1992 incorporated herein by reference under exhibit number indicated. (b) Report on Form 8-K A report on Form 8-K was filed November 24, 1993 announcing Westcorp's quarterly dividend and a Board resolution authorizing its Executive Committee to repurchase up to 1,000,000 shares of its common stock. A report on Form 8-K was filed February 1, 1994 announcing that on January 25, 1994, the Bank was informed by the OTS that the OTS agreement will be lifted. 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. WESTCORP By STEPHEN W. PROUGH Stephen W. Prough President and Dated: March 15, 1994 Chief Operating Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following on behalf of the registrant in the capacities and on the dates indicated. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS WESTCORP CONSOLIDATED FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT AUDITORS REPORT OF INDEPENDENT AUDITORS Board of Directors Westcorp We have audited the consolidated statements of financial condition of Westcorp and Subsidiaries listed in the accompanying Index to Financial Statements (Item 14(a)). These financial statements are the responsibility of Westcorp'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 consolidated financial position of Westcorp 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. ERNST & YOUNG Los Angeles, California January 19, 1994 WESTCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION ASSETS See notes to consolidated financial statements. WESTCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME See notes to consolidated financial statements. WESTCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY See notes to consolidated financial statements. WESTCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS WESTCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) See notes to consolidated financial statements. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 NOTE A -- A SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The accompanying consolidated financial statements include the accounts of Westcorp, its wholly-owned subsidiary, Western Financial Savings Bank (the "Bank") and its subsidiaries ("Westcorp"). All significant intercompany accounts and transactions have been eliminated upon consolidation. Westcorp is a majority owned subsidiary of American Assets, Inc. Investment Securities and Mortgage-Backed Securities Available for Sale: Securities to be held for indefinite periods of time and not necessarily intended to be held to maturity or on a long-term basis are classified as available for sale and carried at the lower of amortized cost or market value. Securities held for indefinite periods of time include securities that management intends to use as part of its asset/liability management strategy and that may be sold in response to changes in interest rates and resultant prepayment risk, or other factors. Effective December 31, 1992, management classified the entire investment securities and mortgage-backed securities portfolios as available for sale and have recorded these portfolios at the lower of amortized cost or market value. Management may, in the future, originate or purchase investment securities or mortgage-backed securities for investment purposes. Gains and losses on sales of securities are determined by the difference between sales proceeds and the carrying value of the specific securities being sold. Interest on Fee Income: Interest income on discounted retail installment sales contracts is being determined on a monthly basis using the sum-of-the-months digits method which approximates the interest method. These contracts are charged off in the normal course of business after 120 days past due, including any interest accrued thereon, unless Westcorp can clearly demonstrate that repayment would occur regardless of delinquency status, i.e., the loan is well secured by collateral and is in the process of collection. Interest income on real estate loans is accrued daily based upon the principal amount outstanding. The accrual of interest is discontinued when, in management's judgement, the interest will not be collectible in the normal course of business or when the loan is 90 days or more past due or full collection of principal is suspect. When a loan is placed on nonaccrual status, interest accrued to date is reversed against interest income. Westcorp amortizes loan origination and commitment fees and certain deferred loan origination costs. The net amount is amortized as an adjustment to the related loan's yield. Westcorp is amortizing these amounts over the contractual life of the related loans. Commitment fees based on a percentage of a customer's unused line of credit and fees related to standby letters of credit are recognized over the commitment period. Fees for other services are recorded as income when earned. Unearned fees on loans sold or paid in full are recognized as income. Allowance for Loan Losses: The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, growth and composition of the loan portfolio, and other relevant factors. The allowance is increased by provisions for loan losses charged against income. Loans Available for Sale: Loans available for sale are stated at the lower of aggregate amortized cost or market. The carrying amount of specific loan pools sold is used to compute gain or loss. Market value is based on prevailing market quotes. Westcorp converts loans to mortgage-backed securities ("MBS") guaranteed by agencies of the federal government, either holding such securities for its own portfolio or selling such securities to investors and servicing underlying mortgage loans. Upon securitization, Westcorp reviews its financial position and liquidity needs in determining the classification of the MBS. Westcorp has also sold mortgage loans to third parties including FNMA and FHLMC without prior securitization. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Westcorp also securitizes and sells retail installment sales contracts while retaining servicing rights. As servicer, Westcorp holds and remits funds collected from the borrowers on behalf of the trustee. These amounts are reported as amounts held on behalf of trustee. Gains and losses on sales of loans and contracts are determined by the difference between sales proceeds and the cost of the loans or contracts adjusted for the present value of the difference, if any, between the estimated future servicing revenues and normal servicing revenues for those loan sales where servicing is retained by Westcorp. Premiums resulting from the present value of such excess revenues are capitalized and amortized over the estimated lives of the loans or contracts. Westcorp regularly evaluates the reasonableness of the assumptions used in the present value gain calculation to reflect actual experience and changes in economic conditions and adjusts the carrying value. Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation and amortization computed principally on the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the lives of the respective leases or the service lives of the improvements, whichever is shorter. Real Estate Owned: Real estate acquired through foreclosure is recorded at the lower of the unpaid principal balance on the loan at the foreclosure date or fair value less selling costs. Subsequent valuation adjustments are made if the fair value of the property falls below the carrying amount. Real Estate Owned also includes properties classified as insubstance foreclosed loans. Loans are classified as insubstance foreclosed when, in management's judgement, the risks and rewards of ownership have been shifted from the borrower to Westcorp as defined by generally accepted accounting principles. These properties are transferred to real estate owned at the lower of the unpaid balance on the loan or fair value. Subsequent valuation adjustments are made if the fair value of the property falls below the carrying amount. The accompanying consolidated financial statements also include the accounts of certain real estate joint venture partnerships. Westcorp has an ownership interest of greater than 50% in all of its real estate partnership transactions. All significant intercompany transactions have been eliminated in consolidation. Real estate acquired for development and sale is carried at the lower of cost or net realizable value. Improvements and holding costs, including interest, are capitalized during construction. The recognition of gains from the sale of real estate is dependent on a number of factors relating to the nature of the property sold, the terms of the sale and the future involvement of Westcorp in the property sold. Real estate owned is carried net of an allowance for potential losses and is maintained at a level believed adequate by management to absorb potential losses in the portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loss experience, current economic conditions, selling costs and other relevant factors. Income Taxes: Westcorp files consolidated federal and state tax returns with all its subsidiaries except for Westhrift, which files a separate tax return. In February 1992, the Financial Accounting Standards Board issued Statement No. 109, "Accounting for Income Taxes." On January 1, 1992, Westcorp adopted the provisions of the new standard in its financial statements for the year ended December 31, 1992. 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 liability method prescribed by Statement 96, which is superseded by Statement 109. Among other changes, Statement 109 changes the recognition and measurement criteria for deferred tax assets included in WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Statement 96. The adoption of Statement 109 had no effect on the net income of Westcorp and prior years' financial statements have not been restated. Excess of Purchase Cost over Net Assets Acquired: The excess of amounts paid over the fair value of assets acquired of a business purchased in 1982 is being amortized over twenty-five years, using the straight-line method. Insurance Commissions: Commissions on insurance policies sold are recognized as income over the life of the policies. Insurance Premiums: Premiums for life and accident/health insurance policies are recognized as income over the term of the insurance contract. Net Income Per Common Share: Net income per common share is based on average shares outstanding during each year plus the net effect of dilutive stock options. Fair Values of Financial Instruments: In December 1991, the Financial Accounting Standards Board issued Statement No. 107, "Disclosures about Fair Value of Financial Instruments". It 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. Statement 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 Westcorp. Cash and Cash Equivalents: Cash and cash equivalents include cash, interest-bearing deposits with other financial institutions and other short-term investments and have no material restrictions as to withdrawal or usage. Reclassifications: Certain amounts for 1992 and 1991 have been reclassified to conform with the 1993 presentation. NOTE B -- INVESTMENT SECURITIES AVAILABLE FOR SALE The aggregate carrying amounts and approximate market values of investment securities available for sale at December 31 were: WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Gross unrealized and realized gains and losses for 1993 were as follows: Gross unrealized and realized gains and losses for 1992 were as follows: Westcorp has no realized losses during 1992. At December 31, 1993, the stated maturities of Westcorp's investment securities available for sale were as follows: WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE C -- MORTGAGE-BACKED SECURITIES AVAILABLE FOR SALE Mortgage-backed securities ("MBS") available for sale consisted of the following at December 31: Unrealized gains and losses for 1993 and 1992 were as follows: Realized gains and losses for 1993 and 1992 were as follows: The stated maturities of Westcorp's mortgage-backed securities available for sale at December 31, 1993 were as follows: Westcorp has issued certain mortgage-backed securities that include recourse provisions. Subject to certain limitations, Westcorp is required for the life of the loans to repurchase the buyer's interest in individual loans on which foreclosure proceedings have been completed. Securities with recourse sold by Westcorp had a total outstanding balance of $36.6 million and $37.7 million at December 31, 1993 and 1992, respectively. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Westcorp has provided for possible losses that may occur as a result of its recourse obligations through the allowance for loan losses. The maximum remaining exposure under these recourse provisions at December 31, 1993 and 1992 was $32.5 and $33.1 million, respectively. Westcorp has pledged $30.3 million of securities as collateral under these recourse provisions. NOTE D -- NET LOANS RECEIVABLE Net loans receivable consisted of the following at December 31: The allowance for loan loss by loan category was as follows at December 31: Loans serviced by Westcorp for the benefit of others totaled approximately $2,170,426,000, $1,410,699,000 and $1,172,994,000 at December 31, 1993, 1992, and 1991, respectively. These amounts are not reflected in the accompanying consolidated financial statements. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Changes in the allowance for loan losses were as follows: At the end of the year, interest on nonaccrual loans excluded from interest income was $1.2 million in 1993 and $8.1 million in 1992. NOTE E -- PREMISES AND EQUIPMENT Premises and equipment consisted of the following at December 31: Interest cost capitalized for the year ended December 31, 1993 was $4,902. NOTE F -- REAL ESTATE OWNED Real estate owned consisted of the following at December 31: Changes in the allowance for real estate losses were as follows: Westcorp has entered into various partnership agreements to acquire and develop real property. Westcorp's interest in each project is greater than 50% and, in some cases, includes a participating share of the profits realized upon sale. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Condensed financial information for these partnerships follows: - --------------- (1) These amounts are eliminated or reclassified upon consolidation. NOTE G -- ACCRUED INTEREST RECEIVABLE Accrued interest receivable consisted of the following at December 31: NOTE H -- SAVINGS DEPOSITS Savings deposits consisted of the following: WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 The aggregate amount of savings deposits in denominations greater than or equal to $100,000 at December 31, 1993 was $355,901,000. Scheduled maturities of certificate accounts as of December 31, 1993 are as follows: Interest expense on savings deposits consisted of the following at December 31: The following table summarizes certificate accounts by interest rate within maturity categories at December 31, 1993 and 1992: WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE I -- SHORT-TERM BORROWINGS Short-term borrowings consisted of the following at December 31: The maximum amount of commercial paper outstanding at any month-end during 1993 and 1992 was $199,606,000 and $199,041,000, respectively. The average amount of commercial paper outstanding during 1993 and 1992 was $53,079,000 and $58,377,000, respectively, with a weighted average interest rate of 3.30% and 4.06%, respectively. NOTE J -- FEDERAL HOME LOAN BANK ADVANCES Advances from the Federal Home Loan Bank (FHLB) are collateralized by the pledge of certain real estate loans with an uncollected principal balance of approximately $603,527,000 and $778,744,000 at December 31, 1993 and 1992, respectively. Information as to interest rates and maturities on the advances from the FHLB as of December 31, 1993 and 1992 follows: The Bank had an unused line of credit with the FHLB at December 31, 1993 of approximately $203,255,000. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE K -- OTHER BORROWINGS AND SUBORDINATED DEBT Other borrowings consisted of the following at December 31: On June 17, 1993, the Bank issued $125,000,000 of 8.5% Subordinated Capital Debentures. Underwriting discounts and expenses totaling $4,851,797 associated with the issuance were capitalized and are being amortized over seven years. The debentures are redeemable, in whole or in part, at the option of the Bank, on or after July 1, 2000 at 100% of the principal amount being redeemed plus accrued interest to the date of redemption. For regulatory purposes, the subordinated debentures, subject to certain limitations, are included as part of the supplementary capital. On April 29, 1987, the Bank issued $75,000,000 of 11% subordinated debentures, due May 1, 1999. Underwriting discounts and expenses totaling $2,024,000 associated with the issuance were capitalized and amortized over five years. The debentures were redeemed, in whole at the option of the Bank, using the proceeds from the new subordinated debenture offering, on September 10, 1993 at 104.4% of the principal amount then outstanding. This early redemption created an extraordinary loss of $1,113,486 net of respective tax benefit of $811,295. The Bank notified holders of the Bonds of its intent to redeem on April 1, 1994, the bonds due in 1995 as allowed within the Bond indenture. The aggregate amount of maturities for each of the next five years, adjusted for the planned bond redemption, are as follows: WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE L -- COMMITMENTS AND CONTINGENCIES Future minimum payments under noncancelable operating leases on premises and equipment with terms of one year or more as of December 31, 1993, are as follows: Rental expense for premises and equipment amounted to $1,958,996, $1,653,886, and $1,816,043 in 1993, 1992, and 1991, respectively. Westcorp's outstanding loan commitments were as follows at December 31: At December 31, 1993 Westcorp had a letter of credit outstanding for $1,016,000, which expires September 23, 1994. Westcorp has pledged certain assets relative to amounts held on behalf of trustees at December 31, 1993 as follows: NOTE M -- STOCK OPTIONS In 1986, Westcorp reserved 945,000 shares of common stock for future issuance to certain employees under an incentive stock option plan. Reserved, unoptioned shares totaled 352,433 and 349,388 shares at December 31, 1993 and 1992, respectively. The options may be exercised at $7.62 per share at any time, in whole or in part, within five years after the date of grant. In 1991, Westcorp reserved an additional 3,150,000 shares of common stock for future issuance to certain employees under a stock option plan. Reserved, unoptioned shares totaled 2,538,316 and 2,746,916 shares at December 31, 1993 and 1992, respectively. The options may be exercised at prices ranging from $7.62 to $11.90 per share at any time, in whole or in part, within five years after the date of grant. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Stock option activity, adjusted for the 1991 stock dividend, is summarized as follows: At December 31, 1993, there were 89,964 and 206,774 exercisable stock options under the 1986 and 1991 plans, respectively. NOTE N -- REGULATORY CAPITAL One of the most significant changes made by FIRREA was that new capital requirements be adopted for savings institutions similar to those of national banks. The new capital standards include three minimum requirements: (1) a leverage (core) ratio; (2) a tangible capital requirement; and (3) a risk-based capital requirement. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 The Bank currently exceeds all current capital standards. A reconciliation of the Bank's capital under generally accepted accounting principles (GAAP) as included in its consolidated balance sheet and regulatory capital at December 31, 1993 is as follows: - --------------- (1) As a percentage of total adjusted assets. (2) As a percentage of risk-weighted assets. (3) Subsequent to December 31, 1993 this requirement was reduced to 3%. NOTE O -- DIVIDENDS AND OTHER RESTRICTIONS Westcorp paid cash dividends of $.20, $.19, and $.13 per share for the years ended December 31, 1993, 1992, and 1991, respectively. The Bank is restricted by regulation and by the indenture for its 8.50% Subordinated Capital Debentures (see Note K) as to the amount of funds which can be transferred to Westcorp in the form of dividends. Under the most restrictive of these terms, on December 31, 1993, restricted shareholder's equity of the Bank totaled $179.3 million. The Bank must notify the OTS of its intent to declare cash dividends 30 days before declaration, and may not make a loan to Westcorp to the extent Westcorp engages in any activity not permitted for a bank holding company. During 1993, the Bank paid no dividends to Westcorp. NOTE P -- PENSION PLAN Westcorp has an Employee Stock Ownership and Salary Savings Plan, which covers essentially all full-time employees who have completed one year of service. Contributions to the plan are discretionary and determined by the Board of Directors within limits set forth by Treasury regulations. Contributions to the plan are fully expensed in the year to which the contribution applies. Westcorp's contribution to the plan amounted to $1,000,000 in 1993. Westcorp did not contribute to the plan in 1992. Contributions to the plan amounted to $1,256,826 in 1991. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE Q -- INCOME TAXES Federal and state franchise taxes (receivable) payable at December 31, were as follows: Other assets include federal and state tax receivables of $4,732,058 at both December 31, 1993 and 1992. Income tax expense (benefit) consisted of the following: The difference between total tax provisions and the amounts computed by applying the statutory federal income tax rate of 35% to income before taxes are due to: On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 was signed into law. Among other things, it provided for a higher tax rate of 35% (previously the tax rate was 34%). This new tax rate was effective beginning January 1, 1993. Approximately $0.3 million has been included in Westcorp's deferred tax asset as a result of this change in the law. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Deferred 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 Westcorp's deferred tax liabilities and assets as of December 31, 1993 and 1992 are as follows: DEFERRED TAX POSITION ASSETS/(LIABILITIES) (IN THOUSANDS) NOTE R -- FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by Westcorp in estimating its fair value disclosures for financial instruments: Cash and cash equivalents: The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets' fair values. Investment securities (including mortgage-backed securities): Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Loans Receivable: For variable-rate loans that reprice frequently, fair values are based on carrying values. The fair values for certain mortgage loans (e.g., one-to-four family residential), and other consumer loans (including automobile loans) are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. The fair values for other loans (e.g., rental property mortgage 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. Savings Deposits: The fair values disclosed for passbook accounts, and certain types of money market accounts are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits. Short-term borrowings: The carrying amounts of a commercial paper line with the FHLB and a bank line of credit approximate their fair values. Long-term borrowings: The fair values of Westcorp's long-term borrowings (other than deposits) are estimated using discounted cash flow analyses, based on Westcorp's current incremental borrowing rates for similar types of borrowing arrangements. The estimated fair values of Westcorp's financial instruments are as follows: NOTE S -- WESTCORP (PARENT COMPANY ONLY) FINANCIAL INFORMATION STATEMENTS OF FINANCIAL CONDITION WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 STATEMENTS OF INCOME WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 STATEMENTS OF CASH FLOWS WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE T -- QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1993 and 1992. Certain quarterly amounts have been adjusted to conform with the year-end presentation. WESTCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 NOTE U -- CURRENT ACCOUNTING PRONOUNCEMENTS In May 1993, the Financial Accounting Standards Board ("FASB") issued Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114") which is effective for fiscal years beginning after December 15, 1994. SFAS 114 is not expected to have a material impact on Westcorp's financial statements. In May 1993, the Financial Accounting Standards Board ("FASB") issued standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115") which is effective for fiscal years beginning after December 15, 1993. Under SFAS 115, Westcorp would be required to recognize unrealized gains and losses on "available for sale" securities as a component of shareholders' equity. While SFAS 115 has not been adopted by Westcorp, had it been in effect at December 31, 1993 Westcorp would have recognized an increase of approximately $1.0 million (net of tax) in shareholders' equity. EXHIBIT INDEX - --------------- * Exhibits previously filed with Westcorp Registration Statement on Form S-4 (File No. 33-34286), filed April 11, 1990 incorporated herein by reference under Exhibit Number indicated. ** Exhibit previously filed with Westcorp Registration Statement in Form S-1 (File No. 33-4295), filed May 2, 1986 incorporated by reference under Exhibit Number indicated. *** Exhibit previously filed with Westcorp Registration Statement on Form S-8 (No. 33-43898), filed December 11, 1991 incorporated by reference under the Exhibit Number indicated.

774459_1993.txt

774459_1993

1993

774459

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.

23675_1993.txt

23675_1993

1993

23675

ITEM 1. BUSINESS (a) General Development of Business - ----------------------------------- Consolidated Freightways, Inc. is a holding company which participates through subsidiaries in various forms of long-haul and regional trucking, intermodal rail and ocean services, domestic and international air cargo delivery services and related transportation activities. These operations are organized into three primary business groups: Long-Haul Trucking (CF MotorFreight), Regional Trucking and Intermodal (Con-Way Transportation Services), and Air Freight (Emery Worldwide). Consolidated Freightways, Inc. was incorporated in Delaware in 1958 as a successor to a business originally established in 1929. It is herein referred to as the "Registrant" or "Company". (b) Financial Information About Industry Segments - ------------------------------------------------- The operations of the Company are primarily conducted in the U.S. and Canada and to a lesser extent in major foreign countries. An analysis by industry group of revenues, operating income (loss), depreciation and capital expenditures for the years ended December 31, 1993, 1992 and 1991, and identifiable assets as of those dates is presented in Note 11 on pages 43 and 44 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. Geographic group information is also presented therein. Intersegment revenues are not material. (c) Narrative Description of Business - ------------------------------------- The Company has designated three principal operating groups: the CF MotorFreight Group provides intermediate and long-haul, less-than-truckload freight service in the U.S. and portions of Mexico, Canada, the Caribbean, Latin and Central America and Europe; the Con-Way Transportation Services Group provides regional trucking, intermodal movements of truckload freight, non-vessel operating common carriage and ocean container freight services; and, the Emery Worldwide Group is responsible for all domestic and international air freight activities. CF MOTORFREIGHT ---------------- CF MotorFreight (CFMF), the Company's largest single operating unit, is based in Menlo Park, California. The group is composed of Consolidated Freightways Corporation of Delaware (CFCD), which includes CF MotorFreight and three other operating units, and three non-carrier component operations. Its carrier group provides general freight services nationwide and in portions of Canada, Mexico, the Caribbean area, Latin and Central America and Europe. General freight is typically shipments of manufactured or non-perishable processed products having high value and requiring expedited service, compared to the bulk raw materials characteristically transported by railroads, pipelines and water carriers. The basic business of the general freight industry is to transport freight that is less-than-truckload (LTL), an industry designation for shipments weighing less than 10,000 pounds. CFMF is one of the nation's largest motor carriers in terms of 1993 revenues. Competition within the industry has intensified since the passage of the Motor Carrier Act of 1980. Consequently, pricing has become increasingly important as a competitive factor. To retain market share, CFMF is also evolving to provide faster, more time definite, higher quality and lower cost services as shippers seek to compress production cycles and cut distribution costs. As a large carrier of LTL general commodity freight, CFMF has pick-up and delivery fleets in each area served, and a fleet of intercity tractors and trailers. It has a network of 539 U.S. and Canadian freight terminals including 28 regional consolidation centers. CFMF is supported by a sophisticated data processing system for the control and management of the business. CFMF provides a regular route, common and contract carrier freight service between points in all 50 states, the Caribbean area, Mexico, Latin and Central America and Europe and to points served by Canadian subsidiaries as discussed below. There is a broad diversity in the customers served, size of shipments, commodities transported and length of haul. No single customer or commodity accounts for more than a small fraction of total revenues. CFMF operates daily schedules utilizing primarily relay drivers driving approximately eight to ten hours each. Some schedules operate with sleeper teams driving designated routes. Road equipment consists of one tractor pulling two 28-foot double trailers or, to a limited extent, one semi-trailer or three 28-foot trailers. Legislation enacted in 1982 has provided for the use of 28-foot double trailers and 48-foot semi-trailers throughout the United States. (See "State Regulation" below.) Trailers in double or triple combination are more efficient and economical than a tractor and single semi-trailer combination. CFMF utilizes trailer equipment 102-inches in width. In 1993, the Company operated in excess of 537 million linehaul miles in North America, about 90% of which was conducted by equipment in doubles and triples configuration. The accident frequency of the triples configuration was better than all other types of vehicle combinations used by the Company. CFMF and other subsidiaries of CFCD serve Canada through terminals in the provinces of Alberta, British Columbia, Manitoba, New Brunswick, Nova Scotia, Ontario, Quebec, Saskatchewan and in the Yukon Territory. Non-Carrier Operations ---------------------- Menlo Logistics provides logistics management services for industrial and retail businesses including carrier management, dedicated fleet and warehouse operations, just-in-time delivery programs, customer order processing and freight bill payment and auditing. The other non-carrier operations within the CF MotorFreight Group generate a majority of their sales from other companies within the CF Group. Road Systems, Inc. primarily manufactures trailers. Willamette Sales Co. serves as a distributor of heavy-duty truck, marine and construction equipment parts. Employees --------- Approximately 88% of CFMF's domestic employees are represented by various labor unions, primarily the International Brotherhood of Teamsters (IBT). CFMF and the IBT are parties to a National Master Freight Agreement. The current agreement with the IBT expires on March 31, 1994. Labor costs, including fringe benefits, average approximately 65% of revenues. This results in a relatively high proportion of variable costs, which allows CFMF flexibility to adjust certain costs to fluctuations in business levels. CFMF's domestic employment has declined to 21,000 employees at December 31, 1993 from approximately 22,000 at December 31, 1992, primarily the result of declining tonnage and several programs to streamline operations during 1993. Fuel ---- Fuel prices have fluctuated during the last three years with prices declining in 1991 following a resolution of the Middle East conflict and fuel prices continued to decline in 1992. Fuel prices declined slightly in 1993 despite increased fuel taxation and stricter environmental regulations. CFMF's average annual diesel fuel cost per gallon (without tax) declined from $.671 in 1991 to $.632 and $.615 in 1992 and 1993, respectively. Federal and State Regulation ---------------------------- On July 1, 1980, the Motor Carrier Act of 1980 became effective. The Act made substantial changes in federal regulation of the motor carrier industry. It provided for easier access to the industry by new trucking companies and eased restrictions on expansion of services by existing carriers. In addition, CFMF's operations are subject to a variety of economic regulations by state authorities. Historically, such regulations also covered, among other things, size and weight of motor carrier equipment. Federal legislation applies to the interstate highway system and to other qualifying federal-aid primary system highways in all states. Full implementation of the federal legislation has been hampered by regulations in certain states, which have imposed trailer length, size and weight limitations on access and intercity routes. These limitations do not conform with the federal requirements and therefore are obstacles to efficient operations. CFMF's mainline operations are designed to avoid locales with these limitations. Canadian Regulation ------------------- The provinces in Canada have regulatory authority over intra-provincial operations of motor carriers and have been delegated by the federal authority to regulate inter-provincial motor carrier activity. Federal legislation to phase in deregulation of the inter-provincial motor carrier industry took effect January 1, 1988. The new legislation relaxes economic regulation of inter-provincial trucking by easing market entry regulations, and implements effective safety regulations of trucking services under Federal jurisdiction. The Company wrote-off substantially all of the unamortized cost of its Canadian operating authority in 1992. CON-WAY TRANSPORTATION SERVICES ------------------------------- Con-Way Transportation Services, Inc. (CTS) is a holding company for operations that individually provide various transportation services, specifically regional trucking, trailer-on-flatcar or containerized movements of truckload freight, non-vessel operating common carriage and ocean container freight services. CTS has five operating units and approximately 7,600 employees. The Con-Way's face more competition than in the past as national LTL companies continue to acquire regional operations, combining previously independent carriers into an inter-regional network. However, growth in quick-response logistics and new service product offerings will provide new market opportunities. Refer to the CF MotorFreight section for a discussion of other factors affecting surface transportation. Regional Carriers ----------------- Each of CTS' four regional carriers operates within a defined geographic area to provide primarily next-day and second day service for freight moving up to 1,000 miles. Con-Way Western Express, Inc. (CWX) began operations in May 1983 and operates in California, Nevada, Arizona, New Mexico, western portions of Texas, Hawaii and Mexico. At December 31, 1993, CWX served customers from 51 service centers. Con-Way Central Express, Inc. (CCX) inaugurated operations in June 1983 and provides service in 13 states of the mid-west, east, north-east and eastern Canada. CCX operated 156 service centers at December 31, 1993. Con-Way Southern Express, Inc. (CSE) began operations in April 1987 and operates in Florida, Alabama, Tennessee, Virginia, North and South Carolina, Maryland, Georgia and Puerto Rico. CSE served customers from 54 service centers at December 31, 1993. Con-Way Southwest Express, Inc. (CSW) began operations in November 1989 and operates in seven southwestern states and Mexico. CSW operated 41 service centers at December 31, 1993. A joint service program initiated by CTS allows the regional carriers to move freight in two-day lanes from a region serviced by one operating unit to regions serviced by other of the operating units within the existing infrastructure. The program allows CTS to compete for second day business not individually serviced by regional carriers. Con-Way Intermodal Inc. ----------------------- The Company offers truckload service and ocean container freight handling. The truckload portion of the Company provides door-to-door intermodal movement of full truckload shipments via rail trailer, and with dedicated containers and pick-up and delivery resources in a nationwide stack train network. The ocean service portion provides international shipping services through offices in more than two dozen international trade centers and serves the U.S., Europe, Hong Kong, Australia, other Pacific Rim nations and most recently Latin America. EMERY WORLDWIDE --------------- Emery Worldwide (EWW), the Company's air freight unit, was formed when the Company purchased Emery Air Freight Corporation in April 1989 and merged it with its air freight operation, CF AirFreight, Inc. The combined companies immediately expanded EWW's ability to deliver air freight within North America and to 88 countries worldwide. EWW provides global air cargo services through an integrated freight system designed for the movement of parcels and packages of all sizes and weights. In North America, EWW provides these services through a system of branch offices and overseas through foreign subsidiaries, branches and agents. EWW provides door-to-door service within North America by using its own airlift system, supplemented with commercial airlines. International services are performed by operating as an air freight forwarder, using commercial airlines, and with controlled lift, only when necessary. Emery also operates approximately 1,590 trucks, vans and tractors. As of December 31, 1993, EWW utilized a fleet of 50 aircraft, 28 of which are leased on a long-term basis, 9 are owned and 13 are contracted on a short- term basis to supplement nightly volumes and to provide feeder services. The nightly lift capacity of the aircraft fleet, excluding charters, is approximately 3.3 million pounds. Emery Worldwide's hub-and-spoke system is centralized at the Dayton International Airport where a leased air cargo facility (Hub) and related support facilities are located. The Hub handles all types of shipments, ranging from small packages to heavyweight cargo, with a total effective sort capacity of approximately 1 million pounds per hour. The operation of the Hub in conjunction with EWW's airlift system enables it to maintain a high level of service reliability. In addition to its nightly Prime Time system, the Company added a new transcontinental daylight service. In the daylight program, two DC-8 freighters crisscross between Hartford, CT and Los Angeles, CA transconnecting the Dayton HUB. These originating cities then connect with their respective regional HUBs. The company added capacity and scheduled the daylight flights to handle increased business levels, respond to customer service needs in key market lanes. The two daylight aircraft are also used in the Prime Time schedule thus achieving better utilization of our assets. Through a separate subsidiary of the Company, Emery Worldwide Airlines, Inc. (EWA), the Company provides nightly cargo airline services under a contract with the U.S. Postal Service (USPS) to carry Express and Priority Mail, using 21 aircraft, 6 of which are leased on a long-term basis and 15 are owned. The original contract for this operation was awarded to EWA in 1989 and had been renewed and extended through early January 1994. A new ten year USPS contract was awarded to the Company during 1993 with service beginning in January 1994. The contract is similar to the previous USPS contract with the exception that the sortation function is not included. The Company has recognized approximately $138 million, $141 million and $199 million of revenue in 1993, 1992 and 1991, respectively, from contracts to carry Express and Priority Mail for the U.S. Postal Service. Customers --------- EWW services, among others, the aviation, automotive, machinery, metals, electronic and electrical equipment, chemical, apparel and film industries. Service industries and governmental entities also utilize EWW's services. Both U.S. and International operations of EWW have wide customer bases. Competition ----------- The heavy air-freight market within North American is highly competitive and price sensitive. Emery has the largest market share in the heavy air-freight segment. EWW competes with other integrated air freight carriers as well as freight forwarders. Competition in the international markets is also service and price sensitive. In these markets, which are more fragmented than the domestic market, EWW competes with both United States and international airlines and air freight forwarders. The North Atlantic market is especially price sensitive due to the abundance of airlift capacity. Customers are seeking companies such as EWW with combined integrated carrier and freight forwarding capabilities for flexible, cost effective service. Emery believes this infrastructure and the convenience of its 235 worldwide service locations are its principal methods of competing in the market in which it operates. Regulation ---------- Regulation of Air Transportation -------------------------------- The air transportation industry is subject to federal regulation by the Federal Aviation Act of 1958, as amended (Aviation Act) and regulations issued by the Department of Transportation (DOT) pursuant to the Aviation Act. EWW, as an air freight forwarder, and EWA, as an airline, are subject to different regulations. Air freight forwarders are exempted from most DOT economic regulations and they are not subject to Federal Aviation Administration (FAA) safety regulations so long as they do not have operational control of aircraft. Airlines are subject to economic regulation by DOT and maintenance, operating and other safety-related regulation by FAA. Thus, EWA and other airlines conducting operations for EWW are subject to DOT and FAA regulation while EWW, itself, is not covered by most DOT and FAA regulations. Regulation of Ground Transportation ----------------------------------- When EWW provides ground transportation of cargo having a prior or subsequent air movement, the ground transportation is exempt from regulation by the Interstate Commerce Commission (ICC). However, EWW holds ICC and intrastate motor carrier authorities which can be utilized in providing non-exempt ground transportation. Registration of ICC authorities is required in each state where a motor carrier conducts non-exempt operations, and some states also have required EWW to register as an exempt interstate operator. Environmental Matters --------------------- During recent years, operations at several airports have been subject to restrictions or curfews on arrivals or departures during certain night-time hours designed to reduce or eliminate noise for surrounding residential areas. None of these restrictions have materially affected EWW's operations. If such restrictions were to be imposed with respect to the airports at which EWW's activities are centered and no alternative airports were available to serve the affected areas, EWW's operations could be more adversely affected. As provided in Section 611 of the Aviation Act, the FAA with the assistance of the Environmental Protection Agency (EPA), is authorized to establish aircraft noise standards. Under the National Emission Standards Act of 1967, as amended by the Clean Air Act Amendments of 1970, the administrator of the EPA is authorized to issue regulations setting forth standards for aircraft emissions. EWW believes that its present fleet of owned, leased or chartered aircraft is operating in compliance with the applicable noise and emission laws. The Aviation Noise and Capacity Act of 1990 was passed in November of 1990 to establish a national aviation noise policy. The FAA has promulgated regulations under this Act regarding the phase-in requirements for compliance. This legislation and the related regulations will require all of EWW's and EWA's owned and leased aircraft to either undergo modifications or otherwise comply with Stage 3 noise restrictions by year-end 1999. Fuel and Supplies Cost ---------------------- EWW purchases substantially all of its jet fuel from major oil companies, refiners and trading companies on annual contracts with prepaid and/or volume discounts. These contract purchases are supplemented by spot purchases. The weighted average price of domestic jet fuel declined in 1993 and 1992, respectively. During 1991, the weighted average price of domestic jet fuel declined following the resolution of the Middle East conflict early in the year. The 1993 domestic cost per gallon was approximately $.64 compared with 1992 and 1991 weighted average prices of approximately $.67 and $.72 per gallon, respectively. EWW believes that it has the flexibility to continue its operations without material interruption unless there are significant curtailments of its jet fuel supplies. Neither Emery Worldwide nor the operators of the aircraft it charters have experienced or anticipate any fuel supply problems. There is a four-million gallon fuel storage facility at the Hub. Employees --------- As of December 31, 1993, Emery Worldwide had approximately 7,500 full and permanent part-time employees as compared to 6,700 in 1992 and 7,000 in 1991. Approximately 15% of these employees are covered by union contracts. GENERAL - ------- The research and development activities of the Company are not significant. During 1993, 1992 and 1991 there was no single customer of the Company that accounted for more than 10% of consolidated revenues. The total number of employees is presented in the "Ten Year Financial Summary" on pages 46 and 47 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. The Company has been designated a Potentially Responsible Party (PRP) by the EPA with respect to the disposal of hazardous substances at various sites. The Company expects its share of the clean-up cost to be immaterial. The Company expects the costs of complying with existing and future federal, state and local environmental regulations to continue to increase. On the other hand, they do not anticipate that such cost increases will have any materially adverse effects on capital expenditures, earnings or competitive position. (d) Financial Information About Foreign and Domestic Operations and Export Sales ---------------------------------------- Information as to revenues, operating income (loss) and identifiable assets for each of the Company's business segments and for its foreign operations for 1993, 1992 and 1991 is contained in Note 11 on page 43 and 44 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES The following summarizes the terminals and freight service centers operated by the Company at December 31, 1993: Owned Leased Total ----- ------ ----- CF MotorFreight 275 264 539 Con-Way Transportation Services 38 264 302 Emery Worldwide 9 226 235 The following table sets forth the location and square footage of the Company's principal freight handling facilities: Location Square Footage -------- -------------- CFMF - motor carrier LTL consolidation center terminals Mira Loma, CA 280,672 Chicago, IL 231,159 * Columbus, OH 118,774 Memphis, TN 118,745 Nashville, TN 118,622 Orlando, FL 101,557 * Minneapolis, MN 94,890 St. Louis, MO 88,640 * Pocono, PA 86,285 Chicopee, MA 85,164 Akron, OH 82,494 Sacramento, CA 81,286 Atlanta, GA 77,920 Houston, TX 77,346 Dallas, TX 75,358 * Fremont, IN 73,760 Location Square Footage -------- -------------- CFMF - motor carrier LTL consolidation center terminals * Peru, IL 73,760 Buffalo, NY 73,380 Cheyenne, WY 71,298 Milwaukee, WI 70,661 Salt Lake City, UT 68,480 Charlotte, NC 66,896 Seattle, WA 59,720 * York, PA 56,384 Kansas City, MO 55,288 * Indianapolis, IN 54,716 Portland, OR 47,824 Phoenix, AZ 20,237 CTS - freight assembly centers Chicago, IL 113,116 Oakland, CA 85,600 Dallas, TX 82,000 Atlanta, GA 56,160 Cincinnati, OH 55,618 Columbus, OH 48,527 Detroit, MI 46,240 Santa Fe Springs, CA 45,936 Aurora, IL 44,235 Ft. Wayne, IN 35,400 Pontiac, MI 34,450 St. Louis, MO 29,625 Milwaukee, WI 22,940 Emery - facilities *Dayton, OH 620,000 Los Angeles, CA 78,264 Indianapolis, IN 38,500 * Facility partially or wholly financed through the issuance of industrial revenue bonds. Principal amount of debt is secured by the property. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The legal proceedings of the Company are summarized in Note 10 on page 43 of the 1993 Annual Report to Shareholders and are incorporated herein by reference. A discussion of certain environmental matters is presented in Item 1 and Item 7. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ------- ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The Company's common stock is listed for trading on the New York and Pacific Stock Exchanges. The Company's Common Stock Price is included in Note 12 on page 45 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. Cash dividends on common shares had been paid in every year from 1962 to 1990. In June 1990, however, the Company's Board of Directors suspended the quarterly dividend to minimize the Company's cash requirements. Under the terms of the restructured TASP Notes, as set forth on pages 35 and 36 of the 1993 Annual Report to Shareholders, the Company is restricted from paying dividends in excess of $10 million plus 50% of the cumulative net income applicable to common shareholders since the commencement of the agreement. As of December 31, 1993, there were 15,785 holders of record of the common stock ($.625 par value) of the Company. The number of shareholders is also presented in the "Ten Year Financial Summary" on pages 46 and 47 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data is presented in the "Ten Year Financial Summary" on pages 46 and 47 of 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 Management's Discussion and Analysis of Financial Condition and Results of Operations is presented in the "Financial Review and Management Discussion" on pages 24 through 26, inclusive, of the 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and Auditors' Report are presented on pages 27 through 33, inclusive, of the 1993 Annual Report to Shareholders and are incorporated herein by reference. The unaudited quarterly financial data is included in Note 12 on page 45 of the 1993 Annual Report to Shareholders 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 COMPANY The identification of the Company's Directors is presented on pages 3 through 9, inclusive, of the Proxy Statement dated March 18, 1994 and those pages are incorporated herein by reference. The Executive Officers of the Company, their ages at December 31, 1993 and their applicable business experience are as follows: Donald E. Moffitt, 61, President and Chief Executive Officer. Mr. Moffitt joined Consolidated Freightways Corporation of Delaware, the Company's principal motor carrier subsidiary, as an accountant in 1955 and advanced to Vice President - Finance in 1973. In 1975, he transferred to the Company as Vice President - Finance and Treasurer and in 1981 was elected Executive Vice President - Finance and Administration. In 1983 he assumed the additional duties of President, CF International and Air, Inc., where he directed the Company's international and air freight businesses. Mr. Moffitt was elected Vice Chairman of the Board of the Company in 1986. He retired as an employee and as Vice Chairman of the Board of Directors in 1988 and returned to the Company as Executive Vice President - Finance and Chief Financial Officer in 1990. Mr. Moffitt was named President and Chief Executive Officer of the Company and was elected to the Board of Directors in 1991. Mr. Moffitt serves on the Executive Committee of the Board of Directors of the Highway Users Federation and is a member of the Board of Directors of the Bay Area Council, the Automotive Safety Foundation and the American Red Cross. He is a member of the California Business Roundtable and a member of the Business Advisory Council of the Northwestern University Transportation Center. He also serves on the Advisory Council of the Peninsula Conflict Resolution Center. Mr. Moffitt is a member of the Advisory Nominating and the Executive Committees of the Company. W. Roger Curry, 55, President and Chief Executive Officer of Emery Air Freight Corporation and Senior Vice President of the Company. Mr. Curry joined CFCD in 1969 as a Systems Analyst and became Coordinator, On-Line Systems of the Company in 1970. In 1972 he was named Director of Terminal Properties for CFCD. He became President of CFAF in 1975 and Chief Executive Officer in 1984. Mr. Curry relinquished both offices with CFAF in 1986 when he was elected Senior Vice President - Marketing of the Company. In 1991 he was elected President of Emery Air Freight Corporation. Robert H. Lawrence, 56, Executive Vice President - Operations of the Company and President and Chief Executive Officer of CFCD. Mr. Lawrence joined the Company in 1969 as an Assistant Terminal Manager and advanced to Vice President of the Eastern Area by 1977. He became Vice President of Operations for CFCD in 1979 and President in 1986. In 1989, while continuing as President of CFCD, he was elected a Senior Vice President of the Company. In 1991, he was elected as Executive Vice President - Operations of the Company. Gregory L. Quesnel, 45, Executive Vice President and Chief Financial Officer. Mr. Quesnel joined Consolidated Freightways Corporation of Delaware in 1975 as Director of Financial Accounting. Through several increasingly responsible financial positions, he advanced to become the top financial officer of CFCD. In 1989 he was elected Vice President-Accounting for the Company and in 1990 was named Vice President and Treasurer. Mr. Quesnel became Senior Vice President-Finance and Chief Financial Officer of the Company in 1991 and later Executive Vice President and Chief Financial Officer in 1993. Robert T. Robertson, 52, President and Chief Executive Officer of Con-Way Transportation Services, Inc. and Senior Vice President of the Company. Mr. Robertson joined CFCD in 1970 as a sales representative and advanced to Manager of Eastern Area Sales by 1973. He transferred to Texas in 1976 where he became involved in CFCD's operations and was promoted to Division Manager in 1978. In 1983 he was named Vice President and General Manager of Con-Way Transportation Services, Inc. In 1986, Mr. Robertson was elected President of CTS. Eberhard G.H. Schmoller, 50, Senior Vice President and General Counsel of the Company. Mr. Schmoller joined CFCD in 1974 as a staff attorney and in 1976 was promoted to CFCD assistant general counsel. In 1983, he was appointed Vice President and General Counsel of CF Airfreight and assumed the same position with Emery after the acquisition in 1989. Mr. Schmoller was named Senior Vice President and General Counsel of the Company in 1993. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The required information for Item 11 is presented on pages 13 through 16, inclusive, of the Proxy Statement dated March 18, 1994, and those pages are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The required information for Item 12 is included on pages 10 and 11 of the Proxy Statement dated March 18, 1994, and 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) Financial Statements and Exhibits Filed --------------------------------------- 1. Financial Statements See Index to Financial Information. 2. Financial Statement Schedules See Index to Financial Information. 3. Exhibits See Index to Exhibits. (b) Reports on Form 8-K ------------------- There were no reports on Form 8-K filed for the three months 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 Form 10-K Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. CONSOLIDATED FREIGHTWAYS, INC. (Registrant) March 28, 1994 /s/Donald E. Moffitt -------------------------------------- Donald E. Moffitt President and Chief Executive Officer March 28, 1994 /s/Gregory L. Quesnel -------------------------------------- Gregory L. Quesnel Executive Vice President and Chief Financial Officer March 28, 1994 /s/Robert E. Wrightson -------------------------------------- Robert E. Wrightson Vice President and Controller 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. March 28, 1994 /s/Raymond F. O'Brien ------------------------------------- Raymond F. O'Brien Chairman of the Board March 28, 1994 /s/Donald E. Moffitt ------------------------------------- Donald E. Moffitt President, Chief Executive Officer and Director March 28, 1994 /s/John C. Bolinger, Jr. ------------------------------------- John C. Bolinger, Jr., Director March 28, 1994 /s/Earl F. Cheit ------------------------------------- Earl F. Cheit, Director March 28, 1994 /s/G. Robert Evans ------------------------------------- G. Robert Evans, Director March 28, 1994 /s/Robert Jaunich II ------------------------------------- Robert Jaunich II, Director March 28, 1994 /s/John S. Perkins ------------------------------------- John S. Perkins, Director CONSOLIDATED FREIGHTWAYS, INC. FORM 10-K Year Ended December 31, 1993 - --------------------------------------------------------------------------- - --------------------------------------------------------------------------- INDEX TO FINANCIAL INFORMATION ------------------------------ Consolidated Freightways, Inc. and Subsidiaries - ----------------------------------------------- The following Consolidated Financial Statements of Consolidated Freightways, Inc. and Subsidiaries appearing on pages 27 through 45, inclusive, of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference: Report of Independent Public Accountants Consolidated Balance Sheets - December 31, 1993 and 1992 Statements of Consolidated Operations - Years Ended December 31, 1993, 1992 and 1991 Statements of Consolidated Cash Flows - Years Ended December 31, 1993, 1992 and 1991 Statements of Consolidated Shareholders' Equity - Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements In addition to the above, the following consolidated financial information is filed as part of this Form 10-K: Page ---- Consent of Independent Public Accountants 20 Report of Independent Public Accountants 20 Schedule V - Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 21 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment - Years Ended December 31, 1993, 1992 and 1991 22 Schedule VIII - Valuation and Qualifying Accounts 23 Schedule X - Supplementary Income Statement Information 24 The other schedules (Schedules I through IV, VII, IX and XI through XIV) have been omitted because either (1) they are neither required nor applicable or (2) the required information has been included in the consolidated financial statements or notes thereto. SIGNATURE CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS ----------------------------------------- As independent public accountants, we hereby consent to the incorporation of our reports included and incorporated by reference in this Form 10-K, into the Company's previously filed Registration Statement File Nos. 2-81030, 33-29793, 33-45313 and 33-52599. /s/Arthur Andersen & Co. ------------------------- ARTHUR ANDERSEN & CO. San Francisco, California March 28, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- To the Shareholders and Board of Directors of Consolidated Freightways, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Consolidated Freightways, Inc.'s 1993 Annual Report to Shareholders incorporated by reference 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 those statements taken as a whole. The schedules on pages 21 through 24 are the responsibility of the Company's management and are presented for the 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. -------------------------- ARTHUR ANDERSEN & CO. San Francisco, California January 28, 1994 SCHEDULE VIII CONSOLIDATED FREIGHTWAYS, INC. VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 (In thousands) DESCRIPTION - ----------- ALLOWANCE FOR DOUBTFUL ACCOUNTS ADDITIONS BALANCE AT CHARGED TO CHARGED TO BALANCE AT BEGINNING COSTS AND OTHER END OF OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS PERIOD ---------- ---------- ---------- ---------- ---------- 1993 $26,198 $27,127 $ - $(23,545) (a) $29,780 ------- ------- -------- --------- ------- 1992 $25,742 $29,707 $ - $(29,251) (a) $26,198 ------- ------- -------- --------- ------- 1991 $30,385 $29,858 $ - $(34,501) (a) $25,742 ------- ------- -------- --------- ------- a) Accounts written off net of recoveries. SCHEDULE X CONSOLIDATED FREIGHTWAYS, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, (In thousands) 1993 1992 1991 -------- ------- -------- Maintenance and Repairs $131,512 $146,375 $151,475 ======== ======== ======== Taxes, other than Payroll and Income Taxes: Fuel $ 63,147 $ 56,066 $ 54,385 Other 43,647 39,675 41,142 -------- -------- -------- $106,794 $ 95,741 $ 95,527 ======== ======== ======== INDEX TO EXHIBITS ITEM 14(a)(3) Exhibit No. - ----------- (3) Articles of incorporation and by-laws: 3.1 Consolidated Freightways, Inc. Certificates of Incorporation, as amended. (Exhibit 3(a)(2) to the Company's Quarterly Report Form 10-Q for the quarter ended March 31, 1987*) 3.2 Consolidated Freightways, Inc. By-laws, as amended March 29, 1993. (4) Instruments defining the rights of security holders, including debentures: 4.1 Consolidated Freightways, Inc. Stockholder Rights Plan. (Exhibit 1 on Form 8-A dated October 27, 1986*) 4.2 Certificate of Designations of the Series B Cumulative Convertible Preferred Stock. (Exhibit 4.1 as filed on Form SE dated May 25, 1989*) 4.3 Indenture between the Registrant and Security Pacific National Bank, trustee, with respect to 9-1/8% Notes Due 1999 and Medium- Term Notes, Series A. (Exhibit 4.1 as filed on Form SE dated March 20, 1990*) 4.4 Form of Security for 9-1/8% Notes Due 1999 issued by Consolidated Freightways, Inc. (Exhibit 4.1 as filed on Form SE dated August 25, 1989*) 4.5 Officers' Certificate dated as of August 24, 1989 establishing the form and terms of debt securities issued by Consolidated Freightways, Inc. (Exhibit 4.2 as filed on Form SE dated August 25, 1989*) 4.6 Form of Security for Medium-Term Notes, Series A to be issued by Consolidated Freightways, Inc. (Exhibit 4.1 as filed on Form SE dated September 18, 1989*) 4.7 Officers' Certificate dated September 18, 1989, establishing the form and terms of debt securities to be issued by Consolidated Freightways, Inc. (Exhibit 4.2 as filed on Form SE dated September 19, 1989*) 4.8 Form of Certificate of Designations of the Series C Conversion Preferred Stock (incorporated by reference to Exhibit 4.3 contained in Form SE dated January 29, 1992*). 4.9 Form of Stock Certificate for Series C Conversion Preferred Stock (incorporated by reference to Exhibit 4.4 contained in Form SE dated January 29, 1992*). 4.10 Subsidiary Guaranty Agreement dated July 30, 1993 among Consolidated Freightways, Inc. and various financial institutions in connection with the $250 million Credit Agreement of the same date. (Exhibit 4.1 to the Company's Form 10-Q for the quarterly period ended June 30, 1993*). * Previously filed with the Securities and Exchange Commission and incorporated herein by reference. Exhibit No. - ----------- (4) Instruments defining the rights of security holders, including debentures (continued): Instruments defining the rights of security holders of long-term debt of Consolidated Freightways, Inc., and its subsidiaries for which financial statements are required to be filed with this Form 10-K, of which the total amount of securities authorized under each such instrument is less than 10% of the total assets of Consolidated Freightways, Inc. and its subsidiaries on a consolidated basis, have not been filed as exhibits to this Form 10-K. The Company agrees to furnish a copy of each applicable instrument to the Securities and Exchange Commission upon request. (10) Material contracts: 10.1 Consolidated Freightways, Inc. Long-Term Incentive Plan of 1978, as amended through Amendment No. 4. (Exhibit 10(e) to the Company's Form 10-K for the year ended December 31, 1983*) 10.2 Amendments 5, 6 and 7 to the Consolidated Freightways, Inc. Long-Term Incentive Plan of 1978, as amended through Amendment No. 4. (Exhibit 10.1 as filed on Form SE dated March 25, 1991*) 10.3 Consolidated Freightways, Inc. Long-Term Incentive Plan of 1988. (Exhibit 10(g) to the Company's Form 10-K for the year ended December 31, 1987*) 10.4 Amendment 3 to the Consolidated Freightways, Inc. Long-Term Incentive Plan of 1988. (Exhibit 10.2 as filed on Form SE dated March 25, 1991*) 10.5 Consolidated Freightways, Inc. Stock Option Plan of 1978, as amended through Amendment No. 1. (Exhibit 10(e) to the Company's Form 10-K for the year ended December 31, 1981*) 10.6 Consolidated Freightways, Inc. Stock Option Plan of 1988 as amended. (Exhibit 10(i) to the Company's Form 10-K for the year ended December 31, 1987 as amended in Form S-8 dated December 16, 1992*) 10.7 Forms of Stock Option Agreement (with and without Cash Surrender Rights) under the Consolidated Freightways, Inc. Stock Option Plan of 1988. (Exhibit 10(j) to the Company's Form 10-K for the year ended December 31, 1987*) 10.8 Form of Consolidated Freightways, Inc. Deferred Compensation Agreement. (Exhibit 10(i) to the Company's Form 10-K for the year ended December 31, 1981*) 10.9 Consolidated Freightways, Inc. Retirement Plan (formerly Emery Air Freight Corporation Pension Plan), as amended effective through January 1, 1985, and amendments dated as of October 30, 1987. (Exhibit 4.22 to the Emery Air Freight Corporation Quarterly Report on Form 10-Q dated November 16, 1987**) * Previously filed with the Securities and Exchange Commission and incorporated herein by reference. ** Incorporated by reference to indicated reports filed under the Securities Act of 1934, as amended, by Emery Air Freight Corporation File No. 1-3893. Exhibit No. - ----------- 10.10 Emery Air Freight Plan for Retirees, effective October 31, 1987. (Exhibit 4.23 to the Emery Air Freight Corporation Quarterly Report on Form 10-Q dated November 16, 1987**) 10.11 Consolidated Freightways, Inc. Common Stock Fund (formerly Emery Air Freight Corporation Employee Stock Ownership Plan, as effective October 1, 1987 ("ESOP"). (Exhibit 4.33 to the Emery Air Freight Corporation Annual Report on Form 10-K dated March 28, 1988**) 10.12 Employee Stock Ownership Trust Agreement, dated as of October 8, 1987, as amended, between Emery Air Freight Corporation and Arthur W. DeMelle, Daniel J. McCauley and Daniel W. Shea, as Trustees under the ESOP Trust. (Exhibit 4.34 to the Emery Air Freight Corporation Annual Report on Form 10-K dated March 28, 1988**) 10.13 Amended and Restated Subscription and Stock Purchase Agreement dated as of December 31, 1987 between Emery Air Freight Corporation and Boston Safe Deposit and Trust Company in its capacity as successor trustee under the Emery Air Freight Corporation Employee Stock Ownership Plan Trust ("Boston Safe"). (Exhibit B to the Emery Air Freight Corporation Current Report on Form 8-K dated January 11, 1988**) 10.14 Supplemental Subscription and Stock Purchase Agreement dated as of January 29, 1988 between Emery Air Freight Corporation and Boston Safe. (Exhibit B to the Emery Air Freight Corporation Current Report on Form 8-K dated February 12, 1988**) 10.15 Trust Indenture, dated as of November 1, 1988, between City of Dayton, Ohio and Security Pacific National Trust Company (New York), as Trustee and Bankers Trust Company, Trustee. (Exhibit 4.1 to Emery Air Freight Corporation Current Report on Form 8-K dated December 2, 1988**) 10.16 Bond Purchase Agreement dated November 7, 1988, among the City of Dayton, Ohio, the Emery Air Freight Corporation and Drexel Burnham Lambert Incorporated. (Exhibit 28.7 to the Emery Air Freight Corporation Current Report on Form 8-K dated December 2, 1988**) 10.17 Lease agreement dated November 1, 1988 between the City of Dayton, Ohio and Emery Air Freight Corporation. (Exhibit 10.1 to the Emery Air Freight Corporation Annual Report on Form 10-K for the year ended December 31, 1988**) * Previously filed with the Securities and Exchange Commission and incorporated herein by reference. ** Incorporated by reference to indicated reports filed under the Securities Act of 1934, as amended, by Emery Air Freight Corporation File No. 1-3893. Exhibit No. - ----------- 10.18 Credit Agreement dated January 14, 1993, by and among Emery Receivables Corporation as the borrower, Emery Air Freight Corporation, Consolidated Freightways, Inc., individually and as Servicer and various financial institutions. (Exhibit 10.19 to the Company's Form 10-K for the year ended December 31, 1992*). 10.19 Purchase and Sale Agreement, dated January 14, 1993, among Emery Air Freight Corporation and Emery Distribution Systems, Inc., as Originators, Emery Receivables Corporation, and Consolidated Freightways, Inc., as Servicer. (Exhibit 10.20 to the Company's Form 10-K for the year ended December 31, 1992*). 10.20 Consolidated Freightways, Inc. Directors' Election Form for deferral payment of director's fees. 10.21 Consolidated Freightways, Inc. 1993 Executive Deferral Plan. (Exhibit 10.22 to the Company's Form 10-K for the year ended December 31, 1992*). 10.22 Consolidated Freightways, Inc. Executive Incentive Plan for 1994. 10.23 CF MotorFreight Incentive Plan for 1994. 10.24 Con-Way Transportation Services, Inc. Incentive Plan for 1994. 10.25 Emery Worldwide Incentive Plan for 1994. 10.26 $250 million Credit Agreement dated July 30, 1993 among Consolidated Freightways, Inc. and various financial institutions. (Exhibit 10.1 to the Company's Form 10-Q for the quarterly period ended June 30, 1993*). 10.27 Letter of Credit Facility Agreement dated as of July 30, 1993 between Consolidated Freightways, Inc. and Bank of America National Trust and Savings Association. (Exhibit 10.2 to the Company's Form 10-Q for the quarterly period ended June 30, 1993*). 10.28 Official Statement of the Issuer's Special Facilities Revenue Refunding Bonds, 1993 Series E and F dated September 29, 1993 among the City of Dayton, Ohio and Emery Air Freight Corporation. (Exhibit 10.1 to the Company's Form 10-Q for the quarterly period ended September 30, 1993*). 10.29 Trust Indenture, dated September 1, 1993 between the City of Dayton, Ohio and Banker's Trust Company as Trustee. (Exhibit 10.2 to the Company's Form 10-Q for the quarterly period ended September 30, 1993*). 10.30 Supplemental Lease Agreement dated September 1, 1993 between the City of Dayton, Ohio, as Lessor, and Emery Air Freight Corporation, as Lessee. (Exhibit 10.3 to the Company's Form 10-Q for the quarterly period ended September 30, 1993*). 10.31 Supplemental Retirement Plan dated January 1, 1990. 10.32 Directors' 24-Hour Accidental Death and Dismemberment Plan. 10.33 Executive Split-Dollar Life Insurance Plan dated January 1, 1994. 10.34 Board of Directors' Compensation Plan dated January 1, 1994. 10.35 Excess Benefit Plan dated January 1, 1987. 10.36 Directors' Business Travel Insurance Plan. * Previously filed with the Securities and Exchange Commission and incorporated herein by reference. Exhibit No. - ---------- 10.37 Deferred Compensation Plan for Executives dated October 1, 1993. 10.38 1993 Nonqualified Employee Benefit Plans Trust Agreement dated October 1, 1993. (13) Annual report to security holders: Consolidated Freightways, Inc. 1993 Annual Report to Shareholders (Only those portions referenced herein are incorporated in this Form 10-K. Other portions such as "To Our Shareholders and Employees" are not required and, therefore, are not "filed" as part of this Form 10-K.) (22) Significant Subsidiaries of the Company. (28) Additional documents: 28.1 Consolidated Freightways, Inc. 1993 Notice of Annual Meeting and Proxy Statement dated March 18, 1994. (Only those portions referenced herein are incorporated in this Form 10-K. Other portions are not required and, therefore, are not "filed" as a part of this Form 10-K.) 28.2 Note Agreement dated as of July 17, 1989, between the ESOP, Consolidated Freightways, Inc. and the Note Purchasers named therein. (Exhibit 28.1 as filed on Form SE dated July 21, 1989*) 28.3 Guarantee and Agreement dated as of July 17, 1989, delivered by Consolidated Freightways, Inc. (Exhibit 28.2 as filed on Form SE dated July 21, 1989*). 28.4 Form of Restructured Note Agreement between Consolidated Freightways, Inc., Thrift and Stock Ownership Trust as Issuer and various financial institutions as Purchasers named therein, dated as of November 3, 1992. (Exhibit 28.4 to the Company's Form 10-K for the year ended December 31, 1992*). 28.5 Form of Restructured Guarantee and Agreement between Consolidated Freightways, Inc., as Issuer and various financial institutions as Purchasers named therein, dated as of November 3, 1992. (Exhibit 28.5 to the Company's Form 10-K for the year ended December 31, 1992*). The remaining exhibits have been omitted because either (1) they are neither required nor applicable or (2) the required information has been included in the consolidated financial statements or notes thereto. * Previously filed with the Securities and Exchange Commission and incorporated herein by reference.

357301_1993.txt

357301_1993

1993

357301

Item 1. Business General TrustCo Bank Corp NY ("TrustCo") is a one-bank holding company having its principal place of business at 320 State Street, Schenectady, New York 12305. TrustCo Bank Corp NYwas organized in 1981 to acquire all of the outstanding stock of Trustco Bank New York, formerly known as The Schenectady Trust Company. Following the necessary regulatory approvals, TrustCo commenced business on July 1, 1982. Through policy and practice, TrustCo continues to emphasize that it is an equal opportunity employer. There are 452 full-time equivalent employees at year-end. Bank Subsidiary TrustCo's subsidiary, Trustco Bank New York ("Bank"), is a New York State chartered trust company, engaged in a general commercial banking business serving individuals, partnerships, corporations, municipalities and governments of New York. The largest part of such business consists of accepting deposits and making loans and investments. The Bank provides a wide range of both personal and business banking services. The Bank is a member of the Federal Reserve system and its deposits are insured by the Federal Deposit Insurance Corporation to the extent permitted by law. The Bank accounted for substantially all of TrustCo's 1993 consolidated net income and average assets. The trust department of the Bank acts as executor of estates and trustee of personal trusts, gives estate planning and related advice, provides custodial services and acts as trustee of various types of employee benefit plans and corporate pension and profit sharing trusts. The aggregate market value of the assets under trust, custody or management was approximately $671 million as of December 31, 1993. The daily operations of the Bank remains the responsibility of its Board of Directors and officers, subject to the overall supervision of TrustCo. TrustCo, as the parent corporation, derives most of its income from dividends paid to it by its subsidiary Bank. TrustCo's Bank subsidiary is included in TrustCo's consolidated financial statements. ORE Subsidiary During 1993, TrustCo created ORE Subsidiary Corp., a New York corporation, to hold and manage certain foreclosed properties. The accounts of this new subsidiary are included in TrustCo's consolidated financial statements. Competition TrustCo's subsidiary Bank encounters keen competition from other commercial banks, including New York City-based holding companies which are some of the largest and most competitive institutions in the United States. In addition, savings banks, savings and loan associations, credit unions and other financial and related institutions compete for the banking, trust, investment and other financial services which Bank offers. On a regular basis, TrustCo has discussions with other financial institutions relative to potential merger or acquisition opportunities. Supervision and Regulation Banking is a highly regulated industry, with numerous federal and state laws and regulations governing the organization and operation of banks and their affiliates. As a bank holding company under the Bank Holding Company Act of 1956, as amended (the "Act"), TrustCo is regulated and examined by the Board of Governors of the Federal Reserve System (the "Board"). The Act requires that TrustCo obtain prior Board approval for bank and non-bank acquisitions and restricts the business operations permitted to TrustCo. The Bank is subject to regulation and examination by the New York State Banking Department. Virtually all aspects of TrustCo's and the Bank's business are subject to regulation and examination by the Board, the Federal Deposit Insurance Corporation and the New York State Banking Department. Most of TrustCo's revenues consist of cash dividends paid to TrustCo by its subsidiary Bank, payment of which is subject to various state and federal regulatory limitations. (Reference is made to Note 1(j) of TrustCo's consolidated financial statements for information concerning restrictions on TrustCo's ability to pay dividends.) In addition, the Federal Deposit Insurance Corporation and the Board have established guidelines with respect to the maintenance of appropriate levels of capital by a bank holding company under their jurisdictions. Compliance with the standards set forth in such guidelines could also limit the amount of dividends which a bank or a bank holding company may pay. The banking industry is also affected by the monetary and fiscal policies of the federal government, including the Board, which exerts considerable influence over the cost and availability of funds obtained for lending and investing. Proposals to change the laws and regulations governing the operations and taxation of banks, companies which control banks and other financial institutions are frequently raised in Congress and in the New York state legislature and before various bank regulatory authorities. The likelihood of any major changes and the impact such changes might have on TrustCo are impossible to determine. Foreign operations Neither TrustCo nor the Bank engage in material operations in foreign countries or have any outstanding loans to foreign debtors. Statistical Information Analysis The "Financial Review" on pages 26-44 of TrustCo's Annual Report to Shareholders for the year ended December 31, 1993, which contains a presentation and discussion of statistical data relating to TrustCo, are hereby incorporated by reference. The information with respect to such tables should not be construed to imply any conclusion on the part of the management of TrustCo that the results, causes or trends indicated therein will continue in the future. The nature and effects of governmental monetary policy, supervision and regulation, future legislation, inflation and other economic conditions and many other factors which affect interest rates, investments, loans, deposits and other aspects of TrustCo's operations are extremely complex and could make historical operations, earnings, assets and liabilities not indicative of what may occur in the future. Item 2. Item 2. Properties TrustCo's executive offices are located at 320 State Street, Schenectady, New York, 12305. The Bank operates 43 offices, of which 20 are owned and 23 are leased from others. These properties, when considered in the aggregate, are not material to the operation of TrustCo. Item 3. Item 3. Legal Proceedings The nature of TrustCo's business generates a certain amount of litigation against TrustCo and its subsidiary Bank involving matters arising in the ordinary course of business. In the opinion of management of TrustCo, there are no proceedings pending to which TrustCo or either of its subsidiaries is a party, or of which its property is the subject which, if determined adversely to TrustCo or such subsidiary, would be material in relation to TrustCo's consolidated stockholders' equity and financial condition. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. Executive Officers of TrustCo The following is a list of the names and ages of the executive officers of TrustCo and their business history for the past five years: PART II Item 5. Item 5. Market for the Corporation's Common Equity and Related Stockholder Matters Page 45 of TrustCo's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated herein by reference. The closing price for the Corporation's common stock on March 10, 1994, was $21.50. Item 6. Item 6. Selected Financial Data Page 26 of TrustCo's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Pages 26 through 44 of TrustCo's Annual Report to Shareholders for the year ended December 31, 1993, are incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data The financial statements, together with the report thereon of KPMG Peat Marwick on pages 10 through 25 of TrustCo's Annual Report to Shareholders for the year ended December 31, 1993, 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. Director and Executive Officers of TrustCo The information under the captions "Information on TrustCo Directors and Nominees" and "Information on TrustCo Executive Officers Not Listed Above" on pages 3 through 5, and "COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934" on page 18, of TrustCo's Proxy Statement for its Annual Meeting of Shareholders to be held May 16, 1994, is incorporated herein by reference. The required information regarding TrustCo's executive officers is contained in PART I in the item captioned "Executive Officers of TrustCo." Item 11. Item 11. Executive Compensation The information under the captions "TrustCo and Trustco Bank Executive Officer Compensation" and "TrustCo Retirement Plans" on pages 6 through 9 of TrustCo's Proxy Statement for its Annual Meeting of Shareholders to be held May 16, 1994, is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information under the captions "Information on TrustCo Directors and Nominees,""Information on TrustCo Executive Officers Not Listed Above," on pages 6 through 9 and "OWNERSHIP OF TRUSTCO COMMON STOCK BY CERTAIN BENEFICIAL OWNERS" on page 17 of TrustCo's Proxy Statement for its Annual Meeting of Shareholders to be held May 16, 1994, is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions The information under the caption "Transactions with TrustCo and Trustco Bank Directors, Officers and Associates" on page 18 of TrustCo's Proxy Statement for its Annual Meeting of Shareholders to be held May 16, 1994, is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K The following financial statements of TrustCo and its consolidated subsidiary, and the accountants' report thereon are incorporated herein by reference. Consolidated Financial Statements. Consolidated Statements of Condition--December 31, 1993 and 1992. Consolidated Statements of Income--Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Changes in 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. Financial Statement Schedules--Not Applicable. All required schedules for the corporation and its subsidiary have been included in the consolidated financial statements or related notes thereto The following exhibits are incorporated herein by reference: The following exhibits are filed herewith: Reports on Form 8-K: On October 18, 1993, TrustCo filed a Current Report on Form 8-K reporting (1) a 2 for 1 stock split payable on November 18, 1993, to shareholders of record at the close of business on October 15, 1993, and (2) second-quarter and six-month earnings. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the TrustCo Bank Corp NY(the "Corporation") pursuant to the foregoing provisions, or otherwise, the Corporation 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 indeminifcation against such liabilities (other than the payment by the Corporation of expenses incurred or paid by a director, officer or controlling person of the Corporation 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 Corporation 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 indeminification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. ________________ [FN] the exhibits included under Exhibit 10 constitute all management contracts, compensatory plans and arrangements required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. 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 by the undersigned, thereunto duly authorized. TrustCo Bank Corp NY By/s/Robert A. McCormick _____________________________ Robert A. McCormick President (chief executive officer) By/s/William F. Terry _____________________________ William F. Terry Secretary (chief financial officer) By/s/Peter A. Zakriski _____________________________ Peter A. Zakriski Treasurer (chief accounting officer) Date: March 22, 1993 EXHIBIT INDEX Reg S-K Item 601 Exhibit No. Exhibit ________________________________________________________________________ 3(i) TrustCo's Amended and Restated Certificate of Incorporation. 3(ii) Amended and Restated By-laws of TrustCo Bank Corp NY, as amended to August 15, 1989 Exhibit 3(a) to TrustCo Bank Corp NY's S-4 Registration Statement (File No. 33-40379) effective May 8, 1991 is incorporated by reference. 10(a) Employment Agreement dated January 1, 1992 and Amendment dated November 16, 1993, between TrustCo Bank Corp NY, Trustco Bank New York and Robert A. McCormick. 10(b) Employment Agreement dated January 1, 1992 and Amendment dated November 16, 1993, between TrustCo Bank Corp NY, Trustco Bank New York and Nancy A. McNamara. 10(c) Employment Agreement dated January 1, 1992 and Amendment dated November 16, 1993, between TrustCo Bank Corp NY, Trustco Bank New York and William F. Terry. 10(d) Employment Agreement dated January 1, 1992 and Amendment dated November 16, 1993, between TrustCo bank Corp NY, Trustco Bank New York and Peter A. Zakriski. 10(e) Employment Agreement dated January 1, 1992 and Amendment dated November 16, 1993, between TrustCo Bank Corp NY, Trustco Bank New York and Ralph A. Pidgeon. 10(f) TrustCo Bank Corp NY Amended and Restated 1985 Stock Option Plan. 10(g) TrustCo Bank Corp NY Directors Stock Option Plan. 11 Computation of Net Income Per Common Share. 13 Annual Report to Security Holders of Trustco for the year ended December 31, 1993. GRAPHICS APPENDIX Cross References to Page of Omitted Charts Annual Report _________________________________________________________________________ 1. Total Average Equity 3 2. Average Earning Assets 3 3. Net Income Per Common Share 3 4. Cash Dividends Per Common Share 3 5. Total Average Assets--10 Year History 7 6. Assets Per Employee--10 Year History 7 7. Net Income--10 Year History 7 8. Return on Equity--10 Year History 7 9. Market Price/Share--10 Year History 7 The above listed charts were omitted from the EDGAR version of Exhibit 13, however, the information depicted in the charts was adequately discussed and/or displayed in tabular format in the EDGAR Version. 21 List of Subsidiaries of TrustCo. 23 Independent Auditors' Consent of KPMG Peat Marwick. 24 Power of Attorney. 99 Independent Auditors' Report of KPMG Peat Marwick. ________________ [FN] Incorporated by reference. [DESCRIPTION] EXHIBIT 3(i) TO FORM 10-K State of New York Department of State ss: I hereby certify that I have compared the annexed copy with the original document filed by the Department of State and that the same is a correct transcript of said original. Witness my hand and seal of the Department of State on Aug 6 1993 Secretary of State DOS-200 (12/87) AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF TRUSTCO BANK CORP NY UNDER SECTION 807 OF THE BUSINESS CORPORATION LAW Filed By: William F. Terry, Secretary TrustCo Bank Corp NY 320 State Street/P.O. Box 1082 Schenectady, New York 12301 AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF TRUSTCO BANK CORP NY UNDER SECTION 807 OF THE BUSINESS CORPORATION LAW We, Robert A. McCormick and William F. Terry, being respectively, the President and Chief Executive Officer and Senior Vice President and Secretary of TrustCo Bank Corp NY, certify: FIRST. (_) The name of the Corporation is TRUSTCO BANK CORP NY. SECOND. (_) The Certificate of Incorporation was filed by the Department of State on the twenty-eighth day of October 1981. An Amended and Restated Certificate of Incorporation was filed by the Department of State on the fifteenth day of July 1988 and an Amendment to the Amended and Restated Organization Certificate was filed by the Department of State on the twenty- ninth day of August 1991. THIRD. (_) The Certificate of Incorporation of the Corporation is restated as set forth in its entirety below. The only change to the certificate of incorporation is increase in the number of authorized shares of common stock set forth in Section 4.1 of Article IV from 10,000,000 shares to 25,000,000 shares. FOURTH. (_) The Certificate of Incorporation, as amended and restated, is set forth below: Article I Name 1. (_) The name of the corporation is: TrustCo Bank Corp NY (hereinafter called the "Corporation"). Article II Purposes 2. (_) Subject to any limitation provided in the Business Corporation Law or any other statute of the State of New York, and except as otherwise specifically provided in this Certificate, the purposes for which the Corporation is formed are: 2.1 (_) To the extent that a corporation formed under the Business Corporation Law of the State of New York may lawfully do so, to acquire, own, control, hold with power to vote, deal in and with, and dispose of, in any manner, interests in financial institutions, including, without limitation, banks, trust companies, savings banks, national banking associations, savings and loan associations, industrial banks, investment banks, service banks, safe deposit companies, credit unions, and mutual trust investment companies, located within or without the State of New York, and to acquire, own, control, hold with power to vote, deal in and with, and dispose of, in any manner, interests in any other companies, corporations, partnerships, trusts, unincorporated associations, joint stock associations, and other entities, which are engaged in activities related to the business of banking. 2.2 (_) To the extent that a corporation formed under the Business Corporation Law of the State of New York may lawfully do so, to engage in, carry on, conduct, and participate in activities, enterprises and businesses permitted to be engaged in, carried on, conducted and participated in by bank holding companies under applicable provisions of law and also research, experimenting, manufacturing, assembling, building, erecting, trading, buying, selling, collecting, distributing, wholesaling, retailing, importing, exporting, processing, compounding, producing, refining, synthesizing, mining, extracting, growing, liquidating, dismantling, demolishing, servicing, promoting, exhibiting and publishing activities, enterprises and businesses; and also any activities, enterprises, ventures and businesses similar or incidental to any of the foregoing. 2.3 (_) To create, acquire, hold, deal in and with, and dispose of, in any manner, any legal or equitable interest in real property and chattels real, and, without limiting the generality of the foregoing, to purchase, receive, take (by grant, gift, devise, bequest or otherwise), own, hold, improve, employ, use, operate, manage, repair, control, maintain, sell, assign, transfer, convey, exchange, lease, alter, construct, mortgage or encumber real property, whether improved or unimproved, and structures and improvements on real property, or leaseholds, or any other legal or equitable interests or rights therein. 2.4 (_) To create, acquire, hold, deal in and with, and dispose of, in any manner, any legal or equitable interest in tangible or intangible personal property, and, without limiting the generality of the foregoing, to make, purchase, receive, take (by grant, gift, bequest, lease, exchange or otherwise), own, hold, improve, employ, use, operate, manage, repair, control, maintain, process, import, export, sell, assign, transfer, convey, exchange, lease, or otherwise dispose of, mortgage, ledge or otherwise encumber or in any manner to exploit, turn to account, trade or deal in or with, personal property, whether tangible or intangible, or any other legal or equitable interests or rights therein. 2.5 (_) To make, create, apply for, renew, take (by grant, gift, bequest or otherwise), purchase, lease or otherwise acquire, to hold, own, register, use, operate, to sell, assign, license, lease, transfer, exchange or otherwise dispose of, to mortgage, pledge or otherwise encumber, to acquire or grant licenses with respect to, or in any manner to exploit, turn to account, trade or deal in or with, copyrights, trademarks, service marks, designs, inventions, discoveries, improvements, developments, processes, formulas, patents, trade names, labels, prints, or any interest or right, whether legal or equitable, therein. 2.6 (_) To purchase, take (by grant gift, bequest or otherwise), receive, subscribe for, invest in or otherwise acquire, own, hold, employ, sell, lend, lease, exchange, transfer, assign, or otherwise dispose of, mortgage, pledge, use, and otherwise deal in and with, or in respect of shares, stock, bonds, debentures, warrants, rights, scrip, notes, evidences of indebtedness, certificates of interest or participation in profit-sharing agreements, collateral trust certificates, preorganization certificates and subscriptions, investment contracts, voting trust certificates, certificates of deposit or other securities or obligations of any kind by whomsoever issued (whether or not engaged in similar or different businesses, governmental or other activities); to exercise in respect thereof all powers and privileges of individual or corporate ownership or interest therein, including the right to vote thereon (by proxy or otherwise) for any and all purposes; to consent or otherwise act with respect thereto, without limitation and to issue in exchange therefor the Corporation's shares, stock, bonds, debentures, warrants, rights, scrip, notes, evidences of indebtedness, or other securities or obligations of any kind. 2.7 (_) To make contracts, incur debts and other liabilities, and borrow money on such terms and at such rate of interest as the Corporation may determine; and to mortgage, pledge, convey, assign, in trust or otherwise encumber or dispose of, the property, good will, franchises or other assets of the Corporation, including contract rights and including after-acquired property. 2.8 (_) To lend money, with or without security; provided that the Corporation shall not have the power to engage in the business of banking. 2.9 (_) To issue, reissue, sell, assign, exchange, pledge, negotiate or otherwise dispose of, to purchase, receive, take, own, hold or otherwise acquire, to deal in or with, or to cancel, shares, stock, bonds, debentures, warrants, rights, scrip, notes, evidences of indebtedness or other securities or obligations of the corporation of any kind, whether secured or unsecured, and whether or not convertible into or subordinated to any other class of securities. 2.10 (_) In furtherance of its corporate business, to guarantee or assume liability for the payment of the principal of, or dividends or interest on, or sinking fund payments in respect of, shares, stock, bonds, debentures, warrants, rights, scrip, notes, evidences of indebtedness, certificates of interest or participation in profit-sharing agreements, collateral trust certificates, preorganization certificates and subscriptions, investment contracts, voting trust certificates, certificates of deposit, or other securities or obligations of any kind by whomsoever issued; and to guarantee or assume liability for the performance of any other contract or obligation, made or issued by any domestic or foreign corporation, partnership, association, trustee, group, individual or entity; and, when authorized in any manner provided by law, to give any guaranty although not in furtherance of the Corporation's purposes 2.11 (_) In furtherance of its corporate business, to be a promoter, partner, co-venturer, member, associate or manager of other business enterprises or ventures, or to be an agent thereof, or to the extent permitted in any jurisdiction to be an incorporator of other corporations of any kind or type. 2.12 (_) To cause to be formed under the laws of any state or country, to control or in any manner participate in the management of, to reorganize, merge, consolidate, and to liquidate or dissolve any corporation, association or organization of any kind. 2.13 (_) To engage in, carry on, conduct and/or participate in any activity, enterprise or business which is similar or related to any activity, enterprise or business herein set forth, or which is capable of being conveniently carried on incidental to any such activity, enterprise or business or which may directly or indirectly protect or enhance the value of any of the rights or property of the Corporation. 2.14 (_) To engage in, carry on, conduct and/or participate in any general or specific branch or phase of the activities, enterprises or businesses authorized in this Certificate in the State of New York or in any other state of the United States and in all foreign countries, and in all territories, possessions and other places, and in connection with the same, or any thereof, to he and act either as principal, agent, contractor or otherwise. 2.15 (_) To do everything necessary, suitable, convenient or proper for the accomplishment, attainment or furtherance of, to do every other act or thing incidental to, appurtenant to, growing out of or connected with, the purposes set forth in this Certificate, whether alone or in association with others; to possess all the rights, powers and privileges now or hereafter conferred by the law of the State of New York upon a corporation organized under the Business Corporation Law of the State of New York (as the same may be amended from time to time) or any statute which may be enacted to supplement or replace it, and, in general, to carry on any of the activities and to do any of the things herein set forth to the same extent and as fully as a natural person or a partnership, association, corporation, or other entity, or any of them, might or could do; provided that nothing herein set forth shall be construed as authorizing the Corporation to possess any purpose, object, or power, or to do any act or thing forbidden by law to a corporation organized under the Business Corporation Law of the State of New York. The foregoing provisions of this Article shall be construed as purposes, objects and powers, and each as an independent purpose, object and power, in furtherance, and not in limitation, of the purposes, objects and powers granted to the Corporation by the laws of the State of New York; and except as otherwise specifically provided in any such provision, no purpose, object or power herein set forth shall be in any way limited or restricted by reference to, or inference from, any other provision of this Certificate. Article III Office The office of the corporation is to be located in the City of Schenectady, County of Schenectady, and State of New York. Article IV Number of Shares; Preemptive Rights Denied 4.1 (_) The total number of shares of Common Stock which the Corporation shall have authority to issue is 25,000,000 shares of the par value of $1 per share. The total number of shares of Preferred Stock which the Corporation shall have authority to issue is 500,000 shares of the par value of $10 per share. The Board of Directors of the Corporation shall have the authority to provide for the issuance of the Preferred Stock in one or more series, with such voting powers, full or limited, but not to exceed one vote per share, or without voting powers, and with such designations, conversion rights, redemption prices, dividend rates and similar matters, including preferences over shares of Common Stock or other series of Preferred Stock as to dividends or distributions of assets and relative participation, optional or other special rights, and qualifications, limitations or restrictions thereof, as shall be set forth in resolutions providing for the issuance thereof that may be adopted by the Board of Directors. 4.2 (_) No holder of shares of the Corporation shall be entitled as of right to subscribe for, purchase or receive any new or additional shares of any class, whether now or hereafter authorized, or any notes, bonds, debentures or other securities convertible into, or carrying options or warrants to purchase, shares of any class; but all such new or additional shares of any class, or notes, bonds, debentures or other securities convertible into, or carrying options or warrants to purchase, shares of any class may be issued or disposed of by the Board of Directors to such persons and on such terms as it, in its absolute discretion, may deem advisable. Article V Designation of Secretary of State; Mailing Address 5. (_) The Secretary of State is designated as the agent of the Corporation upon whom process in any action or proceeding against the Corporation may be served, and the address to which the Secretary of State shall mail a copy of process in any action or preceeding against the Corporation which may be served upon him is: 320 State Street Schenectady, New York 12301 Attn: Corporate Secretary Article VI Directors; Election and Classification 6. (_) The entire Board of Directors, consisting of not less than twelve (12) members and not more than fifteen (15) members, shall be divided into three (3) classes of not less than four (4) members each, which classes are hereby designated as Class A, Class B and Class C. The number of directors of Class A shall equal one-third (1/3) of the total number of directors as determined in the manner provided in the By-Laws (with any fractional remainder to count as one); the number of directors of Class B shall equal one-third (1/3) of the total number of directors (or the nearest whole number thereto); and the number of directors of Class C shall equal said total number of directors minus the aggregate number of directors of Classes A and B. At the election of the first Board of Directors, the class of each of the members then elected shall be designated. The term of office of each member then designated as a Class A director shall expire at the annual meeting of shareholders next ensuing, that of each member then designated as a Class B director at the annual meeting of shareholders one year thereafter, and that of each member then designated as a Class C director at the annual meeting of shareholders two years thereafter. At each annual meeting of shareholders held after the election and classification of the first Board of Directors, directors to succeed those whose terms expire at such annual meeting shall be elected to hold office for a term expiring at the third succeeding annual meeting of shareholders and until their respective successors are elected and have qualified or until their respective earlier displacement from office by resignation, removal or otherwise. Article VII Duration 7. (_) The duration of the Corporation is to be perpetual. Article VIII Shareholders<197>Quorum, Voting and Special Meetings 8. (_) The holders of at least a majority of the outstanding Voting Stock of the Corporation shall be present in person or by proxy at any meeting of shareholders in order to constitute a quorum for the transaction of any business, and the affirmative vote of at least a majority of the Corporation's outstanding Voting Stock shall be needed to approve any matter on which such shareholders are entitled to vote except that the affirmative vote or request, as the case may be, of at least two-thirds of the Corporation's Voting Stock shall be needed to effect a change, modification or repeal of any provision in the Certificate of Incorporation or By-Laws and to call a Special Meeting of the shareholders. This provision does not affect those circumstances under which shareholders may call a Special Meeting for the election of directors as a matter of law and the right of management to call shareholder meetings as set forth in the By-Laws. Article IX Quorum and Voting Requirements at Directors' Meeting 9. (_) A majority of the Board of Directors shall be present at any meeting of Directors in order to constitute a quorum for the transaction of any business. The affirmative vote of a majority of the entire Board of Directors shall be necessary for the transaction of any business or specified item of business, except as otherwise provided in this Certificate, and except that, the affirmative vote of two-thirds of the entire Board of Directors shall be necessary to change, amend or repeal any provision of the Certificate of Incorporation or By-Laws. Article X Business Combination 10.1 (_) Shareholder Approval of Business Combinations<197>Maximum Vote. (A) (_) Except as otherwise expressly provided in Section 10.2 of this Article 10, the approval of any Business Combination (as hereinafter defined) shall, in addition to any affirmative vote required by law or any other provision of this Certificate of Incorporation or any preferred stock designation of the Corporation, require the affirmative vote of the holders of not less than two-thirds of the shares of the Corporation then entitled to vote generally in the election of directors of the Corporation (hereinafter in this Article 10 referred to as "Voting Stock"), voting together as a single class, with each share of Voting Stock to have one (1) vote. (B) (_) The term "Business Combination" as used in this Article 10 shall mean: (i) (_) any merger or consolidation of the Corporation or any Subsidiary (as hereinafter defined) with (a) any Substantial Shareholder (as hereinafter defined) or (b) any other corporation which, after such merger or consolidation, would be a Substantial Shareholder, regardless of which entity survives; (ii) (_) any sale, lease, exchange, mortgage, pledge, transfer or other disposition (in one transaction or a series of transactions) to or with any Substantial Shareholder of all or any significant part of the assets of the Corporation or any Subsidiary, or both, with a "significant part of the assets" to be defined as more than ten percent (10%) of the total assets of such entity as shown on its audited statement of condition as of the end of the most recent fiscal year ending prior to the time the particular transaction is announced; (iii) (_) the adoption of any plan or proposal for the liquidation or dissolution of the Corporation proposed by or on behalf of any Substantial Shareholder; or (iv) (_) any transaction involving the Corporation or any Subsidiary, including any issuance, transfer or reclassification of any securities of, or any recapitalization of, the Corporation or any Subsidiary, or any merger or consolidation of the Corporation with any Subsidiary (whether or not involving a Substantial Shareholder), if the transaction would have the effect, directly or indirectly, of increasing the proportionate share of the outstanding shares of any class of equity or convertible securities of the Corporation or any Subsidiary which is owned directly or indirectly by a Substantial Shareholder. 10.2 (_) Exception to Maximum Vote Requirement. The provision of Section 10.1 of this Article 10 shall not be applicable to any Business Combination, and such Business Combination shall require only such affirmative shareholder vote as is required by law or otherwise, if, in the case of a Business Combination which does not involve any cash or other consideration being received by shareholders of the Corporation (in their capacities as shareholders), the condition specified in the following paragraph (i) is met, or, in the case of any Business Combination, either the condition specified in the following paragraph (i) is met or the condition specified in the following paragraph (ii) is met: (i) (_) the Business Combination shall have been approved by two-thirds of the Disinterested Directors (as hereinafter defined), it being understood that this condition shall not be capable of satisfaction unless there is at least one Disinterested Director. (ii) (_) the consideration to be received per share by holders of Common Stock of the Corporation and by holders of each other class of Voting Stock outstanding, if any, shall be Fair Consideration (as hereinafter defined). 10.3 (_) Definitions. (A) (_) "Fair Consideration" shall mean, (i) (_) in the case of shares of Common Stock, an amount in cash or readily available funds at least equal to the highest of the following (whether or not the Substantial Shareholder has previously acquired such shares): (a) (_) the highest per share price paid by the Substantial Shareholder for any such shares acquired by it within the three-year period immediately preceding the first public announcement of the proposal of the Business Combination (hereinafter referred to as the "Announcement Date"), plus an "Interest Adjustment" of such price, as defined hereafter in this Section 10.3(A); (b) (_) the highest reported per share price at which such shares were publicly traded during the three-year period immediately preceding the Announcement Date, plus an "Interest Adjustment" of such price, as defined hereafter in this Section 10.3(A); (c) (_) the per share fair market value of such shares on the Announcement Date, plus an "Interest Adjustment" of such value, as defined hereafter in this Section 10.3(A); (d) (_) the book value per share of Common Stock as of the end of the latest fiscal quarter preceding the Announcement Date, plus an "Interest Adjustment" of such value, as defined hereafter in this Section 10.3(A); (ii) (_) and in the case of shares of any class of Voting Stock of the Corporation outstanding, an amount in cash or readily available funds at least equal to the highest of the following (whether or not the Substantial Shareholder has previously acquired any such shares); (a) (_) the highest per share price paid by the Substantial Shareholder for any such shares acquired by it within the three-year period immediately preceding the Announcement Date, plus an "Interest Adjustment" of such price, as defined hereafter in this Section 10.3(A); (b) (_) the highest reported per share price at which such shares were public traded during the three-year period immediately preceding the Announcement Date, plus an "Interest Adjustment" of such price, as defined hereafter in this Section 10.3(A); (c) (_) the per share fair market value of such shares on the Announcement Date, plus an "Interest Adjustment" of such value, as defined hereafter in this Section 10.3(A); (d) (_) the highest preferential amount per share to which the holders of such shares are entitled in the event of voluntary or involuntary liquidation or dissolution of the Corporation. An "Interest Adjustment" of any price or value per share for a class of shares under this Section 10.3(A) shall equal an amount of interest on such price or value compounded annually from the Announcement Date until the Consummation Date of the Business Combination (the "Consummation Date"), or, in the case of subdivisions (a) and (b) in each of the subsections (A)(i) and (A)(ii) in this Section 10.3, from the date the Substantial Shareholder first became a Substantial Shareholder (the "Determination Date") until the Consummation Date, at a market prime rate of interest as may be determined from time to time by a majority of the Disinterested Directors, less the aggregate amount of any cash dividends per share paid on such class of shares during such period up to but not in excess of such amount of interest. (B) (_) "Substantial Shareholder" shall mean and include any individual, corporation, partnership or other person or entity (other than the Corporation or any Subsidiary) which, together with its "Affiliates" and "Associates" (as such terms were defined as of December 11, 1984, in Rule 12b-2 under the Securities Exchange Act of 1934) is the "Beneficial Owner" (as defined in accordance with the criteria set forth as of December 11, 1984, under Rule 13d-3 under the Securities Exchange Act of 1934) in the aggregate of more than five percent (5%) of the voting power of the then-outstanding Voting Stock of the Corporation of any Affiliate or Associate of any such individual, corporation, partnership or other person or entity. (C) (_) "Subsidiary" shall mean any corporation of which a majority of any class of equity security is owned, directly or indirectly, by the Corporation. (D) (_) "Disinterested Director" shall mean any member of the Board of Directors of the Corporation (the "Board") who is unaffiliated with the Substantial Shareholder and who was a member of the Board prior to the Determination Date or became a member of the Board after the Determination Date and was recommended or elected by a majority of Disinterested Directors then on the Board. 10.4 (_) Interpretative Power of Disinterested Directors. A majority of the Disinterested Directors from time to time shall have the power and duty to determine, on the basis of facts known to them after reasonable inquiry, all facts necessary to determine compliance with this Article 10, including, without limitation, (1) whether a person or entity is a Substantial Shareholder, (2) whether the price in a proposed Business Combination is Fair Consideration, (3) the number of shares of Voting Stock beneficially owned by any person or entity at any given time, and (4) the fair market value as of any given date of the shares of any class of Voting Stock. 10.5 (_) Alteration, Amendment and Repeal Notwithstanding any provision of this Certificate of Incorporation or any provision of law or any preferred stock designation of the Corporation which might otherwise permit a lesser vote or no vote, but in addition to any affirmative vote of the holders of any particular class or series of the Voting Stock required by law or this Certificate of Incorporation or any preferred stock designation of this Corporation, the affirmative vote of the holders of at least two-thirds of the voting power of the then-outstanding shares of Voting Stock, voting together as a single class, shall be required to alter, amend or repeal, or to adopt any provision inconsistent with, this Article 10 or any provision of this Article 10. Article XI 11. (_) To the fullest extent that the Business Corporation Law of the State of New York, as the same exists or may hereafter be amended, permits elimination or a limitation of the liabilities of directors, no director of the corporation shall be liable to the corporation, or its shareholders for any breach of duty in such capacity. Any repeal or modification of this Article by the shareholder of the corporation shall be prospective only and shall not adversely affect any elimination or limitation of the personal liability of a director of the corporation for acts or omissions occurring prior to the effective date of such repeal or modification. FIFTH. (_) This Amendment was authorized by a vote of the Board of Directors, followed by a vote of the holders of a majority of all outstanding shares entitled to vote thereon at a meeting of Shareholders on the seventeenth day of May, 1993. SIXTH. (_) This restatement of the Certificate of Incorporation of the Corporation was authorized by a majority vote of the Board of Directors pursuant to section 807 of the Business Corporation Law. IN WITNESS WHEREOF, THE UNDERSIGNED HAVE SIGNED THIS CERTIFICATE THIS 27th DAY OF JULY, 1993, AND DO HEREBY AFFIRM THE CONTENTS TO BE TRUE UNDER THE PENALTIES OF PERJURY. ROBERT A. McCORMICK President WILLIAM F. TERRY Secretary STATE OF NEW YORK ) ) ss. COUNTY OF SCHENECTADY ) ROBERT A. McCORMICK, being duly sworn, deposes and says that he is the President and Chief Executive Officer of TRUSTCO BANK CORP NY, the Corporation named in the foregoing Certificate, that he has read and signed said Certificate and knows the contents thereof, and that the statements contained therein are true. ROBERT A. McCORMICK PRESIDENT AND CHIEF EXECUTIVE OFFICER Sworn to before me this 27th day of July, 1993 Notary Public RESOLUTION RELATING TO AMENDMENT AND RESTATEMENT OF ORGANIZATION CERTIFICATE RESOLVED, That the Certificate of Incorporation of the Corporation be and hereby is restated to reflect the amendments to the Certificate of Incorporation adopted since the previous restatement on the eighth day of July, 1988, including the amendment adopted at the meeting of the shareholders of the Corporation on the seventeenth day of May, 1993; such Amended and Restated Certificate of Incorporation, in the form presented to this meeting, correctly sets forth the corresponding provisions of the Certificate of Incorporation, as amended, and is hereby adopted on behalf of the Corporation. RESOLVED, That the appropriate officers of the Corporation be, and they hereby are, authorized and directed to execute and deliver and file such certificates and other documents, including the delivery of an Amended and Restated Certificate of Incorporation, to the Department of State of the State of New York, and to take such action and do such other things as may, in their judgment, be necessary and advisable in order to fully effectuate the foregoing resolutions. I hereby certify that the above is a true and correct excerpt from the minutes of a regular meeting of the Board of Directors of TrustCo Bank Corp NY held on July 20, 1993, at the Main Office of the Company at 320 State Street, Schenectady, New York, that a quorum of directors was present and acting throughout the meeting, and that the resolutions adopted at the meeting as set forth above are in full force and effect by a majority of the Board of Directors. Secretary Date [DESCRIPTION] EXHIBIT 10(a) TO FORM 10-K Executive Employment Agreement for R.A. McCormick EMPLOYMENT AGREEMENT between TRUSTCO BANK NEW YORK and TRUSTCO BANK CORP NY and ROBERT A. McCORMICK EMPLOYMENT AGREEMENT AGREEMENT, dated as of January 1, 1992, (the "Agreement"), by and between TRUSTCO BANK NEW YORK, a New York banking corporation (the "Bank") and TRUSTCO BANK CORP NY, a New York business corporation (the "Company") (hereinafter referred to collectively as the "Companies"), with principal offices at 320 State Street, Schenectady, New York 12301 and ROBERT A McCORMICK (the "Executive"), residing at 16 Greenlea Drive, Clifton Park, New York 12065. 1. Engagement. The Companies agree to engage the Executive and the Executive agrees to serve the Companies as President and Chief Executive Officer. 2. Term. The term of this Agreement shall commence on January 1, 1992 and shall continue until December 31, 1994. Beginning on January 1, 1995, and on January 1 of each and every year thereafter, this Agreement shall renew, automatically, for the succeeding three year term, unless the Executive is notified by the method described in Paragraph 10 herein to the contrary ("Nonrenewal Notice"). Nothing contained herein, however, shall be construed to extend the Executive's right to employment beyond the age of 65 years or the then mandatory retirement age in effect at the Companies, whichever shall be greater. 3. Services. The Executive shall exert his best efforts and devote substantially all of his time and attention to the affairs of the Companies. The Executive shall be the President and Chief Executive Officer of the Companies, and shall have full authority and responsibility for the operation of the Companies, subject to the general direction, approval, and control of the Boards of Directors of the Companies in all respects. His powers shall include the authority to hire and fire personnel of the Companies, including employees who are also members of the Boards of Directors, and to retain consultants when he deems necessary in order to implement the Companies' policies. 4. Compensation. For purposes of this Agreement, Annual Compensation shall be deemed to be the Executive's Annual Base Salary plus executive incentive. During the first twelve months of employment pursuant to this Agreement, the Executive shall be paid by the Companies the Annual Base Salary provided on Schedule A attached hereto, which Annual Base Salary shall be paid biweekly, plus executive incentive. Thereafter, Annual Compensation shall be negotiated between the parties hereto and shall be deemed a part of this Agreement, provided, however, that Annual Compensation shall not be less than Executive's Annual Compensation for the immediately preceding calendar year. 5. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive, the Executive shall be allowed to participate fully in any disability, death benefit, retirement, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. 6. Termination of Employment. In the event there is a Termination (as hereinafter defined) of the Executive for any reason other than for good cause (as hereinafter defined), death, retirement or disability, the Executive shall receive, upon his Termination of employment with either of the Companies, the Termination Benefits set forth hereinbelow. The Executive's Termination for good cause shall be limited to the Executive's having committed an act of fraud, embezzlement, or theft constituting a felony, or an act intentionally against either of the Companies which causes either Company material injury, or a final determination by a court that the Executive has committed a material breach of his duties and responsibilities in connection with rendering services to either of the Companies pursuant to this Agreement. 7. Termination. Termination shall include, but is not limited to, (i) any reduction in the Executive's Annual Compensation, disability, death, retirement, pension or profit sharing benefits (unless such reduction shall have been applied to all Bank employees as part of a validly adopted plan of cost containment), responsibilities or duties, or (ii) either Company's relocation or a change in the Executive's base location, or (iii) a Nonrenewal Notice given pursuant to Paragraph 2 of this Agreement, or (iv) the unilateral election of the Executive to terminate the Agreement. Such election shall be communicated to the Companies pursuant to Paragraph 10 hereof. 8. Termination Benefits. The following benefits shall be Termination Benefits: (a) The Companies shall pay to the Executive the Executive's full Annual Compensation through the effective date of his Termination at the rate in effect at the time notice of termination is given or at time of Termination, if earlier, and in addition (b) The Companies shall pay to the Executive, at Executive's option, either: (i) within ten (10) days of his Termination an additional lump sum amount equal to three (3) times the Annual Compensation then in effect pursuant to paragraph 4 above, which sum shall be reduced to present value as determined by a certified public accountant to be agreed upon between the parties, or (ii) three equal payments each in an amount equal to the Executive's Annual Compensation then in effect, the first such payment to be made within ten (10) days of the Termination and each subsequent payment to be made annually on the anniversary date of the initial payment, and in addition (c) The Companies shall pay to the Executive all benefits payable to the Executive under the Companies' retirement, pension and profit sharing plans, and in addition (d) The Companies shall pay the Executive all legal fees and expenses incurred by the Executive as a result of such Termination, and in addition (e) The Companies shall provide the Executive, for the greater of one year or the remaining term of this Agreement following his Termination, health insurance and group life insurance benefits substantially similar to those the Executive was receiving immediately prior to his Termination. 9. Indemnity. The Companies shall indemnify the Executive and hold him harmless for any acts or decisions made by him in good faith while performing services for either of the Companies and shall use their best efforts to obtain coverage for him under any insurance policy now in force or hereinafter obtained during the term of this Agreement covering the other officers and directors of the Companies against lawsuits. The Companies will pay all expenses, including attorney's fees, actually and necessarily incurred by the Executive in connection with any appeal thereon including the cost of court settlements. 10. Notices. All notices, requests, demands and other communications provided for by this Agreement shall be in writing and shall be deemed to have been given at the time when mailed at any general or branch United States Post Office enclosed in a certified post paid envelope and addressed to the address of the respective party stated below or to such changed address as such party may have fixed by notice. To the Companies: Trustco Bank Corp NY Trustco Bank New York 320 State Street Schenectady, NY 12301 To the Executive: Robert A. McCormick 16 Greenlea Drive Clifton Park, NY 12065 provided, however, that any notice of change of address shall be effective only upon receipt. 11. Successors and Assigns. This Agreement shall inure to the benefit of and be binding upon the Companies, their successors and assigns, including, without limitation, any person or entity which may acquire all or substantially all of either Company's assets or business or into which either Company may be consolidated or merged, and the Executive, his heirs, executors, administrators and legal representatives. The Executive may assign his right to payment under this Agreement, but not his obligations under this Agreement. 12. Governing Law. This Agreement shall be governed by the laws of the State of New York. 13. Modification. This Agreement supersedes all prior understandings and agreements between the parties, and may not be amended or modified orally, but only by a writing signed by the parties hereto. TRUSTCO BANK CORP NY By: TRUSTCO BANK NEW YORK By: ROBERT A. McCORMICK C011091BC1 Schedule A to Agreement among Companies and Robert A. McCormick Calendar Year Annual Salary Approval of Companies 1992 $550,000.00 1993 $650,000.00 1994 $700,000.00 TRUSTCO BANK CORP NY By: TRUSTCO BANK NEW YORK By: AGREEMENT OF EXECUTIVE By: Robert A. McCormick AMENDMENT NO. 1 TO EMPLOYMENT AGREEMENT BETWEEN TRUSTCO BANK NEW YORK AND TRUSTCO BANK CORP NY AND ROBERT A. McCORMICK WHEREAS, Trustco Bank New York and Trustco Bank Corp NY (herein referred to as the "Companies") entered into an Employment Agreement dated as of July 15, 1992, (herein referred to as the "Agreement"); with Robert A. McCormick (herein referred to as the "Executive"); and WHEREAS, the Companies and the Executive desire to amend the Agreement, effective as of November 16, 1993; NOW, THEREFORE, the Agreement is hereby amended effective June 21, 1993, in the following respect: Section 5 of the Agreement is hereby deleted in its entirety and the following is substituted in lieu thereof: "5. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive: a. The Executive shall be allowed to participate fully in any disability, death benefit, retirement, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans; and b. Upon termination of the Executive's employment due to retirement or disability (both as defined in the Retirement Plan of Trustco Bank New York), the Companies shall provide to the Executive and his spouse, for the life of the Executive, the health insurance benefits provided to retirees by the Companies under their medical insurance plan. The Companies shall provide to the Executive for his life the life insurance benefits provided to retirees by the Companies under their life insurance plan. The obligations of the Companies pursuant to this subparagraph b. shall survive the termination of this Agreement." IN WITNESS WHEREOF, the Companies and the Executive have executed this Amendment No. 1 this 16 day of November, 1993. TRUSTCO BANK NEW YORK TRUSTCO BANK CORP NY By: By: Robert A. McCormick Robert A. McCormick [DESCRIPTION] EXHIBIT 10(b) TO FORM 10-K Executive Employment Agreement for N.A. McNamara EMPLOYMENT AGREEMENT between TRUSTCO BANK NEW YORK and TRUSTCO BANK CORP NY and NANCY A. MCNAMARA AGREEMENT AGREEMENT, dated as of July 15, 1992, (the "Agreement"), by and between Trustco Bank New York (the "Bank"), a New York banking corporation and Trustco Bank Corp NY (the "Company"), a New York business corporation (hereinafter referred to collectively as the "Companies"), with principal offices at 320 State Street, Schenectady, New York and Nancy A. McNamara (the "Executive"), residing at 26 Berkshire Drive West, Clifton Park, New York 12065. 1. Engagement. The Companies agree to engage the Executive and the Executive agrees to serve the Companies as an Executive. 2. Term. The term of this Agreement shall commence on the date first above written and shall continue until December 31, 1992. Beginning on January 1, 1993, and on January 1, of each and every year thereafter, this Agreement shall automatically renew for an additional year on the same terms and conditions, except to the extent modified in writing, unless the Executive is notified by the method set forth in Paragraph 11 herein that Executive has been terminated ("Nonrenewal Notice"). Nothing contained herein, however, shall be construed to extend the Executive's right to employment beyond the age of 65 years or the then mandatory retirement age in effect, whichever shall be greater. 3. Purpose and Effect. The purpose of this Agreement is to provide Termination Benefits, as defined in Paragraph 9 hereof, in the event of a Termination, as defined in Paragraph 8 hereof. 4. Service. The Executive shall exert Executive's best efforts and devote substantially all of Executive's time and attention to the affairs of the Bank. The Executive shall perform all the services and duties necessary or appropriate for the management of the Bank's businesses, subject to the general direction, approval, and control of the Chief Executive Officer and his designees. 5. Compensation. For purposes of this Agreement, Annual Compensation shall be deemed to be the Executive's Annual Base Salary. Commencing January 1, 1992, Executive shall be paid by the Companies, the Annual Base Salary established on Schedule A attached hereto, (which base salary shall be paid in bi-weekly installments). Thereafter, Annual Base Salary shall continue at such level or such other level as may have been agreed to among the parties and evidenced as provided in this Paragraph, until renegotiated among the parties hereto and either confirmed in a writing signed by either the Chief Executive Officer of or a member of the Board of Directors of the Companies, or endorsed on Schedule A and signed by either the Chief Executive Officer of or by a member of the Board of Directors of the Companies. 6. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive, the Executive shall be eligible to participate fully in any retirement, executive incentive compensation, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. Nothing in this Agreement shall be construed as a waiver of any of the terms of or conditions precedent to participation in such plans. 7. Termination of Employment. If there shall be a Termination (as hereinafter defined) of the Executive for any reason other than for good cause, death, retirement at the mandatory retirement age, or disability, the Executive shall receive upon his Termination of employment with either of the Companies, the Termination Benefits set forth herein. The Executive's Termination for good cause shall be limited to the Executive's having committed an act of fraud, embezzlement, or theft, constituting a felony or any act intentionally against either of the Companies which causes either Company material injury, or a final determination by a court that the Executive has committed a material breach of his duties and responsibilities in connection with rendering services to either of the Companies pursuant to this Agreement. 8. Termination. Termination shall include, but is not limited to, (i) any reduction in the Executive's Annual Base Salary, retirement other than at the mandatory retirement age, executive incentive compensation, pension or profit sharing benefits, (unless such reductions shall have been applied to all bank employees as apart of a validly adopted plan of cost containment), responsibilities or duties, or (ii) either Companies' relocation or a change in the Executive's base location, or (iii) a non-renewal notice given pursuant to Paragraph 2 of this Agreement, or (iv) the unilateral election of the Executive to terminate the Agreement. Such election shall be communicated to the Companies pursuant to Paragraph 11 hereof. 9. Termination Benefits. The following benefits shall be Termination Benefits: (a) The Companies shall pay to the Executive the Executive's full compensation through the effective date of his termination at the rate in effect at the time notice of termination is given or at time of termination, if earlier, and in addition (b) The Companies shall pay to the Executive within ten (10) days of Termination an additional lump sum amount equal to that Executive's Annual Base Salary then in effect, and in addition (c) The Companies shall pay to the Executive all benefits payable to the Executive under the Companies' retirement, executive incentive compensation, pension and profit sharing plans, and in addition (d) The Companies shall pay the Executive all legal fees and expenses incurred by the Executive as a result of such Termination, and in addition (e) The Companies shall provide the Executive, for one year following his Termination, Health Insurance and Group Life Insurance benefits substantially similar to those the Executive was receiving immediately prior to his Termination. 10. Indemnity. The Companies shall indemnify the Executive and hold Executive harmless for any acts or decisions made by Executive in good faith while performing services for either of the Companies and shall use their best efforts to obtain coverage for Executive under any insurance policy now in force or hereinafter obtained during the term of this Agreement covering the other officers and directors of the Companies against lawsuits. The Companies will pay all expenses, including attorney's fees, actually and necessarily incurred by the Executive in connection with any appeal thereon including the cost of court settlements. 11. Notices. All notices, request, demands and other communications provided for by this Agreement shall be in writing and shall be deemed to have been given at the time when personally delivered or mailed at any general or branch United States Post Office enclosed in a post paid envelope and addressed to the address of the respective party stated below or to such changed address as such party may have fixed by notice. To the Companies: Trustco Bank Corp NY Trustco Bank New York 320 State Street Schenectady, NY 12305 To the Executive: Nancy A. McNamara 26 Berkshire Drive West Clifton Park, NY 12065 Provided, however, that any notice of change of address shall be effective only upon receipt. 12. Successors and Assigns. This Agreement shall inure to the benefit of and be binding upon the Companies, their successors and assigns, including, without limitation, any person or entity which may acquire all or substantially all of either Company's assets or business or into which either Company may be consolidated or merged, and the Executive, as well as Executive's heirs, executors, administrators and legal representatives. The Executive may assign the right to payment under this Agreement, but not obligations under this Agreement. 13. Governing Law. This Agreement shall be governed by the laws of the State of New York. 14. Complete Agreement. This Agreement supersedes all prior understandings and agreements between the parties, and may not be amended or modified orally, but only by a writing signed by the parties hereto. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the 15th day of July, 1992. TRUSTCO BANK CORP NY By: President and Chief Executive Officer TRUSTCO BANK NEW YORK By: President and Chief Executive Officer By: Nancy A. McNamara Attest: Secretary C071092CAM2 Schedule A to Agreement among Companies and Nancy A. McNamara Calendar Year Annual Salary Approval of Companies 1992 $160,000.00 1993 $200,000.00 1994 $230,000.00 TRUSTCO BANK CORP NY By: President and Chief Executive Officer TRUSTCO BANK NEW YORK By: President and Chief Executive Officer AGREEMENT OF EXECUTIVE By: Nancy A. McNamara AMENDMENT NO. 1 TO EMPLOYMENT AGREEMENT BETWEEN TRUSTCO BANK NEW YORK AND TRUSTCO BANK CORP NY AND NANCY A. MCNAMARA WHEREAS, Trustco Bank New York and Trustco Bank Corp NY (herein referred to as the "Companies") entered into an Employment Agreement dated as of July 15, 1992, (herein referred to as the "Agreement"); with Nancy A. McNamara (herein referred to as the "Executive"); and WHEREAS, the Companies and the Executive desire to amend the Agreement, effective as of November 16, 1993; NOW, THEREFORE, the Agreement is hereby amended effective June 21, 1993, in the following respect: Section 6 of the Agreement is hereby deleted in its entirety and the following is substituted in lieu thereof: "6. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive: a. The Executive shall be eligible to participate fully in any, retirement, executive incentive compensation, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. Nothing in this agreement shall be construed as a waiver of any of the terms of or conditions precedent to participation in such plans; and, b. Upon termination of the Executive's employment due to retirement or disability (both as defined in the Retirement Plan of Trustco Bank New York), the Companies shall provide to the Executive and his spouse, for the life of the Executive, the health insurance benefits provided to retirees by the Companies under their medical insurance plan. The Companies shall provide to the Executive for his life the life insurance benefits provided to retirees by the Companies under their life insurance plan. The obligations of the Companies pursuant to this subparagraph b. shall survive the termination of this Agreement." IN WITNESS WHEREOF, the Companies and the Executive have executed this Amendment No. 1 this 16 day of November, 1993. TRUSTCO BANK NEW YORK TRUSTCO BANK CORP NY By: By: Nancy A. McNamara Nancy A. McNamera [DESCRIPTION] EXHIBIT 10(c) TO FORM 10-K Executive Employment Agreement for W.F. Terry EMPLOYMENT AGREEMENT between TRUSTCO BANK NEW YORK and TRUSTCO BANK CORP NY and WILLIAM F. TERRY AGREEMENT AGREEMENT, dated as of July 15, 1992, (the "Agreement"), by and between Trustco Bank New York (the "Bank"), a New York banking corporation and Trustco Bank Corp NY (the "Company"), a New York business corporation (hereinafter referred to collectively as the "Companies"), with principal offices at 320 State Street, Schenectady, New York and William F. Terry (the "Executive"), residing at 9 Birchwood Court, Loudonville, New York 12211. 1. Engagement. The Companies agree to engage the Executive and the Executive agrees to serve the Companies as an Executive. 2. Term. The term of this Agreement shall commence on the date first above written and shall continue until December 31, 1992. Beginning on January 1, 1993, and on January 1, of each and every year thereafter, this Agreement shall automatically renew for an additional year on the same terms and conditions, except to the extent modified in writing, unless the Executive is notified by the method set forth in Paragraph 11 herein that Executive has been terminated ("Nonrenewal Notice"). Nothing contained herein, however, shall be construed to extend the Executive's right to employment beyond the age of 65 years or the then mandatory retirement age in effect, whichever shall be greater. 3. Purpose and Effect. The purpose of this Agreement is to provide Termination Benefits, as defined in Paragraph 9 hereof, in the event of a Termination, as defined in Paragraph 8 hereof. 4. Service. The Executive shall exert Executive's best efforts and devote substantially all of Executive's time and attention to the affairs of the Bank. The Executive shall perform all the services and duties necessary or appropriate for the management of the Bank's businesses, subject to the general direction, approval, and control of the Chief Executive Officer and his designees. 5. Compensation. For purposes of this Agreement, Annual Compensation shall be deemed to be the Executive's Annual Base Salary. Commencing January 1, 1992, Executive shall be paid by the Companies, the Annual Base Salary established on Schedule A attached hereto, (which base salary shall be paid in bi-weekly installments). Thereafter, Annual Base Salary shall continue at such level or such other level as may have been agreed to among the parties and evidenced as provided in this Paragraph, until renegotiated among the parties hereto and either confirmed in a writing signed by either the Chief Executive Officer of or a member of the Board of Directors of the Companies, or endorsed on Schedule A and signed by either the Chief Executive Officer of or by a member of the Board of Directors of the Companies. 6. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive, the Executive shall be eligible to participate fully in any retirement, executive incentive compensation, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. Nothing in this Agreement shall be construed as a waiver of any of the terms of or conditions precedent to participation in such plans. 7. Termination of Employment. If there shall be a Termination (as hereinafter defined) of the Executive for any reason other than for good cause, death, retirement at the mandatory retirement age, or disability, the Executive shall receive upon his Termination of employment with either of the Companies, the Termination Benefits set forth herein. The Executive's Termination for good cause shall be limited to the Executive's having committed an act of fraud, embezzlement, or theft, constituting a felony or any act intentionally against either of the Companies which causes either Company material injury, or a final determination by a court that the Executive has committed a material breach of his duties and responsibilities in connection with rendering services to either of the Companies pursuant to this Agreement. 8. Termination. Termination shall include, but is not limited to, (i) any reduction in the Executive's Annual Base Salary, retirement other than at the mandatory retirement age, executive incentive compensation, pension or profit sharing benefits, (unless such reductions shall have been applied to all bank employees as apart of a validly adopted plan of cost containment), responsibilities or duties, or (ii) either Companies' relocation or a change in the Executive's base location, or (iii) a non-renewal notice given pursuant to Paragraph 2 of this Agreement, or (iv) the unilateral election of the Executive to terminate the Agreement. Such election shall be communicated to the Companies pursuant to Paragraph 11 hereof. 9. Termination Benefits. The following benefits shall be Termination Benefits: (a) The Companies shall pay to the Executive the Executive's full compensation through the effective date of his termination at the rate in effect at the time notice of termination is given or at time of termination, if earlier, and in addition (b) The Companies shall pay to the Executive within ten (10) days of Termination an additional lump sum amount equal to that Executive's Annual Base Salary then in effect, and in addition (c) The Companies shall pay to the Executive all benefits payable to the Executive under the Companies' retirement, executive incentive compensation, pension and profit sharing plans, and in addition (d) The Companies shall pay the Executive all legal fees and expenses incurred by the Executive as a result of such Termination, and in addition (e) The Companies shall provide the Executive, for one year following his Termination, Health Insurance and Group Life Insurance benefits substantially similar to those the Executive was receiving immediately prior to his Termination. 10. Indemnity. The Companies shall indemnify the Executive and hold Executive harmless for any acts or decisions made by Executive in good faith while performing services for either of the Companies and shall use their best efforts to obtain coverage for Executive under any insurance policy now in force or hereinafter obtained during the term of this Agreement covering the other officers and directors of the Companies against lawsuits. The Companies will pay all expenses, including attorney's fees, actually and necessarily incurred by the Executive in connection with any appeal thereon including the cost of court settlements. 11. Notices. All notices, request, demands and other communications provided for by this Agreement shall be in writing and shall be deemed to have been given at the time when personally delivered or mailed at any general or branch United States Post Office enclosed in a post paid envelope and addressed to the address of the respective party stated below or to such changed address as such party may have fixed by notice. To the Companies: Trustco Bank Corp NY Trustco Bank New York 320 State Street Schenectady, NY 12305 To the Executive: William F. Terry 9 Birchwood Court Loudonville, NY 12211 Provided, however, that any notice of change of address shall be effective only upon receipt. 12. Successors and Assigns. This Agreement shall inure to the benefit of and be binding upon the Companies, their successors and assigns, including, without limitation, any person or entity which may acquire all or substantially all of either Company's assets or business or into which either Company may be consolidated or merged, and the Executive, as well as Executive's heirs, executors, administrators and legal representatives. The Executive may assign the right to payment under this Agreement, but not obligations under this Agreement. 13. Governing Law. This Agreement shall be governed by the laws of the State of New York. 14. Complete Agreement. This Agreement supersedes all prior understandings and agreements between the parties, and may not be amended or modified orally, but only by a writing signed by the parties hereto. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the 15th day of July, 1992. TRUSTCO BANK CORP NY By: President and Chief Executive Officer TRUSTCO BANK NEW YORK By: President and Chief Executive Officer By: William F. Terry Attest: Secretary C071092CAM1 Schedule A to Agreement among Companies and William F. Terry Calendar Year Annual Salary Approval of Companies 1992 $160,000.00 1993 $200,000.00 1994 $230,000.00 TRUSTCO BANK CORP NY By: President and Chief Executive Officer TRUSTCO BANK NEW YORK By: President and Chief Executive Officer AGREEMENT OF EXECUTIVE By: William F. Terry AMENDMENT NO. 1 TO EMPLOYMENT AGREEMENT BETWEEN TRUSTCO BANK NEW YORK AND TRUSTCO BANK CORP NY AND WILLIAM F. TERRY WHEREAS, Trustco Bank New York and Trustco Bank Corp NY (herein referred to as the "Companies") entered into an Employment Agreement dated as of July 15, 1992, (herein referred to as the "Agreement"); with William F. Terry (herein referred to as the "Executive"); and WHEREAS, the Companies and the Executive desire to amend the Agreement, effective as of November 16, 1993; NOW, THEREFORE, the Agreement is hereby amended effective June 21, 1993, in the following respect: Section 6 of the Agreement is hereby deleted in its entirety and the following is substituted in lieu thereof: "6. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive: a. The Executive shall be eligible to participate fully in any, retirement, executive incentive compensation, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. Nothing in this agreement shall be construed as a waiver of any of the terms of or conditions precedent to participation in such plans; and, b. Upon termination of the Executive's employment due to retirement or disability (both as defined in the Retirement Plan of Trustco Bank New York), the Companies shall provide to the Executive and his spouse, for the life of the Executive, the health insurance benefits provided to retirees by the Companies under their medical insurance plan. The Companies shall provide to the Executive for his life the life insurance benefits provided to retirees by the Companies under their life insurance plan. The obligations of the Companies pursuant to this subparagraph b. shall survive the termination of this Agreement." IN WITNESS WHEREOF, the Companies and the Executive have executed this Amendment No. 1 this 16 day of November, 1993. TRUSTCO BANK NEW YORK TRUSTCO BANK CORP NY By: By: William F. Terry William F. Terry [DESCRIPTION] EXHIBIT 10(d) TO FORM 10-K Executive Employment Agreement for P.A. Zakriski EMPLOYMENT AGREEMENT between TRUSTCO BANK NEW YORK and TRUSTCO BANK CORP NY and PETER A. ZAKRISKI AGREEMENT AGREEMENT, dated as of July 15, 1992, (the "Agreement"), by and between Trustco Bank New York (the "Bank"), a New York banking corporation and Trustco Bank Corp NY (the "Company"), a New York business corporation (hereinafter referred to collectively as the "Companies"), with principal offices at 320 State Street, Schenectady, New York and Peter A. Zakriski (the "Executive"), residing at 86 St. Stephen's Lane West, Scotia, New York 12302. 1. Engagement. The Companies agree to engage the Executive and the Executive agrees to serve the Companies as an Executive. 2. Term. The term of this Agreement shall commence on the date first above written and shall continue until December 31, 1992. Beginning on January 1, 1993, and on January 1, of each and every year thereafter, this Agreement shall automatically renew for an additional year on the same terms and conditions, except to the extent modified in writing, unless the Executive is notified by the method set forth in Paragraph 11 herein that Executive has been terminated ("Nonrenewal Notice"). Nothing contained herein, however, shall be construed to extend the Executive's right to employment beyond the age of 65 years or the then mandatory retirement age in effect, whichever shall be greater. 3. Purpose and Effect. The purpose of this Agreement is to provide Termination Benefits, as defined in Paragraph 9 hereof, in the event of a Termination, as defined in Paragraph 8 hereof. 4. Service. The Executive shall exert Executive's best efforts and devote substantially all of Executive's time and attention to the affairs of the Bank. The Executive shall perform all the services and duties necessary or appropriate for the management of the Bank's businesses, subject to the general direction, approval, and control of the Chief Executive Officer and his designees. 5. Compensation. For purposes of this Agreement, Annual Compensation shall be deemed to be the Executive's Annual Base Salary. Commencing January 1, 1992, Executive shall be paid by the Companies, the Annual Base Salary established on Schedule A attached hereto, (which base salary shall be paid in bi-weekly installments). Thereafter, Annual Base Salary shall continue at such level or such other level as may have been agreed to among the parties and evidenced as provided in this Paragraph, until renegotiated among the parties hereto and either confirmed in a writing signed by either the Chief Executive Officer of or a member of the Board of Directors of the Companies, or endorsed on Schedule A and signed by either the Chief Executive Officer of or by a member of the Board of Directors of the Companies. 6. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive, the Executive shall be eligible to participate fully in any retirement, executive incentive compensation, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. Nothing in this Agreement shall be construed as a waiver of any of the terms of or conditions precedent to participation in such plans. 7. Termination of Employment. If there shall be a Termination (as hereinafter defined) of the Executive for any reason other than for good cause, death, retirement at the mandatory retirement age, or disability, the Executive shall receive upon his Termination of employment with either of the Companies, the Termination Benefits set forth herein. The Executive's Termination for good cause shall be limited to the Executive's having committed an act of fraud, embezzlement, or theft, constituting a felony or any act intentionally against either of the Companies which causes either Company material injury, or a final determination by a court that the Executive has committed a material breach of his duties and responsibilities in connection with rendering services to either of the Companies pursuant to this Agreement. 8. Termination. Termination shall include, but is not limited to, (i) any reduction in the Executive's Annual Base Salary, retirement other than at the mandatory retirement age, executive incentive compensation, pension or profit sharing benefits, (unless such reductions shall have been applied to all bank employees as apart of a validly adopted plan of cost containment), responsibilities or duties, or (ii) either Companies' relocation or a change in the Executive's base location, or (iii) a non-renewal notice given pursuant to Paragraph 2 of this Agreement, or (iv) the unilateral election of the Executive to terminate the Agreement. Such election shall be communicated to the Companies pursuant to Paragraph 11 hereof. 9. Termination Benefits. The following benefits shall be Termination Benefits: (a) The Companies shall pay to the Executive the Executive's full compensation through the effective date of his termination at the rate in effect at the time notice of termination is given or at time of termination, if earlier, and in addition (b) The Companies shall pay to the Executive within ten (10) days of Termination an additional lump sum amount equal to that Executive's Annual Base Salary then in effect, and in addition (c) The Companies shall pay to the Executive all benefits payable to the Executive under the Companies' retirement, executive incentive compensation, pension and profit sharing plans, and in addition (d) The Companies shall pay the Executive all legal fees and expenses incurred by the Executive as a result of such Termination, and in addition (e) The Companies shall provide the Executive, for one year following his Termination, Health Insurance and Group Life Insurance benefits substantially similar to those the Executive was receiving immediately prior to his Termination. 10. Indemnity. The Companies shall indemnify the Executive and hold Executive harmless for any acts or decisions made by Executive in good faith while performing services for either of the Companies and shall use their best efforts to obtain coverage for Executive under any insurance policy now in force or hereinafter obtained during the term of this Agreement covering the other officers and directors of the Companies against lawsuits. The Companies will pay all expenses, including attorney's fees, actually and necessarily incurred by the Executive in connection with any appeal thereon including the cost of court settlements. 11. Notices. All notices, request, demands and other communications provided for by this Agreement shall be in writing and shall be deemed to have been given at the time when personally delivered or mailed at any general or branch United States Post Office enclosed in a post paid envelope and addressed to the address of the respective party stated below or to such changed address as such party may have fixed by notice. To the Companies: Trustco Bank Corp NY Trustco Bank New York 320 State Street Schenectady, NY 12305 To the Executive: Peter A. Zakriski 86 St. Stephen's Lane West Scotia, NY 12302 Provided, however, that any notice of change of address shall be effective only upon receipt. 12. Successors and Assigns. This Agreement shall inure to the benefit of and be binding upon the Companies, their successors and assigns, including, without limitation, any person or entity which may acquire all or substantially all of either Company's assets or business or into which either Company may be consolidated or merged, and the Executive, as well as Executive's heirs, executors, administrators and legal representatives. The Executive may assign the right to payment under this Agreement, but not obligations under this Agreement. 13. Governing Law. This Agreement shall be governed by the laws of the State of New York. 14. Complete Agreement. This Agreement supersedes all prior understandings and agreements between the parties, and may not be amended or modified orally, but only by a writing signed by the parties hereto. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the 15th day of July, 1992. TRUSTCO BANK CORP NY By: President and Chief Executive Officer TRUSTCO BANK NEW YORK By: President and Chief Executive Officer By: Peter A. Zakriski Attest: Secretary C071092CAM4 Schedule A to Agreement among Companies and Peter A. Zakriski Calendar Year Annual Salary Approval of Companies 1992 $110,000.00 1993 $115,000.00 1994 $120,000.00 TRUSTCO BANK CORP NY By: President and Chief Executive Officer TRUSTCO BANK NEW YORK By: President and Chief Executive Officer AGREEMENT OF EXECUTIVE By: Peter A. Zakriski AMENDMENT NO. 1 TO EMPLOYMENT AGREEMENT BETWEEN TRUSTCO BANK NEW YORK AND TRUSTCO BANK CORP NY AND PETER A. ZAKRISKI WHEREAS, Trustco Bank New York and Trustco Bank Corp NY (herein referred to as the "Companies") entered into an Employment Agreement dated as of July 15, 1992, (herein referred to as the "Agreement"); with Peter A. Zakriski (herein referred to as the "Executive"); and WHEREAS, the Companies and the Executive desire to amend the Agreement, effective as of November 16, 1993; NOW, THEREFORE, the Agreement is hereby amended effective June 21, 1993, in the following respect: Section 6 of the Agreement is hereby deleted in its entirety and the following is substituted in lieu thereof: "6. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive: a. The Executive shall be eligible to participate fully in any, retirement, executive incentive compensation, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. Nothing in this agreement shall be construed as a waiver of any of the terms of or conditions precedent to participation in such plans; and, b. Upon termination of the Executive's employment due to retirement or disability (both as defined in the Retirement Plan of Trustco Bank New York), the Companies shall provide to the Executive and his spouse, for the life of the Executive, the health insurance benefits provided to retirees by the Companies under their medical insurance plan. The Companies shall provide to the Executive for his life the life insurance benefits provided to retirees by the Companies under their life insurance plan. The obligations of the Companies pursuant to this subparagraph b. shall survive the termination of this Agreement." IN WITNESS WHEREOF, the Companies and the Executive have executed this Amendment No. 1 this 16 day of November, 1993. TRUSTCO BANK NEW YORK TRUSTCO BANK CORP NY By: By: Peter A. Zakriski Peter A. Zakriski [DESCRIPTION] EXHIBIT 10(e) TO FORM 10-K Executive Employment Agreement for R.A. Pidgeon EMPLOYMENT AGREEMENT between TRUSTCO BANK NEW YORK and TRUSTCO BANK CORP NY and RALPH A. PIDGEON AGREEMENT AGREEMENT, dated as of July 15, 1992, (the "Agreement"), by and between Trustco Bank New York (the "Bank"), a New York banking corporation and Trustco Bank Corp NY (the "Company"), a New York business corporation (hereinafter referred to collectively as the "Companies"), with principal offices at 320 State Street, Schenectady, New York and Ralph A. Pidgeon (the "Executive"), c/o Trustco Bank New York, 320 State Street, Schenectady, New York 12305. 1. Engagement. The Companies agree to engage the Executive and the Executive agrees to serve the Companies as an Executive. 2. Term. The term of this Agreement shall commence on the date first above written and shall continue until December 31, 1992. Beginning on January 1, 1993, and on January 1, of each and every year thereafter, this Agreement shall automatically renew for an additional year on the same terms and conditions, except to the extent modified in writing, unless the Executive is notified by the method set forth in Paragraph 11 herein that Executive has been terminated ("Nonrenewal Notice"). Nothing contained herein, however, shall be construed to extend the Executive's right to employment beyond the age of 65 years or the then mandatory retirement age in effect, whichever shall be greater. 3. Purpose and Effect. The purpose of this Agreement is to provide Termination Benefits, as defined in Paragraph 9 hereof, in the event of a Termination, as defined in Paragraph 8 hereof. 4. Service. The Executive shall exert Executive's best efforts and devote substantially all of Executive's time and attention to the affairs of the Bank. The Executive shall perform all the services and duties necessary or appropriate for the management of the Bank's businesses, subject to the general direction, approval, and control of the Chief Executive Officer and his designees. 5. Compensation. For purposes of this Agreement, Annual Compensation shall be deemed to be the Executive's Annual Base Salary. Commencing January 1, 1992, Executive shall be paid by the Companies, the Annual Base Salary established on Schedule A attached hereto, (which base salary shall be paid in bi-weekly installments). Thereafter, Annual Base Salary shall continue at such level or such other level as may have been agreed to among the parties and evidenced as provided in this Paragraph, until renegotiated among the parties hereto and either confirmed in a writing signed by either the Chief Executive Officer of or a member of the Board of Directors of the Companies, or endorsed on Schedule A and signed by either the Chief Executive Officer of or by a member of the Board of Directors of the Companies. 6. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive, the Executive shall be eligible to participate fully in any retirement, executive incentive compensation, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. Nothing in this Agreement shall be construed as a waiver of any of the terms of or conditions precedent to participation in such plans. 7. Termination of Employment. If there shall be a Termination (as hereinafter defined) of the Executive for any reason other than for good cause, death, retirement at the mandatory retirement age, or disability, the Executive shall receive upon his Termination of employment with either of the Companies, the Termination Benefits set forth herein. The Executive's Termination for good cause shall be limited to the Executive's having committed an act of fraud, embezzlement, or theft, constituting a felony or any act intentionally against either of the Companies which causes either Company material injury, or a final determination by a court that the Executive has committed a material breach of his duties and responsibilities in connection with rendering services to either of the Companies pursuant to this Agreement. 8. Termination. Termination shall include, but is not limited to, (i) any reduction in the Executive's Annual Base Salary, retirement other than at the mandatory retirement age, executive incentive compensation, pension or profit sharing benefits, (unless such reductions shall have been applied to all bank employees as apart of a validly adopted plan of cost containment), responsibilities or duties, or (ii) either Companies' relocation or a change in the Executive's base location, or (iii) a non-renewal notice given pursuant to Paragraph 2 of this Agreement, or (iv) the unilateral election of the Executive to terminate the Agreement. Such election shall be communicated to the Companies pursuant to Paragraph 11 hereof. 9. Termination Benefits. The following benefits shall be Termination Benefits: (a) The Companies shall pay to the Executive the Executive's full compensation through the effective date of his termination at the rate in effect at the time notice of termination is given or at time of termination, if earlier, and in addition (b) The Companies shall pay to the Executive within ten (10) days of Termination an additional lump sum amount equal to that Executive's Annual Base Salary then in effect, and in addition (c) The Companies shall pay to the Executive all benefits payable to the Executive under the Companies' retirement, executive incentive compensation, pension and profit sharing plans, and in addition (d) The Companies shall pay the Executive all legal fees and expenses incurred by the Executive as a result of such Termination, and in addition (e) The Companies shall provide the Executive, for one year following his Termination, Health Insurance and Group Life Insurance benefits substantially similar to those the Executive was receiving immediately prior to his Termination. 10. Indemnity. The Companies shall indemnify the Executive and hold Executive harmless for any acts or decisions made by Executive in good faith while performing services for either of the Companies and shall use their best efforts to obtain coverage for Executive under any insurance policy now in force or hereinafter obtained during the term of this Agreement covering the other officers and directors of the Companies against lawsuits. The Companies will pay all expenses, including attorney's fees, actually and necessarily incurred by the Executive in connection with any appeal thereon including the cost of court settlements. 11. Notices. All notices, request, demands and other communications provided for by this Agreement shall be in writing and shall be deemed to have been given at the time when personally delivered or mailed at any general or branch United States Post Office enclosed in a post paid envelope and addressed to the address of the respective party stated below or to such changed address as such party may have fixed by notice. To the Companies: Trustco Bank Corp NY Trustco Bank New York 320 State Street Schenectady, NY 12305 To the Executive: Ralph A. Pidgeon c/o Trustco Bank New York 320 State Street Schenectady, NY 12305 Provided, however, that any notice of change of address shall be effective only upon receipt. 12. Successors and Assigns. This Agreement shall inure to the benefit of and be binding upon the Companies, their successors and assigns, including, without limitation, any person or entity which may acquire all or substantially all of either Company's assets or business or into which either Company may be consolidated or merged, and the Executive, as well as Executive's heirs, executors, administrators and legal representatives. The Executive may assign the right to payment under this Agreement, but not obligations under this Agreement. 13. Governing Law. This Agreement shall be governed by the laws of the State of New York. 14. Complete Agreement. This Agreement supersedes all prior understandings and agreements between the parties, and may not be amended or modified orally, but only by a writing signed by the parties hereto. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the 15th day of July, 1992. TRUSTCO BANK CORP NY By: President and Chief Executive Officer TRUSTCO BANK NEW YORK By: President and Chief Executive Officer By: Ralph A. Pidgeon Attest: Secretary C071092CAM3 Schedule A to Agreement among Companies and Ralph A. Pidgeon Calendar Year Annual Salary Approval of Companies 1992 $160,000.00 1993 $200,000.00 1994 $230,000.00 TRUSTCO BANK CORP NY By: President and Chief Executive Officer TRUSTCO BANK NEW YORK By: President and Chief Executive Officer AGREEMENT OF EXECUTIVE By: Ralph A. Pidgeon AMENDMENT NO. 1 TO EMPLOYMENT AGREEMENT BETWEEN TRUSTCO BANK NEW YORK AND TRUSTCO BANK CORP NY AND RALPH A. PIDGEON WHEREAS, Trustco Bank New York and Trustco Bank Corp NY (herein referred to as the "Companies") entered into an Employment Agreement dated as of July 15, 1992, (herein referred to as the "Agreement"); with Ralph A. Pidgeon (herein referred to as the "Executive"); and WHEREAS, the Companies and the Executive desire to amend the Agreement, effective as of November 16, 1993; NOW, THEREFORE, the Agreement is hereby amended effective June 21, 1993, in the following respect: Section 6 of the Agreement is hereby deleted in its entirety and the following is substituted in lieu thereof: "6. Retirement, Pension and Profit Sharing. As further compensation for the services of the Executive: a. The Executive shall be eligible to participate fully in any, retirement, executive incentive compensation, pension or profit sharing plans maintained by the Companies, pursuant to the terms of such plans. Nothing in this agreement shall be construed as a waiver of any of the terms of or conditions precedent to participation in such plans; and, b. Upon termination of the Executive's employment due to retirement or disability (both as defined in the Retirement Plan of Trustco Bank New York), the Companies shall provide to the Executive and his spouse, for the life of the Executive, the health insurance benefits provided to retirees by the Companies under their medical insurance plan. The Companies shall provide to the Executive for his life the life insurance benefits provided to retirees by the Companies under their life insurance plan. The obligations of the Companies pursuant to this subparagraph b. shall survive the termination of this Agreement." IN WITNESS WHEREOF, the Companies and the Executive have executed this Amendment No. 1 this 16 day of November, 1993. TRUSTCO BANK NEW YORK TRUSTCO BANK CORP NY By: By: Ralph A. Pidgeon Ralph A. Pidgeon [DESCRIPTION] EXHIBIT 10(f) TO FORM 10-K 1985 TRUSTCO BANK CORP NY STOCK OPTION PLAN (as amended through December 31, 1992) SECTION 1: PURPOSE This Stock Option Plan (the "Plan") has been established by TrustCo Bank Corp NY (the "Company") to advance the interests of the Company and its stockholders by providing to certain key employees an opportunity to acquire equity ownership in the Company and the incentive advantages inherent in that equity ownership. SECTION 2: DEFINITIONS When capitalized and used in this Plan, each of the following terms or phrases has the indicated meaning, unless a different meaning is clearly implied by the context: "Adoption Date" means the date this plan is duly adopted by the Board. "Board" means the Company's Board of Directors. "Code" means the Internal Revenue Code of 1986, as amended. "Committee" means the Committee to be appointed by the Board from time to time and to consist of three or more members of the Board who have not been eligible to receive options under the Plan at any time within a period of one year immediately preceding the date of their appointment to such Committee. "Company" means TrustCo Bank Corp NY and its subsidiaries. "Disability" means a Participant's termination of employment by the Company or a Participating Subsidiary by reason of his permanent and total disability, as defined in Code Section 22(e)(3). "Eligible Employee" means any executive or other key managerial employee of the Company or any Participating Subsidiary who is a full-time, salaried employee of the Company or any Participating Subsidiary, provided he is so employed at the date any Stock Option is granted to him. "Fair Market Value" means the current fair market value of any Stock subject to a Stock Option. During such time as the Stock is not listed on an established stock exchange, fair market value per share shall be the mean between the closing dealer "bid" and "ask" prices for the Stock as quoted by NASDAQ for the day of the grant and if "bid" and "ask" prices are quoted for the day of the grant, the fair market value shall be determined by reference to such prices on the next preceding day on which such prices were quoted. If the Stock is listed on an established stock exchange or exchanges, the fair market value shall be deemed to be the highest closing price of the Stock on such stock exchange or exchanges on the day the option is granted or, if no sale of Stock has been made on any stock exchange on that day, the fair market value shall be determined by reference to such price for the next preceding day on which a sale occurred. In the event that Stock is not traded on an established stock exchange, and no closing dealer "bid" and "ask" prices are available, then the purchase price shall be 100 percent of the fair market value of one share of Stock on the day the option is granted, as determined by the Committee in good faith. The purchase price shall be subject to adjustment only as provided in Section 9 of the Plan. "Incentive Stock Option" means an option granted to a Participant under this Plan to purchase the Company's Stock, which is designated as an Incentive Stock Option and which satisfies the requirements of Code Section 422, as amended. "Nonqualified Stock Option" means an option granted to a Participant under this Plan to purchase the Company's Stock and which is not an Incentive Stock Option. "Option Agreement" means the written agreement executed between the Participant and the Company evidencing the award of Stock Options under this Plan, as more particularly described in Section 7. "Participant" means any Eligible Employee who has been awarded any Stock Option(s) under this Plan and his heirs, legatees, or personal representatives who may succeed to his interests under any Option Agreement at his death. "Participating Subsidiary" means a Subsidiary some or all of whose employees have been designated as Eligible Employees by the Board. "Plan" means the TrustCo Bank Corp NY Stock Option Plan as embodied in this document including all amendments to this document made from time to time. "Shareholder-Employee" means any Eligible Employee who at the time an Incentive Stock Option is to be granted to him under this Plan owns (within the meaning of Code Section 442(b)(6) and (c)(5)) more than 10 percent of the combined voting power of all classes of the Company's Stock or of its parent or subsidiary companies (if any). "Stock" means shares of the Company's common stock. "Stock Appreciation Right" means a right, granted to a Participant concurrently with the grant of a Nonqualified Stock Option, to receive a cash payment from the Company upon the partial or complete cancellation of that option by a Participant. Each option agreement may provide that the Participant may from time to time elect to cancel all or any portion of the option then subject to exercise, in which event the Company's obligation in respect of such option may be discharged by payment to the Participant of an amount in cash equal to the excess, if any, of the fair market value at the time of cancellation of the shares subject to the option or the portion thereof so cancelled, over the aggregate purchase price for such shares as set forth in the option agreement. In the event of such a cancellation, the number of shares as to which such option was cancelled shall not become available for use under the Plan. "Stock Option" or "Option" means a right granted under this Plan to purchase Company Stock, including a Nonqualified Stock Option or an Incentive Stock Option. "Subsidiary" means a corporation of which stock possessing 50% or more of the total combined voting power of all classes of its stock entitled to vote generally in the election of directors is owned in the aggregate by the Company directly or indirectly through one or more Subsidiaries. SECTION 3: PLAN ADMINISTRATION The Plan is to be administered by the Committee except as otherwise provided in the Plan. Subject to all other Plan provisions, the Committee is expressly empowered to: 1. select the Eligible Employees who are to receive Stock Options and Stock Appreciation Rights under this Plan from time to time and grant those Options and Stock Appreciation Rights; 2. determine the time(s) at which Stock Options and Stock Appreciation Rights are to be granted; 3. determine the number of shares of Stock to be subject to a Stock Option granted to any Participant; 4. determine the option price and term of each Stock Option granted under this Plan (including whether it is to be an Incentive Stock Option or Nonqualified Stock Option) and all other terms and conditions to be included in the Option Agreement relating to any Stock Options under this Plan; 5. determine the duration and purposes of leaves of absence which may be granted to a Participant without constituting a termination of employment or service for purposes of the Plan; 6. determine all matters of interpretation of the Plan and any Option Agreement, and the Committee's decision is to be binding and conclusive on all persons; 7. determine, in its sole discretion, whether the Company is to accept Stock previously acquired by a Participant as payment of the option price for Stock Options granted under this Plan; 8. prescribe, amend and rescind all rules and regulations relating to the Plan and its operations; 9. in the event of the Company's or a Participating Subsidiary's merger, consolidation, dissolution or liquidation, accelerate the exercise date and expiration date for any unexercised Stock Options then outstanding; and 10. make all other determinations and decisions and take all further actions deemed necessary or advisable for the Plan's administration. Notwithstanding any conflicting Plan provision, the Board reserves the right, by written resolution duly adopted by the Board, to terminate from time to time any and all powers delegated to the Committee by the express Plan provisions and, in that event, those Committee powers so terminated by the Board shall revert to and be fully exercisable by the Board to the same extent as they were exercisable by the Committee, provided that no termination of the Committee's powers shall be retroactively effective. Any termination of the Committee's powers under this Plan shall not be deemed a Plan amendment. No Committee or Board member may participate in the decision to award any Stock Option or Stock Appreciation Right under this Plan to himself. Neither the Board nor the Committee may, without the Participant's consent, change the terms and conditions of any Option Agreement after its execution, except to the extent that the Agreement may, by its terms, be so amended. SECTION 4: PLAN EFFECTIVE DATE AND DURATION This Plan is effective as of the Adoption Date, subject, however, to the Plan's approval by the Company's shareholders either on or before the Adoption Date or within the 12-month period following the Adoption Date. If shareholder approval is not so obtained, all Stock Options, Stock Appreciation Rights and Option Agreements granted under this Plan shall automatically be null and void, ab initio. No Stock Option may be granted under this Plan at any date which is 10 years or more after the Adoption Date. SECTION 5: AMENDMENTS AND TERMINATIONS This plan may be amended, suspended, terminated or reinstated, in whole or in part, at any time by the Board; provided, however, that without the approval of the Company's stockholders, the Board may not: 1. except as provided in Section 9, increase the number of shares of Stock subject to Stock Options issued under this Plan; 2. extend the maximum period during which a Stock Option may be exercised; 3. extend the maximum period during which Incentive Stock Options may be granted under this Plan; or 4. change the class of Eligible Employees. SECTION 6: SHARES SUBJECT TO THE PLAN The total number of shares available for grants of Stock Options under this Plan is 60,000, subject to the adjustments under Section 9. If a Stock Option or a portion thereof expires or terminates for any reason without being exercised in full, the unpurchased shares covered by the Option are to be available for future Stock Option grants under this Agreement. SECTION 7: GRANTS OF OPTIONS Nonqualified Stock Options may be granted to any Eligible Employee, at the time(s) and upon such terms and conditions as may be selected by the Committee. At the time of grant of a Nonqualified Stock Option, the Committee may, in its discretion, also grant to the Eligible Employee Stock Appreciation Rights for the total number of shares subject to that Option. The grant of a Nonqualified Stock Option and, if appropriate, Stock Appreciation Rights shall be evidenced by an Option Agreement between the Eligible Employee and the Company containing any terms and conditions specified by the Committee, but including the terms described in Section 8. Incentive Stock Options may be granted to any Eligible Employee, at the time(s) and upon such terms and condition as may be selected by the Committee, subject, nevertheless to the following: 1. The aggregate Fair Market Value (as of the date the Incentive Stock Option is granted) of the Stock subject to Incentive Stock Options granted to any Eligible Employee during one calendar year (under this Plan and all other plans of the Company and its Subsidiaries providing "incentive stock options" within the meaning of Code Section 422A(b)) shall not exceed the sum of: (i) $100,000; and (ii) the amount of any "unused limit carryover" which may be taken into account for that calendar year with respect to that Eligible Employee under Code Section 422(A)(c)(4). 2. the grant shall be evidenced by an Option Agreement between the Company and the Eligible Employee containing any terms and conditions specified by the Committee, except that those terms and conditions must conform with Section 8 and must be consistent with the requirements for an "incentive stock option" as described in Code Section 422A(b). SECTION 8: TERMS OF OPTIONS AGREEMENT All Option Agreements for Incentive Stock Options issued under this Plan must include terms that are consistent with the following: 1. The Participant shall be entitled to purchase the number of shares subject to the Stock Option, upon his exercise of that Option, at a price no less than 100% of the Stock's Fair Market Value at the date of the grant; provided, however, that in the case of an Incentive Stock Option granted to a Shareholder-Employee, the option price is to be no less than 110% of that Fair Market Value. 2. At the option's exercise, the option price may be paid in cash or cash equivalent--that is, by certified check, bank draft or postal or express money orders made payable to the Company's order in U.S. dollars. Alternatively, in the Committee's sole discretion, the option price may be paid, in whole or in part, by the Participant's exchange of Company Stock previously acquired by him, based on that Stock's Fair Market Value at the date of exchange. However, no Company Stock may be accepted in payment of the option price upon exercise of an Incentive Stock Option, if that Stock was acquired by the Participant's previous exercise of an Incentive Stock Option unless that Stock has been held by the Participant for more than 2 years after the date that previous Option was granted and more than 1 year after the date that previous Option was exercised. 3. The option may not be exercisable after the earlier of the following dates: (i) If the Participant is not a Shareholder-Employee at the date of grant or the Option is not an Incentive Stock Option, the date 10 years after the date of grant; (ii) If the Participant is a Shareholder-Employee at the date of grant and the Option is an Incentive Stock Option, the date 5 years after the date of grant; (iii) If the Participant's employment terminates for reasons other than his death, disability, or retirement, the date three months after the date his employment terminates. Notwithstanding the foregoing, the Committee, in its discretion, may further limit the period during which all or any portion of a Stock Option may be exercised and may accelerate the time at which an Option may be exercised. 4. Acceleration and the immediate right to exercise options in full will occur if any one or more of the following takes place: (i) a contract providing for a merger or consolidation of the Company with or into another entity (except in the case where the Company is the surviving entity and the merger does not affect the stock interest of the stockholders of the Company) or a sale of substantially all the assets of the Company is executed; (ii) a single entity or individual (including any related parties to such entity or individual) acquires 20% or more of the outstanding stock of the Company; or (iii) a situation occurs in which, during any period of 12 consecutive months, individuals who at the beginning of such period were members of the Board cease for any reason to constitute at least a majority of the Board, unless the nomination or election of each new director was approved by at least two-thirds of the directors then still in office who were directors at the beginning of such period. 5. The Stock Option(s) and any related Stock Appreciation Rights may be exercised only by the Participant during his lifetime and, after his death, only by his heirs, legatees or personal representatives who succeed to his interest under the Option Agreement. Neither the Option Agreement, the Stock Options nor the Stock Appreciation Rights issued under this Plan shall be transferable by the Participant other than by will or by the laws of descent and distribution. 6. Notwithstanding anything else to the contrary, no Incentive Stock Option may be exercised while there is outstanding (within the meaning of Code Section 422(c)(7)) any "incentive stock option" (within the meaning of Code Section 422A(b)) to purchase stock of the Company or any Subsidiary which was granted to the Participant prior to the grant of the Option sought to be exercised. The provisions of this Item 6 shall apply only to Incentive Stock Options granted prior to January 1, 1987. 7. In the case of Nonqualified Stock Options, the Option may be exercised while there is outstanding another Stock Option to purchase Stock of the Company or a Subsidiary which was granted to the Participant prior to the grant of the Option sought to be exercised. 8. The aggregate fair market value (determined at the time the option is granted) of the stock with respect to which Incentive Stock Options are exercisable for the first time by such individual during any calendar year (under all such plans of the individual's employer corporation and its parent and subsidiary corporation) shall not exceed $100,000. The provisions of this Item 8 shall apply to Incentive Stock Options granted after December 31, 1986. 9. The acceleration provisions of Section 8, Item 4 of the Plan shall override restrictions contained in Section 8, Item 8. 10. As to each Option granted a Participant since November 19, 1985, if the Participant's employment terminates by his death, disability or retirement, the exercise of each such Option shall accelerate and become exercisable in full upon such termination, and shall remain exercisable throughout the period permitted for exercise. SECTION 9: RECAPITALIZATION The number of shares of Stock subject to this Plan, the number of shares of Stock covered by each outstanding Option (and any corresponding Stock Appreciation Rights), and the price per share in each Option, are to be proportionately adjusted for any increase or decrease in the number of issued shares of Company Stock resulting from a subdivision or consolidation of shares or the payment of a stock dividend (but only on the Company's common stock) or any other increase or decrease in the number of those shares effected without receipt of consideration by the Company. Subject to any required action by the Stockholders if the Company shall be the surviving corporation in any merger or consolidation, each outstanding Stock Option (and any corresponding Stock Appreciation Rights) shall pertain to and apply to the securities to which a holder of the number of shares of stock subject to that Option would have been entitled. A dissolution or liquidation of the Company, a proposed sale of substantially all of the assets of the Company, or a merger or consolidation in which the Company is not the surviving Corporation, shall cause each outstanding Option (and any corresponding Stock Appreciation Rights) to terminate as of a date to be fixed by the Board; provided that no less than 30 days written notice of the date so fixed shall be given to each Optionee, and each Optionee shall have the right, during the period of 30 days preceding such termination, to exercise his option as to all or any part of the shares covered thereby, including shares as to which such option would not otherwise be exercisable. The foregoing adjustments shall be made by the Committee. Fractional shares resulting from any adjustment in options pursuant to this Section 9 may be settled as the Committee or the Board (as the case may be) shall determine. SECTION 10: GOVERNMENT AND OTHER REGULATIONS No Option shall be exercisable, no Stock shall be issued, no certificate for shares of Stock shall be delivered, and no payment shall be made under this Plan except in compliance with all applicable federal and state laws and regulations. The Company shall have the right to rely on the opinion of its counsel as to such compliance. Any share certificate issued to evidence Stock for which an Option is exercised may bear such legends and statements as the Committee may deem advisable to assure compliance with federal and state laws and regulations. No Option shall be exercisable, no Stock shall be issued, no certificate for shares shall be delivered, and no payment shall be made under this Plan until the Company has obtained such consent or approval as the Committee may deem advisable from regulatory bodies having jurisdiction over such matters. SECTION 11: INDEMNIFICATION OF COMMITTEE In addition to such other rights of indemnification that they may have as officers or directors, the Committee members shall be indemnified by the Company against the reasonable expenses, including attorneys' fees actually and necessarily incurred in connection with the Plan's administration and the defense of any action, suit, or proceeding, or in connection with any appeal therein, to which they or any of them may be a party by reasons of any action taken or failure to act under or in connection with the Plan or any Option or Stock Appreciation Right granted thereunder. The Committee members are also to be indemnified against all amounts paid by them in settlement thereof (provided that settlement is approved by independent legal counsel selected by the Company) or paid by them in satisfaction of a judgment in any such action, suit or proceeding, except in relation to matters as to which it shall be adjudged in such action, suit or proceeding that such Committee member is liable for gross negligence or willful misconduct in the performance of his/her duties; provided that within 60 days after institution of any such action, suit or proceeding a Committee member shall in writing offer the Company the opportunity, at its own expense, to handle and defend the same. SECTION 12: MISCELLANEOUS The adoption of this Plan, its operation, or any documents describing or referring to this Plan (or any part thereof) shall not confer upon any employee any right to continue in the employ of the Company or in any way affect any right and power of the Company to terminate the employment of any employee at any time with or without assigning a reason thereof. This Plan, insofar as it provides for grants, shall be unfunded, and the Company shall not be required to segregate any assets that may at any time be represented by grants under the Plan. Any liability of the Company to any person with respect to any grant under this Plan shall be based solely upon any contractual obligations which may be created pursuant to this Plan. No such obligation of the Company shall be deemed to be secured by any pledge of, or other encumbrance on, any property of the Company. The Plan shall be administered in the State of New York and the validity, construction, interpretation, administration and effect of the Plan shall be determined solely in accordance with the laws of that State. [DESCRIPTION] EXHIBIT 10(g) TO FORM 10-K [TEXT] TRUSTCO BANK CORP NY DIRECTORS STOCK OPTION PLAN SECTION 1: PURPOSE OF THE PLAN This Directors Stock Option Plan (the "Plan") has been established by TrustCo Bank Corp NY (the "Company") to advance the interest of stockholders and the Company by encouraging Directors to acquire a larger ownership in the Company. The resulting increased proprietary interest in the Company increases their incentive to continue active service as a Director and to oversee the success and growth of the Company. SECTION 2: DEFINITIONS "Adoption Date" means the date this plan is duly adopted by the Board. "Board" means the Company's Board of Directors. "Code" means the Internal Revenue Code of 1986, as amended. "Committee" means the Compensation Committee of the Board. "Company" means TrustCo Bank Corp NY. "Director" means a member of the Board of Directors of TrustCo Bank Corp NY. "Fair Market Value" means the current fair market value of any Stock subject to a Stock Option. During such time as the Stock is not listed on an established stock exchange, fair market value per share shall be the mean between the closing dealer "bid" and "ask" prices for the Stock as quoted by NASDAQ for the day of the grant, and if no "bid" and "ask" prices are quoted for the day of the grant, the fair market value shall be determined by reference to such prices on the next preceding day on which such prices were quoted. If the Stock is listed on an established stock exchange or exchanges, the fair market value shall be deemed to be the highest closing price of the Stock on such stock exchange or exchanges on the day the option is granted or, if no sale of Stock has been made on any stock exchange on that day, the fair market value shall be determined by reference to such price for the next preceding day on which a sale occurred. In the event that Stock is not traded on an established stock exchange, and no closing dealer "bid" and "ask" prices are available, then the purchase price shall be 100 percent of the fair market value of one share of Stock on the day the option is granted, as determined by the Committee in good faith. The purchase price shall be subject to adjustment only as provided in Section 15 of the Plan. "Grant Date" as used with respect to a particular Option, means the date as of which such Option is granted by the Committee pursuant to the Plan. "Option" means the right, granted by the Committee pursuant to Section 7 of the Plan, to purchase shares of Stock. "Optionee" means the Director to which an Option is granted by the Committee pursuant to the Plan, except that employees of TrustCo Bank Corp NY or its subsidiaries, who are also Directors, shall not be eligible to receive grants under this plan. "Plan" means this Directors Stock Option Plan as it may be amended from time to time. "Stock" means shares of the Company's common stock. "Total and Permanent Disability" as applied to an Optionee, means that the Optionee; (i) has established to the satisfaction of the Committee that the Optionee is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months (all within the meaning of Section 22(e)(3) of the Code); and (ii) has satisfied any other requirement imposed by the Committee. SECTION 3: PLAN ADMINISTRATION The Plan shall be administered by a committee composed of three or more Directors who are appointed by the Board as the Board's Compensation Committee and who may be members of the committee appointed to administer the TrustCo Bank Corp NY Stock Option Plan. The Board may from time to time remove members from, or add members to, the Committee. Vacancies on the Committee, however caused, shall be filled by the Board. The Board shall elect one of the Committee's members as Chairman. The Committee shall hold meetings at such times and places as it may determine, subject to rules and to procedures not inconsistent with the provisions of the Plan. A majority of the authorized number of members of the Committee shall constitute a quorum for the transaction of business. Acts reduced to or approved in writing by a majority of the members of the Committee then serving shall be the valid acts of the Committee. A member of the Committee shall be eligible to be granted Options under this Plan while a member of the Committee. The Committee shall be vested with full authority to make such rules and regulations as it deems necessary or desirable to administer the Plan and to interpret the provisions of the Plan. Any determination, decision or action of the Committee in connection with the construction, interpretation, administration or application of the Plan shall be final, conclusive and binding upon all Optionees and any person claiming under or through an Optionee, unless otherwise determined by the Board. Any determination, decision or action of the Committee provided for in the Plan may be made or taken by action of the Board if it so determines, with the same force and effect as if such determination, decision or action had been made or taken by the Committee. No member of the Committee or of the Board shall be liable for any determination, decision or action made in good faith with respect to the Plan or any Option granted under the Plan. The fact that a member of the Board shall at the time be, or shall theretofore have been or thereafter may be, a person who has received or is eligible to receive an Option shall not disqualify him or her from taking part in and voting at any time as a member of the Board in favor of or against any amendment or repeal of the Plan. SECTION 4: PLAN EFFECTIVE DATE AND DURATION This Plan is effective as of the Adoption Date, subject, however, to the Plan's approval by the Company's shareholders either on or before the Adoption Date of within the 12 month period following the Adoption Date. If shareholder approval is not so obtained, all Options granted under this Plan shall automatically be null and void, ab initio. No Option may be granted under this Plan at any date which is 10 years or more after the Adoption Date. SECTION 5: AMENDMENT OR TERMINATION OF THE PLAN The Board may at any time terminate, amend, modify or suspend the Plan, provided that, without the approval of the shareholders of the Company, no amendment or modification shall be made by the Board which: (a) Increases the maximum number of shares as to which Options may be granted under the Plan; (b) Alters the method by which the Option price is determined; (c) Extends any Option for a period longer than 10 years after the Grant Date; (d) Materially modifies the requirements as to eligibility for participation in the Plan; (e) Amends Paragraphs 9(a) or 9(b) at intervals more frequent than once every six months except to the extent necessary to comport with changes in the Code, the Employee Retirement Income Security Act, or the rules thereunder; or (f) Alters this Section 5 so as to defeat its purpose. Further, no amendment, modification, suspension or termination of the Plan shall in any manner affect any Option theretofore granted under the Plan without the consent of the Optionee or any person validly claiming under or through the Optionee. SECTION 6: STOCK SUBJECT TO THE PLAN (a) The stock to be issued upon exercise of Options granted under the Plan shall be TrustCo Bank Corp NY Stock, which shall be made available, at the discretion of the Board, either from authorized but unissued Stock or from Stock acquired by the Company, including shares purchased in the open market. The aggregate number of shares of Stock which may be issued under or subject to Options granted under this Plan shall not exceed 50,000 shares. The limitation established by the preceding sentence shall be subject to adjustment as provided in Section 15 of the Plan. (b) In the event that any outstanding Option or portion thereof under the Plan for any reason expires or is terminated, the shares of Stock allocable to the unexercised portion of such Option may again be made subject to Option under the Plan. SECTION 7: GRANT OF OPTIONS The Committee may from time to time, subject to the provisions of the Plan, grant Options to Directors to purchase shares of Stock allotted in accordance with Section 6. All Options granted under this Plan shall be "Nonqualified Stock Options" for purposes of the Code. SECTION 8: OPTION PRICE The purchase price per share of each share of Stock which is subject to an Option shall be 100 percent of the Fair Market Value of a share of Stock on the date of the Grant Date. SECTION 9: ELIGIBILITY OF OPTIONEES (a) Options on 1,000 shares of Stock shall be granted annually at a meeting of the Board of Directors to be held each August, commencing with August, 1993, to those persons who are then Directors of the Company, except that if Counsel to the Company determines in his sole discretion that on such date the Company is in possession of material non-public information concerning its affairs, such grant shall be delayed until the third day on which trading occurs following the public dissemination of such information or the date of an event which renders such information immaterial. (b) Subject to the terms of the Plan, and subject to review by the Board, the Committee shall have exclusive jurisdiction (i) to determine the dates on which, or the time periods during which, the Option may be exercised, (ii) to determine the purchase price of the shares subject to each Option in accordance with Section 8 of the Plan and (iii) to prescribe the form, which shall be consistent with the Plan, of the instrument evidencing any Options granted under the Plan. (c) Neither anything contained in the Plan or in any document under the Plan nor the grant of any Option under the Plan shall confer upon any Optionee any right to continue as a Director of the Company or limit in any respect the right of the Company shareholders to terminate the Optionee's directorship at any time and for any reason. SECTION 10: NON-TRANSFERABILITY OF OPTIONS No Option granted under the Plan shall be assignable or transferable by the Optionee other than by will or the laws of descent and distribution, and during the lifetime of an Optionee the Option shall be exercisable only by such Optionee. SECTION 11: TERM AND EXERCISE OF OPTIONS (a) Each Option granted under the Plan shall terminate on the date which is 10 years after the Grant Date. The Committee at its discretion may provide further limitations on the exercisability of Options granted under the Plan. An Option may be exercised only during the continuance of the Optionee's service as a Director, except as provided in Sections 12 and 13 of the Plan. (b) A person electing to exercise an Option shall give written notice to the Company of such election and of the number of shares he or she has elected to purchase, in such forms as the Committee shall have prescribed or approved, and shall at the time of exercise tender the full purchase price of the shares he or she has elected to purchase. The purchase price shall be paid in full in cash upon the exercise of the Option; provided, however, that in lieu of cash, with the approval of the Committee at or prior to exercise, an Optionee may exercise his or her Option by tendering to the Company shares of Stock owned by him or her and having a fair market value equal to the cash exercise price applicable to his or her Option, with the then fair market value of such stock to be determined in the same manner as provided in Section 8 of the Plan with respect to the determination of the fair market value of Stock on the date an Option is granted. (c) An Optionee or a transferee of an Option shall have no rights as a stockholder with respect to any shares covered by his or her Option until the date the stock certificate is issued evidencing ownership of the shares. No adjustments shall be made for dividends (ordinary or extraordinary), whether in cash, securities or other property, or distributions or other rights, for which the record date is prior to the date such stock certificate is issued, except as provided in Section 15 hereof. SECTION 12: TERMINATION OF DIRECTORSHIP If an Optionee's status as a Director ceases for any reason, any Option granted to him or her under the Plan shall terminate, and all rights under the Option shall cease, except: (a) In the case of a Stock Option held by an Optionee that is not subject to Total and Permanent Disability, such Stock Option shall terminate 18 months after the termination of the Optionee's status as Director. (b) In the case of a Stock Option held by an Optionee who is subject to Total and Permanent Disability, such Stock Option shall terminate upon its expiration date. (c) In the case of the Optionee's death while serving as a director, such Stock Option shall terminate eighteen months after the date of death. (d) The foregoing notwithstanding, no Option shall be exercisable after its expiration date. SECTION 13: DEATH OF AN OPTIONEE If an Optionee dies after ceasing to serve as a Director but within the period during which he or she could have exercised the Option under Section 12 of the Plan, then the Option may be exercised by the executors or administrators of the Optionee's estate, or by any person or persons who have acquired the Option directly from the Optionee by bequest or inheritance, within a period prescribed by the Committee after the Optionee's death, except that no Option shall be exercisable after its expiration date. SECTION 14: MODIFICATION, EXTENSION AND RENEWAL OF OPTIONS Subject to the terms and conditions and within the limitations of the Plan, the Committee may modify, extend or renew outstanding Options granted under the Plan or accept the surrender of outstanding Options (to the extent not theretofore exercised) and grant new Options in substitution therefor. Without limiting the generality of the foregoing, the Committee may grant to an Optionee, if he or she is otherwise eligible and consents thereto, a new or modified Option in lieu of an outstanding Option for a number of shares, at an exercise price and for a term which are greater or lesser than under the earlier Option, or may do so by cancellation and regrant, amendment, substitution or otherwise, subject only to the general limitations and conditions of the Plan. The foregoing notwithstanding, no modification of an Option shall, without the consent of the Optionee, alter or impair any rights or obligations under any Option theretofore granted under the Plan. SECTION 15: CHANGES IN CAPITALIZATION (a) In the event that the shares of the Company, as presently constituted, shall be changed into or exchanged for a different number or kind of shares of stock or other securities of the Company or of another corporation (whether by reason of merger, consolidation, recapitalization, reclassification, stock dividend, stock split, combination of shares or otherwise) or if the number of such shares of stock shall be increased through the payment of a stock dividend, then, subject to the provisions of Subsection (c) below, there shall be substituted for or added to each share of stock of the Company which was theretofore appropriated, or which thereafter may become subject to an Option under the Plan, the number and kind of shares of stock or other securities into which each outstanding share of the stock of the Company shall be so changed or for which each such share shall be exchanged or to which each such share shall be entitled, as the case may be. Outstanding Options shall also be appropriately amended as to price and other terms, as may be necessary to reflect the foregoing events. (b) If there shall be any other change in the number or kind of the outstanding shares of the stock of the Company, or of any stock or other securities into which such stock shall have been changed, or for which it shall have been exchanged, and if the Board or the Committee (as the case may be), shall in its sole discretion, determine that such change equitably requires an adjustment in any Option which was theretofore granted or which may thereafter be granted under the Plan, then such adjustment shall be made in accordance with such determination. (c) A dissolution or liquidation of the Company or a merger or a consolidation in which the Company is not the surviving corporation, shall cause each outstanding Option to terminate, except to the extent that another corporation may and does in the same transaction assume and continue the Option or substitute its own Options. In either event, the Board or the Committee (as the case may be) shall have the right to accelerate the time within which the Option may be exercised. (d) Fractional shares resulting from any adjustment in Options pursuant to this Section 15 may be settled as the Board or the Committee (as the case may be) shall determine. (e) To the extent that the foregoing adjustments relate to stock or securities of the Company such adjustments shall be made by the Committee, whose determination in that respect shall be final, binding and conclusive. Notice of any adjustment shall be given by the Company to each holder of an Option which shall have been so adjusted. (f) The grant of an Option pursuant to the Plan shall not affect in any way the right or power of the Company to make adjustments, reclassifications, reorganizations or changes of its capital or business structure, to merge, to consolidate, to dissolve, to liquidate or to sell or transfer all or any part of its business or assets. SECTION 16: LISTING AND REGISTRATION OF SHARES (a) No Option granted pursuant to the Plan shall be exercisable in whole or in part if at any time the Board or the Committee (as the case may be) shall determine in its discretion that the listing, registration or qualification of the shares of Stock subject to such Option on any securities exchange or under any applicable law, or the consent or approval of any governmental regulatory body, is necessary or desirable as a condition of, or in connection with, the granting of such Option or the issue of shares thereunder, unless such listing, registration, qualification, consent or approval shall have been effected or obtained free of any conditions not acceptable to the Board. (b) If a registration statement under the Securities Act of 1933 with respect to the shares issuable upon exercise of any Option granted under the Plan is not in effect at the time of exercise, as a condition of the issuance of the shares the person exercising such Option shall give the Committee a written statement, satisfactory in form and substance to the Committee, that he or she is acquiring the shares for his or her own account for investment and not with a view to their distribution. The Company may place upon any stock certificate for shares issuable upon exercise of such Option the following legend or such other legend as the Committee may prescribe to prevent disposition of the shares in violation of the Securities Act of 1933 or other applicable law: THE SHARES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933 (THE "ACT") AND MAY NOT BE SOLD, PLEDGED, HYPOTHECATED OR OTHERWISE TRANSFERRED OR OFFERED FOR SALE IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT WITH RESPECT TO THEM UNDER THE ACT OR A WRITTEN OPINION OF COUNSEL FOR THE COMPANY THAT REGISTRATION IS NOT REQUIRED. SECTION 17: MISCELLANEOUS The Plan shall be administered in the State of New York and the validity, construction, interpretation, administration and effect of the Plan shall be determined solely in accordance with the laws of that State. [DESCRIPTION] EXHIBIT 11 TO FORM 10-K Exhibit 11 TRUSTCO BANK CORP NY 1993 FORM 10-K Computation of Net Income Per Common Share Year Ended December 31 Note: Daily average shares outstanding for all years have been adjusted to reflect the 2 for 1 stock split in November 1993 and the 5 for 4 stock split in November 1992. [DESCRIPTION] EXHIBIT 13 TO FORM 10-K 1993 Annual Report TRUSTCO Bank Corp NY Subsidiary Bank: Trustco Bank New York Schenectady, New York Member FDIC Total Average Equity (dollars in millions) 1989 $ 51 1990 $ 57 1991 $ 75 1992 $116 1993 $126 Average Earning Assets (dollars in millions) 1989 $ 720 1990 $ 821 1991 $1,091 1992 $1,768 1993 $1,835 President's Message I am happy to report that 1993 was another record year at TrustCo. It is nice to be able to report our continuing progress during this period when apparently the banking industry has attained significant recovery from the difficulties of the past three or four years. Throughout this period, TrustCo has managed to avoid the pitfalls many others have experienced by sticking to the basics of the business and avoiding the current or in vogue products and precepts. We expect to continue in this vein, and are grateful for the enthusiasm of our staff and Boards in making this success a reality. Shareholder values continue to progress with net income for 1993 at $20.3 million, up a significant 16.1% over 1992. As planned, TrustCo's most important ratio, Return on Average Shareholders' Equity, was 16.2% for 1993, up from 15.1% in 1992. It is our commitment to ensure Return on Average Equity measures up favorably in any peer group, and we are comfortable that it does. TrustCo's five year average Return on Equity was 17.1%, and we have plans to methodically increase ROE to the 18% level for 1995. Barton Andreoli, President of Towne Paving Inc., joined the Boards of Trustco Bank New York and TrustCo Bank Corp NY during 1993; and Bernard King, Chairman of King Road Materials Inc., retired from both Boards during 1993. We thank Bernie for his many contributions and wish him well in retirement. I would like to thank all our Board members for their continued support and guidance through the year. We note with sorrow the passing of David Hume, Honorary Director, who served the Boards with distinction for many years. Senior staff changes included William Milton and James McLoughlin being promoted to Administrative Vice Presidents; Madeline Busch, Donald Csaposs, Ann Noble, Matthew Waschull, and George Wickswat were appointed Vice Presidents in their respective areas of responsibility. We closed the former Home & City main office on State Street, Albany and successfully merged the account base into Trustco's State Street office. We consider the consolidation complete, leaving us with 43 branch offices, with the expectation of at least one new office during the current year. We continue with our upgrading, targeting each branch for major renovation on an approximate 7 year cycle. Our search for appropriately priced acquisitions in our market area continues, though we are not engaged in any significant acquisition conversations at this time. We continue to work with some of the problem loans we acquired and want to report continuing progress in the legal actions. Though the litigation is taking longer than originally anticipated, we want shareholders to know we reserved sufficiently for these loans to ensure there will be no negative impact on TrustCo's future financial results as they are brought to conclusion. We completed a two for one stock split during the fourth quarter, effectively increasing dividend payments by 29.4% over last year. Our quarterly cash dividends have increased at a 25.9% compound annual rate over the last five years, a major accomplishment in the current banking climate. Trustco's Affordable Housing Program, designed to assist with homeownership, was expanded to the other markets that we serve after our initial success in Schenectady. This program is a model for community reinvestment and one of the most effective in our state. It has been suggested by reporters on occasion that TrustCo is a boring company to follow because the consistently good results don't make stimulating copy. All in all, 1993 was another "boring" year here at TrustCo with increases in all important areas and continuing benefits to the owners, employees, and the community. Our expectation is that 1994 will also be "boring." Our plans call for a repeat of 1993 income and growth successes, and newly added branches are contributing solidly to loan and deposit growth. The emphasis will continue on the Home Equity Loan and Home Equity Credit Line products on the lending side and the NOW account on the deposit side. Our Trust Department currently manages assets in excess of $600 million, and we look forward to increased penetration in the former Home & City branch territories. With the difficult economy, community needs have increased and Trustco has responded accordingly. As mentioned previously, we continue to expand our Affordable Housing Program. We have been able to provide increased employee and management participation in charitable and community organizations, as well as increase our corporate charitable donations in the Capital District area. The interesting times of the '90s in banking have been very challenging at TrustCo. We believe we have met the challenge successfully and will be able to continue this success into the future. We have a strong marketplace with the right products and a team of super employees to bring about the kind of results in the future that have brought us success in the past. With our focus, enthusiasm, and commitment, we will be able to compete successfully in the banking environment of the future. Sincerely, Robert A. McCormick, President and Chief Executive Officer P.S. December 31, 1993 marked the completion of my first decade as CEO of the Bank and Holding Company. I thought it appropriate to report the results of that stewardship. I thank the Company's Board and all of our employees for making us look so good. Challenge and Progress 1983-1993 1983-1993--A period characterized by turbulence in the banking industry. First the go-go times, followed quickly by the savings and loan debacle which decimated the industry, immediately followed by the commercial banking fiasco. Taken in total, this period was a very serious financial blow to taxpayers and to the shareholders of many banking institutions. Through it all, TrustCo has served its shareholders well with exemplary growth in the value of their investments, emerging as a leader in the financial services marketplace. The past decade has been a proving ground for our management team to significantly enhance the bank's profitability and productivity in behalf of shareholders. TrustCo's success is founded on its accountability and vitality which are well reflected in the following statistics: Total Average Assets ($) 12/31/83 $ 324,994,000 12/31/84 459,655,000 12/31/85 506,786,000 12/31/86 587,793,000 12/31/87 640,010,000 12/31/88 714,294,000 12/31/89 762,532,000 12/31/90 868,069,000 12/31/91 1,149,775,000 12/31/92 1,852,180,000 12/31/93 1,946,715,000 Assets per Employee ($) 12/31/83 $ 1,245,188 12/31/84 1,423,080 12/31/85 1,619,125 12/31/86 1,770,461 12/31/87 1,904,792 12/31/88 2,052,569 12/31/89 2,310,703 12/31/90 2,575,872 12/31/91 2,332,201 12/31/92 3,834,741 12/31/93 4,250,469 Net Income ($) 12/31/83 $ 3,362,000 12/31/84 3,828,000 12/31/85 4,851,000 12/31/86 5,650,000 12/31/87 6,671,000 12/31/88 7,826,000 12/31/89 9,446,000 12/31/90 10,575,000 12/31/91 12,861,000 12/31/92 17,503,000 12/31/93 20,325,000 Return on Equity (%) 12/31/83 12.30% 12/31/84 12.93% 12/31/85 14.89% 12/31/86 15.70% 12/31/87 16.68% 12/31/88 17.51% 12/31/89 18.62% 12/31/90 18.49% 12/31/91 17.16% 12/31/92 15.06% 12/31/93 16.20% Market Price/Share ($) 12/31/83 $ 2.83 12/31/84 3.62 12/31/85 5.81 12/31/86 5.74 12/31/87 6.69 12/31/88 8.56 12/31/89 10.08 12/31/90 9.45 12/31/91 13.50 12/31/92 16.88 12/31/93 22.75 Since 1983, deposits have risen 534 percent. Average assets during this same period were boosted 499 percent to $1.947 billion. Our 43 branches--an increase of 207 percent--are staffed by 458 employees working in their own home towns, promoting the Bank's strong commitment and presence as a respected local employer. Assets per employee are up by 258 percent to $4.3 million, a tribute to our diligence in creating efficiency in operations. The net income of TrustCo was $3.36 million in 1983. It has increased 505 percent, ending 1993 at $20.33 million. During the past ten years, Return on Equity rose from 12.3 percent to 18+ percent, then diminished to 16.2 percent, and is on the way back to a planned 18 percent. This all important measure will stand up favorably against any index for any period we have been able to find. Last August, TrustCo increased its common stock dividend to shareholders for the seventeenth consecutive year. The price per share of TrustCo stock has climbed 704 percent. To put these achievements into perspective, consider that 100 shares of common stock purchased at the beginning of 1983 would be worth 1,611 shares of common stock today. It is important to note that TrustCo's achievements have been publicly recognized by external resources such as Louis Rukeyser's Wall Street in 1992 for its remarkable dividend record; selected in the same year by Financial World as one of the top 200 growth companies in the United States; cited on the 1993 Honor Roll for sustained superior performance over 10 years by the respected investment banking firm of Keefe, Bruyette & Woods, Inc.--one of only ten banks in the nation to earn this recognition. TrustCo continues to set and break its own records for financial performance and favorable trends quarter after quarter, year after year. The lifeblood of the bank is its capacity to adapt to the changing economy and the needs of its constituencies: shareholders, customers, and community. TrustCo has at its core a versatile management team whose diversity allows it to identify a range of initiatives and translate them into positive results. Conservative, proactive planning, consistent pursuit of the Capital Region retail and commercial customer markets, and exceeding the expectations of our shareholders are the guiding principles which have contributed to our success. Consolidated Statements of Income 10 Consolidated Statements of Condition 11 Consolidated Statements of Changes in Shareholders' Equity 12 Consolidated Statements of Cash Flows 13 Notes to Consolidated Financial Statements 15 Independent Auditors' Report 25 Five-Year Summary 26 Financial Review 27 Distribution of Assets, Liabilities and Shareholders' Equity: Interest Rates and Interest Differential 44 Price Range of Common Stock and Dividends Per Share 45 Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies (a) Basis of Presentation The accounting and financial reporting policies of TrustCo Bank Corp NY (Company) and Trustco Bank New York (Bank) conform to general practices within the banking industry and are in accordance with generally accepted accounting principles. A description of the more significant policies follows. During 1993, the Company created a new subsidiary to hold and manage certain foreclosed properties. The enclosed consolidated financial statements include the accounts of this new subsidiary. (b) Consolidation The consolidated financial statements of the Company include the accounts of the subsidiaries after elimination of all significant intercompany accounts and transactions. (c) Investment Securities and Securities Held for Sale Investment securities are stated at cost, adjusted for amortization of premiums and accretion of discounts to first call or maturity date. Securities held for sale are held at the lower of amortized cost or market. Gains and losses on dispositions of these securities are based on the adjusted cost of the specific security sold. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability to hold securities until maturity, they are classified as investment securities and carried at amortized historical cost. Securities to be held for indefinite periods of time and not intended to be held to maturity are classified as held for sale and carried at the lower of cost or market value. Securities held for indefinite periods of time include securities that management intends to use as part of its asset/liability management strategy and that may be sold in response to changes in interest rates and other factors related to interest rate and resultant prepayment risk changes. Assets held in trading accounts are carried at market value. (d) Loans Loans are carried at the principal amount outstanding. Related loan fees are generally amortized into income over the applicable loan or service period. Interest on discounted loans is accrued based upon methods which approximate the interest method. Loan income is recognized on the accrual basis of accounting. When in the opinion of management the collection of principal or interest is in doubt, the loan is categorized as non-accrual. Thereafter, no interest is taken into income until the borrower demonstrates the ability to make scheduled payments of interest and principal. (e) Allowance for Possible Loan Losses An allowance for possible loan losses is maintained at a level considered adequate by management to provide for potential loan losses based on analysis of the credit risk of the loan portfolio including a review of past loan experience, current economic conditions and the underlying collateral value. The allowance is increased by provisions charged against income and reduced by net charge-offs. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for losses on loans and real estate owned. Such agencies may require the Company to recognize additions to the allowances based on their judgements of information available to them at the time of their examination. (f) Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation computed on either the straight-line or accelerated methods over the remaining useful lives of the assets. Occupancy expense comprises all expenses, including maintenance and repair, related to the operation of Bank premises, net of rental income. Gains or losses attributed to the retirement or sale of assets are credited or charged to operations in the year realized. (g) Real Estate Owned Included in other assets are assets received from foreclosures and in-substance foreclosures. A loan is considered an in-substance foreclosure when little or no equity is present in the underlying collateral, considering the current fair value of the collateral; proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral; control of the collateral is effectively abandoned, or because of the current financial condition it is doubtful that equity will be rebuilt or the loan repaid in the foreseeable future. Foreclosed assets, including in-substance foreclosures, held for sale are recorded on an individual basis at the lower of (1) fair value minus estimated costs to sell or (2) "cost" (defined as the fair value at initial foreclosure). When a property is acquired or identified as in-substance foreclosure, the excess of the loan balance over fair value is charged to the allowance for loan losses. Subsequent write downs are included in other noninterest expense. At December 31, 1993, the value of real estate owned was $19.2 million. The value of real estate owned at December 31, 1992 was $26.6 million. (h) Income Taxes Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and has chosen not to restate prior year financial statements. 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. (i) Financial Instruments The Company is a party to certain financial instruments with off- balance sheet risk such as commitments to extend credit, unused lines of credit and letters of credit. It is the Company's policy to record such instruments when funded. In December 1991, the FASB issued Statement No. 107 which requires additional disclosure about fair value of financial instruments. The Company has adopted the provisions of Statement No. 107 and has provided the required disclosures in Note 15. (j) Dividend Restrictions Banking regulations restrict the amount of cash dividends which may be paid during a year without the written consent of the appropriate bank regulatory agency. Based on these restrictions, the Company could pay $32.4 million plus one hundred percent of 1994 net profits. (k) Amortization of Goodwill The excess of the fair value of consideration paid over net assets acquired (goodwill) was fully amortized as of December 31, 1992. (l) Reclassification of Prior Year Statements It is the Company's policy to reclassify prior year financial statements to conform to the current year presentation. (m) Pension and Other Postretirement Plans The Company has a defined benefit pension plan covering substantially all of its employees. The benefits are based on years of service and the employee's compensation during the five years before retirement. The cost of this program is being funded currently. The Company sponsors a defined benefit health care plan for substantially all retirees and employees. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," which establishes a new accounting principle for the cost of retiree health care and other postretirement benefits (also see note 12). Prior to 1993, the Company recognized these benefits on the pay-as-you-go method (i.e., cash basis). The cumulative effect of the change in method of accounting for postretirement benefits other than pensions is reported in the 1993 consolidated statement of income. (2) Acquisition of Home & City Savings Bank On September 30, 1991, the Company acquired all of the outstanding common stock of Home & City Savings Bank of Albany, New York in a purchase business combination. The aggregate purchase price for the transaction was approximately $72 million consisting of cash and 1,441,050 shares of TrustCo common stock. The excess purchase price over the fair value of net assets acquired (goodwill) of approximately $2.5 million has been fully amortized. The results of operations of Home & City are included in the Company's consolidated statements of income from the date of acquisition. Assuming the acquisition had taken place January 1, 1991 a summary of the Company's unaudited consolidated results of operations on a pro forma basis for the twelve months ended December 31, 1991 would have been as follows: The pro forma results are not necessarily representative of the actual results that would have occurred in the period presented, or what may be obtained in the future. (3) Balances at Other Banks Trustco Bank New York maintains deposit accounts with several other commercial banks as compensation for services provided to the Bank in the normal course of business. These balances are not legally restricted as to withdrawal but result from informal agreements and are in lieu of fee assessments. As of December 31, 1993, a total of $79,000 was on deposit at other banks. This balance was $195,000 as of December 31, 1992. In addition, the Bank maintains a reserve balance at the Federal Reserve Bank of New York as required by regulation by the Federal Reserve System. This balance, legally restricted as to withdrawal, totaled $15,907,000 as of December 31, 1993, and $13,455,000 as of December 31, 1992. For the years ending December 31, 1993 and 1992 these balances averaged $15,517,000 and $14,961,000, respectively. (4) Securities Held for Sale The book and market values of Securities Held for Sale at December 3l, 1993 and 1992 follows: The gross unrealized gains and losses in Securities Held for Sale at December 31, 1993 and 1992 follow: The gross unrealized gains and losses in Investment Securities at December 31, 1993 and 1992 follow: The anticipated maturity schedule of book and market values of Investment Securities at December 31, 1993 follows: Proceeds from sales of debt instruments included in investment securities during 1993, 1992, and 1991 were approximately $0, $107,639,000, and $37,178,000 respectively. All of the 1993 sales of debt securities were made from those securities designated as Held for Sale (See note 4). During 1993, the Company realized proceeds of approximately $1,877,000 from the sale of its portfolio of equity securities. Proceeds from this portfolio sale were used to acquire a small portfolio of equity securities. Management has designated these securities as trading assets and holds them at market value. The market value of trading securities at December 31, 1993 was $2,106,000. There were no trading assets as of December 31, 1992. The gross realized gains on sales of debt instruments in 1993, 1992, and 1991 were $0, $3,346,000, and $492,000 respectively. Gross realized gains on sales of equity instruments in 1993 were approximately $229,000. Gross realized losses on the sales and calls of debt instruments for 1993, 1992, and 1991 were $0, $407,000, and $26,000 respectively. Gross realized losses on sales of equity instruments in 1993 were approximately $21,000. The book value of securities pledged to secure public deposits and for other purposes required by law amounted to $85,634,000 and $121,075,000 at December 31, 1993 and 1992, respectively. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Statement is effective for financial statements for fiscal years beginning after December 15, 1993. This Statement addresses the accounting for 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 Company has the positive intent and ability to hold to maturity are classified as "held-to-maturity" 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" or "trading securities" are classified as "available-for-sale securities" and reported at fair value, with unrealized gains and losses excluded from earnings an reported in a separate component of stockholders' equity. Management believes, at this time, that the Statement will have no material impact on the financial statements. (6) Loans and Discounts A summary of outstanding Loans and Discounts at December 3l, 1993 and 1992 follows: Real estate construction loans include $2,870,000 in residential loans and $11,302,000 in commercial loans at December 31, 1993 and $1,750,000 in residential loans and $17,252,000 in commercial loans at December 31, 1992. Information with regard to non-accrual loans follows: Loans contractually past due 90 days or more and still accruing at year end were $1,853,000, $6,438,000, and $3,340,000 for 1993, 1992 and 1991 respectively. There were no restructured loans at December 31, 1993, 1992 and 1991. There were no unused commitments on nonaccrual loans at December 31, 1993 or 1992. The Bank has pledged certain of its GNMA mortgage pools as collateral for standby letters of credit which have been issued. The book value of pledged mortgages was $16,611,000 and $25,354,000 at December 31, 1993, and 1992 respectively. In the ordinary course of business, the Bank has loan, deposit and other transactions with executive officers and directors and organizations with whom such persons are associated. Such transactions are on the same terms, including interest rates and collateral as to loans, as those prevailing at the time for comparable transactions with others. The aggregate amount of loans to executive officers, directors and their immediate families, and to corporations where executive officers and directors beneficially own a 10% or greater equity interest was $11,163,000 and $14,320,000 at December 31, 1993 and 1992, respectively. During 1993, loan advances involving these individuals amounted to $2,080,000 while repayments totaled $5,237,000. On May 31, 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," (SFAS No. 114). SFAS No. 114, which is effective for financial statements issued for fiscal years beginning after December 15, 1994, prescribes recognition criteria for loan impairment and measurement methods for certain impaired loans and loans whose terms are modified in troubled-debt restructurings. Although the Company has not yet performed a detailed analysis of the effects of the implementation of SFAS No. 114, the Company does not expect its adoption to have a material effect on its consolidated financial statements. (7) Allowance for Possible Loan Losses A summary of changes in the allowance for possible loan losses for the years ending December 31, 1993, 1992 and 1991 follows: (8) Bank Premises and Equipment A summary of bank premises and equipment at December 31, 1993 and 1992 follows: Depreciation and amortization approximated $2,373,000 for the year 1993, $2,245,000 for 1992, and $1,193,000 for 1991. Occupancy expense of Bank premises included rental expense of $1,388,000, $1,430,000, and $846,000 for the years 1993, 1992 and 1991, respectively. (9) Short-term Debt Short-term debt consisting primarily of Securities Sold Under Agreements to Repurchase with maturities of generally less than ninety days was as follows for the years ending December 31, 1993 and 1992: (10) Long-term Debt Long-term debt consists of the following: As of December 31, 1993, the Company's long-term debt was comprised of $2.75 million borrowed against a $10 million revolving credit facility, at the prime rate (6.0%). The interest rate increases to one quarter of one percent above the prime rate for the period July 1, 1995 through June 30, 1998. Beginning October 1, 1995 and on the first day of each calendar quarter thereafter, one twelfth of the outstanding principal balance as of June 30, 1995 will be repaid. The entire unpaid balance of principal and interest will be due July 1, 1998. (11) Income Taxes A summary of Income Tax expense (benefit) included in the consolidated statements of income follows: Prior to 1993, the Company accounted for income taxes under APB 11. Under APB 11, deferred tax expense (benefit) resulted from timing differences in the recognition of revenue and expense for tax and financial statement purposes. The sources of these differences and the tax effect for each year follow: Effective January 1, 1993, the Company adopted SFAS No. 109. The effect of adoption was not material to the financial statements. 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 are presented below. The valuation allowance as established by management takes into consideration the historical level of taxable income in the prior years as well as the time period that the items giving rise to the deferred tax assets turn around. The effective tax rates differ from the statutory federal income tax rate. The reasons for these differences are as follows: (12) Employee Benefits The Company maintains a trusteed non-contributory pension plan covering substantially all full-time employees. The benefits are based on the sum of (a) a benefit equal to a prior service benefit plus the average of the employees' highest five consecutive years compensation in the ten years preceding retirement multiplied by a percentage of service after a specified date plus (b) a benefit based upon career average compensation. The amounts contributed to the plan are determined annually on the basis of (a) the maximum amount that can be deducted for federal income tax purposes or (b) the amount certified by a consulting actuary as necessary to avoid an accumulated funding deficiency as defined by the Employee Retirement Income Security Act of 1974. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. Assets of the funds are primarily invested in common stock and fixed income common funds administered by the Bank. The following table sets forth the plans' funded status and amounts recognized in the Company's consolidated statements of condition at December 31, 1993 and 1992: The discount rates used in determining the actuarial present value of the projected benefit obligation were 6.75 percent in 1993 and 7.5 percent in 1992 and 1991. The rate of increase in future compensation levels used in the actuarial present value of projected benefit obligations was 5.0 percent in 1993 and 6.0 percent in 1992 and 1991. The expected long-term rate of return on assets was 6.5 percent in 1993, 7.0 percent in 1992 and 8.5 percent in 1991. The Bank also has unfunded supplementary pension plans under which additional retirement benefits are accrued for eligible senior and executive officers. The Bank also provides a profit-sharing plan for substantially all employees. Contributions to the plan, which are based on management discretion as defined in the plan, amounted to $1,302,000 in 1993, $1,294,000 in 1992, and $966,000 in 1991. An executive incentive plan for executive officers and other designated senior officers became effective January 1, 1983. Contributions to the plan are based on the Bank's performance and estimated distributions to participants are accrued during the year and generally paid in the following year. Under the terms of the Company's Stock Option Plan, 1,264,230 shares are reserved for options and stock appreciation rights (SAR's). As of December 31, 1993, 887,564 options and 17,704 SAR's remain issued and outstanding. Of these, 406,465 options and 17,704 SAR's are vested with exercise prices ranging from $5.27 to $20.19. Under the plan, 107,982 shares remain available to grant at December 31, 1993. During 1993, 21,919 options were exercised and no options cancelled. Additionally, 280,000 options were granted with an exercise price of $20.19. Under the terms of the Directors Stock Option Plan, 100,000 shares are reserved for options. As of December 31, 1993, 20,000 vested options remain issued and outstanding, with an exercise price of $21.38. Under the Plan, 78,000 shares remain available to grant at December 31, 1993. During 1993, 22,000 options were granted and 2,000 options were exercised. In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Statement 106 requires a calculation of the present value of expected benefits to be paid to employees after their retirement and an allocation of those benefits to the periods that employees render service to earn the benefits. The Company permits retirees under age 65 to participate in the Company's medical plan by paying the same premium as the active employees. At age 65, Trustco Bank provides a Medicare Supplemental Program to retirees. The retirees contribute at the same percentage as active employees. Contributions increase annually or as the premium increases. Since these benefits are currently being provided, the Company adopted SFAS No. 106 effective January 1, 1993, and has reported the cumulative effect of that change in the December 31, 1993 Consolidated Statement of Income. Accumulated postretirement benefit obligation at December 31, 1993: Expense for 1993 related to the transition obligation was $5.3 million, with an after-tax cost of $3.3 million. Periodic benefit cost amounts to $467 thousand for the year. The Company funded the plan in full through the use of a benefit trust during the first quarter of 1993. As a result, periodic benefit costs in future years are expected to decrease. The trust holding the plan assets is subject to federal income taxes at a 35.0 percent tax rate at December 31, 1993. The expected long term rate of return on plan assets, after estimated income taxes was 3.3 percent for the year ended December 31, 1993. Net period postretirement benefit cost for 1993 includes the following components: For measurement purposes, a 16 percent annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) was assumed for 1993; the rate was assumed to decrease gradually to 5.75 percent by the year 2002 and remain 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 benefit obligation as of December 31, 1993, by approximately $1.1 million, and the aggregate of the service and the interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993, by approximately $236 thousand. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 6.75 percent at December 31, 1993. (13) Lease Commitments and Contingent Liabilities (a) Leases The Bank leases certain banking premises. Accounting for these leases is under the "operating method," with minimum rental commitments in the amounts presented below. The majority of these leases contain options to renew. (b) Litigation Existing litigation arising in the normal course of business is not expected to result in any material loss to the Company. (14) Off-Balance-Sheet Financing and Concentrations of Credit Risk The Bank is a party to certain 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 letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the statements of condition. The contract amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Bank's exposure to credit loss in the event of nonperformance by the other party to the commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet instruments. Contract amounts of financial instruments that represent credit risk as of December 31, 1993 and 1992 at fixed and variable interest rates are as follows: 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 fully drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral, if any, required by the Bank upon the extension of credit is based on management's credit evaluation of the customer. Mortgage and construction loan commitments are secured by a first lien on real estate. Collateral on extensions of credit for commercial loans varies but may include accounts receivable, inventory, property, plant and equipment, and income producing commercial property. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support borrowing arrangements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank grants commercial, installment and residential loans to customers throughout the Capital District of New York State. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon the real estate sector as well as the overall strength of the economy. (15) Fair Value of Financial Instruments The Financial Accounting Standards Board issued Statement No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS 107), which requires that the Bank disclose estimated fair values for its financial instruments. SFAS No. 107 defines fair value of financial instruments 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. SFAS No. 107 uses the same definition for a financial instrument as the Financial Accounting Standards Board Statement No. 105, "Disclosure of Information about Financial Instruments With Off-Balance Sheet Risk and Financial Instruments With Concentrations of Credit Risk" (SFAS No. 105). SFAS No. 105 defines a financial instrument as cash, evidence of ownership interest in an entity, or a contract that imposes on one entity a contractual obligation to deliver cash or another financial instrument to a second entity or to exchange other financial instruments on potentially unfavorable terms with a second entity and conveys to that second entity a contractual right to receive cash or another financial instrument from the first entity or to exchange other financial instruments on potentially favorable terms with the first entity. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Bank's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Bank's financial instruments, fair value estimates are based on judgements regarding future expected net cash flows, 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 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 that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include the deferred tax assets and liabilities and property, plant, and equipment. 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 in the estimates of fair value under SFAS No. 107. In addition there are significant intangible assets that SFAS 107 does not recognize, such as the value of "core deposits," the Bank's branch network and other items generally referred to as "goodwill." Investments and Securities Held for Sale The carrying amounts for short-term investments approximate fair value because they mature in 90 days or less and do not present unanticipated credit concerns. The fair value of longer-term investments, except certain state and municipal securities, is estimated based on bid prices published in financial newpapers or bid quotations received from securities dealers. The fair value of certain state and municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued. See footnotes 4 and 5 for detail disclosure of investment securities and securities held for sale. Loans Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, installment and real estate. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing 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 maturity is based on the contractual term of the loans to maturity. Fair value for significant nonperforming loans is based on recent external appraisals and discounting of cash flows. Estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information. The following table presents information for loans. The fair value estimate for credit card loans is based on the value of existing loans at December 31, 1993 and December 31, 1992. This estimate does not include the value that relates to estimated cash flows from new loans generated from existing card holders over the remaining life of the portfolio. Deposit Liabilities Under SFAS 107, the fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, NOW accounts, money market and checking accounts, is estimated to be the amount payable on demand as of 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 the rates currently offered for deposits of similar remaining maturities. The fair value estimates above do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market. Long Term Debt The fair value of the Company's long term debt, which consists of a revolving credit facility at the prime interest rate, is estimated to be book value at December 31, 1993 and December 31, 1992. Other Financial Instruments The fair value of cash and cash equivalents, accrued interest receivable, accrued interest payable and short term debt are estimated to be book value at December 31, 1993 and December 31, 1992. Commitments to Extend Credit, Standby Letters of Credit, and Financial Guarantees Written The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial guarantees written and letters of credit is based on fees currently charged for similar agreements, or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. Fees such as these are not a major part of the Bank's business. Therefore, based upon the above facts, book value equals fair value and the amounts are not significant. (16) Parent Company Only The following statements pertain to TrustCo Bank Corp NY: (17) Unaudited Interim Financial Information Following is a summary of unaudited consolidated quarterly financial information for each quarter of 1993 and 1992: INDEPENDENT AUDITORS' REPORT KPMG Peat Marwick Certified Public Accountants 74 North Pearl Street Albany, New York 12207 The Board of Directors and Shareholders of TrustCo Bank Corp NY: We have audited the accompanying consolidated statements of condition of TrustCo Bank Corp NY and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' 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 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 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 TrustCo Bank Corp NY 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 notes 1 and 11 to the consolidated financial statements, in 1993 the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" which changed its method of accounting for income taxes. As discussed in note 12 to the consolidated financial statements, the Company also adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" in 1993 which changed its method of accounting for postretirement benefits other than pensions. KPMG Peat Marwick January 26, 1994 Five-Year Summary The management of TrustCo has identified return on equity as the principal measurement index in evaluating its effectiveness in fulfilling its responsibility to the shareholders. Return on assets, while an important measure of performance, is regarded as a less sensitive indicator of true shareholder return. The Company's return on average shareholders' equity for 1993 was 16.18 percent. This key performance indicator has exceeded 15 percent in each of the past five years. Return on average assets performance has remained consistently positive throughout the period as well, providing further evidence of steady performance. Cash dividends per share have increased 2.5 times over the past five years, for a compound annual increase of 25.9 percent. Management believes that retained earnings should be maintained at a level that fully supports, but does not exceed, the Company's needs, with earnings above such a level returned to the owners in the form of cash dividends. This consistently strong performance in all areas indicates the success enjoyed by the Company in promoting the Bank's image as "YOUR HOME TOWN BANK" to a broad range of customers. Management intends to continue to focus its attention on being the best retail banking company in the Capital District. Financial Review LIQUIDITY AND INTEREST SENSITIVITY A sound asset/liability management program must balance the goals of maintaining sufficient liquidity to meet depositors' requirements, while at the same time continuing to satisfy credit needs in our markets. Management has addressed these issues by developing a maturity mix that maximizes flexibility in responding to both liquidity needs and interest rate fluctuations, and by consistently focusing attention on developing and expanding stable funding sources. The continuing volatility of interest rates during 1993, a year in which Federal funds rates fluctuated by 275 basis points, serves to highlight the importance of active management of earning assets and interest bearing liabilities in enabling the Company to attain its financial goals. TrustCo has emphasized the funding of asset growth through the expansion of its core deposit base. These funds (which represent total deposits, less certificates of deposit of $100,000 or more) have historically proven to be the most stable and least costly sources of funds. Despite ongoing competitive pressures, the level of core deposits has increased steadily, rising from 91.0 percent of average total liabilities in 1991 to 93.9 percent in 1992. During 1993, the level of core deposits continued to expand, reaching an impressive 95.2 percent of average total liabilities at December 31, 1993. This growth was centered during 1993 in savings accounts, which increased significantly, while other forms of deposits declined in aggregate. Core deposit growth for 1993 of 6.3 percent outpaced the 5.2 percent increase in interest earning assets, providing a further indication of the stability of funding sources. Liquidity and interest sensitivity are related in that each is affected by maturing assets and liabilities. Interest sensitivity analysis, however, takes the additional step of considering that certain assets and liabilities are subject to rate adjustment(s) prior to maturity. The objective of interest sensitivity management is to establish and maintain satisfactory net interest margins throughout all phases of a full interest rate cycle. The measurement of the interest rate sensitivity position at any specific point in time involves numerous assumptions and estimates. Within this context, the accompanying interest sensitivity analysis, divided into future repricing timeframes, helps to illustrate the potential impact of future interest rate changes on net interest income. It should be noted that interest sensitivity is only one indicator of the extent to which changes in interest rates have the potential to affect net interest income. The components of the earning asset and interest bearing liability portfolios are also changing continuously. The Company has not, to date, used financial futures or interest rate swaps in the management of interest rate risk. For purposes of this analysis, the maturity and repricing of loans is based on stated maturity or earliest repricing date. For securities held for sale and investment securities, the earlier of average life or stated maturity is used. The category of regular savings, NOW and money market accounts includes balances of $110,630,000, $238,871,000, $11,537,000 and $719,999,000 for Money Market accounts, NOW accounts, Investment checking accounts and regular savings respectively. Although these deposits are subject to immediate withdrawal, it is management's experience that they mature or reprice over a full interest rate cycle. Time accounts, short term debt and long term debt are based on stated maturity. NET INTEREST INCOME Net interest income represents the difference between interest related income and expense. Taxable equivalent net interest income for 1993 rose $4.6 million, or 6.7 percent to $74.0 million, after a $23.8 million increase in 1992. Despite ongoing competitive pressure in both funding sources and investment alternatives, taxable equivalent net interest income as a percentage of average assets increased 6 basis points to 4.04 percent in 1993, after declining 22 basis points in 1992. The following table summarizes the major components of net interest income. Changes in interest income and expense result from variances in the volume of outstanding interest earning assets and interest bearing liabilities, from fluctuations in the level of interest rates earned and paid, or from a combination of these factors. Average interest earning assets have steadily increased, reaching $1.8 billion in 1993. Taxable equivalent yields on these assets have fallen with the general level of interest rates, declining 1.2 percent in 1992, and an additional 1.0 percent to 7.4 percent in 1993. Interest bearing liabilities have consistently increased, growing to $1.7 billion in 1993. Interest paid on these funds has declined steadily with overall rate movements, decreasing 1.3 percent in 1992 and an additional 1.1 percent to 3.6 percent in 1993. The following table sets forth, for each major category of interest earning assets and interest bearing liabilities, changes in 1993 and 1992 taxable equivalent interest income and expense, allocating the changes to variances in either volume or rate. (a) The dollar amount of changes in interest income and interest expense attributable to changes in rate/volume (change in rate times change in volume) has been allocated between rate and volume variances based on the absolute relationship of such variances to each other. The following schedule sets forth the classification of consolidated loans by major category as of year end: INTEREST AND FEES ON LOANS Taxable equivalent interest and fees on loans for the last 5 years are summarized below: Increases in taxable equivalent interest and fees on loans allocable to changes in average volume and rate for the two most recent years are presented below: COMMERCIAL LOANS Both average commercial loan outstandings and taxable equivalent interest income on commercial loans decreased during 1993. The decline in volume is attributable in part to generally flat loan demand in the Bank's market area, and in part to the resolution of a number of problem credits acquired in connection with the purchase of Home & City Savings Bank in 1991. Average commercial loan outstandings decreased 12.5 percent to $237 million in 1993. Taxable equivalent interest income on commercial loans was reduced 17.3 percent during 1993 as a result of decreasing average volume, in combination with declining interest rates. The taxable equivalent interest rate on commercial loans was 8.6 percent in 1993, compared with 9.1 percent in 1992 and 10.2 percent in 1991. The Bank's commercial loan portfolio is a component of management's asset/liability management program. As indicated in the following table, 52.1 percent of the commercial loan portfolio either matures within one year or has a floating interest rate. Good corporate citizenship and a resource allocation strategy that emphasizes diversification have led the Bank to pursue opportunities in the commercial lending area that allow it to address the needs of businesses within its marketplace, while at the same time maintaining the high quality of the loan portfolio. Requests for commercial loans secured by real estate are evaluated on an individual-case basis. Collateral standards conform to all applicable regulatory standards. Although commercial loans are generally granted for a specified duration, certain loans may be renewed in the ordinary course of business. Requests for loan renewals are based on internal credit evaluation standards, and on market conditions in effect at the time renewal requests are received. The Bank continues to hold no foreign debt. In addition, the commercial loan portfolio contains no concentrations of credit with either individual borrowing interests or with specific industries. Substantially all loans in the portfolio have been originated locally, and their diversity is reflective of the heterogeneity of the Capital Region's economy. REAL ESTATE LOANS Real estate-related credit products (primarily first mortgages and Home Equity Credit Lines) comprised the growth portion of the Bank's loan portfolio during 1993. Competitive pricing and aggressive marketing of these products have allowed the Bank to expand portfolio volume in an increasingly crowded marketplace as it works toward fulfilling its mission of functioning as the premier retail bank in the Capital Region. Home Equity Credit Lines outstanding at December 31, 1993 aggregated $202.0 million, compared with year-end balances of $195.2 million in 1992 and $168.2 million in 1991. Mortgage balances, with attractive rate offerings and active promotion, increased $73.3 million at December 31, 1993. Average interest rates on real estate loans continued to decline, reflecting national and local trends. The average interest rate for 1993 was 8.3 percent, compared with 9.0 percent in 1992 and 10.0 percent in 1991. The increase in the size of the Bank's portfolio, however, contributed to an increase of 1.2 percent in 1993 in interest income on real estate loans. Loans secured by one- to four-family residential properties represented over 99 percent of the Bank's real estate loan portfolio at December 31, 1993. The vast majority of the loans in portfolio are collateralized by properties within Trustco's market areas. The Bank's knowledge of local properties and market conditions enhances the quality of its real estate loans, all of which are underwritten in accordance with collateralization standards which conform to applicable regulatory standards. Loans funded by the Bank in 1993, as has been the case in prior years, are retained in portfolio rather than being packaged for secondary market resale. On May 31, 1993 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" (SFAS No. 114). SFAS No. 114, which is effective for financial statements issued for fiscal years beginning after December 15, 1994, prescribes recognition criteria for loan impairment and measurement methods for certain impaired loans and loans whose terms are modified in troubled debt restructurings. Although the Company has not yet performed a detailed analysis of the effects of the implementation of SFAS No. 114, the Company does not expect its adoption to have a material effect on its consolidated financial statements. INSTALLMENT LOANS Tax law changes have reduced the attractiveness of installment loans for many customers. Despite this, Trustco continues to offer a full range of these products as part of its comprehensive commitment to retail banking in its markets. Average balances, including credit card outstandings, decreased 31.1 percent in 1993 to $33.1 million. The volume of applications for all types of installment loans was reduced during 1993. The average yield on installment loan products, after increasing from 13.8 percent in 1991 to 14.6 percent in 1992, declined again to 13.8 percent in 1993, reflecting the general downward trend in interest rates. SECURITIES HELD FOR SALE Securities held for sale represent that portion of the investment portfolio which the Company does not intend to hold until maturity. These securities are managed in conjunction with short-term investment vehicles such as Federal funds sold, and with potentially volatile funding sources such as short-term debt and large ($100,000 or more) certificates of deposit in such a way as to maximize management's flexibility in responding to structural changes in the composition of borrowed funds and to seasonal and/or cyclical fluctuations in loan demand. The portfolio of securities held for sale as of December 31, 1993 consisted of U.S. Treasury Notes with a book value of $230.6 million and a market value of $236.5 million, and corporate bonds with a book value of $10.2 million and a market value of $11.6 million. Securities held for sale having a book value of $41.2 million were pledged to secure public deposits and for purposes required by law at December 31, 1993. The average taxable equivalent yield on securities held for sale in 1993 was 6.9 percent, a decline of 52 basis points from 1992 levels. INVESTMENT SECURITIES Investment securities represent that portion of the investment portfolio which the Company has both the capacity and the intent to hold until maturity. These securities are held to increase yield as part of management's program for maximizing longer-term overall returns. The quality of the portfolio, both of investment securities and of securities held for sale, is evidenced by the fact that over 96 percent of total holdings consist of either U.S. Treasury securities, or instruments carrying one of the top three investment grades from at least one leading rating agency. The December 31, 1993 book value of securities pledged to secure public deposits or for purposes required by law was $85.6 million. The only obligations (other than U.S. Treasury and agency issues) that represented more than 10 percent of equity capital at December 31, 1993 were bonds issued by General Electric Capital Corporation. These bonds are rated Aaa, and mature in 1994 and 1995. The Tax Reform Act of 1986 affected the income potential of the portfolio by eliminating the deduction for carrying non-qualified municipal investments. Accordingly, investments are selected with a view toward safety of principal, as well as the generation of the highest possible income. Trustco Bank New York continues to serve Capital Region governmental units by providing capital and operating funds through active participation in the municipal bond and note market. The weighted average maturity of investment securities and investments held for sale declined in 1993, increasing the rate sensitivity of the portfolio. The approximate weighted average portfolio maturity was 3 years, 7 months at December 31, 1993, compared with 4 years, 3 months at the end of 1992, and 5 years, 9 months at year-end 1991. The following tables detail the maturity distribution and weighted average yield of the Company's investment securities and securities held for sale as of December 31, 1993. The Company's mortgage backed securities are calculated in the maturity section of the table on the basis of their stated average life of 3 years, 6 months rather than their weighted average maturity of 14 years, 8 months. Weighted average yields are calculated on the basis of effective yield to the earlier of call or maturity date, considering applicable premium or discount, but not converting yields to a taxable equivalent basis. The following tables set forth the book value and market value by maturity distribution (based on the earlier of call or maturity date) of the Company's investment securities and securities held for sale at December 31, 1993. The market value of the investment portfolio at December 31, 1993 was $21.8 million above the book value. Market appreciation aggregated $21.1 million and $19.2 million at the end of 1992 and 1991, respectively. The Company realized $6.2 million in gains from the sale of securities, primarily U.S. Treasury Notes. The proceeds of these sales were reinvested in securities of similar quality and maturity, which were designated as Held for Sale. The following tables detail the classification of the Company's investment securities and securities held for sale by type, and provides information on their book value. Investment income recorded in each of the last five years is set forth in the following tables. The following tables set forth, by category of investment, changes in taxable equivalent interest income resulting from either changes in average balances or in average rate for 1993 as compared with 1992, and for 1992 as compared with 1991. Taxable equivalent earnings on investment securities declined 33.1 percent to $29.6 million, partially as a result of the reclassification of certain securities into the Held for Sale designation, and partly due to a 130 basis point decline to 6.5 percent in average taxable equivalent yield. Earnings on investment securities in 1992 rose 20.2 percent, as a 36.0 percent increase in volume more than offset a reduction of 11.6 percent in average taxable equivalent yield. U.S. Government and Agency obligations represented 60.1 percent of the average book value of investment securities in 1993, compared to 60.3 percent in 1992 and 67.2 percent in 1991. Taxable equivalent interest income on this segment of the portfolio decreased 35.5 percent to $16.9 million in 1993, as a generally declining trend in interest rates combined with the reduction in book value resulting from management's designation of a Held for Sale portfolio. The Company's average investment in the obligations of states and political subdivisions declined 40.2 percent from 1992 levels to $32.7 million, or 7.2 percent of the book value of the 1993 average investment portfolio. This decrease is associated with the limited availability of qualifying designated small issue obligations that meet the Company's standards for credit rating, maturity and yield. The average taxable equivalent yield on these securities in 1993 was 6.4 percent, compared to 7.3 percent in 1992 and 8.4 percent in 1991. Taxable equivalent income on state and municipal obligations fell 48.2 percent to $2.1 million in 1993. The Company holds a portfolio of mortgage backed securities, in which management has invested because such instruments offer market liquidity, relatively high yields, limited credit risk and simplified payment collection. The primary risk connected with these instruments is that declining interest rates will accelerate prepayment volume for the loans supporting the securities, an event which reduces the effective yield of the investment and exposes the amounts prepaid to interest rate risk. Average holdings of mortgage backed securities decreased 20.1 percent from 1992 to 1993. Holdings of mortgage backed securities backed by U.S. Government agencies or sponsored agencies (GNMA, FNMA, and FHLMC) increased during 1993, but the Company sold its holdings of Collateralized Mortgage Obligations (CMOs) late in 1992. There are no other mortgage derivative products in the Company's portfolio at December 31, 1993. The average yield on mortgage backed securities was 7.1 percent at December 31, 1993. Income on mortgage backed securities was $8.4 million for 1993, as compared to $12.4 million in 1992 and $4.5 million in 1991. Other securities in portfolio at December 31, 1993 consist primarily of investment grade corporate bonds. In May, 1993 the Financial Accounting Standards Board issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Statement is effective for fiscal years beginning after December 15, 1993. This Statement addresses the accounting for equity issues 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 Company has the positive intent and ability to hold to maturity are classified as "held-to-maturity" 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" 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 stockholders' equity. Management believes at this time that the Statement will have no material impact on the financial statements. FEDERAL FUNDS SOLD The Company has historically allocated a significant portion of its available resources to Federal funds sold. Factors considered by management in determining appropriate levels for this form of investment include: available rates on other short-term products, the volume of short-term borrowings and large-denomination ($100,000 and over) certificates of deposit, and overall corporate liquidity goals. Average Federal funds balances in 1993 were $163.6 million, a 44.2 percent increase over 1992. Interest income from Federal funds sales rose 28.9 percent in 1993 to $4.9 million. The average interest rate on this investment continued to decline, decreasing 39.2 percent between 1991 and 1992, and exhibiting a further 36 basis point reduction to an average rate of 3.0 percent in 1993. DEPOSITS The following tables detail average consolidated deposits and interest expense for the last five years. The following table sets forth changes in interest expense for each deposit category. The changes are allocated to variances in either average balance or in rate for 1993 as compared to 1992, and for 1992 as compared to 1991. Despite an increase of $88.0 million in aggregate interest bearing deposits, interest expense on deposits decreased $14.3 million in 1993, a reflection of continuing downward movement in interest rates. The average rate paid on interest bearing time deposits was 3.6 percent, as compared to 4.7 percent in 1992 and 6.0 percent in 1991. Non-interest bearing demand deposits are a significant funding resource for the Bank, and play an important role in liability management, with a direct effect on net income. Average demand deposits rose 4.6 percent in 1993 to $92.8 million. These funds represented 5.2 percent of average total deposits in 1993 as compared to 5.3 percent in 1992 and 8.2 percent in 1991. The categories of interest bearing deposits which experienced growth in 1993 were regular savings and NOW accounts. Both of these products were marketed aggressively during 1993, and the growth in outstandings represents the attraction of new funds and expansion of Capital Region market share. Average regular savings account balances rose 26.4 percent to $730.2 million. Approximately half of the increase represented new customer accounts, with the balance consisting of internal transfers and interest credits. Despite the increase in average balances, a decline of 121 basis points in the average rate paid on these accounts resulted in a decrease of $2.1 million in interest expense on savings accounts. Average NOW account balances grew 3.7 percent to $242.9 million during 1993. However, interest expense declined 34.1 percent in 1993 due to continuing reductions in average rates, which dropped from 4.2 percent in 1991, to 2.7 percent in 1992, and to 1.7 percent in 1993. Other types of interest bearing deposits decreased in 1993. The average volume of money market checking accounts decreased by 14.6 percent to $113.6 million during 1993. Other time accounts, comprised primarily of certificates of deposit under $100,000 and Individual Retirement Accounts, fell 7.1 percent in 1993. The average rate paid on these accounts dropped from 7.3 percent in 1991, to 6.0 percent in 1992, and to 5.2 percent in 1993. The Bank does not rely to any significant extent on certificates of deposit in amounts of $100,000 or more. During 1993, the average volume of these instruments fell to $33.4 million, a drop of 25.0 percent from the 1992 average volume of $44.6 million. The average rate paid on these certificates declined from 5.78 percent in 1992 to 5.44 percent in 1993. The following table sets forth, by time remaining until maturity, the aggregate amount of certificates of deposit of $100,000 or more that were carried on the books of the Company as of December 31, 1993. The following table details the classification of the Company's average consolidated deposits by type of depositor. There is no concentration of deposits whose loss could have a material adverse effect on the business operations of TrustCo. Public funds are secured by the pledge of collateral in accordance with applicable state and federal regulations. TrustCo's investment portfolio is managed in a manner which accommodates such requirements. SHORT-TERM DEBT Short-term debt consists primarily of securities sold under agreements to repurchase. These transactions involve contracts under which the Bank sells a U.S. Treasury security to a customer, while simultaneously agreeing to repurchase the same security on a specified future date at a predetermined price. The transactions do not normally exceed ninety days in duration. The average volume of the Company's short-term debt declined 31.6 percent to $17.4 million in 1993, following a 40.6 percent decline in 1992. The average rate paid on these transactions in 1993 was 2.2 percent, as compared to 3.0 percent in 1992 and 5.1 percent in 1991. Interest expense on short-term debt for 1993 was $380 thousand, down from $757 thousand in 1992 and $2.2 million in 1991. The following table details consolidated short-term debt over the past three years. LONG-TERM DEBT At December 31, 1992, consolidated long-term debt consisted solely of $5.0 million in 9.4 percent senior notes. These obligations were paid in full on September 30, 1993. Consolidated long-term debt at December 31, 1993 consists entirely of $2.75 million borrowed by ORE Subsidiary Corporation at the prime rate under a $10 million revolving credit facility. Interest paid on long term debt declined to $357 thousand in 1993, after aggregating $470 thousand in both 1992 and 1991. PROVISION FOR POSSIBLE LOAN LOSSES The provision for possible loan losses represents a charge to expense related to potential future loss in the loan portfolio. The amount charged in each period reflects management's assessment of the risks inherent in the portfolio at a specific point in time, based on loan volume, economic conditions, and the Bank's historical loan loss experience. The 1993 provision for loan losses of $11.6 million was 8.8 percent lower than the amount charged in 1992, while the provision of $12.7 million in 1992 was 95.6 percent higher than in 1991. The average allowance for loan losses, as a percentage of average loans outstanding, was 3.0 percent in 1993, as compared with 2.4 percent in 1992 and 2.6 percent in 1991. OTHER INCOME The following table details the major components of other income over the past five years. Total non-interest income of $19.2 million for 1993 was up 24.4 percent from 1992, which in turn increased 56.7 percent from the 1991 level. Service charges on deposit accounts and other fees represented the largest component of other income in 1993, rising 1.7 percent to $6.5 million. Net gains on securities designated as "held for sale" aggregated $5.9 million in 1993, primarily as the result of sales of U.S. Treasury Notes. Fee income in the Trust Department in 1993 was $4.3 million, an increase of 12.4 percent over 1992 levels, which had declined 2.6 percent since 1991. OTHER EXPENSES The following table provides a detailed summary of other expenses over the past five years. Aggregate non-interest expenses grew 1.7 percent to $43.5 million in 1993. Non-interest expenses for 1992 were 51.7 percent above 1991 levels, primarily due to the acquisition of Home & City Savings Bank. The largest component of non-interest expense continues to be salaries and employee benefits. These costs rose 5.0 percent in 1993 after increases of 35.7 percent in 1992 and 17.7 percent in 1991. The increases were primarily due to routine wage adjustments, increased payroll taxes, and the growing cost of providing employee benefits. While compensation costs continue to represent a significant component of non-interest expense, the effectiveness of management controls in this area is evidenced by the Bank's consistent placement in the most efficient quartile of comparable organizations as defined in the Federal Financial Institutions Examination Council's Uniform Bank Performance Reports. Significant items within the category of other expenses for 1993 included a reduction of $1.2 million, or 53.9 percent, in advertising and promotional expense as a result of management's decision to scale down all advertising campaigns. Professional expenses decreased $1.8 million, or 41.6 percent in 1993, mainly as the result of eliminating computer consultant services. These costs, which were associated with various systems conversions, totalled $1.4 million in 1992. Other real estate expenses increased $4.5 million in 1993, as several sizable problem assets acquired in the Home & City purchase moved toward resolution. In 1990, the Financial Accounting Standards Board issued Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Statement No. 106 requires a calculation of the present value of expected benefits to be paid to employees after their retirement and an allocation of those benefits to the periods in which the employees render service to earn the benefits. The Company adopted Statement No. 106 on January 1, 1993 at a cost of $5,770,000. The Company funded the resulting liability during the first quarter of 1993 with investments which will generate earnings that will reduce period post retirement benefit costs in future years. APPLICABLE INCOME TAXES Applicable income taxes and effective tax rates were $12.5 million and 34.6 percent for 1993, $9.3 million and 34.8 percent for 1992 and $4.9 million and 27.4 percent for 1991. Income taxes for financial reporting purposes differ from the amount computed by applying the statutory rate to income before taxes. This difference is due primarily to tax-exempt income from certain loans and investment securities and non-deductible expenses, primarily goodwill. For additional information concerning income taxes, refer to Note 11 of the Notes to Consolidated Financial Statements. The Company currently accounts for income taxes under FASB Statement No. 109, which changed the Company's method of accounting for income taxes from the deferred method required under APB 11 to the asset and liability method. Under the deferred method, annual income tax expense is matched with pretax accounting income by providing deferred taxes at current tax rates for timing differences between the determination of net income for financial reporting and tax purposes. The objective of the asset and liability method is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The tax effects of temporary differences that give rise to deferred tax assets and deferred tax liabilities are detailed in Note 11 of the Notes to Consolidated Financial Statements. CAPITAL RESOURCES TrustCo meets all the regulatory requirements for designation as a well capitalized bank holding company. The Company has established the regulatory standards for designation as a well capitalized company as its internal minimum capital requirement. Designation by the regulatory agencies as a well capitalized bank holding company requires: a leverage ratio of 5.0 percent or greater; a Tier I risk-based capital ratio of 6.0 percent or greater; and a total risk-based capital ratio of 10.0 percent or greater. At December 31, 1993, Trustco had a leverage ratio of 6.67 percent, a Tier I risk- based capital ratio of 12.06 percent, and a total risk-based capital ratio of 13.34 percent. The Company's capital ratios were all in excess of regulatory minimums for designation as well capitalized for 1992 and 1991 as well. Equity capital stood at $129.9 million at December 31, 1993, an increase of $9.5 million over the 1992 level, which in turn had grown $9.3 million from year-end 1991. Substantially all of the increase in equity capital in this period was the result of earnings retention. At December 31, 1993, equity capital represented 6.6 percent of total assets, compared with 6.2 percent at year-end 1992 and 6.3 percent at the end of 1991. The strength of the equity capital of the Company and its subsidiary Bank affords protection to the depositors, and also affords the Company ready access to the debt and equity markets. The book value of TrustCo stock has increased steadily, growing from $8.50 per share at year-end 1991, to $9.15 at the end of 1992, and to $9.82 per share at December 31, 1993. The Company had no commitments for the future issuance of securities, other than its stock option plan, in place at December 31, 1993. Dividends paid on common stock in 1993 totalled $11.6 million, or 56.9 percent of net income. In addition, the Company paid a 2 for 1 stock split in November, 1993, while simultaneously raising the annualized dividend rate to $1.00 per share. During 1992, cash dividends represented 51.1 percent of income, and a 5 for 4 stock split was paid. The 1991 cash dividend payout of 45.0 percent of income was supplemented with a 10 percent stock dividend. CREDIT RISK REVIEW Much of what is discussed in this financial review is based on the underlying principle of prudent management of the Company's resources. Management has consistently endeavored to be appropriately responsive to a variety of changes in the Company's markets, while at all times preserving its financial strength. The Company has a well-established tradition of avoiding high-risk resource allocation strategies in favor of more secure opportunities based on sound financial relationships. Historical levels of non-performing loans, charge-offs, and the allowance for loan losses are all indicative of the prudence of this approach. However, the extension of credit involves the inherent risk that funds advanced will not be repaid. Weighing risks against rewards within the context of the Company's overall business strategy is the primary task in portfolio management. This effort requires the thorough review of a prospective borrower's business strategy, financial statements, credit history and available collateral prior to the extension of credit. It also requires the regular scrutiny of existing loans, affording management the opportunity to respond quickly to deteriorating credits in order to minimize their consequences. The loan portfolio is subject to ongoing internal review, as well as to periodic examination by state and federal supervisory authorities and the Company's independent certified public accountants. The Company has historically experienced modest levels of net loan losses. Net loans charged against the allowance for loan losses during 1993 were $4.4 million, as compared to $4.8 million in 1992 and $1.6 million in 1991. Net charge-offs represented 0.43 percent of average outstanding loans in 1993, 0.48 percent in 1992, and 0.26 percent in 1991. The increase in net charge-offs after 1991 is associated with the volume of problem credits acquired in connection with the purchase of Home & City Savings Bank. Management currently anticipates that charge-offs will continue in the range of 0.40 percent of average outstanding loans. The allowance for loan losses at December 31, 1993 was $34.1 million, or 3.2 percent of net loans outstanding as of that date. At year-end 1992 and 1991, the allowance for loan losses represented, respectively, 2.6 and 1.9 percent of outstanding loans. Charge-off coverage (the ratio of the year-end allowance for loan losses to net charge-offs for the year) is an indicator of the adequacy of the allowance. This ratio was 7.7 times for 1993, as compared with 5.6 times for 1992 and 11.8 times for 1991. The most recent examination by the New York State Banking Department and the Federal Reserve Bank found that the allowance for loan losses was adequate at the date of the examination. The table which follows details the historical relationship among outstanding loans, the loan loss allowance, additions to the allowance charged to operating expense, charge-offs and recoveries. DISCUSSION OF LOAN PORTFOLIO RISK ELEMENTS Management's assessment of the adequacy of the allowance for loan losses is influenced by a variety of factors, including: the Company's standards for granting new loans and evaluating existing credits; the component elements of the loan portfolio and the growth patterns exhibited therein; current economic conditions; the loss potential of loans classified by internal reviewers, supervisory authorities and independent accountants; the level of past due and non-accrual loans; and the Company's historical loan loss experience. The allowance for loan losses over the past five years has averaged 2.61 percent of average loans outstanding, while net loan losses for the same period have averaged a significantly lower 0.34 percent of average loans. Additionally, while it is common industry practice for the total of non-accrual loans, loans in excess of 90 days delinquent and renegotiated loans to exceed the allowance for loan losses, the Company's volume of loans so classified of $1.9 million at year-end 1993 and $7.4 million at year-end 1992 was far lower than the year-end allowance for loan loss levels of $34.1 million in 1993 and $26.9 million in 1992. The ratio of recoveries on prior period charge-offs to loans charged off is a test of both the conservatism of charge-off practices and the forcefulness of collection efforts. Over the past five years, the Company's recovery ratio has averaged 27.0 percent on a weighted basis, indicating that charge-offs are taken in a timely manner and that recovery efforts are effective. The adequacy of the loan loss allowance is further supported by the lack of foreign debt in the portfolio, the absence of single-borrower or single-industry concentrations, and the local composition of the loan portfolio. Past experience suggests that it is not practical for management to allocate the allowance for loan losses to specific categories within the loan portfolio on a statistical or other basis. NON-PERFORMING LOANS Loans categorized as "non-performing" include those credits on a non- accrual basis, credits contractually past due 90 days or more, and credits whose terms have been renegotiated due to the financial deterioration of the borrower. Non-performing loans receive management's close attention. Loans are placed in non-accrual status when, in the opinion of management, the collection of additional interest is in doubt. Thereafter, no interest is taken into income unless received in cash or until such time as the borrower demonstrates the ability to make scheduled payments of interest and principal. The following table sets forth information with regard to non-performing loans: Non-performing year-end 1993 commercial loans of $114 thousand were 0.05 percent of outstandings (compared with 1.6 percent and 0.1 percent at year-end 1992 and 1991 respectively). Real estate loans of $1.5 million were 0.2 percent of outstandings (compared with 0.4 percent at year-end 1992 and 0.6 percent at year-end 1991). There were $250 thousand in non-performing installment loans, or 0.9 percent of outstandings, at year-end 1993 compared to 0.9 percent at year-end 1992 and 0.5 percent at year-end 1991. Most of the increase in non- performing loans was due to loans acquired from Home & City Savings Bank in 1991. With respect to loans in non-accrual status at December 31, 1993, the gross interest income that would have been recorded during 1993 had the loans remained current was $1 thousand, and the amount that was actually recorded amounted to $1 thousand. As of December 31, 1993, there were no other loans classified for regulatory purposes that management reasonably expects will materially impact future operating results, liquidity, or capital resources. OTHER REAL ESTATE OWNED Real estate properties acquired in satisfaction of loans are classified as other assets and recorded on an individual basis at the lower of fair value minus estimated costs to sell or "cost" (defined as the fair value at initial foreclosure). The value of real estate owned was $6.2 million at December 31, 1993 and $5.9 million at December 31, 1992. In-substance foreclosures were valued at $14.9 million at the end of 1993 and $20.7 million at the end of 1992. Most of the increase in real estate owned and in-substance foreclosure was due to assets acquired from Home & City Savings Bank in 1991. Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential The following table summarizes the component distribution of average balance sheet, related interest income and expense and the average yields on earning assets and rates on interest bearing liabilities of the Company and the Bank on a tax equivalent basis for each of the reported periods. Non-accrual loans are included in loans for this analysis. When a loan is placed in non-accrual status, interest income is recorded only to the extent actually received in cash. Price Range of Common Stock and Dividends Per Share The common stock of the Company is traded on the NASDAQ National Market System. The prices in the table are actual transactions, but may be purchases and sales of shares between dealers and may not include mark-ups, mark-downs or commissions. Dividends and stock prices have been adjusted for a 2 for 1 Stock Split in November 1993 and 5 for 4 stock split paid to shareholders in November 1992. On December 31, 1993, the last transaction on NASDAQ of the common stock of the Company was $22.75 a share. The Company had 3,963 shareholders of record at year end. See Notes to Consolidated Financial Statements (1)(j) regarding dividend restrictions. Officers PRESIDENT AND CHIEF EXECUTIVE OFFICER Robert A. McCormick VICE PRESIDENT Nancy A. McNamara SECRETARY William F. Terry ASSISTANT SECRETARY AND TREASURER Peter A. Zakriski Board of Directors Barton A. Andreoli President, Towne Construction and Paving Co. Lionel O. Barthold Vice-Chairman, Power Technologies, Inc. (Consulting Engineers) M. Norman Brickman President, D. Brickman, Inc. (Wholesale Fruit and Produce) C.W. Carl, Jr. Retired, Former President, The Carl Company (Department Store) Robert A. McCormick President and Chief Executive Officer Trustco Bank New York Nancy A. McNamara Senior Vice President Trustco Bank New York Dr. John S. Morris President Emeritus, Union College and Former Chancellor, Union University James H. Murphy, D.D.S. Orthodontist Richard J. Murray, Jr. President, R.J. Murray Co., Inc. (Air Conditioning Distributors) Kenneth C. Petersen President, Schenectady International, Inc. William J. Purdy President, Welbourne & Purdy Realty, Inc. Daniel J. Rourke, M.D. Physician William F. Terry Senior Vice President and Secretary Trustco Bank New York Philip J. Thompson Retired, Former Vice President, and Director New York Telephone Directors of TrustCo Bank Corp NY are also Directors of Trustco Bank New York HONORARY DIRECTORS Donald E. Craig Dr. Caryl P. Haskins Bernard J. King H. Gladstone McKeon William H. Milton, III Anthony M. Salerno Edwin O. Salisbury Harry E. Whittingham, Jr. Henry D. Wright Officers Trustco Bank New York PRESIDENT AND CHIEF EXECUTIVE OFFICER Robert A. McCormick SENIOR VICE PRESIDENT Nancy A. McNamara SENIOR VICE PRESIDENT Ralph A. Pidgeon SENIOR VICE PRESIDENT AND SECRETARY William F. Terry BANK SERVICES, FINANCIAL MANAGEMENT, INFORMATION SERVICES, TRUST Senior Vice President William F. Terry BANK SERVICES Administrative Vice President Peter A. Zakriski FINANCIAL MANAGEMENT Administrative Vice President Linda C. Christensen INFORMATION SERVICES Administrative Vice President William H. Milton Senior Information Services Officer Danielle M. Eddy TRUST DEPARTMENT Administrative Vice President Joseph A. Gorman, III Vice President and Senior Trust Officer James Niland Vice President and Trust Officer Matthew G. Waschull Trust Officers Christopher J. Fagan John P. Fulgan Investment Officer Robert Scribner AUDITOR John C. Fay BRANCH ADMINISTRATION, MARKETING and COMMUNITY RELATIONS Senior Vice President Ralph A. Pidgeon MARKETING Vice President Madeline S. Busch BRANCH OFFICERS Richard E. Bailey Thomas H. Lauster James H. Tyler LOAN DIVISION and OPERATIONS Senior Vice President Nancy A. McNamara LOAN DIVISION COMMERCIAL LOANS Vice Presidents Donald J. Csaposs George W. Wickswat Senior Commercial Loan Officer Nancy E. Wurth INSTALLMENT LOANS Senior Installment Loan Officer Thomas H. Poitras MORTGAGE LOANS Senior Mortgage Officer Elinore J. Vine OPERATIONS Administrative Vice President James D. McLoughlin PERSONNEL Vice President Ann M. Noble Management Information Officer Lynn D. Hackler Branch Locations Trustco Bank New York Altamont Ave. Office 1400 Altamont Ave., Rotterdam Telephone: 356-1317 Altamont Ave. West Office 1900 Altamont Ave., Rotterdam Telephone: 355-1900 Bay Road Office 292 Bay Road, Queensbury Telephone: 792-2691 Brandywine Office State St. at Brandywine Ave., Schenectady Telephone: 346-4295 Central Avenue Office 163 Central Ave., Albany Telephone: 426-7291 Clifton Park Office 1018 Route 146, Clifton Park Telephone: 371-8451 Clifton Country Road Office 7 Clifton Country Road Clifton Park Telephone: 371-5002 Colonie Office 1892 Central Ave., Colonie Plaza, Colonie Telephone: 456-0041 Delmar Office 167 Delaware Ave., Delmar Telephone: 439-9941 East Greenbush Office 501 Columbia Turnpike, Rensselaer Telephone: 479-7233 Glens Falls Office 3 Warren Street, Glens Falls Telephone: 798-8131 Greenwich Office 131 Main St., Greenwich Telephone: 692-2233 Guilderland Office 3900 Carman Road, Schenectady Telephone: 355-4890 Halfmoon Office Country Dollar Plaza, Halfmoon Telephone: 371-0593 Hoosick Falls Office 47 Main St., Hoosick Falls Telephone: 686-5352 Hudson Office 507 Warren St., Hudson Telephone: 828-9434 Latham Office 1 Johnson Road, Latham Telephone: 785-0761 Loudon Plaza Office 372 Northern Blvd., Albany Telephone: 462-6668 Madison Avenue Office 1084 Madison Ave., Albany Telephone: 489-4711 Main Office 320 State St., Schenectady Telephone: 377-3311 Mayfair Office Saratoga Road at Mayfair, Glenville Telephone: 399-9121 Mont Pleasant Office Crane St. at Main Ave., Schenectady Telephone: 346-1267 New Scotland Office 301 New Scotland Ave., Albany Telephone: 438-7838 Newton Plaza Office 588 New Loudon Road, Latham Telephone: 786-3687 Niskayuna-Woodlawn Office 3461 State St., Schenectady Telephone: 377-2264 Plaza Seven Office 1208 Troy-Schenectady Road, Latham Telephone: 785-4744 Queensbury Office 33 Quaker Road, Queensbury Telephone: 798-7226 Rotterdam Office Curry Road Shopping Ctr., Rotterdam Telephone: 355-8330 Rotterdam Square Office 2 Campbell Road, Rotterdam Telephone: 377-2393 Route 9 Office--Latham 754 New Loudon Rd., Latham Telephone: 786-8816 Sheridan Plaza Office 1350 Gerling St., Schenectady Telephone: 377-8517 Shoppers' World Office Old Rte. 146 and Plank Rd., Clifton Park Telephone: 383-6851 State Farm Road Office Route 20 and 155 South, Guilderland Telephone: 452-6913 State Street Office 112 State St., Albany Telephone: 436-9043 Stuyvesant Plaza Office Western Ave. at Fuller Road, Albany Telephone: 489-2616 Tanners Main Office 345 Main Street, Catskill Telephone: 943-2500 Tanners West Side Office 238 West Bridge St., Catskill Telephone: 943-5090 Troy Office 5th Ave., and State St., Troy Telephone: 274-5420 Union Street East Office 1700 Union St., Schenectady Telephone: 382-7511 Upper New Scotland Office 583 New Scotland Ave., Albany Telephone: 438-6611 Upper Union Street Office 1620 Union St., Schenectady Telephone: 374-4056 Wilton Mall Office Route 50, Saratoga Springs Telephone: 583-1716 Wolf Road Office 34 Wolf Road, Albany Telephone: 458-7761 General Information ANNUAL MEETING Monday, May 16, 1994 12:00 Noon Trust Building 192 Erie Boulevard Schenectady, New York 12305 CORPORATE HEADQUARTERS 320 State Street Schenectady, New York 12305 (518-377-3311) DIVIDEND REINVESTMENT PLAN A Dividend Reinvestment Plan is available to shareholders of TrustCo Bank Corp NY. It provides for the reinvestment of cash dividends and optional cash payments to purchase additional shares of TrustCo stock. The Plan is free of administrative charges, and provides a convenient method of acquiring additional shares. Trustco Bank New York, our wholly owned bank subsidiary, acts as administrator for this service, and has designated Glens Falls National Bank and Trust Company to act as agent for shareholders in these transactions. Shareholders who want additional information may contact the TrustCo Shareholder Services Department (518-381-3699, ext. 1292). EQUAL OPPORTUNITY AT TRUSTCO Trustco Bank New York is an Affirmative Action Equal Opportunity Employer. FORM 10-K TrustCo Bank Corp NY will provide without charge a copy of its Form 10-K upon written request. Requests and related inquiries should be directed to William F. Terry, Secretary, TrustCo Bank Corp NY, P.O. Box 1082, Schenectady, New York 12301-1082. NASDAQ SYMBOL:TRST The Corporation's common stock is traded on the NASDAQ National Market System. SUBSIDIARIES: Trustco Bank New York Schenectady, New York Member FDIC ORE Subsidiary Corp. Schenectady, New York TRANSFER AGENT Trustco Bank New York Securities Department P.O Box 380 Schenectady, New York 12301-380 [DESCRIPTION] EXHIBIT 21 TO FORM 10-K Exhibit 21 LIST OF SUBSIDIARIES OF TRUSTCO Trustco Bank New York New York State chartered trust company ORE Subsidiary Corp. New York corporation [DESCRIPTION] EXHIBIT 23 TO FORM 10-K Exhibit 23 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The Board of Directors TrustCo Bank Corp NY: We consent to incorporation by reference in the Registration Statements, Form S-8 (No. 33-43153) filed on October 3, 1991, Form S-8 (No. 33-67176) filed on August 6, 1993 of TrustCo Bank Corp NY and subsidiaries of our report dated January 26, 1994, relating to the consolidated statements of condition of TrustCo Bank Corp NY and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity, 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 TrustCo Bank Corp NY. /s/KPMG Peat Marwick ______________________________________ KPMG Peat Marwick Albany, New York March 29, 1994 [DESCRIPTION] EXHIBIT 24 TO FORM 10-K Exhibit 24 POWER OF ATTORNEY The undersigned persons do hereby appoint William F. Terry or Peter A. Zakriski as a true and lawful Attorney In Fact for the sole purpose of affixing their signatures to the 1993 Annual Report (Form 10-K) of TrustCo Bank Corp NY to the Securities and Exchange Commission. /s/Barton A. Andreoli /s/Lionel O. Barthold ________________________________ ____________________________ Barton A. Andreoli Lionel O. Barthold /s/M. Norman Brickman /s/Charles W. Carl,Jr. ________________________________ ____________________________ M. Norman Brickman Charles W. Carl, Jr. /s/Robert A. McCormick /s/Nancy A. McNamara ________________________________ ____________________________ Robert A. McCormick Nancy A. McNamara /s/Dr. John S. Morris /s/Dr. James H. Murphy ________________________________ ____________________________ Dr. James S. Morris Dr. James H. Murphy /s/Richard J. Murray, Jr. /s/Kenneth C. Petersen ________________________________ ____________________________ Richard J. Murray, Jr. Kenneth C. Petersen /s/William J. Purdy /s/Dr. Daniel J. Rourke ________________________________ ____________________________ William J. Purdy Dr. Daniel J. Rourke /s/William F. Terry /s/Philip J. Thompson ________________________________ ____________________________ William F. Terry Philip J. Thomspon Sworn to before me this 15th day of February 1994. /s/Joan Clark ________________________________ Joan Clark Notary Public, State of New York Qualified in Albany County No. 01CL4822282 Commission Expires Nov. 30, 1994 [DESCRIPTION] EXHIBIT 99 TO FORM 10-K Exhibit 99 INDEPENDENT AUDITORS' REPORT KPMG Peat Marwick Certified Public Accountants 74 North Pearl Street Albany, New York 12207 The Board of Directors and Shareholders of TrustCo Bank Corp NY: We have audited the accompanying consolidated statements of condition of TrustCo Bank Corp NY and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' 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 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 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 TrustCo Bank Corp NY 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 notes 1 and 11 to the consolidated financial statements, in 1993 the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" which changed its method of accounting for income taxes. As discussed in note 12 to the consolidated financial statements, the Company also adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" in 1993 which changed its method of accounting for postretirement benefits other than pensions. /s/KPMG Peat Marwick ______________________________________ KPMG Peat Marwick January 26, 1994 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 by the undersigned, thereunto duly authorized. TrustCo Bank Corp NY _____________________________ Robert A. McCormick President (chief executive officer) _____________________________ William F. Terry Secretary (chief financial officer) _____________________________ Peter A. Zakriski Treasurer (chief accounting officer) Date: March 22, 1993

850693_1993.txt

850693_1993

1993

850693

ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS Allergan, Inc. ("Allergan" or the "Company") is a global provider of specialty therapeutic products principally in the areas of eye and skin care. Its worldwide consolidated revenues are generated by prescription and non-prescription pharmaceutical products in the areas of ophthalmology and dermatology, intraocular lenses (IOLs) and other ophthalmic surgical products, and contact lens care products. Allergan was incorporated in California in 1948 and reincorporated in Delaware in 1977. In 1980, the Company was acquired by SmithKline Beckman Corporation (then known as "SmithKline Corporation" and herein "SmithKline"). The Company operated as a wholly- owned subsidiary of SmithKline from 1980 until July 27, 1989 when Allergan again became a stand-alone public company through a spin- off distribution by SmithKline. During the fourth quarter of 1991, the Company divested its computer-based ophthalmic diagnostic instrument business, Allergan Humphrey. In November 1992, the Company sold its contact lens business in North and South America. In August 1993, the Company sold its contact lens business outside of the Americas. ALLERGAN BUSINESSES The following table sets forth, for the periods indicated, the net sales from continuing operations for each of the Company's specialty therapeutics businesses: The foregoing table does not include sales of discontinued operations. See Note 10 of Notes to Consolidated Financial Statements on page 46 of the 1993 Annual Report for further information concerning foreign and domestic operations. Specialty Pharmaceuticals Allergan develops, manufactures and markets a broad range of prescription ophthalmic products designed to treat diseases and disorders of the eye, including glaucoma, inflammation, infection, allergy and ophthalmic muscle disorders. In addition, the specialty over-the-counter ("OTC") product line consists of products designed to treat ocular surface disease, including artificial tears and ocular decongestants. The largest segment of the market for ophthalmic prescription drugs is for the treatment of glaucoma, a sight-threatening disease characterized by elevated intraocular pressure. For initial treatment of glaucoma, Allergan sells BETAGAN(R) ophthalmic solution, a beta adrenergic blocking agent; BETAGAN(R) is Allergan's largest selling pharmaceutical product. PROPINE(R) ophthalmic solution is the product which is used alone or in combination with other drugs when initial drug therapy for glaucoma becomes inadequate. Patent protection for both products expired in the United States in 1991. Although the Company has not experienced generic competition to date, such competition is expected to develop in 1994. In 1993, Allergan entered into an agreement with Schein Pharmaceutical, Inc. whereby Schein will market generic versions of certain Allergan products that are off- patent in the U.S.; in March 1994, Schein began marketing a generic version of BETAGAN(R) . Also in March 1994, Bausch & Lomb announced that it had obtained approval from the United States Food and Drug Administration ("FDA") to market a generic version of BETAGAN(R) . Allergan holds a major share of the U.S. market for ophthalmic steroids. The Company's PRED FORTE(R) product is widely prescribed to fight ocular inflammation. In 1993, Allergan entered into a strategic alliance with Fisons Corporation to co-promote certain ophthalmic pharmaceuticals in the United States. The alliance currently involves Allergan's ACULAR(R) 1 ophthalmic solution for the relief of itch associated with seasonal allergic conjunctivitis. Later, under the terms of the alliance, co-promotion is planned to expand to include Fisons' OPTICROM(R) 2 ophthalmic solution and nedocromil sodium ophthalmic solution. Allergan's specialty pharmaceuticals include BOTOX(R) (Botulinum Toxin Type A) purified neurotoxin complex for the treatment of certain neuromuscular disorders which are characterized by involuntary muscle contractions or spasms. BOTOX(R) purified neurotoxin complex is being marketed in the United States, Canada, Germany, France, Italy, New Zealand and a number of other countries for the treatment of blepharospasm (the uncontrollable abnormal contraction of the eyelid muscles which can force the eye closed) and strabismus (misalignment of the eyes) in people 12 years of age and over. In March 1991, an application was filed with United States FDA for approval of a nonophthalmic claim for an indication related to a neck and shoulder neuromuscular disorder known as cervical dystonia (torticollis). Allergan has been asked to provide supplemental clinical data to support the torticollis filing. Building upon its strength in marketing to medical specialties and taking advantage of synergies in research and development, Allergan's skin care division (known as Allergan Herbert) develops, manufactures and markets a line of therapeutic skin care products primarily to dermatologists in the United States. Its product line includes GRIS-PEG(R) tablets, a systemic anti-fungal product, ELIMITE(R) cream for the treatment of scabies and NAFTIN(R) , a topical anti-fungal gel and cream. ___________________________________ (1)ACULAR(R) is a registered trademark, which is llicensed from Syntex (U.S.A.) Inc. (2)OPTICROM(R) is a registered trademark of Fisons Corporation. Surgical Allergan's surgical division (known as Allergan Medical Optics or AMO) develops, manufactures and markets intraocular lenses (IOLs), surgically related pharmaceuticals, phacoemulsification equipment and other ophthalmic surgical products. The largest segment of the surgical market is for the treatment of cataracts. IOLs are used to replace the natural lens of a cataract patient when it has become clouded. To meet the wide range of IOL products demanded by the market, Allergan currently offers a variety of models, including rigid multi-piece and single-piece and small incision designs. Lenses for small incision surgery include the AMO(R) PHACOFLEX(R) small incision IOL, introduced in 1989, and the AMO(R) Foldable PHACOFLEX(R) II SI-30NB(TM) small incision IOL, introduced in April 1993. Small incision IOLs continue to grow in popularity along with increasing use of phacoemulsification, a method of cataract extraction that uses ultrasound waves to break the natural lens into small fragments that can be removed through a hollow needle. Phacoemulsification requires only a 3 to 4 millimeter incision, compared to incisions of up to 12 millimeters for other techniques. In 1993, AMO introduced the AMO(R) PRESTIGE(TM), which Allergan believes represents a significant technological advance in phacoemulsification equipment. Sales growth of IOLs in the U.S. has been adversely impacted by price erosion resulting from competitive pressures. Optical The Company has been in the contact lens care market since 1960. It develops, manufactures and markets a broad range of products worldwide for use with every available type of contact lens. These products include daily cleaners to remove undesirable film and deposits from hard, rigid gas permeable and soft contact lenses; enzymatic cleaners to remove protein deposits from the surface of contact lenses; and disinfecting solutions to destroy harmful microorganisms on the surface of contact lenses. Allergan offers products that can be used in each of the three disinfecting systems now available: heat systems, cold chemical systems and hydrogen peroxide systems. ULTRACARE(R) neutralizer/disinfectant, Allergan's one-step hydrogen peroxide disinfection system, was approved by the FDA in March 1992 for general marketing in the U.S. COMPLETE(R) , a one-bottle "cold chemical" disinfection system for soft contact lenses was launched in several countries in the Pan-Asia and Europe regions during 1993. The U.S. filing for marketing approval of COMPLETE(R) was made with the FDA in December 1991. Sales of the Company's proprietary enzymatic cleaners represented 12%, 11% and 11% of total Company sales in 1991, 1992 and 1993, respectively, and sales of the Company's hydrogen peroxide disinfection systems represented 14%, 13% and 14% of total Company sales in 1991, 1992 and 1993, respectively. EMPLOYEE RELATIONS At December 31, 1993 the Company employed approximately 4,749 persons throughout the world, including approximately 2,185 in the United States. None of the Company's U.S.-based employees are represented by unions. The Company considers that its relations with its employees are, in general, very good. INTERNATIONAL OPERATIONS The Company believes that international markets represent a significant opportunity for continued growth. Allergan believes that its well-established international market presence provides it with a competitive advantage, enabling the Company to maximize the return on its investment in research, product development and manufacturing. Allergan established its first foreign subsidiary in 1964 and currently sells products in approximately 100 countries. Marketing activities are coordinated on a worldwide basis and resident management teams provide leadership and infrastructure for customer focused rapid introduction of new products in their local markets. In Japan, the second largest eye care market in the world, certain of Allergan's eye care pharmaceutical products are licensed to Santen Pharmaceuticals (the largest eye care pharmaceutical manufacturer in Japan), and Allergan's contact lens care products are sold through a joint venture between Santen and Allergan. IOLs and other eye care surgical products are sold directly in Japan. SALES AND MARKETING Allergan maintains global marketing and regional sales organizations. Supplementing the sales efforts and promotional activities aimed at eye and skin care professionals, as well as neurologists outside the U.S., who use, prescribe and recommend its products, Allergan has been shifting its resources increasingly toward managed care providers. In addition, Allergan advertises in professional journals and has an extensive direct mail program of descriptive product literature and scientific information to specialists in the ophthalmic and dermatological fields. The Company's specialty therapeutic products are sold to drug wholesalers, independent and chain drug stores, commercial optical chains, mass merchandisers, food stores, hospitals, ambulatory surgery centers (ASCs) and medical practitioners, including neurologists. At December 31, 1993 the Company employed approximately 800 sales representatives throughout the world. RESEARCH AND DEVELOPMENT The Company's global research and development efforts focus on eye care, skin care and neuromuscular products that are safe, effective, convenient and have an economic benefit. The Company's own research and development activities are supplemented by a commitment to identifying and obtaining new technologies through in-licensing, joint ventures and acquisition efforts including the establishment of research relationships with academic institutions and individual researchers. Research and development efforts for specialty pharmaceuticals focus primarily on new therapeutic products for glaucoma, inflammation, dry eye, allergy, dystonias and other neuromuscular disorders, and new anti-infective pharmaceuticals for eye care, acne, inflammation and psoriasis. During the first quarter of 1993, Allergan began Phase III clinical trials with its proprietary topical retinoid tarazotene (AGN190168) for both acne and psoriasis. The results of these trials are expected to be available beginning in the middle of 1994. Research and development activities for the surgical division concentrate on improved cataract surgical systems, implantation instruments and methods, and new IOL materials and designs, including the AMO(R) ARRAY(R) multifocal IOL, designed to allow patients to see well over a range of distances. Research and development in the contact lens care product area is aimed at care systems which, without sacrificing efficacy or antimicrobial activity, will be more convenient for patients to use and thus lead to a higher rate of compliance with recommended lens care procedures. Improved compliance can enhance safety and extend the time a patient will be a contact lens wearer. The Company believes that continued development and commercialization of disinfection systems that are both easy-to-use and efficacious will be important for the future success of this part of the Company's business. During 1992, the Company entered into a joint venture with Ligand Pharmaceuticals Corporation to combine Ligand's knowledge of intracellular receptor technology with the Company's experience in receptor-selective retinoids for topical use. The joint venture filed an Investigational New Drug Application with the FDA in November 1993 for the use of 9-cis Retinoic acid (LGD1057) to be given orally for cancer therapy. In 1993, the Company signed an agreement with Sandoz Pharmaceuticals Corporation to develop, manufacture and market cyclosporine A for all topical ophthalmic uses. In addition, the Company has entered into a number of collaborative arrangements with academic institutions. The continuing introduction of new products supplied by the Company's research and development efforts and in-licensing opportunities is critical to the success of the Company. Delays or failures in one or more significant research projects could have a material adverse impact on the future operations of the Company. At December 31, 1993 there were an aggregate of approximately 630 people involved in the Company's research and development efforts. The Company's research and development expenditures associated with continuing operations for 1991, 1992 and 1993 were $70.4 million, $89.5 million and $102.5 million respectively. COMPETITION Allergan faces strong competition in all of its markets. Numerous companies are engaged in the development, manufacture and marketing of health care products competitive with those manufactured by Allergan, although these companies do not necessarily compete in all of Allergan's product lines. Major eye care competitors include Merck, Alcon Laboratories (a subsidiary of Nestle), Bausch & Lomb, Ciba Vision Corp. (a subsidiary of Ciba-Geigy), IOLab (a subsidiary of Johnson & Johnson), Pharmacia Ophthalmics (a subsidiary of Kabi Pharmacia), Sola/Barnes-Hind (a subsidary of Pilkington plc) and Wessley-Jessen, Inc. (a subsidiary of Schering- Plough Corporation). These competitors have equivalent or greater resources than Allergan. The Company's skin care business competes against a number of companies which have greater resources than Allergan. In marketing its products to health care professionals, the Company competes primarily on the basis of product technology, service and price. GOVERNMENT REGULATION Drugs, biologics and medical devices, including IOLs and contact lens care products, are subject to regulation by the FDA, state agencies and, in varying degrees, by foreign health agencies. FDA regulation of many of the Company's products generally requires extensive testing of new products and filing applications for approval by the FDA prior to sale in the United States. The FDA reviews these applications and determines whether the product is safe and effective. The process of developing data to support a pre-market application and FDA review can be costly and take many years to complete. Manufacturers of drugs, medical devices and biologics are operating in a more rigorous regulatory environment than has been the case in previous years. Several legislative and administrative measures to strengthen government regulation of medical devices and drugs have recently been implemented in the United States, such as the Safe Medical Devices Act of 1990, which among other things, increased reporting requirements of adverse events associated with medical devices, and the Prescription Drug Law Fee Act of 1992, which requires payment of substantial fees to the FDA for new drug applications. Other measures are pending or have been proposed. In addition, there has been increased scrutiny of drug and device manufacturers by the FDA as a result of a scandal in the generic drug industry and controversies surrounding the safety of certain medical devices. While the Company is not primarily involved in these areas of business, the impact of increased FDA scrutiny is felt by all companies in the drug and device industries. Moreover, in Europe and other major Allergan markets, the regulation of drugs and medical devices is likewise increasing. The Company is working to ensure that its operations remain in compliance with FDA and other regulatory requirements. The total cost of providing health care services has been and will continue to be subject to review by governmental agencies and legislative bodies in the major world markets, including the United States, which are faced with significant pressure to lower health care costs. Prices for some of the Company's products, specifically IOLs and pharmaceutical products, accounting for approximately 60% of the Company's 1993 sales, are expected to come under increased pressure as governments and managed care providers generally increase their efforts to contain health care costs. In the United States, a significant percentage of the patients who receive the Company's IOLs are covered by the federal Medicare program. When a cataract extraction with IOL implantation is performed in an ambulatory surgery center ("ASC"), Medicare provides the ASC with a fixed $150 allowance to cover the cost of the IOL. When the procedure is performed in a hospital outpatient department, the hospital's reimbursement is determined using a complex formula that blends the hospital's costs with the $150 allowance paid to ASCs. In November 1990, the U.S. Health Care Financing Administration (HCFA) issued proposed regulations under which Medicare would not recognize hospitals' expenditures for IOLs implanted during outpatient cataract surgery to the extent that those expenditures exceed the ASC allowance. The Company cannot predict whether HCFA will promulgate a final regulation imposing this limitation. The cost of prescription drugs is receiving substantial attention in the United States Congress. Legislation enacted in 1990, and amended and strengthened in 1992, requires pharmaceutical manufacturers to rebate to the government a portion of their revenues from drugs furnished to Medicaid patients. In 1992, legislation was enacted that extends these requirements to covered outpatient pharmaceuticals, and also mandates a reduction in pharmaceutical prices charged to certain federally-funded facilities as well as to certain hospitals serving a disproportionate share of low-income patients. A provision of the Omnibus Budget Reconciliation Act of 1993 limits tax benefits currently realized by U.S. manufacturers as a result of the manufacture of certain products in Puerto Rico, beginning in 1994. It is likely that Congressional attention will continue to focus on the costs of drugs generally, and particularly on increases in drug prices in excess of the rate of inflation, given the current government initiatives pertaining to the overall reform of the U.S. health care system, and those specifically directed at lowering total costs. The Clinton Administration's health reform bill would provide all Medicare beneficiaries with a comprehensive drug benefit; however, manufacturers would be required to pay a "rebate" to the government based on the volume of a manufacturer's products sold to Medicare beneficiaries. The Company cannot predict the likelihood of passage of these or other similar or related bills. Congress also devoted significant attention in 1992 and in preceding years to proposing amendments to the Orphan Drug Act. Under one proposal, once cumulative sales of an orphan drug exceed a designated dollar amount the FDA would be authorized to approve competitors' marketing applications. The Company currently markets one orphan drug product, BOTOX (Botulinum Toxin Type A) purified neurotoxin complex. The Company cannot predict what effect these measures would have if they were ultimately enacted into law. Nor can it predict whether or in what form health care legislation being formulated by the new Administration will be passed. However, in general, the adoption of such measures can be expected to have an adverse impact on the Company's business. PATENTS, TRADEMARKS AND LICENSES Allergan owns or is licensed under numerous patents relating to its products, product uses and manufacturing processes. It now has numerous patents issued in the United States and corresponding foreign patents issued in the major countries in which it does business. Allergan believes that its patents and licenses are important to its business, but that with the exception of those relating to hydrogen peroxide disinfection systems, no one patent or license is currently of material importance in relation to its business as a whole. Allergan markets its products under various trademarks and considers these trademarks to be valuable because of their contribution to the market identification of the various products. ENVIRONMENTAL MATTERS The Company is subject to federal, state, local and foreign environmental laws and regulations. The Company believes that its operations comply in all material respects with applicable environmental laws and regulations in each country where the Company has a business presence. Although Allergan continues to make capital expenditures for environmental protection, it does not anticipate any significant expenditures in order to comply with such laws and regulations which would have a material impact on the Company's capital expenditures, earnings or competitive position. The Company is not aware of any pending litigation or significant financial obligations arising from current or past environmental practices. There can be no assurance, however, that environmental problems relating to properties owned or operated by the Company will not develop in the future, and the Company cannot predict whether any such problems, if they were to develop, could require significant expenditures on the part of the Company. In addition, 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. ITEM 2. ITEM 2. PROPERTIES Allergan's operations are conducted in owned and leased facilities located throughout the world. Its primary administrative and research facilities are located in Irvine, California. The following table describes the general character of the major existing facilities as of February 28, 1994: The company believes its present facilities are adequate for its current needs. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Securities Litigation On November 29,1993, the United States District Court for the Central District of California granted the Company's Motion for Summary Judgment in the case captioned, "In Re Allergan Shareholders Litigation," SACV 89-643 AHS (RWRx), described in the Annual Report on Form 10-K for the year ended December 31, 1992 (the "1992 10-K"), dismissing all of plaintiffs' claims pending against the Company and the other defendants. Plaintiffs subsequently filed a Notice of Appeal in the United States Court of Appeals for the Ninth Circuit. During March 1994, the parties, and others, entered into an agreement (the "Settlement") as a result of which the appeal was dismissed with prejudice and the litigation brought to an end. Additionally, the Settlement brought to an end the derivative action captioned Peter Stuyvesant, Ltd. v. Herbert, et al., No. B009384, described in the 1992 10-K. Other Litigation The Company and its subsidiaries are involved in various litigation and claims arising in the normal course of business which Allergan considers to be normal in view of the size and nature of its business. *** Although the ultimate outcome of pending litigation cannot be precisely ascertained at this time, Allergan believes that any liability resulting from the aggregate amount of uninsured damages for outstanding lawsuits and claims will not have a material adverse effect on its consolidated financial position. However, in view of the unpredictable nature of litigation, no assurances can be given in this regard. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company did not submit any matter 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. ITEM I-A. EXECUTIVE OFFICERS OF ALLERGAN, INC. The executive officers of the Company and their ages as of February 28, 1994 are as follows: Officers are appointed by and hold office at the pleasure of the Board of Directors. Dr. Anido has been Corporate Vice President and President, Americas Region since June 1993. Prior thereto, he had 18 years of experience with pharmaceutical companies. Dr. Anido was Vice President, Business Management of the U.S. Prescription Products Division of Marion Merrell Dow, Inc. from 1991 to 1993, President and General Manager (1990-1991) and Vice President, Sales & Marketing (1989-1990) of Nordic Laboratories, Inc. He also held various management positions with Marion Laboratories, Inc. Mr. Cummins has been Corporate Vice President and Chief Financial Officer of the Company since 1991 and had been Senior Vice President, Finance and Chief Financial Officer from 1986 to 1991. Mr. Cummins was Treasurer from 1986 to 1989. Prior thereto he held various senior level financial positions with American Hospital Supply/Baxter Travenol. Mr. Cummins is a Director of OSI Corp. Mr. D'Eliscu has been Corporate Vice President, Corporate Communications since 1992 and was Vice President, Investor Relations and Public Communications from 1991. Mr. D'Eliscu had been Senior Director, Investor Relations of the Company from June 1989 to February 1991 and prior thereto, he had been Director of Business Development from 1988 and Senior Product Manager from December 1985. Mr. D'Eliscu first joined the Company in 1979. Mr. Donohoe has been Corporate Vice President and President, Europe Region since 1992. Prior thereto, he was Corporate Vice President and President, Optical, Consumer/OTC Group from 1991. Mr. Donohoe was Senior Vice President and General Manager, Contact Lenses from 1990 to 1991 and Area Vice President, Northern Europe from 1989 to 1990. Mr. Donohoe held the position of Senior Vice President, Worldwide Marketing for the Optical Division from 1988 to 1989 and was Vice President, International Marketing from 1987 to 1988. Mr. Donohoe first joined the Company in 1987. Mr. Haugen has been Executive Vice President and Chief Operating Officer since April 1992 and had been Corporate Vice President of the Company and President, Worldwide Eye Marketing and Sales & Operations since January 1992. Prior thereto, Mr. Haugen was Corporate Vice President and President, Americas Region in 1991 and had been President of Allergan Optical and Senior Vice President of the Company from 1989 to 1991. Prior thereto he was Senior Vice President and President of Allergan Pharmaceuticals from 1988 to 1989 and was Senior Vice President, Planning and Business Development since 1987. Mr. Haugen first joined the Company in 1976. Mr. Herbert has been Chairman of the Board since 1977 and was also Chief Executive Officer from 1977 to 1991. Prior thereto, Mr. Herbert had been President and Chief Executive Officer of the Company since 1961. He was Executive Vice President of SmithKline Beckman Corporation from 1986 to 1989 and President of SmithKline Beckman Corporation's Eye and Skin Care Products Operations from 1981 to 1989. Mr. Herbert was a founder of the Company in 1950. Mr. Hilles has been Corporate Vice President, Human Resources since 1991 and prior thereto was Senior Vice President, Human Resources from 1986 to 1991. He was Vice President, Human Resources from 1981 to 1986. Mr. Hilles first joined SmithKline Beckman Corporation in 1965. Dr. Kaplan has been Corporate Vice President, Research and Development since 1992. He had been Senior Vice President, Pharmaceutical Research and Development since 1991, Senior Vice President, Research and Development since 1989 and Vice President since 1988. Dr. Kaplan had served as Senior Director in Group Research and Development from 1986 to 1988 and as Associate Director, Discovery Research from 1984 to 1986. Dr. Kaplan first joined the Company in 1983. Dr. McGraw has been Corporate Vice President, Corporate Development since April 1993. Prior thereto, he was President of Carerra Capital Management, Inc., an investment firm, from 1991 to 1993 and President of MedTech Trends, Inc., an investment analysis firm, from 1990 to 1993. During the period from 1978 to 1990, Dr. McGraw held various management positions, including Vice President, Development, with Marion Merrell Dow, Inc. and Marion Laboratories, Inc., pharmaceutical companies. Mr. Reichardt has been Corporate Vice President, Optical since 1992. Prior thereto, he was Senior Vice President, Marketing/Business Development, Optical from 1991 and Senior Vice President, Northern Europe from 1983. Mr. Reichardt first joined the Company in 1972. Ms. Schiavo has been Corporate Vice President, Worldwide Operations since 1992. She was Senior Vice President, Operations from 1991 and Vice President, Operations from 1989. Prior thereto, she was Senior Director, Operations from 1988 to 1989. Ms. Schiavo first joined the Company in 1980. Mr. Shepherd has been President and Chief Executive Officer of the Company since 1992 and prior thereto had been President and Chief Operating Officer from 1984 to 1991. Prior to 1984, Mr. Shepherd was President of Allergan U.S., Senior Vice President, U.S. Operations and Vice President, Operations. Mr. Shepherd first joined the Company in 1966. Mr. Tunney has been Corporate Vice President, General Counsel and Secretary of the Company since 1991 and prior thereto was Senior Vice President, General Counsel and Secretary from 1989 to 1991. Mr. Tunney had served as Vice President, General Counsel and Assistant Secretary of the Company since 1986, and as Associate General Counsel of the Company since 1985. Prior thereto he was Senior International Attorney for SmithKline Beckman Corporation which he joined in 1979. Mr. Yoder has been Vice President and Controller of the Company since 1990. Prior thereto, Mr. Yoder held various management positions with Del Taco, Inc. from 1983 to 1989, including Vice President, Finance of Del Taco/Naugles Restaurants and Vice President, Controller of Del Taco, Inc. Mr. Yoder first joined the Company in 1990. The information required by Item 405 of Regulation S-K is included on page 7 of the Proxy Statement and is incorporated herein by reference. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The sections entitled "Shareholder Information" and "Stock Listing" on page 54 of the Annual Report are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The table entitled "Summary of Selected Financial Data" on page 51 of the Annual Report is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations for the Three Year Period Ended December 31, 1993" on pages 25-30 of the Annual Report is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, including the notes thereto, together with the sections entitled "Independent Auditors' Report" and "Quarterly Results (unaudited)" of the Annual Report included on pages 31-47, 49 and 50, respectively, are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The section entitled "Independent Auditors" on page 26 of the Proxy Statement is incorporated herein by reference. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF ALLERGAN, INC. Information under this Item is included on pages 2-4 of the Proxy Statement and such information is incorporated herein by reference. Information with respect to executive officers is included on pages 11-13 of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The section entitled "Executive Compensation," and the subsection entitled "Director Compensation" included in the Proxy Statement on pages 11-15 and 6-7, respectively, are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The common stock information in the section entitled "Security Ownership of Certain Beneficial Owners and Management" on pages 8-10 of the Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The subsections entitled "Other Matters" and "Compensation Committee Interlocks and Insider Participation" on pages 7 and 19, respectively, of the Proxy Statement are incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K * Incorporated by reference from the indicated pages of the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1993 (and except for these pages, the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1993, is not deemed filed as part of this report). Schedules numbered in accordance with Rule 5.04 of Regulation S-X: All other schedules have been omitted for the reason that the required information is presented in financial statements or notes thereto, the amounts involved are not significant or the schedules are not applicable (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the last quarter of 1993. (c) Item 601 Exhibits Reference is made to the Index of Exhibits beginning at page 17 of this report. (d) Other Financial Statements There are no financial statements required to be filed by Regulation S-X which are excluded from the annual report to shareholders by Rule 14 a-3(b)(1). 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. Date: March 22, 1994 ALLERGAN, INC. By /S/ WILLIAM C. SHEPHERD William C. Shepherd 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. Date: March 22, 1994 By /S/ WILLIAM C. SHEPHERD William C. Shepherd President and Chief Executive Officer Date: March 22,1994 By /S/ EDGAR J. CUMMINS Edgar J. Cummins Corporate Vice President/ Chief Financial Officer Date: March 22, 1994 By /S/ TAMARA J. ERICKSON Tamara J. Erickson, Director Date: March 22, 1994 By /S/ HANDEL E. EVANS Handel E. Evans, Director Date: March 22, 1994 By /S/ WILLIAM R. GRANT William R. Grant, Director Date: March 22, 1994 By /S/ HOWARD E. GREENE,JR. Howard E. Greene, Jr., Director Date: March 22, 1994 By /S/ RICHARD M. HAUGEN Richard M. Haugen, Director Date: March 22, 1994 By /S/ GAVIN S.HERBERT Gavin S. Herbert Chairman of the Board Date: March 23, 1994 By /S/ KENNETH N. KERMES Kenneth N. Kermes, Director Date: March 22,1994 By /S/ LESLIE G. MCCRAW Leslie G. McCraw, Director Date: March 22, 1994 By /S/ LOUIS T. ROSSO Louis T. Rosso, Director Date: March 22, 1994 By /S/ LEONARD D. SCHAEFFER Leonard D. Schaeffer, Director Date: March __, 1994 By _______________________ Henry Wendt, Director INDEX OF EXHIBITS INDEX OF EXHIBITS INDEPENDENT AUDITORS' REPORT ON SCHEDULES To the Stockholders and Board of Directors of Allergan, Inc.: Under date of January 24, 1994, we reported on the consolidated balance sheets of Allergan, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings and cash flows for each of the years in the two-year period ended December 31, 1993, which are included in the 1993 Annual Report to Stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the Company's Annual Report on Form 10-K for the year 1993. In connection with our audit of the aforementioned consolidated financial statements, we also audited the related 1993 and 1992 consolidated financial statement schedules in the Form 10-K. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such 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 5 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." As discussed in note 7 to the consolidated financial statement, the Company also adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions, " in 1992. KPMG PEAT MARWICK Orange County, California January 24, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Allergan, Inc. We have audited the consolidated financial statements and the financial statement schedules of Allergan, Inc. and Subsidiaries listed in the index on page 14 of this Form 10-K as of December 31, 1991 and for the year ended December 31, 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 results of operations and cash flows of Allergan, Inc. and Subsidiaries for the year ended December 31, 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. COOPERS & LYBRAND Newport Beach, California February 24, 1992 SCHEDULE II ALLERGAN, INC. Loans Outstanding to Employees (in thousands) For the year ended December 31, 1992 For the year ended December 31, 1991 Loans to employees for items arising in the ordinary course of business including loans in connection with the Company's employee relocation program and expatriate tax equalization program are excluded from the above schedule. Footnote A: Collateralized by American Depository Receipts of SmithKline Beecham at 6% annual interest rate. S-1 SCHEDULE V ALLERGAN, INC. Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 (Dollars in millions) _________________________ (a) Includes adjustments from translating at current exchange rates, transfers to and from other accounts and assets of businesses sold or acquired. S-2 SCHEDULE VI ALLERGAN, INC. Accumulated Depreciation of Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 (Dollars in millions) _________________________ (a) Includes adjustments from translating at current exchange rates, transfers to and from other accounts and assets of businesses sold or acquired. S-3 SCHEDULE VIII ALLERGAN, INC. Allowance for Doubtful Accounts Years Ended December 31, 1993, 1992 and 1991 (Dollars in millions) _________________________ (a) Provision charged to earnings. (b) Accounts written off. (c) Allowance of business sold. S-4 SCHEDULE IX ALLERGAN, INC. Short-Term Borrowings 1993, 1992 and 1991 (Dollars in millions) At the end of each year presented, $30 million of commercial paper was classified as short-term borrowings while $72.9 million, $42.7 million and $51.7 million, at December 31, 1993, 1992 and 1991 respectively, was classified as long-term debt because the Company has the ability to refinance this debt on a long-term basis under the terms of the revolving credit facility described below. Interest rate calculations and amounts outstanding during the year are based on the full amount of commercial paper outstanding. The average amounts outstanding during the year were computed using month-end balances. The weighted average interest rates during the year were computed by dividing the associated interest expense for the period by the average amount of borrowings outstanding during the year. The Company has various short-term lines of credit at its foreign subsidiaries used in the normal course of business. In December 1993, the Company entered into a domestic $200 million revolving credit facility with several banks. A $50 million portion of the facility expires in December 1994 while the remaining $150 million expires in December 1998. This credit facility replaced a similar facility entered into in July 1989. The facility offers various interest rates at the Company's option based on a percentage of prime or the London interbank borrowing rates, or other negotiated rates, and is used to support general corporate purposes and the issuance of commercial paper in the United States. S-5 SCHEDULE X ALLERGAN, INC. Supplementary Income Statement Information Years Ended December 31, 1993, 1992 and 1991 (Dollars in millions) The following amounts have been charged to earnings: S-6

746838_1993.txt

746838_1993

1993

746838

ITEM 1. BUSINESS - ----------------- Unisys Corporation ("Unisys") provides information services, technology and software on a worldwide basis. Unisys operates primarily in one business segment: information management systems and related services and supplies. This segment represents more than 90% of consolidated revenue, operating profit and identifiable assets. Financial information concerning revenue, operating profit and identifiable assets relevant to the segment is set forth in Note 13, "Business segment information", of the Notes to Consolidated Financial Statements appearing in the Unisys 1993 Annual Report to Stockholders, and such information is incorporated herein by reference. Principal executive offices of Unisys are located at Township Line and Union Meeting Roads, Blue Bell, Pennsylvania 19424. Principal Products and Services - ------------------------------- Principal information management systems products and services include enterprise systems and servers, departmental servers and desktop systems, software, custom defense systems, information services and systems integration and equipment maintenance. Enterprise systems and servers comprise a complete line of small to large processors and related communications and peripheral products, such as printers, storage devices and document handling processors and equipment. Departmental servers and desktop systems include UNIX servers, workstations, personal computers and terminals. Software consists of application and systems software. Custom defense systems include specialized information processing systems, software and services marketed primarily to government defense agencies. Information services and systems integration includes systems integration, outsourcing services, application development, information planning and education. Equipment maintenance results from charges for preventive maintenance, spare parts and other repair activities. ___________________ UNIX is a registered trademark licensed exclusively by X/Open Company, Ltd. Information about revenue from classes of similar products and services for the three years ended December 31, 1993, appears under the heading "Revenue by similar classes of products and services" in the Unisys 1993 Annual Report to Stockholders, and such information is incorporated herein by reference. Unisys markets its products and services throughout most of the world, primarily through a direct sales force. In certain foreign countries, Unisys products and services are marketed primarily through distributors. Unisys manufactures a significant portion of its product lines. Some products, including certain personal and UNIX open system-based computers, peripheral products, electronic components and subassemblies and software products, are manufactured for Unisys to its design or specifications by other business equipment manufacturers, component manufacturers or software suppliers. Raw Materials - ------------- Raw materials essential to the conduct of the business are generally readily available at competitive prices in reasonable proximity to those plants utilizing such materials. Patents, Trademarks and Licenses - -------------------------------- Unisys owns many domestic and foreign patents relating to the design and manufacture of its products, has granted licenses under certain of its patents to others and is licensed under the patents of others. Unisys does not believe that its business is materially dependent upon any single patent or license or related group thereof. Trademarks used on or in connection with Unisys products are considered to be valuable assets of Unisys. Backlog - ------- Unisys does not accumulate backlog information on a company-wide basis. Unisys believes that backlog is not a meaningful indicator of future revenues due to the significant portion of Unisys revenue received from software, information services and systems integration, and equipment maintenance (approximately 49% in 1993) and the shortening of the time period from receipt of a purchase order to billing upon shipment of equipment. Unisys "lead time" for commercial equipment (the time that customers are told that it will take from receipt of an order to shipment) is between 13 and 150 days depending upon the type of system and location of customer. However, the average is between 35 and 45 days. Therefore, Unisys believes that the dollar amount of backlog is not material to an understanding of its business taken as a whole. U.S. Government Business - ------------------------ Revenue and earnings connected with defense and other U.S. governmental business are particularly subject to the size and phasing of federal government programs in which Unisys may participate. During 1993, revenue from sales of custom systems and services under Federal defense and space contracts and subcontracts represented approximately 17% of total consolidated revenue. Sales of commercial products to the U.S. government represented an additional 13% of total consolidated revenue. Competition - ----------- Unisys business is affected by rapid change in technology in the information systems and services field and aggressive competition from many domestic and foreign companies, including computer hardware manufacturers, software providers and information services companies. Unisys competes primarily on the basis of product performance, service, technological innovation and price. Unisys believes that its continued investment in engineering and research and development, coupled with its marketing capabilities, will have a favorable impact on its competitive position. Research and Development - ------------------------ Unisys engineering and research and development costs were $934.7 million in 1993, $980.7 million in 1992 and $1,147.4 million in 1991. Excluding capitalized software and hardware support, Unisys-sponsored research and development costs were $515.2 million in 1993, $535.9 million in 1992 and $638.9 million in 1991. Customer-sponsored research and development costs were $231.2 million in 1993, $243.3 million in 1992, and $286.9 million in 1991. Environmental Matters - --------------------- Capital expenditures, earnings and the competitive position of Unisys have not been materially affected by compliance with federal, state and local laws regulating the protection of the environment. Capital expenditures for environmental control facilities are not expected to be material in 1994 and 1995. Employees - --------- As of December 31, 1993, Unisys had approximately 49,000 employees. International and Domestic Operations - ------------------------------------- Financial information by geographic area is set forth in Note 13, "Business segment information", of the Notes to Consolidated Financial Statements appearing in the Unisys 1993 Annual Report to Stockholders, and such information is incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES - ------------------- In the United States, Unisys had 65 major facilities, each having approximately 50,000 square feet of floor space or more, as of December 31, 1993. The aggregate floor space of these major facilities was approximately 13,707,028 square feet, of which an aggregate of approximately 12,176,973 square feet was located in the following states: California, Illinois, Michigan, Minnesota, New Jersey, New York, Pennsylvania, Utah and Virginia. Seventeen of the major facilities in the United States, with an aggregate of approximately 5,488,753 square feet of floor space, were owned by Unisys while 48 of the major facilities in the United States, with approximately 8,218,275 square feet of floor space, were leased to Unisys. Of the aggregate floor space of major facilities in the United States, approximately 12,743,653 square feet were in current operation, approximately 652,688 square feet were subleased to others and approximately 310,687 square feet were being held in reserve or were declared surplus with disposition efforts in progress. Outside of the United States, Unisys had 50 major facilities, each having approximately 50,000 square feet of floor space or more, as of December 31, 1993. The aggregate floor space of these major facilities was approximately 5,215,364 square feet, of which an aggregate of approximately 4,006,042 square feet was located in the following countries: Australia, Brazil, Canada, France, Germany, Italy, Mexico, the Netherlands, Sweden, Switzerland and the United Kingdom. Eleven of the major facilities outside of the United States, with approximately 1,650,474 square feet of floor space, were owned by Unisys while 39 of the major facilities outside the United States, with approximately 3,564,890 square feet of floor space, were leased to Unisys. Of the aggregate floor space of major facilities outside the United States, approximately 4,413,091 square feet were in current operation, approximately 447,393 square feet were subleased to others and approximately 354,880 square feet were being held in reserve or were declared surplus with disposition efforts in progress. Unisys major facilities include offices, laboratories, manufacturing plants, warehouses and distribution and sales centers. Unisys believes that its facilities are suitable and adequate for current and presently projected needs. Unisys continuously reviews its anticipated requirements for facilities, and, on the basis thereof, will from time to time acquire additional facilities, expand existing facilities and dispose of existing facilities or parts thereof. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - -------------------------- As of March 1, 1994, Unisys has no material pending legal proceedings reportable under the requirements of this Item 3. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ No matters were submitted to a vote of security holders of Unisys during the fourth quarter of 1993. ITEM 10. EXECUTIVE OFFICERS OF THE REGISTRANT - ---------------------------------------------- Information concerning the executive officers of Unisys set forth below is as of March 1, 1994. Name Age Position with Unisys ---- --- -------------------- James A. Unruh 52 Chairman of the Board and Chief Executive Officer Hugh J. Lynch 59 Executive Vice President; President, Computer Systems Group Albert F. Zettlemoyer 59 Executive Vice President; President, Government Systems Group Harold S. Barron 57 Senior Vice President and General Counsel Edward A. Blechschmidt 41 Senior Vice President; President, Pacific Asia Americas Division Victor E. Millar 58 Senior Vice President; President, Worldwide Information Services William B. Patton, Jr. 58 Senior Vice President; President, United States Division George T. Robson 46 Senior Vice President and Chief Financial Officer Jack A. Blaine 49 Vice President; General Manager, Latin American and Caribbean Group, Pacific Asia Americas Division Frank G. Brandenberg 47 Vice President; Deputy President, Computer Systems Group George R. Gazerwitz 53 Vice President, Marketing, United States Division John J. Holton 61 Vice President, Strategic Account Marketing, United States Division Deborah C. Hopkins 39 Vice President and Controller Clive W. Ingham 48 Vice President; Group General Manager, European Group, Europe/Africa Division Jack F. McHale 45 Vice President, Investor and Corporate Communications Thomas E. McKinnon 49 Vice President, Human Resources James L. Murtaugh 55 Vice President, Engineering, Computer Systems Group Dewaine L. Osman 59 Vice President, Corporate Planning and Business Development John W. Perry 55 Vice President; President, Financial Line of Business, Information Services and Systems Group Stefan C. Riesenfeld 45 Vice President and Treasurer William G. Rowan 51 Vice President, Chief Information Officer Bobette Jones 65 Secretary There are no family relationships among any of the above- named executive officers. The By-Laws provide that the officers of Unisys shall be elected annually by the Board of Directors and that each officer shall hold office for a term of one year and until a successor is elected and qualified, or until the officer's earlier resignation or removal. Mr. Unruh has been the Chairman of the Board and Chief Executive Officer since 1990. He was President and Chief Operating Officer from 1989 to 1990 and Executive Vice President from 1986 to 1989. He has also held the position of Senior Vice President and Chief Financial Officer. Mr. Unruh has been a member of the Board of Directors since 1986 and has been an officer since 1982. Mr. Lynch has been an Executive Vice President of Unisys and President of the Computer Systems Group since 1991. He was Senior Vice President of the Computer Systems Product Group from 1990 to 1991. Prior to 1990, he held various sales, marketing and engineering positions at NCR Corporation, including Vice President and General Manager, General Purpose Systems Division. Mr. Lynch has been an officer since 1991. Mr. Zettlemoyer was elected an Executive Vice President of Unisys and named President of Unisys Government Systems Group in August 1993. He was a Senior Vice President of Unisys and President of Paramax Systems Corporation, a subsidiary of Unisys, from December 1992 to August 1993. He was Vice President, Corporate Planning, from July to December 1992; President, Electronic and Information Systems Group, of Paramax Systems Corporation from 1991 to 1992; President, Electronic and Information Systems Group, Defense Systems Division from 1989 to 1991; and Vice President and General Manager, Computer Systems Division, Defense Systems Division from 1986 to 1989. Mr. Zettlemoyer has been an officer since 1987. Mr. Barron has been Senior Vice President and General Counsel of Unisys since 1992. He was Vice President and General Counsel from 1991 to 1992 and a member of the law firm Seyfarth, Shaw, Fairweather and Geraldson from 1986 to 1991. Mr. Barron has been an officer since 1991. Mr. Blechschmidt was elected Senior Vice President of Unisys in February 1994 and has been President of the Pacific Asia Americas Division since 1990. He was Vice President from 1990 to February 1994; Vice President, Japan Operations; and President of the Unisys Japan Limited subsidiary from 1987 to 1990. Mr. Blechschmidt has been an officer since 1990. Mr. Millar has been a Senior Vice President of Unisys and President of the Worldwide Information Services Group since 1992. He was Chairman of PSF Management International, a professional services consulting organization, from 1990 to 1992 and Chairman and Chief Executive Officer of Saatchi & Saatchi Consulting Ltd. from 1986 to 1990. Mr. Millar has been an officer since 1992. Mr. Patton has been a Senior Vice President of Unisys and President of the United States Division since 1991. He was Chairman and Chief Executive Officer of Parallan Computer, Inc. from 1990 to 1991; a private investor from 1989 to 1990; and President and Chief Executive Officer of MAI Basic Four from 1984 to 1989. Mr. Patton has been an officer since 1991. Mr. Robson has been Senior Vice President and Chief Financial Officer since 1991. He was Vice President and Chief Financial Officer from 1990 to 1991 and Vice President and Corporate Controller from 1987 to 1990. Mr. Robson has been an officer since 1987. Mr. Blaine has been Vice President and General Manager, Latin American and Caribbean Group, of the Pacific Asia Americas Division since 1990. He was Vice President, Human Resources, of Unisys from 1988 to 1990. Mr. Blaine has been an officer since 1988. Mr. Brandenberg has been a Vice President of Unisys and the Deputy President of the Computer Systems Group since 1992. He was Vice President and General Manager of the Computer Systems Group from 1990 to 1992; Vice President and General Manager of the Diversified Products Group from 1989 to 1990 and Vice President and General Manager of the Financial Products Group from 1985 to 1989. Mr. Brandenberg has been an officer since 1990. Mr. Gazerwitz has been Vice President, Marketing, of the United States Division since December 1992. He was Vice President and Group Vice President, Eastern Region, United States Information Systems from 1990 to 1992; and Vice President and President, Customer Services and Support, United States Information Systems from 1988 to 1990. Mr. Gazerwitz has been an officer since 1984. Mr. Holton has been Vice President, Strategic Account Marketing, since 1990. He was Vice President, Corporate Marketing, from 1989 to 1990. Mr. Holton has been an officer since 1985. Ms. Hopkins has been Vice President and Controller since January 1993. She was Vice President, Corporate Business Analysis from 1991 to 1993; and Director, Image Business Development, Program Management, of the Computer Systems Product Group from 1989 to 1991. Ms. Hopkins has been an officer since January 1993. Mr. Ingham has been Vice President and Group General Manager, European Group, Europe/Africa Division since November 1993. He was Vice President, Corporate Marketing, from 1991 until November 1993; and Vice President and General Manager, Asia Group, of the Pacific Asia Americas Division from 1989 to 1991. Mr. Ingham has been an officer since 1992. Mr. McHale has been Vice President, Investor and Corporate Communications, since 1989. He was Vice President, Public and Investor Relations, from 1986 to 1989. Mr. McHale has been an officer since 1986. Mr. McKinnon has been Vice President, Human Resources, since 1990. He was Vice President of the Pacific Asia Americas Division from 1989 to 1990; and Staff Vice President, Corporate Human Resources, from 1987 to 1989. Mr. McKinnon has been an officer since 1991. Mr. Murtaugh has been Vice President, Engineering, of the Computer Systems Group since 1991. He was Vice President and General Manager, Information Networking Group, Computer Systems Product Group from 1990 to 1991; and Vice President, General Systems Group, Corporate Systems Group from 1988 to 1990. Mr. Murtaugh has been an officer since 1989. Mr. Osman has been Vice President, Corporate Planning and Business Development, since 1992 and acting Vice President, Commercial Marketing since November 1993. Prior to October 1992, he had been President of Ascom Timeplex, Inc. (formerly Timeplex, Inc., the communications networking subsidiary of Unisys) since its divestiture by Unisys in 1991. From 1986 to 1991, Mr. Osman was an officer of Unisys, serving as President of the Communications and Networks Group and as President of Timeplex, Inc. from 1989 to 1991; Executive Vice President of the United States Information Systems Division from January to June 1989 and President of the Communications and Airlines Division from 1986 to 1989. He was reelected an officer in 1992. Mr. Perry has been a Vice President of Unisys since 1990 and President, Financial Line of Business, Information Services and Systems Group since August 1993. He was Vice President and General Manager of Unisys Limited, the United Kingdom subsidiary of Unisys, from 1986 to August 1993. Mr. Perry has been an officer since 1990. Mr. Riesenfeld has been Vice President and Treasurer since 1989. He was Vice President, Corporate Development, from 1986 to 1989. Mr. Riesenfeld has been an officer since 1988. Mr. Rowan has been Vice President, Chief Information Officer since 1992. He was Vice President and Controller from 1991 to 1992; Vice President, Business Operations, from February to April 1991; and Vice President, Finance, of the Pacific Asia Americas Division from 1986 to 1991. Mr. Rowan has been an officer since 1991. Ms. Jones has been Secretary since 1990. She was Acting Corporate Secretary and Staff Vice President, Administrative Information, from June to October 1990; and Assistant Secretary, Associate General Counsel and Staff Vice President, Administrative Information, from 1987 to 1990. Ms. Jones has been an officer since 1990. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED - ------------------------------------------------------------- STOCKHOLDER MATTERS - ------------------- Information as to the markets for Unisys Common Stock, the high and low sales prices for Unisys Common Stock, the approximate number of record holders of Unisys Common Stock, the payment of dividends, and restrictions on such payment is set forth under the headings "Quarterly financial information", "Selected financial data", "Common Stock Information", "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes 10 and 15 of the Notes to Consolidated Financial Statements in the Unisys 1993 Annual Report to Stockholders and is incorporated herein by reference. The approximate number of holders is based upon record holders as of December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- A summary of selected financial data for Unisys for each of the last five years is set forth under the heading "Selected financial data" in the Unisys 1993 Annual Report to Stockholders and 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 of financial condition, changes in financial condition and results of operations is set forth under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Unisys 1993 Annual Report to Stockholders and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- The financial statements of Unisys, consisting of the consolidated balance sheet at December 31, 1993 and 1992 and the related consolidated statements of income and cash flows for each of the three years in the period ended December 31, 1993, appearing in the Unisys 1993 Annual Report to Stockholders, together with the report of Ernst & Young, independent auditors, on the financial statements at December 31, 1993 and 1992 and for each of the three years ended December 31, 1993, 1992, and 1991, appearing in the Unisys 1993 Annual Report to Stockholders, are incorporated herein by reference. Supplementary financial data, consisting of information appearing under the heading "Quarterly financial information" in the Unisys 1993 Annual Report to Stockholders, is incorporated herein by reference. 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 - ----------------------------------------------------------- (a) Identification of Directors. Information concerning the directors of Unisys Corporation is set forth under the headings "Nominees for Election to the Board of Directors", "Members of the Board of Directors Continuing in Office -- Term Expiring in 1995" and "Members of the Board of Directors Continuing in Office -- Term Expiring in 1996" in the Unisys Proxy Statement for the 1994 Annual Meeting of Stockholders and is incorporated herein by reference. (b) Identification of Executive Officers. Information concerning executive officers of Unisys Corporation is set forth under the caption "EXECUTIVE OFFICERS OF THE REGISTRANT" in Part I, Item 10, of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - ------------------------------- Information concerning executive compensation is set forth under the heading "EXECUTIVE COMPENSATION" in the Unisys Proxy Statement for the 1994 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL - ------------------------------------------------- OWNERS AND MANAGEMENT --------------------- (a) Security Ownership of Certain Beneficial Owners. The TCW Group, Inc. (865 South Figueroa Street, Los Angeles, California 90017) has filed a Schedule 13G with the Securities and Exchange Commission dated February 6, 1994 reporting beneficial ownership of 12,692,350 shares of Unisys Common Stock. Such shares represented approximately 7.4% of the total outstanding shares of Unisys Common Stock as of March 1, 1994. The TCW Group, Inc. has reported sole voting power and sole dispositive power with respect to all such shares. To Unisys knowledge, as of March 1, 1994, no other person was the beneficial owner of more than 5% of the total outstanding shares of Unisys Common Stock. (b) Security Ownership of Management. Certain information furnished by members of management with respect to shares of Unisys equity securities beneficially owned as of March 1, 1994 by all directors individually, by certain named officers and by all directors and officers of Unisys as a group is set forth under the heading "SECURITY OWNERSHIP BY CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" in the Unisys 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 concerning certain relationships and transactions between Unisys and members of its management is set forth under the headings "EXECUTIVE COMPENSATION" and "REPORT OF THE COMPENSATION AND ORGANIZATION COMMITTEE -- Compensation Committee Interlocks and Insider Participation" in the Unisys 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 ----------- (a) The following documents are filed as part of this report: 1. Financial Statements from the Unisys 1993 Annual Report to Stockholders which are incorporated herein by reference: Annual Report Page No. Consolidated Balance Sheet at ------------- December 31, 1993 and December 31, 1992...............25 Consolidated Statement of Income for each of the three years in the period ended December 31, 1993.....23 Consolidated Statement of Cash Flows for each of the three years in the period ended December 31, 1993.....27 Notes to Consolidated Financial Statements..............30-41 Report of Independent Auditors..........................43 2. Financial Statement Schedules filed as part of this report pursuant to Item 8 of this report: Schedule Form 10-K Number Page No. - -------- --------- II Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties.............19 VIII Valuation and Qualifying Accounts................22 IX Short-Term Borrowings............................23 The financial statement schedules should be read in conjunction with the consolidated financial statements and notes thereto in the Unisys 1993 Annual Report to Stockholders. Financial statement schedules not included with this report have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. Separate financial statements of subsidiaries not consolidated with Unisys and entities in which Unisys has a fifty percent or less ownership interest have been omitted since these operations do not meet any of the conditions set forth in Rule 3-09 of Regulation S-X. 3. Exhibits. Those exhibits required to be filed by Item 601 of Regulation S-K are listed in the Exhibit Index included in this report at pages 24 through 27. Management contracts and compensatory plans and arrangements are listed as Exhibits 10.1 through 10.24. (b) Reports on Form 8-K. During the quarter ended December 31, 1993, no Current Reports on Form 8-K were filed. 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. UNISYS CORPORATION By: /s/ James A. Unruh --------------------------- James A. Unruh Chairman of the Board and Chief Executive Officer 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 indicated on March 28, 1994. /s/ James A. Unruh *Gail D. Fosler - --------------------- --------------------- James A. Unruh Gail D. Fosler Chairman of the Board Director and Chief Executive Officer (principal executive officer) and Director /s/ George T. Robson *Melvin R. Goodes - --------------------- --------------------- George T. Robson Melvin R. Goodes Senior Vice President and Director Chief Financial Officer (principal financial officer) /s/ Deborah C. Hopkins *Edwin A. Huston - --------------------- --------------------- Deborah C. Hopkins Edwin A. Huston Vice President and Director Controller (principal accounting officer) *J. P. Bolduc *Kenneth A. Macke - --------------------- --------------------- J. P. Bolduc Kenneth A. Macke Director Director *James J. Duderstadt *Robert McClements, Jr. - --------------------- ----------------------- James J. Duderstadt Robert McClements, Jr. Director Director *William G. Milliken *Donald V. Seibert - --------------------- ----------------------- William G. Milliken Donald V. Seibert Director Director *Alan E. Schwartz - --------------------- Alan E. Schwartz Director *By:/s/ George T. Robson ----------------------- George T. Robson Attorney-in-Fact EXHIBIT INDEX Exhibit Number Description - ------- ----------- 3.1 Restated Certificate of Incorporation of Unisys Corporation, incorporated by reference to Exhibit 3(a) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 3.2 By-Laws of Unisys Corporation, incorporated by reference to Exhibit 3(b) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 4.1 Agreement to furnish to the Commission on request a copy of any instrument defining the rights of the holders of long-term debt which authorizes a total amount of debt not exceeding 10% of the total assets of the registrant, incorporated by reference to Exhibit 4 to the registrant's Annual Report on Form 10-K for the year ended December 31, 1982 (File No. 1-145). 4.2 Form of Rights Agreement dated as of March 7, 1986 between Burroughs Corporation and Harris Trust Company of New York, as Rights Agent, which includes as Exhibit A, the Certificate of Designations for the Junior Participating Preferred Stock, and as Exhibit B, the Form of Rights Certificate, incorporated by reference to Exhibit 1 to the registrant's Registration Statement on Form 8-A, dated March 11, 1986. 4.3 Second Rights Agreement, dated as of June 28, 1990, by and between registrant and Mitsui & Co., Ltd. and joined by Harris Trust Company of New York, incorporated by reference to Exhibit 4.4 to the registrant's Current Report on Form 8-K dated June 28, 1990. 4.4 Purchase Agreement, dated as of June 25, 1990, between the registrant and Mitsui & Co., Ltd., incorporated by reference to Exhibit 4.3 to the registrant's Current Report on Form 8-K dated June 28, 1990. 10.1 Deferred Compensation Plan for Officers of Unisys Corporation, as amended and restated as of January 1, 1994. 10.2 Deferred Compensation Plan for Directors of Unisys Corporation, as amended and restated as of January 1, 1994. 10.3 Unisys Worldwide Information Services Long Term Incentive Plan effective as of January 1, 1993. 10.4 Form of Executive Employment Agreement, incorporated by reference to Exhibit 10(a) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 10.5 Form of Executive Employment Agreement, incorporated by reference to Exhibit 10.1 to the registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1987. 10.6 Employment Agreement, dated August 6, 1991, between the registrant and Reto Braun, incorporated by reference to Exhibit 10(c) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1991. 10.7 Employment Agreement, dated December 20, 1991, between the registrant and James A. Unruh, incorporated by reference to Exhibit 10(e) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1991. 10.8 Form of Retention Agreement for Key Executives, incorporated by reference to Exhibit 10(f) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1991. 10.9 Form of Retention Agreement for Key Executives, incorporated by reference to Exhibit 10(g) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1991. 10.10 Stock Unit Plan for Directors of Unisys Corporation, as amended and restated as of September 23, 1993, incorporated by reference to Exhibit 10 to the registrant's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1993. 10.11 Summary of supplemental executive benefits provided to officers of Unisys Corporation, incorporated by reference to Exhibit 10(k) of the registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 10.12 Unisys Executive Annual Variable Compensation Plan, incorporated by reference to Exhibit A to the registrant's Proxy Statement, dated March 23, 1993, for its 1993 Annual Meeting of Stockholders. 10.13 1982 Unisys Long-Term Incentive Plan, as amended and restated through September 1, 1989, incorporated by reference to Exhibit 10(p) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 10.14 Amendment, dated December 11, 1989, to the 1982 Unisys Long-Term Incentive Plan, incorporated by reference to Exhibit 10(o) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 10.15 Amendment, dated July 25, 1990, to 1982 Unisys Long- Term Incentive Plan, incorporated by reference to Exhibit 10(r) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 10.16 1990 Unisys Long-Term Incentive Plan, effective as of January 1, 1990 incorporated by reference to Exhibit A to the registrant's Proxy Statement, dated March 20, 1990, for its 1990 Annual Meeting of Stockholders. 10.17 Sperry Corporation Pension Plan for Outside Directors of the Board of Directors, as amended, incorporated by reference to Exhibit 10-J to the Annual Report of Sperry Corporation on Form 10-K for the fiscal year ended March 31, 1984 (File No. 1- 3908). 10.18 Form of Loan Agreement including Note used for bridge loans to executive officers purchasing residences, incorporated by reference to Exhibit 10(kk) to the registrant's Annual Report on Form 10- K for the year ended December 31, 1986. 10.19 Form of Loan Agreement including Note used for term loans to executive officers purchasing residences, incorporated by reference to Exhibit 10(ll) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1986. 10.20 Unisys Corporation Officers' Car Allowance Program, effective as of July 1, 1991, incorporated by reference to Exhibit 10(hh) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1991. 10.21 Form of Indemnification Agreement between Unisys Corporation and each of its Directors, incorporated by reference to Exhibit B to the registrant's Proxy Statement, dated March 22, 1988, for the 1988 Annual Meeting of Stockholders. 10.22 Unisys Corporation Elected Officer Pension Plan, effective June 1, 1988, incorporated by reference to Exhibit 10(zz) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 10.23 Amendment, dated February 27, 1992, to Unisys Corporation Elected Officers' Pension Plan, incorporated by reference to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 10.24 Unisys Corporation Supplemental Executive Retirement Income Plan, as amended and restated effective April 1, 1988, incorporated by reference to Exhibit 10(aaa) to the registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 11 Computation of earnings per share. 12 Computation of Ratio of Earnings to Fixed Charges. 13 Portions of the Annual Report to Stockholders of the registrant for the year ended December 31, 1993. 21 Subsidiaries of Unisys Corporation. 23 Consent of Ernst & Young. 24 Power of Attorney.

714560_1993.txt

714560_1993

1993

714560

Item 1. BUSINESS USAir Group, Inc. ("USAir Group" or the "Company") is a corporation organized under the laws of the State of Delaware. The Company's executive offices are located at 2345 Crystal Drive, Arlington, Virginia 22227 (telephone number (703) 418-5306). USAir Group's primary business activity is ownership of all the common stock of USAir, Inc. ("USAir"), Pennsylvania Commuter Airlines, Inc. (which is operating as Allegheny Commuter Airlines) ("Alleghe- ny"), Piedmont Airlines, Inc. ("Piedmont") (formerly Henson Aviation, Inc.), Jetstream International Airlines, Inc. ("Jet- stream"), USAir Fuel Corporation ("USAir Fuel"), USAir Leasing and Services, Inc. ("USAir Leasing and Services") and Material Services Company, Inc. In May 1987, the Company acquired Pacific Southwest Airlines ("PSA"), which merged into USAir on April 9, 1988. In November 1987 the Company completed its acquisition of Piedmont Aviation, Inc. ("Piedmont Aviation"), which merged into USAir on August 5, 1989. On July 15, 1992, the Company sold three wholly- owned subsidiaries, Piedmont Aviation Services, Inc., Air Service, Inc. and Aviation Supply Corporation. The former subsidiaries were engaged in fixed base operations and the sale and repair of aircraft and aircraft components. During the third quarter of 1992, the Company merged one wholly-owned subsidiary, Allegheny Commuter Airlines, Inc. into another, Pennsylvania Commuter Airlines, Inc. Significant Impact of Low Cost, Low Fare Competition As discussed in greater detail in "Management's Discussion and Analysis of Financial Condition and Results of Operations," the dramatic expansion of low fare competitive service in many of USAir's markets in the eastern U.S. during the first quarter of 1994 and USAir's competitive response in February 1994 by reducing its fares up to 70 percent in those markets and other affected markets in order to preserve its market share led the Company to announce that it expected to experience greater losses in 1994 than it experienced in 1993. In September 1993, Southwest Airlines, Inc. ("Southwest"), a low cost, low fare, "no frills" air carrier which had not previous- ly provided service to or in the eastern U.S., inaugurated service to Chicago and Cleveland from Baltimore/ Washington International Airport ("BWI") at fares substantially below those previously offered by USAir and other airlines in the same markets. BWI is one of USAir's hub airports. Unlike the other major U.S. air carriers, Southwest does not structure its operations around connecting hub airports, relying instead on high frequency point- to-point service. USAir responded by matching most of Southwest's fares and increasing the frequency of service in related markets. On March 22, 1994, Southwest announced that on May 26, 1994, and June 6, 1994, it will expand service between BWI and Chicago. Southwest also announced that on May 26, 1994, it will initiate its low fare service between BWI and St. Louis, and on July 8, 1994, between BWI and Birmingham, Alabama and Louisville, Kentucky. At this time, USAir has not determined its response to the Southwest announcement. In October 1993, Continental Airlines ("Continental"), which had reorganized under bankruptcy proceedings earlier in 1993, inaugurated low fare service on certain routes in the eastern U.S. USAir is a competitor in most of the markets served by these routes. While Continental initiated service to certain cities, such as Charleston, South Carolina; Greensboro, North Carolina; and Jacksonville, Florida; most of the markets included as part of its new program (for example, Baltimore) were previously served by Continental through its hubs at Newark, Cleveland, and Houston. However, under its new program, Continental linked certain of these cities independently of its hubs while continuing to provide many of the same services that are available on its hub flights, including advance seat assignment, frequent traveler mileage credits and interline connections. Under its new program, Continental served approximately 80 city pair markets, from which USAir has historically realized approximately 4% of its total passenger revenue. When Continental started the new program it was uncertain whether the program was an experiment or a beachhead from which Continental planned to expand further. USAir, therefore, made a measured response by matching most of the low fares offered by Continental. On January 31, 1994, Continental increased its competitive threat. It announced that by March 9, 1994, it would expand the low fare program to approximately 356 city pair markets, most of which USAir served and from which USAir has historically realized approximately 8% of its passenger revenue. Moreover, if secondary markets within a 90-mile radius, or a reasonable driving distance, were viewed as being included in Continental's new program, markets from which USAir has historically realized approximately 36% of its passenger revenue were affected. Contemporaneously, Continental announced that it would substantially reduce service at its Denver hub and redeploy significant aircraft and personnel resources to the eastern U.S. Although Continental's balance sheet continues to have significant leverage following its bankruptcy reorganization, its liquidity position improved substantially as a result of equity and debt infusions completed as part of that reorganization. Moreover, Continental completed a common stock offering in December 1993, which may indicate the market's receptivity to its efforts to raise additional funds. Continental has operating (including labor) costs that are substantially lower than those of USAir and the other major air carriers. On February 8, 1994, in response to the expansion of Continen- tal and to avoid loss of market share in the eastern U.S., USAir lowered in primary and secondary markets affected by the Continen- tal expansion, by as much as 50%, the fares most commonly used by business travelers on many east coast routes. In addition, USAir lowered leisure fares by as much as 70% in the same markets. In many of the markets, free companion fares are available with business fares. These reduced fares have no expiration date. However, USAir could adjust the fares at some time in the future. Increases in traffic which are stimulated by the lower fares offered by Southwest, Continental and USAir will not offset USAir's reduced revenue resulting from lower yields in these markets. USAir believes that Southwest, Continental or other low cost carriers with a significant cost advantage over USAir likely will expand their operations to additional markets. For example, in December 1993, Southwest completed its acquisition of Morris Air, a regional air carrier with operations concentrated in the western U.S. This acquisition could enable Southwest to divert resources to expand its operations in the eastern U.S. Furthermore, media reports indicate that Southwest has entered into a long-term agreement for the use of four additional gates at BWI, where it currently operates from two gates. On March 4, 1994, Continental further escalated prospective competition by announcing that it will further reduce operations at its Denver, Colorado hub and establish a flight crew base at Greensboro, North Carolina. These measures are likely to increase losses at USAir because they could enable Continental, which has significantly lower costs than USAir, to expand further its high frequency, low fare service described above in additional short-haul markets served by USAir with substantial detriment to USAir. In addition, other low cost carriers may enter other USAir markets. For example, America West Airlines ("America West") announced on February 15, 1994 that it will commence service on April 18, 1994 between Columbus, Ohio where it operates a hub and Philadelphia, where USAir has a hub operation. Other carriers, including some of the larger carriers, have also indicated their intent to develop similar low-fare short- haul service. In March 1994, USAir announced that it expected a pre-tax loss for the quarter ended March 31, 1994 of approximately $200 million and that it expected a pre-tax loss for the full year of 1994 in excess of the $350 million loss reported for 1993. USAir, whose operating costs are among the highest in the domestic airline industry, believes that it must reduce those costs significantly if it is to survive in this low fare competitive environment. The largest single component of USAir's operating costs, approximately 40 percent, relates to personnel costs. USAir also announced in March 1994 that it had initiated discussions with the leaders of its unionized employees regarding efforts to reduce these costs, including reductions in wages, improvements in productivity and other cost savings. The outcome of those discussions is uncertain. There are recent examples of companies in the airline industry which have obtained employee concessions in agreements also resulting in the recapitalization of the companies, including employee ownership stakes and employee participation in corporate governance as well as the restructuring of debt and lease obligations. In other cases, airlines have filed for bankruptcy protection under Chapter 11 of the bankruptcy code, and some airlines have ceased operation altogether when their operating costs remained excessive in relation to their revenues, and their liquidity became insufficient to sustain their operations. In addition, other factors beyond the Company's control, such as a downturn in the economy, a dramatic increase in fuel prices or intensified industry fare wars, could have a material adverse effect on the Company's and USAir's prospects and financial condition. Because the Company and USAir are highly leveraged and currently do not have access to bank credit and receivables facilities which had supplied a substantial portion of their liquidity, they could be more vulnerable to these factors than their financially stronger competitors. See "Managem- ent's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." British Airways Announcement Regarding Additional Investment in the Company; Code Sharing As described in greater detail in "British Airways Investment Agreement" below, on January 21, 1993, the Company and British Airways Plc ("BA") entered into an Investment Agreement (as subsequently amended, the "Investment Agreement"). Pursuant to the Investment Agreement, on the same date, BA invested $300 million in certain preferred stock of the Company. In June 1993, pursuant to BA's exercise of its preemptive and optional purchase rights under the Investment Agreement which were triggered by the issuance by the Company to the public, and under certain employee benefit plans, of certain shares of common stock, BA purchased $100.7 million of additional series of preferred stock of the Company. The Company has benefitted from the additional equity provided by BA and also from the resulting enhancement of the Company's image in the marketplace and in the investment community. However, on March 7, 1994, BA announced that because of the Company's continued substantial losses it would make no additional investments in the Company until the outcome of the Company's efforts to reduce its costs is known. See "Significant Impact of Low Fare, Low Cost Competition" above and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." At the same time, BA indicated it would continue to cooperate with USAir on the code sharing arrangements discussed below. In addition, since January 1993, pursuant to the Investment Agreement, BA and USAir have entered into code sharing arrangements whereby certain USAir flights carry the airline designator code of both USAir and BA. Code sharing is a common practice in the airline industry whereby one carrier sells the flights of another carrier (its code sharing partner) as if it provides those flights with its own equipment and personnel. On March 17, 1994, the U.S. Department of Transportation (the "DOT") issued an order renewing for one year all of the code share authority it had previously approved for USAir and BA which includes authority to code share to 64 airports in the U.S. through 12 gateways and to Mexico City through Philadelphia. The DOT did not act on other pending applications by BA and USAir for expanded code share authority. Major Airline Operations USAir, a certificated air carrier engaged primarily in the business of transporting passengers, property and mail, is the Company's principal operating subsidiary, accounting for more than 93% of USAir Group's operating revenues in 1993. USAir is one of nine passenger carriers classified as "major" airlines (those with annual revenues greater than $1 billion) by the United States Department of Transportation (the "DOT"). USAir enplaned more than 54.0 million passengers in 1993, and is the sixth largest United States air carrier ranked by revenue passenger miles ("RPMs") flown. At January 31, 1994, USAir provided regularly scheduled jet service through 118 airports to more than 154 cities in the continental United States, Canada, the Bahamas, Bermuda, the Cayman Islands, Puerto Rico, Germany, France and the Virgin Islands. USAir ceased serving the United Kingdom in January 1994. See "British Airways Investment Agreement". USAir's executive offices are located at 2345 Crystal Drive, Arlington, Virginia 22227 (telephone number (703) 418-7000), and its primary connecting hubs are located at the Pittsburgh, Charlotte/Douglas, Philadelphia and Baltimore/Washington International ("BWI") Airports. A substantial portion of USAir's RPMs is flown within or to and from the eastern United States. USAir Group and USAir incurred substantial operating and net losses during 1991, 1992 and 1993. During the first quarter of 1992, USAir's RPMs decreased over the same period in 1991, however, yield, or passenger revenue per RPM, improved. The decline in traffic was attributable to the May 1991 Restructuring (discussed below) and the economic recession. It is not possible to estimate accurately how many business and leisure travelers decided not to travel during 1991 and 1992 as a result of the recession and perceived weak recovery. During the second quarter of 1992, American Airlines, Inc. ("American") introduced a four-tier fare structure which resulted in the proliferation of deeply discounted promotional fares in the second and third quarters of 1992. Although the promotional fares significantly stimulated traffic during the second and third quarters of 1992, yields suffered substantial declines versus comparable periods in 1991. Although yields at USAir recovered and improved significantly in the fourth quarter of 1992 and in the first three quarters of 1993, yields started to erode in the fourth quarter of 1993 and declined versus the comparable quarter of 1992 due to proliferation of discount and promotional fares which were designed to stimulate passenger traffic. Yields have continued to be weak in the first quarter of 1994 due primarily to USAir's action to reduce fares to remain competitive with low cost low fare carriers which had entered many of USAir's markets in the eastern U.S. During 1993, systemwide traffic remained relatively weak. In addition, the domestic airline industry was characterized in 1991 - 1993 by substantial losses, excess capacity, intense competition and certain carriers operating under the protection of Chapter 11 of the Bankruptcy Code. Any of these factors or other developments, including the emergence of America West from bankruptcy, the entry or potential entry of low cost carriers in USAir's markets and a resurgence in low fare competition from these and other carriers could have a material adverse effect on the Company's yields, liquidity and financial condition. See "Significant Impact of Low Fare, Low Cost Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." For information on possible further effects of the recent economic recession, increased competition from low cost, low fare carriers, possible restructuring of the Company and USAir, consolidation in the domestic airline industry and globalization of the airline industry, see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." USAir implemented several operational changes during the period 1991 through 1993 in efforts to return to profitability and has announced plans for additional action in 1994. On May 2, 1991, USAir ceased operating its fleet of 18 British Aerospace BAe 146-200 ("BAe-146") aircraft, ceased serving eight airports in California, Oregon and Washington, and eliminated some flights at Baltimore/Washington and Cleveland Hopkins International Airports. Although other service was added to partially offset these reductions, the net effect was a decrease of approximately three percent in USAir's system available seat miles ("ASMs"), and a net reduction in scheduled departures of ten percent from January 1991 service levels. In connection with this restructuring, USAir closed four flight crew bases, two heavy maintenance facilities and one reservations office (these measures are collectively referred to as the "May 1991 Restructuring"). (In April 1993, USAir reintroduced long-haul service at John Wayne Airport in Orange County, California, one of the airports that USAir ceased serving in the May 1991 Restructuring). Effective January 7, 1992, USAir discontinued its hub operations at Dayton, Ohio due to operating losses there. Daily jet departures from Dayton were reduced from 72 to 23. The majority of USAir's jet flights between Dayton and smaller and medium-sized "spoke" cities was shifted to USAir's hub at Pitts- burgh, Pennsylvania, and there was no reduction in total systemwide capacity as a result of this action. In September 1993, USAir announced steps to reduce projected operating costs in 1994 by approximately $200 million. These measures include a workforce reduction of approximately 2,500 full time positions, revision of USAir's vacation, holiday and sick leave policy and a review of planned 1994 capital expenditures. The workforce reduction, which USAir anticipates will be completed by the end of the first quarter of 1994, will be comprised primarily of the elimination of approximately 1,800 customer service, 200 flight attendant and 200 maintenance positions. USAir recorded a non-recurring charge of approximately $68.8 million primarily in the third quarter of 1993 for severance, early retirement and other personnel-related expenses in connection with the workforce reduction. In March 1994, USAir initiated discussions with the leadership of its unionized employees regarding reductions in wages, improve- ments in productivity and other cost savings as a result of the entry of low cost low fare carriers in many of its markets and USAir's response to this low fare competition. See "Significant Impact of Low Cost, Low Fare Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations". In counterpoint to the reductions outlined above, USAir has also taken, or plans to take, the following steps to augment or enhance its service. In December 1991, USAir reached agreements with General Electric Capital Corporation ("GE Capital") and with The Boeing Company ("Boeing") to acquire up to 40 757-200 aircraft during 1992-1997. USAir agreed to lease ten aircraft owned by GE Capital and formerly operated by Eastern Air Lines ("Eastern"). In December 1992, USAir agreed to sublease an additional 757-200 aircraft from Boeing that was formerly operated by Eastern. USAir added these 11 aircraft to its operating fleet during 1992. USAir also agreed with Boeing to purchase 15 new 757-200 aircraft in 1993 and 1994, and took options to purchase 15 more 757-200s in 1996 and 1997. In April 1993, USAir and Boeing reached an agreement to exercise the options on 757-200 aircraft previously scheduled for delivery in 1996-1997 and accelerate their delivery to 1995-1996, and to convert a firm order for a 767-200 aircraft, originally scheduled for delivery in 1994, to a firm order for a 757-200 aircraft, also scheduled for delivery in 1994. Boeing granted USAir options to purchase 15 additional 757-200 aircraft for 1995 and beyond, three of which have expired. In addition, Boeing relieved USAir of its obligation to purchase 20 of its 60 firm orders for Boeing 737 series aircraft and agreed to reschedule delivery of the remaining 40 on order. No new firm order 737 aircraft are scheduled to be delivered to USAir between 1994-1996, while 12 new 737 aircraft will be delivered annually in the years 1997-1999 and four will be delivered in the year 2000. USAir is using the Boeing 757-200 aircraft, which seats approximately 190 passengers, on long-haul routes and in high demand markets where potential passenger traffic may not currently be accommodated on smaller aircraft at peak travel times. USAir considers the 757-200 aircraft to be more suitable for these missions than the Boeing 767-200 and Boeing 737 aircraft types. The above actions supple- ment USAir's agreements with Boeing in 1990 and 1991 to defer delivery of several 737 and 767 aircraft originally scheduled for the 1991-1994 period. Overall, the deferrals have substantially reduced USAir's capital commitments and financing needs during that time period. USAir is engaged in negotiations with Boeing regarding, among other things, the current schedule of new aircraft deliveries. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and Item 8A. Note 4 to the Company's Consolidat- ed Financial Statements. On January 17, 1992, USAir purchased 62 jet take-off and landing slots and 46 commuter slots at New York City's LaGuardia Airport ("LaGuardia") and six jet slots at Washington National Airport from Continental Airlines ("Continental") for $61 million. USAir also assumed Continental's leasehold obligations associated with the East End Terminal, which commenced operations on Septem- ber 12, 1992, and a flight kitchen at LaGuardia. USAir acquired all 46 commuter slots and 24 of the jet slots at LaGuardia on February 1, 1992; the remaining 38 jet slots at LaGuardia and all six jet slots at Washington National Airport were transferred to USAir on May 1, 1992. As a result of the acquisition, USAir expanded its operations at LaGuardia including the initiation of non-stop service to eight additional cities, four of which are in Florida. The New York-Florida markets are among the largest in the nation. USAir Express carriers used the commuter slots to expand service primarily to cities in the northeastern United States. (See "Commuter Airline Operations"). Expansion into these jet and commuter markets enhanced USAir's presence in the New York area and in the northeast. In addition, the East End Terminal permitted USAir to consolidate its mainline, commuter and USAir Shuttle operations in adjoining facilities, which USAir believes are the most comfortable and convenient at LaGuardia. USAir sold substan- tially all the assets associated with the flight kitchen operation on October 9, 1992. USAir Group reached an agreement during 1992 with the creditors of the Trump Shuttle to manage and operate the Shuttle under the name "USAir Shuttle" for a period of up to ten years. Under the agreement, USAir Group has an option to purchase the shuttle operation on or after October 10, 1996. The USAir Shuttle commenced operations in April 1992 between New York City, Boston and Washington D.C. Effective August 1, 1992, USAir leased 28 take-off and landing slots at Washington National Airport from Northwest Airlines, Inc. ("Northwest"). USAir is using the slots to offer expanded service from Washington to five Florida cities and New Orleans. In August 1993, USAir purchased eight of these slots from Northwest. USAir continues to lease the remaining slots from Northwest. On October 1, 1992, USAir moved its hub operation at Pitts- burgh, which is the largest on its system, to the new Pittsburgh International Airport terminal, where USAir leases 53 of 75 gates. USAir believes that the Pittsburgh hub, one of the largest hub airports (measured by departures) in the U.S., is one of the most efficient connecting complexes in the nation. Effective February 1, 1993, USAir and USAir Express service within the state of Florida commenced operating under the brand name "USAir Florida Shuttle". In addition, USAir started hourly service between Miami and Tampa and Miami and Orlando. On February 1, 1993 total USAir and USAir Express daily departures in the intra-Florida markets and to cities outside Florida increased approximately 27% over February 1992 levels. To enhance customer service and bolster brand loyalty within the state, USAir offered special benefits, bonus miles and upgrades to Florida residents participating in its Frequent Traveler Program. (See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - General Economic Conditions and Industry Capacity.") By June 1993 USAir increased capacity between key cities on the west coast of the U.S. and cities in the midwestern and eastern parts of the nation as it realigned west coast schedules and increased its emphasis on long-haul flights. Much of the increase in capacity was achieved by replacing smaller aircraft types with 757-200 aircraft. During 1993 and thus far in 1994 USAir and BA have gradually implemented code sharing arrangements pursuant to the Investment Agreement. As of March 1, 1994, USAir and BA had implemented code sharing to 34 of the 65 airports currently authorized by the DOT. See "British Airways Announcement Regarding Additional Investment in the Company; Code Sharing" above and "British Airways Investment Agreement" below. In March 1994, USAir (i) purchased from United Air Lines, Inc. ("United") certain takeoff and landing slots at Washington National Airport and New York LaGuardia Airport; (ii) purchased from United certain gates and related space at Orlando International Airport and (iii) granted to United options to purchase certain gates and related space, and a right of first refusal to purchase certain takeoff and landing slots, at Chicago O'Hare International Airport. In December 1993, USAir reached an agreement with United to negotiate a code sharing agreement with United regarding USAir's flights to and from Miami and United's flights between Miami and Latin America. Consummation of the code sharing agreement is subject to a number of conditions, including governmental approvals and definitive documentation. At this time, USAir cannot predict when the transactions contemplated by the code sharing agreement with United will be consummated. In September 1993, USAir received a civil investigative demand from the U.S. Department of Justice ("DOJ") related to an investigation of violations of Section 1 of the Sherman Act in connection with USAir's agreement with United regarding the above transactions. Although there can be no certainty, USAir does not believe the DOJ will seek to overturn the transactions described in (i), (ii) and (iii) above. In 1994, USAir has implemented and plans to implement certain changes to its service on certain short-haul routes to reduce the cost and increase the efficiency of those operations. In addition, in the second half of 1993 and early 1994, USAir experienced increased competition from low cost, low fare carriers. See "Significant Impact of Low Cost, Low Fare Competition" and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition". In response to the entry of certain low cost, low fare competitors at BWI and as part of USAir's measures to reduce the cost and increase the efficiency of its shorthaul service, USAir has substantially expanded its operations at BWI. As of March 1994, USAir had 121 daily jet departures at that airport compared to 91 daily jet departures in March 1993. See Item 7. "Manage- ment's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition." In November 1993, USAir commenced service between BWI and St. Thomas, Virgin Islands and between Charlotte and Tampa and Grand Cayman, Cayman Islands. In addition, USAir commenced nonstop service from Philadelphia to Mexico City in March 1994 and will commence non-stop service from Tampa to Mexico City in May 1994. As a result of seasonal adjustments, increased service to existing markets and service to new destinations, on May 8, 1994, USAir also plans to increase daily jet departures at its Pittsburgh hub from 327 to 355 and at its Charlotte hub from 323 to 334. In summary, in 1993, USAir continued to try to capitalize on its strong franchise in the northeastern U.S. and in Florida, based on measures it had implemented in 1991 and 1992. By the end of the third quarter of 1993, however, due to continued fare discounting, a resurgence of low fare competition from low cost carriers, persistent consumer price consciousness and, despite significant countermeasures, increased operating expenses, it became clear that for USAir to remain competitive, it needed to reduce costs and become more efficient. This realization resulted in, among other steps, the reduction in force of 2,500 full-time positions initiated in 1993, the innovations in short-haul service and the initiation of discussions with the leadership of USAir's unionized employees regarding wage reductions, improved productivity and other costs savings described in "Significant Impact of Low Cost, Low Fare Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition." USAir is engaged in formulating additional plans to reduce its operating costs in 1994. USAir's operating statistics during the years 1989 through 1993 are set forth in the following table: * Scheduled service only. c = cents (1) Statistics for 1989 are set forth on a pro forma basis to include the jet operations of Piedmont Aviation as if it had merged into USAir effective January 1, 1989. (2) Passenger load factor is the percentage of aircraft seating capacity that is actually utilized (RPMs/ASMs). (3) Breakeven load factor represents the percentage of aircraft seating capacity that must be utilized, based on fares in effect during the period, for USAir to break even at the pre- tax income level, adjusted to exclude non-recurring and special items. (4) Adjusted to exclude non-recurring and special items. (5) Financial statistics for 1993 exclude revenue and expense generated under the BA wet lease arrangement. Commuter Airline Operations Most commuter airlines in the United States are affiliated with a major or regional jet carrier. USAir provides reservations and, at certain stations, ground support services, in return for service fees, to 10 commuter carriers (including Allegheny, Piedmont and Jetstream) which operate under the name "USAir Express." At certain other stations, the commuter carriers commenced performing ground support for their operations in 1993. These airlines share USAir's two-letter designator code and feed connecting traffic into USAir's route system at several points, including its major hub operations at Pittsburgh, Charlotte, Philadelphia and BWI. At January 5, 1994, USAir Express carriers served 181 airports in the United States, Canada and the Bahamas, including 88 also served by USAir. During 1993, USAir Express' combined operations enplaned approximately 8.7 million passengers. Piedmont's collective bargaining agreement with the Air Line Pilots Association ("ALPA"), which represents its pilot employees, became amendable on December 1, 1992. On February 22, 1994, the National Mediation Board (the "NMB"), which had assigned a mediator to the negotiations between Piedmont and ALPA on a new agreement, declared these negotiations at an impasse and commenced a thirty- day "cooling-off" period. Upon the expiration of this period at midnight on March 25, 1994, the Piedmont pilots would be free to strike and Piedmont could resort to self-help measures. As USAir's largest commuter affiliate, Piedmont provides significant passenger feed to USAir. In addition, if the Piedmont pilots commence a strike, other USAir Express or USAir employees could refuse to cross picket lines or engage in sympathy strikes. USAir would view such activity as violative of applicable contracts and the Railway Labor Act and would pursue all legal remedies to halt it. Suspension of the operations of Piedmont, other USAir Express carriers or USAir for a prolonged period due to strikes or self- help measures could have a material adverse effect on the Company's and USAir's financial condition and prospects. USAM Corp. At December 31, 1992, USAM Corp. ("USAM"), a subsidiary of USAir, owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided CRS services to travel agent subscribers in Europe. Covia was then separated into three entities. As a result, at December 31, 1993, USAM owns 11% of the Galileo International Partnership, approximately 11% of the Galileo Japan Partnership and approximately 21% of the Apollo Travel Services Partnership. The Galileo International Partnership owns and operates the Galileo CRS ("Galileo"). Galileo Japan Partnership markets CRS services in Japan. Apollo Travel Services markets CRS services in the U.S. and Mexico. Galileo is the second largest of the four such systems in the U.S. based on revenues generated by travel agency subscribers. A subsidiary of United controls 38% of the partnership, and the other partners exclusive of USAir's interest are subsidiaries of BA, Swissair, KLM Royal Dutch Airlines, Alitalia, Air Canada, Olympic Airways, Austrian Airlines, Aer Lingus and TAP Air Portugal. CRSs play a significant role in the marketing and distribution of airline tickets. During 1993, travel agents issued tickets which generated the majority of USAir's passenger revenues. Most travel agencies use one or more CRSs to obtain information about airline schedules and fares and to book their clients' travel. Employees At December 31, 1993, USAir Group's various subsidiaries employed approximately 48,500 full-time equivalent employees. USAir employed approximately 5,400 pilots, 10,100 maintenance and related personnel, 12,300 station personnel, 4,100 reservations personnel, 8,600 flight attendants and 4,900 personnel in other administrative and miscellaneous job categories, while the commuter and other subsidiaries employed approximately 1,000 pilots, 800 maintenance personnel, 400 station personnel, 400 flight attendants and 500 personnel in other administrative and miscellaneous job categories. Approximately 24,400, or 50%, of the employees of USAir Group's subsidiaries are covered by collective bargaining agreements with various labor unions. As indicated in "Significant Impact of Low Cost, Low Fare Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations," because of the entry of low cost low fare carriers in certain of USAir's markets and USAir's response to this market penetration, in March 1994 USAir initiated discussions with the leadership of its unionized employees for wage reductions, improved productivity and other cost savings. USAir must reduce its operating costs significantly if it is to survive in this low fare competitive environment. Historically, USAir implemented a workforce reduction program in September 1990, in response to the economic recession and financial losses that caused USAir to decrease its planned capacity growth for 1991. More than 3,600 positions were eliminated through layoffs, furloughs and voluntary separations in connection with that program. A further reduction of more than 3,500 positions resulted from the May 1991 Restructuring. In September 1993, USAir announced steps to reduce projected operating costs in 1994. These measures will include a workforce reduction of approximately 2,500 full time positions and certain other cost reductions discussed under "Major Airline Operations". In addition, USAir believes that it was largely successful in implementing during 1992 and 1993 the elements of the comprehensive cost reduction program that it announced in October 1991. The cost reduction program included salary and wage reductions for a fixed time period, suspension of longevity/step increases in wages and salary, the freeze of a defined benefit pension plan applicable to non-contract employees, productivity improvements, contributions by employees for a portion of the cost of medical and dental benefits and implementation of a new managed care program intended to reduce the cost and retard the growth of these benefits. Consistent with this program, USAir sought concessionary contracts with each of its unions and stated that salary reductions for non-contract employees would take effect only when the first major union agreed to wage reductions. In the second quarter of 1992, ALPA, which represents USAir's pilot employees, reached agreement on a new contract which becomes amendable on May 1, 1996. The new contract included wage reduc- tions and suspension of longevity/step increases which resulted in savings of approximately $58 million over the twelve-month period which began June 1992. Additional savings of approximately $15 million resulted from productivity improvements over the same period. If fully implemented, USAir expects the productivity improvements will save the airline up to approximately $83 million annually. In addition, the pilots agreed to participate in contributory managed care medical and dental programs, which USAir expects will save approximately $10 million annually. In June 1993, the wages of pilot employees reverted to pre- reduction levels, and on September 1, 1993, in accordance with the terms of ALPA's agreement with USAir, pilot employees received a 2.5% increase in their wages. These employees are scheduled to receive further wage increases on (i) July 1, 1994, of approximate- ly 6.9%; (ii) July 1, 1995 of 2%; and (iii) January 1, 1996 of 1%. In accordance with its previously announced policy, when ALPA agreed to the cost reduction program, USAir imposed wage reductions and suspension of longevity/step increases on its non-contract employees for the twelve-month period commencing in June 1992. USAir estimates that it saved approximately $32 million from these measures. Earlier in 1992, USAir had implemented the contributory managed care medical and dental programs for non-contract employ- ees, which result in approximately $20 million in annual savings. Prior to January 1, 1992, USAir exclusively paid contributions to the basic defined benefit pension plan for its non-contract employees. USAir froze this pension plan at the end of 1991, which resulted in a one-time book gain of approximately $107 million in 1991. USAir implemented a defined contribution pension plan for these employees on January 1, 1993, which is composed of three components: contributions by USAir based on a percentage of salary, a partial match by USAir of employee contributions to a savings plan and a profit-sharing plan. On October 8, 1992, following a four-day strike, USAir reached agreement with the International Association of Machinists ("IAM"), which represents USAir's mechanics and related employees, on a new contract which becomes amendable on October 1, 1995. The new contract included wage reductions and suspension of longevity/step increases for the twelve-month period commencing October 1992, which USAir estimates resulted in savings of approximately $20 million. USAir also estimates that productivity improvements, which are also provided for in the new contract, resulted in savings of approximately $22 million in 1993 and will result in savings of $45 million annually if the improvements are fully implemented. In addition, IAM employees agreed to participate in contributory managed care medical and dental programs, which USAir expects will save approximately $14 million annually. In November 1993, the wages of the IAM-represented employees reverted to pre-reduction levels and on November 1, 1993, in accordance with the terms of the IAM's agreement with USAir, the wages of these employees increased by 2%. These employees are scheduled to receive further wage increases on June 1, 1994 and April 1, 1995 of approximately 3.9% and 4.7%, respectively. In February 1993, USAir announced that it had reached a tentative agreement with the Association of Flight Attendants ("AFA"), which represents its flight attendant employees, on a new contract which would become amendable on January 1, 1997. The contract, which was ratified by the AFA membership in March 1993, provides for wage reductions and suspension of longevity/step increases for a twelve-month period commencing April 1, 1993, which USAir expects will result in savings of approximately $10 million. USAir also estimates that productivity improvements, which are also provided for in the new contract, will result in savings of approximately $18 million over the twelve-month period commencing April 1, 1993 and $43 million annually if the improvements are fully implemented. In addition, AFA employees agreed to partici- pate in contributory managed care medical and dental programs, which USAir expects will save approximately $7 million annually. In March 1994, the wages of the flight attendant employees will revert to pre-reduction levels, and on April 1, 1994, in accordance with the terms of the AFA agreement with USAir, the wages of these employees will increase by 3%. These employees are scheduled to receive further wage increases on January 31, 1995 and January 31, 1996 of approximately 4% commencing on each date. On March 31, 1993 the Transport Workers Union (the "TWU"), which represents 175 flight dispatch employees, reached agreement with USAir on a contract which becomes amendable on September 1, 1996. The agreement provides for productivity improvements. These employees also participate in wage reductions, suspension of longevity/step increases and contributory managed care medical and dental programs because of their non-contract status when those measures were implemented for non-contract employees. The defined benefit plan for the flight dispatch employees was frozen on December 31, 1991 because of their non-contract status at that time. On July 29, 1993, USAir reached agreement with the TWU, which also represents approximately 60 USAir flight simulator engineers, on a new four-year contract which becomes amendable on August 1, 1997. The contract will result in savings of approximately $140,000 over the 12-month period commencing August 1, 1993, in the form of temporary salary reductions and suspension of longevi- ty/step increases. In addition, the flight simulator engineers agreed to participate in contributory managed care medical and dental programs which the Company expects will save approximately $50,000 annually. In addition, the defined benefit pension plan for these employees was frozen effective August 31, 1993, and will be replaced by a defined contribution pension plan beginning September 1, 1994. Taken together, the above measures provided for temporary wage reductions and suspension of longevity/step increases in wages that USAir estimates saved approximately $120 million during the period June 1992 through March 1994. These concessions provide for productivity improvements which are expected to save USAir approximately $55 million during the same period. If fully implemented, these productivity enhancements may save an additional $171 million annually. All employees affected by these changes have also agreed to participate in contributory managed care medical and dental program which are expected to save approximately $51 million annually. In exchange for the concessions agreed upon by its unionized employees, USAir included "no furlough" provisions in each of the new labor agreements with the ALPA, IAM, AFA and TWU, which prohibit USAir from furloughing employees hired on or before the effective date of the agreements during the term of each respective contract. USAir recorded a non-recurring charge of approximately $36.8 million in the fourth quarter of 1993 based on a projection of the repayment of the amount of the temporary wage and salary reductions discussed above in the event that the employees who sustained the pay cuts leave the employ of USAir. USAir will adjust this accounting charge in subsequent periods to reflect the change in the present value of the liability and changes in actuarial assumptions including, among other things, actual experience with the rate of attrition for these employees and whether such employees have received payments under the profit sharing program discussed in the next paragraph. In exchange for the pay reductions and pension freeze, affected employees will participate in a profit sharing program and have been, or will be, granted options to purchase USAir Group common stock. The profit sharing program is designed to recompense those employees whose pay has been reduced in an amount equal to (i) two times salary foregone plus; (ii) one times salary foregone (subject to a minimum of $1,000) for the freeze of pension plans described above. Estimated savings of approximately $23 million attributable to the suspension of longevity/step increases will not be subject to repayment through the profit sharing program. For each year the profit sharing program is in effect, pre-tax profits, as defined in the program, of USAir Group would be distributed to participating employees as follows: 25% of the first $100 million in pre-tax profits 35% of the next $100 million in pre-tax profits 40% of the pre-tax profits exceeding $200 million This profit sharing program will be in effect until USAir employees are recompensed for salary and pension benefits forgone and is independent of the profit sharing plan which is an element of the new defined contribution pension plan for non-contract employees discussed above. Under the stock option program, employees whose pay has been reduced have received or will receive options to purchase 50 shares of USAir Group common stock at $15 per share for each $1,000 of salary reduction. The options were, or become, exercisable following the twelve-month period of the salary reduction program for each group of employees. Generally, participating employees have five years from the grant date to exercise such options. As of December 31, 1993, USAir Group had granted options to purchase approximately five million shares of common stock to USAir employees under the program. At December 31, 1993, the market value of a share of USAir Group common stock was $12.875. Certain unions are engaged in efforts to unionize USAir's customer service and reservations employees. The Railway Labor Act (the "RLA") governs, and the NMB has jurisdiction over, such campaigns. Under the RLA, the NMB could order an election among a class or craft of eligible employees if a union submitted an application to the NMB supported by the authorization cards from at least 35% of the applicable class or craft of employees. If the NMB ordered an election and a majority of the eligible employees voted for representation, USAir would be required to negotiate a collective bargaining agreement with the union that wins the election. On January 28, 1994, the IAM, United Steelworkers of America ("USWA") and International Brotherhood of Teamsters filed applications with the NMB requesting that an election be held among USAir's fleet service employees, a class or craft of approximately 8,000 workers included among USAir's customer service employees. On March 1, 1994, after determining that each of the three applicant unions had submitted the required number of authorization cards, the NMB declared an election among the fleet service agents. At this time, the NMB has not determined the dates for the mailing or tabulation of ballots, however, USAir expects this process will be completed by the end of the third quarter of 1994. USAir cannot predict the outcome of the election, nor can it predict, if a union is certified, when a collective bargaining agreement would be negotiated or what its terms would be. On March 21, 1994, the USWA filed an additional application with the NMB requesting an election among USAir's passenger service employees, a class or craft of approximately 10,000 workers included among USAir's customer service employees. The NMB is in the process of determining whether this application is supported by sufficient authorization cards to warrant an election. USAir cannot predict whether an election will be held among the passenger service class or craft and if an election were held, the outcome. Nor can it predict if a union is certified when a collective bargaining agreement would be negotiated or what its terms would be. If unions are certified to represent the fleet service employees and the passenger service employees, substantially all of USAir's non-management employees would be unionized. USAir also cannot predict whether any union might submit authorization cards to the NMB sufficient to obtain an election among any other class or craft of employees. Except as noted, the following table presents the status of USAir's labor agreements as of December 31, 1993: As indicated under "Significant Impact of Low Fare, Low Cost Competition," in March 1994, USAir initiated discussions with the leadership of its unionized employees regarding wage reductions, improved productivity and other cost savings. If these discussions are successful, the terms of the above labor agreements will be renegotiated. See also "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition." See"-Commuter Airline Operations" for information regarding negotiations between Piedmont and ALPA. Jet Fuel USAir and USAir Fuel have contracts with 25 different fuel suppliers to meet a large percentage of USAir's current jet fuel requirements. The contracts for these jet fuel purchases are generally for one-year terms and expire at various dates. The pricing provisions of these agreements may be based upon many factors including crude oil, heating oil or jet fuel market conditions. In some cases, USAir has the right to terminate the agreements if contract prices become unacceptable. As market conditions permit, USAir also may purchase a portion of its fuel on the spot market at day-to-day prices depending upon availability, price and purchasing strategy. The most important single factor affecting petroleum product prices, including the price of jet fuel, continues to be the actions of the OPEC countries in setting targets for the produc- tion, and pricing of crude oil. In addition, jet fuel prices are affected by the markets for heating oil, diesel fuel, automotive gasoline and natural gas. Seasonally, second and third quarter jet fuel prices are typically lower than during the first and fourth quarters as the demand for heating oil, which competes with jet fuel for refinery production, subsides and refiners switch to gasoline production which also increases the output of jet fuel. Due primarily to OPEC's unwillingness or inability to restrain crude oil production and recession-dampened demand for petroleum products by the industrialized nations, USAir benefitted during 1993 from a general downward trend in jet fuel prices. For 1993, USAir's jet fuel cost averaged approximately 58.4 cents per gallon (versus an average of 61 cents in 1992) with quarterly averages of 59.8, 59.5, 56.7, and 57.7 cents. USAir continues to adjust its jet fuel purchasing strategy to take advantage of the best available prices while attempting to ensure that supplies are secure. While USAir believes that jet fuel prices will remain relatively stable in 1994, all petroleum product prices continue to be subject to unpredictable economic, political and market factors. Also, the balance among supply, demand and price has become more reactive to world market condi- tions. Accordingly, the price and availability of jet fuel, as well as other petroleum products, continues to be unpredictable. In addition, USAir has entered into agreements to hedge the price of a portion of its jet fuel needs, which may have the net effect of increasing or decreasing USAir's fuel expense. See Note 1 to Consolidated Financial Statements of USAir. In early August 1993, the Clinton Administration's budget package was enacted. The budget package included a 4.3 cent per gallon tax on transportation fuels beginning October 1, 1993. The airline industry is exempt from the tax until October 1, 1995. Imposition of the fuel tax will increase USAir's operating expenses. If the fuel tax had been in effect on January 1, 1993, USAir's fuel expense in 1993 would have increased by approximately $50 million. The following table sets forth statistics about USAir's jet fuel consumption and cost for each of the last three years: (1) Operating expenses have been adjusted to exclude non-recurring and special items. Insurance The Company and its subsidiaries maintain insurance of the types and in amounts deemed adequate to protect them and their property. Principal coverage includes liability for bodily injury to or death of members of the public, including passengers; damage to property of the Company, its subsidiaries and others; loss of or damage to flight equipment, whether on the ground or in flight; fire and extended coverage; and workers' compensation and em- ployer's liability. Effective February 1, 1991, the Company reduced the hull insurance coverage on its narrowbody aircraft from replacement value to the higher of book value or the loss value required by applicable leases or other contractual provisions. Coverage for environmental liabilities is expressly excluded from the Company's insurance policies. Industry Conditions The airline industry has historically been cyclical, in that demand for air transportation has tended to mirror general economic conditions. Although airline traffic and operating revenues generally benefitted from the economic growth that occurred through much of the 1980s, the Company and the industry have been adversely affected by the recent economic recession. Historically, the Company's airline operations have also been subject to seasonal variations in demand. First and fourth quarter results have often been adversely affected by winter weather and, with certain exceptions, reduced travel demand, while the second and third quarters generally have been characterized by more favorable weather conditions as well as higher levels of passenger travel. The restructuring of USAir's route system in recent years to emphasize its strengths in the northeastern U.S. and to capitalize in the first, second and fourth quarters on passenger traffic to Florida may result in changes in historic seasonality. Most of USAir's operations are in competitive markets. USAir and its commuter affiliates experience competition in varying degrees with other air carriers and with all forms of surface transportation. USAir competes with at least one major airline on most of its routes between major cities. Vigorous price competi- tion exists in the airline industry, and competitors have frequent- ly offered sharply reduced discount fares in many of these markets. Airlines use discount fares and other promotions to stimulate traffic during normally slack travel periods, to generate cash flow and to increase relative market share in selected markets. Discount and promotional fares are often subject to various restrictions such as minimum stay requirements, advance ticketing, limited seating and refund penalties. USAir has often elected to match those discount or promotional fares. In 1993, Southwest Airlines, Inc. and Continental, two low cost carriers, entered several of USAir's markets in the eastern U.S. and commenced low fare service. Continental substantially expanded its low fare operations in the first quarter of 1994, and, in anticipation of that expansion, USAir substantially reduced its fares in many markets. See "Significant Impact of Low Fare, Low Cost Competi- tion" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition." USAir expects that it will continue to face vigorous price competition. To the extent that low fares continue and their depressive effect on revenues is not offset by stimulation of additional traffic or by reduced costs, USAir's and the Company's earnings and liquidity will continue to be materially and adversely affected. Of the eleven airlines classified as "major" carriers by the DOT in January 1991, two have ceased operations, one is currently operating under Chapter 11 of the Bankruptcy Code and two filed for bankruptcy protection, reorganized and emerged from bankruptcy in 1993. Eastern, which declared bankruptcy in March 1989, ceased operations in January 1991. Pan American World Airways filed for Chapter 11 protection from creditors in January 1991 and ceased operations in December 1991. Continental, America West and Trans World Airlines ("TWA") filed for bankruptcy in December 1990, June 1991 and January 1992, respectively. Continental and TWA reorga- nized and emerged from bankruptcy in April 1993 and November 1993, respectively. America West is seeking to emerge from bankruptcy in 1994. In addition, Midway Airlines, a smaller carrier that had been a competitor of USAir at Philadelphia, declared bankruptcy in March 1991 and ceased operations in November 1991. Airlines operating under Chapter 11 often engage in discount pricing to generate the cash flow necessary for their survival. In addition, when these airlines emerge from bankruptcy they may have substantially reduced their debt and lease obligations and other operating costs, as was the case when Continental and TWA emerged. These reduced costs may permit the reorganized carriers to enter new markets and offer discount fares, which may be intended to generate cash flow, preserve and enhance market share and rehabili- tate the carriers' image in the marketplace. Since its reorganiza- tion, Continental has entered many of USAir's markets in the eastern U.S. and offered fares that were substantially lower than those that were previously available. See "Significant Impact of Low Fare, Low Cost Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost Low Fare Competition." The availability of the assets of bankrupt carriers has enabled certain financially stronger participants in the market, including, to a lesser extent, USAir, to consolidate their position by purchasing routes, aircraft, takeoff and landing slots and other assets. While substantial capacity has been removed in certain domestic markets, these bankruptcies and failures illustrate the difficulties facing the airline industry today. Regulation All domestic airlines, including USAir and its commuter affiliates, are subject to regulation by the FAA under the Federal Aviation Act of 1958, as amended. The Federal Aviation Administra- tion ("FAA") has regulatory jurisdiction over flight operations generally, including equipment, ground facilities, security systems, maintenance and other safety matters. To assure compli- ance with its operational standards, the FAA requires air carriers to obtain operations, airworthiness and other certificates, which may be suspended or revoked for cause. The FAA also conducts safety audits and has the power to impose fines and other sanctions for violations of aviation safety and security regulations. USAir has developed extensive maintenance programs which consist of a series of phased checks for each aircraft type. These checks are performed at specified intervals measured either by time flown or by the number of takeoffs and landings ("cycles") performed. They range from daily "walkaround" inspections, to more involved overnight maintenance checks, to exhaustive and time- consuming overhauls. The "Q Check", for example, requires more than 7,000 personnel-hours of work and includes stripping the airframe, extensively testing the airframe structure and a large number of parts and components, and reassembling the overhauled airframe with new or rebuilt components. Aircraft engines are subject to phased, or continuous, maintenance programs designed to detect and remedy potential problems before they occur. The service lives of certain parts and components of both airframes and engines are time or cycle controlled. Parts and other components are replaced or overhauled prior to the expiration of their time or cycle limits. The FAA approves all airline maintenance programs, including changes to the programs. In addition, the FAA licenses the mechanics who perform the inspections and repairs, as well as the inspectors who monitor the work. The FAA frequently issues airworthiness directives, often in response to specific incidents or reports by operators or manufac- turers, requiring operators of specified equipment to perform prescribed inspections, repairs or modifications within stated time periods or number of cycles. In response to several incidents involving older aircraft, the FAA, in cooperation with airframe manufacturers and operators, has developed mandatory programs requiring extensive testing, modifica- tions and repairs to certain models of older aircraft as a condition of their continuing in service beyond specified time periods or number of cycles. USAir is modifying its Boeing 727- 200, Boeing 737-200 and Douglas DC-9-30 aircraft to comply with the first phase of the "aging aircraft" requirements, which requires that a series of structural modifications be performed. The second phase, announced in November 1990, involves intensified corrosion control and detection procedures. Many of USAir's aircraft will be brought into compliance well in advance of the FAA's time and cycle requirements, because the work is scheduled to be accomplished in conjunction with other maintenance. A continuing regulatory issue currently facing the airline industry involves air traffic delays and landing rights. While the volume of aircraft operations in domestic airspace has increased during recent years, the capacity of the national air traffic control system has not kept pace. This situation causes frequent and significant air traffic delays, especially at the nation's busiest airports. These delays have led the FAA to require monthly reporting by air carriers of on-time performance and have prompted various proposals for reform of the FAA, which oversees and regulates the air traffic control system. The National Commission to Ensure a Strong Competitive Airline Industry (the "Airline Commission") issued its report in August 1993. Among other things, the Airline Commission recommended that: (1) the air traffic control system be modernized and the FAA air traffic control functions be performed by an independent federal corporation; (2) the federal regulatory burden be reduced; (3) the airlines be granted certain tax relief; and (4) the bankruptcy process be shortened. The Airline Commission also favored raising the statutory limit on foreign ownership of voting securities in U.S. airlines to 49 percent under certain circumstances. It further urged that the current international system of bilateral agreements be replaced with multilateral arrangements. In addition, the Airline Commission recommended that the DOT review the airlines' business, capital or financial plans with the assistance of a presidentially appointed advisory committee and, if an airline repeatedly failed to heed warnings or concerns of the DOT Secretary, the DOT could "exercise its existing authority," among other things, to revoke an airline's operating certificate. In January 1994, the Clinton Administration issued a report which described its program to implement certain of the Airline Commission's recommendations. Among other things, the Administra- tion stated that it supported the recommendation described above regarding the FAA, supported increasing to 49 percent the foreign ownership restrictions provided there are reciprocal opportunities for U.S. airlines and investors abroad, and opposed the recommenda- tions regarding tax relief and the appointment of the advisory committee discussed above. At this time, it is impossible to predict whether any of the Airline Commission's recommendations will be enacted and, if enacted, their effect on USAir. It is also difficult to anticipate whether the Congress will act in the near term on any of the proposals requiring legislation. The FAA, through its High Density Traffic Airport Rule, limits the number of flight operations at Washington National Airport, Chicago's O'Hare International Airport and New York City's John F. Kennedy International and LaGuardia Airports during specified time periods. Takeoff and landing rights ("slots") are assigned to airlines serving these high density airports. The FAA has promulgated regulations governing the allocation and use of slots that permit them to be traded, leased, purchased and sold. In addition, in 1992, the FAA amended its regulations governing the use of slots to require slotholders to increase their average monthly use of their slots. In 1993, the DOT began a comprehensive examination of the High Density Rule. As part of its study, the DOT will determine whether the operating limitations imposed by the rule can be eliminated or modified to better utilize available capacity at these airports. USAir holds a substantial number of slots at LaGuardia and National Airports, including those assigned a value when the Company acquired Piedmont Aviation. Any DOT action which would eliminate those slots or compel USAir to transfer those slots could have a material adverse effect on USAir's operations and financial position. Revision of the High Density Rule at National Airport, however, would require legisla- tion by the Congress. The DOT has indicated that it expects to complete its study by late 1994. The FAA also has authority to set noise standards for civil aircraft. Three noise level categories exist under FAA regula- tions. Stage 1 aircraft, which were designed before the first FAA noise regulations were promulgated in 1969, are no longer permitted to operate in the United States unless retrofitted to meet Stage 2 requirements. Stage 2 aircraft comply with regulations limiting noise emissions to specified levels. Aircraft designed after 1977 must meet the even more stringent noise limitations of Stage 3. At December 31, 1993, 260 aircraft, or 62% of USAir's operating fleet (excluding 33 Fokker aircraft exempt from the Stage 3 require- ments because their gross takeoff weights do not exceed 75,000 pounds), were Stage 3 aircraft. The Airport Noise and Capacity Act of 1990, with minor qualifications, prohibits operation of Stage 2 aircraft after 1999. Regulations promulgated by the FAA in 1991 require operators to modify or reduce the number of Stage 2 aircraft they operated during 1990 by 25% by the end of 1994, by 50% by the end of 1996, and by 75% by the end of 1998. Alterna- tively, an operator may elect to operate a fleet that is at least 55% Stage 3 by the end of 1994, 65% Stage 3 by the end of 1996 and 75% Stage 3 by the end of 1998. Modification costs will depend on the technology that is developed in response to the need, but these costs could be substantial for some aircraft types. See Note 4 to the Company's Consolidated Financial Statements. USAir intends to convert up to 64 of its Boeing 737-200 and 31 of its Douglas DC-9- 30 aircraft from Stage 2 to Stage 3. In May 1993, USAir entered into agreements to purchase hushkits for a substantial portion of its Boeing 737-200 fleet. The installation of these hushkits will bring the aircraft into compliance with federally mandated Stage 3 noise level requirements. These agreements are in addition to a previously existing agreement to purchase hushkits for certain of USAir's DC-9-30 aircraft. Installation of the hushkits will be accomplished during 1994-1999. Certain airport operators have adopted local regulations which, among other things, impose curfews, restrict the number of aircraft operations and require aircraft to meet prescribed decibel limits. Local noise regulations affect USAir's scheduling flexibility by requiring that only certain aircraft be scheduled at certain airports and at specified times of the day. In compliance with FAA regulations, USAir has implemented a drug testing program that involves not only education and training, but also periodic drug testing of personnel performing safety and security-related work, including pilots, flight attendants, mechanics, instructors, dispatchers and security screeners, and drug testing of all newly hired employees regardless of job classification. The FAA's drug testing regulations are comprehen- sive and complex. They require, among other things, six categories of drug tests: pre-employment, probable cause, periodic, random, post-accident and return to duty. In addition, all USAir Express operators have drug testing programs in place that comply with the FAA's drug testing regulations. The DOT has recently promulgated rules requiring by January 1995 the periodic testing of airline employees in safety-related jobs for alcohol use. USAir cannot predict at this time the effect of these new rules. Several aspects of airlines' operations are subject to regulation or oversight by Federal agencies other than the FAA. The DOT has jurisdiction over certain aviation matters such as international routes and fares, consumer protection and unfair competitive practices. The antitrust laws are enforced by the DOJ. Labor relations in the air transportation industry are generally regulated under the RLA, which vests in the NMB certain regulatory powers with respect to disputes between airlines and labor unions that arise under collective bargaining agreements. USAir and other airlines certificated prior to October 24, 1978 are also subject to regulations issued by the Department of Labor which implement the statutory preferential hiring rights granted by the Airline Deregulation Act of 1978 to certain airline employees who have been furloughed or terminated (other than for cause). The Company must also comply with federal and state environ- mental laws and regulations and has developed formal policies and procedures designed to ensure its ongoing compliance. The Company expects that its operating expenses will increase in the future as a result of governmental rulemaking and more stringent enforcement of applicable existing environmental laws. The Company cannot predict the magnitude of those increased costs or when they may be incurred, but in order to conduct their operations, airlines, including USAir and the USAir Express carriers, release and discharge pollutants into the environment. For example, USAir and the other airlines operating at Pittsburgh are subject to a Pennsylvania consent decree to reduce the runoff of deicing fluid which has resulted in the construction of new deicing pads, the cost of which will be passed on to the airlines. In addition, the Clean Air Act, as amended, as it may be implemented by the various states, may require operational upgrades and tighter emissions controls not only on aircraft but also on ground equipment operated by airlines. The airlines' operations in certain states, for example, California, where air pollution is a serious problem, may be affected more significantly than in other states. Moreover, many airports were constructed before the enactment of various environmental laws. The cost of correcting environmental problems at these airports may be passed onto the airlines operating at these airports through increased rents and fees. See also the disclosure above regarding the FAA's regulations regarding noise standards for civil aircraft and noise regulation by other governmental authorities and Note 4(d) to the Company's Con- solidated Financial Statements for disclosure regarding capital commitments related to compliance with these FAA regulations. British Airways Investment Agreement The following summary of certain terms of the Investment Agreement is subject to, and is qualified in its entirety by, the Investment Agreement and the exhibits thereto, which are exhibits to this report. On March 7, 1994, BA announced it would make no additional investments in the Company until the outcome of measures by the Company to reduce costs and improve its financial results is known. As of March 1, 1994, BA owned preferred stock in the Company constituting approximately 22% of the total voting interest in the Company. See Item 12. "Security Ownership of Certain Beneficial Owners and Management." Terms of the Series F Preferred Stock On January 21, 1993, the Company sold, pursuant to the Investment Agreement, 30,000 shares of the Company's Series F Cumulative Convertible Senior Preferred Stock, without par value, ("Series F Preferred Stock") to BA for an aggregate purchase price of $300 million. The Series F Preferred Stock is convertible into shares of Common Stock at a conversion price of $19.41 and will have a liquidation preference of $10,000 per share plus an amount equal to accrued dividends. See "Miscellaneous" for a discussion of an antidilution adjustment to the conversion price of the Series F Preferred Stock. The Series F Preferred Stock may be converted at the option of USAir Group at any time after January 21, 1998 if the average composite closing market price of Common Stock during any 30-day calendar period is at least 133% of the conversion price. The Series F Preferred Stock will be entitled to cumulative quarterly dividends of 7% per annum when and if declared and to share in certain other distributions. The Series F Preferred Stock must be redeemed by USAir Group on January 15, 2008. Each share of the Series F Preferred Stock will be entitled to a number of votes equal to the number of shares of Common Stock into which it is convertible and will vote with the Common Stock and USAir Group's Series A Cumulative Convertible Preferred Stock, without par value ("Series A Preferred Stock"), and any other capital stock with general voting rights for the election of directors, as a single class. Subject to adjustment, 515.2886 shares of Common Stock are issuable on conversion per share of Series F Preferred Stock (determined by dividing the $10,000 liquidation preference per share of Series F Preferred Stock by the $19.41 conversion price), and 15,458,658 shares of Common Stock would be issuable on conversion of all Series F Preferred Stock. However, under the terms of any USAir Group preferred Stock that is or will be held by BA ("BA Preferred Stock"), conversion rights (and as a result voting rights) may not be exercised to the extent that doing so would result in a loss of USAir Group's or any of its subsidiaries' operating certificates and authorities under Foreign Ownership Restrictions, as defined under "Board Representation" below, and it is assumed for this purpose that Series F Preferred Stock will be fully converted before any other BA Preferred Stock. Under Foreign Ownership Restrictions, no more than 25% of the Company's voting interest may be held by persons other than U.S. citizens, including BA. With respect to dividend rights and rights on liquidation, dissolution and winding up, the Series F Preferred Stock ranks senior to USAir Group's $437.50 Series B Cumulative Convertible Preferred Stock, without par value, and Junior Participating Preferred Stock, Series D, no par value, and Common Stock, and pari passu with BA Preferred Stock and Series A Preferred Stock. Moreover, the Certificate of Designation for the Series F Preferred Stock provides that if on any one occasion on or prior to January 21, 1996, any court or regulatory authority issues a final order that any material part of the Investment Agreement is unenforceable (except pursuant to bankruptcy or like event), then the conversion price of Series F Preferred Stock shall be reduced by 10.2564%. In that event, if the then conversion price of the Series F Preferred Stock were $19.41, it would be reduced to $17.42. On March 15, 1993, the DOT issued an order (the "DOT Order") finding, among other things, that "BA's initial investment of $300 million does not impair USAir's citizenship" under Foreign Ownership Restrictions as defined under "Board Representation" below. However, the DOT instituted a proceeding to consider whether USAir will remain a U.S. citizen if the transactions and acts contemplated by the Investment Agreement, including the transactions discussed under "Possible Additional BA Investments" and "Certain Governance Matters" below, are consummated. The DOT has suspended indefinitely the period for comments from interested parties to the proceeding pending its resolution of requests by other airlines for production of additional documents from USAir. The DOT Order states that the DOT expects and advises USAir Group and BA not to proceed with the Second Purchase and Final Purchase, as such terms are defined under "Possible Additional BA Invest- ments," until the DOT has completed its review of USAir's citizen- ship. In any event, on March 7, 1994, BA announced that it would make no additional investments in the Company until the outcome of measures by the Company to reduce its costs and improve its financial results is known. See "Significant Impact of Low Fare, Low Cost Competition" and "British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" above. The Company cannot predict the outcome of the proceeding or if the transactions contemplated under the Investment Agreement, particu- larly those discussed under "Possible Additional BA Investments" and "Certain Governance Matters", will be consummated. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of issues and consider- ations pertaining to globalization of the airline industry and "Miscellaneous" for information regarding BA's purchase of two additional series of preferred stock from USAir Group pursuant to its exercise of optional and preemptive purchase rights under the Investment Agreement and its decision not to exercise its optional purchase rights with respect to three additional series of preferred stock. Board Representation USAir Group increased the size of its Board of Directors by three on January 21, 1993 and the Board of Directors filled the newly created directorships with designees of BA. Under the terms of the Investment Agreement, USAir Group must use its best efforts to cause BA to be proportionally represented on the Board of Directors (on the basis of its voting interest), up to a maximum representation of 25% of the total number of autho- rized directors ("Entire Board"), assuming that such proportional representation is permitted by then applicable U.S. statutory and DOT regulatory or interpretative foreign ownership restrictions ("Foreign Ownership Restrictions"), until the later of the closing of the Second Purchase, as defined under "Possible Additional BA Investments" below, and the date on which BA may exercise under Foreign Ownership Restrictions the rights described under "Certain Governance Matters" below. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Industry Globalization" for a discussion of currently applicable Foreign Ownership Restrictions. U.S.-U.K. Routes Under the Investment Agreement, USAir Group agreed that as promptly as commercially practicable it would divest or, if divestiture were not possible, relinquish, all licenses, certificates and authorities for each of USAir's routes between the U.S. and the U.K. (the "U.K. Routes") at such time as BA and USAir implement the code-sharing arrangement contemplated by the Investment Agreement discussed below. USAir Group and BA have agreed that they should attempt to mitigate any negative impact on Company employees or communities served by the U.K. Routes and to share any losses suffered as a result of such divestiture or relinquishment with due regard to their respective interests. Accordingly, BA is operating and marketing certain routes formerly operated by USAir under a "wet lease." Under a "wet lease," an airline, in this case USAir, leases its aircraft and cockpit and cabin crews to another airline, in this case BA, for the purpose of operating certain routes or flights. The wet leases have an initial term of one year and may be extended by USAir Group and BA for a cumulative lease term not to exceed two years and eleven months. Rentals under the wet lease are based on USAir's costs. BA will retain the cumulative profits received by it in respect of these routes on the basis of its fully diluted stock ownership in USAir Group and pay the balance of the profits to USAir Group annually. See "Code Sharing" below. If the contemplated profit sharing cannot be performed, BA will reimburse USAir Group for a portion of any losses suffered by USAir Group in the divesture or relinquishment of the U.K. Routes based on a formula set forth in the Investment Agreement. The route authorities which USAir was required to sell or relinquish were the Philadelphia-London and BWI-London route authorities purchased by USAir from TWA in April 1992 for $50 million, and its route authority between Charlotte and London. Assets related to the U.K. Routes were carried on USAir's books at approximately $47 million at December 31, 1993 and USAir expects to recover such amount in full pursuant to the provisions of the Investment Agreement described above. During March and April of 1993, USAir reached agreement with two air carriers to sell the Philadelphia-London and BWI-London route authorities, provided, among other conditions, governmental authorities permitted the transfer of these route authorities to other cities. In June 1993, the DOT denied applications for such transfers on the grounds that the U.S.-U.K. bilateral air services agreement does not permit such transfers. In July 1993, the DOT awarded the Philadelphia-London route authority to American. USAir ceased operating the BWI-London route authority on October 1, 1993 as a result of the implementation of the wet leasing and code sharing arrangements with BA. See "Code Sharing" below. In April 1993, USAir agreed to sell to the Metropolitan Nashville Airport Authority, Nashville, Tennessee for $5 million its operating authority between Charlotte and London Gatwick Airport. In December 1993, the DOT issued an order which disapproved USAir's proposed sale of this route to Nashville and awarded the BWI-London and Charlotte-London route authorities to American, which will transfer the U.S. gateway cities for these route authorities to Nashville and Raleigh/Durham, North Carolina. USAir ceased serving the Charlotte-London route on January 19, 1994 and implemented the code sharing and wet leasing arrangement with BA in that market on that date. Code Sharing BA and USAir Group entered into a code share agreement on January 21, 1993 (the "Code Share Agreement") pursuant to which certain USAir flights will carry the airline designator code of both BA and USAir. Code sharing is a common practice in the airline industry whereby one carrier sells the flights of another carrier (its code sharing partner) as if it provides those flights with its own equipment and personnel. These flights are intended by USAir Group and BA eventually to include all routes provided for under the bilateral air services agreement between the U.S. and the U.K. to the extent possible, consistent with commer- cial viability and technical feasibility. The DOT Order, among other things, granted USAir for one year a statement of authorization, and BA an exemption, for certain code sharing and wet leasing arrangements contemplated by the Investment Agreement (the "Initial Code Share Authority"). USAir believes that the one-year term of the Initial Code Share Authority was consistent with DOT policy and precedents with respect to other code sharing arrangements. As contemplated in the Initial Code Share Authority, USAir can code share with BA to approximately 38 airports in the U.S. beyond the BWI, Philadelphia and Pittsburgh gateways. Since the DOT Order was issued in March 1993, the DOT also granted USAir code sharing authorization for 26 additional U.S. airports and Mexico City through nine additional U.S. gateways, including Charlotte (the "Supplemental Code Share Authority"). Although the DOT granted the Supplemental Code Share Authority for periods shorter than one year in an effort to exert pressure on the U.K. to liberalize access to the U.K., particularly London's Heathrow Airport, in negotiations on a revised U.S.-U.K. bilateral air services agreement, the DOT eventually extended the Supplemental Code Share Authority to March 17, 1994, the same date the Initial Code Share Authority expired. As of March 1, 1994, USAir and BA had implemented the code sharing arrangements for 34 U.S. cities. On March 17, 1994, the DOT issued an order renewing for one year the code share authorization granted under the Initial Code Share Authority and Supplemental Code Share Authority. In January 1994, USAir and BA filed applications to code share to 65 additional U.S., and seven additional foreign, destinations via the same and several additional U.S. gateways. The DOT did not act on these applications in its March 17, 1994 order. The Company and BA are in the process of exploring the economies and synergies that may be possible as a result of the Code Share Agreement. The Company believes that (i) the code-share cities in the U.S. will receive greater access to international markets; (ii) it will have greater access to international traffic; and (iii) BA's and its customers will benefit from better on-line connections as well as coordinated check-in and baggage checking procedures. The Company believes that the code sharing arrange- ments will generate increased revenues; however, the magnitude of any increase cannot be estimated at this time. The DOT may continue to link further renewals of the code share authorization to the U.K.'s liberalization of U.S. air carrier access to the U.K.; however, the code sharing arrangements contemplated by the Code Share Agreement are expressly permitted under the bilateral air services agreement between the U.S. and U.K. Accordingly, USAir expects that the existing code share authorization will continue to be renewed; however, there can be no assurance that this will occur. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Industry Globaliza- tion." USAir does not believe that the DOT's failure to renew further the authorization would result in a material adverse change in its financial condition; however, if the authorization is not renewed, consummation of the Second Purchase and the Final Purchase, as defined under "Possible Additional BA Investments" below, may be less likely. In any event, on March 7, 1994 BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce costs and improve its financial results is known. As discussed under "Possible Additional BA Investments" below, USAir cannot predict whether or when the Second Purchase or the Final Purchase will be consummated in any event. Possible Additional BA Investments On March 7, 1994 BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce costs and improve its financial results is known. Under the terms of the Investment Agreement, assuming the Series F Preferred Stock or any shares issued upon conversion thereof are outstanding and BA has not sold any shares of preferred stock issued to it by USAir Group or any common stock or other securities received upon conversion or exchange of the preferred stock, BA is entitled at its option to elect to purchase from USAir Group, on or prior to January 21, 1996, 50,000 shares of Series C Cumulative Convertible Senior Preferred Stock, without par value ("Series C Preferred Stock"), at a purchase price of $10,000 per share, to be paid by BA's surrender of the Series F Preferred Stock and a payment of $200 million (the "Second Purchase"), and, on or prior to Janu- ary 21, 1998, assuming that BA has purchased or is purchasing simultaneously Series C Preferred Stock, 25,000 (or more in certain circumstances) shares of Series E Cumulative Convertible Exchange- able Senior Preferred Stock, without par value ("Series E Preferred Stock"), at a purchase price of $10,000 per share (the "Final Purchase"). Series E Preferred Stock is exchangeable under certain circumstances at the option of USAir Group into certain USAir Group debt securities ("BA Notes"). If the DOT approves all the transactions and as contemplated by the Investment Agreement, at the election of either BA or USAir Group on or prior to January 21, 1998, BA's purchase of the Series C Preferred Stock (unless previously consummated) and BA's purchase of the Series E Preferred Stock would be consummated under certain circumstances. If BA has not elected to purchase the Series C Preferred Stock by January 21, 1996, then USAir Group may at its option redeem, in whole or in part, Series F Preferred Stock at the higher of market value or the price of $10,000 per share, plus accrued dividends. USAir cannot predict whether or when the Second Purchase and Final Purchase will be consummated. Terms of the Series C Preferred Stock and Series E Preferred Stock The Series C Preferred Stock and Series E Preferred Stock are substantially similar to Series F Preferred Stock, except as follows. Series C Preferred Stock will be convertible into shares of Class B Common Stock or Non-Voting Class C Stock (as such terms are defined under "Terms of BA Common Stock" below) at an initial conversion price of approximately $19.79, subject to Foreign Ownership Restrictions. Each share of Series C Preferred Stock will be entitled to a number of votes equal to the number of share of Class B Common Stock into which it is convertible, subject to Foreign Ownership Restrictions. If shares of Series C Preferred Stock are transferred to a third party, they convert automatically at the seller's option into either shares of Common Stock or a like number of shares of Series G Cumulative Convertible Senior Preferred Stock. Series E Preferred Stock will be convertible into shares of Common Stock or Non-Voting Class ET Stock (as defined under "Terms of BA Common Stock" below) at an initial conversion price of approximately $21.74, subject to increase if the Series E Preferred Stock is originally issued on or after January 21, 1997, subject to Foreign Ownership Restrictions. Each share of Series E Preferred Stock will be entitled to a number of votes equal to the number of shares of Common Stock into which it is convertible, subject to Foreign Ownership Restrictions. Terms of BA Common Stock To the extent permitted by Foreign Ownership Restrictions, an amendment to USAir Group's charter, which is to be filed with the Delaware Secretary of State immedi- ately prior to the Second Purchase, which BA has announced it will not complete under current circumstances, will create three new classes of common stock - Class B Common Stock, par value $1.00 per share ("Class B Common Stock"), Non-Voting Class C Common Stock, par value $1.00 per share ("Non-Voting Class C Stock"), and Non- Voting Class ET Common Stock, par value $1.00 per share ("Non- Voting Class ET Common Stock," collectively with Class B Common Stock and Non-Voting Class C Common Stock, "BA Common Stock") all of which may be held only by BA or one of its wholly-owned subsidiaries. Except with respect to voting and conversion rights, the BA Common Stock will be substantially identical to the Common Stock. Shares of BA Common Stock will convert automatically to shares of Common Stock upon their transfer to a third party. Subject to Foreign Ownership Restrictions, Class B Common Stock will be entitled to one vote per share. After the effectiveness of the above charter amendment, to the extent permitted by Foreign Ownership Restrictions, Class B Common Stock will vote as a single class with Series C Preferred Stock on the election of one-fourth of the directors and the approval of the holders of Class B Common Stock and Series C Preferred Stock voting as a single class will be required for certain matters. Certain Governance Matters Following the Second Purchase, which BA has announced it will not complete under current circum- stances, and assuming these changes are permitted under Foreign Ownership Restrictions, the above charter amendment will fix the size of USAir Group's Board of Directors at 16, one-fourth of whom would be elected by BA. In addition, the vote of 80% of the USAir or USAir Group Boards of Directors will be required for approval of the following (with certain limited exceptions): (i) any agreement with the DOT regarding citizenship and fitness matters; (ii) any annual operating or capital budgets or financing plans; (iii) incurring capital expenditure not provided for in a budget approved by the vote of 80% of the board in excess of $10 million in the aggregate during any fiscal year; (iv) declaring and paying dividends on any capital stock of USAir Group or any of its subsidiaries (other than dividends paid only to USAir Group or any wholly-owned subsidiary of USAir Group and any dividends on preferred stock); (v) making investments in other entities not provided for in approved budgets in excess of $10 million in the aggregate during any fiscal year; (vi) incurring additional debt (other than certain debt specified in the Investment Agreement) not in an approved financing plan in excess of $450 million in the aggregate during any fiscal year; (vii) incurring off-balance sheet liabilities (e.g., operating leases) not in an approved financing plan in excess of $50 million in the aggregate during any fiscal year; (viii) appointment, compensation and dismissal of certain senior executives; (ix) acquisition, sale, transfer or relinquish- ment of route authorities or operating rights; (x) entering into material commercial or marketing agreements or joint ventures; (xi) issuance of capital stock (or debt or other securities convertible into or exchangeable for capital stock), other than (A) the stock options granted to employees in return for pay reductions under the USAir Group 1992 Stock Option Plan, as described under "Employees" above, (B) to USAir Group or any direct or indirect wholly owned subsidiary of USAir Group, (C) pursuant to the terms of USAir Group securities outstanding when a certain amendment to USAir Group's charter required in connection with consummation of the Second Purchase becomes effective, or (D) pursuant to the terms of securities the issuance of which was previously approved by the vote of 80% of the board; (xii) acquisition of its own equity securities other than from USAir Group or its subsidiaries, or pursuant to sinking funds or an approved financing plan; and (xiii) establishment of a board of directors' committee with power to approve any of the foregoing. This supermajority vote requirement would allow any four directors, including those elected by BA, to withhold approval of the actions described above if they believe them to be contrary to the best interests of USAir. The super- majority vote would not be required with regard to the foregoing actions to the extent they involve the enforcement by USAir Group of its rights under the Investment Agreement. Following the Second Purchase, which BA has indicated it will not complete under current circumstances, to the extent permitted under Foreign Ownership Restrictions, USAir Group and BA will integrate certain of their respective business operations pursuant to certain "Integration Principles" included in the Investment Agreement. In addition, to the extent permitted by Foreign Ownership Restrictions or pursuant to specific DOT approval, an "Integration Committee," headed by the chief executive officers of USAir Group and BA and by an Executive Vice President-Integration of USAir Group, would oversee the integration subject to the ultimate discretion of USAir Group's board of directors. As of the Final Purchase, which BA has indicated it will not complete under current circumstances, to the extent permitted by Foreign Ownership Restrictions, the Investment Agreement provides for the establish- ment of a committee ("Appointments Committee") of the board of directors of USAir Group, composed of USAir Group's chief executive officer, BA's chief executive officer and another director serving on both USAir Group's and BA's board of directors, to handle all employment matters relating to managers at the level of vice president and above, except for certain senior executives. BA's governance rights after the Second Purchase and the Final Purchase, which BA has indicated it will not complete under current circumstances, are subject to reduction if BA reduces its holding in USAir Group under the following circumstances. If BA sells or transfers, in one or more transactions, BA Preferred Stock, Common Stock or BA Common Stock (collectively, Common Stock and BA Common Stock are hereinafter referred to as "Non-Preferred Stock") issued directly or indirectly upon the conversion thereof such that the aggregate purchase price of the BA Preferred Stock, BA Notes, Non- Preferred Stock or other equity securities of USAir Group held by BA and its directly or indirectly wholly owned subsidiaries following such sale or transfer (the "BA Holding") is less than both two-thirds of the aggregate purchase price of all BA Preferred Stock, BA Notes, Non-Preferred Stock or other equity securities of USAir Group acquired by BA and its subsidiaries following Janu- ary 21, 1993 and $750 million (or $500 million if the Final Purchase has not occurred), then (i) the number of directors elected by the Class B Common Stock and the Series C Preferred Stock, voting together as a single class, will be limited to two; (ii) the directors elected by the Common Stock, Series A Preferred Stock, Series E Preferred Stock, Series T Preferred Stock, as defined under "Miscellaneous" below, and other capital stock with voting rights will no longer be required to include two directors selected from among the outside directors on the board of directors of BA; (iii) special class voting rights applicable to the Class B Common Stock and Series C Preferred Stock will no longer apply and; (iv) BA will no longer participate in the Appointments Committee. In addition, if the BA Holding becomes less than both one-third of the aggregate purchase price of all BA Preferred Stock, BA Notes, Non-Preferred Stock or other equity securities of USAir Group acquired by BA and its subsidiaries following January 21, 1993 and $375 million (or $250 million if the Final Purchase has not occurred), then the number of directors elected by the Class B Common Stock and the Series C Preferred Stock, voting together as a single class, will be reduced to one. If the BA Holding becomes less than $100 million, then the Class B Common Stock and the Series C Preferred Stock will no longer vote together as a single class with respect to the election of any directors of USAir Group, but will vote together with the Common Stock, the Series A Preferred Stock and any other class or series of capital stock with voting rights with respect to the election of directors of USAir Group. Miscellaneous Under the terms of the Investment Agreement, BA has the right to maintain its proportionate ownership (based on the assumed consummation of the Second Purchase and the Final Purchase) of USAir Group's securities under certain circumstances by purchasing shares of certain series of Series T Cumulative Convertible Exchangeable Senior Preferred Stock, without par value ("Series T Preferred Stock"), Common Stock or BA Common Stock. Pursuant to these provisions, on June 10, 1993, BA purchased (i) 152.1 shares of Series T-1 Preferred Stock for approximately $1.5 million as a result of certain issuances during the period January 21 through March 31, 1993 of Common Stock in connection with the exercise of certain employee stock options and to certain defined contribution retirement plans; and (ii) 9,919.8 shares of Series T-2 Preferred Stock for approximately $99.2 million as a result of USAir Group's issuance on May 4, 1993 of 11,500,000 shares of Common Stock for net proceeds of approximately $231 million pursuant to a public underwritten offering. Because BA partially exercised its preemptive right in connection with the Common Stock offering and the offering price was below a certain level, the conversion price of the Series F Preferred Stock was antidilutively adjusted on June 10, 1993 from $19.50 to $19.41 per share. As a result, the Series F Preferred stock is convertible into 15,458,658 shares of Common Stock or Non-Voting Class ET Common Stock. On March 7, 1994, BA advised the Company that it would not exercise its optional purchase rights under the Invest- ment Agreement to buy three additional series of Series T Preferred Stock triggered by issuances of common stock of the Company pursuant to certain Company benefit plans during the second, third and fourth quarters of 1993. The Investment Agreement also imposes certain restrictions on BA's right to acquire additional voting securities, participate in solicitations with respect to USAir Group securities or otherwise propose or discuss extraordinary transactions concerning USAir Group. In addition, the Investment Agreement restricts BA's right to transfer certain securities and requires that prior to transfer- ring such securities, BA must, in most cases, first offer to sell the securities to USAir Group. BA has certain rights to require USAir Group to register for sale USAir Group securities sold to it pursuant to the Investment Agreement. USAir Group believes that the investments made by BA, the code sharing arrangements and consummation of the other transactions contemplated by the Investment Agreement have enabled and would further enable it to compete more effectively by (i) increasing USAir Group's equity capital and strengthening its balance sheet; (ii) improving its liquidity and access to capital markets; (iii) providing financial resources to help it withstand adverse economic conditions and fare competition; (iv) providing financial resources for the purchase of strategic assets which may be on the market from time to time; and (v) giving USAir greater access to interna- tional traffic. However, BA has announced that while it will continue to code share with USAir, it will not make additional investments in the Company under current circumstances. It is unclear whether or when any additional investments by BA will occur. Item 2. Item 2. PROPERTIES Flight Equipment At December 31, 1993, USAir operated the following jet aircraft: (1) Of the owned aircraft, 119 were collateral for various secured financing obligations aggregating $2.0 billion at December 31, 1993, 31 were collateral under USAir Group's Credit Agreement (see Item 8A, Notes to the Consolidated Financial Statements of USAir Group). (2) The terms of the leases expire between 1994 and 2015. (3) The above table excludes one owned and one leased Boeing 767- 200ER which USAir leased to BA under a wet lease arrangement at December 31, 1993. See "British Airways Investment Agreement - U.S.-U.K. Routes." At December 31, 1993, USAir Group's three commuter airline subsidiaries operated the following propeller-driven aircraft: (1) Of the owned aircraft, four were collateral for various secured financing obligations aggregating $3.6 million at December 31, 1993, 35 were collateral under USAir Group's Credit Agreement (see Item 8A, Notes to the Consolidated Financial Statements of USAir Group), 14 were owned by USAir Leasing and Services, and 17 were owned by USAir. (2) The terms of the leases expire between 1994 and 2010. USAir is party to purchase agreements that provide for the future acquisition of new jet aircraft. See Note 4(d) to the Company's Consolidated Financial Statements for outstanding commitments and options for the purchase of flight equipment. The Company's subsidiary airlines maintain inventories of spare engines, spare parts, accessories and other maintenance supplies sufficient to meet their operating requirements. USAir owns one and leases 17 BAe 146-200 aircraft, leases 8 Boeing 727-200 and owns 12 Fokker-1000 aircraft that were parked in storage facilities and not operating at December 31, 1993. In addition, certain of the Company's subsidiaries lease five owned-1000 aircraft to outside parties. USAir is a participant in the Civil Reserve Air Fleet ("CRAF"), a voluntary program administered by the Air Mobility Command ("MAC"). USAir's commitment under CRAF is to provide two Boeing 767 aircraft in support of military operations, probably for aeromedical missions, as specified by MAC. To date, MAC has not requested USAir to activate any of its aircraft under CRAF. Ground Facilities USAir leases the majority of its ground facilities, including executive and administrative offices in Arlington, Virginia adjacent to Washington National Airport; its principal operating, overhaul and maintenance bases at the Pittsburgh and Charlotte/Douglas International Airports; major training facilities in Pittsburgh and Charlotte; central reservations offices in several cities; and line maintenance bases and local ticket, cargo and administrative offices throughout its system. USAir owns property in Fairfax, Virginia, a training facility in Winston- Salem, North Carolina, a reservations and training facility in San Diego, California, and a reservations facility in Orlando, Florida. Allegheny owns its principal ground facilities in Middletown, Pennsylvania. Jetstream leases its principal ground facilities in Dayton, Ohio. Piedmont leases its principal ground facilities in Salisbury, Maryland, Norfolk, Virginia and Jacksonville, Florida. The Company's airline subsidiaries utilize public airports for their flight operations under lease arrangements with the govern- ment entities that own or control these airports. Airport authorities frequently require airlines to execute long-term leases to assist in obtaining financing for terminal and facility construction. Future requirements for new or improved airport facilities and passenger terminals will require additional expenditures and long-term commitments. Several significant projects which affect large airports on USAir's route system are discussed below. The new terminal at Pittsburgh International Airport commenced operation in October 1992. The construction cost of the new terminal was approximately $800 million, a substantial portion of which was financed through the issuance of airport revenue bonds. As the principal tenant of the new facility, USAir will pay a portion of the cost of the new terminal through rents and other charges pursuant to a use agreement which expires in 2018. While USAir's terminal rental expense at Pittsburgh increased from approximately $14 million annually prior to relocation to the new facility, to approximately $49 million annually in 1993, the new facility has provided additional gate capacity for USAir and has enhanced the efficiency and quality of its hub services at Pittsburgh. In addition to the annual terminal rental expense, USAir is recognizing approximately $18 million annual rental expense for property and equipment typically owned by USAir at other airports. The annual terminal rental expense is subject to adjustment, depending on the actual airport operating costs, among other factors. These additional rents are reflected in Note 4(b), "Lease Commitments", to the Company's and USAir's respective Consolidated Financial Statements. The East End Terminal at New York LaGuardia Airport, which cost approximately $177 million to construct, opened in the third quarter of 1992. USAir, USAir Express and the USAir Shuttle operations at LaGuardia are conducted from this new terminal and the adjoining USAir Shuttle terminal. The East End Terminal has 12 jet gates. USAir will recognize approximately $31.6 million in annual rental expense for the new terminal and is responsible for all maintenance and operating costs. In 1993, USAir and the City of Philadelphia reached an agreement to proceed with certain capital improvements at Philadel- phia International Airport, where USAir has its third largest hub. The improvements include between $60 million and $90 million in various terminal renovations and a new $214 million commuter airline runway expansion project, exclusive of financing costs. Depending on the timing of certain federal environmental reviews, USAir expects construction will begin some time in 1994 or 1995 and will be completed in 1996 or 1997. The Washington National Airport Authority, which operates Washington National Airport ("National"), is currently undertaking a $930 million capital development project at National, which includes construction of a new terminal currently expected to commence operation in the fourth quarter of 1996. Based on current projections, the Company estimates that its annual operating expenses at Washington National Airport will increase by approxi- mately $15-$20 million. During 1990, Congress enacted legislation to permit airport authorities, with prior approval from the DOT, to impose passenger facility charges ("PFCs") as a means of funding local airport projects. These charges, which are collected by the airlines from their passengers, are limited to $3.00 per enplanement, and to no more than $12.00 per round trip. The legislation provides that the airlines will be reimbursed for the cost of collecting these charges and remitting the funds to the airport authorities. To date, approximately 200 airports, including airports at Boston, Baltimore, Washington, Newark, New York City, Philadelphia, Orlando and Tampa (which are major markets served by USAir), have imposed or are seeking approval to impose PFCs. These airports will receive more than $1 billion annually in PFCs. By the end of 1993, most major airports had imposed, or announced their intent to impose, PFCs. As a result of downward competitive pressure on fares, USAir and other airlines have been unable in many instances to pass on the cost of the PFCs to passengers through fare increases. With respect to the magnitude of airport rent and landing and other user fees generally, federal law prohibits States and their subdivisions from collecting these fees, other than reasonable rental charges, landing fees and other service charges, from aircraft operators for the use of airport facilities. In the absence of guidance from the FAA and the DOT, which are charged with enforcing such laws, regarding the "reasonableness" of fees charged at certain airports, controversies have arisen in recent years concerning the allocation of airport costs among the airlines, general aviation and concessionaires operating at the airport. Until these agencies act, governmental authorities will continue to assess fees in excess of what the airlines believe is reasonable at certain airports. In addition, during 1993, the controversy surrounding the diversion by airport and other governmental authorities of airport revenues continued to grow. Airport revenues typically consist primarily of rents and landing and other user fees paid by the airlines operating at the airport. Under federal law, federal transportation funds could be denied to certain airports that engage in diversion of these revenues. During 1993, a number of airlines operating at Los Angeles International Airport ("LAX") withheld a portion of the fees assessed by LAX on the grounds that airport revenues were being diverted to the City of Los Angeles. The LAX airport authority threatened to prohibit certain airlines, including USAir, from operating at LAX until the fees were paid. Although, following litigation, the airlines eventually paid the fees at LAX, the Company expects that the temptation to divert airport revenues will continue at certain airports because of increasing governmental budgets and a reluctance to increase taxes and other sources of revenue. Item 3. Item 3. LEGAL PROCEEDINGS USAir has been named as party to, or may be affected by, legal proceedings brought by owners and residents of property located in the vicinity of certain commercial airports. The plaintiffs generally seek to enjoin certain aircraft operations at such airports or to obtain awards of damages on the defendant airport operators and air carriers as a result of alleged aircraft noise or air pollution. The relative rights and liabilities among property owners, airport operators, air carriers and Federal, state and local governments are unclear. Any liability imposed on airport operators or air carriers, or the granting of any injunctive relief against them, could result in higher costs to air carriers, including the Company's airline subsidiaries. The Equal Employment Opportunity Commission and various state and local fair employment practices agencies are investigating charges by certain job applicants, employees and former employees of the Company's subsidiaries involving allegations of employment discrimination in violation of Federal and state laws. The plaintiffs in these cases generally seek declaratory and injunctive relief and monetary damages, including back pay. In some instances they also seek classification adjustment and punitive damages. The above proceedings are in various stages of litigation and investigation, and the outcome of these proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition. In 1989 and 1990, a number of U.S. air carriers, including USAir received two Civil Investigative Demands ("CIDs") from the DOJ (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The Attorney General of the State of Florida has also issued CIDs to USAir and other airlines concerning the same subject matter. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carrier's responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered by the Court until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter an amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on further passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or 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 fourth quarter of 1993. PART II Item 5A. MARKET FOR USAir Group's COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Stock Exchange Listings The common stock of the Company is traded on the New York Stock Exchange (Symbol U). On February 28, 1994, there were approximately 59,265,000 shares (exclusive of approximately 1,815,000 shares held in treasury) of common stock of the Company outstanding. The stock was held by 35,763 stockholders of record. The holders reside throughout the United States and abroad. Market Prices of Common Stock Presented below are the high and low sale prices of the common stock of the Company as reported on the New York Stock Exchange Composite Tape during 1993 and 1992: Holders of the common stock are entitled to receive such dividends as may be lawfully declared by the Board of Directors of the Company. A common stock dividend of $.03 per share was paid in every quarter from the second quarter of 1980 through the second quarter of 1990. In September 1990, however, the Board of Directors suspended the payment of dividends on common stock for an indefinite period. Item 5B. MARKET FOR USAir's COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no established public trading market for USAir's common stock, which is all owned by USAir Group. No dividends were paid in 1992 or 1993. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI- TION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations presented below relates to the Consoli- dated Financial Statements of USAir Group, Inc. ("USAir Group" or the "Company") presented in Item 8A. Consolidated Financial Statements for USAir, Inc. ("USAir"), the Company's principal subsidiary, are presented in Item 8B. USAir's operating revenue accounted for more than 93% of the Company's operating revenue in each of the last three years. USAir Group also owns three commuter airline subsidiaries, which accounted for more than 5% of the Company's operating revenue in each of the last three years. Therefore, the following discussion and analysis of results of operations relates principally to the operations of USAir and to the airline industry. The following general factors are among those that influence USAir's financial results and its future prospects: 1. General economic conditions and industry capacity. 2. A decline in the proportion of passengers paying higher yield "business fares" to passengers paying lower yield fares. 3. The emergence and growth of low cost, low fare airlines and USAir's high cost structure. 4. The trend toward globalization in the airline industry and related regulatory limitations. These and other factors are discussed in the following sections. General Economic Conditions and Industry Capacity Historically, demand for air transportation has tended to mirror general economic conditions. Economic conditions in the United States and fare competition in the domestic airline industry continued to be major factors affecting the financial condition of USAir and the airline industry in 1993. In recent years, the change in industry capacity has failed to mirror the reduction in demand for domestic air transportation due primarily to continued delivery of new aircraft and, secondarily, to the operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code for extended periods. While industry capacity has leveled off and the general economy has shown signs of improvement, the Company expects that the airline industry will remain extremely competitive for the foreseeable future. See the discussion of low cost, low fare airlines below. During the recent economic recession, some observers of the travel industry speculated that the business traveler became less reliant on air transportation as teleconferencing, telecopying and other technological developments gained wider acceptance. In addition, some observers have speculated that corporate restructur- ing and furloughs in the U.S. have reduced the number of business travelers and that the leisure traveler has become conditioned to waiting for promotional fares before making travel plans. The Company is unable to determine whether these structural changes have occurred in the air transportation market or if these changes have occurred, how long-lived these trends will be. However, the Company believes that for the foreseeable future the demand for higher yield "business fares" will remain essentially flat and relatively inelastic while the lower yield "leisure" market will continue to grow with the general economy. This trend could make it more difficult for the domestic airlines, including USAir, to sustain meaningful yield increases in the future. Financial circumstances have compelled certain bankrupt or financially weakened carriers to sell assets, including foreign routes, gates and take-off and landing slots at capacity con- strained airports. Proceeds from asset sales provide cash infusions to weaker carriers, but also augment the route systems and market presence of the stronger carriers. Although USAir has completed route and other asset purchases from a number of weaker carriers, the purchases illustrate a trend of consolidation of strategic assets and financial strength within the industry which appears to benefit the three largest U.S. carriers in the long- term. In the short-term, however, these carriers have suffered from the cost of integrating these assets into their systems and from the incremental capacity which has been exacerbated by declines in passenger travel and fare wars. As a result, these carriers have taken or announced actions including reduction in workforce and salary and other employee benefits, concessions from unionized employees, deferral of new aircraft deliveries, early retirement of inefficient aircraft types, and termination of unprofitable service. USAir implemented similar measures during 1990-1993, including a workforce reduction of 2,500 full-time positions between November 1993 and the first quarter of 1994, which, along with other measures, is expected to save the Company approximately $200 million in 1994. USAir will pursue additional measures in 1994 to reduce further its operating costs. See Item 1. "Business - Significant Impact of Low Cost, Low Fare Competi- tion" and "-British Airways Announcement Regarding Additional Investment in the Company; Code Sharing." In 1993, USAir reached an agreement with the Boeing Company ("Boeing") to, among other things, exercise options to purchase additional B757-200 aircraft on an accelerated basis and to cancel and reschedule the delivery of certain Boeing 737 aircraft on order into the future. This agreement reduced USAir's capital expendi tures by more than $880 million between 1993 and 1996. USAir is currently in negotiations with Boeing regarding, among other things, the current schedule of new aircraft deliveries. Each major airline has developed a frequent traveler program that offers its passengers incentives to maximize travel on that particular carrier. Participants in such programs typically earn "mileage credits" for every trip they fly that can be redeemed for airline travel or, in some cases, for other benefits. Under USAir's Frequent Traveler Program ("FTP"), participants receive mileage credits equal to the greater of actual miles flown or 750 miles for each paid flight on USAir or USAir Express, or actual miles flown on one of USAir's FTP airline partners. Participants flying on first or business class tickets receive additional credits. Participants may also earn mileage credits by staying at participating hotels or by renting cars from participating car rental companies within 24 hours of a flight. Mileage credits can be redeemed for certificates for various travel awards, including fare discounts, first class upgrades and tickets on USAir or other airlines participating in USAir's FTP. Certain awards also include hotel and car rental awards. Award certificates may not be brokered, bartered or sold, and have no cash value. USAir and its airline partners limit the number of seats allocated per flight for award recipients. The number of seats varies depending upon flight, day, season and destination. Award travel is not permitted on blackout dates, which generally correspond to certain holiday periods in the United States or peak travel dates to foreign destinations. Hotel awards are valid at participating hotels and are subject to room availability, which is limited. Car rental awards are valid only at participating locations. The number of cars available for award usage is limited, and no cars are available for award usage on blackout dates. USAir reserves the right to terminate the FTP or portions of the program at any time, and the FTP's official rules, partners, special offers, blackout dates, awards and mileage levels are subject to change with or without prior notice. USAir accounts for its FTP under the incremental cost method, whereby travel awards are valued at the incremental cost of carrying one additional passenger. Such costs are accrued when FTP participants accumulate sufficient miles to be entitled to claim award certificates. No value is assigned to airline, hotel or car rental award certificates that are to be honored by other parties. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance and denied boarding compensation expenses expected to be incurred on a per passenger basis. No profit or overhead margin is included in the accrual for incremental costs. FTP participants had accumulated mileage credits for approxi- mately 3,896,000 awards (at the 20,000 mile level required for a free domestic flight on USAir) at December 31, 1993, compared with 3,199,000 awards at December 31, 1992. However, because USAir expects that some award certificates will be redeemed by other airlines participating in USAir's FTP, that some certificates will expire, and that some accumulated mileage credits will never be applied towards award certificates, the calculations of the accrued liability for incremental costs at December 31, 1993 and 1992 were based on approximately 88% and 86%, respectively, of the accumulat- ed credits. Mileage for FTP participants who have accumulated less than the minimum number of mileage credits necessary to claim an award is excluded from the calculation of the accrual. Most participants belong to more than one frequent traveler program and it is not possible to project when or if participants will accrue additional mileage credits required to earn an award. Incremental changes in the liability resulting from additional mileage credits are recorded as part of the regular review process. Effective January 1, 1995, USAir will increase the minimum mileage level required for a free domestic flight from 20,000 to 25,000. USAir's customers redeemed approximately 841,000, 626,000 and 654,000 awards for free travel on USAir in 1993, 1992 and 1991, respectively, representing approximately 8.0%, 4.9% and 5.3% of USAir's revenue passenger miles ("RPMs") in those years, respec- tively. During 1993, two "free ticket for segments flown" promotions were completed which increased the number of awards used for free travel on USAir. These promotions were offered in response to similar promotions offered by USAir's competitors. USAir does not believe that usage of FTP awards results in any significant displacement of revenue passengers. USAir has the ability, through its inventory management system, to identify markets and flights expected to have high load factors and, through capacity controls, to maximize use of FTP awards on flights with lower demand and available seats. Also, blackout dates forestall the usage of awards on peak travel days. Furthermore, USAir's exposure to the displacement of revenue passengers is not signifi- cant, as the number of USAir flights that depart 100% full is minimal. In the third quarter of 1993 (the third quarter being the period of the year when USAir generally experiences its highest load factor and expects the usage of FTP awards to be highest), for example, fewer than 2.2% of USAir's flights departed 100% full. During this same quarterly period, only approximately 1.9% of USAir's flights departed 100% full and also had one or more passengers on board who were traveling on FTP award tickets. Airlines often use other competitive promotions, such as offering extra credits or reduced award thresholds under certain conditions, as incentives to stimulate travel. USAir reviews these promotions to determine the proper accounting treatment for each one. To the extent these promotions are determined to be an integral part of the FTP, they are accounted for in the same manner as free travel earned through mileage credits. Low Cost, Low Fare Competition In September 1993, Southwest Airlines, Inc. ("Southwest"), a low cost, low fare, "no frills" air carrier which had not previous- ly provided service to or in the eastern U.S., inaugurated service to Chicago and Cleveland from Baltimore/ Washington International Airport ("BWI") at fares substantially below those previously offered by USAir and other airlines in the same markets. BWI is one of USAir's hub airports. Unlike the other major U.S. air carriers, Southwest does not structure its operations around connecting hub airports, relying instead on high frequency point- to-point service. USAir responded by matching most of Southwest's fares and increasing the frequency of service in related markets. On March 22, 1994, Southwest announced that on May 26, 1994, and June 6, 1994, it will expand service between BWI and Chicago. Southwest also announced that on May 26, 1994, it will initiate its low fare service between BWI and St. Louis, and on July 8, 1994, between BWI and Birmingham, Alabama and Louisville, Kentucky. At this time, USAir has not determined its response to the Southwest announcement. In October 1993, Continental Airlines ("Continental"), which had reorganized under bankruptcy proceedings earlier in 1993, inaugurated low fare service on certain routes in the eastern U.S. USAir is a competitor in most of the markets served by these routes. While Continental initiated service to certain cities, such as Charleston, South Carolina; Greensboro, North Carolina; and Jacksonville, Florida; most of the markets included as part of its new program (for example, Baltimore) were previously served by Continental through its hubs at Newark, Cleveland, and Houston. However, under its new program, Continental linked certain of these cities independently of its hubs while continuing to provide many of the same services that are available on its hub flights, including advance seat assignment, frequent traveler mileage credits and interline connections. Under its new program, Continental served approximately 80 city pair markets, from which USAir has historically realized approximately 4% of its total passenger revenue. When Continental started the new program it was uncertain whether the program was an experiment or a beachhead from which Continental planned to expand further. USAir, therefore, made a measured response by matching most of the low fares offered by Continental. On January 31, 1994, Continental increased its competitive threat. It announced that by March 9, 1994, it would expand the low fare program to approximately 356 city pair markets, most of which USAir served and from which USAir has historically realized approximately 8% of its passenger revenue. Moreover, if secondary markets within a 90-mile radius, or a reasonable driving distance, were viewed as being included in Continental's new program, markets from which USAir has historically realized approximately 36% of its passenger revenue were affected. Contemporaneously, Continental announced that it would substantially reduce service at its Denver hub and redeploy significant aircraft and personnel resources to the eastern U.S. Although Continental's balance sheet continues to have significant leverage following its bankruptcy reorganization, its liquidity position improved substantially as a result of equity and debt infusions completed as part of that reorganization. Moreover, Continental completed a common stock offering in December 1993, which may indicate the market's receptivity to its efforts to raise additional funds. Continental has operating (including labor) costs that are substantially lower than those of USAir and the other major air carriers. On February 8, 1994, in response to the expansion of Continen- tal and to avoid loss of market share in the eastern U.S., USAir lowered in primary and secondary markets affected by the Continen- tal expansion, by as much as 50%, the fares most commonly used by business travelers on many east coast routes. In addition, USAir lowered leisure fares by as much as 70% in the same markets. In many of the markets, free companion fares are available with business fares. These reduced fares have no expiration date. However, USAir could adjust the fares at some time in the future. Increases in traffic which are stimulated by the lower fares offered by Southwest, Continental and USAir will not offset USAir's reduced revenue resulting from lower yields in these markets. USAir believes that Southwest, Continental or other low cost carriers with a significant cost advantage over USAir likely will expand their operations to additional markets. For example, in December 1993, Southwest completed its acquisition of Morris Air, a regional air carrier with operations concentrated in the western U.S. This acquisition could enable Southwest to divert resources to expand its operations in the eastern U.S. Furthermore, media reports indicate that Southwest has entered into a long-term agreement for the use of four additional gates at BWI, where it currently operates from two gates. On March 4, 1994, Continental further escalated prospective competition by announcing that it will further reduce operations at its Denver, Colorado hub and establish a flight crew base at Greensboro, North Carolina. These measures are likely to increase losses at USAir because they could enable Continental, which has significantly lower costs than USAir, to expand further its high frequency, low fare service described above in additional short-haul markets served by USAir with substantial detriment to USAir. In addition, other low cost carriers may enter other USAir markets. For example, America West announced on February 15, 1994 that it will commence service on April 18, 1994 between Columbus, Ohio where it operates a hub and Philadelphia, where USAir has a hub operation. Other carriers, including some of the larger carriers, have also indicated their intent to develop similar low-fare short-haul service. Unless USAir is able to reduce its operating costs, present and increasing competition from low cost, low fare airlines in USAir's markets could have a material adverse impact on USAir's cash position and therefore, its ability to sustain operations. In March 1994, USAir announced that it had initiated discussions with the leadership of its unionized employees regarding wage reduc- tions, improved productivity and other cost savings. The outcome of these negotiations is uncertain, but if timely agreements are not reached, the Company may seek other restructuring alternatives. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition". In 1993, Northwest Airlines, Inc. ("Northwest") and Trans World Airlines, Inc. ("TWA") sought and obtained from unionized employees substantial concessions and productivity improvements. In exchange, these employees have received ownership interests in those companies. In December 1993, United Airlines, Inc. ("Unit- ed") announced that it had reached agreement with two of its unions to trade concessions for a substantial ownership stake by all employees, subject to approval by United's stockholders. The memberships of these two unions have ratified the agreement. The stated intent and purpose of these labor concessions are to enable these carriers to lower their operating costs. At this time, it is uncertain whether the United transaction will be consummated and whether these events constitute isolated incidents or a trend of employee ownership in the airline industry. As an airline with relatively high labor costs and a route system with a significant percentage of short-haul flying, USAir is considering additional ways to reduce these costs which could involve an exchange of employee concessions for an ownership interest in the Company. USAir is currently engaged in discussions with the leaders of its unionized employees regarding efforts to reduce costs, including reductions in wages, improvements in productivity and other cost savings. The outcome of these discussions is uncertain. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competi- tion." USAir has been examining various ways to restructure its operations to increase efficiency and lower unit costs in markets of approximately 500 miles or less in distance. Certain carriers, such as Southwest and Continental, have a substantial cost advantage over USAir in these short-haul markets. In addition, consumers appear to be increasingly price conscious, particularly for short distance flights. In February 1994, USAir implemented the first phase of the introduction of a new short-haul product in 18 city-pair markets of approximately 500 miles or less, resulting in increased utilization and productivity of aircraft, personnel, and ground facilities in these markets by decreasing the amount of time that aircraft spend on the ground between flights from an average of 45 minutes to approximately 25 minutes. Initiation of the first phase of this service did not involve any immediate pricing changes or new personnel. Ultimately, USAir anticipates that enhancements to the short-haul product will be completed in summer 1994, and that long-haul and transatlantic service will be redesigned later in 1994. USAir plans to expand this higher frequency service to additional short-haul and other markets in July 1994, with a total fleet of approximately 100 aircraft. Although USAir expects this higher frequency operation will result in reduced unit costs in relevant markets, certain variable costs generally associated with providing the incremental flights, including jet fuel, landing fees and labor, will increase. There can be no assurance, therefore, that the changes will result in improved financial results for USAir. If USAir cannot find ways to compete effectively with low cost carriers by lowering its operating costs, and to generate sufficient additional passengers to offset the effect of sharply reduced fares, USAir's revenue and results of operations will continue to be materially and adversely affected. Industry Globalization and Regulation The trend toward globalization of the airline industry has accelerated in recent years as the three largest U.S. carriers have initiated foreign service and purchased the foreign routes of financially distressed or bankrupt U.S. carriers. In addition, certain foreign carriers have made substantial investments in U.S. carriers which have frequently been tied to marketing alliances or, less frequently, reciprocal investments by the U.S. carrier in its foreign partner. In August 1993, Continental announced that it had reached agreement with Air France on a joint marketing agreement. Earlier in the year, Air Canada made a substantial equity invest- ment in Continental in connection with Continental's bankruptcy reorganization. In October 1993, United and Lufthansa German Airlines announced that they had reached an agreement to implement code sharing to link some of their flights. Continuing privatiza- tion of sovereign carriers and foreign airline deregulation may encourage further foreign investment. Foreign investment in U.S. air carriers is restricted by statute and may be subject to review by the U.S. Department of Transportation ("DOT") and, on antitrust grounds, by the U.S. Department of Justice ("DOJ"). On January 21, 1993, USAir Group and British Airways Plc ("BA") entered into an Investment Agreement ("Investment Agree- ment") under which a wholly-owned subsidiary of BA has purchased certain preferred stock of the Company for $400.7 million. On March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See "Liquidity and Capital Resources" and Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "- British Airways Investment Agreement" for additional information related to the investment. Under the Investment Agreement, USAir and BA have entered into a code sharing arrangement under which certain domestic USAir flights, connecting to certain BA transatlantic flights, may be listed on computerized reservation systems either under USAir's or BA's two letter designation code, subject to authorization by the DOT. As of March 1, 1994, USAir and BA offered code share service to and from 34 of the 65 airports authorized by the DOT. On March 17, 1994, the DOT issued an order renewing for one year the existing code sharing authority. In January 1994, USAir and BA filed applica- tions with the DOT to code share to 65 additional domestic and seven additional foreign destinations. The DOT did not act on these applications in its March 17, 1994 order. See Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "-British Airways Investment Agreement". USAir and BA are in the process of expanding their code sharing arrangement. USAir believes that it will have greater access to international traffic and that its and BA's customers will benefit from better on-line connections as well as coordinated check-in and baggage checking procedures. USAir also believes that the code sharing arrangement will generate increased revenues, the magnitude of which cannot be reasonably estimated at this time. The DOT may continue to link further renewals of the code share authorization to the United Kingdom's ("U.K.") liberalization of U.S. air carrier access to the U.K. markets. However, the code sharing arrangement is expressly permitted under the bilateral air services agreement between the U.S. and U.K. USAir expects that the authorization will be renewed in the future; however, there can be no assurance that this will occur. USAir does not believe that the DOT's failure to renew the code share authorization or grant the pending application would result in a material adverse change in its financial condition. However, further investment in the Company by BA, as contemplated in the Investment Agreement, may be less likely. See Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "-British Airways Investment Agreement." Current U.S. law provides that foreign ownership or control of the voting interest in a certificated U.S. air carrier may not exceed 25%, non-U.S. citizens may not constitute more than a third of the board of directors and managing officers of the air carrier and the president of the air carrier must be a U.S. citizen. Over the years in the context of "fitness" reviews to determine whether air carriers could be issued, or continue to hold, operating certificates, the DOT has also issued interpretations regarding whether investments by, or other arrangements with, foreign investors constitute de facto control over a U.S. air carrier. Although the Company believes the policy has no basis in law, recently and particularly during 1992 and 1993, the DOT has linked its review of foreign investment in, and foreign alliances with, U.S. air carriers to the status of the bilateral air transportation treaty between the U.S. and the country of origin of the foreign airline. The willingness of the DOT to allow proposed foreign investments, alliances and participation in corporate governance has been linked to its perception of the liberality of the relevant treaty with respect to the right of U.S. air carriers to operate to, from and beyond the foreign country. For example, the Netherlands entered into a new bilateral treaty with the U.S. in 1992 which permitted "open skies", or unrestricted access to the Netherlands by U.S. air carriers. As a result, in 1992 the DOT approved Northwest's proposal to integrate its operations with those of KLM Royal Dutch Airlines, an airline based in that nation. However, the DOT has refused to allow USAir and BA to proceed with the second and third phases of their Investment Agreement, which calls for an additional investment of $450 million by BA, unless and until the U.K. government agrees to amend its bilateral air services agreement with the U.S. to permit new services by U.S. carriers to the U.K. and particularly to London's Heathrow Airport. The U.S. and U.K. governments held several negotiating sessions during the past year and have exchanged proposals to amend the bilateral agreement, but to date the two governments have failed to resolve their differences. As a result, USAir and BA were unable to proceed with the second and third phases of the Investment Agreement in 1993. In any event, on March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See Item 1. "Business - British Airways Announcement Regarding Additional Investment in the Company; Code Sharing" and "-British Airways Investment Agreement." The National Commission to Ensure a Strong Competitive Airline Industry ("Airline Commission") issued its report in August 1993. The Airline Commission was a presidentially-appointed committee with the task of analyzing the condition of the U.S. airline industry and reporting to the Clinton Administration its findings and recommendations. Among other things, the Airline Commission recommended that: (i) the air traffic control system be modernized and the Federal Aviation Administration's ("FAA") air traffic control functions be performed by an independent federal corpora- tion; (ii) the federal regulatory burden be reduced; (iii) the airlines be granted certain tax relief; and (iv) the bankruptcy process be shortened. The Airline Commission also favored raising the statutory limit on foreign ownership of voting securities in the U.S. airlines to 49 percent under certain circumstances. It further urged that the current international system of bilateral agreements be replaced with multilateral arrangements. In addition, the Airline Commission recommended that the DOT review the airlines' business, capital or financial plans with the assistance of a presidentially-appointed advisory committee and, if an airline repeatedly failed to heed warnings or concerns of the DOT Secretary, the DOT could "exercise its existing authority", among other things, to revoke an airline's operating certificate. In January 1994, the Clinton Administration issued a report which described its program to implement certain of the Airline Commission's recommendations. Among other things, the Administra- tion stated that it supported the recommendation described above regarding the FAA, supported increasing to 49 percent the foreign ownership restrictions provided there are reciprocal opportunities for U.S. airlines and investors abroad, and opposed the recommenda- tions regarding tax relief and the appointment of the advisory committee discussed above. At this time, it is impossible to predict whether any of the Airline Commission's recommendations will be enacted and, if enacted, their effect on USAir. It is also difficult to anticipate whether the Congress will act in the near term on any of the proposals requiring legislation. As part of its initiative in the transportation industry, the Clinton Administration also indicated that the DOT has begun a comprehensive examination of the "high density rule" which limits airline operations at Chicago O'Hare, New York's LaGuardia ("LaGuardia") and John F. Kennedy International, and Washington National ("National") Airports by restricting the number of takeoff and landing slots. As part of its study, the DOT will determine whether the operating limitations imposed by the rule can be eliminated or modified to better utilize available capacity at these airports. USAir holds a substantial number of slots at LaGuardia and National, including those assigned a value when the Company acquired Piedmont Aviation, Inc. Any DOT action which would eliminate those slots or compel USAir to transfer those slots could have a material adverse effect on USAir's operations and financial position. Revision of the high density rule at National, however, would require legislation by the Congress. The DOT has indicated that it expects to complete its study by late 1994. RESULTS OF OPERATIONS 1993 Compared with 1992 The Company recorded a net loss of $393.1 million on revenue of $7.1 billion, in 1993 compared with the 1992 net loss of $1.2 billion on revenue of $6.7 billion. Several non-recurring items, which include the cumulative effect of accounting changes, make it difficult to compare these results. After excluding the effect of certain non-recurring items discussed below, which amount to $153.2 million and $759.3 million in 1993 and 1992, respectively, the net loss would have been $239.9 million in 1993 ($5.69 per common share after preferred dividend requirement) compared with a loss of $469.6 million in 1992 ($11.09 per common share after preferred dividend requirement). The Company's 1993 financial results contain $153.2 million of non-recurring items, including (i) $68.8 million for severance, early retirement and other personnel-related expenses recorded in connection with a workforce reduction of approximately 2,500 full- time positions between November 1993 and the first half of 1994; (ii) $43.7 million for the cumulative effect of an accounting change, as required by Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership, which operates a computerized reservations system; and (vi) an $18.4 million credit related to non-operating aircraft. The Company's 1992 financial results contain $759.3 million of non-recurring items, including (i) $628.1 million for the cumula- tive effect of an accounting change, as required by Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"); (ii) $107.4 million related to aircraft which have been withdrawn from service; (iii) $34.1 million loss related to the sale of ten McDonnell Douglas 82 ("MD-82") aircraft which USAir had on order but eliminated from its fleet plan; and (iv) $10.3 million gain resulting from the sale of three of the Company's subsidiaries during 1992. Operating Revenue - The Company's Passenger Transportation Revenue increased by $356.5 million (5.8%) in 1993 compared with 1992, primarily due to the $296.0 million (5.1%) increase at USAir. USAir's capacity, as measured by available seat miles ("ASM" - one ASM is equal to one seat flown one mile), decreased by 0.3% in 1993 compared with 1992, its passenger revenue per ASM increased by 5.4% to 10.22 cents and its passenger load factor, a measure of capacity utilization, increased by 0.4 points to 59.2%. The increase in passenger revenue per ASM is largely attributed to the lower level of discounting in 1993 versus 1992. The Company expects that it will experience a 1 - 2% increase in ASMs (including the effect of weather-related cancellations) in 1994 compared with 1993. Continued fare discounting and low fares offered by USAir to compete with low cost, low fare carriers discussed above, are expected to have a negative impact on the Company's passenger revenue. It is not expected that the resulting decrease in revenue per ASM will be totally offset by additional passengers. The severe winter weather conditions in the U.S. during the early part of 1994 have caused a reduction in revenue which the Company estimates at approximately $50 million. In March 1993, USAir and five other U.S. air carriers entered into a settlement in the Domestic Air Transportation Antitrust Litigation class action lawsuit, which alleged that the airlines used the Airline Tariff Publishing Company to signal and communi- cate carrier pricing intentions and otherwise limit price competi- tion for travel to and from numerous hub airports. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has estimated that any incremental cost associated with the settlement will not be material based on the nominal equivalent free trips associated with the settlement. See Note 4 to the Company's Consolidated Financial Statements for additional information. The Company's Other Revenue increased by $38.8 million (12.3%) in 1993. USAir's increase of $90.5 million (32.3%) was partially offset at the Company level by a decrease in non-airline subsidiary revenue resulting from the sale of three wholly-owned subsidiaries in July 1992. USAir's 32.3% improvement resulted from increased passenger cancellation and rebooking fees, frequent traveler participation fees, and various other sources. Expense - The Company's total operating expenses increased $141.7 million (2.0%) in 1993 compared with 1992. The Company's Personnel Costs increased by $217.7 million (8.3%), $205.6 million of which is attributable to USAir. USAir's increase includes (i) $65.6 million of the $68.8 million non-recurring charge related to a workforce reduction of 2,500 full-time positions; and (ii) the $36.8 million charge based on an estimate of the repayment of certain employee pay reductions, both discussed above. Without the effect of these non-recurring charges, USAir experienced an increase in employee salaries of $91.4 million (4.7%) and an increase in employee benefits of $11.8 million (2.1%). The increase in employee salaries is generally due to contractual and general salary increases which occurred during 1993. The amount saved as a result of the 12-month salary reduction program was approximately the same in 1993 and 1992. USAir expects that due to scheduled contractual increases and the effect of the expiration of the 12-month salary reduction program, employee salaries will increase in 1994 to the extent that the reduction of 2,500 full- time positions and any other possible measures do not offset the increases. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition" and "- Employees" for information related to the possible unionization of additional employee groups. The $11.8 million increase in employee benefits is the result of increased pension expense, offset partially by a decrease in other postretir- ement benefit expense. The increased pension expense in 1993 resulted from the establishment of a defined contribution pension plan for USAir's non-contract employees on January 1, 1993. The defined benefit plan for these employees was frozen at December 31, 1991. Because of the interest rates on long-term, high quality corporate bonds which prevailed at December 31, 1993, the Company has lowered its discount rate used to calculate the actuarial present value of its pension and postretirement obligations. This action will cause an increase in the Company's pension and other postretirement benefits expense in 1994 of approximately $70 million over 1993. See Note 11 to the Company's Consolidated Financial Statements. The Company's Aviation Fuel Expense decreased $43.2 million (5.7%) as a result of a lower cost per gallon and decreased consumption. In early August 1993, the Clinton Administration's budget package was enacted. The budget package included a 4.3 cent per gallon tax on transportation fuels beginning October 1, 1993. The airline industry is exempt from the tax until October 1, 1995. See Item 1. "Business - Jet Fuel" and Note 1 to the Company's Consolidated Financial Statements. Commissions increased by $27.2 million (4.8%) as a result of the 5.8% increase in Passenger Transportation Revenue. The Company's Other Rent and Landing Fees increased $64.3 million (15.8%) primarily due to an increase in USAir's facility rental expense following the opening of the new terminal at Pittsburgh in October 1992, and the $8.9 million of non-recurring expense recorded for certain airport facilities, discussed above. The Company's Aircraft Rent Expense included a $72.4 million non- recurring charge in 1992 (part of the $107.4 million discussed above). Without this charge, aircraft rent expense increased $15.0 million (3.3%) due to the addition of new leased aircraft in 1993. Excluding the effect of non-recurring items in 1992 and 1993, Aircraft Maintenance Expense increased by $37.6 million (10.6%) resulting from the timing of aircraft maintenance cycles. Other Operating Expense decreased by $58.0 million (4.0%), reflecting a $25.0 million (1.8%) decrease at USAir and a $58.4 million decrease which resulted from the sale of three wholly-owned subsidiaries in July 1992, offset by increases at the Company's other wholly-owned subsidiaries. The Company's Interest Capitalized decreased $10.0 million (36.1%) as the level of outstanding purchase deposits decreased with the delivery of new aircraft and changes in delivery sched- ules. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", ("FAS 109"). The adoption of FAS 109 resulted in no cumulative adjustment. Results for 1993 do not include any income tax credit due to the FAS 109 limitations in recognizing a current benefit for net operating losses. See Note 6 to the Company's Consolidated Financial Statements for additional information. 1992 Compared With 1991 The Company recorded a net loss of $1.2 billion on revenue of $6.7 billion in 1992, compared with the 1991 net loss of $305.3 million on revenue of $6.5 billion. Several non-recurring items, which include the cumulative effect of an accounting change, make it difficult to compare these results. In addition, the Company recorded no tax credit in 1992. After excluding the effect of certain non-recurring items which amount to a net charge of $759.3 million and a net gain of $45.9 million in 1992 and 1991, respec- tively, the pre-tax loss would have been $469.6 million in 1992 ($11.09 per common share after preferred dividend requirement) compared with a pre-tax loss of $460.7 million in 1991 ($11.01 per common share after preferred dividend requirement). This compari- son does not consider the ongoing effect to the Company's operating expenses which result from the adoption of FAS 106, the freezing of the pension plan for non-contract employees, or other changes. The Company's 1992 financial results contained $759.3 million of non-recurring items, detailed above. Operating results for 1991 included (i) $107 million pre-tax gain related to the freeze of the fully funded pension plan for USAir's non-contract employees; (ii) a $21 million pre-tax charge related to USAir's parked British Aerospace BAe-146 ("BAe-146") fleet; (iii) $21.6 million pre-tax expense related to early retirement incentives; and (iv) $18.5 million, net, in miscellaneous non-recurring charges. On October 5, 1992, the International Association of Machin- ists ("IAM"), which represents USAir's mechanics and related employees, commenced a strike against USAir. At that time, USAir implemented a reduced flight schedule equal to approximately 60% of the normal flight schedule. On October 8, 1992, USAir reached agreement with the IAM on a new collective bargaining agreement which becomes amendable in October 1995. Following ratification of the agreement by the IAM-represented employees, USAir resumed full service on October 12, 1992. USAir immediately offered various incentives including bonus frequent traveler miles and relaxed advance purchase restrictions in an effort to attract passengers following the disruption of service. The Company estimates that the IAM strike had a negative effect on results of approximately $45 million for the year. Operating Revenue - The Company's Passenger Transportation Revenue increased $164.6 million (2.7%) in 1992, reflecting a $97.9 million increase in USAir passenger transportation revenue and a $66.7 million increase in commuter airline passenger revenue. USAir's ASMs increased by 2.4% in 1992, its passenger revenue per ASM decreased by 0.7% to 9.7 cents, and its passenger load factor increased by 0.2 points to 58.8%. USAir's average 1992 passenger revenue per ASM was adversely affected by widespread fare promo- tions. The improvement in commuter airline passenger revenue is attributed to increased traffic made possible by 20.1% increase in capacity during 1992 over 1991, as measured by ASMs, at the Company's commuter airline subsidiaries. USAir's Other Revenue increased $81.3 million (40.9%) in 1992 as compared with 1991, due to increases in revenue generated by passenger cancellation and re-booking fees, fees received from commuter affiliates for handling certain of their flights, and other miscellaneous sources. Operating Expenses - The Company's Personnel Costs increased $102.5 million (4.1%) in 1992 compared with 1991, driven by USAir's increase in personnel costs of $99.7 million (4.2%). Personnel Costs are comprised of two components: (i) employee wages and salaries; and (ii) employee benefits. USAir's wage and salary expense decreased $21.9 million (1.1%) during 1992 as a result of partial-year wage concessions on the part of pilots, non-contract employees and mechanics, all of which ended in 1993. USAir's employee benefit expense increased $121.6 million (27.8%) in 1992 resulting from the adoption of FAS 106 in 1992, and the 1991 freeze of the fully-funded pension plan for non-contract employees. The 1991 pension freeze resulted in a $107 million gain. The Company estimates that USAir's pension expense was approximately $40 million lower in 1992 than would have been the case if the freeze had not occurred. Expense for postretirement medical and death benefits, calculated in accordance with FAS 106, was $114.7 million in 1992, compared with approximately $8 million cash-basis expense in 1991. USAir's medical and dental benefit expense for active employees decreased $26.7 million (14.2%) in 1992 compared with 1991 as a result of a contributory managed care program that was implemented during 1992 for most employee groups. Excluding the effects of FAS 106 and the pension freeze, USAir employee benefit expense decreased approximately $48 million, or 8.8%, in 1992 compared with 1991. The Company's Aviation Fuel Expense decreased $45.8 million (5.7%) during 1992 compared with 1991 as a result of lower cost per gallon, partially offset by an increase in consumption. The price of fuel was inflated during early 1991 as a result of the Iraqi invasion of Kuwait and ensuing Desert Storm operation in August 1990 - January 1991, and did not return to pre-invasion levels until the second quarter of 1991. Commissions increased $29.6 million (5.5%) as a result of the 2.7% increase in passenger transportation revenue and the mix of travel agency sales versus total sales. Other Rent and Landing Fees Expense for the Company increased $56.6 million (16.2%) during 1992. This increase was largely due to increased expense at LaGuardia which resulted from USAir's assumption of Continental's leasehold obligations associated with the East End Terminal there in January, 1992 and the increased operation at LaGuardia during the year using the take-off and landing slots acquired from Continental. Also contributing to the increase was the October 1992 opening of the new terminal at the Pittsburgh International Airport, USAir's largest hub. The Company's Aircraft Rent Expense increased $152.3 million (40.3%) during 1992. A charge related to USAir's grounded BAe-146 fleet accounted for $81 million of the increase. The remainder of the increase was caused by additional leased aircraft both at USAir and the commuter airline subsidiar- ies. The Company's Aircraft Maintenance Expense decreased $33.9 million (8.2%) during 1992. This decrease reflects USAir's decrease in aircraft maintenance of $43.4 million, or 12.0%, and an increase of $9.5 million at the Company's commuter airline subsidiaries during the same period. The improvement in USAir's aircraft maintenance expense is largely attributable to the grounding of its BAe-146 fleet in May 1991, the shifting of certain aircraft engine repairs in-house from outside vendors and the negotiation of a new vendor repair contract in 1991 for certain aircraft engines. The increase in maintenance expense at the commuter airline subsidiaries is due primarily to an increased fleet size in 1992. Maintenance expense for 1992 and 1991 includes charges of $25.0 million and $25.5 million, respectively, related to grounded aircraft. The Company's Other Operating Expense, Net increased $63.6 million (4.6%) in 1992 compared with 1991. Expense for 1992 includes $25 million related to an employee suggestion program which netted estimated savings of $22 million in 1992 and $110 million in 1993. The remainder of the increase is attributable to changes in various smaller expense categories. USAir Group's Interest Income decreased $8.7 million (46.9%) during 1992 due to a lower average level of short-term investments during 1992 coupled with lower interest rates in 1992. Both USAir's interest income and expense include intercompany amounts which have been eliminated in the USAir Group consolidation process. The Company's Interest Expense decreased $10.4 million (4.0%) in 1992 due to a lower average level of debt outstanding related to USAir Group's revolving bank credit agreement, partially offset by additional interest associated with higher levels of aircraft-related debt in 1992. Interest Capitalized decreased $7.8 million (21.8%) as a result of a lower level of outstanding equipment deposits coupled with a lower capitalized interest rate. The Company's Other Non-Operating Expense, Net increased $17.0 million, or 40.2%, during 1992. In 1992, this category included a gain of $10.3 million from the sale of three wholly-owned subsid- iaries and a $34.1 million loss related to the sale of ten MD-82 aircraft discussed above. In 1991, this category included a $12.5 million loss incurred in conjunction with the sale of nine Boeing B727-200 aircraft which had been previously retired from service. All of the Company's remaining available tax credit, or $117.6 million, was recognized upon the adoption of FAS 106 on January 1, 1992. The Company could not recognize any tax credit associated with the 1992 results due to limitations under Accounting Princi- ples Board Opinion No. 11. Inflation and Changing Prices Inflation and changing prices do not have a significant effect on the Company's operating revenues, operating expenses, and operating income because such revenues and expenses, other than depreciation and amortization, generally reflect current price levels. Depreciation and amortization expense is based on historical cost. For assets acquired through the purchase of Pacific Southwest Airlines, USAir's historical cost is based on fair market value of the assets on May 29, 1987. In the case of Piedmont Aviation, Inc., USAir's historical cost is based on the fair market value of the assets on November 5, 1987, reduced by the tax effect of that portion of fair market value not deductible for tax purposes in the form of depreciation and amortization. Therefore, aggregate depreciation and amortization is lower than if this expense reflected today's replacement costs for existing productive assets. In evaluating how inflation would increase depreciation expense, however, consideration should also be given to the reduction in other operating expenses, such as aircraft maintenance and aviation fuel, that would be achieved from the operating efficiencies of newer, more technologically advanced productive assets. LIQUIDITY AND CAPITAL RESOURCES Cash used by operations was $21.3 million during 1993, including a $220.0 million payment under USAir's revolving accounts receivable sale program ("Receivables Agreement"). At December 31, 1993, cash and cash equivalents totaled approximately $368.3 million, excluding $163.7 million which was deposited in trust accounts to collateralize letters of credit or workers compensation policies and classified as "Other Assets" on the Company's balance sheet. Although not currently available (see below), at Decem- ber 31, 1993, USAir Group had $300 million in commitments available for borrowing under its revolving credit agreement with a group of banks ("Credit Agreement") and no outstanding loans thereunder, and USAir had approximately $141 million of available funds under its Receivables Agreement. At February 28, 1994, cash and cash equivalents totaled approximately $363.5 million. Funds under the Credit Agreement and Receivables Agreement are not available to the Company and USAir because of violations of minimum net worth covenants in those agreements. On March 14, 1994, the Company and USAir announced that they are seeking waivers of compliance with the minimum net worth covenant and other anticipated covenant violations. There can be no assurance that the Company or USAir will be able to obtain the waivers or arrange replacement facilities. The Company and USAir are highly leveraged. In order to meet debt service, lease and other obligations and to finance daily operations, the Company and USAir require substantial liquidity and working capital. In addition, developments may occur which are beyond the control of the Company and USAir, including intensified fare wars or substantial increases in jet fuel prices, which could have a material adverse effect on the Company's prospects and financial condition. The Company and USAir have unencumbered assets, particularly if the Credit Agreement is terminated and the mortgage of aircraft equipment related thereto is released. The Company expects that it could use these unencumbered assets to raise funds to provide an infusion of liquidity. In addition, the second and third quarters of the year historically have been characterized by higher revenues and working capital than in the first and fourth quarters. Moreover, USAir is seeking in discus- sions with the leadership of its unionized employees substantial wage reductions, improved productivity and other cost savings. However, if unforeseen adverse developments occur, if the Company and USAir are unable to finance unencumbered assets, or if timely agreements with the employees are not reached, the Company and USAir may pursue other restructuring alternatives. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition" and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competi- tion." During 1993, the Company's investment in new aircraft acquisitions and purchase deposits totaled $545.3 million. USAir took delivery of 11 Boeing 757-200, one Boeing 767-200, and six MD- 82 aircraft during the year. The MD-82s were immediately sold to a third party. In addition, USAir sold two other MD-82 aircraft which had been delivered in the fourth quarter of 1992. Proceeds from the sale of the MD-82s approximated $168 million. The Company has completed financing arrangements for, including the $337.7 million issue of Pass Through Certificates ("Certificates") which USAir sold through an underwritten public offering on November 1, 1993, or internally funded, all of its 1993 aircraft expenditures. See Note 4(d) to the Company's Consolidated Financial Statements for the projected cash flows associated with aircraft orders and other contractual capital commitments. The Company has arranged committed financing for 100% of its 1994 and 1995 aircraft deliveries. On January 21, 1993, a wholly-owned subsidiary of BA purchased 30,000 shares of the 7% Series F Cumulative Convertible Senior Preferred Stock ("Series F Preferred Stock"), for $300 million. Substantially all of the $300 million received by the Company from the sale of the Series F Preferred Stock was used to pay down debt under the Company's Credit Agreement. The Series F Preferred Stock is subject to mandatory redemption on January 15, 2008. On May 4, 1993, the Company sold 11.5 million shares of $1 par value Common Stock at $20.75 per share which netted proceeds of approximately $231 million. BA partially exercised its preemptive right to maintain its proportionate ownership percentage by purchasing, on June 10, 1993, 9,919.8 shares of redeemable Series T-2 Cumulative Exchangeable Senior Preferred Stock ("Series T-2 Preferred Stock") for approximately $99.2 million. For additional information, see Note 8 to the Company's Consolidated Financial Statements. On March 7, 1994, BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce costs and improve financial results is known. On July 8, 1993, USAir sold $300 million principal amount of 10% Senior Notes due 2003 (the "10% Notes") through an underwritten public offering. The offering netted proceeds of approximately $294 million. The 10% Notes are unconditionally guaranteed by the Company. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes due 2001 (the "9 5/8% Notes") through an underwritten public offering. The offering netted proceeds of approximately $172 million. The 9 5/8% Notes are unconditionally guaranteed by the Company. The 9 5/8% Notes are not reflected in the Company's December 31, 1993 balance sheet because they were issued after that time. All net proceeds received by USAir or the Company from the Common Stock offering, the sale to BA of the Series T-2 Preferred Stock, the sale of the 10% Notes and 9 5/8% Notes were added to the working capital of the Company for general corporate purposes, including the possible early repayment of certain outstanding debt with high interest rates. USAir and the Company have filed with the Securities and Exchange Commission ("SEC") a shelf registration for $700 million of various debt and equity securities. Approximately $187 million of securities remain available for sale on the shelf registration following the sale of the 9 5/8% Notes and may be sold from time- to-time depending on market conditions. The Company will continue to evaluate opportunities in the financial markets. On September 29, 1993, the maximum commitment available under the Credit Agreement decreased to $300 million from $600 million in accordance with the terms of the agreement. The Credit Agreement is due to expire on September 30, 1994. In September 1993, USAir Group obtained a waiver of compliance with the coverage ratio test required to be maintained as part of the Credit Agreement, for the period July 1 through September 30, 1993. Without this waiver, USAir Group would have violated this test on September 30, 1993. As of September 30, 1993, USAir Group was in compliance with the other financial covenants required to be maintained as part of the Credit Agreement. Moreover, in December 1993, USAir Group obtained an additional waiver under the Credit Agreement of compliance during the period October 1 through December 31, 1993 with the coverage ratio test. Without this waiver, USAir Group would have violated this test on December 31, 1993. The Company is currently unable to borrow under the Credit Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir Group expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir Group will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. In September 1993 and December 1993, USAir obtained waivers of the coverage ratio test under the Receivables Agreement on the same terms as described above with respect to the Credit Agreement. At December 31, 1993, USAir was in compliance with the other financial covenants and had no amounts outstanding under the Receivables Agreement. The maximum amount of receivables which USAir may sell under the Receivables Agreement was $240 million at December 31, 1993 and will be adjusted downward to $190 million on June 30, 1994 if the Company's consolidated net worth does not exceed $1.5 billion. For purposes of this net worth comparison, the Company's actual net worth is adjusted to add back the initial and ongoing impact of adopting FAS 106 and certain other accounting pronounce- ments. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projec- tions of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. The Company's and USAir's debt and equity securities are presently rated below investment grade by Standard and Poor's Corporation ("S&P") and Moody's Investors Service, Inc. ("Moo- dy's"). Following the January 21, 1993 transaction in which a subsidiary of BA purchased $300 million of the Company's Series F Preferred Stock, Moody's placed the ratings on watch for possible upgrade. On March 19, 1993, Moody's confirmed its ratings of USAir Group and USAir securities. Following DOT approval of the purchase of the Series F Preferred Stock and the code sharing and wet lease relationship between USAir and BA, S&P affirmed its ratings of USAir Group and USAir securities, stating its ratings outlook was positive. In December 1993, S&P affirmed its ratings of USAir Group and USAir securities. However, the agency revised the ratings outlook to negative, citing, among other considerations, the status of the negotiations on a revised U.S.-U.K. bilateral air services agreement and the entrance and possible expansion of the operations of low fare, low cost air carriers into USAir's markets. In February 1994, as a result of USAir's low fare initiative in certain markets and its high cost structure, S&P and Moody's placed the securities of the Company and USAir on watch with negative implications. On March 24, 1994, S&P further downgraded the Company's and USAir's securities. This downgrade will make it more difficult for the Company and USAir to effect additional financing. In addition, the Company's and USAir's securities remain on watch with negative implications at S&P. In 1992, the Company's investment in new aircraft acquisitions and purchase deposits, net of deposits refunded, totaled $458.7 million. The Company purchased eight Fokker and four deHavilland Dash 8 aircraft during 1992. The acquisition of these aircraft was financed through a combination of secured debt financings and interim debt financings. In addition, USAir took delivery of four MD-82s, two of which were immediately sold to a third party. The remaining two aircraft delivered in 1992 were sold to a third party in early 1993. Cash outflows for other property during the period totaled $277.2 million, which includes $61 million paid to Continental for landing and take-off slots at LaGuardia and Washington National Airports and $50 million paid to TWA for London routes from BWI and Philadelphia International Airports. See Item 1. "Business - British Airways Investment Agreement - U.S.-U.K. Routes." Proceeds from disposition of assets of $429.5 million were realized during the year, primarily from sale-leaseback transactions, the sale of the two MD-82 aircraft, and the sale of three wholly-owned subsidiaries. During 1991, acquisition of new aircraft and purchase deposit payments amounted to $345 million. During 1991, USAir took delivery of two Boeing 767-200ER, nine Boeing 737-400, 12 Fokker 100, and five deHavilland Dash 8 aircraft. The acquisition of these aircraft was financed through a combination of sale-leaseback transactions, secured debt financings and interim debt financings. Expenditures for other property, consisting primarily of ground support equipment, leasehold improvements, and major aircraft components, totaled $97 million. Proceeds from disposition of property of $286 million were realized during 1991, primarily as a result of aircraft sale-leaseback transactions. In May 1991, USAir Group sold 4,263,050 Depositary Shares, each representing 1/100 of a share of $437.50 Series B Cumulative Convertible Preferred Stock, without par value, for net proceeds of $207.8 million. Such proceeds were used to repay indebtedness under USAir Group's Credit Agreement. At December 31, 1993, USAir Group's ratio of current assets to current liabilities was 0.53 to 1 and the debt component of USAir Group's capitalization structure was approximately 82% (100% if the redeemable Series A Cumulative Convertible Preferred Stock, the Series F Preferred Stock and the redeemable Series T Cumulative Convertible Exchangeable Senior Preferred Stock are considered to be debt). Item 8A. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION USAir Group, Inc. Independent Auditors' Report The Stockholders and Board of Directors USAir Group, Inc.: We have audited the accompanying consolidated balance sheets of USAir Group, Inc. and subsidiaries ("Group") as of December 31, 1993 and 1992, and the related consolidated statements of opera- tions, cash flows, and changes in stockholders' equity (deficit) for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibil- ity of Group'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 USAir Group, Inc. 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 11 to the consolidated financial statements, effective January 1, 1993, Group changed its method of accounting for postemployment benefits and effective January 1, 1992, Group changed its method of accounting for postretirement benefits other than pensions. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. USAir Group, Inc. Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying consolidated financial statements include the accounts of USAir Group, Inc. ("USAir Group" or the "Company") and its wholly-owned subsidiaries USAir, Inc. ("USAir"), Piedmont Airlines, Inc. ("Piedmont") (formerly Henson Aviation, Inc.), Jetstream International Airlines, Inc. ("Jetstream"), Pennsylvania Commuter Airlines, Inc. ("PCA"), USAir Leasing and Services, Inc. ("Leasing"), USAir Fuel Corporation and Material Services Company, Inc. All significant intercompany accounts and transactions have been eliminated. At December 31, 1992, USAM Corp. ("USAM"), a subsidiary of USAir, owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided CRS services to travel agent subscribers in Europe. Covia was then separated into three new entities. As a result, at December 31, 1993, USAM owns 11% of the Galileo International Partnership which owns and operates the Galileo CRS, approximately 11% of the Galileo Japan Partnership which markets the Galileo CRS in Japan, and approximately 21% of the Apollo Travel Services Partnership which markets the Galileo CRS in the U.S. and Mexico. USAM accounts for these investments using the equity method. On August 1, 1992, two wholly-owned USAir Group's commuter airline subsidiaries, Allegheny Commuter Airlines, Inc. and PCA, merged. PCA, the surviving entity, operates under the name of Allegheny Commuter Airlines, with headquarters in Middletown, Pennsylvania. On July 15, 1992, USAir Group completed the sale of three of its wholly-owned subsidiaries: Piedmont Aviation Services, Inc., Air Service, Inc. and Aviation Supply Corporation. The Company realized a gain of $10.3 million as a result of the sale. The three former subsidiaries engaged in fixed base operations and the sale and repair of aircraft and aircraft components. These subsidiaries were included in the accounts until their sale. On October 9, 1991, USAir reached agreement for the sale of certain assets of its wholly-owned subsidiary Pacific Southwest Airmotive ("Airmotive"). Airmotive discontinued operations in the third quarter of 1991. USAir did not realize any material gain or loss on the sale and discontinuance of Airmotive's operations. USAir Group's principal operating subsidiary, USAir, and its three commuter airline subsidiaries, Piedmont, Jetstream and PCA, operate within one industry (air transportation); therefore, no segment information is provided. Certain 1992 and 1991 amounts have been reclassified to conform with 1993 classifications. (b) Cash and Cash Equivalents For financial statement purposes, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. (c) Materials and Supplies Inventories of materials and supplies are valued at average cost and are charged to operations as consumed. An allowance for obsolescence is provided for flight equipment expendable parts. (d) Property and Equipment Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Maintenance and repairs, including the overhaul of aircraft components, are charged to operating expense as incurred and costs of major improvements are capitalized for both owned and leased assets. Interest related to deposits on aircraft purchase contracts and facility and equipment construction projects is capitalized as additional cost of the asset or as leasehold improvement if the asset is leased. Depreciation and amortization for principal asset classifications is provided on a straight-line basis to estimated residual values over estimated depreciable lives as follows: Property acquired under capital lease is amortized on a straight-line basis over the term of the lease and charged to depreciation expense. (e) Goodwill, Other Intangibles and Other Assets Goodwill, the cost in excess of fair value of identified net assets acquired, is being amortized on a straight-line basis over 40 years as other non-operating expense. Accumulated amortization at December 31, 1993 and 1992 was $98 million and $82 million, respectively. Intangible assets consist of purchased operating rights at various airports, purchased route authorities, and the intangible assets associated with the underfunded amounts of certain pension plans. The operating rights, valued at purchase cost or appraised value if acquired from Piedmont Aviation, Inc. ("Piedmont Avia- tion") or Pacific Southwest Airlines ("PSA"), are being amortized over periods ranging from ten to 25 years as Other Rent and Landing Fees Expense. The purchased route authorities are amortized over periods of 25 years as other operating expense. Accumulated amortization at December 31, 1993 and 1992 was $72 million and $65 million, respectively. The decrease in Other Intangibles, net in 1993 is primarily attributable to the $47 million reclassification of two London routes to Other Assets as a result of USAir's relinquishment of these routes as contemplated by the January 21, 1993 Investment Agreement ("Investment Agreement") between the Company and British Airways Plc ("BA"). USAir relinquished its Charlotte to London route authority in January 1994. In addition, takeoff and landing slots at Washington National Airport were purchased from Northwest Airlines, Inc. ("Northwest") for $10 million during 1993. (f) Restricted Cash and Investments Restricted cash and investments consist primarily of deposits in trust accounts to collateralize letters of credit or workers compensation policies and short-term investments restricted for specified construction projects. These amounts are classified as Other Assets on the accompanying balance sheets. (g) Deferred Gains on Sale and Leaseback Transactions Gains on aircraft sale and leaseback transactions are deferred and amortized over the term of the leases as a reduction of rental expense. (h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered. At the time of sale, a liability is established (Traffic Balances Payable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program. (j) Investment Tax Credit Investment tax credit benefits are recorded using the "flow- through" method as a reduction of the Federal income tax provision. (k) Earnings Per Share Earnings per share is computed by dividing net loss, after deducting preferred stock dividend requirements, by the weighted average number of shares of Common Stock outstanding, net of treasury stock. USAir Group's outstanding redeemable Series A Cumulative Convertible Preferred Stock ("Series A Preferred Stock"), Series B Cumulative Convertible Preferred Stock ("Series B Preferred Stock"), redeemable Series F Cumulative Senior Preferred Stock ("Series F Preferred Stock"), redeemable Series T Cumulative Convertible Exchangeable Senior Preferred Stock ("Series T Preferred Stock) and common stock equivalents are anti-dilutive. (l) Swap Agreements USAir has entered into hedging arrangements to reduce its exposure to fluctuations in the price of jet fuel. Net settlements are recorded as adjustments to aviation fuel expense. USAir is party to such hedging arrangements with several entities. Under these arrangements, the Company's maximum commitments, which are offset by amounts received under the arrangements, totaled approximately $100.3 million and $158.7 million at December 31, 1993 and 1992, respectively. Although the agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements, the Company does not anticipate such nonperformance. The Company has entered into interest rate swap transactions to manage interest rate exposure. Net settlements are recorded as an adjustment to interest expense. The Company is party to such interest rate swap agreements with banks and other financial institutions. The notional principal amounts of these agreements were $150 million and $400 million at December 31, 1993 and 1992, respectively. Under these swap agreements, the Company pays interest at fixed rates averaging 9.8% and 9.7% at December 31, 1993 and 1992, respectively, and receives floating rate interest payments based on three-month LIBOR. Although the agreements, which expire in 1995, expose the Company to credit loss in the event of non-performance by the other parties to the agreements, the Company does not anticipate such non-performance. (2) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Unless a quoted market price indicates otherwise, the fair values of cash and investments generally approximate carrying values because of the short maturity of these instruments. The Company has estimated the fair value of long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities. The estimated fair values of the Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock are obtained by consulting with an independent external valuation source. The fair values of interest rate swap agreements, energy swap agreements and foreign currency contracts are obtained from dealer quotes whereby these values represent the estimated amount the Company would receive or pay to terminate such agreements. The estimated fair values of the Company's financial instru- ments are summarized as follows: (3) LONG-TERM DEBT Details of long-term debt are as follows: Maturities of long-term debt and debt under capital leases for the next five years are as follows: (in thousands) 1994 $ 87,833 1995 75,344 1996 73,464 1997 84,027 1998 152,180 Thereafter 2,059,002 In addition to the varying interest rate on Credit Agreement borrowings as described below, interest rates on $239 million principal amount of long-term debt at December 31, 1993 are subject to adjustment to reflect prime rate and other rate changes. The Company and a group of banks are parties to a Credit Agreement dated as of March 30, 1987, as amended (the "Credit Agreement") which makes a $300 million revolving credit facility available to the Company as of December 31, 1993. The Credit Agreement expires on September 30, 1994. At December 31, 1993, loans under the Credit Agreement, at the option of the Company, would have borne interest at a reference rate, a Eurodollar rate plus 2.50% - 2.65% per annum, determined by the Company's coverage ratio discussed below, or a bid rate if offered by a lending bank. During 1993, 1992 and 1991, the maximum amount of credit agreement borrowings outstanding at any month end was $250 million, $450 million and $733 million, respectively. All outstanding Credit Agreement borrowings were paid off in May 1993 and no other funds were borrowed during the remainder of 1993. The average amount of Credit Agreement borrowings outstanding and weighted average interest rate for 1993 were $37 million and 5.8%, respectively. The average amount of Credit Agreement borrowings outstanding and the weighted average interest rate for 1992 were $174 million and 6.2%, respectively. The average amount of Credit Agreement borrowings and the weighted average interest rate for 1991 were $510 million and 8.3%, respectively. On June 21, 1993, USAir Group entered into the Seventh Amendment to the Credit Agreement. The Seventh Amendment increased the limit of unsecured debt of subsidiaries to $300 million from $200 million. On December 21, 1993, the Company obtained a waiver under the Credit Agreement which further increased the limit of unsecured debt of subsidiaries to $620 million for the period commencing December 21, 1993 and ending on the final annual reduction date of September 30, 1994. This waiver also exempted the Company from compliance, for the quarter ended December 31, 1993, with the coverage ratio test which must be maintained as part of the Credit Agreement. The Company would not otherwise have complied with this test as of December 31, 1993 but was in compliance with the other financial covenants required to be maintained as part of the Credit Agreement. USAir Group is currently unable to borrow under the Credit Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir Group expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir Group will be able to obtain a waiver of compliance with these covenants or arrange a replacement facility. Certain USAir, Piedmont and PCA aircraft and engines with a net book value of $247 million at December 31, 1993 secure the Credit Agreement. Equipment financings totaling $2.0 billion are collateralized by aircraft and engines with a net book value of $2.2 billion at December 31, 1993. An aggregate of $32 million of future principal payments of the Equipment Financing Agreements are payable in Japanese Yen. This foreign currency exposure has been hedged to maturity. Although the Company is exposed to credit loss in the event of non- performance by the counterparty to the hedge agreement, the Company does not anticipate such non-performance. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes ("9 5/8% Senior Notes") which are uncondi- tionally guaranteed by the Company. The 9 5/8% Senior Notes are not reflected in the above table because they were sold after December 31, 1993. (4) COMMITMENTS AND CONTINGENCIES (a) Operating Environment The economic conditions in the United States, fare competition and the emergence and growth of lower cost, lower fare carriers in the domestic airline industry are factors affecting the financial condition of USAir Group. Industry capacity has recently failed to mirror changes in demand due primarily to the continued delivery of new aircraft and secondarily, to the prolonged operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code. USAir competes with at least one major airline on most of its routes between major cities. Although the economy generally has shown signs of improvement, the Company expects that the competitive environment in the airline industry, the entry of low cost, low fare carriers into USAir's markets, and the excess capacity in the domestic airline industry will continue to have an adverse effect on USAir's passenger revenue for the foreseeable future. The extent or duration of these conditions cannot be reasonably determined at this time. (b) Lease Commitments The Company's airline subsidiaries lease certain aircraft, engines, computer and ground equipment, in addition to the majority of their ground facilities. Ground facilities include executive offices, overhaul and maintenance bases and ticket and administra- tive offices. Public airports are utilized for flight operations under lease arrangements with the municipalities or agencies owning or controlling such airports. Substantially all leases provide that the lessee shall pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased property. Most leases also include renewal options and some aircraft leases include purchase options. The following amounts applicable to capital leases are included in property and equipment: At December 31, 1993, obligations under capital and noncancel- able operating leases for future minimum lease payments were as follows: Rental expense under operating leases for 1993, 1992 and 1991 was $781 million, $707 million and $605 million, respectively. Rental expense for 1993 excludes a charge of $9 million related to certain airport facilities where USAir has, among other things, discontinued or reduced its service. Rental expense for 1992 excludes a charge of $72 million related to USAir's grounded BAe- 146 fleet. Rental expense for 1991 excludes a credit of $9 million for the BAe-146 fleet. (c) Legal Proceedings The Company and various subsidiaries have been named as defendants in various suits and proceedings which involve, among other things, environmental concerns and employment matters. These suits and proceedings are in various stages of litigation, and the status of the law with respect to several of the issues involved is unsettled. For these reasons the outcome of these suits and proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition or results of operations. In 1989 and 1990, a number of U.S. air carriers, including USAir, received two Civil Investigative Demands ("CIDs") from the U.S. Department of Justice ("DOJ") (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carriers' responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered by the Court until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter the amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. (d) Aircraft Commitments At December 31, 1993 USAir's new aircraft on firm order, options for new aircraft and scheduled payments for new aircraft orders (including progress payments, buyer furnished equipment, spares, and capitalized interest) were: USAir may elect, under certain circumstances, to convert Boeing 737 Series and Boeing 767 Series firm order or option deliveries to Boeing 757-200 deliveries. If USAir were to elect such a substitution, the payments presented in the table above would change. USAir is currently in negotiations with Boeing regarding, among other things, the above schedule of new aircraft deliveries. In addition, USAir has a commitment to purchase hushkits for certain of its McDonnell Douglas DC-9-30 aircraft and a substantial portion of its Boeing 737-200 aircraft. The installation of these hushkits will bring the aircraft into compliance with Federal Aviation Administration ("FAA") Stage 3 noise level requirements. The projected payments associated with the purchase of the hushkits are: $29.1 million - 1994; $12.0 million - 1995; $42.3 million - 1996; $43.4 million - 1997; $44.0 million - 1998; and $30.8 million thereafter. (e) Concentration of Credit Risk USAir Group does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, most of the Company's receivables related to tickets sold to individual passengers through the use of major credit cards (48%) or to tickets sold by other airlines (17%) and used by passengers on USAir or the commuter subsidiaries. These receivables are short- term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (f) Guarantees At December 31, 1993, USAir guaranteed payments of certain debt obligations of the Galileo International Partnership amounting to approximately $16 million. (5) SALE OF RECEIVABLES USAir is party to an agreement ("Receivables Agreement") to sell, on a revolving basis, undivided interest of up to $240 million in a pool of designated receivables. Approximately $141 million was available for sale at December 31, 1993 based on receivable balances at that date. The maximum amount available under the Receivables Agreement to be sold gradually reduces from $240 million at December 31, 1993, to $190 million on June 30, 1994. The Receivables Agreement expires on December 21, 1994. USAir had no outstanding amounts due under the Receivable Agreement at December 31, 1993. The net amounts sold reduce receivables in the accompanying balance sheet by $220 million and $188 million at December 31, 1992 and 1991, respectively. Included in the accounts payable balances at December 31, 1992 and 1991, are $74 million and $64 million, respectively, which represent funds held by USAir related to previously sold receivables that had been collected. USAir obtained a waiver from the purchaser of the receivables and its operating agent, exempting USAir from compliance with the coverage ratio financial covenant in the Receivables Agreement for the quarter ended December 31, 1993. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 required a change from the deferred method under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. No cumulative adjustment at January 1, 1993, and no income tax credit for the year ended December 31, 1993, were recognized due to the FAS 109 limitation in recognizing benefits for net operating losses. The Company files a consolidated Federal income tax return with its wholly-owned subsidiaries. The components of the provision (credit) for income taxes are as follows: The significant components of deferred income tax expense/- (benefit) for the year ended December 31, 1993, are as follows: Deferred tax benefit (exclusive of the other components listed below) $(136,191) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (8,880) Increase for the year in the valuation allowance for deferred tax assets 145,071 -------- Total $ 0 ======== For the years ended December 31, 1992 and 1991 deferred income taxes result from differences in the recognition of revenue and expenses and investment tax credits for tax and financial reporting purposes. The major items resulting in these differences and the related tax effects are shown in the following chart: A reconciliation of taxes computed at the statutory Federal tax rate on earnings before income taxes to the provision (credit) for income taxes is 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 are presented below: (in thousands) Deferred tax assets: Leasing transactions $ 132,551 Tax benefits purchased/sold 79,434 Gain on sale and leaseback transactions 164,613 Employee benefits 430,257 Net operating loss carryforwards 557,494 Alternative minimum tax credit carryforwards 21,146 Investment tax credit carryforwards 49,802 Other deferred tax assets 62,615 --------- Total gross deferred tax assets 1,497,912 Less valuation allowance (564,838) --------- Net deferred tax assets 933,074 Deferred tax liabilities: Equipment depreciation and amortization (874,640) Other deferred tax liabilities (58,434) --------- Net deferred tax liabilities (933,074) --------- Net deferred taxes $ 0 ========= The valuation allowance for deferred tax assets as of January 1, 1993, was $420 million. The increase in the valuation allowance during 1993 was $145 million. At December 31, 1993, the Company had unused net operating losses of $1.5 billion for Federal tax purposes, which expire in the years 2005-2008. The Company also has available, to reduce future taxes payable, $460 million alternative minimum tax net operating losses expiring in 2007 and 2008, $50 million of investment tax credits expiring in 2002 and 2003, and $21 million of minimum tax credits which do not expire. The Federal income tax returns of the Company through 1986 have been examined and settled with the Internal Revenue Service. (7) BRITISH AIRWAYS PLC INVESTMENT On January 21, 1993, USAir Group and BA entered into the Investment Agreement under which a wholly-owned subsidiary of BA purchased certain series of convertible preferred stock during 1993 (see Note 8 - Redeemable Preferred Stock) and BA entered into code sharing and wet lease arrangements with USAir contemplated by the Investment Agreement. On March 7, 1994, BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce its costs and improve its financial results is known. At December 31, 1993, the preferred stock held by BA con- stituted approximately 22% of the total voting interest in the Company. To the extent permitted by foreign ownership restrictions which are applicable by statute regulations or interpretation by regulatory authorities, including the U.S. Department of Transpor- tation ("DOT") ("Foreign Ownership Restrictions"), the preferred stock owned by BA votes on all matters presented to the Company's stockholders for a vote and has voting power equal to the underly- ing shares of Common Stock. Under the Investment Agreement, on January 21, 1993, BA designated three of its officers to serve on the Company's Board of Directors. The Company has agreed to use its best efforts to place these designees on the slate of nominees for election as Directors of the Company. In addition to BA's holdings of the Company's preferred stock at December 31, 1993, BA has the option, which it has announced it will not exercise under current circumstances, to purchase, at a minimum, an additional $450 million of the Company's preferred stock. Under certain circumstances, BA is entitled, at its option, to purchase, on or prior to January 21, 1996, 50,000 shares of Series C Cumulative Convertible Senior Preferred Stock ("Series C Preferred Stock") resulting in an additional cash investment in the Company of $200 million, and, on or prior to January 21, 1998, 25,000 shares of Series E Cumulative Convertible Senior Preferred Stock ("Series E Preferred Stock") resulting in an additional cash investment in the Company of $250 million. If the DOT approves all the transactions and acts contemplated by the Investment Agreement, at the election of either BA or the Company on or prior to January 21, 1998, BA's purchase of the Series C Preferred Stock (unless previously consummated) and BA's purchase of the Series E Preferred Stock must be consummated under certain circumstances. On March 15, 1993, the DOT issued an order ("DOT Order") stating, among other things, that BA's initial investment does not impair USAir's citizenship under current U.S. Foreign Ownership Restrictions. However, the DOT instituted a proceeding to consider whether USAir will remain a U.S. citizen if the transactions and acts contemplated by the Investment Agreement, including the possible sale of Series C Preferred Stock and Series E Preferred Stock, to BA, are consummated. The DOT has indefinitely suspended the period for comments from interested parties pending its resolution of requests by other airlines for production of additional documents from USAir. The DOT Order states that the DOT expects and advises USAir and BA not to proceed with the closing of the purchase of the Series C Preferred Stock or the Series E Preferred Stock until the DOT has completed its review of USAir's citizenship. In any event, on March 7, 1994, BA announced it would not make any additional investments in the Company under current circumstances. USAir cannot predict the outcome of the proceedings or if further transactions contemplated under the Investment Agreement, including the sale of Series C and Series E Preferred Stock to BA, will be consummated. The sale of additional preferred stock to BA on June 10, 1993 (see Note 8(c)), did not result in BA's ownership of voting stock in the Company exceeding applicable foreign ownership restrictions and therefore does not affect the Company's U.S. citizenship under those restrictions. (8) REDEEMABLE PREFERRED STOCK (a) Series A Preferred Stock At December 31, 1993, the Company had 358,000 shares of its 9 1/4% Series A Cumulative Convertible Redeemable Preferred Stock ("Series A Preferred Stock"), without par value, outstanding which was convertible into 9,239,944 shares of the Company's Common Stock at a conversion price of approximately $38.74 per share. The Series A Preferred Stock ranks pari passu with the Series F Cumulative Convertible Senior Preferred Stock ("Series F Preferred Stock"), without par value, and Series T-_ Cumulative Convertible Exchangeable Senior Preferred Stock ("Series T Preferred Stock"), without par value, and senior to the Series B Cumulative Convert- ible Preferred Stock ("Series B Preferred Stock"), without par value, Junior Participating Preferred Stock, Series D ("Series D Preferred Stock"), without par value, and the Common Stock, with respect to dividend payments and the distribution of assets. At December 31, 1993, the Series A Preferred Stock is entitled to approximately 25.81 votes per share (determined by dividing the $1,000 liquidation preference per share of Series F Preferred Stock by the $38.74 conversion price), or a total of 9,239,944 votes, and votes together with the Series F Preferred Stock, the Series T Preferred Stock and the Common Stock, on all matters submitted to a vote of stockholders of the Company. The Series A Preferred Stock is redeemable on August 7, 1999 at $1,000 per share. The Company has the right to redeem the stock at a 10% premium until that time. The agreement relating to the sale of the Series A Preferred Stock imposes certain restrictions on the purchaser's ability to increase its ownership of, and to transfer, its stock in USAir Group. There have been no changes in the balance sheet value of the Series A Preferred Stock since its issuance in 1989. (b) Series F Preferred Stock At December 31, 1993, the Company had outstanding 30,000 shares of its 7% Series F Preferred Stock which was convertible into 15,458,658 shares of the Company's Common Stock at a conver- sion price of approximately $19.41 per share. The Series F Preferred Stock ranks pari passu with the Series A Preferred Stock and Series T Preferred Stock and senior to the Series B Preferred Stock, Series D Preferred Stock, and the Common Stock, with respect to dividend payments and the distribution of assets. At December 31, 1993, each share of Series F Preferred Stock was entitled to approximately 515.29 votes per share to the extent permitted by the existing Foreign Ownership Restrictions and votes with the Company's Series A Preferred Stock, the Series T Preferred Stock and the Company's Common Stock as a single class. Under Foreign Ownership Restrictions, no more than 25% of the Company's voting interest may be held by persons other than U.S. citizens. In accordance with the terms of any preferred stock held by BA, conversion rights and voting rights may not be exercised to the extent that doing so would result in a loss of the Company's or any of its subsidiaries' operating certificates and authorities under Foreign Ownership Restrictions, and it is assumed for this purpose that Series F Preferred Stock will be fully converted before any other preferred stock held by BA. The Series F Preferred Stock is convertible at any time on or after January 21, 1997 to the extent that such conversion would not violate U.S. Foreign Ownership Restrictions. Series F Preferred Stock may be converted at the option of the Company at any time after January 21, 1998 if the average composite closing market price of Common Stock during any 30-day calendar period is at least 133% of the conversion price. The Series F Preferred Stock is mandatorily redeemable on January 21, 2008. If BA has not purchased the Series C Preferred Stock by January 21, 1996, then the Company may at its option redeem, in whole or in part, Series F Preferred Stock at the higher of market value or the price of $10,000 per share, plus accrued dividends. The Series F Certifi- cate provides that if on any one occasion on or prior to Janu- ary 21, 1996, any court or regulatory authority issues a final order that any material part of the Investment Agreement is unenforceable (except pursuant to bankruptcy or like event), then the conversion price of Series F Preferred Stock shall be reduced by 10.2564%. There have been no changes in the balance sheet value of the Series F Preferred Stock since its issuance in 1993. (c) Series T Preferred Stock Under the Investment Agreement, BA has preemptive and optional purchase rights to maintain its proportionate ownership of the Company's Common Stock and convertible securities, measured in terms of the BA Percentage ("BA Percentage") which approximates BA's fully diluted ownership percentage based on BA's current and potential holdings in the Company. The BA Percentage is calculated without regard to Foreign Ownership Restrictions at the time of the calculation. BA may exercise such preemptive or optional purchase rights by purchasing, from time-to-time, a series of Series T Preferred Stock. At December 31, 1993, the Company had two series of the Series T Preferred Stock outstanding. On June 10, 1993, BA exercised its preemptive purchase right by purchasing 9,919.8 shares of a series of the Series T Preferred Stock ("Series T-2 Preferred Stock") for approximately $99.2 million and exercised its optional purchase right by purchasing 152.1 shares of a series of Series T Preferred Stock ("T-1 Preferred Stock") for approximately $1.5 million. BA's preemptive right was triggered by the issuance of Common Stock, as described in Note 8 - Stockholders' Equity, and BA's optional purchase rights were triggered by the Company's issuance of additional shares of Common Stock through the exercise of options under various employee stock option plans and through the sale of shares to certain defined contribution plans during the period from January 21, 1993 to March 31, 1993. On March 7, 1994, BA advised the Company that it would not exercise its optional purchase rights to buy three additional series of Series T Preferred Stock triggered by the Company's issuance of common stock pursuant to certain employee benefit plans during the second, third and fourth quarters of 1993. There have been no changes in the balance sheet value of the Series T-1 Preferred Stock and Series T-2 Preferred Stock since their issuance in 1993. The terms of all series of the Series T Preferred Stock are substantially similar to those of the Series F Preferred Stock except as noted. Each share of Series T-2 Preferred Stock carries a conversion price of $26.40 and is convertible into approximately 378.79 shares of Common Stock or Non-Voting Class ET stock. Each share of Series T-1 Preferred Stock has a conversion price of $20.50 and is convertible into approximately 487.80 shares of Common Stock or Non-Voting Class ET stock. With respect to the Series T Preferred Stock, dividends are payable quarterly in arrears, at 50 basis points over the three-month LIBOR rate. Any shares of the Series T Preferred Stock held by any person other than BA or its subsidiaries may be redeemed for cash at any time at the option of the Company at $10,000 plus accrued dividends plus a redemption premium equal to $700 from the date of issue until the first anniversary thereof and reduced by $46.67 on each anniversary thereafter. The Series T Preferred Stock is exchangeable, at the option of the Company, for that principal amount of floating rate convertible subordinated notes of the Company ("T Notes") equal to the liquidation preference of the shares to be exchanged and bearing interest at the dividend rate. Any accrued dividends on the Series T Preferred Stock to be exchanged will be treated as accrued interest on the T Notes. Each $10,000 aggregate principal amount of such T Notes will be entitled to a number of votes equal to the number of votes to which each share of Series T Preferred Stock was entitled at the time of its exchange for T Notes, subject to adjustment. If issued, T Notes will have terms otherwise consis- tent with the terms of the Series T Preferred Stock. (9) STOCKHOLDERS' EQUITY (a) Common Stock The Company had 150,000,000 and 100,000,000 authorized shares of Common Stock, par value $1, at December 31, 1993 and 1992, respectively. If BA purchases the Series C Preferred Stock (see Note 6 - British Airways Plc Investment), the number of authorized shares of various classes of Common Stock will increase to 300,000,000. BA has indicated, however, that it will not make any additional investments in the Company under current circumstances. At December 31, 1993, approximately 52,618,000 shares were reserved for issuance upon the conversion of preferred stock and for offerings under employee stock purchase, stock option and stock incentive plans. On May 4, 1993, the Company sold 11.5 million shares of previously unissued Common Stock at $20.75 per share through a public, underwritten offering. The offering netted proceeds of approximately $231 million. (b) Preferred Stock and Senior Preferred Stock At December 31, 1993, the Company had 5,000,000 authorized shares of preferred stock, without nominal or par value, of which 358,000 shares were issued as Series A Preferred Stock, 43,000 shares were issued as Series B Preferred Stock and 1,035,000 shares were reserved as Series D Preferred Stock. Also, at December 31, 1993, the Company had 3,000,000 authorized shares of Senior Preferred Stock, without nominal or par value, of which 30,000 shares were issued as Series F Preferred Stock and approximately 10,000 were issued as Series T Preferred Stock. (c) Series B Preferred Stock At December 31, 1993, the Company had 4,263,050 Depositary Shares, representing 42,630.5 shares of its $437.50 Series B Preferred Stock outstanding. Each Depositary Share represents 1/100 of a share of the Series B Preferred Stock. The Series B Preferred Stock is convertible at any time, at the option of the holder, at the rate of 249.25 shares of Common Stock of the Company per preferred share, or 2.4925 shares of Common Stock per De- positary Share. The Series B Preferred Stock ranks junior to the Company's Series A Preferred Stock, the Series F Preferred Stock and the Series T Preferred Stock and senior to the Series D Preferred Stock and the Common Stock with respect to dividend payments and the distribution of assets, whether upon liquidation or otherwise. Except under certain circumstances, the holders of Series B Preferred Stock have no voting rights. The Series B Preferred Stock is not redeemable prior to May 15, 1994. The Series B Preferred Stock is redeemable, at the option of the Company and with consent of the holders of Series F Preferred Stock, on or after May 15, 1994, (i) in whole but not in part, only in certain circumstances, for so long as any shares of Series A Preferred Stock are outstanding; and (ii) in whole or in part if no shares of Series A Preferred Stock are outstanding, in each case initially at a redemption price of approximately $53.06 per 1/100 of a share and thereafter at prices declining to $50 per 1/100 of a share (equivalent to $5,000 per share of Series B Preferred Stock) on or after May 15, 2001, plus dividends accrued and accumulated but unpaid to the redemption date. (d) Preferred Stock Purchase Rights Each outstanding share of Common Stock is accompanied by one Preferred Share Purchase Right ("Right") and each outstanding share of Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock is accompanied by a Right for each share into which it is convertible. Each Right entitles the holder to buy 1/100th of a share of Series D Preferred Stock at an exercise price of $175 per Right. The Rights expire on June 29, 1996. As long as the Rights remain outstanding, the Company will issue one Right with each new share of Common Stock issued upon the conversion of any preferred stock into, or the exercise of any options for, Common Stock, as long as such preferred stock or options were outstanding prior to the Rights becoming exercisable. Generally, the Rights become exercisable only if a party other than, under certain circumstances, BA acquires 20% or more of the Company's Common Stock or announces a tender offer for 20% or more of the Common Stock. The Rights are redeemable at $.03 per Right at any time before 20% or more of the Company's Common Stock has been acquired. If at any time after the Rights become exercisable and before they have been redeemed the Company is involved in a merger or other business combination transaction, the Rights will automatically entitle a holder, other than a holder of 20% or more of the Company's Common Stock, to receive, upon exercise of each Right, a number of shares of Common Stock, or a number of common shares of the acquiring company, as the case may be, having a market value of two times the exercise price of each Right. In addition, at any time after the acquisition of 30% or more of the Common Stock by any person and prior to the acquisition by such person of 50% or more of the Common Stock, the Board of Directors of the Company may exchange the Rights (other than Rights owned by such person which have become void), in whole or in part, at an exchange ratio of one share of Common Stock, or 1/100th of a share of Series D Preferred Stock, per Right. Until the first to occur of the redemption or expiration of the Rights, the Company will issue one Right with each new share of Common Stock issued upon the conversion of any securities into, or the exercise of any options or warrants for, Common Stock if such securities, options or warrants were outstanding prior to when Rights became exercisable. (e) Treasury Stock In 1989, the Company's Board of Directors authorized the repurchase from time-to-time of up to 9.4 million shares of its Common Stock in open market transactions. In 1989, approximately 2.1 million shares were repurchased. The Company sold approximate- ly 500,000 shares and approximately 390,000 shares of its treasury stock during 1993 and 1992, respectively. The remaining shares are carried on the accompanying balance sheet at the average acquisi- tion cost. (f) Employee Stock Option and Purchase Plans During 1992, the Company's stockholders approved the 1992 Stock Option Plan ("1992 Plan") which allows for the issuance of stock options to purchase up to 8,125,000 shares of USAir Group Common Stock to USAir employees who participate in the previously announced cost reduction program. Under the stock option program, employees whose pay was or is currently being reduced receive options to purchase 50 shares of Common Stock at a price not less than $15 per share for each $1,000 of salary reduction. The Company will grant stock options under the 1992 Plan only in connection with salary reductions. Participating employees have five years from the grant date to exercise such options. Options, with an exercise price of $15, have been granted to purchase ap- proximately five million shares of Common Stock in conjunction with salary reductions. The Company plans to seek authority from its stockholders at its 1994 Annual Meeting to reduce the number of shares reserved for this plan. At December 31, 1993, 5.3 million shares of Common Stock are reserved for the granting of stock options or restricted stock under the Company's 1984 Stock Option and Stock Appreciation Rights ("SARs") Plan and 1988 Stock Incentive Plan. These plans provide that options may be granted as either nonqualified or incentive stock options. Options awarded prior to 1991, except for those that reverted, have vested. Options awarded during 1991, 1992 and 1993, except under the 1992 Plan, become exercisable generally within three years from date of grant. Optionees may also receive SARs which permit them to receive, in lieu of the right to exercise the stock option, an amount equivalent to the difference between the stock option price and the fair market value of the Common Stock on the date of exercising the right. This amount may be paid in stock, in cash, or in any combination of the two. Also, restricted stock award grants for 57,000 shares and 111,600 shares were outstanding at December 31, 1993 and 1992, respectively. Deferred compensation related to the restricted stock, which vests over periods of up to five years, amounted to $.3 million and $ .6 million at December 31, 1993 and 1992, respectively. As of December 31, 1993, options to acquire approximately 9 million shares under all three plans, including 85,000 SARs, were outstanding at a weighted average exercise price of $18.77. Of those outstanding, approximately six million options were exercis- able at December 31, 1993. Options were exercised to purchase approximately 33,500 and 6,000 shares of Common Stock at average exercise prices of $17.24 and $10.44 during 1993 and 1992, respectively. (g) Dividend Restrictions The Company's Credit Agreement does not contain specific provisions which restrict the payment of dividends by USAir Group. The amount of dividends, however, is indirectly restricted through the existence of certain covenants contained in the Credit Agreement. At December 31, 1993, under the most restrictive of these provisions, the Company's ability to pay dividends is limited to approximately $77 million. (10) EMPLOYEE STOCK OWNERSHIP PLAN In August 1989, USAir established an Employee Stock Ownership Plan ("ESOP"). The Company sold 2,200,000 shares of Common Stock to an Employee Stock Ownership Trust to hold on behalf of USAir's employees, exclusive of officers, in accordance with the terms of the Trust and the ESOP. Financing of approximately $111.4 million for the Trust's purchase of the shares was provided by USAir through a 9 3/4% loan to the Trust, and an additional $2.2 million was contributed to the Trust by USAir. The loan is being repaid with contributions made by USAir. The contributions are made in amounts equal to the periodic loan payments as they come due, less dividends available for loan payment. The amount of dividends used for debt service by the ESOP was $127,000 in 1991. As the loan is repaid over time, participating employees receive allocations of the Common Stock purchased by the Trust. The initial maturity of the loan is 30 years. However, the ESOP provides that if the Company's profitability as measured by return on sales exceeds certain goals during the life of the ESOP, USAir's contributions and the repayment of the loan will be accelerated. Contributions made by USAir and therefore loan repayments made by the Trust were $11.4 million in 1993, 1992 and 1991. The interest portion of these contributions was $10.5 million in 1993, $10.6 million in 1992 and $10.7 million in 1991. Approximately 366,000 shares of Common Stock have been allocated to employees. USAir recognized approximately $4 million of compensation expense related to the ESOP in each of 1993, 1992 and 1991 based on shares allocated to employees (the "shares allocated" method). Deferred compensation related to the ESOP amounted to approximately $95 million, $98 million and $102 million at December 31, 1993, 1992 and 1991, respectively. (11) EMPLOYEE BENEFIT PLANS (a) Pension Plans The Company's subsidiaries have several pension plans in effect covering substantially all employees. One qualified defined benefit plan covers USAir maintenance employees and provides benefits of stated amounts for specified periods of service. Qualified defined benefit plans for substantially all other employees provide benefits based on years of service and compensa- tion. The qualified defined benefit plans are funded, on a current basis, to meet requirements of the Employee Retirement Income Security Act of 1974. The defined benefit pension plan for USAir non-contract employees was frozen at the end of 1991 for all non-contract participants, resulting in a one-time book gain of approximately $107 million in 1991. All non-contract plan participants became 100% vested at the time of the freeze. As a result of this plan curtailment, the accrual of service costs related to defined benefits for USAir non-contract employees ceased at the end of 1991. USAir implemented a defined contribution pension plan for non-contract employees in January 1993. The funded status of the qualified defined benefit plans at December 31, 1993 and 1992 was as follows: Approximately 97% of the accumulated benefit obligation was vested at December 31, 1993 and 1992. Unrecognized transition assets are being amortized over periods up to 27 years. The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.6% and 8.75% as of December 31, 1993 and 1992, respectively. The expected long-term rate of return on plan assets used in 1993 and 1992 was 9.5%. Rates of 3% to 6% were used to estimate future salary levels. At December 31, 1993, plan assets consisted of approxi- mately 8% in cash equivalents and short-term debt investments, 37% in equity investments, and 55% in fixed income and other invest- ments. At December 31, 1992, plan assets consisted of approximate- ly 4% in cash equivalents and short-term debt investments, 70% in equity investments, and 26% in fixed income and other investments. The following items are the components of the net pension cost for the qualified defined benefit plans: Net pension cost for 1993 and 1991 presented above excludes a settlement charge of approximately $33.9 million and $21.6 million, respectively, related to "early-out" incentive programs offered to a limited number of USAir employees during the years. No such charges were incurred in 1992. Non-qualified supplemental pension plans are established for certain employee groups, which provide incremental pension payments from the Company's funds so that total pension payments equal amounts that would have been payable from the Company's principal pension plans if it were not for limitations imposed by income tax regulations. The following table sets forth the non-qualified plans' status at December 31, 1993 and 1992: Net supplementary pension cost for the two years included the following components: The discount rate used to determine the actuarial present value of the projected benefit obligation was 7.5% and 8.75% as of December 31, 1993 and 1992, respectively. Rates of 3% to 6% were used to estimate future salary levels. In addition to the qualified and non-qualified defined benefit plans described above, USAir also contributes to certain defined contribution plans primarily for employees not covered under a collective bargaining agreement. Company contributions are based on a formula which considers the age and pre-tax earnings of each employee and the amount of employee contributions. The Company's contribution expense was $42 million for 1993. The Company recognized no such expense in 1992 or 1991. (b) Postretirement Benefits Other Than Pensions USAir offers medical and life insurance benefits to employees who retire from the Company and their eligible dependents. The medical benefits provided by USAir are coordinated with Medicare benefits. Retirees generally contribute amounts towards the cost of their medical expenses based on years of service with the Company. USAir provides uninsured death benefit payments to survivors of retired employees for stated dollar amounts, or in the case of retired pilot employees, death benefit payments determined by age and level of pension benefit. The plans for postretirement medical and death benefits are funded on the pay-as-you-go basis. USAir adopted Statement of Financial Accounting Standards No. 106 ("FAS 106") during 1992 and elected to record the January 1, 1992 Accumulated Postretirement Benefit Obligation ("APBO") using the immediate recognition approach. The cumulative effect of adopting FAS 106 was $745.7 million ($628.1 million net of tax benefit). The following table sets forth the financial status of the plans as of December 31, 1993 and 1992: The components of net periodic postretirement benefit cost are as follows: The postretirement benefit expense for 1993 presented above excludes a charge of approximately $15.5 million related to "early out" programs offered to a limited number of employees during the year. No such charges were incurred in 1992 or 1991. The discount rate used to determine the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate used in measuring the APBO was 10.5% in 1993 and 1994, declining by 1% per year after 1994 to an ultimate rate of 4.5%. If the assumed health care cost trend rate were increased by one percentage point, the APBO at December 31, 1993 would be increased by 10% and 1993 periodic postretirement benefit cost would increase 13%. Prior to the adoption of FAS 106, USAir recognized expense for retiree health care at an estimated monthly rate (based on payments) and recognized expense for death benefits when paid. The expense using this methodology was approximately $8 million for 1991. (c) Postemployment Benefits USAir adopted Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits" ("FAS 112"), during 1993. FAS 112 requires the use of an accrual method to recognize postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 was $43.7 million. (12) SUPPLEMENTAL BALANCE SHEET INFORMATION The components of certain accounts in the accompanying balance sheets are as follows: (13) NON-RECURRING AND UNUSUAL ITEMS (a) 1993 The Company's results for 1993 include non-recurring charges of (i) $43.7 million for the cumulative effect of an accounting change, as required by FAS 112 which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (ii) $68.8 million for severance, early retirement and other personnel-related expenses recorded primarily during the third quarter of 1993 in connection with a workforce reduction of approximately 2,500 full- time positions between November 1993 and the first half of 1994; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions, recorded in the fourth quarter of 1993; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service, recorded in the fourth quarter of 1993; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership which operates a computerized reserva- tions system, recorded in the fourth quarter of 1993; and (vi) $18.4 million credit related to non-operating aircraft recorded in the second quarter of 1993. (b) 1992 The Company's results for 1992 include (i) a charge of $628.1 million for the cumulative effect of an accounting change as required by FAS 106, effective January 1, 1992; (ii) a $107.4 million charge related to certain aircraft which have been withdrawn from service, recorded in the fourth quarter of 1992; (iii) a $34.1 million non-operating loss related to the sale of ten MD-82 aircraft which USAir eliminated from its fleet plan, recorded in the fourth quarter of 1992; and (iv) a $10.3 million gain on the sale of three wholly-owned subsidiaries, recorded in the third quarter of 1992 (see Note (1)). (c) 1991 The Company's results for 1991 include (i) a $107 million pre- tax gain related to freezing of the fully funded non-contract employee pension plan; (ii) a $21.6 million pre-tax expense related to early retirement incentives offered to certain employees during 1991; (iii) a $21 million pre-tax charge to establish an additional reserve for USAir's grounded BAe-146 fleet; and (iv) $18.5 million, net, in miscellaneous non-recurring charges. (14) SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents selected quarterly financial data for 1993 and 1992: Item 8B. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION USAir, Inc. Independent Auditors' Report The Stockholder and Board of Directors USAir, Inc.: We have audited the accompanying consolidated balance sheets of USAir, Inc. and subsidiaries ("USAir") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of USAir'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 USAir, Inc. 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 9 to the consolidated financial state- ments, effective January 1, 1993, USAir changed its method of accounting for postemployment benefits and effective January 1, 1992, USAir changed its method of accounting for postretirement benefits other than pensions. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 (PAGE> (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying consolidated financial statements include the accounts of USAir, Inc. ("USAir") and its wholly-owned subsidiary USAM Corp. ("USAM"). USAir is a wholly-owned subsidiary of USAir Group, Inc. ("USAir Group" or "the Company"). All significant intercompany accounts and transactions have been eliminated. At December 31, 1992, USAM owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided services to travel agent subscribers in Europe. Covia was then separated into three new entities. As a result, at Decem- ber 31, 1993, USAM owns 11% of the Galileo International Partner- ship which owns and operates the Galileo CRS, approximately 11% of the Galileo Japan Partnership which markets the Galileo CRS in Japan and approximately 21% of the Apollo Travel Services Partner- ship which markets the Galileo CRS in the U.S. and Mexico. USAM accounts for these investments using the equity method. On October 9, 1991, USAir reached agreement for the sale of certain assets of its wholly-owned subsidiary Pacific Southwest Airmotive ("Airmotive"). Airmotive discontinued operations in the third quarter of 1991. USAir did not realize any material gain or loss on the sale and discontinuance of Airmotive's operations. Certain 1992 and 1991 amounts have been reclassified to conform with 1993 classifications. (b) Cash and Cash Equivalents For financial statement purposes, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. (c) Materials and Supplies Inventories of materials and supplies are valued at average cost and are charged to operations as consumed. An allowance for obsolescence is provided for flight equipment expendable parts. (d) Property and Equipment Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Maintenance and repairs, including the overhaul of aircraft components, are charged to operating expense as incurred and costs of major improvements are capitalized for both owned and leased assets. Interest related to deposits on aircraft purchase contracts and facility and equipment construction projects is capitalized as additional cost of the asset or as leasehold improvement if the asset is leased. Depreciation and amortization for principal asset classifications is provided on a straight-line basis to estimated residual values over estimated depreciable lives as follows: Property acquired under capital lease is amortized on a straight-line basis over the term of the lease and charged to depreciation expense. (e) Goodwill, Other Intangibles and Other Assets Goodwill, the cost in excess of fair value of identified net assets acquired, is being amortized on a straight-line basis over 40 years as other non-operating expense. Accumulated amortization at December 31, 1993 and 1992 was $98 million and $82 million, respectively. Intangible assets consist of purchased operating rights at various airports, purchased route authorities, and the intangible assets associated with the underfunded amounts of certain pension plans. The operating rights, valued at purchase cost or appraised value if acquired from Piedmont Aviation, Inc. ("Piedmont Avia- tion") or Pacific Southwest Airlines ("PSA"), are being amortized over periods ranging from ten to 25 years as Other Rent and Landing Fees Expense. The purchased route authorities are amortized over periods of 25 years as other operating expense. Accumulated amortization at December 31, 1993 and 1992 was $72 million and $64 million, respectively. The decrease in Other Intangibles, net in 1993 is primarily attributable to the $47 million reclassification of two London routes to Other Assets as a result of USAir's relinquishment of these routes as contemplated by the January 21, 1993 Investment Agreement ("Investment Agreement") between the Company and British Airways Plc ("BA"). USAir relinquished its Charlotte to London route authority in January 1994. In addition, takeoff and landing slots at Washington National Airport were purchased from Northwest Airlines, Inc. ("Northwest") for $10 million during 1993. (f) Restricted Cash and Investments Restricted cash and investments consist primarily of deposits in trust accounts to collateralize letters of credit or workers compensation policies and short-term investments restricted for specified construction projects. These amounts are classified as Other Assets on the accompanying balance sheets. (g) Deferred Gains on Sale and Leaseback Transactions Gains on aircraft sale and leaseback transactions are deferred and amortized over the term of the leases as a reduction of rental expense. (h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered. At the time of sale, a liability is established (Traffic Balances Payable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. Approximately $29 million and $28 million of amounts owed to wholly-owned subsidiaries of USAir Group for passenger transportation revenue are included in Traffic Balances Payable and Unused Tickets at December 31, 1993 and 1992, respectively. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program. (j) Investment Tax Credit Investment tax credit benefits are recorded using the "flow- through" method as a reduction of the Federal income tax provision. (k) Swap Agreements USAir has entered into hedging arrangements to reduce its exposure to fluctuations in the price of jet fuel. Net settlements are recorded as adjustments to aviation fuel expense. USAir is party to such hedging arrangements with several entities. Under these arrangements, the Company's maximum commitments, which are offset by amounts received under the arrangements, totaled approximately $100.3 million and $158.7 million at December 31, 1993 and 1992, respectively. Although the agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements, the Company does not anticipate such nonperformance. (2) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Unless a quoted market price indicates otherwise, the fair values of cash and investments generally approximate carrying values because of the short maturity of these instruments. USAir has estimated the fair value of long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities. The fair values of energy swap agreements and foreign currency contracts are obtained from dealer quotes whereby these values represent the estimated amount USAir would receive or pay to terminate such agreements. The estimated fair values of USAir's financial instruments are summarized as follows: (3) LONG-TERM DEBT Details of long-term debt are as follows: Maturities of long-term debt and debt under capital leases for the next five years are as follows: (in thousands) 1994 $ 85,715 1995 75,691 1996 75,715 1997 86,496 1998 155,234 Thereafter 2,153,879 Interest rates on $239 million principal amount of long-term debt at December 31, 1993 are subject to adjustment to reflect prime rate and other rate changes. Equipment financings totaling $2.1 billion are collateralized by aircraft and engines with a net book value of $2.2 billion at December 31, 1993. In addition, certain USAir aircraft and engines with a net book value of $162 million collateralize USAir Group's Credit Agreement borrowings. An aggregate of $32 million of future principal payments of the Equipment Financing Agreements are payable in Japanese Yen. This foreign currency exposure has been hedged to maturity. Although the Company is exposed to credit loss in the event of non- performance by the counterparty to the hedge agreement, the Company does not anticipate such non-performance. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes ("9 5/8% Senior Notes") which are uncondi- tionally guaranteed by the Company. The 9 5/8% Senior Notes are not reflected in the above table because they were sold after December 31, 1993. (4) COMMITMENTS AND CONTINGENCIES (a) Operating Environment The economic conditions in the United States, fare competition and the emergence and growth of low cost, low fare carriers in the domestic airline industry are factors affecting the financial condition of USAir. Industry capacity has recently failed to mirror changes in demand due primarily to the continued delivery of new aircraft and secondarily, to the prolonged operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code. USAir competes with at least one major airline on most of its routes between major cities. Although the economy generally has shown signs of improvement, the Company expects that the competitive environment in the airline industry, the entry of low cost, low fare carriers into USAir's markets, and the excess capacity in the domestic airline industry will continue to have an adverse effect on USAir's passenger revenue for the foreseeable future. The extent or duration of these conditions cannot be reasonably determined at this time. (b) Lease Commitments USAir leases certain aircraft, engines, computer and ground equipment, in addition to the majority of its ground facilities. Ground facilities include executive offices, overhaul and mainte- nance bases and ticket and administrative offices. Public airports are utilized for flight operations under lease arrangements with the municipalities or agencies owning or controlling such airports. Substantially all leases provide that the lessee shall pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased property. Most leases also include renewal options and some aircraft leases include purchase options. The following amounts applicable to capital leases are included in property and equipment: At December 31, 1993, obligations under capital and noncancel- able operating leases for future minimum lease payments were as follows: Rental expense under operating leases for 1993, 1992 and 1991 was $739 million, $678 million and $576 million, respectively. Rental expense for 1993 excludes a charge of $9 million related to certain airport facilities where USAir has, among other things, discontinued or reduced its service. Rental expense for 1992 excludes a charge of $72 million related to USAir's grounded BAe- 146 fleet. Rental expense for 1991 excludes a credit of $9 million for the BAe-146 fleet. (c) Legal Proceedings USAir and various subsidiaries have been named as defendants in various suits and proceedings which involve, among other things, environmental concerns and employment matters. These suits and proceedings are in various stages of litigation, and the status of the law with respect to several of the issues involved is unset- tled. For these reasons the outcome of these suits and proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition or results of operations. In 1989 and 1990, a number of U.S. air carriers, including USAir, received two Civil Investigative Demands ("CIDs") from the U.S. Department of Justice ("DOJ") (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carriers' responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter the amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. (d) Aircraft Commitments At December 31, 1993, USAir's new aircraft on firm order, options for new aircraft and scheduled payments for new aircraft orders (including progress payments, buyer furnished equipment, spares, and capitalized interest) were: USAir may elect, under certain circumstances, to convert Boeing 737 Series and Boeing 767 Series firm order or option deliveries to Boeing 757-200 deliveries. If USAir were to elect such a substitution, the payments presented in the table above would change. USAir is currently in negotiations with Boeing regarding, among other things, the above schedule of new aircraft deliveries. In addition, USAir has a commitment to purchase hushkits for certain of its McDonnell Douglas DC-9-30 aircraft and a substantial portion of its Boeing 737-200 aircraft. The installation of these hushkits will bring the aircraft into compliance with Federal Aviation Administration ("FAA") Stage 3 noise level requirements. The projected payments associated with the purchase of the hushkits are: $29.1 million - 1994; $12.0 million - 1995; $42.3 million - 1996; $43.4 million - 1997; $44.0 million - 1998; and $30.8 million thereafter. (e) Concentration of Credit Risk USAir does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, most of USAir's receivables related to tickets sold to individual passen- gers through the use of major credit cards (47%) or to tickets sold by other airlines (16%) and used by passengers on USAir or USAir Group's commuter subsidiaries. These receivables are short-term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (f) Guarantees At December 31, 1993, USAir guaranteed payments of certain debt obligations of the Galileo International Partnership amounting to approximately $16 million. In addition, at December 31, 1993, USAir guaranteed payments of debt and lease obligations of USAir Group's three wholly-owned subsidiaries amounting to approximately $148 million. (5) SALE OF RECEIVABLES USAir is party to an agreement ("Receivables Agreement") to sell, on a revolving basis, undivided interest of up to $240 million in a pool of designated receivables. Approximately $141 million was available for sale at December 31, 1993 based on receivable balances at that date. The maximum amount available under the Receivable Agreement to be sold gradually reduces from $240 million at December 31, 1993, to $190 million on June 30, 1994. The Receivables Agreement expires on December 21, 1994. USAir had no outstanding amounts due under the Receivable Agreement at December 31, 1993. The net amounts sold reduce receivables in the accompanying balance sheet by $220 million and $188 million at December 31, 1992 and 1991, respectively. Included in the accounts payable balances at December 31, 1992 and 1991, are $74 million and $64 million, respectively, which represent funds held by USAir related to previously sold receivables that had been collected. USAir obtained a waiver from the purchaser of the receivables and its operating agent, exempting USAir from compliance with the coverage ratio financial covenant in the Receivables Agreement for the quarter ended December 31, 1993. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or arrange a replacement facility. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 required a change from the deferred method under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. No cumulative adjustment at January 1, 1993, and no income tax credit for the year ended December 31, 1993, were recognized due to the FAS 109 limitation in recognizing benefits for net operating losses. USAir files a consolidated Federal income tax return with its parent USAir Group pursuant to a tax allocation agreement. The components of the provision (credit) for income taxes are as follows: The significant components of deferred income tax ex- pense/(benefit) for the year ended December 31, 1993, are as follows: (in thousands) Deferred tax benefit (exclusive of the other components listed below) $(121,847) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (9,429) Increase for the year in the valuation allowance for deferred tax assets 131,276 -------- Total $ 0 ======== For the years ended December 31, 1992 and 1991, deferred income taxes result from differences in the recognition of revenue and expenses and investment tax credits for tax and financial reporting purposes. The major items resulting in these differences and the related tax effects are shown in the following chart: A reconciliation of taxes computed at the statutory Federal tax rate on earnings before income taxes to the provision (credit) for income taxes is 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 are presented below: (in thousands) Deferred tax assets: Leasing transactions $ 129,276 Tax benefits purchased/sold 79,434 Gain on sale and leaseback transactions 162,400 Employee benefits 429,312 Net operating loss carryforwards 508,240 Alternative minimum tax credit carryforwards 20,881 Investment tax credit carryforwards 47,880 Other deferred tax assets 61,210 --------- Total gross deferred tax assets 1,438,633 Less valuation allowance (568,816) --------- Net deferred tax assets 869,817 Deferred tax liabilities: Equipment depreciation and amortization (840,584) Other deferred tax liabilities (29,233) --------- Net deferred tax liabilities (869,817) --------- Net deferred taxes $ 0 ========= The valuation allowance for deferred tax assets as of January 1, 1993, was $438 million. The increase in the valuation allowance for 1993 was $131 million. At December 31, 1993, the Company had unused net operating losses of $1.3 billion for Federal tax purposes, which expire in the years 2005-2008. USAir also has available, to reduce future taxes payable, $429 million alternative minimum tax net operating losses expiring in 2007 and 2008, $47 million of investment tax credits expiring in 2002 and 2003, and $20 million of minimum tax credits which do not expire. The Federal income tax returns of the Company through 1986 have been examined and settled with the Internal Revenue Service. (7) STOCKHOLDER'S EQUITY USAir Group owns all of the outstanding common stock of USAir. USAir Group's Credit Agreement includes a provision that limits USAir's ability to declare dividends to USAir Group. (8) EMPLOYEE STOCK OWNERSHIP PLAN In August 1989, USAir established an Employee Stock Ownership Plan ("ESOP"). USAir Group sold 2,200,000 shares of its Common Stock to an Employee Stock Ownership Trust to hold on behalf of USAir's employees, exclusive of officers, in accordance with the terms of the Trust and the ESOP. Financing of approximately $111.4 million for the Trust's purchase of the shares was provided by USAir through a 9 3/4% loan to the Trust, and an additional $2.2 million was contributed to the Trust by USAir. The loan is being repaid with contributions made by USAir. The contributions are made in amounts equal to the periodic loan payments as they come due, less dividends available for loan payment. The amount of dividends used for debt service by the ESOP was $127,000 in 1991. As the loan is repaid over time, participating employees receive allocations of the Common Stock purchased by the Trust. The initial maturity of the loan is 30 years. However, the ESOP provides that if the Company's profitability as measured by return on sales exceeds certain goals during the life of the ESOP, USAir's contributions and the repayment of the loan will be accelerated. Contributions made by USAir and therefore loan repayments made by the Trust were $11.4 million in 1993, 1992 and 1991. The interest portion of these contributions was $10.5 million in 1993, $10.6 million in 1992 and $10.7 million in 1991. Approximately 366,000 shares of Common Stock have been allocated to employees. USAir recognized approximately $4 million of compensation expense related to the ESOP in each of 1993, 1992 and 1991 based on shares allocated to employees (the "shares allocated" method). Deferred compensation related to the ESOP amounted to approximately $95 million, $98 million and $102 million at December 31, 1993, 1992 and 1991, respectively. (9) EMPLOYEE BENEFIT PLANS (a) Pension Plans USAir has several pension plans in effect covering substan- tially all employees. One qualified defined benefit plan covers USAir maintenance employees and provides benefits of stated amounts for specified periods of service. Qualified defined benefit plans for substantially all other employees provide benefits based on years of service and compensation. The qualified defined benefit plans are funded, on a current basis, to meet requirements of the Employee Retirement Income Security Act of 1974. The defined benefit pension plan for USAir non-contract employees was frozen at the end of 1991 for all non-contract participants, resulting in a one-time book gain of approximately $107 million in 1991. All non-contract plan participants became 100% vested at the time of the freeze. As a result of this plan curtailment, the accrual of service costs related to defined benefits for USAir non-contract employees ceased at the end of 1991. USAir implemented a defined contribution pension plan for non-contract employees in January 1993. The funded status of the qualified defined benefit plans at December 31, 1993 and 1992 was as follows: Approximately 97% of the accumulated benefit obligation was vested at December 31, 1993 and 1992. Unrecognized transition assets are being amortized over periods up to 27 years. The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.6% and 8.75% as of December 31, 1993 and 1992, respectively. The expected long-term rate of return on plan assets used in 1993 and 1992 was 9.5%. Rates of 3% to 6% were used to estimate future salary levels. At December 31, 1993, plan assets consisted of approxi- mately 8% in cash equivalents and short-term debt investments, 37% in equity investments, and 55% in fixed income and other invest- ments. At December 31, 1992, plan assets consisted of approximate- ly 4% in cash equivalents and short-term debt investments, 70% in equity investments, and 26% in fixed income and other investments. The following items are the components of the net pension cost for the qualified defined benefit plans: 1993 1992 1991 ---- ---- ---- (in millions) Service cost (benefits earned during the year) $ 90 $ 79 $ 98 Interest cost on projected benefit obligation 188 171 168 Actual return on plan assets (224) (114) (353) Net amortization and deferral 40 (65) 201 ---- ---- ---- Net pension cost $ 94 $ 71 $ 114 ==== ==== ==== Net pension cost for 1993 and 1991 presented above excludes a charge of approximately $33.9 million and $21.6 million, respec- tively, related to "early-out" incentive programs offered to a limited number of USAir employees during the years. No such charges were incurred in 1992. Non-qualified supplemental pension plans are established for certain employee groups, which provide incremental pension payments from the Company's funds so that total pension payments equal amounts that would have been payable from the Company's principal pension plans if it were not for limitations imposed by income tax regulations. The following table sets forth the non-qualified plans' status at December 31, 1993 and 1992: Net supplementary pension cost for the two years included the following components: The discount rate used to determine the actuarial present value of the projected benefit obligation was 7.5% and 8.75% as of December 31, 1993 and 1992, respectively. Rates of 3% and 6% were used to estimate future salary levels. In addition to the qualified and non-qualified defined benefit plans described above, USAir also contributes to certain defined contribution plans primarily for employees not covered under a collective bargaining agreement. Company contributions are based on a formula which considers the age and pre-tax earnings of each employee and the amount of employee contributions. USAir's contribution expense was $42 million for 1993. USAir recognized no such expense in 1992 and 1991. (b) Postretirement Benefits Other Than Pensions USAir offers medical and life insurance benefits to employees who retire from the Company and their eligible dependents. The medical benefits provided by USAir are coordinated with Medicare benefits. Retirees generally contribute amounts towards the cost of their medical expenses based on years of service with the Company. USAir provides uninsured death benefit payments to survivors of retired employees for stated dollar amounts, or in the case of retired pilot employees, death benefit payments determined by age and level of pension benefit. The plans for postretirement medical and death benefits are funded on the pay-as-you-go basis. USAir adopted Statement of Financial Accounting Standards No. 106 ("FAS 106") during 1992 and elected to record the January 1, 1992 Accumulated Postretirement Benefit Obligation ("APBO") using the immediate recognition approach. The cumulative effect of adopting FAS 106 was $745.5 million ($638.8 million net of tax benefit). The following table sets forth the financial status of the plans as of December 31, 1993 and 1992: The postretirement benefit expense for 1993 presented above excludes a charge of approximately $15.5 million related to "early- out" programs offered to a limited number of employees during the year. No such charges were incurred in 1992 or 1991. The discount rate used to determine the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate used in measuring the APBO was 10.5% in 1993 and 1994, declining by 1% per year after 1994 to an ultimate rate of 4.5%. If the assumed health care cost trend rate were increased by 1 percentage point, the APBO at December 31, 1993 would be increased by 10% and 1993 periodic postretirement benefit cost would increase 13%. Prior to the adoption of FAS 106, USAir recognized expense for retiree health care at an estimated monthly rate (based on payments) and recognized expense for death benefits when paid. The expense using this methodology was approximately $8 million for 1991. (c) Postemployment Benefits USAir adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), during 1993. FAS 112 requires the use of an accrual method to recognize postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 was $43.7 million. (10) SUPPLEMENTAL BALANCE SHEET INFORMATION The components of certain accounts in the accompanying balance sheets are as follows: (11) NON-RECURRING AND UNUSUAL ITEMS (a) 1993 USAir's results for 1993 include non-recurring charges of (i) $43.7 million for the cumulative effect of an accounting change, as required by FAS 112 which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (ii) $68.8 million for severance, early retirement and other personnel-related expenses recorded primarily during the third quarter of 1993 in connection with a workforce reduction of approximately 2,500 full-time positions between November 1993 and the first half of 1994; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions, recorded in the fourth quarter of 1993; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service, recorded in the fourth quarter of 1993; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership, which operates a computerized reservation system, recorded in the fourth quarter of 1993; and (vi) $18.4 million credit related to non-operating aircraft, recorded in the second quarter of 1993. (b) 1992 USAir's results for 1992 include (i) a charge of $628.1 million for the cumulative effect of an accounting change as required by FAS 106, effective January 1, 1992; (ii) a $107.4 million charge related to certain aircraft which have been withdrawn from service, recorded in the fourth quarter of 1992; and (iii) a $34.1 million non-operating loss related to the sale of ten MD-82 aircraft which USAir eliminated from its fleet plan, recorded in the fourth quarter of 1992. (c) 1991 USAir's results for 1991 include (i) a $107 million a pre-tax gain related to freezing of the fully funded non-contract employee pension plan; (ii) a $21.6 million pre-tax expense related to early retirement incentives offered to certain employees during 1991; (iii) a $21 million pre-tax charge to establish an additional reserve for USAir's grounded BAe-146 fleet; and (iv) a $18.5 million, net, in miscellaneous pre-tax non-recurring charges. (12) SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents selected quarterly financial data for 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 USAir Group, Inc. Each of the persons listed below is currently a director of the Company and was elected in 1993 by the stockholders of the Company. Each director of the Company is also a director of USAir. Except as noted otherwise, the following biographies disclose the age and describe the business experience of each Director for at least the past five years. As required by the Investment Agreement, the Board of Directors amended the Company's By-Laws on January 21, 1993 to increase the authorized number of directors by three and immediately thereafter elected Messrs. Marshall, Maynard and Stevens to fill the new directorships. Under the Investment Agreement, the Company is required to use its best efforts to ensure that the slate of persons nominated by the Company for election as directors of the Company includes that number of persons designated by BA that is the percentage of the total then authorized number of directors, which is currently 16, of the Company that is nearest to but not greater than the percentage (but in no event greater than 25%) of the aggregate voting power of the securities that vote with the Common Stock as a single class for the election of directors of the Company then held by BA and its wholly-owned subsidiaries. Under this provision of the Investment Agreement, BA is entitled to designate three directors to the Board of Directors and has accordingly designated Messrs. Marshall, Maynard and Stevens. Served as Director since -------- Warren E. Buffett, 63.... Mr. Buffett has been Chairman 1993 and Chief Executive Officer of Berkshire Hathaway Inc. (insurance, candy, retailing, manufacturing and publishing) since 1970. He is also a Director of Capital Cities/ ABC, Inc., The Coca-Cola Company, The Gillette Comp- pany and Salomon Inc. Mr. Buffett is a member of the Finance and Planning Committee of the Board of Directors. Edwin I. Colodny, 67..... Mr. Colodny is of counsel to 1975 the law firm of Paul, Has- tings, Janofsky & Walker. He retired as Chairman of the Company and of USAir in July 1992. He served as Chief Executive Officer of USAir from 1975 until retiring as an employee of USAir in June 1991. Mr. Colodny is a Director of Martin Marietta Corporation, Comsat Corporation and Ester- line Technologies, Inc., and is a member of the Board of Trustees of the University of Rochester. He is a member of the Finance and Planning and Nominating Committees of the Board of Directors. Mathias J. DeVito, 63.... Mr. DeVito is Chairman of the 1981 Board and Chief Executive Officer of The Rouse Com- pany (real estate develop- ment and management). He also serves as a Director of First Maryland Bancorp and subsidiaries of The Rouse Company. He is a member of the Board of the Business Committee for the Arts and former Chair of the Greater Baltimore Committee. Mr. DeVito is Chairman of the Compensation and Benefits Committee and a member of the Finance and Planning Committee of the Board of Directors. George J. W. Goodman, 63.. Mr. Goodman is President of 1978 Continental Fidelity, Inc. which provides editorial and investment services. He is the author of a number of books and articles on finance and economics under the pen name "Adam Smith" and is the host of a television series of that name seen on public broadcasting stations in the U.S. and on other networks abroad. He is a Director of Cambrex Corporation. Mr. Goodman also serves as a mem- ber of the Advisory Committee of the Center for International Relations at Princeton Univer- sity, and is a Trustee of the Urban Institute. He is a mem- ber of the Compensation and Benefits and Finance and Planning Committees of the Board of Directors. John W. Harris, 47....... Mr. Harris is President of 1991 The Harris Group (real estate development). From 1972 through 1991, he was President of The Bissell Companies, Inc. (real estate development). He is a Director of Southern Bell Telephone and Telegraph Company. Mr. Harris is former Chairman of the Greater Charlotte Chamber of Commerce and a member of the Board of Trustees of the University of North Carolina and serves on the boards of several community service organiza- tions. He is a member of the Audit and Compensation and Benefits Committees of the Board of Directors. Edward A. Horrigan, Jr., 64 Mr. Horrigan is Chairman and 1987 Chief Executive Officer of Liggett Group Inc. (consumer products), a position he has held since May 1993. He is also the retired Vice Chairman of the Board of RJR Nabisco, Inc. and retired Chairman and Chief Executive Officer of R. J. Reynolds Tobacco Company, Winston -Salem, North Carolina (consumer products). He is a Director of the Haggai Foun- dation. Mr. Horrigan is a member of the Audit and Nominating Committees of the Board of Directors. Robert LeBuhn, 61......... Mr. LeBuhn is Chairman of 1966 Investor International (U.S.), Inc. (investments) and is a Director of Acceptance Insur- ance Companies, Amdura Corp., Lomas Financial Corp. and Cambrex Corporation. He is Trustee and President of the Geraldine R. Dodge Foun- dation, Morristown, New Jersey and is a member of the New York Society of Security Analysts. He is Chairman of the Finance and Planning Committee and a member of the Nominating Committee of the Board of Directors. Sir Colin Marshall, 60.... Sir Colin was elected Chairman 1993 of BA in February 1993. Prev- iously, he had been Chief Executive of BA and a member of BA's Board of Directors since 1983. Sir Colin is a Director of Grand Metropolitan plc, HSBC Holdings Plc, and IBM United Kingdom Holdings Limited. He is a member of the Finance and Planning Committee of the Board of Directors. Roger P. Maynard, 51...... Mr. Maynard has been Director 1993 of Corporate Strategy of BA since 1991. Previously, from 1987, he had held various positions at BA, including Director of Investor Relations & Marketplace Performance and Executive Vice President North America. Mr. Maynard is a member of the Nominating and Compensation and Benefits Committees of the Board of Directors. John G. Medlin, Jr, 60.... Mr. Medlin is Chairman of the 1987 Board and, until December 31, 1993, was Chief Executive Officer of Wachovia Corpor- ation (bank holding company). Mr. Medlin also serves as a Director of BellSouth Company, Media General, Inc., National Services Industries, Inc. and RJR Nabisco, Inc. He is Chair- man of the Nominating Committee and a member of the Compen- sation and Benefits Committee of the Board of Directors. Hanne M. Merriman, 52..... Mrs. Merriman is the Principal 1985 in Hanne Merriman Associates (retail business consultants). Previously, she served as President of Nan Duskin, Inc. (retailing), President and Chief Executive Officer of Honeybee, Inc., a division of Spiegel, Inc., and President of Garfinckel's, a division of Allied Stores Corporation. Mrs. Merriman is a Director of CIPSCO, Inc. Central Public Service Company, State Farm Mutual Automobile Insurance Company, The Rouse Company and Ann Taylor Stores Corporation. She is a member of the National Women's Forum and a Trustee of The American-Scandinavian Founda- tion. She was a member of the Board of Directors of the Federal Reserve Bank of Richmond, Virginia from 1984- 1990 and served as Chairman in 1989-1990. Mrs. Merriman is Chairman of the Audit Committee and is a member of the Nominating Committee of the Board of Directors. Charles T. Munger, 70..... Mr. Munger is Vice Chairman of 1993 Berkshire Hathaway Inc. (insur- ance, candy, retailing, manu- facturing and publishing) of which he has been an officer and Director since 1975. He is Chairman of Daily Journal Corporation and is a Director of Salomon Inc. and Wesco Financial Corporation. Mr. Munger is a member of the Audit Committee of the Board of Directors. Seth E. Schofield, 54..... Mr. Schofield was elected 1989 Chairman of the Board of Directors of the Company and USAir in June 1992. In June 1991 he was elected President and Chief Execu- tive Officer of the Company and of USAir. In June 1990 he was elected President and Chief Operating Officer of USAir. He had served as Executive Vice President- Operations of USAir since 1981. Mr. Schofield joined USAir in 1957 and has held various corporate staff positions. Mr. Schofield is a Director of the Erie Insurance Group, the PNC Bank, N.A., the Greater Washington Board of Trade, the Flight Safety Foundation, and the Greater Pittsburgh Council of the Boy Scouts of America. Mr. Schofield is Chairman of the Board of Directors of the Greater Pittsburgh Chamber of Commerce, and a Board Member of the Pennsylvania Business Roundtable, Penn's Southwest Association and the Virginia Business Council. He is also a member of the Allegheny Conference on Community Development and the Federal City Council. Richard P. Simmons, 62.... Mr. Simmons is Chairman of 1987 the Board and Chairman of the Executive Committee of Allegheny Ludlum Corp. and served as its President and Chief Execu- tive Officer from 1980 to 1990. Allegheny Ludlum pro- duces stainless steel and other high alloyed steels. Mr. Simmons is also a Director and Chairman of the Executive Committee of PNC Bank Corp. and Consolidated Natural Gas. He is a member of the Ameri- can Institute of Mining, Metallurgical and Petroleum Engineers and is a fellow and Distinguished Life Member of the American Society for Metals. Mr. Simmons is a member of the M.I.T. Corpor- ation and serves on the boards of several community service organizations. He is a member of the Audit and Finance and Planning Committees of the Board of Directors. Raymond W. Smith, 56..... Mr. Smith is Chairman of 1990 the Board and Chief Executive Officer of Bell Atlantic Com- pany, which is engaged princi- pally in the telecommunications business and is one of the seven regional companies formed as a result of the divestiture of the Bell System. Previously, Mr. Smith had served as Vice Chairman and President of Bell Atlantic and Chairman of The Bell Telephone Com- pany of Pennsylvania. He is a member of the Board of Directors of CoreStates Financial Company, a trustee of the University of Pittsburgh and is active in many civic and cultural organizations. He is a mem- ber of the Compensation and Benefits and Nominating Committees of the Board of Directors. Derek M. Stevens, 55...... Mr. Stevens has been Chief 1993 Financial Officer of and a Director of BA since 1989. Previously, from 1981, he was Finance Director of TSB Group plc (financial institution). Mr. Stevens is a member of the Audit Commit- tee of the Board of Directors. The law firm of Paul, Hastings, Janofsky and Walker, with which Mr. Colodny is affiliated on an Of Counsel basis, provided legal services to USAir during 1993 and is expected to provide such services during 1994. The following persons are executive officers of the Company. For purposes of Rule 405 under the Securities Act of 1933, Messrs. Lagow, Long, Schwab, Fornaro, Frestel, Harper and Ms. Risque Rohrbach are deemed to be executive officers of the Company. There are no family relationships among any of the officers listed above. No officer was selected pursuant to any arrangement between him or her and any other person. Officers are elected annually to serve for the following year or until the election and qualification of their successors. All the executive officers except Ms. Risque Rohrbach and Messrs. Lagow, Salizzoni, Aubin, Frestel, Fornaro and Harper have been actively engaged in the business and affairs of the Company and USAir during the past five years. The business experience of the officers listed above since January 1, 1989 is as follows: Mr. Schofield was elected Executive Vice President of the Company in July 1989. At that time he was also elected Vice Chairman of the Board of the Company and of USAir. Mr. Schofield served as Executive Vice President-Operations of USAir until his election as President and Chief Operating Officer of USAir in June 1990. Effective on July 1, 1991, Mr. Schofield was elected President and Chief Executive Officer of both the Company and USAir. Effective on July 1, 1992, Mr. Schofield was elected Chairman of the Board of Directors of both the Company and USAir. Mr. Lagow was Senior Vice President-Market Planning of Northwest Airlines until February 1988, when he became Senior Vice President-Planning of United Airlines. Mr. Lagow held that position until he was elected Executive Vice President-Marketing of USAir in February 1992. Mr. Lloyd engaged in the private practice of law in Washing- ton, D.C. from 1967 until election as Vice President, General Counsel and Secretary of the Company and as Senior Vice President and General Counsel of USAir in 1987. He served in those capaci- ties until his election as Executive Vice President, Secretary and General Counsel of the Company and Executive Vice President and General Counsel of USAir in January 1991. Mr. Long served as Senior Vice President-Administration of USAir until his election as Senior Vice President-Customer Operations of USAir in June 1989. He served in that capacity until his election as Senior Vice President-Customer Services in March 1991. Mr. Long served as Senior Vice President-Customer Services until his election as Executive Vice President-Customer Services in May 1992. Mr. Salizzoni was Vice Chairman and Chief Financial Officer of Trans World Airlines and Trans World Corporation until 1987, when he became Vice Chairman and Chief Financial Officer of TW Services, Inc. He was Chairman and Chief Executive Officer of TW Services from April 1987 until August 1989, just before that company went private. Mr. Salizzoni was associated with Mancusco and Co. from August 1989 until he was elected Executive Vice President-Finance of the Company and of USAir in November 1990. Mr. Schwab served as Vice President-Management Information Systems of USAir until his election as Senior Vice President- Management Information Systems of USAir in July 1989. Mr. Schwab served in that capacity until his election as Executive Vice President-Operations in April 1991. He also served as President of USAM Corp. from April 1988 through April 1991. Mr. Aubin was Executive Advisor to the Vice Chairman, President and Chief Executive Office of Air Canada and, prior to that position, Senior Vice President Technical Operations and Chief Technical Officer of Air Canada during the relevant time. He was elected Senior Vice President-Maintenance Operations of USAir in January 1994. Mr. Fornaro was Vice President-Research of Jesup & Lamont Securities until February 1988, when he became Senior Vice President-Marketing of Braniff, Inc. In August 1988, Mr. Fornaro became Senior Vice President-Market Planning of Northwest Airlines, the position he held until February 1992. He was elected Senior Vice President-Planning of USAir in March 1992. Mr. Frestel was Vice President-Personnel and Labor Relations for The Atchinson, Topeka & Santa Fe Railway during the relevant time, and was a Director of that company from June 1988, until his election as Senior Vice President-Human Resources of USAir in January 1989. Mr. Harper was Senior Vice President-Marketing and Information Systems at Axe-Houghton Management (investment management) until his election as Vice President and Controller of the Company and USAir in December 1991. He served in that position until his election as Senior Vice President-Information Systems of USAir in October 1992. Ms. Rohrbach was a public policy and communications consultant during 1993. She was Assistant Secretary of Labor for Policy at the U.S. Department of Labor during 1991-1992. Ms. Rohrbach served on the White House staff as a member of the legislative liaison team (1981-1986) and subsequently as Assistant to the President and Secretary to the Cabinet (1987-1988). In 1989 and 1990, she was a resident fellow at Harvard University's Institute of Politics, a consultant to the Department of Energy and in the private sector. From 1988-1993, she also served as a member of the National Commission on Children. She was elected Vice President-Public and Community Relations of the Company and Senior Vice President-Public and Community Relations of USAir in January 1994. Item 11. EXECUTIVE COMPENSATION Compensation of Directors Each director, except Mr. Schofield, is paid a retainer fee of $18,000 per year for service on the Board of Directors of the Company and a fee of $600 per Board meeting or committee meeting attended. Consistent with a comprehensive cost reduction program at USAir, the retainer fee was reduced by 20% to $14,400 for an eighteen-month period commencing January 1, 1992 and ending on June 30, 1993. Mr. LeBuhn, Chairman of the Finance and Planning Committee, Mr. DeVito, Chairman of the Compensation Committee, and Mrs. Merriman, Chairman of the Audit Committee each receives an additional fee of $2,000 per year for serving in those respective capacities. Mr. Medlin, Chairman of the Nominating Committee, receives an additional fee of $1,000 per year for serving in that capacity. Mr. Schofield receives a salary in his capacity as an officer of USAir and receives no additional compensation as a director of the Company and USAir. In 1987 the Company established a retirement plan for directors who are not also employees of the Company and its subsidiaries. The plan provides that such directors shall be eligible to receive retirement benefits thereunder if they have attained seventy years of age and served at least five consecutive years on the Board of Directors or, if they have not attained age seventy, have served for at least ten consecutive years on the Board of Directors. Eligible directors receive an annual retirement benefit equal to the highest annual retainer in effect for active directors during the five years prior to retirement. If the annual retainer for active directors is increased, the annual retirement benefit paid to retired directors is increased by an amount equal to 50% of the increase in retainer paid to active directors. If a director dies prior to retirement and had served for at least five consecutive years on the Board of Directors, the deceased director's surviving spouse is eligible under the plan to receive, for a period of five years following such death, an annual death benefit equal to 50% of the annual retainer paid to such director at the time of his or her death. If a retired eligible director dies, the director's surviving spouse is eligible under the plan to receive, for a period of five years following such death, 50% of the annual retirement benefit payable to the director at the time of his or her death. The plan is administered by the Compensation Committee. COMPENSATION OF EXECUTIVE OFFICERS The Summary Compensation Table below sets forth the compensation paid during the years indicated to each of the Chief Executive Officer and the four remaining most highly compensated executive officers of the Company (including its subsidiaries). SUMMARY COMPENSATION TABLE - -------- * Under the SEC's transition rules, no disclosure is required. (A) Mr. Schofield was elected Chief Executive Officer effective June 1, 1991. (B) Mr. Lagow's employment with USAir commenced on February 7, 1992. (C) Amounts disclosed reflect reductions in salary during (i) 1993 of $24,365, $14,942, $12,250, $10,904 and $10,904, and (ii) 1992 of $87,019, $49,272, $43,750, $38,942 and $38,942 for Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab, respectively, which were implemented for all USAir officers for a fifteen-month period commencing on January 1, 1992 and ending on March 29, 1993 pursuant to a comprehensive cost reduction program at USAir. (D) Amounts disclosed include for (i) 1993, $271,288, $33,259, $73,215, and $27,621 and (ii) 1992, $171,410, $22,523, $47,974 and $16,784, received by Messrs. Schofield, Salizzoni, Lloyd and Schwab, respectively, to cover incremental tax liability resulting from income derived from the lapsing of restrictions on disposition of Restricted Stock. Any amounts disclosed in the column that are in excess of the amounts disclosed in the preceding sentence represent income derived from personal travel on USAir. (E) At December 31, 1993, Messrs. Schofield, Salizzoni, Lloyd and Schwab owned 30,000, 6,000, 4,000 and 3,200 shares of Restricted Stock, respectively. At the fair market value of the Common Stock on that date, these holdings of Restricted Stock were valued at $386,250, $77,250, $51,500, $41,200, respectively. (F) Under USAir's split dollar life insurance plan, described under "Additional Benefits" below, individual life insurance coverage is available to the named officers. During 1992, each officer paid the amount of the premium associated with the term life component of the coverage. In 1993, USAir commenced paying the premium associated with this coverage. In 1992 and 1993, USAir paid the remainder of the premium associated with the whole life component of the coverage. If all assumptions as to life expectancy and other factors occur in accordance with projections, USAir expects to recover the premiums it pays with respect to the whole life component of the coverage. The following amounts reflect the value of the benefits accrued during the years indicated, calculated on an actuarial basis, ascribed to the insurance policies purchased on the lives of the named officers (plus, with respect to 1993, the dollar value of premiums paid by USAir with respect to term life insurance): 1993--Mr. Schofield-- $29,328, Mr. Lagow--$9,716, Mr. Salizzoni--$26,010, Mr. Lloyd--$17,291 and Mr. Schwab--$11,170; 1992--Mr. Schofield--$38,495; Mr. Lagow--$12,902; Mr. Salizzoni--$34,382; Mr. Lloyd--$21,382 and Mr. Schwab--$15,555. During 1993, USAir made contributions of $34,974, $22,805, $26,212, $18,897 and $18,897 to the accounts of Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab in certain defined contribution pension plans. (G) Upon the commencement of his employment, USAir agreed to pay Mr. Lagow $1 million over four years, which amount was intended to compensate him for restricted stock and stock options which he forfeited when he left his former employer. The amount disclosed includes the first installment, $250,000, of the total payment. (H) Amount disclosed also reflects $125,000 paid to Mr. Lagow in the form of a "sign-on bonus" and $4,715 for reimbursement of relocation expenses. (I) Amount disclosed also reflects $25,380 for reimbursement of relocation expenses. Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values The following table provides information on the number of options held by the named executive officers at fiscal year-end 1993. None of the officers exercised any options during 1993 and none of the unexercised options held by these officers were in-the-money based on the fair market value of the Common Stock on December 31, 1993 ($12.875). The values reflected in the above chart represent the application of the Retirement Plan formula to the specified amounts of compensation and years of service. The credited years of service under the Retirement Plan for each of the individuals included in the Summary Compensation Table are as follows: Mr. Schofield-32 years, Mr. Lagow-2 years, Mr. Salizzoni-3 years, Mr. Lloyd-7 years and Mr. Schwab-6 years. USAir has entered into agreements with Messrs. Lagow, Salizzoni, Lloyd and Schwab which provide for a supplement to their retirement benefits under the Retirement Plan. This supplement is designed to provide such persons with those benefits they would have received had they been employed by USAir for the minimum number of years to be entitled to full retirement benefits under the Retirement Plan. USAir adopted, effective January 1, 1993, a defined contribu- tion retirement program for its eligible non-contract employees (the "Retirement Savings Plan") as a replacement for the Retirement Plan described above. Under the Retirement Savings Plan, eligible employees may elect to contribute on a tax-deferred basis up to 13% of their pre-tax compensation, subject to a maximum annual contribution of $8,994 in 1993. USAir will also contribute to each employee's account in the Retirement Savings Plan (i) a matching contribution equal to 50% of each employee's contribution, subject to a maximum of 2% of the employee's annual pre-tax compensation, (ii) a basic contribution which ranges, depending on the employee's age, from 2% to 8% of the employee's annual pre-tax compensation and (iii) if USAir's pre-tax profit margin, as defined, exceeds certain thresholds, a profit sharing contribution up to a maximum of 7.5% of an employee's annual pre-tax compensation. USAir made no contributions under the profit sharing component of the Retirement Savings Plan in 1993. Pre-tax compensation is defined for purposes of the Retirement Savings Plan as all compensation which USAir must report as wages on an employee's Form W-2, plus an employee's tax deferred contributions under such Plan up to a maximum of $235,840 in 1993. USAir also established a non-qualified supplemental defined contribution plan (the "Supplemental Savings Plan") in 1993, which credits amounts to accounts of certain officers who participate in the Retirement Savings Plan but who are adversely affected by the maximum benefit limitations under qualified plans imposed by the Code. Amounts obligated to be paid by USAir under the Supplemental Savings Plan will be deposited in a trust established for the benefit of the participants. See the "All Other Compensation" column of the Summary Compensation Table for the amounts contributed or allocated in 1993 to Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab under the Retirement Savings Plan and the Supplemental Savings Plan. Under the Retirement Savings Plan and the Supplemental Savings Plan, participants may direct the investment of their contributions and USAir's contributions to their accounts among certain invest- ment funds. Participants' contributions are fully vested when made. USAir's contributions vest when the participant has been employed by USAir for at least two years. Additional Benefits USAir has in effect an Officers' Supplemental Benefit Plan, which provides certain benefits to a current or retired officer's spouse and children under age 19 following the officer's death. These benefits include: (i) dependent survivors' monthly income benefit and (ii) dependent survivors' health care insurance. A dependent survivors' monthly income benefit is payable to the eligible spouse or children of a deceased officer or retired officer in an amount equal to 20% of the monthly basic rate of salary payable to the officer the day prior to death or, in the case of a deceased retired officer, the day prior to retirement. Monthly income benefits will be reduced by the amount of any spouse protection benefit payable from Retirement Plan funds, and are subject to cessation upon the occurrence of certain specified events. In no case are monthly income benefits payable for more than 19 years following the date of death. The eligible surviving spouse or children of a deceased officer or retired officer are also entitled to receive dependent survivors' health care insurance, which provides the medical, major medical and dental insurance benefits generally available to dependents of salaried employees of USAir. Eligibility for this coverage ceases upon the occurrence of certain specified events. USAir also maintains a split-dollar life insurance plan under which individual term life insurance is available to its officers in the amount of three times base salary. The plan also provides for accrual of a cash value component for each officer who holds a policy. Under the plan, during 1993, USAir paid the premiums on the term and whole life insurance components of the policy. The premium attributable to the term life insurance of the policy is treated as income to the participant. At death, prior to transfer of the policy to the participant, the beneficiary receives the amount of the coverage less any amount necessary to reimburse the employer for its investment, and the employee is entitled to any additional proceeds. Upon transfer of the policy to the partici- pant, the participant is entitled to the cash surrender value of the policy in excess of the amount payable to the employer for recovery of its investment. See the "All Other Compensation" column of the Summary Compensation Table for information concerning compensation with respect to Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab that was attributable to the split dollar life insurance plan. Arrangements Concerning Termination of Employment and Change of Control USAir currently has employment contracts (the "Employment Contracts") with the executive officers (the "Executives") named in the Summary Compensation Table. The terms of the Employment Contracts extend until the earlier of the fourth anniversary thereof or the Executive's normal retirement date and are subject to automatic one-year annual extensions on each anniversary date (to the fourth anniversary of such anniversary date) unless advance written notice is given by USAir. In exchange for each Executive's commitment to devote his or her full business efforts to USAir, the agreements provide that each Executive will be re-elected to a responsible executive position with duties substantially similar to those in effect during the prior year and will receive (1) an annual base salary at a rate not less than that in effect during the previous year, (2) incentive compensation as provided in the contract and (3) insurance, disability, medical and other benefits generally granted to other officers. In the event of a change of control, as defined in each Employment Contract, the term of each Employment Contract is automatically extended until the earlier of the fourth anniversary of the change of control date or the Executive's normal retirement date. As a result of amendments to the Employment Contracts entered into in June 1992, the acquisition of 20% or more of the outstanding securities of the Company under circumstances in which the acquiror would obtain the power to elect 20% or more of the members of the Board of Directors was added to the definition of a change of control under the Employment Contracts. To the extent permitted by Foreign Ownership Restric- tions and assuming the consummation of the Second Purchase (the "Second Closing") results in BA's electing at least 20% of the Board of Directors, the Second Closing would be treated as a change of control and would result in extension of the term of each Employment Contract until the earlier of the fourth anniversary of the Second Closing or the Executive's normal retirement date. On March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See Item 1. "Business-British Airways Announcement Regarding Additional Investments in the Company; Code Sharing." The Employment Contracts provide that, should USAir or any successor fail to re-elect the Executive to his or her position, assign the Executive to inappropriate duties which result in a diminution in the Executive's position, authority or responsibili- ties, fail to compensate the Executive as provided in the Employ- ment Contract, transfer the Executive in violation of the Employ- ment Contract, fail to require any successor to USAir to comply with the Employment Contract or otherwise terminate the Executive's employment in violation of the Employment Contract, the Executive may elect to treat such failure as a breach of the Employment Contract if the Executive then terminates employment. As liquidat- ed damages as the result of an event not following a change of control that is deemed to be a breach of the Employment Contracts, USAir or its successor would be required to pay the Executive an amount equal to his or her annual base salary for the then remaining term of the Employment Contract, and to continue granting certain employee benefits for the then remaining term of the Executive's Employment Contract. If the breach follows a change of control, the Executive would be entitled to receive (i) an amount equal to the product of three times the sum of the Executive's annual base salary plus an annual bonus, (ii) a lump sum equal to the actuarial equivalent of the pension benefits which the Executive would have received had he or she remained employed by USAir until the end of the term of the Employment Contract, (iii) medical benefits until such time as the Executive qualifies for group medical benefits from another employer, (iv) travel benefits for the Executive's life, (v) reimbursement of reductions in salary sustained by the Executive as a result of a comprehensive cost reduction program initiated by USAir in October 1991, and (vi) continuation of certain other benefits during the remainder of the term of the Employment Contract. In addition, except under the circumstances described in the immediately following paragraph, during the 30-day period immediately following the first anniversa ry of a change of control any Executive could elect to terminate his or her Employment Contract for any reason and receive the liquidated damages described in the immediately preceding sentence. Each Employment Contract provides that if USAir breaches the Employment Contract, as described above, each Executive shall be entitled to recover from USAir reasonable attorney's fees in connection with enforcement of such Executive's rights under the Employment Contract. Each Employment Contract also provides that any payments the Executive receives in the event of a termination shall be increased, if necessary, such that, after taking into account all taxes he or she would incur as a result of such payments, the Executive would receive the same after-tax amount he or she would have received had no excise tax been imposed under Section 4999 of the Code. In order to facilitate consummation of the acts and transac- tions contemplated by the Investment Agreement, the Executives agreed in January 1993 to an amendment to their Employment Contracts that will become effective upon the Second Closing (i) to eliminate their right to elect to terminate their Employment Contracts without any reason during the 30-day period immediately following the first anniversary of the Second Closing; (ii) that USAir may transfer the Executive's employment to any location that meets certain criteria in the Employment Contracts without such relocation constituting a breach of the Employment Contracts; (iii) that consummation of the Second Closing would be treated as the only change of control with respect to BA; and (iv) that following the Second Closing, USAir may make certain changes in benefit plans affecting the Executives that are not material, as that term is defined in the Employment Contracts, provided that the changes apply to all eligible officers of USAir and are approved by a majority of the directors of the Company not elected by BA. Currently, under the Company's 1984 Stock Option and Stock Appreciation Rights Plan (the "1984 Plan") and 1988 Stock Incentive Plan (the "1988 Plan," and together with the 1984 Plan, the "Plans"), pursuant to which employees of the Company and its subsidiaries have been awarded stock options and stock appreciation rights with respect to Common Stock and, in the case of the 1988 Plan, shares of Restricted Stock, occurrence of a change of control, as defined, would make all granted options immediately exercisable without regard to the vesting provisions thereof. In addition, grantees would be able, during the 60-day period immediately following a change of control (the "Cash-out Right"), to surrender all unexercised stock options not issued in tandem with stock appreciation rights under the Plans to the Company for a cash payment equal to the excess, if any, of the fair market value of the Common Stock over the exercise prices of such stock options or the positive value of any stock appreciation rights. As described above, in June 1992, the Company amended the definition of a change of control in the Plans with the result that, to the extent permitted by Foreign Ownership Restrictions and assuming the Second Closing results in BA's electing at least 20% of the Board of Directors, the Second Closing would be treated as a change of control thereunder. As of March 1, 1994, there were unexercised stock options to purchase 548,310 shares of Common Stock (of which 84,600 had tandem stock appreciation rights) under the 1984 Plan and unexercised stock options to purchase 3,625,500 shares of Common Stock (none of which had tandem stock appreciation rights) under the 1988 Plan. (As of March 1, 1994, 3,177,400 of the 3,625,500 options outstanding under the 1988 Plan and 322,910 of the 548,310 options outstanding under the 1984 Plan were exercis- able pursuant to their normal vesting schedule.) The weighted average exercise price of all the outstanding stock options was approximately $23.15. On February 28, 1994, the closing price of a share of Common Stock on the NYSE was $11.375. See the "Aggre- gated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values" table for information regarding stock options held by the Executives. Currently, 50,400 shares of Restricted Stock previously granted to the Executives may (i) become free of transfer restric- tions upon their normal vesting schedule or (ii) be subject to accelerated vesting upon a termination of employment which triggers the payment of liquidated damages under the Employment Contracts, as discussed above, regardless of whether the termination occurred following a change of control as defined in the Employment Contracts. See "Beneficial Security Ownership" for information regarding Restricted Stock owned by the Executives. With respect to Mr. Lagow, in order to induce him to accept its offer of employment in 1992, USAir agreed, among other things, to pay Mr. Lagow $1 million in four equal installments, each installment being due and payable on the first four anniversaries of the commencement of his employment by USAir, provided Mr. Lagow remains employed by USAir. This payment was intended to compensate Mr. Lagow for stock options and restricted stock which he forfeited when he left his former employer. In the event of a change of control under his Employment Contract or wrongful termination thereunder, USAir has also agreed to pay Mr. Lagow in a lump sum any unpaid balance of this obligation. Notwithstanding anything to the contrary set forth in any of the Company's or USAir's filings under the Securities Act of 1933, as amended (the "Securities Act"), or the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that incorporates by reference this Proxy Statement, in whole or in part, the following Report and Performance Graph shall not be incorporated by reference into any such filings. Report of the Compensation and Benefits Committee of the Board of Directors The Compensation Committee policies with respect to compensa- tion of the Company's executive officers are to: 1. Attract and retain talented and experienced senior management by offering compensation that is competitive with respect to other major U.S. airlines and other U.S. companies of comparable size. 2. Motivate senior management to provide a high-quality product to consumers with the ultimate goal of maximizing profit- ability and stockholder returns by offering incentive and long-term compensation that is linked to return on sales and the market value of the Common Stock. The Compensation Committee has played an active role in the oversight and review of all executive compensation paid to executive officers of the Company during the last fiscal year. Ordinarily, the Compensation Committee and the full Board of Directors, in consultation with the Senior Vice President-Human Resources of USAir and, if warranted, an independent compensation consultant, annually review the total compensation package (comprised of base salary, incentive compensation, and long-term incentive compensation) of the Chairman, President and Chief Executive Officer. The Compensation Committee reviews the market rate for peer-level positions of the other major domestic passenger carriers including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." Based primarily on this comparison, the Compensation Committee establishes the Chief Executive Officer's base salary. Mr. Schofield does not participate in Compensation Committee or Board of Directors deliberations or decision-making regarding any aspect of his compensation. Correspondingly, the Compensation Committee established the compensation reported for 1993 for the Company's other executive officers, including the four officers named in the Summary Compensation Table, based upon a comparison of peer positions at the other major U.S. airlines including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." The principal elements of the Company's compensation paid to the executive officers in the last completed fiscal year are discussed below. Base Salary. As part of a comprehensive program to reduce costs at USAir, the Compensation Committee reduced the salaries of the executive officers and the other officers of USAir for a fifteen month period commencing on January 1, 1992 and ending on March 29, 1993. The Compensation Committee reduced each ex- ecutive's base salary in accordance with the following graduated schedule: ~ First $20,000 of salary reduced by 0% ~ Next $30,000 of salary reduced by 10% ($20,000 to $50,000) ~ Next $50,000 of salary reduced by 15% ($50,000 to $100,000) ~ Any amount of salary in excess of $100,000 reduced by 20%. Each of the executive officers agreed to the reductions in salary, which otherwise would have constituted grounds for the executives to have terminated their employment agreements with USAir. The amounts of salary not paid in 1992 and 1993 to Mr. Schofield and the other four executive officers named in the Summary Compensation Table are disclosed in footnote (C) to that table. As stated above, the Compensation Committee establishes the base salaries of the Company's executive officers primarily by reference to the salaries of officers holding comparable positions at other major U.S. airlines including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." Historically, the Compensation Committee had awarded merit increases based on measuring individual performance against objectives. However, due to the Company's poor financial performance, the Compensation Committee last awarded merit increases in executive base salaries in 1989. Since 1989 the Compensation Committee had increased the salaries of executive officers solely as a result of a promotion or an increase in responsibilities. The Company commissioned an independent compensation consultant to conduct a comprehensive study of the salaries of comparable airline officers in 1992. The study disclosed that the salaries (prior to the fifteen-month reduction described above) of most officers were substantially below those of salaries for analogous positions at major competi- tors. Following the study, in July 1992, the Compensation Committee prospectively set the salaries of executive officers generally at the median of the comparative range adjusted by individual performance and experience, effective April 1993. In connection with the same review, the Compensation Committee proposed to increase Mr. Schofield's base salary (before adjustment for the fifteen-month salary reductions) from $500,000 to $590,000, effective April 1993. Because the Company has continued to sustain losses, Mr. Schofield declined to accept the increase in base salary. Annual Cash Incentive Compensation Program: The Compensation Committee adopted the Executive Incentive Compensation Plan effective on January 1, 1988. The plan is administered by the Compensation Committee. All officers, including executive officers, of the Company are eligible to participate in this plan. The Compensation Committee is authorized to grant awards under this plan only if the Company achieves for a fiscal year a two percent or greater return on sales ("ROS"). The target level of performance is four percent ROS. If the Company achieves the target performance of four percent ROS, the full target percentage (which varies depending on position) is applied against the individual's base salary for the year to determine the target bonus award (the "Target Award") for the individual. Target Awards for executive officers range between 30% and 50% of base salary. If the minimum level of performance of two percent ROS is achieved, 50% of the Target Award would be available for distribution. If the maximum level of performance of six percent ROS is achieved, 200% of the Target Award would be available for payment. The Compensation Committee may adjust awards made to executive officers based on individual performance; however, no award may exceed 250% of the Target Award for any individual. The Compensation Committee last approved payments to executive officers under this plan for the fiscal year ended December 31, 1988. The Company has not achieved the minimum two percent ROS in any fiscal year, and the Compensation Committee has not made any awards under the plan, since then. Long-Term Incentive Programs Stock Options: The executive officers of the Company partici- pate in the Company's 1984 Stock Option and Stock Appreciation Rights Plan (the "1984 Plan") and 1988 Stock Incentive Plan (the "1988 Plan", and together with the 1984 Plan, the "Plans") which are both administered by the Compensation Committee. The Compensation Committee is authorized to grant options under these Plans only at an exercise price equal to the fair market value of a share of Common Stock on the date of grant. During 1993, the Compensation Committee did not grant any options from either of the Plans to the executive officers. The Compensation Committee determines the size of any option grant under the Plans based upon (i) the Compensation Committee's perceived value of the grant to motivate and retain the individual executive, (ii) a comparison of long-term incentive practices within the commercial airline industry, (iii) a comparison of awards provided to peer executives within the Company and (iv) the number of outstanding options held by the grantee and the exercise prices of these options. Although the Compensation Committee supports and encourages stock ownership in the Company by executive officers, it has not promulgated any standards regarding levels of ownership by executive officers. Pursuant to the reductions in the executive officers' salaries discussed above, in 1992 the Compensation Committee granted these persons non-qualified stock options to purchase 50 shares of Common Stock at $15 per share for each $1,000 of salary foregone during the wage reduction program, as is the case for each USAir employee whose pay was reduced pursuant to the program. Restricted Stock The Compensation Committee did not award any Restricted Stock under the 1988 Plan during 1993. (Grants of Restricted Stock are not authorized under the 1984 Plan). From 1988-1990, the Compensation Committee granted Restricted Stock to a total of nine executive officers, some of whom are no longer employed by USAir. During 1993, restrictions on disposition expired on a total of 23,200 shares of Restricted Stock held by Mr. Schofield, which shares were originally granted between 1988 and 1990. Restrictions on disposition also lapsed during 1993 on a total of 10,900 shares of Restricted Stock held by Messrs. Salizzoni, Lloyd and Schwab, which shares were originally granted between 1988 and 1990. The Omnibus Budget Reconciliation Act of 1993 added Section 162(m) to the Internal Revenue Code. Section 162(m) provides that companies will not be entitled to a tax deduction for certain compensation paid to any executive officer to the extent that the compensation exceeds $1 million in a taxable year. The Compensa- tion Committee is studying Section 162(m) and the proposed rules thereunder and is in the process of determining whether to recommend that the Company take the necessary measures to conform its compensation to Section 162(m). The Compensation Committee will continue to review all compensation and benefit matters presented to it and will act based upon the best information available in the best interests of the Company, its stockholders and employees. Mathias J. DeVito, Chairman George J. W. Goodman John W. Harris Roger P. Maynard John G. Medlin, Jr. Raymond W. Smith PERFORMANCE GRAPH This graph compares the performance of the Company's Common Stock during the period January 1, 1989 to December 31, 1993 with the S&P 500 Index and the S&P Airline Index. The graph depicts the results of investing $100 in the Company's Common Stock, the S&P 500 Index and the S&P Airline Index at closing prices on Decem- ber 31, 1988. The stock price performance shown on the graph is not necessarily indicative of future performance. The S&P Airline Index consists of AMR Corporation, Delta Air Lines, Inc., UAL Corporation and the Company. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following information pertains to Common Stock, Series A Preferred Stock, Series F Preferred Stock, Series T Preferred Stock and Depositary Shares ("Depositary Shares"), each representing 1/100 of a share of the Company's $437.50 Series B Cumulative Convertible Preferred Stock, without par value ("Series B Preferred Stock"), beneficially owned by all directors and executive officers of the Company as of March 1, 1994. Unless indicated otherwise, the information refers to ownership of Common Stock. Unless indicated otherwise by footnote, the owner exercises sole voting and investment power over the securities (other than unissued securities, the ownership of which has been imputed to such owner). Series F Preferred Stock and Series T Preferred Stock, Common Stock receivable upon conversion. In addition, such Rights are issuable on a one-for-one basis with respect to shares of Common Stock receivable upon exercise of stock options or conversion of Depositary Shares. (2) Percentages are shown only where they exceed one percent of the number of shares outstanding and, in the case of Common Stock holdings are based on shares of Common Stock outstanding (exclusive of treasury stock) on March 1, 1994. (3) Various affiliates of Berkshire Hathaway Inc. ("Berkshire") are recordholders of 358,000 or 100% of the outstanding shares of Series A Preferred Stock. Messrs. Buffett and Munger are Chairman and Chief Executive Officer and Vice Chairman, respectively, of Berkshire and may be deemed to control that company. Messrs. Buffett and Munger each disclaims beneficial ownership of Series A Preferred Stock. Series A Preferred Stock is currently convertible into 9,239,944 shares of Common Stock, which represents approximately 10.5% of the total voting interest represented by Common Stock, Series F Pre- ferred Stock, Series T Preferred Stock and Series A Preferred Stock at March 1, 1994. (4) The listing of Mr. Colodny's holding includes 67,000 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options. (5) Mr. Goodman's holdings of Depositary Shares is convertible into 498 shares of Common Stock. (6) A wholly-owned subsidiary of BA is recordholder of 30,000 or 100% of the outstanding shares of Series F Preferred Stock, 152.1 or 100% of the outstanding shares of the Series T-1 Preferred Stock and 9,919.8 or 100% of the outstanding shares of the Series T-2 Preferred Stock pursuant to the Investment Agreement. Messrs. Marshall, Maynard and Stevens are Chair- man, Director of Corporate Strategy and Chief Financial Offic- er, respectively, of BA and have been designated by BA to act as directors of the Company pursuant to the Investment Agreement. Messrs. Marshall, Maynard and Stevens each dis- claims beneficial ownership of Series F Preferred Stock and Series T Preferred Stock. (7) The listing of Mr. Schofield's holding includes 335,069 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options, and 30,000 shares of Common Stock subject to certain restrictions upon disposition ("Restricted Stock"). (8) The listing of Mr. Lagow's holding reflects shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options. (9) The listing of Mr. Salizzoni's holding includes 152,800 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 6,000 shares of Restricted Stock. (10) The listing of Mr. Lloyd's holding includes 169,742 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 4,000 shares of Restricted Stock. (11) The listing of Mr. Schwab's holding includes 167,992 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 3,200 shares of Restricted Stock. (12) The listing of all directors' and officers' holdings includes 1,193,583 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 50,400 shares of Restricted Stock. The only persons known to the Company (from Company records and reports on Schedules 13D and 13G filed with the Securities and Exchange Commission (the "SEC")) which owned, as of March 1, 1994, more than 5% of its Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock are listed below: (1) Represents percent of class of stock outstanding (exclusive of treasury stock) on March 1, 1994. (2) Number of shares as to which such person has shared voting power-358,000; shared dispositive power-358,000. (3) These shares of Series A Preferred Stock are owned directly by affiliates of Berkshire, are convertible, under certain circumstances and subject to certain antidilution adjustments, into 9,239,944 shares of Common Stock and represent approxi- mately 10.5% of the combined voting power of the outstanding Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock, voting as a single class, at March 1, 1994. A number of Rights, equal to the number of shares of Common Stock into which the Series A Preferred Stock is convertible, is also owned by this person. As disclosed above, two directors of the Company, Messrs. Buffett and Munger, may be deemed to control Berkshire and disclaim beneficial ownership of Series A Preferred Stock. (4) Number of shares as to which BA has sole voting power and sole dispositive power-30,000. (5) BritAir Acquisition Corp. Inc. is a wholly-owned subsidiary of BA and owns Series F Preferred Stock and Series T Preferred Stock pursuant to the Investment Agreement. Series F Preferred Stock and Series T Preferred Stock are convertible, under certain circumstances on or after January 21, 1997 and subject to certain antidilution adjustments and Foreign Ownership Restrictions, into a total of 15,458,658 and 3,831,695 shares of Common Stock, respectively. Together, the Series F Pre- ferred Stock and Series T Preferred Stock represent approxi- mately 21.9% of the combined voting power of the outstanding Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock, voting as a single class, at March 1, 1994. A number of Rights, equal to the number of shares of Common Stock into which the Series F Preferred Stock and Series T Preferred Stock are convertible, is owned by this person. As disclosed above, three directors of the Company, Messrs. Marshall, Maynard and Stevens, have been designated by BA to act as directors of the Company pursuant to the Invest- ment Agreement and disclaim beneficial ownership of Series F Preferred Stock and Series T Preferred Stock. (6) Reflects 152.1 or 100% of the outstanding shares of Series T-1 Preferred Stock and 9,919.8 or 100% of the outstanding shares of Series T-2 Preferred Stock. BA has sole voting power and sole dispositive power as to all these outstanding shares of Series T Preferred Stock. (7) The Schedule 13G dated January 6, 1994 disclosing such ownership was jointly filed by such person with five French mutual insurance companies ("Mutuelles AXA") and AXA. The Schedule 13G indicated that each of Mutuelles AXA, as a group, and AXA expressly declares that the filing of the Schedule 13G should not be construed as an admission that it is, for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended, the beneficial owner of any securities covered by the Schedule 13G. The Company is investigating whether, owing to the investment of Mutuelles AXA and AXA (collectively, "AXA") in the Equitable Companies Incorporated ("Equitable"), AXA is the beneficial owner of these shares. If it is determined that AXA is the beneficial owner, then self-effectuating provisions of the Company's restated certificate of incorporation, as amended, would provide that the subject shares would be non-voting shares. The Company does not know whether Equitable would cause such shares to be sold in the event such shares have no voting rights. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Industry Globalization and Regula- tion" for information regarding U.S. statutory limitations on foreign ownership of U.S. air carriers and Item 1. "Business- British Airways Investment Agreement" and notes (4), (5) and (6) above for information regarding BA's ownership interest in the Company. (8) Number of shares as to which person has sole voting power- 5,669,403; shared voting power-1,300; no voting power-636,800; sole dispositive power-6,305,703; shared dispositive power- none; no dispositive power-1,800. (9) The shares are owned by a direct and an indirect subsidiary of the person. Number of shares as to which such subsidiaries have sole voting power-4,832,200; sole dispositive power- 4,832,200. In connection with BA's purchase of the Series T Preferred Stock in June 1993, Messrs. Marshall, Maynard and Stevens and BA were required by Section 16 of the Securities Exchange Act of 1934, as amended, and rules thereunder to file by July 10, 1993, Form 4 reports disclosing this change of ownership. Messrs. Marshall, Maynard and Stevens and BA filed these reports on September 14, 1993. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None 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. FINANCIAL STATEMENTS (i) The following consolidated financial statements of USAir Group are included in Part II, Item 8A of this report: - Consolidated Statements of Operations for each of the Three Years Ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and - Consolidated Statements of Cash Flows for each of the Three Years Ended December 31, 1993 - Consolidated Statements of Changes in Stockholders' Equity for each of the Three Years Ended December 31, - Notes to Consolidated Financial Statements (ii) The following consolidated financial statements of USAir are included in Part II, Item 8B of this report: - Consolidated Statements of Operations for each of the Three Years Ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and - Consolidated Statements of Cash Flows for each of the Three Years Ended December 31, 1993 - Consolidated Statements of Changes in Stockholder's Equity for each of the Three Years Ended December 31, - Notes to Consolidated Financial Statements 2. FINANCIAL STATEMENT SCHEDULES (i) Independent Auditors' Report on Consolidated Financial Statement Schedules of USAir Group. - Consolidated Financial Statement Schedules - Three Years Ended December 31, 1993: V - Property, Equipment and Leasehold Improvements VI - Accumulated Depreciation and Amortization of Prop- erty, Equipment and Leasehold Improvements VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts and Reserves X - Supplementary Income Statement Information (ii) Independent Auditors' Report on Consolidated Financial Statement Schedules of USAir. - Consolidated Financial Statement Schedules - Three Years Ended December 31, 1993: IV - Indebtedness to Related Parties - Not Current V - Property, Equipment and Leasehold Improvements VI - Accumulated Depreciation and Amortization of Prop- erty, Equipment and Leasehold Improvements VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts and Reserves X - Supplementary Income Statement Information All other schedules are omitted because they are not appli- cable or not required, or because the required information is either incorporated herein by reference or included in the financial statements or notes thereto included in this report. (b) Reports on Form 8-K During the quarter ended December 31, 1993, the Company and USAir filed Current Reports dated September 23, October 20, and November 4, 1993, on Form 8-K regarding the Second Waiver dated September 15, 1993 to the Credit Agreement, results for the quarter ended September 30, 1993 and the sale of $337.7 million of pass through certificates, respectively. The Company and USAir filed a Current Report dated January 18, 1994 on Form 8-K regarding the Third Waiver dated as of December 21, 1993 to the Credit Agreement. In addition, the Company and USAir filed a Current Report dated January 25, 1994 on Form 8-K regarding the press release dated January 25, 1994 of USAir Group, Inc. and USAir, Inc., with consolidated statements of operations for each company. On March 9, 1994, the Company and USAir filed a Current Report on Form 8-K disclosing projected losses for the first quarter and year 1994 and the initiation of negotiations with the leadership of USAir's unions regarding pay reductions and productivity improvements. 3. EXHIBITS Designation Description 3.1 Restated Certificate of Incorporation of USAir Group (incorporated by reference to Exhibit 3.1 to USAir Group's Registration Statement on Form 8-B dated January 27, 1983), including the Certificate of Amend- ment dated May 13, 1987 (incorporated by reference to Exhibit 3.1 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987), the Certificate of Increase dated June 30, 1987 (incorporated by reference to Exhibit 3 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987), the Certificate of Increase dated October 16, 1987 (incorporated by reference to Exhibit 3.1 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended September 30, 1987), the Certificate of Increase dated August 7, 1989 (incorporated by reference to Exhibit 3.1 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989), the Certificate of Increase dated April 9, 1992, the Certificate of Increase dated January 21, 1993, and as amended by Amendment No. 1 dated May 26, 1993 (incorporated by reference to Appendix II to USAir Group's Proxy State- ment dated April 26, 1993). 3.2 By-Laws of USAir Group (incorporated by reference to Exhibit 3.2 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1992). 3.3 Rights Agreement, dated as of July 29, 1989, as amended and restated as of January 21, 1993, between USAir Group and Chemical Bank, as Rights Agent (incorporated by reference to Exhibit 28.4 to USAir Group's Current Report on Form 8-K dated January 21, 1993). 3.4 Restated Certificate of Incorporation of USAir (in- corporated by reference to Exhibit 3.1 to USAir's Registration Statement on Form 8-B dated January 27, 1983). 3.5 By-Laws of USAir (incorporated by reference to Exhibit 3.5 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1992). 4.1 Amended Certificate of Designation, Preferences, and Rights of the Series D of Junior Preferred Stock of USAir Group (incorporated by reference to Exhibit 4(c) to USAir Group's Current Report on Form 8-K dated August 11, 1989). 4.2 Certificate of Designation of Series A Cumulative Convertible Preferred Stock of USAir Group (incorpo- rated by reference to Exhibit 4(b) to USAir Group's Current Report on Form 8-K dated August 11, 1989). 4.3 Certificate of Designation of Series B Cumulative Convertible Preferred Stock of USAir Group (incorpo- rated by reference to Exhibit 3.3 to Amendment No. 4 to USAir Group's Registration Statement on Form S-3 (Registration No. 33-39540) dated May 17, 1991). 4.4 Agreement between USAir Group and Berkshire Hathaway Inc. dated August 7, 1989 (incorporated by reference to Exhibit 4(a) to USAir Group's Current Report on Form 8- K dated August 11, 1989). 4.5 Certificate of Designation of Series F Cumulative Convertible Senior Preferred Stock of USAir Group (incorporated by reference to Exhibit 28.2 to USAir Group's Current Report on Form 8-K dated January 21, 1993). 4.6 Form of Certificate of Designation of Series T-_ Cumulative Exchangeable Convertible Senior Preferred Stock of USAir Group (incorporated by reference to Appendix VII to USAir Group's Proxy Statement dated April 26, 1993). Neither USAir Group nor USAir is filing any instrument (with the exception of holders of exhibits 10.1(a-h)) defining the rights of holders of long-term debt because the total amount of securities authorized under each such instrument does not exceed ten percent of the total assets of USAir. Copies of such instruments will be furnished to the Securities and Exchange Commission upon request. 10.1(a) Credit Agreement dated as of March 30, 1987 and Amended and Restated as of October 21, 1988 among the Banks named therein and USAir Group (incorporated by reference to Exhibit 28.2 to Amendment No. 1 dated October 28, 1988 to Piedmont's Registration Statement on Form S-3 No. 33-24870 dated October 7, 1988). 10.1(b) First Amendment, dated as of July 28, 1989, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 10.1(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.1(c) Second Amendment, dated as of February 15, 1990, to USAir Group's Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.1 to USAir Group's Current Report on Form 8-K dated October 26, 1990). 10.1(d) Third Amendment, dated as of September 30, 1990, to USAir Group's Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.2 to USAir Group's Current Report on Form 8-K dated October 26, 1990). 10.1(e) Fourth Amendment, dated as of March 29, 1991, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to the Exhibit to USAir Group's Current Report on Form 8-K dated April 23, 1991). 10.1(f) Fifth Amendment, dated as of April 26, 1991, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28.7 to USAir Group's Registration Statement on Form S-8 No. 33-39540 dated April 26, 1991). 10.1(g) Sixth Amendment, dated as of October 14, 1992, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28.3 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992). 10.1(h) Seventh Amendment, dated as of June 21, 1993, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28 to USAir Group's Current Report on Form 8-K filed on July 1, 1993). 10.2(a) Supplemental Agreement No. 16, dated July 19, 1990, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(a) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1990). 10.2(b) Supplemental Agreement No. 17, dated November 28, 1990, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1990). 10.2(c) Supplemental Agreement No. 18, dated December 23, 1991, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(c) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1991). 10.3 Purchase Agreement No. 1725 dated December 23, 1991 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.3 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended Decem- ber 31, 1991). 10.4 USAir, Inc. Executive Incentive Compensation Plan (incorporated by reference to Exhibit 10.3 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.5 USAir, Inc. Officers' Supplemental Benefit Plan (incorporated by reference to Exhibit 10.5 to USAir's Annual Report on Form 10-K for the year ended December 31, 1980). 10.6 USAir, Inc. Supplementary Retirement Benefit Plan (incorporated by reference to Exhibit 10.5 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.7 USAir Group's 1984 Stock Option and Stock Appreciation Rights Plan (incorporated by reference to Exhibit A to USAir Group's Proxy Statement dated March 30, 1984). 10.8 USAir Group's 1988 Stock Incentive Plan (incorporated by reference to Exhibit 10.15 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1987). 10.9 USAir Group's 1992 Stock Option Plan (incorporated by reference to Exhibit A to USAir Group's Proxy Statement dated March 30, 1992). 10.10 Employment Agreement between USAir and its President and Chief Executive Officer (which is similar in form to the employment agreements of USAir Group's other executive officers) (incorporated by reference to Exhibit 10.9 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1991). 10.11 Agreements providing supplemental retirement benefits for the following officers of USAir: Executive Vice President and General Counsel (incorporated by reference to Exhibit 10.14 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1987), Executive Vice President-Operations, Senior Vice President-Corporate Communications and Senior Vice President-Human Resources (incorporated by reference to Exhibit 10.9 to USAir Group's Annual Report on Form 10- K for the year ended December 31, 1989). 10.12(a) Trust Agreement dated as of August 1, 1989 between USAir Group and Wachovia Bank and Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 10.10(a) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.12(b) Trust Agreement dated as of August 1, 1989 between USAir and Wachovia Bank and Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 10.10(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.13 Investment Agreement dated as of January 21, 1993 between USAir Group and British Airways Plc (incorporated by reference to Exhibit 28.1 to USAir Group's and USAir's Current Report on Form 8-K filed on January 28, 1993, as amended by Amendment No. 1 on Form 8 filed on April 13, 1993). 10.13(a) Amendment dated as of February 21, 1994 to the Investment Agreement dated as of January 21, 1993 between USAir Group and British Airways Plc. 11 Computation of primary and fully diluted earnings per share of USAir Group for the five years ended December 31, 1993. 21 Subsidiaries of USAir Group and USAir. 23.1 Consent of the Auditors of USAir Group to the incorporation of their report concerning certain financial statements contained in this report in certain registration statements. 23.2 Consent of the Auditors of USAir to the incorporation of their report concerning certain financial statements contained in this report in certain registration statements. 24.1 Powers of Attorney signed by the directors of USAir Group, authorizing their signatures on this report. 24.2 Powers of Attorney signed by the directors of USAir, authorizing their signatures on this report. SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, USAir Group, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. USAir Group, Inc. By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) 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 USAir Group, Inc. and in the capacities and on the dates indicated. March 25, 1994 By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) March 25, 1994 By: /s/Frank L. Salizzoni --------------------------------- Frank L. Salizzoni Executive Vice President-Finance (Principal Financial Officer) March 25, 1994 By: /s/Ann Greer-Rector --------------------------------- Ann Greer-Rector Vice President & Controller (Principal Accounting Officer) March 25, 1994 By: * -------------------------------- Warren E. Buffett Director March 25, 1994 By: * --------------------------------- Edwin I. Colodny Director March 25, 1994 By: * -------------------------------- Mathias J. DeVito Director March 25, 1994 By: * -------------------------------- George J. W. Goodman Director March 25, 1994 By: * --------------------------------- John W. Harris Director March 25, 1994 By: * --------------------------------- Edward A. Horrigan, Jr. Director March 25, 1994 By: * --------------------------------- Robert LeBuhn Director March 25, 1994 By: * --------------------------------- Sir Colin Marshall Director March 25, 1994 By: * --------------------------------- Roger P. Maynard Director March 25, 1994 By: * --------------------------------- John G. Medlin, Jr. Director March 25, 1994 By: * --------------------------------- Hanne M. Merriman Director March 25, 1994 By: * -------------------------------- Charles T. Munger Director March 25, 1994 By: * --------------------------------- Richard P. Simmons Director March 25, 1994 By: * --------------------------------- Raymond W. Smith Director March 25, 1994 By: * -------------------------------- Derek M. Stevens Director By: /s/Frank L. Salizzoni ------------------------------ Frank L. Salizzoni Attorney-In-Fact SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, USAir, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. USAir, Inc. By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) 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 USAir, Inc. and in the capacities and on the dates indicated. March 25, 1994 By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) March 25, 1994 By: /s/Frank L. Salizzoni --------------------------------- Frank L. Salizzoni Executive Vice President-Finance (Principal Financial Officer) March 25, 1994 By: /s/Ann Greer-Rector --------------------------------- Ann Greer-Rector Vice President & Controller (Principal Accounting Officer) March 25, 1994 By: * -------------------------------- Warren E. Buffett Director March 25, 1994 By: * --------------------------------- Edwin I. Colodny Director March 25, 1994 By: * -------------------------------- Mathias J. DeVito Director March 25, 1994 By: * -------------------------------- George J. W. Goodman Director March 25, 1994 By: * --------------------------------- John W. Harris Director March 25, 1994 By: * --------------------------------- Edward A. Horrigan, Jr. Director March 25, 1994 By: * --------------------------------- Robert LeBuhn Director March 25, 1994 By: * --------------------------------- Sir Colin Marshall Director March 25, 1994 By: * --------------------------------- Roger P. Maynard Director March 25, 1994 By: * --------------------------------- John G. Medlin, Jr. Director March 25, 1994 By: * --------------------------------- Hanne M. Merriman Director March 25, 1994 By: * -------------------------------- Charles T. Munger Director March 25, 1994 By: * --------------------------------- Richard P. Simmons Director March 25, 1994 By: * --------------------------------- Raymond W. Smith Director March 25, 1994 By: * -------------------------------- Derek M. Stevens Director By: /s/Frank L. Salizzoni ------------------------------ Frank L. Salizzoni Attorney-In-Fact Independent Auditors' Report On Consolidated Financial Statement Schedules - USAir Group, Inc. The Stockholders and Board of Directors USAir Group, Inc.: Under date of February 25, 1994, we reported on the consoli- dated balance sheets of USAir Group, Inc. and subsidiaries ("Group") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholders' equity (deficit) for each of the years in the three- year period ended December 31, 1993, as included in Item 8A in this 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 as listed in Item 14(a)2(i). These consolidated financial statement schedules are the responsibility of Group's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such 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. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 Independent Auditors' Report On Consolidated Financial Statement Schedules - USAir, Inc. The Stockholder and Board of Directors USAir, Inc.: Under date of February 25, 1994, we reported on the consolidated balance sheets of USAir, Inc. and subsidiaries ("USAir") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993, as included in Item 8B in this 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 as listed in Item 14(a)2(ii). These consolidated financial statement schedules are the responsibility of USAir's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such 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. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 Exhibit 21 SUBSIDIARIES OF USAIR GROUP, INC. AND USAIR, INC. USAir Group, Inc. - ----------------- USAir, Inc. Piedmont Airlines, Inc. (formerly Henson Airlines, Inc.) Jetstream International Airlines, Inc. Pennsylvania Commuter Airlines, Inc. (d/b/a/ Allegheny Commuter Airlines) USAir Leasing and Services, Inc. USAir Fuel Corporation Material Services Corp. USAir, Inc. (the following companies are also indirect subsidiaries - ------------------------------------------------------------------- of USAir Group, Inc.) - --------------------- USAM Corp. Pacific Southwest Airmotive (substantially all of the assets of this company were sold on October 9, 1991) Exhibit 23.1 CONSENT OF INDEPENDENT AUDITORS The Board of Directors USAir Group, Inc. We consent to the incorporation by reference in the Registration Statements on Form S-8 Nos. 2-98828, 33-26762, 33-39896, 33-44835, 33-60618 and 33-60620 and the Registration Statement on Form S-3 No. 33-41821 of USAir Group, Inc., of our reports dated February 25, 1994 relating to the consolidated balance sheets of USAir Group, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and changes in stockholders' equity, and the related consolidated financial statement schedules for each of the years in the three- year period ended December 31, 1993 which reports appear in the December 31, 1993 annual report on Form 10-K of USAir Group, Inc. and USAir, Inc. KPMG PEAT MARWICK Washington, D.C. March 25, 1994 Exhibit 23.2 CONSENT OF INDEPENDENT AUDITORS The Board of Directors USAir, Inc. We consent to the incorporation by reference in the Registration Statement on Form S-3 No. 33-35509 of USAir, Inc., of our reports dated February 25, 1994 relating to the consolidated balance sheets of USAir, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and changes in stockholders' equity, and the related consolidated financial statement schedules for each of the years in the three- year period ended December 31, 1993 which reports appear in the December 31, 1993 annual report on Form 10-K of USAir Group, Inc. and USAir, Inc. KPMG PEAT MARWICK Washington, D.C. March 25, 1994 Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Warren E. Buffett, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Warren E. Buffett (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edwin I. Colodny, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 25 day of January, 1994. /s/Edwin I. Colodny (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Mathias J. DeVito, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Mathias J. DeVito (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, George J. W. Goodman, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13 day of January, 1994. /s/George J. W. Goodman (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John W. Harris, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/J. W. Harris (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edward A. Horrigan, Jr., Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Edward A. Horrigan, Jr. (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Robert LeBuhn, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14th day of January, 1994. /s/Robert LeBuhn (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Colin Marshall, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/C. Marshall (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Roger P. Maynard, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/R. Maynard (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John G. Medlin, Jr., Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 19th day of January, 1994. /s/John G. Medlin, Jr. (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Hanne M. Merriman, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Hanne M. Merriman (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Charles T. Munger, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 24th day of January, 1994. /s/Charles T. Munger (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Richard P. Simmons, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13th day of January, 1994. /s/Richard P. Simmons (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Raymond W. Smith, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/R. W. Smith (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Derek M. Stevens, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/Derek M. Stevens (L.S.) --------------------------------- Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Warren E. Buffett, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Warren E. Buffett (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edwin I. Colodny, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 25 day of January, 1994. /s/Edwin I. Colodny (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Mathias J. DeVito, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Mathias J. DeVito (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, George J. W. Goodman, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13 day of January, 1994. /s/George J. W. Goodman (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John W. Harris, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/J. W. Harris (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edward A. Horrigan, Jr., Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Edward A. Horrigan, Jr. (L.S.) --------------------------------- Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Robert LeBuhn, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14th day of January, 1994. /s/Robert LeBuhn (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Colin Marshall, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/C. Marshall (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Roger P. Maynard, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/R. P. Maynard (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John G. Medlin, Jr., Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 19th day of January, 1994. /s/John G. Medlin, Jr. (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Hanne M. Merriman, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Hanne M. Merriman (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Charles T. Munger, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 24th day of January, 1994. /s/Charles T. Munger (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Richard P. Simmons, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13th day of January, 1994. /s/Richard P. Simmons (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Raymond W. Smith, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/R. W. Smith (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Derek M. Stevens, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/Derek M. Stevens (L.S.) ------------------------------ Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI- TION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations presented below relates to the Consoli- dated Financial Statements of USAir Group, Inc. ("USAir Group" or the "Company") presented in Item 8A. Consolidated Financial Statements for USAir, Inc. ("USAir"), the Company's principal subsidiary, are presented in Item 8B. USAir's operating revenue accounted for more than 93% of the Company's operating revenue in each of the last three years. USAir Group also owns three commuter airline subsidiaries, which accounted for more than 5% of the Company's operating revenue in each of the last three years. Therefore, the following discussion and analysis of results of operations relates principally to the operations of USAir and to the airline industry. The following general factors are among those that influence USAir's financial results and its future prospects: 1. General economic conditions and industry capacity. 2. A decline in the proportion of passengers paying higher yield "business fares" to passengers paying lower yield fares. 3. The emergence and growth of low cost, low fare airlines and USAir's high cost structure. 4. The trend toward globalization in the airline industry and related regulatory limitations. These and other factors are discussed in the following sections. General Economic Conditions and Industry Capacity Historically, demand for air transportation has tended to mirror general economic conditions. Economic conditions in the United States and fare competition in the domestic airline industry continued to be major factors affecting the financial condition of USAir and the airline industry in 1993. In recent years, the change in industry capacity has failed to mirror the reduction in demand for domestic air transportation due primarily to continued delivery of new aircraft and, secondarily, to the operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code for extended periods. While industry capacity has leveled off and the general economy has shown signs of improvement, the Company expects that the airline industry will remain extremely competitive for the foreseeable future. See the discussion of low cost, low fare airlines below. During the recent economic recession, some observers of the travel industry speculated that the business traveler became less reliant on air transportation as teleconferencing, telecopying and other technological developments gained wider acceptance. In addition, some observers have speculated that corporate restructur- ing and furloughs in the U.S. have reduced the number of business travelers and that the leisure traveler has become conditioned to waiting for promotional fares before making travel plans. The Company is unable to determine whether these structural changes have occurred in the air transportation market or if these changes have occurred, how long-lived these trends will be. However, the Company believes that for the foreseeable future the demand for higher yield "business fares" will remain essentially flat and relatively inelastic while the lower yield "leisure" market will continue to grow with the general economy. This trend could make it more difficult for the domestic airlines, including USAir, to sustain meaningful yield increases in the future. Financial circumstances have compelled certain bankrupt or financially weakened carriers to sell assets, including foreign routes, gates and take-off and landing slots at capacity con- strained airports. Proceeds from asset sales provide cash infusions to weaker carriers, but also augment the route systems and market presence of the stronger carriers. Although USAir has completed route and other asset purchases from a number of weaker carriers, the purchases illustrate a trend of consolidation of strategic assets and financial strength within the industry which appears to benefit the three largest U.S. carriers in the long- term. In the short-term, however, these carriers have suffered from the cost of integrating these assets into their systems and from the incremental capacity which has been exacerbated by declines in passenger travel and fare wars. As a result, these carriers have taken or announced actions including reduction in workforce and salary and other employee benefits, concessions from unionized employees, deferral of new aircraft deliveries, early retirement of inefficient aircraft types, and termination of unprofitable service. USAir implemented similar measures during 1990-1993, including a workforce reduction of 2,500 full-time positions between November 1993 and the first quarter of 1994, which, along with other measures, is expected to save the Company approximately $200 million in 1994. USAir will pursue additional measures in 1994 to reduce further its operating costs. See Item 1. "Business - Significant Impact of Low Cost, Low Fare Competi- tion" and "-British Airways Announcement Regarding Additional Investment in the Company; Code Sharing." In 1993, USAir reached an agreement with the Boeing Company ("Boeing") to, among other things, exercise options to purchase additional B757-200 aircraft on an accelerated basis and to cancel and reschedule the delivery of certain Boeing 737 aircraft on order into the future. This agreement reduced USAir's capital expendi tures by more than $880 million between 1993 and 1996. USAir is currently in negotiations with Boeing regarding, among other things, the current schedule of new aircraft deliveries. Each major airline has developed a frequent traveler program that offers its passengers incentives to maximize travel on that particular carrier. Participants in such programs typically earn "mileage credits" for every trip they fly that can be redeemed for airline travel or, in some cases, for other benefits. Under USAir's Frequent Traveler Program ("FTP"), participants receive mileage credits equal to the greater of actual miles flown or 750 miles for each paid flight on USAir or USAir Express, or actual miles flown on one of USAir's FTP airline partners. Participants flying on first or business class tickets receive additional credits. Participants may also earn mileage credits by staying at participating hotels or by renting cars from participating car rental companies within 24 hours of a flight. Mileage credits can be redeemed for certificates for various travel awards, including fare discounts, first class upgrades and tickets on USAir or other airlines participating in USAir's FTP. Certain awards also include hotel and car rental awards. Award certificates may not be brokered, bartered or sold, and have no cash value. USAir and its airline partners limit the number of seats allocated per flight for award recipients. The number of seats varies depending upon flight, day, season and destination. Award travel is not permitted on blackout dates, which generally correspond to certain holiday periods in the United States or peak travel dates to foreign destinations. Hotel awards are valid at participating hotels and are subject to room availability, which is limited. Car rental awards are valid only at participating locations. The number of cars available for award usage is limited, and no cars are available for award usage on blackout dates. USAir reserves the right to terminate the FTP or portions of the program at any time, and the FTP's official rules, partners, special offers, blackout dates, awards and mileage levels are subject to change with or without prior notice. USAir accounts for its FTP under the incremental cost method, whereby travel awards are valued at the incremental cost of carrying one additional passenger. Such costs are accrued when FTP participants accumulate sufficient miles to be entitled to claim award certificates. No value is assigned to airline, hotel or car rental award certificates that are to be honored by other parties. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance and denied boarding compensation expenses expected to be incurred on a per passenger basis. No profit or overhead margin is included in the accrual for incremental costs. FTP participants had accumulated mileage credits for approxi- mately 3,896,000 awards (at the 20,000 mile level required for a free domestic flight on USAir) at December 31, 1993, compared with 3,199,000 awards at December 31, 1992. However, because USAir expects that some award certificates will be redeemed by other airlines participating in USAir's FTP, that some certificates will expire, and that some accumulated mileage credits will never be applied towards award certificates, the calculations of the accrued liability for incremental costs at December 31, 1993 and 1992 were based on approximately 88% and 86%, respectively, of the accumulat- ed credits. Mileage for FTP participants who have accumulated less than the minimum number of mileage credits necessary to claim an award is excluded from the calculation of the accrual. Most participants belong to more than one frequent traveler program and it is not possible to project when or if participants will accrue additional mileage credits required to earn an award. Incremental changes in the liability resulting from additional mileage credits are recorded as part of the regular review process. Effective January 1, 1995, USAir will increase the minimum mileage level required for a free domestic flight from 20,000 to 25,000. USAir's customers redeemed approximately 841,000, 626,000 and 654,000 awards for free travel on USAir in 1993, 1992 and 1991, respectively, representing approximately 8.0%, 4.9% and 5.3% of USAir's revenue passenger miles ("RPMs") in those years, respec- tively. During 1993, two "free ticket for segments flown" promotions were completed which increased the number of awards used for free travel on USAir. These promotions were offered in response to similar promotions offered by USAir's competitors. USAir does not believe that usage of FTP awards results in any significant displacement of revenue passengers. USAir has the ability, through its inventory management system, to identify markets and flights expected to have high load factors and, through capacity controls, to maximize use of FTP awards on flights with lower demand and available seats. Also, blackout dates forestall the usage of awards on peak travel days. Furthermore, USAir's exposure to the displacement of revenue passengers is not signifi- cant, as the number of USAir flights that depart 100% full is minimal. In the third quarter of 1993 (the third quarter being the period of the year when USAir generally experiences its highest load factor and expects the usage of FTP awards to be highest), for example, fewer than 2.2% of USAir's flights departed 100% full. During this same quarterly period, only approximately 1.9% of USAir's flights departed 100% full and also had one or more passengers on board who were traveling on FTP award tickets. Airlines often use other competitive promotions, such as offering extra credits or reduced award thresholds under certain conditions, as incentives to stimulate travel. USAir reviews these promotions to determine the proper accounting treatment for each one. To the extent these promotions are determined to be an integral part of the FTP, they are accounted for in the same manner as free travel earned through mileage credits. Low Cost, Low Fare Competition In September 1993, Southwest Airlines, Inc. ("Southwest"), a low cost, low fare, "no frills" air carrier which had not previous- ly provided service to or in the eastern U.S., inaugurated service to Chicago and Cleveland from Baltimore/ Washington International Airport ("BWI") at fares substantially below those previously offered by USAir and other airlines in the same markets. BWI is one of USAir's hub airports. Unlike the other major U.S. air carriers, Southwest does not structure its operations around connecting hub airports, relying instead on high frequency point- to-point service. USAir responded by matching most of Southwest's fares and increasing the frequency of service in related markets. On March 22, 1994, Southwest announced that on May 26, 1994, and June 6, 1994, it will expand service between BWI and Chicago. Southwest also announced that on May 26, 1994, it will initiate its low fare service between BWI and St. Louis, and on July 8, 1994, between BWI and Birmingham, Alabama and Louisville, Kentucky. At this time, USAir has not determined its response to the Southwest announcement. In October 1993, Continental Airlines ("Continental"), which had reorganized under bankruptcy proceedings earlier in 1993, inaugurated low fare service on certain routes in the eastern U.S. USAir is a competitor in most of the markets served by these routes. While Continental initiated service to certain cities, such as Charleston, South Carolina; Greensboro, North Carolina; and Jacksonville, Florida; most of the markets included as part of its new program (for example, Baltimore) were previously served by Continental through its hubs at Newark, Cleveland, and Houston. However, under its new program, Continental linked certain of these cities independently of its hubs while continuing to provide many of the same services that are available on its hub flights, including advance seat assignment, frequent traveler mileage credits and interline connections. Under its new program, Continental served approximately 80 city pair markets, from which USAir has historically realized approximately 4% of its total passenger revenue. When Continental started the new program it was uncertain whether the program was an experiment or a beachhead from which Continental planned to expand further. USAir, therefore, made a measured response by matching most of the low fares offered by Continental. On January 31, 1994, Continental increased its competitive threat. It announced that by March 9, 1994, it would expand the low fare program to approximately 356 city pair markets, most of which USAir served and from which USAir has historically realized approximately 8% of its passenger revenue. Moreover, if secondary markets within a 90-mile radius, or a reasonable driving distance, were viewed as being included in Continental's new program, markets from which USAir has historically realized approximately 36% of its passenger revenue were affected. Contemporaneously, Continental announced that it would substantially reduce service at its Denver hub and redeploy significant aircraft and personnel resources to the eastern U.S. Although Continental's balance sheet continues to have significant leverage following its bankruptcy reorganization, its liquidity position improved substantially as a result of equity and debt infusions completed as part of that reorganization. Moreover, Continental completed a common stock offering in December 1993, which may indicate the market's receptivity to its efforts to raise additional funds. Continental has operating (including labor) costs that are substantially lower than those of USAir and the other major air carriers. On February 8, 1994, in response to the expansion of Continen- tal and to avoid loss of market share in the eastern U.S., USAir lowered in primary and secondary markets affected by the Continen- tal expansion, by as much as 50%, the fares most commonly used by business travelers on many east coast routes. In addition, USAir lowered leisure fares by as much as 70% in the same markets. In many of the markets, free companion fares are available with business fares. These reduced fares have no expiration date. However, USAir could adjust the fares at some time in the future. Increases in traffic which are stimulated by the lower fares offered by Southwest, Continental and USAir will not offset USAir's reduced revenue resulting from lower yields in these markets. USAir believes that Southwest, Continental or other low cost carriers with a significant cost advantage over USAir likely will expand their operations to additional markets. For example, in December 1993, Southwest completed its acquisition of Morris Air, a regional air carrier with operations concentrated in the western U.S. This acquisition could enable Southwest to divert resources to expand its operations in the eastern U.S. Furthermore, media reports indicate that Southwest has entered into a long-term agreement for the use of four additional gates at BWI, where it currently operates from two gates. On March 4, 1994, Continental further escalated prospective competition by announcing that it will further reduce operations at its Denver, Colorado hub and establish a flight crew base at Greensboro, North Carolina. These measures are likely to increase losses at USAir because they could enable Continental, which has significantly lower costs than USAir, to expand further its high frequency, low fare service described above in additional short-haul markets served by USAir with substantial detriment to USAir. In addition, other low cost carriers may enter other USAir markets. For example, America West announced on February 15, 1994 that it will commence service on April 18, 1994 between Columbus, Ohio where it operates a hub and Philadelphia, where USAir has a hub operation. Other carriers, including some of the larger carriers, have also indicated their intent to develop similar low-fare short-haul service. Unless USAir is able to reduce its operating costs, present and increasing competition from low cost, low fare airlines in USAir's markets could have a material adverse impact on USAir's cash position and therefore, its ability to sustain operations. In March 1994, USAir announced that it had initiated discussions with the leadership of its unionized employees regarding wage reduc- tions, improved productivity and other cost savings. The outcome of these negotiations is uncertain, but if timely agreements are not reached, the Company may seek other restructuring alternatives. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition". In 1993, Northwest Airlines, Inc. ("Northwest") and Trans World Airlines, Inc. ("TWA") sought and obtained from unionized employees substantial concessions and productivity improvements. In exchange, these employees have received ownership interests in those companies. In December 1993, United Airlines, Inc. ("Unit- ed") announced that it had reached agreement with two of its unions to trade concessions for a substantial ownership stake by all employees, subject to approval by United's stockholders. The memberships of these two unions have ratified the agreement. The stated intent and purpose of these labor concessions are to enable these carriers to lower their operating costs. At this time, it is uncertain whether the United transaction will be consummated and whether these events constitute isolated incidents or a trend of employee ownership in the airline industry. As an airline with relatively high labor costs and a route system with a significant percentage of short-haul flying, USAir is considering additional ways to reduce these costs which could involve an exchange of employee concessions for an ownership interest in the Company. USAir is currently engaged in discussions with the leaders of its unionized employees regarding efforts to reduce costs, including reductions in wages, improvements in productivity and other cost savings. The outcome of these discussions is uncertain. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competi- tion." USAir has been examining various ways to restructure its operations to increase efficiency and lower unit costs in markets of approximately 500 miles or less in distance. Certain carriers, such as Southwest and Continental, have a substantial cost advantage over USAir in these short-haul markets. In addition, consumers appear to be increasingly price conscious, particularly for short distance flights. In February 1994, USAir implemented the first phase of the introduction of a new short-haul product in 18 city-pair markets of approximately 500 miles or less, resulting in increased utilization and productivity of aircraft, personnel, and ground facilities in these markets by decreasing the amount of time that aircraft spend on the ground between flights from an average of 45 minutes to approximately 25 minutes. Initiation of the first phase of this service did not involve any immediate pricing changes or new personnel. Ultimately, USAir anticipates that enhancements to the short-haul product will be completed in summer 1994, and that long-haul and transatlantic service will be redesigned later in 1994. USAir plans to expand this higher frequency service to additional short-haul and other markets in July 1994, with a total fleet of approximately 100 aircraft. Although USAir expects this higher frequency operation will result in reduced unit costs in relevant markets, certain variable costs generally associated with providing the incremental flights, including jet fuel, landing fees and labor, will increase. There can be no assurance, therefore, that the changes will result in improved financial results for USAir. If USAir cannot find ways to compete effectively with low cost carriers by lowering its operating costs, and to generate sufficient additional passengers to offset the effect of sharply reduced fares, USAir's revenue and results of operations will continue to be materially and adversely affected. Industry Globalization and Regulation The trend toward globalization of the airline industry has accelerated in recent years as the three largest U.S. carriers have initiated foreign service and purchased the foreign routes of financially distressed or bankrupt U.S. carriers. In addition, certain foreign carriers have made substantial investments in U.S. carriers which have frequently been tied to marketing alliances or, less frequently, reciprocal investments by the U.S. carrier in its foreign partner. In August 1993, Continental announced that it had reached agreement with Air France on a joint marketing agreement. Earlier in the year, Air Canada made a substantial equity invest- ment in Continental in connection with Continental's bankruptcy reorganization. In October 1993, United and Lufthansa German Airlines announced that they had reached an agreement to implement code sharing to link some of their flights. Continuing privatiza- tion of sovereign carriers and foreign airline deregulation may encourage further foreign investment. Foreign investment in U.S. air carriers is restricted by statute and may be subject to review by the U.S. Department of Transportation ("DOT") and, on antitrust grounds, by the U.S. Department of Justice ("DOJ"). On January 21, 1993, USAir Group and British Airways Plc ("BA") entered into an Investment Agreement ("Investment Agree- ment") under which a wholly-owned subsidiary of BA has purchased certain preferred stock of the Company for $400.7 million. On March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See "Liquidity and Capital Resources" and Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "- British Airways Investment Agreement" for additional information related to the investment. Under the Investment Agreement, USAir and BA have entered into a code sharing arrangement under which certain domestic USAir flights, connecting to certain BA transatlantic flights, may be listed on computerized reservation systems either under USAir's or BA's two letter designation code, subject to authorization by the DOT. As of March 1, 1994, USAir and BA offered code share service to and from 34 of the 65 airports authorized by the DOT. On March 17, 1994, the DOT issued an order renewing for one year the existing code sharing authority. In January 1994, USAir and BA filed applica- tions with the DOT to code share to 65 additional domestic and seven additional foreign destinations. The DOT did not act on these applications in its March 17, 1994 order. See Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "-British Airways Investment Agreement". USAir and BA are in the process of expanding their code sharing arrangement. USAir believes that it will have greater access to international traffic and that its and BA's customers will benefit from better on-line connections as well as coordinated check-in and baggage checking procedures. USAir also believes that the code sharing arrangement will generate increased revenues, the magnitude of which cannot be reasonably estimated at this time. The DOT may continue to link further renewals of the code share authorization to the United Kingdom's ("U.K.") liberalization of U.S. air carrier access to the U.K. markets. However, the code sharing arrangement is expressly permitted under the bilateral air services agreement between the U.S. and U.K. USAir expects that the authorization will be renewed in the future; however, there can be no assurance that this will occur. USAir does not believe that the DOT's failure to renew the code share authorization or grant the pending application would result in a material adverse change in its financial condition. However, further investment in the Company by BA, as contemplated in the Investment Agreement, may be less likely. See Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "-British Airways Investment Agreement." Current U.S. law provides that foreign ownership or control of the voting interest in a certificated U.S. air carrier may not exceed 25%, non-U.S. citizens may not constitute more than a third of the board of directors and managing officers of the air carrier and the president of the air carrier must be a U.S. citizen. Over the years in the context of "fitness" reviews to determine whether air carriers could be issued, or continue to hold, operating certificates, the DOT has also issued interpretations regarding whether investments by, or other arrangements with, foreign investors constitute de facto control over a U.S. air carrier. Although the Company believes the policy has no basis in law, recently and particularly during 1992 and 1993, the DOT has linked its review of foreign investment in, and foreign alliances with, U.S. air carriers to the status of the bilateral air transportation treaty between the U.S. and the country of origin of the foreign airline. The willingness of the DOT to allow proposed foreign investments, alliances and participation in corporate governance has been linked to its perception of the liberality of the relevant treaty with respect to the right of U.S. air carriers to operate to, from and beyond the foreign country. For example, the Netherlands entered into a new bilateral treaty with the U.S. in 1992 which permitted "open skies", or unrestricted access to the Netherlands by U.S. air carriers. As a result, in 1992 the DOT approved Northwest's proposal to integrate its operations with those of KLM Royal Dutch Airlines, an airline based in that nation. However, the DOT has refused to allow USAir and BA to proceed with the second and third phases of their Investment Agreement, which calls for an additional investment of $450 million by BA, unless and until the U.K. government agrees to amend its bilateral air services agreement with the U.S. to permit new services by U.S. carriers to the U.K. and particularly to London's Heathrow Airport. The U.S. and U.K. governments held several negotiating sessions during the past year and have exchanged proposals to amend the bilateral agreement, but to date the two governments have failed to resolve their differences. As a result, USAir and BA were unable to proceed with the second and third phases of the Investment Agreement in 1993. In any event, on March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See Item 1. "Business - British Airways Announcement Regarding Additional Investment in the Company; Code Sharing" and "-British Airways Investment Agreement." The National Commission to Ensure a Strong Competitive Airline Industry ("Airline Commission") issued its report in August 1993. The Airline Commission was a presidentially-appointed committee with the task of analyzing the condition of the U.S. airline industry and reporting to the Clinton Administration its findings and recommendations. Among other things, the Airline Commission recommended that: (i) the air traffic control system be modernized and the Federal Aviation Administration's ("FAA") air traffic control functions be performed by an independent federal corpora- tion; (ii) the federal regulatory burden be reduced; (iii) the airlines be granted certain tax relief; and (iv) the bankruptcy process be shortened. The Airline Commission also favored raising the statutory limit on foreign ownership of voting securities in the U.S. airlines to 49 percent under certain circumstances. It further urged that the current international system of bilateral agreements be replaced with multilateral arrangements. In addition, the Airline Commission recommended that the DOT review the airlines' business, capital or financial plans with the assistance of a presidentially-appointed advisory committee and, if an airline repeatedly failed to heed warnings or concerns of the DOT Secretary, the DOT could "exercise its existing authority", among other things, to revoke an airline's operating certificate. In January 1994, the Clinton Administration issued a report which described its program to implement certain of the Airline Commission's recommendations. Among other things, the Administra- tion stated that it supported the recommendation described above regarding the FAA, supported increasing to 49 percent the foreign ownership restrictions provided there are reciprocal opportunities for U.S. airlines and investors abroad, and opposed the recommenda- tions regarding tax relief and the appointment of the advisory committee discussed above. At this time, it is impossible to predict whether any of the Airline Commission's recommendations will be enacted and, if enacted, their effect on USAir. It is also difficult to anticipate whether the Congress will act in the near term on any of the proposals requiring legislation. As part of its initiative in the transportation industry, the Clinton Administration also indicated that the DOT has begun a comprehensive examination of the "high density rule" which limits airline operations at Chicago O'Hare, New York's LaGuardia ("LaGuardia") and John F. Kennedy International, and Washington National ("National") Airports by restricting the number of takeoff and landing slots. As part of its study, the DOT will determine whether the operating limitations imposed by the rule can be eliminated or modified to better utilize available capacity at these airports. USAir holds a substantial number of slots at LaGuardia and National, including those assigned a value when the Company acquired Piedmont Aviation, Inc. Any DOT action which would eliminate those slots or compel USAir to transfer those slots could have a material adverse effect on USAir's operations and financial position. Revision of the high density rule at National, however, would require legislation by the Congress. The DOT has indicated that it expects to complete its study by late 1994. RESULTS OF OPERATIONS 1993 Compared with 1992 The Company recorded a net loss of $393.1 million on revenue of $7.1 billion, in 1993 compared with the 1992 net loss of $1.2 billion on revenue of $6.7 billion. Several non-recurring items, which include the cumulative effect of accounting changes, make it difficult to compare these results. After excluding the effect of certain non-recurring items discussed below, which amount to $153.2 million and $759.3 million in 1993 and 1992, respectively, the net loss would have been $239.9 million in 1993 ($5.69 per common share after preferred dividend requirement) compared with a loss of $469.6 million in 1992 ($11.09 per common share after preferred dividend requirement). The Company's 1993 financial results contain $153.2 million of non-recurring items, including (i) $68.8 million for severance, early retirement and other personnel-related expenses recorded in connection with a workforce reduction of approximately 2,500 full- time positions between November 1993 and the first half of 1994; (ii) $43.7 million for the cumulative effect of an accounting change, as required by Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership, which operates a computerized reservations system; and (vi) an $18.4 million credit related to non-operating aircraft. The Company's 1992 financial results contain $759.3 million of non-recurring items, including (i) $628.1 million for the cumula- tive effect of an accounting change, as required by Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"); (ii) $107.4 million related to aircraft which have been withdrawn from service; (iii) $34.1 million loss related to the sale of ten McDonnell Douglas 82 ("MD-82") aircraft which USAir had on order but eliminated from its fleet plan; and (iv) $10.3 million gain resulting from the sale of three of the Company's subsidiaries during 1992. Operating Revenue - The Company's Passenger Transportation Revenue increased by $356.5 million (5.8%) in 1993 compared with 1992, primarily due to the $296.0 million (5.1%) increase at USAir. USAir's capacity, as measured by available seat miles ("ASM" - one ASM is equal to one seat flown one mile), decreased by 0.3% in 1993 compared with 1992, its passenger revenue per ASM increased by 5.4% to 10.22 cents and its passenger load factor, a measure of capacity utilization, increased by 0.4 points to 59.2%. The increase in passenger revenue per ASM is largely attributed to the lower level of discounting in 1993 versus 1992. The Company expects that it will experience a 1 - 2% increase in ASMs (including the effect of weather-related cancellations) in 1994 compared with 1993. Continued fare discounting and low fares offered by USAir to compete with low cost, low fare carriers discussed above, are expected to have a negative impact on the Company's passenger revenue. It is not expected that the resulting decrease in revenue per ASM will be totally offset by additional passengers. The severe winter weather conditions in the U.S. during the early part of 1994 have caused a reduction in revenue which the Company estimates at approximately $50 million. In March 1993, USAir and five other U.S. air carriers entered into a settlement in the Domestic Air Transportation Antitrust Litigation class action lawsuit, which alleged that the airlines used the Airline Tariff Publishing Company to signal and communi- cate carrier pricing intentions and otherwise limit price competi- tion for travel to and from numerous hub airports. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has estimated that any incremental cost associated with the settlement will not be material based on the nominal equivalent free trips associated with the settlement. See Note 4 to the Company's Consolidated Financial Statements for additional information. The Company's Other Revenue increased by $38.8 million (12.3%) in 1993. USAir's increase of $90.5 million (32.3%) was partially offset at the Company level by a decrease in non-airline subsidiary revenue resulting from the sale of three wholly-owned subsidiaries in July 1992. USAir's 32.3% improvement resulted from increased passenger cancellation and rebooking fees, frequent traveler participation fees, and various other sources. Expense - The Company's total operating expenses increased $141.7 million (2.0%) in 1993 compared with 1992. The Company's Personnel Costs increased by $217.7 million (8.3%), $205.6 million of which is attributable to USAir. USAir's increase includes (i) $65.6 million of the $68.8 million non-recurring charge related to a workforce reduction of 2,500 full-time positions; and (ii) the $36.8 million charge based on an estimate of the repayment of certain employee pay reductions, both discussed above. Without the effect of these non-recurring charges, USAir experienced an increase in employee salaries of $91.4 million (4.7%) and an increase in employee benefits of $11.8 million (2.1%). The increase in employee salaries is generally due to contractual and general salary increases which occurred during 1993. The amount saved as a result of the 12-month salary reduction program was approximately the same in 1993 and 1992. USAir expects that due to scheduled contractual increases and the effect of the expiration of the 12-month salary reduction program, employee salaries will increase in 1994 to the extent that the reduction of 2,500 full- time positions and any other possible measures do not offset the increases. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition" and "- Employees" for information related to the possible unionization of additional employee groups. The $11.8 million increase in employee benefits is the result of increased pension expense, offset partially by a decrease in other postretir- ement benefit expense. The increased pension expense in 1993 resulted from the establishment of a defined contribution pension plan for USAir's non-contract employees on January 1, 1993. The defined benefit plan for these employees was frozen at December 31, 1991. Because of the interest rates on long-term, high quality corporate bonds which prevailed at December 31, 1993, the Company has lowered its discount rate used to calculate the actuarial present value of its pension and postretirement obligations. This action will cause an increase in the Company's pension and other postretirement benefits expense in 1994 of approximately $70 million over 1993. See Note 11 to the Company's Consolidated Financial Statements. The Company's Aviation Fuel Expense decreased $43.2 million (5.7%) as a result of a lower cost per gallon and decreased consumption. In early August 1993, the Clinton Administration's budget package was enacted. The budget package included a 4.3 cent per gallon tax on transportation fuels beginning October 1, 1993. The airline industry is exempt from the tax until October 1, 1995. See Item 1. "Business - Jet Fuel" and Note 1 to the Company's Consolidated Financial Statements. Commissions increased by $27.2 million (4.8%) as a result of the 5.8% increase in Passenger Transportation Revenue. The Company's Other Rent and Landing Fees increased $64.3 million (15.8%) primarily due to an increase in USAir's facility rental expense following the opening of the new terminal at Pittsburgh in October 1992, and the $8.9 million of non-recurring expense recorded for certain airport facilities, discussed above. The Company's Aircraft Rent Expense included a $72.4 million non- recurring charge in 1992 (part of the $107.4 million discussed above). Without this charge, aircraft rent expense increased $15.0 million (3.3%) due to the addition of new leased aircraft in 1993. Excluding the effect of non-recurring items in 1992 and 1993, Aircraft Maintenance Expense increased by $37.6 million (10.6%) resulting from the timing of aircraft maintenance cycles. Other Operating Expense decreased by $58.0 million (4.0%), reflecting a $25.0 million (1.8%) decrease at USAir and a $58.4 million decrease which resulted from the sale of three wholly-owned subsidiaries in July 1992, offset by increases at the Company's other wholly-owned subsidiaries. The Company's Interest Capitalized decreased $10.0 million (36.1%) as the level of outstanding purchase deposits decreased with the delivery of new aircraft and changes in delivery sched- ules. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", ("FAS 109"). The adoption of FAS 109 resulted in no cumulative adjustment. Results for 1993 do not include any income tax credit due to the FAS 109 limitations in recognizing a current benefit for net operating losses. See Note 6 to the Company's Consolidated Financial Statements for additional information. 1992 Compared With 1991 The Company recorded a net loss of $1.2 billion on revenue of $6.7 billion in 1992, compared with the 1991 net loss of $305.3 million on revenue of $6.5 billion. Several non-recurring items, which include the cumulative effect of an accounting change, make it difficult to compare these results. In addition, the Company recorded no tax credit in 1992. After excluding the effect of certain non-recurring items which amount to a net charge of $759.3 million and a net gain of $45.9 million in 1992 and 1991, respec- tively, the pre-tax loss would have been $469.6 million in 1992 ($11.09 per common share after preferred dividend requirement) compared with a pre-tax loss of $460.7 million in 1991 ($11.01 per common share after preferred dividend requirement). This compari- son does not consider the ongoing effect to the Company's operating expenses which result from the adoption of FAS 106, the freezing of the pension plan for non-contract employees, or other changes. The Company's 1992 financial results contained $759.3 million of non-recurring items, detailed above. Operating results for 1991 included (i) $107 million pre-tax gain related to the freeze of the fully funded pension plan for USAir's non-contract employees; (ii) a $21 million pre-tax charge related to USAir's parked British Aerospace BAe-146 ("BAe-146") fleet; (iii) $21.6 million pre-tax expense related to early retirement incentives; and (iv) $18.5 million, net, in miscellaneous non-recurring charges. On October 5, 1992, the International Association of Machin- ists ("IAM"), which represents USAir's mechanics and related employees, commenced a strike against USAir. At that time, USAir implemented a reduced flight schedule equal to approximately 60% of the normal flight schedule. On October 8, 1992, USAir reached agreement with the IAM on a new collective bargaining agreement which becomes amendable in October 1995. Following ratification of the agreement by the IAM-represented employees, USAir resumed full service on October 12, 1992. USAir immediately offered various incentives including bonus frequent traveler miles and relaxed advance purchase restrictions in an effort to attract passengers following the disruption of service. The Company estimates that the IAM strike had a negative effect on results of approximately $45 million for the year. Operating Revenue - The Company's Passenger Transportation Revenue increased $164.6 million (2.7%) in 1992, reflecting a $97.9 million increase in USAir passenger transportation revenue and a $66.7 million increase in commuter airline passenger revenue. USAir's ASMs increased by 2.4% in 1992, its passenger revenue per ASM decreased by 0.7% to 9.7 cents, and its passenger load factor increased by 0.2 points to 58.8%. USAir's average 1992 passenger revenue per ASM was adversely affected by widespread fare promo- tions. The improvement in commuter airline passenger revenue is attributed to increased traffic made possible by 20.1% increase in capacity during 1992 over 1991, as measured by ASMs, at the Company's commuter airline subsidiaries. USAir's Other Revenue increased $81.3 million (40.9%) in 1992 as compared with 1991, due to increases in revenue generated by passenger cancellation and re-booking fees, fees received from commuter affiliates for handling certain of their flights, and other miscellaneous sources. Operating Expenses - The Company's Personnel Costs increased $102.5 million (4.1%) in 1992 compared with 1991, driven by USAir's increase in personnel costs of $99.7 million (4.2%). Personnel Costs are comprised of two components: (i) employee wages and salaries; and (ii) employee benefits. USAir's wage and salary expense decreased $21.9 million (1.1%) during 1992 as a result of partial-year wage concessions on the part of pilots, non-contract employees and mechanics, all of which ended in 1993. USAir's employee benefit expense increased $121.6 million (27.8%) in 1992 resulting from the adoption of FAS 106 in 1992, and the 1991 freeze of the fully-funded pension plan for non-contract employees. The 1991 pension freeze resulted in a $107 million gain. The Company estimates that USAir's pension expense was approximately $40 million lower in 1992 than would have been the case if the freeze had not occurred. Expense for postretirement medical and death benefits, calculated in accordance with FAS 106, was $114.7 million in 1992, compared with approximately $8 million cash-basis expense in 1991. USAir's medical and dental benefit expense for active employees decreased $26.7 million (14.2%) in 1992 compared with 1991 as a result of a contributory managed care program that was implemented during 1992 for most employee groups. Excluding the effects of FAS 106 and the pension freeze, USAir employee benefit expense decreased approximately $48 million, or 8.8%, in 1992 compared with 1991. The Company's Aviation Fuel Expense decreased $45.8 million (5.7%) during 1992 compared with 1991 as a result of lower cost per gallon, partially offset by an increase in consumption. The price of fuel was inflated during early 1991 as a result of the Iraqi invasion of Kuwait and ensuing Desert Storm operation in August 1990 - January 1991, and did not return to pre-invasion levels until the second quarter of 1991. Commissions increased $29.6 million (5.5%) as a result of the 2.7% increase in passenger transportation revenue and the mix of travel agency sales versus total sales. Other Rent and Landing Fees Expense for the Company increased $56.6 million (16.2%) during 1992. This increase was largely due to increased expense at LaGuardia which resulted from USAir's assumption of Continental's leasehold obligations associated with the East End Terminal there in January, 1992 and the increased operation at LaGuardia during the year using the take-off and landing slots acquired from Continental. Also contributing to the increase was the October 1992 opening of the new terminal at the Pittsburgh International Airport, USAir's largest hub. The Company's Aircraft Rent Expense increased $152.3 million (40.3%) during 1992. A charge related to USAir's grounded BAe-146 fleet accounted for $81 million of the increase. The remainder of the increase was caused by additional leased aircraft both at USAir and the commuter airline subsidiar- ies. The Company's Aircraft Maintenance Expense decreased $33.9 million (8.2%) during 1992. This decrease reflects USAir's decrease in aircraft maintenance of $43.4 million, or 12.0%, and an increase of $9.5 million at the Company's commuter airline subsidiaries during the same period. The improvement in USAir's aircraft maintenance expense is largely attributable to the grounding of its BAe-146 fleet in May 1991, the shifting of certain aircraft engine repairs in-house from outside vendors and the negotiation of a new vendor repair contract in 1991 for certain aircraft engines. The increase in maintenance expense at the commuter airline subsidiaries is due primarily to an increased fleet size in 1992. Maintenance expense for 1992 and 1991 includes charges of $25.0 million and $25.5 million, respectively, related to grounded aircraft. The Company's Other Operating Expense, Net increased $63.6 million (4.6%) in 1992 compared with 1991. Expense for 1992 includes $25 million related to an employee suggestion program which netted estimated savings of $22 million in 1992 and $110 million in 1993. The remainder of the increase is attributable to changes in various smaller expense categories. USAir Group's Interest Income decreased $8.7 million (46.9%) during 1992 due to a lower average level of short-term investments during 1992 coupled with lower interest rates in 1992. Both USAir's interest income and expense include intercompany amounts which have been eliminated in the USAir Group consolidation process. The Company's Interest Expense decreased $10.4 million (4.0%) in 1992 due to a lower average level of debt outstanding related to USAir Group's revolving bank credit agreement, partially offset by additional interest associated with higher levels of aircraft-related debt in 1992. Interest Capitalized decreased $7.8 million (21.8%) as a result of a lower level of outstanding equipment deposits coupled with a lower capitalized interest rate. The Company's Other Non-Operating Expense, Net increased $17.0 million, or 40.2%, during 1992. In 1992, this category included a gain of $10.3 million from the sale of three wholly-owned subsid- iaries and a $34.1 million loss related to the sale of ten MD-82 aircraft discussed above. In 1991, this category included a $12.5 million loss incurred in conjunction with the sale of nine Boeing B727-200 aircraft which had been previously retired from service. All of the Company's remaining available tax credit, or $117.6 million, was recognized upon the adoption of FAS 106 on January 1, 1992. The Company could not recognize any tax credit associated with the 1992 results due to limitations under Accounting Princi- ples Board Opinion No. 11. Inflation and Changing Prices Inflation and changing prices do not have a significant effect on the Company's operating revenues, operating expenses, and operating income because such revenues and expenses, other than depreciation and amortization, generally reflect current price levels. Depreciation and amortization expense is based on historical cost. For assets acquired through the purchase of Pacific Southwest Airlines, USAir's historical cost is based on fair market value of the assets on May 29, 1987. In the case of Piedmont Aviation, Inc., USAir's historical cost is based on the fair market value of the assets on November 5, 1987, reduced by the tax effect of that portion of fair market value not deductible for tax purposes in the form of depreciation and amortization. Therefore, aggregate depreciation and amortization is lower than if this expense reflected today's replacement costs for existing productive assets. In evaluating how inflation would increase depreciation expense, however, consideration should also be given to the reduction in other operating expenses, such as aircraft maintenance and aviation fuel, that would be achieved from the operating efficiencies of newer, more technologically advanced productive assets. LIQUIDITY AND CAPITAL RESOURCES Cash used by operations was $21.3 million during 1993, including a $220.0 million payment under USAir's revolving accounts receivable sale program ("Receivables Agreement"). At December 31, 1993, cash and cash equivalents totaled approximately $368.3 million, excluding $163.7 million which was deposited in trust accounts to collateralize letters of credit or workers compensation policies and classified as "Other Assets" on the Company's balance sheet. Although not currently available (see below), at Decem- ber 31, 1993, USAir Group had $300 million in commitments available for borrowing under its revolving credit agreement with a group of banks ("Credit Agreement") and no outstanding loans thereunder, and USAir had approximately $141 million of available funds under its Receivables Agreement. At February 28, 1994, cash and cash equivalents totaled approximately $363.5 million. Funds under the Credit Agreement and Receivables Agreement are not available to the Company and USAir because of violations of minimum net worth covenants in those agreements. On March 14, 1994, the Company and USAir announced that they are seeking waivers of compliance with the minimum net worth covenant and other anticipated covenant violations. There can be no assurance that the Company or USAir will be able to obtain the waivers or arrange replacement facilities. The Company and USAir are highly leveraged. In order to meet debt service, lease and other obligations and to finance daily operations, the Company and USAir require substantial liquidity and working capital. In addition, developments may occur which are beyond the control of the Company and USAir, including intensified fare wars or substantial increases in jet fuel prices, which could have a material adverse effect on the Company's prospects and financial condition. The Company and USAir have unencumbered assets, particularly if the Credit Agreement is terminated and the mortgage of aircraft equipment related thereto is released. The Company expects that it could use these unencumbered assets to raise funds to provide an infusion of liquidity. In addition, the second and third quarters of the year historically have been characterized by higher revenues and working capital than in the first and fourth quarters. Moreover, USAir is seeking in discus- sions with the leadership of its unionized employees substantial wage reductions, improved productivity and other cost savings. However, if unforeseen adverse developments occur, if the Company and USAir are unable to finance unencumbered assets, or if timely agreements with the employees are not reached, the Company and USAir may pursue other restructuring alternatives. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition" and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competi- tion." During 1993, the Company's investment in new aircraft acquisitions and purchase deposits totaled $545.3 million. USAir took delivery of 11 Boeing 757-200, one Boeing 767-200, and six MD- 82 aircraft during the year. The MD-82s were immediately sold to a third party. In addition, USAir sold two other MD-82 aircraft which had been delivered in the fourth quarter of 1992. Proceeds from the sale of the MD-82s approximated $168 million. The Company has completed financing arrangements for, including the $337.7 million issue of Pass Through Certificates ("Certificates") which USAir sold through an underwritten public offering on November 1, 1993, or internally funded, all of its 1993 aircraft expenditures. See Note 4(d) to the Company's Consolidated Financial Statements for the projected cash flows associated with aircraft orders and other contractual capital commitments. The Company has arranged committed financing for 100% of its 1994 and 1995 aircraft deliveries. On January 21, 1993, a wholly-owned subsidiary of BA purchased 30,000 shares of the 7% Series F Cumulative Convertible Senior Preferred Stock ("Series F Preferred Stock"), for $300 million. Substantially all of the $300 million received by the Company from the sale of the Series F Preferred Stock was used to pay down debt under the Company's Credit Agreement. The Series F Preferred Stock is subject to mandatory redemption on January 15, 2008. On May 4, 1993, the Company sold 11.5 million shares of $1 par value Common Stock at $20.75 per share which netted proceeds of approximately $231 million. BA partially exercised its preemptive right to maintain its proportionate ownership percentage by purchasing, on June 10, 1993, 9,919.8 shares of redeemable Series T-2 Cumulative Exchangeable Senior Preferred Stock ("Series T-2 Preferred Stock") for approximately $99.2 million. For additional information, see Note 8 to the Company's Consolidated Financial Statements. On March 7, 1994, BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce costs and improve financial results is known. On July 8, 1993, USAir sold $300 million principal amount of 10% Senior Notes due 2003 (the "10% Notes") through an underwritten public offering. The offering netted proceeds of approximately $294 million. The 10% Notes are unconditionally guaranteed by the Company. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes due 2001 (the "9 5/8% Notes") through an underwritten public offering. The offering netted proceeds of approximately $172 million. The 9 5/8% Notes are unconditionally guaranteed by the Company. The 9 5/8% Notes are not reflected in the Company's December 31, 1993 balance sheet because they were issued after that time. All net proceeds received by USAir or the Company from the Common Stock offering, the sale to BA of the Series T-2 Preferred Stock, the sale of the 10% Notes and 9 5/8% Notes were added to the working capital of the Company for general corporate purposes, including the possible early repayment of certain outstanding debt with high interest rates. USAir and the Company have filed with the Securities and Exchange Commission ("SEC") a shelf registration for $700 million of various debt and equity securities. Approximately $187 million of securities remain available for sale on the shelf registration following the sale of the 9 5/8% Notes and may be sold from time- to-time depending on market conditions. The Company will continue to evaluate opportunities in the financial markets. On September 29, 1993, the maximum commitment available under the Credit Agreement decreased to $300 million from $600 million in accordance with the terms of the agreement. The Credit Agreement is due to expire on September 30, 1994. In September 1993, USAir Group obtained a waiver of compliance with the coverage ratio test required to be maintained as part of the Credit Agreement, for the period July 1 through September 30, 1993. Without this waiver, USAir Group would have violated this test on September 30, 1993. As of September 30, 1993, USAir Group was in compliance with the other financial covenants required to be maintained as part of the Credit Agreement. Moreover, in December 1993, USAir Group obtained an additional waiver under the Credit Agreement of compliance during the period October 1 through December 31, 1993 with the coverage ratio test. Without this waiver, USAir Group would have violated this test on December 31, 1993. The Company is currently unable to borrow under the Credit Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir Group expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir Group will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. In September 1993 and December 1993, USAir obtained waivers of the coverage ratio test under the Receivables Agreement on the same terms as described above with respect to the Credit Agreement. At December 31, 1993, USAir was in compliance with the other financial covenants and had no amounts outstanding under the Receivables Agreement. The maximum amount of receivables which USAir may sell under the Receivables Agreement was $240 million at December 31, 1993 and will be adjusted downward to $190 million on June 30, 1994 if the Company's consolidated net worth does not exceed $1.5 billion. For purposes of this net worth comparison, the Company's actual net worth is adjusted to add back the initial and ongoing impact of adopting FAS 106 and certain other accounting pronounce- ments. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projec- tions of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. The Company's and USAir's debt and equity securities are presently rated below investment grade by Standard and Poor's Corporation ("S&P") and Moody's Investors Service, Inc. ("Moo- dy's"). Following the January 21, 1993 transaction in which a subsidiary of BA purchased $300 million of the Company's Series F Preferred Stock, Moody's placed the ratings on watch for possible upgrade. On March 19, 1993, Moody's confirmed its ratings of USAir Group and USAir securities. Following DOT approval of the purchase of the Series F Preferred Stock and the code sharing and wet lease relationship between USAir and BA, S&P affirmed its ratings of USAir Group and USAir securities, stating its ratings outlook was positive. In December 1993, S&P affirmed its ratings of USAir Group and USAir securities. However, the agency revised the ratings outlook to negative, citing, among other considerations, the status of the negotiations on a revised U.S.-U.K. bilateral air services agreement and the entrance and possible expansion of the operations of low fare, low cost air carriers into USAir's markets. In February 1994, as a result of USAir's low fare initiative in certain markets and its high cost structure, S&P and Moody's placed the securities of the Company and USAir on watch with negative implications. On March 24, 1994, S&P further downgraded the Company's and USAir's securities. This downgrade will make it more difficult for the Company and USAir to effect additional financing. In addition, the Company's and USAir's securities remain on watch with negative implications at S&P. In 1992, the Company's investment in new aircraft acquisitions and purchase deposits, net of deposits refunded, totaled $458.7 million. The Company purchased eight Fokker and four deHavilland Dash 8 aircraft during 1992. The acquisition of these aircraft was financed through a combination of secured debt financings and interim debt financings. In addition, USAir took delivery of four MD-82s, two of which were immediately sold to a third party. The remaining two aircraft delivered in 1992 were sold to a third party in early 1993. Cash outflows for other property during the period totaled $277.2 million, which includes $61 million paid to Continental for landing and take-off slots at LaGuardia and Washington National Airports and $50 million paid to TWA for London routes from BWI and Philadelphia International Airports. See Item 1. "Business - British Airways Investment Agreement - U.S.-U.K. Routes." Proceeds from disposition of assets of $429.5 million were realized during the year, primarily from sale-leaseback transactions, the sale of the two MD-82 aircraft, and the sale of three wholly-owned subsidiaries. During 1991, acquisition of new aircraft and purchase deposit payments amounted to $345 million. During 1991, USAir took delivery of two Boeing 767-200ER, nine Boeing 737-400, 12 Fokker 100, and five deHavilland Dash 8 aircraft. The acquisition of these aircraft was financed through a combination of sale-leaseback transactions, secured debt financings and interim debt financings. Expenditures for other property, consisting primarily of ground support equipment, leasehold improvements, and major aircraft components, totaled $97 million. Proceeds from disposition of property of $286 million were realized during 1991, primarily as a result of aircraft sale-leaseback transactions. In May 1991, USAir Group sold 4,263,050 Depositary Shares, each representing 1/100 of a share of $437.50 Series B Cumulative Convertible Preferred Stock, without par value, for net proceeds of $207.8 million. Such proceeds were used to repay indebtedness under USAir Group's Credit Agreement. At December 31, 1993, USAir Group's ratio of current assets to current liabilities was 0.53 to 1 and the debt component of USAir Group's capitalization structure was approximately 82% (100% if the redeemable Series A Cumulative Convertible Preferred Stock, the Series F Preferred Stock and the redeemable Series T Cumulative Convertible Exchangeable Senior Preferred Stock are considered to be debt). Item 8A. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION USAir Group, Inc. Independent Auditors' Report The Stockholders and Board of Directors USAir Group, Inc.: We have audited the accompanying consolidated balance sheets of USAir Group, Inc. and subsidiaries ("Group") as of December 31, 1993 and 1992, and the related consolidated statements of opera- tions, cash flows, and changes in stockholders' equity (deficit) for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibil- ity of Group'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 USAir Group, Inc. 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 11 to the consolidated financial statements, effective January 1, 1993, Group changed its method of accounting for postemployment benefits and effective January 1, 1992, Group changed its method of accounting for postretirement benefits other than pensions. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. USAir Group, Inc. Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying consolidated financial statements include the accounts of USAir Group, Inc. ("USAir Group" or the "Company") and its wholly-owned subsidiaries USAir, Inc. ("USAir"), Piedmont Airlines, Inc. ("Piedmont") (formerly Henson Aviation, Inc.), Jetstream International Airlines, Inc. ("Jetstream"), Pennsylvania Commuter Airlines, Inc. ("PCA"), USAir Leasing and Services, Inc. ("Leasing"), USAir Fuel Corporation and Material Services Company, Inc. All significant intercompany accounts and transactions have been eliminated. At December 31, 1992, USAM Corp. ("USAM"), a subsidiary of USAir, owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided CRS services to travel agent subscribers in Europe. Covia was then separated into three new entities. As a result, at December 31, 1993, USAM owns 11% of the Galileo International Partnership which owns and operates the Galileo CRS, approximately 11% of the Galileo Japan Partnership which markets the Galileo CRS in Japan, and approximately 21% of the Apollo Travel Services Partnership which markets the Galileo CRS in the U.S. and Mexico. USAM accounts for these investments using the equity method. On August 1, 1992, two wholly-owned USAir Group's commuter airline subsidiaries, Allegheny Commuter Airlines, Inc. and PCA, merged. PCA, the surviving entity, operates under the name of Allegheny Commuter Airlines, with headquarters in Middletown, Pennsylvania. On July 15, 1992, USAir Group completed the sale of three of its wholly-owned subsidiaries: Piedmont Aviation Services, Inc., Air Service, Inc. and Aviation Supply Corporation. The Company realized a gain of $10.3 million as a result of the sale. The three former subsidiaries engaged in fixed base operations and the sale and repair of aircraft and aircraft components. These subsidiaries were included in the accounts until their sale. On October 9, 1991, USAir reached agreement for the sale of certain assets of its wholly-owned subsidiary Pacific Southwest Airmotive ("Airmotive"). Airmotive discontinued operations in the third quarter of 1991. USAir did not realize any material gain or loss on the sale and discontinuance of Airmotive's operations. USAir Group's principal operating subsidiary, USAir, and its three commuter airline subsidiaries, Piedmont, Jetstream and PCA, operate within one industry (air transportation); therefore, no segment information is provided. Certain 1992 and 1991 amounts have been reclassified to conform with 1993 classifications. (b) Cash and Cash Equivalents For financial statement purposes, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. (c) Materials and Supplies Inventories of materials and supplies are valued at average cost and are charged to operations as consumed. An allowance for obsolescence is provided for flight equipment expendable parts. (d) Property and Equipment Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Maintenance and repairs, including the overhaul of aircraft components, are charged to operating expense as incurred and costs of major improvements are capitalized for both owned and leased assets. Interest related to deposits on aircraft purchase contracts and facility and equipment construction projects is capitalized as additional cost of the asset or as leasehold improvement if the asset is leased. Depreciation and amortization for principal asset classifications is provided on a straight-line basis to estimated residual values over estimated depreciable lives as follows: Property acquired under capital lease is amortized on a straight-line basis over the term of the lease and charged to depreciation expense. (e) Goodwill, Other Intangibles and Other Assets Goodwill, the cost in excess of fair value of identified net assets acquired, is being amortized on a straight-line basis over 40 years as other non-operating expense. Accumulated amortization at December 31, 1993 and 1992 was $98 million and $82 million, respectively. Intangible assets consist of purchased operating rights at various airports, purchased route authorities, and the intangible assets associated with the underfunded amounts of certain pension plans. The operating rights, valued at purchase cost or appraised value if acquired from Piedmont Aviation, Inc. ("Piedmont Avia- tion") or Pacific Southwest Airlines ("PSA"), are being amortized over periods ranging from ten to 25 years as Other Rent and Landing Fees Expense. The purchased route authorities are amortized over periods of 25 years as other operating expense. Accumulated amortization at December 31, 1993 and 1992 was $72 million and $65 million, respectively. The decrease in Other Intangibles, net in 1993 is primarily attributable to the $47 million reclassification of two London routes to Other Assets as a result of USAir's relinquishment of these routes as contemplated by the January 21, 1993 Investment Agreement ("Investment Agreement") between the Company and British Airways Plc ("BA"). USAir relinquished its Charlotte to London route authority in January 1994. In addition, takeoff and landing slots at Washington National Airport were purchased from Northwest Airlines, Inc. ("Northwest") for $10 million during 1993. (f) Restricted Cash and Investments Restricted cash and investments consist primarily of deposits in trust accounts to collateralize letters of credit or workers compensation policies and short-term investments restricted for specified construction projects. These amounts are classified as Other Assets on the accompanying balance sheets. (g) Deferred Gains on Sale and Leaseback Transactions Gains on aircraft sale and leaseback transactions are deferred and amortized over the term of the leases as a reduction of rental expense. (h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered. At the time of sale, a liability is established (Traffic Balances Payable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program. (j) Investment Tax Credit Investment tax credit benefits are recorded using the "flow- through" method as a reduction of the Federal income tax provision. (k) Earnings Per Share Earnings per share is computed by dividing net loss, after deducting preferred stock dividend requirements, by the weighted average number of shares of Common Stock outstanding, net of treasury stock. USAir Group's outstanding redeemable Series A Cumulative Convertible Preferred Stock ("Series A Preferred Stock"), Series B Cumulative Convertible Preferred Stock ("Series B Preferred Stock"), redeemable Series F Cumulative Senior Preferred Stock ("Series F Preferred Stock"), redeemable Series T Cumulative Convertible Exchangeable Senior Preferred Stock ("Series T Preferred Stock) and common stock equivalents are anti-dilutive. (l) Swap Agreements USAir has entered into hedging arrangements to reduce its exposure to fluctuations in the price of jet fuel. Net settlements are recorded as adjustments to aviation fuel expense. USAir is party to such hedging arrangements with several entities. Under these arrangements, the Company's maximum commitments, which are offset by amounts received under the arrangements, totaled approximately $100.3 million and $158.7 million at December 31, 1993 and 1992, respectively. Although the agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements, the Company does not anticipate such nonperformance. The Company has entered into interest rate swap transactions to manage interest rate exposure. Net settlements are recorded as an adjustment to interest expense. The Company is party to such interest rate swap agreements with banks and other financial institutions. The notional principal amounts of these agreements were $150 million and $400 million at December 31, 1993 and 1992, respectively. Under these swap agreements, the Company pays interest at fixed rates averaging 9.8% and 9.7% at December 31, 1993 and 1992, respectively, and receives floating rate interest payments based on three-month LIBOR. Although the agreements, which expire in 1995, expose the Company to credit loss in the event of non-performance by the other parties to the agreements, the Company does not anticipate such non-performance. (2) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Unless a quoted market price indicates otherwise, the fair values of cash and investments generally approximate carrying values because of the short maturity of these instruments. The Company has estimated the fair value of long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities. The estimated fair values of the Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock are obtained by consulting with an independent external valuation source. The fair values of interest rate swap agreements, energy swap agreements and foreign currency contracts are obtained from dealer quotes whereby these values represent the estimated amount the Company would receive or pay to terminate such agreements. The estimated fair values of the Company's financial instru- ments are summarized as follows: (3) LONG-TERM DEBT Details of long-term debt are as follows: Maturities of long-term debt and debt under capital leases for the next five years are as follows: (in thousands) 1994 $ 87,833 1995 75,344 1996 73,464 1997 84,027 1998 152,180 Thereafter 2,059,002 In addition to the varying interest rate on Credit Agreement borrowings as described below, interest rates on $239 million principal amount of long-term debt at December 31, 1993 are subject to adjustment to reflect prime rate and other rate changes. The Company and a group of banks are parties to a Credit Agreement dated as of March 30, 1987, as amended (the "Credit Agreement") which makes a $300 million revolving credit facility available to the Company as of December 31, 1993. The Credit Agreement expires on September 30, 1994. At December 31, 1993, loans under the Credit Agreement, at the option of the Company, would have borne interest at a reference rate, a Eurodollar rate plus 2.50% - 2.65% per annum, determined by the Company's coverage ratio discussed below, or a bid rate if offered by a lending bank. During 1993, 1992 and 1991, the maximum amount of credit agreement borrowings outstanding at any month end was $250 million, $450 million and $733 million, respectively. All outstanding Credit Agreement borrowings were paid off in May 1993 and no other funds were borrowed during the remainder of 1993. The average amount of Credit Agreement borrowings outstanding and weighted average interest rate for 1993 were $37 million and 5.8%, respectively. The average amount of Credit Agreement borrowings outstanding and the weighted average interest rate for 1992 were $174 million and 6.2%, respectively. The average amount of Credit Agreement borrowings and the weighted average interest rate for 1991 were $510 million and 8.3%, respectively. On June 21, 1993, USAir Group entered into the Seventh Amendment to the Credit Agreement. The Seventh Amendment increased the limit of unsecured debt of subsidiaries to $300 million from $200 million. On December 21, 1993, the Company obtained a waiver under the Credit Agreement which further increased the limit of unsecured debt of subsidiaries to $620 million for the period commencing December 21, 1993 and ending on the final annual reduction date of September 30, 1994. This waiver also exempted the Company from compliance, for the quarter ended December 31, 1993, with the coverage ratio test which must be maintained as part of the Credit Agreement. The Company would not otherwise have complied with this test as of December 31, 1993 but was in compliance with the other financial covenants required to be maintained as part of the Credit Agreement. USAir Group is currently unable to borrow under the Credit Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir Group expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir Group will be able to obtain a waiver of compliance with these covenants or arrange a replacement facility. Certain USAir, Piedmont and PCA aircraft and engines with a net book value of $247 million at December 31, 1993 secure the Credit Agreement. Equipment financings totaling $2.0 billion are collateralized by aircraft and engines with a net book value of $2.2 billion at December 31, 1993. An aggregate of $32 million of future principal payments of the Equipment Financing Agreements are payable in Japanese Yen. This foreign currency exposure has been hedged to maturity. Although the Company is exposed to credit loss in the event of non- performance by the counterparty to the hedge agreement, the Company does not anticipate such non-performance. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes ("9 5/8% Senior Notes") which are uncondi- tionally guaranteed by the Company. The 9 5/8% Senior Notes are not reflected in the above table because they were sold after December 31, 1993. (4) COMMITMENTS AND CONTINGENCIES (a) Operating Environment The economic conditions in the United States, fare competition and the emergence and growth of lower cost, lower fare carriers in the domestic airline industry are factors affecting the financial condition of USAir Group. Industry capacity has recently failed to mirror changes in demand due primarily to the continued delivery of new aircraft and secondarily, to the prolonged operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code. USAir competes with at least one major airline on most of its routes between major cities. Although the economy generally has shown signs of improvement, the Company expects that the competitive environment in the airline industry, the entry of low cost, low fare carriers into USAir's markets, and the excess capacity in the domestic airline industry will continue to have an adverse effect on USAir's passenger revenue for the foreseeable future. The extent or duration of these conditions cannot be reasonably determined at this time. (b) Lease Commitments The Company's airline subsidiaries lease certain aircraft, engines, computer and ground equipment, in addition to the majority of their ground facilities. Ground facilities include executive offices, overhaul and maintenance bases and ticket and administra- tive offices. Public airports are utilized for flight operations under lease arrangements with the municipalities or agencies owning or controlling such airports. Substantially all leases provide that the lessee shall pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased property. Most leases also include renewal options and some aircraft leases include purchase options. The following amounts applicable to capital leases are included in property and equipment: At December 31, 1993, obligations under capital and noncancel- able operating leases for future minimum lease payments were as follows: Rental expense under operating leases for 1993, 1992 and 1991 was $781 million, $707 million and $605 million, respectively. Rental expense for 1993 excludes a charge of $9 million related to certain airport facilities where USAir has, among other things, discontinued or reduced its service. Rental expense for 1992 excludes a charge of $72 million related to USAir's grounded BAe- 146 fleet. Rental expense for 1991 excludes a credit of $9 million for the BAe-146 fleet. (c) Legal Proceedings The Company and various subsidiaries have been named as defendants in various suits and proceedings which involve, among other things, environmental concerns and employment matters. These suits and proceedings are in various stages of litigation, and the status of the law with respect to several of the issues involved is unsettled. For these reasons the outcome of these suits and proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition or results of operations. In 1989 and 1990, a number of U.S. air carriers, including USAir, received two Civil Investigative Demands ("CIDs") from the U.S. Department of Justice ("DOJ") (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carriers' responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered by the Court until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter the amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. (d) Aircraft Commitments At December 31, 1993 USAir's new aircraft on firm order, options for new aircraft and scheduled payments for new aircraft orders (including progress payments, buyer furnished equipment, spares, and capitalized interest) were: USAir may elect, under certain circumstances, to convert Boeing 737 Series and Boeing 767 Series firm order or option deliveries to Boeing 757-200 deliveries. If USAir were to elect such a substitution, the payments presented in the table above would change. USAir is currently in negotiations with Boeing regarding, among other things, the above schedule of new aircraft deliveries. In addition, USAir has a commitment to purchase hushkits for certain of its McDonnell Douglas DC-9-30 aircraft and a substantial portion of its Boeing 737-200 aircraft. The installation of these hushkits will bring the aircraft into compliance with Federal Aviation Administration ("FAA") Stage 3 noise level requirements. The projected payments associated with the purchase of the hushkits are: $29.1 million - 1994; $12.0 million - 1995; $42.3 million - 1996; $43.4 million - 1997; $44.0 million - 1998; and $30.8 million thereafter. (e) Concentration of Credit Risk USAir Group does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, most of the Company's receivables related to tickets sold to individual passengers through the use of major credit cards (48%) or to tickets sold by other airlines (17%) and used by passengers on USAir or the commuter subsidiaries. These receivables are short- term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (f) Guarantees At December 31, 1993, USAir guaranteed payments of certain debt obligations of the Galileo International Partnership amounting to approximately $16 million. (5) SALE OF RECEIVABLES USAir is party to an agreement ("Receivables Agreement") to sell, on a revolving basis, undivided interest of up to $240 million in a pool of designated receivables. Approximately $141 million was available for sale at December 31, 1993 based on receivable balances at that date. The maximum amount available under the Receivables Agreement to be sold gradually reduces from $240 million at December 31, 1993, to $190 million on June 30, 1994. The Receivables Agreement expires on December 21, 1994. USAir had no outstanding amounts due under the Receivable Agreement at December 31, 1993. The net amounts sold reduce receivables in the accompanying balance sheet by $220 million and $188 million at December 31, 1992 and 1991, respectively. Included in the accounts payable balances at December 31, 1992 and 1991, are $74 million and $64 million, respectively, which represent funds held by USAir related to previously sold receivables that had been collected. USAir obtained a waiver from the purchaser of the receivables and its operating agent, exempting USAir from compliance with the coverage ratio financial covenant in the Receivables Agreement for the quarter ended December 31, 1993. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 required a change from the deferred method under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. No cumulative adjustment at January 1, 1993, and no income tax credit for the year ended December 31, 1993, were recognized due to the FAS 109 limitation in recognizing benefits for net operating losses. The Company files a consolidated Federal income tax return with its wholly-owned subsidiaries. The components of the provision (credit) for income taxes are as follows: The significant components of deferred income tax expense/- (benefit) for the year ended December 31, 1993, are as follows: Deferred tax benefit (exclusive of the other components listed below) $(136,191) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (8,880) Increase for the year in the valuation allowance for deferred tax assets 145,071 -------- Total $ 0 ======== For the years ended December 31, 1992 and 1991 deferred income taxes result from differences in the recognition of revenue and expenses and investment tax credits for tax and financial reporting purposes. The major items resulting in these differences and the related tax effects are shown in the following chart: A reconciliation of taxes computed at the statutory Federal tax rate on earnings before income taxes to the provision (credit) for income taxes is 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 are presented below: (in thousands) Deferred tax assets: Leasing transactions $ 132,551 Tax benefits purchased/sold 79,434 Gain on sale and leaseback transactions 164,613 Employee benefits 430,257 Net operating loss carryforwards 557,494 Alternative minimum tax credit carryforwards 21,146 Investment tax credit carryforwards 49,802 Other deferred tax assets 62,615 --------- Total gross deferred tax assets 1,497,912 Less valuation allowance (564,838) --------- Net deferred tax assets 933,074 Deferred tax liabilities: Equipment depreciation and amortization (874,640) Other deferred tax liabilities (58,434) --------- Net deferred tax liabilities (933,074) --------- Net deferred taxes $ 0 ========= The valuation allowance for deferred tax assets as of January 1, 1993, was $420 million. The increase in the valuation allowance during 1993 was $145 million. At December 31, 1993, the Company had unused net operating losses of $1.5 billion for Federal tax purposes, which expire in the years 2005-2008. The Company also has available, to reduce future taxes payable, $460 million alternative minimum tax net operating losses expiring in 2007 and 2008, $50 million of investment tax credits expiring in 2002 and 2003, and $21 million of minimum tax credits which do not expire. The Federal income tax returns of the Company through 1986 have been examined and settled with the Internal Revenue Service. (7) BRITISH AIRWAYS PLC INVESTMENT On January 21, 1993, USAir Group and BA entered into the Investment Agreement under which a wholly-owned subsidiary of BA purchased certain series of convertible preferred stock during 1993 (see Note 8 - Redeemable Preferred Stock) and BA entered into code sharing and wet lease arrangements with USAir contemplated by the Investment Agreement. On March 7, 1994, BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce its costs and improve its financial results is known. At December 31, 1993, the preferred stock held by BA con- stituted approximately 22% of the total voting interest in the Company. To the extent permitted by foreign ownership restrictions which are applicable by statute regulations or interpretation by regulatory authorities, including the U.S. Department of Transpor- tation ("DOT") ("Foreign Ownership Restrictions"), the preferred stock owned by BA votes on all matters presented to the Company's stockholders for a vote and has voting power equal to the underly- ing shares of Common Stock. Under the Investment Agreement, on January 21, 1993, BA designated three of its officers to serve on the Company's Board of Directors. The Company has agreed to use its best efforts to place these designees on the slate of nominees for election as Directors of the Company. In addition to BA's holdings of the Company's preferred stock at December 31, 1993, BA has the option, which it has announced it will not exercise under current circumstances, to purchase, at a minimum, an additional $450 million of the Company's preferred stock. Under certain circumstances, BA is entitled, at its option, to purchase, on or prior to January 21, 1996, 50,000 shares of Series C Cumulative Convertible Senior Preferred Stock ("Series C Preferred Stock") resulting in an additional cash investment in the Company of $200 million, and, on or prior to January 21, 1998, 25,000 shares of Series E Cumulative Convertible Senior Preferred Stock ("Series E Preferred Stock") resulting in an additional cash investment in the Company of $250 million. If the DOT approves all the transactions and acts contemplated by the Investment Agreement, at the election of either BA or the Company on or prior to January 21, 1998, BA's purchase of the Series C Preferred Stock (unless previously consummated) and BA's purchase of the Series E Preferred Stock must be consummated under certain circumstances. On March 15, 1993, the DOT issued an order ("DOT Order") stating, among other things, that BA's initial investment does not impair USAir's citizenship under current U.S. Foreign Ownership Restrictions. However, the DOT instituted a proceeding to consider whether USAir will remain a U.S. citizen if the transactions and acts contemplated by the Investment Agreement, including the possible sale of Series C Preferred Stock and Series E Preferred Stock, to BA, are consummated. The DOT has indefinitely suspended the period for comments from interested parties pending its resolution of requests by other airlines for production of additional documents from USAir. The DOT Order states that the DOT expects and advises USAir and BA not to proceed with the closing of the purchase of the Series C Preferred Stock or the Series E Preferred Stock until the DOT has completed its review of USAir's citizenship. In any event, on March 7, 1994, BA announced it would not make any additional investments in the Company under current circumstances. USAir cannot predict the outcome of the proceedings or if further transactions contemplated under the Investment Agreement, including the sale of Series C and Series E Preferred Stock to BA, will be consummated. The sale of additional preferred stock to BA on June 10, 1993 (see Note 8(c)), did not result in BA's ownership of voting stock in the Company exceeding applicable foreign ownership restrictions and therefore does not affect the Company's U.S. citizenship under those restrictions. (8) REDEEMABLE PREFERRED STOCK (a) Series A Preferred Stock At December 31, 1993, the Company had 358,000 shares of its 9 1/4% Series A Cumulative Convertible Redeemable Preferred Stock ("Series A Preferred Stock"), without par value, outstanding which was convertible into 9,239,944 shares of the Company's Common Stock at a conversion price of approximately $38.74 per share. The Series A Preferred Stock ranks pari passu with the Series F Cumulative Convertible Senior Preferred Stock ("Series F Preferred Stock"), without par value, and Series T-_ Cumulative Convertible Exchangeable Senior Preferred Stock ("Series T Preferred Stock"), without par value, and senior to the Series B Cumulative Convert- ible Preferred Stock ("Series B Preferred Stock"), without par value, Junior Participating Preferred Stock, Series D ("Series D Preferred Stock"), without par value, and the Common Stock, with respect to dividend payments and the distribution of assets. At December 31, 1993, the Series A Preferred Stock is entitled to approximately 25.81 votes per share (determined by dividing the $1,000 liquidation preference per share of Series F Preferred Stock by the $38.74 conversion price), or a total of 9,239,944 votes, and votes together with the Series F Preferred Stock, the Series T Preferred Stock and the Common Stock, on all matters submitted to a vote of stockholders of the Company. The Series A Preferred Stock is redeemable on August 7, 1999 at $1,000 per share. The Company has the right to redeem the stock at a 10% premium until that time. The agreement relating to the sale of the Series A Preferred Stock imposes certain restrictions on the purchaser's ability to increase its ownership of, and to transfer, its stock in USAir Group. There have been no changes in the balance sheet value of the Series A Preferred Stock since its issuance in 1989. (b) Series F Preferred Stock At December 31, 1993, the Company had outstanding 30,000 shares of its 7% Series F Preferred Stock which was convertible into 15,458,658 shares of the Company's Common Stock at a conver- sion price of approximately $19.41 per share. The Series F Preferred Stock ranks pari passu with the Series A Preferred Stock and Series T Preferred Stock and senior to the Series B Preferred Stock, Series D Preferred Stock, and the Common Stock, with respect to dividend payments and the distribution of assets. At December 31, 1993, each share of Series F Preferred Stock was entitled to approximately 515.29 votes per share to the extent permitted by the existing Foreign Ownership Restrictions and votes with the Company's Series A Preferred Stock, the Series T Preferred Stock and the Company's Common Stock as a single class. Under Foreign Ownership Restrictions, no more than 25% of the Company's voting interest may be held by persons other than U.S. citizens. In accordance with the terms of any preferred stock held by BA, conversion rights and voting rights may not be exercised to the extent that doing so would result in a loss of the Company's or any of its subsidiaries' operating certificates and authorities under Foreign Ownership Restrictions, and it is assumed for this purpose that Series F Preferred Stock will be fully converted before any other preferred stock held by BA. The Series F Preferred Stock is convertible at any time on or after January 21, 1997 to the extent that such conversion would not violate U.S. Foreign Ownership Restrictions. Series F Preferred Stock may be converted at the option of the Company at any time after January 21, 1998 if the average composite closing market price of Common Stock during any 30-day calendar period is at least 133% of the conversion price. The Series F Preferred Stock is mandatorily redeemable on January 21, 2008. If BA has not purchased the Series C Preferred Stock by January 21, 1996, then the Company may at its option redeem, in whole or in part, Series F Preferred Stock at the higher of market value or the price of $10,000 per share, plus accrued dividends. The Series F Certifi- cate provides that if on any one occasion on or prior to Janu- ary 21, 1996, any court or regulatory authority issues a final order that any material part of the Investment Agreement is unenforceable (except pursuant to bankruptcy or like event), then the conversion price of Series F Preferred Stock shall be reduced by 10.2564%. There have been no changes in the balance sheet value of the Series F Preferred Stock since its issuance in 1993. (c) Series T Preferred Stock Under the Investment Agreement, BA has preemptive and optional purchase rights to maintain its proportionate ownership of the Company's Common Stock and convertible securities, measured in terms of the BA Percentage ("BA Percentage") which approximates BA's fully diluted ownership percentage based on BA's current and potential holdings in the Company. The BA Percentage is calculated without regard to Foreign Ownership Restrictions at the time of the calculation. BA may exercise such preemptive or optional purchase rights by purchasing, from time-to-time, a series of Series T Preferred Stock. At December 31, 1993, the Company had two series of the Series T Preferred Stock outstanding. On June 10, 1993, BA exercised its preemptive purchase right by purchasing 9,919.8 shares of a series of the Series T Preferred Stock ("Series T-2 Preferred Stock") for approximately $99.2 million and exercised its optional purchase right by purchasing 152.1 shares of a series of Series T Preferred Stock ("T-1 Preferred Stock") for approximately $1.5 million. BA's preemptive right was triggered by the issuance of Common Stock, as described in Note 8 - Stockholders' Equity, and BA's optional purchase rights were triggered by the Company's issuance of additional shares of Common Stock through the exercise of options under various employee stock option plans and through the sale of shares to certain defined contribution plans during the period from January 21, 1993 to March 31, 1993. On March 7, 1994, BA advised the Company that it would not exercise its optional purchase rights to buy three additional series of Series T Preferred Stock triggered by the Company's issuance of common stock pursuant to certain employee benefit plans during the second, third and fourth quarters of 1993. There have been no changes in the balance sheet value of the Series T-1 Preferred Stock and Series T-2 Preferred Stock since their issuance in 1993. The terms of all series of the Series T Preferred Stock are substantially similar to those of the Series F Preferred Stock except as noted. Each share of Series T-2 Preferred Stock carries a conversion price of $26.40 and is convertible into approximately 378.79 shares of Common Stock or Non-Voting Class ET stock. Each share of Series T-1 Preferred Stock has a conversion price of $20.50 and is convertible into approximately 487.80 shares of Common Stock or Non-Voting Class ET stock. With respect to the Series T Preferred Stock, dividends are payable quarterly in arrears, at 50 basis points over the three-month LIBOR rate. Any shares of the Series T Preferred Stock held by any person other than BA or its subsidiaries may be redeemed for cash at any time at the option of the Company at $10,000 plus accrued dividends plus a redemption premium equal to $700 from the date of issue until the first anniversary thereof and reduced by $46.67 on each anniversary thereafter. The Series T Preferred Stock is exchangeable, at the option of the Company, for that principal amount of floating rate convertible subordinated notes of the Company ("T Notes") equal to the liquidation preference of the shares to be exchanged and bearing interest at the dividend rate. Any accrued dividends on the Series T Preferred Stock to be exchanged will be treated as accrued interest on the T Notes. Each $10,000 aggregate principal amount of such T Notes will be entitled to a number of votes equal to the number of votes to which each share of Series T Preferred Stock was entitled at the time of its exchange for T Notes, subject to adjustment. If issued, T Notes will have terms otherwise consis- tent with the terms of the Series T Preferred Stock. (9) STOCKHOLDERS' EQUITY (a) Common Stock The Company had 150,000,000 and 100,000,000 authorized shares of Common Stock, par value $1, at December 31, 1993 and 1992, respectively. If BA purchases the Series C Preferred Stock (see Note 6 - British Airways Plc Investment), the number of authorized shares of various classes of Common Stock will increase to 300,000,000. BA has indicated, however, that it will not make any additional investments in the Company under current circumstances. At December 31, 1993, approximately 52,618,000 shares were reserved for issuance upon the conversion of preferred stock and for offerings under employee stock purchase, stock option and stock incentive plans. On May 4, 1993, the Company sold 11.5 million shares of previously unissued Common Stock at $20.75 per share through a public, underwritten offering. The offering netted proceeds of approximately $231 million. (b) Preferred Stock and Senior Preferred Stock At December 31, 1993, the Company had 5,000,000 authorized shares of preferred stock, without nominal or par value, of which 358,000 shares were issued as Series A Preferred Stock, 43,000 shares were issued as Series B Preferred Stock and 1,035,000 shares were reserved as Series D Preferred Stock. Also, at December 31, 1993, the Company had 3,000,000 authorized shares of Senior Preferred Stock, without nominal or par value, of which 30,000 shares were issued as Series F Preferred Stock and approximately 10,000 were issued as Series T Preferred Stock. (c) Series B Preferred Stock At December 31, 1993, the Company had 4,263,050 Depositary Shares, representing 42,630.5 shares of its $437.50 Series B Preferred Stock outstanding. Each Depositary Share represents 1/100 of a share of the Series B Preferred Stock. The Series B Preferred Stock is convertible at any time, at the option of the holder, at the rate of 249.25 shares of Common Stock of the Company per preferred share, or 2.4925 shares of Common Stock per De- positary Share. The Series B Preferred Stock ranks junior to the Company's Series A Preferred Stock, the Series F Preferred Stock and the Series T Preferred Stock and senior to the Series D Preferred Stock and the Common Stock with respect to dividend payments and the distribution of assets, whether upon liquidation or otherwise. Except under certain circumstances, the holders of Series B Preferred Stock have no voting rights. The Series B Preferred Stock is not redeemable prior to May 15, 1994. The Series B Preferred Stock is redeemable, at the option of the Company and with consent of the holders of Series F Preferred Stock, on or after May 15, 1994, (i) in whole but not in part, only in certain circumstances, for so long as any shares of Series A Preferred Stock are outstanding; and (ii) in whole or in part if no shares of Series A Preferred Stock are outstanding, in each case initially at a redemption price of approximately $53.06 per 1/100 of a share and thereafter at prices declining to $50 per 1/100 of a share (equivalent to $5,000 per share of Series B Preferred Stock) on or after May 15, 2001, plus dividends accrued and accumulated but unpaid to the redemption date. (d) Preferred Stock Purchase Rights Each outstanding share of Common Stock is accompanied by one Preferred Share Purchase Right ("Right") and each outstanding share of Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock is accompanied by a Right for each share into which it is convertible. Each Right entitles the holder to buy 1/100th of a share of Series D Preferred Stock at an exercise price of $175 per Right. The Rights expire on June 29, 1996. As long as the Rights remain outstanding, the Company will issue one Right with each new share of Common Stock issued upon the conversion of any preferred stock into, or the exercise of any options for, Common Stock, as long as such preferred stock or options were outstanding prior to the Rights becoming exercisable. Generally, the Rights become exercisable only if a party other than, under certain circumstances, BA acquires 20% or more of the Company's Common Stock or announces a tender offer for 20% or more of the Common Stock. The Rights are redeemable at $.03 per Right at any time before 20% or more of the Company's Common Stock has been acquired. If at any time after the Rights become exercisable and before they have been redeemed the Company is involved in a merger or other business combination transaction, the Rights will automatically entitle a holder, other than a holder of 20% or more of the Company's Common Stock, to receive, upon exercise of each Right, a number of shares of Common Stock, or a number of common shares of the acquiring company, as the case may be, having a market value of two times the exercise price of each Right. In addition, at any time after the acquisition of 30% or more of the Common Stock by any person and prior to the acquisition by such person of 50% or more of the Common Stock, the Board of Directors of the Company may exchange the Rights (other than Rights owned by such person which have become void), in whole or in part, at an exchange ratio of one share of Common Stock, or 1/100th of a share of Series D Preferred Stock, per Right. Until the first to occur of the redemption or expiration of the Rights, the Company will issue one Right with each new share of Common Stock issued upon the conversion of any securities into, or the exercise of any options or warrants for, Common Stock if such securities, options or warrants were outstanding prior to when Rights became exercisable. (e) Treasury Stock In 1989, the Company's Board of Directors authorized the repurchase from time-to-time of up to 9.4 million shares of its Common Stock in open market transactions. In 1989, approximately 2.1 million shares were repurchased. The Company sold approximate- ly 500,000 shares and approximately 390,000 shares of its treasury stock during 1993 and 1992, respectively. The remaining shares are carried on the accompanying balance sheet at the average acquisi- tion cost. (f) Employee Stock Option and Purchase Plans During 1992, the Company's stockholders approved the 1992 Stock Option Plan ("1992 Plan") which allows for the issuance of stock options to purchase up to 8,125,000 shares of USAir Group Common Stock to USAir employees who participate in the previously announced cost reduction program. Under the stock option program, employees whose pay was or is currently being reduced receive options to purchase 50 shares of Common Stock at a price not less than $15 per share for each $1,000 of salary reduction. The Company will grant stock options under the 1992 Plan only in connection with salary reductions. Participating employees have five years from the grant date to exercise such options. Options, with an exercise price of $15, have been granted to purchase ap- proximately five million shares of Common Stock in conjunction with salary reductions. The Company plans to seek authority from its stockholders at its 1994 Annual Meeting to reduce the number of shares reserved for this plan. At December 31, 1993, 5.3 million shares of Common Stock are reserved for the granting of stock options or restricted stock under the Company's 1984 Stock Option and Stock Appreciation Rights ("SARs") Plan and 1988 Stock Incentive Plan. These plans provide that options may be granted as either nonqualified or incentive stock options. Options awarded prior to 1991, except for those that reverted, have vested. Options awarded during 1991, 1992 and 1993, except under the 1992 Plan, become exercisable generally within three years from date of grant. Optionees may also receive SARs which permit them to receive, in lieu of the right to exercise the stock option, an amount equivalent to the difference between the stock option price and the fair market value of the Common Stock on the date of exercising the right. This amount may be paid in stock, in cash, or in any combination of the two. Also, restricted stock award grants for 57,000 shares and 111,600 shares were outstanding at December 31, 1993 and 1992, respectively. Deferred compensation related to the restricted stock, which vests over periods of up to five years, amounted to $.3 million and $ .6 million at December 31, 1993 and 1992, respectively. As of December 31, 1993, options to acquire approximately 9 million shares under all three plans, including 85,000 SARs, were outstanding at a weighted average exercise price of $18.77. Of those outstanding, approximately six million options were exercis- able at December 31, 1993. Options were exercised to purchase approximately 33,500 and 6,000 shares of Common Stock at average exercise prices of $17.24 and $10.44 during 1993 and 1992, respectively. (g) Dividend Restrictions The Company's Credit Agreement does not contain specific provisions which restrict the payment of dividends by USAir Group. The amount of dividends, however, is indirectly restricted through the existence of certain covenants contained in the Credit Agreement. At December 31, 1993, under the most restrictive of these provisions, the Company's ability to pay dividends is limited to approximately $77 million. (10) EMPLOYEE STOCK OWNERSHIP PLAN In August 1989, USAir established an Employee Stock Ownership Plan ("ESOP"). The Company sold 2,200,000 shares of Common Stock to an Employee Stock Ownership Trust to hold on behalf of USAir's employees, exclusive of officers, in accordance with the terms of the Trust and the ESOP. Financing of approximately $111.4 million for the Trust's purchase of the shares was provided by USAir through a 9 3/4% loan to the Trust, and an additional $2.2 million was contributed to the Trust by USAir. The loan is being repaid with contributions made by USAir. The contributions are made in amounts equal to the periodic loan payments as they come due, less dividends available for loan payment. The amount of dividends used for debt service by the ESOP was $127,000 in 1991. As the loan is repaid over time, participating employees receive allocations of the Common Stock purchased by the Trust. The initial maturity of the loan is 30 years. However, the ESOP provides that if the Company's profitability as measured by return on sales exceeds certain goals during the life of the ESOP, USAir's contributions and the repayment of the loan will be accelerated. Contributions made by USAir and therefore loan repayments made by the Trust were $11.4 million in 1993, 1992 and 1991. The interest portion of these contributions was $10.5 million in 1993, $10.6 million in 1992 and $10.7 million in 1991. Approximately 366,000 shares of Common Stock have been allocated to employees. USAir recognized approximately $4 million of compensation expense related to the ESOP in each of 1993, 1992 and 1991 based on shares allocated to employees (the "shares allocated" method). Deferred compensation related to the ESOP amounted to approximately $95 million, $98 million and $102 million at December 31, 1993, 1992 and 1991, respectively. (11) EMPLOYEE BENEFIT PLANS (a) Pension Plans The Company's subsidiaries have several pension plans in effect covering substantially all employees. One qualified defined benefit plan covers USAir maintenance employees and provides benefits of stated amounts for specified periods of service. Qualified defined benefit plans for substantially all other employees provide benefits based on years of service and compensa- tion. The qualified defined benefit plans are funded, on a current basis, to meet requirements of the Employee Retirement Income Security Act of 1974. The defined benefit pension plan for USAir non-contract employees was frozen at the end of 1991 for all non-contract participants, resulting in a one-time book gain of approximately $107 million in 1991. All non-contract plan participants became 100% vested at the time of the freeze. As a result of this plan curtailment, the accrual of service costs related to defined benefits for USAir non-contract employees ceased at the end of 1991. USAir implemented a defined contribution pension plan for non-contract employees in January 1993. The funded status of the qualified defined benefit plans at December 31, 1993 and 1992 was as follows: Approximately 97% of the accumulated benefit obligation was vested at December 31, 1993 and 1992. Unrecognized transition assets are being amortized over periods up to 27 years. The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.6% and 8.75% as of December 31, 1993 and 1992, respectively. The expected long-term rate of return on plan assets used in 1993 and 1992 was 9.5%. Rates of 3% to 6% were used to estimate future salary levels. At December 31, 1993, plan assets consisted of approxi- mately 8% in cash equivalents and short-term debt investments, 37% in equity investments, and 55% in fixed income and other invest- ments. At December 31, 1992, plan assets consisted of approximate- ly 4% in cash equivalents and short-term debt investments, 70% in equity investments, and 26% in fixed income and other investments. The following items are the components of the net pension cost for the qualified defined benefit plans: Net pension cost for 1993 and 1991 presented above excludes a settlement charge of approximately $33.9 million and $21.6 million, respectively, related to "early-out" incentive programs offered to a limited number of USAir employees during the years. No such charges were incurred in 1992. Non-qualified supplemental pension plans are established for certain employee groups, which provide incremental pension payments from the Company's funds so that total pension payments equal amounts that would have been payable from the Company's principal pension plans if it were not for limitations imposed by income tax regulations. The following table sets forth the non-qualified plans' status at December 31, 1993 and 1992: Net supplementary pension cost for the two years included the following components: The discount rate used to determine the actuarial present value of the projected benefit obligation was 7.5% and 8.75% as of December 31, 1993 and 1992, respectively. Rates of 3% to 6% were used to estimate future salary levels. In addition to the qualified and non-qualified defined benefit plans described above, USAir also contributes to certain defined contribution plans primarily for employees not covered under a collective bargaining agreement. Company contributions are based on a formula which considers the age and pre-tax earnings of each employee and the amount of employee contributions. The Company's contribution expense was $42 million for 1993. The Company recognized no such expense in 1992 or 1991. (b) Postretirement Benefits Other Than Pensions USAir offers medical and life insurance benefits to employees who retire from the Company and their eligible dependents. The medical benefits provided by USAir are coordinated with Medicare benefits. Retirees generally contribute amounts towards the cost of their medical expenses based on years of service with the Company. USAir provides uninsured death benefit payments to survivors of retired employees for stated dollar amounts, or in the case of retired pilot employees, death benefit payments determined by age and level of pension benefit. The plans for postretirement medical and death benefits are funded on the pay-as-you-go basis. USAir adopted Statement of Financial Accounting Standards No. 106 ("FAS 106") during 1992 and elected to record the January 1, 1992 Accumulated Postretirement Benefit Obligation ("APBO") using the immediate recognition approach. The cumulative effect of adopting FAS 106 was $745.7 million ($628.1 million net of tax benefit). The following table sets forth the financial status of the plans as of December 31, 1993 and 1992: The components of net periodic postretirement benefit cost are as follows: The postretirement benefit expense for 1993 presented above excludes a charge of approximately $15.5 million related to "early out" programs offered to a limited number of employees during the year. No such charges were incurred in 1992 or 1991. The discount rate used to determine the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate used in measuring the APBO was 10.5% in 1993 and 1994, declining by 1% per year after 1994 to an ultimate rate of 4.5%. If the assumed health care cost trend rate were increased by one percentage point, the APBO at December 31, 1993 would be increased by 10% and 1993 periodic postretirement benefit cost would increase 13%. Prior to the adoption of FAS 106, USAir recognized expense for retiree health care at an estimated monthly rate (based on payments) and recognized expense for death benefits when paid. The expense using this methodology was approximately $8 million for 1991. (c) Postemployment Benefits USAir adopted Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits" ("FAS 112"), during 1993. FAS 112 requires the use of an accrual method to recognize postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 was $43.7 million. (12) SUPPLEMENTAL BALANCE SHEET INFORMATION The components of certain accounts in the accompanying balance sheets are as follows: (13) NON-RECURRING AND UNUSUAL ITEMS (a) 1993 The Company's results for 1993 include non-recurring charges of (i) $43.7 million for the cumulative effect of an accounting change, as required by FAS 112 which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (ii) $68.8 million for severance, early retirement and other personnel-related expenses recorded primarily during the third quarter of 1993 in connection with a workforce reduction of approximately 2,500 full- time positions between November 1993 and the first half of 1994; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions, recorded in the fourth quarter of 1993; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service, recorded in the fourth quarter of 1993; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership which operates a computerized reserva- tions system, recorded in the fourth quarter of 1993; and (vi) $18.4 million credit related to non-operating aircraft recorded in the second quarter of 1993. (b) 1992 The Company's results for 1992 include (i) a charge of $628.1 million for the cumulative effect of an accounting change as required by FAS 106, effective January 1, 1992; (ii) a $107.4 million charge related to certain aircraft which have been withdrawn from service, recorded in the fourth quarter of 1992; (iii) a $34.1 million non-operating loss related to the sale of ten MD-82 aircraft which USAir eliminated from its fleet plan, recorded in the fourth quarter of 1992; and (iv) a $10.3 million gain on the sale of three wholly-owned subsidiaries, recorded in the third quarter of 1992 (see Note (1)). (c) 1991 The Company's results for 1991 include (i) a $107 million pre- tax gain related to freezing of the fully funded non-contract employee pension plan; (ii) a $21.6 million pre-tax expense related to early retirement incentives offered to certain employees during 1991; (iii) a $21 million pre-tax charge to establish an additional reserve for USAir's grounded BAe-146 fleet; and (iv) $18.5 million, net, in miscellaneous non-recurring charges. (14) SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents selected quarterly financial data for 1993 and 1992: Item 8B. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION USAir, Inc. Independent Auditors' Report The Stockholder and Board of Directors USAir, Inc.: We have audited the accompanying consolidated balance sheets of USAir, Inc. and subsidiaries ("USAir") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of USAir'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 USAir, Inc. 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 9 to the consolidated financial state- ments, effective January 1, 1993, USAir changed its method of accounting for postemployment benefits and effective January 1, 1992, USAir changed its method of accounting for postretirement benefits other than pensions. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 (PAGE> (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying consolidated financial statements include the accounts of USAir, Inc. ("USAir") and its wholly-owned subsidiary USAM Corp. ("USAM"). USAir is a wholly-owned subsidiary of USAir Group, Inc. ("USAir Group" or "the Company"). All significant intercompany accounts and transactions have been eliminated. At December 31, 1992, USAM owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided services to travel agent subscribers in Europe. Covia was then separated into three new entities. As a result, at Decem- ber 31, 1993, USAM owns 11% of the Galileo International Partner- ship which owns and operates the Galileo CRS, approximately 11% of the Galileo Japan Partnership which markets the Galileo CRS in Japan and approximately 21% of the Apollo Travel Services Partner- ship which markets the Galileo CRS in the U.S. and Mexico. USAM accounts for these investments using the equity method. On October 9, 1991, USAir reached agreement for the sale of certain assets of its wholly-owned subsidiary Pacific Southwest Airmotive ("Airmotive"). Airmotive discontinued operations in the third quarter of 1991. USAir did not realize any material gain or loss on the sale and discontinuance of Airmotive's operations. Certain 1992 and 1991 amounts have been reclassified to conform with 1993 classifications. (b) Cash and Cash Equivalents For financial statement purposes, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. (c) Materials and Supplies Inventories of materials and supplies are valued at average cost and are charged to operations as consumed. An allowance for obsolescence is provided for flight equipment expendable parts. (d) Property and Equipment Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Maintenance and repairs, including the overhaul of aircraft components, are charged to operating expense as incurred and costs of major improvements are capitalized for both owned and leased assets. Interest related to deposits on aircraft purchase contracts and facility and equipment construction projects is capitalized as additional cost of the asset or as leasehold improvement if the asset is leased. Depreciation and amortization for principal asset classifications is provided on a straight-line basis to estimated residual values over estimated depreciable lives as follows: Property acquired under capital lease is amortized on a straight-line basis over the term of the lease and charged to depreciation expense. (e) Goodwill, Other Intangibles and Other Assets Goodwill, the cost in excess of fair value of identified net assets acquired, is being amortized on a straight-line basis over 40 years as other non-operating expense. Accumulated amortization at December 31, 1993 and 1992 was $98 million and $82 million, respectively. Intangible assets consist of purchased operating rights at various airports, purchased route authorities, and the intangible assets associated with the underfunded amounts of certain pension plans. The operating rights, valued at purchase cost or appraised value if acquired from Piedmont Aviation, Inc. ("Piedmont Avia- tion") or Pacific Southwest Airlines ("PSA"), are being amortized over periods ranging from ten to 25 years as Other Rent and Landing Fees Expense. The purchased route authorities are amortized over periods of 25 years as other operating expense. Accumulated amortization at December 31, 1993 and 1992 was $72 million and $64 million, respectively. The decrease in Other Intangibles, net in 1993 is primarily attributable to the $47 million reclassification of two London routes to Other Assets as a result of USAir's relinquishment of these routes as contemplated by the January 21, 1993 Investment Agreement ("Investment Agreement") between the Company and British Airways Plc ("BA"). USAir relinquished its Charlotte to London route authority in January 1994. In addition, takeoff and landing slots at Washington National Airport were purchased from Northwest Airlines, Inc. ("Northwest") for $10 million during 1993. (f) Restricted Cash and Investments Restricted cash and investments consist primarily of deposits in trust accounts to collateralize letters of credit or workers compensation policies and short-term investments restricted for specified construction projects. These amounts are classified as Other Assets on the accompanying balance sheets. (g) Deferred Gains on Sale and Leaseback Transactions Gains on aircraft sale and leaseback transactions are deferred and amortized over the term of the leases as a reduction of rental expense. (h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered. At the time of sale, a liability is established (Traffic Balances Payable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. Approximately $29 million and $28 million of amounts owed to wholly-owned subsidiaries of USAir Group for passenger transportation revenue are included in Traffic Balances Payable and Unused Tickets at December 31, 1993 and 1992, respectively. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program. (j) Investment Tax Credit Investment tax credit benefits are recorded using the "flow- through" method as a reduction of the Federal income tax provision. (k) Swap Agreements USAir has entered into hedging arrangements to reduce its exposure to fluctuations in the price of jet fuel. Net settlements are recorded as adjustments to aviation fuel expense. USAir is party to such hedging arrangements with several entities. Under these arrangements, the Company's maximum commitments, which are offset by amounts received under the arrangements, totaled approximately $100.3 million and $158.7 million at December 31, 1993 and 1992, respectively. Although the agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements, the Company does not anticipate such nonperformance. (2) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Unless a quoted market price indicates otherwise, the fair values of cash and investments generally approximate carrying values because of the short maturity of these instruments. USAir has estimated the fair value of long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities. The fair values of energy swap agreements and foreign currency contracts are obtained from dealer quotes whereby these values represent the estimated amount USAir would receive or pay to terminate such agreements. The estimated fair values of USAir's financial instruments are summarized as follows: (3) LONG-TERM DEBT Details of long-term debt are as follows: Maturities of long-term debt and debt under capital leases for the next five years are as follows: (in thousands) 1994 $ 85,715 1995 75,691 1996 75,715 1997 86,496 1998 155,234 Thereafter 2,153,879 Interest rates on $239 million principal amount of long-term debt at December 31, 1993 are subject to adjustment to reflect prime rate and other rate changes. Equipment financings totaling $2.1 billion are collateralized by aircraft and engines with a net book value of $2.2 billion at December 31, 1993. In addition, certain USAir aircraft and engines with a net book value of $162 million collateralize USAir Group's Credit Agreement borrowings. An aggregate of $32 million of future principal payments of the Equipment Financing Agreements are payable in Japanese Yen. This foreign currency exposure has been hedged to maturity. Although the Company is exposed to credit loss in the event of non- performance by the counterparty to the hedge agreement, the Company does not anticipate such non-performance. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes ("9 5/8% Senior Notes") which are uncondi- tionally guaranteed by the Company. The 9 5/8% Senior Notes are not reflected in the above table because they were sold after December 31, 1993. (4) COMMITMENTS AND CONTINGENCIES (a) Operating Environment The economic conditions in the United States, fare competition and the emergence and growth of low cost, low fare carriers in the domestic airline industry are factors affecting the financial condition of USAir. Industry capacity has recently failed to mirror changes in demand due primarily to the continued delivery of new aircraft and secondarily, to the prolonged operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code. USAir competes with at least one major airline on most of its routes between major cities. Although the economy generally has shown signs of improvement, the Company expects that the competitive environment in the airline industry, the entry of low cost, low fare carriers into USAir's markets, and the excess capacity in the domestic airline industry will continue to have an adverse effect on USAir's passenger revenue for the foreseeable future. The extent or duration of these conditions cannot be reasonably determined at this time. (b) Lease Commitments USAir leases certain aircraft, engines, computer and ground equipment, in addition to the majority of its ground facilities. Ground facilities include executive offices, overhaul and mainte- nance bases and ticket and administrative offices. Public airports are utilized for flight operations under lease arrangements with the municipalities or agencies owning or controlling such airports. Substantially all leases provide that the lessee shall pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased property. Most leases also include renewal options and some aircraft leases include purchase options. The following amounts applicable to capital leases are included in property and equipment: At December 31, 1993, obligations under capital and noncancel- able operating leases for future minimum lease payments were as follows: Rental expense under operating leases for 1993, 1992 and 1991 was $739 million, $678 million and $576 million, respectively. Rental expense for 1993 excludes a charge of $9 million related to certain airport facilities where USAir has, among other things, discontinued or reduced its service. Rental expense for 1992 excludes a charge of $72 million related to USAir's grounded BAe- 146 fleet. Rental expense for 1991 excludes a credit of $9 million for the BAe-146 fleet. (c) Legal Proceedings USAir and various subsidiaries have been named as defendants in various suits and proceedings which involve, among other things, environmental concerns and employment matters. These suits and proceedings are in various stages of litigation, and the status of the law with respect to several of the issues involved is unset- tled. For these reasons the outcome of these suits and proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition or results of operations. In 1989 and 1990, a number of U.S. air carriers, including USAir, received two Civil Investigative Demands ("CIDs") from the U.S. Department of Justice ("DOJ") (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carriers' responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter the amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. (d) Aircraft Commitments At December 31, 1993, USAir's new aircraft on firm order, options for new aircraft and scheduled payments for new aircraft orders (including progress payments, buyer furnished equipment, spares, and capitalized interest) were: USAir may elect, under certain circumstances, to convert Boeing 737 Series and Boeing 767 Series firm order or option deliveries to Boeing 757-200 deliveries. If USAir were to elect such a substitution, the payments presented in the table above would change. USAir is currently in negotiations with Boeing regarding, among other things, the above schedule of new aircraft deliveries. In addition, USAir has a commitment to purchase hushkits for certain of its McDonnell Douglas DC-9-30 aircraft and a substantial portion of its Boeing 737-200 aircraft. The installation of these hushkits will bring the aircraft into compliance with Federal Aviation Administration ("FAA") Stage 3 noise level requirements. The projected payments associated with the purchase of the hushkits are: $29.1 million - 1994; $12.0 million - 1995; $42.3 million - 1996; $43.4 million - 1997; $44.0 million - 1998; and $30.8 million thereafter. (e) Concentration of Credit Risk USAir does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, most of USAir's receivables related to tickets sold to individual passen- gers through the use of major credit cards (47%) or to tickets sold by other airlines (16%) and used by passengers on USAir or USAir Group's commuter subsidiaries. These receivables are short-term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (f) Guarantees At December 31, 1993, USAir guaranteed payments of certain debt obligations of the Galileo International Partnership amounting to approximately $16 million. In addition, at December 31, 1993, USAir guaranteed payments of debt and lease obligations of USAir Group's three wholly-owned subsidiaries amounting to approximately $148 million. (5) SALE OF RECEIVABLES USAir is party to an agreement ("Receivables Agreement") to sell, on a revolving basis, undivided interest of up to $240 million in a pool of designated receivables. Approximately $141 million was available for sale at December 31, 1993 based on receivable balances at that date. The maximum amount available under the Receivable Agreement to be sold gradually reduces from $240 million at December 31, 1993, to $190 million on June 30, 1994. The Receivables Agreement expires on December 21, 1994. USAir had no outstanding amounts due under the Receivable Agreement at December 31, 1993. The net amounts sold reduce receivables in the accompanying balance sheet by $220 million and $188 million at December 31, 1992 and 1991, respectively. Included in the accounts payable balances at December 31, 1992 and 1991, are $74 million and $64 million, respectively, which represent funds held by USAir related to previously sold receivables that had been collected. USAir obtained a waiver from the purchaser of the receivables and its operating agent, exempting USAir from compliance with the coverage ratio financial covenant in the Receivables Agreement for the quarter ended December 31, 1993. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or arrange a replacement facility. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 required a change from the deferred method under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. No cumulative adjustment at January 1, 1993, and no income tax credit for the year ended December 31, 1993, were recognized due to the FAS 109 limitation in recognizing benefits for net operating losses. USAir files a consolidated Federal income tax return with its parent USAir Group pursuant to a tax allocation agreement. The components of the provision (credit) for income taxes are as follows: The significant components of deferred income tax ex- pense/(benefit) for the year ended December 31, 1993, are as follows: (in thousands) Deferred tax benefit (exclusive of the other components listed below) $(121,847) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (9,429) Increase for the year in the valuation allowance for deferred tax assets 131,276 -------- Total $ 0 ======== For the years ended December 31, 1992 and 1991, deferred income taxes result from differences in the recognition of revenue and expenses and investment tax credits for tax and financial reporting purposes. The major items resulting in these differences and the related tax effects are shown in the following chart: A reconciliation of taxes computed at the statutory Federal tax rate on earnings before income taxes to the provision (credit) for income taxes is 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 are presented below: (in thousands) Deferred tax assets: Leasing transactions $ 129,276 Tax benefits purchased/sold 79,434 Gain on sale and leaseback transactions 162,400 Employee benefits 429,312 Net operating loss carryforwards 508,240 Alternative minimum tax credit carryforwards 20,881 Investment tax credit carryforwards 47,880 Other deferred tax assets 61,210 --------- Total gross deferred tax assets 1,438,633 Less valuation allowance (568,816) --------- Net deferred tax assets 869,817 Deferred tax liabilities: Equipment depreciation and amortization (840,584) Other deferred tax liabilities (29,233) --------- Net deferred tax liabilities (869,817) --------- Net deferred taxes $ 0 ========= The valuation allowance for deferred tax assets as of January 1, 1993, was $438 million. The increase in the valuation allowance for 1993 was $131 million. At December 31, 1993, the Company had unused net operating losses of $1.3 billion for Federal tax purposes, which expire in the years 2005-2008. USAir also has available, to reduce future taxes payable, $429 million alternative minimum tax net operating losses expiring in 2007 and 2008, $47 million of investment tax credits expiring in 2002 and 2003, and $20 million of minimum tax credits which do not expire. The Federal income tax returns of the Company through 1986 have been examined and settled with the Internal Revenue Service. (7) STOCKHOLDER'S EQUITY USAir Group owns all of the outstanding common stock of USAir. USAir Group's Credit Agreement includes a provision that limits USAir's ability to declare dividends to USAir Group. (8) EMPLOYEE STOCK OWNERSHIP PLAN In August 1989, USAir established an Employee Stock Ownership Plan ("ESOP"). USAir Group sold 2,200,000 shares of its Common Stock to an Employee Stock Ownership Trust to hold on behalf of USAir's employees, exclusive of officers, in accordance with the terms of the Trust and the ESOP. Financing of approximately $111.4 million for the Trust's purchase of the shares was provided by USAir through a 9 3/4% loan to the Trust, and an additional $2.2 million was contributed to the Trust by USAir. The loan is being repaid with contributions made by USAir. The contributions are made in amounts equal to the periodic loan payments as they come due, less dividends available for loan payment. The amount of dividends used for debt service by the ESOP was $127,000 in 1991. As the loan is repaid over time, participating employees receive allocations of the Common Stock purchased by the Trust. The initial maturity of the loan is 30 years. However, the ESOP provides that if the Company's profitability as measured by return on sales exceeds certain goals during the life of the ESOP, USAir's contributions and the repayment of the loan will be accelerated. Contributions made by USAir and therefore loan repayments made by the Trust were $11.4 million in 1993, 1992 and 1991. The interest portion of these contributions was $10.5 million in 1993, $10.6 million in 1992 and $10.7 million in 1991. Approximately 366,000 shares of Common Stock have been allocated to employees. USAir recognized approximately $4 million of compensation expense related to the ESOP in each of 1993, 1992 and 1991 based on shares allocated to employees (the "shares allocated" method). Deferred compensation related to the ESOP amounted to approximately $95 million, $98 million and $102 million at December 31, 1993, 1992 and 1991, respectively. (9) EMPLOYEE BENEFIT PLANS (a) Pension Plans USAir has several pension plans in effect covering substan- tially all employees. One qualified defined benefit plan covers USAir maintenance employees and provides benefits of stated amounts for specified periods of service. Qualified defined benefit plans for substantially all other employees provide benefits based on years of service and compensation. The qualified defined benefit plans are funded, on a current basis, to meet requirements of the Employee Retirement Income Security Act of 1974. The defined benefit pension plan for USAir non-contract employees was frozen at the end of 1991 for all non-contract participants, resulting in a one-time book gain of approximately $107 million in 1991. All non-contract plan participants became 100% vested at the time of the freeze. As a result of this plan curtailment, the accrual of service costs related to defined benefits for USAir non-contract employees ceased at the end of 1991. USAir implemented a defined contribution pension plan for non-contract employees in January 1993. The funded status of the qualified defined benefit plans at December 31, 1993 and 1992 was as follows: Approximately 97% of the accumulated benefit obligation was vested at December 31, 1993 and 1992. Unrecognized transition assets are being amortized over periods up to 27 years. The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.6% and 8.75% as of December 31, 1993 and 1992, respectively. The expected long-term rate of return on plan assets used in 1993 and 1992 was 9.5%. Rates of 3% to 6% were used to estimate future salary levels. At December 31, 1993, plan assets consisted of approxi- mately 8% in cash equivalents and short-term debt investments, 37% in equity investments, and 55% in fixed income and other invest- ments. At December 31, 1992, plan assets consisted of approximate- ly 4% in cash equivalents and short-term debt investments, 70% in equity investments, and 26% in fixed income and other investments. The following items are the components of the net pension cost for the qualified defined benefit plans: 1993 1992 1991 ---- ---- ---- (in millions) Service cost (benefits earned during the year) $ 90 $ 79 $ 98 Interest cost on projected benefit obligation 188 171 168 Actual return on plan assets (224) (114) (353) Net amortization and deferral 40 (65) 201 ---- ---- ---- Net pension cost $ 94 $ 71 $ 114 ==== ==== ==== Net pension cost for 1993 and 1991 presented above excludes a charge of approximately $33.9 million and $21.6 million, respec- tively, related to "early-out" incentive programs offered to a limited number of USAir employees during the years. No such charges were incurred in 1992. Non-qualified supplemental pension plans are established for certain employee groups, which provide incremental pension payments from the Company's funds so that total pension payments equal amounts that would have been payable from the Company's principal pension plans if it were not for limitations imposed by income tax regulations. The following table sets forth the non-qualified plans' status at December 31, 1993 and 1992: Net supplementary pension cost for the two years included the following components: The discount rate used to determine the actuarial present value of the projected benefit obligation was 7.5% and 8.75% as of December 31, 1993 and 1992, respectively. Rates of 3% and 6% were used to estimate future salary levels. In addition to the qualified and non-qualified defined benefit plans described above, USAir also contributes to certain defined contribution plans primarily for employees not covered under a collective bargaining agreement. Company contributions are based on a formula which considers the age and pre-tax earnings of each employee and the amount of employee contributions. USAir's contribution expense was $42 million for 1993. USAir recognized no such expense in 1992 and 1991. (b) Postretirement Benefits Other Than Pensions USAir offers medical and life insurance benefits to employees who retire from the Company and their eligible dependents. The medical benefits provided by USAir are coordinated with Medicare benefits. Retirees generally contribute amounts towards the cost of their medical expenses based on years of service with the Company. USAir provides uninsured death benefit payments to survivors of retired employees for stated dollar amounts, or in the case of retired pilot employees, death benefit payments determined by age and level of pension benefit. The plans for postretirement medical and death benefits are funded on the pay-as-you-go basis. USAir adopted Statement of Financial Accounting Standards No. 106 ("FAS 106") during 1992 and elected to record the January 1, 1992 Accumulated Postretirement Benefit Obligation ("APBO") using the immediate recognition approach. The cumulative effect of adopting FAS 106 was $745.5 million ($638.8 million net of tax benefit). The following table sets forth the financial status of the plans as of December 31, 1993 and 1992: The postretirement benefit expense for 1993 presented above excludes a charge of approximately $15.5 million related to "early- out" programs offered to a limited number of employees during the year. No such charges were incurred in 1992 or 1991. The discount rate used to determine the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate used in measuring the APBO was 10.5% in 1993 and 1994, declining by 1% per year after 1994 to an ultimate rate of 4.5%. If the assumed health care cost trend rate were increased by 1 percentage point, the APBO at December 31, 1993 would be increased by 10% and 1993 periodic postretirement benefit cost would increase 13%. Prior to the adoption of FAS 106, USAir recognized expense for retiree health care at an estimated monthly rate (based on payments) and recognized expense for death benefits when paid. The expense using this methodology was approximately $8 million for 1991. (c) Postemployment Benefits USAir adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), during 1993. FAS 112 requires the use of an accrual method to recognize postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 was $43.7 million. (10) SUPPLEMENTAL BALANCE SHEET INFORMATION The components of certain accounts in the accompanying balance sheets are as follows: (11) NON-RECURRING AND UNUSUAL ITEMS (a) 1993 USAir's results for 1993 include non-recurring charges of (i) $43.7 million for the cumulative effect of an accounting change, as required by FAS 112 which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (ii) $68.8 million for severance, early retirement and other personnel-related expenses recorded primarily during the third quarter of 1993 in connection with a workforce reduction of approximately 2,500 full-time positions between November 1993 and the first half of 1994; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions, recorded in the fourth quarter of 1993; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service, recorded in the fourth quarter of 1993; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership, which operates a computerized reservation system, recorded in the fourth quarter of 1993; and (vi) $18.4 million credit related to non-operating aircraft, recorded in the second quarter of 1993. (b) 1992 USAir's results for 1992 include (i) a charge of $628.1 million for the cumulative effect of an accounting change as required by FAS 106, effective January 1, 1992; (ii) a $107.4 million charge related to certain aircraft which have been withdrawn from service, recorded in the fourth quarter of 1992; and (iii) a $34.1 million non-operating loss related to the sale of ten MD-82 aircraft which USAir eliminated from its fleet plan, recorded in the fourth quarter of 1992. (c) 1991 USAir's results for 1991 include (i) a $107 million a pre-tax gain related to freezing of the fully funded non-contract employee pension plan; (ii) a $21.6 million pre-tax expense related to early retirement incentives offered to certain employees during 1991; (iii) a $21 million pre-tax charge to establish an additional reserve for USAir's grounded BAe-146 fleet; and (iv) a $18.5 million, net, in miscellaneous pre-tax non-recurring charges. (12) SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents selected quarterly financial data for 1993 and 1992: 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 USAir Group, Inc. Each of the persons listed below is currently a director of the Company and was elected in 1993 by the stockholders of the Company. Each director of the Company is also a director of USAir. Except as noted otherwise, the following biographies disclose the age and describe the business experience of each Director for at least the past five years. As required by the Investment Agreement, the Board of Directors amended the Company's By-Laws on January 21, 1993 to increase the authorized number of directors by three and immediately thereafter elected Messrs. Marshall, Maynard and Stevens to fill the new directorships. Under the Investment Agreement, the Company is required to use its best efforts to ensure that the slate of persons nominated by the Company for election as directors of the Company includes that number of persons designated by BA that is the percentage of the total then authorized number of directors, which is currently 16, of the Company that is nearest to but not greater than the percentage (but in no event greater than 25%) of the aggregate voting power of the securities that vote with the Common Stock as a single class for the election of directors of the Company then held by BA and its wholly-owned subsidiaries. Under this provision of the Investment Agreement, BA is entitled to designate three directors to the Board of Directors and has accordingly designated Messrs. Marshall, Maynard and Stevens. Served as Director since -------- Warren E. Buffett, 63.... Mr. Buffett has been Chairman 1993 and Chief Executive Officer of Berkshire Hathaway Inc. (insurance, candy, retailing, manufacturing and publishing) since 1970. He is also a Director of Capital Cities/ ABC, Inc., The Coca-Cola Company, The Gillette Comp- pany and Salomon Inc. Mr. Buffett is a member of the Finance and Planning Committee of the Board of Directors. Edwin I. Colodny, 67..... Mr. Colodny is of counsel to 1975 the law firm of Paul, Has- tings, Janofsky & Walker. He retired as Chairman of the Company and of USAir in July 1992. He served as Chief Executive Officer of USAir from 1975 until retiring as an employee of USAir in June 1991. Mr. Colodny is a Director of Martin Marietta Corporation, Comsat Corporation and Ester- line Technologies, Inc., and is a member of the Board of Trustees of the University of Rochester. He is a member of the Finance and Planning and Nominating Committees of the Board of Directors. Mathias J. DeVito, 63.... Mr. DeVito is Chairman of the 1981 Board and Chief Executive Officer of The Rouse Com- pany (real estate develop- ment and management). He also serves as a Director of First Maryland Bancorp and subsidiaries of The Rouse Company. He is a member of the Board of the Business Committee for the Arts and former Chair of the Greater Baltimore Committee. Mr. DeVito is Chairman of the Compensation and Benefits Committee and a member of the Finance and Planning Committee of the Board of Directors. George J. W. Goodman, 63.. Mr. Goodman is President of 1978 Continental Fidelity, Inc. which provides editorial and investment services. He is the author of a number of books and articles on finance and economics under the pen name "Adam Smith" and is the host of a television series of that name seen on public broadcasting stations in the U.S. and on other networks abroad. He is a Director of Cambrex Corporation. Mr. Goodman also serves as a mem- ber of the Advisory Committee of the Center for International Relations at Princeton Univer- sity, and is a Trustee of the Urban Institute. He is a mem- ber of the Compensation and Benefits and Finance and Planning Committees of the Board of Directors. John W. Harris, 47....... Mr. Harris is President of 1991 The Harris Group (real estate development). From 1972 through 1991, he was President of The Bissell Companies, Inc. (real estate development). He is a Director of Southern Bell Telephone and Telegraph Company. Mr. Harris is former Chairman of the Greater Charlotte Chamber of Commerce and a member of the Board of Trustees of the University of North Carolina and serves on the boards of several community service organiza- tions. He is a member of the Audit and Compensation and Benefits Committees of the Board of Directors. Edward A. Horrigan, Jr., 64 Mr. Horrigan is Chairman and 1987 Chief Executive Officer of Liggett Group Inc. (consumer products), a position he has held since May 1993. He is also the retired Vice Chairman of the Board of RJR Nabisco, Inc. and retired Chairman and Chief Executive Officer of R. J. Reynolds Tobacco Company, Winston -Salem, North Carolina (consumer products). He is a Director of the Haggai Foun- dation. Mr. Horrigan is a member of the Audit and Nominating Committees of the Board of Directors. Robert LeBuhn, 61......... Mr. LeBuhn is Chairman of 1966 Investor International (U.S.), Inc. (investments) and is a Director of Acceptance Insur- ance Companies, Amdura Corp., Lomas Financial Corp. and Cambrex Corporation. He is Trustee and President of the Geraldine R. Dodge Foun- dation, Morristown, New Jersey and is a member of the New York Society of Security Analysts. He is Chairman of the Finance and Planning Committee and a member of the Nominating Committee of the Board of Directors. Sir Colin Marshall, 60.... Sir Colin was elected Chairman 1993 of BA in February 1993. Prev- iously, he had been Chief Executive of BA and a member of BA's Board of Directors since 1983. Sir Colin is a Director of Grand Metropolitan plc, HSBC Holdings Plc, and IBM United Kingdom Holdings Limited. He is a member of the Finance and Planning Committee of the Board of Directors. Roger P. Maynard, 51...... Mr. Maynard has been Director 1993 of Corporate Strategy of BA since 1991. Previously, from 1987, he had held various positions at BA, including Director of Investor Relations & Marketplace Performance and Executive Vice President North America. Mr. Maynard is a member of the Nominating and Compensation and Benefits Committees of the Board of Directors. John G. Medlin, Jr, 60.... Mr. Medlin is Chairman of the 1987 Board and, until December 31, 1993, was Chief Executive Officer of Wachovia Corpor- ation (bank holding company). Mr. Medlin also serves as a Director of BellSouth Company, Media General, Inc., National Services Industries, Inc. and RJR Nabisco, Inc. He is Chair- man of the Nominating Committee and a member of the Compen- sation and Benefits Committee of the Board of Directors. Hanne M. Merriman, 52..... Mrs. Merriman is the Principal 1985 in Hanne Merriman Associates (retail business consultants). Previously, she served as President of Nan Duskin, Inc. (retailing), President and Chief Executive Officer of Honeybee, Inc., a division of Spiegel, Inc., and President of Garfinckel's, a division of Allied Stores Corporation. Mrs. Merriman is a Director of CIPSCO, Inc. Central Public Service Company, State Farm Mutual Automobile Insurance Company, The Rouse Company and Ann Taylor Stores Corporation. She is a member of the National Women's Forum and a Trustee of The American-Scandinavian Founda- tion. She was a member of the Board of Directors of the Federal Reserve Bank of Richmond, Virginia from 1984- 1990 and served as Chairman in 1989-1990. Mrs. Merriman is Chairman of the Audit Committee and is a member of the Nominating Committee of the Board of Directors. Charles T. Munger, 70..... Mr. Munger is Vice Chairman of 1993 Berkshire Hathaway Inc. (insur- ance, candy, retailing, manu- facturing and publishing) of which he has been an officer and Director since 1975. He is Chairman of Daily Journal Corporation and is a Director of Salomon Inc. and Wesco Financial Corporation. Mr. Munger is a member of the Audit Committee of the Board of Directors. Seth E. Schofield, 54..... Mr. Schofield was elected 1989 Chairman of the Board of Directors of the Company and USAir in June 1992. In June 1991 he was elected President and Chief Execu- tive Officer of the Company and of USAir. In June 1990 he was elected President and Chief Operating Officer of USAir. He had served as Executive Vice President- Operations of USAir since 1981. Mr. Schofield joined USAir in 1957 and has held various corporate staff positions. Mr. Schofield is a Director of the Erie Insurance Group, the PNC Bank, N.A., the Greater Washington Board of Trade, the Flight Safety Foundation, and the Greater Pittsburgh Council of the Boy Scouts of America. Mr. Schofield is Chairman of the Board of Directors of the Greater Pittsburgh Chamber of Commerce, and a Board Member of the Pennsylvania Business Roundtable, Penn's Southwest Association and the Virginia Business Council. He is also a member of the Allegheny Conference on Community Development and the Federal City Council. Richard P. Simmons, 62.... Mr. Simmons is Chairman of 1987 the Board and Chairman of the Executive Committee of Allegheny Ludlum Corp. and served as its President and Chief Execu- tive Officer from 1980 to 1990. Allegheny Ludlum pro- duces stainless steel and other high alloyed steels. Mr. Simmons is also a Director and Chairman of the Executive Committee of PNC Bank Corp. and Consolidated Natural Gas. He is a member of the Ameri- can Institute of Mining, Metallurgical and Petroleum Engineers and is a fellow and Distinguished Life Member of the American Society for Metals. Mr. Simmons is a member of the M.I.T. Corpor- ation and serves on the boards of several community service organizations. He is a member of the Audit and Finance and Planning Committees of the Board of Directors. Raymond W. Smith, 56..... Mr. Smith is Chairman of 1990 the Board and Chief Executive Officer of Bell Atlantic Com- pany, which is engaged princi- pally in the telecommunications business and is one of the seven regional companies formed as a result of the divestiture of the Bell System. Previously, Mr. Smith had served as Vice Chairman and President of Bell Atlantic and Chairman of The Bell Telephone Com- pany of Pennsylvania. He is a member of the Board of Directors of CoreStates Financial Company, a trustee of the University of Pittsburgh and is active in many civic and cultural organizations. He is a mem- ber of the Compensation and Benefits and Nominating Committees of the Board of Directors. Derek M. Stevens, 55...... Mr. Stevens has been Chief 1993 Financial Officer of and a Director of BA since 1989. Previously, from 1981, he was Finance Director of TSB Group plc (financial institution). Mr. Stevens is a member of the Audit Commit- tee of the Board of Directors. The law firm of Paul, Hastings, Janofsky and Walker, with which Mr. Colodny is affiliated on an Of Counsel basis, provided legal services to USAir during 1993 and is expected to provide such services during 1994. The following persons are executive officers of the Company. For purposes of Rule 405 under the Securities Act of 1933, Messrs. Lagow, Long, Schwab, Fornaro, Frestel, Harper and Ms. Risque Rohrbach are deemed to be executive officers of the Company. There are no family relationships among any of the officers listed above. No officer was selected pursuant to any arrangement between him or her and any other person. Officers are elected annually to serve for the following year or until the election and qualification of their successors. All the executive officers except Ms. Risque Rohrbach and Messrs. Lagow, Salizzoni, Aubin, Frestel, Fornaro and Harper have been actively engaged in the business and affairs of the Company and USAir during the past five years. The business experience of the officers listed above since January 1, 1989 is as follows: Mr. Schofield was elected Executive Vice President of the Company in July 1989. At that time he was also elected Vice Chairman of the Board of the Company and of USAir. Mr. Schofield served as Executive Vice President-Operations of USAir until his election as President and Chief Operating Officer of USAir in June 1990. Effective on July 1, 1991, Mr. Schofield was elected President and Chief Executive Officer of both the Company and USAir. Effective on July 1, 1992, Mr. Schofield was elected Chairman of the Board of Directors of both the Company and USAir. Mr. Lagow was Senior Vice President-Market Planning of Northwest Airlines until February 1988, when he became Senior Vice President-Planning of United Airlines. Mr. Lagow held that position until he was elected Executive Vice President-Marketing of USAir in February 1992. Mr. Lloyd engaged in the private practice of law in Washing- ton, D.C. from 1967 until election as Vice President, General Counsel and Secretary of the Company and as Senior Vice President and General Counsel of USAir in 1987. He served in those capaci- ties until his election as Executive Vice President, Secretary and General Counsel of the Company and Executive Vice President and General Counsel of USAir in January 1991. Mr. Long served as Senior Vice President-Administration of USAir until his election as Senior Vice President-Customer Operations of USAir in June 1989. He served in that capacity until his election as Senior Vice President-Customer Services in March 1991. Mr. Long served as Senior Vice President-Customer Services until his election as Executive Vice President-Customer Services in May 1992. Mr. Salizzoni was Vice Chairman and Chief Financial Officer of Trans World Airlines and Trans World Corporation until 1987, when he became Vice Chairman and Chief Financial Officer of TW Services, Inc. He was Chairman and Chief Executive Officer of TW Services from April 1987 until August 1989, just before that company went private. Mr. Salizzoni was associated with Mancusco and Co. from August 1989 until he was elected Executive Vice President-Finance of the Company and of USAir in November 1990. Mr. Schwab served as Vice President-Management Information Systems of USAir until his election as Senior Vice President- Management Information Systems of USAir in July 1989. Mr. Schwab served in that capacity until his election as Executive Vice President-Operations in April 1991. He also served as President of USAM Corp. from April 1988 through April 1991. Mr. Aubin was Executive Advisor to the Vice Chairman, President and Chief Executive Office of Air Canada and, prior to that position, Senior Vice President Technical Operations and Chief Technical Officer of Air Canada during the relevant time. He was elected Senior Vice President-Maintenance Operations of USAir in January 1994. Mr. Fornaro was Vice President-Research of Jesup & Lamont Securities until February 1988, when he became Senior Vice President-Marketing of Braniff, Inc. In August 1988, Mr. Fornaro became Senior Vice President-Market Planning of Northwest Airlines, the position he held until February 1992. He was elected Senior Vice President-Planning of USAir in March 1992. Mr. Frestel was Vice President-Personnel and Labor Relations for The Atchinson, Topeka & Santa Fe Railway during the relevant time, and was a Director of that company from June 1988, until his election as Senior Vice President-Human Resources of USAir in January 1989. Mr. Harper was Senior Vice President-Marketing and Information Systems at Axe-Houghton Management (investment management) until his election as Vice President and Controller of the Company and USAir in December 1991. He served in that position until his election as Senior Vice President-Information Systems of USAir in October 1992. Ms. Rohrbach was a public policy and communications consultant during 1993. She was Assistant Secretary of Labor for Policy at the U.S. Department of Labor during 1991-1992. Ms. Rohrbach served on the White House staff as a member of the legislative liaison team (1981-1986) and subsequently as Assistant to the President and Secretary to the Cabinet (1987-1988). In 1989 and 1990, she was a resident fellow at Harvard University's Institute of Politics, a consultant to the Department of Energy and in the private sector. From 1988-1993, she also served as a member of the National Commission on Children. She was elected Vice President-Public and Community Relations of the Company and Senior Vice President-Public and Community Relations of USAir in January 1994. Item 11. Item 11. EXECUTIVE COMPENSATION Compensation of Directors Each director, except Mr. Schofield, is paid a retainer fee of $18,000 per year for service on the Board of Directors of the Company and a fee of $600 per Board meeting or committee meeting attended. Consistent with a comprehensive cost reduction program at USAir, the retainer fee was reduced by 20% to $14,400 for an eighteen-month period commencing January 1, 1992 and ending on June 30, 1993. Mr. LeBuhn, Chairman of the Finance and Planning Committee, Mr. DeVito, Chairman of the Compensation Committee, and Mrs. Merriman, Chairman of the Audit Committee each receives an additional fee of $2,000 per year for serving in those respective capacities. Mr. Medlin, Chairman of the Nominating Committee, receives an additional fee of $1,000 per year for serving in that capacity. Mr. Schofield receives a salary in his capacity as an officer of USAir and receives no additional compensation as a director of the Company and USAir. In 1987 the Company established a retirement plan for directors who are not also employees of the Company and its subsidiaries. The plan provides that such directors shall be eligible to receive retirement benefits thereunder if they have attained seventy years of age and served at least five consecutive years on the Board of Directors or, if they have not attained age seventy, have served for at least ten consecutive years on the Board of Directors. Eligible directors receive an annual retirement benefit equal to the highest annual retainer in effect for active directors during the five years prior to retirement. If the annual retainer for active directors is increased, the annual retirement benefit paid to retired directors is increased by an amount equal to 50% of the increase in retainer paid to active directors. If a director dies prior to retirement and had served for at least five consecutive years on the Board of Directors, the deceased director's surviving spouse is eligible under the plan to receive, for a period of five years following such death, an annual death benefit equal to 50% of the annual retainer paid to such director at the time of his or her death. If a retired eligible director dies, the director's surviving spouse is eligible under the plan to receive, for a period of five years following such death, 50% of the annual retirement benefit payable to the director at the time of his or her death. The plan is administered by the Compensation Committee. COMPENSATION OF EXECUTIVE OFFICERS The Summary Compensation Table below sets forth the compensation paid during the years indicated to each of the Chief Executive Officer and the four remaining most highly compensated executive officers of the Company (including its subsidiaries). SUMMARY COMPENSATION TABLE - -------- * Under the SEC's transition rules, no disclosure is required. (A) Mr. Schofield was elected Chief Executive Officer effective June 1, 1991. (B) Mr. Lagow's employment with USAir commenced on February 7, 1992. (C) Amounts disclosed reflect reductions in salary during (i) 1993 of $24,365, $14,942, $12,250, $10,904 and $10,904, and (ii) 1992 of $87,019, $49,272, $43,750, $38,942 and $38,942 for Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab, respectively, which were implemented for all USAir officers for a fifteen-month period commencing on January 1, 1992 and ending on March 29, 1993 pursuant to a comprehensive cost reduction program at USAir. (D) Amounts disclosed include for (i) 1993, $271,288, $33,259, $73,215, and $27,621 and (ii) 1992, $171,410, $22,523, $47,974 and $16,784, received by Messrs. Schofield, Salizzoni, Lloyd and Schwab, respectively, to cover incremental tax liability resulting from income derived from the lapsing of restrictions on disposition of Restricted Stock. Any amounts disclosed in the column that are in excess of the amounts disclosed in the preceding sentence represent income derived from personal travel on USAir. (E) At December 31, 1993, Messrs. Schofield, Salizzoni, Lloyd and Schwab owned 30,000, 6,000, 4,000 and 3,200 shares of Restricted Stock, respectively. At the fair market value of the Common Stock on that date, these holdings of Restricted Stock were valued at $386,250, $77,250, $51,500, $41,200, respectively. (F) Under USAir's split dollar life insurance plan, described under "Additional Benefits" below, individual life insurance coverage is available to the named officers. During 1992, each officer paid the amount of the premium associated with the term life component of the coverage. In 1993, USAir commenced paying the premium associated with this coverage. In 1992 and 1993, USAir paid the remainder of the premium associated with the whole life component of the coverage. If all assumptions as to life expectancy and other factors occur in accordance with projections, USAir expects to recover the premiums it pays with respect to the whole life component of the coverage. The following amounts reflect the value of the benefits accrued during the years indicated, calculated on an actuarial basis, ascribed to the insurance policies purchased on the lives of the named officers (plus, with respect to 1993, the dollar value of premiums paid by USAir with respect to term life insurance): 1993--Mr. Schofield-- $29,328, Mr. Lagow--$9,716, Mr. Salizzoni--$26,010, Mr. Lloyd--$17,291 and Mr. Schwab--$11,170; 1992--Mr. Schofield--$38,495; Mr. Lagow--$12,902; Mr. Salizzoni--$34,382; Mr. Lloyd--$21,382 and Mr. Schwab--$15,555. During 1993, USAir made contributions of $34,974, $22,805, $26,212, $18,897 and $18,897 to the accounts of Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab in certain defined contribution pension plans. (G) Upon the commencement of his employment, USAir agreed to pay Mr. Lagow $1 million over four years, which amount was intended to compensate him for restricted stock and stock options which he forfeited when he left his former employer. The amount disclosed includes the first installment, $250,000, of the total payment. (H) Amount disclosed also reflects $125,000 paid to Mr. Lagow in the form of a "sign-on bonus" and $4,715 for reimbursement of relocation expenses. (I) Amount disclosed also reflects $25,380 for reimbursement of relocation expenses. Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values The following table provides information on the number of options held by the named executive officers at fiscal year-end 1993. None of the officers exercised any options during 1993 and none of the unexercised options held by these officers were in-the-money based on the fair market value of the Common Stock on December 31, 1993 ($12.875). The values reflected in the above chart represent the application of the Retirement Plan formula to the specified amounts of compensation and years of service. The credited years of service under the Retirement Plan for each of the individuals included in the Summary Compensation Table are as follows: Mr. Schofield-32 years, Mr. Lagow-2 years, Mr. Salizzoni-3 years, Mr. Lloyd-7 years and Mr. Schwab-6 years. USAir has entered into agreements with Messrs. Lagow, Salizzoni, Lloyd and Schwab which provide for a supplement to their retirement benefits under the Retirement Plan. This supplement is designed to provide such persons with those benefits they would have received had they been employed by USAir for the minimum number of years to be entitled to full retirement benefits under the Retirement Plan. USAir adopted, effective January 1, 1993, a defined contribu- tion retirement program for its eligible non-contract employees (the "Retirement Savings Plan") as a replacement for the Retirement Plan described above. Under the Retirement Savings Plan, eligible employees may elect to contribute on a tax-deferred basis up to 13% of their pre-tax compensation, subject to a maximum annual contribution of $8,994 in 1993. USAir will also contribute to each employee's account in the Retirement Savings Plan (i) a matching contribution equal to 50% of each employee's contribution, subject to a maximum of 2% of the employee's annual pre-tax compensation, (ii) a basic contribution which ranges, depending on the employee's age, from 2% to 8% of the employee's annual pre-tax compensation and (iii) if USAir's pre-tax profit margin, as defined, exceeds certain thresholds, a profit sharing contribution up to a maximum of 7.5% of an employee's annual pre-tax compensation. USAir made no contributions under the profit sharing component of the Retirement Savings Plan in 1993. Pre-tax compensation is defined for purposes of the Retirement Savings Plan as all compensation which USAir must report as wages on an employee's Form W-2, plus an employee's tax deferred contributions under such Plan up to a maximum of $235,840 in 1993. USAir also established a non-qualified supplemental defined contribution plan (the "Supplemental Savings Plan") in 1993, which credits amounts to accounts of certain officers who participate in the Retirement Savings Plan but who are adversely affected by the maximum benefit limitations under qualified plans imposed by the Code. Amounts obligated to be paid by USAir under the Supplemental Savings Plan will be deposited in a trust established for the benefit of the participants. See the "All Other Compensation" column of the Summary Compensation Table for the amounts contributed or allocated in 1993 to Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab under the Retirement Savings Plan and the Supplemental Savings Plan. Under the Retirement Savings Plan and the Supplemental Savings Plan, participants may direct the investment of their contributions and USAir's contributions to their accounts among certain invest- ment funds. Participants' contributions are fully vested when made. USAir's contributions vest when the participant has been employed by USAir for at least two years. Additional Benefits USAir has in effect an Officers' Supplemental Benefit Plan, which provides certain benefits to a current or retired officer's spouse and children under age 19 following the officer's death. These benefits include: (i) dependent survivors' monthly income benefit and (ii) dependent survivors' health care insurance. A dependent survivors' monthly income benefit is payable to the eligible spouse or children of a deceased officer or retired officer in an amount equal to 20% of the monthly basic rate of salary payable to the officer the day prior to death or, in the case of a deceased retired officer, the day prior to retirement. Monthly income benefits will be reduced by the amount of any spouse protection benefit payable from Retirement Plan funds, and are subject to cessation upon the occurrence of certain specified events. In no case are monthly income benefits payable for more than 19 years following the date of death. The eligible surviving spouse or children of a deceased officer or retired officer are also entitled to receive dependent survivors' health care insurance, which provides the medical, major medical and dental insurance benefits generally available to dependents of salaried employees of USAir. Eligibility for this coverage ceases upon the occurrence of certain specified events. USAir also maintains a split-dollar life insurance plan under which individual term life insurance is available to its officers in the amount of three times base salary. The plan also provides for accrual of a cash value component for each officer who holds a policy. Under the plan, during 1993, USAir paid the premiums on the term and whole life insurance components of the policy. The premium attributable to the term life insurance of the policy is treated as income to the participant. At death, prior to transfer of the policy to the participant, the beneficiary receives the amount of the coverage less any amount necessary to reimburse the employer for its investment, and the employee is entitled to any additional proceeds. Upon transfer of the policy to the partici- pant, the participant is entitled to the cash surrender value of the policy in excess of the amount payable to the employer for recovery of its investment. See the "All Other Compensation" column of the Summary Compensation Table for information concerning compensation with respect to Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab that was attributable to the split dollar life insurance plan. Arrangements Concerning Termination of Employment and Change of Control USAir currently has employment contracts (the "Employment Contracts") with the executive officers (the "Executives") named in the Summary Compensation Table. The terms of the Employment Contracts extend until the earlier of the fourth anniversary thereof or the Executive's normal retirement date and are subject to automatic one-year annual extensions on each anniversary date (to the fourth anniversary of such anniversary date) unless advance written notice is given by USAir. In exchange for each Executive's commitment to devote his or her full business efforts to USAir, the agreements provide that each Executive will be re-elected to a responsible executive position with duties substantially similar to those in effect during the prior year and will receive (1) an annual base salary at a rate not less than that in effect during the previous year, (2) incentive compensation as provided in the contract and (3) insurance, disability, medical and other benefits generally granted to other officers. In the event of a change of control, as defined in each Employment Contract, the term of each Employment Contract is automatically extended until the earlier of the fourth anniversary of the change of control date or the Executive's normal retirement date. As a result of amendments to the Employment Contracts entered into in June 1992, the acquisition of 20% or more of the outstanding securities of the Company under circumstances in which the acquiror would obtain the power to elect 20% or more of the members of the Board of Directors was added to the definition of a change of control under the Employment Contracts. To the extent permitted by Foreign Ownership Restric- tions and assuming the consummation of the Second Purchase (the "Second Closing") results in BA's electing at least 20% of the Board of Directors, the Second Closing would be treated as a change of control and would result in extension of the term of each Employment Contract until the earlier of the fourth anniversary of the Second Closing or the Executive's normal retirement date. On March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See Item 1. "Business-British Airways Announcement Regarding Additional Investments in the Company; Code Sharing." The Employment Contracts provide that, should USAir or any successor fail to re-elect the Executive to his or her position, assign the Executive to inappropriate duties which result in a diminution in the Executive's position, authority or responsibili- ties, fail to compensate the Executive as provided in the Employ- ment Contract, transfer the Executive in violation of the Employ- ment Contract, fail to require any successor to USAir to comply with the Employment Contract or otherwise terminate the Executive's employment in violation of the Employment Contract, the Executive may elect to treat such failure as a breach of the Employment Contract if the Executive then terminates employment. As liquidat- ed damages as the result of an event not following a change of control that is deemed to be a breach of the Employment Contracts, USAir or its successor would be required to pay the Executive an amount equal to his or her annual base salary for the then remaining term of the Employment Contract, and to continue granting certain employee benefits for the then remaining term of the Executive's Employment Contract. If the breach follows a change of control, the Executive would be entitled to receive (i) an amount equal to the product of three times the sum of the Executive's annual base salary plus an annual bonus, (ii) a lump sum equal to the actuarial equivalent of the pension benefits which the Executive would have received had he or she remained employed by USAir until the end of the term of the Employment Contract, (iii) medical benefits until such time as the Executive qualifies for group medical benefits from another employer, (iv) travel benefits for the Executive's life, (v) reimbursement of reductions in salary sustained by the Executive as a result of a comprehensive cost reduction program initiated by USAir in October 1991, and (vi) continuation of certain other benefits during the remainder of the term of the Employment Contract. In addition, except under the circumstances described in the immediately following paragraph, during the 30-day period immediately following the first anniversa ry of a change of control any Executive could elect to terminate his or her Employment Contract for any reason and receive the liquidated damages described in the immediately preceding sentence. Each Employment Contract provides that if USAir breaches the Employment Contract, as described above, each Executive shall be entitled to recover from USAir reasonable attorney's fees in connection with enforcement of such Executive's rights under the Employment Contract. Each Employment Contract also provides that any payments the Executive receives in the event of a termination shall be increased, if necessary, such that, after taking into account all taxes he or she would incur as a result of such payments, the Executive would receive the same after-tax amount he or she would have received had no excise tax been imposed under Section 4999 of the Code. In order to facilitate consummation of the acts and transac- tions contemplated by the Investment Agreement, the Executives agreed in January 1993 to an amendment to their Employment Contracts that will become effective upon the Second Closing (i) to eliminate their right to elect to terminate their Employment Contracts without any reason during the 30-day period immediately following the first anniversary of the Second Closing; (ii) that USAir may transfer the Executive's employment to any location that meets certain criteria in the Employment Contracts without such relocation constituting a breach of the Employment Contracts; (iii) that consummation of the Second Closing would be treated as the only change of control with respect to BA; and (iv) that following the Second Closing, USAir may make certain changes in benefit plans affecting the Executives that are not material, as that term is defined in the Employment Contracts, provided that the changes apply to all eligible officers of USAir and are approved by a majority of the directors of the Company not elected by BA. Currently, under the Company's 1984 Stock Option and Stock Appreciation Rights Plan (the "1984 Plan") and 1988 Stock Incentive Plan (the "1988 Plan," and together with the 1984 Plan, the "Plans"), pursuant to which employees of the Company and its subsidiaries have been awarded stock options and stock appreciation rights with respect to Common Stock and, in the case of the 1988 Plan, shares of Restricted Stock, occurrence of a change of control, as defined, would make all granted options immediately exercisable without regard to the vesting provisions thereof. In addition, grantees would be able, during the 60-day period immediately following a change of control (the "Cash-out Right"), to surrender all unexercised stock options not issued in tandem with stock appreciation rights under the Plans to the Company for a cash payment equal to the excess, if any, of the fair market value of the Common Stock over the exercise prices of such stock options or the positive value of any stock appreciation rights. As described above, in June 1992, the Company amended the definition of a change of control in the Plans with the result that, to the extent permitted by Foreign Ownership Restrictions and assuming the Second Closing results in BA's electing at least 20% of the Board of Directors, the Second Closing would be treated as a change of control thereunder. As of March 1, 1994, there were unexercised stock options to purchase 548,310 shares of Common Stock (of which 84,600 had tandem stock appreciation rights) under the 1984 Plan and unexercised stock options to purchase 3,625,500 shares of Common Stock (none of which had tandem stock appreciation rights) under the 1988 Plan. (As of March 1, 1994, 3,177,400 of the 3,625,500 options outstanding under the 1988 Plan and 322,910 of the 548,310 options outstanding under the 1984 Plan were exercis- able pursuant to their normal vesting schedule.) The weighted average exercise price of all the outstanding stock options was approximately $23.15. On February 28, 1994, the closing price of a share of Common Stock on the NYSE was $11.375. See the "Aggre- gated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values" table for information regarding stock options held by the Executives. Currently, 50,400 shares of Restricted Stock previously granted to the Executives may (i) become free of transfer restric- tions upon their normal vesting schedule or (ii) be subject to accelerated vesting upon a termination of employment which triggers the payment of liquidated damages under the Employment Contracts, as discussed above, regardless of whether the termination occurred following a change of control as defined in the Employment Contracts. See "Beneficial Security Ownership" for information regarding Restricted Stock owned by the Executives. With respect to Mr. Lagow, in order to induce him to accept its offer of employment in 1992, USAir agreed, among other things, to pay Mr. Lagow $1 million in four equal installments, each installment being due and payable on the first four anniversaries of the commencement of his employment by USAir, provided Mr. Lagow remains employed by USAir. This payment was intended to compensate Mr. Lagow for stock options and restricted stock which he forfeited when he left his former employer. In the event of a change of control under his Employment Contract or wrongful termination thereunder, USAir has also agreed to pay Mr. Lagow in a lump sum any unpaid balance of this obligation. Notwithstanding anything to the contrary set forth in any of the Company's or USAir's filings under the Securities Act of 1933, as amended (the "Securities Act"), or the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that incorporates by reference this Proxy Statement, in whole or in part, the following Report and Performance Graph shall not be incorporated by reference into any such filings. Report of the Compensation and Benefits Committee of the Board of Directors The Compensation Committee policies with respect to compensa- tion of the Company's executive officers are to: 1. Attract and retain talented and experienced senior management by offering compensation that is competitive with respect to other major U.S. airlines and other U.S. companies of comparable size. 2. Motivate senior management to provide a high-quality product to consumers with the ultimate goal of maximizing profit- ability and stockholder returns by offering incentive and long-term compensation that is linked to return on sales and the market value of the Common Stock. The Compensation Committee has played an active role in the oversight and review of all executive compensation paid to executive officers of the Company during the last fiscal year. Ordinarily, the Compensation Committee and the full Board of Directors, in consultation with the Senior Vice President-Human Resources of USAir and, if warranted, an independent compensation consultant, annually review the total compensation package (comprised of base salary, incentive compensation, and long-term incentive compensation) of the Chairman, President and Chief Executive Officer. The Compensation Committee reviews the market rate for peer-level positions of the other major domestic passenger carriers including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." Based primarily on this comparison, the Compensation Committee establishes the Chief Executive Officer's base salary. Mr. Schofield does not participate in Compensation Committee or Board of Directors deliberations or decision-making regarding any aspect of his compensation. Correspondingly, the Compensation Committee established the compensation reported for 1993 for the Company's other executive officers, including the four officers named in the Summary Compensation Table, based upon a comparison of peer positions at the other major U.S. airlines including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." The principal elements of the Company's compensation paid to the executive officers in the last completed fiscal year are discussed below. Base Salary. As part of a comprehensive program to reduce costs at USAir, the Compensation Committee reduced the salaries of the executive officers and the other officers of USAir for a fifteen month period commencing on January 1, 1992 and ending on March 29, 1993. The Compensation Committee reduced each ex- ecutive's base salary in accordance with the following graduated schedule: ~ First $20,000 of salary reduced by 0% ~ Next $30,000 of salary reduced by 10% ($20,000 to $50,000) ~ Next $50,000 of salary reduced by 15% ($50,000 to $100,000) ~ Any amount of salary in excess of $100,000 reduced by 20%. Each of the executive officers agreed to the reductions in salary, which otherwise would have constituted grounds for the executives to have terminated their employment agreements with USAir. The amounts of salary not paid in 1992 and 1993 to Mr. Schofield and the other four executive officers named in the Summary Compensation Table are disclosed in footnote (C) to that table. As stated above, the Compensation Committee establishes the base salaries of the Company's executive officers primarily by reference to the salaries of officers holding comparable positions at other major U.S. airlines including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." Historically, the Compensation Committee had awarded merit increases based on measuring individual performance against objectives. However, due to the Company's poor financial performance, the Compensation Committee last awarded merit increases in executive base salaries in 1989. Since 1989 the Compensation Committee had increased the salaries of executive officers solely as a result of a promotion or an increase in responsibilities. The Company commissioned an independent compensation consultant to conduct a comprehensive study of the salaries of comparable airline officers in 1992. The study disclosed that the salaries (prior to the fifteen-month reduction described above) of most officers were substantially below those of salaries for analogous positions at major competi- tors. Following the study, in July 1992, the Compensation Committee prospectively set the salaries of executive officers generally at the median of the comparative range adjusted by individual performance and experience, effective April 1993. In connection with the same review, the Compensation Committee proposed to increase Mr. Schofield's base salary (before adjustment for the fifteen-month salary reductions) from $500,000 to $590,000, effective April 1993. Because the Company has continued to sustain losses, Mr. Schofield declined to accept the increase in base salary. Annual Cash Incentive Compensation Program: The Compensation Committee adopted the Executive Incentive Compensation Plan effective on January 1, 1988. The plan is administered by the Compensation Committee. All officers, including executive officers, of the Company are eligible to participate in this plan. The Compensation Committee is authorized to grant awards under this plan only if the Company achieves for a fiscal year a two percent or greater return on sales ("ROS"). The target level of performance is four percent ROS. If the Company achieves the target performance of four percent ROS, the full target percentage (which varies depending on position) is applied against the individual's base salary for the year to determine the target bonus award (the "Target Award") for the individual. Target Awards for executive officers range between 30% and 50% of base salary. If the minimum level of performance of two percent ROS is achieved, 50% of the Target Award would be available for distribution. If the maximum level of performance of six percent ROS is achieved, 200% of the Target Award would be available for payment. The Compensation Committee may adjust awards made to executive officers based on individual performance; however, no award may exceed 250% of the Target Award for any individual. The Compensation Committee last approved payments to executive officers under this plan for the fiscal year ended December 31, 1988. The Company has not achieved the minimum two percent ROS in any fiscal year, and the Compensation Committee has not made any awards under the plan, since then. Long-Term Incentive Programs Stock Options: The executive officers of the Company partici- pate in the Company's 1984 Stock Option and Stock Appreciation Rights Plan (the "1984 Plan") and 1988 Stock Incentive Plan (the "1988 Plan", and together with the 1984 Plan, the "Plans") which are both administered by the Compensation Committee. The Compensation Committee is authorized to grant options under these Plans only at an exercise price equal to the fair market value of a share of Common Stock on the date of grant. During 1993, the Compensation Committee did not grant any options from either of the Plans to the executive officers. The Compensation Committee determines the size of any option grant under the Plans based upon (i) the Compensation Committee's perceived value of the grant to motivate and retain the individual executive, (ii) a comparison of long-term incentive practices within the commercial airline industry, (iii) a comparison of awards provided to peer executives within the Company and (iv) the number of outstanding options held by the grantee and the exercise prices of these options. Although the Compensation Committee supports and encourages stock ownership in the Company by executive officers, it has not promulgated any standards regarding levels of ownership by executive officers. Pursuant to the reductions in the executive officers' salaries discussed above, in 1992 the Compensation Committee granted these persons non-qualified stock options to purchase 50 shares of Common Stock at $15 per share for each $1,000 of salary foregone during the wage reduction program, as is the case for each USAir employee whose pay was reduced pursuant to the program. Restricted Stock The Compensation Committee did not award any Restricted Stock under the 1988 Plan during 1993. (Grants of Restricted Stock are not authorized under the 1984 Plan). From 1988-1990, the Compensation Committee granted Restricted Stock to a total of nine executive officers, some of whom are no longer employed by USAir. During 1993, restrictions on disposition expired on a total of 23,200 shares of Restricted Stock held by Mr. Schofield, which shares were originally granted between 1988 and 1990. Restrictions on disposition also lapsed during 1993 on a total of 10,900 shares of Restricted Stock held by Messrs. Salizzoni, Lloyd and Schwab, which shares were originally granted between 1988 and 1990. The Omnibus Budget Reconciliation Act of 1993 added Section 162(m) to the Internal Revenue Code. Section 162(m) provides that companies will not be entitled to a tax deduction for certain compensation paid to any executive officer to the extent that the compensation exceeds $1 million in a taxable year. The Compensa- tion Committee is studying Section 162(m) and the proposed rules thereunder and is in the process of determining whether to recommend that the Company take the necessary measures to conform its compensation to Section 162(m). The Compensation Committee will continue to review all compensation and benefit matters presented to it and will act based upon the best information available in the best interests of the Company, its stockholders and employees. Mathias J. DeVito, Chairman George J. W. Goodman John W. Harris Roger P. Maynard John G. Medlin, Jr. Raymond W. Smith PERFORMANCE GRAPH This graph compares the performance of the Company's Common Stock during the period January 1, 1989 to December 31, 1993 with the S&P 500 Index and the S&P Airline Index. The graph depicts the results of investing $100 in the Company's Common Stock, the S&P 500 Index and the S&P Airline Index at closing prices on Decem- ber 31, 1988. The stock price performance shown on the graph is not necessarily indicative of future performance. The S&P Airline Index consists of AMR Corporation, Delta Air Lines, Inc., UAL Corporation and the Company. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following information pertains to Common Stock, Series A Preferred Stock, Series F Preferred Stock, Series T Preferred Stock and Depositary Shares ("Depositary Shares"), each representing 1/100 of a share of the Company's $437.50 Series B Cumulative Convertible Preferred Stock, without par value ("Series B Preferred Stock"), beneficially owned by all directors and executive officers of the Company as of March 1, 1994. Unless indicated otherwise, the information refers to ownership of Common Stock. Unless indicated otherwise by footnote, the owner exercises sole voting and investment power over the securities (other than unissued securities, the ownership of which has been imputed to such owner). Series F Preferred Stock and Series T Preferred Stock, Common Stock receivable upon conversion. In addition, such Rights are issuable on a one-for-one basis with respect to shares of Common Stock receivable upon exercise of stock options or conversion of Depositary Shares. (2) Percentages are shown only where they exceed one percent of the number of shares outstanding and, in the case of Common Stock holdings are based on shares of Common Stock outstanding (exclusive of treasury stock) on March 1, 1994. (3) Various affiliates of Berkshire Hathaway Inc. ("Berkshire") are recordholders of 358,000 or 100% of the outstanding shares of Series A Preferred Stock. Messrs. Buffett and Munger are Chairman and Chief Executive Officer and Vice Chairman, respectively, of Berkshire and may be deemed to control that company. Messrs. Buffett and Munger each disclaims beneficial ownership of Series A Preferred Stock. Series A Preferred Stock is currently convertible into 9,239,944 shares of Common Stock, which represents approximately 10.5% of the total voting interest represented by Common Stock, Series F Pre- ferred Stock, Series T Preferred Stock and Series A Preferred Stock at March 1, 1994. (4) The listing of Mr. Colodny's holding includes 67,000 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options. (5) Mr. Goodman's holdings of Depositary Shares is convertible into 498 shares of Common Stock. (6) A wholly-owned subsidiary of BA is recordholder of 30,000 or 100% of the outstanding shares of Series F Preferred Stock, 152.1 or 100% of the outstanding shares of the Series T-1 Preferred Stock and 9,919.8 or 100% of the outstanding shares of the Series T-2 Preferred Stock pursuant to the Investment Agreement. Messrs. Marshall, Maynard and Stevens are Chair- man, Director of Corporate Strategy and Chief Financial Offic- er, respectively, of BA and have been designated by BA to act as directors of the Company pursuant to the Investment Agreement. Messrs. Marshall, Maynard and Stevens each dis- claims beneficial ownership of Series F Preferred Stock and Series T Preferred Stock. (7) The listing of Mr. Schofield's holding includes 335,069 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options, and 30,000 shares of Common Stock subject to certain restrictions upon disposition ("Restricted Stock"). (8) The listing of Mr. Lagow's holding reflects shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options. (9) The listing of Mr. Salizzoni's holding includes 152,800 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 6,000 shares of Restricted Stock. (10) The listing of Mr. Lloyd's holding includes 169,742 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 4,000 shares of Restricted Stock. (11) The listing of Mr. Schwab's holding includes 167,992 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 3,200 shares of Restricted Stock. (12) The listing of all directors' and officers' holdings includes 1,193,583 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 50,400 shares of Restricted Stock. The only persons known to the Company (from Company records and reports on Schedules 13D and 13G filed with the Securities and Exchange Commission (the "SEC")) which owned, as of March 1, 1994, more than 5% of its Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock are listed below: (1) Represents percent of class of stock outstanding (exclusive of treasury stock) on March 1, 1994. (2) Number of shares as to which such person has shared voting power-358,000; shared dispositive power-358,000. (3) These shares of Series A Preferred Stock are owned directly by affiliates of Berkshire, are convertible, under certain circumstances and subject to certain antidilution adjustments, into 9,239,944 shares of Common Stock and represent approxi- mately 10.5% of the combined voting power of the outstanding Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock, voting as a single class, at March 1, 1994. A number of Rights, equal to the number of shares of Common Stock into which the Series A Preferred Stock is convertible, is also owned by this person. As disclosed above, two directors of the Company, Messrs. Buffett and Munger, may be deemed to control Berkshire and disclaim beneficial ownership of Series A Preferred Stock. (4) Number of shares as to which BA has sole voting power and sole dispositive power-30,000. (5) BritAir Acquisition Corp. Inc. is a wholly-owned subsidiary of BA and owns Series F Preferred Stock and Series T Preferred Stock pursuant to the Investment Agreement. Series F Preferred Stock and Series T Preferred Stock are convertible, under certain circumstances on or after January 21, 1997 and subject to certain antidilution adjustments and Foreign Ownership Restrictions, into a total of 15,458,658 and 3,831,695 shares of Common Stock, respectively. Together, the Series F Pre- ferred Stock and Series T Preferred Stock represent approxi- mately 21.9% of the combined voting power of the outstanding Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock, voting as a single class, at March 1, 1994. A number of Rights, equal to the number of shares of Common Stock into which the Series F Preferred Stock and Series T Preferred Stock are convertible, is owned by this person. As disclosed above, three directors of the Company, Messrs. Marshall, Maynard and Stevens, have been designated by BA to act as directors of the Company pursuant to the Invest- ment Agreement and disclaim beneficial ownership of Series F Preferred Stock and Series T Preferred Stock. (6) Reflects 152.1 or 100% of the outstanding shares of Series T-1 Preferred Stock and 9,919.8 or 100% of the outstanding shares of Series T-2 Preferred Stock. BA has sole voting power and sole dispositive power as to all these outstanding shares of Series T Preferred Stock. (7) The Schedule 13G dated January 6, 1994 disclosing such ownership was jointly filed by such person with five French mutual insurance companies ("Mutuelles AXA") and AXA. The Schedule 13G indicated that each of Mutuelles AXA, as a group, and AXA expressly declares that the filing of the Schedule 13G should not be construed as an admission that it is, for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended, the beneficial owner of any securities covered by the Schedule 13G. The Company is investigating whether, owing to the investment of Mutuelles AXA and AXA (collectively, "AXA") in the Equitable Companies Incorporated ("Equitable"), AXA is the beneficial owner of these shares. If it is determined that AXA is the beneficial owner, then self-effectuating provisions of the Company's restated certificate of incorporation, as amended, would provide that the subject shares would be non-voting shares. The Company does not know whether Equitable would cause such shares to be sold in the event such shares have no voting rights. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Industry Globalization and Regula- tion" for information regarding U.S. statutory limitations on foreign ownership of U.S. air carriers and Item 1. "Business- British Airways Investment Agreement" and notes (4), (5) and (6) above for information regarding BA's ownership interest in the Company. (8) Number of shares as to which person has sole voting power- 5,669,403; shared voting power-1,300; no voting power-636,800; sole dispositive power-6,305,703; shared dispositive power- none; no dispositive power-1,800. (9) The shares are owned by a direct and an indirect subsidiary of the person. Number of shares as to which such subsidiaries have sole voting power-4,832,200; sole dispositive power- 4,832,200. In connection with BA's purchase of the Series T Preferred Stock in June 1993, Messrs. Marshall, Maynard and Stevens and BA were required by Section 16 of the Securities Exchange Act of 1934, as amended, and rules thereunder to file by July 10, 1993, Form 4 reports disclosing this change of ownership. Messrs. Marshall, Maynard and Stevens and BA filed these reports on September 14, 1993. 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) The following documents are filed as part of this report: 1. FINANCIAL STATEMENTS (i) The following consolidated financial statements of USAir Group are included in Part II, Item 8A of this report: - Consolidated Statements of Operations for each of the Three Years Ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and - Consolidated Statements of Cash Flows for each of the Three Years Ended December 31, 1993 - Consolidated Statements of Changes in Stockholders' Equity for each of the Three Years Ended December 31, - Notes to Consolidated Financial Statements (ii) The following consolidated financial statements of USAir are included in Part II, Item 8B of this report: - Consolidated Statements of Operations for each of the Three Years Ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and - Consolidated Statements of Cash Flows for each of the Three Years Ended December 31, 1993 - Consolidated Statements of Changes in Stockholder's Equity for each of the Three Years Ended December 31, - Notes to Consolidated Financial Statements 2. FINANCIAL STATEMENT SCHEDULES (i) Independent Auditors' Report on Consolidated Financial Statement Schedules of USAir Group. - Consolidated Financial Statement Schedules - Three Years Ended December 31, 1993: V - Property, Equipment and Leasehold Improvements VI - Accumulated Depreciation and Amortization of Prop- erty, Equipment and Leasehold Improvements VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts and Reserves X - Supplementary Income Statement Information (ii) Independent Auditors' Report on Consolidated Financial Statement Schedules of USAir. - Consolidated Financial Statement Schedules - Three Years Ended December 31, 1993: IV - Indebtedness to Related Parties - Not Current V - Property, Equipment and Leasehold Improvements VI - Accumulated Depreciation and Amortization of Prop- erty, Equipment and Leasehold Improvements VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts and Reserves X - Supplementary Income Statement Information All other schedules are omitted because they are not appli- cable or not required, or because the required information is either incorporated herein by reference or included in the financial statements or notes thereto included in this report. (b) Reports on Form 8-K During the quarter ended December 31, 1993, the Company and USAir filed Current Reports dated September 23, October 20, and November 4, 1993, on Form 8-K regarding the Second Waiver dated September 15, 1993 to the Credit Agreement, results for the quarter ended September 30, 1993 and the sale of $337.7 million of pass through certificates, respectively. The Company and USAir filed a Current Report dated January 18, 1994 on Form 8-K regarding the Third Waiver dated as of December 21, 1993 to the Credit Agreement. In addition, the Company and USAir filed a Current Report dated January 25, 1994 on Form 8-K regarding the press release dated January 25, 1994 of USAir Group, Inc. and USAir, Inc., with consolidated statements of operations for each company. On March 9, 1994, the Company and USAir filed a Current Report on Form 8-K disclosing projected losses for the first quarter and year 1994 and the initiation of negotiations with the leadership of USAir's unions regarding pay reductions and productivity improvements. 3. EXHIBITS Designation Description 3.1 Restated Certificate of Incorporation of USAir Group (incorporated by reference to Exhibit 3.1 to USAir Group's Registration Statement on Form 8-B dated January 27, 1983), including the Certificate of Amend- ment dated May 13, 1987 (incorporated by reference to Exhibit 3.1 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987), the Certificate of Increase dated June 30, 1987 (incorporated by reference to Exhibit 3 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987), the Certificate of Increase dated October 16, 1987 (incorporated by reference to Exhibit 3.1 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended September 30, 1987), the Certificate of Increase dated August 7, 1989 (incorporated by reference to Exhibit 3.1 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989), the Certificate of Increase dated April 9, 1992, the Certificate of Increase dated January 21, 1993, and as amended by Amendment No. 1 dated May 26, 1993 (incorporated by reference to Appendix II to USAir Group's Proxy State- ment dated April 26, 1993). 3.2 By-Laws of USAir Group (incorporated by reference to Exhibit 3.2 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1992). 3.3 Rights Agreement, dated as of July 29, 1989, as amended and restated as of January 21, 1993, between USAir Group and Chemical Bank, as Rights Agent (incorporated by reference to Exhibit 28.4 to USAir Group's Current Report on Form 8-K dated January 21, 1993). 3.4 Restated Certificate of Incorporation of USAir (in- corporated by reference to Exhibit 3.1 to USAir's Registration Statement on Form 8-B dated January 27, 1983). 3.5 By-Laws of USAir (incorporated by reference to Exhibit 3.5 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1992). 4.1 Amended Certificate of Designation, Preferences, and Rights of the Series D of Junior Preferred Stock of USAir Group (incorporated by reference to Exhibit 4(c) to USAir Group's Current Report on Form 8-K dated August 11, 1989). 4.2 Certificate of Designation of Series A Cumulative Convertible Preferred Stock of USAir Group (incorpo- rated by reference to Exhibit 4(b) to USAir Group's Current Report on Form 8-K dated August 11, 1989). 4.3 Certificate of Designation of Series B Cumulative Convertible Preferred Stock of USAir Group (incorpo- rated by reference to Exhibit 3.3 to Amendment No. 4 to USAir Group's Registration Statement on Form S-3 (Registration No. 33-39540) dated May 17, 1991). 4.4 Agreement between USAir Group and Berkshire Hathaway Inc. dated August 7, 1989 (incorporated by reference to Exhibit 4(a) to USAir Group's Current Report on Form 8- K dated August 11, 1989). 4.5 Certificate of Designation of Series F Cumulative Convertible Senior Preferred Stock of USAir Group (incorporated by reference to Exhibit 28.2 to USAir Group's Current Report on Form 8-K dated January 21, 1993). 4.6 Form of Certificate of Designation of Series T-_ Cumulative Exchangeable Convertible Senior Preferred Stock of USAir Group (incorporated by reference to Appendix VII to USAir Group's Proxy Statement dated April 26, 1993). Neither USAir Group nor USAir is filing any instrument (with the exception of holders of exhibits 10.1(a-h)) defining the rights of holders of long-term debt because the total amount of securities authorized under each such instrument does not exceed ten percent of the total assets of USAir. Copies of such instruments will be furnished to the Securities and Exchange Commission upon request. 10.1(a) Credit Agreement dated as of March 30, 1987 and Amended and Restated as of October 21, 1988 among the Banks named therein and USAir Group (incorporated by reference to Exhibit 28.2 to Amendment No. 1 dated October 28, 1988 to Piedmont's Registration Statement on Form S-3 No. 33-24870 dated October 7, 1988). 10.1(b) First Amendment, dated as of July 28, 1989, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 10.1(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.1(c) Second Amendment, dated as of February 15, 1990, to USAir Group's Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.1 to USAir Group's Current Report on Form 8-K dated October 26, 1990). 10.1(d) Third Amendment, dated as of September 30, 1990, to USAir Group's Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.2 to USAir Group's Current Report on Form 8-K dated October 26, 1990). 10.1(e) Fourth Amendment, dated as of March 29, 1991, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to the Exhibit to USAir Group's Current Report on Form 8-K dated April 23, 1991). 10.1(f) Fifth Amendment, dated as of April 26, 1991, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28.7 to USAir Group's Registration Statement on Form S-8 No. 33-39540 dated April 26, 1991). 10.1(g) Sixth Amendment, dated as of October 14, 1992, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28.3 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992). 10.1(h) Seventh Amendment, dated as of June 21, 1993, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28 to USAir Group's Current Report on Form 8-K filed on July 1, 1993). 10.2(a) Supplemental Agreement No. 16, dated July 19, 1990, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(a) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1990). 10.2(b) Supplemental Agreement No. 17, dated November 28, 1990, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1990). 10.2(c) Supplemental Agreement No. 18, dated December 23, 1991, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(c) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1991). 10.3 Purchase Agreement No. 1725 dated December 23, 1991 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.3 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended Decem- ber 31, 1991). 10.4 USAir, Inc. Executive Incentive Compensation Plan (incorporated by reference to Exhibit 10.3 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.5 USAir, Inc. Officers' Supplemental Benefit Plan (incorporated by reference to Exhibit 10.5 to USAir's Annual Report on Form 10-K for the year ended December 31, 1980). 10.6 USAir, Inc. Supplementary Retirement Benefit Plan (incorporated by reference to Exhibit 10.5 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.7 USAir Group's 1984 Stock Option and Stock Appreciation Rights Plan (incorporated by reference to Exhibit A to USAir Group's Proxy Statement dated March 30, 1984). 10.8 USAir Group's 1988 Stock Incentive Plan (incorporated by reference to Exhibit 10.15 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1987). 10.9 USAir Group's 1992 Stock Option Plan (incorporated by reference to Exhibit A to USAir Group's Proxy Statement dated March 30, 1992). 10.10 Employment Agreement between USAir and its President and Chief Executive Officer (which is similar in form to the employment agreements of USAir Group's other executive officers) (incorporated by reference to Exhibit 10.9 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1991). 10.11 Agreements providing supplemental retirement benefits for the following officers of USAir: Executive Vice President and General Counsel (incorporated by reference to Exhibit 10.14 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1987), Executive Vice President-Operations, Senior Vice President-Corporate Communications and Senior Vice President-Human Resources (incorporated by reference to Exhibit 10.9 to USAir Group's Annual Report on Form 10- K for the year ended December 31, 1989). 10.12(a) Trust Agreement dated as of August 1, 1989 between USAir Group and Wachovia Bank and Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 10.10(a) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.12(b) Trust Agreement dated as of August 1, 1989 between USAir and Wachovia Bank and Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 10.10(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.13 Investment Agreement dated as of January 21, 1993 between USAir Group and British Airways Plc (incorporated by reference to Exhibit 28.1 to USAir Group's and USAir's Current Report on Form 8-K filed on January 28, 1993, as amended by Amendment No. 1 on Form 8 filed on April 13, 1993). 10.13(a) Amendment dated as of February 21, 1994 to the Investment Agreement dated as of January 21, 1993 between USAir Group and British Airways Plc. 11 Computation of primary and fully diluted earnings per share of USAir Group for the five years ended December 31, 1993. 21 Subsidiaries of USAir Group and USAir. 23.1 Consent of the Auditors of USAir Group to the incorporation of their report concerning certain financial statements contained in this report in certain registration statements. 23.2 Consent of the Auditors of USAir to the incorporation of their report concerning certain financial statements contained in this report in certain registration statements. 24.1 Powers of Attorney signed by the directors of USAir Group, authorizing their signatures on this report. 24.2 Powers of Attorney signed by the directors of USAir, authorizing their signatures on this report. SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, USAir Group, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. USAir Group, Inc. By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) 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 USAir Group, Inc. and in the capacities and on the dates indicated. March 25, 1994 By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) March 25, 1994 By: /s/Frank L. Salizzoni --------------------------------- Frank L. Salizzoni Executive Vice President-Finance (Principal Financial Officer) March 25, 1994 By: /s/Ann Greer-Rector --------------------------------- Ann Greer-Rector Vice President & Controller (Principal Accounting Officer) March 25, 1994 By: * -------------------------------- Warren E. Buffett Director March 25, 1994 By: * --------------------------------- Edwin I. Colodny Director March 25, 1994 By: * -------------------------------- Mathias J. DeVito Director March 25, 1994 By: * -------------------------------- George J. W. Goodman Director March 25, 1994 By: * --------------------------------- John W. Harris Director March 25, 1994 By: * --------------------------------- Edward A. Horrigan, Jr. Director March 25, 1994 By: * --------------------------------- Robert LeBuhn Director March 25, 1994 By: * --------------------------------- Sir Colin Marshall Director March 25, 1994 By: * --------------------------------- Roger P. Maynard Director March 25, 1994 By: * --------------------------------- John G. Medlin, Jr. Director March 25, 1994 By: * --------------------------------- Hanne M. Merriman Director March 25, 1994 By: * -------------------------------- Charles T. Munger Director March 25, 1994 By: * --------------------------------- Richard P. Simmons Director March 25, 1994 By: * --------------------------------- Raymond W. Smith Director March 25, 1994 By: * -------------------------------- Derek M. Stevens Director By: /s/Frank L. Salizzoni ------------------------------ Frank L. Salizzoni Attorney-In-Fact SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, USAir, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. USAir, Inc. By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) 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 USAir, Inc. and in the capacities and on the dates indicated. March 25, 1994 By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) March 25, 1994 By: /s/Frank L. Salizzoni --------------------------------- Frank L. Salizzoni Executive Vice President-Finance (Principal Financial Officer) March 25, 1994 By: /s/Ann Greer-Rector --------------------------------- Ann Greer-Rector Vice President & Controller (Principal Accounting Officer) March 25, 1994 By: * -------------------------------- Warren E. Buffett Director March 25, 1994 By: * --------------------------------- Edwin I. Colodny Director March 25, 1994 By: * -------------------------------- Mathias J. DeVito Director March 25, 1994 By: * -------------------------------- George J. W. Goodman Director March 25, 1994 By: * --------------------------------- John W. Harris Director March 25, 1994 By: * --------------------------------- Edward A. Horrigan, Jr. Director March 25, 1994 By: * --------------------------------- Robert LeBuhn Director March 25, 1994 By: * --------------------------------- Sir Colin Marshall Director March 25, 1994 By: * --------------------------------- Roger P. Maynard Director March 25, 1994 By: * --------------------------------- John G. Medlin, Jr. Director March 25, 1994 By: * --------------------------------- Hanne M. Merriman Director March 25, 1994 By: * -------------------------------- Charles T. Munger Director March 25, 1994 By: * --------------------------------- Richard P. Simmons Director March 25, 1994 By: * --------------------------------- Raymond W. Smith Director March 25, 1994 By: * -------------------------------- Derek M. Stevens Director By: /s/Frank L. Salizzoni ------------------------------ Frank L. Salizzoni Attorney-In-Fact Independent Auditors' Report On Consolidated Financial Statement Schedules - USAir Group, Inc. The Stockholders and Board of Directors USAir Group, Inc.: Under date of February 25, 1994, we reported on the consoli- dated balance sheets of USAir Group, Inc. and subsidiaries ("Group") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholders' equity (deficit) for each of the years in the three- year period ended December 31, 1993, as included in Item 8A in this 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 as listed in Item 14(a)2(i). These consolidated financial statement schedules are the responsibility of Group's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such 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. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 Independent Auditors' Report On Consolidated Financial Statement Schedules - USAir, Inc. The Stockholder and Board of Directors USAir, Inc.: Under date of February 25, 1994, we reported on the consolidated balance sheets of USAir, Inc. and subsidiaries ("USAir") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993, as included in Item 8B in this 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 as listed in Item 14(a)2(ii). These consolidated financial statement schedules are the responsibility of USAir's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such 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. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 Exhibit 21 SUBSIDIARIES OF USAIR GROUP, INC. AND USAIR, INC. USAir Group, Inc. - ----------------- USAir, Inc. Piedmont Airlines, Inc. (formerly Henson Airlines, Inc.) Jetstream International Airlines, Inc. Pennsylvania Commuter Airlines, Inc. (d/b/a/ Allegheny Commuter Airlines) USAir Leasing and Services, Inc. USAir Fuel Corporation Material Services Corp. USAir, Inc. (the following companies are also indirect subsidiaries - ------------------------------------------------------------------- of USAir Group, Inc.) - --------------------- USAM Corp. Pacific Southwest Airmotive (substantially all of the assets of this company were sold on October 9, 1991) Exhibit 23.1 CONSENT OF INDEPENDENT AUDITORS The Board of Directors USAir Group, Inc. We consent to the incorporation by reference in the Registration Statements on Form S-8 Nos. 2-98828, 33-26762, 33-39896, 33-44835, 33-60618 and 33-60620 and the Registration Statement on Form S-3 No. 33-41821 of USAir Group, Inc., of our reports dated February 25, 1994 relating to the consolidated balance sheets of USAir Group, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and changes in stockholders' equity, and the related consolidated financial statement schedules for each of the years in the three- year period ended December 31, 1993 which reports appear in the December 31, 1993 annual report on Form 10-K of USAir Group, Inc. and USAir, Inc. KPMG PEAT MARWICK Washington, D.C. March 25, 1994 Exhibit 23.2 CONSENT OF INDEPENDENT AUDITORS The Board of Directors USAir, Inc. We consent to the incorporation by reference in the Registration Statement on Form S-3 No. 33-35509 of USAir, Inc., of our reports dated February 25, 1994 relating to the consolidated balance sheets of USAir, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and changes in stockholders' equity, and the related consolidated financial statement schedules for each of the years in the three- year period ended December 31, 1993 which reports appear in the December 31, 1993 annual report on Form 10-K of USAir Group, Inc. and USAir, Inc. KPMG PEAT MARWICK Washington, D.C. March 25, 1994 Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Warren E. Buffett, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Warren E. Buffett (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edwin I. Colodny, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 25 day of January, 1994. /s/Edwin I. Colodny (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Mathias J. DeVito, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Mathias J. DeVito (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, George J. W. Goodman, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13 day of January, 1994. /s/George J. W. Goodman (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John W. Harris, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/J. W. Harris (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edward A. Horrigan, Jr., Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Edward A. Horrigan, Jr. (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Robert LeBuhn, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14th day of January, 1994. /s/Robert LeBuhn (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Colin Marshall, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/C. Marshall (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Roger P. Maynard, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/R. Maynard (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John G. Medlin, Jr., Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 19th day of January, 1994. /s/John G. Medlin, Jr. (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Hanne M. Merriman, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Hanne M. Merriman (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Charles T. Munger, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 24th day of January, 1994. /s/Charles T. Munger (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Richard P. Simmons, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13th day of January, 1994. /s/Richard P. Simmons (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Raymond W. Smith, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/R. W. Smith (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Derek M. Stevens, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/Derek M. Stevens (L.S.) --------------------------------- Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Warren E. Buffett, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Warren E. Buffett (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edwin I. Colodny, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 25 day of January, 1994. /s/Edwin I. Colodny (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Mathias J. DeVito, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Mathias J. DeVito (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, George J. W. Goodman, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13 day of January, 1994. /s/George J. W. Goodman (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John W. Harris, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/J. W. Harris (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edward A. Horrigan, Jr., Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Edward A. Horrigan, Jr. (L.S.) --------------------------------- Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Robert LeBuhn, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14th day of January, 1994. /s/Robert LeBuhn (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Colin Marshall, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/C. Marshall (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Roger P. Maynard, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/R. P. Maynard (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John G. Medlin, Jr., Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 19th day of January, 1994. /s/John G. Medlin, Jr. (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Hanne M. Merriman, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Hanne M. Merriman (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Charles T. Munger, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 24th day of January, 1994. /s/Charles T. Munger (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Richard P. Simmons, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13th day of January, 1994. /s/Richard P. Simmons (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Raymond W. Smith, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/R. W. Smith (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Derek M. Stevens, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/Derek M. Stevens (L.S.) ------------------------------

33213_1993.txt

33213_1993

1993

33213

Item 1. Business (a)Equitable Resources, Inc. ("Equitable" or the "Company") was formed under the laws of Pennsylvania by the consolidation and merger in 1925 of two constituent companies, the older of which was organized in 1888. The Company owns all the capital stock of subsidiary companies. Principal subsidiaries are Equitable Resources Energy Company ("Equitable Resources Energy") and Kentucky West Virginia Gas Company ("Kentucky West"). Equitable Resources Energy owns all the capital stock of Equitable Resources Marketing Company ("ERMCO") and Andex Energy, Inc. ("Andex"). Kentucky West owns all the capital stock of Equitrans, Inc. ("Equitrans") and Nora Transmission, Inc. ("Nora"). ERMCO owns all the capital stock of Louisiana Intrastate Gas Company ("LIG"). The Company and all such subsidiaries are referred to as the "Company and its Subsidiaries" or the "Companies." The Companies operate in the Appalachian area and, to a lesser extent, in the Rocky Mountain, Southwest, Louisiana and Gulf Coast offshore areas, the Canadian Rockies and has interests in Colombia, South America. The Companies engage primarily in the exploration for, development, production, purchase, transmission, storage, distribution and marketing of natural gas, the extraction of natural gas liquids, the exploration for, development, production and sale of oil and contract drilling. LIG was acquired by the Company on June 30, 1993 as described in Note L to the consolidated financial statements in Part II. LIG owns a 1,900 mile intrastate pipeline system in Louisiana, four natural gas processing plants and is also engaged in gas marketing. Hershey Oil Corporation ("Hershey") was acquired on July 8, 1993. Hershey owns natural gas and oil reserves and acreage in Alberta, Canada. These subsidiaries are included in the Energy Resource segment. (b)The Company's business is comprised of two business segments, Energy Resources and Utility Services. Financial information by business segment is presented in Note K to the consolidated financial statements contained in Part II. (b) (1)Not applicable. (b) (2)Not applicable. (c) (1)ENERGY RESOURCES. Energy Resources activities are conducted by Equitable Resources Energy Company through its divisions and subsidiaries. Its activities are principally in the Appalachian area where it explores for, develops, produces and markets natural gas and oil, performs contract drilling and well maintenance services, and extracts and markets natural gas liquids. Energy Resources also conducts operations in the Rocky Mountain area including the Canadian Rockies where it explores for, develops and produces oil, and to a lesser extent natural gas. In Louisiana, the segment provides intrastate transportation of gas and extracts and markets natural gas liquids. Item 1. Business (Continued) In the Southwest and Gulf Coast offshore areas, this segment participates in exploration and development of gas and oil projects. Energy Resources also owns an interest in two natural gas liquids plants in Texas. Andex participates in ventures to explore for and develop oil in Colombia, South America. ERMCO operates nationwide as a full-service natural gas marketing and supply company. ERMCO provides a full range of energy services, including monthly "spot" and longer term contracts, peak shaving and transportation arrangements. UTILITY SERVICES. Utility Services activities are conducted by Equitable Gas Company ("Equitable Gas"), a division of the Company, and three wholly-owned subsidiaries: Kentucky West, Equitrans and Nora. Equitable Gas is a natural gas utility, regulated by state public utility commissions in Pennsylvania, West Virginia and Kentucky and is engaged in the purchase, distribution, marketing and transportation of natural gas. The territory served by Equitable Gas embraces principally the city of Pittsburgh and surrounding municipalities in southwestern Pennsylvania, a few municipalities in northern West Virginia and field line sales in eastern Kentucky. Kentucky West, regulated by the Federal Energy Regulatory Commission (FERC), is an open access natural gas pipeline company. Prior to restructuring pursuant to FERC Order 636, Kentucky West purchased gas from the Energy Resource segment and independent producers in Kentucky. Most of Kentucky West's sales were to Equitrans and, to a lesser extent, to industrial customers and other utilities. Kentucky West also transported gas independently marketed by Energy Resources. With the FERC Order 636 restructuring, which was effective July 1, 1993, Kentucky West provides only open-access transportation service. Transportation service is provided to Equitable Gas, Equitrans, Energy Resources and other industrial end-users. Kentucky West's pipelines are not physically connected with those of Equitrans or Equitable Gas and deliveries are made to Columbia Gas Transmission Corporation, a nonaffiliate, which in turn delivers like quantities to Equitrans in West Virginia and Pennsylvania under a Transportation and Exchange Agreement. Equitrans is a FERC regulated open access pipeline company with production, storage and transmission facilities in Pennsylvania and West Virginia. Prior to FERC Order 636 restructuring, Equitrans produced, purchased and sold gas and provided transportation and underground storage services. With the FERC Order 636 restructuring, which was effective September 1, 1993, Equitrans provides transportation and storage services. Equitrans provides transportation service for Equitable Gas Company and nonaffiliates including customers in off-system markets. Storage services are provided for Equitable Gas Company and nine nonaffiliated customers. Nora is a FERC regulated pipeline company which transports Energy Resources' gas produced in Virginia and Kentucky. Utility services, principally gas service, are provided to more than 265,000 customers located mainly in the city of Pittsburgh and its environs. Residential and commercial sales volumes reflect annual variations which are primarily related to weather. In addition, commercial and industrial sales volumes have decreased mainly as the result of customers acquiring gas directly from third parties. However, this gas is transported and delivered by Utility Services. Item 1. Business (Continued) (c) (1) (i)Operating revenues as a percentage of total operating revenues for each of the two business segments during the years 1991 through 1993 are as follows: 1993 1992 1991 Energy Resources: Natural gas - production 10% 10% 8% - marketing 45 32 26 Natural gas liquids 4 3 3 Contract drilling 1 2 2 Oil 3 5 6 Intrastate transportation 1 - - Other 1 1 1 Total Energy Resources 65 53 46 Utility Services: Residential 23 30 34 Commercial 5 7 9 Industrial 1 2 2 Transportation 4 6 7 Marketed gas 1 - - Utilities and Other 1 2 2 Total Utility Services 35 47 54 Total Revenues 100% 100% 100% (c) (1) (ii)Not applicable. (c) (1) (iii)The following pages (4, 5 and 6) summarize gas and oil supply and disposition for the years 1991 through 1993. Item 1. Business (Continued) Item 1. Business (Continued) Item 1. Business (Continued) Item 1. Business (Continued) During 1993, a total of 325,377,000 Mcf of gas was produced and purchased by the Companies compared with 225,627,000 Mcf in 1992. The increase reflects greater marketing activity, including the consolidation of LIG, and increased production. GAS PURCHASES. Total purchases in 1993 amounted to 269,855,000 Mcf, of which 222,037,000 Mcf was applicable to marketing operations and 47,818,000 Mcf was for system supply, compared with 131,711,000 Mcf for marketing operations and 42,975,000 Mcf for system supply in 1992. Through gas purchase contracts for system supply, the Company controls proved reserves on acreage developed by independent producers. The majority of these contracts cover the productive lives of the wells. NATURAL GAS AND OIL PRODUCTION. Natural gas production by Energy Resources in 1993 of 53,550,000 Mcf increased over the 1992 total of 48,243,000 Mcf. Utility Services production in 1993 of 1,972,000 Mcf decreased from the 1992 total of 2,698,000 Mcf. Production of crude oil in 1993 was 2,112,000 barrels, compared with 2,406,000 barrels in 1992. In 1993, Energy Resources drilled 212 gross wells (152.7 net wells). The primary focus of drilling activity was in Kentucky and Virginia. Drilling in this area was for development of oil in the Big Lime formation and coalbed methane. The Company has been able to develop gas reserves at costs which make it very competitive in marketing its gas to pipeline and commercial buyers. As a result, even in periods of surplus gas supply, the Company has been able to sell gas produced by energy resource operations at a profit. NATURAL GAS AND OIL RESERVES. The Company's estimate of proved developed and undeveloped gas reserves for the Energy Resource segment comprised 822.6 Bcf as of December 31, 1993. These reserves included 759.3 Bcf of proved developed reserves. The Company's oil reserves at December 31, 1993 consisted of 16.5 million barrels of proved developed and undeveloped reserves; proved developed oil reserves amounted to 16.4 million barrels. Substantially all of the gas and approximately one half of the oil reserves are located in the Appalachian area. See Note P to the Consolidated Financial Statements in Part II for details of gas and oil producing activities. STORAGE. Net storage withdrawals for system use during the 1992-93 heating season were 11.0 Bcf, compared with 9.8 Bcf the previous heating season. Net withdrawals of 12.8 Bcf were made during the 1992-93 heating season for storage service customers compared with 13.4 Bcf the previous heating season. SUPPLY OUTLOOK. The Company's near-term utility gas supply is excellent. The long-range gas supply outlook also is very favorable. Annual gas supply is forecasted to exceed demand at least for the next decade. Item 1. Business (Continued) Energy Resources has also been in a favorable supply position and reserves have continued to increase. However, the development or purchase of future supplies will depend largely on energy prices. (c) (1) (iv) Equitable Gas is regulated by the Pennsylvania Public Utility Commission and the Public Service Commissions of West Virginia and Kentucky; LIG is regulated by the Louisiana Public Service Commission; Kentucky West, Equitrans, Nora, LIG and Equitable Resources Energy are regulated by the Federal Energy Regulatory Commission under the Natural Gas Act and the Natural Gas Policy Act. Equitable Gas, Kentucky West, Equitrans, Nora, LIG and Equitable Resources Energy are also subject to regulation by the Department of Transportation under the Natural Gas Pipeline Safety Act of 1968 with respect to safety requirements in the design, construction, operation and maintenance of pipelines and related facilities. (c) (1) (v) and (vi) Approximately 65 percent of annual Utility Service revenue is recorded during the winter heating season from November through March. Significant quantities of purchased gas are placed in underground storage inventory during the off-peak season to accommodate high customer demands during the winter heating season. Funds required to finance this inventory are obtained through short-term loans. Energy Resource's revenues are not subject to seasonal variation to the same degree as Utility Service revenues. (c) (1) (vii)Not applicable. (c) (1) (viii)Not applicable. (c) (1) (ix)Not applicable. (c) (1) (x)Equitable Gas is in competition with others for the purchase of natural gas and Equitable Resources Energy is in competition with others for the acquisition of gas and oil leases. Equitable Gas competes for gas sales with other utilities in its service area, as well as with other fuels and forms of energy and other sources of natural gas available to existing or potential customers. Utility Services has been successful in meeting competition with aggressive marketing which retained load and added new residential, commercial and off-system customers in areas served by two or more energy suppliers. This has been achieved by responding to market requirements with a portfolio of firm and interruptible services at competitive prices. See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Part II regarding FERC Order 636 and its impact on the operations of the Utility Service companies. (c) (1) (xi) Not material. Item 1. Business (Continued) (c) (1) (xii)The Company and its subsidiaries are subject to federal, state and local environmental laws and regulations. Principal concerns are with respect to oil and thermal pollution of waterways, storage and disposal of hazardous wastes and liquids and erosion and sedimentation control in pipeline construction work. For further discussion of environmental matters, see Management's Discussion and Analysis of Financial Condition and Results of Operations and Note N to the consolidated financial statements in Part II. (c) (1) (xiii)The Companies had 2,454 regular employees at the end of 1993. (d) Not material. Item 2. Item 2. Properties Principal facilities are owned by the Company's business segments with the exception of several office locations and warehouse buildings. The terms of the leases on these facilities expire at various times from 1994 through 2014. All leases contain renewal options for various periods. A minor portion of equipment is also leased. With few exceptions, utility transmission, storage and distribution pipelines are located on or under (1) public highways under franchises or permits from various governmental authorities, or (2) private properties owned in fee, or occupied under perpetual easements or other rights acquired for the most part without examination of underlying land titles. The Company's facilities have adequate capacity, are well maintained and, where necessary, are replaced or expanded to meet operating requirements. UTILITY SERVICES. Equitable Gas owns and operates natural gas distribution properties as well as other general property and equipment in Pennsylvania, West Virginia and Kentucky. Equitrans owns and operates production, underground storage and transmission facilities as well as other general property and equipment in Pennsylvania and West Virginia. Kentucky West owns and operates gathering and transmission properties as well as other general property and equipment in Kentucky. ENERGY RESOURCES. This business segment owns or controls and operates substantially all of the Company's gas and oil production properties, the majority of which are located in the Appalachian area. This segment also owns an intrastate pipeline system and four hydrocarbon extraction plants in Louisiana, hydrocarbon extraction facilities in Kentucky with a 100-mile liquid products pipeline which extends into West Virginia and an interest in two hydrocarbon extraction plants in Texas. This business segment owns or controls acreage of proved developed and undeveloped gas and oil lands located principally in the Appalachian area and, to a lesser extent, in the Rocky Mountain area including the Canadian Rockies, the Southwest and Gulf Coast offshore areas and in Colombia, South America. The acquisition of Canadian properties in 1993 is described in Note L to the consolidated financial statements and significant purchases of oil and gas properties in 1991 are described in Note M to the consolidated financial statements contained in Part II. Information relating to Company estimates of natural gas and oil reserves and future net cash flows is summarized in Note P to the consolidated financial statements in Part II. No report has been filed with any Federal authority or agency reflecting a five percent or more difference from the Company's estimated total reserves. Item 2. Properties (Continued) Gas and Oil Production (Energy Resources): 1993 1992 1991 Gas - MMcf 53,550 48,243 40,022 Oil - Thousands of Barrels 2,112 2,406 2,006 Natural Gas: Average field sales price of natural gas produced during 1993, 1992 and 1991 was $2.27, $1.93 and $1.81 per Mcf, respectively. Average production cost (lifting cost) of natural gas during 1993, 1992 and 1991 was $.458, $.443 and $.460 per Mcf, respectively. Oil: Average sales price of oil produced during 1993, 1992 and 1991 was $16.18, $18.07 and $18.98 per barrel, respectively. Average production cost (lifting cost) of oil during 1993, 1992 and 1991 was $4.30, $3.75 and $3.77 per barrel, respectively. Gas Oil Total productive wells at December 31, 1993: Total gross productive wells 5,838 876 Total net productive wells 4,301 535 Total acreage at December 31, 1993: Total gross productive acres 725,000 Total net productive acres 596,000 Total gross undeveloped acres 3,192,000 Total net undeveloped acres 2,341,000 Number of net productive and dry exploratory wells and number of net productive and dry development wells drilled: 1993 1992 1991 Exploratory wells: Productive 12.0 11.6 12.4 Dry 6.7 6.3 8.6 Development wells: Productive 123.4 134.1 120.4 Dry 10.6 12.0 12.6 As of December 31, 1993, the Company had 4 gross wells (2.16 net wells) in the process of being drilled. Item 3. Item 3. Legal Proceedings LIG is a party to certain claims involving its gas purchase contracts, including take-or-pay liabilities. As more fully described in Note L to the consolidated financial statements in Part II, the seller, and/or the previous owner of LIG, have provided indemnifications for the Company. There are no other material pending legal proceedings, other than those which are adequately covered by insurance, to which the Company or any of its subsidiaries is a party, or to which any of their property is subject. The Company is claimant as a creditor in Columbia Gas Transmission Company's bankruptcy proceeding as described in Notes B and N to the consolidated financial statements in Part II. 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 last quarter of its fiscal year ended December 31, 1993. Item 10. Directors and Executive Officers of the Registrant (b) Identification of executive officers Name and Age Title Business Experience First elected to present position Donald I. Moritz Chairman and Chief December 17, 1993; (66) Executive Officer President and Chief Executive Officer from August 1, 1978. First elected to present position December 17, 1993; Executive Vice President and Chief Operating Officer Frederick H. President and from June 1, 1992; Abrew (56) Chief Operating Officer Executive Vice President from June 1, 1991; Executive Vice President - Utility Services from June 1, 1988. First elected to Senior Vice present position Jeremiah J. Ayres President - February 1, 1991; (61) Environment and Vice President - Technology Corporate Services from March 26, 1987. Augustine A. Senior Vice First elected to Mazzei, Jr. (57) President and present position General Counsel June 1, 1988. First elected to Robert E. Daley Vice President and present position (54) Treasurer May 22, 1986. First elected to present position June 1, 1992; President - Equitable Harry E. Gardner, Vice President - Resources Energy Jr. (56) Energy Resources Company since January 1, 1991; President Equitable Resources Exploration Division from July 1, 1987. Joseph L. Giebel Vice President - First elected to (63) Accounting and present position Administration February 1, 1991; Vice President - Accounting from May 1, 1981. Name and Age Title Business Experience First elected to present position January 1, 1994; Vice President - Utility Services from June 1, John C. Gongas, Vice President - 1992; President of Jr. (49) Utility Group Kentucky West Virginia Gas Company since April 20, 1992; President of Equitrans, Inc. from February 26, 1988. Vice President and First elected to Audrey C. Moeller Corporate present position May (58) Secretary 22, 1986. First elected to present position January 1, 1994; Vice President - Corporate Development from August 1, 1991; Director - Special Projects from October Richard Riazzi Vice President - 1, 1990; President - (39) Energy Group Equitable Resources Marketing Company from February 27, 1989; Vice President - Strategic Planning for Equitable Resources Energy Company from July 1, 1987. Officers are elected annually to serve during the ensuing year or until their successors are chosen and qualified. Except as indicated, the officers listed above were elected on May 21, 1993. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters (a) The Company's common stock is listed on the New York Stock Exchange and the Philadelphia Stock Exchange. The high and low sales prices reflected in the New York Stock Exchange Composite Transactions as reported by The Wall Street Journal and the dividends declared and paid per share are summarized as follows: (b)As of December 31, 1993, there were 8,994 shareholders of record of the Company's common stock. (c)(1)The indentures under which the Company's long-term debt is outstanding contain provisions limiting the Company's right to declare or pay dividends and make certain other distributions on, and to purchase any shares of, its common stock. Under the most restrictive of such provisions, $387,755,000 of the Company's consolidated retained earnings at December 31, 1993, was available for declarations or payments of dividends on, or purchases of its common stock. (c)(2)The Company anticipates dividends will continue to be paid on a regular quarterly basis. Item 6. Item 6. Selected Financial Data Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW Equitable's consolidated net income for 1993 of $73.5 million, or $2.27 per share, was the second highest in the Company's history. The 1993 results represent a 22 percent increase over 1992 net income of $60.0 million, or $1.92 per share, and a 14 percent increase over 1991 net income of $64.2 million, or $2.05 per share. Earnings for all three years include income from regulatory approvals for the recovery of higher wellhead prices for natural gas produced and sold in prior years as more fully described in Note B to the consolidated financial statements. The recovery increased income by approximately $4.7 million for both 1993 and 1992 and $14.9 million for 1991. The increase in net income for 1993 compared to 1992 is due primarily to increases in production and average wellhead prices for natural gas and increased margins from utility service operations. These increases were partially offset by a $5 million increase in 1993 federal income taxes as a result of a one percent increase in the federal corporate income tax rate as more fully described in Note C to the consolidated financial statements. The increase in net income for 1992 compared to 1991, excluding the effect of the direct billing settlements, is the result of increased sales of produced gas and oil, higher average wellhead prices for natural gas and increased retail gas sales reflecting colder weather in 1992. RESULTS OF OPERATIONS This discussion supplements the detailed financial information by business segment presented in Note K to the consolidated financial statements. ENERGY RESOURCES Operating revenues were $743.1 million in 1993 compared with $461.6 million in 1992 and $367.3 million in 1991. The increase in revenues between the periods is due primarily to increases in gas marketing activity, production and average wellhead prices for natural gasand increased production of natural gas liquids in 1993. The increase in marketed natural gas and production of natural gas liquids for 1993 is due primarily to the acquisition of Louisiana Intrastate Gas Company (LIG) on June 30, 1993 as more fully described in Note L to the consolidated financial statements. Increased production of natural gas and oil for 1992 compared to 1991 reflects the full-year impact of 1991 acquisitions. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Energy Resources 1993 1992 1991 Operating Revenues (thousands): Natural Gas: Production . . . . . . . . $121,360 $ 92,864 $ 72,498 Marketing . . . . . . . . . 505,830 269,182 185,901 Oil . . . . . . . . . . . . 34,176 43,469 38,074 Natural Gas Liquids . . . . . 47,121 21,256 23,573 Direct Billing Settlements . 7,815 7,815 24,960 Other . . . . . . . . . . . . 26,762 27,056 22,291 Total Revenues . . . . . $743,064 $461,642 $367,297 Sales Quantities: Natural Gas (MMcf): Production . . . . . . . . 53,550 48,243 40,022 Marketing . . . . . . . . . 218,031 131,711 102,456 Oil (MBls) . . . . . . . . . 2,112 2,406 2,006 Natural Gas Liquids (thousands of gallons) . . . 162,191 64,938 64,200 Gas purchased amounted to $533.7 million in 1993 compared with $277.0 million in 1992 and $193.1 million in 1991. The increased cost in 1993 reflects the increase in volume of marketed natural gas and requirements for the higher production level of natural gas liquids. The increase for 1992 is due to the increase in volume of marketed natural gas. Other operating expenses were $155.2 million in 1993, $143.4 million in 1992 and $127.6 million in 1991. Increases for the respective years are attributed to increased production expenses, depreciation and depletion related to the higher level of natural gas production and the consolidation of LIG in 1993. Operating income, excluding income from direct billing settlements, was $46.4 million in 1993 compared with $33.4 million in 1992 and $21.6 million in 1991. The increase in operating income for 1993 compared to 1992 reflects primarily the increase in average wellhead prices and production of natural gas. The increase for 1992 compared to 1991 is due mainly to increased production of natural gas and oil and higher average wellhead prices for gas. Energy resource operations accounted for more than half of consolidated net income in 1993. This was achieved through the combination of improved wellhead prices for natural gas and increased production realized from recent acquisitions as well as ongoing development activity. Average wellhead prices increased 18 percent in 1993 and reached a level that has not been experienced since 1988. Production was increased by 11 percent in 1993 and represents a 34 percent increase since 1991 when wellhead prices were at their lowest point in more than ten years. Appalachian gas reserves and acreage position remain a firm foundation for the segment's strategy of traditional development and expanding diversification into other areas. The recent acquisition of LIG has enhanced expansion of marketing activities in the Gulf coast area where the Company has been active in natural gas production. LIG will serve as the nucleus for development of a "market hub" with broad access in this area of major production activity as well as interconnections with major pipelines serving substantially all regions of the country. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) In 1994, the segment's $90.5 million capital expenditure program includes $35.3 million for development of Appalachian holdings, $24.6 million for the Rocky Mountain area, $17.2 million for off-shore drilling in the Gulf of Mexico and $2.6 million for participation in exploration in South America. Bolstered by the frigid weather experienced in early 1994, the Company believes the market for natural gas will sustain recent price trends. Market and price trends will continue to be the principal factors for the economic justification of drilling investments under the 1994 program. In addition, $10.8 million in the 1994 capital program is earmarked for other projects, including further development of LIG. The Company is also proceeding with plans to fund and develop storage and interchange facilities which will interconnect with LIG and the Henry Hub. These facilities will establish the capability to provide services necessary for the creation of a separate market hub. UTILITY SERVICES Operating revenues, which are derived principally from the sale and transportation of natural gas, were $397.3 million in 1993 compared with $393.6 million in 1992 and $381.7 million in 1991. The increase in revenues for 1993 compared to 1992 is due to the full-year impact of a retail rate increase for Pennsylvania customers that went into effect in July of 1992, offset by lower retail rates to pass-through decreased purchased gas costs to customers. The increase in revenues for 1992 compared to 1991 is due primarily to increased retail gas sales resulting from colder weather which were offset somewhat by lower off-system sales and transportation. Utility Services 1993 1992 1991 Operating Revenues (thousands): $314,312 $305,310 $291,955 Pipeline Gas Sales . . . . . 12,257 24,186 24,071 Transportation Service . . . 44,760 48,732 48,829 Storage Service . . . . . . . 6,927 5,553 5,935 Marketed Gas Sales . . . . . 10,200 - - Other . . . . . . . . . . . . 8,841 9,847 10,865 Total Revenues . . . . . . $397,297 $393,628 $381,655 Sales Quantities (MMcf): Retail Gas Sales . . . . . . 39,982 38,907 36,688 Pipeline Gas Sales . . . . . 2,814 5,779 5,823 Transportation . . . . . . . 66,272 71,166 70,897 Marketed Gas . . . . . . . . 4,052 - - Heating Degree Days (Normal - 5,968) . . . . . . 5,628 5,629 5,030 Gas purchased amounted to $153.6 million in 1993, $170.6 million in 1992 and $163.4 million in 1991. The decrease in gas costs for 1993 reflects the pass-through of lower costs in rates to retail customers. The increase in 1992 is due primarily to the increase in retail sales volumes. Other operating expenses amounted to $167.4 million in 1993, $149.8 million in 1992 and $148.3 million in 1991. The increase in other operating expenses for 1993 reflects increased labor and employee benefits, increased depreciation, higher taxes other than income, and recording of a reserve for possible refund of interstate billings. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Operating income was $76.3 million in 1993 compared with $73.2 million in 1992 and $70.0 million in 1991. The increase in operating income for 1993 compared to 1992 is due primarily to the full-year impact of the retail rate increase that went into effect in July 1992. The increase in operating income for 1992 compared to 1991 is attributed to higher retail sales. In May 1992, the Federal Energy Regulatory Commission (FERC) issued new regulations, in its Order 636, that significantly altered the manner in which natural gas is sold and transported in interstate commerce. The main feature of the new regulations requires pipelines to unbundle their services and rates by function and permit customers to select one or more of the services offered by the pipeline, i.e., transportation, storage, etc. Under the new structure, local distribution utilities, other marketers and end users will purchase their own gas supply and use pipeline services for handling and transporting the gas. The regulations require pipelines to establish new rates using a straight fixed variable design. Under this method, all fixed costs, including return on investment in facilities, are recovered through a fixed demand or capacity charge based on peak requirements reserved by customers. The vast majority of costs in pipeline rates are fixed costs. The remaining variable costs are recovered in commodity rates based on actual customer usage. The regulations also provide a rate mechanism for pipelines to recover prudently incurred transition costs as they move away from the merchant function. The Company's interstate pipelines, Kentucky West and Equitrans, have successfully implemented their Order 636 restructured tariffs effective July 1, 1993 and September 1, 1993, respectively. All restructuring issues have been resolved for Kentucky West. On September 2, 1993, Equitrans filed a new rate case to address operational and transitional cost recovery issues which were severed from its Order 636 compliance filing by the FERC. On September 30, 1993, the FERC issued an order accepting and suspending certain tariff provisions and rejecting other conditions. The major area of difference was the timing and method of recovering some $60 million of transition costs. While Equitrans continues to recover other costs in restructured rates, it has filed a request for rehearing with the FERC regarding the recovery of transition costs. CAPITAL RESOURCES AND LIQUIDITY Operating Activities Cash required for operations is impacted primarily by the seasonal nature of the Company's utility operations. Gas purchased for storage during the nonheating season is financed with short-term loans which are repaid as gas is withdrawn from storage and sold during the heating season. Short-term loans are also used to provide other working capital requirements during the nonheating season. Investing Activities The Company's business requires major ongoing expenditures for replacements, improvements and additions to utility plant and continuing development and expansion of its energy resources. Such expenditures during 1993 were $339.4 million including approximately $209 million for the purchase of LIG and Hershey Oil Corporation as described in Note L to the consolidated financial statements. A total of $151.2 million has been authorized for the 1994 capital expenditure program, including $90.5 million for energy resources. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Short-term loans are used as interim financing for a portion of capital expenditures. The Company expects to finance its 1994 capital expenditures with cash generated from operations and temporarily with short-term loans. Capital expenditures, including acquisitions, totaled about $865 million during the five- year period ended December 31, 1993, of which 45 percent was financed from operations. Financing Activities The Company believes it has adequate borrowing capacity to meet its financing requirements. Bank loans and commercial paper, supported by available credit, are used to meet short-term financing requirements. Interest rates on these short-term loans ranged from 2.94 percent to 3.78 percent during 1993. At December 31, 1993, $189.9 million of commercial paper and $64.0 million of bank loans were outstanding at an average interest rate of 3.30 percent. Lines of credit currently available to the Company total $325 million which require commitment fees averaging one-tenth of one percent. Adequate lines of credit are expected to continue to be available in the future. On September 29, 1993, the Company issued 3 million shares of common stock at a price of $38.50 per share. Net proceeds of approximately $111.6 million, after underwriters' commissions and other issuance costs, were used to repay a portion of the short- term debt incurred to purchase the stock of LIG. The Company filed a shelf-registration in March 1992 to issue $100 million of medium-term notes to be used primarily to retire short-term loans incurred to finance a portion of acquisitions made in 1991. Given the advantage of short-term interest rates during 1992 and 1993, the Company issued only $24.5 million of the medium-term notes during 1992 and an additional $32 million during 1993. It is anticipated that the remaining $43.5 million of medium-term notes will be issued in the first half of 1994. As more fully described in Note H to the consolidated financial statements, the Company has redeemed $31.6 million of long-term debt during the past two years to further reduce interest costs. These redemptions were temporarily financed with short-term debt. Accounting Developments The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109) effective January 1, 1993 and elected to restate its financial statements as of January 1, 1988. The Company also adopted SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (OPEBS) effective January 1, 1993. The effect of adoption of SFAS No. 109 and SFAS No. 106 are more fully described in Notes C and E, respectively, to the consolidated financial statements. The effect of adoption of both standards on net income was the deferral of increased expenses related to rate regulated utility operations. At December 31, 1993, regulatory assets related to deferred income taxes under SFAS No. 109 and accounting for OPEBS under SFAS No. 106 were approximately $76.4 million and $2.9 million, respectively. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Federal Income Tax Provisions In August 1993, the Omnibus Budget Reconciliation Act of 1993 (OBRA) was signed into law. One of the provisions of OBRA was to raise the maximum corporate income tax rate from 34 percent to 35 percent. The effect of this tax rate change increased deferred tax liabilities by approximately $11 million and increased regulatory assets by approximately $6 million. Cash flow has been affected by the Alternative Minimum Tax (AMT) since 1988. Despite the availability of nonconventional fuels tax credit, the Company has incurred an AMT liability in each of the years 1988 through 1993. Although AMT payments can be carried forward indefinitely and applied to income tax liabilities in future periods, they reduce cash generated from operations. At December 31, 1993, the Company has available $69.3 million of AMT credit carryforwards. The collection of revenues from direct billing settlements described in Note B to the consolidated financial statements will improve cash flow with the utilization of carryover credits. Nevertheless, the impact of AMT on cash flow will continue to depend on the future levels of energy prices. AMT is not expected to affect the Company's ability to finance future capital requirements. Under current law, wells drilled after 1992 do not qualify for the nonconventional fuels tax credit. While production from qualified Energy Resources' wells drilled in the Appalachian area will generate tax credits through the year 2002, it is anticipated that the amount of such credits will decline after 1993 as the related reserves are depleted. The credits recorded in 1993, 1992 and 1991 reduced the Company's federal income tax provisions by $20.6 million, $14.1 million and $11.0 million, respectively. Environmental Matters Management does not know of any environmental liabilities that will have a material effect on the Company's financial position or results of operations. The Company has identified situations that require remedial action for which $6.0 million is accrued at December 31, 1993. The portion of amounts expensed through 1993 that have been deferred and included in regulatory assets amounts to $3.1 million. Environmental matters are described in Note N to the consolidated financial statements. Balance Sheet Changes The increase in deferred purchased gas cost is due to the timing of pass-through of gas costs to ratepayers. Changes in deferred purchased gas cost generally do not affect results of operations due to regulatory procedures for purchased gas cost recovery in rates. Gas stored underground--current inventory increased because all inventory is valued at average cost. See Note A to the consolidated financial statements. The increases in accounts receivable, accounts payable and other current liabilities reflect mainly the consolidation of LIG and increased marketing activities. AUDIT COMMITTEE The Audit Committee, composed entirely of outside directors, meets periodically with the Company's independent auditors, its internal auditor and management to review the Company's financial statements and the results of audit activities. The Audit Committee, in turn, reports to the Board of Directors on the results of its review and recommends the selection of independent auditors. Item 8. Item 8. Financial Statements and Supplementary Data Page Reference Report of Independent Auditors 23 Statements of Consolidated Income for each of the three years in the period ended December 31, 1993 24 Consolidated Balance Sheets December 31, 1993 and 1992 25 & 26 Statements of Consolidated Cash Flows for each of the three years in the period ended December 31, 1993 27 Statements of Common Stockholders' Equity for each of the three years in the period ended December 31, 1993 28 Long-term Debt, December 31, 1993 and 1992 29 Notes to Consolidated Financial Statements 30 - 47 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Equitable Resources, Inc. We have audited the accompanying consolidated balance sheets and statements of long-term debt of Equitable Resources, Inc., and Subsidiaries at 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Equitable Resources, 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 taken as a whole, present fairly in all material respects the information set forth therein. As described in Note C and Note E to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits in 1993. s/ Ernst & Young ------------------------------- Ernst & Young Pittsburgh, Pennsylvania February 22, 1994 EQUITABLE RESOURCES, INC. AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See notes to consolidated financial statements Pages 30 to 47, inclusive EQUITABLE RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS, DECEMBER 31, 1993 AND 1992 See notes to consolidated financial statements Pages 30 to 47, inclusive EQUITABLE RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS, DECEMBER 31, 1993 AND 1992 See notes to consolidated financial statements Pages 30 to 47, inclusive EQUITABLE RESOURCES, INC. AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See notes to consolidated financial statements Pages 30 to 47, inclusive EQUITABLE RESOURCES, INC. AND SUBSIDIARIES STATEMENTS OF COMMON STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See notes to consolidated financial statements Pages 30 to 47, inclusive EQUITABLE RESOURCES, INC. AND SUBSIDIARIES LONG-TERM DEBT DECEMBER 31, 1993 AND 1992 See notes to consolidated financial statements Pages 30 to 47, inclusive A. Summary of Significant Accounting Policies (1)PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of Equitable Resources, Inc. and Subsidiaries (the "Company" or "Companies"). All subsidiaries are 100% owned. (2)PROPERTIES, DEPRECIATION AND DEPLETION: The cost of property additions, replacements and improvements capitalized includes labor, material and overhead. The cost of property retired, plus removal costs less salvage, is charged to accumulated depreciation. Depreciation for financial reporting purposes is provided on the straight-line method at composite rates based on estimated service lives, except for most gas and oil production properties as explained below. Depreciation rates are based on periodic studies. The Company uses the successful efforts method of accounting for exploration and production activities. Under this method, the cost of productive wells and development dry holes, as well as productive acreage, are capitalized and depleted on the unit- of-production method. Capitalized acquisition costs of unproved properties are periodically assessed for impairment of value, and any loss is recognized at the time of impairment. (3)ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: The Federal Energy Regulatory Commission (FERC) prescribes a formula to be used for computing overhead allowances for funds used during construction (AFC). AFC applicable to equity funds capitalized is included in other income and amounted to $1,022,000 in 1993, $1,297,000 in 1992 and $914,000 in 1991. AFC applicable to borrowed funds, as well as other interest capitalized for the nonregulated companies, is applied as a reduction of interest charges and amounted to $1,841,000 in 1993, $1,267,000 in 1992 and $1,263,000 in 1991 (4)INVENTORIES: Inventories are stated at cost which is below market. Gas stored underground--current inventory at December 31, 1993 of $18,059,000 is stated at cost under the average cost method. The December 31, 1992 balance includes $5,918,000, which is stated at cost under the last-in, first-out method (LIFO). As a result of FERC Order 636, certain gas stored underground has been transferred, at book value (LIFO), to property, plant and equipment. This gas represents cushion gas for the regulated interstate pipeline operations, a portion of which will be necessary to compensate for gas imbalances until replaced in-kind by customers. Material and supplies are stated generally at average cost. (5)INCOME TAXES: The Companies file a consolidated federal income tax return. The current provision for income taxes represents amounts paid or payable. Deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities. Where deferred tax liabilities will be passed through to customers in regulated rates, the Company establishes a corresponding regulatory asset for the increase in future revenues that will result when the temporary differences reverse. Investment tax credits realized in prior years were deferred and are being amortized over the estimated service lives of the related properties where required by ratemaking rules. A. Summary of Significant Accounting Policies (Continued) (6)DEFERRED PURCHASED GAS COST: Where permitted by regulatory authorities under purchased gas adjustment clauses or similar tariff provisions, the Companies defer the difference between purchased gas cost, less refunds, and the billing of such cost and amortize the deferral over subsequent periods in which billings either recover or repay such amounts. (7)REGULATORY ASSETS: Certain costs, which will be passed through to customers under ratemaking rules for regulated operations, are deferred by the Company as regulatory assets. The amounts deferred relate primarily to the accounting for income taxes. (8)CASH FLOWS: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. (9)RECLASSIFICATION: Certain amounts contained in prior year comparative information have been reclassified to conform with the 1993 presentation. B. Direct Billing Settlements In 1990, a subsidiary, Kentucky West Virginia Gas Company, received FERC approval of settlement agreements with all customers, except Columbia Gas Transmission Company, for the direct billing to recover the higher Natural Gas Policy Act (NGPA) prices which the FERC had denied on natural gas produced from energy resource properties between 1978 and 1983. The settlements were individually negotiated and contain differing terms providing for the collection of $100.3 million over periods ranging from four to ten years. The recovery of $85 million of the $89 million settlement with the Equitable Gas division was subject to Pennsylvania Public Utility Commission (PUC) review as described below. The agreements that were fully approved were recorded at present value using a discount rate of 9%. In 1991, the Equitable Gas division received PUC approval to recover $25 million of increased gas costs relating to the FERC settlement, including $4.9 million of additional carrying charges. The PUC also approved the recovery of $7.8 million relating to the settlement in each of the years 1993 and 1992. The amounts approved increased net income reported for the third quarter of 1993 and 1992 by $4.7 million and $14.9 million for the third quarter of 1991. Approximately $49 million from the settlement remains to be recovered in future gas cost filings with the PUC over the next seven years. A final settlement proposal negotiated with Columbia for the recovery of $19 million was approved by the FERC in February 1993. The settlement agreement has been accepted in Columbia's bankruptcy proceeding. However, in view of Columbia's pending reorganization under Chapter 11 of the Bankruptcy Code, the amount of recovery from Columbia remains uncertain and therefore has not been recognized. C. Income Taxes The Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109) effective January 1, 1993 and elected to restate prior period financial statements for the effect of the change. As of January 1, 1988, retained earnings was reduced by approximately $12 million; periodic net income since that date was not restated because the effect of the change in accounting on all periods reported was not material. Application of the new rules increased deferred income tax liabilities at January 1, 1992 by approximately $77 million and created regulatory assets of approximately $65 million. The sources and tax effects of the temporary differences are as follows: December 31, 1993 1992 (Thousands) Deferred tax liabilities (assets): Exploration and development costs expensed for income tax reporting $138,089 $124,254 Tax depreciation in excess of book depreciation . . . . . . 250,032 141,183 Regulatory temporary differences 36,841 28,710 Deferred purchased gas cost . . . 8,413 2,423 Alternative minimum tax . . . . . (69,333) (48,920) Investment tax credit . . . . . . (10,340) (10,121) Other . . . . . . . . . . . . . . (21,829) 4,958 Total (including amounts classified as current liabilities of $733 for 1993 and $182 for 1992) . $331,873 $242,487 As of December 31, 1993 and 1992, $76.4 million and $68.4 million, respectively, of the net deferred tax liabilities are related to rate regulated operations and have been deferred as regulatory assets. Income tax expense is summarized as follows: Years Ended December 31, 1993 1992 1991 (Thousands) Current: Federal . . . . . . . . $15,577 $13,540 $11,770 State . . . . . . . . . 3,687 7,245 4,192 Deferred: Federal . . . . . . . . (2,758) (4,547) 1,254 State . . . . . . . . . 3,514 2,532 2,720 Total . . . . . . . . $20,020 $18,770 $19,936 C. Income Taxes (Continued) Provisions for income taxes are less than amounts computed at the federal statutory rate of 35% for 1993 and 34% for 1992 and 1991 on pretax income. The reasons for the difference are summarized as follows: Years Ended December 31, 1993 1992 1991 (Thousands) Tax at statutory rate . $ 32,716 $ 26,791 $28,595 State income taxes . . . 4,332 6,453 4,562 Increase in federal income tax rate . . . . 5,070 - - Nonconventional fuels tax credit . . . . . . . . (20,600) (14,051) (10,998) Other . . . . . . . . . (1,498) (423) (2,223) Income tax expense . . $ 20,020 $ 18,770 $ 19,936 Effective tax rate . . . 21.4% 23.8% 23.7% In August 1993, the Omnibus Budget Reconciliation Act of 1993 (Act) was signed into law. One of the provisions of the Act was to raise the maximum corporate income tax rate from 34% to 35%. The effect of this tax rate change increased deferred tax liabilities by approximately $11 million and increased regulatory assets by approximately $6 million. The consolidated federal income tax liability of the Companies has been settled through 1990. The Company has available $69.3 million of alternative minimum tax credit carryforward which has no expiration date. In addition, the Company has net operating loss carryforwards for federal income tax purposes of $13.8 million which begin to expire in 2006. The net operating loss carryforwards are the result of the acquisition of Louisiana Intrastate Gas Company as described in Note L. Amortization of deferred investment tax credits amounted to $1,373,000 for 1993, $1,138,000 for 1992 and $850,000 for 1991. D. Employee Pension Benefits The Companies have several trusteed retirement plans covering substantially all employees. The Companies' annual contributions to the plans are based on a 25-year funding level. Plans covering union members generally provide benefits of stated amounts for each year of service. Plans covering salaried employees use a benefit formula which is based upon employee compensation and years of service to determine benefits to be provided. Plan assets consist principally of equity and debt securities. D. Employee Pension Benefits (Continued) The following table sets forth the plans' funded status and amounts recognized in the Company's consolidated balance sheets: December 31, 1993 1992 (Thousands) Actuarial present value of benefit obligations: Vested benefit obligation $132,402 $112,372 Accumulated benefit obligation $135,809 $115,192 Market value of plan assets $159,433 $149,351 Projected benefit obligation 148,265 124,100 Excess of plan assets over projected benefit obligation 11,168 25,251 Unrecognized net asset (3,237) (3,664) Unrecognized net gain (16,732) (27,305) Unrecognized prior service cost 10,403 8,246 Prepaid pension cost recognized in the consolidated balance sheets $ 1,602 $ 2,528 At year-end the discount rate used in determining the actuarial present value of benefit obligations was 7 1/4% for 1993, 8 1/4% for 1992 and 8 1/2% for 1991. The assumed rate of increase in compensation levels was 4 1/2% for 1993 and 5% for 1992 and 1991. The Companies' pension cost, using a 9% average rate of return on plan assets at the beginning of 1993 and 1992 and 8 1/2% for 1991, comprised the following: Years Ended December 31, 1993 1992 1991 (Thousands) Service cost benefits earned during the period $ 2,806 $ 2,345 $ 2,726 Interest cost on projected benefit obligation 10,472 9,917 10,305 Actual return on assets (17,224) (18,214) (27,681) Net amortization and deferral 5,486 7,069 16,946 Net periodic pension cost $ 1,540 $ 1,117 $ 2,296 E. Other Postretirement Benefits In addition to providing pension benefits, the Companies provide certain health care and life insurance benefits for retired employees and their dependents. Substantially all employees are eligible for these benefits upon retirement from the Companies. E. Other Postretirement Benefits (Continued) SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (OPEBS) requires, among other things, the accrual of retirement health care and life insurance benefits during the years an employee provides services. The new standard requires that the accumulated plan benefit obligation existing at the date of adoption (transition obligation) either be recognized immediately or deferred and amortized over future periods. Historically, the Company recognized the cost of retiree health care and life insurance benefits as paid and has retained the right to modify or discontinue these benefits at any time. However, the Company was required to adopt the new standard effective January 1, 1993 and will amortize the resulting transition obligation over 20 years. In determining the accumulated postretirement benefit obligation at January 1, 1993, the Company used an inflation factor for medical costs beginning at 13% per year, which decreases gradually thereafter to 6% within 15 years and a discount rate of 8 1/4%. At December 31, 1993, the beginning inflation factor was 11% decreasing gradually to 4 3/4% within 17 years and the discount rate was 7 1/4%. The following summarizes the status of the Company's accrued OPEBS: December 31, January 1, 1993 1993 (Thousands) Accumulated postretirement benefit obligation: Retired employees $ 23,078 $ 24,971 Active employees: 8,942 7,361 Fully eligible Other 16,741 13,780 Total obligation 48,761 46,112 Unrecognized net gain 40 -0- Unrecognized transition obligation (43,806) (46,112) Accrued postretirement benefit cost $ 4,995 $ -0- The net periodic cost for postretirement health care and life insurance benefits for 1993 includes the following: (Thousands) Service cost . . . . . . . . . . . . . . . . . $1,065 Interest cost . . . . . . . . . . . . . . . . 3,936 Amortization of transition obligation . . . . 2,306 Periodic cost . . . . . . . . . . . . . . . . $7,307 E. Other Postretirement Benefits (Continued) As of December 31, 1993, $2.9 million of the accrued OPEBS related to rate regulated operations have been deferred as regulatory assets. Rate filings will be made to seek full recovery of the costs accrued under SFAS No. 106 over periods of up to 20 years. An increase of one percent in the assumed medical cost inflation rate would increase the accumulated postretirement benefit obligation by 8% and would increase the periodic cost by 10%. The Company paid current claims for OPEBS of $3,421,000 in 1993. The cost of OPEBS for 1992 and 1991 was recognized as paid and amounted to $2,919,000 and $3,537,000, respectively. F. Common Stock (1) Common Stock Issuance On September 29, 1993, the Company issued 3 million shares of common stock at a price of $38.50 per share. Net proceeds after underwriters' commissions and other issuance costs were approximately $111.6 million. The proceeds were used to repay a portion of the short-term debt incurred to purchase the stock of Louisiana Intrastate Gas Company as described in Note L. (2) Restricted Stock Options and Awards The Equitable Resources, Inc., Key Employee Restricted Stock Option and Stock Appreciation Rights Incentive Compensation Plan is nonqualified and provides for the granting of restricted stock awards or options to purchase common stock of the Company at prices ranging from 75% to 100% of market value on the date of grant. Stock options may be granted with or without stock appreciation units. Options expire five years from the date of grant. Stock awarded under the Plan or purchased through the exercise of options, and the value of certain stock appreciation units, are restricted and subject to risk of forfeiture should an optionee terminate employment prior to specified vesting dates. In 1991, restricted stock awards of 41,625 shares were made to key employees. The Company used treasury shares repurchased from plan participants for these awards. F. Common Stock (Continued) The following schedule summarizes the stock option activity: Years Ended December 31, 1993 1992 1991 Options outstanding January 1 139,725 228,787 286,820 Granted 148,543 - 99,000 Exercised (33,325) (89,062) (152,158) Canceled, forfeited, surrendered or expired (1,875) - (4,875) Options outstanding December 31 253,068 139,725 228,787 Average price of options $18.97 $17.07 $15.14 At December 31: Prices of options outstanding $17.50 $15.20 $15.20 to to to $36.50 $20.13 $21.59 Average option price $29.69 $19.76 $18.71 Shares reserved for issuance 671,349 705,209 794,558 (3)Dividend Reinvestment and Stock Purchase Plan Pursuant to this plan, stockholders can reinvest dividends and make limited additional investments in shares of common stock. Shares issued through the plan have been acquired on the open market. Beginning in 1994, shares issued through the plan may continue to be acquired on the open market or by issuance of previously unissued shares. At December 31, 1993, 241,314 shares of common stock were reserved for issuance under the plan. G. Short-Term Loans Maximum lines of credit available to the Company were $360,000,000 during 1993, $140,000,000 during 1992 and $180,000,000 during 1991. The Company is not required to maintain compensating bank balances. Commitment fees averaging one-tenth of one percent are paid to maintain credit availability. G. Short-Term Loans (Continued) At December 31, 1993, short-term loans consisted of $189,900,000 of commercial paper and $64,000,000 of bank loans; and at December 31, 1992, $79,000,000 and $35,000,000, respectively. The maximum amounts of outstanding short-term loans were $339,000,000 in 1993, $130,500,000 in 1992 and $153,000,000 in 1991. The average daily total of short-term loans outstanding was approximately $174,900,000 during 1993, $107,389,000 during 1992 and $61,535,000 during 1991; weighted average annual interest rates applicable thereto were 3.3% in 1993, 3.8% in 1992 and 5.9% in 1991. H. Long-Term Debt The Company filed a shelf registration in March 1992 to issue $100 million of Medium-Term Notes--Series B to be used primarily to retire short-term loans incurred to temporarily finance a portion of 1991 acquisitions. Through December 31, 1993, the Company issued $56.5 million of Medium-Term Notes. These notes have maturity dates ranging from three to thirty years and a weighted average interest rate of 6.30%. Considering the advantage of lower short-term interest rates, the Company has delayed issuance of the remaining notes. On March 31, 1993, the Company redeemed $16.4 million of First Mortgage Bonds, 8% series due June 15, 1997. The bonds were redeemed at 101.05 percent of the principal amount thereof, plus accrued interest through the date of redemption. On August 3, 1992, the Company redeemed $8.6 million of 9% Debentures due June 15, 1996. The debentures were redeemed at 100.79 percent of the principal amount thereof, plus accrued interest through the date of redemption. On March 2, 1992, the Company redeemed $6.6 million of First Mortgage Bonds, 6 1/4% series due September 1, 1992. The 9 1/2% Convertible Subordinated Debentures are convertible at any time into common stock at a conversion price of $11.06 per share. During 1993, 1992 and 1991, $564,000, $259,000 and $1,084,000 of these debentures were converted into 50,983, 23,399 and 97,983 shares of common stock, respectively. At December 31, 1993, 240,918 shares of common stock were reserved for conversions. Interest expense on long-term debt amounted to $33,161,000 in 1993, $31,899,000 in 1992 and $25,318,000 in 1991. Aggregate maturities of long-term debt will be $1,971,000 in 1994, $24,500,000 in 1995, $75,000,000 in 1996, none in 1997 and $5,000,000 in 1998. I. Fair Value of Financial Instruments The carrying value of cash and cash equivalents as well as short- term loans approximates fair value due to the short maturity of the instruments. I. Fair Value of Financial Instruments (Continued) The estimated fair value of long-term debt, including the portion due within one year, at December 31, 1993 and 1992 would be $433,048,000 and $388,642,000, respectively. The fair value was estimated based on the quoted market prices as well as the discounted values using a current discount rate reflective of the remaining maturity. The Company's 8 1/4% Debentures and 7 1/2% Debentures may not be redeemed prior to maturity. The 9.9% Debentures require payment of premiums for early redemption, exclusive of annual sinking fund requirements. J. Concentrations of Credit Risk Energy resources operating revenues and related accounts receivable are generated primarily from gas marketing activities, the sale of produced natural gas, natural gas liquids and oil and intrastate transportation of gas. The gas marketing activities are nationwide to large volume customers for resale or end use. Produced natural gas is sold primarily to utility and industrial customers located mainly in the Appalachian area. Produced natural gas liquids are sold to refinery customers in Louisiana and Kentucky. Produced oil is sold to refinery customers in the Rocky Mountain and Appalachian areas. The intrastate gas transportation is concentrated in Louisiana. Utility services operating revenues and related accounts receivable are generated through regulated interstate pipeline and natural gas utility sales, transportation and storage services. Interstate natural gas sales, transportation and storage services are to the affiliated utility, Equitable Gas, as well as other utility and end-user customers located in nine mid-Atlantic and northeastern states. Utility sales and transportation services are provided to more than 265,000 residential, commercial and industrial customers located in southwest Pennsylvania and parts of West Virginia and Kentucky. Under state regulations, the utility is required to provide continuous gas service to residential customers during the winter heating season. In this regard, the Company continually reviews the credit worthiness of customers and, when necessary, requests deposits to secure future service. The Company is not aware of any significant credit risks which have not been recognized in provisions for doubtful accounts. K. Financial Information by Business Segment The Company reports its operations in two business segments energy resources and utility services. Energy resource activities comprise exploration, development, production, gathering and marketing of natural gas and oil, intrastate transportation of natural gas, extraction and sale of natural gas liquids and contract drilling. Utility service activities comprise primarily a natural gas utility and three regulated gas pipelines. K. Financial Information by Business Segment (Continued) The following table sets forth financial information for each of the two business segments: Years Ended December 31, 1993 1992 1991 (Thousands) Operating Revenues: Energy Resources $ 743,064 $ 461,642 $ 367,297 Utility Services 397,297 393,628 381,655 Sales between segments (45,567) (42,896) (69,321) Total $1,094,794 $ 812,374 $ 679,631 Operating Income: Energy Resources $ 54,153 $ 41,198 $ 46,605 Utility Services 76,344 73,228 69,972 Total $ 130,497 $ 114,426 $ 116,577 Net Income: Energy Resources $ 38,000 $ 29,502 $ 31,929 Utility Services 35,455 30,524 32,239 Total $ 73,455 $ 60,026 $ 64,168 Identifiable Assets (a): Energy Resources $1,085,407 $ 696,801 $ 695,907 Utility Services 906,920 822,064 801,209 Eliminations (45,420) (50,441) (56,523) Total $1,946,907 $1,468,424 $1,440,593 Depreciation and Depletion: Energy Resources $ 53,423 $ 45,638 $ 36,002 Utility Services 23,471 20,302 18,591 Total $ 76,894 $ 65,940 $ 54,593 Capital Expenditures: Energy Resources (including acquisitions) $ 296,245 $ 52,923 $ 189,472 Utility Services 43,166 46,666 45,717 Total $ 339,411 $ 99,589 $ 235,189 (a) Amounts for 1992 and 1991 have been restated for the effect of adoption of SFAS No. 109 as described in Note C. L. Acquisitions On June 30, 1993, the Company purchased the outstanding common stock of Louisiana Intrastate Gas Company (LIG) for $191 million. LIG owns a 1,900 mile intrastate pipeline system in Louisiana, four natural gas processing plants and is also engaged in gas marketing. The purchase was funded initially with short-term debt, a portion of which was repaid with the proceeds from the issuance of common stock as described in Note F to the consolidated financial statements. Under terms of the purchase agreement, the seller, and/or the previous owner of LIG, have indemnified the Company against losses resulting from claims of liability under gas purchase contracts and substantially all environmental liabilities attributable to operation of LIG prior to June 30, 1993. On July 8, 1993, the Company purchased all of the outstanding stock of Hershey Oil Corporation (Hershey) for approximately $18 million. Hershey's assets consist primarily of approximately 68 billion cubic feet of proved natural gas reserves and 17,000 net undeveloped acres in Alberta, Canada. The acquisitions were accounted for under the purchase method and are included in the energy resource segment. Had the purchases occurred as of the beginning of 1993 and 1992, unaudited proforma consolidated results for the Company would have been: revenues of $1.119 billion and $872 million; net income of $74.0 million and $68.6 million; and earnings per share of $2.29 and $2.19 for the years ended December 31, 1993 and 1992, respectively. M. Purchase of Properties On September 30, 1991, the Company purchased oil and gas properties in the Rocky Mountain area for approximately $64 million. The purchase, which was effective July 1, 1991, includes interests in approximately 400 wells and 438,000 net acres situated primarily in Wyoming, Montana, North Dakota and Utah. On November 25, 1991, the Company purchased gas properties and drilling programs in the Appalachian Basin for approximately $75 million. The purchase, which was effective September 1, 1991, includes properties located in western Virginia consisting of approximately 200 producing wells, 218,000 net acres and 205 miles of gathering and transmission lines which are connected to a major interstate pipeline. In both cases, the entire purchase price was attributed to the properties. N. Commitments and Contingencies Rent expense was $9,834,000 in 1993, $9,333,000 in 1992 and $8,353,000 in 1991. Long-term leases are principally for division operating headquarters and warehouse buildings and computer hardware and have renewal options ranging to 20 years from December 31, 1993. Future minimum rentals for all noncancelable long-term leases at December 31, 1993 are as follows: 1994, $5,448,000; 1995, $4,605,000; 1996, $3,622,000; 1997, $3,137,000; 1998, $2,803,000 and $15,424,000 thereafter for a total of $35,039,000. Utility Services has annual commitments of approximately $43 million for demand charges under existing long-term contracts with pipeline suppliers for periods extending up to 9 years at December 31, 1993. However, substantially all of these costs are recoverable in customer rates. The Company is subject to federal, state and local environmental laws and regulations. These laws and regulations, which are constantly changing, can require expenditures for remediation and may in certain instances result in assessment of fines. The Company has established procedures for on-going evaluation of its operations to identify potential environmental exposures and assure compliance with regulatory policies and procedures. On-going expenditures for compliance with environmental laws and regulations, including investments in plant and facilities to meet environmental requirements, have not been material. Management believes that any such required expenditures will not be significantly different in either their nature or amount in the future. The estimated costs associated with identified situations that require remedial action are accrued. However, certain of these costs are deferred when recoverable by claims against third parties or through regulated rates. Management does not know of any environmental liabilities that will have a material effect on the Company's financial position or results of operations. As described in Note B, the Company has a claim in Columbia Gas Transmission Company's bankruptcy proceeding related to the direct billing settlements. In addition, the Company has various claims against Columbia for abrogation of contracts to purchase gas from the Company. The amount that may be realized, if any, under the claims cannot be estimated in view of Columbia's bankruptcy proceeding. O. Interim Financial Information (Unaudited) The following quarterly summary of operating results reflects variations due primarily to the seasonal nature of the Company's business and the activities of new subsidiaries from the date of acquisition as described in Note L. March June September December 31 30 30 31 (Thousands except per share amounts) Operating revenues $269,819 $207,782 $272,745 $344,448 Operating income 55,349 13,978 24,787 36,383 Net income 30,795 8,831 8,612 25,217 Earnings per share $.98 $.28 $.27 $.73 Operating revenues $245,208 $161,352 $144,429 $261,385 Operating income 50,351 8,678 14,358 41,039 Net income 26,105 3,626 7,161 23,134 Earnings per share $.83 $.12 $.23 $.74 P. Natural Gas and Oil Producing Activities The supplementary information summarized below presents the results of natural gas and oil activities for the Energy Resource segment in accordance with SFAS No. 69, "Disclosures About Oil and Gas Producing Activities." The information presented excludes data associated with natural gas reserves related to rate regulated operations. These reserves (proved developed) are less than 5% of total Company proved reserves for the years presented. P. Natural Gas and Oil Producing Activities (Continued) (1)Production Costs The following table presents the costs incurred relating to natural gas and oil production activities: 1993 1992 1991 (Thousands) At December 31: Capitalized costs . . . $836,638 $748,325 $718,140 Accumulated depreciation and depletion . . . . 256,508 216,005 187,321 Net capitalized costs . $580,130 $532,320 $530,819 Costs incurred : Property acquisition: Proved properties . . $29,345 $ 663 $119,308 Unproved properties . - - 20,806 Exploration . . . . . . 13,928 13,166 22,924 Development . . . . . . 62,336 46,321 37,498 (2) Results of Operations for Producing Activities The following table presents the results of operations related to natural gas and oil production: 1993 1992 1991 (Thousands) Revenues: Affiliated . . . . . . $ 15,467 $ 8,964 $ 16,407 Nonaffiliated . . . . 140,380 127,369 94,165 Production costs . . . . 33,620 30,385 25,971 Exploration expenses . . 13,559 16,439 17,144 Depreciation and depletion 43,841 40,744 31,863 Income tax expense . . . 5,039 5,221 2,748 Results of operations from producing activities (excluding corporate overhead) . . . . . . . $ 59,788 $ 43,544 $ 32,846 P. Natural Gas and Oil Producing Activities (Continued) (3) Reserve Information (Unaudited) The information presented below represents estimates of proved gas and oil reserves prepared by Company engineers. Proved developed reserves represent only those reserves expected to be recovered from existing wells and support equipment. Proved undeveloped reserves represent proved reserves expected to be recovered from new wells after substantial development costs are incurred. Substantially all reserves are located in the United States. Natural Gas 1993 1992 1991 (Millions of Cubic Feet) Proved developed and undeveloped reserves: Beginning of year 720,032 695,898 620,755 Revision of previous estimates 9,399 25,736 (2,959) Purchase of natural gas in place - net 86,113(a) 434 89,925 Extensions, discoveries and other additions Production (53,550) (48,243) (40,022) End of year 822,583(b) 720,032 695,898 Proved developed reserves: Beginning of year 665,194 621,846 528,573 End of year 759,282(c) 665,194 621,846 (a) Includes 68,000 MMcf purchased in Canada. (b) Includes 70,000 MMcf proved reserves in Canada. (c) Includes 46,000 MMcf proved developed reserves in Canada. P. Natural Gas and Oil Producing Activities (Continued) Oil 1993 1992 1991 (Thousands of Barrels) Proved developed and undeveloped reserves: Beginning of year 20,023 19,427 12,253 Revision of previous estimates (4,876) 951 (309) Purchase (sale) of oil in place - net 418(a) (138) 7,907 Extensions, discoveries and other additions 3,015 2,189 1,582 Production (2,112) (2,406) (2,006) End of year 16,468(b) 20,023 19,427 Proved developed reserves: Beginning of year 18,540 17,072 11,166 End of year 16,442(c) 18,540 17,072 (a) Includes 68,000 barrels purchased in Canada. (b) Includes 65,000 barrels proved reserves in Canada. (c) Includes 39,000 barrels proved developed reserves in Canada. (4) Standard Measure of Discounted Future Cash Flows (Unaudited) Management cautions that the standard measure of discounted future cash flows should not be viewed as an indication of the fair market value of gas and oil producing properties, nor of the future cash flows expected to be generated therefrom. The information presented does not give recognition to future changes in estimated reserves, selling prices or costs and has been discounted at an arbitrary rate of 10%. Estimated future net cash flows from natural gas and oil reserves based on selling prices and costs at year-end price levels are as follows: 1993 1992 1991 (Thousands) Future cash inflows $2,140,151 $2,058,973 $1,835,380 Future production costs (598,707) (551,987) (462,367) Future development costs (24,579) (41,612) (63,243) Future income tax expenses (434,362) (409,970) (351,087) Future net cash flow 1,082,503 1,055,404 958,683 10% annual discount for estimated timing of cash flows (515,023) (507,082) (456,624) Standardized measure of discounted future net cash flows $ 567,480(a) $ 548,322 $ 502,059 (a) Includes $31,267,000 in Canada. Summary of changes in the standardized measure of discounted future net cash flows: 1993 1992 1991 (Thousands) Sales and transfers of gas and oil produced - net $ (122,227) $ (105,948) $ (84,601) Net changes in prices, production and development costs (80,256) 11,370 (141,414) Extensions, discoveries, and improved recovery, less related costs 90,035 77,759 43,188 Development costs incurred 18,482 27,807 25,588 Purchase (sale) of minerals in place - net 62,843 (142) 120,533 Revisions of previous quantity estimates (14,910) 1,709 (4,440) Accretion of discount 69,284 62,548 64,829 Net change in income taxes (8,584) (21,093) 49,691 Other 4,491 (7,747) (9,150) Net increase 19,158 46,263 64,224 Beginning of year 548,322 502,059 437,835 End of year $ 567,480 $ 548,322 $ 502,059 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 Item 10 with respect to directors is incorporated herein by reference to the section describing "Election of Directors" in the Company's definitive proxy statement relating to the annual meeting of stockholders to be held on May 27, 1994, which will be filed with the Commission within 120 days after the close of the Company's fiscal year ended December 31, 1993. Information required by Item 10 with respect to executive officers is included herein after Item 4 at the end of Part I. Item 11. Item 11. Executive Compensation Information required by Item 11 is incorporated herein by reference to the section describing "Executive Compensation", "Employment Contracts and Change-In-Control Arrangements" and "Pension Plan" in the Company's definitive proxy statement relating to the annual meeting of stockholders to be held on May 27, 1994. Item 12. Item 12.Security Ownership of Certain Beneficial Owners and Management Information required by Item 12 is incorporated herein by reference to the section describing "Voting Securities and Record Date" in the Company's definitive proxy statement relating to the annual meeting of stockholders to be held on May 27, 1994. 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 listed in the accompanying index to financial statements and financial statement schedules (page 51) are filed as part of this annual report. 2. Financial statement schedules The financial statement schedules listed in the accompanying index to financial statements and financial statement schedules (page 51) are filed as part of this annual report. 3. Exhibits The exhibits listed on the accompanying index to exhibits (pages 62 through 65) are filed as part of this annual report. (b) Reports on Form 8-K filed during the quarter ended December 31, 1993. None (c) Each management contract and compensatory arrangement in which any director or any named executive officer participates has been marked with an asterisk (*) in the Index to Exhibits. EQUITABLE RESOURCES, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14 (a)) 1. The following consolidated financial statements of Equitable Resources, Inc. and Subsidiaries are included in Item 8: Page Reference Statements of Consolidated Income for each of the three years in the period ended December 31, 1993 24 Consolidated Balance Sheets December 31, 1993 and 1992 25 & 26 Statements of Consolidated Cash Flows for each of the three years in the period ended December 31, 1993 27 Statements of Common Stockholders' Equity for each of the three years in the period ended December 31, 1993 28 Long-term Debt, December 31, 1993 and 1992 29 Notes to Consolidated Financial Statements 30 thru 47 2. Schedules for the Years Ended December 31, 1993, 1992 and 1991 included in Part IV: V - Property, Plant and Equipment 52, 53 & 54 VI - Accumulated Depreciation, Depletion and Amortization 55, 56, 57, 58 of Property, Plant and Equipment & 59 VIII- Valuation and Qualifying Accounts and Reserves 60 X - Supplementary Income Statement Information 61 Schedules I, II, III, IV, VII, XI, XII, XIII and XIV are omitted since the subject matter thereof is either not present or is not present in amounts sufficient to require submission of the schedules as permitted by Regulation S-X. The information called for in Schedule IX is set forth in the consolidated balance sheet and notes to consolidated financial statements. EQUITABLE RESOURCES, INC. NOTES TO SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands) A. Includes $1,859 depreciation of automotive equipment charged to transportation clearing account and then distributed principally to various operating expenses and construction accounts. B. Net change in retirement work in progress. C. Retirements shown in Schedule V, Property, Plant and Equipment are reconciled with the amounts shown in Column D of this schedule as deductions from accumulated retirement reserves, as follows: Retirements or sales as shown in Schedule V $18,736 Add - Cost of removal 798 $19,534 Deduct: Salvage 1,276 Retirements not charged to reserve 5,235 Retirements, renewals and replacements as shown in Column D of this schedule $13,023 (Thousands) A. Includes $2,022 depreciation of automotive equipment charged to transportation clearing account and then distributed principally to various operating expenses and construction accounts. B. Net change in retirement work in progress. C. Retirements shown in Schedule V, Property, Plant and Equipment are reconciled with the amounts shown in Column D of this schedule as deductions from accumulated retirement reserves, as follows: Retirements or sales as shown in Schedule V $34,297 Add - Cost of removal 243 $34,540 Deduct: Salvage 2,311 Retirements not charged to reserve 10,291 Retirements, renewals and replacements as shown in Column D of this schedule $21,938 EQUITABLE RESOURCES, INC. AND SUBSIDIARIES NOTES TO SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands) A. Includes $1,791 depreciation of automotive equipment charged to transportation clearing account and then distributed principally to various operating expenses and construction accounts. B. Net change in retirement work in progress. C. Retirements shown in Schedule V, Property, Plant and Equipment are reconciled with the amounts shown in Column D of this schedule as deductions from accumulated retirement reserves, as follows: Retirements or sales as shown in Schedule V $13,162 Add - Cost of removal 726 $13,888 Deduct: Salvage 914 Retirements not charged to reserve 938 Retirements, renewals and replacements as shown in Column D of this schedule $12,036 EQUITABLE RESOURCES, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 Column A Column B Column C Column D Column E Balance At Additions Charged Balance Beginning To Costs At End Description Of Period and Expenses Deductions Of Period (Thousands) Accumulated Provision for Doubtful Accounts $9,503 $9,352 $8,749(A) $10,106 Accumulated Provision for Doubtful Accounts $8,722 $8,998 $8,217(A) $9,503 Accumulated Provision for Doubtful Accounts $7,531 $8,534 $7,343(A) $8,722 Note: (A) Customer accounts written off, less recoveries. EQUITABLE RESOURCES, INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 Column A Column B Charged to Item Costs and Expenses 1993 1992 1991 (Thousands) 1. Maintenance and repairs $29,024 $26,327 $24,441 2. Depreciation and amortization of intangible assets (Note A) (Note A) (Note A) 3. Taxes other than payroll and income taxes: Pennsylvania gross receipts $14,837 $12,233 $13,268 State severance taxes 8,970 8,581 6,853 Other 10,707 10,978 9,225 Total $34,514 $31,792 $29,346 4. Royalties (Note B) $14,978 $15,736 $13,780 5. Advertising costs (Note A) (Note A) (Note A) Notes: (A) Not material in amount. (B) Substantially all royalties are reflected as a reduction of gas and oil revenues in the financial statements. EXHIBITS DESCRIPTION METHOD OF FILING 2.01 (a) Stock Purchase Agreement Filed as Exhibit 2.1 (a) dated May 5, 1993 among to Form 8-K Dated June 30, Arkla, Inc., Arkla Finance 1993 Corporation and Equitable Pipeline Company for the purchase of Louisiana Intrastate Gas Company 2.01 (b) Schedule 4.1.11 to the Filed as Exhibit 2.1 (b) Stock Purchase Agreement to Form 8-K Dated June 30, pertaining to outstanding 1993 litigation claims 2.01 (c) Schedule 4.1.15 to the Filed as Exhibit 2.1 (c) Stock Purchase Agreement to Form 8-K Dated June 30, pertaining to environmental 1993 matters 2.01 (d) Letter Agreement Dated June Filed as Exhibit 2.1 (d) 30, 1993 amending the Stock to Form 8-K Dated June 30, Purchase Agreement 1993 3.01 Restated Articles of Filed herewith at page 68 Incorporation of the Company dated May 21, 1993 (effective May 27, 1993) 3.02 By-Laws of the Company Filed herewith at page 77 (amended through December 17, 1993 4.01 (a) Indenture dated as of April Filed as Exhibit 4.01 1, 1983 between the Company (Revised) to Post- and Pittsburgh National Effective Amendment No. 1 Bank relating to Debt to Registration Statement Securities (Registration No. 2-80575) 4.01 (b) Instrument appointing Refiled herewith at page Bankers Trust Company as 96 pursuant to Rule 24 of successor trustee to SEC's Rules of Practice Pittsburgh National Bank 4.01 (c) Resolution adopted June 26, Refiled herewith at page 1986 by the Finance 106 pursuant to Rule 24 of Committee of the Board of SEC's Rules of Practice Directors of the Company establishing the term of the $75,000,000 of debentures, 8 1/4% Series due July 1, 1996 4.01 (d) Resolutions adopted June Refiled herewith at page 22, 1987 by the Finance 109 pursuant to Rule 24 of Committee of the Board of SEC's Rules of Practice Directors of the Company establishing the terms of the 75,000 units (debentures with warrants) issued July 1, 1987 4.01 (e) Resolution adopted April 6, Refiled herewith at page 1988 by the Ad Hoc Finance 118 pursuant to Rule 24 of Committee of the Board of SEC's Rules of Practice Directors of the Company establishing the terms and provisions of the 9.9% Debentures issued April 14, 4.01 (f) Supplemental indenture Filed as Exhibit 4.3 to dated March 15, 1991 with Form S-3 (Registration Bankers Trust Company Statement 33-39505) filed eliminating limitations on August 21, 1991 liens and additional funded debt 4.01 (g) Resolution adopted August Filed as Exhibit 4.05 to 19, 1991 by the Ad Hoc Form 10-K for the year Finance Committee of the ended December 31, 1991 Board of Directors of the Company Addenda Nos. 1 thru 27, establishing the terms and provisions of the Series A Medium-Term Notes EXHIBITS DESCRIPTION METHOD OF FILING 4.01 (h) Resolutions adopted July 6, Filed as Exhibit 4.05 to 1992 and February 19, 1993 Form 10-K for the year by the Ad Hoc Finance ended December 31, 1992 Committee of the Board of Directors of the Company and Addenda Nos. 1 thru 8, establishing the terms and provisions of the Series B Medium-Term Notes *10.01 Equitable Resources, Inc. Filed as Exhibit 10.07 to Key Employee Restricted Form 10-K for the year Stock Option and Stock ended December 31, 1989 Appreciation Rights Incentive Compensation Plan (as amended through March 17, 1989) *10.02(a) Employment Agreement dated Refiled herewith at page as of March 18, 1988 with 126 pursuant to Rule 24 of Frederick H. Abrew SEC's Rules of Practice *10.02(b) Amendment effective June 1, Refiled herewith at page 1989 to Employment 153 pursuant to Rule 24 of Agreement with Frederick H. SEC's Rules of Practice Abrew *10.03(a) Employment Agreement dated Refiled herewith at page as of March 18, 1988 with 154 pursuant to Rule 24 of Augustine A. Mazzei, Jr. SEC's Rules of Practice *10.03(b) Amendment effective June 1, Refiled herewith at page 1989 to Employment 181 pursuant to Rule 24 of Agreement with Augustine A. SEC's Rules of Practice Mazzei, Jr. *10.04(a) Agreement dated December Filed as Exhibit 10.16 to 15, 1989 with Barbara B. Form 10-K for the year Sullivan for deferred ended December 31, 1989 payment of 1990 director fees *10.04(b) Agreement dated December Filed as Exhibit 10.16 to 21, 1990 with Barbara B. Form 10-K for the year Sullivan for deferred ended December 31, 1990 payment of 1991 director fees *10.04(c) Agreement dated December Filed as Exhibit 10.16 to 13, 1991 with Barbara B. Form 10-K for the year Sullivan for deferred ended December 31, 1991 payment of 1992 director fees *10.04(d) Agreement dated December Filed herewith at page 182 28, 1993 with Barbara B. Sullivan for deferred payment of 1994 director fees * 10.05 Supplemental Executive Filed herewith at page 187 Retirement Plan (as amended and restated through December 17, 1993) *10.06 Retirement Program for the Filed as Exhibit 10.19 to Board of Directors of Form 10-K for the year Equitable Resources, Inc. ended December 31, 1989 (as amended through August 1, 1989) *10.07 Supplemental Pension Plan Filed herewith at page 197 (as amended and restated through December 17, 1993) *10.08 Policy to Grant Filed as Exhibit 10.21 to Supplemental Deferred Form 10-K for the year Compensation Benefits in ended December 31, 1989 Selected Instances to a Select Group of Management or Highly Compensated Employees (as amended and restated through August 1, 1989) EXHIBITS DESCRIPTION METHOD OF FILING *10.09(a) Equitable Resources, Inc. Filed as Exhibit 10.22 to and Subsidiaries Short-Term Form 10-K for the year Incentive Compensation Plan ended December 31, 1987 dated January 18, 1988 *10.09(b) Amendment dated February Filed as Exhibit 10.22 to 17, 1993 to Equitable Form 10-K for the year Resources, Inc. and ended December 31, 1992 Subsidiaries Short-Term Incentive Compensation Plan *10.10(a) Agreement dated December Refiled herewith at page 31, 1987 with Malcolm M. 206 pursuant to Rule 24 of Prine for deferred payment SEC's Rules of Practice of 1988 director fees *10.10(b) Agreement dated December Refiled herewith at page 30, 1988 with Malcolm M. 211 pursuant to Rule 24 of Prine for deferred payment SEC's Rules of Practice of 1989 director fees *10.11(a) Agreement dated September Refiled herewith at page 30, 1986 with Daniel M. 216 pursuant to Rule 24 of Rooney for deferred payment SEC's Rules of Practice of 1986 and 1987 director fees *10.11(b) Agreement dated December Refiled herewith at page 21, 1987 with Daniel M. 221 pursuant to Rule 24 of Rooney for deferred payment SEC's Rules of Practice of 1988 director fees *10.11(c) Agreement dated December Refiled herewith at page 30, 1988 with Daniel M. 226 pursuant to Rule 24 of Rooney for deferred payment SEC's Rules of Practice of 1989 director fees *10.11(d) Agreement dated December Filed as Exhibit 10.27 to 15, 1989 with Daniel M. Form 10-K for the year Rooney for deferred payment ended December 31, 1989 of 1990 director fees *10.11(e) Agreement dated December Filed as Exhibit 10.27 to 21, 1990 with Daniel M. Form 10-K for the year Rooney for deferred payment ended December 31, 1990 of 1991 director fees *10.11(f) Agreement dated December Filed as Exhibit 10.27 to 13, 1991 with Daniel M. Form 10-K for the year Rooney for deferred payment ended December 31, 1991 of 1992 director fees *10.11(g) Agreement dated December Filed as Exhibit 10.27 to 18, 1992 with Daniel M. Form 10-k for the year Rooney for deferred payment ended December 31, 1992 of 1993 director fees *10.11(h) Agreement dated December Filed herewith at page 231 14, 1993 with Daniel M. Rooney for deferred payment of 1994 director fees 10.12 Trust Agreement with Filed as Exhibit 10.28 to Pittsburgh National Bank to Form 10-K for the year act as Trustee for ended December 31, 1989 Supplemental Pension Plan, Supplemental Deferred Compensation Benefits, Retirement Program for Board of Directors, and Supplemental Executive Retirement Plan EXHIBITS DESCRIPTION METHOD OF FILING 11.01 Statement re Computation of Filed herewith at page 236 Earnings Per Share 21 Schedule of Subsidiaries Filed herewith at page 237 23.01 Consent of Independent Filed herewith at page 238 Auditors 99.01 Equitable Resources, Inc. Filed herewith at page 239 Employees Savings Plan Form 11-K Annual Report The Company agrees to furnish to the Commission, upon request, copies of instruments with respect to long-term debt which have not previously been filed. 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. EQUITABLE RESOURCES, INC. (Registrant) By: s/ Donald I. Moritz (Donald I. Moritz) Chairman and Chief Executive Officer Date: March 18, 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. Chairman and Chief Executive Officer and Director s/ Donald I. Moritz (Principal Executive Officer) March 18, 1994 Donald I. Moritz Vice President and Treasurer s/ Robert E. Daley (Chief Financial Officer) March 18, 1994 Robert E. Daley Vice President - Accounting and Administration s/ Joseph L. Giebel (Chief Accounting Officer) March 18, 1994 Joseph L. Giebel President and Chief Operating Officer s/ Frederick H. Abrew and Director March 18, 1994 Frederick H. Abrew Director March 18, 1994 Clifford L. Alexander, Jr. s/ Merle E. Gilliand Director March 18, 1994 Merle E. Gilliand SIGNATURES (Continued) s/ E. Lawrence Keyes, Jr. Director March 18, 1994 E. Lawrence Keyes, Jr. s/ Thomas A. McConomy Director March 18, 1994 Thomas A. McConomy Director March 18, 1994 Malcolm M. Prine s/ Daniel M. Rooney Director March 18, 1994 Daniel M. Rooney Director March 18, 1994 David S. Shapira s/ Barbara Boyle Sullivan Director March 18, 1994 Barbara Boyle Sullivan

791024_1993.txt

791024_1993

1993

791024

ITEM 1 -- BUSINESS GENERAL Home Shopping Network, Inc. ("HSN" or the "Company") is a holding company, the subsidiaries of which conduct the day-to-day operations of the Company's various business activities. The Company's primary business, and principal source of revenue, is electronic retail sales by Home Shopping Club, Inc. ("HSC"), a wholly-owned subsidiary of the Company and a leader in the electronic retailing industry. On July 13, 1993, the Company elected to change its annual reporting period from a year ending August 31 to a year ending December 31, effective January 1, 1993. The change in year end was made following the acquisition of voting control of the Company (the "Acquisition") by a wholly-owned subsidiary of Liberty Media Corporation, a Delaware corporation ("Liberty"), which reports its financial position and results of operations using a December 31 year end. HOME SHOPPING CLUB, INC. HSC sells a variety of consumer goods and services by means of HSC's live, customer-interactive retail sales programs which are transmitted twenty-four hours a day, seven days per week, via satellite to cable television systems, affiliated broadcast television stations and satellite dish receivers. HSC produces three separate retail sales programming networks, HSN 1, HSN 2, and HSN Spree. HSN 1 is carried by cable television systems throughout the country and is the original HSC programming network. HSN 2 is carried by broadcast television stations which are affiliated with HSC. HSN 2 is also carried by cable television systems which primarily retransmit the broadcast television signal of one of the independent broadcast television stations carrying HSN 2. HSN Spree is carried primarily on a part-time basis by both cable television systems and broadcast television stations. This provides system operators and broadcasters with income producing programming during portions of the day in which programming may not otherwise be scheduled. As of December 31, 1993, there were approximately 93.7 million homes in the United States with a television set, 60.0 million basic cable television subscribers and 3.1 million homes with satellite dish receivers. As of December 31, 1993, approximately 21.8 million homes throughout the United States were able to receive HSN 1 via over 1,526 cable systems. HSN 2 was broadcast at the same date via 35 full power and 9 low power broadcast television stations in areas with a total viewership of approximately 25.9 million households. In addition, approximately 19.7 million households were able to receive HSN 2 via over 770 cable systems. See "Broadcast Television Affiliations -- Cable Re-regulation Law." As of December 31, 1993, HSN Spree was carried on a full-or part-time basis by 112 broadcast television stations, including certain stations that are in areas also served by cable television systems or broadcast television stations which carry HSN 1 and/or HSN 2. Approximately 3.1 million additional households also were able to receive HSN 1, HSN 2 or HSN Spree by means of satellite dish receivers. Approximately 7.8 million of the cable television households receiving HSC programming are considered multiple service households which receive HSN 1 and HSN 2. In addition, an indeterminate number of television households which are capable of receiving HSN 1 or HSN 2 by means of broadcast television stations or cable may also receive HSN Spree and, in certain markets, HSN Spree is carried by cable television systems located within the coverage area of broadcast television stations which broadcast HSN Spree. Each of HSC's three programming services may be received by households with satellite dish receivers which households may also be located within areas served by cable television systems or broadcast television stations which carry HSC programming. HSC'S RETAIL SALES PROGRAMMING HSC's electronic retail marketing and programming concept is the "Home Shopping Club" (the "Club"). The distinctive format of the Club is intended to promote sales through a combination of product information, price information, entertainment and the creation of confidence in HSC and its products, thus promoting customer loyalty and repeat purchases. HSC programming is divided into segments. Each segment is televised live with an experienced show host. The show host presents merchandise one product at a time and conveys to the viewer information relating to the product, including price, quality, uses and attributes. Viewers place orders for products by calling a toll-free telephone number. Show hosts engage callers in spontaneous on-the-air discussions regarding the Club, the currently featured product or the caller's previous experience with the Club and its products. This distinctive format creates a spontaneous and entertaining program. First-time purchasers of merchandise receive a complimentary membership in the Club. HSC attempts to stimulate Club member loyalty by providing Club members with incentives to purchase additional items from the Club using, for example, the "Bargaineer" magazine which, among other features, offers discounts on HSC purchases. The Club format is used on HSN 1, HSN 2 and HSN Spree. MEMBER SERVICES AND RETURN POLICY HSC believes that satisfied Club members will be loyal and will purchase merchandise from HSC on a regular basis. To help ensure Club member satisfaction, HSC has member services personnel and voice response units available to handle calls relating to member inquiries. The member services department maintains toll-free lines operating on weekdays from 8:00 a.m. to 12 midnight, Eastern Time, to assist Club members. As part of HSC's member service policy, a Club member may, generally within thirty days, return for any reason any item purchased from HSC, except certain special sale items, for a full refund of the purchase price, including the original shipping and handling charges. PRODUCT PURCHASING AND LIQUIDATION The Company believes that a primary factor contributing to the success of its business is its ability to locate and take advantage of opportunities to purchase, and to have manufactured to its specifications, large quantities of quality merchandise at favorable prices. HSC principally purchases merchandise made to its specifications and also purchases merchandise from manufacturers' lines, overproduction closeouts and the overstock inventories of wholesalers. The mix of products and source of such merchandise depends upon a variety of factors including price and availability. HSC has no long-term commitments with any of its vendors, and historically, there have been various sources of supply available for each category of merchandise sold by HSC. HSC's product offerings include: jewelry; hardgoods, which include consumer electronics, housewares and toys; softgoods, which consist primarily of clothing; and other product categories which include collectibles, cosmetics and consumables. For calendar 1993, jewelry, hardgoods, softgoods and other categories accounted for approximately 49%, 34%, 15% and 2%, respectively, of HSC's sales. The Company liquidates merchandise through its six outlet stores. The Company opened the fifth outlet store in the second quarter of 1993 and the sixth outlet store in the fourth quarter of 1993. Merchandise that becomes damaged and is unsuitable for sale via the Club or the outlet stores is liquidated by the Company through traditional channels. For the first five months of calendar 1993, the Company liquidated merchandise through Western Hemisphere Sales, Inc. ("Western"), a company owned by a former related party. See "Legal Proceedings" and "Certain Relationships and Related Transactions." Sales of damaged merchandise by Western were less than .5% of the total sales of the Company for the year ended December 31, 1993. Merchandise also is disposed of from time to time through charitable contributions. TRANSMISSION AND PROGRAMMING HSC produces retail sales programs in its studios located in St. Petersburg, Florida. These programs are distributed to cable television systems, broadcast television stations and satellite dish receivers by means of HSN's satellite uplink facilities to satellite transponders leased by HSN which retransmit the signals received from HSN. Any cable television system, broadcast television station or individual satellite dish owner in the United States and the Caribbean Islands equipped with standard satellite receiving facilities is capable of receiving HSC programming. HSN has lease agreements securing full time use of three transponders on three domestic communications satellites, Satcom C-3, Satcom C-4, and SatcomR. The three Satcom transponders are located on domestic communications satellites owned by GE American Communications, Inc. ("GE"). Two lease agreements which relate to Satcom C-3 used by HSN 1 and Satcom C-4 used by HSN 2 grant HSN "protected" rights. The lease agreement which relates to SatcomR used for HSN Spree provides HSN with "transponder protected" rights. Domestic communication satellite transponders may be leased full-or part-time on a "protected," "transponder protected" or "unprotected" basis. When the carrier provides services to a customer on a "protected" basis, replacement transponders are reserved on board the satellite for use in the event the "protected" transponder fails. Should there be no reserve transponders available, the "protected" customer will displace an "unprotected" transponder customer on the same satellite. The carrier also maintains a protection satellite and should a satellite fail completely, all lessors' "protected" transponders would be moved to the protection satellite. The customer who leases a "transponder protected" transponder has the same level of protection as the "protected" customer except for the availability of the back-up protection satellite. The customer who leases an "unprotected" transponder has no reserve transponders available, and may have its service interrupted for indefinite periods when its transponder is required to restore a "protected" service. GE provides one (1) back-up transponder for every four (4) transponders, and one (1) back-up satellite for all their satellites. A transponder failure that would necessitate a move to another transponder on the same satellite would not result in any significant interruptions of service to the cable systems and/or television stations which receive HSC's programming. However, a failure that would necessitate a move to another satellite may temporarily affect the number of cable systems and/or television stations which receive HSC's programming because of the need to reorient earth stations to the substitute satellite transponder. Satcom C-3 and Satcom C-4 were launched in September and August 1992, respectively. The terms of the contracts are for the life of the satellites, which are projected to be 12 years. The transponder agreement for SatcomR has been extended to December 31, 1994. HSN has commenced negotiations to secure a replacement transponder. HSN anticipates that it will be able to negotiate a transponder lease to replace the lease on SatcomR. Although HSN believes it is taking every reasonable measure to ensure its continued satellite transmission capability, there can be no assurance that termination or interruption of satellite transmissions will not occur. HSN's access to three transponders pursuant to long-term agreements would enable HSC to continue transmission of its two primary programming services, HSN 1 and HSN 2, should any one of the satellites fail. Such a termination or interruption of service by one or more of these satellites could have a material adverse effect on the operation and financial condition of HSN. See "Federal Government Regulation of Satellite Transmissions." The availability of replacement satellites and transponder time beyond current leases is dependent on a number of factors over which HSN has no control, including competition among prospective users for available transponders and the availability of satellite launching facilities for replacement satellites. FEDERAL GOVERNMENT REGULATION OF SATELLITE TRANSMISSIONS The Federal Communications Commission ("FCC") grants licenses to construct and operate satellite uplink facilities which transmit signals to satellites. These licenses are generally issued without a hearing if suitable frequencies are available. HSN has been granted two (2) licenses for operation of C-band satellite transmission facilities and two (2) licenses for operation of KU-band satellite transmission facilities on a permanent basis in Clearwater and St. Petersburg, Florida. The FCC has jurisdiction over satellite service and facility providers. Under current FCC policy, domestic satellite service and facility providers are not subject to the market exit provisions of Section 214 of the Communications Act of 1934 (the "Communications Act"). Thus, FCC policies would not preclude GE from ceasing to provide communication services to customers on short notice, and the Company would need to rely principally upon protections in its lease agreements described above. See "Transmission and Programming." HSN has not received notification that GE has any intention to cease providing transmission services. GE is required by the FCC to provide services on terms and conditions that are just, reasonable and non-discriminatory, and are subject to complaints filed with the FCC pursuant to the Communications Act. CABLECASTING HOME SHOPPING CLUB PROGRAMMING HSC has entered into affiliation agreements with a number of cable system operators to carry HSN 1, HSN 2 or both HSN 1 and HSN 2. HSC's standard affiliation agreement provides that the cable operator will receive a commission of 5% of the net sales of merchandise sold to Club members located within the cable operator's franchise area in return for distributing to its customers HSC's sales programs as part of the cable operator's cable service. Cable operators which have executed affiliation agreements to carry HSN 2 are compensated for all sales on HSN 2 of merchandise within their franchise areas, regardless of whether a customer's order results from watching the program via cable, satellite dish, or on a broadcast television station within the cable operator's franchise area. Although there is some variation among affiliation agreements with cable operators, the current standard affiliation agreement provides for an initial term of five years which is automatically renewable for subsequent one year terms. The agreement may be terminated, however, by either party ninety days prior to the end of the term. The agreements obligate a cable operator to assist the promotional efforts of HSC by carrying commercials regarding the Home Shopping Club and distributing HSC's marketing materials to their subscribers. HSC also purchases advertising availabilities from many cable operators on programming networks other than the Club as an incentive to the cable operators to carry HSC programming and as a marketing device to increase awareness of HSC programming among viewers in a given cable system. To further promote cable carriage of HSC programming, HSC has, in certain markets, guaranteed a minimum level of commissions to cable operators which agree to carry the HSC programming or offered additional compensation based upon the sales performance of HSC programming in the cable operator's franchise area. HSC has also increased cable carriage of HSN 2 and HSN Spree as a result of the cable re-regulation law. See "BROADCAST TELEVISION AFFILIATIONS -- Cable Re-regulation Law." The Company has entered into agreements with broadcast television stations to carry HSN Spree on both a part-time and full-time basis. Cable operators within the coverage areas of such broadcast television stations may carry a station's broadcast signal of HSN Spree and, if under contract, receive a commission on all sales made during the hours between 12 midnight and 9:00 a.m., Eastern Time, via HSN Spree within the cable operator's wired franchise area. HSN Spree is also carried by "superstation" WWOR, from 3 a.m. to 6 a.m., Eastern Time, which is transmitted to approximately 17.0 million cable subscribers. 1987 CABLE OPERATORS STOCK OPTION PLAN During fiscal 1987, the Company offered certain cable operators the opportunity to participate in the 1987 Cable Operators Stock Option Plan (the "1987 Plan"). The special affiliation agreement executed by participants in the 1987 Plan provided that a cable operator would carry HSN 1, HSN 2 or both HSN 1 and HSN 2 for a period of five years beginning no later than January 31, 1988. In exchange for the commitment to carry HSC programming for five years, cable operators received (1) options to purchase the Company's common stock, exercisable over a five year period which expired July 1, 1992, and (2) the standard commission of 5% on sales of the Company's merchandise via television in the cable operator's territory. The exercise price for the options was $13.00 per share, and none were exercised prior to expiration. For each subscriber to which a cable operator agreed to transmit HSN 1 or HSN 2, the cable operator was granted an option to purchase $10.00 worth of the Company's common stock. The Company granted an option to purchase $20.00 worth of its common stock for each subscriber to which a cable operator agreed to transmit both HSN 1 and HSN 2. Under the 1987 Plan, cable operators were granted certain piggyback and mandatory registration rights with respect to the shares into which the options are exercisable. In December 1987, the Company re-opened the offering of the 1987 Plan to additional cable operators and provided cable operators already participating in the 1987 Plan with the opportunity to reduce the exercise price of options previously granted under the 1987 Plan. The Company offered cable operators not participating in the 1987 Plan the opportunity to receive an option to purchase 77 shares of common stock for every 100 subscribers to which the cable operator agreed to transmit HSN 1 and HSN 2 for up to seven years. Cable operators which agreed to carry HSN 1 and HSN 2 for a period of five years received options exercisable in five equal annual installments with an exercise price of $7.00 per share. Cable operators which agreed to carry HSN 1 and HSN 2 for a period of seven years received options exercisable in three equal annual installments with an exercise price of $6.00 per share. The options issued to five year participants expired in 1993, and the options issued to seven year participants will expire in June 1994. Cable operators already participating in the 1987 Plan were able to reduce the exercise price of options granted under the 1987 Plan to $7.00 per share exercisable in five equal annual installments, provided they agreed to carry HSN 1 or HSN 2 for a total of five years. In addition, cable operators holding options under the 1987 Plan were able to further reduce the exercise price of options granted under the 1987 Plan to $6.00 per share exercisable in three equal annual installments provided they agreed to carry HSN 1 or HSN 2 for a total of seven years. As a result of the distribution by the Company of the capital stock of its former wholly-owned subsidiary, Precision Systems, Inc., in 1992, the exercise prices of these options were adjusted from $7.00 to $6.651 and from $6.00 to $5.701, respectively and were further adjusted from $6.651 to $6.491 and from $5.701 to $5.564, respectively as a result of the distribution by the Company of the capital stock of its former wholly-owned subsidiary, Silver King Communications, Inc. ("SKC"). Under the 1987 Plan, the Company may cancel options issued to a cable operator if the cable operator fails to carry the Company's programming to the agreed upon number of cable system subscribers. The number of shares subject to options, therefore, may be reduced from time to time to reflect the number of cable system subscribers actually receiving HSC programming under the 1987 Plan. During fiscal 1993, cable operators exercised options for approximately 3.3 million shares contributing approximately $20.4 million to the Company's Stockholders' Equity under the 1987 Plan. As of December 31, 1993, options to purchase approximately .5 million shares of common stock were outstanding under the 1987 Plan. The Company may, in the future, issue options to purchase the Company's common stock in order to help secure cable carriage. DISTRIBUTION, DATA PROCESSING AND TELECOMMUNICATIONS The Company's fulfillment subsidiaries ship merchandise purchased by Club members from warehouses located in St. Petersburg, Florida; Salem, Virginia; Waterloo, Iowa; and Reno, Nevada. Substantially all inventory resides at the Company's four fulfillment centers prior to being offered for sale. Merchandise typically is delivered to customers within 7 to 10 business days of placing an order with HSC. HSN currently operates several Unisys main frame computers and has extensive proprietary data processing and order processing systems which facilitate the timely delivery of merchandise to customers. HSN's computerized systems track purchase orders, inventory, member orders, shipping records, and member payments and also enhance credit verification and authorization. The Company believes these software systems, which would be difficult for competitors to duplicate, have been a primary factor in HSC's ability to meet the demands of its sales growth. To further facilitate the delivery of merchandise to Club members, HSC installed a state-of-the-art fiber optic telephone system and switching complex which was developed for the Company in fiscal 1988. HSC also utilizes a computerized voice response phone answering system (the "VRU system") capable of handling incoming sales calls. The VRU system provides callers with the option to place their order by means of touch tone input or to be transferred, in the case of new members or if the member requires personal service, to an operator. BROADCAST TELEVISION AFFILIATIONS AFFILIATION WITH BROADCASTERS In July 1986, the Company initiated a program to broaden the viewership of HSC's programming services by acquiring broadcast television stations in principal television markets through SKC. On December 28, 1992, the Company distributed the capital stock of SKC (the "Distribution") to the Company's shareholders of record as of December 24, 1992, in the form of a pro rata stock dividend. Intercompany indebtedness in an amount of $135.2 million owed by SKC was converted into a secured long-term senior loan between SKC and a wholly-owned subsidiary of the Company pursuant to a loan agreement (the "Loan Agreement"), evidenced by a promissory note (the "Note"), bearing interest on the unpaid principal amount at a rate of 9.5% per annum. The terms of the Note are governed by the Loan Agreement and the liability evidenced thereby is secured by substantially all of SKC's assets. The Note is payable in equal monthly installments of principal and interest over fifteen years. The Note provides that the principal amount and the payment schedule of the loan may be adjusted to increase or decrease payments over the remaining term of the loan to reflect certain liabilities pursuant to a Tax Sharing Agreement, which was entered into in connection with the distribution of the capital stock of SKC. The Loan Agreement contains certain restrictive covenants and default provisions. The balance of the Note, including interest receivable, at December 31, 1993, was $132.3 million. So long as any indebtedness is outstanding under the Loan Agreement, each SKC station is required to maintain an affiliation agreement with HSC to carry HSC's programming. HSC pays an affiliation fee to SKC based on hourly rates and, upon reaching certain sales levels, commissions on net sales. Certain of the SKC stations have realized additional compensation during the second year, and those stations, and possibly others, are expected to continue to receive additional compensation during subsequent years of their affiliation agreements if "must carry" survives legal challenge. See "Cable Re-regulation Law." SKC, through its subsidiaries, owns twelve broadcast television stations, including one television satellite station, located in many of the top markets in the United States. These stations exclusively broadcast HSC programming, except for a portion of broadcast time which is used to provide public affairs and other non-entertainment programming and advertising inserts. SKC also owns 14 low power television ("LPTV") stations that broadcast HSC's programming services. LPTV stations have lower power transmitters than conventional television stations, and therefore, the broadcast signal of an LPTV station does not cover as broad a geographical area as conventional broadcast stations. In addition to affiliation agreements with the SKC broadcast television and LPTV stations, HSC has entered into affiliation agreements with other broadcast television stations and LPTV stations to carry either HSN 2 or HSN Spree for a predetermined number of hours per day. The broadcast station affiliation agreements may generally be terminated upon proper notice and specify the payment of fixed fees for the carriage of HSC programming. HSN Spree programming is available in one hour segments twenty-four hours per day which allow broadcast and cable affiliates to distribute HSN Spree in available daytime, evening, or overnight time slots that would not otherwise produce revenue. As of December 31, 1993, HSC had entered into either full-or part-time affiliation agreements with 35 broadcast television stations to carry HSN 2 (including broadcast television stations owned by SKC), 70 television stations to carry HSN Spree and 51 LPTV stations to carry HSN 2 or HSN Spree. The Company may also affiliate with additional broadcast television stations and LPTV stations in the coming year. CABLE RE-REGULATION LAW On October 5, 1992, the Cable Television Consumer Protection and Competition Act of 1992 was enacted into law. Among the many provisions of this new cable re-regulation law is one that mandates that cable systems carry the signals of local commercial television stations ("must carry") or, at the station's option, that cable systems and television stations negotiate a fee to be paid by cable systems for the retransmission by such cable systems of the local television station's broadcast signal. HSC's full-time broadcast affiliates have all requested "must carry" status in lieu of a retransmission fee. On July 2, 1993, the FCC ruled that stations predominantly used for the transmission of sales presentations or program-length commercials operate in the public interest and are entitled to "must carry" status. A petition for reconsideration of the FCC's ruling currently is pending before the FCC. The Company has filed an opposition to that petition. Also, the Supreme Court of the United States has heard oral arguments regarding a decision by the United States District Court for the District of Columbia upholding "must carry" generally. A ruling is expected in mid-1994. As a result of "must carry," HSC has experienced increased cable distribution of its programming due to an increase in the number of cable systems that carry HSC programming. On September 23, 1993, the FCC adopted a Notice of Inquiry initiating a proceeding to evaluate the commercial programming practices of broadcast television stations (including stations with shop at home formats) and seeking comment on whether the public interest would be served by establishing limits on the amount of commercial matter broadcast by television stations. The FCC has received comments and reply comments. Although the FCC is only seeking comments at this time and has not made any proposals to limit the amount of commercialization on television stations, there can be no assurance whether or when such proposals will be forthcoming, what the nature of such proposals might be, whether they will be implemented, and thus what impact, if implemented, they would have on the Company. ADDITIONAL SUBSIDIARY BUSINESSES In addition to the electronic retailing business, the Company's subsidiaries are involved in mail order, insurance and other businesses complementary to electronic retailing. HSN Mail Order, Inc. ("Mail Order") markets a variety of merchandise through four mail order catalogs distributed to individuals on mailing lists developed by Mail Order or rented from agents. The catalogs include Home Shopping Values(TM), Bargaineer Shopping Values(TM), Private Showing Jewelry Values By Mail, and Stuart McGuire Men's Footwear and Accessories. Mail Order also markets a variety of products by inserting marketing materials, including its catalogs, in packages containing products shipped to Club members. HSN Insurance, Inc. ("HSI") is a full-service insurance agency marketing a wide range of insurance products such as life, health, auto, homeowners and commercial policies to the public and Club members locally. Mass-marketing of other insurance and service-related products such as a private-label auto club, a legal services plan, a dental insurance plan, an extended services plan for electronics, and an appliance protection plan are also offered to the Club members nationally. HSI also handles the placement of all property and liability insurance for HSN and its subsidiaries as well as employee benefits insurance products. HSN Mistix Corporation serves as a computerized ticketing and campground reservations company. HSN Lifeway Health Products, Inc. markets natural vitamin and mineral supplements, over-the-counter items, health and wellness merchandise and a complete line of skin and hair products. More than 280 products are offered under the Lifeway(R) line and are marketed via HSC's programming services, mail order catalogs and continuity-based outbound telemarketing. COMPETITION The Company operates in a highly competitive environment. It is in direct competition with businesses which are engaged in retail merchandising and competes most intensely with other electronic retailers, direct marketing retailers such as mail order companies, companies that sell from catalogs, and other discount volume retail outlets. The Company also competes for access to its customers with broadcasters and alternative forms of entertainment and information, such as programming for network and independent broadcast television stations, basic and pay cable television services, satellite master antenna systems, home satellite dishes and home entertainment centers. In particular, the price and availability of programming for cable television systems affects the availability of these channels for the Company's programs and the compensation which must be paid to the cable operators for carriage of HSC programming. In addition, the Company believes that due to a number of factors, including the development by cable operators of alternative sources of cable operator owned programming, the competition for channel capacity has substantially increased. With the advent of new compression technologies on the horizon, this competition for channel capacity may substantially decrease, although additional competitors may have the opportunity to enter the marketplace. No predictions can be made with respect to the viability of these technologies or the extent to which they will ultimately impact the availability of channel capacity. The Company was the first specialty retailer to market merchandise by means of live, nationally televised sales programs. The Company's principal competitor in the electronic retail industry is QVC, Inc ("QVC"). The Company and QVC account for the majority of sales in the electronic retail industry. Within the last year, new electronic retailers have commenced or enhanced operations, and several others have announced their intention to enter the business. There are other companies, some having an affiliation or common ownership with cable operators, that now market merchandise by means of live television. A number of other entities are engaged in direct retail sales businesses which utilize television in some form and which target the same markets in which the Company operates. Some of the Company's competitors are larger and more diversified than the Company, or are affiliated with cable operators which have a substantial number of subscribers. The Company cannot predict the degree of success with which it will meet competition in the future. In addition to the above factors, the Company's affiliation with broadcast television stations creates another set of competitive conditions. These stations compete for television viewers primarily within local markets. The Company's affiliated broadcast television stations are located in highly competitive markets and compete against both VHF and UHF stations. Due to technical factors, a UHF television station generally requires greater power and a higher antenna to secure substantially the same geographical coverage as a VHF television station. Under present FCC regulations, additional UHF commercial television broadcasting stations may be operated in all such markets, with the possible exception of New York City. The Company cannot quantify the competitive effect of the foregoing or any other sources of video programming on any of the Company's affiliated television stations, nor can it predict whether such competition will have a material adverse effect on its operations. In summary, the Company operates in a highly competitive environment in which, among other things, technological change, changes in distribution patterns, media innovations, data processing improvements and new entrants make the competitive position of both the Company and its competitors extremely difficult to predict. TRADEMARKS, TRADENAMES AND COPYRIGHTS The Company has registered and continues to register, when appropriate, its trade and service marks as they are developed and used, and the Company vigorously protects its trade and service marks. The Company believes that its marks are a primary marketing tool. EMPLOYEES At December 31, 1993, the Company had 4,266 full-time employees and 752 part-time employees. The Company believes it has generally good employee relationships. ITEM 2 ITEM 2 -- PROPERTIES During fiscal 1986, the Company purchased a 165,000 square foot facility located at 1529 U.S. Highway 19 South in Clearwater, Florida, which housed its corporate headquarters, studios and certain of its administrative offices. The Company occupies approximately 82,000 square feet of this facility and leases approximately 83,000 square feet to third parties. The Company operates out of a campus facility at 2501 118th Avenue North, St. Petersburg, Florida, containing in excess of 580,000 square feet which, since September 30, 1987, has housed television studios, broadcast facilities and most of the Company's administrative offices and training facilities. In fiscal 1986, the Company purchased a 160,000 square foot warehouse located in Waterloo, Iowa, and leased a 200,000 square foot warehouse located near Reno, Nevada, with an option to purchase the property. The lease expires September 30, 2002. Both facilities are used as fulfillment centers. The Company operates a 450,000 square foot warehouse and fulfillment center with administrative offices located in Salem, Virginia, which is leased from the City of Salem Industrial Development Authority. At the end of the term of such lease, on November 1, 1999, the Company will have the option to purchase the property for $1. In fiscal 1991, the Company completed a 215,000 square foot expansion of this facility, at an approximate cost of $4.2 million. In December 1986, the Company purchased a 43,200 square foot fulfillment center located in St. Petersburg, Florida. In July and September 1991, the Company purchased three properties, which it formerly leased, from a former related party. The properties, consisting of approximately 90,000 square feet in Clearwater and St. Petersburg, Florida, are currently used for warehouse space. The Company's subsidiaries also lease office and/or warehouse space in several states to operate its businesses. The Company considers its properties suitable and adequate for its present needs. ITEM 3 ITEM 3 -- LEGAL PROCEEDINGS On February 12, 1993, a class action complaint titled Arazie v. Malone, et al. was filed by a shareholder of the Company in the Court of Chancery of the State of Delaware, in and for the County of New Castle (the "Delaware Court"), against the Company, John C. Malone, Peter R. Barton, Robert R. Bennett, John M. Draper, Roy M. Speer and Liberty. Shortly thereafter, four other class action complaints were filed with the Delaware Court by shareholders of the Company; certain of these actions also named as defendants Les R. Wandler and RMS Limited Partnership, a Nevada Limited Partnership ("RMS") in addition to the defendants named in Arazie. On February 19, 1993, the five Delaware actions were consolidated for all purposes in an action titled In re: Home Shopping Network, Inc. Shareholders Litigation, Civil Action No. 12868 (the "Delaware Action"). On March 15, 1993, three additional class action complaints were consolidated into the Delaware Action. On April 26, 1993, the plaintiffs in the Delaware Action filed a consolidated amended and supplemental class action complaint (the "Supplemental Complaint"). The Supplemental Complaint was brought on behalf of all public stockholders of the Company (other than defendants) as of February 12, 1993, and their successors in interest, and names as defendants the persons and entities named in the prior pending complaint in the Delaware Action, as well as Liberty, Liberty Program Investments, Inc. ("LPI") and three current or former directors of the Company (Gerald F. Hogan, J. Anthony Forstmann and John J. McNamara). In the Supplemental Complaint, the plaintiffs allege, among other things, that (i) Mr. Speer and RMS breached their fiduciary duties in agreeing to the Acquisition, and that Liberty aided and abetted the supposed wrongdoing by Mr. Speer and RMS; (ii) Liberty and LPI have breached their fiduciary duties by commencing an unfairly priced, improperly timed, coercive and manipulative tender offer (the "Tender Offer"); (iii) the offer to purchase disseminated by Liberty and LPI in connection with the Tender Offer contains several misrepresentations and omits material information; and (iv) the members of the Board of Directors of the Company have breached their fiduciary duties of loyalty, due care and candor by failing to protect the public stockholders of the Company from the Tender Offer. Plaintiffs seek to rescind the Acquisition, to enjoin consummation of the Tender Offer and to enjoin the defendants from taking any action to eliminate the separate class voting rights of the holders of the Shares and the Class B Shares on any future proposal relating to a merger or other business combination involving the Company. On May 10, 1993, the plaintiffs filed a Second Consolidated Amended and Supplemental Class Action Complaint (the "Second Supplemental Complaint"). In addition to the parties and allegations contained in the Supplemental Complaint that plaintiffs filed on April 26, 1993, the Second Supplemental Complaint contains allegations, among other things, that the Tender Offer is false, misleading and coercive. On July 14, 1993, the Delaware Chancery Court granted the plaintiffs leave to file a third consolidated amended and supplemental class action complaint (the "Third Supplemental Complaint"). In addition to the parties and allegations contained in the Second Supplemental Complaint, the Third Supplemental Complaint adds claims and allegations and adds QVC as an additional party defendant. The Third Supplemental Complaint alleges that the QVC merger proposal of July 12, 1993 to form a business combination with the Company (the "QVC Merger Proposal") was inadequate and grossly unfair to the Company's minority stockholders. It asserts class action claims against all defendants other than QVC for breach of fiduciary duty, and against QVC for aiding and abetting Liberty's alleged breaches of fiduciary duty in connection with the QVC Merger Proposal. In addition to the relief sought in the Second Supplemental Complaint, the Third Supplemental Complaint seeks to rescind the Tender Offer or obtain damages in connection therewith. On November 5, 1993, QVC withdrew the QVC Merger Proposal. On April 26, 1993, four stockholders of the Company filed with the Delaware Court a purported class action complaint, styled as 7547 Corp. V. Liberty Media Corp., C.A. No. 12956, on behalf of an unspecified class of stockholders of the Company (the "Delaware State Law Action"). The defendants including Liberty, LPI, the Company, and certain current and former directors of the Company (Messrs. Speer, Forstmann, McNamara, Wandler, Chu, James, Ramsey and Roberts). Plaintiffs contend, among other things, that (i) the Board of Directors of the Company failed to approve the Agreement in Principle between RMS and Liberty relating to purchase of a controlling interest in the Company by Liberty before RMS and Liberty reached an agreement, arrangement or understanding regarding the Acquisition; (ii) any approval of the Agreement in Principle by the Board of Directors of the Company on December 4, 1992, was ineffective to exempt Liberty from the restrictions of Section 203 of the Delaware General Corporation Law; and (iii) the Tender Offer is a prohibited "business combination" under Section 203. Plaintiffs sought an injunction hearing prohibiting consummation of the Tender Offer and sought a declaratory judgment prohibiting Liberty from engaging in a "business combination," as defined in Section 203 of the Delaware General Corporation Law (including a business combination with the Company) until December 3, 1995. On May 17, 1993, a hearing was held in the Delaware Court on the motions for preliminary injunction filed by the plaintiffs in the Delaware Action and in the Delaware State Law Action. On May 19, 1993, the Delaware Court issued an Order denying plaintiffs' motions for preliminary injunction, ruling that plaintiffs in the Delaware Action had not demonstrated a reasonable probability of success on the merits of their disclosure claims, and that plaintiffs in the Delaware State Law Action had not demonstrated a reasonable probability of success on their claim that the proposed tender offer was in violation of the Delaware Business Combinations Act, 8 Del. C. Section 203. On July 19, 1993, certain named plaintiffs filed a Class Action Complaint styled Bartnik, et al. V. Home Shopping Network, Inc., Liberty Media Corp., QVC Network, Inc., Roy M. Speer, Les R. Wandler, John C. Malone, Peter R. Barton, Robert R. Bennett, Gerald F. Hogan, J. Anthony Forstmann, and John J. McNamara, Civil Action No. 93-336, in the United States District Court for the District of Delaware (the "Bartnik Complaint"). The Bartnik Complaint alleges class action claims against Roy M. Speer, Liberty, Gerald F. Hogan, John C. Malone, Peter R. Barton, and Robert R. Bennett for violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder in connection with an alleged scheme to maintain an artificially low market price for the common stock of the Company and to induce class members to sell the Company's common stock during the class period at artificially depressed prices. The Bartnik Complaint contains a class action claim against QVC for aiding and abetting the defendants in their alleged violations of Section 10(b) and Rule 10b-5. The Bartnik Complaint also alleges class action claims against defendants Liberty, Hogan, Malone, Barton, and Bennett for violating Sections 20 and 20A of the Exchange Act through their alleged control over the Company and its disclosures during the class period. The Bartnik Complaint further alleges class action claims against all defendants except QVC, alleging that Liberty's Offer to Purchase and 14D-1 dated on or about April 22, 1993, and the Company's 14D-9 dated on or about May 6, 1993, were materially false and misleading in violation of Section 14(e) of the Exchange Act. The Bartnik Complaint also alleges claims against all defendants except QVC for negligent misrepresentation. On or about July 22, 1993, plaintiff Meny Beriro filed a purported class action complaint, Beriro V. Home Shopping Network, Inc., et al., No. 93-347, in the United States District Court for the District of Delaware (the "Beriro Complaint"). On or about August 17, 1993, plaintiff Lawrence G. Metzger filed a purported class action complaint, Metzger V. Home Shopping Network, Inc. et al., No. 93-406, in the United States District Court for the District of Delaware (the "Metzger Complaint"). The Beriro and Metzger Complaints name the same defendants and contain substantially the same claims as the Bartnik Complaint. On September 14, 1993, the United States District Court for the District of Delaware entered an order consolidating the Beriro Complaint and the Metzger Complaint into the Bartnik Complaint as the Complaint for the consolidated action. On December 16, 1993, four actions that had been filed in, consolidated by and transferred from the United States District Court for the District of Colorado were consolidated with the Bartnik Complaint (the "Delaware Federal Action"). On February 15, 1994, plaintiffs filed a consolidated and amended complaint. The action seeks unspecified damages on behalf of a purported class consisting of all purchasers of the Company's common stock prior to April 9, 1993 who thereafter sold such shares on public exchanges prior to July 12, 1993 or in the Tender Offer. The defendants include Liberty, LPI, John C. Malone, Peter R. Barton and Robert R. Bennett (collectively, the "Liberty Defendants"), QVC, the Company, Gerald F. Hogan, J. Anthony Forstmann, John J. McNamara, Roy M. Speer and Les R. Wandler. Plaintiffs allege that, between March 30, 1993 and July 12, 1993, the Liberty Defendants failed to disclose their supposed "plans and expectations" for a merger of the Company and QVC. Plaintiffs also allege that (i) defendants supposedly made misleading and overly negative disclosures between April-July 1993 regarding the business activities and prospects of the Company which had the effect of artificially depressing the price of the Company's shares; (ii) defendants allegedly misled sellers of the Company's shares by failing to disclose defendants' expectations regarding a July 1993 ruling by the Federal Communications Commission which improved the business prospects of the Company; and (iii) Liberty and the Company supposedly misled the Company's stockholders by making incorrect disclosures (particularly in connection with the Tender Offer) regarding Liberty's ability to control the Company's stockholder vote on certain fundamental corporate transactions. Plaintiffs assert that the foregoing alleged acts and omissions violated the federal securities laws and state law. On December 31, 1993, an agreement in principle was reached to settle the Delaware Action and the Delaware Federal Action. The Company does not anticipate having to contribute to the settlement of these actions or pay any of the plaintiffs' attorneys' fees or expenses therein. The settlement of these actions is conditioned on, among other things, court approval after notice to the shareholders and a hearing on the fairness of the settlement. On February 12, 1993, a class action complaint entitled Mizell et al. V. Speer et al., C.A. No. 93-000494-CI-020, was filed in the Circuit Court for Pinellas County, Florida against Roy M. Speer, Les R. Wandler, Franklin J. Chu, J. Anthony Forstmann, Thomas A. James, John J. McNamara, William J. Ramsey, Michael V. Roberts and Liberty ("Mizell "). On February 19, 1993, plaintiffs in Mizell filed an amended complaint adding the Company as an additional defendant. The Mizell plaintiffs allege, among other things, that the Liberty merger proposal delivered to the Board of Directors of the Company following the closing of the Acquisition (the "Liberty Merger Proposal") was fundamentally unfair to the Company's public stockholders; did not represent the current value of the Company's Common Stock, assets and business; and that certain of the defendants breached their fiduciary duties to plaintiffs and to the Company's other shareholders. The plaintiffs seek, inter alia, an injunction enjoining any merger or other business combination resulting from the Liberty Merger Proposal and unspecified monetary damages. Liberty and the other defendants in the Mizell action have filed motions to dismiss the amended complaint on various grounds or, in the alternative, to stay that proceeding in favor of the prior-filed Delaware action. On January 19, 1994, the Mizell plaintiffs voluntarily dismissed the Mizell lawsuit without prejudice. On April 13 and 14, 1993, seven purported class action lawsuits were filed in the United States District Court for the Middle District of Florida, Tampa Division (the "Court") against the Company and Roy M. Speer and, in two of the cases, current or former officers and directors of the Company. RMS is also named as a defendant in two of the actions. The complaints filed in four of the suits are virtually identical and allege that certain statements made by Roy Speer and the Company in press releases and in an information statement dated March 11, 1993, failed to disclose material facts relating to the Company's business practices. Goldstein V. Roy M. Speer, et al. and Home Shopping Network, Inc., Civil Action No. 93-602-CIV-T-23B; Milton Partners, L.P. V. Roy M. Speer, et al. and Home Shopping Network, Inc., Civil Action No. 93-608-CIV-T-15C; Kirsch V. Roy M. Speer, et al. and Home Shopping Network, Inc., Civil Action No. 93-623-CIV-T-23A; and Greenwald V. Roy M. Speer, et al. and Home Shopping Network, Inc., Civil Action No. 93-624-CIV-T-17B. In particular, these suits allege that employees of the Company improperly accepted compensation from vendors; that the Company paid Nando DiFilippo, former executive vice-president, general counsel and secretary of the Company, to prevent him from disclosing such vendor bribes; and that the Company had failed to properly disclose certain related party transactions in its filings with the SEC. These suits allege that the failure to disclose these matters violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and Section 20 of the Exchange Act and constituted common law fraud. In International Gemmological Institute, Inc. et al. V. Home Shopping Network, Inc. et al., Civil Action No. 93-610-CIV-T-21B, another of the purported class action suits, the plaintiffs assert that Speer and the Company misstated material facts or omitted to state material facts in certain public filings and announcements, that certain insiders of the Company (Franklin Chu, John McNamara, Michael Roberts, and Edward Vaughn) traded securities of the Company while in the possession of material nonpublic information and that Speer and the Company engaged in certain activities which amount to common law fraud and deceit and negligent misrepresentation. This purported class action seeks damages, including punitive damages, interest, costs and fees. The allegations in this complaint are similar to those in the class action suits described above. Likewise, in Arnold Jerome Sussman, et al. V. Home Shopping Network, Inc., Civil Action No. 93-613-CIV-T-17B the plaintiffs assert violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder based upon a failure to properly disclose certain bribes allegedly paid by unspecified vendors to Mr. Speer and Lowell W. Paxson, a former president of the Company, the fact that certain payments to Mr. DiFilippo allegedly were to cover-up financial wrongdoing, that corporate assets were purportedly transferred to Western and that an improper loan was made to a consultant of the Company. The plaintiffs in this action seek damages, prejudgment interest, costs, expenses and attorneys' fees and other unspecified relief. The plaintiff in one of the putative class actions, Kas V. Home Shopping Network Inc., et al., Civil Action No. 93-621-CIV-T-15A, voluntarily dismissed his claims without prejudice. On or about April 23, 1993, plaintiffs Mike and Natalie Magula filed another purported class action in the Court titled Magula V. Home Shopping Network, Inc., Civil Action No. 93-679-CIV-T-21C. The defendants in this action are the Company, Roy M. Speer, Les R. Wandler, Franklin J. Chu, Fernando DiFilippo, Jr., Lowell W. Paxson and RMS. The plaintiffs allege violations of Section 10 of the Exchange Act, Rule 10b-5 promulgated thereunder and Section 20(a) of the Exchange Act as well as a Florida statute relating to commercial bribery in seeking an unspecified amount of damages, including punitive damages, prejudgment interest, costs and attorneys' fees. The complaint alleges that (i) the Company failed to properly disclose the nature of certain payments made by Mr. Speer and Mr. Paxson to Mr. DiFilippo; (ii) the Company knew or recklessly disregarded the fact that certain vendors to the Company allegedly paid bribes to certain employees of the Company; (iii) that the Company's Annual Report on Form 10-K for the year ended August 31, 1992, and Report on Form 10-Q for the period ended November 30, 1992, contained misleading financial statements because they failed to disclose the payments to Mr. DiFilippo and that certain employees of the Company had allegedly been paid bribes; (iv) that the Company failed to disclose certain information regarding its inventory levels and a recent change in management's policies which resulted in an increase in the Company's inventory reserve; and (v) that the Company failed to accurately disclose the existence of a known trend that would have a material impact on the business of the Company. On or about April 28, 1993, another purported class action lawsuit, Newborn V. Home Shopping Network, Inc., et al., Civil Action No. 93 681 CIV T 17A was filed in the Court against the Company, Mr. Speer and RMS. The plaintiff alleges violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and the plaintiff seeks an unspecified amount of damages, including prejudgment interest, plus costs, expenses and attorneys' fees. The plaintiff alleges that the defendants engaged in improper activities including (i) improper payments to Mr. Speer, Mr. Paxson, and possibly other senior executives of the Company; (ii) diversion of Company funds to Western; (iii) a cover-up of the alleged improper payments, including payments to Mr. DiFilippo and an alleged improper loan to a financial advisor to the Company; and (iv) issuance of materially false and misleading statements to the investing public. Plaintiffs have moved to consolidate all of the pending class action suits filed in April 1993 in the Court against the Company and various defendants (the "Florida Federal Securities Actions"). On December 30, 1993, the counsel for both the Company and the plaintiffs in the Florida Federal Securities Actions, entered into an agreement in principle to settle the Florida Federal Securities Actions. Pursuant to the terms of the agreement in principle to settle the Florida Federal Securities Actions, the Company agreed to pay $9,600,000 in full settlement of any and all claims whatsoever which have been or could have been made in the Florida Federal Securities Actions by any members of a plaintiff class consisting of all purchasers of the Company's common stock (other than the defendants) from June 1, 1992 through and including April 12, 1993 (collectively the "Purchaser Class"). Any attorneys' fees awarded by the Court to the plaintiffs' attorneys will be paid out of the $9,600,000 settlement fund. The settlement of the Florida Federal Securities Actions is conditioned on, among other things, Court approval after notice to the Purchaser Class and a hearing on the fairness of the settlement. On December 15, 1992, a shareholder derivative lawsuit was filed by 7457 Corp., a Colorado corporation, against certain current and former officers and directors of the Company (Roy M. Speer, Les Wandler, Franklin J. Chu, J. Anthony Forstmann, Thomas A. James, John J. McNamara, William J. Ramsey, and Michael R. Roberts) (the "Named Directors"), and against the Company as a nominal defendant in the United States District Court for the Middle District of Florida, Tampa Division, Case No. 92-1966-CIV-T-15A. Another shareholder derivative suit was filed in the Court against the Named Directors and the Company as a nominal defendant on December 31, 1992, by Isaac Fillosov and Claire Rand. On February 23, 1993, the Court granted a motion to consolidate these two actions as 7547 Corp. et al. V. Speer et al. (the "Derivative Action") with leave to file a consolidated amended complaint. On April 16, 1993, the plaintiffs filed a consolidated amended complaint. On May 24, 1993, the court granted plaintiffs leave to file a second consolidated amended complaint (the "Second Amended Complaint"). The amendments add Richard Speer, Western, Liberty and LPI as defendants and add Ricky Werbosky as plaintiff. The Company is named as a nominal defendant in a derivative capacity with respect to one of the claims asserted in the Second Amended Complaint. The suit alleges a breach of fiduciary duties owed to the Company and its stockholders by the Named Directors and a failure to exercise due care and diligence in the management and administration of the affairs of the Company. Western and Richard Speer are alleged to have aided and abetted such breaches. The suit challenges the validity of a license agreement with Western pursuant to which the Company was given the exclusive rights to certain software and alleges that the Company wrongfully made, and continues to make, payments to Western pursuant to a computer services agreement which was allegedly terminated. The suit alleges that the Company wrongfully made payments to Western of $3,502,000, $3,286,000 and $3,084,000 during the Company's 1992, 1991 and 1990 fiscal years, respectively, pursuant to the agreement. Merchandise that is unsuitable for sale via the Company's programs or outlet stores was sold by Western, which received a commission of 15% on the amount realized upon disposition. Western received $1,469,000, $1,615,000 and $1,427,000 and through this arrangement during the Company's 1992, 1991 and 1990 fiscal years, respectively. The suit also alleges that this 15% commission was commercially unreasonable. The sole stockholder of Western is Richard Speer, the son of Roy M. Speer. The suit alleges that the above-described arrangements would not have been entered into by the Company with an unrelated third party and that Roy and Richard Speer owned undisclosed interests in unspecified firms which sell merchandise to the Company. The Second Amended Complaint also asserts a class action claim relating to certain alleged misstatements or omissions of material facts in the Company's proxy statements for 1990, 1991 and 1992. In particular, the suit alleges that the proxy statements (i) did not disclose certain unspecified interests of Roy and Richard Speer in vendors which did business with the Company; (ii) mischaracterized certain payments made to Mr. DiFilippo as consulting fees rather than as amounts paid to DiFilippo to secure his silence concerning certain alleged, unspecified misconduct by Speer; (iii) failed to properly disclose the Western arrangements and the fact that the Audit Committee of the Board of Directors had not approved related party transactions, and (iv) that one of the Named Directors was the President of a company alleged to have been controlled by Roy Speer. The suit seeks findings that the Named Directors, Richard Speer and Western breached their fiduciary duties to the Company and its stockholders or aided and abetted such breaches; that the Named Directors, Richard Speer and Western must account to the Company for any losses, plus interest; that the plaintiffs be awarded all costs for the action; that the Named Directors return to the Company all compensation received by them during the relevant time periods; that certain defendants be enjoined from paying additional money or delivering valuable assets to Richard Speer or Western and that certain of the Named Directors take corrective action with respect to the Company's alleged disclosure violations. The Second Amended Complaint alleges class action claims against Liberty and LPI for violations of Section 13(e) and 14(e) of the Exchange Act and Rules 13e-3 and 13e-4 promulgated thereunder in connection with the Offer to Purchase. The Second Amended Complaint also contains a class action claim against Liberty and LPI alleging that Liberty controlled the contents of the Solicitation/Recommendation section of the Schedule 14D-9 the Company filed on May 6, 1993, and that the 14D-9 is materially false and misleading in violation of Sections 14(d) and 14(e) of the Exchange Act and Rule 14e-2 promulgated thereunder. On or about February 8, 1994, counsel for the Company, with the approval of the special litigation committee of its Board of Directors, signed an agreement in principle to settle the Derivative Action. Pursuant to the terms of this agreement, Roy M. Speer has agreed to pay the Company $2,000,000 and to pay the Company an additional $1,000,000 to partially fund the $9,600,000 settlement in the Florida Federal Securities Actions. The Company has agreed to pay Western, the successor to Pioneer Data Processing, Inc. ("Pioneer"), $4,500,000 in exchange for releases and cancellation or acquisition of a 1985 license agreement involving the Company and Pioneer. This agreement in principle also provides for certain limitations on the rights of Roy M. Speer to seek indemnification for the advancement of expenses from the Company and that the parties to the Derivative Action agree to release certain claims against each other. The Company also has agreed to pay such attorneys' fees as may be awarded by the Court to the plaintiffs' counsel. The settlement of the Derivative Action is conditioned on, among other things, Court approval after notice to the shareholders and a hearing on the fairness of the settlement. On April 1, 1993, Mr. Allen P. Allweiss, a former executive vice president and general counsel of the Company, filed a lawsuit styled Allweiss V. HSN, et al., in the Circuit Court of the Sixth Judicial Circuit of the State of Florida for Pinellas County, Case No. 93-1176CI13, against the Company, Roy M. Speer, Francis Santangelo, Liberty, Gerald F. Hogan and John M. Draper complaining about, among other things, his February 24, 1993, termination from the Company (the "Allweiss Suit"). The Allweiss Suit asserted that the defendants violated certain provisions of Florida law relating to stock options and restricted stock (the "Stock Rights") issued to Allweiss under the Company's 1986 Stock Option Plan for Employees (the "Employee Plan") and the Company's 1990 Executive Stock Award Program (the "Award Program"). Additional allegations against one or more of the defendants relating to Mr. Allweiss' Stock Rights include securities fraud, an alleged fraudulent scheme to deprive him of the value of such rights, theft, conversion, breach of contract, interference with a business or contractual relationship and deprivation of unpaid wages. In addition, Mr. Allweiss alleged that his discharge was in retaliation for bringing to the attention of the Company certain alleged improprieties by Mr. Speer, Mr. Santangelo and certain former officers and directors of the Company. The Allweiss Suit is seeking an unspecified amount of damages for losses associated with his Stock Rights and lost benefits and wages, treble damages against the Company, Speer and Santangelo for an alleged pattern of criminal activities that allegedly injured Mr. Allweiss and relief for intentional infliction of emotional distress. During his tenure with the Company, Mr. Allweiss was granted certain stock options and restricted stock under the Company's Employee Plan and the Award Program. Following his dismissal, the Company notified Allweiss that all of the options granted under the Employee Plan had vested and were exercisable at $8.229 per share, the exercise price set upon the initial grant of the options. Mr. Allweiss maintains that the exercise price had been amended following the initial grant date and that the correct exercise price is $4.753 per share. The Award Program provides that nonvested shares of stock are forfeited upon the termination of a participant's employment with the Company unless such termination results from a change in control of the Company. Mr. Allweiss alleges that the Company has violated certain of his rights by failing to notify him of the status of the stock granted to him under the Award Program. In addition to the counts relating to the Stock Rights, the Allweiss Suit refers to a variety of allegedly improper transactions and purportedly inaccurate or incomplete disclosures involving (i) the severance arrangements between the Company, Mr. Speer and Mr. Paxson, and Mr. DiFilippo; (ii) transactions between the Company and Pioneer and Western; (iii) the failure of the Company's Audit Committee to approve certain related party transactions; (iv) disclosures to the IRS relating to payments to Pioneer and a proposed reorganization of Western; (v) the independence of a former member of the Audit Committee of the Board of Directors; (vi) disclosures contained in certain documents filed with the FCC; (vii) transactions between the Company and Francis Santangelo; and (viii) certain additional matters. The Allweiss Suit maintains, among other things, that Mr. Allweiss' efforts to disclose or rectify these matters caused him to be dismissed. On August 30, 1993, Mr. Allweiss filed an amended complaint (the "Amended Complaint") in the Circuit Court of the Sixth Judicial Circuit of the State of Florida for Pinellas County, Case No. 93-1176CI13. The Amended Complaint restates several of the causes of action in the original complaint and contains essentially the same allegations of purported wrongdoing as the original complaint but no longer includes several counts including the claims for securities fraud, common law fraud, deprivation for unpaid wages, and intentional infliction of emotional distress. The Amended Complaint also adds counts for conspiracy to commit theft, conversion, and retaliatory discharge. The Amended Complaint also includes a claim for civil remedies for alleged criminal practices against the Company, Mr. Speer and Mr. Santangelo, along with a claim for interference with business and contractual relations against Santangelo only. On October 26, 1993, the court denied the defendants' motions to dismiss the Amended Complaint except that the court dismissed the retaliatory discharge count with prejudice as to all of the defendants except the Company. Plaintiff also filed on August 30, 1993, a notice of appeal as to those claims dismissed without leave to amend by the court's July 29, 1993, order in the Allweiss Suit. The appeal was dismissed on October 15, 1993, as premature. On December 2, 1993, the Company filed a counterclaim against Mr. Allweiss alleging breach of fiduciary duties, legal malpractice and breach of a confidentiality agreement. The Company believes it has meritorious defenses and intends to vigorously defend this action. On December 27, 1990, a customer of HSC filed an amended class action complaint against the Company styled Mauger V. Home Shopping Network, Inc., in the Court of Common Pleas, Philadelphia County, Pennsylvania. Plaintiff alleged violation of the Pennsylvania Unfair Trade Practices and Consumer Protection Law in relation to the Company's pricing practices with respect to diamond and imitation diamond jewelry. Plaintiff seeks certification of the class, compensatory damages or $100 per class member, treble damages, attorney's fees, costs, interest and other relief. Plaintiff claims that the diamond ring she purchased from HSC was not of the same value stated in an appraisal provided to the customer. On June 22, 1991, another customer of HSC filed a class action complaint against the Company, styled Powell V. Home Shopping Network, Inc., making similar allegations concerning jewelry purchased from HSC and seeking similar relief. On April 19, 1993, the Mauger and Powell cases were consolidated in the Court of Common Pleas of Bucks County, Pennsylvania, (Case No. 91-6152-20-1). On May 4, 1993, the Court entered an order granting the plaintiffs' motion for class certification and declared the plaintiffs to be class representatives and the class to be "all Pennsylvania residents who purchased any jewelry containing diamonds or imitation diamonds from Home Shopping Network, Inc's subsidiary Home Shopping Club, Inc. between December 27, 1984 and May 20, 1991." On July 23, 1993 the court denied the Company's motion for interlocutory appeal of the May 4, 1993 order. The Company believes that it has meritorious defenses and intends to continue vigorously defending this action. The Company has been informed that the Securities and Exchange Commission has entered a formal order of investigation involving matters relating to, among other things, certain of the Company's SEC filings and other public disclosures. The Company has furnished documents in connection with this formal investigation and is cooperating in the investigation while maintaining its legal privileges, including the attorney/client privilege. This is a nonpublic investigation and the scope of the investigation is confidential. The Company has been advised that this inquiry should not be construed as an indication by the Commission or its staff that any violations of law have occurred, nor should it be considered a reflection upon any person, entity or security. The Company has been informed that a federal grand jury impaneled in the Middle District of Florida is investigating matters relating to the Company. The Company has furnished documents in connection with this investigation and has taken action to protect its legal privileges in these proceedings, including the attorney/client privilege. Information related to the scope of matters occurring before the grand jury is confidential. The Company was advised by the federal government that the Company is not a target, at this time, of the Grand Jury investigation. Pursuant to existing indemnification agreements with current and former officers and directors, the Company has paid in 1993 approximately $1,983,000 in attorneys' fees and expenses of its current and former officers and directors in connection with the foregoing described litigation. On March 4, 1993, the Company's Board of Directors formed a Special Committee to investigate the allegations in the Derivative Action and certain other matters and to take such action in response to the Derivative Action and other litigation as the Committee determined to be in the interests of the Company and its stockholders. The members of the Special Committee are Messrs. Hindery, Draper and Bennett. Both Messrs. Draper and Bennett are officers of Liberty. The Special Committee has retained legal counsel to assist in its investigation. The Special Committee is finalizing their review in connection with the settlement of the matters. In conjunction with the proposed settlement of the Delaware Federal Action, the Delaware Action, the Derivative Action and the Florida Federal Securities Actions, certain defendants in those lawsuits agreed through their attorneys on February 8, 1994 that, upon the final consummation of the proposed settlements in all such actions, all such parties will release each other as to any claims for contribution relating to the claims actually asserted in those proceedings (the "Release Agreement"). The parties to the Release Agreement are the Company, Roy M. Speer, Les R. Wandler, Franklin J. Chu, J. Anthony Forstmann, Gerald F. Hogan, Thomas A. James, John J. McNamara, William J. Ramsey, Michael V. Roberts, RMS, Liberty, LPI, John C. Malone, Peter R. Barton, Robert R. Bennett and John M. Draper. The foregoing descriptions of these actions and the proposed settlements of the Delaware Action, the Delaware Federal Action, the Derivative Action and the Florida Federal Securities Actions do not purport to be a complete summary thereof and are qualified in their entirety by reference to the complaints and other pleadings in these actions and the documents associated with the proposed settlements. The Company has determined that the publicity surrounding the legal proceedings referenced above has not, and is not expected to, materially adversely affect the Company's business operations. 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 information set forth under the caption "Price Range of Common Stock" on page 61 of the 1993 Annual Report, is incorporated herein by reference. The total number of stockholders of record as of March 18, 1994, was 8,804. The Company has paid no cash dividends on its common stock to date and does not anticipate that it will pay cash dividends in 1994. Any payment of future dividends and the amounts thereof will be dependent upon the Company's earnings, financial requirements and other factors deemed relevant by the Board of Directors. On December 28, 1992, the Company distributed the capital stock of SKC to the Company's stockholders of record on December 24, 1992, in the form of a pro rata stock dividend. The distribution also included Telemation, Inc., formerly a wholly-owned subsidiary of the Company that operates video production and post-production facilities, the capital stock of which was contributed to SKC prior to the distribution. The distribution of the capital stock of SKC was a taxable transaction. The Company recognized a gain for income tax purposes in the amount equal to the difference between the fair market value of the SKC capital stock distributed and the Company's basis in such SKC capital stock. This gain resulted in additional income tax expense of approximately $1.5 million which was recorded during the four months ended December 31, 1992. ITEM 6 ITEM 6 -- SELECTED FINANCIAL DATA The information set forth under the caption "Summary Financial Data" on page 60 of the 1993 Annual Report, is incorporated herein by reference. ITEM 7 ITEM 7 --MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth under the caption "Management's Discussion and Analysis" on pages 21 through 34 of the 1993 Annual Report, is incorporated herein by reference. ITEM 8 ITEM 8 -- CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Registrant and Independent Auditors' Reports set forth on pages 35 through 59 of the 1993 Annual Report are incorporated herein by reference: Independent Auditors' Reports for the year ended December 31, 1993, the four months ended December 31, 1992, and the years ended August 31, 1992 and 1991. Consolidated Balance Sheets as of December 31, 1993, and 1992 and August 31, 1992. Consolidated Statements of Operations for the year ended December 31, 1993, the four months ended December 31, 1992, and the years ended August 31, 1992 and 1991. Consolidated Statements of Stockholders' Equity for the year ended December 31, 1993, the four months ended December 31, 1992, and the years ended August 31, 1992 and 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, the four months ended December 31, 1992, and the years ended August 31, 1992 and 1991. Notes to Consolidated Financial Statements. ITEM 9 ITEM 9 --CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES A report was filed on Form 8-K for the event occurring February 23, 1993, reflecting the change in accountants from Deloitte & Touche to KPMG Peat Marwick. PART III ITEM 10 ITEM 10 --DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth under the caption "Election of Directors" in the Proxy Statement dated March 29, 1994, for the Annual Meeting of Stockholders to be held May 4, 1994, is incorporated herein by reference. ITEM 11 ITEM 11 -- EXECUTIVE COMPENSATION The information set forth under the captions "Summary Compensation Table" and "Employment Agreements" in the Proxy Statement dated March 29, 1994, for the Annual Meeting of Stockholders to be held May 4, 1994, is incorporated herein by reference. ITEM 12 ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Security ownership by management as outlined under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement dated March 29, 1994, for the Annual Meeting of Stockholders to be held May 4, 1994, is incorporated herein by reference. ITEM 13 ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the captions "Compensation of Directors and Executive Officers" and "Certain Transactions and Business Relationships" in the Proxy Statement dated March 29, 1994, for the Annual Meeting of Stockholders to be held on May 4, 1994, is incorporated herein by reference. 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 Independent Auditors' Report -- KPMG Peat Marwick. Independent Auditors' Report -- Deloitte & Touche. Consolidated Balance Sheets as of December 31, 1993 and 1992, and August 31, 1992. Consolidated Statements of Operations for the year ended December 31, 1993, the four months ended December 31, 1992, and the years ended August 31, 1992 and 1991. Consolidated Statements of Stockholders' Equity for the year ended December 31, 1993, the four months ended December 31, 1992, and the years ended August 31, 1992 and 1991. Consolidated Statements of Cash Flows for the year ended December 31, 1993, the four months ended December 31, 1992, and the years ended August 31, 1992 and 1991. Notes to Consolidated Financial Statements. (2) Financial Statement Schedules The reports of the Company's independent auditors with respect to the above listed financial statement schedules appears on pages 27 and 28. All other financial statements and schedules not listed have been omitted since the required information is included in the Consolidated Financial Statements or the notes thereto, or is not applicable or required. (3) Exhibits (numbered in accordance with Item 601 of Regulation S-K) - --------------- * Reflects management contracts and compensatory plans. (b) Reports on Form 8-K Report dated November 5, 1993, reporting the termination of merger negotiations with QVC, 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. March 25, 1994 HOME SHOPPING NETWORK, INC. By: /s/ GERALD F. HOGAN ---------------------------------- Gerald F. Hogan President and Chief Executive Officer 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 INDICATED ON MARCH 25, 1994. INDEPENDENT AUDITORS' REPORT The Board of Directors Home Shopping Network, Inc. Under date of February 15, 1994, we reported on the consolidated balance sheets of Home Shopping Network, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, stockholders' equity, and cash flows for the year ended December 31, 1993 and the four months ended December 31, 1992 as contained in the Company's 1993 Annual Report. 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. 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 St. Petersburg, Florida February 15, 1994 INDEPENDENT AUDITORS' REPORT The Board of Directors Home Shopping Network, Inc. We have audited the consolidated financial statements of Home Shopping Network, Inc. and subsidiaries (the "Company") as of August 31, 1992 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the two years in the period ended August 31, 1992, and have issued our report thereon dated October 15, 1992 (February 15, 1994 as to Note H to the consolidated financial statements); such consolidated financial statements and report are included in your 1993 Annual Report and are incorporated herein by reference. Our audits also included the financial statement schedules of the Company, 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. DELOITTE & TOUCHE Tampa, Florida October 15, 1992 (February 15, 1994 as to Note H to the consolidated financial statements) SCHEDULE II HOME SHOPPING NETWORK, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES - --------------- (1) Amounts lent in April 1989 to Roberts Broadcasting Corporation, of which Michael V. Roberts is Chairman of the Board, were not considered as a related party transaction until his election to the Company's Board in September 1990. Michael V. Roberts resigned from the Company's Board on February 11, 1993. (2) Amount renewable annually which bears an interest rate of 10%. (3) Amount includes loan plus accrued interest. (4) Deduction relating to subsidiary spin-off. (5) Represents accrued interest. (6) Company's former Chairman of the Board of Directors and CEO was a related party until his resignation in August 1993. Receivable originated on December 30, 1993, in connection with lawsuit settlements. SCHEDULE V HOME SHOPPING NETWORK, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT - --------------- (1) Represents equipment traded with no gain or loss in connection with a new lease. (2) Assets relating to subsidiary spin-off of $18.3 million. Land and Buildings of $1.4 million were transferred to other assets held for sale. (3) Represents assets relating to subsidiary spin-off. (4) Represents reclassifications of amounts among property and equipment classifications. SCHEDULE VI HOME SHOPPING NETWORK, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - --------------- (1) Represents equipment traded with no gain or loss in connection with new lease. (2) Accumulated depreciation related to subsidiary spin-off of $3.2 million. Accumulated depreciation related to building transferred to other assets held for sale of $.3 million. (3) Represents accumulated depreciation related to subsidiary spin-off. (4) Represents reclassifications of amounts among property and equipment classifications. SCHEDULE VIII HOME SHOPPING NETWORK, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS - --------------- (1) Accounts written off as uncollectible. SCHEDULE X HOME SHOPPING NETWORK, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION - --------------- (1) Represents all costs related to the Company's marketing department. (2) Decrease is primarily due to the stock distribution of SKC in December 1992.

96238_1993.txt

96238_1993

1993

96238

Item 1. Business. (a) Developments since January 1, 1993. On October 22, 1993 Talley Industries, Inc. (herein referred to as either "Talley" or the "Company" or the "Registrant") completed a major debt refinancing program by issuing Senior Notes and Senior Discount Debentures, and by securing a credit facility with two institutional lenders. The terms of the agreements are summarized below in Section (e) of this Item 1. The Company completed the sale of the net assets of its precision potentiometer business for $2.8 million in July 1993 as part of the program to reduce outstanding debt. In late 1992, the Company's Board of Directors approved a plan to discontinue the Realty segment. Accordingly, effective December 31, 1992, the Company classified its Realty segment as a discontinued operation for financial reporting purposes. In September 1993, in connection with the offering of the Senior Notes and Senior Discount Debentures, the staff of the Securities and Exchange Commission (SEC) informed the Company that it disagreed with the Company's classification of its Realty segment as a discontinued operation. Pursuant to these discussions, the Company has reclassified the real estate operations to continuing operations. The reclassification does not alter the Company's commitment to exit the real estate business. An amended Form 10-K on Form 10-K/A was filed in November 1993 to reflect the restatement. (b) Financial Information about Industry Segments. A segment description along with tables showing sales and operating income for each of the last five years, and identifiable assets for each of the last three years attributable to each of the Company's five business segments in continuing operations, including the year ended December 31, 1993, are incorporated by reference to the material appearing in the Notes to Consolidated Financial Statements on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. For an additional discussion of segment operations, see also "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. (c) Narrative Description of Business. General Talley is a diversified manufacturer of a wide range of proprietary and other specialized products for defense, industrial and commercial applications. Through its Government Products and Services segment, the Company manufactures an extensive array of propellant devices and electronic components for defense systems and commercial applications and provides naval architectural and marine engineering services. The Company participates in the rapidly expanding market for automotive airbags through its royalty agreement with TRW, Inc. ("TRW"), which provides the Company with a quarterly royalty payment through April 30, 2001 for any airbag manufactured and sold by TRW worldwide and for any other airbag installed in a vehicle manufactured or sold in North America. Talley's Industrial Products segment manufactures and distributes stainless steel products, high-voltage ceramic insulators used in power transmission and distribution systems, and specialized welding equipment and systems. The Company's Specialty Products segment manufactures and sells aerosol insecticides, air fresheners and sanitizers for the commercial and agricultural markets, and custom designed metal buttons for military and commercial uniforms and upscale fashion apparel. Talley is also engaged in the orderly sale of the assets of its real estate operations, the net proceeds from which will be utilized to prepay certain outstanding indebtedness. (1) Government Products and Services Segment. The Company's Government Products and Services segment provides a wide range of products and services for government programs. The vast majority of the Company's products are smaller components of larger units and systems and are generally designed to enhance safety or improve performance. A significant portion of the Company's government revenue represents the replacement of existing Talley products. Products manufactured by Talley which have significant replacement requirements include items having finite shelf lives, such as propellants for pilot ejection seats, as well as products regularly consumed in training and combat situations. Many of the Company's existing products and its new product development efforts are focused on mobile, tactical and "smart" military weapons and systems. Solid Propellant Devices and Related Products A majority of the products manufactured by the Company's Government Products and Services segment are based upon Talley's core technologies and expertise in the design and manufacture of propellants and related products. Propellants are solid fuels which, when ignited, produce a specified thrust or volume of gas for a designated period. Talley's propellant products are typically custom designs developed by the Company in response to customers' technical requirements and specifications. The following sets forth a brief summary of several of the solid propellant devices and related products manufactured by Talley: o Pilot Ejection Systems. The Company manufactures ejection seats and related propellant devices for aircraft ejection systems in high performance military aircraft. The Company also manufactures escape systems for a number of foreign aircraft. o Rocket Motors. Talley manufactures a wide range of rocket motors and rocket catapults. These products include booster rockets for decoy missiles, as well as for unmanned vehicles. The Company also manufactures rocket catapults for its aircraft escape systems. o Gas Generators. Talley manufactures a broad range of solid propellant gas generators. These products provide pneumatic power for guidance and control systems, hydraulic systems, and safe and arming devices on a wide range of missile systems. o Extended Range Munitions Components. Talley's extended range munitions components utilize propellant technologies to dramatically extend the range of U.S. artillery. The Company's base burner assembly utilizes a solid propellant drag reduction system to extend the range of existing howitzer artillery. o Dispersion Systems. Talley pioneered the use of airbag technologies for modern munitions delivery systems. The Company's dispersion systems utilize airbag assemblies to eject submunitions (i.e., small bombs or missiles) from missile systems. o Weapons Systems. Talley is actively involved in the development of the next generation of light-weight disposable shoulder- launched weapons. These weapon systems include the M72 E-Series light anti-armor weapon and a light-weight disposable version of a U.S. Marine Corps shoulder-launched weapon system. Talley has also contracted with the U.S. Army to develop new warhead and launcher technology for the next generation of shoulder-launched weapon systems. o Ejector Racks. Over 8,000 ejector racks manufactured by Talley are currently installed on various U.S. helicopters. These ejection racks enable helicopter pilots to discard munitions, missiles or extra fuel in emergency situations. o Countermeasure Systems. The Company manufactures several training and combat countermeasure systems for naval, aircraft and submarine applications. Countermeasure systems are designed to divert incoming weapons from their targets. o Insensitive Munitions. The Company is currently developing new propellant products which are being qualified to meet certain rigorous safety requirements. These munitions are generally insensitive to shock, puncture, and high temperature and pressure. o Electro Explosive Devices ("EED"). Electro-explosive devices manufactured by the Company include rocket motor igniters, explosive bolts and separation nuts and booster cartridges, as well as initiators for these and other components. High Reliability Electronic Products Talley designs and manufactures specialized electronic display and monitoring devices, electromechanical instruments and components, and high performance cable assemblies which are used by the aerospace and defense industries. The Company's products are designed to perform at a high level of reliability, conform to tight tolerance specifications and withstand harsh operating environments. The following sets forth a brief summary of the primary electronic products manufactured by Talley: o Air Traffic Control Systems. The Company has supplied electronic displays to the FAA for over 20 years for use in certain air traffic control applications, and is currently the sole supplier of video mapper systems to the FAA. The Company's proprietary video mappers superimpose accurate, high resolution electronic map images, including ground topography and weather, onto radar screens which are used by both commercial and military air traffic controllers to coordinate the position of aircraft. o Airborne Flight Data Recorders. The Company is the sole manufacturer of flight data recorders that are used on military aircraft. These flight data recorders are used to evaluate training simulations and record flight information, and are designed to maintain data integrity in the event of a crash. o Safe and Arming Devices. Talley manufactures electronic and electromechanical devices which are used to safely control, arm and fire warheads on torpedoes and missiles. These products are designed to meet a high standard for safety requirements. o Indicators. Talley is a producer of elapsed time indicators, event counters and fault indicators, with a significant share of the domestic aerospace market. The Company's indicator products are capable of functioning with a high degree of accuracy and are built to withstand the harsh operating environment present in aerospace applications. o Interconnect Products. The Company also designs, manufactures and sells high quality interconnect products and accessories for military, aerospace and commercial marketplaces. These products include high voltage silicone wire and cable, multi-pin high and low voltage connector and cable assembly interconnection systems, and triax and coax high voltage connections and cable assemblies. The major applications for these products include medical equipment, radar and CRT displays, satellite detectors and power supplies. Naval Architecture and Marine Engineering Services The Company's naval architecture and marine engineering business provides a broad range of consulting services for the U.S. Navy, as well as for commercial clients and shipyards. The Company's naval design and engineering business has provided services for over 35 years and possesses domestic and international experience in all phases of the design process for military and commercial ships. These services include initial feasibility and conceptual studies, contract design, and detail design and engineering for new and retrofitted ships. The Company also provides the engineering services necessary to physically integrate combat systems and electronics into Navy ships and provides program management and logistics support services to the Navy and commercial customers. The Company maintains separate segments to meet the different technical, performance and administrative needs of its customers. Direct contracts with the U.S. Navy currently account for approximately 60% of the Company's naval architecture and marine engineering revenue, with an additional 20% attributable to subcontracts under Navy contracts. The remaining 20% of revenues are derived from commercial shipyards or industrial customers for ship and other marine design services. The majority of the Company's contracts with the U.S. Navy are cost plus a fixed fee. Under these contracts, the Company is reimbursed for its actual costs plus a percentage fee based on the estimated costs in the original contract. The demand for design services for the U.S. Navy is largely driven by the number of new ship classes being developed or older classes being retrofitted, versus the actual number of ships within a class being built or operated. The majority of engineering and detail design costs are incurred with the introduction of a new class of ship or the retrofit of one or more ships of an existing class. Although the current administration has announced its intention to reduce the number of ships within the U.S. Naval fleet, the magnitude of this reduction is still uncertain. Marketing The Company markets its government products and services directly to the Department of Defense, other U.S. government departments and agencies, and other contractors. The Company's marketing strategy focuses on those contracts and programs which are likely to be emphasized in the current defense environment and for which Talley has a competitive advantage in technology and expertise. The Company's technical sales personnel are strategically located across the country for easy access to its customers. The Company also uses independent sales agents to market its products to various foreign governments and to sell its electronic component products. In addition, the Company enters into joint marketing agreements with foreign manufacturers to provide access to markets not available to Talley. Competition Competition for the Company's government products and services varies widely. The markets for several of the Company's products and services are highly competitive, and many of Talley's competitors have greater financial resources than the Company. However, the Company also competes in a variety of small niche markets. Production of the products within these markets frequently requires government certification, which can be costly and time-consuming to obtain. Once a contract has been awarded, the relatively small size of these markets often discourages additional suppliers from obtaining certification. Within these markets the Company is frequently a sole supplier, and therefore faces little or no competition. A wide variety of industrial companies compete with the Company in the market for propellant devices, with particularly intense competition in the markets for gas generators and dispersion systems. The market for the Company's electronics components products is highly competitive. Competition is particularly intense among Texas Instruments, IBM and Raytheon for air traffic control equipment. The Company is the sole supplier of data acquisition and display systems for the B-1, B-2, T-45 and military aircraft, but there is significant competition for other applications. The Company believes that it shares the market for aerospace elapsed time indicators, fault indicators and events counters primarily with one competitor, Airpax, a North American Phillips company. The Company believes that its safe and arming devices compete with companies such as KDI, Motorola, Quantic and Magnavox. The Company believes that its market for naval architectural and marine engineering services is served by Talley and a small number of other major firms including M. Rosenblatt & Son, Inc., Gibbs & Cox, Inc., Advanced Marine Enterprises, Incorporated, George G. Sharp, Inc. and CDI Marine Company. These companies actively compete with each other, and to a lesser extent with smaller design firms, for U.S. Navy programs, foreign contracts and subcontracts with private shipyards. Government Contract Matters Substantially all of the Company's government defense contracts are fixed-price contracts except for the Company's naval architecture and marine engineering contracts which are generally cost reimbursable. Although the Company's fixed-price contracts generally permit the Company to retain unexpected profits if costs are less than projected, the Company bears the risk that increased or unexpected costs may reduce profit or cause the Company to sustain losses on a particular contract. From time to time the Company accepts fixed-price contracts for products that have not been previously developed. In such cases, the Company is subject to the risk of delays and cost over-runs. Under U.S. Government regulations, certain costs, including financing and interest costs and foreign marketing expenses, are not allowable. The U.S. Government also regulates the methods under which costs are allocated to Government contracts. With respect to U.S. Government contracts that are obtained pursuant to an open bid process and therefore result in a firm fixed price, the Government has no right to renegotiate any profits earned thereunder. In Government contracts where the price is negotiated at a fixed price rather than on a cost- plus basis, as long as the financial and pricing information supplied to the Government is current, accurate and complete, the Government similarly has no right to renegotiate any profits earned thereunder. However, if the Government later conducts an audit of the contractor and determines that such data was inaccurate, or incomplete or not current in overstating the costs, and that the contractor thereby made an excessive profit, the Government may initiate an action to recover the amount of any significantly overstated costs plus applicable profit or fee and interest. If the submission of inaccurate, incomplete or not current data was knowingly made, then the Government may seek to recover an additional penalty equal to the amount of the overstated costs; and if the submission was willful or intentional the Government may seek additional penalties and damages. U.S. Government contracts are, by their terms, subject to termination by the Government either for its convenience or for default of the contractor. Fixed-price contracts provide for payment upon termination for items delivered to and accepted by the Government. If the termination is for convenience, fixed-price contracts provide for payment of the contractor's costs incurred plus the costs of settling and paying claims by terminated subcontractors, other settlement expenses and a reasonable profit on its incurred performance costs. However, if a fixed-price contract termination is for default, (i) the contractor is paid such amount as may be agreed upon for completed and partially completed products and services accepted by the Government, (ii) the Government is not liable for the contractor's costs with respect to unaccepted items and is entitled to repayment of advance payments and progress payments, if any, related to the terminated portions of the contracts and (iii) the contractor may be liable for excess costs incurred by the Government in procuring undelivered products and services from another source. Foreign defense contracts generally contain comparable provisions relating to termination at the convenience of the government. Companies supplying defense-related products and services to the U.S. Government are subject to certain additional business risks unique to that industry. These risks include: the ability of the Government to unilaterally suspend the Company from new contracts pending resolution of alleged violations of certain procurement laws or regulations; procurements which are dependent upon appropriated funds by the Government; changes in the Government's procurement policies (such as a greater emphasis on competitive procurements or cancellation of programs due to budgetary changes); the possibility of inadvertent Government disclosure of a contractor's proprietary information to third parties; and the possible need to bid on programs in advance of design completion. A reduction in expenditures by the Government for the Company's products and services, lower margins resulting from increasingly competitive procurement policies, a reduction in the volume of contracts or subcontracts awarded to the Company, incomplete, inaccurate or non-current data allegations, terminations or cancellations of programs, or substantial cost over-runs could have an adverse effect on the Company's results of operations. Backlog The backlog of firm orders in the Government Products and Services segment amounted to approximately $128 million at December 31, 1993, $143 million at December 31, 1992 and $155 million at December 31, 1991. The backlog in 1991 and 1992 included a major non-recurring program for extended range munitions. The Company estimates that approximately $105 million of the orders outstanding at December 31, 1993 will be delivered by December 31, 1994. (2) Airbag Royalties Segment. As an outgrowth of the research and development efforts in its core propellant businesses, Talley was a pioneer in the development of the automotive airbag. Airbags supplied by the Company were installed by General Motors in approximately 12,000 automobiles during the 1970's and were the first airbags installed in any significant number of automobiles. While the Company's program with General Motors was successful, low market awareness and acceptance prevented the airbag from attaining wide-spread popularity for a number of years. During this period, Talley continued to develop and refine its airbag technology, while establishing relationships with certain U.S. and foreign automakers and suppliers. As demand for airbags increased in the 1980's, Talley's technology, manufacturing expertise and strong customer relationships made it a leading supplier of automobile airbags, and Talley designed and constructed a highly automated production facility that began producing airbags in volume during 1988. In 1989, Talley sold its automotive airbag business to TRW, in part because TRW's offer involved not only an attractive cash price for the business, but also an opportunity to participate in the future growth of the industry. This participation comes through a unique royalty agreement under which royalties are payable both on TRW's worldwide airbag sales and on its competitors' airbags installed in vehicles manufactured or sold in North America. At the closing of the 1989 sale of TRW, Talley received $97.8 million in cash and entered into the 12-year Airbag Royalty Agreement. The Airbag Royalty Agreement requires TRW to pay the Company quarterly royalties through April 30, 2001 (the "Airbag Royalty") based upon the following formula: (i) $1.14 for each airbag "unit" (inflator plus one or more components) manufactured and sold by TRW worldwide (the per- unit amount increases by $.01 on May 1 of each year); (ii) 75% of the per-unit amount for each inflator manufactured and sold separately by TRW worldwide; and (iii) $0.55 for each airbag unit supplied by any other airbag manufacturer and installed in any vehicle manufactured or sold in North America. The Company will receive the Airbag Royalty for any airbag using a gas-generating composition; the higher royalty amount for TRW airbags applies regardless of whether the specific technology used is that which was originally licensed by the Company to TRW. The Company also is entitled to receive royalties from TRW for technology licenses and similar arrangements under which TRW makes its airbag technology available to third parties. Royalties to the Company from such arrangements have not been significant to date. The terms of the Airbag Royalty Agreement allow the Company to participate in the rapidly expanding market for airbags. A continued increase in the use of dual vehicle airbags is expected as a consequence of several factors, including: (i) government legislation mandating the use of dual airbags in all cars, light trucks, sport utility vehicles and vans sold in the U.S. on a phased-in basis; (ii) increasing consumer demand as a result of the demonstrated effectiveness of airbags at saving lives and preventing serious injury, and the convenience of airbags as compared with automatic seatbelts; and (iii) the decreasing price of airbags as competition and production volumes increase. The U.S. government has passed legislation mandating that airbags be installed as standard equipment according to the following schedule: (i) 95% of 1997 model year cars (100% of 1998 models) are to be equipped with driver and passenger side airbags for the front seat, and (ii) 80% of 1998 model-year light trucks, vans and sport utility vehicles (100% of 1999 models) are to be equipped with driver and passenger side airbags for the front seat. (3) Industrial Products Segment. The Company's Industrial Products segment operates in three product areas: stainless steel, high-voltage ceramic insulators and other specialized industrial products. Demand for the Company's products is directly related to the level of general economic activity and therefore has been negatively impacted by the recent recession. The Company's operations are technologically advanced and its products are highly competitive in terms of quality, brand recognition and price. The Company's stainless steel mini-mill has utilized its state-of-the- art computer automation, strict quality controls, and strong engineering and technical capabilities to maintain its position as a low cost, high quality producer. Stainless Steel The Company operates a state-of-the-art stainless steel mini-mill which purchases stainless steel billets and converts them into a variety of sizes of hot rolled and cold finished bar and rod. The facility utilizes computer automation and quality control processes that have resulted in a high standard of product quality, service and deliveries. Located in South Carolina, the mini-mill has relatively low labor and power costs and is situated close to major north-south and east-west interstate highways. The Company recently installed three annealing furnaces, a new pickling line and a new cold-drawing facility which will enable the Company to convert certain shaped bars to smaller sizes with close tolerances. Prior to these enhancements, the Company either subcontracted these processes out or was not able to meet customers' custom finishing requests. The Company sells its products to over 25 independent steel distributors, including two distributors which are owned by the Company, and to a lesser extent to industrial end-users. The Company-owned distributors sell stainless steel sheet, angle and plate, and also provide certain cutting, grinding and boring services. The Company's U.S. distributor, which resells approximately 25% of the mini-mill's production currently, has five distribution depots in South Carolina, New Jersey, Pennsylvania, Illinois and Texas. The Canadian distributor, which sells principally flat stainless steel products (not produced by the mini-mill), has two locations, in Ontario and Quebec. High-Voltage Ceramic Insulators The Company's high-voltage ceramic insulator business manufactures and sells electrical insulators and related items for use in power transmission and distribution systems, principally to electric utilities, municipalities and other government units, as well as to electrical contractors and OEMs. High-voltage ceramic insulators are required to perform with high levels of reliability and typically require product certification from electric utilities to be used for new or replacement applications. Demand for these products is influenced by the level of economic activity, particularly housing starts, with a fairly stable minimum demand level due to normal replacement and repair cycles. The Company's primary customers include OEMs as well as many of the major utilities throughout the U.S. and the world. Other Specialized Industrial Products The Company designs, manufactures and sells specialized advanced- technology welding equipment and systems, power supply systems and humidistats, and also provides contract assembly and manufacturing for OEMs. The Company's welding equipment and systems are highly- engineered and advanced technologically, and the Company holds over 30 patents for these products. The Company's product line includes patented welding systems which can be remotely controlled for use in radioactive and other contaminated environments. These products are sold to the utility, pipeline, shipbuilding, aerospace and specialty construction industries. The power supply systems manufactured by the Company are principally low-wattage systems and are sold to OEMs in the telecommunications, medical, computer and other industrial markets. The power supply market is highly competitive, with more than 500 manufacturers in the U.S. The Company also manufactures and sells humidistats. Humidistats are used to regulate humidity levels and are principally sold to home appliance manufacturers. Marketing The Company markets its industrial products to domestic and foreign business organizations and government entities. These organizations vary in size, complexity and purchasing structures. The Company's sales and marketing efforts use a combination of direct sales, independent distributors and OEM arrangements. Competition The Company's Industrial Products businesses are highly competitive, with competition typically based on price, quality, delivery time, engineering expertise and customer service. The Company's competitors include major domestic and international companies, many of which have financial, technical, marketing, manufacturing, distribution and other resources substantially greater than those of the Company, as well as smaller competitors which focus on specific market niches. Backlog The backlog of firm orders in the Industrial Products segment totalled approximately $19 million at December 31, 1993, $12 million at December 31, 1992 and $8 million at December 31, 1991. The Company estimates that substantially all of the orders outstanding at December 31, 1993 will be delivered by December 31, 1994. Increases are attributed to a major steel mill competitor exiting the market along with an increase in demand from new and current customers. (4) Specialty Products Segment. The Company's Specialty Products segment is focused on two primary markets: insect and odor control for the industrial maintenance supply, pest control and agricultural markets, and custom designed metal buttons for the military and commercial uniform and upscale fashion markets. Insect and Odor Control The Company offers a complete line of insecticides, air fresheners and sanitizers for sale through distributors to the industrial maintenance supply, pest control and agricultural markets. The Company's insecticide products are sold under the Q-Mist and CB trademarks to pest control distributors who sell to pest control professionals. The Company's insecticide formulations focus on using natural active ingredients including pyrethrin (derived from the chrysanthemum flower), boric acid and sassafras. The Company offers a complete line of insecticides to control the most common crawling and flying insects. The insecticides are mixed and packaged at the Company's Louisiana manufacturing plant and formulated into aerosol, liquid and powder form. Air freshening and sanitizing products are formulated and packaged for specific air freshening and sanitizing situations, which vary based on room size, type of odor to be treated, and desired fragrance. In addition, the products are designed for one of four different delivery methods: (i) metered, automatic aerosols for areas up to 6,000 cubic feet, (ii) fan delivered solids for areas up to 1,500 cubic feet, (iii) manual aerosols for immediate air freshening and (iv) passive solids for small enclosed areas. In addition to manufacturing odor and insect control formulations, the Company also manufactures and sells metered and fan driven dispensers for these products. Metered dispensers utilize a timing mechanism to deliver aerosol spray at programmable time intervals. Fan driven dispensers utilize battery operated fans to distribute the scent of selected air fresheners. Custom Metal Buttons The Company designs and manufactures a wide range of custom metal buttons for the military and commercial uniform and upscale fashion markets. The Company also produces insignias, cuff links and other accessories as a complement to its button products. The buttons are individually stamped from custom designed hand carved steel dies. The use of hand carved steel dies and the brass stamping process allow the Company to produce button designs with extremely fine detail and high resolution. The Company custom designs and produces metal buttons for the U.S. military based on detailed military specifications. The Company has seen the volume of military sales decline in recent years as a result of reductions in military personnel. Management expects future modest reductions in military button sales as military force reductions continue. Military sales currently account for less than 20% of the Company's button revenues. The market for commercial uniform buttons includes local police, fire departments and other civil servants. The Company continues to increase its presence in the fashion apparel market by working with apparel manufactures on custom button designs for their manufactured garments. Marketing The Company utilizes 1,700 independent distributors to market its insect and odor control products to the various pest control and sanitation companies that service the industrial maintenance supply and commercial pest control industry. The agricultural market is served by over 100 independent agricultural products distributors. The Company has a three person marketing staff which is responsible for working with and overseeing the distributors who carry its products. The Company's button business maintains a three person sales force which is responsible for obtaining new and maintaining existing customer relationships. Sales representatives are focused on either the military uniform, commercial uniform or fashion apparel markets. The Company's advertising for its Specialty Products businesses is limited to product brochures and ads in various trade publications. Competition Competitors for the Company's pest and odor control products consist of numerous small companies as well as divisions of large corporations. Because pest and odor control is a broad market, competitors include a range of chemical, manufacturing and pet care companies. Competition for pest control products is based on product efficiency, quality, price and the ability to offer a broad range of product formulations. Competitors for the Company's custom button business consist principally of four companies, all of which are similar in size. The Company maintains the strongest position in the military and commercial uniform market, while three of the Company's competitors dominate the fashion market. Backlog The backlog of firm orders in the Specialty Products segment totalled approximately $1.4 million at December 31, 1993, $2.5 million at December 31, 1992 and $2.5 million at December 31, 1991. The Company estimates that substantially all of the orders outstanding at December 31, 1993 will be delivered by December 31, 1994. (5) Real Estate Held for Orderly Disposition. In late 1992, the Company initiated a plan for the orderly disposition of all of its remaining real estate assets and discontinued its real estate operations for financial reporting purposes. As a result, the Company's financial statements as reflected in its 1992 Form 10-K and subsequent Form 10-Q's accounted for the real estate business as a discontinued operation. In connection with the Company's recent refinancing effort, the staff of the SEC informed the Company that it disagreed with the Company's presentation of its Realty business as a discontinued operation because of, among other factors, the anticipated three to five year disposal period. Pursuant to these discussions, the Company returned the real estate operation to continuing operations and amended its 1992 Form 10-K and subsequent Form 10-Q's in November 1993. The reclassification does not alter the Company's commitment to exit the real estate business. It is the Company's intention to dispose of its remaining real estate assets in an orderly fashion. The Company's real estate portfolio consists primarily of undeveloped commercial, industrial and residential land located in the greater Phoenix, San Diego and San Antonio areas. (6) Other General information. Research and Development. During the years ended December 31, 1993, 1992 and 1991, the Company's consolidated expenditures for Company-sponsored research and development activities were approximately $3.1 million, $3.9 million and $4.2 million, respectively. For the same reporting periods, customer-sponsored research and development expenditures were $11.6 million, $2.4 million and $4.0 million, respectively. Environmental Protection. The Company does not anticipate that compliance with various laws and regulations relating to the protection of the environment will have any material effect upon its capital expenditures, earnings or competitive position. (Also see Item 3 "Legal Proceedings" and "Commitments and Contingencies" note to the consolidated financial statements, included in a separate section of this report). Employees. As of December 31, 1993, the Company employed 2,607 persons, approximately 12% of whom are represented by unions. Proprietary Rights. Various of the Company's businesses are dependent in part upon unpatented know-how and technologies, including the solid propellent businesses. While various patents, trademarks and tradenames are held by the Company and are used in its businesses, none is critical to any segment, and the Company's business is not dependent upon them to a material extent. (d) Financial Information about Foreign and Domestic Operations and Export Sales. Information required by this item is incorporated by reference to the Notes to Consolidated Financial Statements appearing under the heading "Segment Operations" on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. (e) Provisions of New Debt Agreements. On October 22, 1993 the Company completed a major debt refinancing program. The Company received gross proceeds of $70 million from the issuance of Senior Discount Debentures, due 2005, which were issued to yield 12.25%. In addition, Talley Manufacturing and Technology, Inc., ("Talley Manufacturing") a newly formed wholly owned subsidiary of the Company, which owns all of the Company's subsidiaries (except the subsidiaries holding the Company's real estate operations), issued $115 million of Senior Notes, due 2003, with an interest rate of 10.75%. Talley Manufacturing also completed a secured credit facility with two institutional lenders. The $185 million gross proceeds of the public offerings, plus the initial borrowings under the secured credit facility, after payment of underwriting and other fees and expenses associated with these financings, were used to repay substantially all of the Company's previously outstanding debt. The indentures for the Senior Notes and the Senior Discount Debentures and the loan agreement relating to the secured credit facility contain covenants requiring specified fixed charge coverage ratios, working capital levels, capital expenditure limits, net worth levels and certain other restrictions on dividends and other payments, incurrence of debt, etc. Substantially all of the receivables, inventory and property, plant and equipment of Talley Manufacturing and its subsidiaries are pledged as collateral in connection with the secured credit facility. In addition, the subsidiaries of Talley Manufacturing have guaranteed Talley Manufacturing's obligations under the Senior Notes and the secured credit facility and the Company has guaranteed the Senior Notes on a subordinated basis. The capital stock of Talley Manufacturing has been pledged by the Company to secure the Senior Discount Debentures. The Senior Notes mature on October 15, 2003 and Talley Manufacturing is required to make mandatory sinking fund payments of $11.5 million on October 15, in each of 2000, 2001 and 2002. Interest is payable semi-annually, commencing April 15, 1994. The Senior Discount Debentures mature on October 15, 2005. No interest on the Discount Debentures is payable until April 15, 1999, when interest will be payable semi-annually on April 15 and October 15 of each year. The secured credit facility consists of a five year revolving credit facility of up to $40 million and a five year $20 million term loan facility; however, upon the occurrence of certain specified events at any time following the third anniversary of the facility, the agent thereunder may elect to terminate the facility. The term facility requires monthly amortization payments based on a seven year amortization schedule. (f) Executive Officers of the Registrant. Reference is hereby made to the information contained in Item 10(b) of this Form 10-K. Item 2. Item 2. Properties. The Company's operations are conducted at a number of manufacturing and assembly facilities of various sizes and a number of warehouse, office and sales facilities located in 18 states in the United States, as well as warehouse, office and sales facilities in Canada and the Netherlands. The principal facilities of the Government Products and Services segment include over 750,000 square feet of manufacturing and assembly facilities, as well as an additional 200,000 square feet of warehouse, office and sales facilities. The principal manufacturing and assembly facilities for this segment are located in Mesa, Arizona; Phoenix, Arizona; Rolling Meadows, Illinois; and Toledo, Ohio. The majority of these facilities are owned by the Company. The Company owns the plants and equipment at two of the Arizona facilities, and leases the underlying land from the State of Arizona under long-term leases of 10 years and 40 years. The Company's naval architectural and engineering services are provided out of several offices, with the major ones located in New York, New York; Arlington, Virginia; Newport News, Virginia; Ocean Springs, Mississippi; and Pascagoula, Mississippi, all of which are leased. Facilities used by the Industrial Products segment include over 800,000 square feet of manufacturing and assembly plants and related office, warehouse and sales space, located in Davidson, North Carolina; Carey, Ohio; Knoxville, Tennessee; Hartsville, South Carolina; and eight sales and warehouse facilities in New Brunswick, New Jersey; Hermitage, Pennsylvania; Chicago, Illinois; Houston, Texas; Charlotte, North Carolina; Toronto and Montreal, Canada, and the Netherlands. The operations of the Specialty Products segment are conducted in several facilities consisting of approximately 214,000 square feet of manufacturing and warehouse space in four locations: Waterbury, Connecticut; Randolph, Vermont; Biddeford, Maine; and Independence, Louisiana, together with 13,000 square feet of office space in Waterbury, Connecticut. All of these facilities are owned by the Company with the exception of eight Industrial Products segment sales and warehouse facilities and three Specialty Products segment warehouses which are leased. In total, approximately two-thirds of all the facilities (by square footage) are owned by the Company and have been pledged as collateral to secure the credit facility. The Company's facilities, which are continually added to or modernized, are generally considered to be in good condition and adequate for the business operations currently being conducted. Item 3. Item 3. Legal Proceedings. Information required by this item is incorporated by reference to the Notes to Consolidated Financial Statements appearing under the heading "Commitments and Contingencies" on page to of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. 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 information required by this item is incorporated by reference to the material under the captions "Long-Term Debt" on pages through, "Capital Stock" on pages through and "Stock Market Data" on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. Item 6. Item 6. Selected Financial Data. The information required by this item is incorporated by reference to the material under the captions "Summary of Operations," "Selected Financial Data" and "Stock Market Data" on pages and through , respectively, of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information required by this item is incorporated by reference to the material on pages through of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. Item 8. Item 8. Financial Statements and Supplementary Data. The Consolidated Financial Statements, together with the report thereon by Price Waterhouse, along with the material appearing under the caption "Quarterly Financial Results (Unaudited)" on page of the Company's financial statements for the year ended December 31, 1993, are included in a separate section of this report. (See "Index to Financial Statements and Schedules" on page.) Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. The Company's Independent Accountants during the two most recent fiscal years have neither resigned, declined to stand for re-election nor been dismissed. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. (a) Directors. The information required by this item is incorporated by reference to the material appearing under the caption "VII - Election of Directors" of the Company's 1994 Proxy Statement. (b) Executive Officers. The names and ages of all executive officers of the Registrant, as of March 8, 1994, the offices and all other positions with the Registrant presently held by them, the dates of their first election to those offices and their other positions and business experience during the past five years are listed on the following page. There are no family relationships between any of the executive officers of the Registrant. All officers of the Registrant are elected each year at the organizational meeting of the Board of Directors of the Registrant, held after the annual meeting of stockholders, to serve at the pleasure of the Board of Directors of the Registrant. There are no agreements or understandings between any officer of the Registrant and any person other than the Registrant pursuant to which he was selected as an officer of the Registrant. There have been no events under any bankruptcy or insolvency law, no criminal proceedings and no judgments, orders or injunctions relating to securities or commodities activities or business practices material to the evaluation of the ability or integrity of any officer of the Registrant during the past five years. (c) Compliance with Section 16(a) of the Exchange Act. The information required by this item is incorporated by reference to the material appearing under the caption "XII - Compliance With Section 16(a) of the Exchange Act" of the Company's 1994 Proxy Statement. Item 11. Item 11. Executive Compensation. The information required by this item is incorporated by reference to the material appearing under the captions "IX - Executive Compensation" and "IV - The Board of Directors and its Committees" of the Company's 1994 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 material appearing under the captions "VI - Security Ownership of Certain Beneficial Owners" and "VIII - Security Ownership of Management of the Company" of the Company's 1994 Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. The information required by this item is incorporated by reference to the material appearing under the caption "V - Other Relationships and Certain Transactions" of the Company's 1994 Proxy Statement. Also, reference is made to 10-K Schedule II, "Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties" on page of this filing, and Notes to Consolidated Financial Statements under the caption "Related Parties Transaction" on page of the Company's financial statements for the year ended December 31, 1993, included in a separate section of this report. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)-1 Financial Statements A list of the financial statements included herein is set forth in the Index to Financial Statements and Schedules submitted as a separate section of this Report. (a)-2 Financial Statement Schedules A list of the financial statement schedules included herein is contained in the accompanying Index to Financial Statements and Schedules submitted as a separate section of this Report. (a)-3 Exhibits Exhibits listed in the Exhibit Index on the pages preceding the exhibits of this report are filed as a part of this report. (b) Reports on Form 8-K There were no reports on Form 8-K filed for the three months 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. TALLEY INDUSTRIES, INC. By Mark S. Dickerson March 22, 1994 Mark S. Dickerson Phoenix, Arizona Vice President, General Counsel 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. William H. Mallender Director, Chairman William H. Mallender of the Board Principal Executive Officer March 22, 1994 Jack C. Crim Director, President Jack C. Crim Chief Operating Officer March 22, 1994 Kenneth May Vice President, Kenneth May Controller Principal Accounting Officer March 22, 1994 Daniel R. Mullen Vice President, Daniel R. Mullen Treasurer Principal Financial Officer March 22, 1994 Neil W. Benson Director March 22, 1994 Neil W. Benson Director Paul L. Foster Townsend W. Hoopes Director March 22, 1994 Townsend W. Hoopes Fred Israel Director March 22, 1994 Fred Israel John D. MacNaughton, Jr. Director March 22, 1994 John D. MacNaughton, Jr. Emiel T. Nielsen, Jr. Director March 22, 1994 Emiel T. Nielsen, Jr. Joseph A. Orlando Director March 22, 1994 Joseph A. Orlando John W. Stodder Director March 22, 1994 John W. Stodder Donald J. Ulrich Director March 22, 1994 Donald J. Ulrich David Victor Director March 22, 1994 David Victor Alex Stamatakis Director March 22, 1994 Alex Stamatakis INDEX TO FINANCIAL STATEMENTS AND SCHEDULES The following documents are filed as part of this report: Page in This Report (1) Financial Statements: Management's Discussion and Analysis of Financial Condition and Results of Operations......F-2 Consolidated Statement of Operations - Years ended December 31, 1993, 1992 and 1991......................F-12 Consolidated Balance Sheet - December 31, 1993 and 1992..............................................F-13 Consolidated Statement of Changes in Stockholders' Equity - Years ended December 31, 1993, 1992 and 1991..........................................F-15 Consolidated Statement of Cash Flows - Years ended December 31, 1993, 1992 and 1991................F-16 Notes to Consolidated Financial Statements, including Summary of Segment Operations...............F-17 Summary of Operations...................................F-47 Report of Independent Accountants.......................F-48 Quarterly Financial Results.............................F-49 Selected Financial Data and Supplemental Data...........F-51 Stock Market Data.......................................F-52 Financial Statement Schedules: II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties.......................F-56 III - Condensed Financial Information of Registrant.......................................F-57 VIII - Valuation and Qualifying Accounts and Reserves.........................................F-63 IX - Short-Term Borrowings............................F-64 XI - Real Estate and Accumulated Depreciation.........F-65 XII - Mortgage Loans on Real Estate....................F-67 All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. Separate financial statements for 50% or less owned companies accounted for by the equity method have been omitted because each such company does not constitute a significant subsidiary. Introduction On October 22, 1993 the Company completed the refinancing of substantially all of its debt. Talley Industries, Inc. issued Senior Discount Debentures with gross proceeds of $70 million. Talley Manufacturing and Technology, Inc., a newly formed wholly owned subsidiary of the Company, which owns all of the Company's subsidiaries (except for the subsidiaries holding the Company's real estate operations) issued $115 million in Senior Notes and obtained a secured credit facility. The $185 million proceeds from the public offerings, plus initial borrowings under the secured credit facility, were used to repay substantially all of the Company's outstanding non-real estate related debt. As part of the program to reduce outstanding debt, in July 1993 the Company also sold its precision potentiometer business. Results of operations improved significantly over 1992 as the Company benefited from efforts to restructure the Company's operations and control costs. The expanding demand for automotive airbags has increased the Company's airbag royalties, which has been another major factor in the improved results. For the year ended December 31, 1993 the Company had a net loss of $6.5 million, an improvement over the loss of $14.6 million in 1992, a year that included an $11.9 million charge to earnings resulting from an adjustment in the value of foreclosed real estate assets, offset in part by a $3.5 million reversal of an income tax accrual. Interest expense decreased by $5.9 million due primarily to a significant paydown of debt in November 1992. Revenues in 1993 were $324.2 million, compared to $320.7 million in 1992. Improvement in revenues from the Company's steel operations of $13.7 million were offset by decreases in certain defense contract revenues. The reduction in defense contract revenue is primarily associated with a scheduled pricing reduction under the extended range munitions program, following the recovery of the Company's investment in a new production facility associated with this program. Revenue also decreased as a result of the July 1993 sale of the Company's precision potentiometer business and the May 1992 sale of the specialty advertising business. In late 1992 the Company also initiated a plan for the orderly disposition of all its remaining real estate assets. In 1993 sales of real estate were $6.1 million compared to 1992 sales of $1.2 million. Introduction, continued The gross profit percentage on sales and services from continuing operations decreased in 1993 from 25.2% in 1992 to 23.1%, a level more consistent with historical results. Revenue for the year ended December 31, 1992 decreased $16.2 million when compared to 1991. The net loss of $14.6 million in 1992 compares to a net loss of $43.2 million in the prior year, a year that included a $5.0 million restructuring charge and a $21.0 million provision for reserves on realty assets. The gross profit percentage from continuing operations increased from 23.0% in 1991 to 25.2% in 1992. The 1992 percentage is above historical levels due to the mix of contracts and product line sales. Government Products and Services Revenue from the Government Products and Services segment in 1993 decreased $12.8 million or 7.0% compared with 1992. Operating income decreased $1.7 million or 6.7%. The decrease in revenue and operating income resulted primarily from a scheduled pricing reduction under the extended range munitions program, following the recovery of the Company's investment in a new production facility. While pricing declined, unit sales of extended range munitions were slightly higher than the comparable period in 1992. Revenues from naval engineering services have improved due to increases in design requirements for three U.S. Naval projects. U.S. Defense spending is projected to decline over the next several years as part of the current Administration's pledge to refocus national spending and reduce the federal budget deficit. However, management believes that its defense businesses are relatively well-positioned within their respective markets and are focused on products consistent with the current military philosophy, which emphasizes "smart", tactical weapons and lighter, more mobile fighting forces. In addition, management believes that the diversity of the Company's programs and significant sales of replacement products should reduce the impact of cutbacks in, or the elimination of, any individual program or system. Revenue and operating income for the year ended December 31, 1992 increased by $14.2 million and $2.2 million, respectively, when compared to 1991. The increase is associated with increased production and sales of extended range munitions and rocket motors. Airbag Royalties Revenue from airbag royalties increased from $5.6 million in 1992 to $9.6 million in 1993. The improvement was due to an increase in airbags manufactured and sold. The timing and amount of increases in the airbag royalty stream are dependent on several factors, such as the number of vehicles manufactured or sold in the United States, the timing of U.S. car makers' compliance with legislative mandates and the market shares of the licensee (both foreign and domestic), which are beyond the control of the Company. Discontinuance of such royalty payments for any reason would have an adverse impact on the Company's future earnings. (See also Commitments and Contingencies note to the consolidated financial statements.) Royalty income from automotive airbags increased from $3.2 million in 1991 to $5.6 million in 1992. Industrial Products The Industrial Products segment had increased revenue of $12.3 million, or 12.9%, and increased operating income of $2.5 million in 1993 when compared to 1992. The increase in revenue is primarily related to the improved demand for stainless steel bars and rods. Operating results increased due to sales increases and cost reduction and streamlining efforts at the Company's steel and ceramic insulator operations. In 1992, revenue decreased $22.6 million and operating income decreased $.9 million, respectively, when compared to 1991, due to softness in many of the markets served by the industrial segment. Specialty Products The Specialty Products segment had decreases in revenue and operating income in 1993 when compared to 1992 of $4.9 million and $.1 million, respectively. The decrease in earnings was primarily due to the May 1992 disposition of the specialty advertising business. The specialty advertising business had sales of $4.5 million prior to the May 1992 disposition, compared to sales of $13.6 million for the year ended December 31, 1991. Revenue and operating income in 1992 decreased $5.3 million and $.3 million, respectively, over 1991, as a result of the disposition of the specialty advertising business. Realty As noted above, the Company initiated a plan for the orderly disposition of all its remaining real estate assets. In connection with this plan and as the result of an improved real estate market, sales in the Realty segment increased to $6.1 million in 1993 from $1.2 million in 1992. The 1993 operating loss of $4.4 million is an improvement compared with the operating loss of $16.4 million in 1992. Results in 1992 included a $1.4 million pretax charge in the third quarter representing the book value in excess of the fair value of real estate assets transferred to creditors to settle debt associated with such assets and a charge to earnings of $11.9 million to adjust the carrying amount of foreclosed assets held for sale. An extraordinary gain of $1.4 million was also recognized in 1992, which represents the excess of the carrying amount of the debt over the fair value of the properties transferred to creditors. The valuation of one of the Company's major real estate assets (a fully consolidated joint venture, in which the Company's interest was $29.2 million on December 31, 1993) is premised upon the future sale of the property following the completion of planned improvements. While the venture will continue to try to sell this property in its current condition, the Company believes that a sale is not likely unless the joint venture is able to obtain additional financing to perfect and maintain the development entitlements and to construct the necessary infrastructure and other improvements to obtain salable development tracts and lots. If the Company is unable to sell the property in its current condition and is also unable to obtain development financing, the Company could incur a loss of substantially all of its investment in the project. Outstanding senior mortgage debt and related accrued interest of approximately $18.5 million matures in 1994. Although there can be no assurance that the joint venture will be able to restructure the notes to extend their maturities, the notes have been successfully restructured in the past and the Company believes they can be successfully restructured again. It may prove advantageous for the joint venture to consummate its debt restructuring through bankruptcy proceedings, particularly if a significant portion of the debt is converted into equity participation. Real estate sales were $6.0 million in 1991 and the operating loss was $26.9 million. The loss included a $21.0 million pretax, non-cash charge to adjust property values to reflect foreclosures and net realizable value assessments. Realty, continued The estimated net realizable value for each Realty property equals or exceeds its book value. It is currently the Company's intention to dispose of these properties in an orderly process over time. Accordingly, the lower of historical cost or estimated net realizable value is the appropriate carrying value for properties under generally accepted accounting principles. If, however, the Company were to change its intention and any of these properties were sold in bulk at the market values, the Company could incur a material loss. Additionally, if market conditions deteriorate further or continue to remain depressed for an extended period of time (and as a result the sales do not occur as estimated in the net realizable value analyses), the Company may incur material losses. Other Matters In 1993, other income, net of other expenses was $(3.0) million, which compares to $(2.7) million in 1992 and $(1.7) million in 1991. The Company had expenses in connection with holding and developing real estate properties combined with losses from realty joint ventures totalling $4.0 million in 1993, $4.2 million in 1992 and $4.1 million in 1991. Interest income, which is one of the major other components of other income, and is related to the balance in notes receivable and short-term investments, was $.6 million in 1993, $2.7 million in 1992 and $3.0 million in 1991. The effective tax rate on the loss from operations for 1993 is lower than the United States statutory rate due to an unrecognized federal tax carryforward benefit, offset by higher state income taxes, resulting from losses in states where no benefits will be realized due to regulations on carryback and carryforward provisions for such losses. The income tax benefit in 1992 on marginal pretax earnings is the result of a reversal of an accrual for taxes previously accrued due to a favorable tax ruling. Substantially all operations of the Company are located within the United States. The Company operates a steel distribution system in Canada which had sales in 1993 of $11.6 million or 3.6% of consolidated revenue and nominal earnings before income taxes of $3,000. Other Matters, continued Foreign exchange gains and losses for each of the last three years have not been material. The general lack of inflationary pressures in areas where the Company and its subsidiaries operate also limited the impact of changing prices on the Company's sales and income from operations for the three years ended December 31, 1993. During the first quarter of 1993 the Company adopted the Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Company is amortizing an unrecognized transition obligation of approximately $2.0 million over 20 years for the single subsidiary affected by the new pronouncement. For the year ended December 31, 1993 the amortization of the unrecognized transition obligation was approximately $188,000. Current service costs and interest costs for the year were $16,000 and $96,000, respectively. Other pronouncements issued by the Financial Accounting Standards Board with future effective dates are either not applicable or not material to the consolidated financial statements of the Company. As more fully explained in the Commitments and Contingencies note to the Consolidated Financial Statements, litigation between the Company and TRW, the buyer of the Company's airbag business and licensee of the Company's patented and unpatented technology related thereto, has been pending since 1989. In mid-February 1994 TRW filed a new declaratory judgment action asserting claims already made in the existing action and further claiming the Company, through the actions of a subsidiary, breached a non- compete provision of the Asset Purchase Agreement by rendering services to competitors of TRW, and requesting among other things a court order that a contemporaneous notice and payment that TRW sent to the Company are valid, entitling it to terminate the airbag royalty and obtain a paid up license for the Company's airbag technology. The Company intends to resist the claims in all the TRW litigation vigorously, and believes that it has valid defenses against each and that no such claim gives TRW any right to terminate or reduce the airbag royalty payment obligation. A subsidiary of the Company has been named as a potentially responsible party by the Environmental Protection Agency ("EPA") under the Comprehensive Environmental Response Compensation and Other Matters, continued Liability Act in connection with the remediation of the Beacon Heights Landfill in Beacon Falls, Connecticut and has been identified as a potentially responsible party by another company in connection with the Laurel Park Landfill in Naugatuck, Connecticut. Management's review indicates that the Company sent ordinary rubbish and off-specification plastic parts to these landfills and did not send any hazardous wastes to either site. With respect to the Beacon Heights Landfill, a coalition of potentially responsible parties has entered into a consent decree with the EPA to remediate the site. This coalition has in turn brought an action against other potentially responsible parties, including a subsidiary of the Company, to contribute to the cleanup costs. The court hearing this case recently entered an order granting a motion for summary judgment in the Company's favor, which order the Beacon Heights Coalition has indicated it intends to appeal. The Laurel Park Landfill remediation program has not advanced as far as the program at Beacon Heights. A coalition of potentially responsible parties, not including the subsidiary of the Company, has entered into a consent decree and is undertaking remediation of the site. The Laurel Park Coalition has thus far been unsuccessful in its attempts to name the subsidiary in an action for contribution to the remediation costs. Based upon management's review and the status of these proceedings, management believes that these claims will not result in a material adverse impact on the results of operations or the financial position of the Company. In March 1992, a trucking company spilled approximately 500 gallons of solvent on the ground at a facility in Athens, Georgia, formerly operated by a subsidiary of the Company. The current owner of the site initiated emergency response action, ultimately including excavation and off-site disposal of contaminated soil. The current owner has brought an action against the trucking company, seeking reimbursement for emergency response costs and related damages from the spill. In March 1993 the trucking company brought the Company into the litigation pending in United States District Court for the Middle District of Georgia, claiming that an unspecified portion of the remediation costs claimed by the current owner was due to pre-existing soil and groundwater contamination. Other Matters, continued The Company has denied any liability to the trucking company and is separately conducting an investigation of the alleged contamination in cooperation with the current owner of the site. The Company has determined from this investigation that it may face some liability with respect to pre-existing contamination of the site. Based upon remediation estimates received, management believes that any reasonably anticipated losses from the alleged contamination will not result in a material adverse impact on the results of operations or the financial position of the Company. Liquidity and Capital Resources In November 1992, Talley completed a restructuring of substantially all of its existing senior and senior subordinated debt. The restructuring was required following certain covenant defaults resulting from the write-downs in the Company's real estate portfolio between 1989 and 1992. The terms of the restructuring included a principal payment of $40.2 million at the closing. Because over $100 million of the restructured debt was scheduled to mature during 1994 (including approximately $13 million as of June 30, 1994), Talley, in October 1993, completed a major refinancing program. This refinancing program included an offering of $185 million of debt securities, consisting of $70 million gross proceeds of Senior Discount Debentures due 2005, issued by the Company to yield 12.25% and $115 million of Senior Notes due 2003, with an interest rate of 10.75% issued by Talley Manufacturing. In connection with this refinancing, Talley Manufacturing obtained a secured credit facility with institutional lenders. If one of the lenders shall not have sold at least $20 million of its percentage interest in the maximum amount of the facility within 120 days after the closing of the facility, the maximum will be reduced by $10 million. At December 31, 1993 availability under the facility, based primarily on inventory and receivable levels, was $57.1 million, of which $46.7 million was borrowed. The proceeds from the offering and the initial borrowings under the secured credit facility were used to repay substantially all of the Company's previously outstanding non-real estate related debt. Liquidity and Capital Resources, continued The Company anticipates that the new capital structure will support the long-term growth of Talley's core businesses and permit the implementation of its strategy to use proceeds received from the increasing airbag royalties and from the orderly sale of the assets of its real estate operations to reduce its total indebtedness. As a holding company with no significant operating or income- producing assets beyond its stock interest in Talley Manufacturing and the subsidiaries holding its real estate operations, Talley will be dependent primarily upon distributions from those subsidiaries in order to meet its debt service and other obligations. Talley will be entitled to receive certain distributions from Talley Manufacturing (absent certain defaults under Talley Manufacturing indebtedness) for a period of five years, to be used to fund certain carrying and other costs associated with the orderly disposition of Talley's real estate assets. Additional funding is also available for real estate costs from the anticipated redemption of preferred stock of Talley Manufacturing purchased for an agreed upon amount by Talley in connection with the recent refinancing and from a portion of the net cash proceeds from the sale of real estate assets. Talley will be required to use certain funds received from Talley Manufacturing and certain funds from real estate sales to make offers to redeem certain indebtedness of Talley. Because the cash available to Talley is required to be used for these specific purposes, and because certain debt covenants limit Talley's ability to incur additional indebtedness, Talley will be dependent upon the payment of dividends from Talley Manufacturing (which payments will generally be limited by debt covenants of Talley Manufacturing) and to future sales of equity securities as its primary sources of discretionary liquidity. To the extent such sources do not provide adequate funds, Talley may be unable to fund expected costs and improvements associated with its real estate holdings or to make cash interest payments on its outstanding indebtedness when required. Nevertheless, and particularly in light of the absence of requirements for Talley to make cash payments of interest on certain outstanding indebtedness until April 15, 1999, the Company believes that Talley will have funds available in sufficient amounts, and at the required times, to permit Talley to meet its obligations. Liquidity and Capital Resources, continued At December 31, 1993, the Company had $12.2 million in cash and cash equivalents and $63.8 million in working capital. During 1993 the Company generated $3.8 million of cash flow from operating activities. This amount reflects an increase in accounts receivable of $8.6 million, a decrease in inventories of $1.2 million, an increase in accounts payable and accrued expenses totalling $9.4 million and an increase in other assets of $10.8 million. The increase in other assets is primarily deferred debt costs related to the Company's October 1993 refinancing efforts. The Company used $.5 million of cash for investing activities during the year, the result of the $2.8 million received from the sale of the precision potentiometer business, a $2.1 million reduction in long-term receivables and $.3 million proceeds from sale of property and equipment, offset by $5.3 million in capital expenditures and a $.4 million increase in long-term receivables. Proceeds from the Company's fourth quarter new financing of approximately $233 million were used to repay substantially all of the Company's outstanding debt. Borrowings and pay downs under revolving credit facilities, of approximately equal amounts, are also included in financing activities. The Company has not made any dividend payments on its preferred and common stock since the first quarter of 1991, and the ability to pay dividends in the future is limited by the provisions of the Company's debt agreements. Dividends in arrears on preferred shares totaled $6.0 million at December 31, 1993. TALLEY INDUSTRIES, INC. AND SUBSIDIARIES Consolidated Balance Sheet December 31, 1993 1992 ASSETS Cash and cash equivalents $ 12,194,000 $ 10,168,000 Accounts receivable, net of allowance for doubtful accounts of $1,091,000 in 1993 and $867,000 in 1992 60,579,000 48,952,000 Inventories 64,808,000 67,400,000 Deferred income taxes 900,000 1,446,000 Prepaid expenses 9,664,000 7,786,000 Total current assets 148,145,000 135,752,000 Realty assets 117,869,000 108,733,000 Long-term receivables, net 9,900,000 16,858,000 Property, plant and equipment, at cost, net of accumulated depreciation of $82,300,000 in 1993 and $77,426,000 in 1992 49,937,000 53,563,000 Intangibles, at cost, net of accumulated amortization of $13,883,000 in 1993 and $12,619,000 in 1992 44,928,000 47,081,000 Deferred charges and other assets 11,659,000 1,835,000 Total assets $382,438,000 $363,822,000 TALLEY INDUSTRIES, INC. AND SUBSIDIARIES December 31, 1993 1992 LIABILITIES AND STOCKHOLDERS' EQUITY Current maturities of long-term debt $ 2,176,000 $ 10,857,000 Current maturities of realty debt 16,795,000 13,211,000 Accounts payable 23,621,000 19,406,000 Accrued expenses 41,775,000 32,390,000 Total current liabilities 84,367,000 75,864,000 Long-term debt 231,669,000 217,304,000 Long-term realty debt 11,446,000 12,452,000 Deferred income taxes 12,320,000 11,086,000 Other liabilities 6,094,000 6,335,000 Commitments and contingencies - - Stockholders' equity: Preferred stock, $1 par value, authorized 5,000,000; shares issued: 71,000 shares of Series A (71,000 in 1992) ($1,775,000 involuntary liquidation preference) 71,000 71,000 1,548,000 shares of Series B (1,548,000 in 1992) ($30,960,000 involuntary liquidation preference) 1,548,000 1,548,000 120,000 shares of Series D (120,000 in 1992) ($18,000,000 involuntary liquidation preference) 120,000 120,000 Common stock, $1 par value, authorized 20,000,000; shares issued: 10,047,000 shares (9,519,000 in 1992) 10,047,000 9,519,000 Capital in excess of par value 86,026,000 83,537,000 Foreign currency translation adjustments (370,000) (83,000) Accumulated deficit (60,429,000) (53,931,000) 37,013,000 40,781,000 Less 33,000 shares of Common stock in treasury, at cost (471,000) - Total stockholders' equity 36,542,000 40,781,000 Total liabilities and stockholders' equity $382,438,000 $363,822,000 The accompanying notes are an integral part of the financial statements. Notes to Consolidated Financial Statements Significant Accounting Policies Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its majority-owned domestic and foreign subsidiaries. Real estate joint ventures that are majority-owned and under the control of the Company are also included in the consolidated accounts of the Company. All unconsolidated companies are reflected in the financial statements on the equity basis. All material intercompany transactions have been eliminated. Cash and Cash Equivalents: The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Cash equivalents, which consist primarily of commercial paper and money market funds, are stated at cost plus accrued interest, which approximates market. Inventories: Inventories are valued at the lower of cost or market. Cost is determined by the first-in, first-out method for substantially all commercial inventories. Costs accumulated under government contracts are stated at actual cost, net of progress payments, not in excess of estimated realizable value. Realty Assets: Realty assets consist of those parcels and developments which are expected to be sold within the operating cycle of the Realty segment. Historically, the operating cycle of the Realty segment has been three to five years. Realty assets are stated at the lower of historical cost or estimated net realizable value and include land held for sale together with related development and carrying costs (interest and property taxes during development), and equity investments in realty joint ventures. For financial reporting purposes, realty assets must be carried at the lower of historical cost or estimated net realizable value. Net realizable value differs from market value in that, among other things, market value is based on the price obtainable in a bulk cash sale at the present time, considers a potential purchaser's requirement for future profit and discounts the timing of expected cash receipts at a market rate of interest, whereas net realizable value is the Significant Accounting Policies (continued) Realty Assets (continued): price obtainable in the future for individual properties as improved, net of disposal costs, without provision for future profit and without discounting future cash receipts to present value. The estimated net realizable value for each property equals or exceeds its book value. It is currently the Company's intention to dispose of these properties in an orderly process over time. Accordingly, the lower of historical cost or estimated net realizable value is the appropriate carrying value for properties under generally accepted accounting principles. If, however, the Company were to change its intention and any of these properties were sold in bulk at the market values, the Company could incur a material loss. Additionally, if market conditions deteriorate further or continue to remain depressed for an extended period of time (and as a result the sales do not occur as estimated in the net realizable value analyses), the Company may incur material losses. In the fourth quarter of 1992, pursuant to the issuance of Statement of Position (SOP) - No. 92-3 "Accounting For Foreclosed Assets," issued by the American Institute of Certified Public Accountants, the Company changed its accounting for foreclosed assets and adjusted the carrying amount of foreclosed realty assets to reflect the fair value less the estimated costs to sell the assets. Revenue Recognition: Sales are generally recorded by the Company when products are shipped or services performed. Sales under government contracts are recorded when the units are shipped and accepted by the government or as costs are incurred on the percentage-of-completion method. Applicable earnings are recorded pro rata based upon total estimated earnings at completion of the contracts. Anticipated future losses on contracts are charged to income when identified. Airbag royalties are recognized on an accrual basis, based on production of airbag units by the licensee and production and sales of automobiles for airbag units not produced by the licensee. Significant Accounting Policies (continued) Property and Depreciation: Property, plant and equipment are recorded at cost and include expenditures which substantially extend their useful lives. Expenditures for maintenance and repairs are charged to earnings as incurred. With the exception of items being depreciated under composite lives, profit or loss on items retired or otherwise disposed of is reflected in earnings. When items being depreciated under composite lives are retired or otherwise disposed of, accumulated depreciation is charged with the asset cost and credited with any proceeds with no effect on earnings; however, abnormal dispositions of these assets are reflected in earnings. Depreciation of plant and equipment, other than buildings and improvements on leased land, is computed primarily by the straight-line method over the estimated useful lives of the assets. Depreciation of buildings on leased land and amortization of leasehold improvements and equipment are computed on the straight-line method over the shorter of the terms of the related leases or the estimated useful lives of the buildings or improvements. Income Taxes: The Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting For Income Taxes," retroactive to January 1, 1992. This pronouncement requires a Company to recognize deferred tax liabilities and assets for the expected future tax consequences of events that have been recognized in a Company's financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on 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 differences are expected to reverse. United States income taxes are provided on the portion of earnings remitted or expected to be remitted from foreign subsidiaries. Prior to 1992, the provision for income taxes was based on income and expenses included in the accompanying consolidated statements of operations. Differences between taxes so computed and taxes payable under applicable statutes and regulations were classified as deferred taxes arising from timing differences. Significant Accounting Policies (continued) Earnings Per Share: Net earnings per share of Common stock and Common stock equivalents has been computed on the basis of the average number of Common shares outstanding during each year. The average number of shares has been adjusted for assumed exercise at the beginning of the year (or date of grant, if later) for any dilutive stock options, with funds obtained thereby used to purchase shares of the Company's Common stock at the average price during the year, and assumed conversion of all dilutive convertible preferred stock. The conversion of all convertible debt, after elimination of related interest expense, would result in minimal dilution. Common stock equivalents that are anti-dilutive are excluded from the computation of earnings per share and earnings are reduced by the dividend requirements on such equivalents. Intangibles: The excess cost of investments in subsidiaries over the equity in net assets at acquisition date is being amortized using the straight-line method over periods not in excess of 40 years. Loss Applicable to Common Shares: Earnings or loss applicable to Common shares is computed by reducing the net earnings or loss by dividends, including undeclared or unpaid dividends, of the Company's Preferred A, B and D stocks. Interest Rate Swap Agreements: The Company enters into interest rate swap agreements to effectively convert a portion of its floating-rate borrowings into fixed-rate obligations. The interest rate differential to be received or paid is recognized over the lives of the agreements as an adjustment to interest expense. Terminations of such agreements may result in a gain or loss based on interest rates in effect and the calculated market value on the termination date. Such gain or loss would be amortized as a rate adjustment to the underlying debt obligation. Significant Accounting Policies (continued) Accounting For Foreclosed Assets: In Accordance with Statement of Position (SOP) - No. 92-3 "Accounting For Foreclosed Assets," which was issued by the American Institute of Certified Public Accountants in 1992, the Company accounts for and reports the value of foreclosed realty assets at fair value less the estimated costs to sell the assets. Inventories Inventories are summarized as follows: (balances in thousands) 1993 1992 Raw material and supplies $ 10,293 $11,909 Work-in-process 9,584 8,622 Finished goods 26,470 24,919 Inventories substantially applicable to fixed-price government contracts in process, reduced by progress payments of $9,110,000 and $8,344,000 in 1993 and 1992, respectively 18,461 21,950 $64,808 $67,400 Realty Assets The Company has adopted a plan to divest itself of realty assets which is expected to be accomplished over several years. Realty assets at December 31, 1993 of $117,869,000 are primarily unimproved commercial, industrial and mixed use properties. During the fourth quarter of 1991 the Company completed a formal review of its real estate properties held for investment. The review included valuations and appraisals by professional appraisal firms. These reviews were updated during 1992 and 1993. As a result of the 1991 review, the Realty asset reserve and a corresponding non-cash charge to earnings of $21,000,000 was recorded. Pursuant to the 1992 and 1993 updated review, no adjustment to Realty asset values was necessary. In the fourth quarter of 1992, pursuant to the issuance of Statement of Position (SOP) No. 92-3, "Accounting For Foreclosed Assets," issued by the American Institute of Certified Public Accountants, the Company was required to change its accounting for foreclosed assets and adjusted the carrying amount of foreclosed realty assets to reflect the fair value less the estimated costs to sell the assets, which resulted in an $11,908,000 writedown of realty assets and a corresponding charge to earnings of realty operations. Those assets previously had been carried at "net realizable value", which was the proper carrying value for those assets prior to the change in accounting rules. Realty Assets, continued Pretax charges to earnings of $1,166,000 and $1,433,000 were made during 1993 and 1992, respectively, which represented the book value in excess of the fair value of real estate assets transferred to creditors in full payment of non-recourse debt associated with such assets. Extraordinary gains in amounts equal to the charges were also recognized reflecting the settlement of the debt. In reference to the Company's consolidated cash flow in 1993 non-cash Realty asset transactions included an increase in Realty assets and an increase in Realty debt and accrued expenses in the amount of $19,128,000 upon the consolidation of a previously unconsolidated joint venture. Non-cash realty items also included reductions of $4,677,000 due to forfeitures of properties and other transactions. In 1992, non-cash Realty asset transactions included the non-cash writedown related to the change in accounting for foreclosed assets of $11,908,000 and forfeitures of properties in settlement of liabilities and exchanges of assets of $8,744,000. In 1991 non-cash transactions included a $21,000,000 decrease in Realty assets, resulting from the above-mentioned charge which was partially offset by a non-cash increase of $11,038,000, as a result of actual or in-substance foreclosures on notes receivable. At December 31, 1992, the Company had an investment in an unconsolidated Realty joint venture of $29,184,000. During 1993, the joint venture was consolidated with the Company's other operations and accordingly left no investment in unconsolidated joint ventures at December 31, 1993. During the three year period ending December 31, 1993 the joint venture had no sales and no earnings or losses. At December 31, 1993 the Company had an unconsolidated joint venture with no net investment which had assets at December 31, 1993 and 1992 of $6,694,000 and $6,943,000, respectively. Revenues for this unconsolidated joint venture for 1993, 1992 and 1991 were $522,000, $494,000 and $1,679,000, respectively. Net losses for the joint venture for 1993, 1992 and 1991 were $322,000, $1,398,000 and $62,000, respectively. The Company's share of these losses for 1993, 1992 and 1991 were $214,000, $932,000 and $31,000, respectively. Long-Term Receivables Long-term receivables consist of the following: (balances in thousands) 1993 1992 Notes receivable, including accrued interest and income tax refunds $ 10,103 $ 17,344 Amounts due within one year, included in accounts receivable (203) (486) $ 9,900 $ 16,858 Long-term receivables include income tax receivables of $4,264,000. The remaining notes range in length from one to fifteen years and bear interest at December 31, 1993 at rates ranging from 5% to 12%. Payment terms vary by note, but generally require monthly, quarterly or annual interest and principal payments. The notes receivable balance is net of reserves of $2,274,000 and $1,669,000 at December 31, 1993 and 1992, respectively. Notes receivable related to the Realty segment include non-cash reductions of $510,000, resulting from forfeitures, settlements of liabilities and exchanges of assets. Property, Plant and Equipment Property, plant and equipment, is summarized as follows: (balances in thousands) 1993 1992 Machinery and equipment $ 97,054 $ 97,958 Buildings and improvements 32,468 30,312 Land 2,715 2,719 $132,237 $130,989 Depreciation of property, plant and equipment for continuing operations was $8,286,000, $8,667,000, and $9,254,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Long-Term Debt Long-term debt consists of the following: (balances in thousands) 1993 1992 10-3/4% Senior Notes, due 2003 $115,000 $ - 12-1/4% Senior Discount Debentures, $126,255,000 face amount, due 2005 71,667 - Notes, interest based on prime or other variable market rates, due 1998 20,000 126,347 Revolving credit facilities 26,743 17,616 12.87%-14.59% subordinated notes - 38,344 Subordinated notes, interest based on prime or LIBOR - 30,000 12.8% note - 2,954 9% convertible subordinated debentures - 7,677 8-1/8% debentures - 3,894 Capitalized leases and other 435 1,329 233,845 228,161 Less current maturities 2,176 10,857 Long-term debt $231,669 $217,304 On October 22, 1993 the Company completed a major debt refinancing program. The Company received gross proceeds of $70,000,000 from the issuance of Senior Discount Debentures, due 2005, which were issued to yield 12.25%. In addition, Talley Manufacturing and Technology, Inc., ("Talley Manufacturing") a newly formed wholly-owned subsidiary of the Company, which owns all of the Company's subsidiaries (except for the subsidiaries holding the Company's real estate operations), issued $115,000,000 of Senior Notes, due 2003, with an interest rate of 10.75%. Talley Manufacturing also completed a secured credit facility with two institutional lenders. The gross proceeds of the public offerings, plus an initial borrowing under the secured credit facility, after payment of underwriting and other fees and expenses associated with these financings, were used to repay substantially all of the Company's previously outstanding debt. Long-Term Debt, (continued) The indentures for the Senior Notes and the Senior Discount Debentures and the loan agreement relating to the secured credit facility contain covenants requiring specified fixed charge coverage ratios, working capital levels, capital expenditure limits, net worth levels, cash flow levels and certain other restrictions on dividends, other payments and incurrence of debt. As a holding company with no significant operating or income- producing assets beyond its stock interests in Talley Manufacturing and the subsidiaries holding its real estate operations, Talley is dependent primarily upon distributions from these subsidiaries to meet its debt service and other obligations. Payments from the subsidiaries are generally limited by the debt covenants of Talley Manufacturing. Substantially all of the receivables, inventory and property, plant and equipment of Talley Manufacturing and its subsidiaries are pledged as collateral in connection with the secured credit facility. In addition, the subsidiaries of Talley Manufacturing have guaranteed Talley Manufacturing's obligations under the Senior Notes and the secured credit facility and Talley has guaranteed the Senior Notes on a subordinated basis. The capital stock of Talley Manufacturing has been pledged by Talley to secure the Senior Discount Debentures. The Senior Notes mature on October 15, 2003 and Talley Manufacturing is required to make mandatory sinking fund payments of $11,500,000 on October 15, in each of 2000, 2001 and 2002. Interest is payable semi-annually, commencing April 15, 1994. The Senior Discount Debentures mature on October 15, 2005. No interest on the Discount Debentures will be payable until April 15, 1999, when interest will be payable semi-annually on April 15 and October 15 of each year. In the event that certain financial and other conditions are satisfied, the Discount Debentures require prepayments based on defined levels of airbag royalties received and proceeds from real estate sales. The secured credit facility consists of a five year revolving credit facility of up to $40,000,000 and a five year $20,000,000 term loan facility. The balance outstanding under the revolving credit facility at December 31, 1993 was $26,743,000. Upon the occurrence of certain specified events at any time following the third anniversary of the facility, the agent thereunder may elect to terminate the facility. The five-year term facility requires monthly amortization payments based on a seven year amortization schedule, with the balance due upon expiration in October 1998. The credit facility interest rate is prime plus one percent with an additional fee of one-quarter of one percent on unused amounts under the revolving facility. Long-Term Debt, (continued) Aggregate maturities of long-term debt for the years ending December 31, 1994 through December 31, 1998, are $2,176,000, $3,216,000, $3,233,000, $3,094,000 and $35,461,000, respectively. Cash payments for total interest, net of amounts capitalized, during 1993, 1992 and 1991 were $21,675,000, $30,459,000 and $32,465,000, respectively. Accrued interest expense at December 31, 1993, 1992 and 1991 was $10,999,000, $3,689,000 and $5,453,000, respectively. Included in deferred charges at December 31, 1993 are debt costs of $11,362,000. The costs were incurred in 1993 in connection with the newly issued debt and are being amortized over the life of the respective debt instruments. Amortization of debt expense in 1993 was $952,000, including $296,000 related to the new debt. Total capitalized lease obligations on buildings and equipment included in long-term debt at December 31, 1993 is $436,000, of which $124,000 is due within one year. Realty Debt Realty debt consists primarily of amounts payable in connection with properties acquired by the Company's real estate operations. The various notes bear interest at rates ranging from 7.6% to 12.0% with maturities ranging from 1994 through 2004. Payment terms vary by note, but generally require monthly, quarterly or annual interest and principal payments. Realty debt at December 31, 1993 and 1992 was $28,241,000 and $25,663,000, respectively. Aggregate maturities of Realty debt for the years ending December 31, 1994 through 1998 are $16,795,000, $4,111,000, $5,357,000, $560,000 and $232,000, respectively. Realty debt is collateralized by properties and notes receivable of the Company's real estate operations with a carrying value of approximately $103,000,000. Stock Options At December 31, 1993, under the 1990 and 1978 Stock Option Plans, 544,000 and 478,000 shares of Common stock, respectively, were reserved for sale to officers and employees. The plans require incentive stock option prices to be no less than the market value of the stock at the date of grant and that all options, incentive and non-qualified, become exercisable in ten years or less from the date of grant, as specified in the individual grants. During the year ended December 31, 1993 438,000 options were granted under the 1990 Stock Option Plan and 132,000 grants were made under the 1978 Stock Option Plan. During the year ended December 31, 1993, no options were exercised under either of the two stock option plans. There were 63,000 options that expired or were canceled under the 1978 Stock Option Plan during the year ended December 31, 1993. Prior to 1993 there were no options granted under the 1990 Stock Option Plan. Stock Options, (continued) In 1992, no options were exercised and 49,500 options were canceled under the 1978 Stock Option Plan. In 1991, no options were exercised, and 58,750 options were canceled under the 1978 Stock Option Plan. At December 31, 1993, there were 856,000 total options outstanding at an average price of $6.09, with 205,000 options exercisable. At December 31, 1992, 335,000 options were outstanding at an average price of $9.53 with 211,000 exercisable. Common stock reserved for future option grants under the 1978 Plan amounted to 60,000 and 130,000 shares at December 31, 1993 and 1992, respectively. Common stock reserved for future option grants under the 1990 Plan amounted to 105,000 and 444,000 at December 31, 1993 and 1992, respectively. During the year ended December 31, 1993, 476,000 and 52,000 shares were issued under the 1983 Long-Term Incentive Plan and the 1983 Restricted Stock Plans, respectively. There were no shares issued under either of these Plans in 1992 or 1991. Capital Stock Each share of Series A Convertible Preferred stock entitles its holder to receive an annual cash dividend of $1.10 per share; to convert it into .95 of a share of Common stock, as adjusted in the event of future dilution; to receive up to $25.00 per share in the event of involuntary or voluntary liquidation; and, subject to certain conditions in loan agreements, may be redeemed at the option of the Company at a price of $25.00 per share. Each share of Series B $1.00 Cumulative Convertible Preferred stock entitles its holder to receive an annual cash dividend of $1.00 per share; to convert it into 1.31 shares of Common stock, as adjusted in the event of future dilution; to receive up to $20.00 per share in the event of involuntary or voluntary liquidation; and, subject to certain conditions in loan agreements, may be redeemed at the option of the Company at a price of $52.50 per share. Each share of Common stock has a preferred stock purchase Right attached, allowing the holder, upon the occurrence of a change in control, as defined in a Rights agreement, to buy one one-hundredth of a share of Series C Junior Participating Preferred stock at an exercise price of $70. The Series C stock, which may be purchased upon exercise of the Rights, is nonredeemable and junior to other series of the Company's preferred stock. No shares of Series C stock have been issued as of December 31, 1993. Capital Stock, (continued) Each share of Series D Convertible Preferred stock entitles its holder to receive an annual cash dividend of $4.50 per share ($15.75 after February 28, 1998); to convert it into 10 shares of Common stock, as adjusted in the event of future dilution; to receive $150 per share ($175 after February 28, 1998) in the event of involuntary or voluntary liquidation; and subject to certain conditions in loan agreements, may be redeemed at the option of the Company at the higher of $150 per share ($175 after February 28, 1998) or the average of the conversion value per share for the last ten trading days prior to redemption (not to exceed $200 per share). Dividends on the shares of Series A, Series B and Series D Preferred stock are cumulative and must be paid in the event of liquidation and before any distribution to holders of Common stock. The Company has not made any dividend payments on its preferred and common stock since the first quarter of 1991, and the ability to pay dividends in the future is limited by the provision of the Company's debt agreements. Cumulative dividends on preferred shares that have not been declared or paid since the first quarter of 1991 are approximately: Series A - $215,000 ($3.025 per share), Series B - $4,258,000 ($2.750 per share) and Series D - $1,489,000 ($12.375 per share). The failure to pay the regular quarterly dividends for the first three quarters of 1992 on the Preferred stock gave rise at that time to the right of the holders of the three series to elect two directors to the Company's Board of Directors. At December 31, 1993 there were 5,161,000 shares of Common stock reserved for conversion of preferred stock, for exercise of stock options, and for issuance of shares under the Employee Stock Purchase Plan. Leases Rental expense for continuing operations (reduced by rental income from subleases of $340,000 in 1993, $693,000 in 1992 and $741,000 in 1991) amounted to $5,622,000 in 1993, $6,641,000 in 1992 and $7,203,000 in 1991. Aggregate future minimum rental payments required under operating leases having an initial lease term in excess of one year for years ending December 31, 1994 through December 31, 1998 are $4,410,000, $4,087,000, $3,079,000, $2,026,000 and $1,921,000, respectively, with $1,285,000 payable in future years. Minimum operating lease payments have not been reduced by future minimum sublease rentals of $653,000. Leases, (continued) Aggregate future minimum payments under capital leases for years ending December 31, 1994 through December 31, 1997 are $172,000, $170,000, $170,000 and $18,000, respectively, with no payments in later years. Minimum capital lease payments have not been reduced by future minimum sublease rentals of $755,000. The present value of net minimum lease payments is $436,000 after deduction of $94,000, representing interest and estimated executory costs. The net book value of leased buildings and equipment under capital leases at December 31, 1993 and 1992 amounted to $324,000 and $435,000, respectively. Employee Benefit Plans The Company and its subsidiaries have pension plans covering a majority of its employees. Normal retirement age is 65, but provisions are made for early retirement. For subsidiaries with defined benefit plans, benefits are generally based on years of service and salary levels. Contributions to the respective defined contribution plans are based on each participant's annual pay and age. Pension expense for continuing operations in 1993, 1992 and 1991 was $5,394,000, $4,085,000 and $5,999,000, respectively. The Company generally contributes the greater of the amounts expensed or the minimum statutory funding requirements. Pension costs for continuing operations for defined benefit plans include the following components: (balances in thousands) 1993 1992 1991 Service cost-benefits earned during the year $ 1,594 $ 1,251 $ 2,664 Interest cost on projected benefit obligation 2,504 2,327 2,090 Actual return on assets (5,712) (3,313) (8,985) Net amortization and deferral 3,173 550 7,296 Net pension cost $ 1,559 $ 815 $ 3,065 Employee Benefit Plans, (continued) The following table sets forth the aggregate funded status of defined benefit plans at December 31, 1993: Assets Exceed Accumulated Accumulated Benefits (balances in thousands) Benefits Exceed Assets Fair value of plan assets $ 39,879 $ 1,535 Projected benefit obligation (36,524) 1,948 Projected benefit obligation (in excess of) or less than plan assets 3,355 (413) Unrecognized net loss (gain) (3,826) (143) Unrecognized prior service cost (279) 5 Unrecognized net liability 725 551 Unfunded accumulated benefit obligation - (413) Accrued pension liability $ (25) $ (413) Accumulated benefits $ 36,524 $ 1,948 Vested benefits $ 30,996 $ 1,932 In accordance with Statement of Financial Accounting Standards No. 87 "Employers' Accounting for Pensions," the Company has accrued a liability of $413,000 representing the unfunded accumulated benefit obligation, and has recognized an equal amount as an intangible asset. Assumptions used in 1993 to develop the net periodic pension costs were: Assumed discount rate 7.0% Assumed rate of compensation increase 5.0% Expected rate of return on plan assets 9.0% Assets of the Company's pension plans consist of marketable equity securities, guaranteed investment contracts and corporate and government debt securities. The total value of defined benefit plan assets exceed total vested benefits by $8,486,000. Effective January 1, 1984, the Company established an employee stock purchase plan for eligible U.S. employees. Each eligible employee who elects to participate may contribute 1% to 5% of his or her pretax compensation from the Company. The Company contributes an amount equal to 50% of the employee contributions. Employee Benefit Plans, (continued) During 1991, 1992 and 1993 the Company also made discretionary contributions. Pursuant to a 1986 amendment to the Plan which gives the Administration Committee authority to direct the trustee to borrow funds to purchase Company securities, a promissory note for $2,000,000 was executed on April 17, 1989 to purchase 141,500 shares of Talley Industries, Inc. Common stock. Company contributions to the Plan were used, in part, by the Employee Stock Ownership Plan (ESOP) to make loan and interest payments. As the loan is repaid, a portion of the Common stock acquired by the Plan is allocated to each employee in amounts based on the beginning of month balances of the respective participant's accounts. Total Company contributions during 1993 and 1992 were $692,000 and $781,000, respectively. On October 22, 1993, the Company paid down the loan as part of the debt refinancing program. As a result, the Company acquired the securities not allocated to the Plan. Treasury stock valued at $471,000 at December 31, 1993 represents the shares to be allocated to the Plan upon receipt of future payments from the Plan. Interest expense on the amount payable by the Plan for 1993 and 1992 was $26,000 and $48,000, respectively. Any dividends received on the shares held by the ESOP are reinvested in shares of Company stock. No dividends were received during 1992 and 1993. Health care and life insurance benefits are presently provided to a small number of retired employees of one of the Company's subsidiaries. The cost of retiree health care and life insurance benefits are minor in amount and are recognized as benefits are paid. The Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in the first quarter of 1993, as required by the pronouncement. The transition obligation of approximately $2,000,000 is being amortized over a 20 year period. The amortization of the unrecognized transition obligation for the single subsidiary affected by the new pronouncement was $188,000 in 1993. Current service costs and interest costs for 1993 were approximately $16,000 and $96,000, respectively. Income Taxes Earnings from continuing operations before income taxes and the provision (credit) for income taxes consists of the following: (balances in thousands) 1993 1992 1991 Earnings (loss) before income taxes: United States $ (3,229) $(18,623) $(42,704) Foreign 3 (528) (355) $ (3,226) $(19,151) $(43,059) Current tax expense (credit): United States $ 347 $ 953 $(12,451) Foreign 59 (285) 49 State and local 581 921 (604) 987 1,589 (13,006) Deferred tax expense (credit): United States (347) (953) 12,408 Foreign 8 94 (112) State and local 2,120 (2,677) 1,635 1,781 (3,536) 13,931 $ 2,768 $ (1,947) $ 925 In 1992, the Company adopted the Statement of Financial Accounting Standards No. 109 "Accounting For Income Taxes." The adoption of SFAS No. 109 changes the Company's method of accounting for income taxes from the deferred method to an asset and liability approach. The adoption had no effect on earnings in 1992. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. Temporary differences and carryforwards which give rise to a significant portion of deferred tax assets and liabilities for 1993 and 1992 are as follows: (balances in thousands) 1993 1992 Gross deferred tax assets: Net operating losses and tax credit carryforward $ 8,964 $ 1,332 Reserves on realty assets 12,201 17,285 Debt restructuring charges - 3,966 Accrued expenses 7,919 5,658 Other 1,518 1,153 Valuation allowance for deferred tax assets (25,597) (22,167) Net deferred tax asset 5,005 7,227 Gross deferred tax liabilities: Depreciation 7,642 8,396 Accrued expenses 7,606 6,163 Other 1,177 2,308 Gross deferred tax liability 16,425 16,867 Net deferred tax liabilities $ 11,420 $ 9,640 Income Taxes (continued) The sources of significant timing differences for 1991 which gave rise to deferred taxes and their effects were as follows: (balances in thousands) 1991 Depreciation $ (911) Restructuring 972 Losses on realty assets not utilized 10,602 Other 3,268 $ 13,931 Reasons for the differences between the amount of income tax determined by applying the applicable statutory federal income tax rate to pretax income from continuing operations are: 1993 1992 1991 Computed tax at statutory U.S. tax rates $(1,098) $ (6,511) $(14,640) Operating losses not utilized 1,098 6,525 14,597 State and local taxes 2,701 (1,756) 1,031 Other 67 (205) (63) $ 2,768 $ (1,947) $ 925 United States income taxes have not been provided on $2,800,000 of undistributed earnings from continuing operations of subsidiaries incorporated outside the United States, since it is the Company's intent to reinvest such earnings. Net cash receipts for income taxes during 1993, 1992 and 1991 were $828,000, $10,491,000 and $7,332,000, respectively. At December 31, 1993, the Company had an unrecognized net operating loss carryforward for financial statement purposes of approximately $67,000,000. The Company's 1993 net operating loss for federal tax purposes of approximately $21,000,000 is available for carryforward for 15 years. In addition, the Company has alternative minimum tax credits of approximately $1,700,000 which can be utilized against regular taxes in the future. During the second quarter of 1992, the Company was granted a favorable state income tax ruling and, as a result, recognized a tax benefit of $3,508,000. Commitments and Contingencies TRW Claims. Litigation between the Company and TRW has been pending in the United States District Court in Phoenix, Arizona since November 1989. Certain of the claims raised in this litigation have previously been resolved by two arbitration proceedings, but other claims remain outstanding. The outstanding claims repeat allegations from the arbitration regarding deficiencies in the airbag plant, insufficient real estate to permit construction of certain additional facilities and misrepresentations concerning the airbag plant capacity. During the second quarter of 1992, an arbitration panel made its determination on the TRW's $34.0 million plant claim and awarded TRW a judgment of $5.1 million, which has been paid by the Company. Based on the outcome of the 1992 arbitration decision, and on consultation with counsel the Company believes that TRW's remaining claims are not well founded and were resolved by the 1992 arbitration decision. After submission to arbitration, discovery was stayed. Other than for the amounts claimed in the arbitration, TRW has not claimed a specific dollar amount with respect to those issues in the 1989 action. It is not possible, therefore, to quantify any damages claimed or to predict with certainty the ultimate outcome. In April 1993, a second arbitrator made his determination on the TRW accounting claim and denied any award. In mid-February 1994 TRW filed a new declaratory judgment action asserting claims already made in the existing action and further claiming the Company, through the actions of a subsidiary, breached a non-compete provision of the Asset Purchase Agreement by rendering services to competitors of TRW, and requesting among other things a court order that a contemporaneous notice and payment that TRW sent to the Company are valid, entitling it to terminate the airbag royalty and obtain a paid up license for the Company's airbag technology. Based on interviews with Company and subsidiary personnel, review of relevant documents, and consultation with counsel, the Company believes that TRW's notice and attempted payment are without any merit and believes that various legal and factual defenses are available to the allegations and claims made by TRW. The Company has not had any discovery into the motives and claimed basis for this latest move by TRW, nor has it decided the manner or magnitude of the claims that it will make against TRW, including, but not limited to, loss of royalties due to mismanagement of TRW's airbag business. The Company intends to resist the claims in all the TRW litigation vigorously, and believes that it has valid defenses against each and that no such claim gives TRW any right to terminate or reduce the airbag royalty payment obligations. Commitments and Contingencies (continued) Environmental. A subsidiary of Talley Manufacturing has been named as a potentially responsible party by the Environmental Protection Agency ("EPA") under the Comprehensive Environmental Response Compensation and Liability Act in connection with the remediation of the Beacon Heights Landfill in Beacon Falls, Connecticut and has been identified as a potentially responsible party by another company in connection with the Laurel Park Landfill in Naugatuck, Connecticut. Management's review indicates that the Company sent ordinary rubbish and off-specification plastic parts to these landfills and did not send any hazardous wastes to either site. Two coalitions of potentially responsible parties have entered into consent decrees with the EPA to remediate the sites. The Beacon Heights Coalition has in turn brought an action against other potentially responsible parties, including one of the Company's subsidiaries, to contribute to cleanup costs. The court hearing this case recently entered an order granting a motion for summary judgment in the Company's favor, which order the Beacon Heights Coalition has indicated it intends to appeal. The Laurel Park Landfill remediation program has not advanced as far as the program at Beacon Heights. A coalition of potentially responsible parties, not including the subsidiary of the Company, has entered into a consent decree and is undertaking remediation of the site. The Laurel Park Coalition has thus far been unsuccessful in its attempts to name the subsidiary in an action for contribution to the remediation costs. Based upon management's review and the status of these proceedings, management believes that any reasonably anticipated losses from these claims will not result in a material adverse impact on the results of operations or the financial position of the Company. In March 1992, a trucking company spilled approximately 500 gallons of solvent on the ground at a facility in Athens, Georgia, formerly operated by a subsidiary of the Company. The current owner of the site initiated emergency response action, ultimately including excavation and off-site disposal of contaminated soil. The current owner has brought an action against the trucking company, seeking reimbursement for emergency response costs and related damages from the spill. In March 1993 the trucking company brought the Company into the litigation pending in United States District Court for the Middle District of Georgia, claiming that an unspecified portion of the remediation costs claimed by the current owner was due to pre-existing soil and groundwater contamination. The Company has denied any liability to the trucking company and is separately conducting an investigation of the alleged contamination in cooperation with the current owner of the site. The Company has determined from this investigation that it may face some liability with respect to pre-existing contamination of the site. Based upon remediation estimates received, management believes that any reasonably anticipated losses from the alleged contamination will not result in a material adverse impact on the results of operations or the financial position of the Company. Commitments and Contingencies (continued) Environmental, continued. In September 1990, the Department of Environmental Quality of the State of Arizona brought a civil action against a subsidiary of Talley Manufacturing claiming violations of various environmental regulations. The subsidiary met with agency officials to resolve the dispute, and in connection therewith paid $0.5 million as civil penalty. The subsidiary also agreed to certain restrictions and procedures imposed by the State of Arizona relating to the disposal of hazardous waste; the Company does not anticipate that the agreed restrictions and procedures will interfere with operations or result in any significant expense. Tax. The Arizona Department of Revenue issued Notices of Correction of Income Tax dated March 17, 1986 to the Company for the fiscal year ending March 31, 1983. These Notices pertain to whether subsidiaries of the Company must file separate income tax returns in Arizona rather than allowing the Company to file on a consolidated basis. The amount of additional Arizona income tax alleged to be due as a result of the Notices of Correction was $0.4 million plus interest. In May 1992 the Arizona Tax Court granted judgment in favor of the Company and against the Department on all claims asserted against the Company. In October 1992 the Tax Court entered judgment in favor of the Company awarding the Company approximately $0.6 million for the Arizona income taxes the Company overpaid for its fiscal year ending March 31, 1983 together with interest and attorneys' fees. The judgment entered by the Tax Court was appealed by the Department and is currently pending before the Arizona Court of Appeals. In May 1993, the Arizona Department of Revenue issued assessments with respect to calendar years 1984 through 1989 alleging that the Company owes additional Arizona income tax and interest in the amount of $16.6 million. Management's preliminary review of the assessments indicates that they were calculated on essentially the same basis used by the Department in its previous claims for income tax due with respect to its fiscal year ended March 31, 1983. However, due to a change in the applicable law for tax years commencing after 1985, the outcome of the litigation currently pending involving 1983 is not necessarily indicative of the merits or possible outcome of the claims made by the Arizona Department of Revenue for the periods commencing after 1985. Nevertheless, the Company intends to vigorously litigate the recent assessments. Notwithstanding such change in the law, based upon the 1992 rulings of the Arizona Tax Court in favor of the Company, advice from its counsel and the Company's income tax reserves, management believes that these assessments will not result in a material adverse impact on the results of operations or the financial position of the Company. Fair Value of Financial Instruments The carrying amount of cash and cash equivalents approximates fair value because of the short maturity of those instruments. Long-term receivables and Realty debt instruments have been issued in connection with the Company's real estate operations and as a result of foreclosure, forfeiture and renegotiation of such instruments in conjunction with the constant evaluation of the real estate portfolio it is believed that the fair value of such instruments as they have been restructured, or renegotiated, approximates the carrying value of these instruments. On October 22, 1993 the Company completed the refinancing of substantially all of the Company's debt as more fully explained in the long-term debt note to the financial statements. Consequently, at December 31, 1993 the estimated fair value of long-term debt is approximately equal to the carrying value. The Company has the right to receive royalty payments under a license agreement executed in April 1989 in connection with the sale of its airbag operations to TRW, Inc. Under the agreement, the Company is entitled to receive royalties for the twelve year period commencing May 1, 1989 and ending April 30, 2001. The rates at which these royalties are to be paid are; $1.14 for each airbag unit manufactured and sold anywhere in the world by TRW and its subsidiaries (this amount increases by $.01 per unit on May 1 of each year of the royalty term); 75% of the per-unit amount specified above for each inflator manufactured and sold anywhere in the world by TRW and subsidiaries; and $.55 for each airbag unit supplied by companies other than TRW for use in a vehicle manufactured or sold in North America. The fair value of the royalty stream is dependent upon automobile production, the number of produced vehicles with airbag systems and the market share of TRW, Inc.; accordingly, the fair value cannot be estimated. Royalties recognized in the year ending December 31, 1993 were $9,606,000. Research and Development Costs Research and development costs were $3,122,000, $3,904,000 and $4,223,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Extraordinary Gains (Loss) As a result of the termination of the interest swap agreement and the payoff of the underlying debt in 1993, the Company recognized an extraordinary loss of $1,670,000. Due to the consolidated tax position of the Company there was no tax benefit recognized in connection with this loss. During December 1993, an extraordinary gain of $1,166,000 was recognized in Extraordinary Gains (Loss) (continued) connection with the transfer of real estate assets to creditors to settle debt associated with such assets. The gain represents the excess of the carrying value of the debt over the fair value of the properties transferred to the creditor. Included in losses from operations is a corresponding charge representing the book value in excess of the fair value of the properties transferred. During June 1992, the Company completed two transactions in which it exchanged 200,824 and 519,922 newly issued shares of its common stock with institutional investors for $1,200,000 principal amount of its 9% convertible subordinated debentures and $2,100,000 principal amount of its 12.87% subordinated notes, respectively. An extraordinary gain of $1,204,000 was recognized in connection with the extinguishment of debt. Due to the tax position of the Company there were no taxes applicable to the exchange of shares. An extraordinary gain was also recognized in the third quarter of 1992 with the transfer of real estate assets to creditors to settle debt associated with such assets. The gain of $1,433,000 represents the excess of the carrying amount of the debt over the fair value of the properties transferred to the creditors. Included in losses from operations is a corresponding $1,433,000 charge representing the book value in excess of the fair value of the properties transferred. Acquisitions and Dispositions As part of its restructuring plans the Company sold the net assets of its precision potentiometer business in July 1993, for a cash purchase price of $2,756,000, which approximated the book value of the net assets sold. On May 19, 1992 the Company sold the net assets of its specialty advertising subsidiary for $7,866,000, which was approximately $400,000 below its book value. In connection with restructuring efforts the Company recorded 1991 fourth quarter pretax charges to earnings of $5,000,000. Restructuring costs were for restructuring fees to lenders and professional services in connection with the Company's restructuring of its debt and costs incurred as a part of downsizing of, or relocations of, subsidiary operations in connection with cost control efforts. The excess of cost over tangible and identifiable intangible assets acquired, net of amortization at December 31, 1993, 1992 and 1991 was $43,696,000, $45,501,000 and $50,299,000, respectively. Discontinued Operations On May 30, 1991 the Company sold its federal savings bank, (which was acquired on January 30, 1989), for $41.6 million cash, which approximated book value on the date of closing. For the five months ended May 31, 1991 net interest income for the savings bank operations was $8,418,000. Earnings from the discontinued savings bank operations for the five months preceding the sale was $825,000. Related Party Transactions In each of the last three years the Company and its subsidiaries incurred legal fees payable to the law firm of one of the Company's directors. During 1993, 1992 and 1991 total billings for the firm were $715,000, $1,045,000 and $422,000, respectively, and were for foreign and domestic services relating to litigation and general corporate matters. Fees were paid to a second law firm in 1993 of $329,000. A 1993 addition to the Company's board of directors was a partner in such firm until he retired in June 1993. Recently Issued Accounting Standards At the beginning of 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The new standard requires that companies use the accrual method of accounting to expense the estimated cost of providing postretirement health-care and other benefits over the years of each employee's active service. In 1992, the Company elected early adoption of the provisions of Statement of Accounting Standard No. 109, "Accounting For Income Taxes," which is more fully explained in the "Significant Accounting Policies" and "Income Taxes" Notes to Consolidated Financial Statement. Also in 1992, pursuant to the issuance of Statement of Position (SOP) No. 92-3, "Accounting For Foreclosed Assets," issued by the American Institute of Certified Public Accountants, the Company changed its accounting for foreclosed assets and adjusted the carrying amount of foreclosed realty assets to reflect the fair value less the estimated costs to sell the assets, which resulted in an $11,908,000 writedown of realty assets and a corresponding charge to earnings from operations. Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" was issued in November 1992 and requires adoption no later than fiscal years beginning after December 15, 1993. This Statement establishes accounting standards for employers who provide benefits to former Recently Issued Accounting Standards (continued) or inactive employees after employment but before retirement. The Company does not presently provide any material postemployment benefits defined in this pronouncement. Other pronouncements issued by the Financial Accounting Standards Board or other rule making body, with future effective dates, are either not applicable or not material to the consolidated financial statements of the Company. Segment Operations The Company is a diversified manufacturer of a wide range of proprietary and other specialized products for defense, industrial and commercial applications. Through its Government Products and Services segment, the Company manufactures an extensive array of propellant devices and electronic components for defense systems and commercial applications and provides naval architectural and marine engineering services. The Company participates in the rapidly expanding market for automotive airbags through its royalty agreement with TRW, which provides the Company with a quarterly royalty payment through April 30, 2001 for any airbag manufactured and sold by TRW worldwide and for any other airbag installed in a vehicle manufactured or sold in North America. Talley's Industrial Products segment manufactures and distributes stainless steel products, high-voltage ceramic insulators used in the power transmission and distribution systems, and specialized welding equipment and systems. The Company's Specialty Products segment manufactures and sells aerosol insecticides, air fresheners and sanitizers, and custom designed metal buttons. The Company is also engaged in the orderly sale of the assets of its real estate operations. Government Products and Services The Company's Government Products and Services segment provides a wide range of products and services for government programs. The vast majority of the Company's products are smaller components of larger units and systems and are generally designed to enhance safety or improve performance. A significant portion of the Company's government revenue represents the replacement of existing Company products. The Company manufactures proprietary propellant products which, when ignited, produce a specified thrust or volume of gas within a desired time period. Propellant products manufactured include ballistic devices for aircraft ejection systems, rocket motors, extended range munitions components and dispersion systems. Segment Operations, (continued) Government Products and Services, continued The Company's propellant devices are currently used on ejection seats on high performance domestic and foreign military aircraft. Rocket motors manufactured by the Company include a complete line of rocket boosters and propulsion systems used for reconnaissance, surveillance, and target acquisition. The Company's extended range munitions components utilize propellant technologies to significantly extend the range of existing U.S. artillery. Naval architecture and marine engineering services provided by the Company include detail design and engineering services for new military and commercial construction as well as a significant amount of maintenance and retrofit work for existing ships. The Company's Government Products and Services segment also manufactures specialized electronic display and monitoring devices and high performance cable connection assemblies. Direct sales to the U.S. Government and its agencies, primarily from the Government Products and Services segment accounted for approximately 24%, 32% and 28% of the Company's sales from continuing operations for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993 and 1992 the amount billed but not paid by customers under retainage provisions in long-term contracts was $1,402,000 and $1,659,000, respectively. The $1,402,000 receivable under retainage provisions is expected to be collected in 1994 through 1997 in the amounts of $288,000, $100,000, $168,000 and $846,000, respectively. Amounts in process but unbilled at December 31, 1993 and 1992 were $5,425,000 and $6,396,000, respectively. Airbag Royalties The Company participates in the rapidly expanding market for automotive airbags through its royalty agreement with TRW. The Company entered into the Airbag Royalty Agreement as part of the 1989 sale of its automotive airbag manufacturing business. The terms of the Airbag Royalty Agreement require TRW to make quarterly royalty payments to Talley through April 30, 2001 for any airbag units manufactured and sold worldwide by TRW as well as for any other airbags installed in vehicles manufactured or sold in North America. Industrial Products The Company's Industrial Products segment operates in three product areas: stainless steel, high-voltage ceramic insulators and automated welding equipment. Demand for these products is directly related to the level of general economic activity. Through its stainless steel operation, the Company operates a state-of-the-art mini-mill which converts purchased stainless steel Segment Operations, (continued) Industrial Products, continued billets into a variety of sizes of both hot rolled and cold finished bar and rod. The Company's stainless steel mini-mill has utilized advanced computer automation, strict quality controls, and strong engineering and technical capabilities to maintain its position as a low cost, high quality producer. In addition to its stainless steel manufacturing operation, the Company distributes stainless steel and other specialty steel products through seven locations in the U.S. and Canada. The Industrial Products segment also manufactures and distributes high-voltage ceramic insulators for electric utilities, municipalities and other governmental units, as well as for electrical contractors and OEMs. In addition, Talley manufactures specialized advanced-technology welding systems, power supply systems and humidistats for the utility, pipeline and OEM markets. Specialty Products The Company's Specialty Products segment is focused on two distinct markets: aerosol insecticides, air fresheners and sanitizers servicing the industrial maintenance supply, pest control and agricultural markets, and custom designed metal buttons for the military and commercial uniform and upscale fashion markets. The majority of the Company's aerosol insecticides are proprietary formulations of natural active ingredients. Realty In 1992, management adopted a plan to dispose of the Company's real estate operations, reflecting a strategic decision to exit this business. Talley's real estate portfolio consists primarily of undeveloped commercial, industrial and residential land located in the greater Phoenix, San Diego and San Antonio areas. The Company's U.S. operations had export sales of $26,672,000, $16,216,000 and $30,095,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Substantially all facilities and operations of the Company's continuing operations are located within the United States. The Company operates a steel distribution system located in Canada with sales for the year ended December 31, 1993 and total assets at December 31, 1993 of $11.6 million and $8.0 million, respectively. Foreign exchange losses included in earnings for the years ended December 31, 1993, 1992 and 1991 were not material. The foreign currency translation adjustment included in stockholders' equity decreased from $(83,000) at December 31, 1992 to $(370,000) at December 31, 1993. Segment Operations, (continued) Sales between segments are not significant and have been eliminated. Operating income is total revenue less operating expenses and excludes general Corporate expenses, non-segment interest income and interest expense. Interest income associated with segment assets is included in segment operations income. Corporate assets consist principally of cash and cash equivalents, notes receivable, income taxes receivable and a building. Segment Operations (continued) The tables which follow show assets, depreciation and amortization and capital expenditures by segment: (in thousands) 1993 1992 1991 Assets by Segment Government Products and Services $114,347 $113,385 $119,489 Airbag Royalties 3,704 1,644 2,260 Industrial Products 86,879 83,904 95,656 Specialty Products 27,951 27,190 38,825 Realty 121,355 116,064 136,713 354,236 342,187 392,943 Corporate 28,202 21,635 73,948 $382,438 $363,822 $466,891 Depreciation and Amortization by Segment Government Products and Services $ 4,163 $ 4,235 $ 4,227 Airbag Royalties - - - Industrial Products 4,427 4,616 4,739 Specialty Products 1,138 1,319 1,785 Realty 15 33 40 9,743 10,203 10,791 Corporate 342 395 444 $ 10,085 $ 10,598 $ 11,235 Capital Expenditures by Segment Government Products and Services $ 1,648 $ 2,122 $ 4,766 Airbag Royalties - - - Industrial Products 2,842 1,045 804 Specialty Products 754 1,101 936 Realty 1 28 8 5,245 4,296 6,514 Corporate 102 296 61 $ 5,347 $ 4,592 $ 6,575 Summary of Segment Operations, (continued) Operating income in 1992 includes a charge to earnings of $11,908,000 to adjust the carrying value of foreclosed assets of the Realty segment. Operating income in 1991 includes a pretax provision for a reserve on real estate assets of $21,000,000 and an increase to the restructuring reserve of $5,000,000. Operating income in 1990 includes a charge of $15,000,000 related to the Company's restructuring program and the Realty segment includes a $65,000,000 reserve provision for real estate assets. Operating income in 1989 for the Industrial Products segment includes a pretax gain on sale of the Company's airbag operations of $59,997,000, while the operating loss for the Realty segment includes a pretax charge to earnings for a reserve established for real estate assets of $36,600,000. Sales from the airbag operations included in the Industrial Products segment were $11,567,000 in 1989. Report of Independent Accountants To the Board of Directors and Shareholders of Talley Industries, Inc. In our opinion, the consolidated financial statements listed in the index appearing on page present fairly, in all material respects, the financial position of Talley Industries, 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 financial 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, the 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 the notes to the financial statements titled "Employee Benefit Plans" and "Significant Accounting Policies" the Company changed its method of accounting for postretirement benefits other than pensions in 1993 and changed its method of accounting for income taxes and foreclosed assets in 1992. PRICE WATERHOUSE Phoenix, Arizona February 22, 1994 Talley Industries, Inc. and Subsidiaries Quarterly Financial Results (Unaudited) - continued In the fourth quarter of 1993, the Company recognized an extraordinary loss of $1,670,000 due to the termination of an interest rate swap agreement and the payoff of the underlying debt. An extraordinary gain of $1,166,000 was also recognized in the fourth quarter in connection with the transfer of real estate assets to creditors to settle debt associated with such assets. During the second quarter of 1992 the Company recognized an extraordinary gain of $1,204,000 in connection with the debt exchange for common stock transaction. An extraordinary gain of $1,433,000 was also recognized in the third quarter with the transfer of real estate assets to creditors to settle corresponding debt. In the fourth quarter of 1992 a charge to earnings of $11,908,000 was recorded to adjust the carrying value of foreclosed assets of the Company's real estate operations. In the fourth quarter of 1991 the Company increased the reserve on real estate assets by $21,000,000 and an increase to the reserve related to the Company's restructuring program of $5,000,000. SCHEDULE III Page 1 of 6 TALLEY INDUSTRIES, INC. (Registrant Only) STATEMENT OF CONDITION (BALANCE SHEET) (IN THOUSANDS) DECEMBER 31, 1993 1992 Assets Current assets: Cash and cash equivalents $ 5,750 $ - Prepaid expenses 296 - Total current assets 6,046 - Investment in and advances to affiliates 100,968 97,385 Deferred charges and other assets 3,194 - Total assets $110,208 $ 97,385 See accompanying notes and the notes to the consolidated financial statements. SCHEDULE III Page 2 of 6 TALLEY INDUSTRIES, INC. (Registrant Only) STATEMENT OF CONDITION (BALANCE SHEET) (IN THOUSANDS) DECEMBER 31, 1993 1992 Liabilities and Stockholders' Equity Current liabilities: Accrued expenses 101 583 Total current liabilities 101 583 Long-term debt 71,667 56,021 Other liabilities 1,898 - Stockholders' equity: Preferred stock, $1 par value, authorized 5,000,000 shares - Series A 71 71 - Series B 1,548 1,548 - Series D 120 120 Common stock, $1 par value, authorized 20,000,000 shares 10,047 9,519 Capital in excess of par value 86,026 83,537 Foreign currency translation adjustments (370) (83) Retained earnings (60,429) (53,931) 37,013 40,781 Less 33,000 shares of Common stock in treasury, at cost 471 - Total stockholders' equity 36,542 40,781 Total liabilities and stockholders' equity $110,208 $ 97,385 See accompanying notes and the notes to the consolidated financial statements. SCHEDULE III Page 3 of 6 TALLEY INDUSTRIES, INC. (Registrant Only) STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) 1993 1992 1991 Selling, general and administrative expenses $ 1,695 $ - $ - Administrative allocations to subsidiaries - - - 1,695 - - Other income 69 - - 1,626 - - Interest expense 7,367 6,942 7,382 (8,993) (6,942) (7,382) Income tax provision (benefit) (3,624) (4,259) 1,202 Loss before earnings of subsidiaries and extraordinary gains (5,369) (2,683) (8,584) Extraordinary gain (loss), net of taxes (568) 1,204 - Loss from subsidiaries (561) (13,088) (35,400) Earnings from discontinued operations, net of taxes - - 825 Net loss $ (6,498) $(14,567) $(43,159) See accompanying notes and the notes to the consolidated financial statements. SCHEDULE III Page 4 of 6 TALLEY INDUSTRIES, INC. (Registrant Only) STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) 1993 1992 1991 Cash flows from operating activities $ (6,919) $(16,848) $(42,949) Cash flows from investing activities: Net (increase) decrease in investment in subsidiaries, net (168) 20,544 17,056 Cash from investing activities (168) 20,544 17,056 Cash flows from financing activities: Proceeds from long-term debt 70,000 - - Reduction of long-term debt (56,021) - - Proceeds from sale of savings bank - - 41,603 Dividends paid - - (984) Decrease in due from affiliates, net (1,142) (3,696) (14,726) Cash from financing activities 12,837 (3,696) 25,893 Increase in cash and cash equivalents 5,750 - - Balance at beginning of year - - - Balance at end of year $ 5,750 $ - $ - See accompanying notes and the notes to the consolidated financial statements. SCHEDULE III Page 5 of 6 TALLEY INDUSTRIES, INC. (Registrant Only) Notes to Financial Statements The following notes supplement information provided in the notes accompanying the consolidated financial statements. 1. Basis of Presentation Investments in and advances to affiliates represents interest in majority-owned subsidiaries and associated companies. The investments are accounted for on the equity method and, accordingly, the carrying value approximates the Company's equity in the recorded value of the underlying net assets. In July 1993, Talley Manufacturing and Technology, Inc. ("Talley Manufacturing"), a wholly-owned subsidiary of Talley Industries, Inc. ("Talley"), was formed. The formation of the Company was in anticipation of the offering of Senior Notes by Talley Manufacturing and Senior Discount Debentures by Talley. Concurrently with the issuance of these securities, Talley contributed the capital stock of its operating subsidiaries (other than its real estate operations held for orderly sale) to Talley Manufacturing, which also assumed a substantial portion of Talley's indebtedness and liabilities. At the same time, the Company entered into a new credit facility with certain lenders. The net proceeds from the Senior Notes, the Senior Discount Debentures and the new credit facility were used to repay substantially all of the indebtedness of Talley and its subsidiaries, including indebtedness assumed by Talley Manufacturing. Upon completion of the reorganization of entities under the common control of Talley described above and the new financing, Talley Manufacturing owns all of the capital stock of the operating subsidiaries of Talley (other than the real estate operations held for orderly sale). The financial statements of Talley have been prepared for all periods presented, giving effect to the reorganization described above. 2. Long-Term Debt December 31, Long-term debt consists of the following: 1993 1992 (balances in thousands) 12-1/4% Senior Discount Debentures, due 2005 $ 71,667 $ - 12.87% - 14.59% subordinated notes - 38,344 9% convertible subordinated debentures - 7,677 Subordinated notes, interest based on prime or LIBOR - 10,000 71,667 56,021 Less current maturities - - Long-term debt $ 71,667 $ 56,021 SCHEDULE III Page 6 of 6 TALLEY INDUSTRIES, INC. (Registrant Only) Notes to Financial Statements 3. Income Taxes The parent company and its domestic subsidiaries file a consolidated federal income tax return. The provision for income taxes represents the difference between amounts attributable to each subsidiary, generally determined on a separate return basis, and the tax computed on a consolidated basis. During 1992, the Company adopted the provisions of the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" retroactive to January 1, 1992. This accounting pronouncement requires a change from the deferred to the liability method of computing deferred income taxes. This change had no effect on reported net earnings or loss for 1992 or prior years. 4. Dividends Received The registrant received dividends from, or made contributions to consolidated subsidiaries, unconsolidated subsidiaries and 50 percent or less owned persons accounted for by the equity method during the years ended December 31, 1993, 1992 and 1991 of $2,752,000, $(10,499,000) and $22,367,000, respectively. EXHIBIT INDEX 3.1 Restated Certificate of Incorporation as presently in effect, a copy of which was attached as Exhibit 2 of Registrant's current report on Form 8-K for the month of July, 1976, incorporated herein by this reference. 3.2 Certificate of Amendment of Certificate of Incorporation dated May 22, 1987, attached as Exhibit 3 to the Company's Form 10-Q for the quarter ended March 31, 1988, incorporated herein by this reference. 3.3 By-laws of Registrant as amended March 9, 1993, attached as Exhibit 3.3 to the Company's Form 10-K for the year ended December 31, 1992, incorporated herein by this reference. 4.1 Rights Agreement between Registrant and Manufacturers Hanover Trust Company of California, as Rights Agent, dated as of April 30, 1986, specifying the terms of the Rights (the "Rights Agreement"), attached as Exhibit (a) to the Company's Form 8-K dated April 29, 1986, incorporated herein by this reference. 4.2 Certificate of Designations for Registrant's Series C $1 Junior Participating Preferred Stock (Exhibit A to the Rights Agreement), attached as Exhibit (b) to the Company's Form 8-K dated April 29, 1986, incorporated herein by this reference. 4.3 Specimen Right Certificate (Exhibit B to the Rights Agreement), attached as Exhibit (c) to the Company's Form 8-K dated April 29, 1986, incorporated herein by this reference. 4.4 First Amendment to Rights Agreement, dated April 30, 1986, attached as Exhibit 4 to the Company's Form 10-Q for the quarter ended June 30, 1986, incorporated herein by this reference. 4.5 Form of Purchase Agreement between the Company and a selling shareholder or a representative thereof, attached as Exhibit 28.1 to the Company's Form S-3 filed on November 14, 1986 (Registration No. 33-10193), incorporated herein by this reference. 4.6 Report dated May 4, 1987 reporting the April 28, 1987 Board of Directors' declaration of a five-for-four split of the Company's Common Stock, filed on Form 8-K on May 4, 1987, incorporated herein by this reference. 4.7 Certificate of Designation, Preferences and Rights of Series D Cumulative Convertible Preferred Stock which was attached as Exhibit 4 of Registrant's current report on Form 8-K dated March 17, 1988, incorporated herein by this reference. 4.8 Certificate of Designation, Preferences and Rights of Series A Preferred Stock of Talley Manufacturing and Technology, Inc., attached as Exhibit 4(e) to the Company's Form S-1 dated October 15, 1993, incorporated herein by reference. 4.9 Indenture Agreement between Talley Industries, Inc. and Bank One, Columbus, N.A., a national banking association, as Trustee, dated as of October 15, 1993 relating to the 12-1/4% Senior Discount Debentures due 2005 issued by Talley Industries, Inc. and the exhibits thereto, attached as Exhibit 4.1 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 4.10 Indenture Agreement among Talley Manufacturing and Technology, Inc., the Subsidiary Guarantors (as defined), Talley Industries, Inc. and Bank One, Columbus, N.A., a national banking association, as Trustee, dated as of October 15, 1993 relating to the 10-3/4% Senior Notes due 2003 issued by Talley Manufacturing and Technology, Inc. and the exhibits thereto, attached as Exhibit 4.2 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 9 Voting Trust Agreement entered into as of February 29, 1988, by and among Talley Industries, Inc., John J. McMullen and First Interstate Bank of Arizona, N.A. attached as Exhibit 9 of Registrant's current report on Form 8-K dated March 17, 1988, incorporated herein by this reference. 10.1** Employment Agreement dated June 26, 1984 between the Company and William H. Mallender, attached as Exhibit 10.1 to the Company's Form 10-K for the year ended December 31, 1984, incorporated herein by this reference. 10.2** Amendment to Employment Agreement dated September 30, 1985, between the Company and William H. Mallender, attached as Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 1985, incorporated herein by this reference. 10.3** Second Amendment to Employment Agreement dated February 25, 1986 between the Company and William H. Mallender, attached as Exhibit 10.3 to the Company's Annual Report on Form 10-K for the period ended December 31, 1988, incorporated herein by this reference. 10.4** Third Amendment to Employment Agreement dated December 1, 1988 between the Company and William H. Mallender, attached as Exhibit 10.4 to the Company's Annual Report on Form 10-K for the period ended December 31, 1988, incorporated herein by this reference. 10.5** Fourth Amendment to Employment Agreement dated February 27, 1990 between the Company and William H. Mallender, attached as Exhibit 28.2 to the Company's Form 10-Q for the quarter ended March 31, 1990, incorporated herein by this reference. 10.6** Executive Incentive Plan of the Company adopted March 9, 1983, effective April 1, 1983, attached as Exhibit 10.8 to the Company's Annual Report on Form 10-K for the year ended March 31, 1983, incorporated herein by this reference. 10.7** Long-Term Incentive Plan of the Company adopted July 26, 1983, attached as Exhibit 4.1 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1983, incorporated herein by this reference. 10.8** Amended and Restated 1978 Stock Option Plan of the Company, adopted July 26, 1983, attached as Exhibit 4.3 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 1983, incorporated herein by this reference. 10.9** 1990 Stock Option Plan of the Company attached as Exhibit A to the Company's Proxy Statement dated March 21, 1990, incorporated herein by this reference. 10.10 Partnership Agreement for Phoenix Metro Investors dated December 30, 1983, between Talley Realty Development, Inc., a wholly-owned subsidiary of the Company and Empire Holding Company Limited Partnership, attached as Exhibit 10.14 to the Company's Annual Report on Form 10-K for the period ended December 31, 1983, incorporated herein by this reference. 10.11 Plan for Deferral of Directors' Fees as established by the Company on December 30, 1975, attached as Exhibit 10.15 to the Company's Annual Report on Form 10-K for the period ended December 31, 1983, incorporated herein by this reference. 10.12 Amendment dated December 14, 1979 to the Plan for Deferral of Directors' Fees established by the Company on December 30, 1975, attached as Exhibit 10.16 to the Company's Annual Report on Form 10-K for the period ended December 31, 1983, incorporated herein by this reference. 10.13** Second Amended and Restated 1978 Stock Option Plan of the Company, dated July 8, 1987, attached as Exhibit 4.8 to the Company's Form S-8 Registration Statement, filed June 18, 1987, incorporated herein by this reference. 10.14 Restated Talley Industries, Inc. Retirement Plan Directors Only effective July 28, 1987, dated June 14, 1988, attached as Exhibit 10.18 to the Company's Annual Report on Form 10-K for the period ended December 31, 1988, incorporated herein by this reference. 10.15 License Agreement by and between Talley Industries, Inc., Talley Defense Systems, Inc. and Talley Automotive Products, Inc., and TRW Inc., dated April 21, 1989 attached as Exhibit 28.1 to the Company's Form 8-K dated April 21, 1989, incorporated herein by this reference. 10.16** First Amendment to the Talley Industries, Inc. Executive Death and Retirement Supplemental Plan, dated March 25, 1981, attached as Exhibit 10.34 to the Company's Form 10-K for the period ended December 31, 1990, incorporated herein by this reference. 10.17** Talley Industries, Inc. Executive Death and Retirement Supplemental Plan dated July 1, 1987, attached as Exhibit 10.31 to the Company's Form 10-K for the period ended December 31, 1989, incorporated herein by this reference. 10.18** Talley Industries, Inc. Restoration Benefit Plan dated November 30, 1975, attached as Exhibit 7 to the Company's Annual Report on Form 10-K for the fiscal year ended March 31, 1976, incorporated herein by this reference. 10.19** First Amendment to the Restoration Benefit Plan of Talley Industries, Inc., dated January 2, 1990, attached as Exhibit 10.34 to the Company's Form 10-K for the period ended December 31, 1989, incorporated herein by this reference. 10.20** Second Amendment to The Restoration Benefit Plan of Talley Industries, Inc. dated March 25, 1991, attached as Exhibit 10.39 to the Company's Form 10-K for the period ended December 31, 1990, incorporated herein by this reference. 10.21 Interest Rate Swap Agreement dated February 3, 1988 between Security Pacific National Bank and Talley Industries, Inc., attached as Exhibit 28.7 to the Company's Annual Report on Form 10-K for the period ended December 31, 1988, incorporated herein by this reference. 10.22 First Amendment to Interest Rate Swap Agreement, dated as of November 10, 1992, by and among Bank of America National Trust and Savings Association, Talley Industries, Inc., and Talley Realty Holding Company, Inc., attached as Exhibit (2.7) to the Company's Form 8-K dated November 20, 1992, incorporated herein by this reference. 10.23 Second Amendment to Talley Industries, Inc. Retirement Plan Directors Only effective January 1, 1991, dated May 7, 1991, attached as Exhibit 10.2 to the Company's Form 10-Q for the quarter ended June 30, 1991, incorporated herein by reference. 10.24** 1983 Restricted Stock Plan of the Company attached as Exhibit B to the Company's Proxy Statement dated June 8, 1983, incorporated herein by reference. 10.25 Form of Indemnification Procedures Agreement between each director of Holdings and Holdings, attached as Exhibit 10(hh) to Amendment No. 1 of the Company's Form S-1 dated September 10, 1993, incorporated herein by reference. 10.26 Form of Indemnification Procedures Agreement between Holdings and each director of Holdings who is also an officer, attached as Exhibit 10(ii) to Amendment No. 1 of the Company's Form S-1 dated September 10, 1993, incorporated herein by reference. 10.27 Form of Indemnification Procedures Agreement between Talley Manufacturing and each of its directors, attached as Exhibit 10(jj) to Amendment No. 1 of the Company's Form S-1 dated September 10, 1993, incorporated herein by reference. 10.28** Memorandum of Terms and Conditions applicable to: Performance Units granted for calendar years 1993 through 1997 under the 1983 Long-Term Incentive Plan and Stock Options granted in 1993 under The Second Amended and Restated 1978 Stock Option Plan and the 1990 Stock Option Plan, attached as Exhibit 10.1 to the Company's Form 10-Q for the quarter ended March 31, 1993, incorporated herein by reference. 10.29 Tax Sharing Agreement among Talley Industries, Inc., Talley Manufacturing and Technology, Inc. and each of their respective subsidiaries, dated as of October 22, 1993, attached as Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 10.30 Restructuring, Assumption and Cost sharing Agreement among Talley Industries, Inc., Talley Manufacturing and Technology, Inc. and Talley Real Estate Company, Inc. dated as of October 22, 1993, attached as Exhibit 10.2 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 11* Computation of earnings per share. 21* Subsidiaries of the Registrant. 23.1* Consent of Company's Independent Public Accountants to the incorporation by reference of their reports for the current year accompanying the financial statements included in the Registrant's Forms S-1, S-3 and S-8 Registration Statements. 23.2* Consent of Company's Independent Public Accountants to the incorporation by reference of their report for the current year accompanying the financial statements included in the Form 11-K Annual Report (Exhibit 99.1 herein) for the year ended December 31, 1993 into the Registrant's applicable Form S-8 Registration Statements. 99.1* Annual Report on Form 11-K for The Employee Stock Purchase Plan of Talley Industries, Inc. and Affiliated Companies for the year ended December 31, 1993. 99.2 Loan and Security Agreement among Talley Manufacturing and Technology, Inc., the Lenders listed therein and Transamerica Business Credit Corporation, as Agent dated October 22, 1993, attached as Exhibit 99.1 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 99.3 Airbag Collateral Security, Intercreditor and Agency Agreement dated as of October 22, 1993 among Talley Manufacturing and Technology, Inc., Talley Technology, Inc., Talley Defense Systems, Inc., Talley Automotive Products, Inc., Talley Metals Technology, Inc. and Transamerica Business Credit Corporation as Agent and as collateral agent for the Lenders (as defined) and the Senior Note Trustee, Lenders and Bank One, Columbus, N.A., a national banking association, as Trustee for the holders of the 10-3/4% Senior Notes due 2003 issued by Talley Manufacturing and Technology, Inc., attached as Exhibit 99.2 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 99.4 Form of Subsidiary Loan Agreement dated as of October 22, 1993 between Talley Manufacturing and Technology, Inc. and each of certain subsidiaries, attached as Exhibit 99.3 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 99.5 Subsidiary Loan and Security Agreement dated as of October 22, 1993 between Talley Manufacturing and Technology, Inc. and Talley Technology, Inc., attached as Exhibit 99.4 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. 99.6 Form of Subsidiary Continuing Guaranty and Security Agreement dated as of October 22, 1993 between Transamerica Business Credit Corporation, a Delaware corporation and each of certain subsidiaries, attached as Exhibit 99.5 to the Company's Form 10-Q for the quarter ended September 30, 1993, incorporated herein by reference. * Documents marked with an asterisk are filed with this report. ** An executive compensation plan or arrangement.

704386_1993.txt

704386_1993

1993

704386

ITEM 1. BUSINESS VLSI Technology, Inc., a Delaware corporation ("VLSI" or the "Company"), was incorporated in May 1987 as a successor to the business of VLSI Technology, Inc., a California corporation, ("VLSI-California"). The merger of VLSI-California with and into the Company was consummated on December 31, 1987. All references herein to "VLSI" or the "Company" include its predecessor VLSI-California unless specified or unless the context otherwise requires. OVERVIEW VLSI designs, manufactures and sells complex application-specific integrated circuits ("ASICs"), which are custom designed chips for an individual customer, and application-specific standard products ("ASSPs"), which are semi-custom chips designed for a particular market application that may be used by several different customers. Through its subsidiary, COMPASS Design Automation, Inc. ("COMPASS"), VLSI offers an integrated suite of electronic design automation ("EDA") software tools, foundry-flexible libraries and support services for use by systems and circuit designers (see "COMPASS DESIGN AUTOMATION"). VLSI applies its value-added technology to deliver products targeted at specific segments of the electronics marketplace. These products address a range of applications in the personal computer ("PC"), communications, workstation, government, high-performance computer, industrial and consumer markets. VLSI targets a limited number of key Original Equipment Manufacturer ("OEM") customers who are leaders in their respective industries. The Company's top customers in 1993 include Apple Computer, Inc. ("Apple"), Compaq Computer Corporation ("Compaq"), Telefonaktiebolaget LM Ericsson ("Ericsson"), Hewlett-Packard Company ("Hewlett-Packard") and International Business Machines Corporation ("IBM"). See "MARKETING AND CUSTOMERS" below. The Company has a market segment approach to its method of planning and organization of its business. Through this approach, the Company has targeted a limited number of growth markets in which it has built significant expertise and can use its library of proprietary cells and highly integrated building blocks to assist customers in designing products and bringing them to market rapidly. The Company's objective is to design and manufacture highly-integrated, complex semiconductor devices that allow its customers to develop and bring to market higher value-added systems and products. VLSI emphasizes high performance applications where its products are critical elements of complex electronic systems. Key elements in its strategy to achieve this objective include: 1) Develop differentiated products -- VLSI seeks to develop differentiated products that allow a customer both to distinguish the customer's products from those offered by its competitors and to reduce the customer's product cost. The Company creates highly complex products that reduce the number of chips required for an application and contain advantageous combinations of features and functionality. For example, VLSI has developed the QuadNote(TM), a highly integrated two-chip solution for subnotebook personal computers on the 486 architecture. The QuadNote product was the result of a 1993 joint development effort between the Company and Compaq, which announced its first products incorporating the chip set in 1994. 2) Establish strategic alliances -- VLSI has actively established and maintained strategic relationships with a number of systems and component manufacturers, including Intel Corporation ("Intel"), Apple, Acorn Computers Limited ("Acorn") and Hitachi, Ltd. ("Hitachi"). As a result of its relationship with Intel, VLSI is developing products based upon the Intel 386SL(TM) and 486 microprocessors for use in handheld computing applications. The Company's strategic relationship with Apple and Acorn, through the joint venture Advanced RISC Machines, Ltd. ("ARM"), has led to the development of the ARM(TM) RISC-based microprocessor, a low-power, high performance device which the Company has targeted at embedded control applications in handheld computers and multimedia systems. Hitachi is working with the Company to develop leading edge manufacturing and process expertise. 3) Focus on large, industry-leading OEM customers -- VLSI focuses its manufacturing and research and development resources on products for a limited number of OEM customers who are leaders in their respective industries. The Company believes that such large OEM customers provide the Company with significant profit potential. During the year ended December 25, 1993, approxmiately two-thirds of the Company's net revenues were derived from sales to its top 20 customers. 4) Balance manufacturing -- The Company balances its wafer production between its own facilities and foundry services of third party wafer subcontractors. The Company believes that this strategy improves quality, cost-effectiveness, responsiveness to customers, access to capacity, ability to implement leading edge process technology and time to market, as compared to wafer manufacturers lacking fabrication facilities, while providing a partial buffer against over-capacity in times of diminished demand. During 1993, VLSI produced approximately 75% of its wafer requirements at its own facilities. When demand exceeds industry-wide fabrication facility capacity, the Company believes that this manufacturing strategy also results in enhanced response times to customers, as compared to semiconductor companies lacking fabrication facilities. In addition, the Company's principal fabrication facility in San Antonio, Texas is designed with modules and bays that permit the Company to more than double current manufacturing capacity at that facility. 5) Use FSB(TM) library to reduce customers' time to market -- VLSI's Functional System Block ("FSB") library, an expanding collection of pre-designed cells and high-level building blocks, provides design short-cuts for frequently used integrated circuit functions. The FSB library allows VLSI and its customers to design and update ASIC and ASSP products rapidly, thereby reducing VLSI's customers' time to market. VLSI's library of FSBs includes Graphics Controllers (LCD and CRT), a DES Encryption FSB, a PCI FSB, Floppy Disk Controllers, SCSI Controllers, T1 Controllers and a suite of analog functions for communications FSBs. 6) Provide superior customer support -- The Company seeks to differentiate itself from its competitors not only through the quality of its products, but also through the level of its technological support and service. VLSI operates a network of geographically dispersed Technology Centers where highly experienced engineers work directly with customers to develop designs for new products and to provide continuing after-sale customer support. SILICON OPERATIONS PRODUCTS AND SERVICES VLSI has organized its business around targeted market segments, establishing divisions to address specific silicon markets. Each of the Company's silicon divisions maintains independent marketing and applications research and development capabilities. The Company's market-focused structure permits VLSI to dedicate certain of its engineers to develop systems expertise in, and experience with issues peculiar to, applications in a particular market. VLSI believes that this increased systems expertise allows it to offer more value to the customer through the development of ASSPs and FSBs to address those specific issues. VLSI's customers in such market segments have a choice of using a proprietary ASIC solution, a standard VLSI ASSP solution that is shared among multiple customers, or a combination of both. The Personal Computer Division designs, manufactures and markets ASIC and ASSPs for X86 architecture desktop and portable computers. The VLSI Product Divisions design, manufacture and market ASICs and ASSPs for a variety of markets, including personal computer (Apple operating systems), communications (such as broadcast satellite systems and wireless communication devices), workstation, government (encrypted communications), high-performance computing applications (such as interactive television and supercomputing), and industrial and consumer applications (such as robotics and medical diagnostics). PERSONAL COMPUTER DIVISION The Personal Computer Division ("PCD"), located in Tempe, Arizona, supplies system-logic chip sets and peripheral components for desktop, notebook, subnotebook and handheld personal computers based on X86 architectures. The product line consists of high-integration core logic and peripheral input/output ("I/O") devices for X86-based systems. The division serves a wide range of customers worldwide, including major manufacturers such as Hewlett-Packard, IBM, Compaq, AST Research, Inc. and other leaders in the PC industry. VLSI's chip sets currently support Intel, IBM and other X86 microprocessors. The PC chip set market segment has been characterized by intense competition among a large number of suppliers resulting in rapid and unanticipated fluctuations in demand and price (see "COMPETITION"). In an effort to reduce the effect of such forces, VLSI has continued to shift its emphasis away from "clone" PC board manufacturers to industry-leading PC system manufacturers who currently dominate market share. This response includes targeting the high volume and high performance desktop and low voltage notebook and handheld computer manufacturers. PCD's efforts involve timely introduction of high-integration chip sets, enabling PC manufacturers to supply high-performance, cost-effective computing systems to end users. PCD seeks to offer cost-effective manufacturing solutions, taking advantage of new technologies in wafer processing, packaging, testing and statistical process control. In 1993, the microprocessor architecture used by most PC manufacturers was the 486 system. PCD responded by increasing production of SC480(TM) and SC486(TM) single-chip controllers with an optional combination I/O chip. During the year, PCD established commercial volume production of a high performance (40MHz) 0.8-micron advanced technology SC480 single-chip controller with integrated cache controller for 486SX/DX systems. The older SC486 and its next-generation replacement, the SC480, implement the bulk of the logic functions of a PC motherboard and were PCD's largest selling products during 1993. PCD also announced the SC483, the EcoChip(TM), with power management functions enabling OEMs to produce "Green PCs" compliant with the Environmental Protection Agency's Energy Star(TM) initiative. PCD also announced the SCAMP IV chip set for portable PCs in 1993. This highly integrated chip set is scheduled to ramp to commercial production volumes in 1994. The Technology and Manufacturing Agreement, signed by VLSI and Intel in July 1992, provides VLSI with access to Intel 386SL(TM) microprocessor technology for integration into products for the handheld market. Handheld computers are a class of electronic devices that range from palmtop PCs to organizers and electronic notebooks. These products include advanced wireless communication capabilities. In the agreement with Intel, VLSI provided proprietary FSB libraries and design tools. Intel contributed its PC architecture leadership, 32-bit CPU technology and high-volume manufacturing capability. In September 1993, VLSI shipped the first working silicon samples of the Polar(TM) product, which integrates the Intel 386SL(TM) core with its proprietary FSB libraries to create customer-specific and application-specific standard product chip set solutions. Intel will manufacture for VLSI the VLSI-designed chips containing the 386SL core, while VLSI will manufacture the companion chips. An additional ongoing development effort in association with Intel is underway to develop a handheld device based on 486 microprocessor technology called Draco(TM). Volume production is not expected to begin on devices for handheld computers before 1995. VLSI PRODUCT DIVISIONS The VLSI Product Divisions ("VPD") consist of five market segment divisions: the Apple Products Division ("APD"), the Computer and Government Products Division ("CGD"), the Consumer and Industrial Products Division ("CID"), the Network Products Division ("NPD") and the Wireless Products Division ("WPD"). The key to the success of VPD is providing customers with timely silicon solutions optimized for their applications. These solutions consist of ASICs, ASSPs and proprietary FSB library elements, which, when combined, provide integrated system level solutions. This combination of product offerings is intended to permit the rapid market introduction of customer products coupled with the ability to customize for specific customer requirements. The proprietary FSB library elements consist of system level blocks that provide a higher level implementation than in a traditional ASIC library, but a lower level solution than a complete ASSP. These blocks are designed to be combined with other FSB blocks, random logic and compiled elements to provide the optimum silicon circuit with minimum design time for the customer. FSB cells are intended to speed the development of both ASICs and ASSPs, resulting in faster time to market for customers. These FSB elements are either designed in-house or licensed and are developed for use in VPD's target market segments. For example, development of a proprietary FSB library to support embedded control applications resulted in VLSI's introduction of first silicon of a proprietary ARM-based microcontroller in 1993. VPD's competition comes from a wide variety of large, established ASIC providers as well as standard products companies, including LSI Logic Corporation ("LSI"), Texas Instruments Incorporated ("TI"), Motorola, Inc. ("Motorola") and Toshiba Corporation ("Toshiba"). VPD responds to this competition by offering differentiated, user-configurable solutions based on application-specific FSB elements and its cell-based methodology to offer customers complex ASIC proprietary solutions without bearing the financial burden and time investment of custom approaches. VLSI is also working to develop ASSPs for various market segments based on emerging industry standards to speed customer development cycles and to differentiate VLSI from other suppliers. Apple Products Division The APD provides ASIC and ASSP solutions to Apple, its subcontractors and licensees and Apple-compatible peripheral suppliers worldwide. The APD has historically provided Apple with high-performance gate array and cell-based products. Such devices are used in Apple's LC, Centris, Quadra and Powerbook computer lines based on the Macintosh platform and in a host of printer products. Apple gave notice to the Company in December 1993 of Apple's intention to reschedule and, in some cases, cancel orders for several VLSI products. As a result, planned 1994 shipments are likely to decline up to $20 million, of which as much as $15 million may occur during the first half of 1994. See Item 7 of Part II hereof. Computer and Government Products Division The computer target market segments include workstation (from entry-level through high-end graphic) servers, parallel processors, mass storage devices and peripherals. Significant customers include Silicon Graphics, Inc. ("Silicon Graphics"), American Telephone and Telegraph Company, Storage Technology Corporation and Digital Equipment Corporation. The computer group develops high-end computing ASIC solutions, including high-performance and high-resolution chip sets for Silicon Graphics. VLSI believes that the dramatic growth of client server distributed processing offers excellent ASIC and ASSP business opportunities. The government target market segments include avionics, missiles, C3I (Communication, Control, Command and Intelligence), and Secure Information Technology. The government group does not earn its revenue from the federal government directly; it derives revenue principally from prime contractors in support of government contracts. This group provides ASICs to large defense contractors in the electronics industry. In 1993, the government group focused its development efforts in the area of Secure Information Technology. VLSI believes that the increase in distributed processing, portable computing and wireless communications offers significant opportunities for encryption products. Two such products developed during 1993 were Clipper and Capstone, both of which incorporate an embedded antifuse cell (pFSB) that greatly reduces the possibility of reverse engineering of the encryption algorithm. This VLSI proprietary one-time programmable technology, which allows for the customization of product at final test or by the customer (when mounted on the circuit board), is intended to be attractive in a wide range of applications. Consumer and Industrial Products Division The CID addresses the consumer and industrial market segments, primarily targeting interactive television, video, HDTV, manufacturing and robotics applications. The customer base for the CID includes The 3DO Company, Scientific-Atlanta, Inc., and the Allen-Bradley Division of Rockwell International Corporation. Network Products Division NPD supports its communications customers with application-specific libraries and ASIC and ASSP expertise. NPD supports customers such as DSC Communications Corporation, Alcatel Alsthom Compagnie Generale d'Electricite and Tellabs Incoporated in several application areas, including transmission, digital cross-connect, switching, multiplexing, and networking/internetworking applications. These FSB cells are high level communications-specific building blocks designed to comply with the relevant industry standards and include high complexity analog, digital and memory functions Specific solutions for major customers include FSB cells for various networking standards, including T1, E1 and Sonet/SDH. In addition, VLSI has introduced a T1 Line Interface Unit (LIU). Wireless Products Division WPD provides its wireless communications voice and data customers with independent systems solutions by supplying both ASIC and ASSP silicon products, systems expertise and application-specific libraries. FSB cells have been introduced to speed the development of both ASICs and ASSPs, resulting in a faster time to market. The FSB blocks typically contain high level systems functions that are designed to meet international industry standards and include high complexity analog, digital and memory functions. Using VLSI's ability to integrate analog and digital functions on one chip, WPD is able to provide cost-effective ASIC and ASSP solutions to complex digital wireless communication problems. Using baseband signal processing technology developed to support European voice standards, WPD provides ASIC GSM (cellular) solutions for European wireless manufacturers, including Ericsson. Additionally, WPD has developed and announced ASSP-based solutions for the CT2 and DECT (cordless) markets. MARKETING AND CUSTOMERS The Company uses a direct sales force, commissioned representatives and distributors to sell its silicon products. VLSI silicon operations has 31 sales offices (23 in the United States, four in Europe, two in Japan and two in the Asia-Pacific region) as well as 20 Technology Centers (12 in the United States, four in Europe, two in the Asia-Pacific region and two in Japan). Direct sales represent the Company's primary distribution channel, allowing VLSI to bring to bear the technical and systems expertise necessary to sell ASICs. Its direct sales force is assisted by VLSI engineers located in a network of geographically dispersed Technology Centers. The Company's Technology Centers support VLSI's customers by offering a range of design services. These services include system definition, complete logic and circuit design and test program generation. Staffed by experienced system and integrated circuit designers, the Technology Centers are strategically located near large concentrations of potential customers at locations throughout the world. VLSI utilizes its systems expertise to work with customers to develop designs for new markets and next generation products. Approximately two-thirds of the Company's net revenues for 1993 were derived from sales to the Company's top 20 customers, eleven of whom operate in the personal computer industry. As a result of this concentration of its customer base, loss of business from any of these customers, significant changes in scheduled deliveries to any of these customers or decreases in the prices of products sold to any of these customers could materially adversely affect the Company's results of operations. For example, during 1993 and 1992, Apple was the Company's largest customer, accounting for approximately 19% and 15%, respectively, of the Company's net revenues. In December 1993, Apple postponed and, in some cases, cancelled $20 million of shipments planned for delivery in 1994, adversely affecting the anticipated results of operations for the first half of 1994. See "Business -- SILICON OPERATIONS -- VLSI PRODUCT DIVISIONS - -- Apple Products Division" above. Other present significant customers include Compaq, Ericsson, and Hewlett-Packard. MANUFACTURING The fabrication of integrated circuits ("IC's") is an extremely complex and precise process consisting of hundreds of separate steps and requiring production in a highly controlled, clean environment. Minute impurities, errors in any step of the fabrication process, defects in the masks used to print circuits on a wafer or a number of other factors can cause a substantial percentage of wafers to be rejected or numerous die on each wafer to be nonfunctional. Semiconductor manufacturing is highly capital intensive, and capital costs have tended to significantly increase as geometries have decreased in size. The marketplace has placed emphasis on ever-smaller geometries, evidenced by increasing demand for 0.8-micron devices, requiring the Company to increase its capital investment requirements to keep abreast of market demand. Most of the Company's products are currently manufactured using a 1.0-or a 0.8-micron CMOS process. The Company balances its wafer manufacturing between its own wafer fabrication facilities and those of third-party wafer subcontractors. This strategy allows manufacturing flexibilities and the ability to realize economies of scale by operating the Company-owned fabrication facilities at capacity and allowing a buffer in case of changes in demand. Approximately 80% of the Company's wafers in 1992 were manufactured internally. This percentage decreased to approximately 75% during 1993, as demand for the Company's products exceeded the rate of expansion of internal manufacturing capacity. VLSI's manufacturing flexibility is also increased by the ability of the Company-owned fabrication facilities to run multiple processes and products concurrently. The Company expects a majority of 1994 production to be at the 0.8-micron level, with volume production planned to ramp up in 0.6-micron technology during 1994. There can be no assurance that the Company will be able to profitably manufacture devices in the 0.6-micron geometry. The Company's success is partially dependent upon its ability to develop and implement new manufacturing process technologies. Semiconductor design and process methodologies are subject to rapid technological change, requiring large expenditures for research and development. The Company believes that the transition to smaller geometry process technologies will be important to remaining competitive. In addition to large research and development expenditures required to shrink device geometries, capital expenditure requirements to manufacture at such small geometries also increase. Decreases in geometries call for sophisticated design efforts, advanced manufacturing equipment and cleaner fabrication environments. The Company made significant investments during 1993 into sub-micron manufacturing and expects to continue a high level of investment in these areas in the future. The Company has three manufacturing facilities. Its San Jose, California plant performs wafer fabrication, probe, final test and process development. The San Antonio, Texas facility is dedicated to wafer fabrication and includes four modules of 10,000 square feet each. All of Module A and approximately one-half of Module B have been facilitized and equipped. The remaining one-half of Module B has been facilitized as a Class 1 clean room and is available for installation of equipment in increments as additional capacity is needed. The Tempe, Arizona site contains IC assembly, probe and final test facilities. The Company's San Jose wafer fabrication facility, which currently accounts for approximately 35% of its total internal wafer production, is located near major earthquake faults and in an area that has in the recent past experienced an extended drought. Additionally, as a 10-year-old fabrication facility, it faces technological limitations. Due to the age of the Class 10 San Jose facility and other factors, it is uncertain whether geometries smaller than the 1.0-micron level can ever be profitably manufactured there. Even though the Company utilizes both of its fabrication plants and multiple subcontractors to manufacture its wafers and has the ability to shift manufacturing from one plant to another for many of its products, disruption of operations at either the Company's production facilities or those of its subcontractors for any reason, such as fire or earthquake, would cause delays in shipments until the Company could shift the products from the affected facility or subcontractor to another facility. In addition to manufacturing in its own facilities, VLSI has wafer manufacturing arrangements with integrated circuit manufacturing companies. These wafer subcontractors are themselves subject to all of the manufacturing risks that are applicable to VLSI's own wafer manufacturing operations. In addition, the Company's foreign subcontract manufacturing arrangements are subject to risks such as changes in government policies, transportation delays, increased tariffs, fluctuations in foreign exchange rates, and export and tax controls. The Company subcontracts virtually all of its integrated circuit packaging and approximately 30% of its final testing to third parties. The final tested circuits are normally returned to the Company for shipment to customers. Subcontractors include Anam Semiconductor Technology Co. Ltd. in Korea (see Item 13 in Part III hereof). Although the Company has no long-term contractual commitments from these suppliers, the Company believes that these sources of packaging and testing services are relatively reliable given their level of interdependence with the Company and the overall level of availability of worldwide subcontract packaging and testing capacity. Any problems experienced in obtaining acceptable wafers from third party wafer subcontractors on a timely basis to augment the Company's internal manufacturing capacity or in the integrated circuit packaging, assembly and test operations performed by subcontractors could delay shipments of the Company's products and affect the Company's results of operations. The principal raw materials used by the Company in the manufacture of its products are silicon wafers, processing chemicals and gases, ceramic and plastic packages, and some precious metals. Certain of the raw materials used in the manufacture of circuits are available from a limited number of suppliers in the United States and elsewhere. The Company does not generally depend on long-term fixed supply contracts with its suppliers. However, shortages could occur in various essential materials due to interruption of supply or increased demand in the industry. If VLSI was unable to procure certain of such material from any source, it would be required to reduce its manufacturing operations. To date, the Company has experienced no significant difficulty in obtaining the necessary raw materials. The Company's operations also depend upon a continuing adequate supply of electricity, natural gas and water. The Company may experience problems in achieving acceptable yields in the manufacture of wafers, particularly in connection with any expansion of its capacity, shrink in manufacturing geometry or change in its processing steps. For example, in late 1992, the Company switched processes at one step in the manufacturing line, causing certain VLSI devices to fail at extreme temperatures. COMPETITION The semiconductor industry in general and the markets in which the Company competes in particular are intensely competitive, exhibiting both rapid technological change and ongoing price erosion as technologies mature. From time to time, the industry has also experienced significant downturns, often in connection with, or in anticipation of, declines in general economic conditions. These downturns, which in some cases have lasted for more than a year, have been characterized by diminished product demand, production over-capacity and subsequent accelerated erosion of average sales prices. Competition in the personal computer market, the Company's largest market segment, is especially intense and is subject to significant shifts in demand and severe pricing pressures. For example, during the third quarter of 1992, the migration of the PC market from the 386 to the 486 architecture caused a decline in demand for 386 chip sets and related devices, resulting in an excess of worldwide supply of such chip sets and significant price declines as competitors struggled to maintain market share. The Company competes with large domestic and foreign companies that have substantially greater financial, technical, marketing and management resources than the Company, such as Intel, Motorola, TI and Toshiba. In addition, Samsung Electonics, Co., Ltd. announced its intention in 1993 to enter the PC chip set market. The Company's competitors also include present and potential customers and strategic partners. Intel, one of the Company's strategic partners, recently announced an embedded control product that could be used to compete with VLSI in the handheld computer market, and is also currently a competitor in the PC chip set market. The Company also competes with smaller companies attempting to sell products in certain segments of the Company's markets, such as OPTi, Inc. in the PC chip set segment. Competition is based on such factors as design capabilities (including both the design tool features and the skills of the design team), quality, delivery time and price. The Company believes that its competitive strengths include: a growing expertise in systems applications in specific market segments, its proprietary FSB libraries, its high quality wafer processing technology and fabrication facilities, its experienced engineering staff, test capabilities, cost effectiveness, technical design services offered through its network of Technology Centers and design tools and services. BUSINESS RELATIONSHIPS/STRATEGIC ALLIANCES VLSI believes that strategic alliances with other technology companies enable the Company to develop new products more rapidly, access advanced manufacturing process technology, make more effective use of the Company's research and development resources and expand the Company's global market presence. To this end, VLSI has established and maintains strategic relationships with the following companies: 1) Intel Corporation -- In July 1992, VLSI signed a technology and manufacturing agreement with Intel (the "Intel Agreement"). Under the Intel Agreement, the two companies agreed to work together to manufacture, with VLSI responsible for designing, marketing and selling, chip sets incorporating the Intel 386SL(TM) microprocessor for use in handheld computers. Under the terms of the Intel Agreement, VLSI provided FSB libraries, customer-specific solutions and COMPASS design tools, while Intel contributed its 32-bit CPU technology, system design expertise and high-volume manufacturing capability. When commercial production is initiated (estimated to be 1995), Intel will manufacture the VLSI-designed chips containing the Intel microprocessor core, while VLSI will manufacture the companion chips. In September 1993, Intel and VLSI jointly announced the Polar chip set, which is designed to be utilized in a variety of 386-based handheld computer products. An additional ongoing design effort is underway in association with Intel to develop companion devices for the 486 microprocessor for the handheld market. In connection with the Intel Agreement, Intel invested $50 million in VLSI to acquire 5,355,207 shares of Common Stock, representing approximately 15.3% of VLSI's outstanding Common Stock as of December 25, 1993, and a warrant to purchase 2,677,604 additional shares of Common Stock at an exercise price of $11.69 per share. In addition to Intel's current common stock and warrant holdings, Intel has a right to maintain its original percentage of equity ownership (excluding warrant shares) at 16.4% of VLSI's outstanding common shares (providing for the right to purchase an additional 521,758 shares at $13.31 per share as of February 26, 1994). Intel has the right to demand registration of all of such shares for resale. Such rights may be exercised by Intel at any time, subject to the Company's ability to delay registration for 90 days if Intel makes the demand during or shortly after an offering by the Company. 2) Apple and Acorn -- The ARM joint venture was formed in November 1990 with Apple and Acorn, a technology partner since 1986, to develop products for 32-bit Reduced Instruction-Set Computing ("RISC") applications using technology developed by Acorn using COMPASS IC design tools. VLSI uses the ARM microprocessor family in low cost, low power consumption embedded control products. 3) Hitachi -- VLSI has had a joint development and cross-license agreement with Hitachi since 1988. In December 1992, the two companies agreed to extend the joint development agreement through 1997. Under the agreement, the parties have developed a 0.8-micron manufacturing process and are currently developing a 0.6-micron process, as well as other advanced sub-micron processes, including a "deep sub-micron" (geometries equal to or smaller than 0.5-micron) process. VLSI believes that this technology alliance has accelerated VLSI's progress in basic technology and manufacturing processes. RESEARCH AND DEVELOPMENT The Company believes that research and development ("R&D") is fundamental to its success, and that its continued success will depend largely on its ability to continue development and improvement of its systems applications expertise, process and packaging technologies and cell-based libraries and gate arrays. Research and development expenditures increased to $83.8 million in 1993 from $69.5 million in 1992 and $58.0 million in 1991; Company-funded R&D for the three years was in the range of 10% to 13% of net revenues. The Company's future success depends to a significant extent on its ability to continue to develop and introduce new products that compete effectively on the basis of price and performance and that satisfy customer requirements. New product development often requires long-term forecasting of market trends, development and implementation of new processes and technologies and substantial capital commitments. For example, the Company is currently investing significant resources in developing products for the handheld computer market and has entered into a strategic relationship with Intel relating to such product development efforts. To date, the handheld computer market has developed slowly, and there can be no assurance that VLSI's current focus on this market will be successful. If the Company is unable to design, develop, manufacture and market new products successfully and in a timely manner, its operating results could be adversely affected. No assurance can be given that the Company's product and process development efforts will be successful. The Company's process technology development activities in 1993 concentrated on the successful transfer to production of a 0.6-micron ASIC process and the development of a 0.5-micron ASIC process. Additionally, evaluations were begun for the selection of equipment needed for the development of deep sub-micron technologies. R&D in systems applications presently includes development of handheld computing products based upon X86 microprocessors and development of wireless products for voice and data applications. Process technology development efforts in conjunction with Hitachi include integration of sub-micron CMOS process and manufacturing methodologies in the San Antonio, Texas wafer fabrication facility. Research and development in the packaging area focuses on high performance, high pin-count plastic packaging and assembly techniques. Research and development activities are often augmented through significant alliances with other companies, including Intel, ARM and Hitachi. COMPASS DESIGN AUTOMATION The Company's COMPASS subsidiary designs, develops, markets and services software-based products used by systems or circuit designers to design complex integrated circuits using either schematic capture, high level design languages, data path descriptions or state diagrams. These design tools integrate many steps of the design process, from design specification (beginning with synthesis and test) through physical layout and verification. COMPASS product offerings are organized into four main product lines: logic design and analysis tools, physical design tools, library development tools and physical libraries. These products are intended to reduce overall time to market and decrease engineering and production costs for advanced integrated circuit design. COMPASS produces a complete set of tools for all levels of design from VHDL and Verilog down to basic silicon structures. In the top-down design market segment, COMPASS is focused on VHDL and Verilog-based synthesis, simulation and test-generation tools, along with services to import custom libraries from ASIC vendors to work on the COMPASS toolset. In the physical design software area, COMPASS develops tools for floorplanning, automatic place and route, a range of symbolic and polygon-based custom layout tools, and a complete set of physical layout verification tools. In library technology, COMPASS develops a wide range of Foundry Flexible(TM) libraries, memory and datapath compilers. It also develops high-productivity tools to automate the process of library generation. COMPASS' R&D efforts are focused on making its array of software technology capable of supporting a wider variety of semiconductor vendors' design tools and semiconductor foundries. Current development efforts are focused on perfecting a complete front-to-back-end design environment capable of supporting the requirements imposed by deep sub-micron designs. During 1994, COMPASS will focus development on deep sub-micron physical libraries. Continued development will be focused on high-level design tools, including VHDL and synthesis, to achieve the productivity required by such large design projects. COMPASS competes with other software vendors in the high end of the computer-aided engineering market for integrated circuit design automation. Competition in the EDA market has come primarily from a few large established vendors, such as Cadence Design Systems, Inc., Mentor Graphics Corporation, Viewlogic Systems, Inc., and Synopsys, Inc. Competition is based on such factors as design capabilities (including both the design tool features and the skills of the design team), quality, delivery time and price. The Company believes that a principal competitive strength of COMPASS is its ability to provide a fully integrated suite of design tools, and further integration of design tools with libraries. The Company's ability to compete in the EDA market will depend upon the expansion of ASIC vendor libraries available for the logic design system and the foundries that can fabricate designs using COMPASS libraries. COMPASS libraries are supported by many semiconductor vendors, including Fujitsu Limited, General Electric Corporation Ltd.'s Plessey Division, Hitachi, National Semiconductor Corporation, Nippon Electric Corporation and VLSI. COMPASS uses direct sales, commissioned representatives and distributors to sell its software products. COMPASS' 14 sales offices (nine in the United States, four in Europe and one in Japan) include its three worldwide development centers. Direct sales represent COMPASS' primary domestic and European distribution channels, allowing COMPASS to bring to focus the technical and systems expertise necessary to sell EDA software. COMPASS generally licenses its design tools under nontransferable, non-exclusive license agreements and provides post-contract customer and software revision support. In addition, COMPASS offers training and consulting services to customers. COMPASS retains ownership rights to all software that it develops. COMPASS uses various security schemes to protect the software from unauthorized use or copying. BACKLOG The Company's sales are made primarily pursuant to standard purchase orders for delivery of products, with such purchase orders officially acknowledged by VLSI according to its own terms and conditions. Due to industry practice with respect to cancellation of orders, VLSI believes that backlog is a potentially misleading indicator of future revenue levels. EMPLOYEES As of December 25, 1993, the Company and its subsidiaries had approximately 2,659 employees worldwide. Management believes that the future success of VLSI will depend in part on its ability to attract and retain qualified employees, including high-level executives. The Company has granted stock options to many of its employees and has implemented stock purchase and profit sharing programs. In addition, the Company currently has Management Continuity Agreements with seven of its officers (see Exhibit 10.60 and the information contained in the Proxy Statement under the caption "Executive Officer Compensation -- Management Continuity Agreements" on page 10, which information is incorporated herein by reference). PATENTS AND LICENSES The Company has filed a number of patent applications and currently holds various U.S. patents expiring from 2003 to 2011 covering inventions in the areas of computer-aided engineering and electronic circuitry. VLSI has also filed corresponding patent applications in foreign jurisdictions. The Company expects to file future patent applications from time to time both in the United States and abroad. VLSI does not consider the success of its business to be materially dependent on any single patent or group of patents. The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights and positions, which have on occasion resulted in protracted and expensive litigation. The Company is currently one of four remaining defendants in a major patent infringement suit brought by TI (see Item 3 of Part I hereof, Legal Proceedings). While the outcome of this matter is currently not determinable, management believes that the ultimate resolution of these matters will not have a material adverse effect on the Company's consolidated position or results of operations. However, should the ultimate outcome of this matter be unfavorable, VLSI may be required to pay damages and other expenses. There can be no assurance that additional intellectual property claims will not be made against the Company in the future or that the Company will not be prohibited from using the technologies subject to such claims or be required to obtain licenses and make corresponding royalty payments for past or future use. There can be no assurance that any such licenses could be obtained on commercially reasonable terms. VLSI has also entered into a number of licensing agreements and technology swap agreements with various strategic partners and other third parties in order to allow VLSI limited access to third party technology, or to allow third parties limited access to VLSI's technology. WORKING CAPITAL PRACTICES Information regarding the Company's working capital practices is incorporated herein by reference from Item 7 of Part II hereof under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" and from Item 8 of Part II hereof under the heading "Revenues" in Note 1 of "Notes to Consolidated Financial Statements". FINANCIAL INFORMATION BY BUSINESS SEGMENT AND GEOGRAPHIC DATA This information is included in Note 10 of "Notes to Consolidated Financial Statements", which information is included in Item 8 of Part II hereof. ENVIRONMENTAL ISSUES The Company is subject to a variety of federal, state and local governmental regulations related to the storage, use, discharge and disposal of toxic, volatile or otherwise hazardous chemicals used in its manufacturing process. Increasing public attention has been focused on the environmental impact of semiconductor manufacturing operations. The Company's San Jose, California facilities are located near recently developed residential areas, which could increase the incidence of environmental complaints or investigations. There can be no assurance that changes in environmental regulations will not impose the need for additional capital equipment or other requirements. Although the Company is not aware of any failure by it to control the use of, or adequately to restrict the discharge of, hazardous substances under present or future regulations, any such failure could subject VLSI to substantial liability or could cause its manufacturing operations to be suspended. Such liability or suspension of manufacturing operations could have a potentially adverse effect on the Company's operating results. ITEM 2. ITEM 2. PROPERTIES The Company has three manufacturing facilities located in San Jose, California, Tempe, Arizona and San Antonio, Texas. In addition, VLSI (including its subsidiary, COMPASS) has 45 sales offices (32 in the U.S., eight in Europe, three in Japan and two in the Asia-Pacific region) and 20 Technology Centers (12 in the U.S., four in Europe, two in Japan and two in the Asia-Pacific region). Except for its Tempe, Arizona and San Antonio, Texas facilities, the Company's properties are occupied under operating leases that expire from January 1994 through October 2013 with options to renew in most instances. The Tempe facility building is owned by VLSI and is situated on land held under a long-term ground lease which expires in December 2037; the San Antonio land and facilities are owned by the Company. The Company's San Jose facility, which includes manufacturing, COMPASS, VPD Marketing and corporate support services such as its computer center, technology development, primary shipping location and major design center, is located near earthquake faults. Should an earthquake cause an interruption in operations, operating results would be materially adversely affected. The San Antonio facility began qualified production in 1989 and is dedicated to wafer fabrication. Module A of 4 planned modules of 10,000 square feet of class 1 clean room was completed in 1990. A portion of module B was facilitized, equipped and used to augment capacity beginning in 1991 with the balance of facilitization completed in 1993. As of the end of 1993, approximately one-half of module B has been equipped. The remaining one-half of module B can be incrementally equipped in order to expand internal fabrication capacity. Future expansion strategy has not been established for unfacilitized, unequipped modules C and D at the San Antonio plant. The Tempe site contains the primary research and development resources for PCD, assembly and test facilities, marketing, sales and Technology Center functions. The facility, occupied in 1987, was expanded on 6.2 acres of immediately adjacent property in 1992. PCD R&D efforts were moved into that facility in 1993. VLSI expanded into new leased facilities adjacent to its San Jose headquarters in 1993 and believes its currently available space is adequate to meet its requirements in the short term. The Company anticipates that any new space requirements will be satisfied by available space in Tempe and additional San Jose real property leases. Additional manufacturing capacity (approximately one-fourth of 1993 production) has been provided by subcontractors. Further information concerning production capacity and utilization is incorporated by reference from the section titled "MANUFACTURING" in Item 1 of Part I, above. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a named defendant in several lawsuits, including claims for alleged patent infringement in one case and four lawsuits alleging violations of the Securities Exchange Act of 1934, as amended ("the 34 Act"). The ongoing costs of defending these lawsuits utilizes cash and management resources. Should the ultimate outcome of any of these actions be unfavorable to the Company, VLSI could be required to pay damages and other expenses which could be material to a particular quarter's results of operations. In July 1990, TI filed two actions against the Company and four other defendants, Analog Devices, Inc., Integrated Device Technology, Inc. ("IDT"), LSI and Cypress Semiconductor Corporation (the Company and such other defendants are collectively referred to as the "TI Defendants"). IDT settled its cases with TI in late December 1992. In the action filed before the United States International Trade Commission ("ITC"), TI sought to exclude from importation into the U.S. all TI Defendants' products manufactured outside the U.S. that allegedly utilize a plastic encapsulation process described in U.S. Patent No. 4,043,027 (the "027 patent"). On October 15, 1991, the Administrative Law Judge ("ALJ") found the 027 patent to be valid and infringed by the Company's old plastic encapsulation gating process. However, a new plastic encapsulation gating process developed and used by the TI Defendants was found not to infringe the 027 patent. In December 1991, the full ITC determined that it would not consider TI's appeal to overturn the ALJ's decision on noninfringement of the new process. As a result, the Company believes that the importation of its products containing the new noninfringing plastic encapsulation gating process will continue unabated. The United States Court of Appeals for the Federal Circuit affirmed the ITC decision in March 1993. TI also filed a patent infringement action against the TI Defendants in the United States District Court for the Northern District of Texas seeking an injunction against the sale and/or manufacture by the TI Defendants of products that allegedly infringe the 027 patent. The action also seeks damages for alleged past infringement of the 027 patent and expired U.S. Patent No. 43,716,764. The motions of both TI and the TI Defendants for Summary Judgment in this case are pending. A trial in this matter has not yet been scheduled. If the patent infringement claim is upheld, the Company believes that licenses will be available for a negotiated fee. If VLSI is unable to pass any increased costs of manufacturing due to patent license fees on to its customers, VLSI's gross margins would be adversely affected. No assurance can be given that TI would offer a license to VLSI, that the terms of any such license would be favorable, or that any patent dispute will be resolved without a material adverse impact on the Company. Should licenses be unavailable, the Company may be required to discontinue its use of certain processes or the manufacture and sale of certain of its products. In addition, in the normal course of business, the Company receives and makes inquiries with regard to other possible patent infringement. Where deemed advisable, the Company may seek or extend licenses or negotiate settlements. In December 1993, four civil class action complaints relating to the drop in price of VLSI stock were filed in U.S. District Court, Northern District of California, against the Company and certain of its officers and directors, alleging violations of federal securities laws for alleged material mirepresentations and omissions of fact concerning the Company's business. Plaintiffs in those actions filed a consolidated amended complaint, known as Waldron et al. vs. Fiebiger et al., Civ. No. C-93-20930-RMW (PVT) (N.D. Cal. filed March 9, 1994). The suit was filed on behalf of the named plaintiffs and all others who purchased the Company's stock between June 28, 1993 and December 3, 1993. Plaintiffs seek an award of damages according to proof, with interest. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders of the Company during the fourth quarter of fiscal 1993, which ended December 25, 1993. EXECUTIVE OFFICERS OF THE COMPANY Information concerning executive officers of the Company who are not also directors is set forth below: MR. JOHN C. BATTY, age 39, was elected Vice President and Treasurer in December 1992. Mr. Batty joined the Company in June 1986 as Financial Manager. From April 1989 to April 1991, Mr. Batty was the Tempe, Arizona Site Controller. From April 1991 to December 1992, Mr. Batty was Director, Corporate Financial Planning. From August 1982 until joining the Company, Mr. Batty was employed by Intel Corporation, a semiconductor company, in various financial capacities, most recently as Controller, Military Products Division from June 1984 to May 1986. MR. DONALD L. CIFFONE, JR., age 38, was elected Vice President and General Manager of the VLSI Product Divisions in August 1992. Mr. Ciffone joined the Company in November 1991 as Vice President, Primary and Emerging Markets Division. From March 1991 until joining the Company, Mr. Ciffone was Director of Marketing for Oasic Technology, an ASIC company. Mr. Ciffone was employed by National Semiconductor Corporation, a semiconductor company, in various capacities from 1978 until 1991, most recently as Director of Marketing, ASIC Division, from March 1989 until March 1991 and as Marketing Manager, ASIC Division, from 1986 to March 1989. MR. GREGORY K. HINCKLEY, age 47, was elected Vice President, Finance and Chief Financial Officer of the Company in August 1992 upon joining the Company. From December 1991 until August 1992, he was an independent consultant. From January 1989 until December 1991, Mr. Hinckley was Senior Vice President and Chief Financial Officer of Crowley Maritime Corporation, a U.S. shipping company. From 1983 until January 1989, he was Vice President, Finance and Chief Financial Officer of Bio-Rad Laboratories, Inc., a manufacturer of instruments and materials for life science, human diagnostic and semiconductor companies. Mr. Hinckley is a director of Advanced Molecular Systems, Inc. MR. BALAKRISHNAN S. IYER, age 37, joined the Company in April 1993 as Vice President and Controller. From July 1992 until joining VLSI, Mr. Iyer was Corporate Controller for Cypress Semiconductor Corporation, a semiconductor manufacturer. From August 1988 until July 1991, Mr. Iyer was Group Controller at Advanced Micro Devices, Inc., a semiconductor manufacturer. MR. L. DON MAULSBY, age 42, was elected Vice President, Worldwide Sales and Technology Center Operations, in November 1992. Mr. Maulsby joined the Company in 1988 as a Regional Sales Manager. Mr. Maulsby was Area Sales Manager from January 1989 to September 1990. From September 1990 to August 1991, Mr. Maulsby was Vice President, Central U.S. Business Unit; and from August 1991 to November 1992, Vice President, North American Sales and Technology Center Operations. MR. DIETER J. MEZGER, age 50, has been President of the Company's subsidiary, COMPASS Design Automation, Inc., since its formation in February 1991. Since July 1990, Mr. Mezger has also been Senior Vice President of the Company. He joined the Company in 1984 as Director and General Manager of the Company's European operations. From December 1988 until March 1991, he was President of VLSI Technology Europe. MR. THOMAS F. MULVANEY, ESQ., age 45, was elected Vice President and Secretary of the Company in July 1990. Mr. Mulvaney joined the Company in May 1990 as the Company's General Counsel, in which capacity he continues to serve. Prior to joining the Company, he was employed at CP National Corporation ("CPN"), a telecommunications concern, from 1981 to May 1990, as Vice President and General Counsel. He also served as President and Chief Executive Officer of Control Communications Industries, Inc., CPN's manufacturing entity, from December 1988 to May 1990. DR. JAMES R. FIEBIGER, age 52, served as President from February 1988 to August 1993, when he resigned his position with the Company. There are no family relationships among the named officers. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS FINANCIAL INFORMATION BY QUARTER (UNAUDITED) (THOUSANDS, EXCEPT PER SHARE AMOUNTS) - --------------- (1) Included in operations for the second quarter of 1993 is a special charge of $1.0 million, representing a charge for purchased in-process research and development relating to the acqusition of certain assets and development efforts. See Note 6 of Notes to Consolidated Financial Statements. (2) The Company's Common Stock is traded on the NASDAQ National Market System under the symbol VLSI. The prices per common share represent the highest and lowest closing prices for VLSI's Common Stock in the NASDAQ National Market System during each quarter. On February 25, 1994, there were approximately 1,636 stockholders of record. The Company has not paid cash dividends and is currently prohibited from doing so. See Note 2 of Notes to Consolidated Financial Statements. (3) Included in operations for the fourth quarter of 1992 is a special charge of $22.5 million related to the de-emphasis of older technologies, costs of streamlining sales distribution channels, costs of relocating certain offices, write-downs of non-performing assets and costs associated with intellectual property matters. See Note 6 of Notes to Consolidated Financial Statements. (4) See Note 1 of Notes to Consolidated Financial Statements. Subsequent to 1993 fiscal year end, all outstanding shares of the Company's Series B Common Stock, $.01 par value per share ("Junior Common Stock"), a series of Common Shares, automatically converted into shares of Common Stock on a one-for-one basis. Such automatic conversion was triggered by the Company's attainment of certain revenue and pre-tax income milestones specified in the Company's Certificate of Incorporation, as amended. Accordingly, there were no shares of Junior Common Stock outstanding as of March 11, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - --------------- 1. Included in operations for the second quarter of 1993 is a special charge of $1.0 million, representing a charge for purchased in-process research and development relating to the acquisition of certain assets and development efforts. See Note 6 of Notes to Consolidated Financial Statements. 2. Included in operations for the fourth quarter of 1992 is a special charge of $22.5 million related to the de-emphasis of older technologies, costs of streamlining sales distribution channels, costs of relocating certain offices, write-downs of non-performing assets and costs associated with intellectual property matters. See Note 6 of Notes to Consolidated Financial Statements. 3. Included in operations for the third quarter of 1990 is a charge of $12.8 million, reflecting the estimated cost of corporate reorganization related to exiting the memory business. The Company has never paid any cash dividends and is currently prohibited from doing so. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW VLSI recorded net income of $15.9 million on net revenues of $515.9 million in 1993, compared to a net loss of $32.2 million on net revenues of $428.5 million in 1992 and net income of $9.9 million on net revenues of $413.4 million in 1991. In 1993, the Company experienced growth in product shipments which, when combined with gross margin improvements, returned the Company to profitability after the first quarter. Improved operating results during 1993 reflect revenue growth, improved gross margins, more efficient utilization of manufacturing capacity and enhanced yields. A major cause of the net loss in 1992 was a special charge of $22.5 million in the fourth quarter related to the de-emphasis of older technologies, costs of streamlining sales distribution channels, costs of relocating certain offices, write-downs of non-performing assets and costs associated with intellectual property matters. Net income in 1991 reflected high unit volumes, primarily for the TOPCAT(TM) chip set devices. RESULTS OF OPERATIONS VLSI's net revenues for 1993 were $515.9 million, a 20% increase over 1992 net revenues of $428.5 million and 25% over 1991 net revenues of $413.4 million. Net revenues are derived primarily from the sales of Application-Specific Integrated Circuits (ASICs) and Application-Specific Standard Products (ASSPs) through VLSI's Personal Computer Division and VLSI Product Divisions (VPD). VPD serves system manufacturers in the computer, communications, workstation, government, high-performance computer, industrial and consumer markets. VLSI also has a subsidiary, COMPASS Design Automation, Inc. (COMPASS), formed in 1991, focused on developing, marketing and selling Electronic Design Automation (EDA) software products. A major contributor to the 1993 increase in net revenues over 1992 was higher unit sales of VLSI's devices for personal computer applications -- both the X86 and 68000 microprocessor architectures. In addition, average sales prices VLSI realized for X86 chip sets in 1993 did not decline as rapidly as in prior periods due to increased chip set functionality, increased demand for X86 chip sets, reduced competition (as several of the Company's competitors had dropped out of that business) and shifts in customer mix. Due to the historical volatility of X86 chip set average sales prices and overall personal computer demand, past net revenue performance from the personal computer market should not be construed to indicate future net revenue trends. For example, in December 1993, Apple Computer, Inc. (Apple), the Company's largest customer, postponed and in some cases, canceled -- shipments planned for delivery in 1994. Net revenues from the personal computer market declined slightly in 1992 from 1991 as a decline in average sales prices for mainstream 386-based chip sets was partially offset by the introduction of new 486-based chip sets, increased volumes supporting Apple's new products and a shift of emphasis away from low-end PC board manufacturers to system manufacturers. Revenues from the personal computer market in 1991 consisted primarily of 386-based and 68000-based products. Other silicon net revenues grew in 1993 from 1992 and 1991, due to higher unit volume on 0.8-micron designs. This net revenue growth primarily reflects increased sales in wireless and networking communications applications. Other high-end computing applications exhibited flat to declining net revenues in 1993 from 1992, while the Company's net revenues from workstation applications have increased. COMPASS' 1993 net revenues increased from 1992 net revenue levels, which were higher than 1991 net revenues. International net revenues (including export sales) have increased at a faster rate than domestic net revenues for the second year in a row. International net revenues were 50% of net revenues in 1993, compared to 45% in 1992 and 43% in 1991. Export sales, predominantly PC chip sets to the Asia-Pacific region, increased 54% over 1992 levels, which were 23% higher than 1991 export levels. European net revenues increased 24% in 1993 over 1992, versus 8% in 1992 over 1991 levels. The consecutive annual increase in European and Asia-Pacific net revenues reflects major OEM orders shifting from domestic to overseas manufacturing facilities, as well as revenue strength from wireless applications in Europe. Gross margins as a percentage of net revenues improved to 39% in 1993, compared to 35% in 1992 and 37% in 1991. The improvement in 1993 reflects the effect of a reduction in the rate of decline of X86 chip set average sales prices, favorable changes in product mix and improved manufacturing performance. The 1993 improvements in manufacturing performance are primarily attributable to more efficient utilization of internal capacity, higher wafer yields and declines in assembly cost for a high volume package. Gross margins have also improved due to the ongoing implementation of 0.8-micron process technologies. The implementation of new process technologies typically results in products that have higher gross margins than are realized when the technology becomes widely available. The gross margin percentage decline in 1992 from 1991 reflects continuing competitive price pressures on ASSPs, partially offset by higher gross margins on certain ASIC products, the benefits obtained through a continuing shift to 0.8-micron processes and improvements in production and yields. Future gross margins will vary with the general condition of the economy, customer acceptance of new technologies and products, shifts in product mix and the success of ongoing manufacturing cost reduction activities. The Company currently anticipates a decline in gross margins during the first half of 1994 from the second half of 1993 as it commences volume shipments of devices for the portable computer market which will initially have low gross margins. The Company is implementing die size reduction programs, but does not expect improved gross margins on these products until the second half of 1994. No assurance can be given that these die size reduction programs will be successful or that, if successful, gross margins on these products will actually improve as a result. Increases in research and development (R&D) expense in 1993 over 1992 and 1991 reflect additional expenditures for the development of new products for desktop and handheld personal computer devices, communications devices and for the EDA market. Significant amounts were expended in 1993 in support of the joint development effort in portable and handheld products related to the agreement with Intel Corporation (Intel) signed in 1992 (see Note 5 of Notes to Consolidated Financial Statements). Results of this effort include the 1993 introduction and initial samples of the Polar(TM) chip set, intended to serve the handheld marketplace. The Company has another ongoing development effort in association with Intel for the development of a 486-based product for the handheld market. As discussed in "Factors Affecting Future Results," there can be no assurance that these development efforts will be financially successful. R&D expense in 1993 as a percentage of net revenues was consistent with the 1992 level of 16%, but above the 1991 level of 14%. 1992 expenses focused on software, library and new device product development efforts, as well as process technology development efforts in the 0.6-micron architecture that were continued in 1993. R&D expenses include customer-funded development (see Note 1 of Notes to Consolidated Financial Statements). Typically, the intellectual property associated with such development is owned by the customer contracting for the development. Company-funded R&D in the years 1993, 1992 and 1991 was in the range of 10% to 13% of net revenues and is expected to rise slightly in 1994. Marketing, general and administrative costs have increased in each of the three years ending in 1993. In 1993, the Company continued to monitor the ratio of marketing, general and administrative costs to net revenues. In 1993, the strength of the dollar against European currencies provided a decreased expense level in dollar spending terms. Both R&D and marketing, general and administrative expenses were adversely affected in 1992 by the weakness of the U. S. dollar in relation to foreign exchange rates, resulting in increased reported expenses after translation. In the second quarter of 1993, VLSI recorded a $1.0 million special charge for purchased in-process research and development associated with an asset acquisition by COMPASS. During the fourth quarter of 1992, following a review of its operations, the Company recorded a special charge of $22.5 million, reflecting actions and decisions in the quarter regarding the de-emphasis of older technologies, costs of streamlining sales distribution channels, costs of relocating certain offices, write-downs of non-performing assets and costs associated with intellectual property matters. Specifically, the Company terminated a sales representative, resulting in a one-time termination payment, discontinued certain subcontracted manufacturing and design projects, and approved a plan to relocate certain international and domestic sales offices. Based on this review and certain decisions by the Company in connection with such restructuring activities, the Company determined that there were certain non-performing manufacturing and technology assets that needed to be written down to their net realizable value. Finally, costs associated with the ongoing litigation with Texas Instruments Incorporated (TI) were estimated in conjunction with settlement negotiations with TI, which were conducted for the first time during the fourth quarter of 1992. The special charge affected results of operations for the fourth quarter of 1992 significantly, but did not have a material effect on 1993 and is not expected to have a material effect on future operations as there has been no change in management's original estimates. The Company's 1993 liquidity and capital resources were affected by cash paid for the sales representative termination, subcontractor manufacturing payments and office relocation expenses. Liquidity in 1994 will not be materially affected by the remaining office relocation expenses. The effect of the TI litigation on liquidity and capital resources cannot be determined at this time. Also see "Factors Affecting Future Results" below and Notes 4 and 6 of Notes to Consolidated Financial Statements. Interest income and other expenses, net, in 1993 reflect the impact of higher average cash balances on which the Company earned interest during 1993 over 1992 and a decrease in overall litigation and foreign currency transaction costs. The higher cash balances are a result of the sale of $50 million in equity to Intel in the third quarter of 1992. Litigation costs in 1993, 1992 and 1991 reflect accruals for the TI litigation (see Notes 1 and 4 of Notes to Consolidated Financial Statements). The Company expects the TI litigation to be adjudicated in 1994. As VLSI has accrued costs associated with intellectual property matters in conjunction with the 1992 special charge, the Company does not anticipate that the adjudication of the TI litigation will increase expenses in 1994. VLSI's foreign exchange gain was minimal in 1993, compared to net foreign exchange losses of $0.5 million and $2.0 million in 1992 and 1991, respectively. Foreign exchange losses for 1992 and 1991 primarily reflect unfavorable fluctuations in European currencies. Interest expense decreased $1.0 million in 1993 from 1992 and $0.2 million in 1992 from 1991 levels, mainly due to the timing of new equipment financing agreements and the overall decline in interest rates over the three-year period. The 1993 income tax provision of $4.6 million (22.6% of pre-tax income) reflects the benefit of operating loss and credit carryforwards from prior years. The Company was able to utilize only a portion of its U.S. credit carryforwards in 1993 due to alternative minimum tax limitations. The provision for income taxes for 1992 primarily consists of taxes on foreign income. The 1991 provision for taxes on income was $2.9 million (22.7% of pre-tax income), reflecting the benefit of U.S. tax credits. The Company notes that its effective tax rate increased in the fourth quarter of 1993, due to increased foreign withholding taxes. The effective tax rate may increase in 1994, dependent on the overall profitability of the Company, the Company's income in certain foreign countries and the Company's ability to use its remaining net operating loss and credit carryforwards. As discussed in Note 1 of Notes to Consolidated Financial Statements, the effect of VLSI's adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", in 1993 was not material. FACTORS AFFECTING FUTURE RESULTS Historically, the semiconductor manufacturing industry has been characterized by shortening product life cycles, continuous evolution of process technology, high fixed costs and additions of manufacturing capacity in large increments. Net revenues from semiconductor device sales are generated after a significant investment for the design and manufacturing of devices. In addition, advances in semiconductor design and manufacturing technology have resulted in declining average sales prices for a typical product over its life cycle, as alternative and next-generation solutions become available. In order to maintain profit margins in this environment, semiconductor manufacturers must introduce new products and new manufacturing processes and seek to lower costs through programs to reduce die sizes, increase manufacturing capacity utilization and improve manufacturing yields. The Company believes that its future operating results will be subject to the factors described above. Additional factors that may affect VLSI include the cyclical nature of both the semiconductor industry in general and the markets addressed by the Company's products in particular, competitive factors, changes in product mix, fluctuations in manufacturing yields, the availability and extent of utilization of manufacturing capacity and the Company's ability to develop and implement new technologies. The Company expects to continue to invest in the research and development of new products for all market segments in 1994, although there can be no assurance that such new products will be successful. In addition, in circumstances where the Company is operating at less than full capacity or has targeted a market segment as a long-term strategic focus, the Company may choose, in the face of severe pricing pressure, to manufacture products at low or no profitability. During 1993, 1992 and 1991, VLSI's top 20 customers represented approximately 68%, 57% and 56%, respectively, of the Company's net revenues. As a result of this concentration of its customer base, loss of business from any of these customers, significant changes in scheduled deliveries to any of these customers or decreases in the prices of products sold to any of these customers could materially adversely affect the Company s results of operations. For example, in the fourth quarter of 1993, Apple, which accounted for 19% of 1993 net revenues, postponed and, in certain cases, canceled $20 million of shipments planned for delivery in 1994, adversely impacting the anticipated results of operations for the first half of 1994. Current material pending litigation and contingencies are set forth in Note 4 of Notes to Consolidated Financial Statements. While the Company cannot accurately predict the eventual outcome of these or any other such matters, management believes the eventual outcome will not result in a material adverse effect on VLSI's consolidated financial position or results of operations. An unfavorable outcome could have an adverse effect on VLSI's future operations and/or liquidity and could be material to any particular quarter's results of operations. Additionally, the ongoing effort of defending the Company against lawsuits utilizes cash and management resources. The Company is subject to a variety of federal, state and local governmental regulations related to the storage, use, discharge and disposal of toxic, volatile or otherwise hazardous chemicals used in its manufacturing process. Increasing public attention has been focused on the environmental impact of semiconductor manufacturing operations. The Company's San Jose, California facilities are located near recently developed residential areas, which could increase the incidence of environmental complaints or investigations. There can be no assurance that changes in environmental regulations will not impose the need for additional capital equipment or other requirements. Although the Company is not aware of any failure by it to control the use of, or adequately to restrict the discharge of, hazardous substances under present or future regulations, any such failure could subject VLSI to substantial liability or could cause its manufacturing operations to be suspended. Such liability or suspension of manufacturing operations could have a material adverse effect on the Company's operating results. The Company's San Jose facility, which includes manufacturing, COMPASS, VPD Marketing and corporate support services such as its computer center, technology development, primary shipping location and a major design center, is located near earthquake faults. Should an earthquake cause an interruption in operations, operating results would be materially adversely affected. Because of the foregoing factors, as well as other factors affecting the Company's operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. In addition, the Company's participation in a highly dynamic industry often results in significant volatility of the Company's common stock price. The Company must adopt Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (FAS 115), in fiscal 1994. Adoption of FAS 115 will not have a material effect on the Company's consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES VLSI typically uses cash generated by operations and sales of common stock to pay debt and lease obligations as they become due and to purchase capital equipment needed for sub-micron semiconductor engineering and manufacturing. At December 25, 1993, total cash and cash equivalents were $41.5 million, as compared to $69.7 million at December 26, 1992. This change primarily reflects the purchase of liquid investments of $31.1 million having maturities of greater than 90 days but less than one year. Other factors affecting total cash and cash equivalents include profitable 1993 operations and new loan and lease financing offset by purchases of fixed assets, increasing inventory levels to support higher revenues and payments on debt and capital lease obligations, including a $3.5 million payoff of the Industrial Development Revenue Bond obligation in November 1993. At year-end 1992, total cash and cash equivalents had increased $21.7 million from year-end 1991, primarily reflecting the $50 million equity investment by Intel, as described in Note 5 of Notes to Consolidated Financial Statements, offset by a $23 million reduction in short-term borrowings. VLSI increased cash and cash equivalents through operations and the sale of liquid investments in 1991, while keeping capital expenditures and financing payments comparable with prior-year levels. The net effect of the above factors was that working capital increased to $114.4 million at December 25, 1993, compared to $102.1 million at December 26, 1992. Cash generated from operations was $64.4 million, $40.4 million and $56.8 million in 1993, 1992 and 1991, respectively. The significant differences among the years resulted from the net loss incurred in 1992 before the special charge of $22.5 million. Accounts receivable decreased $2.8 million in 1993 compared to 1992, as opposed to an increase of $6.5 million in 1992 from 1991. The 1993 decrease reflects strong collections activity and improved sales linearity in the last quarter of 1993. Year-end 1992 accounts receivable levels increased primarily due to the growth in net revenues in the fourth quarter of 1992 compared to the fourth quarter of 1991. Year-end 1993 inventory increased over 1992 for standard products built during the fourth quarter for anticipated demand. Lower inventories at the end of 1992 versus year-end 1993 and 1991 levels reflect increased customer demand at the end of 1992. In 1993, accounts payable and accrued liabilities increased $11.8 million over 1992, primarily due to increases in accrued compensation and benefits and taxes payable. The 1992 increase in accounts payable and accrued liabilities of $0.5 million over 1991 supported increases in accounts receivable. The reserve for special charge decreased for payments made in 1993 against obligations identified in the 1992 special charge. Sequential increases in deferred income over the three-year period primarily reflect increased postcontract customer support software revenues. Cash used for investing activities was $84.1 million, $31.1 million and $13.8 million in 1993, 1992 and 1991, respectively. The major use of cash in each of the three years was for investment in property, plant and equipment. In 1993, the Company used cash for net purchases of liquid investments, while in 1991, the Company generated cash through net sales of liquid investments. VLSI invested $71.6 million in property, plant and equipment during 1993, compared to $40.1 million in 1992 and $55.4 million in 1991. A significant portion of the 1993 investment was used to upgrade manufacturing facilities to a 0.8-micron wafer fabrication process and to purchase equipment for research into more complex designs in the 0.6-micron geometry. A significant portion of 1992 capital expenditures was used to upgrade manufacturing facilities to 1.0- and 0.8-micron wafer fabrication processes and to purchase equipment for research into more complex designs. Capital expenditures in 1991 reflect acquisition of equipment for advanced CMOS technology and for increasing 1.0-micron and submicron wafer fabrication production and associated sort and test capacity. VLSI currently anticipates that capital expenditures for 1994 will approximate $100 million, significant portions of which will be for additional 0.8-micron and new 0.6-micron wafer fabrication capacity, additional sort and test capacity, packaging options and research equipment. Of such planned capital expenditures, the level of which could change as necessary during the year, the Company had outstanding commitments for purchases of equipment of approximately $22.3 million at December 25, 1993. Cash flow associated with financing activities reflects the generation of cash of $12.4 million in 1992, and the use of cash of $8.5 million and $9.9 million in 1993 and 1991, respectively. The principal components of financing activities are payments on debt and capital lease obligations, short-term financing and sales of common stock. In August 1992, Intel invested $49.4 million, net of issuance costs, to purchase VLSI common stock and a warrant. During the three years ended December 25, 1993, VLSI's only other financings were through equipment leases, equipment loans and employee stock plans. Cash generated by employee stock purchase and stock option plans increased in 1993 over prior years, as a result of higher stock prices during the third quarter, which resulted in a substantial increase in the exercise of employee stock options. Proceeds from the employee stock purchase and stock option plans also increased in 1992 over 1991. In 1991, VLSI increased short-term borrowings, while in 1992 all short-term borrowings were repaid after VLSI received the proceeds from the equity investment by Intel. During 1993, the Company filed a registration statement with the Securities and Exchange Commission for an anticipated public offering of common stock. The offering was postponed during the fourth quarter due to unfavorable fluctuations in the stock price and has not been consummated. VLSI believes that its present capital resources, along with cash flows from 1994 operations and other sources of financing, will be sufficient to meet its operating and capital expenditure needs through 1994. While the Company believes that its current capital resources are sufficient to meet its near-term needs, in order to meet its longer-term needs, VLSI continues to investigate the possibility of generating financial resources through technology or manufacturing partnerships, as well as equity or debt financing based on market conditions. As of February 25, 1994, VLSI had $14.2 million in available and unused credit and equipment financing arrangements. VLSI TECHNOLOGY, INC. ANNUAL REPORT ON FORM 10-K YEAR ENDED DECEMBER 25, 1993 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The chart entitled "Financial Information by Quarter (Unaudited)" contained in Item 5 of Part II hereof is hereby incorporated by reference into this Item 8 of Part II of this Form 10-K. VLSI TECHNOLOGY, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Consolidated Financial Statements Included in Item 8: Schedules other than those listed above 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 consolidated financial statements or the notes thereto. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Stockholders VLSI Technology, Inc. We have audited the accompanying consolidated balance sheets of VLSI Technology, Inc. as of December 25, 1993 and December 26, 1992, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three fiscal years in the period ended December 25, 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of VLSI Technology, Inc. at December 25, 1993 and December 26, 1992, and the consolidated results of its operations and its cash flows for each of the three fiscal years in the period ended December 25, 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 San Jose, California January 19, 1993 VLSI TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS AND SHARES IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) - --------------- (1) See Note 9 for related party disclosures. See accompanying Notes to Consolidated Financial Statements. VLSI TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (THOUSANDS) See accompanying Notes to Consolidated Financial Statements. VLSI TECHNOLOGY, INC. CONSOLIDATED BALANCE SHEETS (DOLLARS AND SHARES IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ASSETS See accompanying Notes to Consolidated Financial Statements. VLSI TECHNOLOGY, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (THOUSANDS) See accompanying Notes to Consolidated Financial Statements. VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED DECEMBER 25, 1993 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of presentation The consolidated financial statements include the accounts of VLSI Technology, Inc. (VLSI or the Company) and its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Fiscal year The Company's fiscal year ends on the last Saturday in December. Fiscal years 1993, 1992 and 1991 ended December 25, 26 and 28, respectively. All fiscal years consisted of 52 weeks. Cash equivalents and liquid investments Cash equivalents reflect highly liquid short-term investments with maturities at date of purchase of three months or less. These investments are readily convertible to known amounts of cash, while investments with maturities of between three and twelve months are considered liquid investments. Liquid investments consist of commercial paper and are valued at fair value, which approximates market. Inventories Inventories are stated at the lower of cost or market. Cost is computed on a currently adjusted standard basis (which approximates average cost on a FIFO basis); market is based upon estimated net realizable value. Property, plant and equipment Property, plant and equipment are stated at cost. Depreciation and amortization are provided on the straight-line method for financial reporting purposes and on accelerated methods for tax purposes. Assets leased under capitalized leases are recorded at the present value of the lease obligations and amortized on a straight-line basis over the lease term. Capitalization of software development costs Capitalization of software costs begins when technological feasibility is established. Such costs are stated at the lower of unamortized cost or net realizable value. Amortization is computed using (a) the straight-line method based on the estimated economic life of each product (not to exceed two years), or (b) the ratio of each product's current gross revenue for that product to the total of current and anticipated gross revenue for that product, whichever is greater. Software development costs of $0.8 million, $0.2 million and $1.3 million were capitalized in 1993, 1992 and 1991, respectively, of which $0.8 million, $0.5 million and $0.1 million were amortized to cost of sales in 1993, 1992 and 1991, respectively. Revenues Revenues from silicon product sales to customers other than distributors are recognized upon shipment. Certain sales made to distributors are under agreements allowing the right of return and price protection on merchandise not sold by the distributors. Accordingly, the Company defers recognition of revenue and profit until the merchandise is sold by the distributors. VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 Revenues associated with software system sales and software licenses are generally recognized at the time of shipment. Postcontract customer support revenues are recognized ratably over the term of the related agreements. Training and consulting revenues are recognized as the related services are performed. Revenues relating to the licensing of technology are generally recognized when the significant contractual obligations have been fulfilled and the fees are billable. Net revenues include design and engineering revenues of approximately $30.5 million in 1993, $32.9 million in 1992 and $33.7 million in 1991. Related costs, which approximate the revenues, are included either in cost of sales or research and development, depending on the nature of such revenues. Translation of foreign currencies VLSI translates accounts denominated in foreign currencies using the respective local subsidiary currency as the functional currency. Thus, results from foreign operations are subject to exchange rate fluctuations and foreign currency transaction costs. In 1993, net foreign currency transaction gains included in interest income and other expenses, net, were not material, while in 1992 and 1991, net foreign currency transaction losses were $532,000 and $1,972,000, respectively. Foreign translation gains and losses and the effect of foreign currency exchange rate fluctuations on cash flows in all years have not been material. Foreign exchange contracts The Company's policy is to hedge all material monetary assets, liabilities and commitments denominated in currencies other than the functional currency of the Company's subsidiaries. This activity is primarily performed using forward contracts, with a lesser amount of currency option use. This policy of hedging is intended to eliminate material monetary exposures on a going-forward basis. No high correlation hedging activities are performed, as all currency risks are hedged with instruments using the same currency. Market value gains and losses on such hedges are offset against foreign exchange gains or losses on the items hedged. At December 25, 1993, VLSI had 1) foreign exchange contracts to sell $9.8 million in foreign currency and buy $6.1 million in foreign currency and 2) cross currency contracts to exchange 27.2 million French francs for Deutsche marks. The contracts matured through January 1994. Concentrations of credit risk Financial instruments which potentially subject VLSI to concentration of credit risk consist principally of cash equivalents, liquid investments and trade receivables. VLSI places its investments with high-credit-quality financial institutions and, by policy, limits the amount of credit exposure to any one financial institution. A majority of VLSI's trade receivables are derived from sales to manufacturers of computer systems, with the remainder spread across various other industries. Management believes that any risk of accounting loss is significantly reduced due to the diversity of its products, end customers and geographic sales areas. VLSI performs ongoing credit evaluations of its customers financial condition and requires collateral, such as letters of credit and bank guarantees, whenever deemed necessary. Fair value disclosures The following estimated fair values have been determined by the Company using available market information and appropriate valuation methodologies: Cash, cash equivalents and liquid investments -- The carrying amounts of these items are a reasonable estimate of their fair value. VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 Debt (See Note 2) -- Quoted market prices of the Company's Convertible Subordinated Debentures are currently available. Interest rates that are currently available to the Company for issuance of debt similar to existing secured equipment loans are used to estimate the fair value of remaining maturities of existing secured equipment loans. Foreign currency contracts -- The estimated fair value of foreign currency contracts is based on quoted market prices obtained from dealers. The carrying amount and fair value of the Company's financial instruments at December 25, 1993 and December 26, 1992 are as follows: The fair value estimates presented are based on pertinent information available to management as of December 25, 1993 and December 26, 1992, respectively. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since such dates, and current estimates of fair value may differ significantly from the amounts presented. The Company must adopt Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (FAS 115), in fiscal 1994. Adoption of FAS 115 will not have a material effect on the Company's consolidated financial statements. Interest income and other expenses, net Interest income and other expenses, net, include costs associated with material litigation, such as that brought by Texas Instruments Incorporated (TI) (see Note 4). Such litigation costs were $0.1 million in 1993, $3.2 million in 1992 and $1.1 million in 1991. Also included in interest income and other expenses, net, in 1992 is $0.9 million associated with a stockholder class action lawsuit settlement regarding alleged violations of federal securities and certain state laws. Income taxes Effective December 27, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109), for the 1993 fiscal year. Under FAS 109, the liability VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 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 FAS 109, the Company used the liability method under FAS 96. Under FAS 109, future events can be considered to support recognition of deferred tax assets. Generally, FAS 96 prohibited consideration of any other future events in calculating deferred taxes. The cumulative effect, as well as the current year effect, of the adoption of FAS 109 was not material. As permitted by FAS 109, the Company has elected not to restate the financial statements of any prior years. Net income (loss) per share Net income (loss) per share is computed using the weighted average number of shares of outstanding Common Stock and dilutive common equivalent shares -- shares issuable under the stock option plans and a warrant and certain rights to maintain a percentage equity ownership held by Intel Corporation (Intel). The Convertible Subordinated Debentures are not included, because the effect would be antidilutive. Fully diluted earnings per share have not been presented, because the amounts would be antidilutive. Reclassifications Certain prior year amounts previously reported as marketing, general and administrative expense and cost of sales in the Consolidated Statements of Operations have been reclassified among these same categories to conform to the 1993 presentation. 2. LONG-TERM DEBT Total debt at December 25, 1993 and December 26, 1992 consists of the following: As of December 25, 1993, VLSI had unsecured domestic and foreign uncommitted credit facilities plus committed lease and secured equipment financing aggregating $26.9 million ($15.0 million available at December 25, 1993). Interest on short-term borrowing facilities was based on market rates. Interest on long-term borrowing facilities is at contractual rates based on U.S. Treasury securities. Certain secured equipment loans require adherence to certain financial covenants, one of which prohibits payment of cash dividends. Interest on the Convertible Subordinated Debentures (Debentures) is payable semi-annually on November 1 and May 1 of each year. The Debentures are convertible into Common Stock of the Company at any time prior to maturity, unless previously redeemed, at a conversion price of $22.00 per share, subject to adjustment under certain conditions. Required annual sinking fund payments commencing May 1, 1998 will VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 retire 70% of the Debentures prior to maturity. At December 25, 1993, the Debentures were redeemable at the Company's option at 102.8% of the principal amount and at diminishing prices thereafter. The Debentures are subordinated in right of payment to senior indebtedness as defined. Maturities of debt are as follows: 1994 -- $6.3 million, 1995 -- $5.9 million, 1996 -- $4.3 million, 1997 -- $2.6 million, 1998 -- $4.5 million and thereafter (starting in 1999) -- $57.6 million. 3. LEASES AND OTHER COMMITMENTS Obligations under capital leases represent the present value of future rental payments under various agreements to lease manufacturing equipment. The Company has options to purchase leased assets at the end of the lease terms for their fair market values or at stipulated values up to 30% of original cost. Accumulated amortization of these leased assets was $47.8 million and $42.1 million at December 25, 1993 and December 26, 1992, respectively. The Company rents certain equipment and manufacturing and office facilities under operating lease agreements which expire through 2037 and contain renewal options and provisions adjusting the lease payments, based upon changes in the Consumer Price Index or in fixed increments. VLSI is generally responsible for taxes, insurance and utilities under these leases. Future minimum lease payments under capital leases, together with the present value of those payments and the aggregate annual rental commitments under noncancelable operating leases as of December 25, 1993, are shown as follows: Rental expense was approximately $11.8 million in 1993 ($10.7 million in 1992 and $9.2 million in 1991). Other commitments Commitments for purchase of equipment totaled approximately $22.3 million at December 25, 1993. 4. LITIGATION AND CONTINGENCIES The Company is a named defendant in several lawsuits, including claims for alleged patent infringement in one case and four lawsuits alleging violations of the Securities Exchange Act of 1934, as amended (the 34 Act). VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 In 1990, patent infringement claims were filed by TI against the Company and four other defendants with the International Trade Commission (ITC) and the U.S. District Court for the Northern District of Texas, Dallas Division (District Court), seeking to preclude importation into the U.S. of, and an injunction against the sale and/or manufacture of, parts using the allegedly protected process and seeking unspecified damages, respectively. During 1991, the Company developed an alternate process and has discontinued use of the allegedly protected process. In February 1992, the ITC determined that the Company infringed the original patented process, but found the newly developed process to be non-infringing. The Court of Appeal, for the Federal Circuit, affirmed the ITC decision in 1993. At the request of the District Court, the parties filed Motions for Summary Judgement and responses thereto in January and February 1994, respectively. A trial date has not been set in the District Court case. If the patent infringement is upheld relative to the Company's products that used the old process, damages for past infringement may be assessed. If the newly developed process is found to be infringing and the patent infringement claim is upheld, the Company believes that licenses will be available for a negotiated fee. No assurance can be given that the terms of any offered license will be favorable, or that any patent dispute will be resolved without an adverse effect on the Company. If VLSI is unable to pass any increased costs of manufacturing due to patent license fees on to its customers, VLSI's gross margins would be adversely affected. Should licenses be unavailable, the Company may be required to discontinue its use of certain processes and/or the manufacture and sale of certain of its products. The Company is vigorously defending itself against the TI claims. However, should the ultimate outcome of this matter be unfavorable, VLSI may be required to pay damages and other expenses. In addition, in the normal course of business, the Company receives and makes inquiries with regard to other possible patent infringement. Where deemed advisable, the Company may seek or extend licenses or negotiate settlements. The 34 Act claims are purported class actions filed against the Company and certain officers and directors in U.S. District Court, Northern District of California, San Jose Division, for alleged violations of federal securities laws. The lawsuits were filed in December 1993. Three of the four claims are identical except for plaintiff names. No trial date has been set. The Company will vigorously defend itself in these matters and management believes these actions, either individually or in the aggregate, should not have a materially adverse impact on its results of operations or financial position. While the outcome of these matters is currently not determinable, management believes that the ultimate resolution of these matters will not have a material adverse effect on the Company's consolidated financial position or results of operations. However, should the ultimate outcome of either of these matters be unfavorable, VLSI may be required to pay damages and other expenses. 5. STOCKHOLDERS EQUITY During 1992, the Company amended its certificate of incorporation, increasing the number of authorized shares to 57,000,000 shares of Capital Stock, 55,000,000 shares of which are designated Common Shares and 2,000,0000 shares of which are designated Preferred Shares. The Common Shares are authorized to be issued in series, with the first series designated Common Stock and consisting of 54,000,000 shares. All other series of Common Shares (other than Common Stock) are designated, as a group, Junior Common Stock and consist of 1,000,000 shares. The Board of Directors (Board) has the authority to issue the Preferred Shares and Common Shares in series, the rights, preferences and privileges of which can be determined by the Board without stockholder approval. VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 Intel Agreements On August 25, 1992, Intel invested $50 million in VLSI to acquire 5,355,207 shares of the Company's Common Stock (Intel Shares) plus a warrant (Warrant) to purchase an additional 2,677,604 shares of the Company's Common Stock (Warrant Shares) at $11.69 per share pursuant to the Intel/VLSI Stock and Warrant Purchase Agreement (Equity Agreement). In addition, on July 8, 1992, VLSI and Intel entered into a Technology and Manufacturing Agreement (Technology Agreement). Pursuant to the Technology Agreement, the two companies are working together to manufacture -- with VLSI responsible for designing, marketing and selling -- chips that will enable manufacturers to build handheld computers on the standardized system platform to be developed by the companies. The Equity Agreement provides Intel with certain rights, including a right of first refusal upon a proposed sale of corporate control of VLSI, demand registration rights with respect to the Intel Shares and the Warrant Shares, a right of Intel to representation on the VLSI Board, a right for Intel to purchase additional securities (481,924 shares at December 25, 1993) in order to maintain its original percentage equity ownership, a right to initiate a tender offer for VLSI stock under certain circumstances, and a right to respond to a third-party tender offer by making its own tender offer for VLSI stock. The Equity Agreement also imposes certain restrictions on Intel, including a limitation on Intel's ability to acquire additional shares of VLSI voting stock (referred to as a standstill), a requirement that Intel vote its VLSI shares in the same proportion as other stockholders on matters submitted to the VLSI stockholders for approval (unless it would be materially adverse to Intel's interest), restrictions on transfer of the Intel Shares, the Warrant and the Warrant Shares and a limited right of first refusal by VLSI upon a proposed transfer of VLSI securities by Intel in certain circumstances following a hostile tender offer. The Warrant, which expires in August 1995, contains certain antidilution provisions, including price-based antidilution. In the event that VLSI is acquired (by merger, sale of assets or otherwise) for consideration other than common stock of the acquiring corporation during the three-year term of the Warrant, the warrant-holder is entitled to receive minimum consideration from the acquiring corporation. As of December 25, 1993, such minimum amount was equal to $1.81 per Warrant Share and decreases on a straight-line daily basis over the three-year term of the Warrant to zero. The Warrant does not give the holder any voting rights prior to exercise of the Warrant and issuance of the Warrant Shares. Stockholders' Rights Plan On August 11, 1992, the Board of Directors approved the adoption of the First Amended and Restated Rights Agreement (Restated Rights Agreement), which replaces the Common Shares Rights Agreement dated as of November 7, 1989 (Prior Rights Agreement) and amends the outstanding rights issued pursuant to the Prior Rights Agreement (Rights). Among other things, the Restated Rights Agreement provides that each Right will now relate to a fraction of a share of Series A Participating Preferred Stock of the Company (a Unit), which is economically equivalent to one share of Common Stock. On August 24, 1992, the Board of Directors further amended the Restated Rights Agreement for the purpose of excepting certain transactions contemplated by the Equity Agreement between the Company and Intel from operation of the Restated Rights Agreement. The Rights can be transferred or exercised (initially at a price of $45 per Unit) only upon the occurrence of certain events involving substantial transfers of ownership of Common Shares. The Rights are redeemable, in whole but not in part, at VLSI's option at $.01 per Right, at any time prior to becoming exercisable and in certain other circumstances. The Rights expire no later than November 7, 1999. VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 Directors' Stock Option Plan At December 25, 1993, non-employee directors held options to purchase 70,000 shares of Common Stock at exercise prices ranging from $6.75 to $8.63 per share, of which 20,000 were exercisable. In addition, 220,000 shares were available for future grant under this Plan. The Board has approved, subject to shareholder approval, various changes to this Plan, including eliminating a limitation on the number of shares that may be granted to directors and extending both the expiration of the Plan from 1996 to 2001 and the term of each future option from five to ten years. Employee Stock Purchase Plan Under VLSI's Employee Stock Purchase Plan, qualified employees are entitled to purchase shares of Common Stock at 85% of the fair market value at certain specified dates. Of the 6,600,000 shares authorized to be issued under this Plan, 5,117,004 shares have been issued through December 25, 1993. Incentive Stock Option Plans Employees and consultants may be granted options to purchase shares of VLSI's authorized but unissued Common Stock, as well as certain other awards under the Company's 1992 Stock Plan. Additionally, employees and consultants may exercise options to purchase shares of VLSI Common Stock previously granted under the 1982 Incentive Stock Option Plan. No new options may be granted under the 1982 Incentive Stock Option Plan. Options granted under these Plans may either be incentive stock options or nonstatutory options. All outstanding options have exercise prices equal to the fair market value on the date of grant. Generally, outstanding options expire ten years from date of grant and become exercisable at a rate of 25% per year from date of grant. At December 25, 1993, 828,841 shares were available for grant under the 1992 Stock Plan. This Plan expires in 2002. Additional information relative to the Plans is as follows: During 1993, VLSI recorded a tax benefit related to options exercised under the Plans, resulting in a $1,680,000 increase in stockholders' equity ($600,000 in 1992). 6. SPECIAL CHARGES The special charge in 1993 of $1.0 million represents a charge for purchased in-process research and development relating to the acquisition of certain assets and development efforts of Open Solutions, Inc. and its subsidiary, CAD Language Systems, Inc., by COMPASS Design Automation, Inc., a Company subsidiary, in June 1993. The acquisition was accounted for as a purchase. Results of operations from the effective date to VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 year-end are included in the statement of operations. The aggregate purchase price totaled $2.4 million, including assumption of liabilities. During the fourth quarter of 1992, the Company recorded a special charge of $22.5 million related to the de-emphasis of older technologies, costs of streamlining sales distribution channels, costs of relocating certain offices, write-downs of non-performing assets and costs associated with intellectual property matters. 7. EMPLOYEE BENEFIT PLANS The Company accrued approximately $3,751,000, $206,000 and $2,140,000 in 1993, 1992 and 1991, respectively, for its Employee Profit Sharing Plan, Executive Performance Incentive Plan and Performance Recognition Plan. The Company's contribution expenses associated with its 401(k) plan were approximately $548,000, $480,000 and $478,000 in 1993, 1992 and 1991, respectively. 8. INCOME TAXES The provision for taxes on income is as follows: Pre-tax income (loss) from foreign operations was $1.2 million in 1993, $(3.0) million in 1992 and $(1.9) million in 1991. VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 The provision for taxes reconciles with the amount computed by applying the U.S. statutory rate to income (loss) before provision for taxes as follows: Deferred income taxes reflect tax credits and loss carryforwards and the 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. As required by FAS 109, significant components of the Company's deferred tax liabilities and assets as of December 25, 1993 are as follows: The valuation allowance decreased $462,000 during 1993. Approximately $3.6 million of the valuation reserve is related to benefits of stock option deductions, which will be allocated directly to additional paid-in capital when realized. VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 The sources and effects of the deferred tax provision are as follows, (see FAS 109 disclosure above for 1993): For U.S. tax purposes, at December 25, 1993, VLSI had investment, research and alternative minimum tax credit carryforwards of approximately $10.7 million. Foreign subsidiaries have tax loss carryforwards of approximately $6.5 million. Such credit and loss carryforwards expire in various years beginning in 1997. The Company's federal income tax returns have been examined by the Internal Revenue Service (IRS) for all years through 1990. All issues have been resolved with no material effect, and the IRS has closed those years. Certain foreign subsidiaries have accumulated earnings of $3.7 million, on which no U.S. deferred taxes have been provided. There is no intention to distribute these earnings. If distributed, there would be minimal incremental income taxes. 9. RELATED PARTIES As of December 25, 1993, VLSI had received advances of $5.5 million from Intel in accordance with the Technology Agreement, of which $2.2 million was amortized to income in 1993 in accordance with the terms of the Technology Agreement. Consequently, $3.3 million of these advanced funds are reflected as an accrued liability at December 25, 1993, and are expected to be amortized to income during 1994 in accordance with the terms of the Technology Agreement. VLSI purchased $38.1 million, $23.3 million and $25.6 million in 1993, 1992 and 1991, respectively, of production, assembly and test services from a company with whom a director of the Company is affiliated. Outstanding amounts payable to that company were $2.3 million and $2.4 million in 1993 and 1992, respectively. 10. INDUSTRY SEGMENT AND GEOGRAPHIC INFORMATION VLSI operates in a single industry segment and designs, manufactures and markets primarily custom and semi-custom integrated circuits of high complexity, along with associated integrated circuit computer-aided engineering and design software and systems. In 1993, 1992 and 1991, Apple Computer, Inc. accounted for 19%, 15% and 13%, respectively, of net revenues. Major operations outside the United States include sales offices and technology centers in Western Europe, Japan and Asia-Pacific. Foreign operations are subject to risks of political instability and foreign currency exchange rate fluctuations. Transfers between geographic areas are accounted for at amounts that are generally above cost and consistent with the rules and regulations of governing tax authorities. Such transfers are eliminated in the VLSI TECHNOLOGY, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED DECEMBER 25, 1993 consolidated financial statements. Identifiable assets are those assets that can be directly associated with a particular geographic area and thus do not include assets used for general corporate purposes, such as cash, cash equivalents and liquid investments. The following is a summary of operations located within the indicated geographic areas for the three years ended December 25, 1993: U.S. export revenues, primarily to the Asia-Pacific region, were approximately $126.7 million, $82.2 million and $66.8 million in 1993, 1992 and 1991, respectively. 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 regarding directors appearing under the caption "Election of Directors -- Nominees for Director" in the Proxy Statement is hereby incorporated herein by reference. Information regarding executive officers who are not also directors is incorporated herein by reference from Part I hereof under the heading "Executive Officers of the Company" immediately following Item 4 in Part I hereof. Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, is hereby incorporated herein by reference from the section entitled "Information Concerning Solicitation and Compliance and Voting -- Security Ownership -- Compliance with Section 16(a) Filing Requirements" in the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference from the Proxy Statement under the captions "Election of Directors -- Nominees for Director", "Election of Directors -- Compensation Committee Interlocks and Insider Participation", "Executive Officer Compensation" and "Election of Directors -- Director Compensation". ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference from the Proxy Statement under the caption "Information Concerning Solicitation and Voting -- Security Ownership". ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference from the Proxy Statement under the captions "Election of Directors -- Certain Transactions", "Executive Officer Compensation" and "Election of Directors -- Compensation Committee Interlocks and Insider Participation". PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements The financial statements (including the notes thereto) listed in the accompanying index to financial statements and financial statement schedules are filed within this Annual Report on Form 10-K. 2. Financial Statement Schedules The financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. 3. Exhibits The exhibits listed under Item 14(c) hereof are filed as part of this Annual Report on Form 10-K. (b) Reports on Form 8-K The Company filed one Report on Form 8-K during the fourth quarter ended December 25, 1993. Such Report on Form 8-K, dated December 3, 1993, reported under Item 5 thereof a notice of reduction in orders from Apple and the possible effect on the Company's results of operations for 1994. (c) Exhibits - --------------- * Denotes a compensation plan in which an executive officer participates. ** Denotes a document for which SEC confidential treatment has been requested for selected portions. *** Denotes a document for which confidential treatment has been granted for selected portions. (d) Financial Statement Schedules See Item 14(a)(2) above. CONSENT OF ERNST & YOUNG, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements (Forms S-8 Nos. 2-86600, 2-90890, 33-4797, 33-12909, 33-21116, 33-27872, 33-39653 and 33-52908) pertaining to the Employee Stock Purchase Plan, 1992 Stock Plan, 1982 Incentive Stock Option Plan, 1983 Incentive Junior Stock Plan and 1986 Directors' Stock Option Plan of VLSI Technology, Inc. and in the related Prospectuses, of our report dated January 19, 1994, with respect to the consolidated financial statements and schedules of VLSI Technology, Inc. included in this Annual Report (Form 10-K) for the year ended December 25, 1993. /s/ ERNST & YOUNG Ernst & Young San Jose, California March 22, 1994 VLSI TECHNOLOGY, INC. SCHEDULE I -- MARKETABLE SECURITIES -- OTHER INVESTMENTS YEAR ENDED DECEMBER 25, 1993 (IN THOUSANDS) S-1 VLSI TECHNOLOGY, INC. SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES - --------------- (1) Unsecured, full recourse promissory note bearing interest at the rate of 8.75% per annum due December 1988 (paid March 1994). (2) Terminated employment in January 1988. (3) Non-interest bearing promissory notes secured by deeds of trust on employees' homes in accordance with Internal Revenue Code Section 7872. At December 25, 1993, notes were due September 1995 for Mr. Larsen (paid January 1994) and February 1995 for the noncurrent portion for Mr. Mezger. (4) Amount forgiven in lieu of bonuses paid. (5) Terminated employment in 1991. Of the amounts collected, $70,000 for Mr. Larsen and $30,000 for Mr. Saltich were forgiven in lieu of bonuses paid. (6) Interest bearing promissory notes secured by deeds of trust on employees' homes in accordance with Internal Revenue Code Section 7872. At December 25, 1993, notes were due July 1994 for the current portion for Mr. Mezger and October 1994 for Mr. Potts. S-2 VLSI TECHNOLOGY, INC. SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) - --------------- (1) Assets under leases with total cost of $2,554 in 1993, $1,912 in 1992 and $5,050 in 1991 were purchased from lessors and are included in "Additions (Transfers) at Cost" as a transfer from "Assets leased under capital leases" to "Machinery and equipment". Land is stated at cost. Buildings and building improvements are stated at cost and depreciated over the estimated useful lives of the assets (10 to 31.5 years) using the straight-line method. Leasehold improvements are stated at cost and amortized generally over the shorter of the useful life of the asset or the lease term including expected option periods, using the straight-line method. Machinery and equipment are stated at cost and depreciated over the estimated useful lives of the assets (3 to 7 years) using the straight-line method. Assets under capital leases are recorded at the present value of the lease obligations and amortized over the lease term using the straight-line method. Sale-leaseback transactions were conducted in 1993 for $3,957 (at original cost) of assets that are included in both additions and retirement totals for the year. S-3 VLSI TECHNOLOGY, INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PLANT AND EQUIPMENT (IN THOUSANDS) NOTE: Balances do not conform to the prior year's presentation due to corrections in the allocation of depreciation and amortization between fixed asset categories for all periods presented. - --------------- (1) Accumulated amortization associated with assets under leases which were purchased from lessors and included in "Additions (Transfers) at Cost" was $2,519 in 1993, $1,898 in 1992 and $4,809 in 1991. S-4 VLSI TECHNOLOGY, INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS) - --------------- (1) Deductions represent amounts written off against the allowance. S-5 VLSI TECHNOLOGY, INC. SCHEDULE IX--SHORT-TERM BORROWINGS (IN THOUSANDS) - --------------- (1) Computed by taking the average of the end of the month balances. (2) Computed by dividing the total amount of related interest expense by the average amount outstanding during the period. S-6 VLSI TECHNOLOGY, INC. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS) Items have been omitted if they are less than 1% of net revenues or if they are separately reported in the consolidated financial statements. S-7 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. VLSI TECHNOLOGY, INC. (Registrant) By: /s/ ALFRED J. STEIN Alfred J. Stein, Chairman of the Board, Chief Executive Officer and President Date: March 11, 1994 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appear below constitutes and appoints Alfred J. Stein and Gregory K. Hinckley, 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 Annual 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. S-8 INDEX TO EXHIBITS - --------------- * Denotes a compensation plan in which an executive officer participates. ** Denotes a document for which SEC confidential treatment has been requested for selected portions. *** Denotes a document for which confidential treatment has been granted for selected portions. (d) Financial Statement Schedules See Item 14(a)(2) above.

350572_1993.txt

350572_1993

1993

350572

ITEM 1. BUSINESS. GENERAL Worthen Banking Corporation (hereinafter referred to as "WBC", "Company" or "Registrant" and includes WBC's subsidiaries and affiliates unless the context otherwise requires), was incorporated in the State of Arkansas in August 1968 to buy, sell, own and operate banks and to offer a diversified range of commercial banking, trust and other financial services to retail and commercial customers. The Company is the second largest multi-bank holding company in Arkansas with corporate headquarters located in the Worthen National Bank Building in Little Rock, Arkansas. Operations of the Company are conducted through bank and nonbank subsidiaries and affiliates. The existing and future activities of the Company are limited by the Bank Holding Company Act of 1956, as amended, which generally prohibits a bank holding company from acquiring or engaging in any businesses other than banking, managing or controlling banks, and furnishing or performing certain bank related services and activities. The Company is primarily engaged in buying, selling, owning, managing and operating commercial banks and other financial services companies and its subsidiaries are primarily engaged in the commercial banking, trust and securities brokerage businesses. The income and other operating results of the nonbank subsidiaries and affiliates as compared to the consolidated operating results of the Company, are not substantial enough to require financial and other information concerning industry segments to be included in this Annual Report on Form 10-K. The Company commenced active operations in March, 1969 with the acquisition of a controlling interest in Worthen National Bank of Arkansas, Little Rock, Arkansas ("WNBA") and became a multi-bank holding company upon the acquisition of a controlling interest in Worthen National Bank of Hot Springs, Arkansas ("WNB-Hot Springs") in October, 1970. In 1971, the Arkansas legislature enacted a law prohibiting the acquisition of additional banks, which law remained in effect until the passage of Act 128 of 1983, the Arkansas Bank Holding Company Act of 1983. Act 128, which permits the acquisition of additional banks in accordance with certain guidelines, became effective September 30, 1983. During fiscal year 1993, WBC owned eleven banks, which were located in Arkansas and the Austin, Texas area. All of these are national banks, chartered pursuant to the laws of the United States. Since its organization and commencement of operations, WBC's revenues and net income or net losses have resulted principally from its banking subsidiaries. In addition to commercial banking, WBC also provides, through its subsidiaries and affiliates, mortgage banking, appraisal services, trust services, credit life and disability insurance, investment advisory services, full service and discount brokerage services, data processing and other related financial services. On May 7, 1993, Worthen Banking Corporation acquired 100% of the stock of The Union of Arkansas Corporation ("Union") with the issuance of 4,550,000 shares of WBC common stock to the Union stockholders. Union's principal subsidiary bank, Union National Bank of Arkansas ("Union-Little Rock"), was merged with WNBA on May 28, 1993. Union-Little Rock was a commercial bank with approximately $595 million in assets, $482 million in deposits and $54 million in equity operating from twenty-two locations in central and southern Arkansas and had two mortgage banking subsidiaries. Union's only other banking subsidiary was Union National Bank of Texas ("Union-Texas") operating out of six locations in Austin, Texas. Union-Texas had approximately $120 million in assets, $112 million in deposits and $6 million in equity at December 31, 1992. Union-Texas has been renamed Worthen National Bank of Texas. This transaction was accounted for using the pooling-of-interests method of accounting. On September 10, 1993, the Company acquired 100% of First Bentonville Bancshares, Inc., the parent corporation of First Bank of Bentonville, Arkansas ("FirstBank"). WBC paid approximately $3.9 million in cash, $4.1 million in debt repayment and 250,000 newly-issued shares of WBC's common stock. For the year ended December 31, 1992, FirstBank reported total assets of $88,546,000, net interest income of $2,826,000 and net income of $805,000. FirstBank was merged into Worthen National Bank of Northwest Arkansas on October 31, 1993. This acquisition was accounted for as a purchase and the results of operations of FirstBank are included in the Company's consolidated financial statements from the date of purchase. Each subsidiary of the Company operates with a high degree of autonomy. WBC, as the corporate parent, provides various technical and advisory services and establishes general policy for the management and coordination of the resources of its subsidiaries to more effectively service the credit and financial services needs of the subsidiaries' customers and communities. The Company coordinates the activities of its subsidiaries in certain areas, including without limitation, credit policy, accounting, internal auditing, regulatory compliance, loan review, investment coordination, asset/liability management, public relations, and business development. However, the subsidiaries operate under the direct supervision and day-to-day management of their own directors and officers who formulate their own policies subject to the Company's general policy guidelines and regulatory compliance. WBC's principal sources of income are dividends and management service fees paid by its subsidiaries. Dividend payments are determined quarterly in relation to subsidiary income, assets, deposit growth and capital position in compliance with regulatory guidelines and, in certain cases, prior regulatory approval. Management service fees represent reimbursements received for services performed by the corporate parent. COMMERCIAL BANKING SUBSIDIARIES The Company's principal source of income is derived from its eleven subsidiary commercial banks and through certain of its nonbank subsidiaries. The main offices of these subsidiaries are located in Batesville, Camden, Conway, Fayetteville, Harrison, Hot Springs, Little Rock, Newark, Pine Bluff and Russellville, Arkansas and Austin, Texas. All offer a broad range of commercial bank services to the markets and communities which they serve, as well as provide other related financial services in a majority of locations. BANK RELATED SUBSIDIARIES AND AFFILIATES The Company's non-bank subsidiaries include: 1) a full service and discount brokerage company, which is a registered broker dealer and investment adviser, whose business is conducted at a majority of the Company's banking subsidiaries throughout the state; 2) a mortgage banking company whose business is originating and servicing mortgage loans; 3) a credit life insurance company which insures or reinsures credit life and accident and health insurance; 4) a data processing and operations support company which provides data processing and transmission services, item processing and similar functions for the Company's banking subsidiaries; 5) a trust company which provides trust administration and operations; 6) an appraisal company whose business is appraising property proposed to be offered as loan collateral; and 7) two small and relatively inactive companies related to industrial lending and real estate development. SUPERVISION AND REGULATION The following summaries of statutes and regulations affecting bank holding companies and their commercial banking subsidiaries do not purport to be complete but are given to provide a general overview. The summaries are qualified in their entirety by reference to the provisions of the statutes and regulations summarized. STATE USURY LAW Prior to its amendment in 1982, the Constitution of the State of Arkansas limited the rate of interest which could be charged on borrowed funds to 10% per annum simple interest, and provided for forfeiture of principal and interest in the event that a greater amount of interest was charged or received. The effect of that constitutional limitation had been mitigated to some extent by Public Law 96-221 (the "Deregulation Act") under which the United States Congress, pursuant to the Supremacy Clause of the United States Constitution, pre-empted state constitutions and state usury laws in regard to business-and agricultural loans over $1,000 in amount and in regard to first mortgage residential real estate loans. Under the Deregulation Act, WBC's lending affiliates were permitted to make business and agricultural loans at 5% over the applicable Federal Reserve Bank discount rate and first mortgage residential real estate loans without any percentage limitation. The usury pre-emptive provisions of the Deregulation Act expired generally on April 15, 1985, although loans made prior to that date continue to be governed by the provisions of the Deregulation Act The first mortgage real estate loan preemption in the Deregulation Act continues in effect and will constitute a permanent preemption of the Constitution of the State of Arkansas in regard to first mortgage residential real estate loans. In 1982, The Interest Rate Control Amendment ("Constitutional Amendment") to the Constitution of the State of Arkansas was adopted, which provides, in summary, that "consumer loans and credit sales" have a maximum percentage limitation of 17% per annum and that all "general loans" have a maximum limitation of 5% over the Federal Reserve Discount Rate in effect at the time the loan was made. In 1983, the Arkansas Supreme Court determining that "consumer loans and credit sales" are "general loans" and are subject to the limitation of 5% over the Federal Reserve Discount Rate, as well as a maximum limitation of 17% per annum. The Constitutional Amendment also provided penalties for usurious "general loans" and "consumer loans and credit sales," including forfeiture of all principal and interest on consumer loans and credit sales made at a greater rate of interest than 17% per annum, and, on "general loans" made at usurious rates, forfeiture of uncollected interest and refund to the borrower of twice the interest collected. The relative importance of the Arkansas usury laws and federal pre-emption thereof to the financial operations of WBC varies from time to time, depending on a number of factors, including general economic conditions and prevailing interest rates. Limitations on the interest earnings of WBC subsidiary banks occur during periods of high interest rates. The effect of such limitations cannot be accurately predicted because of the factors mentioned above. The Texas usury law establishes different usury limits for various types of loans. These interest rate limits may vary from time to time. The interest rate limitations currently in effect are more than sufficient when compared to prevailing interest rates. STATE REGULATION The Arkansas Bank Holding Company Act of 1983 permits Arkansas bank holding companies to own and control multiple banks and subjects Arkansas bank holding companies to regulation by the Arkansas State Bank Department. Under Arkansas law, bank holding companies are limited to owning or controlling banks having in the aggregate no more than 25% of the total deposits held by all state and national banks in Arkansas. For purposes of this limitation, deposits include all individual, partnership, and corporate deposits, but not correspondent accounts of banks or the fluids of national, state, or local government authorities. The Arkansas State Bank Department ("ASBD") is authorized to administer the provisions of the Arkansas Bank Holding Company Act and to determine those activities of bank holding companies that it deems to be "directly related to banking activities." Under current interpretations and regulations of the ASBD, permissible non-banking activities under the Bank Holding Company Act of 1956, as amended, are given due consideration as being "directly related to banking activities" under the Arkansas Act. During 1988, the Arkansas General Assembly passed Act 539 which authorized county-wide and eventually statewide branching and regional interstate banking effective January 1, 1989. Unlimited branching in contiguous counties will be allowed beginning alter 1993 while unlimited statewide branching will become effective after 1998. The Texas Banking Code permits an "out-of state" bank holding company to acquire control of a bank located in the state of Texas, if such bank received a charter and was continually operated for at least five years prior to the acquisition, and subjects the "out-of state" bank holding company to the supervision and regulation by the Banking Department of Texas. On January 29, 1993, the Company entered into an agreement with the Banking Department of Texas as required by the Texas Banking Code. Pursuant to the agreement, the Company represented that Worthen National Bank of Texas ("Worthen-Texas") would comply with applicable capital adequacy guidelines and that the consolidated equity capital of Worthen-Texas during the first three years after the acquisition will at all times equal or exceed the dollar level existing immediately prior to the acquisition. The Company further agreed that a majority of the board of directors of Worthen-Texas will reside in the state of Texas, that it would not acquire an institution located in the state of Texas, the deposits of which are insured by the Federal Deposit Insurance Corporation, unless the institution is a bank as defined by the Bank Holding Company Act of 1956, as amended, and that additional information or reports would be filed with the Banking Department of Texas upon request. Under the Texas Banking Code an "out-of state" bank holding company is limited in that it can not control more than 25% of the total deposits of all state and national banks domiciled in the state of Texas. For purpose of this limitation, the term "deposit" is given the meaning assigned to that term in Section 23 of the Federal Deposit Insurance Act, as amended. ARKANSAS CORPORATE CODE In 1987, the Arkansas General Assembly passed the Arkansas Business Corporation Act of 1987 (the "1987 Act"), which was signed into law on April 14, 1987, and which became effective January 1, 1988. As a compromise to the passage of the 1987 Act, the General Assembly included a provision allowing existing Arkansas corporations to continue to be governed by the present corporate code (the "1965 Act"), unless a corporation affirmatively elected to be governed under the 1987 Act The 1987 Act provides that existing Arkansas corporations, such as WBC, may elect to be governed by its provisions upon receiving requisite stockholder approval and further that such an election, once made, is irrevocable. On February 23, 1988, WBC's stockholders adopted and approved various proposals, including a proposal to amend and restate the Articles of Incorporation adopting the 1987 Act as the corporate law which shall govern the affairs of WBC. WBC's Amended and Restated Articles of Incorporation were subsequently filed with the Arkansas Secretary of State and became effective February 24, 1988. Upon the filing of the Amended and Restated Articles of Incorporation, the 1987 Act became the applicable state corporate code governing the affairs of WBC. The 1987 Act was based primarily upon the American Bar Association's Model Business Corporation Act as substantially revised in 1984 and was legislated in partly the need to update and modernize the law affectIng Arkansas corporations. In general as compared to the 1965 Act, the 1987 Act is thought to be more flexible, easier to understand, and to permit corporations to avail themselves of many modern financIng techniques and management procedures not available under the 1965 Act. The 1987 Act should result in more predictable judicial interpretations by Arkansas courts. BANK HOLDING COMPANY ACT OF 1956, AS AMENDED WBC is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended ("BHC Act"), and is registered as such with the Board of Governors of the Federal Reserve System("FRB"). As a bank holding company, WBC is required to file with the FRB an annual report and such additional information as the FRB may require pursuant to the BHC Act The FRB also periodically examines WBC and each of its subsidiaries. Under the terms of the BHC Act, WBC, as a bank holding company, is generally required to obtain regulatory approval from the FRB before it may acquire or dispose of a substantial interest in any bank or bank holding company. With certain exceptions, the BHC Act further restricts nonbanking acquisitions by registered bank holding companies to shares of companies whose activities the FRB deems to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the FRB is required to consider whether the performance of such activities by an affiliate can reasonably be expected to produce benefits to the public, such as increased competition or gains in efficiency, against the risks of possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The FRB has determined by regulation that certain activities, including among others making and servicing loans, operating an industrial loan institution, performing certain fiduciary functions, leasing real and personal property, providing certain investment and financing advice and brokerage services, performing certain data processing operations, acting as an insurance agent for certain types of insurance, and underwriting credit life and disability insurance related to credit transactions within the particular holding company system, among others, are permissible activities for bank holding companies and their affiliates. Further the BHC Act and regulations of the FRB prohibit bank holding companies, such as WBC, from engaging in certain tie-in arrangements in connection with extensions of credit, lease or sale transactions or the furnishing of services. RISK-BASED CAPITAL GUIDELINES On January 19, 1989, the FRB issued final guidelines to implement risk-based capital requirements for bank holding companies. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures into account in assessing capital adequacy, and minimizes disincentives to holding liquid, low-risk assets. The Company's year end 1993 total risk based capital ratio of 14.11% exceeds the current minimum regulatory requirement of 8.00%. FEDERAL RESERVE ACT The FRB has cease-and-desist powers over parent holding companies and nonbanking subsidiaries where actions of such holding companies and nonbanking subsidiaries would constitute a serious threat to the safety, soundness or stability of a subsidiary bank. The FRB also has authority to regulate debt obligations, other thin commercial paper, issued by bank holding companies. The Company is an "affiliate" of its subsidiary banking institutions and will be an "affiliate" of any other acquired banks within the meaning of the Federal Reserve Act The Federal Reserve Act imposes restrictions on loans by the subsidiary banks to WBC or to any other affiliated companies, on investments by the subsidiary banks in the securities of WBC, and on the use of such securities as collateral security for loans by subsidiary banks to any borrower. WBC is also subject to certain restrictions with respect to engaging in the business of issuing, underwriting, public sale and distribution of securities. In the event that WBC's subsidiary banks experience significant loan losses or rapid growth of loans or deposits, WBC may, as the sole or majority shareholder, be required by regulatory authorities to invest additional capital in order to maintain the capital of each subsidiary bank at or above applicable regulatory minima. GENERAL The national bank subsidiaries of WBC are subject to supervision and regular examination by the Office of the Comptroller of the Currency ("OCC"). All of WBC's subsidiary banks are members of the Federal Deposit Insurance Corporation ("FDIC") which currently insures the deposits of each member bank to a maximum of $100,000 per deposit relationship. For this protection, each bank pays a semi-annual statutory assessment to the FDIC and is subject to the rules and regulations of the FDIC and to examinations by the FDIC. WBC and its subsidiaries (including bank-related subsidiaries) are also subject to examinations and regulation by the FRB under provisions of the Bank Holding Company Act of 1956, as amended, and WBC is required to file annual reports with the FRB and the ASBD, annual and other periodic reports with the United States Securities and Exchange Commission, and to file such additional reports as the FRB may require pursuant to that Act. The bank subsidiaries and their affiliates are subject to various state and federal statutes and regulations governing capital, reserves, deposits, investments, loans, mergers, issuance of securities, dividends, establishment of branches, brokerage and investment advisory services and other aspects of their operations. The approval of the OCC is required if the total of all dividends declared by the Board of Directors of any national bank subsidiary in any calendar year exceeds the total of the respective bank's net income for that year combined with retained net profit for the preceding two years, less any transfers to surplus. Various bills and regulations including the Financial Institutions Regulatory and Interest Rate Control Act of 1978, the Depository Institutions Deregulation and Monetary Control Act of 1980, the Garn-St. Germain Depository Institutions Act of 1982, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 have been enacted or adopted, and other legislation is being considered in the United States Congress and various other governmental regulatory and legislative bodies which could result in additional regulation affecting WBC and its subsidiaries and otherwise affect the powers of banks, bank holding companies, and bank-related companies. MONETARY POLICY The monetary policy of the FRB has a significant effect on the operating results of bank holding companies and their subsidiary banks as a result of its controlling influence upon the national supply and cost of bank credit. The FRB implements monetary policy principally through open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, and change in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use affects interest rates charged on loans or paid for deposits. The policies of the FRB have a direct effect on the amount of bank loans and deposits and the interest rates charged and paid thereon. FRB monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. WBC's financial statements reflect the various effects of monetary policies. The nature of future monetary policies and the effect of such policies on the future business and earnings of WBC cannot be accurately predicted; however, such economic policies can materially affect the revenues and net income of commercial banks. PATENTS, SEASONALITY OF BUSINESS AND CUSTOMERS Patents or trademarks are not material to the conduct of the Company's business. Historically, the business of the Company has not been seasonal in nature nor does management of WBC anticipate any differences or seasonal trends in the future. Although certain depositors and loan customers are important to the Company's banking subsidiaries, the Company is not dependent upon any single customer or a few customers, the loss of any one or more of which would have a material adverse effect on the financial condition or results of operations of the Company on a consolidated basis. COMPETITION The activities engaged in by WBC and its subsidiaries are highly competitive. With each activity engaged in, the Company encounters intense competition from other banks, lending institutions, credit unions, savings and loan associations, brokerage firms, mortgage companies, industrial loan associations, finance companies, and several other financial and financial service institutions. The amount of competition has increased significantly over the past few years since the deregulation of the banking industry. The Company's subsidiary banks actively compete with other banks and financial institutions in their efforts to obtain deposits and make loans, in the scope and type of services offered, in interest rates paid on time deposits and charged on loans and in other aspects of commercial banking. They are also in competition with major international retail establishments, brokerage firms and other financial institutions within and outside Arkansas. Competition with these financial institutions is expected to increase, especially with the passage of legislation authorizing interstate banking. According to information obtained from the Arkansas Association of Bank Holding Companies, during 1993 there were approximately 34 multi-bank holding companies in Arkansas and an approximate 104 additional single bank holding companies. As of December 31, 1993, the Company was the second largest multi-bank holding company in Arkansas in terms of total assets and total deposits. EMPLOYEES As of December 31, 1993, the Company and its subsidiaries employed 2,252 persons. None of the employees are represented by any union or similar groups and the Company has not experienced any labor disputes or strikes arising from any such organized labor groups. The Company considers its relationship with its employees to be good. EXECUTIVE OFFICERS OF THE REGISTRANT As of March 16, 1994, the executive officers of the Registrant are as follows: SERVED AS AN CURRENT TITLE EXECUTIVE NAME AND POSITION AGE OFFICER SINCE - ---- ------------ --- ------------- Curtis F. Bradbury, Jr. Chairman, President 44 1985 and Chief Executive Officer of WBC and Chairman and Chief Executive Officer of WNBA Andrew T. Melton Executive Vice 47 1986 President, Chief Financial Officer and Treasurer James C. Patridge Executive Vice 43 1987 President SERVED AS AN CURRENT TITLE EXECUTIVE NAME AND POSITION AGE OFFICER SINCE - ---- ------------ --- ------------- Michael F. Heald Senior Vice President 34 1988 and Director of Audit William G. Hobbs Senior Vice President 44 1986 Asset/Liability and Funds Management Alan C. King Senior Vice President, 42 1987 Controller and Chief Accounting Officer Gary A. Rickenbach Senior Vice President 36 1988 Director of Loan Review and Mergers and Acquisitions Gary L. Smith Senior Vice President and 40 1985 Assistant to the Chairman The Executive Officers are elected and employed by WBC's Board of Directors to serve for terms set from time to time by the Board in its discretion until re-elected or replaced. Each executive officer has held the same position or another executive position with the Company or one of its subsidiaries during the past five years. In addition to the foregoing persons, executive officers of the Company's banking subsidiaries are members of a committee that exercises certain policy making functions. Therefore, although not employed by or occupying officer positions with the Company, they may for certain purposes be deemed as "executive officers." As of March 16, 1994, the persons occupying such positions include: Dale E. Cole, Worthen National Bank, Batesville and Worthen National Bank of Newark; Edwin M Horton, Worthen National Bank of South Arkansas; Marlin D. Jackson and Frank Oldham, Worthen National Bank of Conway; Brooks H. Morris, Worthen National Bank of Harrison; David Bartlett, Worthen National Bank of Hot Springs; Thomas Spillyards, Worthen National Bank of Pine Bluff; Robert Y. Taylor, Worthen Bank National Bank of Russellville; James F. Stobaugh and Rick L. Parsons, Worthen National Bank of Northwest Arkansas; and John I. Fleischauer, Jr., Worthen National Bank of Arkansas. With the guidance of the Board of Directors and executive management of the Company, each of these persons is employed by the Boards of Directors of the respective banking subsidiaries to serve for terms set from time to time by such Boards until re-elected or replaced. SELECTED STATISTICAL INFORMATION The information required in response to this portion of Item 1 is incorporated by reference from the disclosures contained in the Registrant's 1993 Annual Report to Stockholders, portions of which are included herein as Exhibit 13. ITEM 2. ITEM 2. PROPERTIES. The principal offices of the Company and its largest subsidiary, WNBA, are located in the Worthen National Bank of Arkansas building at 200 West Capitol Avenue in downtown Little Rock, Arkansas. The building is owned by WNBA. The Company and its banking subsidiaries maintain 119 locations throughout the State of Arkansas and the Austin, Texas area. The majority of these offices are owned by the respective subsidiary banks. In the opinion of management of the Company, the physical properties of the Company and its subsidiaries are adequate and fully utilized. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In the ordinary course of business, there are various legal proceedings pending against the Company, its subsidiaries and affiliates, most of which are considered litigation incidental to the conduct of business, including, among other matters, defense of routine corporate, employment, banking, lender liability and securities related litigation. Management, after consultation with legal counsel and based upon available facts and proceedings to date which are preliminary in certain instances, is of the opinion that the ultimate resolution of these proceedings will have no material adverse effect on the consolidated financial position of the Company. However, certain matters disclosed in this Annual Report on Form 10-K for the fiscal year ended December 31, 1993, may be considered to be material in amount or nature. In January of 1993, the Company, its directors, and certain of its officers and shareholders were sued in the United States District Court for the Southern District of New York, in WINICKI V. WORTHEN BANKING CORPORATION, ET AL.. 93-CIV-0135. The complaint alleged that the defendants violated Section 14(a) of the Securities Exchange Act of 1934 ("Exchange Act"), Rule 14a-9 of the Securities and Exchange Commission ("SEC" or "Commission"), and certain state law provisions relating to fiduciary duties in connection with the matters disclosed in the Company's proxy statement distributed in December of 1992. The complaint was filed as a class action and sought an injunction to prevent the Company from holding a special meeting or from consummating certain transactions which were the subject of the proxy statement, and unspecified monetary damages. The Company has denied all material allegations in the complaint and in January 1993, the parties entered into a Memorandum of Understanding ("MOU") under which the Company agreed to distribute revised disclosure material to its shareholders and not to oppose an application by plaintiff's counsel for fees in an agreed amount. On January 21, 1994, the Court provisionally certified a class for purposes of settlement. The settlement remains subject to Court approval following a fairness hearing at which class members may raise any objections to the settlement. Notice of the settlement was sent to class members beginning on February 9, 1994, and a fairness hearing is scheduled for April 5, 1994. On March 31, 1993, the Board of Governors of the Federal Reserve System ("FED") advised WBC that the Company's application to merge The Union of Arkansas Corporation with a subsidiary of WBC had been approved. The FED approved the merger, in part, in reliance upon representations and commitments made to the FED by the Company, by Stephens Group, Inc. and by certain Stephens family members. These included a representation that Stephens Group, Inc. does not and will not exert control over the management and policies of WBC and that Stephens Group, Inc. and its subsidiaries will comply with the restrictions imposed by Sections 23A and 23B of the Federal Reserve Act. Management believes that such representations and commitments will not materially affect the Company's general business policies, financial condition, or results of operations. The Company has also been advised that the FED has made a determination that Stephens Group, Inc. and its affiliates, are affiliates of the Company, as that term is defined in Sections 23A and 23B of the Federal Reserve Act. The Board of Governors also notified the Company on March 31, 1993 that the Board of Governors had ordered an investigation to review the ownership and control of the Company for compliance with the Bank Holding Company Act and the Change in Bank Control Act, including the nature and extent of the relationships between the Company and Stephens Group, Inc. and its subsidiaries. The Company is not aware of any assertion by the Board of Governors that the Company is not in compliance with the Bank Holding Company Act or the Change in Bank Control Act. In the event the Board of Governors determines that there has been a violation of the Bank Holding Company Act, it is authorized to initiate certain administrative enforcement actions against the Company and its institution-affiliated parties. These actions could include, among other things, the issuance of an order to cease and desist or the assessment of monetary penalties against the Company or its institution-affiliated parties. The amount of such monetary penalties, if any, would be determined by the Board of Governors on the basis of the facts and circumstances surrounding the alleged violations and might or might not have a material adverse effect upon the Company's financial condition or results of operations. In addition, under regulations promulgated by the Board of Governors, in the event it determines that an impermissible control relationship exists, it would have discretion to order either termination of the impermissible control relationship, or the filing of an application seeking the approval of such control relationship, or to pursue other remedial actions. However, the Company cannot now predict the results or the final outcome of the investigation. The Company intends to continue to cooperate with the Board of Governors in this investigation. WILKINS V. UNION NATIONAL BANK Case No. 90 CH 9203, in the Circuit Court of Cook County, Illinois, County Department, Chancery Division. In September of 1990, plaintiffs Herbert L. Wilkins and Mary Wilkins sued Union National Bank ("Union") in a purported class action complaint which sought remedies against both Union and WNBA as successor of Union, including: (1) a declaration that Union's method of calculating escrow deposit requirements was unlawful, (2) refunds of excess escrow balances existing in mortgage escrow accounts (through application of such balances as prepayments of mortgage principal or through direct refunds), (3) payment of interest on excess escrow balances carried in such escrow accounts, (4) punitive damages in an unspecified amount, (5) an injunction prohibiting defendant from imposing excessive escrow requirements in the future, and (6) attorney's fees. Union and WNBA have denied all material allegations of the complaint. Management of WNBA believes that WNBA has valid and meritorious defenses to the allegations set forth in the complaint and intends to defend this matter vigorously unless a settlement satisfactory to WNBA can be reached. WNBA has reached a settlement agreement on a basis favorable to WNBA with counsel for plaintiffs. The settlement is subject to court approval, which has not yet been obtained. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No vote of holders of securities issued by WBC was taken on any matter during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Earnings, Dividends and Price Range Per Share" on Page 21 of the Registrant's 1993 Annual Report to Stockholders. The last trade price for the Company's common stock on March 16, 1994 was $21.50. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Selected Financial Data" on page 7 of the Registrant's 1993 Annual Report to Stockholders. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 8 through 22 of the Registrant's 1993 Annual Report to Stockholders. ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required in response to this Item, including the opinion of KPMG Peat Marwick, is incorporated by reference from the disclosures contained under the captions "Consolidated Financial Statements" and "Selected Quarterly Financial Data" on pages 23 through 45 and page 22, respectively, of the Registrant'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 in response to this Item is incorporated by reference from the Registrant's Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on Form 10-K See also the caption "Executive Officers of the Registrant" under Item 1 of this Annual Report on Form lo-K ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required in response to this Item is incorporated by reference from the Registrant's Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required in response to this Item is incorporated by reference from the Registrant's Definitive Proxy Statement which wall be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required in response to this Item is incorporated by reference from the Registrant's Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on Form 10-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. ITEM 14(a)(1) AND (2) WORTHEN BANKING CORPORATION AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE The following consolidated financial statements and the report of independent auditors of Worthen Banking Corporation and subsidiaries for the year ended December 31, 1993 as required by Item 8, are: The report of independent auditors of The Union of Arkansas Corporation and subsidiaries for the years ended December 31, 1992 and 1991 is included as Exhibit 99 of the Exhibits in Item 14(a)(3). The following consolidated financial statement schedule of Worthen Banking Corporation and subsidiaries, including the independent auditors' report thereon, is included in Item 14(d): Schedule II - Guarantees of Securities of Other Issuers at December 31, 1993. Schedules other than those listed above (or columns omitted from the Schedule filed herein) required by Article 9 of Regulation S-X are not required under the related instructions or are inapplicable, and, therefore, have been omitted. ITEM 14(a)(3) - EXHIBITS The exhibits required by Item 601 of Regulation S-K which are required to be filed in response to this Item 14(a)(3) are submitted as a separate section of this Annual Report on Form 10-K under the caption "Exhibit Index." ITEM 14(b) - REPORTS ON FORM 8-K No current reports on Form 8-K were filed by the Company during the three months ended December 31, 1993. ITEM 14(c) - EXHIBITS The exhibits required by Item 601 of Regulation S-K which are required to be filed in response to this Item 14(c) are submitted as a separate section of this Annual Report on Form 10-K under the caption "Exhibit Index." ITEM 14(d) - FINANCIAL STATEMENT SCHEDULES The response to this portion of Item 14 is submitted as a separate section of this Annual Report on Form 10-K immediately following the signature pages of this 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, there unto duly authorized, on the 30th day of March, 1993. WORTHEN BANKING CORPORATION By: \s\ Curtis F. Bradbury. Jr. --------------------------- Curtis F. Bradbury, Jr. Chairman, President and Chief Executive Officer POWER OF ATTORNEY Each person whose signature appears below hereby authorizes Curtis F. Bradbury, Jr., or Andrew T. Melton, to file one or more amendments to this Annual Report on Form 10-K, which amendments may make such changes, additions, deletions or modifications to the Annual Report on Form 10-K as they deem appropriate, and each such person hereby appoints Curtis F. Bradbury, Jr. or Andrew T. Melton as his lawful attorney-in-fact to execute in the name and on behalf of each such person individually, and in each capacity stated below, any such amendments to the Annual Report on Form 10-K. 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/ Curtis F. Bradbury, Jr. Chief Executive Officer March 30, 1994 - -------------------------- and Director Curtis F. Bradbury, Jr. /s/ Andrew T. Melton Chief Financial Officer March 30, 1994 - --------------------------- Andrew T. Melton /s/ Alan C. King Controller and Chief March 30, 1994 - --------------------------- Accounting Officer Alan C. King /s/ James H. Atkins Director March 30, 1994 - --------------------------- James H. Atkins /s/ Gus M. Blass, II Director March 30, 1994 - --------------------------- Gus M. Blass, II /s/ Fred I. Brown, Jr. Director March 30, 1994 - --------------------------- Fred I. Brown, Jr. /s/Alex Dillard Director March 30, 1994 - --------------------------- Alex Dillard /s/ Michael T. Flynn Director March 30, 1994 - --------------------------- Michael T. Flynn /s/ Kaneaster Hodges, Jr. Director March 30, 1994 - --------------------------- Kaneaster Hodges, Jr. /s/T. Milton Honea Director March 30, 1994 - --------------------------- T.Milton Honea /s/George C. Kell Director March 30, 1994 - --------------------------- George C. Kell /s/Herbert H. McAdams. II Director March 30, 1994 - --------------------------- Herbert H. McAdams, II /s/Raymond P. Miller, M.D. Director March 30, 1994 - --------------------------- Raymond P. Miller, M.D. /s/A. Dan Phillips Director March 30, 1994 - --------------------------- A.Dan Phillips /s/Winthrop Paul Rockefeller Director March 30, 1994 - --------------------------- Winthrop Paul Rockefeller /s/David Solomon Director March 30, 1994 - --------------------------- David Solomon /s/Leland E. Tollett Director March 30, 1994 - --------------------------- Leland E. Tollett REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Worthen Banking Corporation Under date of February 25, 1994, we reported on the consolidated balance sheet of Worthen Banking Corporation and Subsidiaries as of December 31, 1993 and the related consolidated statements of earnings, stockholders' equity and cash flows for the year 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 audit of the aforementioned consolidated financial statements, we have audited the financial statement schedule listed in the accompanying index. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statement schedule based on our audit In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ KPMG Peat Marwick ----------------------------- KPMG PEAT MARWICK Little Rock, Arkansas February 25, 1994 SCHEDULE II GUARANTEES OF SECURITIES OF OTHER ISSUERS WORTHEN BANKING CORPORATION DECEMBER 31, 1993 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION PAGE - -------------- ----------- ----- 3(a) Amended and Restated Articles of N/A Incorporation of Registrant (filed as Exhibit 3(a) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987 and incorporated by reference herein). 3(b) Amended and Restated Bylaws of Registrant N/A (filed as Exhibit 3 to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 1988 and incorporated by reference herein). 3(c) Amended and Restated Articles of Incorporation N/A (filed as Exhibit 3(i) to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 1993) incorporated by reference herein. 11 Statement of computation of per share N/A earnings (see Consolidated Financial Statements of the Registrant contained in the Registrant's 1993 Annual Report) which is included herein as Exhibit 13. 13 Pages 7 - 45 of the Registrant's 1993 Annual Report. --- 21 Subsidiaries of the Registrant. --- 23(a) Consent of KPMG Peat Marwick. --- 23(b) Consent of Frost and Company. 24 Power of Attorney (see Signature Page). 17 99 Report of independent auditors of The Union of --- Arkansas Corporation and subsidiaries for the years ended December 31, 1992 and 1991.

11199_1993.txt

11199_1993

1993

11199

ITEM 1 - BUSINESS Bemis Company, Inc., a Missouri corporation, continues a business formed in 1858. The Registrant was incorporated in 1885 as Bemis Bro. Bag Company with the name changed to Bemis Company, Inc. in 1965. The Registrant is a principal manufacturer of flexible packaging products and specialty coated and graphics products. Information about the Registrant's operations in different business segments appearing on pages 38 and 39 of the the accompanying 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report. As of December 31, 1993, the Registrant had approximately 7,600 employees, of which an estimated 5,100 were classified as production employees. Most of the production employees are covered by collective bargaining contracts involving six different international unions and 22 individual contracts with terms ranging from three to five years. During 1993, six contracts covering approximately 800 employees at six different locations in the United States were successfully negotiated. During 1994, seven labor agreements are scheduled to expire. Working capital elements throughout the year fluctuate in relation to the level of business. Customer and vendor payment terms are generally net 30 days; exceptions to these terms are not material. Inventory levels reflect a reasonable balance between raw material pricing and availability, and our commitment to promptly fill customer orders. Backlogs are not a significant factor in the industries in which the Registrant operates; most orders placed with the Registrant are for delivery within 90 days or less. The Registrant owns patents, licenses, trademarks, and trade names on its products. The loss of any or all patents, licenses, trademarks, or trade names would not have a materially adverse effect on the Registrant's results as a whole or either of its segments. The business of each of the segments is not seasonal to any - 2 - significant extent. A summary of the Registrant's business activities reported by its two business segments follows: FLEXIBLE PACKAGING PRODUCTS - The Registrant and its subsidiaries manufacture a broad range of industrial and consumer packaging comprised of coated and laminated films, polyethylene packaging, packaging machinery, multiwall and consumer-size paper packaging and specialty containers. Coated and laminated film packaging includes extruding, coating, laminating, metallizing, printing and converting to perishable and frozen food packaging, and products such as stretch film and carton sealing tape. Coated and laminated films accounted for 32%, 32% and 31%, of consolidated net sales for the years 1993, 1992 and 1991, respectively. Polyethylene packaging products include extruded products, printed roll stock and pre-formed bags. Polyethylene products accounted for 16%, 10% and 9% of consolidated net sales for the years 1993, 1992 and 1991, respectively. Packaging machinery includes the manufacture of packaging systems for an extensive list of consumer and industrial products ranging from toilet tissue, candy and frozen vegetables to fertilizer, insulation materials, detergent and pharmaceutical products. Packaging machinery accounted for 9%, 9% and 9% of consolidated net sales for the years 1993, 1992 and 1991, respectively. Multiwall and consumer-size paper bags are produced for a wide range of industrial and consumer packaging products such as seed, feed, flour, cement and chemicals, and small consumer-size packages for such products as sugar, flour, rice and petfood. Sales of this product line accounted for 17%, 16% and 17% of consolidated net sales for the years 1993, 1992 and 1991, respectively. - 3 - SPECIALTY COATED AND GRAPHICS PRODUCTS - The Registrant manufactures pressure- sensitive materials which includes a full line of industrial adhesive products for mounting and bonding, quality roll label and sheet print stocks for numerous applications including packaging labels, and a line of highly specialized laminates for graphics and photography. Pressure-sensitive materials accounted for 24%, 27% and 25% of consolidated net sales for the years 1993, 1992 and 1991, respectively. This product segment also includes the manufacture of pressure-sensitive label applicating equipment, rotogravure cylinders and film services. MARKETING, DISTRIBUTION AND COMPETITION While the Registrant's sales are made through a variety of distribution methods, more than 70% of each segment's sales are made by the Registrant's sales force. Sales offices and plants are located throughout the United States, Canada, Great Britain, Europe and Scandinavia to provide prompt and economical service to more than 30,000 customers. The highly technical sales force is supported by product development engineers, design technicians and a customer service organization. No single customer accounts for 10% or more of the Registrant's total sales of either of its two business segments. Furthermore, the loss of one or a few major customers would not have a material adverse effect on their operating results. The major markets in which the Registrant sells its products are highly competitive. Areas of competition include price, innovation, quality and service. This competition is significant as to both the size and number of competing firms. Major competitors in the Flexible Packaging Products segment include American National Can, Printpack, James River, Cryovac, Huntsman Chemical, AEP Industries, Stone Container and Union Camp. In the Specialty Coated and Graphics Products segment major competitors include Avery-Dennison, Flexcon, Minnesota Mining and Manufacturing, Jackstadt (Germany) and Haarla (Finland). - 4 - The Registrant considers itself to be a significant factor in the market niches it serves; however, due to the diversity of the Flexible Packaging and Specialty Coated and Graphics Products segments, the Registrant's precise competitive position in these markets is not reasonably determinable. Advertising is limited primarily to business and trade publications, and emphasizes our packaging and related capabilities and the individual problem- solving approach to customer problems. RAW MATERIALS Plastic resins, paper and chemicals constitute the basic major raw materials. These are purchased from a variety of industry sources. While temporary shortages of raw materials may occur occasionally, these items are currently readily available. RESEARCH AND DEVELOPMENT EXPENSE Research and development expenditures were as follows: ENVIRONMENT CONTROL Compliance with federal, state and local provisions which have been enacted or adopted regulating discharges of materials into the environment, or otherwise relating to the protection of the environment is not expected to have a material effect upon the capital expenditures, earnings and competitive position of the Registrant and its subsidiaries. ITEM 2 ITEM 2 - PROPERTIES Properties utilized by the Registrant and its subsidiaries at December 31, 1993, were as follows: - 5 - FLEXIBLE PACKAGING PRODUCTS - The Registrant has 33 manufacturing plants of which seven are leased, located in 17 states and two foreign countries. Leases generally provide for minimum terms of two to 45 years and have one or more five-year renewal options. The initial terms of leases in effect at December 31, 1993, expire between 1994 and 2009. SPECIALTY COATED AND GRAPHICS PRODUCTS - The Registrant has nine manufacturing plants of which three are leased, located in four states and three foreign countries. Leases generally provide for minimum terms of five to 25 years and have one or more renewal options. The initial terms of leases in effect as of December 31, 1993, expire between 1996 and 2008. CORPORATE - The executive offices of the Registrant, which are leased, are located in Minneapolis, Minnesota. The Registrant considers its plants and other physical properties to be suitable, adequate and of sufficient productive capacity to meet the requirements of its business. The manufacturing plants operate at varying levels of capacity depending on the type of operation and market conditions. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS The Registrant is involved in a number of lawsuits, including superfund litigation, incidental to its business. None of the litigation is material to the Registrant, and the Registrant is not aware of any pending or threatened litigation that is likely to have a material adverse affect upon the Registrant's business, operating results or financial condition. The Registrant is a potentially responsible party (PRP) in approximately twenty superfund sites around the United States. At over one half of these sites the Registrant has full insurance protection. At a majority of the remaining sites the Registrant is a "de minimis" PRP and has negotiated a position as such. In all cases in which the Registrant is uninsured or where insurance coverage is in dispute, the Registrant has reserved an amount that it believes to be adequate to cover its exposure. - 6 - ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5 ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDERS MATTERS The information required by this item appearing on pages 1 and 22 of the accompanying 1993 Annual Report to Shareholders is incorporated by reference in this Form 10-K Annual Report. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA The information required by this item appearing on page 23 of the accompanying 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 required by this item appearing on pages 19 to 22 of the accompanying 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 financial statements, together with the report thereon of Price Waterhouse dated January 24, 1994, and quarterly data appearing on pages 24 to 39 of the accompanying 1993 Annual Report to Shareholders are incorporated by reference in this Form 10-K Annual Report. With the exception of the aforementioned information and the information incorporated in items 1, 5, 6, 7 and 8, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this Form 10-K Annual Report. ITEM 9 ITEM 9 - DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None - 7 - ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information on directors is omitted because the Registrant will have filed with the Commission a definitive proxy statement pursuant to Regulation 14A within 120 days after December 31, 1993. The following sets forth the name, age and business experience for the last five years of the principal executive officers of the Registrant. Unless otherwise noted, each officer has been an employee of the Registrant for the last five years and the positions described relate to positions with the Registrant. - 8 - ITEM 11 ITEM 11 - MANAGEMENT REMUNERATION The information required by this item is omitted because the Registrant will have filed with the Commission a definitive proxy statement pursuant to Regulation 14A within 120 days after December 31, 1993. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is omitted because the Registrant will have filed with the Commission a definitive proxy statement pursuant to Regulation 14A within 120 days after December 31, 1993. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is omitted because the Registrant will have filed with the Commission a definitive proxy statement pursuant to Regulation 14A within 120 days after December 31, 1993. - 9 - ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of the report: All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. - 10 - (3) Exhibits 13. 1993 Annual Report to Shareholders 22. Subsidiaries of the Registrant All other exhibits are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (b) There were no reports on Form 8-K filed during the fourth quarter ended December 31, 1993. - 11 - REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Bemis Company, Inc. Our audits of the consolidated financial statements referred to in our report dated January 24, 1994, appearing on page 24 of the 1993 Annual Report to Shareholders of Bemis Company, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of Financial Statement Schedules listed in Item 14(a) 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 PRICE WATERHOUSE Minneapolis, Minnesota January 24, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-8 (number 2-61796) of Bemis Company, Inc. of our report dated January 24, 1994, appearing on page 24 of the Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules which appears above. Price Waterhouse PRICE WATERHOUSE Minneapolis, Minnesota March 14, 1994 - 12 - 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. BEMIS COMPANY, INC. Benjamin R. Field, III By LeRoy F. Bazany - ---------------------------------- ------------------------------ Benjamin R. Field, III, Senior LeRoy F. Bazany, Vice President Vice President, Chief Financial and Controller Officer and Treasurer Date March 18, 1994 Date March 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. Howard Curler Edward W. Asplin - ---------------------------------- ------------------------------- Howard Curler, Director Edward W. Asplin, Director Date March 18, 1994 Date March 18, 1994 ----------------------------- -------------------------- John H. Roe E. Thomas Binger - ---------------------------------- ------------------------------- John H. Roe, President and Chief E. Thomas Binger, Director Executive Officer; Director Date March 18, 1994 Date March 18, 1994 ----------------------------- -------------------------- Robert A. Greenkorn Robert F. Zicarelli - ---------------------------------- ------------------------------- Robert A. Greenkorn, Director Robert F. Zicarelli, Director Date March 18, 1994 Date March 18, 1994 ----------------------------- -------------------------- - 13 - - 18 - - 19 - APPENDIX TO THE ELECTRONIC FILING - 1993 FORM 10-K Data appearing on bar charts on indicated pages of the 1993 Annual Report.

44801_1993.txt

44801_1993

1993

44801

ITEM 1. BUSINESS GENERAL Hadson Corporation, a Delaware corporation (the "Company"), is engaged, through its consolidated subsidiaries, in providing energy products and services, consisting of the purchasing, gathering, processing, storing and transporting of natural gas and natural gas liquids ("NGLs"), as well as the marketing of such products and related services. Prior to July 15, 1993, the Company owned approximately 49% of the outstanding common stock of Hadson Energy Resources Corporation ("HERC"), which conducts oil and gas exploration, development and production activities, both domestically and internationally. On July 15, 1993, the Company sold its equity interest in HERC to Apache Corporation ("Apache"). See "--Recent Developments -- Sale of HERC Shares" below and "--Operations of Unconsolidated Subsidiaries" below. Discontinued operations include the Company's defense systems business, primarily conducted by HRB Systems, Inc. and Ultrasystems Defense Inc., which were sold, respectively, in October 1990 and February 1991, and the Company's power systems business, conducted by Hadson Power Systems, Inc. ("Hadson Power"), which the Company sold in December 1991. See "-- Recent Developments -- Sale of Discontinued Operations" and "--Discontinued Operations" below. The Company was incorporated in Ohio in 1964 as Hadson Ohio Oil Company. In 1980, it effected a change of domicile to the state of Delaware, and in 1986 its name was changed to Hadson Corporation. The Company's corporate headquarters are located at 101 Park Avenue, Suite 1400, Oklahoma City, Oklahoma 73102, and its telephone number is (405) 235-9531. Effective approximately April 15, 1994, the corporate headquarters will be relocated to 2777 Stemmons Freeway, Suite 700, Dallas, Texas 75207, and the telephone number will be (214) 640-6800. RECENT DEVELOPMENTS Merger of Adobe Gas Pipeline Company with and into the Company On December 14, 1993, the stockholders of the Company approved and adopted an Agreement of Merger, dated July 28, 1993, as amended (the "Merger Agreement"), among the Company, Santa Fe Energy Resources, Inc. ("Santa Fe") and Adobe Gas Pipeline Company ("AGPC"), then an indirect-wholly owned subsidiary of Santa Fe. Pursuant to the Merger Agreement, AGPC was merged (the "Merger") with and into the Company (which was the surviving corporation in the Merger). AGPC, through its wholly-owned subsidiaries, was engaged in the gathering, processing, transmission and marketing of natural gas, had interests in 10 natural gas pipeline systems and three natural gas processing plants and, prior to the Merger, entered into a master gas purchase agreement (the "Gas Contract") having a term of approximately seven years and providing for the purchase by AGPC of essentially all the domestic natural gas production of Santa Fe, as well as natural gas that Santa Fe has the right to market. In addition to effecting the acquisition by the Company of AGPC, the Merger also effected a restructuring of the Company's debt and equity capitalization (including an approximate one-for-15 reverse split of the Company's Common Stock). Pursuant to the Merger Agreement, among other things: (i) all of the outstanding common stock of AGPC (which was owned by a wholly-owned subsidiary of Santa Fe) was converted into (A) 2,080,000 shares of new Senior Cumulative Preferred Stock, Series A, par value $.01 per share, of the Company and (B) 10,395,665 shares new Common Stock, par value $.01 per share, of the Company ("New Common Stock" ), which is equal to approximately 40% of the outstanding New Common Stock, giving effect to the issuance and deposit by the Company to the "H/P Trust", described below, of 4,983,180 shares of New Common Stock; (ii) each outstanding share of the Company's 8% Junior Cumulative Convertible Preferred Stock, Series B, par value $.01 per share ("Old Junior Preferred Stock" ), was converted into (A) 1.50733 shares of New Common Stock (5,723,652 shares in the aggregate) and (B) 1.09667 shares of new Junior Exercisable Automatically Convertible Preferred Stock, Series B, par value $.01 per share, of the Company ("New Junior Preferred Stock") (4,163,852 shares in the aggregate), each share of which entitles the holder to purchase from the Company, upon surrender of such share and payment of the exercise price, one share of New Common Stock (an aggregate of 4,983,180 shares, including the shares issuable upon the exercise of the additional shares of New Junior Preferred Stock described in clause (iii) below) at an exercise price of $3.225 per share of New Common Stock (in each case subject to adjustment) at any time prior to the automatic conversion of such share of New Junior Preferred Stock into .001 of a share of New Common Stock, which will occur on the second anniversary of the Merger (or earlier under certain circumstances); (iii) each outstanding share of the existing Common Stock, par value $.01 per share, of the Company ("Old Common Stock") was converted into (A) .06667 (approximately 1/15th) of a share of New Common Stock (3,277,488 shares in the aggregate) and (B) approximately .01667 of a share of New Junior Preferred Stock (819,328 shares in the aggregate); (iv) all of the outstanding shares of the Company's Class B Common Stock, par value $.01 per share ("Class B Common Stock"), all of which were held by The Prudential Insurance Company of America and certain of its affiliates (collectively, "Prudential" ), were converted into the right to receive a portion of the "P Interest" in the H/P Trust described below, which interest (in its entirety) initially represented a beneficial trust interest in 4,983,180 shares of New Common Stock deposited by the Company to the H/P Trust (the "Trust Shares" ) and could ultimately result in the payment to Prudential of an amount equal to the amount of all proceeds payable upon the exercise of the shares of New Junior Preferred Stock issued in the Merger (which could total as much as approximately $16.1 million), as described below; (v) each outstanding share of the Company's Class C Common Stock, par value $.01 per share ("Class C Common Stock"), all of which were held by Prudential, was converted into .06667 (approximately 1/15th) of a share of New Common Stock (approximately 756,104 shares in the aggregate); and (vi) all of the outstanding shares of the Company's 7% Senior Cumulative Preferred Stock, Series A, par value $.01 per share ("Old Senior Preferred Stock" ), which had an aggregate liquidation preference of $49.5 million and were held by Prudential, were converted into (A) an aggregate of approximately 553,658 shares of New Common Stock, (B) the right to receive the remainder of the "P Interest" in the H/P Trust and (C) the right to receive $33 million aggregate principal amount of new 8% Senior Secured Notes Due 2003 ("New Senior Secured Notes") of the Company. The H/P Trust was established by the Company in connection with the Merger. The Company issued the Trust Shares to the H/P Trust immediately following the Merger. As a result of the Merger, Prudential received the "P Interest" in the H/P Trust, which initially represented beneficial ownership of all of the Trust Shares. As holders of shares of New Junior Preferred Stock exercise their right to purchase shares of Common Stock, the Company will periodically deposit, or cause to be deposited, to the H/P Trust all proceeds of such exercises. At the end of each calendar quarter and upon termination of the H/P Trust, if the dollar amount of exercise proceeds held in the H/P Trust has reached certain levels, the trustee will pay such proceeds to Prudential and will distribute a corresponding number of Trust Shares to the Company. Upon termination of the H/P Trust, all remaining Trust Shares, if any, will be distributed to Prudential. Concurrently with the Merger, the Company and Prudential entered into a securities purchase agreement (the "New Securities Purchase Agreement") pursuant to which the Company issued, subject to certain conditions, an additional $23.4 million of New Senior Secured Notes in exchange for $23.4 million of 6.20% Senior Secured Notes Due 2000 (the "6.20% Notes") of the Company held by Prudential prior to the Merger. See Note 2 of the Notes to Consolidated Financial Statements appearing elsewhere herein. Prudential and Santa Fe entered into a voting agreement (the "Voting Agreement") in connection with the Merger pursuant to which, among other things, Santa Fe has agreed to vote all shares of Common Stock of the Company beneficially owned by it following the Merger in favor of any one person designated from time to time by Prudential for election as a Class I director of the Company, Prudential has agreed to vote all shares of Common Stock beneficially owned by it following the Merger in favor of persons designated from time to time by Santa Fe for election as directors of the Company up to a specified maximum, and each of Santa Fe and Prudential have agreed to vote the shares of Common Stock beneficially owned by it following the Merger in favor of any one person jointly designated from time to time by Santa Fe and Prudential as a Class III director of the Company. Concurrently with the consummation of the Merger, the Company entered into a new working capital facility with the Bank of Montreal ("BMO"). This new facility ("New BMO Credit Agreement") provides for up to $60 million of letters of credit and replaces an agreement between BMO and Hadson Energy Products and Services, Inc. Consummation of the New BMO Credit Agreement was a condition precedent for completion of the Merger and the New Securities Purchase Agreement. Finally, in connection with the Merger, the Company's Restated Certificate of Incorporation was amended to provide, among other things, for an increase in the number of directors constituting the entire Board of Directors of the Company to eight and to divide the Company's Board of Directors into three classes. Sale of HERC Shares Pursuant to a sale agreement entered into by the Company and Apache on June 17, 1993, the Company, on July 15, 1993, sold the stock of HERC owned by the Company (the "HERC Shares") to Apache for $45 million in cash ($3 million of which was paid in November 1993 following the satisfaction of a condition relating to the acquisition by Apache of additional shares of HERC's common stock). In consideration of the release by Prudential of its security interest in the HERC Shares, the Company applied the proceeds from the sale of the HERC Shares as follows: $1 million to pay costs and expenses related to the sale; approximately $2.2 million was applied to pay in full all principal remaining outstanding under a credit agreement between the Company and Prudential pursuant to which Prudential had provided interim financing to fund the costs of the Company's financial reorganization in 1992 (the "Prudential Credit Agreement"), as well as all accrued and unpaid interest thereon; $1 million to prepay the New Senior Secured Notes upon closing of the Merger; approximately $1.3 million was applied to pay all accrued and unpaid interest under the 6.20% Notes through the date of such sale and certain fees due to Prudential; and $33 million was applied to the prepayment of principal under the 6.20% Notes. The remaining approximately $6.5 million of such proceeds was used by the Company for the payment of transaction costs related to the Merger and related transactions and for working capital. Financial Reorganization In December 1992, the Company completed a restructuring of its long-term debt through a "pre-packaged" bankruptcy proceeding (the "1992 Restructuring"). The Company solicited votes for and against its plan of reorganization (the "Plan") from its senior secured lenders (Prudential), holders of the Company's 7-3/4% Convertible Subordinated Debentures and its common stockholders. Votes in favor of the Plan were received sufficient to allow for confirmation of the Plan, and, on October 15, 1992, the Company filed its Chapter 11 bankruptcy petition as well as the Plan in the Western District of Oklahoma. The bankruptcy court confirmed the Plan on November 30, 1992, and the Plan was consummated on December 16, 1992. Pursuant to the Plan, approximately $131.9 million of long-term debt with the related accrued interest and certain other obligations were converted into $56.4 million of the 6.20% Notes and into shares of Old Senior Preferred Stock, Old Junior Preferred Stock, Class B and Class C Common Stock and Old Common Stock. Sale of Discontinued Operations In late 1989, the Company planned and began to implement a corporate restructuring and debt-reduction program in response to (i) high debt service requirements which severely restricted the Company's ability to capitalize on business opportunities and (ii) operating losses in the third and fourth quarters of 1989, which resulted in violations of certain financial covenants contained in the Company's credit agreements with its major lenders. The Company was able to negotiate temporary amendments to these agreements, enabling it to be in compliance with the agreements while the Company analyzed ways by which it could reduce and restructure long-term debt. The disposition of the Company's defense systems and power systems operations, completed in February 1991 and December 1991, respectively, were key components of the debt-reduction plan developed by the Company. Substantially all of the proceeds of such sales was used to repay all outstanding bank debt and to reduce the Company's indebtedness to Prudential. See "-- Discontinued Operations" below. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS For financial information about industry segments, see Note 1 of the Notes to Consolidated Financial Statements appearing elsewhere herein. ENERGY PRODUCTS AND SERVICES General The Company's energy products and services business is concentrated primarily in three areas: (1) natural gas marketing operations and related energy services, (2) natural gas facilities operations, which include gathering, transportation, processing, treatment and storage operations, and (3) natural gas liquids transportation and marketing operations. For the year ended December 31, 1993, these activities accounted for approximately 99% of the consolidated revenues of the Company from continuing operations. Such activities were conducted through Hadson Energy Products and Services, Inc. ("HEPSI"). Effective December 14, 1993, the Company merged HEPSI with and into the Company, with the Company being the surviving corporation, and made Western Natural Gas and Transmission Corporation ("Western") a direct subsidiary of the Company. The primary operating subsidiaries of the Company are Hadson Gas Systems, Inc. ("Gas Systems"), Llano, Inc. ("Llano"), Minerals, Inc. ("Minerals"), United LP Gas Corporation ("United"), Western, and the former AGPC subsidiaries which are now wholly-owned subsidiaries of the Company and renamed as follows: Hadson Gas Co., Hadson Gas Marketing Co. and Hadson Gas Gathering & Processing Co. The energy products and services business is seasonal, and affected by weather patterns in the market areas served by the Company. West Coast, Southwest and Southeast markets typically have higher demand for the Company's products in the summer months, while the Northeast and Midwest market demand is generally greater in the winter. Natural Gas Marketing Operations The majority of the Company's natural gas marketing operations are conducted through Gas Systems. As part of the services it offers customers, Gas Systems aggregates supplies of natural gas from gas producers and processors, uses its knowledge of federal, state and local regulations and the natural gas industry to contract for transportation services, arranges for transportation of gas over the most expeditious and economical pipeline routes and assists its customers in complying with regulatory filings and other matters relating to the requirements of the Federal Energy Regulatory Commission ("FERC"). Gas Systems believes that the growth of its gas marketing business depends primarily upon its ability to provide quality services in response to evolving customer needs and market conditions. The volume of gas transported and marketed by Gas Systems has increased from an average of 83 million cubic feet of gas ("MMCF") per day in 1985 to average daily volumes of approximately 452 MMCF in 1993. As of December 31, 1993, Gas Systems had approximately 520 direct gas sales contracts with industrial firms, local gas distribution companies, electric utilities, large commercial entities and institutions such as hospitals, military bases and universities. Gas Systems maintains a diverse customer base in order to limit its reliance on any one industry or region. No customer accounted for 10% or more of Gas Systems' total gas sales in 1993. Gas Systems competes with other gas marketers primarily on the basis of market-responsive pricing, reliability of supply and customer service. In connection with its gas marketing operations, Gas Systems purchases and takes title to gas at the wellhead, processing plants or other points of delivery primarily from independent producers and major integrated oil companies and sells such gas to industrial and institutional users, local gas distribution companies and electric utilities across the United States. It is Gas Systems' general practice to contract for a diverse supply of gas from various geographic locations and producers to minimize its reliance on any single source or region and to maximize its ability to deliver gas to its customers by the most advantageous route. Gas Systems believes that it has retained and increased its sources of supply because of its demonstrated ability to market and transport the quantities of gas purchased. When interruptible transportation is used, Gas Systems generally arranges for the transportation of gas from the point of purchase to the customer's delivery point. If firm transportation is used, generally this transportation is contracted for by the customer, although Gas Systems has executed a limited number of firm transportation agreements. Gas is purchased under contracts that, to the extent possible, complement Gas Systems' gas sales contracts as to term and pricing. Gas Systems purchases gas under long-term contracts, as well as in the "spot" market for contract terms of generally 30 days, or less. Because most of Gas Systems' gas purchase contracts contain market-sensitive pricing mechanisms, Gas Systems is to a large extent insensitive to changes in natural gas prices. Some of Gas Systems' gas sales contracts are terminable by either Gas Systems or its customers upon relatively short notice (generally 30 to 90 days). This contract structure is designed to maintain Gas Systems' flexibility to respond to changes in customer needs, market conditions and regulations. In response to changes currently taking place in the gas industry, Gas Systems has been de-emphasizing its short-term markets, and an increasing proportion of its revenues are earned pursuant to value-added services, such as those provided by the CD Conversion contracts, described below, and other energy management services described below. As a result of the Merger, the Company succeeded to the rights and obligations of AGPC under the Gas Contract with Santa Fe and Santa Fe Energy Operating Partners, L.P. ("SFEOP"). Following the Merger, the Company assigned the Gas Contract to Gas Systems. The Gas Contract has a term of approximately seven years and provides for the purchase by the Company of essentially all of Santa Fe's and SFEOP's existing domestic natural gas production as well as natural gas production that either Santa Fe or SFEOP has the right to market. In addition, the Company has the right to purchase new production from certain development properties of Santa Fe and SFEOP. The price to be paid by the Company for natural gas purchases under the Gas Contract is based on generally recognized published price indices. The Gas Contract provides, among other things, terms (i) for the release of gas dedicated under the Gas Contract, (ii) for payment by the Company and (iii) for termination of the Gas Contract under certain conditions. Regulatory changes beginning in 1985 have caused the largest purchasers of natural gas (primarily gas distribution companies and electric utilities) to convert a growing percentage of their supply portfolio or "contract demand" away from the traditional pipeline supplier to new suppliers such as natural gas producers and marketing companies. As a result of such regulatory changes, utilities and end-users holding contract demand with interstate pipelines are now able to convert those contracts to firm pipeline transportation capacity ("CD Conversions") and thereby assure delivery of their new supply sources. During 1993, Gas Systems delivered approximately 161 MMCF of gas per day to such CD Conversion customers. Gas Systems offers end-users contracted management services to reduce or eliminate administrative expense associated with energy procurement, and assists natural gas producers in managing the delivery of their product to market through gas volume accounting, transportation and related services. Customers for Gas Systems' energy management services are typically larger industrial, commercial and governmental consumers that operate multiple facilities in various geographic areas or producers that desire to avoid the administrative complexity and costs of natural gas marketing and transportation regulatory requirements. These value-added energy service contracts are generally long-term (three to five years). Gas Systems believes that its value-added service approach enhances its ability to respond to evolving customer and producer requirements in the changing natural gas industry. Natural gas prices have become extremely volatile over the past two years. Mid-month price volatility has increased from typically five cents per million British thermal unit ("MMBtu") during 1991 to as much as 45 cents or more per MMBtu during 1993. Gas Systems has begun to assist customers and producers in managing the risk associated with such changes in natural gas prices. This is accomplished by utilizing various financial instruments such as natural gas futures contracts, options and swap arrangements. In addition, Gas Systems may provide such services via fixed-price sales or supply contracts which are then coupled with these financial instruments to hedge price risk exposure to Gas Systems. Such hedging strategies are subject to inefficiencies in the financial instruments utilized, as well as management's judgment in the design and execution of the strategies. Another tool which Gas Systems utilizes in its gas sales and purchase contracts to combat price volatility is market-sensitive pricing which reflects monthly and/or daily commodity pricing. Short-term or "spot" sales of natural gas comprised 42% of Gas Systems' sales of natural gas in 1993. These activities will continue to play a critical role in Gas Systems' overall strategy because they provide an important source of market intelligence, while serving a portfolio balancing function. Natural Gas Facilities Operations The Company's natural gas facilities operations include natural gas gathering, treatment, processing, underground storage, intrastate transmission and contract production operations, as well as field and technical services, and are conducted through the Company's subsidiaries. These operations are concentrated in southeastern New Mexico, the Louisiana Gulf Coast and the Permian Basin of West Texas (as a result of AGPC's operations in that area). Assets employed to conduct these operations include Llano's 650-mile intrastate pipeline in southeastern New Mexico (the "Llano Pipeline"), six separate gathering systems consisting of 26 miles of pipeline, two gas processing facilities and an underground gas storage facility with a current working capacity of approximately 6 billion cubic feet ("BCF") of gas. In addition, as a result of the Merger, the Company acquired either a 100% interest or some lesser interest in nine gas gathering systems, six of which are operated by the Company through its subsidiaries, and one gas transmission system. The Company also acquired three gas processing plants through the Merger. The principal asset of the Company's natural gas facilities operations is the Llano Pipeline. The Llano Pipeline, which has a design capacity of approximately 180 MMCF of gas per day, is capable of delivering gas to four different interstate pipelines and directly to three end-users, as well as receiving gas from three interstate pipelines. The Company, through its various subsidiaries, purchases gas from over 55 producers connected directly to the Llano Pipeline and sells the gas directly to end-user customers or delivers the gas into one of the interstate pipelines for sale by Gas Systems. The Company, through its various subsidiaries, also transports natural gas through the Llano Pipeline for third parties and is paid a transportation fee for such services. In connection with gas moved through the Llano Pipeline, the Company, through its various subsidiaries, also provides gas treatment and contract operation services. During 1993, an average of approximately 114 MMCF of natural gas per day moved through the Llano Pipeline, as compared to approximately 124 MMCF of natural gas per day in 1992 and approximately 118 MMCF of natural gas per day in 1991. The nine gas gathering systems in which AGPC previously held interests gathered approximately 30 MMCF of natural gas per day during 1993 (net to AGPC's interest). The one gas transmission system, in which AGPC held an interest, transported 24 MMCF of natural gas per day during 1993 (net to AGPC's interest). In certain circumstances, these pipeline systems are used to transport or gather natural gas for others in return for a transportation fee. Connected to the Llano Pipeline are two natural gas processing facilities, including a cryogenic unit capable of processing approximately 50 MMCF per day of natural gas. These facilities extract NGLs, including propane, ethane, butanes and natural gasoline, from the natural gas stream, at which point the mixed stream of liquids is sold to United. In 1992, the facilities processed approximately 39 million gallons of NGLs. During 1993, approximately 44 million gallons of NGLs were processed and sold from these facilities. The interests in the three gas processing facilities acquired through the Merger, Sale Ranch, Antelope Ridge and Apple Creek, produced approximately 24 million gallons of NGLs (net to AGPC's interest) during 1993. The Antelope Ridge Plant was recently refurbished and connected to the Llano Pipeline, in addition to the two plants described above. Also connected to the Llano Pipeline is a natural gas storage facility. This facility has current working capacity of approximately 6 BCF. This capacity could be increased to approximately 10 BCF by decreasing mechanical limits on withdrawals from and injections into the facility. The Company, through its subsidiary, offers this storage capacity to third parties on a fee basis. During 1993, approximately 6 BCF (the entire current working capacity) was leased to other parties. NGL Marketing and Transportation Through United, the Company engages in NGL purchasing, transporting, marketing and trading, primarily in Oklahoma, Texas and Louisiana. United generally purchases NGLs from "landlocked" gas processing plants and transports the liquids through its fleet of 32 trucks to injection points on common carrier and private pipelines. Five of these injection facilities are owned and operated by United. The liquids are then transported via the pipelines to fractionation plants, at which point the liquids are normally sold. United also markets NGLs which are not transported by its own trucks. Because the NGLs transported by United are highly volatile, the Company carries insurance, in amounts it believes are in line with industry practice, against risks involved in transporting these liquids. During 1993, United transported approximately 129 million gallons of NGLs and marketed approximately 387 million gallons of NGLs. In December 1992, United entered into a three-year contract to market all NGLs produced by a large independent oil and gas producer. This transaction involves marketing approximately 4 million gallons per month on behalf of this particular producer. United is working to expand its marketing efforts in the wholesale distribution of NGLs, especially propane. Potential customers in this market include industrial users of propane, some of which are currently customers of the Company's natural gas marketing operations. Since 1990, United has owned a 40% interest in Beck & Root Fuel Company, a retail propane sales and distribution company located in Oklahoma. Competition The Company, through its various subsidiaries, competes with gas pipelines, producers and other gas marketers primarily on the basis of market-responsive pricing, reliability of markets and supply, and customer service. The Company believes that its ownership and control of gathering and transmission facilities, its detailed knowledge of market and regulatory factors affecting the industry and its ability to respond quickly and flexibly to changes in market conditions, governmental regulations and customer needs have been important factors in its success to date. The Company devotes significant management time and resources to monitoring closely federal and local gas regulation developments and, where appropriate, seeking regulatory enforcement or other appropriate action. The Company faces intense competition in marketing gas to end-user customers and local distribution companies. Its competitors include the major integrated oil companies, pipeline-affiliated marketing companies, and regional gas gatherers, brokers and marketers of widely varying sizes, financial resources and experience. Some of these competitors, such as the major integrated companies, have capital resources many times greater than the Company's and control substantially greater supplies of natural gas. In some cases, local utilities and gas distribution companies (some of which are customers of the Company) also engage, directly and through affiliates, in marketing activities that compete with the Company's subsidiaries. Environmental Matters The Company believes that it is in substantial compliance with applicable material environmental regulations. The construction and operation of pipelines, plants and other facilities for transporting, gathering, processing, treating or storing natural gas and other products are subject to federal, state and local environmental laws and regulations, including those that can impose obligations to clean up hazardous substances at the locations at which the Company operates or to which it sends waste for disposal. In most instances, the applicable regulatory requirements relate to water and air pollution control or solid waste management measures. Environmental regulation can increase the cost of planning, design, initial installation and operation of such facilities. Historically, the Company's expenditures for environmental control facilities and for remediation have not been significant in relation to its results of operations. The Company believes, however, that it is reasonably likely that the trend in environmental legislation and regulations will continue to be towards stricter standards. The Company is not aware of any future environmental standards that it believes are reasonably likely to be adopted that will have a material adverse effect on the Company's results of operations, but cannot rule out that possibility. It is not anticipated that the Company will be required in the near future to expend amounts that are material in relation to its total capital expenditures program by reason of environmental laws and regulations, but inasmuch as such laws and regulations are frequently changed, the Company is unable to predict the ultimate cost of compliance. Governmental Regulation The production, transportation and certain sales of natural gas are subject to federal, state or local regulations which have a significant impact upon the Company's energy products and services business. Regulation at the federal level of domestically produced or transported natural gas is administered primarily by the FERC pursuant to the Natural Gas Act (the "NGA") and the Natural Gas Policy Act (the "NGPA"). Maximum selling prices of certain categories of gas, whether sold in interstate or intrastate commerce, previously were regulated pursuant to NGPA. The NGPA established various categories of gas and provided for graduated deregulation of price controls of several categories of gas and the deregulation of sales of certain categories of gas. All price deregulation contemplated under the NGPA has already taken place. Subsequently, the Natural Gas Wellhead Control Act of 1989 terminated all NGA and NGPA price controls on "first" sales of domestic natural gas on January 1, 1993. The sale for resale of certain natural gas in interstate commerce is regulated, in part, pursuant to the NGA, which requires certificate and abandonment authority to initiate and terminate such sales. In addition, natural gas marketed by Gas Systems is usually transported by interstate pipeline companies that are subject to the jurisdiction of the FERC. See "-- Order No. 636" below. Similarly, some of the transportation and storage services provided by Llano are subject to FERC regulation under section 311 of the NGPA. These services are frequently sold to gas distribution companies that contract with interstate pipeline companies for transportation from the Llano facility to their respective service areas. Section 311 permits intrastate pipelines under certain circumstances to sell gas to, transport gas for, or have gas transported by, interstate pipeline companies, and assign contract rights to purchase surplus gas from producers to interstate pipeline companies without being regulated as interstate pipelines under the NGA. The FERC has established regulations governing the rates, construction of facilities and conditions of service applicable to section 311 service performed by intrastate pipelines. Pursuant to these rules and related FERC orders, Llano is currently required to obtain approval of its rates at least once every three years. Llano's current section 311 rates were approved by an order issued August 13, 1991, which also required Llano to seek new rate approval no later than July 3, 1993. Llano has informally advised the FERC staff of its inadvertent failure to satisfy this requirement, and that it will apply for such approval in April or May 1994, after completion of certain related market studies and the required rate application. Rates charged for section 311 transportation performed by Llano since July 3, 1993 will be subject to refund and the outcome of FERC action on this filing, when made. In addition, until this filing is made, Llano will not be in compliance with the FERC's order. Under the NGPA, the FERC has authority to assess penalties of up to $5,000 per day per violation of its regulations and orders implementing the NGPA. However, given the tenor of the Company's informal discussions about this matter with the FERC staff and the past action taken by the FERC in similar circumstances, the Company does not believe that Llano will be assessed any material penalty. In addition, the Company does not believe that Llano will be required to make any material rate refunds. In 1990, FERC's broad interpretation of the scope of NGPA section 311 transportation authority was reversed by an appellate court. FERC has since issued a new rule (Order 537) interpreting the "on-behalf-of" test found in section 311. The revised rule requires the on-behalf-of entity to either have physical custody of and transport the natural gas at some point during the transaction or hold title to the natural gas for a purpose related to its status as an intrastate pipeline, local distribution company or interstate pipeline, as applicable. The new rules narrow the scope of transactions that can be performed under section 311, but the Company does not believe this will adversely affect the Llano Pipeline or the availability of transportation for gas sold by the Company's subsidiaries. Under the NGA, natural gas gathering facilities are exempt from FERC jurisdiction. Interstate transmission facilities are, on the other hand, subject to FERC jurisdiction. The FERC has historically distinguished between these types of activities on a very fact-specific basis which makes it difficult to predict with certainty the status of the Company's gathering facilities. While the FERC has not issued any order or opinion declaring the Company's facilities as gathering rather than transmission facilities, the Company believes that these systems meet the traditional tests that the FERC has used to establish a pipeline's status as a gatherer. Members of the FERC have recently expressed the intention to reassess the FERC's traditional gathering criteria in light of the implementation of Order No. 636, discussed below. The Company cannot predict what, if any, changes such reassessment might cause in the traditional gathering test applied by the FERC. Except as discussed in the foregoing paragraphs, regulation of natural gas gathering (other than gatherings by interstate pipelines) and intrastate transportation activities is primarily a matter of state oversight. Regulation of gathering and transportation activities in New Mexico, as in most other states, includes various safety, environmental and non-discriminatory purchase requirements. While some states provide for the rate regulation of pipelines engaged in the intrastate transportation of natural gas, such regulation has not generally been applied against gatherers of natural gas. However, Oklahoma has recently enacted legislation that prohibits the imposition of unjustly or unlawfully discriminatory gathering rates. The Company's gathering systems could be adversely affected should they be subjected in the future to the application of such state or federal regulation. Order Nos. 436 and 500. Under the rules promulgated by the FERC beginning in 1985 (the "Order 436/500 Rules"), transportation service by interstate pipelines must be provided on an open access, nondiscriminatory basis. The effect of the Order 436/500 Rules has been to enable the Company, through its subsidiaries, to market natural gas as well as other services to a broad array of customers via the national network of natural gas transportation and distribution facilities. The opportunity to compete directly with other users for firm or interruptible interstate transportation services at nondiscriminatory rates and terms has substantially increased the Company's access to such services and its ability to arrange for transportation of its gas to customers, a significant factor in the growth of the Company's gas marketing operations. The Order 436/500 Rules were challenged in the United States Court of Appeals. After a number of changes were made by the FERC in response to several rulings by such Court from 1987 to 1990 (none of which altered the basic open access requirement of the rules), the substantive provisions of the Order 436/500 Rules have been upheld by the courts and become final. Order No. 636. In the summer of 1991, the FERC initiated further rulemaking proceedings for the purpose of modifying the terms and conditions under which open access transportation is provided in order to ensure that "unbundled" transportation service (i.e., transportation service not sold as an integral part of a sale of natural gas supplies) is provided on an open access basis "comparable" to the transportation services that the pipelines "bundle" with their own, regulated sales. These proceedings became generally known in the industry as the "Mega-NOPR" (for "Mega Notice of Proposed Rulemaking") proceedings. The FERC stated that its goal, recognizing that pipelines have become predominantly transporters, not sellers, of gas, was to "create a regulatory framework that will accommodate the meeting of as many gas sellers and gas buyers as possible", and to thereby further enhance competition in the domestic natural gas markets. In April 1992, the FERC adopted final rules in this proceeding which were designated as Order No. 636 (the "Order 636 Rules"). The Order 636 Rules are currently in effect but are subject to pending requests for judicial review and possible modification or reversal as a result. The Order 636 Rules reaffirm the basic open access transportation regime of the Order 436/500 Rules and extend that regulatory approach in several ways: (i) Equality of service -- the equal access rules. The Order 636 Rules require interstate pipelines to provide a level of transmission and storage service that is equal for all shippers regardless of whether the gas commodity is sold by the interstate pipeline or by a competing gas merchant. In particular, the rules require interstate pipelines to provide equal access in a number of specified areas, including: equal access to transmission facilities; equal access to most storage facilities; equal and timely access to information relevant to the availability of the open access transmission services; equal access to a new flexible delivery service; and equal access to a pipeline's contract rights to receive certain transmission services from upstream pipelines. (ii) Flexibility of service. The Order 636 Rules seek to expand shippers' ability to use all receipt and delivery points on a pipeline on a more flexible basis than in the past, such that, subject to reasonable pipeline operating requirements, shippers will be able to receive natural gas from any person at any point on the pipeline facilities and deliver gas to any person at any point as long as the receipt and delivery points are within the path of the firm transportation capacity to which the shipper is entitled and for which it pays. The rules also prohibit pipeline tariff provisions that inhibit the development of "market centers" (areas where gas may be delivered into multiple pipeline interconnects). Defining the scope and operation of this requirement has been left to case-by-case implementation procedures. (iii) Mandatory "unbundling" of pipeline system sales. The Order 636 Rules find that the traditional interstate pipeline practice of making "bundled," city-gate firm gas sales causes considerable competitive harm to all segments of the natural gas industry and constitutes an unlawful restraint of trade which is not balanced by the "no-notice" aspect of the service. This "bundled" sales service is the traditional pipeline sales service in which the interstate pipeline sells the gas commodity to retail local distribution companies ("LDCs") on a delivered basis at the point of interconnection between the physical facilities of the LDC and the interstate pipeline. As a remedy to this finding of unlawful restraint of trade, the FERC under Order 636 ordered all interstate pipelines to "unbundle" their gas sales from the transmission, storage and related services and make any sales at aggregation points in or near gas production areas. Pipelines will be allowed to make such unbundled sales pursuant to new "blanket" certificate authorizations under which the FERC intends to provide great pricing and operational flexibility ("light-handed regulation" of unbundled pipeline sales). It is anticipated that this light-handed regulation will allow fully market-based pricing of gas sales by the unbundled pipeline merchant in the great majority of cases. The Order 636 Rules contemplate that all gas merchants (unbundled pipelines, producers and marketers) will be able to contract for or manage the various unbundled component services in order to offer a "repackaged" delivered service to LDCs and others. To ensure that the pipeline's unbundled gas merchant service does not gain an improper competitive advantage from its association with the pipeline-as-transporter, the Order 636 Rules forbid the pipeline-as-transporter from giving any preference to shippers of gas sold by the pipeline over shippers of gas sold by any other merchant in matters relating to open access transportation. To implement this prohibition, the Order 636 Rules require the operating employees of merchant and transportation departments of all interstate pipelines to "function independently" of each other "to the maximum extent practicable" and to adopt various record-keeping and reporting requirements regarding dealings between the pipeline- transporter and the pipeline-merchant. Gas Systems has voiced concerns in regulatory proceedings as to the adequacy of these rules and procedures to achieve the FERC's stated goals. (iv) Customer option to terminate supply contracts with pipelines. The Order 636 Rules allow LDCs to reduce or even terminate their existing contracts to purchase gas from the pipeline-as-merchant. The purpose of this requirement is to enable those customers to freely negotiate to purchase gas from the pipeline under its new market-based sales service or to purchase gas from other gas suppliers. (v) Capacity assignment and "release" programs. The Order 636 Rules adopt certain capacity reallocation or "release" mechanisms, the stated purpose of which is to allow LDCs and other firm shippers the ability to better access supplies on pipeline systems to which they are not directly interconnected and to indirectly make available to others the firm capacity that the shipper holds but is not using. The intent of these provisions is to facilitate the development of a secondary transportation market while eliminating the potential for firm shippers to unduly discriminate in the assignment of capacity rights. (vi) Pregranted abandonment. The Order 636 Rules adopt several procedures governing a pipeline's ability under the NGA to terminate service at the expiration of the contract term. In general, these provisions allow a pipeline to terminate transmission service at the end of the contract term for (A) all contracts for interruptible transmission services and (B) short-term contracts for firm transmission contracts (i.e., contracts of one year or less). For longer- term contracts for firm transmission service, the Order 636 Rules adopt a "right of first refusal" mechanism which allows the firm shipper a federal right to extend its service under specified circumstances. Finally, the Order 636 Rules allow the termination of a pipeline's sales obligation at the expiration of the contract for the unbundled sales service. (vii) Policy favoring "straight fixed-variable" rates. As a general matter, the FERC will require pipeline transportation rates to be set so as to recover all fixed costs (including the pipeline's return on equity and associated income taxes) through fixed monthly demand charges. This shift will tend to increase the price of reserving firm capacity while lowering the price of actually using an incremental unit of the reserved firm capacity. (viii) Transition costs. The Order 636 Rules adopt major changes in how pipelines will be allowed to recover costs associated with certain take-or-pay contracts, upstream transmission contracts and certain other costs of the transition to operations in the Order 636 Rules. These changes essentially allow all such costs which are prudently incurred to be passed on by the pipeline to its firm open-access transportation customers. This aspect of the Order 636 Rules therefore tends to increase costs of transportation on affected pipelines, although, due to the pricing structure of most of its purchase, sales and transportation transactions, the Company does not believe that this has an adverse effect on its operations. (ix) Implementation and effectiveness. The Order 636 Rules are subject to pending court review, a process which is anticipated to take at least 12 months to complete. Hence, it is not certain to what extent the Order 636 Rules will be affirmed following completion of judicial review. The Order 636 Rules are effective during this process, however, and following case by case rulings by the FERC during 1992 and 1993 are currently in effect on essentially all interstate pipelines. Most of these rulings are now the subject of court challenges and are not expected to be resolved for at least 12 months. While the first phase of implementation of the Order 636 Rules is now largely completed many of the operational and other implementation issues are expected to continue to evolve in the next 12 to 18 months. The Company anticipates that these regulatory developments will generally present additional opportunities to the Company and its subsidiaries in providing gas sales and/or energy and capacity management services while creating certain risks associated with potential penalties for shippers exceeding allowed tolerance levels. Other Regulations. In October 1992, the Energy Policy Act of 1992 was enacted. This Act streamlined the permitting process necessary to import Canadian gas and altered the treatment of such gas under the NGPA, eliminating the FERC's jurisdiction over the price of non-pipeline sales of gas imported from Canada. Canadian gas imports still require import authorizations from the Department of Energy's Office of Fossil Energy under Section 3 of the NGA and construction and siting authorizations, where applicable, from the FERC. These changes could enhance the ability of Canadian producers to export gas to the United States and increase competition in the domestic natural gas market. In December 1992, the FERC issued Order No. 547, governing the issuance of blanket marketer sales certificates to all gas sellers other than interstate pipelines. The order eliminates the need for gas producers and marketers to seek specific authorization under Section 7 of the NGA from the FERC to make certain sales of natural gas, such as imported gas and gas purchased from interstate pipelines. Instead, effective January 7, 1993, these gas sellers, by operation of the order, have been issued blanket certificates of public convenience and necessity allowing them to make jurisdictional gas sales for resale at negotiated rates without seeking specific FERC authorization. The FERC intends Order No. 547, in tandem with Order No. 636, to foster a competitive market for natural gas by giving gas purchasers access to multiple supply sources at market-driven prices. Order No. 547 may also increase competition in the natural gas market while presenting opportunities for the offering of supply and capacity management services. Additional proposals and proceedings that might affect the natural gas industry are considered from time to time by the United States Congress, the FERC, state public utility regulatory bodies and the courts. The Company cannot predict when or whether any such proposals or proceedings may become effective, or their effect, if any, on the Company's operations. In addition, the natural gas industry historically has been very heavily regulated; therefore, there can be no assurance that the light-handed regulatory approach currently pursued by the FERC and Congress will continue indefinitely into the future. Certain pipeline systems which the Company acquired as a result of the Merger are subject to the jurisdiction of the Railroad Commission of Texas (the "RRC"). The RRC has the authority, under the Texas Gas Utility Regulatory Act and other statutes, to regulate the rates, services and operations of gas utilities in Texas. The Company believes that its activities subject to such regulation materially comply with all applicable laws and regulations of the RRC. OPERATIONS OF UNCONSOLIDATED SUBSIDIARIES Prior to July 15, 1993, the Company owned an approximate 49% interest in HERC, an independent oil and gas exploration, development and production company with interests principally offshore Western Australia, in the Mid-Continent Region of the United States and in Indonesia. HERC was formed as part of the Company's debt-reduction plan, whereby the Company accomplished a partial disposition of its oil and gas exploration and production operations by transferring to HERC, in February 1990, two major oil and gas subsidiaries of the Company in exchange for HERC common stock and the assumption by HERC of related indebtedness of approximately $62 million. On July 15, 1993, the Company sold such interest to Apache for $45 million in cash ($3 million of which was paid in November 1993 following the satisfaction of a condition relating to the acquisition by Apache of additional shares of HERC's common stock). The Company's interest in HERC was reported in its financial statements under the equity method of accounting. The Company has an approximate 17% interest in Midwest Energy Company ("Midwest"), whose current activities are centered around production from its existing domestic wells, as well as exploration in the Paris and Aquitaine Basins of France, where Midwest owns various interests in six oil and gas exploration permits granted by the French government. The Company's interest in Midwest is reported in its financial statements under the cost method of accounting. The Company, through its United subsidiary, owns a 40% interest in Beck & Root Fuel Company ("Beck & Root"). Beck & Root is a propane retailer with outlets located in central and western Oklahoma. The Company's interest in Beck & Root is reported in its financial statements under the equity method of accounting. DISCONTINUED OPERATIONS Defense Systems Operations The defense systems operations were conducted through two subsidiaries, Ultrasystems Defense Inc. ("UDI") and HRB Systems, Inc. ("HRB") (collectively, "Defense Systems"). The Company acquired UDI in April 1988 in conjunction with the acquisition of Ultrasystems Incorporated (through which the Company acquired its power systems operations described below) and acquired HRB in August 1988. Both UDI and HRB were engaged in the design and development of sophisticated software and hardware for the United States Department of Defense and federal intelligence agencies. The Company sold HRB in October 1990 to E-Systems, Inc. ("E-Systems") for $65 million in cash. In February 1991, the Company sold substantially all the operations of UDI to Logicon, Inc. ("Logicon") for approximately $5.5 million in cash. The Company retained accounts receivable totaling approximately $1 million related to certain government contracts, of which approximately $.5 million has been collected as of December 31, 1993, and lease obligations related to facilities formerly occupied by UDI. Such lease obligations were settled in conjunction with the confirmation of the Plan. Power Systems Operations The Company, through Hadson Power, was engaged in the development, engineering, construction, operation and ownership of power generation facilities. The Company sold Hadson Power in December 1991 to a subsidiary of LG&E Energy Corp. ("LG&E") for a purchase price of $50.5 million, subject to adjustment upon certain events. The agreement related to the sale of Hadson Power provided for an adjustment to the purchase price based upon the net worth of Hadson Power as of the date of the sale. The amount of such adjustment was the subject of a dispute between the Company and LG&E. However, as discussed below, the Company and LG&E have reached agreement regarding the amount of such adjustment. Of the $50.5 million purchase price, LG&E retained $2.5 million as a "hold-back" to in effect secure the Company's indemnification obligations to LG&E with respect to certain engineering and construction contracts of the power systems business; any amounts not utilized as reimbursement for the indemnity obligations are to be released to the Company upon the occurrence of certain events. In conjunction with the 1992 Restructuring, the Company and LG&E reached settlement on certain, but not all, of the indemnity obligations. As a result, LG&E paid the Company a total of approximately $.4 million and the new hold-back amount was established at approximately $2.2 million. LG&E has also agreed that other indemnity claims against the Company cannot exceed $.5 million. Based on the current status of various claims of LG&E subject to the hold-back amount, the Company believes it unlikely that it will receive any significant amount of the hold-back. Pursuant to the stock purchase agreement with LG&E, the Company retained the equity interests in six cogeneration facilities and a waste wood processing facility formerly held by Hadson Power. The Company disposed of its interest in the wood processing facility and its interests in four of such cogeneration facilities during 1992. NUMBER OF PERSONS EMPLOYED As of December 31, 1993, there were 226 people employed by the Company and its consolidated subsidiaries. ITEM 2. ITEM 2. PROPERTIES Natural Gas Gathering Facilities. The Company, through certain subsidiaries, owns, or has an interest in, 12 natural gas gathering systems, of which nine were previously owned by AGPC. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation." These systems are located in Texas, Louisiana, Montana and Oklahoma. Other Gathering and Transmission Facilities and Related Property. The Company, through a subsidiary, owns the Llano Pipeline, a 650-mile intrastate gas pipeline system in southeastern New Mexico with a throughput capacity of 180 MMCF of gas per day. The Company, through a subsidiary, has an interest in a 74-mile gas transmission system located in Texas. This system, which was previously owned by AGPC, has a design capacity of 80 MMCF of gas per day. The Company, through certain subsidiaries, also owns and operates five natural gas processing plants located in southeastern New Mexico and western Texas with a total design capacity of 125 MMCF of gas per day. Three of these natural gas processing facilities were acquired through the Merger. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation." The Company, through a subsidiary, owns and operates an underground natural gas storage facility adjacent to its pipeline system in southeastern New Mexico with a current working capacity of approximately 6 BCF of natural gas. Natural Gas Liquids Facilities and Related Property. The Company, through certain of its subsidiaries, operates 33 tractors (8 owned and 25 leased) and 32 trailers (29 owned and 3 leased), primarily in Oklahoma, Texas and Louisiana. The Company owns and operates five proprietary pipeline injection points and is a joint owner in a sixth facility, each of which include storage facilities. Additionally, the Company has exclusive injection rights at three facilities owned by others. Other. The Company is currently headquartered in Oklahoma City, Oklahoma, where it leases approximately 30,000 square feet of office space. In April 1994, the Company's headquarters will be moved to Dallas, Texas, where the Company will lease approximately 40,000 square feet of office space. Various subsidiaries of the Company lease office space in Irving, Texas; Washington, D.C.; Denver, Colorado; and Chicago, Illinois. Additionally, the Company owns real estate in Hobbs, New Mexico, where Llano maintains offices and service facilities. Power Systems Properties. The following table provides information regarding the two power projects in which the Company currently owns an equity interest: (1) Wholly-owned subsidiary of Tucson Electric. (2) Wholly-owned subsidiary of Pacific Enterprises, formerly Pacific Lighting Corporation. (3) Wholly-owned subsidiary of Baltimore Gas & Electric Company. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Fixed-Price Contract Dispute. In May 1990, the United States Army terminated a contract with a subsidiary of the Company alleging that the subsidiary had defaulted in the performance of the contract. In August 1990, the subsidiary appealed such termination to the Armed Services Board of Contract Appeals on the grounds that the contract was in fact terminated for the convenience of the government. In addition, the subsidiary submitted a claim to the government for additional costs related to the contract and amounting to more than $13 million. The Army alleged that the subsidiary was obligated to repay progress payments in the amount of approximately $5.3 million and the costs of reprocuring the terminated contract from another party. Although the government had filed a claim in the Company's Chapter 11 case, in November 1992 the Army, in settlement of that claim, agreed that the Company's liability, if any, under the subsidiary's contract would be limited to a maximum of $750,000, payable over a 10-year period. On September 22, 1993, the subsidiary and the Army entered into a settlement agreement whereby each party agreed to release all claims against the other and the Army agreed to release to the subsidiary amounts due under other government contracts amounting to approximately $1.8 million and to make a payment to the subsidiary of $7 million, which amount was received in full in November 1993. On September 28, 1993, the Armed Services Board of Contract Appeals entered an order granting a stipulated settlement pursuant to this agreement. Gas Sales Contract Dispute. On July 16, 1991, Western and PDH Energy Partnership, Ltd. ("PDH") entered into a Gas Purchase and Sale Contract (the "PDH Contract") obligating Western to deliver to PDH, subject to certain conditions, through 2007, all of PDH's requirements for natural gas up to a maximum of 2,000 MMBtu per day. The price to be paid by PDH for gas delivered under the PDH Contract is $1.50 per MMBtu during the first year of the contract with provisions for escalation of 4% per year during each of the first 10 years of the contract, and 6% per year thereafter. By letter dated September 15, 1993, Western notified PDH that Western was exercising its right to terminate the PDH Contract. The PDH Contract contains a provision permitting Western to terminate the PDH Contract in the event of any acts by governmental authorities which, in Western's sole judgment, are unduly burdensome or unacceptable. PDH has disputed Western's ability to terminate the PDH Contract, and attempts to settle the dispute have proven unsuccessful to date. PDH has threatened to sue Western for breach of contract. In addition, PDH's project lender has threatened suit against Western based on a consent to assignment of the PDH Contract executed by Western. If either or both of such suits should be filed, Western intends to dispute such claims (to both of which it believes that it has meritorious defenses), but there can be no assurance that Western will prevail in either matter. While, to the knowledge of the Company, no specific damage claims have been made to date, should either PDH or the project lender, or both, prevail, the resulting judgment(s) could have a material adverse effect on the Company and its results of operations. Personal Injury Case. On October 6, 1992, United was named as a defendant, along with several other companies, in a lawsuit involving a propane explosion in which two individuals were severely burned. One of the individuals died 13 days after the accident. The case, Annie Moore, et al. v. A-1 Propane, et al., is currently pending in the District Court of Harris County, Texas, 113th Judicial District. The plaintiffs have alleged that United was the supplier of the propane which exploded and that United, along with the other defendants in the case, were grossly negligent, inter alia, in their failure to insure that the propane was adequately odorized. The plaintiffs have not yet specified the amount of damages which they will assert against the defendants if this matter goes to trial. The plaintiffs have requested punitive damages equal to four times the amount of actual damages. United has primary insurance coverage for up to $1 million. The applicability of various other insurance coverages for amounts in excess of $1 million is uncertain. In the event it is determined that United's liability exceeds $1 million and additional coverage is not available, the resulting judgment or settlement, as the case may be, could have a material adverse effect on United and its results of operations. Joint Venture Case. In December 1990, West Texas Transmission Corp. and Brent Jordan filed a lawsuit in the District Court of Harris County, Texas, 190th Judicial District, against a number of defendants, including AGPC, Adobe Gas Co. and Adobe Gas Marketing Co. As a result of the Merger, Adobe Gas Co. (now known as Hadson Gas Co.) and Adobe Gas Marketing Co. (now known as Hadson Gas Marketing Co.) are subsidiaries of the Company. This lawsuit arises out of the purchase, in 1987, by Adobe Gas Co. of the plaintiffs' joint venture interests in the Power-Tex joint venture. Plaintiffs have alleged, inter alia, that Adobe Gas Co., as the operator of the Power-Tex joint venture, failed to disclose certain material information which affected the value of the joint venture interests sold to Adobe Gas Co. The plaintiffs allege causes of action for breach of fiduciary duty, breach of the duty of good faith and fair dealing, fraud and conspiracy, as well as other allegations. Discovery is in process, and the matter is set for trial in November 1994. The plaintiffs' most recent petition does not assert any particular dollar amount of damages. The Company is continuing to assess the merit of the plaintiffs' various assertions. In addition to the matters mentioned above, the Company is from time to time involved as a defendant in litigation incidental to its business. The Company does not believe that any such other lawsuits in which the Company is currently involved will have a material adverse effect on the Company's financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS A special meeting of stockholders of the Company was held on December 14, 1993 for the purpose of (1) authorizing, approving and adopting the Merger Agreement and (2) approving the Company's 1992 Equity Incentive Plan, as amended and restated as of November 5, 1993. Both items were approved by the Company's stockholders with votes cast as follows: 1992 EQUITY INCENTIVE PLAN, AS AMENDED AND RESTATED AS OF NOVEMBER 5, 1993 (1) A "broker non-vote" occurs if a broker or other nominee does not have discretionary authority to vote on and has not received instructions with respect to a particular proposal. (2) With the holders of such classes of stock voting together as a single class on such matter. (3) With the holders of the Old Senior Preferred Stock voting separately as a class on such matter. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS COMMON STOCK The Common Stock is traded on the New York Stock Exchange (the "NYSE") under the symbol "HAD." As of December 31, 1993, the Company did not meet certain of the NYSE's continued listing criteria as a result of the Company's recent financial results, and the NYSE has advised the Company that careful consideration will continue to be given to the appropriateness of continued listing of the Company's securities. Accordingly, there can be no assurance that the NYSE will not delist the Common Stock in the future if the Company continues not to meet the NYSE's requirements for continued listing. The following table sets forth, for the periods indicated, the high and low closing sales prices of the Common Stock, as reported on the NYSE Composite Tape, adjusted to give effect to the approximate one-for-15 reverse split of the Old Common Stock which occurred December 14, 1993 through the Merger. (1) The 1992 Restructuring was consummated on December 16, 1992. See "Item 1. Business -- Recent Developments -- Financial Reorganization." (2) The Merger, which effected a restructuring of the Company's debt and equity capitalization (including an approximate one-for-15 reverse split of the Old Common Stock), was consummated on December 14, 1993. See "Item 1. Business --Recent Developments -- Merger of Adobe Gas Pipeline Company With and Into the Company." On March 14, 1994, the closing price of the Common Stock on the NYSE was $2-7/8. On March 14, 1994, there were 25,689,147 shares of Common Stock outstanding and approximately 4,079 holders of record of Common Stock. DIVIDENDS The Company has never paid a cash dividend on the Common Stock and will not do so in the foreseeable future. The Company's ability to pay cash dividends on the Common Stock is dependent upon its financial condition. The Company is currently prohibited from paying cash dividends on its capital stock under the New Securities Purchase Agreement with Prudential. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA Set forth below is certain selected historical consolidated financial information of the Company as of December 31, 1989, 1990, 1991, 1992 and 1993 and for each of the five years in the period ended December 31, 1993. The selected historical consolidated financial information as of December 31, 1992 and 1993 and for each of the three years in the period ended December 31, 1993 has been derived from the Company's audited consolidated financial statements appearing elsewhere herein. The selected historical consolidated financial information as of December 31, 1989, 1990 and 1991, and for each of the two years in the period ended December 31, 1990, has been derived from audited historical consolidated financial statements previously filed with the Commission but not contained or incorporated herein. The following information should be read in conjunction with "Item 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES In December 1993, the Company completed the Merger and related transactions (the Merger, the New Securities Purchase Agreement and the New BMO Credit Agreement are collectively referred to herein as the "Transactions"). The Transactions were pivotal to the Company in enhancing its control of natural gas production for its natural gas marketing operations, increasing its operational and financial credibility, and improving its financial stability and capital structure. As a result of the Transactions, the sale of the HERC Shares and the contract dispute settlement discussed below, from December 31, 1992 to December 31, 1993, (i) the Company's total assets increased from approximately $155 million to $212 million (ii) total stockholders' equity increased from approximately $19 million to $39 million and (iii) working capital increased from a deficit of approximately $3.5 million to a positive amount of approximately $4.1 million. In 1993, the Company completed the sale of its approximate 49% interest in HERC to Apache for $45 million in cash. The $45 million in gross proceeds from the sale of the HERC Shares were used in the following manner: $1 million to pay costs and expenses related to the sale; approximately $1.3 million to pay accrued interest on the 6.20% Notes and restructuring fees due Prudential; approximately $2.2 million to repay all amounts due Prudential pursuant to the Prudential Credit Agreement, which was used to pay for costs and expenses related to the 1992 Restructuring; $1 million to prepay the New Senior Secured Notes upon closing of the Transaction; and $33 million to prepay principal outstanding under the 6.20% Notes. The remainder of approximately $6.5 million was used for costs and expenses associated with the Transactions and for working capital. In September 1993, the Company reached a settlement with the United States Army regarding various claims relating to a contract between a subsidiary of the Company and the United States Army. See "Item 3. Legal Proceedings -- Fixed-Priced Contract Dispute." As a part of this settlement, the Army released to the Company amounts due pursuant to other government contracts which totaled approximately $1.8 million and made a cash payment to the Company of $7 million. After payment of litigation costs of approximately $1.7 million, the net cash proceeds to the Company from this settlement totaled approximately $7.1 million. These proceeds were used to prepay the New Senior Secured Notes by $1.5 million upon closing of the Transactions with the balance utilized for working capital. As a result of the Merger, the Company acquired gas gathering, transmission and processing assets which have produced operating cash flow in excess of $7.5 million annually for recent years. In December 1993, subsequent to the Merger, the Company and a producer entered into an agreement regarding one of the assets, the Sale Ranch gathering system and processing plant. Pursuant to this agreement, the producer dedicated certain natural gas production to the system and paid the Company $2.5 million in cash, and the Company transferred to the producer an approximate 30% interest in the system. The amount of additional natural gas production dedicated to the system will increase over the next two years; however, in the short run, the Company's share of operating cash flow from the Sale Ranch system is expected to be less than in prior years, because of the reduction in the Company's ownership interest in the system. Also in late 1993, a producer terminated a natural gas processing agreement regarding the Apple Creek processing plant, which was acquired in the Merger. This producer had been the sole source of supply for this processing plant. The Company expects to be able to utilize the processing capacity of the Apple Creek plant in conjunction with its other operations in the area. However, operating cash flow will be negatively impacted in the near term as a result of these events. Had these events concerning the Sale Ranch gathering system and processing plant and the Apple Creek processing plant occurred in prior years, the Company estimates the historical annual operating cash flow from these assets, as described above, would have decreased by approximately $2.0 million. In addition to the incremental cash flow expected to be provided by the assets acquired in the Merger, the Gas Contract with Santa Fe and SFEOP is expected to provide the Company with a long-term source of natural gas supply which will not require security in the form of letters of credit. Furthermore, the added financial stability expected to result from the Transactions, including the New BMO Credit Agreement, should enhance the Company's general creditworthiness and, over time, reduce the Company's dependence on letters of credit to support purchases of natural gas and NGLs. The consummation of the Transactions is expected to result in an enhancement of the Company's ability to support working capital credit agreements by expanding the Company's "borrowing base." The Company has entered into the New BMO Credit Agreement. The new facility initially provides for letters of credit of up to $50 million, subject to availability under a borrowing base formula, which amount may increase to $60 million upon the syndication of the facility to one or more additional banks. The Company and BMO are currently in the process of syndicating this facility and hope to conclude these efforts early in the second quarter of 1994. The facility allows for direct borrowings of up to $10 million on a revolving basis (as compared to $5 million under the former agreement with BMO), within the $50 million or $60 million overall limit (as compared to $37.5 million under the former agreement with BMO). However, specified amounts of these borrowings must be repaid on a quarterly basis (which is generally referred to as a "clean-up" provision). The new facility is secured by a first priority lien, granted in favor of a collateral agent for the benefit of BMO and Prudential, primarily on the stock of the Company's operating and certain other subsidiaries, as well as the accounts receivable and other personal property of the Company, and by a first priority lien in favor of BMO on the accounts receivable and other personal property of certain of the Company's operating subsidiaries. The facility limits the incurrence of additional debt, the payment of dividends, investments and the sale of assets, all within specified limits. The Company is also required to maintain certain minimum levels of net worth, working capital and liquidity. This agreement has a term of two years and may be extended for a third year by the mutual consent of the Company and the lenders thereunder, subject to certain conditions. At February 28, 1994, $10.0 million in borrowings and letters of credit amounting to approximately $37.4 million were outstanding under the New BMO Credit Agreement, leaving approximately $2.6 million available under this facility. The ability of the Company to purchase natural gas and NGLs is dependent in large part on its ability to obtain trade credit, either with or without credit enhancements such as letters of credit. Since the 1992 Restructuring, the Company has enjoyed success in certain circumstances in procuring unsecured trade credit. However, the recent failures of several gas marketing companies, as well as the Company's recent financial results, have resulted in a heightened awareness within the industry as to credit exposure. As a result, in certain other instances the Company has experienced increased demand for letters of credit to secure its performance obligations under purchase contracts. As discussed above, management believes the Transactions will have a positive effect on the Company's ability to obtain unsecured trade credit in addition to increasing its ability to obtain letters of credit, thereby increasing the Company's ability to purchase and resell natural gas and NGLs. To that effect, during the first quarter of 1994, the Company's purchases and sales of natural gas have increased significantly as compared to the first quarter of 1993. Pursuant to the Merger, all outstanding shares of Old Junior Preferred Stock were converted into shares of New Junior Preferred Stock (which carry no dividend rights) and New Common Stock. Therefore, the Company will have no dividend requirements related to these securities. Pursuant to the Transactions, all securities held by Prudential were exchanged for New Senior Secured Notes, New Common Stock and the P Interest in the H/P Trust. Annual interest costs on the New Senior Secured Notes will initially amount to approximately $4.3 million and mandatory prepayments of principal (other than the $2.5 million prepayment made upon the closing of the Transactions and a $1 million prepayment due by August 1994) will begin in 1996. The New Senior Secured Notes are secured by the first priority lien granted in favor of the collateral agent for the benefit of BMO and Prudential described above. The terms of the New Securities Purchase Agreement restrict the incurrence of additional debt, the payment of dividends, investments and the sale of assets within certain limitations, but generally are much less restrictive than the terms of the previous securities purchase agreement with Prudential that governed the 6.20% Notes. Cash flow used by operations amounted to approximately $4.2 million for the year ended December 31, 1993 compared to approximately $4.1 million provided by operations for the same period of 1992 and approximately $5.2 million used by continuing operations in 1991. The decrease in 1993 is primarily attributable to lower earnings from operations in 1993. Additions to property, equipment and improvements for the year ended December 31, 1993 were higher than for the same period in 1992 due to increased drilling activity around the Company's pipeline systems in New Mexico and the resulting addition of new gathering facilities to connect new wells. Additions to property, equipment and improvements in 1991 included certain amounts related to discontinued operations. Cash flows from financing activities during 1993 included the payment of approximately $1 million of costs and claims related to the 1992 Restructuring and $1.8 million related to transactions completed in connection with the Merger. Between December 31, 1992 and December 31, 1993, certain significant changes took place in the amounts reflected under certain captions of the consolidated balance sheets included in the Consolidated Financial Statements appearing elsewhere herein. Accounts receivable and accounts payable increased significantly due to increased natural gas marketing activity late in 1993 and increased natural gas prices. Inventories increased due to greater volumes of NGLs held at year end 1993. Prepaid expenses and other current assets increased due to prepaid insurance and transportation costs as well as amounts to be received from the Sale Ranch gathering system and processing plant transaction discussed above. Other assets declined due to the write-off of goodwill in 1993 and the realization of amounts due under certain government contracts. Deferred revenues decreased due to the reclassification of certain amounts as other long-term liabilities. Other long-term liabilities consist of certain accrued costs payable more than one year from December 31, 1993 and deferred revenue and gas imbalances not estimated to be settled within one year. The Company may consider disposing of certain assets acquired through the Merger or other non-strategic assets in order to re-deploy its capital in more strategic areas. The Company's ability to do this will be limited to some degree by restrictions in the New BMO Credit Agreement and the New Securities Purchase Agreement. In addition, the Company intends to explore ways to further increase its equity capital and its control over supplies of natural gas. This might entail issuing common equity as full or partial consideration for additional natural gas gathering or processing facilities or for a dedication of natural gas production for the Company's natural gas marketing operations. RESULTS OF OPERATIONS General. During 1992, the ongoing operations of the Company were impacted by the 1992 Restructuring. The uncertainty generally associated with a Chapter 11 bankruptcy case caused many suppliers and other business partners to be very cautious in dealing with the Company. Furthermore, the use of available financial resources necessary to effect the 1992 Restructuring precluded the Company from applying those resources to its ongoing operations and thereby reduced operational flexibility to some degree. In 1993, these negative influences continued to a large extent. The uncertainty within the industry discussed above and poor results from certain of the Company's operations have tended to have additional negative influences. Management believes that over time, and in light of the Merger, these negative influences will diminish. Discontinued Operations. The Company's discontinued operations consist of the defense systems operations, which were sold in two separate transactions in October 1990 and February 1991, and the power systems operations, the majority of which were sold in December 1991 and a resulting gain of approximately $4.9 million was recognized. See "Item 1. Business -- Discontinued Opertions." The loss of approximtely $8.1 million in 1992 related primarily to discontinued operations resulting from the adjustment of amounts expected to be realized from certain contingent payments from the sale of Hadson Power and from a note received in the sale of a waste-wood processing facility. The gain of approximately $5.6 million in 1993 resulted from the settlement of a contract dispute between a subsidiary and the United States Army. See Note 3 of the Notes to the Consolidated Financial Statements of the Company appearing elsewhere herein. Earnings from HERC. Equity in earnings of unconsolidated affiliate in 1991 was a loss of approximately $1 million, which reflected an adjustment to the carrying value of HERC's domestic oil and gas properties. During 1992 and 1993, the corresponding amounts were earnings of approximately $1.7 million and $0.6 million, respectively, to the Company's interest. In 1993, the Company sold its interest in HERC and recorded a gain of approximately $6.4 million. See Note 4 of the Notes to the Consolidated Financial Statements of the Company included elsewhere herein. Energy Products and Services - General. The Company's ongoing operations include natural gas and NGL purchasing, gathering, processing, storage, transportation and marketing operations. Revenues, gross profit, sales volume and gross margin information related to these operations are provided below. Certain nonrecurring items are excluded from the average gross margins for natural gas. These items include in 1993 approximately $2.3 million in charges related to the re-valuation of certain natural gas imbalances and transportation liabilities. Natural Gas. Sales volumes for natural gas increased in 1993 as compared to 1992. The volumes in 1992 were negatively impacted by the 1992 Restructuring as the Company curtailed certain business activities during that period. In 1993, the Company began resuming normal operations and correspondingly, sales volumes increased. During 1993, a decrease in gas volumes sold under "spot" contracts partially offset an increase in volumes sold under term contracts, primarily with local distribution companies. The Company has continued to emphasize longer term contracts and has consistently been increasing the number of such contracts. Since 1990, the Company and the natural gas industry in general have experienced generally tighter margins due to competitive pressures. Margins for natural gas sales declined during 1992 and 1993 as compared to prior periods due primarily to certain sales to small industrial end-users. These sales were made through the Company's Western subsidiary pursuant to long-term contracts, many of which have fixed-prices which are redetermined on a periodic (quarterly or annual) basis. During the fall and winter of 1992 and continuing into early 1993, natural gas prices increased dramatically, particularly in the Permian Basin and Rocky Mountain areas of the country. As a result, the cost of acquiring gas supplies exceeded the sales price on many of these contracts. This situation was exacerbated by the fact that the relationship, or "basis differential", between Permian Basin and Rocky Mountain prices on the one hand and the prices reflected by natural gas futures contracts on the other hand changed from what had been experienced in the past. This caused certain of the Company's hedging transactions related to those fixed-price contracts to be ineffective. These circumstances concerning Western resulted in a decline in gross profit of $2.9 million from 1991 to 1992 and of approximately $3.8 million from 1992 to 1993. During 1993, the Company renegotiated substantially all of these contracts such that Western returned to profitable operations in the fourth quarter of 1993. Margins from natural gas sales were also negatively affected in 1993 by dramatic price changes which occurred in May and to a lesser extent December. During these months, natural gas prices dropped significantly from first of the month prices. These large price changes caused certain customers to change supply sources from the Company during the month to take advantage of the relatively inexpensive mid-month prices. The Company had committed for supplies to serve these markets at the higher price levels; therefore, the Company found itself with relatively expensive supplies which it was forced to dispose of at a loss in some cases. Subsequent to that time, the Company has renegotiated the pricing provisions of substantially all of these sales contracts to provide for pricing mechanisms which reflect what has become highly volatile intra-month pricing of natural gas. NGL. Sales volumes of NGLs remained relatively consistent during 1991, 1992 and 1993. Average gross margins on sales of NGL in 1993 decreased from 1992 primarily because of continually increasing competition which has led to compressed margins. During 1993, high inventory levels at certain key product aggregation points have also placed downward pressures on premium margins arising from location differentials. In the fourth quarter of 1993, the Company liquidated certain inventory positions at losses and lowered the carrying value of its remaining inventory at December 31, 1993 by $1 million to reflect the net realizable value of such inventory. Margins for NGL sales in 1992 reflect the effect of liquidating certain inventory positions at losses. In order to maintain liquidity during 1992, the Company established a schedule for the sale of certain NGL inventories. Those transactions resulted in losses of approximately $2 million. Production of NGLs. Volumes decreased slightly in 1992 from 1991 levels because of reduced natural gas through-put while one of the Company's processing plants was undergoing repairs and modifications. During 1993, production increased due to certain plant enhancements and modifications which were completed in the first quarter of 1993. Gross profit from NGL production is primarily a function of NGL prices and the cost of the natural gas which is processed. NGL prices in 1992 were slightly lower than during 1991, and 1993 prices were lower than 1992 prices. Fuel and shrinkage costs, which are directly related to the cost of natural gas, were substantially higher in 1992 and 1993 than in the previous periods because of the significant increase in natural gas prices. In addition, during 1992 the Company incurred certain repair and maintenance costs associated with the processing plant which were not incurred in the previous year. Beginning in 1993, significant incremental volumes of natural gas have been purchased under reserve dedication contracts which contemplate that such volumes will be processed by the Company and that proceeds from the sale of extracted NGLs and processed gas will be shared between the Company and the producer. Due to delays in adding additional processing capacity such additional gas volumes were not being processed until late in 1993. However, the Company continued to incur additional operating and gas purchase costs related to these gas volumes. Selling, General and Administrative. Selling, general and administrative expenses increased slightly in 1993 as compared to 1992. This increase was due primarily to additional bad debt expense recognized in the fourth quarter of 1993. These expenses decreased from 1991 to 1992 as a result of the Company's cost reduction efforts. Interest Expense. Interest expense was lower for 1993 than 1992. This decrease is due to a combination of lower debt balances and lower interest rates in 1993 compared to 1992. The lower debt balances and lower interest rates are attributable to the 1992 Restructuring of the Company's debt and equity capitalization which was completed in December of 1992. Interest expense in 1992 was higher than in 1991 because of a change in the estimate of interest applicable to discontinued operations in 1991. Other. Results for 1992 include a gain of $925,000 related to the 1992 Restructuring which represents the difference between the carrying value of the Company's 7-3/4% Convertible Subordinated Debentures and the liquidation preference of the Old Junior Preferred Stock into which it was converted, less costs and expenses of the 1992 Restructuring. Results for 1991 include $703,000 related to the sale of certain gas gathering systems. In the fourth quarter of 1993, the Company wrote off all remaining goodwill which amounted to approximately $3.1 million and related to United and Western. Due to the recent financial results of these entities, management did not feel that these operations continued to support such goodwill. Also in the fourth quarter of 1993 the Company recorded a charge of approximately $2.7 million related to the moving of its corporate office from Oklahoma City to Dallas and the consolidation of certain other functions, including those related to the Merger. Neither the provisions of the Omnibus Budget Reconciliation Act of 1993 nor any recently issued accounting standards are expected to have a material effect on the Company's financial statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to Item 8 is submitted in a separate section of this report. See the Consolidated Financial Statements and Schedules of Hadson Corporation and Subsidiaries attached hereto and listed in Item 14 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 appearing under the captions "Voting Information," "Election of Directors," "Nominees for Election to Board of Directors - Class I," "Members of Board of Directors Continuing in Office - Class II," "Members of Board of Directors Continuing in Office - Class III," "Board of Directors and Committees of the Board," "Executive Officers" and "Beneficial Ownership of Securities" set forth in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities and Exchange Act of 1934, as amended, is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under the captions "Certain Relationships and Related Transactions," "Management Compensation," "Compensation Committee Report" and "Comparison of Total Stockholder Return" set forth in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under the following captions set forth in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, is incorporated herein by reference: "Beneficial Ownership of Securities" and "Certain Relationships and Related Transactions." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under the caption "Management Compensation" and "Certain Relationships and Related Transactions" set forth in the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF THIS ANNUAL REPORT ON FORM 10-K: (1) Financial Statements: The consolidated financial statements of the Company filed as part of this report are listed in the "Index to Financial Statements and Financial Statement Schedules" on Page hereof. (2) Financial Statement Schedules: The financial statement schedules of the Company filed as part of this report are listed in the "Index to Financial Statements and Financial Statement Schedules" on Page hereof. (3) Exhibits: (Asterisk (*) indicates exhibits incorporated herein by reference.) *2.01 - Agreement of Merger, dated as of July 28, 1993, by and among Santa Fe, AGPC and the Company (filed as exhibit (c)(i) to the Copmany's Schedule 13E-3, File No. 5-14102, as amended, and incorporated herein by reference) *2.02 - Amendment No. 1 to Agreement of Merger, dated as of November 9, 1993, by and among Santa Fe, AGPC and the Company (filed as exhibit (c)(iv) to the Company's Schedule 13E-3, File No. 5-14102, as amended, and incorporated herein by reference) *3.01 - Restated Certificate of Incorporation of the Company (filed as exhibit 4.01 to the Company's Registration Statement on Form S-3, File No. 33-51373, and incorporated herein by reference) *3.02 - Amended and Restated Bylaws of the Company (filed as exhibit 4.2 to the Company's Registration Statement on Form S-3, File No. 33-51373, and incorporated herein by reference) *4.01 - Specimen certificate of the Common Stock of the Company (filed as exhibit 4.3 to the Company's Registration Statement on Form S-3, File No. 33-51373, and incorporated herein by reference) *4.02 - Specimen certificate of new Senior Cumulative Preferred Stock, Series A, of the Company (filed as exhibit 4.01 to the Company's Registration Statement on Form S-4, File No. 33-68224, and incorporated herein by reference) *4.03 - Specimen certificate of new Junior Exercisable Preferred Stock, Series B, of the Company (filed as exhibit 4.02 to the Company's Registration Statement on Form S-4, File No. 33-68224, and incorporated herein by reference) *4.04 - Securities Purchase Agreement dated as of December 14, 1993, between the Company and Prudential (filed as exhibit 4.2 to the Company's Current Report on Form 8-K dated December 14, 1993 and incorporated herein by reference) *4.05 - Restated Securities Purchase Agreement, dated as of December 16, 1992, by and between the Company and Prudential (filed as Exhibit 10.1 to the Company's Current Report on Form 8-K dated October 15, 1992 and incorporated herein by reference) *4.06 - Trust Agreement dated as of December 14, 1993 among the Company, Prudential and Liberty Bank and Trust Company of Oklahoma City, N.A., as Trustee (filed as exhibit 4.3 to the Company's Current Report on Form 8- K dated December 14, 1993 and incorporated herein by reference) *9 - Voting Agreement dated December 14, 1993 between Prudential and Santa Fe (filed as exhibit 9 to the Company's Registration Statement on Form S-4, File No. 33-68224, and incorporated herein by reference) *10.01 - Form of Indemnity Agreement between the Company and its directors (filed as exhibit 10.02 to the Company's Registration Statement on Form S-2, File No. 33-12577 and incorporated herein by reference) 10.02 - Form of Employment Agreement dated as of March 31, 1994 between the Company and James Ervin Cannon. 10.03 - Form of Employment Agreement dated as of March 31, 1994 between the Company and Greg G. Jenkins. *10.04 - Employment Agreement dated as of April 3, 1990 between the Company and J. Michael Adcock (filed as exhibit 10.04 to the Company's Form 10-K for the year ended December 31, 1990 and incorporated herein by reference) *10.05 - Amendment to Employment Agreement dated as of December 14, 1993 between the Company and J. Michael Adcock (filed as exhibit 10.3 to the Company's Current Report on Form 8-K dated December 14, 1993 and incorporated herein by reference) *10.06 - Employment Agreement dated as of April 3, 1990 between the Company and Robert P. Capps (filed as exhibit 10.08 to the Company's Form 10-K for the year ended December 31, 1990 and incorporated herein by reference) 10.07 - Form of Amended and Restated Employment Agreement dated as of March 31, 1994 between the Company and Robert P. Capps. *10.08 - Employment Agreement dated as of April 1, 1990 between Gas Systems and Robert L. Laughman (filed as exhibit 10.24 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) *10.09 - Employment Agreement dated as of April 1, 1990 between Hadson Liquid Fuels, Inc. and C. Jeff Goodell filed as exhibit 10.25 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference) *10.10 - Hadson Corporation Employee 401(k) Savings Plan as Amended and Restated Effective January 1, 1992 (filed as exhibit 10.16 to the Company's Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) *10.11 - Purchase and Sale Agreement, dated December 6, 1991 but effective as of July 1, 1991, by and between Reliance Gas Marketing Company and Gas Systems filed as exhibit 10.21 to the Company's Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) *10.12 - Stock Purchase Agreement dated June 17, 1993, by and between the Company and Apache (filed as exhibit 2.1 to the Company's Current Report on Form 8-K, dated July 15, 1993, and incorporated herein by reference) *10.13 - Credit Agreement, dated as of December 16, 1992, among the Company and Prudential (filed as exhibit 10.2 to the Company's Current Report on Form 8-K dated October 15, 1992 and incorporated herein by reference) *10.14 - Stock Purchase Agreement by and among the Company, HD Energy Corporation, LG&E Energy Corp., and LG&E Energy Systems Inc. dated as of December 13, 1991 (filed as exhibit 10.4 to the Company's Current Report on Form 8-K dated December 15, 1992 and incorporated herein by reference) *10.15 - Credit Agreement dated as of December 14, 1993 among the Company, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.2 to the Company's Current Report on Form 8-K dated December 14, 1993 and incorporated herein by reference) *10.16 - Cash Collateral Agreement, dated as of July 15, 1993, by and between the Company and Prudential (filed as exhibit 10.21 to the Company's Registration Statement on Form S-4, File No. 33-68224, and incorporated herein by reference) *10.17 - Amendment No. 1 to Cash Collateral Agreement, dated as of August 31, 1993, by and among the Company and Prudential (filed as exhibit 10.27 to the Company's Registration Statement on Form S-4, File No. 33-68224, and incorporated herein by reference) *10.18 - Registration Rights Agreement dated as of December 14, 1993 among the Company, Santa Fe and Prudential (filed as exhibit 10.2 to the Company's Current Report on Form 8-K dated December 14, 1993 and incorporated herein by reference) *10.19 - Form of Hadson Corporation 1992 Equity Incentive Plan as amended and restated as of November 5, 1993 (included as Appendix V to the Proxy Statement Prospectus) 10.20 - Hadson Corporation 1992 Equity Incentive Plan, as amended and restated as of March 9, 1994 *10.21 - Form of Master Gas Purchase Agreement dated December 14, 1993 among Santa Fe, SFEOP and AGPC (filed as exhibit 10.23 to the Company's Registration Statement on Form S-4, File No. 33-68224, and incorporated herein by reference) *10.22 - Form of Nonstatutory Stock Option Agreement dated December 13, 1993 that was entered between the Company with each of Harry G. Hadler, S. D. Wilks, C.D., and Walter C. Wilson (filed as exhibit 10.28 to the Company's Registration Statement on Form S-4, File No. 33-68224, and incorporated herein by reference) 10.23 - Form of Nonstatutory Stock Option Agreement dated December 14, 1993 that was entered into by and between the Company and each of Messrs. Payne, Haasbeek, Thompson and Rosinski *10.25 - Credit Agreement, dated November 30, 1990, by and among HEPSI, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.21 to the Company's Form 10-K for the year ended December 31, 1990 and incorporated herein by reference) *10.26 - Fourth Amendment to Credit Agreement, dated January 31, 1992 but effective as of December 31, 1991, by and among HEPSI, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.23 to the Company's Form 10-K for the year ended December 31, 1991 and incorporated herein by reference) *10.27 - Fifth Amendment to Credit Agreement, dated as of June 25, 1992, by and among HEPSI, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.25 to the Company's Registration Statement on Form S-4, File No. 33-49386, and incorportaed herein by reference) *10.28 - First Modification to Fifth Amendment to Credit Agreement, dated as of August 4, 1992, by and among HEPSI, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.26 to the Company's Registration Statement on Form S-4, File No. 33- 49386, and incorporated herein by reference) *10.29 - Second Modification to Fifth Amendment to Credit Agreement, dated as of September 11, 1992, by and among HEPSI, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.27 to the Company's Registration Statement on Form S-4, File No. 33- 49386, and incorporated herein by reference) *10.30 - Third Modification to Fifth Amendment to Credit Agreement, dated as of September 24, 1992, by and among HEPSI, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.28 to the Company's Registration Statement on Form S-4, File No. 33- 49386, and incorporated herein by reference) *10.31 - Sixth Amendment to Credit Agreement, dated March 31, 1993, by and among HEPSI, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.25 to the Company's Registration Statement on Form S-4, File No. 33- 49386 and incorporated herein by reference) *10.32 - Seventh Amendment to Credit Agreement, dated as of September 30, 1993, by and among HEPSI, Gas Systems, United, Western and BMO, individually and as Agent for the other Banks which may become a party thereto (filed as exhibit 10.26 to the Company's Registration Statement on Form S-4, File No. 33- 49386 and incorporated herein by reference) 11 - Computation of per share earnings 22.01 - List of subsidiaries of the Company 23 - Consent of independent public accountants (B) REPORTS ON FORM 8-K. During the quarter ended December 31, 1993, Registrant filed the following Reports on Form 8-K: (1) Form 8-K dated July 15, 1993, reporting the disposition of the Company's 49% interest in Hadson Energy Resources Corporation. An unaudited pro forma consolidated balance sheet and unaudited pro forma statements of operations were filed as part of the Report. (2) Amendment No. 1 to Form 8-K dated July 15, 1993, amending in its entirety Form 8-K dated July 15, 1993, reporting the disposition of the Company's 49% interest in Hadson Energy Resources Corporation. An unaudited pro forma consolidated balance sheet and unaudited pro forma statements of operations were filed as part of the Amendment. (3) Form 8-K dated September 22, 1993, reporting the settlement agreement between the Company's wholly-owned subsidiary, Hadson Defense Systems, Inc. (formerly Ultrasystems Defense and Space, Inc.) and the United States (the "Government") resolving all claims and disputes between those parties relating to a contract between the parties which was terminated by the Government on May 24, 1990. (4) Form 8-K dated December 14, 1993, reporting the Merger of Adobe Gas Pipeline Company ("AGPC") with and into the Company pursuant to an Agreement of Merger dated as of July 28, 1993 between the Company, Santa Fe Energy Resources, Inc. and AGPC. No financial statements were filed as a part of the Report. (5) Amendment No. 1 to Form 8-K dated December 14, 1993, amending such Form 8-K in its entirety. (C) SEE SUBITEM (A)(3) ABOVE. (D) SEE SUBITEM (A)(2). 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. HADSON CORPORATION DATE: March 9, 1994 By:/s/ GREG G. JENKINS ----------------------------------- Greg G. Jenkins, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, 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/ GREG G. JENKINS President, Chief Executive March 9, 1994 - -------------------------- Officer and Director Greg G. Jenkins (Principal Executive Officer) /s/ ROBERT P. CAPPS Executive Vice President, March 9, 1994 - -------------------------- Chief Financial Officer Robert P. Capps (Principal Financial Officer) /s/ MARTHA A. BURGER Vice President - Controller March 9, 1994 - -------------------------- (Principal Accounting Officer) Martha A. Burger Chairman of the Board of - -------------------------- Directors J. E. Cannon /s/ MICHAEL ADCOCK Director March 9, 1994 - -------------------------- J. Michael Adcock /s/ B. M. THOMPSON Director March 9, 1994 - -------------------------- B. M. Thompson /s/ JAMES L. PAYNE Director March 9, 1994 - -------------------------- James L. Payne /s/ MICHAEL J. ROSINSKI Director March 9, 1994 - -------------------------- Michael J. Rosinski /s/ J. FRANK HAASBEEK Director March 9, 1994 - -------------------------- J. Frank Haasbeek /s/ JAMES A. BITZER Director March 9, 1994 - -------------------------- James A. Bitzer HADSON CORPORATION AND SUBSIDIARIES Index to Financial Statements and Financial Statement Schedules HADSON CORPORATION AND SUBSIDIARIES REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Hadson Corporation In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Hadson Corporation and its subsidiaries (the "Company") at December 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. 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 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, 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 Oklahoma City, Oklahoma February 18, 1994 HADSON CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in Thousands) ASSETS See accompanying notes to consolidated financial statements. HADSON CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In Thousands, except per share data) See accompanying notes to consolidated financial statements. HADSON CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years Ended December 31, 1991, 1992 and 1993 (In Thousands) See accompanying notes to consolidated financial statements. HADSON CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands) HADSON CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (In Thousands) See accompanying notes to consolidated financial statements. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Business Hadson Corporation (the "Company") and its subsidiaries are engaged in the purchasing, gathering, processing, storing, transporting and marketing of natural gas and natural gas liquids ("NGL"). Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries. Material intercompany balances and transactions have been eliminated. The Company's proportionate share of assets, liabilities, revenues and expenses of various energy related partnerships and joint ventures is included in the consolidated financial statements in accordance with industry practice. Investments in other joint ventures and partnerships, which are owned 50% or less and in which the Company exercises significant management influence, are included in the consolidated financial statements under the equity method of accounting. Business Segment Information The Company's operations consist of only one segment; therefore, no segment information is presented for the three years ending December 31, 1993. During 1991, 1992 and 1993, no one customer accounted for more than 10% of total revenues from operations. Fair Value of Financial Instruments In accordance with the requirements of Statement of Financial Accounting Standards ("SFAS") No. 107, "Disclosures about Fair Value of Financial Instruments," the Company has provided fair value information about valuation methodologies in various notes to the consolidated financial statements. Cash and Cash Equivalents Cash and cash equivalents consist of demand deposits and funds invested in highly liquid instruments which are available on short notice, generally overnight. The carrying amount approximates fair value because of the short maturity of those instruments. Concentration of Credit Risk The Company's accounts receivable relate primarily to sales of energy products and services in the United States to end-user and utility markets. Receivables which are considered a credit risk are backed by letters of credit. Credit terms, typical of industry standards, are of a short-term nature. Gas Imbalances and Inventories In the course of buying and selling natural gas, the Company may receive or deliver volumes that are different than the amount nominated. Such variances arise as a result of certain attributes of the natural gas commodity and the industry itself. These transactions result in volumetric receivable and payable balances which are recovered or repaid through the receipt or delivery of gas in the future, or settled in cash. Natural gas imbalances expected to be settled within one year are classified as current assets or liabilities, with the remaining net imbalance position reflected in other long-term liabilities as of December 31, 1993. As of December 31, 1992, all natural gas imbalances were classified as current. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Amounts classified as inventories consist of natural gas contained in a gas storage facility which is expected to be withdrawn and sold within one year, NGL held in storage facilities, natural gas imbalances due from others and NGL exchange balances. Gas held in storage and NGL are valued as of year-end at the lower of net realizable value or cost on an average cost basis. Exchange balances (quantities of product due to/from others) are carried at market value. The accompanying statements of operations for the three years ended December 31, 1993 reflect adjustments to NGL inventory to estimated realizable value of $2.5 million, $-0- and $1.0 million. The major classes of inventory at December 31, 1992 and 1993 are as follows: Accounting for Futures Contracts The Company enters into natural gas futures contracts primarily for the purpose of hedging price risks associated with certain firm purchase and sales commitments. Realized gains or losses related to fixed purchase price commitments and changes in the market value of open futures contracts are deferred until the gain or loss of the hedged transaction or futures contract is recognized. The amounts of speculative futures gains and losses are immaterial in the periods presented. Property, Equipment and Improvements Natural gas gathering and transportation facilities are depreciated using the straight-line method over the expected life of the underlying natural gas reserves, which range from three to 15 years. Depreciation of other property and equipment is provided using the straight-line method over estimated useful lives of three to 10 years. Intangible Assets The excess of the acquisition costs over the fair value of purchased businesses is recorded within other assets as goodwill ($5,522,000 at December 31, 1992). In 1993, due to lower than expected performance of the previously purchased businesses, the entire balance of goodwill was written off in the accompanying statement of operations. The gas supply contract acquired pursuant to the December 14, 1993 merger of Adobe Gas Pipeline Company ("AGPC") with and into the Company (the "Merger") is being amortized on a straight-line basis over its seven-year term. (See Note 2.) Stock Options No accounting is made with respect to stock options until they are exercised as all options have been granted at a price equal to or greater than fair value at date of grant. Upon exercise, the excess of the proceeds over the par value of the shares issued is credited to additional paid-in capital. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Income Taxes The Company has provided deferred taxes for the difference in the tax and financial reporting bases of assets and liabilities in accordance with SFAS No. 109, "Accounting for Income Taxes." Investment and energy tax credits, when available, are accounted for under the flow-through method. Net Earnings Per Common Share For the three years ended December 31, 1993, net loss per common share was based upon the weighted average shares of common stock outstanding of 2,517,000, 2,826,000 and 8,383,000, respectively, as the inclusion of any common stock equivalents would be anti-dilutive. The weighted average shares of Common Stock are computed after giving effect to the approximate one-for-15 reverse split of the Common Stock effected by the Merger in December 1993 and described in Note 2. Fully diluted earnings per common share assume the conversion of convertible debt securities and common stock equivalents which would arise from the exercise of stock options, unless such items would be anti-dilutive. Therefore, primary and fully diluted earnings per share are the same for all periods presented. As of December 31, 1993, there were 25,689,147 shares of Common Stock outstanding. Basis of Presentation Certain reclassifications have been made in the consolidated financial statements for the years ended December 31, 1991 and 1992 to conform to the presentation used for the December 31, 1993 financial statements. (2) MERGER AND RECAPITALIZATION OF DEBT AND EQUITY In December 1992, the Company's then-existing debt and equity capitalization was restructured (the "1992 Restructuring") pursuant to a "prepackaged" plan of reorganization filed by the Company in connection with its October 1992 filing of a voluntary proceeding for reorganization under Chapter 11 of the United States Bankruptcy Code. The Company recognized a net gain on the 1992 Restructuring of $925,000. The Merger was consummated on December 14, 1993. Prior to the Merger, AGPC was an indirect-wholly owned subsidiary of Santa Fe Energy Resources, Inc. ("Santa Fe") and engaged, through its wholly-owned subsidiaries, in the gathering, processing, transmission and marketing of natural gas, with interests in 10 natural gas pipeline systems located in Texas, New Mexico, Oklahoma and Montana (of which six were operated by AGPC) and three natural gas processing plants (collectively, and including the various contracts associated with such facilities, the "AGPC Assets"). In addition to effecting the acquisition by the Company of AGPC, the Merger also effected a restructuring of the Company's debt and equity capitalization (including an approximate one-for-15 reverse split of the Company's common stock (the "Reverse Stock Split")). Prior to the Merger, AGPC entered into a gas contract (the "Gas Contract") with Santa Fe and Santa Fe Energy Operating Partners, L.P. ("SFEOP"). As a result of the Merger, the Company succeeded to the rights and obligations of AGPC under the Gas Contract. Following the Merger, the Company assigned such contract to Hadson Gas Systems, Inc., a wholly-owned subsidiary of the Company through which the majority of the Company's natural gas marketing operations are conducted. The Gas Contract has a term of approximately seven years and provides for the purchase by the Company of essentially all of Santa Fe's and SFEOP's existing domestic natural gas production as well as natural gas production that either Santa Fe or SFEOP has the right to market. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (2) MERGER AND RECAPITALIZATION OF DEBT AND EQUITY (Continued) Pursuant to the Merger, the Company issued to Santa Fe, in exchange for the stock of AGPC, 2,080,000 shares of Senior Cumulative Preferred Stock, Series A, ("Senior Preferred Stock") having an aggregate liquidation preference of $52 million and 10,395,665 shares of post reverse-split Common Stock representing approximately 40% of the total number of shares of Common Stock outstanding immediately after the Merger. The combination of AGPC and its subsidiaries and the Company has been accounted for using the purchase method of accounting. The value of the net assets acquired by the Company in the Merger was more readily determinable than the value of the total consideration issued by the Company and, therefore, net assets were used in determining the fair value of such consideration. The value of the AGPC Assets was determined primarily based on a multiple of expected cash flow from those assets. The value of the Gas Contract was determined by evaluating estimated savings in gas purchase costs over historical gas purchase costs expected to be afforded the Company over the term of the Gas Contract discounted to net present value at 12%. The value of the Senior Preferred Stock was determined based on the yield of the Senior Preferred Stock as compared to the yield of other securities deemed to be comparable. A summary of the purchase price and consideration follows: Components of the restructuring of the Company's debt and equity recapitalization which were effected by the Merger are described below. Transaction costs associated with the recapitalization were approximately $1.8 million. All of the shares of the Company's Class B Common Stock, Class C Common Stock, 7% Senior Cumulative Preferred Stock, Series A ("Old Senior Preferred Stock"), all of which were held by The Prudential Insurance Company of America and certain of its affiliates (collectively, "Prudential") and $23.4 million in 6.20% Senior Secured Notes Due 2000 ("Old Senior Secured Notes") due to Prudential were exchanged for or converted, pursuant to the Merger, into, in the aggregate, $56.4 million of 8% Senior Secured Notes due 2003 ("New Senior Secured Notes"), 1,309,762 shares of Common Stock, and the "P Interest" in a trust formed in connection with the Merger (the "H/P Trust") (see Note 6), which interest represented a beneficial trust interest in 4,983,180 shares of Common Stock which were deposited by the Company to the H/P Trust (the "Trust Shares") and could result in the payment to Prudential of an amount equal to the amount of all proceeds payable upon the exercise of New Junior Exercisable Automatically Convertible Preferred Stock, Series B ("New Junior Preferred Stock") (See Note 6). Such amount could total approximately $16 million. The shares of Common Stock issued to the H/P Trust are treated as outstanding by the Company. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (2) MERGER AND RECAPITALIZATION OF DEBT AND EQUITY (Continued) The 3,796,814 shares of 8% Junior Cumulative Convertible Preferred Stock, Series B ("Old Junior Preferred Stock") outstanding at the time of the Merger were converted into 5,723,052 shares of Common Stock and 4,163,852 shares of New Junior Preferred Stock. To effect the Reverse Stock Split, the 49,159,867 shares of common stock outstanding at the time of the Merger were converted into 3,277,488 shares of Common Stock and 819,328 shares of New Junior Preferred Stock. The following represents the unaudited pro forma results of operations as if the 1992 Restructuring, the sale of the common stock of Hadson Energy Resources Corporation ("HERC") (see Note 4), the Merger and the recapitalization of debt and equity had occurred on January 1, 1992: The pro forma financial information does not purport to be indicative of the results of operations that would have occurred had the transactions taken place at the beginning of the periods presented or of future results of operations. (3) DISCONTINUED OPERATIONS The power systems group ("Power Systems"), excluding certain assets, was sold in December 1991 for proceeds of $50.5 million which resulted in a gain of $4.9 million. The proceeds from the transaction were subject to certain adjustments and had additional amounts payable under certain circumstances. The adjustments to proceeds included a purchase price adjustment, the amount of which was the subject of a dispute between the Company and the purchaser. Of the $50.5 million purchase price, the purchaser retained $2.5 million as a "holdback" to secure certain of the Company's indemnification obligations related to the sale. In 1992, the Company and the purchaser reached agreement regarding the settlement of certain matters relating to this sale, including the purchase price adjustment, certain indemnity claims and the manner and time period for resolving other indemnity claims. Pursuant to such settlement agreement, the purchaser paid the Company $0.4 million and continues to hold $2.2 million as security for certain indemnity claims that may arise. The purchaser has also agreed that other indemnity claims against the Company cannot exceed $0.5 million. If, however, within the time limits set forth in the settlement agreement, the claims are less than the $2.2 million held by the purchaser, then the balance of the holdback will be returned to the Company. In connection with the settlement agreement, the Company charged $4.2 million to loss on discontinued operations in 1992, as the Company believes that it is unlikely to receive any significant additional amounts. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (3) DISCONTINUED OPERATIONS (Continued) The assets of Power Systems retained by the Company after the 1991 sale related to subsidiaries of the Company having investments in joint ventures which own six cogeneration projects and one waste wood processing facility. In 1992, the Company disposed of four of its subsidiaries having investments in cogeneration projects and the one having the investment in the waste-wood processing facility. The Company recognized a loss of $3.9 million in connection with these dispositions. In September 1993, the Company reached a settlement with the United States Army regarding various claims relating to a contract between a defense subsidiary of the Company and the Army. As a part of this settlement, the Army released to the Company amounts due to the subsidiary pursuant to certain other government contracts which totalled approximately $1.8 million and made a cash payment to the Company of $7 million. After payment of litigation costs of approximately $1.7 million, the net cash proceeds to the Company from this settlement were approximately $7.1 million. Of the proceeds, $1.5 million was applied as a principal prepayment of the New Senior Secured Notes issued pursuant to the Merger and the rest was retained by the Company to pay transaction costs related to the Merger and related transactions and for general corporate purposes. The accompanying consolidated statement of operations for the year ended December 31, 1993 reflects a gain of $5.6 million related to the settlement. Power Systems and the Defense Systems Group have been accounted for as discontinued operations in the accompanying consolidated financial statements. Their operating results are reported in this manner for all years presented in the accompanying consolidated statements of operations and other related income data. Net sales for these groups totalled $119,312,000, $-0- and $-0- for the years ending December 31, 1991, 1992 and 1993, respectively. (4) SALE OF ASSETS In July 1993, the Company completed the sale of its approximately 49% interest in the outstanding common stock of HERC. The equity method was utilized in accounting for the investment. Total proceeds from the sale of $45 million were applied as follows: (i) $33.0 million principal prepayment of the Company's Old Senior Secured Notes, (ii) approximately $1.3 million to pay accrued interest on the Old Senior Secured Notes and fees due Prudential, (iii) approximately $2.2 million in repayment of all borrowings and accrued interest under an interim financing facility with Prudential described in Note 5, (iv) $1.0 million in repayment of the New Senior Secured Notes and (v) the remainder was retained by the Company for costs and expenses related to the sale and other corporate purposes. A gain of approximately $6.4 million was recognized on the sale. In February of 1994, the Company assigned a 30% interest in a gathering system and processing plant to a joint owner in return for (i) the dedication of additional production to the system, (ii) the assignment of a gathering system in New Mexico along with its dedicated production, and (iii) $2.5 million in cash. Due to the recent valuation of the gathering system and processing plant in the Merger, no gain or loss was recognized on the sale. The accompanying consolidated balance sheet includes $2.5 million in current assets related to the assets which were sold. In December 1991, the Company completed the sale of certain Oklahoma and Texas gathering systems and processing facilities which had been held through joint ventures for which the Company was managing partner. The sale proceeds totalled $2,890,000, which resulted in a gain to the Company of $703,000. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (5) LONG-TERM DEBT AND NOTE PAYABLE Long-term debt consists of the following: (A) In December 1993, in connection with the debt and equity recapitalization effected by the Merger, the Company entered into a Securities Purchase Agreement (the "Securities Purchase Agreement") with Prudential. See Note 2. The agreement provided that all outstanding Old Senior Secured Notes be cancelled. Pursuant to the Securities Purchase Agreement, the Company issued $56.4 million of New Senior Secured Notes. Upon completion of the Merger, the Company paid $2.5 million to Prudential in partial repayment of the notes. The New Senior Secured Notes bear interest at the rate of 8.0% per annum and mature on December 31, 2003. Such notes are prepayable in whole or in part (in minimum increments of $500,000) without premium or penalty. Remaining required principal prepayments are as follows: (i) $1.0 million by August 1, 1994, (ii) an additional $2.5 million by December 31, 1996, (iii) an additional $5.9 million by December 31, 1997 and (iv) an additional $8 million by December 31 of each year thereafter through 2002 with a final payment of $4.5 million due by December 31, 2003. The Company is also required to prepay the New Senior Secured Notes in an amount equal to proceeds of asset sales over certain amounts. The New Senior Secured Notes are secured by the first priority lien on all the stock of certain of the Company's subsidiaries, on the accounts receivable and other personal property of the Company (but not of its operating subsidiaries), which lien has been granted to a collateral agent for the benefit of Prudential and Bank of Montreal ("BMO"), as more fully discussed below. The Securities Purchase Agreement restricts the payment of dividends, including the payment of dividends on the Senior Preferred Stock (other than those dividends payable in additional shares of Senior Preferred Stock). In addition, the outstanding principal balance of the New Senior Secured Notes must be reduced to certain specified levels before any cash dividends may be paid on the Senior Preferred Stock. See Note 6. Other provisions of the Securities Purchase Agreement include restrictions on the incurrence of additional debt, the creation of liens, investments, issuance of capital stock by subsidiaries and dispositions of assets and subsidiaries. Because the New Senior Secured Notes were issued late in 1993 and were priced to approximate a market yield for similar securities, the carrying value of the New Senior Secured Notes approximates fair value. (B) Upon consummation of the Merger, the Company entered into a new credit agreement with BMO ("BMO Credit Agreement") which replaced its existing credit agreement with BMO. The Company and certain of its marketing subsidiaries are obligors under the BMO Credit Agreement. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (5) LONG-TERM DEBT AND NOTE PAYABLE (Continued) The BMO Credit Agreement provides for aggregate borrowings of up to $10 million and the issuance of letters of credit of up to $50 million (less the amount of any outstanding borrowings) primarily to support trade obligations, all on a revolving basis and subject to availability under a "borrowing base." Upon the syndication of a portion of the facility to one or more additional banks, the limit of the facility may be increased to $60 million, subject to the borrowing base. Under the facility, the borrowing base at any time will be equal to the sum of approximately 80% of the aggregate dollar amount of eligible accounts receivable of certain of the Company's subsidiaries in which BMO has a security interest plus the full amount of the Company's cash and certain short-term investments in which BMO has a security interest. Borrowings outstanding under the BMO Credit Agreement bear interest, payable quarterly, at the base rate announced from time to time by BMO plus 1% per annum. In addition, the Company is required to pay a letter of credit fee of 1-7/8% per annum, payable quarterly, on the amount of any outstanding letters of credit, a commitment fee of 0.5% per annum, payable quarterly, on the unused portion of the facility and a facility fee of .125% per annum, payable quarterly, on the maximum amount of the facility. In addition, during each of the four quarters of 1994, the Company is required to reduce the outstanding amount of borrowings under the facility to no more than $5 million and, during each fiscal quarter thereafter, the Company is required to reduce such borrowings to zero, in each case for not less than 10 consecutive business days. Amounts outstanding under the facility will be due and payable upon the termination of the facility on December 14, 1995, provided that the facility may be extended for an additional year by the mutual consent of the Company and all of the Banks then parties to such facility, subject to the payment of a fee and certain customary conditions. During 1993, the average amount of borrowings outstanding under the BMO Credit Agreement and the credit agreement with BMO which it replaced was $3,176,000. At December 31, 1993, letters of credit amounting to $29,636,000 were outstanding under the BMO Credit Agreement. Of this amount, $24,679,000 relates to standby letters of credit which support trade accounts payable included in the accompanying current year consolidated balance sheet. The Company's obligations under the BMO Credit Agreement are secured by a first priority lien, granted in favor of a collateral agent for the benefit of BMO and Prudential, on the outstanding capital stock of certain of the Company's subsidiaries, on the accounts receivable and other personal property of the Company and on certain other miscellaneous collateral, and by a first priority lien granted in favor of BMO on the accounts receivable and other personal property of the Company's subsidiaries that are obligors under the BMO Credit Agreement. Pursuant to certain intercreditor arrangements entered into by BMO and Prudential, the proceeds of any sale by the collateral agent, following an event of default, of any collateral that is subject to such intercreditor arrangements will be applied first to the payment of amounts due under the BMO Credit Agreement and second to payment of the New Senior Secured Notes. Debt issuance costs are included in current assets on the accompanying consolidated balance sheet and are amortized on a straight-line basis over the term of the BMO Credit Agreement. The BMO Credit Agreement contains restrictions on, among other things, the incurrence of additional debt, payments of dividends, investments, issuance of capital stock by subsidiaries and dispositions of assets and subsidiaries. In addition, it calls for the Company to maintain minimum levels of working capital, liquidity and net worth. Because the credit facility is priced at an interest rate that floats along with a market rate, the carrying amount approximates fair value. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (5) LONG-TERM DEBT AND NOTE PAYABLE (Continued) As of December 31, 1993, annual maturities of long-term debt for each of the next five years are as follows: Note Payable In order to fund the costs of effecting the 1992 Restructuring, Prudential had made advances to the Company through three separate facilities. In December 1992, the Company entered into the third of the facilities, (the "Credit Agreement") which provided for maximum advances of $2.2 million. In January 1993, there was $2.2 million outstanding under the Credit Agreement. In June 1993, the Company paid all interest and principal due pursuant to the Credit Agreement with proceeds from sale of its investment in HERC and the Credit Agreement was cancelled. See Note 4. (6) CAPITAL STOCK Senior Cumulative Preferred Stock, Series A ("Senior Preferred Stock") The 2,080,000 shares of Senior Preferred Stock outstanding on December 31, 1993 were issued to Santa Fe pursuant to the Merger. The shares have a par value of $.01, have an aggregate liquidation preference of $52 million, or $25 per share, and are senior in liquidation preference to all other classes of equity securities of the Company. Dividends accumulate at a rate of 11.25% per annum of the liquidation preference ($2.81 per share per year) from December 14, 1993 through December 31, 1995 and 10.70% per annum ($2.67 per share per year) commencing January 1, 1996. Dividends are cumulative and are payable quarterly in arrears. Through December 31, 1995, dividends are payable only in shares of Senior Preferred Stock having a liquidation preference equal to the dividend payable. Beginning January 1, 1996, dividends are payable only in cash. Beginning January 1, 1999, the Senior Preferred Stock is redeemable for cash at the option of the Company, in whole or in part, at per share redemption prices which begin at $26.25 for 1999 and decrease to $25.00 for 2004 and thereafter. The Securities Purchase Agreement and the BMO Credit Agreement limit such redemption. Holders of Senior Preferred Stock have class voting rights in connection with certain fundamental corporate transactions, including amendments to the Company's certificate of incorporation which would alter or change the powers, preferences or special rights of such stock so as to affect them adversely, certain mergers and consolidations involving the Company which may have a material adverse effect on such powers, preferences or special rights and the creation of senior or pari passu securities. In addition, if at any time regular dividends are in an amount equal to six full quarterly regular dividend payments in arrears and unpaid, then until all such regular dividend payments shall be paid in full, the holders of the Senior Preferred Stock, voting separately as a class, will be entitled to elect two directors of the Company. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (6) CAPITAL STOCK (Continued) Junior Exercisable Automatically Convertible Preferred Stock, Series B ("New Junior Preferred Stock") The 4,983,180 shares of New Junior Preferred Stock outstanding at December 31, 1993 were issued in December 1993, through the Merger, to the holders of the 8% Junior Preferred Stock and the holders of the common stock pursuant to the conversion of such stock in the Merger. Each share of New Junior Preferred Stock has a par value of $.01 and a liquidation preference of $.75. No dividends are payable on the New Junior Preferred Stock. Each share of New Junior Preferred Stock entitles the holder to purchase one share of Common Stock (an aggregate of 4,983,180 shares) upon surrender of such share of New Junior Preferred Stock and payment of the exercise price of $3.225 per share of Common Stock (in each case subject to adjustment under certain circumstances) until the date of automatic conversion described below. Pursuant to the trust agreement governing the H/P Trust, the Company is required to deposit all proceeds from such exercise to the H/P Trust as described below. The H/P Trust was established by the Company in connection with the Merger. As a result of the Merger, Prudential received the "P Interest" in the H/P Trust, which initially represented beneficial ownership of all of the Trust Shares. As holders of New Junior Preferred Stock exercise their right to purchase shares of Common Stock, the Company will periodically deposit to the H/P Trust all proceeds of such exercises. At the end of each calendar quarter and upon termination of the H/P Trust, if the dollar amount of exercise proceeds held in the H/P Trust has reached certain levels, the trustee will pay such proceeds to Prudential and will distribute a corresponding number of Trust Shares to the Company. Upon termination of the H/P Trust, all remaining Trust Shares, if any, will be distributed to Prudential. Each outstanding share of New Junior Preferred Stock will automatically convert into .001 of a share of Common Stock on the earlier of (i) the date that is 30 days after the first date (the "Trigger Date") on which the closing price per share of the Common Stock on each of the immediately preceding 40 consecutive trading days shall have exceeded 200% of the exercise price of the New Junior Preferred Stock in effect on such trading day (the Company will be required to mail a notice of such automatic conversion to each holder of shares of New Junior Preferred Stock within 10 days following the Trigger Date) and (ii) December 14, 1995. (7) INCOME TAXES The significant components of income tax (benefit) are as follows: HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (7) INCOME TAXES (Continued) Reconciliations from the expected statutory income tax (benefit) to the income tax (benefit) are as follows: Temporary differences between the financial statement carrying amounts and the tax bases of assets and liabilities that give rise to significant portions of the deferred tax liabilities at December 31, 1991, 1992 and 1993 relate to the following: HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (7) INCOME TAXES (Continued) The net change in the valuation allowance for deferred tax assets was an increase of $528,000 in 1991; a decrease of $8,561,000 in 1992; and a decrease of $18,982,000 in 1993. The increase in 1991 was primarily attributable to the provision of valuation allowance on the net increase in loss carryovers. The decrease in 1992 was primarily attributable to the anticipated $28,479,000 reduction of the net operating loss which would have been required had the Company made a certain election under the Internal Revenue Code of 1986, as amended. The net decrease in 1993 was primarily attributable to additional expected utilization of net operating loss carryovers against the future realization of the taxable temporary differences created as a result of the Merger. At December 31, 1993, the Company has carryovers of tax benefits as follows: The capital loss carryover expires in 1994. The depletion carryover is not subject to expiration. All other carryovers principally expire between 1998 and 2008. All of the carryovers of tax benefits generated prior to the December 16, 1992 effective date of the Company's plan of reorganization under Chapter 11 of the Bankruptcy Code (see Note 2) are, due to the greater than 50% change of ownership effected by such plan, subject to an annual limitation of $4,510,000 under sections 382 and 383 of the Code. Such annual limitation may be increased by any realized built-in gains and unused annual limitation from a prior year. Accordingly, the portion of the carryovers above not limited under section 382 consist of the $10,143,000 of regular net operating loss and $9,650,000 of alternative minimum tax net operating loss generated during the period from December 17, 1992 to December 31, 1993. During the first quarter of 1991, the Company received a refund of taxes previously paid of $324,000 and interest amounting to $1,776,000 related to the settlement of an audit of previous years' federal income tax returns by the Internal Revenue Service. (8) EMPLOYEE BENEFIT PLANS Effective January 1, 1992, the Hadson Employee Stock Ownership/401(k) Savings Plan (the "Old Employee Plan"), which was organized into two parts, the Profit Sharing Portion and the ESOP Portion, was amended and restated as the Hadson Corporation Employee 401(k) Savings Plan (the "Employee Plan"). Under the Employee Plan, the ESOP Portion of the Old Employee Plan was eliminated. Additionally, the Employee Plan provides for the Company matching of a participant's compensation, as defined, from 3% to 8% based upon length of service. Employees vest immediately in their contribution. The Company's contribution vests over a four-year period of HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (8) EMPLOYEE BENEFIT PLANS (Continued) service. The Company's contribution to the Employee Plan for each of the years ended December 31, 1992 and 1993 was $347,000 and $351,000, respectively. The Company's contribution to the Old Employee Plan was $1,893,000 for the year ended December 31, 1991. The Company also has various incentive compensation plans for officers and employees. Amounts available for incentive compensation are based on various financial and operational results. For each of the years ended December 31, 1991, 1992 and 1993, such incentive compensation amounted to $243,000, $121,000 and $62,000, respectively. In connection with the 1992 Restructuring, all existing stock options and warrants were cancelled and the Company implemented a new Stock Option Plan (the "Stock Plan") for the benefit of employees and non-employee directors. The maximum number of shares of Common Stock issuable under the Stock Plan was 300,000 at December 31, 1992 and 633,365 at December 31, 1993. The exercise price of options granted under the Stock Plan, other than incentive stock options, must be equal to the market value of the Common Stock at the date of grant. Options are exercisable in whole or in part over a 10-year period from the date of grant. Information as to common shares subject to options is as follows: (9) RELATED PARTY TRANSACTIONS Certain officers and directors are shareholders, partners or principals of companies or firms which have provided various services to the Company and its subsidiaries. Aggregate billings to the Company, a portion of which were billed to other parties, approximated $54,000, $22,000 and $-0-, respectively, for each of the years ended December 31, 1991, 1992 and 1993. HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (10) COMMITMENTS AND CONTINGENCIES The Company leases equipment and office facilities under non-cancellable operating leases which expire from 1993 through 2004. The leases require annual rentals of the following: (In Thousands) 1994 $ 2,600 1995 1,837 1996 1,384 1997 922 1998 699 Thereafter 3,376 ------- $10,818 ======= Rent expense for each of the years ended December 31, 1991, 1992 and 1993 was $6,877,000, $2,157,000 and $2,611,000, respectively. A wholly-owned subsidiary of the Company is a defendant, along with several co-defendants, in a lawsuit involving an explosion of propane which resulted in the death of one individual and severe injury to another. The plaintiffs have requested an as yet unspecified amount of damages and punitive damages against the defendants. The subsidiary's ultimate proportionate share of any settlement or judgment cannot be determined at this time. The Company has primary insurance coverage for losses of this type up to $1 million. The availability of insurance coverage for any amounts in excess of this amount, however, is uncertain at this time due to questions regarding the applicability of various other insurance coverages. The Company has established provisions in the accompanying financial statements for any liability which can be reasonably estimated and for which it is probable that the subsidiary will be held ultimately liable. The Company is subject to other various legal proceedings and claims which arise in the normal course of business. In the opinion of management, based in part on consultation with counsel, the amount of ultimate liability with respect to those actions will not materially affect the Company's financial position. (11) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Quarterly results of operations for the years ended December 31, 1992 and 1993 are as follows: HADSON CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (11) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (Continued) Schedule V HADSON CORPORATION AND SUBSIDIARIES CONSOLIDATED PROPERTY AND EQUIPMENT Three Years Ended December 31, 1993 (In Thousands) (a) Includes reclassification of property and equipment to current assets of $2,832. Schedule VI HADSON CORPORATION AND SUBSIDIARIES CONSOLIDATED ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY AND EQUIPMENT Three Years Ended December 31, 1993 (In Thousands) Schedule VIII HADSON CORPORATION AND SUBSIDIARIES CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS Three Years Ended December 31, 1993 (In Thousands) (a) Adjustment of reserve to required level.

814677_1993.txt

814677_1993

1993

814677

ITEM 1. BUSINESS. A. Introduction (i) Background. PLM International, Inc. ("PLM International" or the "Company" or "PLMI"), a Delaware corporation, is a transportation equipment leasing company specializing in the management of equipment on operating leases domestically and internationally. The Company is also the leading sponsor of syndicated investment programs organized to invest primarily in transportation equipment. The Company operates and manages approximately $1.4 billion of transportation equipment and related assets for its account and various investment partnerships and third party accounts. An organization chart for PLM International indicating the relationships of active legal entities is shown in Table I: TABLE 1 ORGANIZATION CHART PLM International, Inc., a Delaware corporation, the parent corporation. Subsidiaries of PLM International, Inc.: PLM Financial Services, Inc., a Delaware corporation; PLM Railcar Management Services, Inc., a Delaware corporation; and Transportation Equipment Indemnity Company, Ltd., a Bermuda corporation. Subsidiaries of PLM Financial Services, Inc.: PLM Investment Management, Inc., a California corporation; PLM Transportation Equipment Corporation, a California corporation; PLM Securities Corp., a California corporation. A Subsidiary of PLM Transportation Equipment Corporation is PLM Rental, Inc., a Delaware corporation. A Subsidiary of PLM Railcar Management Services, Inc. is PLM Railcar Management Services Canada, Ltd., an Alberta corporation. Note: All entities are 100% owned PAGE (ii) Description of Business PLM International owns and manages a portfolio of transportation equipment consisting of approximately 50,000 individual items with an original cost of approximately $1.4 billion (shown in Table 2). The Company manages equipment and related assets for approximately 71,000 investors in various limited partnerships or investment programs. (iii) Equipment Owned. The Company leases its own equipment to a wide variety of lessees. In general, the equipment leasing industry is an alternative to direct equipment ownership. It is a highly competitive industry that offers varying lease terms that range from day-to-day to a term equal to the economic life of the equipment ("Full Payout"). Generally, leases that are for a term less than the economic life of the equipment are known as operating leases because the aggregate lease rentals accruing over the initial lease period are less than the cost of the leased equipment. PLM International's focus is on providing equipment under operating leases. This type of lease generally commands a higher lease rate for the equipment than Full Payout leases. This emphasis on operating leases requires highly experienced management and support staff, as the equipment must be periodically re-leased to continue generating rental income, and thus, to maximize the long-term return on investment in the equipment. In appropriate circumstances, certain equipment, mainly marine containers, is leased to utilization-type pools which pools include equipment owned by unaffiliated parties. In such instances, revenues received by the Company consist of a specified percentage of the pro-rata share of lease revenues generated by the pool operator from leasing the pooled equipment to its customers, after deducting certain direct operating expenses of the pooled equipment. With respect to trailer leasing activities, the Company has refocused its direction by marketing over-the-road trailers through its subsidiary PLM Rental, Inc. ("PLM Rental") on short-term leases through rental yards located in ten major U.S. cities. In addition, the Company markets its intermodal trailers on short-term arrangements through a licensing agreement with a short line railroad. In 1991, the Company expanded its short-term trailer rental operations by purchasing seven existing rental yards, transferring portions of its existing fleet to rental yard operations and purchasing additional trailers at attractive prices. In addition, the Company markets on-site storage units protected by a patented security system through both existing facilities and PLM Rental's facilities. Over the past five years, approximately 95% of all equipment (owned and managed) on average, was on lease. (See Table 3.) Set forth below in Table 3 are details of the development of the Company's managed equipment portfolio and off-lease performance over the past five years. (iv) Subsidiary Business Segments: (A) PLM Financial Services, Inc. The Company's financial services activities, as conducted by PLM Financial Services, Inc. ("FSI") along with its primary subsidiaries: PLM Transportation Equipment Corporation ("TEC"); PLM Securities Corp. ("PLM Securities"); and PLM Investment Management, Inc. ("IMI"), center on the development, syndication and management of investment programs, principally limited partnerships, which acquire and lease transportation equipment. Depending on the objectives of the particular program, the programs feature various combinations of current cash flow and income tax benefits through investments in long-lived, low obsolescence transportation and related equipment. Programs sponsored by FSI are offered nationwide through a network of unaffiliated national and regional broker-dealers and financial planning firms. FSI has completed the offering of fourteen public programs which have invested in diversified portfolios of transportation and related equipment. In 1986, FSI introduced the PLM Equipment Growth Fund ("EGFs") investment series. The EGFs are limited partnerships designed to invest primarily in used transportation equipment for lease in order to generate current operating cash flow for (i) distribution to investors and (ii) reinvestment into additional used transportation equipment. An objective of the EGFs is to maximize the value in the equipment portfolio and provide cash distributions to investors by acquiring and selling items of equipment at times when prices are most advantageous to the investor. The cumulative equity raised by PLM International for its affiliated investment limited partnerships now stands at $1.5 billion. The Company has raised more syndicated equity for equipment leasing programs than any other syndicator in United States history. Annually, since 1983, PLM International has been one of the top three equipment leasing syndicators in the United States. Annually, from 1990 through 1993, the Company has ranked as the number one diversified transportation equipment leasing syndicator in the United States. PLMI's market share for all syndicated equipment leasing programs rose to 22% in 1993 from 18% in 1992. In 1993 the Company was the number one overall equipment leasing syndicator. Since 1983, the Company is the only syndicator of equipment leasing programs to raise on average over $100,000,000 annually. EGFI, EGFII and EGFIII are listed for trading on the American Stock Exchange. Changes in the federal tax laws which could cause a partnership such as an EGF to be taxed as a corporation rather than treated as a nontaxable entity in the event its partnership interests become publicly traded prompted management of PLM International to structure EGF IV, EGF V, EGF VI and EGF VII so that they will not be publicly traded. These tax law changes do not currently apply to EGF I, EGF II or EGF III. In general, investment programs that acquire assets on an all-cash basis with the primary goal of maximizing cash flow for distribution to investors are known as income funds. The EGFs, as growth funds, may, if it is deemed advantageous to the overall program, obtain limited leverage and typically reinvest a portion of their current cash flow to acquire additional equipment to grow the equipment [FN] The Stanger Review, Partnership Sales Summary portfolio. Each of EGF I, EGF II, EGF III, EGF IV, EGF V and EGF VI have entered into long-term debt agreements with independent banks and financial institutions permitting each partnership to borrow an amount equal to approximately 20% of the original cost of equipment in the respective EGF's portfolio. The loans are non- recourse except to the assets of the respective partnerships. FSI's revenues are derived from services performed in connection with the organization, marketing and management of its investor programs. These services include acquiring and leasing equipment and a variety of management services for which the following fees are received: (1) placement fees earned from the sale of equity in the investment programs; (2) acquisition and lease negotiation fees earned for arranging delivery of equipment and the negotiation of initial use of equipment; (3) debt placement fees, as applicable, earned at the time loans (other than loans associated with the refinancing of existing indebtedness) are funded; (4) management fees earned on revenues or cash flows generated from equipment portfolios; and (5) commissions and subordinated incentive fees earned upon sale of the equipment during the liquidation stage of the program. FSI serves as the general partner for most of the partnerships offered by PLM Securities Corp. As general partner, FSI retains a 1% to 5% equity interest. FSI recognizes as other income its equity interest in the earnings or cash distributions of partnerships for which it serves as general partner. (B) PLM Transportation Equipment Corporation PLM Transportation Equipment Corporation ("TEC") is responsible for selection of equipment; negotiation and purchase of equipment; initial use and re-lease of equipment; and financing of equipment. This process includes identification of prospective lessees, analyses of lessees' credit worthiness, negotiation of lease terms, negotiations with equipment owners, manufacturers or dealers for the purchase, delivery and inspection of equipment, preparation of debt offering materials and negotiation of loans. TEC purchases transportation equipment for PLM International's own portfolio and on an interim basis for resale to various affiliated limited partnerships at cost, or to third parties. (C) PLM Securities Corp. PLM Securities Corp. ("PLM Securities") markets the investment programs through unaffiliated broker/dealers and financial planning firms throughout the United States. Sales of investment programs are not made directly to the public by PLM Securities. During 1993, approximately 200 selected broker/dealer firms with over 20,000 agents sold investment units in EGFVI and EGFVII. During 1993, Wheat First Butcher Singer and Equico Securities, Inc. accounted for approximately 16% and 12%, respectively, of the equity sales. In 1992, Equico Securities, Inc. and J.C. Bradford and Co. sold approximately 18% and 13%, respectively, of the limited partnership units offered by PLM Securities. Approximately 17.0% of the investment program units sold in 1991 were placed by Equico Securities, Inc. No other selected agent has accounted for the sale of more than 10% of the investment programs during these periods. The marketing of the investment programs is supported by PLM Securities representatives who deal directly with account executives of participating broker/dealers. PLM Securities earns a placement fee for the sale of the aforementioned investment units of which a significant portion is reallowed to the originating broker/dealer. Placement fees may vary from program to program, but in the EGF VII program, PLM Securities receives a fee of up to 9% of the capital contributions to the partnership, of which commissions of up to 8% are reallowed to the unaffiliated selling entity with the difference being retained by PLM Securities. For the year ended December 31, 1993, the Company raised investor equity totalling approximately $92,500,000 for its EGF VI and EGF VII programs. FSI continues to sponsor syndicated investor offerings involving diversified equipment types. (D) PLM Investment Management, Inc. PLM Investment Management, Inc. ("IMI") manages equipment owned by the Company and by investors in the various investment programs. The equipment consists of the following: aircraft (commercial, commuter, corporate and emergency medical services); aircraft engines; railcars and locomotives; tractors (highway); trailers (highway and intermodal, refrigerated and non- refrigerated); marine containers (refrigerated and non-refrigerated), marine vessels (dry bulk carriers and product tankers) and mobile off-shore drilling units ("MODUs"). IMI is obligated to invoice and collect rents, arrange for maintenance and repair of the equipment, pay operating expenses, debt service and certain taxes, determine that the equipment is used in accordance with all operative contractual arrangements, arrange insurance, correspond with program investors, provide or arrange clerical and administrative services necessary to the operation of the equipment, prepare financial statements and tax information materials and make distributions to investors. IMI also monitors equipment regulatory requirements and application of investor program debt covenants. (E) PLM Railcar Management Services, Inc. PLM Railcar Management Services, Inc. ("RMSI") markets and manages railcar fleets which are owned by the Company and the various investment programs. RMSI is also involved in negotiating the purchase and sale of railcars. Much of the historical responsibilities of RMSI are now being conducted by TEC. PLM Railcar Management Services Canada Limited, a wholly-owned subsidiary of RMSI and headquartered in Calgary, Alberta, Canada, provides fleet management services to the owned and managed railcars operating in Canada. (F) Transportation Equipment Indemnity Company Ltd. Transportation Equipment Indemnity Company Ltd. ("TEI") is a Bermuda-based insurance company licensed to underwrite a full range of insurance products including property and casualty risk. TEI's primary objective is to minimize the long term cost of insurance coverages for all owned and managed equipment. A substantial portion of the risks underwritten by TEI are reinsured with unaffiliated underwriters. (G) PLM Rental, Inc. PLM Rental markets trailers and storage units owned by the Company and its affiliated investor programs on short term leases through a network of rental facilities. Presently, facilities are located in Atlanta, Chicago, Dallas, Detroit, Indianapolis, Kansas City, Miami, Newark, Orlando and Tampa. All subsidiaries are 100% owned directly or indirectly by PLM International. (v) Equipment Leasing Markets Within the equipment leasing industry, there are essentially three leasing markets: the Full Payout lease, short-term rentals and the mid-term operating lease. The Full Payout lease, in which the combined rental payments are sufficient to cover the lessor's investment and to provide a return on the investment, is the most common form of leasing. This type of lease is sometimes referred to as a finance lease. Under United States generally accepted accounting principles a finance lease is accounted for as a purchase of the underlying asset. From the lessee's perspective, the election to enter into a Full Payout lease is usually made on the basis of a lease versus purchase analysis which will take into account the lessee's ability to utilize the depreciation tax benefits of ownership, its liquidity and cost of capital, and financial reporting considerations. Short-term rental lessors direct their services to a user's short-term equipment needs. This business requires a more extensive overhead commitment in the form of marketing and operating personnel by the lessor/owner. There is normally less than full utilization in the lessor's equipment fleet as lessee turnover is frequent. Lessors usually charge a premium for the additional flexibility provided through short-term rentals. To satisfy lessee short-term needs, certain equipment is leased through pooling arrangements or utilization leases. For lessees these arrangements can work effectively with respect to interchangeable equipment such as marine containers, trailers and marine vessels. From the lessor's perspective these arrangements diversify risk. Operating leases for transportation equipment generally run for a period of one to six years. Operating lease rates are usually higher than Full Payout lease rates, but lower than short-term rental rates. From a lessee's perspective, the advantages of a mid-term operating lease compared to a Full Payout lease are flexibility in its equipment commitment and the fact that the rental obligation under the lease need not be capitalized on its balance sheet. The advantage from the lessee's perspective of a mid-term operating lease compared to a short-term rental, apart from the lower monthly cost, is greater control over future costs and the ability to balance equipment requirements over a specific period of time. Disadvantages of the mid-term operating lease from the lessee's perspective are that the equipment may be subject to significant changes in lease rates for future periods or may even be required to be returned to the lessor at the expiration of the initial lease. A disadvantage from the lessor's perspective of the mid-term operating lease (as well as the short-term rental) compared to the Full Payout lease is that the equipment generally must be re-leased at the expiration of the initial lease term in order for the lessor to recover its investment. PLM International, its subsidiaries and affiliated investment programs lease their equipment primarily on mid-term operating leases and short-term rentals. Many of its leases are "net" operating leases. In a net operating lease, expenses such as insurance and maintenance are the responsibility of the lessee. The effect of entering into net operating leases is to reduce the lease rates as compared to non-net lease rates for comparable lease terms. However, the overall profitability of net operating leases is more predictable and less risk is assumed over time as the lessees absorb maintenance costs that generally increase as equipment ages. Per diem rental agreements are used mainly on equipment in the Company's trailer, marine container, and storage unit rental operations. Per diem rentals for the most part require the Company to absorb maintenance costs which again tend to increase as the equipment ages. (vi) Management Programs FSI also has sponsored programs in which the equipment is individually owned by the program investors. Management agreements, with initial terms ranging from 3 to 10 years, are typically employed to provide for the management of this equipment. These agreements require that the Company or one of its subsidiaries use its best efforts to lease the equipment, and to otherwise perform all managerial functions necessary for the operation of the equipment, including arranging for maintenance and repair, collection of lease revenues and disbursement of operating expenses. Management agreements also require that the Company correspond with program investors, prepare financial statements and tax information materials and make distributions to investors. Operating revenues and expense for equipment under management agreements are generally pooled in each program and shared prorata by the participants. Management fees are received by IMI for these services based on a flat fee per unit of equipment per month. (vii) Lessees Lessees of equipment range from Fortune 500 companies to small, privately-held corporations and entities. All (i) equipment acquisitions, (ii) equipment sales, and (iii) lease renewals relating to equipment having an original cost basis in excess of $1 million must be approved by a credit committee consisting of senior executives of PLM International. PLM Rental, which leases equipment primarily on short-term rentals, follows guidelines set by the credit committee in determining the credit worthiness of its respective lessees. Deposits, prepaid rents, corporate and personal guarantees and letters of credit are utilized, when necessary, to provide credit support for lessees which alone do not have a financial condition satisfactory to the credit committee. No single lessee of the Company's equipment accounted for more than 10% of revenues for the year ended December 31, 1993. (viii) Competition In the distribution of investment programs, FSI competes with numerous organizations engaged in limited partnership syndications. While management of the Company does not believe that any sponsor dominates the offering of similar investment programs, there are other sponsors of such programs which may have greater assets and financial resources or may have the ability to borrow on more favorable terms, or may have other significant competitive advantages. The principal competitive factors in the organization and distribution of investment programs are: the ability to reach investors through an experienced marketing force, the performance of prior investment programs, the particular terms of the investment program, and the development of a client base which is willing to consider periodic investments in such programs. Competition for investors' funds also exists with other financial instruments and intermediaries such as: certificates of deposits, money market funds, stocks, bonds, mutual funds, investment trusts, real estate, brokerage houses, banks and insurance companies. FSI believes that the structure of its current partnership programs permits it to compete with other equipment leasing programs as well as with oil and gas and real estate programs. FSI's investment programs compete directly with numerous other entities for equipment acquisition and leasing opportunities and for debt financing. The $93,100,000 invested in the Company's public-sponsored partnerships in 1991 ranked it the number one syndicator of transportation equipment leasing programs in 1991. In 1992, the $111,100,000 invested in EGF VI ranked the Company as the number two syndicator of transportation equipment leasing programs. The $92,500,000 invested in the Company's public- sponsored equity programs in 1993 ranked PLM Securities the number one syndicator of equipment leasing programs for the year. Since 1983, the Company is the only syndicator of transportation equipment programs to raise on average more than $100,000,000 annually. In connection with operating leases, the Company encounters considerable competition from lessors offering Full Payout leases on new equipment. In comparing lease terms for the same equipment, Full Payout leases provide longer lease periods and lower monthly rent than the Company offers. However, lower lease rates can generally be offered for used equipment under operating leases than can be offered on similar new equipment under a Full Payout lease. For the most part, long lived, low-obsolescence equipment such as used transportation equipment can be utilized by a lessee to the same extent as new equipment. The shorter length of operating leases also provides lessees with flexibility in their equipment commitments. The Company also competes with equipment manufacturers who offer operating leases and Full Payout leases. Manufacturers may provide ancillary services which the Company cannot offer such as specialized maintenance services (including possible substitution of equipment), warranty services, spare parts, training and trade-in privileges. The Company competes with many equipment lessors, including ACF Industries, Inc. (Shippers Car Line Division), American Finance Group, Chancellor Corporation, General Electric Railcar Services Corporation, Greenbrier Leasing Company, Polaris Aircraft Leasing Corp., G.P.A. Group Plc., and certain limited partnerships, some of which engage in syndications, and which lease the same type of equipment. (ix) Government Regulations PLM Securities is registered with the Securities and Exchange Commission ("SEC") as a broker-dealer. As such, it is subject to supervision by the SEC and securities authorities in each of the states. In addition, it is a member of the National Association of Securities Dealers, Inc. and is subject to that entity's rules and regulations. These rules and regulations govern such matters as program structure, sales methods, net capital requirements, record keeping requirements, trade practices among broker-dealers and dealings with investors. Sales of investment programs must be made in compliance with various complex federal and state securities laws. Failure to comply with provisions of these laws, even though inadvertent, could result in investors having rights of rescission or claims for damages. [FN] The Stanger Review, Partnership Sales Summary. The transportation industry, in which a substantial majority of the equipment owned and managed by the Company operates, has been subject to substantial regulation by various federal, state, local and foreign governmental authorities. For example, the United States Oil Pollution Act of 1990 ("O.P.A.") requires that all newly constructed oil tankers and oceangoing barges operating in United States waters have double hulls. Additionally, under O.P.A. owners are required to either retrofit existing single hulled vessels with double hulls or remove them from service in United States waters in accordance with a statutory timetable before the year 2015. Also, the Airport Noise and Capacity Act of 1990 generally prohibits the operation of commercial jets which do not comply with Stage 3 noise level restrictions at United States airports after December 1999. Both of these enactments could affect the performance of marine vessels and aircraft owned and managed by the Company. It is not possible to predict the positive or negative effect of future regulatory changes in the transportation industry. (x) Employees As of March 15, 1994, the Company and its subsidiaries had 215 employees. None of the Company's employees are subject to collective bargaining arrangements. On August 21, 1989, PLM International sold 4,923,077 shares of Series A Convertible Preferred Stock (the "Preferred Stock") to the PLM International Employee Stock Ownership Plan Trust (the "ESOP Trust") for $13.00 per share. The Preferred Stock is a voting security, representing approximately 32% of the voting shares of PLM International. The Company believes employee relations are good. ITEM 2. ITEM 2. PROPERTIES At December 31, 1993, the Company owned transportation equipment and related assets originally costing approximately $221 million. The Company leases approximately 46,000 square feet as its principal office at One Market, Steuart Street Tower, San Francisco, California. The Company leases business offices in Chicago, Illinois; Hurst, Texas; and Calgary, Alberta, Canada. In addition, the Company leases trailer rental yard facilities in Atlanta, Georgia; Chicago, Illinois; Dallas, Texas; Detroit, Michigan; Indianapolis, Indiana; Kansas City, Kansas; Miami, Florida; Newark, New Jersey; Orlando, Florida and Tampa, Florida. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is involved as plaintiff or defendant in various legal actions incident to its business. Except as described below, management does not believe that any of these actions will be material to the financial condition of the Company. Five current members of the Board of Directors of PLM International (the "Individual Defendants") were named as defendants in an amended complaint that was filed on October 4, 1993, in the Superior Court of the State of California in and for the County of San Francisco, Case No. 953005, by purported PLMI shareholder Robert D. Hass on behalf of himself and derivatively on behalf of PLMI. The action alleges intentional breaches of fiduciary duties, abuse of control, waste of corporate assets, gross mismanagement, and unjust enrichment, and seeks injunctive relief and damages. Specifically, the plaintiff alleges that certain or all of the individual defendants breached their duties by (i) establishing and maintaining the Company's Employee Stock Ownership Plan, (ii) amending on January 25, 1993 the Company's Shareholder Rights Agreement and (iii) granting to each other excessive and unjustified compensation. The Individual Defendants have denied and continue to deny all of the claims and contentions of alleged wrongdoing or liability. On February 14, 1994, the Individual Defendants, Mr. Hass and the Company entered into a Stipulation of Settlement (the "Stipulation"), wherein they agreed to settle the lawsuit, subject to court approval. The Stipulation provides, in part, that the Company Board of Directors will take certain actions with respect to the compensation and make-up of such Board of Directors. The Stipulation also provides that the Company will pay up to $160,000 to plaintiffs' attorneys for fees and costs. On March 11, 1994, the court approved the Stipulation and entered its Final Order and Judgment. The settlement was reached after all of the parties concluded that such settlement was desirable in order to avoid the expense, inconvenience, uncertainty and distraction of further legal proceedings. The Company believes that the settlement is fair, reasonable and adequate and in the best interests of PLM and its shareholders. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS. At the Annual Meeting of Stockholders of PLM International held on Thursday, May 12, 1993, one proposal was submitted to a vote of the Company's security holders. Allen V. Hirsch was re- elected as a Class III director of the Company. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. Common Stock: The Company's Common Stock trades (under the ticker symbol "PLM") on the American Stock Exchange ("AMEX"). As of the date of this Annual Report, there are 10,486,782 common shares outstanding and approximately 13,000 shareholders of record. Table 4, below, sets forth the high and low prices of the Company's common stock for 1992 and 1993 as reported by the AMEX: Four hundred thousand shares of the Company's common stock were held in escrow on behalf of Transcisco Industries, Inc. ("Transcisco"), holder of approximately 32% of the common stock of the Company, which were to be released to Transcisco only if the Company met certain tests based on achievement of predetermined target stock prices and target earnings per share levels at any point prior to January 1, 1993. The Company did not meet any of the applicable tests and the 400,000 shares were transferred to treasury. Historically, these shares have been treated as contingent recallable shares for all calculations of earnings (loss) per share. On March 2, 1989, Transcisco amended its Schedule 13D filed in connection with its investment in the Company indicating an intention to dispose of its entire holdings of the Company. In July, 1991, Transcisco filed a petition for reorganization in the United States Bankruptcy Court. On October 20, 1993, the Bankruptcy Court issued an order confirming a joint plan of reorganization (the "Plan") in Transcisco's Chapter 11 bankruptcy case. Under the Plan, in consideration for a release by Transcisco's bondholders of all claims against Transcisco, Transcisco will transfer to Securities Holding, L.P., a California limited partnership that will act as the bondholders' representative, the 3,367,367 shares of the Company's Common Stock and a $5 million subordinated note from the Company (the "PLMI Note"). Transcisco will retain a 40% interest in the PLMI Note. As of the date of this report, the foregoing transactions had not been completed. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SUMMARY OF SELECTED FINANCIAL DATA (In thousands except per share amounts) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Comparison of the Company's Operating Results for the Years Ended December 31, 1993 and 1992 The Company owns a diversified portfolio of transportation equipment from which it earns operating lease revenue and incurs operating expenses. The Company also raises investor equity through syndicated partnerships and invests the equity raised in transportation equipment which it manages on behalf of its investors. The Company earns various fees and equity interest from syndication and investor equipment management activities. The Company's transportation equipment held for operating leases is mainly equipment built prior to 1988. As trailer equipment ages, the Company is generally replacing it with newer equipment. However, aged equipment for other equipment types may not be replaced. Rather, proceeds from the liquidation of other equipment types may be invested in trailers or in other Company investment opportunities. Failure to replace equipment may result in shorter lease terms and higher costs of maintaining and operating aged equipment and in certain instances, limited remarketability. During 1992 the Company embarked on a strategic restructuring plan designed to identify underperforming assets in its own transportation equipment portfolio for both valuation adjustments and sale opportunities, to reduce senior indebtedness primarily from the proceeds of such sales and associated interest costs, and to reduce the operational cost structure. During 1993, the Company continued to execute on this strategy and realized significant progress in the restructuring plan. Below is an analysis of the impact the restructuring plan had on operations for the year. Following is an analysis of other operational factors that impacted the financial results for 1993. Restructuring Plan: Impact on Operating Results Results from sales of equipment that were designated in 1992 as assets held for sale demonstrated the intended purpose of the asset sale strategy. Assets with a net book value of approximately $24.9 million were sold at a gain of $2.4 millon in 1993. During 1992 there were sales having a net book value of $14.6 million and corresponding gains of $2.0 million. The Company had $9.3 million in equipment held for sale at December 31, 1993 versus $29.9 million at December 31, 1992. The proceeds generated by sales of equipment, combined with excess operating cash flow, have been used to reduce senior indebtedness from $100 million as of July 1992 to $45 million as of December 31, 1993. Outstanding senior and other secured debt was reduced by $37.2 million in 1993. This reduction in outstanding debt resulted in a decrease in interest expense of $1.5 million in 1993. Sales of equipment impacted operational results in several other areas as well. Operating lease revenues decreased by $6.2 million versus 1992 due to the reduced asset base. This included sale of most of the railcar fleet, an 18% reduction in the aircraft fleet, and a 13% reduction in both trailers and marine containers. The reduction in the lease fleet also accounted for a $1.7 million decrease in depreciation expense versus 1992. Review of the Company's equipment portfolio and identification of underperforming assets led to valuation adjustments charged to operations for reductions in carrying values of assets. These adjustments amounted to $2.2 million in 1993 as compared to $36.2 million in 1992. Equipment types that were subject to valuation adjustments in 1993 were primarily containers, trailers and railcars. Equipment types that were subject to valuation adjustments in 1992 were primarily commuter aircraft and trailers. The Company continues to review the performance and carrying values of its transportation equipment portfolio in relation to expected net realizable values. Future adjustments to the carrying value of the Company's equipment may occur if permanent impairments are identified. The strategic restructuring of operations led to a reduction in operations support costs of approximately $4.0 million for 1993. These decreases result from the reduction in the Company's portfolio of assets, efficiencies gained in accounting functions as well as the closing of the PLM Rental headquarters office and subsequent consolidation of its functions in San Francisco. The Company's sales office in London was closed in 1993 and other cost savings measures were implemented. Employee count was reduced from 247 at December 31, 1992 to 209 at December 31, 1993. During 1992 and 1993, the Company settled its long-standing class action litigation and other material litigation resulting in a reduction of litigation costs. The Company also charged to expense in 1992 certain capitalized costs as a result of restructuring of the Company's senior loan agreement. Litigation and other charges amounted to $7.6 million in 1992. Other Operational Factors: Impact on Operating Results Revenue: The Company's total revenue for the years ended December 31, 1993 and 1992 were $69.7 million and $75.0 million, respectively. The above analysis of the restructuring plan explains a $6.2 million negative variance in lease revenue. Various other factors impacting revenues in 1993 are explained below: Operating lease revenue was unfavorably impacted by lower utilization of interim bridge financing to acquire equipment for resale to one or more of the Company's affiliated partnerships or to independent parties. In 1993, the bridge financing was shared with either EGF VI or EGF VII. During the period that equipment is acquired by use of the bridge facility, the lease revenue generated by this equipment is earned by the Company. This revenue is offset by corresponding equipment operating costs as well as by the interest accruing on the interim debt. There was a decrease of $1.3 million in leasing revenue resulting from lower utilization of the bridge facility in 1993 versus 1992. Management fees remained relatively constant at $10.8 million between 1993 and 1992. These fees are, for the most part, based on the revenues generated by equipment under management. The managed equipment portfolio grows correspondingly with new syndication activity. Affiliated partnership and investment program surplus operating cash flows and loan proceeds invested in additional equipment favorably influence management fees. While equipment under management increased from 1992 to 1993, lease rates for affiliated partnerships and investment programs fell so that gross revenues, which give rise to the management fees, remained relatively constant. Equipment managed at year end 1993 and 1992 (measured at acquisition cost) amounted to $1,141,000,000 and $1,082,000,000, respectively. Commission revenue and other fees are derived from raising syndicated equity and acquiring and leasing equipment for Company sponsored investment programs. Commission revenue consists of placement fees which are earned on the amount of equity raised. Acquisition and lease negotiation fees are earned on the amount of equipment purchased and leased on behalf of syndicated investment programs. These fees are governed by applicable program agreements and securities regulations. The Company also receives a residual interest in additional equipment acquired by affiliated partnerships. Income is recognized on residual interests based upon the general partner's share of the present value of the estimated disposition proceeds of the equipment portfolios of the affiliated partnerships. Placement fees in 1993 decreased $1.7 million (18%) from 1992 as a result of less syndicated equity being raised. Equity raised in 1993 decreased to $92,462,000 from $111,123,000 in 1992. Acquisition and lease negotiation fees and other fees increased $5.0 million in 1993 from the 1992 levels. Equipment placed in service, or remarketed, totalled $186,606,000 in 1993 and $93,185,000 in 1992. At December 31, 1993 cash resources available to certain investment programs would permit additional equipment acquisitions of approximately $19 million. These cash resources are expected to be used by the programs to acquire additional equipment in 1994. In 1993, the Company ranked as the number one equipment leasing syndicator in the United States, as reported by Stanger, an industry trade publication. Costs and Expenses: Certain costs and expense reductions related to the effects of the restructuring plan, as detailed above resulted in specific expense reductions in 1993 versus 1992 totalling $39.7 million as follows: equipment valuation adjustments of $34.0 million, depreciation of $1.7 million and operation support costs of $4.0 million. Various other factors impacting 1993 expenses are explained below: Commission expenses are primarily incurred by the Company in connection with the syndication of investment partnerships. Commissions are also paid to certain of the Company's employees directly involved in leasing activities. The 1993 commission expenses decreased $2.3 million (21%) from 1992 levels reflecting the decrease in syndicated equity raised in 1993 versus 1992. General and administrative expenses increased $2.6 million (32%) during 1993. A portion of the increase relates to reclassification of certain activities previously classified as operations support. While headcount has decreased as discussed above, there have been certain severance related costs that reduce the favorable cost comparison for the periods reported. Additionally, professional service costs were $1.0 million higher in 1993. Interest income decreased $0.6 million (11%) in 1993 primarily due to the decrease in the interest rates applicable to restricted cash deposits and marketable securities. Other income (expense) was an expense of a $0.3 million in 1993 versus income of $0.5 million in 1992. Included is a charge of $0.7 million in 1993 resulting from accelerating certain expenses related to the Company interest rate swap agreement required by its senior loan agreement. The Company's income taxes include foreign, state and federal elements and reflect a provision of 19% in 1993 and a benefit of 46% in 1992. The effective tax rate varies from the statutory rate in 1993 due to non-recurring tax credits and the change in the effect of the ESOP dividend due to implementation of FASB 109. The 1992 benefit of 46% differs from the statutory rate due primarily to the effect of the ESOP dividend as prescribed under FASB 96. As a result of all the foregoing, net income to common shares for the year ended December 31, 1993 was $1,432,000 compared to net loss to common shares of $25,271,000 in 1992. Comparison of Company's Operating Results for the Years ended December 31, 1992 and 1991 Restructuring Plan: Impact of Operating Results Revenues: Sales of equipment, pursuant to the restructuring plan announced in the third quarter of 1992, had a negative impact on lease revenue during 1992. Rail and aircraft revenue declined by $3.4 million in 1992 due to the Company's reduction in the aircraft fleet from 50 aircraft on December 31, 1991 to 39 aircraft as of December 31, 1992 and its railcar fleet from 614 railcars on December 31, 1991 to 407 railcars on December 31, 1992. As part of the restructuring plan the Company sold certain underperforming assets having a net book value of $14.6 million for a gain of $2.0 million. This compared to a gain on the sale of transportation equipment in 1991 of $0.1 million. Costs and Expenses The restructuring plan had a negative impact on the expenses of the Company. In 1992, the Company reduced the carrying value of certain assets, primarily aircraft and trailers, by $36.2 million. This resulted from the Company's decision to exit certain market niches and from permanent declines in the net realizable value of equipment. During 1991 the Company reduced the carrying value of one aircraft by $0.4 million. The Company also recorded a nonrecurring charge in 1992 of $7.6 million for litigation and other costs. This related to settlement of litigation as well as expenses incurred in the course of addressing lawsuits arising in the normal course of business operations. The Company also charged to expense certain capitalized costs as a result of restructuring the Company's senior loan agreement. The sale of equipment in 1992 caused a reduction in depreciation expenses of $0.8 million. Other Operational Factors: Impact on Operating Results The Company's total revenue for the years ended December 31, 1992 and 1991 were $75.0 million and $72.8 million, respectively. The results of the restructuring plan account for a negative impact on revenues of $3.4 million. Various other factors affected revenues in 1992 and are explained below: Operating lease revenue increased $2.5 million in 1992 compared to 1991. Trailer revenues increased $4.4 million in 1992 due to the Company's decision to acquire more trailers for its per diem rental operations, increased utilization of trailers, and increased revenue from its new storage unit division. During 1992, there was an increase of $0.8 million in leasing revenue resulting from equipment being held on an interim basis for resale to its sponsored programs. Management fees and partnership interests. Management fees decreased $0.4 million (3%) in 1992 over the fees earned in 1991. While equipment under management increased from 1991 to 1992, lease revenues of affiliated partnerships and investment programs fell slightly. Equipment oversupply, weaker demand and lower interest rates all contributed to lower lease rates in commercial aircraft and marine vessels in 1992. Equipment managed at year end 1992 and 1991 (measured at acquisition cost) amounted to $1,082,000,000 and $1,036,000,000, respectively. Income from partnership interests decreased $1.1 million (22%) primarily due to a retroactive special allocation of income in 1991. Commission revenue and other fees. Placement fees in 1992 increased $1.6 million (20%) from 1991 as a result of more syndicated equity being raised. Equity raised in 1992 increased to $111,123,000 from $93,092,000 in 1991. In 1992, the Company ranked as the number one diversified transportation equipment syndicator and number two overall equipment syndicator in the United States. Acquisition and lease negotiation fees and other fees decreased 31% in 1992 from 1991 levels. Equipment placed in service by the Company's affiliated partnerships totalled $93,185,000 in 1992 and $120,699,000 in 1991. At December 31, 1992, cash resources available to certain investment programs would permit additional equipment acquisitions of approximately $25 million. These cash resources were used by the investment programs to acquire additional equipment in 1993. Costs and Expenses: Certain cost and expense variances relating to the restructuring plan, as detailed above, resulted in specific variations as follows: increase in equipment valuation adjustments of $35.8 million and a decrease in depreciation expense of $0.8 million. Various other factors impacting 1992 expenses are explained below: Operations support expense increased $2.4 million (11%) in 1992 from 1991 levels. The change for 1992 is due principally to (i) a one-time favorable bad debt settlement received in 1991; (ii) expense incurred in the expansion of storage equipment operations; (iii) increased utilization of trailer equipment and (iv) expansion of PLM Rental operations (Company-owned trailers in daily rental operations increased to 5,000 units in 1992 from approximately 4,700 in 1991). Commission expenses increased in 1992 $2.0 million (22%) from 1991 levels reflecting the increased in syndicated equity raised in 1992 versus 1991. General and administrative expenses decreased $0.6 million (7%) during 1992. This expense reduction resulted primarily from the loss incurred on the sublease of the Company's former principal offices totaling $0.3 million in 1992 compared to $1.25 million in 1991. This was offset in 1992 by an increase in professional fees of $0.4 million. Other Items: Interest expense decreased $1.6 million (10%) in 1992 from that incurred in 1991. The decrease reflects the effect of reduced interest rates in 1992 versus 1991 which more than offset the increase in average borrowings during 1992. Interest income decreased $1.9 million (24%) in 1992 primarily due to the decrease in the interest rates for restricted cash deposits and marketable securities. Income taxes. The Company's income taxes include foreign, state, and federal elements and reflect a benefit of 46% in 1992 and a provision of 1% in 1991. The effective tax rate varies from the statutory rate principally due to the tax effect of the ESOP dividend. As a result of all the foregoing, net loss to common shares for the year ended December 31, 1992 was $25,271,000 compared to net income available to common shares of $3,063,000 in 1991. This decline was primarily attributable to restructuring adjustments and litigation and other costs. Liquidity and Capital Resources Cash requirements have been historically satisfied through cash flow from operations, borrowings or sales of transportation equipment. During 1993 cash flow from operations was significantly impacted by the Company's restructuring plan, announced in August 1992, which plan includes the sale of equipment to pay down senior indebtedness. Equipment sales generated $16.6 million in 1992 and $27.3 million in 1993. At July 1, 1992, the outstanding principal balance on the senior secured loan totalled $100 million. At December 31, 1993, the principal balance of the senior loan was $45 million. Reduced lease revenues resulting from a smaller transportation equipment portfolio have been offset by the lower interest expense exposure resulting from the reduction in senior indebtedness, as well as operational cost reductions implemented by the Company also as part of the restructuring plan. As a result, cash and cash equivalents are at a historical high for the Company. Liquidity beyond 1993 will depend in part on continued remarketing of the remaining equipment portfolio at similar lease rates, continued success in raising syndicated equity for the sponsored programs, effectiveness of cost control programs, ability of the Company to secure new financings and possible additional equipment sales. Specifically, future liquidity will be influenced by the following: (a) Debt Financing: Senior and Subordinated Debt: On October 28, 1992, the Company's senior secured term loan agreement was amended to provide an accelerated principal amortization schedule. The amended agreement provides for the net proceeds from the sale of transportation equipment to be placed into collateral accounts to be used for principal reductions. Cash proceeds received from equipment sales totaling $43.9 million in 1992 and 1993 have contributed substantially to the $55 million reduction of this loan to $45.0 million. The Company will make an additional principal payment in the amount of $8.2 million on March 31, 1994. Final maturity of the senior secured indebtedness is June 30, 1994. The Company is presently marketing replacement financing for the senior secured indebtedness and a portion of its subordinated debt. Management of the Company believes this replacement financing will be completed prior to maturity of the senior secured debt facility. The Company also negotiated an amendment to the Senior Subordinated Notes agreement in October 1992 adjusting certain covenants to accommodate the Company's restructuring plan. Bridge Financing: Assets held on an interim basis for placement with affiliated partnerships have, from time to time, been partially funded by a $25.0 million short-term equipment acquisition loan facility. This facility, made available to the Company effective June 30, 1993, provides 80 percent financing, and the Company uses working capital for the non-financed costs of these transactions. The commitment for this facility expires on July 13, 1994. This facility, which is shared with a PLM Equipment Growth Fund, allows the Company to purchase equipment prior to the designated program or partnership being identified or prior to having raised sufficient resources to purchase the equipment. During 1993 the Company bought and sold, at its cost, $18.1 million of these interim held assets to affiliated partnerships. The Company usually enjoys a spread between the net lease revenue earned and the interest expense during the interim holding period. Decreased utilization of this facility versus use of a similar facility available to the Company in 1992 resulted in lower lease revenues of $1.3 million in 1993. (b) Equity Financing: On August 21, 1989 the Company established a leveraged employee stock ownership plan ("ESOP"). PLM International issued 4,923,077 shares of Preferred Stock to the ESOP for $13.00 per share, for an aggregate purchase price of $64,000,001. The sale was originally financed, in part, with the proceeds of a loan (the "Bank Loan") from a commercial bank (the "Bank") which proceeds were lent on to the ESOP the ("ESOP Debt") on terms substantially the same as those in the Bank Loan agreement. The ESOP Debt is secured, in part, by the shares of Preferred Stock while the Bank Loan is secured with cash equivalents and marketable securities. Preferred dividends are payable semi-annually on February 21 and August 21, which corresponds to the ESOP Debt payment dates. Bank Loan debt service is covered through release of the restricted cash security. While the annual ESOP dividend is fixed at $1.43 per share the interest rate on the ESOP debt varies resulting in uneven debt service requirements. With declining interest rates, the ESOP dividends for 1993 exceeded required ESOP Debt service and the excess was used for additional principal payments totalling $2.4 million in 1993. If interest rates continue at current levels it is expected that ESOP dividends during 1994 will again exceed the required ESOP Debt service. Management, as part of its overall strategic planning process, is evaluating the effectiveness of the ESOP and the Company's other qualified benefit plan. On January 20, 1992, the Company's Board of Directors voted to suspend the $0.10 per share quarterly dividend on its common shares. This reduced cash requirements for dividend payments in 1992 by approximately $4.0 million. The amended and restated senior secured term loan agreement restricts dividend payments until its principal balance is reduced below $30 million. (c) Portfolio Activities: During 1993, the Company continued to execute on the restructuring plan announced effective for the second quarter of 1992. The restructuring plan was designed to identify under performing assets in the Company's own transportation equipment portfolio for both valuation and sale opportunities, reduce senior indebtedness primarily from the proceeds of such sales and associated interest costs, and reduce operational cost structures. The overall effect of this Plan will be to reduce future lease revenues and related interest, depreciation and operations support expenses allocable to the sold equipment and position the Company for future improved profitability. The Company generated proceeds of $27.3 million from the sale of equipment during 1993. The assets sold during the year consisted primarily of aircraft, railcars, trailers and containers. The Company believes the remaining fleet of leased assets has higher earnings potential and more stable residual values than the disposed equipment. As stated last year, the Company did not expect to commit substantial capital resources for acquisition of new transportation equipment in 1993. Accordingly, $1.5 million of transportation equipment was acquired in 1993, compared to $9.8 million in 1992. These purchases are in market niches targeted by the Company as profitable with long term growth potential. As of the date of this report, there were commitments in place totaling approximately $9.4 million to acquire transportation equipment that is intended to be assigned to one or more of the investment programs sponsored by the Company. The purchase of this equipment will be funded by the assigned program. (d) Syndication Activities: The Company earns fees generated from syndication activities which enhances cash flow. In May 1993, PLM Equipment Growth and Income Fund VII ("EGF VII") became effective and selling activities commenced. Through March 25, 1994 a total of $53 million syndicated equity had been raised for this investment program of the maximum of $150 million which was registered. The Company will likely continue to offer units in EGF VII through the end of 1994. Inflation did not have a material impact on the financial performance of the Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA The response to this item is submitted as a separate section of this report. See 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 COMPANY. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. ITEM 12. ITEM 12. SECURITY OWNERSHIPS OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. A definitive proxy statement of the Company 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 under "Identification of Directors and Officers," "Compensation of Executive Officers," "Employee Stock Ownership Plan," and "Certain Business Relationships" and "Security Ownership of Certain Beneficial Owners and Management" in such proxy statement is incorporated herein by reference for Items 10, 11, 12 and 13, above. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Financial Statements and Schedules (1) The consolidated financial statements listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. (2) The consolidated financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this Annual Report on Form 10-K. (3) Exhibits are listed at item (c), below. (b) Reports on Form 8-K Filed in Last Quarter of 1993 None. (c) Exhibits 3.1 Certificate of Incorporation, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 1990. 3.2 Bylaws, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 1990. 10.1 Third Amended and Restated Loan Agreement, dated as of October 28, 1992, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.2 $23,000,000 Note Agreement, dated as of January 15, 1989, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 1990. 10.3 Second Amended and Restated Loan Agreement, dated as of December 9, 1991, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 30, 1992. 10.4 Warehousing Credit Agreement, dated as of June 30, 1993, as amended. 10.5 Form of Employment contracts for executive officers, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.6 Rights Agreement, as amended, filed with Forms 8-K, March 12, 1989, August 12, 1991 and January 23, 1993 and incorporated herein by reference 10.7 PLM International Employee Stock Ownership Plan filed with Form 8-K, August 21, 1989 and incorporated herein by reference. 10.8 PLM International Employee Stock Ownership Plan Trust filed with Form 8-K, August 21, 1989 and incorporated herein by reference. 10.9 PLM International Employee Stock Ownership Plan Certificate of Designation filed with Form 8-K, August 21, 1989 and incorporated herein by reference. 10.10 Directors' 1992 Non Qualified Stock Option Plan, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.11 Form of Company Non Qualified Stock Option Agreement, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.12 Form of Executive Deferred Compensation Agreement, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1993. 10.13 Lease Agreement for premises at 655 Montgomery Street, San Francisco, California, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 2, 1990. 10.14 Office Lease for premises at One Market, San Francisco, California, incorporated by reference to the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 1, 1991. 11.1 Statement regarding computation of per share earnings. 22.1 Subsidiaries of the Company. 24.1 Consents of Independent Auditors 25.1 Powers of Attorney. (d) Financial Statement Schedules The consolidated financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this 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 Company has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. Date: March 25, 1994 PLM International, Inc. By: /s/ J. Michael Allgood J. Michael Allgood 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 Company and in the capacities and on the dates indicated. Signature Title Date /s/J. Michael Allgood Vice President and March 25, 1994 J. Michael Allgood Chief Financial Officer * _____________________ Director, Executive March 25, 1994 Allen V. Hirsch Vice President * _____________________ Director March 25, 1994 Walter E. Hoadley * _____________________ Director March 25, 1994 J. Alec Merriam * _____________________ Director March 25, 1994 Robert L. Pagel * _____________________ Director, President March 25, 1994 Robert N. Tidball * Stephen Peary, by signing his name hereto, does sign this document on behalf of the persons indicated above pursuant to powers of attorney duly executed by such persons and filed with the Securities and Exchange Commission. /s/ Stephen Peary Stephen Peary Attorney-in-Fact PAGE INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (Item 14(a)(1)(2)) Description Page Independent Auditors' Report 27 Consolidated Statements of Operations for years ended December 31, 1993, 1992, and 1993 28 Consolidated Balance Sheets at December 31, 1993 and 1992 29 Consolidated Statements of Changes in Shareholders' Equity for years ended December 31, 1991, 1992, and 1993 30 Consolidated Statements of Cash Flows for years ended December 31, 1993, 1992, and 1991 31 Notes to Consolidated Financial Statements 33 Schedule I - Schedule of Marketable Securities 50 Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other than Related Parties 51 Schedules V and VI - Schedule of Equipment and Accumulated Depreciation 52 Schedule IX - Short Term Borrowings 55 Exhibit XI - Computation of Earnings (Loss) Per Common Share 56 All other schedules are omitted since the required information is not pertinent 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 and notes thereto. PAGE INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders PLM International, Inc. We have audited the consolidated financial statements of PLM International, Inc. and subsidiaries as listed in the accompanying index to financial statements (Item 14 (a)) for the years ended December 31, 1993, 1992, and 1991. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules for the years ended December 31, 1993, 1992, and 1991, 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 PLM 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 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. /s/KPMG PEAT MARWICK KPMG PEAT MARWICK SAN FRANCISCO, CALIFORNIA MARCH 25, 1994 PAGE PAGE PAGE PAGE Supplemental schedule of noncash financing activities: In December 1991, the Company issued 343,291 shares of its common stock as partial consideration for the purchase of all remaining shares of the common stock of Rent-A-Vault, Inc. not previously held. In 1992, there was a net credit to Paid in Capital resulting from a $2.0 million Consolidation (see Note 1) settlement offset by related tax effect and adjustment of deferred taxes for the effect of the taxable premium paid from the 1988 Consolidation transaction. In 1993, the Company recalled 400,000 contingently issued shares from Transcisco due to certain earnings per share and market price amounts not being met by the Company. Of the recalled shares, the Company has issued 29,530 to former participants in the Company's Employee Stock Ownership Plan and is holding the remaining 370,470 shares as treasury stock. See accompanying notes to these financial statements PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying consolidated financial statements present the financial position, changes in equity, results of operations and cash flows of PLM International, Inc. and its wholly owned subsidiaries ("PLM International" or the "Company"). PLM International began operations on February 1, 1988 through an exchange of 10,554,033 shares of its common stock and other consideration for the assets, subject to related liabilities, of 21 limited partnerships (the "Partnerships") and for the common stock of PLM Financial Services, Inc. and its wholly owned subsidiaries and certain of its affiliates (collectively referred to as "FSI"). Transcisco Industries, Inc.("Transcisco"), the former parent of FSI, received 3,766,667 shares of the Company's common stock, which included 400,000 contingent shares which were recalled on January 1, 1993 as certain earnings per common share and market price amounts were not met. The entire transaction is referred to as the "Consolidation." All significant intercompany transactions among the consolidated group were eliminated. FSI was the general partner of the Partnerships and due to the existing affiliation prior to the Consolidation, PLM International accounted for the exchange as a reorganization of entities under common control, with the historical account balances carried forward from those of the predecessor exchanging entities to the new organization. Accounting for Leases PLM International's leasing operations generally consist of operating leases. Under the operating lease method of accounting, the leased asset is recorded at cost and depreciated over its estimated useful life. Rental payments are recorded as revenue over the lease term. Lease origination costs are capitalized and amortized over the terms of the lease. Transportation Equipment Transportation equipment held for operating leases is stated at the lower of depreciated cost or estimated net realizable value. Depreciation is computed on the straight line method down to its estimated salvage value utilizing the following estimated useful lives (in years): Aircraft 8-20; Trailers 8-18; Marine containers 10-15; Marine vessels 15; and Storage vaults 15. Salvage value is 15% of original equipment cost. If projected future lease revenue plus residual values are less than the net book value of the equipment a valuation allowance is recorded. Transportation equipment held for sale is valued at the lower of depreciated cost or estimated net realizable value. Lease rentals earned prior to sale are recorded as operating lease revenues with an offsetting charge to depreciation and amortization expense. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Except for trailers and storage units at the Company's per-diem rental yards, maintenance costs are usually the obligation of the lessee. If they are not covered by the lessee they are charged against operations as incurred except for dry docking costs on marine vessels which are estimated and reserved for prior to dry docking. To meet the maintenance obligations of certain aircraft engines, escrow accounts are prefunded by the lessees. The escrow accounts are included in the consolidated balance sheet as restricted cash and other liabilities. Certain railcars and trailers are maintained under fixed price maintenance contracts with third parties. Repairs and maintenance expense was $4,380,858, $5,587,000, and $5,151,000 for 1993, 1992, and 1991, respectively. Commissions and Fees PLM International engages in the organization, sale and management of transportation equipment leasing investment programs, which are mainly limited partnerships, and receives for its services an equity interest in the partnership and equity placement, equipment acquisition, lease negotiation, debt placement, and equipment management fees from these affiliated investment programs and limited partnerships. Fees are recognized as revenue at the time the related services have been performed. Placement fees, generally 9% of equity raised, are earned upon the purchase by investors of partnership units. Equipment acquisition, lease negotiation and debt placement fees are earned through the purchase, initial lease and financing of equipment, and are generally recognized as revenue when the Company has completed substantially all of the services required to earn the fee, generally when binding commitment agreements are signed. Management fees are earned for managing the equipment portfolio and administering investor programs as provided for in various agreements and are recognized as revenue over time as they are earned. As compensation for organizing a partnership, FSI is generally granted an interest (ranging between 1% and 5%) in the earnings and cash distributions of the partnership for which FSI is the general partner. The Company recognizes as management fees and partnership interests its equity interest in the earnings of the partnership after adjusting such earnings to reflect the use of straight-line depreciation and the effect of special allocations of the partnership's gross income allowed under the respective partnership agreements. The Company also recognizes as income its interest in the estimated net residual interest in the assets of the partnership as they are being purchased. The amounts recorded are based on management's estimate of the net proceeds to be distributed upon disposition of the partnership equipment at the end of the partnerships. These residual value interests are recorded in commissions and other fees at the present value of the Company's share of estimated disposition proceeds as assets are purchased by the partnerships. As required by FASB Technical Bulletin 1986-2, the discount on the Company's residual value interests is not accreted over the holding period. The Company reviews the carrying value of its residual interests at least annually in relation to expected future market values for the underlying equipment for the purpose of assessing recoverability of recorded amounts. When a limited partnership is in the liquidation phase, distributions received by the Company will initially be treated as recoveries of its equity interest in the partnership. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Commission expense includes placement commissions of approximately 8% of equity raised which is paid to outside brokers and up to 1.6% paid to the Company's wholesalers. The expense is recognized on the same basis as placement fees earned. Marketable Securities In May 1993, the Financial Accounting Standards Board issued statement No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). SFAS 115 addresses the accounting and reporting for investments in equity securities that have readily determinable fair value and for all investments in debt securities. SFAS 115 is effective for fiscal years beginning after December 15, 1993. Initial adoption must be at the beginning of the fiscal year, and retroactive adoption is not allowed. The Company intends to adopt SFAS 115 when required, and does not believe that such adoption will have a material impact on its consolidated financial statements. Earnings (Loss) Per Common Share Primary earnings (loss) per common share is calculated using the weighted average number of shares outstanding during each period (less 400,000 contingent shares held in escrow for 1992 and 1991 considered common stock subject to recall). These recallable shares and the outstanding stock options (see Note 11) are treated as common stock equivalents. Fully diluted earnings (loss) per common share is anti-dilutive or substantially the same as primary earnings (loss) per common share for each period reported on and, therefore, is not reported separately. Income Taxes As of January 1, 1993, the Company has adopted Statement of Financial Accounting Standards No. 109 ("Accounting for Income Taxes")("SFAS No. 109"). SFAS No. 109 continues to require the liability method of accounting for income taxes as under SFAS No. 96. No additional tax assets were recorded and no valuation allowances or additional liability was required upon adoption of SFAS No. 109. As permitted under adoption of SFAS 109, the Company has elected not to restate prior years' financial statements. The consolidated statement of operation for 1993 reflect the required changes in the presentation of the tax benefit from the dividend payable on the preferred shares held by the Company Employee Stock Ownership Plan. Under the liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Deferred income taxes arise primarily because of differences in the timing of reporting transportation equipment depreciation, partnership income, and certain reserves for financial statement and income tax reporting purposes. Deferred income taxes were established at the Consolidation to account for differences between the net book value and tax bases of transportation equipment and other items received from the Partnerships. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Intangibles Intangibles are included in other assets on the balance sheet and consist primarily of goodwill related to acquisitions. The goodwill is being amortized over 15 years from the acquisition date. Cash, Cash Equivalents and Marketable Securities The Company considers highly liquid investments that are readily convertible into known amounts of cash with original maturities of ninety days or less to be cash equivalents. Marketable securities are valued at the lower of cost or market. Financial Instruments Financial instruments are used to hedge financial risk caused by fluctuating interest rates. The amounts to be paid or received on interest-rate swap agreements accrue and are recognized over the lives of the related debt agreements. Reclassification Certain prior year amounts have been reclassified in order to conform to the current year's presentation. 2. VALUATION ADJUSTMENTS In 1993, as part of the Company's ongoing strategic planning process, the Company reviewed its transportation equipment portfolio resulting in the reduction of the carrying value of certain equipment to its net realizable value by $2.2 million. The valuation adjustments included containers ($0.9 million), trailers ($0.7 million), railcars ($0.4 million), and aircraft ($0.2 million). In 1992, as part of this process, the Company took valuation adjustments totalling $36.2 million, consisting of revaluations of the carrying value of certain aircraft ($13.8 million), trailers ($18.6 million), and other related assets and equipment ($3.8 million). Of these adjustments, $19.6 million resulted from the Company reassessing its investment in certain equipment for which projected earnings potential had declined and decided to exit certain equipment niches and to sell the related equipment. In addition, certain other transportation equipment was put up for sale because of marketing limitations resulting from its physical condition or unique configurations. Of the $29.9 million in net book value of these assets held for sale at the end of 1992, $18.3 million in net book value were sold during 1993 at a net gain of $2.4 million. In addition, the valuation adjustments included a $7.0 million adjustment on its refrigerated over-the-road trailers as they were transitioned from fixed-term leases to per diem rental yard operations as a result of increased maintenance and other operating costs associated with operating refrigerated trailers in per diem rental service. These revaluations also included adjustments to the carrying value of aircraft of $4.1 million resulting from reduced demand and increased availability of such aircraft due to the weak performance in the airline industry. Other valuation adjustments totaling $5.5 million were taken on various equipment to reduce the carrying value to its estimated net realizable value. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 During 1991, the Company took a $0.4 million charge to reduce the carrying value of an aircraft to its estimated net realizable value. 3. ASSETS HELD FOR SALE Assets held for sale include assets acquired with the intent to resell them to unrelated parties or to affiliated partnerships, certain transportation equipment that the Company intends to sell rather than re-lease, and participation interests in equipment residual values. At December 31, 1993 the components of assets held for sale were: airplanes $4,801,000; trailers $2,341,000; residual option contracts on equipment $1,824,000; and marine containers $90,000. The components of assets held for sale at December 31, 1992 were: airplanes $13,638,000; railcars $10,464,000; trailers $3,680,000; residual option contracts on equipment $1,960,000; and marine containers $200,000. 4. EQUITY INTEREST IN AFFILIATES PLM International, through subsidiaries, is the general partner in 23 limited partnerships (not included in the Consolidation), and generally holds an equity interest in each ranging from 1% to 5%. Summarized combined financial data for these affiliated partnerships, reflecting straight line depreciation, is as follows (in thousands and unaudited): PAGE PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Operating results for the years ended December 31,: During 1991 certain limited partnership agreements were amended to accelerate the timing of special allocations of gross income to the general partner from the liquidation stage of the partnership to the present. Current income allocated to the general partner increased retroactively by an amount equal to the difference between cumulative cash distributions paid to the general partner and the general partner's equity in earnings of the partnership before special allocations. Taxable income allocated to the limited partners was reduced by a similar amount. Cash distributions to the partners was not effected as a result of the change. During the fourth quarter of 1991 the Company recognized $1.2 million of additional equity in earnings of the managed affiliated partnerships to record the special allocations of income resulting from these amendments. While none of the partners are directly liable for partnership borrowings and while the general partner maintains insurance against liability for bodily injury, death and property damage for which a partnership may be liable, the general partner may be contingently liable for claims against the partnership that exceed asset values. 5. TRANSPORTATION EQUIPMENT HELD FOR OPERATING LEASE Transportation equipment, at cost, held for operating lease at December 31, 1993 is represented by the following types: Aircraft 42%; Trailers 37%; Marine vessels and Marine cargo containers 17%; other 4%. Future minimum rentals receivables under non-cancelable leases at December 31, 1993 are approximately $11,219,000 in 1994; $5,215,000 in 1995; $4,540,000 in 1995; $2,226,000 in 1997; $1,627,000 in 1998; and $1,279,000 thereafter. In addition, per diem and contingent rentals consisting of utilization rate lease payments included in revenue for 1993 amounted to approximately $15,957,000. At December 31, 1993, the Company had committed approximately 83% of its trailer equipment to rental yard and per diem operations. 6. RESTRICTED CASH AND RESTRICTED MARKETABLE SECURITIES Restricted cash consists of bank accounts and short term investments that are subject to withdrawal restrictions as per lease agreements or loan agreements. Certain lease agreements, primarily on aircraft, require prepayments to the Company for periodic engine maintenance. Certain debt agreements require proceeds from the sale of particular assets to be deposited into a collateral bank account and the funds used to reduce the outstanding balance. Restricted marketable securities are valued at the lower of amortized cost or market and consist of investments subject to withdrawal restrictions imposed by the Employee Stock Ownership Plan loan agreement (See Note 7). At December 31, 1993 the fair value of these securities approximated the original acquisition cost. 7. SECURED DEBT (in thousands): Secured debt consists of the following at December 31: The institutional debt agreement contains financial covenants related to tangible net worth, ratios for leverage, interest coverage ratios and collateral coverage all of which were met at December 31, 1993. The Company is also restricted from paying dividends on its common stock until the senior secured debt is reduced to approximately $30,000. In addition, there are the restrictions based on computation of tangible net worth, financial ratios and cash flows, as defined. The Company is presently marketing replacement financing for the senior secured debt and a portion of its subordinated debt. Management of the Company believes this replacement financing will be completed prior to maturity of the senior secured debt. Principal payments on long term secured debt are approximately $48,386 in 1994; $3,100 in 1995; $3,396 in 1996; $3,957 in 1997; $4,076 in 1998, and $35,204 thereafter. The book value of the senior secured debt and ESOP debt approximates fair value due to the variable interest rates on the debt. The Company estimates,based on recent transactions, that the fair value of the other secured debt is approximately equal to its book value. In the fourth quarter of 1991 the Company entered into interest rate swap agreements expiring in 1994 and 1996 that effectively convert $20 million of its variable rate institutional debt into fixed obligations at rates ranging from 5.538% to 7.23%. Under the terms of these agreements, the Company makes payments at fixed rates and receives payments on variable rates based on LIBOR. The net interest paid or received is included in interest expense. The Company estimates, based on quoted market prices for similar swaps, that the fair value to release the Company of its obligation thereunder would be approximately $882 at December 31, 1993, which has been accrued. 8. SUBORDINATED DEBT (in thousands) Subordinated debt consists of the following at December 31: The senior subordinated debt agreement contains certain financial covenants and other provisions, including an acceleration provision in the event that, under certain circumstances, a person or group obtains certain percentages of the voting stock of the Company or seeks to influence the voting on certain matters at a meeting of shareholders. In addition, extensions to the senior secured debt may cause payment of this debt to be delayed. Absent the aforementioned, principal payments due on subordinated debt in the next five years are $8,000 in 1995, $5,750 in 1996, $5,750 in 1997, $5,750 in 1998 and $5,750 thereafter. The subordinated $8,000 notes maturity dates may be extended under certain circumstances. Therefore, the Company is not able to estimate the fair market value of this debt. Based on the borrowing rates estimated to be available to the Company, if the Company's subordinated debt could be replaced in the current market, the Company estimates the fair value of this debt to be $1,000 higher than its face value as of December 31, 1993. 9. INCOME TAXES (in thousands) As discussed in Note 1, the Company adopted SFAS 109 as of January 1, 1993. No additional tax assets were recorded and no valuation allowances or additional liability was required upon the adoption of SFAS 109. As permitted under the adoption of SFAS 109, the Company has elected not to restate prior year's financial statements. Total income tax benefit of $976,000 for the year ended December 31, 1993 was allocated as follows: Income from operations $ 1,455 Tax benefit of ESOP dividend charged to shareholders equity (2,182) Tax benefit of net operating losses from merged subsidiary reducing goodwill (249) Total tax benefit $ (976) The provisions for (benefit from) income taxes attributable to income from operations consist of the following: Amounts for the current year are based upon estimates and assumptions as of the date of this report and could vary significantly from amounts shown on the tax returns ultimately filed. Accordingly, the variances from the amounts previously reported for prior years are primarily the result of adjustments to conform to the tax returns as filed. PAGE PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 The difference between the effective rate and the expected Federal statutory rate is reconciled below: During 1993 the Company recorded a tax benefit of $716,000 relating to federal tax credits allocated from its prior affiliated group and a net state tax benefit of $294,000 relating to California solar energy credits with a reduction of the deferred income tax liability. During 1991 the Company resolved audit issues with federal and state tax authorities related to deductibility of depreciation and allowability of investment and energy tax credits associated with FSI's investment in alternative energy programs prior to the Consolidation. Approximately $220,000 paid to resolve the State audit issues was charged against deferred income taxes. In addition, the provision for income tax expense for 1991 has been reduced by $680,000 with a corresponding reduction in the deferred income tax liability retained at the end of 1990 to provide for exposure related to this uncertainty. Components of the deferred tax provision are as follows for the years ending December 31, (in thousands): Net operating loss carryforwards for federal income tax purposes amounted to $20,744 and $41,478 at December 31, 1993 and 1992, respectively. These net operating losses have a 15 year carryforward period. The net operating losses at December 31, 1993, will expire as follows: $9,358 in 2004; $3,475 in 2005; $7,149 in 2006 and $762 in 2007. Alternative minimum tax credit carryforwards at December 31, 1993 are $7,022. For financial statement purposes, there are no operating loss or alternative minimum tax credit carryforwards. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 The tax effects of temporary differences that give rise to significant portions of the deferred tax liabilities at December 31, 1993 are presented below: Deferred Tax Assets: Tax credits carryforwards $ 7,782 Net operating loss carryforwards 7,921 Federal benefit of state taxes 1,090 Other 473 Total deferred tax assets 17,266 Deferred Tax Liabilities: Transportation equipment, principally differences in depreciation 28,376 Partnership Interests 8,276 Total deferred tax liabilities 36,652 Net deferred tax liabilities $ 19,386 10. COMMITMENTS AND CONTINGENCIES Litigation The Company is involved as plaintiff or defendant in various legal actions incidental to its business. Management does not believe that any of these actions will be material to the financial condition of the Company. Five current members of the Board of Directors of PLM International, Inc. (the "Individual Defendants") were named as defendants in an amended complaint that was filed on October 4, 1993, in the Superior Court of the State of California in and for the County of San Francisco, Case No. 953005, by purported PLMI shareholder Robert D. Hass on behalf of himself and derivatively on behalf of PLMI. The action alleges intentional breaches of fiduciary duties, abuse of control, waste of corporate assets, gross mismanagement, and unjust enrichment, and seeks injunctive relief and damages. Specifically, the plaintiff alleges that certain or all of the individual defendants breached their duties by (i) establishing and maintaining the Company's ESOP, (ii) amending on January 25, 1993 the Company's Shareholder Rights Agreement and (iii) granting to each other excessive and unjustified compensation. The Individual Defendants have denied and continue to deny all of the claims and contentions of alleged wrongdoing or liability. On February 14, 1994, the Individual Defendants, Mr. Hass and the Company entered into a Stipulation of Settlement (the "Stipulation"), wherein they agreed to settle the lawsuit, subject to court approval. The Stipulation provides, in part, that the PLM International Board of Directors will take certain actions with respect to the compensation and make-up of such Board of Directors. The Stipulation also provides that the Company will pay up to $160,000 to plaintiffs' attorneys for fees and costs. On March 11, 1994, the court approved the Stipulation and entered its Final Order and Judgment. The settlement was reached after all of the parties concluded that such settlement was desirable in order to avoid the expense, inconvenience, uncertainty and distraction of further legal proceedings. The Company believes that the settlement is fair, reasonable and adequate and in the best interests of PLM and its shareholders. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Lease Agreements The Company's net rent expense was $2,353,000, $2,351,000, and $2,133,000 in 1993, 1992 and 1991, respectively. In December 1990, the Company negotiated a lease for new office space and moved into this space in June 1991. The new office space is leased through May 2001 with annual rentals of $1,329,000 through May 1996 and annual rentals of $1,535,000 in 1997 and $1,649,000 through May 2001. A rent abatement existed for the first year. Rental expense averages $1,350,000 per year under this lease. The Company is obligated under the lease for approximately $400,000 of leasehold improvements which is being paid over the term of the lease with interest at 10.5%. The lease agreement also provided for a loan of $750,000 to fund the sub-leasing deficit on the Company's former space, which is being repaid over the term of the lease with interest at 10.5%. The Company is obligated under a lease for its former office space through April 1994. The rental payments on the former office space are $167,000 for 1994. The Company's contracted rentals from subleasing its former space are less than its obligations, and consequently the Company recorded an expense of $149,000 in 1993, $300,000 in 1992, and $1,250,000 in 1991. The Company also has leases for other office space and for rental yard operations. The applicable rent expense recorded in 1993 was $1,003,000; $1,048,000 in 1992; and $848,000 in 1991. Annual lease rental commitments for these locations total $826,000, $572,000, $411,000, $181,000, and $39,000 for years 1994 through 1998, respectively. Letter of Credit At December 31, 1993 the Company had a $500,000 open letter of credit to cover its guarantee of the payment of the outstanding debt of a Canadian railcar repair facility, in which the Company has a 10% equity interest. This letter of credit must be extended or replaced under the terms of the guarantee. Other The Company provides employment contracts to certain officers for periods of up to three years which provide for certain payments in the event of a change of control and termination of employment. The Company has agreed to provide supplemental retirement benefits to twelve current or former members of management. The benefits accrue over a maximum of 15 years and will result in payments over five years based on the average base rate of pay during the 60 month period prior to retirement as adjusted for length of participation in the plan. Expense for the plan was $429,000 for 1993, $80,000 for 1992 and $38,000 for 1991. As of December 1993, the total estimated future obligation relating to the current participants is $9,031,000 including vested benefits of $1,123,000. In connection with this plan, whole life insurance contracts were purchased on the participants. Insurance premiums of $122,000 and $238,000 were paid during 1993 and 1992, respectively, of which $229,000 has been capitalized to reflect the cash surrender value of these contracts as of December 31, 1993. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 11. SHAREHOLDERS' EQUITY Common Stock PLM International has authorized 50,000,000 shares of common stock at $.01 par value; 10,554,033 shares were issued on February 1, 1988 in connection with the Consolidation which remain outstanding. Common shares have been reserved for the conversion of preferred stock and the exercise of stock options. On December 13, 1991, 343,291 shares of common stock were issued as payment under an acquisition agreement. Of Transcisco's 3,766,667 shares issued in the Consolidation (See Note 1) 400,000 shares were recallable if certain earnings per common share and market price amounts were not met by January 1, 1993. These conditions were not met and the shares were recalled in January 1993. Of the shares recalled from Transcisco, the Company has issued 29,530 of these shares to former participants in the Company's Employee Stock Ownership Plan and is holding the remaining 370,470 shares as treasury stock. In December 1993 as part of a lawsuit settled earlier, the Company reclassified 61,548 shares as treasury stock. Consequently, the total shares outstanding at December 31, 1993, decreased to 10,465,306 from 10,897,324 outstanding at December 31, 1992. Transcisco has emerged from Chapter 11 bankruptcy proceedings and as part of its plan of reorginization will be transfering its shares of PLM International to certain creditors of Trancisco. Preferred Stock PLM International has authorized 10,000,000 shares of preferred stock at $.01 par value; 4,923,077 Series A Cumulative Convertible preferred shares (the "Preferred Stock") were issued on August 21, 1989 to the ESOP for $13.00 per share; as of December 31, 1993, 4,916,301 were outstanding. Each share is entitled to receive a fixed annual dividend of $1.43 and is convertible into and carries voting rights equivalent to a common share (subject to adjustment). The Preferred Stock is redeemable at the option of the Company at anytime after August 21, 1992 at $14.43 per share, decreasing ratably to $13.00 per share anytime after August 21, 1999. In addition, the Preferred Stock is redeemable by the Company at the liquidating value should the ESOP cease to be a "qualified plan" as defined in the Internal Revenue Code or in the event of certain tax law changes. In 1993, 5,831 shares and in 1992, 509 shares were redeemed in accordance with the ESOP. Dividend Restrictions Pursuant to certain credit agreements (see Note 7), at December 31, 1993, the Company is restricted from paying dividends on its common stock until current senior debt levels have been reduced by approximately $15 million to an outstanding principal balance of $30 million. Stock Options The granting of non-qualified stock options to key employees and directors is provided for in plans that reserve up to 660,000 shares of the Company's common stock. The price of the shares issued under option must be at least 85% of the fair market value of the common stock at the date of grant. Vesting of options granted generally occurs in three equal installments of 33 1/3% per year, initiating from the date of grant. In 1992, the previously issued and outstanding stock options were cancelled and replaced with new stock options with a lower per share price which approximated the current market price. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Stock option transactions during 1993 and 1992 are summarized as follows: At December 31, 1993, 193,767 of these options were exercisable. Shareholder Rights On March 12, 1989, the Company adopted a Shareholder Right's Plan ("Plan") under which one common stock purchase right (a "Right") was distributed as a dividend on each outstanding share of common stock. The Plan, which was amended on August 12, 1991 and on January 18, 1993, is designed to protect against unsolicited and coercive attempts to acquire control of PLM International and other abusive tactics. The Plan is not intended to preclude an acquisition of PLM International which is determined to be fair to, and in the best interest of, its shareholders. Upon the occurrence of certain events which may be characterized as unsolicited or abusive attempts to acquire control of the Company, each Right will entitle its holder (other than holders and their affiliates participating in such attempts), to purchase, for the exercise price, shares of the Company's common stock (or in certain circumstances, other securities, cash, or properties) having a fair market value equal to twice the exercise price. In addition, in certain other events involving the sale of the Company or a significant portion of its assets, each Right not owned by the acquiring entity and its affiliates will entitle the holder to purchase, at the Right's exercise price, equity securities of such acquiring entity having a market value equal to twice the exercise price. Previously, the Plan did not provide for the issuance of rights to the holder of preferred stock except upon conversion of the preferred stock into common stock. On January 18, 1993 the Plan was amended to distribute additional rights as a dividend on each outstanding share of the Company's Series A Cumulative Preferred Stock held at the close of business on February 1, 1993. PLM International generally will be entitled to redeem the Rights in whole at a price of one cent per Right at any time prior to the Rights becoming exercisable. The Rights will expire on March 31, 1999 and carry no voting privileges. PLM INTERNATIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 Employee Stock Ownership Plan On August 21, 1989 the Company established a leveraged Employee Stock Ownership Plan ("ESOP"). PLM International issued 4,923,077 shares of Series A Cumulative Convertible Preferred Stock to the ESOP for $13.00 per share, for an aggregate purchase price of $64,000,001. The sale was financed, in part, with the proceeds of a bank loan which proceeds were loaned to the ESOP on terms substantially the same as those in the bank loan agreement (see Note 7). The ESOP debt is secured, in part by preferred shares. As the ESOP makes payments to the Company, it releases shares to be allocated to employee accounts. Interest income earned on the loan to the ESOP by the Company and interest expense due on the bank note each amounted to approximately $1,726,000 for 1993 compared to $2,153,000 for 1992. The ESOP covers substantially all U.S. employees. Cash contributions and total costs are determined by the amount of principal and interest payments required to service the ESOP debt. The primary source for these payments is the dividend on the preferred shares which may be supplemented by Company cash contributions. In 1993 and 1992 there were no cash contributions and no contribution expense. During 1993 and 1992, the reductions in interest rates resulted in the preferred dividend being greater than required to service the interest and principal on the ESOP debt. ESOP cash not required to service the debt was used to reimburse the Company for, or directly pay for, trustee fees and other expenses applicable to the operation of the ESOP and for prepayment of additional principal on the ESOP debt in 1993 and 1992. Preferred dividends are payable semi-annually on February 21 and August 21, which corresponds to the ESOP debt service dates. As of December 31, 1993 and 1992, 1,312,487 and 956,547 preferred shares were allocated to employee accounts, respectively. The ESOP is administered by a trustee. In the event the trustee were to convert Preferred Stock owned by the ESOP trust to Common Stock, the Company would need to make additional contributions to the ESOP trust in an amount equal to the difference between any actual dividends paid on the Company's Common Stock and the principal and interest amounts due in order for the ESOP trust to be able to meet its obligations to the Company under the ESOP note receivable. Conversion of a substantial portion of the Preferred Stock could have a material impact on earnings (loss) per common share for future periods and on the current calculation of fully- diluted earnings (loss) per common share. Certain participants in the Company's incentive compensation plans have agreed to forego incentive compensation up to the amount of any additional contributions to the ESOP trust necessitated by a conversion of all of the ESOP's Preferred Stock in order to reduce the impact on calculations of earnings per common share of such a conversion. 12. TRANSACTIONS WITH AFFILIATES In addition to various fees payable to the Company or its subsidiaries (see Notes 1 and 4), the affiliated partnerships reimburse the Company for certain expenses as allowed in the partnership agreements. Reimbursed expenses totaling approximately $10,000,000 in 1993 and 1992 have been recorded as reductions of expense. Outstanding amounts are paid within normal business terms or treated as a capital contribution if excess organization and offering costs exceed the partnership agreement limitations. The Company amortizes such capital contributions over the estimated life of the partnership. PLM INTERNTIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 13. OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK Off-Balance-Sheet Risk: The Company has entered into interest rate swap agreements to exchange fixed and variable rate interest payment obligations without the exchange of the underlying principal amounts in order to manage interest rate exposures. The agreements have been used to adjust interest on the Company's senior secured debt (see Note 7). Concentrations of Credit Risk: Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments, marketable securities and trade receivables. The Company places its temporary cash investments and marketable securities with financial institutions and other credit worthy issuers and limits the amount of credit exposure to any one party. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base, and their dispersion across different businesses and geographic areas. As of December 31, 1993 and 1992, management believes the Company had no significant concentrations of credit risk. 14. QUARTERLY RESULTS OF OPERATIONS (unaudited) The following is a summary of the quarterly results of operations for the years ended December 31, 1993 and 1992 (in thousands, except per share amounts): In the second quarter of 1992 the Company recorded a restructuring adjustment of $36,000 of which $33,300 was related to revaluation of equipment and related assets. The restructuring adjustment net of its tax benefits decreased net income by $22,300 or $2.13 per common share. PLM INTERNTIONAL, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 In the fourth quarter of 1992, the Company added $2,900 to the restructuring adjustment reflecting lower performance expectations in the aircraft market ($2,300) and the anticipated sale of certain railcars ($600). The Company also recorded $800 of bonus expense. The effect of these adjustments was to reduce fourth quarter net income to common shares by $2,300 or $0.22 per common share. In the fourth quarter of 1993, the Company reduced the carrying value of certain equipment by $1.3 million. This was partially offset by tax credits of $0.2 million and by the revenue generated by the purchase of $61 million for the managed programs. 15. THE COMPANY'S 401(k) SAVINGS PLAN The Company adopted the PLM International Employers Profit Sharing and Tax-Advantaged Savings Plan effective as of February 1, 1988. The plan provides for a deferred compensation arrangement as described in 401(k) of the Internal Revenue Code. The 401(k) Plan is a non-contributing plan and is available to substantially all full-time employees of the Company. In 1993, employees of the Company who participated in the 401(k) Plan could elect to defer and contribute to the trust established under the 401(k) Plan up to $8,999 of pre-tax salary or wages. The Company makes no contributions to the 401(k) Plan. PAGE SCHEDULE I PLM INTERNATIONAL, INC. December 31, 1993 Schedule of Marketable Securities (in thousands) PAGE SCHEDULES V AND VI PLM INTERNATIONAL, INC. Year Ended December 31, 1993 Schedule of Equipment and Accumulated Depreciation (in thousands) PLM INTERNATIONAL, INC. Year Ended December 31, 1992 Schedule of Equipment and Accumulated Depreciation (in thousands) SCHEDULES V AND VI PLM INTERNATIONAL, INC. Year Ended December 31, 1991 Schedule of Equipment and Accumulated Depreciation (in thousands) PAGE SCHEDULE IX PLM INTERNATIONAL, INC. December 31, 1993, 1992 and 1991 SHORT-TERM BORROWINGS (in thousands) PAGE EXHIBIT XI PLM INTERNATIONAL, INC. COMPUTATION OF EARNINGS (LOSS) PER COMMON SHARE (a) Years ended December 31, PAGE EXHIBIT XI, Page 2 PLM INTERNATIONAL, INC. COMPUTATION OF EARNINGS (LOSS) PER COMMON SHARE Years ended December 31,

869844_1993.txt

869844_1993

1993

869844

Item 1. Business The Sears Credit Account Trust 1990 E (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of December 1, 1990 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2. Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in November, 1990 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. 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 Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. 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) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on, or before the Distribution Date each month (on, or the first business day after, the 15th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993 and December 15, 1993. 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. Sears Credit Account Trust 1990 E (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1990 E 8.80% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated February 19, 1991 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest..$88.00 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$88.00 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest.................... $0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods.................................$443,741,135.81 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.................................$117,808,180.74 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$341,853,855.74 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates.................................$91,797,197.02 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$101,887,280.07 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate..................................$26,010,983.72 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest.............$0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest.......................................$0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest..............................................$0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer..........$7,708,333.33 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods.................................$249,999,999.96 15) The aggregate amount of Investment Income during the related Due Periods...........................$3,973,171.52 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year........................................$249,999,999.96 17) The Deficit Accumulation Amount, as of the end of the reportable year.......................................$0.00 18) The aggregate amount which was deposited in the Interest Funding Account in respect of Certificate Interest during the related Due Periods...............$44,000,000.04 19) The total amount on deposit in the Interest Funding Account in respect of Certificate Interest, as of the end of the reportable year...................$22,000,000.02 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1989E November 13, 1989 Sears Credit Account Trust 1990A January 12, 1990 Sears Credit Account Trust 1990B February 22, 1990 Sears Credit Account Trust 1990C July 31, 1990 Sears Credit Account Trust 1990D October 15, 1990 Sears Credit Account Trust 1990E December 1, 1990 It is understood that this report is solely for your information and is not to be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations Report. We found such amounts to be in agreement. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Association as Trustee Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

745448_1993.txt

745448_1993

1993

745448

ITEM 1. BUSINESS. MascoTech, Inc. (formerly Masco Industries, Inc.) is a diversified manufacturer of original equipment and aftermarket parts for the transportation industry; commercial, institutional and residential building products for the construction industry; and other diversified products principally for the defense industry. Sophisticated technology plays a significant role in the Company's businesses and in the design, engineering and manufacturing of many of its products. Transportation-Related Products are manufactured utilizing a variety of metalworking and other process technologies. Although published industry statistics are not available, the Company believes that it is a leading independent producer of many of the industrial component parts that it produces using cold, warm or hot forming processes. In addition to its manufacturing activities, the Company provides design and engineering services primarily for the automotive, heavy truck and aerospace industries. MascoTech was incorporated under the laws of Delaware in 1984 as a wholly-owned subsidiary of Masco Corporation, which in May, 1984 transferred to MascoTech its industrial businesses. The Company became a separate public company in July, 1984 when Masco Corporation distributed shares of Company Common Stock as a special dividend to its stockholders. Masco Corporation currently owns approximately 42 percent of the Company's outstanding Common Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Corporate Development," included in Item 7 of this Report. Except as the context otherwise indicates, the terms "MascoTech" and the "Company" refer to MascoTech, Inc. and its consolidated subsidiaries. RECENT DEVELOPMENTS The Company has undertaken the planned disposition of its energy-related business segment, which consisted of seven business units, as part of its long-term strategic plan to de-leverage its balance sheet and increase the focus on its core operating capabilities. As a result, the Company's financial statements have been reclassified to present such businesses as discontinued operations. These businesses manufactured specialized tools, equipment and other products for energy-related industries. Two of the businesses were sold in late 1993, including one business to the Company's affiliate, TriMas Corporation, and the Company expects to divest the remaining businesses in 1994. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Discontinued Operations," included in Item 7 of this Report. Except as the context otherwise indicates, all information contained herein has been reclassified for these discontinued operations. In July, 1993, the Company issued $216 million (liquidation value) of Dividend Enhanced Convertible StockSM. In late 1993, the Company redeemed for cash its outstanding $100 million of 10% Exchangeable Preferred Stock and, following a call for redemption, the outstanding $187 million of the Company's 6% Convertible Subordinated Debentures due 2011 were converted into 10.4 million shares of Company Common Stock (including approximately 7 million shares issued to Masco Corporation). In early 1994, the Company issued, in a public offering, $345 million of 4 1/2% Convertible Subordinated Debentures due 2003 which are convertible into Company Common Stock at $31.00 per share. The net proceeds from this offering were used to redeem, on February 1, 1994, the outstanding $250 million of the Company's 10 1/4% Senior Subordinated Notes due 1997 and reduce outstanding bank debt. INDUSTRY SEGMENTS The following table sets forth for the three years ended December 31, 1993, the contribution of the Company's continuing industry segments to net sales and operating profit: - ------------------------- (1) Results in 1992 and 1991 have been reclassified to conform with the presentation adopted in 1993 (including amounts for discontinued operations -- see the Note to the Company's Consolidated Financial Statements captioned "Discontinued Operations" included in Item 8 of this Report). (2) Amounts are before general corporate expense. Additional financial information concerning the Company's operations by industry segments as of and for the three years ended December 31, 1993, is set forth in Item 8 of this Report in the Note to the Company's Consolidated Financial Statements captioned "Segment Information." TRANSPORTATION-RELATED PRODUCTS The Company manufactures a broad range of semi-finished components, subassemblies and assemblies for the transportation industry. Transportation-Related Products represented 76 percent of 1993 sales from continuing operations and primarily consist of original equipment products for the automotive and truck industries. The Company's products include a number of high-performance products for which reliability, quality and certainty of supply are major factors in customers' selection of suppliers. Over half of the products are used for engine and drivetrain applications (such as semi-finished transmission shafts, drive gears, engine connecting rods, wheel spindles and front wheel drive and exhaust system components) and for chassis and suspension functions (including electromechanical solenoids and relays and suspension components). Products manufactured for exterior body trim applications include automotive trim, luggage racks and accessories, and metal stampings. Aftermarket products include fuel and emission systems components, windshield wiper blades, constant-velocity joints, brake hardware repair kits, and luggage racks and accessories. In addition to its manufacturing activities, the Company provides engineering services primarily for the automotive and heavy-duty truck industries, and is engaged in specialty vehicle development and conversion programs. Products are manufactured using various metalworking technologies, including cold, warm and hot forming, powdered metal forming and stamping. Approximately one-quarter of the Company's sales of Transportation-Related Products resulted from using cold, warm or hot metal forming technologies. The Company believes that its metalworking technologies provide cost-competitive, high-performance, quality components that are required in order to meet the increasing demands of the automotive and truck markets it serves. Approximately 85 percent of the Company's Transportation-Related Products sales in 1993 were original equipment automotive products and services. Sales to original equipment manufacturers are made through factory sales personnel and independent sales representatives. During 1993, sales to various divisions and subsidiaries of Ford Motor Company, General Motors Corporation and Chrysler Corporation accounted for approximately 20 percent, 14 percent and 12 percent, respectively, of the Company's net sales. Sales to the automotive aftermarket are made primarily to distributors utilizing factory sales and service personnel. SPECIALTY PRODUCTS Architectural Products The Company manufactures a variety of Architectural Products for commercial, institutional and residential markets. Products include steel doors and frames; stainable and low maintenance steel doors; wood windows and aluminum-clad wood windows; leaded, etched and beveled glass for decorative windows and entryways; residential entry systems; garage doors; sectional and rolling doors; security grilles; and modular metal partitions. The Company's commercial and institutional markets include office buildings, factories, hotels, schools, hospitals, retail stores and malls, warehouses and mini-warehouses. Residential markets include single family new construction as well as repair and remodeling. Architectural Products are sold principally to wholesale distributors who sell the products to builders, developers, dealers, retailers (such as do-it-yourself home centers) and residential, commercial, industrial and institutional end users. Security grilles are sold directly to builders, developers and end users. Other Specialty Products The Company's Other Specialty Products consist primarily of Defense Products, including large diameter cold formed cartridge cases, projectiles and casings for rocket motors and missiles for the United States government and its suppliers. Changes in government procurement practices and requirements have adversely affected orders, sales and profits of such products in recent years and are expected to continue to do so in the future. As a result, the Company is pursuing other commercial applications for the resources related to the manufacturing of Defense Products, including its metal forging capability and waste-water treatment capability. Since obtaining the necessary permits in 1990, the Company has marketed waste-water treatment services to other industrial companies principally in southern California. The Company's government contracts contain standard clauses providing for termination at the convenience of the government which, in such cases, would provide the Company with compensation for work performed and costs of termination. Defense Products are sold both directly to the federal government and to other prime contractors to the federal government. GENERAL INFORMATION CONCERNING INDUSTRY SEGMENTS No material portion of the Company's business is seasonal or has special working capital requirements. The Company does not consider backlog orders to be a material factor in its industry segments, and, except as noted above, no material portion of its business in its other industry segments is dependent upon any one customer or subject to renegotiation of profits or termination of contracts at the election of the federal government. Compliance with federal, state and local regulations relating to the discharge of materials into the environment, or otherwise relating to the protection of the environment, is not expected to result in material capital expenditures by the Company or to have a material effect on the Company's earnings or competitive position. See, however, "Legal Proceedings," included as Item 3 of this Report, for a discussion of certain pending proceedings concerning environmental matters. In general, raw materials required by the Company are obtainable from various sources and in the quantities desired. INTERNATIONAL OPERATIONS The Company, through its subsidiaries, has businesses located in Canada, Germany, Italy and the United Kingdom. Products manufactured by the Company outside of the United States include forged automotive component parts, constant-velocity joints and extruded urethane lineals. In addition, the Company provides engineering services outside of the United States, primarily serving automotive manufacturers in the United Kingdom and Germany. For 1991 through 1993, the Company's annual net export sales from the United States to other countries, as a percentage of annual consolidated net sales from continuing operations, approximated five percent. The Company's foreign operations are subject to political, monetary, economic and other risks attendant generally to international businesses. These risks generally vary from country to country. EQUITY INVESTMENTS TriMas Corporation The Company owns approximately 43 percent of the outstanding common stock of TriMas Corporation ("TriMas"). The Company's common equity interest in TriMas increased from 28 percent as a result of the late 1993 conversion of TriMas convertible preferred stock held by the Company into 7.8 million shares of TriMas common stock. TriMas manufactures a number of industrial products, including a variety of steel, stainless steel, aluminum and other non-ferrous fasteners for the building construction, farm implement, medium and heavy-duty truck, appliance, aerospace, electronics and other industries. TriMas also provides metal treating services for manufacturers of fasteners and comparable products. TriMas manufactures towing systems products, including vehicle hitches, jacks, winches, couplers and related accessories for the passenger car, light truck, recreational vehicle, marine, agricultural and industrial markets. TriMas also manufactures specialty container products, including industrial container closures, sealing caps and dispensing spigots primarily for the chemical, agricultural, food, petroleum and health care industries, as well as high-pressure seamless compressed gas cylinders used for shipping, storing and dispensing oxygen, nitrogen, argon and helium, specialty industrial gaskets for refining, petrochemical and other industrial applications, and a complete line of low-pressure welded cylinders used to contain and dispense acetylene gas for the welding and cutting industries. In addition, TriMas manufactures flame-retardant facings and jacketings used in conjunction with fiberglass insulation, principally for commercial and industrial construction applications, pressure-sensitive specialty tape products and a variety of specialty precision tools such as center drills, cutters, end mills, reamers, master gears, gages and punches. Emco Limited The Company owns approximately 43 percent of the outstanding common stock and convertible debentures of Emco Limited ("Emco"), as a result of the transactions described under "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Corporate Development," included in Item 7 of this Report. Emco is a major, publicly traded, Canadian-based manufacturer and distributor of building and home improvement products, including roofing materials, wood fiber products, vinyl siding, stainless steel sinks and vinyl windows, and a distributor of plumbing and related products. In addition, Emco manufactures and distributes worldwide fluid handling equipment for the petroleum and petrochemical and other industries, and produces custom components, brass and aluminum forgings, plastic components, tools, dies and molds. Emco also provides other services on a contract basis for original equipment manufacturers and others. Titan Wheel International, Inc. The Company owns approximately 21 percent of the outstanding common stock of Titan Wheel International, Inc. ("Titan"), as a result of the transactions described in the Note to the Company's Consolidated Financial Statements captioned "Equity and Other Investments in Affiliates," included in Item 8 of this Report. Titan is a manufacturer of wheels and other products for agricultural, construction and other off-highway equipment. Other Equity Investments The Company has equity investments in several other companies which are engaged in activities related to the Company's businesses, including the manufacture of plastic component parts utilizing the reaction injection molding process, primarily for the automotive and truck industries, and the manufacture of electrical and electronic components, primarily for the automotive and truck industries. PATENTS AND TRADEMARKS The Company holds a number of patents, patent applications, licenses, trademarks and trade names. The Company considers its patents, patent applications, licenses, trademarks and trade names to be valuable, but does not believe that there is any reasonable likelihood of a loss of such rights which would have a material adverse effect on the Company's industry segments or its present business as a whole. COMPETITION The major domestic and foreign markets for the Company's products in its industry segments are highly competitive. Competition is based primarily on price, performance, quality and service, with the relative importance of such factors varying among products. Government procurement practices are an additional factor in the case of Defense Products. In the case of Transportation-Related Products, the Company's competitors include a large number of other well-established independent manufacturers as well as certain customers who have their own metalworking and engineering capabilities. Although a number of companies of varying size compete with the Company in its industry segments, no single competitor is in substantial competition with the Company with respect to more than a few of its product lines and services. EMPLOYEES At December 31, 1993, the Company employed approximately 12,200 people. Satisfactory relations have generally prevailed between the Company and its employees. ITEM 2. ITEM 2. PROPERTIES. The following list includes the Company's principal manufacturing facilities by location and the industry segments utilizing such facilities: Arizona..............Chandler (2) California...........Santa Fe Springs (4), Vernon (3) and Yuba City (1) Florida..............Auburndale (2), Deerfield Beach (1) and Orlando (2) Georgia..............Adel (1), Lawrenceville (1) and Valdosta (1) Indiana..............Kendallville (1) Iowa.................Dubuque (2) Kentucky.............Nicholasville (1) Michigan.............Auburn Hills (1)(1), Brighton (1), Burton (1), Coopersville (1), Detroit (1)(1)(1), Farmington Hills (1), Fraser (1), Green Oak Township (1 and 3), Hamburg (1 and 3), Holland (1), Livonia (1), Mesick (1), Mt. Clemens (1), Oxford (1) (1) (1), Port Huron (1), Redford (1), Roseville (1), Royal Oak (1), Shelby Township (1), St. Clair (1), St. Clair Shores (1), Sterling Heights (1), Traverse City (1) (1) (1) (1) (1), Troy (1)(1), Warren (1) (1), West Branch (2) and Ypsilanti (1) Mississippi..........Nesbit (2) New York.............Brooklyn (2) and Maspeth (2) Ohio.................Blue Ash (2), Bluffton (1), Canal Fulton (1), Columbus (2), Lima (1), Minerva (1), Perrysburg (2), Port Clinton (1) and Upper Sandusky (1) Oklahoma.............Tulsa (4) Pennsylvania.........Ridgway (1) Texas................Bryan (4), Dallas (4), Greenville (4) and Houston (4) (4) (4) Virginia.............Duffield (1) Germany..............Riedstadt (2) and Zell am Harmersbach (1 and 3) Italy................Poggio Rusco (1) United Kingdom.......Wednesfield, England (1) Note: Multiple footnotes within the same parenthesis indicate the facility is engaged in significant activities relating to more than one segment. Multiple footnotes to the same municipality denote separate facilities in that location. Industry segments in the preceding table are identified as follows: (1) Transportation-Related Products; (2) Specialty Products -- Architectural; (3) Specialty Products -- Other; and (4) Discontinued Operations. The Company's largest manufacturing facility is located in Vernon, California and is a multi-plant facility of approximately 920,000 square feet. The Company owns the largest plant, comprising approximately 540,000 square feet and operates the remaining portions of this facility under leases, the earliest of which expires at the end of 1994. Except for the foregoing facility and an additional manufacturing facility covering approximately 605,000 square feet, the Company's manufacturing facilities range in size from approximately 25,000 square feet to 325,000 square feet, are owned by the Company or leased, and are not subject to significant encumbrances. The Company's executive offices are located in Taylor, Michigan, and are provided by Masco Corporation to the Company under a corporate services agreement. The Company's buildings, machinery and equipment have been generally well maintained, are in good operating condition, and are adequate for current production requirements. The following list identifies the manufacturing facilities of TriMas by location and the industry segments utilizing such facilities: California.................... Commerce(a) Illinois...................... Wood Dale(a) Indiana....................... Auburn(c), Elkhart(b), Frankfort(a) and Mongo(b) Louisiana..................... Baton Rouge(c) Massachusetts................. Plymouth(d) Michigan...................... Canton(b), Detroit(a) and Warren(d)(d)(d)(d) New Jersey.................... Edison(d), Netcong(d) and North Bergen(d) Ohio.......................... Lakewood(a) Texas......................... Houston(c) and Longview(c) Wisconsin..................... Mosinee(b) Australia..................... Dandenong South, Victoria(b) Canada........................ Brampton, Ontario(c), Fort Erie, Ontario(c) and Oakville, Ontario(b) Mexico........................ Mexico City(c) Note: Multiple footnotes to the same municipality denote separate facilities in that location. Industry segments in the preceding table are identified as follows: (a) Specialty Fasteners; (b) Towing Systems; (c) Specialty Container Products; and (d) Corporate Companies. TriMas' buildings, machinery and equipment have been generally well maintained, are in good operating condition, and are adequate for current production requirements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. A civil suit was filed in the United States District Court for the Central District of California in April, 1983 by the United States of America and the State of California against 30 defendants, including the Company's NI Industries, Inc. subsidiary ("NI"), for alleged release into the environment of hazardous waste disposed of at the Stringfellow Disposal Site in California. The plaintiffs have requested, among other things, that the defendants clean up the contamination at that site. A consent decree has been entered into by the plaintiffs and the defendants, including NI, providing that the consenting parties perform partial remediation at the site. Another civil suit was filed in the United States District Court for the Central District of California in December, 1988 by the United States of America and the State of California against more than 180 defendants, including NI, for alleged release into the environment of hazardous waste disposed of at the Operating Industries, Inc. site in California. This site served for many years as a depository for municipal and industrial waste. The plaintiffs have requested, among other things, that the defendants clean up the contamination at that site. Two partial consent decrees have been entered into by the plaintiffs and a group of the defendants, including NI, providing that the consenting parties perform certain interim remedial work at the site and reimburse the plaintiffs for certain past costs incurred by the plaintiffs at the site. Based upon its present knowledge, and subject to future legal and factual developments, the Company does not believe that any of this litigation will have a material adverse effect on its consolidated financial position. In November, 1993 the California Environmental Protection Agency issued a proposed enforcement order and a tentative civil penalty in the amount of $180,000 against the Company's subsidiary, NI Industries, Inc., principally on account of alleged past violations of certain California environmental laws and regulations relating to the subsidiary's handling of waste material and relating to its permit allowing it to treat industrial waste. The proposed enforcement order is under negotiation and is not yet final. During the fourth quarter of 1991, a division of the Company was assessed a civil penalty in excess of $100,000 by a municipal sewer authority for alleged past violations of limitations of waste-water discharges into the authority's sanitary sewer system. This assessment was appealed by the division, and the appeal is pending. The division is now in compliance with all applicable waste-water discharge requirements and the Company believes that the costs of penalties, if paid, would be immaterial to the Company. The Company is subject to other claims and litigation in the ordinary course of its business, but does not believe that any such claim or litigation will have a material adverse effect on its consolidated financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. SUPPLEMENTARY ITEM. EXECUTIVE OFFICERS OF REGISTRANT (PURSUANT TO INSTRUCTION 3 TO ITEM 401(B) OF REGULATION S-K). Each of the executive officers is elected to a term of one year or less and serves at the discretion of the Board of Directors. Mr. Manoogian is and has been for over five years a Director, Chairman of the Board and the Chief Executive Officer of Masco Corporation, an affiliate of the Company that is a manufacturer of building and home improvement and home furnishings products for the home and family. Mr. Manoogian also is a Director and Chairman of the Board of TriMas Corporation. Mr. Gardner was appointed President and Chief Operating Officer of the Company in October, 1992. Prior to his appointment, Mr. Gardner was President -- Automotive. He joined the Company in 1987, and in 1990 assumed responsibility for all of the Company's businesses serving the transportation industry. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock commenced trading on the New York Stock Exchange ("NYSE") on June 23, 1993 under the symbol "MSX." The Company's Common Stock was previously traded over-the-counter and quoted on the National Association of Securities Dealers Automated Quotation System -- National Market System ("NASDAQ-NMS") under the symbol "MASX." The following table sets forth for the periods indicated the high and low sales prices of the Company's Common Stock as reported on the NASDAQ-NMS for the periods prior to June 23, 1993 and as reported on the NYSE Composite Tape commencing June 23, 1993: On March 15, 1994 there were approximately 5,600 holders of record of the Company's Common Stock. The Company commenced paying cash dividends on its Common Stock in August, 1993 and to date has declared four and paid three quarterly dividends, each in the amount of $.02 per share. Future declarations of dividends on the Common Stock are discretionary with the Board of Directors and will depend upon the Company's earnings, capital requirements, financial condition and other factors. Dividends may not be paid on Company Common Stock if there are any dividend arrearages on the Company's outstanding Preferred Stock. In addition, certain of the Company's long-term debt instruments contain provisions that restrict the dividends that it may pay on its capital stock. See the Note to the Company's Consolidated Financial Statements captioned "Long-Term Debt," included in Item 8 of this Report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following table sets forth summary consolidated financial information of the Company, for the years and dates indicated (information related to the statements of income and, in 1993, the balance sheet, have been reclassified for discontinued operations): Results for 1993 and 1992 include pre-tax income of approximately $9 million and $25 million, respectively, as a result of gains associated with the sale of common stock through public offerings by equity affiliates and, in 1992, a prepayment premium related to the redemption of debentures held by the Company. This income was largely offset by costs and expenses related to cost-reduction initiatives, the restructuring of certain operations and product lines, adjustments to the carrying value of certain long-term assets, and other costs and expenses. Results for 1993 were reduced by a charge of approximately $.03 per common share reflecting the increased 1993 federal corporate income tax rate related to adjusting deferred tax balances as of December 31, 1992 for the higher income tax rate. Results for 1993 are before the effect of a $5.8 million pre-tax extraordinary charge ($3.7 million after-tax or $.06 per common share) related to the early extinguishment of subordinated debt (see the Note to the Company's Consolidated Financial Statements captioned "Long-Term Debt," included in Item 8 of this Report). 1993 results are also before an after-tax charge of approximately $22 million ($.39 per common share) related to the disposition of a segment of the Company's business (see the Note to the Company's Consolidated Financial Statements captioned "Discontinued Operations," included in Item 8 of this Report). Net income for 1993 before preferred stock dividends was $47.6 million or $.57 per common share. Income from continuing operations per common share in 1993 is presented on a fully diluted basis. Primary earnings from continuing operations per common share were $.97 in 1993. For years 1989 through 1992, the assumed conversion of dilutive securities is anti-dilutive. Income from continuing operations before extraordinary loss attributable to common stock was $56.0 million and $29.7 million after preferred stock dividends in 1993 and 1992, respectively. Results for 1991 include the effect of charges for restructurings and other costs, aggregating approximately $41 million pre-tax, which reduced operating profit by $27 million, income from continuing operations before extraordinary income by $27 million and earnings per common share by $.45. Loss from continuing operations attributable to common stock in 1991 was $20.0 million after preferred stock dividends. Results for 1990 include the effect of charges for restructurings and other costs, aggregating approximately $40 million pre-tax, which reduced operating profit by $38 million, income from continuing operations before extraordinary income by $26 million and earnings per common share by $.35. Net loss in 1990 was $18.6 million or $.25 per common share after inclusion of extraordinary income of $8.2 million or $.11 per common share related to the early extinguishment of debt. Results for 1989 include the effect of charges for restructurings and other costs, aggregating approximately $54 million pre-tax, which reduced operating profit by $39 million, income from continuing operations before extraordinary income by $36 million and earnings per common share by $.45. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. MASCOTECH Masco Corporation undertook a major corporate restructuring during 1984, transferring its Products for Industry businesses to the Company at their historical net book value. MascoTech became a separate public company in mid-1984, when Masco Corporation distributed common shares of MascoTech as a special dividend to its shareholders. At December 31, 1993, Masco Corporation owned approximately 42 percent of MascoTech Common Stock. In 1993 the Company changed its name to MascoTech, Inc. from Masco Industries, Inc. to reflect the significance of technology in the design, engineering and manufacturing of many of the Company's products. CORPORATE DEVELOPMENT Since mid-1984, the Company has acquired a number of businesses for approximately $650 million in cash and Company Common Stock. These acquisitions have contributed significantly to the more than tripling of the sales volume of the Company during this time. The Company has invested more than $1.2 billion in capital expenditures and acquisitions combined to build up the Company's technological positions in its industrial markets. Since late 1988 the Company has divested several operations as part of its long-term strategic plan to de-leverage its balance sheet and focus on its core operating capabilities. The Company's divestiture activity included several businesses transferred to its equity affiliate, TriMas Corporation ("TriMas"), and in late 1993 the announcement of the Company's plan to dispose of its energy-related business segment. In addition to its continuing common equity ownership interest in TriMas (43 percent at December 31, 1993), the Company has realized cash proceeds of approximately $400 million through December 31, 1993 from its divestiture activity which has been applied to reduce the Company's indebtedness. In early 1993, the Company acquired from Masco Corporation 10 million shares of Company Common Stock, $77.5 million of the Company's 12% Exchangeable Preferred Stock held by Masco Corporation, and Masco Corporation's holdings of Emco Limited ("Emco") common stock and convertible debentures. In exchange, Masco Corporation received from the Company $87.5 million in cash, $100 million of the Company's 10% Exchangeable Preferred Stock (subsequently redeemed in 1993) and seven-year warrants to purchase 10 million shares of Company Common Stock at $13 per share. As part of this transaction, as modified in late 1993, Masco Corporation agreed to purchase from the Company, at the Company's option through March, 1997, up to $200 million of subordinated debentures. As a result of these transactions, the Company owns approximately 43 percent of the outstanding common stock and convertible debentures of Emco, a major, publicly traded, Canadian-based manufacturer and distributor principally of building and other industrial products with annual sales of approximately $800 million in 1993. DISCONTINUED OPERATIONS In late November, 1993, the Company adopted a formal plan to divest its energy-related business segment which consisted of seven business units. Accordingly, the applicable financial statements and related notes have been reclassified to present such energy-related segment as discontinued operations and include a 1993 fourth quarter charge of approximately $22 million after-tax to reflect the estimated loss from the disposition of this segment. During 1993, two energy-related business units were sold for approximately $93 million, including the sale of one business unit to the Company's equity affiliate, TriMas, for $60 million. The remaining five energy-related business units had net assets at December 31, 1993 of approximately $68 million (adjusted to reflect the anticipated loss upon disposition, net of tax benefit) and are expected to be disposed of during 1994. Net sales attributable to the discontinued operations during 1993 (through the decision to discontinue), 1992 and 1991 were $192 million, $202 million and $201 million, respectively. The discontinued operations had operating profit of approximately $6 million, $3 million and $1 million in 1993, 1992 and 1991, respectively. PROFIT MARGINS -- CONTINUING OPERATIONS Operating profit margin from continuing operations was nine percent in 1993, eight percent in 1992 and three percent in 1991. The increase in the operating profit margin from continuing operations in 1993 compared with the previous two years is primarily attributable to increased sales volumes in the Transportation-Related Products segment, and from the benefits of internal cost reductions and restructuring initiatives undertaken in recent years. Margins in 1993 related to the Company's Specialty Products segment continue to be hampered by the depressed industry conditions affecting the construction and defense markets that the Company serves. Operating profit from continuing operations was reduced by significant charges aggregating approximately $27 million in 1991. These charges reflect expenses related to the discontinuance of product lines, costs related to the restructuring of several businesses and other expenses. Of these charges, approximately $15 million in 1991 relate to the Company's automotive vehicle conversion business, which has been restructured and returned to profitability. In addition, margins from continuing operations were negatively impacted in 1991 as a result of reduced sales volumes in certain of the Company's Transportation-Related Products operations, due to production cutbacks by automotive customers, and in virtually all of the Company's other product groups due to recessionary market conditions. CASH FLOWS AND CAPITAL EXPENDITURES Net cash flow from operating activities, including discontinued operations, increased to $100 million in 1993 from $58 million in 1992 principally as a result of improved operating performance. In 1993, the Company received approximately $210 million from the issuance of equity (6% Dividend Enhanced Convertible StockSM -- the "DECS") and $93 million from the sale of two energy-related businesses. These proceeds were applied to reduce the Company's indebtedness. The Company redeemed $100 million of non-convertible preferred stock for cash and, in early 1993, the Company invested $87.5 million as described in Corporate Development. During 1991 and 1992, the Company received approximately $260 million in cash from the disposition of its investment in Masco Capital (during 1991 the Company had advanced Masco Capital approximately $44 million to fund debt repayment obligations and working capital requirements) and from the early redemption by TriMas, including a prepayment premium, of TriMas' subordinated debentures held by the Company. These proceeds were applied to reduce the Company's indebtedness in late 1991 and 1992. From January 1, 1991 to December 31, 1993, the Company repaid or repurchased over $380 million, net, of its outstanding debt, and an additional $187 million of convertible debt was converted to Company Common Stock. The Company has substantial new business opportunities over the next few years in its Transportation-Related Products segment which are anticipated to require an increase from the recent level of capital expenditures and increased working capital needs. INVENTORIES The Company's investment in inventories decreased to $140 million at December 31, 1993. This decrease was the result of the sale during 1993 of a portion of the Company's energy-related segment and the reclassification of the remaining inventories in the energy-related segment at December 31, 1993 into net assets of discontinued operations. The Company's continued emphasis on inventory management, utilizing Just-In-Time (JIT) and other inventory management techniques has contributed to higher inventory turnover rates in recent years. FINANCIAL POSITION AND LIQUIDITY During 1993, the Company's financial position was substantially improved as the Company's equity increased by approximately $314 million while its total indebtedness decreased by approximately $339 million. This improvement in financial position resulted from the Company's positive operating performance, the issuance of the DECS, the conversion of the Company's previously outstanding convertible debt into Company Common Stock and from the collection of $93 million of proceeds related to the sale of two of the Company's energy-related businesses. The Company also redeemed its $100 million of 10% Exchangeable Preferred Stock with significantly lower cost bank borrowings, and invested $87.5 million as part of the transactions whereby it acquired the Emco holdings. The Company's financial flexibility and liquidity were also substantially improved during 1993. In September, 1993, the Company entered into a new $675 million revolving credit agreement, replacing a prior bank agreement which required principal payments commencing September 30, 1993. Amounts outstanding under this new agreement are due in January, 1997; however, under certain circumstances the due date may be extended until July, 1998. In addition, the Company in early 1994 sold $345 million of 4 1/2% Convertible Subordinated Debentures due 2003. The proceeds from this offering were used to redeem $250 million of 10 1/4% Subordinated Notes (called in late 1993 for redemption on February 1, 1994) and to retire other indebtedness. The Company at December 31, 1993 had cash and cash investments of $83 million. As a result of the above mentioned transactions, the Company's debt as a percent of debt plus equity was reduced to 54 percent at December 31, 1993 from 76 percent at December 31, 1992. In addition, the Company's annual financing costs have been reduced by approximately $20 million after-tax. As of December 31, 1993, adjusted on a pro forma basis for the issuance in early 1994 of the 4 1/2% Convertible Debentures, the Company had floating rate debt of approximately $213 million (at a current interest rate of approximately 4%) and $578 million of fixed rate debt (at a weighted average interest rate of under 7%). At December 31, 1993 current assets, which aggregated approximately $556 million, were approximately three times current liabilities. In addition, the Company has significant financial assets, including 20 percent or more ownership positions in the securities of three publicly traded companies with an aggregate carrying value of approximately $137 million. This compares with an aggregate quoted market value at December 31, 1993 (which may differ from the amounts that would have been realized upon disposition) of approximately $524 million. The Company's cash, additional borrowings available under the Company's new revolving credit agreement and anticipated internal cash flow are expected to provide sufficient liquidity to fund its near-term working capital and other investment needs. The Company believes that its longer-term working capital and other general corporate requirements, including the retirement of Senior Subordinated Notes maturing in 1995, will be satisfied through its internal cash flow, proceeds from the early 1994 issuance of the 4 1/2% Convertible Debentures, divestiture of the remaining businesses in the energy-related segment, other nonstrategic operating assets and certain additional financial assets and, to the extent necessary, future financings in the financial markets. GENERAL FINANCIAL ANALYSIS 1993 versus 1992 -- Continuing Operations In 1993, net sales from continuing operations increased nine percent to $1.58 billion from $1.46 billion in 1992. Income from continuing operations in 1993, after preferred stock dividends, was $56.0 million or $.91 per common share, assuming full dilution, compared with income from continuing operations, after preferred stock dividends, of $29.7 million or $.49 per common share in 1992. Including the results of discontinued operations and the loss upon disposition of those businesses, and an extraordinary loss ($3.7 million after-tax) related to the early extinguishment of debt, earnings for 1993 after preferred stock dividends were $.57 per common share, compared with earnings, after preferred stock dividends, of $.48 per common share in 1992. Sales of Transportation-Related Products increased 13 percent, principally due to increased levels of automotive production. Sales also benefitted from new product introductions which were partially offset by the phase-out of existing programs, including the mid-1993 completion of the Company's conversion program for the Ford Mustang convertible. Operating profit in 1993 for Transportation- Related Products increased to $160 million from $124 million in 1992. Operating margins, in 1993, continued to be favorably impacted by higher sales volumes for most of the Company's Transportation-Related Products. Margins in both 1993 and 1992 have benefitted from the internal cost reductions and restructuring initiatives that the Company has undertaken in recent years. Sales of Specialty Products in 1993 decreased approximately two percent from 1992 levels reflecting the continued unfavorable market conditions for the Company's Architectural and Defense Products. Operating profit declined to $1 million in 1993 from $5 million in 1992 as the result of the $4 million operating loss for Architectural Products in 1993. This loss was principally the result of costs and expenses related to the consolidation of certain operating activities, start-up costs associated with a new manufacturing process and the unfavorable conditions existing in the markets served by these products. Other expense, net decreased to $25 million in 1993 from $44 million in 1992. Other expense, net in 1993 benefitted from reduced interest expense resulting from a reduction in debt and lower interest rates; and from increased equity and interest income from affiliates related primarily to the Company's Emco holdings. Additionally, 1993 and 1992 results benefitted from gains from sales of marketable securities of approximately $11.5 million and $4.0 million, respectively. Other expense, net for 1993 and 1992 include gains aggregating approximately $13 million and $25 million pre-tax, respectively. These gains resulted from the sale of stock through public offerings by equity affiliates (including in 1993, affiliate shares held by the Company) and, in 1992, a prepayment premium related to the redemption of debentures held by the Company. The Company's equity affiliates may, from time to time, issue additional common equity depending upon their financing requirements. This income was largely offset by costs and expenses related to cost reduction initiatives, the restructuring of certain operations and product lines, adjustments to the carrying values of certain long-term assets and other costs and expenses. Earnings in 1993 were reduced by an extraordinary charge of $3.7 million after-tax related to the early extinguishment of debt. Although the federal statutory corporate tax rate increased in 1993, the Company's effective tax rate on income from continuing operations declined slightly in 1993 as compared with 1992. This decrease was the result of the relationship of substantially higher pre-tax income in 1993 to certain book expenses that are not deductible for tax purposes and to the Company's foreign and state tax expenses. In addition, the application of the increased tax rate to deferred tax balances at December 31, 1992 resulted in a 1993 third quarter one-time charge of approximately $.03 per common share. 1992 versus 1991 -- Continuing Operations In 1992, net sales from continuing operations increased 15 percent to $1.46 billion from $1.27 billion in 1991. Income from continuing operations in 1992, after preferred stock dividends, was $29.7 million or $.49 per common share, compared with a loss from continuing operations, after preferred stock dividends, of $20.0 million or $.33 per common share in 1991. Sales of Transportation-Related Products increased 21 percent due to a modest improvement in levels of automotive production, increased market penetration and the inclusion of a full year of Creative Industries Group sales. Excluding the acquisition of Creative Industries Group, 1992 Transportation-Related Products sales would have increased 16 percent. Operating profit in 1992 for Transportation-Related Products increased 68 percent to $124 million from $74 million in 1991. Operating margins, in 1992, were favorably impacted by higher sales volumes for most of the Company's Transportation-Related Products. In addition, 1992 margins have benefitted from the internal cost reductions and restructuring initiatives that the Company has undertaken in recent years. Sales of Specialty Products were generally unchanged from 1991, as a seven percent increase in sales of Architectural Products was substantially offset by reduced sales of Other Specialty Products. Operating profit for Specialty Products in 1992 was $5 million compared with an operating loss of $15 million in 1991. This improvement resulted principally from improved operating performance of the Architectural Products group which had operating profit of $2 million in 1992 compared with a loss of $16 million in 1991. The 1991 Architectural Products group results were impacted by $8 million of charges related to discontinuance of product lines, restructuring costs and other expenses. Other expense, net decreased to $44 million in 1992 from $56 million in 1991. Other expense, net in 1992 benefitted from reduced interest expense resulting from a reduction in debt and lower interest rates. This was partially offset by reduced interest income as a result of the redemptions of TriMas subordinated debentures previously held by the Company and lower income from sales of marketable securities. Other expense, net for 1992 benefitted from the inclusion of income aggregating approximately $25 million pre-tax in the second quarter resulting from a prepayment premium related to the redemption by TriMas of the subordinated debentures held by the Company, and from the change in the Company's common equity ownership interest in TriMas. This income was substantially offset by costs and expenses aggregating approximately $21 million pre-tax in the second quarter (of which $15 million is included in other expense) related to the restructuring of certain operations, and for adjustments to the carrying values of certain long-term assets. Other expense, net in 1991 benefitted from the inclusion of an approximate $22 million gain related to the disposition of certain operations and reduced interest expense, principally as a result of lower interest rates. Additionally, net gains from sales of marketable securities, including the effect of valuation allowances, aggregated approximately $12 million in 1991. The Company's effective tax rate exceeds the statutory rate primarily as a result of the impact of state taxes and nondeductible amortization. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of MascoTech, Inc.: We have audited the accompanying consolidated balance sheet of MascoTech, Inc. and subsidiaries (formerly Masco Industries, Inc.) as of December 31, 1993 and 1992, and the related consolidated statements of income and cash flows for each of the three years in the period ended December 31, 1993, and the financial statement schedules as listed in Item 14(a)(2)(i) 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 MascoTech, 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. COOPERS & LYBRAND Detroit, Michigan February 24, 1994 MASCOTECH, INC. CONSOLIDATED BALANCE SHEET DECEMBER 31, 1993 AND 1992 The accompanying notes are an integral part of the consolidated financial statements. MASCOTECH, INC. CONSOLIDATED STATEMENT OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------------------- * Anti-dilutive The accompanying notes are an integral part of the consolidated financial statements. MASCOTECH, INC. CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes are an integral part of the consolidated financial statements. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ACCOUNTING POLICIES: Principles of Consolidation. The consolidated financial statements include the accounts of the Company and all majority-owned subsidiaries. All significant intercompany transactions have been eliminated. Corporations that are 20 to 50 percent owned are accounted for by the equity method of accounting. Capital transactions by equity affiliates at amounts differing from the Company's carrying amount are reflected in other income or expense and the investment in affiliates account. Certain amounts for the years ended December 31, 1992 and 1991 have been reclassified to conform to the presentation adopted in 1993. The statements of income and cash flows for 1993, 1992 and 1991 and related notes have been reclassified to present the Energy-related segment as discontinued operations. In addition, the balance sheet as of December 31, 1993 reflects the Energy-related segment as discontinued operations (see "Discontinued Operations" note). The balance sheet as of December 31, 1992 has not been reclassified for discontinued operations. Effective June 23, 1993 the Company changed its name to MascoTech, Inc. from Masco Industries, Inc. The Company has a corporate services agreement with Masco Corporation, which at December 31, 1993 owned approximately 42 percent of the Company's Common Stock. Under the terms of the agreement, the Company pays fees to Masco Corporation for various corporate staff support and administrative services, research and development and facilities. Such fees, which are determined principally as a percentage of net sales, including net sales related to discontinued operations, aggregated approximately $11 million in each of 1993, 1992 and 1991. Cash and Cash Investments. The Company considers all highly liquid debt instruments with an initial maturity of three months or less to be cash and cash investments. The carrying amount reported in the balance sheet for cash and cash investments approximates fair value. At December 31, 1993, the Company has $33 million on deposit with a German bank that is subject to currency exchange rate fluctuations. Receivables. Receivables are presented net of allowances for doubtful accounts of $5.1 million and $7.2 million at December 31, 1993 and 1992, respectively. Inventories. Inventories are stated at the lower of cost or net realizable value, with cost determined principally by use of the first-in, first-out method. Property and Equipment, Net. Property and equipment additions, including significant betterments, are recorded at cost. Upon retirement or disposal of property and equipment, the cost and accumulated depreciation are removed from the accounts, and any gain or loss is included in income. Repair and maintenance costs are charged to expense as incurred. Depreciation and Amortization. Depreciation is computed principally using the straight-line method over the estimated useful lives of the assets. Annual depreciation rates are as follows: buildings and land improvements, 2 1/2 to 10 percent, and machinery and equipment, 6 2/3 to 33 1/3 percent. Deferred financing costs are amortized over the lives of the related debt securities. The excess of cost over net assets of acquired companies is amortized using the straight-line method over the period estimated to be benefitted, not exceeding 40 years. At each balance sheet date management assesses whether there has been a permanent impairment of the excess of cost over net assets of acquired companies by comparing anticipated undiscounted future cash flows from operating activities with the carrying amount of the excess of cost over net assets of acquired companies. The factors considered by management in performing this assessment include current operating results, business prospects, market trends, potential product obsolescence, competitive activities and other economic factors. Based on this assessment there was no permanent impairment related to excess of cost over net assets of acquired companies at December 31, 1993. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1993 and 1992, accumulated amortization of the excess of cost over net assets of acquired companies and patents was $98.4 million and $105.1 million, respectively. Amortization expense was $22.2 million, $22.8 million and $21.2 million in 1993, 1992 and 1991, respectively, including amortization expense of approximately $1.6 million in each year related to discontinued operations. Income Taxes. In January, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"), "Accounting for Income Taxes." SFAS No. 109 is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, SFAS No. 109 generally allows consideration of all expected future events other than enactments of changes in the tax law or tax rates. Previously, the Company used the SFAS No. 96 asset and liability approach that gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. There was no income statement impact from the adoption of SFAS No. 109 and the required balance sheet reclassification was immaterial. Provision is made for U.S. income taxes on the undistributed earnings of foreign subsidiaries unless such earnings are considered permanently reinvested. Earnings (Loss) Per Common Share. Primary earnings (loss) per common share are based on the weighted average number of shares of common stock and common stock equivalents outstanding (including the dilutive effect of options and warrants, utilizing the treasury stock method) of 57.4 million, 60.9 million and 59.7 million in 1993, 1992 and 1991, respectively, and earnings (loss) after deducting preferred stock dividends of $14.9 million, $9.3 million and $9.6 million in 1993, 1992 and 1991, respectively. Fully diluted earnings (loss) per common share are only presented when the assumed conversion of convertible debentures is dilutive. Fully diluted earnings per share in 1993 were calculated based on 68.8 million weighted average common shares outstanding. Convertible securities did not have a dilutive effect on earnings (loss) in 1992 or 1991. The shares of Dividend Enhanced Convertible Stock DECSSM (the "DECS") issued in 1993 (see "Shareholders' Equity" note) are common stock equivalents, but are not included in the calculation of primary or fully diluted shares outstanding as such inclusion would be anti-dilutive. In late 1993, approximately 10.4 million shares were issued as a result of the conversion of the 6% Convertible Subordinated Debentures (see "Shareholders' Equity" note). If such conversion had taken place at the beginning of 1993, the primary earnings per common and common equivalent share amounts would have approximated the amounts presented for earnings per common and common equivalent share, assuming full dilution, for the year ended December 31, 1993. Adoption of Statements of Financial Accounting Standards. The Company expects that the adoption of Statements of Financial Accounting Standards ("SFAS") No. 112 "Employers' Accounting for Postemployment Benefits", SFAS No. 114 "Accounting by Creditors for Impairment of a Loan" and SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities" will not have a material impact on the financial position or the results of operations of the Company when adopted in 1994 and 1995. SUPPLEMENTARY CASH FLOWS INFORMATION: Significant transactions not affecting cash were: in 1993: in addition to the payment by the Company of $87.5 million, the non-cash portion of the issuance of Company Preferred Stock and warrants in exchange for Company Common Stock, Company Preferred Stock and Masco Corporation's holdings of Emco Limited common stock and convertible debentures (see "Shareholders' Equity" note); conversion of $187 million of convertible debentures into Company Common Stock MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (see "Shareholders' Equity" note); and conversion of the Company's TriMas Corporation ("TriMas") convertible preferred stock holdings into TriMas common stock (see "Equity and Other Investments in Affiliates" note); and in 1991: an exchange of certain operating assets (see "Dispositions of Other Operations" note); and the assumption of liabilities of $18 million in partial exchange for the acquisition of Creative Industries Group (see "Equity and Other Investments in Affiliates" note). Income taxes paid were $32 million in 1993 and $23 million in 1992. Income tax refunds of $8 million were received in 1991. Interest paid was $82 million, $91 million and $115 million in 1993, 1992 and 1991, respectively. DISCONTINUED OPERATIONS: In late November, 1993, the Company adopted a formal plan to divest its Energy-related business segment, which consisted of seven business units. Accordingly, the consolidated statements of income and cash flows and related notes have been reclassified to present such Energy-related segment as discontinued operations. During 1993, two such business units were sold for approximately $93 million, including the sale of one business unit to the Company's equity affiliate, TriMas for $60 million cash. The expected loss from the planned disposition of the Company's Energy-related segment resulted in a fourth quarter 1993 pre-tax charge of approximately $41 million (approximately $22 million after-tax), including a provision for the businesses not yet sold and the deferral of a portion of the gain (approximately $6 million after-tax) related to the sale of the business to TriMas. The Company expects to sell the remaining business units in privately negotiated transactions in 1994. Selected financial information for discontinued operations is as follows as at December 31, 1993 and for the period up to the decision to discontinue in 1993 and for the years ended December 31, 1992 and 1991: The unusual relationship of income taxes to pre-tax income in 1992 results principally from foreign losses for which no tax benefit was recorded. Operating and pre-tax income include charges of $6 million in 1991, principally related to the discontinuance of product lines and the cost of restructuring several businesses. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DISPOSITIONS OF OTHER OPERATIONS: In separate transactions from late 1989 to early 1991, the Company divested itself of three subsidiaries and received consideration of approximately $160 million, of which $108 million was received in 1990. The remaining $52 million was received in 1991. In addition, in 1991 the Company disposed of certain equity affiliates, and exchanged operating assets aggregating approximately $27 million. These transactions, including the disposition of Masco Capital Corporation (see "Equity and Other Investments in Affiliates" note), resulted in an approximate $22 million pre-tax gain in 1991. INVENTORIES: EQUITY AND OTHER INVESTMENTS IN AFFILIATES: Equity and other investments in affiliates consist primarily of the following common stock interests in publicly traded affiliates: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The carrying amount of investments in affiliates at December 31, 1993 and 1992 and quoted market values at December 31, 1993 for publicly traded affiliates (which may differ from the amounts that could have been realized upon disposition) are as follows: In 1988, the Company transferred several businesses to TriMas, a publicly traded, diversified manufacturer of commercial, industrial and consumer products. In exchange, the Company received $128 million principal amount of 14% Subordinated Debentures (which were subsequently redeemed resulting in prepayment premium income to the Company of $9 million in 1992 and $4 million in 1991), $70 million (liquidation value) of 10% Convertible Participating Preferred Stock and 9.3 million shares of TriMas common stock. During the second quarter of 1992, TriMas sold 9.2 million shares of newly issued common stock at $9.75 per share in a public offering, which reduced the Company's common equity ownership interest in TriMas to 28 percent from 41 percent. As a result, the Company recognized a pre-tax gain of $16.7 million from the change in the Company's common equity ownership interest in TriMas. In late 1993, the TriMas 10% Convertible Participating Preferred Stock held by the Company was converted at a conversion price of $9 per share into 7.8 million shares of TriMas common stock, increasing the Company's common equity ownership interest in TriMas to 43 percent. In 1993, the Company sold a business unit to TriMas for $60 million cash (see "Discontinued Operations" note). Included in notes receivable are approximately $10.7 million of notes which resulted from the sale by the Company of one million shares of its TriMas common stock holdings to members of the Company's executive management group in mid-1989. The notes have an effective interest rate of nine percent, payable at maturity in mid-1994. Ownership and resale of certain of such shares is restricted and subject to the continuing employment of these executives. TriMas' Board of Directors declared a 100 percent stock distribution (one additional share for every share held) to its shareholders effective July 19, 1993. TriMas share amounts and per share prices have been restated to reflect this distribution. The Company's holdings in Emco Limited ("Emco") were acquired from Masco Corporation in 1993 (see "Shareholders' Equity" note). Emco is a major, publicly traded, Canadian-based MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) manufacturer and distributor of building and other industrial products with annual sales of approximately $800 million. At December 31, 1992, the Company had an approximate 47 percent common equity ownership interest in Titan Wheel International, Inc. ("Titan"), a manufacturer of wheels and other products for agricultural, construction and other off-highway equipment markets. In May, 1993, Titan completed an initial public offering of three million shares of common stock at $15 per share (including 292,000 shares held by the Company), reducing the Company's common equity ownership interest in Titan to 24 percent. The Company's ownership interest was further reduced in late 1993 to 21 percent as a result of the issuance of additional common shares by Titan in connection with an acquisition by Titan. These transactions resulted in 1993 gains aggregating approximately $12.8 million pre-tax (principally in the second quarter) as a result of the sale of shares held by the Company and from the change in the Company's common equity ownership interest in Titan. During the second quarter of 1991, the Company acquired the remaining 50 percent equity ownership interest of Creative Industries Group, which had sales in 1990 of approximately $150 million. In 1991, Masco Capital Corporation ("Masco Capital") sold its principal asset and used the proceeds to repay its outstanding bank borrowings and to make loan repayments and distributions to its shareholders, whereby the Company received approximately $65 million (including repayment of $44 million advanced during 1991). In addition, the Company subsequently sold its 50 percent equity ownership interest in Masco Capital to the other shareholder, Masco Corporation, for approximately $50 million (which resulted in a pre-tax gain of approximately $5 million) and contingent amounts based on the future value of certain assets held by Masco Capital. In addition to its equity and other investments in publicly traded affiliates, the Company retains interests in privately held manufacturers of automotive components, including the Company's 50 percent common equity ownership interests in Autostyle, Inc., a manufacturer of reaction injection molded automotive components, and Elbi-Hi Ram, Inc., a manufacturer of electrical and electronic automotive components. Approximate combined condensed financial data of the Company's equity affiliates (including Emco after date of investment, Creative Industries Group through date of acquisition (second quarter 1991) and Masco Capital through date of disposition) are as follows: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Equity and interest income from affiliates consists of the following: PROPERTY AND EQUIPMENT, NET: Depreciation expense totalled $48 million, $46 million and $47 million in 1993, 1992 and 1991, respectively. These amounts include depreciation expense of approximately $8 million in each year related to discontinued operations. ACCRUED LIABILITIES: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) LONG-TERM DEBT: In 1993, the Company entered into a new $675 million revolving credit agreement with a group of banks, replacing its prior bank credit agreement (which had consisted of a revolving credit facility and a bank term loan at December 31, 1992). Amounts outstanding under the revolving credit agreement are due in January, 1997; however, under certain circumstances, the due date may be extended to July, 1998. The interest rates applicable to the revolving credit agreement are principally at alternative floating rates provided for in the agreement (approximately four percent at December 31, 1993). The revolving credit agreement requires the maintenance of a specified level of shareholders' equity, with limitations on the ratio of senior debt to earnings, long-term debt (at December 31, 1993 additional borrowing capacity of approximately $380 million was available under this agreement), intangible assets and the acquisition of Company Capital Stock. Under the most restrictive of these provisions, $120 million of retained earnings was available at December 31, 1993 for the payment of cash dividends and the acquisition of Company Capital Stock. The 6% Convertible Subordinated Debentures were converted into Company Common Stock in late 1993 (see "Shareholders' Equity" note). The senior subordinated notes contain limitations on the payment of cash dividends and the acquisition of Company Capital Stock. In late 1993, the Company called for redemption, on February 1, 1994, the $250 million of 10 1/4% Senior Subordinated Notes. During 1992, the Company repurchased, in open-market transactions, approximately $67 million of its 10% Senior Subordinated Notes at prices approximating face value. In early 1994, the Company issued, in a public offering, $345 million of 4 1/2% Convertible Subordinated Debentures due December 15, 2003. These debentures are convertible into Company Common Stock at $31 per share. The net proceeds were used to redeem the $250 million of 10 1/4% Subordinated Notes (called in late 1993 for redemption on February 1, 1994) and to reduce other indebtedness. In the fourth quarter of 1993, the Company recognized a $5.8 million pre-tax extraordinary charge ($3.7 million after-tax) related to the call premium (1.25%) and unamortized prepaid debenture expense associated with the call for early extinguishment of the $250 million of 10 1/4% Subordinated Notes. The 10 1/4% Subordinated Notes are classified as non-current as the Company had the intent and the ability to maintain these borrowings on a long-term basis (due to the issuance of the 4 1/2% Convertible Subordinated Debentures). The maturities of long-term debt during the next five years are as follows (in millions): 1994 -- $3; 1995 -- $234; 1996 -- $1; 1997 -- $303; and 1998 -- $0. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) SHAREHOLDERS' EQUITY: On March 31, 1993, the Company acquired from Masco Corporation 10 million shares of Company Common Stock, recorded at $100 million, $77.5 million of the Company's previously outstanding 12% Exchangeable Preferred Stock, and Masco Corporation's holdings of Emco Limited common stock and convertible debentures, recorded at $80.8 million. In exchange, Masco Corporation received $100 million (liquidation value) of the Company's 10% Exchangeable Preferred Stock, seven-year warrants to purchase 10 million shares of Company Common Stock at $13 per share, recorded at $70.8 million, and $87.5 million in cash. The transferable warrants are not exercisable by Masco Corporation if an exercise would increase Masco Corporation's common equity ownership interest in the Company above 35 percent. The cash portion of this transaction is included in the accompanying statement of cash flows as cash used for investing activities of $87.5 million. As part of this transaction, as modified in late 1993, Masco Corporation agreed to purchase from the Company, at the Company's option through March, 1997, up to $200 million of subordinated debentures. In late 1993, the Company redeemed the 10% Exchangeable Preferred Stock for its $100 million liquidation value. In July, 1993, the Company issued 10.8 million shares of 6% Dividend Enhanced Convertible Stock (DECS) at $20 per share ($216 million aggregate liquidation amount) in a public offering (classified as MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Convertible Preferred Stock). The net proceeds from this issuance were used to reduce the Company's indebtedness. On July 1, 1997, each of the then outstanding shares of the DECS will convert into one share of Company Common Stock, if not previously redeemed by the Company or converted at the option of the holder, in both cases for Company Common Stock. Each share of the DECS is convertible at the option of the holder anytime prior to July 1, 1997 into .806 of a share of Company Common Stock, equivalent to a conversion price of $24.81 per share of Company Common Stock. Dividends are cumulative and each share of the DECS has 4/5 of a vote, voting together as one class with holders of Company Common Stock. Beginning July 1, 1996, the Company, at its option, may redeem the DECS at a call price payable in shares of Company Common Stock principally determined by a formula based on the then current market price of Company Common Stock. Redemption by the Company, as a practical matter, will generally not result in a call price that exceeds one share of Company Common Stock or is less than .806 of a share of Company Common Stock (resulting from the holder's conversion option). The Company's 6% Convertible Subordinated Debentures were called for redemption in late 1993. Substantially all holders, including Masco Corporation, exercised their right to convert these debentures into Company Common Stock (at a conversion price of $18 per share), resulting in the issuance of approximately 10.4 million shares of Company Common Stock. The Company's consideration for a 1987 acquisition included two million shares of Company Common Stock which were subject to a stock value guarantee agreement. During the second quarter of 1993, the Company's stock value guarantee obligation was settled, resulting in no material financial impact to the Company. The Company commenced paying cash dividends on its Common Stock in August, 1993 and declared three and paid two quarterly dividends in 1993, each in the amount of $.02 per common share. STOCK OPTIONS AND AWARDS: For the three years ended December 31, 1993, stock option data pertaining to stock option plans for key employees of the Company and affiliated companies are as follows: As of December 31, 1993, options have been granted and are outstanding with exercise prices ranging from $4 1/2 to $26 per share, the fair market value at the dates of grant. Pursuant to restricted stock incentive plans, the Company granted long-term incentive awards, net, for 202,000, 251,000 and 675,000 shares of Company Common Stock during 1993, 1992 and 1991, respectively, to key employees of the Company and affiliated companies. The unamortized costs of MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) incentive awards, aggregating approximately $20 million at December 31, 1993, are being amortized over the ten-year vesting periods. At December 31, 1993 and 1992, a combined total of 5,631,000 and 5,759,000 shares, respectively, of Company Common Stock were available for the granting of options and incentive awards under the above plans. EMPLOYEE BENEFIT PLANS: Pension and Profit-Sharing Benefits. The Company sponsors defined-benefit pension plans for most of its employees. In addition, substantially all salaried employees participate in noncontributory profit-sharing plans, to which payments are approved annually by the Directors. Aggregate charges to income under these plans were $10.9 million in 1993, $10.3 million in 1992 and $8.3 million in 1991, including approximately $.9 million in each year related to discontinued operations. Net periodic pension cost for the Company's defined-benefit pension plans includes the following components for the three years ended December 31, 1993: Major assumptions used in accounting for the Company's defined-benefit pension plans are as follows: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The funded status of the Company's defined-benefit pension plans at December 31, 1993 and 1992 is as follows: Postretirement Benefits. The Company provides postretirement medical and life insurance benefits for certain of its active and retired employees. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106") for its postretirement benefit plans. This statement requires the accrual method of accounting for postretirement health care and life insurance based on actuarially determined costs to be recognized over the period from the date of hire to the full eligibility date of employees who are expected to qualify for such benefits. In conjunction with the adoption of SFAS 106, the Company elected to recognize the transition obligation on a prospective basis and accordingly, the net transition obligation is being amortized over 20 years. Net periodic postretirement benefit cost includes the following components for the year ended December 31, 1993: The incremental cost in 1993 of accounting for postretirement health care and life insurance benefits under SFAS 106 amounted to approximately $1.7 million. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Postretirement benefit obligations, none of which are funded, are summarized as follows for the year ended December 31, 1993: The discount rate used in determining the accumulated postretirement benefit obligation was seven percent. The assumed health care cost trend rate in 1993 was 12 percent, decreasing to an ultimate rate in the year 2000 of seven percent. If the assumed medical cost trend rates were increased by one percent, the accumulated postretirement benefit obligation would increase by $2.6 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost would increase by $.2 million. SEGMENT INFORMATION: The Company's business segments involve the production and sale of the following: Transportation-Related Products: Precision products, generally produced using advanced metalworking technologies with significant proprietary content, and aftermarket products for the transportation industry. Specialty Products: Architectural -- Doors, windows, security grilles and office panels and partitions for commercial and residential markets. Other -- Products manufactured principally for the defense industry. Amounts related to the Company's Energy-related segment have been presented as discontinued operations. Corporate assets consist primarily of cash and cash investments, equity and other investments in affiliates and notes receivable. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) - --------------- (A) Included within this segment are sales to one customer of $324 million, $268 million and $217 million in 1993, 1992 and 1991, respectively; sales to another customer of $222 million, $216 million and $201 million in 1993, 1992 and 1991, respectively; and sales to a third customer of $186 million, $184 million and $126 million in 1993, 1992 and 1991, respectively. (B) Included in 1991 operating profit (principally Transportation-Related Products and Architectural Products) are charges of $27 million to reflect the expenses related to the discontinuance of product lines, and the costs of restructuring several businesses. Other expense, net in 1992 and 1991, includes approximately $15 million and $14 million, respectively, to reflect disposition costs related to idle facilities and other long-term assets. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) OTHER INCOME (EXPENSE), NET: Gains realized from sales of marketable securities are determined on a specific identification basis at the time of sale. INCOME TAXES: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The components of the net deferred taxes as at December 31, 1993 were as follows: The following is a reconciliation of tax computed at the U.S. federal statutory rate to the provision for income taxes (credit) allocated to income (loss) from continuing operations before income taxes (credit) and extraordinary loss: Provisions for deferred income taxes by temporary difference components for the years ended December 31, 1992 and 1991 were as follows: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FAIR VALUE OF FINANCIAL INSTRUMENTS: In accordance with Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," the following methods were used to estimate the fair value of each class of financial instruments: Notes Receivable and Other Assets. Fair values of financial instruments included in notes receivable and other assets were estimated using various methods including quoted market prices and discounted future cash flows based on the incremental borrowing rates for similar types of investments. In addition, for variable-rate notes receivable that fluctuate with the prime rate, the carrying amounts approximate fair value. Long-Term Debt. The carrying amount of bank debt and certain other long-term debt instruments approximate fair value as the floating rates inherent in this debt reflect changes in overall market interest rates. The fair values of the Company's subordinated debt instruments are based on quoted market prices. The fair values of certain other debt instruments are estimated by discounting future cash flows based on the Company's incremental borrowing rate for similar types of debt instruments. The carrying amounts and fair values of the Company's financial instruments as at December 31, 1993 and 1992 are as follows: MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INTERIM AND OTHER SUPPLEMENTAL FINANCIAL DATA (UNAUDITED): MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Certain amounts presented above have been reclassified to present a segment of the Company's business as discontinued operations (see "Discontinued Operations" note). Results for the second quarters of 1993 and 1992 include pre-tax income of approximately $9 million and $25 million, respectively, as a result of gains associated with the sale of common stock through public offerings by equity affiliates and, in 1992, a prepayment premium related to the redemption of debentures held by the Company. This income was largely offset by costs and expenses related to cost reduction initiatives, the restructuring of certain operations and product lines, adjustments to the carrying value of certain long-term assets, and other costs and expenses. Results for the third quarter of 1993 were reduced by a charge of approximately $.04 per common share reflecting the recently increased 1993 federal corporate income tax rate. The fourth quarter of 1993 net loss includes the effect of a $5.8 million pre-tax extraordinary charge ($3.7 million after-tax or $.06 per common share) related to the early extinguishment of subordinated debt (see "Long-Term Debt" note). The fourth quarter of 1993 net loss also includes an after-tax charge of approximately $22 million ($.38 per common share) related to the disposition of a segment of the Company's business (see "Discontinued Operations" note). The 1993 results include the benefit of approximately $11.5 million pre-tax income ($6.7 million after-tax or $.12 per common share), primarily in the third and fourth quarters, resulting from net gains from sales of marketable securities. The 1992 results include the benefit of approximately $4 million pre-tax income ($2 million after-tax or $.04 per common share), primarily in the fourth quarter, resulting from net gains from sales of marketable securities. The 1993 income (loss) per common share amounts for the quarters do not total to the full year amounts due to the changes in the number of common shares outstanding during the year and the dilutive effect of first, second and third quarter 1993 results. The calculation of earnings per common and common equivalent share for the fourth quarter of 1993 results in dilution for income from continuing operations, assuming full dilution. Therefore, the fully diluted earnings per share computation is used for all computations, even though the result is anti-dilutive for one of the per share amounts. MASCOTECH, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONCLUDED) The following supplemental unaudited financial data combine the Company with Masco Capital Corporation (through date of disposition) and TriMas and have been presented for analytical purposes. The Company had a common equity ownership interest in TriMas of approximately 43 percent at December 31, 1993 and 28 percent at December 31, 1992. The interests of the other common shareholders are reflected below as "Equity of other shareholders of TriMas." All significant intercompany transactions have been eliminated. 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 regarding executive officers required by this Item is set forth as a Supplementary Item at the end of Part I hereof (pursuant to Instruction 3 to Item 401(b) of Regulation S-K). Other information required by this Item will be contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, to be filed on or before April 30, 1994, and such information is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information required by this Item will be contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, to be filed on or before April 30, 1994, and such information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required by this Item will be contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, to be filed on or before April 30, 1994, and such information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required by this Item will be contained in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, to be filed on or before April 30, 1994, and such information is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) LISTING OF DOCUMENTS. (1) Financial Statements. The Company's Consolidated Financial Statements included in Item 8 hereof, as required at December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, consist of the following: Consolidated Balance Sheet Consolidated Statement of Income Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements (2) Financial Statement Schedules. (i) Financial Statement Schedules of the Company appended hereto, as required for the years ended December 31, 1993, 1992 and 1991, consist of the following: II. Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties 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 (ii) (A) TriMas Corporation and Subsidiaries Consolidated Financial Statements appended hereto, as required at December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, consist of the following: Consolidated Statements of Income Consolidated Balance Sheets Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements (ii) (B) TriMas Corporation and Subsidiaries Financial Statement Schedules appended hereto, as required for the years ended December 31, 1993, 1992 and 1991, consist of the following: 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 (3) Exhibits. 3.i Restated Certificate of Incorporation of MascoTech, Inc. and amendments thereto. 3.ii Bylaws of MascoTech, Inc., as amended.(3) 4.a Indenture dated as of November 1, 1986 between Masco Industries, Inc. (now known as MascoTech, Inc.) and Morgan Guaranty Trust Company of New York, as Trustee, and Directors' resolutions establishing the Company's 4 1/2% Convertible Subordinated Debentures Due 2003. - ------------------------- (1) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated November 22, 1993. (2) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (3) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated June 22, 1993. (4) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Registration Statement on Form S-3 dated March 9, 1993. (5) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated February 1, 1993. (6) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1992. (7) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1991. (8) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1990. (9) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1989. (B) REPORTS ON FORM 8-K. The following Current Reports on Form 8-K were filed by MascoTech, Inc. in the calendar quarters ended December 31, 1993 and March 31, 1994: 1. Report on Form 8-K dated November 22, 1993 reporting under Item 2 "Acquisition or Disposition of Assets" the Company's plan to dispose of its energy-related businesses and to treat such businesses as discontinued operations for financial reporting purposes. The following financial statements and financial information were filed with such report: (i) MascoTech, Inc. and Subsidiaries unaudited pro forma consolidated condensed balance sheet as of September 30, 1993, and unaudited pro forma consolidated condensed statements of income for the year ended December 31, 1992 and the nine-month period ended September 30, 1993. 2. Report on Form 8-K dated January 11, 1994 reporting under Item 5 "Other Events" the reclassification of certain of the Company's financial statements and financial information to reflect the treatment of the Company's energy-related businesses as discontinued operations in connection with the Company's previously reported plan to dispose of such businesses. The following financial statements and financial information were filed with such report: (i) Selected Financial Data; (ii) MascoTech, Inc. and Subsidiaries Audited Consolidated Financial Statements as of December 31, 1992 and 1991 and for the three years in the period ended December 31, 1992 and notes thereto; and (iii) MascoTech, Inc. and Subsidiaries Unaudited Consolidated Condensed Financial Statements as of September 30, 1993 and December 31, 1992 and for the three month and nine month periods ended September 30, 1993 and 1992 and notes thereto. 3. Report on Form 8-K dated March 2, 1994 reporting under Item 5 "Other Events" certain financial information related to 1993. The following financial statements were filed with such report: (i) MascoTech, Inc. and Subsidiaries Audited Consolidated Financial Statements as of December 31, 1993 and 1992 and for the three years in the period ended December 31, 1993 and notes thereto. 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. MASCOTECH, INC. By /s/ TIMOTHY WADHAMS -------------------------------------- TIMOTHY WADHAMS Vice President -- Controller and Treasurer March 22, 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. MASCOTECH, INC. FINANCIAL STATEMENT SCHEDULES PURSUANT TO ITEM 14(A)(2) OF FORM 10-K ANNUAL REPORT TO THE SECURITIES AND EXCHANGE COMMISSION FOR THE YEAR ENDED DECEMBER 31, 1993 MASCOTECH, INC. FINANCIAL STATEMENT SCHEDULES Schedules, as required for the years ended December 31, 1993, 1992 and 1991: MASCOTECH, INC. SCHEDULE II. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 All amounts receivable are related to an incentive program of the Company that has been disclosed in previous proxy statements of the Company and that will be described in the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders to be filed on or before April 30, 1994. NOTES: (A) Represents accrual of interest. (B) Amounts receivable (including interest of $3,400,000) from employees are due June 30, 1994. The stated rate of interest is 7%. (C) Represents the discount pertaining to the difference between the stated rate of interest of 7% and the effective rate of interest of approximately 9%. Activity in 1992 includes discount amortization of $550,000, interest of $710,000 and the cancellation of the receivable balance of $1,350,000 for an ex-employee. Activity in 1991 includes discount amortization of $340,000 and interest of $1,040,000. MASCOTECH, INC. SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 NOTES: (A) Includes property, plant and equipment additions of $20 million in 1991 obtained through the acquisition of companies. (B) Includes property, plant and equipment from the disposition of certain operations in 1991. (C) Adjustments and reclassifications to present the Energy-related segment as discontinued operations in 1993, and the effect of foreign currency translation. MASCOTECH, INC. SCHEDULE VI. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Includes accumulated depreciation of property, plant and equipment from the disposition of operations in 1991. (B) Adjustments and reclassifications to present the Energy-related segment as discontinued operations in 1993, and the effect of foreign currency translation. MASCOTECH, INC. SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Allowance of companies reclassified for discontinuance of Energy-related segment in 1993, and other adjustments, net in 1991. (B) Deductions, representing uncollectible accounts written off, less recoveries of accounts written off in prior years. MASCOTECH, INC. SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: Other captions provided for under this schedule are excluded, as the amounts related to such captions are not material. Amounts reflect the reclassification of the Company's Energy-related segment as discontinued operations. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders of TriMas Corporation: We have audited the consolidated financial statements and the financial statement schedules of TriMas Corporation and subsidiaries listed in Item 14(a)(2)(ii) 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 TriMas Corporation 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. COOPERS & LYBRAND Detroit, Michigan February 8, 1994 TRIMAS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME The accompanying notes are an integral part of the consolidated financial statements. TRIMAS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of the consolidated financial statements. TRIMAS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of the consolidated financial statements. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of TriMas Corporation and its majority owned subsidiaries (the "Company"). All significant intercompany transactions have been eliminated. AFFILIATES As of December 31, 1993 MascoTech, Inc.'s common stock ownership in the Company approximated 43 percent, and Masco Corporation's common stock ownership approximated 5 percent. The Company has a corporate services agreement with Masco Corporation. Under the terms of the agreement, the Company pays a fee to Masco Corporation for various corporate support staff, administrative services, and research and development services. Such fee equals .8 percent of the Company's net sales, subject to certain adjustments. 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. INVENTORIES Inventories are stated at the lower of cost or net realizable value, with cost determined principally by use of the first-in, first-out method. PROPERTY AND EQUIPMENT Property and equipment additions, including significant betterments, are recorded at cost. Upon retirement or disposal of property and equipment, the cost and accumulated depreciation are removed from the accounts and any gain or loss is included in income. Maintenance and repair costs are charged to expense as incurred. DEPRECIATION AND AMORTIZATION Depreciation is computed principally using the straight-line method over the estimated useful lives of the assets. Annual depreciation rates are as follows: buildings and land improvements, 2 1/2 to 5 percent, and machinery and equipment, 6 2/3 to 33 1/3 percent. The excess of cost over net assets of acquired companies is being amortized using the straight-line method over the periods estimated to be benefitted, not exceeding 40 years. At December 31, 1993 and 1992 accumulated amortization of the excess of cost over net assets of acquired companies and other intangible assets was $21.5 million and $17.0 million, respectively. Amortization expense was $4.5 million, $4.2 million, and $3.4 million in 1993, 1992 and 1991, respectively. As of each balance sheet date management assesses whether there has been an impairment in the value of excess of cost over net assets of acquired companies by comparing anticipated undiscounted future cash flows from the related operating activities with the carrying value. The factors considered by management in performing this assessment include current operating results, trends and prospects, as well as the effects of obsolescence, demand, competition and other economic factors. Based on this assessment there was no impairment at December 31, 1993. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 1. ACCOUNTING POLICIES (CONTINUED) INCOME TAXES The Company uses the liability method of accounting for income taxes. Deferred income taxes result from temporary differences between the tax basis of assets and liabilities and the basis as reported in the consolidated financial statements. The Company has not provided for taxes on $9.4 million of undistributed earnings of foreign subsidiaries at December 31, 1993, because such earnings are considered permanently reinvested. FOREIGN CURRENCY TRANSLATION Net assets of the Company's operations outside of the United States are translated into U.S. dollars using current exchange rates with the effects of translation adjustments deferred and included as a separate component of shareholders' equity. Revenues and expenses are translated at the average rates of exchange during the period. EARNINGS PER COMMON SHARE On June 7, 1993 the Company's Board of Directors adopted a resolution for a stock split, effected in the form of a 100 percent stock distribution, with issuance to shareholders on July 6, 1993. Accordingly, information in the consolidated financial statements and related notes, including the number of common shares and per common share amounts, has been adjusted to reflect this distribution. Primary earnings per common share in 1993, 1992 and 1991 were calculated on the basis of 31.1 million, 26.0 million and 19.8 million weighted average common and common equivalent shares outstanding. Fully diluted earnings per common share in 1993, 1992 and 1991 were calculated on the basis of 39.1 million, 33.9 million and 27.6 million weighted average common and common equivalent shares outstanding. On December 15, 1993 MascoTech, Inc. converted all of the $100 Convertible Participating Preferred Stock into 7.8 million shares of Company common stock. On a pro forma basis, as if the conversion had occurred on January 1, 1993, primary and fully diluted earnings per common share for 1993 would have been $1.03 and $1.01, respectively. NOTE 2. ACQUISITIONS In 1993 the Company acquired all of the capital stock of Lamons Metal Gasket Co. ("Lamons") from MascoTech, Inc. for $60.3 million cash and the assumption of certain liabilities. The acquisition was accounted for as a purchase. The excess of cost over net assets acquired of approximately $45.4 million is being amortized on a straight-line basis over 40 years. The results of operations of Lamons have been included in the consolidated financial statements from the effective date of the transaction. Additional purchase price amounts, contingent upon the achievement of specified levels of future profitability by Lamons, may be payable to MascoTech, Inc. beginning in 1997. These payments, if required, will be recorded as additional excess of cost over net assets of acquired businesses. Lamons is engaged in the manufacture of specialty metallic and non-metallic gaskets used in the refinery, chemical and petrochemical industries. The acquisition was financed through partial use of the Company's bank credit facility. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 2. ACQUISITIONS (CONTINUED) On a pro forma, unaudited basis, as if the Lamons acquisition had occurred as of January 1, 1992, net sales, net income, earnings available for common stock, primary earnings per common share and fully diluted earnings per common share for 1993 would have been $475.6 million, $40.6 million, $35.4 million, $1.14 and $1.08, respectively, and net sales, income before extraordinary charge, net income, earnings available for common stock, primary earnings per common share before extraordinary charge, fully diluted earnings per common share before extraordinary charge, primary earnings per common share and fully diluted earnings per common share for 1992 would have been $437.8 million, $33.7 million, $27.9 million, $20.9 million, $1.02, $.99, $.80 and $.80, respectively. During 1991 the Company acquired all of the capital stock of Monogram Aerospace Fasteners, Inc. for $50.2 million cash and the assumption of certain operating liabilities. The acquisition was accounted for as a purchase. The excess of cost over net assets acquired of $13.4 million is being amortized on a straight-line basis over 40 years. The results of operations of Monogram Aerospace Fasteners, Inc. have been included in the consolidated financial statements from the date of acquisition. NOTE 3. SUPPLEMENTAL CASH FLOWS INFORMATION NOTE 4. RECEIVABLES Accounts receivable are presented net of an allowance for doubtful accounts of $1.8 million and $1.4 million at December 31, 1993 and 1992, respectively. Accounts receivable at December 31, 1993 include approximately $3.2 million due from MascoTech, Inc. relating to the acquisition of Lamons Metal Gasket Co. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 5. INVENTORIES NOTE 6. PROPERTY AND EQUIPMENT Depreciation expense was $13.9 million, $12.7 million and $10.6 million in 1993, 1992 and 1991, respectively. NOTE 7. NOTES RECEIVABLE Notes receivable are net of an allowance for doubtful accounts of $.7 million at both December 31, 1993 and 1992, and consist principally of the long-term portion of notes receivable arising from the sale of certain products in the normal course of business. These notes bear various fixed interest rates and mature through 2000. At December 31, 1993 the carrying value of these notes receivable approximated their estimated fair value as calculated using the interest rates in effect on that date. NOTE 8. ACCRUED LIABILITIES TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 9. LONG-TERM DEBT In August, 1993 the Company issued $115.0 million of 5% Convertible Subordinated Debentures Due 2003. The Debentures are convertible into Company common stock at $22 5/8 per share, subject to adjustment in certain events. The Debentures are redeemable, at a premium, at the Company's option after August 1, 1996. The Company has a $350.0 million revolving credit facility maturing in 1998 with a group of domestic and international banks. The facility permits the Company to borrow under several different interest rate options. The facility contains certain restrictive covenants, the most restrictive of which, at December 31, 1993, requires $186.4 million of shareholders' equity. Borrowings from banks at December 31, 1993 and 1992 include $122.0 million and $147.0 million, respectively, owing under the Company's revolving credit facilities. At December 31, 1993 the blended interest rate on borrowings equalled 3.5 percent. The Company had available credit of $228.0 million under the credit facility at December 31, 1993. At December 31, 1992 the Company had borrowed $30.0 million from several banks under short term, uncommitted credit facilities. As the Company had the ability and the intent to maintain these borrowings on a long-term basis, borrowings under these short term facilities were classified as long-term debt. NOTE 10. SUBORDINATED DEBT HELD BY AFFILIATE On December 31, 1991 the Company utilized available cash to retire $40.0 million of the $128.0 million 14 percent Subordinated Debentures due 2008, held by MascoTech, Inc., and recognized a $3.9 million pre-tax extraordinary charge ($2.5 million after tax, or $.13 per common share) relative to the payment of the redemption premium associated with the early extinguishment. Effective January 1, 1992 the Company exchanged the remaining $88.0 million of 14 percent Subordinated Debentures for a new issue of $88.0 million 12 percent Subordinated Debentures due 1999. In April, 1992 the Company retired the $88.0 million 12 percent Subordinated Debentures and recognized a $9.0 million pre-tax extraordinary charge ($5.7 million after tax, or $.22 per common share) relative to the payment of the redemption premium associated with the early extinguishment. At December 31, 1993 there were no outstanding Subordinated Debentures held by MascoTech, Inc. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 11. SHAREHOLDERS' EQUITY During 1993, dividends on the $100 Convertible Participating Preferred Stock, held by MascoTech, Inc., converted from an annual to a quarterly payment schedule. Therefore, the Company paid $12.3 million in preferred stock dividends in 1993 representing dividends accrued through the first three quarters of 1993 and the full year 1992. On December 15, 1993 MascoTech, Inc. converted all of the preferred stock into 7.8 million shares of Company common stock. On the basis of amounts paid (declared), cash dividends per common share were $.11 ($.11 1/2) in 1993 and $.02 1/2 ($.05) in 1992. NOTE 12. STOCK OPTIONS AND AWARDS The Company has a Stock Option Plan and a Restricted Stock Incentive Plan which permit the grant of up to a combined total of 2,000,000 shares of Company common stock for stock options or awards to key employees of the Company and its affiliates. Shares available for grant through these two plans were 419,944 and 549,156 at December 31, 1993 and December 31, 1992, respectively. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 12. STOCK OPTIONS AND AWARDS (CONTINUED) Stock option data are as follows (option prices are the fair market value at the dates of grant): Restricted long-term incentive stock awards of a net total of 974,056 shares have been granted as of December 31, 1993, with the related costs being expensed over the ten year vesting period. At December 31, 1993 non-vested incentive stock awards had an aggregate carrying value of $7.8 million. NOTE 13. RETIREMENT PLANS The Company has noncontributory retirement benefit plans, both defined benefit plans and profit-sharing and other defined contribution plans, for most of its employees. At December 31, 1993 the combined assets of the Company's defined benefit plans exceeded the combined accumulated benefit obligation by $5.7 million. The annual expense for all plans was: Contributions to profit-sharing and other defined contribution plans are generally determined as a percentage of the covered employee's annual salary. Defined benefit plans provide retirement benefits for salaried employees based primarily on years of service and average earnings for the five highest consecutive years of compensation. Defined benefit plans covering hourly employees generally provide benefits of stated amounts for each year of service. These plans are funded based on an actuarial evaluation and review of the assets, liabilities and requirements of each plan. Plan assets are held by a trustee and invested principally in cash equivalents and marketable equity and fixed income instruments. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13. RETIREMENT PLANS (CONTINUED) Net periodic pension cost of defined benefit plans includes the following components: Net amortization and deferral consists of amortization of the net asset or overfunded position at the date of adoption and deferral and amortization of subsequent net gains and losses caused by the actual plan and investment experience differing from that assumed. Weighted average rate assumptions used were as follows: The following table sets forth the funded status of the defined benefit plans: Several of the Company's subsidiaries and divisions provide certain postretirement health care and life insurance benefits for eligible retired employees under unfunded plans. Some of the plans have cost-sharing provisions. Prior to 1993, the expense recognized for postretirement health care and life insurance benefits was based on actual expenditures. Effective January 1, 1993 the estimated costs TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 13. RETIREMENT PLANS (CONTINUED) of these postretirement benefits are being accrued in accordance with the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. The new accounting method has no effect on the Company's cash flows related to these retiree benefits. The Company has decided to amortize the unrecognized accumulated postretirement benefit obligation existing at January 1, 1993 over 20 years as permitted by the new Standard. Net periodic postretirement benefit cost for 1993 includes the following components: Rate assumptions used were as follows: The following sets forth the plans' status reconciled with the amount recognized in the Company's balance sheet as of December 31, 1993: Accumulated postretirement benefit obligation: A one percentage point increase each year in the assumed rate of increase in health care costs would have increased the aggregate of the service and interest cost components of net periodic postretirement benefit cost by approximately $.1 million during 1993, and would have increased the accumulated postretirement benefit obligation at December 31, 1993 by approximately $.8 million. NOTE 14. OTHER INCOME (EXPENSE), NET TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 15. BUSINESS SEGMENT INFORMATION The Company's operations in its business segments consist principally of the manufacture and sale of the following: Specialty Fasteners: Cold formed fasteners and related metallurgical processing. Towing Systems: Vehicle hitches, jacks, winches, couplers and related towing accessories. Specialty Container Products: Industrial container closures, pressurized gas cylinders and metallic and non-metallic gaskets. Corporate Companies: Specialty drills, cutters and specialized metal finishing services, and flame-retardant facings and jacketings and pressure-sensitive tapes. Corporate assets consist primarily of cash and cash equivalents and notes receivable. Operations are located principally in the United States. (A) Includes $8.2 million from business acquired. (B) Includes $19.0 million from business acquired. TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16. INCOME TAXES The following is a reconciliation of the U.S. federal statutory tax rate to the effective tax rate applicable to income before income taxes and extraordinary charge: TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE 16. INCOME TAXES (CONTINUED) Items that gave rise to deferred taxes: At December 31, 1993 capital loss carryforwards, for tax purposes only, equalled $3.2 million and expire in 1995. NOTE 17. INTERIM FINANCIAL INFORMATION (UNAUDITED) TRIMAS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONCLUDED) NOTE 17. INTERIM FINANCIAL INFORMATION (UNAUDITED) (CONTINUED) Quarterly earnings per common share amounts for 1993 do not total to the full year amount due to the change in the number of common shares outstanding occurring during the year. Earnings per common share in the fourth quarter of 1993 and 1992 were improved by $.04 and $.03, net, respectively, resulting from various year-end adjustments to accrual estimates recorded earlier in each year. QUARTERLY COMMON STOCK PRICE AND DIVIDEND INFORMATION: TRIMAS CORPORATION AND SUBSIDIARIES SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Including fixed asset additions of $8,210,000 in 1993 and $18,990,000 in 1991 obtained through the acquisition of companies. (B) Adjustments and reclassifications between accounts. TRIMAS CORPORATION AND SUBSIDIARIES SCHEDULE VI. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Note: (A) Adjustments and reclassifications between accounts. TRIMAS CORPORATION AND SUBSIDIARIES SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Notes: (A) Allowance of companies acquired, and other adjustments, net. (B) Doubtful accounts charged off, less recoveries. TRIMAS CORPORATION AND SUBSIDIARIES SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Other captions provided under this schedule are excluded as the amounts related to such captions are not material, or they are disclosed in the notes to the financial statements. EXHIBIT INDEX - ------------------------- (1) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated November 22, 1993. (2) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (3) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated June 22, 1993. (4) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Registration Statement on Form S-3 dated March 9, 1993. (5) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Current Report on Form 8-K dated February 1, 1993. (6) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1992. (7) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1991. (8) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1990. (9) Incorporated by reference to the Exhibits filed with MascoTech, Inc.'s Annual Report on Form 10-K for the year ended December 31, 1989.

840251_1993.txt

840251_1993

1993

840251

Item 3. Legal Proceedings. East Line Litigation and FERC Proceeding: In August 1992, two East Line refiners, Navajo Refining Company ("Navajo") and El Paso Refinery, L.P. ("El Paso") and its general partner, El Paso Refining, Inc., filed separate, though similar, lawsuits against the Partnership in New Mexico and Texas, respectively, seeking total actual damages in excess of $190 million, plus punitive damages, arising from the Partnership's alleged failure to provide additional pipeline capacity to Phoenix and Tucson, Arizona from El Paso, Texas. The Navajo action also sought an injunction to prohibit the Partnership from reversing the direction of flow (from westbound to eastbound) of its six-inch diameter pipeline between Phoenix and Tucson. Generally, the lawsuits allege that the refiners proceeded with significant refinery expansions under the belief that the Partnership would provide whatever pipeline capacity was required to transport their product into Arizona, and that they were damaged by their inability to ship additional volumes into that highly competitive market. In addition, El Paso filed a protest/complaint with the FERC in September 1992 seeking to block the reversal of the six-inch pipeline and challenging the Partnership's proration policy as well as the Partnership's existing East Line tariffs. The FERC ruled in April 1993, and has subsequently confirmed on rehearing, that the challenges to proration, line reversal and East Line tariffs must proceed under a complaint proceeding. That ruling expressly places the burden of proof on the complaining parties, who must show that the Partnership's rates and practices there at issue violate the requirements of the Interstate Commerce Act. In August 1993, Chevron U.S.A. Products Company ("Chevron") filed a complaint with the FERC challenging the Partnership's West Line tariffs and claiming that a service charge at the Partnership's Watson Station is in violation of the Interstate Commerce Act. In September 1993, the FERC ruled that the Partnership's West Line tariffs are deemed "just and reasonable" under the Energy Policy Act of 1992 and may only be challenged on the basis of "changed circumstances" and consolidated the various outstanding matters into a single proceeding. ARCO Products Company and Texaco Refining and Marketing Inc. intervened in the proceeding in January 1994. Navajo, Refinery Holding Company, L.P., a partnership formed by El Paso's long-term, secured creditors that purchased El Paso's refinery in May 1993, and an association of airlines serving the Phoenix airport constitute the remaining major outside parties to this FERC proceeding. Navajo, which had been under a 1985 FERC rate case settlement moratorium prohibiting it from challenging the Partnership's rates until November 1993, filed a separate complaint against both the East Line and West Line tariffs in December 1993. In November 1993, the FERC Administrative Law Judge ordered the Partnership to prepare a cost and revenue study, within certain guidelines, detailing rate base, revenues, and cost of service for calendar year 1993. On February 14, 1994, the Partnership submitted the 1993 cost and revenue study for its South Line to the parties to the FERC proceeding. Additional discovery requests were filed by the shippers and FERC staff on or before March 14, 1994. The present procedural schedule calls for the shippers to present their case against the Partnership in late May 1994, and the FERC staff to present their case by late June 1994, although this timetable may be extended. The Partnership is maintaining a vigorous defense in the FERC proceeding as well as continuing efforts to resolve these matters. In October 1992, El Paso filed a petition for reorganization under Chapter 11 of the federal bankruptcy laws and halted refinery operations. All activity in El Paso's civil action against the Partnership has been stayed indefinitely by virtue of the bankruptcy proceeding. In November 1993, the El Paso bankruptcy was converted from a Chapter 11 to a Chapter 7 proceeding, and an interim trustee was appointed. In addition, El Paso's general partner is presently in Chapter 11 bankruptcy proceedings. In February 1994, a permanent trustee and a new judge were named to handle these proceedings. On July 28, 1993, the Partnership reached a settlement with Navajo whereby Navajo agreed to dismiss its pending civil litigation in New Mexico and withdraw any challenge to the direction of flow of the six-inch pipeline, including any such challenge in the FERC proceeding. The Partnership agreed to make certain cash payments to Navajo over three years and to undertake and complete an additional pipeline capacity expansion between El Paso and Phoenix if certain events related to volume levels and proration of pipeline capacity should occur within the next five years. During the quarter ended September 30, 1993, the Partnership recorded a $12 million provision for litigation costs, which reflects the terms of the Navajo settlement as well as anticipated legal fees and other costs related to defense and ultimate resolution of the FERC proceeding and the remaining civil action brought by El Paso and its general partner. It is the opinion of management that any additional costs, in excess of recorded liabilities, incurred to defend and resolve these matters, or any capital expenditures which may be required under the terms of the Navajo settlement, will not have a material adverse effect on the Partnership's financial condition; nevertheless, it is possible that the Partnership's results of operations, in particular quarterly or annual periods, could be materially affected by the ultimate resolution of these matters. Environmental Matters: The Partnership is, from time to time, subject to environmental clean up and enforcement actions. In particular, the federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA" or "Superfund" law) generally imposes joint and several liability for cleanup and enforcement costs, without regard to fault or the legality of the original conduct, on current or predecessor owners and operators of a site. Since August 1991, the Partnership, along with several other respondents, has been involved in one cleanup ordered by the United States Environmental Protection Agency ("EPA") related to ground water contamination in the vicinity of the Partnership's storage facilities and truck loading terminal at Sparks, Nevada. In addition, the Partnership is also involved in six ground water hydrocarbon remediation efforts under administrative orders issued by the California Regional Water Quality Control Board at, or adjacent to, its facilities at Colton, Concord, Mission Valley, Brisbane, San Jose and West Sacramento, California. The investigation and remediation at the Sparks terminal is also the subject of a lawsuit brought in January 1991 by the Nevada Division of Environmental Protection against the respondents to the EPA order in the Second Judicial District Court of the State of Nevada. This lawsuit was subsequently joined by the County of Washoe Health District and the City of Sparks, Nevada and seeks unspecified, but potentially significant, damages. The Partnership may be required to pay in excess of $100,000 in fines arising from these lawsuits. In addition, the Partnership is one of the defendants in a number of lawsuits brought by property owners seeking unspecified, but potentially significant, damages for alleged property value diminishment attributable to soil or ground water contamination arising from the defendants' operations. To date, no significant progress has been made in any of these cases. The Partnership is vigorously defending itself in these actions, although it may pursue settlement discussions in certain cases to avoid the costs and uncertainties of extended litigation. 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. The amount and terms of the fines and associated costs arising from this Notice of Violations remains under discussion with the EPA, however, management believes that the total cost to the Partnership will not be material to its results of operations or financial condition, but may be in excess of $100,000. Reference is made to Note 6 to the Partnership's consolidated financial statements, beginning on page 38 of this Report, for further discussion of these matters. Other: The Partnership is also party to a number of other legal actions arising in the ordinary course of business. While the final outcome of these legal actions cannot be predicted with certainty, it is the opinion of management that none of these legal actions, when finally resolved, will have a material adverse effect on the Partnership's financial condition. 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 1993. 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 Registrant's Preference Units are traded, the high and low sales prices of such Units and distributions declared on such Units for the two years ended December 31, 1993, and the approximate number of record holders of such Units is set forth in Note 11 to the Partnership's consolidated financial statements on page 45 of this Report. Upon the payment of the cash distribution for the fourth quarter of 1993, the period of subordination of the Partnership's Common Units to its Preference Units ended. The subordination period, which began in December 1988, was a period during which cash distributions on the Common Units were subject to the preferential rights of the holders of the publicly traded Preference Units to receive the minimum quarterly distribution of $0.55 per unit. As of January 1, 1994, all differences and distinctions between the Preference Units and the Common Units were eliminated, as a result of which Common Units will have equivalent rights with respect to cash distributions. From and after January 1, 1994, the Preference Units will be treated as and called Common Units. Notice will be given to holders of Preference Units in the near future informing them of the method for exchanging their Preference Units for Common Units. Item 6. Item 6. Selected Financial Data. The following table sets forth, for the periods and at the dates indicated, selected consolidated financial data for the Partnership. Year Ended December 31, -------------------------------------------- 1989 1990 1991 1992 1993 -------- -------- -------- -------- -------- (in thousands, except per unit data) Income Statement Data: Total revenues..... $187,945 $192,868 $193,438 $205,025 $219,471 Operating expenses (excluding depreciation & amortization) (a). 80,608 78,110 80,775 95,340 122,178 Depreciation & amortization ..... 14,351 15,884 16,834 18,327 18,971 Operating income... 92,986 98,874 95,829 91,358 78,322 Interest expense... 35,633 37,327 36,924 36,937 37,086 Income before cumulative effect of accounting change ........... 59,285 63,560 60,604 54,118 41,616 Cumulative effect of accounting change (b)........ -- -- -- (16,407) -- Net income......... $ 59,285 $ 63,504 $ 60,604 $ 37,711 $ 41,616 Per Unit Data: Income before cumulative effect of accounting change............ $ 3.07 $ 3.28 $ 3.10 $ 2.77 $ 2.13 Cumulative effect of accounting change............ -- -- -- (0.84) -- Net income......... 3.07 3.28 3.10 1.93 2.13 Cash distributions paid.............. 1.778 2.50 2.70 2.80 2.80 Cash distributions declared.......... 2.30 2.55 2.75 2.80 2.80 Capital Expenitures....... $ 35,652 $ 29,236 $ 27,715 $ 30,931 $ 21,084 Balance Sheet Data (at year end): Properties, plant and equipment, net.............. $583,675 $598,021 $605,461 $618,098 $616,610 Total assets...... 646,163 665,177 677,480 684,852 696,980 Long-term debt.... 355,000 355,000 355,000 355,000 355,000 Total partners' capital.......... 272,977 288,092 296,075 279,010 265,851 (a) 1993 operating expenses include a $27.0 million provision for environmental and litigation costs and 1992 operating expenses include a $10.0 million provision for environmental costs. (b) Effective January 1, 1992, the Partnership adopted new accounting standards for postretirement and postemployment benefits (Statements of Financial Accounting Standards Nos. 106 and 112). Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Results of Operations 1993 Compared with 1992: The Partnership reported 1993 net income of $41.6 million, or $2.13 per unit, compared to net income of $37.7 million, or $1.93 per unit, in 1992. Excluding the effects of provisions for environmental and litigation costs aggregating $27 million in 1993 and a $10 million provision for environmental costs in 1992, 1993 net income would have been $68.1 million, or $3.48 per unit, compared to net income of $63.9 million, or $3.27 per unit, before the cumulative effect of an accounting change in 1992. Total 1993 revenues of $219.5 million were 7% above prior year levels. Trunk revenues of $171.8 million were $10.7 million higher than in 1992 due to higher volumes, a longer average length of haul, a favorable shift of volumes from the East Line to the West Line and the full year effect in 1993 of a May 1992 California intrastate tariff increase. Total volumes transported increased 2.9% in 1993, with commercial volumes 3.6% higher, and military volumes approximately 10% lower, than in 1992. The longer average haul reflects increased deliveries to Arizona and Nevada, as well as increased deliveries to Tucson from Los Angeles as a result of reduced supply from El Paso refineries in 1993. The refinery formerly owned by El Paso Refinery, L.P., which had been out of service since that company entered bankruptcy in October 1992, began operating at a reduced level during the third quarter of 1993. Management expects that a portion of this refinery's production will continue to be shipped to Arizona, resulting in a shift of certain volumes from the West Line back to the East Line in 1994. Storage and terminaling revenues were $3.2 million higher due to a January 1993 terminal services rate increase. Other revenues increased $0.5 million due to higher volumes. Total 1993 operating expenses of $141.1 million included a $15.0 million provision to increase the Partnership's existing reserve for environmental remediation and investigation costs and a $12.0 million provision to reflect anticipated legal fees and other costs related to defense and ultimate resolution of certain East Line civil litigation as well as a related Federal Energy Regulatory Commission ("FERC") proceeding. Total 1992 operating expenses of $113.7 million included a $10.0 million provision for environmental remediation costs. Excluding the environmental and litigation provisions, 1993 operating expenses of $114.1 million were $10.5 million, or 10%, higher than in 1992, with higher field operating expenses ($5.0 million), general and administrative expenses ($3.0 million), power cost ($0.8 million), facilities costs ($0.7 million) and depreciation and amortization ($0.6 million), and a smaller product gain ($0.4 million) accounting for that increase. The increase in field operating expenses is largely attributable to higher major maintenance costs due to preventative pipeline repairs associated with the Partnership's ongoing internal inspection program and flood damage repairs, partially offset by lower environmental remediation costs subsequent to recording the $15.0 million provision in September 1993. Also contributing to higher field operating expenses were $1.5 million in pipeline inspection costs associated with the potential conversion of one of the Partnership's pipelines to crude oil service, greater usage of drag reducing agent to increase capacity on certain lines and higher salary costs. The increase in general and administrative expense is largely attributable to higher outside legal and consulting costs associated with the East Line civil litigation and FERC proceeding that were incurred prior to recording the $12.0 million litigation provision in September 1993. The increase in power cost reflects increased volumes and length of haul. The increase in facilities costs primarily resulted from higher right of way rentals and property taxes. This increase in property taxes and the increase in depreciation and amortization expense resulted from the Partnership's expanding capital asset and software base. The product gain is within industry measurement standards and may vary from period to period. 1992 Compared with 1991: 1992 net income of $54.1 million, before the cumulative effect of an accounting change, was $6.5 million, or 11%, lower than in 1991, primarily due to a $10.0 million provision for environmental costs recorded in the third quarter of 1992. Excluding the environmental provision, 1992 net income before the cumulative effect of the accounting change would have been $63.9 million, or 5.5%, higher than in 1991. Total 1992 revenues of $205.0 million were 6% above prior year levels. Trunk revenues of $161.1 million were 4% higher than in 1991 due to the May 1992 California intrastate tariff increase, which generated an additional $4.1 million in revenues, and increased volumes and longer average length of haul. Total volumes transported increased 0.7% in 1992, with commercial volumes 1% higher and military volumes 6% lower than in 1991. Long-haul deliveries to Arizona and Nevada improved over prior year levels, while short-haul movements in the Los Angeles area and between San Francisco Bay area refineries were lower, contributing to an overall 2.5% increase in barrel-miles. Total California deliveries approximated 1991 levels. During much of 1992, East Line volumes increased, and West Line volumes decreased, as a result of East Line capacity expansions completed in late 1991 and 1992 and the shift of Phoenix-bound volumes from the West Line to the East Line. Storage and terminaling revenues of $34.0 million were 2% higher in 1992 due to increased volumes and a military rate increase. Other revenues, of $9.9 million, increased about 85% due to new services offered to customers, including the vapor handling system at Watson Station and detergent additive injection at all California terminals. Total operating expenses of $113.7 million were $16.1 million higher than in 1991, largely as the result of the $10.0 million provision recorded for environmental remediation costs at the Partnership's Sparks, Nevada terminal and two facilities in California. Excluding that provision, operating expenses would have been $6.1 million, or 6%, higher than in 1991, with higher field operating expenses ($1.7 million), depreciation and amortization ($1.5 million), general and administrative expenses ($1.2 million), facilities costs ($0.9 million) and a smaller product gain ($0.7 million) accounting for that increase. The increase in field operating expenses is largely attributable to higher environmental compliance and remediation costs, greater usage of drag reducing agent to increase East Line capacity, and higher salary cost. Depreciation and amortization increased due to an expanding capital base, higher composite depreciation rates in 1992, and amortization of pipeline system operating software. The increase in general and administrative expense is largely attributable to the $1.8 million current year accrual resulting from the change in accounting for postretirement and postemployment benefits effective January 1, 1992, higher outside legal costs associated with lawsuits and a FERC proceeding initiated by certain East Line shippers in September 1992, and higher information services costs, partially offset by lower employee health insurance and incentive compensation program costs. The increase in facilities costs resulted from higher insurance premiums for environmental and related coverage. The product gain is within industry measurement standards and may vary from period to period. Excluding the environmental provision and the current year accrual of $1.8 million associated with the accounting change, operating expenses would have been up $4.2 million, or 4%, over the prior year. Other income, net was $2.1 million lower in 1992 due to lower market interest rates on short-term investments and a $1.1 million nonrecurring arbitration award in 1991. Effective January 1, 1992, the Partnership adopted new accounting standards for postretirement and postemployment benefits (Statements of Financial Accounting Standards Nos. 106 and 112). As a result, 1992 net income was reduced by $16.4 million, or $0.84 per unit, representing the cumulative effect of the new principle for years prior to 1992. Financial Condition - Liquidity and Capital Resources For the year ended December 31, 1993, cash flow from operations before working capital and minority interest adjustments totaled $82.8 million, compared to $84.0 million in 1992. Working capital cash requirements were $2.2 million in 1993, whereas in 1992 working capital components provided an additional $2.0 million in cash flow, largely due to the maturity of $4.9 million in short- term investments in 1992 and due to timing differences in collection of accounts receivable and payment of accrued obligations. The $81.6 million of net cash provided by operations in 1993 was largely used to pay cash distributions of $55.9 million and fund capital expenditures of $21.1 million, resulting in a net increase in cash and cash equivalents of $4.8 million for the year. Total cash and cash equivalents of $32.2 million at December 31, 1993 included $14.0 million for the fourth quarter 1993 cash distribution, which was paid in February 1994. Since the useful lives of the pipeline system and terminal properties are generally long and technological change is limited, replacement of facilities is relatively infrequent. The principal need for capital, therefore, has been in connection with capacity expansions, service enhancements, compliance with increasingly stringent environmental and safety regulations and installation of Supervisory Control and Data Acquisition ("SCADA") equipment and related operations systems software. For the year ended December 31, 1993, Partnership capital expenditures aggregated $21.1 million, of which approximately $5 million was used for revenue-generating projects, and the balance for sustaining projects. The primary revenue-generating project was completion of the second phase of an expansion of East Line capacity which became operational in August 1992 and increased the daily pumping capacity between El Paso, Texas and Tucson, Arizona from 67,000 barrels to 95,000 barrels, and increased daily capacity from Tucson to Phoenix, Arizona from 25,000 barrels to 55,000 barrels. 1993 sustaining expenditures were primarily in the areas of environmental and safety compliance, operating systems software development, replacement of two flood damaged river crossings in Arizona, pipeline relocations, investments towards reducing or containing power costs, station automation and cathodic protection. Environmental and safety projects included additions and modifications to storage tanks and vapor recovery systems to comply with more stringent regulations, oily water handling facilities and fire protection improvements. Such expenditures aggregated approximately $5 million in 1993 and are expected to increase over time in response to increasingly rigorous governmental environmental and safety standards. Systems software development included the application of knowledge-based systems to products movement scheduling and enhancements to the SCADA system. The planned 1994 capital program aggregates approximately $22 million, of which approximately $4 million is planned for income- enhancing projects, with the balance expected to be invested in sustaining projects. The Partnership presently anticipates that ongoing capital expenditures will average approximately $25 to $30 million per year over the next five years, however additional facility improvements, pipeline expansions or acquisitions may be pursued under certain circumstances. The Partnership is currently investigating the potential conversion of one of its pipelines to crude oil service. Should the Partnership proceed with the crude line project, in addition to the necessary capital investment, a significant portion of the associated expenditures may be required to be expensed. The Partnership expects that it will generally finance its ongoing capital program with internally-generated funds, however the Partnership may use borrowed funds or proceeds from additional equity offerings to finance a portion of future capital expenditures. Future capital expenditures will continue to depend on numerous factors, some of which are beyond the Partnership's control, including demand for refined petroleum products in the pipeline system's market areas, governmental regulations and the availability of sufficient funds from operations to pay for such expenditures. Due to the capital-intensive nature of the Partnership's business, inflation generally causes an understatement of operating expenses because depreciation is based on the historical costs of assets rather than the replacement costs of assets. Long-term debt at December 31, 1993 and 1992 consisted of $355 million of First Mortgage Notes at an average interest rate of 10.51% per annum. Principal repayments are required beginning December 15, 1994, however, the Partnership intends to refinance some or all of this debt as it becomes payable. To facilitate such refinancing and provide for additional financial flexibility, the Partnership arranged a $60 million multi-year term credit facility and a $20 million working capital facility with three banks in October 1993. The term facility may be used for refinancing a portion of the Partnership's long-term debt and capital projects, while the working capital facility replaced a $20 million facility originally established in April 1990 and is available for general short-term borrowing purposes. To date, neither of these facilities have been utilized. Other Matters Environmental Matters: The Partnership's transportation and terminal operations are subject to extensive regulation under federal, state and local environmental laws concerning, among other things, the generation, handling, transportation and disposal of hazardous materials, and the Partnership is, from time to time, subject to environmental cleanup and enforcement actions. In particular, the federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA" or "Superfund" law) generally imposes joint and several liability for cleanup and enforcement costs, without regard to fault or the legality of the original conduct, on current or predecessor owners and operators of a site. Along with several other respondents, the Partnership is presently involved in one cleanup ordered by the United States Environmental Protection Agency ("EPA") related to ground water contamination in the vicinity of the Partnership's storage facilities and truck loading terminal at Sparks, Nevada. In addition, the Partnership is also involved in six ground water hydrocarbon remediation efforts under administrative orders issued by the California Regional Water Quality Control Board at, or adjacent to, certain of its facilities in California. The Partnership is cooperating with the United States military in investigating the extent of its responsibility with respect to ground water hydrocarbon contamination adjacent to its pump station and a major military fuel storage facility at Norwalk, California. The Partnership is also cooperating with a request from the Arizona Department of Environmental Quality to participate in a joint industry investigation of possible ground water hydrocarbon contamination in the vicinity of the Partnership's terminal at Phoenix. The Partnership is also involved in soil and ground water remediation projects, at and adjacent to various other terminal and pipeline locations, that have not been mandated by government agencies but are conducted in the ordinary course of business. In a number of these cleanup projects, the Partnership is participating with other entities ranging from large integrated petroleum companies to certain less financially sound parties. During the quarter ended September 30, 1993, the Partnership completed a comprehensive re-evaluation of its potential liabilities associated with environmental remediation activities and, as a result, recorded a $15 million provision to increase its existing reserve for environmental remediation costs. This provision reflects the estimated cost of completing all remediation projects presently known to be required, either by government mandate or in the ordinary course of business, as well as the cost of performing preliminary environmental investigations at several locations, including the investigation of potential contamination in the vicinity of the Partnership's Phoenix terminal. 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. The cash expenditures related to these projects are primarily expected to occur over the next five years; however, certain remediation projects, including the largest project at Sparks, are expected to continue for a period of approximately ten years. Estimates of the Partnership's ultimate liabilities associated with environmental remediation activities and related costs are particularly difficult to make with certainty due to the number of variables involved, including the early stage of investigation at certain sites, the lengthy time frames required to complete remediation at most locations, the number of parties involved, the number of remediation alternatives available, and the uncertainty of potential recoveries from third parties. Based on the information presently available, it is the opinion of management that any such costs, to the extent they exceed recorded liabilities, will not have a material adverse effect on the Partnership's financial condition; nevertheless, it is possible that the Partnership's results of operations in particular quarterly or annual periods could be materially affected as conditions change or additional information becomes available. Rate Regulation: The Partnership's interstate common carrier pipeline operations are subject to rate regulation by the Federal Energy Regulatory Commission ("FERC") under a methodology adopted in 1985 for establishing allowable rates for liquid petroleum pipelines. The methodology is subject to clarification in individual cases and leaves many issues for determination on a case-by-case basis. In addition, rates may be established under an alternative form of "light-handed" rate regulation where it can be demonstrated that the carrier lacks significant market power. Intrastate common carrier operations in California are also subject to regulation by the California Public Utilities Commission ("CPUC"). In 1993, tariffs subject to FERC and CPUC regulation each accounted for approximately one-half of total transportation revenues. The Energy Policy Act of 1992 required the FERC to develop a simplified rate-making methodology for oil pipelines by October 1993, and also established as "just and reasonable" all existing pipeline tariffs that had not been under protest for 365 days prior to the date the bill was passed. This excluded the Partnership's East Line tariffs, which had been challenged in September 1992. In October 1993, the FERC issued Order 561 establishing a new rate-making methodology, to be effective January 1995, that would allow for annual indexing of tariffs, with the indexing factor based on changes in the Producer Price Index minus one percent. The Partnership and other parties petitioned for a rehearing of the FERC order because the index selected by the FERC does not adequately reflect historical cost increases incurred by the industry. The FERC granted the request for rehearing for purposes of reconsideration of the index and has also issued Notices of Inquiry regarding cost-based rate- making under certain conditions, and market-based rates for carriers that can demonstrate lack of market power. At the present time, it is not possible to predict with certainty what final simplified rate-making methodology will be adopted or what effect such methodology may have on future Partnership tariffs. East Line Litigation and FERC Proceeding: Certain of the Partnership's shippers have filed civil suits and initiated a FERC proceeding alleging, among other things, that the shippers had been damaged by the Partnership's failure to fulfill alleged promises to expand the East Line's capacity between El Paso, Texas and Phoenix, Arizona to meet shipper demand. The FERC proceeding also involves claims, among other things, that certain of the Partnership's tariffs and charges on the East and West Lines are excessive. During the quarter ended September 30, 1993, the Partnership recorded a $12 million provision for litigation costs, which reflects the terms of settlement of one of the civil actions, as well as anticipated legal fees and other costs related to defense and ultimate resolution of the FERC proceeding and the remaining civil action. Management believes that it has acted properly with respect to its expansion of the East Line. Management also believes that the Partnership's tariffs are just and reasonable and, so long as certain of the underlying assumptions and interpretations of rate-making methodology made by the Partnership in supporting these tariffs are ruled upon favorably, that these tariffs will be upheld should the FERC proceeding progress to its completion. However, because of the nature of FERC rate-making methodology, it is not possible to predict with certainty whether the Partnership's assumptions and rate-making approach will be upheld by the FERC and, hence, it is impossible to predict the outcome of the FERC proceeding. It is the opinion of management that any additional costs, in excess of recorded liabilities, incurred to resolve these matters, or any capital expenditures for further expansion of the East Line, which may be required if certain events occur during the next five years, will not have a material adverse effect on the Partnership's financial condition; nevertheless, it is possible that the Partnership's results of operations, in particular quarterly or annual periods, could be materially affected by the ultimate resolution of these matters. Demand for Refined Petroleum Products: Demand for transportation and terminaling services is principally a function of product consumption and competition in markets served by the pipeline system. Commercial volumes are generally dependent upon such factors as prevailing economic conditions, demographic changes, transportation and terminaling alternatives and, to a lesser degree, product prices. Military volumes are dependent upon the level of activity at military bases served by the Partnership. Partnership management anticipates that commercial deliveries of refined petroleum products will continue to gradually increase as the economies of those Western states served by the Partnership continue to recover from the economic downturn that has been apparent since late 1990. Military volumes, which accounted for 5% of total 1993 volumes, showed improvement over 1992 in the fourth quarter, but are not expected to increase over the foreseeable future. As of year end 1993, three military bases historically served by the Partnership had been closed and realignment of certain other bases continues to occur. During 1993, the pipeline systems, on average, operated at approximately 75% of capacity. While capacity utilization on individual system segments generally ranged from 70% to 90% of capacity, the lines from the Los Angeles area to San Diego and Colton, California operated at full capacity for a portion of the year and the line from Rocklin, California to Reno, Nevada was prorated for a significant period during the year. Overall, volumes have been moderately seasonal, with somewhat lower than average volumes being transported during the first and fourth quarters of each year, although deliveries to specific locations also experience seasonal variations. Item 8. Item 8. Financial Statements and Supplementary Data. The Partnership's consolidated financial statements, together with the report thereon of Price Waterhouse dated January 28, 1994, are set forth on pages 29 through 49 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. The Registrant has no officers, directors or employees. Set forth below is certain information concerning the directors and executive officers of the General Partner. Edward F. Swift, age 70, is a director of the General Partner, Chairman of the Audit Committee and a member of the Compensation and Benefits Committee and Committee on Directors. He has been a consultant to Lehman Brothers (investment bankers) since 1990 and previously had been an advisory director of Shearson Lehman Hutton, Inc. (investment banker and broker-dealer) since 1988. Mr. Swift is also a director of Santa Fe and Illinois Tool Works, Inc. Orval M. Adam, age 63, is a director of the General Partner, Chairman of the Compensation and Benefits Committee and a member of the Audit Committee and Committee on Directors. He retired in January 1991 from his position as Senior Vice President and Chief Financial Officer of Santa Fe, which he held since April 1988. Mr. Adam is also a director of SFP Pipeline Holdings, Inc., the sole shareholder of the General Partner. Wilford D. Godbold, Jr., age 55, is a director of the General Partner and a member of the Audit Committee and Committee on Directors. Mr. Godbold has served as President and Chief Executive Officer of Zero Corporation (container manufacturer) since 1984. Mr. Godbold is also a director of Zero Corporation, Pacific Enterprises and Southern California Gas Company. Robert D. Krebs, age 51, is a director of the General Partner, Chairman of the Committee on Directors and a member of the Compensation and Benefits Committee. Mr. Krebs has served as Chairman, President and Chief Executive Officer of Santa Fe since June 1988 and, previously, served as President and Chief Executive Officer of Santa Fe from July 1987. Mr. Krebs is a director of Santa Fe and the Atchison, Topeka and Santa Fe Railway Company and is also a director of Phelps Dodge Corporation, Northern Trust Corporation, Catellus Development Corporation and Santa Fe Energy Resources, Inc. Denis E. Springer, age 48, is a director of the General Partner and a member of the Compensation and Benefits Committee and Committee on Directors. Mr. Springer has been Senior Vice President and Chief Financial Officer of Santa Fe since October 1993. Mr. Springer previously served Santa Fe as Senior Vice President, Treasurer and Chief Financial Officer since January 1992, Vice President, Treasurer and Chief Financial Officer since January 1991 and Vice President-Finance from April 1988 to December 1990. Mr. Springer is also a director of SFP Pipeline Holdings, Inc., the sole shareholder of the General Partner, and the Atchison, Topeka and Santa Fe Railway Company. Irvin Toole, Jr., age 52, is President, Chief Executive Officer and Chairman of the Board of Directors of the General Partner. From November 1988 until assignment to his present position in September 1991, Mr. Toole served as Senior Vice President, Treasurer and Chief Financial Officer, and previously as Vice President-Administration from February 1986 to November 1988. Mr. Toole is also Chairman of the Board of Directors of SFP Pipeline Holdings, Inc., the sole shareholder of the General Partner. Robert L. Edwards, age 38, is a director of the General Partner and has been Senior Vice President, Treasurer and Chief Financial Officer of the General Partner since December 1991. Mr. Edwards served Santa Fe from July 1990 through November 1991 as Vice President-Administration; from March 1989 through June 1990 as Vice President-Human Resources and Administration; and from June 1988 through February 1989 as Assistant Vice President-Executive Department. Prior to that, Mr. Edwards held various executive positions with the General Partner since May 1985. Mr. Edwards is also a director of SFP Pipeline Holdings, Inc., the sole shareholder of the General Partner. John M. Abboud, age 51, has been Senior Vice President of the General Partner since 1985. In his current capacity, Mr. Abboud is responsible for operations, engineering and environmental affairs. Barry R. Pearl, age 44, has been Senior Vice President of the General Partner since January 1992, with responsibility for business development, planning and information systems. Mr. Pearl previously served as Vice President-Business Development and Planning between November 1988 and January 1992 and Vice President-Operations between May 1986 and November 1988. Lyle B. Boarts, age 50, is Vice President-Human Resources of the General Partner. Mr. Boarts joined the General Partner in June 1986 as the Director of Human Resources and was named to his current position in November 1988. R. Gregory Cunningham, age 48, was appointed Vice President- General Counsel in January 1994. Previously, he served as General Counsel of the General Partner since January 1991 and, prior to such date, as General Attorney since November 1985. William M. White, age 48, has served as Vice President- Engineering of the General Partner, with responsibility for engineering and construction, since January 1993. Mr. White previously was Manager-Northern District from May 1986 through December 1992. Burnell H. DeVos III, age 40, has served as Controller and Secretary of the General Partner since January 1993. Mr. DeVos was Assistant Controller of the General Partner from May 1989 through December 1992 and, previously, was Controller of a Los Angeles law firm from February 1989 through May 1989, and a Senior Audit Manager at Price Waterhouse through February 1989. Patrick L. Avery, age 41, has served as Vice President- Environmental and Safety of the General Partner since October 1993. Mr. Avery was Corporate Environmental Manager at Amerada Hess Corporation from October 1992 to October 1993. Previously, he held various positions at ARCO Products Company since 1982, including Director-California Government Relations and Environmental Health and Safety Manager at ARCO's Los Angeles refinery. Messrs. Krebs, Springer and Edwards each filed a delinquent Form 3, "Initial Statement of Beneficial Ownership of Securities," during 1993. In addition, neither Mr. White nor Mr. Avery filed a Form 3 upon appointment to his present position and each has, therefore, filed a delinquent Form 3 in 1994. In February 1994, Mr. Edwards filed a delinquent Form 4 in connection with one transaction. Item 11. Item 11. Executive Compensation. The directors, officers and employees of the General Partner receive no direct compensation from the Partnership for their services to the Partnership. The Partnership reimburses the General Partner for all direct costs incurred in managing the Partnership and all indirect costs (principally salaries and other general and administrative costs) allocable to the Partnership. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. (a) Security Ownership of Certain Beneficial Owners To the best of the General Partner's knowledge, the following persons are the only persons who are beneficial owners of more than five percent of the Registrant's equity securities: Percent Title of Class Name and Address Amount of Class -------------- ------------------------- --------- -------- Common Units Santa Fe Pacific Pipelines, Inc. 8,148,148 100% 888 South Figueroa Street Los Angeles, CA 90017 (b) Security Ownership of Management As of March 1, 1994, Units beneficially held by all directors and officers as a group represent less than 1% of the Partnership's outstanding Units. Item 13. Item 13. Certain Relationships and Related Transactions. The Registrant and the Operating Partnership are managed by the General Partner pursuant to the Amended and Restated Agreement of Limited Partnership of the Partnership (the "Partnership Agreement"), and the Amended and Restated Agreement of Limited Partnership of the Operating Partnership (the "Operating Partnership Agreement"). Under the Partnership Agreement and Operating Partnership Agreement, the General Partner and certain related parties are entitled to reimbursement of all direct and indirect costs and expenses related to the business activities of the Partnership and the Operating Partnership. These costs and expenses include compensation and benefits payable to officers and employees of the General Partner, payroll taxes, corporate office building rentals, general and administrative costs, and legal and other professional services fees. These costs to the Partnership totaled $43.0 million, $37.1 million and $35.8 million in 1993, 1992 and 1991, respectively. The Partnership Agreement provides for incentive distribution payments to the General Partner out of the Partnership's "Available Cash" (as defined in the Partnership Agreement) which increase as quarterly distributions to Unitholders exceed certain specified targets. The incremental incentive distributions payable to the General Partner are 8%, 18% and 28% of all distributions of Available Cash that exceed, respectively, $0.60, $0.65 and $0.70 per Unit. Such incentive distributions aggregated $1.2 million in 1993 and in 1992 and $0.8 million in 1991. 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 and (2) Financial Statement Schedules: See Index to Financial Statements on page 28 for financial statements and financial statement schedules filed as a part of this Report. (3) Exhibits: The following exhibits are filed as a part of this Report. With the exception of Exhibits 21 and 24, all exhibits listed herein are incorporated by reference, with the location of the exhibit in the Registrant's previous filing indicated parenthetically. Exhibit Number Description ------- ----------------------------------------------------------- 3.1 Amended and Restated Agreement of Limited Partnership of the Registrant, dated as of December 19, 1988. (1988 Form 10-K - Exhibit 3.1) 3.2 Amended and Restated Agreement of Limited Partnership of the Operating Partnership, dated as of December 19, 1988. (1988 Form 10-K - Exhibit 3.2) 3.3 Certificate of Limited Partnership of the Registrant, dated as of August 23, 1988. (1988 Form 10-K - Exhibit 3.3) 3.4 Certificate of Limited Partnership of the Operating Partnership, dated as of August 23, 1988. (1988 Form 10-K - Exhibit 3.5) 3.5 Assumption Agreement between the Registrant and Santa Fe Pacific Pipelines, Inc., dated as of December 7, 1989. (1989 Form 10-K - Exhibit 3.4) 3.6 Amendment No. 1 to Amended and Restated Agreement of Limited Partnership of the Registrant, dated as of December 7, 1989. (1989 Form 10-K - Exhibit 3.2) 3.7 Certificate of Amendment to Certificate of Limited Partnership of the Registrant, dated as of December 7, 1989. (1989 Form 10-K - Exhibit 3.3) 3.8 Amendment No. 1 to Amended and Restated Agreement of Limited Partnership of the Operating Partnership, dated as of December 7, 1989. (1989 Form 10-K - Exhibit 3.5) 3.9 Certificate of Amendment to Certificate of Limited Partnership of the Operating Partnership, dated as of December 7, 1989. (1989 Form 10-K - Exhibit 3.6) 3.10 Amendment No. 2 to Amended and Restated Agreement of Limited Partnership of the Operating Partnership, dated as of January 24, 1990. (1989 Form 10-K - Exhibit 3.8) 3.11 Certificate of Amendment No. 2 to Certificate of Limited Partnership of the Operating Partnership, dated as of January 30, 1990. (1989 Form 10-K - Exhibit 3.9) 4.1 Form of Deposit Agreement between the Registrant, American Stock Transfer & Trust Company and the General Partner, as attorney-in-fact for holders of units and depositary receipts. (Form S-1 Registration Statement No. 33-24395 - Exhibit 4.1) 4.2 First Mortgage Note Agreement, dated December 8, 1988 (a conformed composite of 54 separate note agreements, identical except for signatures). (1988 Form 10-K - Exhibit 4.2) 4.3 Deed of Trust, Security Agreement and Fixture Filing, dated December 8, 1988, between the Operating Partnership, the General Partner, Chicago Title Insurance Company and Security Pacific National Bank. (1988 Form 10-K - Exhibit 4.3) 4.4 Trust Agreement, dated December 19, 1988, between the Operating Partnership, the General Partner and Security Pacific National Bank. (1988 Form 10-K - Exhibit 4.4) 4.5 The Operating Partnership has established a $60 million term credit facility with three banks, dated as of October 14, 1993. As the maximum allowable borrowings under this facility do not exceed 10% of the Registrant's total assets, this instrument is not filed as an exhibit to this Report, however, the Registrant hereby agrees to furnish a copy of such instrument to the Security and Exchange Commission upon request. 21 Subsidiaries of the Registrant* 24 Powers of attorney* * Filed herewith. (b) Reports on Form 8-K filed during the quarter ended December 31, 1993: None SIGNATURES Santa Fe Pacific Pipeline Partners, L.P., 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 PIPELINE PARTNERS, L.P. (Registrant) By: Santa Fe Pacific Pipelines, Inc., as General Partner Dated: March 25, By: /s/ IRVIN TOOLE, JR. 1994 -------------------------------------- Irvin Toole, Jr. Chairman, 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 with Santa Fe Pacific Pipelines, Inc., as General Partner, and on the date indicated. Signature Title ----------------------------- ------------------------- Chairman, President and Chief Executive Officer /s/ IRVIN TOOLE, JR. (Principal Executive ----------------------------- Officer) Irvin Toole, Jr. and Director Senior Vice President, Treasurer and Chief Financial Officer /s/ ROBERT L. EDWARDS (Principal Financial ----------------------------- Officer) Robert L. Edwards and Director /s/ BURNELL H. DEVOS III Controller and ----------------------------- Secretary Burnell H. DeVos III (Principal Accounting Officer) EDWARD F. SWIFT* ----------------------------- Edward F. Swift Director ORVAL M. ADAM* ----------------------------- Orval M. Adam Director WILFORD D. GODBOLD, JR.* ----------------------------- Wilford D. Godbold, Jr. Director ROBERT D. KREBS* ----------------------------- Robert D. Krebs Director DENIS E. SPRINGER* ----------------------------- Denis E. Springer Director *By: /s/ ROBERT L. EDWARDS Senior Vice President, ----------------------------- Treasurer Robert L. Edwards, and Chief Financial attorney in fact Officer Dated: March 25, 1994 SANTA FE PACIFIC PIPELINE PARTNERS, L.P. Page -------- Financial Statements: Report of Independent Accountants................................ 29 Consolidated Balance Sheet as of December 31, 1993 and 1992 ..... 30 Consolidated Statement of Income for the three years ended December 31, 1993....................... 31 Consolidated Statement of Cash Flows for the three years ended December 31, 1993....................... 32 Consolidated Statement of Partners' Capital for the three years ended December 31, 1993....................... 33 Notes to Consolidated Financial Statements....................... 34 Financial Statement Schedules for the three years ended December 31, 1993: V - Property, Plant and Equipment............................... 47 VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment......................... 48 X - Supplementary Income Statement Information.................. 49 All other schedules have been omitted because they are not applicable or the required information is presented in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Partners of Santa Fe Pacific Pipeline Partners, L.P. In our opinion, the consolidated financial statements listed in the index appearing on page 28 present fairly, in all material respects, the financial position of Santa Fe Pacific Pipeline Partners, L.P. and its majority-owned operating partnership 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 Partnership'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. Note 2 to the consolidated financial statements includes a description of a change in the method of accounting for postretirement and postemployment benefits effective January 1, 1992. PRICE WATERHOUSE Los Angeles, California January 28, 1994 SANTA FE PACIFIC PIPELINE PARTNERS, L.P. CONSOLIDATED BALANCE SHEET (In thousands) December 31, ---------------------- 1993 1992 --------- --------- A S S E T S Current assets Cash and cash equivalents.................... $ 32,162 $ 27,356 Accounts receivable, net .................... 32,787 28,151 Other current assets......................... 2,801 2,882 --------- --------- Total current assets.................... 67,750 58,389 --------- --------- Properties, plant and equipment .................. 683,082 668,397 Less accumulated depreciation ............... 66,472 50,299 --------- --------- Net properties, plant and equipment .... 616,610 618,098 Other assets...................................... 12,620 8,365 --------- --------- Total assets............................ $ 696,980 $ 684,852 ========= ========= LIABILITIES AND PARTNERS' CAPITAL Current liabilities Accounts payable............................. $ 2,403 $ 2,994 Accrued liabilities.......................... 33,235 18,599 --------- --------- Total current liabilities............... 35,638 21,593 Long-term debt ................................... 355,000 355,000 Other long-term liabilities ...................... 39,283 27,763 --------- --------- Total liabilities ...................... 429,921 404,356 --------- --------- Minority interest ................................ 1,208 1,486 --------- --------- Commitments and contingencies (Note 6)............ --------- --------- Partners' capital General Partner ............................. 1,208 1,486 Common Unitholder............................ 52,454 57,936 Preference Unitholders ...................... 212,189 219,588 --------- --------- Total partners' capital ................ 265,851 279,010 --------- --------- Total liabilities and partners' capital $ 696,980 $ 684,852 ========= ========= See Notes to Consolidated Financial Statements. SANTA FE PACIFIC PIPELINE PARTNERS, L.P. CONSOLIDATED STATEMENT OF INCOME (In thousands, except per unit amounts) Year ended December 31, -------------------------- 1993 1992 1991 -------- -------- -------- Operating revenues Trunk revenues............................. $171,848 $161,116 $154,800 Storage and terminaling revenues........... 37,213 34,020 33,314 Other revenues............................. 10,410 9,889 5,324 -------- -------- -------- Total operating revenues.............. 219,471 205,025 193,438 -------- -------- -------- Operating expenses Field operating expenses................... 36,325 31,331 29,680 General and administrative expenses........ 22,378 19,420 18,178 Facilities costs........................... 19,555 18,876 18,000 Depreciation and amortization.............. 18,971 18,327 16,834 Power cost................................. 18,940 18,116 17,975 Provisions for environmental and litigation costs (Note 6) ........... 27,000 10,000 -- Product (gains) losses..................... (2,020) (2,403) (3,058) -------- -------- -------- Total operating expenses.............. 141,149 113,667 97,609 -------- -------- -------- Operating income................................ 78,322 91,358 95,829 Interest expense................................ 37,086 36,937 36,924 Other income, net............................... 1,262 843 2,899 -------- -------- -------- Net income before minority interest and cumulative effect of accounting change.... 42,498 55,264 61,804 Less minority interest ........................ (882) (1,146) (1,200) -------- -------- -------- Net income before cumulative effect of accounting change ........................... 41,616 54,118 60,604 Cumulative effect of change in accounting for postretirement and postemployment benefits, net of minority interest ........... -- 16,407 -- -------- -------- -------- Net income ..................................... $ 41,616 $ 37,711 $ 60,604 ======== ======== ======== Income per Unit: Before cumulative effect of accounting change .. $ 2.13 $ 2.77 $ 3.10 Cumulative effect of accounting change ......... -- (0.84) -- -------- -------- -------- Net income ..................................... $ 2.13 $ 1.93 $ 3.10 ======== ======== ======== Operating expenses reflected above include the following expenses incurred by, and reimbursed to, the General Partner (Note 7) .. $ 43,025 $ 37,065 $ 35,810 ======== ======== ======== See Notes to Consolidated Financial Statements. SANTA FE PACIFIC PIPELINE PARTNERS, L.P. CONSOLIDATED STATEMENT OF CASH FLOWS (In thousands) Year ended December 31, ------------------------------- 1993 1992 1991 --------- --------- --------- Cash flows from operating activities: Net income ............................... $ 41,616 $ 37,711 $ 60,604 --------- --------- --------- Adjustments to reconcile net income to net cash provided by operating activities-- Depreciation and amortization .......... 18,971 18,327 16,834 Cumulative effect of change in accounting principle .............. -- 16,407 -- Provisions for environmental and litigation costs ................ 27,000 10,000 -- Environmental and litigation costs paid (4,275) (275) -- Other, net ............................. (464) 1,825 -- Minority interest in net income ........ 882 1,146 1,200 Changes in-- Accounts receivable .................. (4,636) (820) (1,281) Accounts payable and accrued liabilities ................ 2,375 (2,689) 4,041 Other current assets.................. 81 5,460 3,475 --------- --------- --------- Total adjustments................... 39,934 49,381 24,269 --------- --------- --------- Net cash provided by operating activities............. 81,550 87,092 84,873 --------- --------- --------- Cash flows from investing activities: Capital expenditures ..................... (21,084) (30,931) (27,715) Other .................................... 276 487 1,041 --------- --------- --------- Net cash used by investing activities............. (20,808) (30,444) (26,674) Cash flows from financing activities: Distributions to partners and minority interest ................. (55,936) (55,936) (53,542) --------- --------- --------- Increase in cash and cash equivalents ...... 4,806 712 4,657 Cash and cash equivalents-- Beginning of year ........................ 27,356 26,644 21,987 --------- --------- --------- End of year .............................. $ 32,162 $ 27,356 $ 26,644 ========= ========= ========= Interest paid............................... $ 37,326 $ 37,326 $ 37,326 ========= ========= ========= See Notes to Consolidated Financial Statements. SANTA FE PACIFIC PIPELINE PARTNERS, L.P. CONSOLIDATED STATEMENT OF PARTNERS' CAPITAL (In thousands) General Common Preference Partner Unitholder Unitholders Total -------- --------- --------- --------- Partners' capital at December 31, 1990 ............ $ 1,569 $ 61,765 $224,758 $288,092 1991 net income ................... 1,200 25,278 34,126 60,604 1991 cash distributions ........... (921) (22,000) (29,700) (52,621) -------- --------- -------- --------- Partners' capital at December 31, 1991 ............ 1,848 65,043 229,184 296,075 1992 net income before cumulative effect of accounting change ..... 1,146 22,542 30,430 54,118 Cumulative effect of accounting change ............... (347) (6,834) (9,226) (16,407) 1992 cash distributions ........... (1,161) (22,815) (30,800) (54,776) -------- --------- -------- --------- Partners' capital at December 31, 1992 ............ 1,486 57,936 219,588 279,010 1993 net income ................... 882 17,333 23,401 41,616 1993 cash distributions ........... (1,160) (22,815) (30,800) (54,775) -------- --------- -------- --------- Partners' capital at December 31, 1993 ............ $ 1,208 $ 52,454 $212,189 $265,851 ======== ======== ======== ========= See Notes to Consolidated Financial Statements. SANTA FE PACIFIC PIPELINE PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Basis of Accounting The accompanying consolidated financial statements include the accounts of Santa Fe Pacific Pipeline Partners, L.P. (the "Trading Partnership") and SFPP, L.P., (the "Operating Partnership"), collectively referred to as the "Partnership", on a consolidated basis. The Trading Partnership is a publicly traded limited partnership organized under the laws of the state of Delaware in 1988 which owns a 99% limited partnership interest in the Operating Partnership, through which the Partnership conducts all its operations. The Operating Partnership was acquired by the Trading Partnership in December 1988 and is engaged in the transportation of refined petroleum products and related services. The Operating Partnership is managed by its general partner, Santa Fe Pacific Pipelines, Inc. (the "General Partner"), which, by virtue of this 1% general partner interest, represents the minority interest in the Partnership's consolidated financial statements. The General Partner, which is a wholly owned indirect subsidiary of Santa Fe Pacific Corporation ("Santa Fe"), also holds the 1% general partner interest in the Trading Partnership and, therefore, in total, holds a 2% general partner interest in the Partnership on a consolidated basis. In addition, the General Partner owns approximately 42% of the limited partner interests in the Trading Partnership ("common units"). Public ownership represented by the preference units is approximately 56%. Revenue Recognition Substantially all revenues are derived from pipeline transportation and storage and terminaling charges and are recognized in income upon delivery. Other revenues, primarily incidental service charges and tank and land rentals, are recognized as earned. The Partnership's interstate common carrier pipeline operations are subject to rate regulation by the Federal Energy Regulatory Commission ("FERC") under a "trended original cost methodology" adopted in 1985 for establishing a petroleum products pipeline's tariffs. The methodology is subject to clarification and reconsideration in individual cases and leaves many issues for determination on a case-by-case basis. Properties, Plant and Equipment Properties are stated at cost and include capitalized interest on borrowed funds. Additions and replacements are capitalized. Expenditures for maintenance and repairs are charged to income. Upon sale or retirement of depreciable properties, cost less salvage is charged to accumulated depreciation. Properties are depreciated on a straight-line basis over the estimated service lives of the related assets. Rates for the Partnership's interstate pipeline properties are prescribed by the FERC. The Partnership's intrastate pipeline properties and its terminal properties are depreciated using similar rates. The following annual rates were used in computing depreciation: Rights-of-way.......... ............................... 2.60% Line pipe, fittings and pipeline construction. 2.22% to 2.60% Buildings and field equipment................. 2.95% to 4.00% Storage tanks and delivery facilities......... 3.10% to 3.20% Vehicles, office and communications equipment 3.00% to 15.70% Income Per Unit Income per unit is computed based upon net income of the Partnership less an allocation of income to the general partner of the Trading Partnership in accordance with the partnership agreement, and is based upon 19,148,148 partnership units, comprising 11,000,000 preference and 8,148,148 common units. The quarterly allocation of net income to the general partner of the Trading Partnership (which is always equivalent to the minority interest in net income) is based on its percentage of cash distributions from Available Cash at the end of each quarter (see Note 10). The general partner of the Trading Partnership was allocated 2.07%, 2.07% and 1.94% of net income before minority interest for 1993, 1992 and 1991, respectively. Cash Equivalents and Short Term Investments The Partnership considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Income Tax For federal and state income tax purposes, the Partnership is not a taxable entity. Accordingly, the taxable income or loss resulting from the operations of the Partnership is ultimately includable in the federal and state income tax returns of the general and limited partners, and may vary substantially from the income or loss reported for financial reporting purposes. NOTE 2 - 1992 CHANGE IN METHOD OF ACCOUNTING FOR POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS During the fourth quarter of 1992, the General Partner and the Partnership adopted Statement of Financial Accounting Standards ("FAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", and FAS No. 112, "Employers' Accounting for Postemployment Benefits", retroactive to January 1, 1992. FAS No. 106 requires that an actuarial method be used to accrue the expected cost of postretirement health care and other benefits over employees' years of service. FAS No. 112 relates to benefits provided to former or inactive employees after employment but before retirement and requires recognition of these benefits if they are vested and payment is probable and reasonably estimable. Prior to 1992, the costs of postretirement and postemployment benefits were generally expensed when paid. For the Partnership, the cumulative effect of the accounting change attributable to years prior to 1992 was to decrease 1992 net income by $16,407,000, net of minority interest of $347,000. The impact of FAS No. 106 comprised approximately 95% of the change. Additionally, 1992 general and administrative expenses were approximately $1,825,000 higher as a result of the change in accounting for these costs. NOTE 3 - DETAIL OF SELECTED BALANCE SHEET ACCOUNTS December 31, ------------------ 1993 1992 -------- -------- (in thousands) Accounts receivable: Trade accounts receivable............. $22,587 $18,654 Recollectible construction and maintenance expenditures other...... 10,200 9,497 -------- -------- $32,787 $28,151 ======== ======== Accrued liabilities: East Line litigation costs............ $ 6,570 $ -- Environmental remediation costs....... 6,270 1,170 Military product loss reserve......... 5,111 3,873 Property taxes........................ 3,210 1,924 Capital expenditures and major maintenance................... 2,685 2,763 Interest.............................. 1,709 1,709 Postretirement and postemployment benefits............................ 800 500 Insurance premiums and claims......... 656 3,389 Other................................. 6,224 3,271 -------- -------- $33,235 $18,599 ======== ======== Other long-term liabilities: Postretirement and postemployment benefits............................ $19,403 $18,938 Environmental remediation costs....... 16,880 8,825 East Line litigation costs............ 3,000 -- -------- -------- $39,283 $27,763 ======== ======== NOTE 4 - PROPERTIES Properties, plant and equipment consist of the following: December 31, -------------------- 1993 1992 --------- --------- (in thousands) Land.................................... $ 55,545 $ 56,680 Rights-of-way........................... 12,601 12,522 Line pipe, fittings and pipeline construction.......................... 287,008 283,848 Buildings and equipment................. 162,412 152,284 Storage tanks and delivery facilities... 144,678 140,293 Construction in progress................ 20,838 22,770 --------- --------- 683,082 668,397 Less accumulated depreciation........... 66,472 50,299 --------- --------- $616,610 $618,098 ========= ========= Depreciation expense aggregated $16,921,000, $16,148,000 and $14,974,000 in 1993, 1992 and 1991, respectively. NOTE 5 - LONG-TERM DEBT Long-term debt consists of the following First Mortgage Notes (the "Notes") at December 31, 1993 and 1992 (in thousands): Series A 9.85% due December 1994..... $ 11,000 Series B 10.00% due December 1995..... 17,000 Series C 10.05% due December 1996..... 22,000 Series D 10.15% due December 1997..... 28,500 Series E 10.25% due December 1998..... 32,500 Series F 10.70% due December 1999 through 2004.................. 244,000 -------- $355,000 ======== The Partnership intends to refinance the Series A Notes on a long-term basis upon their maturity and, therefore, has included them in long-term debt at December 31, 1993. The Series F Notes become payable in annual installments ranging from $31.5 million in 1999 to the final payment of $49.5 million in December 2004. The Notes may also be prepaid beginning in 1999 in full or in part at a price equal to par plus, in certain circumstances, a premium. The Notes are secured by mortgages on substantially all of the properties of the Partnership ("the Mortgaged Property"). The Notes contain covenants specifying certain limitations on the Partnership's operations including the amount of additional debt or equity that may be issued, cash distributions, investments and property dispositions. Management does not believe such limitations will adversely affect the Partnership's ability to fund its operations or planned capital expenditures. The fair value of the Partnership's long-term debt is approximately $450 million at December 31, 1993. Such estimate represents the present value of interest and principal payments on the Notes discounted at present market yields, and assumes the Series F Notes will be prepaid in full in 1999 at par plus a premium. Interest on the Notes is payable semiannually in June and December. Interest capitalized during the years 1993, 1992 and 1991 aggregated $598,000, $760,000 and $756,000, respectively. The Partnership arranged a $60 million multi-year term credit facility and a $20 million working capital facility with three banks in October 1993. The term facility may be used for refinancing a portion of the Partnership's long-term debt and capital projects, and may be utilized on a revolving basis through October 1997, with any outstanding balance at that time converted to a three-year amortizing term loan. Borrowings under this facility would also be secured by the Mortgaged Property and would generally be subject to the same terms and conditions of the First Mortgage Notes. The working capital facility replaced a $20 million facility originally established in April 1990, and is subject to annual renewal. Advances under this credit line can be used for general Partnership purposes and would be secured by certain of the Partnership's accounts receivable. This facility may not be utilized for a 45-day period, the designation of such period to be at the Partnership's discretion, during each year, and is also subject to other reasonable and customary terms and conditions. Both facilities provide for certain interest rate options. To date, neither of these facilities have been utilized. NOTE 6 - COMMITMENTS AND CONTINGENCIES East Line Litigation and FERC Proceeding Certain of the Partnership's shippers have filed civil suits and initiated a Federal Energy Regulatory Commission ("FERC") proceeding alleging, among other things, that the shippers had been damaged by the Partnership's failure to fulfill alleged promises to expand the East Line's capacity between El Paso, Texas and Phoenix, Arizona to meet shipper demand. The FERC proceeding also involves claims, among other things, that certain of the Partnership's tariffs and charges on its East and West Lines are excessive. In July 1993, the Partnership reached a settlement with one of these shippers, Navajo Refining Company ("Navajo"), whereby Navajo agreed to dismiss its pending civil litigation in New Mexico and withdraw any challenge to the direction of flow of the Partnership's six-inch pipeline between Phoenix and Tucson, Arizona, including any such challenge in the FERC proceeding. The Partnership agreed to make certain cash payments to Navajo over three years and to undertake and complete an additional pipeline capacity expansion between El Paso, Texas and Phoenix if certain events related to volume levels and proration of pipeline capacity should occur within the next five years. During the quarter ended September 30, 1993, the Partnership recorded a $12 million provision for litigation costs, which reflects the terms of the Navajo settlement as well as anticipated legal fees and other costs related to defense and ultimate resolution of the FERC proceeding and the remaining civil action brought by El Paso Refinery, L.P. and its general partner. Management believes that it has acted properly with respect to expansion of the East Line and the direction of flow of the six-inch pipeline from Phoenix to Tucson. Management also believes that the Partnership's tariffs are just and reasonable and, if certain of the underlying assumptions and interpretations of rate-making methodology made by the Partnership in supporting these tariffs are ruled upon favorably, that these tariffs will be upheld should the FERC proceeding progress to its completion. However, because of the nature of FERC rate-making methodology, it is not possible to predict with certainty whether the Partnership's assumptions and rate-making approach will be upheld by the FERC and, hence, it is impossible to predict the outcome of the FERC proceeding. It is the opinion of management that any additional costs, in excess of recorded liabilities, incurred to defend and resolve these matters, or any capital expenditures which may be required under the terms of the Navajo settlement, will not have a material adverse effect on the Partnership's financial condition; nevertheless, it is possible that the Partnership's results of operations, in particular quarterly or annual periods, could be materially affected by the ultimate resolution of these matters. Environmental The Partnership's transportation and terminal operations are subject to extensive regulation under federal, state and local environmental laws concerning, among other things, the generation, handling, transportation and disposal of hazardous materials and the Partnership is, from time to time, subject to environmental cleanup and enforcement actions. In particular, the federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA" or "Superfund" law) generally imposes joint and several liability for cleanup and enforcement costs, without regard to fault or the legality of the original conduct, on current or predecessor owners and operators of a site. Along with several other respondents, the Partnership is presently involved in one cleanup ordered by the United States Environmental Protection Agency ("EPA") related to ground water contamination in the vicinity of the Partnership's storage facilities and truck loading terminal at Sparks, Nevada. In addition, the Partnership is also involved in six ground water hydrocarbon remediation efforts under administrative orders issued by the California Regional Water Quality Control Board at, or adjacent to, its facilities at Colton, Concord, Mission Valley, Brisbane, San Jose and West Sacramento, California. In April 1993, the Partnership was notified that the United States military expects the Partnership to participate in the remediation of ground water hydrocarbon contamination in the vicinity of the Partnership's pump station at Norwalk, California, which is adjacent to a major military fuel storage facility. The Partnership is currently investigating the extent of its responsibility for the contamination. The Partnership is cooperating with a request from the Arizona Department of Environmental Quality to participate in a joint industry investigation of possible ground water hydrocarbon contamination in the vicinity of the Partnership's terminal at Phoenix. The Partnership is also involved in soil and ground water remediation projects at and adjacent to various other terminal and pipeline locations, that have not been mandated by government agencies but are conducted in the ordinary course of business. In a number of these cleanup projects, the Partnership is participating with other entities ranging from large integrated petroleum companies to certain less financially sound parties. During the quarter ended September 30, 1993, the Partnership completed a comprehensive re-evaluation of its potential liabilities associated with environmental remediation activities and, as a result, recorded a $15 million provision to increase its existing reserve for environmental remediation costs. This provision reflects the estimated cost of completing all remediation projects presently known to be required, either by government mandate or in the ordinary course of business, as well as the cost of performing preliminary environmental investigations at several locations, including the investigation of potential contamination in the vicinity of the Partnership's Phoenix terminal. 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. The cash expenditures related to these projects are primarily expected to occur over the next five years; however, certain remediation projects, including the largest project at Sparks, are expected to continue for a period of approximately ten years. Estimates of the Partnership's ultimate liabilities associated with environmental remediation activities and related costs are particularly difficult to make with certainty due to the number of variables involved, including the early stage of investigation at certain sites, the lengthy time frames required to complete remediation at most locations, the number of parties involved, the number of remediation alternatives available, and the uncertainty of potential recoveries from third parties. Based on the information presently available, it is the opinion of management that any such costs, to the extent they exceed recorded liabilities, will not have a material adverse effect on the Partnership's financial condition; nevertheless, it is possible that the Partnership's results of operations in particular quarterly or annual periods could be materially affected as conditions change or additional information becomes available. Other Claims and Litigation The Partnership is also party to a number of other legal actions arising in the ordinary course of business. While the final outcome of these other legal actions cannot be predicted with certainty, it is the opinion of management that none of these other legal actions, when finally resolved, will have a material adverse effect on the consolidated financial condition of the Partnership; nevertheless, it is possible that the Partnership's results of operations, in particular quarterly or annual periods, could be materially affected by the ultimate resolution of these matters. Lease Commitments The General Partner leases space in an office building and certain computer equipment, the rent on which is charged to the Partnership. The General Partner's total lease commitments not subject to cancellation at December 31, 1993 are as follows: $2,135,000 in 1994, $2,105,000 in 1995 and $1,330,000 in 1996. The Partnership also leases certain rights-of-way and land under agreements that can be canceled at any time should they not be required for operations. The annual payments associated with these leases aggregated approximately $5 million in 1993, however a substantial portion of this amount is subject to renegotiation effective January 1, 1994. While the lessor has requested a significant increase in the annual lease payment for 1994 and future years, it is not presently possible to predict the annual rent associated with these leases which will be established either through negotiation or arbitration. Rental expense for all operating leases was $7,130,000, $6,600,000 and $7,000,000 for the years 1993, 1992 and 1991, respectively. NOTE 7 - RELATED PARTY TRANSACTIONS The Partnership has no employees and is managed by the General Partner. Under certain partnership and management agreements, the General Partner and Santa Fe or its subsidiaries are entitled to reimbursement of all direct and indirect costs related to the business activities of the Partnership. These expenses, which are included in field operating and general and administrative expenses in the Partnership's statement of income, totaled $43.0 million, $37.1 million and $35.8 million for the years 1993, 1992 and 1991, respectively, and include compensation and benefits payable to officers and employees of the General Partner, payroll taxes, corporate office building rentals, general and administrative costs, tax information and reporting costs and legal and other professional services fees. NOTE 8 - PENSION AND POSTRETIREMENT PLANS The General Partner is included with certain other affiliates in the trusteed non-contributory Santa Fe Pacific Retirement Plan ("the Plan") which fully complies with ERISA requirements. The Plan covers substantially all officers and employees of Santa Fe and its subsidiaries not covered by collective bargaining agreements. Benefits payable under the Plan are based on years of service and compensation during the sixty highest paid consecutive months of service during the ten years immediately preceding retirement. Santa Fe's funding policy is to contribute annually at a rate not less than the ERISA minimum, and not more than the maximum amount deductible for income tax purposes. Since the General Partner is included with certain other affiliates, detailed Plan information for the General Partner is not available in all cases, however, as of September 30, 1993, the fair value of Plan assets allocated to employees associated with the Partnership's operations was $51.4 million, and the actuarial present value of projected Plan obligations, discounted at 7.0%, was $47.5 million. The expected return on the market value of Plan assets was 9.75% and compensation levels were assumed to increase at 4.0% per year. Primarily as a result of the excess of Plan assets over liabilities, pension income of $435,000, $605,000 and $290,000 was recognized in 1993, 1992 and 1991, respectively. In addition to the defined benefit pension plan, salaried employees who have attained age 55 and who have rendered 10 years of service are eligible for both medical benefits and life insurance coverage during retirement. The retiree medical plan is contributory and provides benefits to retirees, their covered dependents and beneficiaries. Retiree contributions are adjusted annually. The plan also contains fixed deductibles, coinsurance and out-of-pocket limitations. The life insurance plan is non- contributory and covers retirees only. The Partnership adopted FAS No. 106 effective January 1, 1992 (see Note 2). Net periodic postretirement benefit cost in 1993 and 1992 was $1,557,000 and $2,231,000, respectively, and included the following components (in thousands): Life Insurance Medical Plan Plan ----------------- ----------------- 1993 1992 1993 1992 ------- ------- ------- ------- Service cost............... $ 553 $ 718 $ 37 $ 26 Interest cost.............. 1,066 1,275 213 212 Amortization of prior service credit........... (312) -- -- -- ------- ------- ------- ------- Net periodic postretirement benefit cost............. $1,307 $1,993 $ 250 $ 238 ======= ======= ======= ======= Prior to 1992, the costs of these benefits were generally recognized when paid and were $430,000 in 1991. The Partnership's policy is to fund benefits payable under the medical and life insurance plans as due. The following table shows the reconciliation of the plans' obligations to amounts accrued at December 31, 1993 and 1992 (in thousands): Life Insurance Medical Plan Plan ----------------- ----------------- 1993 1992 1993 1992 -------- -------- -------- -------- Accumulated postretirement benefit obligation: Retirees.................... $ 5,253 $ 4,252 $ 2,086 $ 1,985 Fully eligible active plan participants......... 1,148 753 -- -- Other active plan participants................ 9,199 7,124 648 576 -------- -------- -------- -------- 15,600 12,129 2,734 2,561 Unrecognized prior service credit............ 3,763 4,075 -- -- Unrecognized net gain (loss) (2,249) 46 (243) (42) -------- -------- -------- -------- Accrued postretirement liability................. $17,114 $16,250 $ 2,491 $ 2,519 ======== ======== ======== ======== The unrecognized prior service credit, which is the result of a plan amendment effective January 1, 1993, will be amortized straight-line over the average future service to full eligibility of the active population. For 1994, the assumed health care cost trend rate for managed care medical costs is 11.5% and is assumed to decrease gradually to 5% by 2006 and remain constant thereafter. For medical costs not in managed care, the assumed health care cost trend is 14% in 1994 and is assumed to decrease gradually to 6.5% by 2006 and remain constant 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 for the medical plan by $2.9 million and the aggregate of the service and interest components of net periodic postretirement benefit cost recognized in 1993 by $330,000. In 1993, the assumed health care cost trend rate for managed care medical costs was 12% and was assumed to decrease gradually to 5.5% by 2006 and remain constant thereafter. For medical costs not in managed care, the assumed health care cost trend was 15% in 1993 and was assumed to decrease gradually to 6.5% by 2006 and remain constant thereafter. The weighted-average discount rate assumed in determining the accumulated postretirement benefit obligation was 7% and 8.5% in 1993 and 1992, respectively. The assumed weighted- average salary increase was 4.0% and 5.5% in 1993 and 1992, respectively. NOTE 9 - OPERATING REVENUE FROM MAJOR CUSTOMERS Operating revenues received from three major petroleum companies each exceeded 10% of total 1993 revenues and, individually, account for 16.9%, 12.9% and 10.2% of total operating revenues. In 1992, these same customers accounted for 17.1%, 13.7% and 10.8% of total operating revenues and, in 1991, they accounted for 16.0%, 13.1% and 10.9% of total operating revenues. NOTE 10 - CASH DISTRIBUTIONS The Partnership makes quarterly cash distributions of substantially all of its available cash, generally defined as consolidated cash receipts less consolidated cash expenditures and such retentions for working capital, anticipated capital expenditures and contingencies as the General Partner deems appropriate or as are required by the terms of the Notes. Distributions are made 98% to the common and preference unitholders (the "unitholders") and 2% to the General Partner, subject to the payment of incentive distributions to the General Partner which increase as quarterly distributions to unitholders exceed certain specified target levels. The incremental incentive distributions payable to the General Partner are 8%, 18% and 28% of all quarterly distributions of available cash that exceed, respectively, $0.60, $0.65 and $0.70 per common and preference unit. Such incentive distributions aggregated $1,202,000 in 1993 and in 1992 and $770,000 in 1991. Cash distributions declared for the four quarters ended December 31, 1993, 1992 and 1991 aggregated $2.80, $2.80 and $2.75 per unit, respectively. In January 1994 the Partnership announced a fourth quarter 1993 distribution of $0.70 per common and preference unit, payable in February 1994. Prior to December 31, 1993, in the event that there was not sufficient available cash to pay the minimum distribution of $0.55 per unit to all unitholders at the end of a quarter, preference unitholders were entitled to receive the minimum quarterly distribution, plus any arrearages, prior to any distribution of available cash to the common unitholders. With the Partnership having met certain financial criteria, this subordination period ended on December 31, 1993, and all units will henceforth have equivalent rights with respect to cash distributions and shall be called common units. Since the formation of the Partnership in December 1988, there has been no arrearage of cash distributions. NOTE 11 - SUMMARIZED QUARTERLY OPERATING RESULTS AND PREFERENCE UNIT INFORMATION (UNAUDITED) Quarterly results of operations are summarized below: First Second Third Fourth Quarter Quarter Quarter Quarter -------- -------- -------- -------- (In thousands, except per unit amounts) 1993: Net revenues................. $49,674 $57,222 $56,778 $55,797 Operating income............. 21,758 29,150 1,478 25,936 Net income (loss)............ 12,516 19,674 (7,326) 16,752 Income (loss) per unit....... $ 0.64 $ 1.01 $ (0.37) $ 0.86 1992: Net revenues................. $47,153 $52,752 $53,382 $51,738 Operating income............. 21,823 27,606 16,700 25,229 Net income before cumulative effect of accounting change 12,639 18,380 7,369 15,730 Net income (loss)............ (3,768) 18,380 7,369 15,730 Income per unit before cumulative effect of accounting change.......... $ 0.65 $ 0.94 $ 0.38 $ 0.80 Income (loss) per unit....... (0.19) 0.94 0.38 0.80 Notes: Third quarter 1993 included a $27.0 million provision for environmental and litigation costs and third quarter 1992 included a $10.0 million provision for environmental costs. First quarter 1992 included the $16.4 million cumulative effect of an accounting change. The sum of net income (loss) per unit for the four quarters of 1993 does not equal net income per unit for the full year due to the effect of rounding differences. Santa Fe Pacific Pipeline Partners, L.P. units are traded on the New York Stock Exchange, under the symbol SFL. The quarterly price range per unit and cash distributions declared per unit for 1993 and 1992 are summarized below: High Low Cash Unit Unit Distributions Price Price Declared ------ ------ ------------- 1993: Fourth Quarter.................... 39-7/8 36-3/8 $0.70 Third Quarter..................... 40 36-3/8 0.70 Second Quarter.................... 40-3/4 36-3/8 0.70 First Quarter..................... 39-3/4 35-3/4 0.70 1992: Fourth Quarter.................... 39-1/4 33-1/4 $0.70 Third Quarter..................... 39-3/4 34-3/8 0.70 Second Quarter.................... 35-3/8 30-3/4 0.70 First Quarter..................... 36-5/8 31-3/4 0.70 As of January 31, 1994, there were approximately 18,000 holders of Partnership units. SCHEDULE V SANTA FE PACIFIC PIPELINE PARTNERS, L.P. PROPERTY, PLANT AND EQUIPMENT (In thousands) Year ended December 31, 1993 ----------------------------------------------------- Balance at Balance beginning Additions Other at end of year at cost Retirements changes(a) of year --------- --------- --------- --------- --------- Land.................... $ 56,680 $ 321 $ (1,456) $ -- $ 55,545 Rights-of-way........... 12,522 79 -- -- 12,601 Line pipe, fittings and pipeline construction. 283,848 3,178 (7) (13) 287,008 Buildings and equipment. 152,284 10,040 (481) 569 162,412 Storage tanks and delivery facilities... 140,293 5,245 (84) (776) 144,678 Construction in progress 22,770 2,221 -- (4,153) 20,838 --------- --------- --------- --------- --------- $668,397 $ 21,084 $ (2,028) $ (4,371) $683,082 ========= ========= ========= ========= ========= Year ended December 31, 1992 ----------------------------------------------------- Balance at Balance beginning Additions Other at end of year at cost Retirements changes(a) of year --------- --------- --------- --------- --------- Land.................... $ 56,655 $ 25 $ -- $ -- $ 56,680 Rights-of-way........... 11,875 210 -- 437 12,522 Line pipe, fittings and pipeline construction. 278,803 8,388 (83) (3,260) 283,848 Buildings and equipment. 135,733 14,824 (1,864) 3,591 152,284 Storage tanks and delivery facilities... 132,252 9,921 (594) (1,286) 140,293 Construction in progress 27,138 (2,437) -- (1,931) 22,770 --------- --------- --------- --------- --------- $642,456 $ 30,931 $ (2,541) $ (2,449) $668,397 ========= ========= ========= ========= ========= Year ended December 31, 1991 ----------------------------------------------------- Balance at Balance beginning Additions Other at end of year at cost Retirements changes(a) of year --------- --------- --------- --------- --------- Land.................... $ 56,653 $ 2 $ -- $ -- $ 56,655 Rights-of-way........... 11,646 37 -- 192 11,875 Line pipe, fittings and pipeline construction. 278,501 633 (156) (175) 278,803 Buildings and equipment. 127,749 8,195 (266) 55 135,733 Storage tanks and delivery facilities... 122,904 11,049 (977) (724) 132,252 Construction in progress 23,983 7,799 -- (4,644) 27,138 --------- --------- --------- --------- --------- $621,436 $ 27,715 $ (1,399) $ (5,296) $642,456 ========= ========= ========= ========= ========= (a)Other changes in "Construction in progress" primarily reflect the reclass- ification of certain software costs to the "Other assets" caption of the Partnership's consolidated balance sheet and reclassifications of certain properties between categories upon final valuation for rate-making purposes. SCHEDULE VI SANTA FE PACIFIC PIPELINE PARTNERS, L.P. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In thousands) Year ended December 31, 1993 ----------------------------------------------------- Balance at Balance beginning Additions Other at end of year at cost Retirements changes of year --------- --------- --------- --------- --------- Rights-of-way........... $ 1,071 $ 326 $ -- $ -- $ 1,397 Line pipe, fittings and pipeline construction. 25,858 6,807 (7) (13) 32,645 Buildings and equipment. 11,907 5,483 (481) (16) 16,893 Storage tanks and delivery facilities... 11,463 4,305 (83) (148) 15,537 --------- --------- --------- --------- --------- $ 50,299 $ 16,921 $ (571) $ (177) $ 66,472 ========= ========= ========= ========= ========= Year ended December 31, 1992 ----------------------------------------------------- Balance at Balance beginning Additions Other at end of year at cost Retirements changes of year --------- --------- --------- --------- --------- Rights-of-way........... $ 752 $ 319 $ -- $ -- $ 1,071 Line pipe, fittings and pipeline construction. 19,391 6,683 (83) (133) 25,858 Buildings and equipment. 8,885 5,026 (1,864) (140) 11,907 Storage tanks and delivery facilities... 7,967 4,120 (594) (30) 11,463 --------- --------- --------- --------- --------- $ 36,995 $ 16,148 $ (2,541) $ (303) $ 50,299 ========= ========= ========= ========= ========= Year ended December 31, 1991 ----------------------------------------------------- Balance at Balance beginning Additions Other at end of year at cost Retirements changes of year --------- --------- --------- --------- --------- Rights-of-way........... $ 491 $ 261 $ -- $ -- $ 752 Line pipe, fittings and pipeline construction. 12,983 6,714 (156) (150) 19,391 Buildings and equipment. 4,863 4,364 (266) (76) 8,885 Storage tanks and delivery facilities... 5,078 3,635 (977) 231 7,967 --------- --------- --------- --------- --------- $ 23,415 $ 14,974 $ (1,399) $ 5 $ 36,995 ========= ========= ========= ========= ========= SCHEDULE X SANTA FE PACIFIC PIPELINE PARTNERS, L.P. SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) The following have been charged to expense: Year ended December 31, ------------------------------- 1993 1992 1991 -------- -------- ------- 1. Maintenance and repairs ................ $24,000(a) $20,320(a) $ 9,385 2. Depreciation and amortization of intangible assets, preoperating costs and similar deferrals ............ 2,050 2,180 2,215 3. Taxes, other than payroll and income taxes ........................... 12,350 12,175 10,865 (a) These amounts include provisions for environmental costs of $15 million and $10 million in 1993 and 1992, respectively.

811671_1993.txt

811671_1993

1993

811671

Item 1 - Business Sterling Financial Corporation Sterling Financial Corporation (the "Corporation") is a Pennsylvania business corporation, based in Lancaster, Pennsylvania, which was organized on February 23, 1987 and became a bank holding company through the acquisition of all the outstanding stock of The First National Bank of Lancaster County, now by change of name, Bank of Lancaster County, N.A., on June 30, 1987. In addition, Sterling Financial Corporation also owns all of the outstanding stock of a non-bank subsidiary, Sterling Mortgage Services, Inc. Sterling Mortgage Services, Inc. is a mortgage service company formed by Sterling Financial Corporation as a wholly owned subsidiary. Approval was received September 13, 1988, pursuant to Section 4 of the Bank Holding Company Act for Sterling Financial Corporation to operate Sterling Mortgage Services, Inc. as a mortgage service company. This information was reported in Form 10-Q dated November 10, 1988. However, during the third quarter of 1989, Sterling Financial Corporation took action to shutdown the mortgage company subsidiary and presently it is considered inactive. This information was reported in Form 10-Q dated November 10, 1989. Sterling Financial Corporation provides a wide variety of commercial banking and trust services through the foregoing wholly owned subsidiary, Bank of Lancaster County, N.A. The principal source of operating funds for the Corporation is dividends provided by the Bank of Lancaster County, N.A. The Corporation's expenses consist principally of operating expenses. Dividends paid to stockholder's are, in general, primarily obtained by the Corporation from dividends declared and paid to it by Bank of Lancaster County, N.A. As a bank holding company, Sterling Financial Corporation is registered with the Federal Reserve Board in accordance with the requirements of the Federal Bank Holding Company Act and is subject to regulation by the Federal Reserve Board and by the Pennsylvania Department of Banking. Bank of Lancaster County Bank of Lancaster County, N.A., a full service commercial bank operating under charter from the Comptroller of the Currency, was organized in 1863. On July 29, 1863, authorization was given by the Comptroller of the Currency to The First National Bank of Strasburg to commence the business of banking. On September 1, 1980, the title of this association was changed to The First National Bank of Lancaster County and at the time of the holding company reorganization, June 30, 1987, the bank name was changed to its present name, Bank of Lancaster County, N.A. At December 31, 1993, the bank had total assets of $587,883,000 and total deposits of $506,131,000. The main office of the Association is located at 1 East Main Street, Strasburg, Pennsylvania. In addition to its main office, the Bank had eighteen (18) branches in Lancaster County and one (1) branch in Chester County in operation at December 31, 1993. Bank of Lancaster County provides a full range of banking services. These include demand, savings and time deposit services, NOW (Negotiable Order of Withdrawal) accounts, money market accounts, safe deposit boxes, VISA credit card, and a full spectrum of personal and commercial lending activities. The Bank maintains correspondent relationships with <\PAGE> major banks in New York and Philadelphia. Through these correspondent relationships, the Bank can offer a variety of collection and international services. With the installation of three automated teller machines (ATMs) in April of 1983, Bank of Lancaster County was the first financial institution in Lancaster County to join the MAC (Money Access Center) Network. Presently the Bank has 16 ATMs in Lancaster County. The Bank became a participating member of the Plus System in the Fall of 1984. This membership entitles our MAC/Plus cardholders to have access to a nationwide network of over 80,000 ATMs. The Bank introduced Discount Brokerage Service in July, 1983. This service is offered in coordination with Trade Saver, Inc., a subsidiary of PNC Bank Corporation of Philadelphia, Pennsylvania and meets the needs of the commission-conscious, independent-minded investor. In 1992 we began offering mutual funds to customers. We believe these services are important additions to our product line and make a statement about our aggressive attitude in providing financial services for the future. The Bank was given permission to open a Trust Department by the Comptroller of the Currency on May 10, 1971. The Trust Department provides personal and corporate trust services. These include estate planning, administration of estates and the management of living and testamentary trusts and investment management services. Other services available are pension and profit sharing trusts and self-employed retirement trusts. Trust Department assets totaled over $126 million at December 31, 1993. On January 31, 1983, Bank of Lancaster County purchased Town & Country, Inc. which is a vehicle and equipment leasing company operating in Pennsylvania and other states. Its principal office is located at 640 East Oregon Road, Lancaster, PA. Town & Country, Inc. employs thirty (30) people. Bank of Lancaster County's principal market area is Lancaster County, which continues to be one of the fastest growing counties in Pennsylvania. Lancaster County is now the sixth largest county in Pennsylvania, behind Philadelphia, Allegheny, Montgomery, Delaware and Bucks. Lancaster County, with an area of 946 square miles has a population of approximately 430,000. The county's tradition of economic stability has continued, with agriculture, industry and tourism all contributing to the overall strength of the economy. One of the best agricultural areas in the nation, Lancaster County ranks first among Pennsylvania counties and one of the top 20 farm markets in the country. Lancaster County is also one of the leading industrial areas in the state. The county is considered a prime location for manufacturing, away from congested areas, yet close to major east coast markets. Diversification of industry helps to maintain the economic stability of the county. The unemployment rate of the county in December 1993 was 4.5% which was lower than the state (6.3%) and national (6.4%) levels. Lancaster County, with its many historic sites, well-kept farmlands and the large Amish community has become very attractive to tourists and is one of the top tourist attractions in the U.S. The Bank and its subsidiaries are subject to intense competition in all respects and areas of their business from banks and other financial institutions, including savings and loan associations, finance companies, credit unions and other providers of financial services. There are 15 full-service commercial banks with offices in Lancaster County with some of these banks having branches located throughout the County. The banks range in asset size from approximately $112 million to over $29 billion. Of these banks, eight (8) exceed $700 million in assets and seven (7) of the eight (8) exceed $1.3 billion in total assets. Four (4) banks in our trade area exceed $3.8 billion. Several banks are part of bank holding companies. One bank is part of a bank holding company that has assets in excess of $36 billion while another bank is part of a bank holding company that has over $23 billion in assets. Due to our location, we are in direct competition with the larger banks as well as a number of smaller banks. As of December 31, 1993, the Bank ranked, as measured by total deposits, as the fourth largest in county market share of the banks doing business in Lancaster County. The Bank is not, however, the fourth largest bank in Lancaster County. As of December 31, 1993, the Bank had total assets of over $587 million and ranked ninth on this basis among the commercial banks with offices located in Lancaster County. There has not been a material portion of the Bank's deposits obtained from a single person or a few persons, including federal, state or local governments and agencies thereunder and the loss of any single or any few customers would not have a materially adverse effect on the business of the bank. The Bank has no significant foreign sources or applications of funds. As of December 31, 1993, there were 342 persons employed by Bank of Lancaster County-263 full-time and 79 part-time. These figures listed do not include employees of Town & Country, Inc. which are listed elsewhere in this report. Bank of Lancaster County, N.A. is subject to regulation and periodic examination by the Comptroller of the Currency. Its deposits are insured by the Federal Deposit Insurance Corporation as provided by law. Item 2 Item 2 - Properties Bank of Lancaster County, N.A., in addition to its main office, had at December 31, 1993, a branch network of 19 offices and 2 off-site electronic MAC/ATM installations. All branches are located in Lancaster County with the exception of one office which is located in Chester County. Branches at 7 locations are occupied under leases and at three branches, Bank of Lancaster County owns the building, but leases the land. One off-site MAC/ATM installation is occupied under lease. The Administrative Service Center of Bank of Lancaster County, N.A. is owned in fee by the bank, free and clear of encumbrances. The building occupied by Town & Country, Inc., a wholly owned subsidiary of Bank of Lancaster County, N.A. is owned in fee by Town & Country, Inc., free and clear of encumbrances. The leases referred to above expire intermittently over the years through 2022 and most are subject to one or more renewal options. Item 3 Item 3 - Legal Proceedings As of December 31, 1993, there were no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Corporation or its subsidiaries are a party or of which any of their property is the subject. 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 the Registrant's Common Equity and Related Stockholder Matters The common stock of Sterling Financial Corporation is not actively traded. There are 10,000,000 shares of common stock authorized and the total number of shares outstanding as of December 31, 1993 was 2,882,920. As of December 31, 1993, the Corporation had approximately 1,969 holders of record of its common stock. There is no other class of common stock authorized or outstanding. During 1993, the price range of the common stock known to management was $31.50 to $46.00 per share. During the last quarter of 1993, prices known to management were $42.50 to $46.00 per share. The Corporation declared a three-for-two stock split in 1992. The following table reflects the bid and asked prices reported for the common stock at the end of the period indicated and the cash dividends declared on the common stock for the periods indicated. In the absence of an active market, these prices may not reflect the actual market value of Sterling Financial Corporation's stock for the periods reported. The prices used in the previous table represent bid and asked prices furnished by F.J. Morrissey & Company; Prudential Securities; Ryan, Beck & Company; or The National Quotation Bureau. Sterling Financial Corporation maintains a Dividend Reinvestment and Stock Purchase Plan for eligible shareholders who elect to participate in the plan. A copy of the Prospectus for this plan can be obtained by writing to: Bank of Lancaster County, N.A. Dividend Reinvestment and Stock Purchase Plan, 25 North Duke Street, Lancaster, Pennsylvania 17602. Item 6 Item 6 - Selected Financial Data The following selected financial data should be read in conjunction with the Corporation's consolidated financial statements and the accompanying notes presented elsewhere herein. Item 7 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion provides management's analysis of the consolidated financial condition and results of operations of Sterling Financial Corporation (the Corporation) and subsidiaries, Bank of Lancaster County, N.A. (the Bank) and its subsidiary, Town & Country, Inc. and Sterling Mortgage Services, Inc. (presently inactive). It should be read in conjunction with audited financial statements and footnotes appearing elsewhere in this report. Results of Operations Summary Net income for 1993 was $7,802,000, an increase of $959,000 or 14% over the $6,843,000 earned in 1992. The results of 1992 were $939,000 or 15.9% higher than the $5,904,000 reported in 1991. Earnings per share on net income amounted to $2.72, $2.43, and $2.12 for the years ended 1993, 1992 and 1991 respectively. Earnings per share were computed by dividing net income by the weighted average number of shares of common stock outstanding which were 2,864,200, 2,817,651 and 2,775,778 for 1993, 1992 and 1991 respectively. Figures prior to 1993 were retroactively restated to reflect a three-for-two stock split in the form of a 50% stock dividend paid in 1992 and a 5% stock dividend paid in December 1993. Return on average total assets was 1.41% in 1993 compared with 1.34% in 1992 and 1.25% in 1991. Return on average stockholders' equity was 16.90% in 1993 compared with 16.99% in 1992 and 16.63% in 1991. Growth in earning assets was the primary factor contributing to the increased earnings for both 1993 and 1992. As of December 31, 1993, earning assets were approximately $522 million compared to $481 million at December 31, 1992 and $445 million at December 31, 1991. Average earning assets for 1993 increased nearly $43 million to approximately $498 million, up 9.5% from the prior year. Similarly, in 1992 average earning assets increased approximately $31 million, up 7.3% from 1991. The current year increase as well as the increase in 1992 was primarily due to increases in both loans and investments. Average interest-bearing liabilities increased nearly $31.5 million or 7.7% in 1993 compared to an increase of nearly $27 million, or 7% in 1992. The increase in average earning assets exceeded the increase in average interest-bearing liabilities in both 1993 and 1992. These increases along with lower cost of funds contributed to strong net interest margins in each period. Provision for loan losses increased to $2,430,000 in 1993 from $2,296,000 in 1992. The provision in 1991 was $1,789,000. Non-interest income increased $1,053,000 in 1993. This compares to an increase of $1,205,000 in 1992. These increases are primarily a result of mortgage banking activities. Non-interest expenses increased $2,126,000 or 11.2% in 1993, up slightly from the comparable period last year. The increase in 1992 over 1991 was $1,927,000 or 11.3%. Net Interest Income The primary component of the Corporation's net earnings is net interest income, which is the difference between interest and fees earned on interest-earning assets and interest paid on deposits and borrowed funds. For presentation and analytical purposes, net interest income is adjusted to a taxable equivalent basis. For purposes of calculating yields on tax-exempt interest income, the taxable equivalent adjustment equates tax-exempt interest rates to taxable interest rates as noted in Table 1. Adjustments are made using a statutory federal tax rate of 34% for 1993, 1992 and 1991. Table 1 presents average balances, taxable equivalent interest income and expense and the yields earned or paid on these assets and liabilities. The increase in net interest income during 1993 and 1992 was due primarily to increases in average earning assets. Average earning assets increased 9.5% in 1993 and 7.3% in 1992. These increases were primarily funded with interest-bearing liabilities which increased 7.7% in 1993 and 7% in 1992. Table 1 - Distribution of Assets, Liabilities and Stockholders' Equity Interest Rates and Interest Differential-Tax Equivalent Yields (Unaudited) Net interest income on a fully taxable equivalent increased by $2,673,000 in 1993 compared to an increase of $2,516,000 in 1992. Table 2 indicates that of the increase in 1993, $2,872,000 was the result of increased volumes while $199,000 of the increase was the result of overall rate decreases. Likewise, the increase in 1992 was a result of increased volumes totaling $2,078,000 while $438,000 of the increase was a result of rate decreases. Table 2 - Analysis of Changes in Net Interest Income The rate-volume variance analysis set forth in the table below, which is computed on a tax equivalent basis, analyses changes in net interest income for the periods indicated by their rate and volume components. For the year 1993 compared to 1992, loan volumes, on average, increased over $28.3 million and income earned on loans decreased $229,000, tax adjusted. This compares to a volume increase of nearly $13.5 million in 1992 over 1991 with a decrease in income earned on loans amounting to $2,895,000. During both periods compared, the decrease in interest income due to lower rates exceeded the increase in interest income generated by increased volumes of loans. Loan demand declined in both 1993 and 1992 due primarily to a slowing economy. Consequently, the loan growth rate was not as great as previous years. However, the loan growth in 1993 was an improvement over 1992. With the decline in loan demand, the Bank increased its holdings in investment securities. The increase in investment securities, on average, was nearly $15.6 million in 1993 compared to nearly $22 million in 1992. As a result of these increased volumes, interest income increased. Table 2 indicates that of the increase in 1993, $1,275,000 was the result of increased volumes while there was a decrease of $1,058,000 due to decreases in rates resulting in a total increase of $217,000. In 1992 interest income increased $900,000. Interest-bearing deposits, on average, grew nearly $25 million in 1993. However, the lower cost of funds reflect a decrease in interest expense. Provision for Loan Losses The provision for loan losses charged against earnings was $2,430,000 in 1993 compared to $2,296,000 in 1992 and $1,789,000 in 1991. The provision reflects the amount deemed appropriate by management to produce an adequate reserve to meet the present and foreseeable risk characteristics of the loan portfolio. Management's judgement is based on the evaluation of individual loans and their overall risk characteristics, past loan loss experience, and other relevant factors. Net charge-offs amounted to $650,000 in 1993, $1,296,000 in 1992 and $764,000 in 1991. The provision for loan loss was increased during 1993 in order for the Bank to provide an adequate reserve based on the evaluation of individual loans and their current characteristics and current economic condition. The reserve accordingly was increased to 2.00% of net loans outstanding from 1.55%. Net charge-offs for the year 1994 should range between $700,000 and $1,300,000. Additions to the loan loss provision are expected to be between $800,000 and $1,400,000. Non-Interest Income Non-interest income, recorded as other operating income, consists of income from fiduciary activities, service charges on deposit accounts, other service charges, commissions and fees, mortgage banking income and other income such as safe deposit box rents and income from operating leases. Income from fiduciary activities in the amount of $639,000 in 1993 was $43,000 or 7.2% over the $596,000 recorded in 1992. Income in 1992 was $28,000 or 5% greater than the $568,000 recorded in 1991. Service charges on deposit accounts increased to $1,891,000, an increase of $10,000 or .5% over 1992 service charge income of $1,881,000. The increase in 1993 income resulted primarily from a higher volume of activity on certain deposit transactions. Service charges on deposit accounts in 1992 exceeded the 1991 income of $1,654,000 by $227,000 or 13.7%. Other service charges, commissions and fees amounted to $1,577,000 in 1993 compared to $1,370,000 in 1992 and $1,234,000 in 1991. A major contributor to the increase in 1993 was certain fees relating to VISA operations as well as fees generated from mutual funds sales, a new product introduced in 1992. Income from mortgage banking activities in the amount of $2,435,000 increased $934,000 over 1992. Other operating income decreased $122,000 to $2,429,000 in 1993 from $2,551,000 in 1992. Other income for 1991 was $2,349,000. A major contributor to other operating income is income generated from operating leases. Investment securities transactions reflect a gain of $8,000 in 1993 compared to $27,000 in 1992 and $3,000 in 1991. The gains listed for these years resulted when certain securities were called at a premium. Securities had been written to par when calls were made thus generating a gain on the securities called. There were no securities sold for the periods listed. As a result of the above, total other operating income increased $1,053,000 in 1993 over 1992 compared to an increase of $1,205,000 in 1992 over 1991. Non-Interest Expense Non-interest expense consists of salaries and employee benefits, net occupancy expense, furniture and equipment expense and other operating expenses. Total operating expenses for 1993 were $21,048,000 compared to $18,922,000 in 1992. This represented an increase of $2,126,000 or 11.2%. This compares to an increase of $1,927,000 or 11.3% in 1992. Salaries and employee benefits expense increased to $11,566,000 in 1993 or $1,212,000 (11.7%) over the $10,354,000 reported in 1992. In 1992, expenses increased $1,096,000 (11.8%) over the $9,258,000 reported in 1991. The increase in 1993 and 1992 was primarily due to increases in staff as well as increases in wages and increased costs of employee benefits. Beginning in 1993, Sterling adopted Financial Accounting Standards Board Standard No. 106 - Employer's Accounting for Postretirement Benefits Other than Pensions. Under SFAS No. 106, the cost of postretirement benefits other than pensions must be recognized on an accrual basis as employees perform services to earn the benefits. This is a significant change from the previous generally accepted practice of accounting for these benefits which was on a cash basis. As a result of the adoption of the Standard No. 106, an additional expense of $192,060 was required to comply with the Standard. Occupancy expense increased $136,000 or 11.2% to $1,355,000 in 1993 from $1,219,000 in 1992. By comparison, during 1992, there was an increase of $223,000 or 22.4%. A new branch was opened in late 1991 and one was opened in early 1992. This contributed to the increase in 1992. Two new branch facilities were added in late 1993. One of the facilities was a branch relocation. Furniture and equipment expenses were $1,253,000 for 1993 and $1,177,000 for 1992. This represents an increase of $76,000 or 6.5%. Reflected in this increase is an increase of depreciation expense in 1993 amounting to $39,000. Expenses in 1992 were $87,000 greater than those recorded in 1991. Another contributor to the increase in total other operating expenses was the increase in the assessment for FDIC insurance. The assessment for 1993 was $1,052,000 which was $68,000 or 6.9% greater than the $984,000 reported in 1992. The assessment in 1992 was $143,000 or 17% greater than the $841,000 reported in 1991. The Bank expects continued costly increases in the assessment rate as the Federal Deposit Insurance Corporation attempts to maintain the solvency of the bank insurance fund. Other operating expenses increased $634,000 or 12.2% in 1993 compared to an increase of $378,000, or 7.9% in 1992. The increase noted in both years is in line with rising costs associated with acquiring services covered in this category of expense. Expenses covered in this category include postage, PA Shares Tax, advertising and marketing, professional services, telephone, stationery and forms, ATM fees, Visa fees, insurance premiums and other expense categories not specifically identified on the income statement. Income Taxes Income tax expense totaled $2,749,000 in 1993 compared to $2,331,000 in 1992 and $1,929,000 in 1991. These increases result from higher levels of taxable income and increased earnings each year. The Corporation's effective tax rate was 26.1% in 1993 compared with 25.4% in 1992 and 24.6% in 1991. Financial Condition Investment Portfolio Table 3 - Investment Securities at Cost The following table shows the carrying value of Sterling Financial Corporation's investment portfolio as of the dates indicated. Investment securities are stated at cost adjusted for amortization of premiums and accretion of discounts. Table 4 - Investment Securities (Yields) The following table shows the maturities of debt securities at carrying value as of December 31, 1993 and weighted average yields of such securities. Yields are shown on a tax equivalent basis, assuming a 34% federal income tax rate. Loans Table 5 - Loan Portfolio Table 6 - Loan Maturity and Interest Sensitivity The following table sets forth the maturity and interest sensitivity of the loan portfolio as of December 31, 1993: Loans due after one year totaling $45,661,000 have variable interest rates. The remaining $32,472,000 in loans have fixed rates. Table 7 - Nonaccrual, Past Due and Restructured Loans The following table presents information concerning the aggregate amount of nonaccrual, past due and restructured loans: The general policy has been to cease accruing interest on loans when it is determined that a reasonable doubt exists as to the collectibility of additional interest. Interest income on these loans is only recognized to the extent payments are received. Loans on a nonaccrual status amounted to $2,960,000 at December 31, 1993 compared to $4,129,000 at December 31, 1992. If interest income had been recorded on all such loans for the years indicated, such interest income would have been increased by approximately $267,295 and $293,967 for 1993 and 1992 respectively. Interest income recorded on the nonaccrual loans in 1993 and 1992 was none and $47,858 respectively. Potential problem loans are loans which are included as performing loans, but for which possible credit problems of the borrower causes management to have doubts as to the ability of such borrower to comply with present repayment terms and which may eventually result in disclosure as a non- performing loan. At December 31, 1993 there were commercial loans to two related borrowers aggregating $1.6 million which were considered as potential problem loans which were not included as nonaccrual loans. At December 31, 1993, there were no concentrations exceeding 10% of total loans. A concentration is defined as amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly affected by changes in economic or other conditions. There were no foreign loans outstanding at December 31, 1993. Allowance for Loan Losses Table 8 - Summary of Loan Loss Experience The provision for loan losses charged to operating expense reflects the amount deemed appropriate by management to produce an adequate reserve to meet the present and inherent risk to the loan portfolio. Management's judgement is based on the evaluation of individual loans and their overall risk characteristics, past loan loss experience, and other relevant factors. Management had not allocated specific portions of the allowance to specific loan categories prior to 1993. Table 9 reflects the allocation at December 31, 1993. Management regularly monitors the creditworthiness and financial condition of its borrowers and does not anticipate any material changes in the net charge-offs in any loan category during the next full year of operations. Table 9 - Allocation of Allowance for Loan Losses Deposits Table 10 - Average Deposit Balances and Rates Paid The average amounts of deposits and rates paid for the years indicated, are summarized below: Table 11 - Deposit Maturity The maturities of time deposits of $100,000 or more at December 31, 1993 are summarized below: Capital Stockholders' equity increased by nearly $6.7 million or 15.6% in 1993 to $49,467,000. Total stockholders' equity at December 31, 1992 in the amount of $42,794,000 represents an increase of $5,057,000 or 13.4% over the $37,737,000 reported at December 31, 1991. Strong earnings as well as capital acquired through stock issued pursuant to a dividend reinvestment and stock purchase plan and employee stock plan generated this fine growth in stockholders' equity. Dividends declared amounted to $2,985,000, $2,575,000 and $2,245,000 for 1993, 1992 and 1991 respectively. In 1989, federal regulatory authorities approved risk- based capital guidelines applicable to banks and bank holding companies in an effort to make regulatory capital more responsive to the risk exposure related to various categories of assets and off-balance sheet items. These new guidelines required that banking organizations meet a minimum risk-based capital by December 31, 1992 and redefine the components of capital, categorize assets into different risk classes and include certain off-balance sheet items in the calculation of capital requirements. The components of capital are called Tier 1 and Tier 2 capital. Tier 1 capital is the shareholders' equity and Tier 2 capital is the allowance for loan losses. The risk-based capital ratios are computed by dividing the components of capital by risk-weighted assets. Risk-weighted assets are determined by assigning various levels of risk to different categories of assets and off-balance sheet items. Required minimum levels of risk-adjusted capital were phased in during the time period December 31, 1990 and December 31, 1992. During this period, the minimum for Tier 1 capital was 3.625% and the total capital ratio minimum was 7.25%. Sterling's ratios at December 31, 1992 and 1991 were above the final risk-based capital standards which had to be reached by December 31, 1992 that require Tier 1 capital of at least 4% and total capital of 8% of risk-weighted assets. The Tier 1 capital ratio at December 31, 1993 was 10.67% and the total capital ratio was 11.92%, which exceeds the minimum capital guidelines. Tier 1 capital ratio was 10.04% and the total capital ratio was 11.29% at December 31, 1992 while Tier 1 capital ratio was 9.71% and the total capital ratio was 10.84% at December 31, 1991. Table 12 - Capital and Performance Ratios The following are selected ratios for the years ended December 31: Liquidity and Interest Rate Sensitivity Liquidity is the ability to meet the requirements of customers for loans and deposit withdrawals in the most economical manner. Some liquidity is ensured by maintaining assets which may be immediately converted into cash at minimal cost. Liquidity from asset categories is provided through cash, noninterest-bearing and interest-bearing deposits with banks, federal funds sold and marketable investment securities maturing within one year. Securities maturing within one year amounted to $22,701,000 at December 31, 1993 compared to $20,767,000 at December 31, 1992. Interest-bearing deposits with banks totaled $40,000 at December 31, 1993 compared to $900,000 at December 31, 1992. Federal funds sold was $12,350,000 and $3,200,000 at December 31, 1993 and 1992 respectively. The loan portfolio also provides an additional source of liquidity due to the Bank of Lancaster County participating in the secondary mortgage market. Sales of residential mortgages into the secondary market of approximately $72 million and $53 million respectively for 1993 and 1992 provided funding which allowed the bank to meet the needs of customers for new mortgage financing. A favorable low interest rate environment in 1993 resulted in significant mortgage loan refinancing which increased liquidity within the bank's loan portfolio. Mortgage loans held for investment and non-conforming for secondary market sale in the amount of approximately $5.5 million were refinanced and sold on the secondary market. Additional liquidity is provided by other sources such as maturing loans. On the liability side, liquidity is available through customer deposits. Federal funds purchased and other forms of short term borrowings are also sources of liquidity. Liquidity must constantly be monitored because future customer demands for funds are uncertain. The amount of liquidity needed is determined by the changes in levels of deposits and in the demand for loans. Management believes that the sources of funds mentioned above provide the liquidity to meet customer demands for funds. Interest sensitivity is related to liquidity because each is affected by maturing assets and sources of funds. Interest sensitivity, however, is also concerned with the fact that certain types of assets and liabilities may have interest rates that are subject to change prior to maturity. Management endeavors to manage the exposure of the net interest margin to interest-sensitive assets and liabilities so as to minimize the impact of fluctuating interest rates on earnings. The Bank of Lancaster County's asset/liability committee manages interest rate risk by various means including "GAP" management of its asset and liability portfolios. The Bank has various investments structured to change investment yield with current market conditions. Assets subject to repricing include federal funds sold (repricing daily), loans tied to "Treasury Bill" indexes (repricing monthly) and loans tied to "prime" or other indexes subject to immediate change. In addition to assets currently available for repricing there are future scheduled principal repayments on loans, loans available for repricing at future dates and maturities of investments. These investment repayments will have to be reinvested at current market yields. The Bank's funding liabilities repricing has become more complex, since deposit products that historically were rate insensitive have become repriceable liabilities. Time deposits and debt instruments are repriceable at maturity. Other interest bearing liabilities are subject to interest rate change, but not subject to rate change to the same degree as asset repricing. To compensate for this inequality in repricing, historic correlations between "prime" rate changes and deposit rate changes are calculated for each deposit product. The resulting pricing correlation is then used to adjust deposit product balances to an interest sensitive equivalent balance. For example, money market deposits have an 80% pricing correlation to an equivalent change in "prime". Therefore, 80% of these balances are considered interest rate sensitive in asset/liability management. NOW Accounts have a 39% pricing correlation to "prime" and 39% of these balances are considered interest rate sensitive. The pricing correlation is based on relevant past events and is refined monthly. Interest repricing of assets and liabilities is measured over future time periods (interest rate sensitivity gaps). While all time gaps are measured, the Bank's primary focus is the cumulative gaps through six months, as these gaps directly affect net interest income in the short time horizon and are harder to make reactive adjustment to actual interest rate movements. Excluded from the interest rate sensitivity gaps are "matched" funded fixed rate leases and associated fixed rate debt totaling $17.8 million. Table 13 - Interest Rate Sensitivity Gaps New Financial Accounting Standards The Financial Accounting Standards Board (FASB) issued Standard No. 112 which establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement. This standard is effective for fiscal years beginning after December 15, 1993. Sterling Financial Corporation has determined that the application of this standard will not have a material effect on earnings. FASB Statement No. 114 addresses the accounting by creditors for impairment of a loan by specifying how allowances for credit losses related to certain loans should be determined. A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. This statement shall be effective for financial statements for fiscal years beginning after December 15, 1994. Sterling has not completed the complex analysis required to estimate the impact of this statement. The Financial Accounting Standard Board issued Standard No. 115 which addresses the accounting and reporting for certain investments in debt securities and equity securities. It requires that these securities be classified into one of three categories: held-to-maturity, available-for-sale, or trading. Specific accounting treatments apply to each of the three categories. Securities held-to-maturity will be reported at amortized cost, trading securities are reported at fair value, with unrealized gains and losses included in earnings and available-for-sale will be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity. The statement shall be effective for fiscal years beginning after December 15, 1993. Sterling will apply this statement beginning January 1, 1994 at which time securities will be categorized as required. The Financial Accounting Standards Board issued Standard No. 116. This Statement establishes standards of financial accounting and reporting for contributions received and contributions made. This Statement shall be effective for financial statements issued for fiscal years beginning after December 15, 1994 and interim periods within those fiscal years. Sterling has determined that the application of this standard will not have a material effect on earnings. Item 8 Item 8 - Financial Statements and Supplementary Data (a) The following audited consolidated financial statements and related documents are set forth in this Annual Report on Form 10-K on the following pages: (b) The following supplementary data is set forth in this Annual Report on Form 10-K on the following pages: Trout, Ebersole & Groff Certified Public Accountants 1705 Oregon Pike Lancaster, Pennsylvania 17601 (717)569-2900 FAX (717) 569-0141 Independent Auditors' Report Board of Directors and Shareholders Sterling Financial Corporation and Subsidiaries Lancaster, Pennsylvania We have audited the accompanying consolidated balance sheets of Sterling Financial 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 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 Sterling Financial 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. Trout, Ebersole & Groff Trout, Ebersole & Groff Certified Public Accountants January 21, 1994 Lancaster, Pennsylvania NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Sterling Financial Corporation and Subsidiaries Note 1 - Formation of Sterling Financial Corporation As a result of a plan of reorganization, The First National Bank of Lancaster County, now by name change, Bank of Lancaster County, N.A. (Bank), became the wholly owned subsidiary of Sterling Financial Corporation (Parent Company), a new bank holding company, at the close of business June 30, 1987. Each outstanding share of the Bank's common stock (par value $10.00) was converted into two shares of common stock (par value $5.00) of the Parent Company. The authorized capital of the Parent Company is 10,000,000 shares of common stock. Note 2 - Summary of Significant Accounting Policies The accounting and reporting policies of Sterling Financial Corporation and its subsidiaries conform to generally accepted accounting principles and to general practices within the banking industry. The following is a summary of the most significant policies. Principles of Consolidation - The accompanying consolidated financial statements include the accounts of Sterling Financial Corporation and its wholly owned subsidiaries, Bank of Lancaster County, N.A. and its subsidiary Town & Country, Inc., and Sterling Mortgage Services, Inc. (presently inactive). All significant intercompany transactions have been eliminated in the consolidation. Investment Securities - Investment securities are carried at cost adjusted for amortization of premiums and accretion of discounts, both computed on the constant yield method. Investment securities primarily consist of debt securities which are carried at amortized cost. It is management's intent to hold investment account securities until maturity. Gains and losses on the sale of investment securities are determined on the specific identification basis and are included in Other Operating Income in the Consolidated Statements of Income. Permanent impairments of market value are reflected in the period ascertained. No securities were considered available for sale or held for trading purposes at December 31, 1993 and 1992. Premises and Equipment - Premises, furniture and equipment, leasehold improvements, and capitalized leases are stated at cost, less accumulated depreciation and amortization. For book purposes, depreciation is computed primarily by using the straight-line method over the estimated useful life of the asset. Charges for maintenance and repairs are expensed as incurred. Gains and losses on dispositions are reflected in current operations. Other Real Estate Owned - Other real estate owned is carried at the lower of cost or an amount not in excess of estimated fair value. Allowance for Loan Losses - The provision for loan losses charged to operating expense reflects the amount deemed appropriate by management to produce an adequate reserve to meet the present and foreseeable risk characteristics of the loan portfolio. Management's judgement is based on the evaluation of individual loans and their overall risk characteristics, past loan loss experience, and other relevant factors. Loan losses are charged directly against the allowance and recoveries on previously charged-off loans are added to the allowance. Interest Income - Interest on installment loans is recognized primarily on the simple interest, actuarial and the rule of seventy- eights methods. Interest on other loans is recognized based upon the principal amount outstanding. The general policy has been to cease accruing interest on loans when it is determined that a reasonable doubt exists as to the collectibility of additional interest. Interest income on these loans is only recognized to the extent payments are received. Federal Income Taxes - Applicable income taxes are based on income as reported in the consolidated financial statements. Deferred income taxes are provided for those elements of income and expense which are recognized in different periods for financial reporting and income tax purposes. Statement of Financial Accounting Statements (SFAS) No. 109 - Accounting for Income Taxes, which changes the method of accounting for income taxes, was retroactively applied in 1993 which resulted in a decrease of $310,000 in retained earnings beginning January 1, 1991. Earnings after this date have not been restated since the change is not considered material. Trust Department Assets and Income - Trust assets held by the Bank in a fiduciary or agency capacity for customers of the Trust Department are not included in the financial statements since such items are not assets of the Bank. Trust income has been recognized on the cash basis which is not significantly different from amounts that would have been recognized on the accrual basis. Earnings per Share - Earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding which were 2,864,200, 2,817,651, and 2,775,778 for 1993, 1992 and 1991 respectively, after giving retroactive effect to a three-for-two stock split in the form of a 50% stock dividend paid in 1992 and a 5% stock dividend paid in December 1993. Presentation of Cash Flows - For purposes of reporting cash flows, cash and due from banks includes cash on hand and amounts due from banks (including cash items in process of clearing). Reclassifications - Certain income items for prior years have been reclassified in order to conform with the current year presentation with no effect to net income. Note 3 - Restrictions on Cash and Due From Banks The Bank is required to maintain average reserve balances with the Federal Reserve Bank. The average amount of these reserve balances for the year ended December 31, 1993 was approximately $6,658,000. Balances maintained at the Federal Reserve Bank are included in cash and due from banks. Note 4 - Investment Securities Securities pledged to secure government and other public deposits, trust deposits, short-term borrowings, and other balances as required or permitted by law were carried at $28,295,144 in 1993 and $22,463,103 in 1992. The amortized cost and estimated market values of investment securities are as follows: The balance sheet lists Investment Securities by major categories while certain footnotes or tables list mortgage-backed securities as a separate category. Mortgage-backed securities are either Obligations of Other U.S. Government Agencies or Other (Corporate) Securities. In 1993, such securities were listed at $5,834,000 of which $5,023,000 were Obligations of Other U.S. Government Agencies and $811,000 were listed in Other Securities. In 1992, $7,175,000 were listed as mortgage-backed securities of which $6,552,000 were Obligations of Other U.S. Government Agencies and $623,000 were listed in Other Securities. The amortized cost and estimated market value of debt securities 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. There were no sales of investments in debt securities during 1993, 1992 or 1991. Note 5 - Loans Loans on a non-accrual status amounted to $2,960,038 at December 31, 1993, compared to $4,129,295 at December 31, 1992. If interest income had been recorded on all such loans for the years indicated, such interest income would have increased by approximately $267,295 and $293,967 for 1993 and 1992 respectively. Note 6 - Allowance for Loan Losses Changes in the Allowance for Loan Losses were as follows: Note 7 - Premises and Equipment Depreciation expense amounted to $983,345 in 1993, $940,843 in 1992 and $854,252 in 1991. Note 8 - Other Assets Included in other assets for 1993 and 1992 is $17,186,239 and $16,809,324 respectively which represents operating leases generated by Town & Country, Inc. The income generated from the leases for 1993 and 1992 amounted to $1,736,814 and $1,824,796 respectively and is reflected in other operating income. The following schedule provides an analysis of Town & Country's investment in property on operating leases and property held for lease by major classes as of December 31, 1993 and 1992: Note 9 - Time Certificates of Deposit At December 31, 1993 and 1992, time certificates of deposit of $100,000 or more aggregated $13,159,166 and $13,681,887 respectively. Note 10 - Other Liabilities for Borrowed Money The following represents other liabilities for borrowed money at December 31: Liabilities in connection with Town & Country, Inc. leasing operations are payable to various lenders at various terms. The estimated current portion of this debt is $8,027,368 at December 31, 1993. The borrowings from the Federal Home Loan Bank of Pittsburgh consist of two advances in 1993. One in the amount of $621,450, bears interest monthly at the rate of 4.49% per year and matures July 29, 1996. The second, in the amount of $950,000 bears interest at the rate of 5.39% per year and matures September 13, 2000. Note 11 - Mortgages Payable and Capitalized Lease Liability The Bank entered into a transaction with the Lancaster Industrial Development Authority in 1976 through The First Federal Savings and Loan Association of Lancaster, which became Penn Savings Bank, which has now become Sovereign Bank, to finance the construction of the Millersville office. The balance on this obligation was $85,292 on December 31, 1992. This obligation was paid in full in 1993. The rate of interest was 7 1/2%. In 1978, the Bank entered into another transaction with the Lancaster Industrial Development Authority through The First Federal Savings and Loan Association of Lancaster, which became Penn Savings Bank, which has now become Sovereign Bank, to purchase the building for our Duke Street (Lancaster) Office. The balance on this obligation was $109,844 on December 31, 1992. This obligation was paid in full in 1993. The rate of interest was 7%. The Bank leases the Fruitville Pike Office building. This lease was entered into in 1979. This is a capitalized lease and is accounted for and depreciated as bank-owned property, with lease payments accounted for as interest and debt reduction. The obligation under capitalized lease liability amounted to $11,188 on December 31, 1993 and $23,350 on December 31, 1992. Lease payments amount to $1,676 monthly of which $1,175.61 is applied as interest and debt reduction and the remaining $500.39 is for land rental and treated as an operating lease. The term of this lease is 15 years with renewal options available. The following is a schedule of the total future minimum lease payments together with the present value of the net minimum lease payments related to the capitalized lease payments as of December 31, 1993. Note 12 - Pension and Employee Stock Bonus Plan The Bank of Lancaster County, N.A. and its subsidiary, Town & Country, Inc. maintains a qualified non-contributory pension plan for their employees. The Plan specifies fixed benefits to provide a monthly pension benefit at age 65 for life (with payments guaranteed for 10 years) equal to one and one-half percent of each participant's final average salary (highest five consecutive years' base compensation preceding retirement) for each year of credited service. All employees with one year of service who work at least 1,000 hours per year and who are at least age 21 are eligible to participate. A participant becomes 100% vested upon completion of five years of service. Sterling Financial Corporation has adopted the provision of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions", for the year ended December 31, 1987. The net periodic pension cost for 1993, 1992 and 1991 was $574,627, $328,019 and $257,444 respectively. Net periodic pension cost for 1993, 1992 and 1991 included the following: The 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 6.5% and 5%, respectively, at December 31, 1993. The expected long-term rate of return on plan assets in 1993 was 9%. The Board of Directors of the Bank adopted an employee stock plan effective July 1, 1981. The assets of the Plan will be entirely invested in Sterling Financial Corporation common stock. The Plan covers all Bank employees who are age 18 and over, are employed for at least 1,000 hours per year and have completed at least one year of service. The Plan has two parts: *The Thrift Incentive portion of the Plan permits any eligible participant to make voluntary contributions to the Plan ranging from 2% to 6% of compensation. The Bank will contribute 25% of what the participant contributes. This portion of the Plan is intended to encourage thrift and investment in Sterling Financial Corporation stock. *The Performance Incentive portion of the Plan allows the Bank to make annual contributions to the Plan based on certain overall Bank performance objectives. These contributions will be allocated to the participants based on compensation. Bank contributions to the Plan vest in each participant's account at the rate of 20% for each year of service. Normally, benefits may be paid from the Plan on retirement, termination, disability or death. Participants in the Plan may withdraw their own contribution earlier under several restricted conditions of hardship with approval of the Plan Committee. The Plan provides that each participant may vote the shares in his or her account through the Plan Trustee at any shareholder meeting. The Bank of Lancaster County Trust Department serves as Trustee for the Plan. All dividends received on Sterling Financial Corporation stock are reinvested in additional shares of Sterling Financial Corporation stock. The contribution to the Performance Incentive portion of the Plan was $200,000, $165,000 and $150,000 for 1993, 1992 and 1991 respectively. The contribution to the Thrift Incentive portion of the Plan was $41,766 in 1993, $37,291 in 1992 and $32,685 in 1991. Note 13 - Applicable Income Taxes The effective income tax rates for financial reporting purposes are less than the Federal statutory rate of 34% for 1993, 1992 and 1991 for reasons shown as follows: The Financial Accounting Standards Board has issued Statement No. 109, Accounting for Income Taxes, which significantly changes the recognition and measurement of deferred income tax assets and liabilities. Statement 109 requires that deferred income taxes be recorded on an asset/liability method and adjusted when new tax rates are enacted. The Company adopted Statement No. 109 beginning with its year ending December 31, 1993. The Statement provides that the effect of its adoption may be recorded entirely in the year of adoption retroactively by restating one or more prior years. The statement was retroactively applied in 1993. Note 14 - Operating Leases The Bank leases certain banking facilities under operating leases which expire on various dates to 2022. Renewal options are available on these leases. Minimum future rental payments as of December 31, 1993 are as follows: Total rent expense charged to operations amounted to $373,332 in 1993, $334,654 in 1992 and $282,760 in 1991. Note 15 - Disclosures about Fair Value of Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value. Cash and Short-Term Investments- For those short-term instruments, the carrying amount is a reasonable estimate of fair value. Investment Securities- For investment securities, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Loans- For certain homogenous categories of loans, such as some residential mortgages, fair value is estimated using the quoted market prices 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. Lease contracts as defined in FASB Statement No. 13, Accounting for Leases, are not included in this disclosure statement. 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. The fair value of fixed-maturity certificates of deposits is estimated using the rates currently offered for deposits of similar remaining maturities. U.S. Treasury Demand Notes- For U.S. Treasury demand notes, the carrying amount is a reasonable estimate of fair value. Other Borrowings- Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt. Commitments to Extend Credit and Standby Letters of Credit- The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and committed rates. The fair value of guarantees and letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. The estimated fair values of the Corporation's financial instruments are as follows: * The amounts shown under "Carrying Amount" represent accruals or deferred income (fees) arising from those unrecognized financial instruments. Note 16 - Commitments and Contingent Liabilities In the normal course of business, there are various commitments and contingent liabilities which are not reflected in the financial statements. These include lawsuits and commitments to extend credit, guarantees and letters of credit. In the opinion of management, there are no material commitments which represent unusual risks. A summary of the more significant commitments as of December 31, 1993 and 1992 are as follows: Summary of Quarterly Financial Data (Unaudited) Sterling Financial Corporation and Subsidiaries The following is a summary of the quarterly results of operations for the years ended December 31, 1993 and 1992. Net income per share of common stock has been restated to retroactively reflect a three-for-two stock split in the form of a 50% stock dividend paid in 1992 and a 5% stock dividend in 1993. 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 is the information appearing under the heading "Information about Nominees and Continuing Directors" on pages 5 and 6 of the 1994 Proxy Statement and under the heading "Officers and Executive Officers" on page 7 of the 1994 Proxy Statement. Item 11 Item 11 - Executive Compensation Incorporated by reference is the information under the heading "Compensation of Directors" on page 11 of the 1994 Proxy Statement and under the heading "Executive Compensation" on page 7 of the 1994 Proxy Statement. Item 12 Item 12 - Security Ownership of Certain Beneficial Owners and Management Incorporated by reference is the information appearing under the heading "Voting of Shares of Principal Holders Thereof" on page 3 of the 1994 Proxy Statement and under the heading "Information about Nominees and Continuing Directors" on pages 5 and 6 of the 1994 Proxy Statement. Item 13 Item 13 - Certain Relationships and Related Transactions Incorporated by reference is the information appearing under the heading "Transactions with Directors and Executive Officers" on page 12 of the 1994 Proxy Statement and under "Notes to Consolidated Financial Statements - Note 17 - Related Party Transactions" on page 34 of the Form 10-K for the year ended December 31, 1993. PART IV Item 14 Item 14 - Exhibits, Financial Statement Schedules and Reports of Form 8-K (a) The following documents are filed as part of this report: 1. The financial statements listed on the index set forth in Item 8 of this Annual Report on Form 10-K are filed as part of this Annual Report. 2. Financial Statement Schedules All schedules are omitted because they are not applicable, the data are not significant or the required information is shown in the financial statements or the notes thereto or elsewhere herein. 3. Exhibits The following is a list of the Exhibits required by Item 601 of Regulation S-K and are incorporated by reference herein or annexed to this Annual Report. 1. Articles of Incorporation and Bylaws of Sterling Financial Corporation incorporated by reference to Exhibit 3 of Registration Statement on Form S-4 (No. 33-12635) filed with the Securities and Exchange Commission on March 13, 1987. 2. Material Contracts - Employment Agreement of John E. Stefan, President and Chief Executive Officer of Sterling Financial Corporation and Bank of Lancaster County, N.A. - incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended September 30, 1987. 3. List of Subsidiaries 4. Consent of Auditors (b) Reports on Form 8-K A report on Form 8-K dated October 26, 1993 was filed during the third quarter of 1993 pursuant to Item 5 of Form 8-K relating to a 5% stock dividend declared on October 26, 1993, to shareholders of record, November 17, 1993 and payable December 6, 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. STERLING FINANCIAL CORPORATION By: John E. Stefan 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 indicated. Signature Title JOHN E. STEFAN President and Chief (John E. Stefan) Executive Officer; Director RONALD L. BOWMAN Secretary/Treasurer (Ronald L. Bowman) RICHARD L. ALBRIGHT, JR. Director (Richard H. Albright, Jr.) JOHN E. BURKHOLDER Director (John E. Burkholder) ROBERT H. CALDWELL Director (Robert H. Caldwell) HOWARD E. GROFF, JR. Director (Howard E. Groff, Jr.) J. ROBERT HESS Director (J. Robert Hess) CALVIN G. HIGH Director (Calvin G. High) E. GLENN NAUMAN Director (E. Glenn Nauman) GLENN R. WALZ Director (Glenn R. Walz) Trout, Ebersole & Groff Certified Public Accountants 1705 Oregon Road Lancaster, Pennsylvania 17601 (717) 569-2900 FAX (717) 569-0141 Exhibit 24 Consent of Independent Certified Public Accountants We hereby consent to the incorporation by reference in Registration Statement No. 33-16049 on form S-3 filed July 24, 1987 of our opinion dated January 21, 1994, on the consolidated financial statements of Sterling Financial Corporation for the year ended December 31, 1993 as set forth in this Form 10-K. TROUT, EBERSOLE & GROFF Trout, Ebersole & Groff Certified Public Accountants Lancaster, Pennsylvania March 8, 1994

723916_1993.txt

723916_1993

1993

723916

ITEM 1. Meridian Bancorp, Inc. Meridian Bancorp, Inc. (the "Registrant"), a multi-bank holding company registered under the federal Bank Holding Company Act of 1956, as amended, was incorporated as a Pennsylvania business corporation as a result of the statutory consolidation on June 30, 1983 of American Bancorp, Inc. and Central Penn National Corp. The Registrant's subsidiaries presently engaged in the business of banking are (i) Meridian Bank, formed in 1986 as a result of the merger of the Registrant's then-existing three banking subsidiaries (American Bank and Trust Co. of Pa., Central Penn National Bank and The First National Bank of Allentown), (ii) Delaware Trust Company, acquired in January 1988, and (iii) Meridian Bank, New Jersey, which commenced operations in April 1993 upon the acquisition of Cherry Hill National Bank. Recent Transactions On August 31, 1993, the Registrant acquired Commonwealth Bancshares Corporation ("Commonwealth"), a bank holding company headquartered in Williamsport, Pennsylvania. The acquisition was accounted for as a "pooling of interests" and constituted a tax- free exchange for federal income tax purposes. Concurrently with the transaction, Commonwealth Bank, the sole banking subsidiary of Commonwealth, was merged into Meridian Bank. At August 31, 1993, Commonwealth had total consolidated assets of approximately $2.2 billion and total deposits of approximately $1.6 billion. On April 26, 1993, in connection with the acquisition of Commonwealth, the Registrant agreed to a merger of The Grange National Bank of Susquehanna County ("Grange"), a two-branch national bank headquartered in New Milford, Pennsylvania, into Meridian Bank. At December 31, 1993, Grange had approximately $28.5 million in total assets and $25.3 million in total deposits. The acquisition is expected to be accounted for as a "pooling of interests" and to constitute a tax-free exchange for federal income tax purposes. The acquisition is expected to be completed in the second quarter of 1994. The Registrant will issue up to 166,500 shares of Common Stock in connection with the merger. In November 1993, Meridian Bank assumed approximately $76 million of deposits of Provident Savings Bank of Jersey City, and paid a premium of $540 thousand. This acquisition was accounted for as a purchase. On December 10, 1993, the Registrant acquired First Bath Corp. ("FBC"), a bank holding company headquartered in Bath, Pennsylvania. The acquisition was accounted for as a "pooling of interests" and constituted a tax-free exchange for federal income tax purposes. Concurrently with the transaction, The First National Bank of Bath, FBC's sole subsidiary, was merged into Meridian Bank. At December 10, 1993, FBC had total consolidated assets of approximately $120 million and total consolidated deposits of approximately $110 million. On December 16, 1993, the Registrant entered into a definitive agreement to acquire McGlinn Capital Management, Inc., an investment advisory firm with $2.8 billion in assets under direct management, for 500,000 warrants for shares of the Registrant's Common Stock and cash. The transaction, which is subject to regulatory approval, is expected to be completed by the end of the second quarter of 1994. Bank Subsidiaries - Meridian Bank, Delaware Trust Company and Meridian Bank, New Jersey Meridian Bank conducts its business principally through 269 banking offices located in 29 eastern and central Pennsylvania counties. Delaware Trust, a Delaware banking corporation, was incorporated in 1899 under the Delaware General Corporation Law and acquired banking powers through its merger in 1910 with Delaware Savings Bank, which was created in 1905 by a special act of the General Assembly of the State of Delaware. Delaware Trust operates 26 branches in New Castle, Kent and Sussex Counties, Delaware. In January 1993, the Registrant caused the formation of Meridian Bank, New Jersey, a New Jersey state-chartered banking institution, to effect the acquisition of Cherry Hill National Bank, which was completed in April 1993. Meridian Bank, New Jersey operates 8 branches in Camden and Burlington Counties, New Jersey. At December 31, 1993, Meridian Bank, Delaware Trust and Meridian Bank, New Jersey had total deposits of $10.1 billion, $1.2 billion and $176 million, respectively, total loans of $8.4 billion, $944 million and $70 million, respectively, and total assets of $12.3 billion, $1.4 billion and $196 million, respectively. Meridian Bank, Delaware Trust and Meridian Bank, New Jersey provide a wide variety of services, including secured and unsecured financing, real estate financing, checking, savings and time deposit accounts, as well as the offering of cash management and a variety of other specialized financial services to individuals, businesses, municipalities and other governmental bodies. In addition, Meridian Capital Markets, Inc. a division of Meridian Bank, engages in the underwriting of municipal obligations and various other investment banking, merchant banking, mortgage banking and related activities permitted by law for banks. On July 9, 1992, the Registrant entered into an agreement to acquire 21 branches in seven counties of central and southern New Jersey, of Security Savings Bank, SLA ("Security"), a wholly- owned subsidiary of Security Investments Group, Inc. ("Security Investments"). Under the terms of the agreement, Meridian Bank, New Jersey was to have acquired selected non-classified and performing assets and real estate having, based on June 30, 1992 data and fair values, a book value of approximately $820 million in exchange for the assumption of deposits and Federal Home Loan Bank borrowings having an aggregate book value of a like amount and the payment of a deposit premium based on the amount of deposit liabilities assumed. On December 4, 1992, Office of Thrift Supervision declared Security insolvent and placed it in conservatorship with the Resolution Trust Company ("RTC"). The RTC, in its capacity as receiver of Security, repudiated the agreement in the fourth quarter of 1993 in accordance with its authority under applicable banking law. Other Subsidiaries of the Registrant Meridian Life Insurance Company is a wholly-owned subsidiary of the Registrant that reinsures life insurance and accident and health insurance issued to borrowers in connection with loans and other extensions of credit made to such borrowers by the Registrant's subsidiary banks. Meridian Funding Corp. is a wholly-owned subsidiary of the Registrant that issues commercial paper for the use of the Registrant and its subsidiaries. Meridian Asset Management, Inc. ("MAM") and its subsidiaries, Meridian Trust Company, Meridian Trust Company of California and Meridian Investment Company, provide services formerly provided by the trust departments of the predecessors of Meridian Bank. These services include personal and corporate trust, asset management and related services and investment advisory services. Meridian Trust Company is a Pennsylvania trust company with full trust powers. Meridian Investment Company is an investment advisory firm registered with the Securities and Exchange Commission and the Pennsylvania Securities Commission. As of December 31, 1993, assets being administered in one or more fiduciary capacities by MAM or one of its subsidiaries had an aggregate market value of approximately $15.5 billion, of which MAM or one of such subsidiaries had sole or joint investment responsibility for approximately $4.4 billion. Meridian Trust Company of California, based in San Francisco, was organized by MAM in 1989 and engages in personal and corporate trust activities in California. In addition to fiduciary services provided by MAM and its subsidiaries, Delaware Trust Capital Management, Inc., a Delaware bank and trust company and a wholly-owned subsidiary of Delaware Trust, performs trust and related financial services. Prior to the commencement of operations by Delaware Trust Capital Management, Inc. in January 1989, such services were performed by the Capital Management Group of Delaware Trust. As of December 31, 1993, assets being administered in one or more fiduciary capacities by Delaware Trust Capital Management, Inc. had an aggregate market value of approximately $12 billion, of which it had sole or joint investment responsibility for approximately $1.7 billion. Meridian Securities, Inc. is registered as a broker with the Securities and Exchange Commission and the Pennsylvania Securities Commission and is a member of the National Association of Securities Dealers, Inc. Meridian Capital Corp., a wholly-owned subsidiary of the Registrant, is a small business investment company licensed by the SBA, the business emphasis of which is small businesses located in the tri-state area of Pennsylvania, Delaware and New Jersey. This subsidiary is under agreement of sale. Meridian Acceptance Corp., a wholly-owned subsidiary of the Registrant, engages in the business of purchasing motor vehicle installment sale contracts originating in the State of New Jersey. Until August 1990, Meridian Mortgage Corporation ("Meridian Mortgage") operated as a wholly-owned mortgage banking subsidiary of the Registrant. In August 1990, Meridian Mortgage became a wholly-owned subsidiary of Meridian Bank. Meridian Mortgage was incorporated in mid-1983 and provides a full range of real estate financing services for owners of residential and commercial properties. Meridian Mortgage originates mortgage loans, services residential and commercial mortgages through offices in New Jersey, Pennsylvania, New York, Florida, Washington State and Delaware and securitizes and sells mortgages and servicing in the secondary markets. During the third quarter of 1993, the Registrant decided to significantly reduce the scope of its mortgage banking business through a sale of substantially all of the mortgage servicing operations conducted by Meridian Mortgage. Meridian Delaware Investments, Inc., a wholly-owned subsidiary of the Registrant, is a Delaware business corporation that invests in and holds certain investments. Meridian Leasing, Inc. specializes in leasing office and business equipment. In October 1991, Meridian Leasing, Inc. was reorganized as a direct subsidiary of Meridian Bank. In November 1989, Meridian Bank formed Meridian Auto Leasing, Inc. This corporation conducts the automobile leasing activities previously conducted by Meridian Bank. Meridian Asset Servicing Corp. was formed in 1993 to hold title to real estate acquired through foreclosure on defaulted loans. On June 30, 1992, the Registrant completed the sale of its title insurance operations to Fidelity National Financial, Inc., of Irvine, California. Supervision and Regulation Various requirements and restrictions under the laws of the United States and the states in which the Company and its subsidiaries do business affect the Registrant and its subsidiaries. General The Registrant is a bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") under the Bank Holding Company Act of 1956, as amended (the "BHCA"). As a bank holding company, the Registrant's activities and those of its banking and nonbanking subsidiaries are limited to the business of banking and activities closely related or incidental to banking, and the Registrant may not directly or indirectly acquire the ownership or control of more than 5% of any class of voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. The Registrant's subsidiary banks are subject to supervision and examination by applicable federal and state banking agencies. All of the Registrant's subsidiary banks are insured by, and therefore subject to the regulations of, the Federal Deposit Insurance Corporation (the "FDIC"). In addition, Meridian Bank is a Pennsylvania bank and trust company and member of the Federal Reserve System subject to supervision and regulation by the Pennsylvania Department of Banking and the Federal Reserve Board. Delaware Trust Company is a Delaware banking corporation subject to supervision and regulation by the Delaware State Bank Commissioner. Meridian Bank, New Jersey, is a New Jersey state bank subject to supervision and regulation by the New Jersey Department of Banking. The Registrant's subsidiary banks are also subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon, and limitations on the types of investments that may be made and the types of services that may be offered. Various consumer laws and regulations also affect the operations of the Registrant's subsidiary banks. 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. Holding Company Structure The Registrant's subsidiary banks are subject to restrictions under federal law which limit the transfer of funds by each of them to the Registrant and its nonbanking subsidiaries, whether in the form of loans, other extensions of credit, investments or asset purchases. Such transfers by any subsidiary bank to the Registrant or any nonbanking subsidiary are limited in amount to 10% of such subsidiary bank's capital and surplus and, with respect to the Registrant and all nonbanking subsidiaries, to an aggregate of 20% of such subsidiary bank's capital and surplus. Furthermore, such loans and extensions of credit are required to be secured in specified amounts. The Federal Reserve Board has issued regulations under the BHCA that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the Federal Reserve Board, pursuant to such regulations, may require the Registrant to stand ready to use its resources to provide adequate capital funds to its banking subsidiaries during periods of financial stress or adversity. This support may be required at times when, absent such regulations, the bank holding company might not otherwise provide such support. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (the "Improvement Act"), a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become "undercapitalized" (as described below) with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency, up to specified limits. Under the BHCA, the Federal Reserve Board has the authority to require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the Federal Reserve Board's determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company. Under the Financial Institutions Reform, Recovery, and Enforcement Act ("FIRREA"), 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 depository institution in danger of default. Regulatory Restrictions on Dividends Dividend payments by Meridian Bank to the Registrant are subject to the Pennsylvania Banking Code of 1965 (the "Banking Code") and the Federal Deposit Insurance Act. Under the Banking Code, no dividends may be paid except from "accumulated net earnings" (generally, undivided profits). Under the Federal Deposit Insurance Act, no dividends may be paid by an insured bank if the bank is in arrears in the payment of any insurance assessment due to the FDIC. The declaration and payment of dividends by Delaware Trust to the Registrant are subject to the Delaware Banking Code and the Federal Deposit Insurance Act. Under the Delaware Banking Code, no dividends may be paid except from "net profits" (generally, net income as defined under federal regulations and reported to the State Bank Commissioner). Additional restrictions apply unless Delaware Trust's surplus fund is equal to the amount of its common stock. The declaration and payment of dividends by Meridian Bank, New Jersey to the Company are subject to the New Jersey Banking Act of 1948 and the Federal Deposit Insurance Act. Under the New Jersey Banking Act of 1948, Meridian Bank, New Jersey cannot pay a cash dividend unless following such dividend, the Bank's surplus will equal at least fifty percent of the capital stock or the payment of the dividend will not reduce the Bank's surplus. State and federal regulatory authorities have adopted standards for the maintenance of adequate levels of capital by banks. Adherence to such standards further limits the ability of banks to pay dividends. Under these policies and subject to the restrictions applicable to the Registrant's subsidiary banks, such subsidiary banks could declare in the remainder of 1994, without prior regulatory approval, aggregate dividends of $147.1 million, plus net profits for the remainder of 1994. The payment of dividends by any subsidiary bank may also be affected by other regulatory requirements and policies, such as the maintenance of adequate capital. If, in the opinion of the applicable regulatory authority a bank under its jurisdiction is engaged in, or is about to engage in, an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), such authority may require, after notice and hearing, that such bank cease and desist from such practice. The Federal Reserve Board and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions. FDIC Insurance Assessments On January 1, 1993, the FDIC began to implement a risk-related premium schedule for all insured depository institutions that will result in the assessment of premiums based on capital and supervisory measures. The risk-related premium schedule was implemented during 1993; the FDIC began implementing a permanent system on January 1, 1994. Under the risk-related premium schedule, the FDIC, on a semiannual basis, will assign each institution to one of three capital groups (well-capitalized, adequately capitalized or undercapitalized) and further assign such institution to one of three subgroups within a capital group corresponding to the FDIC's judgment of its strength based on supervisory evaluations, including examination reports, statistical analysis and other information relevant to assessing the risk characteristics of the institution. Only institutions with a total capital to risk-adjusted assets ratio of 10% or greater, a Tier 1 capital to risk-adjusted assets ratio of 6% or greater and a Tier 1 leverage ratio of 5% or greater, are assigned to the well-capitalized group. Institutions deemed to have the highest risk would pay up to $.31 for every $100 of deposits annually while those deemed to have the least risk would pay $.23 for every $100 of deposits annually. After the risk-based premium schedule is fully phased in, the weakest institutions will face semiannual premium increases until their premium classification is upgraded or they merge with a stronger institution or fail. Capital Adequacy The Federal Reserve Board adopted risk-based capital guidelines for bank holding companies, such as the Registrant. The guidelines were phased in over a two-year period ended December 31, 1992. Currently, the required minimum ratio of total capital to risk-weighted assets (including off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the total capital is required to be "Tier 1 capital," consisting principally of common shareholders' equity, noncumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill. The remainder ("Tier 2 capital") may consist of a limited amount of subordinated debt and intermediate-term preferred stock, certain hybrid capital instruments and other debt securities, perpetual preferred stock, and a limited amount of the general loan loss allowance. During the two-year phase-in period, a limited portion of Tier 2 capital was permitted to be included as Tier 1 capital. In addition to the risk-based capital guidelines, the Federal Reserve Board established minimum leverage ratio (Tier 1 capital to total assets) guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio of 3% for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion. All other bank holding companies are required to maintain a leverage ratio of at least 1% to 2% above the 3% stated minimum. Each of the Registrant's subsidiary banks is subject to similar capital requirements adopted by its primary federal regulator. In 1993, each of the federal banking agencies, including the Federal Reserve Board and the FDIC, adopted uniform changes to the risk-based capital guidelines with respect to intangibles. Under the new rules, the only types of identifiable intangible assets that may be included in (i.e., not deducted from) an institution's capital are readily marketable purchased mortgage servicing rights ("PMSRs") and purchased credit card relationships ("PCCRs"), provided that, in the aggregate, the total amount of PMSRs and PCCRs included in capital does not exceed 50% of Tier 1 capital. PCCRs are subject to a separate sublimit of 25% of Tier 1 capital. The amount of PMSRs and PCCRs that an institution may include in its capital is the lesser of (i) 90% of such assets' fair market value (as determined under the guidelines) or (ii) 100% of such assets' book value on a discounted basis, guidelines) or (iii) 100% of such assets' book value on a discounted basis, each determined quarterly. Identifiable intangible assets other than PMSRs and PCCRs, including core deposit intangibles, acquired for purposes of the test applicable to bank holding companies on or before February 19, 1992 (the date the Federal Reserve Board issued its original proposal for public comment) generally will not be deducted from capital for supervisory purposes, although they will continue to be deducted for purposes of evaluating applications filed by bank holding companies. Other Provisions of the Improvement Act The Improvement Act required the federal banking agencies to promulgate regulations specifying the levels at which an insured institution would be considered "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." In October 1992, each of the Federal banking agencies issued uniform final regulations defining such capital levels. Under these regulations, a bank will be considered "well capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier 1 risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level. An "adequately capitalized" bank is defined under the regulations as one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier 1 risk-based capital ratio of 4% of greater, (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with the highest composite regulatory examination rating) and (iv) does not meet the definition of a well capitalized bank. A bank will be considered (A) "undercapitalized" if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier 1 risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of a bank with the highest regulatory examination rating of 1); (B) "significantly undercapitalized" if the bank has (i) a total risk-based capital ratio of less than 6%, (ii) a Tier 1 risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3%; and (C) "critically undercapitalized" if the bank has a ratio of tangible equity to total assets of equal to or less than 2%. Notwithstanding the foregoing, the applicable federal bank regulator for a depository institution could, under certain circumstances, reclassify a "well capitalized" institution as "adequately capitalized" or require an "adequately capitalized" or "undercapitalized" institution to comply with supervisory actions as if it were in the next lower category. Such a reclassification could be made if the regulatory agency determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings). Undercapitalized institutions, including significantly and critically undercapitalized institutions, are required to submit capital restoration plans to the appropriate federal banking regulator and are subject to restrictions on operations, including prohibitions on branching, engaging in new activities, paying management fees, making capital distributions such as dividends, and growing without regulatory approval. In May 1992, the FDIC issued regulations implementing provisions of the Improvement Act regulating brokered deposits. "Brokered deposits" are defined as deposits solicited through deposit brokers or deposits which an insured depository institution attracts by offering significantly above-market interest rates (as defined). Under the new regulations, "well capitalized" banks may accept brokered deposits without restriction, "adequately capitalized" banks may accept brokered deposits with a waiver from the FDIC (subject to certain restrictions imposed on payment of rates), while "undercapitalized" banks may not accept brokered deposits. The Improvement Act requires each federal banking agency to review, every two years, its capital standards to prevent or minimize loss to the Bank Insurance Fund (the "BIF") and the Savings Association Insurance Fund (the "SAIF"). Each agency must also revise its risk-based capital standards to ensure that those standards adequately take into account interest-rate risk, concentration of credit risk and risks of nontraditional activities, as well as reflect the actual performance and expected risk of loss on multi-family mortgages. In September 1993, the Federal Reserve Board and the FDIC issued a joint notice of proposed rulemaking seeking public comment on a proposed framework for revisions to the risk-based capital rules to take account of these factors. The proposal offers two alternatives to measure interest rate risk and the corresponding increased capital required as a result thereof. The Registrant is unable to predict the final form in which these proposed regulations will ultimately be adopted or the effect such regulation would have on the operations and capital adequacy of the Registrant and its subsidiaries. Prior to December 31, 1992, each federal banking agency was required to review the accounting procedures it requires institutions it regulates to utilize in preparing reports or statements to be filed with such agency to ensure compliance with generally accepted accounting principles ("GAAP"). Additionally, certain accounting reforms require the federal banking agencies to implement regulations to require that "off balance sheet" assets and liabilities be taken into account in the preparation of a depository institution's financial statements. Furthermore, the federal banking agencies must develop a method for and require disclosure of the fair value of a depository institution's assets and liabilities in financial statements. Commencing in fiscal years after December 31, 1992, each depository institution must submit audited financial statements to its primary regulator and the FDIC, which reports will be publicly available. The audit committee of each institution must consist of outside directors and the audit committee at "large institutions" (as defined by FDIC regulation) must include members with banking or financial management expertise. The audit committee at "large institutions" must have access to independent outside counsel. In addition, an institution must notify the FDIC and the institution's primary regulator of any change in the institution's independent auditor, and annual management letters must be provided to the FDIC and the depository institution's primary regulator. The regulations define a "large institution" as one with over $500 million in assets. which would include the Company. Also, under the rule, an institution's independent auditor must examine the institution's internal controls over financial reporting and perform agreed-upon procedures to test compliance with laws and regulations concerning safety and soundness. In 1993, federal banking agencies prescribed certain standards for depository institutions and their holding companies, including ratio of classified assets to capital, minimum earnings, compensation standards for officers, directors and employees and, to the extent feasible, a minimum ratio of market value to book value for publicly traded securities of such institutions and holding companies. The Improvement Act authorizes the FDIC to issue obligations to and to borrow from BIF members in order to recapitalize the BIF. BIF members may only purchase obligations of or make loans to the FDIC to the extent of the bank's capital or retained earnings. In accounting for any investment in an obligation purchased from, or loan made to, the FDIC, the amount of such investment or loan will be treated by such bank as an asset. The Improvement Act gives the FDIC authority to impose special assessments upon depository institutions to the extent necessary to repay the obligations of the FDIC. Any such assessment must be allocated between BIF members and SAIF members in amounts which reflect the degree to which proceeds borrowed are used for the benefit of the respective insurance funds. Provisions of the Improvement Act relax certain requirements for mergers and acquisitions among financial institutions, including authorization of mergers of insured institutions that are not members of the same insurance fund, and provide specific authorization for a federally chartered savings association or national bank to be acquired by any insured depository institution. Under the Improvement Act, all depository institutions must provide 90 days notice to their primary federal regulator of branch closings, and penalties are imposed for false reports by financial institutions. Commencing in 1993, depository institutions with assets in excess of $100 million must be examined on-site annually by their primary federal or state regulator or the FDIC. The Improvement Act also sets forth Truth in Savings disclosure and advertising requirements applicable to all depository institutions. Proposed Legislation The United States Senate and House Banking Committees have each passed, by strong margins, similar bills that would permit interstate ownership of banks by bank holding companies, and interstate branching by a single bank. If one of these bills is enacted, the effect would be to eliminate present federal and state law limitations on full interstate banking powers, over a phase-in period of eighteen months. States would be able to "opt-out" of the interstate banking provisions by enacting legislation to that effect. While many similar bills have been introduced in the past, the two pending bills appear to have greater support than previous bills. If one of the bills is enacted, the Registrant believes that industry costs will decrease as redundant operating structures are eliminated, but there will also be an increase in competition for banking customers, as well as an increase in consolidation of the banking industry. The Registrant is unable to predict whether any such legislation will be enacted, and what specific effect it might have on the Registrant. Legislation has been introduced in Congress, from time to time, that would repeal portions of the Glass Steagall Act, which forbids commercial banks from underwriting corporate securities and certain municipal securities. There is no active consideration by Congress of such proposed legislation at this time. In lieu of new legislation regarding the Glass Steagall Act, bank holding companies have received limited authority to underwrite and deal in certain securities through orders issued by the Federal Reserve Board. The Registrant is continuously evaluating whether it can and should avail itself of these limited approvals regarding securities powers. In this regard, the Registrant's various subsidiaries and divisions that engage in customer securities activities were restructured organizationally in the fourth quarter of 1988 to centralize control of all such activities (except for those under the direction of MAM and its subsidiaries) in anticipation of the possible expansion of securities trading and underwriting powers. Competition Meridian Bank, Delaware Trust, and Meridian Bank, New Jersey compete with numerous other banking and financial institutions in their respective markets. Commercial banks, savings and loan associations and credit unions actively compete for savings and time deposits and for many types of loans. Such institutions, as well as an undetermined number of consumer finance companies, investment counseling firms, insurance companies, stock brokerage firms, money market funds, equipment leasing companies and corporate trustees, in addition to retailers of goods and services who offer consumer credit, may be considered major competitors of Meridian Bank, Delaware Trust and Meridian Bank, New Jersey with respect to one or more of the services they offer. Pennsylvania law permits a Pennsylvania bank holding company (such as the Registrant) to expand by acquiring banks located in any state of the United States or the District of Columbia the laws of which allow such expansion. Also, bank holding companies located in another state are permitted by Pennsylvania law to acquire banks and bank holding companies in Pennsylvania, but only if the other state has enacted reciprocal legislation. "Reciprocal" legislation generally means legislation that permits Pennsylvania bank holding companies to acquire banks in such states and permits bank holding companies in those states to acquire Pennsylvania banks. In addition, pending legislation in the U.S. Congress to amend federal law to permit interstate bank ownership and branching appears to have such support. As a result, the Registrant expects the operating environment for Pennsylvania-based financial institutions to become increasingly competitive. Additionally, the manner in which banking institutions conduct their operations may change materially as the activities in which bank holding companies and their banking and nonbanking subsidiaries are permitted to engage increase, and funding and investment alternatives continue to broaden, although the long-range effects of these changes cannot be predicted, with reasonable certainty, at this time. These changes most probably will further narrow the differences and intensify competition between and among commercial banks, thrift institutions and other financial service companies. The marketplace continues to see intense competition from financial institutions and nonbanks for deposits, credit and associated services. Further deregulation is expected to open up opportunities for new product offerings that will replace and complement existing product lines. The ability of the Registrant and its subsidiaries to remain competitive with such other financial institutions offering similar services will depend upon how successfully the Registrant can respond to the rapidly evolving competitive, regulatory, technological, and demographic developments which affect its operations. Employees As of December 31, 1993, the Registrant and its subsidiaries employed 6,917 persons on a full-time equivalent basis. The Registrant and its subsidiaries provide a full range of employment benefits and consider their relationships with their employees to be excellent. ITEM 2. ITEM 2. PROPERTIES As of December 31, 1993, the Registrant, or a subsidiary of the Registrant, owned 201 properties in fee and leased 190. The properties owned in fee were at such date subject to liens, encumbrances or collateral assignments amounting in the aggregate to approximately $2.9 million. The principal office of the Registrant and of Meridian Bank is owned in fee and is located at 35 North Sixth Street, Reading, Pennsylvania 19601. The principal office of Delaware Trust is leased and located at 900 Market Street Mall, Wilmington, Delaware 19899. The principal office of Meridian Bank, New Jersey is leased and is located at 176 Route 70, Medford, New Jersey 08055. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Registrant and certain of its subsidiaries are party (plaintiff or defendant) to a number of lawsuits. While any litigation has an element of uncertainty, management, after reviewing these actions with its legal counsel, is of the opinion that the liability, if any, resulting from all legal actions will not have a material effect on the consolidated financial condition or results of operations of the Registrant. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT Certain information, including principal occupation during the past five years, relating to each executive officer of the Registrant is set forth below: Principal Occupation Name Age For Last Five Years Samuel A. McCullough 55 Chairman and Chief Executive Officer, Registrant since February 1988; prior thereto, President and Chief Executive Officer, Registrant from June 1983; also, a Director of the Registrant and Chairman, Meridian Bank. Ezekiel S. Ketchum 58 President, Registrant since February 1988 and Chief Operating Officer since December 1992; prior thereto, Vice Chairman, Registrant from September 1984; also, a Director of the Registrant and President and Chief Executive Officer, Meridian Bank. David E. Sparks 49 Vice Chairman and Chief Financial Officer, Registrant and Meridian Bank since February 1991; also a Director of the Registrant and Meridian Bank since 1993; prior thereto, Vice Chairman, Treasurer and Chief Financial Officer, Registrant and Meridian Bank from February 1990; prior thereto, Executive Vice President, Midlantic Corporation from 1985. Russell J. Kunkel 51 Vice Chairman, Registrant since February 1985; President and Chief Executive Officer, Meridian Mortgage Corporation since December 1992; also, Vice Chairman, Meridian Bank. John F. Porter, III 59 Chairman, President and Chief Executive Officer, Delaware Trust Company since July 1988; prior thereto, President, Delaware Trust Company. Paul W. McGloin 46 Executive Vice President, Registrant and Meridian Bank from July 1985. Robert J. Unruh 47 Chairman, Meridian Securities, Inc. since April 1990; also, Executive Vice President, Registrant and Meridian Bank from February 1985. Jan S. Berninger 37 President, Lehigh Valley Division, Meridian Bank since December 1992; prior thereto, Executive Vice President, Corporate and Commercial Banking, Delaware Valley Division, Meridian Bank, June 1992 to December 1992; prior thereto, Senior Vice President, Meridian Bank from 1986. David R. Bright 55 President, Delaware Valley Division, Meridian Bank since February 1988; prior thereto, Executive Vice President, Berks/Schuylkill Division, Meridian Bank since 1987. Thomas P. Dautrich 45 President, Susquehanna Valley Division, Meridian Bank since February, 1990; prior thereto, Executive Vice President, Registrant from December 1989; prior thereto, Senior Vice President, Registrant and Meridian Bank from 1986. Glenn E. Moyer 43 President, Berks/Schuylkill Division, Meridian Bank since February 1988; prior thereto, Senior Vice President, Delaware Valley Division, Meridian Bank (or its predecessor). Alice D. Flaherty 46 Executive Vice President, Registrant and Meridian Bank since December 1991; prior thereto, Senior Vice President, Registrant and Meridian Bank from 1985. Wayne R. Huey, Jr. 49 Executive Vice President, Registrant and Meridian Bank since January 1988; prior thereto, President Lehigh Valley Division, Meridian Bank from April 1986. Richard E. Meyers 48 Executive Vice President, Registrant since 1983; also, Executive Vice President, Meridian Bank. George W. Millward 44 Executive Vice President, Registrant since May 1992; prior thereto, managing associate, Coopers & Lybrand January 1987 to April 1992. Chester Q. Mosteller 41 Executive Vice President, Registrant and Meridian Bank since December 1989; prior thereto, Senior Vice President, Registrant and Meridian Bank. P. Sue Perrotty 40 Executive Vice President, Registrant and Meridian Bank since July 1989; prior thereto, Senior Vice President, Registrant and Meridian Bank. Thomas G. Strohm 44 Executive Vice President, Registrant since April 1991; prior thereto Senior Vice President, Registrant from 1986. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Shares of the Registrant's Common Stock are traded nationally in the over-the-counter market under the symbol MRDN and are quoted on the NASDAQ National Market System. As of February 15, 1994, the Registrant had 27,349 shareholders of record holding the Registrant's Common Stock. The following sets forth the quarterly ranges of high and low bid prices, and the closing sale price, for shares of the Registrant's Common Stock for the periods indicated. Such prices represent quotations between dealers and do not include mark-ups, mark-downs or commissions, and may not necessarily represent actual transactions. The table also reflects cash dividends declared during the periods indicated. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following sets forth certain selected historical consolidated financial data of Meridian for the periods indicated. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL HIGHLIGHTS Meridian Bancorp, Inc. (Meridian) reported record net income of $157.8 million in 1993 compared to $136.7 million in 1992, an increase of 15%. Earnings per fully diluted share were $2.74 in 1993 compared to $2.44 in 1992. The returns on average assets and on average common shareholders' equity were 1.11% and 14.17%, respectively, in 1993 compared to 1.00% and 13.63%, respectively, in 1992. The merger with Commonwealth Bancshares Corporation of Williamsport, Pa. (Commonwealth) was completed during the third quarter of 1993. Financial information for all prior periods presented has been restated to include the results of operations and financial position of Commonwealth. The change in net income between 1993 and 1992 was primarily due to the following items: - An increase in net interest income of $44.1 million ($23.5 million after-tax). - A decrease in the provision for possible loan losses of $12.7 million ($9.0 million after-tax). - An after-tax loss of $33.7 million in the mortgage banking subsidiary. - Expenses of $11.9 million related to Meridian's merger with Commonwealth less securities gains of $8.3 million at Commonwealth, resulting in a reduction in pre-tax income of $3.6 million ($3.1 million after-tax). - An increase in other securities gains of $14.2 million ($9.2 million after-tax), and - Tax benefits of $7.2 million representing the cumulative effect on prior years of a change in the method of accounting for income taxes. Net interest income was $617.3 million in 1993 compared to $573.2 million in 1992, an increase of 8%. Widening spreads during the past twelve months between the yield on interest- earning assets and the cost of interest-bearing liabilities and a higher level of interest-earning assets resulted in a net interest margin on a taxable-equivalent basis of 4.96% in 1993 compared to 4.77% in 1992, an increase of 19 basis points. Meridian's provision for possible loan losses was $56.1 million in 1993, down from $68.8 million in 1992. The decline over the past year was due to continuing improvement in loan quality. Non-performing loans decreased for the eighth consecutive quarter to $127.6 million at December 31, 1993, or 1.42% of loans, from $143.6 million or 1.68% at the end of last year. The ratio of the allowance for possible loan losses to non-performing loans was 136% at December 31, 1993 compared to 115% a year ago. Net loans charged-off in 1993 were $51.3 million, or .59% of average loans, down from $84.6 million, or 1.00% of average loans, in 1992. The allowance for possible loan losses was 1.93% of total loans at December 31, 1993 compared to 1.94% a year ago. Total non-performing assets also declined for the eighth consecutive quarter to $178.8 million at December 31, 1993, or 1.98% of loans and assets acquired in foreclosures, compared to $214.2 million or 2.48% at year-end 1992. The loss in the mortgage banking subsidiary of $33.7 million ($.58 per fully diluted share) compared to a loss of $9.0 million in 1992 resulted primarily from several factors. A restructuring charge of $17.5 million in the third quarter of 1993 resulted from Meridian's decision to refocus its mortgage activities on the origination of residential mortgage loans and to substantially reduce the scope of its mortgage servicing business. Amortization of purchased mortgage servicing rights and other servicing-related assets increased by $11.6 million during 1993. The provision for possible credit losses on mortgage servicing portfolios purchased with recourse increased by $5.0 million compared to last year. Each of these changes is more fully explained in the "Mortgage Banking" portion of the "Primary Business Activities" section. Net income for the year also was impacted by expenses related to Meridian's merger with Commonwealth of $11.9 million less securities gains of $8.3 million at Commonwealth, resulting in a reduction in pre-tax income of $3.6 million ($3.1 million after-tax or $.05 per fully diluted share). Expenses include transaction costs, equipment and related asset write-offs, various contract terminations and severance. Commonwealth's balance sheet was restructured in accordance with Meridian's asset and liability strategy and a reserve was established for anticipated prepayment penalties on certain long-term borrowings. Securities gains resulted from the sale of mortgage-backed investments susceptible to prepayment risk in the current low interest rate environment. Other income was $285.3 million in 1993 compared to $242.9 million in 1992. Revenues in Meridian's broker-dealer and investment banking unit increased by $15.2 million or 28% between the two years. Service charges on deposits and fees for other customer services increased by $7.5 million, or 8%, over last year. Net securities gains, which include gains of $8.3 million related to Commonwealth, increased by $22.5 million between the two years, as more fully explained later. Other expenses were $636.9 million in 1993 compared to $561.9 million in 1992, an increase of 13%. Factors contributing to the increase include the mortgage banking restructuring charge and the increase in the provision for possible mortgage servicing-related credit losses which aggregated $22.5 million, one-time expenses of $11.9 million related to the Commonwealth merger, the continuing expansion of Meridian's broker-dealer and investment banking area, and increases in operating expenses in the banking unit partially as a result of several acquisitions during the year. Total assets at December 31, 1993 were $14.1 billion compared to $14.3 billion at the end of 1992. Total loans were $9.0 billion compared to $8.6 billion a year ago, a 5% increase. The consumer portfolio increased by 13% between the two years and the commercial portfolio grew by 4%. This growth was partially offset by a decline in residential mortgage loans. Total deposits were $11.3 billion at December 31, 1993 compared to $11.8 billion a year ago, a 4% decrease. Meridian continues to fund a significant portion of its assets with deposits acquired in its local marketplace. Shareholders' equity increased to $1.2 billion or 8.42% of total assets at December 31, 1993 compared to $1.1 billion or 7.41% a year ago. The ratio of tangible shareholders' equity to assets, which excludes $96.8 million of intangible assets, was 7.78% at December 31, 1993 compared to 6.44% at December 31, 1992. Meridian's risk-based capital ratio was 13.67% of total risk weighted assets at December 31, 1993, well above regulatory requirements. The ratio was 11.61% at December 31, 1992. Book value per common share was $20.39 at December 31, 1993 compared to $18.75 at December 31, 1992, an increase of 9%. PRIMARY BUSINESS ACTIVITIES Table 1 presents a summary of the operating results of Meridian's primary business activities. Capital is allocated primarily using regulatory risk-based capital guidelines. Staff support and product processing costs are allocated to the business units based on actual usage, with general costs supporting the entire corporation being retained by the parent company. Non-bank business units are allocated balance credits for deposit balances provided to the banking units. Banking. The banking unit provides a full range of retail and corporate banking services to customers in central and eastern Pennsylvania, as well as Delaware and southern New Jersey. Net income of the banking unit was $192.4 million in 1993 compared to $143.7 million in 1992, an increase of 34%. An increase in net interest income, higher levels of securities gains and a decrease in the provision for possible loan losses more than offset an increase of 5% in operating expenses. Net interest income on a taxable-equivalent basis increased 7% from $570.1 million in 1992 to $611.7 million in 1993. Widening spreads between the yields on interest-earning assets and the cost of interest-bearing liabilities and an increase in interest-earning assets produced a net interest margin on a taxable-equivalent basis of 4.77% in 1993 compared to 4.57% in 1992. Loans outstanding at December 31, 1993 were $9.4 billion compared to $9.2 billion at the end of 1992. Increases in the commercial and consumer loan portfolios more than offset a decrease in residential mortgage loans. Total deposits at December 31, 1993 were $11.3 billion compared to $11.7 billion a year ago, a 3% decrease. Changes in these categories are more fully explained in the "Loans" and "Deposits" sections. During 1993, Meridian completed the following four bank acquisitions: Mortgage Banking. Meridian Mortgage Corporation originates financing for residential and multifamily properties, provides servicing for residential, commercial and multifamily mortgages, and purchases and sells servicing. New loan originations from both wholesale and retail operations aggregated $2.7 billion in 1993 compared to $2.9 billion in 1992. The mortgage banking unit incurred a loss of $33.7 million in 1993 compared to a loss of $9.0 million in 1992. The increase in the loss from last year resulted primarily from: - A restructuring charge of $17.5 million, reflecting write-downs of $9.6 million to estimated fair value of mortgage servicing intangibles and other related assets and the establishment of reserves of $7.9 million associated with substantially reducing the scope of Meridian's mortgage servicing-related activities. Such reserves were established primarily for anticipated cash outflows related to various contract terminations, severance, and legal and other sale-related costs. As previously mentioned, Meridian decided in the third quarter of 1993 to refocus its mortgage activities on the origination of residential mortgage loans. Assets related to the sale of mortgage servicing aggregated $36.0 million at the end of 1993, almost unchanged from when the decision to sell such servicing was announced. It is currently expected that the sale will be completed in the first half of 1994. - An increase in amortization of $11.6 million for purchased mortgage servicing rights and other servicing-related assets. - An increase of $5.0 million in the provision for possible credit losses on mortgage servicing portfolios purchased with recourse. The impact of these changes was partially lessened by higher gains on sales of loans and mortgage servicing, which were $19.3 million in 1993, an increase of $3.7 million from a year ago. Balance credits received by the mortgage banking unit were $6.0 million in 1993 compared to $7.4 million in 1992. The increase in amortization for purchased mortgage servicing rights and other servicing-related assets resulted primarily from a significant increase in prepayments of mortgage loans that were being serviced, which reduced the value of these assets. The increase in prepayments resulted from the low level of long-term interest rates which has existed over the past year. The increase in the provision for possible credit losses on mortgage servicing portfolios purchased with recourse resulted primarily from the continuing delinquencies in such portfolios and the financial difficulties, including bankruptcies, of the banks and thrifts in New England from which this servicing was purchased. Recourse servicing losses result principally from the inability of sellers to fulfill their obligations with respect to this servicing, repurchases of loans, indemnification and loss sharing payments, servicing advances, and costs of collection which are not reimbursed by third parties. Meridian is not currently experiencing any material credit losses on the remainder of the purchased recourse portfolios or from originated recourse servicing. At December 31, 1993, aggregate reserves with respect to recourse servicing (both purchased and originated) were $13.3 million compared to $7.0 million a year ago. The mortgage portfolio serviced by Meridian Mortgage Corporation was $7.0 billion at December 31, 1993 compared to $9.7 billion at the end of 1992. The decline was caused primarily by mortgage loan refinancing activity and sales of mortgage servicing during 1993. Asset Management. Meridian Asset Management combines traditional bank trust services with investment and money management products and services for individuals, corporations and institutions. Net income from the asset management subsidiary was $2.4 million in 1993 compared to $3.8 million in 1992. Revenues increased by 7% between the two years. Contributing to the higher level of revenues were increases in personal trust fees and employee benefit and investment advisory fees. The increase in revenues was more than offset by an increase in operating expenses, such as personnel expense and professional fees, including payments to outside consultants for enhancements to operating systems. Balance credits received by the asset management unit were $1.3 million in 1993 compared to $1.5 million in 1992. The market value of customers' assets administered by Meridian increased by 21% during the year from $22.7 billion at year-end 1992 to $27.5 billion at December 31, 1993. Included in these totals are assets for which Meridian has investment management responsibility of $6.1 billion at the end of 1993, an increase of 11% from last year. Asset growth in corporate trust, institutional accounts, and corporate services within the Delaware marketplace accounted for most of the increase in total assets in 1993. Securities. Meridian Securities underwrites, brokers and distributes securities and loan servicing to institutional and individual investors. In addition, the company buys, sells and securitizes loans. The company also provides investment banking services by acting as financial advisors in facilitating municipal and corporate transactions in the capital market. The securities unit experienced continued growth in 1993 with net income totaling $18.7 million compared to $15.6 million in 1992, an increase of 20%. Revenues increased by 27% in 1993, reflecting the continued expansion of the customer base and an increase in trading volume. The low interest rate environment prompted an increase in activity in mortgage related products, resulting in higher trading gains and commission income on the sale of securities and mortgage loans. Net interest income also increased between the two years, primarily because of higher levels of loans and investments related to the expanded activity of the securities unit. Operating expenses increased by 36% in 1993, mostly as a result of growth and expansion throughout the unit and increases in volume sensitive expenses such as commissions and other incentive-related compensation, and brokerage and clearance fees. Parent Company and Other Units. Staff support expense and other corporate expenses not allocated by the parent company to the business units, net of taxes, were $22.1 million in 1993 compared to $17.4 million in 1992. Merger expenses related to Commonwealth and other acquisitions in 1993 of $11.5 million (after-tax $8.3 million) were the primary reason for the increase between the two years. NET INTEREST INCOME AND RELATED ASSETS AND LIABILITIES Net interest income is the single largest component of Meridian's operating income. Net interest income increased 8% to $617.3 million in 1993 from $573.2 million in 1992. For the same period, taxable- equivalent net interest income also increased 8% to $639.3 million from $594.0 million in 1992. The level of net interest income results from the interaction among the volume and mix of interest-earning assets, the funding sources supporting these assets, and the interest rates earned on assets relative to those paid on the funding sources. The growth in net interest income in 1993 is attributable to a 3% increase in average interest-earning assets and to a 19 basis point improvement in the net interest margin from 4.77% in 1992 to 4.96% in 1993. Average interest-earning assets increased to $12.9 billion in 1993 from $12.5 billion in 1992. The mix of earning assets remained almost unchanged. Loans accounted for 67% and 68% of average interest-earning assets in 1993 and 1992, respectively, while short and long-term investments accounted for 28% in each period. Loans accounted for approximately one-half of earning asset growth, increasing 3% to $8.7 billion from $8.4 billion in 1992. Average commercial loans increased by 1% in 1993. The lack of commercial loan growth is reflective of the continued weak loan demand within Meridian's marketplace throughout 1993. Average residential mortgage loans declined 14%, the result of accelerated prepayments of mortgages in the low interest rate environment that prevailed in 1993. Consumer loan growth was strong, with average outstandings increasing 16%. Most of this growth occurred in the home equity and indirect automobile loan categories, due to the low interest rate environment and enhanced marketing efforts. Meridian's securities portfolios accounted for the remainder of overall earning asset growth. Average securities and short- term investments increased 4% to $3.6 billion in 1993 from $3.4 billion in 1992. This growth resulted primarily from the investment of proceeds received from banking acquisitions and from Meridian Bank's issuance, in March 1993, of $150 million of 6 5/8% subordinated notes due in 2003. Deposit balances remained almost unchanged in 1993 compared to 1992, averaging $11.3 billion in both years. Meridian continued to experience a substantial shift in the mix of its deposit base, as customers elected to transfer proceeds from maturing time deposits into more liquid savings and interest- bearing transaction accounts. The combined average balances of savings, money market deposit and interest-bearing transaction accounts increased by $534 million in 1993, while short and long- term time deposits decreased by $548 million. Continued increases in demand deposit balances were offset by comparable declines in large dollar certificates of deposit. These deposit mix shifts can be attributed to the low interest rate environment. Average short-term borrowings increased to $1.0 billion in 1993 from $853 million in 1992. Much of this increase was temporary and short-term borrowings declined to approximately $800 million by year-end 1993. Average balances of long-term debt increased from $241 million in 1992 to $439 million in 1993. Increases in this category primarily reflect proceeds from Meridian Bank's issuance of subordinated debt during 1993. The net interest margin is affected by both the net interest spread and the level of non-interest bearing sources of funds. The net interest spread increased by 27 basis points between the two years. This increase can be attributed to the substantial shift in Meridian's funding mix from higher costing time deposits into lower costing savings and interest-bearing transaction accounts, the wide spread earned on national commercial rate-based loans relative to their short-term funding costs, and the favorable yield curve that prevailed throughout the year. Average yields on loans declined by 62 basis points between 1992 and 1993, while rates paid on interest-bearing liabilities declined by 96 basis points. The amount of interest income not recognized on non- performing loans was reduced from $13.1 million in 1992 to $9.5 million in 1993. The negative impact on the net interest spread of carrying non-performing loans was 7 basis points in 1993 and 11 basis points in 1992. Interest free funding sources increased 14% to $1.8 billion in 1993. However, the beneficial effect of growth in interest- free funding on overall funding costs was not sufficient to offset the reduced value of these funds in the low interest rate environment. The overall effect of these changes in non-interest bearing funds reduced the net interest margin by 8 basis points in 1993 compared to 1992. Meridian's profitability has benefitted from the favorable interest rate environment that existed during the past several years. The spread between the national commercial rate, which affects variable-rate loan products, and the federal funds rate, which affects the cost of deposits and borrowings, continues to be wider than in prior periods. Management cannot predict whether market conditions will continue to provide similar opportunities, and currently anticipates future contraction in the net interest margin. However, management believes that the negative impact of declining spreads should be mitigated by anticipated improvement in economic activity and the resultant anticipated increase in loan demand. Interest Rate Risk Management. The absolute level and volatility of interest rates can have a significant impact on Meridian's profitability. The objective of interest rate risk management is to identify and manage the sensitivity of net interest income to changing interest rates and other financial market factors, in order to achieve overall financial goals. Based on economic conditions, on and off-balance sheet positions, asset quality and various other considerations, management establishes tolerance ranges for interest rate sensitivity and manages within these ranges. Meridian generates a mix of loans and deposits that tends to create an asset sensitive interest rate risk profile primarily because Meridian's retail core deposit base does not reprice as quickly as the loan portfolios. An asset sensitive profile indicates that net interest income would be positively impacted in periods of rising interest rates and negatively impacted in periods of declining interest rates. Meridian manages this tendency towards asset sensitivity by adjusting the mix and repricing characteristics of assets and liabilities on the balance sheet through its securities and purchased funding portfolios and by the use of off-balance sheet derivative products, mainly interest rate swaps. The notional amount of interest rate swap contracts, which include forward interest rate swaps of $150 million, was $2.3 billion at December 31, 1993 compared to $2.2 billion a year ago. Meridian uses interest rate swaps as a tool to alter the repricing characteristics of a portion of the core deposit base. Interest expense on deposits was reduced by approximately $43 million in 1993 and $45 million in 1992 as a result of interest rate swaps. The majority of the interest rate swap contracts outstanding at December 31, 1993, or approximately $2.1 billion, represents contracts on which Meridian receives a fixed rate of interest and pays a variable rate, thereby favorably impacting net interest income in periods of declining interest rates. The average fixed rate received at the end of 1993 was 4.95% with a remaining term of approximately 1.6 years. Forward interest rate swaps of $150 million, with a fixed rate of 4.84% and a term of approximately 1.7 years, were entered into in late 1993 to replace maturities of swaps in 1994. The average floating rate paid on interest rate swaps is based on short-term variable rates such as LIBOR (London Interbank Offered Rate). The average floating rate paid was 3.39% at December 31, 1993. The favorable impact of Meridian's interest rate swaps on net interest income will decrease in a rising interest rate environment. This change should be mitigated by the anticipated growth in net interest income mainly because of the anticipated expansion of Meridian's banking business. During 1993, new swap contracts entered into aggregated $1.6 billion and maturities and terminations of contracts aggregated $1.5 billion. Deferred gains resulting from the termination of swap contracts were $2.0 million at the end of 1993 and will be accreted into income over approximately the next two years. Interest rate swaps involve credit risk as a result of Meridian's reliance on counterparties to make payments over the life of the contracts. The credit risk is limited to the estimated aggregate replacement cost of those agreements in a gain position (favorably impacting net interest income) and amounted to approximately $5 million at December 31, 1993. Meridian has credit policies and procedures addressing counterparty exposures and operates within established credit limits. Meridian uses income simulation modeling as the primary tool in measuring interest rate risk. Simulation modeling considers not only the impact of changing interest rates on future net interest income, but also other potential causes of variability such as earning-asset volume and mix, yield curve relationships, loan spreads, customer preferences and general market conditions. A managerial gap analysis is used to supplement simulation modeling. The traditional gap analysis considers the contractual maturity and repricing characteristics of all assets, liabilities and off-balance sheet positions and identifies mismatches between these positions at various time intervals. This traditional analysis indicates a large liability sensitive position through the one-year time period beginning December 31, 1993. However, it does not accurately reflect Meridian's interest rate sensitivity, as previously discussed. Meridian's net interest income has not been subject to the degree of sensitivity indicated by this traditional gap analysis because the analysis does not reflect the fact that the rates on Meridian's core deposits do not reprice as quickly as market rates. Consequently, adjustments are made to this analysis to reflect management's experience and assumptions regarding the impact of product pricing, interest rate spread relationships and customer behavior. These managerial adjustments are necessarily subjective and will vary over time with loan and deposit changes, customer preferences and market conditions. However, management believes the managerial adjusted gap analysis provides a more realistic picture of the interest rate risk characteristics of Meridian's balance sheet. The managerial adjusted gap position at December 31, 1993, as provided in Table 4, indicates a moderate liability sensitive position through the one-year time period. Liquidity. The objective of liquidity management is to ensure that sufficient funding is available, at reasonable cost, to meet the ongoing and potential cash needs of Meridian and to take advantage of income producing opportunities as they arise. While the desired level of liquidity may vary depending upon a variety of factors, it is a primary goal of Meridian to maintain a high level of liquidity in all economic environments. Management considers Meridian's liquidity position at the end of 1993 to be sufficient to meet its foreseeable cash flow requirements. Liquidity management is influenced by several key elements, including Meridian's reputation, asset quality, the maturity structure of its assets and liabilities, cash flow generated by assets, and Meridian's ability to access funds in the capital markets. The single most important source of liquidity for Meridian is its core deposit base, which consists of deposits from customers with long-standing relationships. Meridian continues to promote the acquisition of core deposits through the capabilities of its retail distribution systems and through selective banking acquisitions. Long-term debt and shareholders' equity also contribute to liquidity by reducing the need for short-term funding. In 1993, Meridian funded approximately 80% of total assets with deposits acquired within its local marketplace and approximately 90% of total assets with core deposits, long-term debt and shareholders' equity. Meridian places strong emphasis on the maintenance of an appropriate level of asset liquidity. Liquid assets include short-term money market investments, securities available for sale, and interest-bearing deposits with other banks. Cash flow from mortgage and asset-backed securities also provide a significant source of liquidity. Meridian is committed to maintaining additional funding flexibility through access to the debt and capital markets. Meridian Bank, Meridian's principal banking subsidiary, has access to a variety of money market sources of funds, such as Federal funds purchased and securities sold under agreements to repurchase, as well as to term funding through the potential issuance of bank notes, bank deposit notes and subordinated debt. Additionally, Meridian has the capacity to issue securities under its shelf registration filed with the Securities and Exchange Commission. In January, 1993, Meridian increased the availability under its shelf registration by $150 million. As of December 31, 1993, Meridian had debt and preferred equity securities registered but unissued under this registration totalling $250 million. The cost and availability of external funding is influenced by Meridian's credit ratings. The following is a summary of Meridian's and Meridian Bank's ratings at December 31, 1993, as issued by various credit rating agencies: Reference should also be made to the Statements of Cash Flows appearing in the Consolidated Financial Statements for additional information on liquidity. The statement of cash flows for 1993 reflects $376.2 million of cash provided by operations, $50.5 million used by investing activities and $459.4 million used by funding activities. Operating activities include $157.8 million in net income for 1993. Investing activities are primarily comprised of both proceeds from and purchases of short- term investments, investment securities, investment securities available for sale and loans. Financing activities present the net change in Meridian's various deposit accounts and short-term borrowings, and also include $197.6 million in net proceeds from the issuance of long-term debt in 1993. Cash flows from operations and the issuance of long-term debt were used to fund the decreases in deposits and short-term borrowings during 1993. Loans. The lending function is Meridian's principal business activity and it is Meridian's continuing policy to serve the credit needs of its customer base. The economy in Meridian's primary marketplace is broad-based and diverse and the loan portfolio reflects that diversity. Lending to individual consumers in this marketplace accounts for approximately one- third of total loans. The remainder of the portfolio consists predominantly of commercial loans and commercial real estate loans in Meridian's primary marketplace. Loans were $9.0 billion at December 31, 1993 compared to $8.6 billion at December 31, 1992, an increase of 5%. Increases in the commercial and consumer loan portfolios more than offset a decrease in residential mortgage loans. Commercial loans amounted to $5.4 billion at December 31, 1993 compared to $5.2 billion at December 31, 1992, a 4% increase. Meridian's commercial loan portfolio is oriented toward diversified, small and medium-sized businesses within Meridian's market area, with limits on the size of loans to any single borrower according to credit risk. These loans are predominantly in the services, real estate, and manufacturing industries. Credit risk associated with these borrowers is principally influenced by general economic conditions and the resulting impact on the borrower's operations. Geographical coverage of Meridian's commercial lending activity extends across central and eastern Pennsylvania, southern New Jersey and Delaware. Real estate-related commercial loans, including real estate construction and commercial mortgages, totalled $1.9 billion and represented 21% of total loans at December 31, 1993 compared to $1.9 billion and 22% at December 31, 1992. Construction loans decreased by $24.4 million or 9% from year-end 1992 and partially offset a slight increase in commercial mortgages. The construction and commercial mortgage real estate portfolios are located primarily in markets in which Meridian has a local banking presence. Collateral types are diverse and include the real estate of borrowers who utilize the property in their businesses as well as real estate investors. At December 31, 1993, real estate investor outstandings comprised 12% of total loan outstandings compared to 13% at December 31, 1992. Construction loans comprised 3% of total loan outstandings at December 31, 1993, unchanged from the end of 1992. Commercial, financial and agricultural loans totalled $3.6 billion and represented 40% of total loans at December 31, 1993 compared to $3.4 billion and 40% at the end of 1992. Consumer lending includes primarily loans to individuals in communities served by Meridian. These loans include open-ended credit arrangements, such as home equity loans, and closed-end loans subject to specific contractual payment schedules, such as installment loans and residential mortgages. Residential mortgage loans decreased from $1,057.6 million at December 31, 1992 to $993.5 million at December 31, 1993. This change resulted primarily from mortgage refinancing activity in the low interest rate environment during the past year. Management remains committed to serving the residential mortgage market through both the retail branches of Meridian's commercial banks and its mortgage banking subsidiary. Consumer loans, which consist of loans made to individuals on an installment or revolving credit basis, totalled $2.5 billion at December 31, 1993 compared to $2.2 billion at December 31, 1992, an increase of 13%. The increase in consumer loans during 1993, mostly home equity loans and other types of personal loans, resulted primarily from enhanced marketing efforts in the relatively low interest rate environment during the year. Investment Securities and Investment Securities Available for Sale. The classification of securities is determined at the time of purchase. Securities are classified as investments and carried at amortized cost if management has the intent and ability to hold the securities until maturity. The carrying value of the investment portfolio at December 31, 1993 was $2.8 billion and net unrealized gains totalled $28.6 million. Such gains include gross unrealized gains of $35.7 million and gross unrealized losses of $7.1 million. At the end of 1992, the carrying value of the investment portfolio was $2.5 billion and net unrealized gains totalled $44.6 million. The average maturity of the investment portfolio at December 31, 1993 was 2.8 years compared to 2.5 years at December 31, 1992. Securities expected to be held for an indefinite period of time are classified as investment securities available for sale and are carried at the lower of aggregate amortized cost or fair value. Decisions to purchase or sell these securities are based on an assessment of economic and financial conditions, including changes in interest rates and prepayment risks, liquidity and capital needs, alternative asset and liability management strategies, regulatory requirements and tax considerations. The carrying value of this portfolio at December 31, 1993 was $275.7 million, with net unrealized gains of $12.5 million. Such gains include gross unrealized gains of $12.7 million and gross unrealized losses of $203 thousand. The carrying value of this portfolio and net unrealized gains at year-end 1992 were $945.2 million and $28.2 million, respectively. The average maturity of the investment securities available for sale portfolio, which includes tax-exempt obligations of states and municipalities, was 5.5 years at December 31, 1993 compared to 5.9 years at December 31, 1992. The significant decline in investment securities available for sale is attributable to a restructuring of Commonwealth's balance sheet in accordance with Meridian's asset and liability strategy. Securities gains of $8.3 million resulted from the sale of mortgage-backed investments susceptible to prepayment risk in the current low interest rate environment. Additionally, in the first quarter of 1993, Meridian sold $217 million of U.S. Treasury and federal agency securities with maturities of less than one year, recognizing gains of $5.5 million. Meridian's securities portfolios (investment securities and investment securities available for sale) are comprised of U.S. Treasury and federal agency securities, mortgage-backed securities, tax-exempt obligations of states and municipalities, corporate securities, including privately issued asset-backed securities, and equity securities. U.S. Treasury and federal agency securities (other than mortgage-backed securities) totalled $733 million at year-end 1993 and accounted for approximately 24% of total securities holdings. Mortgage-backed securities remain the largest component of Meridian's securities portfolios, accounting for approximately 55% of the total at year-end 1993. This portfolio is comprised of federal agency mortgage-backed securities and other collateralized mortgage obligations which are backed by federal agency collateral or are AAA rated private issues. Because of the intent to hold a majority of these securities to maturity, management evaluates and closely monitors cash flow projections for all mortgage-backed securities. Investment strategy over the past several years has focused primarily on the purchase of mortgage-backed securities which have generally predictable cash flows. The expected average life of mortgage-backed securities at December 31, 1993, based on projected prepayment rates, was 2.2 years compared to 2.5 years at year-end 1992. Meridian's current credit guidelines call for purchases of securities issued by either the U.S. Treasury or federal agencies, or by states and municipalities or corporate entities that are rated A or higher by Moody's Investor Services, Inc. or Standard and Poor's Corporation. At December 31, 1993, the carrying value of state and municipal securities was $410 million, 90% of which was rated A or higher by the rating agencies. Securities rated Baa and below totalled $1.6 million and $40.9 million were non-rated. In the first quarter of 1994, $30.5 million of the non-rated securities were called, reducing the balance to $10.4 million. Generally, non-rated securities are collateralized by letters of credit or are securities in which the principal and interest is supported by government obligations set aside in escrow accounts. At December 31, 1993, the carrying value of corporate securities, excluding AAA rated private mortgage-backed and asset-backed securities, was $11.5 million. Corporate securities rated Baa and below totalled $5.2 million and $3.8 million of such securities were non-rated. Tax-exempt obligations of state and municipalities comprised 13% of the securities portfolios at year-end 1993 compared to 15% at year-end 1992. The decline is attributable to maturities and calls of higher-yielding securities in the low interest-rate environment. Management continues to purchase qualified tax- exempt securities. Effective in the first quarter 1994, Meridian will adopt Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" which requires investments in equity securities with a readily determinable fair value and investments in all debt securities to be classified in one of three categories. The three categories are (1) held to maturity -- carried at amortized cost; (2) available for sale -- carried at fair value (with unrealized gains and losses, net of related tax effect, recorded as a separate component of shareholders' equity); and (3) trading account - carried at fair value (with unrealized gains and losses recorded in the income statement). The impact of this accounting change, had Meridian elected to adopt this statement at December 31, 1993, would have been to increase shareholders' equity by approximately $8.1 million or less than 1%, representing the after-tax unrealized gain in the available for sale portfolio. Deposits. Total deposits were $11.3 billion at December 31, 1993 compared to $11.8 billion at year-end 1992, a decrease of 4%. Approximately 60% of the decline occurred in time deposit categories and resulted from anticipated runoff of deposits from recent acquisitions. The lower interest rates on deposits also resulted in depositors seeking alternative investment opportunities. The remaining 40% of the decline is attributable to a planned reduction in certificates of deposit of $100,000 and more. Short-Term Borrowings. At December 31, 1993, short-term borrowings, comprised of Federal funds purchased, securities sold under agreements to repurchase, and Federal Home Loan Bank and other borrowings totalled $791.7 million compared to $877.1 million a year earlier, a 10% decrease. Long-Term Debt and Other Borrowings. This category amounted to $421.3 million at December 31, 1993 compared to $313.8 million at December 31, 1992, an increase of 34%. Subordinated debt of $321.6 million is included in this category, along with capitalized lease obligations, longer-term borrowings from the Federal Home Loan Bank, and various other loans and mortgages payable. The increase is attributable to Meridian Bank's issuance, in March 1993, of $150 million of 6 5/8% subordinated notes due in 2003. Proceeds were used by Meridian Bank to retire $60 million of subordinated notes issued to Meridian and $7 million of outstanding subordinated notes issued to the public. The remaining net proceeds were used for general corporate purposes. Reference should be made to Note 6 of the Notes to Consolidated Financial Statements for an additional analysis of short-term borrowings and long-term debt. PROVISION FOR POSSIBLE LOAN LOSSES AND RELATED CREDIT QUALITY Meridian manages asset quality and controls credit risk through diversification of the loan portfolio and the application of policies designed to foster sound underwriting and loan monitoring practices. Meridian's loan administration function is charged with monitoring asset quality, establishing credit policies and procedures, and enforcing the consistent application of these policies and procedures across Meridian. Commercial loans are assigned risk ratings by loan officers. The appropriateness of these ratings, in addition to the overall lending process, is reviewed by credit policy personnel. A quarterly review and reporting process is in place for monitoring those loans that have been identified as problems or potential problems. A separate loan workout department is involved with the collection of problem loans. Because of their relatively homogeneous nature and small dollar size, consumer and residential mortgage loans are generally reviewed in the aggregate. When establishing the appropriate levels for the provision and the allowance for possible loan losses, management performs an analysis of the loan portfolio by considering a variety of factors. This analysis includes periodic reviews by loan review and loan workout personnel of all borrowers with aggregate balances of $250,000 or greater. Meridian also reviews, at least on a quarterly basis, problem borrowers with balances of $500,000 or greater, as well as selected lower balance loans. Consideration is given to the impact of current and anticipated economic conditions, the diversification of the loan portfolio, historical loss experience, delinquency statistics, reviews performed by loan officers who are primarily responsible for compliance with established lending policy, the perceived financial strength of borrowers, and the perceived adequacy of underlying collateral. Consideration is also given to examinations performed by regulatory authorities. Lending procedures and the loan portfolio are examined periodically by several banking regulatory agencies as part of their supervisory activities. For Meridian, the most comprehensive of these examinations is performed by the Federal Reserve Bank. To assist in determining the adequacy of the provision and the allowance, management first sets the allocated portion of the allowance for possible loan losses. For commercial loans, allocations of the allowance to individual loans are based on borrower specific data determined by reviewing individual non- performing, delinquent, problem, and other loans and by considering those items described in the preceding paragraph. In addition, general allocations of the allowance are made to the commercial loan category. General allocations to commercial loans also consider the impact of current and anticipated economic conditions on both individual borrowers and the commercial loan portfolio taken as a whole. Consumer and residential mortgage loan allocations are determined in the aggregate and are based on recent chargeoff history and delinquency trends, anticipated losses over the foreseeable future, and the impact of current and anticipated economic conditions in the local, regional and national economies. The unallocated portion of the allowance is that amount, which when added to the allocated allowance, brings the total allowance to the amount deemed adequate by management at the time. Management considers the unallocated portion of the allowance, which is determined by reviewing those items described in the preceding paragraph, as a subset of the entire allowance and, consequently, available to absorb losses anywhere within the loan portfolio. The loan portfolio represents loans made primarily in Meridian's market area in eastern and central Pennsylvania and in Delaware and southern New Jersey. Management continues to monitor the economic conditions in this market area. The ultimate collectibility of a substantial portion of Meridian's loans, especially its real estate loans, and the market value of other real estate owned, is susceptible to changes in economic conditions in this primary market area, as was especially evident over the past several years. Determining the level of the allowance for possible loan losses at any given date is difficult, particularly in a continually changing economy. Management must make estimates, using assumptions and information which are often subjective and changing. Management continues to review Meridian's loan portfolio in light of a changing economy and possible future changes in the banking and regulatory environment. Although the economy continues to improve slowly, the balance in the allowance at December 31, 1993 reflects Meridian's continuing concerns about the strength and the duration of the current economic recovery, especially in the commercial and construction real estate sectors of the economy, in the geographic markets served by Meridian. In management's opinion, the allowance for possible loan losses is adequate at December 31, 1993. The balance in the allowance for possible loan losses was $173.4 million or 1.93% of total loans at the end of 1993 compared to $165.5 million or 1.94% of total loans at the end of 1992. Although there was an overall improvement in loan quality in 1993, as evidenced by a decline in non-performing loans, the relatively high level in the allowance reflects management's continuing concerns about the strength and the duration of the current economic recovery. The provision for possible loan losses represents charges made to earnings to maintain an adequate allowance for possible loan losses. The provision for possible loan losses was $56.1 million in 1993 compared to $68.8 million in 1992. The decline of $12.7 million resulted primarily from the continuing improvement in loan quality. The overall improvement in asset quality was also evident in a decrease of $12.4 million in writedowns and other expenses associated with foreclosed real estate, from $23.3 million in 1992 to $10.9 million in 1993. Net charge-offs were $51.3 million or .59% of average loans in 1993 compared to $84.6 million or 1.00% of average loans in 1992. Recoveries were $11.2 million in 1993 compared to $10.6 million in 1992. The impact of the recent recession has made it increasingly more difficult to realize significant recoveries of previously charged-off loans, especially in the real estate area. Table 13 presents a summary of various indicators of credit quality. At December 31, 1993, non-performing assets as a percentage of period-end loans and assets acquired in foreclosures were 1.98% compared to 2.48% at the end of last year. Non-performing assets were $178.8 million at December 31, 1993 and decreased by $35.4 million during the past year from $214.2 million a year ago. This decrease resulted from an overall improvement in asset quality during the year and an increase in payments received, combined with continuing high levels of loan chargeoffs and writedowns of other real estate. Real estate-related non-performing assets were 65% of total non- performing assets at December 31, 1993. Non-performing loans were 1.42% of total loans at December 31, 1993 compared to 1.68% at the end of last year. Non- performing loans amounted to $127.6 million at December 31, 1993 and decreased by $16.0 million during the past year from $143.6 million a year ago. Non-performing assets and loans past due 90 or more days as to interest or principal at December 31, 1993 were $203.6 million or 2.25% of loans and assets acquired in foreclosures compared to $255.3 million or 2.96% one year ago, a decrease of $51.7 million. The ratio of the allowance for possible loan losses to non- performing loans was 136% at December 31, 1993 compared to 115% at year -end 1992. The coverage of non-performing assets was 97% at year-end 1993 compared to 77% at December 31, 1992. It should be noted that any possible future losses on foreclosed real estate and in-substance foreclosures which are included in non- performing assets are charged directly to earnings and not to the allowance for possible loan losses. Foreclosed real estate is carried at the lower of cost or fair value, less estimated costs of disposal. Non-performing assets are comprised of non-accrual loans, loans categorized as troubled debt restructurings, and assets acquired in foreclosures which includes in-substance foreclosures. Non-performing assets do not include loans past due 90 days or more as to interest or principal which are well secured and in the process of collection, the majority of which represent residential mortgage loans. Generally, a commercial loan is classified as non-accrual when it is determined that the collection of interest or principal is doubtful, or when a default of interest or principal has existed for 90 days or more, unless such loan is well secured and in the process of collection. When the accrual of interest is discontinued, unpaid interest is reversed through a charge to interest income. The majority of non-accrual loans are secured by various forms of collateral, the ultimate recoverability of which is, however, subject to economic conditions and other factors. Residential mortgages which are 180 days or more delinquent are placed on nonaccrual status when total principal, interest, and escrow owed exceeds 80% of the property's appraised value. Properties are re-appraised when foreclosure proceedings are initiated. Non-accrual loans totalled $124.3 million at December 31, 1993 compared to $142.7 million one year ago, a decrease of $18.4 million or 13%. The carrying value of non-accrual commercial loans at December 31, 1993 has already been reduced by charge- offs and payments to 57% of the aggregate carrying value when such loans were originally placed into a non-performing status. Payments of $19.1 million were received on these loans in 1993, almost all of which was applied as a reduction in the principal outstanding. Meridian's non-accrual loans include only six loans with balances in excess of $2.5 million (only one of which is over $5 million), indicating that a substantial portion of the risk is spread across a significant number of borrowers. These six loans aggregated $25.0 million or approximately one-fifth of total non-accrual loans at December 31, 1993. Table 15 classifies non-accrual loans according to various levels of payment performance. A loan is categorized as a troubled debt restructuring if the original interest rate on the loan, repayment terms, or both, were restructured on a below market basis due to a deterioration in the financial condition of the borrower. If restructured loans are not performing according to revised terms, such amounts are included in non-accrual loans. The level of assets acquired in foreclosures (except consumer related), including in-substance foreclosures, was $50.0 million at December 31, 1993 compared to $68.3 million a year ago. A loan is classified as an in-substance foreclosure when the borrower is perceived to have little or no equity in the project, the borrower appears to be unable or unwilling to rebuild equity or repay the loan in the foreseeable future, and the bank can reasonably anticipate proceeds for repayment only from the operation or sale of the collateral. These assets are carried at the lower of cost or fair value, less estimated selling expenses. Assets acquired in foreclosures at December 31, 1993 have already been reduced by charge-offs and payments to 43% of the aggregate carrying value when such assets were originally placed into non-performing status. Assets acquired in foreclosures include only three properties with balances in excess of $2.5 million (one of which is over $5 million) at year-end 1993, aggregating $16.1 million or approximately one-third of the total of such assets. At present, the marketability of Meridian's foreclosed real estate remains somewhat limited principally because of general illiquidity in the commercial real estate market. If real estate values decline further, additional writedowns of the current portfolio may be necessary and foreclosures may increase. Reference should be made to Table 5 for a summary of the period-end balances in the loan portfolio. There has not been a significant change in the percentage of each category to total loans from a year ago except for those changes caused by the decline in residential mortgage loans and the increase in other consumer loans, as previously discussed. In addition, reference should be made to Table 16 for a breakdown of commercial loans by major industry and to Table 17 for a breakdown of commercial real estate loans by category. As can be seen in these tables, Meridian's portfolio of commercial loans and commercial real estate loans is diversified and covers a wide range of borrowers. This diversification generally characterizes the economy of Meridian's primary market area. Of Meridian's commercial real estate loans, almost all, or 99%, are to borrowers for property in Pennsylvania, Delaware, and New Jersey, of which Pennsylvania has 81%, or the largest single share. In connection with the decision to extend credit to particular borrowers, Meridian takes into account, among other things, asset diversification and particular risks presented by the different industries in which such borrowers compete, in light of changing economic circumstances. Loan concentrations are considered to exist when a multiple number of borrowers are engaged in similar activities and have similar economic characteristics which would cause their ability to meet contractual obligations to be similarly impacted by economic or other conditions. At December 31, 1993, Meridian's commercial loans and commitments did not have any industry concentration or other known concentration that exceeded 10% of total loans and commitments. However, the effect of the recent recession has had a negative impact on the financial performance of many companies involved in retail trade. At December 31, 1993 Meridian's loans to companies in retail trade totalled $721.6 million, or 8% of total loans outstanding and 13% of total commercial loans outstanding. Included in this total were loans to department stores and other retailers of $358.9 million and loans to automobile dealers of $362.7 million. Loans to companies in retail trade included $16.9 million of loans in a non-accrual status at December 31, 1993, representing 13% and 18% of non-performing loans and non-performing commercial loans, respectively, at that date. Meridian has no foreign loan exposure. A leveraged buyout generally produces a new company with a large amount of debt relative to equity. Such debt is usually secured primarily by the assets of the acquired company. If interest rates rise or if economic conditions deteriorate, a highly leveraged company may have difficulty servicing its debt obligation. Meridian's policy has been to participate selectively in large, public, highly leveraged transactions. The majority of such transactions is currently in the telecommunications industry and its cable television and cellular phone segments. According to the guidelines issued by the Federal Reserve Board, loans and exposures are characterized as highly leveraged transactions if they meet certain defined leverage criteria and the total financing package (including all obligations held by all participants) originally exceeded $20 million. At December 31, 1993, Meridian's highly leveraged transactions aggregated $67.3 million in outstanding balances or less than 1% of total loans, and an additional $27.7 million in commitments. All such balances were current as to principal and interest at the end of 1993. Cable television and cellular phone exposures represented $49.6 million of such loans outstanding and $14.5 million of the commitments outstanding. Potential problem loans consist of loans which are included in performing loans at December 31, 1993, but for which potential credit problems of the borrowers have caused management to have concerns as to the ability of such borrowers to comply with present repayment terms. At December 31, 1993, such potential problem loans, not included in Table 13, amounted to approximately $31 million compared to approximately $34 million one year ago. No loans to companies in retail trade were included in potential problem loans at December 31, 1993. Depending on the state of the economy and the impact thereof on Meridian's borrowers, as well as other future events, these loans and others not currently so identified could be classified as non-performing assets in the future. OTHER INCOME Meridian's businesses generate various sources of other income, such as trust revenues, mortgage banking fee income and gains on sales of mortgage loans and mortgage servicing, broker- dealer and investment banking revenues, securities gains, service charges on deposit accounts, and other service charges, commissions and fees. Other income was $285.3 million in 1993 compared to $242.9 million in 1992, an increase of 17%. Trust revenues were $41.7 million in 1993 compared to $38.5 million in 1992, an increase of 8%. Contributing to the higher level of revenues were increases in personnel trust, employee benefit and investment advisory fees. Mortgage banking revenues were $36.0 million in 1993 compared to $47.7 million in 1992. Net servicing revenues decreased by $15.5 million between the two years, mainly because of an increase in amortization of $11.6 million for purchased mortgage servicing rights and other servicing-related assets. This amount is recorded as a reduction of mortgage banking revenues. Servicing revenues also decreased due to the lower level of mortgage loans being serviced because of loan payoffs in the declining interest rate environment and sales of servicing. The negative impact of the decline in net servicing revenues was partially offset by higher gains on sales of loans and mortgage servicing, which were $19.3 million in 1993, an increase of $3.7 million from a year ago. In addition to the changes in mortgage banking revenues described previously, earnings in the mortgage banking unit were affected by a $17.5 million restructuring charge, mentioned previously, which is classified as an other operating expense. Broker-dealer and investment banking revenues totalled $69.4 million in 1993 compared to $54.2 million in 1992, an increase of 28%. The increase in revenues is due to the continued growth within the securities unit. This growth is reflected in the increase in net trading gains resulting from higher levels of sales of securities and mortgage loans. Net tender option bond fees increased from the prior year, primarily due to the decline in interest rates during 1993. Commissions and fees increased from last year due to the growth in retail brokerage activity. Because of the continued high level of mortgage loan refinancing activity during the past two years, revenues were reduced by charges related to reserves against certain investments in collateralized mortgage obligation residuals. The impact of these reserves was lessened by gains from the sales of various other investments in both years. Service charges on deposits increased by 10% between the two years, from $49.0 million in 1992 to $53.8 million in 1993. Increases in certain fees for deposit products, as well as additional deposit accounts because of bank acquisitions over the past year, contributed to the higher level of service charges. Net securities gains were $25.3 million in 1993 compared to $2.8 million in 1992. The amount in 1993 included gains of $25.5 million and losses of $203 thousand. These gains are in addition to gains of $2.0 million from sales primarily of mortgage-related investments, which are included in broker-dealer and investment banking revenues. Included in the total for 1993 is a gain of $8.6 million on the sale of Meridian's common stock investment in Fidelity National Financial, Inc. This stock was acquired as part of the sale of Meridian's title insurance operations in 1992. A gain of $5.5 million was recognized from the sale of investment securities available for sale in the first quarter of 1993, mainly U.S. Treasury and federal agency securities with maturities of less than one year. Finally, a gain of $8.3 million was recognized from the sale of some of Commonwealth's mortgage-backed investments which are susceptible to prepayment risk in the current low interest rate environment. OTHER EXPENSES Other expenses were $636.9 million in 1993 compared to $561.9 million in 1992. The increase resulted primarily from the following factors: - A restructuring charge associated with reducing the scope of Meridian's mortgage servicing-related activities and an increase in the provision for possible credit losses on mortgage servicing portfolios with recourse, which aggregated $22.5 million, as previously described in the "Primary Business Activities" section. - One-time expenses of $11.9 million relating to the merger with Commonwealth, as previously described in the "Financial Highlights" section. Exclusive of these changes in 1993, other expenses would have increased by $40.6 million or 7% between the two years. Salaries, which represent the largest component of other expenses, increased by 13% during the year, from $212.4 million in 1992 to $239.4 million in 1993. An increase in staff levels, primarily in the banking unit because of acquisitions over the past year and in the broker-dealer and investment banking function because of ongoing expansion, an increase in commissions and other incentive-related compensation, and merit increases for employees contributed to the increase in salaries. Full-time equivalent employment was 6,917 at December 31, 1993 compared to 6,741 a year ago, an increase of 176 or 3%. Higher staff levels in the banking branch system accounted for one-half of this increase. Meridian currently provides postretirement health care and life insurance benefits to employees. The medical portion is contributory and life insurance coverage is non-contributory to the participants. Effective January 1, 1993, Meridian adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The new accounting rules require the accrual of the expected cost of these benefits over the period the employee earns the benefits. Meridian elected to defer and amortize over 20 years the cumulative obligation for such benefits at the beginning of 1993. The annual expense of Meridian's postretirement benefits other than pensions under these new accounting rules was $4.5 million in 1993 compared to approximately $2.0 million on the cash basis of accounting previously used, or an increase of $2.5 million. In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits". This statement, which becomes effective in 1994, establishes accounting standards for employers who provide benefits to former employees after employment but before retirement. Such benefits include, among other things, severance and workers' compensation benefits. Management is currently evaluating this statement and, based on the analysis to date, believes that its impact on Meridian's consolidated results of operations will not be material. Net occupancy expense was $42.6 million in 1993 compared to $41.3 million in 1992, an increase of 3%. Equipment expense increased from $37.1 million in 1992 to $38.0 million in 1993, an increase of 2%. The increases in both expense categories were related to expansion, banking acquisitions and the upgrading of Meridian's data processing and operations capabilities. The increase in other operating expenses from $228.0 million in 1992 to $242.6 million in 1993 resulted from several factors. Loan related expenses, primarily in Meridian's mortgage banking subsidiary, increased by $8.4 million or 26% in 1993. Included in this total was an increase of $5.0 million in the provision for possible credit losses on mortgage servicing portfolios purchased with recourse. Higher premium rates increased FDIC insurance expense by $4.0 million, or 16%, between the two years. Professional fees, mostly payments to outside consultants for enhancements to operating systems, increased by $4.0 million, or 22%. Other categories reflecting increases between the two years included advertising, accounting and legal fees, and educational development expenses. Partially offsetting these increases was a decline of $12.3 million in foreclosed real estate expenses. PROVISION FOR INCOME TAXES The provision for income taxes for 1993 was $59.1 million compared to $48.7 million for 1992. The effective tax rate, which is the ratio of income tax expense to income before income taxes, was 28% in 1993, up from 26% in 1992. The tax rate for both periods was less than the federal statutory rate of 35% in 1993 and 34% in 1992 primarily because of tax-exempt investment and loan income. Reference should be made to Note 11 of the Notes to Consolidated Financial Statements for an additional analysis of the provision for income taxes for 1993. Effective January 1, 1993, Meridian adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which requires a change from the deferred method of accounting for income taxes to the liability method. Under the liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement and tax bases of existing assets and liabilities. 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. 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 of the rate change. As permitted by SFAS No. 109, Meridian has elected not to restate the financial statements of any prior years. The implementation of these new tax accounting rules resulted in an increase in consolidated net income of $7.2 million in the first quarter of 1993. This amount represents the cumulative effect of adopting this statement at the beginning of 1993. The impact of the Statement on future periods is not expected to be material. At December 31, 1993, deferred tax assets amounted to $105.5 million and deferred tax liabilities amounted to $60.0 million. No valuation allowance has been established for deferred tax assets because management believes that it is more likely than not that the deferred tax assets will be realized. Deferred tax assets are realizable primarily through carryback of existing deductible temporary differences to recover taxes paid in prior years, and through future reversal of existing taxable temporary differences. The Omnibus Budget Reconciliation Act of 1993 was signed into law during August 1993. The most significant change included in this act is an increase in the marginal tax rate from 34% to 35%, retroactive to the beginning of 1993. This change resulted in an increase in income tax expense. However, the benefit from Meridian's deferred tax assets, which are similar to tax loss carryforwards, was increased to reflect the higher tax rates, resulting in a one-time reduction in income tax expense. This change in deferred tax assets partially offset the increase in tax rates on operating income, resulting in a net increase of $350 thousand in income tax expense in 1993. Because of the increase in marginal tax rates on operating income, the new tax act will also have a negative effect on future periods. CAPITAL RESOURCES The maintenance of appropriate levels of capital is a management priority. Overall capital adequacy and dividend policy are monitored on an on-going basis and are reviewed quarterly by the Board of Directors. Meridian's principal capital planning goals are to maintain a strong capital base to support the risks inherent in various lines of business, to retain sufficient earnings to meet capitalization objectives, especially those related to growth and expansion, and to provide an adequate return to shareholders. Capital is managed for each of Meridian's subsidiaries based on their respective risks and growth opportunities, as well as regulatory requirements. Meridian is positioned to take advantage of market opportunities to strengthen capital. A shelf registration with the Securities and Exchange Commission is available to facilitate the issuance of an additional $250 million of debt and preferred equity securities, if and when the need arises for capital and market conditions warrant. Capital ratios have increased since December 31, 1992, the result of the issuance of subordinated debt and the retention of earnings. In March, 1993, Meridian Bank issued $150 million of 6 5/8% subordinated notes due in March 2003, as previously described in the "Long-Term Debt" section. These notes qualify as Tier 2 capital for risk-based capital purposes. Total shareholders' equity was $1,185.6 million at December 31, 1993 compared to $1,059.3 million at the end of 1992, an increase of 12%. Net income for the year was $157.8 million and dividends declared during the year were $67.5 million, resulting in a common dividend payout ratio of 43%. Meridian's capital adequacy at December 31, 1993 can be determined by analyzing the capital ratios presented in Table 20. As can be seen in this table, Meridian's consolidated ratios at the end of 1993 exceeded all regulatory requirements. The risk- based capital ratio was 13.67% at December 31, 1993 compared to 11.61% at December 31, 1992. The ratio of tangible shareholders' equity to assets, which excludes $96.8 million of intangible assets (goodwill, core deposit intangibles, and purchased mortgage servicing rights) was 7.78% at December 31, 1993 compared to 6.44% at December 31, 1992. The risk-based capital ratios of each of Meridian's commercial banks also exceeded regulatory requirements at the end of 1993, as shown in the table. Federal Reserve Board regulations define a well-capitalized institution as having a Tier 1 capital ratio of 6% or more, a total risk-based capital ratio of 10% or more, and a leverage ratio of 5% or more. Consolidated ratios at December 31, 1993 exceeded these guidelines, as did the ratios of each of Meridian's commercial banks. The common stock of Meridian is traded in the over-the- counter market. The monthly average number of common shares traded in 1993 was 4.0 million compared to 3.4 million in 1992. Table 22 sets forth the high and low market price quotations for the periods indicated. Price quotations are available through the National Market System of the National Association of Securities Dealers Automated Quotation System. These prices represent quotations between dealers and do not include retail markups, markdowns or commissions, and may not represent actual transactions. Book value per common share was $20.39 at December 31, 1993 compared to a market value of $28.50 per share. Book value and market value at the end of 1992 were $18.75 and $31.88, respectively. The market to book value ratio was 140% at the end of 1993 compared to 170% one year ago. Meridian's market capitalization at December 31, 1993 was approximately $1.7 billion compared to $1.8 billion one year ago, a decrease of 8.4%. Market capitalization represented 12% of total assets at year-end 1993 and 13% at year-end of 1992. Reference should be made to the Statement of Changes in Shareholders' Equity appearing in the Consolidated Financial Statements for a summary of the changes in total shareholders' equity for each of the years in the three-year period ended December 31, 1993. In January 1994, Meridian announced the repurchase of up to one million shares of common stock from time to time in transactions in the open market or in privately negotiated transactions. Repurchased shares will be used to satisfy the obligation under warrants to acquire 500,000 shares of Meridian's common stock issuable in connection with the acquisition of McGlinn Capital Management, Inc. announced in the fourth quarter of 1993, and Meridian's obligations under present and future employee stock option and other employee benefit plans. These actions are expected to decrease the risk-based capital ratio by approximately 25 basis points by the end of 1994. ANALYSIS OF 1992 COMPARED TO 1991 Financial Highlights. Net income was $136.7 million in 1992 compared to $117.7 million in 1991. The increase in earnings occurred despite an after-tax gain in 1991 of $26.8 million on the sale of Meridian's credit card portfolio. Net income in 1991 was reduced by a loss of $6.5 million from Meridian's discontinued title insurance operations. The improvement in earnings resulted primarily from the following factors: - An increase of $73.2 million in the net interest income. - A reduction of $38.0 million in the provision for possible loan losses. - An increase in net income of $4.4 million in the securities unit, from $11.1 million in 1991 to $15.5 million in 1992. The improvement in earnings was achieved despite a net loss of $9.0 million from the mortgage banking unit, compared to net income of $7.6 million in 1991. Income from continuing operations was $136.7 million in 1992 compared to $124.2 million in 1991. The returns on average assets and on average common shareholders' equity in 1992 were 1.00% and 13.63%, respectively, compared to .96% and 14.31%, respectively, in 1991. The improvement in income from continuing operations between the two years resulted primarily from the factors described previously. Total assets at December 31, 1992 were $14.3 billion compared to $13.2 billion at December 31, 1991. Total loans increased 1% to $8.6 billion at December 31, 1992. An increase in consumer loans more than offset declines in the commercial and residential mortgage loan portfolios. Total deposits increased by 8% from $10.9 billion at the end of 1991 to $11.8 billion at December 31, 1992. The ratio of shareholders' equity to assets was 7.41% at December 31, 1992 compared to 7.18% at the end of 1991. Meridian's risk-based capital ratio was 11.61% at December 31, 1992 compared to 10.37% at the end of 1991. Book value per common share was $18.75 at December 31, 1992 compared to $17.21 at December 31, 1991. Net Interest Income and Related Assets and Liabilities. Net interest income on a taxable equivalent basis increased 13% from $526.2 million in 1991 to $594.0 million in 1992. Widening spreads between the yields on interest-earning assets and the cost of interest-bearing liabilities and an increase in interest- earning assets produced a net interest margin on a taxable- equivalent basis of 4.77% in 1992 compared to 4.47% in 1991. Interest-earning assets averaged $12.5 billion in 1992, 6% above the 1991 level. The increase resulted primarily from three banking acquisitions which were completed during the year. The net interest margin improved between the two years, mostly because rates on interest-bearing liabilities decreased faster than yields on interest-earning assets in the declining rate environment during this period. Average loans outstanding were $8.4 billion in 1992 compared to $8.8 billion in 1991, a 4% decline. Average commercial loans decreased by 3% between the two years because of continued weak loan demand in Meridian's marketplace. Average residential real estate mortgage loans declined by 20%. Accelerated prepayments of mortgages in the low interest rate environment during 1992, together with the decision in late 1991 to securitize and sell approximately $121 million of mortgage loans, were the main reasons for this decline. Average consumer loans increased 3%, with strong growth in installment loans partially offset by the impact of the sale of Meridian's credit card portfolio in mid- 1991. Average deposits were $11.3 billion in 1992 compared to $10.6 billion in 1991, an increase of 7%, primarily as a result of three banking acquisitions. Provision for Possible Loan Losses and Related Credit Quality. The provision for possible loan losses was $68.8 million in 1992 compared to $106.8 million in 1991. The decline of $38.0 million resulted primarily from an improvement in loan quality. While the decline between the two years was significant, its positive impact on earnings was partially reduced by an increase of $16.0 million in writedowns and other expenses associated with foreclosed real estate. Net loans charged-off were $84.6 million in 1992 compared to $85.1 million in 1991. The balance in the allowance for possible loan losses was $165.5 million or 115% of non-performing loans at December 31, 1992 compared to $179.2 million and 106% at the end of 1991. Other Income. Other income was $242.9 million in 1992 compared to $261.2 million in 1991. The gain of $40.6 million from the sale of the credit card portfolio is included in this category in 1991. Without this non-recurring transaction, other income would have increased by 10% between the two years. Revenues from the mortgage banking, asset management, and securities activities were $140.4 million in 1992, an increase of $24.8 million, or 21%, over revenues of 1991. Most of the increase was in the securities unit and related to higher levels of trading gains from sales of securities and mortgage loans and higher tender option bond fees and commission income. Service charges on deposits and fees for other customer services increased by $8.7 million, or 11%, between the two years. Other Expenses. Other expenses were $561.9 million in 1992 compared to $486.4 million in 1991, an increase of 16%. Approximately one-half of the increase relates to additional credit-related reserves, writedowns of foreclosed real estate, and higher operating expenses in Meridian's mortgage banking subsidiary. Operating expenses in the broker-dealer and investment banking unit increased between the two years because of the ongoing expansion of the unit. In the banking subsidiaries, increases were experienced in foreclosed real estate expenses and in operating costs from banking acquisitions that added fourteen branches to Meridian's network in 1992. Salaries and employee benefits were $255.5 million in 1992 compared to $235.2 million in 1991, an increase of 9%. Staff levels increased in all of the major business units, either because of acquisitions or because of an increase in business activity. Net occupancy expense was $41.3 million in 1992 compared to $39.6 million in 1991, an increase of 4%. Equipment expense increased from $32.8 million in 1991 to $37.1 million in 1992, or 13%. The increases in both expense categories were related to expansion, banking acquisitions and the upgrading of Meridian's data processing and operations capabilities. The increase in other operating expenses from $178.7 million in 1991 to $228.0 million in 1992 resulted from several factors. Loan related expenses, primarily in Meridian's mortgage banking subsidiary, increased by $16.3 million, or 98%, in 1992. Included in this total was an increase of $9.6 million in the provision for possible credit losses on mortgage servicing portfolios purchased with recourse. These reserves, as well as $6.3 million of the following increase in expenses related to foreclosed real estate, resulted mainly from financial difficulties of certain banks and thrifts from which this servicing was purchased. Foreclosed real estate expenses, including writedowns, were $23.3 million in 1992 compared to $7.2 million in 1991. Higher premium rates and deposit levels increased FDIC insurance expense by $3.3 million, or 15%, between the two years. Amortization of intangible assets increased by $2.7 million, mostly because of banking acquisitions. Provision for Income Taxes. The effective tax rate was 26% in 1992, unchanged from the rate in 1991. The tax rate for both periods was less than the federal statutory rate of 34% primarily because of tax-exempt investment and loan income. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 1) Summary of Significant Accounting Policies The following is a description of the more significant accounting policies and reporting practices of Meridian Bancorp, Inc. and its subsidiaries (Meridian). They are in accordance with generally accepted accounting principles and have been followed on a consistent basis, except for the accounting changes described in Notes 8 and 11. Basis of Presentation The consolidated financial statements include the accounts of Meridian Bancorp, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. On August 31, 1993, Meridian acquired Commonwealth Bancshares Corporation (Commonwealth). The acquisition of Commonwealth was accounted for as a pooling of interests and resulted in the issuance of 10,946,000 shares of Meridian's common stock. Commonwealth had assets of $2.2 billion and deposits of $1.6 billion at August 31, 1993. Financial information for all prior periods presented has been restated to include the results of operations and financial position of Commonwealth. Certain other amounts in prior period financial statements have been reclassified to conform with the presentation used in the 1993 financial statements. These reclassifications have no effect on net income. Cash and Cash Equivalents In the accompanying Consolidated and Parent Company Statements of Cash Flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold, and securities purchased under agreements to resell. The original maturities of such instruments are less than 90 days. Federal funds are sold and securities are purchased under agreements to resell for generally one-day periods. Investment Securities Securities, other than securities classified as available for sale and marketable equity securities, are carried at amortized cost when Meridian has the intent and the ability at the time of purchase to hold such securities until maturity. Securities to be held for indefinite periods of time and not intended to be held to maturity are classified as available for sale and carried at the lower of aggregate amortized cost or fair value. Decisions to dispose of these securities are based on an assessment of economic and financial conditions affecting Meridian's financial position, including interest rate risk and the resultant prepayment risk, liquidity, capital adequacy, an evaluation of alternative asset and liability management strategies, regulatory requirements, and tax considerations. This category of securities was established during the third quarter of 1992. The amortization of premiums and accretion of discounts to the expected maturity date of the related debt obligations are based on a method which approximates a constant yield. Marketable equity securities are carried at the lower of aggregate cost or fair value. Unrealized losses on marketable equity securities that are considered temporary in nature are recorded as a reduction of shareholders' equity. When a determination is made that the decline in fair value below cost for a marketable equity or debt security is other than temporary, the cost basis of the individual security is written down to a new cost basis and the amount of the write-down is accounted for as a realized loss. Gains and losses on the sale of securities are computed on the specific identification method. Trading account securities are carried at fair value and unrealized gains or losses are included in the Consolidated Statements of Income. Effective in the first quarter 1994, Meridian will adopt Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities",which requires investments in equity securities with a readily determinable fair value and investments in all debt securities to be classified, at the date of adoption, in one of three categories. The three categories are (1) held to maturity -- carried at amortized cost; (2) available for sale -- carried at fair value (with unrealized gains and losses, net of related tax effect, recorded as a separate component of shareholders' equity); and (3) trading account - carried at fair value (with unrealized gains and losses recorded in the income statement). The impact of this accounting change, had Meridian elected to adopt this statement at December 31, 1993, would have been to increase shareholders' equity by approximately $8.1 million, or less than 1%, representing the after-tax unrealized gain in the available for sale portfolio. Interest Rate Swaps Interest rate swaps, the principal derivative product used by Meridian, are a tool used mainly to alter the repricing characteristics of a portion of the core deposit base. There is no effect on the recorded total assets or liabilities of Meridian. Net amounts receivable or payable under agreements designated as hedges are recorded as adjustments to the interest income or expense related to the hedged asset or liability. Related fees are deferred and amortized over the term of the swap agreement. Gains or losses resulting from the termination of interest rate swaps are deferred and amortized over the remaining term of the hedged asset or liability. Loans Loans are stated net of deferred fees and costs and unearned discount. Loan interest income is accrued using various methods which approximate a constant yield. Interest income is not accrued on commercial loans where management has determined that borrowers may be unable to meet contractual principal or interest payments, or where such payments are 90 or more days past due unless the loan is well secured and in the process of collection. Interest on loans that have been restructured is recognized according to the renegotiated terms. Residential mortgages which are 180 days or more delinquent are placed on nonaccrual status when total principal, interest, and escrow owed exceeds 80% of the property's appraised value. Properties are re-appraised when foreclosure proceedings are initiated. Loan origination and commitment fees and direct loan origination costs are deferred and recognized over the life of the related loans as an element of the yield. Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" requires that 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 underlying collateral. This statement is effective for fiscal years beginning after December 15, 1994 and, based on the analysis to date, management believes that the impact on Meridian's consolidated results will not be material. Allowance for Possible Loan Losses The allowance for possible loan losses is established through provisions for possible loan losses charged against income. Loans deemed to be uncollectible are charged against the allowance. Subsequent recoveries, if any, are credited to the allowance. The balance in the allowance is based on a periodic evaluation of the loan portfolio and reflects an amount that in management's opinion is adequate to absorb losses inherent in the portfolio. When establishing the appropriate levels for the provision and the allowance for possible loan losses, management performs an analysis of the loan portfolio by considering a variety of factors. This analysis includes periodic reviews by loan review and loan workout personnel of all borrowers with aggregate balances of $250,000 or greater. Meridian also reviews, at least on a quarterly basis, problem borrowers with balances of $500,000 or greater, as well as selected lower balance loans. Consideration is given to the impact of current and anticipated economic conditions, the diversification of the loan portfolio, historical loss experience, delinquency statistics, reviews performed by loan officers who are primarily responsible for compliance with established lending policy, the perceived financial strength of borrowers, and the perceived adequacy of underlying collateral. Consideration is also given to examinations performed by regulatory authorities. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed on the straight line method and is charged to operations over the estimated useful lives of the related assets. Leasehold improvements are amortized on a straight line basis over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. Other Assets Goodwill is the excess of the purchase price over the fair value of net assets of companies acquired through business combinations accounted for as purchases. Included in other assets is $35.0 million of goodwill that is being amortized using the straight line method over various periods not exceeding 18 years. Core deposit intangibles are a measure of the value of consumer demand and savings deposits acquired in business combinations accounted for as purchases. Included in other assets is $21.9 million of core deposit intangibles which are being amortized on an accelerated method, with at least two- thirds of the original balance being amortized within seven years following the date of acquisition. The recoverability of the carrying value of intangible assets is evaluated on an ongoing basis and permanent declines in value, if any, are charged to expense. Assets acquired in foreclosures consist of real estate acquired through foreclosure or in settlement of debt and loans considered to be in an in-substance foreclosure status. These assets are carried at the lower of cost or fair value less estimated costs of disposal. Trust Assets Assets held by Meridian in a fiduciary or agency capacity for customers are not included in the consolidated financial statements since such items are not assets of Meridian or its subsidiaries. Trust income is reported on the accrual method. Mortgage Banking Mortgage servicing fees received from permanent investors for servicing their loan portfolios are recorded as income when received. Mortgage loan servicing includes collecting monthly mortgagor payments, forwarding payments and related accounting reports to investors, collecting escrow deposits for the payment of mortgagor property taxes and insurance, and paying taxes and insurance from escrow funds when due. In the third quarter of 1993 Meridian decided to refocus its mortgage activities on the origination of residential loans and to substantially reduce the scope of its mortgage servicing business. Mortgage servicing intangibles and other related assets are carried at fair value and are included in mortgage loans and other assets held for sale in the consolidated balance sheets. Acquisition costs of mortgage servicing rights purchased prior to the third quarter of 1993 were capitalized and amortized in proportion to, and over the period of, estimated net servicing revenue (undiscounted servicing revenues in excess of undiscounted servicing costs). In estimating future servicing revenues, management takes into consideration a number of factors including the current rate of anticipated prepayments of the underlying mortgage loans. Changes in the assumptions used could significantly affect management's estimates. If actual results differed significantly from those estimated by management, adjustments to the carrying value of purchased mortgage servicing rights could occur. Excess servicing fees are computed as the present value of the difference between the estimated future net revenues and normal servicing revenues as established by the federally sponsored secondary market makers. Resultant premiums are deferred and amortized over the estimated life of the related mortgages using the constant yield method. The amortization of both purchased mortgage servicing rights and excess servicing fees is recorded as a reduction of servicing revenue. Mortgage loans and other assets held for sale are carried at the lower of aggregate cost or fair value, with resulting gains and losses included in other income. The fair value calculation includes consideration of all open positions, outstanding commitments from investors and related fees paid. Securities Operations Forward rate agreements (commitments to sell securities) and tender option bonds (commitments to purchase securities) are off- balance sheet items that represent contingent liabilities and are therefore not included in the consolidated financial statements. Realized gains and losses and net interest spread income on these instruments are included in other income. Securities designated to cover forward rate agreements are included in trading account securities and are carried at the lower of cost or contract price. Collateralized mortgage obligation residuals, rights acquisition contracts and guaranteed interest rate contracts are other financial instruments and are included in the consolidated financial statements in investment securities, investment securities available for sale and interest-bearing deposits, respectively. Income Taxes Certain items of income and expense are included in one reporting period for financial accounting purposes and another reporting period for income tax purposes. Under the liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement and tax bases of existing assets and liabilities. Postretirement Benefits Meridian has a non-contributory defined benefit pension plan covering substantially all employees who qualify as to age and length of service. The plan benefits are based on years of service and an earnings formula that considers average salaries during a defined period prior to retirement. The projected unit credit method is used to measure net periodic pension cost over employees' service lives. The plan is funded using the entry age actuarial cost method to the extent deductible under existing federal income tax regulations. Meridian currently provides postretirement health care and life insurance benefits to its employees. The medical portion is contributory and life insurance coverage is non-contributory to the participants. The expected cost of these benefits is accrued over the period the employee earns the benefits. There are currently no plan assets attributable to these postretirement benefits. Preferred Stock Meridian has 25 million shares of preferred stock authorized that carries a $25.00 par value per share. No shares of preferred stock were issued and outstanding as of December 31, 1993. Meridian's Board of Directors has the authority to issue the preferred stock from time to time as a class without series, or in one or more series. Common Stock Dividends Meridian adopted a new dividend payment schedule effective in 1992. In addition to the dividend of $.30 per share paid on January 1, 1992 (declared November 1991), the Board of Directors also declared dividends of $.30 per share in April, July and October 1992 for payment on June 1, September 1 and December 1, 1992, respectively. Accordingly, a dividend was not declared in the quarter ended March 31, 1992. Earnings Per Share Primary earnings per share is computed by dividing net income after deduction of any preferred stock dividends by the weighted average number of common stock and common stock equivalents outstanding during the year. Stock options are considered common stock equivalents and are included in the computation of the number of outstanding shares using the treasury stock method, unless such options are anti-dilutive Fully diluted earnings per share gives effect to the assumed conversion of any convertible preferred stock as well as to the exercise of stock options. Net income and dividends per common share and average shares outstanding for the last three years are as follows: 2) ACQUISITIONS The merger with Commonwealth on August 31, 1993 was accounted for as a pooling-of-interests and resulted in the issuance of 10,946,000 shares of Meridian common stock. Financial information for all prior periods presented has been restated to include the results of operations and financial position of Commonwealth. A reconciliation of amounts, as previously reported for 1992 and 1991, to the consolidated amounts reported in the accompanying financial statements is as follows (dollars in thousands, except per share data): In April 1993, Meridian acquired all of the outstanding common shares of Cherry Hill National Bank of Medford, New Jersey. The acquisition was accounted for as a pooling-of- interests and resulted in the issuance of 477,000 shares of Meridian's common stock. Cherry Hill had assets of $113 million and deposits of $101 million at the time of the merger. In November 1993, Meridian Bank assumed approximately $76 million of deposits of Provident Savings Bank of Jersey City, and paid a premium of $540 thousand. This acquisition was accounted for as a purchase. In December 1993, Meridian, acquired all of the outstanding common shares of First Bath Corp. The acquisition was accounted for as a pooling-of-interests and resulted in the issuance of 565,000 shares of Meridian's common stock. First Bath had assets of approximately $120 million and deposits of $110 million at the time of the merger. The above four acquisitions added 74 new branches to Meridian's branch network. On July 9, 1992 Meridian entered into an agreement to acquire 21 branches in seven counties of central and southern New Jersey of Security Savings Bank, SLA, a wholly-owned subsidiary of Security Investments Group, Inc. Under the terms of the agreement, Meridian was to have acquired selected nonclassified and performing assets and real estate. On December 4, 1992, the Office of Thrift Supervision declared Security insolvent and placed it in receivership with the Resolution Trust Corporation which, in its capacity as receiver of Security, repudiated the agreement with Meridian during the fourth quarter of 1993. On December 16, 1993, Meridian entered into a definitive agreement to acquire McGlinn Capital Management, Inc., an investment advisory firm with $2.8 billion in assets under direct management, for 500,000 warrants for shares of Meridian common stock and cash. The transaction, which is subject to regulatory approval, is expected to be completed by the end of the second quarter of 1994. 3) INVESTMENT SECURITIES, INVESTMENT SECURITIES AVAILABLE FOR SALE AND SECURITIES GAINS A summary of the carrying value and approximate fair value of investment securities included in the Consolidated Balance Sheets is as follows: A summary of the gross unrealized gains and losses on investment securities is as follows: The carrying value and approximate fair value of investment securities at December 31, 1993 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations. Investment securities carried at approximately $1.8 billion at December 31, 1993 were pledged as collateral for public deposits, trust deposits, repurchase agreements, and certain other deposits as required by law. No securities of an individual issuer aggregated more than 10% of shareholders' equity at December 31, 1993. Tax-free income on investment securities for 1993, 1992 and 1991 amounted to $20.6 million, $21.8 million and $28.4 million, respectively. INVESTMENT SECURITIES AVAILABLE FOR SALE A summary of the carrying value, approximate fair value and gross unrealized gains and losses of investment securities available for sale included in the Consolidated Balance Sheets is as follows. This category of securities was established during the third quarter of 1992. The carrying value and approximate fair value of investment securities available for sale at December 31, 1993 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations. TOTAL SECURITIES GAINS Total gains from securities transactions, which were included in the following categories in the other income section of the consolidated statements of income, are as follows: Net securities gains included gross gains of $25.5 million, $6.1 million, $9.8 million and gross losses of $203 thousand, $3.4 million and $5.9 million during 1993, 1992 and 1991, respectively. Securities gains in 1993 include a gain of $8.6 million on the sale of Meridian's common stock investment in Fidelity National Financial, Inc. This stock was acquired as part of the sale of Meridian's title insurance operations in 1992. Exclusive of this gain, securities gains in 1993 resulted primarily from sales of investments classified as available for sale. 4) Loans A summary of loans included in the Consolidated Balance Sheets is as follows: Included within the loan portfolio are restructured loans and loans on which Meridian has discontinued the accrual of interest. Such loans amounted to $127.6 million, $143.6 million, and $169.3 million at December 31, 1993, 1992, and 1991, respectively. If these non-performing loans had been current in accordance with their original terms and had been outstanding throughout the period, gross interest income for 1993, 1992, and 1991 would have increased $9.5 million, $13.5 million, and $19.2 million, respectively. Interest income on these non-performing loans included in income for 1993, 1992, and 1991 amounted to $706.0 thousand, $3.1 million, and $1.5 million, respectively. Tax-free income on loans for 1993, 1992, and 1991 amounted to $14.4 million, $16.6 million, and $22.2 million, respectively. The aggregate amount of loans by Meridian to its directors and executive officers, including loans to related persons and entities, was $37.1 million at December 31, 1993 and $54.9 million at December 31, 1992. These loans were made in the ordinary course of business at substantially the same terms and conditions as those with other borrowers and did not involve more than the normal risk of collectibility. An analysis of the activity in 1993 for these loans follows: Other, Net includes the addition of loans to new directors and officers and the reductions in loans because of persons who no longer meet the criteria for classification as a related person or entity. 5) Allowance for Possible Loan Losses A summary of activity in the allowance for possible loan losses follows: 6) SHORT-TERM BORROWINGS AND LONG-TERM DEBT AND OTHER BORROWINGS Short-term borrowings consisted of the following: Meridian had unused lines of credit of $30 million and $202 million at December 31, 1993 and 1992, respectively. The table below provides outstanding balances and related information for federal funds purchased and securities sold under repurchase agreements. Average interest rates for the year are computed by dividing interest expense by the respective average daily balances. Long-term debt and other borrowings consisted of the following: The floating rate subordinated notes bear interest at a rate of 1/8 of 1% above the arithmetic mean of London interbank offering quotations for three-month Eurodollar deposits, determined quarterly. The notes carry a floor interest rate of 5 1/8%. The notes are subordinate and junior in right of payment of senior indebtedness of Meridian. Since December 1, 1988, Meridian has had the option to exchange of the notes for capital securities, or under certain circumstances, cash, prior to maturity of the notes on December 1, 1996. The effect of the capital securities which may be issued in connection with these notes has not been included in the computation of earnings per share. In December, 1993, Meridian received approval from the Federal Reserve Bank to revoke its obligation to exchange the notes for capital securities at maturity. During 1993, Meridian Bank, Meridian's principal banking subsidiary, sold $150 million of 6.625% fixed rate subordinated notes due March 15, 2003. The net proceeds are being used for general corporate purposes, including possible branch acquisitions and other acquisitions of all or portions of failed institutions from the Resolution Trust Corporation or the Federal Deposit Insurance Corporation. Meridian has long-term borrowings from the Federal Home Loan Bank which total $75 million. These borrowings require Meridian to maintain membership in the Federal Home Loan Bank of Pittsburgh and to maintain collateral with a fair value which approximates the total amount of the outstanding debt. The remaining long-term debt consists of debt of Meridian's banking subsidiaries and is subordinated in the right of payment to the depositors of such subsidiaries. Substantially all of the notes are redeemable prior to maturity at certain amounts based on sinking fund provisions or, when applicable, approval of the appropriate regulatory agency. 7) DIVIDEND, CAPITAL AND OTHER REGULATORY RESTRICTIONS Various laws restrict the amount of dividends that can be paid to Meridian by its subsidiary banks without regulatory approval. Under current regulations, Meridian's subsidiary banks, without prior approval of bank regulators, may declare dividends to Meridian in 1994 totalling approximately $147.1 million plus additional amounts equal to the net profits earned by such subsidiary banks for the period from January 1, 1994, through the date of declaration, less dividends previously paid in 1994. Meridian is required to maintain minimum amounts of capital to total "risk weighted" assets, as defined by the banking regulators. Meridian is required to have minimum Tier 1 and total capital ratios of 4.00% and 8.00%, respectively. Meridian's actual ratios at December 31, 1993 were 9.60% and 13.67%, respectively, well above regulatory requirements. Meridian is also required to maintain a leverage ratio of 3% plus an additional cushion of 100 to 200 basis points. Meridian's leverage ratio at December 31, 1993 was 7.84%. The Federal Reserve Act also places restrictions on the amount of credit that may be extended to Meridian by its subsidiary banks. During 1993, there were no loans or advances made to Meridian by any of its subsidiary banks. Meridian's banking subsidiaries are required to maintain reserve balances with the Federal Reserve. These balances totalled $94.3 million at December 31, 1993 and averaged $91.6 million for the year then ended. 8) EMPLOYEE BENEFIT PLANS Pension Plans Total pension expense for 1993, which includes several informal pension arrangements in addition to the Meridian and Commonwealth plans, was $2.9 million. Total pension expense for 1992 and 1991 was $59 thousand and $2.5 million, respectively. Pension expense in 1992 reflects significantly better than expected investment returns on plan assets. Net periodic pension expense (credit) of the Meridian and Commonwealth plans includes the following components: The following table sets forth the funded status of the Meridian and Commonwealth plans and amounts recognized in the Consolidated Balance Sheets at December 31. Net periodic pension expense is determined using certain assumptions as of the beginning of the year whereas the funded status of the plan is determined using assumptions as of the end of the year. The discount rate used in determining the actuarial present value of Meridian's projected benefit obligation was 7.0% in 1993 and 8.0% in 1992 and 1991. The expected long-term rate of return on plan assets was 9.5% in 1993, 1992 and 1991. The rate of increase in future compensation levels was 5.3% in 1993 and 6.3% in 1992 and 1991. The discount rate used in determining the actuarial present value of Commonwealth's projected benefit obligation was 7.0% in 1993, 7.5% in 1992 and 8.0% in 1991. The expected long-term rate of return on plan assets was 9.5% in 1993, 8.0% in 1992 and 9.0% in 1991. The rate of increase in future compensation levels was 5.3% in 1993 and 5.25% in 1992 and 1991. The assets of the Meridian and Commonwealth plans are administered by Meridian Asset Management, Inc., and consist primarily of common stock, fixed income securities such as obligations of the United States government and corporations, and units of certain common trust funds. Meridian provides postretirement health care and life insurance plans to its employees. The medical portion is contributory and life insurance coverage is noncontributory to the participants. Effective January 1, 1993, Meridian adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The new accounting rules require the accrual of the expected cost of these benefits over the period the employee earns the benefits. Meridian elected to defer and amortize over 20 years the cumulative obligation for such benefits at the beginning of 1993. The annual expense of Meridian's postretirement benefits other than pensions under these new accounting rules was $4.5 million in 1993 compared to approximately $2.0 million on the cash basis of accounting previously used, or an increase of $2.5 million. The health care trend rate assumption used to determine accumulated benefit obligations applicable to these benefits was 11% for 1993 decreasing over time to an annual rate of 5.5% and remaining at that level thereafter. The discount rate used in determining the present value of the projected benefit obligation was 7%. Net periodic expense of the Meridian and Commonwealth postretirement healthcare and life insurance plans includes the following components: The following table sets forth the funded status of the Meridian and Commonwealth postretirement healthcare and life insurance plans and amounts recognized in the Consolidated Balance Sheets at December 31. There are currently no plan assets attributable to these postretirement benefits. A change in the health care trend rate assumption of one percent would increase annual service cost by approximately $100,000 and the accumulated postretirement benefit obligation at December 31, 1993 by approximately $800,000. In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits". This statement, which becomes effective in 1994, establishes accounting standards for employers who provide benefits to former employees after employment but before retirement. Such benefits include, among other things, severance and workers' compensation benefits. Management is currently evaluating this statement and, based on the analysis to date, believes that its impact on Meridian's consolidated results of operations will not be material. Savings Plan Meridian also offers a savings plan which covers substantially all employees who qualify as to age and length of service. A participating employee must contribute at least 1% and may contribute a maximum of 10% of his or her compensation. Meridian will match up to the first 6% that each employee contributes. Investment options include Meridian common stock. Contributions are charged to current expense. The total expense relating to the Meridian savings plan was $7.1 million in 1993, $6.5 million in 1992 and $5.7 million in 1991. Stock Option Plan Under Meridian's stock option plan, options to acquire a maximum of 3,500,000 shares of common stock may be granted to key officers. The plan provides for the granting of options at the fair market value of Meridian's common stock at the time the options are granted. Each option granted under the plan may be exercised within a period of ten years from the date of the grant; however, no option may be exercised within one year from the date of grant. A stock appreciation rights (SARs) plan grants SARs in tandem with stock option grants, up to a maximum of 750,000 units. The exercise of SARs reduces the stock options otherwise exercisable; similarly, the exercise of stock options cancels the corresponding SARs. There were no SARs outstanding at December 31, 1993. Under Meridian's stock option plan, the exercisable option prices ranged from $10.50 to $31.12 at December 31, 1993. An analysis of the activity in this plan for the last three years follows: Total rental expense for all operating leases for 1993, 1992 and 1991 amounted to $20.5 million, $18.2 million, and $16.4 million, respectively. 10) OTHER OPERATING EXPENSES The following represents the most significant categories of other operating expenses for the years ended December 31: 11) INCOME TAXES Effective January 1, 1993, Meridian adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109),which requires a change from the deferred method of accounting for income taxes to the liability method. Under the liability method, deferred tax assets and liabilities are recognized for future tax consequences attributable to temporary differences between the financial statement and tax bases of existing assets and liabilities. 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. 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 of the rate change. As permitted by SFAS No. 109, Meridian has elected not to restate the financial statements of any prior years. The implementation of these new tax accounting rules resulted in an increase in consolidated net income of $7.2 million in the first quarter of 1993. This amount represents the cumulative effect of adopting SFAS No. 109 at the beginning of 1993. The impact of SFAS No. 109 on future periods is not expected to be material. At December 31, 1993, deferred tax assets amounted to $105.5 million and deferred tax liabilities amounted to $60 million. No valuation allowance has been established for deferred tax assets because management believes that it is more likely than not that the deferred tax assets will be realized. Deferred tax assets are realizable primarily through carryback of existing deductible temporary differences to recover taxes paid in prior years and through future reversal of existing taxable temporary differences. The Omnibus Budget Reconciliation Act of 1993 was signed into law during August 1993. The most significant change included in this act is an increase in the marginal tax rate from 34% to 35%, retroactive to the beginning of 1993. This change resulted in an increase in income tax expense. However, the benefit from Meridian's deferred tax assets, which are similar to tax loss carryforwards, was increased to reflect the higher tax rates, resulting in a one-time reduction in income tax expense. This change in deferred tax assets partially offset the increase in tax rates on operating income, resulting in a net increase of $350 thousand in income tax expense in 1993. Because of the increase in marginal tax rates on operating income, the new tax act will also have a negative effect on future periods. The provision for income taxes on continuing operations consists of the following: The effective tax rate is less than the federal statutory rate in each year as a result of the following items: The significant components of deferred income tax expense attributable to income from continuing operations for the year ended December 31, 1993 are as follows: For the years ended December 31, 1992 and 1991, deferred income tax benefit of $6.6 and $5.6 million, respectively, results 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 components of the deferred tax asset and liabilities are as follows: 12) Commitments and Contingencies Financial Instruments with Off-Balance-Sheet Risk Meridian uses various financial instruments in conducting its business activities and in managing its balance sheet risks. These instruments are properly not included in the accompanying consolidated financial statements. The instruments involve, to varying degrees, elements of credit risk, interest rate risk, and liquidity risk. A summary of the contractual or notional amounts of these financial instruments along with a discussion of the instruments and their underlying risk characteristics is as follows: Meridian extends binding loan commitments to prospective borrowers. Such commitments assure the borrower of financing for a specified period of time or at a specified rate and usually require the payment of a fee. The risk to Meridian in an undrawn loan commitment is limited by the terms of the contract. For example, Meridian may not be obligated to advance funds if the customer's financial condition deteriorates or if the customer fails to meet specific covenants. An undrawn loan commitment represents both a potential credit risk once the funds are advanced to the customer and liquidity risk since the customer may demand immediate cash that would require a funding source. Meridian's credit review and approval process for loan commitments is the same as the process used for loans. In addition, Meridian's Credit Policy Committee reviews customer requests for loan commitments and monitors outstanding commitments on an ongoing basis. Meridian's current liquidity position continues to satisfy its needs for funds. In addition, since a portion of these loan commitments normally expire unused, the total amount of outstanding commitments at any point in time will not require a funding source. A standby letter of credit is an instrument issued by a bank that represents an obligation to guarantee payments on certain transactions of its customers. Meridian evaluates the creditworthiness of each of its letter of credit customers, using the same review and approval process that is used for loans. In addition, Meridian has established guidelines limiting the amount of total outstanding standby letters of credit to a specified percentage of its shareholders' equity. Compliance with these guidelines is monitored on a monthly basis. The amount of collateral received on loan commitments and on standby letters of credit is dependent upon the individual transaction and the creditworthiness of the customer. Meridian originates and sells residential mortgage loans as part of various mortgage-backed security programs sponsored by United States government agencies or government-sponsored agencies, such as the Government National Mortgage Association, Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association. These sales are often subject to certain recourse provisions in the event of default by the borrower. Meridian provides for potential losses against these mortgage- backed securities by establishing reserves at the time of sale and evaluates the adequacy of these reserves on an ongoing basis. Forward rate agreements are used in transactions with municipalities that generally have a debt payment due in the future. Under these agreements, Meridian agrees to deliver primarily securities, usually United States Treasury securities, that will mature on or before the required payment date. The type and associated interest rate of these securities is established when the agreement is entered into. The principal risk associated with forward rate agreements is interest rate risk to the extent the required securities have not been purchased. If interest rates fall, securities yielding the higher agreed upon fixed rate will be more expensive for Meridian to purchase. Meridian has commitments to sell mortgage-backed securities or loans with delivery at a future date but typically within 120 days. The risk associated with these instruments consists primarily of loans not closing in sufficient volumes and at appropriate yields to meet mandatory obligations. Meridian is also subject to interest rate risk in a decreasing rate environment. Hedges are used to decrease the impact of such risk. Tender option bonds are also instruments associated with municipalities. A municipality generally issues a tax-free, fixed rate, long-term security in order to finance the origination of single family residential mortgages. The municipality enters into a tender option bond program with Meridian, which converts the fixed rate long-term instrument into a variable rate short-term product. Under the terms of this agreement, the municipality will pay a fixed rate to Meridian over the life of the underlying bond. Meridian, in turn, pays a short-term variable rate to the ultimate bondholder, who has the option to sell the bonds back to Meridian. Meridian also receives the right to remarket any purchased bonds at a short- term, tax-exempt, variable rate. The risk to Meridian in tender option bonds is one of interest rate risk in a rising rate environment. If interest rates increase, the rate paid on the short-term instrument will also increase and the spread between the fixed rate that Meridian receives and the short-term rate Meridian pays to bondholders will decrease. If short-term rates exceed the fixed rate on the long-term instrument, then the short-term instrument will be sold at a discount and Meridian would incur a loss. Meridian's position in forward rate agreements and tender option bonds is sometimes hedged through the use of other interest rate sensitive financial instruments such as options. In addition, these two instruments have interest rate sensitivities that move in opposite directions. Interest rate swap agreements involve the exchange of fixed and floating rate interest payments without the exchange of the underlying contractual or notional amounts. Interest rate options, caps, and floors involve the receipt of a fee by Meridian in exchange for assumption of the risk of interest rate movements beyond a predetermined level. Interest rate caps or floors are written to enable customers to manage their interest rate risks. Interest rate swaps, the principal derivative product used by Meridian, are used as part of the asset and liability management program to alter the repricing characteristics of a portion of the core deposit base. Risk in these transactions involves the risk of counterparty nonperformance under the terms of the contract. The notional or contract amount does not represent the risks inherent in these agreements. The risk of loss can be approximated by estimating the cost, on a present value basis, of replacing an instrument at current market interest rates. Credit risk is managed by performing credit reviews and through ongoing credit monitoring procedures. Reference should be made to Note 14 of the Notes to Consolidated Financial Statements for a discussion of contingent liabilities related to the discontinued title insurance operations. Concentrations of Credit Risk Loan concentrations are considered to exist when a multiple number of borrowers are engaged in similar activities and have similar economic characteristics which would cause their ability to meet contractual obligations to be similarly impacted by economic or other conditions. At December 31, 1993, Meridian's commercial loans and commitments did not have any industry concentration or other known concentration that exceeded 10% of total loans and commitments. However, the effect of the recent recession has had a negative impact on the financial performance of many companies involved in retail trade. At December 31, 1993 Meridian's loans to companies in retail trade totalled $721.6 million, or 8% of total loans outstanding and 13% of total commercial loans outstanding. Included in this total were loans to department stores and other retailers of $358.9 million and loans to automobile dealers of $362.7 million. Legal Meridian and certain of its subsidiaries were party (plaintiff or defendant) to a number of lawsuits. While any litigation has an element of uncertainty, management, after reviewing these actions with its legal counsel, is of the opinion that the liability, if any, resulting from all legal actions will not have a material effect on the consolidated financial condition or results of operations of Meridian. 13) FAIR VALUES OF FINANCIAL INSTRUMENTS In December 1991, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," (SFAS No. 107). SFAS No. 107 requires disclosure of the fair value of all financial instruments, whether or not recognized on the balance sheet, for which it is practicable to estimate such value. Fair value estimates and assumptions are presented below for Meridian's financial instruments. Fair value estimates are made at a point in time, based on relevant market information and available information about the financial instrument. Fair values are based on quoted market prices for financial instruments where prices exist in the market. In cases where quoted market prices are not available, fair values are derived from estimates using present value or other valuation techniques. Because a quoted market price does not exist for a significant portion of Meridian's financial instruments, fair value estimates are based on judgments regarding future cash flow expectations, perceived credit risk, interest rate risk, prepayment risk, economic conditions, and other factors. The estimates are therefore subjective and may not reflect the amount that could be realized upon immediate sale of the instrument. Changes in the assumptions could also significantly affect the estimates. Also, the estimates do not reflect any additional premium or discount that could result from the sale of Meridian's entire holdings of a particular financial instrument. Only existing on and off-balance sheet financial instruments are subject to fair value estimates. A value is not assigned to fee-based businesses such as Meridian's asset management and trust operations, with customers' assets of approximately $27.0 billion, and the mortgage banking business, where Meridian services approximately $7 billion in residential and commercial loans. In addition, core deposits represent the intangible value derived from retaining low-cost deposits for an expected future period of time. The positive value of core deposits held by Meridian is not reflected in these fair value estimates because it is not a requirement of SFAS No. 107. The value of other non- financial instruments, such as property, plant and equipment, and deferred tax assets is also not considered. In addition, tax implications related to the realization of unrealized gains and losses can significantly affect fair value and have not been considered in these estimates. Because of these reasons, the aggregate fair values disclosed in this footnote to the financial statements are not meant to represent an estimate of the underlying value of Meridian Bancorp, Inc. taken as a whole. At December 31, 1993 and 1992, the carrying, contract, or notional values and estimated fair values of financial instruments of Meridian are as follows: Off-Balance Sheet Financial Instruments Meridian uses various off-balance sheet financial instruments in conducting its business activities and in managing its balance sheet risks. The value of these instruments is based on their respective settlement values, or the amount that Meridian would either pay or receive to assume Meridian's position in these contracts. The following methods and assumptions were used by Meridian in estimating the fair value of its financial instruments: Cash and Due from Banks. The carrying amounts reported in the balance sheet approximate fair value due to the short-term nature of these assets. Short-Term Investments. Short-term investments include trading account securities which are marked-to-market for financial reporting purposes and therefore already approximate fair value. The carrying amounts of other short-term investments on Meridian's balance sheet approximate fair value since the maturity of these instruments is generally 90 days or less. For short-term investments with maturities of greater than 90 days, fair value estimates are based on market quotes for similar instruments, adjusted for such differences between the quoted instruments and the instruments being valued as maturity and credit quality. Investment Securities and Investment Securities Available for Sale. The fair values of investment securities and investment securities available for sale are based on quoted market prices as of the balance sheet date, where available. In cases where a market price is not available, external pricing services that approximate fair value are used. For certain instruments, fair value is estimated by obtaining quotes from independent securities dealers. Loans. Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are aggregated by commercial, residential real estate, and consumer categories. Each loan portfolio is further classified by variable rate or fixed rate loans and by performing or nonperforming loans. For performing variable-rate loans, fair values are based on carrying amounts, as these loans reprice frequently as market rates change. Additionally, most variable rate loans are reviewed and extended on at least an annual basis. At the time of that review, these loans are repriced to reflect the current credit risk inherent in the loan. For performing fixed-rate loans, the fair value methodology varies according to each loan portfolio. Fair values for residential real estate and consumer loans are estimated using quoted market prices, where available. Where quoted market prices are not available, quotations are obtained for similar instruments and adjusted for such differences in loan characteristics as maturity and credit quality. The fair value of performing fixed-rate commercial loans is estimated by discounting the expected cash flows by a discount rate that reflects the interest rate and credit risk inherent in the loan. The estimated maturity of these loans reflects both contractual maturity and management's assessment of prepayments, economic conditions, and other factors that may affect the maturity of the portfolio. The discount rate is based on the rate that would be currently offered for loans with similar terms to borrowers of similar credit quality. Nonperforming loans are included in each of the loan portfolios previously described. The fair value of nonperforming loans is estimated by discounting the expected return of principal over the period of time Meridian anticipates receiving principal payments on the loan. The discount rate used is a rate reflective of the higher risk surrounding these assets compared to a performing loan. Accrued Interest Receivable and Other Assets. The carrying value of certain financial instruments included in these categories, such as accrued interest receivable, approximates fair value. For other financial instruments, such as assets related to servicing certain loans, fair value is estimated by discounting the scheduled cash flows through estimated maturity by a discount rate that reflects the interest rate and credit risk inherent in the instrument. Deposits. The fair value of deposits with no stated maturity, such as non-interest bearing deposits, NOW accounts, savings, and money market deposit accounts, is the amount payable on demand as of year end. The fair value of low-cost core deposits is not considered in the value of deposits nor is it recorded as an intangible asset in the balance sheet, as previously discussed. For time deposits, fair value is estimated by discounting the contractual cash flows using a discount rate equal to the rate currently offered for similar deposits of similar maturities. Short-Term Borrowings. The carrying values of federal funds purchased, securities sold under agreements to repurchase, and other short-term borrowings approximate fair values. Long-Term Debt and Other Borrowings. The fair values of long-term debt and other borrowings are estimated by discounting the contractual cash flows for each instrument. The discount rate applied is based on the current incremental borrowing rates for similar arrangements with similar maturities. Accrued Interest Payable and Other Liabilities. The carrying value of certain financial instruments included in these categories, such as accrued interest payable, approximates fair value. Off-Balance Sheet Financial Instruments. Fair values for Meridian's off-balance sheet financial instruments are calculated based on market prices (forward rate agreements and interest rate swaps); market prices for comparable instruments, adjusted for such differences between the two instruments as maturity or credit quality (mortgage loans sold or loan servicing acquired with recourse, commitments to purchase or sell securities, tender option bonds and other interest rate contracts); and fees currently charged to enter into similar agreements, taking into account the remaining term of the agreement and the present credit risk assessment of the counterparty (commitments to extend credit and standby letters of credit). 14) Discontinued Operations The sale of Meridian's title insurance operations to Fidelity National Financial, Inc. of Irvine, California was completed on June 30, 1992. Meridian retained an investment of $20 million in preferred stock of American Title Insurance Company. This investment is mandatorily redeemable by American Title in 2004 and is included in other assets in the consolidated balance sheets. However, the redemption price and carrying value of the preferred stock on the books of Meridian is subject, under certain circumstances, to reduction to the extent that claims accruals or payments on title policies issued prior to year-end 1991 by American Title and certain other general litigation accruals or payments, net of recoveries, exceed reserves (approximately $46 million) on the books of American Title at December 31, 1991. Meridian is also obligated to pay an amount, up to $11 million, to the extent that claims payments, net of recoveries, by both Meridian Title Insurance Company and American Title on policies issued prior to year-end 1991 exceed the preferred stock redemption price of $20 million plus reserves (approximately $53 million) on the books of both Meridian Title and American Title at December 31, 1991. 15) MERIDIAN BANCORP, INC. (PARENT COMPANY ONLY) 16) Industry Segment Reporting Meridian operates principally in two business segments - banking and securities. Reference should be made to the discussion and tables appearing under "Banking" and "Securities" in the section "Primary Business Activities" in Management's Discussion and Analysis of Earnings and Financial Position for financial information on each of these business segments. Opinion of Independent Auditors The Board of Directors Meridian Bancorp, Inc. We have audited the accompanying consolidated balance sheets of Meridian Bancorp, Inc. and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' 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 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 Meridian Bancorp, Inc. and its 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 Notes 8 and 11, respectively, to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's 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, in 1993. KPMG PEAT MARWICK January 19, 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 Incorporated by reference is the following information included in the Proxy Statement relating to the Registrant's Annual Meeting of Shareholders to be held on April 26, 1994 (the "Proxy Statement"), filed by the Registrant with the Securities and Exchange Commission: with respect to the directors of the Registrant, the section captioned "Election of Directors (Matter No. 1); General." Information regarding executive offices of the Registrant is presented in Part I, Item 4A of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference is the information included in the Proxy Statement under the headings "Election of Directors (Matter No. 1); Compensation Paid to Executive Officers." "Election of Directors (Matter No. 1); Executive Employment Agreements" and "Election of Directors (Matter No. 1); Compensation Committee Interlocks and Insider Participation." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference is the following information included in the Proxy Statement: (1) with respect to shares owned by certain beneficial owners, the section captioned "General; Principal Shareholders" and (2) with respect to shares owned by directors and executive officers, the section captioned "Election of Directors (Matter No. 1); Security Ownership of Management." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference is the information included in the Proxy Statement under the heading "Election of Directors (Matter No. 1); Certain Transactions." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K The following documents are filed as part of this report: A.1. Financial Statements (included under Item 8) (a) Meridian Bancorp, Inc. and Subsidiaries - Management's Statement of Responsibility for Financial Information - Consolidated Balance Sheets - Consolidated Statements of Income - Consolidated Statements of Changes in Shareholders' Equity - Consolidated Statements of Cash Flows - Notes to Consolidated Financial Statements - Opinion of Independent Auditors 2. All financial schedules are omitted because they are not applicable, the data are not significant or the required information is shown in the Annual Report. (The information that would be shown in Meridian Bancorp, Inc.'s (Parent Company Only) Statements of Changes in Shareholders' Equity is identical to the information supplied in the Consolidated Statements of Changes in Shareholders' Equity which appears herein.) 3. Exhibits (numbered as in Item 601 of Regulation S-K) (3.1) Articles of Incorporation of Meridian Bancorp, Inc., as amended, incorporated herein by reference to Exhibit 3.1 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1988. (3.2) By-laws of Meridian Bancorp, Inc., as amended, incorporated herein by reference to Exhibit 3.2 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991. (4) Agreement to furnish instruments defining the rights of holders of long-term debt of Meridian Bancorp, Inc. and its consolidated subsidiaries, incorporated herein by reference to Exhibit 4 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991. (9) Voting Trust Agreement (none). (10.1) Meridian Bancorp, Inc. Executive Annual Incentive Plan, as amended, incorporated herein by reference to Exhibit 10.1 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.2) Meridian Bancorp, Inc. Retirement Restoration Plan, as amended, incorporated herein by reference to Exhibit 10.2 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.3) Meridian Bancorp, Inc. Stock Option Plan, as amended, incorporated herein by reference to Exhibit 10.3 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.4) Meridian Bancorp, Inc. Stock Appreciation Rights Plan, incorporated herein by reference to Exhibit 10.4 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1992.* (10.5) Meridian Bancorp, Inc. Directors' Deferred Compensation Plan dated July 1, 1983, incorporated herein by reference to Exhibit 10.8 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1990.* (10.6) Form of Deferred Compensation Agreements entered into on January 12, 1987 between Meridian Bancorp, Inc. and Samuel A. McCullough, incorporated herein by reference to Exhibit 10.6 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.7) Form of Directors' Deferred Compensation Agreement, incorporated herein by reference to Exhibit 10.7 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.8) Termination Agreement between Meridian Bancorp, Inc. and Samuel A. McCullough dated as of July 1, 1986, incorporated herein by reference to Exhibit 10.8 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.9) Termination Agreement between Meridian Bancorp, Inc. and Ezekiel S. Ketchum dated as of July 1, 1986, incorporated herein by reference to Exhibit 10.9 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.10) Termination Agreement between Meridian Bancorp, Inc. and Russell J. Kunkel dated as of July 1, 1986, incorporated herein by reference to Exhibit 10.11 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.11) Termination Agreement between Meridian Bancorp, Inc. and David E. Sparks dated as of January 23, 1990, incorporated herein by reference to Exhibit 10.22 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1990.* (10.12) Meridian Bancorp, Inc. Supplemental Salary Reduction Plan, as amended, incorporated herein by reference to Exhibit 10.14 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.13) Meridian Bancorp, Inc. Supplemental Executive Retirement Plan, incorporated herein by reference to Exhibit 10.15 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.14) Meridian Bancorp, Inc. Executive Intermediate Performance Plan adopted January 1, 1990, incorporated herein by reference to Exhibit 10.23 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1990.* (10.15) Rights Agreement dated as of July 25, 1989 between Meridian Bancorp, Inc. and Meridian Trust Company, incorporated by reference to Exhibit 4 of the Current Report on Form 8-K of the Registrant dated August 11, 1989. (10.16) Lease of The First National Bank of Allentown building dated August 6, 1984, as amended by First Amendment to Lease dated September 25, 1984, incorporated herein by reference to Exhibit 10.9 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1990. (10.17) Purchase and Assumption Agreement dated October 13, 1989 between Resolution Trust Corporation, Receiver of Hill Financial Savings Association and Meridian Financial Savings Association, F.A., incorporated by reference to Exhibit 1 of the Current Report on Form 8-K of the Registrant dated October 27, 1989. (10.18) Preferred Stock Purchase Agreement, dated August 23, 1991, among Meridian Bank, American Title Insurance Company and First Title Insurance Company, incorporated herein by reference to Exhibit 2.2 of the Current Report on Form 8-K of the Registrant dated August 23, 1991. (10.19) Agreement, dated as of March 30, 1993, between Commonwealth Bancshares Corporation and the Registrant, incorporated by reference to Exhibit 2.1 to Registration Statement No. 33-65780 on Form S-4 of the Registrant. (11) Statement regarding Computation of Per Share Earnings (included herein). (12) Statement regarding Computation of Ratios (not applicable). (18) Letter regarding Change in Accounting Principles (not applicable). (19) Previously Unfiled Documents (none). (21) List of Subsidiaries of the Registrant (included herein). (22) Published Report Regarding Matters Submitted to a Vote of Security Holders (none). (23) Consent of KPMG Peat Marwick (included herein). (24) Power of Attorney (none). (28) Information from reports furnished to state insurance regulatory authorities (not applicable). (99) Additional Exhibits (none). ________________________ *Denotes compensatory plan or arrangement. B.1 Reports on Form 8-K. On November 14, 1993, the Registrant filed an amendment to a Current Report on Form 8-K dated August 31, 1993 for the purpose of filing under Item 7 of the Current Report the following financial statements relating to the Registrant's acquisition of Commonwealth Bancshares Corporation: 1. Consolidated Statements of Condition as of December 31, 1992 and 1991, and the Consolidated Statements of Income, Consolidated Statements of Changes in Shareholders' Equity and Consolidated Statements of Cash Flows for the years ended December 31, 1992, 1991 and 1990 of Commonwealth Bancshares Corporation, and the related Notes to Consolidated Financial Statements. 2. Unaudited Consolidated Statement of Condition as of June 30, 1993, the Unaudited Consolidated Statements of Income for the three-month and six- month periods ended June 30, 1993 and 1992, and the Unaudited Consolidated Statements of Cash Flows for the six-month periods ended June 30, 1993 and 1992 of Commonwealth Bancshares Corporation, and the related Notes to Unaudited Consolidated Financial Statements. 3. Pro forma financial statements of the Registrant and Commonwealth Bancshares 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. MERIDIAN BANCORP, INC. (Registrant) /s/ Samuel A. McCullough Samuel A. McCullough, Chairman and Chief Executive Officer Date: March 22, 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 and on the dates indicated. Signature Title Date /s/ Samuel A. McCullough Chairman, Chief March 22, 1994 Samuel A. McCullough Executive Officer and Director (Principal Executive Officer) /s/ David E. Sparks Vice Chairman, March 22, 1994 David E. Sparks Chief Financial Officer and Director (Principal Financial Officer) /s/ Michael J. Mizak, Jr. Senior Vice March 22, 1994 Michael J. Mizak, Jr. President and Controller (Principal Accounting Officer) /s/ Delight E. Breidegam, Jr. Director March 22, 1994 DeLight E. Breidegam, Jr. /s/ Thomas F. Burke, Jr. Director March 22, 1994 Thomas F. Burke, Jr. /s/ Robert W. Cardy Director March 22, 1994 Robert W. Cardy /s/ Harry Corless Director March 22, 1994 Harry Corless /s/ William D. Davis Director March 22, 1994 William D. Davis _____________________________ Director March 22, 1994 Julius W. Erving /s/ Fred D. Hafer Director March 22, 1994 Fred D. Hafer /s/ Joseph H. Jones Director March 22, 1994 Joseph H. Jones _________________________ Director March 22, 1994 Lawrence C. Karlson /s/ Ezekiel S. Ketchum Director March 22, 1994 Ezekiel S. Ketchum /s/ Sidney D. Kline, Jr. Director March 22, 1994 Sidney D. Kline, Jr. /s/ George W. Leighow Director March 22, 1994 George W. Leighow /s/ Joseph F. Paquette, Jr. Director March 22, 1994 Joseph F. Paquette, Jr. /s/ Daniel H. Polett Director March 22, 1994 Daniel H. Polett _____________________________ Director March 22, 1994 Lawrence R. Pugh /s/ Paul R. Roedel Director March 22, 1994 Paul R. Roedel /s/ Wilmer R. Schultz Director March 22, 1994 Wilmer R. Schultz /s/ Robert lB. Seidel Director March 22, 1994 Robert B. Seidel /s/ Judith M. von Seldeneck Director March 22, 1994 Judith M. von Seldeneck _____________________________ Director March 22, 1994 George Strawbridge, Jr. /s/ Anita A. Summers Director March 22, 1994 Anita A. Summers /s/ Earle A. Wootton Director March 22, 1994 Earle A. Wootton EXHIBIT INDEX Page Number Sequentially Numbered Number Description Original - ------ ----------- ------------ (3.1) Articles of Incorporation of Meridian Bancorp, Inc., as amended, incorporated herein by reference to Exhibit 3.1 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1988. (3.2) By-laws of Meridian Bancorp, Inc., as amended, incorporated herein by reference to Exhibit 3.2 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991. (4) Agreement to furnish instruments defining the rights of holders of long- term debt of Meridian Bancorp, Inc. and its consolidated subsidiaries, incorporated herein by reference to Exhibit 4 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991. (9) Voting Trust Agreement (none). (10.1) Meridian Bancorp, Inc. Executive Annual Incentive Plan, as amended, incorporated herein by reference to Exhibit 10.1 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.2) Meridian Bancorp, Inc. Retirement Restoration Plan, as amended, incorporated herein by reference to Exhibit 10.2 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.3) Meridian Bancorp, Inc. Stock Option Plan, as amended, incorporated herein by reference to Exhibit 10.3 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.4) Meridian Bancorp, Inc. Stock Appreciation Rights Plan, incorporated herein by reference to Exhibit 10.4 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1992.* (10.5) Meridian Bancorp, Inc. Directors' Deferred Compensation Plan dated July 1, 1983, incorporated herein by reference to Exhibit 10.8 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1990.* (10.6) Form of Deferred Compensation Agreements entered into on January 12, 1987 between Meridian Bancorp, Inc. and Samuel A. McCullough, incorporated herein by reference to Exhibit 10.6 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.7) Form of Directors' Deferred Compensation Agreement, incorporated herein by reference to Exhibit 10.7 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.8) Termination Agreement between Meridian Bancorp, Inc. and Samuel A. McCullough dated as of July 1, 1986, incorporated herein by reference to Exhibit 10.8 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.9) Termination Agreement between Meridian Bancorp, Inc. and Ezekiel S. Ketchum dated as of July 1, 1986, incorporated herein by reference to Exhibit 10.9 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.10) Termination Agreement between Meridian Bancorp, Inc. and Russell J. Kunkel dated as of July 1, 1986, incorporated herein by reference to Exhibit 10.11 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.11) Termination Agreement between Meridian Bancorp, Inc. and David E. Sparks dated as of January 23, 1990, incorporated herein by reference to Exhibit 10.22 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1990.* (10.12) Meridian Bancorp, Inc. Supplemental Salary Reduction Plan, as amended, incorporated herein by reference to Exhibit 10.14 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.13) Meridian Bancorp, Inc. Supplemental Executive Retirement Plan, incorporated herein by reference to Exhibit 10.15 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1991.* (10.14) Meridian Bancorp, Inc. Executive Intermediate Performance Plan adopted January 1, 1990, incorporated herein by reference to Exhibit 10.23 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1990.* (10.15) Rights Agreement dated as of July 25, 1989 between Meridian Bancorp, Inc. and Meridian Trust Company, incorporated by reference to Exhibit 4 of the Current Report on Form 8-K of the Registrant dated August 11, 1989. (10.16) Lease of The First National Bank of Allentown building dated August 6, 1984, as amended by First Amendment to Lease dated September 25, 1984, incorporated herein by reference to Exhibit 10.9 of the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1990. (10.17) Purchase and Assumption Agreement dated October 13, 1989 between Resolution Trust Corporation, Receiver of Hill Financial Savings Association and Meridian Financial Savings Association, F.A., incorporated by reference to Exhibit 1 of the Current Report on Form 8-K of the Registrant dated October 27, 1989. (10.18) Preferred Stock Purchase Agreement, dated August 23, 1991, among Meridian Bank, American Title Insurance Company and First Title Insurance Company, incorporated herein by reference to Exhibit 2.2 of the Current Report on Form 8-K of the Registrant dated August 23, 1991. (10.19) Agreement, dated as of March 30, 1993, between Commonwealth Bancshares Corporation and the Registrant, incorporated by reference to Exhibit 2.1 to Registration Statement No. 33-65780 on Form S-4 of the Registrant. (11) Statement regarding Computation of Per Share Earnings (included herein). (12) Statement regarding Computation of Ratios (not applicable). (18) Letter regarding Change in Accounting Principles (not applicable). (19) Previously Unfiled Documents (none). (21) List of Subsidiaries of the Registrant (included herein). (22) Published Report Regarding Matters Submitted to a Vote of Security Holders (none). (23) Consent of KPMG Peat Marwick (included herein). (24) Power of Attorney (none). (28) Information from reports furnished to state insurance regulatory authorities (not applicable). (99) Additional Exhibits (none). /TABLE WORD PERFECT SYSTEM Long Document Name: FORM 10-K/MERIDIAN BANCORP, INC. System Document Name: C:\DMS\RDG\WJR\0003006.WP Document Location: Reading Additional Information: scanned and converted from syntrex/FORM 10-K/MERIDIAN BANCORP, INC. DO YOU WANT LINE NUMBERS: ____ yes ____ no RETURN DOCUMENT IN: ____ draft ____ final LINE SPACING: ____ same; ____ 1.0; ____ 1.5; ____ 2.0 NOTE(S) TO NEXT WORD PROCESSING SPECIALIST: EDGAR DOCUMENT - DO NOT USE TABLES OR PARALLEL COLUMNS Origination Date: 3-16-94 Author's Initials: wjr/dws Last WPD Specialist: nb/sm/ems&laz/ems/laz/ems/ems/ems Last Revision Date: 3-17/3-18/3-21/3-21-94/3-22/3-23/3-23 Paragraph Outline: 1 = 2 = 3 = 4 = 5 = 6 = 7 = 8 =

40211_1993.txt

40211_1993

1993

40211

Item 1. Business GATX Corporation is a holding company whose subsidiaries engage in the leasing and management of railroad tank cars and specialized freight cars; provide equipment and capital asset financing and related services; own and operate tank storage terminals, pipelines and related facilities; engage in Great Lakes shipping; and provide distribution and logistics support services, warehousing facilities, and related real estate services. Information concerning financial data of business segments and the basis for grouping products or services is contained in Exhibit 13, GATX Annual Report to Shareholders for the year ended December 31, 1993 on page 27 and pages 32 through 35, which is incorporated herein by reference (page references are to the Annual Report to Shareholders). 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. The following table sets forth the approximate tank car fleet capacity of Transportation as of the end of each of the years indicated and the number of cars of all types added to Transportation's fleet during such 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 Services 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. Financial Services GATX Financial Services, through its principal subsidiary, GATX Capital Corporation, provides asset-based financing of transportation and industrial equipment through capital leases, secured equipment loans, and operating leases. GATX Capital also provides related financial services which include the arrangement of lease transactions for investment by other lessors and the management of lease portfolios for third parties. In these underwriting and management activities, GATX Capital seeks fee income and residual participation income. In addition to its San Francisco headquarters, GATX Capital has offices in six foreign countries. The financial services industry is both crowded and efficient. GATX Capital is one of the larger non-bank capital services companies. Capital competes with captive leasing companies, leasing subsidiaries of commercial banks, independent leasing companies, lease underwriters and brokers, investment bankers, and also with the manufacturers of equipment. Financing companies compete on the basis of service and effective rates. GATX Capital participates in selected areas where it believes the application of its strengths can result in above-market returns in exchange for assuming appropriate levels of risk. GATX Capital has developed a portfolio of assets diversified across industries and equipment classifications, the largest of which include air and rail. At December 31, 1993, GATX Capital had approximately 750 financing contracts with 500 customers, aggregating $1.3 billion of investments before reserves. Of this amount, 47% consisted of investments associated with commercial jet aircraft, 15% railroad equipment, 8% real estate, 8% golf courses, 7% warehouse and production equipment, 6% marine equipment and 9% other equipment. 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. Great Lakes Shipping American Steamship Company (ASC), with the largest carrying capacity of the domestic Great Lakes vessel fleets, provides modern and efficient waterborne transportation of dry bulk materials to the integrated steel, electric utility and construction industries. ASC's fleet is entirely comprised of self- unloading vessels which do not require any shoreside assistance to discharge cargo. ASC's eleven vessels range in size from 635 feet to 1,000 feet, transport cargoes from 17,000 net tons up to 70,000 net tons depending on vessel size, and can unload at speeds from 2,800 net tons per hour up to 10,000 net tons per hour. Because the Great Lakes are fresh water, Great Lakes vessels are not subject to the severe rusting condition typical of salt water vessels. As a result, ASC's vessels have expected lives of 50 to 75 years. In 1993, ASC carried 24.4 million tons of cargo. The primary materials ASC transported were iron ore, coal and limestone aggregates. Other commodities transported include sand, salt, potash, gypsum, marble chips and slag. ASC competes with three other U.S. flag Great Lakes commercial fleets, which include U.S.S. Great Lakes Fleet, Inc., Columbia Transportation, and Interlake Steamship, and with all steel companies which operate captive fleets. Great Lakes shipping is the only major activity of GATX which consumes substantial quantities of petroleum products; fuel for these operations is presently in adequate supply. Competition is based primarily on service and price. ASC is headquartered in Buffalo, New York, with one regional office. No single customer accounts for more than 21% of ASC's revenue. Logistics and Warehousing GATX Logistics, Inc. (Logistics) is the largest third-party provider in the United States of distribution and logistics support services, warehousing facilities, and related real estate services. Logistics operates 119 facilities and approximately 22 million square feet of warehousing space in North America with utilization of 94 percent at the end of 1993. Value-adding services are strategically the most important benefit GATX Logistics provides. Examples of these services are logistics planning, information systems, just-in-time delivery systems, packaging, sub-assembly, and returns management. GATX Logistics serves about 750 customers, many of which are Fortune 1000-type companies. Most customers are manufacturers, but the customer base also includes retailers. In the warehousing sector, GATX Logistics competes primarily with in-house or private operations and with other national operators as well as multi-regional and local operators. In providing transportation and logistics services, GATX Logistics competes with the major trucking companies and providers of specialized distribution services. GATX Logistics' revenue source by industry served during 1993 was 30% consumer products, 20% grocery, 11% farm and construction equipment, 10% motor vehicle parts and components, 5% major appliances, 5% health care, 4% electronics and 15% other. No single customer accounts for more than 8% of Logistics' revenue. Trademarks, Patents and Research Activities Patents, trademarks, licenses, and research and development activities are not material to these businesses taken as a whole. Seasonal Nature of Business Great Lakes shipping is seasonal due to the effects of winter weather conditions. However, seasonality is not considered significant to the operations of GATX and its subsidiaries taken as a whole. Customer Base GATX 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 GATX as a whole. Employees GATX and its subsidiaries have approximately 5,500 active employees, of whom 25% are hourly employees covered by union contracts. Environmental Matters Certain of GATX'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, GATX is committed to protecting the environment, as well as complying with applicable environmental protection laws and regulations. GATX, 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, GATX's foreign operations are subject to environmental regulations in effect in each respective jurisdiction. GATX's policy is to monitor and actively address environmental concerns in a responsible manner. GATX 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, GATX 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, GATX 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, GATX's total clean-up costs at these sites cannot be predicted with certainty; however, GATX'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, GATX 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. In addition, GATX has provided indemnities for environmental issues to the buyers of two divested companies for which GATX believes it has adequate reserves. GATX's environmental reserve at the end of 1993 was $81 million and reflects GATX'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, GATX 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 GATX will make annual expenditures at a similar level over the next five years for regulatory and environmental requirements. Item 2. Item 2. Properties Information regarding the location and general character of certain properties of GATX is included in Item 1, Business, of this document. The major portion of Terminals' land is owned; the balance is leased. Most of the warehouses operated by GATX Logistics are leased; the others are managed for third parties. 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 General American Transportation Corporation (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. Further, 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 GATX'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, GATX 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 GATX 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 GATX's consolidated financial position or results of operations. In October 1991, GATX and five of its senior officers were named as defendants in Searls vs. Glasser, et al, filed in the U.S. District Court for the Northern District of Illinois, a class action filed on behalf of certain purchasers of GATX's common stock alleging violation of the securities laws, common law fraud and negligent misrepresentation in various public statements made by GATX during 1991 concerning 1992 forecasted earnings. Upon the completion of extensive discovery, GATX filed a motion for summary judgment which the court has taken under consideration. GATX believes that it has a strong defense and that the complaint is without merit. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. Executive Officers of the Registrant Pursuant to General Instruction G(3), the following information regarding executive officers is included in Part I in lieu of inclusion in the GATX Proxy Statement: Office Held Name Office Held Since Age James J. Glasser Chairman of the Board, President and Chief Executive Officer 1978 59 John F. Chlebowski, Jr.Vice President, Finance and 1985 48 Chief Financial Officer William L. Chambers Vice President, Human Resources 1993 56 Paul A. Heinen Vice President, General Counsel and Secretary 1981 63 Ralph L. O'Hara Controller 1986 49 E. Paul Dunn, Jr. Treasurer 1990 40 Officers are elected annually by the Board of Directors. Previously, Mr. Chambers was the Senior Vice President of Human Resources and Corporate Relations for Beatrice Company from 1986 to 1990. From 1991 until 1993, Mr. Chambers was engaged in human resource consulting. Previously, Mr. Dunn was Assistant Treasurer of The Hertz Corporation from 1985-1990. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Shareholder Matters Information required by this item is contained in Exhibit 13, GATX Annual Report to Shareholders for the year ended December 31, 1993 on page 59, which is incorporated herein by reference (page reference is to the Annual Report to Shareholders). Item 6. Item 6. Selected Financial Data Information required by this item is contained in Exhibit 13, GATX Annual Report to Shareholders for the year ended December 31, 1993, on pages 60 and 61, which is incorporated herein by reference (page references are to the Annual Report to Shareholders). Item 7. Item 7. Management Discussion and Analysis of Financial Condition and Results of Operations Information required by this item is contained in Item 1, Businss, section of this document and in Exhibit 13, GATX Annual Report to Shareholders for the year ended December 31, 1993, the management discussion and analysis on pages 29, 30, 31, 37, 39, 41 and 42, the financial data of business segments on pages 32 through 35, and the discussion of 1992 and 1991 operations on pages 62 and 63, which is incorporated herein by reference (page references are to the Annual Report to Shareholders). Item 8. Item 8. Financial Statements and Supplementary Data The following consolidated financial statements of GATX Corporation, included in Exhibit 13, GATX Annual Report to Shareholders for the year ended December 31, 1993, which is incorporated herein by reference (page references are to the Annual Report to Shareholders): Statements of Consolidated Income and Reinvested Earnings -- Years ended December 31, 1993, 1992 and 1991, on page 36. Consolidated Balance Sheets -- December 31, 1993 and 1992, on page 38. Statements of Consolidated Cash Flows -- Years ended December 31, 1993, 1992 and 1991, on page 40. Notes to Consolidated Financial Statements on pages 43 through 58. Quarterly results of operations are contained in Exhibit 13, GATX Annual Report to Shareholders for the year ended December 31, 1993 on page 59, which is incorporated herein by reference (page reference is to the Annual Report to Shareholders). 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 required by this item regarding directors is contained in sections entitled "Nominees For Directors" and "Additional Information Concerning Nominees" in the GATX Proxy Statement dated March 11, 1994, which sections are incorporated herein by reference. Information regarding officers is included at the end of Part I. Item 11. Item 11. Executive Compensation Information required by this item regarding executive compensation is contained in sections entitled "Compensation of Directors" and "Compensation of Executive Officers" in the GATX Proxy Statement dated March 11, 1994, which sections are incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information required by this item regarding the Company's Common Stock is contained in sections entitled "Nominees For Directors," "Security Ownership of Management" and "Beneficial Ownership of Common Stock" in the GATX Proxy Statement dated March 11, 1994, which sections are incorporated herein by reference. The following are the only persons known to the Company who beneficially owned as of March 4, 1994 more than 5% of the Company's $3.875 Cumulative Convertible Preferred Stock ("CCP Stock"): Item 13. Item 13. Certain Relationships and Related Transactions None. PART IV Item 14. Item 14. Financial Statement Schedules, Reports on Form 8-K and Exhibits. a) 1. -Financial Statements The following consolidated financial statements of GATX Corporation included in the Annual Report to Shareholders for the year ended December 31, 1993, are filed in response to Item 8: Statements of Consolidated Income and Reinvested Earnings -- Years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets -- December 31, 1993 and 1992 Statements of Consolidated Cash Flows -- Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. -Financial Statement Schedules: Page Schedule IIICondensed Financial Information of Registrant................ 17 Schedule V Property, Plant and Equipment.............. 21 Schedule VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment................................ 25 Schedule VIIIValuation and Qualifying Accounts ......... 29 Schedule IX Short-Term Borrowings...................... 30 Schedule X Supplementary Income Statement Information. 31 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) EXHIBIT INDEX Exhibit Number Exhibit Description Page 3A. Restated Certificate of Incorporation of GATX Corporation, as amended, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 1-2328. 3B. Bylaws of GATX Corporation, as amended, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, file number 1-2328. 4A. Rights Agreement dated as of May 15, 1986, as amended and restated as of June 2, 1989, between GATX Corporation and Manufacturers Hanover Trust Company, as Rights Agent, incorporated by reference to Exhibit 4 contained in GATX's Amendment on Form 8 dated July 14, 1989, to its Registration Statement on Form 8-A, file number 1-2328. 10A. GATX Corporation 1980 Long Term Incentive Compensation Plan, as amended, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 1-2328. 10B. GATX Corporation 1985 Long Term Incentive Compensation Plan, as amended, and restated as of April 27, 1990, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, file No. 1-2328. Amendment to said Plan effective as of April 1, 1991, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 1-2328. 10C. Management Incentive Compensation Plan dated January 1, 1993, file number 1-2328, submitted to the SEC along with the electronic submission of this Report on Form 10-K. 10D. GATX Corporation Deferred Fee Plan for Directors, effective April 1982, as amended, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 1-2328. 10E. 1984 Executive Deferred Income Plan Participation Agreement between GATX Corporation and participating directors and executive officers dated September 1, 1984, as amended, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 1-2328. EXHIBIT INDEX - CONTINUED Exhibit Number Exhibit Description Page 10F. 1985 Executive Deferred Income Plan Participation Agreement between GATX Corporation and participating directors and executive officers dated July 1, 1985, as amended, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 1-2328. 10G. 1987 Executive Deferred Income Plan Participation Agreement between GATX Corporation and participating directors and executive officers dated December 31, 1986, as amended, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 1-2328. 10H. Amendment to Executive Deferred Income Plan Participation Agreements between GATX and certain participating directors and participating executive officers entered into as of January 1, 1990, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, file number 1-2328. 10I. Retirement Supplement to Executive Deferred Income Plan Participation Agreements entered into as of January 23, 1990, between GATX and certain participating directors incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, file number 1-2328 and between GATX and certain other participating directors incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, file number 1-2328. 10J. Amendment to Executive Deferred Income Plan Participation Agreements between GATX and participating executive officers entered into as of April 23, 1993. Submitted to the SEC along with the electronic submission of this Report on Form 10-K. 10K. Agreement for Continued Employment Following Change of Control or Disposition of a Subsidiary between GATX Corporation and certain executive officers dated as of January 1, 1992, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 1-2328 and between GATX and an additional executive officer dated as of January 1, 1992, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, file number 1-2328. EXHIBIT INDEX - CONTINUED Exhibit Number Exhibit Description Page 10L. Letter agreement dated March 5, 1986, between GATX Corporation and an executive officer of GATX, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, file number 1-2328. 10M. Letter agreement dated June 5, 1987, between GATX Corporation and an executive officer of GATX, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, file number 1-2328. 10N. Director Retirement Plan effective January 1, 1992, incorporated by reference to GATX's Annual Report on Form 10- K for the fiscal year ended December 31, 1992, file number 1- 2328. 11. Statements regarding computation of net income (loss) per share. 32-33 12. Statement regarding computation of ratios of earnings to combined fixed charges and preferred stock dividends.34 13. Annual Report to Shareholders for the year ended December 31, 1993, pages 27-65, with respect to the Annual Report on Form 10-K for the fiscal year ended December 31, 1993, file number 1-2328. Submitted to the SEC along with the electronic submission of this Report on Form 10-K. 22. Subsidiaries of the Registrant. 35 24. Consent of Independent Auditors. 36 25. Powers of Attorney with respect to the Annual Report on Form 10-K for the fiscal year ended December 31, 1993, file number 1-2328. Submitted to the SEC along with the electronic submission of this Report on Form 10-K. 28A. Undertakings to the GATX Corporation 1980 Long Term Incentive Plan, incorporated by reference to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1982, file number 1-2328. 28B. Undertakings to the GATX Corporation Salaried Employees Retirement Savings Plan, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1982, file number 1-2328. 28C. Undertakings to the GATX Corporation 1985 Long Term Incentive Plan, incorporated by reference to GATX's Annual Report on Form 10-K for the fiscal year ended December 31, 1985, file number 1-2328. REPORT OF INDEPENDENT AUDITORS To the Shareholders and Board of Directors GATX Corporation We have audited the consolidated financial statements and related schedules of GATX Corporation and subsidiaries listed in Item 14 (a)(1) and (2) of the Annual Report on Form 10-K of GATX Corporation for the year ended December 31, 1993. These financial statements and related schedules are the responsibility of GATX'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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of GATX 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, in our opinion, the related financial statements 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 the postretirement benefits other than pensions and income taxes. ERNST & YOUNG Chicago, Illinois January 25, 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. GATX CORPORATION (Registrant) /s/James J. Glasser ------------------------------- James J. Glasser Chairman of the Board, President and Chief Executive Officer 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/James J. Glasser ---------------------- James J. Glasser Chairman of the Board, President March 21, 1994 and Chief Executive Officer /s/John F. Chlebowski, Jr. ------------------------- John F. Chlebowski, Jr. Vice President, Finance and March 21, 1994 Chief Financial Officer /s/Ralph L. O'Hara ---------------------- Ralph L. O'Hara Controller and March 21, 1994 Principal Accounting Officer Weston R. Christopherson Director Franklin A. Cole Director James W. Cozad Director By /s/Paul A. Heinen Robert J. Day Director (Paul A. Heinen, James L. Dutt Director Attorney-in-Fact) Deborah M. Fretz Director Richard A. Giesen Director Charles Marshall Director Michael E. Murphy Director Marcia T. Thompson Director Date: March 21, 1994 SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT GATX CORPORATION (PARENT COMPANY) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONT'D) GATX CORPORATION (PARENT COMPANY) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONT'D) GATX CORPORATION (PARENT COMPANY) See notes to Schedule V on page 24. See notes to Schedule V on page 24. See notes to Schedule V on page 24. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (CONT'D) GATX CORPORATION AND SUBSIDIARIES Note A - The estimated useful lives of depreciable assets are as follows: Railcars 20 - 33 years Great Lakes vessels 30 - 40 years Buildings, leasehold improvements, storage tanks and pipelines 5 - 45 years Machinery and related equipment 3 - 20 years Operating lease investments 3 - 40 years Note B - Represents primarily the sale leaseback of certain railcar additions. Note C - Represents adjustments associated with transfers and reclassifications of certain facilities and other assets, and foreign currency translation adjustments. Note D - Represents adjustments associated with transfers and reclassifications of operating lease assets and in 1993 represents primarily the sale leaseback of a rail equipment portfolio. Note E - Primarily represents expiration of capital lease related to one of the vessels. Note F - Represents primarily asset values assigned to GATX Logistics' acquisitions. See notes to Schedule VI on page 28. See notes to Schedule VI on page 28. See notes to Schedule VI on page 28. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D) GATX 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. Note C - Represents adjustments associated with transfers and reclassifications of operating lease assets.

27673_1993.txt

27673_1993

1993

27673

ITEM 1. BUSINESS. THE COMPANY The principal business of John Deere Capital Corporation (Capital Corporation) is the purchasing and financing of retail installment sales and loan contracts (retail notes) from the equipment sales branches in the United States operated by Deere & Company and its wholly-owned subsidiaries (collectively called John Deere). These notes are acquired by the sales branches through John Deere retail dealers in the United States and originate in connection with retail sales by dealers of new John Deere agricultural equipment, industrial equipment and lawn and grounds care equipment, as well as used equipment. The Capital Corporation and its subsidiaries also purchase and finance retail notes unrelated to John Deere equipment, representing primarily recreational vehicle and recreational marine product notes acquired from independent dealers of those products and from marine mortgage service companies (recreational product retail notes). The Capital Corporation and its subsidiaries also lease John Deere equipment to retail customers, finance and service unsecured revolving charge accounts acquired from merchants in the agricultural, lawn and grounds care and marine retail markets, and provide wholesale financing for recreational vehicles and John Deere engine inventories held by dealers of those products. The Capital Corporation and its subsidiaries: Deere Credit, Inc., Farm Plan Corporation, Deere Credit Services, Inc. and John Deere Receivables, Inc. are collectively called the Company. John Deere Credit Company, a wholly-owned finance holding subsidiary of Deere & Company, is the parent of the Capital Corporation. Retail notes, revolving charge accounts, financing leases and wholesale notes receivable are collectively called "Receivables." Receivables and operating leases are collectively called "Receivables and Leases." The Capital Corporation was incorporated under the laws of Delaware and commenced operations in 1958. At January 1, 1994, the Company had 852 full- and part-time employees. BUSINESS OF JOHN DEERE John Deere's operations are categorized into five business segments: John Deere's worldwide AGRICULTURAL EQUIPMENT segment manufactures and distributes a full range of equipment used in commercial farming -- including tractors; tillage, soil preparation, planting and harvesting machinery; and crop handling equipment. John Deere's worldwide INDUSTRIAL EQUIPMENT segment manufactures and distributes a broad range of machines used in construction, earthmoving and forestry -- including backhoe loaders; crawler dozers and loaders; four-wheel-drive loaders; scrapers; motor graders; excavators; and log skidders. This segment also includes the manufacture and distribution of engines and drivetrain components for the original equipment manufacturer (OEM) market. John Deere's worldwide LAWN AND GROUNDS CARE EQUIPMENT segment manufactures and distributes equipment for commercial and residential uses - including small tractors for lawn, garden and utility purposes; riding and walk-behind mowers; golf course equipment; utility transport vehicles; snowblowers; and other outdoor power products. The products produced by the equipment segments are marketed primarily through independent retail dealer networks. The CREDIT segment includes the operations of the Company (described herein), the Company's parent, John Deere Credit Company, and John Deere Finance Limited, which primarily purchases and finances retail notes from John Deere's equipment sales branches in Canada. The INSURANCE AND HEALTH CARE segment issues policies in the United States and Canada primarily for: a general line of property and casualty insurance to John Deere and non-Deere dealers and to the general public; group life and group accident and health insurance for employees of participating John Deere dealers; group life and group accident and health insurance for employees of John Deere; life and annuity products to the general public and credit physical damage insurance in connection with certain retail sales of John Deere products financed by the credit subsidiaries. This segment also provides health management programs and related administrative services in the United States to corporate customers and employees of John Deere. John Deere's total worldwide net sales and revenues in 1993 and 1992, which include net sales of agricultural equipment, industrial equipment and lawn and grounds care equipment and revenues from credit, insurance and health care operations, were as follows: total net sales and revenues, $7.8 billion and $7.0 billion; total sales of equipment, $6.5 billion and $5.7 billion; agricultural equipment sales, $4.1 billion and $3.8 billion; industrial equipment sales, $1.3 billion and $1.0 billion; and lawn and grounds care equipment sales, $1.1 billion and $.9 billion, respectively. John Deere believes that its worldwide sales of agricultural equipment during recent years have been greater than those of any other business enterprise. It also believes that it is an important provider of most of the types of industrial equipment that it markets and a leader in some size ranges. John Deere also believes that it is the largest manufacturer of lawn and garden tractors and provides the broadest line of grounds care equipment in North America. John Deere's 1993 worldwide income before the effects of special items (accounting changes, restructuring charges and the new United States tax law) was $286 million compared with $37 million in 1992. Additional information concerning the special items is presented in the Deere & Company Annual Report on Form 10-K for the fiscal year ended October 31, 1993. John Deere's improved 1993 results were mainly attributable to North American equipment operations. Sales and production volumes in North America were higher this year in response to increased retail demand. Price realization also improved in all of John Deere's North American equipment businesses compared with 1992 as sales incentive cost levels were significantly lower. Also, North American productivity continued to improve during 1993. Additionally, income of John Deere's financial services subsidiaries was significantly higher in 1993 compared with 1992. After the effects of restructuring charges, the incremental expenses from the accounting changes and the tax rate change, John Deere's worldwide income in 1993 was $184 million. John Deere incurred a worldwide net loss in 1993 of $921 million after all of the special items, including the cumulative effect of the accounting changes. North American agricultural economic conditions were generally more favorable in 1993 than in 1992. Although flooding and excessively wet conditions in certain areas of the Midwest and drought conditions in parts of the Southeast resulted in an estimated 31 percent decrease in corn production and a 16 percent decline in soybean production in 1993, United States farm net cash income is expected to achieve a record level in 1993. The lower production caused grain prices to rise above 1992 levels. Livestock producers enjoyed favorable prices and profit margins during 1993 and farmers boosted their cash flow by selling inventories accumulated from record corn and soybean yields in 1992. Additionally, direct government payments to farmers are expected to increase in 1993, aiding farmers most heavily impacted by this year's flooding. Uncertainties over the passage of a new investment tax credit were resolved in 1993 as the anticipated tax credit was not included in the final tax legislation. Consequently, many United States farmers who had delayed making purchases in 1992 bought equipment this year. Sales in Canada were boosted by a special 13-month investment tax credit in effect from December 1992 to December 1993. As a result of these developments, North American retail sales of John Deere agricultural equipment were considerably higher in 1993 compared with last year. The North American general economy continued its slow expansion in 1993. In the United States, housing starts increased about five percent during the year with second-half strength overcoming a very sluggish first half. Real public construction was up slightly from the previous year's level while nonresidential construction was flat. However, the cumulative effects of the rebound in economic activity were felt in 1993, as housing starts were up more than 25 percent from their 1991 level and real public construction was nine percent larger. North American retail sales of industrial and construction machinery for both the industry and John Deere rose significantly in 1993. Consumer spending for durable goods rose briskly in 1993, and North American retail sales of John Deere lawn and grounds care equipment increased significantly. Sales were also supported by favorable moisture conditions over most areas throughout the prime selling season. However, dry conditions did emerge in portions of the Southeast and Northeast which impeded some late season buying activity. Industry retail sales of agricultural equipment in overseas markets in general remained relatively weak during 1993. However, overseas retail sales of John Deere agricultural equipment were higher in 1993 than in 1992, reflecting good acceptance of John Deere's new tractors and combines. Despite recessionary conditions prevailing in most European markets and in Japan, overseas retail sales of John Deere lawn and grounds care equipment continued to expand in 1993. Overseas industrial and construction equipment markets were relatively flat in 1993 compared with 1992. RELATIONSHIPS OF THE COMPANY WITH JOHN DEERE The operations and results of the Company are affected by its relationships with John Deere, including, among other things, the terms on which the Company acquires Receivables and Leases and borrows funds from John Deere, the reimbursement for waiver and low-rate finance programs from John Deere and the payment to John Deere for various expenses applicable to the Company's operations. In addition, the Capital Corporation and John Deere have joint access to all of the Capital Corporation's bank lines of credit. The Company's acquisition of Receivables and Leases is largely dependent upon the level of retail sales and leases of John Deere products. The level of John Deere retail sales and leases is responsive to a variety of economic, financial, climatic and other factors which influence demand for its products. Since 1986, the Company has also been providing retail sales financing through dealers of certain unrelated manufacturers of recreational vehicles and recreational marine products. The net balance of recreational product retail notes outstanding under these arrangements at October 31, 1993 totaled $804 million. The Company bears all of the credit risk (net of recovery from withholdings from certain John Deere dealers and Farm Plan merchants) associated with its holding of Receivables and Leases, and performs all servicing and collection functions. The Company compensates John Deere for originating retail notes and leases on John Deere products or through John Deere dealers. John Deere is also reimbursed for staff and other administrative services at estimated cost, and for credit lines provided to the Company based on utilization of those lines. The terms of retail notes and the basis on which the Company acquires retail notes from John Deere are governed by agreements with the sales branches, terminable by either the sales branches or the Company on 30 days notice. As provided in these agreements, the Company sets its terms and conditions for purchasing the retail notes from the sales branches. Under these agreements, the sales branches are not obligated to sell retail notes to the Company, and the Company is obligated to purchase retail notes from the sales branches only if the notes comply with the terms and conditions set by the Company. The terms of retail notes and the basis on which the sales branches acquire retail notes from the dealers are governed by agreements with the independent John Deere dealers, terminable at will by either the dealers or the sales branches. In acquiring the retail notes from dealers, the terms and conditions, as set forth in agreements with the dealers, conform with the terms and conditions adopted by the Company in determining the acceptability of retail notes to be purchased from the sales branches. The dealers are not obligated to send retail notes to the sales branches, and the sales branches are not obligated to accept retail notes from the dealers. In practice, retail notes are acquired from dealers only if the terms of the notes and the creditworthiness of the customers are acceptable to the Company for purchase of the notes from the sales branches. The Company acts on behalf of both itself and the sales branches in determining the acceptability of the notes and in acquiring acceptable notes from dealers. The terms of leases, and the basis on which the Company enters into such leases with retail customers through John Deere dealers, are governed by agreements between dealers and the Company. Leases are accepted based on the lessees' creditworthiness, the anticipated residual values of the equipment and the intended uses of the equipment. Deere & Company has expressed an intention of conducting its business with the Company on such terms that the Company's consolidated ratio of earnings before fixed charges to fixed charges will not be less than 1.05 to 1 for any fiscal quarter. For 1993, the ratio was 1.99 to 1 (excluding the effects of accounting changes) and for 1992, it was 1.74 to 1. For additional information concerning these accounting changes, see note 1 to the consolidated financial statements. This arrangement is not intended to make Deere & Company responsible for the payment of obligations of the Company. DESCRIPTION OF RECEIVABLES AND LEASES Receivables and Leases arise mainly from the retail sale or lease (including the sale to John Deere dealers for rental to users) of John Deere products, used equipment accepted in trade for them, and equipment of unrelated manufacturers, and also include revolving charge accounts receivable and wholesale notes receivable. The great majority derive from retail sales and leases of agricultural equipment, industrial equipment and lawn and grounds care equipment sold by John Deere dealers. The Company also offers financing to recreational product customers through the secured retail financing of recreational vehicles and recreational marine products. The Company also offers Farm Plan revolving charge accounts which are used primarily by agri-businesses to finance customer purchases, as well as credit cards which are used primarily by retail customers to finance purchases of John Deere lawn and grounds care equipment and marine equipment. Retail notes provide for retention by John Deere or the Company of security interests under certain statutes, including the Uniform Commercial Code or comparable state statutes, certain Federal statutes, and state motor vehicle laws. See notes 1 and 2 to the consolidated financial statements. Recreational product retail notes conform to industry standards different from those for John Deere retail notes and often have smaller down payments and longer repayment terms. In addition, the volumes, margins, and collectibility of recreational product retail notes are affected by different economic, marketing and competitive factors and cycles, such as fluctuations in fuel prices and recreational spending patterns, than those affecting retail notes arising from the sale of John Deere equipment. Recreational product retail notes are acquired from more than 1,400 recreational vehicle dealers throughout the United States, representing a variety of manufacturers, and from approximately 900 marine product dealers. Receivables and Leases are eligible for acceptance if they conform to prescribed finance and lease plan terms. Guidelines relating to down payments and contract terms on retail notes and leases are described in note 2 to the consolidated financial statements. The John Deere Credit Revolving Plan is used primarily by retail customers of John Deere dealers to finance purchases of John Deere lawn and grounds care equipment. Additionally, through its Farm Plan credit product, the Company finances revolving charge accounts offered by approximately 2,100 participating agri-businesses in the 48 contiguous states to their retail customers for the purchase of goods and services. Farm Plan account holders consist mainly of farmers purchasing equipment parts and service at implement dealerships. Farm Plan revolving charge accounts are also used by customers patronizing other agribusinesses, including farm supply, feed and seed, parts supply, bulk fuel, building supply and veterinarians. John Deere Marine Finance is used by the Company's marine customers to finance the purchase of marine related products. See notes 1 and 2 to the consolidated financial statements under "Revolving Charge Accounts Receivable." The Company finances recreational vehicle inventories and John Deere engines for approximately 300 dealers. A portion of the wholesale financing provided by the Company is with dealers from whom it also purchases recreational product retail notes. See notes 1 and 2 to the consolidated financial statements under "Wholesale Receivables." The Company requires that theft and physical damage insurance be carried on all equipment leased or securing retail notes. The customer may, at his own expense, have the Company purchase this insurance or obtain it from other sources. Theft and physical damage insurance is also required on wholesale notes and can be purchased through the Company or from other sources. If the customer elects to purchase theft and physical damage insurance through the Company, the Company purchases it from insurance subsidiaries of Deere & Company. Insurance is not required for revolving charge accounts. In some circumstances, Receivables and Leases may be accepted and acquired even though they do not conform in all respects to the established guidelines. Acceptability and servicing of retail notes, wholesale notes and leases, according to the finance plans and retail terms, including any waiver of conformity with such plans and terms, is determined by Company personnel. Officers of the Company are responsible for reviewing the performance of the Company in accepting and collecting retail notes, wholesale notes and leases. The Company normally makes all routine collections, compromises, settlements and repossessions on Receivables and Leases. FINANCE RATES ON RETAIL NOTES As of October 31, 1993, approximately 57 percent of the net dollar value of retail notes held by the Company bore a variable finance rate. Recreational product retail notes are primarily fixed-rate notes. A portion of the finance income earned by the Company arises from retail sales of John Deere equipment sold in advance of the season of use or in other sales promotions by John Deere on which finance charges are waived by John Deere for a period from the date of sale to a specified subsequent date. Some low-rate financing programs are also offered by John Deere. The Company receives compensation from John Deere approximately equal to the normal net finance charge on retail notes for periods during which finance charges have been waived or reduced. The portions of the Company's finance income earned that were received from John Deere on retail notes containing waiver of finance charges or reduced rates was 19 percent in 1993 and 17 percent in 1992. RECEIVABLES AND LEASES ACQUIRED AND HELD Receivable and Lease acquisitions during the fiscal years ended and amounts held at October 31, 1993 and 1992 were as follows in millions of dollars: John Deere equipment note acquisitions were slightly lower in the current year due primarily to a larger volume of cash purchases by John Deere customers and a more competitive agricultural financing environment. Lower acquisitions of agricultural and lawn and grounds care equipment notes were partially offset by higher acquisitions of industrial equipment notes. Acquisitions of recreational product retail notes were 20 percent lower in the current year due to a more competitive market for recreational product financing. The Company's business is somewhat seasonal, with overall acquisitions of credit receivables traditionally higher in the second half of the fiscal year than in the first half, and overall collections of credit receivables traditionally somewhat higher in the first six months than in the last half of the fiscal year. From time to time, the Capital Corporation sells retail notes to other financial institutions and in the public market. The Capital Corporation received net proceeds from such sales of John Deere retail notes of $1.143 billion in 1993 and $683 million in 1992. The net unpaid balance of all retail notes previously sold was $1.394 billion at October 31, 1993 and $688 million at October 31, 1992. For additional information on the terms, conditions, recourse and accounting for such sales, see note 2 to the consolidated financial statements. AVERAGE ORIGINAL TERM AND AVERAGE LIFE OF RETAIL NOTES AND LEASES The following table shows the estimated average original term in months (based on dollar amounts) for retail notes and leases acquired by the Company during 1993 and 1992: Because of prepayments, the average actual life of retail notes is considerably shorter than the average original term. The following table shows the estimated average life in months (based on dollar amounts) for John Deere retail notes and leases liquidated in 1993 and 1992: DEPOSITS WITHHELD ON RECEIVABLES AND LEASES Generally, the Company has limited recourse against certain John Deere dealers on retail notes and leases and against certain Farm Plan merchants on revolving charge account balances acquired from or through those dealers and merchants. For these John Deere dealers and Farm Plan merchants, separate withholding accounts are maintained by the Company. The total amount of deposits withheld from John Deere dealers and Farm Plan merchants totaled $104.9 million and $100.7 million at October 31, 1993 and 1992, respectively. Of this amount, deposits withheld from Farm Plan merchants totaled $.4 million at October 31, 1993 and $ .8 million at October 31, 1992. Credit losses are charged against these withheld deposits. To the extent that a loss cannot be absorbed by the deposit withheld from the dealer or merchant from which the retail note, lease or Farm Plan account was acquired, it is charged against the Company's allowance for credit losses. Beginning in January 1992, all industrial equipment retail notes have been accepted on a non-recourse basis, and the withholding of dealer deposits on those notes ceased. See note 1 to the consolidated financial statements. The Company does not withhold deposits on recreational product retail notes, credit card receivables, or wholesale notes acquired. However, an allowance for credit losses has been established by the Company in an amount considered to be appropriate in relation to the Receivables and Leases outstanding. In addition, for wholesale notes relating to recreational vehicles, there are agreements with the recreational vehicle manufacturers for the repurchase of new inventories held by dealers. For additional information on credit losses and deposits withheld on Receivables and Leases, see note 3 to the consolidated financial statements. DELINQUENCIES AND LOSSES RETAIL NOTES. The following table shows unpaid installments 60 days or more past due on retail notes held by the Company and the total unpaid balances on the retail notes with such delinquencies, on the basis of retail note terms in effect at the indicated dates, in millions of dollars and as a percentage of retail notes at face value held by the Company at such dates: The following table shows losses on retail notes in millions of dollars (after charges to withheld dealer deposits) and as a percentage of retail notes liquidated: The decrease in losses in 1993 and 1992 related mainly to lower write-offs of recreational product retail notes, primarily as a result of the development and use of more selective credit criteria over the past few years, and lower write-offs of John Deere industrial equipment retail notes. The losses incurred in 1991 related primarily to recreational product retail notes, resulting from recessionary pressures and lower resale values of repossessed equipment. Write-offs of recreational product retail notes totaled $16.9 million in 1993 compared with $24.2 million in 1992 and $33.3 million in 1991. REVOLVING CHARGE ACCOUNTS. The following table shows revolving charge account payments 60 days or more past due in millions of dollars and as a percentage of total revolving charge accounts receivable: The following table shows losses on revolving charge accounts in millions of dollars and as a percentage of revolving charge amounts liquidated: Losses declined in 1993 and 1992 for both Farm Plan and the John Deere Credit Revolving Plan reflecting improvements in the Company's overall collection procedures and improved economic conditions. The losses incurred in 1991 were due primarily to general recessionary conditions in the economy. LEASES. The following table shows finance and operating lease payments 60 days or more past due in millions of dollars and as a percent of the total lease payments receivable: The following table shows losses absorbed by the Company, in millions of dollars and as a percent of total lease proceeds, on terminated financing and operating leases (after charges to withheld dealer deposits). Total lease proceeds include collections from regularly scheduled lease payments and proceeds from the disposal of equipment. The decline in 1993 losses resulted from improvements in the Company's overall collection procedures and improved economic conditions. The decline in 1992 losses resulted from a more seasoned and smaller lease portfolio. The losses incurred in 1991 related primarily to the overall recessionary environment. WHOLESALE NOTES. The following table shows wholesale note payments 60 days or more past due in millions of dollars and as a percentage of wholesale notes receivable: The following table shows wholesale note losses in millions of dollars and as a percentage of wholesale note amounts liquidated: The losses in 1993 and 1991 resulted primarily from relatively large losses incurred with two recreational vehicle dealers, one in each of those years. COMPETITION The businesses in which the Company is engaged are highly competitive. The Company competes for customers based upon customer service and finance rates (or time-price differentials) charged. The proportion of John Deere equipment retail sales and leases financed by the Company is influenced by conditions prevailing in the agricultural equipment, industrial equipment and lawn and grounds care equipment industries, in the financial markets, and in business generally. A significant portion of such retail sales during 1993 were financed by the Company. A substantial part of the retail sales and leases eligible for financing by the Company is financed by others, including banks and other finance and leasing companies. The Company attempts to emphasize convenient service to retail customers and to offer terms desired in its specialized markets such as seasonal installment schedules of repayment and rental. The Company's sales and loan finance rates, time-price differentials and lease rental rates are believed to be in the range of those of sales finance and leasing companies generally, although not as low as those of some banks and other lenders and lessors. REGULATION In a number of states, the maximum finance rate or time-price differential on retail notes is limited by state law. The present state limitations have not, thus far, significantly limited the Company's variable-rate finance charges, which are determined in relation to a base rate quoted by a bank, nor the fixed-rate finance charges established by the Company. However, if interest rate levels should increase, maximum state rates or time-price differentials could affect the Company by preventing the variable rates on outstanding variable-rate retail notes from increasing above the maximum state rate or time-price differential, and/or by limiting the fixed rates or time-price differentials on new notes. In some states, the Company may be able to qualify new retail notes for a higher maximum limit by using retail installment sales contracts (rather than loan contracts) or by using fixed-rate rather than variable-rate contracts. In addition to rate regulation, various state and federal laws and regulations apply to some Receivables and Leases, principally retail notes for goods sold for personal, family or household use and to Farm Plan and John Deere revolving charge accounts receivable for such goods. To date, such laws and regulations have not had a significant, adverse effect on the Company. ITEM 2. ITEM 2. PROPERTIES. The Company's properties principally consist of office equipment and leased office space in Reno, Nevada; West Des Moines, Iowa; Moline, Illinois; Madison, Wisconsin; and Ft. Lauderdale, Florida. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is subject to various unresolved legal actions which arise in the normal course of its business. The most prevalent of such actions relates to state and federal regulations concerning retail credit. There are various claims and pending actions against the Company with respect to commercial and consumer financing matters. These matters include lawsuits pending in federal and state courts in Texas alleging that certain of the Company's retail finance contracts for recreational vehicles and boats violate certain technical provisions of Texas consumer credit statutes dealing with maximum rates, licensing and disclosures. The plaintiffs in Texas claim they are entitled to common law and statutory damages and penalties. On November 6, 1992, the federal District Court certified a federal class action under Rule 23(b)(3) of the Federal Rules of Civil Procedure in an action brought by Russell Durrett, individually and on behalf of others, against John Deere Company (filed in state court on February 19, 1992 and removed on February 26, 1992 to the United States District Court for the Northern District of Texas, Dallas Division). On October 12, 1993, in a case named DEERE CREDIT, INC. V. SHIRLEY Y. MORGAN, ET AL., filed February 20, 1992, the 281st District Court for Harris County, Texas, certified a class under Rules 42(b)(1)(A), 42(b)(1)(B) and 42(b)(2) of the Texas Rules of Civil Procedure, of all persons who opt out of the federal class action. The Company believes that it has substantial defenses and intends to defend the actions vigorously. Although it is not possible to predict the outcome of these unresolved legal actions, and the amounts of claimed damages and penalties are large, the Company believes that these unresolved legal actions will not have a material adverse effect on its consolidated financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted pursuant to instruction J(2). PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All of the Capital Corporation's common stock is owned by John Deere Credit Company, a finance holding company that is wholly-owned by Deere & Company. In 1993, the Capital Corporation paid a cash dividend to John Deere Credit Company of $82 million, which in turn paid an $82 million cash dividend to Deere & Company. Similarly during 1992, the Capital Corporation paid a $70 million dividend. During the first quarter of 1994, the Capital Corporation declared and paid a dividend of $150 million to John Deere Credit Company, which in turn declared and paid a dividend of $150 million to Deere & Company. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Omitted pursuant to instruction J(2). ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS 1993 COMPARED WITH 1992 Total acquisitions of Receivables and Leases by the Company increased five percent during 1993 compared with acquisitions in 1992. The higher acquisitions this year resulted from an increased volume of John Deere leases, revolving charge accounts and wholesale receivables, which more than offset lower acquisitions of retail notes. Receivables and Leases held by the Company at October 31, 1993 totaled $3.437 billion compared with $4.060 billion one year ago. This decrease resulted from sales of retail notes during 1993. Receivables and Leases administered, which include retail notes previously sold but still administered, amounted to $4.873 billion at the end of 1993 compared with $4.796 billion at October 31, 1992. During 1993, net retail notes (face value less unearned finance income) acquired by the Company decreased three percent compared with 1992. Net retail note acquisitions totaled $2.136 billion during 1993 compared with 1992 acquisitions of $2.207 billion. Acquisitions of recreational product retail notes accounted for nine percent of total note acquisitions in 1993 and 11 percent in 1992. Net retail note acquisitions from John Deere decreased by $22 million in 1993, due primarily to a larger volume of cash purchases by John Deere customers and a more competitive agricultural financing environment. Lower acquisitions of agricultural and lawn and grounds care equipment notes were partially offset by higher acquisitions of industrial equipment notes. Note acquisitions in 1993 from John Deere continued to represent a significant proportion of the total United States retail sales of John Deere equipment. Net acquisitions of recreational product retail notes, representing primarily recreational vehicle and recreational marine product notes acquired from independent dealers of several unrelated manufacturers, were $202 million in 1993 compared with $251 million in 1992. This decline was due mainly to a more competitive market for recreational product financing and more selective acquisition criteria. At October 31, 1993, the net amount of retail notes held by the Company was $2.792 billion compared to $3.509 billion last year. Included in these amounts were recreational product notes of $804 million in 1993 and $870 million in 1992. The net balance of John Deere retail notes decreased from $2.639 billion at October 31, 1992 to $1.988 billion at the end of 1993, even though net retail notes acquired exceeded collections. This decrease resulted primarily from the sale of retail notes during 1993. The Company periodically sells retail notes as one of several funding techniques. In 1993 and in 1992, the Company received net proceeds of $1.143 billion and $455 million, respectively, from the sale of retail notes to limited-purpose business trusts which utilized the notes as collateral for the issuance of asset backed securities to the public. During 1992, the Company also sold retail notes to other financial institutions receiving proceeds of $228 million. The net balance of retail notes administered by the Company, which include retail notes previously sold, amounted to $4.185 billion at 31 October 1993, compared with $4.197 billion at 31 October 1992. The net balance of retail notes previously sold was $1.394 billion at October 31, 1993 compared with $688 million at October 31, 1992. Additional sales of retail notes are expected to be made in the future. On October 31, 1993, the Company was contingently liable for recourse in the maximum amount of $108 million on retail notes sold. Retail notes bearing variable finance rates totaled 57 percent of the total retail note portfolio at October 31, 1993 compared with 54 percent one year earlier. The Company actively manages the increased interest rate risk posed by fixed-rate retail notes through the issuance of fixed-rate borrowings and the use of financial instruments such as interest rate swaps and interest rate caps. See "Capital Resources and Liquidity" on pages 22 through 24. At the end of fiscal 1993, revolving charge accounts receivable totaled $331 million, an increase of 24 percent compared with $268 million at October 31, 1992. The balance at October 31, 1993 included $147 million of John Deere Credit Revolving Plan receivables (including a small balance of marine finance receivables) and $184 million of Farm Plan receivables compared with $114 million and $154 million, respectively, at October 31, 1992. The John Deere Credit Revolving Plan, which was introduced in 1993, contains terms that increase the maximum amount financed, offer more attractive financing conditions and provide more flexible payment terms. Revolving charge account acquisitions increased 23 percent in 1993 compared with last year. The portfolio of net financing leases totaled $85 million at both October 31, 1993 and October 31, 1992. The net investment in operating leases was $119 million and $85 million at the end of 1993 and 1992, respectively. Overall, lease acquisitions increased 84 percent in 1993 primarily due to a new lease program applicable to some models of John Deere tractors. In addition, $19 million of municipal leases were sold to Deere & Company during 1993 compared with $21 million sold last year. At October 31, 1993, the net unpaid balance of leases sold to John Deere was $43 million compared with $48 million at October 31, 1992. Wholesale notes on recreational vehicle and John Deere engine inventories totaled $110 million at October 31, 1993 compared with $112 million at October 31, 1992. Total Receivable and Lease amounts 60 days or more past due were $12.7 million at October 31, 1993 compared with $14.6 million at October 31, 1992. These past-due amounts represented .30 percent of the face value of Receivables and Leases held at October 31, 1993 and .29 percent at October 31, 1992. The total face amount of retail notes held with any installment 60 days or more past due was $42.3 million at October 31, 1993 compared with $55.6 million one year earlier. The amount of retail note installments 60 days or more past due was $7.0 million at both October 31, 1993 and October 31, 1992. These past-due installments represented .19 percent of the unpaid face value of retail notes at October 31, 1993 and .15 percent at October 31, 1992. The total balance of revolving charge accounts receivable 60 days or more past due was $5.3 million at October 31, 1993 compared with $6.4 million at October 31, 1992. These past due amounts represented 1.6 and 2.4 percent of the revolving charge accounts receivable held at each of those respective dates. The total balance of financing and operating lease payments 60 days or more past due was $0.5 million at October 31, 1993 compared with $1.2 million at October 31, 1992. These past-due installments represented .3 percent of the total lease payments receivable at October 31, 1993 and .8 percent at October 31, 1992. At October 31, 1993, the Company's allowance for credit losses, totaled $77 million and represented 2.3 percent of the total net Receivables and Leases financed compared with $83 million and 2.0 percent, respectively, one year earlier. Deposits withheld from dealers and merchants, which are available for potential credit losses, totaled $105 million at October 31, 1993 compared with $101 million one year earlier. The Capital Corporation's consolidated income for the fiscal year ended October 31, 1993, before the cumulative effect of adopting new accounting standards related to postretirement and postemployment benefits, was $111.0 million compared with 1992 net income of $95.0 million. The ratio of earnings before fixed charges to fixed charges was 1.99 to 1 (excluding the effects of accounting changes) for 1993 compared with 1.74 to 1 last year. The improvement in net income resulted primarily from higher securitization and servicing fee income from retail notes previously sold, lower credit losses, higher financing margins, and increased gains from the sale of retail notes, which more than offset the effects of a lower balance of Receivables and Leases financed. Net income totaled $107.2 million in 1993, including the cumulative effect of adopting FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, and FASB Statement No. 112, Employers' Accounting for Postemployment Benefits. Total revenues decreased one percent during 1993 to $466 million compared with $471 million in 1992. The average balance of total net Receivables and Leases financed was seven percent lower in 1993 compared with last year due primarily to the sale of receivables during 1993. Revenues were also affected by the lower level of interest rates and the corresponding lower finance charges earned in 1993 compared with last year. These decreases in revenues were partially offset by higher securitization and servicing fee income from retail notes previously sold. However, borrowing rates were also lower this year resulting in the slightly improved financing margins. The lower borrowing rates and decrease in average borrowings this year resulted in an 11 percent decrease in interest expense, which totalled $168 million in 1993 compared with $189 million last year. Average borrowings were $3.127 billion in 1993, a seven percent decline from last year's average borrowings of $3.379 billion. The weighted average annual interest rate incurred on all interest-bearing borrowings this year declined to 5.1 percent from 5.4 percent in 1992. Finance income earned on retail notes was $314 million this year compared with $356 million in 1992, a decrease of 12 percent. The average balance of the net retail note portfolio financed during 1993 was 10 percent lower than during 1992. Revenues earned on revolving charge accounts amounted to $54 million in 1993, a 14 percent increase over revenues of $47 million earned during 1992. This increase was primarily due to a 20 percent increase in the average balance of Farm Plan receivables financed and a 15 percent increase in the average balance of John Deere Credit Revolving Plan receivables financed in 1993 compared with 1992. The average net investment in financing and operating leases decreased by two percent in 1993 compared with 1992. However, total lease revenues increased eight percent to $39.6 million in 1993 compared with $36.8 million in 1992. Lease revenues were favorably affected in 1993 by a significant increase in rentals earned on operating leases. The net gain on retail notes sold totaled $15.6 million during 1993 compared with $8.5 million for 1992. The Company received proceeds from the sale of retail notes in the amount of $1.143 billion during 1993 and $683 million in 1992. Securitization and servicing fee income totaled $22.3 million in 1993 compared with $1.1 million during 1992. Securitization and servicing fee income relates to retail notes sold to limited-purpose business trusts and includes the amortization of present value receivable amounts from the trusts established at the time of sale and reimbursed administrative expenses received from the trusts. The amount of securitization and servicing fee income was small in 1992 because the first retail note sale to a trust occurred near the end of that year. Administrative and operating expenses increased 18 percent to $75 million in 1993 compared with $63 million in 1992. These expenses increased primarily due to higher employment costs and legal expenses. The Company incurred additional costs associated with efforts relating to future growth and improving the quality of the portfolio. The provision for credit losses declined to $28 million in 1993 from $48 million last year mainly as a result of improved credit experience resulting in lower Receivable and Lease write-offs. The decline in write-offs related particularly to recreational product retail notes and John Deere industrial equipment retail notes. ACCOUNTING CHANGES In the fourth quarter of 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, effective November 1, 1992. Prior quarters of 1993 were restated as required by this Statement. This Statement generally requires the accrual of retiree health care and other postretirement benefits during employees' years of active service. The Company elected to recognize the pretax transition obligation of $5.4 million ($3.6 million net of deferred income taxes) as a one-time charge to earnings in the current year. This obligation represents the portion of future retiree benefit costs related to service already rendered by both active and retired employees up to November 1, 1992. The 1993 postretirement benefits expense and related disclosures have been determined according to the provisions of FASB Statement No. 106. For years prior to 1993, postretirement benefits were generally included in costs as covered expenses were actually incurred. The adoption of FASB Statement No. 106 resulted in an incremental pretax expense of $.2 million compared with the expense determined under the previous accounting principle. This increase in the current year expense is in addition to the previously mentioned one-time charge relating to the transition obligation. In the fourth quarter of 1993, the Company also adopted FASB Statement No. 112, Employers' Accounting for Postemployment Benefits, effective November 1, 1992. This Statement requires the accrual of certain benefits provided to former or inactive employees after employment but before retirement during employees' years of active service. The Company previously accrued certain disability related benefits when the disability occurred. Results for the first quarter of 1993 were restated for the cumulative pretax charge resulting from this change in accounting as of November 1, 1992 which totaled $.3 million ($.2 million net of deferred income taxes). The adoption of FASB Statement No. 112 had an immaterial effect on 1993 expenses. 1992 COMPARED WITH 1991 Total acquisitions of Receivables and Leases by the Company decreased three percent during 1992 compared with acquisitions in 1991. Receivables and Leases held by the Company at October 31, 1992 totaled $4.060 billion compared with $4.398 billion one year ago. This decrease resulted from sales of retail notes during 1992. Receivables and Leases administered, which include retail notes previously sold but still administered, amounted to $4.796 billion at the end of 1992 compared with $4.693 billion at October 31, 1991. During 1992, the volume of net retail notes acquired by the Company decreased eight percent compared with 1991. Net retail note acquisitions totaled $2.207 billion during 1992 compared with 1991 acquisitions of $2.400 billion. Acquisitions of recreational product retail notes accounted for 11 percent of total note acquisitions in 1992 and 13 percent in 1991. Net retail note acquisitions from John Deere decreased by $142 million in 1992, due primarily to a decrease in retail sales of John Deere agricultural equipment. Acquisitions of industrial equipment retail notes also were lower in 1992 while lawn and grounds care equipment note acquisitions were significantly higher due mainly to finance waiver programs on lawn and garden tractors. Note acquisitions in 1992 from John Deere continued to represent a significant proportion of the total United States retail sales of John Deere equipment. Net acquisitions of recreational product retail notes were $251 million in 1992 compared with $301 million in 1991. This decline was due mainly to a more competitive financing environment and the development of more selective retail note acquisition criteria by the Company over the past few years. At October 31, 1992, 1991 and 1990, the net amount of retail notes held by the Company was $3.509 billion, $3.854 billion and $3.074 billion, respectively. Included in these amounts were non-Deere notes of $870 million, $888 million and $773 million at those respective dates. The net balance of John Deere retail notes decreased from $2.966 billion at October 31, 1991 to $2.639 billion at the end of 1992. John Deere retail notes totaled $2.301 billion at the end of 1990. The decrease in 1992 resulted primarily from the sale of retail notes. During 1992, the Company sold retail notes to other financial institutions and the public, receiving net proceeds of $683 million. Notes were not sold in 1991. At October 31, 1992, 1991 and 1990, the net unpaid balance of retail notes sold was $688 million, $242 million and $521 million, respectively. Additional sales of retail notes are expected to be made in the future. Retail notes bearing variable finance rates totaled 54 percent of the total retail note portfolio at October 31, 1992 compared with 56 percent one year earlier. Revolving charge accounts receivable totaled $268 million at October 31, 1992 compared with $240 million one year earlier. The increase in the outstanding balance at October 31, 1992 was due mainly to an increase in Farm Plan volume. The October 31, 1992 balance of revolving charge accounts receivable includes $114 million of credit card receivables and $154 million of Farm Plan receivables, compared with $112 million and $128 million, respectively, at October 31, 1991. At October 31, 1992, the net investment in financing and operating leases on John Deere equipment was $170 million compared with $213 million at October 31, 1991. Lease acquisitions declined 27 percent in 1992 compared with 1991 due to a decrease in agricultural lease activity and competitive pressures. Lease liquidations during 1992 exceeded acquisitions, as the high lease acceptances of several years ago continued to mature. Also, $21 million net value of municipal leases were sold to John Deere during 1992 compared with $27 million sold in 1991. At October 31, 1992, the net unpaid balance of leases sold to John Deere was $48 million compared with $53 million at October 31, 1991. Wholesale notes receivable totaled $112 million at October 31, 1992 compared with $91 million at October 31, 1991, as wholesale note acquisitions increased 37 percent in 1992. Total Receivable and Lease amounts 60 days or more past due were $14.6 million at October 31, 1992 compared with $27.1 million at October 31, 1991. These past due amounts represented .29 percent of the face value of Receivables and Leases held at October 31, 1992 and .49 percent at October 31, 1991. The total face amount of retail notes held with any installment 60 days or more past due was $55.6 million at October 31, 1992 compared with $108.0 million one year earlier. The amount of retail note installments 60 days or more past due was $7.0 million at October 31, 1992, a decrease of 60 percent compared with $17.5 million at October 31, 1991. These past-due installments represented .15 percent of the unpaid face value of retail notes held at October 31, 1992 and .35 percent at October 31, 1991. The total balance of revolving charge accounts receivable 60 days or more past due was $6.4 million at October 31, 1992 compared with $8.5 million at October 31, 1991. These past due amounts represented 2.4 and 3.5 percent of the revolving charge accounts receivable held at each of those respective dates. The total balance of financing and operating lease payments 60 days or more past due was $1.2 million at October 31, 1992 compared with $1.0 million at October 31, 1991. These past-due installments represented .8 percent of the total lease payments receivable at October 31, 1992 and .5 percent at October 31, 1991. At October 31, 1992, the Company's allowance for credit losses totaled $83 million and represented 2.0 percent of the total net Receivables and Leases financed compared with $78 million and 1.8 percent at October 31, 1991. Deposits withheld from dealers and merchants amounted to $101 million at October 31, 1992 compared with $99 million one year earlier. Net income in 1992 totaled $95.0 million, an increase of 30 percent compared with 1991 income of $73.0 million. The ratio of earnings before fixed charges to fixed charges was 1.74 to 1 for 1992 compared with 1.48 to 1 in 1991. The improvement in net income in 1992 resulted primarily from a higher average volume of Receivables and Leases financed and improved credit loss experience. Results in 1992 also benefited from after-tax income of $5.6 million from sales of retail notes. The average balance of total net Receivables and Leases financed was seven percent higher in 1992 compared with 1991, although the year-end balance was lower due to the sale of a substantial amount of retail notes in October 1992. However, total revenues decreased three percent to $471 million in 1992 compared with $487 million in 1991, as the average yield earned on the portfolio was lower this year. While revenues were affected by the lower level of interest rates and correspondingly lower finance charges earned in 1992 compared with last year, borrowing costs were also lower this year. Interest expense totaled $189 million in 1992, a decrease of 17 percent compared with $228 million in 1991. Total average borrowings were $3.379 billion in 1992, an 11 percent increase over fiscal year 1991 average borrowings of $3.053 billion. The weighted average interest rate incurred on all interest-bearing borrowings during 1992 declined to 5.4 percent from 7.2 percent in 1991. Finance income earned on retail notes was $356 million this year compared with $383 million in 1991, a decrease of seven percent. The average balance of the net retail note portfolio financed during 1992 was seven percent higher than during 1991. Revenues earned on revolving charge accounts amounted to $47 million in 1992, an 11 percent increase over revenues of $43 million earned during 1991. This increase was primarily due to a 17 percent increase in the average balance of Farm Plan receivables financed and a 10 percent increase in the average balance of credit card receivables financed in 1992 compared with 1991. The average net investment in financing and operating leases decreased by 13 percent in 1992 compared with 1991. In addition, total lease revenues decreased slightly to $36.8 million in 1992 compared with $36.9 million in 1991. Lease revenues were favorably affected in 1992 by a significant increase in rentals earned on operating leases. Administrative and operating expenses for 1992 were $63 million, an increase of eight percent compared with $59 million for 1991. These expenses increased primarily due to the costs associated with the larger average portfolio financed. The provision for credit losses decreased to $48 million in 1992 from $66 million in 1991 mainly as a result of improved credit experience resulting in lower Receivable and Lease write-offs. The most significant decline in write-offs related to recreational product notes, resulting primarily from more selective note acquisition criteria used by the Company. Write-offs of recreational product notes totaled $24.2 million in 1992 compared with $33.3 million in 1991. CAPITAL RESOURCES AND LIQUIDITY The Company relies on its ability to raise substantial amounts of funds to finance its Receivable and Lease portfolios. The Company's primary sources of funds for this purpose are a combination of borrowings and equity capital. Additionally, the Company periodically sells substantial amounts of retail notes in the public market. The Company's ability to obtain funds is affected by its debt ratings, which are closely related to the outlook for and the financial condition of Deere & Company, and the nature and availability of support facilities, such as its lines of credit. For information regarding Deere & Company and its business, see Exhibit 99.1. The Company's ability to meet its debt obligations is supported in a number of ways as described below. All commercial paper issued is backed by bank credit lines. The assets of the Company are self-liquidating in nature. A strong equity position is available to absorb unusual losses on these assets. Liquidity is also provided by the Company's ability to sell or "securitize" these assets. Asset-liability risk is also actively managed to minimize exposure to interest rate fluctuations. The Company's business is somewhat seasonal, with overall acquisitions of Receivables and Leases traditionally higher in the second half of the fiscal year than in the first half, and overall collections of Receivables and Leases traditionally somewhat higher in the first six months than in the last half of the fiscal year. The Company's cash flows from operating activities were $157 million in 1993. See "Statement of Consolidated Cash Flows" on page 34. Net cash provided by investing activities totaled $477 million in 1993, primarily due to net proceeds of $1.143 billion received from the securitization and sale of receivables in the public market, which was partially offset by funds used for Receivable and Lease acquisitions which exceeded collections by $698 million in 1993. Collections of receivables in 1993 were slightly lower than last year, due primarily to the lower retail note portfolio financed in 1993. The aggregate cash provided by operating and investing activities was used for financing activities and a $74 million increase in cash and cash equivalents. Cash used for financing activities totaled $561 million in 1993, representing a net decrease in outside borrowings of $853 million and the payment of an $82 million dividend to Deere & Company which were partially offset by a $374 million increase in payables to Deere & Company. Over the past three years, operating activities have provided $453 million in cash. Proceeds from the sale of receivables and an increase in payables to Deere & Company provided $1.893 and $423 million, respectively, during the same period. These amounts were used mainly to fund Receivable and Lease acquisitions which exceeded collections by $2.101 billion, a decrease of $438 million in net outside borrowings, $202 million in dividends and an increase in cash and cash equivalents of $67 million. In common with other large finance and credit companies, the Company actively manages the relationship of the types and amounts of its funding sources to its Receivable and Lease portfolios in an effort to diminish risk due to interest rate and currency fluctuations, while responding to favorable competitive and financing opportunities. Accordingly, from time to time, the Company enters into interest rate swap and interest rate cap agreements to hedge its interest rate exposure in amounts corresponding to a portion of its borrowings. See notes 4 and 5 to the consolidated financial statements for further details. The credit and market risks under these agreements are not considered to be significant. Total indebtedness amounted to $2.777 billion at October 31, 1993 compared with $3.256 billion at October 31, 1992. Total short-term indebtedness amounted to $1.299 billion at October 31, 1993 compared with $2.017 billion at October 31, 1992. See note 4 to the consolidated financial statements. Total long-term indebtedness amounted to $1.478 billion at October 31, 1993 and $1.239 billion at October 31, 1992. See note 5 to the consolidated financial statements. The decrease in total indebtedness at October 31, 1993 compared with October 31, 1992 was due primarily to the decline in Receivables and Leases financed. The ratio of total interest-bearing debt to stockholder's equity was 3.8 to 1 and 4.6 to 1 at October 31, 1993 and October 31, 1992, respectively. In 1993, the Company issued $150 million of 5% notes due in 1995 and $200 million of 4-5/8% notes due in 1996. The Company also retired $150 million of 7.40% notes due in 1993, $125 million of 9.0% debentures due in 1993 and $47 million of 7-1/2% debentures due in 1998. In November 1993, the Capital Corporation announced that on January 4, 1994 it will redeem the $40 million balance of outstanding 9.35% subordinated debentures due 2003. Additional information on these borrowings is included in the discussion of "Long-Term Borrowings" on page 41. During 1993, the Capital Corporation issued $337 million and retired $176 million of medium-term notes. At October 31, 1993, $737 million of medium-term notes were outstanding having original maturity dates of between one and seven years and interest rates that ranged from 3.4 percent to 9.5 percent. At October 31, 1993, the Capital Corporation and Deere & Company, jointly, had unsecured lines of credit with various banks in North America and overseas totaling $3.025 billion. Included in the total credit lines were three long-term credit agreement commitments totaling $3.016 billion. At October 31, 1993, $2.265 billion of the lines of credit were unused. For the purpose of computing unused credit lines, the aggregate of total short-term borrowings, excluding the current portion of long-term borrowings, of the Capital Corporation, Deere & Company, John Deere Limited (Canada) and John Deere Finance Limited (Canada) were considered to constitute utilization. Annual facility fees on the credit agreements are paid by Deere & Company and a portion is charged to the Capital Corporation based on utilization. In 1993, the Capital Corporation paid a dividend of $82 million to John Deere Credit Company, which, in turn, paid an $82 million dividend to Deere & Company. During the first quarter of 1994, the Capital Corporation declared and paid a dividend of $150 million to John Deere Credit Company, which in turn declared and paid a dividend of $150 million to Deere & Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See accompanying table of contents of financial statements. 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 instruction J(2). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Omitted pursuant to instruction J(2). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Omitted pursuant to instruction J(2). ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Omitted pursuant to instruction J(2). PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) (1) Financial Statements (2) Financial Statement Schedules See the table of contents to financial statements and schedules immediately preceding the financial statements and schedules to consolidated financial statements. (3) Exhibits See the index to exhibits immediately preceding the exhibits filed with this report. (b) Reports on Form 8-K Current Report on Form 8-K dated August 24, 1993 (Items 5 and 7). Current Report on Form 8-K dated August 4, 1993 (Items 5 and 7). (THIS PAGE INTENTIONALLY LEFT BLANK) 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. JOHN DEERE CAPITAL CORPORATION By: /s/ Hans W. Becherer ---------------------- Hans W. Becherer, Chairman Date: 24 January 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 ----------- ----- ---- /s/ Hans W. Becherer Director, Chairman and Principal ) -------------------- Executive Officer ) Hans W. Becherer ) ) /s/ J. Michael Dunn Director ) -------------------- ) J. Michael Dunn ) ) /s/ J. W. England Director, Vice President and ) ------------------- Principal Accounting Officer ) J. W. England ) ) /s/ B. L. Hardiek Director ) ------------------- ) B. L. Hardiek ) ) /s/ B. C. Harpole Director ) ------------------- ) B. C. Harpole ) ) /s/ D. E. Hoffmann Director ) ------------------- ) D. E. Hoffmann ) ) /s/ J. K. Lawson Director ) 24 January 1994 ------------------- J. K. Lawson /s/ Pierre E. Leroy Director ) - -------------------- ) Pierre E. Leroy ) ) /s/ M. P. Orr Director and President ) - -------------------- ) M. P. Orr ) ) /s/ E. L. Schotanus Director, Vice President and ) 24 January 1994 - -------------------- Principal Financial Officer ) E. L. Schotanus ) ) /s/ D. H. Stowe, Jr. Director ) - -------------------- ) D. H. Stowe, Jr. ) ) /s/ S. E. Warren Director ) - -------------------- ) S. E. Warren ) [LOGO] INDEPENDENT AUDITORS' REPORT John Deere Capital Corporation: We have audited the accompanying consolidated balance sheets of John Deere Capital Corporation and subsidiaries as of October 31, 1993 and 1992 and the related statements of consolidated income and retained earnings and of consolidated cash flows for each of the three years in the period ended October 31, 1993. Our audits also included the financial statement schedules listed in the Table of Contents on page 31. 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 financial position of John Deere Capital Corporation and 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. 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 1 to the consolidated financial statements, effective November 1, 1992 the company changed its method of accounting for postretirement benefits other than pensions. DELOITTE & TOUCHE December 10, 1993 [LOGO] FINANCIAL STATEMENTS: Page ---- John Deere Capital Corporation and Subsidiaries (consolidated): Statement of Consolidated Income and Retained Earnings for the Years Ended October 31, 1993, 1992 and 1991...............32 Consolidated Balance Sheet, October 31, 1993 and 1992...........33 Statement of Consolidated Cash Flows for the Years Ended October 31, 1993, 1992 and 1991...............................34 Notes to Consolidated Financial Statements......................35 FINANCIAL STATEMENT SCHEDULES: Schedule VIII - Valuation and Qualifying Accounts for the Years Ended October 31, 1993, 1992 and 1991...................46 Schedule IX - Short-term Borrowings for the Years Ended October 31, 1993, 1992 and 1991...............................47 SCHEDULES OMITTED The following schedules are omitted because of the absence of the conditions under which they are required: I, II, III, IV, V, VI, VII, X, XI, XII, XIII and XIV. STATEMENT OF CONSOLIDATED INCOME AND RETAINED EARNINGS CONSOLIDATED BALANCE SHEET STATEMENT OF CONSOLIDATED CASH FLOWS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CORPORATE ORGANIZATION John Deere Capital Corporation (Capital Corporation) is a wholly-owned subsidiary of John Deere Credit Company, a finance holding company which is wholly-owned by Deere & Company. The Capital Corporation and its subsidiaries, Deere Credit Services, Inc. (DCS), Farm Plan Corporation (FPC), Deere Credit, Inc. (DCI), and John Deere Receivables, Inc. (JDRI), are collectively called the Company. Deere & Company with its other wholly-owned subsidiaries are collectively called John Deere. Retail notes, revolving charge accounts, financing leases and wholesale notes receivable are collectively called "receivables." Receivables and operating leases are collectively called "receivables and leases." The risk of credit losses applicable to John Deere retail notes and leases, net of recovery from withholdings from John Deere dealers, is borne by the Company. John Deere is compensated by the Company at a rate of 2.9 percent or less of the finance income earned, depending on prevailing bank interest rate levels, for originating retail notes on John Deere products. John Deere is reimbursed by the Company for staff support and other administrative services at estimated cost, and for credit lines provided by Deere & Company based on utilization of the lines. John Deere is compensated for originating leases on John Deere products and is reimbursed for staff support in a manner similar to the procedures for retail notes. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the financial statements of the Capital Corporation and its subsidiaries, all of which are wholly-owned. ACCOUNTING CHANGES In the fourth quarter of 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, effective November 1, 1992. Prior quarters of 1993 were restated as required by this Statement. This Statement generally requires the accrual of retiree health care and other postretirement benefits during employees' years of active service. The Company elected to recognize the pretax transition obligation of $5.4 million ($3.6 million net of deferred income taxes) as a one-time charge to earnings in the current year. This obligation represents the portion of future retiree benefit costs related to service already rendered by both active and retired employees up to November 1, 1992. The 1993 postretirement benefits expense and related disclosures have been determined according to the provisions of FASB Statement No. 106. For years prior to 1993, postretirement benefits were generally included in costs as covered expenses were actually incurred. The adoption of FASB Statement No. 106 resulted in an incremental pretax expense of $.2 million compared with the expense determined under the previous accounting principle. This increase in the current year expense is in addition to the previously mentioned one-time charge relating to the transition obligation. In the fourth quarter of 1993, the Company adopted FASB Statement No. 112, Employers' Accounting for Postemployment Benefits, effective November 1, 1992. This Statement requires the accrual of certain benefits provided to former or inactive employees after employment but before retirement during employees' years of active service. The Company previously accrued certain disability related benefits when the disability occurred. Results for the first quarter of 1993 were restated for the cumulative pretax charge resulting from this change in accounting as of November 1, 1992 which totaled $.3 million ($.2 million net of deferred income taxes). The adoption of FASB Statement No. 112 had an immaterial effect on 1993 expenses. In the fourth quarter of 1993, the Company adopted FASB Statement No. 107, Disclosures about Fair Values of Financial Instruments. Disclosures of the fair values of financial instruments which do not approximate the carrying values in the financial statements are included in the appropriate financial statement notes. Fair values of other financial instruments approximate the carrying amounts because of the short maturities or current market interest rates of those instruments. In the second quarter of 1992, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. See note 10 for further information. RETAIL NOTES RECEIVABLE The Company purchases and finances retail notes from John Deere's agricultural equipment, industrial equipment and lawn and grounds care equipment sales branches in the United States. The notes are acquired by the sales branches through John Deere retail dealers and principally originate in connection with retail sales by dealers of new John Deere equipment and used equipment. The Company also purchases and finances retail NOTES TO CONSOLIDATED FINANCIAL STATEMENTS notes unrelated to John Deere equipment, representing primarily recreational vehicle and recreational marine product notes acquired from independent dealers of those products and from marine mortgage service companies (recreational product retail notes). Finance income included in the face amount of retail notes is amortized into income over the lives of the notes on the effective-yield basis. Unearned finance income on variable-rate notes is adjusted monthly based on fluctuations in the base rate of a specified bank. Costs incurred in the acquisition of retail notes are deferred and amortized into income over the expected lives of the notes on the effective-yield basis. A portion of the finance income earned by the Company arises from retail sales of John Deere equipment sold in advance of the season of use or in other sales promotions by John Deere on which finance charges are waived by John Deere for a period from the date of sale to a specified subsequent date. Some low-rate financing programs are also offered by John Deere. The Company receives compensation from John Deere approximately equal to the normal net finance charge on retail notes for periods during which finance charges have been waived or reduced. The portions of the Company's finance income earned that were received from John Deere on retail notes containing waiver of finance charges or reduced rates were 19 percent in 1993, 17 percent in 1992 and 20 percent in 1991. A deposit equal to one percent of the face amount of John Deere agricultural and lawn and grounds care equipment retail notes originating from each dealer is withheld from that dealer and recorded by the Company. Any subsequent retail note losses are charged against the withheld deposits. To the extent that a loss on a retail note cannot be absorbed by deposits withheld from the dealer from which the retail note was acquired, it is charged against the Company's allowance for credit losses. At the end of each calendar year, the balance of each dealer's withholding account in excess of a specified percent (currently 3 percent) of the total balance outstanding on retail notes originating with that dealer is remitted to the dealer, and any negative balance in the dealer withholding account is written off and absorbed by the Company's allowance for credit losses. All John Deere industrial equipment retail notes are currently acquired on a non-recourse basis and there is no withholding of dealer deposits on those notes. This procedure originated in January 1992. Industrial notes acquired prior to January 1992 remain subject to the agricultural and lawn and grounds care equipment procedures, noted in the above paragraph, until the notes are paid in full, or the withholding accounts are depleted. Because of this change, the allowance for credit losses was increased to compensate for the additional credit risk. The Company does not withhold deposits on recreational product retail notes. The Company requires that theft and physical damage insurance be carried on all equipment leased or securing retail notes. The customer may, at his own expense, have the Company purchase this insurance or obtain it from other sources. Theft and physical damage insurance is also required on wholesale notes and can be purchased through the Company or from other sources. Insurance is not required on revolving charge accounts. Generally, when an account becomes 120 days delinquent, accrual of finance income is suspended, the collateral is repossessed or the account is designated for litigation, and the estimated uncollectible amount, after charging the dealer's withholding account, if any, is written off to the allowance for credit losses. REVOLVING CHARGE ACCOUNTS RECEIVABLE Revolving charge account income is generated primarily by two revolving credit products: Farm Plan and the John Deere Credit Revolving Plan. Farm Plan is primarily used by agri-businesses to finance customer purchases, such as parts and service labor, which would otherwise be carried by the merchants as accounts receivable. Farm Plan income includes a discount paid by merchants for the purchase of customer accounts and finance charges paid by customers on their outstanding revolving charge account balances. Merchant recourse and a merchant reserve are established on some receivables purchased. The John Deere Credit Revolving Plan is used primarily by retail customers of John Deere dealers to finance lawn and grounds care equipment. Income includes a discount paid by dealers on most transactions and finance charges paid by customers on their outstanding account balances. Accrual of revolving charge account income is suspended generally when an account becomes 120 days delinquent. Accounts are deemed to be uncollectible and written off to the allowance for credit losses when delinquency reaches 180 days for a Farm Plan account and 150 days for John Deere Credit Revolving Plan accounts. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DIRECT FINANCING LEASES AND EQUIPMENT ON OPERATING LEASES The Company leases John Deere agricultural equipment, industrial equipment and lawn and grounds care equipment directly to retail customers. At the time of accepting a lease that qualifies as a direct financing lease under FASB Statement No. 13, the Company records the gross amount of lease payments receivable, estimated residual value of the leased equipment for non-purchase option leases and unearned lease income. The unearned lease income is equal to the excess of the gross lease receivable plus the estimated residual value over the cost of the equipment. The unearned lease income is recognized as revenue over the lease term on the effective-yield method. Leases that do not meet the criteria for direct financing leases as outlined by FASB Statement No. 13 are accounted for as operating leases. Rental payments applicable to equipment on operating leases are recorded as income on a straight-line method over the lease terms. Operating lease assets are recorded at cost and depreciated on a straight-line method over the terms of the leases. Lease acquisition costs are accounted for in a manner similar to the procedures for retail notes. Deposits withheld from John Deere dealers and related losses on leases are handled in a manner similar to the procedures for retail notes. In addition, a lease payment discount program, allowing reduced payments over the term of the lease, is administered in a manner similar to finance waiver on retail notes. Equipment returned to the Company upon termination of leases and held for subsequent sale or lease is recorded at the estimated wholesale market value of the equipment. Generally, when an account becomes 120 days delinquent, accrual of lease revenue is suspended, the equipment is repossessed or the account is designated for litigation and the estimated uncollectible amount, after charging the dealer's withholding account, if any, is written off to the allowance for credit losses. WHOLESALE RECEIVABLES The Company finances recreational vehicle inventory and John Deere engines held by dealers of those products. Wholesale finance income is recognized monthly based on the daily balance of wholesale receivables outstanding and the applicable effective interest rate. Interest rates vary with a prevailing bank base rate, the type of equipment financed and the balance outstanding. Wholesale receivables are secured by the recreational vehicle and engine inventories financed. Although amounts are not withheld from dealers to cover uncollectible receivables, there are repurchase agreements with manufacturers for new inventories held by dealers. Generally, when an account becomes 60 days delinquent, accrual of finance income is suspended, the collateral is repossessed and the estimated uncollectible amount is written off to the allowance for credit losses. OTHER RECEIVABLES During 1993 and 1992, the Company sold retail notes to limited-purpose business trusts, which utilized the notes as collateral for the issuance of asset backed securities to the public. At the time of the sales, "other receivables" from the trusts were recorded at net present value. The receivables relate to deposits made pursuant to recourse provisions and other payments to be received under the sales agreements. The receivables will be amortized to their value at maturity using the interest method. The Company is also compensated by the trusts for certain expenses incurred in the administration of these receivables. Securitization and servicing fee income includes both the amortization of the above receivables and reimbursed administrative expenses. CONCENTRATION OF CREDIT RISK Receivables and leases have significant concentrations of credit risk in the agricultural, industrial, lawn and grounds care, and recreational product business sectors as shown in note 2, "Receivables and Leases." On a geographic basis, there is not a disproportionate concentration of credit risk in any area of the United States. The Company retains as collateral a security interest in the equipment associated with receivables and leases other than revolving charge accounts. RECLASSIFICATIONS Certain amounts for 1991 and 1992 have been reclassified to conform with 1993 financial statement presentations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 RECEIVABLES AND LEASES RETAIL NOTES RECEIVABLE Retail notes receivable by product category at October 31 in millions of dollars follow: During 1993, the average effective yield on retail notes held by the Company was approximately 9.8 percent compared with 10.1 percent in 1992. Retail notes acquired by the Company during the year ended October 31, 1993 had an estimated average original term (based on dollar amounts) of 67 months. During 1992 and 1991, the estimated average original term was 68 and 66 months, respectively. Historically, because of prepayments, the average actual life of retail notes has been considerably shorter than the average original term. During 1993, the Company received net proceeds of $1.143 billion from the sale of retail notes to limited-purpose business trusts, which utilized the notes as collateral for the issuance of asset backed securities to the public. During 1992, the Company received net proceeds of $683 million from the sale of retail notes. At October 31, 1993 and 1992, the net balance of all retail notes previously sold by the Company was $1.394 billion and $688 million, respectively. Additional sales of retail notes are expected to be made in the future. The Company recognizes any gain or loss at the time of the sale of retail notes. The sale price of retail notes sold to financial institutions is subject to subsequent monthly adjustments to reflect changes in short-term interest rates and variations in timing between actual and anticipated collections. The Company acts as agent for the buyers in collection and administration of all the notes it has sold and was contingently liable for recourse in the maximum amount of $108 million and $67 million at October 31, 1993 and 1992, respectively. All retail notes sold are collateralized by security agreements on the related machinery sold to the customers. There is a minimal amount of market risk due to monthly adjustments to the sale price of a small portion of the retail notes. There is no anticipated credit risk related to the nonperformance by the counterparties. REVOLVING CHARGE ACCOUNTS RECEIVABLE Revolving charge accounts receivable at October 31, 1993 totaled $331 million compared with $268 million at October 31, 1992. Account holders may pay the account balance in full at any time, or make payments over a number of months according to a payment schedule. A minimum amount is due each month from customers selecting the revolving payment option. FINANCING LEASES RECEIVABLE Financing leases receivable by product category at October NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 31 are as follows in millions of dollars: Residual values represent the amounts estimated to be recoverable at maturity from disposition of the leased equipment under non-purchase option financing leases. Initial lease terms for financing leases range from 12 months to 72 months. Payments on financing leases receivable at October 31 are scheduled as follows in millions of dollars: The Company sold $19 million of municipal leases to Deere & Company in 1993 compared with $21 million in 1992. At October 31, 1993, the net balance of leases sold was $43 million compared with $48 million at October 31, 1992. Additional sales of leases may be made in the future. WHOLESALE RECEIVABLES Wholesale receivables at October 31, 1993 totaled $110 million compared with $112 million at October 31, 1992. Maturities range from 12 to 24 months, with scheduled principal reductions from invoice date to maturity. EQUIPMENT ON OPERATING LEASES The cost of equipment on operating leases by product category at October 31 follows in millions of dollars: Initial lease terms for equipment on operating leases range from 12 months to 72 months. Rental payments for equipment on operating leases at October 31 are scheduled as follows in millions of dollars: FAIR VALUE At October 31, 1993, the estimated fair value of total net receivables and leases was $3.516 billion compared with the carrying value of $3.436 billion. The fair values of fixed-rate retail notes and financing leases were based on the discounted values of their related cash flows at current market interest rates. The fair values of variable-rate retail notes, revolving charge accounts and wholesale notes approximate the carrying amounts. NOTE 3 ALLOWANCE FOR CREDIT LOSSES Allowances for credit losses on receivables and leases are maintained in amounts considered to be appropriate in relation to the receivables and leases outstanding based on estimated collectibility and collection experience. An analysis of the allowance for credit losses on total receivables and losses follows in millions of dollars: The allowance for credit losses represented 2.3 percent, 2.0 percent and 1.8 percent of receivables and leases outstanding at October 31, 1993, 1992 and 1991, respectively. In addition, the Company had $105 million, $101 million and $99 million at October 31, 1993, 1992 and 1991, respectively, of deposits withheld from John Deere dealers and Farm Plan merchants available for certain potential credit losses originating from those dealers and merchants. The lower provisions in 1993 and 1992 resulted from a decrease in write-offs of uncollectible receivables and leases, particularly recreational product retail notes. The decrease in write-offs of recreational product notes resulted primarily from the development of more selective recreational product retail note acquisition criteria by the Company over the past few years and improved collection effectiveness. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 4 SHORT-TERM BORROWINGS On October 31, 1993, short-term borrowings were $1.299 billion, $454 million of which was commercial paper. Short-term borrowings were $2.017 billion one year ago, $1.487 billion of which was commercial paper. Original maturities of commercial paper outstanding on October 31, 1993 ranged up to 244 days. The weighted average remaining term of commercial paper outstanding on October 31, 1993 was approximately 71 days. The Capital Corporation's short-term debt also includes amounts borrowed from Deere & Company, which totaled $439.5 million at October 31, 1993. The Capital Corporation pays a market rate of interest to Deere & Company based on the average outstanding borrowings each month. The weighted average interest rates on all short-term borrowings, excluding current maturities of long-term borrowings, for 1993, 1992 and 1991 were 4.0 percent, 5.0 percent and 6.9 percent, respectively. At October 31, 1993, the Capital Corporation and Deere & Company, jointly, had unsecured lines of credit with various banks in North America and overseas totaling $3.025 billion. Included in the total credit lines are three long-term credit agreements expiring on various dates through March 1996 for an aggregate maximum amount of $3.016 billion. At October 31, 1993, $2.265 billion of the lines of credit were unused. For the purpose of computing unused credit lines, the aggregate of total short-term borrowings, excluding the current portion of long-term borrowings, of the Capital Corporation, Deere & Company, John Deere Limited (Canada) and John Deere Finance Limited (Canada) were considered to constitute utilization. Annual facility fees on the credit agreements are paid by Deere & Company and charged to the Capital Corporation based on utilization. At October 31, 1993, the Capital Corporation had no borrowings outstanding under the credit agreements. These agreements require the Capital Corporation to maintain its consolidated ratio of earnings before fixed charges to fixed charges at no less than 1.05 to 1 for each fiscal quarter. In addition, the Capital Corporation's ratio of senior debt to total stockholder's equity plus subordinated debt may not be more than 8 to 1 at the end of any fiscal quarter. For purposes of these calculations, "earnings" consist of income before income taxes to which are added fixed charges. "Fixed charges" consist of interest on indebtedness, amortization of debt discount and expense, an estimated amount of rental expense under capitalized leases which is deemed to be representative of the interest factor and rental expense under operating leases. "Senior debt" consists of the Company's total interest-bearing obligations, excluding subordinated debt, but including borrowings from Deere & Company. The Company's ratio of earnings to fixed charges was 1.99 to 1 (excluding the effect of the accounting changes), 1.74 to 1 and 1.48 to 1 in 1993, 1992 and 1991, respectively. The Company's ratio of senior debt to total stockholder's equity plus subordinated debt was 2.2 to 1 at October 31, 1993 compared with 2.7 to 1 at October 31, 1992. In common with other large finance and credit companies, the Company actively manages the relationship of the types and amounts of its funding sources to its receivable and lease portfolios in an effort to diminish risk due to interest rate and currency fluctuations, while responding to favorable competitive and financing opportunities. Accordingly, from time to time, the Company has entered into interest rate swap and interest rate cap agreements to hedge its interest rate exposure in amounts corresponding to a portion of its short-term borrowings. At October 31, 1993 and 1992, the total notional principal amounts of interest rate swap agreements were $510 million and $150 million having rates of 3.6 to 9.6 percent terminating in up to 28 months and 14 months, respectively. The total notional principal amounts of interest rate cap agreements at October 31, 1993 and 1992 were $44 million and $105 million having capped rates of 8.0 percent to 9.0 percent terminating in up to 15 months and 28 months, respectively. The differential to be paid or received on all swap and cap agreements is accrued as interest rates change and is recognized over the lives of the agreements. The credit and market risk under these agreements is not considered to be significant. The estimated fair value and carrying value of these interest rate swap and cap agreements were not significant at October 31, 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5 LONG-TERM BORROWINGS Long-term borrowings of the Capital Corporation at October 31 consisted of the following in millions of dollars: In 1993, the Capital Corporation issued $150 million of 5% notes due in 1995 and $200 million of 4-5/8% notes due in 1996. The Capital Corporation also retired $150 million of 7.4% notes due in 1993, $125 million of 9.0% debentures due in 1993 and $47 million of 7-1/2% debentures due in 1998. During 1993, the Capital Corporation issued $337 million and retired $176 million of medium-term notes. In November 1993, the Capital Corporation announced that on January 4, 1994 it will redeem the $40 million balance of outstanding 9.35% subordinated debentures due 2003. The Capital Corporation has entered into interest rate swap agreements with independent parties that change the effective rate of interest on certain long-term borrowings to a variable rate based on specified United States commercial paper rate indices. The table reflects the effective year-end variable interest rates relating to these swap agreements. The notional principal amounts and maturity dates of these swap agreements are the same as the principal amounts and maturities of the related borrowings. In addition, the Capital Corporation has interest rate swap agreements corresponding to a portion of its fixed rate long-term borrowings. At October 31, 1993, the total notional principal amount of these interest rate swap agreements was $347 million, having variable rates of 3.4 percent to 3.8 percent, terminating in up to 40 months. The Capital Corporation also has interest rate swap and cap agreements associated with medium-term notes. The table reflects the interest rates relating to these swap and cap agreements. At October 31, 1993 and 1992, the total notional principal amounts of these swap agreements were $138 million and $110 million, terminating in up to 42 months and 54 months, respectively. At October 31, 1993 and 1992, the total notional principal amounts of these cap agreements were $25 million and $125 million, terminating in up to 22 months and 34 months, respectively. A Swiss franc to United States dollar currency swap agreement is also associated with the Swiss franc bonds in the table. The credit and market risk under these agreements is not considered to be significant. At October 31, 1993, the total estimated fair value of the Company's total long-term borrowings was $1.496 billion. The corresponding carrying amount of total long-term borrowings was $1.478 billion. Fair values of long-term borrowings with fixed rates were based on a discounted cash flow model. Fair values of long-term borrowings, which have been swapped to current variable interest rates, approximate their carrying amounts. The estimated fair value and carrying value of the Company's interest rate swap and cap agreements associated with medium-term notes were not significant at October 31, 1993. The approximate amounts of long-term borrowings maturing and sinking fund payments required in each of the next five years, in millions of dollars, are as follows: 1994-$405, 1995-$633, 1996-$262, 1997-$309, 1998-$11. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 FIXED CHARGE COVERAGE Deere & Company has expressed an intention of conducting its business with the Company on such terms that the Company's consolidated ratio of earnings before fixed charges to fixed charges will not be less than 1.05 to 1 for each fiscal quarter. Financial support was not provided in 1993, 1992 or 1991, as the ratios were 1.99 to 1 (excluding the effect of the accounting changes), 1.74 to 1, and 1.48 to 1, respectively. This arrangement is not intended to make Deere & Company responsible for the payment of obligations of the Company. NOTE 7 COMMON STOCK All of the Company's common stock is owned by John Deere Credit Company, a wholly-owned finance holding subsidiary of Deere & Company. No shares of common stock of the Company were reserved for officers or employees or for options, warrants, conversions or other rights at October 31, 1993 or 1992. NOTE 8 DIVIDENDS In October 1993, the Capital Corporation paid a cash dividend to John Deere Credit Company of $82 million, which in turn paid an $82 million cash dividend to Deere & Company. Similarly, during 1992, the Capital Corporation paid a $70 million dividend. During the first quarter of 1994, the Capital Corporation declared and paid a dividend of $150 million to John Deere Credit Company, which in turn declared and paid a dividend of $150 million to Deere & Company. NOTE 9 PENSION AND OTHER RETIREMENT BENEFITS The Company participates in the Deere & Company salaried pension plan, which is a defined benefit plan in which benefits are based primarily on years of service and employees' compensation near retirement. This plan is funded according to the 1974 Employee Retirement Income Security Act (ERISA) and income tax regulations. Plan assets consist primarily of common stocks, common trust funds, government securities and corporate debt securities. Pension expense is actuarially determined based on the Company's employees included in the plan. The Company's pension expense amounted to $1.5 million in 1993, $1.0 million in 1992 and was negligible in prior years. Further disclosure for the plan is included in the Deere & Company 1993 annual report pension note. During the fourth quarter of 1993, the Company adopted FASB Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, effective November 1, 1992. Additional information is presented in the "Summary of Significant Accounting Policies" on page 35, and the "Quarterly Data (unaudited)" on page 45. The Company generally provides defined benefit health care and life insurance plans for retired employees. Health care and life insurance benefits expense is actuarially determined based on the Company's employees included in the plans and amounted to $.6 million in 1993. The 1992 and 1991 expenses were negligible as determined under the previous accounting principle. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10 INCOME TAXES TAXES ON INCOME AND INCOME TAX CREDITS The taxable income of the Company is included in the consolidated United States income tax return of Deere & Company. Provisions for income taxes are made generally as if the Capital Corporation and each of its subsidiaries filed separate income tax returns. DEFERRED INCOME TAXES In 1992, the Company adopted FASB Statement No. 109, Accounting for Income Taxes. There was no cumulative effect of adoption or current effect on continuing operations mainly because the Company had previously adopted FASB Statement No. 96, Accounting for Income Taxes, in 1988. Deferred income taxes arise because there are certain items that are treated differently for financial accounting than for income tax reporting purposes. An analysis of deferred income tax assets and liabilities at October 31 in millions of dollars follows: The provision for income taxes consisted of the following in millions of dollars: The Omnibus Budget Reconciliation Act of 1993, which enacted an increase in the United States federal statutory income tax rate effective January 1, 1993, was signed into law during the fourth quarter of 1993. In accordance with FASB Statement No. 109, Accounting for Income Taxes, deferred tax assets and liabilities as of the enactment date were revalued during the fourth quarter of 1993 using the new rate of 35 percent. This resulted in a credit of $.7 million to the provision for income taxes. EFFECTIVE INCOME TAX PROVISION A comparison of the statutory and effective income tax provisions of the Company and reasons for related differences follow in millions of dollars: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 11 CASH FLOW INFORMATION For purposes of the statement of consolidated cash flows, the Company considers investments with original maturities of three months or less to be cash equivalents. Substantially all of the Company's short-term borrowings mature within three months or less. Cash payments by the Company for interest incurred on borrowings in 1993, 1992 and 1991 were $134.8 million, $172.6 million and $215.9 million, respectively. Cash payments for income taxes during these same periods were $54.9 million, $53.0 million and $53.3 million, respectively. NOTE 12 LEGAL PROCEEDINGS The Company is subject to various unresolved legal actions which arise in the normal course of its business. The most prevalent of such actions relates to state and federal regulations concerning retail credit. There are various claims and pending actions against the Company with respect to commercial and consumer financing matters. These matters include lawsuits pending in federal and state courts in Texas alleging that certain of the Company's retail finance contracts for recreational vehicles and boats violate certain technical provisions of Texas consumer credit statutes dealing with maximum rates, licensing and disclosures. The plaintiffs in Texas claim they are entitled to common law and statutory damages and penalties. On November 6, 1992 the federal District Court certified a federal class action under Rule 23 (b) (3) of the Federal Rules of Civil Procedure in an action brought by Russell Durrett, individually and on behalf of others, against John Deere Company (filed in state court on February 19, 1992 and removed on February 26, 1992 to the United States District Court for the Northern District of Texas, Dallas Division). On October 12, 1993, in a case named DEERE CREDIT, INC. V. SHIRLEY Y. MORGAN, ET AL., filed February 20, 1992, the 281st District Court for Harris County, Texas, certified a class under Rules 42 (b) (1) (A), 42 (b) (1) (B) and 42 (b) (2) of the Texas Rules of Civil Procedure, of all persons who opt out of the federal class action. The Company believes that it has substantial defenses and intends to defend the actions vigorously. Although it is not possible to predict the outcome of these unresolved legal actions, and the amounts of claimed damages and penalties are large, the Company believes that these unresolved legal actions will not have a material adverse effect on its consolidated financial position. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13 QUARTERLY DATA (UNAUDITED) Supplemental consolidated quarterly information for the Company follows in millions of dollars: Schedule VIII JOHN DEERE CAPITAL CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED OCTOBER 31, 1993, 1992 AND 1991 (in thousands of dollars) Schedule IX SHORT-TERM BORROWINGS FOR THE YEARS ENDED OCTOBER 31, 1993, 1992 AND 1991 (in thousands of dollars) - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- INDEX TO EXHIBITS Page No. ------- 3.1 Certificate of Incorporation, as amended 50 3.2 By-laws, as amended 57 4.1 Credit agreements among registrant, Deere & Company, various financial institutions, and Chemical Bank and Deutsche Bank, as Managing Agents, dated as of December 15, 1993. 64 4.2 Revolving evergreen facility linked credit agreement among registrant, Deere & Company and a number of banks dated as of March 26, 1993 (Exhibit 4.2 to Form 10-Q of the registrant for the quarter ended April 30, 1993*). 4.3 Form of certificate for common stock (Exhibit 4.3 to Form 10-Q of the registrant for the quarter ended April 30, 1993*) 4.4 Indenture dated as of February 15, 1991 between registrant and Citibank, N.A., as Trustee (Exhibit 4.5 to Form 10-Q of the registrant for the quarter ended April 30, 1993*). Certain instruments relating to long-term debt constituting less than 10% of the registrant's total assets, are not filed as exhibits herewith pursuant to Item 601(b)(4)(iii)(A) of Regulation S-K. The registrant will file copies of such instruments upon request of the Commission. 9. Not applicable. 10.1 Agreement dated May 11, 1993 between registrant and Deere & Company concerning agricultural retail notes (Exhibit 10.1 to Form 10-Q of registrant for the quarter ended April 30, 1993*). 10.2 Agreement dated May 11, 1993 between registrant and Deere & Company concerning lawn and grounds care retail notes (Exhibit 10.2 to Form 10-Q of the registrant for the quarter ended April 30, 1993*). 10.3 Agreement dated May 11, 1993 between registrant and John Deere Industrial Equipment Company concerning industrial retail notes (Exhibit 10.3 to Form 10-Q of the registrant for the quarter ended April 30, 1993*). 10.4 Agreement dated January 26, 1983 between registrant and Deere & Company relating to agreements with United States sales branches on retail notes (Exhibit 10.4 to Form 10-Q of the registrant for the quarter ended April 30, 1993*). 10.5 Insurance policy no. CL-001 of Sierra General Life Insurance Company providing insurance on lives of purchasers of certain equipment financed with receivables (Exhibit 10.5 to Form 10-Q of the registrant for the quarter ended April 30, 1993*). 11. Not applicable. 12. Statement of computation of the ratio of earnings before fixed charges to fixed charges for each of the five years in the period ended October 31, 1993. 321 13. Not applicable 16. Not applicable 18. Not applicable 21. Omitted pursuant to instruction J(2) 22. Not applicable 23. Consent of Deloitte & Touche 322 24. Not applicable 27. Not applicable 28. Not applicable 99.1 Parts I and II of the Deere & Company Form 10-K for the fiscal year ended October 31, 1993.* - ----------------------------- * Incorporated by reference. Copies of these exhibits are available from the Company upon request.

79209_1993.txt

79209_1993

1993

79209

ITEM 1. BUSINESS. PLY GEM Industries, Inc., a Delaware corporation ("Ply Gem", hereinafter with its subsidiaries referred to collectively as the "Company"), was originally incorporated in 1946 in New York and reincorporated in Delaware in 1987. The Company is a leading manufacturer and distributor of a wide range of specialty products for the home improvement industry. The Company believes that it is among the nation's largest manufacturers of wood windows, vinyl siding and accessories, and vinyl windows, and one of the major suppliers of specialty wood and other related products. Each of the Company's ten wholly- owned subsidiaries and its one division have achieved a leading market position within their respective niches of the home improvement industry. The home improvement industry includes products designed for all remodeling, repair and alteration of residential structures, whether the work is performed by the homeowner (the "do-it-yourselfer" or "D-I-Y"), or by a professional contractor. Home improvement products, which in some cases are also used in new construction applications, are sold either through retailers or specialty wholesale distributors that in turn sell to retailers, contractors and builders. The success of the recently introduced warehouse home center format, such as that utilized by Home Depot, continues to change the traditional way in which home improvement products are sold. The Company's primary objective is to become the supplier of choice to the home improvement industry for high margin specialty products. The Company believes that it is uniquely positioned to provide products and services to the major home center retailers, which the Company believes is the fastest growing segment of the home improvement industry. The Company's products are distributed through an extensive network which includes major retail home center chains, specialty home remodeling distributors, lumber and building products wholesalers, professional contractors and Company operated distribution centers. The products are marketed throughout the United States, Canada and Puerto Rico through Company sales personnel and independent representatives. The Company operates predominantly in one business segment -- Home Improvement Products. Prior to 1992, the Company reported in two industry segments, Home Improvement Products and Home Products. The operations of the latter segment, consisting of manufacturing and distribution of disposable paper and cloth vacuum cleaner bags, have become less significant over the past several years and as a result the Home Products operations are not material to an understanding of the Company's business taken as a whole. BUSINESSES OF THE COMPANY The Company operates in four primary business groups: Windows, Doors and Siding; Specialty Wood Products; Distribution; and Home Products. Set forth below are the operating entities within each group and the year in which the entity was acquired by the Company. Ply*Gem Manufacturing is a division of the Company and constitutes the Company's original business. WINDOWS, DOORS AND SIDING SNE Enterprises, Inc: SNE is a major manufacturer of wood windows, competing with companies such as Andersen, Marvin and Pella. The Company believes that it is the second largest supplier of wood windows to the major home center retailers. SNE manufactures a full line of wood windows and patio doors, glass and polycarbonate skylights, and wooden interior bifold doors and shutters. Its products are sold under the Crestline(R) and Vetter(R) brand names and include double hung, casement, sliding and awning windows as well as hinged and sliding patio doors. SNE will shortly introduce a window that offers the maintenance free and insulating benefits of a solid vinyl window yet has a wood interior that can be painted or stained. SNE's windows are available primed, or with an exterior cladding of either aluminum or vinyl. They are available in both custom and stock sizes, and are sold through an extensive network of home centers, lumber and building materials retailers, and specialized value added distributors. SNE's products are primarily for the home improvement market. The market for wood windows is highly competitive. SNE differentiates itself from its competition by pursuing a dual brand strategy, having a distribution base in both the remodeling and new construction markets, extensive custom design and manufacturing capabilities, and a superior field service and support network. In addition, SNE's strategy of manufacturing window components at its main facility in Central Wisconsin for final assembly at one of four strategically located assembly/distribution centers, allows for the delivery of product to customers on a just-in-time basis. The Company believes that SNE will continue to grow as its existing products gain brand recognition from cooperative and other advertising programs with its retail customers, and as it introduces new products. Furthermore, SNE is exploring opportunities to expand its business into new geographic markets. Variform, Inc.: Variform is a producer of vinyl siding in the United States and a leading supplier to the major home center retailers. Its vinyl siding, soffit and accessories are produced in a variety of patterns and colors, including woodgrains. Vinyl siding is used in both remodeling and new construction applications and has captured an increasing share of the market for exterior siding materials (which primarily includes wood, aluminum and masonry) due to its ease of installation, durability and low maintenance requirements. Vinyl siding is sold to either specialized wholesale distributors who in turn sell directly to remodeling contractors (one-step distribution), or to building materials distributors who sell to home centers and lumberyards who in turn sell to remodeling contractors (two-step distribution). While Variform sells through both channels of distribution, it focuses on the two-step market, where management believes it is a dominant supplier to the major home center retailers and retail lumber yards. The Company believes that Variform is able to compete on favorable terms as a result of its broad distribution coverage, high quality innovative products, and production efficiency. Additionally, Variform is strongest in the retail segment of the market, which continues to grow at a rate that is faster than the overall market, as warehouse retailers continue to take business away from the traditional one- step market by offering remodeling contractors a "one-stop-shop" for all of their home improvement materials needs. Great Lakes Window, Inc.: Great Lakes is a manufacturer of high quality, energy efficient, maintenance free vinyl replacement windows. Its products include double hung, casement, sliding and awning windows as well as hinged and sliding patio doors. Great Lakes offers a wide selection of products, including a variety of exterior colors and interior woodgrains, several different grille patterns and a wide assortment of glass options. Great Lakes products are primarily used in replacement applications, where windows and patio doors are manufactured for a specific order on a custom size basis. Accordingly, Great Lakes maintains relatively little finished goods inventory. Great Lakes has recently introduced a vinyl window to penetrate the new construction market which will be sold primarily through two-step distribution. Great Lakes sells its products through its highly trained sales force. It sells its products to specialty window distributors who in turn sell to remodeling contractors, and direct to large remodeling companies. The Company believes that Great Lakes is able to compete successfully due to the breadth and quality of its product offering, and its merchandising support that the Company believes is one of the best in the industry. In addition, Great Lakes has been the forerunner in introducing new designs to the industry. Great Lakes' innovative locking system, interior woodgrains and its use of various glass treatments, are a few examples of innovations that distinguish Great Lakes from its competition. Great Lakes expects to continue to develop new designs and features for its products in the future. Richwood Building Products, Inc.: Richwood is a manufacturer of siding accessories to the remodeling and new construction markets. Siding accessories include blocks, which allow for the flush mounting of items like light fixtures to the exterior of a home, and gable vents. Their products are sold through a network of manufacturers representatives and directly to home centers, lumberyards and wholesale distributors of building materials, electrical and plumbing products. Richwood is the only manufacturer of siding accessories to offer a color selection that matches the colors offered by most, if not all, major manufacturers of vinyl siding in the United States and Canada. SPECIALTY WOOD PRODUCTS Hoover Treated Wood Products, Inc: Hoover is a producer of pressure treated wood products, selling to home center chains, lumberyards and building materials retailers and wholesalers. Its products include lumber and plywood which have been treated for fire retardancy and for protection against moisture and insect infestation. Sagebrush Sales, Inc.: Sagebrush is a manufacturer and distributor of specialty lumber and building products serving the home improvement and building materials markets in the Southwest. Goldenberg Group, Inc.: Goldenberg is a West Coast manufacturer and distributor of furniture components, laminates and board products to furniture manufacturers and other original equipment manufacturers, building material retailers and wholesalers. Ply*Gem Manufacturing is a manufacturer and distributor of decorative wall coverings. Its products include decorator paneling, planking and tileboard for the home improvement market. Ply Gem Manufacturing recently introduced a complete line of imported ceramic, porcelain and marble floor tile marketed through home centers and lumber yards. Continental Wood Preservers, Inc.: Continental is a Midwestern manufacturer of pressure treated wood products for home improvement retailers and lumberyards in the Midwest. While the specialty wood products industry is very competitive, the Company believes it is able to compete effectively by providing superior customer service, outstanding quality and, wherever possible, proprietary products. The companies within the group focus on high margin, niche markets within the broader defined wood products industry which tends to be commodity driven. Its products are sold through home center retailers and wholesalers of building materials. The Company believes that growth of this segment of its business will result from continued expansion of its share of the growing home center market. DISTRIBUTION Allied Plywood Corporation: Allied is a national distributor of a broad range of high end specialty wood and wood related products, including hardwood plywood, melamine and other laminated board products, hardwood lumber, solid surface materials and cabinet hardware. It is also a major importer of Russian wood products, through its affiliate, Russian Wood Express Inc. ("Russian Wood"). Allied's customers are industrial woodworkers, including cabinet manufacturers, architectural millworkers, and manufacturers of store fixtures, furniture, signs and exhibits. Allied sells its products through an extensive network of twelve company operated warehouse facilities and utilizes numerous public warehouses located in various major port cities. Sales are generated by a well trained and experienced sales force. Allied differentiates itself from its competitors, which primarily include local independent distributors, by its superior customer service, geographic coverage and breadth of product line. As a result, it has become a preferred distributor of many products, selling them on an exclusive, or limited exclusive, basis. The Company believes that Allied's future growth will be from the introduction of new products, expansion of its customer base and the development of further opportunities through Russian Wood. Allied recently began to penetrate the retail home center market with some of its products and, the Company believes, will increase its sales to that industry segment. HOME PRODUCTS Studley Products, Inc.: Studley is a manufacturer of disposable cloth and paper vacuum cleaner bags. In addition, it sells related floor care products, grass catcher bags for the lawn care market, and filtration products for use in pollution control applications. Studley's products are sold to manufacturers of vacuum cleaners, mass merchandisers and other retailers and recently to the retail home center market and other retailers. Even though the market is very competitive, Studley is able to compete on the basis of its technical expertise in the design and manufacture of its products, and in its use of high performance materials. Studley recently introduced an innovative new vacuum cleaner bag that is able to capture pollen and other allergy causing bacteria through the use of high performance materials. The continued introduction of new products and the fact that many consumers are now likely to own more than one vacuum cleaner are expected to provide opportunities for future growth. PRODUCTION AND FACILITIES The Windows, Doors and Siding group operates fifteen manufacturing and warehouse facilities in the United States and one in Canada. Vinyl siding is produced by an extrusion process which forms siding through various dies from certain resin compounds, primarily polyvinyl chloride. Siding accessories are manufactured through an injection molding process using proprietary mold designs. Insulated vinyl framed replacement windows are manufactured, using a patented process, from insulated glass and vinyl extrusions. The manufacturing process of wood windows and patio doors involves cutting and shaping of components that are assembled with high speed tools. Final assembly of most wood window and door products takes place in four distribution centers located in the Eastern and Midwestern United States. The manufacturing plants generally operate in a "make-to-order" environment. In 1993, Variform completed construction of a 75,000 square foot vinyl siding manufacturing facility in Jasper, Tennessee and Great Lakes completed a 90,000 square foot plant expansion at its vinyl window manufacturing facility in Toledo, Ohio. The Specialty Woods group operates thirteen manufacturing and warehouse facilities in the United States. The treatment process of wood products generally involves vacuum pressure impregnation of chemicals into the wood in an enclosed vessel to ensure thorough penetration to meet industry and government standards. Some of the wood is kiln dried after treatment to remove moisture imparted during the pressure impregnation process, providing a clean, dry and easily handled product. The Company's high-speed laminating production facilities in Gloucester City, New Jersey afford flexibility in laminating paper and vinyl to various substrate materials. Furniture components are manufactured from particle board or fiberboard which is machined to customer specifications. Several unique proprietary processes are employed to manufacture these products efficiently. Specialty lumber products, including siding, decking and paneling are manufactured by the Company in three facilities with a combined annual production capacity in excess of 100 million board feet. Distribution operates twelve distribution centers located primarily in the East and utilizes numerous public warehouses located in various major port cities. Disposable and cloth vacuum cleaner bags are manufactured at two facilities in the United States and one in Canada. Disposable paper vacuum cleaner bags are manufactured on highly automated equipment, the major part of which was designed and built by the Company. Cloth vacuum cleaner bags are manufactured by cutting fabric to a preformed pattern which is then sewn into the finished product and packaged. The Company is continuously engaged in designing vacuum cleaner bags for new vacuum cleaner models. RAW MATERIALS The principal raw materials used in the manufacture of the Company's products are polyvinyl chloride, polypropylene, glass, vinyl extrusions, particle board, fiberboard, plywood, various species of lumber such as pine, spruce, luaun, hemlock and fir, various chemicals, filter paper, woven and non woven fabric, and paper. The Company purchases its raw materials from a large number of domestic and international sources. The Company believes that there are alternative sources of supply in the event of its inability to purchase from its present suppliers. SEASONALITY The Company's home improvement business is seasonal, particularly in the Northeast and Midwest regions of the United States where inclement weather during the winter months usually reduces the level of activity in both the home improvement and new construction markets. The Company's lowest sales levels usually occur during the first and fourth quarters. Since a high percentage of the Company's manufacturing overhead and operating expenses are relatively fixed throughout the year, operating income tends to be lower in quarters with lower sales. Inventory and borrowings to satisfy working capital requirements are usually at their highest level during the second and third quarters. BACKLOG In general, the Company does not produce against a backlog of firm orders; production is geared primarily to the level of incoming orders and to projections of future demand. Significant inventories of finished goods, work- in-process and raw materials are maintained to meet delivery requirements of customers. Hoover and Continental maintain a steady backlog of firm orders to be filled in an amount representing approximately 7% of their annual sales. Distribution consists of warehouse operations where orders are filled from stock and where there is no significant backlog. EMPLOYEES On January 3, 1994, Monte R. Haymon became President, Chief Operating Officer and a member of the Board of Directors of Ply Gem. Prior to joining Ply Gem, Mr. Haymon was President and Chief Executive Officer of a $2 billion manufacturing company. Mr. Haymon has over 20 years of experience in successfully managing multiple business units and achieving outstanding financial performance. At December 31, 1993 approximately 4,000 persons were employed by the Company. Approximately 1,300 of such employees are covered by collective bargaining agreements which expire at various times over the next three years. The Company has not had any significant work stoppages and considers its relations with its employees to be good. ITEM 2. ITEM 2. PROPERTIES. The Windows, Doors and Siding group operates fifteen manufacturing and warehouse facilities in the United States and one in Canada ranging in size from approximately 20,000 square feet to 660,000 square feet. Of these facilities, nine are owned, and seven are leased under net leases that expire at various dates through 2016. The group's manufacturing facilities operated at ranges of approximately 75% to 95% of capacity during 1993. The Specialty Woods group has thirteen manufacturing and warehouse facilities in the United States ranging in size from approximately 35,000 square feet to 215,000 square feet. Of these facilities, seven are owned and six facilities are leased under net leases that expire at various dates through 2005. The group's manufacturing facilities operated at ranges of approximately 55% to 90% of capacity during 1993. Distribution operates twelve distribution centers located primarily in the East ranging in size from approximately 16,000 square feet to 70,000 square feet. Two facilities are owned and ten facilities are leased under leases that expire at various dates through 1998. Home Products has two manufacturing facilities in the United States and one in Canada. These facilities range in size from approximately 39,000 square feet to 160,000 square feet and are leased by the company under leases that expire at various dates through 2007. The facilities operated at ranges of approximately 60% to 65% of capacity during 1993. The Company's building, machinery and equipment have been generally well maintained, are in good operating condition and are adequate for current and future production requirements. The Company's executive offices are located at 777 Third Avenue, New York, New York and consist of 9,500 square feet of office space which is leased through 1999. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Hoover, a wholly-owned subsidiary of Ply Gem, is a defendant, along with many other parties, in a number of commercial lawsuits, including a purported class action on behalf of certain Maryland homeowners, alleging property damage caused by alleged defects in certain pressure treated interior wood products it produced and sold through August, 1988. Sales of this product constituted less than 3% of the total sales of Ply Gem and its subsidiaries on a consolidated basis during the period January 1, 1984 through December 31, 1990. Ply Gem is also a defendant in many of these suits. The number of lawsuits pending as of December 31, 1993, as well as the number of lawsuits filed in 1993, has declined significantly. Many of the suits and claims have been settled. In those suits that remain pending, direct defense costs are being paid by either insurance carriers, under reservations of rights agreements, or out of insurance proceeds. Two actions have proceeded to trial against Hoover and resulted in jury verdicts against it. In one of these actions, judgment was entered in Hoover's favor by the court after a jury verdict against it and the plaintiff's petition to appeal from the judgment entered in Hoover's favor has been denied. Hoover is appealing the other judgment and believes that it has meritorious grounds for overturning it in whole or in part. Certain carriers have brought actions challenging coverage. Hoover and Ply Gem believe they have meritorious claims for coverage, are defending these actions, have counterclaimed and are seeking declaratory judgments confirming coverage. Many of the coverage claims have been settled and proceeds from those settlements, along with the proceeds from a settlement of claims by Hoover against certain suppliers of materials used by it in the production of treated wood, are available for the settlement of the underlying property damage actions, including the jury verdict now on appeal. Hoover believes that its remaining coverage disputes will be resolved and a substantial amount of additional coverage will be available to it. Hoover and Ply Gem are vigorously defending those lawsuits which cannot be resolved on a reasonable basis and believe that they have meritorious defenses to those suits including, in the case of Ply Gem, the defense that it has been improperly joined, as it did not manufacture or market the Hoover products at issue, and is not legally liable for the damage allegedly caused by them. In evaluating the effect of the lawsuits, a number of factors have been considered, including: the number and exposure posed by the pending lawsuits; the significant decline in the number of lawsuits filed in 1993; the availability of various legal defenses, including statutes of limitation, the existence of settlement protocols, an agreement indemnifying Hoover as to certain past and future claims and Hoover's experience in settling with its insurance companies and the likely availability of additional insurance. It is estimated that the future cost of resolving those matters not presently covered by existing settlements with insurance carriers and suppliers is sixteen million dollars, which it expects will be covered by future recoveries from additional insurance carriers. Based on its evaluation, the Company believes that the ultimate resolution of the lawsuits and the insurance claims will not have a material adverse effect upon the financial position 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 STOCKHOLDER MATTERS. The Company's common stock is listed on the American Stock Exchange. The following table sets forth, for the periods indicated, the high and low market prices and dividends paid. The Company has paid cash dividends on its Common Stock since 1976 and presently pays quarterly dividends at the annual rate of $.12 per share. The Company's revolving credit facility has limitations on the annual amounts of the Company's dividends. Under the most restrictive provision, at December 31, 1993, approximately $2,192,000 was available for the payments of dividends in 1994. The number of stockholders of record of the Company's common stock as of March 14, 1994 was 2,910. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Set forth below is certain Selected Financial Data for each of the years shown. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis provides information which management believes is relevant to an assessment and understanding of the Company's consolidated results of operations and financial condition. The discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto. RESULTS OF OPERATIONS NET SALES The Company achieved record net sales during 1993 of $722.7 million, an increase of approximately $100 million or 16.0% over 1992 net sales of $623.2 million and an increase of approximately $161 million or 28.7% over 1991 net sales of $561.6 million. Sales in each of the Company's 1993 quarters were above those of comparable 1992 periods. Substantially all operating entities of the Company reported higher net sales for 1993 when compared with 1992. Of the total net sales increase in 1993, approximately 10% is attributable to additional unit volume and approximately 6% to increases in average selling prices. The increase in net sales in 1992, as compared with 1991, was primarily related to additional unit volume. Strong sales in the Company's Windows, Doors, and Siding group continue to fuel the Company's growth as this group has achieved double digit sales growth in each of the last five years. After several years of decline, due primarily to the closing and consolidation of certain facilities and elimination of certain lower margin product lines, Distribution reported substantial improvement in 1993, as net sales were 19% higher than 1992. GROSS PROFIT Gross profit, expressed as a percentage of net sales, was 19.1% in 1993, compared with 20.7% for 1992 and 21.5% in 1991. Higher raw material costs (particularly wood and resin), competitive pricing pressures, and costs of introducing new products accounted for most of the decline in 1993. The lower margin in 1992 as compared to 1991 was due primarily to higher wood costs. The Company's results of operations are affected by fluctuations in the market prices of lumber and other wood products that have been used as raw materials in its various manufacturing operations. During the last several years, the market prices of lumber and other wood products have been volatile. Although the Company attempts to increase the sales price of its products in response to higher lumber and wood products costs, such sales price increases often lag behind the escalation in the cost of the raw materials in question. While the Company intends to increase prices in a timely manner to cover any further increases in the cost of lumber and other wood products, its ability to do so may be limited by competitive or other factors. The Company continues to explore various strategies to improve its gross profit margins, including productivity enhancements, increased yields through more efficient process technologies, cost reduction programs, and reviews of manufacturing capacity and utilization. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative expenses, as a percentage of net sales, were 14.8% in 1993, compared to 16.3% in 1992 and 16.9% in 1991. The improvement reflects the Company's continued progress in its ongoing efforts to manage expense growth relative to revenue growth. The significant improvement in 1993 and 1992 was primarily due to economies resulting from the absorption of fixed expenses over a larger sales base. INCOME FROM OPERATIONS Income from operations increased 15.5% to $31.6 million in 1993 from $27.4 million in 1992. Income from operations was $25.8 million in 1991. The improvements are due to the factors discussed above. INTEREST EXPENSE Interest expense was $10.1 million in 1993 compared to $9.6 million in 1992 and $14.1 million in 1991. The slight increase during 1993 as compared to 1992 is due primarily to higher average debt balances outstanding during 1993. Lower interest rates, coupled with lower average debt outstanding during 1992, favorably affected interest expense in 1992 by $4.5 million as compared to 1991. In February 1994, the Company refinanced substantially all of its bank debt, as more fully explained in Note 7 to the Consolidated Financial Statements and in the Liquidity and Capital Resources discussion below. Pricing under the new credit facility is expected to be substantially similar to pricing under the prior facilities. In March 1994, as more fully explained in Note 8 to the Consolidated Financial Statements, holders of the Company's 10% Convertible Senior Subordinated Discount Debentures ("Debentures") converted a total principal amount of approximately $50 million into 2,751,349 shares of the Company's common stock. As a result of this transaction, the Company will save, on an annual basis, $5 million of interest costs. OTHER INCOME (EXPENSE) Other income (expense) for 1993 and 1992 primarily includes the costs associated with the sale of receivables program, partially offset in 1993 by a gain resulting from an involuntary conversion of property. INCOME TAXES The effective income tax rate was 44.8% in 1993, 44.6% in 1992, and 47.9% in 1991. During 1993 the federal statutory rate was increased by 1% retroactive to January 1, 1993. The rate increase was offset by a proportionately lower amount of non-deductible goodwill amortization in 1993 as compared to income before taxes in 1992 and 1991. The higher tax rate in 1991 is primarily due to operating losses of the Distribution subsidiaries for which no state tax benefits were available. NET INCOME Net income advanced 53% to $9.7 million in 1993 from $6.3 million in 1992. Net income was $4.0 million in 1991. The factors cited above were responsible for the significantly improved results of the Company. The results for 1993 featured a strong operating performance by the Company's business groups. The Company's continuing success in the home improvement industry is primarily attributable to an uncompromising emphasis on quality, excellence in customer service, and superior product design. LIQUIDITY AND CAPITAL RESOURCES The Company's financial position remained strong in 1993. In February 1994, the Company entered into a five-year revolving credit facility ("Credit Facility") with a syndicate of banks, which provides financing of up to $200 million. Initial borrowings were used to repay amounts outstanding under the Company's previous credit facilities. The Credit Facility provides the Company with financing at competitive prices, strengthens its balance sheet by extending debt maturities to 1999, and makes available additional resources for its Teamwork 90s internal growth programs. See Note 7 to the Consolidated Financial Statements for additional information concerning the Credit Facility. As discussed above, holders of the Debentures converted a total principal amount of approximately $50 million into 2,751,349 shares of the Company's common stock. As a result, the Company's net worth will be increased by approximately $50 million, and the Company will save $5 million of annual interest expense. The table below summarizes the Company's cash flow from operating, investing, and financing activities as reflected in the Consolidated Statement of Cash Flows. OPERATING ACTIVITIES The amount of cash provided by operating activities in 1993 was relatively unchanged from 1992. The significant increase in 1991 in cash from operating activities as compared to 1992 resulted from the proceeds from the sale of certain accounts receivable to a financial institution and to the success of the Company's inventory reduction program. The Company's working capital requirements for inventory and receivables are impacted by changes in raw materials costs, the availability of raw materials, growth of the Company's businesses and seasonality. As a result, such requirements may fluctuate significantly. INVESTING ACTIVITIES Investing activities of the Company during the discussion periods primarily consist of the acquisition and sale of property, plant and equipment and the receipt and usage of funds held for construction. During 1992, Variform began construction of a new vinyl siding facility in Jasper, Tennessee and Great Lakes commenced a plant expansion at its facility in Toledo, Ohio. Aggregate construction and initial production equipment costs, which are being financed from the proceeds of industrial revenue bonds, are $11.2 million. The Jasper facility was completed during the second quarter of 1993 and the Toledo facility during the third quarter of 1993. Capital expenditures (excluding approximately $9.6 million of costs incurred through December 31, 1993, of which $4.8 million was incurred during 1993 for the aforementioned construction projects) were $15.7 million in 1993, compared to $12.3 million in 1992 and $9.7 million in 1991. Most of the outlays were for machinery and equipment used to expand capacity and improve productivity. Funds Held for Construction relate to proceeds and usage of cash from the industrial development revenue obligations discussed above. Fixed asset acquisitions provide a basis for future growth. The Company has formalized an intensive review procedure for all capital expenditures. The acceptability of a capital project is based on many factors, including its discounted cash flow return on investment and projected payback period. The Company expects to incur approximately $15 million in 1994 for capital expenditures, excluding costs related to the construction projects discussed above. FINANCING ACTIVITIES During 1993 the Company had borrowings of $ 34.8 million under its revolving credit lines. Bank borrowings were primarily used to finance growth in working capital and capital expenditures. BALANCE SHEET CONTINUES TO BE STRONG The pro forma capitalization of the Company (long-term debt plus stockholders' equity) was $277.5 million at December 31, 1993. The pro forma ratio of debt to capitalization was approximately 36% at December 31, 1993 which is substantially improved from such ratio at December 31, 1992 which was approximately 50%. The current ratio was 3.2 at December 31, 1993, significantly better than the 2.3 ratio at the end of 1992. The factors that contributed to this improvement included the reduction of current debt obligations resulting from the Credit Facility, increased cash balances and higher receivables caused by increased sales. Cash and marketable securities totaled $14.4 million at December 31, 1993. Long-term bank debt at December 31, 1993 was $92.9 million, compared with $62.5 million at December 31, 1992. The higher debt level was needed to finance higher working capital requirements and capital expenditures. In addition to cash from operating activities, the Company has a new Credit Facility available to meet future liquidity needs. After repayment of the prior credit facilities, approximately $63 million was available for borrowing under the Credit Facility. The Company has several interest rate agreements which reduce the Company's exposure to rising interest rates. SEASONAL NATURE OF BUSINESS The home improvement business is seasonal, particularly in the Northeast and Midwest regions of the United States where inclement weather during the winter months usually reduces the level of building and remodeling activity in both the home improvement and new construction markets. The Company's lowest sales levels usually occur during the first and fourth quarters. Since a high percentage of the Company's manufacturing overhead and operating expenses are relatively fixed throughout the year, operating income tends to be lower in quarters with lower sales. Inventory and borrowings to satisfy working capital requirements are usually at their highest level during the second and third quarters. PROSPECTIVE FINANCIAL STANDARDS The Financial Accounting Standards Board (FASB) issued Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and FASB No. 112, Employers' Accounting for Postemployment Benefits, which are effective January 1, 1994. Adoption of these standards is not expected to have a material impact on the Company's results of operations or financial position, nor will it affect the Company's cash flows. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS (THE INDEX TO CONSOLIDATED FINANCIAL STATEMENTS IS INCORPORATED BY REFERENCE IN ITEM 14(A) OF PART IV OF THIS FORM 10-K) (ART) REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Directors and Stockholders Ply Gem Industries, Inc. We have audited the accompanying consolidated balance sheets of Ply Gem Industries, Inc. and Subsidiaries (the "Company") 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 consolidated financial position of Ply Gem Industries, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their 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 New York, New York February 24, 1994 (except for Note 8 as to which the date is March 23, 1994) PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, The accompanying notes are an integral part of these statements. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME The accompanying notes are an integral part of these statements. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes are an integral part of these statements. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these statements. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Ply Gem Industries, Inc. and its wholly-owned subsidiaries after eliminating all significant intercompany accounts and transactions. Certain prior year items have been reclassified to conform to the 1993 presentation. Cash and Cash Equivalents Cash and cash equivalents include cash on hand and temporary investments having a maturity of three months or less. Marketable Securities Marketable securities are carried at the lower of aggregate cost or market. Inventories Inventories are stated at the lower of cost or market. Cost is determined on the first-in, first-out (FIFO) method. Property, Plant and Equipment Owned property, plant and equipment are depreciated, generally on a straight- line basis over their estimated useful lives. Leasehold improvements are amortized on a straight-line basis over their respective lives or the terms of the applicable leases, including expected renewal options, whichever is shorter. Accelerated depreciation methods are used for tax purposes. Capitalized leases are amortized on a straight-line basis over the terms of the leases or their economic useful lives. Intangible Assets (a) Patents and Trademarks Purchased patents and trademarks are recorded at appraised value at time of acquisition and are being amortized on a straight-line basis over their estimated remaining economic lives; thirteen to sixteen years for patents and thirty years for trademarks. (b) Other Intangibles Cost in excess of net assets acquired is being amortized from twenty to thirty years on a straight-line basis and is evaluated annually to determine potential impairment by comparing its carrying value to the estimated future cash flows of the related assets. Other purchased intangibles are being amortized on a straight-line basis generally from ten to thirty-nine years. Income Taxes Deferred income taxes are provided to reflect temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Earnings Per Share Earnings per share of common stock are based on the weighted average number of shares and common equivalent shares outstanding during each of the periods. Primary and fully diluted earnings per share include the dilutive effect of unexercised stock options as modified for options in excess of 20% of shares outstanding. The assumed conversion of the Company's Convertible Subordinated Debentures was not used in the fully diluted calculation because the result would be anti-dilutive. NOTE 2 -- CASH FLOWS Supplemental cash flow information for the years ended December 31 is as follows: NOTE 3 -- SALE OF ACCOUNTS RECEIVABLE In December 1991, the Company entered into a three-year agreement to sell, with limited recourse, up to $20 million of undivided fractional interests in a designated pool of accounts receivable. An interest in new accounts receivable are sold as collections reduce previously sold interests. At December 31, 1993 and 1992, accounts receivable were reduced $20 million by these transactions. Program costs of $1,495,000 and $1,502,000 are included in other income (expense) in the 1993 and 1992 Consolidated Statements of Income, respectively. NOTE 4 -- INVENTORIES Inventories consisted of the following at December 31: NOTE 5 -- PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment at December 31 included: PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 6 -- INTANGIBLE AND OTHER ASSETS The accumulated amortization of cost in excess of net assets acquired and other intangible assets is $26,136,000 at December 31, 1993 and $22,022,000 at December 31, 1992. Other assets at December 31, 1993 include notes receivable from an executive officer of $7,280,000 ($8,220,000 at December 31, 1992) at an average interest rate of 7.1% and are due in approximately equal annual installments through 2003. Under the terms of the notes, principal and interest are forgiven upon the attainment of at least a 20% improvement in net income versus the prior year, or at the discretion of the Board of Directors. The performance goal was achieved in 1993 and 1992. Furthermore, under the terms of the officer's employment agreement the loan shall be forgiven upon the occurrence of a change in control of the Company or permanent disability. NOTE 7 -- LONG-TERM DEBT Long-term debt consists of the following: - -------- (a) At the Company's option, interest rates are at the prevailing prime rate and various LIBOR rates, or combinations thereof. The Company has entered into interest rate cap agreements which limit the maximum interest rates on a portion of these loans. On February 24, 1994 the Company refinanced substantially all of its bank debt under a $200 million five year syndicated bank credit facility which replaced several separate bank agreements including short-term facilities. Accordingly, the table above reflects this transaction as of December 31, 1993. The loan agreement requires the attainment of certain working capital and tangible net worth levels and the maintenance of various financial ratios, among its provisions. Borrowings under this agreement are collateralized by the common stock of the Company's principal subsidiaries. Under the most restrictive of these covenants, at December 31, 1993 approximately $2,192,000 was available for the payment of dividends in 1994. Future maturities of long-term debt, for the years 1995 through 1998 are: 1995--$430,000; 1996--$405,000; 1997--$425,000; and 1998--$448,000. The net book value of property, plant and equipment pledged as collateral under mortgages and industrial revenue bonds approximated $6,688,000 at December 31, 1993. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 8 -- CONVERTIBLE SUBORDINATED DEBENTURES--SUBSEQUENT EVENT During the period February 23, 1994 to March 23, 1994 holders of $49,963,000 principal amount of 10% Convertible Senior Subordinated Discount Debentures, due October 1, 2008, exchanged them for 2,751,349 shares of common stock of the Company. The remaining $37,000 of the original $50 million face amount was redeemed by the Company. The pro forma unaudited consolidated balance sheet reflects this event as of December 31, 1993, including estimated costs. If this transaction had occurred on January 1, 1993 primary and fully diluted earnings per share for 1993 would have been $.84 and $.83, respectively. NOTE 9 -- INCOME TAXES Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The adoption of this standard had no material effect on prior year or 1993 earnings. The provision for income taxes is composed of the following: The significant components of the Company's deferred tax assets and liabilities as of December 31, 1993 are summarized below: PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Prior to the change in accounting methods, the deferred tax provision was comprised as follows: The actual income tax expense varies from the Federal statutory rate applied to consolidated income as follows: NOTE 10 -- RETIREMENT PLANS The Company provides retirement benefits to certain of its salaried and hourly employees through non-contributory defined benefit pension plans. The benefits provided are primarily based upon length of service and compensation, as defined. The Company funds the plans in amounts as actuarially determined and to the extent deductible for Federal income tax purposes. Plan assets consist primarily of investments in mutual funds and unallocated general accounts of guaranteed income contracts. The components of pension expense are as follows: Assumptions used in the computation of net pension expense are as follows: PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The plans' funded status as September 30 is as follows: The Company maintains a discretionary profit sharing plan for certain of its salaried and hourly employees who vest after meeting certain minimum age and service requirements. Profit sharing plan expense is comprised as follows: One of the Company's subsidiaries maintains a 401(k) plan for its salaried employees which provides for a 1/3 match of the first six percent of employee contributions. The matched portion totaled $187,000 in 1993; $187,000 in 1992 and $173,000 in 1991. NOTE 11 -- STOCK OPTION PLANS The Company's Executive Incentive Stock Option Plan provides for the granting of options to key employees to purchase up to 2,037,500 shares of common stock. Option prices must be 100% of fair market value at date of grant except for an employee who owns in excess of 10% of the common stock outstanding, in which case the exercise price is 110% of the fair market value at date of grant. Options are exercisable in full or in part after one year from the date of grant and expire within ten years (within five years for an employee owning in excess of 10% of the outstanding common stock). Shares acquired must be held for one year. The Senior Executive Stock Option Plan ("the Senior Plan") authorizes the granting of either incentive or non-qualified stock options only to executives of businesses acquired by the Company or to newly employed executives. The Senior Plan provides for 750,000 shares of the Company's common stock to be reserved for issuance. The 1989 Employee Incentive Stock Plan ("the 1989 Plan") authorizes the granting of incentive and non-qualified stock options and awards of restricted stock and is to be made available to executives and key employees of the Company. As in the Senior Plan, option terms and holding and exercise periods may vary except that no option may be exercised more than ten years after date of grant. Stock awarded under the Plan will be subject to restrictions as to sale or transfer. These restriction may lapse or be waived based on performance, period of service or other factors. The 1989 Plan provides for 3,500,000 shares of the Company's common stock to be reserved for issuance. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In 1991, the Company granted 250,000 shares of restricted stock to an executive officer of the Company. The restrictions of these shares will be released at the rate of 25,000 shares per year upon the attainment of certain profit goals and the continued employment of the officer. The restrictions will be lifted in the event of a change in control of the Company. The unamortized restricted stock resulting from this stock award has been deducted from stockholders' equity and is being written off over ten years at the fair market value on the dates the restrictions are lifted. For the three years ended December 31, 1993, option activity was as follows: - -------- (a) May be used for incentive and non qualified options and for restricted stock. NOTE 12 -- COMMITMENTS AND CONTINGENCIES LEASES The Company leases certain of its manufacturing, distribution and office facilities as well as some transportation and manufacturing equipment under noncancellable leases expiring at various dates through 2017. Certain of the real estate leases contain escalation clauses and generally provide for payment of various occupancy costs. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Future minimum lease payments under capital and operating leases, together with the present value at December 31, 1993 of net minimum lease payments of capital leases are as follows: Rental expense for operating leases amounted to approximately $21,224,000 in 1993, $20,146,000 in 1992, and $17,694,000 in 1991. HOOVER TREATED WOOD PRODUCTS, INC. ("HOOVER") Hoover, a wholly-owned subsidiary of the Company, is a defendant, along with many other parties, in a number of commercial lawsuits, including a purported class action on behalf of certain Maryland homeowners, alleging property damage caused by alleged defects in certain pressure treated interior wood products it produced and sold through August, 1988. The Company is also a defendant in many of these suits. The number of lawsuits pending as of December 31, 1993, as well as the number of lawsuits filed in 1993, has declined significantly. Many of the suits and claims have been settled. In those suits that remain pending, direct defense costs are being paid by either insurance carriers, under reservations of rights agreements, or out of insurance proceeds. Two actions have proceeded to trial against Hoover and resulted in jury verdicts against it. In one of these actions, judgment was entered in Hoover's favor by the court after a jury verdict against it and the plaintiff's petition to appeal from the judgment entered in Hoover's favor has been denied. Hoover is appealing the other judgment and believes that it has meritorious grounds for overturning it in whole or in part. Certain carriers have brought actions challenging coverage. Hoover and the Company believe they have meritorious claims for coverage, are defending these actions, have counterclaimed and are seeking declaratory judgments confirming coverage. Many of the coverage claims have been settled and proceeds from those settlements, along with the proceeds from a settlement of claims by Hoover against certain suppliers of materials used by it in the production of treated wood, are available for the settlement of the underlying property damage actions, including the jury verdict now on appeal. Hoover believes that its remaining coverage disputes will be resolved and a substantial amount of additional coverage will be available to it. Hoover and the Company are vigorously defending those lawsuits which cannot be resolved on a reasonable basis and believe that they have meritorious defenses to those suits including, in the case of the Company, the defense that it has been improperly joined, as it did not manufacture or market the Hoover products at issue, and is not legally liable for the damage allegedly caused by them. In evaluating the effect of the lawsuits, the Company has considered a number of factors, including: the number and exposure posed by the pending lawsuits; the significant decline in the number of lawsuits filed in PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 1993; the availability of various legal defenses, including statutes of limitation, the existence of settlement protocols, an agreement indemnifying Hoover as to certain past and future claims and Hoover's experience in settling with its insurance companies and the likely availability of additional insurance. The Company estimates that the future cost of resolving those matters not presently covered by existing settlements with insurance carriers and suppliers is sixteen million dollars, which it expects will be covered by future recoveries from additional insurance carriers. Based on its evaluation, the Company believes that the ultimate resolution of the lawsuits and the insurance claims will not have a material adverse effect upon the financial position of the Company. EXECUTIVE COMPENSATION In the event of a change in control of the Company, as defined in resolutions adopted by the Board of Directors, senior management, except for the chairman, have the right to receive payments upon termination of employment or resignation within one year. Such payments are to be 2.75 times average annual compensation, as defined, plus 2.75 times the difference between the market and exercise price of any unexercised incentive stock options. At December 31, 1993, the maximum amount payable, applicable to twenty-five individuals, would be approximately $14,783,000 attributable to compensation and $15,248,000 to the options. LETTERS OF CREDIT At December 31, 1993 $22,580,000 of letters of credit issued by the Company's banks were outstanding, principally in connection with certain financing transactions. OTHER The Company and its subsidiaries are subject to legal actions from time to time which have arisen in the ordinary course of its business. In the opinion of management, the resolution of these claims will not have a material adverse effect upon the financial position of the Company. NOTE 13 -- INDUSTRY SEGMENT The Company operates predominantly in one business segment. Operations in the Home Improvement Products Business consist of the manufacture and sale of exterior vinyl siding, wood and vinyl-framed windows and patio doors, prefinished decorative plywood and solid wood paneling, furniture components and various pressure-treated wood products and the purchase and resale of a variety of other products for the home improvement and industrial markets. One customer accounted for 12.2% and 11.2% of the Company's net sales for the years ended December 31, 1993 and December 31, 1992, respectively. PLY GEM INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 14 -- QUARTERLY RESULTS (UNAUDITED) Earnings per share calculations for each of the quarters presented are based on the weighted average number of shares and common equivalent shares outstanding during such periods. The sum of the quarters may not necessarily be equal to the full year earnings per share amounts. 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 is incorporated by reference from the Proxy Statement prepared with respect to the Annual Meeting of Stockholders to be held on May 12, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required is incorporated by reference from the Proxy Statement prepared with respect to the Annual Meeting of Stockholders to be held on May 12, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required is incorporated by reference from the Proxy Statement prepared with respect to the Annual Meeting of Stockholders to be held on May 12, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required is incorporated by reference from the Proxy Statement prepared with respect to the Annual Meeting of Stockholders to be held on May 12, 1994. 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: Financial Statements: The list of consolidated financial statements is set forth in Part II, Item 8 of this Form 10-K and such Index to Consolidated Financial Statements is incorporated herein by reference. Financial Statement Schedules: The financial statement schedules that are required by Part II, Item 8 of this Form 10-K, will be filed by amendment. Exhibits: (b) Reports on Form 8-K On December 15, 1993 the Company reported the approval of an employment agreement with Monte R. Haymon, President, Chief Operating Officer and a Director of the Company, effective January 3, 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. Ply Gem Industries, Inc. (Registrant) /s/ Jeffrey S. Silverman By: _________________________________ JEFFREY S. SILVERMAN, CHAIRMAN (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. NAME TITLE DATE /s/ Jeffrey S. Silverman Chairman, Chief March 28, 1994 - ------------------------------------- Executive Officer JEFFREY S. SILVERMAN (Principal Executive Officer) and Director /s/ Herbert P. Dooskin Executive Vice March 28, 1994 - ------------------------------------- President and HERBERT P. DOOSKIN Director /s/ Stanford Zeisel Secretary and March 28, 1994 - ------------------------------------- Treasurer STANFORD ZEISEL (Principal Financial Officer) /s/ Jerome Baum Controller March 28, 1994 - ------------------------------------- JEROME BAUM /s/ Albert Hersh Director March 28, 1994 - ------------------------------------- ALBERT HERSH /s/ Elihu H. Modlin Director March 28, 1994 - ------------------------------------- ELIHU H. MODLIN EXHIBIT INDEX

860004_1993.txt

860004_1993

1993

860004

Item 1. Business The Sears Credit Account Trust 1990 B (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of February 22, 1990 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2. Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in February, 1990 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. 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 Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. 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) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on or before the Distribution Date each month (on, or the first business day after, the 15th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993, and December 15, 1993. 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. Sears Credit Account Trust 1990 B (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1990 B 8.75% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated March 30, 1990 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest............................................$87.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$87.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest....................$0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods....................................$232,857,461.00 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.....................................$56,875,137.31 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates...............$170,434,077.86 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$21,664,238.33 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$62,423,383.14 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$35,210,898.98 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest............$0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest......................................$0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest.............................................$0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer.........$2,314,814.82 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods................................$111,111,111.12 15) The aggregate amount of Investment Income during the related Due Periods.........................$11,747,685.19 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year.......................................$194,444,444.46 17) The Deficit Accumulation Amount, as of the end of the reportable year......................................$0.00 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1989E November 13, 1989 Sears Credit Account Trust 1990A January 12, 1990 Sears Credit Account Trust 1990B February 22, 1990 Sears Credit Account Trust 1990C July 31, 1990 Sears Credit Account Trust 1990D October 15, 1990 Sears Credit Account Trust 1990E December 1, 1990 It is understood that this report is solely for your information and is not to be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations Report. We found such amounts to be in agreement. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Association as Trustee Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

275177_1993.txt

275177_1993

1993

275177

Item 1. Business - -------- Carolina Telephone and Telegraph Company (the Company), a wholly-owned subsidiary of Sprint Corporation (Sprint), was incorporated under the laws of the State of North Carolina in 1968, and in 1969 acquired all of the public utility assets of the predecessor company of the same name pursuant to a plan of merger. The Company's principal offices are located at 14111 Capital Boulevard, Wake Forest, North Carolina 27587-5900 and its telephone number is (919) 554-7900. The term Company herein refers to the present Company and, as the context requires, its predecessor of the same name which was incorporated in the State of North Carolina in 1900. The Company is engaged in the business of furnishing communication services, mainly local and long-distance services and network access, in 145 exchange areas serving all or part of 50 counties in the eastern part of North Carolina. As of December 31, 1993, the Company had an investment in property, plant and equipment of $1,595,266,000. Operating revenues for the year 1993 amounted to $638,541,000. No other company furnishes local telephone service in any exchange area served by the Company. The principal industries in the Company's service area are agriculture, textiles, pulp and paper manufacturing, chemicals, fertilizer, and tourism. Military installations, including Fort Bragg, Camp Lejeune, Cherry Point Marine Corps Air Station, the U. S. Coast Guard Base at Elizabeth City and Pope Air Force Base contribute significantly to the economy of the area. Digital switching equipment and fiber optics cable represent a substantial portion of the Company's expansion of long-distance facilities. At December 31, 1993, the Company served 905,534 access lines, distributed among 145 exchange areas as follows: Fayetteville, 14.7 percent; Greenville, 5.5 percent; Rocky Mount, 4.6 percent; Jacksonville, 4.2 percent; Wilson, 3.1 percent; and all other areas less than 3.0 percent each. In addition to furnishing local service, the Company's central offices and toll lines are connected with other telephone companies and with the nationwide toll networks of interexchange carriers. Toll calls may thus be made from any telephone in the Company's service area to anywhere in the United States and most other countries. Other telecommunications services, for the most part furnished in conjunction with other telephone companies, include facilities for private line service, data transmission, radio and television program transmission, mobile radio telephone, cellular and wide area telecommunications service. Revenues from communication services, principally telephone service, constitute about 85.9 percent of the total 1993 operating revenues of the Company. The Company has one wholly-owned subsidiary, Carolina Telephone Long Distance, Inc. (CTLD) which offers zero-plus and one-plus interlata long-distance service. A significant portion of the Company's network access revenues are derived from access charge billings to American Telephone & Telegraph Company (AT&T). Other revenues are derived in large part from the sale of telephone directory listings, the sale of telecommunications equipment, the lease of network facilities, providing operator services and processing customer toll billings for interexchange carriers, primarily AT&T. Carolina Telephone & Telegraph Company Form 10-K Part I Item 1. Business (continued) - -------- The following tables show certain information regarding access lines in service and toll messages handled at the dates or for the periods indicated. Access Lines --------------------------------------------------------------- Change Number at End of Period During Period ---------------------------- ------------------- Period Residence Business Total Number % Change ------ --------- -------- ------- ------ -------- 1993 710,977 194,557 905,534 42,693 4.9 1992 681,167 181,674 862,841 36,343 4.4 1991 655,375 171,123 826,498 36,532 4.6 1990 627,778 162,188 789,966 18,514 2.4 1989 616,808 154,644 771,452 24,516 3.3 Toll Messages --------------------------------------------------------------- Total For Year Average Messages Per Day ---------------------- ------------------------ Period Number % Change Number % Change ------ ----------- -------- --------- -------- 1993 455,139,205 7.3 1,246,957 7.6 1992 424,096,621 8.8 1,158,734 8.5 1991 389,952,486 16.5 1,068,363 16.5 1990 334,783,858 7.4 917,216 7.4 1989 311,673,465 12.4 853,900 12.7 On December 31, 1993, the Company had 4,308 employees, of which 2,117 or 49.1 percent were represented by the Communications Workers of America, and 107 or 2.5 percent were represented by the International Brotherhood of Electrical Workers for collective bargaining purposes. Compliance with federal, state and local provisions relating to the protection of the environment has had no significant effect upon capital expenditures or earnings of the Company, and future effects are not expected to be material. Effective January 1, 1991, the Federal Communications Commission (FCC) adopted a price caps regulatory format for the Regional Bell Operating Companies and the GTE local exchange companies. Other local exchange companies (LECs) could volunteer to become subject to the price caps regulation. Under price caps, prices for access service must be adjusted annually to reflect industry average productivity gains (as specified by the FCC), inflation and certain allowed cost changes. The Company elected to be subject to price caps regulation, and under the form of the plan adopted, the Company has an opportunity to earn up to a 14.25 percent rate of return on investment. Carolina Telephone & Telegraph Company Form 10-K Part I Item 1. Business (continued) - ------- Areas of competition have emerged in the intralata and local market- place. On January 1, 1986, the intralata toll market in North Carolina was opened to non-facilities based carriers (resellers), and on January 1, 1987, facilities-based carriers were authorized to resell intralata toll. In February 1994, the North Carolina Utilities Commission approved an order authorizing long-distance companies to provide intralata toll service on a limited basis. This order, which is effective July 1, 1994, will offer customers choices in deciding which long-distance companies they want to use by dialing 1-0 and a designated 3 digit prefix code indicating the carrier of their choice. In addition, the potential for more direct competition is increasing in the local service market. In May 1988, the Commission issued an order which allows customers to participate in the sharing and resale of local exchange services under shared tenant arrangements. At the interstate level, the FCC has revised its rules to permit connection of customer-owned coin telephones to the local network, exposing LECs to direct coin telephone competition. Additionally, the FCC has assisted Competitive Access Providers (CAPs) in providing access to interexchange carriers and end users by mandating that all Tier I (over $100 million annual operating revenues) LECs allow collocation of CAP equipment in LEC central offices. The FCC's decision regarding collocation is under appeal to the U.S. Court of Appeals for the D.C. Circuit. In October 1992, the FCC adopted a new rate structure and new pricing rules for LEC-provided switched transport. LECs filed new access transport tariffs with the FCC in September 1993, which contain rates that will purportedly reduce the costs of the largest interexchange carrier by less than 1 percent and increase the costs of the smallest carriers by less than 2 percent. The new rates, which went into effect on December 30, 1993, are not expected to have any significant impact to the LECs. The extent and ultimate impact of competition for local exchange carriers will continue to depend, to a considerable degree, on FCC and Commission actions, court decisions and possible federal or state legislation. Legislation designed to stimulate local competition between local exchange service providers and cable programming service providers, in both markets, is presently pending in both houses of the U.S. Congress. Carolina Telephone & Telegraph Company Form 10-K Part I Item 2. Item 2. Properties - ------- The properties of the Company consist principally of land, structures, facilities and equipment. Substantially all of the Company's property, plant and equipment is restricted for use under the terms of long-term debt indentures. Central office equipment represents approximately 38.1 percent of the Company's investment in telephone plant in service; land and buildings (occupied principally by central office equipment) represent 8.2 percent; telephone instruments and related wiring and equipment including private branch exchanges (PBX) (substantially all of which are located on the premises of subscribers) represent 2.9 percent; connecting lines not on subscribers' premises (the majority of which are on or under public highways and streets and the remainder on or under private property) represent 45.9 percent; and other telephone plant represents 4.9 percent. In 141 exchanges serving approximately 84.4 percent of the Company's access lines, central offices are located on land owned by the Company; in 3 exchanges serving 0.9 percent of the Company's access lines, central offices are located in leased quarters. In one exchange (Fayetteville), central offices serving an aggregate of 14.7 percent of the Company's access lines are located in quarters, some of which are owned and some of which are leased. Standard practices prevailing in the telephone industry are followed by the Company in the construction and maintenance of its plant and facilities; and the Company considers that its plant and facilities are, as a whole, in sound physical and operating condition. The following table shows gross additions to and retirements of properties of the Company during the five years ended December 31, 1993 (in thousands): Gross Additions Retirements --------- ----------- 1993 $146,543 $51,020 1992 143,057 89,179 1991 130,332 49,766 1990 122,760 68,754 1989 118,824 67,136 Carolina Telephone & Telegraph Company Form 10-K Part II Item 3. Item 3. Legal Proceedings - ------- No material legal proceedings are pending to which the Company or its subsidiary is a party or of which any of their property is the subject. 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. Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder - ------- Matters The Registrant is a wholly-owned subsidiary of Sprint and consequently its common stock is not traded. Item 6. Item 6. Selected Financial Data (in thousands) - ------- December 31, ---------------------------------------------------- 1993 1992 1991 1990 1989 ---------- ---------- -------- -------- -------- Operating revenues $ 638,541 $ 590,440 $552,986 $509,724 $496,841 Net income 47,168 72,800 77,420 76,649 70,659 Total assets 1,078,910 1,025,295 968,806 920,489 892,575 Long-term debt (excluding current maturities) and redeemable preferred stock 269,087 240,535 224,398 226,881 229,759 During 1993, nonrecurring charges of $46,382,000 were recorded representing the portion of the costs attributable to the Company associated with the merger of Sprint and Centel Corporation. Such charges reduced 1993 net income by $27,765,000. In addition, extraordinary losses on early extinguishments of debt were recorded in 1993, which reduced net income by $2,318,000. Earnings and dividends per share information have been omitted because the Company is a wholly-owned subsidiary of Sprint. Carolina Telephone & Telegraph Company Form 10-K Part II Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and - ------- Results of Operations Recent Development - ------------------ Effective March 9, 1993, Sprint consummated its merger with Centel Corporation, a telecommunications company with local exchange and cellular/wireless communications services operations (see Note 2 of "Notes to Consolidated Financial Statements" for additional information). The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the two companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in a nonrecurring charge to Sprint during 1993. The portion of such charge attributable to the Company was $46,382,000, which reduced 1993 net income by $27,765,000. Liquidity and Capital Resources - ------------------------------- Cash flows from operating activities are the Company's primary source of liquidity. Net cash provided by operating activities increased by $30,230,000 during the year ended December 31, 1993. The increase was primarily attributable to reduced payments of amounts associated with accounts payable as well as improved operating results excluding the effects of the merger and integration costs and non-cash expenses. These increases in cash flows were partially offset by payments made related to the integration of Sprint and Centel. In order to meet customer demands, the Company must continually replace and construct new facilities. The Company's planned construction expenditures for 1994 are $143,131,000 which includes expenditures of $74,307,000 for central office equipment, $46,477,000 for cable facilities, $11,765,000 for general support assets and $10,582,000 for other expenditures. The Company anticipates that the funds for these expenditures will be supplied primarily by operating activities. The primary source of financing for the Company has been long-term debt. In addition, the Company periodically receives cash advances from Sprint and issues commercial paper and notes payable to banks. Net cash used by financing activities increased $30,841,000 during the year ended December 31, 1993, compared to the same period in 1992. During 1993, the Company issued $150,000,000 in long-term debt. The proceeds of this debt were primarily used to reduce short-term debt and to retire existing higher cost long-term debt prior to scheduled maturities. The prepayment penalties incurred in connection with these early extinguishments of debt and the write-off of related debt issuance costs and unamortized premiums and discounts were $3,836,000, which reduced net income by $2,318,000. The increase in cash used related to debt activity was partially offset by reduced dividend payments during 1993. Carolina Telephone & Telegraph Company Form 10-K Part II Item 7. Management's Discussion and Analysis of Financial Condition and - ------- Results of Operations (continued) Liquidity and Capital Resources (continued) - ------------------------------------------- As of December 31, 1993, the Company had a total of $60,000,000 in one-year bank commitments. The bank lines provide for short-term borrowings at market rates of interest and require annual commitment fees based on the unused portion. Such lines of credit, which support commercial paper, may be withdrawn by the banks if there is a material adverse change in the financial condition of Sprint or the Company. As of December 31, 1993, no amounts were borrowed against this credit facility; however, $41,100,000 of the bank line supports the commercial paper outstanding at year end. The Company is also authorized to issue and sell an additional $75,000,000 in debentures. The debentures must be due within thirty years of the date of issue and cannot exceed an interest rate of 7.25 percent. The new debentures, which may be issued and sold in future offerings, are available to refinance existing debt at lower interest rates, if appropriate. The Company's ratio of common equity to total capital was 59.2 percent in 1993, 59.1 percent in 1992, and 61.1 percent in 1991. The Company's ratio of long-term debt to total capital was 35.4 percent in 1993, 33.2 percent in 1992, and 33.2 percent in 1991. The Company's ratio of short-term debt to total capital was 5.4 percent in 1993, 7.7 percent in 1992, and 5.7 percent in 1991. Operating Results - ----------------- Operating revenues are classified as local service, network access, long-distance network and miscellaneous. Local service revenues come from providing local telephone exchange services and leasing equipment. Network access revenues are derived from billing other carriers and telephone customers for their use of the local network to complete long- distance calls in those instances where the long-distance service is not provided by the Company. Long-distance revenues are derived principally from providing long-distance services within designated areas. Miscellaneous revenues primarily relate to directory advertising, billing and collection services for interexchange long-distance carriers, operator services, network facilities leases and sales of telecommunications equipment. Operating revenues increased by $48,101,000 or 8.1 percent during the year ended December 31, 1993 as compared to 1992. All categories of operating revenues increased during the year. Local service revenues increased $20,502,000 or 8.7 percent during 1993 as compared to 1992. Basic area service revenues contributed $10,713,000 to this increase, primarily attributable to a 4.9 percent growth in access lines during 1993. Basic area service revenues have also been impacted by the implementation of regional calling plans which have resulted in a transfer of long distance revenues to the local revenue category. Custom calling and touch tone features also added to the local service revenues as a result of access line gains and increased marketing promotions. Carolina Telephone & Telegraph Company Form 10-K Part II Item 7. Management's Discussion and Analysis of Financial Condition and - ------- Results of Operations (continued) Operating Results (continued) - ----------------------------- Network access revenues increased $19,460,000 or 11.4 percent during the year ended December 31, 1993 as compared to 1992 due primarily to an 8.0 percent growth in access minutes of use during 1993. Miscellaneous revenues increased $6,518,000 or 7.8 percent during the year ended December 31, 1993 as compared to 1992. Additional telephone equipment sales and installation revenue of $6,358,000 is largely responsible for the increase during 1993. The equipment sales revenues related principally to PBX, data and key systems. North Carolina Utility Services (NCUS), a non-regulated business venture specializing in locating underground utility lines, contributed $4,703,000, due to the expansion of the service area and an increase of the customer base in existing service areas. These increases were partially offset by decreased revenues related to billing and collection services provided to interexchange carriers as well as lowered revenues associated with the lease and provision of transmission facilities to interexchange carriers. Customer operations expenses increased $13,379,000 or 18.0 percent during 1993 as compared to 1992. Sales expense increased significantly during 1993, as the Company continues to intensify its efforts to achieve an increased market share and gain knowledge of its customer expectations. The results of these efforts are demonstrated in the current year increase in telephone equipment sales. As a result of continued expansions of its customer base, NCUS experienced increases in cost of goods and services during 1993. Billing services also contributed to the increase in customer operations expense, primarily due to expenses incurred during the first part of 1993 related to the development and implementation of new billing systems. Business office operations also experienced increased expenses during 1993, principally due to increased staffing requirements and expenses related to the administration and service center charges for 800 portability services. As previously discussed, nonrecurring merger and integration costs totaling $46,382,000 were recognized during 1993. Other operating expenses increased $2,836,000 or 17.3 percent during 1993 as compared to 1992. This fluctuation was primarily due to a $4,636,000 increase in cost of equipment sales, generally corresponding with the overall trend in equipment sales. This increase was partially offset by a reduction in the losses associated with nonregulated activities during 1993. In addition to the increases discussed above, plant expense, customer operations expense, corporate operations expense and other operating expense also increased as a result of higher postretirement benefits costs due to the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." The incremental cost associated with this change in accounting principle was approximately $15,159,000. Carolina Telephone & Telegraph Company Form 10-K Part II Item 7. Management's Discussion and Analysis of Financial Condition and - ------- Results of Operations (continued) Effects of Inflation - -------------------- The effects of inflation on the operations of the Company were not significant during 1993, 1992 or 1991. Recent Accounting Developments - ------------------------------ Effective January 1, 1994, the Company will adopt Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (see Note 1 of "Notes to Consolidated Financial Statements" for additional information). Consistent with most local exchange carriers, the Company accounts for the economic effects of regulation pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." The application of SFAS No. 71 requires the accounting recognition of the rate actions of regulators where appropriate, including the recognition of depreciation based on estimated useful lives prescribed by regulatory commissions rather than those which might be utilized by non-regulated enterprises. The Company's management believes that the Company's operations meet the criteria for the continued application of the provisions of SFAS No. 71. With increasing competition and the changing nature of regulation in the telecommunications industry, the ongoing applicability of SFAS No. 71 must, however, be constantly monitored and evaluated. Should the Company no longer qualify for the application of the provisions of SFAS No. 71 at some future date, the accounting impact could result in the recognition of a material, extraordinary, non-cash charge. Carolina Telephone & Telegraph Company Form 10-K Part II Item 8. Item 8. Financial Statements and Supplementary Data - ------- CAROLINA TELEPHONE AND TELEGRAPH COMPANY INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reference -------------- Report of Independent Auditors Page 11 Consolidated Balance Sheets as of December 31, 1993 and 1992 Pages 12 - 13 Consolidated Statements of Income for each of the three years ended December 31, 1993 Page 14 Consolidated Statements of Retained Earnings for each of the three years ended December 31, 1993 Page 15 Consolidated Statements of Cash Flows for each of the three years ended December 31, 1993 Pages 16 - 17 Notes to Consolidated Financial Statements Pages 18 - 30 Carolina Telephone & Telegraph Company Form 10-K Part II REPORT OF INDEPENDENT AUDITORS The Board of Directors Carolina Telephone and Telegraph Company We have audited the accompanying consolidated balance sheets of Carolina Telephone and Telegraph Company, a wholly-owned subsidiary of Sprint Corporation, as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings, 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 and related schedules 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 Carolina Telephone and Telegraph Company 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. As discussed in Note 1 to the consolidated financial statements, Carolina Telephone and Telegraph Company changed its method of accounting for postretirement benefits in 1993. ERNST & YOUNG Kansas City, Missouri January 21, 1994 Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 (In Thousands) 1993 1992 ---------- ---------- ASSETS - ------ CURRENT ASSETS Cash $ 1 $ 1 Receivables Customers and other, net of allowance for doubtful accounts of $1,895 ($1,415 in 1992) 63,090 60,957 Interexchange carriers 20,238 17,713 Affiliated companies 4,699 2,256 Inventories 9,807 7,861 Prepayments and other 870 1,573 ---------- ---------- 98,705 90,361 PROPERTY, PLANT AND EQUIPMENT Land and buildings 128,635 120,560 Telephone network equipment and outside plant 1,370,948 1,296,144 Other 78,455 71,366 Construction in progress 17,228 11,673 ---------- ---------- 1,595,266 1,499,743 Less accumulated depreciation 673,839 610,603 ---------- ---------- 921,427 889,140 DEFERRED CHARGES AND OTHER ASSETS 58,778 45,794 ---------- ---------- $1,078,910 $1,025,295 ========== ========== (Continued) Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED BALANCE SHEETS (CONTINUED) December 31, 1993 and 1992 (In Thousands) 1993 1992 ---------- ---------- LIABILITIES AND STOCKHOLDER'S EQUITY - ------------------------------------ CURRENT LIABILITIES Outstanding checks in excess of cash balances $ 9,303 $ 8,169 Short-term borrowings Commercial paper 41,100 55,500 Advances from parent company - 1,703 Current maturities of long-term debt 568 7,717 Accounts payable: Vendors and other 20,742 14,846 Interexchange carriers 22,950 22,270 Affiliated companies 10,866 5,272 Accrued merger and integration costs 17,035 - Accrued taxes 13,298 13,897 Advance billings 11,653 11,262 Accrued vacation pay 10,550 10,493 Other 20,484 19,056 ---------- ---------- 178,549 170,185 LONG-TERM DEBT 269,087 240,535 DEFERRED CREDITS AND OTHER LIABILITIES Deferred income taxes 113,399 118,540 Deferred investment tax credits 6,790 10,830 Regulatory liability 26,338 32,903 Postretirement benefits obligation 22,542 3,750 Other 11,919 6,847 ---------- ---------- 180,988 172,870 COMMITMENTS COMMON STOCK AND OTHER STOCKHOLDER'S EQUITY Common stock, authorized 5,000,000 shares, par value $20 per share, issued and outstanding 3,626,510 shares 72,530 72,530 Capital in excess of par value 71,991 71,991 Retained earnings 305,765 297,184 ---------- ---------- 450,286 441,705 ---------- ---------- $1,078,910 $1,025,295 ========== ========== See Notes to Consolidated Financial Statements. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED STATEMENTS OF INCOME Years ended December 31, 1993, 1992, and 1991 (In Thousands) 1993 1992 1991 -------- -------- -------- OPERATING REVENUES Local service $257,050 $236,548 $219,194 Network access 189,747 170,287 165,725 Long-distance network 101,581 99,960 97,474 Miscellaneous 90,163 83,645 70,593 -------- -------- -------- 638,541 590,440 552,986 OPERATING EXPENSES Plant expense 192,297 181,658 169,209 Depreciation 114,765 109,865 94,288 Customer operations 87,668 74,289 63,374 Corporate operations 64,400 58,300 59,932 Merger and integration costs 46,382 - - Other operating expenses 19,247 16,411 12,951 Taxes: Federal income: Current 33,786 34,218 37,826 Deferred (9,064) 1,797 1,154 Deferred investment tax credit (4,040) (4,925) (5,369) State, local and miscellaneous 22,352 25,094 25,629 -------- -------- -------- 567,793 496,707 458,994 -------- -------- -------- OPERATING INCOME 70,748 93,733 93,992 INTEREST CHARGES Interest on long-term debt 19,232 18,735 18,783 Other interest 2,728 3,432 1,259 -------- -------- -------- 21,960 22,167 20,042 OTHER INCOME Interest charged to construction 54 632 87 Other, net 644 602 3,383 -------- -------- -------- 698 1,234 3,470 -------- -------- -------- INCOME BEFORE EXTRAORDINARY ITEM 49,486 72,800 77,420 EXTRAORDINARY LOSSES ON EARLY EXTINGUISHMENTS OF DEBT, NET 2,318 - - -------- -------- -------- NET INCOME $ 47,168 $ 72,800 $ 77,420 ======== ======== ======== See Notes to Consolidated Financial Statements. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED STATEMENTS OF RETAINED EARNINGS Years ended December 31, 1993, 1992, and 1991 (In Thousands) 1993 1992 1991 -------- -------- -------- BALANCE AT BEGINNING OF YEAR $297,184 $272,262 $249,445 Net Income 47,168 72,800 77,420 Cash dividends Common stock (38,587) (47,869) (54,578) Preferred stock - (9) (25) -------- -------- -------- BALANCE AT END OF YEAR $305,765 $297,184 $272,262 ======== ======== ======== See Notes to Consolidated Financial Statements. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1993, 1992, and 1991 (In Thousands) 1993 1992 1991 -------- -------- ------- OPERATING ACTIVITIES Net Income $ 47,168 $ 72,800 $ 77,420 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 114,765 109,865 94,288 Deferred income taxes and investment tax credits (14,695) (2,030) (3,240) Extraordinary losses on early extinguishments of debt 3,836 - - Changes in operating assets and liabilities: Receivables, net (7,101) (3,714) (5,489) Inventories (1,946) 264 1,682 Other current assets 703 19 (487) Accounts payable 12,170 (10,371) (2,154) Other current liabilities 19,231 (2,153) 12,735 Noncurrent assets and liabilities, net 23,597 1,000 2,750 Other, net (7,540) (5,722) (4,409) ------- ------- ------- NET CASH PROVIDED BY OPERATING ACTIVITIES 190,188 159,958 173,096 INVESTING ACTIVITIES Additions to property, plant and equipment (146,543) (143,057) (130,332) Net cost to retire plant and equipment (509) (599) (478) Additions to investments (4,865) (8,872) (2,979) -------- -------- -------- NET CASH USED BY INVESTING ACTIVITIES (151,917) (152,528) (133,789) (Continued) Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Years ended December 31, 1993, 1992, and 1991 (In Thousands) 1993 1992 1991 ------- ------- ------- FINANCING ACTIVITIES Proceeds from long-term borrowings $148,638 $ 49,382 $ - Retirements of long-term debt (127,521) (27,537) (2,954) Increase (decrease) in commercial paper (14,400) 25,500 9,900 Increase (decrease) in advances from parent company (1,703) (6,797) 8,500 Redemption of preferred stock - (100) (150) Dividends paid (38,587) (47,878) (54,603) Other (4,698) - - -------- -------- ------- NET CASH USED BY FINANCING ACTIVITIES (38,271) (7,430) (39,307) CHANGE IN CASH - - - CASH AT BEGINNING OF YEAR 1 1 1 -------- -------- -------- CASH AT END OF YEAR $ 1 $ 1 $ 1 ======== ======== ======== See Notes to Consolidated Financial Statements. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ACCOUNTING POLICIES Carolina Telephone and Telegraph Company is engaged in the business of providing communications services, principally local, network access and long distance services in North Carolina. The principal industries in its service area include agriculture, textiles, pulp and paper manufacturing, chemicals, and tourism. Basis of Presentation - --------------------- The accompanying consolidated financial statements include the accounts of Carolina Telephone & Telegraph Company and its wholly-owned subsidiary, Carolina Telephone Long Distance, Inc. (CTLD), collectively referred to as the "Company". All significant intercompany transactions have been eliminated. The Company is a wholly-owned subsidiary of Sprint Corporation (Sprint); accordingly, earnings per share information has been omitted. The Company accounts for the economic effects of regulation pursuant to Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation", which requires the accounting recognition of the rate actions of regulators where appropriate. Such 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. Certain amounts in the accompanying consolidated financial statements for 1992 and 1991 have been reclassified to conform to the presentation of amounts in the 1993 consolidated financial statements. These reclassifications had no effect on net income in either year. Inventories - ----------- Inventories consist of materials and supplies, stated at average cost, and equipment held for resale, stated at the lower of average cost or market. The sales inventory balances were $2,604,000 and $2,156,000 at December 31, 1993 and 1992, respectively. Property, Plant and Equipment - ----------------------------- Property, plant and equipment are recorded at cost. Retirements of depreciable property are charged against accumulated depreciation with no gain or loss recognized. Repairs and maintenance costs are expensed as incurred. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ACCOUNTING POLICIES (continued) Depreciation - ------------ Depreciation expense is generally computed on a straight-line basis over estimated useful lives as prescribed by regulatory commissions. Depreciation rate changes granted by the North Carolina Utilities Commission (Commission) resulted in additional depreciation expense in 1992 of $19,365,000 which reduced net income by $11,245,000 after considering the partial offset from the related revenue settlement and income tax effects. There were no depreciation rate changes during 1993 or 1991. In addition, as ordered by the Commission, the Company recorded nonrecurring charges to depreciation expense in 1991 of $9,000,000 which reduced net income by $5,016,000. Average annual composite depreciation rates, excluding the nonrecurring charges, were 7.5 percent for 1993, 7.6 percent for 1992 and 6.2 percent for 1991. Income Taxes - ------------ Operations of the Company are included in the consolidated federal income tax returns of Sprint. Federal income tax is calculated by the Company on the basis of its filing a separate return. Effective January 1, 1992, the Company changed its method of accounting for income taxes by adopting SFAS No. 109, "Accounting for Income Taxes", which requires an asset and liability approach to accounting for income taxes. Under the provisions of SFAS No. 109, the Company adjusted existing deferred income tax amounts, using current tax rates, for the estimated future tax effects attributable to temporary differences between the tax bases of the Company's assets and liabilities and their reported amounts in the financial statements. The Company's principal temporary difference results from using different depreciable lives and methods with respect to its property, plant and equipment for tax and financial reporting purposes. As a result of corporate income tax rate reductions in prior years and the previous income tax accounting standards which did not permit accumulated deferred income tax amounts to be adjusted for subsequent tax rate changes, adoption of SFAS No. 109 resulted in a decrease in the amount of deferred income tax liabilities recorded. However, because this decrease will accrue to the benefit of the Company's customers through future telephone rates established by the Company's regulators, this decrease in deferred income tax liabilities has been reflected as a regulatory liability in the Company's financial statements. Accordingly, the adoption of SFAS No. 109 had no significant effect upon the Company's 1992 net income. As allowed by SFAS No. 109, prior years' consolidated financial statements were not restated. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ACCOUNTING POLICIES (continued) Income Taxes (continued) - ------------------------ During 1991, in accordance with Accounting Principles Board Opinion No. 11, deferred income taxes were provided for all differences in timing of reporting income and expenses for financial statement and income tax purposes, except for items that were not allowable by the Federal Communications Commission (FCC) or the Commission as an expense for rate- making purposes. Investment tax credits (ITC) are deferred and amortized over the useful life of the related property. The Tax Reform Act of 1986 effectively eliminated ITC after December 31, 1985. Postretirement Benefits - ----------------------- Effective January 1, 1993, the Company changed its method of accounting for postretirement benefits (principally health care benefits) provided to certain retirees by adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires accrual of the expected cost of providing postretirement benefits to employees and their dependents or beneficiaries during the years employees earn the benefits. As permitted by SFAS No. 106, the Company elected to recognize the obligation for postretirement benefits already earned by its current retirees and active work force as of January 1, 1993 by amortizing such obligation on a straight-line basis over a period of twenty years. During 1992 and 1991, the Company expensed postretirement benefits as such costs were paid. Postemployment Benefits - ----------------------- Effective January 1, 1994, the Company will adopt SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Under the new standard, the Company is required to recognize certain previously unrecorded obligations for benefits provided to former or inactive employees and their dependents, after employment but before retirement. Postemployment benefits offered by the Company include severance, workers' compensation and disability benefits, including the continuation of other benefits such as health care and life insurance coverage. As required by the standard, the Company will recognize its obligations for postemployment benefits through a cumulative adjustment in the consolidated income statement. The resulting nonrecurring, non-cash charge will not significantly impact the Company's 1994 net income. Adoption of this standard is not expected to significantly impact future operating expenses. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 1. ACCOUNTING POLICIES (continued) Interest Charged to Construction - -------------------------------- In accordance with the Uniform System of Accounts, as prescribed by the FCC, interest is capitalized only on those telephone plant construction projects for which the estimated construction period exceeds one year. 2. MERGER AND INTEGRATION COSTS Effective March 9, 1993, Sprint consummated its merger with Centel Corporation (Centel), a telecommunications company with local exchange and cellular/wireless communications services operations. Centel's local exchange telephone businesses operate in six states: Florida, North Carolina, Virginia, Illinois, Texas and Nevada. Pursuant to the Agreement and Plan of Merger dated May 27, 1992, Sprint issued 1.37 shares of its common stock in exchange for each outstanding share of Centel common stock. The operations of the merged companies are being integrated and restructured to achieve efficiencies which are expected to yield significant operational synergies and cost savings. The transaction costs associated with the merger and the estimated expenses of integrating and restructuring the operations of the two companies resulted in nonrecurring charges to Sprint during 1993. The portion of such charges attributable to the Company was $46,382,000, which reduced 1993 net income by approximately $27,765,000. 3. EMPLOYEE BENEFIT PLANS Defined Benefit Pension Plan - ---------------------------- Substantially all employees of the Company are covered by a noncontributory defined benefit pension plan. For participants of the plan represented by collective bargaining units, benefits are based upon schedules of defined amounts as negotiated by the respective parties. For participants not covered by collective bargaining agreements, the plan provides pension benefits based upon years of service and participants' compensation. The Company's policy is to make contributions to the plan each year equal to an actuarially determined amount consistent with applicable federal tax regulations. The funding objective is to accumulate funds at a relatively stable rate over the participants' working lives so that benefits are fully funded at retirement. As of December 31, 1993, the plan's assets consisted principally of investments in corporate equity securities and U.S. government and corporate debt securities. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 3. EMPLOYEE BENEFIT PLANS (continued) Defined Benefit Pension Plan (continued) - ---------------------------------------- The components of the net pension credits and related assumptions are as follows (in thousands): 1993 1992 1991 -------- -------- -------- Service cost -- benefits earned during the period $ 5,505 $ 4,739 $ 4,622 Interest cost on projected benefit obligation 15,654 14,745 14,047 Actual return on plan assets (41,636) (15,461) (65,761) Net amortization and deferral 11,403 (9,789) 42,132 -------- -------- -------- Net pension credit $ (9,074) $ (5,766) $ (4,960) ======== ======== ======== Discount rate 8.00% 8.50% 8.50% Expected long-term rate of return on plan assets 9.50% 8.25% 8.25% Anticipated composite rate of future increases in compensation 5.50% 6.33% 7.02% In addition, the Company recognized pension curtailment gains of $98,000 during 1993 as a result of the integration actions as discussed in Note 2. The funded status and amounts recognized in the consolidated balance sheets for the plan, as of December 31, are as follows (in thousands): 1993 1992 --------- --------- Actuarial present value of pension benefit obligations Vested benefit obligation $(207,186) $(166,022) ========= ========= Accumulated benefit obligation $(231,695) $(182,369) ========= ========= Projected benefit obligation $(241,000) $(198,533) Plan assets at fair value 344,187 311,202 --------- --------- Plan assets in excess of the projected benefit obligation 103,187 112,669 Unrecognized net gains (35,769) (40,377) Unrecognized prior service cost (benefit) 5,464 (4,112) Unamortized portion of transition asset (40,236) (44,706) --------- --------- Prepaid pension cost $ 32,646 $ 23,474 ========= ========= Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 3. EMPLOYEE BENEFIT PLANS (continued) Defined Benefit Pension Plan (continued) - ---------------------------------------- The projected benefit obligations as of December 31, 1993 and 1992 were determined using a discount rate of 7.50 percent for 1993 and 8.00 percent for 1992, and anticipated composite rates of future increases in compensation of 4.50 percent for 1993 and 5.50 percent for 1992. Defined Contribution Plans - -------------------------- Sprint sponsors two defined contribution employee savings plans covering substantially all employees of the Company. Participants may contribute portions of their compensation to the plans. Contributions of participants represented by collective bargaining units are matched by the Company based upon defined amounts as negotiated by the respective parties. Contributions of participants not covered by collective bargaining agreements are also matched by the Company. For these participants, the Company provides matching contributions equal to 50 percent of participants' contributions up to 6 percent of their base compensation and may, at the discretion of Sprint's Board of Directors, provide additional matching contributions based upon the performance of Sprint's common stock price in comparison to other telecommunications companies. The Company's contributions to the plans aggregated $3,278,000, $2,195,000 and $2,300,000 in 1993, 1992 and 1991, respectively. Postretirement Benefits - ----------------------- The Company provides other postretirement benefits (principally health care benefits) to certain retirees. Substantially all employees who retired from the Company before January 1, 1991 became eligible for these postretirement benefits at reduced cost to the retirees. Employees retiring after such date, who meet specified age and years of service requirements, are eligible for these benefits on a shared cost basis, with the Company's portion of the cost determined by the retirees' years of credited service at retirement. The Company funds the accrued costs as benefits are paid. For regulatory purposes, the FCC permits recognition of net postretirement benefits costs, including amortization of the transition obligation, in accordance with SFAS No. 106. The Company is also recording postretirement benefits costs in accordance with SFAS No. 106 for state regulatory purposes, pending direction from the Commission in future rate- making procedures. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 3. EMPLOYEE BENEFIT PLANS (continued) Postretirement Benefits (continued) - ----------------------------------- The components of the 1993 net postretirement benefits cost are as follows (in thousands): Service cost-benefits earned during the period $ 2,514 Interest on accumulated postretirement benefits obligation 9,599 Amortization of transition obligation 5,912 --------- Net postretirement benefits cost $ 18,025 ========= For measurement purposes, an annual health care cost trend rate of 13 percent was assumed for 1993, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent increase in the assumed trend rate would have increased the 1993 net postretirement benefits cost by approximately $328,000. The discount rate for 1993 was 8 percent. In addition, the Company recognized postretirement benefits curtailment losses of $2,963,000 during 1993 as a result of the integration actions as discussed in Note 2. The cost of providing health care benefits to retirees was $2,383,000 and $2,382,000 in 1992 and 1991, respectively. The amount recognized in the consolidated balance sheet as of December 31, 1993 is as follows (in thousands): Accumulated postretirement benefits obligation Retirees $ 52,590 Active plan participants - fully eligible 32,830 Active plan participants - other 45,727 --------- 131,147 Unrecognized net gains 3,387 Unrecognized transition obligation (111,992) --------- Accrued postretirement benefits cost $ 22,542 ========= The accumulated benefits obligation as of December 31, 1993 was determined using a discount rate of 7.5 percent. An annual health care cost trend rate of 12 percent was assumed for 1994, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent annual increase in the assumed health care cost trend rate would have increased the accumulated benefits obligations as of December 31, 1993 by approximately $32,830,000. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 4. INCOME TAXES The components of federal and state income tax expense are as follows (in thousands): 1993 1992 1991 -------- -------- -------- Federal income taxes Current $ 33,786 $ 34,218 $ 37,826 Deferred (9,064) 1,797 1,154 Amortization of deferred ITC (4,040) (4,925) (5,369) -------- -------- -------- 20,682 31,090 33,611 State income taxes Current 7,746 8,242 9,162 Deferred (1,591) 1,098 975 -------- -------- -------- 6,155 9,340 10,137 -------- -------- -------- Total income tax expense $ 26,837 $ 40,430 $ 43,748 ======== ======== ======== In 1993 income tax benefits of $1,518,000 associated with the extraordinary losses incurred related to the early extinguishments of debt were reflected as reductions of such losses in the consolidated statements of income. The differences which cause the effective income tax rate to vary from the statutory federal income tax rate of 35 percent in 1993 and 34 percent in 1992 and 1991 are as follows (in thousands): 1993 1992 1991 -------- -------- -------- Federal income tax at the statutory rate $ 26,713 $ 38,498 $ 41,197 Less amortization of deferred ITC 4,040 4,883 5,200 -------- -------- -------- Expected federal income tax provision after amortization of deferred ITC 22,673 33,615 35,997 Effect of Differences required to be flowed through by regulatory commissions 543 673 290 Reversal of rate differentials (1,096) (1,496) (1,821) State income tax, net of federal income tax effect 4,001 6,164 6,690 Other, net 716 1,474 2,592 -------- -------- -------- Income tax expense, including ITC $ 26,837 $ 40,430 $ 43,748 ======== ======== ======== Effective income tax rate 35.2% 35.7% 36.1% ======== ======== ======== Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 4. INCOME TAXES (continued) During 1993 and 1992, in accordance with SFAS No. 109, deferred income taxes were provided for the temporary differences between the carrying amounts of the Company's assets and liabilities for financial statement purposes and their tax bases. The sources of the differences that give rise to the deferred income tax assets and liabilities as of December 31, along with the income tax effect of each, are as follows (in thousands): 1993 1992 --------------------- --------------------- Deferred Income Tax Deferred Income Tax --------------------- --------------------- Assets Liabilities Assets Liabilities -------- ----------- -------- ----------- Property, plant and equipment $ - $122,697 $ - $114,888 Allowance for doubtful accounts 373 - 426 - Expense accruals 2,795 - - 3,235 Deferred ITC - 6,790 - 10,830 Other, net 5,726 - 265 1,296 -------- -------- -------- -------- $ 8,894 $129,487 $ 691 $130,249 ======== ======== ======== ======== On August 10, 1993, the Revenue Reconciliation Act of 1993 (the Act) was enacted which, among other changes, raised the federal income tax rate for corporations to 35 percent from 34 percent, retroactive to the beginning of the year. Pursuant to SFAS No. 71, the resulting adjustments to the Company's deferred income tax assets and liabilities to reflect the revised rate have generally been reflected as reductions to the related regulatory liabilities. During 1991, in accordance with APB No. 11, deferred income tax provisions resulted from the differences in the timing of recognizing certain revenues and expenses for financial statement and income tax purposes. The sources of the differences, along with the income tax effect of each, were as follows (in thousands): Property, plant and equipment $ 6,331 Pension costs 1,869 Revenue accruals 1,098 Expense accruals (6,647) Other, net (522) ------- $ 2,129 ======= Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 5. LONG-TERM DEBT AND EXTRAORDINARY LOSSES ON EXTINGUISHMENTS Long-term debt as of December 31, excluding current maturities, is as follows (in thousands): 1993 1992 --------------------------- -------- Weighted Average Amount Interest Rate Amount -------- ---------------- -------- Debentures, maturities 1995 - 2016 $271,878 6.81% $242,052 Other notes, maturities 1995 - 1998 219 9.51% 345 Unamortized debt discount (3,010) (1,862) -------- -------- $269,087 $240,535 ======== ======== Long-term debt maturities during each of the next five years are as follows (in thousands): Year Amount ---- ------- 1994 $ 568 1995 8,575 1996 12,663 1997 841 1998 6 The first mortgage bonds and notes are secured by substantially all of the Company's property, plant and equipment. As of December 31, 1993, the Company had lines of credit with banks totaling $60,000,000. No amounts were borrowed against these lines of credit at year end. The bank lines, which are renewable in April 1994, provide for short-term borrowings at market rates of interest and require annual commitment fees based on the unused portion. Lines of credit, which support both outstanding commercial paper and notes payable to banks, may be withdrawn by the banks if there is a material adverse change in the financial condition of the Company. During 1993, the Company redeemed prior to scheduled maturities $120,209,000 of first mortgage bonds and debentures with interest rates ranging from 7.75 percent to 11.75 percent. Prepayment penalties incurred in connection with the early extinguishments of debt and the write-off of related debt issuance costs and unamortized debt discounts and premiums, net of the related income tax benefits, are reflected as extraordinary losses in the 1993 consolidated statement of income. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 6. COMMITMENTS Gross rental expense aggregated $6,959,000 in 1993, $6,145,000 in 1992 and $6,967,000 in 1991. The Company's planned capital expenditures for the year ending December 31, 1994 are approximately $143,131,000. Normal purchase commitments have been or will be made for these planned expenditures. 7. RELATED PARTY TRANSACTIONS The Company purchases telecommunications equipment, construction and maintenance equipment, and materials and supplies from its affiliate, North Supply Company. Total purchases for 1993, 1992, and 1991 were $47,401,000, $45,272,000 and $36,421,000, respectively. Under an agreement with Sprint, the Company reimburses Sprint for data processing services, other data related costs and certain management costs which are incurred for the Company's benefit. A credit resulting from deferred income taxes on intercompany profits is also allocated by Sprint to affiliated companies. Total charges to the Company aggregated $55,885,000, $43,481,000 and $36,590,000 in 1993, 1992 and 1991, respectively, and the credit relating to deferred income taxes was $852,500, $714,000 and $824,000 in 1993, 1992 and 1991, respectively. The Company enters into cash advance and borrowing transactions with Sprint; generally, interest on such transactions is computed based on the prior month's thirty-day average commercial paper index, as published in the Federal Reserve Statistical Release H.15, plus 45 basis points. Interest expense on such advances from Sprint was $19,800, $402,000 and $101,000 in 1993, 1992 and 1991, respectively. Interest income on such advances to Sprint was $51,000, $9,100 and $21,500 in 1993, 1992 and 1991, respectively. Sprint Publishing & Advertising, an affiliate, pays the Company a fee for the right to publish telephone directories in the Company's operating territory, a listing fee, and a fee for billing and collection services performed for Sprint Publishing & Advertising by the Company. For 1993, 1992 and 1991, Sprint Publishing & Advertising paid the Company a total of $21,759,000, $21,526,000 and $20,109,000, respectively. The Company paid Sprint Publishing & Advertising $1,543,000, $1,515,000 and $1,174,000 in 1993, 1992 and 1991, respectively, for its costs of publishing the white page portion of the directories. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 7. RELATED PARTY TRANSACTIONS (continued) The Company provides various services to Sprint's long distance communications services division, such as network access, operator and billing and collection services, and the lease of network facilities. The Company recognized income of $18,017,000, $16,698,000 and $15,694,000 in 1993, 1992 and 1991, respectively, for these services. The Company paid Sprint's long distance communications services division $25,000,000, $22,811,000 and $21,797,000 in 1993, 1992 and 1991, respectively, for interexchange telecommunications services. The Company provides services such as operator assistance, directory assistance, end user trouble report processing and payment processing for United Telephone-Southeast, Inc. (an affiliate) and United Telephone Company of the Carolinas, (an affiliate). The Company recognized income of $3,324,000, $2,525,000, and $1,025,000 during 1993, 1992 and 1991, respectively, for these services. Certain directors and officers of the Company are also directors or officers of banks at which the Company conducts borrowings and related transactions. The terms are comparable with other banks at which the Company has similar transactions. 8. ADDITIONAL FINANCIAL INFORMATION Financial Instruments Information - --------------------------------- The Company's financial instruments consist of long-term debt, including current maturities, with carrying amounts as of December 31, 1993 and 1992 of $269,655,000 and $248,252,000, respectively, and estimated fair values of $288,871,000 and $257,624,000, respectively. The fair values are estimated based on quoted market prices for publicly-traded issues, and based on the present value of estimated future cash flows using a discount rate commensurate with the risks involved for all other issues. The carrying values of the Company's other financial instruments (principally short-term borrowings) approximate fair value as of December 31, 1993 and 1992. Carolina Telephone & Telegraph Company Form 10-K Part II CAROLINA TELEPHONE AND TELEGRAPH COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 8. ADDITIONAL FINANCIAL INFORMATION (continued) Supplemental Cash Flows Information - ----------------------------------- The supplemental disclosures required for the consolidated statements of cash flows for the years ended December 31, are as follows (in thousands): 1993 1992 1991 ------- ------- ------- Cash paid for Interest, net of amounts capitalized $20,395 $22,884 $21,564 Income taxes 41,391 44,884 42,030 Major Customer Information - -------------------------- Operating revenues from American Telephone & Telegraph resulting primarily from network access, billing and collection services, and the lease of network facilities aggregated approximately $105,225,000, $101,418,000 and $97,679,000 for 1993, 1992 and 1991, respectively. 9. SUPPLEMENTAL QUARTERLY INFORMATION - UNAUDITED (in thousands) 1993 Quarters Ended ------------------------------------------------ March 31 June 30 September 30 December 31 -------- -------- ------------ ----------- Operating revenues $152,282 $159,756 $163,536 $162,967 Operating income (loss) (1,869) 23,895 28,038 20,684 Income (loss) before extraordinary item (7,464) 18,436 23,147 15,367 Net income (loss) (7,464) 17,070 22,195 15,367 1992 Quarters Ended ------------------------------------------------ March 31 June 30 September 30 December 31 -------- -------- ------------ ----------- Operating revenues $137,608 $146,034 $149,770 $157,028 Operating income 25,058 28,027 25,785 14,863 Net income 19,749 22,905 20,782 9,364 Nonrecurring charges associated with the transaction costs of the Sprint/Centel merger and the estimated expenses of integrating and restructuring the operations of the two companies were recorded during 1993. The portion of such charges attributable to the Company was $41,700,000 and $4,682,000 in the first and fourth quarters of 1993, respectively, which reduced net income by approximately $25,346,000 and $2,419,000, respectively. The Company recorded additional depreciation expense of approximately $19,365,000 during the fourth quarter of 1992 as the result of depreciation rate changes granted by the Commission. The effect of this adjustment on 1992 fourth quarter net income was $11,245,000. Carolina Telephone & Telegraph Company Form 10-K Part II/III/IV Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and - ------- Financial Disclosure None Item 10. Item 10. Directors and Executive Officers of the Registrant - -------- Omitted under the provisions of General Instruction J. Item 11. Item 11. Executive Compensation - -------- Omitted under the provisions of General Instruction J. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - -------- Omitted under the provisions of General Instruction J. Item 13. Item 13. Certain Relationships and Related Transactions - -------- Omitted under the provisions of General Instruction J. Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------- (a) 1. The consolidated financial statements of the Company filed as part of this report are listed in the Index to Consolidated Financial Statements on page 10. 2. The consolidated financial statement schedules of the Company filed as part of this report are listed in the Index to Consolidated Financial Statement Schedules on page 32. (b) The Registrant was not required to file a report on Form 8-K during the last quarter of 1993. (c) The exhibits filed as part of this report are listed in the Index to Exhibits on pages 42 - 44. Carolina Telephone & Telegraph Company Form 10-K Part IV CAROLINA TELEPHONE AND TELEGRAPH COMPANY INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES (ITEM 14(a)2.) Page For each of the three years in the period ended December 31, 1993: Reference - ------------------------------------------------------------------ --------- Schedule V - Property, Plant and Equipment - Consolidated Pages 33-35 Schedule VI - Accumulated Depreciation on Property, Plant and Equipment - Consolidated Pages 36-38 Schedule VIII - Valuation and Qualifying Accounts - Consolidated Page 39 Schedule IX - Short-Term Borrowings - Consolidated Page 40 Schedule X - Supplementary Income Statement Information - Consolidated Page 41 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. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1993 (In Thousands) Balance Retirements Balance beginning Additions or end of year at cost sales of year ---------- ----------- ----------- ---------- Land and buildings $ 120,560 $ 8,619 $ 544 $ 128,635 Other general support assets 65,424 12,853 5,897 72,380 Central office assets 562,672 67,120 28,746 601,046 Information origination/ termination assets 44,301 7,727 5,749 46,279 Cable and wire facilities assets 689,171 44,314 9,862 723,623 Amortizable assets 4,431 355 222 4,564 Property held for future use 310 - - 310 Telephone plant under construction 11,673 5,555 - 17,228 Telephone plant acquisition adjustment 342 - - 342 Nonoperating plant 859 - - 859 ---------- -------- -------- ---------- $1,499,743 $146,543 $51,020 $1,595,266 ========== ======== ======== ========== Depreciation expense is computed on a straight-line basis. The average annual composite depreciation rate in 1993 was 7.5%. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1992 (In Thousands) Balance Retirements Balance beginning Additions or end of year at cost sales of year ---------- ---------- ---------- ---------- Land and buildings $ 92,700 $ 28,394 $ 534 $ 120,560 Other general support assets 59,841 10,911 5,328 65,424 Central office assets 524,038 67,512 28,878 562,672 Information origination/ termination assets 84,180 5,265 45,144 44,301 Cable and wire facilities assets 655,864 42,176 8,869 689,171 Amortizable assets 4,696 161 426 4,431 Property held for future use 376 (66) - 310 Telephone plant under construction 22,969 (11,296) - 11,673 Telephone plant acquisition adjustment 342 - - 342 Nonoperating plant 859 - - 859 ---------- -------- ------- ---------- $1,445,865 $143,057 $89,179 $1,499,743 ========== ======== ======= ========== Depreciation expense is computed on a straight-line basis. The average annual composite depreciation rate in 1992 was 7.6%. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1991 (In Thousands) Balance Retirements Balance beginning Additions or end of year at cost sales of year ---------- ------------ ----------- ----------- Land and buildings $ 86,427 $ 7,078 $ 805 $ 92,700 Other general support assets 55,839 8,831 4,829 59,841 Central office assets 493,218 60,232 29,412 524,038 Information origination/ termination assets 83,571 5,287 4,678 84,180 Cable and wire facilities assets 628,570 37,097 9,803 655,864 Amortizable assets 4,845 90 239 4,696 Property held for future use 1,396 (1,020) - 376 Telephone plant under construction 9,994 12,975 - 22,969 Telephone plant acquisition adjustment 520 (178) - 342 Nonoperating plant 919 (60) - 859 ---------- -------- ------- ---------- $1,365,299 $130,332 $49,766 $1,445,865 ========== ======== ======= ========== Depreciation expense is computed on a straight-line basis. The average annual composite depreciation rate in 1991 was 6.2%. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE VI - ACCUMULATED DEPRECIATION ON PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1993 (In Thousands) Balance Charged to Retirements Balance beginning depreciation Net or end of year expense salvage sales of year --------- ---------- --------- ----------- -------- Buildings $ 27,126 $ 4,154 $ (263) $ 517 $ 30,500 Other general support assets 26,930 8,027 693 5,968 29,682 Central office assets 174,863 54,081 29 28,746 200,227 Information origination/ termination assets 31,000 3,701 637 5,686 29,652 Cable and wire facilities assets 348,091 44,449 (1,600) 9,803 381,137 Amortizable assets 1,422 310 (5) 300 1,427 Property held for future use 25 10 - - 35 Telephone plant acquisition adjustment 487 33 - - 520 Nonoperating plant 659 - - - 659 -------- -------- -------- ------- -------- $610,603 $114,765 $ (509) $51,020 $673,839 ======== ======== ======== ======= ======== Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE VI - ACCUMULATED DEPRECIATION ON PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1992 (In Thousands) Balance Charged to Retirements Balance beginning depreciation Net or end of year expense salvage sales of year -------- ------------ -------- --------- -------- Buildings $ 24,632 $ 3,232 $ (204) $ 534 $ 27,126 Other general support assets 24,366 7,347 544 5,327 26,930 Central office assets 151,089 53,136 (483) 28,879 174,863 Information origination/ termination assets 72,007 3,489 648 45,144 31,000 Cable and wire facilities assets 315,768 42,363 (1,171) 8,869 348,091 Amortizable assets 1,526 255 67 426 1,422 Property held for future use 15 10 - - 25 Telephone plant acquisition adjustment 454 33 - - 487 Nonoperating plant 659 - - - 659 -------- -------- -------- ------- -------- $590,516 $109,865 $ (599) $89,179 $610,603 ======== ======== ======== ======= ======== Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE VI - ACCUMULATED DEPRECIATION ON PROPERTY, PLANT AND EQUIPMENT - CONSOLIDATED Year Ended December 31, 1991 (In Thousands) Balance Charged to Retirements Balance beginning depreciation Net or end of year expense salvage sales of year -------- ------------ ------- ----------- ------- Buildings $ 23,384 $ 2,107 $ (99) $ 760 $ 24,632 Other general support assets 23,494 5,426 275 4,829 24,366 Central office assets 140,203 40,979 (912) 29,181 151,089 Information origination/ termination assets 73,119 2,663 1,180 4,955 72,007 Cable and wire facilities assets 283,716 42,820 (965) 9,803 315,768 Amortizable assets 1,476 250 38 238 1,526 Property held for future use - 10 5 - 15 Telephone plant acquisition adjustment 421 33 - - 454 Nonoperating plant 659 - - - 659 -------- ------- ------- ------- -------- $546,472 $94,288 $ (478) $49,766 $590,516 ======== ======= ======= ======= ======== Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS - CONSOLIDATED Years Ended December 31, 1993, 1992 and 1991 (In Thousands) Deductions ----------- Additions Accounts Balance at ---------- charged off Balance beginning Charged to net of at end of year expense collections of year ---------- ---------- ----------- ------- Year ended December 31, 1993 - ---------------------------- Deducted from assets: Allowance for uncollectible accounts $1,415 $1,965 $1,485 $1,895 ====== ====== ====== ====== Year ended December 31, 1992 - ---------------------------- Deducted from assets: Allowance for uncollectible accounts $1,319 $1,613 $1,517 $1,415 ====== ====== ====== ====== Year ended December 31, 1991 - ---------------------------- Deducted from assets: Allowance for uncollectible accounts $1,478 $1,816 $1,975 $1,319 ====== ====== ====== ====== Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE IX - SHORT-TERM BORROWINGS - CONSOLIDATED Years Ended December 31, 1993, 1992 and 1991 (In Thousands) 1993 1992 1991 Commercial Commercial Commercial Paper Paper Paper ---------- ---------- ---------- Amount outstanding at end of year $41,100 $55,500 $30,000 ======= ======= ======= Maximum amount outstanding at any month end $59,900 $55,500 $30,000 ======= ======= ======= Approximate average amount outstanding during the year $46,764 $30,129 $24,930 ======= ======= ======= Approximate weighted average interest rate for the year (computed by dividing the annual interest expense by the average debt outstanding during the year) 3.24% 4.17% 6.06% ======= ======= ======= Average interest rate at end of year 3.37% 4.12% 5.31% ======= ======= ======= Commercial paper is generally carried for periods ranging from 15 days to 30 days. Carolina Telephone and Telegraph Company Form 10-K Part IV SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION - CONSOLIDATED Years Ended December 31, 1993, 1992 and 1991 (In Thousands) Year ended December 31, --------------------------- 1993 1992 1991 ------- ------- ------- Taxes other than payroll and income taxes: Gross receipts taxes $ 7,009 $ 6,562 $ 6,031 Property taxes 8,484 8,054 8,080 Other state and local taxes 704 1,138 1,381 ------- ------- ------- $16,197 $15,754 $15,492 ======= ======= ======= Maintenance expense is the primary component of plant expense which is shown separately in the Consolidated Statement of Income. The Company had no significant advertising expense and paid no royalties during 1993, 1992 and 1991. Carolina Telephone and Telegraph Company Form 10-K Part IV INDEX TO EXHIBITS ITEM 14(c) Exhibit No. 3 Articles of incorporation and by-laws (filed as Exhibit 3 to 1980 Annual Report Form 10-K and incorporated herein by reference). 4 Instruments defining the rights of security holders, including indentures, contained in documents previously filed with the Commission are incorporated herein by reference. 4(A) Indenture dated as of February 1, 1963, from the Company to Bankers Trust Company, Trustee (See Current Report Form 8-K for February 1963, Exhibit 4-F). 4(B) Indenture dated as of March 1, 1965, from the Company to Bankers Trust Company, Trustee (See Current Report Form 8-K for March 1965, Exhibit A). 4(C) Indenture dated as of March 1, 1966, from the Company to Bankers Trust Company, Trustee (See Current Report Form 8-K for March 1966, Exhibit A). 4(D) Indenture dated as of January 15, 1968, from the Company to North Carolina National Bank as Trustee (See Registration No. 2-27816, Exhibit 4-J). 4(E) Indenture dated as of October 1, 1970, from the Company to Bankers Trust Company, as Trustee (See Registration NO. 2- 38292, Exhibit 4-J). 4(F) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of July 1, 1948 (See Registration No. 2-34018, Exhibit 4-K). 4(G) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of August 1, 1952 (See Registration No. 2-34018, Exhibit 4-L). 4(H) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of August 1, 1957 (See Registration No. 2-34018, Exhibit 4-M). Carolina Telephone & Telegraph Company Form 10-K Part IV INDEX TO EXHIBITS (CONTINUED) ITEM 14(c) Exhibit No. 4(I) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of February 1, 1963 (See Registration No. 2- 34018, Exhibit 4-N). 4(J) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of March 1, 1965 (See Registration No. 2-34018, Exhibit 4-O). 4(K) Supplemental Indenture from the Company to Bankers Trust Company dated as of March 28, 1969 supplementing Indenture dated as of March 1, 1966 (See Registration No. 2-34018, Exhibit 4-P). 4(L) Supplemental Indenture from the Company to North Carolina National Bank dated as of March 28, 1969 supplementing Indenture dated as of January 15, 1968 (See Registration No. 2-34018, Exhibit 4-Q). 4(M) Indenture dated as of August 1, 1969 from the Company to Bankers Trust Company (See Registration No. 2-34018, Exhibit 4-A). 4(N) Indenture dated as of October 1, 1971 from the Company to Bankers Trust Company (See Registration No. 2-41721, Exhibit 2-A). 4(O) Indenture dated as of November 1, 1973 from the Company to Bankers Trust Company (See Registration No. 2-49251, Exhibit 2-A). 4(P) Indenture dated as of May 1, 1978 from the Company to Bankers Trust Company (See Registration No. 2-61151, Exhibit 2-A). 4(Q) Indenture dated as of October 26, 1978 from the Company to Bankers Trust Company (See Administrative Proceeding File No. 3-5541, Exhibit 5). 4(R) Indenture dated as of December 27, 1979 from the Company to Bankers Trust Company (See the Company's Application, File Nos. 2-34018, 2-38292, 2-41721, 2-49251 and 2-61151, Exhibit 5). Carolina Telephone & Telegraph Company Form 10-K Part IV INDEX TO EXHIBITS (CONTINUED) ITEM 14(c) Exhibit No. 4(S) Indenture dated as of May 15, 1986 from the Company to Bankers Trust Company (See Amendment No. 1 to Registration No. 33-5350 Exhibit 4-A). 4(T) Indenture dated as of December 1, 1992 from the Company to Bankers Trust Company. (See Registration No. 33-54936, Exhibit 4). 4(U) Indenture dated as of August 15, 1993 from the Company to Bankers Trust Company. (See Registration No. 33-64476, Exhibit 4). 10 Incentive Compensation Plan (filed as Exhibit 10(c) (vi) to United Telecommunications, Inc., Registration Statement No. 2-72988 and incorporated herein by reference). 12 Computation of Ratio of Earnings to Fixed Charges. 23 Consent of Ernst & Young. Carolina Telephone & Telegraph Company Form 10-K Part IV 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. CAROLINA TELEPHONE AND TELEGRAPH COMPANY Date: March 9, 1994 By s/ F. E. Westmeyer --------------- ----------------------------------------- F. E. Westmeyer, 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. Date Signature and Title ---- ------------------- March 9, 1994 s/ W. E. McDonald - -------------- -------------------------------------------- W. E. McDonald, President, Director and Chief Executive Officer March 9, 1994 s/ F. E. Westmeyer - -------------- -------------------------------------------- F. E. Westmeyer, Vice President-Finance March 9, 1994 s/ T. J. Geller - -------------- -------------------------------------------- T. J. Geller, Controller March 9, 1994 s/ F. J. Boling - -------------- -------------------------------------------- F. J. Boling, Jr, Director March 9, 1994 s/ T. G. Crewe - -------------- -------------------------------------------- T. G. Crewe, Jr, Director March 9, 1994 s/ E. I. Davis - -------------- -------------------------------------------- E. I. Davis, Director March 9, 1994 s/ N. B. DeFriece - -------------- -------------------------------------------- N. B. DeFriece, Director March 9, 1994 s/ C. D. Evans - -------------- -------------------------------------------- C. D. Evans, Director Carolina Telephone & Telegraph Company Form 10-K Part IV SIGNATURES (CONTINUED) Date Signature and Title ---- ------------------- March 9, 1994 s/ J. A. Hackney, III - -------------- -------------------------------------------- J. A. Hackney, III, Director March 9, 1994 s/ W. P. Hendricks - -------------- -------------------------------------------- W. P. Hendricks, Director March 9, 1994 s/ J. W. Jones, Jr - -------------- -------------------------------------------- J. W. Jones, Jr, Director March 9, 1994 s/ J. A. Laughery - -------------- -------------------------------------------- J. A. Laughery, Director March 9, 1994 s/ G. W. Little - -------------- -------------------------------------------- G. W. Little, Director March 9, 1994 s/ B. R. McCain - -------------- -------------------------------------------- B. R. McCain, Director March 9, 1994 s/ J. M. Mead - -------------- -------------------------------------------- J. M. Mead, Director - -------------- -------------------------------------------- M. K. Norris, Director March 9, 1994 s/ D. W. Peterson - -------------- -------------------------------------------- D. W. Peterson, Director - -------------- -------------------------------------------- J. J. Powell, Director March 9, 1994 - -------------- -------------------------------------------- D. L. Ward, Jr, Director

31277_1993.txt

31277_1993

1993

31277

Item 1. Business Eaton Corporation (herein referred to as Eaton or Company) was incorporated in 1916. Eaton is a global manufacturer of vehicle powertrain components and a broad variety of controls serving transportation, industrial, commercial, aerospace, and military markets. The Company offers thousands of high-quality products worldwide. Principal products include truck transmissions and axles, engine components, electrical equipment and controls. The Company had 1993 net sales of $4.4 billion and 38,000 employees at 120 manufacturing facilities in 17 countries. In May 1993, the Company redeemed its share purchase rights at a redemption price of 3-1/3 cents for each right, for a total payment of $2 million. In June 1993, the Company distributed a two-for-one stock split effected in the form of a 100% stock dividend and increased its quarterly dividend on Common Shares to 30 cents per share from the post-split rate of 27-1/2 cents per share. Also, in June 1993, the Company reconsolidated the net assets and operating results of its remaining discontinued operations. The Company has concluded that, although it would still prefer to divest these operations, due to the ongoing contraction in the defense industry and uncertainty in the defense electronics market at the present time, it would be extremely difficult to implement its divestiture plans on an acceptable basis. Financial information for these operations is presented under Defense Systems in "Business Segment Information" on page 38 of this report. In December 1993, the Company recorded a $55 million acquisition integration charge before income tax credits ($34 million after income tax credits, or $.49 per Common Share) in conjunction with the January 31, 1994 acquisition of the Distribution and Control Business Unit (DCBU) of Westinghouse Electric Corporation. The acquisition, which will be accounted for as a purchase in 1994, was for a purchase price of $1.1 billion, plus the assumption of certain liabilities. The purchase price is subject to adjustment based upon changes in DCBU's adjusted net assets. DCBU will be combined with the Company's Industrial Control and Power Distribution Operations, which market Cutler-Hammer products, to form a Cutler-Hammer business unit with annual sales of $1.6 billion. DCBU had 1993 sales of $1.1 billion and Eaton's consolidated sales are expected to increase 25% as a result of the acquisition. Further information regarding the acquisition and its financing is presented under "Subsequent Event - Acquisition of DCBU and Integration Charge" on pages 20 through 22 of this report. Information regarding principal products, net sales, operating profit and identifiable assets by business segment and geographic region is found under "Business Segment and Geographic Region Information" on pages 35 to 39 of this report. Additional information regarding Eaton's business segments and its business in general is presented below. Vehicle Components Patents and Trademarks - Eaton owns, controls or is licensed under many patents related to this business segment. Although Eaton emphasizes its EATON trademark in the marketing of many of its products within this business segment, it also markets under a number of other trademarks, including CHAR-LYNN, DILL, FULLER, ROADRANGER and TOP SPEC. Seasonal Fluctuations - Sales of truck, passenger car and off-highway vehicle components are generally reduced in the third quarter of each year as a result of preparations by vehicle manufacturers for the following model year and their temporary shut-downs for taking physical inventories. Competition - The principal methods of competition in this business segment are price, service and product performance. Eaton occupies a strong competitive position in relation to its many competitors in this business segment and, with respect to many products, is considered among the market leaders. Major Customers - Approximately 18% of net sales in 1993 of the Vehicle Components segment were made to divisions and subsidiaries of Ford Motor Company. Also, approximately 39% of net sales in 1993 of the Vehicle Components segment were made to divisions and subsidiaries of five other large companies. Eaton has been doing business with each of these companies for many years. Sales to these companies include a number of different products and different models or types of the same product, the sales of which are not dependent upon one another. With respect to many of the products sold, the various divisions and subsidiaries of each of the companies are in the nature of separate customers, and sales to one division or subsidiary are not dependent upon sales to other divisions or subsidiaries. Electrical and Electronic Controls Patents and Trademarks - Eaton owns, controls or is licensed under many patents related to this business segment. The EATON, C-H CONTROL, CUTLER-HAMMER, DOLE, DURANT, DYNAMATIC, HEINEMANN, KENWAY, and PANELMATE trademarks are used in connection with the marketing of products included in this business segment. In addition, in conjunction with its January 1994 acquisition of DCBU, the Company has the right to use the CHALLENGER, COMMANDER and WESTINGHOUSE trademarks in the marketing of certain products. The use of the WESTINGHOUSE trademark is limited to a period of ten years. Competition - The principal methods of competition in this business segment are price, geographic coverage, service and product performance. The number of competitors varies with respect to the different products. Eaton occupies a strong competitive position in this business segment and, with respect to many products, is considered among the market leaders. Major Customers - Approximately 8% of net sales in 1993 of the Electrical and Electronic Controls segment were made to the United States Government. All contracts that the Company has with the United States Government are subject to termination at the election of the Government. Approximately 6% of net sales in 1993 of the Electrical and Electronic Controls segment were made to divisions and subsidiaries of Ford Motor Company, which is a major customer of the Company's Vehicle Components segment. Defense Systems Patents and Trademarks - Eaton owns, controls or is licensed under many patents related to this business segment. The AIL, INCHWORM and HYPERMANUAL trademarks are used in connection with the marketing of products included in this business segment. Competition - The principal methods of competition in this business segment are price, technological capability and product performance. The number of competitors is limited and varies with respect to the different technologies. Major Customers - Almost all net sales in 1993 of the Defense Systems segment were made to the United States Government. All contracts that the Company has with the United States Government are subject to the termination at the election the Government. Information Concerning Eaton's Business in General Raw Materials - The principal raw materials used by Eaton are iron, steel, copper, aluminum, brass, insulating materials, silver, rubber and plastic. These materials are purchased in various forms, such as pig iron, metal sheets and strips, forging billets, bar stock and plastic pellets. Eaton purchases its raw materials, as well as parts and other components, from many suppliers and under normal circumstances has no difficulty obtaining them. Order Backlog - Since a significant proportion of open orders placed with Eaton by original equipment manufacturers of trucks, passenger cars and off-highway vehicles are historically subject to month-to-month releases by the customers during each model year, such orders are not considered technically firm. In computing its backlog of orders, Eaton includes only the amount of such orders released by such customers as of dates listed. Using this criterion, Eaton's total backlog was approximately $1 billion and $900 million as of December 31, 1993 and 1992, respectively. The backlog should not be relied upon as being indicative of results of operations for future periods. Research and Development - Research and development expenses for new products and the improvement of existing products were $154 million in 1993, $151 million in 1992 and $138 million in 1991. Protection of the Environment - The operations of the Company involve the use, disposal and cleanup of certain substances regulated under environmental protection laws, as further discussed under "Protection of the Environment" on page 26 of this report. Subject to the difficulty in estimating future environmental costs, the Company expects that any sum it may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed will not have a material adverse effect on its financial condition or results of operations. Eaton's estimated capital expenditures for environmental control facilities are not expected to be material for the remainder of 1994 and 1995. Employees - Eaton employed 38,000 individuals as of December 31, 1993. As a result of its January 1994 acquisition of DCBU, the Company added 12,500 employees. Item 2. Item 2. Properties Eaton's world headquarters is located in Cleveland, Ohio. The Company maintains manufacturing facilities at 120 locations in 17 countries. In addition, as a result of its January 1994 acquisition of DCBU, the Company acquired 36 manufacturing facilities in various domestic and international locations, as well as 27 satellite operations and 12 distribution centers. The Company is a lessee under a number of operating leases for certain real properties and equipment. Information regarding the Company's commitments for operating leases is found under "Lease Commitments" on page 28 of this report. Eaton's principal research facilities are located in Southfield, Michigan, in Milwaukee, Wisconsin, and near Cleveland, Ohio. In addition, certain Eaton divisions conduct research in their own facilities. Management believes that the Company's manufacturing facilities are adequate for its operations, and such facilities are maintained in good condition. Item 3. Item 3. Legal Proceedings None required to be reported. 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 Company's Common Shares are listed for trading on the New York, Chicago, Pacific and London stock exchanges. Information regarding cash dividends paid and the high and low market price per Common Share for each quarter in 1993 and 1992 is found under "Quarterly Data" on page 34 of this report. At December 31, 1993, there were 15,417 holders of record of the Company's Common Shares. Additionally, 15,508 employees were shareholders through participation in the Company's Share Purchase and Investment Plan. Item 6. Item 6. Selected Financial Data Information regarding selected financial data of the Company is found in the "Five-Year Consolidated Financial Summary" on page 49 of this 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" is found on pages 41 to 48 of this report. Item 8. Item 8. Financial Statements and Supplementary Data The consolidated financial statements and financial review of Eaton Corporation and the report of independent auditors are found on pages 13 through 39 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 The information contained on pages 5 through 8 in the Company's definitive proxy statement dated March 18, 1994, with respect to directors of the Company, is incorporated herein by reference in response to this Item. The following is a list of Eaton's officers, their ages and their current positions and offices, as of February 1, 1994. Name Age Position (Date elected to position) - ---------------- --- ------------------------------------------- William E. Butler 62 Chairman and Chief Executive Officer (January 1, 1992); Director John S. Rodewig 60 President; Chief Operating Officer - Vehicle Components (September 22, 1993); Director Stephen R. Hardis 58 Vice Chairman and Chief Financial and Administrative Officer (April 23, 1986); Director Alexander M. Cutler 42 Executive Vice President; Chief Operating Officer - Controls (September 22, 1993); Director Gerald L. Gherlein 55 Executive Vice President and General Counsel (September 4, 1991) John M. Carmont 55 Vice President and Treasurer (December 1, 1981) Adrian T. Dillon 40 Vice President - Planning (March 1, 1991) Patrick X. Donovan 58 Vice President - International (April 27, 1988) John D. Evans 63 Vice President - Human Resources (January 1, 1982) Earl R. Franklin 50 Secretary and Associate General Counsel (September 1, 1991) John W. Hushen 58 Vice President - Corporate Affairs (August 1, 1991) Stanley V. Jaskolski 55 Vice President - Technical Management (October 1, 1990) Ronald L. Leach 59 Vice President - Accounting (December 1, 1981) William T. Muir 51 Vice President - Manufacturing Technologies (April 1, 1989) Derek R. Mumford 52 Vice President - Information Technologies (April 1, 1992) Billie K. Rawot 42 Vice President and Controller (March 1, 1991) All of the officers listed above have served in various capacities with Eaton over the past five years. There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. All officers hold office for one year and until their successors are elected and qualified, unless otherwise specified by the Board of Directors; provided, however, that any officer is subject to removal with or without cause, at any time, by a vote of a majority of the Board of Directors. Item 11. Item 11. Executive Compensation The information contained on pages 11 through 25 in Eaton's definitive proxy statement dated March 18, 1994, with respect to executive compensation, is incorporated herein by reference in response to this Item. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information contained on pages 28 and 29 of the Company's definitive proxy statement dated March 18, 1994, with respect to security ownership of certain beneficial owners and management, is incorporated herein by reference in response to this Item. Item 13. Item 13. Certain Relationships and Related Transactions The information contained on page 10 of the Company's definitive proxy statement dated March 18, 1994, with respect to certain relationships and related transactions, is incorporated herein by reference in response to this Item. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) The following consolidated financial statements and financial review of Eaton Corporation are filed as a separate section of this report: Consolidated Balance Sheets - December 31, 1993 and 1992 - Pages 14 and 15 Statements of Consolidated Income - Years ended December 31, 1993, 1992 and 1991 - Page 16 Statements of Consolidated Cash Flows - Years ended December 31, 1993, 1992 and 1991 - Page 17 Statements of Consolidated Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991 - Page 18 Financial Review - Pages 19 to 39 (2) The summarized financial information for Eaton ETN Offshore Ltd. on page 40 and the following consolidated financial statement schedules for Eaton Corporation are filed as a separate section of this report: Schedule V - Property, Plant and Equipment - Page 50 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment - Page 51 Schedule IX - Short-Term Borrowings - Page 52 Schedule X - Supplementary Income Statement Information - All other schedules for which provision is made in Regulation S-X of the Securities and Exchange Commission, are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) Exhibits 3 Amended Articles of Incorporation (as amended and restated as of January 24, 1989, filed on Form SE on March 13, 1989) and Amended Regulations (as amended and restated as of April 27, 1988, filed on Form SE on March 13, 1989) 4(a) Instruments defining rights of security holders, including indentures (Pursuant to Regulation S-K Item 601(b)(4), the Company agrees to furnish to the Commission, upon request, a copy of the instruments defining the rights of holders of long-term debt of the Company and its subsidiaries) 10 Material contracts (1) DCBU Purchase Agreement dated as of August 10, 1993 between Westinghouse Electric Corporation (Seller) and Eaton Corporation (Buyer) Regarding the Distribution and Control Business Unit of Westinghouse Electric Corporation (Agreement) - Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 Including the following Exhibits to the Agreement: (i) Form of Technology Agreement (Ex. 2.1) (ii) Terms of Lease for Shared Facilities (Ex.9.6(a) (1)) (iii) Terms of Sublease for Shared Facilities (Ex. 9.6(a) (2)) (iv) Terms of Lease for Vidalia, Georgia Shared Facility (Ex. 9.6(b) (1) (i)) (v) Terms of Lease by Buyer of Part of Horseheads Facility (Ex. 9.6(b) (1) (ii)) (vi) Terms for Jackson, Mississippi Sublease (Ex. 9.6(b) (2)) (vii) Form of Services Agreement (Ex. 9.8) (viii) Form of WESCO Distributor Agreement (Ex. 9.9) (ix) Form of Interim NEWCO Distributor Agreement (Ex. 7.15.2) (x) Form of NEWCO Distributor Agreement (xi) Form of Supplier and Vendor Agreement (Ex. 9.10) (2) The following are either a management contract or a compensatory plan or arrangement: (a) Deferred Incentive Compensation Plan (as amended and restated May 1, 1990; filed as a separate section of this report) (b) Executive Strategic Incentive Plan, effective as of January 1, 1991 - Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (c) Group Replacement Insurance Plan (GRIP), effective as of June 1, 1992 - Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (d) 1991 Stock Option Plan - Incorporated herein by reference to the Company's definitive proxy statement dated March 18, 1991 (e) The following are incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990: (i) Strategic Incentive and Option Plan (as amended and restated as of January 1, 1989) (ii) Limited Eaton Service Supplemental Retirement Income Plan (as amended and restated as of January 1, 1989) (iii) Amendments to the 1980 and 1986 Stock Option Plans (iv) Form of "Change in Control" Agreement entered into with all officers of Eaton Corporation (v) Eaton Corporation Supplemental Benefits Plan (as amended and restated as of January 1, 1989) (which provides supplemental retirement benefits) (vi) Eaton Corporation Excess Benefits Plan (as amended and restated as of January 1, 1989) (with respect to Section 415 limitations of the Internal Revenue Code) (f) The following are incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (filed on Form SE dated March 28, 1991): (i) Executive Incentive Compensation Plan (ii) Plan for the Deferred Payment of Directors' Fees (as amended and restated as of January 1, 1989) (iii) Plan for the Deferred Payment of Directors' Fees (originally adopted in 1980 and amended and restated in 1989) (iv) Eaton Corporation Retirement Plan for Non-Employee Directors (as amended and restated as of January 1, 1989) 11 Statement regarding computations of net income per Common Share (filed as a separate section of this report) 21 Subsidiaries of Eaton Corporation (filed as a separate section of this report) 23 Consent of Independent Auditors (filed as a separate section of this report) 24 Power of Attorney (filed as a separate section of this report) (b) Reports on Form 8-K There were no reports on Form 8-K filed during the fourth quarter of 1993. (c) & (d) Exhibits and Financial Statement Schedules Certain exhibits and financial statement schedules required by this portion of Item 14 are filed as a separate section 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. Eaton Corporation -------------------- Registrant Date: March 28, 1994 /s/ Stephen R. Hardis --------------------- Stephen R. Hardis Vice Chairman and Chief Financial and Administrative Officer; Principal Financial Officer; 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 the registrant and in the capacities and on the date indicated. DATE: March 28, 1994 Signature Title - -------------------- ------------------------------------- * - -------------------- William E. Butler Chairman and Chief Executive Officer; Principal Executive Officer; Director * - -------------------- John S. Rodewig President; Chief Operating Officer - Vehicle Components; Director * - -------------------- Alexander M. Cutler Executive Vice President; Chief Operating Officer - Controls; Director /s/ Ronald L. Leach - -------------------- Ronald L. Leach Vice President - Accounting; Principal Accounting Officer * - -------------------- Billie K. Rawot Vice President and Controller * - -------------------- Neil A. Armstrong Director * - -------------------- Phyllis B. Davis Director * - -------------------- Arthur Dole III Director * - -------------------- Charles E. Hugel Director * - -------------------- John R. Miller Director * - -------------------- Furman C. Moseley Director * - -------------------- Hooper G. Pattillo Director * - -------------------- A. William Reynolds Director * - -------------------- Gary L. Tooker Director *By /s/ Stephen R. Hardis -------------------------------------- Stephen R. Hardis, Attorney-in-Fact for the officers and directors signing in the capacities indicated Eaton Corporation 1993 Annual Report on Form 10-K Items 6, 7, 8 & Item 14 (c) and (d) Report of Independent Auditors Consolidated Financial Statements and Financial Review Summary Financial Information for Eaton ETN Offshore Ltd. Management's Discussion and Analysis of Financial Condition and Results of Operations Five-Year Consolidated Financial Summary Financial Statement Schedules Exhibits REPORT OF INDEPENDENT AUDITORS - ------------------------------ To the Shareholders Eaton Corporation We have audited the accompanying consolidated balance sheets of Eaton Corporation and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the summary financial information and financial statement schedules listed in Item 14(a). These financial statements, schedules and summary financial information are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements, schedules and summary financial information 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 Eaton Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and 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 summary financial information and 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 described under "Accounting Changes" on page 22 of this report, in 1992 the Company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. Ernst & Young Cleveland, Ohio February 1, 1994 FINANCIAL REVIEW - ---------------- On June 28, 1993, the Company distributed a two-for-one stock split effected in the form of a 100% stock dividend. Accordingly, all per share amounts, average shares outstanding used in the calculation of per share amounts and stock option information have been adjusted retroactively to reflect the stock split. In June 1993, the Company reconsolidated the net assets and operating results of its remaining discontinued operations. Prior years have been restated to include these results. The Company has concluded that, although it would still prefer to divest these operations, due to the ongoing contraction in the defense industry and uncertainty in the defense electronics market at the present time, it would be extremely difficult to implement its divestiture plans on an acceptable basis. Financial information for these operations is presented under Defense Systems in "Business Segment Information" in the Financial Review. ACCOUNTING POLICIES - ------------------- Consolidation - ------------- The consolidated financial statements include accounts of the Company and all majority-owned subsidiaries. The equity method of accounting is used for investments where the Company has a 20% to 50% ownership interest. Foreign Currency Translation - ---------------------------- Financial statements for subsidiaries outside the United States, except those in highly inflationary economies, are translated into U.S. dollars at year-end exchange rates as to assets and liabilities and weighted average exchange rates as to revenues and expenses. The resulting translation adjustments are recorded in shareholders' equity. Financial statements for subsidiaries in highly inflationary economies are translated into U.S. dollars in the same manner except for inventories and property, plant and equipment-net, and related expenses, which are translated at historical exchange rates. The resulting translation adjustments are included in net income. Short-Term Investments - ---------------------- Short-term investments are carried at cost and are not considered to be cash equivalents for purposes of classification in the statements of consolidated cash flows. Inventories - ----------- Inventories are carried at lower of cost or market. Inventories in the United States, other than those associated with long-term contracts, are accounted for using the last-in, first-out (LIFO) method and all other inventories using the first-in, first-out (FIFO) method. Long-Term Contracts - ------------------- Income and costs on long-term contracts, which relate primarily to the Defense Systems business segment, are recognized on the percentage-of-completion method. Provision is made for anticipated losses on uncompleted contracts. Certain government contracts provide for incentive awards or penalties which are reflected in operations at the time amounts can be reasonably determined. Depreciation and Amortization - ----------------------------- Depreciation and amortization are computed by the straight-line method for financial statement purposes. Depreciation of plant and equipment is provided over the useful lives of the various classes of assets. Excess of cost over net assets of businesses acquired is amortized over fifteen to forty years (accumulated amortization was $78 million and $69 million at the end of 1993 and 1992, respectively). Other intangible assets, principally patents, are amortized over their respective lives. Income Taxes - ------------ In 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", as discussed under "Accounting Changes" in the Financial Review. Deferred income taxes are not provided for undistributed earnings of consolidated subsidiaries outside the United States when such earnings are reinvested for an indefinite period of time by the subsidiaries. Financial Instruments - --------------------- Gains or losses on interest rate swap and cap agreements which hedge interest on debt are accrued in interest expense. Gains or losses on foreign currency forward exchange contracts and options which hedge specific transactions are recognized in net income, offsetting the underlying foreign currency transaction gains or losses. Gains or losses on foreign currency forward exchange contracts and options which hedge net investments in consolidated subsidiaries outside the United States are accrued in shareholders' equity. Premiums related to interest rate swap and cap agreements and foreign currency forward exchange contracts and options are amortized to net income over the life of the agreement. Net Income Per Common Share - --------------------------- Net income per Common Share is computed by dividing net income by the average month-end number of shares outstanding during each period. The dilutive effect of common stock equivalents is not material. SUBSEQUENT EVENT - ACQUISITION OF DCBU AND INTEGRATION CHARGE - ------------------------------------------------------------- On January 31, 1994, the Company acquired the Distribution and Control Business Unit (DCBU) of Westinghouse Electric Corporation for a purchase price of $1.1 billion, plus the assumption of certain liabilities. The purchase price is subject to adjustment based upon changes in DCBU's adjusted net assets. This acquisition will be accounted for as a purchase in 1994. DCBU had sales of $1.1 billion in 1993 and has estimated net assets of $600 million. DCBU is a leading North American manufacturer of electrical distribution equipment and industrial controls, headquartered in Pittsburgh, Pennsylvania. It has approximately 12,500 employees who are located at 36 plants and facilities in the United States, Puerto Rico, Central and South America, Canada and the United Kingdom, and at 27 satellite operations and 12 distribution centers. The purchase includes Challenger Electrical Equipment Corporation, which was acquired by Westinghouse in 1987. DCBU will be combined with Eaton's Industrial Control and Power Distribution Operations (ICPDO), which market Cutler-Hammer products, to form a Cutler-Hammer business unit with annual sales of $1.6 billion. Eaton's consolidated sales are expected to increase by 25% as a result of the acquisition. In order to finance the acquisition, the Company issued $930 million of short-term commercial paper. The Company plans to reduce these short-term financings by the middle of 1994 through equity and long-term debt financings. The timing and mix of these financings will depend on market conditions. Of these short-term financings, $555 million will be classified as long-term debt because the Company intends, and has the ability under a new five-year $555 million revolving credit agreement entered into in January 1994, to refinance this debt on a long-term basis. Also, in January 1994, the Company entered into a $555 million 364-day revolving credit agreement. In 1993, the Company entered into several interest rate hedge agreements related to the planned financing of the acquisition. In September 1993, the Company entered into four interest rate swaps commencing on January 18, 1994. Two thirty-year swaps will effectively convert $100 million of floating rate debt into fixed rate debt at an average rate of 6.685%, and two ten-year swaps will effectively convert $100 million of floating rate debt into fixed rate debt at an average rate of 5.788%. In October 1993, the Company purchased a one-year interest rate cap commencing on January 1, 1994 that effectively places a 5.5% ceiling on $400 million of floating rate debt, and a ten-month interest rate cap commencing January 1, 1995 that effectively places a 5.5% ceiling on $100 million of floating rate debt. In December 1993, in conjunction with the acquisition, the Company recorded a $55 million acquisition integration charge before income tax credits ($34 million after income tax credits, or $.49 per Common Share). Part of a comprehensive business plan, the charge addresses the costs of the integration of ICPDO product lines and operations with DCBU, related workforce reductions and an $8 million write-down of assets, largely in the United States. Expenditures are expected to occur over approximately the next four years and will be funded through cash flow from the combined operations. The Company anticipates that integration of the businesses will create permanent value by streamlining product lines, manufacturing capacity and organization structure and enable the businesses to attain maximum benefit from synergy of complementary product offerings, operations and technical expertise. Positive incremental benefits are anticipated following the first year of integration activities. EXTRAORDINARY ITEM AND RESTRUCTURING CHARGE - ------------------------------------------- In March 1993, the Company called for redemption, in April 1993, the $74 million outstanding balance of its 9% debentures, and in December 1993, the Company called for redemption, in January 1994, the $89 million outstanding balance of its 8.5% debentures. The extraordinary loss on these redemptions, including the write-off of debt issue costs, was $11 million before income tax credits ($7 million after income tax credits, or $.10 per Common Share). In 1991, as a result of the review of operating strategies and in order to improve competitiveness and future profitability, the Company recorded a restructuring charge of $39 million before income tax credits ($25 million after income tax credits, or $.38 per Common Share). The charge included provisions for restructuring, relocation and rationalization of product lines and operations and permanent workforce reductions involving a significant number of operations, primarily in the United States and Europe. ACCOUNTING CHANGES - ------------------ In 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". SFAS No. 106 requires accrual of these benefits, primarily postretirement health care and life insurance for retirees in the United States, over the working lives of employees rather than recognition of expenses as claims are incurred. Included in net income for 1992 is the cumulative effect of this accounting change for prior years of $442 million before income tax credits ($274 million after income tax credits, or $3.97 per Common Share). As a result of this accounting change, 1992 postretirement health care and life insurance costs increased $25 million before income tax credits ($16 million after income tax credits, or $.23 per Common Share). Results for 1991 have not been restated for this accounting change. SFAS No. 106 has no effect on cash flows since claims will continue to be paid as incurred. In 1992, the Company also adopted SFAS No. 109, "Accounting for Income Taxes". The adoption of this standard changed the method of accounting for income taxes to the liability method from the deferred method. The liability method requires recognition of deferred income taxes based on temporary differences between the financial reporting and income tax bases of assets and liabilities, using currently- enacted income tax rates and regulations. Included in net income for 1992 is the cumulative effect of this accounting change for prior years of $6 million, or $.09 per Common Share. Results for 1991 have not been restated for this accounting change. SFAS No. 109 has no effect on cash flows. ACCOUNTS RECEIVABLE - ------------------- Included in accounts receivable at December 31, 1993 and 1992 were unbilled amounts of $23 million and $91 million, respectively, primarily related to long-term contracts of the Defense Systems business segment with the United States Government. These receivables will be billed in accordance with applicable contract terms and are expected to be collected within one year. Accounts receivable are net of an allowance for doubtful accounts of $10 million at the end of 1993 and 1992. INVENTORIES - ----------- December 31 --------------- (Millions of dollars) 1993 1992 ---- ---- Raw materials $141 $128 Work in process 238 264 Finished goods 139 146 ---- ---- Gross inventories at FIFO 518 538 Excess of current cost over LIFO cost (84) (83) ---- ---- Net inventories at LIFO $434 $455 ==== ==== Gross inventories accounted for using the LIFO method were $314 million and $294 million at the end of 1993 and 1992, respectively. DEBT AND OTHER FINANCIAL INSTRUMENTS - ------------------------------------ Information related to the 1994 financing of the acquisition of DCBU is contained under "Subsequent Event - Acquisition of DCBU and Integration Charge" in the Financial Review. The Company has lines of credit, primarily short-term, aggregating $119 million from various banks worldwide. Most of these arrangements do not have termination dates, but are reviewed periodically for renewal. At December 31, 1993, the Company had $24 million outstanding under lines of credit with banks. A summary of long-term debt, excluding the current portion, follows: December 31 --------------- (Millions of dollars) 1993 1992 ---- ---- 9% notes payable, due 2001 $100 $100 8% debentures, due 2006 (due 1996 at option of debenture holder) 86 86 8.9% debentures, due 2006 100 100 7% debentures, due 2011, net of unamor- tized discount of $95 million in 1993 and $96 million in 1992 (effective interest rate 14.6%) 105 104 8-7/8% debentures, due 2019 (due 2004 at option of debenture holder) 38 38 8.1% debentures, due 2022 100 100 Notes payable of Employee Stock Ownership Plan due through 1999 82 96 8.5% sinking fund debentures 89 9% sinking fund debentures 74 Other 38 46 ---- ---- $649 $833 ==== ==== During 1993, the Company called for redemption the $74 million outstanding balance of its 9% debentures and the $89 million outstanding balance of its 8.5% debentures, resulting in an extraordinary loss of $7 million. Notes payable of the Employee Stock Ownership Plan (ESOP), which are guaranteed by the Company, consist of $65 million at a floating interest rate (3.00% at December 31, 1993) based on LIBOR and $31 million at a fixed interest rate of 7.62%. The Company has entered into a series of interest rate swaps, which expire ratably through 1999, and which change the interest rate on the $31 million of fixed interest rate notes payable to fixed interest rates of 7.07% and 6.85% as to $9 million and $18 million, respectively, and to a floating interest rate (2.075% at December 31, 1993) based on LIBOR as to $4 million. In 1991, an unrelated party exercised its option under a 1990 agreement to enter into an interest rate swap expiring in 2000 with the Company. The agreement effectively converts $100 million of floating rate debt into fixed rate obligations. Payments are received at a floating interest rate (3.375% at December 31, 1993) based on LIBOR and are made at a fixed interest rate of 9%. Aggregate mandatory sinking fund requirements and annual maturities of long-term debt are as follows (in millions): 1994, $110; 1995, $21; 1996, $106; 1997, $21; and 1998, $22. The amount for 1994 includes $89 million of 8.5% debentures called for redemption in January 1994. The amount for 1996 includes $86 million of 8% debentures due in 1996 at the option of the debenture holder. Interest cost capitalized as part of acquisition or construction of major assets (in millions) was $12, $8, and $7 in 1993, 1992 and 1991, respectively. Interest paid (in millions) was $90, $94 and $81 in 1993, 1992 and 1991, respectively. At December 31, 1993, the Company held foreign currency forward exchange contracts and options, which primarily mature in 1994, for purchase or sale of largely European and Canadian currencies to hedge foreign currency transactions and net investment positions. Open purchase contracts totaled $63 million and open sales contracts totaled $290 million. Counterparties to various hedging instruments are a number of major international financial institutions. While the Company may be exposed to credit losses in the event of nonperformance by these counterparties, it does not anticipate losses due to its control over the limit of positions entered into with any one party and the strong credit ratings of these institutions. The following table summarizes the carrying amount and fair value of financial instruments: The fair value of equity investments, marketable securities, long-term debt and interest rate derivatives was principally based on quoted market prices. The fair value of foreign currency forward exchange contracts and options was estimated based on quoted market prices of comparable contracts, adjusted through interpolation where necessary for maturity differences. The carrying amount of financial instruments is not affected by the fair value measurement. PROTECTION OF THE ENVIRONMENT - ----------------------------- The Company has been named a potentially responsible party (PRP) under the Federal Superfund law at a number of waste disposal sites. Although this law technically imposes joint and several liability upon each PRP at each site, the extent of the Company's required financial contribution to the cleanup of these sites is expected to be limited based on the number and financial strength of the other named PRP's and the volumes of waste involved which might be attributable to the Company. The Company is also involved in remedial response and voluntary environmental cleanup expenditures at a number of other sites which are not the subject of any Superfund law proceeding, including certain of its currently-owned or formerly-owned plants. Although it is difficult to quantify the potential financial impact of compliance with environmental protection laws, management estimates that there is a reasonable possibility that the remediation and other costs associated with all of these sites may range between $10 million and $68 million, and that such costs would be incurred over a period of several years. The Company accrues for these costs when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. At December 31, 1993, the Company's balance sheet included an accrual for the estimated remediation and other environmental costs of approximately $14 million. Actual costs to be incurred at identified sites in future periods may vary from the estimates, given inherent uncertainties in evaluating environmental exposures. Subject to the difficulty in estimating future environmental costs, the Company expects that any sum it may be required to pay in connection with environmental matters in excess of the amounts recorded or disclosed above will not have a material adverse effect on its financial condition or results of operations. With respect to the DCBU operations acquired at January 31, 1994, to date the Company has conducted only a due diligence, pre-acquisition review of the environmental loss contingencies and expenditures at these operations. Although additional investigation and review is in progress, the Company is not yet able to evaluate conclusively the scope of any environmental issues. The Company expects that these operations will have environmental exposure similar to that of other electrical equipment manufacturers. The Company's exposure is limited, however, by the agreement between the Company and Westinghouse Electric Corporation, pursuant to which the Company acquired DCBU. With respect to environmental conditions existing prior to the acquisition, Westinghouse has agreed to retain certain responsibilities, to share the cost of others and to indemnify the Company for its share of those costs to the extent that they exceed $3.5 million annually. For locations in the United States, this obligation to share and to indemnify extends for ten years, and for locations elsewhere it extends for fifteen years. The Company continues to modify, on an ongoing, regular basis, certain of its processes in order to reduce the impact on the environment. Efforts in this regard include the removal of many underground storage tanks and the reduction or elimination of certain chemicals and wastes in its operations. OPTIONS FOR COMMON SHARES - ------------------------- Options have been granted to certain employees, under various plans, to purchase the Company's Common Shares at prices equal to fair market value as of date of grant. These options expire ten years from date of grant. A summary of stock option activity follows: SHAREHOLDERS' EQUITY - -------------------- There are 150 million Common Shares authorized. There were 11 million and 12 million Common Shares held in treasury at the end of 1992 and 1991, respectively, which were reissued in conjunction with the June 1993 two-for-one stock split. At December 31, 1993, 5.8 million Common Shares were reserved principally for exercise and grant of stock options. At December 31, 1993, there were 15,417 holders of record of Common Shares. Additionally, 15,508 employees were shareholders through participation in the Share Purchase and Investment Plan. In private placements the Company sold 1.3 million Common Shares in 1993 for aggregate net proceeds of $62 million, and sold an additional 800,000 Common Shares in January 1994 for aggregate net proceeds of $38 million. In May 1993, the Company redeemed its share purchase rights at a redemption price of 3-1/3 cents for each right, for a total payment of $2 million. The Company's Employee Stock Ownership Plan (ESOP) was established to prefund a portion of the anticipated matching contributions through 1999 to its Share Purchase and Investment Plan (SPIP) for participating United States employees. That portion of SPIP expense related to the ESOP is calculated by first determining the ratio of shares allocated to employee ESOP accounts relative to shares released, and then applying that ratio to the amount contributed to the ESOP. That amount, along with dividends on unallocated Common Shares held by the ESOP, is used to repay the notes, including interest, in level installments. Unallocated ESOP shares are allocated to employee ESOP accounts in aggregate amounts based on loan principal payments made by the ESOP. LEASE COMMITMENTS - ----------------- Future minimum rental commitments as of December 31, 1993, under noncancelable operating leases, which expire at various dates and in most cases contain renewal options, are as follows (in millions): 1994, $28; 1995, $23; 1996, $17; 1997, $14; 1998, $12; and after 1998, $91. Rental expense in 1993, 1992 and 1991 (in millions) was $43, $45 and $49, respectively. PENSION PLANS - ------------- The Company has non-contributory defined benefit pension plans covering the majority of employees. Plans covering salaried and certain hourly employees provide benefits that are generally based on years of service and final average compensation. Benefits for other hourly employees are generally based on years of service. Company policy is to fund at least the minimum amount required by applicable regulations. In the event of a change in control of the Company, excess pension plan assets of North American operations may be dedicated to funding of health and welfare benefits for employees and retirees. The components of pension (expense) income are as follows: Year ended December 31 -------------------------- (Millions of dollars) 1993 1992 1991 ---- ---- ---- Service cost - benefits earned during year $(42) $(39) $(39) Interest cost on projected benefit obligation (97) (96) (92) Actual return on assets 155 203 216 Net amortization and deferral (17) (73) (90) ---- ---- ---- $ (1) $ (5) $ (5) ==== ==== ==== The following table sets forth, by funded status, the asset (liability) recognized in the consolidated balance sheets for pension plans: Measurement of the projected benefit obligation was based on a discount rate of 7.25% in 1993 and 8.25% in 1992 and 1991. The expected compensation growth rate was 4.95% in 1993 and 5.95% in 1992 and 1991. The expected long-term rate of return on assets was 10% in all three years; actual returns during each of these three years exceeded the expected 10% rate. Plan assets were invested in equity and fixed income securities and other instruments. Underfunded plans are associated principally with operations outside the United States. The change in the discount rate to 7.25% at the end of 1993 had the effect of increasing the accumulated pension benefit obligation by $103 million with an offsetting decrease in the unamortized net gain. This change will have an immaterial effect on future expense. POSTRETIREMENT BENEFIT PLANS OTHER THAN PENSIONS - ------------------------------------------------ Generally, employees become eligible for postretirement benefits other than pensions, primarily health care and life insurance for retirees in the United States, when they retire. These benefits are payable for life, although the Company retains the right to modify or terminate the plans providing these benefits. The plans are primarily contributory, with retiree contributions adjusted annually, and contain other cost-sharing features, including deductibles and co-payments. Effective January 1, 1993, certain plans were amended to limit the annual amount of the Company's future contributions towards employees' postretirement health care benefits. Company policy is to pay claims as they are incurred since, unlike pensions, there is no effective method to obtain a tax deduction for prefunding of these benefits under existing United States income tax regulations. Expense for postretirement benefits other than pensions, with amounts for 1993 and 1992 calculated under SFAS No. 106, is as follows: Year ended December 31 ---------------------- (Millions of dollars) 1993 1992 1991 ---- ---- ---- Service cost - benefits earned during year $ (7) $(12) Interest cost on projected benefit obligation (37) (44) Amortization of unrecognized prior service cost 9 Claims incurred and expensed $(27) ---- ---- ---- $(35) $(56) $(27) ==== ==== ==== The liability recognized in the consolidated balance sheets for postretirement benefit plans other than pensions is as follows: December 31 --------------- (Millions of dollars) 1993 1992 ---- ---- Accumulated postretirement benefit obligation Retirees $368 $345 Eligible plan participants 38 45 Noneligible plan participants 120 161 Unamortized amounts not yet recognized Prior service cost 91 Net loss (73) (5) ---- ---- $544 $546 ==== ==== Measurement of the accumulated postretirement benefit obligation at December 31, 1993, was based on a 12% annual rate of increase in per capita cost of covered health care benefits (13% for 1992). For 1993, the rate was assumed to decrease ratably to 5% through 2000 and remain at that level thereafter (6% for 1992). The discount rate was 7.25% in 1993 and 8.5% in 1992. An increase of 1% in assumed health care cost trend rates would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $34 million and the net periodic cost for 1993 by $2 million. The changes in assumed rates had the effect of increasing the accumulated postretirement benefit obligation by $49 million with an offsetting increase in the unamortized net loss. This change will have an immaterial effect on future expense. INVESTMENT IN LIFE INSURANCE - ---------------------------- In 1993, the Company purchased company-owned life insurance policies insuring the lives of a portion of its active United States employees. These policies offer an attractive means of accumulating assets to meet future liabilities including the payment of employee benefits such as health care. At December 31, 1993, the investment in this life insurance, included in other assets, was $7 million, net of policy loans of $110 million. Net life insurance expense of $2 million, including interest expense of $4 million in 1993, was included in selling and administrative expense. INCOME TAXES - ------------ Year ended December 31 ---------------------- (Millions of dollars) 1993 1992 1991 ---- ---- ---- Income before income taxes United States $214 $147 $ 85 Outside the United States 48 34 16 ---- ---- ---- $262 $181 $101 ==== ==== ==== Income taxes, with amounts for 1993 and 1992 derived under SFAS No. 109, are summarized below: Year ended December 31 ---------------------- (Millions of dollars) 1993 1992 1991 ---- ---- ---- Current United States Federal $108 $ 42 $ 64 State and local 7 5 10 Outside the United States 30 20 10 ---- ---- ---- 145 67 84 Deferred United States Increase in statutory tax rate (5) Other Federal (50) (14) (47) State and local (2) (1) (8) Outside the United States Operating loss carryforwards (7) (11) Reduction of valuation allowance for deferred tax assets (5) Increase in statutory tax rate (1) Other 7 (2) ---- --- --- (63) (26) (57) ---- --- --- $ 82 $41 $27 ==== === === Significant components of net current and net long-term deferred income taxes derived under SFAS No. 109 are as follows: December 31, 1993 ------------------------------- Current Long-term Long-term (Millions of dollars) assets assets liabilities ------- --------- ----------- Accruals and other adjustments Employee benefits $ 44 $209 $ (4) Inventory 15 Long-term contracts 16 Restructuring 15 13 Depreciation and amortization (140) (15) Other 22 5 Operating loss carryforwards 50 2 Valuation allowance (15) Other items 15 (10) 7 ---- ---- ---- $127 $112 $(10) ==== ==== ==== December 31, 1992 ------------------------------- Current Long-term Long-term (Millions of dollars) assets assets liabilities ------- --------- ----------- Accruals and other adjustments Employee benefits $ 28 $209 $ (3) Inventory 26 Long-term contracts 17 (9) Restructuring 14 Depreciation and amortization (137) (19) Other 23 4 Operating loss carryforwards 42 4 Valuation allowance (20) Other items 12 (28) 4 ---- ---- ---- $120 $ 61 $(14) ==== ==== ==== The deferred income tax provision of $57 million for 1991 related primarily to long-term contracts. At December 31, 1993 certain subsidiaries outside the United States had tax loss carryforwards aggregating $115 million. Carryforwards of $68 million have no expiration dates and the balance expire at various dates from 1995 through 2005. The adoption of SFAS No. 109 reduced 1992 income tax expense by $11 million and the effective income tax rate by 6%, in comparison to the prior accounting method. The parent company has not provided income taxes on undistributed earnings of consolidated subsidiaries outside the United States of $332 million at December 31, 1993, since the earnings retained have been reinvested by the subsidiaries. If distributed, such remitted earnings would be subject to withholding taxes but substantially free of United States income taxes. Worldwide income tax payments, including Federal and state income taxes in the United States, in 1993, 1992 and 1991 (in millions) were $156, $71 and $97, respectively. QUARTERLY DATA - -------------- (Unaudited) Quarter ended (Millions of dollars except ----------------------------------- for per share data) Dec. 31 Sept. 30 June 30 Mar. 31 ------- -------- ------- ------- Net sales $1,115 $1,053 $1,147 $1,086 Gross margin 297 266 279 275 Percent of sales 27% 25% 24% 25% Income before extraordinary item 30 44 53 53 Extraordinary item (4) (3) Net income 26 44 53 50 Per Common Share Income before extraordinary item $ .41 $ .63 $ .77 $ .76 Extraordinary item (.05) (.05) Net income .36 .63 .77 .71 Cash dividends paid .30 .30 .275 .275 Market price High 55-3/8 51-3/4 47-1/8 43-3/4 Low 48 43 41-1/2 38-1/4 Net sales $1,030 $1,012 $1,064 $ 995 Gross margin 253 223 256 235 Percent of sales 24% 22% 24% 24% Income before cumulative effect of accounting changes 39 28 41 32 Cumulative effect of accounting changes Postretirement benefits other than pensions (274) Income taxes 6 Net income (loss) 39 28 41 (236) Per Common Share Income before cumulative effect of accounting changes $ .57 $ .40 $ .60 $ .46 Cumulative effect of accounting changes Postretirement benefits other than pensions (4.00) Income taxes .09 Net income (loss) .57 .40 .60 (3.45) Cash dividends paid .275 .275 .275 .275 Market price High 40-7/8 40-3/8 41-5/8 39-3/8 Low 35 35-7/8 35-1/2 30-7/8 The fourth quarter of 1993 includes an acquisition integration charge of $55 million before income tax credits ($34 million after income tax credits, or $.49 per Common Share). The redemption of debentures in 1993 resulted in extraordinary losses of $5 million and $6 million before income tax credits in the first and fourth quarters, respectively ($3 million and $4 million after income tax credits, or $.05 per Common Share in each quarter). The previously reported first quarter results were restated to segregate the extraordinary loss. Gross margin for the second quarter of 1993 was reduced by a charge of $9 million for the restructuring of certain vehicle components operations in Europe. The third quarter of 1992 includes an $11 million gain, before income taxes, on the sale of an interest in a limited partnership. The gain was partially offset by the accrual in the third quarter of 1992 of the contribution to the Company's charitable trust of marketable securities with a market value of $8 million. In 1992, the Company adopted the new accounting standards for postretirement benefits other than pensions and income taxes, retroactive to January 1, 1992. Net income in the first quarter of 1992 includes the cumulative effect of the accounting change for postretirement benefits other than pensions for prior years of $442 million before income tax credits ($274 million after income tax credits, or $4.00 per Common Share). Net income in the first quarter of 1992 also includes the cumulative effect of the accounting change for income taxes for prior years of $6 million, or $.09 per Common Share. BUSINESS SEGMENT AND GEOGRAPHIC REGION INFORMATION - -------------------------------------------------- Operations are classified among three business segments: Vehicle Components, Electrical and Electronic Controls and Defense Systems. The major classes of products included in each segment and other information follow. Vehicle Components - ------------------ Truck Components - Heavy and medium duty mechanical transmissions; power take-offs; drive, trailer and steering axles; brakes; locking differentials; engine valves; valve lifters; leaf springs; viscous fan drives; fans and fan shrouds; power steering pumps; tire pressure control systems; tire valves. Passenger Car Components - Engine valves; hydraulic valve lifters; viscous fan drives; fans and fan shrouds; locking differentials; spring fluid dampers; superchargers; tire valves. Off-Highway Vehicle Components - Mechanical and automatic transmissions; drive and steering axles; brakes; engine valves; hydraulic valve lifters; gear and piston pumps and motors; transaxles and steering systems; geroters; control valves and cylinders; forgings; tire valves. The principal market for these products is original equipment manufacturers of trucks, passenger cars and off-highway vehicles. Most sales of these products are made directly from the Company's plants to such manufacturers. Electrical and Electronic Controls - ---------------------------------- Industrial and Commercial Controls - Electromechanical and electronic controls: motor starters, contactors, overloads and electric drives; programmable controllers, counters, man/machine interface panels and pushbuttons; photoelectric, proximity, temperature and pressure sensors; circuit breakers; loadcenters; safety switches; panelboards; switchboards; dry type transformers; busway; meter centers; portable tool switches; commercial switches; relays; illuminated panels; annunciator panels; electrically actuated valves and actuators. Automotive and Appliance Controls - Electromechanical and electronic controls: convenience, stalk and concealed switches; knock sensors; climate control components; speed controls; timers; pressure switches; water valves; range controls; thermostats; gas valves; infinite switches; temperature and humidity sensors. Specialty Controls - Automated material handling systems; automated guided vehicles; stacker cranes; ion implanters; engineered fasteners; golf grips; industrial clutches and brakes. The principal markets for these products are industrial, commercial, automotive, appliance, aerospace and government customers. Sales are made directly by the Company or indirectly through distributors and manufacturers' representatives. Defense Systems - --------------- Strategic countermeasures; tactical jamming systems; electronic intelligence; electronic support measures. The principal market for these products is the United States Government. Other Information - ----------------- Operating profit represents net sales less operating expenses for each segment and geographic region and excludes interest expense and income, and general corporate expenses--net. Identifiable assets for each segment and geographic region represent those assets used in operations (including excess of cost over net assets of businesses acquired) and exclude general corporate assets (consisting principally of short-term investments, deferred income taxes, investments carried at equity, property and other assets). Net sales to divisions and subsidiaries of one customer, primarily from the Vehicle Components business segment, were $541 million in 1993, $491 million in 1992 and $394 million in 1991 (12% of sales in 1993, 12% in 1992 and 11% in 1991). Geographic Region Information Summary Financial Information for Eaton ETN Offshore Ltd. - --------------------------------------------------------- Eaton ETN Offshore Ltd. (Eaton Offshore) was incorporated by Eaton under the laws of Ontario, Canada, primarily for the purpose of raising funds through the offering of debt securities in the United States and making these funds available to Eaton and/or one or more of Eaton's direct or indirect subsidiaries. All of the issued and outstanding capital stock of Eaton Offshore is owned directly or indirectly by Eaton. In addition, Eaton Offshore owns all of the issued and outstanding capital stock of Eaton Yale ltd. (Eaton Yale) previously owned by Eaton. Eaton Yale is engaged principally in the manufacture of fasteners, leaf spring assemblies and electrical and electronic controls. In January 1992, Eaton Yale acquired Franz Kirsten KG. In January 1994, Eaton Yale acquired the Canadian operations of the Distribution and Control Business Unit of the Westinghouse Electric Corporation. Summary financial information for Eaton Offshore and its consolidated subsidiaries is as follows: Year ended December 31 ------------------------------------ (Millions of dollars) 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Income statement data Net sales $281 $295 $165 $188 $207 Gross profit 38 42 26 29 29 Net income 13 17 13 12 7 Balance sheet data Current assets $144 $144 $124 $ 91 $ 49 Net intercompany receivables (payables) 22 24 33 17 (11) Noncurrent assets 81 86 42 48 45 Current liabilities 42 51 20 21 12 Noncurrent liabilities 109 115 104 73 12 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW - -------- The Company experienced an extraordinary year of achievement in 1993. Income after income taxes for the year increased to $214 million in 1993 before the recognition of a $34 million acquisition integration charge and a $7 million extraordinary loss on the redemption of debentures. This represents a 53% increase compared to income of $140 million in 1992 (before the cumulative effect of 1992 accounting changes). Earnings per Common Share, before the special charges, rose to $3.06 in 1993, a 51% increase over $2.03 (before the impact of accounting changes) in 1992. On January 31, 1994, the Company acquired Westinghouse Electric Corporation's Distribution and Control Business Unit (DCBU), and in December of 1993 recorded a $55 million charge ($34 million after income tax credits, or $.49 per Common Share) for the integration of the Company's Industrial Control and Power Distribution Operations (ICPDO) with DCBU to form the Cutler- Hammer business unit. This acquisition provides greater product depth with world class technology and substantially increases product offering and distribution opportunities. During March and December 1993, the Company called for redemption a total of $163 million of debentures. The loss on the redemptions was accounted for as an extraordinary item in each of those periods. In June, a two-for-one common stock split was distributed, effected in the form of a 100% stock dividend, and the quarterly dividend on Common Shares was increased by 2-1/2 cents (9%) to 30 cents per share, the third dividend increase in seven years. In June, the Company reconsolidated the net assets and operating results of its remaining discontinued operations. Prior years have been restated to include those results. 1993 COMPARED TO 1992 - --------------------- NET SALES - --------- Net sales in 1993 increased by 7% to $4.40 billion, over $4.10 billion in 1992. The increase occurred principally in the United States and was largely due to a strengthened North American market for heavy and light trucks, vans and sport utility vehicles, responding to a U.S. economic recovery. The improvement in North America more than offset the effects of the continued deep European recession. In North America, certain markets, which had been sluggish through most of 1993, showed sales improvements in the fourth quarter. The Vehicle Components segment net sales increased to $2.36 billion for 1993, rising 13% over 1992 sales of $2.09 billion. This improvement was largely due to significant growth in sales of truck components, following the best factory sales of heavy trucks in North America since 1979. The passenger car and light truck markets also showed improvement in 1993. Off-highway equipment markets, which had been down for several years, improved considerably. Strong sales growth in North America was partially offset by reduced sales in Europe where vehicle markets remain weak. The Electrical and Electronic Controls segment showed a net sales increase of 4% in 1993 to $1.85 billion compared to $1.78 billion in 1992. This increase was largely due to increased sales in the areas of industrial and commercial controls and specialty controls. Strong North American markets for automotive and appliance controls were largely offset, however, by the continued weakness in the corresponding European markets due to the economic recession and the negative impact of foreign currency exchange rate fluctuations. Rising demand for portable tools, factory equipment and residential housing drove the increase in sales of industrial and commercial controls. Sales of the Company's industrial and power distribution equipment, which tend to lag any North American economic recovery, rose sharply in the fourth quarter. The semiconductor equipment business, included in specialty controls, experienced strong results throughout the year, with a 19% improvement in sales for 1993 over 1992. OPERATING RESULTS - ----------------- Gross margin increased to $1.12 billion (25.4% of sales) in 1993, rising from $967 million (23.6% of sales) in 1992, due to significant sales growth as well as benefits achieved through ongoing cost containment and productivity improvements. This improvement in margin was achieved in spite of a $9 million charge, included in cost of products sold in 1993, for the restructuring of certain vehicle components operations in Europe. Selling and administrative expenses showed an increase of 2% in 1993 compared to 1992, with expense of $591 million in 1993 and $578 million in 1992. This level of increase is a clear indication of the results of cost control and restructuring efforts, which is further evidenced by their relationship to net sales, 13% in 1993 compared to 14% in 1992. Research and development expenses for 1993 were $154 million, rising from $151 million in 1992. This level of expenditure reflects the continued commitment to achieving expressed corporate targets in product innovation and enhancements and to maintaining leading-edge technology. The Vehicle Components segment operating profit rose to $247 million (10% of sales) for 1993, a substantial improvement over $170 million (8% of sales) for 1992 despite a $9 million restructuring charge recorded in 1993 for restructuring certain European operations. This improvement was largely a result of the improved market in North America for heavy and light trucks, vans and sport utility vehicles. Other factors contributing to increased profits were continuing stringent cost containment efforts and the economies achieved through restructuring certain businesses, which have better positioned operations to benefit from further growth in vehicle markets. The Electrical and Electronic Controls segment operating profit significantly improved, before the effect of the $55 million acquisition integration charge, rising 62% to $138 million in 1993 (7% of sales) from $85 million (5% of sales) in 1992. This improved segment profit picture is partially due to the sales growth experienced in certain controls markets, but is also a clear reflection of the continuing emphasis placed on containing and controlling costs and the realization of anticipated benefits of earlier restructuring efforts. The depressed European economy negatively impacted the controls businesses, particularly automotive and appliance controls. Profit for this segment was also reduced by a $55 million pretax charge recorded in December 1993 for the integration of ICPDO product lines and operations with DCBU to form the new Cutler-Hammer business unit. The DCBU acquisition will bring a more even balance in sales and earnings between the Electrical and Electronic Controls segment and the historically strong Vehicle Components segment. Interest expense declined to $75 million for 1993, the lowest level since 1986, from $89 million for 1992 largely due to the reduction of higher interest rate debt, lower debt levels during 1993 and increased capitalized interest. Other income--net was $12 million in 1993, down from $23 million in 1992, largely due to the $11 million pretax gain on the sale of the Company's interest in a limited partnership recorded in 1992. An analysis of changes in income taxes and the effective income tax rate is presented under "Income Taxes" in the Financial Review. In 1992, the Company adopted two new accounting standards for postretirement benefits other than pensions and for income taxes, which together reduced net income by $268 million due to the recognition of their cumulative effect for prior years. CHANGES IN FINANCIAL CONDITION - ------------------------------ The Company's financial condition remained strong during 1993. The current ratio was 1.9 at December 31, 1993 compared to 2.0 at December 31, 1992. The decline in working capital to $679 million at year-end 1993 from $751 million at year-end 1992 was primarily the result of an increase in the current portion of long-term debt due to the decision to redeem, in early 1994, the $89 million outstanding balance of 8.5% debentures. Cash and short-term investments increased by $84 million to $300 million at December 31, 1993 due to improved cash flow from operations and the sale of 1.3 million Common Shares in 1993 for net proceeds of $62 million. In spite of the increase in sales in 1993 to record levels, heightened emphasis on efficient asset management is reflected in the $21 million decline in inventories to $434 million at December 31, 1993. An increase in accounts receivable resulting from improved 1993 sales was more than offset by a reduction due to the collection of receivables at AIL as a consequence of the definitization of contract modifications as agreed to with the United States Air Force late in 1992; the net impact of the increase and offsetting decrease resulted in a $78 million decline in accounts receivable to $550 million at December 31, 1993. In addition, accounts receivable days sales outstanding at December 31, 1993 was 43, historically one of the lowest levels, in spite of the expanding economy and sales growth. Long-term debt declined to $649 million at year-end 1993 from $833 million at the end of 1992 primarily due to the call for redemption of $74 million of 9% debentures in March 1993 and $89 million of 8.5% debentures in December 1993. In private placements the Company sold 1.3 million Common Shares in 1993 for aggregate net proceeds of $62 million and, in January 1994, an additional 800,000 Common Shares for $38 million. Beginning in April 1995, the holder of these shares has the right to require the Company to register their public sales under the Federal securities law. Capital expenditures were $227 million, one of the Company's highest levels, in 1993 compared with $186 million in 1992, as the Company maintained its emphasis on enhancing manufacturing efficiencies and capabilities. Capital expenditures in 1994 are anticipated to be higher than 1993 for those businesses unrelated to the acquisition of DCBU. Further capital expenditures are planned relative to the combining of DCBU and ICPDO. During 1993, the Company invested $14 million in small businesses, primarily to establish a joint venture, which will round out product lines and open avenues for market expansion. Net cash provided by operating activities increased to $435 million for 1993 from $381 million for 1992. This increase resulted primarily from improved net income, reflecting higher sales and rigorous cost controls. Changes in operating assets and liabilities also contributed to the increase in net cash provided by operating activities in 1993. Operating cash flow and proceeds from the sale of Common Shares during 1993 were more than adequate to fund capital expenditures, cash dividends, the investment in certain small businesses and other corporate purposes. On May 25, 1993, the Company redeemed its share purchase rights at a redemption price of 3-1/3 cents for each right for a total payment of $2 million. At the end of 1993, as a result of the trend of declining long-term interest rates, the discount rate used to measure the projected benefit obligation for pensions was reduced to 7.25% from 8.25%. This change had the effect of increasing the accumulated pension benefit obligation by $103 million with an offsetting decrease in the unamortized net gain. In addition, the rates used to measure the projected benefit obligation for postretirement benefits other than pensions were changed. The changes in rates included a reduction in the discount rate to 7.25% from 8.5%, and in the annual rate of increase in per capita cost of covered health care benefits. These rate changes had the effect of increasing the accumulated postretirement benefit obligation by $49 million with an offsetting increase in the unamortized net loss. The effect on future expense for pensions and postretirement benefits other than pensions will be immaterial. At December 31, 1993 and 1992, the Company had net deferred income tax assets included in current and long-term assets. Management believes it is more likely than not that these tax benefits will be realized through the reduction of future taxable income. Significant factors considered by management in its determination of the probability of the realization of the deferred tax assets include the historical operating results of the Company, expectations of future earnings and the extended period of time over which the postretirement health care liability will be paid. On January 31, 1994, the Company acquired DCBU from Westinghouse Electric Corporation and issued $930 million of short-term commercial paper to finance the acquisition. The Company plans to reduce these short-term financings by the middle of 1994 through expanded use of equity and long-term debt financings. The timing and mix of these financings will depend on market conditions. Of these short-term financings, $555 million will be classified as long-term debt because the Company intends, and has the ability under a new five-year $555 million revolving credit agreement entered into in January 1994, to refinance this debt on a long-term basis. Also, in January 1994, the Company entered into a $555 million 364-day revolving credit agreement. Strong cash flow, reinforced by the projected results of the newly created Cutler-Hammer business unit, should permit the repayment of the financings within the next five years. The Company is maintaining the strength of its balance sheet, and two major debt-rating agencies, Standard and Poor's and Moody's, have confirmed the "A" rating on its long-term debt. The Company expects that the economic and market growth experienced in North America during 1993 will continue to expand to additional markets in 1994; however, that growth will likely be moderated by lingering weakness in Europe. Long-range plans continue to be focused on enhancements in quality, productivity and growth in all its major markets. The acquisition of DCBU and integration with ICPDO should create permanent value by streamlining product lines, manufacturing capacity and organization structure and will enable the businesses to realize the synergies resulting from complementary product offerings, operations and technical expertise. This acquisition will reinforce the goal of improving the balance in sales and earnings between the historically strong Vehicle Components segment and the Electrical and Electronic Controls segment. Investments in the form of research and development, marketing and manufacturing programs continue in all key product lines, and plans are to continue to make niche acquisitions which will promote the Company's position in worldwide markets. The Company believes capital resources available in the form of working capital on hand, lines of credit and funds provided by operations will more than adequately meet anticipated capital requirements for capital expenditures and business expansion through niche acquisitions. The acquisition of DCBU required the additional capital resources discussed above. The operations of the Company involve the use, disposal and cleanup of certain substances regulated under environmental protection laws, as further discussed under "Protection of the Environment" in the Financial Review. Subject to the difficulty in estimating future environmental costs, the Company expects that any sum it may have to pay in connection with environmental matters in excess of the amounts recorded or disclosed will not have a material adverse effect on its financial condition or results of operations. RESULTS OF OPERATIONS - --------------------- 1992 COMPARED TO 1991 - --------------------- Net Sales - --------- Net sales for 1992 were $4.10 billion, up 12% from $3.66 billion in 1991. Certain markets in North America experienced a modest recovery in 1992. However, economies in Europe, Japan and South America continued to weaken, affecting businesses in those areas, and offsetting some strength in North America. The Vehicle Components segment net sales increased to $2.09 billion for 1992, 16% higher than sales of $1.81 billion recorded for 1991. North American sales of heavy and light trucks, vans and sport utility vehicles were strong throughout the year. A marked increase in heavy truck production in North America during the second half of 1992 had a significant favorable impact on this segment's results. Heavy truck production increased 30% in 1992 over prior year levels. Strategic investments also contributed to sales growth through expansion of business into new products and territories. Sales of passenger car and off-highway vehicle equipment slowed in the last half of the year, after showing increases during the first half. Overseas vehicle markets, primarily in Europe, were depressed, and weakened further in the fourth quarter. The Electrical and Electronic Controls segment had net sales of $1.78 billion for 1992, rising 13% from sales of $1.58 billion in 1991. This increase reflects the acquisition of Kirsten, a European automotive controls manufacturer with 1992 sales of approximately $120 million, and other smaller acquisitions during 1992 and 1991. Existing automotive and appliance controls businesses experienced a strong rebound in their markets, adding to the improved results. Sales from industrial and commercial controls businesses were flat, with the recovery in residential markets offset by continued contraction in military and commercial aircraft industries. Sales from specialty controls businesses declined slightly, reflecting the continued weakening of the North American automated materials handling market, as well as significant softening of the semiconductor equipment markets in the United States and Japan. Operating Results - ----------------- Higher sales levels, benefits of recent restructurings and rigorous inventory controls produced an improved gross margin of $967 million in 1992 (24% of sales), up from $851 million in 1991 (23% of sales). Gross margin in 1992 was reduced by $17 million of increased expense related to the accounting change for postretirement benefits other than pensions. Selling and administrative expenses were held level relative to sales due to stringent cost controls, as well as the benefits of recent restructurings, with $578 million reported in 1992 compared to $520 million in 1991 (14% of sales in both years). The Company's continued commitment to improvement of established product lines, and to product innovation and development in markets offering the greatest potential for growth was reflected in the increase in research and development expenses to $151 million in 1992 from $138 million in 1991. The Vehicle Components segment operating profit showed a substantial increase to $170 million for 1992 over profit of $63 million in 1991. Profit for 1992 was reduced by $14 million due to recognition of additional expenses for postretirement benefits other than pensions. The improved profit was largely a result of increased demand for heavy and light trucks, vans and sport utility vehicles previously described and, additionally, benefitted from recent restructurings, for which a $22 million charge was recorded in 1991. Strict cost containment also contributed to growth in profit. Strategic investments in marketing, research and development, and manufacturing improvements should further promote sustainable growth and increases in profit as markets served by this segment strengthen. The Electrical and Electronic Controls segment operating profit was $85 million in 1992 compared to $88 million in 1991. Profit for this segment for 1992 was reduced by $11 million due to recognition of additional expenses related to the accounting change for postretirement benefits other than pensions. Profit for 1991 was reduced by a $17 million restructuring charge recorded in the first quarter. Start-up costs for integration of Kirsten and other acquisitions depressed 1992 profits, but these investments should provide opportunities for growth and profit improvement in the future. The acquisition of Kirsten, a European automotive controls manufacturer with operations in Germany, France and Spain, is a good example of the Company's investment in growth businesses through acquisitions. Restructuring costs due to downsizing of military-related operations reduced profits. In addition, profits for 1992 were affected by depressed sales in certain businesses, as discussed above, the costs of long-range programs in marketing, research and development, and manufacturing improvement, and cost/price pressures. Other income--net rose to $23 million for 1992 from $18 million for 1991, primarily due to an $11 million pretax gain on the sale of the Company's interest in a limited partnership recorded in 1992. An analysis of changes in income taxes and the effective income tax rate is presented under "Income Taxes" in the Financial Review. Eaton Corporation 1993 Annual Report on Form 10-K Item 14(c) Listing of Exhibits Filed 3 Amended Articles of Incorporation (as amended and restated as of January 24, 1989, filed on Form SE on March 13, 1989) and Amended Regulations (as amended and restated as of April 27, 1988, filed on Form SE on March 13, 1989) 4(a) Instruments defining rights of security holders, including indentures (Pursuant to Regulation S-K Item 601(b)(4), the Company agrees to furnish to the Commission, upon request, a copy of the instruments defining the rights of holders of long-term debt of the Company and its subsidiaries) 10 Material contracts (1) DCBU Purchase Agreement dated as of August 10, 1993 between Westinghouse Electric Corporation (Seller) and Eaton Corporation (Buyer) Regarding the Distribution and Control Business Unit of Westinghouse Electric Corporation (Agreement) - Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 Including the following Exhibits to the Agreement: (i) Form of Technology Agreement (Ex. 2.1) (ii) Terms of Lease for Shared Facilities (Ex.9.6(a) (1)) (iii) Terms of Sublease for Shared Facilities (Ex. 9.6(a) (2)) (iv) Terms of Lease for Vidalia, Georgia Shared Facility (Ex. 9.6(b) (1) (i)) (v) Terms of Lease by Buyer of Part of Horseheads Facility (Ex. 9.6(b) (1) (ii)) (vi) Terms for Jackson, Mississippi Sublease (Ex. 9.6(b) (2)) (vii) Form of Services Agreement (Ex. 9.8) (viii) Form of WESCO Distributor Agreement (Ex. 9.9) (ix) Form of Interim NEWCO Distributor Agreement (Ex. 7.15.2) (x) Form of NEWCO Distributor Agreement (xi) Form of Supplier and Vendor Agreement (Ex. 9.10) (2) The following are either a management contract or a compensatory plan or arrangement: (a) Deferred Incentive Compensation Plan (as amended and restated May 1, 1990; filed as a separate section of this report) (b) Executive Strategic Incentive Plan, effective as of January 1, 1991 - Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (c) Group Replacement Insurance Plan (GRIP), effective as of June 1, 1992 - Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (d) 1991 Stock Option Plan - Incorporated herein by reference to the Company's definitive proxy statement dated March 18, 1991 (e) The following are incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1990: (i) Strategic Incentive and Option Plan (as amended and restated as of January 1, 1989) (ii) Limited Eaton Service Supplemental Retirement Income Plan (as amended and restated as of January 1, 1989) (iii) Amendments to the 1980 and 1986 Stock Option Plans (iv) Form of "Change in Control" Agreement entered into with all officers of Eaton Corporation (v) Eaton Corporation Supplemental Benefits Plan (as amended and restated as of January 1, 1989) (which provides supplemental retirement benefits) (vi) Eaton Corporation Excess Benefits Plan (as amended and restated as of January 1, 1989) (with respect to Section 415 limitations of the Internal Revenue Code) (f) The following are incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (filed on Form SE dated March 28, 1991): (i) Executive Incentive Compensation Plan (ii) Plan for the Deferred Payment of Directors' Fees (as amended and restated as of January 1, 1989) (iii) Plan for the Deferred Payment of Directors' Fees (originally adopted in 1980 and amended and restated in 1989) (iv) Eaton Corporation Retirement Plan for Non-Employee Directors (as amended and restated as of January 1, 1989) 11 Statement regarding computations of net income per Common Share (filed as a separate section of this report) 21 Subsidiaries of Eaton Corporation (filed as a separate section of this report) 23 Consent of Independent Auditors (filed as a separate section of this report) 24 Power of Attorney (filed as a separate section of this report)

799036_1993.txt

799036_1993

1993

799036

Item 1. Business GENERAL The Company, through its subsidiaries, provides health and life insurance underwriting, marketing and managed healthcare services throughout the nation. In 1993 the Company was organized into three Business Divisions: Insurance (Life & Health Units), Marketing and Managed Care. The Divisions were designed to allow management to focus on the specific needs, problems, customers and opportunities in each business area. The Health Unit of the Insurance Division underwrites small group and individual major hospital and medical policies, Medicare supplement, home health care and other specialty products. Medicare supplement insurance, which the Company began offering in 1966 at the inception of the federal Medicare program, accounted for approximately 33% of the Company's health insurance premiums written in 1993. Major hospital insurance plans designed for small business owners and self-employed individuals accounted for approximately 59% of the Company's health insurance premiums written in 1993. The Life Unit underwrites term life, interest sensitive life, universal life, and annuities. In 1990 the Company acquired Manhattan National Life Insurance Company, which has now become the Company's major life and annuity subsidiary. Manhattan National Life's products are distributed primarily through 8,000 brokers throughout the nation. In 1992 all life and annuity administration was consolidated at this subsidiary to enhance efficiency and service. The Marketing Division provides insurance and non-insurance marketing services for insurance companies, associations and financial institutions. The Division operates through four distribution channels: a nationwide network of approximately 1,500 career agents market insurance products to self-employed individuals and small business owners. Senior insurance products are marketed through nearly 15,000 independent agents. A network of 8,000 brokers sells life and annuity products. In 1993 the Company acquired Continental Marketing Corp. which provided a telemarketing system marketing products directly to 8,000 brokers throughout the nation. The Marketing Division markets the Company's insurance products as well as insurance products of other unaffiliated companies. This allows the Company to derive revenue in territories where it is not licensed and to distribute policies not otherwise offered by the Company. The Marketing Division also includes a non-insurance unit which primarily designs benefit packages and provides membership management services to associations across the nation. This unit also provides an emergency air ambulance service for members of associations it manages. The Managed Care Division provides healthcare coordination to control medical expense costs for insurance companies, government agencies, self- insured businesses, unions, HMO's and third-party administrators. Services include pre certification of care, provider networks and case management. In early 1990 the Company acquired National Health Services, Inc. to provide these types of services for its own subsidiaries as well as unaffiliated companies and organizations. In 1993 the Company acquired Healthcare Review Corporation which provides service primarily to government agencies. The Company was organized in Delaware in 1982 as a successor to an Illinois holding company formed in 1957. The Company's largest operating insurance subsidiary is Pioneer Life Insurance Company of Illinois (Pioneer Life), a successor to a company organized in 1926. Health and Life Insurance Company of America, National Group Life Insurance Company, Manhattan National Life Insurance Company and Continental Life & Accident Company were acquired in 1985, 1986, 1990 and 1993, respectively, primarily for specialized marketing purposes. In 1993 the Company relocated its corporate offices from Rockford, Illinois to Schaumburg, Illinois. The executive offices of the Company are now located at 1750 East Golf Road, Schaumburg, Illinois 60173 and its telephone number is (708) 995-0400. The term "Company" refers to Pioneer Financial Services, Inc. (PFS) and, unless the context otherwise requires, its subsidiaries. Information on revenue and income by Business Division is set forth in Note 19 of the Notes to Consolidated Financial Statements. PRODUCTS Health Insurance Unit The Company's accident and health insurance products, all of which are individually underwritten and issued, include Medicare supplement insurance, major hospital insurance plans, medical/hospital supplement insurance, long term care, home health care and various specialty health coverages. Medicare supplement insurance provides coverage for certain hospital and other medical costs not covered by the Medicare program. Major hospital insurance plans, which are offered on a group trust and association basis as well as on an individual basis, provide coverage for specified hospital costs. Medical/hospital supplemental policies provide coverage for hospital, medical and surgical costs within various prescribed policy deductible and benefit limits. Long term care policies provide coverage for nursing home expenses and other extended care situations. Home health care policies provide coverage for extended in-home medical care. The Company's specialty health products include supplemental medical/surgical plans. Product development efforts have generated new versions of these products as market needs have changed. The Company may adjust premium rates by class, policy form and state in which the policy is issued in order to maintain anticipated loss ratios. Since premium rate adjustments can have the tendency to increase policy lapses, conservation and customer service activities are emphasized. As a result, the Company successfully avoided any significant increases in policy lapses in either the small business or senior divisions. The Health Insurance unit also has a distinct department to focus solely on premium rate adjustments. This proactive approach involves strict scrutiny of all health premium rates on a monthly basis. The matching of pricing structure with actual claims experience varies by product line and state. This ongoing analysis provides the time basis necessary for orderly adjustment of premiums. The Company's loss ratios have varied over the years reflecting changes in medical claim costs and the frequency of benefit utilization by its insureds. The following table sets forth the earned premiums, losses and loss adjustment expenses incurred and loss ratios for the Company's accident and health business. Earned premiums reflect written premiums adjusted for reinsurance and changes in unearned premiums. In the Company's statement of consolidated operations, premiums represent premiums written, adjusted for reinsurance; the changes in unearned premiums are reflected in benefits, together with losses and loss adjustment expenses. Losses and loss adjustment expenses include losses incurred on insurance policies and the expenses of settling insurance claims, including legal and other related fees and expenses. Year Ended December 31, 1993 1992 1991 1990 1989 (Dollars in thousands) Medicare Supplement Earned premiums . . . . . $199,333 $211,756 $233,033 $197,771$146,707 Losses and loss adjustment expenses . . . . . . . 126,300 143,181 159,423 136,093 93,809 Loss ratio . . . . . . . 63% 68% 68% 69% 64% Medical/Hospital Supplement Earned premiums . . . . . $ 9,410 $11,706 $ 15,725 $ 9,281$ 6,796 Losses and loss adjustment expenses . . . . . . . 7,140 9,865 12,757 6,025 4,361 Loss ratio . . . . . . . 76% 84% 81% 65% 64% Major Hospital Earned premiums . . . . . $375,275 $302,881 $294,431 $234,004$124,744 Losses and loss adjustment expenses . . . . . . . 251,955 200,781 176,222 168,939 61,951 Loss ratio . . . . . . . 67% 66% 60% 72% 50% Specialty Health Earned premiums . . . . . $34,739 $41,235 $ 49,895 $ 42,357$ 30,747 Losses and loss adjustment expenses . . . . . . . 21,121 23,103 28,266 31,189 14,088 Loss ratio . . . . . . . 61% 56% 57% 74% 46% Total Accident and Health Earned premiums . . . . . $618,757 $567,578 $593,084 $483,413$308,994 Losses and loss adjustment expenses . . . . . . . $406,516 $376,930 376,668 342,246 174,209 Loss ratio . . . . . . . 66% 66% 64% 71% 56% Medicare Supplement. Since the inception of the Medicare program in 1966, the Company has offered policies designed to supplement Medicare benefits. Such policies accounted for approximately 39% of health insurance premiums in 1991, approximately 37% of health premiums in 1992, and approximately 33% of health premiums in 1993. These policies provide payment for deductibles and the excess over maximum limits of the federal Medicare program. Under these policies, annual premiums are increased if policy benefits increase as a result of changes in Medicare coverage. In 1991 the National Association of Insurance Commissioners (NAIC) defined 10 model Medicare supplement policies. In states which have adopted the NAIC model, only those 10 policies can be sold. In anticipation of state actions, the Company in 1991 developed 8 of the 10 model policies -- those which the Company believes are most applicable to the Company's market. This regulation, along with mandated changes to agent commissions, resulted in marketing changes. By July 1992 all states were required to have adopted the NAIC model or similar legislation which specifically defines policy models. It is not possible to predict the impact which any future Medicare legislation may have on the Company's Medicare supplement business. Medical/Hospital Supplement. The Company offers medical/hospital policies which provide limited supplemental benefits for hospital, surgical and medical expenses on either an individual or a family basis. Generally, these policies are automatically renewable at the option of the policyholder, but the Company has the right to adjust premium rates on a class basis. Policy benefits are limited to a specified aggregate amount for all covered expenses. These policies generally provide a fixed benefit for each day of hospitalization, a limited fee schedule for surgical benefits and a limited amount payable for miscellaneous expenses depending upon the length of hospital stay. Major Hospital. The Company offers major hospital insurance plans on an individual basis and on a group trust and association basis and has issued master policies for such plans to several trusts and associations. These plans, which are individually underwritten, are designed to cover in- hospital expenses for small business owners, self employed individuals, employees and their families. Hospital, surgical and other medical expenses are covered on an expense incurred basis with certain benefit limits after a prescribed deductible. Some plans offer a "reducing deductible" which provides for the lowering of the deductible if no claims are filed over a number of consecutive years. The Company has more recently introduced new products with benefit alternatives such as increased deductibles and different benefit structures designed to enable policyholders to maintain insurance protection without increased premium rates. In 1991 the Company introduced a new line of products called Design Benefit Plans which provide greater flexibility of benefit structure for policyholders. In December of 1991, the NAIC adopted the Small Employers Availability Act ("Act"). This act affects the rating and underwriting methodology that can be applied to insurance coverage sold to small employers, generally categorized as those employing 25 people or less. The Company does not anticipate this Act will have a material impact on its existing business. In response to the Act, the Company has modified its new products for sale in those states adopting the Act. Specialty Health. The Company offers various specialty health products which typically are sold in conjunction with the Company's principal accident and health products. Policies include hospital indemnity, cancer and short-term disability plans, as well as fixed dollar per diem payments for long-term convalescent care. The Company also offers a short-term major medical policy which provides coverage for a limited period of time. This policy is designed for recent school graduates, individuals between jobs, and others with short term needs. The policy does not cover any pre-existing conditions. The Company also offers long term care and home health care products designed principally for senior citizens. Long term care policies generally provide specified per day benefits for nursing home confinements. Home health care policies provide specified per day benefits for medically necessary health services received in the home and may include benefits for adult day care facility services. The Company also offers comprehensive long term care coverages which provide benefits for all levels of nursing home care, home health care and adult day care. Life Insurance Unit Substantially all of the Company's life insurance policies and annuities are individually and medically underwritten and issued, other than small accidental death benefit policies, which are not material to the Company. The following table sets forth the breakdown of premiums collected (including receipts not related to policy charges) among traditional life policies, interest-sensitive and universal life policies and annuities for the periods shown: Year Ended December 31, 1993 1992 1991 Amount Percent Amount Percent Amount Percent (Dollars in thousands) Traditional . . . . . $26,353 50 $20,300 45 $17,968 34 Interest-Sensitive & Universal Life. . 16,300 31 18,399 41 20,676 40 Annuities . . . . . . 10,004 19 6,212 14 13,479 26 Total . . . . . . . $52,657 100 $44,911 100 $52,123 100 For 1991, premiums collected from the Company's life insurance products were approximately 26% first year and 74% renewal, for 1992 approximately 27% were first year and 73% renewal, and for 1993 premiums collected were approximately 24% first year and 76% renewal. Traditional policy types accounted for 52%, 49% and 59% of the renewal premiums in the years 1991, 1992 and 1993, respectively. The Company's gross life insurance in force was as follows at the dates shown: December 31, 1993 1992 1991 (Dollars in millions) Traditional policies . . . . . . $10,320 $ 8,757 $ 7,507 Interest-sensitive and universal life policies . . . . . . . . 1,503 1,582 1,634 Total . . . . . . . . . . $11,823 $10,339 $ 9,141 Interest-Sensitive and Universal Life. The Company's interest- sensitive and universal life insurance provide whole life insurance with rates of return which are adjusted in relation to prevailing interest rates. The policies permit the Company to change the rate of interest credited to the policy from time to time. The Company offers single premium policies which provide for payment of the entire premium at time of issuance, and also offers multiple premium policies, including universal life. Universal life insurance products credit current interest rates to cash value accumulations, permit adjustments in benefits and premiums at the policyholder's option, and deduct mortality and expense charges monthly. Under other interest-sensitive policies, premiums are flexible, allowing the policyholders to vary the frequency and amount of premium payments, but typically death benefit changes may not be made by the policyholders. Some universal life products offer lower premiums for non- smokers in good health. For both universal life and other interest- sensitive policies, surrender charges are deducted from the policyholder's account value, if any. No surrender charges are deducted if death benefits are paid or if the policy remains in force for a specified period. Traditional Life. The traditional life insurance sold by the Company has consisted almost entirely of modified premium whole life policies, which provide permanent coverage with payments of higher premiums in early years than in subsequent years. These policies provide for cash values which are relatively insignificant in early years and gradually increase over the life of the policy. Modified premium whole life policies have frequently been sold in conjunction with annuity riders which supplement the accumulated cash values. Manhattan National Life offers a variety of non-participating individual life insurance policies, including universal, term and traditional whole life products. Manhattan National Life does not offer group life insurance. For a number of years, Manhattan National Life has offered individually underwritten insurance on the lives of persons who, to varying degrees, do not meet the requirements of standard insurability. Higher premiums are charged for these "impaired" or "substandard" lives and, where the amount of insurance is large or the risk is significant, a portion of the risk is reinsured. Annuities. The Company's single and flexible premium deferred annuities are offered to individuals. An annuity contract generally involves the accumulation of premiums at a compound interest rate until the maturity date, at which time the policyholder can choose one of the various payment options. Options include periodic payments during the annuitant's lifetime or the lifetimes of the annuitant and spouse, with or without a guaranteed minimum period; periodic payments for a fixed period regardless of the survival of the annuitant; or lump sum cash payment of the accumulated value. The Company's annuities typically provide for the crediting of interest at rates set from time to time by the Company. Marketing Division The Company's Marketing Division includes two units: insurance and non-insurance. Insurance Unit. This unit markets products to self-employed individuals and small employers through a nationwide network of over 1,500 career agents. Products include catastrophic hospital and major medical expense plans, multiple employer trusts, group and individual dental programs, managed care programs and a variety of supplemental products for tax favored (Section 125 and 401(k)) use. The division markets life and annuity products through approximately 8,000 brokers nationwide. In 1993 the Company acquired Continental Marketing Corporation, which provided a new distribution system - a telemarketing organization which markets products directly to 8,000 brokers throughout the nation. The Marketing Division also operates its own telemarketing lead generation company for both the self-employed and senior markets. An established independent brokerage network of nearly 15,000 insurance brokers throughout the nation sells health insurance products to senior Americans. Products include Medicare supplement, home health care, long term care, cancer coverage, life and annuities. Some of these products are underwritten by PFS insurance companies; others are underwritten by non-affiliated carriers. Non-Insurance Unit. This division designs benefit packages and provides membership management services to associations across the nation. Benefit packages include group discounts on eyewear, pharmaceuticals, hearing aids, travel, legal and other services. Membership services can range from recruitment campaigns to periodic billing and other administrative services. This unit also provides an emergency air ambulance service for the members of associations it manages. Marketing Subsidiaries Design Benefit Plans. The Company's group trust and association major hospital plans for small business owners are marketed through Design Benefit Plans, a subsidiary of National Benefit Plans, which contracts with approximately 1,500 agents and managers who operate exclusively on behalf of the organization through approximately 70 regional offices. The marketing organization is responsible for recruiting, training and supervising these agents. Policies issued under these plans are individually underwritten and issued by the Company at its regional service center in the Dallas, Texas metropolitan area. For 1991, 1992 and 1993, marketing efforts to small businesses produced approximately $288,040,000, $297,734,000, and $354,427,000 respectively, of the Company's written premiums, almost all attributable to accident and health products. Through this marketing organization, the Company has recently entered into agreements with several other insurance companies to market certain coverages which are designed to expand its product lines and marketing territories. These products include large group plans (up to 99 lives), disability income, and tax-deferred annuities. The Company has an established telemarketing subsidiary with facilities in Phoenix, Arizona, and Arlington, Texas. Currently, these facilities, together with the Company's direct mail activity, provide approximately 18,000 qualified leads a week to this division. The Senior Brokerage offers products to the senior market. Currently there are approximately 15,000 brokers associated with this unit. Major products include Medicare Supplement, Long Term Care and Home Health Care, as well as life and annuity products specifically designed for seniors. Continental Marketing. With the 1993 acquisition of Continental Marketing Corporation (CMC), the Marketing Division added its fourth distribution system. CMC conducts telemarketing at the brokerage-producer level by providing product and market support. In addition to taking on this new distribution system, the Company is expanding the portfolio available to this group of producers. Managed Care Division The Managed Care Division of the Company provides health care coordination to control costs for government agencies, self-insured businesses, insurance companies, unions, HMO's and third-party administrators. Major services provided include pre certification of care, utilization review, preferred or exclusive provider networks (PPOs, EPOs, and HMOs), large case management, risk management and occupational medical management. The Managed Care Division generated substantial claims savings for the Company's insurance subsidiaries in 1993. These savings primarily were passed on to policyholders in the form of lower premium rate adjustments. In 1992 the division began to expand its product line, to include additional products which meet the needs of small employers. These occupational medical programs include specific management of worker's compensation cases to lower employer medical costs and return the employee to the workplace more quickly. The division has also continued to expand its PPO (preferred provider organization) network which is available to clients on a fee dependent on savings achieved. By expanding the network, it becomes even more attractive and more marketable to additional companies and organizations. A new EPO (exclusive provider organization) was also successfully test marketed late in 1992. The EPO was attached to a major medical insurance policy underwritten by a health insurance subsidiary of the Company. The EPO was used to reduce the insurance premiums on the policy by taking advantage of lower negotiated medical expense rates with the exclusive provider. Premium Distribution The Company's insurance subsidiaries collectively are licensed to sell insurance in 49 states and the District of Columbia. The importance to the Company of particular states may vary over time as the composition of its agency network changes. The geographic distribution of collected premiums (before reinsurance) of the Company's subsidiaries in 1993 was as follows: Total Percent (Dollars in thousands) Florida $69,985 10.4 California 67,391 10.0 Texas 64,279 9.5 Illinois 51,436 7.6 North Carolina 28,925 4.3 Ohio 22,532 3.3 Georgia 21,619 3.2 Missouri 20,256 3.0 Other (1) 327,752 48.7 Total $674,175 100.0 (1) Includes 41 other states, the District of Columbia, and certain U.S. territories and foreign countries, each of which account for less than 3% of collected premiums. UNDERWRITING Substantially all of the Company's insurance coverages are individually underwritten to assure that policies are issued by the Company's insurance subsidiaries based upon the underwriting standards and practices established by the Company. Applications for insurance are reviewed to determine if any additional information is required to make an underwriting decision, which depends on the amount of insurance applied for and the applicant's age and medical history. Such additional information may include medical examinations, statements from doctors who have treated the applicant in the past and, where indicated, special medical tests. If deemed necessary, the Company uses investigative services to supplement and substantiate information. For certain coverages, the Company may verify information with the applicant by telephone. After reviewing the information collected, the Company either issues the policy as applied for, issues the policy with an extra premium charge due to unfavorable factors, issues the policy excluding benefits for certain conditions for a period of time or rejects the application. For certain of its coverages, the Company has adopted simplified policy issue procedures in which the applicant submits a simple application for coverage typically containing only a few health related questions instead of a complete medical history. In common with other life and health insurance companies, the Company may be exposed to the risk of claims based on AIDS. The Company's AIDS claims to date have been insignificant. Because of its emphasis on policies written for the senior citizen market and its underwriting procedures and selection processes, the Company believes its risk of AIDS claims is less than the risk to the industry in general. REINSURANCE The Company's insurance subsidiaries reinsure portions of the coverages provided by their insurance products with other insurance companies on both an excess of loss and co-insurance basis. Co-insurance generally transfers a fixed percentage of the Company's risk on specified coverages to the reinsurer. Excess of loss insurance generally transfers the Company's risk on coverages above a specified retained amount. Under its excess of loss reinsurance agreements, the maximum risk retained by the Company on one individual in the case of life insurance is $100,000 ($250,000 in the case of Manhattan National Life) and in the case of accident and health insurance is $250,000. Reinsurance agreements are intended to limit an insurer's maximum loss on the specified coverages. The ceding of reinsurance does not discharge the primary liability of the original insurer to the insured, but it is the practice of insurers (subject to certain limitations of state insurance statutes) to account for risks which have been reinsured with other approved companies, to the extent of the reinsurance, as though they are not risks for which the original insurer is liable. See Note 5 of Notes to Consolidated Financial Statements. The Company has occasionally used assumption reinsurance to acquire blocks of business from other insurers. In addition, the Company has from time to time entered into agreements to assume certain insurance business from companies for which it is marketing insurance products. The Company intends to continue these programs if they assist in expanding product lines and marketing territories. INVESTMENTS Investment income represents a significant portion of the Company's total revenues. Insurance company investments are subject to state insurance laws and regulations which limit the types and concentration of investments. The following table provides information on the Company's investments as of the dates indicated. December 31, 1993 1992 Amount % Amount % (Dollars in thousands) Fixed maturities to be held to maturity: U.S. Treasury $ 9,124 1% $ 15,363 3% States and political subdivisions 5,200 1 199 - Corporate securities 119,276 18 98,836 17 Mortgage-backed securities 192,912 29 320,328 56 Total fixed maturities to be held to maturity 326,512 49 434,726 76 Fixed maturities available for sale: U.S. Treasury 26,894 4 1,425 - States and political subdivisions 21,571 3 - - Foreign governments 4,056 1 - - Corporate securities 73,981 11 6,343 2 Mortgage-backed securities 131,215 19 30,983 6 Total fixed maturities available for sale 257,717 38 38,751 8 Equity securities........... 17,436 3 19,537 3 Mortgage and policy loans... 27,189 4 21,969 4 Short-term investments...... 45,352 6 53,366 9 Total Investments...... $674,206 100% $568,349 100% At December 31, 1993, the average expected term of the Company's fixed maturity investments was approximately six years. The results of the investment portfolio for the periods shown were as follows: Year Ended December 31, 1993 1992 1991 (Dollars in thousands) Average month-end investments . $592,546 $549,643 $532,336 Net investment income . . . . . 40,242 43,555 47,974 Average annualized yield on investments (1) . . . . . . . 6.8% 7.9% 9.0% Realized investment gains/ (losses) (2) . . . . . . . . . $(1,336) $ (47) $ 7,189 (1) Not computed on a taxable equivalent basis. Includes interest income paid or accrued on debt securities and loans and dividends on equity securities. (2) See Note 3 of Notes to Consolidated Financial Statements for information on unrealized appreciation on investments. The Company's investment policy is to balance its portfolio between long-term and short-term investments so as to achieve investment returns consistent with preservation of capital and maintenance of liquidity adequate to meet payment of policy benefits and claims. Current policy is to invest primarily in fixed income securities of the U.S. government and its agencies and authorities, and in fixed income corporate securities with investment grade ratings of Baa or better. At December 31, 1993, less than 1% of the Company's total investment portfolio was below investment grade or unrated. The Company intends to invest no more than 5% of its total invested assets in securities below investment grade. At December 31, 1993, approximately 2% of the Company's total investment portfolio were mortgage-backed derivative securities. The significant decline in interest rates during 1992 and 1993 caused the value of these securities to deteriorate. The Company has partially written-down the carrying value of these securities in 1992 and 1993. This write-down was generally offset by realized gains on the remaining portfolio. POLICY LIABILITIES The Company records reserves for future policy benefits to meet future obligations under outstanding policies. These reserves are amounts which are calculated to be sufficient to meet policy and contract obligations as they mature. The amount of reserves for insurance policies is calculated using assumptions for interest, mortality and morbidity, expenses and withdrawals. Reserves are established at the time the policy is issued and adjusted periodically based on reported and unreported claims or other information. See Note 1 of Notes to Consolidated Financial Statements. COMPETITION The insurance business is highly competitive and includes a large number of insurance companies, many of which have substantially greater financial resources and larger and more experienced staffs than the Company. The Company competes with other insurers to attract and retain the allegiance of its independent agents and marketing organizations who at this time are responsible for most of the Company's premiums. Methods of competing for agents are described under "Marketing." Methods of competition include the Company's ability to offer competitive products and to service these programs efficiently. Other competitive factors applicable to the Company's business include policy benefits, service to policyholders and premium rates. HEALTHCARE REFORM The Company expects that a federal healthcare "reform" program will be passed by Congress and will be implemented over the remainder of the decade. It is most likely to include most of the following in some form: universal access, minimum mandated benefits, coverage for pre-existing conditions and guaranteed portability. The Company's insurance subsidiaries have already adapted to state small group healthcare reform programs by making the necessary adjustments in our products and marketing structure. The Company also expects to adapt and adjust to a federal reform program in much the same way. The best-case "reform" scenario for the Company would be mandated workplace medical coverage--required either of individuals or employers-- while retaining the current free market system and wide choices for consumers. This would increase the market by over 30 million and allow the Company to continue our current distribution system. The worst-case scenario would be the elimination of current indemnity "fee-for-service" medical policies for small groups by any but a handful of insurance companies. This oligopoly would eliminate a major health insurance market and revenue source for the Company. As a result, we are now placing a major concentration on growth in supplemental and senior health insurance and life insurance and annuities. These areas are not likely to be adversely impacted by any of the reform programs currently proposed. If federal healthcare reforms are enacted that eliminate indemnity "fee-for-service" health plans or limit our ability to adjust premium rates (price controls), there could be a significant impact on our deferred policy acquisition costs (DAC) on our small group major medical business which represents approximately one-third of our DAC asset and is significantly offset by benefit reserves. The larger part of our DAC asset is in our senior health, life and annuity products, which should not be impacted by healthcare reform. With federal healthcare reform, there could be a material increase in the rate of amortization of DAC in the future for our small employer medical insurance. While the Company must consider alternative actions for worst case scenarios, we are optimistic that the final compromise reform legislation will not have this type of impact on our business. GOVERNMENT REGULATION In common with all domestic insurance companies, the Company's insurance subsidiaries are subject to regulation and supervision in the jurisdictions in which they do business under statutes which typically delegate regulatory, supervisory and administrative powers to state insurance commissions. The method of such regulation varies, but regulation relates generally to the licensing of insurers and their agents, the nature of and limitations on investments, approval of policy forms, reserve requirements, the standards of solvency which must be met and maintained, deposits of securities for the benefit of policyholders, periodic examination of insurers, and trade practices, among other things. The Company's accident and health coverages generally are subject to rate regulation by state insurance commissions which in certain cases require that certain minimum loss ratios be maintained. Certain states also have insurance holding company laws which require registration and periodic reporting by insurance companies controlled by other corporations licensed to transact business within their respective jurisdictions. The Company's insurance subsidiaries are subject to such laws and are registered as controlled insurers in those jurisdictions in which such registration is required. Such laws vary from state to state but typically require periodic disclosure concerning the corporation which controls the registered insurers and all subsidiaries of such corporation, and prior notice to, or approval by, the state insurance commission of intercorporate transfers of assets and other transactions (including payments of dividends in excess of specified amounts by the insurance subsidiary) within the holding company system. EMPLOYEES As of December 31, 1993, the Company employed approximately 1,900 persons on a full-time basis. The Company considers its employee relations to be good. EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the executive officers and directors of the Company is set forth below: Peter W. Nauert............... 50 Chairman, Chief Executive Officer, President and Director William B. Van Vleet.......... 69 Executive Vice President, General Counsel and Director Charles R. Scheper............ 41 Executive Vice President Anthony J. Pino............... 46 Executive Vice President Joan F. Boyle.................. 46 Senior Vice President Philip J. Fiskow.............. 37 Senior Vice President Ernest T. Giambra, Jr.......... 46 Senior Vice President Thomas J. Brophy.............. 58 Senior Vice President David I. Vickers.............. 33 Treasurer and Chief Financial Officer Michael A. Cavataio.......... 49 Director Richard R. Haldeman.......... 50 Director Nolanda S. Hill.............. 48 Director Karl-Heinz Klaeser........... 61 Director Michael K. Keefe............. 49 Director Robert F. Nauert............. 69 Director All executive officers are elected annually and serve at the pleasure of the Board of Directors. Peter W. Nauert has been Chief Executive Officer and a director of the Company since its incorporation in 1982. He was President of the Company from 1982 to 1988 and became Chairman of the Company in 1988. On September 1, 1991, he was again elected President. Since 1968, Mr. Nauert has been employed in an executive capacity by one or more of the Company's insurance subsidiaries. William B. Van Vleet has been Executive Vice President of the Company since 1986 and a director of the Company since 1982. He was General Counsel of the Company from 1982 to 1988. In June 1991, he was again elected General Counsel. Mr. Van Vleet has served Pioneer Life since 1948 as General Counsel and a Director. Mr. Van Vleet also serves as an Officer and Director of other subsidiaries of the Company. Charles R. Scheper has been Vice President of the Company since 1991 and was Chief Financial Officer from May 1993 to December 1993. In March 1992, he was elected Executive Vice President. Since February 14, 1992, he has been President and Vice Chairman of the Board of Manhattan National Life. Prior to the Company's acquisition of Manhattan National Life, Mr. Scheper was Manhattan's Senior Vice President and Chief Financial Officer, a position which he held from May 1987. Prior to joining Manhattan National Life, Mr. Scheper was with Union Central Life from 1979, having served as Vice President and Controller since 1985. Anthony J. Pino was elected Executive Vice President of the Company in May 1993. He was Senior Vice President of the Company from March 1992 to May 1993 and was President of National Group Life Insurance Company from July 1991 to June 1992. Mr. Pino has served as President of National Health Services since 1992. Prior to joining the Company, Mr. Pino was Chief Operating Manager of American Postal Workers' Union Health Plan, a position which he held from October 1982. Joan F. Boyle has been Senior Vice President since joining the Company in September of 1992. She is also an Officer of other subsidiaries of the Company. Prior to joining the Company, Ms. Boyle was Vice President of Sales of Empire Blue Cross/Blue Shield from October 1991 to August 1992. From 1969 to 1991, she was Executive Vice President and Chief Financial Officer with New Jersey Blue Cross/Blue Shield. Philip J. Fiskow has been Senior Vice President since May 1993 and the Chief Investment Officer since joining the Company in 1991. He was Vice President of the Company from June 1991 until May 1992. He is also an officer of other subsidiaries of the Company. Mr. Fiskow was with Asset Allocation and Management as an Investment Advisory Portfolio Manager from January 1989 to June 1991. From May 1987 to December 1988 he was an Investment Advisor with Van Kampen Merritt and a Portfolio Manager with Aon Corporation from May 1981 to May 1987. Ernest T. Giambra, Jr. was elected Senior Vice President of the Company in June 1993. Prior to joining the Company, Mr. Giambra had been with Bankers Life Holding Corporation since 1969 where he had served as Vice President of Sales since 1988. Thomas J. Brophy has been Senior Vice President since joining the Company in November 1993. Prior to joining the Company, Mr. Brophy was President and Chief Operating Officer of Southwestern Life Insurance Company from June 1990 to September 1993. Mr. Brophy also held various senior executive positions with various I.C.H. Corporation subsidiaries from March 1974 to his joining of the Company in November 1993. David I. Vickers has been with the Company since June 1992 and has been a Vice President of the Company since December 1992, Treasurer since May 1993 and Chief Financial Officer since January 1994. He is also an Officer and Director of several subsidiaries of the Company. Prior to joining the Company he was with the public accounting firm of Ernst & Young since 1983 where he was a Senior Manager in the Insurance Division. Mr. Vickers also serves as Treasurer for certain of the Company's insurance subsidiaries. Michael A. Cavataio has been a Director of the Company since 1986. Mr. Cavataio has also been President of Lillians, a chain of retail clothing stores, since 1980. Richard R. Haldeman has been a Director of the Company since 1986 and was Secretary from 1988 to June 1990. Mr. Haldeman has been a partner of Haldeman & Associates, a law firm, since June 1990. He was a partner of Williams & McCarthy, P.C., a law firm, from 1975 to May 1990. Nolanda S. Hill has been a Director of the Company since May 1992. Ms. Hill has been Chairman and Chief Executive Officer of Corridor Broadcasting Corporation since 1984. From 1976 to 1984, Ms. Hill served as Chief Executive Officer and Chief Financial Officer of National Business Network, a television station. Karl-Heinz Klaeser has been a Director of the Company since 1986. Mr. Klaeser has also been a Director of LSW Holding Corporation and Insurance Investors Life Insurance Company and the Chairman of the Board of Life Insurance Company of the Southwest since 1989 and a Director of Personal Assurance Company PLC (United Kingdom) since 1991. Michael K. Keefe has been a Director of the Company since March 1994. Mr. Keefe has been Chief Executive Officer and Chairman of the Board of Keefe Real Estate, Inc., a family owned real estate brokerage operation since 1982. Mr. Keefe has also been Chairman of the Board of Southern Wisconsin Bankshares, Inc. since 1988. Robert F. Nauert has been a Director of the Company since November 1991. Mr. Nauert has also been a Director and President of Pioneer Life since 1988 and is a Director and Officer of various subsidiaries of the Company. Mr. Nauert is the brother of Peter W. Nauert. Item 2. Item 2. Properties The principal executive offices of the Company are located in Schaumburg, Illinois in a building purchased by the Company in January 1994. The Company, through a subsidiary, owns three buildings in Rockford, Illinois. The Company believes these facilities will adequately serve its needs for the foreseeable future and could accommodate expansion of the Company's business. The Company, through another subsidiary, also owns a building in the Dallas, Texas metropolitan area which currently serves as the main administrative office for the Company's small business market of the Health Insurance unit. The Company leases the office of its other regional service centers. The executive and administrative offices of Manhattan National Life are located in Cincinnati, Ohio in leased space. Item 3. Item 3. Legal Proceedings The Company and its subsidiaries are named as defendants in various legal actions, some claiming significant damages, arising primarily from claims under insurance policies, disputes with agents, and other matters. The Company's management and its legal counsel are of the opinion that the disposition of these actions will not have a material adverse effect on the Company's 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 Stockholders Matters The Company's Common Stock is traded on the New York Stock Exchange and Chicago Stock Exchange. The following table sets forth, for the periods indicated, the high and low last reported sale prices for the Common Stock on the New York Stock Exchange as reported on the consolidated transaction reporting system. High Low Quarter ended: March 31, 1992.............. 9 1/8 6 1/4 June 30, 1992............... 8 5/8 6 1/4 September 30, 1992.......... 6 3/4 4 7/8 December 31, 1992........... 6 4 March 31, 1993.............. 5 1/2 4 3/4 June 30, 1993............... 9 1/8 5 1/4 September 30, 1993.......... 10 7/8 8 3/8 December 31, 1993........... 14 10 1/2 As of December 31, 1993, there were approximately 600 holders of record of the Company's Common Stock. On March 18, 1994, the PFS Board of Directors announced a quarterly common stock dividend of 3.75 cents per share with an expectation of a total of 15 cents per share to be paid for 1994. Item 6. Item 6. Selected Consolidated Financial Data The following selected consolidated financial data for the five years ended December 31, 1993; are derived from the consolidated financial statements of the Company. The data should be read in conjunction with the consolidated financial statements, related notes, and other financial information included herein. The comparability of the results for the periods presented is affected by certain transactions as described in Note 18 of Notes to the Consolidated Financial Statements. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS 1993 Compared to 1992 Division Overview The income (loss) before income taxes by Division for 1993 and 1992 are as follows (in thousands): 1993 1992 Insurance: Health Unit $ 8,578 $(26,613) Life Unit 7,623 340 Marketing 10,205 3,345 Managed Care (1,211) 335 Corporate (6,431) (2,843) Total $18,764 $(25,436) Health The significant increase in pre tax income for 1993 is due principally to the $30 million pre tax write-down of deferred policy acquisition costs in 1992. The remaining increase is due to the improved loss ratios on the Medicare supplement business and stabilized loss ratios on major hospital products. The improved loss ratios on Medicare supplement (63.4% in 1993 versus 67.6% in 1992) allowed the Company to freeze 1994 premiums for certain of these products in many states. The Company has received positive customer response to this action and expects that will increase retention on this business. Cost reduction programs have reduced the general insurance expense ratios (excludes commissions) down to 9.8% in 1993 from 10.2% in 1992 despite one-time consolidation costs of certain operations. Life The consolidation of all life insurance administration to one location on December 31, 1992, contributed to reduced general expenses in 1993 and the resulting increase in pre tax income. The unit cost per policy in- force decreased from $150 in 1992 to approximately $80 in 1993. In addition, interest spreads on life and annuity business improved despite the decline in investment yields in 1993. The mortality on the existing block of life business continued to improve in 1993 from the levels experienced in 1992. The Company is placing more emphasis on increasing life and annuity business during the next five years to mitigate any adverse effects due to healthcare reform. Marketing The increase in pre tax income was due to a 14% increase in revenue over a relatively fixed expense base. The division continued to lower lead generation costs and development costs associated with a new commission payment system during 1993. The 1992 results were negatively affected by approximately $2 million due to the settlement of certain disputes with former agents. The Marketing Division currently receives the commission overrides previously due these agents pursuant to the settlement. Managed Care The division experienced a pre tax loss of $1.2 million primarily due to start-up costs associated with a new third-party administrator and occupational medical management company formed in 1993, as well as costs of a complete rewrite of the medical criteria. The division discontinued the operation of the third-party administrator in the fourth quarter of 1993. The core business of the division increased over 100% during 1993. The significant increase in revenue was offset by sales development costs and personnel additions to support a foundation for future growth. Corporate Interest expense increased from $2,189,000 in 1992 to $3,276,000 in 1993 due to the issuance of convertible debentures. Corporate expenses also increased due to costs associated with new investor relations programs, expenses related to the public offering, and reallocation of certain senior management personnel who monitor and control division profitability at the corporate level. Consolidated Financial Condition and Results of Operations The Company reported net income of $12,145,000 for the twelve months ended December 31, 1993, compared to a net loss of $16,959,000 for the comparable period in 1992. The net loss for 1992 was primarily attributable to a $30,000,000 pre-tax write-down of deferred policy acquisition costs. The remaining increase was due to improved loss ratios on the Medicare supplement business, expense reductions in the Life Insurance Unit and increased revenue and margins in the Marketing Division. Total revenues increased $47,751,000 or 7% for the twelve month period in 1993 as compared to 1992. The increase in revenue is due to the increase in premiums and policy charges of $50,449,000 which was partially offset by reduced levels of net investment income. Accident and health insurance premiums increased $41,790,000, or 7%, in 1993 as compared to 1992. Premiums from major hospital plans increased $56,694,000 in 1993 as compared to 1992 due to rate increases implemented in 1993, and approximately $11,000,000 from the acquisition of Continental Life & Accident Company. Offsetting the increase was a decline in Medicare supplement premiums of $9,176,000 due to lower than anticipated new sales and a $3,496,000 decrease in premiums of specialty health care plans. Life and annuity premiums and policy charges increased $8,659,000 due to an increase in new life sales during 1993. Net investment income decreased $3,313,000 or 8% in 1993 compared to 1992. Annualized investment yields decreased from 7.9% in 1992 to 6.8% in 1993. The decrease in investment yield was due to the general decline in current interest rates and a higher quality portfolio with a shortened duration. Other income and realized investment gains and losses increased $615,000, or 4% in 1993 as compared to 1992. Other income increased $1,904,000 in 1993 due to increased sales to unaffiliated customers in both the Marketing and Managed Care Divisions. Realized investment losses increased $1,289,000 due to write-downs on certain mortgage-backed derivative securities. As disclosed in Note 3 to the Consolidated Financial Statements, the Company has established an allowance for losses on investments held in the amount of $4,200,000, which the Company believes is adequate to provide for other-than-temporary market declines. Total benefits increased $26,310,000 or 6% in 1993 as compared to 1992. Life and annuity benefits decreased $3,607,000 or 8% due to the general decline in credited rates during 1993 and improved mortality over the higher levels experienced during 1992. Accident and health benefits, which includes the change in unearned premiums, increased $29,917,000 or 8% in 1993 as compared to 1992. The change was primarily due to the 7% increase in accident and health premiums. The Company's accident and health loss ratios were unchanged over 1992 at 66%. The improved loss ratios on the Medicare supplement business were offset by the fourth quarter loss ratio on Continental Life & Accident business of 79%. The Company is attempting to control claim costs on this block of business by implementing additional managed healthcare efforts. In 1993 and 1992, managed healthcare efforts resulted in estimated net savings to the Company's Health Insurance Unit of $41 million and $27 million, respectively. These savings were primarily used to lower the amount of premium increases for policyholders, which the Company believes generally has the effect of decreasing lapse rates of these policies. The principal efforts and their approximate relative contributions to these estimated savings were as follows: 1993* 1992* 1991* PPOs (preferred provider organization) networks 49% 64% 72% Precertification 5 17 16 Large case management 32 11 2 Other 14 8 10 100% 100% 100% * Percent of total estimated savings from managed healthcare efforts. The Company expects to continue to emphasize managed care procedures to control claim costs. Although the Company cannot accurately determine the amount savings which may be realized from such efforts in the future, the Company believes that it will be increasingly difficult to maintain this level of growth in cost savings due to the efficiencies that have already been achieved. Amortization of deferred policy acquisition costs (DAC) decreased $23,840,000, or 24%, in 1993 as compared to 1992. The decrease was due to the $30 million pre tax write-down of DAC in the fourth quarter of 1992 primarily on major medical policies sold in the self-employed and small business owner market. The 1993 amortization rate on Medicare supplement is higher than 1992 because of the accelerated rate increase implementation which occurred in 1993. As discussed previously, the Company expects the Medicare supplement persistency to improve in 1994 with the modest rate action required. The Company continues to monitor persistency closely since future rate increases and regulatory reforms could adversly impact lapses in the future. Increased lapses resulting in an increase in the amortization rate of DAC could adversely impact future earnings. The Company's effective tax rate was approximately 35% in 1993. The Company recorded a tax benefit for 1992 due to the operating loss incurred. The effective federal income tax rate increased in 1993 due to the Revenue Reconciliation Act of 1993. Effective January 1, 1993 the Company adopted Financial Accounting Standards Board (FASB) Statement No. 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." FASB Statement No. 113 requires that reinsurance receivables, including amounts related to claims incurred but not reported, and prepaid insurance premiums, be reported as assets as opposed to reductions in the related liabilities. As a result of the adoption of FASB Statement No. 113, amounts on deposit and due from reinsurers and policy liabilities each increased $19,453,000 at December 31, 1993. Effective January 1, 1993, the Company also changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109 "Accounting For Income Taxes." The cumulative effect of adopting FASB Statement No. 109 was not significant. President Clinton presented his health care reform policy in September of 1993. Numerous proposals have been introduced to Congress and the state legislatures to reform the current healthcare system. Proposals have included, among other things, modifications to the existing employer-based insurance system, a quasi-regulated system of "managed competition" among health plans and a single payer, public program which would replace some of the Company's current major hospital products. Changes in healthcare policy could significantly affect the Company's Health Unit. The Company is unable to accurately predict what effects these reforms may have on its future operations and is unable to evaluate what impact the expectations of such reforms may have had on past consumer behavior. The Company expects the final package approved by Congress will differ significantly from the program presented by President Clinton. (See Healthcare Reform Section) Investments, equipment, policy liabilities, and general expenses and other liabilities increased due to the acquisition of Continental Life & Accident. Other assets increased primarily due to expenses capitalized in conjunction with the public offering of the convertible subordinated debentures. RESULTS OF OPERATIONS 1992 Compared to 1991 The Company reported a net loss of $16,959,000 for the twelve months ended December 31, 1992, compared to net income of $8,872,000 for the comparable period in 1991. The net loss for 1992 was primarily attributable to a $30,000,000 write-down of deferred policy acquisition costs. The remaining decrease was primarily due to reduced levels of new production of senior health insurance, the continued impact of medical inflation, increased utilization of medical services in the health insurance small business market, and lower other income and realized investment gains. Total revenues decreased $52,649,000 or 7% in 1992 as compared to 1991. The decrease was primarily due to reduced writings of accident and health insurance policies principally in the senior market and lower other income and realized gains. Total premiums and policy charges decreased $31,444,000, or 5%, in 1992 as compared to 1991. During 1992 and 1991, in an effort to control the volume and quality of the business produced, the Company reduced the number of brokers and agents selling its products and restructured certain of its agency relationships. These changes resulted in reduced levels of new business being written. Accident and health insurance premiums decreased $33,342,000, or 6%, in 1992 as compared to 1991. Premiums from the Company's Medicare supplement plans decreased approximately $35,203,000. In addition, $7,135,000 of the decrease was attributable to a decrease in premium in specialty health care plans. Somewhat offsetting the decrease were premiums from major hospital plans which increased $9,694,000 in 1992 as compared to 1991. Life and annuity premium and policy charges were relatively unchanged for the twelve month period in 1992 as compared to 1991. Net investment income decreased $4,303,000, or 9%, in 1992 compared to 1991. Annualized investment yields decreased from 9.0% in 1991 to 7.9% in 1992. The decrease in net investment income was primarily due to the general decline in interest rates, and also the sale of a subsidiary, Union Benefit Life Insurance Company on September 1, 1991. Other income and realized investment gains and losses decreased $16,902,000, or 49%, in 1992 as compared to 1991. Other income decreased $8,957,000 in 1992 as compared to 1991. The decrease is principally due to reduced revenues from the Company's non-insurance marketing subsidiaries. The Company's Marketing Division experienced a $6,287,000, or 32%, decrease in revenues, which reflected the discontinuation of certain agent programs. The Company does not expect further declines in revenue from the discontinuation of these agent programs. The Company's Managed Care Division contributed revenues comparable to those in 1991. Realized investment gains, excluding the sale of a subsidiary, decreased $7,236,000 in 1992 as compared to 1991. This is primarily due to the write-down of $5,700,000 on mortgage-backed derivative securities in 1992. As disclosed in Note 3 to the Consolidated Financial Statements, the Company has established an allowance for losses on investments held in the amount of $1,900,000, which the Company believes is adequate to provide for any other-than-temporary market declines. Total benefits decreased $7,280,000, or 2%, in 1992 as compared to 1991 due to the reduced writings of accident and health insurance policies. Life and annuity benefits were relatively unchanged in 1992 as compared to 1991. Accident and health benefits, which include the increase in unearned premiums, decreased $8,774,000, or 2%, in 1992 as compared to 1991. In 1992 the Company's accident and health loss ratio increased to 66% as compared to 64% in 1991. The increase was due to the continued impact of medical inflation and increased utilization of medical services in the small business market. The Company is attempting to minimize the effect of medical inflation and control claim costs by implementing certain managed healthcare efforts. In 1992 and 1991, managed healthcare efforts resulted in estimated net savings to the Company's Health Insurance Unit of $27 million and $13 million, respectively. These savings were primarily used to lower the amount of premium increases for policyholders, which the Company believes generally has the effect of decreasing lapse rates of these policies. The principal efforts and their approximate relative contributions to these estimated savings were as follows: 1992* 1991* PPOs (preferred provider organization) networks 64% 72% Precertification 17 16 Large case management 11 2 Other 8 10 100% 100% * Percent of total estimated savings from managed healthcare efforts. The Company expects to continue to emphasize managed care procedures to control claim costs. Although the Company cannot accurately determine the amount of any savings which may be realized from such efforts in the future, the Company believes that it will be increasingly difficult to maintain this level of cost savings due to the efficiencies that have already been achieved. The Company initiated group medical premium rate adjustments in September 1992. These adjustments were intended to offset the impact of increased benefits and to improve loss ratios. These adjustments helped stabilize loss ratios in the fourth quarter. Policy lapses increased only modestly in the fourth quarter due to the Company's aggressive conservation activities. Insurance and general expenses decreased $10,853,000, or 6%, in 1992 as compared to 1991. The reduction in these expenses is primarily due to the reduced level of new business being written and the corresponding cost reduction programs in the insurance units, which was partially offset by an increase in the level of expenses incurred by the Company's non-insurance subsidiaries. Interest expense decreased $727,000, or 25%, in 1992 as compared to 1991 due to a decrease in the weighted average notes payable outstanding and a decrease in interest rates. However, notes payable increased from December 31, 1991, as Pioneer Life Insurance Company of Illinois entered into a loan agreement in March of 1992. Amortization of deferred policy acquisition costs increased $4,967,000, or 5%, in 1992 as compared to 1991. In the fourth quarter of 1992 the Company wrote off approximately $30,000,000 of deferred policy acquisition costs. The adjustment was primarily the result of certain policies sold in the self-employed and small business owner market. These were policies issued without managed care and cost containment features (including scheduled benefits) which are part of all of the Company's policies now issued. The adjustment included primarily individual policy contracts issued in certain states where strict regulatory approval requirements have delayed implementation of necessary premium adjustments. In all other states, the Company sells group medical plans to the small business owner market. While these group policies are individually underwritten, they provide more latitude for expedient rate adjustments that correspond with actual claims experience. Recently, the Company has experienced improved persistency, primarily on the policies issued in 1991 and 1992, which has resulted in decreased amortization of deferred acquisition costs in 1992 as compared to 1991 on this block of business. The Company continues to monitor persistency closely since general economic conditions and future premium rate adjustments could adversely impact lapses in the future. Increased lapses resulting in an increase in the amortization rate of deferred policy acquisition costs could adversely impact future earnings. The Company recorded a net tax benefit for 1992 due to the operating loss incurred. Investments increased during 1992 as a result of the investment of loan proceeds received in March of 1992 and a reduced level of ceded reinsurance. Premiums and other receivables, accrued investment income, and general expenses and other liabilities decreased due to reduced levels of new business. Deferred policy acquisition costs decreased as a result of the fourth quarter write-down and the decrease in 1992 new business issues. Other assets increased due to federal income tax recoverables and the prepayment of certain agent compensation. Federal legislation required all states to adopt certain standardized benefit provisions for the sale of Medicare supplement policies. The Company has introduced new Medicare supplement plans in response to this legislation. In addition, in 1991, the National Association of Insurance Commissioners adopted the Small Employers Availability Act (Act). The Act affects the rating and underwriting methodology that can be applied to insurance coverage sold to small employers, generally categorized as those employing 25 people or less. The Company believes the Act will not have a material impact on its existing business. In response to the Act, the Company has modified its products, and will continue to modify products (if required) for sale in those states adopting the Act. Deferred Policy Acquisition Costs Under generally accepted accounting principles, a deferred acquisition cost asset (DAC) is established to properly spread the acquisition costs for a block of policies against the expected future revenues from the policies. The acquisition costs which are capitalized and amortized consist of first year commissions in excess of renewal commissions and certain home office expenses related to selling, policy issue, and underwriting. The deferred acquisition costs for accident and health policies and traditional life policies are amortized over future revenues of the business to which the costs are related. The rate of amortization depends on the expected pattern of future revenues for the block of policies. The scheduled amortization for a block of policies is established when the policies are issued. The amortization schedule is based on the expected persistency of the policies. The actual amortization of DAC reflects the actual persistency of the business. For example, if actual policy terminations are higher than expected, DAC will be amortized more rapidly than originally scheduled. Effect of Inflation In pricing its insurance products, the Company gives effect to anticipated levels of inflation; however, the Company believes that the high rate of medical cost inflation during the last three years had an adverse impact on its major hospital accident and health claims experience. The Company has implemented rate increases in response to this experience. Liquidity and Capital Resources The Company's consolidated liquidity requirements are created and met primarily by operations of its insurance subsidiaries. The primary sources of cash are premiums, investment income, proceeds from public offerings and investment sales and maturities. The primary uses of cash are operating costs, repayment of notes payable, policy acquisition costs, payments to policyholders and investment purchases. In addition, liquidity requirements of the Company are created by dividend requirements of the $2.125 Preferred Stock and debt service requirements. The Company's liquidity requirements are met primarily by dividends declared by its non-insurance subsidiaries. As disclosed in Note 9 of Notes to Consolidated Financial Statements, payment of dividends by the insurance subsidiaries to the Company is subject to certain regulatory restrictions. The Company's life and health insurance subsidiaries require capital to fund acquisition costs incurred in the initial year of policy issuance and to maintain adequate surplus levels for regulatory purposes. These capital requirements have been met principally from internally generated funds, including premiums and investment income, and capital provided from reinsurance and the financing or sale of agent debit balances. The Company has terminated existing financial reinsurance agreements with respect to policies issued subsequent to July 1991. The current reinsurance agreements in force have been approved by the appropriate regulatory authorities and the Company believes they meet the current NAIC model regulations. If circumstances arose that would affect the Company's continued ability to include capital provided from reinsurance in the insurance subsidiaries' statutory capital and surplus, it could have an adverse impact on the Company's business. The Company is not aware of any circumstances that would have such an effect. Certain subsidiaries of the Company have entered into agreements for the sale of agent debit balances. Proceeds from such sales during 1993 and 1992 were $25.4 million and $20.3 million, respectively. The Company's agent debit balance program has been reviewed without objection by applicable regulatory authorities. If restrictions are imposed on including in capital the proceeds from this type of financing in the future, the Company would consider alternative financing arrangements or discontinue its agent advancing program. In the past, the Company has obtained funds from public stock and debt offerings and bank borrowings and contributed a portion of the proceeds to the insurance subsidiaries to support the growth of its insurance business. The level of premium volume of the Company's insurance subsidiaries will depend on the amount of their statutory capital and surplus. The statutory basis premium to surplus ratio for 1993 for the Company's major insurance subsidiaries were as follows: Manhattan National Life: 1.5 times; Pioneer Life Insurance Company of Illinois: 4.4 times; Continental Life & Accident Company 6.8 times; and National Group Life Insurance Company: 3.3 times. The concept of risk-based capital has been adopted for regulatory monitoring of the life and health insurance industry. The risk-based capital rules for life and health insurance companies were effective for 1993 annual statement filings. Risk based capital standards will be used by regulators to set in motion appropriate regulatory actions relating to insurers which show signs of weak or deteriorating conditions. The Company's insurance subsidiaries total adjusted capital, authorized control risk based capital, and related ratio by company as disclosed in the 1993 annual statement are as follows: Authorized Adjusted Control Company Capital Level RBC RBC Ratio (Dollars in thousands) Pioneer Life Insurance Company of Illinois $77,460 $23,080 336% Manhattan National Life Insurance Company 24,424 4,316 566% National Group Life Insurance Company 34,756 9,016 385% Continental Life & Accident Company 11,791 4,996 236% Health & Life Insurance Company of America 3,803 240 1,585% The Company has offered agent commission financing to certain of its agents and marketing organizations which consists primarily of annualization of first year commissions. This means that when the first year premium is paid in installments, the Company will advance a percentage of the commissions that the agent would otherwise receive over the course of the first policy year. On October 31, 1990, the Company through a subsidiary entered into an agreement with an unaffiliated corporation to provide financing for its agent commission financing program through the sale of agent receivables. This financing program was replaced with an amended agreement which was executed on October 1, 1992, to provide such subsidiary with the same type of financing. Pursuant to this amended agreement the termination date of the program is December 31, 1994, subject to extension or termination as provided therein. In April 1992, the Company settled certain disputes with several former agents and in addition to certain cash payments issued promissory notes representing future commission. The remaining total of $1,490,000 at December 31, 1993 was repaid in January 1994. In July 1993 the Company issued $57.5 million of 8% convertible subordinated debentures due 2000. Interest on the debentures is payable in January and July of each year. Net proceeds from the offering totaled approximately $54 million. The debentures are convertible into the Company's common stock at any time prior to maturity, unless previously redeemed, at a conversion price of $11.75 per share. The proceeds were used in part to repay the $15,000,000 and $10,000,000 term loans outstanding. In August 1993 the Company borrowed $1,500,000 to finance the acquisition of Healthcare Review Corporation. Interest on the note is payable quarterly at six percent. The note requires principal repayments of $75,000 per quarter through July 31, 1998. Interest paid amounted to $1,023,000, $2,274,000 and $2,416,000 for 1993, 1992, and 1991, respectively. Management believes that the diversity of the Company's investment portfolio and the liquidity attributable to the large concentration of investments in highly liquid United States government agency securities provide sufficient liquidity to meet foreseeable cash requirements. In the fourth quarter of 1992 the Company segregated the fixed maturity portfolio into two components: fixed maturities held to maturity and fixed maturities available for sale. Because the Company's insurance subsidiaries experience strong positive cash flows, including sizeable monthly cash flows from mortgage-backed securities, the Company does not expect its insurance subsidiaries to be forced to sell the held to maturity investments prior to their maturities and realize material losses or gains. However, if the Company experiences changes in credit risk, it may be required to sell assets whose fair value is less than carrying value and incur losses. Life insurance and annuity liabilities are generally long term in nature although subject to earlier surrender as a result of the policyholder's ability to withdraw funds or surrender the policy, subject to surrender and withdrawal penalties. The Company believes its policyholder liabilities should be backed by an investment portfolio that generates predictable investment returns. The Company seeks to limit exposure to risks associated with interest rate fluctuations by concentrating its invested assets principally in high quality, readily marketable debt securities of intermediate duration and by attempting to balance the duration of its invested assets with the estimated duration of benefit payments arising from contract liabilities. The Company has no material commitments for capital expenditures at the present time. The Company acquired its corporate headquarters in Schaumburg, Illinois in January 1994 which will be primarily used for investment real estate. Investment Portfolio At December 31, 1993, the Company had invested assets of $674 million, compared to $568 million at December 31, 1992. The Company manages all of its investments internally with resource and evaluation assistance provided by independent investment consultants. Government and mortgage-backed obligations and corporate fixed maturity securities collectively comprised approximately 87% and 84% of the Company's investment portfolio at December 31, 1993 and 1992, respectively. The remainder of the invested assets were in short-term investments, equity securities, policy loans and mortgage loans. Fixed Maturity Investments. With the adoption of risk based capital rules and consumer concerns over insurance company solvency and financial stability, the asset quality of insurance companies' investment portfolios has become of greater concern to policyholders and has come under closer scrutiny by insurance regulators and investors. In response, the Company reduced its investments in below-investment grade fixed maturity securities to less than 1% of its invested assets at December 31, 1993, and 3.4% at December 31, 1992, down from 4.5% at December 31, 1991, and 5.0% at December 31, 1990. These reductions resulted from sales and write-downs of the carrying value of such securities in each of these periods, and the elimination of new purchases. The Company has a policy not to invest more than 5% of its total invested assets in securities below investment grade. Investments in below-investment grade fixed maturity securities generally have greater risks (and potentially greater returns) than other corporate fixed maturity investments. Risk of loss upon default by the issuer is significantly greater for these securities because they are generally unsecured and are often subordinated to other creditors of the issuer, and because these issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. Also, the market for below-investment grade securities is less liquid and not as actively traded as the market for investment grade securities. The investment objectives of the Company are to maximize investment yield without sacrificing high investment quality and matched liquidity. The Company continually evaluates the creditworthiness of each issuer of securities held in its portfolio. When the fair value of an individual security declines materially, or when the Company's ongoing evaluation indicates that it may be likely that the Company will be unable to realize the carrying value of its investment, significant review and analytical procedures are performed to determine the extent to which such declines are attributable to changing market expectations regarding general interest rates and inflation and other factors, such as a perceived increase in the credit risk of the issuer, a general decrease in a particular industry sector or an overall economic decline. Declines in fair value attributable to factors other than market expectations regarding general interest rates and inflation are reviewed and analyzed in further detail to determine if the decline in value is other than temporary, and the carrying amount of the investment is reduced to its net realizable value based upon estimated non-discounted cash flows. The amount of the reduction is reported as a realized loss on investments and the net realizable value becomes the new cost basis of the investment. In addition, the Company reverses any accrued interest income previously recorded for the investment and records future interest income only when cash is received. The Company's use of non-discounted cash flows to evaluate net realizable value may result in lower realized losses in the current period than if the Company had elected to use discounting in its evaluation process. Also, yields recognized in future periods on such investments may be less than yields recognized on other investments and will be less than the yield expected when the fixed maturity security was originally purchased. The affect on net income from declines in interest income and portfolio yield from impaired securities in future periods will depend on many factors, including, in life insurance business, the level of interest rates credited to policyholder account balances. Inasmuch as interest rates credited to the Company's policyholders are typically only guaranteed for one year, the Company does not expect any material adverse affect on net income in future periods from declines in yields from impaired securities. Mortgage-Related Securities. At December 31, 1993, the Company had $324 million, or 55%, of its fixed maturities portfolio in mortgage-related securities ($351 million at December 31, 1992). The yield characteristics of mortgage-related securities differ from those of traditional fixed income securities. The major differences typically include more frequent interest and principal payments, usually monthly, and the possiblity that prepayments of principal may be made at any time. Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic, social and other factors and cannot be predicted with certainty. The yields to maturity of the mortgage-related securities will be affected by the actual rate of payment (including prepayments) of principal of the underlying mortgage loans. In general, prepayments on the underlying mortgage loans, and subsequently the mortgage-related securities backed by these loans, increases when the level of prevailing interest rates declines significantly below the interest rates on such loans. When declines in interest rates occur, the proceeds from the prepayment of such securities are likely to be reinvested at lower rates than the Company was earning on such securities. Prior to 1991, the Company's investments in mortgage-related securities consisted primarily of pass-through certificates which provide for regular monthly principal and interest payments. During 1991 and 1992, the Company restructured its portfolio by investing in principal only and inverse floaters/interest only tranches of collateralized mortgage obligations (CMOs) and accrual bonds (derivative securities) and other CMOs by selling pass-through certificates. The Company also purchased additional CMO investments with cash flows generated by policyholder premium collections, reinvestment of investment income and scheduled principal payments or maturities of investments and proceeds from the sales of fixed maturity investments, including significant sales of higher-coupon mortgage-related securities in 1991 and 1992. The Company's mortgage-related securities portfolio is well diversified as to collateral, maturity/duration and other characteristics. The majority of the mortgage-related securities portfolio has the guarantee or backing of agencies of the United States government. Generally, the mortgage-related securities consist of pools of single-family, residential mortgages. The derivative securities were acquired to protect the Company in the event of adverse interest rate fluctuations. The yields and fair values of the derivative securities are generally more sensitive to changes in interest rates and prepayments than other mortgage-related securities. Accrual bonds are CMOs structured such that the payments of coupon interest is deferred until principal payments begin on the bonds. On each accrual date, the principal balance is increased by the amount of the interest (based upon the stated coupon rate) that otherwise would have been payable. As such, these securities act much the same as zero coupon bonds until cash payments begin. Cash payments typically do not commence until earlier classes in the CMO structure have been retired, which can be significantly influenced by the prepayment experience of the underlying mortgage loan collateral in the CMO structure. Because of the zero coupon element of these securities and the potential uncertainty as to the timing of cash payments, their fair values and yields are more sensitive to changing interest rates than pass-through securities and coupon bonds. The Company's mortgage-related securities portfolio at December 31, 1993, also included $37 million of CMOs and pass-through certificates issued by non-government agencies ($57 million at December 31, 1992). The Company's holdings consist solely of senior securities in the CMO structures which are collateralized by first mortgage liens on single family residences. These securities are rated AAA or AA by Standard & Poor's, or the comparable equivalent rating by another independent nationally recognized rating agency. The credit worthiness of these securities is based solely on the underlying mortgage loan collateral and credit enhancements in the form of senior/subordinated structures, letters of credit, mortgage insurance or surety bonds. The underlying mortgage loan collateral principally consists of whole loan mortgages that exceed the $202,000 maximum imposed by both the Federal National Mortgage Associaton and the Federal Home Loan Mortgage Corporation and, as such, the collateral tends to be concentrated in states with the greatest number of higher priced single family residences, including California, New York, New Jersey, Maryland, Virginia and Illinois. The maximum average loan-to-value ratio for the collateral is 80%. The following table summarizes the components of the Company's mortgage-related securities portfolio at December 31, 1993, and December 31, 1992 (in thousands): December 31, 1993 December 31, 1992 Estimated Estimated Carrying Fair Carrying Market Value Value (1) Value Value (1) Inverse floaters and interest only CMO tranches $ 18,954 $ 16,003 $ 30,810 $ 24,632 Accrual bonds: U.S. government agency 6,968 7,386 7,852 8,215 Other CMOs: U.S. government agency 187,871 190,141 200,860 204,161 Non-government agency 21,154 21,919 40,635 41,772 Total other CMOs 209,025 212,060 241,495 245,933 U.S. government agency pass-through73,285 74,004 54,902 56,104 Non-government agency pass-through 15,895 16,041 16,252 16,584 Total mortgage-backed securities $324,127 $325,494 $351,311 $351,468 (1) Fair values are generally derived from independent pricing services. Fair values for principal only and inverse floater/interest only tranches of CMOs at December 31, 1993, and 1992 reflect a discounted cash flow due to a lack of a liquid market for these securities. Recently Issued Accounting Standards For a discussion of a new income tax accounting standard and a new reinsurance accounting standard and the impact these standards had on the financial statements of the Company, see Note 2 of Notes to Consolidated Financial Statements. Item 8. Item 8. Financial Statements and Supplementary Data Consolidated Financial Statements are included in Part IV, Item 14 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 section of the definitive proxy statement to be filed with the Securities and Exchange Commission and mailed to stockholders before April 1, 1994, in connection with the Company's 1994 annual meeting of stockholders entitled "Election of Directors" is incorporated herein by this reference. For information on executive officers of the registrant, reference is made to the item entitled "Executive Officers of the Registrant" in Part I of this report. Item 11. Item 11. Executive Compensation The section of the definitive proxy statement to be filed with the Securities and Exchange Commission and mailed to stockholders before April 1, 1994, in connection with the Company's 1994 annual meeting of stockholders entitled "Executive Compensation" is incorporated herein by this reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The section of the definitive proxy statement to be filed with the Securities and Exchange Commission and mailed to stockholders before April 1, 1994, in connection with the Company's 1994 annual meeting of stockholders entitled "Principal Holders of Securities" is incorporated herein by this reference. Item 13. Item 13. Certain Relationships and Related Transactions The section of the definitive proxy statement to be filed with the Securities and Exchange Commission and mailed to stockholders before April 1, 1994, in connection with the Company's 1994 annual meeting of stockholders entitled "Certain Transactions" is incorporated herein by this reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents filed as a part of this report: PIONEER FINANCIAL SERVICES, INC. 1. Financial Statements Report of Independent Auditors . . . . . . . . . . . . Consolidated Financial Statements . . . . . . . . . . . Statements of Consolidated Operations . . . . . . Consolidated Balance Sheets . . . . . . . . . . . Statements of Consolidated Stockholders' Equity. . Statements of Consolidated Cash Flows . . . . . . Notes to Consolidated Financial Statements . . . . 2. Financial Statement Schedules Schedule I - Consolidated Summary of Investments - Other Than Investments in Related Parties . . . . . . Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties . . . . . . Schedule III - Condensed Financial Information of Registrant - Condensed Balance Sheets . . . . . . Schedule III - Condensed Financial Information of Registrant - Condensed Statements of Operations . . . Schedule III - Condensed Financial Information of Registrant - Condensed Statements of Cash Flows. . . . . . . . . . . . . . . . . . . . . . Schedule III - Note to Condensed Financial Statements Schedule V - Supplementary Insurance Information. . . Schedule VI - Reinsurance . . . . . . . . . . . . . . Schedule VIII - Valuation and Qualifying Accounts . . Schedule IX - Short-Term Borrowings . . . . . . . . . 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. 3. Exhibits See Exhibit Index below. (b) Reports on Form 8-K The Company filed no reports on Form 8-K during the fourth quarter of 1993. (c) Index to Exhibits Exhibit Sequentially Number Description of Document Numbered Page 3 (a) Certificate of Incorporation of the Company (filed as Exhibit 3(a) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 3 (b) Amended Bylaws of the Company (filed as Exhibit 3(b) to Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (a) Certificate of Designations with respect to the Company's $2.125 Cumulative Convertible Exchangeable Preferred Stock ("Preferred Stock") (filed as Exhibit 4(a) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (b) Proposed form of Indenture with respect to the Company's 8 1/2% Convertible Subordinated Debentures due 2014 into which the Preferred Stock is exchangeable (filed as Exhibit 4(b) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (c) Rights Agreement dated as of December 12, 1990 between the Company and First Chicago Trust Company of New York as Rights Agent (including exhibits thereto) (filed as Exhibit 1 to the Company's registration statement on Form 8-A dated December 14, 1990 and incorporated herein by reference) 10 (a) Form of contract with independent agents (filed as Exhibit 10(f) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 10 (b) Nonqualified Stock Option Plan (filed as Exhibit 10(g) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 10 (c) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(d) to the Company's Registration Statement on Form S-8 [No. 33-26455] and incorporated herein by reference) 10 (d) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(c) to the Company's Registration Statement on Form S-1 [No. 33-17011] and incorporated herein by reference) 10 (e) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(e) to the Company's registration statement on Form S-8 [No. 33-37305] and incorporated herein by reference) 10 (f) Amended and Restated Receivables purchase agreement dated as of October 1, 1992 by and between Design Benefit Plans, Inc. (formerly National Group Marketing Corporation) and National Funding Corporation (filed herewith) *10 (g) Employment Agreement dated December 3, 1993 by and between the Company and Peter W. Nauert (filed herewith) 10 (h) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and Pioneer Life Insurance Company of Illinois (filed as Exhibit 10(v) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) 10 (i) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and National Group Life (filed as Exhibit 10(w) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (j) Employment Agreement dated December 31, 1991 by and between National Benefit Plans, Inc. and Peter W. Nauert (filed as Exhibit 10(x) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (k) Amendment to Employment Agreement dated March 26, 1993 by and between National Benefit Plans, Inc. and Peter W. Nauert (filed herewith) *10 (l) Employment Agreement dated December 31, 1991 by and between Direct Financial Services, Inc. and Peter W. Nauert (filed as Exhibit 10(y) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (m) Amendment to Employment Agreement dated March 26, 1993 by and between Direct Financial Services, Inc. and Peter W. Nauert (filed herewith) 10 (n) Credit Agreement dated as of December 22, 1993 by and among the Company and American National Bank and Trust Company of Chicago, as Agent and American National Bank and Trust Company of Chicago, Firstar Bank Milwaukee, N.A. and Bank One, Rockford, NA, as Banks (filed herewith) 11 Statement of Computation of per share net income or loss (filed herewith) __ 21 List of subsidiaries (filed herewith) __ 23 Consent of Ernst & Young (filed herewith) __ ____________________ * Indicates management employment contracts or compensatory plans or arrangements. Pioneer Financial Services, Inc. and Subsidiaries Financial Statements Year ended December 31, 1993 Contents Report of Independent Auditors . . . . . . . . . . . . . . . Financial Statements Statements of Consolidated Operations . . . . . . . . . . . . Consolidated Balance Sheets . . . . . . . . . . . . . . . . . Statements of Consolidated Stockholders Equity . . . . . . . Statements of Consolidated Cash Flows . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . Report of Independent Auditors Board of Directors Pioneer Financial Services, Inc. We have audited the accompanying consolidated balance sheets of Pioneer Financial Services, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated operations, 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pioneer Financial Services, 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 consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Chicago, Illinois March 2, 1994 Pioneer Financial Services, Inc. and Subsidiaries Statements of Consolidated Operations (In Thousands, Except Per Share Amounts) Year ended December 31 1993 1992 1991 Revenues Premiums and policy charges (Note 5): Accident and health $ 601,684 $ 559,894 $ 593,236 Life and annuity 43,878 35,219 33,321 645,562 595,113 626,557 Net investment income (Note 3) 40,242 43,555 47,974 Other income and realized investment gains and losses (Note 3) 17,920 17,305 34,207 703,724 655,973 708,738 Benefits and expenses Benefits: Accident and health 397,963 368,046 376,820 Life and annuity 44,015 47,622 46,128 441,978 415,668 422,948 Insurance and general expenses 162,831 162,837 173,806 Interest expense (Note 7 and 10) 3,276 2,189 2,916 Amortization of deferred policy acquisition costs (Notes 3 and 8) 76,875 100,715 95,748 684,960 681,409 695,418 Income (loss) before income taxes 18,764 (25,436) 13,320 Income taxes (benefit) (Note 4): Current 10,858 2,878 7,228 Deferred (4,239) (11,355) (7,780) 6,619 (8,477) 4,448 Net income (loss) 12,145 (16,959) 8,872 Preferred stock dividends (Note 11) 2,021 2,039 2,039 Income (loss) applicable to common stockholders $ 10,124 $ (18,998) $ 6,833 Net income (loss) per common share: Primary $ 1.51 $ (2.85) $ 1.02 Fully diluted 1.26 (2.85) 1.02 Average common and common equivalent shares outstanding: Primary 6,724 6,660 6,699 Fully diluted 10,731 8,195 8,234 See notes to consolidated financial statements. Pioneer Financial Services, Inc. and Subsidiaries Consolidated Balance Sheets (In Thousands, Except Share and Per Share Amounts) December 31 1993 1992 Assets Investments (Note 3): Fixed maturities: Held to maturity - principally at amortized cost (fair value: 1993 $325,540; 1992 - $434,195) $326,512 $434,726 Available for sale - at lower of aggregate amortized cost or fair value (fair value: 1993 - $ 263,263; 1992 - $39,992) 257,717 38,751 Equity securities at fair value (cost: 1993 - $12,382; 1992 $14,925) 17,436 19,537 Mortgage loans at unpaid balance 3,201 583 Policy loans at unpaid balance 23,988 21,386 Short-term investments at cost, which approximates fair value 45,352 53,366 Total investments 674,206 568,349 Cash 23,379 18,686 Premiums and other receivables, less allowance for doubtful accounts (Notes 6 and 17) 20,734 22,056 Reinsurance receivables and amounts on deposit with reinsurers (Note 2 and 5) 74,366 56,931 Accrued investment income 8,482 7,164 Deferred policy acquisition costs (Note 8) 260,432 269,674 Land, building, and equipment at cost, less accumulated depreciation (Note 17) 22,248 18,210 Deferred federal income taxes (Note 4) 3,922 - Other 20,502 17,619 $1,108,271 $978,689 December 31 1993 1992 Liabilities, redeemable preferred stock, and stockholders equity Policy liabilities (Note 2): Future policy benefits: Life $244,249 $232,940 Annuity 208,155 180,553 Accident and health 158,330 144,922 Unearned premiums 87,945 90,880 Policy and contract claims 189,389 148,141 Other 15,037 8,260 903,105 805,696 General liabilities: General expenses and other liabilities 48,442 48,011 Deferred federal income taxes (Note 4) - 159 Short-term notes payable (Note 7) 5,575 12,931 Long-term notes payable (Note 7) 1,125 25,170 Convertible subordinated debentures (Note 10) 57,477 - Total liabilities 1,015,724 891,967 Commitments and contingencies (Notes 4 to 9 and 14) Redeemable Preferred Stock, no par value (Note 11): $2.125 cumulative convertible exchangeable preferred stock: Authorized: 5,000,000 shares Issued and outstanding: (1993 - 947,000 shares; 1992 - 959,600 shares) 23,675 23,900 Stockholders equity (Notes 4 and 9 to 13): Common Stock, $1 par value: Authorized: 20,000,000 shares Issued, including shares in treasury (1993 - 6,900,000; 1992 - 6,820,000) 6,900 6,820 Additional paid-in capital 28,814 28,399 Unrealized appreciation of equity securities (Note 3) 3,285 3,044 Retained earnings 34,645 24,521 Less treasury stock at cost (1993 - 556,800 shares; 1992 - 10,600 shares) (4,772) (52) Total stockholders equity 68,872 62,732 $1,108,271 $978,689 See notes to consolidated financial statements. See notes to consolidated financial statements. Pioneer Financial Services, Inc. and Subsidiaries Statements of Consolidated Cash Flows (In Thousands) Year ended December 31 1993 1992 1991 Operating activities Net income (loss) $ 12,145 $ (16,959)$ 8,872 Adjustments to reconcile net income or loss to net cash provided by operating activities: Decrease (increase) in premiums receivable(3,912) 5,673 6,782 Increase in policy liabilities 31,132 12,734 51,280 Deferral of policy acquisition costs (67,633) (56,936) (102,824) Amortization of deferred policy acquisition costs (Note 8) 76,875 100,715 95,748 Deferred income tax benefit (4,239) (11,355) (2,780) Change in other assets and liabilities (13,423) (10,597) (4,107) Depreciation, amortization, and accretion 9,795 10,303 2,761 Realized losses (gains) (Note 3) 1,336 47 (7,897) Net cash provided by operating activities 42,076 33,625 47,835 Investing activities Net decrease (increase) in short-term investments 28,792 (21,403) 57,883 Purchases of investments and loans made (382,339) (621,017) (400,871) Sales of investments 192,697 451,422 294,333 Maturities of investments and receipts from repayment of loans 118,620 151,042 32,734 Net purchases of property and equipment (3,956) (4,434) (3,470) Sale of subsidiary, net of cash sold of $166 - - 8,386 (Note 18) Purchase of subsidiaries including a cash overdraft of $1,019 (Note 18) (9,685) - - Net cash used by investing activities (55,871) (44,390) (11,005) Financing activities Net proceeds from issuance of convertible subordinated debentures (Note 10) 54,055 - - Increase in notes payable - 14,030 - Repayment of notes payable (31,401) (3,900) (15,247) Proceeds from sale of agent receivables (Note 6) 25,376 20,347 36,950 Transfer of collections on previously sold agent receivables (Note 6) (22,981) (22,437) (43,539) Dividends paid (2,021) (2,039) (2,039) Stock options exercised 451 165 - Purchase of treasury stock (4,720) (52) - Retirement of preferred stock (315) - - Other 44 717 - Net cash provided (used) by financing activities 18,488 6,831 (23,875) Increase (decrease) in cash 4,693 (3,934) 12,955 Cash at beginning of year 18,686 22,620 9,665 Cash at end of year $ 23,379 $ 18,686 $ 22,620 See notes to consolidated financial statements. Pioneer Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Accounting Policies Principles of Consolidation The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) and include the accounts and operations, after intercompany eliminations, of Pioneer Financial Services, Inc. (PFS) and its subsidiaries. Investments PFS's fixed maturity portfolio is segregated into two components: fixed maturities held to maturity and fixed maturities available for sale. Fixed maturities, where the intent is to hold to maturity, are carried at amortized cost, adjusted for other-than-temporary impairments. In cases where there are changes in credit risk, fixed maturities that are carried at amortized cost may be liquidated prior to maturity. Fixed maturities that are available for sale are carried, on an aggregate basis, at the lower of amortized cost or fair value. Changes in aggregate unrealized depreciation on fixed maturities available for sale are reported directly in stockholders' equity, net of applicable deferred income taxes. The amortized cost of fixed maturities classified as held to maturity or available for sale is adjusted for amortization of premiums and accretion of discounts to maturity, or, for mortgage-backed securities, over the estimated life of the security. Such amortization is included in net investment income. To the extent that the estimated lives of mortgage- backed securities change as a result of changes in prepayment rates, the accumulated amortization of premiums and the accretion of discounts is adjusted retrospectively with a charge or credit to current operations. As regards equity securities, changes in unrealized appreciation or temporary depreciation, after deferred income tax effects, are reported directly in stockholders equity. Realized gains and losses on the sale of investments are determined on the specific identification basis and are included in other income in the statements of operations. Revenues Revenues for interest-sensitive life insurance and annuities consist of charges assessed against policy account values. For accident and health and other life insurance, premiums are recognized as revenue when due. Accident and health group association dues and fees, included in other revenues, are recognized as revenue when received. Pioneer Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (consolidated) 1. Accounting Policies (continued) Future Policy Benefits The liabilities for future policy benefits related to the annuity and interest-sensitive life insurance policies are calculated based on accumulated fund values. As of December 31, 1993, interest credited during the contract accumulation period ranged from 5.0% to 8.0%. Investment spreads and mortality gains are recognized as profits when realized, based on the difference between actual experience and amounts credited or charged to policies. The carrying amounts of PFS's liabilities for investment-type insurance contracts were $200,894,000 and $173,930,000 at December 31, 1993 and 1992, respectively. The fair values of these liabilities at December 31, 1993 and 1992 were $191,816,000 and $165,739,000, respectively. The liabilities for future policy benefits on other life and accident and health insurance policies have been computed by a net level method based on estimated future investment yield, mortality or morbidity, and withdrawals, including provisions for adverse deviation. Interest rate assumptions range from 3.5% to 8.5% depending on the year of issue. The provisions for future policy benefits and the deferral and amortization of policy acquisition costs are intended to result in benefits and expenses being associated with premiums proportionately over the policy periods. Unearned Premiums Unearned premiums are calculated using the monthly pro-rata basis. Deferred Policy Acquisition Costs Costs that vary with, and are primarily related to, the production of new business are deferred. Such costs are primarily related to accident and health business and principally include the excess of new business commissions over renewal commissions and underwriting and sales expenses. For annuities and interest-sensitive life insurance policies, deferred costs are amortized generally in proportion to expected gross profits arising from the difference between investment and mortality experience and amounts credited or charged to policies. That amortization is adjusted retrospectively when estimates of current or future gross profits (including the impact of realized investment gains and losses) to be realized from a group of products are revised. For other life and accident and health policies, costs are amortized over the premium-paying period of the policies, using the same mortality or morbidity, interest, and withdrawal assumptions that are used in calculating the liabilities for future policy benefits. 1. Accounting Policies (continued) The unamortized cost of purchased insurance in force is included in deferred policy acquisition costs ($23,078,000 and $20,200,000 at December 31, 1993 and 1992, respectively). Amortization of these amounts is in relation to the present value of estimated gross profits over the estimated remaining life of the related insurance in force. Policy and Contract Claims The liabilities for policy and contract claims, principally accident and health, are determined using case-basis evaluations and statistical analyses based on past experience and represent estimates of the ultimate net cost of incurred claims and the related claim adjustment expenses. Although considerable variability is inherent in such estimates, management believes that these liabilities are adequate. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations. Reinsurance Reinsurance premiums, commissions, expense reimbursements, and receivables related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums reinsured to other companies have been reported as reductions of premium revenues. Amounts recoverable for reinsurance related to future policy benefits, unearned premium reserves, and claim liabilities have been reported as reinsurance receivables; expense allowances received in connection with reinsurance have been accounted for as a reduction of the related deferred policy acquisition costs and are deferred and amortized accordingly. Acquisition costs relating to the production of new business result in a reduction of statutory-basis net income. PFS had entered into certain financial reinsurance agreements that have the effect of deferring this statutory-basis reduction and amortizing costs over future periods. The remaining effect of such reinsurance has been eliminated from the accompanying consolidated financial statements. 1. Accounting Policies (continued) Federal Income Taxes Federal income tax provisions are based on income or loss reported for financial statement purposes and tax laws and rates in effect for the years presented. For 1992 and 1991, deferred federal income taxes were provided for the differences between the recognition of income and loss determined for financial reporting purposes and income tax purposes. Effective January 1, 1993, deferred federal income taxes have been provided using the liability method an accordance with Financial Accounting Standards Board (FASB) Statement No. 109 "Accounting for Income Taxes" (See Note 2). Under this method deferred tax assets and liabilities are determined based on the differences between their financial reporting and their tax bases and are measured using enacted tax rates. Depreciation Building and equipment are recorded at cost and are depreciated using principally the straight-line method. Net Income or Loss Per Common Share Primary net income or loss per share of Common Stock is determined by dividing net income or loss, less dividends on Preferred Stock, by the weighted-average number of Common Stock and Common Stock equivalents (dilutive stock options) outstanding. Where the effect of Common Stock equivalents on net income or loss per share would be antidilutive, they are excluded from the average shares outstanding. Fully diluted net income or loss per share is computed as if the Preferred Stock and Convertible Subordinated Debentures had been converted to Common Stock. Where the effect of the assumed conversion on net income or loss per share would be antidilutive, fully diluted net income or loss per share represents the primary amount. 1. Accounting Policies (continued) Cost in Excess of Net Assets of Companies Acquired The cost in excess of net assets of companies acquired (goodwill) ($5,449,000 and $3,776,000 at December 31, 1993 and 1992, respectively) is included in other assets and is being amortized principally on a straight- line basis over periods from seven to forty years. Treasury Stock The board of directors has authorized PFS to buy back shares of its own common and preferred stock on the open market from time to time. During 1993 and 1992, PFS repurchased 546,200 and 10,600 shares, respectively, of their common stock. During 1993, PFS repurchased 12,600 shares of their preferred stock. Treasury stock is accounted for using the cost method. Cash Flow Information Cash includes cash on hand and demand deposits. Fair Values of Financial Instruments The following methods and assumptions were used by PFS in estimating its fair values for financial instruments: Cash, short-term investments, short-term notes payable, and accrued investment income: The carrying amounts reported in the balance sheets for these instruments approximate their fair values. Investment securities: Fair values for fixed maturity securities (including redeemable preferred stocks) are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services, or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the yield,quality, and maturity of the investments. The fair values for equity securities are based on quoted market prices and are recognized in the balance sheets. Mortgage loans and policy loans: The carrying amount of PFS's mortgage loans approximates their fair values. The fair values for policy loans are estimated using capitalization of earnings methods, using interest rates currently being offered for similar loans to borrowers with similar credit ratings. Investment contracts: Fair values for PFS's liabilities under investment- type insurance contracts are based on current cash surrender values. Fair values for PFS's insurance policies other than investment contracts are not required to be disclosed. However, the fair values of liabilities under all insurance policies are taken into consideration in PFS's overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance policies. Long-term notes payable: The fair value of PFS's long-term notes payable approximates the carrying value. Convertible subordinated debentures: The fair value of PFS's convertible subordinated debentures is based on quoted market prices. New Accounting Standard In 1993 the FASB issued Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which PFS must adopt prospectively effective January 1, 1994. Under the new rules, fixed maturities that PFS has both the positive intent and ability to hold to maturity will be carried at amortized cost. Fixed maturities that PFS does not have the positive intent and ability to hold to maturity and all marketable equity securities will be classified as available-for-sale or trading and carried at fair value. Unrealized holding gains and losses on securities classified as available-for-sale will be included as a separate component of stockholders' equity. Unrealized holding gains and losses on securities classified as trading will be reported in earnings. PFS does not anticipate categorizing any fixed maturities as trading. In connection with the adoption of the Statement No. 115, PFS may reclassify certain investments in fixed maturities between the available for sale and held to maturity categories. Accordingly, as of January 1, 1994, although the carrying value of investments in fixed maturities is expected to increase based on the December 31, 1993 fair values, the net effect on stockholders' equity has not been determined. Previously reported financial statements are not permitted to be restated for this Statement. Reclassifications Certain amounts in the 1991 and 1992 financial statements have been reclassified to conform to the 1993 presentation. 2. Changes in Accounting Principles Federal Income Taxes Effective January 1, 1993, PFS changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement 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 No. 109 as of January 1, 1993 was not significant and has not been separately disclosed (See Note 4 for further income tax disclosures). Reinsurance Effective January 1, 1993, PFS changed its method of accounting for reinsurance contracts in accordance with FASB Statement No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long- Duration Contracts". Under Statement No. 113, all assets and liabilities related to reinsured insurance contracts are reported on a gross basis rather than the previous practice of reporting such assets and liabilities net of reinsurance. The effect of adopting Statement No. 113 was to increase both assets and liabilities by $19,453,000 and $16,391,000 at December 31, 1993 and 1992, respectively. The amounts recoverable from reinsurers are now classified as reinsurance receivables on the balance sheets. As permitted under Statement No. 113, the accompanying December 31, 1992 balance sheet has been reclassified to the gross basis. The adoption of Statement No. 113 had no effect on net income. 3. Investments Realized investment gains (losses), including provisions for losses on investments held, and unrealized appreciation (depreciation) on equity securities, fixed maturities, and other investments are summarized as follows: Fixed Equity Maturities Securities Other Total (In Thousands) Realized $ (1,638) $ 293 $ 9 $(1,336) Unrealized 3,864 442 - 4,306 $ 2,226 $ 735 $ 9 2,970 Realized $ (91) $ 44 $ - $ (47) Unrealized (11,144) 6,998 - (4,146) $(11,235) $ 7,042 $ - $(4,193) Realized $ 7,280 $ (244) $ 861 $ 7,897 Unrealized 15,379 3,899 - 19,278 $ 22,659 $ 3,655 $ 861 $ 27,175 For annuities and interest-sensitive life insurance policies, GAAP requires that deferred policy acquisition costs be amortized in proportion to the estimated profits, including realized investment gains, expected to be realized over the life of the policies. In 1991, PFS sold investments related to this life and annuity business and realized a substantial amount of gains. As required by GAAP, realizing these higher-than-expected gains caused additional deferred policy acquisition cost amortization totaling $3,800,000 in 1991. At December 31, 1993 and 1992, the allowance for losses on investments held amounted to $4,200,000 and $1,900,000, respectively. At December 31, 1993, gross unrealized appreciation pertaining to equity securities was $5,067,000 and gross unrealized depreciation was $13,000. Deferred taxes of $1,769,000 and $1,568,000 have been provided on the net unrealized appreciation at December 31, 1993 and 1992, respectively. A comparison of amortized cost to fair value of fixed maturity investments by category is as follows: Gross Gross Amortized UnrealizedUnrealized Fair Cost Gains Losses Value (In Thousands) At December 31, 1993: Held to Maturity U.S. Treasury $ 9,124 $ 100 $ (61) $ 9,163 States and political subdivisions 5,200 - - 5,200 Corporate securities 119,276 2,653 (312) 121,617 Mortgage-backed securities 192,912 1,908 (5,260) 189,560 $326,512 $4,661 $(5,633) $325,540 Available for Sale U.S. Treasury $ 26,894 $ 570 $ (26) $ 27,438 States and political subdivisions 21,571 121 - 21,692 Foreign governments 4,056 2 (119) 3,939 Corporate securities 73,981 744 (465) 74,260 Mortgage-backed securities 131,215 5,029 (310) 135,934 $257,717 $6,466 $ (920) $263,263 Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value (In Thousands) At December 31, 1992: Held to Maturity U.S. Treasury $ 15,363 $ 406 $ (71) $ 15,698 States and political subdivisions 199 12 - 211 Corporate securities 98,836 1,344 (1,366) 98,814 Mortgage-backed securities 320,328 7,140 (7,996) 319,472 $434,726 $8,902 $(9,433) $434,195 Available for Sale U.S. Treasury $ 1,425 $ 109 $ - $ 1,534 Corporate securities 6,343 181 (62) 6,462 Mortgage-backed securities 30,983 1,263 (250) 31,996 $ 38,751 $1,553 $(312) $ 39,992 The amortized cost and fair value of fixed maturities 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 prepayment penalties. Amortized Fair Cost Value Held to Maturity: (In Thousands) Due in 1994 $ 657 $ 673 Due 1995-1998 16,707 17,254 Due 1999-2003 67,455 68,611 Due after 2003 48,781 49,442 Mortgage-backed securities 192,912 189,560 $326,512 $325,540 Available for Sale: Due in 1994 $ 2,308 $ 2,378 Due 1995-1998 36,109 36,544 Due 1999-2003 61,750 62,036 Due after 2003 26,335 26,371 Mortgage-backed securities 131,215 135,934 $257,717 $263,263 The fair value of PFS's investment in policy loans was estimated to be $21,011,000 and $18,037,000 at December 31, 1993 and 1992, respectively. Proceeds from sales of investments (principally fixed maturities) during 1993, 1992 and 1991 were $192,697,000, $451,422,000 and $294,333,000, respectively. Gross gains of $10,834,000, $8,073,000 and $7,808,000 and gross losses of $12,472,000, $8,164,000 and $528,000 were realized on fixed maturity sales in 1993, 1992 and 1991, respectively. Major categories of net investment income are summarized as follows: 1993 1992 1991 (In Thousands) Fixed maturities $34,529 $39,384 $38,687 Short-term investments 2,691 2,083 6,311 Other 4,069 3,733 4,079 Total investment income 41,289 45,200 49,077 Investment expenses (1,047) (1,645) (1,103) Net investment income $40,242 $43,555 $47,974 At December 31, 1993, securities with a carrying value of $92,624,000 were on deposit with various government authorities to meet regulatory requirements. At December 31, 1993, the carrying value of investments in any one entity and/or in their affiliates which exceeded 10% of PFS s consolidated stockholders equity were as follows: Fixed Maturities Ford Capital $18,684,000 GMAC 17,472,000 State of Washington 10,023,000 Associates Corporation 7,242,000 At December 31, 1993, PFS held unrated or less-than-investment-grade securities of $803,000, net of reserves for losses, with an aggregate fair value of $824,000. Those holdings amounted to less than 1% of PFS s total investments at December 31, 1993. At December 31, 1993, fixed maturities with a carrying value of $18,129,000 had been non-income producing for the preceding 12-month period. 4. Federal Income Taxes As discussed in Note 2, PFS adopted FASB Statement No. 109 as of January 1, 1993. The cumulative effect of the change in accounting for income taxes was not significant. 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 PFS's deferred tax liabilities and assets as of December 31, 1993 are as follows (in thousands): Deferred tax liabilities Deferred policy acquisition costs $86,545 Net unrealized appreciaton on marketable equity securities 1,769 Other 1,367 Total deferred tax liabilities 89,681 Deferred tax assets Policy liabilities 77,493 Financial reinsurance 11,150 Other 8,833 Total deferred tax assets 97,476 Valuation allowance for deferred tax assets (3,873) Deferred tax assets net of valuation allowance allowance 93,603 Net deferred tax asset $ 3,922 The nature of PFS's deferred tax assets and liabilities are such that the reversal pattern for these temporary differences should generally result in realization of PFS's deferred tax assets. PFS establishes a valuation allowance for any portion of the deferred tax asset that management believes may not be realized. In 1993, the valuation allowance was increased by $1,221,000 principally due to the acquisition of Continental Life & Accident Company (See Note 18). The deferred tax benefit for 1992 and 1991 includes the effects of the following items: 1992 1991 (Dollars in thousands) Deferred policy acquisition costs $(16,232) $ (440) Policy liabilities 2,966 (5,967) Decrease in operating loss carryforward 143 2,050 General expenses 1,537 522 Financial statement capital gains greater than tax capital gains 148 743 Other 83 312 Deferred federal income tax benefit $(11,355) $(2,780) PFS s effective federal income tax rate varied from the statutory federal income tax rate as follows: Deferred Method Liability Method 1993 1992 1991 Amount % Amount % Amount % (Dollars in Thousands) Statutory federal income tax rate applied to income or loss before income taxes $6,567 35.0% $(8,648) 34.0% $ 4,529 34.0% Nondeductible goodwill amortization 319 1.7 192 (.8) 212 1.6 Realized gain on sale of subsidiary in excess of tax-basis gain (Note 18) - - - - (247) (1.9) Tax exempt interest (99) (.5) - - - - Other (168) (.9) (21) .1 (46) (.3) Income taxes (benefit) and effective rate $ 6,619 35.3% $(8,477) 33.3% $ 4,448 33.4% Taxes paid amounted to $5,735,000, $8,828,000, and $2,566,000 for 1993, 1992, and 1991, respectively. Under pre-1984 life insurance company income tax laws, a portion of a life insurance company s gain from operations was not subjected to current income taxation but was accumulated, for tax purposes, in a memorandum account designated as the policyholders surplus account. The balance in this account at December 31, 1993 for PFS s life insurance subsidiaries was $10,040,000. Should the policyholders surplus accounts of PFS s life insurance subsidiaries exceed their respective maximums, or should distributions in excess of their tax-basis shareholders surplus account be made by the life insurance subsidiaries, such excess or distribution would be subject to federal income taxes at rates then in effect. Deferred taxes of $3,500,000 have not been provided on amounts included in the policyholders surplus accounts, since PFS contemplates no such taxable events in the foreseeable future. As of December 31, 1993, PFS s life insurance subsidiaries had combined tax-basis shareholders surplus accounts of $36,100,000. Distributions up to that amount would result in no income tax liability. 5. Reinsurance PFS s insurance subsidiaries reinsure risks with other companies to permit the recovery of a portion of the direct losses. These reinsured risks are treated as though, to the extent of the reinsurance, they are risks for which the subsidiaries are not liable. PFS remains liable to the extent that the reinsuring companies do not meet their obligations under these reinsurance treaties. PFS's premiums were reduced for reinsurance premiums by $40,592,000, $30,469,000, and $33,789,000 in 1993, 1992, and 1991, respectively. Under various reinsurance arrangements, PFS's premiums were increased by $19,338,000, $15,403,000, and $13,933,000 in 1993, 1992, and 1991, respectively. PFS's policy benefits have been reduced for reinsurance recoveries of $21,871,000 in 1993, $22,171,000 in 1992, and $28,714,000 in 1991. At December 31, 1993, approximately 67% of PFS's reinsurance receivables and amounts on deposit with reinsurers were due from Employers Reinsurance Corporation. 6. Sale of Agent Receivables In 1993, 1992, and 1991 a subsidiary of PFS sold agent receivables to an unaffiliated company for proceeds of $25,376,000, $20,347,000, and $36,950,000, respectively. The outstanding balances of such agent receivables sold that remained uncollected at December 31, 1993 and 1992 were $9,815,000 and $6,339,000, respectively. PFS remains subject to a maximum credit exposure under this agreement amounting to 10% of agent receivables at December 31, 1993. 7. Notes Payable In 1992, PFS settled certain disputes with several former agents and in addition to certain cash payments issued promissory notes representing future commissions. A final payment of $1,490,000 is payable for these notes in 1994. At December 31, 1993, PFS had $3,785,000 of short-term debt liability for which a PFS agency subsidiary s future renewal commissions were pledged as collateral. At December 31, 1993, a PFS subsidiary had an unsecured loan of $1,425,000. The portion of the loan due in 1994 of $300,000 is included in short-term notes payable. The remainder of the note is included in long-term notes payable. The note bears interest currently at 6% per annum and is payable quarterly with the final payment due July 1998. Interest paid amounted to $1,023,000, $2,274,000, and $2,416,000 for 1993, 1992, and 1991, respectively. 8. Accident and Health Business In making the determination that policy liabilities, future premiums, and anticipated investment income will be adequate to provide for future claims and expenses (including the amortization of deferred policy acquisition costs), PFS has made assumptions with regard to each of these items. Although there is significant variability inherent in these estimates, management believes that these assumptions are reasonable. Pursuant to an actuarial study performed in the fourth quarter of 1992, PFS revised certain of these assumptions to reflect present and anticipated future experience. This study resulted in increased amortization of deferred policy acquisition costs of approximately $30,000,000 in the fourth quarter of 1992. 9. Statutory-Basis Financial Information The following tables compare combined net income and stockholders' equity for PFS's insurance subsidiaries determined on the basis as prescribed or permitted by regulatory authorities (statutory basis) with consolidated net income (loss) and stockholders' equity reported in accordance with GAAP. Statutory basis accounting emphasizes solvency rather than matching revenues and expenses during an accounting period. The significant differences between statutory basis accounting and GAAP are as follows: Deferred Policy Acquisition Costs. Costs of acquiring new policies are expensed when incurred (statutory basis) rather than capitalized and amortized over the term of the related polices (GAAP). Policy Liabilities. Certain policy liabilities are calculated based on statutorily required methods and assumptions (statutory basis) rather than on estimated expected experience or, for annuity and interest-sensitive life insurance, actual account balances (GAAP). Financial Reinsurance. The effects of certain financial reinsurance transactions are included in the statutory basis financial statements but are eliminated from the GAAP financial statements. Deferred Federal Income Taxes. Deferred federal income taxes are not provided on a statutory basis for differences between financial statement and tax return amounts. Surplus Notes. Surplus notes are reported in capital and surplus (statutory basis) rather than as liabilities (GAAP). Non-insurance Companies' Equity. Contributions by PFS to the capital and surplus of its insurance subsidiaries increases the stockholders' equity of those insurance subsidiaries on a statutory basis but does not effect the consolidated stockholders' equity on a GAAP basis. 1993 1992 1991 (in thousands) Combined net income on a statutory basis $10,155 $ 3,629 $15,150 Adjustments for: Deferred policy acquisition costs (12,842) (43,779) 7,076 Policy liabilities (18,494) (19,957) (28,530) Financial reinsurance 34,017 33,118 3,862 Deferred federal income taxes 4,239 11,355 2,780 Non-insurance companies, eliminations, and other adjustments (4,930) (1,325) 8,534 Consolidated net income (loss) in accordance with GAAP $12,145 $(16,959) $ 8,872 December 31 1993 1992 (in thousands) Combined stockholders' equity on a statutory basis $ 106,567 $ 82,432 Adjustments for: Deferred policy acquisition costs 260,432 269,674 Policy liabilities (206,966) (184,862) Financial reinsurance (30,292) (64,309) Deferred federal income taxes 3,922 (159) Non-admitted assets 11,743 19,160 Surplus - (29,128) Non-insurance companies' equity, eliminations, and other adjustments (76,534) (30,076) Consolidated stockholders' equity in accordance with GAAP $ 68,872 $ 62,732 Dividends from PFS's insurance subsidiaries are limited to the greater of the prior-year statutory-basis net gain from operations or 10% of statutory-basis surplus. The total amount of dividends that could be paid without regulatory approval was $10,117,000 at December 31, 1993. At December 31, 1993, PFS's retained earnings is $20,861,000 in excess of the combined statutory-basis unassigned surplus of the insurance subsidiaries. PFS is required to maintain adequate amounts of statutory-basis capital and surplus to satisfy regulatory requirements and provide capacity for production of new business. Acquisition costs relating to the production of new business result in a reduction of statutory-basis net income and capital and surplus. 10. Convertible Subordinated Debentures In July 1993 PFS issued $57,477,000 of 8% convertible subordinated debentures due in 2000. Interest on the debentures is payable in January and July of each year. Net proceeds from the offering totaled approximately $54,000,000 and were used, in part, to repay the long-term notes payable. The debentures are convertible into PFS's Common Stock at any time prior to maturity, unless previously redeemed, at a conversion price of $11.75 per share. The fair value of the debentures was $70,122,000 at December 31, 1993. The debentures are redeemable by PFS under certain conditions after July 1996. At December 31, 1993, 4,891,660 shares of PFS's Common Stock were reserved for conversion of the outstanding convertible subordinated debentures. 11. Redeemable Preferred Stock In 1989, PFS issued 1,000,000 shares of $2.125 Cumulative Convertible Exchangeable Preferred Stock. The proceeds of the public offering were $23,337,000 after reduction for expenses of $1,663,000, which expenses were charged to additional paid-in capital. The Preferred Stock is carried on PFS s balance sheet at the redemption and liquidation value of $25 per share. Each share of Preferred Stock is convertible by the holders at any time into 1.6 shares of PFS Common Stock. Annual cumulative dividends of $2.125 per share are payable quarterly. The preferred stock is nonvoting unless dividends are in arrears. At December 31, 1993, 1,515,200 shares of PFS's Common Stock were reserved for conversion of the outstanding preferred stock. The Preferred Stock is redeemable at the option of the holders upon certain acquisitions or other business combinations involving PFS Common Stock. The Preferred Stock is redeemable by PFS at redemption prices of $26.275 per share in 1993, declining to $25 in 1999. The Preferred Stock is exchangeable in whole at PFS s option on any dividend payment date for PFS s 8 1/2% Convertible Subordinated Debentures due in 2014 at the rate of $25 principal amount of Subordinated Debentures for each share of Preferred Stock. 12. Shareholder Rights Agreement In 1990, PFS distributed one preferred share purchase right for each outstanding share of Common Stock. The rights are intended to cause substantial dilution to a person or group that attempts to acquire PFS on terms not approved by PFS s directors. The rights expire in 2000 or PFS may redeem the rights prior to exercise for $.01 per right. The rights are not exercisable unless a person or group acquires, or offers to acquire, 20% or more of PFS s Common Stock under certain circumstances. The rights, when exercisable, entitle the holder to purchase one-tenth of a share of a new series of PFS Series A Junior Preferred Stock at a purchase price of $45. Such preferred shares, of which 2,000,000 are authorized, would be voting and would be entitled to distributions that are ten times the distributions to common shareholders. Subsequent to exercise of the rights, in the event of certain business combinations involving PFS, a holder of rights would have the right to receive PFS Common Stock with a value of two times the exercise price of the rights. 13. Stock Options and Rights PFS has a nonqualified stock option plan principally for directors and key employees of PFS and its subsidiaries. PFS s Board of Directors grants the options and specifies the conditions of the options. Options expire ten years after grant. Information with respect to these options is as follows: 1993 1992 Number Number of Exercise of Exercise Shares Price Shares Price Options outstanding at beginning of year 594,250 $5.50-$12.00 799,750 $5.50- $12.00 Granted 225,000 5.50 35,000 7.25 Exercised 72,000 5.50- 12.00 30,000 5.50 Canceled/repurchased 14,000 5.50 210,000 5.50-12.00 Options outstanding at end of year 733,250 $5.50-$12.00 594,250 $5.50-$12.00 Options exercisable at end of year 573,250 471,750 Unoptioned shares available for granting of options 22,900 233,900 14. Commitments and Contingencies PFS and its subsidiaries are named as defendants in various legal actions, some claiming significant damages, arising primarily from claims under insurance policies, disputes with agents, and other matters. PFS s management and its legal counsel are of the opinion that the disposition of these actions will not have a material adverse effect on PFS s financial position. PFS leases various office facilities and computer equipment under noncancelable operating leases on an annual basis. Rent expense was $4,516,000, $3,700,000, and $3,653,000 in 1993, 1992, and 1991, respectively. Minimum future rental commitments in connection with noncancelable operating leases are as follows: 1994 $2,075,000 1995 1,637,000 1996 969,000 1997 619,000 1998 130,000 PFS has entered into employment agreements with certain officers. 15. Benefit Plan PFS has a defined-contribution employee benefit plan that covers substantially all home office employees who have attained age 21 and completed one year of service. Plan participants may contribute from 1% to 10% of their total compensation subject to an annual maximum. The plan also provides for PFS to match participants contributions up to $1,000 per year and 50% of participants contributions above $1,000 up to the annual Internal Revenue Service limit ($8,994 in 1993). PFS makes employer contributions to the plan in cash or in PFS Common Stock at the discretion of PFS s Board of Directors. At December 31, 1993 the Plan's assets included PFS Common Stock of $3,478,000, at fair value. PFS's contibutions charged to operations were $1,073,000 in 1993, $852,000 in 1992, and $831,000 in 1991. A PFS subsidiary, which owns insurance and agency companies, had a stock purchase plan that allowed certain eligible agents to purchase common stock in the subsidiary at the subsidiary s per share book value. The plan was terminated in November 1992. In accordance with the plan's provisions, agents became fully vested. Eligible agents were given the option to participate in a new agent stock purchase plan. This new plan allows agents to purchase PFS Common Stock. Stock purchases are limited to a specific percentage of the agent's commission as determined by PFS but in no event to be less than 3%. Under the plan the agents are also credited with additional shares of PFS Common Stock as determined by PFS. In 1993 and 1992, 8,057 shares and 163,566 shares, respectively, of PFS Common Stock were issued under this plan. The subsidiary received proceeds of $499,000 in 1991 relating to the minority stock sales and paid $353,000 in 1992, and $1,862,000 in 1991 relating to repurchases of these shares from the agents at book value. In addition, in 1991, in connection with stock option agreements, the subsidiary issued shares to agents. Proceeds on these sales amounted to $559,000 and a charge to operations of $47,000 was recognized. The subsidiary subsequently repurchased the shares in 1991 at book value in the amount of $606,000. 16. Related Party Transactions PFS paid, on a per use basis, a transportation company owned by an officer, a total of $81,000, $127,000, and $130,000 in 1993, 1992, and 1991, respectively, for transportation of employees and agents. In 1993, certain of PFS's marketing subsidiaries paid rent of approximately $107,000 and parking fees of approximately $12,000 to a partnership in which an officer owns a 50% interest. PFS believes that the rates charged to PFS's subsidiaries were the same as those charged to unaffiliated third parties. In 1991, PFS paid commissions of $2,135,000 to an agent training company. That company s expenses included distributions to the agents, the cost of marketing leads purchased from PFS of $774,000 in 1991, and training and other expenses. Certain officers had interests in the agent training company. In 1991 PFS paid a company in which certain officers had interests, $2,450,000 for telecommunication, printing, and mailing services. 17. Allowances and Accumulated Depreciation Allowances for doubtful accounts related to other receivables amounted to $1,271,000 at December 31, 1993 and $1,504,000 at December 31, 1992. Accumulated depreciation related to building and equipment amounted to $16,891,000 at December 31, 1993 and $11,646,000 at December 31, 1992. 18. Purchase and Sale of Subsidiaries In August 1993, PFS purchased 80% of the outstanding common stock of Continental Life & Accident Company and 100% of the outstanding common stock of Continental Marketing Corporation for $7,100,000 in cash. The total assets acquired at the purchase date were approximately $80,000,000. Also in August 1993, PFS purchased Healthcare Review Corporation, a managed care company for $1,566,000 in cash. The total assets acquired at the purchase date were approximately $2,000,000. Revenues included in PFS's 1993 consolidated statements of operations relating to these acquired entities were $25,671,000. The operations of the entities did not have a material effect on PFS's 1993 net income. In September 1991, PFS sold a subsidiary for proceeds of $8,552,000 and recorded a gain of $708,000. Revenues included in PFS's consolidated statements of operations relating to the subsidiary's operations were $4,689,000 in 1991. The subsidiary represented a portion of the life and annuity segment. 19. Segment Information PFS has three business segments: insurance, managed care and marketing. The segments are based on PFS's strategic business units. Allocations of investment income and certain general expenses are based on various assumptions and estimates, and reported operating results by segment would change if different methods were applied. Assets are not individually identifiable by segment and have been allocated based on the amount of policy liabilities by segment and by other formulas. Depreciation expense and capital expenditures are not considered material. Realized investment gains and losses are allocated to the appropriate segment. General corporate expenses are not allocated to the individual segments. Revenues, income or loss before income taxes, and identifiable assets by business segment are as follows: Revenues 1993 1992 1991 (in thousands) Insurance: Accident and health $ 611,822 $ 572,280 $ 612,215 Life and annuity 72,376 68,411 80,059 Marketing: Unaffiliated 15,020 13,361 14,630 Inter-segment 30,439 26,500 35,054 Managed care: Unaffiliated 4,506 1,921 1,834 Inter-segment 4,358 2,041 409 738,521 684,514 744,201 Eliminations 34,797 28,541 35,463 Total $ 703,724 $ 655,973 $ 708,738 Income (loss) before income taxes Insurance: Accident and health $ 8,578 $ (26,613) $ 1,886 Life and annuity 7,623 340 5,838 Marketing 10,205 3,345 8,556 Managed care (1,211) 335 62 Corporate expenses (6,431) (2,843) (3,022) Total $ 18,764 $ (25,436) $ 13,320 Identifiable assets at year-end Insurance: Accident and health $ 571,169 $ 489,053 $ 496,493 Life and annuity 514,154 478,529 460,752 Marketing 18,244 9,590 10,585 Managed care 4,704 1,517 1,360 Total $1,108,271 $ 978,689 $ 969,190 20. Credit Arrangements PFS has a line of credit arrangement for short-term borrowings with three banks amounting to $20,000,000 through April 1996, all of which all was unused at December 31, 1993. The line of credit arrangement can be terminated, in accordance with the agreement, at PFS's option. 21. Quarterly Financial Data (Unaudited) A summary of unaudited quarterly results of operations for 1993 and 1992 is as follows: 1st 2nd 3rd 4th Premiums and policy charges $155,343 $154,189 $154,132 $181,898 Net investment income and other 14,369 13,928 15,802 14,063 Net income 2,295 2,627 3,128 4,095 Net income per share: Primary .26 .31 .40 .54 Fully diluted .26 .31 .31 .37 1st 2nd 3rd 4th Premiums and policy charges $144,054 $149,969 $143,973 $157,117 Net investment income and other 17,131 17,286 14,876 11,567 Net income (loss) 1,495 357 710 (19,521) Net income (loss) per share: Primary .15 (.02) .03 (2.98) Fully diluted .15 (.02) .03 (2.98) See Note 8 for a discussion of a 1992 fourth quarter adjustment. SCHEDULE I PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES December 31, 1993 Amount Shown in the Consolidated Amortized Fair Balance Type of Investment Cost Value Sheet (in thousands) Fixed maturities to be held to maturity: U.S. Treasury $ 9,124 $ 9,163 $ 9,124 States and political subdivisions 5,200 5,200 5,200 Corporate securities 119,276 121,617 119,276 Mortgage-backed securities 192,912 189,560 192,912 TOTAL FIXED MATURITIES TO BE HELD TO MATURITY 326,512 $325,540 326,512 Fixed maturities available for sale: U.S. Treasury 26,894 $ 27,438 26,894 States and political subdivisions 21,571 21,692 21,571 Foreign governments 4,056 3,939 4,056 Corporate securities 73,981 74,260 73,981 Mortgage-backed securities 131,215 135,934 131,215 TOTAL FIXED MATURITIES AVAILABLE FOR SALE 257,717 $263,263 257,717 Equity securities: Common stocks: Banks, trusts, and insurance companies 6,632 $ 11,536 11,536 Nonredeemable preferred stocks 5,750 5,900 5,900 TOTAL EQUITY SECURITIES 12,382 $ 17,436 17,436 Mortgage loans on real estate 3,201 3,201 Policy loans 23,988 23,988 Short-term investments 45,352 45,352 TOTAL INVESTMENTS $669,152 $674,206 SCHEDULE II PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES Balance at Balance Beginning of at End of Year Additions Collected Year (in thousands) Year Ended December 31, 1993 Tim O'Keefe mortgage loan from Pioneer Life Insurance Co. due October, 1997 $ - $140 $ 2 $138 Year Ended December 31, 1992: None Year Ended December 31, 1991: William McRee note payable to Design Benefit Plans, Inc. (formerly National Group Marketing)-- 5% due on demand $125 $ - $125 $ - SCHEDULE III PIONEER FINANCIAL SERVICES, INC. (Parent Company) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS (In thousands, except share and per share amounts) December 31 1993 1992 ASSETS Investments in subsidiaries* $107,620 $ 83,606 Cash 1,711 543 Note receivable and accrued interest from Pioneer Life Insurance Company of Illinois (PLIC)* - 29,128 Notes receivable from United Group Holdings, Inc. (UGH)* 37,495 - Other notes receivable from subsidiaries* 403 3,994 Due from affiliates* 1,014 1,190 Prepaid expenses 573 454 Deferred debenture offering expenses 3,799 - Other assets 363 181 $152,978 $119,096 LIABILITIES, REDEEMABLE PREFERRED STOCK AND, STOCKHOLDERS' EQUITY Liabilities: General expenses and other liabilities $ 2,444 $ 264 Preferred stock dividends payable 510 510 Short-term notes payable - 7,850 Long-term notes payable - 23,750 Convertible subordinated debentures 57,477 - 60,431 32,374 Redeemable Preferred Stock, no par value: $2.125 cumulative convertible exchangeable preferred stock Authorized: 5,000,000 shares Issued and outstanding: (1993 - 947,000 shares;23,675 23,990 1992 - 959,600 shares) Stockholders' equity: Common Stock, $1 par value: Authorized: 20,000,000 shares Issued, including shares in treasury (1993 - 6,900,000 shares; 1992 - 6,820,000 shares) 6,900 6,820 Additional paid-in capital 28,814 28,399 Unrealized appreciation of equity securities 3,285 3,044 Retained earnings 34,645 24,521 Less treasury stock at cost (1993 - 556,800 shares; 1992 - 10,600 shares) (4,772) (52) Total stockholders' equity 68,872 62,732 $152,978 $119,096 See note to condensed financial statements. *Eliminated in consolidation. SCHEDULE III PIONEER FINANCIAL SERVICES, INC. (Parent Company) CONDENSED FINANCIAL INFORMATION OF REGISTRANT--Continued CONDENSED STATEMENTS OF OPERATIONS (In thousands) Year Ended December 31 1993 1992 1991 Revenues: Interest income from subsidiaries* $ 1,090 $ 1,835 $ 1,209 Other investment income 62 15 243 Dividends from consolidated subsidiaries* 10,345 10,482 15,672 11,497 12,332 17,124 Expenses: Operating and administrative expenses 4,702 2,154 1,681 Interest expense 3,204 2,206 2,893 7,906 4,360 4,574 Income before equity in undistributed net income or loss of subsidiaries 3,591 7,972 12,550 Equity in undistributed net income (loss) of subsidiaries* 8,554 (24,931) (3,678) Net income (loss) 12,145 (16,959) 8,872 Preferred stock dividends 2,021 2,039 2,039 Income (loss) applicable to common stockholders $ 10,124 $(18,998) $ 6,833 See note to condensed financial statements. *Eliminated in consolidation. SCHEDULE III PIONEER FINANCIAL SERVICES, INC. (Parent Company) CONDENSED FINANCIAL INFORMATION OF REGISTRANT--Continued CONDENSED STATEMENTS OF CASH FLOWS (In thousands) Year Ended December 31 1993 1992 1991 OPERATING ACTIVITIES Net income (loss) $ 12,145 $(16,959) $ 8,872 Adjustments to reconcile net income or loss to net cash provided by operating activities: Change in other assets and liabilities 1,678 (929) 4,289 Equity in undistributed net (income) loss of subsidiaries* (8,554) 24,931 3,678 NET CASH PROVIDED BY OPERATING ACTIVITIES 5,269 7,043 16,839 INVESTING ACTIVITIES Additional investment in consolidated subsidiaries* (15,219) (13) (83) FINANCING ACTIVITIES Decrease (increase) in notes receivable from PLIC 29,128 (11,597) (1,012) Increase in notes receivable from UGH (37,495) - - Net proceeds from issuance of convertible subordinated debentures 54,055 - - Increase in notes payable - 10,000 - Repayment of notes payable (31,600) (3,900) (13,000) Decrease (increase) in other notes receivable from subsidiaries* 3,591 (447) (218) Stock options exercised 451 165 - Dividends paid (2,021) (2,039) (2,039) Purchase of treasury stock (4,720) (52) - Retirement of preferred stock (315) - - Other 44 717 - NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES 11,118 (7,153) (16,269) INCREASE (DECREASE) IN CASH 1,168 (123) 487 CASH AT BEGINNING OF YEAR 543 666 179 CASH AT END OF YEAR $ 1,711 $ 543 $ 666 See note to condensed financial statements. *Eliminated in consolidation. SCHEDULE III PIONEER FINANCIAL SERVICES, INC. (Parent Company) NOTE TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of Pioneer Financial Services, Inc. At December 31, 1992, the notes receivable from Pioneer Life Insurance Company of Illinois ("PLIC") represented $15,000,000 and $10,000,000 in surplus debentures and $4,128,000 of accrued interest. The interest rate on the $15,000,000 surplus debenture was 6.75% through June 30, 1992 and was 7% thereafter. The interest rate on the $10,000,000 surplus debenture was 7%. The payment of principal and interest to the parent company from PLIC requires regulatory approval. The surplus debentures were repaid in the third quarter of 1993. At December 31, 1993, the notes receivable from United Group Holdings of Delaware (UGH) represents the purchase of National Group Life Insurance Company from the parent company. The note bears interest at the rate of 8% and matures on December 31, 1998. SCHEDULE V PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands) December 31 Deferred Future Policy Policy Benefits and Acquisition Policy and Unearned Other Policy Segment Costs Contract Claims Premiums Liabilities 1993: Insurance: Accident and health $203,861 $341,916 $ 87,945 $ 8,066 Life and annuity 56,571 458,207 - 6,971 Marketing - - - - Managed care - - - - $260,432 $800,123 $ 87,945 $ 15,037 1992: Insurance: Accident and health $215,157 $288,966 $ 90,880 $ 2,832 Life and annuity 54,517 417,590 - 5,428 Marketing - - - - Managed care - - - - $269,674 $706,556 $ 90,880 $ 8,260 1991: Insurance: Accident and health $257,695 $266,430 $ 99,748 $ 2,075 Life and annuity 55,758 404,189 - 4,129 Marketing - - - - Managed care - - - - $313,453 $670,619 $ 99,748 $ 6,204 SCHEDULE V (continued) PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands) SCHEDULE VI PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES REINSURANCE (In thousands) Assumed Percentage Ceded to from of Amount Gross Other Other Net Assumed Amount Companies Companies Amount to net Year Ended December 31, 1993: Life insurance in force* $11,823,127$3,859,945 $ - $7,963,182 - Premiums and Policy Charges: Insurance: Accident and health $ 606,788$ 24,154 $ 19,050$ 601,684 3.2% Life and annuity 60,028 16,438 288 43,878 .7 Marketing - - - - - Managed care - - - - - $ 666,816$ 40,592 $ 19,338$ 645,562 3.9% Year Ended December 31, 1992: Life insurance in force* $10,338,557$3,929,621 $ - $6,408,936 - Premiums and Policy Charges: Insurance: Accident and health $ 558,847$ 14,328 $ 15,375$ 559,894 2.7% Life and annuity 51,332 16,141 28 35,219 .1 Marketing - - - - - Managed care - - - - - $ 610,179$ 30,469 $ 15,403$ 595,113 2.8% Year Ended December 31, 1991: Life insurance in force* $ 9,140,882$4,579,278 $ - $4,561,604 - Premiums and Policy Charges: Insurance: Accident and health $ 597,046$ 17,726 $ 13,916$ 593,236 2.3% Life and annuity 49,367 16,063 17 33,321 .1 Marketing - - - - - Managed care - - - - - $ 646,413$ 33,789 $ 13,933$ 626,557 2.4% *At end of year SCHEDULE VIII PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (In thousands) Deductions- Doubtful Accounts Written Balance at Additions- off During Balance Beginning Charged to the Year at End of Year Expense /Disposals of Year Description Year Ended December 31, 1993: Allowance for doubtful accounts $1,504 $1,171 $1,404 $1,271 Accumulated depreciation on building and equipment 11,646 5,515 270 16,891 Year Ended December 31, 1992: Allowance for doubtful accounts 147 1,475 118 1,504 Accumulated depreciation on building and equipment 9,122 3,245 721 11,646 Year Ended December 31, 1991: Allowance for doubtful accounts 40 147 40 147 Accumulated depreciation on building and equipment 6,488 2,844 210 9,122 SCHEDULE IX PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS (Dollars in thousands) * Bank borrowing represents short term arrangements generally at prime rates. These amounts exclude current portion of long-term notes payable. ** The average amounts outstanding during the year were computed based on the month-end principal balances. *** The weighted average interest rates during the year were computed by dividing the actual interest expense by average short-term debt outstanding. 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. PIONEER FINANCIAL SERVICES, INC. BY: /S/ Peter W. Nauert Peter W. Nauert, Chairman/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. Date: March 30, 1993 /S/ Peter W. Nauert /S/ Michael A. Cavataio Peter W. Nauert, Chairman, Michael A. Cavataio Chief Executive Officer, and Director Director /S/ William B. Van Vleet /S/ Nolanda S. Hill William B. Van Vleet, Executive Nolanda S. Hill Vice President and Director Director /S/ David I. Vickers /S/ Karl-Heinz Klaeser David I. Vickers, Treasurer Karl-Heinz Klaeser and Chief Financial Officer Director /S/ Robert F. Nauert /S/ Richard R. Haldeman Robert F. Nauert Richard R. Haldeman Director Director /S/ Michael K. Keefe Michael K. Keefe Director Index to Exhibits Exhibit Sequentially Number Description of Document Numbered Page 3 (a) Certificate of Incorporation of the Company (filed as Exhibit 3(a) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 3 (b) Amended Bylaws of the Company (filed as Exhibit 3(b) to Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (a) Certificate of Designations with respect to the Company's $2.125 Cumulative Convertible Exchangeable Preferred Stock ("Preferred Stock") (filed as Exhibit 4(a) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (b) Proposed form of Indenture with respect to the Company's 8 1/2% Convertible Subordinated Debentures due 2014 into which the Preferred Stock is exchangeable (filed as Exhibit 4(b) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (c) Rights Agreement dated as of December 12, 1990 between the Company and First Chicago Trust Company of New York as Rights Agent (including exhibits thereto) (filed as Exhibit 1 to the Company's registration statement on Form 8-A dated December 14, 1990 and incorporated herein by reference) 10 (a) Form of contract with independent agents (filed as Exhibit 10(f) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 10 (b) Nonqualified Stock Option Plan (filed as Exhibit 10(g) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 10 (c) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(d) to the Company's Registration Statement on Form S-8 [No. 33-26455] and incorporated herein by reference) 10 (d) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(c) to the Company's Registration Statement on Form S-1 [No. 33-17011] and incorporated herein by reference) 10 (e) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(e) to the Company's registration statement on Form S-8 [No. 33-37305] and incorporated herein by reference) 10 (f) Amended and Restated Receivables purchase agreement dated as of October 1, 1992 by and between Design Benefit Plans, Inc. (formerly National Group Marketing Corporation) and National Funding Corporation (filed herewith) *10 (g) Employment Agreement dated December 3, 1993 by and between the Company and Peter W. Nauert 10 (h) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and Pioneer Life Insurance Company of Illinois (filed as Exhibit 10(v) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) 10 (i) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and National Group Life (filed as Exhibit 10(w) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (j) Employment Agreement dated December 31, 1991 by and between National Benefit Plans, Inc. and Peter W. Nauert (filed as Exhibit 10(x) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (k) Amendment to Employment Agreement dated March 26, 1993 by and between National Benefit Plans, Inc. and Peter W. Nauert (filed herewith) *10 (l) Employment Agreement dated December 31, 1991 by and between Direct Financial Services, Inc. and Peter W. Nauert (filed as Exhibit 10(y) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (m) Amendment to Employment Agreement dated March 26, 1993 by and between Direct Financial Services, Inc. and Peter W. Nauert (filed herewith) 10 (n) Credit Agreement dated as of December 22, 1993 by and among the Company and American National Bank and Trust Company of Chicago, as Agent and American National Bank and Trust Company of Chicago, Firstar Bank Milwaukee, N.A. and Bank One, Rockford, NA, as Banks 11 Statement of Computation of per share net income or loss . . . . . . . . . . . . . . . . . __ 21 List of subsidiaries . . . . . . . . . . . __ 23 Consent of Ernst & Young . . . . . . . . . __ Exhibit 10(g) EMPLOYMENT AGREEMENT This Agreement is made this December 3, 1993, by and between PIONEER FINANCIAL SERVICES, INC., a Delaware corporation, having its principal place of business at 304 N. Main Street, Rockford, Illinois, 61101 (hereinafter "Pioneer Financial"); and PETER W. NAUERT, an individual residing at 5019 Parliament Place, Rockford, Illinois 61107. W I T N E S S E T H: WHEREAS, Pioneer Financial is an insurance holding company which has life insurance subsidiaries and affiliated administrative service and marketing companies; and WHEREAS, Nauert is current Chairman and Chief Executive Officer of Pioneer Financial and Nauert possesses valuable skills, expertise and abilities in the life and accident and health insurance business; and WHEREAS, Pioneer Financial is desirous of retaining the services of Nauert as a key managerial employee; and WHEREAS, Nauert desires to be employed by Pioneer Financial on the terms set forth herein: NOW, THEREFORE, for and in consideration of the covenants contained herein, Pioneer Financial hereby employs Nauert and Nauert accepts such employment with Pioneer Financial upon the terms and conditions hereinafter set forth. 1. Employment. Pioneer Financial hereby employs Nauert and Nauert hereby agrees to be employed by Pioneer Financial for a term of three (3) calendar years commencing on the first day of January, 1994, and continuing through the 31st day of December, 1996 and for successive three- year periods thereafter until terminated as provided herein, to perform the duties set forth herein. 2. Duties. Subject to the control of the Board of Directors of Pioneer Financial, Nauert shall serve during the Term as Chairman and Chief Executive Officer of Pioneer Financial and in such capacity shall render such services as the Board of Directors of Pioneer Financial shall direct. In addition, Nauert shall serve in such other offices or capacities as the Board of Directors of Pioneer Financial may from time to time determine. Nauert shall have such executive powers and authority as may reasonably be required by him in order to discharge such duties in an efficient and proper manner. 3. Compensation. Pioneer Financial shall in the aggregate pay to Nauert for all services to be rendered hereunder: (a) an annual salary in the amount of $600,000; provided that the Board of Directors of Pioneer Financial shall annually make a review of Nauert's salary and increase such annual salary as it deems appropriate; and (b) an annual bonus, as determined by the compensation committee of the Board of Directors of Pioneer Financial, based upon achieving the Pioneer Financial's company-wide performance standards as established by such committee. 4. Loan. As further compensation to Nauert for his employment hereunder, Pioneer Financial agrees to make available to Nauert at any time prior to June 30, 1994, a three-year term loan not in excess of $1,300,000 of principal indebtedness at an annual rate of interest of 3.71% payable annually, said loan to provide Nauert forgiveness not in excess of 50% of the initial principal indebtedness dependent on PFSI's attaining, as of 12/31/96, either of the following specified performance goals of PFSI's compensation committee: Specified 12/31/96 Amount of Loan PFSI Performance Goals Forgiveness at 12/31/96 Cumulative, fully diluted $325,000, loan PFSI GAAP net income per forgiveness common share ("Cumulative EPS") from 1/1/94 through 12/31/96, inclusive, of $4.50 Cumulative EPS from From Cumulative EPS (but 1/1/94 through 12/31/96, not to exceed $7.50) inclusive, greater than subtract $4.50, divide $4.50 the result by $3.00 and multiply the resulting quotient by $975,000. Add the amount so produced to $325,000 to arrive at loan forgiveness. Said loan shall be evidenced by a Note in a form substantially similar to Exhibit "A" hereto. 5. Benefits. During his employment hereunder, Nauert shall be entitled to participate in all employee benefits made available to management personnel of Pioneer Financial and its subsidiaries. 6. Death. Nauert's employment by Pioneer Financial will terminate immediately upon his death. No compensation for any period after Nauert's death will be payable to Nauert's estate. 7. Disability. If during Nauert's employment hereunder, Nauert becomes totally or partially disabled, Pioneer Financial shall continue to pay to Nauert as long as such disability continues during the Term (or until Nauert's employment is terminated by Pioneer Financial in accordance with Section 8 (if earlier)) the level of annual salary payable to Nauert at the date his disability is determined, reduced dollar-for-dollar to the extent of any disability insurance payments paid to Nauert through insurance programs, the premiums for which were paid by Pioneer Financial or its Subsidiaries or affiliates. For purposes of this Agreement, the term "total disability" shall mean Nauert's inability due to illness, accident or other physical or mental incapacity to engage in the full time performance of his duties under this Agreement as reasonably determined by the Board of Directors of Pioneer Financial based on such evidence as such Board shall deem appropriate. For purposes of this Agreement, "partial disability" shall mean Nauert's ability due to illness, accident or other physical or mental incapacity to engage in only the partial performance of his duties under this Agreement, as reasonably determined by the Board of Directors of Pioneer Financial based on such evidence as such Board shall deem appropriate. 8. Termination. (a) For Cause. Pioneer Financial shall have the right to terminate Nauert's employment hereunder at any time during the Term "for cause". For purposes of this Agreement, "for cause" shall mean any of the following actions (or inactions) by Nauert: illegal conduct of a severity greater than a misdemeanor, gross neglect of, and the continued failure to perform substantially, Nauert's duties under this Agreement. Notwithstanding anything herein to the contrary, Nauert's inability to perform the duties of his position due to his total or partial disability (as defined herein) shall not be deemed to constitute cause. If, in the opinion of the Board of Directors of Pioneer Financial, Nauert's employment shall become subject to termination for cause, such Board of Directors shall give Nauert notice to that effect, which notice shall describe the matter or matters constituting such cause. Thereafter, for a period of thirty (30) days from the receipt of such notice, Nauert shall have the opportunity to eliminate or cure the matter or matters constituting such cause. If at the end of such thirty (30) day period, Nauert has not substantially eliminated or cured each such matter or matters, then Pioneer Financial shall have the right to give Nauert notice of the termination of his employment. Nauert's employment hereunder shall be considered terminated for cause as of the date specified in such notice of termination unless and until there is a final determination by a court of competent jurisdiction that the cause of termination of Nauert's employment did not exist at the time of giving said notice of termination. Upon termination of Nauert's employment "for cause," this Agreement shall terminate without further obligations to Nauert other than Pioneer Financial's obligation (a) to pay to Nauert in a lump sum in cash within 30 days after the date of termination Nauert's base salary through the date of termination to the extent not theretofore paid and (b) to the extent not theretofore paid or provided, to pay or provide, to Nauert on a timely basis any other amounts or benefits required to be paid or provided or which Nauert is eligible to receive under any plan, program, policy or practice or contract or agreement of Pioneer Financial. (b) Without Cause. Pioneer Financial shall have the right to terminate Nauert's employment hereunder without cause at any time during the Term. If the Board of Directors determines to terminate Nauert's employment without cause, Pioneer Financial shall give notice of the termination to Nauert and Nauert's employment hereunder shall be considered terminated without cause as of the date specified in such notice of termination. Upon the date of the termination of Nauert's employment without cause, Nauert shall be paid an amount equal to the present value, discounted to the present at an annual rate of 8%, of the salary which would have been payable during a period of twenty-four (24) months commencing on the date of termination at the level of annual salary payable to Nauert at the date of termination. (c) By Nauert. Nauert may terminate his employment hereunder at any time by retirement or resignation, upon notice to Pioneer Financial. Upon such termination by Nauert, no compensation for any period after the date of such termination shall be payable to Nauert; provided, however, that if such termination by Nauert is for "good reason" (as defined in Section 9(c)), then Nauert shall be entitled to the payment described in the last sentence of Section 8(b). (d) Change in Control Effect. No payments shall be made to Nauert pursuant to this Section 8 in the event that Nauert is entitled to Change in Control Compensation pursuant to Section 9. 9. Change in Control. (a) Change in Control Severance Compensation. If, within two years following a "change in control", Nauert's employment is terminated by Pioneer Financial other than "for cause" (as defined in Section 8(a)) or is terminated by Nauert for "good reason" (as defined in Section 9(c)), Nauert shall be entitled to receive from Pioneer Financial a lump sum cash payment in an amount equal to three times his annual salary for the year in which such termination occurs ("Change in Control Compensation"). Pioneer Financial shall pay such amount to Nauert within ten (10) days of the date of termination. If Nauert's employment is terminated by Pioneer Financial for cause, by reason of Nauert's death or retirement, or by Nauert without good reason, the Change in Control Compensation will not be paid. If Nauert was totally or partially disabled as of the Change in Control, the Change in Control Compensation will not be paid. (b) Change in Control. For purposes of this Agreement, "Change in Control" shall mean the occurrence of any of the following events: (i) any person or persons acting as a group, other than a person which as of the date of this Agreement is the beneficial owner of voting securities of Pioneer Financial and other than Nauert or a group including Nauert, shall become the beneficial owner of securities of Pioneer Financial representing at least twenty percent (20%) of the combined voting power of Pioneer Financial's then outstanding securities; or (ii) any consolidation or merger to which Pioneer Financial is a party, if following such consolidation or merger, stockholders of Pioneer Financial immediately prior to such consolidation or merger shall not beneficially own securities representing at least eighty-one percent (81%) of the combined voting power of the outstanding voting securities of the surviving or continuing corporation; or (iii) any sale, lease, exchange or other transfer (in one transaction or in a series of related transactions) of all, or substantially all, of the assets of Pioneer Financial, other than to an entity (or entities) of which Pioneer Financial or the stockholders of Pioneer Financial immediately prior to such transactions beneficially own securities representing at least eighty-one percent (81%) of the combined voting power of the outstanding voting securities. (c) Good Reason. For purposes of this Agreement, "good reason" shall mean any of the following: (i) the assignment to Nauert of any duties or responsibilities which are inconsistent with Nauert's status and position in effect immediately prior to the Change in Control, or a reduction in the duties and responsibilities exercised by Nauert immediately prior to the Change in Control; (ii) any action by Pioneer Financial which renders Nauert unable to effectively discharge the duties and responsibilities exercised by Nauert immediately prior to the Change in Control; (iii) a reduction in Nauert's level of annual salary as in effect immediately prior to the Change in Control or failure to maintain Nauert's minimum annual salary in accordance with Section 3(a); (iv) a failure by Pioneer Financial to continue in effect, without material change, any benefit or incentive plan or arrangement in which Nauert participated immediately prior to the Change in Control, or the taking of any action by Pioneer Financial which would materially and adversely affect Nauert's participation in or materially reduce Nauert's benefits under any such plan or arrangement; (v) a relocation of Nauert's workplace by Pioneer Financial to any place more than twenty-five (25) miles from the location at which Nauert performed his duties immediately prior to the Change in Control, except for required travel by Nauert on Pioneer Financial's business to an extent substantially consistent with Nauert's business travel obligations immediately prior to the Change in Control; (vi) a failure by Pioneer Financial to provide to Nauert paid vacation benefits on the basis and to extent provided immediately prior to the Change in Control; or (vii) any failure by Pioneer Financial to obtain the assumption of this Agreement by any successor or assignee thereto. (d) Gross-Up. In the event that any payment received or to be received by Nauert in connection with a Change in Control of Pioneer Financial or the termination of Nauert's employment (whether payable pursuant to the terms of this Agreement or any other plan, arrangement or agreement with Pioneer Financial or any person whose actions result in a Change in Control of Pioneer Financial or any person affiliated with Pioneer Financial or such person (the "Change in Control Payments") will be subject to the tax (the "Excise Tax") imposed by Section 4999 of the Internal Revenue Code, as amended (the "Code"), Pioneer Financial shall pay to Nauert, upon payment of the Change in Control Compensation, an additional amount (the "Gross-Up Payment") such that the net amount retained by Nauert, after deduction of any Excise Tax on the Change in Control Payments and any federal and state and local income tax and Excise Tax upon the Gross-Up Payment, shall be equal to the Change in Control Payments. For purposes of determining whether any of the Change in Control Payments will be subject to the Excise Tax and the amount of such Excise Tax, any Change in Control Payments shall be treated as a "parachute payment" within the meaning of Section 280G(b)(2) of the Code, and all "parachute payments" in excess of the "base amount" within the meaning of Section 280G(b)(3) of the Code shall be treated as subject to the Excise Tax, unless in the opinion of tax counsel selected by Pioneer Financial and acceptable to Nauert such Change in Control Payments (in whole or in part) do not constitute parachute payments, or such parachute payments in excess of the base amount (in whole or in part) are otherwise not subject to the Excise Tax. For purposes of determining the amount of the Gross-Up Payment, Nauert shall be deemed to pay federal income taxes at the highest marginal rate of federal income taxation in the calendar year in which the Gross-Up Payment is to be made and state and local income taxes at the highest marginal rate of taxation in the state and locality of his residence on the date of termination, net of the maximum reduction in federal income taxes which could be obtained from deduction of such state and local taxes. In the event that the Excise Tax is subsequently determined to be less than the amount originally taken into account hereunder Nauert shall repay to Pioneer Financial at the time that the amount of such reduction in Excise Tax is finally determined, the portion of the Gross-Up Payment attributable to such reduction plus interest on the amount of such repayment at the rate provided in Section 1274(b)(2)(B) of the Code. In the event that the Excise Tax is determined to exceed the amount originally taken into account hereunder, Pioneer Financial shall make an additional Gross-Up Payment in respect of such excess at the time that the amount of such excess is finally determined. Nauert shall notify Pioneer Financial of any audit or review by the Internal Revenue Service of Nauert's federal income tax return for the year in which a Change in Control Payment or Gross-Up Payment under this Agreement is made within ten (10) days of Nauert's receipt of notification of such audit or review. In addition, Nauert shall also notify Pioneer Financial of the final resolution of such audit or review within ten (10) days of such resolution. 10. Confidential Information and Trade Secrets. (a) Nature. During Nauert's employment by Pioneer Financial, Nauert will enjoy access to Pioneer Financial's "confidential information" and "trade secrets". For purposes of this Agreement, "confidential information" shall mean information which is not publicly available, including without limitation, information concerning customers, material sources, suppliers, financial projections, marketing plans and operation methods, Nauert's access to which derives solely from Nauert's employment with Pioneer Financial. For purposes of this Agreement, "trade secrets" shall mean Pioneer Financial's processes, methodologies and techniques known only to those employees of Pioneer Financial who need to know such secrets in order to perform their duties on behalf of Pioneer Financial. Pioneer Financial take numerous steps, including these provisions, to protect the confidentiality of its confidential information and trade secrets, which it considers unique, valuable and special assets. (b) Restricted Use and Non-Disclosure. Nauert, recognizing Pioneer Financial's significant investment of time, efforts, and money in developing and preserving its confidential information, shall not, during his employment hereunder and for a two (2) year period after the end of Nauert's employment hereunder, use for his direct or indirect personal benefit any of Pioneer Financial's confidential information or trade secrets. For a two (2) year period after the end of Nauert's employment hereunder, Nauert shall not disclose to any person any of Pioneer Financial's confidential information or trade secrets. (c) Return of Pioneer Financial Property. Upon termination of Nauert's employment with Pioneer Financial, for whatever reason and in whatever manner Nauert shall return to Pioneer Financial all copies of all writings and records relating to Pioneer Financial's business, confidential information or trade secrets, which are in Nauert's possession at such time. 11. Non-Competition and Non-Solicitation. (a) Pioneer's Financial Investment. Pioneer Financial is spending and will spend much time, money and effort in building relationships with agents and insureds, and will pay Nauert valuable consideration pursuant hereto in exchange for Nauert's promises herein, including without limitation the covenants in Section 10 and in this Section 11. Pioneer Financial has engaged Nauert as Chairman and Chief Executive Officer of Pioneer Financial in order to, among other reasons, take advantage of Nauert's unique knowledge of, and contacts within, the life and accident and health insurance industry. Further, Pioneer Financial will invest significant time and money in the further development of Nauert's business ability, image and standing. As Nauert is Chairman and Chief Executive Officer of Pioneer Financial, the reputation and success of Nauert will be closely tied to the reputation and success of Pioneer Financial and, during the Term, Nauert will be heavily identified with Pioneer Financial's business. (b) Non-Competition. During Nauert's employment hereunder and for a twelve (12) month period after termination of such employment, unless such termination is made by Pioneer Financial without cause or unless there has been a Change in Control prior to such termination, Nauert shall not engage, directly or indirectly, whether as an owner, partner, employee, officer, director, agent, consultant or otherwise, in any location where Pioneer Financial or any of its subsidiaries is engaged in business after the date hereof and prior to the termination of Nauert's employment, in a business the same as, or similar to, any business now, or at any time after the date hereof and prior to Nauert's termination, conducted by Pioneer Financial or any of its subsidiaries, provided, however, that the mere ownership of 5% or less of the stock of a company whose shares are traded on a national securities exchange or are quoted on the National Association of Securities Dealers Automated Quotation System shall not be deemed ownership which is prohibited hereunder. (c) Non-Solicitation. During the twenty-four (24) month period following termination of Nauert's employment with Pioneer Financial, Nauert shall not, directly or indirectly induce employees of Pioneer Financial or any of its subsidiaries to leave such employment with the result that such employees would engage in business activities which are substantially similar or are closely related to the business activities such employee performed on behalf of Pioneer Financial and which compete against Pioneer Financial. Notwithstanding the above, in the event Nauert is terminated by Pioneer Financial without cause, then the twenty-four (24) month period referred to in this Section 11(c) shall be reduced to twelve (12) months. (d) Enforceability. The necessity of protection against the competition of Nauert and the nature and scope of such protection has been carefully considered by the parties hereto. The parties hereto agree and acknowledge that the duration, scope and geographic areas applicable to the non-competition covenant in this Section 11 are fair, reasonable and necessary, that adequate compensation has been received by Nauert for such obligations, and that these obligations do not prevent Nauert from earning a livelihood. If, however for any reason any court determines that the restrictions in this Agreement are not reasonable, that consideration is inadequate or that Nauert has been prevented from earning a livelihood, such restrictions shall be interpreted, modified or rewritten to include as much of the duration, scope and geographic area identified in this Section 11 as will render such restrictions valid and enforceable. 12. Retention of PFSI Stock. During the Term, Nauert shall retain, directly or indirectly, ownership of not less than 1,000,000 shares of PFSI Common Stock unless, and except to the extent, released from this obligation by a written release from Pioneer Financial. For purposes of this Agreement, "retain indirectly" shall mean and refer to any shares of PFSI Common Stock, which would be considered to be owned by Nauert under Section 267(c), or the income of which would be taxable to Nauert, his spouse or his children, or to any trust of which Nauert would be deemed the owner under any of Sections 671 through 677, inclusive, of the Internal Revenue Code of 1986. 13. Rights of First Refusal. During the Term, Nauert shall not transfer any shares of stock of Pioneer Financial for consideration to any person other than a relative of Nauert, unless Nauert has offered to transfer such shares to Pioneer Financial on the same terms, provided, however, that this provision shall not apply at any time when the average last reported sale price for Common Stock of Pioneer Financial on the New York Stock Exchange for the immediately preceding five trading days is greater than or equal to $12.00 per share. 14. Related Company Agreements and Options. Parties hereto recognize that Pioneer Financial has a number of related companies and that Nauert currently has employment agreements with two such companies, namely, Direct Financial Services, Inc. and National Benefit Plans, Inc. This agreement in no way supersedes or modifies any of the terms, undertaking, responsibilities or rights of any of the parties to said employment agreements. Notwithstanding the foregoing, and in consideration of Pioneer Financial's execution of this Agreement, Nauert agrees to forego his right to certain bonuses equal to 10% of net income under his current employment agreements with Pioneer Financial's subsidiaries National Benefit Plans, Inc. and Direct Financial Services, Inc. 15. Breach or Threatened Breach of Non-Competition Covenant. In the event of a breach or threatened breach by Nauert of any provision of Section 10 or 11 hereof, Nauert acknowledges that the remedy at law would be inadequate and that Pioneer Financial shall be entitled to an injunction restraining Nauert from such act or threatened breach. Nothing herein contained shall be construed as prohibiting Pioneer Financial from pursuing any other remedies available to it for such breach or threatened breach, including the recovery of monetary damages. 16. Business Days. Any date specified in this Agreement which is a Saturday, Sunday or legal holiday shall be extended to the first regular business day after such date which is not a Saturday, Sunday or legal holiday. 17. Choice of Law. This Agreement has been executed and made in accordance with the laws of the State of Illinois and is to be construed, enforced and governed in accordance therewith. 18. Counterparts. This Agreement may be executed in several counterparts, each of which shall be an original, but all of which together shall constitute one and the same instrument. 19. Entire Agreement Amendments. This Agreement contains the entire agreement among the parties hereto with respect to the subject matter hereof. No change or modification of this Agreement, or any waiver of the provisions hereof, shall be valid unless same is in writing and signed by the parties hereto. Waiver by any party hereto of a breach by the other party of any provisions of this Agreement shall not operate or be construed as a waiver of any subsequent breach by such party. 20. Headings. The headings used herein are for each of interpretation and shall have no effect on the interpretation of any provision of this Agreement. 21. Notices. All notices, requests, demands and other communications hereunder shall be in writing and shall, until receipt of contrary written instructions, be delivered personally to, or mailed by certified or registered mail with proper postage prepaid, to the party at the address as follows: To Pioneer Financial: Pioneer Financial Services, Inc. 304 N. Main Street Rockford, Illinois 61101 To Nauert: Mr. Peter W. Nauert 5019 Parliament Place Rockford, Illinois 61107 22. Severability. If any provision of this Agreement is held for any reason to be invalid, it will not invalidate any other provisions of this Agreement which are in themselves valid, nor will it invalidate the provisions of any other agreement between the parties hereto. Rather, such invalid provision shall be construed so as to give it the maximum effect allowed by applicable law. Any other written agreement between the parties hereto shall be conclusively deemed to be an agreement independent of this Agreement. 23. Successors and Assigns. This Agreement and all the provisions hereof shall be binding upon and inure to the benefit of the parties hereto and their respective heirs, legal representatives, successors and permitted assigns. This Agreement and the rights and obligations hereunder may not be assigned by either party without the prior written consent of the other. 24. Time of the Essence. Time is of the essence of this Agreement. IN WITNESS WHEREOF, the parties hereto have caused this Employment Agreement to be executed on the date first above written. Attest: "Pioneer Financial" PIONEER FINANCIAL SERVICES, INC. /s/ Chuck R. Scheper By: /s/ Karl-Heinz Klaeser Title: Chairman - Compensation Committee Witness: "Nauert" /s/ Philip J. Urbanek /s/ Peter W. Nauert Peter W. Nauert EXHIBIT A $1,300,000 Rockford, Illinois January 1, 1994 NON-NEGOTIABLE PROMISSORY NOTE ______________________________ For value received, PETER W. NAUERT ("Nauert") hereby promises to pay to PIONEER FINANCIAL SERVICES, INC., a Delaware corporation ("PFSI"), at its principal office at 304 N. Main Street, Rockford, Illinois or such other address as the holder hereof may designate, the sum of One Million, Three Hundred Thousand and No/One Hundredths Dollars ($1,300,000.00). Payment shall be made in a single payment on the last day of December, 1996. In addition, on the 31st day of December, 1994, 1995 and 1996, Nauert shall pay PFSI interest at the rate of 3.71 percent per annum on the principal balance outstanding from time to time computed from the date hereof until paid. This Note is the note referred to in, and is being issued to Nauert by PFSI in accordance with Paragraph 14 of that certain Employment Agreement dated __________, 1993 by and between Nauert and PFSI, and is subject thereto. Any payment due under this Note may be prepaid in whole or in part at any time and from time to time before its payments date. Any such prepayment shall be first applied against the principal amount of this Note and then against interest accrued thereon. Notwithstanding the foregoing, in the event either of the following specified performance goals of PFSI's compensation committee is achieved, the initial principal indebtedness of $1,300,000 shall be forgiven as of 12/31/96 as follow: Specified 12/31/96 Amount of Loan PFSI Performance Goals Forgiveness at 12/31/96 ______________________ _______________________ Cumulative, fully diluted $325,000, loan PFSI GAAP net income per forgiveness common share ("Cumulative EPS") from 1/1/94 through 12/31/96, inclusive, of $4.50 Specified 12/31/96 Amount of Loan PFSI Performance Goals Forgiveness at 12/31/96 ______________________ _______________________ Cumulative EPS from From Cumulative EPS (but 1/1/94 through 12/31/96, not to exceed $7.50) inclusive, greater than subtract $4.50, divide $4.50 the result by $3.00 and multiply the resulting quotient by $975,000. Add the amount so produced to $325,000 to arrive at loan forgiveness. In the event that PFSI's GAAP financial results as of 12/31/96 are not determinable with reasonable accuracy on 12/31/96, or even upon the due date of this Notice if such date is after 12/31/96, the PFSI's compensation committee may estimate the amount of forgiveness for purposes of Nauert's timely payoff of this Note, less the forgiveness. In such event, not later than June 30, 1997, PFSI's compensation committee shall obtain certified GAAP financial results for PFSI as of 12/31/96 and submit such certified financial results to Nauert. At such time, the difference between the amount of forgiveness previously estimated and allowed Nauert at the time of this Note's repayment and the amount of such forgiveness indicated by said certified financial results shall be reimbursed by PFSI to Nauert, or paid by Nauert to PFSI, as the case may be, together with interest thereon at the rate of 8% per annum from the date of this Note's repayment to the date of said reimbursement, or payment, as the case may be. The following shall be deemed events of default hereunder: (a) failure by Nauert to make any payment hereunder within five (5) business days of the due date of such payment; (b) the filing by Nauert of a voluntary petition, or the filing against Nauert of an involuntary petition which is not dismissed within sixty (60) days, under the provisions of Title 11 of the United State Code or any state insolvency law; (c) application for or appointment of a receiver for Nauert; (d) issuance of a warrant of attachment or writ of execution against Nauert or his property; (e) any assignment by Nauert for the benefit of his creditors; or (f) termination by Nauert of his employment under the above referenced Employment Agreement, except for "good reason" (as defined in Section 9(c) of said Employment Agreement). Upon the occurrence of an event of default hereunder, the holder may, at his option, declare the entire unpaid balance of the principal hereunder, together with interest thereon, immediately due and payable by delivering to Nauert written notice of such effect. Nauert hereby waives presentment for payment, notice of dishonor, protest or diligence in bringing suit hereon. In the event any payments herein provided for shall not be made at the time they shall become due, Nauert shall reimburse the holder hereof for all costs of collection and for reasonable attorneys' fees incurred to obtain such payments. This Note shall be construed in accordance with and governed in all respects by the laws and decisions of the State of Illinois. /s/ Peter W. Nauert Peter W. Nauert Exhibit 10(n) CREDIT AGREEMENT Dated as of December 22, 1993 among PIONEER FINANCIAL SERVICES, INC., AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO, as Agent and AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO, FIRSTAR BANK MILWAUKEE, N.A. and BANK ONE, ROCKFORD, NA Page SECTION 1 CERTAIN DEFINITIONS . . . . . . . . . . . . . . 1 SECTION 1.1 Terms Defined in this Agreement . . . . . . . . . . 1 SECTION 2 BANK'S COMMITMENT; BORROWING PROCEDURES; LCs . . . . . . . 11 SECTION 2.1 Bank's Commitment to Make Loans . . . . . . . . . . 11 SECTION 2.3 Procedure for Borrowing . . . . . . . . . . . . . . 12 SECTION 2.4 Conversion and Continuation Elections. . . . . . . 13 SECTION 2.5 LC Documentation. . . . . . . . . . . . . . . . . . 15 SECTION 2.6 Agreement to Repay LC Drawings. . . . . . . . . . . 17 SECTION 2.6A Participations. . . . . . . . . . . . . . . . . . . 17 SECTION 2.7 Mandatory Payment of LC Liability. . . . . . . . . 20 SECTION 2.8 LC Operations. . . . . . . . . . . . . . . . . . . 20 SECTION 2.9 Voluntary Termination or Reduction of Commitments. . . . . . . . . . . . . . . . . . . . . . . . . 21 SECTION 2.11 Mandatory Prepayment. . . . . . . . . . . . . . . . 21 SECTION 2.12 Repayment. . . . . . . . . . . . . . . . . . . . . 21 SECTION 3 NOTES EVIDENCING THE LOANS . . . . . . . . . . . . . 22 SECTION 3.1 Notes . . . . . . . . . . . . . . . . . . . . . . . 22 SECTION 4 INTEREST, FEES AND COSTS . . . . . . . . . . 22 SECTION 4.1 Interest . . . . . . . . . . . . . . . . . . . . . 22 SECTION 4.2 Fees. . . . . . . . . . . . . . . . . . . . . . . . 23 (a) Closing Fee. . . . . . . . . . . . . . . . . . . . . . . 23 (b) Unused Commitment Fees. . . . . . . . . . . . . . . . . 23 (c) Letter of Credit Fees. . . . . . . . . . . . . . . . . . 23 (d) Letter of Credit Issuance Fees. . . . . . . . . . . . . 23 SECTION 4.3 Computation of Fees and Interest. . . . . . . . . . 24 SECTION 4.4 Increased Costs; Capital Adequacy . . . . . . . . . 24 SECTION 4.5 Funding Losses. . . . . . . . . . . . . . . . . . . 26 SECTION 5 MAKING OF PAYMENTS . . . . . . . . . . . . . . . 26 SECTION 5.1 Payments by the Company . . . . . . . . . . . . . . 26 SECTION 5.2 Payments by the Banks to the Agent. . . . . . . . . 27 SECTION 5.3 Setoff . . . . . . . . . . . . . . . . . . . . . . 28 SECTION 5.4 Sharing of Payments. . . . . . . . . . . . . . . . 29 SECTION 6 REPRESENTATIONS AND WARRANTIES . . . . . . . . . . . . 29 SECTION 6.1 Corporate Organization . . . . . . . . . . . . . . 29 SECTION 6.2 Authorization; No Conflict . . . . . . . . . . . . 30 SECTION 6.3 Validity and Binding Nature . . . . . . . . . . . . 30 SECTION 6.4 Financial Statements . . . . . . . . . . . . . . . 30 i SECTION 6.5 Litigation and Contingent Liabilities . . . . . . . 30 SECTION 6.6 Employee Benefit Plans . . . . . . . . . . . . . . 31 SECTION 6.7 Investment Company Act . . . . . . . . . . . . . . 32 SECTION 6.8 Regulation U . . . . . . . . . . . . . . . . . . . 32 SECTION 6.9 Accuracy of Information . . . . . . . . . . . . . . 32 SECTION 6.10 Labor Controversies . . . . . . . . . . . . . . . . 32 SECTION 6.11 Tax Status . . . . . . . . . . . . . . . . . . . . 32 SECTION 6.12 No Default . . . . . . . . . . . . . . . . . . . . 33 SECTION 6.13 Compliance with Applicable Laws . . . . . . . . . . 33 SECTION 6.14 Insurance . . . . . . . . . . . . . . . . . . . . . 33 SECTION 6.15 Solvency. . . . . . . . . . . . . . . . . . . . . . 33 SECTION 6.16 Use of Proceeds. . . . . . . . . . . . . . . . . . 34 SECTION 6.17 Subsidiaries. . . . . . . . . . . . . . . . . . . . 34 SECTION 7 COVENANTS . . . . . . . . . . . . . . . . . 34 SECTION 7.1 Reports, Certificates and Other Information . . . . 34 (a) Annual Report. . . . . . . . . . . . . . . . . . . . . . 35 (b) Interim Reports. . . . . . . . . . . . . . . . . . . . . 35 (c) Statutory Statements. . . . . . . . . . . . . . . . . . 35 (d) Reports to SEC. . . . . . . . . . . . . . . . . . . . . 35 (e) Certificates . . . . . . . . . . . . . . . . . . . . . . 35 (f) Notice of Default, Litigation and ERISA Matters . . . . 35 (g) Other Information . . . . . . . . . . . . . . . . . . . 36 SECTION 7.2 Corporate Existence and Franchises . . . . . . . . 36 SECTION 7.3 Books, Records and Inspections . . . . . . . . . . 36 SECTION 7.4 Insurance . . . . . . . . . . . . . . . . . . . . . 36 SECTION 7.5 Taxes and Liabilities . . . . . . . . . . . . . . . 37 SECTION 7.6 Cash Flow Coverage . . . . . . . . . . . . . . . . 37 SECTION 7.7 Net Worth. . . . . . . . . . . . . . . . . . . 37 SECTION 7.8 Funds for Refinancing. . . . . . . . . . . . . 37 SECTION 7.9 Indebtedness. . . . . . . . . . . . . . . . . 37 SECTION 7.10 Risk-Based Capital . . . . . . . . . . . . . . . . 38 SECTION 7.11 Real Estate Concentration. . . . . . . . . . . . . 38 SECTION 7.12 Investment Quality. . . . . . . . . . . . . . . . . 38 SECTION 7.13 Intentionally Omitted. . . . . . . . . . . . . . . 38 SECTION 7.14 Insurance Company Leverage Ratio. . . . . . . . . 38 SECTION 7.15 Intentionally Omitted. . . . . . . . . . . . . . . 38 SECTION 7.17 Change in Nature of Business . . . . . . . . . . . 39 SECTION 7.18 Depository Relationship . . . . . . . . . . . . . . 39 SECTION 7.19 Employee Benefit Plans . . . . . . . . . . . . . . 40 SECTION 7.20 Use of Proceeds . . . . . . . . . . . . . . . . . . 40 SECTION 7.21 Other Agreements . . . . . . . . . . . . . . . . . 40 SECTION 7.22 Compliance with Applicable Laws . . . . . . . . . . 40 SECTION 7A UNRESTRICTED SUBSIDIARIES . . . . . . . . . . . . . 40 SECTION 7A.1 Unrestricted Subsidiaries. . . . . . . . . . . . . 40 SECTION 7A.2 Additional Unrestricted Subsidiaries. . . . . . . . 41 SECTION 7A.3 Effectiveness of Designation. . . . . . . . . . . . 42 SECTION 8 ii CONDITIONS TO MAKING LOANS AND ISSUING LCS . . . . . . . . 42 SECTION 8.1 Initial Loans. . . . . . . . . . . . . . . . . . . 42 (a) Fees and Expenses . . . . . . . . . . . . . . . . . . . 42 (b) Documents . . . . . . . . . . . . . . . . . . . . . . . 42 SECTION 8.2 All Loans and LCs. . . . . . . . . . . . . . . . . 43 (a) No Default, etc. . . . . . . . . . . . . . . . . . . . . 44 (b) Notice. . . . . . . . . . . . . . . . . . . . . . . . . 44 SECTION 9 EVENTS OF DEFAULT AND THEIR EFFECT . . . . . . . . . . . 44 SECTION 9.1 Events of Default . . . . . . . . . . . . . . . . . 44 (a) Nonpayment of the Loan . . . . . . . . . . . . . . 44 (b) Nonpayment of Other Indebtedness . . . . . . . . . . . . 44 (c) Bankruptcy or Insolvency . . . . . . . . . . . . . . . . 45 (d) Specified Noncompliance with this Agreement . . . . . . 45 (e) Other Noncompliance with this Agreement . . . . . . . . 45 (f) Representations and Warranties . . . . . . . . . . . . . 45 (g) Employee Benefit Plans . . . . . . . . . . . . . . . . . 46 (h) Judgments . . . . . . . . . . . . . . . . . . . . . . . 46 SECTION 9.2 Effect of Event of Default . . . . . . . . . . . . 46 SECTION 9A THE AGENT . . . . . . . . . . . . . . . . . 47 SECTION 9A.1 Appointment and Authorization . . . . . . . . . . . 47 SECTION 9A.2 Delegation of Duties . . . . . . . . . . . . . . . 47 SECTION 9A.3 Liability of Agent . . . . . . . . . . . . . . . . 47 SECTION 9A.4 Reliance by Agent . . . . . . . . . . . . . . . . . 47 SECTION 9A.5 Notice of Default . . . . . . . . . . . . . . . . . 48 SECTION 9A.6 Credit Decision . . . . . . . . . . . . . . . . . . 48 SECTION 9A.7 Indemnification . . . . . . . . . . . . . . . . . . 49 SECTION 9A.8 Agent in Individual Capacity . . . . . . . . . . . 50 SECTION 9A.9 Successor Agent . . . . . . . . . . . . . . . . . . 50 SECTION 10 GENERAL . . . . . . . . . . . . . . . . . 50 SECTION 10.1 Amendments and Waivers . . . . . . . . . . . . . . 50 SECTION 10.2 Notices . . . . . . . . . . . . . . . . . . . . . . 51 SECTION 10.3 Accounting Terms; Computations . . . . . . . . . . 52 SECTION 10.4 Costs, Expenses and Taxes . . . . . . . . . . . . . 52 SECTION 10.5 Indemnification . . . . . . . . . . . . . . . . . . 53 SECTION 10.6 Captions and References . . . . . . . . . . . . . . 53 SECTION 10.7 No Waiver; Cumulative Remedies. . . . . . . . . . . 53 SECTION 10.8 Governing Law; Jury Trial; Severability . . . . . . 54 SECTION 10.9 Counterparts . . . . . . . . . . . . . . . . . . . 55 SECTION 10.10 Successors and Assigns . . . . . . . . . . . . . . 55 SECTION 10.11 Prior Agreements . . . . . . . . . . . . . . . . . 55 SECTION 10.12 Assignments; Participations . . . . . . . . . . . . 55 SECTION 10.13 Confidentiality. . . . . . . . . . . . . . . . . . 56 SECTION 10.14 Notification of Addresses, Etc. . . . . . . . 57 iii EXHIBITS EXHIBIT A Form of Note EXHIBIT B Form of Notice of Borrowing EXHIBIT C Form of Notice of Conversion/Continuation iv CREDIT AGREEMENT This Credit Agreement dated as of December 22, 1993 (this "Agreement"), is among (i) PIONEER FINANCIAL SERVICES, INC., a Delaware corporation (herein, together with its successors and assigns, called the "Company"), (ii) AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO, as administrative agent (in such capacity, the "Agent") and (iii) AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO, a national banking association (herein, together with its successors and assigns, called the "ANB"), FIRSTAR BANK MILWAUKEE, N.A., a national banking association (herein, together with its successors and assigns, called "Firstar") and BANK ONE, ROCKFORD, NA, a national banking association (herein, together with its successors and assigns, called "Bank One") (ANB, Firstar and Bank One collectively referred to as the "Banks" and individually as a "Bank"). W I T N E S S E T H: WHEREAS, the Company has requested the Banks severally to make available to the Company a revolving credit facility for the purposes as set forth herein; and WHEREAS, the Banks are willing to make available to the Company a revolving facility in the aggregate amount of $20,000,000, under which each Bank severally shall lend funds and ANB, in its capacity as Issuing Bank, shall issue letters of credit from time to time to or for the benefit of the Company subject to the terms and conditions set forth in this Agreement; NOW, THEREFORE, in consideration of the mutual agreements contained herein, the parties hereto agree as follows: SECTION 1 CERTAIN DEFINITIONS SECTION 1.1 Terms Defined in this Agreement. When used herein the following terms shall have the following respective meanings: "Adjusted Capital and Surplus" means, with respect to each Insurance Subsidiary as of any date, the sum of (i) Capital and Surplus for such Insurance Subsidiary and (ii) the asset valuation reserve of such Insurance Subsidiary as of such date determined in accordance with Statutory Accounting Principles. "Affiliate" means, with respect to any Person, any other Person directly or indirectly controlling, controlled by, or under direct or indirect common control with, such Person. A Person shall be deemed to control another Person if such first Person possesses, directly or indirectly, the power to direct or cause the direction of the management and policies of such other Person, whether through ownership of voting securities, by contract or otherwise. "Agent's Payment Office" means the address for payments set forth on the signature page hereto in relation to the Agent or such other address as the Agent may from time to time specify in accordance with Section 10.2. "Agent-Related Persons" means the Agent and any successor Agent appointed under Section 9A.9, together with their respective Affiliates, and the officers, directors, employees, agents and attorneys-in-fact of such Persons and Affiliates. "Aggregate Commitment" means the combined Commitments of the Banks in the amount of twenty million dollars ($20,000,000), as such amount may be reduced from time to time pursuant to this Agreement. "Aggregate Stated Amount" shall mean, as of the date of determination, the aggregate Stated Amounts of all LCs. "Agreement" means this Credit Agreement as it may be amended, supplemented or otherwise modified from time to time in accordance with the terms hereof. "ANB" - see Preamble. "Applicable Margin" means (a) with respect to Base Rate Loans, -0-, (b) with respect to CD Rate Loans, two percent (2.00%) per annum, and (c) with respect to Eurodollar Rate Loans, two percent (2.00%) per annum. "Authorized Control Level RBC" shall have the same meaning as the term "Authorized Control Level RBC" as defined in the NAIC Risk-Based Capital (RBC) for Life and/or Health Insurers Model Act, as such term may be amended by the NAIC from time to time. "Authorized Officer" means the Chairman, the President, any Executive Vice President, the Treasurer or any Vice Presidents of the Company that are designated as authorized officers pursuant to a resolution of the Board of Directors of the Company (each Bank shall be entitled to rely on such resolution until revoked or amended in writing by the Company). "Available Cash Flow" means, for any accounting period, without duplication of items that may be included in more than one of the following computations, the sum of (i) the aggregate Distributable Profits from the Insurance Subsidiaries for such period, and (ii) the combined net after tax income of the Non-Insurance Operating Subsidiaries for such period, plus depreciation, amortization and other non-cash expenses of the Non-Insurance Operating Subsidiaries for such period, minus all capitalized expenditures of the Non-Insurance Operating Subsidiaries for such period, all to be determined in accordance with GAAP. "Bank" or "Banks" - see Preamble. "Bank Parties" - see Section 10.5. "Base Rate" means at any time and from time to time the rate of interest per annum which ANB most recently announced as its base rate at Chicago, Illinois, which rate shall not necessarily be the lowest rate of interest which ANB charges its customers. "Base Rate Loan" means a Loan that bears interest based on the Base Rate. "Borrowing" means a borrowing hereunder consisting of the several Loans made to the Company on the same day by each Bank pursuant to Section 2 hereof and having the same interest rate basis and Interest Period. "Business Day" means any day of the year on which each Bank is open for business in the city where such Bank's main office is located. "Capital and Surplus" means, with respect to each Insurance Subsidiary, such Insurance Subsidiary's capital and surplus as reported on such Insurance Subsidiary's Statutory Statements most recently filed with the department of insurance of such Insurance Subsidiary's state of incorporation. "CD Rate" means with respect to each Interest Period to be applicable to a CD Rate Loan, the rate of interest per annum payable on a certificate or certificates of deposit purchased by the Company from ANB concurrently in connection with the extension of a CD Rate Loan. "CD Rate Loan" means a Loan that bears interest based on the CD Rate. "Clean-up Date" shall mean the first day of any Clean-up Period. "Clean-up Period" shall mean, during such period of twelve consecutive months determined on a rolling basis, any period of sixty consecutive days in which no Loans are outstanding. "Closing Date" means the date on which all conditions precedent set forth in Section 8.1 are satisfied or waived by all the Banks. "Commitment", with respect to each Bank, has the meaning specified in Section 2.1. "Commitment Percentage" means, as to any Bank, the percentage equivalent at the time of determination of such Bank's Commitment divided by the Aggregate Commitment. "Company" - see Preamble. "Conversion Date" means any date on which the Company converts a Base Rate Loan to a Eurodollar Rate Loan or a CD Rate Loan; a CD Rate Loan to a Eurodollar Rate Loan or a Base Rate Loan; or a Eurodollar Rate Loan to a CD Rate Loan or a Base Rate Loan. "Debt Service Requirements" means, for any accounting period, the aggregate of the principal, interest and other dividends, payments or distributions made or required to be made (i) to each Bank under this Agreement, (ii) with respect to other Indebtedness and (iii) with respect to the Preferred Stock. "Distributable Profits" means, for any accounting period, (i) the greater of (A) 10% of the aggregate Capital and Surplus of all Insurance Subsidiaries, and (B) the aggregated net after-tax profits of all Insurance Subsidiaries, determined in accordance with Statutory Accounting Principles for such period minus (ii) the after-tax profits of each Principal Insurance Subsidiary that must be retained by such Principal Insurance Subsidiary to maintain the Total Adjusted Capital required by Section 7.10.y "Dollar(s)" and the sign "$" means lawful money of the United States of America. "Environmental Laws" means any and all federal, state or local environmental or health and safety-related laws, regulations, rules, ordinances, orders or directives. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended, and any successor statute of similar import, together with the regulations thereunder and under the Internal Revenue Code of 1986, as amended, in each case as in effect from time to time. References to sections of ERISA shall be construed to also refer to any successor sections. "ERISA Affiliate" means any corporation, trade or business that is, along with the Company, a member of a controlled group of corporations or a controlled group of trades or businesses, as described in Sections 414(b) and 414(c), respectively, of the Internal Revenue Code of 1986, as amended, or Section 4001 of ERISA. "Eurodollar Rate Loan" means a Loan that bears interest based on LIBOR. "Event of Default" means any of the events described in Section 9.1. "FDIC" means the Federal Deposit Insurance Corporation, or any entity succeeding to any of its principal functions. "Federal Funds Rate" means, for any day, the rate set forth in the weekly statistical release designated as H.15(519), or any successor publication, published by the Federal Reserve Board (including any such successor, "H.15(519)") for such date opposite the caption "Federal Funds (Effective)". If on any relevant day such rate is not yet published in H.15(519), the rate for such day will be the rate set forth in the daily statistical release designated as the Composite 3:30 p.m. Quotations for U.S. Government Securities, or any successor publication, published by the Federal Reserve Bank of New York (including any such successor, the "Composite 3:30 p.m. Quotation") for such day under the caption "Federal Funds Effective Rate". If on any relevant day the appropriate rate is not yet published in either H.15(519) or the Composite 3:30 p.m. Quotations, the rate for such day will be the arithmetic mean as determined by the Agent of the rates for the last transaction in overnight Federal funds arranged prior to 9:00 a.m. (New York time) on that day by each of three leading brokers of Federal funds transactions in New York City selected by the Agent. "Federal Reserve Board" means the Board of Governors of the Federal Reserve System, or any entity succeeding to any of its principal functions. GAAP means the generally accepted accounting principles in the United States of America with such changes thereto as (i) shall be consistent with the then-effective principles promulgated or adopted by the Financial Accounting Standards Board and its predecessors and successors and (ii) shall be concurred in by the independent certified public accountants of recognized standing certifying any financial statements of the Company and its Subsidiaries. "Indebtedness" means, as of any date, all indebtedness, obligations or other liabilities of the Company and its Subsidiaries as of such date (i) for borrowed money, (ii) evidenced by bonds, debentures, notes or other similar instruments for borrowed money, or (iii) pursuant to any guarantee of any indebtedness, obligations or other liabilities of any other Person of the type described in clauses (i) or (ii); provided, however, that (a) the amounts set forth in clauses (i), (ii) and (iii) shall not be double counted and (b) Indebtedness shall not include indebtedness, obligations or other liabilities of the Company to any Subsidiary or indebtedness, obligations or other liabilities of any Subsidiary to the Company or another Subsidiary. "Indemnified Liabilities" - see Section 10.5. "Insurance Company Leverage Ratio" means, for each Principal Insurance Subsidiary on an individual basis as of any date and for all Principal Insurance Subsidiaries on a combined basis as of any date, the ratio of Adjusted Capital and Surplus to Total Assets. "Insurance Laws" means any and all federal or state laws, regulations, rules, ordinances, orders or directives that pertain to the regulation of insurance companies, as such. "Insurance Subsidiaries" means, as of any date, all Subsidiaries of the Company that are engaged in the insurance business and are subject to regulation by the insurance commission or department of any state or other jurisdiction. The Insurance Subsidiaries of the Company as of the date of this Agreement are set forth in Schedule 6.17 attached hereto. "Interest Payment Date" means, (a) with respect to any CD Rate Loan or Eurodollar Rate Loan, the last day of each Interest Period applicable to such Loan, provided, however, that if any Interest Period for a CD Rate Loan or Eurodollar Rate Loan exceeds 90 days or three months, respectively, the date which falls 90 days or three months (as the case may be) after the beginning of such Interest Period and after each Interest Payment Date thereafter shall also be an Interest Payment Date, and (b) with respect to any Base Rate Loan, the last Business Day of each calendar quarter and each date upon which such Loan is prepaid or converted to a Eurodollar Rate Loan or a CD Rate Loan. "Interest Period" means, (a) with respect to any Eurodollar Rate Loan, the period commencing on the Business Day the Loan is disbursed or continued or on the Conversion Date on which the Loan is converted to the Eurodollar Rate Loan and ending on the date one, two, three or six months thereafter, as selected by the Company in its Notice of Borrowing or Notice of Conversion/Continuation; and (b) with respect to any CD Rate Loan, the period commencing on the Business Day the CD Rate Loan is disbursed or continued or on the Conversion Date on which a Loan is converted to the CD Rate Loan and ending 30, 60, 90 or 180 days thereafter, as selected by the Company in its Notice of Borrowing or Notice of Conversion/Continuation; provided that: (i) if any Interest Period pertaining to a Eurodollar Rate Loan or CD Rate Loan would otherwise end on a day which is not a Business Day, that Interest Period shall be extended to the next succeeding Business Day unless, in the case of a Eurodollar Rate Loan, the result of such extension would be to carry such Interest Period into another calendar month, in which event such Interest Period shall end on the immediately preceding Business Day; (ii) any Interest Period pertaining to a Eurodollar Rate Loan that begins on the last Business Day of a calendar month (or on a day for which there is no numerically corresponding day in the calendar month at the end of such Interest Period) shall end on the last Business Day of the calendar month at the end of such Interest Period; and (iii) no Interest Period for any Loan shall extend beyond a Clean-up Date or the Termination Date. "Investment Grade Obligations" means, as of any date for each Insurance Subsidiary, investments having an NAIC investment rating of 1 or 2; or a Standard & Poor's rating within the range of ratings from AAA to BBB-; or a Moody's rating within the range of ratings from Aaa to Baa3. "Issuing Bank" means American National Bank and Trust Company of Chicago in its capacity as issuing bank with respect to LCs issued under and pursuant to the terms of this Agreement. "LC" - see Section 2.2. "LC Application" - see Section 2.5. "Liabilities" means any and all of the Company's obligations to the Banks, howsoever created, arising or evidenced, whether direct or indirect, absolute or contingent, now or hereafter existing, or due or to become due, which arise out of or in connection with this Agreement or the Related Documents. "LIBOR" means, with respect to each Interest Period to be applicable to a Eurodollar Rate Loan, the rate of interest per annum determined by the Agent obtained by dividing (a) the Telerate Screen Rate for such Interest Period or (b) if the Telerate Screen Rate is unavailable at the time the LIBOR rate is to be determined, a rate determined on the basis of the offered rates for deposits in U.S. dollars for a period approximately equal to such Interest Period which appear on the Reuters Screen LIBO Page, as of 11:00 a.m., London time, on the day that is two London banking days preceding the beginning of such Interest Period by (c) a percentage equal to 100% minus the stated maximum rate (expressed as a percentage) as prescribed by the Federal Reserve Board of all reserve requirements (including, without limitation, any marginal, emergency, supplemental, special or other reserves) applicable on the first day of such Interest Period to any member bank of the Federal Reserve System in respect of Eurodollar funding or liabilities. "Lien" means any mortgage, pledge, lien, security interest or other charge or encumbrance, including the retained security title of a conditional vendor or lessor. "Loan" means an extension of credit by a Bank to the Company pursuant to Section 2, and may be a Base Rate Loan, CD Rate Loan or a Eurodollar Rate Loan. "Majority Banks" means at any time Banks then having Commitments equal to at least 51% of the Aggregate Commitment. "Margin Stock" has the meaning given to such term in Regulation U. "Material Subsidiary" means any Subsidiary of the Company, the financial condition of which, when consolidated with the financial condition of the Company, has a material effect on such financial condition of the Company, and shall include, without limitation, each Principal Insurance Subsidiary. "Mortgage" means, as of any date, as to each Insurance Subsidiary, the amount of such Insurance Subsidiary's mortgage loans on real estate calculated in accordance with Statutory Accounting Principles. "Multiemployer Plan" means a "multiemployer plan" as defined in ERISA. "NAIC" means the National Association of Insurance Commissioners and any successor thereto. "Net Worth" means, with respect to the Company, as at the time any determination thereof is made, the consolidated shareholders' equity (including common stock, additional paid-in capital, retained earnings, and net unrealized gains and losses). "Non-Insurance Operating Subsidiaries" means, as of any date, all Subsidiaries of the Company that are not Insurance Subsidiaries. The Non- Insurance Operating Subsidiaries of the Company as of the date of this Agreement are set forth in Schedule 6.17 attached hereto. "Non-Investment Grade Obligations" means, as of any date, for each Insurance Subsidiary, any fixed maturity debt instrument investment that is not an Investment Grade Obligation. "Note" or "Notes" - see Section 3 and Exhibit A. "Notice of Borrowing" means a notice given by the Company to the Agent pursuant to Section 2.3, in substantially the form of Exhibit B. "Notice of Conversion/Continuation" means a notice given by the Company to the Agent pursuant to Section 2.4, in substantially the form of Exhibit C. "PBGC" means the Pension Benefit Guaranty Corporation and any entity succeeding to any or all of its functions under ERISA. "Permitted Liens" - see Section 7.16. "Person" means an individual or a corporation, partnership, trust, incorporated or unincorporated association, joint venture, joint stock company, government (or any agency or political subdivision thereof) or other entity of any kind. "Plan" means an "employee pension benefit plan", as such term is defined in Section 3(2) of ERISA, an "employee welfare benefit plan," as such term is defined in Section 3(1) of ERISA, or any bonus, deferred compensation, stock purchase, stock option, severance, salary continuation, vacation, sick leave, fringe benefit, incentive, insurance, welfare or similar arrangement. "Policy Liabilities" means the aggregate liabilities of a Principal Insurance Subsidiary for future policy benefits with respect to life and annuity policies issued by such Principal Insurance Subsidiary, determined in accordance with GAAP. "Preferred Stock" means the shares of the Company's Cumulative Convertible Exchangeable Preferred Stock, having a stated value of $25 per share. "Principal Insurance Subsidiaries" means, as of any date, any Insurance Subsidiary that is or becomes engaged in a material amount of insurance business and has been designated in writing by all of the Banks and the Company as a Principal Insurance Subsidiary. The following Insurance Subsidiaries shall be deemed to be Principal Insurance Subsidiaries as of the date of this Agreement and until designated otherwise by all of the Banks and the Company : Pioneer Life Insurance Company of Illinois, an Illinois corporation; National Group Life Insurance Company, an Illinois corporation; and Manhattan National Life Insurance Company, an Illinois corporation. "Real Estate Concentration Ratio" means, as of any date, as to each Insurance Subsidiary, the ratio of (a) the sum of (i) Real Estate Investments plus (ii) Mortgages to (b) Capital and Surplus. "Real Estate Investments" means, as of any date, as to each Insurance Subsidiary, the sum of (a) the book value of properties acquired in satisfaction of debt calculated in accordance with Statutory Accounting Principles plus (b) the investment in investment real estate calculated in accordance with Statutory Accounting Principles; provided, that the properties occupied by the Company or any Subsidiary shall be excluded from the calculation of Real Estate Investments for purposes of this Agreement. "Regulation U" means Regulation U of the Board of Governors of the Federal Reserve System and any successor rule or regulation of similar import as in effect from time to time. "Reimbursement Obligations" - see Section 2.6. "Related Documents" means, collectively, this Agreement, each Note issued by the Company to each Bank, and all other documents, instruments and agreements executed by the Company and delivered to the Agent or the Banks pursuant to or in connection with this Agreement or any of the foregoing. "Reportable Event" means a reportable event (as defined in Section 4043(b) of ERISA) for which notice has not been waived pursuant to applicable regulations. "Reuters Screen LIBO Page" means the display page designated "LIBO" on the Reuters Monitor Money Rates Service (or such other page that may replace that page on such service for the purpose of displaying comparable rates). "Stated Amount" shall mean, with respect to any LC and as of the date of determination, the maximum amount for which a draw or demand for payment may then be made thereunder, whether or not such maximum amount is defined in such LC as the "Stated Amount" thereof. "Statutory Accounting Principles" means the accounting principles used in the preparation of Statutory Statements in accordance with the rules and regulations prescribed by the insurance commission or department of each Insurance Subsidiary's respective state of domicile in effect as of the date of this Agreement. In the event that there is a material change in such accounting principles subsequent to the date hereof, the covenants contained herein and affected by such change shall be adjusted as necessary to preserve the force and effect of such covenants by the Company (provided that prior to any such adjustment the Company shall consult with the Agent with respect to any such adjustment) subject to the reasonable objection of the Majority Banks. "Statutory Statements" means, with respect to an Insurance Subsidiary, the annual or quarterly accounting statement for such Insurance Subsidiary prepared in accordance with Statutory Accounting Principles, as filed with the insurance commissioner or department of each jurisdiction in which such Insurance Subsidiary is subject to regulation. "Subsidiary" means a corporation, association or business entity of which the Company and/or its other Subsidiaries own, directly or indirectly, such number of outstanding shares as have more than 50% of the ordinary voting power for the election of such entity's directors. "Telerate Screen Rate" means, for any Interest Period to be applicable to a Eurodollar Rate Loan, the rate for deposits in U.S. dollars for a period approximately equal to such Interest Period which appears on Page 3750 of the Dow Jones Telerate Service (or such other page that may replace that page on such service for the purpose of displaying comparable rates) as of 11:00 a.m., London time, on the day that is two London banking days preceding the beginning of such Interest Period. "Termination Date" - means the earlier to occur of: (a) April 30, 1996; and (b) the date on which the Aggregate Commitment shall terminate in accordance with the provisions of this Agreement. "Total Adjusted Capital" shall have the same meaning as the term "Total Adjusted Capital" as defined in the NAIC Risk-Based Capital (RBC) for Life and/or Health Insurers Model Act, as such term may be amended by the NAIC from time to time. "Total Assets" means, as of any date, as to each Insurance Subsidiary, the total net admitted assets calculated as of such date in accordance with Statutory Accounting Principles. "Total Invested Assets" means, as of any date, as to each Insurance Subsidiary, the amount of such Insurance Subsidiary's cash and invested assets calculated in accordance with Statutory Accounting Principles. "Unrestricted Subsidiary" - see Section 7A.1. SECTION 2 BANK'S COMMITMENT; BORROWING PROCEDURES; LCs SECTION 2.1 Bank's Commitment to Make Loans. (a) On the terms and subject to the conditions set forth in this Agreement, each Bank severally agrees to make revolving loans (each such loan called a "Loan" and collectively called the "Loans") to the Company from time to time on any Business Day during the period from the Closing Date to the Termination Date, in an aggregate amount not to exceed at any time outstanding the amount set forth opposite such Bank's name on the signature page hereof under the heading "Commitment" (such amount as the same may be reduced pursuant to Section 2.9 or as a result of one or more assignments pursuant to Section 10.12, such Bank's "Commitment") minus the sum of (a) such Bank's Commitment Percentage of the aggregate Stated Amount of all LCs issued and outstanding and (b) such Bank's Commitment Percentage of the aggregate amount of all Reimbursement Obligations; provided, however, that after giving effect to any Borrowing of Loans, the aggregate principal amount of all outstanding Loans plus the sum of (c) the Aggregate Stated Amount of all LCs issued and outstanding and (d) the aggregate amount of all Reimbursement Obligations, shall not exceed the Aggregate Commitment. The Company and each Bank agree and acknowledge that each Bank's portion of each Borrowing of Loans shall be based pro rata on such Bank's Commitment Percentage determined at the time of such Borrowing. (b) The Company agrees that, with respect to each Bank's Commitment Percentage of each Loan that is a CD Rate Loan, the Company shall purchase from such Bank a certificate or certificates of deposit in an amount equal to such Bank's Commitment Percentage of each such Loan having a term equal to the Interest Period applicable to such Loan. SECTION 2.2 Issuing Bank's Commitment to Issue LCs. On the terms and subject to the conditions set forth in this Agreement, the Issuing Bank agrees, as the Company may from time to time request, to issue for the account of the Company letters of credit (each such letter of credit called an "LC" and collectively called the "LCs") from time to time on any Business Day during the period from the Closing Date to the Termination Date, in a Stated Amount not to exceed the Aggregate Commitment minus the sum of (a) the aggregate principal amount of all Loans then outstanding and not repaid, (b) the aggregate Stated Amount of all LCs previously issued and then outstanding and (c) the aggregate amount of all Reimbursement Obligations. SECTION 2.3 Procedure for Borrowing. (a) Each Borrowing of Loans shall be made upon the Company's irrevocable written notice delivered to the Agent in accordance with Section 10.2 in the form of a Notice of Borrowing (which notice must be received by the Agent prior to 11:00 a.m. (Chicago time) (i) two Business Days prior to the requested Borrowing date, in the case of Eurodollar Rate Loans, (ii) one Business Day prior to the requested Borrowing Date, in the case of CD Rate Loans, and (iii) on the requested Borrowing date, in the case of Base Rate Loans) specifying: (A) the amount of the Borrowing, which shall be in an aggregate minimum principal amount of one hundred thousand dollars ($100,000); (B) the requested Borrowing date, which shall be a Business Day; (C) whether the Borrowing is to be comprised of Eurodollar Rate Loans, CD Rate Loans or Base Rate Loans; (D) in the case of Eurodollar Rate Loans and CD Rate Loans, the duration of the Interest Period applicable to such Loans included in such notice. If the Notice of Borrowing shall fail to specify the duration of the Interest Period for any Borrowing comprised of CD Rate Loans or Eurodollar Rate Loans, such Interest Period shall be 30 days or one month, respectively; and (E) the account of the Company to which the proceeds of such Borrowing shall be deposited. (b) Upon receipt of the Notice of Borrowing, the Agent will promptly notify each Bank thereof and of the amount of such Bank's Commitment Percentage of the Borrowing. (c) Each Bank will make the amount of its Commitment Percentage of the Borrowing available to the Agent for the account of the Company at the Agent's Payment Office by 2:00 p.m. (Chicago time) on the Borrowing date requested by the Company in funds immediately available to the Agent. Promptly after receipt of all such amounts by the Agent, the proceeds of all such Loans will be disbursed by the Agent to such account of the Company designated in writing by the Company in the Notice of Borrowing in like funds as received by the Agent. (d) Unless the Majority Banks shall otherwise agree, during the existence of an Event of Default, the Company may not elect to have a Loan be made as, or converted into or continued as, a Eurodollar Rate Loan or a CD Rate Loan. SECTION 2.4 Conversion and Continuation Elections. (a) The Company may upon irrevocable written notice to the Agent in accordance with Section 2.4(b): (i) elect to convert on any Business Day, any Base Rate Loans (or any part thereof in an amount not less than $100,000) into Eurodollar Rate Loans or CD Rate Loans; or (ii) elect to convert on the last day of any Interst Period with respect thereto any Eurodollar Rate Loans (or any part thereof in an amount not less than $100,000) into Base Rate Loans or CD Rate Loans; or (iii) elect to convert on the last day of any Interest Period with respect thereto any CD Rate Loans (or any part thereof in an amount not less than $100,000) into Base Rate Loans or Eurodollar Rate Loans; or (iv) elect on the last day of any Interest Period with respect to any Eurodollar Rate Loans or CD Rate Loans (or any part thereof in an amount not less than $100,000) to continue such Eurodollar Rate Loans or CD Rate Loans (or such part thereof) as such; provided, that if the aggregate amount of CD Rate Loans or Eurodollar Rate Loans shall have been reduced, by payment, prepayment, or conversion of part thereof, to be less than $100,000, such CD Rate Loans or Eurodollar Rate Loans shall automatically convert into Base Rate Loans, and on and after such date until the amount of Loans shall exceed $100,000 the right of the Company to continue such Loans as, and convert such Loans into, Eurodollar Rate Loans or CD Rate Loans, as the case may be, shall terminate. (b) The Company shall deliver a Notice of Conversion/ Continuation in accordance with Section 10.2 to be received by the Agent not later than 11:00 a.m. (Chicago time) at least (i) two Business Days in advance of the Conversion Date or continuation date, if the Loans are to be converted into or continued as Eurodollar Rate Loans, (ii) one Business Day in advance of the Conversion Date or continuation date, if the Loans are to be converted into or continued as CD Rate Loans, and (ii) on the Conversion Date, if the Loans are to be converted into Base Rate Loans, specifying: (A) the proposed Conversion Date or continuation date; (B) the aggregate amount of Loans to be converted or continued; (C) the nature of the proposed conversion or continuation; and (D) the duration of the requested Interest Period. (c) If upon the expiration of any Interest Period applicable to CD Rate Loans or Eurodollar Rate Loans, the Company has failed to select timely a new Interest Period to be applicable to such CD Rate Loans or Eurodollar Rate Loans, as the case may be, or if any Event of Default shall then exist, the Company shall be deemed to have elected to convert such CD Rate Loans or Eurodollar Rate Loans into Base Rate Loans effective as of the expiration date of such current Interest Period. (d) Upon receipt of a Notice of Conversion/Continuation, the Agent will promptly notify each Bank thereof, or, if no timely notice is provided by the Company, the Agent will promptly notify each Bank of the details of any automatic conversion. (e) Unless the Majority Banks shall otherwise agree, during the existence of an Event of Default, the Company may not elect to have a Loan converted into or continued as a Eurodollar Rate Loan or a CD Rate Loan. SECTION 2.5 LC Documentation. (a) Each of the Company's requests for an LC must be received by the Agent and the Issuing Bank at least two Business Days prior to the requested issue date of such LC, and shall be accompanied by a duly completed application therefor (the "LC Application") and such other documents, in support thereof as the Issuing Bank may reasonably require, and all of such applications and documents shall be in form and substance reasonably satisfactory to the Issuing Bank. In addition, the proposed form of each LC shall be in form and substance reasonably satisfactory to the Issuing Bank, due regard being given to the customs and conventions followed by the Issuing Bank in the issuance of letters of credit generally and the advice of the Banks from time to time given to the Issuing Bank as to necessary or desirable terms and provisions in the form of any such proposed LC. Upon receipt of any request for an LC, the Agent will promptly notify each Bank thereof and deliver to each Bank a copy of the LC Application and each other document received by the Agent in connection with such request for an LC. Each LC shall have an expiry date that shall in no event be later than one year after the Termination Date. (b) Subject to the terms and conditions of this Agreement, including, without limitation, Section 2.2, Section 2.5(a) and Section 8.2 hereof, the Issuing Bank shall issue the requested LC in accordance with the Issuing Bank's usual and customary business practices on the date requested for such issuance by the Company in the request made by the Company pursuant to the terms of Section 2.5(a) hereof. Notwithstanding the foregoing, if the Issuing Bank shall have received written notice from the Agent or any Bank on or before the Business Day prior to the date of the Issuing Bank's issuance of such proposed LC that one or more of the conditions set forth in Section 8.2 is not then satisfied, then, until such condition is satisfied and the Issuing Bank receives written notice thereof, the Issuing Bank shall have no obligation to issue any LC. Each Bank agrees that it shall not unreasonably give any such notice or unreasonably fail to withdraw any such notice. (c) The Issuing Bank shall promptly give the Agent notice upon the issuance of an LC hereunder and a copy of the LC so issued by such Issuing Bank, and the Agent shall promptly thereafter give notice of such issuance and a copy of such LC to the Banks. An LC otherwise issued in accordance with the terms of this Agreement shall be an LC notwithstanding any failure by the Issuing Bank or the Agent to provide any such notice or copies in a timely manner. (d) The Company may request that an LC be extended beyond its stated expiry date or otherwise renewed by giving the Issuing Bank and the Agent written notice of any such extension or renewal not later than ten Business Days prior to the date (the "LC Extension Date") that such LC would have expired absent such extension or renewal. Each such notice (an "LC Extension Request") shall specify the LC that is being extended or renewed and the proposed new expiration date of such LC. The Agent shall promptly advise each Bank of its receipt of, and provide to each Bank a copy of, each LC Extension Request. The new expiration date proposed for any LC may not be a date that is on or after one year after the Termination Date. Following proper delivery of an LC Extension Request pursuant to this Section, the Issuing Bank shall, subject to Section 8.2, extend the expiration date of or renew any LC issued by the Issuing Bank. Notwithstanding the foregoing, if the Issuing Bank shall have received written notice from the Agent or any Bank on or before the Business Day prior to the Issuing Bank's proposed extension of the expiration date of an LC that one or more of the conditions set forth in Section 8.2 is not then satisfied, then, until such condition is satisfied and the Issuing Bank receives written notice thereof, the Issuing Bank shall have no obligation to extend the expiration date of such LC. (e) The Company may request that an LC be amended at any time by giving the Issuing Bank and the Agent written notice thereof not later than ten Business Days prior to the date proposed for such amendment. Each such notice (an "LC Amendment Request") shall specify in reasonable detail the changes that are then being requested to be made in the applicable LC and the changes, if any, in the information specified in the original request with respect to such LC delivered pursuant to Section 2.5(a). The Agent shall promptly advise the Banks of its receipt of, and provide a copy to each Bank of, each LC Amendment Request. If the Issuing Bank and the Agent, after consultation with any Bank that provides comments on any such LC Amendment Request, agree to such amendment, such amendment shall be given effect; provided, that (i) any extension of the expiration date or renewal of an LC shall be subject to the terms of Section 2.5(d), and (ii) any amendment which increases the face amount of an LC shall be deemed an issuance of a new LC with a face amount equal to the amount of such increase, and shall be subject to the provisions of this Agreement, including without limitation, Section 2.2, Section 2.5(a) and Section 8.2. SECTION 2.6 Agreement to Repay LC Drawings. (a) The Company hereby agrees to reimburse the Issuing Bank (collectively called the "Reimbursement Obligations" and individually a "Reimbursement Obligation"), for each payment or disbursement made by the Issuing Bank under any LC honoring any demand for payment made by the beneficiary thereunder immediately following the occurrence of any such payment or disbursement. Any Reimbursement Obligation not repaid on the date of the applicable payment or disbursement giving rise thereto shall bear interest on the amount so paid or disbursed by the Issuing Bank from the date of payment or disbursement made by the Issuing Bank to but not including the date the Issuing Bank is reimbursed therefor, at a rate per annum equal to the Base Rate from time to time in effect plus two percent (2.00%) per annum. Interest shall be computed for the actual number of days elapsed on the basis of a year consisting of 360 days. (b) Any action taken or omitted to be taken by the Issuing Bank under or in connection with any LC, if taken or omitted in the absence of willful misconduct or gross negligence, shall not put the Issuing Bank under any resulting liability to any Bank or, assuming that the Issuing Bank has complied with the applicable procedures specified herein and a Bank has not given a notice contemplated by Section 2.5(b) that continues in full force and effect, relieve any Bank of its obligations hereunder to the Issuing Bank. SECTION 2.6A Participations. (a) Upon the issuance by the Issuing Bank of any LC in accordance with the procedures and the terms set forth herein, each Bank shall be deemed to have irrevocably and unconditionally purchased and received from the Issuing Bank, without recourse or warranty, an undivided interest and participation to the extent of such Bank's Commitment Percentage in such LC (including, without limitation, all obligations of the Company with respect thereto other than amounts owing to the Issuing Bank under Section 4.2(d)), provided, that the participation of any Bank in any LC hereunder shall at no time exceed an amount equal to such Bank's Commitment minus the sum of (i) the aggregate principal amount of all Loans made by such Bank then outstanding and not repaid, (ii) such Bank's Commitment Percentage of the aggregate Stated Amount of all LCs previously issued and then outstanding and (iii) such Bank's Commitment Percentage of the aggregate amount of all Reimbursement Obligations. (b) (i) In the event that the Issuing Bank makes any payment or disbursement under any LC and the Company shall not have repaid such amount to the Issuing Bank pursuant to Section 2.6(a), the Issuing Bank shall promptly notify the Agent, which shall promptly notify each Bank, of such failure, and each Bank severally agrees to promptly and unconditionally pay to the Agent for the account of the Issuing Bank the amount of such Bank's Commitment Percentage of such payment or disbursement in same day funds and the Agent shall promptly pay such amount, and any other amounts received by the Agent for the Issuing Bank's account pursuant to this Section 2.6A(b), to the Issuing Bank. If the Agent so notifies such Bank prior to 11:00 A.M. (Chicago time) on any Business Day, such Bank shall make available to the Agent for the account of the Issuing Bank its Commitment Percentage of the amount of such payment or disbursement on such Business Day in same day funds (or on the next succeeding Business Day if notice is given after such time). The failure of any Bank to make available to the Agent for the account of the Issuing Bank its Commitment Percentage of any such payment or disbursement shall not relieve any other Bank of its obligation hereunder to make available to the Agent for the account of the Issuing Bank its Commitment Percentage of any payment or disbursement on the date such payment is to be made. (ii) In the event that any Bank fails to fund its Commitment Percentage of any payment or disbursement required to be made by the Banks to the Agent for the benefit of the Issuing Bank in accordance with the provisions of clause (i) above, until the earlier of such Bank's cure of such failure and the termination of the Bank's Commitment, the proceeds of all amounts thereafter paid or repaid to the Agent by the Company (or any Person on behalf of the Company) and contemplated hereunder to be disbursed to such Bank for application against amounts owing such Bank hereunder shall be disbursed instead to the Issuing Bank by the Agent on behalf of such Bank to cure, in full or in part, such failure by such Bank, and, upon such disbursement payment to such Bank shall be deemed to have been made. Notwithstanding anything in this Agreement to the contrary: (A) if the Issuing Bank has theretofore applied any portion of any cash collateral pledged to it to secure Reimbursement Obligations relating to the applicable LC as reimbursement for such Reimbursement Obligations, any amounts disbursed to the Issuing Bank by the Agent in accordance with this Section 2.6A(b)(ii) (net of any interest due the Issuing Bank) shall be used by the Issuing Bank to restore such cash collateral; and (B) a Bank shall be deemed to have cured its failure to fund its Commitment Percentage of any such required payment in respect of an LC at such time as an amount equal to such Bank's Commitment Percentage (determined as of the time of the Agent's receipt of notice of the failure by the Company to reimburse the Issuing Bank with respect to a payment or disbursement under such LC) of such required payment plus any interest accrued thereon is fully funded to the Issuing Bank, whether made by such Bank itself, by operation of the terms of this Section 2.6A(b)(ii) or by the Company directly to the Issuing Bank. Interest shall accrue on the amount that should have been paid by the defaulting Bank, for each day from the date such amount shall have been due until the date such amount is repaid to the Agent for the benefit of the Issuing Bank, at the Federal Funds Rate as in effect for each such day. The provisions of this Section 2.6A(b) shall not relieve the Company from paying interest at the applicable interest rate under Section 2.6(a). (c) Whenever the Issuing Bank receives a payment on account of a Reimbursement Obligation, including any interest thereon, as to which the Agent has received for the account of the Issuing Bank any payments from the Banks pursuant to this Section 2.6A, it shall promptly pay to the Agent and the Agent shall promptly pay to each Bank that has funded its participating interest therein, in the kind of funds so received, an amount equal to such Bank's Commitment Percentage thereof (according to the amounts so funded). Each such payment shall be made by the Issuing Bank or the Agent, as the case may be, on the Business day on which such Person receives the funds paid to it pursuant to the preceding sentence, if received prior to 11:00 a.m. (Chicago time) on such Business Day, and otherwise on the next succeeding Business Day. If the Issuing Bank or the Agent, as the case may be, shall fail to pay to any Bank the amount due such Bank pursuant to this Section when due, the Issuing Bank or the Agent, as the case may be, shall be obligated to pay to such Bank interest on the amount that should have been paid hereunder for each day from the date such amount shall have become due until the date such amount is paid, at the Federal Funds Rate as in effect for each such day. (d) The obligations of (i) a Bank to make payments to the Agent for the account of the Issuing Bank with respect to a payment or disbursement made under an LC issued pursuant to this Agreement and (ii) the Company to reimburse the Issuing Bank for payments and disbursements made by the Issuing Bank under any LC shall, in each case, be absolute and unconditional under any and all circumstances and irrespective of any setoff, counterclaim or defense to payment which the Company may have or have had against the Issuing Bank or such beneficiary, including, without limitation, any defense based on the failure of such demand for payment to conform to the material terms of such LC or any nonapplication or misapplication by such beneficiary of the proceeds of such demand for payment or the legality, validity, regularity or enforceability of such LC or any document or contract related to or required to be presented under the terms of such LC; provided, however, that neither the Company nor the Banks shall be obligated to reimburse the Issuing Bank for any wrongful payment or disbursement made by such Issuing Bank under such LC as a result of acts or omissions constituting negligence or willful misconduct on the part of the Issuing Bank. SECTION 2.7 Mandatory Payment of LC Liability. The Company agrees that, upon (i) its receipt of a written notice from the Agent acting upon the written request of the Majority Banks stating that an Event of Default has occurred or (ii) its receipt of a written notice from the Agent that the Termination Date has occurred, it will promptly pay to the Agent for the account of the Issuing Bank an amount equal to the amount of the then aggregate Stated Amount of all LCs issued and outstanding hereunder. The Agent, the Issuing Bank and the Company hereby agree that the Company's payment of such amount shall be by means of purchasing from the Issuing Bank or its designee a certificate or certificates of deposit in an amount equal to the amount of the then aggregate Stated Amount of all LCs issued and outstanding hereunder. Any amounts so received by the Issuing Bank or certificates of deposit issued by the Issuing Bank or its designee pursuant to the provisions of the foregoing sentence shall be retained by the Issuing Bank as collateral security for the Reimbursement Obligation of the Company with respect to such LCs. Subject to Section 2.6A and so long as no Event of Default has occurred and is continuing, upon the expiration of any LC, the Issuing Bank will return to the Agent, and the Agent shall return to the Company, all such funds with respect to such LC not used to pay Reimbursement Obligations. SECTION 2.8 LC Operations. The Issuing Bank shall, promptly following its receipt thereof, (i) examine all documents purporting to represent a demand for payment by the beneficiary under any LC to ascertain that the same appear on their face to be in conformity with the terms and conditions of such LC and (ii) notify the Agent and the Company in writing of each such demand for payment. If, after examination, the Issuing Bank shall have determined that a demand for payment under such LC does not conform to the terms and conditions of such LC, then the Issuing Bank shall, as soon as reasonably practicable, give notice to the beneficiary, the Agent and the Company to the effect that negotiation was not in accordance with the terms and conditions of such LC, stating the reasons therefor and that the relevant document is being held at the disposal of such beneficiary or is being returned to such beneficiary, as the Issuing Bank may elect. The beneficiary may attempt to correct any such nonconforming demand for payment under such LC if, and to the extent that, such beneficiary is entitled (without regard to the provisions of this sentence) and able to do so. If the Issuing Bank determines that a demand for payment under such LC conforms to the terms and conditions of such LC, then the Issuing Bank shall make payment to the beneficiary in accordance with the terms of such LC. The Issuing Bank shall have the right to require the beneficiary to surrender such LC to the Issuing Bank on the stated expiration date of such LC. SECTION 2.9 Voluntary Termination or Reduction of Commitments. The Company may, upon not less than one Business Days' prior written notice to the Agent, terminate the Aggregate Commitment or permanently reduce the Aggregate Commitment by an aggregate minimum amount of $100,000; provided that no such reduction or termination shall be permitted if, after giving effect thereto and to any prepayments of the Loans made on the effective date thereof, the sum of (i) the then outstanding principal amount of the Loans, (ii) the Aggregate Stated Amount of all LCs issued and outstanding and (iii) the aggregate amount of all Reimbursement Obligations, would exceed the amount of the Aggregate Commitment then in effect. Any reduction of the Aggregate Commitment shall be applied to each Bank's Commitment in accordance with such Bank's Commitment Percentage. All commitment fees with respect to the portion of the Commitments that are being reduced that have accrued to, but not including, the effective date of any reduction or termination of Commitments, shall be paid on the effective date of such reduction or termination. SECTION 2.10 Optional Prepayments. Subject to Section 4.5, the Company may, at any time or from time to time, ratably prepay Loans in whole or in part in any amount; provided that the Company's written notice of such prepayment shall be delivered to the Agent in accordance with Section 10.2 prior to 11:00 a.m. (Chicago time) (i) two Business Days prior to the requested date of prepayment, in the case of Eurodollar Rate Loans; (ii) one Business Day prior to the requested date of prepayment, in the case of CD Rate Loans, and (iii) on the requested date of prepayment, in the case of Base Rate Loans. Such notice of prepayment shall specify the date of repayment, the aggregate amount of such prepayment, and whether such prepayment is of Base Rate Loans, CD Rate Loans or Eurodollar Rate Loans, or any combination thereof. Such notice shall not thereafter be revocable by the Company. The Agent will promptly notify each Bank of such notice and of such Bank's Commitment Percentage of such prepayment. If such notice is given by the Company, the Company shall make such prepayment and the payment amount specified in such notice shall be due and payable on the date specified therein, together with accrued interest to each such date on the amount prepaid and any amounts required pursuant to Section 4.5. SECTION 2.11 Mandatory Prepayment. On each Clean-up Date, the Company shall make a mandatory prepayment to the Agent for the benefit of the Banks of the outstanding principal amount of all Loans outstanding on such Clean-up Date together with accrued interest to such Clean-up Date on such Loans and any amounts required pursuant to Section 4.5. SECTION 2.12 Repayment. The Company shall repay to the Agent for the benefit of the Banks in full on the Termination Date the aggregate principal amount of the Loans outstanding on the Termination Date. SECTION 3 NOTES EVIDENCING THE LOANS SECTION 3.1 Notes. Each Bank's Loans shall be evidenced by a promissory note (herein, as the same may be amended, modified or supplemented from time to time, and together with any renewals thereof or exchanges or substitutions therefor, individually called a "Note" and collectively called the "Notes"), substantially in the form set forth in Exhibit A, with appropriate insertions, dated the Closing Date, payable to the order of such Bank in the principal amount equal to such Bank's Commitment or the aggregate principal amount of the Loans outstanding to such Bank, whichever is less. The date and amount of the Loans made by each Bank and of each repayment of principal thereon received by such Bank shall be recorded by such Bank in its records or, at its option, on the schedule attached to its Note. The aggregate unpaid principal amount so recorded shall be rebuttable presumptive evidence of the principal amount owing and unpaid on such Note to such Bank. The failure so to record any such amount or any error in so recording any such amount, however, shall not limit or otherwise affect the Company's obligations hereunder or under such Note to repay the principal amount of the Loans evidenced by such Note together with all interest accruing thereon. Each Note shall provide for the payment of interest as provided in Section 4. SECTION 4 INTEREST, FEES AND COSTS SECTION 4.1 Interest. (a) Subject to Section 4.1(c), each Loan shall bear interest on the outstanding principal amount thereof from the date when made until it becomes due at a rate per annum equal to the CD Rate, LIBOR or the Base Rate, as the case may be, plus the Applicable Margin. (b) Interest on each Loan shall be paid in arrears on each Interest Payment Date. Interest shall also be paid on the date of any prepayment of Loans pursuant to Section 2.10 for the portion of the Loans so prepaid and upon payment (including prepayment) in full thereof, including, without limitation, on each Clean-up Date pursuant to Section 2.11 and, during the existence of any Event of Default, interest shall be paid on demand. (c) If any amount of principal of or interest on any Loan, or any other amount payable hereunder or under any of the other Loan Documents is not paid in full when due (whether at stated maturity, by acceleration, demand or otherwise), the Company agrees to pay interest on such unpaid principal or other amount, from the date such amount becomes due until the date such amount is paid in full, payable on demand, at a fluctuating rate per annum equal to the Base Rate plus two percent (2.00%) per annum. SECTION 4.2 Fees. (a) Closing Fee. On the Closing Date the Company shall pay to the Agent for the account of each Bank a one-time closing fee equal to 0.30% of each Bank's Commitment. (b) Unused Commitment Fees. The Company shall pay to the Agent for the account of each Bank an unused commitment fee at the rate of 0.30% per annum on the daily average amount of the difference between such Bank's Commitment from time to time in effect minus the sum of (i) such Bank's Commitment Percentage of the aggregate principal amount of all Loans then outstanding and not repaid, (ii) such Bank's Commitment Percentage of the aggregate Stated Amount of all LCs issued and outstanding and (iii) such Bank's Commitment Percentage of the aggregate amount of all Reimbursement Obligations. The Agent shall provide the Company with an invoice for the amount of the unused commitment fee due to each Bank for each quarterly period ending on the last day of each March, June, September and December, commencing on December 31, 1993. Such unused commitment fee shall accrue from the Closing Date to the Termination Date and shall be due and payable quarterly in arrears no later than thirty (30) days after the Company receives the invoice referred to above, with the final payment to be made on the Termination Date; provided that, in connection with any reduction or termination of Commitments pursuant to Section 2.9, the accrued, unused commitment fee calculated for the period ending on such date shall also be paid on the date of such reduction or termination, with the next succeeding quarterly payment being calculated on the basis of the period from the reduction or termination date to such quarterly payment date. The unused commitment fees provided in this subsection shall accrue at all times after the Closing Date, including during any Clean-up Period. (c) Letter of Credit Fees. The Company shall pay to the Agent for the account of each Bank a letter of credit fee at the rate of 1.00% per annum of such Bank's Commitment Percentage of the aggregate Stated Amount of all LCs issued and outstanding. Such letter of credit fee shall accrue from the date of issuance of each LC to the date of termination of such LC as set forth in such LC and shall be due and payable quarterly in advance, with the first such payment due on the date of issuance of each such LC. (d) Letter of Credit Issuance Fees. The Company shall pay to the Agent for the account of the Issuing Bank a letter of credit issuance fee on the date of issuance of each LC at a rate to be determined according to the standard fee schedules of the Issuing Bank with respect to letters of credit. SECTION 4.3 Computation of Fees and Interest. (a) All computations of interest in respect of the Base Rate and all computations of letter of credit fees pursuant to Section 4.2(c) shall be made on the basis of a year of 365 or 366 days, as the case may be, and actual days elapsed. All other computations of fees and interest under this Agreement shall be made on the basis of a 360-day year and actual days elapsed. Interest and fees shall accrue during each period during which interest or such fees are computed from and including the first day thereof to but excluding the last day thereof. (b) The Agent will, with reasonable promptness, notify the Company and the Banks of each determination of a Eurodollar Rate or CD Rate; provided, however, that any failure to do so shall not relieve the Company of any liability hereunder or provide the basis for any claim against the Agent. Each determination of an interest rate by the Agent pursuant hereto shall be conclusive and binding on the Company and the Banks in the absence of manifest error. SECTION 4.4 Increased Costs; Capital Adequacy. (a) If (i) Regulation D of the Board of Governors of the Federal Reserve System, or (ii) after the date hereof, 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 the interpretation or administration thereof, or compliance by a Bank with any request or directive (whether or not having the force of law) of any such authority, central bank or comparable agency issued after the date hereof, (i) shall subject such Bank to any tax, duty or other charge with respect to any Eurodollar Rate Loan or CD Rate Loan made by such Bank, the Note issued to such Bank, such Bank's obligation to make or maintain any such Loan, any LC issued by the Issuing Bank or the Issuing Bank's obligation to make or maintain any such LC, or shall change the basis of taxation of payments to a Bank or the Issuing Bank, as the case may be, of the principal of or interest on any such Eurodollar Rate Loan or CD Rate Loan or such LC or any other amounts due under this Agreement in respect of any such Eurodollar Rate Loan or CD Rate Loan or such LC or such Bank's or the Issuing Bank's, as the case may be, obligation to make or maintain any such Eurodollar Rate Loan or CD Rate Loan or such LC (except for changes in the rate of tax on the overall net income of such Bank imposed by the jurisdiction in which such Bank's principal executive office is located); or (ii) shall impose, modify or deem applicable any reserve (including, without limitation, any reserve imposed by the Federal Reserve Board but excluding, in the case of Eurodollar Rate Loans, any reserve prescribed by the Federal Reserve Board included in the determination of LIBOR), special deposit or similar requirement against assets of, deposits with or for the account of, or credit extended by, such Bank; and the result of any of the foregoing is to increase the cost to such Bank of making or maintaining any Loan or to the Issuing Bank of issuing or maintaining any LC, or to reduce the amount of any sum received or receivable by such Bank or the Issuing Bank, as the case may be, under this Agreement or under its Note with respect thereto, then within 30 days after demand by such Bank, with a copy of such demand to the Agent (which demand shall be accompanied by a statement setting forth in reasonable detail the basis of such demand), the Company shall pay to the Agent for the account of such Bank such additional amount or amounts as will compensate such Bank for such increased costs or such reduction, provided, however, that any such amount or amounts payable by the Company shall not exceed the increased costs or amount of reduction of such Bank or the Issuing Bank, as the case may be, in direct proportion to any such Loan or any such LC. (b) If either (i) the introduction of or any change in or in the interpretation of any law or regulation or (ii) compliance by a Bank with any new guideline or request from any central bank or other governmental authority affects or would affect the amount of capital required or expected to be maintained by such Bank or any corporation controlling such Bank and the amount of such capital is increased by or based upon the existence of such Bank's commitment to make or maintain any Loan by such Bank hereunder or in the case of the Issuing Bank, its commitment to issue any LC hereunder, then, within 30 days after demand by such Bank, with a copy to the Agent (which demand shall set forth in reasonable detail the basis of such demand), the Company shall pay to the Agent for the account of such Bank, from time to time as reasonably specified by such Bank, additional amounts sufficient to compensate such Bank in the light of such circumstances, to the extent that such Bank reasonably determines such increase in capital to be allocable to the existence of such Bank's commitment to make or maintain any Loan hereunder or in the case of the Issuing Bank, its commitment to issue any LC hereunder, provided, however, that any such amount or amounts payable by the Company shall not exceed the increased amount of capital required to be maintained by such Bank and allocable to any such Loan or any such LC, as the case may be, in direct proportion to any such Loan or any such LC. SECTION 4.5 Funding Losses. The Company agrees to reimburse each Bank and to hold each Bank harmless from any loss or expense which such Bank may sustain or incur as a consequence of: (a) the failure of the Company to make when due any payment of principal of any Eurodollar Rate Loan or CD Rate Loan (including payments made after any acceleration thereof) not resulting from any Bank's failure to act; (b) the failure of the Company to borrow, continue or convert a Loan after the Company has given (or is deemed to have given) a Notice of Borrowing or a Notice of Conversion/ Continuation; (c) the failure of the Company to make any prepayment after the Company has given a notice in accordance with Section 2.10 or Section 2.11; (d) the prepayment of a Eurodollar Rate Loan or a CD Rate Loan on a day which is not the last day of the Interest Period with respect thereto; or (e) the conversion pursuant to Section 2.4 of any Eurodollar Rate Loan or CD Rate Loan to a Loan of another type on a day that is not the last day of the Interest Period with respect thereto; including, in each case, (i) any such loss or expense arising from the liquidation or reemployment of funds obtained by it to maintain its Eurodollar Rate Loans or CD Rate Loans hereunder or from fees payable to terminate the deposits from which such funds were obtained and (ii) with respect to any certificate of deposit purchased by the Company from each Bank in connection with a CD Rate Loan, any penalty assessed by such Bank for the early withdrawal of the funds deposited under any such certificate of deposit in accordance with such Bank's usual and customary practices. SECTION 5 MAKING OF PAYMENTS SECTION 5.1 Payments by the Company. (a) All payments (including prepayments) to be made by the Company on account of principal, interest, fees and other amounts required hereunder shall, except as otherwise expressly provided herein, be made to the Agent for the ratable account of the Banks at the Agent's Payment Office without condition or reservation of right in immediately available funds, no later than 12:00 noon (Chicago time) on the date specified herein. Any payment which is received by the Agent later than 12:00 noon (Chicago time) shall be deemed to have been received on the immediately succeeding Business Day and any applicable interest or fee shall continue to accrue. The Agent will promptly distribute to each Bank its Commitment Percentage of such principal, interest, fees or other amounts, in like funds as received, but in any event shall distribute such amounts no later than the close of business on the date received by the Agent if received by the Agent no later than 12:00 noon on such date. If the Agent shall fail to pay to any Bank the amount due such Bank pursuant to this Section when due, the Agent shall be obligated to pay to such Bank interest on the amount that should have been paid hereunder for each day from the date such amount shall have become due until the date such amount is paid, at the Federal Funds Rate as in effect for each such day. (b) Whenever any payment hereunder shall be stated to be due on a day other than a Business Day, such payment shall be made on the next succeeding Business Day, and such extension of time shall in such case be included in the computation of interest or fees, as the case may be; subject to the provisions set forth in the definition of "Interest Period" herein. (c) Unless the Agent shall have received written notice from the Company prior to the date on which any payment is due to the Banks hereunder that the Company will not make such payment in full as and when required hereunder, the Agent may assume that the Company has made such payment in full to the Agent on such date in immediately available funds and the Agent may (but shall not be so required), in reliance upon such assumption, cause to be distributed to each Bank on such due date an amount equal to the amount then due such Bank. If and to the extent the Company shall not have made such payment in full to the Agent, each Bank shall repay to the Agent on demand such amount distributed to such Bank, together with interest thereon for each day from the date such amount is distributed to such Bank until the date such Bank repays such amount to the Agent, at the Federal Funds Rate as in effect for each such day. SECTION 5.2 Payments by the Banks to the Agent. (a) Unless the Agent shall have received written notice from a Bank, with respect to each Borrowing (other than a Borrowing of Base Rate Loans), at least one Business Day prior to the date of any proposed Borrowing (or, in the case of a Borrowing of Base Rate Loans, on the applicable Borrowing date), that such Bank will not make available to the Agent as and when required hereunder for the account of the Company the amount of that Bank's Commitment Percentage of the Borrowing, the Agent may assume that each Bank has made such amount available to the Agent in immediately available funds on the Borrowing date and the Agent may (but shall not be so required), in reliance upon such assumption, make available to the Company on such date a corresponding amount. If and to the extent any Bank shall not have made its full amount available to the Agent in immediately available funds and the Agent in such circumstances has made available to the Company such amount, that Bank shall on the next Business Day following the date of such Borrowing make such amount available to the Agent, together with interest at the Federal Funds Rate for and determined as of each day during such period. A notice of the Agent submitted to any Bank with respect to amounts owing under this Section 5.2(a) shall be conclusive, absent manifest error. If such amount is so made available, such payment to the Agent shall constitute such Bank's Loan on the date of Borrowing for all purposes of this Agreement. If such amount is not made available to the Agent on the next Business Day following the date of such Borrowing, the Agent shall notify the Company of such failure to fund and, upon demand by the Agent, the Company shall pay such amount to the Agent for the Agent's account, together with interest thereon for each day elapsed since the date of such Borrowing, at a rate per annum equal to the interest rate applicable at the time to the Loans comprising such Borrowing. (b) The failure of any Bank to make any Loan on any date of Borrowing shall not relieve any other Bank of any obligation hereunder to make a Loan on the date of such Borrowing, but no Bank shall be responsible for the failure of any other Bank to make the Loan to be made by such other Bank on the date of any Borrowing. SECTION 5.3 Setoff. (a) The Company agrees that, if at any time (i) any amount owing by it under this Agreement or any Related Document is then due and payable to a Bank or (ii) any Event of Default shall have occurred and be continuing, then such Bank, in its sole discretion, may apply to the payment of the Liabilities any and all balances, credits, deposits, accounts or moneys of the Company then or thereafter with such Bank. (b) Without limitation of Section 5.3(a), the Company agrees that, upon and during the continuance of any Event of Default, such Bank is hereby authorized, at any time and from time to time, without notice to the Company, (i) to set off against and to appropriate and apply to the payment of the Liabilities (whether matured or unmatured) any and all amounts which such Bank is obligated to pay over to the Company (whether matured or unmatured, and, in the case of deposits, whether general or special, time or demand and however evidenced) and (ii) pending any such action, to the extent necessary, to hold such amounts as collateral to secure such Liabilities. (c) Notwithstanding any other provision of this Agreement, the Notes or any other Related Document, the Banks shall not set off against, or appropriate or apply to the payment of any Liabilities, any of the deposits, accounts or other assets of any Insurance Subsidiary. SECTION 5.4 Sharing of Payments. If, other than as expressly provided elsewhere herein, any Bank shall obtain on account of the Liabilities held by such Bank any payment (whether voluntary, involuntary, through the exercise of any right of set-off, or otherwise) in excess of its Commitment Percentage of payments on account of the Liabilities obtained by all the Banks, such Bank shall promptly (a) notify the Agent of such fact and (b) upon demand purchase from the other Banks a portion of the Liabilities held by such other Banks as shall be necessary to cause such purchasing Bank to share the excess payment ratably with each of them based upon each Bank's Commitment Percentage; provided, however, that if all or any portion of such excess payment is thereafter recovered from the purchasing Bank, such purchase shall to that extent be rescinded and each other Bank shall repay to the purchasing Bank the purchase price paid therefor, together with an amount equal to such paying Bank's Commitment Percentage of any interest or other amount paid or payable by the purchasing Bank in respect of the total amount so recovered. The Company agrees that any Bank so purchasing a portion of another Bank's Liabilities pursuant to this Section 5.4 may, to the fullest extent permitted by law, exercise all of its rights of payment (including the right of setoff) with respect to such purchased Liabilities as fully as if such Bank were the direct creditor of the Company in the amount of such purchased Liabilities. The Agent will keep records (which shall be conclusive and binding in the absence of manifest error) of amounts purchased pursuant to this Section 5.4 and will in each case notify the Banks following any purchases or repayments. SECTION 6 REPRESENTATIONS AND WARRANTIES To induce each Bank to enter into this Agreement and to make Loans and to induce the Issuing Bank to enter into this Agreement and issue LCs hereunder, the Company represents and warrants to each Bank, the Issuing Bank and the Agent that: SECTION 6.1 Corporate Organization. The Company is a corporation duly existing and in good standing under the laws of the State of Delaware and is duly qualified and in good standing as a foreign corporation authorized to do business in Illinois, which is the only other jurisdiction in which the Company is required to be duly qualified and in good standing as a foreign corporation. The Company's failure to be so qualified in any other jurisdiction does not materially and adversely affect the Company's business, operations or financial condition or its ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 6.2 Authorization; No Conflict. The Company's execution, delivery and performance of this Agreement and each of the Related Documents to which it is a party and the consummation of the transactions contemplated by this Agreement and each of the Related Documents are within the Company's corporate powers, have been duly authorized by all necessary corporate action, require no governmental, regulatory or other approval, and (a) do not and will not contravene or conflict with any provision of (i) any law the failure of the Company to comply with in the Company's determination materially and adversely affects the Company's business, operations or financial condition or its ability to perform its obligations hereunder and under the Related Documents to which it is a party, (ii) any judgment, decree or order applicable to the Company, or (iii) the Company's articles of incorporation or by-laws, and (b) do not and will not contravene or conflict with any provision of any agreement or instrument binding upon the Company or upon any property of the Company that in the Company's determination materially and adversely affects the Company's business, operations or financial condition or its ability to perform its obligations hereunder or under the Related Documents to which it is a party. SECTION 6.3 Validity and Binding Nature. This Agreement and the Related Documents to which the Company is a party are (or, when duly executed and delivered, will be) the legal, valid and binding obligations of the Company enforceable against the Company in accordance with their respective terms. SECTION 6.4 Financial Statements. The annual and quarterly historical balance sheets and statements of operations that have been or shall hereafter be furnished to the Agent, the Issuing Bank or any Bank by or at the direction of the Company for the purposes of or in connection with this Agreement do and will present fairly the financial condition of the Persons involved as of the dates thereof and the results of their operations for the period(s) covered thereby, all in accordance with GAAP, consistently applied, unless otherwise noted therein. SECTION 6.5 Litigation and Contingent Liabilities. (a) No litigation (including, without limitation, derivative actions), arbitration proceedings, governmental proceedings or investigations or regulatory proceedings are pending or, to the best of its knowledge, threatened against the Company or any Material Subsidiary which in the Company's determination materially and adversely affects the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. In addition, to the best of the Company's knowledge, there are no inquiries, formal or informal, which give rise to such actions, proceedings or investigations. (b) The Company and, to the best of the Company's knowledge, each Material Subsidiary has obtained all licenses, permits, franchises and other governmental authorizations necessary to the ownership of its properties or to the conduct of its businesses, including without limitation all licenses, permits, franchises and other governmental authorizations required under all applicable Environmental Laws, a failure to obtain or violation of which in the Company's determination materially and adversely affects the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. (c) The Company does not have any material contingent liabilities required to be disclosed pursuant to GAAP that are not provided for or disclosed in the financial statements referred to in Section 6.4 hereof. SECTION 6.6 Employee Benefit Plans. To the best of the Company's knowledge, each Plan complies in all material respects with all applicable statutes and governmental rules and regulations (including, without limitation, the requirements of Section 401(a) of the Internal Revenue Code of 1986, as amended, to the extent that such Plan is intended to conform to that section) and during the 12-consecutive-month period prior to the Closing Date, (i) no Reportable Event has occurred and is continuing with respect to any Plan subject to Title IV of ERISA, (ii) neither the Company nor any ERISA Affiliate has withdrawn from any Plan subject to Title IV of ERISA or instituted steps to do so, (iii) no steps have been instituted to terminate any Plan subject to Title IV of ERISA, (iv) no contribution failure has occurred with respect to any Plan sufficient to give rise to a lien under Section 302(f) of ERISA, or (v) each Plan which is intended to be qualified pursuant to Section 401(a) of the Internal Revenue Code of 1986, as amended, has received a favorable determination letter. To the best of the Company's knowledge, no condition exists or event or transaction has occurred in connection with any Plan which would result in the incurrence by the Company or any ERISA Affiliate of any liability, fine or penalty, which in the Company's determination materially and adversely affects the Company's business, operations or financial condition, or the ability of the Company to perform its obligations hereunder and under the Related Documents to which it is a party. Neither the Company nor any ERISA Affiliate presently maintains, contributes to or, to the best of the Company's knowledge, has any liability (including current or potential withdrawal liability) with respect to any Multiemployer Plan. To the best of the Company's knowledge, neither the Company nor any ERISA Affiliate has any liability with respect to any funded or unfunded postretirement benefit for employees or former employees (including medical, health or life insurance) other than liability for continuation coverage described in Part 6 of Title I of ERISA. SECTION 6.7 Investment Company Act. The Company is not an "investment company" or a company "controlled" by an "investment company", within the meaning of the Investment Company Act of 1940, as amended. SECTION 6.8 Regulation U. The Company is not engaged principally, or as one of its important activities, in the business of extending credit for the purpose of purchasing or carrying Margin Stock. SECTION 6.9 Accuracy of Information. To the best of the Company's knowledge, all factual information heretofore or contemporaneously furnished by the Company to the Agent, the Issuing Bank or any Bank for purposes of or in connection with this Agreement or any transaction contemplated hereby is, and all other factual information hereafter furnished by the Company to the Agent, the Issuing Bank or any Bank will be, true and accurate in every material respect on the date as of which such information is dated or certified, and the Company has not knowingly omitted and will not knowingly omit any material fact it deems necessary to prevent such information from being false or misleading. SECTION 6.10 Labor Controversies. There are no labor controversies pending or threatened against the Company or any Material Subsidiary which in the Company's determination materially and adversely affect the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 6.11 Tax Status. Except as set forth in Schedule 6.11 hereto, the Company and, to the best of the Company's knowledge, each Material Subsidiary, have made or filed all income and other tax returns, reports and declarations required by any jurisdiction to which it is subject, have paid all taxes, assessments and other charges shown or determined to be due on such returns, reports and declarations (other than those being diligently contested in good faith by appropriate proceedings), and have set aside adequate reserves against liability for taxes, assessments and charges applicable to periods subsequent to those covered by such returns, reports and declarations, a failure of which to file, to pay or to set aside in the Company's determination materially and adversely affects the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 6.12 No Default. No event has occurred and no condition exists which, upon the execution and delivery of, or consummation of any transaction contemplated by, this Agreement or any Related Document, or upon the funding of any Loan or the issuance of any LC, will constitute an Event of Default. The Company and each Material Subsidiary have not received notice of default with respect to any other material agreement, security or contract, except those for which a default exists that is not capable of being cured with the payment of money or as to which a good faith dispute exists. SECTION 6.13 Compliance with Applicable Laws. The Company and, to the best of the Company's knowledge, each Material Subsidiary are in compliance with the requirements of all applicable laws, rules, regulations, and orders of all governmental authorities (Federal, state, local or foreign, and including, without limitation, Environmental Laws and Insurance Laws), a breach of which would in the Company's determination materially and adversely affect the Company's or such Material Subsidiary's business, operations or financial condition, or the ability of the Company to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 6.14 Insurance. The Company is in its sole determination, maintains adequate general liability, property and casualty insurance for its benefit under policies issued by insurers of recognized responsibility. SECTION 6.15 Solvency. After giving effect to the transactions contemplated hereby and by the Related Documents, the Company is not "insolvent", nor will the Company's incurrence of obligations to repay any Loan or to reimburse the Issuing Bank with respect to the Issuing Bank's honoring a draw under an LC render the Company "insolvent." For the purposes of this Section 6.15, a corporation is "insolvent" if (i) the "present fair salable value" (as defined below) of its assets is less than the amount that will be required to pay its probable liability on its existing debts and other liabilities (including contingent liabilities) as they become absolute and matured; (ii) the property of the Company constitutes unreasonably small capital for the Company to carry out its business as now conducted and as proposed to be conducted including the capital needs of the Company; (iii) the Company intends to, or believes that it will, incur debts beyond its ability to pay such debts as they mature (taking into account the timing and amounts of cash to be received by the Company and amounts to be payable on or in respect of debt of the Company), or the cash available to the Company after taking into account all other anticipated uses of the cash of the Company is anticipated to be insufficient to pay all such amounts on or in respect of debt of the Company when such amounts are required to be paid; or (iv) the Company believes that final judgments against the Company in actions for money damages will be rendered at a time when, or in an amount such that, the Company will be unable to satisfy any such judgments promptly in accordance with their terms (taking into account the maximum reasonable amount of such judgments in any such actions and the earliest reasonable time (as determined in the Company's best judgment) at which such judgments might be rendered), or the cash available to the Company after taking into account all other anticipated uses of the cash of the Company (including the payments on or in respect of debt referred to in clause (iii) of this Section 6.15), is anticipated to be insufficient to pay all such judgments promptly in accordance with their terms. For purposes of this Section 6.15, the following terms have the following meanings: (x) the term "debts" includes any legal liability, whether matured or unmatured, liquidated, absolute, fixed or contingent, (y) the term "present fair salable value" of the Company's assets means the amount which may be realized, within a reasonable time (as determined in the Company's best judgment), either through collection or sale of such assets at their regular market value and (z) the term "regular market value" means the amount which a capable and diligent businessman (as determined in the Company's best judgment) could obtain for the property in question within a reasonable time (as determined in the Company's best judgment) from an interested buyer who is willing to purchase under ordinary selling conditions (as determined in the Company's best judgment). SECTION 6.16 Use of Proceeds. The Company will use the proceeds of any Loans for general corporate purposes, including but not limited to financing future acquisitions and future working capital needs, including transactions with Affiliates. SECTION 6.17 Subsidiaries. The Company has no Subsidiaries except as listed on Schedule 6.17 hereto. SECTION 7 COVENANTS Until the expiration or termination of each Bank's Commitment and thereafter until all Liabilities of the Company are paid in full and all LCs have expired or been terminated, the Company agrees that, unless at any time the Majority Banks (except with respect to such sections that expressly require the written consent of all of the Banks) shall otherwise expressly consent in writing, it will: SECTION 7.1 Reports, Certificates and Other Information. Furnish to the Agent, the Issuing Bank and each of the Banks: (a) Annual Report. On or before the ninetieth (90th) day after each of the Company's fiscal years, a copy of an unqualified annual consolidated audit report of the Company and its Subsidiaries, prepared in conformity with GAAP, duly certified by independent certified public accountants of recognized standing selected by the Company. (b) Interim Reports. On or before the forty-fifth (45th) day after the end of each of the first three quarters of each fiscal year of the Company, a copy of the unaudited financial statements of the Company prepared in a manner consistent with the financial statements referred to in Section 7.1(a) hereof, signed by an Authorized Officer and consisting of, at least, balance sheets as at the close of such quarter and statements of earnings for such quarter and for the period from the beginning of such fiscal year to the close of such quarter. (c) Statutory Statements. Promptly upon the filing thereof, copies of all Statutory Statements required to be filed by the Company and each Principal Insurance Subsidiary with or to the insurance commission or department of such Person's respective state of domicile. (d) Reports to SEC. Promptly upon the filing or making thereof, copies of each Form 10-K and Form 10-Q made by the Company with or to the Securities and Exchange Commission. (e) Certificates. Simultaneously with the furnishing of each annual statement and each quarterly statement provided for in this Section 7.1, a certificate of an Authorized Officer stating that (i) no Event of Default has occurred and is continuing, or, if there is any such event, setting forth the details thereof and the action that the Company is taking or proposes to take with respect thereto and (ii) that the Company either has funds or investments or has the ability to promptly obtain funds from its Subsidiaries, including, without limitation, by means of inter-corporate loans or advances from such Subsidiaries, dividends or other distributions from such Subsidiaries or purchases by such Subsidiaries of stock, other securities or assets of, or fees for services that are due and payable from, other Subsidiaries of the Company, in an amount not less than the sum of (A) the amount of all principal of and interest on all Loans outstanding, (B) the Aggregate Stated Amount of all LCs issued and outstanding and (C) the aggregate amount of all Reimbursement Obligations, and that the ability of the Company to promptly obtain such funds will not violate or result in the breach of any law, rule, regulation or order of any governmental authority (federal, state, local or foreign and including, without limitation, Insurance Laws). (f) Notice of Default, Litigation and ERISA Matters. Promptly upon learning of the occurrence of any of the following, written notice thereof which describes the same and the steps being taken by the Company with respect thereto: (i) the occurrence of an Event of Default, (ii) the institution of, or any adverse determination in, any litigation, arbitration proceeding or governmental proceeding in which any injunctive relief is sought or in which money damages in excess of $5,000,000 are sought, (iii) the occurrence of a material Reportable Event with respect to any Plan subject to Title IV of ERISA, (iv) the institution of any material steps by the Company, the PBGC or any other Person to terminate any Plan subject to Title IV of ERISA, (v) the institution of any material steps by the Company or any ERISA Affiliate to withdraw from any Plan subject to Title IV of ERISA which would result in material liability to the Company, (vi) the failure to make a material required contribution to any Plan if such failure is sufficient to give rise to a lien under Section 302(f) of ERISA, (vii) the taking of any material action with respect to a Plan which could result in the requirement that the Company furnish a bond or other security to the PBGC or such Plan, (viii) the occurrence of any event with respect to any Plan which could result in the incurrence by the Company of any liability, fine or penalty, which would in the Company's determination materially and adversely affect the Company's business, operations or financial condition or the ability of the Company to perform its obligations hereunder and under the Related Documents to which it is a party, or (ix) promptly after the incurrence thereof, notice of any material increase in the contingent liability of the Company with respect to any postretirement Plan benefits. (g) Other Information. Such other material information concerning the Company as the Agent, the Issuing Bank or any Bank may reasonably request from time to time. SECTION 7.2 Corporate Existence and Franchises. Except as otherwise expressly permitted in this Agreement, maintain and cause each Material Subsidiary to maintain in full force and effect its separate existence and all rights, licenses, leases and franchises reasonably necessary in the Company's sole discretion to the conduct of its and each Material Subsidiary's business. SECTION 7.3 Books, Records and Inspections. Maintain, and cause each Material Subsidiary to maintain, books and records in accordance with GAAP in all material respects, the Agent on behalf of the Banks to have access to the Company's books and records, and permit the Agent on behalf of the Banks, upon seven (7) days notice to the Company, to inspect the Company's properties and operations during normal business hours and at reasonable intervals, but no more frequently than semi-annually if no Event of Default has occurred. SECTION 7.4 Insurance. Maintain, and cause each Material Subsidiary to maintain, such insurance as may be required by law. SECTION 7.5 Taxes and Liabilities. Promptly pay, and cause each Material Subsidiary to pay, when due all taxes, duties, assessments and other liabilities (except such taxes, duties, assessments and other liabilities as the Company or such Material Subsidiary is diligently contesting in good faith and by appropriate proceedings; provided that the Company or such Material Subsidiary has provided for and is maintaining adequate reserves with respect thereto in accordance with GAAP), a failure of which to pay in the Company's determination materially and adversely affects the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 7.6 Cash Flow Coverage. Maintain a ratio of (x) Available Cash Flow to (y) Debt Service Requirements equal to or greater than 1.10 to 1 at the end of each fiscal quarter of the Company and its Subsidiaries on a consolidated basis, such ratio to be calculated for the period of the four fiscal quarters ending on the most recent fiscal quarter end prior to the date of computation. SECTION 7.7 Net Worth. Nor permit the Net Worth of the Company to be less than $60,000,000 at any time. SECTION 7.8 Funds for Refinancing. Shall, at all times, either have funds or investments or have the ability to promptly obtain funds from its Subsidiaries, including, without limitation, by means of inter- corporate loans or advances from such Subsidiaries, dividends or other distributions from such Subsidiaries or purchases by such Subsidiaries of stock, other securities or assets of, or fees for services that are due and payable from, other Subsidiaries of the Company, in an amount at all times not less than the sum of (a) the amount of all principal of and interest on all Loans outstanding, (b) the Aggregate Stated Amount of all LCs issued and outstanding and (c) the aggregate amount of all Reimbursement Obligations, and the ability of the Company to promptly obtain such funds shall not violate or result in the breach of any law, rule, regulation or order of any governmental authority (federal, state, local or foreign and including, without limitation, Insurance Laws). SECTION 7.9 Indebtedness. Not incur or permit to exist any Indebtedness that by its terms or otherwise is senior in right of payment to the Liabilities, except (i) Indebtedness hereinafter incurred in connection with the acquisition of assets or property, which Indebtedness is secured by the assets or property so acquired, (ii) Indebtedness originally incurred under this Agreement and converted into term loan Indebtedness pursuant to such terms and subject to such documentation as is satisfactory to the Agent and the Majority Banks in such Majority Banks' reasonable discretion (provided, however, that no Bank shall, without its consent, be compelled to convert any Indebtedness owed to it and originally incurred under this Agreement into term loan Indebtedness) and (iii) Indebtedness in connection with Permitted Liens pursuant to Section 7.16. SECTION 7.10 Risk-Based Capital. Shall cause each Principal Insurance Subsidiary on an individual basis to maintain at all times Total Adjusted Capital equal to or greater than 260% of Authorized Control Level RBC. SECTION 7.11 Real Estate Concentration. Shall cause each Principal Insurance Subsidiary on an individual basis to maintain at all times a Real Estate Concentration Ratio of less than 50%. SECTION 7.12 Investment Quality. Shall cause each Principal Insurance Subsidiary on an individual basis to maintain at all times a ratio of (x) Non-Investment Grade Obligations to (y) Total Invested Assets to be less that 15%. SECTION 7.13 Intentionally Omitted. SECTION 7.14 Insurance Company Leverage Ratio. Shall cause (a) all Principal Insurance Subsidiaries on a combined basis to maintain at all times an aggregate Insurance Company Leverage Ratio of greater than 8.33%, and (b) each Principal Insurance Subsidiary on an individual basis to maintain at all times an Insurance Coverage Leverage Ratio of greater than 7.50%. SECTION 7.15 Intentionally Omitted. SECTION 7.16 Negative Pledge. Shall not permit any Principal Insurance Subsidiary to (a) create or permit to exist any Lien with respect to any assets or properties now owned or hereafter acquired by such Principal Insurance Subsidiary or (b) enter into or consent to any oral or written agreement or arrangement that prohibits or in any manner restricts any such Principal Insurance Subsidiary from creating, incurring, assuming or suffering to exist any Lien upon or with respect to any of such Principal Insurance Subsidiary's assets or properties or to assign or otherwise convey any right to receive income, except the following Liens ("Permitted Liens"): (i) purchase money security interests hereinafter incurred in connection with the acquisition of assets or property; (ii) Liens incurred in connection with the conversion of Indebtedness originally incurred under this Agreement into term loan Indebtedness pursuant to such terms and subject to such documentation as is satisfactory to the Agent and the Majority Banks in such Majority Banks' reasonable discretion (provided, however, that no Bank shall, without its consent, be compelled to convert any Indebtedness owed to it and originally incurred under this Agreement into term loan Indebtedness); (iii) Liens for taxes, assessments or governmental charges or levies on property of the Company if the same shall not at the time be delinquent or thereafter can be paid without penalty, or are being contested in good faith and by appropriate proceedings and as to which the Company shall have set aside on its books such reserves as are required by GAAP with respect to any such taxes, assessments or other governmental charges; (iv) Liens imposed by law, such as carriers', warehousemen's and mechanics' liens and other similar liens, which arise in the ordinary course of business with respect to obligations not yet due or being contested in good faith by appropriate proceedings and as to which the Company shall have set aside on its books such reserves as are required by GAAP with respect to any such Liens; (v) Liens arising out of pledges or deposits under insurance laws, worker's compensation laws, unemployment insurance, old age pensions, or other Social Security or retirement benefits, or similar legislation; (vi) Liens consisting of mortgages, deeds of trust, liens or security interests on any interest of the Company as sublessor under any sublease of property which solely secure obligations of the Company as the lessee of such property and extensions or renewals thereof; and (vii) Liens consisting of mortgages, deeds of trust or similar encumbrances that may be incurred by the Company or an Insurance Subsidiary of the Company in connection with the Company's or such Insurance Subsidiary's purchase or refinancing of the building and property located at 1750 Golf Road, Schaumburg, Illinois; provided, however, that promptly after the creation of any Lien of the type referred to in this subsection (vii), the Company shall provide to the Agent written notice of the creation of such Lien, describing the amount of the obligation secured thereby and the properties and assets subject to such Lien. SECTION 7.17 Change in Nature of Business. Not, and not permit the Company and its Material Subsidiaries as a whole to, make any material change in the nature of its business carried on as of the date first stated above, provided, however, the Company or any Material Subsidiary may make changes in the nature of its business provided that any such change made is related in any way to the medical or insurance businesses. SECTION 7.18 Depository Relationship. The Company shall maintain its primary depository and remittance relationship with the Banks. Pursuant to such primary depository and remittance relationship, the Company shall maintain with each Bank average available demand deposits equal to the amount needed to cover non-credit services provided by such Bank to the Company and its Subsidiaries, such amount to be determined according to the published fee schedules of such Bank. The Company agrees that if the amount of available demand deposits maintained by the Company with such Bank are insufficient to equal the amount needed to cover non- credit services provided by such Bank, then such Bank may charge the Company a deficiency fee sufficient to cover such non-credit services, such deficiency fee to be determined according to the published fee schedules of such Bank or the fees being charged to the Company at that time, whichever are less. SECTION 7.19 Employee Benefit Plans. Not permit, and not permit any ERISA Affiliate to permit, any condition to exist in connection with any Plan which might constitute grounds for the PBGC to institute proceedings to have such Plan terminated or a trustee appointed to administer such Plan; and not engage in, or permit to exist or occur, or permit any ERISA Affiliate to engage in, or permit to exist or occur, any other condition, event or transaction with respect to any Plan which would result in the incurrence by the Company or any ERISA Affiliate of any liability, fine or penalty, which in either case would in the Company's determination materially and adversely affect the Company's business, operations or financial condition, or the ability of the Company to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 7.20 Use of Proceeds. Not, and not permit any Subsidiary to, use or permit the direct or indirect use of any proceeds of or with respect to any Loan for the purpose, whether immediate, incidental or ultimate, of "purchasing or carrying" (within the meaning of Regulation U) Margin Stock. SECTION 7.21 Other Agreements. Not, and not permit any Material Subsidiary to, enter into any agreement containing any provision which would be violated or breached by the performance of the Company's obligations hereunder, under any Related Document or under any instrument or document delivered or to be delivered by the Company hereunder or thereunder or in connection herewith or therewith or which would violate or breach any provision hereof or thereof or of any such instrument or document. SECTION 7.22 Compliance with Applicable Laws. Comply, and cause each Material Subsidiary to comply, with the requirements of all applicable laws, rules, regulations, and orders of all governmental authorities (Federal, state, local or foreign, and including, without limitation, Environmental Laws and Insurance Laws), a breach of which would in the Company's determination materially and adversely affect the Company's or such Material Subsidiary's business, operations or financial condition, or which would impair the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 7A UNRESTRICTED SUBSIDIARIES SECTION 7A.1 Unrestricted Subsidiaries. The Company may, from time to time, by written notice to the Agent, a copy of which the Agent shall promptly deliver to each Bank, designate a Subsidiary as an Unrestricted Subsidiary (referred to herein as an "Unrestricted Subsidiary") provided that each of the following conditions is satisfied: (a) the proposed Unrestricted Subsidiary shall not be a Material Subsidiary existing on the Closing Date; (b) the aggregate Indebtedness of all Unrestricted Subsidiaries, including the Indebtedness of the proposed Unrestricted Subsidiary, shall not exceed $40,000,000; (c) If Loans made to the Company under this Agreement were used by the Company directly or indirectly to acquire the proposed Unrestricted Subsidiary, such Loans shall have been repaid by the Company pursuant to the terms hereof; (d) the proposed Unrestricted Subsidiary shall have no financial obligations, liabilities or dealings of any kind with the Company or any Material Subsidiary of the Company, except for (i) ordinary overhead allocations, (ii) marketing agreements, administration agreements and other agreements which the Company customarily enters into with its Subsidiaries so long as the terms of such agreements are no more favorable to the Company than the terms of agreements the Company enters into with its other Subsidiaries, and (iii) other customary inter-corporate dealings so long as the terms of such dealings are no more favorable to the Company than the terms of dealings the Company enters into with its other Subsidiaries; and (e) the proposed Unrestricted Subsidiary shall not have, permit to exist or incur any undertaking, indebtedness, obligation or other liability pursuant to which recourse may be made to the Company or any Material Subsidiary of the Company, and neither the Company nor any Material Subsidiary of the Company shall be or become a guarantor or surety of, or otherwise be or become responsible in any manner (whether by support agreement or agreement to purchase any obligations, stock, assets, goods or services, or to supply or advance any funds, assets, goods or services, or otherwise) with respect to any undertaking, indebtedness, obligation or other liability of such proposed Unrestricted Subsidiary; provided, however, that the proposed Unrestricted Subsidiary shall be permitted to engage in the types of transactions prohibited by this Section 7A.1(e), and the Company shall be permitted to provide guarantees and sureties, if the Company's obligations under such transactions, guaranties and sureties (i) are expressly subordinated to the Company's obligations under this Agreement and (ii) shall not exceed $2,000,000 in the aggregate for any one Unrestricted Subsidiary. SECTION 7A.2 Additional Unrestricted Subsidiaries. In addition to the Unrestricted Subsidiaries designated pursuant to Section 7A.1 above, the Company and the Majority Banks can agree to designate any Subsidiary as an Unrestricted Subsidiary. Any Indebtedness of an Unrestricted Subsidiary designated as such pursuant to this Section 7A.2 shall be excluded from the calculation of the aggregate Indebtedness permitted pursuant to Section 7A.1. SECTION 7A.3 Effectiveness of Designation. The designation by the Company of a Subsidiary as an Unrestricted Subsidiary shall become effective five (5) Business Days after the Company delivers a written notice of such designation to the Agent, which notice shall certify that all of the conditions set forth in Section 7A.1 have been satisfied with respect to such Unrestricted Subsidiary. The Agent shall promptly deliver to each Bank a copy of such notice. SECTION 7A.4 Effect of Designation. Other than for purposes of the financial statements referenced in Section 7.1 hereof, the assets, liabilities, Indebtedness, income, losses, cash flow, net worth, liens and other relevant amounts and factors concerning any Unrestricted Subsidiary shall be excluded from the computations referenced in Sections 7.6 and 7.9 of this Agreement and, to the extent applicable, the computations referenced in Sections 7.10 through 7.16, inclusive, of this Agreement, and the Unrestricted Subsidiaries shall not be subject to any of the other limitations or restrictions contained herein. SECTION 8 CONDITIONS TO MAKING LOANS AND ISSUING LCS Each Bank's obligation to make any Loan and the Issuing Bank's obligation to issue any LC is subject to the satisfaction of each of the following conditions precedent: SECTION 8.1 Initial Loans. Each Bank's obligation to make its initial Loan and the Issuing Bank's obligation to issue its initial LC is, in addition to the conditions precedent specified in Section 8.2, subject to the satisfaction of each of the following conditions precedent: (a) Fees and Expenses. The Company shall have paid all fees owed to the Agent, the Issuing Bank and each of the Banks and reimbursed the Agent, the Issuing Bank and each of the Banks for all expenses due and payable hereunder on or before the Closing Date including, but not limited to, ANB's counsel fees provided for in Section 10.4 to the extent such counsel shall have requested payment of such fees. (b) Documents. The Agent shall have received in sufficient copies for the Issuing Bank and each of the Banks all of the following, each duly executed and delivered and dated the Closing Date, in form and substance satisfactory to the Agent, the Issuing Bank and each Bank: (i) Agreement. This Agreement, executed by the Company, the Agent and each Bank. (ii) Note. Promissory Notes, substantially in the form of Exhibit A hereto, with appropriate insertions, issued to each Bank and executed by the Company. (iii) Resolutions. Certified copies of resolutions of the Company's Board of Directors authorizing the execution, delivery and performance of this Agreement and the Related Documents to which the Company is a party and any other documents provided for herein or therein to be executed by the Company. (iv) Consents. Certified copies of all documents evidencing any necessary corporate action, consents and governmental approvals, if any, with respect to this Agreement, the Related Documents, and any other documents provided for herein or therein to be executed by the Company. (v) Incumbency and Signatures. A certificate of the Secretary or an Assistant Secretary of the Company certifying the names of the officer or officers of the Company authorized to sign this Agreement and the Related Documents to which the Company is a party and any other documents provided for herein or therein to be executed by the Company, together with a sample of the true signature of each such officer. Each Bank may conclusively rely on each such certificate until formally advised by a like certificate of any changes therein. (vi) Opinion of Counsel. Opinion of counsel to the Company in form and substance reasonably satisfactory to the Agent. (vii) Constitutive Documents. Certified copies of the Company's articles of incorporation and by-laws. (viii) Good Standing Certificates. Certificates of good standing for the Company in Delaware and Illinois and a certificate of the insurance commissioner or similar official of the jurisdiction of incorporation of each Principal Insurance Subsidiary as to the good standing of such Principal Insurance Subsidiary. (ix) Other. Such other documents as the Agent, the Issuing Bank or any Bank may reasonably request. SECTION 8.2 All Loans and LCs. Each Bank's obligation to make its initial Loan and each subsequent Loan, including the obligation of such Bank to convert or continue any Loan pursuant to Section 2.4 hereof, and the Issuing Bank's obligation to issue the initial LC and each subsequent LC, or any extension or amendment thereof, is subject to the following conditions precedent that: (a) No Default, etc. (i) No Event of Default shall have occurred and be continuing or will result from the making of such Loan or the issuance of such LC, and (ii) the Company's representations and warranties contained in Section 6 shall be true and correct as of the date of such requested Loan or LC with the same effect as though made on the date thereof (except to the extent such representations and warranties expressly refer to an earlier date, in which case they shall be true and correct as of such earlier date). (b) Notice. The Agent shall have received a Notice of Borrowing pursuant to and in accordance with the provisions of Section 2.3 hereof or a Notice of Conversion/Continuation pursuant to and in accordance with the provisions of Section 2.4 hereof, as the case may be. SECTION 9 EVENTS OF DEFAULT AND THEIR EFFECT SECTION 9.1 Events of Default. Each of the following shall constitute an Event of Default under this Agreement following the expiration of any applicable notice or cure period: (a) Nonpayment of the Loan. Default in the payment when due of the principal of or interest on any Loan, or the payment when due of any fees or any other amounts payable by the Company hereunder and continuance of such default for five (5) Business Days after the applicable due date. (b) Nonpayment of Other Indebtedness. Default in the payment when due (subject to any applicable grace period), whether by acceleration or otherwise, of any other Indebtedness of, or guaranteed by, the Company or any Material Subsidiary if the aggregate amount of any such other Indebtedness that is accelerated or due and payable, or that may be accelerated or otherwise become due and payable, by reason of such default is $5,000,000 or more, or default in the performance or observance of any obligation or condition with respect to any such other Indebtedness if the effect of such default is to accelerate the maturity of any such Indebtedness or cause any of such Indebtedness of $5,000,000 or more to be prepaid, purchased or redeemed or to permit the holder or holders thereof, or any trustee or agent for such holders, to cause such Indebtedness of $5,000,000 or more to become due and payable prior to its expressed maturity or to cause such Indebtedness of $5,000,000 or more to be prepaid, purchased or redeemed. (c) Bankruptcy or Insolvency. The Company becomes insolvent or generally fails to pay, or admits in writing its general inability to pay, debts as they become due; or the Company applies for, consents to, or acquiesces in the appointment of, a trustee, receiver or other custodian for the Company, or any property thereof, or makes a general assignment for the benefit of creditors; or, in the absence of such application, consent or acquiescence, a trustee, receiver or other custodian is appointed for the Company or for a substantial part of the property thereof and is not discharged within 60 days; or any bankruptcy, reorganization, debt arrangement, or other case or proceeding under any bankruptcy or insolvency law, or any dissolution or liquidation proceeding, is commenced in respect of the Company, and if such case or proceeding is not commenced by the Company, it is consented to or acquiesced in by the Company or remains for 60 days undismissed; or the Company takes any corporate action to authorize, or in furtherance of, any of the foregoing or the insurance commission or department of any Principal Insurance Subsidiary's state of domicile takes any action against such Principal Insurance Subsidiary or the Company in connection with any of the foregoing. (d) Specified Noncompliance with this Agreement. Failure by the Company to comply with or to perform under Section 7.2 (only with respect to the maintenance of the existence of the Company), Sections 7.6 through 7.16, inclusive, and Section 7.21 hereunder and continuance of such failure for five (5) Business Days after (i) written notice thereof to the Company from the Agent or (ii) any Authorized Officer of the Company knew or should have known of such failure to comply or perform; provided, however, that, with respect to the failure by the Company to comply with or to perform under Sections 7.10 through 7.14, inclusive, the continuance of such failure shall be extended from five (5) Business Days to thirty (30) days if the Agent receives written notice from the Company prior to the expiration of such five (5) Business Day period that such failure is curable within such thirty (30) day period. (e) Other Noncompliance with this Agreement. Failure by the Company to comply with or to perform any provision of this Agreement (and not constituting an Event of Default under any of the other provisions of this Section 9) and continuance of such failure for sixty (60) days after (i) written notice thereof to the Company from the Agent or (ii) any Authorized Officer of the Company knew of such failure to comply or perform. (f) Representations and Warranties. Any representation or warranty made by the Company herein or in any Related Document is breached in any material respect or is known by the Company to have been false or misleading in any material respect when given, or any schedule, certificate, financial statement, report, notice, or other writing furnished by the Company to the Agent, the Issuing Bank or any Bank is known by the Company to have been false or misleading in any material respect on the date as of which the facts therein set forth are stated or certified. (g) Employee Benefit Plans. (i) Institution by the PBGC, the Company or any ERISA Affiliate of steps to terminate a Plan subject to Title IV of ERISA if as a result of such termination, the Company or any ERISA Affiliate would be required to make a material contribution to such Plan, or would incur a material liability or obligation to such Plan; (ii) occurrence of a contribution failure with respect to any Plan sufficient to give rise to a lien under Section 302(f) of ERISA, or (iii) incurrence of any material liability (including current or potential withdrawal liability) by the Company or any ERISA Affiliate with respect to any Multiemployer Plan. (h) Judgments. There shall be entered against the Company one or more final unappealable judgments or decrees in excess of $5,000,000 in the aggregate at any one time outstanding for the Company, excluding those judgments or decrees (i) that shall have been stayed, vacated or bonded, (ii) that shall have been outstanding less than 30 days from the entry thereof, (iii) for and to the extent to which the Company is insured and with respect to which the insurer specifically has determined that it shall assume responsibility in writing or (iv) for and to the extent to which the Company is otherwise indemnified if the terms of such indemnification are satisfactory to the Majority Banks. SECTION 9.2 Effect of Event of Default. If any Event of Default described in Section 9.1(c) shall occur, the Commitments (if they have not theretofore terminated) shall immediately terminate and all Loans, the Notes and all other Liabilities shall become immediately due and payable, all without presentment, demand or notice of any kind, all of which, except as expressly set forth herein, are hereby expressly waived by the Company; and, in the case of any other Event of Default, the Agent shall, at the request of, or may, with the consent of, the Majority Banks, by written notice to the Company, declare the Commitments (if they have not theretofore terminated) to be terminated and all Loans, the Notes and all other Liabilities to be due and payable, whereupon such Loans, the Notes and all other Liabilities shall become immediately due and payable, all without presentment, demand or notice of any kind, all of which, except as expressly set forth herein, are hereby expressly waived by the Company. SECTION 9A THE AGENT SECTION 9A.1 Appointment and Authorization. Each Bank hereby appoints, designates and authorizes the Agent to take such action on its behalf under the provisions of this Agreement and each other Related Document and to exercise such powers and perform such duties as are expressly delegated to it by the terms of this Agreement or any other Related Document, together with such powers as are reasonably incidental thereto. Notwithstanding any provision to the contrary contained elsewhere in this Agreement or in any other Related Document, the Agent shall not have any duties or responsibilities, except those expressly set forth herein, nor shall the Agent have or be deemed to have any fiduciary relationship with any Bank, and no implied covenants, functions, responsibilities, duties, obligations or liabilities shall be read into this Agreement or any other Related Document or otherwise exist against the Agent. SECTION 9A.2 Delegation of Duties. The Agent may execute any of its duties under this Agreement or any other Related Document by or through agents, employees or attorneys-in-fact and shall be entitled to advice of counsel concerning all matters pertaining to such duties. The Agent shall not be responsible for the negligence or misconduct of any agent or attorney-in-fact that it selects with reasonable care. SECTION 9A.3 Liability of Agent. None of the Agent-Related Persons shall (i) be liable to any Bank for any action taken or omitted to be taken by any of them under or in connection with this Agreement or any other Related Document (except for its own gross negligence or willful misconduct) or (ii) be responsible in any manner to any of the Banks for any recital, statement, representation or warranty made by the Company or any officer thereof contained in this Agreement or in any other Related Document, or in any certificate, report, statement or other document referred to or provided for in, or received by the Agent under or in connection with, this Agreement or any other Related Document, or the validity, effectiveness, genuineness, enforceability or sufficiency of this Agreement or any other Related Document, or for any failure of the Company to perform its obligations hereunder or under any Related Document. No Agent-Related Person shall be under any obligation to any Bank to ascertain or to inquire as to the observance or performance of any of the agreements contained in, or conditions of, this Agreement or any other Related Document, or to inspect the properties, books or records of the Company or any of the Company's Subsidiaries or Affiliates. SECTION 9A.4 Reliance by Agent. (a) The Agent shall be entitled to rely, and shall be fully protected in relying, upon any writing, resolution, notice, consent, certificate, affidavit, letter, telegram, facsimile, telex or telephone message, statement or other document or conversation believed by it to be genuine and correct and to have been signed, sent or made by the proper Person or Persons, and upon advice and statements of legal counsel, independent accountants and other experts selected by the Agent. The Agent shall be fully justified in failing or refusing to take any action under this Agreement or any other Related Document unless it shall first receive such advice or concurrence of the Majority Banks as it deems appropriate and, if it so requests, it shall first be indemnified to its satisfaction by the Banks (to the extent not indemnified by the Company) against any and all liability and expense that may be incurred by it by reason of taking or continuing to take any such action. The Agent shall in all cases be fully protected in acting, or in refraining from acting, under this Agreement or any other Related Document in accordance with a request or consent of the Majority Banks (or, when expressly required hereby, all the Banks) and such request and any action taken or failure to act pursuant thereto shall be binding upon all of the Banks. (b) For purposes of determining compliance with the conditions specified in Section 8.1, each Bank that has executed this Agreement shall be deemed to have consented to, approved or accepted or to be satisfied with each document or other matter either sent by the Agent to such Bank for consent, approval, acceptance or satisfaction, or required thereunder to be consented to or approved by or acceptable or satisfactory to such Bank. SECTION 9A.5 Notice of Default. The Agent shall not be deemed to have knowledge or notice of the occurrence of any Event of Default, except with respect to defaults in the payment of principal, interest and fees required to be paid to the Agent for the account of the Banks, unless the Agent shall have received written notice from a Bank or the Company referring to this Agreement, describing such Event of Default and stating that such notice is a "notice of default". In the event that the Agent receives such a notice, the Agent shall promptly give notice thereof to the Banks. The Agent shall take such action with respect to such Event of Default as shall be requested by the Majority Banks in accordance with Section 9; provided, however, that unless and until the Agent shall have received any such request, the Agent may (but shall not be obligated to) take such action, or refrain from taking such action, with respect to such Event of Default as it shall deem advisable or in the best interest of the Banks. SECTION 9A.6 Credit Decision. Each Bank expressly acknowledges that none of the Agent-Related Persons has made any representation or warranty to it and that no act by the Agent hereinafter taken, including any review of the affairs of the Company and its Subsidiaries shall be deemed to constitute any representation or warranty by the Agent to any Bank. Each Bank represents to the Agent that it has, independently and without reliance upon the Agent and based on such documents and information as it has deemed appropriate, made its own appraisal of and investigation into the business, prospects, operations, property, financial and other condition and creditworthiness of the Company and its Subsidiaries, and all applicable bank regulatory laws relating to the transactions contemplated thereby, and made its own decision to enter into this Agreement and extend credit to the Company hereunder. Each Bank also represents that it will, independently and without reliance upon the Agent and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit analysis, appraisals and decisions in taking or not taking action under this Agreement and the other Related Documents, and to make such investigations as it deems necessary to inform itself as to the business, prospects, operations, property, financial and other condition and creditworthiness of the Company and its Subsidiaries. Except for notices, reports and other documents expressly herein required to be furnished to the Banks by the Agent, the Agent shall not have any duty or responsibility to provide any Bank with any credit or other information concerning the business, prospects, operations, property, financial and other condition or creditworthiness of the Company and its Subsidiaries that may come into the possession of any of the Agent-Related Persons. SECTION 9A.7 Indemnification. Whether or not the transactions contemplated hereby shall be consummated, the Banks shall indemnify upon demand the Agent-Related Persons (to the extent not reimbursed by or on behalf of the Company and without limiting the obligation of the Company to do so), ratably from and against any and all liabilities, obligations, losses, damages, penalties, actions, judgments, suits, costs, expenses and disbursements of any kind whatsoever that may at any time (including at any time following the repayment of the Loans and reimbursement of the LCs and the termination or resignation of the related Agent) be imposed on, incurred by or asserted against any such Person in any way relating to or arising out of this Agreement or any document contemplated by or referred to herein or the transactions contemplated hereby or any action taken or omitted by any such Person under or in connection with any of the foregoing; provided, however, that no Bank shall be liable for the payment to any Agent-Related Person of any portion of such liabilities, obligations, losses, damages, penalties, actions, judgments, suits, costs, expenses or disbursements resulting from any Agent-Related Person's gross negligence or willful misconduct. Without limitation of the foregoing, each Bank shall reimburse the Agent upon demand for its ratable share of any costs or out-of-pocket expenses (including attorney costs) incurred by the Agent in connection with the administration, modification, amendment or enforcement (whether through negotiations, legal proceedings or otherwise) of, or legal advice in respect of rights or responsibilities under, this Agreement, any other Related Document, or any document contemplated by or referred to herein to the extent that the Agent is not reimbursed for such expenses by or on behalf of the Company. The obligation of the Banks in this Section shall survive the payment of all Obligations hereunder. SECTION 9A.8 Agent in Individual Capacity. ANB and its Affiliates may make loans to, issue letters of credit for the account of, accept deposits from, acquire equity interests in and generally engage in any kind of banking, trust, financial advisory or other business with the Company and its Subsidiaries and Affiliates as though ANB were not the Agent hereunder and without notice to or consent of the Banks. With respect to its Loans, ANB shall have the same rights and powers under this Agreement as any other Bank and may exercise the same as though it were not the Agent, and the terms "Bank" and "Banks" shall include ANB in its individual capacity. SECTION 9A.9 Successor Agent. The Agent may resign as Agent upon 30 days' notice to each of the Banks and the Company. If the Agent shall resign as Agent under this Agreement, the Majority Banks shall appoint from among the Banks a successor agent for the Banks which successor agent shall be approved by the Company, which consent shall not be unreasonably withheld. If no successor agent is appointed prior to the effective date of the resignation of the Agent, the Agent may appoint, after consulting with the Banks and the Company, a successor agent from among the Banks. Upon the acceptance of its appointment as successor agent hereunder, such successor agent shall succeed to all the rights, powers and duties of the retiring Agent and the term "Agent" shall mean such successor agent and the Agent's appointment, powers and duties as Agent shall be terminated. After any retiring Agent's resignation hereunder as Agent, the provisions of this Section 9A and Sections 10.4 and 10.5 shall inure to its benefit as to any actions taken or omitted to be taken by it while it was Agent under this Agreement. Notwithstanding the foregoing, the Agent's resignation shall not be effective until a successor agent is appointed and such successor agent accepts such appointment as successor agent hereunder. SECTION 10 GENERAL SECTION 10.1 Amendments and Waivers. No amendment or waiver of any provision of this Agreement or any other Related Document, and no consent with respect to any departure by the Company therefrom, shall be effective unless the same shall be in writing and signed by the Majority Banks, acknowledged by the Agent, and, in the case of amendments, signed by the Company, and then any such waiver shall be effective only in the specific instance and for the specific purpose for which given; provided, however, that no such waiver, amendment, or consent shall, unless in writing and signed by all the Banks, acknowledged by the Agent, and, in the case of an amendment, signed by the Company, do any of the following: (a) increase or extend the Commitment of any Bank (or reinstate any Commitment terminated pursuant to Section 2.9) or subject any Bank to any additional obligations; (b) postpone or delay any date fixed for any payment of principal, interest, fees or other amounts due to the Banks (or any of them) hereunder or under any other Related Document; (c) reduce the principal of, or the rate of interest specified herein on any Loan, or of any fees or other amounts payable hereunder or under any other Related Document; (d) change the percentage of the Commitments which shall be required for the Banks or any of them to take action hereunder; or (e) amend this Section 10.1 or any provision providing for consent or other action by all Banks; and, provided further, that no amendment, waiver or consent shall, unless in writing and signed by the Agent in addition to the Majority Banks or all the Banks, as the case may be, affect the rights or duties of the Agent under this Agreement or any other Related Document. SECTION 10.2 Notices. All notices hereunder shall be in writing. Notices given by mail shall be deemed to have been given (i) five Business Days after the date sent if sent by registered or certified mail, postage prepaid, (ii) the next Business Day if sent by overnight delivery service, (iii) the day sent if sent by telecopy or telex if sent prior to 5:00 p.m. local time on a Business Day, otherwise the following day, or (iv) the day delivered if sent by personal messenger, and: (a) if to the Company, addressed to the Company at its address shown below its signature hereto; (b) if to the Agent, addressed to the Agent at the address shown below its signature hereto; or (c) if to a Bank, addressed to such Bank at the address shown below its signature hereto; or in the case of any party, such other address as such party, by written notice received by the other parties to this Agreement, may have designated as its address for notices. SECTION 10.3 Accounting Terms; Computations. All accounting terms used herein and not expressly defined in this Agreement shall have the respective meanings given to them in accordance with GAAP as in effect on the Closing Date. Where the character or amount of any asset or liability or item of income or expense is required to be determined, or any consolidation or other accounting computation is required to be made, for purposes of this Agreement such determination or calculation shall, to the extent applicable and except as otherwise specified in this Agreement or agreed to in writing by the Majority Banks, be made in accordance with GAAP as then in effect. SECTION 10.4 Costs, Expenses and Taxes. (a) The Company agrees to pay within thirty (30) days after demand by ANB (including in its capacity as Agent) all of ANB's (including in its capacity as Agent) reasonable out-of-pocket costs and expenses (including the reasonable fees and out-of-pocket expenses of ANB's counsel) in connection with the preparation, execution and delivery of this Agreement, the Related Documents and all other instruments or documents provided for herein or delivered or to be delivered hereunder or in connection herewith (including, without limitation, all amendments, supplements and waivers executed and delivered pursuant hereto or in connection herewith). (b) The reasonable costs and expenses which the Agent (on behalf of itself, the Issuing Bank and all other Banks) incurs in any manner or way with respect to the following shall be part of the Liabilities, payable by the Company within thirty (30) days after demand if at any time after the date of this Agreement the Agent (on behalf of itself, the Issuing Bank and all other Banks): (i) reasonably employs counsel for advice or other representation (A) to represent the Agent (on behalf of itself, the Issuing Bank and all other Banks) in any litigation, contest, dispute, suit or proceeding or to commence, defend or intervene or to take any other action in or with respect to any litigation, contest, dispute, suit or proceeding (whether instituted by the Agent, the Issuing Bank, such Bank, any other Bank, the Company or any other Person) in any way or respect relating to this Agreement or the Related Documents, (B) to enforce any of the Agent's, the Issuing Bank's or any such Bank's rights with respect to the Company under this Agreement and the Related Documents; and/ or (ii) reasonably seeks to enforce or enforces any of the Agent's, the Issuing Bank's or any such Bank's rights and remedies with respect to the Company under this Agreement and the Related Documents; provided, however, that notwithstanding the foregoing, if the interests of the Issuing Bank or any Bank conflict with the interests of such other Bank as determined by the Issuing Bank or such Bank, as the case may be, then the reasonable costs and expenses incurred by the Issuing Bank or such Bank, as the case may be, in respect of the foregoing shall be payable by the Company within thirty (30) days after demand by the Issuing Bank or such Bank, as the case may be. (c) All of the Company's obligations provided for in this Section 10.4 shall be Liabilities of the Company hereunder. SECTION 10.5 Indemnification. In consideration of the Agent's, the Issuing Bank's and each Bank's execution and delivery of this Agreement and each Bank's agreement to extend its Commitment and to make and maintain Loans and the Issuing Bank's commitment to issue LCs, the Company hereby agrees to indemnify, exonerate and hold the Agent, the Issuing Bank and each Bank and each of its officers, directors, employees and agents (herein collectively called the "Bank Parties" and individually called a "Bank Party") free and harmless from and against any and all actions, causes of action, suits, losses, costs (including, without limitation, all documentary or other stamp taxes or duties), liabilities and damages, and expenses in connection therewith (irrespective of whether such Bank Party is a party to the action for which indemnification hereunder is sought) (the "Indemnified Liabilities"), including, without limitation, reasonable attorneys' fees and disbursements, incurred by such Bank Parties or any of them as a result of, or arising out of, or relating to (except for such Indemnified Liabilities arising on account of such Bank Party's gross negligence or willful misconduct): (a) any transaction financed or to be financed in whole or in part, directly or indirectly, with the proceeds of any Loan or LC; (b) the execution, delivery, performance, administration or enforcement of this Agreement and the Related Documents in accordance with their respective terms by any of such Bank Parties; (c) any misrepresentation or breach of any representation or warranty or covenant herein by the Company. If and to the extent that the foregoing agreements described in this Section 10.5 may be unenforceable for any reason, the Company 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 10.6 Captions and References. The recitals to this Agreement (except for definitions) and the section captions used in this Agreement are for convenience only, and shall not affect the construction of this Agreement. SECTION 10.7 No Waiver; Cumulative Remedies. No failure to exercise and no delay in exercising, on the part of the Agent, the Issuing Bank or any Bank, any right, remedy, power or privilege hereunder, shall operate as a waiver thereof; nor shall any single or partial exercise of any right, remedy, power or privilege hereunder preclude any other or further exercise thereof or the exercise of any other right, remedy, power or privilege. SECTION 10.8 Governing Law; Jury Trial; Severability. This Agreement and each Note shall be a contract made under and governed by the laws of the State of Illinois, without regard to conflict of laws principles. Wherever possible, each provision of this Agreement shall be interpreted in such manner as to be effective and valid under applicable law, but if any provision of this Agreement shall be prohibited by or invalid under such law, such provision shall be ineffective only to the extent of such prohibition or invalidity, without invalidating the remainder of such provision or the remaining provisions of this Agreement. All obligations of the Company and rights of the Agent, the Issuing Bank and any Bank, which obligations and rights are described herein or in the Note issued to such Bank, shall be in addition to and not in limitation of those provided by applicable law. THE COMPANY HEREBY IRREVOCABLY WAIVES ANY RIGHT TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING (i) TO ENFORCE OR DEFEND ANY RIGHTS UNDER OR IN CONNECTION WITH THIS AGREEMENT, THE RELATED DOCUMENTS, ANY LOAN, ANY LC OR ANY AMENDMENT, INSTRUMENT, DOCUMENT OR AGREEMENT DELIVERED OR WHICH MAY IN THE FUTURE BE DELIVERED IN CONNECTION HEREWITH OR THEREWITH, OR (ii) ARISING FROM ANY DISPUTE OR CONTROVERSY IN CONNECTION WITH OR RELATED TO THIS AGREEMENT, THE RELATED DOCUMENTS, ANY LOAN, ANY LC, OR ANY SUCH AMENDMENT, INSTRUMENT, DOCUMENT OR AGREEMENT, AND AGREES THAT ANY SUCH ACTION OR COUNTERCLAIM SHALL BE TRIED BEFORE A COURT AND NOT BEFORE A JURY. ____________________ Agreed and Acknowledged by the Company THE COMPANY IRREVOCABLY AGREES THAT, SUBJECT TO THE AGENT'S, THE ISSUING BANK'S AND EACH BANK'S SOLE AND ABSOLUTE ELECTION, ANY ACTION OR PROCEEDING IN ANY WAY, MANNER OR RESPECT ARISING OUT OF THIS AGREEMENT, THE RELATED DOCUMENTS, ANY LOAN, ANY LC OR ANY AMENDMENT, INSTRUMENT, DOCUMENT OR AGREEMENT DELIVERED OR WHICH MAY IN THE FUTURE BE DELIVERED IN CONNECTION HEREWITH OR THEREWITH, OR ARISING FROM ANY DISPUTE OR CONTROVERSY ARISING IN CONNECTION WITH OR RELATED TO THIS AGREEMENT, THE RELATED DOCUMENTS, ANY LOAN, ANY LC OR ANY SUCH AMENDMENT, INSTRUMENT, DOCUMENT OR AGREEMENT SHALL BE LITIGATED IN THE COURTS HAVING SITUS WITHIN THE CITY OF CHICAGO, THE STATE OF ILLINOIS, AND THE COMPANY HEREBY CONSENTS AND SUBMITS TO THE JURISDICTION OF ANY LOCAL, STATE OR FEDERAL COURT LOCATED WITHIN SUCH CITY AND STATE. THE COMPANY HEREBY WAIVES ANY RIGHT IT MAY HAVE TO TRANSFER OR CHANGE THE VENUE OF ANY LITIGATION BROUGHT AGAINST THE COMPANY BY THE AGENT, THE ISSUING BANK OR ANY BANK IN ACCORDANCE WITH THIS SECTION 10.8. SECTION 10.9 Counterparts. This Agreement and any amendment or supplement hereto or any waiver or consent granted in connection herewith may be executed in any number of counterparts and by the different parties on separate counterparts and each such counterpart shall be deemed to be an original, but all such counterparts shall together constitute but one and the same Agreement. SECTION 10.10 Successors and Assigns. Subject to Section 10.12, this Agreement shall be binding upon the Company, each Bank and their respective successors and assigns, and shall inure to the benefit of the Company, each Bank and each Bank's successors and assigns. The Company shall have no right to assign its rights or delegate its duties under this Agreement. SECTION 10.11 Prior Agreements. The terms and conditions set forth in this Agreement shall supersede all prior negotiations, agreements, discussions, correspondence, memoranda and understandings (whether written or oral) of the Company and the Agent, the Issuing Bank and any Bank concerning or relating to the subject matter of this Agreement (including, without limitation, the terms set forth in the proposal letter dated October 20, 1993 issued by the Banks to Mr. Peter W. Nauert). SECTION 10.12 Assignments; Participations. (a) Each Bank shall have the right to assign, with the written consent of the Company, which shall not be unreasonably withheld, to any Affiliate of such Bank and to one or more banks or other financial institutions, all or a portion of its rights and obligations under this Agreement (including, without limitation, all or a portion of its Commitment, the Loans, the LCs and the Note issued to such Bank) and the Related Documents. For purposes of this Section, it shall not be unreasonable for the Company to withhold its consent to a proposed assignee if, as a result of such proposed assignment, any one Bank's Commitment Percentage would be in excess of fifty percent (50%) or there would be more than six (6) banks or financial institutions party to this Agreement. Upon any such assignment, (x) the assignee shall become a party hereto and, to the extent of such assignment, have all rights and obligations of such Bank hereunder and under the Related Documents and (y) such Bank shall, to the extent of such assignment, relinquish its rights and be released from its obligations hereunder and under the Related Documents. The Company hereby agrees to execute and deliver such documents, and to take such other actions, as such Bank may reasonably request to accomplish the foregoing. Upon such assignment, this Agreement shall be deemed to be amended to the extent, but only to the extent, necessary to reflect the addition of the assignee and the resulting adjustment of the Commitments arising therefrom. The Commitment allocated to each assignee shall reduce such Commitment of the assigning Bank pro tanto. (b) In addition to the assignments permitted in clause (a) of this Section 10.12, each Bank and any assignee pursuant to clause (a) above shall have the right with the written consent of the Company to grant participations to one or more banks or other financial institutions in or to its Commitment, any Loan, any LC, the Related Documents, and the Note held by such Bank or such assignee, provided that (i) each Bank's obligations under this Agreement shall remain unchanged and (ii) the Company and the Agent shall continue to deal solely and exclusively with such Bank. No holder of a participation in all or any part of a Commitment, the Loans, the LCs, the Related Documents, or any Note shall have any rights under this Agreement; provided, however, that, to the extent permitted by applicable law, each holder of a participation shall have the same rights as each Bank under Section 5.3. (c) The Company hereby consents to the disclosure of any information obtained in connection herewith (i) by each Bank, to any bank or other financial institution which is an assignee or potential assignee with respect to which the Company has given its written consent pursuant to clause (a) above, and (ii) by each Bank and any assignee pursuant to clause (a) above, to any bank or other financial institution which is a participant or potential participant with respect to which the Company has given its written consent pursuant to clause (b) above, it being understood that each Bank and each assignee shall advise any such bank or other financial institution of its obligation to keep confidential any nonpublic information disclosed to it pursuant to this Section 10.12. SECTION 10.13 Confidentiality. Each Bank agrees to take normal and reasonable precautions and exercise due care to maintain the confidentiality of all information provided to it by the Company, or by the Agent on the Company's behalf, in connection with this Agreement or any other Related Document, and neither it nor any of its Affiliates shall use any such information for any purpose or in any manner other than pursuant to the terms contemplated by this Agreement, except to the extent such information (i) was or becomes generally available to the public other than as a result of a disclosure by such Bank, or (ii) was or becomes available on a non-confidential basis from a source other than the Company, provided that such source is not bound by a confidentiality agreement with the Company known to such Bank; provided, further, however, that any Bank may disclose such information (A) at the request or pursuant to any requirement of any governmental or regulatory authority to which such Bank is subject or in connection with an examination of such Bank by any such authority; (B) pursuant to subpoena or other court process, provided that, if it is lawful to do so, such Bank shall give prompt notice to the Company of service thereof so that the Company may seek a protective order or other appropriate remedy or waive compliance with the provisions of this Section 10.13; (C) when required to do so in accordance with the provisions of any applicable requirement of law; (D) to the extent reasonably required in connection with any litigation or proceeding to which the Agent, any Bank or their respective Affiliates may be party, (E) to the extent reasonably required in connection with the exercise of any remedy hereunder or under any other Related Document, and (F) to such Bank's independent auditors and other professional advisors. SECTION 10.14 Notification of Addresses, Etc. Each Bank shall notify the Agent in writing of any changes in the address to which notices to such Bank should be directed, of payment instructions in respect of all payments to be made to it hereunder and of such other administrative information as the Agent shall reasonably request. IN WITNESS WHEREOF, the Company, the Agent, and each Bank have caused this Agreement to be executed and delivered as of the day and year first above written. THE COMPANY: PIONEER FINANCIAL SERVICES, INC. By: /s/ Val Rajic Title: Vice President 1750 Golf Road Schaumburg, Illinois 60101 Attention: David Vickers Val Rajic Telephone: (708) 995-0400 Telecopy: (708) 413-7195 THE AGENT: AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO By /s/ Arthur Murray Vice President 33 North LaSalle Street Chicago, Illinois 60690 Attention: Arthur W. Murray Telephone: (312) 661-7298 Telecopy: (312) 661-6929 THE BANKS: COMMITMENT: AMERICAN NATIONAL BANK AND TRUST $9,000,000 COMPANY OF CHICAGO By /s/ Arthur Murray Vice President 33 North LaSalle Street Chicago, Illinois 60690 Attention: Arthur W. Murray Telephone: (312) 661-7298 Telecopy: (312) 661-6929 $6,000,000 FIRSTAR BANK MILWAUKEE, N.A. By /s/ Stephen Check Title: Vice President 777 East Wisconsin Avenue Milwaukee, Wisconsin 53202 Attention: Stephen E. Check Telephone: ________________________ Telecopy: _________________________ $5,000,000 BANK ONE, ROCKFORD, NA By /s/ Robert Opperman Title: Vice President East State at Mulford Road Rockford, Illinois 61110-4900 Attention: Robert Opperman Telephone: ________________________ Telecopy: _________________________ EXHIBIT 11 PIONEER FINANCIAL SERVICES, INC. STATEMENT OF COMPUTATION OF PER SHARE NET INCOME OR LOSS For the Year Ended December 31 1993 1992 1991 Net Income (loss) $ 12,145,000 $(16,959,000) $ 8,872,000 Less Dividends on Preferred Stock (2,021,000) (2,039,000) (2,039,000) Primary Basis-Net Income (loss) $ 10,124,000 $(18,998,000) $ 6,833,000 Fully Diluted Basis- Net Income (loss)** $ 13,507,000 $(16,959,000) $ 8,872,000 Average shares outstanding 6,546,719 6,659,657 6,626,447 Common Stock equivalents from dilutive stock options, based on the treasury stock method using average market price 176,883 - 72,092 TOTAL-PRIMARY BASIS 6,723,602 6,659,657 6,698,539 Additional shares assuming conversion of Preferred Stock 1,515,200 1,535,360 1,535,360 Additional shares assuming conversion of Subordinated Debentures 2,282,774 - - Additional Common Stock equivalents from dilutive stock options, based on the treasury stock method using closing market price 209,618 - - TOTAL-FULLY DILUTED 10,731,194 8,195,017 8,233,899 Net income (loss) per share- Primary $ 1.51 $(2.85) $ 1.02 Net income (loss) per share- Fully Diluted $ 1.26 $(2.85)* $ 1.02 * * In 1991 and 1992 fully diluted net income (loss) per share is equivalent to primary net income (loss) per share due to the fully diluted computation being anti-dilutive for these periods. ** In 1993 fully diluted net income per share was calculated after adding tax effected interest on Subordinated Debentures of $1,362,000. Exhibit 21 PIONEER FINANCIAL SERVICES, INC. Subsidiary Jurisdiction 1. Pioneer Life Insurance Company of Illinois Illinois 2. Health and Life Insurance Company of America Illinois 3. National Group Life Insurance Company Illinois 4. First Pioneer Equity Corporation Delaware 5. Pioneer Fire & Casualty Insurance Company Pennsylvania 6. Administrators Service Corporation Illinois 7. Association Management Corporation Illinois 8. Network Air Medical Systems, Inc. Illinois 9. National Benefit Plans, Inc. formerly National Group Holding Corporation Delaware 10. Design Benefit Plans, Inc. formerly National Group Marketing Corporation Illinois 11. Partners Health Group, Inc. formerly Union Capital Corporation Delaware 12. National Marketing Specialists Delaware 13. National Business Concepts, formerly Design Benefit Plans, Inc. formerly National Marketing Corporation Illinois 14. Target Ad Group, Inc. formerly National Benefit Finance, formerly Select Marketing Corporation Illinois 15. Response Air Ambulance Network, Inc. Illinois 16. National Training Corporation formerly NGM Training Corporation formerly Educational Communications, Inc. Texas 17. Direct Financial Services, Inc. Illinois 18. Association Specialty Corporation Illinois 19. National Health Services, Inc. Wisconsin 20. Manhattan National Life Insurance Company North Dakota 21. United Group Holdings of Delaware, Inc. Delaware 22. Advantage Financial Systems, Inc. Delaware 23. NHS Coordinated Care of Texas, Inc. formerly American Managed Care of Texas, Inc. Texas 24. NHS Coordinated Care, Inc. Nevada 25. Continental Life & Accident Company Iowa 26. Continental Marketing Corporation Idaho 27. Healthcare Review Corporation Kentucky EXHIBIT 23 CONSENT OF ERNST & YOUNG, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements pertaining to the Nonqualified Stock Option Plan of Pioneer Financial Services, Inc. (Form S-8 No. 33-37305), the Pioneer Financial Services, Inc. Employee Savings and Stock Ownership Plan (Form S-8 No. 33-45894) and the National Benefit Plans, Inc. 1992 Agent Stock Purchase Plan (Form S-8 No. 33-53686) of our report dated March 2, 1994, with respect to the consolidated financial statements and schedules of Pioneer Financial Services, Inc. and subsidiaries included in the Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG Chicago, Illinois March 28, 1994

7332_1993.txt

7332_1993

1993

7332

ITEM 1. BUSINESS Southwestern Energy Company (the Company) is a diversified natural gas company which conducts its primary activities through four wholly owned subsidiaries. The Company operates principally in the exploration and production segment and the gas distribution segment of the natural gas industry. The Company was incorporated on July 2, 1929, under the laws of the State of Arkansas. The Company operates an integrated natural gas gathering, transmission and distribution system in northwest Arkansas, and natural gas distribution systems in northeast Arkansas and parts of Missouri. The nature of the Company's natural gas transmission and distribution operations changed in 1992 when a new 258 mile long intrastate pipeline in which the Company owns an interest commenced operations. The intrastate pipeline crosses three interstate pipelines and ties the Company's distribution and gathering pipeline systems in northwest Arkansas to its distribution systems in northeast Arkansas and southeast Missouri. The Company also serves as operator of the pipeline. In 1943, the Company commenced a program of exploration for and development of natural gas reserves in Arkansas for supply to its utility customers. In 1971, the Company initiated an exploration and development program outside Arkansas, unrelated to the utility requirements. Since that time, the Company's exploration and development activities outside Arkansas have expanded. The exploration, development and production activities are a separate, primary business of the Company. The Company is an exempt holding company under the Public Utility Holding Company Act of 1935. Exploration and production activities consist of ownership of mineral interests in productive and undeveloped leases located entirely within the United States. The Company engages in gas and oil exploration and production through its subsidiaries, SEECO, Inc. (SEECO) and Southwestern Energy Production Company (SEPCO). SEECO operates exclusively in the State of Arkansas and holds a large base of both developed and undeveloped gas reserves and conducts an ongoing drilling program in the historically productive Arkansas section of the Arkoma Basin. SEPCO conducts an exploration program in areas outside Arkansas, primarily the Gulf Coast areas of Texas and Louisiana. SEPCO also holds a block of leasehold acreage located on the Fort Chaffee military reservation in western Arkansas and in other parts of Arkansas away from the operating areas of the Company's other subsidiaries. The Company's subsidiary Arkansas Western Gas Company (Arkansas Western) operates integrated natural gas distribution systems in Arkansas and Missouri. Arkansas Western is the largest single purchaser of SEECO's gas production. Southwestern Energy Pipeline Company (SWPL) owns an interest in the NOARK Pipeline System (NOARK), an intrastate natural gas transmission system which extends across northern Arkansas. A discussion of the primary businesses conducted by the Company through its wholly owned subsidiaries follows. NATURAL GAS AND OIL EXPLORATION AND PRODUCTION Substantially all of the Company's exploration and production activities and reserves are concentrated in the Arkoma Basin of Arkansas and the Gulf Coast areas of Texas and Louisiana. At December 31, 1993, the Company had proved natural gas reserves of 318.8 billion cubic feet (Bcf) and proved oil reserves of 479 thousand barrels (MBbls). Revenues of the exploration and production subsidiaries are predominately generated from production of natural gas. The Company's gas production increased for the sixth consecutive year in 1993, totaling 35.4 Bcf, up 39% from 25.5 Bcf in 1992. Sales of gas production accounted for 97% of total operating revenues for this segment in 1993, 95% in 1992 and 91% in 1991. SEECO's largest customer for sales of its gas production was the Company's utility subsidiary. Sales to unaffiliated purchasers by both SEECO and SEPCO have increased significantly, however, during the last few years primarily as a result of higher production from Arkansas properties and from discoveries made in earlier years offshore in the Gulf of Mexico. Sales to unaffiliated purchasers accounted for 64% of total gas volumes sold by the exploration and production segment in 1993, 55% in 1992 and 35% in 1991. Gas volumes sold by SEECO to Arkansas Western for its northwest Arkansas division (AWG) were approximately 7.1 Bcf in 1993, 7.2 Bcf in 1992 and 7.6 Bcf in 1991. Through these sales, SEECO furnished approximately 50% of the northwest Arkansas system's requirements in each of these years. SEECO also delivered approximately 2.2 Bcf in 1993, 2.8 Bcf in 1992 and .6 Bcf in 1991 directly to certain large business customers of AWG through a transportation service of the utility subsidiary that became effective in October, 1991. These customers previously purchased the majority of their requirements directly from AWG through a spot market purchasing program offered by the utility. Most of the sales to AWG are pursuant to a twenty-year contract between SEECO and AWG which committed to the utility all Company owned reserves in Arkansas as of the contract date of July 24, 1978. Most reserves committed to this contract were classified as Section 105 gas under the Natural Gas Policy Act of 1978 (NGPA). Section 105 covers gas committed to intrastate commerce at the date of enactment of the NGPA and provides that the price received for any such gas will be the contract price, provided that the contract price does not exceed the maximum price as published quarterly by the Federal Energy Regulatory Commission (FERC) for Section 102 gas under the NGPA. The pricing under this contract has been frozen at the December, 1984 level. All gas dedicated to this contract was deregulated as of January 1, 1993. Reserves discovered after the contract date in areas not previously committed to the utility may be sold to the utility at prices determined by present gas market conditions or to unaffiliated companies. The contract also contains provisions for the release of dedicated reserves for sale to unaffiliated companies in certain circumstances. In addition to this contract, SEECO also sells gas to AWG under newer long-term contracts with flexible pricing provisions and under short-term spot market arrangements. SEECO's sales to AWG accounted for approximately 31%, 45% and 49% of total exploration and production revenues in 1993, 1992 and 1991, respectively. In November, 1993, the Arkansas Public Service Commission (APSC or Commission) issued an order which found the purchases of AWG under the 1978 contract to be in violation of an Arkansas statute requiring that gas purchases be made "from the lowest or most advantageous market." The APSC order is discussed more fully below under "Natural gas gathering, transmission and distribution." SEECO's sales to Associated Natural Gas Company (Associated), a division of Arkansas Western which operates natural gas distribution systems in northeast Arkansas and parts of Missouri, were 5.7 Bcf in 1993, 4.3 Bcf in 1992 and 5.3 Bcf in 1991. These deliveries accounted for approximately 67% of Associated's total requirements in 1993, 56% in 1992 and 55% in 1991. These sales represented 15% of total exploration and production revenues in 1993, 14% in 1992 and 20% in 1991. Deliveries to Associated increased in 1993 primarily due to colder winter heating weather and storage requirements during the summer months. The decrease in volumes delivered to Associated in 1992, as compared to 1991, was primarily the result of some of Associated's larger industrial customers switching to transportation service. Effective October, 1990, SEECO entered into a ten-year contract with Associated to supply its base load system requirements at a price to be redetermined annually. Deliveries under this contract were made at a price of $1.90 per thousand cubic feet (Mcf) from inception of the contract through the first nine months of 1993, and are currently being made at a price of $2.385 per Mcf. In 1990, SEECO completed the initial mapping and engineering phases of a multi-year geological field study of the Arkoma Basin of Arkansas. The product developed was an extensive database and geologic interpretations of the distribution of gas-bearing sands in the region and resulted in the identification of 69.7 Bcf of proved undeveloped reserves that were added to the Company's base of proved reserves. At December 31, 1993, after transfers and revisions, the remaining proved undeveloped reserves identified by the study were 55.8 Bcf. The data base developed is continually updated by drilling activity and serves as the guide for a development drilling program that the Company plans to continue over the next several years. The development drilling program added 27.0 Bcf in 1993 and 22.5 Bcf in 1992 of new natural gas reserve additions and resulted in the transfer of 2.6 Bcf in 1993 and 8.7 Bcf in 1992 from the proved undeveloped category to the proved developed category. SEECO participated in a total of 74 development wells during 1993 with a completion rate of 73% and expects the number of wells drilled in 1994 to approximate the number drilled in 1993. SEECO's sales to unaffiliated purchasers increased to 9.7 Bcf in 1993, from 4.5 Bcf in 1992 and 1.1 Bcf in 1991. The increase in both years resulted from the Company's development drilling program. At present, SEECO's contracts for sales of gas to unaffiliated customers consist of short-term sales made to customers of AWG's transportation program, which became effective in October, 1991, and spot sales into markets away from AWG's distribution system. In the past, the Company's ability to enter into sales arrangements with unaffiliated customers has generally been constrained by a lack of pipeline transportation to markets away from the Arkoma Basin. Initiatives of the FERC to restructure the natural gas interstate pipeline service rules through its Order No. 636 series have improved and should continue to improve the Company's ability to market its existing and potential reserves. Also contributing to the increase in the ability of SEECO to market its gas to unaffiliated customers was the completion in September, 1992 of NOARK, as explained more fully below under "Natural gas gathering, transmission and distribution." At December 31, 1993, the gas reserves of SEPCO were located primarily in the states of Arkansas, Oklahoma, Louisiana and offshore Texas, while its oil reserves were located primarily in Oklahoma, North Dakota, Louisiana and offshore Texas. SEPCO holds about 22% of the Company's natural gas reserves and all of its oil reserves. SEPCO's gas sales increased to 12.9 Bcf in 1993, from 9.6 Bcf in 1992 and 5.9 Bcf in 1991. The increase in 1993 was primarily the result of increased production from properties located in the Gulf of Mexico. The increase in 1992 was the result of sales from Fort Chaffee, as discussed below. The Company's production from Fort Chaffee and the Gulf of Mexico is sold under contracts which reflect current short-term prices and which are subject to seasonal price swings. The Company curtailed gas production during 1992 and 1991 when sales prices were deemed below acceptable levels. Oil production was 96 MBbls in 1993, compared to 120 MBbls in 1992, and 176 MBbls in 1991. The Company's exploration program has been directed almost exclusively toward natural gas in recent years. The Company plans to continue to concentrate on developing gas reserves for production but will also selectively seek opportunities to participate in projects oriented toward oil production. Over the long-term, however, oil sales are not expected to account for a significant part of the Company's future revenues. SEPCO's gas and oil sales accounted for approximately 33% of total gas and oil operating revenues in 1993, 31% in 1992, and 26% in 1991. In 1989, SEPCO purchased at oral auction 11,000 undrilled acres containing 17 separate drilling units on the Fort Chaffee military reservation of western Arkansas. The total cost of this acreage was approximately $11.0 million. Conflicts with military training activities have limited SEPCO's drilling operations at Fort Chaffee. The primary training function at Fort Chaffee was transfered to another military installation during 1993 and it appears that scheduling conflicts should be lessened in the future. To date the Company has drilled or participated in eight wells at Fort Chaffee that have discovered an estimated 46.6 Bcf of new gas reserves, net to the Company's interest. SEPCO is currently completing evaluation of a seven line seismic program on its Fort Chaffee acreage. The data provided by the seismic program will be used to develop an exploration plan covering the remainder of SEPCO's acreage at Fort Chaffee. The plan will then be submitted for military approval with a goal of conducting further exploration drilling during 1994. Sales of gas production from Fort Chaffee began in August, 1991 and totaled 5.1 Bcf in 1993, 5.8 Bcf in 1992 and 2.2 Bcf in 1991. Since late 1992, sales from Fort Chaffee have taken place under a firm sales contract for 25 million cubic feet per day (MMcfd) to an independent marketer. The gas was transported by the marketer under a firm transportation contract on NOARK. The Company met its obligation under the firm sales contract in part by providing gas supplied from SEECO's development drilling program. In late 1993, the marketer filed suit against NOARK, the Company and certain of its affiliates, seeking rescission of the firm sales and transportation contracts. Since that time, the Company has entered into its own sales arrangements covering the affected gas production and does not believe its sales will be adversely affected while the litigation is proceeding. This gas production continues to be transported through NOARK at a price based on current spot market prices, net of transportation. See discussion at "Natural gas gathering, transmission and distribution" for additional information concerning the independent marketer's decision to cease honoring its contractual obligations. Outside Arkansas, the Company added 19.0 Bcf of new reserves from drilling, with 15.2 Bcf of that from an onshore discovery in the coastal area of southeast Louisiana. The Gulf Coast region continues to be the focus of most of the Company's exploration activity outside Arkansas. The Company expects in the future to direct its exploration activities toward the onshore Gulf Coast by focusing on the internal generation of prospects in the upper Texas Gulf Coast and in south Louisiana. SEPCO is also participating with an interest of approximately 50% in an exploration program on a 135,000 acre farmout by a major oil company of acreage held by production in the Oklahoma Panhandle. Though the wells drilled are of smaller magnitude than SEPCO's typical Gulf Coast prospect, drilling costs in the Oklahoma Panhandle are low and the wells are economically attractive. Six tests drilled to date have resulted in five completions. Approximately seven new test wells are planned for 1994. In the natural gas and oil exploration segment, competition is encountered primarily in obtaining leaseholds for future exploration. Competition in the State of Arkansas has increased in recent years, due largely to the development of improved access to interstate pipelines. Due to the Company's significant holdings of undeveloped acreage in Arkansas and its long-time presence and reputation in this area, the Company believes it will continue to be successful in acquiring new leases in Arkansas. While improved intrastate and interstate pipeline transportation in Arkansas should increase the Company's access to markets for its gas production, these markets will generally be served by a number of other suppliers. Thus, the Company will encounter competition which may affect both the price it receives and contract terms it must offer. Outside Arkansas, the Company is less well-established and faces competition from a larger number of other producers. The Company has in recent years been successful in building its inventory of undeveloped leases and obtaining participating interests in drilling prospects outside Arkansas. The Company expects its 1994 capital expenditures for gas and oil exploration and development to total $50.0 million, up from $37.4 million in 1993. Most of the increase in capital spending will be directed to the onshore Gulf Coast along with Fort Chaffee and the Oklahoma Panhandle. The Company will review this budget periodically during the year for possible adjustment depending upon cash flow projections related to fluctuating prices for oil and natural gas. NATURAL GAS GATHERING, TRANSMISSION AND DISTRIBUTION The Company's natural gas distribution operations are concentrated primarily in north Arkansas and southeast Missouri. The Company serves approximately 160,000 retail customers and obtains a substantial portion of the gas they consume through its Arkoma Basin gathering facilities. The Company is also a participant in a partnership that owns the NOARK Pipeline System. The complexity of AWG's distribution operations, particularly its gathering system in the Arkoma Basin gas fields, increased significantly with the start up of NOARK. AWG provides field management services to NOARK under a contract with the partnership and AWG's gathering system delivers to NOARK a substantial part of the gas NOARK transports. The Company completed a pipeline in 1993 that connects NOARK to Associated's distribution system, tying together the Company's two primary gas distribution systems. Arkansas Western consists of two operating divisions. The AWG division gathers natural gas in the Arkansas River Valley of western Arkansas and transports the gas through its own transmission and distribution systems, ultimately delivering it at retail to approximately 93,000 customers in northwest Arkansas. The Associated division currently receives its gas from transportation pipelines and delivers the gas through its own transmission and distribution systems, ultimately delivering it at retail to approximately 67,000 customers primarily in northeast Arkansas and southeast Missouri. Associated, formerly a wholly owned subsidiary of Arkansas Power and Light Company, was acquired and merged into Arkansas Western, effective June 1, 1988. The Arkansas Public Service Commission (APSC) and the Missouri Public Service Commission (MPSC) regulate the Company's utility rates and operations. In Arkansas, the Company operates through municipal franchises which are perpetual by state law. These franchises, however, are not exclusive within a geographic area. In Missouri, the Company operates through municipal franchises with various terms of existence. AWG and Associated deliver natural gas to residential, commercial and industrial customers. The industrial customers are generally smaller concerns using gas for plant heating or product processing. AWG has no restriction on adding new residential or commercial customers and will supply new industrial customers which are compatible with the scale of its facilities. AWG has never denied service to new customers within its service area or experienced curtailments because of supply constraints. Associated has not denied service to new customers within its service area or experienced curtailments because of supply constraints since the acquisition date, although service restrictions and supply related curtailments did occur prior to that time. Curtailment of large industrial customers of AWG and Associated occurs only infrequently when extremely cold weather requires their systems to be dedicated exclusively to human needs customers. AWG and Associated have experienced a general trend in recent years toward lower rates of usage among their customers, largely as a result of conservation efforts which the Company encourages. Competition is increasingly being experienced from alternative fuels, primarily electricity, fuel oil and propane. A significant amount of fuel switching has not been experienced, though, as natural gas is generally the least expensive, most readily available fuel in the service territories of AWG and Associated. The Company is, however, beginning to experience competition from alternative suppliers of natural gas. The competition from alternative fuels and alternative sources of natural gas has intensified in recent years as a result of the significant declines in prices of petroleum products and the deliverability surplus of natural gas experienced in the recent past. Industrial customers are most likely to consider utilization of these alternatives, as they are less readily available to commercial and residential customers. In an effort to provide some pricing alternatives to its large industrial customers with relatively stable loads, AWG offers an optional tariff to its larger business customers and to any other large business customer which shows that it has an alternate source of fuel at a lower price or that one of its direct competitors in another area has access to cheaper sources of energy. This optional tariff enables those customers willing to accept the risk of price and supply volatility to direct AWG to obtain a certain percentage of their gas requirements in the spot market. Participating customers continue to pay the nongas costs of service included in AWG's present tariff for large business customers and agree to reimburse AWG for any take-or-pay liability caused by spot market purchases on the customer's behalf. In an effort to more fully meet the service needs of larger business customers, both AWG and Associated instituted a transportation service in October, 1991, that allows such customers in Arkansas to obtain their own gas supplies directly from other suppliers. Associated has offered transportation service to its larger customers in Missouri for several years and AWG's spot market purchasing program has provided customers in northwest Arkansas with many of the benefits of transportation service. Under the programs, transportation service is available in Arkansas to any large business customer which consumes a minimum of 150,000 Mcf per year and no less than 3,000 Mcf per month. Transportation service is available in Missouri to any customer whose average monthly useage exceeds 2,000 Mcf. The minimums can be met by aggregating facilities under common ownership. A total of eleven customers are currently using the Arkansas transportation service, including AWG's three largest customers in northwest Arkansas and Associated's largest customer in northeast Arkansas. In its order approving the transportation program, the APSC indicated that it would review the program after one year and consider the desirability of lowering the minimum volume requirement. The APSC also indicated that it would consider in 1992 whether AWG's spot market purchasing program should be continued. The APSC has deferred the review of both programs to a later date. AWG purchases its system gas supply directly at the wellhead under long-term contracts. Purchases are made from approximately 310 working interest owners in 475 producing wells. Most of the volumes purchased by AWG are covered by contracts which contain provisions for periodic or automatic escalation in the price to be paid. In the mid-1980's, however, AWG took steps to freeze the prices paid under those contracts containing indefinite price escalators tied to Section 102 or prices escalating under Section 103 of the NGPA. Producers under these contracts were offered an amendment freezing the price at the December, 1984 level, with a right to renegotiate in one year. AWG received acceptances from producers holding the majority of the reserves under such contracts, either accepting the amendment or agreeing to freeze the price. Since that time, the price freeze has remained in effect and AWG has continued to make payments at the frozen 1984 price levels. This price freeze applies to gas purchased from SEECO, as well as to purchases from unaffiliated producers. A significant portion of AWG's supply comes from newer, market responsive, long-term contracts which take advantage of the lower prices presently available from gas suppliers. At December 31, 1993, AWG had a gas supply available to its northwest Arkansas system of approximately 237 Bcf of proved developed reserves, equal to 17 times current annual usage. Of this total, approximately 116 Bcf were net reserves available from SEECO. For purposes of determining AWG's available gas supply, deliveries to AWG's spot market purchasing program or transportation customers and the reserves related to those deliveries are not considered. Prior to 1993, Associated purchased gas for its system supply from six interstate pipelines, SEECO and various spot market suppliers. As a result of the unbundling of gas sales, gathering, transmission and storage services by interstate pipelines mandated by the FERC's Order No. 636, (discussed more fully below), Associated now purchases gas for its system supply from unaffiliated suppliers in the producing fields accessed by interstate pipelines and from SEECO. As previously discussed, Associated purchases its base load system requirements from SEECO under a ten-year contract with annual price redeterminations. Purchases made from unaffiliated suppliers are under purchase contracts with expiration dates ranging from October, 1994 to December, 1995. The rates charged by these suppliers include demand components to ensure availability of gas supply, administration fees and a commodity component which is based on spot market gas prices. Associated's gas purchases are transported through nine pipelines. The pipeline transportation rates include demand charges to reserve pipeline capacity and commodity charges based on volumes transported. Associated has also contracted with five of the interstate pipelines for storage capacity to meet its peak seasonal demands. These contracts involve demand charges based on the maximum deliverability, capacity charges based on the maximum storage quantity, and charges for the quantities injected and withdrawn. Over the past several years changes at the federal level have brought significant changes to the regulatory structure governing interstate sales and transportation of natural gas. The FERC's Order No. 636 series changed a major portion of the gas acquisition merchant function provided to gas distributors by interstate pipelines. AWG already obtains its supply at the wellhead directly from producers and will not be directly impacted by Order No. 636. Associated has acquired the bulk of its gas supply at the wellhead since its acquisition by AWG, but continues to purchase a portion of both its peak and base requirements from interstate suppliers. During 1993, Associated renegotiated those contracts in accordance with the pipeline restructurings before the FERC. The changes mandated by Order No. 636 have placed the responsibility for arranging firm supplies of natural gas directly on local distribution companies and have, as a result, lessened the ability of Associated to purchase gas on the short-term spot market. Some of AWG's long-term purchase contracts with unaffiliated companies provide for payments to be made if AWG does not take an annual, minimum quantity of gas (take-or-pay). Any payments made are recovered if the gas is taken before a certain date in the future. As of December 31, 1993, AWG had no unrecovered payments of this type. Associated's previous gas purchase contracts with interstate pipelines also contained take-or-pay provisions. To date, Associated has paid approximately $3.2 million for contract reformation costs incurred by its interstate pipeline suppliers and for contracted quantities of gas not taken. The Company believes these costs are recoverable from its utility customers and expects approval from the proper regulatory agencies after the payments are reviewed in the normal course of business. To date Associated has recovered, subject to refund, approximately $1.6 million of these charges from its customers. The implementation in 1991 of transportation service in Arkansas increases the exposure of AWG and Associated to take-or-pay liabilities, but the Company expects to continue to be able to satisfactorily manage this exposure. AWG has negotiated certain modifications to some of its gas purchase contracts which contain market-out provisions to decrease its exposure to take-or-pay liabilities. The gas heating load is one of the most significant uses of natural gas and is sensitive to outside temperatures. Sales, therefore, vary throughout the year. Profits, however, have become less sensitive to fluctuations in temperature in recent years as the structure of the Company's utility rates has become somewhat flatter; i.e., most recovery of return on rate base is built into a customer charge and the first step of its rates. AWG and Associated pass along to customers through an automatic cost of gas adjustment clause any increase or decrease experienced in purchased gas costs. As previously mentioned, the APSC and the MPSC regulate the Company's utility rates and operations. Late in 1990, the APSC and the MPSC approved rate increases for the Company totaling $7.4 million annually. AWG received an increase of $5.7 million annually and Associated was awarded an increase of $.9 million annually for its Missouri properties and $.8 million annually for its system in Arkansas. Arkansas Western has no immediate plans to file for additional rate increases as customer growth and transportation revenues have helped to offset the effects of attrition since the last rate case. AWG's rates for gas delivered to its customers are not regulated by the FERC, but its transmission and gathering pipeline systems are subject to the FERC's regulations concerning open access transportation since AWG accepted a blanket transportation certificate in connection with its merger with Associated. In its order approving the 1990 Arkansas rate increase, the APSC established procedures to investigate a number of changes in the regulatory mechanisms under which purchased gas costs are charged to and recovered from the customers of the utility subsidiary. The APSC indicated that its interest was heightened by the fact that Arkansas Western purchases a substantial portion of the gas supply for both AWG and Associated from SEECO. Most of the sales of SEECO's production to AWG take place under a twenty- year, fixed price contract which was approved by the APSC in connection with a corporate rearrangement of the Company in 1978 (the 1978 contract). Additionally, the APSC Staff has regularly examined and accepted the gas purchase costs of the utility subsidiary since the Commission approved the corporate reorganization in 1978. These examinations included a review in the 1990 rate case by an outside consultant hired directly by the APSC Staff. That consultant performed an extensive review of the utility's purchasing practices and gas costs, including its purchases from the Company's exploration and production segment, and recommended in filed testimony sponsored by the APSC Staff that all of the utility's gas costs including purchases under the contract in question, be accepted without adjustment. The APSC originally ordered that its proposals related to gas cost recovery and pricing be considered by the parties to the proceeding with the goal of reaching a mutually agreeable resolution of its concerns. After meeting extensively, the parties were unable to reach such a resolution and each party to the proceeding filed its own report with the APSC in July, 1991. In February, 1992, the APSC issued an order establishing a procedural schedule to further address the issues raised by its Staff and Office of the Attorney General of the State of Arkansas (AG). In establishing the schedule, the APSC stated that the record developed does not contain adequately developed evidence on which an informed decision on those issues can be based. The APSC also stated that it will consider only those proposals proffered by the parties which address prospective gas cost reductions. The APSC conducted a hearing in January, 1993, concerning the issues raised in its 1990 order. In November, 1993, the APSC issued an order that found AWG's purchases under the contract in question to be in violation of an Arkansas statute requiring that gas purchases be made "from the lowest or most advantageous market" and that the price paid by AWG was too high. In that same order, the APSC found that purchases by Associated were in compliance with the statute. The order also scheduled a hearing for mid- January, 1994 to accept additional evidence as to the price which should be paid under the AWG contract. At the January, 1994 hearing, both the Staff of the APSC and the AG presented testimony describing recommendations designed to lower the price received by the Company's exploration and production subsidiary under the contract. The Company presented testimony which it believes reinforced its position that the contractual arrangements questioned by the Commission are the most advantageous to its utility customers. Legal briefs were filed in late February, 1994, and the Company expects a Commission order to be forthcoming. If necessary, the Company intends to continue to defend its gas purchasing practices through the courts. The Company does not expect any outcome of this proceeding to have a material adverse impact on the financial position of the Company. Of the Company's 35.4 Bcf of gas production in 1993, approximately 6.0 Bcf was sold under the contract in question. As mentioned above, NOARK is an intrastate pipeline constructed by a limited partnership in which SWPL holds a 47.33% general partnership interest and is the pipeline's operator. NOARK's main line was completed and placed in service in September, 1992. A lateral line of NOARK that allows the Company's gas distribution segment to augment its supply to an existing market as well as supply gas to new markets was completed and placed in service in November, 1992. The 258 mile long pipeline originates near the Fort Chaffee military reservation in western Arkansas and terminates in northeast Arkansas. NOARK interconnects with three major interstate pipelines and provides additional access to markets for gas production of both the Company and other producers. Construction of an eight-mile interstate pipeline connecting NOARK to the distribution system of Associated was completed during 1993. NOARK has a capacity of 141 MMcfd and cost approximately $103.0 million to construct. NOARK's original cost estimate was approximately $73.0 million. The cost overrun was the result of the addition of a major central compressor station and increased costs incurred as a result of the rocky, mountainous terrain through which NOARK passes. NOARK completed its first full year of operation in 1993 and had an average daily throughput during the year of 79 MMcfd. Arkansas Western has contracted for 41 MMcfd of firm capacity on NOARK under a ten-year transportation contract. NOARK also has a five-year transportation contract with an independent marketer to transport 50 MMcfd through NOARK on a firm basis. The Company's exploration and production segment supplies 25 MMcfd of the volumes transported by the marketer under that agreement. In late 1993, the gas marketing company filed suit against NOARK, the Company and certain of its affiliates, and, effective January 1, 1994, ceased transporting gas under its agreement with NOARK. The complaint seeks rescission of the transportation contract and a contract to purchase gas from the Company's affiliates, and actual and punitive damages. The Company and NOARK both believe the suit is without merit and have filed counterclaims seeking enforcement of the contracts and damages. The Company is currently making its own sales arrangements and transporting through NOARK the 25 MMcfd of production which was previously purchased by the marketer. NOARK provides additional pipeline capacity to a portion of the Arkoma Basin in Arkansas which was not previously adequately served by pipelines offering firm transportation. NOARK is currently incurring losses and the Company expects further losses from its equity investment in NOARK until the pipeline is able to increase its level of throughput and until improvement occurs in the competitive conditions which determine the transportation rates NOARK can charge. NOARK competes primarily with two interstate pipelines in its gathering area. One of those elected to become an open access transporter subsequent to NOARK's start of construction. That pipeline does not offer firm transportation, but the increased availability of interruptible transportation services intensified the competitive environment within which NOARK operates. The Company believes that the FERC's Order No. 636 restructuring rules implemented in the latter part of 1993 will have a positive impact on NOARK. The unbundling of gas sales, gathering, transmission and storage services required by Order No. 636 should provide NOARK with expanded options for accessing gas supply and for transporting gas to downstream customers. NOARK is a public utility regulated by the APSC. The APSC established NOARK's maximum transportation rate based on its original construction cost estimate of approximately $73.0 million. The Company is subject to laws and regulations relating to the protection of the environment. The Company's policy is to accrue environmental and cleanup related costs of a non-capital nature when it is both probable that a liability has been incurred and when the amount can be reasonably estimated. The Company has no material amounts accrued at December 31, 1993. Additionally, management believes any future remediation or other compliance related costs will not have any material effect upon capital expenditures, earnings or the competitive position of the Company's subsidiaries in the segments in which they operate. REAL ESTATE DEVELOPMENT A. W. Realty Company (AWR) owns approximately 170 acres of real estate, most of which is undeveloped. AWR's real estate development activities are concentrated on a 130-acre tract of land located near the Company's headquarters in a growing part of Fayetteville, Arkansas. The Company has owned an interest in this land for many years. The property is zoned for commercial, office and multi-family residential development. AWR continues to review with a joint venture partner various options for developing this property which would minimize the Company's initial capital expenditures but still enable it to retain an interest in any appreciation in value. This activity, however, does not represent a significant portion of the Company's business. EMPLOYEES At December 31, 1993, the Company had 651 employees, 85 of whom are represented under a collective bargaining agreement. INDUSTRY SEGMENT AND STATISTICAL INFORMATION The following portions of the 1993 Annual Report to Shareholders (filed as Exhibit 13 to this filing) are hereby incorporated by reference for the purpose of providing additional information about its business. Refer to Note 9 to the financial statements for information about industry segments and "Financial and Operating Statistics" for additional statistical information, including the average sales price per unit of gas produced and of oil produced and the average production cost per unit. ITEM 2. ITEM 2. PROPERTIES The portions of the 1993 Annual Report to Shareholders (filed as Exhibit 13 to this filing) listed below are hereby incorporated by reference for the purpose of describing its properties. Refer to the Appendix for information concerning areas of operation of the Company's gas distribution systems. For information concerning the Company's exploration and production areas of operation, also refer to the Appendix. See the table entitled "Operating Properties" at the Appendix for information concerning miles of pipe of the Company's gas distribution systems and for information regarding leasehold acreage and producing wells by geographic region of the Company's exploration and production segment. Also, see Notes 5 and 6 to the financial statements for additional information about the Company's gas and oil operations. For information concerning capital expenditures, refer to the "Capital Expenditures" section of "Management's Discussion and Analysis of Financial Condition and Results of Operations". Also refer to "Financial and Operating Statistics" for information concerning gas and oil wells drilled and gas and oil produced. The following information is provided to supplement that presented in the 1993 Annual Report to Shareholders: NET WELLS DRILLED DURING THE YEAR WELLS IN PROGRESS AS OF DECEMBER 31, 1993 Due to the insignificance of the Company's oil reserves and producing oil wells to its total reserves and producing wells, separate disclosure of gas and oil producing wells has not been made. No individually significant discovery or other major favorable or adverse event has occurred since December 31, 1993. During 1993, SEECO and SEPCO were required to file Form 23, "Annual Survey of Domestic Oil and Gas Reserves" with the Department of Energy. The basis for reporting reserves on Form 23 is not comparable to the reserve data included in Note 6 to the financial statements in the 1993 Annual Report to Shareholders. The primary differences are that Form 23 reports gross reserves, including the royalty owners' share and includes reserves for only those properties where either SEECO or SEPCO is the operator. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are not involved and were not involved at December 31, 1993, in any material pending legal proceedings. The outcome of litigation in which the Company is involved would not have a material effect on the consolidated financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of the fiscal year ended December 31, 1993, to a vote of security holders, through the solicitation of proxies or otherwise. EXECUTIVE OFFICERS OF THE REGISTRANT The following is information with regard to executive officers of the Company: All officers are elected at the Annual Meeting of the Board of Directors for one-year terms or until their successors are duly elected. There are no arrangements between any officer and any other person pursuant to which he was selected as an officer. There is no family relationship between any of the executive officers. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The "Shareholder Information" and "Financial and Operating Statistics" sections of the 1993 Annual Report to Shareholders (filed as Exhibit 13 to this filing) are hereby incorporated by reference for information concerning the market for and prices of the Company's common stock, the number of shareholders and cash dividends paid. The terms of the Company's long-term debt instruments and agreements impose restrictions on the payment of cash dividends. At December 31, 1993, $102,793,000 of retained earnings was available for payment as cash dividends. These covenants generally limit the payment of dividends in a fiscal year to the total of net income earned since January 1, 1990, plus $20,000,000 less dividends paid and purchases, redemptions or retirements of capital stock during the period since December 4, 1991. The Board of Directors increased the quarterly dividend by 20% in the third quarter of 1993, to $.06 per share, equal to an annual rate of $.24 per share (after the effect of a three-for-one stock split distributed August 5, 1993). 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 and capital requirements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA, AND ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, AND ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following portions of the 1993 Annual Report to Shareholders (filed as Exhibit 13 to this filing) are hereby incorporated by reference. "Financial and Operating Statistics" for selected financial data of the Company. The comparability of data between years is affected by the acquisition of Associated Natural Gas Company in June, 1988. "Management's Discussion and Analysis of Financial Condition and Results of Operations." The consolidated financial statements as detailed in item 14 (a)(1) below. 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 accounting and financial disclosure. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The definitive proxy statement to holders of the Company's common stock in connection with the solicitation of proxies to be used in voting at the Annual Meeting of Shareholders on May 25, 1994 (the 1994 Proxy Statement), is hereby incorporated by reference for the purpose of providing information about the identification of directors. Refer to the sections "Election of Directors" and "Security Ownership of Nominees and Executive Officers" for information concerning the directors. Information concerning executive officers is presented in Part I, Item 4 of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The 1994 Proxy Statement is hereby incorporated by reference for the purpose of providing information about executive compensation. Refer to the section "Executive Compensation." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The 1994 Proxy Statement is hereby incorporated by reference for the purpose of providing information about security ownership of certain beneficial owners and management. Refer to the section "Security Ownership of Nominees and Executive Officers" of the proxy statement for information about security ownership of certain beneficial owners and management. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The 1994 Proxy Statement is hereby incorporated by reference for the purpose of providing information about related transactions. Refer to the section "Security Ownership of Nominees and Executive Officers" and "Compensation Committee Interlocks and Insider Participation" for information about transactions with members of the Company's Board of Directors. 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 Company and its subsidiaries, included with its 1993 Annual Report to Shareholders (filed as Exhibit 13 to this filing) and the report of independent auditors on such report are hereby incorporated by reference: Report of Independent Auditors. 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 Cash Flows for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements, December 31, 1993, 1992 and 1991. (2) The following financial statement schedules for the years 1993, 1992 and 1991 are submitted herewith: All other schedules are omitted because they are not required, inapplicable, or the information is otherwise shown in the financial statements or notes thereto. (3) The exhibits listed on the accompanying Exhibit Index (pages 23 - 25) immediately following the financial statement schedules are filed as part of, or incorporated by reference into, this Report. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the quarter ended December 31, 1993. The Company filed on January 17, 1994, a Current Report on Form 8-K reporting that the Arkansas Public Service Commission issued an order on November 29, 1993, in a three-year-old gas cost case involving purchases by Arkansas Western under a long-term gas purchase contract with SEECO. The order found Arkansas Western's purchases under the contract in question to be in violation of an Arkansas statute requiring that gas purchases be made "from the lowest or most advantageous market." The order found that the price paid by Arkansas Western to its affiliate was too high, determined that purchases under the contract should be indexed to an "appropriate market price", but stated that "additional evidence is necessary in order to determine the most equitable pricing methodology" and "the parties should provide testimony on any premium that should be attached to the published price to reflect Arkansas Western's gas requirements." The Commission scheduled a public hearing on these issues to begin on January 18, 1994. Additionally, as reported on the Form 8-K, a class action refund complaint was filed against Arkansas Western in December, 1993, asking the APSC to order Arkansas Western to refund amounts related to gas costs collected from its customers since 1978. The claim purports to be a class action, although no Arkansas law specifically authorizes the pursuit of class action complaints before the APSC. The complaint is based on the APSC's order discussed above. The complaint requests that the Commission order Arkansas Western to refund its ratepayers and customers at least $14 million per year since 1978 or $210 million or the amount by which the rates charged have exceeded the amount reasonably justified by the rules of the APSC and the statutes of Arkansas. The complaint does not explain how the refund amount was calculated, and no refund amount can be calculated from the order because the order made no finding as to the appropriate price. In the order issued by the APSC, it was reiterated that refunds were not at issue in this docket and that Arkansas Western's gas purchasing practices, affiliate transactions, gas costs and gas cost allocation practices were being addressed on a prospective basis only. The Registrant believes the complaint is frivolous. The Company filed on January 19, 1994, a current report on Form 8-K reporting that Vesta Energy Company ("Vesta") filed on December 21, 1993, and amended on January 6, 1994, a complaint in the Federal District Court for the Northern District of Oklahoma against the Registrant, four of its subsidiaries, and the NOARK Pipeline System. The complaint makes several allegations and generally claims that the defendants induced Vesta to enter into a contract to transport 50,000 Million British Thermal Units (MMBtu) of gas per day on NOARK and a separate contract to purchase 25,000 MMBtu per day of the total from two of the Registrant's subsidiaries through a series of false representations. On February 17, 1994, Vesta requested permission to amend its complaint a second time to allege anti-trust violations under the Sherman Act. Vesta is seeking rescission of the contracts, actual damages in excess of $1.0 million and punitive damages in excess of $1.0 million. The Registrant believes that Vesta's claim is wholly without merit and in February, 1994, NOARK and the Registrant filed separate lawsuits against Vesta in state and federal courts in Arkansas seeking enforcement of the contracts and damages. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THE REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. SOUTHWESTERN ENERGY COMPANY --------------------------- (Registrant) BY: /s/ STANLEY D. GREEN ------------------------ Stanley D. Green, Dated: March 25, 1994 Executive Vice President - Finance and Corporate Development, 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 25, 1994. /s/ CHARLES E. SCHARLAU - ------------------------------- Director, Chairman, and Charles E. Scharlau Chief Executive Officer /s/ STANLEY D. GREEN Executive Vice President - - ------------------------------- Finance and Corporate Development, Stanley D. Green and Chief Financial Officer /s/ GREGORY D. KERLEY Vice President - Treasurer - -------------------------------- and Secretary, and Gregory D. Kerley Chief Accounting Officer /s/ E. J. BALL Director - -------------------------------- E. J. Ball /s/ JAMES B. COFFMAN Director - -------------------------------- James B. Coffman /s/ JOHN PAUL HAMMERSCHMIDT Director - -------------------------------- John Paul Hammerschmidt /s/ CHARLES E. SANDERS Director - -------------------------------- Charles E. Sanders SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. Not Applicable REPORT OF INDEPENDENT AUDITORS ON SUPPORTING SCHEDULES AS OF DECEMBER 31, 1993, 1992, AND 1991 AND FOR THE YEARS THEN ENDED To the Board of Directors and Shareholders of Southwestern Energy Company: We have audited in accordance with generally accepted auditing standards the financial statements included in Southwestern Energy Company's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 7, 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 the index above 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. Tulsa, Oklahoma February 7, 1994 SCHEDULE V SCHEDULE VI SCHEDULE IX SCHEDULE X EXHIBIT INDEX EXHIBIT NO. DESCRIPTION REFERENCE - ------- ----------- --------- 3. Articles of Incorporation and Bylaws of the Company * 4. Shareholder Rights Agreement, dated May 5, 1989 (v) Material Contracts: 10.1 Gas Purchase Contract between SEECO, Inc., and Arkansas Western Gas Company, dated July 24, 1978, and amended May 21, 1979 (i) 10.2 Agreement between Southwestern Energy Company, Arkansas Western Gas Company, Arkansas Power & Light Company and Associated Natural Gas Company, dated September 1, 1987, as amended February 22, 1988, and May 16, 1988 (iii), (iv) 10.3 Gas Purchase Contract between SEECO, Inc., and Associated Natural Gas Company, dated October 1, 1990 (vii) 10.4 Compensation Plans: (a) Summary of Southwestern Energy Company Annual and Long-Term Incentive Compensation Plan, effective January 1, 1985, as amended July 10, 1989, (Replaced by Southwestern Energy Company 1993 Incentive Compensation Plan, effective January 1, 1993. (i), (vi) (b) Summary of Southwestern Energy Company 1993 Incentive Compensation Plan, effective January 1, 1993. * (c) Nonqualified Stock Option Plan, as amended July 10, 1989 (Replaced by Southwestern Energy Company 1993 Stock Incentive Plan, dated April 7, 1993). (ii) (d) Exploration Incentive Plan A, effective January 1, 1988, as amended July 10, 1989. (vi) (e) Southwestern Energy Company 1993 Stock Incentive Plan, dated April 7, 1993. (x) (f) Southwestern Energy Company 1993 Stock Incentive Plan for Outside Directors, dated April 7, 1993. (x) 10.5 Southwestern Energy Company Supplemental Retirement Plan, adopted May 31, 1989, and Amended and Restated as of December 15, 1993. * 10.6 Southwestern Energy Company Supplemental Retirement Plan Trust, dated December 30, 1993. * 10.7 Executive Severance Agreement for Charles E. Scharlau, effective August 4, 1989. (vi) 10.8 Executive Severance Agreement for Stanley D. Green, effective August 4, 1989. (vi) 10.9 Executive Severance Agreement for B. Brick Robinson, effective August 4, 1989. (vi) 10.10 Executive Severance Agreement for Dan B. Grubb, effective July 8, 1992. (ix) 10.11 Consulting Agreement between the Company and J. B. Coffman & Associates, Inc., effective November 8, 1989. (vi) 10.12 Employment Agreement for Charles E. Scharlau, dated December 18, 1990, effective January 1, 1991. (vii) 10.13 Employment Agreement for Dan B. Grubb, effective July 8, 1992. (ix) 10.14 Form of Indemnity Agreement, between the Company and each officer and director of the Company, dated May 25, 1988 or October 9, 1991. (iv), (viii) 10.15 Gas Transportation Agreement between NOARK Pipeline System, Limited Partnership and Arkansas Western Gas Company, dated February 4, 1991, and amended February 14, 1992. (ix) 10.16 Limited Partnership Agreement of NOARK Pipeline System, Limited Partnership, dated October 10, 1991, and amended February 24, 1993. (viii), (ix) 10.17 Operating Agreement of NOARK Pipeline System, dated March 19, 1991. (viii) 10.18 Agreement for Sale of Partnership Interest between Southwestern Energy Pipeline Company and GRUBB NOARK Pipeline, Inc., dated July 24, 1992. (ix) 13. 1993 Annual Report to Shareholders, except for those portions not expressly incorporated by reference into this report. Those portions not expressly incorporated by reference are not deemed to be filed with the Securities and Exchange Commission as part of this report. * 22. Subsidiaries of the Registrant. (ix) _______________ (i) Incorporated by reference to the exhibit filed with the Company's filing on Form 10-K for the year ended December 31, 1984. (ii) Incorporated by reference to the exhibit filed with the Company's filing on Form 10-K for the year ended December 31, 1985. (iii) Incorporated by reference to the exhibit filed with the Company's filing on Form 10-K for the year ended December 31, 1987. (iv) Incorporated by reference to the exhibit filed with the Company's filing on Form 10-K for the year ended December 31, 1988. (v) Incorporated by reference to the exhibit filed with the Company's Form 8-K on May 10, 1989. (vi) Incorporated by reference to the exhibit filed with the Company's filing on Form 10-K for the year ended December 31, 1989. (vii) Incorporated by reference to the exhibit filed with the Company's filing on Form 10-K for the year ended December 31, 1990. (viii) Incorporated by reference to the exhibit filed with the Company's filing on Form 10-K for the year ended December 31, 1991. (ix) Incorporated by reference to the exhibit filed with the Company's filing on form 10-K for the year ended December 31, 1992. (x) Incorporated by reference to the appendix filed with the Company's definitive proxy statement to holders of the Registrant's Common Stock in connection with the solicitation of proxies to be used in voting at the Annual Meeting of Shareholders on May 26, 1993. * Exhibit filed with the Company's filing on Form 10-K for the year ended December 31, 1993.

47111_1993.txt

47111_1993

1993

47111

Item 1.BUSINESS Hershey Foods Corporation and its subsidiaries (the "Corporation") are engaged in the manufacture, distribution and sale of consumer food products. The Corporation, primarily through its Hershey Chocolate U.S.A., Hershey Grocery, Hershey International and Hershey Pasta Group divisions and its subsidiary Hershey Canada Inc., produces and distributes a broad line of chocolate, confectionery, grocery and pasta products. The Corporation was organized under the laws of the State of Delaware on October 24, 1927, as a successor to a business founded in 1894 by Milton S. Hershey. In March 1993, the Corporation purchased certain assets of three Cleveland, Ohio area pasta companies: Ideal Macaroni Company, Il Pranzo D'oro Corporazoine, Inc. and Weiss Noodle Company. In September 1993, the Corporation purchased all of the shares of Sperlari, S.r.l. from Heinz Italia S.p.A. Sperlari manufactures, markets, sells, and distributes a wide range of confectionery products in Italy, including sugar candies and nougat. In October 1993, the Corporation purchased all of the outstanding shares of Overspecht B.V. Through its subsidiaries, this company manufactures and sells chocolate and non-chocolate confectionery products, cookies, biscuits, and ice cream primarily in the Netherlands and Belgium. The Corporation's principal product groups include: chocolate and confectionery products sold in the form of bar goods, bagged items, boxed items, and throat drops; grocery products in the form of baking ingredients, chocolate drink mixes, peanut butter, dessert toppings, and beverages; pasta products sold in a variety of different shapes, sizes and packages; and refrigerated puddings. The Corporation believes it is a major factor in these product groups in North America. Operating profit margins vary considerably among individual products and brands. Generally, such margins on chocolate and confectionery products are greater than those on pasta and other food products. The Corporation manufactures chocolate and confectionery products in a variety of packaged forms and markets them under more than 50 brands. The different packaged forms include various arrangements of the same bar products, such as boxes, trays and bags, as well as a variety of different sizes and weights of the same bar product, such as snack size, standard, king size, large and giant bars. Among the principal chocolate and confectionery products in the United States are: HERSHEY'S COOKIES 'N' MINT chocolate bars, HERSHEY'S HUGS chocolates, HERSHEY'S HUGS WITH ALMONDS chocolates, HERSHEY'S KISSES chocolates, HERSHEY'S KISSES WITH ALMONDS chocolates, HERSHEY'S milk chocolate bars, HERSHEY'S milk chocolate bars with almonds, HERSHEY'S MINIATURES chocolate bars, AMAZIN' FRUIT gummy bears fruit candy, BAR NONE candy bars, CADBURY'S CREME EGGS candy, CARAMELLO candy bars, KIT KAT wafer bars, LUDEN'S throat drops, MR. GOODBAR milk chocolate bars with peanuts, PETER PAUL ALMOND JOY candy bars, PETER PAUL MOUNDS candy bars, REESE'S crunchy peanut butter cups, REESE'S peanut butter cups, REESE'S PIECES candies, ROLO caramels in milk chocolate, SKOR toffee bars, SYMPHONY milk chocolate bars, WHATCHAMACALLIT candy bars, Y&S TWIZZLERS licorice-type candy, YORK peppermint pattie candy, and 5TH AVENUE candy bars. The Corporation also markets a line of grocery products in the baking, beverage, peanut butter, puddings and toppings categories. Principal products include HERSHEY'S baking chocolate, HERSHEY'S baking chips, HERSHEY'S chocolate drink, HERSHEY'S chocolate milk mix, HERSHEY'S cocoa, HERSHEY'S CHOCOLATE SHOPPE toppings, HERSHEY'S syrup, REESE'S peanut butter and REESE'S peanut butter chips. Refrigerated HERSHEY'S chocolate bar flavor puddings are available throughout the United States. HERSHEY'S chocolate milk is produced and sold under license by approximately 25 independent dairies throughout the United States, using a chocolate milk mix manufactured by the Corporation. Principal products in Canada include CHIPITS chocolate chips, GLOSETTE chocolate-covered raisins, peanuts and almonds, LIFE SAVERS candy, OH HENRY! candy bars, PLANTERS peanuts, POT OF GOLD boxed chocolates, REESE PEANUT BUTTER CUPS candy, and Y&S TWIZZLERS licorice-type candy. The Corporation's chocolate, confectionery and grocery products are sold primarily to grocery wholesalers, chain grocery stores, candy distributors, mass merchandisers, chain drug stores, vending companies, wholesale clubs, convenience stores, concessionaires and food distributors by full-time sales representatives, food brokers and part-time retail sales merchandisers throughout the United States and Canada. The Corporation also manufactures, imports, markets, sells and distributes chocolate products in Mexico under the HERSHEY'S brand name. These products are sold through chain grocery stores, food distributors, and wholesale clubs. The Corporation believes its chocolate and confectionery products are sold in over 2 million retail outlets in North America. Selected products in Canada are sold through a network of independent brokers. The Corporation manufactures, markets, sells and distributes high-quality assorted pralines and seasonal chocolate products in Germany under the GUBOR brand name which are sold directly to retailers. Additionally, the Corporation imports, markets, sells and distributes selected HERSHEY'S chocolate and confectionery products in the Japanese market. In Italy, the Corporation manufactures, markets, sells, and distributes various confectionery and nougat products under several brand names including SPERLARI, DONDI, SCARAMELLINI, FRESH CLUB, SPRINT, GALATINE, and GNAMMY. In the Netherlands and Belgium, the Corporation manufactures and sells chocolate and confectionery products, cookies, biscuits, and ice cream. These products are sold primarily under private labels, but products are also marketed and sold under the WIVER and JAMIN brand names. The Corporation manufactures and sells quality pasta products throughout the United States. The Corporation markets its products on a regional basis under several brand names, including AMERICAN BEAUTY, LIGHT 'N FLUFFY, P&R, RONZONI, SAN GIORGIO, and SKINNER, as well as certain private labels. These products are sold through chain grocery stores, grocery wholesalers, wholesale clubs, convenience stores and food distributors. The Corporation's marketing strategy for its products is based upon the consistently superior quality of its products, mass distribution and the best possible consumer value in terms of price and weight. In addition, the Corporation devotes considerable resources to the identification, development, testing, manufacturing and marketing of new products. The Corporation utilizes a variety of promotional programs for customers and advertising and promotional programs for consumers. The Corporation employs promotional programs at various times during certain seasons of the year to stimulate sales of certain products. Chocolate, confectionery and grocery seasonal and holiday related sales have typically been highest during the third and fourth quarters of the year. The Corporation recognizes that the mass distribution of its consumer food products is an important element in maintaining sales growth and providing service to its customers. The Corporation attempts to meet the changing demands of its customers by planning optimum stock levels and reasonable delivery times consistent with achievement of economies of distribution. To achieve these objectives, the Corporation has developed a distribution network from its manufacturing plants, distribution centers and field warehouses strategically located throughout the United States, Puerto Rico, Canada and Mexico. The Corporation uses a combination of public and contract carriers to deliver its products from the distribution points to its customers. In conjunction with sales and marketing efforts, the distribution system has been instrumental in the effective promotion of new, as well as established, products on both national and regional scales. From time to time the Corporation has changed the prices and weights of its consumer food products to accommodate changes in the cost of manufacturing, including the cost of raw materials; the competitive environment; and profit objectives, while at the same time maintaining consumer value. The Corporation changes the weight on portions of its standard bar line periodically, and selected weight changes were made in 1993. As a result of higher semolina costs, the Corporation implemented a price increase averaging 3.5% in November 1993 on its pasta products and announced a curtailment of certain promotional allowances effective February 1994. The most significant raw material used in the production of the Corporation's chocolate and confectionery products is cocoa beans. This commodity is imported principally from West African, South American and Far Eastern equatorial regions. West Africa accounts for approximately 60% of the world's crop. Cocoa beans are not uniform, and the various grades and varieties reflect the diverse agricultural practices and natural conditions found in the many growing areas. The Corporation buys a mix of cocoa beans to meet its manufacturing objectives. It attempts to minimize the effect of cocoa bean price fluctuations by the forward purchasing, from time to time, of substantial quantities of cocoa beans, chocolate liquor and cocoa butter, and by the purchase and sale of cocoa futures and options contracts. The table below sets forth annual cocoa prices for each of the calendar years indicated. The prices are the monthly average of the quotations at noon of the three active futures trading contracts closest to maturity on the New York Coffee, Sugar and Cocoa Exchange. Because of the Corporation's forward purchasing practices and premium prices paid for certain varieties of cocoa beans, these average futures contract prices are not necessarily indicative of the Corporation's average cost of cocoa beans or cocoa products. Cocoa Futures Contract Prices (cents per pound) 1989 1990 1991 1992 1993 Average 54.6 55.5 52.8 47.6 47.3 High 66.8 63.5 60.0 56.2 56.7 Low 42.4 43.6 45.6 41.3 41.8 Source: International Cocoa Organization Quarterly Bulletin of Cocoa Statistics The price of sugar, the Corporation's second most important commodity for its domestic chocolate and confectionery products, is subject to price supports under farm legislation. Due to import quotas and duties imposed to support the price of sugar established by that legislation, sugar prices paid by United States users are currently substantially higher than prices on the world sugar market. The average wholesale list price of refined sugar, F.O.B. Northeast, has remained relatively stable in a range of 28 cents to 31 cents per pound for the past ten years. The Corporation utilizes forward purchasing and other procurement practices, including, from time to time, the purchase and sale of sugar futures contracts. Therefore, the reported prices of sugar are not necessarily indicative of the Corporation's actual costs. Other raw materials purchased in substantial quantities for domestic manufacturing purposes include milk, peanuts, and almonds. The price of milk is affected by Federal Marketing Orders and the prices of milk and peanuts are affected by price support programs administered by the United States Department of Agriculture. The Food, Agriculture, Conservation, and Trade Act of 1990, which is a five-year extension of prior farm legislation, was passed by Congress in October 1990. While this law is not substantially different from the previous farm legislation, it continues to have an impact on the price of sugar, peanuts and milk because it sets price support levels for these and other commodities. During the first three quarters of 1993, domestic milk prices averaged well below year earlier levels, reflecting strong milk production throughout the country. As a result of the wet weather conditions in the Midwest during the summer, production in the Minnesota-Wisconsin milkshed dropped significantly below the prior year levels in the fourth quarter. For the year, milk prices were not materially different from the 1992 levels. As a result of an excellent 1992 crop harvest, domestic market prices for peanuts were relatively stable through the first three quarters of 1993. However, prices increased modestly during the fourth quarter due to a lower than average 1993 crop harvest. Domestic almond prices began 1993 at moderate levels but gradually increased during the first and second quarters due to very low carry-in stocks and lower than average new crop prospects. Prices rose substantially during the third and fourth quarters as the below average 1993 crop was harvested and prices finished the year at a record high. Pasta is made from semolina milled from durum wheat, a class of hard wheat grown in the United States, principally in North Dakota. The Corporation purchases semolina from commercial millers and also is engaged in custom milling arrangements to obtain sufficient quantities of high quality semolina. A decrease in plantings and adverse weather conditions in the Midwest combined to reduce the quantity and quality of the 1993 durum wheat crop, and resulted in a substantial cost increase for this raw material. Supplies are expected to remain tight at least until the harvest of the new crop during the fall of 1994 and prices may remain at elevated levels in the interim. The Corporation has agreements with Cadbury Beverages Inc. and affiliated companies which license the Corporation to manufacture and/or market and distribute PETER PAUL ALMOND JOY and PETER PAUL MOUNDS confectionery products worldwide as well as YORK, CADBURY and CARAMELLO confectionery products in the United States. The Corporation's rights under these agreements are extendable on a long-term basis at the Corporation's option. The license for CADBURY and CARAMELLO products is subject to a minimum sales requirement which the Corporation substantially exceeded in 1993. The Corporation also has an agreement with Societe des Produits Nestle SA, which licenses the Corporation to manufacture and distribute in the United States the KIT KAT and ROLO confectionery products. The Corporation's rights under this agreement are extendable on a long-term basis at the Corporation's option, subject to certain conditions, including minimum unit volume sales. In 1993, minimum volume requirements were substantially exceeded. The Corporation's products are manufactured and sold in the Philippines pursuant to a technical assistance and trademark licensing agreement. The Corporation manufactures and distributes the SKOR toffee bar in the United States and Canada under a technology license from Freia Marabou a.s of Oslo, Norway. The Corporation has license agreements with Snow Brand Milk Products Co., Ltd. ("Snow Brand") of Sapporo, Japan. Snow Brand manufactures and sells in Japan certain beverage and ice cream products under the Corporation's trademarks. The Corporation has a Technical Assistance and Know-How and Trademark License Agreement with Hai-Tai Confectionery Co., Ltd. ("Hai-Tai") of Seoul, South Korea. Pursuant to that agreement, Hai-Tai manufactures and sells in the South Korean market certain of the Corporation's chocolate and confectionery products. The Corporation has a license agreement with Maeil Dairy Industry Co., Ltd. ("Maeil Dairy") of South Korea. Pursuant to the agreement, Maeil Dairy manufactures, sells and distributes HERSHEY'S chocolate drink and chocolate puddings in South Korea. Competition Many of the Corporation's brands enjoy wide consumer acceptance and are among the leading brands sold in the marketplace. However, these brands are sold in highly competitive markets and compete with many other multinational, national, regional and local firms, some of which have resources in excess of those available to the Corporation. Trademarks The Corporation has various registered and unregistered trademarks, service marks and licenses which are of material importance to the Corporation's business. Backlog of Orders The Corporation manufactures primarily for stock and fills customer orders from finished goods inventories. While at any given time there may be some backlog of orders, such backlog is not material in respect to total sales, nor are the changes from time to time significant. Research and Development The Corporation engages in considerable research activities which principally involve development of new products, improvement of the quality of existing products, and improvement and modernization of production processes. The Corporation also carries out development and evaluation of new processing techniques for both current and proposed product lines. Regulation The Corporation's domestic plants are subject to inspection by the Food and Drug Administration and various other governmental agencies, and its products must comply with regulations under the Federal Food, Drug and Cosmetic Act and with various comparable state statutes regulating the manufacturing and marketing of food products. Environmental Considerations In the past the Corporation has made investments based on compliance with environmental laws and regulations. Such expenditures have not been material with respect to the Corporation's capital expenditures, earnings or competitive position. Employees As of December 31, 1993, the Corporation had approximately 14,300 full-time and 1,600 part-time employees, of whom approximately 6,300 were covered by collective bargaining agreements. The Corporation considers its employee relations to be good. Item 2. Item 2. PROPERTIES The following is a list of the Corporation's principal manufacturing properties. The Corporation owns each of these properties. UNITED STATES Hershey, Pennsylvania - Confectionery Products (3 principal plants) Oakdale, California - Confectionery Products Stuarts Draft, Virginia - Confectionery Products Winchester, Virginia - Pasta Products CANADA Smiths Falls, Ontario - Confectionery and Snack Nut Products In addition to the locations indicated above, the Corporation owns or leases several other less significant properties used for manufacturing confectionery and pasta products, sales, distribution and administrative functions. The Corporation's plants are efficient and well maintained. These plants generally have adequate capacity and can accommodate seasonal demands, changing product mixes and certain additional growth. The largest plant is located in Hershey, Pennsylvania. Many additions and improvements have been made to this facility over the years and the plant's manufacturing equipment includes equipment of the latest type and technology. Item 3. Item 3. LEGAL PROCEEDINGS The Corporation has no material pending legal proceedings, other than ordinary routine litigation incidental to its business. 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 Information concerning the principal United States trading market for, market prices of and dividends on the Corporation's Common Stock and Class B Common Stock, and the approximate number of stockholders, may be found in the section "Market Prices and Dividends" on pages 18 and 19 of the Corporation's 1993 Annual Report to Stockholders, which information is incorporated herein by reference and reproduced herein as Exhibit 13. Item 6. Item 6. SELECTED FINANCIAL DATA The following information, for the five years ended December 31, 1993, found in the section "Eleven-Year Consolidated Financial Summary" on page 40 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference and reproduced herein as Exhibit 13: Net Sales; Income from Continuing Operations before accounting changes; Income Per Share from Continuing Operations before accounting changes (excluding Notes g and h); Dividends Paid on Common Stock (and related Per Share amounts); Dividends Paid on Class B Common Stock (and related Per Share amounts); Long-term Portion of Debt; and Total Assets. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The section "Management's Discussion and Analysis", found on pages 16 through 19, 21, 23, and 25 of the Corporation's 1993 Annual Report to Stockholders, is incorporated herein by reference and reproduced herein as Exhibit 13. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following audited consolidated financial statements of the Corporation and its subsidiaries are found at the indicated pages in the Corporation's 1993 Annual Report to Stockholders, and such financial statements, along with the report of the independent public accountants thereon, are incorporated herein by reference and reproduced herein as Exhibit 13. 1. Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991. (Page 20) 2. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. (Page 22) 3. Consolidated Balance Sheets as of December 31, 1993 and 1992. (Page 24) 4. Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991. (Page 26) 5. Notes to Consolidated Financial Statements (Pages 27 through 37), including "Quarterly Data (Unaudited)." (Page 37) 6. Report of Independent Public Accountants. (Page 38) 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 names, ages, positions held with the Corporation, periods of service as a director, principal occupations, business experience, and other directorships of nominees for director of the Corporation are set forth in the section "Election of Directors" in the Corporation's Proxy Statement for its 1994 Annual Meeting of Stockholders. This information is incorporated herein by reference. Executive Officers of the Corporation as of March 1, 1994 Name Age Positions Held During the Last Five Years CORPORATE K. L. Wolfe 55 Chairman of the Board and Chief Executive Officer (1993); President and Chief Operating Officer (1985) R. A. Zimmerman(1) 61 Retired Chairman of the Board and Chief Executive Officer (1993); Chairman of the Board and Chief Executive Officer (1985) J. P. Viviano 55 President and Chief Operating Officer (1993); President, Hershey Chocolate U.S.A., a division of Hershey Foods Corporation (1985) W. F. Christ 53 Senior Vice President and Chief Financial Officer (1994); President, Hershey International, a division of Hershey Foods Corporation (1988) C. L. Duncan 54 Vice President, Research and Development (1981) T. C. Fitzgerald 54 Vice President and Treasurer (1990); Treasurer (1985) S. A. Lambly 53 Vice President, Human Resources (1989) W. Lehr, Jr. 53 Vice President and Secretary (1994); Senior Vice President and Secretary and Associate General Counsel (Securities) (1988) R. M. Reese 44 Vice President and General Counsel (1993); Assistant General Counsel (1987) J. B. Stiles 42 Vice President and Corporate Controller (1990); Controller and Chief Accounting Officer (1987) B. L. Zoumas 51 Vice President, Science and Technology (1992); Vice President, Technical, Hershey Chocolate U.S.A. (1990); Vice President, Science and Technology (1981) DIVISION J. F. Carr 49 President, Hershey International (1994); Vice President, Marketing, Hershey Chocolate U.S.A. (1984) M. F. Pasquale 46 President, Hershey Chocolate U.S.A. (1994); Senior Vice President and Chief Financial Officer (1988) Executive Officers of the Corporation Name Age Positions Held During the Last Five Years R. W. Meyers 50 President, Hershey Canada Inc., a subsidiary of Hershey Foods Corporation (1990); Acting President, Hershey Canada Inc. (1989) C. M. Skinner 60 President, Hershey Pasta Group, a division of Hershey Foods Corporation (1984) R. Brace 50 Vice President, Manufacturing, Hershey Chocolate U.S.A. (1987) F. Cerminara 45 Vice President, Commodities Procurement, Hershey Chocolate U.S.A. (1994); Vice President, Corporate Development and Commodities (1988) D. N. Eshleman(2) 39 General Manager, Hershey Grocery, a division of Hershey Foods Corporation (1994); Director, Marketing, Hershey Chocolate U.S.A. (1988) M. H. Holmes(2) 49 Vice President and General Manager, Chocolate Confection, Hershey Chocolate U.S.A. (1994); General Manager, Grocery, Hershey Chocolate U.S.A. (1989) M. T. Matthews 47 Vice President, Sales, Hershey Chocolate U.S.A. (1989) (1) Mr. Zimmerman retired on December 31, 1993. (2) Messrs. Eshleman's and Holmes' positions prior to 1994 were not executive officer positions. There are no family relationships among any of the above named officers of the Corporation. Corporate Officers and Division Presidents are generally elected each year at the organization meeting of the Board of Directors following the Annual Meeting of Stockholders in April. Item 11. Item 11. EXECUTIVE COMPENSATION Information concerning compensation of the five most highly compensated executive officers of the Corporation individually, and compensation of directors, is set forth in the sections "1993 Executive Compensation" and "Compensation of Directors" in the Corporation's Proxy Statement for its 1994 Annual Meeting of Stockholders. This information is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning ownership of the Corporation's voting securities by certain beneficial owners, individual nominees for directors, and by management, including the five most highly compensated executive officers, is set forth in the section "Voting Securities" in the Corporation's Proxy Statement for its 1994 Annual Meeting of Stockholders. This information is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning "Certain Relationships and Related Transactions" is set forth in the section "Certain Transactions and Relationships" in the Corporation's Proxy Statement for its 1994 Annual Meeting of Stockholders. This information is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Item 14(a)(1): Financial Statements The audited consolidated financial statements of the Corporation and its subsidiaries and the Report of Independent Public Accountants thereon, as required to be filed with this report, are set forth in Item 8 of this report and are incorporated therein by reference to specific pages of the Corporation's 1993 Annual Report to Stockholders and reproduced herein as Exhibit 13. Item 14(a)(2): Financial Statement Schedules The following consolidated financial statement schedules of the Corporation and its subsidiaries for the years ended December 31, 1993, 1992 and 1991 are filed herewith on the indicated pages in response to Item 14(d): 1. Schedule V--Property, Plant and Equipment (Page 15) 2. Schedule VI--Accumulated Depreciation of Property, Plant and Equipment (Page 16) 3. Schedule VIII--Valuation and Qualifying Accounts (Page 17) 4. Schedule IX--Short-Term Borrowings (Page 18) Other schedules have been omitted as not applicable or required, or because information required is shown in the consolidated financial statements or notes thereto. Financial statements of the parent corporation only are omitted because the Corporation is primarily an operating corporation and there are no significant restricted net assets of consolidated and unconsolidated subsidiaries. Item 14(a)(3): Exhibits The following items are attached or incorporated by reference in response to Item 14(c): (3) Articles of Incorporation and By-laws The Corporation's Restated Certificate of Incorporation, as amended, is incorporated by reference from Exhibit No. 3 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended April 3, 1988. The By-laws, as amended on December 3, 1991, are incorporated by reference from Exhibit No. 3 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. (4) Instruments defining the rights of security holders, including indentures The Corporation has issued certain long-term debt instruments, no one class of which creates indebtedness exceeding 10% of the total assets of the Corporation and its subsidiaries on a consolidated basis. These classes consist of the following: a. 8.45% to 9.92% Medium-Term Notes due 1994-1998 b. 8.8% Debentures due 2021 c. Other Obligations The Corporation will furnish copies of the above debt instruments to the Commission upon request. In 1993 the Corporation called and redeemed its 9.5% Sinking Fund Debentures due 2009 and its 9.125% Sinking Fund Debentures due 2016. (10) Material contracts a. "After Eight, Kit Kat, and Rolo License Agreement" (License Agreement) between Hershey Foods Corporation and Rowntree Mackintosh Confectionery Limited is incorporated by reference from Exhibit No. 10(a) to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1980. The License Agreement was amended in 1988 and the Amendment Agreement is incorporated by reference from Exhibit No. 19 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended July 3, 1988. The License Agreement was assigned by Rowntree Mackintosh Confectionery Limited to Societe des Produits Nestle SA as of January 1, 1990. The Assignment Agreement is incorporated by reference from Exhibit No. 19 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. b. Peter Paul/York Domestic Trademark & Technology License Agreement between Hershey Foods Corporation and Cadbury Schweppes Inc. (now Cadbury Beverages Inc.) dated August 25, 1988, is incorporated by reference from Exhibit No. 2(a) to the Corporation's Current Report on Form 8-K dated September 8, 1988. c. Cadbury Trademark & Technology License Agreement among Hershey Foods Corporation and Cadbury Schweppes Inc. (now Cadbury Beverages Inc.) and Cadbury Limited dated August 25, 1988, is incorporated by reference from Exhibit No. 2(a) to the Corporation's Current Report on Form 8-K dated September 8, 1988. Executive Compensation Plans: d. The "1987 Key Employee Incentive Plan" (the "Plan") is incorporated by reference from Exhibit No. 10(b) to the Corporation's Annual Report on Form 10-K for the year ended December 31, 1987. The Plan was amended in 1991, and the amendment is incorporated by reference from Exhibit No. 10 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 1991. The Plan was further amended in 1992, and the amendment is incorporated by reference from Exhibit No. 19 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. e. Hershey Foods Corporation's "Supplemental Executive Retirement Plan" is incorporated by reference from Exhibit No. 10(c) to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1982. f. Hershey Foods Corporation's "Non-Management Director Retirement Plan" is incorporated by reference from Exhibit No. 19 to the Corporation's Quarterly Report on Form 10-Q for the quarter ended March 29, 1992. g. Hershey Foods Corporation's "Deferral Plan for Non- Management Directors" is incorporated by reference from Exhibit No. 10 to the Corporation's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (12) Computation of ratio of earnings to fixed charges statement A computation of ratio of earnings to fixed charges for the years ended December 31, 1993, 1992, 1991, 1990, and 1989 is attached as Exhibit No. 12. (13) Annual report to security holders The financial section of the Corporation's 1993 Annual Report to Stockholders is attached as Exhibit No. 13. (21) Subsidiaries of the Registrant A list setting forth subsidiaries of the Corporation is attached as Exhibit No. 21. Item 14(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. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HERSHEY FOODS CORPORATION (Registrant) Date: March 7, 1994 By W. F. CHRIST (W. F. Christ, 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 Corporation and in the capacities and on the date indicated. Signature Title Date K. L. WOLFE Chief Executive Officer March 7, 1994 (K. L. Wolfe) and Director W. F. CHRIST Chief Financial Officer March 7, 1994 (W. F. Christ) J. B. STILES Chief Accounting Officer March 7, 1994 (J. B. Stiles) J. P. VIVIANO Director March 7, 1994 (J. P. Viviano) H. O. BEAVER, JR. Director March 7, 1994 (H. O. Beaver, Jr.) T. C. GRAHAM Director March 7, 1994 (T. C. Graham) B. GUITON Director March 7, 1994 (B. Guiton) J. C. JAMISON Director March 7, 1994 (J. C. Jamison) S. C. MOBLEY Director March 7, 1994 (S. C. Mobley) F. I. NEFF Director March 7, 1994 (F. I. Neff) Signature Title Date R. J. PERA Director March 7, 1994 (R. J. Pera) J. M. PIETRUSKI Director March 7, 1994 (J. M. Pietruski) V. A. SARNI Director March 7, 1994 (V. A. Sarni) H. R. SHARBAUGH Director March 7, 1994 (H. R. Sharbaugh) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To Hershey Foods Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in Hershey Foods Corporation's 1993 annual report to stockholders incorporated by reference 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 those statements taken as a whole. The schedules listed in Item 14(a)(2) on page 9 are the responsibility of the Corporation'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. January 28, 1994 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated January 28, 1994, included or incorporated by reference in this Form 10-K for the year ended December 31, 1993, into the Corporation's previously filed Registration Statements on Forms S-8 or S-3 (File No. 33-12718, File No. 33-35062, File No. 33-45431, File No. 33-45556 and File No. 33-51089). ARTHUR ANDERSEN & CO. New York, N.Y. March 7, 1994 HERSHEY FOODS CORPORATION ANNUAL REPORT ON FORM 10-K Index to Exhibits Exhibit No. 12 - Computation of ratio of earnings to fixed charges statement 13 - Financial section of 1993 Annual Report to Stockholders 21 - Subsidiaries of the Registrant

764625_1993.txt

764625_1993

1993

764625

ITEM 1. Business Enserch Exploration Partners, Ltd. ("EP"), a Texas limited partnership, was formed in 1985 to succeed to substantially all of the domestic gas and oil exploration and production business of ENSERCH Corporation ("ENSERCH"). ENSERCH and an affiliate own more than 99% of the outstanding limited partnership units and the remaining units of slightly more than 800,000, are publicly held. EP operates through EP Operating Limited Partnership ("EPO"), a Texas limited partnership, in which EP holds a 99% limited partner's interest and the general partners own a 1% interest. Enserch Exploration, Inc. ("EEI") is the managing general partner and ENSERCH is the special general partner of EP and EPO. EP is engaged in the exploration for and the development, production and marketing of natural gas and crude oil throughout Texas, offshore in the Gulf of Mexico, onshore in the Gulf Coast and Rocky Mountain areas and in various other areas in the United States. Activities include geological and geophysical studies; acquisition of gas and oil leases; drilling of exploratory wells; development and operation of producing properties; acquisition of interests in developed or partially developed properties; and the marketing of natural gas, crude oil and condensate. Production offices are maintained in Dallas, Houston, Athens, Bridgeport, Longview and Midland, Texas. EP has no officers, directors or employees. Instead, officers, directors and employees of EEI perform all management and operating functions for EP. At December 31, 1993, EEI employed 382 persons, including 36 geologists, 21 geophysicists and 19 land representatives who investigate prospective areas, generate drilling prospects, review submitted prospects and acquire leasehold acreage in prospective areas. In addition, EEI maintains a staff of 56 engineers and 46 technologists who plan and supervise the drilling and completion of wells, evaluate prospective gas and oil reservoirs, plan the development and management of fields, and manage the daily production of gas and oil. Spot-market sales, which include monthly and short-term industrial sales, covered about 70% of 1993 gas sales, compared with 80% in 1992 and 75% in 1991. During 1994, the percentage of gas sold in the spot market is expected to be in the range of 75% to 85%. Approximately 70% of EP's natural-gas sales volumes (75% of gas revenues) for the year ended December 31, 1993 was sold to affiliated customers. In 1993, affiliated revenues include gas sales under new contracts effective March 1, 1993 with Enserch Gas Company covering essentially all gas production not committed under existing contracts. Affiliated purchasers do not have a preferential right to purchase natural gas produced by EP other than under existing contracts. Sales data are set forth under "Selected Financial and Operating Data" in Appendix A to this report. Following is a summary of EP's exploration and development activity during 1993: Gulf of Mexico. Offshore exploration provides EP the opportunity to improve its ratio of production to reserve base by the addition of gas wells with relatively higher production rates. This is coupled with ongoing deep- water development projects, which are expected to provide long-term reserves. State-of-the-art technology, including three-dimensional ("3-D") seismic, specialized seismic processing, and innovative well completion and production techniques, are being used to help accomplish these objectives. Mississippi Canyon Block 441, the first development project in the Gulf of Mexico that EP has operated, is indicative of this approach. A 3-D seismic program, prior to field development, confirmed that the majority of the reservoir lies beneath a shipping fairway. A production program was developed that involved drilling highly deviated wells under the shipping fairway, subsea completing the deep-water wells, and tying the wells back to a conventional shallow-water production platform using bundled flowlines. The high-angle wells required special gravel-pack completion techniques. After a year of production, the field has been essentially maintenance free, producing some 70 million cubic feet ("MMcf") of natural gas and more than 500 barrels ("Bbls") of condensate per day from six wells. The 3-D seismic on Mississippi Canyon Block 441 is being reprocessed, using depth migration and other state-of-the-art techniques to aid in the identification of deeper exploratory targets, which, if successfully drilled, could add to the field reserves. EP has a 37.5% working interest in this project. The Garden Banks Block 388 oil development project remains on schedule, with initial production anticipated by mid-1995. Installation of the offshore facilities, which consist of a subsea template, gathering and sales pipelines, and shallow-water production facilities, will begin by mid-1994. After the rig and all facilities are in place, the three existing wells will be connected, with initial production from the first well expected to be approximately 5 thousand barrels ("MBbls") of oil and 5 MMcf of gas per day. Peak daily production from the project is anticipated to be 40 MBbls of oil and 60 MMcf of gas. EP is 100% owner and operator of the Garden Banks Block 388 project. Another prospect delineated by seismic amplitude anomalies lies approximately four miles to the west of Garden Banks Block 388 on Garden Banks Blocks 386/387. If successfully drilled, this prospect could add production to the Block 388 development by incorporating some of the production technology that was utilized on Mississippi Canyon Block 441. In 1994, an offset well to EP's discovery on Green Canyon Block 254 is scheduled to be drilled. The exploratory well, which was drilled in 1991, encountered 11 sands with a combined thickness of more than 360 feet of oil pay. EP has a 25% working interest in this block and a similar working interest in three adjacent blocks believed to be part of the same project. Onshore. EP participated in 78 development wells (62 net) in 1993, with the majority completed as gas producers in East Texas. Thirty-six wells were in progress at yearend. In East Texas, EP is positioned in a prolific gas- prone area which, despite its maturity, provides growth opportunities. EP is one of the oldest and most active operators in this basin in East Texas, which includes Opelika, Tri-Cities, Whelan, Willow Springs, North Lansing and Freestone fields. In early 1993, EP initiated a 26-well program in East Texas to accelerate the development of natural-gas reserves from the Travis Peak formation in the Opelika field. The program was targeted to test new techniques for shortening the average life of its reserve base. The project was completed in seven months yielding initial daily per well production rates of up to 1.8 MMcf of gas and 48 Bbls of oil. EP has a 100% working interest in these wells. EP performed additional development drilling in the Freestone field, where seven well completions flowed at daily rates ranging from 1.0 MMcf to 2.3 MMcf of gas per well. EP has 50% to 100% working interests in these wells. In the Bralley field in West Texas, the combined daily oil production rate from six wells increased to 800 Bbls from 500 Bbls following production optimization work. EP owns a 50% working interest in each of these wells. In South Texas, seven wells drilled and completed in the Fashing field flowed at daily rates of 1.2 MMcf to 2.6 MMcf of gas and 14 Bbls to 30 Bbls of oil per well. Twelve wells drilled and completed in the Boonsville field in north central Texas resulted in daily production of .4 MMcf to 1.5 MMcf of gas per well. Onshore development activity planned for 1994 includes drilling approximately 35 wells outside East Texas. Some of the larger projects include wells in the Fashing, Rancho Viejo and Boonsville fields. In the Fashing field, results of three wells and a field study indicate development potential for new wells, as well as recompletions that could result in reserve additions. Competition Competition in the natural gas and oil exploration and production business is intense and is present from a large number of firms of varying sizes and financial resources, some of which are much larger than EP. Competition involves all aspects of marketing products (including terms, prices, volumes and length of contracts), terms relating to lease bonus and royalty arrangements, and the schedule of future development activity. Regulation Environmental Protection Agency ("EPA") rules, regulations and orders affect the operations of EP. EPA regulations promulgated under the Superfund Amendments and Reauthorization Act of 1986 require EP to report on locations and estimates of quantities of hazardous chemicals used in EP's operations. The EPA has determined that most gas and oil exploration and production wastes are exempt from the hazardous waste management requirements of the Resource Conservation Recovery Act. However, the EPA determined that certain exploration and production wastes resulting from the maintenance of production equipment and transportation are not exempt, and these wastes must be managed and disposed of as hazardous waste. Also, regulations issued by the EPA under the Clean Water Act require a permit for "contaminated" stormwater discharges from exploration and production facilities. Many states have issued new regulations under authority of the Clean Air Act Amendments of 1990, and such regulations are in the process of being implemented. These regulations may require certain gas and oil related installations to obtain federally enforceable operating permits and may require the monitoring of emissions; however, the impact of these regulations on EP is expected to be minor. Several states have adopted regulations on the handling, transportation, storage, and disposal of naturally occurring radioactive materials that are found in gas and oil operations. Although applicable to certain EP facilities, it is not believed that such regulations will materially impact current or future operations. In the aggregate, compliance with federal and state environmental rules and regulations is not expected to have a material effect on EP's operations. The Railroad Commission of Texas ("RRC") regulates the production of natural gas and oil by EP in Texas. Similar regulations are in effect in all states in which EP explores for and produces natural gas and oil. These regulations generally require permits for the drilling of gas and oil wells and regulate the spacing of the wells, the prevention of waste, the rate of production, and the prevention and cleanup of pollution and other materials. ITEM 2. ITEM 2. Properties The following table sets forth a summary of certain information relating to EP's gas and oil properties: The 1994 capital spending budget has been set at $114 million, about the same as 1993 actual capital expenditures. More than half of the 1994 capital expenditures is earmarked for domestic onshore drilling. The exploration program includes a balanced mix of projects with regard to reserve potential and risk, focusing on as many core area opportunities as possible. See "Financial Review - Capital Resources and Liquidity" included in Appendix A to this report. During 1993, Enserch Exploration filed Form EIA-23 with the Department of Energy reflecting reserve estimates for the year 1992. Such reserve estimates were not materially different from the 1992 reserve estimates reported in Note 7 of the Notes to Consolidated Financial Statements included in Appendix A to this report. A summary of EP's average sales prices, average production costs and amortization are set forth under "Selected Financial and Operating Data" included in Appendix A to this report. EP owned leasehold interests or licenses in 17 states and offshore Texas and Louisiana, as of December 31, 1993, as follows: The number of wells drilled is not a significant measure or indicator of the relative success or value of a drilling program because the significance of the reserves and economic potential may vary widely for each project. It is also important to recognize that reported completions may not necessarily track capital expenditures, since Securities and Exchange Commission guidelines do not allow a well to be reported as complete until it is ready for production. In the case of offshore wells, this may be several years following initial drilling because of construction of platforms, pipelines and other necessary facilities. Additional information relating to the gas and oil activities of EP is set forth in Note 7 of the Notes to Financial Statements appearing in Appendix A to this report. ITEM 3. ITEM 3. Legal Proceedings The information required hereunder is set forth in Note 5 of the Notes to Financial Statements in Appendix A to this report. 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 information required hereunder is set forth under "Depositary Unit Market Prices and Distribution Information" set forth in Appendix A to this report. ITEM 6. ITEM 6. Selected Financial Data The information required hereunder is set forth under "Selected Financial and Operating Data" set forth in Appendix A to this report. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information required hereunder is set forth under "Financial Review" included in Appendix A to this report. ITEM 8. ITEM 8. Financial Statements and Supplementary Data The information required hereunder is set forth under "Independent Auditors' Report," "Management Report on Responsibility for Financial Reporting," "Statements of Operations," "Statements of Cash Flows," "Balance Sheets," "Statements of Changes in Partners' Capital" and "Notes to Financial Statements" included in Appendix A 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 Set forth below is information concerning the directors and executive officers of EEI and directors of ENSERCH who are involved with the conduct of operations of EP. Presently, all directors of EEI and ENSERCH are elected annually. Directors of ENSERCH D. W. Beigler, age 47, is Chairman and President, Chief Executive Officer of ENSERCH. Prior to his election to his present position in 1993, he served Lone Star Gas Company, the utility division of the Corporation, as President from 1985 and as Chairman from 1989 and was elected President and Chief Operating Officer of the Corporation in 1991. Mr. Biegler is a Director of ENSERCH, Texas Commerce Bancshares, Inc. and Trinity Industries, Inc. He has been a Director of ENSERCH since 1991. W. C. McCord, age 65, is retired Chairman and Chief Executive Officer of ENSERCH. Mr. McCord is a Director of Lone Star Technologies, Inc., and Pool Energy Services Co. He has been a Director of ENSERCH since 1970. Preston M. Geren, Jr., age 70, is an investor active in real estate, oil and gas, and banking. He was formerly the owner of Geren Associates, Architects, Engineers & Planners. Mr. Geren has been a Director of ENSERCH since 1973 and serves as Chairman of the Audit Committee and is a member of the Policy and Conflicts of Interest Committee. He is a Director of Overton Bancshares, Inc., Overton Bank & Trust Co., Pool Energy Services Co., and Cassco Development Corporation. W. Ray Wallace, age 71, is Chairman, President and Chief Executive Officer, and Director, Trinity Industries, Inc., a fabricated steel products company. Mr. Wallace has been a Director of ENSERCH since 1978 and serves as Chairman of the Compensation Committee and is a member of the Audit Committee. He is a Director of Lomas Financial Corporation. William B. Boyd, age 70, is retired Chairman of the Board, President and Chief Executive Officer, American Standard Inc., a manufacturer of air conditioning, building, and transportation products. Mr. Boyd has been a Director of ENSERCH since 1984 and serves as Chairman of the Nominating Committee and is a member of the Compensation Committee. Mr. Boyd is a Director of Armco Inc. and FMC Corporation. B. A. Bridgewater, Jr., age 60, is Chairman, President and Chief Executive Officer, and Director, Brown Group, Inc., a consumer products company with operations in footwear and specialty retailing. Mr. Bridgewater has been a Director of ENSERCH since 1987 and serves as Chairman of the Policy and Conflicts of Interest Committee and is a member of the Audit Committee. He is a Director of Boatmen's Bancshares, Inc., FMC Corporation, and McDonnell Douglas Corporation. J. M. Haggar, Jr., age 69, is retired Chairman of the Board, and Director, Haggar Apparel Company, a manufacturer of apparel for men. Mr. Haggar has been a Director of ENSERCH since 1988 and is a member of the Directors' Nominating Committee and the Policy and Conflicts of Interest Committee. He is a Director of Brinker International, Inc. Dr. L. E. Fouraker, age 70, is retired from the position of Dean of the Harvard Business School. Dr. Fouraker has been a Director of ENSERCH since 1990 and is member of the Compensation Committee and the Directors' Nominating Committee. He is a Director of Alcan Aluminum Limited, Citicorp, General Electric Company, Gillette Company, Ionics, Inc., and The New England. M. J. Girouard, age 54, is President and Chief Operating Officer, and Director, Pier 1 Imports, Inc. Mr. Girouard has been a Director of ENSERCH since 1992 and is a member of the Compensation Committee and the Directors' Nominating Committee. Dr. Diana S. Natalicio, age 54, is President, University of Texas at El Paso. Dr. Natalicio has been in her present position since 1988. She is a Director of Lomas Financial Corporation and Sandia Corporation. The Policy and Conflicts of Interest Committee of ENSERCH reviews areas of potential conflict between EP and ENSERCH, its subsidiaries and affiliates ("ENSERCH" companies) and takes such action as it deems appropriate in order to provide reasonable assurances of fair dealings between such entities. The Committee meets at least annually, and more frequently if necessary. ITEM 11. ITEM 11. Executive Compensation The total amount of compensation paid by EEI to all its executive officers for the year ended December 31, 1993, which was charged to EP, was $500,129 (2 persons). The amounts paid include base salary, bonus and other miscellaneous earnings categories. The directors of EEI are not compensated in their capacities as directors. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management As of March 9, 1994: Name and Address of Beneficial Owner Amount and Nature Percent of Depositary Units of Beneficial Ownership of Class - -------------------- ----------------------- ---------- ENSERCH Corporation 101,694,162 Indirect 99.2(1) 300 South St. Paul Street Dallas, Texas 75201 - ------------ (1) Includes 98,581,800 units representing limited partnership interests held by an affiliate, Enserch Processing Partners, Ltd., which may be exchanged at any time for Depositary Units of EP. No Directors or Officers of ENSERCH or EEI own any units. ITEM 13. ITEM 13. Certain Relationships and Related Transactions EP commenced operations in 1985 following the transfer to it of substantially all of the domestic gas and oil exploration and production business of ENSERCH. For a description of the transactions and properties involved in the transfer, see "Business", "Properties" and Notes to Financial Statements in Appendix A to this report. For information concerning related party transactions between EP and ENSERCH (including its affiliates), see "Directors and Executive Officers of Registrant-Directors of ENSERCH" and the Notes to Financial Statements in Appendix A to this report. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a)-1 Financial Statements The following items appear in the Financial Information section included as Appendix A to this report: Item Page ----- ---- Selected Financial and Operating Data. . . . . . . . . . . . . . . A-2 Financial Review . . . . . . . . . . . . . . . . . . . . . . . . . A-3 Independent Auditors' Report . . . . . . . . . . . . . . . . . . . A-7 Management Report on Responsibility for Financial Reporting. . . . A-8 Financial Statements: Statements of Operations . . . . . . . . . . . . . . . . . . . A-10 Statements of Cash Flows . . . . . . . . . . . . . . . . . . . A-11 Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . A-12 Statements of Changes in Partners' Capital . . . . . . . . . . A-13 Notes to Financial Statements. . . . . . . . . . . . . . . . . . . A-14 Depositary Unit Market Prices and Distribution Information . . . . A-25 (a)-2 Financial Statement Schedules The following items are included in Appendix B to this report: Item Page ---- ---- Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . B-2 Financial Statement Schedules for the Three Years Ended December 31, 1993: IV -Indebtedness to Related Parties . . . . . . . . . . B-3 V -Property, Plant and Equipment . . . . . . . . . . . B-4 VI -Accumulated Depreciation and Amortization of Property, Plant and Equipment . . . . . . . . . . . B-5 X -Supplementary Statements of Operations Information . . . . . . . . . . . . . . . . . . . . B-6 The financial statement schedules, other than those listed above, are omitted because of the absence of the conditions under which they are required or because the required information is included in the financial statements or notes thereto. (a)-3 Exhibits 4.1* - Agreement of Limited Partnership of EP and amendment No. 1 thereto as currently in effect, filed as Exhibit 4.1 to Registrant's Form 10-K for the fiscal year ended December 31, 1992. 4.2* - Form of Certificate for Limited Partner's Units of EP filed as Exhibit 3.2 and included as Annex I to Exhibit B to the Prospectus included in Registration Statement No. 2-96373. 4.3* - Agreement of Limited Partnership of EPO and amendments No. 1 and No. 2 thereto currently in effect, filed as Exhibit 4.3 to Registrant's Form 10-K for the fiscal year ended December 31, 1992. 4.4* - Depositary Agreement among EP, Harris Trust Company of New York as the Depositary and the Unitholders, relating to EP Depositary Units, filed as Exhibit 4.1 to Registration Statement No. 2- 96373. 4.5* - Form of Specimen Depositary Receipt filed as Exhibit 4.2 to Registration Statement No. 2-96373. 10.1*- Assignment and Conveyance from EP Operating Limited Partnership "Grantor" to Encogen One Partners, Ltd. "Grantee" dated February 29, 1988, filed as Exhibit 10.1 to Registrant's Form 10-K for the fiscal year ended December 31, 1987. 23** - Consent of DeGolyer and MacNaughton. 24** - Powers of Attorney - ------------ * Incorporated and herein by reference made a part hereof. ** Filed herewith (b) No reports on Form 8-K were filed during the three months 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: ENSERCH EXPLORATION PARTNERS, LTD. (A Texas Limited Partnership): By: ENSERCH EXPLORATION, INC. Managing General Partner March , 1994 By /s/ D. W. Biegler ---------------------- D. W. Biegler, Chairman 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 date indicated. Signature and Title Date ------------------ ------ D. W. Biegler, Chairman, Chief Executive Officer and Director; Gary J. Junco, President, Chief Operating Officer and Director; R. L. Kincheloe, Senior Vice President, Offshore and International, March , 1994 and Director; W. T. Satterwhite, Director; S. R. Singer, Director; and J. W. Pinkerton, Vice President and Controller By: /s/ D. W. Biegler D. W. Biegler As Attorney-in-Fact APPENDIX A ENSERCH EXPLORATION PARTNERS, LTD. INDEX TO FINANCIAL INFORMATION December 31, 1993 Page Selected Financial and Operating Data. . . . . . . . . . . . . . . . . . A-2 Financial Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-3 Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . . A-7 Management Report on Responsibility for Financial Reporting. . . . . . . A-8 Financial Statements: Statements of Operations. . . . . . . . . . . . . . . . . . . . A-10 Statements of Cash Flows. . . . . . . . . . . . . . . . . . . . A-11 Balance Sheets. . . . . . . . . . . . . . . . . . . . . . . . . A-12 Statements of Changes in Partners' Capital. . . . . . . . . . . A-13 Notes to Financial Statements. . . . . . . . . . . . . . . . . . . . . . A-14 Depositary Unit Market Prices and Distribution Information . . . . . . . A-25 A-1 A-2 ENSERCH EXPLORATION PARTNERS, LTD. FINANCIAL REVIEW RESULTS OF OPERATIONS EP had a net loss of $4 million in 1993, compared with a loss of $20 million in 1992 and a loss of $50 million in 1991. The 1992 loss included a $16 million write-off of an idle pipeline and shallow-water production facility from an abandoned offshore project, and 1991 results included a $51 million noncash charge for a write-down under the "ceiling test" for the "full cost" method of accounting. Excluding the write-downs, EP's 1993 net loss was about the same as in 1992 and compares with income of $1.8 million in 1991. Excluding the write-downs, operating income for 1993 was $26 million versus $16 million in 1992 and $21 million in 1991. The improvement resulted from significantly increased natural-gas prices and higher sales volumes. Revenues for 1993 of $185 million were 12% higher than 1992 and 6% above 1991. Natural-gas revenues were $145 million, compared with $117 million for 1992 and $122 million for 1991. The average natural-gas price per thousand cubic feet (Mcf) in 1993 was $2.09, up 15% from $1.82 in 1992 and 19% from $1.76 in 1991. Natural-gas sales volumes in 1993 of 69 billion cubic feet increased 7% from the 1992 level and were virtually the same as in 1991. The increase in volumes for 1993 was principally due to accelerated natural-gas development drilling in East Texas and offshore production from Mississippi Canyon Block 441 in the Gulf of Mexico, which went on stream in the second quarter of 1993. Spot-market sales, which include monthly and short-term industrial sales, covered about 70% of 1993 gas sales, compared with 80% in 1992 and 75% in 1991. During 1994, the percentage of gas sold in the spot market is expected to be in the range of 75% to 85%. Oil revenues were $34 million in 1993, compared with $41 million in 1992 and $49 million in 1991. The average sales price per barrel for 1993 of $17.20 was 10% below 1992 and 16% under 1991. Oil sales volumes for 1993 were 2.0 million barrels (MMBbls), an 8% decline from the 1992 level which was down 11% from the 1991 level. The lower volumes in 1993 were primarily the result of declining production from several North Texas reservoirs. Excluding the previously noted write-downs, costs and expenses for 1993 were $159 million, compared with $150 million in 1992 and $153 million in 1991. The increase in expenses for 1993 reflects provisions totaling $7.1 million for pending litigation. Also, depreciation and amortization expense for 1993 of $77 million was $1.6 million higher than 1992, primarily due to increased production. The overall rate of amortization was $.91 per million British thermal units (MMBtu) produced for both 1993 and 1992, compared with $.83 in 1991. Costs of additional offshore projects and increased development costs associated with older East Texas fields largely account for the increase from 1991. Average production cost per MMBtu in 1993 was $.54, compared with $.53 in 1992 and $.56 in 1991. A-3 Interest expense in 1993 of $30 million was approximately $10 million higher than both 1992 and 1991. The increase reflects a $6 million provision for interest due royalty owners. A higher level of debt and less interest capitalized also contributed to the 1993 increase. EP's natural-gas reserves at January 1, 1994, were 1.09 trillion cubic feet (Tcf), compared with 1.10 Tcf the year earlier, as estimated by DeGolyer and MacNaughton, independent petroleum consultants. Oil and condensate reserves, including natural gas liquids attributable to leasehold interest, were 38 MMBbls, virtually the same as the year-ago level. At January 1, 1994, estimated future net cash flows from EP's owned proved gas and oil reserves, based on average prices and contracts in effect in December 1993, were $2.0 billion, about the same as the year earlier. The net present value of such cash flows, discounted at the Securities and Exchange Commission (SEC)-prescribed 10%, was $1.1 billion, virtually the same as the prior year. These discounted cash flow amounts are the basis for the SEC-prescribed cost- center ceiling under the full-cost accounting method. The margin between the cost-center ceiling and the unamortized capitalized costs of U.S. gas and oil properties was approximately $150 million at December 31, 1993. Product prices are subject to seasonal and other fluctuations. A significant decline in prices from yearend 1993 or other factors, without mitigating circumstances, could cause a future write-down of capitalized costs and a noncash charge against earnings. CAPITAL RESOURCES AND LIQUIDITY Net cash flows from operating activities in 1993 were $76 million, $12 million lower than 1992 primarily due to less cash provided by changes in net current operating assets and liabilities, and were virtually the same as in 1991. Investing activities required net cash flows of $124 million, compared with $69 million in 1992 and $105 million in 1991. The increase in 1993 is primarily due to a higher level of capital spending for natural-gas and oil exploration and development programs. In 1993, $48 million was required for investing activities after cash provided by operations, and cash of $31 million was required for the payment of distributions to unitholders. The total requirement of $79 million was provided by an increase in borrowings from affiliated companies and advances under leasing arrangements that temporarily exceeded disbursements for the facilities under construction. EP has budgeted $114 million for additions to property, plant and equipment in 1994, compared with expenditures of $113 million in 1993. In 1992, EP's capital spending was sharply curtailed to $63 million in response to poor prices for both natural gas and oil. If the early 1994 weakness in oil prices persists throughout 1994, appropriate cutbacks in spending may be undertaken. More than half of EP's 1994 capital expenditures is earmarked for domestic onshore drilling. In 1992, EP entered into operating lease arrangements to provide financing for its portion of the offshore platforms and related facilities for the Mississippi Canyon Block 441 (37.5% owned) and Garden Banks Block 388 (100% owned) projects. A total of $34 million was required for the Mississippi Canyon Block 441 project, which was completed in early 1993. The lease arrangement to A-4 fund the construction costs for the Garden Banks facility is estimated to total $235 million when completed in 1995. (See Note 5) On January 3, 1994, EP paid a quarterly distribution of $.075 per unit. In February 1994, EP announced that the quarterly distributions to unitholders had been indefinitely suspended. Even though inflation has abated considerably from the levels of the early 1980s, and was only about 2.5% in 1993, it continues to have some influence on EP's operations. Most notable is that allowances for depreciation and amortization based on the historical cost of fixed assets may be insufficient to cover the replacement of some long-lived fixed assets. The impact of the Clean Air Act Amendments of 1990 (Act) on EP cannot be fully ascertained until the regulations that implement that Act have been approved and adopted. Management currently believes that operating costs that will be incurred under the new permit fee structure, any capital expenditures associated with equipment modifications, and any other miscellaneous permitting costs required under the Act will not have a material adverse effect on EP's results of operations. Management expects the provisions of the Act will increase the attractiveness of natural gas as compared with certain alternative fuels; however, it is impossible to quantify any increase in demand for natural gas, if any, that may be created by the Act. FOURTH-QUARTER RESULTS EP had a net loss of $6.5 million for the fourth quarter of 1993, compared with a loss of $16 million for the 1992 fourth quarter, which included the $16 million write-off of the abandoned offshore facilities. Excluding the write- off, operating income for the fourth quarter was $4.8 million versus $6.2 million for the same period of 1992. Revenues in 1993 of $50 million were 14% greater than 1992 primarily due higher natural-gas revenues resulting from a 24% increase in sales volumes. The average natural-gas sales price for the fourth quarter of $2.22 per Mcf was about the same as the prior year. Operating expenses and interest expense were both higher than in the prior year due to the previously noted provisions for pending litigation and interest due royalty owners. DRILLING PROGRAM Drilling activity during the first half of 1993 increased to levels last experienced in 1987, primarily because of development work in East Texas. EP participated in 109 wells (79 net) in 1993, with the majority completed as gas producers in East Texas. Thirty-six wells were in progress at yearend. Recompletions and production optimization measures had a major role in the 1993 production enhancement program. Results for 1994 will include a full year of production from the Mississippi Canyon Block 441 deep-water project in the Gulf of Mexico, which began production in early 1993. The field is producing some 70 million cubic feet (MMcf) of natural gas and more than 500 barrels of condensate per day from six wells. EP is the operator, with a 37.5% working interest in the project. A-5 The Garden Banks Block 388 oil development project, also in the Gulf, remains on schedule and on budget, with initial production anticipated by mid- 1995. The final major contract for the conversion of a semi-submersible drilling rig to a floating production facility was finalized in early 1994. Installation of the offshore facilities, consisting of the subsea template, gathering and sales pipelines and shallow-water operations, will begin by mid-year. Three previously drilled oil wells will be connected to the subsea template in 1995. Initial daily production from three predrilled wells is expected to total 15 thousand barrels (MBbls) of oil and 12 to 15 MMcf of gas by late 1995, with peak daily production from the Garden Banks project anticipated in late 1996 at 40 MBbls of oil and 60 MMcf of gas. Gross proven reserves are presently estimated to be equivalent to 28 MMBbls of oil by DeGolyer and MacNaughton. EP is 100% interest owner and operator of the Garden Banks project. NEW ACCOUNTING STANDARDS SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other than Pensions," which mandates the accounting for medical and life insurance and other nonpension benefits provided to retired employees, was adopted by EP effective January 1, 1993. (See Note 2) SFAS No. 112, "Employer's Accounting for Postemployment Benefits," will become effective for EP in 1994. This standard covers the accounting for estimated costs of benefits provided to former or inactive employees before their retirement. EP receives an allocation of these benefits from ENSERCH which currently accrues costs of benefits to former or inactive employees by varying methods. The new standard is not expected to have a significant effect on results of operations or financial condition. A-6 INDEPENDENT AUDITORS' REPORT To the Partners of Enserch Exploration Partners, Ltd.: We have audited the accompanying balance sheets of Enserch Exploration Partners, Ltd. as of December 31, 1993 and 1992, and the related statements of operations, cash flows and changes in partners' capital for each of the three years in the period ended December 31, 1993. 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, such financial statements present fairly, in all material respects, the financial position of the 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. DELOITTE & TOUCHE Dallas, Texas February 7, 1994 A-7 MANAGEMENT REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of Enserch Exploration, Inc. (a wholly owned subsidiary of ENSERCH), as Managing General Partner of Enserch Exploration Partners, Ltd., is responsible for the preparation, presentation and integrity of the financial statements. These statements have been prepared in conformity with accounting principles generally accepted in the United States and include amounts that represent management's best estimates and judgments. Management has established practices and procedures designed to support the reliability of the estimates and minimize the possibility of a material misstatement. Management also is responsible for the accuracy of the other information presented in the annual report on Form 10-K and for its consistency with the financial statements. Management has established and maintains internal accounting controls that provide reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition, and the prevention and detection of fraudulent financial reporting. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees with significant roles in the financial reporting process and updated as necessary. Management continually monitors compliance with the system of internal accounting controls. ENSERCH maintains a strong internal audit function that evaluates the adequacy of the system of internal accounting controls. As part of the annual audit of the financial statements, Deloitte & Touche also performs a study and evaluation of the system of internal accounting controls as necessary to determine the nature, timing and extent of their auditing procedures. The Board of Directors of ENSERCH maintains an Audit Committee composed of Directors who are not employees. The Audit Committee meets periodically with management, the independent auditors and the internal auditors to discuss significant accounting, auditing, internal accounting control and financial reporting matters. A procedure exists whereby either the independent auditors or the internal auditors through the independent auditors may request, directly to the Audit Committee, a meeting with the Committee. Management has given proper consideration to the independent and internal auditors' recommendations concerning the system of internal accounting controls and has taken corrective action believed appropriate in the circumstances. Management further believes that, as of December 31, 1993, the overall system of internal accounting controls is sufficient to accomplish the objectives discussed herein. A-8 Management recognizes its responsibility for establishing and maintaining a strong ethical climate so that the Partnership's affairs are conducted according to the highest standards as defined in ENSERCH's Statement of Policies. The Statement of Policies is publicized throughout ENSERCH and addresses, among other issues, open communication within ENSERCH; the disclosure of potential conflicts of interest; compliance with the laws, including those relating to financial disclosures; and the confidentiality of proprietary information. Enserch Exploration, Inc. Managing General Partner of Enserch Exploration Partners, Ltd. /s/ Gary J. Junco - ------------------ Gary J. Junco President, Chief Operating Officer /s/J. W. Pinkerton - ------------------ J. W. Pinkerton Vice President and Controller A-9 A-10 A-11 A-12 A-13 ENSERCH EXPLORATION PARTNERS, LTD. NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION AND CONTROL Enserch Exploration Partners, Ltd. ("EP"), a Texas limited partnership, was formed in 1985 to succeed to substantially all of the domestic gas and oil exploration and production business of ENSERCH Corporation ("ENSERCH"). At December 31, 1993, ENSERCH and Enserch Processing Partners, Ltd. ("Processing") owned 3,112,362 (3.0%) and 98,581,800 (96.2%), respectively, of EP's limited partnership units outstanding. The balance of 805,914 (.8%) of EP's units outstanding is held by the public. For administrative convenience, EP operates through EP Operating Limited Partnership ("EPO"), formerly EP Operating Company, a Texas limited partnership, in which EP holds a 99% limited partner's interest and the general partners own a 1% interest. Enserch Exploration, Inc. ("EEI") is the managing general partner and ENSERCH is the special general partner of EP and EPO. EP has no officers, directors or employees. Instead, officers, directors and employees of EEI perform all management and operating functions for EP. Neither ENSERCH nor EEI, as general partners of EP, receives any carried interests, promotions, back-ins or other compensation. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation - The financial statements of EP have been prepared in conformity with generally accepted accounting principles but will not be the basis for reporting taxable income to unitholders. The proportional consolidation method is used whereby the financial statements reflect EP's 99% interest in EPO's assets, liabilities and operations. All dollar amounts except per unit amounts in the notes to financial statements are stated in thousands unless otherwise indicated. Natural Gas and Oil Hedging Contracts - Gains and losses from transactions to hedge against volatile product prices are included in revenues in the statements of operations. Gas and Oil Properties - The full-cost method, as prescribed by the Securities and Exchange Commission (SEC), is used whereby the costs of proved and unproved gas and oil properties, together with successful and unsuccessful exploration and development costs, are capitalized. The carrying value is limited to the present value of estimated future net revenues of proved reserves, the cost of excluded properties and the lower of cost or market value of unproved properties being amortized ("full-cost ceiling"). The full-cost ceiling is calculated quarterly under current SEC rules. In March 1991, EP recorded a $51 million noncash write-down of the carrying value of its gas and oil properties due to the full-cost center ceiling limitation test. Dry-hole costs resulting from exploration activities are classified as evaluated costs and are included in the amortization base. Costs directly associated with the acquisition and evaluation of unproved properties are excluded from the amortization base until the related properties are evaluated. Such unproved properties are assessed periodically and a provision for impairment is made to the full-cost amortization base when appropriate. Sales of gas and oil properties are credited to capitalized costs unless the sale would have a significant impact on the amortization rate. A-14 In December 1992, EP recorded a $16 million noncash write-off of an idle pipeline and shallow-water production facility from an abandoned offshore project. Depreciation and Amortization - Amortization of evaluated gas and oil properties is computed on the unit-of-production method using estimated proved gas and oil reserves quantified on the basis of their equivalent energy content. Depreciation of other property, plant and equipment is provided principally by the straight-line method over the estimated service lives of the related assets. Income Taxes - EP is a partnership and, as a result, the income or loss of the partnership, which reflects differences in the timing of the deduction of certain gas and oil drilling and development costs for federal income tax purposes, is includable in the tax returns of the individual partners. Accordingly, no recognition has been given to income taxes in the financial statements of EP. The assets and liabilities reported in the financial statements of EP exceeded the federal income-tax bases by approximately $704 million and $720 million at December 31, 1993 and 1992, respectively. Retirement Plan - Substantially all personnel who are associated with EP are covered by an ENSERCH retirement plan and are eligible for certain health care and life insurance benefits upon retirement. Total pension costs allocated to EP were $867, $1,054, and $929 in 1993, 1992 and 1991, respectively. Post-retirement health care and life insurance benefit costs allocated to EP were $821, $550, and $577 in 1993, 1992 and 1991, respectively. Postretirement benefits in 1993 reflect the impact of SFAS No. 106 "Employer's Accounting for Postretirement Benefits Other Than Pensions", effective in January 1993. This new standard requires the accrual of these benefits over the working life of the employee rather than charging to expense on a cash basis. Fair Value of Financial Instruments - The fair value of financial instruments has been estimated using valuation methodologies in accordance with SFAS No. 107, "Disclosures About Fair Value of Financial Instruments". Determinations of fair value are based on subjective data and significant judgment relating to timing of payments and collections and the amounts to be realized. Accordingly, the estimates presented are not necessarily indicative of the amounts that EP could realize in a current market exchange. Management believes that the fair value of financial instruments, other than long-term debt, is not materially different than the related carrying value. The estimated fair value for long-term debt is presented in Note 3. A-15 3. LINE OF CREDIT AND BORROWINGS Short-term Borrowing Arrangements - Both EP and EPO maintain separate short-term borrowing arrangements with ENSERCH to meet operating needs. Under these arrangements, ENSERCH may advance funds to EP or EPO, and EP or EPO may advance funds to ENSERCH. EPO further maintains a short-term borrowing arrangement with EEI by which EEI may advance funds to EPO and EPO may advance funds to EEI. Under all these arrangements, the aggregate amount of short-term loans available between the parties is at the respective lender's sole discretion, and any amounts advanced under the arrangements mature within 12 months from the date the advance is made. The interest rate is the 30-day commercial paper rate available for similar amounts on commercial paper borrowings by ENSERCH. Interest is payable monthly. These arrangements are renewed annually. At December 31, 1993, there were $27,216 of net short-term borrowings outstanding under these arrangements at an interest rate of 3.28%. Long-term Notes Payable - Long-term notes payable to Processing are summarized below: Interest on the above notes is payable semiannually on June 30 and December 31. The estimated fair value of these notes was $352 million at December 31, 1993 and $300 million at December 31, 1992. The calculation was made using a discounted cash flow approach based on the interest rates currently available to ENSERCH for debt with similar terms and remaining maturities. 4. RELATED PARTY TRANSACTIONS In the ordinary course of business, EP engages in various transactions with ENSERCH and its affiliates. All such transactions are subject to review by the Policy and Conflicts of Interest Committee of ENSERCH, a committee composed solely of outside directors. The Committee has found no unfair dealings between and among such parties. EP is charged for direct costs incurred by ENSERCH and EEI that are associated with managing EP's business and operations. Additionally, indirect costs (principally general and A-16 administrative costs) applicable to EP are allocated to EP by ENSERCH. Such charges amounted to $2,026, $1,927 and $1,798 in 1993, 1992 and 1991, respectively. EP had sales to affiliated companies (Enserch Gas Company, Lone Star Gas Company and Processing) of $108,916, $32,508 and $32,710 in 1993, 1992 and 1991, respectively. In 1993, affiliated revenues include gas sales of $91,000 under new contracts effective March 1, 1993 with Enserch Gas Company covering essentially all gas production not committed under existing contracts. Net interest costs incurred on affiliated borrowings were $27,120, $25,336, and $22,872 in 1993, 1992 and 1991, respectively. 5. COMMITMENTS AND CONTINGENT LIABILITIES Advances Under Leasing Arrangements - In May 1992, EP entered into an operating leasing arrangement to provide financing for its portion of the offshore platform and related facilities for the 37 1/2% owned Mississippi Canyon Block 441 project. A total of $34 million was required for the project, which was completed in early 1993. EP leased the facilities for an initial period through May 20, 1994, with an option to renew the lease, with the consent of the lessor, for up to 10 successive six-month periods. The lease has been renewed through November 20, 1994 and EP expects to renew the lease for all renewal periods. EP has the option to purchase the facilities throughout the lease periods and as of December 31, 1993, has guaranteed an estimated residual value for the facilities of approximately $27 million should the lease not be renewed. Expenses incurred under the lease in 1993 was $2.1 million. The estimated future minimum net rentals for the Mississippi Canyon operating lease is $6.3 million for 1994. In September 1992, EP entered into an operating lease arrangement to provide financing for the offshore platform and related facilities of its 100% owned Garden Banks Block 388 project. The lessor will fund the construction cost of the facilities quarterly, up to a maximum of $235 million. As of December 31, 1993, a total of $60 million had been advanced to EP under the lease as agent for the lessor, $31 million of which was unexpended and reflected as a current liability. EP will lease the facilities for an initial period through March 31, 1997, with the option to renew the lease, with the consent of the lessor, for up to three successive two-year periods. EP, as agent for the lessors, will acquire, construct and operate the units of leased property and has guaranteed completion of construction of the facilities. EP has the option to purchase the facilities throughout the lease periods and has guaranteed an estimated residual value for the facilities of approximately $188 million, assuming the full lease amounts are advanced and expended, should the lease not be renewed. The estimated future minimum net rentals for the Garden Banks operating lease are as follows: $4.8 million for 1994; $9.1 million for 1995; $9.1 million for 1996; and $2.3 million for 1997. Lease payments are being deferred during the construction period and will be amortized when production begins. A-17 At December 31, 1993, EEI had several noncancelable operating leases, principally for buildings and office space, that expire at various dates through 1998. EP bears an allocated share of rental expenses incurred by EEI under noncancelable operating leases. EP's allocated share of rental expenses (99% of EEI's rental expenses) totaled $4,985, $3,547 and $2,938 in 1993, 1992 and 1991, respectively. Future minimum rentals under such leases, of which EP would bear its proportionate share, are as follows: $1.3 million for 1994; $1.3 million for 1995; $1.4 million for 1996; $1.5 million for 1997; and $1.4 million for 1998. Legal Proceedings - A lawsuit was filed against EEI, ENSERCH, its utility division and EPO in the 348th Judicial District Court of Tarrant County in May 1989. Plaintiffs seek unspecified actual damages and punitive damages in the amount of $5 million. Plaintiffs allege royalties were not fully paid, certain expenses were improperly charged against the amount of royalties due, negligence in the venting of gas and liquid hydrocarbons into the air, and breach of duty of good faith and fair dealing by wrongfully concealing certain material facts concerning sales of gas from the subject leases to the utility division. A lawsuit was filed on February 24, 1987, in the 112th Judicial District of Sutton County, Texas, against subsidiaries and affiliates of ENSERCH, as well as its utility division. The plaintiffs have claimed that defendants failed to make certain production and minimum purchase payments under a gas- purchase contract. In this connection, the plaintiffs have alleged a conspiracy to violate purchase obligations, improper accounting of amounts due, fraud, misrepresentation, duress, failure to properly market gas and failure to act in good faith. In this case, plaintiffs seek actual damages in excess of $5 million and punitive damages in an amount equal to 0.5% of the consolidated gross revenues of ENSERCH for the years 1982 through 1986 (approximately $85 million), interest, costs and attorneys' fees. On December 26, 1989, a lawsuit was filed against EEI and EPO in the 130th Judicial District Court of Matagorda County, Texas. The plaintiff claims that the defendants breached an alledged contract to sell a working interest and net revenue interest in two leases located in Matagorda County. Trial of the case resulted in a jury verdict in favor of the plaintiff. Judgment was entered by the trial court on October 8, 1992, ordering EEI and EPO to convey the leases to the plaintiff and to pay damages of $3.1 million, which includes principal, prejudgment interest, attorneys' fees and costs. This judgment was appealed to the Corpus Christi Court of Appeals on September 2, 1992. Counsel has advised that there is a reasonable basis to believe that the decision of the trial court will be reversed. On October 25, 1991, a lawsuit was filed against EEI, EPO and ENSERCH in the 111th District Court of Webb County Texas. Other parties have intervened. The plaintiffs and intervenors claim that the defendants' failure to reassign A-18 part of an gas and oil lease covering approximately 33,000 net mineral acres in breach of defendants' contractual reassignment obligations entitles them to recover the fair market value of the lost leasehold estate and lost overriding royalty interests. Plaintiffs and intervenors claim actual damages of approximately $3.1 million for the lost leasehold estate, and approximately $2.2 million for the lost overriding royalty interests. They also seek pre- judgment interest, attorney's fees and costs. Management believes that the named defendants have meritorious defenses to the claims made in these and other actions. In the opinion of management, EP will incur no liability from these and all other pending claims and suits that would be considered material for financial reporting purposes. 6. SUPPLEMENTAL FINANCIAL INFORMATION Quarterly Results (Unaudited) - The results of operations by quarters are summarized below. In the opinion of EP's management, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation have been made. Decrease (Increase) in Current Operating Assets and Liabilities by Components - is summarized below: A-19 Interest Costs - are summarized below: 7. SUPPLEMENTAL GAS AND OIL INFORMATION Gas and Oil Producing Activities - The following tables set forth information relating to gas and oil producing activities. Reserve data for natural gas liquids attributable to leasehold interests owned by EP are included in oil and condensate. A-20 Excluded Costs - The following table sets forth the composition of capitalized costs excluded from the amortizable base as of December 31, 1993: At December 31, 1993, approximately 43% of excluded costs relates to offshore activities in the Gulf of Mexico and the remainder relates to domestic onshore exploration activities. The anticipated timing of the inclusion of these costs in the amortization computation will be determined by the rate at which exploratory and development activities continue, which is expected to be accomplished within ten years. Gas and Oil Reserves (Unaudited) - The following table of estimated proved and proved developed reserves of gas and oil has been prepared utilizing estimates of yearend reserve quantities provided by DeGolyer and MacNaughton, independent petroleum consultants. Reserve estimates are inherently imprecise and estimates of new discoveries are more imprecise than those of producing gas and oil properties. Accordingly, the reserve estimates are expected to change as additional performance data becomes available. Oil reserves (which include condensate and natural gas liquids attributable to leasehold interests) are stated in thousands of barrels (MBbl). Gas reserves are stated in million cubic feet (MMcf). All reserves are located in the United States. A-21 Included in oil reserve estimates are natural gas liquids for leaseold interest of 931 MBbl for 1993; 789 MBbl for 1992; and 743 MBbl for 1991. A-22 Results of Operations for Producing Activities (excluding corporate overhead and interest costs) - are as follows: Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Gas and Oil Reserve Quantities (Unaudited) - has been prepared by EP using estimated future production rates and associated production and development costs. Continuation of economic conditions existing at the balance sheet date was assumed. Accordingly, estimated future net cash flows were computed by: applying prices in contracts in effect in December to estimated future production of proved gas and oil reserves; estimating future expend- itures to develop proved reserves; and estimating costs to produce the proved reserves based on average costs for the year. Average prices used in the computations were: Because of the imprecise nature of reserve estimates and the unpredictable nature of other variables used, the standardized measure should be interpreted as indicative of the order of magnitude only and not as precise amounts. A-23 The following table sets forth an analysis of changes in the standardized measure of discounted future net cash flows from proved gas and oil reserves: A-24 ENSERCH EXPLORATION PARTNERS, LTD. DEPOSITARY UNIT MARKET PRICES AND DISTRIBUTION INFORMATION Market Prices EP's Depositary Units evidenced by Depositary Receipts are traded on the New York Stock Exchange. The following table shows the high and low sales prices per unit reported in the New York Stock Exchange - Composite Transactions report for the periods shown, as quoted in The Wall Street Journal. Depositary Unit Data Distributions Per Unit In February 1994, the Board of Directors of EEI, managing general partner of EP, announced that the quarterly cash distributions to unitholders had been indefinitely suspended. Reinstatement of a cash distribution will depend on a number of considerations, including future cash flows and capital spending requirements. The following table shows the distributions per limited partnership unit paid by EP during 1993, 1992 and 1991. A-25 APPENDIX B ENSERCH EXPLORATION PARTNERS, LTD. INDEX TO FINANCIAL STATEMENT SCHEDULES December 31, 1993 Page Independent Auditors' Report . . . . . . . . . . B-2 Financial Statement Schedules for Each of the Three Years in the Period Ended December 31, 1993: IV - Indebtedness to Related Parties. . . . B-3 V - Property, Plant and Equipment. . . . . B-4 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment. . . . . . . . . . B-5 X - Supplementary Statements of Operations Information. . . . . . . . . . . . . . B-6 B-1 INDEPENDENT AUDITORS' REPORT To the Partners of Enserch Exploration Partners, Ltd.: We have audited the financial statements of Enserch Exploration Partners, Ltd. 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 7, 1994; such report is included elsewhere in this Form 10-K. Our audits also included the financial statement schedules of Enserch Exploration Partners, Ltd. listed in Item 14. These financial statement schedules are the responsibility of the Partnership'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. DELOITTE & TOUCHE Dallas, Texas February 7, 1994 B-2

201533_1993.txt

201533_1993

1993

201533

ITEM 1. BUSINESS. GENERAL CMS Energy CMS Energy, incorporated in Michigan in 1987, is the parent holding company of Consumers and Enterprises. Consumers, a combination electric and gas utility company serving most of the Lower Peninsula of Michigan, is the largest subsidiary of CMS Energy. Consumers' customer base includes a mix of residential, commercial and diversified industrial customers, the largest of which is the automotive industry. Enterprises is engaged in several non-utility energy-related businesses including: 1) oil and gas exploration and production, 2) development and operation of independent power production facilities, 3) gas marketing services to end- users, and 4) transmission and storage of natural gas. For further information about subsidiary operations, see Item 1. BUSINESS. SUBSIDIARIES. CMS Energy is exempt from registration under PUHCA, see Item 1. BUSINESS. CMS ENERGY AND CONSUMERS REGULATION. CMS Energy's consolidated operating revenue in 1993 was derived approximately 61 percent from sales of electric energy, approximately 37 percent from sale, transportation and storage of natural gas, and approximately 2 percent from oil and gas exploration and production activities. Consumers' consolidated operations in the electric and gas businesses account for the major share of CMS Energy's total assets, revenue and income. CMS Energy's share of unconsolidated non-utility electric generation and gas transmission revenue for 1993 was $337 million. Consumers Consumers was incorporated in Michigan in 1968 and is the successor to a corporation of the same name which was organized in Maine in 1910 and which did business in Michigan from 1915 to 1968. Consumers is a public utility serving almost 6 million of Michigan's 9 million residents in 67 of the 68 counties in Michigan's Lower Peninsula. Industries in Consumers' service area include automotive, metal, chemical, food and wood products and a diversified group of other industries. Consumers' consolidated operating revenue in 1993 was derived approximately 64 percent from its electric business and approximately 36 percent from its gas business. Consumers' retail rates and certain other aspects of its business are subject to the jurisdiction of the MPSC. Consumers has five direct subsidiaries. For further information about subsidiary operations, see Item 1. BUSINESS. SUBSIDIARIES. BUSINESS SEGMENTS CMS Energy conducts its principal operations through the following five business segments: electric utility operations; gas utility operations; oil and gas exploration and production operations; independent power production; and gas transmission and marketing. Consumers or subsidiaries of Consumers are engaged in two segments: electric operations and gas operations. Consumers' electric and gas businesses are regulated utility operations. Consumers Electric Utility Operations Consumers generates, purchases, transmits and distributes electricity and renders electric service in 61 of the 68 counties in the Lower Peninsula of Michigan. Prin- cipal cities served include Battle Creek, Flint, Grand Rapids, Jackson, Kalamazoo, Muskegon, Saginaw and Wyoming. Consumers Gas Utility Operations Consumers purchases, transports, stores, and distributes gas and renders gas service in 40 of the 68 counties in the Lower Peninsula of Michigan. Principal cities served include Bay City, Flint, Jackson, Kalamazoo, Lansing, Pontiac and Saginaw, as well as the suburban Detroit area. Consumers' wholly owned subsidiary, Michigan Gas Storage, is engaged in the transportation and storage of natural gas in interstate commerce. CMS Enterprises CMS Generation Independent Power Production CMS Generation, a wholly owned subsidiary of Enterprises, invests in, develops, converts and/or constructs and operates non-utility power generation plants both domestically and internationally. CMS Generation currently has ownership in- terests in power plants in Michigan, Cali- fornia, Connecticut, New York and Argentina. CMS Enterprises NOMECO Oil and Gas Exploration and Production NOMECO, a wholly owned subsidiary of Enterprises, and subsidiaries of NOMECO are engaged in the exploration for and production of oil and natural gas in Michigan and 12 other states, the Gulf of Mexico, Australia, Colombia, Ecuador, Equatorial Guinea, New Zealand, Papua New Guinea, Thailand and Yemen. NOMECO has 11 active wholly owned subsidiaries which are engaged in the exploration, development and operation of oil and gas interests and rights. CMS Enterprises Gas Transmission and Storage Enterprises has two subsidiaries which participate in non-utility natural gas businesses, including transportation, treating, storage and marketing. FINANCIAL INFORMATION CMS Energy For information with respect to operating revenue, net operating income (loss) and assets and liabilities attributable to all of CMS Energy's business segments, refer to its Consolidated Financial Statements and to the Notes to Consolidated Financial Statements for the year ended December 31, 1993, in Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA, which is incorporated herein by reference. Consumers For information with respect to the operating revenue, net operating income (loss) and assets and liabilities attributable only to Consumers' business segments, refer to its Consolidated Financial Statements and to the Notes to Consolidated Financial Statements for the year ended Decem- ber 31, 1993, in Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA, which is incorporated herein by reference. EMPLOYEES CMS Energy As of February 28, 1994, CMS Energy and its subsidiaries had 9,874 full- time employees and 294 part-time employees for a total of 10,168 employees. Consumers As of February 28, 1994, Consumers and its subsidiaries had 9,434 full- time employees and 277 part-time employees for a total of 9,711 employees. This total includes 4,212 full-time operating, maintenance and construction employees of Consumers who are represented by the Union. A new collective bargaining agreement was negotiated between Consumers and the Union which became effective on June 1, 1992 and, by its terms, will continue in full force and effect until June 1, 1995. SIGNIFICANT DEVELOPMENTS CONCERNING MCV COST RECOVERY ISSUES The MCV Partnership was formed in January 1987 by subsidiaries of Consumers and Dow to convert a portion of Consumers' abandoned Midland Nuclear Plant into a natural gas-fueled, combined cycle cogeneration facility. The MCV Facility has been certified as a Qualifying Facility under PURPA. CMS Energy, certain other affiliates and the other partners in the MCV Partnership made certain contingent undertakings related to the MCV Partnership's sale and leaseback transaction. These included, but were not limited to, indemnifications related to tax matters and a commitment to extend a $10 million standby working capital facility to the MCV Partnership. In addition, CMS Energy and certain of its affiliates undertook certain indemnifications related to environmental matters regarding the site. Consumers' current interests in the MCV Partnership and the MCV Facility are discussed more fully in Note 3 of the Notes to Consolidated Financial Statements. In 1987, Consumers signed a PPA with the MCV Partnership for the purchase of up to 1,240 megawatts of capacity for a 35-year period beginning with the MCV Facility's commercial operation in March 1990. Consumers' cost recovery from its electric customers for the amount of capacity purchased by Consumers from the MCV Partnership, the price paid by Consumers for that capacity and associated energy, and the method of rate recovery for those purchases had been at issue before the MPSC and the Michigan appellate courts since Consumers' first attempt to recover those costs in its annual power supply cost recovery proceedings. Because the MPSC consistently denied Consumers full recovery of the costs it incurred for its purchases from the MCV Partnership, Consumers incurred significant ongoing annual losses. On March 31, 1993, the MPSC issued an Opinion and Order on a Revised Settlement Proposal, which had been submitted by Consumers, CMS Energy, the MPSC Staff, and ten qualifying facility developers, approving it with certain modifications. For a discussion of the Revised Settlement Proposal as approved by the MPSC's March 31, 1993 Order, see Note 3 of the Notes to Consolidated Financial Statements, which is incorporated by reference herein. With Consumers' acceptance of the MPSC's decision on the Revised Settlement Proposal, the uncertainties surrounding Consumers' cost recoveries related to its purchases from the MCV Partnership were resolved to a sufficient degree that Consumers effected a quasi-reorganization as of December 31, 1992 in which Consumers' accumulated deficit was eliminated against other paid-in capital. Following this quasi-reorganization Consumers resumed paying dividends in 1993. The quasi-reorganization is more fully described in Note 7 of the Notes to Consolidated Financial Statements. A dispute has arisen between the MCV Partnership and Consumers relating to the impact of the order on the fixed energy charge payment, currently approx- imately 7 percent of the charges for capacity and energy, called for in the PPA and Consumers' ability to exercise its rights under the regulatory out provision based on the issuance of the Settlement Order. In accordance with the dispute resolution provisions set out in the PPA, an arbitrator acceptable to both parties has been selected and the arbitration of this dispute has commenced. Consumers is unable to predict the outcome of such arbitration proceedings or of any possible settlement of the issues underlying this dispute. On March 4, 1994, the lessors of the MCV Facility filed a lawsuit in federal district court against CMS Energy, Consumers and CMS Holdings relating to the MCV Partnership's failure to object to the Settlement Order in light of Consumers' interpretation of the Settlement Order, which is the subject of the arbitration between the MCV Partnership and Consumers. While CMS Energy and Consumers believe this lawsuit to be without merit, they are unable to predict the outcome of this action. For a discussion of the arbitration proceedings and the lawsuit filed by the lessors, see Note 3 of the Notes to Consolidated Financial Statements and Item 3. LEGAL PROCEEDINGS, which are incorporated by reference herein. CONSUMERS ELECTRIC UTILITY OPERATIONS Consumers had approximately 1.5 million electric customers at December 31, 1993. Electric system energy sales by Consumers in 1993 totaled 31.66 billion kWh, a 3.8 percent increase from 1992. Electric operating revenue in 1993 was $2.077 billion, an increase of 11.5 percent from 1992. A peak demand of 6,226 MW was achieved in August 1993, representing an increase of 4.8 percent from the peak achieved in 1992 predominantly as a result of warmer than normal weather and improved industrial sales. Consumers' reserve margin was approximately 21 percent in 1993 and 19 percent in 1992, based on weather adjusted peaks. Including the Ludington pumped storage facility, in which it has a 51 percent ownership and capacity entitlement, Consumers owns and operates 28 electric generating plants with an aggregate net demonstrated capability available to Consumers, as of 1993 for summer conditions, of 6,299 MW. See Item 2. ITEM 2. PROPERTIES. CHARACTER OF OWNERSHIP The principal properties of CMS Energy and its subsidiaries are owned in fee, except that most electric lines and gas mains are located, pursuant to ease- ments and other rights, in public roads or on land owned by others. The statements under this item as to ownership of properties are made without regard to tax and assessment liens, judgments, easements, rights of way, contracts, reservations, exceptions, conditions, immaterial liens and encum- brances, and other outstanding rights. None of these outstanding rights impairs the usefulness of such properties. Substantially all of Consumers' properties are subject to the lien of its First Mortgage Bond Indenture. CONSUMERS ELECTRIC UTILITY PROPERTIES Consumers' electric generating system consists of five fossil-fueled plants, two nuclear plants, one pumped storage hydroelectric facility, seven gas combustion turbine plants and 13 hydroelectric plants. Consumers' electric transmission and distribution lines owned and in service are as follows: Structure Sub-Surface (Miles) (Miles) Transmission 345,000 volt 1,137 - 138,000 volt 3,246 4 120,000 volt 19 - 46,000 volt 4,066 9 23,000 volt 31 7 ------ ----- Total transmission 8,499 20 Distribution (2,400-24,900 volt) 50,359 4,756 ------ ----- Total transmission and distribution 58,858 4,776 ====== ===== Consumers owns substations having an aggregate transformer capacity of 36,249,290 kilovoltamperes. CONSUMERS GAS UTILITY PROPERTIES Consumers' gas distribution and transmission system consists of 20,768 miles of distribution mains and 1,084 miles of transmission lines throughout the Lower Peninsula of Michigan. Consumers owns and operates five compressor stations with a total of 116,070 installed horsepower. Consumers' gas storage fields, listed below, have an aggregate certified storage capacity of 241.5 bcf: Total Certified Field Name Location Storage Capacity (bcf) Overisel Allegan and Ottawa Counties 64.0 Salem Allegan and Ottawa Counties 35.0 Ira St Clair County 7.5 Lenox Macomb County 3.5 Ray Macomb County 66.0 Northville Oakland, Washtenaw and Wayne Counties 25.8 Puttygut St Clair County 16.6 Four Corners St Clair County 3.8 Swan Creek St Clair County .6 Hessen St Clair County 18.0 Lyon - 34 Oakland County .7 Michigan Gas Storage owns and operates two compressor stations with a total of 46,600 installed horsepower. Its transmission system consists of 547 miles of pipelines within the Lower Peninsula of Michigan. Michigan Gas Storage's gas storage fields, listed below, have an aggregate certified storage capacity of 117 bcf: Total Certified Field Name Location Storage Capacity (bcf) Winterfield Osceola and Clare Counties 75.0 Cranberry Lake Clare and Missaukee Counties 30.0 Riverside Missaukee County 12.0 Consumers' gas properties also include the Marysville gas reforming plant, located in Marysville, Michigan. Huron entered into a partnership with PanCanadian Petroleum Company and CanStates Investments to use the expanded capacity of the underground caverns at the Marysville plant for commercial storage of liquid hydrocarbons. On February 1, 1994 PanCanadian Petroleum Company purchased CanStates Investments. In addition, Consumers and Novacor Hydrocarbons, Inc. are partners in a partnership to use certain hydrocarbon fractionation facilities at the plant. CMS ENERGY OIL AND GAS EXPLORATION AND PRODUCTION PROPERTIES NOMECO has carried on a domestic oil and gas exploration program since 1967. In 1976, NOMECO entered its first venture outside the United States. Net oil and gas production by NOMECO for the years 1991 through 1993 is shown in the following table. Thousands of barrels of oil and millions of cubic feet of gas, except for reserves 1993 1992 1991 Natural gas (a) 18,487 17,578 14,714 Oil and condensate (a) 1,716 1,417 1,260 Plant products (a) 186 291 283 Average daily production (b) Oil 5.6 4.9 4.1 Gas 62.3 59.2 50.5 Reserves to annual production ratio Oil (MMbbls) 19.1 22.6 21.9 Gas (bcf) 10.9 11.8 13.0 (a) Revenue interest to NOMECO (b) NOMECO working interest (includes NOMECO's share of royalties) The following table shows NOMECO's undeveloped net acres of oil and gas leasehold interests at December 31. Net Acres 1993 1992 Michigan 77,672 120,740 Louisiana (a) 37,295 39,226 Texas (a) 8,083 10,411 North Dakota 5,635 - Indiana 5,034 715 Other states 2,184 2,581 ------- --------- Total domestic 135,903 173,673 ------- --------- Thailand 188,000 188,000 Yemen 120,563 - Papua New Guinea 96,825 63,220 Equatorial Guinea 83,334 83,334 Ecuador 69,160 69,160 New Zealand 602 1,544 China (b) - 589,334 ------- --------- Total international 558,484 994,592 ------- --------- Total 694,387 1,168,265 ======= ========= (a) Includes offshore acreage. (b) Acreage excluded at year-end 1993 as part of an agreement with the state oil company to discontinue its current exploration program because it has been unsuccessful. CONSUMERS OTHER PROPERTIES CMS Midland owns a 49 percent interest in the MCV Partnership which was formed to construct and operate the MCV Facility. The MCV Facility has been sold to five owner trusts and leased back to the MCV Partnership. CMS Holdings is a limited partner in the FMLP, which is a beneficiary of one of these trusts. CMS Holdings' indirect beneficial interest in the MCV Facility is 35 percent. Consumers owns fee title to 1,140 acres of land in the City and Township of Midland, Midland County, Michigan, occupied by the MCV Facility. The land is leased to the owners of the MCV Facility by five separate leases, each leasing an undivided interest and in the aggregate totaling 100 percent, for an initial term ending December 31, 2035 with possible renewal terms to June 15, 2090. Consumers owns or leases three principal General Office buildings in Jackson, Michigan and 53 Regional and other field offices at various locations in Michigan's Lower Peninsula. Of these, two of the General Office buildings and eleven of the Regional and other field offices are leased. Also owned are miscellaneous parcels of real estate not now used in utility operations. CMS ENERGY OTHER PROPERTIES Various subsidiaries of CMS Generation own interests in independent power plants, including a 50 percent partnership interest in a 30 MW wood waste- fueled power plant near Susanville, California; a 50 percent partnership interest in a 54 MW coal and wood waste-fueled power plant in Filer City, Michigan; a 50 percent partnership interest in a 34 MW wood waste-fueled power plant in Grayling Township, Michigan; a 50 percent interest in a 26 MW tire burning power plant near Sterling, Connecticut; a 50 percent interest in a wood waste-fueled power plant in Lyons Falls, New York; an 18.6 percent interest in a consortium which owns an 88 percent interest in a 50 MW fossil-fueled plant in San Nicolas, Argentina; a 25 percent interest in a consortium which owns a 59 percent interest in two hydroelectric power plants, with a total of 1,320 MW of capacity, on the Limay River in western Argentina; and a 50 percent ownership interest in a 18 MW wood waste-fueled power plant near Chateaugay, New York. CMS Gas Transmission owns a 75 percent interest in a general partnership which owns and operates a 25-mile, 16-inch natural gas transmission pipeline in Jackson and Ingham Counties, Michigan; owns a 24 percent limited partnership interest in the Saginaw Bay Area Limited Partnership which owns 125 miles of 10-inch and 16-inch natural gas transmission pipeline in north-central Michigan; owns a 44 percent limited partnership interest in a partnership that owns certain pipelines of 20 and 12 miles interconnected to the Saginaw Bay Area Limited Partnership facilities; owns a 60 percent interest in a partnership that owns and operates a natural gas treating plant in Otsego County, Michigan; and owns 100 percent interest in 41 miles of gas transmission pipeline in Otsego and Montmorency Counties, Michigan. CMS Energy, through certain subsidiaries owns approximately 6,000 acres of undeveloped land in Benzie and Manistee Counties, Michigan, approximately 53 acres of undeveloped land in Muskegon County, Michigan, and approximately 300 acres in undeveloped land in Emmet County, Michigan. CONSUMERS CAPITAL EXPENDITURES Capital expenditures during 1993 for Consumers and its subsidiaries totaled $509 million for capital additions and $52 million for demand-side management programs. These capital additions include approximately $31 million for environmental protection additions. Of the $509 million, $265 million was incurred for electric utility additions, $126 million for gas utility additions, $58 million for capital leases (see Note 14 to Consumers' Consolidated Financial Statements incorporated by reference herein), and $60 million for other additions and capital investments. In 1994, capital expenditures are estimated to be $513 million for capital additions and $40 million for demand-side management programs. These capital addition estimates include approximately $48 million related to environmental protection additions. Of the $513 million, $290 million will be incurred for electric utility additions, $98 million for gas utility additions, $73 million for capital leases, and $52 million for other additions and capital investments. CMS ENERGY CAPITAL EXPENDITURES Capital expenditures during 1993 for CMS Energy and its subsidiaries totaled $714 million for capital additions and $52 million for demand-side management programs. These capital additions include approximately $31 million for environmental protection additions. Of the $714 million, $509 million was incurred by Consumers as discussed above. The remaining $205 million in capital additions include $81 million for oil and gas exploration, $110 million for independent power production and $14 million for gas transmission and marketing. In 1994, capital expenditures are estimated to be $752 million for capital additions and $40 million for demand-side management programs. This capital addition estimate includes approximately $48 million related to environmental protection additions. Of the $752 million, $513 million will be incurred by Consumers as discussed above. The remaining $239 million in capital additions will be incurred as follows: $117 million for oil and gas exploration, $84 million for independent power production and $38 million for gas transmission and marketing. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Consumers and some of its subsidiaries and affiliates are parties to certain routine lawsuits and administrative proceedings incidental to their businesses involving, for example, claims for personal injury and property damage, contractual matters, income taxes, and rates and licensing. Reference is made to the Notes to the Consolidated Financial Statements included herein for additional information regarding various pending administrative and judicial proceedings involving rate, operating and environmental matters. The Attorney General, ABATE, and the MPSC Staff typically intervene in MPSC proceedings concerning Consumers. Unless otherwise noted below, these parties have intervened in such proceedings. For many years, almost every significant MPSC order affecting Consumers has been appealed. Appeals from such MPSC orders are pending in the Michigan Court of Appeals and the Michigan Supreme Court. Consumers is vigorously pursuing these matters. Under Michigan civil procedure, parties may file a claim of appeal with the Michigan Court of Appeals which serves as a notice of appeal. The grounds on which the appeal is being made are not set forth until a later date when the parties file their briefs. 1. Electric Rate Case Proceedings A. Appeal of MPSC Orders Related to the Abandoned Midland Nuclear Plant Investment In November 1983, Consumers filed an electric rate case with the MPSC which sought recovery of its investment in the abandoned portion of the Midland nuclear plant. This case was separated into two phases in September 1984: a financial stabilization phase, MPSC Case No. U-7830, Step 3A, and a prudence phase, MPSC Case No. U-7830, Step 3B. Numerous orders were issued in these cases, including one issued in 1985 in the financial stabilization phase which contained certain conditions to Consumers' receiving financial stabilization rate relief. On May 7, 1991, the MPSC issued final orders in both Step 3A and Step 3B proceedings in which, among other things, the MPSC ruled that Consumers could recover approximately $760 million of the $2.1 billion of abandoned Midland investment. Consumers, as well as the Attorney General and ABATE, among others, filed applications for rehearing with the MPSC of the May 7 Orders in Step 3A and Step 3B. which were all denied by the MPSC. Several parties, including Consumers, have appealed the MPSC determinations in these orders to the Court of Appeals. The Attorney General and ABATE primarily disagree with the standard used by the MPSC to determine the amount of investment that is recoverable by Consumers from its electric customers, contending that recovery should not be allowed for utility assets that have not been placed in service. Consumers disagrees with the date the MPSC determined it would have been prudent for Consumers to abandon construction of the Midland nuclear facility and the reduction in recoverable investment that resulted from this determination. All briefs have been filed in these appeals. Oral argument has not yet been scheduled on the Step 3B appeals; oral argument was held on the Step 3A appeal in December 1993. B. Appeal of 1991 General Electric Rate Case Order On May 7, 1991, the MPSC issued an order in Case No. U-9346, a general electric rate case the MPSC ordered Consumers to file in response to a complaint filed by ABATE. On July 1, 1991, the MPSC issued another order in this proceeding modifying the May 7 Order. These orders, together with the other orders discussed in paragraph A above, reduced Consumers' electric retail rates by an annual amount of approximately $73 million. Certain aspects of the May 7, 1991 and July 1, 1991 electric rate case orders were appealed by the Attorney General, ABATE, and the Michigan Association of Home Builders. The appeals of the Attorney General and the Michigan Association of Home Builders have both been dismissed. ABATE's appeal, which primarily seeks a reduction in the rates authorized by the MPSC, remains pending. Briefs have been filed in the ABATE appeal and oral argument was held in December 1993. C. 1993 Electric Rate Case On May 10, 1993, Consumers filed an application with the MPSC seeking an increase in its base electric rates (MPSC Case No. U-10335). As a result of the new statutory federal tax rate and interest rate savings resulting from the refinancing of certain long-term debt, Consumers subsequently revised its requested electric rate increase to approximately $133 million in 1994 while its requested electric rate increase for 1995 remained at $38 million. In their initial brief, the MPSC Staff recommended approximately $98 million in annual rate relief beginning in 1994. The MPSC Staff also recommended a lower return on electric common equity (11.75 percent compared with Consumers' proposal of 13.25 percent), and using a projected actual equity ratio in the projected capitalization structure rather than a target ratio. The MPSC Staff did not support Consumers' request for additional rate relief for 1995 as part of this proceeding, but did support Consumers' rate design proposal to significantly reduce the level of cross-subsidization of residential customers' rates by commercial and industrial customers. A PFD was issued in this case on March 4, 1994. In the PFD the ALJ recommended a rate increase in 1994 of approximately $83 million with no incremental increase in 1995 to be granted as part of this proceeding. The ALJ adopted MPSC Staff's recommendation of an 11.75 percent return on common equity and the use of 1994 projected actual capital structure rather than the target structure proposed by Consumers. The PFD rejected a proposal made by Consumers through which returns above the authorized level would be shared with customers, but recommended the implementation of a performance incentive proposal Consumers had initially proposed with some modifications. The PFD also recommended the adoption of the cross- subsidization reduction proposed by Consumers modified so that subsidization would be immediately reduced by 50 percent in 1994 rates rather than the phased-in 20 percent per year over a three year period reduction proposed by Consumers. Exceptions to the PFD are due March 18 with replies to exceptions due April 1. The PFD is not binding on the MPSC. An order of the MPSC will be issued sometime thereafter. D. 1986 Proceedings - Palisades Outages The Palisades nuclear plant was out of service for maintenance from May 1986 until April 1987. In the 1986 PSCR reconciliation case decided December 22, 1988, the MPSC disallowed recovery of $22.4 million of replacement power costs associated with the 1986 portion of this outage and refunds to the customers were made. In an appeal filed in 1989 and now pending decision by the Court of Appeals, Consumers is challenging the adequacy of the MPSC's findings supporting the disallowance. Oral arguments were held in December 1993 and in March 1994 the Court of Appeals affirmed the MPSC order in a per curiam opinion. 2. Settlement Proposals Relating to Consumers' Purchases from the MCV Partnership On March 31, 1993, the MPSC issued the Settlement Order which approved with modifications the Revised Settlement Proposal filed by Consumers, the MPSC Staff and 10 small power and cogeneration developers. The scope of the Settlement Order included three major components: 1) treatment of cost recovery issues regarding the PPA, 2) resolution of PURPA issues raised by certain developers of Qualifying Facilities that had wanted contracts with Consumers, and 3) resolution of the remand to the MPSC ordered by the Court of Appeals in the Capacity Charge Order. In December 1992, Consumers recognized an after-tax loss of $343 million for the present value of estimated future underrecoveries of power costs under the PPA as a result of the Settlement Order. On May 26, 1993, the MPSC denied petitions filed by the Attorney General, ABATE, MMCG and a small project developer which requested a rehearing of the Settlement Order by the MPSC. ABATE and the Attorney General have filed claims of appeal of the Settlement Order and the May 26, 1993 MPSC order with the Court of Appeals. Briefs have been filed with the Court of Appeals on this matter but oral argument has not yet been scheduled. In their respective briefs in opposition to the Settlement Order, ABATE and the Attorney General essentially reiterate the arguments they made before the MPSC in their petitions for rehearing. The substance of ABATE's and the Attorney General's arguments is that the MPSC exceeded its authority in approving the Revised Settlement Proposal as modified by the Settlement Order and the rates established thereby are not just and reasonable and lack evidentiary support. ABATE and the Attorney General also contend that the MPSC's procedures for the hearing on the Revised Settlement Order violated due process and denied ABATE and the Attorney General a fair hearing. In defense of the Settlement Order, the Independent Cogenerators, Consumers and the MPSC argue in their respective briefs to the Court of Appeals that the determinations of the MPSC in the Settlement Order are lawful and reasonable and that the Attorney General and ABATE have failed to meet the statutory burden of proof minimally necessary for the Court of Appeals to find otherwise. In accordance with the terms of the Settlement Order, appeals of MPSC orders relating to MCV cost recovery issues in Consumers' 1990, 1991 and 1992 PSCR cases that had been pending before the Court of Appeals and the Michigan Supreme Court have been withdrawn. 3. MPSC Case No. U-10029 - Intrastate Gas Supply In November 1991, Consumers filed with the MPSC Case No. U-10029 seeking several kinds of relief with respect to a contract with one of Consumers' intrastate gas suppliers, North Michigan, including lowering a contract price. North Michigan filed an objection with the MPSC and in July 1992 filed a collateral case in Federal Court seeking an injunction to block the MPSC case. On April 8, 1993, the Federal Court dismissed Northern Michigan's suit. An appeal of the Federal Court's decision is pending in the U.S. Sixth Circuit Court of Appeals. On February 8, 1993, the MPSC issued an order granting Consumers' request to lower the price to be paid North Michigan under its contract. In March 1993, North Michigan filed an appeal of the MPSC's February 8, 1993 order with the Court of Appeals. In July 1993, consistent with the MPSC's February 8, 1993 Order, Consumers notified North Michigan that it planned to terminate the contract in November 1993. In early October 1993, North Michigan sought to have the Court of Appeals stay Consumers' cancellation of the contract. The Court of Appeals denied this request in late October 1993 and Consumers terminated its contract with North Michigan effective November 1, 1993. If the MPSC order is overturned, Consumers would have to pay North Michigan higher contract costs for purchases in 1993 which may not be authorized by the MPSC for recovery from Consumers' customers. Should North Michigan obtain a favorable decision on all of the issues on appeal, including Consumers' termination of the contract in 1993, Consumers' total remaining exposure would be $24 million, for which Consumers previously accrued a loss. Consumers cannot predict the outcome of this appeal. 4. Palisades Plant - Spent Nuclear Fuel Storage In April 1993, the NRC amended its regulations, effective May 7, 1993, to approve the design of the dry spent fuel storage casks to be used by Consumers at Palisades. In May 1993, the Attorney General and certain other parties commenced litigation to block Consumers' use of the storage casks, alleging that the NRC had failed to comply adequately with the National Environmental Policy Act. As of February, 1994, the courts have declined to prevent such use and have refused to issue temporary restraining orders or stays. Several appeals related to this matter are now pending at the U.S. Sixth Circuit Court of Appeals. As of mid-August 1993, Consumers has loaded two dry storage casks with spent nuclear fuel and expects to load additional casks in 1994 prior to Palisades' 1995 refueling outage. 5. CMS Energy's Exemption Under the Public Utility Holding Company Act of 1935 CMS Energy is exempt from registration under PUHCA. In December 1991, the Attorney General and the MMCG filed a request with the SEC for the revocation of CMS Energy's exemption. In January 1992, CMS Energy responded to the revocation request affirming its position that it is entitled to the exemption. In April 1992, the MPSC filed a statement with the SEC that recommended that the SEC impose nine conditions on CMS Energy's exemption. The suggested conditions would (1) preclude CMS Energy's making non-utility investments without prior SEC approval; (2) prohibit CMS Energy's subsidiaries from making any upstream loans without prior SEC approval; (3) prohibit CMS Energy from pledging Consumers' assets as security without prior SEC approval; (4) prohibit the sale or transfer of utility securities or assets by CMS Energy without SEC concurrence; (5) prevent Consumers paying other than "normal" dividend; (6) require that all contracts and leases over $500,000 annual cost be filed with the SEC and MPSC; (7) require that access to the books and records of CMS Energy, its affiliates and their joint ventures, be provided to the SEC and the MPSC; (8) establish complaint procedures, with penalty provisions for addressing challenges to CMS Energy's compliance with the conditions; and (9) require that all pleadings filed with the SEC relating to the conditions be served contemporaneously on the MPSC. On July 9, 1993, the Attorney General submitted to the SEC a response to the MPSC's statement opposing the MPSC's recommendations and reiterating his argument that CMS Energy should not be allowed an exemption under PUHCA. On July 12, 1993, the MMCG submitted to the SEC a reply to CMS Energy's January 1992 response to the revocation request. On September 30, 1993, CMS Energy responded to the Attorney General's and the MMCG's July submissions. CMS Energy also contemporaneously submitted comments on the MPSC's April 1992 statement. In its response to the Attorney General and MMCG, CMS Energy again refuted the allegations made by the Attorney General and MMCG regarding CMS Energy's exemption, noting in particular that the matters complained of by the Attorney General and MMCG have all been addressed and resolved in proceedings before other regulatory and judicial authorities, primarily at the State level, with the Attorney General and MMCG participating. In its comments on the MPSC's April 1992 statement, CMS Energy updated events from the time the MPSC statement was filed during which the substantive issues underlying the MPSC's recommendations were resolved. Should the SEC revoke CMS Energy's current exemption from registration under PUHCA, CMS Energy could either become a registered holding company or be granted a new exemption, possibly subject to conditions similar to those recommended by the MPSC. Registration under PUHCA could require divestment by CMS Energy of either its gas utility or electric utility business by some future date following registration. As a registered company, CMS Energy could also be precluded from engaging in businesses that are not functionally related to its utility operations; in addition, SEC approval would be required for the issuance of securities by CMS Energy and its subsidiaries. If divestiture of Consumers' gas utility or its electric utility business ultimately were required, the effect on Consumers and CMS Energy would depend on the method of divestitures and the extent of the proceeds received, which cannot now be predicted. CMS Energy is vigorously contesting the revocation request and believes it will maintain the exemption. There has been no action taken by the SEC on this matter. 6. Ludington Pumped Storage Plant In September 1993, the Court of Appeals overturned the dismissal of a lawsuit filed by the Attorney General in September 1986 seeking damages from Consumers and Detroit Edison for alleged injuries to fishing resources due to the operation of the jointly owned Ludington Pumped Storage Plant. In his 1986 complaint, the Attorney General had sought $147.9 million (including interest) in damages for past injuries and approximately $89,000 per day for future damages, subject to adjustment based on the adequacy of the barrier net installed at the plant and other changed conditions. In a second lawsuit, filed in 1987, the Attorney General had also sought to have the plant's bottom lands lease agreement with the State declared void. The Court of Appeals' September 1993 ruling upheld the lower court's dismissal relating to the breach of claim, but would allow the Attorney General to continue his lawsuit for damages against Consumers and Detroit Edison, limiting the recovery of potential damages to those occurring not more than 3 years before filing the lawsuit in 1986. On October 14, 1993, the Court of Appeals made minor modifications to its opinion. Consumers and Detroit Edison have filed an application for leave to appeal with the Michigan Supreme Court seeking a reversal of the September 1993 Court of Appeals' Order and have the trial court's dismissal of the damages claim affirmed. The Attorney General filed a brief in opposition to Consumers' and Detroit Edison's application and also filed an application with the Michigan Supreme Court seeking reversal of the Court of Appeals' rulings as to the lease claims and the statute of limitations holding. The decision to grant or deny these applications is pending at the Michigan Supreme Court. 7. Stray Voltage Lawsuit Consumers experienced an increase in complaints during 1993 relating to so-called stray voltage. Claimants contend that stray voltage results when small electrical currents present in grounded electric systems are diverted from their intended path. Investigation by Consumers of prior stray voltage complaints disclosed that many factors, including improper wiring and malfunctioning of on-farm equipment can lead to the stray voltage phenomenon. Consumers maintains a policy of investigating all customer calls regarding stray voltage and working with customers to address their concerns including, when necessary, modifying the configuration of the customer's hook-up to Consumers. On October 27, 1993, a complaint seeking certification as a class action suit was filed against Consumers in a local circuit court. The complaint alleged that in excess of a billion dollars of damages, primarily related to production by certain livestock owned by the purported class, were being incurred as a result of stray voltage from electricity being supplied by Consumers. Consumers believes the allegations to be without merit and has vigorously opposed the certification of the class and this suit. On March 11, 1994, the court decided to deny class certification for this complaint and to dismiss, subject to refiling as separate suits, the October lawsuit with respect to all but one of the named plaintiffs. 8. Gas Supplier Dispute On September 1, 1993, Consumers commenced gas purchases from Trunkline under a continuation of prior sales agreements at a reduced price compared to prior gas sales. Some of Consumers' direct gas suppliers, who have their contract price tied to the price Consumers pays Trunkline, have claimed that the reduced Trunkline gas cost is not a proper reference price under their contracts with Consumers. To date, four suppliers have filed lawsuits, one in Canada, making these charges and seeking open pricing and/or renegotiation of the pricing provision for their contracts, and also seeking damages for breach of contract. Consumers is disputing these claims and has sought declaratory and other relief on this issue in Michigan courts against nine suppliers. Certain of the suppliers also allege that, absent successful renegotiation, they have the right to terminate their supply contracts with Consumers and have involved the MCV Partnership in the litigation claiming termination rights with respect to the MCV Partnership's supply contracts that were negotiated during the same period. Consumers has reached an agreement in principle to settle with three of the suppliers. Consumers cannot predict the outcome of this matter. Additionally, three of these direct gas suppliers of Consumers made filings with the FERC in Trunkline's Order 636 restructuring case seeking to preclude Trunkline's ability to make the sales to Consumers which commenced on September 1, 1993. Consumers and Trunkline vigorously opposed these filings and in December 1993, the FERC issued an order which, among other things, allowed Trunkline to continue sales of gas to Consumers under tariffs on file with the FERC. 9. Arbitration Proceedings Between Consumers and the MCV Partnership A dispute has arisen between the MCV Partnership and Consumers relating to the impact of the Settlement Order on the fixed energy charge payment called for in the PPA and Consumers' ability to exercise its rights under the regulatory out provision based on the issuance of the Settlement Order. In accordance with the dispute resolution provisions set out in the PPA, an arbitrator acceptable to both parties has been selected and the arbitration of this dispute has commenced. Consumers is unable to predict the outcome of such arbitration proceedings or of any possible settlement of the issues underlying this dispute. The lessors of the MCV Facility have filed a lawsuit in federal district court against CMS Energy, Consumers and CMS Holdings. It alleges breach of contract, breach of fiduciary duty and negligent or fraudulent misrepresentation relating to the MCV Partnership's failure to object to the Settlement Order in light of Consumers' interpretation of the Settlement Order, which is the subject of an arbitration between the MCV Partnership and Consumers. The action alleges damages in excess of $1 billion and seeks injunctive relief relative to Consumers' payments of the fixed energy charge. CMS Energy and Consumers believe that at all times they and CMS Holdings have conducted themselves properly and that the action is without merit. They also believe that a significant portion of the alleged damages represent fixed energy charges in dispute in the arbitration. CMS Energy and Consumers are unable to predict the outcome of this action. 10. 1991 Gas Rate Settlement On December 19, 1991, the MPSC approved a settlement in Case No. U-10037 concerning Consumers' gas rates which had been entered into by Consumers and the MPSC Staff. The settlement provides that Consumers is required to make certain expenditures for gas operation and maintenance activities in 1992, and provides for refunds if these expenditure levels are not met, or if Consumers' gas earnings exceed certain levels. Both the Attorney General and ABATE opposed approval of the settlement agreement and ABATE sought rehearing of the December 19, 1991 Order. On April 15, 1992, the MPSC denied the rehearing request. Both ABATE and the Attorney General have appealed the MPSC's order. On March 10, 1994, the Court of Appeals issued a per curiam opinion affirming the MPSC order. 11. Investigative Demand On July 17, 1991, the Attorney General served a civil investigative demand upon Consumers and CMS Energy indicating that the Attorney General was investigating "possible violations" of the Michigan Antitrust Reform Act by CMS Energy and Consumers and certain of their affiliates, primarily in connection with potential acquisitions and dealings with electric generating companies including the MCV Partnership. CMS Energy and Consumers do not believe any violations of such Act have occurred. The Attorney General has not taken any action on this matter since 1991 and Consumers and CMS Energy believe that this investigation is no longer being pursued. 12. Environmental Matters On September 23, 1993, the EPA filed an administrative complaint against Consumers under Superfund and the Emergency Planning and Community Right-to-Know Act. The complaint alleges, after release of a certain hazardous substance at its J. H. Campbell coal-fired electric generating plant, that Consumers did not immediately notify the appropriate governmental authorities of the release as soon as Consumers had knowledge of the release. The complaint proposes penalties aggregating $100,000. Consumers is disputing these allegations. In addition, Consumers is subject to various federal, state and local laws and regulations relating to the environment. Consumers has been named as a party to several actions involving environmental issues. However, based on its present knowledge and subject to future legal and factual developments, CMS Energy and Consumers believe that it is unlikely that these actions, individually or in total, will have a material adverse effect on their financial condition. See Item 1. BUSINESS. CONSUMERS AND CMS ENERGY ENVIRONMENTAL COMPLIANCE. 13. Retail Wheeling Proceedings In September 1992, in response to an application filed by ABATE, the MPSC issued an order commencing a joint contested case proceeding to consider experimental wheeling tariffs for Consumers and Detroit Edison. ABATE's proposal is that for an experimental period of five years utility customers with maximum demands of 5,000 kW or more be eligible for the retail wheeling tariff. Under the proposal, 60 megawatts of Consumers' load and 90 MW of Detroit Edison's load would be subject to displacement by retail wheeling. Consumers and Detroit Edison each opposed the proposed experimental retail wheeling tariff while the MPSC Staff cited concerns with the impact of the retail wheeling proposals on utility planning and procurement practices as well as regarding certain jurisdictional issues. In the PFD issued in August 1993, the ALJ determined that the MPSC could not order utilities to provide retail wheeling services and expressed concern regarding the proper pricing for this service should a utility voluntarily agree to provide the service. 14. Wholesale Wheeling Proceedings Consumers has an approved open-access interconnection service schedule on file with the FERC for wholesale wheeling transactions. In 1992, Consumers also filed a separate but complementary open-access transmission tariff that would make both firm and non-firm transmission service available to eligible power generators, including investor-owned utilities, facilities that meet the ownership and technical requirements under PURPA, independent power producers, municipal and cooperative utilities. The FERC accepted the filing, effective May 2, 1992, subject to refund, and ordered a hearing before an ALJ. In September 1993, the ALJ issued an initial decision that would compel reductions of the tariff rates ranging from 25 percent to 65 percent. On November 1, 1993, Consumers filed exceptions with the FERC seeking reversal of the rate reductions proposed in the ALJ's initial decision. As of December 31, 1993, the amount of firm transmission service currently subject to the tariff is 23 MW. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. CMS Energy None in the fourth quarter of 1993 for CMS Energy. Consumers None in the fourth quarter of 1993 for Consumers. However, at a special meeting held on January 31, 1994, the shareholders of Consumers approved the creation of a new class of stock, Class A preferred stock. The stock vote taken on the matter was as follows: For Against Abstain Total --- ------- ------- ----- Common and Preferred Stock 84,611,652 103,849 38,072 84,753,573 Preferred Stock 502,863 103,849 38,072 644,784 PART II ITEM 5. ITEM 5. MARKET FOR CMS ENERGY'S AND CONSUMERS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. CMS Energy Market prices for CMS Energy's common stock and related security holder matters are contained herein in Item 8, CMS Energy's Quarterly Financial and Common Stock Information, which is incorporated by reference herein. Number of common shareholders at February 28, 1994 was 66,250. Consumers Consumers' common stock is privately held by its parent, CMS Energy, and does not trade in the public market. In May, August, November and December 1993, Consumers paid $57 million, $21.5 million, $33.5 million and $21 million cash dividends, respectively, on its common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. CMS Energy Selected financial information is contained in Item 8, CMS Energy's Selected Financial Information which is incorporated by reference herein. Consumers Selected financial information is contained in Item 8, Consumers' Selected Financial Information which is incorporated by reference herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. CMS Energy Management's discussion and analysis of financial condition and results of operations is contained in Item 8, CMS Energy's Management's Discussion and Analysis which is incorporated by reference herein. Consumers Management's discussion and analysis of financial condition and results of operations is contained in Item 8, Consumers' Management's Discussion and Analysis which is incorporated by reference herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Index to Financial Statements: CMS Energy Page Selected Financial Information 51 Management's Discussion and Analysis 53 Consolidated Statements of Income 64 Consolidated Statements of Cash Flows 65 Consolidated Balance Sheets 66 Consolidated Statements of Long-Term Debt 68 Consolidated Statements of Preferred Stock 69 Consolidated Statements of Common Stockholders' Equity 70 Notes to Consolidated Financial Statements 71 Report of Independent Public Accountants 96 Quarterly Financial and Common Stock Information 97 Consumers Page Selected Financial Information 101 Management's Discussion and Analysis 102 Consolidated Statements of Income 112 Consolidated Statements of Cash Flows 113 Consolidated Balance Sheets 114 Consolidated Statements of Long-Term Debt 116 Consolidated Statements of Preferred Stock 117 Consolidated Statements of Common Stockholder's Equity 118 Notes to Consolidated Financial Statements 119 Report of Independent Public Accountants 142 Quarterly Financial Information 143 CMS Energy Corporation 1993 Financial Statements (This page intentionally left blank) CMS Energy Corporation Management's Discussion and Analysis CMS Energy is the parent holding company of Consumers and Enterprises. Consumers, a combination electric and gas utility company serving most of the Lower Peninsula of Michigan, is the principal subsidiary of CMS Energy. Consumers' customer base includes a mix of residential, commercial and diversified industrial customers, the largest of which is the automotive industry. Enterprises is engaged in several non-utility energy-related businesses including: 1) oil and gas exploration and production, 2) development and operation of independent power production facilities, 3) gas marketing services to utility, commercial and industrial customers, and 4) storage and transmission of natural gas. Consolidated 1993 Earnings Consolidated net income for 1993 totaled $155 million or $1.90 per share, compared to net losses of $297 million or $3.72 per share in 1992 and $276 million or $3.44 per share in 1991. The increased net income reflects the Settlement Order related to power purchases from the MCV Partnership. Earnings also reflect record-setting utility electric sales and gas deliveries and additional earnings from the growth of non-utility businesses. Cash Position, Financing and Investing CMS Energy's primary ongoing source of operating cash is dividends from its principal subsidiaries. Consumers effected a quasi-reorganization as of December 31, 1992, which allowed it to resume paying common dividends (see Note 7 to the Consolidated Financial Statements). Consumers paid $133 million in common dividends in 1993 and declared a $16 million common dividend in January 1994 from 1993 earnings. CMS Energy also received cash dividends of $11 million from its non-utility subsidiaries. CMS Energy paid $49 million in cash dividends to common shareholders compared to $38 million in 1992. The $11 million increase reflects an annual increase of $.24 per share commencing third quarter 1993. CMS Energy's consolidated cash requirements are met by its operating and financing activities. In 1993 and 1992, CMS Energy's consolidated cash inflow from operations was derived mainly from Consumers' sale and transportation of natural gas and its sale and transmission of electrici- ty, and from NOMECO's sale of oil and natural gas. Consolidated cash from operations for 1993 primarily reflects Consumers' record-setting electric sales and gas deliveries and reduced after-tax cash shortfalls resulting from Consumers' purchases of power from the MCV Partnership. During 1992, CMS Energy's cash from operations decreased as compared to 1991 primarily due to higher operational expenditures and reduced electric rates. In 1991, CMS Energy generated cash primarily from its consolidated operating and investing activities, including $859 million of net proceeds from the sale of a majority of the MCV Bonds. Over the last three years, CMS Energy has used its consolidated cash to fund its extensive utility construction expenditures, to improve the reliability of its utility transmission and distribution systems and to expand its non-utility businesses. It also has used its cash to retire portions of long-term securities and to pay cash dividends. Financing Activities In October 1993, CMS Energy issued 4.6 million shares of common stock at a price of $26 5/8. The net proceeds of $119 million were used to reduce existing debt and for general corporate purposes. During 1993, Consumers significantly reduced its future interest charges by retiring approximately $51 million of high-cost outstanding debt and refinancing approximately $573 million of other debt at lower interest rates. In November 1993, NOMECO amended the terms of its loan agreement and increased the amount to $110 million. For further information, see Note 7. Investing Activities Capital expenditures (excluding assets placed under capital leases of $58 million), deferred DSM costs and investments in unconsolidated subsidiaries totaled $708 million for 1993 as compared to $525 million in 1992. CMS Energy's expenditures for its utility, independent power production, oil and gas exploration and production, and gas transmission and marketing business segments were $503 million, $110 million, $81 million and $14 million, respectively. In December 1993, Consumers sold $309 million of MCV Bonds it held and used the net proceeds to temporarily reduce short-term borrowings and ultimately plans to reduce long-term debt and to finance its construction program. Outlook CMS Energy estimates that capital expenditures, including DSM, new lease commitments and investments in unconsolidated subsidiaries, will total approximately $2.2 billion over the next three years. In Millions Years Ended December 31 1994 1995 1996 ---- ---- ---- Electric and gas utility $553 $461 $471 Oil and gas exploration and production 117 90 100 Independent power production 84 99 98 Gas transmission and marketing 38 40 45 ---- ---- ---- $792 $690 $714 ==== ==== ==== CMS Energy is required to redeem or retire approximately $796 million of long-term debt during 1994 through 1996. Cash generated by operations is expected to satisfy a substantial portion of these capital expenditures and debt retirements. Additionally, CMS Energy will evaluate the capital markets in 1994 as a source of financing its subsidiaries' investing activities. CMS Energy filed a shelf registration statement with the SEC in January 1994 covering the issuance of up to $250 million of unsecured debt securities. The net proceeds will be used to reduce the amount of CMS Energy Notes outstanding and for general corporate purposes. In October 1993, Consumers received MPSC authorization and is proceeding to issue $200 million of preferred stock in 1994. Consumers has several other available sources of credit including unsecured, committed lines of credit totaling $165 million and a $470 million working capital facility. Consumers has FERC authorization to issue or guarantee up to $900 million in short-term debt through December 31, 1994. Consumers uses short-term borrowings to finance working capital, seasonal fuel inventory, and to pay for capital expenditures between long-term financings. Consumers has an agreement permitting the sales of certain accounts receivable for up to $500 million. As of December 31, 1993 and 1992, receivables sold totaled $285 million and $225 million, respectively. On February 15, 1993, Consumers increased the level of receivables sold to $335 million. In February 1994, Consumers called or redeemed approximately $101 million of first mortgage bonds (see Note 7). Electric Utility Operations Comparative Results of Operations Electric Pretax Operating Income: The improvement in 1993 pretax operating income compared to 1992 reflects an increase of $126 million relating to the resolution of the recoverability of MCV power purchase costs under the PPA and increased electric system sales of $45 million, partially offset by higher costs to improve system reliability. The 1992 decrease of $66 million from the 1991 level primarily resulted from an increased emphasis on system reliability improvements and decreased electric rates resulting from the full-year impact of a mid-1991 rate decrease. Electric Sales: Electric system sales in 1993 totaled a record 31.7 billion kWh, a 3.8 percent increase from 1992 levels. In 1993, residential and commercial sales increased 3.4 percent and 3.0 percent, respectively, while industrial sales increased 6.5 percent. Growth in the industrial sector was the strongest in the auto-related segments of fabricated and primary metals and transportation equipment. Electric system sales in 1992 totaled 30.5 billion kWh, essentially unchanged from the 1991 levels. Power Costs: Power costs for 1993 totaled $908 million, a $31 million increase from the corresponding 1992 period. This increase primarily reflects greater power purchases from outside sources to meet increased sales demand and to supplement decreased generation at Palisades due to an extended outage. Power costs for 1992 totaled $877 million, a $17 million decrease as compared to 1991. Operation and Maintenance: Increases in other operation and maintenance expense for 1993 and 1992 reflected increased expenditures to improve electric system reliability. Depreciation: The increased depreciation for 1993 reflects additional capital investments in plant. The 1992 increase resulted from higher depreciation rates, increased amortization of abandoned nuclear investment and increased nuclear plant decommissioning expense. Electric Utility Rates Power Purchases from the MCV Partnership: Consumers is obligated to purchase the following amounts of contract capacity from the MCV Partnership under the PPA: 1995 and Year 1993 1994 thereafter - ---- ----- ----- ---------- MW 1,023 1,132 1,240 Since 1990, recovering capacity and fixed-energy costs for power purchased from the MCV Partnership has been a significant issue. Effective January 1, 1993, the Settlement Order allowed Consumers to recover from electric retail customers substantially all of the payments for its ongoing purchase of 915 MW of contract capacity from the MCV Partnership, significantly reducing the amount of future underrecoveries for these power costs. ABATE and the Attorney General have filed claims of appeal of the Settlement Order with the Court of Appeals. Prior to the Settlement Order, Consumers had recorded losses for underrecoveries from 1990 through 1992. In December 1992, Consumers recognized an after-tax loss of $343 million for the present value of estimated future underrecoveries of power costs under the PPA as a result of the Settlement Order, based on management's best estimates regarding the future availability of the MCV Facility, and the effect of the future wholesale power market on the amount, timing and price at which various increments of the capacity above the MPSC-authorized level could be resold. Except for adjustments to the above loss to reflect the after-tax time value of money through accretion expense, no additional losses are expected unless actual future experience materially differs from management's estimates. The after-tax expense for the time value of money for the $343 million loss is estimated to be approximately $24 million in 1994, and various lower levels thereafter, including $22 million in 1995 and $20 million in 1996. Although the settlement losses were recorded in 1992, the after-tax cash underrecoveries associated with the Settlement Order were $59 million in 1993. Consumers believes there is and will be a market for the resale of capacity purchases from the MCV Partnership above the MPSC-authorized level. If Consumers is unable to sell any capacity above the current MPSC-authorized level, future additional after-tax losses and after-tax cash underrecoveries could be incurred. Estimates for the next five years if none of the additional capacity is sold are as follows: After-tax, In Millions 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- Expected cash underrecoveries $56 $65 $62 $61 $ 8 Possible additional under- recoveries and losses (a) $14 $20 $20 $22 $72 (a) If unable to sell any capacity above the MPSC's authorized level. The PPA, while requiring payment of a fixed energy charge, contains a "regulatory out" provision which permits Consumers to reduce the fixed energy charges payable to the MCV Partnership throughout the entire contract term if Consumers is not able to recover these amounts from its customers. Consumers and the MCV Partnership have commenced arbitration proceedings under the PPA to determine whether Consumers is entitled to exercise its regulatory out regarding fixed energy charges on the portion of available MCV capacity above the current MPSC-authorized levels. An arbitrator acceptable to both parties has been selected. If the arbitrator determines that Consumers cannot exercise its regulatory out, Consumers would be required to make these fixed energy payments to the MCV Partnership. The arbitration proceedings will also determine who is entitled to the fixed energy amounts for which Consumers did not receive full cost recovery during the years prior to settlement. As of December 31, 1993, these amounts total $26 million. Although Consumers intends to aggressively pursue its right to exercise the regulatory out, management cannot predict the outcome of the arbitration proceedings or any possible settlement of the matter. Accordingly, losses were recorded prior to 1993 for all fixed energy amounts at issue in the arbitration. In December 1993, Consumers made an irrevocable offer to pay through September 15, 2007, fixed energy charges to the MCV Partnership on all kWh delivered by the MCV Partnership to Consumers from the contract capacity in excess of 915 MW, which represents a portion of the fixed energy charges in dispute. Consumers made the offer to facilitate the sale of the remaining MCV Bonds in 1993. The lessors of the MCV Facility have filed a lawsuit in federal district court against CMS Energy, Consumers and CMS Holdings. It alleges breach of contract, breach of fiduciary duty and negligent or willful misrepresentation relating to the MCV Partnership's failure to object to the Settlement Order in light of Consumers' interpretation of the Settlement Order, which is the subject of an arbitration between the MCV Partnership and Consumers. The action alleges damages in excess of $1 billion and seeks injunctive relief relative to Consumers' payments of the fixed energy charge. CMS Energy and Consumers believe that at all times they and CMS Holdings have conducted themselves properly and that the action is without merit. They also believe that a significant portion of the alleged damages represent fixed energy charges in dispute in the arbitration. CMS Energy and Consumers are unable to predict the outcome of this action. For further information regarding power purchases from the MCV Partnership, see Note 3. PSCR Matters: Consumers began a planned refueling and maintenance outage at Palisades in June 1993. Following several required, unanticipated repairs that extended the outage, the plant returned to service in early November. Recovery of replacement power costs incurred by Consumers during the outage will be reviewed by the MPSC during the 1993 PSCR reconciliation of actual costs and revenues to determine the prudency of actions taken during the outage and any associated delays. Net replacement power costs were approximately $180,000 per day above the cost of fuel incurred when the plant is operating. The Energy Act imposes an obligation on the utility industry, including Consumers, to decommission DOE uranium enrichment facilities. Consumers currently estimates its payments for decommissioning those facilities to be $2.4 million per year for 15 years beginning in 1992, escalating based on an inflation factor. Consumers believes these costs are recoverable from its customers under traditional regulatory policies. Electric Rate Case: Consumers filed a request with the MPSC in May 1993 to increase its electric rates. Subsequently, as a result of changed estimates, Consumers revised its requested electric rate increase to $133 million annually based on a 1994 test year. Consumers also requested an additional annual electric rate increase of $38 million based on a 1995 test year. In March 1994, an ALJ issued a proposal for decision that recommended Consumers' 1994 final annual rate increase total approximately $83 million, and that the incremental requested 1995 increase not be granted at this time. The ALJ's recommendation included a lower return on electric common equity, reflected reduced anticipated debt costs due to the projected availability of more favorable interest rates and proposed a lower equity ratio for Consumers' projected capitalization structure. The ALJ did, however, generally support Consumers' rate design proposal to significantly reduce the level of subsidization of residential customers by commercial and industrial customers and generally supported a performance incentive which Consumers also supported. For further information, see Note 4. Electric Conservation Efforts In October 1993, Consumers completed the customer participation portion of several incentive-based DSM programs which were designed to encourage the efficient use of energy, primarily through conservation measures. Based on the MPSC's determination of Consumers' effectiveness in implementing these programs, Consumers' future rate of return on electric common equity may be adjusted either upward by up to one percent or downward by up to two percent, for one year following reconciliation hearings with the MPSC. Consumers believes it will receive an increase on its return on common equity based on having achieved all of the agreed upon objectives (see Note 4). Electric Capital Expenditures CMS Energy estimates capital expenditures, including DSM and new lease commitments, related to its electric utility operations of $396 million for 1994, $324 million for 1995 and $332 million for 1996. Electric Environmental Matters and Health Concerns The 1990 amendment of the federal Clean Air Act significantly increased the environmental constraints that utilities will operate under in the future. While the Clean Air Act's provisions will require Consumers to make certain capital expenditures in order to comply with the amendments for nitrogen oxide reductions, Consumers' generating units are presently operating at or near the sulfur dioxide emission limits which will be effective in the year 2000. Therefore, management believes that Consumers' annual operating costs will not be materially affected. In 1990, the State of Michigan passed amendments to the Environmental Response Act, under which Consumers expects that it will ultimately incur costs at a number of sites, even those in which it has a partial or no current ownership interest. It is expected that in most cases, parties other than Consumers with current or former ownership interests may also be considered liable under the law and may be required to share in the costs of any site investigations and remedial actions. CMS Energy and Consumers believe costs incurred for both investigation and any required remedial actions would be recoverable from electric utility customers under established regulatory policies and accordingly are not likely to materially affect their financial positions or results of operations. Consumers is a so-called "Potentially Responsible Party" at several sites being administered under Superfund. Along with Consumers, there are numerous credit-worthy, potentially responsible parties with substantial assets cooperating with respect to the individual sites. Based on information currently known by management, Consumers and CMS Energy believe that it is unlikely that their liability at any of the known Superfund sites, individually or in total, will have a material adverse effect on their financial positions or results of operations. Electric Outlook Consumers expects economic growth, competitive rates and other factors to increase the demand for electricity within its service territory by approximately 1.8 percent per year over the next five years. For the near term, Consumers currently plans a reserve margin of 20 percent and expects to fill the additional capacity required through long- and short-term power purchases. Long-term purchased power will likely be obtained through a competitive bidding solicitation process utilizing the framework established by the MPSC in 1992. Capacity from the MCV Facility above the levels authorized by the MPSC may be offered by Consumers in connection with the solicitation. A recent NRC review of Consumers' performance at Palisades showed a decline in performance. Management believes that an increased emphasis on internal assessments will improve performance at Palisades. To provide NRC senior management with a more in-depth assessment of plant performance, the NRC has initiated a diagnostic evaluation team inspection at Palisades. The inspection will be a broad-based evaluation of all aspects of nuclear plant operation and management which is expected to commence in March 1994, with results of the evaluation expected to be available in May 1994. The outcome of this evaluation cannot be predicted. Similar reviews conducted at nuclear plants of other utilities in recent years have in some cases resulted in increased regulatory oversight or required actions to improve plant operations, maintenance or condition. Consumers is currently collecting $45 million annually from electric retail customers for the future decommissioning of its two nuclear plants. Consumers believes these amounts will be adequate to meet current decommissioning cost estimates. For further information regarding nuclear decommissioning, see Note 2. Consumers' on-site storage pool at Palisades is at capacity, and it is unlikely that the DOE will begin accepting any spent nuclear fuel by the originally scheduled date in 1998. Consumers is using NRC-approved dry casks, which are steel and concrete vaults, for temporary storage. Several appeals relating to NRC approval of the casks are now pending at the U.S. Sixth Circuit Court of Appeals. If Consumers is unable to continue to use the casks as planned, significant costs, including replacement power costs during any resulting plant shutdown, could be incurred. Consumers has experienced an increase in complaints in 1993 relating primarily to the effect of so-called stray voltage on certain livestock. A complaint seeking certification as a class action suit has been filed against Consumers alleging significant damages, primarily related to certain livestock, which Consumers believes to be without merit (see Note 12). Some of Consumers' larger industrial customers are exploring the possibility of constructing and operating their own on-site generating facilities. Consumers is actively working with these customers to develop rate and service alternatives that are competitive with self-generation options. Although Consumers' electric rates are competitive with other regional utilities, Consumers has on file with the FERC two open access interconnection tariffs which could have the effect of increasing competition for wholesale customers. As part of its current electric rate case, Consumers has requested that the MPSC reduce the level of rate subsidization of residential customers by commercial and industrial customers so as to further improve rate competitiveness for its largest customers. The MPSC has completed a hearing on a proposal by ABATE to create an experimental retail wheeling tariff. Certain other parties have proposals in support of retail wheeling under development. In August 1993, an ALJ recommended that the MPSC reject the proposed experiment. An MPSC order is expected early in 1994. Gas Utility Operations Comparative Results of Operations Gas Pretax Operating Income: For 1993, pretax operating income increased $38 million compared to 1992, reflecting higher gas deliveries (both sales and transportation volumes) and more favorable regulatory recovery of gas costs related to transportation. During 1992, gas pretax operating income increased $45 million from the 1991 level, essentially for many of the same reasons as the current period. Gas Deliveries: Gas sales and gas transported in 1993 totaled 410.6 bcf, a 6.9 percent increase from 1992. In 1992, gas sales and gas transported totaled 384.1 bcf, a 6.1 percent increase from 1991 deliveries. Gas Utility Rates Consumers currently plans to file a request in 1994 with the MPSC to increase its gas rates. The request would include, among other things, costs for postretirement benefits computed under SFAS 106, Employers' Accounting for Postretirement Benefits Other than Pensions. A final order should be received approximately nine to twelve months after the request is filed. Certain of Consumers' direct gas suppliers have contract prices tied to the price Consumers pays Trunkline for its gas. The Trunkline contract covers gas deliveries through October 1994 and is at a price reduced in September 1993. Some of Consumers' direct gas suppliers have claimed that the reduced Trunkline gas cost is not a proper reference price under their contracts with Consumers and that their contracts are terminable after a 12-month period. Consumers is disputing these claims. In 1992, the FERC issued Order 636, which makes a number of significant changes to the structure of the services provided by interstate natural gas pipelines to be implemented by the 1993-94 winter heating season. Consumers is a significant purchaser of gas from an interstate pipeline (Trunkline) and is a major transportation customer of a number of pipelines. Management believes that Consumers will recover any transition costs it may incur and such restructuring will not have a significant impact on its financial position or results of operations. In July 1993, Michigan Gas Storage submitted a notice of rate change with the FERC to revise its operation and maintenance expenses for 1993 and update plant costs to reflect the addition of approximately $27 million of new plant additions in 1993 and began collecting the revised rates subject to refund and a hearing in February 1994. Hearings or settlement conferences will follow. For further information regarding gas utility rates, see Note 4. Gas Capital Expenditures CMS Energy estimates capital expenditures, including new lease commitments, related to its gas utility operations of $99 million for 1994, $88 million for 1995 and $81 million for 1996. Gas Environmental Matters Under the Environmental Response Act, Consumers expects that it will ultimately incur costs at a number of sites, including some of the 23 sites that formerly housed manufactured gas plant facilities, even those in which it has a partial or no current ownership interest. It is expected that in most cases, parties other than Consumers with current or former ownership interests may also be considered liable under the law and may be required to share in the costs of any site investigations and remedial actions. There is limited knowledge of manufactured gas plant contamination at these sites at this time. However, Consumers is continuing to monitor this issue. In addition, at the request of the DNR, Consumers prepared plans for remedial investigation/feasibility studies for three of these sites. Work plans for remedial investigation/feasibility studies for four other sites have also been prepared. The DNR has approved two of the three plans for remedial investigation/feasibility studies submitted and is currently reviewing the one remaining. Consumers currently estimates the total cost of conducting the three studies submitted to the DNR to be less than $1 million. The timing and extent of any further site investigation and remedial actions will depend, among other things, on requests received from the DNR and on future site usage by Consumers or other owners. Under the current schedule, Consumers anticipates the first remedial investigation/feasibility study would be completed in mid-1994. Consumers believes the results of the remedial investigation/feasibility studies will allow management to estimate a range of remedial cost estimates for the sites under study, which may be substantial. In 1993, the MPSC addressed the question of recovery of investigation and remedial costs for another Michigan gas utility as part of that utility's gas rate case. In that proceeding, the MPSC determined that prudent investigation and remedial costs could be deferred and amortized over 10-year periods and prudent unamortized costs can be included for recovery in the utility's rate cases. CMS Energy and Consumers believe costs incurred for both investigation and any required remedial actions would be recoverable from gas utility customers under established regulatory policies and accordingly are not likely to materially affect their financial positions or results of operations. Gas Outlook In 1993, Consumers purchased approximately 85 percent of its required gas supply under long-term contracts, and the balance on the spot market. Trunkline supplied approximately 41 percent of the total requirement. Consumers expects gas supply reliability to be ensured through long-term supply contracts, with purchases in the short-term spot market when economically beneficial. Management believes that Consumers' ability to purchase gas during the off-season and store it in its extensive underground storage facilities will continue to help provide customers with low-cost, competitive gas rates. Consumers anticipates growth in gas deliveries of approximately 0.6 percent per year over the next five years. Management believes that environmental benefits, along with the federal requirements included in the Energy Act, create an opportunity for growth in the natural gas vehicle industry. Oil and Gas Exploration and Production Pretax Operating Income 1993 pretax operating income decreased $4 million from 1992, primarily reflecting lower average market prices for oil and $10 million of international write-offs, partially offset by higher gas and oil sales volumes and higher average market prices for gas. 1992 pretax operating income decreased $7 million from 1991, primarily due to lower average market prices for oil, partially offset by increased oil and gas sales volumes. Capital Expenditures During 1993, CMS Energy's oil and gas exploration and production capital expenditures were $81 million. Most expenditures were made to develop existing proven reserves -- oil reserves in Ecuador which will start production in 1994 and Antrim Shale gas in northern Michigan. CMS Energy currently plans to invest $307 million over the next three years in its oil and gas exploration and production operations. These anticipated capital expenditures primarily reflect continued development of Ecuador oil and Antrim Shale gas and reserve acquisitions. International focus will remain on Latin America and the Pacific Rim region. Independent Power Production Pretax Operating Income 1993 pretax operating income increased $21 million, primarily reflecting the addition of new electric generating capacity and improved equity earnings and operating efficiencies. CMS Energy's ownership share of sales and revenues increased 24 percent and 18 percent, respectively, over the prior year. Capital Expenditures In 1993, capital expenditures were $110 million, including investments in unconsolidated subsidiaries. These expenditures were primarily used to obtain ownership interests in an additional 309 MW of owned operating capacity or a 40 percent increase from December 31, 1992. In April 1993, CMS Generation acquired a 50 percent interest in the Lyonsdale cogeneration plant, a 19 MW power plant in upstate New York. CMS Generation has invested $9 million in the project and additional investments relating to this project are expected to be immaterial. In May 1993, a consortium including CMS Generation purchased an 88 percent share in the 650 MW San Nicolas power plant near Buenos Aires, Argentina. As of December 31, 1993, CMS Generation's share of the consortium is 18.6 percent and it has provided notice to exercise its option to increase its share to 21 percent. The plant sells power under long-term contracts to two utilities and Argentina's electric grid system. CMS Generation has invested $21 million in the partnership through December 31, 1993 and plans to invest approximately $3 million in 1994 in exercising its option. In June 1993, CMS Generation was involved in the formation of Scudder Latin American Trust for Independent Power as a lead partner. The fund, which has investment commitments of $25 million from each of the four lead partners, will invest in electric generation and infrastructure resulting from the development of new power generating capacity. CMS Generation has contributed $.5 million through December 31, 1993 and estimates contributions of up to $11 million in 1994. In July 1993, an investment company including CMS Generation S. A. acquired the rights to a 59 percent ownership interest in two hydroelectric power plants on the Limay River in western Argentina. These plants have a total generating capacity of 1,320 MW. The remaining interest in the project is to be held 39 percent by the Argentine provincial government and 2 percent by the plant employees. CMS Generation S.A. has a 25 percent ownership interest in the investment company. The investment company secured a 30-year concession under a government privatization program and in August 1993, began operating these power plants. CMS Generation S.A. entered into letter of credit agreements to support the acquisition. As of December 31, 1993, CMS Energy had approximately $41 million of guarantees relating to this agreement which were reduced to less than $15 million in January 1994. CMS Generation has invested $64 million in equity and loans and plans to invest up to an additional $2 million in 1994. CMS Generation has a 50 percent ownership interest and has invested, through the Oxford/CMS Development Limited Partnership, $7 million in the Exeter waste tire-fueled/electric generation facility near Sterling, Connecticut. Based on a financial restructuring completed in 1993, CMS Generation may be obligated to invest up to an additional $2 million. The 26.5 MW Exeter facility has a capacity of processing 10 million waste tires per year and sells its capacity and energy to Connecticut Light and Power Company under a long-term agreement. Effective November 1, 1993, CMS Generation acquired a 50 percent ownership interest in an 18 MW wood waste-fueled electric generation facility located near Chateaugay, New York for approximately $5 million and became the operator March 1, 1994. The facility sells its entire electric output to New York State Electric and Gas Corporation under a long-term power purchase agreement. CMS Generation expects no additional investment relating to this project. CMS Energy currently plans to invest $281 million relating to its independent power production operations over the next three years, primarily in domestic and international subsidiaries and partnerships. CMS Generation is involved with partnerships that have signed power contracts to construct power plant facilities capable of producing a total of 885 MW of operating capacity in Michigan, Tamil Nadu, India, and two projects in Batangas, Philippines. CMS Generation will also pursue acquisitions in Latin America, southern Asia and the Pacific Rim region. Gas Transmission and Marketing Pretax Operating Income 1993 pretax operating income increased $2 million over 1992, reflecting earnings growth from existing and new gas transportation projects and increased natural gas marketed. In 1993, 60 bcf was marketed compared to 45 bcf in 1992. Capital Expenditures During 1993, CMS Energy's non-utility gas companies made capital expenditures of $14 million and formed two marketing partnerships which will provide natural gas marketing services throughout the Appalachian region of the United States and in Chicago and northern Illinois. In November 1993, CMS Gas Transmission acquired an existing $4 million gas gathering system in the Antrim Shale region of Michigan's Lower Peninsula, which was placed into service in December 1993. CMS Gas Transmission began an $11 million expansion of its carbon dioxide processing facility, with completion expected in March 1994. In December 1993, they signed a letter of intent to invest $18 million to acquire 50 percent ownership in an existing 5 bcf high deliverability salt cavern storage facility on the Gulf Coast of Texas. CMS Energy currently plans to invest $123 million over the next three years relating to its non-utility gas operations. These investments would reflect the significant expansion of certain northern Michigan gas pipeline and carbon dioxide removal plant facilities. It will continue to pursue development of natural gas storage, gas gathering and pipeline operations both domestically and internationally and work toward the development of a Midwest "market center" for natural gas through strategic alliances and asset acquisition and development. Other Other Income: The 1993 other income level reflects lower Midland-related losses than experienced in 1992. The 1992 loss included a $343 million charge related to the Settlement Order. The 1991 loss included $294 million related to an MPSC order received in 1991 that allowed Consumers to recover only $760 million of remaining abandoned Midland investment. Fixed Charges: Fixed charges for 1993 increased $22 million from 1992 and primarily reflect debt outstanding with higher rates of interest in 1993. The significant decrease in fixed charges in 1992 from 1991 primarily reflects Consumers' program aimed at significantly reducing its debt and the refinancing of debt at lower interest rates. Public Utility Holding Company Act Exemption: CMS Energy is exempt from registration under PUHCA. However, the Attorney General and the MMCG have asked the SEC to revoke CMS Energy's exemption from registration under PUHCA. On April 15, 1992, the MPSC filed a statement with the SEC recommending that CMS Energy's current exemption be revoked and a new exemption be issued conditioned upon certain reporting and operating requirements. If CMS Energy were to lose its current exemption, it would become more heavily regulated by the SEC; Consumers could ultimately be forced to divest either its electric or gas utility business; and CMS Energy would be restricted from conducting businesses that are not functionally related to the conduct of its utility business as determined by the SEC. CMS Energy is opposing this request and believes it will maintain its current exemption from registration under PUHCA. CMS Energy Corporation Notes to Consolidated Financial Statements 1: Corporate Structure CMS Energy is the parent holding company of Consumers and Enterprises. Consumers, a combination electric and gas utility company serving most of the Lower Peninsula of Michigan, is the principal subsidiary of CMS Energy. Consumers' customer base includes a mix of residential, commercial and diversified industrial customers, the largest of which is the automotive industry. Enterprises is engaged in several non-utility energy-related businesses including: 1) oil and gas exploration and production, 2) development and operation of independent power production facilities, 3) gas marketing services to utility, commercial and industrial customers, and 4) transmission and storage of natural gas. 2: Summary of Significant Accounting Policies and Other Matters Basis of Presentation The consolidated financial statements include CMS Energy, Consumers and Enterprises and their wholly owned subsidiaries. CMS Energy eliminates all material transactions between its consolidated companies. CMS Energy uses the equity method of accounting for investments in its companies and partnerships where it has more than a 20 percent but less than a majority ownership interest and includes these results in operating revenue. For the years ended December 31, 1993, 1992 and 1991 equity earnings (losses) were $17 million, $(6) million, and $(8) million, respectively. Gas Inventory Consumers uses the weighted average cost method for valuing working gas inventory. Cushion gas, which is gas stored to maintain reservoir pressure for recovery of working gas, is recorded in the appropriate gas utility plant account. Consumers stores gas inventory in its underground storage facilities. Maintenance, Depreciation and Depletion Property repairs and minor property replacements are charged to maintenance expense. Depreciable property retired or sold plus cost of removal (net of salvage credits) is charged to accumulated depreciation. Consumers bases depreciation provisions for utility plant on straight-line and units-of-production rates approved by the MPSC. In May 1991, the MPSC approved an increase of approximately $15 million annually in Consumers' electric and common utility plant depreciation rates. The composite depreciation rate for electric utility property was 3.4 percent for 1993 and 1992 and 3.3 percent for 1991. The composite rate for gas utility plant was 4.4 percent for 1993 and 4.3 percent for 1992 and 1991. NOMECO follows the full-cost method of accounting and, accordingly, capitalizes its exploration and development costs, including the cost of non-productive drilling and surrendered acreage, on a country-by-country basis. The capitalized costs in each cost center are being amortized on an overall units-of-production method based on total estimated proven oil and gas reserves. The composite rates for Consumers' common property, NOMECO's other property, and other property of CMS Energy and its subsidiaries were 4.5 percent in 1993, 4.7 percent in 1992 and 4.1 percent in 1991. New Accounting Standards In November 1992, the FASB issued SFAS 112, Employers' Accounting for Postemployment Benefits, which CMS Energy adopted January 1, 1994. CMS Energy pays for several postemployment benefits, the most significant being workers compensation. Because CMS Energy's postemployment benefit plans do not vest or accumulate, the standard did not materially impact CMS Energy's financial position or results of operations. For new accounting standards related to financial instruments, see Note 8. Nuclear Fuel, Decommissioning and Other Nuclear Matters Consumers amortizes nuclear fuel cost to fuel expense based on the quantity of heat produced for electric generation. Interest on leased nuclear fuel is expensed as incurred. Under federal law, the DOE is responsible for permanent disposal of spent nuclear fuel at costs to be paid by affected utilities under various payment options. However, in a statement released February 17, 1994, the DOE asserted that it does not have a legal obligation to accept spent nuclear fuel without an operational repository. The DOE is exploring options to offset the costs incurred by nuclear utilities in continuing to store spent nuclear fuel on site. For fuel burned after April 6, 1983, Consumers charges disposal costs to nuclear fuel expense, recovers it through electric rates and remits it to the DOE quarterly. Consumers has elected to defer payment for disposal of spent nuclear fuel burned before April 7, 1983 until the spent fuel is delivered to the DOE. As of December 31, 1993, Consumers has recorded a liability to the DOE of $90 million, including interest, to dispose of spent nuclear fuel burned before April 7, 1983. Consumers has been recovering through electric rates the amount of this liability, excluding a portion of interest. Consumers' liability to the DOE becomes due when the DOE takes possession of Consumers' spent nuclear fuel, which was originally scheduled to occur in 1998. In April 1993, the NRC approved the design of the dry spent fuel storage casks now being used by Consumers at Palisades. In May 1993, the Attorney General and certain other parties commenced litigation to block Consumers' use of the storage casks, alleging that the NRC had failed to comply adequately with the National Environmental Policy Act. As of mid- February 1994, the courts have declined to prevent such use and have refused to issue temporary restraining orders or stays. Several appeals relating to this matter are now pending at the U.S. Sixth Circuit Court of Appeals. Consumers loaded two dry storage casks with spent nuclear fuel in 1993 and expects to load additional casks in 1994 prior to Palisades' 1995 refueling. If Consumers is unable to continue to use the casks as planned, significant costs, including replacement power costs during any resulting plant shutdown, could be incurred. Consumers currently estimates decommissioning costs (decontamination and dismantlement) of $208 million and $399 million, in 1993 dollars, for the Big Rock Point and Palisades nuclear plants, respectively. At December 31, 1993, Consumers had recorded $171 million of decommissioning costs and classified the obligation as accumulated depreciation. In January 1987, Consumers began collecting estimated costs to decommission its two nuclear plants through a monthly surcharge to electric customers which currently totals $45 million annually. Consumers expects to file updated decommissioning estimates with the MPSC on or before March 31, 1995. Amounts collected from electric retail customers are deposited in trust. Trust earnings are recorded as an investment with a corresponding credit included in accumulated depreciation. The total amount of the trust will be available for decommissioning Big Rock Point and Palisades at the end of their respective license periods in 2000 and 2007. Consumers believes the amounts being collected are adequate to meet its currently estimated decommissioning costs and current NRC requirements. In November 1993, Palisades returned to service following a planned refueling and maintenance outage that had been extended due to several unanticipated repairs. The results of an NRC review of Consumers' performance at Palisades published shortly thereafter showed a decline in performance ratings for the plant. Management believes that an increased emphasis on internal assessments will improve performance at Palisades. In order to provide NRC senior management with a more in-depth assessment of plant performance, the NRC has initiated a diagnostic evaluation team inspection at Palisades. The inspection will be a broad-based evaluation of all aspects of nuclear plant operation and management. The evaluation is expected to commence in March 1994, with results of the evaluation expected to be available in May 1994. The outcome of this evaluation cannot be predicted. Similar reviews conducted at nuclear plants of other utilities in recent years have in some cases resulted in increased regulatory oversight or required actions to improve plant operations, maintenance or condition. Plateau Resources Ltd. In August 1993, Consumers sold its ownership interest in Plateau to U. S. Energy Corp. As a result of the sale, approximately $14 million of Plateau's cash and cash equivalents, other assets and liabilities, including certain future decommissioning, environmental and other contingent liabilities were transferred to U. S. Energy Corp. In view of prior write-offs, this transaction did not result in any material gains or additional losses. Reclassifications CMS Energy and the MCV Partnership (see Note 16) have reclassified certain prior year amounts for comparative purposes. These reclassifications did not affect the net losses for the years presented. Related-Party Transactions In 1993, 1992, and 1991, Consumers purchased $52 million, $36 million and $26 million, respectively, of electric generating capacity and energy from affiliates of Enterprises. Affiliates of CMS Energy sold, stored and transported natural gas and provided other services to the MCV Partnership totaling approximately $27 million, $21 million and $19 million for 1993, 1992 and 1991, respectively. For additional discussion of related-party transactions with the MCV Partnership and the FMLP, see Notes 3 and 16. Other related-party transactions are immaterial. Revenue and Fuel Costs Consumers accrues revenue for electricity and gas used by its customers but not billed at the end of an accounting period. Consumers also accrues or reduces revenue for any underrecovery or overrecovery of electric power supply costs and natural gas costs by establishing a corresponding asset or liability until Consumers bills these unrecovered costs or refunds the excess recoveries to customers after reconciliation hearings conducted before the MPSC. Utility Regulation Consumers accounts for the effects of regulation under SFAS 71, Accounting for the Effects of Certain Types of Regulation. As a result, the actions of regulators affect when revenues, expenses, assets and liabilities are recognized. Other For significant accounting policies regarding cash equivalents, see Note 14; for income taxes, see Note 5; and for pensions and other postretirement benefits, see Note 10. 3: The Midland Cogeneration Venture The MCV Partnership, which leases and operates the MCV Facility, contracted to supply electricity and steam to The Dow Chemical Company and to sell electricity to Consumers for a 35-year period beginning in March 1990. At December 31, 1993, Consumers, through its subsidiaries, held the following assets related to the MCV: 1) CMS Midland owned a 49 percent general partnership interest in the MCV Partnership; and 2) CMS Holdings held through the FMLP a 35 percent lessor interest in the MCV Facility. In late 1993, Consumers sold its remaining $309 million investment in the MCV Bonds. Power Purchases from the MCV Partnership Consumers is obligated to purchase the following amounts of contract capacity from the MCV Partnership under the PPA: 1995 and Year 1991 1992 1993 1994 thereafter - ---- ----- ----- ----- ----- ---------- MW 806 915 1,023 1,132 1,240 During 1992 and 1991, the MPSC only allowed Consumers to recover costs of power purchased from the MCV Partnership based on delivered energy at rates less than Consumers paid for 840 MW in 1992 and 806 MW in 1991. As a result, Consumers recorded after-tax losses of $86 million in 1992 and $124 million in 1991. On March 31, 1993, the MPSC approved, with modifications, the Revised Settlement Proposal which had been co-sponsored by Consumers, the MPSC staff and 10 small power and cogeneration developers. These parties accepted the Settlement Order and the MCV Partnership confirmed that it did not object to its terms. ABATE and the Attorney General have filed claims of appeal of the Settlement Order with the Court of Appeals. The Settlement Order determined the cost of power purchased from the MCV Partnership that Consumers can recover from its electric retail customers and will significantly reduce the amount of future underrecoveries for these power costs. Effective January 1, 1993, the Settlement Order allowed Consumers to recover substantially all of the payments for its on- going purchase of 915 MW of contract capacity from the MCV Partnership. Capacity and energy purchases from the MCV Partnership above the 915 MW level can be competitively bid into Consumers' next solicitation for power or, if necessary, utilized for current power needs with a prudency review and a pricing recovery determination in annual PSCR cases. In either instance, the MPSC would determine the levels of recovery from customers for the power purchased. The Settlement Order also provides Consumers the right to remarket all of the remaining capacity to third parties. The PPA requires Consumers to pay a minimum levelized average capacity charge of 3.77 cents per kWh, a fixed energy charge and a variable energy charge based primarily on Consumers' average cost of coal consumed. The Settlement Order provided Consumers two options for the recovery that could be used for capacity charges paid to the MCV Partnership. Under the option selected, Consumers is scheduling deliveries of energy from the MCV Partnership whenever it has energy available up to hourly availability limits, or "caps," for the 915 MW of capacity authorized for recovery in the Settlement Order. Consumers can recover an average 3.62 cents per kWh capacity charge and the prescribed energy charges associated with the scheduled deliveries within the caps, whether or not those deliveries are scheduled on an economic basis. Through December 31, 1997, there is no cap applied during on-peak hours to Consumers' recovery for the purchase of capacity made available within the 915 MW authorized. Recovery for purchases during off-peak hours is capped at 80 percent in 1993, 82 percent in 1994 and 1995, 84 percent in 1996 and 1997, increasing to 88.7 percent in 1998 and thereafter at which time the 88.7 percent cap is applicable during all hours. For all economic energy deliveries above the caps to 915 MW, the option also allows Consumers to recover 1/2 cent per kWh capacity payment in addition to the corresponding energy charge. In December 1992, Consumers recognized an after-tax loss of $343 million for the present value of estimated future underrecoveries of power costs under the PPA as a result of the Settlement Order. This loss included management's best estimates regarding the future availability of the MCV Facility, and the effect of the future wholesale power market on the amount, timing and price at which various increments of the capacity above the MPSC-authorized level could be resold. Except for adjustments to the above loss to reflect the after-tax time value of money through accretion expense, no additional losses are expected unless actual future experience materially differs from management's estimates. Because the calculation of the 1992 loss depended in part upon estimates of future unregulated sales of energy to third parties, a more conservative or risk-free investment rate of 7 percent was used to calculate $188 million of the total $343 million after-tax loss. The remaining portion of the loss was calculated using an 8.5 percent discount rate reflecting Consumers' incremental borrowing rate as required by SFAS 90, Regulated Enterprises- Accounting for Abandonments and Disallowances of Plant Costs. The after- tax expense for the time value of money for the loss is estimated to be approximately $24 million in 1994, and various lower levels thereafter, including $22 million in 1995 and $20 million in 1996. Although the settlement losses were recorded in 1992, the after-tax cash underrecoveries, including fixed energy charges, associated with the Settlement Order were $59 million in 1993. Consumers believes there is and will be a market for the resale of capacity purchases from the MCV Partnership above the MPSC-authorized level. However, if Consumers is unable to sell any capacity above the current MPSC-authorized level, future additional after-tax losses and after-tax cash underrecoveries could be incurred. Consumers' estimates of its future after-tax cash underrecoveries and possible additional losses for the next five years if none of the additional capacity is sold are as follows: After-tax, In Millions 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- Expected cash underrecoveries $56 $65 $62 $61 $ 8 Possible additional under- recoveries and losses (a) $14 $20 $20 $22 $72 (a) If unable to sell any capacity above the MPSC's authorized level. The undiscounted, after-tax amount of the $343 million loss was $789 million. At December 31, 1993, the after-tax present value of the Settlement Order liability had been reduced to $307 million, which reflects after-tax cash underrecoveries related to capacity totaling $(54) million, after-tax accretion expense of $23 million and a $(5) million adjustment due to the 1993 corporate tax rate change (see Note 5). The PPA, while requiring payment of a fixed energy charge, contains a "regulatory out" provision which permits Consumers to reduce the fixed energy charges payable to the MCV Partnership throughout the entire contract term if Consumers is not able to recover these amounts from its customers. In connection with the MPSC's approval of the Revised Settlement Proposal, Consumers and the MCV Partnership have commenced arbitration proceedings under the PPA to determine whether Consumers is entitled to exercise its regulatory out regarding fixed energy charges on the portion of available MCV capacity above the current MPSC-authorized levels. An arbitrator acceptable to both parties has been selected. If the arbitrator determines that Consumers cannot exercise its regulatory out, Consumers would be required to make these fixed energy payments to the MCV Partnership even though Consumers may not be recovering these costs. The arbitration proceedings will also determine who is entitled to the fixed energy amounts for which Consumers did not receive full cost recovery during the years prior to settlement. Although Consumers believes its position on arbitration is sound and intends to aggressively pursue its right to exercise the regulatory out, management cannot predict the outcome of the arbitration proceedings or any possible settlement of the matter. Accordingly, losses were recorded prior to 1993 for all fixed energy amounts at issue in the arbitration. As of December 31, 1993, approximately $20 million has been escrowed by Consumers and is included in Consumers' temporary cash investments. In December 1993, Consumers made an irrevocable offer to pay through September 15, 2007, fixed energy charges to the MCV Partnership on all kWh delivered by the MCV Partnership to Consumers from the contract capacity in excess of 915 MW, which represents a portion of the fixed energy charges in dispute. Consumers made the offer to facilitate the sale of the remaining MCV Bonds in 1993. The lessors of the MCV Facility have filed a lawsuit in federal district court against CMS Energy, Consumers and CMS Holdings. It alleges breach of contract, breach of fiduciary duty and negligent or willful misrepresentation relating to the MCV Partnership's failure to object to the Settlement Order in light of Consumers' interpretation of the Settlement Order, which is the subject of an arbitration between the MCV Partnership and Consumers. The action alleges damages in excess of $1 billion and seeks injunctive relief relative to Consumers' payments of the fixed energy charge. CMS Energy and Consumers believe that at all times they and CMS Holdings have conducted themselves properly and that the action is without merit. They also believe that a significant portion of the alleged damages represent fixed energy charges in dispute in the arbitration. CMS Energy and Consumers are unable to predict the outcome of this action. PSCR Matters: Consistent with the terms of the Settlement Order, Consumers has withdrawn its appeals of various MPSC orders issued in connection with the 1992, 1991 and 1990 PSCR cases. Consumers also agreed not to appeal any MCV-related issues raised in future orders for these plan cases and related reconciliations to the extent those issues are resolved by the Settlement Order. Consumers made refunds, including interest, of $69 million in 1993 and $29 million in 1992 to customers for overrecoveries in connection with the 1991 and 1990 PSCR reconciliation cases, respectively. These amounts were included in losses recorded prior to 1993. In 1992, Consumers recovered MCV power purchase costs consistent with the MPSC's 1992 plan case order, and does not anticipate that any MCV-related refunds will be required. 4: Rate Matters Electric Rate Case Consumers filed a request with the MPSC in May 1993 to increase its electric rates. Subsequently, as a result of changed estimates, Consumers revised its requested electric rate increase to $133 million annually based on a 1994 test year. Consumers also requested an additional annual electric rate increase of $38 million based on a 1995 test year. Consumers' request included increased future expenditures primarily related to capital additions, DSM programs, operation and maintenance, higher depreciation and postretirement benefits computed under SFAS 106, Employers' Accounting for Postretirement Benefits Other than Pensions. The filing also proposed experimental incentive provisions that would either reward or penalize Consumers, based on its operating performance. In addition, Consumers would share any returns above its MPSC-authorized level with customers in exchange for the ability to earn not lower than one percentage point below its authorized level. In March 1994, an ALJ issued a proposal for decision that recommended Consumers' 1994 final annual rate increase total approximately $83 million, and that the incremental requested 1995 increase not be granted at this time. The ALJ's recommendation included a lower return on electric common equity, reflected reduced anticipated debt costs due to the projected availability of more favorable interest rates and proposed a lower equity ratio for Consumers' projected capitalization structure. The ALJ did, however, generally support Consumers' rate design proposal to significantly reduce the level of subsidization of residential customers by commercial and industrial customers and generally supported the performance incentive but not the shared return mechanism discussed above. Abandoned Midland Project: In July 1984, Consumers abandoned construction of its unfinished nuclear power plant located in Midland, Michigan, and subsequently took a series of write-downs. In May 1991, Consumers began collecting $35 million pretax annually for the next 10 years and is amortizing the assets against current income over the recovery period using an interest method. Amortization for 1993, 1992 and 1991 was $28 million, $28 million and $18 million, respectively. Consumers was not permitted to earn a return on the portion of the abandoned Midland investment for which the MPSC was allowing recovery. Therefore, under SFAS 90, the recorded losses described above included amounts that reduced the recoverable asset to the present value of future recoveries. During the remaining recovery period, part of the prior losses will be reversed to adjust the unrecovered asset to its present value and is reflected as accretion income. An after-tax total of approximately $35 million of the prior losses remains to be included in accretion income through April 2001. Several parties, including the Attorney General, have filed claims of appeal with the Court of Appeals regarding MPSC orders issued in May and July 1991 that specified the recovery of abandoned investment. Electric DSM: As a result of settlement discussions regarding DSM and an MPSC order in July 1991, Consumers agreed to spend $65 million over two years on DSM programs. Based on the MPSC's determination of Consumers' effectiveness in implementing these programs, Consumers' future rate of return on common equity may be adjusted either upward by up to 1 percent or downward by up to 2 percent. This adjustment, if implemented, would be applied to Consumers' retail electric tariff rates and be in effect for one year following reconciliation hearings with the MPSC that are expected to be initiated in the first quarter of 1994. The estimated revenue effects of the potential adjustment range from an $11 million increase to a $22 million decrease. Consumers believes it will receive an increase on its return on common equity. On October 1, 1993, Consumers completed the customer participation portion of these programs and as part of its current electric rate case has requested MPSC authorization to continue certain programs in 1994. Consumers has also requested recovery of DSM expenditures which exceeded the $65 million level. Consumers is deferring program costs and amortizing the costs over the period these costs are being recovered from its customers in accordance with an accounting order issued by the MPSC in September 1992. The unamortized balance of deferred costs at December 31, 1993 and 1992 was $71 million and $25 million, respectively. PSCR Issues Consumers began a planned refueling and maintenance outage at Palisades in June 1993. Following several required, unanticipated repairs that extended the outage, the plant returned to service in early November. Recovery of replacement power costs incurred by Consumers during the outage will be reviewed by the MPSC during the 1993 PSCR reconciliation of actual costs and revenues to determine the prudency of actions taken during the outage. Any finding of delay due to imprudence could result in disallowances of a portion of replacement power costs. Net replacement power costs were approximately $180,000 per day above the cost of fuel incurred when the plant is operating. The Energy Act imposes an obligation on the utility industry, including Consumers, to decommission DOE uranium enrichment facilities. Consumers currently estimates its payments for decommissioning those facilities to be $2.4 million per year for 15 years beginning in 1992, escalating based on an inflation factor. Consumers believes these costs are recoverable from its customers under traditional regulatory policies. As of December 31, 1993, Consumers' remaining estimated liability was approximately $34 million. Consumers has a regulatory asset of $34 million for the expected recovery of this amount in electric rates. GCR Issues In connection with its 1991 GCR reconciliation case, Consumers refunded $36 million, including interest, to its firm sales and transportation rate customers in April 1992. Consumers accrued the full amount for this refund in 1991. The MPSC issued an order during 1993 that approved an interim settlement agreement for the 12 months ended March 31, 1993. As a result of the settlement, Consumers refunded in August 1993, to its GCR and transportation customers, approximately $22 million, including interest. Consumers previously accrued amounts sufficient for this refund. The MPSC, in a February 1993 order, provided that the price payable to certain intrastate gas producers by Consumers be reduced prospectively. As a result, Consumers was not allowed to recover approximately $13 million of costs incurred prior to February 8, 1993. In 1991, Consumers accrued a loss sufficient for this issue. Future disallowances are not anticipated, unless the remaining appeals filed by the intrastate producers are successful. In 1992, the FERC approved a settlement involving Consumers, Trunkline and certain other parties, which resolved numerous claims and proceedings concerning Trunkline liquified natural gas costs. The settlement represents significant gas cost savings for Consumers and its customers in future years. As part of the settlement, Consumers will not incur any transition costs from Trunkline as a result of FERC Order 636. In November 1992, Consumers had recorded a liability and regulatory asset for the principal amount of payments to Trunkline over a five-year period and a regulatory asset. On May 11, 1993, the MPSC approved a separate settlement agreement that provides Consumers with full recovery of these costs over a five-year period. At December 31, 1993, Consumers' remaining liability and regulatory asset was $116 million. Other Certain of Consumers' direct gas suppliers have contract prices tied to the price Consumers pays Trunkline for its gas. On September 1, 1993, Consumers commenced gas purchases from Trunkline under a continuation of prior sales agreements. The current contract covers gas deliveries through October 1994 and is at a reduced price compared to prior gas sales. Some of Consumers' direct gas suppliers have claimed that the reduced Trunkline gas cost is not a proper reference price under their contracts with Consumers and that their contracts are terminable after a 12-month period. Consumers is disputing these claims. Additionally, three of these direct gas suppliers of Consumers have made filings with the FERC in Trunkline's Order 636 restructuring case seeking to preclude Trunkline's ability to make the sales to Consumers which commenced on September 1, 1993. Consumers and Trunkline vigorously opposed these filings and in December 1993, the FERC issued an order which, among other things, allowed Trunkline to continue sales of gas to Consumers under tariffs on file with the FERC. Estimated losses for certain contingencies discussed in this note have been accrued. Resolution of these contingencies is not expected to have a material impact on the financial statements. 5: Income Taxes CMS Energy and its subsidiaries (including Consumers) file a consolidated federal income tax return. Income taxes are generally allocated to each subsidiary based on each subsidiary's separate taxable income. In 1992, CMS Energy implemented SFAS 109, Accounting for Income Taxes. Deferred tax assets and liabilities are classified as current or noncurrent based on the classification of the related asset or liability, for all temporary differences. Consumers began practicing full deferred tax accounting for temporary differences arising after January 1, 1993 as authorized by a generic MPSC order. The generic order reduces the amount of regulatory assets and liabilities that otherwise could have arisen in future periods by allowing Consumers to reflect the income statement effect in the period temporary differences arise. CMS Energy uses ITC to reduce current income taxes payable and defers and amortizes ITC over the life of the related property. The AMT requires taxpayers to perform a second separate federal tax calculation based on a flat rate applied to a broader tax base. AMT is the amount by which this "broader-based" tax exceeds regular tax. Any AMT paid generally becomes a tax credit that can be carried forward indefinitely to reduce regular tax liabilities in future periods when regular taxes paid exceed the tax calculated for AMT. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 increased the statutory federal tax rate from 34 percent to 35 percent effective January 1, 1993. The cumulative effect of this tax rate change has been reflected in CMS Energy's financial statements. The significant components of income tax expense (benefit) consisted of: In Millions Years Ended December 31 1993 1992 1991(a) - ----------------------- ------- ------ -------- Current federal income taxes $ 19 $ 39 $ 13 Deferred income taxes 67 (177) (143) Deferred income taxes - tax rate change (1) - - Deferred ITC, net (10) (8) 36 ------- ------ ------ $ 75 $(146) $ (94) ======= ====== ====== Operating $ 92 $ 22 $ 25 Other (17) (168) (119) ------- ------ ------ $ 75 $(146) $ (94) ======= ====== ====== (a) The 1991 provision for income taxes was before an extraordinary item that had related deferred income taxes of approximately $7 million. The principal components of CMS Energy's deferred tax assets (liabilities) recognized in the balance sheet are as follows: In Millions December 31 1993 1992 - ----------- ------- -------- Property $(580) $ (521) Unconsolidated investments (194) (128) Postretirement benefits (Note 10) (180) (167) Abandoned Midland project (Note 4) (57) (60) Employee benefit obligations (includes postretirement benefits of $182 and $168) (Note 10) 204 189 MCV power purchases - settlement (Note 3) 165 177 AMT carryforward 110 83 ITC carryforward (expires 2005) 48 52 Other (8) 5 ------- -------- $ (492) $ (370) ======== ======== Gross deferred tax liabilities $(1,571) $(1,416) Gross deferred tax assets 1,079 1,046 -------- -------- $ (492) $ (370) ======== ======== The actual income tax expense (benefit) differs from the amount computed by applying the statutory federal tax rate to income before income taxes as follows: In Millions Years Ended December 31 1993 1992 1991 ------- ------- ------- Net income (loss) before preferred dividends and extraordinary item $ 166 $(286) $(252) Income tax expense (benefit) 75 (146) (94) ------- ------- ------- 241 (432) (346) Statutory federal income tax rate x 35% x 34% x 34% -------- ------- ------- Expected income tax expense (benefit) 84 (147) (118) Increase (decrease) in taxes from: Capitalized overheads previously flowed through 5 5 35 Differences in book and tax depreciation not previously deferred 6 9 8 ITC amortization and utilization (12) (11) (9) Other, net (8) (2) (10) ------- ------- ------- $ 75 $ (146) $(94) ======= ======= ======= 6: Short-Term Financings Consumers has authorization from the FERC to issue or guarantee up to $900 million of short-term debt through December 31, 1994. Consumers has a $470 million facility that is used to finance seasonal working capital requirements and unsecured, committed lines of credit aggregating $165 million. As of December 31, 1993, $235 million and $24 million were outstanding at weighted average interest rates of 4.0 percent and 3.9 percent, respectively. Further, Consumers has an established $500 million trade receivables purchase and sale program. As of December 31, 1993 and 1992, receivables sold under the agreement totaled $285 million and $225 million, respectively. On February 15, 1994, Consumers increased the level of receivables sold to $335 million. 7: Capitalization CMS Energy Capital Stock: CMS Energy's Articles permit it to issue up to 250 million shares of common stock at $.01 par value and up to 5 million shares of preferred stock at $.01 par value. Under its two and one-half year Secured Credit Facility and Indenture pursuant to which the Notes are issued, CMS Energy is permitted to pay as dividends on its common stock an amount not to exceed the total of its net income and any proceeds received from the issuance or sale of common stock as defined in the Indentures and $40 million, provided there exists no event of default under the terms of the Secured Credit Facility or Indentures. The same formula applies to limits available to repurchase or reacquire CMS Energy stock for either the payment of dividends or repurchase of stock. In October 1993, CMS Energy issued an additional 4.6 million shares of common stock at a price of $26 5/8. The net proceeds of $119 million were used to reduce existing debt and for general corporate purposes. Long-Term Debt: In October 1992, CMS Energy received proceeds of $130 million and $219 million from the issuance of Series A and Series B Notes, respectively. Interest will accrue and increase the principal to the face value of $172 million for the Series A Notes and $294 million for the Series B Notes through October 1, 1995. After such date, interest will be paid semi-annually commencing April 1, 1996, at a rate of 9.5 percent per annum for the Series A Notes and 9.875 percent per annum for the Series B Notes. In November 1992, CMS Energy entered into a $220 million Secured Credit Facility. As of December 31, 1993, $18 million was outstanding at a weighted average interest rate of 5.7 percent. The Notes and Secured Credit Facility are secured by a pledge of stock of Consumers, Enterprises, and NOMECO. Additionally, under the terms of the Secured Credit Facility, CMS Energy may only have outstanding, at any one time, an aggregate of $130 million of unsecured debt except for debt issued to refinance existing debt. The establishment of the Secured Credit Facility and the proceeds from the Notes, net of underwriting expenses, were used to retire the $410 million one-year secured revolving credit facility. CMS Energy filed a shelf registration statement with the SEC in January 1994 covering the issuance of up to $250 million of unsecured debt securities. The net proceeds will be used to reduce the amount of CMS Energy Notes outstanding and for general corporate purposes. The unsecured debt securities may be offered from time to time on terms to be determined at the time of the sale. Consumers Capital Stock: As of December 31, 1992, Consumers effected a quasi- reorganization, an elective accounting procedure in which Consumers' accumulated deficit of $574 million was eliminated against other paid-in capital. This action had no effect on CMS Energy's consolidated financial statements. As a result of the quasi-reorganization and subsequent accumulated earnings, Consumers paid $133 million in common stock dividends in 1993 and also declared from 1993 earnings a $16 million common stock dividend in January 1994. Consumers has authorization from the MPSC and is proceeding to issue $200 million of preferred stock in 1994. First Mortgage Bonds: Consumers secures its first mortgage bonds by a mortgage and lien on substantially all of its property. Consumers' ability to issue and sell securities is restricted by certain provisions in its First Mortgage Bond Indenture, Articles and the need for regulatory approvals in compliance with appropriate state and federal law. In September 1993, Consumers issued, with MPSC approval, $300 million of 6 3/8 percent first mortgage bonds, due 2003 and $300 million of 7 3/8 percent first mortgage bonds, due 2023. Consumers used the net proceeds from the bond issuance to refund approximately $515 million of higher interest first mortgage bonds and the balance to reduce short-term borrowings. Unamortized debt costs, premiums and discounts and call premiums on the refunded debt totaling approximately $18 million were deferred under SFAS 71, and are being amortized over the lives of the new debt. In February 1994, Consumers issued a call for redemption totaling approximately $10 million. Consumers also fully redeemed two issues of first mortgage bonds totaling approximately $91 million. These redemptions completed Consumers' commitment to the MPSC, under the 1993 authorization to issue first mortgage bonds, to refinance certain long- term debt. Long-Term Bank Debt: Under its long-term credit agreement at December 31, 1993, Consumers was required to make 10 remaining quarterly principal payments of approximately $47 million. As of December 31, 1993, the outstanding balance under this credit agreement totaled $469 million with a weighted average interest rate of 4.0 percent. In January 1993, Consumers entered into an interest rate swap agreement, exchanging variable-rate interest for fixed-rate interest on the latest maturing $250 million of the then remaining $500 million obligation under its long-term credit agreement. Other: Consumers has a total of $131 million of PCRBs outstanding with a weighted average interest rate of 4.2 percent as of December 31, 1993. Consumers classifies $101 million of PCRBs as long-term because it can refinance these amounts through irrevocable letters of credit expiring after one year. In June 1993, Consumers entered into loan agreements in connection with the issuance of approximately $28 million of adjustable rate demand limited obligation refunding revenue bonds, due 2010, which are secured by an irrevocable letter of credit expiring in 1996. These bonds bear an initial interest rate of 2.65 percent. Consumers also entered into loan agreements in connection with the issuance of $30 million of 5.8 percent limited obligation refunding revenue bonds, due 2010, secured by a financial guaranty insurance policy and certain first mortgage bonds of Consumers. Proceeds of these issues were used to redeem on August 1, 1993 in advance of their maturities, approximately $58 million of outstanding PCRBs. NOMECO As of December 31, 1993, NOMECO had total debt outstanding of $122 million. Senior serial notes amounting to $45 million with a weighted average interest rate of 9.4 percent are outstanding from a private placement. In November 1993, NOMECO amended the terms of its revolving credit agreement and increased the amount to $110 million. At December 31, 1993, $72 million was outstanding at a weighted average interest rate of 4.7 percent. NOMECO also has $5 million outstanding under other credit agreements. Enterprises As of December 31, 1993, MOAPA had $22 million of Clark County, Nevada, tax-exempt bonds outstanding with an interest rate of 3.35%. These bonds are backed by a letter of credit guaranteed by CMS Energy. If the letter of credit is not extended past its current expiration date of June 1, 1994, the bonds could be redeemed with the funds held in a trust account. These funds are invested in certificates of deposits and included in other noncurrent assets. The bonds were issued in 1990 for the purpose of providing partial funding for the development of a tires-to-energy solid waste disposal and resource recovery facility. In December 1993, the Nevada Public Service Commission rejected the power purchase agreement between MOAPA and the Nevada Power Company and subsequently rejected MOAPA's motion for rehearing. 8: Financial Instruments Cash, short-term investments and current liabilities approximate their fair value due to the short-term nature of those instruments. The estimated fair value of long-term investments is based on quoted market prices where available. When specific market prices do not exist for an instrument, the fair value is based on quoted market prices of similar investments or other valuation techniques. All long-term investments in financial instruments approximate fair value. The carrying amount of long-term debt was $2.4 billion and $2.7 billion and the fair value of long-term debt was $2.6 billion and $2.8 million as of December 31, 1993 and 1992, respectively. Although the current fair value of the long-term debt, which is based on calculations made by debt pricing specialists, may be greater than the current carrying amount, settlement of the reported debt is generally not expected until maturity. The fair value of CMS Energy's off-balance sheet financial instruments is based on the amount estimated to terminate or settle the obligation. The fair value of interest rate swap agreements was $6 million and $1 million and guarantees/letters of credit was $96 million and $56 million as of December 31, 1993 and 1992, respectively (see Notes 7 and 12). On January 1, 1994, CMS Energy adopted SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, requiring accounting for investments in debt securities to be held to maturity at amortized cost; otherwise debt and marketable equity securities would be recorded at fair value, with any unrealized gains or losses included in earnings if the security is held for trading purposes or as a separate component of shareholders' equity if the security is available for sale. The implementation of this standard did not materially impact CMS Energy's financial position or results of operations. In May 1993, the FASB issued SFAS 114, Accounting by Creditors for Impairment of a Loan, effective in 1995, requiring certain loans that are determined to be impaired be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of any collateral for a secured loan. CMS Energy does not believe this standard will have a material impact on its financial position or results of operations. 9: Executive Incentive Compensation Under CMS Energy's Performance Incentive Stock Plan, restricted shares of common stock of CMS Energy, stock options and stock appreciation rights may be granted to key employees based on their contributions to the successful management of CMS Energy and its subsidiaries. The plan reserves for award not more than 2 percent of CMS Energy's common stock outstanding on January 1 each year, less the number of shares of restricted common stock awarded and of common stock subject to options granted under the plan during the immediately preceding four calendar years. Any forfeitures are subject to award under the plan. As of December 31, 1993, awards of up to 447,686 shares of common stock may be issued. Restricted shares of common stock are outstanding shares with full voting and dividend rights. Performance criteria were added in 1990 based on CMS Energy's total return to shareholders. Shares of restricted common stock cannot be distributed until they are vested and the performance objectives are met. Further, the restricted stock is subject to forfeiture if employment terminates before vesting. If key employees exceed performance objectives, the plan will allow additional awards. Restricted shares vest fully if control of CMS Energy changes, as defined by the plan. Consumers' Executive Stock Option and Stock Appreciation Rights Plan, an earlier plan approved by shareholders, remains in effect until all authorized options are granted or September 25, 1995. As of December 31, 1993, options for 43,000 shares remained to be granted. Under both plans, for stock options and stock appreciation rights, the exercise price on each grant date equaled the closing market price on the grant date. Options are exercisable upon grant and expire up to 10 years and one month from date of grant. The status of the restricted stock granted under the Performance Incentive Stock Plan and options granted under both plans follows: Restricted Stock Options ---------- ---------------------------- Number Number Price of Shares of Shares per Share ----------- --------- --------------- Outstanding at January 1, 1991 212,500 1,162,216 $ 7.13 - $34.25 Granted 97,000 194,000 $ 21.13 - $21.13 Exercised or Issued (34,437) (65,125) $ 7.13 - $16.00 --------- ---------- --------------- Outstanding at December 31, 1991 275,063 1,291,091 $ 7.13 - $34.25 Granted 101,000 215,000 $ 17.13 - $18.00 Exercised or Issued (37,422) (21,000) $ 13.00 - $16.00 Canceled (15,375) (50,000) $ 20.50 - $33.88 --------- ---------- --------------- Outstanding at December 31, 1992 323,266 1,435,091 $ 7.13 - $34.25 Granted 132,000 249,000 $ 25.13 - $26.25 Exercised or Issued (54,938) (152,125) $ 7.13 - $21.13 Canceled (84,141) (33,000) $ 20.50 - $33.88 --------- ---------- --------------- Outstanding at December 31, 1993 316,187 1,498,966 $ 7.13 - $34.25 ========= ========== =============== 10: Retirement Benefits Postretirement Benefit Plans Other Than Pensions CMS Energy and its subsidiaries adopted SFAS 106 effective as of the beginning of 1992. The standard required CMS Energy to change its accounting for the cost of health care and life insurance benefits that are provided to retirees from a pay-as-you-go (cash) method to a full accrual method. CMS Energy's non-utility subsidiaries expensed their accumulated transition obligation liability. The amount of such transition obligation is not material to the presentation of the consolidated financial statements or significant to CMS Energy's total transition obligation. Consumers recorded a liability of $466 million for the accumulated transition obligation and a corresponding regulatory asset for anticipated recovery in utility rates. Both the MPSC and FERC have generally adopted SFAS 106 costs for ratemaking purposes provided costs recovered through rates are placed in external funds until they are needed to pay benefits. The MPSC's generic order allows utilities three years to seek recovery of costs and provides for recovery from customers of any deferred costs incurred prior to the beginning of rate recovery of such costs. Consumers anticipates recovering its regulatory asset within 20 years. As discussed in Note 4, Consumers has requested recovery of the portion of these costs allocated to the electric business. In late 1994, Consumers plans to request recovery of the gas utility portion of these costs. CMS Energy plans to fund the benefits using external Voluntary Employee Beneficiary Associations. Funding of the health care benefits would begin when Consumers' rate recovery based on SFAS 106 begins. A portion of the life insurance benefits have previously been funded. As of December 31, 1993, the actuary assumed that retiree health care costs increased 10.5 percent in 1994, then decreased gradually to 5.5 percent in 2000 and thereafter. The health care cost trend rate assumption significantly affects the amounts reported. For example, a 1 percentage point increase in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $75 million and the aggregate of the service and interest cost components of net periodic postretirement benefit costs for 1993 by $9 million. For the years ended December 31, 1993 and 1992, the weighted average discount rate was 7.25 percent and 8 percent, respectively, and the expected long-term rate of return on plan assets was 8.5 percent. Net periodic postretirement benefit cost for health care benefits and life insurance benefits was $51 million in 1993 and $50 million in 1992. The 1993 and 1992 cost was comprised of $13 million and $11 million for service plus $38 million and $39 million for interest, respectively. The funded status of the postretirement benefit plans is reconciled with the liability recorded at December 31 as follows: In Millions 1993 1992 ------- ------- Actuarial present value of estimated benefits Retirees $ 282 $ 265 Eligible for retirement 54 50 Active (upon retirement) 190 177 ------- ------- Accumulated postretirement benefit obligation 526 492 Plan assets (premium deposit fund) at fair value 4 4 ------- ------- Projected postretirement benefit obligation in excess of plan assets (522) (488) Unrecognized prior service cost (39) (39) Unrecognized net loss 41 33 ------- ------- Recorded liability $(520) $(494) ======= ======= CMS Energy's postretirement health care plan is unfunded; the accumulated postretirement benefit obligation for that plan is $514 million and $482 million at December 31, 1993 and 1992, respectively. Consumers' regulatory asset is $510 million and $485 million at December 31, 1993 and 1992, respectively. Supplemental Executive Retirement Plan Certain management employees qualify under the SERP. Benefits are based on the employee's service and earnings as defined in the SERP. In 1988, a trust from which SERP benefits are paid was established and funded. Because the SERP is not a qualified plan under the Internal Revenue Code, earnings of the trust are taxable and trust assets are included in Consumers' consolidated assets. As of December 31, 1993 and 1992, trust assets at cost (which approximates market) were $18 million and $16 million, respectively, and were classified as other non-current assets. Defined Benefit Pension Plan A trusteed, non-contributory, defined benefit Pension Plan covers substantially all employees. The benefits are based on an employee's years of accredited service and earnings, as defined in the plan, during an employee's five highest years of earnings. Because the plan is fully funded, no contributions were made for plan years 1991 through 1993. Years Ended December 31 1993 1992 1991 - ----------------------- ----- ----- ----- Discount rate 7.25% 8.5% 8.5% Rate of compensation increase 4.5% 5.5% 5.5% Expected long-term rate of return on assets 8.75% 8.75% 8.75% Net Pension Plan and SERP costs consisted of: In Millions Years Ended December 31 1993 1992 1991 - ----------------------- ------ ------ ------ Service cost $ 19 $ 19 $ 18 Interest cost 50 48 48 Actual return on plan assets (92) (36) (88) Net amortization and deferral 34 (20) 29 ------ ------ ------ Net periodic pension cost $ 11 $ 11 $ 7 ====== ====== ====== The funded status of the Pension Plan and SERP reconciled to the pension liability recorded at December 31 was: In Millions Pension Plan SERP -------------- ------------- 1993 1992 1993 1992 ----- ----- ----- ----- Actuarial present value of estimated benefits Vested $ 471 $ 349 $ 16 $ 11 Non-vested 56 49 - - ----- ----- ----- ----- Accumulated benefit obligation 527 398 16 11 Provision for future pay increases 138 177 8 6 ----- ----- ----- ----- Projected benefit obligation 665 575 24 17 Plan assets (primarily stocks and bonds, including $87 in 1993 and $64 in 1992 in common stock of CMS Energy) at fair value 692 631 - - ----- ----- ----- ----- Projected benefit obligation less than (in excess of) plan assets 27 56 (24) (17) Unrecognized net (gain) loss from experience different than assumed (56) (76) 7 2 Unrecognized prior service cost 45 49 1 1 Unrecognized net transition (asset) obligation (44) (49) 1 1 Adjustment to recognize minimum liability - - (1) - ----- ----- ----- ----- Recorded liability $ (28) $ (20) $ (16) $ (13) ====== ====== ====== ===== Beginning January 1, 1986, the amortization period for the Pension Plan's unrecognized net transition asset is 16 years and 11 years for the SERP's unrecognized net transition obligation. Prior service costs are amortized on a straight-line basis over the average remaining service period of active employees. In 1991, certain eligible employees accepted early retirement incentives. The incentives consisted of lump-sum cash payments and increased pension payments. The pretax cost of the incentives was $25 million. Also in 1991, portions of the projected benefit obligation were settled which resulted in a pretax gain of $25 million that offset the early retirement costs. 11: Leases CMS Energy, Consumers, and Enterprises lease various assets, including vehicles, aircraft, construction equipment, computer equipment, nuclear fuel and buildings. Consumers' nuclear fuel capital leasing arrangement was extended an additional year and is now scheduled to expire in November 1995. The maximum amount of nuclear fuel that can be leased increased from $55 million to $70 million. Consumers further increased this amount in early 1994 to $80 million. The lease provides for an additional one-year extension upon mutual agreement by the parties. Upon termination of the lease, the lessor would be entitled to a cash payment equal to its remaining investment, which was $57 million as of December 31, 1993. Consumers is responsible for payment of taxes, maintenance, operating costs, and insurance. Minimum rental commitments under CMS Energy's non-cancelable leases at December 31, 1993, were: In Millions Capital Operating Leases Leases ------- --------- 1994 $ 43 $ 9 1995 64 8 1996 16 3 1997 15 3 1998 13 3 1999 and thereafter 26 22 ----- ----- Total minimum lease payments 177 $ 48 ===== Less imputed interest 27 ----- Present value of net minimum lease payments 150 Less current portion 35 ----- Non-current portion (a) $115 ===== (a) In January 1994, Consumers amended its nuclear fuel lease to include fuel previously owned at Big Rock Point. This is estimated to increase the non-current portion of capital leases by approximately $6 million. Consumers recovers these charges from customers and accordingly charges payments for its capital and operating leases to operating expense. Operating lease charges, including charges to clearing and other accounts as of December 31, 1993, 1992 and 1991, were $18 million, $15 million and $15 million, respectively. Capital lease expenses for the years ended December 31, 1993, 1992 and 1991 were $34 million, $47 million and $51 million, respectively. Included in these amounts for the years ended 1993, 1992 and 1991, are nuclear fuel lease expenses of $13 million, $17 million and $24 million, respectively. 12: Commitments, Contingencies and Other Ludington Pumped Storage Plant Litigation In 1986, the Attorney General filed a lawsuit on behalf of the State of Michigan in the Circuit Court of Ingham County, seeking damages from Consumers and Detroit Edison for alleged injuries to fishery resources because of the operation of the Ludington Pumped Storage Plant. The state sought $148 million (including $16 million of interest) for past injuries and $89,000 per day for future injuries, with the latter amount to be adjusted upon installation of "adequate" fish barriers and other changed conditions. In 1987, the Attorney General filed a second lawsuit alleging that Consumers and Detroit Edison have breached a bottomlands lease agreement with the state and asked that the lease be declared void. This complaint was consolidated with the suit described in the preceding paragraph. In 1990, both of the lawsuits were dismissed on the basis of federal preemption. In 1993, the Court of Appeals overturned the dismissal, as to damages, effectively allowing the state to continue its damages lawsuit against Consumers and Detroit Edison, but generally affirmed the lower court's ruling as to the breach of lease claim. The Court of Appeals' ruling also limited any potential damages to those occurring no earlier than 1983. Consumers, Detroit Edison and the Attorney General have filed an application for leave to appeal with the Michigan Supreme Court. Consumers and Detroit Edison are seeking to have the trial court's dismissal of the damages claim affirmed. Each year since 1989, Consumers and Detroit Edison have complied with FERC orders by installing a seasonal barrier net from April to October at the Ludington plant site. The FERC is now considering whether the barrier net (along with other actions by Consumers, including contributions to state fish-stocking programs) would be a satisfactory permanent solution. Environmental Matters Consumers is a so-called "Potentially Responsible Party" at several sites being administered under Superfund. Along with Consumers, there are numerous credit-worthy, potentially responsible parties with substantial assets cooperating with respect to the individual sites. Based on information currently known by management, Consumers and CMS Energy believe that it is unlikely that their liability at any of the known Superfund sites, individually or in total, will have a material adverse effect on their financial positions or results of operations. The State of Michigan in 1990 passed amendments to the Environmental Response Act that established a state program similar to the federal Superfund law, though broader in scope. Under this law, Consumers expects that it will ultimately incur costs at a number of sites, including some of the 23 sites that formerly housed manufactured gas plant facilities, even those in which it has a partial or no current ownership interest. It is expected that in most cases, parties other than Consumers with current or former ownership interests may also be considered liable under the law and may be required to share in the costs of any site investigations and remedial actions. There is limited knowledge of manufactured gas plant contamination at these sites at this time. However, Consumers is continuing to monitor this issue. In addition, at the request of the DNR, Consumers prepared plans for remedial investigation/feasibility studies for three of these sites. Work plans for remedial investigation/feasibility studies for four other sites have also been prepared. The purpose of a remedial investigation/feasibility study is to define the nature and extent of contamination at a site and to determine which of several possible remedial action alternatives, including no action, may be required under the Environmental Response Act. The DNR has approved two of the three plans for remedial investigation/feasibility studies submitted and is currently reviewing the one remaining. The cost to conduct one of the approved studies will be approximately $250,000 based on bids received. Although the actual cost of conducting the remaining two remedial investigation/feasibility studies will not be known until bids are received from contractors, Consumers currently estimates the total cost of conducting the three studies submitted to the DNR to be less than $1 million. The timing and extent of any further site investigation and remedial actions will depend, among other things, on requests received from the DNR and on future site usage by Consumers or other owners. Under the current schedule, Consumers anticipates the first remedial investigation/feasibility study would be completed in mid-1994. Consumers believes the results of the remedial investigation/feasibility studies will allow management to estimate a range of remedial cost estimates for the sites under study. Based on Consumers' knowledge of other utility remedial actions, remediation costs for Consumers for these sites may be substantial. In 1993, the MPSC addressed the question of recovery of investigation and remedial costs for another Michigan gas utility as part of that utility's gas rate case. In that proceeding, the MPSC determined that prudent investigation and remedial costs could be deferred and amortized over 10-year periods and prudent unamortized costs can be included for recovery in the utility's rate cases. The MPSC stated the length of the period may be reviewed from time to time, but any revisions would be prospective. Consumers and CMS Energy believe costs incurred for both investigation and any required remedial actions would be recoverable from utility customers under established regulatory policies and accordingly are not likely to materially affect their financial positions or results of operations. Included in the 1990 amendments to the federal Clean Air Act are provisions that limit emissions of sulfur dioxide and nitrogen oxides and require enhanced emissions monitoring. All of Consumers' coal-fueled electric generating units burn low-sulfur coal and are presently operating at or near the sulfur dioxide emission limits which will be effective in 2000. Beginning in 1995, certain coal-fueled generating units will receive emissions allowances (all of Consumers' coal units will receive allowances beginning in 2000). Based on projected emissions from these units, Consumers expects to have excess allowances which may be sold or saved for future use. The Clean Air Act's provisions require Consumers to make capital expenditures estimated to total $74 million through 1999 for completed, in-process and possible modifications at coal-fired units based on existing and proposed regulations. Management believes that Consumers' annual operating costs will not be materially affected. The EPA has asked a number of utilities in the Great Lakes area to voluntarily retire certain equipment containing specific levels of polychlorinated biphenyls. Consumers believes that it is largely in compliance with the EPA's petition. Consumers is continuing to study the request and has been granted an extension for responding until March 30, 1994. Capital Expenditures CMS Energy estimates capital expenditures, including investments in unconsolidated subsidiaries, DSM and new lease commitments, of $792 million for 1994, $690 million for 1995 and $714 million for 1996. Public Utility Holding Company Act Exemption CMS Energy is exempt from registration under PUHCA. However, the Attorney General and the MMCG have asked the SEC to revoke CMS Energy's exemption from registration under PUHCA. In 1992, the MPSC filed a statement with the SEC recommending that CMS Energy's current exemption be revoked and a new exemption be issued conditioned upon certain reporting and operating requirements. If CMS Energy were to lose its current exemption, it would become more heavily regulated by the SEC; Consumers could ultimately be forced to divest either its electric or gas utility business; and CMS Energy would be restricted from conducting businesses that are not functionally related to the conduct of its utility business as determined by the SEC. CMS Energy is opposing this request and believes it will maintain its current exemption from registration under PUHCA. Other As of December 31, 1993, CMS Energy and Enterprises have guaranteed up to $90 million in contingent obligations of unconsolidated affiliates of Enterprises' subsidiaries. NOMECO has hedged its gas supply obligations in the years 2001 through 2006 by purchasing the economic equivalent of 10,000 MMBtu per day at a fixed, escalated price starting at $2.82 per MMBtu in 2001. The settlement periods are each a one-year period ending December 31, 2001 through 2006 on 3.65 MMBtu. If the "floating price," essentially the then current Gulf Coast spot price, for a period is higher than the "fixed price," the seller pays NOMECO the difference, and vice versa. If a party's exposure at any time exceeds $2 million, that party is required to obtain a letter of credit in favor of the other party for the excess over $2 million, to a maximum of $10 million. At December 31, 1993, the seller had arranged a letter of credit in NOMECO's favor for $10 million. NOMECO also periodically enters into oil and gas price hedging arrangements to mitigate its exposure to price fluctuations on the sale of crude oil and natural gas. As of December 31, 1993, the fair value of these hedge arrangements was not material. Consumers experienced an increase in complaints during 1993 relating to so-called stray voltage. Claimants contend that stray voltage results when small electrical currents present in grounded electric systems are diverted from their intended path. Investigation by Consumers of prior stray voltage complaints disclosed that many factors, including improper wiring and malfunctioning of on-farm equipment, can lead to the stray voltage phenomenon. Consumers maintains a policy of investigating all customer calls regarding stray voltage and working with customers to address their concerns including, when necessary, modifying the configuration of the customer's hook-up to Consumers. A complaint seeking certification as a class action suit was filed against Consumers in a local county circuit court in 1993. The complaint alleges the existence of a purported class that has incurred damages of up to $1 billion, primarily to certain livestock owned by the purported class, as a result of stray voltage from electricity being supplied by Consumers. Consumers believes the allegations to be without merit and intends to vigorously oppose the certification of the class and this suit. In addition to the matters disclosed in these notes, Consumers and certain other subsidiaries of CMS Energy are parties to certain lawsuits and administrative proceedings before various courts and governmental agencies, arising from the ordinary course of business involving personal injury and property damage, contractual matters, environmental issues, federal and state taxes, rates, licensing and other matters. The ultimate effect of the proceedings discussed in this note is not expected to have a material impact on CMS Energy's financial position or results of operations. 13: Jointly Owned Utility Facilities Consumers is responsible for providing its share of financing for jointly owned facilities. The following table indicates the extent of Consumers' investment in jointly owned utility facilities: In Millions December 31 1993 1992 - ----------- ---- ---- Net investment Ludington - 51% $114 $112 Campbell Unit 3 - 93.3% 349 360 Transmission lines - various 32 33 Accumulated depreciation Ludington $ 74 $ 71 Campbell Unit 3 210 199 Transmission lines 11 10 14: Supplemental Cash Flow Information For purposes of the Statement of Cash Flows, all highly liquid investments with an original maturity of three months or less are considered cash equivalents. Other cash flow activities and non-cash investing and financing activities for the years ended December 31 were: In Millions 1993 1992 1991 ------ ------ ------ Cash transactions Interest paid (net of amounts capitalized) $193 $203 $325 Income taxes paid (net of refunds) 32 19 21 Non-cash transactions Nuclear fuel placed under capital lease $ 28 $ 30 $ 6 Other assets placed under capital leases 30 39 21 Capital leases refinanced 42 - - Assumption of debt - 15 - Changes in other assets and liabilities as shown on the Consolidated Statements of Cash Flows at December 31 are described below: In Millions 1993 1992 1991 ------ ------ ------ Sale of receivables, net $ 60 $ 25 $ - Accounts receivable 22 6 118 Accrued revenue (48) 88 7 Accrued refunds (48) (143) 102 Inventories (32) 23 (8) Accounts payable (31) 20 (70) Tax Reform Act refund reserve - - (77) Other current assets and liabilities, net (19) 46 (20) Non-current deferred amounts, net 9 (28) 108 ------ ------ ------ $ (87) $ 37 $ 160 ======= ====== ====== 15: Reportable Segments CMS Energy operates principally in the following five business segments: electric utility, gas utility, oil and gas exploration and production, independent power production, and gas transmission and marketing. The Consolidated Statements of Income show operating revenue and pretax operating income by business segment. Other segment information follows: In Millions Years Ended December 31 1993 1992 1991 --------- -------- ------ Depreciation, depletion and amortization Electric utility $ 241 $ 230 $ 172 Gas utility 73 76 70 Oil and gas exploration and production 45 38 33 Independent power production 2 2 2 Gas transmission and marketing 1 1 - Other 3 1 6 -------- ------- -------- $ 365 $ 348 $ 283 ======== ======= ======== Identifiable assets Electric utility (a) $ 4,027 $3,812 $3,399 Gas utility 1,443 1,387 1,186 Oil and gas exploration and production 398 364 334 Independent power production 488 333 321 Gas transmission and marketing 75 60 45 Other 533 892 909 --------- ------- ------- $ 6,964 $6,848 $6,194 ========= ======= ======= Capital expenditures (b)(c)(d) Electric utility (e) $ 365 $ 353 $ 213 Gas utility 127 86 61 Oil and gas exploration and production 81 68 71 Independent power production 110 12 18 Gas transmission and marketing 14 6 17 Other 69 69 33 --------- ------- ------- $ 766 $ 594 $ 413 ========= ======= ======= (a) Includes abandoned Midland investment of $162 million, $175 million and $287 million for 1993, 1992 and 1991, respectively. (b) Includes capital leases for nuclear fuel and other assets (see Note 14). (c) Includes equity investments in unconsolidated partnerships of $108 million for 1993, $12 million for 1992 and $33 million for 1991. (d) Certain prior year amounts have been adjusted for comparative purposes. (e) Includes DSM costs of $52 million for 1993 and $26 million for 1992. 16: Summarized Financial Information of Significant Related Energy Supplier Under the PPA with the MCV Partnership discussed in Note 3, Consumers' 1993 obligation to purchase electricity from the MCV Partnership was approximately 14 percent of Consumers' owned and contracted capacity. Summarized financial information of the MCV Partnership is shown below: Statements of Income In Millions Years Ended December 31 1993 1992 1991 - ----------------------- ------ ------ ------ Operating revenue (a) $ 548 $ 488 $ 425 Operating expenses 362 315 278 ------ ------ ------ Operating income 186 173 147 Other expense, net (189) (190) (186) ------ ------ ------ Net loss $ (3) $ (17) $ (39) ====== ====== ====== Balance Sheets In Millions December 31 1993 1992 - ----------- ------ ------ Assets Current assets (a) $ 181 $ 165 Property, plant and equipment, net 2,073 2,124 Other assets 146 147 ------ ------ $2,400 $2,436 ====== ====== Liabilities and Partners' Equity Current liabilities $ 198 $ 189 Long-term debt and other non-current liabilities (b) 2,147 2,189 Partners' equity (c) 55 58 ------ ------ $2,400 $2,436 ====== ====== (a) Revenue from Consumers totaled $505 million, $444 million and $384 million for 1993, 1992 and 1991, respectively. As of December 31, 1993, 1992 and 1991, $44 million, $38 million and $33 million, respectively, were receivable from Consumers. (b) FMLP is a beneficiary of an owner trust that is the lessor in a long-term direct finance lease with the lessee, MCV Partnership. CMS Holdings holds a 46.4 percent ownership interest in FMLP (see Note 3). At December 31, 1993 and 1992, lease obligations of $1.7 billion were owed to the owner trust of which FMLP is the sole beneficiary. CMS Holdings' share of the interest and principal portion for the 1993 lease payments was $63 million and $16 million, respectively, and for the 1992 lease payments was $65 million and $12 million, respectively. The lease payments service $1.2 billion and $1.3 billion in non-recourse debt outstanding as of December 31, 1993 and 1992, respectively, of the owner-trust whose beneficiary is FMLP. FMLP's debt is secured by the MCV Partnership's lease obligations, assets, and operating revenues. For 1993 and 1992, the owner-trust whose beneficiary is FMLP made debt payments of $172 million and $166 million, respectively, which included $10 million and $8 million principal and $25 million and $26 million interest, respectively, on the MCV Bonds held by MEC Development Corporation during part of 1991 and by Consumers through December 1993. (c) CMS Midland's recorded investment in the MCV Partnership includes capitalized interest, which is being amortized to expense over the life of its investment in the MCV Partnership. Arthur Andersen & Co. Report of Independent Public Accountants To CMS Energy Corporation: We have audited the accompanying consolidated balance sheets and consolidated statements of long-term debt and preferred stock of CMS ENERGY CORPORATION (a Michigan corporation) and subsidiaries 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. 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 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CMS Energy 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. As discussed in Note 5 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. Additionally, as discussed in Note 10 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pensions. ARTHUR ANDERSEN & Co. Detroit, Michigan, January 28, 1994. (This page intentionally left blank) Consumers Power Company 1993 Financial Statements (This page intentionally left blank) Consumers Power Company Management's Discussion and Analysis Consumers is a combination electric and gas utility company serving most of the Lower Peninsula of Michigan, and is the principal subsidiary of CMS Energy, an energy holding company. Consumers' customer base includes a mix of residential, commercial and diversified industrial customers, the largest of which is the automotive industry. Consolidated 1993 Earnings Consolidated net income after dividends on preferred stock totaled $187 million in 1993, compared to net losses of $255 million in 1992 and $260 million in 1991. The increased net income reflects the Settlement Order related to power purchases from the MCV Partnership. Earnings also reflect record setting electric sales and gas deliveries. Cash Position, Financing and Investing Consumers' operating cash requirements are met by its operating and financing activities. In 1993 and 1992, Consumers' cash from operations mainly resulted from its sale and transportation of natural gas and its sale and transmission of electricity. Cash from operations for 1993 primarily reflects record-setting electric sales and gas deliveries and reduced after-tax cash shortfalls resulting from Consumers' purchases of power from the MCV Partnership. During 1992, Consumers' cash from operations increased as compared to 1991 primarily due to lower interest charges resulting from reduced levels of debt, partially offset by higher operating expenditures and reduced electric rates. In 1991, Consumers generated cash primarily from its consolidated operating and investing activities, including $859 million of net proceeds from the sale of a majority of the MCV Bonds. Over the last three years, Consumers has used its cash primarily to fund its extensive construction expenditures and to improve the reliability of its transmission and distribution systems. Consumers has also used its cash to retire portions of long-term debt and to pay cash dividends. Financing Activities As a result of the 1992 quasi-reorganization (see Note 7 to the Consolidated Financial Statements), and subsequent accumulated earnings, Consumers paid $133 million in common stock dividends during 1993 and declared a $16 million common stock dividend in January 1994 from 1993 earnings. During 1993, Consumers significantly reduced its future interest charges by retiring approximately $51 million of high-cost outstanding debt and refinancing approximately $573 million of other debt at lower interest rates. For further information, see Note 7. Investing Activities Capital expenditures (excluding assets placed under capital leases of $58 million) and deferred demand-side management costs totaled $503 million in 1993 as compared to $437 million in 1992. These amounts primarily represent capital investments in Consumers' electric and gas utility segments. In December 1993, Consumers sold $309 million of MCV Bonds it held and used the net proceeds to temporarily reduce short-term borrowings and ultimately plans to reduce long-term debt and to finance its construction program. Outlook Consumers estimates that capital expenditures, including demand-side management and new lease commitments, related to its electric and gas utility operations will total approximately $1.5 billion over the next three years. In Millions Years Ended December 31 1994 1995 1996 ---- ---- ---- Consumers Construction (including DSM) $474 $425 $391 Nuclear fuel lease 46 4 45 Capital leases other than nuclear fuel 27 27 28 Michigan Gas Storage 6 5 7 ---- ---- ---- $553 $461 $471 ==== ==== ==== Consumers is required to redeem or retire approximately $741 million of long-term debt during 1994 through 1996. Cash generated by operations is expected to satisfy a substantial portion of these capital expenditures and debt retirements. Consumers has several other available sources of credit including unsecured, committed lines of credit totaling $165 million and a $470 million working capital facility. Consumers has FERC authorization to issue or guarantee up to $900 million in short-term debt through December 31, 1994. Consumers uses short-term borrowings to finance working capital, seasonal fuel inventory and to pay for capital expenditures between long-term financings. Consumers has an agreement permitting the sales of certain accounts receivable for up to $500 million. As of December 31, 1993 and 1992, receivables sold totaled $285 million and $225 million, respectively. On February 15, 1994, Consumers increased the level of receivables sold to $335 million. In October 1993, Consumers received MPSC authorization and is proceeding to issue $200 million of preferred stock in 1994. In February 1994, Consumers called or redeemed approximately $101 million of first mortgage bonds. At December 31, 1993, Consumers' capital structure consisted of approximately 32 percent common equity, 4 percent preferred stock, and 64 percent long- and short-term debt (including capital leases and notes payable). Consumers' long term goal is to achieve and maintain a capital structure consisting of approximately 37 percent common equity, 8 percent preferred stock and 55 percent debt. Management expects to achieve this structure through debt reductions, accumulated earnings, the issuance of new preferred stock and equity investments from CMS Energy. Electric Utility Operations Comparative Results of Operations Electric Pretax Operating Income: The improvement in 1993 pretax operating income compared to 1992 reflects an increase of $126 million relating to the resolution of the recoverability of MCV power purchase costs under the PPA and increased electric system sales of $45 million, partially offset by higher costs to improve system reliability. The 1992 decrease of $66 million from the 1991 level primarily resulted from an increased emphasis on system reliability improvements and decreased electric rates resulting from the full-year impact of a mid-1991 rate decrease. In Millions 1993 1992 Over Over (Under) (Under) 1992 1991 ------ ------ Sales growth $ 34 $ 11 Weather 11 (16) Resolution of MCV power cost issues 126 - Other regulatory issues 5 (13) O&M, general taxes and depreciation (a) (44) (48) ----- ----- Total change $132 $(66) ===== ===== (a) Largely caused by Consumers' system reliability improvement program. Electric Sales: Electric system sales in 1993 totaled a record 31.7 billion kWh, a 3.8 percent increase from 1992 levels. In 1993, residential and commercial sales increased 3.4 percent and 3.0 percent, respectively, while industrial sales increased 6.5 percent. Growth in the industrial sector was the strongest in the auto-related segments of fabricated and primary metals and transportation equipment. Electric system sales in 1992 totaled 30.5 billion kWh, essentially unchanged from the 1991 levels. Electric Sales Millions of kWh 1993 1992 1991 ------ ------ ------ Residential 10,066 9,733 9,997 Commercial 8,909 8,652 8,692 Industrial 11,541 10,831 10,692 Sales for resale 1,142 1,292 1,311 ------ ------ ------ System sales (a) 31,658 30,508 30,692 ====== ====== ====== Total customers (000) 1,526 1,506 1,492 ====== ====== ====== (a) Excludes intersystem exchanges of power with other utilities through joint dispatching for the economic benefit of customers. The level of intersystem sales has been essentially unchanged during each of the last three years. Power Costs: Power costs for 1993 totaled $908 million, a $31 million increase from the corresponding 1992 period. This increase primarily reflects greater power purchases from outside sources to meet increased sales demand and to supplement decreased generation at Palisades due to an extended outage. Power costs for 1992 totaled $877 million, a $17 million decrease as compared to 1991. Operation and Maintenance: Increases in other operation and maintenance expense for 1993 and 1992 reflected increased expenditures to improve electric system reliability. Depreciation: The increased depreciation for 1993 reflects additional capital investments in plant. The 1992 increase resulted from higher depreciation rates, increased amortization of abandoned nuclear investment and increased nuclear plant decommissioning expense. Electric Utility Rates Power Purchases from the MCV Partnership: Consumers is obligated to purchase the following amounts of contract capacity from the MCV Partnership under the PPA: 1995 and Year 1993 1994 thereafter - ---- ----- ----- ---------- MW 1,023 1,132 1,240 Since 1990, recovering capacity and fixed-energy costs for power purchased from the MCV Partnership has been a significant issue. Effective January 1, 1993, the Settlement Order allowed Consumers to recover from electric retail customers substantially all of the payments for its ongoing purchase of 915 MW of contract capacity from the MCV Partnership, significantly reducing the amount of future underrecoveries for these power costs. ABATE and the Attorney General have filed claims of appeal of the Settlement Order with the Court of Appeals. Prior to the Settlement Order, Consumers had recorded losses for underrecoveries from 1990 through 1992. In December 1992, Consumers recognized an after-tax loss of $343 million for the present value of estimated future underrecoveries of power costs under the PPA as a result of the Settlement Order, based on management's best estimates regarding the future availability of the MCV Facility, and the effect of the future wholesale power market on the amount, timing and price at which various increments of the capacity above the MPSC-authorized level could be resold. Except for adjustments to the above loss to reflect the after-tax time value of money through accretion expense, no additional losses are expected unless actual future experience materially differs from management's estimates. The after-tax expense for the time value of money for the $343 million loss is estimated to be approximately $24 million in 1994, and various lower levels thereafter, including $22 million in 1995 and $20 million in 1996. Although the settlement losses were recorded in 1992, the after-tax cash underrecoveries associated with the Settlement Order were $59 million in 1993. Consumers believes there is and will be a market for the resale of capacity purchases from the MCV Partnership above the MPSC-authorized level. If Consumers is unable to sell any capacity above the current MPSC-authorized level, future additional after-tax losses and after-tax cash underrecoveries could be incurred. Estimates for the next five years if none of the additional capacity is sold are as follows: After-tax, In Millions 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- Expected cash underrecoveries $56 $65 $62 $61 $ 8 Possible additional under- recoveries and losses (a) $14 $20 $20 $22 $72 (a) If unable to sell any capacity above the MPSC's authorized level The PPA, while requiring payment of a fixed energy charge, contains a "regulatory out" provision which permits Consumers to reduce the fixed energy charges payable to the MCV Partnership throughout the entire contract term if Consumers is not able to recover these amounts from its customers. Consumers and the MCV Partnership have commenced arbitration proceedings under the PPA to determine whether Consumers is entitled to exercise its regulatory out regarding fixed energy charges on the portion of available MCV capacity above the current MPSC-authorized levels. An arbitrator acceptable to both parties has been selected. If the arbitrator determines that Consumers cannot exercise its regulatory out, Consumers would be required to make these fixed energy payments to the MCV Partnership. The arbitration proceedings will also determine who is entitled to the fixed energy amounts for which Consumers did not receive full cost recovery during the years prior to settlement. As of December 31, 1993, these amounts total $26 million. Although Consumers intends to aggressively pursue its right to exercise the regulatory out, management cannot predict the outcome of the arbitration proceedings or any possible settlement of the matter. Accordingly, losses were recorded prior to 1993 for all fixed energy amounts at issue in the arbitration. In December 1993, Consumers made an irrevocable offer to pay through September 15, 2007, fixed energy charges to the MCV Partnership on all kWh delivered by the MCV Partnership to Consumers from the contract capacity in excess of 915 MW, which represents a portion of the fixed energy charges in dispute. Consumers made the offer to facilitate the sale of the remaining MCV Bonds in 1993. The lessors of the MCV Facility have filed a lawsuit in federal district court against CMS Energy, Consumers and CMS Holdings. It alleges breach of contract, breach of fiduciary duty and negligent or willful misrepresentation relating to the MCV Partnership's failure to object to the Settlement Order in light of Consumers' interpretation of the Settlement Order, which is the subject of an arbitration between the MCV Partnership and Consumers. The action alleges damages in excess of $1 billion and seeks injunctive relief relative to Consumers' payments of the fixed energy charge. CMS Energy and Consumers believe that at all times they and CMS Holdings have conducted themselves properly and that the action is without merit. They also believe that a significant portion of the alleged damages represent fixed energy charges in dispute in the arbitration. CMS Energy and Consumers are unable to predict the outcome of this action. For further information regarding power purchases from the MCV Partnership, see Note 3. PSCR Matters: Consumers began a planned refueling and maintenance outage at Palisades in June 1993. Following several required, unanticipated repairs that extended the outage, the plant returned to service in early November. Recovery of replacement power costs incurred by Consumers during the outage will be reviewed by the MPSC during the 1993 PSCR reconciliation of actual costs and revenues to determine the prudency of actions taken during the outage and any associated delays. Net replacement power costs were approximately $180,000 per day above the cost of fuel incurred when the plant is operating. The Energy Act imposes an obligation on the utility industry, including Consumers, to decommission DOE uranium enrichment facilities. Consumers currently estimates its payments for decommissioning those facilities to be $2.4 million per year for 15 years beginning in 1992, escalating based on an inflation factor. Consumers believes these costs are recoverable from its customers under traditional regulatory policies. Electric Rate Case: Consumers filed a request with the MPSC in May 1993 to increase its electric rates. Subsequently, as a result of changed estimates, Consumers revised its requested electric rate increase to $133 million annually based on a 1994 test year. Consumers also requested an additional annual electric rate increase of $38 million based on a 1995 test year. In March 1994, an ALJ issued a proposal for decision that recommended Consumers' 1994 final annual rate increase total approximately $83 million, and that the incremental requested 1995 increase not be granted at this time. The ALJ's recommendation included a lower return on electric common equity, reflected reduced anticipated debt costs due to the projected availability of more favorable interest rates and proposed a lower equity ratio for Consumers' projected capitalization structure. The ALJ did, however, generally support Consumers' rate design proposal to significantly reduce the level of subsidization of residential customers by commercial and industrial customers and generally supported a performance incentive which Consumers also supported. For further information, see Note 4. Electric Conservation Efforts In October 1993, Consumers completed the customer participation portion of several incentive-based demand-side management programs which were designed to encourage the efficient use of energy, primarily through conservation measures. Based on the MPSC's determination of Consumers' effectiveness in implementing these programs, Consumers' future rate of return on electric common equity may be adjusted either upward by up to 1 percent or downward by up to 2 percent, for one year following reconciliation hearings with the MPSC. Consumers believes it will receive an increase on its return on common equity based on having achieved all of the agreed upon objectives. For further information, see Note 4. Electric Capital Expenditures Consumers estimates capital expenditures, including demand-side management and new lease commitments, related to its electric utility operations of $396 million for 1994, $324 million for 1995 and $332 million for 1996. Electric Environmental Matters and Health Concerns The 1990 amendment of the federal Clean Air Act significantly increased the environmental constraints that utilities will operate under in the future. While the Clean Air Act's provisions will require Consumers to make certain capital expenditures in order to comply with the amendments for nitrogen oxide reductions, Consumers' generating units are presently operating at or near the sulfur dioxide emission limits which will be effective in the year 2000. Therefore, management believes that Consumers' annual operating costs will not be materially affected. In 1990, the State of Michigan passed amendments to the Environmental Response Act, under which Consumers expects that it will ultimately incur costs at a number of sites, even those in which it has a partial or no current ownership interest. It is expected that in most cases, parties other than Consumers with current or former ownership interests may also be considered liable under the law and may be required to share in the costs of any site investigations and remedial actions. Consumers believes costs incurred for both investigation and any required remedial actions would be recoverable from its electric customers under established regulatory policies and accordingly are not likely to materially affect its financial position or results of operations. Consumers is a so-called "Potentially Responsible Party" at several sites being administered under Superfund. Along with Consumers, there are numerous credit-worthy, potentially responsible parties with substantial assets cooperating with respect to the individual sites. Based on information currently known by management, Consumers believes that it is unlikely that its liability at any of the known Superfund sites, individually or in total, will have a material adverse effect on its financial position or results of operations. Electric Outlook Consumers expects economic growth, competitive rates and other factors to increase the demand for electricity within its service territory by approximately 1.8 percent per year over the next five years. For the near term, Consumers currently plans a reserve margin of 20 percent and expects to fill the additional capacity required through long- and short-term power purchases. Long-term purchased power will likely be obtained through a competitive bidding solicitation process utilizing the framework established by the MPSC in 1992. Capacity from the MCV Facility above the levels authorized by the MPSC may be offered by Consumers in connection with the solicitation. A recent NRC review of Consumers' performance at Palisades showed a decline in performance. Management believes that an increased emphasis on internal assessments will improve performance at Palisades. To provide NRC senior management with a more in-depth assessment of plant performance, the NRC has initiated a diagnostic evaluation team inspection at Palisades. The inspection will be a broad-based evaluation of all aspects of nuclear plant operation and management which is expected to commence in March 1994, with results of the evaluation expected to be available in May 1994. The outcome of this evaluation cannot be predicted. Similar reviews conducted at nuclear plants of other utilities in recent years have in some cases resulted in increased regulatory oversight or required actions to improve plant operations, maintenance or condition. Consumers is currently collecting $45 million annually from electric retail customers for the future decommissioning of its two nuclear plants. Consumers believes these amounts will be adequate to meet current decommissioning cost estimates. For further information regarding nuclear decommissioning, see Note 2. Consumers' on-site storage pool at Palisades is at capacity, and it is unlikely that the DOE will begin accepting any spent nuclear fuel by the originally scheduled date in 1998. Consumers is using NRC-approved dry casks, which are steel and concrete vaults, for temporary storage. Several appeals relating to NRC approval of the casks are now pending at the U.S. Sixth Circuit Court of Appeals. If Consumers is unable to continue to use the casks as planned, significant costs, including replacement power costs during any resulting plant shutdown, could be incurred. Consumers has experienced an increase in complaints in 1993 relating primarily to the effect of so-called stray voltage on certain livestock. A complaint seeking certification as a class action suit has been filed against Consumers alleging significant damages, primarily related to certain livestock, which Consumers believes to be without merit (see Note 12). Some of Consumers' larger industrial customers are exploring the possibility of constructing and operating their own on-site generating facilities. Consumers is actively working with these customers to develop rate and service alternatives that are competitive with self-generation options. Although Consumers' electric rates are competitive with other regional utilities, Consumers has on file with the FERC two open access interconnection tariffs which could have the effect of increasing competition for wholesale customers. As part of its current electric rate case, Consumers has requested that the MPSC reduce the level of rate subsidization of residential customers by commercial and industrial customers so as to further improve rate competitiveness for its largest customers. The MPSC has completed a hearing on a proposal by ABATE to create an experimental retail wheeling tariff. Certain other parties have proposals in support of retail wheeling under development. In August 1993, an ALJ recommended that the MPSC reject the proposed experiment. An MPSC order is expected early in 1994. Gas Utility Operations Comparative Results of Operations Gas Pretax Operating Income: For 1993, pretax operating income increased $37 million compared to 1992, reflecting higher gas deliveries (both sales and transportation volumes) and more favorable regulatory recovery of gas costs related to transportation. During 1992, gas pretax operating income increased $45 million from the 1991 level, essentially for many of the same reasons as the current period. In Millions 1993 1992 Over Over (Under) (Under) 1992 1991 ------ ------ Sales growth $ 7 $ 14 Weather 10 6 Regulatory recovery of gas cost 12 48 O&M, general taxes and depreciation 8 (23) ------ ------ Total change $ 37 $ 45 ====== ====== Gas Deliveries: Gas sales and gas transported in 1993 totaled 410.6 bcf, a 6.9 percent increase from 1992. In 1992, gas sales and gas transported totaled 384.1 bcf, a 6.1 percent increase from 1991 deliveries. Gas Deliveries Bcf 1993 1992 1991 ----- ----- ----- Residential 174.9 166.7 157.2 Commercial 55.9 53.4 50.2 Industrial 13.9 13.5 14.5 Other .2 .2 .2 ----- ----- ----- Gas sales 244.9 233.8 222.1 Transportation deliveries 70.5 66.4 61.5 Transportation for MCV 73.4 63.5 55.0 Off-system transportation service 21.8 20.4 23.4 ----- ----- ----- Total deliveries 410.6 384.1 362.0 ===== ===== ===== Total customers (000) 1,423 1,402 1,382 ===== ===== ===== Gas Utility Rates Consumers currently plans to file a request in 1994 with the MPSC to increase its gas rates. The request would include, among other things, costs for postretirement benefits computed under SFAS 106, Employers' Accounting for Postretirement Benefits Other than Pensions. A final order should be received approximately nine to twelve months after the request is filed. Certain of Consumers' direct gas suppliers have contract prices tied to the price Consumers pays Trunkline for its gas. The Trunkline contract covers gas deliveries through October 1994 and is at a price reduced in September 1993. Some of Consumers' direct gas suppliers have claimed that the reduced Trunkline gas cost is not a proper reference price under their contracts with Consumers and that their contracts are terminable after a 12-month period. Consumers is disputing these claims. In 1992, the FERC issued Order 636, which makes a number of significant changes to the structure of the services provided by interstate natural gas pipelines to be implemented by the 1993-94 winter heating season. Consumers is a significant purchaser of gas from an interstate pipeline (Trunkline) and is a major transportation customer of a number of pipelines. Management believes that Consumers will recover any transition costs it may incur and such restructuring will not have a significant impact on its financial position or results of operations. In July 1993, Michigan Gas Storage submitted a notice of rate change with the FERC to revise its operation and maintenance expenses for 1993 and update plant costs to reflect the addition of approximately $27 million of new plant additions in 1993 and began collecting the revised rates subject to refund and a hearing in February 1994. Hearings or settlement conferences will follow. For further information regarding gas utility rates, see Note 4. Gas Capital Expenditures Consumers estimates capital expenditures, including new lease commitments, related to its gas utility operations of $99 million for 1994, $88 million for 1995 and $81 million for 1996. Gas Environmental Matters Under the Environmental Response Act, Consumers expects that it will ultimately incur costs at a number of sites, including some of the 23 sites that formerly housed manufactured gas plant facilities, even those in which it has a partial or no current ownership interest. It is expected that in most cases, parties other than Consumers with current or former ownership interests may also be considered liable under the law and may be required to share in the costs of any site investigations and remedial actions. There is limited knowledge of manufactured gas plant contamination at these sites at this time. However, Consumers is continuing to monitor this issue. In addition, at the request of the DNR, Consumers prepared plans for remedial investigation/feasibility studies for three of these sites. Work plans for remedial investigation/feasibility studies for four other sites have also been prepared. The DNR has approved two of the three plans for remedial investigation/feasibility studies submitted and is currently reviewing the one remaining. Consumers currently estimates the total cost of conducting the three studies submitted to the DNR to be less than $1 million. The timing and extent of any further site investigation and remedial actions will depend, among other things, on requests received from the DNR and on future site usage by Consumers or other owners. Under the current schedule, Consumers anticipates the first remedial investigation/feasibility study would be completed in mid-1994. Consumers believes the results of the remedial investigation/feasibility studies will allow management to estimate a range of remedial cost estimates for the sites under study, which may be substantial. In 1993, the MPSC addressed the question of recovery of investigation and remedial costs for another Michigan gas utility as part of that utility's gas rate case. In that proceeding, the MPSC determined that prudent investigation and remedial costs could be deferred and amortized over 10-year periods and prudent unamortized costs can be included for recovery in the utility's rate cases. Consumers believes costs incurred for both investigation and any required remedial actions would be recoverable from gas utility customers under established regulatory policies and accordingly are not likely to materially affect its financial position or results of operations. Gas Outlook In 1993, Consumers purchased approximately 85 percent of its required gas supply under long-term contracts, and the balance on the spot market. Trunkline supplied approximately 41 percent of the total requirement. Consumers expects gas supply reliability to be ensured through long-term supply contracts, with purchases in the short-term spot market when economically beneficial. Management believes that Consumers' ability to purchase gas during the off-season and store it in its extensive underground storage facilities will continue to help provide customers with low-cost, competitive gas rates. Consumers anticipates growth in gas deliveries of approximately 0.6 percent per year over the next five years. Management believes that environmental benefits, along with the federal requirements included in the Energy Act, create an opportunity for growth in the natural gas vehicle industry. Other Other Income: The 1993 other income level reflects lower Midland-related losses than experienced in 1992. The 1992 loss included a $343 million charge related to the Settlement Order. The 1991 loss included $294 million, related to an MPSC order received in 1991 that allowed Consumers to recover only $760 million of remaining abandoned Midland investment, and a $92 million loss related to the cancellation of the CMS Debentures. Public Utility Holding Company Act Exemption: CMS Energy is exempt from registration under PUHCA. However, the Attorney General and the MMCG have asked the SEC to revoke CMS Energy's exemption from registration under PUHCA. On April 15, 1992, the MPSC filed a statement with the SEC recommending that CMS Energy's current exemption be revoked and a new exemption be issued conditioned upon certain reporting and operating requirements. If CMS Energy were to lose its current exemption, it would become more heavily regulated by the SEC; Consumers could ultimately be forced to divest either its electric or gas utility business; and CMS Energy would be restricted from conducting businesses that are not functionally related to the conduct of its utility business as determined by the SEC. CMS Energy is opposing this request and believes it will maintain its current exemption from registration under PUHCA. Consumers Power Company Notes to Consolidated Financial Statements 1: Corporate Structure Consumers is a combination electric and gas utility company serving most of the Lower Peninsula of Michigan, and is the principal subsidiary of CMS Energy, an energy holding company. Consumers' customer base includes a mix of residential, commercial and diversified industrial customers, the largest of which is the automotive industry. 2: Summary of Significant Accounting Policies and Other Matters Basis of Presentation The consolidated financial statements include Consumers and its wholly owned subsidiaries. Consumers eliminates all material transactions between its consolidated companies. Consumers uses the equity method of accounting for investments in its companies and partnerships where it has more than a 20 percent but less than a majority ownership interest. Gas Inventory Consumers uses the weighted average cost method for valuing working gas inventory. Cushion gas, which is gas stored to maintain reservoir pressure for recovery of working gas, is recorded in the appropriate gas utility plant account. Consumers stores gas inventory in its underground storage facilities. Maintenance, Depreciation and Depletion Property repairs and minor property replacements are charged to maintenance expense. Depreciable property retired or sold plus cost of removal (net of salvage credits) is charged to accumulated depreciation. Consumers bases depreciation provisions for utility plant on straight-line and units-of-production rates approved by the MPSC. In May 1991, the MPSC approved an increase of approximately $15 million annually in Consumers' electric and common utility plant depreciation rates. The composite depreciation rate for electric utility property was 3.4 percent for 1993 and 1992 and 3.3 percent for 1991. The composite rate for gas utility plant was 4.4 percent for 1993 and 4.3 percent for 1992 and 1991. The composite rate for other plant and property was 4.7 percent for 1993, 5.8 percent for 1992 and 3.7 percent for 1991. New Accounting Standards In November 1992, the FASB issued SFAS 112, Employers' Accounting for Postemployment Benefits, which Consumers adopted January 1, 1994. Consumers pays for several postemployment benefits, the most significant being workers compensation. Because Consumers' postemployment benefit plans do not vest or accumulate, the standard did not materially impact Consumers' financial position or results of operations. For new accounting standards related to financial instruments, see Note 8. Nuclear Fuel, Decommissioning and Other Nuclear Matters Consumers amortizes nuclear fuel cost to fuel expense based on the quantity of heat produced for electric generation. Interest on leased nuclear fuel is expensed as incurred. Under federal law, the DOE is responsible for permanent disposal of spent nuclear fuel at costs to be paid by affected utilities under various payment options. However, in a statement released February 17, 1994, the DOE asserted that it does not have a legal obligation to accept spent nuclear fuel without an operational repository. The DOE is exploring options to offset the costs incurred by nuclear utilities in continuing to store spent nuclear fuel on site. For fuel burned after April 6, 1983, Consumers charges disposal costs to nuclear fuel expense, recovers it through electric rates and remits it to the DOE quarterly. Consumers has elected to defer payment for disposal of spent nuclear fuel burned before April 7, 1983 until the spent fuel is delivered to the DOE. As of December 31, 1993, Consumers has recorded a liability to the DOE of $90 million, including interest, to dispose of spent nuclear fuel burned before April 7, 1983. Consumers has been recovering through electric rates the amount of this liability, excluding a portion of interest. Consumers' liability to the DOE becomes due when the DOE takes possession of Consumers' spent nuclear fuel, which was originally scheduled to occur in 1998. In April 1993, the NRC approved the design of the dry spent fuel storage casks now being used by Consumers at Palisades. In May 1993, the Attorney General and certain other parties commenced litigation to block Consumers' use of the storage casks, alleging that the NRC had failed to comply adequately with the National Environmental Policy Act. As of mid-February 1994, the courts have declined to prevent such use and have refused to issue temporary restraining orders or stays. Several appeals relating to this matter are now pending at the U.S. Sixth Circuit Court of Appeals. Consumers loaded two dry storage casks with spent nuclear fuel in 1993 and expects to load additional casks in 1994 prior to Palisades' 1995 refueling. If Consumers is unable to continue to use the casks as planned, significant costs, including replacement power costs during any resulting plant shutdown, could be incurred. Consumers currently estimates decommissioning costs (decontamination and dismantlement) of $208 million and $399 million, in 1993 dollars, for the Big Rock Point and Palisades nuclear plants, respectively. At December 31, 1993, Consumers had recorded $171 million of decommissioning costs and classified the obligation as accumulated depreciation. In January 1987, Consumers began collecting estimated costs to decommission its two nuclear plants through a monthly surcharge to electric customers which currently totals $45 million annually. Consumers expects to file updated decommissioning estimates with the MPSC on or before March 31, 1995. Amounts collected from electric retail customers are deposited in trust. Trust earnings are recorded as an investment with a corresponding credit included in accumulated depreciation. The total amount of the trust will be available for decommissioning Big Rock Point and Palisades at the end of their respective license periods in 2000 and 2007. Consumers believes the amounts being collected are adequate to meet its currently estimated decommissioning costs and current NRC requirements. In November 1993, Palisades returned to service following a planned refueling and maintenance outage that had been extended due to several unanticipated repairs. The results of an NRC review of Consumers' performance at Palisades published shortly thereafter showed a decline in performance ratings for the plant. Management believes that an increased emphasis on internal assessments will improve performance at Palisades. In order to provide NRC senior management with a more in-depth assessment of plant performance, the NRC has initiated a diagnostic evaluation team inspection at Palisades. The inspection will be a broad-based evaluation of all aspects of nuclear plant operation and management. The evaluation is expected to commence in March 1994, with results of the evaluation expected to be available in May 1994. The outcome of this evaluation cannot be predicted. Similar reviews conducted at nuclear plants of other utilities in recent years have in some cases resulted in increased regulatory oversight or required actions to improve plant operations, maintenance or condition. Plateau Resources Ltd. In August 1993, Consumers sold its ownership interest in Plateau to U. S. Energy Corp. As a result of the sale, approximately $14 million of Plateau's cash and cash equivalents, other assets and liabilities, including certain future decommissioning, environmental and other contingent liabilities were transferred to U. S. Energy Corp. In view of prior write-offs, this transaction did not result in any material gains or additional losses. Reclassifications Consumers and the MCV Partnership (see Note 17) have reclassified certain prior year amounts for comparative purposes. These reclassifications did not affect the net losses for the years presented. Revenue and Fuel Costs Consumers accrues revenue for electricity and gas used by its customers but not billed at the end of an accounting period. Consumers also accrues or reduces revenue for any underrecovery or overrecovery of electric power supply costs and natural gas costs by establishing a corresponding asset or liability until Consumers bills these unrecovered costs or refunds the excess recoveries to customers after reconciliation hearings conducted before the MPSC. Utility Regulation Consumers accounts for the effects of regulation under SFAS 71, Accounting for the Effects of Certain Types of Regulation. As a result, the actions of regulators affect when revenues, expenses, assets and liabilities are recognized. Other For significant accounting policies regarding cash equivalents, see Note 14; for income taxes, see Note 5; and for pensions and other postretirement benefits, see Note 10. 3: The Midland Cogeneration Venture The MCV Partnership, which leases and operates the MCV Facility, contracted to supply electricity and steam to The Dow Chemical Company and to sell electricity to Consumers for a 35-year period beginning in March 1990. At December 31, 1993, Consumers, through its subsidiaries, held the following assets related to the MCV: 1) CMS Midland owned a 49 percent general partnership interest in the MCV Partnership; and 2) CMS Holdings held through the FMLP a 35 percent lessor interest in the MCV Facility. In late 1993, Consumers sold its remaining $309 million investment in the MCV Bonds. Power Purchases from the MCV Partnership Consumers is obligated to purchase the following amounts of contract capacity from the MCV Partnership under the PPA: 1995 and Year 1991 1992 1993 1994 thereafter - ---- ----- ----- ----- ----- ---------- MW 806 915 1,023 1,132 1,240 During 1992 and 1991, the MPSC only allowed Consumers to recover costs of power purchased from the MCV Partnership based on delivered energy at rates less than Consumers paid for 840 MW in 1992 and 806 MW in 1991. As a result, Consumers recorded after-tax losses of $86 million in 1992 and $124 million in 1991. On March 31, 1993, the MPSC approved, with modifications, the Revised Settlement Proposal which had been co-sponsored by Consumers, the MPSC staff and 10 small power and cogeneration developers. These parties accepted the Settlement Order and the MCV Partnership confirmed that it did not object to its terms. ABATE and the Attorney General have filed claims of appeal of the Settlement Order with the Court of Appeals. The Settlement Order determined the cost of power purchased from the MCV Partnership that Consumers can recover from its electric retail customers and will significantly reduce the amount of future underrecoveries for these power costs. Effective January 1, 1993, the Settlement Order allowed Consumers to recover substantially all of the payments for its ongoing purchase of 915 MW of contract capacity from the MCV Partnership. Capacity and energy purchases from the MCV Partnership above the 915 MW level can be competitively bid into Consumers' next solicitation for power or, if necessary, utilized for current power needs with a prudency review and a pricing recovery determination in annual PSCR cases. In either instance, the MPSC would determine the levels of recovery from customers for the power purchased. The Settlement Order also provides Consumers the right to remarket all of the remaining capacity to third parties. The PPA requires Consumers to pay a minimum levelized average capacity charge of 3.77 cents per kWh, a fixed energy charge and a variable energy charge based primarily on Consumers' average cost of coal consumed. The Settlement Order provided Consumers two options for the recovery that could be used for capacity charges paid to the MCV Partnership. Under the option selected, Consumers is scheduling deliveries of energy from the MCV Partnership whenever it has energy available up to hourly availability limits, or "caps," for the 915 MW of capacity authorized for recovery in the Settlement Order. Consumers can recover an average 3.62 cents per kWh capacity charge and the prescribed energy charges associated with the scheduled deliveries within the caps, whether or not those deliveries are scheduled on an economic basis. Through December 31, 1997, there is no cap applied during on-peak hours to Consumers' recovery for the purchase of capacity made available within the 915 MW authorized. Recovery for purchases during off-peak hours is capped at 80 percent in 1993, 82 percent in 1994 and 1995, 84 percent in 1996 and 1997, increasing to 88.7 percent in 1998 and thereafter at which time the 88.7 percent cap is applicable during all hours. For all economic energy deliveries above the caps to 915 MW, the option also allows Consumers to recover 1/2 cent per kWh capacity payment in addition to the corresponding energy charge. In December 1992, Consumers recognized an after-tax loss of $343 million for the present value of estimated future underrecoveries of power costs under the PPA as a result of the Settlement Order. This loss included management's best estimates regarding the future availability of the MCV Facility, and the effect of the future wholesale power market on the amount, timing and price at which various increments of the capacity above the MPSC-authorized level could be resold. Except for adjustments to the above loss to reflect the after-tax time value of money through accretion expense, no additional losses are expected unless actual future experience materially differs from management's estimates. Because the calculation of the 1992 loss depended in part upon estimates of future unregulated sales of energy to third parties, a more conservative or risk-free investment rate of 7 percent was used to calculate $188 million of the total $343 million after-tax loss. The remaining portion of the loss was calculated using an 8.5 percent discount rate reflecting Consumers' incremental borrowing rate as required by SFAS 90, Regulated Enterprises- Accounting for Abandonments and Disallowances of Plant Costs. The after- tax expense for the time value of money for the loss is estimated to be approximately $24 million in 1994, and various lower levels thereafter, including $22 million in 1995 and $20 million in 1996. Although the settlement losses were recorded in 1992, the after-tax cash underrecoveries, including fixed energy charges, associated with the Settlement Order were $59 million in 1993. Consumers believes there is and will be a market for the resale of capacity purchases from the MCV Partnership above the MPSC-authorized level. However, if Consumers is unable to sell any capacity above the current MPSC-authorized level, future additional after-tax losses and after-tax cash underrecoveries could be incurred. Consumers' estimates of its future after-tax cash underrecoveries and possible additional losses for the next five years if none of the additional capacity is sold are as follows: After-tax, In Millions 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- Expected cash underrecoveries $56 $65 $62 $61 $ 8 Possible additional under- recoveries and losses (a) $14 $20 $20 $22 $72 (a) If unable to sell any capacity above the MPSC's authorized level The undiscounted, after-tax amount of the $343 million loss was $789 million. At December 31, 1993, the after-tax present value of the Settlement Order liability had been reduced to $307 million, which reflects after-tax cash underrecoveries related to capacity totaling $(54) million, after-tax accretion expense of $23 million and a $(5) million adjustment due to the 1993 corporate tax rate change (see Note 5). The PPA, while requiring payment of a fixed energy charge, contains a "regulatory out" provision which permits Consumers to reduce the fixed energy charges payable to the MCV Partnership throughout the entire contract term if Consumers is not able to recover these amounts from its customers. In connection with the MPSC's approval of the Revised Settlement Proposal, Consumers and the MCV Partnership have commenced arbitration proceedings under the PPA to determine whether Consumers is entitled to exercise its regulatory out regarding fixed energy charges on the portion of available MCV capacity above the current MPSC-authorized levels. An arbitrator acceptable to both parties has been selected. If the arbitrator determines that Consumers cannot exercise its regulatory out, Consumers would be required to make these fixed energy payments to the MCV Partnership even though Consumers may not be recovering these costs. The arbitration proceedings will also determine who is entitled to the fixed energy amounts for which Consumers did not receive full cost recovery during the years prior to settlement. Although Consumers believes its position on arbitration is sound and intends to aggressively pursue its right to exercise the regulatory out, management cannot predict the outcome of the arbitration proceedings or any possible settlement of the matter. Accordingly, losses were recorded prior to 1993 for all fixed energy amounts at issue in the arbitration. As of December 31, 1993, approximately $20 million has been escrowed by Consumers and is included in Consumers' temporary cash investments. In December 1993, Consumers made an irrevocable offer to pay through September 15, 2007, fixed energy charges to the MCV Partnership on all kWh delivered by the MCV Partnership to Consumers from the contract capacity in excess of 915 MW, which represents a portion of the fixed energy charges in dispute. Consumers made the offer to facilitate the sale of the remaining MCV Bonds in 1993. The lessors of the MCV Facility have filed a lawsuit in federal district court against CMS Energy, Consumers and CMS Holdings. It alleges breach of contract, breach of fiduciary duty and negligent or willful misrepresentation relating to the MCV Partnership's failure to object to the Settlement Order in light of Consumers' interpretation of the Settlement Order, which is the subject of an arbitration between the MCV Partnership and Consumers. The action alleges damages in excess of $1 billion and seeks injunctive relief relative to Consumers' payments of the fixed energy charge. CMS Energy and Consumers believe that at all times they and CMS Holdings have conducted themselves properly and that the action is without merit. They also believe that a significant portion of the alleged damages represent fixed energy charges in dispute in the arbitration. CMS Energy and Consumers are unable to predict the outcome of this action. PSCR Matters: Consistent with the terms of the Settlement Order, Consumers has withdrawn its appeals of various MPSC orders issued in connection with the 1992, 1991 and 1990 PSCR cases. Consumers also agreed not to appeal any MCV-related issues raised in future orders for these plan cases and related reconciliations to the extent those issues are resolved by the Settlement Order. Consumers made refunds, including interest, of $69 million in 1993 and $29 million in 1992 to customers for overrecoveries in connection with the 1991 and 1990 PSCR reconciliation cases, respectively. These amounts were included in losses recorded prior to 1993. In 1992, Consumers recovered MCV power purchase costs consistent with the MPSC's 1992 plan case order, and does not anticipate that any MCV-related refunds will be required. 4: Rate Matters Electric Rate Case Consumers filed a request with the MPSC in May 1993 to increase its electric rates. Subsequently, as a result of changed estimates, Consumers revised its requested electric rate increase to $133 million annually based on a 1994 test year. Consumers also requested an additional annual electric rate increase of $38 million based on a 1995 test year. Consumers' request included increased future expenditures primarily related to capital additions, demand-side management programs, operation and maintenance, higher depreciation and postretirement benefits computed under SFAS 106, Employers' Accounting for Postretirement Benefits Other than Pensions. The filing also proposed experimental incentive provisions that would either reward or penalize Consumers, based on its operating performance. In addition, Consumers would share any returns above its MPSC-authorized level with customers in exchange for the ability to earn not lower than one percentage point below its authorized level. In March 1994, an ALJ issued a proposal for decision that recommended Consumers' 1994 final annual rate increase total approximately $83 million, and that the incremental requested 1995 increase not be granted at this time. The ALJ's recommendation included a lower return on electric common equity, reflected reduced anticipated debt costs due to the projected availability of more favorable interest rates and proposed a lower equity ratio for Consumers' projected capitalization structure. The ALJ did, however, generally support Consumers' rate design proposal to significantly reduce the level of subsidization of residential customers by commercial and industrial customers and generally supported the performance incentive but not the shared return mechanism discussed above. Abandoned Midland Project: In July 1984, Consumers abandoned construction of its unfinished nuclear power plant located in Midland, Michigan, and subsequently took a series of write-downs. In May 1991, Consumers began collecting $35 million pretax annually for the next 10 years and is amortizing the assets against current income over the recovery period using an interest method. Amortization for 1993, 1992 and 1991 was $28 million, $28 million and $18 million, respectively. Consumers was not permitted to earn a return on the portion of the abandoned Midland investment for which the MPSC was allowing recovery. Therefore, under SFAS 90, the recorded losses described above included amounts that reduced the recoverable asset to the present value of future recoveries. During the remaining recovery period, part of the prior losses will be reversed to adjust the unrecovered asset to its present value. and is reflected as accretion income. An after-tax total of approximately $35 million of the prior losses remains to be included in accretion income through April 2001. Several parties, including the Attorney General, have filed claims of appeal with the Court of Appeals regarding MPSC orders issued in May and July 1991 that specified the recovery of abandoned investment. Electric Demand-side Management: As a result of settlement discussions regarding demand-side management and an MPSC order in July 1991, Consumers agreed to spend $65 million over two years on demand-side management programs. Based on the MPSC's determination of Consumers' effectiveness in implementing these programs, Consumers' future rate of return on common equity may be adjusted either upward by up to 1 percent or downward by up to 2 percent. This adjustment, if implemented, would be applied to Consumers' retail electric tariff rates and be in effect for one year following reconciliation hearings with the MPSC that are expected to be initiated in the first quarter of 1994. The estimated revenue effects of the potential adjustment range from an $11 million increase to a $22 million decrease. Consumers believes it will receive an increase on its return on common equity based on having achieved all of the agreed upon objectives. On October 1, 1993, Consumers completed the customer participation portion of these programs and as part of its current electric rate case has requested MPSC authorization to continue certain programs in 1994. Consumers has also requested recovery of demand-side management expenditures which exceeded the $65 million level. Consumers is deferring program costs and amortizing the costs over the period these costs are being recovered from its customers in accordance with an accounting order issued by the MPSC in September 1992. The unamortized balance of deferred costs at December 31, 1993 and 1992 was $71 million and $25 million, respectively. PSCR Issues Consumers began a planned refueling and maintenance outage at Palisades in June 1993. Following several required, unanticipated repairs that extended the outage, the plant returned to service in early November. Recovery of replacement power costs incurred by Consumers during the outage will be reviewed by the MPSC during the 1993 PSCR reconciliation of actual costs and revenues to determine the prudency of actions taken during the outage. Any finding of delay due to imprudence could result in disallowances of a portion of replacement power costs. Net replacement power costs were approximately $180,000 per day above the cost of fuel incurred when the plant is operating. The Energy Act imposes an obligation on the utility industry, including Consumers, to decommission DOE uranium enrichment facilities. Consumers currently estimates its payments for decommissioning those facilities to be $2.4 million per year for 15 years beginning in 1992, escalating based on an inflation factor. Consumers believes these costs are recoverable from its customers under traditional regulatory policies. As of December 31, 1993, Consumers' remaining estimated liability was approximately $34 million. Consumers has a regulatory asset of $34 million for the expected recovery of this amount in electric rates. GCR Issues In connection with its 1991 GCR reconciliation case, Consumers refunded $36 million, including interest, to its firm sales and transportation rate customers in April 1992. Consumers accrued the full amount for this refund in 1991. The MPSC issued an order during 1993 that approved an interim settlement agreement for the 12 months ended March 31, 1993. As a result of the settlement, Consumers refunded in August 1993, to its GCR and transportation customers, approximately $22 million, including interest. Consumers previously accrued amounts sufficient for this refund. The MPSC, in a February 1993 order, provided that the price payable to certain intrastate gas producers by Consumers be reduced prospectively. As a result, Consumers was not allowed to recover approximately $13 million of costs incurred prior to February 8, 1993. In 1991, Consumers accrued a loss sufficient for this issue. Future disallowances are not anticipated, unless the remaining appeals filed by the intrastate producers are successful. In 1992, the FERC approved a settlement involving Consumers, Trunkline and certain other parties, which resolved numerous claims and proceedings concerning Trunkline liquified natural gas costs. The settlement represents significant gas cost savings for Consumers and its customers in future years. As part of the settlement, Consumers will not incur any transition costs from Trunkline as a result of FERC Order 636. In November 1992, Consumers had recorded a liability and regulatory asset for the principal amount of payments to Trunkline over a five-year period and a regulatory asset. On May 11, 1993, the MPSC approved a separate settlement agreement that provides Consumers with full recovery of these costs over a five-year period. At December 31, 1993, Consumers' remaining liability and regulatory asset was $116 million. Other Certain of Consumers' direct gas suppliers have contract prices tied to the price Consumers pays Trunkline for its gas. On September 1, 1993, Consumers commenced gas purchases from Trunkline under a continuation of prior sales agreements. The current contract covers gas deliveries through October 1994 and is at a reduced price compared to prior gas sales. Some of Consumers' direct gas suppliers have claimed that the reduced Trunkline gas cost is not a proper reference price under their contracts with Consumers and that their contracts are terminable after a 12-month period. Consumers is disputing these claims. Additionally, three of these direct gas suppliers of Consumers have made filings with the FERC in Trunkline's Order 636 restructuring case seeking to preclude Trunkline's ability to make the sales to Consumers which commenced on September 1, 1993. Consumers and Trunkline vigorously opposed these filings and in December 1993, the FERC issued an order which, among other things, allowed Trunkline to continue sales of gas to Consumers under tariffs on file with the FERC. Estimated losses for certain contingencies discussed in this note have been accrued. Resolution of these contingencies is not expected to have a material impact on the financial statements. 5: Income Taxes Consumers and its subsidiaries file a consolidated federal income tax return with CMS Energy. Income taxes are generally allocated to each company based on each company's separate taxable income. Consumers' accrued federal income tax benefits from CMS Energy were $49 million and $3 million as of December 31, 1993 and 1992, respectively. In 1992, Consumers implemented SFAS 109, Accounting for Income Taxes. Deferred tax assets and liabilities are classified as current or noncurrent based on the classification of the related asset or liability, for all temporary differences. Consumers began practicing full deferred tax accounting for temporary differences arising after January 1, 1993, as authorized by a generic MPSC order. The generic order reduces the amount of regulatory assets and liabilities that otherwise could have arisen in future periods by allowing Consumers to reflect the income statement effect in the period temporary differences arise. Consumers uses ITC to reduce current income taxes payable and defers and amortizes ITC over the life of the related property. The AMT requires taxpayers to perform a second separate federal tax calculation based on a flat rate applied to a broader tax base. AMT is the amount by which this "broader-based" tax exceeds regular tax. Any AMT paid generally becomes a tax credit that can be carried forward indefinitely to reduce regular tax liabilities in future periods when regular taxes paid exceed the tax calculated for AMT. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 increased the statutory federal tax rate from 34 percent to 35 percent effective January 1, 1993. The cumulative effect of this tax rate change has been reflected in Consumers' financial statements. The significant components of income tax expense (benefit) consisted of: In Millions Years Ended December 31 1993 1992 1991(a) - ----------------------- ------- ------ -------- Current federal income taxes $ 41 $ 52 $ 58 Deferred income taxes 61 (172) (166) Deferred income taxes - tax rate change (2) - - Deferred ITC, net (9) (7) 33 ------- ------ ------ $ 91 $(127) $(75) ======= ====== ====== Operating $ 116 $ 51 $ 48 Other (25) (178) (123) ------- ------ ------ $ 91 $(127) $(75) ======= ====== ====== (a) The 1991 provision for income taxes was before an extraordinary item that had related deferred income taxes of approximately $7 million. The principal components of Consumers' deferred tax assets (liabilities) recognized in the balance sheet are as follows: In Millions December 31 1993 1992 - ----------- ------- -------- Property $ (518) $ (458) Unconsolidated investments (184) (129) Postretirement benefits (Note 10) (178) (165) Abandoned Midland project (Note 4) (57) (60) Employee benefit obligations (includes postretirement benefits of $178 and $165) (Note 10) 200 186 MCV power purchases - settlement (Note 3) 165 177 AMT carryforward 64 51 ITC carryforward (expires 2005) 48 49 Other (8) (4) ------- -------- $ (468) $ (353) ======= ======== Gross deferred tax liabilities $(1,319) $(1,228) Gross deferred tax assets 851 875 -------- -------- $ (468) $ (353) ======== ======== The actual income tax expense (benefit) differs from the amount computed by applying the statutory federal tax rate to income before income taxes as follows: In Millions Years Ended December 31 1993 1992 1991 ------- ------- ------- Net income (loss) before extraordinary item $ 198 $(244) $(235) Income tax expense (benefit) 91 (127) (75) ------- ------- ------- 289 (371) (310) Statutory federal income tax rate x 35% x 34% x 34% -------- ------- ------- Expected income tax expense (benefit) 101 (126) (105) Increase (decrease) in taxes from: Capitalized overheads previously flowed through 5 5 35 Differences in book and tax depreciation not previously deferred 6 9 8 ITC amortization and utilization (10) (10) (7) Affiliated companies' dividends (6) (5) (5) Other, net (5) - (1) ------- ------- ------- $ 91 $(127) $ (75) ======= ======= ======= 6: Short-Term Financings Consumers has authorization from the FERC to issue or guarantee up to $900 million of short-term debt through December 31, 1994. Consumers has a $470 million facility that is used to finance seasonal working capital requirements and unsecured, committed lines of credit aggregating $165 million. As of December 31, 1993, $235 million and $24 million were outstanding at weighted average interest rates of 4.0 percent and 3.9 percent, respectively. Further, Consumers has an established $500 million trade receivables purchase and sale program. As of December 31, 1993 and 1992, receivables sold under the agreement totaled $285 million and $225 million, respectively. On February 15, 1994, Consumers increased the level of receivables sold to $335 million. 7: Capitalization Capital Stock As of December 31, 1992, Consumers effected a quasi-reorganization, an elective accounting procedure in which Consumers' accumulated deficit of $574 million was eliminated against other paid-in capital. The fair values of Consumers' assets and liabilities at the date of the quasi- reorganization were determined by management to approximate their carrying values and no material adjustments to the historical bases were made. This action was approved by Consumers' Board of Directors and did not require shareholder approval. As a result of the quasi-reorganization and subsequent accumulated earnings, Consumers paid $133 million in common stock dividends in 1993 and also declared from 1993 earnings a $16 million common stock dividend in January 1994. Consumers has authorization from the MPSC and is proceeding to issue $200 million of preferred stock in 1994. First Mortgage Bonds Consumers secures its first mortgage bonds by a mortgage and lien on substantially all of its property. Consumers' ability to issue and sell securities is restricted by certain provisions in its First Mortgage Bond Indenture, Articles and the need for regulatory approvals in compliance with appropriate state and federal law. In September 1993, Consumers issued, with MPSC approval, $300 million of 6 3/8 percent first mortgage bonds, due 2003 and $300 million of 7 3/8 percent first mortgage bonds, due 2023. Consumers used the net proceeds from the bond issuance to refund approximately $515 million of higher interest first mortgage bonds and the balance to reduce short-term borrowings. Unamortized debt costs, premiums and discounts and call premiums on the refunded debt totaling approximately $18 million were deferred under SFAS 71, and are being amortized over the lives of the new debt. In February 1994, Consumers issued a call for redemption totaling approximately $10 million. Consumers also fully redeemed two issues of first mortgage bonds totaling approximately $91 million. These redemptions completed Consumers' commitment to the MPSC, under the 1993 authorization to issue first mortgage bonds, to refinance certain long- term debt. Long-Term Bank Debt Under its long-term credit agreement at December 31, 1993, Consumers was required to make 10 remaining quarterly principal payments of approximately $47 million. As of December 31, 1993, the outstanding balance under this credit agreement totaled $469 million with a weighted average interest rate of 4.0 percent. In January 1993, Consumers entered into an interest rate swap agreement, exchanging variable-rate interest for fixed-rate interest on the latest maturing $250 million of the then remaining $500 million obligation under its long-term credit agreement. Other Consumers has a total of $131 million of PCRBs outstanding with a weighted average interest rate of 4.2 percent as of December 31, 1993. Consumers classifies $101 million of PCRBs as long-term because it can refinance these amounts through irrevocable letters of credit expiring after one year. In June 1993, Consumers entered into loan agreements in connection with the issuance of approximately $28 million of adjustable rate demand limited obligation refunding revenue bonds, due 2010, which are secured by an irrevocable letter of credit expiring in 1996. These bonds bear an initial interest rate of 2.65 percent. Consumers also entered into loan agreements in connection with the issuance of $30 million of 5.8 percent limited obligation refunding revenue bonds, due 2010, secured by a financial guaranty insurance policy and certain first mortgage bonds of Consumers. Proceeds of these issues were used to redeem on August 1, 1993 in advance of their maturities, approximately $58 million of outstanding PCRBs. 8: Financial Instruments Cash, short-term investments and current liabilities approximate their fair value due to the short-term nature of those instruments. The estimated fair value of long-term investments is based on quoted market prices where available. When specific market prices do not exist for an instrument, the fair value is based on quoted market prices of similar investments or other valuation techniques. All long-term investments in financial instruments, except as shown below, approximate fair value. Although the current fair value of the long-term debt, which is based on calculations made by debt pricing specialists, may be greater than the current carrying amount, settlement of the reported debt is generally not expected until maturity. The estimated fair values of Consumers' financial instruments are as follows: In Millions Years Ended December 31 1993 1992 - ----------------------- ----------------- ----------------- Carrying Fair Carrying Fair Amount Value Amount Value Investment in stock of affiliates $ 291 $ 323 $ 291 $ 303 Long-term debt 1,839 1,984 2,079 2,123 The fair value of Consumers' off-balance sheet financial instruments is based on the amount estimated to terminate or settle the obligation: In Millions Years Ended December 31 1993 1992 ---------- ---------- Fair Value Fair Value Interest rate swaps (Note 7) $ 5 $ - Guarantees 7 7 On January 1, 1994, Consumers adopted SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, requiring accounting for investments in debt securities to be held to maturity at amortized cost; otherwise debt and marketable equity securities would be recorded at fair value, with any unrealized gains or losses included in earnings if the security is held for trading purposes or as a separate component of shareholders' equity if the security is available for sale. The implementation resulted in an increase in assets of $30 million in January 1994 with a corresponding increase in stockholders' equity of $20 million, net of tax. In May 1993, the FASB issued SFAS 114, Accounting by Creditors for Impairment of a Loan, effective in 1995, requiring certain loans that are determined to be impaired be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of any collateral for a secured loan. Consumers does not believe this standard will have a material impact on its financial position or results of operations. 9: Executive Incentive Compensation Consumers participates in CMS Energy's Performance Incentive Stock Plan. Under the plan, restricted shares of common stock of CMS Energy, stock options and stock appreciation rights may be granted to key employees based on their contributions to the successful management of CMS Energy and its subsidiaries. The plan reserves for award not more than 2 percent of CMS Energy's common stock outstanding on January 1 each year, less the number of shares of restricted common stock awarded and of common stock subject to options granted under the plan during the immediately preceding four calendar years. Any forfeitures are subject to award under the plan. As of December 31, 1993, awards of up to 447,686 shares of common stock may be issued. Restricted shares of common stock are outstanding shares with full voting and dividend rights. Performance criteria were added in 1990 based on CMS Energy's total return to shareholders. Shares of restricted common stock cannot be distributed until they are vested and the performance objectives are met. Further, the restricted stock is subject to forfeiture if employment terminates before vesting. If key employees exceed performance objectives, the plan will allow additional awards. Restricted shares vest fully if control of CMS Energy changes, as defined by the plan. Consumers' Executive Stock Option and Stock Appreciation Rights Plan, an earlier plan approved by shareholders, remains in effect until all authorized options are granted or September 25, 1995. As of December 31, 1993, options for 43,000 shares remained to be granted. Under both plans, for stock options and stock appreciation rights, the exercise price on each grant date equaled the closing market price on the grant date. Options are exercisable upon grant and expire up to 10 years and one month from date of grant. The status of the restricted stock granted under the Performance Incentive Stock Plan and options granted under both plans follows. The number of shares presented also includes shares for employees of CMS Energy and non-utility affiliates. Restricted Stock Options ---------- ---------------------------- Number Number Price of Shares of Shares per Share ----------- --------- --------------- Outstanding at January 1, 1991 212,500 1,162,216 $ 7.13 - $34.25 Granted 97,000 194,000 $ 21.13 - $21.13 Exercised or Issued (34,437) (65,125) $ 7.13 - $16.00 --------- ---------- --------------- Outstanding at December 31, 1991 275,063 1,291,091 $ 7.13 - $34.25 Granted 101,000 215,000 $ 17.13 - $18.00 Exercised or Issued (37,422) (21,000) $ 13.00 - $16.00 Canceled (15,375) (50,000) $ 20.50 - $33.88 --------- ---------- --------------- Outstanding at December 31, 1992 323,266 1,435,091 $ 7.13 - $34.25 Granted 132,000 249,000 $ 25.13 - $26.25 Exercised or Issued (54,938) (152,125) $ 7.13 - $21.13 Canceled (84,141) (33,000) $ 20.50 - $33.88 --------- ---------- --------------- Outstanding at December 31, 1993 316,187 1,498,966 $ 7.13 - $34.25 ========= ========== =============== 10: Retirement Benefits Postretirement Benefit Plans Other Than Pensions Consumers adopted SFAS 106 effective as of the beginning of 1992. The standard required Consumers to change its accounting for the cost of health care and life insurance benefits that are provided to retirees from a pay-as-you-go (cash) method to a full accrual method. Accordingly, Consumers recorded a liability of $466 million for the accumulated transition obligation and a corresponding regulatory asset for anticipated recovery in utility rates. Both the MPSC and FERC have generally adopted SFAS 106 costs for ratemaking purposes provided costs recovered through rates are placed in external funds until they are needed to pay benefits. The MPSC's generic order allows utilities three years to seek recovery of costs and provides for recovery from customers of any deferred costs incurred prior to the beginning of rate recovery of such costs. Consumers anticipates recovering its regulatory asset within 20 years. As discussed in Note 4, Consumers has requested recovery of the portion of these costs allocated to the electric business. In late 1994, Consumers plans to request recovery of the gas utility portion of these costs. Consumers plans to fund the benefits using external Voluntary Employee Beneficiary Associations. Funding of the health care benefits would begin when Consumers' rate recovery based on SFAS 106 begins. A portion of the life insurance benefits have previously been funded. As of December 31, 1993, the actuary assumed that retiree health care costs increased 10.5 percent in 1994 then decreased gradually to 5.5 percent in 2000 and thereafter. The health care cost trend rate assumption significantly affects the amounts reported. For example, a 1 percentage point increase in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $75 million and the aggregate of the service and interest cost components of net periodic postretirement benefit costs for 1993 by $9 million. For the years ended December 31, 1993 and 1992, the weighted average discount rate was 7.25 percent and 8 percent, respectively, and the expected long-term rate of return on plan assets was 8.5 percent. Net periodic postretirement benefit cost for health care benefits and life insurance benefits was $51 million in 1993 and $49 million in 1992. The 1993 and 1992 cost was comprised of $13 million and $10 million for service plus $38 million and $39 million for interest, respectively. The funded status of the postretirement benefit plans is reconciled with the liability recorded at December 31 as follows: In Millions 1993 1992 ------- ------- Actuarial present value of estimated benefits Retirees $ 281 $ 264 Eligible for retirement 54 50 Active (upon retirement) 187 175 ------- ------- Accumulated postretirement benefit obligation 522 489 Plan assets (premium deposit fund) at fair value 4 4 ------- ------- Projected postretirement benefit obligation in excess of plan assets (518) (485) Unrecognized net loss from experience different than assumed 8 - ------- ------- Recorded liability and regulatory asset $ (510) $ (485) ======= ======= Consumers' postretirement health care plan is unfunded; the accumulated postretirement benefit obligation for that plan is $510 million and $478 million at December 31, 1993 and 1992, respectively. Supplemental Executive Retirement Plan Certain management employees qualify under the SERP. Benefits are based on the employee's service and earnings as defined in the SERP. In 1988, a trust from which SERP benefits are paid was established and funded. Because the SERP is not a qualified plan under the Internal Revenue Code, earnings of the trust are taxable and trust assets are included in Consumers' consolidated assets. As of December 31, 1993 and 1992, trust assets at cost (which approximates market) were $16 million and $14 million, respectively, and were classified as other non-current assets. Defined Benefit Pension Plan A trusteed, non-contributory, defined benefit Pension Plan covers substantially all employees. The benefits are based on an employee's years of accredited service and earnings, as defined in the plan, during an employee's five highest years of earnings. Because the plan is fully funded, no contributions were made for plan years 1991 through 1993. Amounts presented for the Pension Plan include amounts for CMS Energy and non-utility affiliates, which are not distinguishable from nor are they significant when compared with the plan's total amounts. Years Ended December 31 1993 1992 1991 - ----------------------- ----- ----- ----- Discount rate 7.25% 8.5% 8.5% Rate of compensation increase 4.5% 5.5% 5.5% Expected long-term rate of return on assets 8.75% 8.75% 8.75% Net Pension Plan and SERP costs consisted of: In Millions Years Ended December 31 1993 1992 1991 ----- ----- ----- Service cost $ 19 $ 19 $ 18 Interest cost 49 47 48 Actual return on plan assets (92) (36) (88) Net amortization and deferral 34 (20) 28 ----- ----- ----- Net periodic pension cost $ 10 $ 10 $ 6 ===== ===== ===== The funded status of the Pension Plan and SERP reconciled to the pension liability recorded at December 31 was: In Millions Pension Plan SERP ------------- ------------- 1993 1992 1993 1992 ----- ----- ----- ----- Actuarial present value of estimated benefits Vested $ 471 $ 349 $ 12 $ 10 Non-vested 56 49 - - ------ ------ ----- ----- Accumulated benefit obligation 527 398 12 10 Provision for future pay increases 138 177 5 5 ------ ------ ----- ----- Projected benefit obligation 665 575 17 15 Plan assets (primarily stocks and bonds,including $87 in 1993 and $64 in 1992 in common stock of CMS Energy) at fair value 692 631 - - ------ ------ ----- ----- Projected benefit obligation less than (in excess of) plan assets 27 56 (17) (15) Unrecognized net (gain) loss from experience different than assumed (56) (76) 5 2 Unrecognized prior service cost 45 49 - 1 Unrecognized net transition (asset) obligation (44) (49) 1 1 ------ ------ ------ ----- Recorded liability $ (28) $ (20) $ (11) $(11) ====== ====== ====== ===== Beginning January 1, 1986, the amortization period for the Pension Plan's unrecognized net transition asset is 16 years and 11 years for the SERP's unrecognized net transition obligation. Prior service costs are amortized on a straight-line basis over the average remaining service period of active employees. In 1991, certain eligible employees accepted early retirement incentives. The incentives consisted of lump-sum cash payments and increased pension payments. The pretax cost of the incentives was $25 million. Also in 1991, portions of the projected benefit obligation were settled which resulted in a pretax gain of $25 million that offset the early retirement costs. 11: Leases Consumers leases various assets, including vehicles, aircraft, construction equipment, computer equipment, nuclear fuel and buildings. Consumers' nuclear fuel capital leasing arrangement was extended an additional year and is now scheduled to expire in November 1995. The maximum amount of nuclear fuel that can be leased increased from $55 million to $70 million. Consumers further increased this amount in early 1994 to $80 million. The lease provides for an additional one-year extension upon mutual agreement by the parties. Upon termination of the lease, the lessor would be entitled to a cash payment equal to its remaining investment, which was $57 million as of December 31, 1993. Consumers is responsible for payment of taxes, maintenance, operating costs, and insurance. Minimum rental commitments under Consumers' non-cancelable leases at December 31, 1993, were: In Millions Capital Operating Leases Leases ------- --------- 1994 $ 40 $ 7 1995 57 6 1996 16 2 1997 15 2 1998 13 2 1999 and thereafter 26 21 ----- ----- Total minimum lease payments 167 $ 40 ===== Less imputed interest 27 ----- Present value of net minimum lease payments 140 Less current portion 34 ----- Non-current portion (a) $106 ===== (a) In January 1994, Consumers amended its nuclear fuel lease to include fuel previously owned at Big Rock Point. This is estimated to increase the non-current portion of capital leases by approximately $6 million. Consumers recovers these charges from customers and accordingly charges payments for its capital and operating leases to operating expense. Operating lease charges, including charges to clearing and other accounts as of December 31, 1993, 1992 and 1991, were $8 million, $12 million and $12 million, respectively. Capital lease expenses for the years ended December 31, 1993, 1992 and 1991 were $32 million, $44 million and $48 million, respectively. Included in these amounts for the years ended 1993, 1992 and 1991, are nuclear fuel lease expenses of $13 million, $17 million and $24 million, respectively. 12: Commitments and Contingencies Ludington Pumped Storage Plant Litigation In 1986, the Attorney General filed a lawsuit on behalf of the State of Michigan in the Circuit Court of Ingham County, seeking damages from Consumers and Detroit Edison for alleged injuries to fishery resources because of the operation of the Ludington Pumped Storage Plant. The state sought $148 million (including $16 million of interest) for past injuries and $89,000 per day for future injuries, with the latter amount to be adjusted upon installation of "adequate" fish barriers and other changed conditions. In 1987, the Attorney General filed a second lawsuit alleging that Consumers and Detroit Edison have breached a bottomlands lease agreement with the state and asked that the lease be declared void. This complaint was consolidated with the suit described in the preceding paragraph. In 1990, both of the lawsuits were dismissed on the basis of federal preemption. In 1993, the Court of Appeals overturned the dismissal, as to damages, effectively allowing the state to continue its damages lawsuit against Consumers and Detroit Edison, but generally affirmed the lower court's ruling as to the breach of lease claim. The Court of Appeals' ruling also limited any potential damages to those occurring no earlier than 1983. Consumers, Detroit Edison and the Attorney General have filed an application for leave to appeal with the Michigan Supreme Court. Consumers and Detroit Edison are seeking to have the trial court's dismissal of the damages claim affirmed. Each year since 1989, Consumers and Detroit Edison have complied with FERC orders by installing a seasonal barrier net from April to October at the Ludington plant site. The FERC is now considering whether the barrier net (along with other actions by Consumers, including contributions to state fish-stocking programs) would be a satisfactory permanent solution. Environmental Matters Consumers is a so-called "Potentially Responsible Party" at several sites being administered under Superfund. Along with Consumers, there are numerous credit-worthy, potentially responsible parties with substantial assets cooperating with respect to the individual sites. Based on information currently known by management, Consumers believes that it is unlikely that its liability at any of the known Superfund sites, individually or in total, will have a material adverse effect on its financial position or results of operations. The State of Michigan in 1990 passed amendments to the Environmental Response Act that established a state program similar to the federal Superfund law, though broader in scope. Under this law, Consumers expects that it will ultimately incur costs at a number of sites, including some of the 23 sites that formerly housed manufactured gas plant facilities, even those in which it has a partial or no current ownership interest. It is expected that in most cases, parties other than Consumers with current or former ownership interests may also be considered liable under the law and may be required to share in the costs of any site investigations and remedial actions. There is limited knowledge of manufactured gas plant contamination at these sites at this time. However, Consumers is continuing to monitor this issue. In addition, at the request of the DNR, Consumers prepared plans for remedial investigation/feasibility studies for three of these sites. Work plans for remedial investigation/feasibility studies for four other sites have also been prepared. The purpose of a remedial investigation/feasibility study is to define the nature and extent of contamination at a site and to determine which of several possible remedial action alternatives, including no action, may be required under the Environmental Response Act. The DNR has approved two of the three plans for remedial investigation/feasibility studies submitted and is currently reviewing the one remaining. The cost to conduct one of the approved studies will be approximately $250,000 based on bids received. Although the actual cost of conducting the remaining two remedial investigation/feasibility studies will not be known until bids are received from contractors, Consumers currently estimates the total cost of conducting the three studies submitted to the DNR to be less than $1 million. The timing and extent of any further site investigation and remedial actions will depend, among other things, on requests received from the DNR and on future site usage by Consumers or other owners. Under the current schedule, Consumers anticipates the first remedial investigation/feasibility study would be completed in mid-1994. Consumers believes the results of the remedial investigation/feasibility studies will allow management to estimate a range of remedial cost estimates for the sites under study. Based on Consumers' knowledge of other utility remedial actions, remediation costs for Consumers for these sites may be substantial. In 1993, the MPSC addressed the question of recovery of investigation and remedial costs for another Michigan gas utility as part of that utility's gas rate case. In that proceeding, the MPSC determined that prudent investigation and remedial costs could be deferred and amortized over 10-year periods and prudent unamortized costs can be included for recovery in the utility's rate cases. The MPSC stated the length of the period may be reviewed from time to time, but any revisions would be prospective. Consumers believes costs incurred for both investigation and any required remedial actions would be recoverable from its customers under established regulatory policies and accordingly are not likely to materially affect its financial position or results of operations. Included in the 1990 amendments to the federal Clean Air Act are provisions that limit emissions of sulfur dioxide and nitrogen oxides and require enhanced emissions monitoring. All of Consumers' coal-fueled electric generating units burn low-sulfur coal and are presently operating at or near the sulfur dioxide emission limits which will be effective in 2000. Beginning in 1995, certain coal-fueled generating units will receive emissions allowances (all of Consumers' coal units will receive allowances beginning in 2000). Based on projected emissions from these units, Consumers expects to have excess allowances which may be sold or saved for future use. The Clean Air Act's provisions require Consumers to make capital expenditures estimated to total $74 million through 1999 for completed, in-process and possible modifications at coal-fired units based on existing and proposed regulations. Management believes that Consumers' annual operating costs will not be materially affected. The EPA has asked a number of utilities in the Great Lakes area to voluntarily retire certain equipment containing specific levels of polychlorinated biphenyls. Consumers believes that it is largely in compliance with the EPA's petition. Consumers is continuing to study the request and has been granted an extension for responding until March 30, 1994. Capital Expenditures Consumers estimates capital expenditures, including demand-side management and new lease commitments, of $553 million for 1994, $461 million for 1995 and $471 million for 1996. Public Utility Holding Company Act Exemption CMS Energy is exempt from registration under PUHCA. However, the Attorney General and the MMCG have asked the SEC to revoke CMS Energy's exemption from registration under PUHCA. In 1992, the MPSC filed a statement with the SEC recommending that CMS Energy's current exemption be revoked and a new exemption be issued conditioned upon certain reporting and operating requirements. If CMS Energy were to lose its current exemption, it would become more heavily regulated by the SEC; Consumers could ultimately be forced to divest either its electric or gas utility business; and CMS Energy would be restricted from conducting businesses that are not functionally related to the conduct of its utility business as determined by the SEC. CMS Energy is opposing this request and believes it will maintain its current exemption from registration under PUHCA. Other Consumers experienced an increase in complaints during 1993 relating to so-called stray voltage. Claimants contend that stray voltage results when small electrical currents present in grounded electric systems are diverted from their intended path. Investigation by Consumers of prior stray voltage complaints disclosed that many factors, including improper wiring and malfunctioning of on-farm equipment, can lead to the stray voltage phenomenon. Consumers maintains a policy of investigating all customer calls regarding stray voltage and working with customers to address their concerns including, when necessary, modifying the configuration of the customer's hook-up to Consumers. A complaint seeking certification as a class action suit was filed against Consumers in a local county circuit court in 1993. The complaint alleges the existence of a purported class that has incurred damages of up to $1 billion, primarily to certain livestock owned by the purported class, as a result of stray voltage from electricity being supplied by Consumers. Consumers believes the allegations to be without merit and intends to vigorously oppose the certification of the class and this suit. In addition to the matters disclosed in these notes, Consumers and certain of its subsidiaries are parties to certain lawsuits and administrative proceedings before various courts and governmental agencies, arising from the ordinary course of business involving personal injury and property damage, contractual matters, environmental issues, federal and state taxes, rates, licensing and other matters. The ultimate effect of the proceedings discussed in this note is not expected to have a material impact on Consumers' financial position or results of operations. 13: Jointly Owned Utility Facilities Consumers is responsible for providing its share of financing for the jointly owned facilities. The following table indicates the extent of Consumers' investment in jointly owned utility facilities: In Millions December 31 1993 1992 - ----------- ---- ---- Net investment Ludington - 51% $114 $112 Campbell Unit 3 - 93.3% 349 360 Transmission lines - various 32 33 Accumulated depreciation Ludington $ 74 $ 71 Campbell Unit 3 210 199 Transmission lines 11 10 14: Supplemental Cash Flow Information For purposes of the Statement of Cash Flows, all highly liquid investments with an original maturity of three months or less are considered cash equivalents. Other cash flow activities and non-cash investing and financing activities for the years ended December 31 were: In Millions 1993 1992 1991 ------ ------ ------ Cash transactions Interest paid (net of amounts capitalized) $177 $176 $308 Income taxes paid (net of refunds) 90 6 30 Non-cash transactions Nuclear fuel placed under capital lease $ 28 $ 30 $ 6 Other assets placed under capital leases 30 39 21 Capital leases refinanced 42 - - Assumption of debt - 15 - Return of Midland related assets (Note 16) - - (92) Increased value of investment in Enterprises' preferred stock (Note 16) - - 100 Changes in other assets and liabilities as shown on the Consolidated Statements of Cash Flows at December 31 are described below: In Millions 1993 1992 1991 ------ ------ ------ Sale of receivables, net $ 60 $ 25 $ - Accounts receivable 19 30 66 Accrued revenue (48) 91 7 Inventories (32) 24 (8) Accounts payable (25) 21 (83) Accrued refunds (48) (143) 102 Tax Reform Act refund reserve - - (77) Other current assets and liabilities, net (59) 38 (56) Non-current deferred amounts, net 8 (36) 170 ------ ------ ----- $(125) $ 50 $ 121 ======= ====== ====== 15: Reportable Segments The Consolidated Statements of Income show operating revenue and pretax operating income by segments. These amounts include earnings (losses) from investments accounted for by the equity method of $6 million, $(10) million and $(2) million for 1993, 1992 and 1991, respectively. Other segment information follows: In Millions Years Ended December 31 1993 1992 1991 - ----------------------- ------ ------ ------ Depreciation, depletion and amortization Electric $ 241 $ 230 $ 172 Gas 73 76 70 Other 2 1 - ------ ------ ------ $ 316 $ 307 $ 242 ====== ====== ====== Identifiable assets Electric (a) $4,027 $3,812 $3,399 Gas 1,443 1,387 1,186 Other (b) 1,081 1,397 1,401 ------ ------ ------ $6,551 $6,596 $5,986 ====== ====== ====== Capital expenditures (c) Electric (d) $ 365 $ 353 $ 213 Gas 127 86 61 Other 69 67 32 ------ ------ ------ $ 561 $ 506 $ 306 ====== ====== ====== (a) Includes abandoned Midland investment of $162 million, $175 million and $287 million for 1993, 1992 and 1991, respectively. (b) Reclassified 1992 and 1991 to include independent power production, which is no longer significant enough for Consumers to report separately. Also, other was reduced by the sale of $309 million of MCV Bonds (see Note 3). (c) Includes capital leases for nuclear fuel and other assets (see Note 14). (d) Includes DSM costs of $52 million for 1993 and $26 million for 1992. 16: Related-Party Transactions Consumers has an investment of $250 million in 10 shares of the preferred stock of Enterprises, an affiliate company of Consumers. Prior to a 1991 amendment to Enterprises' Articles, it was to have redeemed on July 1, 1991 and in each of the next four years, two shares of its preferred stock held by Consumers at a redemption price equal to $25 million per share. Because of the amendment, the dividend rate increased and the first mandatory redemption date became August 1, 1997. The asset value and other paid-in capital of Consumers were increased $100 million as a result of the amendment. In addition, Consumers has an investment in approximately 3 million shares of CMS Energy common stock totaling $42 million at December 31, 1993. As a result of these two investments, Consumers received dividends on affiliates' common and preferred stock totaling $16 million in 1993 and 1992 and $13 million in 1991. In March 1990, Consumers' subsidiary, MGL and Consumers' parent, CMS Energy, entered into an agreement where MGL exchanged its investment in several subsidiaries that held Midland-related assets for CMS Debentures issued by CMS Energy. Consumers recorded the earnings on the CMS Debentures as income from contractual arrangements. In December 1991, the subsidiaries were returned to Consumers and the CMS Debentures were cancelled to comply with various regulatory and court orders. On July 27, 1991, Consumers stopped recording income on the CMS Debentures when it became probable the return would be required. The return resulted in a net after-tax loss of approximately $92 million because the book value of the subsidiaries was less than the CMS Debentures' book value. Consumers purchases a portion of its gas from an affiliate, NOMECO. The amounts of purchases for the years ended 1993, 1992 and 1991 were $3 million, $3 million and $20 million, respectively. In 1993, 1992 and 1991, Consumers purchased $52 million, $36 million and $26 million, respectively, of electric generating capacity and energy from affiliates of Enterprises. Consumers and its subsidiaries sold, stored and transported natural gas and provided other services to the MCV Partnership totaling approximately $14 million for 1993, 1992 and 1991, respectively. For additional discussion of related-party transactions with the MCV Partnership and the FMLP, see Notes 3 and 17. Other related-party transactions are immaterial. 17: Summarized Financial Information of Significant Related Energy Supplier Under the PPA with the MCV Partnership discussed in Note 3, Consumers' 1993 obligation to purchase electricity from the MCV Partnership was approximately 14 percent of Consumers' owned and contracted capacity. Summarized financial information of the MCV Partnership is shown below: Statements of Income In Millions Years Ended December 31 1993 1992 1991 - ----------------------- ------ ------ ------ Operating revenue (a) $ 548 $ 488 $ 425 Operating expenses 362 315 278 ------ ------ ------ Operating income 186 173 147 Other expense, net (189) (190) (186) ------ ------ ------ Net loss $ (3) $ (17) $ (39) ====== ====== ====== Balance Sheets In Millions December 31 1993 1992 - ----------- ------ ------ Assets Current assets (a) $ 181 $ 165 Property, plant and equipment, net 2,073 2,124 Other assets 146 147 ------ ------ $2,400 $2,436 ====== ====== Liabilities and Partners' Equity Current liabilities $ 198 $ 189 Long-term debt and other non-current liabilities (b) 2,147 2,189 Partners' equity (c) 55 58 ------ ------ $2,400 $2,436 ====== ====== (a) Revenue from Consumers totaled $505 million, $444 million and $384 million for 1993, 1992 and 1991, respectively. As of December 31, 1993, 1992 and 1991, $44 million, $38 million and $33 million, respectively, were receivable from Consumers. (b) FMLP is a beneficiary of an owner trust that is the lessor in a long-term direct finance lease with the lessee, MCV Partnership. CMS Holdings holds a 46.4 percent ownership interest in FMLP (see Note 3). At December 31, 1993 and 1992, lease obligations of $1.7 billion were owed to the owner trust of which FMLP is the sole beneficiary. CMS Holdings' share of the interest and principal portion for the 1993 lease payments was $63 million and $16 million, respectively, and for the 1992 lease payments was $65 million and $12 million, respectively. The lease payments service $1.2 billion and $1.3 billion in non-recourse debt outstanding as of December 31, 1993 and 1992, respectively, of the owner-trust whose beneficiary is FMLP. FMLP's debt is secured by the MCV Partnership's lease obligations, assets, and operating revenues. For 1993 and 1992, the owner-trust whose beneficiary is FMLP made debt payments of $172 million and $166 million, respectively, which included $10 million and $8 million principal and $25 million and $26 million interest, respectively, on the MCV Bonds held by MEC Development Corporation during part of 1991 and by Consumers through December 1993. (c) CMS Midland's recorded investment in the MCV Partnership includes capitalized interest, which is being amortized to expense over the life of its investment in the MCV Partnership. Arthur Andersen & Co. Report of Independent Public Accountants To Consumers Power Company: We have audited the accompanying consolidated balance sheets and consolidated statements of long-term debt and preferred stock of CONSUMERS POWER COMPANY (a Michigan corporation and wholly owned subsidiary of CMS Energy Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common stockholder's equity, and 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 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Consumers Power Company 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 discussed in Note 5 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. As discussed in Note 10 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pensions. Additionally, as discussed in Note 7 to the consolidated financial statements, the Company effected a quasi-reorganization on December 31, 1992. ARTHUR ANDERSEN & Co. Detroit, Michigan, January 28, 1994. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. CMS Energy None for CMS Energy. Consumers None for Consumers. PART III (ITEMS 10., 11., 12. and 13.) CMS Energy CMS Energy's definitive Proxy Statement, except for the organization and compensation committee report contained therein, is incorporated by reference herein. See also Item 1. BUSINESS for information pursuant to Item 10. Item 10. Consumers Consumers' definitive Proxy Statement, except for the organization and compensation committee report contained therein, is incorporated by reference herein. See also Item 1. BUSINESS for information pursuant to Item 10. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) Financial Statements and Reports of Independent Public Accountants for CMS Energy and Consumers are listed in Item 8 in the Index to Financial Statements, and are incorporated by reference herein. (a)(2) Financial Statement Schedules and Reports of Independent Public Accountants for CMS Energy and Consumers are listed after the Exhibits in the Index to Financial Statement Schedules, and are incorporated by reference herein. (a)(3) Exhibits for CMS Energy and Consumers are listed after Item (c) below and are incorporated by reference herein. (b) Reports on Form 8-K for CMS Energy and Consumers. CMS Energy Current reports dated September 29, 1993, as amended by Form 8-K/A, Amendment No. 1, dated October 22, 1993, and dated December 10, 1993 covering matters reported pursuant to Item 5. Other Events. and Item 7. Financial Statements and Exhibits., and current reports dated December 28, 1993 and March 4, 1994 covering matters reported pursuant to Item 5. Other Events. Consumers Current reports dated September 21, 1993 and December 10, 1993 covering matters reported pursuant to Item 5. Other Events. and Item 7. Financial Statements and Exhibits., and dated December 28, 1993 and March 4, 1994 covering matters reported pursuant to Item 5. Other Events. (c) Exhibits, including those incorporated by reference (see also Exhibit volume). The following exhibits are applicable to CMS Energy and Consumers except where otherwise indicated "CMS ONLY": CMS Energy and Consumers Exhibit Numbers - --------------- (1)-(2) - Not applicable. (3)(a) (CMS ONLY) - Articles of Incorporation of CMS Energy Corporation, as Amended. (Designated in CMS Energy Corporation's Form S-8 dated June 30, 1989, File No 1-9513, as Exhibit (4).) (3)(b) (CMS ONLY) - Copy of the By-Laws of CMS Energy Corporation. (3)(c) - Restated Articles of Incorporation of Consumers Power Company. (3)(d) - Copy of By-Laws of Consumers Power Company. (4)(a) - Composite Working Copy of Indenture dated as of September 1, 1945, between Consumers Power Company and Chemical Bank (successor to Manufacturers Hanover Trust Company), as Trustee, including therein indentures supplemental thereto through the Forty-third Supplemental Indenture dated as of May 1, 1979. (Designated in Consumers Power Company's Registration No 2-65973 as Exhibit (b)(1)-4.) Indentures Supplemental thereto: Consumers Power Company Sup Ind/Dated as of File Reference Exhibit ------------------- ---------------- ------- 44th 11/15/79 Reg No 2-65973 (b)(1)-7 45th 01/15/80 Reg No 2-68900 (b)(1)-5 46th 01/15/80 Reg No 2-69704 (4)(b) 47th 06/15/80 Form 10-K for year end Dec 31, 1980, File No 1-5611 (4)(b) 48th 03/15/81 Reg No 2-73741 (4)(b) 49th 11/01/81 Reg No 2-75542 (4)(b) 50th 03/01/82 Form 10-K for year end Dec 31, 1981, File No 1-5611 (4)(b) 51st 08/10/82 Reg No 2-78842 (4)(f) 52nd 08/31/82 Reg No 2-79390 (4)(f) 53rd 12/01/82 Reg No 2-81077 (4)(f) 54th 05/01/83 Reg No 2-84172 (4)(e) 55th 09/15/83 Reg No 2-86751 (4)(e) 56th 10/15/83 Reg No 2-87735 (4)(e) 57th 03/01/84 Reg No 2-89215 (4)(e) 58th 07/16/84 Form 10-Q for quarter ended June 30, 1984, File No 1-5611 (4)(f) 59th 10/01/84 Reg No 2-93438 (4)(c) 60th 06/01/85 Form 10-Q for quarter ended June 30, 1985, File No 1-5611 (4)(f) 61st 10/15/86 Reg No 33-9732 (4)(e) 63rd 04/15/87 Form 10-Q for quarter ended June 30, 1987 File No 1-5611 (4)(f) 64th 06/15/87 Form 10-Q for quarter ended June 30, 1987 File No 1-5611 (4)(g) 65th 02/15/88 Form 8-K dated Feb 18, 1988 File No 1-5611 (4) 66th 04/15/88 Form 10-Q for quarter ended March 31, 1988 File No 1-5611 (4)(d) 67th 11/15/89 Reg No 33-31866 (4)(d) 68th 06/15/93 Reg No 33-41126 (4)(c) 69th 09/15/93 Form 8-K dated September 21, 1993 File No 1-5611 (4) (4)(b) (CMS ONLY) - Indenture between CMS Energy Corporation and NBD Bank, National Association, as Trustee. (Designated in CMS Energy's Form S-3 Registration Statement filed May 1, 1992, File No. 33-47629, as Exhibit (4)(a).) First Supplemental Indenture dated as of October 1, 1992 between CMS Energy Corporation and NBD Bank, National Association, as Trustee. (Designated in CMS Energy's Form 8-K dated October 1, 1992, File No. 1-9513, as Exhibit (4).) Second Supplemental Indenture dated as of October 1, 1992 between CMS Energy Corporation and NBD Bank, National Association, as Trustee. (Designated in CMS Energy's Form 8-K dated October 1, 1992, File No. 1-9513, as Exhibit (4).) (5)-(9) - Not applicable. (10)(a) - Credit Agreement dated as of May 1, 1989 among Consumers Power Company, the Co-Managers, as defined therein, the Banks, as defined therein, the Lenders, as defined therein, and Citibank, NA, as Agent, and the Exhibits thereto. (Designated in Consumers Power Company's Form 10-Q for the quarter ended March 31, 1989, File No 1-5611, as Exhibit (19).) Letter amendment dated as of December 11, 1991. (Designated in Consumers Power Company's Form 10-K for the year ended December 30, 1991, File No. 1-5611, as Exhibit (3)(d).) (10)(b) (CMS ONLY) - Amended and Restated Credit Agreement dated as of November 30, 1992 as Amended and Restated as of October 15, 1993, among CMS Energy Corporation, the Banks, the Co-Agents, the Documentation Agent and the Operational Agent, all as defined therein, and the Exhibits thereto. (10)(c) - Employment Agreement dated as of August 1, 1990 among Consumers Power Company, CMS Energy Corporation and William T. McCormick, Jr. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(c).) (10)(d) - Employment contract effective as of March 1, 1987 among CMS Energy Corporation, Consumers Power Company and S. Kinnie Smith, Jr. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1987, File No 1-5611, as Exhibit (10)(g).) (10)(e) - Employment Agreement effective as of June 15, 1988 among Consumers Power Company, CMS Energy Corporation and Victor J. Fryling. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1988, File No 1-5611, as Exhibit (10)(i).) (10)(f) - Employment Agreement dated May 26, 1989 between Consumers Power Company and Michael G. Morris. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1990, File No 1-5611, as Exhibit (10)(f).) (10)(g) - Employment Agreement dated May 26, 1989 between Consumers Power Company and David A. Mikelonis. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit 10(h).) (10)(h) - Employment Agreement dated May 26, 1989 among Consumers Power Company, CMS Energy Corporation and John W. Clark. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(f).) (10)(i) - Employment Agreement dated March 25, 1992 between Consumers Power Company and Alan M. Wright. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1992, File No. 1-5611, as Exhibit 10(j).) (10)(j) - Employment Agreement dated March 25, 1992 between Consumers Power Company and Paul A. Elbert. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1992, File No. 1-5611, as Exhibit 10(k).) (10)(k) - Consumers Power Company's Executive Stock Option and Stock Appreciation Rights Plan effective December 1, 1989. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1990, File No 1-5611, as Exhibit (10)(g).) (10)(l) - CMS Energy Corporation's Performance Incentive Stock Plan effective as of December 1, 1989. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(h).) (10)(m) - CMS Deferred Salary Savings Plan effective January 1, 1994. (10)(n) - Consumers Power Company's Annual Executive Incentive Compensation Plan effective February 1993, as amended March 1994. (10)(o) - Consumers Power Company's Supplemental Executive Retirement Plan effective November 1, 1990. (10)(p) - Senior Trust Indenture, Leasehold Mortgage and Security Agreement dated as of June 1, 1990 between The Connecticut National Bank and United States Trust Company of New York. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 4.1.) Indenture Supplemental thereto: Supplement No. 1 dated as of June 1, 1990. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 4.2.) (10)(q) - Collateral Trust Indenture dated as of June 1, 1990 among Midland Funding Corporation I, Midland Cogeneration Venture Limited Partnership and United States Trust Company of New York, Trustee. (Designated in CMS Energy Corporation's Form 10-Q for the quarter ended June 30, 1990, File No 1-9513, as Exhibit (28)(b).) Indenture Supplemental thereto: Supplement No 1 dated as of June 1, 1990. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 4.4.) (10)(r) - Amended and Restated Investor Partner Tax Indemnification Agreement dated as of June 1, 1990 among Investor Partners, CMS Midland Holdings Corporation as Indemnitor and CMS Energy Corporation as Guarantor. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(v).) (10)(s) - Environmental Agreement dated as of June 1, 1990 made by CMS Energy Corporation to The Connecticut National Bank and Others. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(y) and Form 10-Q for the quarter ended September 30, 1991, File No 1-9513, as Exhibit (19)(d).)** (10)(t) - Indemnity Agreement dated as of June 1, 1990 made by CMS Energy Corporation to Midland Cogeneration Venture Limited Partnership. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(z).)** (10)(u) - Environmental Agreement dated as of June 1, 1990 made by CMS Energy Corporation to United States Trust Company of New York, Meridian Trust Company, each Subordinated Collateral Trust Trustee and Holders from time to time of Senior Bonds and Subordinated Bonds and Participants from time to time in Senior Bonds and Subordinated Bonds. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(aa).)** (10)(v) - Amended and Restated Participation Agreement dated as of June 1, 1990 among Midland Cogeneration Venture Limited Partnership, Owner Participant, The Connecticut National Bank, United States Trust Company, Meridian Trust Company, Midland Funding Corporation I, Midland Funding Corporation II, MEC Development Corporation and Institutional Senior Bond Purchasers. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 4.13.) Amendment No 1 dated as of July 1, 1991. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit (10)(w).) (10)(w) - Power Purchase Agreement dated as of July 17, 1986 between Midland Cogeneration Venture Limited Partnership and Consumers Power Company. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.4.) Amendments thereto: Amendment No 1 dated September 10, 1987. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.5.) Amendment No 2 dated March 18, 1988. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.6.) Amendment No 3 dated August 28, 1989. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.7.) Amendment No 4A dated May 25, 1989. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.8.) (10)(x) - Request for Approval of Settlement Proposal to Resolve MCV Cost Recovery Issues and Court Remand, filed with the Michigan Public Service Commission on July 7, 1992, MPSC Case No. U- 10127. (Designated in CMS Energy Corporation's and Consumers Power Company's Forms 10-K for the year ended December 31, 1991 as amended by Form 8 dated July 15, 1992 as Exhibit (28).) (10)(y) - Settlement Proposal Filed on July 7, 1992 as Revised on September 8, 1992 by Filing with the Michigan Public Service Commission. (Designated in CMS Energy Corporation's and Consumers Power Company's Forms 8-K dated September 8, 1992 as Exhibit (28).) (10)(z) - Michigan Public Service Commission Order Dated March 31, 1993, Approving with Modifications the Settlement Proposal Filed on July 7, 1992, as Revised on September 8, 1992. (Designated in CMS Energy Corporation's and Consumers Power Company's Forms 10-K for the year ended December 31, 1992 as Exhibit (10)(cc). (10)(aa) - Unwind Agreement dated as of December 10, 1991 by and among CMS Energy Corporation, Midland Group, Ltd., Consumers Power Company, CMS Midland, Inc., MEC Development Corp. and CMS Midland Holdings Company. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit (10)(y).) (10)(bb) - Stipulated AGE Release Amount Payment Agreement dated as of June 1, 1990, among CMS Energy Corporation, Consumers Power Company and The Dow Chemical Company. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit (10)(z).) (10)(cc) - Parent Guaranty dated as of June 14, 1990 from CMS Energy Corporation to MCV, each of the Owner Trustees, the Indenture Trustees, the Owner Participants and the Initial Purchasers of Senior Bonds in the MCV Sale Leaseback transaction, and MEC Development. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit (10)(aa).)** (11)-(12) - Not applicable. (13) - Not Applicable. (14)-(20) - Not applicable. (21)(a) (CMS ONLY) - Subsidiaries of CMS Energy Corporation. (21)(b) - Subsidiaries of Consumers Power Company. (22) - Not applicable. (23) - Consents of experts and counsel. (24) - Powers of Attorney. (25)-(28) - Not applicable. *Five copies of this exhibit have been signed by, or on behalf of, each of five Owner Participants. With regard to each of the agreements, each copy is substantially identical in all material respects except as to the parties thereto. Therefore, pursuant to Instruction 2, Item 601(a) of Regulation S-K, CMS Energy Corporation and Consumers Power Company are filing a copy of only one such document. ** Obligations of only CMS Holdings and CMS Midland, second tier subsidiaries of Consumers, and of CMS Energy but not of Consumers. Exhibits listed above which have heretofore been filed with the Securities and Exchange Commission pursuant to various acts administered by the Commission, and which were designated as noted above, are hereby incorporated herein by reference and made a part hereof with the same effect as if filed herewith. Index to Financial Statement Schedules Schedule Page V Property, Plant and Equipment 1993, 1992 and 1991: CMS Energy Corporation 154 Consumers Power Company 157 VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 1993, 1992 and 1991: CMS Energy Corporation 160 Consumers Power Company 163 VIII Valuation and Qualifying Accounts and Reserves 1993, 1992 and 1991: CMS Energy Corporation 166 Consumers Power Company 167 IX Short-Term Borrowings 1993, 1992 and 1991: CMS Energy Corporation 168 Consumers Power Company 169 X Supplementary Income Statement Information 1993, 1992 and 1991: CMS Energy Corporation 170 Consumers Power Company 171 Report of Independent Public Accountants CMS Energy Corporation 172 Consumers Power Company 173 Schedules other than those listed above are omitted because they are either not required, not applicable or the required information is shown in the financial statements or notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. Arthur Andersen & Co. Report of Independent Public Accountants To CMS Energy Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in CMS Energy Corporation's 1993 Annual Report to shareholders incorporated by reference 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 those basic consolidated financial statements taken as a whole. The schedules listed in Item 14(a) 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. Detroit, Michigan, January 28, 1994. Arthur Andersen & Co. Report of Independent Public Accountants To Consumers Power Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Consumers Power Company's 1993 Annual Report to shareholders incorporated by reference 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 those basic consolidated financial statements taken as a whole. The schedules listed in Item 14(a) 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 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. Detroit, Michigan, January 28, 1994. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, CMS Energy Corporation has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 18th day of March 1994. CMS ENERGY CORPORATION By William T. McCormick, Jr. ---------------------------- William T. McCormick, Jr. Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of CMS Energy Corporation and in the capacities and on the 18th day of March 1994. Signature Title - -------------------------------------- ----------------------------------- (i) Principal executive officer: Chairman of the Board, Chief Executive Officer William T. McCormick, Jr. and Director - ------------------------------------- William T. McCormick, Jr. (ii) Principal financial officer: Senior Vice President and A M Wright Chief Financial Officer - ------------------------------------- Alan M. Wright (iii) Controller or principal accounting officer: Vice President, Controller P. D. Hopper and Chief Accounting Officer - ------------------------------------- Preston D. Hopper (iv) A majority of the Directors including those named above: Director - ------------------------------------- James J. Duderstadt Signature Title - ------------------------------------- ----------------------------------- Victor J. Fryling Director - ------------------------------------- Victor J. Fryling Earl D. Holton* Director - ------------------------------------- Earl D. Holton Lois A. Lund* Director - ------------------------------------- Lois A. Lund Frank H. Merlotti* Director - ------------------------------------- Frank H. Merlotti W. U. Parfet* Director - ------------------------------------- William U. Parfet Percy A. Pierre* Director - ------------------------------------- Percy A. Pierre T. F. Russell* Director - ------------------------------------- Thomas F. Russell S. Kinnie Smith, Jr.* Director - ------------------------------------- S. Kinnie Smith, Jr. Director - ------------------------------------- Robert D. Tuttle Kenneth Whipple* Director - ------------------------------------- Kenneth Whipple John B. Yasinsky* Director - ------------------------------------- John B. Yasinsky * By Thomas A. McNish ------------------------------- Thomas A. McNish, Attorney-in-Fact SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Consumers Power Company has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 18th day of March 1994. CONSUMERS POWER COMPANY By William T. McCormick, Jr. --------------------------------- William T. McCormick, Jr. Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of Consumers Power Company and in the capacities and on the 18th day of March 1994. Signature Title - ------------------------------------- ----------------------------------- (i) Principal executive officer: President and Michael G. Morris Chief Executive Officer - ------------------------------------- Michael G. Morris (ii) Principal financial officer: Senior Vice President and A M Wright Chief Financial Officer - ------------------------------------- Alan M. Wright (iii) Controller or principal accounting officer: Vice President and Dennis DaPra Controller - ------------------------------------- Dennis DaPra (iv) A majority of the Directors including those named above: Director - ------------------------------------- James J. Duderstadt Signature Title - ------------------------------------- ----------------------------------- Victor J. Fryling Director - ------------------------------------- Victor J. Fryling Earl D. Holton* Director - ------------------------------------- Earl D. Holton Lois A. Lund* Director - ------------------------------------- Lois A. Lund William T. McCormick, Jr. Director - ------------------------------------- William T. McCormick, Jr. Frank H. Merlotti* Director - ------------------------------------- Frank H. Merlotti W. U. Parfet* Director - ------------------------------------- William U. Parfet Percy A. Pierre* Director - ------------------------------------- Percy A. Pierre T. F. Russell* Director - ------------------------------------- Thomas F. Russell S. Kinnie Smith, Jr.* Director - ------------------------------------- S. Kinnie Smith, Jr. Director - ------------------------------------- Robert D. Tuttle Kenneth Whipple* Director - ------------------------------------- Kenneth Whipple John B. Yasinsky* Director - ------------------------------------- John B. Yasinsky *By Thomas A. McNish -------------------------------- Thomas A. McNish, Attorney-in-Fact ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) Financial Statements and Reports of Independent Public Accountants for CMS Energy and Consumers are listed in Item 8 in the Index to Financial Statements, and are incorporated by reference herein. (a)(2) Financial Statement Schedules and Reports of Independent Public Accountants for CMS Energy and Consumers are listed after the Exhibits in the Index to Financial Statement Schedules, and are incorporated by reference herein. (a)(3) Exhibits for CMS Energy and Consumers are listed after Item (c) below and are incorporated by reference herein. (b) Reports on Form 8-K for CMS Energy and Consumers. CMS Energy Current reports dated September 29, 1993, as amended by Form 8-K/A, Amendment No. 1, dated October 22, 1993, and dated December 10, 1993 covering matters reported pursuant to Item 5. Other Events. and Item 7. Financial Statements and Exhibits., and current reports dated December 28, 1993 and March 4, 1994 covering matters reported pursuant to Item 5. Other Events. Consumers Current reports dated September 21, 1993 and December 10, 1993 covering matters reported pursuant to Item 5. Other Events. and Item 7. Financial Statements and Exhibits., and dated December 28, 1993 and March 4, 1994 covering matters reported pursuant to Item 5. Other Events. (c) Exhibits, including those incorporated by reference (see also Exhibit volume). The following exhibits are applicable to CMS Energy and Consumers except where otherwise indicated "CMS ONLY": CMS Energy and Consumers Exhibit Numbers - --------------- (1)-(2) - Not applicable. (3)(a) (CMS ONLY) - Articles of Incorporation of CMS Energy Corporation, as Amended. (Designated in CMS Energy Corporation's Form S-8 dated June 30, 1989, File No 1-9513, as Exhibit (4).) (3)(b) (CMS ONLY) - Copy of the By-Laws of CMS Energy Corporation. (3)(c) - Restated Articles of Incorporation of Consumers Power Company. (3)(d) - Copy of By-Laws of Consumers Power Company. (4)(a) - Composite Working Copy of Indenture dated as of September 1, 1945, between Consumers Power Company and Chemical Bank (successor to Manufacturers Hanover Trust Company), as Trustee, including therein indentures supplemental thereto through the Forty-third Supplemental Indenture dated as of May 1, 1979. (Designated in Consumers Power Company's Registration No 2-65973 as Exhibit (b)(1)-4.) Indentures Supplemental thereto: Consumers Power Company Sup Ind/Dated as of File Reference Exhibit ------------------- ---------------- ------- 44th 11/15/79 Reg No 2-65973 (b)(1)-7 45th 01/15/80 Reg No 2-68900 (b)(1)-5 46th 01/15/80 Reg No 2-69704 (4)(b) 47th 06/15/80 Form 10-K for year end Dec 31, 1980, File No 1-5611 (4)(b) 48th 03/15/81 Reg No 2-73741 (4)(b) 49th 11/01/81 Reg No 2-75542 (4)(b) 50th 03/01/82 Form 10-K for year end Dec 31, 1981, File No 1-5611 (4)(b) 51st 08/10/82 Reg No 2-78842 (4)(f) 52nd 08/31/82 Reg No 2-79390 (4)(f) 53rd 12/01/82 Reg No 2-81077 (4)(f) 54th 05/01/83 Reg No 2-84172 (4)(e) 55th 09/15/83 Reg No 2-86751 (4)(e) 56th 10/15/83 Reg No 2-87735 (4)(e) 57th 03/01/84 Reg No 2-89215 (4)(e) 58th 07/16/84 Form 10-Q for quarter ended June 30, 1984, File No 1-5611 (4)(f) 59th 10/01/84 Reg No 2-93438 (4)(c) 60th 06/01/85 Form 10-Q for quarter ended June 30, 1985, File No 1-5611 (4)(f) 61st 10/15/86 Reg No 33-9732 (4)(e) 63rd 04/15/87 Form 10-Q for quarter ended June 30, 1987 File No 1-5611 (4)(f) 64th 06/15/87 Form 10-Q for quarter ended June 30, 1987 File No 1-5611 (4)(g) 65th 02/15/88 Form 8-K dated Feb 18, 1988 File No 1-5611 (4) 66th 04/15/88 Form 10-Q for quarter ended March 31, 1988 File No 1-5611 (4)(d) 67th 11/15/89 Reg No 33-31866 (4)(d) 68th 06/15/93 Reg No 33-41126 (4)(c) 69th 09/15/93 Form 8-K dated September 21, 1993 File No 1-5611 (4) (4)(b) (CMS ONLY) - Indenture between CMS Energy Corporation and NBD Bank, National Association, as Trustee. (Designated in CMS Energy's Form S-3 Registration Statement filed May 1, 1992, File No. 33-47629, as Exhibit (4)(a).) First Supplemental Indenture dated as of October 1, 1992 between CMS Energy Corporation and NBD Bank, National Association, as Trustee. (Designated in CMS Energy's Form 8-K dated October 1, 1992, File No. 1-9513, as Exhibit (4).) Second Supplemental Indenture dated as of October 1, 1992 between CMS Energy Corporation and NBD Bank, National Association, as Trustee. (Designated in CMS Energy's Form 8-K dated October 1, 1992, File No. 1-9513, as Exhibit (4).) (5)-(9) - Not applicable. (10)(a) - Credit Agreement dated as of May 1, 1989 among Consumers Power Company, the Co-Managers, as defined therein, the Banks, as defined therein, the Lenders, as defined therein, and Citibank, NA, as Agent, and the Exhibits thereto. (Designated in Consumers Power Company's Form 10-Q for the quarter ended March 31, 1989, File No 1-5611, as Exhibit (19).) Letter amendment dated as of December 11, 1991. (Designated in Consumers Power Company's Form 10-K for the year ended December 30, 1991, File No. 1-5611, as Exhibit (3)(d).) (10)(b) (CMS ONLY) - Amended and Restated Credit Agreement dated as of November 30, 1992 as Amended and Restated as of October 15, 1993, among CMS Energy Corporation, the Banks, the Co-Agents, the Documentation Agent and the Operational Agent, all as defined therein, and the Exhibits thereto. (10)(c) - Employment Agreement dated as of August 1, 1990 among Consumers Power Company, CMS Energy Corporation and William T. McCormick, Jr. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(c).) (10)(d) - Employment contract effective as of March 1, 1987 among CMS Energy Corporation, Consumers Power Company and S. Kinnie Smith, Jr. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1987, File No 1-5611, as Exhibit (10)(g).) (10)(e) - Employment Agreement effective as of June 15, 1988 among Consumers Power Company, CMS Energy Corporation and Victor J. Fryling. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1988, File No 1-5611, as Exhibit (10)(i).) (10)(f) - Employment Agreement dated May 26, 1989 between Consumers Power Company and Michael G. Morris. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1990, File No 1-5611, as Exhibit (10)(f).) (10)(g) - Employment Agreement dated May 26, 1989 between Consumers Power Company and David A. Mikelonis. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit 10(h).) (10)(h) - Employment Agreement dated May 26, 1989 among Consumers Power Company, CMS Energy Corporation and John W. Clark. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(f).) (10)(i) - Employment Agreement dated March 25, 1992 between Consumers Power Company and Alan M. Wright. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1992, File No. 1-5611, as Exhibit 10(j).) (10)(j) - Employment Agreement dated March 25, 1992 between Consumers Power Company and Paul A. Elbert. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1992, File No. 1-5611, as Exhibit 10(k).) (10)(k) - Consumers Power Company's Executive Stock Option and Stock Appreciation Rights Plan effective December 1, 1989. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1990, File No 1-5611, as Exhibit (10)(g).) (10)(l) - CMS Energy Corporation's Performance Incentive Stock Plan effective as of December 1, 1989. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(h).) (10)(m) - CMS Deferred Salary Savings Plan effective January 1, 1994. (10)(n) - Consumers Power Company's Annual Executive Incentive Compensation Plan effective February 1993, as amended March 1994. (10)(o) - Consumers Power Company's Supplemental Executive Retirement Plan effective November 1, 1990. (10)(p) - Senior Trust Indenture, Leasehold Mortgage and Security Agreement dated as of June 1, 1990 between The Connecticut National Bank and United States Trust Company of New York. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 4.1.) Indenture Supplemental thereto: Supplement No. 1 dated as of June 1, 1990. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 4.2.) (10)(q) - Collateral Trust Indenture dated as of June 1, 1990 among Midland Funding Corporation I, Midland Cogeneration Venture Limited Partnership and United States Trust Company of New York, Trustee. (Designated in CMS Energy Corporation's Form 10-Q for the quarter ended June 30, 1990, File No 1-9513, as Exhibit (28)(b).) Indenture Supplemental thereto: Supplement No 1 dated as of June 1, 1990. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 4.4.) (10)(r) - Amended and Restated Investor Partner Tax Indemnification Agreement dated as of June 1, 1990 among Investor Partners, CMS Midland Holdings Corporation as Indemnitor and CMS Energy Corporation as Guarantor. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(v).) (10)(s) - Environmental Agreement dated as of June 1, 1990 made by CMS Energy Corporation to The Connecticut National Bank and Others. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(y) and Form 10-Q for the quarter ended September 30, 1991, File No 1-9513, as Exhibit (19)(d).)** (10)(t) - Indemnity Agreement dated as of June 1, 1990 made by CMS Energy Corporation to Midland Cogeneration Venture Limited Partnership. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(z).)** (10)(u) - Environmental Agreement dated as of June 1, 1990 made by CMS Energy Corporation to United States Trust Company of New York, Meridian Trust Company, each Subordinated Collateral Trust Trustee and Holders from time to time of Senior Bonds and Subordinated Bonds and Participants from time to time in Senior Bonds and Subordinated Bonds. (Designated in CMS Energy Corporation's Form 10-K for the year ended December 31, 1990, File No 1-9513, as Exhibit (10)(aa).)** (10)(v) - Amended and Restated Participation Agreement dated as of June 1, 1990 among Midland Cogeneration Venture Limited Partnership, Owner Participant, The Connecticut National Bank, United States Trust Company, Meridian Trust Company, Midland Funding Corporation I, Midland Funding Corporation II, MEC Development Corporation and Institutional Senior Bond Purchasers. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 4.13.) Amendment No 1 dated as of July 1, 1991. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit (10)(w).) (10)(w) - Power Purchase Agreement dated as of July 17, 1986 between Midland Cogeneration Venture Limited Partnership and Consumers Power Company. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.4.) Amendments thereto: Amendment No 1 dated September 10, 1987. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.5.) Amendment No 2 dated March 18, 1988. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.6.) Amendment No 3 dated August 28, 1989. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.7.) Amendment No 4A dated May 25, 1989. (Designated in Midland Cogeneration Venture Limited Partnership's Form S-1 filed November 23, 1990, File No 33-37977, as Exhibit 10.8.) (10)(x) - Request for Approval of Settlement Proposal to Resolve MCV Cost Recovery Issues and Court Remand, filed with the Michigan Public Service Commission on July 7, 1992, MPSC Case No. U- 10127. (Designated in CMS Energy Corporation's and Consumers Power Company's Forms 10-K for the year ended December 31, 1991 as amended by Form 8 dated July 15, 1992 as Exhibit (28).) (10)(y) - Settlement Proposal Filed on July 7, 1992 as Revised on September 8, 1992 by Filing with the Michigan Public Service Commission. (Designated in CMS Energy Corporation's and Consumers Power Company's Forms 8-K dated September 8, 1992 as Exhibit (28).) (10)(z) - Michigan Public Service Commission Order Dated March 31, 1993, Approving with Modifications the Settlement Proposal Filed on July 7, 1992, as Revised on September 8, 1992. (Designated in CMS Energy Corporation's and Consumers Power Company's Forms 10-K for the year ended December 31, 1992 as Exhibit (10)(cc). (10)(aa) - Unwind Agreement dated as of December 10, 1991 by and among CMS Energy Corporation, Midland Group, Ltd., Consumers Power Company, CMS Midland, Inc., MEC Development Corp. and CMS Midland Holdings Company. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit (10)(y).) (10)(bb) - Stipulated AGE Release Amount Payment Agreement dated as of June 1, 1990, among CMS Energy Corporation, Consumers Power Company and The Dow Chemical Company. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit (10)(z).) (10)(cc) - Parent Guaranty dated as of June 14, 1990 from CMS Energy Corporation to MCV, each of the Owner Trustees, the Indenture Trustees, the Owner Participants and the Initial Purchasers of Senior Bonds in the MCV Sale Leaseback transaction, and MEC Development. (Designated in Consumers Power Company's Form 10-K for the year ended December 31, 1991, File No. 1-5611, as Exhibit (10)(aa).)** (11)-(12) - Not applicable. (13) - Not Applicable. (14)-(20) - Not applicable. (21)(a) (CMS ONLY) - Subsidiaries of CMS Energy Corporation. (21)(b) - Subsidiaries of Consumers Power Company. (22) - Not applicable. (23) - Consents of experts and counsel. (24) - Powers of Attorney. (25)-(28) - Not applicable. *Five copies of this exhibit have been signed by, or on behalf of, each of five Owner Participants. With regard to each of the agreements, each copy is substantially identical in all material respects except as to the parties thereto. Therefore, pursuant to Instruction 2, Item 601(a) of Regulation S-K, CMS Energy Corporation and Consumers Power Company are filing a copy of only one such document. ** Obligations of only CMS Holdings and CMS Midland, second tier subsidiaries of Consumers, and of CMS Energy but not of Consumers. Exhibits listed above which have heretofore been filed with the Securities and Exchange Commission pursuant to various acts administered by the Commission, and which were designated as noted above, are hereby incorporated herein by reference and made a part hereof with the same effect as if filed herewith. Index to Financial Statement Schedules Schedule Page V Property, Plant and Equipment 1993, 1992 and 1991: CMS Energy Corporation 154 Consumers Power Company 157 VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 1993, 1992 and 1991: CMS Energy Corporation 160 Consumers Power Company 163 VIII Valuation and Qualifying Accounts and Reserves 1993, 1992 and 1991: CMS Energy Corporation 166 Consumers Power Company 167 IX Short-Term Borrowings 1993, 1992 and 1991: CMS Energy Corporation 168 Consumers Power Company 169 X Supplementary Income Statement Information 1993, 1992 and 1991: CMS Energy Corporation 170 Consumers Power Company 171 Report of Independent Public Accountants CMS Energy Corporation 172 Consumers Power Company 173 Schedules other than those listed above are omitted because they are either not required, not applicable or the required information is shown in the financial statements or notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. Arthur Andersen & Co. Report of Independent Public Accountants To CMS Energy Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in CMS Energy Corporation's 1993 Annual Report to shareholders incorporated by reference 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 those basic consolidated financial statements taken as a whole. The schedules listed in Item 14(a) 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. Detroit, Michigan, January 28, 1994. Arthur Andersen & Co. Report of Independent Public Accountants To Consumers Power Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Consumers Power Company's 1993 Annual Report to shareholders incorporated by reference 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 those basic consolidated financial statements taken as a whole. The schedules listed in Item 14(a) 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 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. Detroit, Michigan, January 28, 1994. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, CMS Energy Corporation has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 18th day of March 1994. CMS ENERGY CORPORATION By William T. McCormick, Jr. ---------------------------- William T. McCormick, Jr. Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of CMS Energy Corporation and in the capacities and on the 18th day of March 1994. Signature Title - -------------------------------------- ----------------------------------- (i) Principal executive officer: Chairman of the Board, Chief Executive Officer William T. McCormick, Jr. and Director - ------------------------------------- William T. McCormick, Jr. (ii) Principal financial officer: Senior Vice President and A M Wright Chief Financial Officer - ------------------------------------- Alan M. Wright (iii) Controller or principal accounting officer: Vice President, Controller P. D. Hopper and Chief Accounting Officer - ------------------------------------- Preston D. Hopper (iv) A majority of the Directors including those named above: Director - ------------------------------------- James J. Duderstadt Signature Title - ------------------------------------- ----------------------------------- Victor J. Fryling Director - ------------------------------------- Victor J. Fryling Earl D. Holton* Director - ------------------------------------- Earl D. Holton Lois A. Lund* Director - ------------------------------------- Lois A. Lund Frank H. Merlotti* Director - ------------------------------------- Frank H. Merlotti W. U. Parfet* Director - ------------------------------------- William U. Parfet Percy A. Pierre* Director - ------------------------------------- Percy A. Pierre T. F. Russell* Director - ------------------------------------- Thomas F. Russell S. Kinnie Smith, Jr.* Director - ------------------------------------- S. Kinnie Smith, Jr. Director - ------------------------------------- Robert D. Tuttle Kenneth Whipple* Director - ------------------------------------- Kenneth Whipple John B. Yasinsky* Director - ------------------------------------- John B. Yasinsky * By Thomas A. McNish ------------------------------- Thomas A. McNish, Attorney-in-Fact SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Consumers Power Company has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 18th day of March 1994. CONSUMERS POWER COMPANY By William T. McCormick, Jr. --------------------------------- William T. McCormick, Jr. Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the following persons on behalf of Consumers Power Company and in the capacities and on the 18th day of March 1994. Signature Title - ------------------------------------- ----------------------------------- (i) Principal executive officer: President and Michael G. Morris Chief Executive Officer - ------------------------------------- Michael G. Morris (ii) Principal financial officer: Senior Vice President and A M Wright Chief Financial Officer - ------------------------------------- Alan M. Wright (iii) Controller or principal accounting officer: Vice President and Dennis DaPra Controller - ------------------------------------- Dennis DaPra (iv) A majority of the Directors including those named above: Director - ------------------------------------- James J. Duderstadt Signature Title - ------------------------------------- ----------------------------------- Victor J. Fryling Director - ------------------------------------- Victor J. Fryling Earl D. Holton* Director - ------------------------------------- Earl D. Holton Lois A. Lund* Director - ------------------------------------- Lois A. Lund William T. McCormick, Jr. Director - ------------------------------------- William T. McCormick, Jr. Frank H. Merlotti* Director - ------------------------------------- Frank H. Merlotti W. U. Parfet* Director - ------------------------------------- William U. Parfet Percy A. Pierre* Director - ------------------------------------- Percy A. Pierre T. F. Russell* Director - ------------------------------------- Thomas F. Russell S. Kinnie Smith, Jr.* Director - ------------------------------------- S. Kinnie Smith, Jr. Director - ------------------------------------- Robert D. Tuttle Kenneth Whipple* Director - ------------------------------------- Kenneth Whipple John B. Yasinsky* Director - ------------------------------------- John B. Yasinsky *By Thomas A. McNish -------------------------------- Thomas A. McNish, Attorney-in-Fact

1800_1993.txt

1800_1993

1993

1800

ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS Abbott Laboratories is an Illinois corporation, incorporated in 1900. The Company's* principal business is the discovery, development, manufacture, and sale of a broad and diversified line of health care products and services. FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS, GEOGRAPHIC AREAS, AND CLASSES OF SIMILAR PRODUCTS Incorporated herein by reference is the footnote entitled "Industry Segment and Geographic Area Information" of the Consolidated Financial Statements in the Abbott Laboratories Annual Report for the year ended December 31, 1993 ("1993 Annual Report"), filed as an exhibit to this report. Also incorporated herein by reference is the text and table of sales by class of similar products included in the section of the 1993 Annual Report captioned "Financial Review." NARRATIVE DESCRIPTION OF BUSINESS PHARMACEUTICAL AND NUTRITIONAL PRODUCTS Included in this segment is a broad line of adult and pediatric pharmaceuticals and nutritionals. These products are sold primarily on the prescription or recommendation of physicians or other health care professionals. The segment also includes agricultural and chemical products, bulk pharmaceuticals, and consumer products. Principal pharmaceutical and nutritional products include the anti-infectives clarithromycin, sold in the United States under the trademark Biaxin-R- and outside the United States primarily under the trademark Klacid-R- and tosufloxacin, sold in Japan under the trademark Tosuxacin-TM-; various forms of the antibiotic erythromycin, sold primarily as PCE-R- or polymer-coated erythromycin, Erythrocin-R-, and E.E.S.-R-; agents for the treatment of epilepsy, including Depakote-R-; a broad line of cardiovascular products, including Loftyl-R-, a vasoactive agent sold outside the United States; Hytrin-R-, used as an anti-hypertensive and for the treatment of benign prostatic hyperplasia; Abbokinase-R-, a thrombolytic drug; Survanta-R-, a bovine derived lung surfactant; various forms of prepared infant formula, including Similac-R-, Isomil-R-, and Alimentum-R-; and other medical and pediatric nutritionals, including Ensure-R-, Ensure Plus-R-, Jevity-R-, Glucerna-R-, Advera-TM-, PediaSure-R-, Pedialyte-R- and Gain-R-. Consumer products include the dandruff shampoo Selsun Blue-R-; Murine-R- eye care and ear care products; Tronolane-R- hemorrhoid medication; and Faultless-R- rubber sundry products. Agricultural and chemical products include plant growth regulators, including ProGibb-R-; herbicides; larvicides, including Vectobac-R-; and biologically derived insecticides, including DiPel-R- and XenTari-R-. Pharmaceutical and nutritional products are generally sold directly to retailers, wholesalers, health care facilities, and government agencies. In most cases, they are distributed from Company-owned distribution centers or public warehouses. Certain products are co-marketed with other companies. In certain overseas countries, some of these products are marketed and distributed through distributors. Primary marketing efforts for pharmaceutical and nutritional products are directed toward securing the prescription or recommendation of the Company's brand of products by physicians or other health care professionals. Managed care purchasers, for example health maintenance organizations (HMOs) and pharmacy benefit managers, are becoming increasingly important customers. Competition is generally from other broad line and specialized health care manufacturers. A significant aspect of competition is the search for technological innovations. The - ------------------------ * As used throughout the text of this Report, the term "Company" refers to Abbott Laboratories, an Illinois corporation, or Abbott Laboratories and its consolidated subsidiaries, as the context requires. introduction of new products by competitors and changes in medical practices and procedures can result in product obsolescence. In addition, the substitution of generic drugs for the brand prescribed has increased competitive pressures on pharmaceutical products. Consumer products are promoted directly to the public by consumer advertising. These products are generally sold directly to retailers and wholesalers. Competitive products are sold by other diversified consumer and health care companies. Competitive factors include consumer advertising, scientific innovation, price, and availability of generic product forms. Agricultural and chemical products are generally sold to agricultural distributors and pharmaceutical companies. Competition is primarily from large chemical and agricultural companies and companies selling specialized agricultural products. Competition is based on numerous factors depending on the market served. Important competitive factors include product performance for specialized industrial and agricultural uses, price, and technological advantages. The Company is the leading worldwide producer of the antibiotic erythromycin. Similac-R- is the leading infant formula product in the United States. Under an agreement between the Company and Takeda Chemical Industries, Ltd. of Japan (Takeda), TAP Pharmaceuticals Inc. (TAP), owned 50 percent by the Company and 50 percent by Takeda, develops and markets in the United States products based on Takeda research. TAP markets Lupron-R-, an LH-RH analog, and Lupron Depot-R-, a sustained release form of Lupron-R-, in the United States. These agents are used for the treatment of advanced prostatic cancer, endometriosis, and central precocious puberty. The Company also has marketing rights to certain Takeda products in select Latin American markets. The Company also markets Lupron-R-, Lupron Depot-R-, and Lupron Depot-Ped-R- in select markets outside the United States. HOSPITAL AND LABORATORY PRODUCTS Hospital and laboratory products include diagnostic systems for blood banks, hospitals, commercial laboratories, and alternate-care testing sites; intravenous and irrigation fluids and related administration equipment, including electronic drug delivery systems; drugs and drug delivery systems; anesthetics; critical care products; and other medical specialty products for hospitals and alternate-care sites. The principal products included in this segment are parenteral (intravenous or I.V.) solutions and related administration equipment sold as the LifeCare-R- line of products, LifeShield-R- sets, and Venoset-R- products; irrigating fluids; parenteral nutritionals such as Aminosyn-R- and Liposyn-R-; Plum-R- and Omni-Flow-R- electronic drug delivery systems; Abbott Pain Management Provider-R-; patient-controlled analgesia (PCA) systems; venipuncture products; hospital injectables; premixed I.V. drugs in various containers; ADD-Vantage-R- and Nutrimix-R- drug and nutritional delivery systems; anesthetics, including Pentothal-R-, isoflurane, and enflurane; hemodynamic monitoring equipment; Calcijex-R-, an injectable agent for treatment of bone disease in hemodialysis patients; critical care products including Opticath-R-; screening tests for hepatitis B, HTLV-1, hepatitis B core, and hepatitis C; tests for detection of AIDS antibodies and antigens, and other infectious disease detection systems; tests for determining levels of abused drugs with the ADx-R- instrument; physiological diagnostic tests; cancer monitoring tests including tests for prostate specific antigen; laboratory tests and therapeutic drug monitoring systems such as TDx-R-; clinical chemistry systems such as Abbott Spectrum-R-, Abbott Spectrum-R- EPx-R-, Abbott Spectrum-R- CCx-TM-, and Quantum-TM-; Commander-R- and IMx-R- lines of diagnostic instruments and chemical reagents used with immunoassay diagnostics; Abbott Vision-R-, a desk-top blood analyzer, the Abbott TestPack-R- system for diagnostic testing, and a full line of hematology systems and reagents known as the Cell-Dyn-R- series. The hospital and laboratory products the Company expects to introduce in the United States in 1994 include: AxSym-TM-, a diagnostic system; Abbott Maestro-TM-, a data management system; and EnCounter-R-, a desktop hematology analyzer. The Company markets hospital and laboratory products in the United States and many other countries. These products are generally distributed to wholesalers and directly to hospitals, laboratories, and physicians' offices from distribution centers maintained by the Company. Sales are also made in the home infusion services market directly to patients receiving treatment outside the hospital through marketing arrangements with hospitals and other health care providers. Overseas sales are made either directly to customers or through distributors, depending on the market served. The hospital and laboratory products industry segment is highly competitive, both in the United States and overseas. This segment is subject to competition in technological innovation, price, convenience of use, service, instrument warranty provisions, product performance, long-term supply contracts, and product potential for overall cost effectiveness and productivity gains. Products in this segment can be subject to rapid product obsolescence. The Company has benefitted from technological advantages of certain of its current products; however, these advantages may be reduced or eliminated as competitors introduce new products. The Company is one of the leading domestic manufacturers of I.V. and irrigating solutions and related administration equipment, parenteral nutritional products, anesthesia products, and drug delivery systems. It is also the worldwide leader in in vitro diagnostic products, including thyroid tests, therapeutic drug monitoring, cancer monitoring tests, diagnostic tests for the detection of hepatitis and AIDS antibodies, and immunodiagnostic instruments. INFORMATION WITH RESPECT TO THE COMPANY'S BUSINESS IN GENERAL SOURCES AND AVAILABILITY OF RAW MATERIALS The Company purchases, in the ordinary course of business, necessary raw materials and supplies essential to the Company's operations from numerous suppliers in the United States and overseas. There have been no recent availability problems or significant supply shortages. PATENTS, TRADEMARKS, AND LICENSES The Company is aware of the desirability for patent and trademark protection for its products. The Company owns, has applications pending for, and is licensed under a substantial number of patents. Accordingly, where possible, patents and trademarks are sought and obtained for the Company's products in the United States and all countries of major marketing interest to the Company. Principal trademarks and the products they cover are discussed in the Narrative Description of Business on pages 1 and 2. These, and various patents which expire during the period 1994 to 2011, in the aggregate, are believed to be of material importance in the operation of the Company's business. However, the Company believes that no single patent, license, trademark, (or related group of patents, licenses, or trademarks) is material in relation to the Company's business as a whole. SEASONAL ASPECTS, CUSTOMERS, BACKLOG, AND RENEGOTIATION There are no significant seasonal aspects to the Company's business. The incidence of certain infectious diseases which occur at various times in different areas of the world does, however, affect the demand for the Company's anti-infective products. Orders for the Company's products are generally filled on a current basis, and order backlog is not material to the Company's business. No single customer accounted for sales equaling 10 percent or more of the Company's consolidated net sales. No material portion of the Company's business is subject to renegotiation of profits or termination of contracts at the election of the government. RESEARCH AND DEVELOPMENT The Company spent $880,974,000 in 1993, $772,407,000 in 1992, and $666,336,000 in 1991 on research to discover and develop new products and processes and to improve existing products and processes. The Company continues to concentrate research expenditures in pharmaceutical and diagnostic products. ENVIRONMENTAL MATTERS The Company believes that its operations comply in all material respects with applicable laws and regulations concerning environmental protection. Regulations under federal and state environmental laws impose stringent limitations on emissions and discharges to the environment from various manufacturing operations. The Company's capital and operating expenditures for pollution control in 1993 were approximately $32 million and $31 million, respectively. Capital and operating expenditures for pollution control are estimated to approximate $39 million and $36 million, respectively, in 1994. The Company is participating as one of many potentially responsible parties in investigation and/ or remediation at eight locations in the United States and Puerto Rico under the Comprehensive Environmental Response, Compensation, and Liability Act, commonly known as Superfund. The aggregate costs of remediation at these sites by all identified parties are uncertain but have been subject to widely ranging estimates totaling as much as several hundred million dollars. In many cases, the Company believes that the actual costs will be lower than these estimates, and the fraction for which the Company may be responsible is anticipated to be considerably less and will be paid out over a number of years. The Company expects to participate in the investigation or cleanup at these sites. The Company is also voluntarily investigating potential contamination at five Company-owned sites, and has initiated voluntary remediation at four Company-owned sites, in cooperation with the Environmental Protection Agency (EPA) or similar state agencies. While it is not feasible to predict with certainty the costs related to the previously described investigation and cleanup activities, the Company believes that such costs, together with other expenditures to maintain compliance with applicable laws and regulations concerning environmental protection, should not have a material adverse effect on the Company's earnings or competitive position. EMPLOYEES The Company employed 49,659 persons as of December 31, 1993. REGULATION The development, manufacture, sale, and distribution of the Company's products are subject to comprehensive government regulation, and the general trend is toward more stringent regulation. Government regulation by various federal, state, and local agencies, which includes detailed inspection of and controls over research and laboratory procedures, clinical investigations, and manufacturing, marketing, sampling, distribution, recordkeeping, storage and disposal practices, substantially increases the time, difficulty, and costs incurred in obtaining and maintaining the approval to market newly developed and existing products. Government regulatory actions can result in the seizure or recall of products, suspension or revocation of the authority necessary for their production and sale, and other civil or criminal sanctions. Continuing studies of the utilization, safety, and efficacy of health care products and their components are being conducted by industry, government agencies, and others. Such studies, which employ increasingly sophisticated methods and techniques, can call into question the utilization, safety, and efficacy of previously marketed products and in some cases have resulted, and may in the future result, in the discontinuance of marketing of such products and give rise to claims for damages from persons who believe they have been injured as a result of their use. The cost of human health care products continues to be a subject of investigation and action by governmental agencies, legislative bodies, and private organizations in the United States and other countries. In the United States, most states have enacted generic substitution legislation requiring or permitting a dispensing pharmacist to substitute a different manufacturer's version of a pharmaceutical product for the one prescribed. Federal and state governments continue to press efforts to reduce costs of Medicare and Medicaid programs, including restrictions on amounts agencies will reimburse for the use of products. Manufacturers must pay certain statutorily-prescribed rebates on Medicaid purchases for reimbursement on prescription drugs under state Medicaid plans. In addition, the Federal government follows a diagnosis-related group (DRG) payment system for certain institutional services provided under Medicare or Medicaid. The DRG system entitles a health care facility to a fixed reimbursement based on discharge diagnoses rather than actual costs incurred in patient treatment, thereby increasing the incentive for the facility to limit or control expenditures for many health care products. The Veterans Health Care Act of 1992 requires manufacturers to extend additional discounts on pharmaceutical products to various federal agencies, including the Department of Veterans Affairs, Department of Defense, and Public Health Service entities and institutions. In the United States, governmental cost-containment efforts have extended to the federally subsidized Special Supplemental Food Program for Women, Infants, and Children (WIC). All states participate in WIC and have sought and obtained rebates from manufacturers of infant formula whose products are used in the program. All of the states have also conducted competitive bidding for infant formula contracts which require the use of specific infant formula products for the state WIC program. The Child Nutrition and WIC Reauthorization Act of 1989 requires all states participating in WIC to engage in competitive bidding upon the expiration of their existing infant formula contracts. Governmental regulatory agencies now require manufacturers to pay additional fees. Under the Prescription Drug User Fee Act of 1992, the Federal Food and Drug Administration imposes substantial fees on various aspects of the approval, manufacture and sale of prescription drugs. Congress is now considering expanding user fees to medical devices. The Company believes that such legislation, if enacted, will add considerable expense for the Company. In the United States comprehensive legislation has been proposed that would make significant changes to the availability, delivery and payment for healthcare products and services. It is the intent of such proposed legislation to provide health and medical insurance for all United States citizens and to reduce the rate of increases in United States healthcare expenditures. If such legislation is enacted, the Company believes it could have the effect of reducing prices for, or reducing the rate of price increases for health and medical insurance and medical products and services. International operations are also subject to a significant degree of government regulation. Many countries, directly or indirectly through reimbursement limitations, control the selling price of most health care products. Furthermore, many developing countries limit the importation of raw materials and finished products. International regulations are having an impact on United States regulations, as well. The International Organization for Standardization ("ISO") provides the voluntary criteria for regulating medical devices within the European Economic Community. The Food and Drug Administration ("FDA") has announced that it will attempt to harmonize its regulation of medical devices with that of the ISO. Recently published changes to the FDA's regulations governing the manufacture of medical devices appear to encompass and exceed the ISO's approach to regulating medical devices. The FDA's adoption of the ISO's approach to regulation and other changes to the manner in which the FDA regulates medical devices will increase the cost of compliance with those regulations. Efforts to reduce health care costs are also being made in the private sector. Health care providers have responded by instituting various cost reduction and containment measures. It is not possible to predict the extent to which the Company or the health care industry in general might be affected by the matters discussed above. INTERNATIONAL OPERATIONS The Company markets products in approximately 130 countries through affiliates and distributors. Most of the products discussed in the preceding sections of this report are sold outside the United States. In addition, certain products of a local nature and variations of product lines to meet local regulatory requirements and marketing preferences are manufactured and marketed to customers outside the United States. International operations are subject to certain additional risks inherent in conducting business outside the United States, including price and currency exchange controls, changes in currency exchange rates, limitations on foreign participation in local enterprises, expropriation, nationalization, and other governmental action. ITEM 2. ITEM 2. PROPERTIES The Company's corporate offices are located at One Abbott Park Road, Abbott Park, Illinois 60064-3500. The locations of a number of the Company's principal plants are listed below. In addition to the above, the Company has manufacturing facilities in eight other locations in the United States and Puerto Rico. Overseas manufacturing facilities are located in 19 other countries. The Company's facilities are deemed suitable, provide adequate productive capacity, and are utilized at normal and acceptable levels. In the United States and Puerto Rico, the Company owns seven distribution centers. The Company also has twelve United States research and development facilities located at Abbott Park, Illinois; Andover, Massachusetts; Ashland, Ohio; Columbus, Ohio (2 locations); Irving, Texas; Long Grove, Illinois; Madera, California; Mountain View, California; North Chicago, Illinois; Salt Lake City, Utah; and Santa Clara, California. Overseas, the Company has research and development facilities in Argentina, Australia, Canada, Germany, Italy, Japan, The Netherlands, and the United Kingdom. The corporate offices, all manufacturing plants, and all other facilities in the United States and overseas are owned or leased by the Company or subsidiaries of the Company. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in various claims and legal proceedings including (as of January 31, 1994) 7 antitrust suits and 6 investigations in connection with the Company's sale and marketing of infant formula products, 138 product liability cases that allege injuries to the offspring of women who ingested a synthetic estrogen (DES) during pregnancy and 22 antitrust suits in connection with the Company's sale and marketing of pharmaceuticals. The infant formula antitrust suits, which are pending in various federal and state courts, allege that the Company conspired with one or more of its competitors to fix prices for infant formula, to rig a bid on a contract to provide infant formula under the federal government's Special Supplemental Food Program for Women, Infants, and Children (WIC), to deprive states of the benefits of competition in providing rebates to the state pursuant to WIC sales, and to restrain trade and monopolize the market for infant formula products in violation of state and federal antitrust laws. The suits were brought on behalf of individuals, a competitor, the Federal Trade Commission, and state governmental agencies seeking treble damages, civil penalties, and other relief. Three of the 7 cases are pending in state courts in Calhoun County and Shelby County, Alabama and in Austin, Texas. The Calhoun County suit purports to be a class action on behalf of Alabama consumers. The 4 other cases are pending in federal courts in Los Angeles, California, Tallahassee, Florida, Baton Rouge, Louisiana (this suit purports to be a class action on behalf of Louisiana consumers), and Washington, D.C. The Company has filed responses to the complaints denying all substantive allegations. The investigations are being conducted by the Attorneys General of the states of California, Connecticut, New York, Pennsylvania and Wisconsin and by the Canadian Bureau of Competition Policy. The four shareholder derivative suits (which were consolidated in federal court in Chicago, Illinois) that had been filed against certain of the Company's officers and directors regarding the Company's sale and marketing of infant formula products were dismissed with prejudice on January 31, 1994. Twelve of the 22 pharmaceutical antitrust suits are pending in the United States District Court for the Southern District of New York; 4 are pending in state court in San Francisco County, California; the 6 remaining cases are pending in federal district courts in San Francisco, California, Savannah, Georgia, Minneapolis, Minnesota, Charleston, South Carolina, Austin, Texas, and Galveston, Texas. These suits allege that various pharmaceutical manufacturers have conspired to fix drug prices and/or to discriminate in pricing to retail pharmacies by providing discounts to mail-order pharmacies, institutional pharmacies, and HMOs. The suits were brought on behalf of retail pharmacies, seek treble damages and other relief, and some purport to be class actions. The Company intends to respond to the complaints denying all substantive allegations. While it is not feasible to predict the outcome of such pending claims, proceedings, and investigations with certainty, management is of the opinion, with which its General Counsel concurs, that their ultimate disposition should not have a material adverse effect on the Company's financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Officers of the Company are elected annually by the board of directors at the first meeting held after the annual shareholders meeting. Each officer holds office until a successor has been duly elected and qualified or until the officer's death, resignation, or removal. Vacancies may be filled at any meeting of the board. Any officer may be removed by the board of directors when, in its judgment, removal would serve the best interests of the Company. Current corporate officers, and their ages as of February 11, 1994, are listed below. The officers' principal occupations and employment from January 1989 to present and the dates of their first election as officers of the Company are also shown. Unless otherwise stated, employment was by the Company for the period indicated. There are no family relationships between any corporate officers or directors. DUANE L. BURNHAM**, 52 1989 -- Vice Chairman and Chief Financial Officer, and Director. 1989 to 1990 -- Vice Chairman and Chief Executive Officer, and Director. 1990 to present -- Chairman of the Board and Chief Executive Officer, and Director. Elected Corporate Officer -- 1982. THOMAS R. HODGSON**, 52 1989 to 1990 -- Executive Vice President and Director. 1990 to present -- President and Chief Operating Officer, and Director. Elected Corporate Officer -- 1980. ROBERT N. BECK**, 53 1989 to 1992 -- Executive Vice President, BankAmerica and Bank of America. 1992 to present -- Senior Vice President, Human Resources. Elected Corporate Officer -- 1992. PAUL N. CLARK**, 47 1989 to 1990 -- Vice President, Pharmaceutical Operations. 1990 to present -- Senior Vice President, Pharmaceutical Operations. Elected Corporate Officer -- 1985. GARY P. COUGHLAN**, 49 1989 -- Senior Vice President and Chief Financial Officer, Kraft, Inc. 1989 to 1990 -- Senior Vice President, Finance, Kraft General Foods. 1990 to present -- Senior Vice President, Finance and Chief Financial Officer. Elected Corporate Officer -- 1990. LAEL F. JOHNSON**, 56 1989 -- Vice President, Secretary and General Counsel. 1989 to present -- Senior Vice President, Secretary and General Counsel. Elected Corporate Officer -- 1981. JOHN G. KRINGEL**, 54 1989 to 1990 -- Vice President, Hospital Products. 1990 to present -- Senior Vice President, Hospital Products. Elected Corporate Officer -- 1981. J. DUNCAN MCINTYRE**, 56 1989 to 1990 -- Vice President. 1990 to present -- Senior Vice President, International Operations. Elected Corporate Officer -- 1987. THOMAS M. MCNALLY**, 46 1989 -- Area Vice President, Pacific, Asia and Africa, Abbott International, Ltd. (a subsidiary of the Company). 1989 to 1990 -- Vice President, Chemical and Agricultural Products. 1990 to 1993 -- Senior Vice President, Chemical and Agricultural Products. 1993 to present -- Senior Vice President, Ross Products. Elected Corporate Officer -- 1989. ROBERT L. PARKINSON, JR.**, 43 1989 -- Divisional Vice President, Commercial Operations. 1989 to 1990 -- Vice President, Corporate Hospital Marketing. 1990 to 1993 -- Vice President, European Operations. 1993 to present -- Senior Vice President, Chemical and Agricultural Products. Elected Corporate Officer -- 1989. DAVID A. THOMPSON**, 52 1989 to 1990 -- Vice President, Diagnostic Operations. 1990 to present -- Senior Vice President, Diagnostic Operations. Elected Corporate Officer -- 1982. JOY A. AMUNDSON**, 39 1989 to 1990 -- General Manager, Alternate Site. 1990 -- Divisional Vice President and General Manager, Hospital Products Business Sector. 1990 to 1994 -- Vice President, Corporate Hospital Marketing. 1994 to present -- Vice President, Health Systems. Elected Corporate Officer -- 1990. CHRISTOPHER B. BEGLEY, 41 1989 -- Director, Hospital Products Business Sector. 1989 to 1990 -- General Manager, Hospital Products Business Sector. 1990 to 1993 -- Divisional Vice President and General Manager, Hospital Products Business Sector. 1993 -- Vice President, Hospital Products Business Sector. Elected Corporate Officer -- 1993. THOMAS D. BROWN, 45 1989 to 1992 -- Divisional Vice President, Western Hemisphere. 1992 to 1993 -- Divisional Vice President, Diagnostic Commercial Operations. 1993 to present -- Vice President, Diagnostic Commercial Operations. Elected Corporate Officer -- 1993. GARY R. BYERS**, 52 1989 to 1993 -- Divisional Vice President, Corporate Auditing. 1993 to present -- Vice President, Internal Audit. Elected Corporate Officer -- 1993. KENNETH W. FARMER**, 48 1989 -- Vice President, Management Information Services. 1989 to present -- Vice President, Management Information Services and Administration. Elected Corporate Officer -- 1985. THOMAS C. FREYMAN**, 39 1989 to 1991 -- Treasurer, Abbott International, Ltd. (a subsidiary of the Company). 1991 to present -- Vice President and Treasurer. Elected Corporate Officer -- 1991. JAY B. JOHNSTON, 50 1989 to 1992 -- President, Dainabot Co., Ltd. (an affiliate of the Company) and General Manager Asia Pacific, Abbott Diagnostics Division. 1992 -- Divisional Vice President, Business Development. 1992 to 1993 -- Divisional Vice President and General Manager, Diagnostic Assays and Operations. 1993 to present -- Corporate Vice President, Diagnostic Assays and Operations. Elected Corporate Officer -- 1993. JAMES J. KOZIARZ, 44 1989 to 1990 -- General Manager, Hepatitis/Retrovirus Business Sector. 1990 to 1992 -- Vice President and General Manager, Diagnostic Assays. 1992 to present -- Vice President, Diagnostic Products Research and Development. Elected Corporate Officer -- 1993. CHRISTOPHER A. KUEBLER, 40 1989 to 1992 -- Divisional Vice President, Marketing. 1992 to 1993 -- Divisional Vice President, Sales and Marketing. 1993 to present -- Vice President, European Operations. Elected Corporate Officer -- 1993. JOHN F. LUSSEN**, 52 1989 to present -- Vice President, Taxes. Elected Corporate Officer -- 1985. DAVID V. MILLIGAN, PH.D., 53 1989 to 1992 -- Vice President, Diagnostic Products Research and Development. 1992 to present -- Vice President, Pharmaceutical Products Research and Development. Elected Corporate Officer -- 1984. RICHARD H. MOREHEAD**, 59 1989 to present -- Vice President, Corporate Planning and Development. Elected Corporate Officer -- 1985. THEODORE A. OLSON**, 55 1989 to present -- Vice President and Controller. Elected Corporate Officer -- 1988. CARL A. SPALDING, 48 1989 to 1992 -- Vice President, International, Johnson & Johnson. 1992 to present -- Vice President, General Manager, Ross Products. Elected Corporate Officer -- 1993. WILLIAM H. STADTLANDER, 48 1989 to 1992 -- Divisional Vice President, Medical Nutritionals. 1992 to present -- Divisional Vice President and General Manager, Medical Nutritionals. Elected Corporate Officer -- 1993. DANIEL O. STRUBLE**, 53 1989 to present -- Vice President, Corporate Engineering. Elected Corporate Officer -- 1987. ELLEN M. WALVOORD**, 54 1989 to 1991 -- Director, Corporate Communications. 1991 -- Vice President, Investor Relations. 1991 to present -- Vice President, Investor Relations and Public Affairs. Elected Corporate Officer -- 1991. JOSEF WENDLER, 44 1989 to 1990 -- General Manager, Austria & Switzerland. 1990 to 1992 -- Regional Director, Europe, Diagnostic Division. 1992 to 1993 -- Divisional Vice President, Pacific, Asia, Africa. 1993 to present -- Vice President, Pacific/ Asia /Africa Operations. Elected Corporate Officer -- 1993. MILES D. WHITE, 38 1989 to 1990 -- Director of Marketing for the U.S., Abbott Diagnostics Division. 1990 -- Business Unit General Manager, Physiological Diagnostics, Abbott Diagnostics Division and Business Unit General Manager, Cancer Diagnostics. 1990 to 1992 -- Divisional Vice President and General Manager, Hospital Laboratory Sector. 1992 to 1993 -- Divisional Vice President and General Manager, Diagnostic Systems and Operations. 1993 to present -- Vice President, Diagnostic Systems and Operations. Elected Corporate Officer -- 1993. DON G. WRIGHT**, 51 1989 to present -- Vice President, Corporate Quality Assurance and Regulatory Affairs. Elected Corporate Officer -- 1988. - ------------------------ ** Pursuant to Item 401(b) of Regulation S-K the Company has identified these persons as "executive officers" within the meaning of Item 401(b). PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS PRINCIPAL MARKET The principal market for the Company's common shares is the New York Stock Exchange. Shares are also listed on the Chicago and Pacific Stock Exchanges and are traded on the Boston, Cincinnati, and Philadelphia Exchanges. Overseas, the Company's shares are listed on the London Stock Exchange, Tokyo Stock Exchange, and the Swiss Stock Exchanges of Zurich, Basel, Geneva, and Lausanne. Market prices are as reported by the New York Stock Exchange composite transaction reporting system. SHAREHOLDERS There were 82,947 shareholders of record of Abbott common shares as of December 31, 1993. DIVIDENDS Quarterly dividends of $.17 per share and $.15 per share were declared on common shares in 1993 and 1992, respectively after reflecting the May 29, 1992 stock split. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Incorporated herein by reference for the years 1989 through 1993 are the applicable portions of the section captioned "Summary of Selected Financial Data" of the 1993 Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated herein by reference is management's discussion and analysis of financial condition and results of operations for the years 1993, 1992, and 1991 found under the section captioned "Financial Review" of the 1993 Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated herein by reference are the portions of the 1993 Annual Report captioned Consolidated Balance Sheet, Consolidated Statement of Income, Consolidated Statement of Cash Flows, Consolidated Statement of Shareholders' Investment, Notes to Consolidated Financial Statements and Report of Independent Public Accountants (which contains the related report of Arthur Andersen & Co. dated January 14, 1994). Data relating to quarterly interim results is found in Note 8. 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 herein by reference are "Information Concerning Nominees for Directors" and "Compliance with Section 16(a) of The Securities Exchange Act of 1934" found in the 1994 Abbott Laboratories Proxy Statement ("1994 Proxy Statement"), which will be filed with the Commission on or about March 4, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The material in the 1994 Proxy Statement under the heading "Executive Compensation," other than the Report of the Compensation Committee and the Performance Graph, are hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference is the text found under the caption "Information Concerning Security Ownership" in the 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference is that portion of the 1994 Proxy Statement under the caption "Compensation Committee Interlocks and Insider Participation." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) DOCUMENTS FILED AS PART OF THIS FORM 10-K. 1. FINANCIAL STATEMENTS: The Consolidated Financial Statements for the years ended December 31, 1993, 1992, and 1991 and the related report of Arthur Andersen & Co. dated January 14, 1994 appearing under the portions of the 1993 Annual Report captioned Consolidated Balance Sheet, Consolidated Statement of Earnings, Consolidated Statement of Cash Flows, Consolidated Statement of Shareholders' Investment, Notes to Consolidated Financial Statements and Report of Independent Public Accountants, respectively, are incorporated by reference in response to Item 14(a)1. With the exception of the portions of the 1993 Annual Report specifically incorporated herein by reference, such Report shall not be deemed filed as part of this Annual Report on Form 10-K or otherwise deemed subject to the liabilities of Section 18 of the Securities Exchange Act of 1934. 2. FINANCIAL STATEMENT SCHEDULES: The required financial statement schedules are found on the pages indicated below. These schedules should be read in conjunction with the Consolidated Financial Statements in the 1993 Annual Report: 3. EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K: The information called for by this paragraph is incorporated herein by reference to the Exhibit Index on pages 16 and 17 of this Form 10-K. (b) REPORTS ON FORM 8-K DURING THE QUARTER ENDED DECEMBER 31, 1993: No reports on Form 8-K were filed during the quarter ended December 31, 1993. (c) EXHIBITS FILED (SEE EXHIBIT INDEX ON PAGES 16 AND 17). (D) FINANCIAL STATEMENT SCHEDULES FILED (SEE PAGES 18 THROUGH 23). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Abbott Laboratories has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ABBOTT LABORATORIES By /s/ DUANE L. BURNHAM Duane L. Burnham Chairman of the Board and Chief Executive Officer Date: February 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 Abbott Laboratories and in the capacities and on the dates indicated: /s/ DUANE L. BURNHAM Duane L. Burnham Chairman of the Board, Chief Executive Officer, and Director of Abbott Laboratories (principal executive officer) Date: February 11, 1994 /s/ GARY P. COUGHLAN Gary P. Coughlan Senior Vice President, Finance and Chief Financial Officer (principal financial officer) Date: February 11, 1994 /s/ THOMAS R. HODGSON Thomas R. Hodgson President, Chief Operating Officer, and Director of Abbott Laboratories Date: February 11, 1994 /s/ THEODORE A. OLSON Theodore A. Olson Vice President and Controller (principal accounting officer) Date: February 11, 1994 /s/ K. FRANK AUSTEN K. Frank Austen, M.D. Director of Abbott Laboratories Date: February 11, 1994 /s/ H. LAURANCE FULLER H. Laurance Fuller Director of Abbott Laboratories Date: February 11, 1994 /s/ BERNARD J. HAYHOE Bernard J. Hayhoe Director of Abbott Laboratories Date: February 11, 1994 /s/ ALLEN F. JACOBSON Allen F. Jacobson Director of Abbot Laboratories Date: February 11, 1994 /s/ DAVID A. JONES David A. Jones Director of Abbott Laboratories Date: February 11, 1994 /s/ BOONE POWELL, JR. Boone Powell, Jr. Director of Abbott Laboratories Date: February 11, 1994 /s/ A. BARRY RAND A. Barry Rand Director of Abbott Laboratories Date: February 11, 1994 /s/ W. ANN REYNOLDS W. Ann Reynolds Director of Abbott Laboratories Date: February 11, 1994 /s/ WILLIAM D. SMITHBURG William D. Smithburg Director of Abbott Laboratories Date: February 11, 1994 /s/ JOHN R. WALTER John R. Walter Director of Abbott Laboratories Date: February 11, 1994 /s/ WILLIAM L. WEISS William L. Weiss Director of Abbott Laboratories Date: February 11, 1994 EXHIBIT INDEX ABBOTT LABORATORIES ANNUAL REPORT FORM 10-K - --------- * Incorporated herein by reference. The Company will furnish copies of any of the above exhibits to a shareholder upon written request to the Corporate Secretary, Abbott Laboratories, One Abbott Park Road, Abbott Park, Illinois 60064-3500. ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE I--INVESTMENT SECURITIES MATURING AFTER ONE YEAR DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE V--PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE IX SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) ABBOTT LABORATORIES AND SUBSIDIARIES SCHEDULE X-SUPPLEMENTARY CONSOLIDATED STATEMENT OF EARNINGS INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (DOLLARS IN THOUSANDS)

20762_1993.txt

20762_1993

1993

20762

ITEM 1 AND 2. BUSINESS; PROPERTIES Clark Refining & Marketing, Inc. (formerly known as Clark Oil & Refining Corporation), a Delaware Corporation (the "Company" or "Clark"), headquartered in St. Louis, Missouri, is one of the leading independent refiners and marketers of petroleum products in the Midwest. Its principal activities consist of crude oil refining, wholesale marketing of refined petroleum products and retail marketing of gasoline and convenience products. These businesses have been operating under the Clark brand name for over 60 years. The assets related to Clark's business were acquired on November 22, 1988 (the "Acquisition") out of bankruptcy proceedings. The assets acquired consisted of (i) substantially all of the assets of Apex Oil Company, Inc., a Wisconsin corporation (formerly known as OC Oil & Refining Corporation and prior thereto known as Clark Oil & Refining Corporation, a Wisconsin corporation ("Old Clark")) and its subsidiaries and (ii) certain other assets and liabilities of the Novelly/Goldstein Partnership (formerly known as Apex Oil Company), a Missouri general partnership ("Apex"), the indirect owner of Old Clark. All of the outstanding common stock of Clark is owned by Clark R & M Holdings, Inc., a Delaware corporation ("R & M Holdings"), an indirect wholly- owned subsidiary of The Horsham Corporation ("Horsham"), a Quebec corporation. Horsham acquired an initial 60% ownership in R & M Holdings at the Acquisition and 100% ownership in December 1992. Horsham is a Canadian management and holding company which also owns a controlling 20% interest in American Barrick Resources Corporation ("Barrick"), a major gold mining company and 100% of Horsham Properties GmbH which is developing a 600-acre business park near Berlin, Germany. Peter Munk, Horsham's Chairman and Chief Executive Officer and controlling shareholder, is Chairman of the Board and a Director of Clark. INDUSTRY ENVIRONMENT During the period from 1982 to 1993, domestic refining capacity declined by 15.1% from 17.9 million bbls/day to 15.2 million bbls/day due primarily to a significant reduction in the total number of domestic refineries. During the same period, refinery throughput, or production, grew in response to market demand, from 11.8 million bbls/day to 13.9 million bbls/day principally due to increases in the number of operating vehicles and passenger miles driven. Refining capacity utilization grew from 65.8% in 1982 to 91.4% in 1993. Clark believes that the maximum achievable refining utilization for the industry is approximately 93%, because of the requirements for scheduled and unscheduled maintenance shutdowns. The following table sets forth selected US refinery industry information published by the US Energy Information Administration: SELECTED UNITED STATES REFINING INDUSTRY STATISTICS - -------- *1993 figures have been obtained from the American Petroleum Institute. Clark believes that US refining capacity will continue to decline due to a continuing escalation in the cost of new refinery construction combined with the high cost of bringing many older refineries into compliance with current and proposed environmental regulations, such as those mandated by the Clean Air Act. The Clean Air Act Amendments of 1990 provide, among other things, that (i) as of November 1992, the 39 cities which had failed to attain mandated carbon monoxide air quality standards were required to use oxygenated gasoline for four to twelve months of each year depending upon each area's historical noncompliance period and (ii) beginning in 1995, the nine cities which have the worst ozone quality, including the Chicago and Milwaukee metropolitan areas, will be required to use, and another 87 areas which have failed to attain ozone air quality standards may elect to use, "reformulated" gasoline throughout the year in order to decrease the emission of hydrocarbons and toxic pollutants. Because of the expenditures associated with producing reformulated gasoline and compliance with the Clean Air Act and other environmental regulations, various US refiners have announced that they will sell and or close those refineries where capital expenditures needed to ensure compliance would not be economic. Over the near term, many refiners are expected to utilize their capital expenditure budgets to bring their facilities into compliance with environmental requirements, rather than to add to crude oil throughput capacity. Refining and marketing is a cyclical commodity-based business in which individual participants have virtually no control over industry margin levels. BUSINESS STRATEGY Clark's strategic business plan is to position Clark as a low-cost, high- quality refiner and marketer of refined petroleum products. Clark plans to build on its strengths, which include flexibility in feedstock supply and refined product output, a strong integrated wholesale distribution network, a strong retail presence founded in Clark brand name recognition, comprehensive planning and budgeting systems, strong entrepreneurial leadership and a high level of employee participation. Clark is seeking to position itself so that cash flow remains positive even in the worst possible industry margin environment. The refining and marketing industry is mature, highly competitive and extremely capital intensive. However, a highly productive company--in terms of both operational excellence and capital utilization--can produce superior results for its stakeholders. Management believes that there are four critical strategies to achieve these goals: . IMPROVE PRODUCTIVITY OF EXISTING OPERATIONS--Clark's refineries are in the lower half of industry productivity benchmarks, providing much opportunity for improvement. On the retail side, Clark's people and assets have been neglected for many years while competitors have invested heavily in upgrading and expanding their facilities. However, Clark's investment and operating cost of a typical store are substantially lower than most of its competitors--a significant competitive advantage. In 1993, Clark set a goal to achieve pre-tax productivity gains of $75 million. This goal assumes no improvement in industry margins and despite deterioration in these margins in 1993, an estimated gain of $20 million was realized in the last half of the year. . MINIMIZE CAPITAL INVESTMENT--Clark plans to tie capital spending to cash flow generated. Where alternative product markets exist under environmental regulations, Clark intends to base capital investment decisions on economic returns. . CULTURE--Clark believes that it is people, not assets, that make the difference in the success of the organization. The Company is striving to achieve a highly motivated, entrepreneurial workforce where its people understand the goals, objectives and targets of the Company, have the freedom to contribute to the best of their abilities and participate in the organization's success. . GROWTH--Clark plans to grow its retail and refining business through acquisition to benefit from the operating, capital and market synergies associated with greater mass, particularly within current markets. RETAIL DIVISION The Clark retail system began operations during the 1930s with the opening of Old Clark's first store in Milwaukee, Wisconsin and expanded thereafter to Missouri and Illinois and then throughout the Midwest. At its peak in the early 1970s, Old Clark operated more than 1,800 retail stores and had established a strong market presence for high octane gasoline at discount prices. In subsequent years, Old Clark, in line with the general industry trend, rationalized its operating stores, closing down marginal locations. During the 1970s, the majority of stores were dealer-operated. However, to ensure more direct control of its marketing and distribution network, Old Clark assumed management of most of its stores from 1973 through 1983. The high proportion of company-operated stores enables Clark to respond more quickly and uniformly to changing market conditions than major oil companies which generally have most of their stores operated by independent dealers or jobbers. This control over retail operations, combined with its over 60 year history and brand strength throughout the Midwest, gives Clark a unique competitive advantage. Clark has initiated an enhancement program aimed at increasing sales volumes and profits while focusing on return on investment. The program is designed to position Clark as the premier value-oriented gasoline marketer in the Midwest. Clark is reviewing its stores and markets and has developed a long-term retail strategy to capitalize on its over 60 year old franchise, reputation for quality products and efficient distribution network. Recognition of the Clark name may be enhanced by improving the image of the entire network, through superior customer service, graphic reimaging, building improvements and strengthened advertising. Management has adopted "Market Business Planning" principles that define preferred markets by developing a market ranking for existing and potential investment opportunities. These techniques combine economic, demographic and market data to arrive at market specific plans that assist in both asset and operational strategies. The Company plans to focus on those core markets where Clark has, or can develop, a competitive advantage. Clark will consider expanding through development and acquisition of stores in those markets where Clark already has a competitive strength on which to build or where similar opportunities have been identified. In those market areas where the Clark brand name is not strong and Clark has a low market ranking, Clark will divest retail locations if favorable sale opportunities arise. Clark classifies its stores into four categories: basic, upgraded, minimart and "On The Go". A basic store is essentially a store as originally built in the 1950s and 1960s and consists of a small kiosk-style building (generally less than 400 total square feet and 200 square feet of selling area) with two to four "islands" for pumps. Since 1988, Clark has invested in upgrading and rebuilding selected sites. An upgraded store configuration generally consists of the basic format with the addition of a canopy and other minor cosmetic improvements. Most upgraded stores include the installation of new blending pumps and at many locations existing storage tanks have been replaced. A minimart is an upgraded location where the kiosk-style building has been replaced with a convenience store of at least 900 square feet. In 1992, Clark implemented a strategic enhancement program under which stores in preferred market areas will undergo a sales optimization program to modestly increase the sales area to 400 sq. ft. to emphasize quick and convenient purchasing of gasoline and "On The Go" convenience items. This strategy attempts to differentiate Clark stores from (i) major oil company outlets, which typically price gasoline at a higher level, (ii) the convenience store industry, which offers a full range of grocery items in addition to gasoline and (iii) low price independents, whose gasoline quality may be perceived to be inferior. Clark estimates that previously upgraded locations will require an additional investment of approximately $70,000 per site to incorporate this "On The Go" theme and that non-upgraded locations will require approximately $160,000 per site. The Company believes that these investments are significantly less expensive than investments made by competitors for similar upgrading. Emphasis will be placed on the sale of select high volume convenience products without competing directly with the larger convenience store ("C-Store") format of major oil companies or other full scale C-Stores. Market research conducted in the fourth quarter of 1992 indicated that gasoline customers are more likely to shop at Clark if store sizes are increased. Furthermore, Clark believes its existing customers are likely to shop more often and are more likely to purchase additional convenience products from larger stores. Virtually all the basic stores have the physical characteristics permitting them to be converted to the "On The Go" format. The volume per store varies significantly, depending upon location, competition, type and quality of the store improvements. The configuration of the stores was as follows: As of December 31, 1993, Clark had 846 retail stores located in 12 midwestern states, all of which operated under the Clark trade name. Of these 846 stores (of which 763 are owned and 83 are leased), Clark directly operated 836 and the reminder were dealer operated. Virtually all stores were self-service and all sold convenience products. Store locations are geographically diverse. More than half the stores are in suburban areas, with the balance approximately equally divided between urban and rural areas. The geographic distribution of retail stores by state as of December 31, 1993, was as follows: GEOGRAPHICAL DISTRIBUTION OF RETAIL STORES Clark began marketing three grades of gasoline in 1989 with the introduction of special blending dispenser pumps. These pumps enable Clark to improve volumes and margins by marketing a more profitable mid-grade of gasoline without installation of costly additional underground storage tanks. Approximately one-half of Clark's stores now have blending pumps. Management currently expects that by the end of 1995, canopies will have been installed over the pump islands at all of Clark's stores. Management believes that the installation of canopies will improve gasoline sales volume due to the shelter provided from weather conditions. Until early 1989, retail sales were primarily for cash as customers were charged extra for credit card purchases. In 1989, Clark upgraded its credit card processing system, enabling it to receive payments for credit card sales within 48 hours. Simultaneously, to remain competitive, Clark revised its pricing policy to charge the same price for cash and credit card purchases. In late 1989, a business fleet card program was initiated to attract a new segment of customers. Fleet customers are provided with a proprietary credit card and detailed vehicle statistical information which is included on a convenient monthly invoice. Clark has implemented a number of environmental projects at its retail stores. These projects include the ongoing Clark response to the September 1988 regulations concerning the design, construction, installation, repair and testing of underground storage tanks and the requirement of the Clean Air Act to install Stage II vapor recovery systems at certain retail stores. REFINING DIVISION The refining division consists of two refineries in Illinois: Blue Island near Chicago and Hartford near St. Louis, Missouri. The refining division also includes Clark's supply and distribution and wholesale operations. Based upon Clark's current cost structure and business plans, Clark anticipates that it will continue to operate the Blue Island and Hartford refineries at or near their respective full-rated capacities of approximately 70,000 and 60,000 barrels of crude oil per stream day. Each refinery specializes in processing different types of crude oil feedstocks, although both operations are sufficiently flexible to process a variety of crude oils. Clark's refineries are capable of producing a complementary product range, as well as shifting production quickly to take advantage of market opportunities as they arise. Clark employs sophisticated linear programming techniques to optimize the operations of both refineries. These techniques enable Clark to predict feedstock performance, select optimal feedstock combinations and produce the most advantageous refined product mix for a given set of market conditions. Feedstock flexibility and linear programs thus enable Clark to take advantage of lower cost crudes and to adjust the output mix in response to changing market prices at any given time. These refineries compare favorably in the amount of light oil products produced per barrel of crude oil and therefore in competitiveness, with major oil company refineries in their market areas. In addition to gasoline, Clark's refineries produce other types of refined products. Number 2 diesel fuel is used mainly as a fuel for diesel burning engines. Number 2 diesel fuel production is moved via pipeline or barge to Clark's 14 product terminals to be sold over Clark's terminal truck racks or sold via refinery pipeline or barge movement. Other production includes residual oils (slurry oil and vacuum tower bottoms) which are used mainly for heavy industrial fuel (e.g., power generation) and in the manufacturing of roofing shingles or for asphalt used in highway paving. In the Clean Air Act Amendments of 1990, the US Environmental Protection Agency ("EPA") promulgated regulations mandating maximum sulfur content for diesel fuel offered for sale for on-road consumption beginning in October 1993. Additional EPA regulations include guidelines for reformulated gasoline to be effective by 1995 for nine regions in the US, including the Chicago and Milwaukee metropolitan areas. These regulations are expected to be expanded to most major urban centers by the year 2000. See "Regulatory Matters." Clark, and virtually all other domestic refineries producing gasoline, will be required to make significant capital expenditures to comply with these new requirements. Over the period 1994 to 1998, Clark has preliminary plans to complete a number of environmental and other regulatory capital expenditure programs. These environmental expenditures comprise two major categories, those that are mandatory in order to comply with regulations pertaining to ground, water and air contamination and those that are primarily discretionary involving the reformulation of refined fuel for sale into certain defined markets. The total mandatory expenditures for regulatory compliance over the next five years are estimated at approximately $100 million, split evenly between the retail and refining businesses. Costs of potential future regulations cannot be forecast. The expenditures required to comply with reformulated fuels regulations are primarily discretionary, subject to market conditions and economic justification. The reformulated fuels programs impose restrictions on properties of fuels to be refined and marketed, including those pertaining to gasoline volatility, oxygenated fuel, detergent addition and sulfur content. The regulations regarding these fuel properties apply to different markets in which Clark operates, in certain circumstances at different times of the year. Modifications estimated at $10-15 million to produce reformulated gasoline are being considered for the Blue Island refinery. The decision to proceed with such a project will depend on economic justification. A project initiated to produce low sulfur diesel fuel at the Hartford refinery was delayed in 1992 based on internal and third party analyses that indicated an oversupply of low sulfur diesel fuel capacity in Clark's marketplace. These analyses projected relatively narrow price differentials between low and high sulfur diesel products which have thus far borne out after the initial transition to the low sulfur regulations. However, if price differentials widen sufficiently to justify investment, Clark could install the necessary equipment over a 14 to 16 month period at an estimated additional cost of $40 million. Furthermore, if Clark decided to install equipment necessary to produce reformulated gasoline and control sulfur emissions at Hartford, the gasoil desulfurizer and related equipment are estimated to cost an additional $90-130 million. These estimates have declined from a year ago as Clark has found more cost-effective methods of complying with the regulations. Blue Island Refinery The Blue Island refinery is located in Blue Island, Illinois, approximately 17 miles south of Chicago. The refinery is situated on a 170-acre site, bounded by the town of Blue Island and the Calumet-Sag Canal. The facility was initially constructed in 1945 and, through a series of improvements and expansions, has reached a crude oil capacity of 70,000 barrels per stream day. The Blue Island refinery has a Nelson Complexity Rating of 8.78 versus an average rating of 8.61 for all Petroleum Administration for Defense District ("PADD") II refineries. The Nelson Complexity rating is an industry measure of a refinery's ability to produce higher value-added products. Blue Island has among the highest capabilities to produce gasoline relative to the other refineries in its market area. During most of the year, gasoline is the most profitable refinery product. The production of the Blue Island refinery was as follows: BLUE ISLAND REFINERY PRODUCTION YIELD (BARRELS IN THOUSANDS) - -------- (a) Refinery utilization is production yield relative to the rated capacity of the refinery to process crude oil. Production yield may be greater than the rated capacity of the refinery because other feedstocks (including partially refined products and liquefied petroleum gases) which add to the refinery's output are utilized in the refining process. (b) Refinery utilization reflects 1993 maintenance turnaround downtime of approximately two months on selected units. A "maintenance turnaround" is a periodically required standard procedure for refurbishing and maintenance of a refinery that is scheduled approximately every three years. During a turnaround, which usually lasts approximately four to six weeks, refinery production is reduced significantly. Hartford Refinery The Hartford refinery is located in Hartford, Illinois, approximately 17 miles northeast of St. Louis, Missouri. The refinery is situated on a 400-acre site. The facility was initially constructed in 1941 and, through a series of improvements and expansions, has reached a crude oil refining capacity of approximately 60,000 barrels per stream day. The Hartford refinery has a Nelson Complexity Rating of 9.83 versus an average of 8.61 for all PADD II refineries. The Hartford facility has the ability to process lower cost, heavy, high-sulfur crude oil into higher value products such as gasoline. This upgrading capability allows the refinery to produce a high mix of premium products and permits Clark to benefit from higher margins when high sulfur crude oil, such as Maya crude oil, is available at a significant discount to low sulfur crude oil. The production of the Hartford refinery was as follows: HARTFORD REFINERY PRODUCTION YIELD (BARRELS IN THOUSANDS) - -------- (a) Refinery utilization is production yield relative to the rated capacity of the refinery to process crude oil. Production yield may be greater than the rated capacity of the refinery because other feedstocks (including partially refined products and liquefied petroleum gases) which add to the refinery's output are utilized in the refining process. (b) Refinery utilization reflects 1991 maintenance turnaround downtime of approximately two months on selected units. Supply Clark's integrated refining and marketing assets are strategically located in the Midwest in close proximity to a variety of supply and distribution channels. As a result, Clark has the flexibility to acquire crude oil from a variety of sources around the world and the ability to distribute its products to its own retail system and to most wholesale markets. Clark's refineries are located on major inland water transportation routes and are connected to various regional, national and Canadian common carrier pipelines, in some of which Clark has a minority interest. The Blue Island refinery can receive delivery of Canadian crude oil through the Lakehead Pipeline from Canada and foreign and domestic crude oil through the Capline Pipeline system originating in the Louisiana Gulf Coast and domestic crude oil originating in West Texas, Oklahoma and the Rocky Mountains through the Arco Pipeline system. The Hartford refinery has access to foreign and domestic crude oil supplies through the Capline/Capwood Pipeline systems along with access to West Texas, Oklahoma and Rocky Mountain crude oil from the Platte Pipeline system. The fact that both refineries are situated on major water transportation routes provides flexibility to receive crude oil or intermediate feedstocks by barge when economically feasible. Clark has a sour crude oil supply contract with P.M.I. Comercio Internacional, S.A. de C.V., an affiliate of Petroleos Mexicanos, S.A. de C.V. ("Pemex"). This contract is cancelable with three months' notice by either party but it is intended to remain in place for the foreseeable future. The volume is currently 35,000 barrels per day of Maya crude oil, with price determination based on a market related formula applicable to all Pemex-US customers. Other term crude oil supply agreements primarily consist of Canadian crude oil delivered to Blue Island. Approximately 23,000 barrels per day are currently under contract with three Canadian suppliers, cancelable with two months' notice by either party with another 4,000 barrels per day under contract through December 1994 without provision for cancellation. The above- referenced contracts provide approximately 48% of Clark's crude oil requirements which offer some security with respect to supply along with the flexibility to take advantage of spot market opportunities. Management has established product scheduling and supply priorities for gasoline and diesel fuel. These ensure that Clark's retail network needs are met first and then products are distributed to its wholesale operations based on the highest average market returns before being sold into the spot market. Clark employs several strategies to minimize the adverse impact on profitability of the volatility in feedstock costs and refined product prices. One strategy involves the purchase and sale of futures and options contracts on the New York Mercantile Exchange to minimize, on a short-term basis, Clark's exposure to the risk of fluctuations in crude oil prices and refined product margins. The number of barrels of crude oil and refined products covered by such contracts varies from time to time. Such purchases and sales are closely managed, are balanced daily and are subject to internally established risk standards. The results of these hedging activities affect refining costs of sales or inventory costs. Clark's dedicated retail network also reduces risk by providing market sales representing approximately 60% of the refineries' gasoline production. In addition, the retail network benefits from a reliable and cost effective source of supply. Wholesale Marketing and Distribution Refined products are distributed primarily through Clark's terminals, company-owned and common carrier product pipelines and by leased barges over the Mississippi, Illinois and Ohio Rivers. Clark owns and operates 14 product terminals which are strategically located throughout its market area, most of which have product blending capabilities. Terminal blending involves the blending of natural gasoline and other blendstocks with finished gasoline which reduces product cost, lowers emission producing potential and improves product quality. While other refiners engage in terminal blending, Clark believes that its degree of blending and refinery/terminal integration provides Clark with a competitive advantage over other refiners that do not have comparable blending capabilities. In addition to cost efficiencies in supplying its retail network, the terminals provide Clark with an additional source of revenues through sales of gasoline, Number 2 diesel fuel and other refined products to wholesale customers. These terminals allow efficient distribution of refinery production through readily accessible pipeline systems which connect the wholesale distribution network. In addition, the terminals provide flexibility to direct wholesale product sales to more profitable truck rack customers as an alternative to spot market sales as market conditions dictate. Clark plans to broaden its wholesale customer base which is expected to provide, on average, higher margins than spot markets. In anticipation of the October 1993 deadline for low sulfur on- road diesel fuel, Clark focused efforts on building market presence and customer relationships with off-road diesel fuel users. Clark's terminals and respective capacities as of December 31, 1993, were as follows: Clark enters into refined product exchange agreements with unaffiliated companies to broaden its geographical distribution capabilities. Products are also received on exchange through 37 exchange terminals and distribution points throughout the Midwest. Clark's pipeline interests as of December 31, 1993, were as follows: These pipelines are operated as common carriers pursuant to published pipeline tariffs, which also apply to use by Clark. Clark also owns a dedicated pipeline from the Blue Island refinery to the company-owned terminal in Hammond, Indiana. Clark Pipe Line Company, an affiliate of Clark, owns a 33.1% interest in the Capwood Pipeline and leases space of approximately 15,000 barrels per day on the ARCO Pipeline. Each of these pipelines transports crude oil to the Hartford refinery. COMPETITIVE CONSIDERATIONS The petroleum industry is highly competitive in all phases, from the production and procurement of crude oil to the refining, distribution and marketing of refined and intermediate products. Many of Clark's competitors are large, integrated oil companies which, because of their diverse operations, stronger capitalization and better brand name recognition, may be better able than Clark to withstand volatile industry conditions, shortages of crude oil or intense price competition. The principal competitive factors affecting Clark's refining business are crude oil and other feedstock costs, refinery efficiency, refinery product mix and product distribution and marketing transportation costs. Certain of Clark's larger competitors have refineries which are larger and more efficient and as a result, have lower per barrel costs. Clark has no crude oil reserves and is not engaged in exploration. Clark obtains all of its crude oil requirements from unaffiliated sources. Clark believes that it will be able to obtain adequate crude oil and other feedstocks at generally competitive prices for the foreseeable future. The principal competitive factors affecting Clark's retail marketing business are locations of stores, product price and quality, appearance and cleanliness of stores and brand identification. Competition from large, integrated oil and gas companies, as well as convenience stores which sell motor fuel, is expected to continue. Clark believes it competes in the retail sale of gasoline principally on the basis of price, location, store cleanliness and the Clark brand name recognition in the Midwest. REGULATORY MATTERS The release or discharge of petroleum and hazardous materials is not an uncommon occurrence at refineries, terminals and stores and may give rise to liability under various federal, state and local regulations relating to soil and ground water contamination. Clark has identified a variety of potential environmental issues at its refineries, terminals and stores. In addition, each refinery has areas on-site which may contain hazardous waste or hazardous constituent contamination and which may have to be addressed in the future at substantial cost. Many of the terminals may also require remediation due to the age of the underground tanks and facilities and as a result of current or past activities at the terminal properties including several significant spills and past on-site waste disposal practices. Federal, state and local laws and regulations establishing various health and environmental quality standards and providing penalties for violations thereof affect nearly all of the operations of the Company. Included among such statutes are the Clean Air Act of 1955, as amended ("CAA"), the Resource Conservation and Recovery Act of 1977, as amended ("RCRA") and the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"). Also significantly affecting the Company are the rules and regulations of the Occupational Safety and Health Administration ("OSHA"). The CAA requires the Company to meet certain air emission standards and to obtain and comply with the terms of discharge permits. The RCRA empowers the EPA to regulate the treatment and disposal of industrial wastes and to regulate the use and operation of underground storage tanks. CERCLA requires notification to the National Response Center of releases of hazardous materials and provides a program to remediate hazardous releases at uncontrolled or abandoned hazardous waste sites. The Superfund Amendments and Reauthorization Act of 1986 ("SARA") is a five year extension of the CERCLA cleanup program. Title III of SARA, the Emergency Planning and Community Right to Know Act of 1986, relates to planning for hazardous material emergencies and provides for a community's right to know about the hazards of chemicals used or manufactured at industrial facilities. The OSHA rules and regulations call for the protection of workers and provide for a worker's right to know about the hazards of chemicals used or produced at the Company's facilities. Regulations issued by the EPA in 1988 with respect to underground storage tanks require the Company, over a period of up to ten years, to install, where not already in place, detection devices and corrosion protection on all underground tanks and piping at retail gasoline outlets. The regulations also require periodic tightness testing of underground tanks and piping. Commencing in 1998, operators will be required under these regulations to install continuous monitoring systems for underground tanks. In March 1989, the EPA issued Phase I of regulations under authority of the CAA requiring a reduction for summer months in 1989 in the volatility of gasoline ("RVP") (the measure of the amount of light hydrocarbons contained in gasoline, such as normal butane, an octane booster). In June 1990, Phase II of these regulations was issued by the EPA which would require further reduction in RVP beginning in May 1992. The Clean Air Act Amendments also established nationwide RVP standards which will apply as of May 1992, but do not exceed the EPA's Phase II standards. The Clean Air Act Amendments will impact the Company primarily in the following areas: (i) starting in 1995 a "reformulated" gasoline (which would include content standards for oxygen, benzenes and aromatics) is mandated in the nine worst ozone polluting cities, including Chicago and Milwaukee in the Company's market area; (ii) Stage II hose and nozzle controls on gas pumps to capture fuel vapors in nonattainment areas, including 400 company stores; (iii) more stringent refinery permitting requirements; and (iv) stricter refinery waste disposal requirements as a broader group of wastes are classified as hazardous. In addition, EPA regulations required that after October 1, 1993 the sulfur contained in on-road diesel fuel produced in the US must be reduced. Clark cannot predict what environmental legislation or regulations will be enacted in the future or how existing or future laws or regulations will be administered or interpreted with respect to products or activities to which they have not previously been applied. Compliance with more stringent laws or regulations, as well as more vigorous enforcement policies of the regulatory agencies or stricter interpretation of existing laws which may develop in the future, could have an adverse effect on the financial position or operations of Clark and could require substantial additional expenditures by Clark for the installation and operation of pollution control systems and equipment. See "Item 3. ITEM 3. LEGAL PROCEEDINGS Generators of hazardous substances found in off-site disposal locations at which environmental problems are alleged to exist, as well as the owners of those sites and certain other classes of persons, are subject to claims brought by state and federal agencies under CERCLA and analogous state laws, regardless of fault or the legality of original disposal. Under CERCLA, a potentially responsible party ("PRP") may be held jointly and severally liable for any such claims. On or about December 7, 1988, "Clark Oil" was named as PRP by the EPA with respect to a solid waste disposal site in Gary, Indiana known as the 9th Avenue Site and was ordered to participate with approximately 250 other PRPs in the interim clean-up of that site. Information from the EPA and other parties involved indicated that Old Clark may have transported waste oils and solvents to the site during the mid 1970s. Pursuant to an Administrative Services Agreement then in effect between Clark and Old Clark, Clark responded to initial inquiries and advanced $160,000 for preliminary studies and clean-up of that site. Upon the expiration of the Administrative Services Agreement on November 30, 1990, Clark notified the EPA and other parties involved with respect to the site that Clark's involvement on behalf of Old Clark was terminated and advised that further contacts with respect to this site should be directed to Old Clark. Clark has received no information concerning the site since that notification. Clark believes it has no liability for this site because of the terms of the Asset Purchase Agreement with Old Clark, as approved by the Bankruptcy Court, which provided that Clark would not assume environmental liabilities arising prior to the date of closing. Based on information received by Clark during its involvement pursuant to the Administrative Services Agreement, the estimated total clean-up of this site ranged from $22 to $35 million. Clark has no information on the current amounts estimated for clean-up or amounts actually spent for clean-up. On or about March 17, 1989, "Clark Oil" was named as PRP by the EPA with respect to a solid waste disposal site in Chicago, Illinois known as the U.S. Scrap Site and along with approximately 250 other PRPs was ordered to reimburse the EPA for $1.5 million in costs incurred in performing preliminary work on that site. Information from the EPA and other parties indicated that Old Clark may have sent waste oils to the site during the 1970s. No information has been revealed which would indicate that Clark had any involvement with this site. Pursuant to the Administrative Services Agreement with Old Clark then in effect, Clark responded to initial inquiries about the site. However, Clark has advanced no payments related to the EPA's claim for reimbursement. Upon the expiration of the Administrative Services Agreement, on November 30, 1990, Clark notified the EPA that its involvement on behalf of Old Clark was terminated and advised that all future contacts with respect to the site should be directed to Old Clark. Clark has received no other information concerning the site since that notification. To the best of Clark's knowledge, the estimated amount being sought by the EPA was $1.5 million. Clark believes it has no liability for this site because of the terms of the Asset Purchase Agreement with Old Clark. On September 15, 1989, "Clark Oil & Refining Corp." received an inquiry from the EPA concerning any involvement at a disposal site in Texas City, Texas known as the Tex-Tin Site. On October 17, 1989, Clark responded that it had no connection to the site. Upon the expiration of the Administrative Services Agreement on November 30, 1990, Clark further notified the EPA that its involvement on behalf of Old Clark was terminated and advised that all future contacts with respect to the site should be directed to Old Clark. Clark has never received any information concerning potential costs involved in connection with this site, or any other parties which may be involved as potential PRPs. Clark presumes that all contamination would have been the result of activities of Old Clark and that Clark would have no liability because of terms of the Asset Purchase Agreement. As indicated, Clark does not believe that it is a proper party to any of the above-described EPA claims. Clark cannot estimate costs for which it may ultimately be liable with respect to these three sites, but in the opinion of the management of Clark, these costs should not have a material adverse effect on Clark's operations or financial condition. There can be no assurance that Clark will not be named as a PRP at additional sites in the future or that the costs associated with those sites would not be substantial. In late 1990, Clark received a letter from the Illinois Attorney General Environmental Control Division which included a report prepared by the Illinois Environmental Protection Agency ("IEPA") on its investigation of the Village of Hartford, Illinois ground water contamination. The report cited the history of the ground water contamination in the area including the installation by Old Clark in 1978 of recovery systems in Hartford for the removal of hydrocarbons from the surface of the ground water. The report identified Clark or Old Clark and two other oil companies as potential contributors to the contamination. In particular, it contended that Clark or Old Clark is the party primarily responsible for the hydrocarbon contamination and demanded that more aggressive and encompassing efforts be immediately initiated by Clark. Clark submitted its response to the letter and the report on January 15, 1991. In its response Clark indicated that, without admission of legal liability, it would continue to cooperate with the Illinois Attorney General and the IEPA by performing a remediation program meeting the objectives defined by the IEPA in its report. The response also contained data which disputed many of the contentions made by the IEPA. Clark's remediation plan was approved by the IEPA and the IEPA has issued all necessary permits to implement the remediation plan. The IEPA is provided with monthly progress reports. Clark successfully completed a major portion of the remediation work under an implementation plan that was submitted to the IEPA in August 1991. The necessity of future remediation work is being evaluated. Based upon the estimates of an independent environmental engineering firm, Clark established a $10 million provision for the estimated costs of its mitigation and recovery efforts of which $3.6 million has been spent to date. Forty-one civil suits by residents of Hartford, Illinois have been filed against Clark in Madison County Illinois, alleging damage from ground water contamination. The relief sought in each of these cases is an unspecified dollar amount. The litigation proceedings are in the initial stages. Discovery, which could be lengthy and complex, is only just beginning. Clark moved to dismiss thirty-four cases filed in December 1991 on the ground that Clark is not liable for alleged activity of Old Clark. On September 4, 1992, the trial court granted Clark's motions to dismiss. The plaintiffs were given leave to re-file their complaints but based only on alleged activity of Clark occurring since November 8, 1988, the date on which the bankruptcy court with jurisdiction over Old Clark's bankruptcy proceedings issued its "free and clear" order. In November 1992, the plaintiffs filed thirty-three amended complaints. In addition, one new complaint involving nine plaintiffs was filed. It is too early to predict whether any of these cases will go to trial on the merits and if so, what the risk of exposure to Clark would be at trial. It is also not possible to determine whether or to what extent Clark will have any liability to other individuals arising from the ground water contamination. In November 1991, Clark learned that the EPA, the IEPA and the Cook County Department of Environmental Control were investigating the cause or causes of certain apparent exceedences of ambient air quality standards for sulfur dioxide in the vicinity of the Blue Island refinery. The EPA and the IEPA requested certain specific information from Clark, which Clark supplied. Clark has indicated that it will cooperate with the investigation of the apparent sulfur dioxide exceedences and has undertaken the requested monitoring and engineering procedures. Also in connection with the apparent exceedences, Clark received a Notice of Violation from the EPA in February 1992 and an Administrative Complaint and Notice of Proposed Order Assessing a Penalty of $50,000 in October 1992. Clark paid a penalty of $45,000 to the EPA in March 1994. Clark received an Administrative Complaint from the EPA on June 12, 1992 alleging record keeping violations of the RCRA concerning 22 stores in Michigan, Indiana and Wisconsin and seeking civil penalties of $0.6 million. On March 18, 1993, Clark received an Amended Complaint from the EPA involving similar allegations but reducing the amount of civil penalties sought to $0.1 million. Clark received an Administrative Complaint from the EPA on January 5, 1993 alleging record keeping and related violations of the Clean Air Act concerning the Hartford refinery and seeking civil penalties of $0.1 million. On May 5, 1993, Clark received correspondence from the Michigan Department of Natural Resources ("MDNR") indicating that the MDNR believes Clark may be a PRP in connection with ground water contamination in the vicinity of one of its retail stores in the Sashabaw Road area north of Woodhull Lake and Lake Oakland, Oakland County Michigan. Clark has begun an initial investigation into the matters raised by the MDNR. At the request of the MDNR, Clark has conducted an investigation into the historical use of its site, potential contaminants used at the site, third party sites which may be the source of contaminants and is also conducting a subsurface investigation of its site and the surrounding area. Clark has incurred approximately $25,000 in investigative activities to date. Clark does not know whether MDNR has identified other PRPs in connection with this matter, nor has it received any information from MDNR as to what it believes may be the ultimate cost associated with this site. Clark will not be able to prepare a corrective action plan and estimate potential clean-up costs until its investigatory work is complete. An impoundment at the Hartford refinery contains hazardous wastes that were produced as the result of past operations. Clark has been evaluating remedial options with respect to that waste since 1992 and has been in discussions with the IEPA concerning those options. In April 1993 the IEPA told Clark that the presence of those hazardous wastes may require a permit under the RCRA and that in turn may require corrective action with respect to the entire refinery. Clark has received no formal notice or complaint with respect to these issues from the IEPA. Clark has begun an investigation with respect to the need for a permit and consequent corrective action. Based upon the estimates of an independent engineering firm, Clark established a $9.0 million provision for the estimated costs of site clean-up of which $7.2 million has been spent to date on remedial activities performed after notice to and comments from the IEPA. In addition to the proceedings described above, Clark has various suits and claims against it. While it is impossible to estimate with certainty the ultimate legal and financial liability in respect to these other suits and claims, Clark believes the outcome of these other suits and claims will not be material in relation to its financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Inapplicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Inapplicable. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SELECTED FINANCIAL DATA (IN THOUSANDS, EXCEPT RATIOS AND OPERATING DATA) The following table sets forth, for the periods and dates indicated, selected financial and other data derived from the financial statements and related notes and the underlying books and records of Clark for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. These selected financial and other data should be read in conjunction with the financial statements of Clark and related notes appearing elsewhere in this document. - -------- (a) Amortization includes amortization of turnaround costs and organizational costs. (b) Interest and financing costs, net, includes amortization of debt issuance costs of $1.2 million, $2.9 million, $6.0 million, $3.1 million and $9.1 million for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 respectively. Interest and financing costs, net, also includes interest on all indebtedness, net of capitalized interest and interest income. (c) Other income in 1993 includes the final settlement of litigation with Drexel of $8.5 million and a gain from the sale of "non-core" stores of $2.9 million. Other income in 1992 includes the settlement of litigation with Apex and Drexel of $9.2 million and $5.5 million, respectively. Other expense in 1990 included a loss provision for $11.6 million representing the full amount of an overnight deposit held by Drexel. An additional 1990 loss provision of $10.0 million represents estimated costs of mitigation and recovery efforts resulting from alleged responsibility for ground water contamination in the town of Hartford, Illinois, adjacent to the Hartford refinery. A 1990 loss provision of $0.7 million reflected the inability of a former affiliate to repay its note due Clark. (d) Extraordinary item includes the recognition of deferred financing costs, premium amount and interest expense from September 30, 1992 through the redemption date of October 26, 1992, net of applicable income taxes on the redemption of the 12 1/4% First Mortgage Fixed Rate Notes due 1996. (e) On January 1, 1993, Clark adopted SFAS 106. This standard requires that Clark accrue the actuarially determined costs of postretirement benefits during the employees' active service periods. Previously, Clark had accounted for these benefits on a "pay as you go" basis, recognizing an expense when an obligation was paid. In accordance with SFAS 106, Clark elected to recognize the cumulative liability, a non-cash "Transition Obligation" of $9.6 million, net of the tax benefit of $6.0 million, as of January 1, 1993. On January 1, 1993, Clark adopted SFAS 109 and restated the years ended December 31, 1992 and 1991. The cumulative effect through December 31, 1990 is reflected as an adjustment to income in 1990 in this table. The adoption of this standard changes the method of accounting for income taxes from the deferred method to an asset and liability approach. Previously, Clark deferred the past tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. (f) The ratio of earnings to fixed charges is computed by dividing (i) earnings before income taxes (adjusted to recognize only distributed earnings from less than 50% owned persons accounted for under the equity method) plus fixed charges by (ii) fixed charges. Fixed charges consist of interest on indebtedness, including amortization of discount and debt issuance costs and the estimated interest components (one-third) of rental and lease expense. (g) As a result of the losses for the years ended December 31, 1993 and 1992, earnings were insufficient to cover fixed charges by $17.3 million and $20.7 million respectively. (h) Retail operating expenses for 1992 exclude $5.8 million of charges that management considers to be unusual. (i) Refinery utilization is the ratio of total production yield to the rated capacity of the refinery to process crude oil. Production yield may be greater than the rated capacity of the refinery because other feedstocks (including partially refined products and liquefied petroleum gases), which add to the refinery's output are utilized in the refining process. (j) Refinery operating expenses for 1992 exclude $11.5 million ($0.22 per barrel) of charges that management considers to be unusual. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Overview Clark's results are impacted significantly by a variety of factors beyond its control, including movements in crude oil prices, demand for refined products, general oil price levels and industry refinery capacity and utilization rates. Clark's net sales and operating revenues fluctuate significantly with movements in industry crude oil prices but they do not have a direct relationship to net earnings. The effect of changes in crude oil prices on Clark's operating results is determined more by the rate at which the prices of refined products adjust to reflect such changes. Management believes that lower crude oil prices benefit operating results over the longer term due to increased demand, decreased working capital requirements and a greater sensitivity by the major integrated oil companies to profitability in their refining and marketing operations. Higher refinery production is typically associated with improved results of operations. Conversely, lower production, which generally occurs during scheduled refinery maintenance turnarounds, negatively impacts results of operations. The following table sets out the approximate pre-tax earnings impact on Clark of changes in: 1) refining margins--the spread between wholesale and spot market product prices and input (e.g. crude oil) costs and 2) retail margins-- the spread between product prices at the retail level and wholesale product costs. While margins are impacted significantly by the industry factors described above, individual companies can influence their own margins through the efficiency of their operations. *Changes in crude oil prices may affect the carrying value of inventories. Falling crude and product prices reduced 1993 and 1992 net sales and operating revenues, while improved unit volumes partially offset the drop. Crude and product prices have declined from the levels reached during the 1990 Iraqi invasion of Kuwait and the 1991 Soviet coup, which were viewed as potential threats to supply. Net sales and operating revenues were also affected by sales volumes; retail gasoline volumes were up 6% from 1992 and down 1% in 1992 as compared to 1991, and wholesale sales volumes were up 21% from 1992 and up 122% in 1992 as compared with 1991. CLARK FINANCIAL HIGHLIGHTS: *Management considers certain items in 1992 and 1993 at Clark to be "unusual". In 1993, the unusual items netted to a $30.7 million charge before taxes, $18.8 million net of taxes. In 1992, the unusual items netted to a $25.7 million charge before taxes, $13.4 million net of taxes. Detail on these items is presented below. Net earnings excluding unusual items improved in 1993 despite a decline in industry refining margins and reduced production associated with the scheduled maintenance turnaround at Clark's Blue Island, Illinois refinery. The gain was due to the combination of improved retail and refinery productivity and better retail market conditions. These improvements became significant in the latter part of 1993. Excluding unusual items, Clark's 1993 fourth quarter net earnings rose to $7.3 million compared to $0.4 million in 1992 and a loss of $2.5 million in 1991. UNUSUAL ITEMS Several items which are considered by management to be "unusual" are excluded throughout this discussion of Clark's results of operations. A non-cash accounting charge was taken in the fourth quarter of 1993 to reflect the decline in the value of petroleum inventories below carrying value caused by a substantial drop in prices. If petroleum prices were to recover, earnings would benefit up to the extent of this charge. Further deterioration in prices could result in further charges. Effective January 1, 1993, Clark adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (see Note 12 "Postretirement Benefits Other Than Pensions" to the financial statements) and No. 109 "Accounting for Income Taxes", which was accounted for by restating prior periods (see Note 13 "Income Taxes" to the financial statements). Unusual credits included a 1993 gain related to the sale of 21 retail stores located in "non-core" markets and the favorable settlement of litigation. See Note 11 "Other Income" to the financial statements. Unusual charges in 1992 included the early retirement of Clark's 12 1/4% First Mortgage Fixed Rate Notes due July 15, 1996, and provisions related to the environmental clean-up of the storm water basin at the Hartford, Illinois refinery and expected closures of under-performing retail stores. In addition, expenses related to early retirements and a severance program along with a canceled initial public offering were incurred in 1992. Retail Retail Division Operating Statistics: - -------- (1) Excludes unusual charges totaling $5.8 million, primarily related to restructuring and store closures. Clark's retail division contributed $57.6 million in 1993 to operating income, up from $42.4 million excluding unusual items in 1992 and $55.9 million in 1991. The 1993 improvement is due to improved sales volumes and industry margins, while the decline in 1992 as compared to 1991 was due to decreased margins and the closure in late 1991 of stores representing approximately 2% of 1991 volume. Average monthly volumes per store in 1993 were up 9% over 1992 and 4% in 1992 over 1991 as a result of increased promotional activity, improved productivity and the closure of under-performing units. During selected periods of the year and in selected markets Clark ran promotions, including one that offered premium gasoline at the same price as regular unleaded gasoline. Margins per gallon improved in 1993 over the prior two years due to increased sales of higher margin premium gasoline, stronger retail market conditions and decreased competitive pricing pressures along with more responsive pricing strategies. Excluding unusual items, the retail division contributed $16.0 million to 1993 fourth quarter operating income compared to $14.6 million in the same periods of both 1992 and 1991. The 1993 gross margin from convenience product sales rose 15% from 1992, with 1992 up 6% as compared to 1991. The average monthly contribution from convenience product sales per store for the 1993 was up 19% as compared to 1992 and 1992 was up 12% as compared to 1991. These improvements were principally due to improved vendor allowances, increased promotional activity, enhanced store merchandising and manager training, and store incentive plans. The increase in 1993 operating expenses over 1992 and 1991 is related to costs incurred to implement a strategy to rework Clark's organizational structure to more fully involve the general work force in the operation of the business. These increased costs included higher labor, training, promotion and systems-related expenses. The increased promotional activity related to strengthening the Clark brand name, including purchasing of advertising and point of sale materials. Adding to the increase from 1991 to 1992 were expenses related to additional underground storage tank testing, a store associate bonus program and increased participation in the store health insurance program. Refining Refining Division Operating Statistics: - -------- (1) Excludes unusual charges totaling $11.5 million, primarily related to a provision for environmental remediation and restructuring. Clark's refining division contributed $51.1 million to operating income in 1993, flat with the $51.2 million excluding unusual items contributed in 1992 and compared to $77.8 million in 1991. Industry refining margins continued the decline experienced in 1992, moving down further from the levels reached following the 1990 Persian Gulf conflict and the 1991 Soviet coup. This downward trend has occurred despite increasing demand for gasoline and distillate products. As reported by the American Petroleum Institute, US gasoline deliveries for 1993 rose by 1.5% versus a 1.1% increase in 1992, while distillates showed an increase of 2.1%. However, demand has been more than offset by high industry refinery runs, which have reached a crude oil throughput utilization rate of 91.5%, the highest level in at least 20 years. In addition, industry yield (as a percentage of crude oil runs) of light products grew, with gasoline and distillate output rising 2.7% and 5.0% respectively, further increasing the supply of these normally higher-margin products. This changing industry yield pattern has resulted from upgraded light-product processing, showing approximately a 10% increase in throughput over the past five years. Clark's refining margins improved in 1993, especially in the third and fourth quarters and in relation to the decline in industry refining margin indicators. Excluding unusual items, the refining division contributed $20.8 million to 1993 fourth quarter operating income compared to $11.0 million in 1992 and a loss of $0.1 million in the same period of 1991. The third and fourth quarter refining division results improved on the strength of recent productivity initiatives, heavy oil and wholesale margins, and market profit opportunities presented by the mandated transition to low sulfur #2 oil for on-road use. This occurred despite third quarter losses related to a drop in crude and product prices, flooding in the midwestern US, and the significant drop in Midwest #2 oil prices. Refinery production for 1993 was down from 1992 due to the maintenance turnaround at the Blue Island refinery. Production during 1992 exceeded 1991 due to a turnaround at the Hartford refinery in 1991. Another turnaround is scheduled for the Hartford refinery in 1994. Refining operating expenses of $108.2 million in 1993 were just over 1992 operating expenses excluding unusual items of $106.5 million and 1991 expenses of $105.4 million. The uninsured portion of the cost associated with a gasoline spill from one of Clark's storage tanks in January 1994 is not expected to have a material effect on earnings. Outlook Clark believes the demand for refined products will experience flat to only slight growth over the next several years, but expects that regulatory requirements and costs of entry will limit the industry's ability to meet demand. High current industry refinery utilization and the expected closure of marginal refineries due to increasing requirements for regulatory capital investments may result in a more positive long-term outlook for the refining and marketing industry. In the near-term, Clark is looking to achieve significant productivity gains to secure its ongoing profitability. Clark has set a goal to achieve additional pre-tax productivity gains of $55 million in 1994, having achieved estimated gains of $20 million in 1993. These gains assume no improvement in industry margins, and in fact, Clark's earnings before depreciation, interest and taxes improved in the second half of 1993 despite deterioration in refining margins, as a result of the productivity gains achieved to date. In addition to this internal earnings growth, Clark is also pursuing growth in its retail and refining businesses through acquisitions. General and Administrative Expense Clark's general and administrative expenses were $27.5 million, higher than 1992 expenses of $24.8 million excluding unusual items and expenses of $20.8 million in 1991. Expenses in 1993 and 1992 were up principally due to higher labor and related costs, as Clark is making significant changes in its management, systems and procedures to benefit productivity in the longer term. Depreciation and Amortization Depreciation and amortization expenses have increased in the past three years due to the completion of higher cost refinery turnarounds in 1991 and 1993 and the recent higher levels of capital expenditures. Net Interest and Financing Costs Clark's capital structure has changed significantly over the past three years, although the resulting effect on 1993 and 1992 net interest and financing costs has not been substantial. Clark's 1993 net interest and financing cost increase was principally due to lower interest income on less average funds invested and lower rates. See Note 8 "Long-Term Debt" to the financial statements. Other Income (Expenses) See Note 11 "Other Income" to the financial statements for the items that comprise other income. LIQUIDITY AND CAPITAL RESOURCES Financial Position Cash generated by operating activities before working capital changes for the year ended December 31, 1993, was $62.2 million, $25.3 million greater than 1992 but $27.7 million under 1991. Cash flow has been impacted by the fluctuation in Clark's net earnings the past three years. Working capital at December 31, 1993, was $203.8 million, a 1.96 to 1 current ratio, versus working capital of $245.1 million, a 2.31 to 1 current ratio at December 31, 1992, and working capital of $304.1 million, a 2.82 to 1 current ratio, at December 31, 1991. The 1992 decline was principally a result of capital expenditures and the retirement of debt. See Note 8 "Long-Term Debt" to the financial statements. In general, Clark's short-term working capital requirements fluctuate with the price of crude oil. Clark expects internally generated cash flows will be sufficient to meet its needs. Clark has in place a $100 million committed revolving line of credit expiring December 31, 1994, for cash borrowings and for the issuance of letters of credit primarily for purchases of crude oil, other feedstocks and refined products. At December 31, 1993, $51.5 million of the line of credit was utilized for letters of credit. There were no direct borrowings under Clark's line of credit at December 31, 1993 or 1992. Cash flows from investing activities are primarily impacted by capital expenditures including maintenance turnarounds. During 1993, capital expenditures were $67.9 million compared with $59.5 million in 1992 and $58.0 million in 1991. Refinery division capital expenditures were $39.2 million in 1993 compared with $49.2 million in 1992 and $33.4 million in 1991. In addition, $20.6 million, $2.7 million and $17.2 million was spent for maintenance turnaround expenditures in 1993, 1992 and 1991 respectively. The increased spending in the refining division over the past three years has been primarily related to environmental projects. In 1993, projects included Stretford, crude and FCC unit upgrades at the Blue Island refinery while in 1992 projects included the distillate desulfurization project (subsequently delayed), vapor reduction and a new flare at the Hartford refinery. Retail expenditures were $26.5 million, $8.8 million and $23.6 million in 1993, 1992 and 1991 respectively. In 1993 nearly half of retail expenditures were environmental projects related to tanks, lines, vapor recovery and soil remediation. The balance of 1993 retail expenditures included discretionary projects such as store interior remodeling, systems automation and "On The Go" store concept development. Spending declined in 1992 and was limited primarily to environmental projects while a new long-term strategic plan was developed. Clark projects 1994 capital expenditures to be approximately $80 million. Another $15 million is expected to be spent on a maintenance turnaround at the Hartford refinery. Estimated refining division capital expenditures of $40 million include $10 million for various environmental projects and $30 million of discretionary spending such as improvements to Hartford's crude and FCC units. Retail division capital expenditures are estimated to be $40 million including $20 million for environmental projects and $20 million for discretionary projects such as the addition of canopies and new dispensers to existing sites, the expansion of store interior selling space and "reimaging" locations under Clark's new logo and updated color scheme. Discretionary spending in each division will be linked to its operating cash flow. Over the period 1994 to 1998, Clark has preliminary plans to complete a number of environmental and other regulatory capital expenditure programs. These environmental expenditures comprise two major categories, those that are mandatory in order to comply with regulations pertaining to ground, water and air contamination, and those that are primarily discretionary involving the reformulation of refined fuel for sale into certain defined markets. The total mandatory expenditures for regulatory compliance over the next five years are estimated at approximately $100 million, split evenly between the retail and refining businesses. Costs of potential future regulations cannot be forecast. The expenditures required to comply with reformulated fuels regulations are primarily discretionary, subject to market conditions and economic justification. The reformulated fuels programs impose restrictions on properties of fuels to be refined and marketed, including those pertaining to gasoline volatility, oxygenated fuel, detergent addition and sulfur content. The regulations regarding these fuel properties apply to different markets in which Clark operates, in certain circumstances at different times of the year. Modifications estimated at $10-15 million to produce reformulated gasoline are being considered for the Blue Island refinery. The decision to proceed with such a project will depend on economic justification. A project initiated to produce low sulfur diesel fuel at the Hartford refinery was delayed in 1992 based on internal and third party analyses that indicated an oversupply of low sulfur diesel fuel capacity in Clark's marketplace. These analyses projected relatively narrow price differentials between low and high sulfur diesel products which have thus far been borne out after the initial transition to the low sulfur regulations. However, if price differentials widen sufficiently to justify investment, Clark could install the necessary equipment over a 14 to 16 month period at an estimated additional cost of $40 million. Furthermore, if Clark decided to install equipment necessary to produce reformulated gasoline and control sulfur emissions at Hartford, the gasoil desulfurizer and related equipment are estimated to cost an additional $90-130 million. These estimates have declined from a year ago as Clark has found more cost-effective methods of complying with regulations. Clark's net cash flow used in financing activities was $1.1 million in 1993 and $38.7 million in 1992, while $119.1 million was provided in 1991. In 1991 and 1992, long-term debt was retired early and new debt was issued, principally to increase available cash and extend maturities of debt past the period when Clark expected to incur its largest capital expenditure requirements. See Note 8 "Long-Term Debt" to the financial statements. In 1993, Clark entered into several operating leases related to retail store automation equipment, coolers and beverage dispensers, office equipment, refinery lab equipment and a filter press. Funds generated from operating activities, together with Clark's existing cash, cash equivalents and marketable investments, are expected to be adequate to fund requirements for working capital and capital expenditure programs for the next year. Clark's future discretionary or environmentally-mandated spending, or acquisitions may require additional debt or equity capital. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is incorporated herein by reference to Part IV Item 14 (a) 1 and 2. Financial Statements and Financial Statement Schedules. 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 directors and executive officers of Clark and their respective ages and positions are set forth in the table below. The Board of Directors of Clark consists of three directors who serve until the next annual meeting of stockholders or until a successor is duly elected. Directors do not receive any compensation for their services as such. Officers of Clark serve at the discretion of the Board of Directors (and in the case of Messrs. Barnholt and Sigurdson, pursuant to employment agreements). Peter Munk has served as Chairman of the Board since July 1992, as Chairman of the Board and Chief Executive Officer from August 1990 through July 1992 and as Vice Chairman from November 1988 through August 1990. Mr. Munk has served as a director of the Company since November 1988. Mr. Munk has served as Chairman of the Board of Directors of Horsham since its formation in June 1987 and as Chairman and Chief Executive Officer and a director of Barrick since July 1984. Paul D. Melnuk has served as a director since October 1992, as President and Chief Executive Officer since July 1992, as President and Chief Operating Officer from February 1992 through July 1992, as Executive Vice President and Chief Operating Officer from December 1991 through February 1992, as Executive Vice President and Chief Financial Officer from November 1991 through December 1991, as Vice President and Chief Financial Officer from August 1990 through November 1991 and as Vice President from November 1988 through August 1990. Mr. Melnuk has served as President and Chief Operating Officer and as a director of Horsham since March 1992, as Executive Vice President and Chief Financial Officer of Horsham from May 1990 through February 1992 and as Vice President of Horsham from April 1988 through May 1990. C. William D. Birchall has been a director of Clark since November 1988. Mr. Birchall has been Chief Financial Officer of Arlington Investments Limited, a private investment holding company located in Nassau, Bahamas, for the last five years. Mr. Birchall has been a director of Barrick since July 1984 and a director of Horsham since 1987. Brandon K. Barnholt has served as Executive Vice President-Retail Marketing since December 1993 and Vice President-Retail Marketing from July 1992 through December 1993 and as Managing Director-Retail Marketing from May 1992 through July 1992. Mr. Barnholt previously served as Retail Marketing Manager of Conoco, Inc. from March 1991 through March 1992 and Lubricants Sales Manager from April 1988 through March 1991. During 1990 and 1989, Mr. Barnholt served as President of the Denver Conoco Credit Union. Kevin P. Pennington has served as Executive Vice President-Corporate Services since December 1993 and as Vice President-Human Resources from July 1993 through December 1993. Previously Mr. Pennington served as Vice President-Human Resources for the Mercy Health System from April 1991 through July 1993 and as Assistant Vice President-Human Resources at GTE from June 1985 through April 1991. Eric D. Sigurdson has served as Executive Vice President-Refining since December 1993, Vice President-Finance and Administration and Chief Financial Officer from October 1992 through December 1993 and as Vice President-Corporate Development from May 1992 to October 1992. Mr. Sigurdson has served as Vice President and Chief Financial Officer since November 1992 and as Vice President of Horsham since January 1992. From September 1989 through January 1992, Mr. Sigurdson served as President of Toronto Dominion Real Estate Inc. and as Director of Mergers & Acquisitions, Toronto Dominion Securities Inc. From April 1988 through September 1989, he served as corporate finance and real estate consultant at Cormax Capital Ltd. Patrick F. Heider has served as Secretary since October 1992. Mr. Heider has served as in-house counsel since April 1990. Mr. Heider previously was employed as an associate with the St. Louis law firm of Shepard, Sandberg & Phoenix from April 1988 through April 1990. There are no arrangements or understandings between any director or executive officer and any other person pursuant to which such person was elected or appointed as a director or executive officer of Clark. There are no family relationships between any director or executive officer and any other director or executive officer. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth the compensation paid to the most highly compensated executive officers of Clark earning in excess of $100,000. - -------- (a) Mr. Melnuk and Mr. Sigurdson receive compensation from Horsham for their services as President and Chief Operating Officer and Vice President and Chief Financial Officer, respectively, of Horsham. (b) Represents amounts accrued for the accounts of such individuals under the Clark Refining & Marketing, Inc. Savings Plan. (c) Payment of equity protection in sale of personal residence. (d) Number of shares covered by grants which may be exercised as stock options. These shares were granted under the Clark Refining & Marketing Stock Option Plan (the "Option Plan") and are exercisable for Subordinate Voting Shares of Horsham. Mr. Melnuk, Mr. Barnholt, Mr. Pennington and Mr. Sigurdson hold options to acquire Subordinate Voting Shares of Horsham received as compensation from Horsham. Compensation of Clark's executive officers is determined by Clark's Board of Directors. Mr. Melnuk, Clark's President and Chief Executive Officer, is a member of Clark's Board of Directors. OPTION GRANTS IN 1993 There were no grants of stock options pursuant to Clark's Option Plan during the year ended December 31, 1993, to the executive officers named above. In 1993, Mr. Barnholt, Mr. Pennington and Mr. Sigurdson received options to acquire Subordinate Voting Shares of Horsham from Horsham. YEAR-END OPTION VALUES The following table sets forth information with respect to the number and value of unexercised options to purchase Subordinate Voting Shares of Horsham held by the executive officers named in the Summary Compensation Table at December 31, 1993. None of the named executive officers exercised any stock options during 1993. - -------- (a) Based upon the closing price on the New York Stock Exchange--Composite Transactions on December 31, 1993. (b) Mr. Melnuk, Mr. Barnholt, Mr. Pennington and Mr. Sigurdson hold options to acquire Subordinate Voting Shares of Horsham received as compensation from Horsham. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Compensation of Clark's executive officers is determined by the Board of Directors. Mr. Melnuk, Clark's President and Chief Executive Officer, is a member of the Board of Directors. Other than reimbursement of their expenses, Clark's directors do not receive any compensation for their service as directors. EMPLOYMENT AGREEMENTS Clark has an employment agreement with Mr. Sigurdson which provides for a term of three years commencing January 14, 1992 at a minimum annual salary of $150,000. In addition, Mr. Sigurdson was granted an option to purchase 100,000 shares of Subordinate Voting Shares of Horsham by Horsham which option shall become exercisable as to one-third of the shares on each of the first three anniversary dates of the granting of the option. Clark has an employment agreement with Mr. Barnholt which provides for a term of three years commencing May 11, 1992 at a base annual salary of $112,500. In addition, Mr. Barnholt was granted an option to purchase 30,000 shares of Subordinate Voting Shares of Horsham, which option shall become exercisable as to one-third of the shares on each of the first three anniversary dates of the granting of the option. CLARK REFINING & MARKETING, INC. SAVINGS PLAN Clark maintains the Clark Refining & Marketing, Inc. Savings Plan (the "Plan"), a profit sharing plan which permits employee before-tax contributions and provides for employer incentive matching contributions. The Plan was adopted effective January 1, 1989 and as of January 1, 1994 the assets under the related trust that implements and forms a part of the Plan are held in trust by Boatmen's Trust Company. Under the Plan, each employee of Clark and such other related companies as may adopt the Plan, who has attained age 21 (no age requirement effective April 1, 1994) and completed one year of service (six months of service effective April 1, 1994) may become a participant. Participants are permitted to make elective before-tax contributions to the Plan, effected through payroll reduction, from 2% to 12% (15% effective January 1, 1994) of their compensation. Clark makes matching contributions equal to 100% of a participant's elective before-tax contributions up to 6% of compensation (effective April 1, 1994 a 200% match of up to 3% of compensation). Participants are also permitted to make after-tax voluntary contributions through payroll deduction, from 2% to 5% of compensation, which are not matched by employer contributions. All employer contributions are vested at a rate of 20% per year of service, becoming fully vested after five years of service. Participants' vested accounts are distributable upon a participant's disability, death, retirement or separation from service. Subject to certain restrictions, employees may make loans or withdrawals of employee contributions during the term of their employment. CLARK REFINING & MARKETING, INC. STOCK OPTION PLAN In 1991, Clark established a Stock Option Plan (the "Option Plan") under which options to purchase Subordinate Voting Shares of Horsham ("Horsham Shares") could be granted to certain of its non-employee directors and key employees. Under the Option Plan, options were granted for the purpose of attracting and motivating directors, officers and key employees. The Option Plan is administered by a committee of the Board of Directors consisting of two or more directors. Under the terms of the Option Plan, options granted to purchase Horsham Shares were at the market price of the Horsham Shares at the time of grant. In the event that an option holder ceases to be an employee, the holder (or the holder's estate) has three months to exercise the vested options. The maximum number of Horsham Shares authorized for issuance under the Option Plan, as amended, is 600,000. As of December 31, 1993, there were 363,737 options outstanding to purchase shares of Horsham at prices ranging from $7.19 to $11.88 per share. The Company, under a trust agreement, held 253,738 Horsham shares at December 31, 1993 to meet obligations under the Option Plan. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of Clark's common stock is owned by R & M Holdings, which is indirectly wholly owned by Horsham. R & M Holdings was formed by Horsham and AOC L.P. to acquire all of the capital stock of Clark and certain other assets. In connection with the Acquisition, AOC L.P., Horsham, R & M Holdings and Clark entered into a shareholder agreement, pursuant to which Horsham purchased 60% of the equity capital of R & M Holdings for $18 million and AOC L.P. purchased the remaining 40% of the equity capital of R & M Holdings for $12 million. AOC L.P. is a Missouri limited partnership, the sole general partner of which is G & N Investments, Inc. REPURCHASE OF STOCK On December 30, 1992, R & M Holdings repurchased from AOC L.P. 34.67 shares of its common stock (approximately 87% of the shares of R & M Holdings common stock owned by AOC L.P.) and the option held by AOC L.P. to acquire common stock described above, for a purchase price of $90 million in cash and the transfer of all of the shares of CMAT, Inc. ("CMAT"), the principal asset of which is a Colorado ski resort. Horsham purchased the remaining 5.33 shares of common stock (approximately 13% of the shares of R & M Holdings common stock owned by AOC L.P.) for a purchase price of $10 million in cash and a warrant to purchase up to 3,000,000 subordinate voting shares of Horsham at an exercise price of $7.625 per share. In addition, a shareholder agreement was terminated. As of December 31, 1993, Peter Munk held approximately 80.9% voting control of Horsham. In addition, R & M Holdings and Horsham have agreed to pay to AOC L.P. approximately 89% and 11%, respectively, of the Contingent Payment described below. The Contingent Payment is an amount, which shall not exceed in the aggregate $24 million plus interest at 9% per annum, compounded annually, calculated as a percentage of (i) the net cash flow of Clark for the years 1993, 1994, 1995 and 1996, in excess of specified levels and (ii) the net proceeds from sales, prior to January 1, 1997, of any equity security of R & M Holdings or Clark, or of certain assets of Clark or Clark Pipe Line Company or of certain mergers involving R & M Holdings or Clark, at prices in excess of specified levels. Any Contingent Payments due for 1993 were immaterial. The shares of CMAT transferred to AOC L.P. were valued at approximately $9.9 million, following capitalization of certain intercompany debt held by Clark. In connection with the foregoing transaction, AOC L.P., its principals and their affiliates, on the one hand and Horsham, R & M Holdings and Clark, on the other hand, delivered a Mutual Release of all claims, known or unknown, of either party against the other. In consideration of such release, Clark paid to AOC L.P. $2.5 million in cash. To fund the repurchase of shares of its common stock, R & M Holdings borrowed $90 million pursuant to the Horsham Notes. The Horsham Notes consist of (i) a zero coupon note payable to Horsham issued on December 30, 1992 for a price of $75.0 million and maturing on June 28, 1993 in the face amount of approximately $79.6 million and (ii) a zero coupon note payable to a wholly owned subsidiary of Horsham issued on December 21, 1992 for a price of $15.0 million and maturing on June 19, 1993 in the face amount of approximately $15.9 million. The issue price of each of the Horsham Notes represented a yield to maturity of approximately 11.8%. The Horsham Notes were repaid on February 18, 1993 from the proceeds of a private debt placement by R & M Holdings. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Horsham and Clark have agreements to provide certain management services to each other from time to time. During 1990, Clark arranged interim letter of credit facilities with two banks totaling $125.0 million requiring the guarantee of Horsham. Fees related to this interim financing arrangement and associated guarantee paid to Horsham in 1991 totaled $7.0 million. Clark has established trade credit with various suppliers of its petroleum requirements, occasionally requiring the guarantee of Horsham. Fees related to trade credit guarantees totaled $0.4 million during 1991 and $0.1 million in 1992. The business relationships described above and any future business relationships with Horsham will be on terms no less favorable in any respect than those which could be obtained through dealings with third parties. RELATIONSHIP WITH R & M HOLDINGS For Federal income tax purposes, Clark has been a member of the consolidated group of which R & M Holdings is the parent corporation (the "R & M Holdings Group"). Pursuant to a Tax Sharing Agreement in effect among R & M Holdings and each of its direct and indirect subsidiaries, for any year in which Clark is entitled to file a consolidated Federal income tax return with R & M Holdings, Clark generally is required to pay to R & M Holdings an amount equal to the amount of Federal income tax Clark would have paid had it computed its Federal income tax liability as a separate company in such year and any prior year. If Clark has or would have had an unused tax credit or loss which it could have carried back had it filed separate tax returns for all prior years, R & M Holdings must pay Clark an amount equal to the refund to which Clark would have been entitled. However, if Clark leaves the R & M Holdings Group, the Tax Sharing Agreement will cease to apply to it and it will no longer be entitled to reimbursement for the use of any of its losses, even if those losses result in refunds to the R & M Holdings Group or otherwise reduce the Federal income liability of the R & M Holdings Group, unless R & M Holdings otherwise agrees. Clark also may have to pay an additional amount to R & M Holdings or may be entitled to a payment from R & M Holdings if Clark's separately computed income, losses or credits are adjusted as a result of an audit by the Internal Revenue Service. The principles set forth above with respect to the Federal income taxes also apply to state taxes in those states where a combined income tax return can be filed. Holding's address is 8000 South Beech Daly Road, Taylor, Michigan 48180. 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 The financial statements and schedules filed as a part of this Report on Form 10-K are listed in the accompanying index to financial statements and schedules. 3. EXHIBITS (B) REPORTS ON FORM 8-K Registrant filed a Form 8-K dated October 1, 1993 disclosing change of corporate name and trademark. INDEX TO FINANCIAL STATEMENTS AND SCHEDULES REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Clark Refining & Marketing, Inc.: We have audited the accompanying balance sheets of Clark Refining & Marketing, Inc. (formerly Clark Oil & Refining Corporation) (a Delaware corporation and wholly owned subsidiary of Clark R & M Holdings, Inc.) as of December 31, 1993 and 1992 and the related statements of earnings, stockholder's 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 Clark Refining & Marketing, 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. As discussed in notes 12 and 13 to the financial statements, in 1993 the Company changed its method of accounting for postretirement benefits other than pensions and its method of accounting for income taxes. Coopers & Lybrand St. Louis, Missouri, January 28, 1994 CLARK REFINING & MARKETING, INC. BALANCE SHEETS (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) The accompanying notes are an integral part of these statements. CLARK REFINING & MARKETING, INC. STATEMENTS OF EARNINGS (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these statements. CLARK REFINING & MARKETING, INC. STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these statements. CLARK REFINING & MARKETING, INC. STATEMENT OF STOCKHOLDER'S EQUITY DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these statements. CLARK REFINING & MARKETING, INC. NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (TABULAR DOLLAR AMOUNTS IN THOUSANDS OF US DOLLARS) 1. GENERAL Clark Refining & Marketing, Inc., formerly Clark Oil & Refining Corporation, a Delaware corporation ("Clark") was organized in 1988 for the purpose of acquiring the principal assets of OC Oil & Refining Corporation (formerly Clark Oil & Refining Corporation, a Wisconsin Corporation) ("Old Clark"), a wholly- owned subsidiary of Apex Oil Company, Inc. (formerly Apex Oil Company) ("Apex") and certain other assets of Apex. Clark is wholly-owned by Clark R & M Holdings, Inc., a Delaware corporation ("R & M Holdings"), and R & M Holdings is indirectly, wholly-owned by The Horsham Corporation, a Quebec corporation ("Horsham"). During December 1992, the 40% ownership interest of R & M Holdings that was held by AOC Limited Partnership, a Missouri limited partnership and affiliate of Apex ("AOC, LP"), was acquired by R & M Holdings and Horsham. Clark's principal operations include crude oil refining, wholesale and retail marketing of refined petroleum products and the retail marketing of convenience store items in the Central United States. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash and Cash Equivalents; Short-term Investments Clark considers all highly liquid investments, such as time deposits, money market instruments, commercial paper and United States and foreign government securities, purchased within three months of maturity, to be cash equivalents. Short-term investments consist of similar investments, as well as United States government security funds, maturing more than three months from date of purchase and are carried at the lower of cost or market. Clark invests only in AA rated or better fixed income marketable securities or the short-term rated equivalent. Inventories Inventories are stated at the lower of cost, predominantly using the last-in, first-out "LIFO" method, adjusted for realized hedging gains or losses on petroleum products, or market on an aggregate basis. To limit risk related to price fluctuations, Clark purchases and sells crude oil and refined products futures contracts as hedges of its production requirements and physical inventories. Gains and losses on futures contracts are recognized in earnings as a product cost component and as an adjustment to the carrying amount of petroleum inventories and are reflected when such inventories are consumed or sold. Property, Plant and Equipment Depreciation of property, plant and equipment is computed using the straight- line method over the estimated useful lives of the assets or group of assets. The cost of buildings and marketing facilities on leased land and leasehold improvements are amortized on a straight-line basis over the shorter of the estimated useful life or the lease term. Clark capitalizes the interest cost associated with major construction projects based on the effective interest rate on aggregate borrowings. Expenditures for maintenance and repairs are expensed. Major replacements and additions are capitalized. Gains and losses on assets depreciated on an individual basis are included in current income. Upon disposal of assets depreciated on a group basis, unless unusual in nature or amount, residual cost less salvage is charged against accumulated depreciation. CLARK REFINING & MARKETING, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) Environmental Costs Environmental expenditures are expensed or capitalized depending upon their future economic benefit. Costs which improve a property as compared with the condition of the property when originally constructed or acquired and costs which prevent future environmental contamination are capitalized. Costs which return a property to its condition at the time of acquisition are expensed. Deferred Turnaround and Financing Costs A turnaround is a periodically required standard procedure for maintenance of a refinery that involves the shutdown and inspection of major processing units and occurs approximately every three years. Turnaround costs, which are included in "Other assets", are amortized over three years beginning the month following completion. Financing costs related to obtaining or refinancing of debt are deferred and amortized over the expected life of the debt. Income Taxes Clark files a consolidated US federal income tax return with R & M Holdings but computes its provision on a separate company basis. On January 1, 1993, Clark adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") (see Note 13, "Income Taxes"). Deferred taxes are classified as current and included in prepaid or accrued expenses or noncurrent depending on the classification of the assets and liabilities to which the temporary differences relate. Deferred taxes arising from temporary differences that are not related to a specific asset or liability are classified as current or noncurrent depending on the periods in which the temporary differences are expected to reverse. Employee Benefit Plans The Clark Refining & Marketing, Inc. Savings Plan and separate Trust (the "Plan"), a defined contribution plan covers substantially all employees of Clark. Under terms of the Plan, Clark matches the amount of employee contributions, subject to specified limits. Contributions to the Plan during 1993 were $2.7 million (1992--$2.7 million; 1991--$2.7 million). Clark provides certain benefits for retirees once they have reached specified years of service. These benefits include health insurance in excess of social security and an employee paid deductible amount, and life insurance equal to one and one-half times the employee's annual salary. On January 1, 1993, Clark adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106") which changed the method of accounting for such benefits from a cash to an accrual basis (see Note 12, "Postretirement Benefits Other Than Pensions"). 3. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value of Clark's financial instruments as of December 31, 1993 was as follows: The estimated fair value amounts were determined using quoted market prices for the same or similar issues. CLARK REFINING & MARKETING, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) The Financial Accounting Standards Board has issued SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities". The standard generally replaces the historical cost accounting approach to debt securities with one based on fair value. All affected debt and equity securities must be classified as held-to-maturity, trading, or available-for-sale. Classification is critical as it effects the carrying amount of the security, as well as the timing of gain or loss recognition. Clark will adopt this standard beginning January 1, 1994 and expects most securities to be classified as available-for-sale with no material impact on the carrying values of the securities or earnings. 4. INVENTORIES The carrying value of inventories consisted of the following: Inventories at December 31, 1993 were written down to market value which was $26.5 million lower than LIFO cost. The market value of inventories at December 31, 1992, was approximately $13.2 million higher than the carrying value. 5. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consisted of the following: At December 31, 1993, property, plant & equipment included $48.2 million (1992--$57.1 million) of construction in progress. 6. OTHER ASSETS Other assets consisted of the following: CLARK REFINING & MARKETING, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) Amortization of deferred financing costs for the year ended December 31, 1993, was $1.2 million (1992--$2.9 million; 1991--$6.0 million). Amortization of turnaround costs during 1993 totaled $11.8 million (1992--$9.2 million; 1991--$7.0 million). 7. WORKING CAPITAL FACILITY Clark has in place a working capital facility which provides a revolving line of credit for cash borrowings and for the issuance of letters of credit primarily for securing purchases of crude oil, other feedstocks and refined products. The facility is for $100 million and expires December 31, 1994. There are restrictive limitations on inventory positions, and certain financial ratios are required to be maintained, including a net worth requirement of at least $130.0 million in 1993 and $140.0 million effective January 1, 1994. At December 31, 1993, $51.5 million (1992--$57.4 million) of the line of credit was utilized for letters of credit, of which $8.7 million (1992--$31.8 million) supports commitments for future deliveries of petroleum products. There were no direct borrowings outstanding under the facility at December 31, 1993 or 1992. 8. LONG-TERM DEBT The 9 1/2% and 10 1/2% Senior Notes were issued in September 1992 and December 1991, respectively and are both unsecured. The 9 1/2% Senior Notes and 10 1/2% Senior Notes are redeemable by Clark beginning September 1997 and December 1996, respectively at a redemption price which starts at 105% and decreases to 100% of principal two years later. The indentures for the Notes contain certain restrictive covenants including limitations on the payment of dividends, the payment of amounts to related parties, the level of debt, change in control and incurrence of liens. In addition, Clark must maintain a minimum net worth of $100 million. The scheduled maturities of long-term debt during the next five years are (in thousands): 1994--$317 (included in "Accrued expenses and other"); 1995--$106; 1996--$99; 1997--$82; 1998--$121; 1999 and thereafter $400,630. Interest and financing costs Interest and financing costs, net consisted of the following: CLARK REFINING & MARKETING, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) Cash paid for interest in 1993 was $40.1 million (1992--$52.1 million; 1991-- $35.1 million). Interest income in 1993 includes $0.2 million (1992--$2.0 million; 1991-- $(0.2) million) from CMAT (see Note 10 "Related Party Transactions"). Accrued interest payable at December 31, 1993, of $6.9 million (1992--$6.7 million) is included in "Accrued expenses and other". Early Extinguishment of Debt In 1992 Clark repurchased $95.9 million of its First Mortgage Notes on the open market for $103.0 million and redeemed the remaining $104.1 million at 106% of principal amount, or $110.4 million. Available cash was used to extinguish the debt. The costs of the early extinguishment of debt of $11.5 million (net of taxes of $7.2 million) included the premium amount, deferred financing costs, and defeasance-related interest expense. 9. LEASE COMMITMENTS Clark leases premises and equipment under lease arrangements, many of which are non-cancelable. Clark leases store property and equipment with lease terms extending to 2013, some of which have escalation clauses based on a set amount or increases in the Consumer Price Index. Clark also has operating lease agreements for certain pieces of equipment at the refineries, retail stores, and the general office. These lease terms range from 3 to 9 years with the option to purchase the equipment at the end of the lease term at fair market value. The leases generally provide that Clark pay taxes, insurance, and maintenance expenses related to the leased assets. At December 31, 1993, future minimum lease payments under capital leases and non-cancelable operating leases were as follows (in millions): 1994--$4.9; 1995--$4.2; 1996--$4.0; 1997--$1.6; 1998--$1.6 and $4.6 thereafter. Rental expense during 1993 was $3.4 million (1992--$3.7 million; 1991--$3.4 million). 10. RELATED PARTY TRANSACTIONS Transactions of significance with related parties not disclosed elsewhere in the footnotes are detailed below: Apex Oil Company, Inc. and Subsidiaries Clark had various agreements with Apex related to the sale of products (slurry oil, vacuum tower bottoms, asphalt) produced by the refineries. These agreements were terminated or expired in 1992 or 1991. The purchase and sale of products and services between the parties were made at market terms and prices. During 1992, Clark purchased $1.6 million (1991--$51.0 million) of its crude oil and other petroleum requirements from Apex and sold $0.7 million (1991-- $119.6 million) of refined product to Apex. There were no purchases from or sales to Apex in 1993. Clark Executive Trust Clark established a deferred compensation plan called the Clark Refining & Marketing, Inc. Corporation Stock Option Plan (the "Stock Option Plan") which became effective May 1, 1991. Under the Stock Option Plan, as amended, options to purchase up to 600,000 subordinate voting shares of Horsham could be granted to certain employees and non-employee directors. Exercise prices reflect the market value of Horsham stock on the date of issuance. As of December 31, 1993, there were 363,737 options outstanding to purchase shares of Horsham at prices ranging from $7.19 to $11.88 per share. The trust held 253,738 Horsham shares at December 31, 1993. CLARK REFINING & MARKETING, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) CMAT, Inc. On December 30, 1992 the stock of CMAT Inc. ("CMAT") was transferred to an affiliate of Apex as part of the consideration for the acquisition by R & M Holdings for most of R & M Holdings' shares held by AOC, LP, an affiliate of Apex. As part of this transaction, Clark held a $10.0 million note due from CMAT December 31, 1997. This note was paid in full in early 1993. 11. OTHER INCOME Other income consisted of the following: Litigation Settlements In 1993 and 1992, Clark settled litigation and recovered all previous losses incurred relating to a line of credit with a lending syndicate (led by Drexel Trade Finance) that had filed bankruptcy in 1990. Also in 1992, Clark settled litigation against Apex related to a dispute arising out of the November 1988 acquisition of Clark's assets from Apex. Retail Stores In June 1993, Clark sold 21 "non-core" retail stores in Kentucky and Minnesota, which resulted in the recognition of other income of $2.9 million. 12. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS On January 1, 1993, Clark adopted SFAS 106. This standard requires that Clark accrue the actuarially determined costs of postretirement benefits during the employees' active service periods. Previously, Clark had accounted for these benefits on a "pay as you go" basis, recognizing an expense when an obligation was paid. The cost of such benefits in 1992 and 1991 was not significant and these years have not been restated. In accordance with SFAS 106, Clark elected to recognize the cumulative liability, a non-cash "Transition Obligation" of $9.6 million, net of the tax benefit of $6.0 million, as of January 1, 1993. The current year effect of adopting SFAS 106 was $1.9 million ($1.2 million, net of taxes). The following table sets forth the unfunded status for the post retirement health and life insurance plans as of December 31, 1993: CLARK REFINING & MARKETING, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) A discount rate of 7.25% was assumed as well as a 4.5% rate of increase in the compensation level. For measuring the expected postretirement benefit obligation, the health care cost trend rate ranged from 9.8% to 14.0% in 1993, grading down to an ultimate rate in 2001 of 5.25%. The effect of increasing the average health care cost trend rates by one percentage point would increase the accumulated postretirement benefit obligation, as of December 31, 1993, by $2.2 million and increase the annual aggregate service and interest costs by $0.3 million. 13. INCOME TAXES On January 1, 1993, Clark adopted SFAS 109 retroactive to January 1, 1991. The adoption of this standard changes the method of accounting for income taxes from the deferred method to an asset and liability approach. Previously, Clark deferred the past tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. The 1992 and 1991 financial statements have been restated to give retroactive effect to the adoption of SFAS 109. As a result of the restatement, deferred income tax liabilities have increased and retained earnings has decreased at December 31, 1992 and 1991 by $8.4 million and $5.2 million, respectively. Before retroactive application of SFAS 109, the 1992 net loss was $5.1 million and the 1991 net income was $38.3 million. The respective effect of the retroactive application of SFAS 109 on these years' earnings was a $3.1 million and $1.0 million increase in the tax provision, resulting in a net loss for 1992 of $8.2 million and net earnings for 1993 of $37.3 million. The income tax provision (benefit) including the impact of the accounting change in 1993 and the extraordinary item in 1992 is summarized as follows: A reconciliation between the income tax provision computed on pretax income at the statutory federal rate and the actual provision for income taxes is as follows: CLARK REFINING & MARKETING, INC. NOTES TO FINANCIAL STATEMENTS--(CONTINUED) The following represents the approximate tax effect of each significant temporary difference giving rise to deferred tax liabilities and assets. As of December 31, 1993, Clark has made payments of $14.3 million under the Federal alternative minimum tax system which are available to reduce future regular income tax payments. Net cash tax refunds of $6.6 million were received during 1993. Net cash paid for income taxes in 1992 was $2.2 million and $3.2 million in 1991. Federal income taxes payable at December 31, 1993, of $2.7 million (1992-- $5.9 million receivable) are due to R & M Holdings, an affiliate, in accordance with a tax-sharing agreement between Clark and R & M Holdings and are included in "Accounts payable". 14. CONTINGENCIES Forty-one civil suits by residents of Hartford, Illinois have been filed against Clark in Madison County Illinois, alleging damage from ground water contamination. The relief sought in each of these cases is an unspecified dollar amount. The litigation proceedings are in the initial stages. Discovery, which could be lengthy and complex, is only just beginning. Clark moved to dismiss thirty-four cases filed in December 1991 on the ground that Clark is not liable for alleged activity of Old Clark. On September 4, 1992, the trial court granted Clark's motions to dismiss. The plaintiffs were given leave to re-file their complaints but based only on alleged activity of Clark occurring since November 8, 1988, the date on which the bankruptcy court with jurisdiction over Old Clark's bankruptcy proceedings issued its "free and clear" order. In November 1992, the plaintiffs filed thirty-three amended complaints. In addition, one new complaint involving nine plaintiffs was filed. It is too early to predict whether any of these cases will go to trial on the merits and if so, what the risk of exposure to Clark would be at trial. It is also not possible to determine whether or to what extent Clark will have any liability to other individuals arising from the ground water contamination. Clark is subject to various legal proceedings related to governmental regulations and other actions arising out of the normal course of business, including legal proceedings related to environmental matters. While it is not possible at this time to establish the ultimate amount of liability with respect to such contingent liabilities, Clark is of the opinion that the aggregate amount of any such liabilities, for which provision has not been made, will not have a material adverse effect on its financial position. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Clark Refining & Marketing, Inc.: Our report on the financial statements of Clark Refining & Marketing, Inc. (formerly Clark Oil & Refining Corporation) is included on page 30 of this Form 10-K. In connection with our audits of such financial statements, we have also audited the financial statement schedules as of and for the years ended December 31, 1993, 1992 and 1991 listed in Part IV, Item 14(a)(2) of this Form 10-K. In our opinion, these 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 St. Louis, Missouri, January 28, 1994 CLARK REFINING & MARKETING, INC. SCHEDULE I--MARKETABLE SECURITIES--OTHER INVESTMENTS (DOLLARS IN THOUSANDS) CLARK REFINING & MARKETING, INC. SCHEDULE V--PROPERTY, PLANT & EQUIPMENT (A) (DOLLARS IN THOUSANDS) - -------- (a) Depreciation of property, plant and equipment is computed using the straight-line method based upon the following estimated useful lives: (b) 1993 deductions include assets which transferred among divisions within the Company. CLARK REFINING & MARKETING, INC. SCHEDULE VI--ACCUMULATED DEPRECIATION OF PROPERTY, PLANT & EQUIPMENT (DOLLARS IN THOUSANDS) CLARK REFINING & MARKETING, INC. SCHEDULE X--SUPPLEMENTARY EARNINGS STATEMENT INFORMATION (DOLLARS IN THOUSANDS) Other items were not in excess of one percent of total sales and revenues. 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. Clark Refining & Marketing, Inc. /s/ Paul D. Melnuk By: _________________________________ Paul D. Melnuk President and Chief Executive Officer March 25, 1994 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 IN THE CAPACITIES AND ON THE DATE INDICATED. March 25, 1994

4829_1993.txt

4829_1993

1993

4829

Item 1. Business. GENERAL American Cyanamid Company, a Maine corporation organized in 1907, is a research-based life sciences company which, together with its subsidiaries (collectively "Cyanamid"), discovers and develops medical and agricultural products, and manufactures and markets them throughout the world. Cyanamid operates 17 research laboratories, and its products are sold by its divisions and subsidiaries in more than 135 countries. In December 1993, Cyanamid substantially completed the spin-off of Cytec Industries Inc. ("Cytec"), which encompassed substantially all of Cyanamid's chemicals businesses including plant food, and on January 24, 1994, Cytec common shares were distributed as a taxable dividend to shareholders. Cyanamid retained a $200 million preferred stock interest in Cytec. The chemicals businesses included: chemicals for water treating, paper, mining and oil field applications; building block chemicals, including acrylamide, acrylonitrile, melamine and sulfuric acid; amino resins, sold primarily to the coatings industry for use in paints; specialty materials, including adhesives and composites for the aerospace industry; specialty chemicals, including polymer additives, surfactants and phosphine chemicals; and acrylic fibers. Cytec assumed responsibility for substantially all liabilities (including environmental liabilities and liabilities for post- retirement benefits payable to employees of and retirees from Cyanamid's former chemicals business) and obligations associated with Cyanamid's former chemicals businesses (except for environmental liabilities at one former chemicals plant site - see Item 3), and agreed to indemnify Cyanamid against such liabilities and obligations. The Cytec preferred stock issued to Cyanamid contains various financial covenants designed to ensure that Cytec retains adequate financial strength to discharge the liabilities and obligations against which it is indemnifying Cyanamid. The remedies for breach of these financial covenants include Cyanamid's right of approval of Cytec's capital expenditure plans (thus exercising control over cash outlays) and, in certain cases, the ability by Cyanamid to nominate a majority of the Cytec Board of Directors. A two-member committee of the Cytec Board of Directors oversees environmental matters. Cyanamid's representative on the Cytec Board is one of the members of that committee. The operating results of the chemicals businesses have been accounted for as discontinued operations. Accordingly, the 1993 consolidated financial statements exclude amounts for discontinued operations from items under captions applicable to continuing operations. The 1992 and 1991 consolidated financial statements and Form 10-K information and financial statement schedules have been restated to conform with the 1993 presentation. "Operations By Business Groups and Geographic Areas" on pages 49 through 51 of the American Cyanamid Company Annual Report to Shareholders for the year ended December 31, 1993 ("Shareholders Report") are incorporated by reference. BUSINESS GROUPS Medical. Medical products encompass LEDERLE branded and generic pharmaceutical products; over-the-counter products including CENTRUM and other multivitamins; LEDERLE-PRAXIS vaccines; DAVIS & GECK surgical sutures, wound management devices and instruments for minimally invasive surgery; STORZ ophthalmic, ear, nose and throat surgical devices, ophthalmic pharmaceuticals and intraocular lenses; and ACUFEX arthroscopic instruments and equipment. On June 1, 1993, Cyanamid and Immunex Corporation, a biopharmaceutical company based in Seattle, Washington, created a new biopharmaceutical company by merging Cyanamid's North American Lederle oncology business with Immunex. Cyanamid also contributed $350 million in cash to the new company, which retained the Immunex name. Cyanamid received 53.5% of the common stock of the new company. See Note 3 to the Consolidated Financial Statements in the Shareholders Report. Immunex's products consist of LEUKINE granulocyte-macrophage colony stimulating factor and Lederle's oncology products: NOVANTRONE mitoxantrone, leucovorin calcium, thiotepa, methotrexate, AMICAR aminocaproic acid and LEVOPROME methotrimeprazine. See Note 3 to the Consolidated Financial Statements in the Shareholders Report for a description of a global, companywide restructuring program, and the charges related thereto, primarily in the medical business, announced in the fourth quarter of 1993. Agricultural. The agricultural business encompasses herbicides, such as the imidazolinone herbicides marketed as SCEPTER, PURSUIT, PURSUIT Plus and SQUADRON for soybeans, PROWL (marketed as STOMP outside the United States) for soybeans, cotton, corn, cereals, tobacco and vegetables, ARSENAL for vegetation control, and ASSERT for wheat and barley; insecticides, such as COUNTER and THIMET; plant growth regulators, such as CYCOCEL; animal feed supplements and health products, such as AUREOMYCIN; and, outside of the United States, AVOTAN, CYDECTIN and CYGRO, and animal vaccines. In the fourth quarter of 1993, Cyanamid acquired the crop protection businesses outside of North America of the Royal-Dutch Shell Companies. The acquisition included all of the Shell Companies' crop protection products, including insecticides, such as TORQUE, FASTAC, RIPCORD and CASCADE; fungicides, such as DELAN and ACROBAT; and animal health products. It also included a biosciences research center at Schwabenheim, Germany; a major formulations facility in Genay, France; and other formulations sites around the world. Also in the fourth quarter of 1993, Cyanamid acquired Arthur Webster Pty. Ltd., a privately-held Australian veterinary biologicals company to complement its previous acquisitions of Langford Laboratories and Laboratories Sobrino, S.A. Webster manufactures vaccine products at its bacterial and viral vaccine manufacturing facilities in Sydney, Australia. In recent years, operating earnings of the Agricultural Group have been concentrated in the first half of the year. The acquisitions in 1993 are not expected to result in any material change to this concentration. The sales of imidazolinone herbicide products in the aggregate accounted for approximately 16.1% of the sales of Cyanamid in 1993, and 12.9% in 1992 and 11.9% in 1991, restated to exclude sales of the chemicals business. INTERNATIONAL OPERATIONS AND EXPORT SALES Cyanamid products are produced or marketed in approximately 135 countries. United States export sales were $185.4 million in 1993, $178.5 million in 1992, and $164.8 million in 1991. International operations (exclusive of United States export sales) accounted for approximately 39.8% in 1993, 41.7% in 1992 and 42.0% in 1991 of net sales to unaffiliated customers. Because Cyanamid experienced an operating loss of $51.6 million in 1993 due to one-time, pre-tax charges relating to the Immunex acquisition and the restructuring program (see Note 3 to the Consolidated Financial Statements in the Shareholders Report), the calculation of the percentage of operating earnings attributed to international operations ($206.5 million) was not meaningful. International operations accounted for approximately 50.7% and 51.5%, respectively, of operating earnings in 1992 and 1991. International operations are subject to various risks which are not present in domestic operations, including political instability, the possibility of expropriation, restrictions on royalties, dividends and currency remittances, instability of foreign currencies, requirements for governmental approvals for new ventures and local participation in operations such as local equity ownership and workers' councils, and difficulty in obtaining financing for export sales particularly into countries of the former Soviet Union and Eastern Europe. Cyanamid is organizing two joint ventures with Chinese nationals for the manufacture of medical products (mainly vitamins) and animal feed supplements. Special risks in doing business with China arise from current debates under most favored nation trading status under U.S. Trade Laws. DISTRIBUTION Business Group Principal Direct Customers Medical Wholesale and retail drug, food, health and beauty aid and mass merchandiser outlets, managed health care companies, hospitals, physicians, governmental agencies and ambulatory surgery centers. Agricultural Manufacturers of finished products, whole- salers, retailers, farmers and governmental agencies. RESEARCH, PATENTS AND TRADEMARKS Cyanamid maintains 17 research laboratories, located in the United States, the United Kingdom, Germany, France, Australia, Canada, Japan, Italy, Brazil, Spain and the Philippines. Costs for research and process development in 1993, 1992 and 1991 totaled approximately $595.6 million, $530.7 million and $456.2 million, respectively. Cyanamid owns or is licensed under many patents and trademarks for a variety of products and processes. Cyanamid's important imidazolinone herbicide products (including SCEPTER and PURSUIT) are covered by composition of matter and process patents. Many of Cyanamid's important medical products (including ORIMUNE poliomyelitis vaccine) are not covered by composition of matter patents and hence are at greater risk from generic competition than those products which are so covered. Cyanamid believes that in the aggregate its rights under patents, trademarks, and licenses are significant to its operations, but that no single patent, trademark or license, or any group thereof, is individually material to Cyanamid, other than the patents covering the imidazolinone herbicides. EMPLOYEES As of December 31, 1993, Cyanamid had approximately 26,550 employees worldwide, of whom approximately 27% are hourly paid. GOVERNMENT REGULATION Regulation of Products. In the United States, the manufacture and sale of medical products for human or animal use are regulated by the Food and Drug Administration ("FDA"). Cyanamid regularly has numerous applications for pharmaceutical products, medical devices, animal health products and animal feed supplements pending before the FDA. Most applications include results of stringent and costly testing procedures. As a result of the governmental investigations relating to CYGRO coccidiostat combinations (see Item 3) FDA review of Cyanamid's animal health products has been subject to the FDA's fraud policy, and the FDA has generally refused to review any of Cyanamid's animal health applications. With the Justice Department investigation now completed, Cyanamid anticipates being able to commence procedures with the FDA designed to remove Cyanamid from the fraud policy. Cyanamid's human pharmaceutical and vaccine businesses have not been affected by this matter. The FDA is continuing to consider possible restriction on the use of sulfamethazine additives (which are sold by Cyanamid in combination with penicillin and tetracycline additives) in animal feed. Reimbursement of expenditures for drugs and medical devices in state and federally funded programs is regulated by state and federal authorities. The federal Vaccine For Children entitlement program signed into law in 1993 as part of the Omnibus Budget Reconciliation Act ("OBRA") is expected to have an adverse effect on the sales and earnings of the vaccines business beginning in the fourth quarter of 1994 because states will be able to purchase vaccines at federal vaccine prices. In addition, increases in the federal vaccine prices will be limited to increases in the Consumer Price Index. OBRA also included provisions which reduced the federal income tax benefits related to manufacturing activities in Puerto Rico. The reduction in these Puerto Rico tax benefits will have an unfavorable impact on Cyanamid's future results of operations. The Clinton administration and certain members of Congress have introduced legislation including various forms of price regulation which may, if enacted into law, have a significant impact on the health care industry. In addition, proposals related to health care alliances, federally mandated spending restrictions, creation of a Medicare rebate program covering prescription drugs, and various tax-law changes, if enacted, may have significant impact on the industry. Cyanamid cannot predict what health care reform measures will be implemented or the impact of any such measures on Cyanamid's future results of operations and cost of doing business. In the United States, the manufacture and sale of pesticides are regulated by the Environmental Protection Agency ("EPA"). Cyanamid regularly has numerous applications for pesticides pending before the EPA. Most applications include results of stringent and costly testing procedures. No new pesticide, and no existing pesticide for a new use, may be manufactured, processed or used without prior notice to the EPA. The EPA advised Cyanamid that a Special Review under the Federal Fungicide, Insecticide and Rodenticide Act may be initiated for two products, COUNTER terbufos and THIMET phorate, primarily on the basis of suspected avian risk. A Special Review proceeding could ultimately result in the cancellation of EPA registrations for both products. Outside the United States, medical products for human or animal use and agricultural chemicals are regulated by various agencies, often by standards which differ from those in the United States. In addition, pharmaceutical prices are controlled in many countries, and many countries such as Italy and Germany are increasingly imposing reimbursement limitations. Environmental Matters. Federal, state and foreign regulations impose stringent requirements for the control and abatement of air and water pollutants and the manufacture, transportation, storage, labeling, handling and disposal of substances designated hazardous. Cyanamid is and has been involved in legal and regulatory proceedings relating to the investigation and cleanup of sites (both its own and third party sites) where hazardous substances have been disposed. In connection with the spin-off of Cytec, Cytec has assumed the environmental liabilities relating to the chemicals businesses, except for the former chemical business site at Bound Brook. This assumption is not binding on third parties, and if Cytec were unable to satisfy these liabilities, they would, in the absence of other circumstances, be enforceable against Cyanamid. For information about pending environmental litigation, see Item 3, "Legal Proceedings". Cyanamid is also conducting, and may in the future be required to conduct, cleanups of its U.S. operating sites, pursuant to the terms of permits required for the sites and other statutes and regulations relating to hazardous substances. Cyanamid has environmental cleanups planned or in progress at several sites outside the United States including the Genay, France formulations facility purchased from Shell. Capital and operating expenditures for environmental protection in 1993 were approximately $7.5 million and $39.4 million, respectively. Capital expenditures for environmental control facilities in 1994 are estimated to be about $19.9 million. Estimates of capital expenditures for environmental control facilities for 1995 have not yet been completed. Item 2. Item 2. Properties. Cyanamid operates approximately 58 manufacturing, research and distribution facilities throughout the world. Cyanamid adjusts as it deems prudent the productive capacity of its manufacturing facilities. Capital spending, exclusive of acquisitions, in 1993, 1992 and 1991 was approximately $305.5 million, $311.1 million, and $300.2 million, respectively. In 1994, all planned capital expenditures are intended either to provide necessary capacity, to improve the efficiency of production units, to modernize or replace older facilities or to install equipment for protection of the environment. Some of the important United States facilities (all of which are owned by Cyanamid, except as noted), and the business groups served by such facilities, are: Bothell, Washington Medical (Immunex) Bound Brook, New Jersey Medical Carolina, Puerto Rico Medical Clearwater, Florida Medical Danbury, Connecticut Medical Hannibal, Missouri Agricultural Manati, Puerto Rico Medical, Agricultural Mansfield, Massachusetts (leased) Medical Pearl River, New York Medical, Agricultural Princeton, New Jersey Agricultural Sanford, North Carolina Medical Seattle, Washington Medical (Immunex) St. Louis, Missouri Medical Wayne, New Jersey Corporate Headquarters West Henrietta, New York Medical Willow Island, West Virginia Agricultural (leased) Outside the United States, Cyanamid's principal manufacturing facilities are located in Argentina, Australia, Brazil, Canada, France, Germany, Great Britain, Italy, Mexico, Republic of Korea, Spain, Taiwan and Venezuela. Item 3. Item 3. Legal Proceedings. Deductible amounts under Cyanamid's liability insurance coverage (particularly product and environmental liability) are such that Cyanamid must regard itself, for practical purposes, as self-insured with respect to most events. Cyanamid has a self-insurance program which provides reserves for costs based on past claims experience. Cyanamid and its subsidiaries are parties to numerous suits and claims arising out of the conduct of business, many of which involve very large damage claims, including claims for punitive damages. Included among such suits, as of March 30, 1994, are 22 involving personal injury or death allegedly occurring in connection with administration of Cyanamid's DTP (diphtheria-tetanus-pertussis) and oral polio vaccines. In 1990, Cyanamid's supplier of MAXZIDE triamterene/ hydrochlorothiazide filed suit against Cyanamid alleging breach of a 1984 exclusive licensing agreement and seeking damages and rights to the MAXZIDE trademarks and trade dress owned by Cyanamid. After a trial on the merits in Federal District Court, a jury rejected the supplier's claims. Plaintiff's time to appeal has not expired. In 1991, a suit was filed against Cyanamid alleging patent infringement by Cyanamid in the sale of HibTITER Haemophilus b conjugate vaccine in the United States and seeking damages. After trial on the merits, a district court held that the HibTITER vaccine did not infringe the patent claims cited by the plaintiffs and that the cited claims were invalid. The Court of Appeals for the Federal Circuit on October 6, 1993, affirmed the District Court's holding that the cited patent claims were not infringed. Plaintiffs filed a Petition for a Writ of Certiorari in the Supreme Court of the United States on March 7, 1994, which is pending. Early in 1994, Cyanamid pleaded guilty to a record keeping misdemeanor and paid a small fine related to allegations that a company employee had manipulated data related to CYGRO coccidiostat in combination with other products. The Cyanamid employee involved has been named in an Information by the government in the District of Maryland which charges a similar offense. The Federal Trade Commission has subpoenaed information concerning (i) Cyanamid's opposition to a petition by another company to the FDA to reclassify sutures and a patent infringement lawsuit against that company, (ii) sales of childhood vaccines to governmental purchasers, and (iii) prices charged for certain agricultural products. Cyanamid has been informally advised by the Federal Trade Commission that it has closed its investigation relating to childhood vaccines. Cyanamid has been named as one of many defendant pharmaceutical manufacturers and distributors in a number of federal and state civil antitrust suits alleging that the defendants conspired to discriminate against retail druggists by providing lower prices to mail order pharmacies, health maintenance organizations and similar purchasers. As of December 31, 1993, Cyanamid was a party to, or otherwise involved in, legal proceedings directed at the cleanup of 39 Superfund sites, including the Bound Brook site. As of March 30, 1994, the number of Superfund sites is 40. These 40 sites include certain sites for which Cytec and Cyanamid have agreed to share responsibility. See Note 2 to the Consolidated Financial Statements in the Shareholders Report. In many cases, future environmental related expenditures cannot be quantified with a reasonable degree of accuracy. It is Cyanamid's policy to accrue environmental cleanup costs if it is probable that a liability has been incurred and an amount is reasonably estimable. As assessments and cleanups proceed, these liabilities are reviewed periodically and adjusted as additional information becomes available. Environmental liabilities are inherently unpredictable. The liabilities can change substantially due to such factors as additional information on the nature or extent of contamination, methods of remediation required, and other actions by governmental agencies or private parties. The aggregate environmental related accruals were $187.3 and $120.4 at December 31, 1993, and 1992, respectively. The increase in the accrual from 1992 to 1993 relates primarily to the Bound Brook facility and results from the determination of a method and a cost for remediating three lagoons at the Bound Brook site. The cost of cleanups for which Cyanamid remains primarily liable may be in excess of current environmental related accruals. All accruals have been recorded without giving effect to any possible future insurance proceeds. Insurance coverage of various environmental matters are currently being litigated but potential recoveries, if any, are unknown at this time. Cash expenditures often lag by a number of years the period in which an accrual is recorded. While it is not feasible to predict the outcome of all pending suits and claims, based on the most recent review by management of these matters, management is of the opinion that their ultimate disposition will not have a material adverse effect upon the consolidated financial position of Cyanamid. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matter was submitted during the fourth quarter of Cyanamid's fiscal year 1993 to a vote of security holders. Item 10 (in part). Executive Officers of the Registrant. Year first elected Name Position to present office Age Albert J. Costello Director (1990), Chairman 1993 58 of the Board (1993), Chief Executive Officer (1993) and Chairman of the Executive Committee Frank V. AtLee Director (1990), President 1993 53 (1993), Chairman of Cyanamid International, and Member of the Executive Committee David R. Bethune Group Vice President and 1992 53 Member of the Executive Committee David Lilley Group Vice President and 1992 47 Member of the Executive Committee William J. Murray Group Vice President and 1992 49 Member of the Executive Committee Larry Ellberger Vice President 1992 46 Terence D. Martin Vice President, 1991 50 Treasurer (1994), Chief Financial Officer (1991), Chairman of the Committee on Investment of Pension Funds and Member of the Executive Committee Joseph S. McAuliffe Vice President and 1993 54 General Counsel William A. Stiller Vice President 1991 42 Paul W. Wood Vice President, External 1990 49 Affairs All of the executive officers of Cyanamid except Mr. Wood have held positions involving executive or management functions with Cyanamid for at least the past five years. Mr. Wood has been employed at Cyanamid since April 1990. Prior thereto, he had been Vice President, Investor Relations, of Squibb Corporation and previously Director, Investor Relations, of Upjohn Company. The Executive Committee is not a committee of Cyanamid's Board of Directors. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters. "Financial Review-Common Stock and Dividends Paid" in the Shareholders Report on page 33 is incorporated by reference. Item 6. Item 6. Selected Financial Data. "Five-Year Summary" in the Shareholders Report on page 53 is incorporated by reference. The selected financial data should be read in conjunction with the consolidated financial statements. See Item 8. 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" in the Shareholders Report on pages 54 through 58 is incorporated by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The consolidated financial statements on pages 35 through 51, together with the report thereon of KPMG Peat Marwick dated February 8, 1994, on page 52, and "Financial Review-Quarterly Results" on page 34, of the Shareholders Report, are 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 (in part). Directors and Executive Officers of the Registrant. The information set forth on pages 2 through 6 (exclusive of descriptions of committees of the Board of Directors) under "Election of Directors" in the Proxy Statement for the Annual Meeting of Shareholders, dated March 8, 1994, (the "Proxy Statement") is incorporated by reference. The information incorporated by reference hereby is also responsive to the information required by Item 12. See also Item 10 (in part) in Part I of this Report. Item 11. Item 11. Executive Compensation. The information on pages 14 through 29 of the Proxy Statement, under "Executive Compensation" and "Directors' Compensation", is incorporated by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. See Item 10. 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 (Incorporated by reference. See Item 8.) Independent Auditors' Report Consolidated Statements of Operations Consolidated Statements of Earnings Employed in the Business Consolidated Balance Sheets Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements 2. Financial statement schedules. Independent Auditors' Report Financial Statement Schedules for each of the years in the three-year period ended December 31, 1993: V - Plants, equipment and facilities VI - Accumulated depreciation of plants, equipment and facilities VIII - Valuation and qualifying accounts IX - Short-term borrowings All other schedules have been omitted because they are not applicable or the information required is shown in the consolidated financial statements or notes thereto. 3. Exhibits. (3) A - Restated Articles of Incorporation of Registrant as amended through April 20, 1987 are incorporated by reference to Exhibit (3) A of Registrant's Annual Report on Form 10-K for the year ended December 31, 1987. B - By-Laws of Registrant as amended through March 10, 1987 are incorporated by reference to Exhibit (3)D of Registrant's Annual Report on Form 10-K for the year ended December 31, 1986. (4) A - Form of Rights Agreement, dated as of March 10, 1986, between American Cyanamid Company and The Chase Manhattan Bank, N.A., which includes as Exhibit A thereto the Form of Certificate of Designation, Rights and Preferences of Series A Junior Participating Preferred Stock of Registrant, and as Exhibit B thereto the Form of Rights Certificate, is incorporated by reference to Exhibit 1 to the Preferred Stock Purchase Rights Registration Statement on Form 8-A filed by Registrant on March 18, 1986. B - Amendment No. 1, dated April 30, 1986 to Rights Agreement is incorporated by reference to Form 8 filed by Registrant on May 1, 1986. C - Amendment No. 2, dated May 18, 1987 to Rights Agreement is incorporated by reference to Form 8 filed by Registrant on May 19, 1987. D - Letter Agreement, dated March 2, 1992, appointing Mellon Bank, N.A. as successor Rights Agent under the Rights Agreement is incorporated by reference to Exhibit (4)B of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. E - See Exhibits (3)A, (3)B, (4)A, (4)B, (4)C and (4)D for rights of holders of Common Stock. F - No instrument defining the rights of the holders of any long-term debt of Registrant or any subsidiary authorizes issuance of debt securities of 10% or more of the total assets of the Registrant and its subsidiaries on a consolidated basis. Accordingly, Registrant agrees, in lieu of filing any such instruments, to provide copies thereof to the Securities and Exchange Commission upon its request, as contemplated by paragraph (b) (4) (iii) of Item 601 of Regulation S-K. (10) A - Executive Compensation Plans and Arrangements 1 1977 Employees Stock Plan of Registrant, as amended through August 20, 1985, is incorporated by reference to Exhibit (10)B of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 2 Amendments to the 1977 Employees Stock Plan of Registrant, adopted as of April 21, 1987 and April 19, 1988, are incorporated by reference to Exhibit (10)C of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 3 Amendment to the 1977 Employees Stock Plan of Registrant, adopted as of April 17, 1989, is incorporated by reference to Exhibit (10)C of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 4 Amendment to the 1977 Employees Stock Plan of Registrant, adopted as of April 20, 1992 is incorporated by reference to Exhibit (10)B of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. 5 1984 Employees Stock Plan of Registrant, as amended through April 17, 1990, is incorporated by reference to Exhibit (10)D of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 6 Amendment to the 1984 Employees Stock Plan of Registrant, adopted as of April 20, 1992, is incorporated by reference to Exhibit (10)C of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. 7 1992 Employees Stock Plan of Registrant, adopted as of April 20, 1992, is incorporated by reference to Exhibit (10)A of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. 8 Incentive Compensation Plan of Registrant, as amended through December 21, 1993. 9 Form of Agreement under the Incentive Compensation Plan of Registrant, adopted as of August 20, 1985, is incorporated by reference to Exhibit (10)G of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 10 Form of Amendment to Agreement under the Incentive Compensation Plan of Registrant, adopted as of April 19, 1988, is incorporated by reference to Exhibit (10)H of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 11 Executive Income Continuity Plan of Registrant, as amended through August 16, 1993. 12 Amendment to the 1977 Employees Stock Plan, the 1984 Employees Stock Plan, the Executive Income Continuity Plan, the Supplemental Employees Retirement Plan and the Agreements under the Incentive Compensation Plan (Exhibits (10)F and (10)G hereto) of Registrant, adopted as of December 20, 1988, is incorporated by reference to Exhibit (10)J of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 13 Supplemental Employees Retirement Plan of Registrant, as amended through February 21, 1989, is incorporated by reference to Exhibit (10)K of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 14 Supplemental Employees Retirement Plan Trust Agreement, between the Registrant and Morgan Guaranty Trust Company of New York, dated September 19, 1989, is incorporated by reference to Exhibit (10)K of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 15 ERISA Excess Retirement Plan of Registrant, adopted as of February 21, 1989, is incorporated by reference to Exhibit (10)N of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 16 ERISA Excess Retirement Plan Trust Agreement, between the Registrant and Morgan Guaranty Trust Company of New York, dated September 19, 1989, is incorporated by reference to Exhibit (10)M of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 17 Compensation Taxation Equalization Plan of Registrant, adopted as of February 21, 1989, is incorporated by reference to Exhibit (10)P of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 18 Restricted and Deferred Stock Plan for Non-Employee Directors of Registrant, adopted as of April 18, 1988, is incorporated by reference to Exhibit (10)Q of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 19 Amendment to the Restricted and Deferred Stock Plan for Non-Employee Directors of Registrant, adopted as of April 20, 1992, is incorporated by reference to Exhibit (10)E of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. 20 Key Management Group Personal Excess Liability Insurance Policy made available by the Registrant to key management personnel, is incorporated by reference to Exhibit (10)R of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 21 Form of agreement for deferral of directors' compensation is incorporated by reference to Exhibit (10)E to Registrant's Annual Report on Form 10-K for the year ended December 31, 1980. 22 Form of minimum pension guarantee given to certain executive officers is incorporated by reference to Exhibit (10)M of Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 23 Non-Employee Directors Retirement Plan, adopted as of April 18, 1989 and amended as of January 1, 1991, is incorporated by reference to Exhibit (10)S of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 24 Non-Employee Directors Retirement Plan Trust Agreement, between the Registrant and Morgan Guaranty Trust Company of New York, dated September 19, 1989, is incorporated by reference to Exhibit (10)T of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 25 Supplemental Retirement Plan for Existing Retirees, adopted as of August 16, 1988, is incorporated by reference to Exhibit (10)U of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 26 Form of Trust Agreement to the Supplemental Retirement Plan for Existing Retirees, adopted as of August 16, 1988, is incorporated by reference to Exhibit (10)V of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 27 Employment Agreement of T. D. Martin, signed October 17, 1988. (13) Annual Report to Shareholders for the year ended December 31, 1993. Except for those portions thereof which are expressly incorporated by reference in this Annual Report on Form 10-K, such Annual Report to Shareholders is furnished for the information of the Commission and is not deemed "filed" as part of this Annual Report on Form 10-K. (21) Subsidiaries of Registrant. (23) Consent of KPMG Peat Marwick. (24) A-K Powers of Attorney of F. V. AtLee, D. M. Culver, A. R. Dragone, R. Halstead, A. J. Levine, P. W. MacAvoy, V. T. Marchesi, T. D. Martin, G. J. Sella, Jr., M. Tanenbaum and A. Wexler. (b) No reports on Form 8-K were filed during the last quarter of the period covered by this report. Undertaking 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 Nos. 2-61193, 2-76933, 2-95992, 33-34218, 33-50242 and 33-60140. 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 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 by the undersigned, thereunto duly authorized. AMERICAN CYANAMID COMPANY (Registrant) DATE: March 30, 1994 By A. J. Costello A. J. Costello Chairman 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. DATE: March 30, 1994 A. J. Costello A. J. Costello Chairman and Chief Executive Officer (Principal Executive Officer and Director) F. V. AtLee, Director D. M. Culver, Director A. R. Dragone, Director DATE: March 30, 1994 R. Halstead, Director By R. T. Ritter (Attorney-in A. J. Levine, Director Fact) P. W. MacAvoy, Director V. T. Marchesi, Director T. D. Martin, Vice President (Principal Financial Officer) R. T. Ritter, Controller (Principal Accounting Officer) G. J. Sella, Jr., Director M. Tanenbaum, Director A. Wexler, Director Item 14 (a) 2 INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders American Cyanamid Company: Under date of February 8, 1994, we reported on the consolidated balance sheets of American Cyanamid Company and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, earnings employed in the business, 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 Item 14(a)2 of the accompanying Form 10- K. 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 1 to the consolidated financial statements, the company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", and No. 109, "Accounting for Income Taxes", effective January 1, 1993. KPMG Peat Marwick KPMG Peat Marwick Short Hills, New Jersey February 8, 1994 Item 14 (a) 2 PAGE Item 14 (a) 2 Item 14 (a) 2 PAGE UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) / x / ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the fiscal year ended December 31, 1993 OR / /TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the Transition period from to Commission file number 1-3426 AMERICAN CYANAMID COMPANY (Exact name of registrant as specified in its charter) Maine 13-0430890 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) One Cyanamid Plaza Wayne, New Jersey (Address of principal executive offices) 07470 (Zip Code) Registrant's telephone number, including area code (201) 831-2000 Securities registered pursuant to Section 12(b) of the Act: Name of each exchange on Title of each class which registered Common Stock, par value $5 per share New York Stock Exchange 7 3/8% Sinking Fund Debentures Due 2001 New York Stock Exchange 8 3/8% Sinking Fund Debentures Due 2006 New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None (Title of Class) EXHIBITS INDEX TO EXHIBITS (3) A - Restated Articles of Incorporation of Registrant as amended through April 20, 1987 are incorporated by reference to Exhibit (3) A of Registrant's Annual Report on Form 10-K for the year ended December 31, 1987. B - By-Laws of Registrant as amended through March 10, 1987 are incorporated by reference to Exhibit (3)D of Registrant's Annual Report on Form 10-K for the year ended December 31, 1986. (4) A - Form of Rights Agreement, dated as of March 10, 1986, between American Cyanamid Company and The Chase Manhattan Bank, N.A., which includes as Exhibit A thereto the Form of Certificate of Designation, Rights and Preferences of Series A Junior Participating Preferred Stock of Registrant, and as Exhibit B thereto the Form of Rights Certificate, is incorporated by reference to Exhibit 1 to the Preferred Stock Purchase Rights Registration Statement on Form 8-A filed by Registrant on March 18, 1986. B - Amendment No. 1, dated April 30, 1986 to Rights Agreement is incorporated by reference to Form 8 filed by Registrant on May 1, 1986. C - Amendment No. 2, dated May 18, 1987 to Rights Agreement is incorporated by reference to Form 8 filed by Registrant on May 19, 1987. D - Letter Agreement, dated March 2, 1992, appointing Mellon Bank, N.A. as successor Rights Agent under the Rights Agreement is incorporated by reference to Exhibit (4)B of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. E - See Exhibits (3)A, (3)B, (4)A, (4)B, (4)C and (4)D for rights of holders of Common Stock. F - No instrument defining the rights of the holders of any long-term debt of Registrant or any subsidiary authorizes issuance of debt securities of 10% or more of the total assets of the Registrant and its subsidiaries on a consolidated basis. Accordingly, Registrant agrees, in lieu of filing any such instruments, to provide copies thereof to the Securities and Exchange Commission upon its request, as contemplated by paragraph (b) (4) (iii) of Item 601 of Regulation S-K. (10) A - Executive Compensation Plans and Arrangements 1 1977 Employees Stock Plan of Registrant, as amended through August 20, 1985, is incorporated by reference to Exhibit (10)B of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 2 Amendments to the 1977 Employees Stock Plan of Registrant, adopted as of April 21, 1987 and April 19, 1988, are incorporated by reference to Exhibit (10)C of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 3 Amendment to the 1977 Employees Stock Plan of Registrant, adopted as of April 17, 1989, is incorporated by reference to Exhibit (10)C of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 4 Amendment to the 1977 Employees Stock Plan of Registrant, adopted as of April 20, 1992 is incorporated by reference to Exhibit (10)B of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. 5 1984 Employees Stock Plan of Registrant, as amended through April 17, 1990, is incorporated by reference to Exhibit (10)D of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 6 Amendment to the 1984 Employees Stock Plan of Registrant, adopted as of April 20, 1992, is incorporated by reference to Exhibit (10)C of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. 7 1992 Employees Stock Plan of Registrant, adopted as of April 20, 1992, is incorporated by reference to Exhibit (10)A of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. 8 Incentive Compensation Plan of Registrant, as amended through December 21, 1993. 9 Form of Agreement under the Incentive Compensation Plan of Registrant, adopted as of August 20, 1985, is incorporated by reference to Exhibit (10)G of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 10 Form of Amendment to Agreement under the Incentive Compensation Plan of Registrant, adopted as of April 19, 1988, is incorporated by reference to Exhibit (10)H of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 11 Executive Income Continuity Plan of Registrant, as amended through August 16, 1993. 12 Amendment to the 1977 Employees Stock Plan, the 1984 Employees Stock Plan, the Executive Income Continuity Plan, the Supplemental Employees Retirement Plan and the Agreements under the Incentive Compensation Plan (Exhibits (10)F and (10)G hereto) of Registrant, adopted as of December 20, 1988, is incorporated by reference to Exhibit (10)J of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 13 Supplemental Employees Retirement Plan of Registrant, as amended through February 21, 1989, is incorporated by reference to Exhibit (10)K of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 14 Supplemental Employees Retirement Plan Trust Agreement, between the Registrant and Morgan Guaranty Trust Company of New York, dated September 19, 1989, is incorporated by reference to Exhibit (10)K of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 15 ERISA Excess Retirement Plan of Registrant, adopted as of February 21, 1989, is incorporated by reference to Exhibit (10)N of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 16 ERISA Excess Retirement Plan Trust Agreement, between the Registrant and Morgan Guaranty Trust Company of New York, dated September 19, 1989, is incorporated by reference to Exhibit (10)M of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 17 Compensation Taxation Equalization Plan of Registrant, adopted as of February 21, 1989, is incorporated by reference to Exhibit (10)P of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 18 Restricted and Deferred Stock Plan for Non-Employee Directors of Registrant, adopted as of April 18, 1988, is incorporated by reference to Exhibit (10)Q of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 19 Amendment to the Restricted and Deferred Stock Plan for Non-Employee Directors of Registrant, adopted as of April 20, 1992, is incorporated by reference to Exhibit (10)E of Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. 20 Key Management Group Personal Excess Liability Insurance Policy made available by the Registrant to key management personnel, is incorporated by reference to Exhibit (10)R of Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. 21 Form of agreement for deferral of directors' compensation is incorporated by reference to Exhibit (10)E to Registrant's Annual Report on Form 10-K for the year ended December 31, 1980. 22 Form of minimum pension guarantee given to certain executive officers is incorporated by reference to Exhibit (10)M of Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 23 Non-Employee Directors Retirement Plan, adopted as of April 18, 1989 and amended as of January 1, 1991, is incorporated by reference to Exhibit (10)S of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 24 Non-Employee Directors Retirement Plan Trust Agreement, between the Registrant and Morgan Guaranty Trust Company of New York, dated September 19, 1989, is incorporated by reference to Exhibit (10)T of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 25 Supplemental Retirement Plan for Existing Retirees, adopted as of August 16, 1988, is incorporated by reference to Exhibit (10)U of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 26 Form of Trust Agreement to the Supplemental Retirement Plan for Existing Retirees, adopted as of August 16, 1988, is incorporated by reference to Exhibit (10)V of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 27 Employment Agreement of T. D. Martin, signed October 17, 1988. (13) Annual Report to Shareholders for the year ended December 31, 1993. Except for those portions thereof which are expressly incorporated by reference in this Annual Report on Form 10-K, such Annual Report to Shareholders is furnished for the information of the Commission and is not deemed "filed" as part of this Annual Report on Form 10-K. (21) Subsidiaries of Registrant. (23) Consent of KPMG Peat Marwick. (24) A-K Powers of Attorney of F. V. AtLee, D. M. Culver, A. R. Dragone, R. Halstead, A. J. Levine, P. W. MacAvoy, V. T. Marchesi, T. D. Martin, G. J. Sella, Jr., M. Tanenbaum and A. Wexler.

720695_1993.txt

720695_1993

1993

720695

ITEM 1. BUSINESS GENERAL Pathe Communications Corporation (the "Company") is a Delaware corporation with no operating assets or sources of operating income and total liabilities exceeding $269,000,000. The Company is wholly dependent upon Credit Lyonnais Bank Nederland N.V., a Dutch banking institution ("CLBN"), for all capital needed to fund its on-going cash requirements. As used herein, the terms "Registrant" and "Pathe" refer to the Company unless the context indicates otherwise. The Company has its principal executive offices at 10 East 40th Street, New York, New York 10016, telephone (212) 545-1900. During the first four months of fiscal year 1992, the Company was engaged in the financing, production and worldwide distribution of theatrical motion pictures and television programming, and the operation of motion picture theaters in the United Kingdom (the "U.K."), the Netherlands and Denmark. The Company's business was conducted through its principal subsidiary, Metro-Goldwyn-Mayer Inc. ("MGM"), previously known as MGM-Pathe Communications Co. ("MGM-Pathe"). However, as described below, the Company's ownership of 98.5% of the common stock of MGM, which constituted substantial- ly all of the Company's assets, was sold through a foreclosure auction due to the Company's default on its then existing indebtedness. As a result, the Company no longer had any operating assets or sources of income. The Company's predecessor-in-interest, The Cannon Group, Incorporated ("Cannon") was incorporated in New York on October 23, 1967. Subsequently, Cannon effected a merger into the Company, which was effective under New York law on November 25, 1985. In May 1992, the Company took additional actions in Delaware to correct certain deficiencies under Delaware law with respect to such merger. In 1987, in connection with a financial restructuring of the Company, Giancarlo Parretti or certain of his affiliates became the largest stockholders of the Company, assuming control of the Company. In 1988, Florio Fiorini or certain of his affiliates acquired equity ownership in the Company. Mr. Fiorini was then elected Chairman of the Board and exercised joint control with Mr. Parretti in managing the affairs of the Company. (See Item 1 "Business--Changes in Corporate Control".) On November 1, 1990, the Company acquired MGM/UA Communications Co. ("MGM/UA") by means of a merger (the "Merger") of a wholly-owned subsidiary of the Company into MGM/UA. MGM/UA, the surviving corporation in the Merger, became a wholly-owned subsidiary of the Company and changed its name to MGM-Pathe Communications Co. Immediately thereafter, pursuant to an agree- ment entered into in connection with the Merger, MGM-Pathe acquired all of the outstanding capital stock of Pathe Entertainment, Inc. ("PEI") and Cannon Entertainment, Inc. ("CEI"), the two principal subsidiaries of the Company, and concurrently paid off all existing indebtedness of PEI and CEI to the Company. As a result of the restructuring described above, the Company became a holding company operating exclusively through its subsidiaries. Prior to the foreclosure on the Company's shares of MGM common stock described below, the Company's business activities consisted of two business segments, filmed entertainment and theater operations. Since such foreclosure, the Company has engaged in no ongoing business operations and cannot predict whether it will do so in the future. CLBN has to date continued to make advances to the Company to permit the Company to satisfy its various expenditure requirements and debt payment obligations; however, there can be no assurance that CLBN will continue to make such advances. (See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources".) As of May 5, 1992, immediately prior to the foreclosure and tender offer described below, the Company owed CLBN an aggregate amount of approxi- mately $140 million, all of which was in default and overdue and payable. Also as of such date, MGM-Pathe owed CLBN an aggregate amount of approxi- mately $568 million, which indebtedness was in default and all but approximately $145 million of which was payable on demand. At such time, CLBN had the power, in its absolute discretion, to decide whether to advance additional funds to the Company and/or to pursue various remedies available to it based upon the Company's default, which remedies included, among other things, foreclosure upon the MGM-Pathe shares, which constituted virtually all of the assets of the Company. As discussed below, CLBN foreclosed on the Company's MGM-Pathe shares and completed a tender offer for the outstanding and unencumbered shares of the Company's common stock and the then outstanding debt securities. CHANGES IN CORPORATE CONTROL - EXTRAORDINARY EVENTS As further described in the Form 10-K for fiscal 1991 of the Company and in Item 3 "Legal Proceedings", beginning in June 1991, the Company experienced a change in corporate control. As a result of this change, CLBN in its capacity as voting trustee of the Company's common stock acquired the power to designate all of the members of the Board of Directors of the Company. In April, 1991, in connection with the extension of credit by CLBN to the Company, Melia International N.V., a Netherlands corporation ("Melia") and certain of Melia's stockholders and subsidiaries including the Company, (i) guaranteed certain obligations of MGM to CLBN and (ii) pledged to CLBN all shares (including additional shares, if any, to be issued) of the Company and MGM, respectively, owned by such entities (pursuant to the "PCC Pledges" and "MGM Pledge", respectively) to secure all indebtedness owing by the Company, MGM, Melia and their affiliates to CLBN (the "Secured Obligations"), and (iii) placed all of the shares of the Company and MGM owned by such entities (including additional shares, if any, to be issued) under irrevocable voting trust agreements (the "PCC Voting Trusts" and the "MGM Voting Trust") in favor of CLBN. The shares covered by these pledge agreements and/or voting trust agreements represented approximately 89.3% of the outstanding common stock of Pathe and 98.5% of the outstanding common stock of MGM. Such voting trust agreements were initially held in escrow until CLBN broke such escrow as a result of certain actions by Mr. Parretti, the then Chairman of the Board of the Company. Upon breaking the escrow, CLBN exercised its voting powers by written consent pursuant to the MGM Voting Trust, and subsequently pursuant to the MGM Pledges, to remove Parretti and certain other then directors of MGM. The validity of the exercise of such voting rights was confirmed by the Court of Chancery for the State of Delaware in and for Newcastle County on December 30, 1991 (all such related litigation is herein referred to as the "MGM Proceedings"). On July 8, 1991, CLBN, exercising its voting rights pursuant to the PCC Pledges, acted by written consent to remove the directors of the Company. On March 23, 1992, a final order was entered by the Delaware Chancery Court stipulating that the Directors of the Company who had not resigned had been properly removed by CLBN's actions on July 8, 1991. On February 3, 1992, at a meeting of the newly-expanded Board of Directors of the Company, Messrs. Ladd and Stanfill were each elected Co-Chairman of the Board of Directors and Co-Chief Executive Officer of the Company, Charles R. Meeker was elected President and Treasurer of the Company and certain other new officers were elected. During the first quarter of 1992, the Company was in default on its indebtedness to CLBN, which indebtedness was secured by, among other collat- eral, all of the Company's shares of MGM common stock. At such time, CLBN had the power, in its absolute discretion, to decide whether to advance additional funds to the Company and/or to pursue various remedies available to it based upon the Company's default, which remedies included, among other things, foreclosure upon the MGM shares, which constituted virtually all of the assets of the Company. In exercising the remedies available to it, on April 16, 1992, CLBN commenced a foreclosure action (the "Foreclosure") with respect to the 98.5% of outstanding common stock of MGM owned by the Company (the "Company's MGM Shares"). On April 16, 1992, the Board met and formed a special committee (the "Special Committee"), to review, consider and evaluate the Foreclosure and its effect on the Company and its subsidiaries and to advise and make appropriate recommendations to the Board as to the Company's response to the Foreclosure. The Special Committee retained an independent financial adviser and independent legal counsel. In a letter dated April 17, 1992 to the Special Committee, CLBN indicated its belief that any attempt on the part of the Company or holders of the Company's equity and debt securities to forestall or delay the Foreclosure would be harmful to the interests of all parties. CLBN also expressed its willingness to negotiate with the Company with respect to certain benefits to be provided to the holders of the Company's equity and debt securities in connection with the Foreclosure, including by (i) providing credit support for a then to be determined portion of the principal and interest on (x) the then outstanding 12-3/8% Senior Subordinated Notes Due 1994 (the "12-3/8% Notes"), (y) the then outstanding 8-7/8% Convertible Senior Subordinated Debentures due April 15, 2001 (the "8-7/8% Debentures") and (z) the then outstanding 12-7/8% Senior Subordinated Debentures due April 15, 2001 (the "12-7/8% Debentures", and, collectively with the 12-3/8% Notes and the 8-7/8% Debentures, the "Company Bonds" or "Bonds") and (ii) making a tender offer for a then to be determined number, and at a then to be determined price per share, of the outstanding unencumbered shares of Company common stock. During the weeks of April 20, 1992 and April 27, 1992, the Special Committee, the Company, CLBN, certain holders of the Company Bonds, the trustees under the indentures pursuant to which such Bonds were issued and various financial and legal advisors negotiated with respect to the type of credit support to be provided for the Company Bonds. In these negotiations, the Company expressed a strong preference for a cash payment to the holders of its debt and equity securities. Following these negotiations between the Special Committee and representatives of CLBN, the Board of the Company met on May 1, 1992. The three directors of the Company affiliated with CLBN withdrew from the meeting prior to the presentation of the Special Committee. The Special Committee presented a draft of the Company Agreement (as defined below) and recommended that the Board approve the form of the Company Agreement. The remaining directors unanimously approved the recommendation of the Special Committee and, in view of the fact that three directors were employees of CLBN or Credit Lyonnais and that the remaining directors were all officers of the Company and also officers and employees of MGM, the Board decided to express no opinion with respect to any offer by CLBN for securities of the Company. By a letter dated May 1, 1992, by and between the Company and CLBN (the "Company Agreement"), the Company agreed to take no legal action to forestall or delay the Foreclosure, in consideration for which CLBN agreed to make a tender offer for up to 5,800,000 shares of the common stock of the Company, par value $0.01 (the "Shares") at $1.50 per Share, net to the Seller in cash (the "Equity Offer"), and for all of the Company Bonds, to fund certain past due interest on the Company's outstanding debt securities and to provide funding to enable the Company to satisfy its obligations with respect to interest on such debt securities, not owned by CLBN, through May 5, 1993. In connection with such offer, CLBN agreed to purchase the 12-3/8% Notes at $470 per $1,000 principal amount, the 12-7/8% Debentures at $470 per $1,000 principal amount and the 8-7/8% Debentures at $420 per $1,000 principal amount (collectively the "Debt Offers"). On May 5, 1992, CLBN and certain holders of certain Company Bonds (the "Holders") executed a Securities Purchase Agreement (the "Securities Purchase Agreement"), pursuant to which the Holders agreed to sell, and CLBN agreed to purchase, immediately following the Foreclosure, approximately $27 million in aggregate principal amount of such Company Bonds at the same price as under the Debt Offers. Additionally, the Holders agreed to tender any Company Bonds thereafter acquired by them until such time as the Debt Offers closed. On May 1, 1992, CLBN sold and assigned $483,489,000 of the Secured Obligations (the "Assigned Obligations") to MGM Holdings Corporation ("MGM Holdings"), a Delaware corporation and a wholly-owned subsidiary of Credit Lyonnais S.A. ("Credit Lyonnais"). The sale of the Company's MGM Shares at an auction sale (the "Auction") was held as scheduled on May 7, 1992, and MGM Holdings, as the only bidder, acquired ownership of the MGM Shares. In consideration for the MGM Shares, MGM Holdings bid-in the Assigned Obligations. Following the Foreclosure, on May 7, 1992, CLBN commenced the Equity Offer on the terms and subject to the conditions set forth in an Offer to Purchase and in the accompanying Letter of Transmittal (collectively, the "Equity Offer Documents") filed with the Securities and Exchange Commission (the "Commission") in a Schedule 13E-3 on May 7, 1992. In the Equity Offer, Shares which were subject to security interests, liens, pledges, encumbrances, mortgages, claims, hypothecations or voting trust arrangements (collectively, "Encumbrances") were not accepted for payment. Approximately 94% of the issued and outstanding shares of common stock of the Company were owned by Melia, Renta Inmobliara International B.V. ("Renta B.V."), Renta Corp. ("Renta Corp.", and collectively with Renta B.V., the "Rentas") and Comfinance S.A., and were subject to the PCC Pledge and PCC Voting Trusts. In addition, Viajes Melia S.A. ("Viajes"), an affiliate of Melia, owned approximately 0.7% of the shares of common stock of the Company, and were subject to a PCC Voting Trust in favor of CLBN. Since the Shares beneficially owned by Melia, the Rentas, Comfinance and Viajes were subject to Encumbrances in favor of CLBN, such Shares were not tendered in connection with the Equity Offer. The 5,800,000 Shares which CLBN offered to purchase through the Equity Offer constituted approximately 97% of the maximum number of Shares outstanding on May 1, 1992 which could qualify as Shares not subject to Encumbrances ("Unencumbered Shares"), and approximately 10% of the total number of Shares outstanding as of May 1, 1992 and approximately 5% of the aggregate number of such Shares and the Additional Shares, on such date. In conjunction with the Equity Offer, on May 8, 1992, CLBN commenced the Debt Offers to purchase all of the then outstanding Company Bonds at the purchase prices noted above, in each case net to the seller in cash upon the terms and subject to the conditions set forth in the Offer to Purchase and Consent Solicitations (the "Debt Offer Documents") relating to the respective Company Bonds. Consent Solicitations relating to the respective Company Bonds required affirmative consents (the "Consents") by the holders of at least a majority in principal amount of such Bonds outstanding under the respective Indentures to adopt certain amendments (the "Proposed Amendments") in the form of supplemental indentures to the res- pective Indentures for each of the 12-3/8% Notes, the 8-7/8% Debentures and the 12-7/8% Debentures (the "Supplemental Indentures"), as contemplated in the Debt Offer Documents. The Supplemental Indentures amended the Indentures so that (i) certain of the 12-7/8% Debentures and 8-7/8% Debentures (collectively, the "Debentures") previously acquired by the Company were to be used to satisfy any repayment obligation arising from the Company's failure to satisfy the minimum net worth covenant; (ii) any corporation into which the Company may merge or to which the Company may sell substantially all of its assets is no longer required to assume the obligations of the Company under the Indentures; (iii) any Debentures owned by CLBN will be counted in determining whether the holders of the required principal amount of Debentures have concurred in any direction, waiver or consent; and (iv) any Defaults (as defined in the Indentures) waivable under the Indentures are waived. As described above, pursuant to the Securities Purchase Agreement, holders of approximately 66% of the aggregate outstanding principal amount of the debt securities issued under the Indenture dated as of April 15, 1986 between the Company and Chemical Trust Company of California (formerly Manufacturers Hanover Trust Company of California and herein, "Chemical Trust"), under which both 8-7/8% Debentures and certain of the 12-7/8% Debentures were then outstanding (the "8-7/8% Debenture Indenture") and holders of approximately 55% of the debt securities issued under the Indenture dated as of April 15, 1986 between the Company and Chemical Trust under which certain of the 12-7/8% Debentures were then outstanding (the "12- 7/8% Debenture Indenture") consented to the Proposed Amendments to their respective Indentures. As a result of the Equity Offer, CLBN acquired 2,809,739 Shares of the Company. As a result of the Debt Offers, (a) $2,856,000 in aggregate principal amount of the 12-3/8% Notes, $625,000 in aggregate principal amount of the 8-7/8% Debentures and $5,898,000 in aggregate principal amount of the 12-7/8% Debentures (including $2,345,000 principal amount of those 12-7/8% Debentures previously converted from the originally issued 8-7/8% Debentures) were tendered and accepted in the Debt Offers and (b) together with the Consents received pursuant to the Securities Purchase Agreement, the total percentage of Consents received relating to the 12-3/8% Notes Indenture was 49.7%, the total percentage of Consents received relating to the 8-7/8% Debentures Indenture was 82.1% (such Consents consisting of Consents relating to both 8-7/8% Debentures and those 12-7/8% Debentures that were converted 8-7/8% Debentures and which were governed by the 8-7/8% Debenture Indenture) and the total percentage of Consents received relating to the 12-7/8% Debentures Indenture was 77.5%, in each case with respect to the total aggre- gate amount of Bonds outstanding under each respective Indenture. On May 29, 1992, as a result of the performance of the agreements in the Securities Purchase Agreement, the Company announced that it had received a sufficient number of Consents with respect to the 8-7/8% Debenture Indenture and 12-7/8% Debenture Indenture, and that Supplemental Indentures to each such Indenture had been executed. In July, 1992, an additional $100,000 in aggregate principal amount of 12-3/8% Notes were acquired by CLBN and in connection therewith Consents were received with respect to the 12-3/8% Note Indenture so that, together with Consents received previously, the total percentage of Consents received relating to the 12-3/8% Notes was 50.3% of the total outstanding. The Company is currently arranging for the execution of the Supplemental Indenture to the 12-3/8% Note Indenture. The effect of the Equity Offer was to cause the Shares to no longer be eligible for listing on the New York Stock Exchange (the "NYSE") and to be subject to termination of registration under the Securities and Exchange Act of 1934, as amended (the "Exchange Act"). Trading of the Company's common stock was suspended by the NYSE on July 13, 1992 pending application by the NYSE to the Commission to delist the Shares for failure to meet certain listing criteria. Such action was taken because the Company had fallen below the NYSE's continued listing criteria relating to (i) net tangible assets available to common stock together with three-year average net income and (ii) aggregate market value of publicly- held common stock. On August 28, 1992, the Commission, in response to the NYSE's application, issued an order removing the Company's common stock from listing and registration on the NYSE. As of March 18, 1994, there were 1,485 holders of record and approximately 3,191,936 Shares were held by stockholders other than officers, directors, and members of their immediate families and concentrated holdings of 10% or more. The Company is unable to predict at this time whether any public market will exist for the Company's remaining outstanding shares of common stock. The Company does not have any present plans that would result in the repurchase or redemption of its common stock or in the admission for trading of such stock on other exchanges or markets. The Company's stock continues to be subject to deregistration with the Commission if the Company has less than 300 stockholders of record, in which event the Company would no longer file public reports with the Commission. On August 5, 1992, Mr. Meeker was elected President and Treasurer of the Company. Effective October 6, 1992, Alan Ladd, Jr. and Dennis Stanfill each resigned as Co-Chairman of the Company and Rene-Claude Jouannet was elected Chairman of the Company on November 23, 1992. On November 23, 1992, Guy Etienne Dufour and Bahman Naraghi resigned as directors of the Company. Effective as of May 5, 1993, Fredric S. Newman was elected a director of the Company. Effective as of May 6, 1993, Mr. Newman was elected President, Secretary and Treasurer of the Company, Messrs. Meeker and Jouannet resigned as directors of the Company and Mr. Newman became the sole director and the sole officer of the Company. EMPLOYEES As of March 25, 1994, the Company had no employees. ITEM 2. ITEM 2. PROPERTIES None. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Various legal proceedings involving alleged breaches of contract, antitrust violations, copyright infringements and other claims relating to the film entertainment business of the Company are now pending, which proceedings the Company considers to be routine. The Company is subject to a consent decree (the "Consent Decree") entered in the United States District Court for the Central District of California ("California District Court") in a Securities and Exchange Commission civil action commenced against the Company on November 19, 1987, entitled Securities and Exchange Commission v. The Cannon Group. Inc. et al., Case No. 87-07590. This proceeding against the Company and certain of its former directors and officers alleged, among other things, violations or aiding and abetting of violations of the antifraud, reporting, proxy, record keeping and internal controls provisions of the federal securities laws. Without admitting or denying the allegations in the Commission's complaint, the Company and certain individuals settled the action and consented to the entry of a final judgment enjoining them from violating the aforementioned provisions of the federal securities laws. The Consent Decree required the Company to appoint an independent person to examine transactions between the Company and related parties for the period January 1, 1984 through December 31, 1986. The independent person is required to deliver a report to the Company's Board of Directors regarding such transactions together with recommendations regarding what action the Board should take as a result of the examination. The Company appointed a law firm as the independent person. In November 1991, the independent person resigned without having delivered a report to the Board of Directors. In its resignation letter, the independent person stated it had been unable to complete their examination because of the Company's failure to pay the independent person's fees and because certain members of the former management of the Company had failed to cooperate in the examination. Current management also believes that the Company under prior management may have violated other provisions of the Consent Decree. Violations of the Consent Decree could result in further proceedings by the Commission. If the Company were found to have violated the Consent Decree, the Company could be held in contempt of court and could be subjected to substantial penalties. The Company has informed the Commission of its concerns regarding compliance with the Consent Decree and is cooperating with the Commission in its review of this matter. While no assurances can be given, management believes that any punitive measures which may be imposed as a result of violations of the Consent Decree would be imposed upon those persons responsible for such violations (as opposed to the Company's current management) and would not have a material adverse effect upon the Company. The Commission is currently conducting an investigation into certain transactions effected by prior management of the Company. The Company is cooperating fully with the Commission in its investigation. The Company cannot presently determine what, if any, action the Commission might take as a result of its investigation. On November 13, 1990, a complaint was filed in Los Angeles Superior Court against the Company, Cannon Pictures, Inc., Mr. Parretti, Fernando Cappuccio, Danny Dimbort, Lilliana Avincola, Edmund Hamburger and Theodore J. Cohen by plaintiffs William J. Immerman, and Salem Productions, Inc. The first amended complaint, served on January 2, 1991, alleged, inter alia, rescission, breach of contract, breach of the covenant of good faith and fair dealing, interference with contractual relationships, interference with pro- spective economic advantage, promissory fraud, fraud, negligent misrep- resentation, intentional infliction of emotional distress, libel and slander in connection with the termination of plaintiffs' employment contracts. The amended complaint sought compensatory damages, depending on the cause of action, from $250,000 to in excess of $1,000,000, and punitive damages of $5,000,000. The Company filed an answer denying all liability and setting forth various affirmative defenses. A settlement was reached among the parties and the action has been dismissed. The Company's portion of the settlement liability will be covered by insurance. On January 22, 1991, Century West Financial Corporation ("Century West") filed a complaint in Los Angeles Superior Court against the Company, Renta Properties and others for breach of contract, breach of third party beneficiary contract, bad faith denial of contract, breach of the implied covenant of good faith and fair dealing, and tortious interference with prospective economic advantage. Century West alleges that it acted as broker for the sale of 6420 Wilshire Boulevard and is owed a commission. Century West seeks compensatory damages in the amount of $470,000, interest thereon and punitive damages. A Third Amended Complaint was filed in this action on January 14, 1994. Cross-complaints have been filed against the Company, and the Company has filed cross-claims. In addition, the Company is advancing defense costs to a former employee and will indemnify him subject to an undertaking for reimbursement under certain circumstances. The Company intends vigorously to defend this action. On June 18, 1991, a complaint was filed in the United States District Court for the Central District of California against the Company, MGM, Messrs. Parretti, Fiorini, Globus and Aurelio Germes and Maria Cecconi (Mr. Parretti's wife) on behalf of a purported class which acquired MGM's 13% Subordinated Debentures due 1996. On October 10, 1991, J. Phillip Williams, on behalf of a group of MGM bondholders, filed a complaint in the United States District Court for the Central District of California against the Company, MGM, CLBN and Mr. Parretti which alleges that the defendants violated U.S. securities laws, and conspired to deceive plaintiffs about MGM's financial condition, markets, and business prospects, thereby artificially inflating the price of MGM's securities. The complaint seeks unspecified damages. The Company answered the complaint on February 3, 1992. Limited discovery was conducted regarding class certification. On March 23, 1992, the court heard and denied Williams' motion for class certification. On May 18, 1992, the court denied Williams' motion for reconsideration. On July 22, 1992, another bondholder, Herbert Eisen, moved to intervene in the lawsuit. After limited discovery was conducted regarding intervention, the court granted Mr. Eisen's motion to intervene. On December 15, 1992, Mr. Eisen filed a complaint-in-intervention that mirrors the allegations in the Williams' complaint. The Company and MGM answered Eisen's complaint-in- intervention on December 29, 1992. On October 26, 1993, the parties entered into a Stipulation of Settlement which would dispose of this matter subject to Court approval. The settlement, if approved, would create a fund of $4,500,000 against which injured class members may make a claim. Any unclaimed portion of the fund will be returned to the contributing defendants. The Company and MGM have funded the settlement. On September 25, 1991, Century Insurance Ltd. ("Century") filed a complaint in Superior Court against the Company, MGM, Melia, Comfinance S.A. ("Comfinance"), CLBN and Mr. Parretti alleging, among other things, breach of contract, fraud, constructive fraud, conversion and conspiracy. The claims arise out of certain defendants' failure to pay a purported $1.75 million premium in connection with plaintiff's purported issuance of a completion guarantee bond in connection with the financing of the Merger and alleged unpaid premiums in connection therewith. The plaintiff seeks $34,200,000 in alleged management fees on three purported insurance investment bonds and declaratory relief. MGM was voluntarily dismissed from the action on January 3, 1992. The plaintiff served a second amended complaint on February 3, 1992. In addition, on December 6, 1991, this case was consolidated with an earlier declaratory relief suit filed by CLBN against Century. The Company was not a party to this earlier suit. On February 3, 1993, the court dismissed with prejudice Century's complaint against the Company and all of the other defendants, for failure to comply with discovery orders. On July 14, 1993, Century moved to vacate the judgment in the Company's and other defendants' favor, which motion was denied. Century has filed a notice of appeal of denial of its motion to vacate. The parties have not completed the appeal briefing and no date has been set for the hearing of the appeal. On January 18, 1991, Andrea Kune, a stockholder of the Company, filed a derivative lawsuit on behalf of the Company against Messrs. Parretti, Fiorini, Globus, Valentina Parretti, Ms. Cecconi, Antonio Pares-Neira and Lewis P. Horwitz, alleging breach of fiduciary duty, abuse of control, waste of corporate assets, fraud and deceit, negligent misrepresentation and constructive fraud. Certain other individuals formerly associated with the Company were subsequently named as defendants. The Company was named as a nominal defendant only. On September 16, 1991, the Company filed a Statement of Non-Response asserting that it had no obligation to respond to the complaint because the complaint seeks no relief from the Company. A second amended complaint was filed on July 27, 1992 against the same defendants in which the Company was again named as a nominal defendant. Kune alleges claims for breach of fiduciary duty, fraud and deceit, negligent misrepresentation and constructive fraud against the defendants. The amended complaint seeks unspecified damages. The Company remains a nominal defendant only and no claims for monetary relief are asserted against it. On January 8, 1992, Fabio Serena, a former employee of the Company, filed a lawsuit in Los Angeles Superior Court against the Company. The complaint contained causes of action for (1) breach of contract; (2) breach of covenant of good faith and fair dealing; (3) promissory fraud; (4) fraud; (5) intentional infliction of emotional distress; and (6) negligent infliction of emotional distress. The complaint also sought in excess of $6,750,000 in compensatory damages, and $10,000,000 in punitive damages, in addition to costs of the suit and interest. The Company successfully demurred to Plaintiff's Complaint, as well as Plaintiff's first amended complaint and his second amended complaint. All of the Plaintiff's claims were dismissed with the exception of one cause of action for breach of contract which sought damages "in excess of $1,000,000," together with interest and costs of suit. A confidential settlement was agreed in December, 1993, pursuant to which the case was dismissed with prejudice. On January 27, 1992, Linda Carter filed an application for award for employer violation of Section 132(a) of the Labor Code before the Workers' Compensation Appeals Board of the State of California against the Company and MGM seeking reinstatement of employment, back wages at approximately $21,000 per year plus benefits, and costs of suit. The application alleges Ms. Carter was laid off on March 4, 1991, in retaliation for filing a workers' compensation claim. The Company is vigorously defending this action. On January 21, 1992, CLBN filed an action in the Delaware Chancery Court in which CLBN asserted various claims against the Company, Gestione Nuove Attivita Finanziarie S.a.r.l. (a company controlled by Ms. Cecconi) ("GENAF"), Melia and certain subsidiaries of Melia seeking, among other things, a judicial declaration that: (i) a purported transfer of common stock of the Company from Melia and certain of its subsidiaries to GENAF (the "Subject Stock") is null, void and without effect; and (ii) the Company should issue new stock certificates to CLBN representing the Subject Stock or impose a constructive trust on the Subject Stock held by GENAF. On February 4, 1992, the Delaware Chancery Court issued an order sequestering the Subject Stock. The Company, Melia and its subsidiaries have answered the complaint. In addition, Melia has filed a third-party complaint seeking damages and injunctive and declaratory relief against GENAF, Mr. Parretti and Ms. Cecconi alleging, among other things, fraud and conversion. On or about February 6, 1992, Mr. Parretti and GENAF applied to the Civil Court in Rome for the appointment of a custodian of issued shares in the Company and MGM purpor- tedly held by Mr. Parretti and GENAF and for precautionary measures to protect the assets of the Company and MGM against further alleged diminution in value being caused by CLBN. The Court on or about February 24 and March 6, 1992 issued temporary ex parte orders decreeing that the shares of the Company and MGM are validly within the custody of the Court, and appointing Paolo Picozza as custodian of the shares in dispute. With consent of the court of March 6, 1992, Mr. Picozza purported to take action to amend Pathe's By-Laws to increase the number of directors of the Company to thirty and to appoint eight additional directors of the Company. Mr. Picozza also purported to take action to remove the current directors of MGM and to replace them with seven new directors. On March 12, 1992, CLBN filed a special appearance with the Court objecting to the decrees on the ground, among other things, that the stock certificates presented to the Court as evidence of Mr. Parretti's controlling interest in the Company and MGM were either already sequestered by the Delaware Chancery Court on February 12, 1992, pursuant to an order of that court dated February 4, 1992 or previously certified lost and replaced, as well as on various procedural and jurisdictional grounds. A hearing was held on Friday, March 20, 1992 regarding CLBN's special appearance. On March 18, 1992, Mr. Parretti and GENAF filed an appeal with the Italian Supreme Court on jurisdictional issues and CLBN filed a counter appeal (no hearing has so far been fixed by the Supreme Court). A new temporary order was rendered on April 28, 1992 con- firming the two earlier decisions. The April 28, 1992 order provided for an 180 day time period during which Mr. Parretti and GENAF should bring an action on the merits. On October 18, 1992, Mr. Parretti filed an action for damages against CLBN and the first hearing was scheduled for March 22, 1993. The case is, however, suspended until the Italian Supreme Court has rendered its decision on the jurisdictional issues. On May 6, 1992, Robert Solomon filed a complaint in Delaware Chancery Court against the Company, CLBN, Dennis Stanfill, Alan Ladd, Jr., Mr. Meeker, Kenneth Meyer, Jay Kanter, William Jones, Thomas Carson, Rene Claude Jouannet, Bahman Naraghi, Guy Etienne Dufour, G. Goirand and Jacques Bertholier for breach of defendants' duties of fair dealing and breach of fiduciary duties to the public stockholders of the Company in connection with the Foreclosure and CLBN's Tender Offer for the Company's stock at a price of $1.50 per share. Plaintiff filed the action on his own behalf and as a class action on behalf of a purported class of public stockholders of the Company. On March 15, 1994, Solomon filed an amended class action complaint against the Company, CLBN and certain of the previously named individuals. Although the Company is still studying the Amended Complaint, no monetary relief is sought against the Company. The Company plans vigorously to defend the action. On December 7, 1992, MGM filed an action against Tracinda Corporation, Jeffrey Barbakow, Kirk Kerkorian, Stephen Silbert (the "Kerkorian Defendants") and Houlihan, Lokey, Howard & Zukin, Inc. ("HLHZ") in the Superior Court. On December 22, 1992, MGM filed an amended complaint which sets forth claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, breach of contract and negligence in connection with the sale of MGM to the Company in the fall of 1990. MGM alleges, among other things, that the Kerkorian Defendants engaged in a scheme to induce the independent members of MGM's Board to approve the merger to MGM's detriment. MGM seeks damages in an amount of $750,000,000, plus punitive damages according to proof at trial, and a declaration that the indemnity provisions of certain agreements executed in connection with the merger do not cover any judgment, settlement, fees or costs incurred by the Kerkorian Defendants in a legal action. On December 17, 1992, the Kerkorian Defendants filed an answer denying the allegations of the complaint and a cross-complaint against MGM for breach of contract, tortious bad faith, breach of indemnification agreements, equitable indemnity and declaratory relief. The cross-complaint seeks damages according to proof at trial, exemplary damages, attorneys fees and costs. On January 27, 1993, HLHZ filed an answer denying the allegations of the complaint and a cross-complaint against MGM, the Company and CLBN for declaratory relief, fraud, negligent misrepresentation and equitable indemnity. The Company answered HLHZ's cross-complaint on March 29, 1993. HLHZ seeks, among other things, indemnification from the Company under the terms of an engagement letter between HLHZ and the Company and damages for fraud, negligent misrepresentation and equitable indemnity in an amount according to proof at trial, plus attorneys fees, costs and expenses. Discovery in this action has commenced. On October 13, 1993, a Special Referee in this matter recommended that the Court enter an order declaring that the Company be required to advance to HLHZ its reasonable attorneys' fees in this matter pursuant to the engagement letter, subject to repayment if HLHZ were later found to have committed fraud. The Court did enter such an order, and the Company has moved for reconsideration of that decision. If upheld, such a declaration or order could result in the imposition of substantial liability and other obligations upon the Company, in an amount as yet undetermined but likely to be beyond the Company's present financial capabilities or otherwise materially adverse to the Company. The Court has stated that the matter will come on for trial in June, 1994. The Company is vigorously litigating these actions. On April 16, 1993, the Company filed a bankruptcy petition against Melia with the Bankruptcy Chamber of the Amsterdam District Court. This petition was joined by the Dutch tax authorities, Scotti International N.V., Cannon Cinema B.V. and CLBN. At a hearing on April 27, 1993, the Court found that Melia had ceased to pay its debts and declared Melia officially bankrupt. The Court appointed Mr. R.W. De Ruuk as official receiver in the bankruptcy. The appeal period under the governing Dutch Bankruptcy Code has lapsed. Mr. De Ruuk has deposited three public reports with the Dutch authorities. It appears to the Company from such reports that no material recovery benefitting it will be forthcoming. On June 29, 1993, Aurelio Germes, a former officer of the Company, filed a declaratory relief action against the Company. Mr. Germes seeks a declaratory judgment that the Company is obligated to pay Mr. Germes' legal fees in connection with the SEC investigation and in defense of the Kune matter. The Company filed an answer to this complaint on August 12, 1993. The Company intends to vigorously defend this action. Trial of the action is set for May 24, 1994. Demands for the advancement of legal fees and indemnification in the defense of the Kune and Williams actions have been made by Giancarlo Parretti, Maria Cecconi, and Valentina Parretti (collectively, the "Parrettis"). In addition, a demand for the advancement of legal fees for defense of the Kune case has been made by Yoram Globus. The Company has rejected these demands. A claim has also been made by the Parrettis' former attorneys in those cases for fees already incurred, in amounts totalling less than $100,000, and the Company is investigating this matter to determine, what, if any, liabilities it may have in respect of this claim. In addition, there have been additional claims for indemnification and/or the advancement of expenses and legal fees which have been asserted from time to time by former officers, directors and/or employees of the Company, and the Company reviews each demand on a case by case basis. 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 As a consequence of the tender offer described in Item 1 Business above, trading in the Company's common stock was suspended by the NYSE on July 13, 1992 pending application by the NYSE to the Commission to delist the Shares. Such action was taken because, as a result of the tender offer, the Company had fallen below the NYSE's continued listing criteria related to (i) net tangible assets available to common stock together with three-year average net income and (ii) aggregate market value of publicly-held common stock. On August 28, 1992, the Commission, in response to the NYSE's application, issued an order removing the Company's common stock from listing and registration on the NYSE. As of March 18, 1994, there were 1,485 holders of record and approximately 3,191,963 Shares were held by stockholders other than officers, directors, and members of their immediate families and concentrated holdings of 10% or more. No public market currently exists for the Company's remaining outstanding shares of common stock, and the Company is unable to predict at this time whether any public market will exist in the future. The Company does not have any present plans that would result in the repurchase or redemption of its common stock or in the admission for trading of such stock on other exchanges or markets. The Company's stock continues to be subject to deregistration with the Commission if the Company has less than 300 holders of record, in which event the Company would no longer file public reports with the Commission. The Company has never paid a dividend on its common stock. In addition, the Company's subordinated debt indentures contain covenants that limit the Company's ability to pay dividends. The Company's current credit agreement prohibits the payment of dividends. In light of the Company's current financial condition and state of operations, it does not anticipate any payment of dividends in the foreseeable future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA PATHE COMMUNICATIONS CORPORATION Selected Financial Data (in thousands, except per share data) The table below summarizes recent financial information of Pathe Communications Corporation. For further information, see the Company's Financial Statements and the notes thereto contained elsewhere herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the Company's Financial Statements and related notes thereto. References to Notes are to the notes to such statements. General As a result of the Foreclosure on May 7, 1992 (see Note 3), the Company has no operating assets or sources of operating income (see "Liquidity and Capital Resources"). Results of Operations 1993 Versus 1992 Operations General The Company reported a net loss for 1993 of $(26,163,000), or $(.22) per common share as compared to a net loss of $(472,838,000), or $(4.05) per common share (a loss before extraordinary items of $(153,106,000) or $(1.31) per common share) for 1992, in both years based on 116,746,810 weighted average common shares outstanding. General Corporate Administration Expenses General corporate administration expenses increased $3,638,000 (approximately 52%) for 1993 due to payments in settlement of various litigation matters and accruals for legal fees and expenses related to other pending litigation matters. Other Income (Expense) The equity in the net losses of subsidiaries of $(125,037,000) was eliminated for 1993 due to the Foreclosure (see Note 3.). Net interest expense decreased from $20,600,000 for 1992 to $15,838,000 for 1993 due primarily to a reduction in the average debt from CLBN (see Note 4). During 1993, the Company, CLBN, MGM and various other parties settled certain litigation matters filed by Keller Construction Company, by American Savings Bank, F.A., by Fabio Sevena and by Castro & Associates, Inc. The costs of these settlements were $1,250,000, $2,800,000, $300,000 and $37,500, respectively, of which the Company's shares were $1,000,000, $2,500,000, $300,000 and $30,000, respectively (see Note 9). 1992 Versus 1991 Operations General The Company reported a net loss for 1992 of $(472,838,000), or $(4.05) per common share (a loss before extraordinary items of $(153,106,000), or $(1.31) per common share) as compared to a net loss of $(352,935,000), or $(3.02) per common share for 1991, in both years based on 116,746,810 weighted average common shares outstanding. General Corporate Administration Expenses General corporate administration expenses decreased $6,530,000 (approximately 48 percent) during 1992, mainly due to reduced salaries and overhead charges, and a decrease in litigation costs and fees. Other Income (Expense) The Company's equity in the net losses of subsidiaries represents its 98.5 percent share in the losses of MGM through May 7, 1992, the date of the Foreclosure (see Note 3). In 1991, such amount reflected a full year of MGM's losses. Due to the Foreclosure, a loan to an affiliate relating to the funding of the Company's common stock subscriptions has been written off. Net interest expense was $20,602,000 and $30,805,000 in 1992 and 1991, respectively. The net decrease is due to the reduction of the Company's borrowings with CLBN (see Note 4) and lower interest rates during 1992. Other expense during 1991 includes reserves related to the write- off of advances and loans to certain affiliates. Extraordinary Items The Company recorded an extraordinary loss in 1992 of $319,732,000 on its investment in MGM due to the Foreclosure (see Note 3). Liquidity and Capital Resources The Company is currently dependent on CLBN for additional capital to fund its cash requirements. CLBN may, in its absolute discretion, decide whether to advance additional funds to the Company (see Note 4). Additionally, the Company is in default on its existing indebtedness to Sealion (see Note 4). In connection with the tender offer (see Note 5), CLBN agreed to provide funding to the Company to enable it to make scheduled interest payments under the Company's subordinated debenture agreements during the period ended May 5, 1993 on such obligations not owned by CLBN. Subsequent to May 5, 1993, CLBN has provided the Company with the funds necessary to meet the Company's expenses, including interest expenses on the Company's subordinated debt not owned by CLBN, but CLBN has not indicated any intention to fund any of the Company's future expenses, no assurances can be given that CLBN will fund any such expenses and the Company has no other source of funding. The Company's subordinated debt agreements contain cross acceleration provisions which generally provide that if holders of certain other debt of the Company accelerate the maturity of such debt, such acceleration would be a default with respect to the subordinated debt. If such event were to occur and certain notices are given under the various agreements and indentures, a substantial portion of the Company's subordinated debt could be accelerated. The Company has not received any such notices. The Company currently does not meet the minimum net worth covenant under its 12-7/8% and 8-7/8% debenture Indentures as its net worth has been below $37,500,000 for more than two consecutive quarters. Upon the occurrence of such event, such Indentures, as amended (see Note 5), require the Company to redeem 10 percent of the aggregate principal amount of the debentures then outstanding (at 100 percent of the principal amount) plus accrued interest by the last day of the following quarterly period. Similar payments must be made semi-annually thereafter until all outstanding debentures are redeemed, unless the net worth is above $37,500,000 as of the last day of any subsequent quarter. The Company can satisfy the redemption requirement through previously acquired and canceled debentures. Due to the significant amount of such debentures previously acquired by the Company, the Company will not be required to make any cash redemptions for the foreseeable future. Restriction on the Issuance of New Equity Securities In connection with the funding of certain stock subscription agreements entered into concurrent with the acquisition of MGM, the Company, Melia and Comfinance entered into an agreement which prevents the Company from selling shares of the Company, except for shares held by certain companies controlled by prior management, until certain bank debt of such companies (approximately $110,000,000) has been repaid. The agreement also set a minimum price for the sale of such shares and directed the proceeds to be used to repay this bank debt. In May 1991, this Agreement was amended to allow the Company to sell stock of the Company, subject to CLBN's approval of both the issuance of the stock and of the sales price for the stock. The proceeds from any such issuance are required to be applied to the repayment of the Company's CLBN debt. Commitments and Contingencies The Company is a party to various lawsuits (see Item 3, "Legal Proceedings" and Note 9). A significant adverse judgment in one or more of the cases could have a material impact upon the Company's liquidity. Impact of Interest Rates Any significant increase in interest rates would have a substantial adverse effect on the Company's financial position. Video Medien Pool Productions and Vertriebs GmbH Licensing Transaction Discussion of the prior years' licensing transaction with Video Medien Pool Productions and Vertriebs GmbH ("VMP"), and the listing of all titles licensed and delivered, are incorporated herein by reference to the Company's Report on Form 10-K for the fiscal year ended December 31, 1992 (including the further references contained therein). The Company's current management has no knowledge of these transactions. The Company is subject to a Consent Decree entered on November 19, 1987 which requires the Company to provide certain information on a quarterly basis concerning transactions with VMP. The Company is currently in default of its obligations under this consent decree. (See Item 3 above.) Cannon International v.o.f. ("CI"), a subsidiary of the Company prior to the Foreclosure, is a party to a licensing agreement ("Contract No. 42"), which granted VMP video and television exploitation rights to a significant number of motion pictures for various German-speaking territories. Substantially all of the revenues due under Contract No. 42 were recognized by CI in 1986. The Company has previously reported the aggregate payments collected and due from VMP. In August 1992, MGM, as successor owner of CI, reached a comprehensive settlement agreement (the "1992 Settlement") with VMP covering all claims and obligations related to Contract No. 42. In connection with the 1992 Settlement, CI (which is no longer a subsidiary of the Company) agreed to (i) refund certain license fees under Contract No. 42 to VMP of approximately $8,000,000; (ii) reimburse approximately $4,100,000 of VMP's settlements with third parties because VMP had licensed to them motion pictures previously licensed by CI to other parties; and (iii) make substitutions for certain of the motion pictures originally licensed to VMP. As of December 31, 1992, CI has licensed 546 titles (the Company currently classifies all television episodes per series as one title; each episode was previously reported as a separate title) to VMP under Contract No. 42, of which 282 have been delivered to VMP. A third party dispute is currently blocking the delivery of an additional 228 titles. There are 36 titles still to be delivered by the Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PATHE COMMUNICATIONS CORPORATION (PARENT ONLY) AND FINANCIAL STATEMENT SCHEDULES All other schedules are omitted since the required information is not applicable, not material or is included in the financial statements and notes therein. Independent Auditors' Report The Board of Directors Pathe Communications Corporation: We have audited the financial statements of Pathe Communications Corporation (Parent only) ("the Company") as listed in the accompanying index. In connection with our audits of the financial statements, we also have audited the financial statement schedules as listed in the accompanying index. 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. As discussed in Note 9 to the financial statements, the Company is a defendant in numerous lawsuits claiming significant compensatory and punitive damages. The ultimate outcome of this litigation cannot presently be determined. Accordingly, provision for the ultimate liability that may result upon adjudication has not been recognized in the accompanying financial statements. The accompanying financial statements have been prepared assuming the Company will continue as a going concern. As described in Note 1 to the financial statements, Credit Lyonnais Bank Nederlands ("CLBN") foreclosed on the Company's investment in Metro-Goldwyn-Mayer Inc., which constituted all the Company's operating assets and only source of income. In addition, all of the Company's bank indebtedness (see Note 4) is currently in default and any acceleration of such bank debt that could result from such defaults constitutes an event of default under the Company's bond indentures which may accelerate the maturity of the Company's subordinated debt at face value. The Company is currently dependent on the day-to-day financial support and forbearance of CLBN from which there is no commitment to continue making funds available to the Company. All of these conditions raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of these uncertainties. Because of the effects on the financial statements of such adjustments, if any, as might have been required had the outcome of the uncertainties referred to in the two preceding paragraphs been known, we are unable to, and do not, express an opinion on the accompanying financial statements and financial statement schedules. As discussed in Note 7 to the financial statements, the Company changed its method of accounting for income taxes effective January 1, 1993 to conform with Statement of Financial Accounting Standards No. 109. KPMG Peat Marwick Los Angeles, California March 18, 1994 PATHE COMMUNICATIONS CORPORATION (PARENT ONLY) NOTES TO FINANCIAL STATEMENTS NOTE 1 - BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation. The financial statements of Pathe Communications Corporation ("Pathe" or the "Company") have been presented on a separate company (parent only) basis. Credit Lyonnais Bank Nederland N.V. ("CLBN") controls the voting rights with respect to approximately 97% of the Company's common stock. See Notes 5 and 6 regarding CLBN's acquisition of certain of the Company's subordinated debt and common stock. In May 1992, CLBN fore- closed on 59,100,000 shares constituting 98.5% of the common stock of Metro- Goldwyn-Mayer Inc. ("MGM"), which constituted substantially all of the Company's assets (see Note 3). Following the sale of its MGM stock, the Company has no operating assets or sources of income. The Company is currently dependent on CLBN to fund its ongoing cash requirements. Prior to July 1991, the Company engaged in significant transactions with its principal shareholders and certain affiliated companies. Cash Equivalents. The Company considers all highly liquid debt instruments with original maturities of three months or less to be cash equivalents. Debt Issuance Costs. Debt issuance costs are capitalized when incurred, and together with original issue discount, are amortized over the term of the related debt utilizing the bonds outstanding method. Reclassification. Certain 1992 and 1991 amounts have been reclassified to conform with the 1993 presentation. NOTE 2 - MARKET FOR THE COMPANY'S COMMON STOCK Trading in the Company's common stock was suspended by the New York Stock Exchange (the "Exchange") on July 13, 1992 pending application by the Exchange to the Securities and Exchange Commission (the "SEC") to delist the stock. Such action was taken because the Company had fallen below the Exchange's continued listing criteria related to (i) net tangible assets available to common stock together with three-year average net income and (ii) aggregate market value of publicly held common stock. On August 28, 1992, the SEC, in response to the Exchange's application, issued an order removing the Company's common stock from listing and registration on the Exchange. The Company is unable to predict at this time whether any public market will exist for the Company's remaining outstanding shares of common stock. The Company does not have any present plans that would result in the repurchase or redemption of its common stock or in the admission for trading of such stock on other exchanges or markets. The Company's stock may be subject to deregistration with the SEC if the Company has less than 300 stockholders of record, in which event the Company would no longer file public reports with the SEC. NOTE 3 - EXTRAORDINARY ITEM - LOSS ON FORECLOSURE On April 16, 1992, CLBN commenced foreclosure proceedings (the "Foreclosure") upon 59,100,000 shares of MGM's common stock owned by the Company (the "MGM Shares"), representing 98.5% of the issued and outstanding common stock of MGM. In accordance with the Foreclosure, an auction to sell the MGM Shares was held on May 7, 1992 in Wilmington, Delaware. At such auction, MGM Holdings Corporation, an affiliate of CLBN ("MGM Holdings"), bid-in $483,489,000 of the indebtedness of the Company and certain affiliates, which indebtedness had previously been assigned by CLBN to MGM Holdings, and acquired all of the MGM Shares. The Company recorded an extraordinary loss of $319,732,000 in the year ended December 31, 1992, representing the difference between the carrying value of its investment in MGM and the amount of the Company's debt relieved in the Foreclosure. NOTE 4 - BANK AND OTHER DEBT Credit Facilities. The Company previously had a $100,000,000 multi-currency revolving credit facility ("Credit Facility") and a $250,000,000 interim revolving credit facility ("Interim Facility") with CLBN. Borrowings under both facilities bore interest at 2% over the higher of LIBOR or CLBN's cost of funds, payable quarterly. The Credit Facility expired on December 31, 1991 and the Interim Facility expired on January 31, 1992. On May 7, 1992, approximately $140,000,000 of indebtedness, including accrued interest, under the credit facilities was relieved in the Foreclosure (see Note 3). In October 1992, the outstanding balance due to CLBN was converted into a demand promissory note, with interest accruing quarterly at LIBOR (3.25% at December 3, 1993) plus 2%. Any future advances by CLBN will be made under the promissory note and are at the absolute discretion of CLBN. At December 31, 1993 and 1992, the Company had drawn down $23,412,000 and $9,814,000, respectively, under this facility. Interest expense related to this facility was $1,045,000 and $4,130,000 for the years ended December 31, 1993 and 1992, respectively. Bank Note Payable. In November 1990, the Company borrowed $150,000,000 from Sealion Corporation N.V. ("Sealion"), a company affiliated with SASEA Holding S.A. ("SASEA"), which is affiliated with prior management of the Company, and lent the proceeds to Melia International N.V. ("Melia"), the Company's major stockholder. Sealion has assigned, as collateral security, its receivable from the Company to Credit Lyonnais S.A., the parent of CLBN. The Company's obligation is guaranteed by Melia and collateralized by approximately 51% of the Company's outstanding stock and by approximately 67% of the stock of MGM. The obligation bears interest at LIBOR (3.25% at December 31, 1993) plus 2% payable monthly and, as amended, requires principal reductions of $30,000,000 a month beginning in January 1992. None of these interest payments or principal reductions have been made by the Company, and this facility is currently in default. Interest expense related to this bank note was $7,864,000 in 1993 and $8,657,000 in 1992. Maturity Schedule. All of the foregoing debt is currently payable. NOTE 5 - SUBORDINATED DEBT 12.375% Notes. The 12.375% senior subordinated notes ("12.375% Notes") were issued with detachable warrants to purchase 2,100,000 shares of common stock at $25 per share and are due in October 1994. An allocation of $10,500,000 of the $70,000,000 face amount of notes was made to the warrants, which resulted in a similar amount of the original issue discount. The unamortized discount was $380,000 and $785,000 as of December 31, 1993 and 1992, respectively. 12.875% and 8.875% Debentures. The 12.875% senior subordinated debentures ("12.875% Debentures") and 8.875% convertible senior subordinated debentures ("8.875% Debentures") have been redeemable since April 15, 1989. On April 15, 1989, the Company, upon the exercise of an option by the 8.875% Debenture holders, repurchased $19,810,000 of the outstanding 8.875% Debentures and issued $28,550,000 of new 12.875% senior subordinated debentures, priced to yield the then current market rate on the existing 12.875% Debentures, which were trading at a substantial discount from face value. This transaction resulted in original issue discount on the new 12.875% Debentures of $8,740,000. The new debentures have terms similar to the existing 12.875% Debentures. The 12.875% Debentures and 8.875% Debentures are due April 15, 2001. The unamortized discount was $4,438,000 and $4,751,000 as of December 31, 1993 and 1992, respectively, on the 12.875% Debentures. Annual sinking fund payments at 15% of the aggregate principal amounts of these debentures are required to commence in April 1996 through April 2000. Tender Offer. On May 8, 1992, CLBN commenced a tender offer for all of the Company's outstanding 12.375% Notes, 12.875% Debentures and 8.875% Debentures at $470, $470 and $420 per $1,000 principal amount, respectively. CLBN acquired an aggregate principal amount of $9,379,000 pursuant to the tender offer, which expired on June 5, 1992. On May 5, 1992, CLBN entered into an agreement with certain bondholders to purchase $27,013,000 face value of the foregoing obligations, which purchase was completed in May 1992. At December 31, 1993, CLBN held an aggregate $42,488,000 of the foregoing obligations. Interest payments on the portion of those obligations which are still publicly held are being made by CLBN on the Company's behalf. Interest payments due on those obligations held by CLBN have been suppressed effective November 1, 1993 on the 12.375% Notes and October 15, 1993 on the 8.875% and 12.875% Debentures. At December 31, 1993, the Company has accrued approximately $2,700,000 due to CLBN for interest payments which have been suppressed on the foregoing obligations. Restrictive Covenants. The various subordinated debt indentures and note agreements contain various covenants including reporting requirements, dividend and stock purchase limitations and maintenance of minimum equity. The agreements also contain cross acceleration provisions which provide that an event of default occurs if holders of certain other debt of the Company, in aggregate principal amount in excess of $1,000,000, accelerate the maturity of such debt and such acceleration is not rescinded within 60 days. While the Company is in default on many of these covenants, no such debt has been accelerated. If such event were to occur and certain notices are given under the various agreements and indentures, a substantial portion of the Company's subordinated debt could be accelerated. The Company has not received any such notices. In connection with the tender offer, CLBN agreed to provide funding to the Company to enable it to make scheduled interest payments under the Company's subordinated debenture agreements during the period ended May 5, 1993 on such obligations not owned by CLBN after consummation of the tender offer. Subsequent to May 5, 1993, CLBN has continued to provide the Company with the funds necessary to meet the Company's expenses, including interest expenses on the Company's subordinated debt not owned by CLBN, but CLBN has not indicated any intention to fund any of the Company's future expenses and the Company has no other source of funding. In conjunction with the tender offer, the indentures governing the 12.875% Debentures and 8.875% Debentures (the "Indentures") were amended to provide that (a) June 30, 1992 replaces December 28, 1985 as the date after which consolidated net income or loss will be included in the computation of permitted dividends, distributions or stock repurchases and (b) the minimum net worth covenant will be clarified to provide that certain debentures previously acquired by the Company and canceled can be utilized to satisfy any repayment obligation arising from failure to satisfy such covenant. Additionally, there were modifications to certain other covenants. The Company currently does not meet the minimum net worth covenant under such Indentures as its net worth has been below $37,500,000 for more than two consecutive quarters. Upon the occurrence of such event, the Indentures, as amended as described above, require the Company to redeem 10% of the aggregate principal amount of the debentures then outstanding (at 100% of the principal amount) plus accrued interest by the last day of any subsequent quarter. As noted above, the Company can satisfy the redemption requirement through previously acquired and canceled debentures. Due to the significant amount of such debentures previously acquired by the Company, the Company will not be required to make any cash redemptions for the foreseeable future. Maturities. The scheduled maturities of the Company's subordinated debt over the next five years consist of $17,089,000 in 1994 and $34,885,000 after 1998. NOTE 6 - STOCKHOLDERS' EQUITY Common Stock Subscriptions. On November 1, 1990, the Company entered into stock subscription agreements ("Stock Subscriptions") with two of its major shareholders, Melia and Comfinance S.A. ("Comfinance"), providing for the purchase of 57,000,000 shares of the Company's common stock at $10 per share, a total of $570,000,000. Comfinance subscribed for 8,000,000 shares for a total of $80,000,000. In mid-November 1990, the Company loaned $50,000,000 to Comfinance; the Company understands that such funds were used by Comfinance to repay indebtedness it incurred to fund its Stock Subscription. Such indebtedness was offset against amounts owed by the Company to other European Interests. Melia subscribed for 49,000,000 shares for a total of $490,000,000. In November 1990, the Company loaned $150,000,000 to Melia (see Note 4) in connection with Melia's funding of its Stock Subscription. Melia's loan was satisfied (with accrued interest) in April 1991 by Melia's assumption of a like amount of the Company's indebtedness to CLBN. Additionally, $50,000,000 of Melia's total Stock Subscription was funded on December 31, 1990, when a purported loan agreement was entered into with Banca Popolare di Novara ("BPN"). MGM reserved for the contested obligation as a loss due to the uncertainty of reimbursement or indemnification by SASEA if MGM were ultimately found to be liable under the purported loan agreement. However, because this purported loan was entered into in connection with the funding of Melia's Stock Subscription, the Company reclassified the remaining contested obligation (the original amount of $50,000,000 reduced by payments made by SASEA) as an offset to Common Stock Subscriptions at December 31, 1991. Due to the Foreclosure described in Note 3, the potential impact of this note on the Company ceased, resulting in an increase in the Company's investment in MGM and a corresponding increase to equity prior to the recognition of the extraordinary loss due to the Foreclosure. On May 6, 1992, the Company issued 57,000,000 shares of common stock under the subscriptions to Melia and Comfinance. These shares are subject to pledge arrangements in favor of CLBN (see Note 1). Tender Offer. On May 7, 1992, CLBN commenced a tender offer (the "Tender Offer") to purchase up to 5,800,000 of the Company's outstanding unencumbered shares of common stock (the "Shares") at $1.50 per share. The Tender Offer did not include 110,756,450 shares of the Company registered in the name of CLBN, as voting trustees under certain voting trust agreements or otherwise subject to pledge agreements in favor of CLBN. CLBN acquired 2,809,739 shares under the Tender Offer, which expired on June 5, 1992. Loss per Common Share. Per share data is based on 116,746,810 weighted average shares outstanding for 1993, 1992 and 1991. NOTE 7 - DOMESTIC AND FOREIGN TAXES Due to its limited activities, the Company has incurred no currently payable income tax liabilities. The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," during the year ended December 31, 1993. This statement requires the use of the liability method of accounting for deferred income taxes. The implementation did not have a material impact as all deferred tax assets were offset against valuation allowances as a result of loss carryforwards which are not expected to be realized. For income tax reporting purposes the Company has available approximately $56,852,000 in federal net operating loss carryforwards on a parent only reporting basis. Additionally, the Company has available approximately $429,455,000 in capital loss carryforwards. In periods prior to 1993, the provision for taxes has consisted solely of miscellaneous state franchise and other local license fees. Due to the nature of these items, for 1993 such expenses have been treated as general and administrative costs rather than as income tax expenses. NOTE 8 - RELATED PARTY TRANSACTIONS The Company has various credit arrangements with CLBN (see Note 4). Interest of approximately $8,909,000 and $12,760,000 was charged on these facilities during 1993 and 1992, respectively. The Company also paid to CLBN ap- proximately $502,000 in 1992 related to letters of credit and other fees, pursuant to the terms of its credit facilities. No such fees were charged by CLBN to the Company during 1993. In addition, CLBN was the holder of various subordinated notes and debentures issued by the Company. As the Company has no operating assets or significant sources of income, CLBN agreed during 1993 to forego its receipt of interest on the notes and debentures it holds (see Note 5). NOTE 9 - COMMITMENTS AND CONTINGENCIES Litigation. The Company is subject to a consent decree (the "Consent Decree") entered in the United States District Court for the Central District of California ("California District Court") in a civil action commenced by the SEC against the Company on November 19, 1987, entitled Securities and Exchange Commission v. The Cannon Group, Inc., et al., Case No. 87-07590. This proceeding against the Company and certain of its former directors and officers alleged, among other things, violations or aiding and abetting of violations of the anti-fraud, reporting, proxy, record-keeping and internal controls provisions of the federal securities laws. Without admitting or denying the allegations in the SEC's complaint, the Company and certain individuals settled the action and consented to the entry of a final judgment enjoining them from violating the aforementioned provisions of the federal securities laws. The Consent Decree required the Company to appoint an independent person to examine transactions between the Company and related parties for the period January 1, 1984 through December 31, 1986. The independent person is required to deliver a report to the Company's Board of Directors regarding such transactions together with recommendations regarding what action the Board should take as a result of the examination. The Company appointed a law firm as the independent person. In November 1991, the independent person resigned without having delivered a report to the Board of Directors. In its resignation letter, the independent person stated that it had been unable to complete its examination because of the Company's failure to pay the independent person's fees and because certain members of the former management of the Company had failed to cooperate in the examination. Current management also believes that the Company under prior management may have violated other provisions of the Consent Decree. Violations of the Consent Decree could result in further proceedings by the SEC. If the Company were found to have violated the Consent Decree, the Company could be held in contempt of court and could be subjected to substantial penalties. The Company has informed the SEC of its concerns regarding compliance with the Consent Decree and is cooperating with the SEC in its review of this matter. While no assurances can be given, management believes that any punitive measures which may be imposed as a result of violations of the Consent Decree would be imposed upon those persons responsible for such violations (as opposed to the Company's current management) and would not have a material adverse effect upon the Company. The Commission is currently conducting an investigation into certain trans- actions effected by prior management of the Company. The Company is cooperating fully with the Commission in its investigation. The Company cannot presently determine what, if any, action the Commission might take as a result of its investigation. On November 13, 1990, a complaint was filed in Los Angeles Superior Court against the Company, Cannon Pictures, Inc., Mr. Parretti, Fernando Cappuccio, Danny Dimbort, Lilliana Avincola, Edmund Hamburger and Theodore J. Cohen by plaintiffs William J. Immerman and Salem Productions, Inc. The first amended complaint, served on January 2, 1991, alleged, inter alia, rescission, breach of contract, breach of the covenant of good faith and fair dealing, interference with contractual relationships, interference with prospective economic advantage, promissory fraud, fraud, negligent misrepresentation, intentional infliction of emotional distress, libel and slander in connection with the termination of plaintiffs' employment contracts. The amended complaint sought compensatory damages, depending on the cause of action, from $250,000 to in excess of $1,000,000 and punitive damages of $5,000,000. The Company filed an answer denying all liability and setting forth various affirmative defenses. A settlement was reached among the parties and the action has been dismissed. The Company's portion of the settlement liability will be covered by insurance. On January 22, 1991, Century West Financial Corporation ("Century West") filed a complaint in Los Angeles Superior Court against the Company, Renta Properties and others for breach of contract, breach of third party beneficiary contract, bad faith denial of contract, breach of the implied covenant of good faith and fair dealing, and tortuous interference with prospective economic advantage. Century West alleges that it acted as broker for the sale of 6420 Wilshire Boulevard and is owed a commission. Century West seeks compensatory damages in the amount of $470,000, interest thereon and punitive damages. A third amended complaint was filed in this action on January 14, 1994. Cross-complaints have been filed against the Company, and the Company has filed cross-claims. In addition, the Company is advancing defense costs to a former employee and will indemnify him subject to an undertaking for reimbursement under certain circumstances. The Company intends vigorously to defend this action. On June 18, 1991, a complaint was filed in the United States District Court for the Central District of California against the Company, MGM, Messrs. Parretti, Fiorini, Globus and Aurelio Germes and Maria Cecconi (Mr. Parretti's wife) on behalf of a purported class which acquired MGM's 13% Subordinated Debentures due 1996. On October 10, 1991, J. Phillip Williams, on behalf of a group of MGM bondholders, filed an amended complaint against the Company, MGM, CLBN and Mr. Parretti which alleges that the defendants violated U.S. securities laws, conspired to deceive plaintiffs about MGM's financial condition, markets and business prospects, and thereby artificially inflated the price of MGM's securities. The complaint seeks unspecified damages. The Company answered the complaint on February 3, 1992. Limited discovery was conducted regarding class certification. On March 23, 1992, the Court heard and denied Williams' motion for class certification. On May 18, 1992, the court denied Williams' motion for reconsideration. On July 22, 1992, another bondholder, Herbert Eisen, moved to intervene in the lawsuit. After limited discovery was conducted regarding intervention, the Court granted Mr. Eisen's motion to intervene. On December 15, 1992, Mr. Eisen filed a complaint-in-intervention that mirrors the allegations in the Williams' complaint. The Company and MGM answered Mr. Eisen's complaint-in- intervention on December 29, 1992. On October 26, 1993, the parties entered into a Stipulation of Settlement which would dispose of this matter subject to Court approval. The settlement, if approved, would operate a fund of $4,500,000 against which injured class members may make a claim. Any unclaimed portion of the fund will be returned to the contributing defendants. The Company and MGM have funded the settlement. On September 25, 1991, Century Insurance Ltd. ("Century") filed a complaint in Superior Court against the Company, MGM, Melia, Comfinance, CLBN and Mr. Parretti alleging, among other things, breach of contract, fraud, constructive fraud, conversion and conspiracy. The claims arise out of a failure to pay a purported $1,750,000 premium in connection with plaintiff's purported issuance of a completion guarantee bond related to the financing of the merger with MGM. The plaintiff seeks $34,200,000 in alleged management fees on three purported insurance investment bonds and declaratory relief. MGM was voluntarily dismissed from the action on January 3, 1992. The plaintiff served a second amended complaint on February 3, 1992. In addition, on December 6, 1991, this case was consolidated with an earlier declaratory relief suit filed by CLBN against Century. The Company was not a party to this earlier suit. On February 3, 1993, the court dismissed with prejudice Century's complaint against the Company and all of the other defen- dants, for failure to comply with discovery orders. On July 14, 1993, Century moved to vacate the judgment in the Company's and other defendants' favor, which motion was denied. Century has filed a notice of appeal of denial of its motion to vacate. The parties have not completed the appeal briefing and no date has been set for the hearing of the appeal. On January 18, 1991, Andrea Kune, a stockholder of the Company, filed a derivative lawsuit on behalf of the Company against Messrs. Parretti, Fiorini, Globus and Dimbort, Valentina Parretti (Mr. Parretti's daughter), Ms. Cecconi, Antonio Pares-Neira and Lewis P. Horwitz, alleging breach of fiduciary duty, abuse of control, waste of corporate assets, fraud and deceit, negligent misrepresentation and constructive fraud. The Company was named as a nominal defendant only. On September 16, 1991, the Company filed a Statement of Non-Response asserting that it had no obligation to respond to the complaint because the complaint seeks no relief from the Company. A second amended complaint was filed on July 27, 1992 against the same defendants in which the Company was again named as a nominal defendant. Kune alleges claims for breach of fiduciary duty, fraud and deceit, negligent misrepresentation and constructive fraud against the defendants. The amended complaint seeks unspecified damages. The Company remains a nominal defendant only and no claims for monetary relief are asserted against it. On January 8, 1992, Fabio Serena, a former employee of the Company, filed a lawsuit in Los Angeles Superior Court against the Company. The Complaint contains causes of action for (i) breach of contract; (ii) breach of covenant of good faith and fair dealing; (iii) promissory fraud; (iv) fraud; (v) intentional infliction of emotional distress; and (vi) negligent infliction of emotional distress. Mr. Serena's complaint sought in excess of $6,750,000 in compensatory damages, and $10,000,000 in punitive damages, in addition to costs of suit and interest. All of the plaintiff's claims have been dismissed with the exception of one cause of action for breach of contract which seeks damages "in excess of $1,000,000," together with interest and costs of suit. A confidential settlement was agreed in December 1993, pursuant to which the case was dismissed with prejudice. On January 27, 1992, Linda Carter filed an application for award for employer violation of Section 132(a) of the Labor Code before the Workers' Compensation Appeals Board of the State of California against the Company and MGM seeking reinstatement of employment, back wages at approximately $21,000 per year plus benefits and costs of suit. The application alleges Ms. Carter was laid off on March 4, 1991, in retaliation for filing a workers' compensation claim. The Company is vigorously defending this action. On January 21, 1992, CLBN filed an action in the Delaware Chancery Court in which CLBN asserted various claims against the Company, Gestione Nuove Attivita Finanziarie S.a.r.l. (a company controlled by Ms. Cecconi) ("GENAF"), Melia and certain subsidiaries of Melia seeking, among other things, a judicial declaration that: (i) a purported transfer of common stock of the Company from Melia and certain of its subsidiaries to GENAF (the "Subject Stock") is null, void and without effect; and (ii) the Company should issue new stock certificates to CLBN representing the Subject Stock or impose a constructive trust on the Subject Stock held by GENAF. On February 4, 1992, the Delaware Chancery Court issued an order sequestering the Subject Stock. The Company, Melia and its subsidiaries have answered the complaint. In addition, Melia has filed a third-party complaint seeking damages and injunctive and declaratory relief against GENAF, Mr. Parretti and Ms. Cecconi alleging, among other things, fraud and conversion. On or about February 6, 1992, Mr. Parretti and GENAF applied to the Civil Court in Rome for the appointment of a custodian of issued shares in the Company and MGM purportedly held by Mr. Parretti and GENAF and for precautionary measures to protect the assets of the Company and MGM against further alleged diminution in value being caused by CLBN. The Court on or about February 24 and March 6, 1992 issued temporary ex parte orders decreeing that the shares of the Company and MGM are validly within the custody of the Court, and appointing Paolo Picozza as custodian of the shares in dispute. With consent of the court on March 6, 1992, Mr. Picozza purported to take action to amend Pathe's By-Laws to increase the number of directors of the Company to thirty and to appoint eight additional directors of the Company. Mr. Picozza also purported to take action to remove the current directors of MGM and to replace them with seven new directors. On March 12, 1992, CLBN filed a special appearance with the Court objecting to the decrees on the grounds, among other things, that the stock certificates presented to the Court as evidence of Mr. Parretti's controlling interest in the Company and MGM were either already sequestered by the Delaware Chancery Court on February 12, 1992, pursuant to an order of that court dated February 4, 1992, or previously certified lost and replaced, as well as on various procedural and jurisdictional grounds. A hearing was held on Friday, March 20, 1992 regarding CLBN's special appearance. On March 18, 1992, Mr. Parretti and GENAF filed an appeal with the Italian Supreme Court on jurisdictional issues and CLBN filed a counter appeal (no hearing has so far been fixed by the Supreme Court). A new temporary order was rendered on April 28, 1992 confirming the two earlier decisions. The April 28, 1992 order provided for a 180-day time period during which Mr. Parretti and GENAF should bring an action on the merits. On October 18, 1992, Mr. Parretti filed an action for damages against CLBN and the first hearing was scheduled for March 22, 1993. The case is, however, suspended until the Italian Supreme Court has rendered its decision on the jurisdictional issues. On May 6, 1992, Robert Solomon filed a complaint in Delaware Chancery Court against the Company, CLBN, Dennis Stanfill, Alan Ladd, Jr., Charles Meeker, Kenneth Meyer, Jay Kanter, William Jones, Thomas Carson, Rene Claude Jouannet, Bahman Naraghi, Guy Etienne Dufour, G. Goirand and Jacques Bertholier alleging breach of defendants' duties of fair dealing and breach of fiduciary duties to the public stockholders of the Company in connection with the foreclosure and CLBN's Tender Offer for the Company's stock at a price of $1.50 per share. Plaintiff filed the action on his own behalf and as a class action on behalf of a purported class of public stockholders of the Company. On March 15, 1994, Solomon filed an amended class action complaint against the Company, CLBN and certain of the previously named individuals. Although the Company is still studying the amended complaint, no monetary relief is sought against the Company. The Company plans vigorously to defend the action. On December 7, 1992, MGM filed an action against Tracinda, Jeffrey Barbakow, Kirk Kerkorian, Stephen Silbert (the "Kerkorian Defendants") and Houlihan, Lokey Howard & Zukin, Inc. ("HLHZ") in the Superior Court in Los Angeles. On December 22, 1992, MGM filed an amended complaint which sets forth claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, breach of contract and negligence in connection with the sale of MGM to the Company in the fall of 1990. MGM alleges, among other things, that the defendants engaged in a scheme to induce the independent members of MGM's Board to approve the merger to MGM's detriment. MGM seeks damages in an amount of $750,000,000, plus punitive damages according to proof at trial, and a declaration that the indemnity provisions of certain agreements executed in connection with the merger do not cover any judgment, settlement, fees or costs incurred by the Kerkorian Defendants in a legal action. On December 17, 1992, the Kerkorian Defendants filed an answer denying the alle- gations of the complaint and a cross-complaint against MGM for breach of contract, tortious bad faith, breach of indemnification agreements, equitable indemnity and declaratory relief. The cross-complaint seeks damages according to proof at trial, exemplary damages, attorneys' fees and costs. On January 27, 1993, HLHZ filed an answer denying the allegations of the complaint and a cross-complaint against MGM, the Company and CLBN for declaratory relief, fraud, negligent misrepresentation and equitable indemnity. The Company answered HLHZ's cross-complaint on March 29, 1993. HLHZ seeks, among other things, indemnification from the Company under the terms of an engagement letter between HLHZ and the Company and damages for fraud, negligent misrepresentation and equitable indemnity in an amount according to proof at trial, plus attorneys' fees, costs and expenses. Discovery in this action has commenced. On October 13, 1993, a Special Referee in this matter recommended that the Court enter an order declaring that the Company be required to advance to HLHZ its reasonable attorneys' fees in this matter pursuant to the engagement letter, subject to repayment if HLHZ were later found to have committed fraud. The Court did enter such an order, and the Company has moved for reconsideration of that decision. If upheld, such a declaration or order could result in the imposition of substantial liability and other obligations upon the Company, in an amount as yet undetermined but likely to be beyond the Company's present financial capabilities or otherwise materially adverse to the Company. The Court has stated that the matter will come on for trial in June 1994. The Company is vigorously litigating these actions. On April 16, 1993, the Company filed a bankruptcy petition against Melia with the Bankruptcy Chamber of the Amsterdam District Court. This petition was joined by the Dutch tax authorities, Scotti International N.V., Cannon Cinema B.V. and CLBN. At a hearing on April 27, 1993, the Court found that Melia had ceased to pay its debts and declared Melia officially bankrupt. The Court appointed Mr. R.W. De Ruuk as official receiver in the bankruptcy. The appeal period under the governing Dutch Bankruptcy Code has lapsed. Mr. De Ruuk has deposited three public reports with the Dutch authorities. It appears to the Company from such reports that no material recovery benefiting it will be forthcoming. On June 29, 1993, Aurelio Germes, a former officer of the Company, filed a declaratory relief action against the Company. Mr. Germes seeks a declaratory judgment that the Company is obligated to pay Mr. Germes' legal fees in connection with the SEC investigation and in defense of the Kune matter. The Company filed an answer to this complaint on August 12, 1993. The Company intends to vigorously defend this action. Trial of the action is set for May 24, 1994. Demands for the advancement of legal fees and indemnification in the defense of the Kune and Williams actions have been made by Giancarlo Parretti, Maria Cecconi and Valentina Parretti (collectively, the "Parrettis"). In addition, a demand for the advancement of legal fees for defense of the Kune case has been made by Yoram Globus. The Company has rejected these demands. A claim has also been made by the Parrettis' former attorneys in those cases for fees already incurred, in amounts totaling less than $100,000, and the Company is investigating this matter to determine what, if any, liabilities it may have in respect of this claim. In addition, there have been additional claims for indemnification and/or the advancement of expenses and legal fees which have been asserted from time to time by former officers, directors and/or employees of the Company, and the Company reviews each demand on a case-by- case basis. NOTE 10 - SUPPLEMENTARY CASH FLOW INFORMATION Total interest paid was $3,770,000, $6,481,000 and $6,478,000 for fiscal years ended December 31, 1993, 1992 and 1991, respectively. Income taxes paid were $66,000 in fiscal year 1991. Fiscal Year Ended December 31, 1992 On May 7, 1992, approximately $140,000,000 of indebtedness under the credit facilities was relieved in the Foreclosure (see Note 3). Fiscal Year Ended December 31, 1991 In the year ended December 31, 1991, Comfinance and Interpart paid certain Company expenses in the amount of $8,892,000, which payments were offset against certain receivables due from the Company. The Company repaid $50,000,000 of debt by offsetting amounts owed to it by Comfinance with amounts due to other European Interests. The Company repaid indebtedness to CLBN of $150,000,000 upon CLBN's assumption of a $150,000,000 receivable the Company had from Melia. NOTE 11 - QUARTERLY FINANCIAL DATA (UNAUDITED) Selected financial information for the quarterly periods for the fiscal years ended 1993 and 1992 are presented below (in thousands, except per share amounts): During 1993, the Company, CLBN, MGM and various other parties settled certain litigation matters. The Company's share of these costs was $3,830,000 and was accrued by the Company during the fourth quarter of 1993. In addition, the Company accrued $4,000,000 during the fourth quarter of 1993 as additional legal reserves in connection with pending litigation (see Note 9). 1992 Quarterly Results. In May 1992, CLBN foreclosed on the common stock of MGM (see Note 3). The Company recorded a loss provision on its investment during the first quarter of 1992. 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 Fredric S. Newman, age 48, has been the sole director and sole executive officer of the Company since May 6, 1993, when he was elected President, Secretary and Treasurer of the Company. He has been a practicing attorney in New York City for more than the past five years. In 1991 he was the Chief Executive Officer of World Team Tennis, Inc., and prior thereto he was Vice President and General Counsel of Philip Morris Incorporated. Pursuant to an agreement dated as of May 1, 1993 between the Company and Mr. Newman, Mr. Newman is to serve as President, Secretary and Treasurer of the Company with all of the power and authority to direct and manage the affairs of the Company. The agreement calls for an annual compensation of $75,000 plus certain additional compensation determined on an hourly basis dependent upon the services performed. The term of the agreement is one year, renewable annually, and the Company may terminate the agreement at any time upon payment of the agreed compensation. Mr. Newman's election to the Board of Directors of the Company was pursuant to CLBN's right to vote the common stock of the Company under the PCC Voting Trusts (see Item 1 "Changes in Control - Extraordinary Events"). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Except pursuant to the agreement referred to in Item 10, no compensation was awarded to, earned by or paid to Mr. Newman or to any other executive officer or director of the Company for the 1993 fiscal year and no compensation was awarded to, earned by or paid to any person serving as Chief Executive Officer during 1993 for the 1991 or 1992 fiscal years. Mr. Newman earned $81,590 for his services to the Company during 1993. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, as of March 18, 1994, certain information concerning ownership of shares of common stock (the only outstanding class of capital stock to the Company) by (i) each person who is known by the Company to own beneficially more than five percent of its issued and outstanding common stock, (ii) each current Director and (iii) all current officers and Directors of the Company as a group. This information is based on information provided to the Company by or on behalf of the stock- holder or on the most recently available public information filed by or on behalf of the stockholder. (1) Based on 116,746,810 shares of Common Stock issued and outstanding. This figure includes 49,000,000 shares of Common Stock issued to Melia and 8,000,000 shares of Common Stock issued to Comfinance pursuant to subscription agreements dated November 1, 1990, between the Company and each of Melia and Comfinance. Except as indicated below, each of the persons or entities listed above has sole voting and investment power with respect to all share shown for such person or entity. (2) CLBN owns 2,798,424 shares of the Company's common stock, purchased pursuant to a tender offer completed June 5, 1992, as more fully described under the caption Certain Relationships and Related Transactions. CLBN exercises voting power over 110,348,460 shares pursuant to certain voting trusts and pledge agreements. The shares of stock held by Melia, Renta Inmobiliaria International B.V. ("Renta B.V.") and Renta Corp. as well as the 57,000,000 shares issued to Melia and Comfinance pursuant to their subscription agreements with the Com- pany are, as more fully described under the caption "Certain Relationships and Related Transactions--Changes in Corporate Control," pledged to CLBN, subject to a prior pledge by Melia of the shares owned by it to Sealion (see Note 4 of the Notes to the Company's Consolidated Financial Statements -- Bank Note Payable), to secure all obligations of Melia, the Company, MGM and its direct and indirect subsidiaries and affiliates to CLBN, as well as all existing indebtedness of Melia to CLBN, indebtedness and obligations under all other agreements between the Company and CLBN entered into prior to those agreements and under agreements between MGM and CLBN, whether entered into at the time of such agreements or prior thereto pursuant to which there is an existing indebtedness or obligation to CLBN, and under all agreements entered into in connection with, or referred to, in any of those agreements. (3) Mr. Parretti and his wife, Mrs. Cecconi, are the majority owners of Comfinance. (Mr. Parretti holds 14% and Mrs. Cecconi holds 57%.) According to Mr. Parretti, he and Mrs. Cecconi hold their respective shares under a separate property agreement governed by the laws of Italy. They do not share any voting or dispositive power over their respective shares in Comfinance. Interpart S.A. ("Interpart") is beneficially owned by Mr. Parretti and certain of his affiliates. Interpart is currently in voluntary liquidation and its management is conducted by a liquidator. The shares indicated as being beneficially owned by Comfinance and Interpart include approximately 31,000,000 shares (approximately 51.7% of the outstanding shares) held by Melia, 16,551,724 shares (approximately 27.7% of the outstanding shares) held by Renta B.V., 5,812,000 shares (approximately 9.7% of the outstanding shares) held by Renta Corp., and 407,990 shares (approximately .7% of the outstanding shares) held by Viajes Melia ("Viajes"). Comfinance and Interpart together own 48.7% of the outstanding ordinary and preferred stock of Melia (Comfinance holds 24.4% and Interpart holds 24.3.%). SASEA Holding S.A. (anciennement Societe Anonyme Suisse d'Exploitations Agricoles "SASEA") and certain of its affiliates own 50.3% of the outstanding ordinary and preferred stock of Melia (SASEA directly holds 20%). There is currently a dispute in a Swiss court between SASEA and Interpart regarding the ownership of 2.4% of the shares of Melia currently held by SASEA. The outcome of this action will determine the control of Melia. Florio Fiorini, formerly a Director of the Company, was previously a member of the Executive Committee of SASEA, and is purportedly the owner of a significant minority interest in the outstanding stock of SASEA. In October 1992, SASEA was declared bankrupt under Swiss law. The competent court in Geneva, Switzerland appointed special administrators to liquidate SASEA's assets. Management control of Melia is vested in its Board of Managing Directors, which currently consists solely of members appointed by SASEA. A foundation controlled by Mr. Parretti, Mr. Fiorini and Mr. Parretti's daughter, Valentina Parretti, exercises rights with respect to Melia including the approval of certain actions of the Board of Managing Directors and certain rights with respect to the appointment of the Board of Managing Directors. Melia is the controlling stockholder of Viajes through Corporacion Viajes Melia S.A. Melia is the sole stockholder of Renta B.V. which in turn is the sole stockholder of Renta Corp. (4) Includes the 16,551,724 shares owned by Renta B.V. and the 5,812,000 shares owned by Renta Corp. The Company is reviewing the facts and circumstances surrounding the issuance of the 16,551,724 shares owned by Renta B.V. to determine whether such shares were validly issued, including the issue of whether sufficient consideration was received by the Company for the issuance of such shares. ITEM 13. ITEM 13. CERTAIN RELATIONS AND RELATED TRANSACTIONS. For additional information concerning certain transactions with prior management and other related parties, see Notes 4, 6, 8, 9 and 10, of the Notes to the Company's Consolidated Financial statements. Changes in Corporate Control Since June 1991, the Company has experienced changes in corporate control. As a result of these changes, the sole member of the Board of Directors and the sole officer of the Company is a person designated by CLBN, the Company's principal creditor, in its capacity as voting trustee and pledgee of the Company's common stock (see Item 1 "Business--Changes in Corporate Control, Extraordinary Events" and Item 3 "Legal Proceedings"). CLBN The Company is currently dependent on CLBN for additional capital to fund its on-going operations. (See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources".) The Company is in default on its existing indebtedness to CLBN. (See Note 4 of the Notes to the Company's Consolidated Financial Statements.) Legal proceedings in which an officer, director, affiliate or owner of more than five percent of the outstanding voting securities of the company has a material interest adverse to the Company. For information concerning legal proceedings in which an officer, director, affiliate or owner of more than 5% of the outstanding voting securities of the Company has a material interest adverse to the Company, see Item 3 Legal Proceedings. PART IV ITEM14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) and (2) Financial Statements and Schedules The financial statements and schedules listed in the accompanying Index to Financial Statements and Financial Statement Schedules at Page 23 herein are filed as part of this Form 10-K. (a)(3) Exhibits: The exhibits listed in the accompanying Exhibit Index are filed as part of this report. (b) Reports on Form 8-K: During the three months ended December 31, 1993, no reports on Form 8-K were filed by the Company. (c) Other Exhibits: Exhibit 11 is attached hereto (d) Other Financial Statement Schedules: 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. PATHE COMMUNICATIONS CORPORATION By /s/Fredric S. Newman Fredric S. Newman President Dated: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report had been signed below by the following persons on behalf of the Registrant and in the capacities and on the dated indicated. INDEX TO EXHIBITS Exhibit Number Description 3.1 Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1987). 3.2 Amendment dated March 17, 1989 to the Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 1989). 3.3 By-Laws of the Company as amended through May 6, 1993 (incorporated by reference to Exhibit 3 to the Company's Form 10-Q for the quarterly period ending June 30, 1993). 3.4 Amendment dated November 8, 1989 to the Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 1989). 3.5 Resolutions Adopted by the Board of Directors of Pathe Communications Corporation on April 16, 1991 (incorporated by reference to Exhibit 3.5 to the Company's Form 10-K for the year ended December 29, 1990). 3.6 Resolutions adopted by the Board of Directors of MGM-Pathe Communications Co. on April 16, 1991 (incorporated by reference to Exhibit 3 (3) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 4.1 Indenture, dated as of November 1, 1984, between the Company and Bankers Trust Company, as Trustee, in regard to $70,000,000 12-3/8% Senior Subordinated Notes due 1994 (incorporated by reference to Exhibit 4.1 to the Company's Form S-1 Registration Statement No. 2-93526 filed September 28, 1984). 4.2 Indenture, dated as of April 15, 1986, between the Company and Manufacturers Hanover Trust Company of California, as Trustee, in regard to $80,500,000 8-7/8% Convertible Senior Subordinated Debentures due 2001 (incorporated by reference to Exhibit 4.1 to the Company's Form S-1 Registration Statement No. 33-3334 filed February 14, 1986). 4.3 Indenture, dated as of April 15, 1986, between the Company and Manufacturers Hanover Trust Company of California, as Trustee, in regard to $26,500,000 12-7/8% Senior Subordinated Debentures due 2001 (incorporated by reference to Exhibit 4.1 to the Company's Form S-1 Regis- tration Statement No. 33-3333 filed February 14, 1986). 4.4 Warrant Agreement, dated as of October 15, 1987 between the Company and Warner Communications, Inc. (Incorporated by reference to Exhibit 1 to the Company's Report on Form 8-K filed on October 21, 1987). 9.1 Voting Trust Agreement by and between the Company and Credit Lyonnais Bank Nederland N.V. dated April 15, 1991 (incorporated by reference to Exhibit 10(9) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 9.2 Voting Trust Agreement by and between the Company and Credit Lyonnais Bank Nederland N.V. dated April 15, 1991 (incorporated by reference to Exhibit 10(10) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 10.1 Agreement, dated as of May 18, 1989, between the Company, Renta Inmobiliaria, Renta International B.V. and Renta Corp. (incorporated by reference to Exhibit 10.4 to the Company's Annual Report on Form 10-K for the year ended December 30, 1989). 10.2 Agreements between certain G&G Interests and the Company, dated as of July 1, 1983 (incorporated by reference to Exhibit A to the Company's Form S-1 Registration Statement No. 2-86297 filed August 30, 1983). 10.3 Agreement dated as of May 1, 1993 by and between the Company and Fredric S. Newman. 10.4 Loan out Agreement, dated March 1, 1989, between Pathe Entertainment, Inc. and Kanter Corp. for the services of Jay Kanter (incorporated by reference to Exhibit 10.49 to the Company's Annual Report on Form 10-K for the year ended December 30, 1989). 10.5 Property and Share Sale Agreement, dated December 29, 1989 by and among Cannon SE Cinema Properties Limited, Cannon Cinemas Limited, Pathe Group (U.K.) Limited and Cinema 5 Europe N.V. (incorporated by reference to Exhibit 10.52 to the Company's Form 10-K for the year ended December 30, 1989). 10.6 Heads of Agreement, dated December 29, 1989, among Cannon Tuschinski Theaters B.V., Cannon Tuschinski Beheer B.V., Cannon Cinema B.V., Holland Exhibitors B.V., Theaterbedrijf Cinerama Exhibitors Nederland B.V., Nationale Bioscoop Ondernemingen B.V., Cinerama Amsterdam B.V., Cannon Theaters (Nederlands) N.V. and Exploitati- emaatschappij "Midden- Hofstad" B.V. (incorporated by reference to Exhibit 10.53 to the Company's Annual Report on Form 10-K for the year ended December 30, 1989). 10.7 Agreement and Plan of Merger, dated as of June 28, 1990, by and between the Company, MGM/UA Communications Co., and Tracinda Corporation (incorporated by reference to Appendix A to MGM/UA Communications Co. Proxy Statement dated August 31, 1990). 10.8 Stock Purchase Agreement, dated as of October 26, 1990, between the Company and MGM-Pathe Communications Co. (incorporated by reference to Exhibit B to MGM-Pathe Communications Co. Form 8-K dated November 14, 1990). 10.9 Agreement, dated March 26, 1990, among Cineplex Odeon, Cannon Cinemas Limited and Cannon SE Cinema Properties Limited (incorporated by reference to Exhibit 10.14 to the Company's Form 10-K for the year ended December 29, 1990). 10.10 Agreement, dated November 6, 1990, between the Company and Fin Soft Holding S.A. (incorporated by reference to Exhibit 10.15 to the Company's Form 10-K for the year ended December 29, 1990). 10.11 Subscription Agreement, dated November 1, 1990, between the Company and Melia International N.V. (incorporated by reference to Exhibit 10.16 to the Company's Form 10-K for the year ended December 29, 1990). 10.12 Subscription Agreement, dated November 1, 1990, between the Company and Comfinance S.A. (incorporated by reference to Exhibit 10.17 to the Company's Form 10-K for the year ended December 29, 1990). 10.13 Promissory Note, dated November 15, 1990, from Transmarine Holdings S.A. payable to the Company (incorporated by reference to Exhibit 10.18 to the Company's Form 10-K for the year ended December 29, 1990). 10.14 Comfinance Promissory Note dated November 18, 1990 (incorporated by reference to Exhibit 10.19 to the Company's Form 10-K for the year ended December 29, 1990). 10.15 Interim Revolving Credit Facility Agreement and Security Assignment, dated March 22, 1991, by and among MGM-Pathe Communications Co. and certain affiliates and Credit Lyonnais Bank Nederland N.V.(incorporated by reference to Exhibit 10.20 to the Company's Form 10-K for the year ended December 29, 1990). 10.16 Letter Agreement among Credit Lyonnais Bank Nederland N.V., Pathe Communications Corporation, MGM-Pathe Communications Co. and Melia International N.V., dated April 12, 1991 (incorporated by reference to Exhibit 10(5) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 10.17 Memorandum of Facility Agreement among MGM-Pathe Communications Co. and its U.S. subsidiaries and Credit Lyonnais Bank Nederland N.V., dated April 12, 1991 (incorporated by reference to Exhibit 10(6) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 10.18 Stock Sale Agreement among Melia International N.V., the Company and CLINVEST, dated April 13, 1991 (incorporated by reference to Exhibit 10(7) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 10.19 Mandat Exclusif de Vente de Titres among the Company, Melia International N.V. and Credit Lyonnais Bank Nederland N.V., dated as of May 10, 1991. 10.20 Assignment, Assumption and Release Agreement among Pathe Communications Corporation, Melia International N.V. and Credit Lyonnais Bank Nederland N.V., dated as of April 15, 1991 (incorporated by reference to Exhibit 10(8) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 10.21 Agreement regarding Certain Corporate Governance Matters for MGM-Pathe Communications Co. dated April 15, 1991 among Giancarlo Parretti, the Company and MGM-Pathe Communications Co. (incorporated by reference to Exhibit 10(11) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 10.22 Agreement regarding Certain Corporate Governance Matters for Pathe Communications Corporation, among Giancarlo Parretti, the Company and the Company's majority stock- holders (incorporated by reference to Exhibit 10(12) to MGM-Pathe Communications Co. Form 8-K dated May 3, 1991). 10.23 Amended and Restated Credit Agreement between MGM-Pathe Communications Co. and Credit Lyonnais Bank Nederland N.V. dated as of May 15, 1991 (incorporated by reference to Exhibit 10.31 to the Company's Form 10-K for the year ended December 29, 1990). 10.24 Schedule 14D-1 Tender Offer Statement and Amendment No. 9 to Schedule 13D of Pathe Communications Corporation filed with the Securities and Exchange Commission by Credit Lyonnais Bank Nederland N.V. on May 8, 1992 (incorporated by reference). 10.25 Schedule 13E-3 Transaction Statement of Pathe Communications Corporation filed with the Securities and Exchange Commission by Credit Lyonnais Bank Nederland N.V. on May 7, 1992 (incorporated by reference). 11. Computation of Loss Per Common Share.

311100_1993.txt

311100_1993

1993

311100

Item 1. Business Incorporated herein by reference is the information appearing under the heading "Business of Jefferson Bankshares" on page 4 of the 1993 Annual Report to Shareholders ("1993 Annual Report"). Also incorporated herein by reference is the information on pages 7 through 10 of the 1993 Annual Report as to the distribution of the Corporation's assets, liabilities and shareholders' equity; pages 15 and 16 of the 1993 Annual Report as to the Corporation's investment portfolio; pages 12 through 15 of the 1993 Annual Report as to the Corporation's loan loss experience; pages 11 through 15 of the 1993 Annual Report as to the Corporation's loan portfolio; pages 16 and 17 of the 1993 Annual Report as to the Corporation's deposits; page 19 of the 1993 Annual Report as to the Corporation's return on equity and assets; and page 17 of the 1993 Annual Report as to the Corporation's short-term borrowings. Item 2. Item 2. Properties Incorporated herein by reference is the information appearing under the heading "Business of Jefferson Bankshares" on page 4 of the 1993 Annual Report and the discussion of premises and equipment in Note 7 (entitled "Premises and Equipment") to the financial statements in the 1993 Annual Report. Item 3. Item 3. Legal Proceedings There are no legal proceedings against the Corporation that would have a material adverse effect on the Corporation or its financial condition. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None Executive Officers of Jefferson Bankshares The executive officers of the Corporation are set forth below. All officers are elected annually and, except for Hovey S. Dabney who had an employment contract extending until January 1, 1994, serve at the discretion of the Board of Directors. Except as otherwise noted below, each of the executive officers has worked with the Corporation or its affiliates for at least five years. Hovey S. Dabney, 70, is Chairman of the Board of Directors and, until January 1, 1994, was also Chief Executive Officer. O. Kenton McCartney, 50, is President and Chief Executive Officer. Prior to January 1, 1994, Mr. McCartney was President and Chief Operating Officer. Robert H. Campbell, Jr., 59, is Senior Vice President and Treasurer. Allen T. Nelson, Jr., 44, is Senior Vice President and Chief Financial Officer. Mr. Nelson joined the Corporation on December 6, 1993. Prior to that date, Mr. Nelson was Senior Vice President and Controller of Dominion Bankshares, Inc. from February, 1992 until joining the Corporation. Prior to February, 1992 he served as Finance Executive Officer with C&S/Sovran Corporation. Walter A. Pace, Jr., 61, is Senior Vice President. Donald W. Fulton, Jr., 47, is Vice President-Investor Relations. William M. Watson, Jr., 39, is Vice President and Secretary. Mr. Watson joined the Corporation on May 13, 1991. Prior to that date, he was an attorney with McGuire, Woods, Battle & Boothe. Part II Item 5. Item 5. Market for the Registrant's Common Stock and Related Shareholder Matters Incorporated herein by reference is the information on page 18 under the heading "Capital Resources" and in the table captioned "Common Stock Performance and Dividends" on page 19 of the 1993 Annual Report. Incorporated herein by reference is the discussion of restrictions on the payment of cash dividends in Note 8 (entitled "Long Term Debt") to the financial statements in the 1993 Annual Report. Item 6. Item 6. Selected Financial Data Incorporation herein by reference in the information in the table captioned "Selected Financial Data" on page 5 of the 1993 Annual report. Item 7. Item 7. Management's Discussion and Analysis and Results of Operations and Financial Condition Incorporated herein by reference is the information appearing under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 5 through 20 of the 1993 Annual Report, except for the information in the tables captioned "Selected Financial Data," "Summary of Financial Results by Quarter," and "Common Stock Performance and Dividends" on pages 5, 6 and 19, respectively, of the 1993 Annual Report. Item 8. Item 8. Financial Statements and Supplementary Data Incorporated herein by reference is the information appearing under the heading "Independent Auditors' Report," Consolidated Balance Sheets," "Consolidated Statements of Income," "Consolidated Statements of Changes in Shareholders' Equity," "Consolidated Statements of Cash Flows" and "Notes to Consolidated Financial Statements," on pages 21 through 34 of the 1993 Annual Report. Incorporated by reference is the information in the table captioned "Summary of Financial Results by Quarter" on page 6 of the 1993 Annual 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 Registrant The information concerning the Corporation's directors is incorporated by reference to the section entitled "Nominations for Directors" on pages 4 through 6 of the Corporation's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders. The information concerning the Corporation's executive officers is incorporated by reference to Part I hereof entitled "Executive Officers of Jefferson Bankshares." Item 11. Item 11. Executive Compensation The information required by this item is incorporated by reference to the sections entitled "Compensation of Executive Officers and Directors" on pages 6 through 15 of the Corporation's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item is incorporated by reference to the sections entitled "Principal Beneficial Owners" and "Shares Beneficially Owned by Directors and Executive Officers" on pages 2 and 3 of the Corporation's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders. Item 13. Item 13. Certain Relationships The information required by this item is incorporated by reference to the section entitled "Loans to Officers and Directors" on page 15 of the corporation's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders. Part IV Item 14. Item 14. Exhibits, Financial Statements and Reports on Form 8-K (a) The following documents are filed as part of this report: 1. Financial Statements. The following Consolidated Financial Statements of Jefferson Bankshares, Inc. and subsidiaries and the Independent Auditors' Report are incorporated by reference to pages 21 through 34 of the 1993 Annual Report: Independent Auditors' Report. Consolidated Balance Sheets at December 31, 1993 and December 31, 1992. Consolidated Statements of Income for the years ended December 31, 1993, December 31, 1992 and December 31, 1991. Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, December 31, 1992, and December 31, 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, December 31, 1992 and December 31, 1991. Notes to Consolidated Financial Statements. 2. Exhibits. The exhibits listed on the accompanying Index to Exhibits immediately following the signature page are filed as part of, or incorporated by reference into, this report. (b) Reports on Form 8-K The Corporation did not file any reports on Form 8-K for the last fiscal quarter covered by this report. Except for the information referred to in Items 1, 2, 5, 6, 7, 8 and 14(a)(1) hereof, the 1993 Annual Report will not be deemed to be filed pursuant to the Securities Exchange Act of 1934. 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. DATE: March 10, 1994 JEFFERSON BANKSHARES, INC. By: O. Kenton McCartney 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. DATE SIGNATURE CAPACITY ---- --------- -------- March 10, 1994 O. Kenton McCartney President, Chief Executive Officer and Director March 10, 1994 Allen T. Nelson, Jr. Senior Vice President and Chief Financial Officer March 10, 1994 Hovey S. Dabney Chairman of the Board March 10, 1994 John T. Casteen, III* Director March 10, 1994 Hunter Faulconer* Director March 10, 1994 Lawrence S. Eagleburger* Director March 10, 1994 Fred L. Glaize, III* Director March 10, 1994 Henry H. Harrell* Director March 10, 1994 Alex J. Kay, Jr.* Director March 10, 1994 J. A. Kessler, Jr.* Director March 10, 1994 W. A. Rinehart, III* Director March 10, 1994 Gilbert M Rosenthal* Director March 10, 1994 Alson H. Smith, Jr.* Director March 10, 1994 Lee C. Tait* Director March 10, 1994 H. A. Williamson, Jr.* Director *By: William M. Watson, Jr. Attorney-in-Fact EXHIBIT INDEX Exhibit No. Exhibit 3. Articles of Incorporation and Bylaws: (a) Articles of Incorporation incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1984. (b) Articles of Amendment to Articles of Incorporation dated May 7, 1987, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1987. (c) Articles of Amendment to Articles of Incorporation dated March 23, 1993, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1993. (d) Amended and Restated Bylaws incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1991. 4. Instruments defining the rights of security holders including indentures: (a) Articles of Incorporation of Jefferson Bankshares', incorporated by reference to Jefferson Bankshares' 1984 Annual Report on Form 10-K. (b) Articles of Amendment to Articles of Incorporation dated May 7, 1987, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1987. (c) Articles of Amendment to Articles of Incorporation dated March 23, 1993, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1993. (d) Term Loan Agreement dated as of February 1, 1984, between Jefferson Bankshares and Wachovia Bank and Trust Company, N.A., incorporated by reference to Jefferson Bankshares' quarterly report on Form 10-Q for the quarter ended March 31, 1984. (e) Amendments dated September 8, 1988 and September 21, 1989, to the Term Loan Agreement between Jefferson Bankshares and Wachovia Bank and Trust Company, N.A., incorporated by reference to Jefferson Bankshares' quarterly report on Form 10-Q for the quarter ended March 31, 1991. (f) Amendment dated December 20, 1990, to the Term Loan Agreement between Jefferson Bankshares and Wachovia Bank and Trust Company, N.A., incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1990. 10. Material Contracts: (a) Senior Officers Supplemental Pension Plan, incorporated by reference to Jefferson Bankshares' 1982 Annual Report on Form 10-K. (b) Amended and Restated Employment Agreement dated August 26, 1987, with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended September 30, 1987. (c) Amendment dated September 26, 1989 to the Amendment and Restated Employment Agreement with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended September 30, 1989. (d) Amendment dated September 26, 1990 to the Amended and Restated Employment Agreement with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended September 30, 1990. (e) Deferred Compensation Agreement dated December 18, 1979 with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' 1984 Annual Report on Form 10-K. (f) Amendment dated September 26, 1989 to the Deferred Compensation Agreement with Hovey S. Dabney, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended September 30, 1989. (g) Incentive Stock Plan, incorporated by reference to Jefferson Bankshares' report on Form 10-Q for the quarter ended June 30, 1985. (h) Amendment dated April 28, 1992 to the Incentive Stock Plan, incorporated by reference to Exhibit 10(f) to Form S-4 of Jefferson Bankshares, Inc., File No. 33-47929. (i) Amended and Restated Deferred Compensation Plan for Directors, incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1985. (j) Split Dollar Life Insurance Plan, incorporated by reference to Jefferson Bankshares' Annual Report on Form 10-K for 1984. *(k) Executive Severance Agreement dated October 25, A 1993 between Jefferson Bankshares and O. Kenton McCartney is filed herewith. *(l) Executive Severance Agreement dated October 25, B 1993 between Jefferson Bankshares and Robert H. Campbell, Jr. is filed herewith. *(m) Amended and Restated Split Dollar Life Insurance C Agreement dated October 29, 1993 between Jefferson Bankshares and Hovey S. Dabney is filed herewith. *(n) Amended and Restated Split Dollar Life Insurance D Agreement dated October 29, 1993 between Jefferson Bankshares and Robert H. Campbell, Jr. is filed herewith. *(o) Amended and Restated Split Dollar Life Insurance E Agreement dated October 29, 1993 between Jefferson Bankshares and O. Kenton McCartney filed herewith. 13. Annual Report to Security Holders, Form 10-Q or F Quarterly Report to Security Holders 21. Subsidiaries of the Registrant G 23. Consents of Experts and Counsel H Consent of KPMG Peat Marwick to incorporation by reference of auditors' reports into Jefferson Bankshare's Registration Statement Form S-3 is filed herewith. 24. Powers of Attorney I * Management contract or compensatory plan or arrangement of the Corporation required to be filed as an exhibit.

39677_1993.txt

39677_1993

1993

39677

Item 1. Business Avatar Holdings Inc. (a Delaware corporation incorporated in 1970) and its subsidiaries (collectively, "Avatar" or the "Company") are engaged in two principal business activities: real estate and water and wastewater utilities operations. Avatar's real estate operations, which are located in the states of Florida, Arizona and California, include the development and sale of homesites; the development and sale of improved and unimproved homesites and commercial/industrial land tracts; the construction and sale of single family and multifamily housing; operations of amenities and resorts; development, sale and management of vacation ownership units in Avatar's Poinciana community; cable television operations and property management services. Avatar provides financing for a large portion of its homesite sales, mainly under a deed and mortgage arrangement. Avatar's utility operations consist of water and wastewater treatment plants which serve communities in Florida and Arizona. During 1993, approximately 56% and 44% of the total revenues were generated through real estate and utility operations, respectively, net of the gain on the sale of the midwest water utilities discussed below. On August 31, 1993, the Company sold its water and wastewater utilities located in Indiana, Missouri, Ohio, and Michigan (the "Midwest Water Utilities") for an aggregate selling price of $62,000,000, resulting in a pre-tax gain of $21,822,000. In the current year the Company has invested approximately $51,000,000 cash in an investment trading portfolio. (See Liquidity section) Avatar's revised business strategy includes a shift away from homesite sales and toward housing, retail and industrial real estate development, sales of vacation ownership intervals and resort operations. Certain of Avatar's properties are being developed and such developments are at different stages of completion. In addition, Avatar is examining each of its remaining principal properties in an effort to determine the best long-term use or development. Information regarding revenues, results of operations and assets of the two business segments noted above are included in Item 8 under the caption "Notes to Consolidated Financial Statements". Real Estate Avatar's assets include real estate inventory in the states of Florida, Arizona and California. In its Florida communities of Poinciana, Barefoot Bay, Cape Coral, Golden Gate and Leisure Lakes, as well as in its Arizona community of Rio Rico, Avatar's activities include homesite and industrial/commercial land sales, the construction and sale of single family and multifamily housing, and the construction, sale and management of vacation ownership units, with the types of activities varying from community to community. Avatar owns other sites including Harbor Islands in Hollywood, Florida; Banyan Bay in Martin County, Florida; Ocala Springs in Marion County, Florida; and Woodland Hills in Los Angeles County, California. Poinciana, located in central Florida approximately 21 miles south of Orlando and 10 miles from Walt Disney World, encompasses 47,000 acres of land, approximately 15,500 of which are owned by Avatar. This planned community development includes subdivisions for single family, multifamily and manufactured housing, and commercial/industrial areas. Since 1971, 21,860 homesites have been sold and approximately 4,219 housing units, primarily single family houses and townhouses, have been Item 1. Business -- Continued constructed by Avatar and other non-affiliated builders. As of December 31, 1993, approximately 12,965 developed and undeveloped homesites remained in inventory at Poinciana. Additionally, approximately 4,456 acres of land zoned for industrial/commercial and multifamily use also remained in inventory. At December 31, 1993, Avatar had firm contracts at Poinciana to construct 49 single family units with a total sales volume of $3,726,488. Avatar's real estate activities at Poinciana also include the construction, sale and management of vacation ownership units. As of December 31, 1993, 1,606 unit weeks had been sold and 1,306 unit weeks remained in inventory at Poinciana. Avatar also owns and operates a 31,100 square foot shopping center at Poinciana that was 100% occupied at December 31, 1993. Recreational facilities owned and operated by Avatar at the Poinciana development include an 18-hole Devlin Von-Hagge championship golf course, tennis courts, a golf and racquet club with a swimming pool, a community center and a series of nature walks and trails. Barefoot Bay is located on Florida's east coast, midway between Vero Beach and Melbourne. Avatar's operations at Barefoot Bay include the sale of manufactured homes and homesites. Since operations commenced in 1970, approximately 94% of the 5,020 available homesites have been sold. At December 31, 1993, Avatar had firm contracts to construct 8 housing units at a total selling price of $683,000. Recreational facilities owned and operated at Barefoot Bay by Avatar include an 18-hole executive golf course, a community center, swimming pools, tennis courts, a private beach and a fishing pier. Avatar also owns and operates a 13,420 square foot shopping center in Barefoot Bay that was 100% occupied at December 31, 1993. Avatar also owns 268 acres adjacent to Barefoot Bay. Platting, design and engineering for this proposed golf course community of 630 conventional single-family and zero-lot line homesites commenced in 1989 and is continuing through 1994. Cape Coral is a 60,700-acre community, of which approximately 3,727 acres are owned by Avatar, located on Florida's west coast seven miles west of Fort Myers. Its population has increased from 11,470 in 1970 to approximately 84,000 in 1993. To accommodate this increase, Avatar constructed, during 1991, the Camelot Isles Shopping Center, a 70,000 square foot retail center that opened in February 1992. At December 31, 1993, the shopping center was 89% occupied. Remaining inventory at December 31, 1993, included approximately 3,734 single family homesites and 2,700 acres of land zoned for commercial, industrial and multifamily use. Avatar's Tarpon Point Marina, which is located in Cape Coral, accommodates 175 vessels and features dockmaster facilities, a ship's store and fueling facilities. The Camelot Marina, for which the initial phase of construction was completed in 1991, will accommodate 76 vessels and feature 3,500 feet of boardwalk upon completion. Other amenities available to the residents of Cape Coral include Avatar's Cape Coral Golf and Tennis Resort that features an 18-hole championship golf course, a 9-hole executive golf course, eight tennis courts and a 100- room motel. Golden Gate City, located east of Naples in southwest Florida, had remaining inventory as of December 31, 1993 which included 32 single family and duplex homesites, 43 acres of land zoned for multifamily use and 10 acres zoned for commercial use. Golden Gate Estates comprises 2,497 acres of land subdivided into 5,800 homesites. Remaining inventory as of December 31, 1993, includes approximately 130 homesites of varying size, the majority of which are approximately 1 and 1-1/4 acre homesites, and 7,400 acres of land held for future use. Item 1. Business -- Continued Avatar's land holdings in Leisure Lakes, located near the city of Lake Placid in South Central Florida, consist of 3,244 homesites remaining in inventory at December 31, 1993. Amenities at Leisure Lakes include a 9-hole executive golf course, a small lakefront motel, tennis courts, shuffleboard courts, a swimming pool, a club house with pro shop, a coffee shop, a private beach, a boat ramp, a card room and various lakes available for water sports. Rio Rico, a 55,000-acre community development in southern Arizona, is located 57 miles south of Tucson. This community, with a population of approximately 4,700 residents, consists of single family homes and townhouses and includes several areas zoned for commercial and industrial development. Avatar owns and operates a 175-room hotel complex, an 18-hole Robert Trent Jones designed championship golf course and a 36,800 square foot shopping center, which was 98% occupied as of December 31, 1993. Remaining inventory at Rio Rico at December 31, 1993 included approximately 3,575 single family homesites, 2,536 acres of land zoned for commercial, industrial and multifamily use, 4,762 acres of land held for future development, sale or other use, and 2,838 acres of undeveloped mountain range reserved for open space. The Harbor Islands Project encompasses 191 acres, including 30 acres conveyed to the city of Hollywood for future parks, adjoining the Intra-coastal Waterway in Hollywood, Florida. An approved plan for this water-oriented community provides for 2,700 high-rise condominium units, 447 townhouses and triplex dwelling units, 28 single family homesites, 65,000 square feet of commercial space and a 150-room hotel. Additionally, permits have been obtained and preliminary construction completed on a 196-boat slip marina. Banyan Bay, located in Martin County, Florida, comprises 251 acres of land. Future plans contemplate a medium-density residential development of two and four story condominiums. Ocala Springs, located five miles northeast of Ocala in Marion County, Florida, comprises 4,600 acres of land. The concept plan for this project provides for 700 single family ranchettes on 1-1/4 to 1- 1/2 acre lots, 4,800 single family homesites on 1/4 to 1/2 acre lots, 400 homesites for manufactured housing and 1,000 multifamily condominium units. Also planned are an 18-hole golf course and more than 130 acres for commercial, industrial and service facilities. These plans have been reviewed by all appropriate state, regional and local governmental agencies and the plat for Phase I has been filed with and accepted by Marion County. Woodland Hills, located in northwest Los Angeles County, California, consists of the Natoma tract that encompasses approximately 430 acres of land. Conceptual planning for this tract has been completed for 108 luxury homesites. An environmental impact report has been filed and is being reviewed by the City of Los Angeles. In addition to the real estate holdings described above, Avatar owns approximately 2,500 acres of land in Florida that is being held for future development or bulk sales. Utilities Avatar's water and wastewater treatment facilities include 12 water treatment facilities and 10 wastewater treatment facilities serving 6 communities in Florida (including Poinciana, Barefoot Bay and Golden Gate). These facilities provide for the treatment, distribution and sale of water for public and Item 1. Business -- Continued private use, and the treatment and disposal of wastewater. At December 31, 1993, Avatar's utility operations had approximately 35,000 water customers and 29,000 wastewater customers. On January 30, 1993, the Company entered into stock purchase agreements for the sale of its Midwest Water Utilities. The closing of the sale of the Midwest Water Utilities took place on August 31, 1993, for an aggregate selling price of $62,000,000, resulting in a pre-tax gain of $21,822,000. An Avatar subsidiary provides consulting, data processing and other services to non-affiliated utility companies as well as to various Avatar subsidiaries. This subsidiary is beginning to operate water and wastewater systems under contracts with unaffiliated companies. Employees As of December 31, 1993, Avatar employed approximately 950 individuals on a full-time or part-time basis. In addition, Avatar utilizes on a daily basis such additional personnel as may be required to perform various land development activities. Avatar's relations with its employees are satisfactory and there have been no work stoppages. Regulation Avatar's real estate operations are regulated by various local, regional, state and federal agencies, including the Federal Trade Commission (FTC). The extent and nature of these regulations include matters such as planning, zoning, design, construction of improvements, environmental considerations and sales activities. For its community developments in Florida and Arizona, state laws and regulations may require the filing of registration statements, copies of promotional materials and numerous supporting documents, and the delivery of an approved disclosure report to purchasers, prior to the execution of a land sales contract. In addition to Florida and Arizona, certain states impose requirements relating to the inspection of properties, approval of sales literature, disclosures to purchasers of specified information, assurances of future improvements, approval of terms of sale and delivery to purchasers of a report describing the property. Federal regulations adopted pursuant to the Interstate Land Sales Full Disclosure Act provide for the filing or certification of a registration statement with the Office of Interstate Land Sales Regulation of the Department of Housing and Urban Development. Avatar's homesite installment sales activities are required to comply with the Federal Consumer Credit Protection ("Truth-in-Lending") Act. Avatar's utility operations and rate structures are regulated by various federal, state and county agencies and must comply with federal and state treatment standards. All sources of water and wastewater effluent are required to be tested on a regular basis and purified in order to comply with governmental standards. The Company believes it is in compliance with applicable laws and regulations in all material respects. Competition Avatar's real estate operations, particularly in the state of Florida, are highly competitive. In its sales of homesites and housing units, Avatar competes, as to price and product, with several land Item 1. Business -- Continued development companies for the discretionary income of individuals who desire eventually to relocate or establish a second home in Florida or Arizona. In recent years, there have been extensive land development projects in the geographical areas in which Avatar operates. The vacation ownership sales business is also highly competitive with companies throughout the United States and abroad selling vacation ownership unit weeks on terms similar to those offered by Avatar. Item 2. Item 2. Properties Avatar's real estate operations are described in Item 1 above. Land in the process of being developed, or held for investment and/or future development, has an aggregate cost of approximately $113,623,000 as of December 31, 1993. Avatar's utility operations include water and wastewater plants and equipment located in Florida. Such properties have a net book value of $150,812,206 at December 31, 1993. Avatar's corporate headquarters are located at 255 Alhambra Circle, Coral Gables, Florida, in approximately 26,595 square feet of leased office space. For additional information concerning properties leased by Avatar, see Item 8, "Notes to Consolidated Financial Statements." Item 3. Item 3. Legal Proceedings Avatar is involved in various pending litigation matters primarily arising in the normal course of its business. Although the outcome of these and the following matters can not be determined, it is the opinion of management that the resolution of such matters will not have a material effect on Avatar's business or financial position. On October 1, 1993, the United States, on behalf of the U.S. Environmental Protection Agency, filed a civil action against a utility subsidiary of Avatar in the U.S. District Court for the Middle District of Florida. (United States vs. Florida Cities Water Company, Civil Action No. 93-281-C1) The complaint alleges that the subsidiary's wastewater treatment plant in North Fort Myers, Florida, committed various violations of the Clean Water Act, 33 U.S.C. S1251 et seq., including (1) discharge of pollutants without an operating permit from October 1, 1988 to October 31, 1989; (2) discharging from an unpermitted discharge location from November 1, 1989 until July 14, 1992; and (3) discharging pollutants in excess of permit limitations at various times from July 1991 to June of 1992. The government is seeking the statutory maximum civil penalties of $25,000 per day, per violation based upon the allegations. The Subsidiary strongly believes that there are mitigating facts as well as valid legal defenses that could reduce or eliminate the imposition of monetary sanctions. On March 1, 1994, the Wisconsin Department of Natural Resources (the "Department") sent Avatar notice that the Department had recently issued a second Record of Decision ("ROD") in connection with the Edgerton Sand & Gravel Landfill site (the "Site"). The ROD calls for the City of Edgerton's public water supply system to be extended to the owners of private wells in the vicinity of the Site. The ROD also states that other work related to soil and groundwater remedial action would be required at the Site. The Department demanded that all potentially responsible parties ("PRPs") associated with the Site organize into a PRP group to undertake the implementation of the ROD. Avatar was previously identified as a PRP by the Department. Avatar believes that it is not liable for any claims by any governmental or private party in connection with the Site. Item 3. Legal Proceedings -- Continued On February 25, 1994, Mr. Wilkov commenced a lawsuit against Avatar, Mr. Jacobson and Odyssey Partners, L.P. ("Odyssey"), in the Circuit Court of Eleventh Judicial Circuit in and for Dade County Florida, claiming damages arising out of Mr. Wilkov's termination of his employment purportedly for "Good Reason" (as defined in his employment agreement). Mr. Wilkov also seeks to recover damages from Avatar for libel and slander and from Odyssey and Mr. Jacobson based on their alleged malicious interference with his employment agreement. Avatar denies that Mr. Wilkov had Good Reason to terminate his employment agreement. Avatar, Odyssey and Mr. Jacobson do not believe there is any valid basis for Mr. Wilkov's claims, and various affirmative defenses have been asserted. Avatar also has asserted counterclaims against Mr. Wilkov for breach of contract, promissory estoppel and improper inducement in connection with amendments to Mr. Wilkov's employment agreement. Item 4. Item 4. Submission of Matters to a Vote Security Holders None Executive Officers of the Registrant Pursuant to General Instruction G (3) to Form 10-K, the following list is included as an unnumbered item in Part I of this report in lieu of being included in the Proxy Statement for the Annual Meeting of Stockholders to be held on May 26, 1994. The following is a list of names and ages of all of the executive officers of Avatar, indicating all positions and offices with Avatar held by each such person and each such person's principal occupation(s) or employment during the past five years unless otherwise indicated. All such persons have been elected to serve until the next annual election of officers (which is expected to occur on May 26, 1994) when they are reappointed or their successors are elected, or until their earlier resignation or removal. Name Age Office and Business Experience Leon Levy 68 Chairman of the Board since January 1981; General Partner, Odyssey Partners, L.P., a private partnership engaged in investment, trading and related activities; Chairman of the Board of Oppenheimer Funds; former Chairman of the Board (1974-1985) of Oppenheimer Management Corp.; Director of: Electra Investment Trust PLC, Mercury Assets Management, Ltd., and S.G. Warburg & Co., Ltd. (Jersey Funds). Edwin Jacobson 64 President and Chief Executive Officer since February 1994; Chairman of the Executive Committee since June 1992; President and Chief Executive Officer of Chicago Milwaukee Corporation since June 1985; President and Chief Executive Officer of CMC Heartland Partners since September 1990, and President and Chief Executive Officer, since June 1985, of Milwaukee Land Company, a non- diversified, closed-end management investment company, publicly traded since July 1993. Dennis J. Getman 49 Executive Vice President since March 1984. Senior Vice President from September 1981 to March 1984 and General Counsel since September 1981. Charles L. McNairy 47 Executive Vice President since September 1993 and Treasurer and Chief Financial Officer since September 1992. Senior Vice President from September 1992 to September 1993. Vice President - Finance from January 1985 to September 1992, except from April 1987 to September 1988. Juanita I. Kerrigan 47 Vice President and Secretary since September 1980. Executive Officers of the Registrant -- continued G. Patrick Settles 45 Vice President since November 1986 and Assistant General Counsel since September 1983. John J. Yanopoulos 37 Vice President -- Finance and Controller since September 1992. Assistant Vice President from May 1990 to September 1992 and Corporate Controller since May 1989. Formerly Senior Audit Manager, Kenneth Leventhal and Company from 1986 to 1989. The above executive officers have held their present positions with Avatar for more than five years, except as otherwise noted. No director or executive officer of Avatar has any family relationship with any other director or executive officer of Avatar. PART II Item 5. Item 5. Market for Registrant's Common Stock and Related Stockholder Matters The Common Stock of Avatar Holdings Inc. is traded through the National Market System of the National Association of Securities Dealers Automated Quotation System ("NASDAQ") under the symbol AVTR. The approximate number of record holders of Common Stock at February 28, 1994, was 9,100. High and low quotations, as reported, for the last two years were: Avatar has not declared any cash dividends on Common Stock since its issuance and has no present intention to pay cash dividends. Avatar is subject to certain restrictions on the payment of dividends as set forth in Item 8, "Notes to Consolidated Financial Statements". Item 6. Item 6. Selected Financial Data FIVE YEAR COMPARISON OF SELECTED FINANCIAL DATA Dollars in thousands (except per-share data) (1) The Company adopted the installment method for homesite sales effective January 1, 1989. Prior to 1989, Avatar used the full accrual method of profit recognition for homesite sales. During 1993, the sale of the Midwest Water Utilities was completed. (See Results of Operations.) Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) RESULTS OF OPERATIONS The following is management's discussion and analysis of certain significant factors that have affected Avatar during the periods included in the accompanying consolidated statements of operations. A summary of the period to period changes in the items included in the consolidated statements of income is shown below. Operations for the years ended December 31, 1993, 1992 and 1991 resulted in a pre-tax gain (loss) before the changes in accounting methods and extraordinary item of $18,236, ($4,342) and ($12,307), respectively. The improvement in pre-tax income during 1993 compared to 1992 is primarily attributable to the sale of the Midwest Water Utilities for $62,000 which resulted in a pre-tax gain of $21,822 and an adjustment to the estimated development liability for sold land as a result of the purchase of Rio Rico Utilities of $4,532. The improvement in pre-tax results of operations in 1992 compared to 1991 was primarily attributable to higher profit contributions from the Company's utility operations and lower real estate selling expenses. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued RESULTS OF OPERATIONS -- continued Avatar uses the installment method of profit recognition for homesite sales. Under the installment method the gross profit on recorded homesite sales is deferred and recognized in income of future periods, as principal payments on contracts are received. Fluctuations in deferred gross profit result from deferred gross profit on current homesite sales less recognized deferred gross profit on prior years' homesite sales. In accordance with the Company's business plan, the Company continued its gradual transition from selling predominantly Avatar- owned homesites to providing a diversified mix of products and services including introducing additional housing products, developing amenities and support facilities, expanding vacation ownership operations, expanding property management services and converting land holdings into income producing operations. Avatar's business plan also established objectives of modifying the Company's historic homesite sales program with the goal of maintaining or slightly increasing homesite sales volume. A slight improvement in consumer confidence and the economy combined to enable the Company to achieve budgeted levels for homesite sales volume in 1993. The 1993 average selling prices of housing and homesites were comparable to 1992 levels. Gross real estate revenues increased 15% during 1993 when compared to 1992 and decreased 7.9% during 1992 when compared to 1991. The increase in real estate revenues for 1993 when compared to 1992 is primarily a result of increased housing and homesite sales volume. Real estate expenses increased $2,594 or 5.8% in 1993 when compared to 1992 and decreased $7,831 or 14.9% in 1992 when compared to 1991. The increase in real estate expenses for 1993 when compared to 1992 is primarily a result of an increase in cost of products sold due to the increase in real estate sales. Margins have improved based on a reduction in related costs as a percentage of real estate sales and a more profitable sales mix of increased homesite and housing sales for 1993 when compared to 1992. The decline in real estate revenues and expenses for 1992 when compared to 1991 resulted primarily from decreased homesite and housing sales during 1992. Utility revenues decreased $7,252 or 13.6% during 1993 when compared to 1992 and increased $4,078 or 8.3% during 1992 when compared to 1991. Utility expenses decreased $1,991 or 5.4% during 1993 when compared to 1992 and increased $1,173 or 3.3% during 1992 when compared to 1991. Utility revenues decreased in 1993 as a result of the sale of the Midwest Water Utilities which closed on August 31, 1993. Utility expenses did not decline correspondingly primarily due to increased expenses relating to postretirement benefit costs. The increases for 1992 when compared to 1991 are due to increases in Avatar's customer base and rate increases. In comparing the remaining utility subsidiaries, revenues increased $1,565 or 6.4% in 1993 when compared to 1992 and expenses increased $4,699 or 38.9% in 1993 when compared to 1992. The increase in expenses is primarily a result of postretirement benefit costs, the amortization of rate case costs, and the accrual of professional fees. Interest income decreased $2,411 or 14.7% during 1993 when compared to 1992 and $2,686 or 14.1% during 1992 when compared to 1991. The declines in interest income are attributable to lower average aggregate balances of the Company's contract and mortgage notes receivable portfolio. The Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued RESULTS OF OPERATIONS -- continued average balance of Avatar's receivable portfolio was $127,909, $153,053 and $181,550 for 1993, 1992 and 1991, respectively. This decrease in interest income was partially offset by earnings from Avatar's investment securities of $903, $479 and $927 for 1993, 1992 and 1991, respectively. Pre-tax gain on sale of subsidiaries of $21,822 in 1993 is a result of the sale of the Midwest Water Utilities which generated net proceeds of approximately $59,371. Other revenues for 1993 includes a reduction of the estimated development liability for sold land of $4,532 as a result of the purchase of Rio Rico Utilities. General and administrative expenses increased $811 or 10.4% in 1993 compared to 1992 and $196 or 2.6% during 1992 when compared to 1991. The increases in 1993 and 1992 are primarily a result of incentive compensation recorded for senior officers and an increase in professional fees. Additionally, an increase in real estate revenue contributed to the increase for 1993. Interest expense decreased $2,822 or 15.3% in 1993 when compared to 1992 and $738 or 3.8% during 1992 when compared to 1991. These decreases are attributable to an overall decrease in notes, mortgage notes and other debt outstanding during 1993 and lower interest rates during 1992 than in 1991. LIQUIDITY AND CAPITAL RESOURCES Avatar's primary business activities, which include homesite sales, land development and utility services, are capital intensive in nature. Avatar expects to fund its operations and capital requirements through a combination of cash and investment securities on hand, operating cash flows and external borrowings. In 1993, net cash provided by operating activities amounted to $9,925 and resulted primarily from operations including principal payments on contracts receivable of $21,249. Net cash provided by investing activities of $14,823 in 1993 resulted from the proceeds from the sale of subsidiaries of $59,371 and proceeds from the sale of securities of $17,444 reduced by investments in property, plant and equipment of $11,567 and investments in securities of $50,425. Net cash used in financing activities of $20,214 resulted primarily from the principal payment on revolving lines of credit and long-term borrowings of $48,538 and the purchase of treasury stock of $27,000 less net proceeds from revolving lines of credit and long-term borrowings of $26,121 and proceeds from the issuance of common stock in conjunction with the redemption/conversion of the 5-1/4% Debentures (as defined below) of $30,340. Avatar renegotiated certain of its existing bank credit lines and established a new credit line, thereby increasing its secured lines of credit from $36,200 at December 31, 1992, to $45,534 at December 31, 1993. Avatar's unsecured credit lines were decreased from $44,500 at December 31, 1992, to $15,000 at December 31, 1993. The unused portions of these credit lines were $17,000 and $10,325 for the secured and unsecured lines, respectively, at December 31, 1993. Included in these lines of credit is a new line of credit entered into during 1993, secured by investments, which had Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued LIQUIDITY AND CAPITAL RESOURCES -- continued an outstanding balance at December 31, 1993 of $13,000 and will mature during the fourth quarter of 1994. Also included is an amended and restated line of credit with a balance outstanding at December 31, 1993 of $15,534 collateralized by certain contracts receivables and due May 31, 1995. Avatar has planned utility construction for 1994 totaling approximately $22,000. Additionally, the Company has planned land development expenditures of $9,700 during 1994, which will result in additional homesite inventory and preservation of development permits. It is anticipated that land development and utility construction expenditures for 1994 will be funded by operating cash flow and borrowings from external sources. On June 4, 1993 the Company called for the redemption of all its outstanding 5-1/4% convertible-purchase subordinated debentures due May 1, 2007 (the ``5-1/4% Debentures ) at a redemption price of 100% of the principal amount plus accrued and unpaid interest from January 15, 1993 through the redemption date of July 4, 1993. The principal purpose of the redemption was to reduce the Company's annual interest expense, improve its liquidity and increase its stockholders' equity. Holders were entitled to convert their 5-1/4% Debentures into shares of the Company's common stock at a conversion price of $23.00 per share provided they paid in cash an amount equal to the principal amount of the 5-1/4% Debentures being converted, for which they received additional shares of common stock equal to the number issued on conversion. A total of $30,917 principal amount of the 5-1/4% Debentures were converted and 2,688,276 shares of common stock were issued. The remaining $57 principal amount of 5-1/4% Debentures were redeemed as of July 4, 1993. The net result of this transaction, after expenses, was an increase in cash of $30,340, a decrease in debt of $30,973 and an increase in stockholders' equity of $60,835. The closing of the sale of the Midwest Water Utilities took place on August 31, 1993, with an aggregate selling price of $62,000, resulting in a pre-tax gain of $21,822. The Company has invested approximately $51,000 in investment securities which are classified as trading. The Company intends to continue to actively trade such securities in an effort to generate profits and will reinvest such profits until such time as the Company 's cash requirements necessitate the use or partial use of the portfolio proceeds. Avatar's investment portfolio at December 31, 1993 includes $20,045 invested in corporate bonds rated B- or above by Moody's and/or Standard and Poor's and $12,775 invested in non-rated bonds of companies which are in bankruptcy and have defaulted as to payments of principal and interest on such bonds. These bonds are thinly traded and may require sixty to ninety days to liquidate. The portfolio also includes an unsecured claim on a company in bankruptcy of $5,689 which is not readily marketable, $7,020 of equity securities, $1,661 of money market accounts and $3,994 of U.S. Goverment and Agency securities. As of December 31, 1993, $39,932 of the investments serves as collateral for a secured line of credit with an outstanding balance of $13,000. On September 30, 1993 the Company purchased 1,000,000 shares of the Company's common stock from the estate of Peter J. Sharp for $27.00 per share resulting in a decrease in cash of $27,000 and a corresponding decrease in stockholders' equity. These shares are being held in the Company's treasury for future corporate purposes. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued LIQUIDITY AND CAPITAL RESOURCES -- continued Avatar's Board of Directors has authorized expenditures for the purchase of Avatar's 8% and 9% senior debentures. During 1993, Avatar expended $31 for the purchase of its 8% senior debentures and $1,106 for the purchase of its 9% debentures. As of December 31, 1993, the remaining authorization for such expenditures was $4,301. As a result of the proceeds received from the sale of the Midwest Water Utilities and the redemption/conversion of the 5-1/4% Debentures, net of the funds expended for the stock repurchase, the Company believes it has sufficient capital resources to satisfy anticipated liquidity requirements. Management does not anticipate a significant change in interest rates for 1994, and accordingly, does not expect Avatar's primary business activities to be adversely affected by interest rates. Avatar's homesite sales are not dependent upon the customer obtaining third party financing. A high interest rate environment would be likely to adversely affect Avatar's real estate results of operations and liquidity because certain of Avatar's debt obligations are tied to prevailing interest rates. Increases in interest rates affecting the Company's utility operations generally are passed on to the consumer through the regulatory process. EFFECTS OF INFLATION AND ECONOMIC CONDITIONS Inflation has had a minimal impact on Avatar's operations over the past several years, and management believes its effect has been neither significant nor greater than its effect to the industry as a whole. It is anticipated that the impact of inflation on Avatar's operations for 1994 will not be significant. IMPACT OF TAX INSTALLMENT METHOD In 1992, 1991, 1989 and 1988, the Company elected the installment method for recording a substantial amount of its homesite sales in its federal income tax return, which deferred taxable income into future fiscal periods. As a result of this election, the Company may be required to pay compound interest on certain federal income taxes in future fiscal periods attributable to the taxable income deferred under the installment method. The Company believes that the potential interest amount, if any, will not be material to its financial position and results of operations of the affected future periods. RETIREMENT PLANS AND POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The Company adopted this statement in 1993, as required. This statement requires the accrual of postretirement benefits (such as health care benefits) during the years an employee provides services. These benefits for retirees are currently provided only to the employees of the Company's utility subsidiaries. The costs of these benefits were previously expensed on a pay-as-you-go basis. The accrual for postretirement benefit costs at December 31, 1993 amounted to $712. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (dollars in thousands) -- continued RETIREMENT PLANS AND POSTRETIREMENT BENEFITS OTHER THAN PENSIONS--continued As discussed in Notes J and K to the consolidated financial statements, the weighted average discount rate used in determining both the projected benefit obligation for the Company's defined benefit pension plan and the accumulated postretirement benefit obligation for its postretirement benefit plan is 8%. If the Company were to lower the discount rate by 1/2% in 1994, it would result in an increase in the obligation. To illustrate, a decrease in the discount rate from 8% to 7-1/2% in determining the projected benefit obligation for the Company's defined benefit pension plan, would increase the obligation by approximately $275 and pension expense by approximately $44. The same change in discount rate in estimating the accumulated postretirement benefit obligation for the Company's defined benefit postretirement plan, would increase the obligation by approximately $200. Because the Company has elected to record the transition obligation for postretirement benefits over 20 years, as allowed by Statement No. 106, the effect of reducing the discount rate from 8% to 7-1/2% in 1994 would be less than $30. Item 8. Item 8. Financial Statements and Supplementary Data Report of Independent Certified Public Accountants.......... 20 Consolidated Balance Sheets -- December 31, 1993 and 1992... 21 Consolidated Statements of Operations -- For the years ended December 31, 1993, 1992, 1991.............................. 22 Consolidated Statements of Stockholders' Equity -- For the years ended December 31, 1993, 1992, 1991................. 23 Consolidated Statements of Cash Flows -- For the years ended December 31, 1993, 1992, 1991............................... 24 Notes to Consolidated Financial Statements.................. 26 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Stockholders and Board of Directors Avatar Holdings Inc. We have audited the accompanying consolidated balance sheets of Avatar Holdings Inc. 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 three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14. 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 and related schedules 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 Avatar Holdings 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 taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, in 1993 the Company changed its methods of accounting for income taxes, investments and postretirement benefits other than pensions. /s/ ERNST & YOUNG Miami, Florida February 23, 1994, except for the third paragraph of Note R, as to which the date is March 1, 1994 AVATAR HOLDINGS INC. AND SUBSIDIARIES Consolidated Balance Sheets (Dollars in thousands) See notes to consolidated financial statements. AVATAR HOLDINGS INC. AND SUBSIDIARIES Consolidated Statements of Operations (Dollars in thousands except per share data) See notes to consolidated financial statements. AVATAR HOLDINGS INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in thousands except per-share data) (a) $1 par value per share; 15,500,000 shares authorized and 12,715,448, 10,026,956, and 10,020,827, shares issued at December 31, 1993, 1992 and 1991, respectively, including treasury stock. (b) Retained earnings is subsequent to the October 1, 1980 Plan of Reorganization. (c) Treasury stock included 3,620,346 shares at December 31, 1993 and 2,620,346 shares at December 31, 1992 and 1991. There are 5,000,000 authorized shares of preferred stock, none of which are issued. See notes to consolidated financial statements. AVATAR HOLDINGS INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Dollars in Thousands) AVATAR HOLDINGS INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows -- continued (Dollars in Thousands) SUPPLEMENTAL SCHEDULE OF NON-CASH TRANSACTIONS SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES See notes to consolidated financial statements. AVATAR HOLDINGS INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 (Dollars in thousands except per-share data) NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include Avatar Holdings Inc. and its subsidiaries ("Avatar"). All significant intercompany accounts and transactions have been eliminated in consolidation. General: Avatar is principally engaged in the business of developing and selling improved and unimproved real estate, single and multifamily residential housing and providing water and wastewater utility services. Restricted Cash: Restricted cash represents collections of monthly payments on pledged mortgage notes receivable. These collections will be applied to reduce the related mortgage trust notes (See Note H). Land Inventories: Land inventories are stated at the lower of cost or estimated net realizable value. Cost includes expenditures for acquisition, construction, development and carrying charges. Interest costs incurred during the period of land development, when applicable, are capitalized as part of the cost of such projects. Land acquisition costs are allocated to individual land parcels based upon the relationship that the estimated sales prices of specific parcels bear to the total sales price of the entire community. Construction and development costs are added to the value of the specific parcels for which the costs are incurred. Revenues: The Company uses the installment method of profit recognition for sales of homesites and vacation ownership units. Under the installment method, the gross profit on recorded sales is deferred and recognized in income of future periods as principal payments on related contracts are received. Under the installment method, deferred profit is included in the balance sheet, as a reduction of contracts receivable, until recognized. Sales of housing units are recognized in full upon the transfer of title to a purchaser. Revenues from commercial land and bulk land sales are recognized in full at closing, provided the purchaser's initial investment is adequate, all financing is considered collectible, and Avatar is not obligated to perform significant future activities. Utility revenues are recorded as the service is provided. NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- continued Property, Plant and Equipment: Property, plant and equipment are stated at cost and depreciation is computed principally by the straight line method over the estimated useful lives of the assets. Depreciation, maintenance and operating expenses of equipment utilized in the development of land are capitalized as land inventory cost. Property Held for Sale: Property held for sale consists principally of utility property, plant and equipment related to certain water and wastewater utilities which were held for sale at December 31, 1992, and which were sold during 1993. Such assets are reflected at historical cost. Income Taxes: Effective January 1, 1993, the Company adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Under Statement No. 109, the liability method is used in accounting for income taxes. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that are expected to be in effect when the differences reverse. Prior to the adoption of Statement No. 109, income 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 rates in effect in the year the difference originated (deferred method). As permitted by Statement No. 109, the Company has elected not to restate the financial statements of any prior years. The cumulative effect of adopting Statement No. 109 resulted in a charge to net income during the first quarter of 1993 of $964. The cumulative effect of adopting Statement No. 109 for Avatar's utility subsidiaries was not credited or charged to net income, but was recorded as a regulatory liability or regulatory asset in accordance with accounting procedures applicable to regulated enterprises. The regulatory liabilities and regulatory assets will generally be amortized to income or expense over the useful life of the utility system and reflect probable future revenue reductions or increases from ratepayers. The effect of the change on income from continuing operations for the year ended December 31, 1993 was not material. Deferred Customer Betterment Fees: Amounts collected from customers for utility improvements are classified as "Deferred Customer Betterment Fees". These fees will be reclassified to "Contributions in Aid of Construction" when service to the customer begins. Contributions in Aid of Construction: Advances from real estate developers and other direct contributions to utility subsidiaries for plant construction are recorded as "Contributions in Aid of Construction". To the extent required by regulatory agencies, the account balance is amortized over the depreciable life of the utility plant as an offset to depreciation expense. NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- continued Investments: In May 1993, the FASB issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" which, among other things, requires companies to classify certain debt and equity securities as "held to maturity", "available for sale" or "trading." The Company elected to adopt Statement No. 115 as of December 31, 1993, and has classified all of its investment portfolio as trading. This category is defined as including debt and marketable equity securities held for resale in anticipation of earning profits from short-term movements in market prices. Trading account securities are carried at fair value which was $51,184 at December 31, 1993. Subsequent to the initial adoption of Statement No. 115, both realized and unrealized gains and losses will be included in net trading account profit. The cumulative effect as of December 31, 1993 of adopting Statement No. 115 was an increase in net income of $388 (net of income taxes of $238) or $.04 per share. Postretirement Benefits: In 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the accrual of postretirement benefits (such as health care benefits) during the years an employee provides services. These benefits for retirees currently are provided only to the employees of the Company's utility subsidiaries. The costs of these benefits were previously expensed on a pay-as-you-go basis. Net Income Per Common Share: Net income per common share is computed on the basis of the weighted average number of shares outstanding plus common stock equivalents, if any, that would result from the dilutive effect of the assumed conversion (and associated purchase) of the 5-1/4% convertible-purchase subordinated Debentures. In 1993, $30,917 of the Company's 5-1/4% convertible-purchase subordinated Debentures were converted into 2,688,276 shares of common stock. The result of this redemption and conversion was dilutive for the year ended December 31, 1993. The primary and fully diluted computations assume the actual conversion occurred at the beginning of the year. Reclassifications: Certain 1992 and 1991 financial statement items have been reclassified to conform with 1993 presentation. NOTE B - REAL ESTATE SALES The components of real estate sales are as follows: NOTE C - INVESTMENTS Avatar's investment portfolio at December 31, 1993 includes $20,045 invested in corporate bonds rated B- or above by Moody's and/or Standard and Poor's and $12,775 invested in non-rated bonds of companies which are in bankruptcy and have defaulted as to payments of principal and interest on such bonds. These bonds are thinly traded and may require sixty to ninety days to liquidate. The portfolio also includes an unsecured claim on a company in bankruptcy of $5,689 which is not readily marketable, $7,020 of equity securities, $1,661 of money market accounts and $3,994 of U.S. Government and Agency securities. Fair values for actively traded debt securities and equity securities are based on quoted market prices on national markets. Fair values for thinly traded investment securities are generally based on prices quoted by investment brokerage companies. At December 31, 1992 investments securities consisted of U.S. Treasury Notes and Bills. Investments securities at December 31, 1992 are carried at cost which approximates market value. NOTE D - CONTRACTS, MORTGAGE NOTES AND OTHER RECEIVABLES Contracts, mortgage notes and other receivables are summarized as as follows: Contracts and mortgage notes receivable are generated through the sale of homesites at various sales offices located throughout the northeast, midwest and west coast of the United States. A significant portion of the contracts and mortgage notes receivable at December 31, 1993, resulted from sales made to customers in the northeast. Contracts receivable are collectible primarily over a ten year period and bear interest at rates primarily ranging from 7 1/2% to 12% per annum (weighted average rate 9.9%). A contract receivable is considered delinquent if the scheduled installment payment remains unpaid 30 days after its due date. Delinquent principal amounts of contracts and mortgage notes receivable at December 31, 1993, and 1992 were $13,442 or 11.5% and $18,365 or 13.3%, respectively. Scheduled maturities for the five years subsequent to 1993 are: 1994 - $16,072; 1995 - $19,289; 1996 - $20,209; 1997 - $19,546 and 1998 - $16,285. NOTE E - LAND AND OTHER INVENTORIES Inventories consist of the following: NOTE F - ESTIMATED DEVELOPMENT LIABILITY FOR SOLD LAND The estimated cost to complete required land and utility improvements in all areas designated for homesite sales is summarized as follows: These estimates are based on engineering studies of quantities of work to be performed based on current estimated costs. These estimates are reevaluated annually and adjusted accordingly. A major portion of the estimated development liability for sold land relates to utility extensions for homesites at Avatar's Arizona community (Rio Rico) which were sold prior to 1980. At Rio Rico, Avatar entered into various service and construction agreements with Citizens Utilities Company (Citizens), a non-related company, generally providing for Avatar to construct certain utility facilities and deed them to Citizens. Avatar's expenditures, related to the construction of some of these facilities, are expected to be reimbursed from Citizens' present and future customers. Some of these reimbursable amounts are determined by specific formulas. The recovery of these expenditures is dependent upon the community attaining an occupancy and/or usage level sufficient to allow reimbursement prior to the expiration of the agreements. During 1993, Avatar purchased Citizens Utilities' water and wastewater treatment division thereby eliminating the portion of the existing agreement relating to water and wastewater extensions, leaving only the electrical portion. Avatar may be obligated to advance to its utility subsidiary approximately $9,200 (current costs) to complete water and wastewater utility facilities at its Poinciana subdivision. These possible future obligations are based on internal engineering studies and are not included in the estimated development liability discussed above. As such, past and future expenditures are expected to be recovered from customers' fees and future revenues. Expenditures, net of recoveries, for homesite improvement costs totaling $29,933 are estimated as follows: 1994-$8,967, 1995-$8,381 and $12,585 thereafter. Because the timing of the expenditures after 1995 is dependent upon certain future occurrences beyond Avatar's control, projection by year after 1995 is not presently practicable. NOTE G - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment and accumulated depreciation consist of the following: Depreciation charged to operations during 1993, 1992 and 1991 was $6,524, $7,607 and $6,373, respectively, net of amortization of contributions in aid of construction of $2,917, $2,632 and $2,532, during 1993, 1992 and 1991, respectively. NOTE H - NOTES, MORTGAGE NOTES AND OTHER DEBT Notes, mortgage notes and other debt are summarized as follows: NOTE H - NOTES, MORTGAGE NOTES AND OTHER DEBT - continued At December 31, 1993, Avatar had unsecured bank credit lines of $15,000 and secured bank credit lines of $45,534. The unused portions of the unsecured and secured lines were $10,325 and $17,000, respectively. Interest rates for borrowings under these lines range from 4 1/2% to 6% on the unsecured bank credit lines and from 4 3/4% to 6 1/4% on the secured bank credit lines at December 31, 1993. Additionally, certain credit lines provide for fixed rate borrowing pursuant to Eurodollar interest rates. Under the terms of these agreements Avatar is restricted from paying dividends with certain exceptions and is required to maintain a minimum net worth as defined. The secured lines are collateralized by certain contracts and mortgage notes receivable of $20,712 and investment securities of $39,932 at December 31, 1993. In July 1992, Avatar issued $51,160 of 7% Mortgage Trust Notes, pursuant to the securitization of a portion of its homesite receivables. The notes mature on December 15, 2002, however, the Company expects the notes to be repaid in approximately 36 months through the collection of principal payments, including principal prepayments and late collections and all interest payments, net of servicing fee and other adjustments on the mortgage loans. Additionally, all liquidation proceeds with respect to the mortgage loans, proceeds from the sale of property acquired through foreclosure or deed-in-lieu of foreclosure proceedings and proceeds from the purchase of mortgage loans by the issuer are required to be applied to these notes. The balance of these notes at December 31, 1993 was $32,439. Maturities of notes, mortgage notes and other debt at December 31, 1993, are as follows: Maturities for 1994 include approximately $15,633 related to the Company's bank credit lines. There is no assurance that Avatar will be able to obtain satisfactory extensions or refinancing of these or other credit lines. Interest capitalized during 1993, 1992 and 1991 amounted to $381, $772, and $746, respectively. Property, plant and equipment and inventory pledged as collateral for notes, mortgage notes and other indebtedness had a net book value of approximately $151,000 at December 31, 1993. NOTE I - MINORITY INTEREST IN CONSOLIDATED SUBSIDIARIES As of December 31, 1993 and 1992, preferred stock outstanding is as follows: Avatar's utility subsidiary's 9% cumulative preferred stock issue provides for redemption to occur no earlier than March 1, 1997, in whole or in part; however, a minimum of $1,800 of the preferred stock must be redeemed per annum beginning in 1997. A redemption of all outstanding shares shall occur no later than March 1, 2001. Maturities of preferred stock are as follows: 1997-$1,800, 1998 - $1,800 and $5,458 thereafter. Charges to operations recorded as "Other Expenses" relating to preferred stock dividends of subsidiaries amounted to $1,261 in 1993, $1,544 in 1992, and $1,231 in 1991. NOTE J - RETIREMENT PLANS Avatar has two defined contribution savings plans that cover substantially all employees. Under one of the savings plans, Avatar contributes to the plan based upon specified percentages of employees' voluntary contributions. The other savings plan does not provide for contributions by Avatar. Avatar's non-contributory defined benefit pension plan covers substantially all employees of its subsidiary, Avatar Utilities Inc. The benefits are based on years of service and the employees' compensation during the highest 5 out of the last 10 years of employment. Avatar's funding policy is to contribute amounts to the plan sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974. NOTE J - RETIREMENT PLANS - continued The following table sets forth the defined benefit plan's funded status as of December 31, 1993, 1992 and 1991 and the retirement expense recognized in the consolidated statements of income for the years then ended. The 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 8% and 6%, respectively, at December 31, 1993, 1992 and 1991. The expected long-term rate of return on plan assets for 1993, 1992 and 1991 was 8%. At December 31, 1993, and 1992, the plan assets are invested in a group annuity contract with a major insurance company. Approximately 70% and 80%, respectively, of the plan assets at December 31, 1993 and 1992, are invested in a general asset fund of the insurance company that is comprised primarily of fixed income securities. The remaining assets are invested in equity securities, public bonds and cash equivalents in the insurance company's separate accounts. NOTE K - POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Avatar's utility subsidiary sponsors a defined benefit postretirement plan that provides medical and life insurance benefits to both salaried and nonsalaried employees after retirement. The postretirement medical and life insurance plan is non-contributory. Avatar's utility subsidiary's funding policy for its postretirement plan is to fund on a pay-as-you-go basis. Prior to 1993, the expense was also measured on this basis. In 1993, the Company adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which requires accounting for postretirement benefits on an accrual basis. The effect of adopting Statement No. 106 increased net periodic postretirement benefit expense by $712 for 1993. Postretirement expense for 1992 and 1991 has not been restated. The following table sets forth the plan's status as of December 31, 1993: For measurement purposes, a 13% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1993; the rate of increase was assumed to decrease gradually to 6% for the year 2000 and remain 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 1 percentage point each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $626 and the aggregate of the service and interest cost components of net periodic postretirement benefit for the year then ended by $122. The weighted average discount rate used in determining the accumulated postretirement benefit obligation is 8%. NOTE L - LEASE COMMITMENTS Avatar leases the majority of its administration and sales offices under operating leases that expire at varying times through 1999. Rental expenses for the years 1993, 1992 and 1991 were $1,186, $1,513, and $2,037, respectively. Minimum rental commitments under noncancelable operating leases as of December 31, 1993 were as follows: 1994 - $954; 1995 - $929; 1996 - $923; 1997-$746; 1998 - $618; and thereafter - $1,512. NOTE M - ACCRUED AND OTHER LIABILITIES Accrued and other liabilities are summarized as follows: As of December 31, 1993, the Company had agreements with four executive officers providing as incentive compensation a cash payment to each officer (to the extent vested), within ten days following the respective fifth anniversary date of the respective agreement (or the termination date, if earlier), in an amount equal to the excess of a formula amount based upon the closing prices of Avatar common stock during a specified period prior to the respective fifth anniversary date (or termination date, if earlier) over the closing price of Avatar common stock on the date of the respective agreement. Each of these executive officers will vest in the rights to this incentive compensation with respect to one-fifth thereof on each of the first through fifth anniversaries, subject to certain terms and conditions of the contracts should their employment status change prior to the fifth anniversary. For the year ended December 31, 1993, the Company recorded incentive compensation of $469 associated with these agreements. The liability for incentive compensation included in other liabilities at December 31, 1993 and 1992 is $754 and $285, respectively. (See Note R - Contingencies) NOTE N - INCOME TAXES Avatar Holdings Inc. is the successor in interest to GAC Corporation. GAC, together with certain of its subsidiaries, was reorganized pursuant to Chapter X of the Federal Bankruptcy Act of 1898. The Bankruptcy Court confirmed the Trustees' Plan of Reorganization and issued a final decree on October 16, 1981, discharging the Trustees from their duties. Under the installment method of tax reporting for homesite sales, Avatar anticipates that its 1993 consolidated federal income tax return will reflect a net operating loss carryforward of approximately $18,000, which expires in years 2003 through 2004. The net operating loss carryforward was generated after the reorganization as a result of electing the installment method of reporting homesite sales for tax purposes. In addition, investment tax credits and alternative minimum tax credit carryforwards of approximately $5,000 are available, a portion of which expires in years 1994 to 2001. These NOTE N - INCOME TAXES - continued carryforwards have not been examined by the Internal Revenue Service. The Company has recorded a valuation allowance of $33,000 with respect to the deferred income tax assets which remain after offset by the deferred income tax liabilities. Included in the valuation allowance for deferred income tax assets is approximately $9,000 which, if utilized, will be credited to additional paid-in capital. Deferred income taxes reflect the net tax effect 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 income tax assets and liabilities as of December 31, 1993 are as follows: The provision for income taxes consists of the following: Deferred income tax credits result from timing differences in the recognition of certain expenses for tax and financial reporting purposes. For the years ended December 31, 1992 and 1991, the principal components of deferred income tax credits are the theoretical income tax related to the interest discount NOTE N - INCOME TAXES - continued on debentures issued as part of the reorganization and the deferred income tax attributable to the difference between book and income tax depreciation on certain utility assets with long useful lives. A reconciliation of income tax expense (credit) to the expected income tax expense (credit) at the federal statutory rate of 35% for the twelve months ended December 31 is as follows: In 1992, 1991, 1989 and 1988, the Company elected the installment method for recording a substantial amount of its homesite sales in its federal income tax return, which deferred taxable income into future fiscal periods. As a result of such election, the Company may be required to pay compound interest on certain federal income taxes in future fiscal periods attributable to the taxable income deferred under the installment method. The Company believes that the potential interest amount, if any, will not be material to its financial position and results of operations of the affected future periods. NOTE O - SALE OF SUBSIDIARIES On January 30, 1993, the Company entered into stock purchase agreements for the sale of its Midwest Water Utilities located in Indiana, Missouri, Ohio, and Michigan. The closing of the sale of the midwest water utilities took place on August 31, 1993, with an aggregate selling price of $62,000, resulting in a pre-tax gain of $21,822, subject to post-closing adjustments. NOTE P - REDEMPTION/CONVERSION OF 5-1/4% CONVERTIBLE-PURCHASE SUBORDINATED DEBENTURES On June 4, 1993 the Company called for the redemption of all its outstanding 5-1/4% convertible-purchase subordinated Debentures due May 1, 2007 at a redemption price of 100% of the principal amount plus accrued and unpaid interest from January 15, 1993 through the redemption date, July 4, 1993. Holders were entitled to convert their 5-1/4% Debentures into shares of the Company's common stock at a conversion price of $23.00 per share provided they paid in cash an amount equal to the principal amount of the 5-1/4% Debentures being converted, for which they received additional shares of common stock equal to the number issued on conversion. A total of $30,917 principal amount of the 5-1/4% Debentures were converted and 2,688,276 shares of common stock were NOTE P - REDEMPTION/CONVERSION OF 5-1/4% CONVERTIBLE-PURCHASE SUBORDINATED DEBENTURES - continued issued. The remaining $57 principal amount of 5-1/4% Debentures were redeemed as of July 4, 1993. The net result of this transaction, after expenses, was an increase in cash of $30,340, a decrease in debt of $30,973 and an increase in stockholders' equity of $60,835. NOTE Q - TREASURY STOCK PURCHASE On September 30, 1993 the Company purchased 1,000,000 shares of the Company's common stock from the estate of Peter J. Sharp at a purchase price of $27.00 per share. These shares are being held in the Company's treasury for future corporate purposes. NOTE R - CONTINGENCIES Avatar is involved in various pending litigation matters primarily arising in the normal course of its business. Although the outcome of these and the following matters can not be determined, it is the opinion of management that the resolution of these matters will not have a material effect on Avatar's business or financial position. On October 1, 1993, the United States, on behalf of the U.S. Environmental Protection Agency, filed a civil action against a utility subsidiary of Avatar in the U.S. District Court for the Middle District of Florida. (United States vs. Florida Cities Water Company, Civil Action No. 93-281-C1) The complaint alleges that the subsidiary's wastewater treatment plant in North Fort Myers, Florida, committed various violations of the Clean Water Act, 33 U.S.C. S1251 et seq., including (1) discharge of pollutants without an operating permit from October 1, 1988 to October 31, 1989; (2) discharging from an unpermitted discharge location from November 1, 1989 until July 14, 1992; and (3) discharging pollutants in excess of permit limitations at various times from July 1991 to June of 1992. The government is seeking the statutory maximum civil penalties of $25,000 per day, per violation based upon the allegations. The Subsidiary strongly believes that there are mitigating factors as well as valid legal defenses that could reduce or eliminate the imposition of monetary sanctions. On March 1, 1994, the Wisconsin Department of Natural Resources (the "Department") sent Avatar notice that the Department had recently issued a second Record of Decision ("ROD") in connection with the Edgerton Sand & Gravel Landfill site (the "Site"). The ROD calls for the City of Edgerton's public water supply system to be extended to the owners of private wells in the vicinity of the Site. The ROD also states that other work related to soil and groundwater remedial action would be required at the Site. The Department demanded that all potentially responsible parties ("PRP's") associated with the Site organize into a PRP group to undertake the implementation of the ROD. Avatar was previously identified as a PRP by the Department. Avatar believes that it is not liable for any claims by any governmental or private party in connection with the Site. On February 25, 1994, the Company's former President and Chief Executive Officer commenced a lawsuit against Avatar and others claiming damages arising out of his termination of his employment purportedly for "Good Reason" (as defined in his employment agreement.) He also seeks to recover damages from Avatar for libel and slander and from the other defendants based on their alleged malicious interference with his employment agreement. Avatar denies that he had Good Reason to terminate his employment agreement. Avatar does not believe there is any valid basis for his claims, and various affirmative defenses have been asserted. Avatar also has asserted counterclaims against him for breach of contract, promissory estoppel and improper inducement in connection with amendments to his employment agreement. NOTE S - FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS NOTE S - FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS -- continued (a) Avatar's businesses are primarily conducted in the United States. (b) In computing operating profit, interest has been reflected separately. (c) Intersegment revenues contain primarily intercompany interest and management fees charged to affiliates. (d) Identifiable assets by segment are those assets that are used in the operations of each segment. General corporate assets are principally cash, receivables and investments. (e) No significant part of the business is dependent upon a single customer or group of customers. (f) Cable TV, mortgage and hotel and recreational operations which primarily serve Avatar communities do not qualify individually as separate reportable segments and are included in the real estate segment. (g) General corporate expenses are included in the real estate segment. NOTE T- FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts and fair values of the Company's financial instruments at December 31, 1993, are as follows: The following methods and assumptions were used by the Company in estimating the fair value of financial instruments: Cash and restricted cash: The carrying amount reported in the balance sheet for cash approximates its fair value. Investments: The carrying amount in the balance sheet for investments is at fair market value which is generally determined by quoted market prices. Contracts, mortgage notes and other receivables: The fair value amount of the Company's contracts, mortgage notes, and other receivables are estimated based on a discounted cash flow analysis. Notes, mortgage notes and other debt: The carrying amounts of the Company's borrowings under its short-term bank credit lines approximate their fair value. The fair values of the Company's mortgage obligations, mortgage bonds, and promissory notes are estimated using discounted cash flow analysis, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. NOTE T- FAIR VALUE OF FINANCIAL INSTRUMENTS - continued Senior debentures: The fair values of the Company's Senior and Subordinated debentures are estimated based on quoted market prices. Mortgage trust notes: The carrying amount in the balance sheet for mortgage trust notes approximates its fair value. The current market rate for similar types of borrowing arrangements approximates the rate of the mortgage trust notes. NOTE U - QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 is as follows: (1) Net revenues include homesite sales which are recorded on the installment method of profit recognition. Item 9. 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 Registrant A. Identification of Directors The information called for in this item is incorporated by reference to Avatar's 1994 definitive proxy statement (under "Election of Directors") to be filed with the Securities and Exchange Commission on or before April 30, 1994. B. Identification of Executive Officers For information with respect to the executive officers of Avatar, see "Executive Officers of the Registrant" at the end of Part I of this report. Item 11. Item 11. Executive Compensation The information called for by this item is incorporated by reference to Avatar's 1994 definitive proxy statement (under the caption "Executive Compensation and Other Information") to be filed with the Securities and Exchange Commission on or before April 30, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information called for by this item is incorporated by reference to Avatar's 1994 definitive proxy statement (under the captions "Principal Stockholders" and "Security Ownership of Management") to be filed with the Securities and Exchange Commission on or before April 30, 1994. 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 Financial Statements and Schedules: See Item 8 "Financial Statements and Supplementary Data" on Page 17 of this report. Schedules: I - Marketable Securities and Other Investments V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts IX - Short-Term Borrowings X - Supplementary Income Statement Information Schedules other than those listed above are omitted, since the information required is not applicable or is included in the financial statements or notes thereto. Exhibits: 3(a) * Certificate of Incorporation, as amended (previously filed as an exhibit to the Form 10-K for the year ended December 31, 1986). 3(b) By-laws, as amended through March 24, 1994 (filed herewith). 4(a) * Instruments defining the rights of security holders, including indenture for 8% senior debentures (previously filed as an exhibit to the Form 8-K dated as of September 12, 1980). 4(b) * Supplemental Indenture for 8% senior debentures dated as of December 19, 1992 (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 4(c) * Indenture for 9% senior debentures dated as of December 19, 1992 (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 4(d) * Indenture for 5-1/4% convertible-purchase subordinated debentures dated May 1, 1987 (previously filed as an exhibit to Form 10-Q for the period ended March 31, 1987). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K -- continued 10(a) * Consulting Agreement, dated as of December 31, 1990, by and between Avatar Properties Inc. and John Sladkus (previously filed as an exhibit to Form 10-K for the year ended December 31, 1990). Consulting Agreement, dated as of December 31, 1990, by and between Avatar Utilities Inc. and John Sladkus (previously filed as an exhibit to Form 10-K for the year ended December 31, 1990). 10(b) * 1 Employment Agreement, dated as of June 15, 1992, by and between Avatar Holdings Inc. and Lawrence Wilkov (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 10(c) * 1 Employment Agreement, dated as of June 15, 1992, by and between Avatar Holdings Inc. and Edwin Jacobson (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 10(d) 1 Amendment to Employment Agreement, dated as of March 1, 1994, by and between Avatar Holdings Inc. and Edwin Jacobson (filed herewith). 10(e) * Four separate Stock Purchase Agreements dated January 30, 1993, with respect to the sale of the Registrant's utilities located in Indiana, Missouri, Ohio and Michigan, respectively (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(f) * Agreement dated January 30, 1993, with respect to the transactions contemplated by the Stock Purchase Agreements (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(g) * Guarantee by the Registrant (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(h) * Guarantee by American Water Works Company, Inc. (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(i) 1 Incentive Compensation Agreement, dated as of January 18, 1993 by and between Avatar Holdings Inc. and Dennis Getman (filed herewith). 10(j) 1 Incentive Compensation Agreement, dated as of September 9, 1993 by and between Avatar Holdings Inc. and Charles McNairy (filed herewith). 10(k) Revolving Credit Agreement between Avatar Properties Inc. and BHF Bank dated November 30, 1993 (filed herewith). 11 Statement Re: Computation of per share earnings (filed herewith). Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K -- continued 22 Subsidiaries of the Registrant (filed herewith). Reports on Form 8-K: No reports on Form 8-K were filed during the quarter ended December 31, 1993. * These exhibits are incorporated by reference and are on file with the Securities and Exchange Commission. 1 Employment and compensation agreements. SCHEDULE I - MARKETABLE SECURITIES AND OTHER INVESTMENTS AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands, except number of shares) (1) Corporation in Bankruptcy/Principal and Interest in Default SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPEMNT AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) (1) The annual provisions for depreciation have been computed principally in accordance with the following ranges of rates: Utility, plant and equipment 1.5% to 10% Other property, plant and equipment 5% to 20% (a) Charged principally to estimated cost of development of land sold and amortization of contributions in aid of construction. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) (1) Charged to operations as a reduction of revenues. (2) Uncollectible accounts written off (3) Credited principally to interest income or allowance for doubtful accounts upon write-off of uncollectible accounts. (4) Valuation allowance for deferred tax assets recorded in conjunction with the adoption of FASB Statement No. 109. SCHEDULE IX - SHORT-TERM BORROWINGS AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION AVATAR HOLDINGS INC. AND SUBSIDIARIES (Dollars in thousands) Amounts for royalties not presented as such amounts are less than one percent of total revenue. 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. AVATAR HOLDINGS INC. Dated: March 24, 1994 By: /s/Charles L. McNairy Charles L. McNairy, Executive Vice President, Treasurer 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 in the capacities and on the dates indicated. Dated: March 24, 1994 By: /s/Geoffrey C. Hazard, Jr. Geoffrey C. Hazard, Jr., Director and Audit Committee Member Dated: March 24, 1994 By: /s/J. Edward Houston J. Edward Houston, Director, Chairman of the Audit Committee and Executive Committee Member Dated: March 24, 1994 By: /s/Edwin Jacobson Edwin Jacobson, Director, Chairman of the Executive Committee, President and Chief Executive Officer Dated: March 24, 1994 By: /s/Leon T. Kendall Leon T. Kendall, Director and Audit Committee Member Dated: March 24, 1994 By: /s/Leon Levy Leon Levy, Chairman of the Board of Directors and Executive Committee Member Dated: March 24, 1994 By: /s/Martin Meyerson Martin Meyerson, Director and Audit Committee Member Dated: March 24, 1994 By: /s/William Porter William Porter, Director and Audit Committee Member Dated: March 24, 1994 By: /s/Fred Stanton Smith Fred Stanton Smith, Director and Executive Committee Member Dated: March 24, 1994 By: /s/Henry King Stanford Henry King Stanford, Director Dated: March 24, 1994: By: Lawrence Wilkov, Director Dated: March 24, 1994 By: /s/John J. Yanopoulos John J. Yanopoulos, Vice-President - Finance and Controller Exhibit Index 3(a) * Certificate of Incorporation, as amended (previously filed as an exhibit to the Form 10-K for the year ended December 31, 1986). 3(b) By-laws, as amended through March 24, 1994 (filed herewith)........................................60 4(a) * Instruments defining the rights of security holders, including indenture for 8% senior debentures (previously filed as an exhibit to the Form 8-K dated as of September 12, 1980). 4(b) * Supplemental Indenture for 8% senior debentures dated as of December 19, 1992 (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 4(c) * Indenture for 9% senior debentures dated as of December 19, 1992 (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 4(d) * Indenture for 5-1/4% convertible-purchase subordinated debentures dated May 1, 1987 (previously filed as an exhibit to Form 10-Q for the period ended March 31, 1987). 10(a) * Consulting Agreement, dated as of December 31, 1990, by and between Avatar Properties Inc. and John Sladkus (previously filed as an exhibit to Form 10-K for the year ended December 31, 1990). Consulting Agreement, dated as of December 31, 1990, by and between Avatar Utilities Inc. and John Sladkus (previously filed as an exhibit to Form 10-K for the year ended December 31, 1990). 10(b) * Employment Agreement, dated as of June 15, 1992, by 1 and between Avatar Holdings Inc. and Lawrence Wilkov (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 10(c) * Employment Agreement, dated June 15, 1992, by 1 and between Avatar Holdings Inc. and Edwin Jacobson (previously filed as an exhibit to Form 10-K for the year ended December 31, 1992). 10(d) Amendment to Employment Agreement, dated as of March 1, 1994, by and between Avatar Holdings Inc. and Edwin Jacobson (filed herewith).................80 10(e) * Four separate Stock Purchase Agreements dated January 30, 1993, with respect to the sale of the Registrant's utilities located in Indiana, Missouri, Ohio and Michigan, respectively (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(f) * Agreement dated January 30, 1993, with respect to the transactions contemplated by the Stock Purchase Agreements (previously filed as an exhibit to Form 8- K dated as of February 3, 1993). Exhibit Index -- continued 10(g) * Guarantee by the Registrant (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(h) * Guarantee by American Water Works Company, Inc. (previously filed as an exhibit to Form 8-K dated as of February 3, 1993). 10(i) 1 Incentive Compensation Agreement, dated as of January 18, 1993 by and between Avatar Holdings Inc. and Dennis Getman (filed herewith)......................82 10(j) 1 Incentive Compensation Agreement, dated as of September 9, 1993 by and between Avatar Holdings Inc. and Charles McNairy (filed herewith)............... 93 10(k) Revolving Credit Agreement between Avatar Properties Inc. and BHF Bank dated November 30, 1993 (filed herewith)..........................................102 11 Statement Re: Computation of per share earnings (filed herewith)...................................138 22 Subsidiaries of the Registrant (filed herewith)..........................................139 * These exhibits are incorporated by reference and are on file with the Securities and Exchange Commission. 1 Employment and Compensation agreements.

60519_1993.txt

60519_1993

1993

60519

ITEM 1. Business General Louisiana-Pacific Corporation, a Delaware corporation, is a major forest products firm headquartered in Portland, Oregon. It manufactures lumber, pulp, structural and other panel products, hardwood veneers, windows and doors and cellulose insulation. It operates 129 plants and mills in 27 U.S. states, Mexico, and three provinces in Canada, and has approximately 13,000 employees. It distributes its products primarily through distributors and home centers, and to a minor extent through its own distribution centers. The business of Louisiana-Pacific Corporation and its wholly-owned subsidiaries (except where the context otherwise requires, hereinafter referred to collectively as "the registrant" or "L-P") is generally divided into two industry segments: building products and pulp. For 1993, building products accounted for approximately 97 percent of the registrant's gross sales revenues, compared to approximately 3 percent for pulp. With respect to operating profit in 1993, building products contributed approximately 111 percent, offset by an 11 percent loss for pulp. Building Products Lumber. The registrant is among the three largest producers of lumber in the United States. The registrant has 22 Western (whitewood and redwood) sawmills with an annual production capacity of 1,370 million board fee (MMBF), while its 28 Southern sawmills have an annual production capacity of 945 MMBF. Lumber represented 33 percent of the registrant's sales revenue in 1993, down from 53 percent in 1980. The registrant's sawmills produce a variety of standard U.S. dimension lumber as well as specialty grades and sizes, primarily for the North American home building market. A sawmill in Ketchikan, Alaska, produces lumber for export in the traditional sizes used in the Japanese building industry, but has the capability of switching to standard U.S. dimensions. The registrant also operates a planing mill in El Sauzal, Mexico. Panel Products. The registrant manufactures plywood and a variety of reconstituted panel products, including Inner-Seal(R) oriented strand board (OSB) and such other panel products as industrial particleboard, medium density fiberboard, and hardboard. In recent years, the registrant has emphasized development and expansion of its reconstituted panel product lines. While such products accounted for 6 percent of the registrant's sales in 1980, they comprised 33 percent of its sales in 1993. Plywood sales have risen from 12 percent of sales in 1980 to 15 percent of sales in 1993. - 1- The largest consumption of panel products is for structural uses in building and remodeling such as subfloors, walls and roofs. The total structural panel market in the United States (plywood, OSB and other waferboards) is approximately 26 billion square feet annually, of which plywood currently constitutes about 17 billion square feet. In recent years, environmental pressure on timber harvesting, especially in the West, has resulted in reduced supplies and higher costs, causing many plywood mills to close permanently. The lost volume from those closed mills (approximately 2 billion square feet annually according to industry sources) has been replaced by reconstituted structural panel products. The registrant operates seven plywood plants in the South with a combined annual capacity of 1.5 billion square feet. The registrant is the largest domestic producer of oriented strand board through 17 Inner-Seal(R) OSB plants with an aggregate annual capacity of approximately 3.5 billion square feet. Approximately 50 percent of the registrant's 1993 sales volume in this category came from higher margin specialty products such as tongue and groove subflooring, siding, soffit and facia. The registrant's other reconstituted panel products-- industrial particleboard, medium density fiberboard, and hardboard--produced at a total of seven plants, are used primarily in the manufacture of furniture and cabinets. Other Building Products. The registrant's new fiber gypsum wallboard, known as FiberBond(TM), is made from gypsum and waste paper and has improved capabilities over standard wallboard. Other FiberBond(TM) products include fire retardant sheathing and underlayment. The registrant's first fiber gypsum plant, with a production capacity of 78 million square feet, is the first of its kind in North America, although a similar product is manufactured in Europe. The plant began operations in Nova Scotia, Canada, in early 1991. A second plant is scheduled for start-up in mid-1994 in East Providence, Rhode Island. Seven plants in Ohio and one in Nevada manufacture windows and doors. The registrant produces various hardwood veneers at a plant in Wisconsin with both rotary and sliced manufacturing processes. These veneers are sold to customers who overlay the veneers on other materials for use in paneling, furniture and cabinets. The registrant has three engineered I-joist plants located in Red Bluff, California, Fernley, Nevada, and Wilmington, North Carolina. Inner-Seal(R) OSB is cut into sections and used as the web for the I-joists. The registrant also produces laminated veneer lumber (LVL) at Wilmington, North Carolina, and Fernley, Nevada. LVL is - 2 - a high grade structural product used where extra strength is required. It is also used as the flange material in I-joists. Four plants produce cellulose residential insulation from recycled newspaper under the name Nature Guard(TM). This insulation has a higher R-value than comparable thicknesses of conventional fiberglass insulation. Pulp The registrant has three pulp mills located in Ketchikan, Alaska, Samoa, California, and Chetwynd, British Columbia, Canada, with a total annual capacity of 612 million short tons. The Chetwynd mill utilizes a state-of-the-art mechanical pulping process and a zero effluent discharge system to produce 100 percent aspen pulp. The Samoa mill can produce bleached kraft pulp by a chlorine-free process, thereby eliminating dioxins. Competition The registrant competes internationally with several thousand forest products firms, ranging from very large, fully integrated firms to smaller firms which may manufacture only one or a few items. The registrant estimates that approximately 25 forest products firms comprise its major competition. The registrant also competes less directly with firms which manufacture substitutes for wood building products. A majority of the products manufactured by the registrant, including lumber, structural panels and pulp, are commodity products sold primarily on the basis of price in competition with numerous other forest products companies. In recent years, the registrant has introduced a number of new value-enhanced products to complement its traditional lumber and panel products, such as Inner-Seal(R) OSB panels, siding and concrete form. These innovative products are made from abundant, smaller-diameter and affordably-priced tree species, as well as treetops and mill shavings. Such trees have generally not been the target of environmentalist pressure, which has seriously restricted wood supplies for much of the industry, especially in the West. Similarly, the registrant's new fiber gypsum and cellulose insulation products utilize wood fiber from waste paper. The registrant believes development of these new products gives it a competitive advantage through lower and more predictable supply costs, resulting in higher profit margins. Environmental Compliance The registrant is subject to federal, state and local pollution control laws and regulations in all areas in which it has operating facilities. The registrant maintains an accounting reserve for environmental fines and certain other environmental - 3 - costs. Over the past two years, $19.2 million in expense related to these costs has been recorded. At December 31, 1993, $8.1 million remained in the reserve. Amounts which may be required in future years depend on the extent to which more stringent pollution control laws, regulations, and policies may be enacted by Congress, the states, localities, or adopted by enforcement agencies. From time to time, the registrant undertakes construction projects for environmental control facilities or incurs other environmental costs which extend an asset's useful life, improves efficiency or improves the marketability of certain properties. Information concerning legal proceedings related to environmental compliance is set forth under Item 3, Legal Proceedings. Additional Statistical Information Additional information regarding the business of the registrant, including segment information, production volumes, and industry product price trends are presented in the following tables labeled "Sales and Operating Profit by Major Product Group," "Summary of Production Volumes," "Industry Product Price Trends," and "Logs by Source." Additional financial information about industry segments is presented in the table labeled "Industry Segment Information" located within Part II, Item 8, Notes to the Financial Statements. Reference is made to Item 2 ITEM 2. Properties The registrant has three sawmills (redwood and whitewood) located in California with an annual production capacity of 200 MMBF. Twelve other Western sawmills operate in the following states or provinces: Alaska, Montana, Idaho, Oregon, Colorado, Washington, and Sundre, Alberta, Canada. These sawmills have an annual production capacity of 700 MMBF. Western studmills total seven in the following states: Montana, California, Idaho, Wyoming, and Washington, with an annual production capacity of 470 MMBF. The remaining 28 sawmills have an annual production capacity of 945 MMBF and are located in the South in the following states: Louisiana, Texas, Alabama, Florida, Georgia, Mississippi, and North Carolina. The registrant has seven plywood plants located in Texas and Louisiana with a combined annual production capacity of 1.5 billion square feet. There are 17 OSB plants with a combined capacity of 3.5 billion square feet located in Idaho, Texas, Virginia, Alabama, Wisconsin, Maine, Georgia, Colorado, Michigan, Minnesota, Louisiana, and British Columbia, Canada. The registrant has three medium density fiberboard plants located in Alabama, California and Louisiana with a combined capacity of 220 MMSF; three particleboard plants in California, Montana and Texas with a capacity of 350 MMSF; and a hardboard plant in California with an annual production capacity of 210 MMSF. Under the category of other building products, the registrant operates two hardwood veneer plants in Wisconsin, seven window and door plants in Ohio and Nevada, three I-joist and two laminated veneer lumber plants in Nevada, North Carolina, and California, two fingerjoint studmills in Montana and Idaho, and fiber gypsum plants in Nova Scotia, Canada and Rhode Island. The registrant operates three pulp mills with an annual capacity of 612 million short tons in Alaska, California, and British Columbia, Canada. Other manufacturing facilities include: a brick plant, four cellulose insulation plants, a cement fiber shake plant, three chip mills, an insulated glass and vinyl extrusion plant, a planing mill, and ten wood treating plants in these various locations: Mexico, Canada, Texas, Alabama, Florida, Georgia, Mississippi, Missouri, Ohio, Maryland, and California. The registrant also operates seven distribution centers in California, Texas, Kansas, and Oklahoma. Information relating to the registrant's production volumes is located in the table labeled "Summary of Production Volumes" in Item 1. The information on capacities reflects normal operating rates and normal production mixes under current market conditions. Capacities also consider known constraints such as log supply. - 8 - At December 31, 1993, the registrant owned in fee approximately 1,585,900 acres of timberland in the United States. The timberland holdings including whitewoods, fir, pine, redwood, and hardwoods are located in the following states: California, Idaho, Louisiana, Minnesota, North Carolina, Oregon, Texas, Washington, Wisconsin and Wyoming. In addition to its fee-owned timberlands, the registrant has timber cutting rights, under long-term contracts (five years and over) on approximately 110,000 acres and under contracts for shorter periods on approximately 278,000 acres, on government and privately owned timberlands in the vicinities of certain of its manufacturing facilities. Information regarding the sources of the registrant's log requirements is located under the table labeled "Logs By Source" in Item 1. ITEM 3. ITEM 3. Legal Proceedings The registrant has received a Notice of Violation issued by the U.S. Environmental Protection Agency alleging air emissions violations at the registrant's Dungannon, Virginia, OSB plant. The registrant has also received a Notice of Violation issued by the state of Michigan alleging air emissions violations at the registrant's Newberry, Michigan, OSB plant. The potential costs to the registrant cannot be determined at this time, but are not expected to have a material adverse effect on the registrant. The registrant has been informed that it and one or more employees at its Olathe, Colorado, oriented strand board plant are the targets of a federal grand jury investigation concerning alleged tampering with emissions monitoring equipment and alteration of plant records. The registrant does not know when the investigation will be completed. The registrant began an internal investigation in the summer of 1992 and reported its initial findings of irregularities to governmental authorities in September, 1992. On September 9, 1992, the U.S. Department of Justice filed suit in the U.S. District Court in Anchorage, Alaska, against the registrant's wholly-owned subsidiary Ketchikan Pulp Company ("KPC") alleging that the pulp mill in Ketchikan, Alaska, operated by KPC violated the Clean Air Act and the terms of KPC's wastewater discharge permit. The plaintiff seeks to require KPC to correct the alleged violations and also seeks penalties in an unspecified amount. Settlement discussions are currently underway. The registrant has been informed that KPC and one or more employees at KPC's pulp mill are the targets of a federal grand jury investigation concerning wastewater discharges. No charges have been made and the registrant does not know when the investigation will be completed. - 9 - The registrant understands that a federal grand jury is investigating possible violations in connection with the disposal by a contractor of a transformer containing polychlorinated biphenyls (PCBs) previously located at the registrant's former sawmill at Pendleton, Oregon. The registrant does not know whether it or any of its employees are targets of the investigation. On October 19, 1992, the State of Wisconsin filed a suit against the registrant in state court in Dane County Circuit Court alleging that the registrant's oriented strand board plant at Hayward, Wisconsin, is in violation of state and federal clean air laws. The plaintiff seeks to require the registrant to correct the alleged violations and also seeks penalties in an unspecified amount. The case was settled in 1993 for $550,000. Management of the registrant believes that the outcome of the above matters will not have a materially adverse effect on the consolidated business or financial condition or results of operations of the registrant. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of the registrant's security holders during the fourth quarter of 1993. Executive Officers of the Registrant The following table sets forth the name of each executive officer of the registrant (including certain executives whose duties may cause them to be classified as executive officers under applicable SEC rules), the age of the officer and all positions and offices held with the registrant as of March 16, 1994: Messrs. Merlo, Eisses, and Paul are also directors of the registrant. All executive officers serve at the pleasure of the board of directors. The terms of office for which they are elected run - 10 - until the next annual meeting of the board of directors, unless earlier removed. Except as set forth below, all of the executive officers have served in their present capacities for more than five years. In January 1994, Mr. Eisses became executive vice president; from June 1992 to January 1994, he was vice president, operations; previously he was general manager of L-P's Northern Division, a position he still holds. Mr. Paul became vice president, operations, in January 1994; previously he was general manager of L-P's Southern Division, a position he continues to hold. Prior to assuming his present position in March 1992, Mr. Simpson was president of Tricon Forest Products, Inc., a forest products broker. Mr. Hebert became treasurer and chief financial officer in January 1994; previously he was L-P's controller, finance. PART II ITEM 5. ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters The common stock is listed on the New York Stock Exchange, the Dow-Jones newspaper quotations symbol is "LaPac," and the ticker symbol is "LPX." Information regarding market prices for the registrant's common stock is included in the following table labeled "High and Low Stock Prices." Holders of the registrant's common stock may automatically reinvest dividends toward purchase of additional shares of the company's common stock. At March 16, 1994, L-P had approximately 24,600 stockholders of record. LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES HIGH AND LOW STOCK PRICES Information regarding dividends on its common stock declared by the registrant during the past two years is located in the following table. - 11 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES QUARTERLY DATA (Dollar amounts in millions except per share) - 12 - ITEM 6. ITEM 6. Selected Financial Data LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES FINANCIAL SUMMARY (Dollar amounts in millions except per share) - 13 - ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations GENERAL Building Products Continued growth in demand for building products fueled by a gradually improving economy in the United States pushed product prices higher. Tightening timber supplies, due to reductions in federal timber harvest volumes, also contributed to the rise in product prices. Interest rates remained very favorable for the housing industry. Housing starts, an important measure of building products demand, rose for the fourth consecutive year totaling 1.285 million housing starts in 1993, a 7 percent increase over 1992. The low interest rate environment continues to benefit the repair and remodelling business as well. Export markets for building products were quite weak in 1993 as both the Far East and European economies were slow. Pulp High worldwide inventories of market pulp combined with extremely depressed economic conditions in many of the countries that use market pulp caused the worst pulp market in recent memory. As a result the industry experienced sizable losses and significant downtime. The following discussion of L-P's operations and financial condition presents specific highlights, and discusses material changes or trends affecting the results of operations. A thorough review of the table "Financial Summary" in Item 6 and the tables labeled "Sales and Operating Profit by Major Product Group," "Summary of Production Volumes," "Industry Product Price Trends," and "Logs by Source" located in Item 1 will provide a greater understanding of the factors which affect L-P's businesses. Those present, in a tabular format, many of the variables, volumes, operating rates of capacity, representative industry prices, and segment information to enhance the understanding of the financial statements. - 14 - RESULTS OF OPERATIONS Building Products L-P's building products segment, which in 1993 accounted for 97 percent of total sales, posted a record year, both in terms of sales and profits. Sales in 1993 totalled $2.4 billion compared with $2.0 billion in 1992 and $1.5 billion in 1991. The record sales in 1993 resulted from higher volumes and prices of nearly every building products category. Particularly strong performers in 1993 were panel products: oriented strand board (OSB), plywood and industrial panel products. Also turning solid sales gains was L-P's Other Building Products category which includes, among other products, engineered wood products: I-joists and laminated veneer lumber. Operating profits also were a record in 1993 totaling $562 million compared with $364 million in 1992 and $139 million in 1991. Operating profits in each of the past three years have increased despite the rising costs of raw materials. Logs purchased in the open market for sawmills and plywood plants have increased 20-30 percent in each of the past three years. However, purchased wood for L-P's OSB plants has increased 6-8 percent per year in each of the past three years. Sawdust and wood shavings which are the raw materials for industrial panel products have also increased in each of the past three years, primarily due to reductions in sawmill production caused by timber shortages. Pulp Significant downtime in L-P's pulp mills and record low prices resulted in pulp sales for 1993 of only $85 million compared with $185 million in 1992 and $170 million in 1991. L- P's three pulp mills operated at only 37 percent of normal capacity in 1993 due to market related downtime. Operating profits also reflected the conditions in the pulp industry posting a record $59 million loss versus losses of $20 million in 1992 and $3 million in 1991. ENVIRONMENTAL UPDATE The greatest challenge confronting L-P today is the ever changing rules and regulations concerning the environment. Our plants face increasingly stringent standards for air and water emissions. Our timberlands are subject to challenges from preservationist groups focused on locking up the nations' timber supply. L-P's management is dedicated to meeting these challenges by effectively resolving past environmental issues and committing substantial human and financial resources to its future - 15 - environmental performance. In 1993, the company spent over $100 million in environmental costs and capital projects. Its actions are overseen by the company's Department of Environmental Affairs and by the Environmental Affairs Committee of the board of directors. A few examples of the company's environmental performance in the past several years are: the conversion of the company's Samoa, California pulp mill to a chlorine-free process, thereby eliminating dioxins; L-P's agreement with the Environmental Protection Agency (EPA) to install state-of-the-art regenerative thermal oxidization technology at fifteen of its wood panel plants; and, voluntarily eliminating the practice of clear-cutting on the company's timberlands. Although L-P's corporate policy is to comply with all applicable laws, L-P has in the past been required to pay fines for non-compliance and sometimes litigation has resulted from contested environmental actions. Where the environmental infractions were caused by others, L-P vigorously pursues recovery through legal channels. Listed below are some of the environmental actions recently resolved or currently pending against the company. In 1992, as part of as industry-wide inquiry, L-P received notices of violation from the EPA involving fifteen of its wood panel manufacturing facilities. In 1993, L-P reached a precedent-setting settlement which called for L-P to pioneer pollution control technology at these facilities. The agreement also required L-P to pay an $11.1 million fine to EPA. The fine was paid in 1993, but had been substantially accrued for in 1992. L-P has been informed that it and one or more of its employees are the subjects of separate federal grand jury investigations regarding air emissions at its Montrose, Colorado, plant and wastewater discharges at its Ketchikan Pulp Company subsidiary's pulp mill. The investigations have not been completed and no charges against the company or any of its employees have been made. Also, Ketchikan Pulp Company is the subject of a civil enforcement action alleging violations of the Clean Water Act and Clean Air Act. Settlement of this action will likely involve fines and future capital expenditures for environmental projects. Certain of L-P's plants or properties held for sale are suspected of having substances in the ground and groundwater that are considered pollutants. Under the direction of the company's Department of Environmental Affairs, corrective action or plans for corrective action are underway. Management believes that the costs of complying with the above actions will not have a material adverse effect on the business, financial condition or results of operations of the company. Generally, L-P expenses the costs of such actions currently as they become known. - 16 - FINANCIAL POSITION AND LIQUIDITY Sales for 1993 totalled a record $2.5 billion compared with $2.2 billion in 1992 and $1.7 billion in 1991. Income before cumulative effects of accounting changes for 1993 was $254.4 million, including a $4.4 million charge related to the 1 percent increase in the federal statutory tax rate used to calculate beginning of the year deferred income taxes, compared with net income of $176.9 million in 1992 and $55.9 million in 1991. The cumulative effects of accounting changes relate to adoption of Financial Accounting Standards Board Statement No. 109, "Accounting for Income Taxes" which resulted in an after-tax charge of $7.2 million, $.07 per share and Financial Accounting Standards Board Statement No. 106, "Employers' Accounting for Post-retirement Benefits Other Than Pensions" which resulted in a net charge of $3.2 million, $.03 per share. L-P's financial position and liquidity continues to be among the strongest in the industry. Long-term debt as a percent of total capitalization was only 15.5 percent at December 31, 1993 compared with 22 percent at year end 1992 and 29 percent at year end 1991. The company's ratio of current assets to current liabilities was 1.94 at December 31, 1993, 1.82 at December 31, 1992, and 1.78 at December 31, 1991. Cash and cash equivalents totalled $261.6 million at December 31, 1993, up from $228.1 million at December 31, 1992. Record profits in 1993 also resulted in record cash provided from operations of $438.5 million, compared with $360.3 million in 1992 and $250.2 million in 1991. This strong cash flow has allowed the company to invest in environmental projects, added capacity, continued improvement and upgrading of its existing facilities and make investments in timber. It has also allowed the company to make its mandatory debt repayments and consistently increase cash dividends to its stockholders. L-P has an unused line of credit with banks totaling $100 million that is available for general corporate purposes. It maintains short-term credit ratings of A-1 with Standard & Poors and D-1 Plus with Duff & Phelps. L-P has a stock purchase program whereby at management's discretion the company may purchase 2.2 million shares of L-P stock. The company purchased 200,000 shares of L-P common stock in 1993. In 1994, L-P plans capital expenditures of about $325- 350 million. Other cash needs include mandatory debt repayments of $105 million and cash dividends, which at the current dividend rate totals $48 million. - 17 - ITEM 8. ITEM 8. Financial Statements and Supplementary Data The consolidated financial statements and accompanying notes to financial statements together with the report of independent public accountants are located on the following pages. Quarterly data for the registrant's latest two fiscal years is located in the tables labeled "1993 Quarterly Data" and "1992 Quarterly Data" in Item 5. - 18 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollar amounts in millions) - 19 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollar amounts in millions except per share) - 20 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollar amounts in millions) - 21 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollar amounts except per share) - 22 - NOTES TO FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Presentation The consolidated financial statements include the accounts of Louisiana-Pacific Corporation and all of its subsidiaries (L-P), after elimination of intercompany balances and transactions. Earnings Per Share Earnings per share have been computed based on the weighted average number of shares of common stock outstanding during the periods. The effect of common stock equivalents is not material. All per share amounts and number of shares have been retroactively adjusted for a two-for-one stock split declared on May 4, 1993, for stockholders of record on May 18, 1993. The additional shares were issued on June 8, 1993. In 1992, L-P declared a three-for-two stock split. Cash and Cash Equivalents L-P considers all highly liquid securities with a maturity of three months or less to be cash equivalents. Cash paid during 1993, 1992, and 1991 for interest (net of capitalized interest) was $13.2 million, $21.9 million and $31.2 million. Cash paid during 1993, 1992, and 1991 for income taxes (net of refunds received) was $161.1 million, $93.5 million and $25.3 million. At December 31, 1993, Louisiana-Pacific Canada Ltd., a wholly-owned subsidiary of L-P, had restricted cash balances of USD $16.3 million related to loan agreements which require such balances based on changes in the Canadian dollar relative to the U.S. dollar. These balances are interest-bearing to Louisiana-Pacific Canada Ltd. at short-term interest rates. The carrying amounts of cash and cash equivalents approximates fair value because of the short maturity of those instruments. Inventory Valuation Inventories are valued at the lower of cost or market. Inventory costs include material, labor and operating overhead. The - 23 - NOTES TO FINANCIAL STATEMENTS LIFO method is used for most log and lumber inventories. Inventory quantities are determined on the basis of physical inventories, adjusted where necessary for intervening transactions from the date of the physical inventory to the end of the year. The major types of inventories are as follows: Timber L-P follows an overall policy on fee timber that amortizes timber costs over the total fiber available during the estimated growth cycle. Timber carrying costs, such as reforestation and forest management, are expensed as incurred. Cost of timber harvested includes not only the cost of fee timber but also the amortization of the cost of long-term timber deeds. Property, Plant and Equipment L-P uses the units of production method of depreciation for most machinery and equipment which amortizes the cost of equipment over the estimated units that will be produced during its useful life. Provisions for depreciation of buildings and the remaining machinery and equipment have been computed using straight-line rates based on the estimated service lives. The effective straight-line rates for the principal classes of property range from approximately 5 percent to 20 percent. Logging road construction costs are capitalized and included in land and land improvements. These costs are amortized as the timber volume adjacent to the road system is harvested. - 24 - NOTES TO FINANCIAL STATEMENTS L-P capitalizes interest on borrowed funds during construction periods. Capitalized interest is charged to machinery and equipment accounts and amortized over the lives of the related assets. Interest capitalized during 1993, 1992, and 1991 was $3.5 million, $4.9 million, and $12.8 million. L-P defers start-up costs on major construction projects during the start-up phase and amortizes the deferral over seven years. Start-up costs deferred during 1992 and 1991 were $23.8 million and $17.1 million. No start-up costs were deferred during 1993. Income Tax Policies During the first quarter of 1993, L-P adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which utilizes the liability method whereby deferred income taxes are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities using the tax rates applicable at the balance sheet date. Adoption of this standard resulted in a one-time, after tax charge of $7.2 million or seven cents per share. In addition, inventories, timber and timberlands and property, plant and equipment increased by approximately $102.9 million. The effect of adopting this standard did not have a material impact on pre-tax income or income tax expense. - 25 - NOTES TO FINANCIAL STATEMENTS Income before taxes and cumulative effects of accounting changes for the years ended December 31 was taxed under the following jurisdictions: Provision (benefit) for income taxes includes the following: L-P increased its U.S. deferred tax liability in 1993 as a result of legislation enacted during 1993 increasing the corporate tax rate from 34 percent to 35 percent effective January 1, 1993. Included in the deferred tax provision is the effect of the 1 percent increase and other tax law changes related to L-P's deferred income tax liability which resulted in a net charge of $4.4 million, or $.04 per share. - 26 - NOTES TO FINANCIAL STATEMENTS The tax effects of significant temporary differences at December 31, 1993, were as follows: L-P's subsidiary, Louisiana-Pacific Canada Ltd. (LPC), has unrealized foreign investment tax credits (ITC) of approximately C$87 million. These credits can be carried forward to offset future tax of LPC. However, these credits expire C$10 million in 1996, C$5 million in 1997, C$20 million in 1999, C$6 million in 2000 and C$46 million in 2001. In addition, LPC has net operating loss (NOL) carryovers of C$36 million. These NOL carryovers expire C$22 million in 1996, C$5 million in 1997, and C$9 million which will not expire. The following table summarizes the differences between the statutory federal and effective tax rate: Marketable Securities and Securities Transactions The balance sheet caption "Investments and Other Assets" includes marketable equity securities which are carried at the lower of aggregate quoted market value or cost. Unrealized losses - 27 - NOTES TO FINANCIAL STATEMENTS on noncurrent marketable equity securities and related income tax effects are accumulated in the other equity adjustment component of stockholders' equity. Realized gains or losses are computed based on actual transaction prices of the securities sold and are reflected in income in the period in which the transaction occurred. At December 31, 1993, the carrying value of these securities approximates the market value. Foreign Currency Translation Assets and liabilities denominated in foreign currencies are translated to U.S. dollars at the exchange rate on the balance sheet date. Revenues, costs, and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are shown separately in stockholders' equity. OTHER NOTES TO FINANCIAL STATEMENTS Accounts Payable and Accrued Liabilities - 28 - NOTES TO FINANCIAL STATEMENTS - 29 - NOTES TO FINANCIAL STATEMENTS The carrying amounts of L-P's long-term debt approximates fair market value since the debt is primarily variable rate debt. Debt is generally unsecured except for the Santa Fe Industries debt which is secured by the stock of Kirby Forest Industries, Inc. The Sunpine Forest Products debt is secured by the assets of Sunpine and also guaranteed by L-P. The debt represents 100 percent of Sunpine's obligations, however, L-P Canada Ltd. is a 50 percent joint venture partner. Other installment notes and contracts were incurred primarily through acquisitions of plants and timber. Many of L-P's loan agreements contain lender's standard covenants and restrictions. L-P was in compliance with all of the covenants and restrictions of these agreements during 1993 and 1992. L-P has a $100 million revolving credit facility with a group of banks. Any borrowings under the credit facility will be due and payable in 1994. The interest rate to be used for the credit line is based on one of three variable interest rate formulas. L-P pays a commitment fee on the unused credit line. There were no borrowings in 1993 or 1992. The weighted average interest rate for all debt at December 31, 1993, and 1992 was 4.3 percent and 4.6 percent. Required repayment of principal for long-term debt is as follows: Retirement Plans L-P maintains tax-qualified Employee Stock Ownership Trusts (ESOTs), for salaried and certain hourly employees under which 10 percent and 5 percent, respectively, of the eligible employees' annual earnings is contributed to the plans. Approximately 11,000 L-P employees participate in the ESOTs. Fully funded defined benefit plans also supplement the hourly employees' retirement package. - 30 - NOTES TO FINANCIAL STATEMENTS ESOT contributions were as follows: L-P has a number of pension plans covering its hourly employees. Contributions to its defined benefit plans are based on actuarial calculations of amounts to cover current pension and amortization of prior service cost over periods ranging from 10 to 20 years. Contributions to multi-employer defined benefit plans are specified in applicable collective bargaining agreements. The status of L-P administered pension plans are as follows: The actuarial assumptions used to determine pension expense and the funded status of the plans for 1993 and 1992 were: a discount rate on benefit obligations of 7.5 percent in 1993 and 8.75 percent in 1992, a 3.0 percent increase in future compensation levels in 1993 for active participants and 4.0 percent in 1992, and - 31 - NOTES TO FINANCIAL STATEMENTS an 8.75 percent expected long-term rate of return on plan assets in 1993 and 9.5 percent in 1992. The assets of the plans at December 31, 1993, and 1992 consist mostly of government obligations, and minor amounts in cash or cash equivalents. Pension expense included the following components: During the first quarter of 1993, the Company adopted the Financial Accounting Standards Board Statement No. 106, "Employers' Accounting for Post-retirement Benefits Other Than Pensions." The standard requires employers to record the cost of non-pension retirement benefits during the working years of the employee. Adoption of this standard resulted in a one-time charge of $3.2 million or three cents per share, net of $1.9 million in income taxes, to first quarter 1993 earnings. Additional future costs associated with adopting this new standard are not expected to be material. In November 1992, the Financial Accounting Standards Board issued Statement No. 112, "Employers' Accounting for Post- employment Benefits." L-P does not generally provide post- employment benefits, and therefore adoption of this statement will not have a material effect on the financial statements. Stock Options and Plans L-P grants options to key employees to purchase L-P common stock. Options are granted at 85 to 100 percent of market price. The options become exercisable 20 percent per year beginning one year after the grant date and expire 10 years after the date of grant. The options outstanding at December 31, 1993, are exercisable 1,397,242 shares in 1994, 614,210 shares in 1995, 595,380 shares in 1996, 143,190 shares in 1997, and 50,640 shares - 32 - NOTES TO FINANCIAL STATEMENTS in 1998. Shares available for granting of options at December 31, 1993, and 1992 were 596,850 and 798,750. Changes during 1993 in options outstanding and exercisable were as follows: L-P also grants awards under the Louisiana-Pacific Corporation Key Employee Restricted Stock Plan. Shares available for grant at December 31, 1993, were 2,491,500. The shares are issued, at no cost to the employee, only after performance criteria are met. In 1992, the performance criteria was met, and 212,250 shares were issued in 1993. The compensation expense for these shares was recorded in 1992, based on the year-end value, and the additional expense of the value at issuance was recorded in 1993. In 1993, the performance criteria was also met, which resulted in 352,500 shares issued in December of 1993, and 90,000 shares to be issued in 1994. The compensation expense for the shares to be issued in 1994 was recorded in 1993, based on the year-end value. - 33 - NOTES TO FINANCIAL STATEMENTS Changes during 1993 in the Restricted Stock Plan shares were as follows: L-P offers employee stock purchase plans to all employees. Under the plans, employees may subscribe to purchase shares of L-P stock over 24 months at 85 percent of the market price. At December 31, 1993, 517,336 shares and 567,830 shares were subscribed at $29.91 and $19.12 per share under the 1993 and 1992 Employee Stock Purchase Plans. On April 30, 1993, L-P issued 264,165 shares to employees at an average price of $17.35 upon completion of the purchase period for the 1991 Employee Stock Purchase Plan. Litigation; Environmental Matters In 1992, as part of an overall industry inquiry, L-P and Kirby Forest Industries, a wholly owned L-P subsidiary, received notices of violation from the U.S. Environmental Protection Agency (EPA) against fifteen of its manufacturing facilities. During 1993, L-P reached a precedent-setting environmental settlement with the EPA, which called for L-P and Kirby Forest Industries to pioneer pollution control technology for the entire wood panel products industry. The agreement also required L-P to pay an $11.1 million civil penalty to the Federal government. The payment was made on November 1, 1993, but had been substantially accrued for 1992. L-P has been informed that it and one or more of its employees are the subjects of separate federal grand jury investigations regarding air emissions at its Montrose, Colorado, plant and wastewater discharges at its Ketchikan Pulp Company subsidiary's pulp mill. The investigations have not been completed and no charges against the company or any of its employees have been made. Also, Ketchikan Pulp Company is the subject of a civil enforcement action alleging violations of the Clean Water Act and - 34 - NOTES TO FINANCIAL STATEMENTS Clean Air Act. Settlement of this action will likely involve fines and future capital expenditures for environmental projects. Certain of L-P's plant sites are suspected of having substances in the ground or in the groundwater that are considered pollutants. Under the direction of the company's Department of Environmental Affairs, corrective action or plans for corrective action are underway. Where the pollutants were caused by previous owners of the property, L-P is vigorously pursuing those parties through legal channels. In 1991, L-P reached an agreement with the EPA relating to past violations of wastewater discharge limits from L-P's Samoa, California pulpmill. The amount of the settlement was $3 million, which L-P expensed in the second quarter of 1991. Although L-P's corporate policy is to comply with all applicable laws, the company has in the past been required to pay fines for non-compliance and sometimes litigation has resulted from contested environmental actions. Also, the items discussed above could result in fines or penalties against the company. However, management believes that any fines or penalties resulting from the matters discussed above will not have a material adverse effect on the business, financial position or results of operations of L-P. Other Matters L-P and its subsidiaries are party to other legal proceedings. Management believes that the outcome of such proceedings will not have a material adverse effect on the business, financial position or results of operations of L-P. Commitments; Timber Cutting Contracts L-P is obligated to purchase timber under cutting contracts, primarily with the U.S. Forest Service, which extend to 2004. - 35 - NOTES TO FINANCIAL STATEMENTS The table below presents L-P's best estimate of its commitment under timber cutting contracts. Leases The table below presents L-P's future minimum rental payments under non-cancelable operating leases. Payments under all operating leases that were charged to rental expense during 1993, 1992, and 1991 were $7.1 million, $8.7 million and $6.8 million. Other During 1994, L-P plans expenditures of about $325-350 million for plant additions and improvements, timber and logging roads. - 36 - NOTES TO FINANCIAL STATEMENTS Industry Segment Information L-P operates in two major industry segments. The major products included in each segment are detailed further on page 5. Intersegment sales are chips transferred from company-owned building products plants to company-owned pulp mills. All transfers are made at prevailing market prices. Timber and related assets and capital expenditures for such assets have not been allocated to the industry segments as these are a prime source of raw materials for both segments. The cost of logs delivered to the plants and residual fibers are included in the operating results of the segments. Export sales were primarily to customers in the Far East, Europe and Canada. - 37 - NOTES TO FINANCIAL STATEMENTS Information about L-P's industry segments is as follows: Information about L-P's geographic segments is as follows: - 38 - Report of Independent Public Accountants To the Stockholders and Board of Directors of Louisiana-Pacific Corporation: We have audited the accompanying consolidated balance sheets of Louisiana-Pacific Corporation (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 Louisiana-Pacific 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. As discussed in the notes to the consolidated financial statements, effective January 1, 1993, the Company changed its methods of accounting for income taxes and post-retirement benefits other than pensions. Arthur Andersen & Co. Portland, Oregon February 4, 1994 Report of Management The management of Louisiana-Pacific Corporation has prepared the consolidated financial statements and related financial data contained in this Report. The financial statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances and by necessity include some amounts determined using management's best judgments - 39 - and estimates with appropriate consideration to materiality. Management is responsible for the integrity and objectivity of the financial statements and other financial data included in the report. To meet this responsibility management maintains a system of internal accounting controls to provide reasonable assurance that assets are safeguarded and that accounting records are reliable. Management supports a program of internal audits and internal accounting control reviews to provide assurance that the system is operating effectively. The Board of Directors pursues its responsibility for reported financial information through its Audit Committee, composed of five outside directors. The Audit Committee meets periodically with management, the internal auditors and the independent public accountants to review the activities of each. /s/ HARRY A. MERLO Chairman and President /s/ WILLIAM L. HEBERT Treasurer and Chief Financial Officer February 4, 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 Information regarding the directors of the registrant is incorporated herein by reference to the material included under the caption "Item 1 - -Election of Directors" and "General" in the definitive proxy statement to be filed by the registrant for its 1994 annual meeting of stockholders (the "1994 Proxy Statement"). Information regarding the executive officers of the registrant is located in Part I of this report under the caption "Executive Officers of the Registrant." - 40 - ITEM 11. ITEM 11. Executive Compensation Information regarding executive compensation is incorporated herein by reference to the material under the captions "Compensation Committee--Interlocks and Insider Participation," "Summary Compensation Table," "Aggregated Option/SAR Exercises in Last Fiscal year and Fiscal year-End Options/SAR Values," and "Director's Compensation," in the 1994 Proxy Statement. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management Information regarding security ownership of certain beneficial owners and management is incorporated herein by reference to the material under the caption "Holders of Common Stock" in the 1994 Proxy Statement. ITEM 13. ITEM 13. Certain Relationships and Related Transactions Information regarding management transactions is incorporated herein by reference to the material under the captions "Compensation Committee--Interlocks and Insider Participation" and "Management Transactions" in the 1994 Proxy Statement. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K A. Financial Statements and Financial Statement Schedules The financial statements included in this report and the financial statement schedules filed as part of this report are listed in the accompanying index to financial statements and schedules. B. Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended December 31, 1993. C. Exhibits The exhibits filed as part of this report or incorporated by reference herein are listed in the accompanying exhibit index. Each management contract or compensatory plan or arrangement is identified in the index. - 41 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Louisiana-Pacific Corporation, a Delaware corporation (the "registrant"), has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 29, 1994 LOUISIANA-PACIFIC CORPORATION (Registrant) /s/ WILLIAM L. HEBERT William L. Hebert 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 dates indicated. Date Signature and Title March 29, 1994 /s/ HARRY A. MERLO Harry A. Merlo Chairman, President and Director (Principal Executive Officer) March 29, 1994 /s/ JAMES EISSES James Eisses Executive Vice President and Director March 29, 1994 /s/ WILLIAM L. HEBERT William L. Hebert Treasurer (Principal Financial Officer) - 42 - Date Signature and Title March 29, 1994 /s/ JAMES F. ELLISOR James F. Ellisor Controller, Operations (Principal Accounting Officer) March 29, 1994 /s/ PIERRE S. DU PONT IV Pierre S. du Pont IV Director March 29, 1994 /s/ BONNIE F. GUITON Bonnie F. Guiton Director March 29, 1994 /s/ DONALD R. KAYSER Donald R. Kayser Director March 29, 1994 /s/ FRANCINE I. NEFF Francine I. Neff Director March 29, 1994 /s/ CHARLES E. YEAGER Charles E. Yeager Director - 43 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Financial Statements: Consolidated Balance Sheets--December 31, 1993, and 1992. 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. Consolidated Statements of Stockholders' Equity--years ended December 31, 1993, 1992, and 1991. Notes to Financial Statements. Report of Independent Public Accountants. Financial Statement Schedules: Report of Independent Public Accountants Covering Financial Statement Schedules V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment IX - Short-Term Borrowings X - Supplementary Income Statement Information All other financial statement schedules are omitted because they are not applicable or not required. - 44 - REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders and Board of Directors of Louisiana-Pacific Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in this Form 10-K, and have issued our report thereon dated February 4, 1994. Our report on the financial statements includes an explanatory paragraph with respect to the change in the method of accounting for income taxes and postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index to financial statements and schedules 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. Portland, Oregon February 4, 1994 - 45 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT SCHEDULE V (Dollar Amounts in Millions) - 46 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI (Dollar Amounts in Millions) - 47 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES SHORT - TERM BORROWINGS SCHEDULE IX (Dollar Amounts in Millions) - 47 - LOUISIANA-PACIFIC CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION SCHEDULE X (Dollar Amounts in Millions) - 48 - EXHIBIT INDEX On written request, the registrant will furnish to any record holder or beneficial holder of the registrant's common stock any exhibit to this report upon the payment of a fee equal to the registrant's costs of copying such exhibit plus postage. Any such request should be sent to: Pamela A. Selis, Director of Corporate Communications, Louisiana-Pacific Corporation, 111 S.W. Fifth Avenue, Portland, Oregon 97204. Items identified with an asterisk (*) are management contracts or compensatory plans or arrangements. Sequential Exhibit Description of Exhibit Page Number 3.A Restated Certificate of Incorporation of the registrant as amended to date. Incorporated by reference to Exhibit 3(a) to the registrant's Form 10-Q report for the second quarter of 1993. 3.B Bylaws of the registrant as amended to date. Incorporated by reference to Exhibit 3(b) to the registrant's Form 10-Q report for the second quarter of 1993. 4.A The registrant's secured note dated December 22, 1986, in the principal amount of $290,000,000 payable to Santa Fe Industries, Inc. Incorporated by reference to Exhibit 2.B to the registrant's Form 8-K report dated as of December 22, 1986 (File No. 1-7107). 4.B Amendment No. 1 to Secured Note (Exhibit 4.A). Incorporated by reference to Exhibit 4.B to the registrant's Form 10-K report for 1988. 4.C Rights Agreement as Restated as of February 3, 1991, between the registrant and First Chicago Trust Company of New York as Rights Agent. Incorporated by reference to Exhibit 4 to the registrant's Form 8-K report dated as of March 18, 1991. Pursuant to Item 601 (b)(4)(iii) of Regulation S-K, the registrant is not filing certain instruments with respect to its long- term debt because the amount authorized under any such instrument does not exceed 10 percent of the total consolidated assets of the registrant at December 31, 1993. The registrant agrees to furnish a copy of any such instrument to the Securities and Exchange Commission upon request. - 49 - Sequential Exhibit Description of Exhibit Page Number 10.A The registrant's 1984 Employee Stock Option Plan as amended to date. Incorporated by reference to Exhibit 10.B to the registrant's Form 10-K report for 1989.* 10.B The registrant's 1991 Employee Stock Option Plan. Incorporated by reference to Exhibit 10.B to the registrant's Form 10-K report for 1990.* 10.C 1992 Non-Employee Director Stock Option Plan and Related Form of Option Agreement. Incorporated by reference to Exhibit 10.C to the registrant's Form 10-K report for 1992.* 10.D Deferred cash bonus agreement dated May 5, 1986, between the registrant and Harry A. Merlo; and deferred cash bonus agreement dated February 2, 1987, between the registrant and Harry A. Merlo. Incorporated by reference to Exhibit 10.D to the registrant's Form 10-K report for 1986 (File No. 1-7107).* 10.E Louisiana-Pacific Corporation Directors' Deferred Compensation Plan. Incorporated by reference to Exhibit 10.F to the regi- strant's Form 10-K report for 1986 (File No. 1-7107).* 10.F(1) Share Purchase Agreement dated as of December 3, 1986, between Santa Fe Industries, Inc., and the registrant. Incorporated by reference to Exhibit 2.A to the registrant's Form 8-K report dated as of December 22, 1986 (File No. 1-7107). 10.F(2) Pledge Agreement dated December 22, 1986, between the registrant and Santa Fe Industries, Inc. Incorporated by reference to Exhibit 2.C to the registrant's Form 8-K report dated as of December 22, 1986 (File No. 1-7107). 10.F(3) Amendment No. 1 to Pledge Agreement (Exhibit 10.F(2)). Incorporated by reference to Exhibit 10.F(3) to the registrant's Form 10-K report for 1988. 10.G(1) Agency Agreement dated as of December 22, 1986, among the registrant and ten banks, including Morgan Guaranty Trust Company of New York as administrative agent. Incorpor- ated by reference to Exhibit 10.H(2) to the registrant's Form 10-K report for 1986 (File No. 1-7107). - 50 - Sequential Exhibit Description of Exhibit Page Number 10.G(2) Amendment No. 1 to Agency Agreement (Exhibit 10.G(1)). Incorporated by reference to Exhibit 10.G(2) to the registrant's Form 10-K report for 1988. 10.H(1) The registrant's Key Employee Restricted Stock Plan as amended. Incorporated by reference to Exhibit 10.H(1) to the registrant's Form 10-K report for 1990.* 10.H(2) Form of Restricted Stock Award Agreement under Exhibit 10.H(1). Incorporated by reference to Exhibit 10.H(2) to the registrant's Form 10-K report for 1992.* 10.I Lease and Option to Purchase between the registrant as Lessor and Harry A. Merlo as Lessee, as amended. Incorporated by reference to Exhibit 10.I to the regi- strant's Form 10-K report for 1988. 10.J Distribution Agreement dated as of May 23, 1988, between the registrant and Fibreboard Corporation. Incorporated by reference to Exhibit 2.B to the registrant's Form 8-K report dated as of May 23, 1988. 10.K The registrant's Supplemental Benefits Plan. Incorporated by reference to Exhibit 10.K to the registrant's Form 10-K report for 1989.* 11 Louisiana-Pacific Corporation and Subsi- 52 diaries: Calculation of Net Income Per Share For the Year Ended December 31, 1993. 21 List of subsidiaries of the registrant. 53 23 Consent of Independent Public Accountants. 54 - 51 -

10427_1993.txt

10427_1993

1993

10427

ITEM 1. BUSINESS (a) GENERAL DEVELOPMENT OF BUSINESS Bausch & Lomb Incorporated is a world leader in the development, manufacture and marketing of products and services for the personal health, medical, biomedical and optics fields. Bausch & Lomb was incorporated in the State of New York in 1908 to carry on a business which was established in 1853. Its principal executive offices are located in Rochester, New York. Unless the context indicates otherwise, the terms "Bausch & Lomb" and "Company" as used herein refer to Bausch & Lomb Incorporated and its consolidated subsidiaries. Highlights of the general development of the business of Bausch & Lomb Incorporated during 1993 are discussed below. The Company experienced good progress in 1993. Sales increased to $1,872 million, 10% above the 1992 amount of $1,709 million. Including restructuring charges in 1993, earnings amounted to $156.5 million or $2.60 per share. Excluding these charges, earnings advanced to $193.0 million, or $3.21 per share, a 13% increase over the 1992 amounts of $171.4 million and $2.84 per share. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS Information concerning sales, business segment earnings and identifiable assets attributable to each of Bausch & Lomb's reportable industry segments is set forth on pages 3440 and 51-52 of the Annual Report and is incorporated herein by reference. (c) NARRATIVE DESCRIPTION OF BUSINESS Bausch & Lomb's operations have been classified into two industry segments: Healthcare and Optics. Below is a description of each segment and information to the extent that it is material to an understanding of the Company's business taken as a whole. In addition, pages 22-32 of the Annual Report are incorporated herein by reference. Healthcare The Healthcare segment includes personal health, medical and biomedical products. In the personal health area, major lines include solutions used for the care of contact lenses and for the relief of eye irritation, contact lens accessories, Clear Choice mouthwash, certain over-the-counter pharmaceutical products, the Interplak power toothbrushes and other oral care products, and Curel and Soft Sense skin care products. Medical products include contact lenses and lens materials, prescription drugs, the Miracle- Ear line of hearing aids and Steri-Oss dental implants. Biomedical products include purpose-bred laboratory animals for biomedical research, products derived from specific pathogenfree eggs, and a variety of other biotechnical and professional services provided to the scientific research community. The Company markets its personal health products in the U.S. to practitioners through its own sales force and through drug stores, food stores, and mass merchandisers. Personal health products are also marketed through an extensive international marketing organization. Distribution in many other countries is accomplished through distributors or dealers. Medical products are marketed through the Company's sales force to eyecare and dental care practitioners, independent optical laboratories, and hospitals. Hearing aids are distributed through the Miracle-Ear franchise system. Sales to pharmacies are handled by drug wholesalers, while marketing of medical products outside the U.S. is accomplished through the Company's extensive international marketing organization. In some countries, distribution is handled through dealers or distributors. Biomedical products are sold primarily through the Company's sales force worldwide. The Company acquired Steri-Oss, Inc., a California manufacturer of dental implants, during the first quarter of 1993. The breadth and quality of its line of coated and uncoated titanium implants has earned Steri-Oss an excellent reputation among dental professionals. During the second quarter of 1993, Bausch & Lomb acquired the Curel and Soft Sense lines of skin care products from S. C. Johnson and Son, Inc. These lines are expected to benefit from the Company's marketing and distribution expertise. The acquisition of Dahlberg, Inc. during the third quarter of 1993 expanded Bausch & Lomb's participation in the hearing care field. Dahlberg is the maker of the Miracle-Ear line of hearing aids, a widely recognized hearing aid brand name, which has over 1,000 franchised locations in the U.S. During the fourth quarter of 1993, the Company received licenses to product several generic pharmaceuticals in its state- of-the-art, aseptic manufacturing plant in Tampa, Florida. Additional approvals are anticipated during 1994. The Company introduced the Occasions line of contact lenses in 1993. Occasions are worn only once before being discarded and will be especially beneficial in selected situations when contact lenses are preferred over spectacles. Vivivit Q10 vitamins were introduced in Germany by the Company's Dr. Mann Pharma subsidiary during the second half of 1993. Favorable trade acceptance of this product led to a successful launch. Optics The principal products of the Company's Optics segment include sunglasses, binoculars, riflescopes, telescopes and optical thin film applications and products. Optical products are distributed worldwide through distributors, wholesalers, manufacturers' representatives, and independent sales representatives. These products are also distributed through the Company's sales force to optical stores, department stores, catalog showrooms, mass merchandisers, sporting goods stores and, in the case of optical thin films, to a variety of industrial customers. During 1993, the Company launched the Ray-Ban Survivors line of sunglasses. These products feature DiamondHard lens coatings which render glass lenses more scratch resistant. These sunglasses met with good acceptance among active, outdoor oriented consumers. The Company also introduced the Bausch & Lomb Elite riflescope during the year. It features multi-coated optics, durable construction and proven accuracy. It is expected to meet with good aceptance among consumers who demand the highest quality riflescopes. Raw Materials and Parts; Customers Materials and components in both of the Company's industry segments are purchased from a wide variety of suppliers and the loss of any one supplier would not adversely affect the Company's business to a significant extent. No material part of the Company's business in either of its industry segments is dependent upon a single or a few customers. Patents, Trademarks & Licenses While in the aggregate the Company's patents are of material importance to its businesses taken as a whole, no single patent or patent license or group of patents or patent licenses relating to any particular product or process is material to either industry segment. The Company actively pursues technology development and acquisition as a means to enhance its competitive position in its business segments. In the healthcare segment, Bausch & Lomb has developed significant consumer, eye care professional and dental care professional recognition of products sold under the Bausch & Lomb, Sensitive Eyes, ReNu, Boston, SeeQuence, Medalist, The Boston Lens, Optima, Soflens, Charles River, VAF/Plus and Interplak trademarks. Bausch & Lomb, Ray-Ban, Wayfarer and Bushnell are trademarks receiving substantial consumer recognition in the optics segment. Seasonality and Working Capital Some seasonality exists for the Interplak line of power toothbrushes in the Healthcare segment and for sunglasses and sports optics products in the Optics segment. During some periods, the accumulation of inventories of such products in advance of expected shipments reflects the seasonal nature of the products. In general, the working capital practices followed in each of the Company's industry segments are typical of those businesses. Competition Each industry segment is highly competitive in both U.S. and non-U.S. markets. In both of its segments, Bausch & Lomb competes on the basis of product performance, quality, technology, price, service, warranty and reliability. In the Optics segment, the Company also competes on the basis of style. Research and Development Research and development constitutes an important part of Bausch & Lomb's activities. In 1993, the Company's research and development expenditures totaled $58 million, as compared to $53 million in 1992 and $49 million in 1991. Environment Although Bausch & Lomb 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 facilities were not material during 1993 and are not anticipated to be material in 1994 or 1995. Number of Employees Bausch & Lomb employed approximately 15,900 persons as of December 25, 1993. (d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Information as to sales, operating earnings and identifiable assets attributable to each of Bausch & Lomb's geographic regions, and the amount of export sales in the aggregate, is set forth on page 51 of the Annual Report and is incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES The principal manufacturing, distribution and production facilities and other important physical properties of Bausch & Lomb at March 1, 1994 are listed hereafter and grouped under the principal industry segment to which they relate. Certain properties relate to more than one industry segment. Except where otherwise indicated by footnote, all properties shown are held in fee and are not subject to major encumbrances. HEALTHCARE Manufacturing Plants Distribution Centers Yorba Linda, CA (2) Yorba Linda, CA (2) Sarasota, FL (1) Tampa, FL Tampa, FL Tucker, GA (2) Wilmington, MA (2) Golden Valley, MN (1) Golden Valley, MN (1) Greenville, SC (2) Hauppauge, NY (2) Lynchburg, VA (2) Rochester, NY (1),(2) Turtle Lake, WI (1) (Optics Center) Greenville, SC Turtle Lake, WI (1) North Ryde, Australia (2) Porto Alegre, Brazil Rio de Janeiro, Brazil (2) Kitchener, Canada (2) Beijing, China (2) Berlin, Germany Bhiwadi, India Jakarta, Indonesia (2) Waterford, Ireland (2) Milan, Italy Umsong-Gun (Seoul), Korea Naucalcan, Mexico (2) Barcelona, Spain Madrid, Spain Hastings, United Kingdom Production Facilities Hollister, CA (2) Brussels, Belgium Lebanon, CT (2) St. Constant, Canada Preston, CT (2) Henfield, England Summerland Key, FL Margate, England Roanoke, IL (2) L'Arbresle Cedex, France Wilmington, MA (2) Lyons, France Windham, ME (2) St. Aubin-les- Elbeuf, France Portage, MI (2) Extertal, Germany O'Fallon, MO (2) Kisslegg, Germany Raleigh, NC (2) Sulzfeld, Germany Omaha, NE (2) Calco, Italy Pittsfield, NH (2) Monticello Brienza, Italy Newfield (Lakeview), NJ (2) Atsugi, Japan Stone Ridge (Kingston), NY Hino, Japan Reinholds, PA (2) Tskuba, Japan (2) Charleston, SC Someren, Netherlands Houston, TX Barcelona, Spain (2) Oregon, WI (2) OPTICS Manufacturing Plants Distribution Centers Mountain View, CA (2) Mountain View, CA (2) Oakland, MD Richmond Hill, Canada (2) Rochester, NY (1),(2) Broomfield, CO (Optics Center) Overland Park, KS (2) Rochester, NY Rochester, NY (1), (2) (Frame Center) (Optics Center) San Antonio, TX San Antonio, TX North Ryde, Australia (2) Rio de Janeiro, Brazil (2) Pforzheim, Germany New Territories, Hong Kong (2) Bhiwadi, India Waterford, Ireland (2) Naucalcan, Mexico (2) Nuevo Laredo, Mexico (2) CORPORATE FACILITIES Rochester, NY One Chase Square (23rd, 24th, 25th Floors) (2) Euclid Street (2) 42 East Avenue (2) Optics Center (1),(2) 1295 Scottsville Road (2) [FN] (1) This facility is financed under a tax-exempt financing agreement. (2) This facility is leased. Bausch & Lomb considers that its facilities are suitable and adequate for the operations involved. All facilities are being productively utilized. ITEM 3. ITEM 3. LEGAL PROCEEDINGS 1. In June 1990, the Company was served with six "toxic tort" suits filed against it and approximately 80 other defendants in the 21st Judicial District Court of Louisiana. These suits, which have been certified as a class action, alleged claims for personal injury, property damage and "fear of cancer" from waste allegedly generated by the Company and others and transported to an oil reclamation site in Louisiana. Each suit alleges joint and several liability and claims actual and exemplary damages exceeding 10% of the current assets of the Company on a consolidated basis, the Company believes that if its waste is or was present at the site, such waste would have amounted to approximately 0.1% of the site's total waste, and that its share of liability, if any, would be de minimis relative to other defendants' potential liability and that is is not material to the financial condition of the Company. On January 25, 1993, the Company and ten other defendants were dismissed from the action without prejudice, by a motion of the plaintiffs. It is probable that either the plaintiffs or one or more of the defendants will seek to bring the Company back into the proceedings. 2. Since August 1993, the Company's wholly-owned subsidiary, Dahlberg, Inc., has been served with seven lawsuits by individuals seeking to represent a class of consumers, including one action in the United States District Court for the Northern District of California, five actions in the Fourth Judicial District for the State of Minnesota and one in the Circuit Court, Barbour County, Alabama. Each action has been brought on behalf of alleged purchasers of Miracle-Ear hearing aids equipped with the Clarifier circuitry, which were manufactured and distributed by Dahlberg. The complaints allege that Dahlberg induced plaintiffs and others similarly situated to purchase hearing aids through allegedly false and misleading statements concerning the performance capabilities of the Clarifier circuitry. Plaintiffs allege fraud, negligence, and violation of federal and state statutes and are seeking compensatory and punitive damages in an unstated amount. Dahlberg is vigorously contesting the claims of the plaintiffs, including their claim to be representatives of a class. 3. In January 1994, the Department of Justice, acting on behalf of the Federal Trade Commission, commenced an action in the United States District Court for the District of Minnesota against Dahlberg, Inc., a wholly-owned subsidiary of the Company. The FTC is seeking civil penalties and injunctive relief, claiming that certain intended use claims in advertisements for hearing aids equipped with the Clarifier circuitry violated a 1976 consent order between the FTC and Dahlberg. The action seeks penalties of up to $10,000 for each publication of the advertisements. Dahlberg is vigorously contesting both the FTC's authority to regulate intended use claims for hearing aids and the allegation that the subject advertising violated the 1976 consent order. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS Inapplicable. PART II ITEM 5. ITEM 5. MARKET FOR BAUSCH & LOMB INCORPORATED'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The sections entitled "Dividends" and "Quarterly Stock Prices" and table entitled "Selected Financial Data" on pages 44, 45 and 64-65, respectively, of the Annual Report are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The table entitled "Selected Financial Data" on pages 6465 of the Annual Report is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The section entitled "Financial Review" on pages 34-45 of the Annual Report is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements, including the notes thereto, together with the sections entitled "Report of Independent Accountants" and "Quarterly Results" of the Annual Report included on pages 46-63, 63 and 45, respectively, are incorporated herein by reference. 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 BAUSCH & LOMB INCORPORATED Information with respect to non-officer directors is included in the Proxy Statement on pages 3-7, and such information is incorporated herein by reference. Set forth below are the names, ages (as of March 1, 1994), positions and offices held by, and a brief account of the business experience during the past five years of, each executive officer. Name and Age Position Daniel E. Gill (57) Chairman since 1982, Chief Executive Officer since 1981 and Director since l978. Ronald L. Zarrella (44) President and Chief Operating Officer since February, 1993; Executive Vice President (1992February, 1993); Senior Vice President and President, International Division (1987-1993); Vice President and President, Subsidiary Operations, International Division (1986-1987), and Director since April, 1993. Henry L. Foster (68) Senior Vice President since 1988, and Chairman of the Board since 1947 of Charles River Laboratories, Inc., a subsidiary of the Company; President and Chief Executive Officer, Charles River Laboratories, Inc. (1947- 1991); Vice President (1986-1988). Jay T. Holmes (51) Senior Vice President, Corporate Affairs since 1983, Secretary since 1981 and Director since l986. Harold O. Johnson (59) Senior Vice President since l985 and President, Contact Lens Division since l987; President, International Operations (1985-1987). James E. Kanaley (52) Senior Vice President since l985 and President, Personal Products Division since l987; President, Professional Eye Care Products Group (l985-l987). Robert J. Palmisano (49) Senior Vice President since 1992 and President, Eyewear Division since 1988; Vice President (19841992); President, Sports Optics and Scientific Products Group (1986- 1988). Carl E. Sassano (44) Senior Vice President since 1992; Vice President (1986-1992); President, Polymer Technology Corporation, a subsidiary of the Company (1983-1992). Peter Stephenson (54) Senior Vice President - Finance since March 1994; Vice President and Controller (February 1993- February 1994); Vice President and Corporate Treasurer Warner Lambert Company (1990-1991); Vice President and Corporate Controller - Warner Lambert Company (1987-1990). Frank M. Stotz (63) Senior Vice President since March 1994; Senior Vice President, Finance 1991 to March 1994; Partner, Price Waterhouse (1966-1991). Omar Casal (44) Vice President and President - Western Hemisphere Division since 1992; General Manager, Bausch & Lomb IOM S.p.A. (1989-1992); General Manager, Bausch & Lomb Australia Pty., Ltd. (1985-1989). James C. Foster (43) Vice President, and President and Chief Executive Officer of Charles River Laboratories, Inc., a subsidiary of the Company, since 1991; Executive Vice President, Charles River Laboratories (19891991); Senior Vice President, Charles River Laboratories and President, Charles River Biotechnical Services (1987-1988); President, Charles River Biotechnical Services and Vice President, Biotechnical Group (1985-1987). James P. Greenawalt (44) Vice President, Human Resources since 1986. Diane C. Harris (51) Vice President, Corporate Development since 1981. Stephen A. Hellrung (46) Vice President and General Counsel since 1985. Alexander E. Izzard (56) Vice President and President - AsiaPacific Division since 1990; Area Vice President - Far East, International Division since 1985. Franklin T. Jepson (46) Vice President, Communications and Investor Relations since 1986. Barbara M. Kelley (47) Vice President, Public Affairs since April, 1993; Staff Vice President, Public Affairs (19911993); Director, Public Affairs (1986-1991). Alex Kumar (46) Vice President and President - Europe, Middle East and Africa Division since 1989; Vice President, Europe, Middle East and Africa, International Division since 1988; Vice President, European Subsidiary Operations, International Division (1987-1988); Area Vice President, Europe, International Division (1986-1987). Jon M. Larson (60) Vice President since 1981 and Vice President, Quality since 1987; Vice President, Regulatory Affairs (1989-1991); Vice President, Technical Services, International Operations (1986-1987). Stephen C. McCluski (41) Vice President and Controller since March 1994; President - Outlook Eyewear Company (1992February 1994); Vice President Controller, Eyewear Division (1989-1992). B. Joseph Messner (41) Vice President since 1989 and President, Sports Optics Division since 1988; Vice President Operations, Sports Optics Division (1987-1988); Vice President and Controller, Sunglass Division (1984-1987). Alan H. Resnick (50) Vice President and Treasurer since 1986. Thomas M. Riedhammer (45) Vice President and President Worldwide Pharmaceuticals since January 1994; Vice President and President Pharmaceutical Division (1992-1993); Vice President - Research and Development, Pharmaceutical Division (1991-1992); Vice President, Paco Pharmaceutical Services, Inc. and President, Paco Research Corp. (1986-1991). Robert F. Thompson (40) Vice President since December 1993 and President Polymer Technology Corporation, a subsidiary of the Company (1992-1993); Vice President - U.S. Business Operations, Polymer Technology Corporation (1991-1992); Vice President Marketing, Polymer Technology Corporation (19881991). James J. Ward (56) Vice President - Audit Services since February, 1993; Vice President (1984-1993); Controller (1985-1993). Except for Henry and James Foster, who are father and son, there are no family relationships among the persons named above. All officers serve on a year-to-year basis through the day of the annual meeting of shareholders of the Company, and there is no arrangement or understanding between any of the officers of the Company and any other persons pursuant to which such officer was selected as an officer. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The portions of the "Executive Compensation" section entitled "Compensation Tables" and "Defined Benefit Retirement Plans", the second through fourth paragraphs of the section entitled "Board of Directors", and the second paragraph of the section entitled "Related Transactions and Employment Contracts" included in the Proxy Statement on pages 15-21, 1-2 and 21, respectively, are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The section entitled "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement on pages 8-9 is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Page 5 and the first paragraph of the section entitled "Related Transactions and Employment Contracts" on page 21 of the Proxy Statement are incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K The following documents or the portions thereof indicated are filed as a part of this report. (a) INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORTS OF INDEPENDENT ACCOUNTANTS. 1. Data incorporated by reference in Page in Item 8 from the Annual Report Annual Report Report of Independent Accountants 63 Balance Sheet at December 25, 1993 and December 26, 1992 47 For the years ended December 25, 1993, December 26, 1992 and December 28, 1991: Statement of Earnings 46 Statement of Cash Flows Notes to Financial Statements 49-63 2. Filed herewith Report of Independent Accountants on Financial Statement Schedules Exhibit (24) For the years ended December 25, 1993, December 26, 1992 and December 28, 1991: SCHEDULE II-Amounts Receivable from Page S-1 Related Parties and Underwriters, Promoters and Employees Other Than Related Parties SCHEDULE V-Property, Plant and Page S-2 Equipment SCHEDULE VI-Accumulated Depreciation Page S-3 and Amortization of Property, Plant and Equipment SCHEDULE VIII-Valuation and Qualifying Page S-4 Accounts SCHEDULE X-Supplementary Income Page S-5 Statement Information All other schedules have been omitted because 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 consolidated financial statements or the notes thereto. (b) REPORTS ON FORM 8-K No reports on Form 8-K were filed by the Company during the last quarter of 1993. (c) ITEM 601 EXHIBITS Those exhibits required to be filed by Item 601 of Regulation S-K are listed in the Exhibit Index immediately preceding the exhibits filed herewith and such listing is incorporated herein by reference. Each of Exhibits (10)-a through (10)-u is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant ot 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. BAUSCH & LOMB INCORPORATED Date: March 22, 1994 By:/s/ Daniel E. Gill Daniel E. Gill Chairman 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. Principal Executive Officer Date: March 22, 1994 By:/s/Daniel E. Gill Daniel E. Gill Chairman, Chief Executive Officer and Director Principal Financial Officer Date: March 22, 1994 By:/s/ Peter Stephenson Peter Stephenson Senior Vice President, Finance Controller Date: March 22, By:/s/ Stephen C. McCluski Stephen C. McCluski, Vice President and Controller Directors Franklin E. Agnew William Baldersto n III Bradfo rd R. Boss Ruth R. McMull in John R. Purcel l Linda Johnso n Rice Robert L. Tarnow Alvin W. Trivel piece William H. Waltrip Kenneth L. Wolfe Ronald L. Zarrella Date: March 22, 1994 By:/s/Jay T. Holmes Jay T. Holmes Attorney-in-Fact and Director EXHIBIT INDEX S-K Item 601 No. Document (3)-a Certificate of Incorporation of Bausch & Lomb Incorporated (filed as Exhibit (3)-a to the Company's Annual Report on Form 10- K for the fiscal year ended December 29, 1985, File No. 1-4105, and incorporated herein by reference). (3)-b Certificate of Amendment of Bausch & Lomb Incorporated (filed as Exhibit (3)-b to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (3)-c Certificate of Amendment of Bausch & Lomb Incorporated (filed as Exhibit (3)-c to the Company's Annual report on Form 10-K for the fiscal year ended December 26, 1992, File No. 1-4105, and incorporated herein by reference). (3)-d By-Laws of Bausch & Lomb Incorporated, as amended, effective October 28, 1986 (filed as Exhibit (3)-b to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1986, File No. 1- 4105, and incorporated herein by reference). (4)-a Certificate of Incorporation of Bausch & Lomb Incorporated (filed as Exhibit (4)-a to the Company's Annual Report on Form 10- K for the fiscal year ended December 29, 1985, File No. 1-4105, and incorporated herein by reference). (4)-b Certificate of Amendment of Bausch & Lomb Incorporated (filed as Exhibit (4)-b to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (4)-c Certificate of Amendment of Bausch & Lomb Incorporated (filed as Exhibit (4)-c to the Company's Annual report on Form 10-K for the fiscal year ended December 26, 1992, File No. 1-4105, and incorporated herein by reference). (4)-d Form of Indenture, dated as of September 1, 1991, between the Company and Citibank, N.A., as Trustee, with respect to the Company's Medium-Term Notes (filed as Exhibit 4-(a) to the Company's Registration Statement on Form S-3, File No. 33-42858, and incorporated herein by reference). (4)-e Rights Agreement between the Company and The First National Bank of Boston, as successor to Chase Lincoln First Bank, N.A. (filed as Exhibit 1 to the Company's Current Report on Form 8-K dated July 25, 1988, File No. 14105, and incorporated herein by reference). (4)-f Amendment to the Rights Agreement between the Company and The First National Bank of Boston, as successor to Chase Lincoln First Bank, N.A. (filed as Exhibit 1 to the Company's Current Report on Form 8-K dated July 31, 1990, File No. 1-4105, and incorporated herein by reference). (10)-a Change of Control Employment Agreement with certain executive officers of the Company (filed as Exhibit (10)-a to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 1-4105, and incorporated herein by reference). (10)-b The Bausch & Lomb Incorporated Executive Incentive Compensation Plan as restated (filed herewith). (10)-c The Bausch & Lomb Supplemental Retirement Income Plan I, as restated (filed as Exhibit (10)-e to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 14105, and incorporated herein by reference). (10)-d The Bausch & Lomb Supplemental Retirement Income Plan II, as restated (filed as Exhibit (10)-f to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 14105, and incorporated herein by reference). (10)-e The Bausch & Lomb Supplemental Retirement Income Plan III (filed as Exhibit (10)-g to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1992, File No. 1-4105, and incorporated herein by reference). (10)-f The Bausch & Lomb Incorporated Long Term Incentive Program, as restated (filed as Exhibit (10)-g to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1985, File No. 14105, and incorporated herein by reference). (10)-g Amendment to the Bausch & Lomb Incorporated Long Term Incentive Program (filed as Exhibit (10)-i to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (10)-h The Bausch & Lomb Incorporated Long Term Performance Stock Plan I (filed herewith). (10)-i Bausch & Lomb Incorporated Long Term Performance Stock Plan II, as amended (filed herewith). (10)-j The 1982 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit III-F to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1982, File No. 1-4105, and incorporated herein by reference). (10)-k Amendment to the 1982 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit (10)-l to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (10)-l Amendment to the 1982 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit (10)-k to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 1-4105, and incorporated herein by reference). (10)-m The 1987 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit I.B to the Company's Registration Statement on Form S-8, File No. 33-15439, and incorporated herein by reference). (10)-n Amendment to the 1987 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit (10)-n to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-4105, and incorporated herein by reference). (10)-o Amendment to the 1987 Stock Incentive Plan of Bausch & Lomb Incorporated (filed as Exhibit (10)-n to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 1-4105, and incorporated herein by reference). (10)-p The 1990 Stock Incentive Plan of Bausch & Lomb Incorporated, as amended (filed as Exhibit (10)-o to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 14105, and incorporated herein by reference). (10)-q The Bausch & Lomb Incorporated Director Deferred Compensation Plan, as restated (filed as Exhibit (10)-p to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1991, File No. 1-4105, and incorporated herein by reference). (10)-r The Bausch & Lomb Incorporated Executive Deferred Compensation Plan, as restated (filed as Exhibit (10)-q to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1991, File No. 1-4105, and incorporated herein by reference). (10)-s The Bausch & Lomb Incorporated Executive Benefit Plan, as amended (filed as Exhibit (10)-t to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990, File No. 1-4105, and incorporated herein by reference). (10)-t The Bausch & Lomb Incorporated Executive Security Program (filed as Exhibit (10)-s to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 1989, File No. 1-4105, and incorporated herein by reference). (10)-u The Bausch & Lomb Retirement Benefit Restoration Plan (filed as Exhibit (10)-t to the company's Annual Report on Form 10-K for the fiscal year ended December 28, 1991, File No. 1-4105, and incorporated herein by reference). (11) Statement Regarding Computation of Per Share Earnings (filed herewith). (12) Statement Regarding Computation of Ratio of Earnings to Fixed Charges (filed herewith). (13) The Bausch & Lomb 1993 Annual Report to Shareholders for the fiscal year ended December 25, 1993 (filed herewith). With the exception of the pages of the Annual Report specifially incorporated by reference herein, the Annual Report is not deemed to be filed as a part of this Report on Form 10-K. (22) Subsidiaries (filed herewith). (24) Report of Independent Accountants on Financial Statement Schedules and Consent of Independent Accountants (filed herewith). (25) Power of attorney with respect to the signatures of directors in this Report on Form 10-K (filed herewith). EXHIBIT (10)-b THE EXECUTIVE INCENTIVE COMPENSATION PLAN 1.0 INTRODUCTION The Executive Incentive Compensation Plan is established to provide incentive compensation in the form of a supplement to the base salaries of those officers, managers, and key employees who contribute significantly to the growth and success of the Company's business; to attract and to retain, in the employ of the Company, individuals of outstanding ability; and to align the interests of those who hold positions of major responsibility in the Company with the interests of the Company's shareholders. 2.0 ELIGIBILITY Those members of the executive management group whose duties and responsibilities contribute significantly to the growth and success of the Company's business are eligible. This generally includes all positions in the midmanagement/technical band and above, in Rochester based divisions or functions. The plan may be adopted by nonRochester based divisions. The participant must be on the payroll in an eligible position before July 1 of the plan year, to be eligible for an award. 3.0 DEFINITIONS 3.1 A standard incentive award has been established for each salary grade or job band and is expressed as a percentage of period salary (i.e., eligible base salary earnings for the year). Exhibit I defines standard percentage schedules. The standard incentive award is the award payout level which over time, participants, units and the corporation should average, and will be the amount which will be used for financial accrual purposes during the incentive year. 3.2 An approved incentive is the incentive which has been approved by the Chairman of the Board of directors and the Committee On Management of the Board to be paid by the company to the participant. Actual incentive award amounts, based upon individual and organizational performance, can vary from 0% for unacceptable performance, or from a minimum of 25% to a maximum of 175% of standard. In any event, an award cannot exceed the maximum. 4.0 MEASURES OF PERFORMANCE Each organizational unit and eligible participant will set performance measures. These will be applied for incentive plan purposes as follows: 4.1 The "Organizational Performance Management System" (OPMS) has been established to evaluate corporate, division, and profit center performance for Executive Incentive Compensation Plan purposes. The OPMS is based upon specific organizational objectives. These objectives are to be agreed upon at the beginning of the plan year. They must be measurable financial categories such as sales, operating earnings, earnings per share, DSO, inventory turns, or quantifiable strategic goals, for example product development, products introduction market share. Performance levels for 5, 4, 3, 2, and 1 ratings are to be defined at the beginning of the plan year for each goal. There will be a pre-determined weighting among the chosen objectives reflecting the priority of those objectives. In general, it is expected that the calculated organizational results will determine the performance rating for the unit. However, after calculation of year end OPMS results, the CEO and COO may make a modification of +20% to the calculated rating, if performance is not accurately reflected in performance measures (i.e., due to general economic, industry change, corporate strategy change, natural disaster). Adjustments must be made in 5% increments. 4.2 The "Individual Performance Management System" (IPMS) for use with the Executive Incentive Plan will consist of five or fewer specific individual objectives. These objectives are to be agreed upon at the beginning of the Plan year. They must be measurable and generally within the participant's control. Further, there will be a predetermined weighting among the objectives reflecting the priority of these objectives. Individual performance will be determined by the participants' supervisor and approved by the Division/Group Presidents or appropriate corporate staff function head. In general, it is expected that the calculated individual results will determine the performance rating. However, the unit or functional officer may make an adjustment of +20% to the calculated ratings if performance is not accurately reflected in performance measures. Adjustments must be made in 5% increments. 5.0 DEFINITION OF PERFORMANCE The following "definitions of performance" are to be utilized for the plan: 6.0 PROCEDURE FOR BONUS CALCULATION AND APPROVAL Each participant's total bonus will be calculated as follows: 1) The standard bonus (see Section 3.1) is divided into appropriate corporation/unit-individual components (as defined in Section 4.0). 2) For the organizational components; A. The final rating is converted to a percentage factor (see Attachment I conversion table). B. The factor is multiplied by the standard organizational bonus. C. There is no organizational award granted if final rating is below 2.0. 3) For the individual component; A. The final rating is converted to a percentage factor (see Attachment III conversion table). B. The factor is multiplied by the standard individual bonus. C. There is no individual award granted if final rating is below 2.0. 4) To calculate the total bonus, the components are added. The Division Presidents will submit their recommendations for individual incentive awards to their immediate superiors (in some cases only the Chief Operating Officer; in others Group Presidents and COO). In all instances the recommendations for the Corporate awards will be submitted to the Chief Executive Officer for concurrence. Corporate function heads will submit their recommendations for individual awards to their immediate superior who will then submit the recommendations to the Chief Executive Officer for concurrence. 7.0 REMOVAL, TRANSFERS AND TERMINATIONS 7.1 Participants whose employment with the Company is terminated because of retirement, death, or disability: - - After the close of the plan year, but prior to the actual distribution of awards for such year, may be awarded a full incentive award for the plan year. In the case of death, such payment will be made to a beneficiary. - - After the beginning, but prior to the end of the plan year, may receive an incentive award for that year based on a prorated calculation reflecting their employment with the Company and participation in the Plan during year. Awards will not be paid for any period less than six months participation in the plan year. 7.2 Participants who are terminated in the fourth quarter of the year due to a re-structuring which results in job elimination, may receive an incentive award for that year based on a prorated calculation reflecting their employment with the Company and participation in the Plan during that year. 7.3 Participants transferred during the plan year within the Company will be awarded an incentive payment through the division in which the participant is employed at the end of the plan year. It will be based on the contribution made in each division in which the participant was employed during the year. To this end a written evaluation and rating must be completed by the participant's superior upon transfer. The awarding division will be charged for the full amount of the bonus. 7.4 Notwithstanding the foregoing, a special prorated incentive award shall be paid to participants if, during the period between the date of a change in control and the next award date determined pursuant to Section 10: 1) the participant's employment is terminated involuntarily other than for good cause, or 2) the Plan is terminated. The amount of the award shall be calculated as a percentage of period earnings based upon standard performance and prorated through the date of termination of the participant or the Plan, as applicable. A change of control of the Company is defined as follows: A. The acquisition by any individual, entity or group (within the meaning of Section 13 (d) (3) or 14 (d) (2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) (a "Person") of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 20% or more of either (i) the then outstanding shares of common stock of the Company (the "Outstanding Company Common Stock") or (ii) the combined voting power of the then outstanding voting securities of the Company entitled to vote generally in the election of directors (the "Outstanding Company Voting Securities"); provided, however, that the following acquisitions shall not constitute a Change of Control: (i) any acquisition directly from the Company (excluding an acquisition by virtue of the exercise of a conversion privilege unless the security being so converted was itself acquired directly from the Company), (ii) any acquisition by the Company, (iii) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or any corporation controlled by the Company or (iv) any acquisition by any corporation pursuant to a reorganization, merger or consolidation, if, following such reorganization, merger or consolidation, the conditions described in clauses (i), (ii) and (iii) of paragraph C of this Section 7.0 are satisfied; or B. Individuals who, as of the date hereof, constitute the Board of Directors of the Company (the "Board" and, as of the date hereof, the "Incumbent Board") cease for any reason to constitute at least a majority of the Board; provided, however, that any individual becoming a director subsequent to the date hereof whose election, or nomination for election by the Company's shareholders, was approved by a vote of at least a majority of the directors then comprising the Incumbent Board shall be considered as though such individual were a member of the Incumbent Board, but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of either an actual or threatened election contest (as such terms are used in Rule 14a-11 of Regulation 14A promulgated under the Exchange Act) or other actual or threatened solicitation of proxies or consents by or on behalf of a Person other than the Board; or C. Approval by the shareholders of the Company of a reorganization, merger, binding share exchange or consolidation, in each case, unless, following such reorganization, merger, binding share exchange or consolidation, (i) more than 60% of, respectively, the then outstanding shares of common stock of the corporation resulting from such reorganization, merger, binding share exchange or consolidation and the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors is then beneficially owned, directly or indirectly, by all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Company Common Stock and Outstanding Company Voting Securities immediately prior to such reorganization, merger, binding share exchange or consolidation in substantially the same proportions as their ownership, immediately prior to such reorganization, merger, binding share exchange or consolidation, of the Outstanding Company Stock and Outstanding Company Voting Securities, as the case may be, (ii) no Person (excluding the Company, any employee benefit plan (or related trust) of the Company or such corporation resulting from such reorganization, merger, binding share exchange or consolidation and any Person beneficially owning, immediately prior to such reorganization, merger, binding share exchange or consolidation, directly or indirectly, 20% or more of the Outstanding Company Stock or Outstanding Company Voting Securities, as the case may be) beneficially owns, directly or indirectly, 20% or more of, respectively, the then outstanding shares of common stock of the corporation resulting from such reorganization, merger, binding share exchange or consolidation or the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors and (iii) at least a majority of the members of the board of directors of the corporation resulting from such reorganization, merger, binding share exchange or consolidation were members of the Incumbent Board at the time of the execution of the initial agreement providing for such reorganization, merger, binding share exchange or consolidation; or D. Approval by the shareholders of the Company of (i) a complete liquidation or dissolution of the Company or (ii) the sale or other disposition of all or substantially all of the assets of the Company, other than to a corporation, with respect to which following such sale or other disposition, (a) more than 60% of, respectively, the then outstanding shares of common stock of such corporation and the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors is then beneficially owned, directly or indirectly, by all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Company Common Stock and Outstanding Company Voting Securities immediately prior to such sale or other disposition in substantially the same proportion as their ownership, immediately prior to such sale or other disposition, of the same Outstanding Company Common Stock and Outstanding Company Voting Securities, as the case may be, (b) no Person (excluding the Company and any employee benefit plan (or related trust) of the Company or such corporation and any Person beneficially owning, immediately prior to such sale or other disposition, directly or indirectly, 20% or more of the Outstanding Company Common Stock or Outstanding Company Voting Securities, as the case may be) beneficially owns, directly or indirectly, 20% or more of, respectively, the then outstanding shares of common stock of such corporation and the combined voting power of the then outstanding voting securities of such corporation entitled to vote generally in the election of directors and (c) at least a majority of the members of the board of directors of such corporation were members of the Incumbent Board at the time of the execution of the initial agreement or action of the Board providing for such sale or other disposition of assets of the Company. 7.5 Participants who leave the company or are terminated prior to the actual payment of award for reasons other than retirement, death, disability, termination in the fourth quarter due to a restructuring which results in job elimination, change in control, will forfeit the award for that plan year. 8.0 INCENTIVE AWARDS THROUGH CONTRACTUAL AGREEMENTS Incentive awards may be made to participants who do not meet the six month eligibility requirements only if the following conditions are met. (1) Award must be made through contractual agreement made upon hiring, re-assignment, or commencement of special project or assignment. These arrangements must be approved in writing by Division President, Corporate Compensation, Corporate V.P. Human Resources, and normal 1 over 1 approval matrix. 9.0 ADMINISTRATION OF THE PLAN The Committee On Management of the Board of Directors reserves the right to interpret, amend, modify or terminate the existing program in accordance with changing conditions. Further, no participant eligible to receive any payments shall have any rights to pledge, assign, or otherwise dispose of unpaid portion of such payments. The Committee On Management is responsible for overall administration of the Plan. It will determine who will receive incentives and the amount of each incentive. It may also review the standards and objectives for a particular year. The Committee On Management may change or terminate the Plan at any time and no person has any rights with respect to an incentive award until it has been paid. 10.0 INCENTIVE AWARD DISTRIBUTION Incentive awards, when payable, shall be paid in the latter part of the month of February following the close of the preceding fiscal year. Participants may also elect to defer all or part of an incentive award in accordance with the procedure set forth in the Company's Deferred Compensation Plan. EXHIBIT (10)-h LONG TERM PERFORMANCE STOCK PLAN - I I. PURPOSE The Long Term Performance Stock Plan - I (the "Plan") is designed to advance the interests of Bausch & Lomb Incorporated (the "Company") and its shareholders by (i) providing incentives for those key executives who have overall responsibility for the long term performance of the Company; (ii) reinforcing corporate long term financial goals; (iii) providing competitive levels of long term compensation for key executives; and (iv) aligning management and shareholder interests. II. ELIGIBILITY Participation in the Plan is limited to senior officers with overall responsibility for the long term performance of the Company. The Committee on Management of the Board of Directors (the "Committee") will designate executives to participate in the Plan ("Participants"). III. AWARD CYCLES Award cycles ("Award Cycles") will be measured over three year periods, with the performance award, if any, for each Award Cycle to be paid early in the fourth year. There will be a series of overlapping Award cycles with a new Award Cycle starting and an old Award Cycle finishing each year. IV. PERFORMANCE GOALS The chief executive officer of the Company, with approval of the Committee, will establish the performance goals for each Award Cycle, ensuring that the goals are equitable and compatible with the Company's major business objectives. The performance goals for each Award Cycle will be based upon a matrix of sales growth and return on equity ("ROE") for the Company. V. AWARDS If the performance goals of the Company are achieved for an Award Cycle, Participants in the Plan will be eligible for awards which are calculated using an adjusted salary midpoint equal to the Participant's salary midpoint in effect in the first year of the Award Cycle multiplied times 110% ("Adjusted Salary Midpoint"). The Adjusted Salary Midpoint is then multiplied by 50% to calculate the standard award ("Standard Award") for each salary grade. If a Participant's salary grade changes in the course of an Award Cycle, the Participant's Standard Award will be adjusted using the Adjusted Salary Midpoint for the new grade level which was in effect during the first year of that Award Cycle. Depending upon the level of performance achieved by the Company, the amount of a Participant's actual award will range from 50% to 200% of the Standard Award (the "Award"). Awards paid pursuant to this Plan will consist of cash and Bausch & Lomb Class B Stock granted pursuant to the 1990 Stock Incentive Plan or any successor plan (the "Stock Plan"). VI. PERFORMANCE UNITS At the February meeting of the Committee following the commencement of the Award Cycle, each Participant will receive performance units ("Performance Units") equal to the number of shares of Class B Stock which, as of the date of such meeting of the Committee, have an aggregate fair market value (as determined under the Stock Plan) equal to 50% of each Participant's Standard Award. During the Award Cycle, Participants will receive quarterly cash payments on their Performance Units equal to the dividends which would be payable on a like number of shares of Class B Stock. Participant's Standard Award calculation changes because of a salary grade change in the course of an Award Cycle, the number of Performance Units will be adjusted accordingly. VII. PAYOUTS At the end of each Award Cycle, the Standard Award will be adjusted by the Committee to reflect sales growth and ROE performance on the applicable payout matrix to determine the amount of the Award payable to each Participant. The Award payable to a Participant may also be modified by the Committee if the Award does not accurately reflect performance due to general economic conditions, industry changes, corporate strategy changes, natural disasters or any similar condition. One half of that amount shall be paid in cash. The Participant will also receive shares of Class B Stock(pursuant to the Stock Plan) equal to the number of Performance Units granted to the Participant; provided, however, that if the Award is based upon a percentage which is more than or less than 100% of the Standard Award, the number of shares of Class B Stock to be granted will be adjusted up or down by a like percentage. There will be no adjustments in the number of shares of Class B Stock for fluctuations up or down in the fair market value of Class B Stock from the date of grant of Performance Units at the beginning of the Award Cycle to the date of grant of the Class B Stock, if any, after the Award Cycle. Notwithstanding any other provision of this Plan, if a Participant's performance results in calculation of an Award which would be less than 50% of the Standard Award, the Participant will nonetheless be entitled to a minimum grant of Class B Stock equal to 50% of the Performance Units granted to the Participant. Whether or not an Award is paid for an Award Cycle, all Performance Units granted hereunder for an Award Cycle shall expire at the end of the Award Cycle, and Participants shall have no further rights with respect to such Units, except to the extent that their performance entitles them to an Award. Performance Units shall not give Participants any rights under the Stock Plan maintained by the Company. VIII. DEFERRAL Any or all of the cash portion of an Award may be deferred, at the option of the Participant, into the Company's Deferred Compensation Plan. Notice of such a deferral must be given to the Company at least 18 months prior to the end of each Award Cycle for which deferral is requested. IX. TERMINATION OF EMPLOYMENT If the Participant's employment with the Company terminates before the end of any Award Cycle due to death, disability, or retirement, the Participant or his/her beneficiary is entitled to a pro rata share of any Award paid at the end of the Award Cycle, unless the Committee, upon the recommendation of the Chief Executive Officer, decides that a prorated Award should be paid prior to the end of the Award Cycle. If the Participant's employment with the Company terminates before the end of any Award Cycle for any other reason, the Participant's Performance Units shall be forfeited and the Participant shall not be entitled to any Award hereunder. X. ADMINISTRATION OF THE PLAN The Committee is responsible for the overall administration of the Plan. The Committee will, by formal resolution: 1) approve the Performance Goals for the Award Cycle at the beginning of each Award Cycle; 2) set new or adjust previously set performance goals as appropriate to reflect major unforeseen events; and 3) administer the Plan in all respects to carry out its purposes and objectives including, but not limited to, responding to changes in tax laws, regulations or rulings, changes in accounting principles or practices, mergers, acquisitions or divestitures, major technical innovations, or extraordinary, nonrecurring, or unusual items, to preserve the integrity of the Plan's objectives. The Committee reserves the right, in its discretion, to pay any Awards hereunder entirely in cash. The effective date of each Award Cycle is January 1 of the first year of the performance period. XI. RECAPITALIZATION In the event there is any recapitalization in the form of a stock dividend, distribution, split, subdivision or combination of shares of common stock of the Company, resulting in an increase or decrease in the number of common shares outstanding, the number of Performance Units then granted under the Plan shall be increased or decreased proportionately, as the case may be. XII. REORGANIZATION If, pursuant to any reorganization, sale or exchange of assets, consolidation or merger, outstanding Class B Stock is or would be exchanged for other securities of the Company or of another company which is a party to such transaction, or for property, any grant of Performance Units under the Plan theretofore granted shall, subject to the provisions of this Plan for making Awards, apply to the securities or property into which the Class B Stock covered thereby would have been changed or for which such Class B Stock would have been exchanged had such Class B Stock been outstanding at the time. EXHIBIT (10)-i LONG TERM PERFORMANCE STOCK PLAN - II I. PURPOSE The Long Term Performance Stock Plan - II (the "Plan") is designed to advance the interests of Bausch & Lomb Incorporated (the "Company") and its shareholders by (i) providing incentives for those key executives who have a major impact on long term corporate performance; (ii) reinforcing corporate long term financial goals; (iii) providing competitive levels of long term compensation for key executives; and (iv) aligning management and shareholder interests. II. ELIGIBILITY Participation in the Plan is limited to officers and other selected key executives who have a major impact on the performance of the Company. The Company's chief executive officer or his designees will designate executives to participate in the Plan ("Participants"). III. AWARD CYCLES Award cycles ("Award Cycles") will be measured over three year periods, with the performance award, if any, for each Award Cycle to be paid early in the fourth year. Award Cycles will commence on January 1 of the first year of each performance period. IV. PERFORMANCE GOALS The chief executive officer or his designees will establish the performance goals for each Award Cycle, ensuring that the goals are equitable and are compatible with the Company's major business objectives. The performance goals for each Participant will relate to the Participant's area of responsibility and be consistent with the long term goals of the Company. For Participants who are part of the Company's corporate staff, their performance goals will be weighted twothirds based upon the Participant's individual goals and onethird based upon the corporate wide financial goals of return on equity and sales growth. The corporate wide goals will be established by the chief executive officer or his designees. V. AWARDS A. Officer Awards If a Participant who is an officer achieves his or her performance goals for an Award Cycle, such Participant will be eligible for an award which is calculated using an adjusted salary midpoint equal to the Participant's salary midpoint in effect in the first year of the Award Cycle multiplied times 110% ("Adjusted Salary Midpoint"). The Adjusted Salary Midpoint is then multiplied by the appropriate percentage set forth below to calculate the three year standard award ("Standard Award") for each salary grade: B. Non Officer Awards. If a Participant who is not an officer achieves his or her performance goals for an Award Cycle, such Participant will be eligible for an award which is calculated using the Participant's salary in effect in the first year of the Award Cycle multiplied times 110% ("Adjusted Salary"). The Adjusted Salary is then multiplied by 45% to calculate the Standard Award for a non-officer Participant. C. Adjustments to Award Calculation If an officer Participant's salary grade changes in the course of an Award Cycle, such Participant's Standard Award will be adjusted using the Adjusted Salary Midpoint for the new grade level which was in effect during the first year of that Award Cycle. For all non-officer Participants, the calculation of the Standard Award will be adjusted using each such Participant's actual salary in the third year of the Award Cycle. D. Award Amount Depending upon the level of performance achieved by each Participant, the amount of a Participant's actual award, if any, will range from 50% to 200% of the Standard Award as adjusted pursuant to Section V.C. above (the "Award"). Awards paid pursuant to this Plan will consist of cash and Bausch & Lomb Class B Stock granted pursuant to the 1990 Stock Incentive Plan or any successor plan (the "Stock Plan"). If a Participant's performance results in calculation of an Award which would be less than 50% of the Standard Award, the Participant will nonetheless be entitled to a minimum grant of Class B Stock equal to 50% of the Performance Units granted to the Participant pursuant to Section VI below. VI. PERFORMANCE UNITS In February following the commencement of an Award Cycle each Participant will receive performance units ("Performance Units") equal to the number of shares of Class B Stock which, as of the date of the February meeting of the Committee on Management of the Board of Directors (the "Committee"), have an aggregate fair market value (as determined under the Stock Plan) equal to 50% of each Participant's Standard Award. During the Award Cycle, Participants will receive quarterly cash payments on their Performance Units equal to the dividends which would be payable on a like number of shares of Class B Stock. If an officer Participant's Standard Award calculation changes because of a salary grade change due to a promotion in the course of an Award Cycle, the number of Performance Units will be adjusted accordingly at the end of the Award Cycle. For non-officer Participants the number of Performance Units will be adjusted at the end of the third year of the Award Cycle when the non-officer Participant's Standard Award is adjusted for actual salary increases pursuant to Section V.C. above. VII. PAYOUTS At the end of each Award Cycle, the Standard Award (as adjusted pursuant to Section V.C. above) will be modified by the chief executive officer or his designees to reflect performance against the applicable goals and determine the amount of the Award payable to each Participant. The Award payable to a Participant may also be modified by the chief executive officer or his designees if the Award does not accurately reflect performance due to general economic conditions, industry changes, corporate strategy changes, natural disasters or any similar condition. One half of the Award amount shall be paid in cash. The Participant will also receive shares of Class B Stock (pursuant to the Stock Plan) equal to the number of Performance Units granted to the Participant; provided, however, that if the Award is based upon a percentage which is more than or less than 100% of the Standard Award, the number of shares of Class B Stock to be granted will be adjusted up or down by a like percentage. There will be no adjustments in the number of shares of Class B Stock for fluctuations up or down in the fair market value of Class B Stock from the date of grant of Performance Units at the beginning of the Award Cycle to the date of grant of the Class B Stock, if any, after the Award Cycle. Whether or not an Award is paid for an Award Cycle, all Performance Units granted hereunder for an Award Cycle shall expire immediately after the Award Cycle, and Participants shall have no further rights with respect to such Units, except to the extent that their performance entitles them to an Award. Performance Units shall not give Participants any rights under the Stock Plan. VIII. DEFERRAL Any or all of the cash portion of an Award may be deferred, at the option of the Participant, into the Company's Deferred Compensation Plan. Notice of such a deferral must be given to the Company at least 18 months prior to the end of each Award Cycle for which deferral is requested. IX. TERMINATION OF EMPLOYMENT If the Participant's employment with the Company terminates before the end of any Award Cycle due to death, disability, or retirement, the Participant or his/her beneficiary is entitled to a pro rata share of any Award paid at the end of the Award Cycle, unless the chief executive officer or his designees decide that a pro rated Award should be paid prior to the end of the Award Cycle. If the Participant's employment with the Company terminates before the end of any Award Cycle for any other reason, the Participant's Performance Units shall be forfeited and the Participant shall not be entitled to any Award hereunder. X. ADMINISTRATION OF THE PLAN This Plan has been adopted by the Committee, and the Committee may amend, suspend or terminate the Plan or any portion thereof at any time. The Committee is responsible for the design of the Plan and the overall administration of the Plan. Notwithstanding any other provision of this Plan, all grants of Class B Stock made in connection with this Plan shall be subject to the discretion of the Committee which shall make any such grants pursuant to the Stock Plan. The Committee reserves the right, in its discretion, to pay any Awards hereunder entirely in cash. The chief executive officer or his designees will: 1) approve the Performance Goals for each Award Cycle at the beginning of the Award Cycle; 2) set new or adjust previously set performance goals or terminate current Award Cycles and commence new Award Cycles for individual Participants as appropriate to reflect major unforeseen events which are negatively affecting performance; and 3) administer the Plan to carry out its purposes and objectives such as, but not limited to, responding to changes in tax laws, regulations or rulings, changes in accounting principles or practices, mergers, acquisitions or divestitures, major technical innovations, or extraordinary, non-recurring, or unusual items, to preserve the integrity of the Plan's objectives. XI. RECAPITALIZATION In the event there is any recapitalization in the form of a stock dividend, distribution, split, subdivision or combination of shares of common stock of the Company, resulting in an increase or decrease in the number of common shares outstanding, the number of Performance Units then granted under the Plan shall be increased or decreased proportionately, as the case may be. XII. REORGANIZATION If, pursuant to any reorganization, sale or exchange of assets, consolidation or merger, outstanding Class B Stock is or could be exchanged for other securities of the Company or of another company which is a party to such transaction, or for property, any grant of Performance Units under the Program theretofore granted shall, subject to the provisions of this Program for making Awards, apply to the securities or property into which the Class B Stock covered thereby would have been changed or for which such Class B Stock would have been exchanged had such Class B Stock been outstanding at the time. EXHIBIT 22 EXHIBIT (24) REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Bausch & Lomb Incorporated out audits of the consolidated financial statements referred to in our report dated January 25, 1994 appearing on page 63 of the 1993 Annual Report to Shareholders of Bausch & Lomb Incorporated (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 PRICE WATERHOUSE Rochester, New York January 25, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (Nos. 2-56066, 2-85158, 33- 15439 and 33-35667) and in the Prospectus constituting part of the Registration Statement on Form S-3 (No. 3351117) of Bausch & Lomb Incorporated of our report dated January 25, 1994 appearing on page 63 of the 1993 Annual Report to Shareholders of Bausch & Lomb Incorporated which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our above report on the Financial Statement Schedules. /s/ Price Waterhouse PRICE WATERHOUSE Rochester, New York March 23, 1994 EXHIBIT (25) POWER OF ATTORNEY The undersigned directors of Bausch & Lomb Incorporated (the "Company"), each hereby constitutes and appoints Daniel E. Gill and Jay T. Holmes, or either of them, his or her respective true and lawful attorneys and agents, each with full power and authority to act as such without the other, to sign for and on behalf of the undersigned the Company's Annual Report on Form 10-K for the year ended December 25, 1993, to be filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934 and the related rules and regulations thereunder, and any amendment or amendments thereto, the undersigned hereby ratifying and confirming all that said attorneys and agents, or either one of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, this instrument has been executed by the undersigned as of this 22 day of March, 1994. /s/ Franklin E. Agnew /s/ Linda Johnson Rice Franklin E. Agnew Linda Johnson Rice /s/ William Balderson III /s/ Robert L. Tarnow William Balderston III Robert L. Tarnow /s/ Bradford R. Boss /s/ Alvin W. Trivelpiece Bradford R. Boss Alvin W. Trivelpiece /s/ Daniel E. Gill /s/ William H. Waltrip Daniel E. Gill William H. Waltrip /s/ Jay T. Holmes /s/ Kenneth L. Wolfe Jay T. Holmes Kenneth L. Wolfe /s/ Ruth R. McMullin /s/ Ronald L. Zarrella Ruth R. McMullin Ronald L. Zarrella John R. Purcell

63276_1993.txt

63276_1993

1993

63276

Item 1. Business - ------- -------- The Company designs, develops, manufactures, markets and distributes a broad variety of toy products on a worldwide basis. Measured by revenues, the Company is the second largest toy company in the world. The Company's three strongest principal product lines are BARBIE fashion dolls and doll clothing and accessories, FISHER-PRICE toys and juvenile products and the Company's Disney- licensed toys, each of which has broad worldwide appeal. Additional current principal product lines consist of die-cast vehicles and accessories, including HOT WHEELS; large dolls; preschool toys, including SEE 'N SAY talking toys; and the UNO and SKIP-BO games. Revenues for 1993 of $2.7 billion were a record level for the Company. In November 1993, Fisher-Price, Inc. ("Fisher-Price") became a wholly- owned subsidiary of Mattel as a result of a merger transaction (the "Fisher- Price Merger"). See Note 2 to the Consolidated Financial Statements in the Annual Report to Shareholders for the year ended December 31, 1993 (the "Annual Report to Shareholders"), incorporated herein by reference and Item 4 "Submission of Matters to a Vote of Security Holders" below. As used herein, unless the context requires otherwise, "Mattel" refers to Mattel, Inc., and its subsidiaries other than Fisher-Price, and the "Company" refers to Mattel together with Fisher-Price. Mattel was incorporated in California in 1948 and reincorporated in Delaware in 1968. Its executive offices are located at 333 Continental Boulevard, El Segundo, California 90245-5012, telephone (310) 524-2000. Competition and Industry Background - ----------------------------------- Competition in the toy industry is based primarily on price, quality and play value. In recent years, the toy industry has experienced rapid consolidation driven, in part, by the desire of industry competitors to offer a range of products across a broader variety of categories. In the United States, the Company competes with several large toy companies, including Hasbro, Inc. and Tyco Toys, Inc. as well as a number of smaller toy companies. The larger toy companies have pursued a strategy of focusing on core product lines. Core product lines are lines which are expected to be marketed for an extended period of time, and which historically have provided relatively consistent growth in sales and profitability. By focusing on core product lines, toy manufacturers have been able to reduce their reliance on new product introductions and the associated risk and volatility. The juvenile products market, in which Fisher-Price is one of the leading companies, is more fragmented. The more significant competitors in this area include Gerry Baby Products Company, Century Products Company, Graco Children's Products, Inc., Cosco, Inc. and Evenflo Juvenile Furniture Company, Inc. The toy industry is also experiencing a shift toward greater consolidation of retail distribution channels, such as large specialty toy stores and discount retailers, including Toys R Us, Wal-Mart, Kmart and Target, which have increased their overall share of the retail market. This consolidation has resulted in an increasing reliance among retailers on the large toy companies because of their financial stability and their ability to support products through advertising and promotion and to distribute products on a national basis. These retailers' growing acceptance of electronic data interchange has provided toy manufacturers with an ability to more closely monitor consumers' acceptance of a particular product or product line. Over the last ten years, toy companies based in the United States have expanded their international marketing and manufacturing operations. The Company believes a strong international distribution system can add significantly to the sales volume of core product lines and extend the life cycles of newly-developed products. Seasonality - ----------- Sales of toy products at retail are seasonal, with a majority of retail sales occurring during the period from September through December. Consequently, shipments of toy products to retailers are greater in the third and fourth quarters than in each of the first and second quarters. As the large toy retailers become more efficient in their control of inventory levels, this seasonality is likely to increase. In anticipation of this seasonal increase in retail sales, the Company significantly increases its production in advance of the peak selling period, resulting in a seasonal build-up of inventory levels. In addition, the Company and others in the industry develop sales programs, including offering extended payment terms, to encourage retailers to purchase merchandise earlier in the year. These sales programs, coupled with seasonal shipping patterns, result in significant peaks in the third and fourth quarters in the respective levels of inventories and accounts receivable, which contribute to a seasonal working capital financing requirement. See "Seasonal Financing." Products - -------- The Company has been able to record consistent sales and earnings growth by focusing on a number of core product lines supplemented by various new product introductions. The Company's three strongest core product lines are BARBIE fashion dolls and doll clothing and accessories, FISHER-PRICE toys and juvenile products, and the Company's Disney-licensed toys, each of which has broad worldwide appeal. Additional current core product lines consist of die-cast vehicles and accessories, including HOT WHEELS; large dolls; preschool toys, including SEE 'N SAY talking toys; and the UNO and SKIP-BO games. Core product lines are expected to be marketed for an extended period of time and historically have provided relatively consistent growth in sales and profitability. For the year ended December 31, 1993, core products accounted for approximately 86% of sales. In order to provide greater flexibility in the manufacture and delivery of products, and as part of a continuing effort to reduce manufacturing costs, the Company has concentrated production of most of its core products in Company-owned facilities and generally uses independent contractors for the production of non-core products. With respect to new product introductions, the Company's strategy is to begin production on a limited basis until a product's initial success has been proven in the marketplace. The production schedule is then modified to meet anticipated demand. The Company further limits its risk by generally having independent contractors manufacture new product lines in order to minimize capital expenditures associated with new product introductions. This strategy has reduced inventory risk and significantly limited the potential loss associated with new product introductions. New product introductions in 1993 included the HOLLYWOOD HAIR BARBIE doll and the MY SIZE BARBIE doll, the addition of a series of dolls based on the animated feature "Snow White and the Seven Dwarfs" to the Company's Disney line, the BABY WALK 'N ROLL and SALLY SECRETS large dolls and the addition of the ATTACK PACK line of monster trucks to the Company's HOT WHEELS line. The Company also introduced a line of activity toys called McDONALD'S HAPPY MEAL MAGIC. New product introductions in 1994 will include the Gymnast BARBIE, Bedtime BARBIE and DR. BARBIE dolls; Fisher-Price's new plush RUMPLE BEARS, TRIPLE ARCADE electronic game, and electronic learning toys; the additions of COLOR FX and HOT WHEELS TOP SPEED PIPEJAMMER vehicles to the HOT WHEELS line; and the addition to the Company's Disney line of a series of plush products, action figures and small dolls based on the animated feature "The Lion King". The Company also will introduce a new line of large dolls called DREAMLAND Babies, and Nickelodeon THINGMAKER, a new activity toy. In conjunction with the release of the feature film "The Flintstones," the Company will introduce a line of small dolls, large dolls, action figures and accessories. International Operations - ------------------------ Revenues from the Company's international operations represented approximately 40% of total consolidated revenues in 1993. Products which are developed and marketed successfully in the United States typically generate incremental sales and profitability when marketed through the Company's international distribution network. Generally, products marketed internationally are the same as those marketed domestically, although some are developed or adapted for particular international markets. The Company sells its products directly through its wholly-owned subsidiaries in Australia, Austria, the Benelux countries, Canada, Chile, France, Germany, Greece, Italy, Japan, Mexico, Scandinavia, Spain, Switzerland, the United Kingdom and in certain areas of Eastern Europe and Asia. In 1994, the Company will begin selling its products directly in Argentina, Portugal and Venezuela through newly established subsidiaries. In addition to direct sales, the Company sells principally through distributors in Central and South America, the Middle East, South Africa and Southeast Asia. It also licenses some of its products to other toy companies for sale in various other countries. Until December 1993, Mattel also distributed the Nintendo Entertainment System and related products in Australia. See "Licenses and Distribution Agreements." The strength of the U.S. dollar relative to other currencies can significantly affect the revenues and profitability of the Company's international operations. The Company hedges intercompany purchases and sales of inventory in order to protect local cash flows and profitability from currency fluctuations. See "Foreign Currency Contracts." For financial information by geographic area, see Note 8 to the Consolidated Financial Statements in the Annual Report to Shareholders, incorporated herein by reference. Product Design and Development - ------------------------------ Through its product design and development group, the Company regularly refreshes, redesigns and extends existing product lines and develops innovative new product lines. The Company's success is dependent on its ability to continue this activity. Product design and development are principally conducted by a group of professional designers and engineers employed by the Company. License agreements with third parties permit the Company to utilize the name, character or product of the licensor in its product line. A principal licensor is The Walt Disney Company, which licenses many of its characters for use on the Company's products. The Company also has entered into license agreements with, among others, McDonald's, Inc., MCA Universal Merchandising, Inc., the Time Warner Entertainment Company, L.P. and DC Comics, Inc. units of Time Warner Inc., LucasArts Entertainment Company, Turner Home Entertainment, Inc., Hanna-Barbera Productions, Inc., American Greeting Cards, Inc., Children's Television Workshop, and Viacom International, Inc. relating to its Nickelodeon properties. A number of these licenses relate to product lines that are significant to the Company. Independent toy designers and developers bring products to the Company and are generally paid a royalty on the net sales price of products licensed by the Company. These independent toy designers may also create different products for other toy companies. The Company devotes substantial resources to product design and development. During the years ended December 31, 1993, December 31, 1992 and December 31, 1991, the Company expended approximately $75 million, $77 million and $56 million, respectively, in connection with the design and development of products, exclusive of royalty payments. Advertising and Promotion - ------------------------- The Company supports its product lines with extensive advertising and consumer promotions. Advertising continues at varying levels throughout the year and peaks during the Christmas season. Advertising includes television and radio commercials and magazine and newspaper ads. Promotions include in-store displays, coupons, merchandising materials and major events focusing on products and tie-ins with various consumer product companies. To further promote the Company and its products, the Company participates in the attractions "It's A Small World" at Disneyland and Disney World and "Autopia" at Euro Disneyland under a ten-year agreement with The Walt Disney Company. The Company also participates in toy stores in Disneyland and in the Disney Village Market Place near Disney World and commenced participation in a new toy store in Euro Disneyland in December 1993. Separately, the Company has established a total of six BARBIE Boutiques in F.A.O. Schwarz toy stores, including the "BARBIE on Madison" boutique at the F.A.O. Schwarz flagship store in New York City. During the years ended December 31, 1993, December 31, 1992 and December 31, 1991, Mattel spent approximately $427 million (16% of net sales), $403 million (16% of net sales) and $308 million (15% of net sales), respectively, on worldwide advertising and promotion. Marketing and Sales - ------------------- The Company's toy products are sold throughout the world. In the United States, the Company's products are distributed directly to large retailers, including discount and free-standing toy stores, chain stores and department stores, and other retail outlets and, to a limited extent, to wholesalers. Discount and free-standing toy stores continue to increase their market share. During the year ended December 31, 1993, Toys R Us and Wal-Mart accounted for approximately 22% and 10%, respectively, of worldwide consolidated net sales and were the only customers accounting for 10% or more of consolidated net sales. In general, the Company's major domestic and international customers review its product lines and product concepts for the upcoming year at showings beginning in late summer. The Company also participates in the domestic and international toy industry trade fairs in the first quarter of the year. A majority of the full-year orders are received by May 1. As is traditional in the toy industry, these orders may be canceled at any time before they are shipped. Historically, the greater proportion of shipments of products to retailers occurs during the third and fourth quarters of the year. See "Seasonality." Through its marketing research department, the Company conducts basic consumer research and product testing and monitors demographic factors and trends. This information assists the Company in evaluating consumer acceptance of products, including an analysis of increasing or decreasing demand for its products. The Company bases its production schedules on customer orders, modified by historical trends, results of market research and current market information. The actual shipments of products ordered and the order cancellation rate are affected by consumer acceptance of the product line, the strength of competing products, marketing strategies of retailers and overall economic conditions. Unexpected changes in these factors can result in a lack of product availability or excess inventory in a particular product line. Manufacturing - ------------- The Company's products are manufactured in Company facilities and by independent contractors. Products are also purchased from unrelated entities that design, develop and manufacture the products. In order to provide greater flexibility in the manufacture and delivery of products, and as part of a continuing effort to reduce manufacturing costs, the Company has concentrated production of most of its core products in the Company's facilities and generally uses independent contractors for the production of non-core products. As a result of the Fisher-Price Merger, Mattel acquired manufacturing facilities in the states of Kentucky and New York, and in England and Mexico, which are in addition to its existing manufacturing facilities in the Far East (China, Indonesia and Malaysia), Mexico and Italy. The Company also utilizes independent contractors to manufacture products in the United States, the Far East and Australia. To protect the stability of its product supply, the Company produces many of its key products in more than one facility. Foreign countries in which the Company's products are manufactured (principally China, Indonesia, Malaysia and Mexico) currently enjoy "most favored nation" ("MFN") status under U.S. tariff laws, which provides the most favorable category of U.S. import duties. As a result of conditions in China, there has been, and may be in the future, opposition to the extension of MFN status for China. In May 1993, President Clinton signed an executive order extending MFN status for China through June 3, 1994. The loss of MFN status for China would result in a substantial increase in the import duty for toys manufactured in China and imported into the United States and would result in increased costs for the Company and others in the toy industry. The impact of such an event on the Company would be significantly mitigated by the Company's ability to source product for the U.S. market from countries other than China and ship product manufactured in China elsewhere. Toward that end, the Company has extended its production capacity in other countries. In addition, all of the manufacturing facilities gained by the Company in the Fisher-Price Merger are outside of China, although some Fisher-Price product is sourced in China. A number of other factors, including the Company's ability to pass along the added costs through price increases and the pricing policies of vendors in China, could further mitigate the impact of a loss of China's MFN status. On February 8, 1994, the European Union ("EU") adopted quotas on the importation of certain classes of toys (as well as other products) manufactured in China, although regulations implementing the quotas have yet to be promulgated. The Company expects that the impact of these quotas on its business will be significantly mitigated by shifts in demand in favor of toy categories not subject to the quotas, and by the ability of the Company to source product for the EU from countries other than China and ship product manufactured in China elsewhere. The Company does not currently expect that these quotas will have a material effect on its business. Commitments - ----------- In the normal course of business, the Company enters into contractual arrangements for future purchases of goods and services to ensure availability and timely delivery, and to obtain and protect the right to create and market certain toys. Such arrangements include commitments for future inventory purchases and royalty payments pursuant to licensing agreements. Certain of these purchase agreements and licenses contain provisions for guaranteed or minimum payments during the terms of the contracts and licenses. See "Management's Discussion and Analysis of Results of Operations and Financial Condition--Commitments" and Note 7 to the Consolidated Financial Statements in the Annual Report to Shareholders, incorporated herein by reference. Licenses and Distribution Agreements - ------------------------------------ The Company's level of licensing activity has expanded in recent years. Royalties paid to licensors during the years ended December 31, 1993, December 31, 1992 and December 31, 1991 were approximately $69 million, $50 million and $39 million, respectively. The Company also distributes products which are independently designed and manufactured. The Company's agreement for the distribution of the Nintendo Entertainment System and related products in Australia was terminated in December 1993. Foreign Currency Contracts - -------------------------- From time to time, the Company enters into foreign currency forward exchange contracts, swaps and options as hedges of inventory purchases and sales and various other intercompany transactions. The contracts are intended to fix a portion of the Company's product cost and intercompany cash flows, and thereby moderate the impact of currency fluctuations. The Company does not speculate in foreign currencies. For additional information regarding foreign currency contracts, see Note 7 to the Consolidated Financial Statements in the Annual Report to Shareholders, incorporated herein by reference. Seasonal Financing - ------------------ The Company's financing of seasonal working capital typically grows throughout the first half of the year and peaks in the third or fourth quarter, when accounts receivable are at their highest due to increased sales volume and Company sales programs, and when inventories are at their highest in anticipation of expected second half sales volume. See "Seasonality." Borrowings for seasonal financing are generally repaid in full by year-end from cash flows generated in the fourth quarter from sales and collection of accounts receivable. To finance its working capital requirements, the Company maintains and periodically revises or replaces a revolving credit agreement with a commercial bank group. The agreement in effect during 1993, which was recently replaced (see below), was amended in the first quarter of 1993 to increase the total facility to $350 million from $250 millon and to release the banks' lien on Mattel's inventory and receivables. Within the total facility, up to $175.0 million was a standard revolving credit line available for either advances or letters of credit in support of commercial paper issuances. Interest was charged at alternative rates selected by Mattel not greater than the prime rate charged by the agent bank, plus a commitment fee of 3/8 of one percent of the unused line available for advances and 1/2 of one percent of the amount utilized for standby letters of credit. The remaining $175.0 million was available for nonrecourse purchases of certain trade accounts receivable of Mattel by the commercial bank group providing the credit line. The agreement required Mattel to comply with certain consolidated financial ratios and to maintain certain levels of income. In 1993, the Company's domestic seasonal borrowings outstanding under the revolving credit agreement and other bank borrowings averaged approximately $45.1 million and reached a peak of approximately $167.0 million during the third quarter. This balance was fully repaid by December 31, 1993. The Company's 1993 seasonal borrowings outstanding under foreign credit lines averaged approximately $55.1 million, reached a peak of approximately $76.1 million in the third quarter, and were also fully repaid by year end. Effective in March 1994, the Company renegotiated its revolving credit agreement. The new agreement consists of unsecured facilities providing a total of $500.0 million in seasonal financing from the same group of commercial banks. The facilities provide for up to $250.0 million in advances and backup for commercial paper issuances ($125.0 million of which is a 364-day facility and the other $125.0 million is a 3-year facility), and up to an additional $250.0 million (a 3-year facility) for nonrecourse purchases of certain trade accounts receivable by the bank group. In connection with the agreement, the Company is to comply with certain consolidated financial covenants for debt-to-capital, interest coverage and tangible net worth levels. Concurrently with the consummation of the Fisher-Price Merger, the Fisher- Price domestic seasonal credit line was terminated with a view to financing Fisher- Price's domestic seasonal working capital needs under Mattel's revolving credit agreement. During 1994, the Company expects to finance Fisher-Price's foreign seasonal working capital needs under Mattel's seasonal credit facilities and to terminate Fisher-Price's foreign seasonal credit lines. Borrowings for seasonal financing were significantly reduced in 1993 primarily as a result of a higher level of cash at the beginning of the year, the issuance by the Company in May 1993 of $100 million aggregate principal amount of 6-3/4% Notes due 2000 and the utilization of the Company's accounts receivable sales facility. The Company believes the amounts available to it under its revolving credit agreement and its foreign credit lines will be adequate to meet its seasonal financing requirements. Raw Materials - ------------- Packaging materials, most plastics and zinc essential to the production and marketing of toy products are currently in adequate supply. These and other raw materials are generally available from a number of suppliers. Trademarks, Copyrights, and Patents - ----------------------------------- Most of the Company's products are sold under trademarks, trade names and copyrights and a number of those products incorporate patented devices or designs. Trade names and trademarks are significant assets to the Company in that they provide product recognition and acceptance worldwide. The Company customarily seeks patent, trademark or copyright protection covering its products, and it owns or has applications pending for United States and foreign patents covering many of its products. A number of these trademarks and copyrights relate to product lines that are significant to the Company and the Company believes its rights to these properties are adequately protected. The Company also licenses various of its trademarks, characters and other property rights to others for use in connection with the sale by others of non-toy products and other products which do not compete with the Company's products. Government Regulations - ---------------------- The Company's toys are subject to the provisions of the Consumer Product Safety Act, the Federal Hazardous Substances Act and the Flammable Fabrics Act, and the regulations promulgated thereunder. The Consumer Product Safety Act and the Federal Hazardous Substances Act enable the Consumer Product Safety Commission (the "CPSC") to exclude from the market consumer products that fail to comply with applicable product safety regulations or otherwise create a substantial risk of injury, and articles that contain excessive amounts of a banned hazardous substance. The Flammable Fabrics Act enables the CPSC to regulate and enforce flammability standards for fabrics used in consumer products. The CPSC may also require the repurchase by the manufacturer of articles which are banned. Similar laws exist in some states and cities and in various international markets. Fisher-Price's car seats are subject to the provisions of the National Highway Transportation Safety Act, which enables the National Highway Traffic Safety Administration ("NHTSA") to promulgate performance standards for child restraint systems. Fisher-Price conducts periodic tests to ensure that its child restraint systems meet applicable standards. A Canadian agency, Transport Canada, also regulates child restraint systems sold for use in Canada. As with the CPSC, NHTSA and Transport Canada can require the recall and repurchase or repair of products which do not meet their respective standards. The Company maintains a quality control program to ensure product safety compliance with the various federal, state and international requirements. Effects of Inflation - -------------------- Inflation rates in the U.S. and major foreign countries in which the Company operates have not had a significant impact on operating results for the three years ended December 31, 1993. The U.S. Consumer Price Index increased 2.7% in 1993, 2.9% in 1992 and 3.1% in 1991. The Company is afforded some protection from the impact of inflation as a result of high turnover of inventories and benefitted from inflation on the repayment of fixed-rate liabilities during these periods. Employees - --------- The total number of persons employed by the Company and its subsidiaries at any one time varies because of the seasonal nature of its manufacturing operations. At December 31, 1993, the Company's total number of employees, including its international operations, was approximately 21,000. Executive Officers of the Registrant - ------------------------------------ The executive officers of the Company, all of whom are appointed annually by the Board of Directors and serve at the pleasure of the Board, are as follows: Mr. Amerman has been Chairman of the Board & Chief Executive Officer since February 1987 and a member of the Board of Directors since November 1985. Prior to that he served as President of Mattel International. Ms. Barad has been President & Chief Operating Officer since August 1992 and a member of the Board of Directors since November 1991. From December 1989 until August 1992, she was President, Mattel USA. Prior to that she served in various executive positions in the Marketing, Product Design and Product Development areas. Mr. Eskridge has been a member of the Board of Directors since February 1993 and President of Fisher-Price, Inc. since November 1993. Prior to that he was Executive Vice President & Chief Financial Officer of Mattel, Inc. Mr. Gandolfo has been President, Mattel Operations, since April 1990. Prior to that he was General Manager of Manufacturing, Thompson Consumer Electronics. Mr. Williams has been a member of the Board of Directors since November 1991 and has been President, Mattel International for more than five years. Mr. McCafferty has been Executive Vice President & Chief Financial Officer since November 1993. From June 1993 to November 1993 and from November 1985 to October 1992 he was Senior Vice President & Treasurer. During the period from October 1992 to June 1993, he was Senior Vice President & Controller. Mr. McKay has been Senior Vice President, Human Resources and Administration since November 1993. From December 1991 until November 1993 he was Vice President, Human Resources. He was Senior Director Human Resources from March 1991 to December 1991. Prior to that he was Vice President Human Resources-Administration of Mileage Plus, Inc. Mr. Mansour has been Senior Vice President, General Counsel & Secretary since February 1993. From May 1992 until February 1993 he was Senior Vice President & General Counsel and from April 1991 until May 1992 he was Vice President & Associate General Counsel. Prior to that he was Vice President & Assistant General Counsel. Mr. Rolfes has been Senior Vice President & Controller since November 1993. From June 1993 to November 1993 he was Vice President & Controller. Prior to that he held various executive positions within the finance department. Mr. Stavro has been Vice President & Treasurer since November 1993. From March 1992 to November 1993 he was Vice President and Assistant Treasurer. Prior to that he was Assistant Treasurer for more than five years. Item 2. Item 2. Properties - ------- ---------- The Company owns its corporate headquarters consisting of approximately 335,000 square feet in El Segundo, California. The facility is subject to a $45 million mortgage. The Company also leases two buildings in El Segundo which consist of a total of approximately 250,000 square feet for its design and development and audio-visual departments. The Company maintains sales offices in California, Illinois, New York and Texas and warehouse and distribution facilities in California and Texas. The Company owns a computer facility in Phoenix, Arizona. Internationally, the Company has offices and/or warehouse space in Argentina, Australia, Belgium, Canada, Chile, Denmark, France, Germany, Greece, Hong Kong and in certain other areas of Asia, Italy, Japan, The Netherlands, Spain, Switzerland and the United Kingdom. The Company's principal manufacturing facilities, including the Fisher-Price facilities, are located in China, Indonesia, Italy, Malaysia, Mexico, the United Kingdom and the United States. See "Manufacturing." Most of the Company's facilities are occupied under long-term leases and, for the most part, are fully utilized, although excess manufacturing capacity exists from time to time based on product mix and demand. With respect to leases which are scheduled to expire during the next twelve months, the Company may negotiate new lease agreements, renew leases or utilize alternative facilities. As a result of the Fisher-Price Merger, Mattel acquired the approximately 288,000 square foot Fisher-Price headquarters building and a second smaller office building in East Aurora, New York and manufacturing, distribution and warehousing facilities in Kentucky, New York, Tennessee, Belgium, Canada, Mexico and the United Kingdom. In addition, Fisher-Price owns or leases office and showroom space in New York, Texas, Belgium, Canada, Denmark, France, Germany, Hong Kong, Italy, Mexico and the United Kingdom. The Company is currently in the process of evaluating the desirability of maintaining certain of these facilities and expects to sell, sublease or not renew the leases of those facilities which are vacant, underutilized or redundant of Mattel facilities. Item 3. Item 3. Legal Proceedings - ------- ----------------- The Company's Fisher-Price subsidiary has executed a consent order with the State of New York involving a remedial action/feasibility study for voluntary cleanup of contamination at one of its manufacturing plants. The ultimate liability associated with this cleanup presently is estimated to be less than $850,000. The Company is involved in various litigation and other legal matters which are being defended and handled in the ordinary course of business. None of these matters is expected to result in outcomes having a material adverse effect on the Company's liquidity, operating results or consolidated financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------ --------------------------------------------------- A Special Meeting of Stockholders of Mattel was held on November 30, 1993 to consider the three proposals described below. Proxies for the meeting were solicited pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, and there was no solicitation in opposition to that of management. Each of the proposals was approved based upon the respective tallies of votes set forth below. Proposal 1: To approve the issuance of shares of Mattel common stock in connection with the Agreement and Plan of Merger, dated as of August 19, 1993, among Mattel, MAT Acquisition, Inc., a wholly-owned subsidiary of Mattel ("Sub"), and Fisher-Price pursuant to which (i) Sub was merged into Fisher-Price and Fisher-Price became a wholly-owned subsidiary of Mattel, and (ii) each outstanding share of Fisher-Price common stock (other than shares owned by Fisher-Price as treasury stock or by its subsidiaries or by Mattel or its subsidiaries, all of which were canceled), were converted into 1.275 shares of Mattel common stock, including the corresponding percentage of rights to purchase Mattel's Series E Junior Participating Preference Stock. Votes Cast Votes Cast Votes Broker For Against Abstaining Non-votes ---------- ---------- ---------- --------- 76,565,585 761,611 155,626 6,753,524 Proposal 2: To approve an amendment to the Amended & Restated Certificate of Incorporation of Mattel to increase the number of shares of common stock authorized to be issued from 150,000,000 to 300,000,000. Votes Cast Votes Cast Votes Broker For Against Abstaining Non-votes ---------- ---------- ---------- --------- 80,704,897 2,741,169 790,280 0 Proposal 3: To approve an amendment to the Mattel 1990 Stock Option Plan to increase, above the 1% limitation set forth in the plan, the amount of capital stock that may be the subject of awards granted wholly or partly in stock in 1993 by 3,000,000 shares of capital stock (with any such capital stock which is not the subject of awards in 1993 to be carried forward and available for awards in succeeding calendar years). Votes Cast Votes Cast Votes Broker For Against Abstaining Non-votes ---------- ---------- ---------- --------- 64,197,291 12,446,002 839,528 6,753,525 PART II ------- Item 5. Item 5. Market for the Registrant's Common Equity and Related - ------- Stockholder Matters ----------------------------------------------------- For information regarding the markets in which the Company's common stock is traded, see the cover page hereof, and for information regarding the high and low sales prices of the Company's common stock for the last two calendar years, see Note 9 to the Consolidated Financial Statements in the Annual Report to Shareholders, incorporated herein by reference. As of March 18, 1994, the Company had approximately 40,000 holders of record of its common stock. In April 1992 the Company paid a dividend of $0.026 per share of common stock. The Company paid per share dividends of $0.040 in July and October of 1992 and in January and April of 1993. In each of July and October of 1993 and January of 1994, the Company paid dividends of $0.048 per share. The dividends have been adjusted to reflect a three-for-two stock split and a five-for-four stock split which the Company declared on its common stock to holders of record on May 18, 1992 and December 17, 1993, respectively. Item 6. Item 6. Selected Financial Data - ------- ----------------------- The information under the caption "Five-Year Financial Summary" on page 27 in the Annual Report to Shareholders is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations - ------- and Financial Condition ------------------------------------------------------------- The information under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 28 through 31 in the Annual Report to Shareholders is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data - ------- ------------------------------------------- The consolidated financial statements of Mattel, Inc. and Subsidiaries, together with the report of Price Waterhouse dated February 8, 1994, included on pages 32 through 51 in the 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 - --------- -------------------------------------------------- Information required under this Item relating to members of the Board of Directors is incorporated by reference herein from the Company's 1994 Notice of Annual Meeting of Stockholders and Proxy Statement. The information with respect to executive officers of the Company appears under the heading "Executive Officers of the Registrant" in Part I herein. Item 11. Item 11. Executive Compensation - -------- ---------------------- The information required under this Item is incorporated by reference herein from the Company's 1994 Notice of Annual Meeting of Stockholders and Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and - -------- Management --------------------------------------------------- The information required under this Item is incorporated by reference herein from the Company's 1994 Notice of Annual Meeting of Stockholders and Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions - -------- ---------------------------------------------- The information required under this Item is incorporated by reference herein from the Company's 1994 Notice of Annual Meeting of Stockholders and Proxy Statement. PART IV ------- Item 14. Item 14. Exhibits, Financial Statements, and Reports on Form 8-K - -------- ------------------------------------------------------- (a) The following documents are filed as part of this report: Annual Report Page Number(1) ------------- (1) Financial Statements Consolidated Balance Sheets as of 32-33 December 31, 1993 and December 31, 1992 Consolidated Results of Operations for 34 the years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Statements of Cash Flows for 35 the years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Statements of Shareholders' 36 Equity for the years ended December 31, 1993, December 31, 1992 and December 31, 1991 Notes to Consolidated Financial Statements 37-50 Report of Price Waterhouse, Independent Accountants 51 to the Company (1) Incorporated by reference from the indicated pages of the Annual Report to Shareholders for the year ended December 31, 1993. With the exception of the information incorporated by reference in Items 1, 5, 6, 7, 8 and 14 of this report, the Annual Report to Shareholders is not deemed filed as part of this report. REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Board of Directors and Stockholders of Fisher-Price, Inc. We have audited the consolidated balance sheet of Fisher-Price, Inc. and subsidiaries as of January 3, 1993, and the related consolidated statements of income, stockholder's equity and cash flows for the fiscal year then ended. We have also audited the financial statement schedules. 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 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 Fisher-Price, Inc. and subsidiaries as of January 3, 1993, and the consolidated results of their operations and their cash flows for the fiscal year 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. /s/ Coopers & Lybrand - --------------------- Boston, Massachusetts February 4, 1993 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- To the Board of Directors and Stockholders of Fisher-Price, Inc.: We have audited the consolidated statement of income, stockholders' equity and cash flows of Fisher-Price, Inc. (a Delaware Corporation) and subsidiaries for the six months ended December 29, 1991, prior to the restatement (and, therefore, are not presented herein) for the merger between Mattel, Inc. and Fisher-Price, Inc. as described in Note 2 to the Mattel, Inc. and subsidiaries consolidated financial statements included in Mattel, Inc.'s Form 10-K as of December 31, 1993. Fisher-Price, Inc.'s consolidated financial statements and schedules related thereto referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on Fisher-Price, Inc.'s consolidated financial statements and 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 financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Fisher-Price, Inc. and subsidiaries for the six months ended December 29, 1991, in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements prior to the restatement, taken as a whole. The schedules, prior to the restatement (and therefore, not presented herein), listed in Part IV, Item 14(a)2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. Fisher-Price, Inc.'s schedules, prior to restatement, 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, prior to restatement, taken as a whole. /s/ ARTHUR ANDERSEN & CO. - ------------------------- Rochester, New York February 11, 1992 (2) Financial Statement Schedules for the years ended December 31, 1993, December 31, 1992 and December 31, 1991 (1) Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties Schedule VIII - Valuation and Qualifying Accounts and Allowances (3) Exhibits (Listed by numbers corresponding to Item 601 of Regulation S-K) 2.0 Agreement and Plan of Merger, dated as of August 19, 1993, by and among the Company, MAT Acquisition, Inc. and Fisher-Price, Inc. (incorporated by reference from Exhibit 2.1 to the Company's Registration Statement on Form S-4, Registration Statement No. 33-50749) 3.0 Restated Certificate of Incorporation of the Company 3.1 By-laws of the Company, as amended to date (incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992) 4.0 Rights Agreement, dated as of February 7, 1992, between the Company and The First National Bank of Boston, as Rights Agent (incorporated by reference to Exhibit 1 to the Company's Registration Statement on Form 8-A, dated February 12, 1992) (The Company has not filed certain long-term debt instruments under which the principal amount of securities authorized to be issued does not exceed 10% of the total assets of the Company. Copies of such agreements will be provided to the Securities and Exchange Commission upon request.) 10.0 Credit Agreement (Multi-Year Facility) dated as of March 18, 1994 among the Company, the Banks named therein and Bank of America National Trust and Savings Association, as Agent (incorporated by reference to Exhibit 99.1 to the Company's Current Report on Form 8-K dated March 23, 1994) 10.1 Credit Agreement (364-Day Facility) dated as of March 18, 1994 among the Company, the Banks named therein and Bank of America National Trust and Savings Association, as Agent (incorporated by reference to Exhibit 99.2 to the Company's Current Report on Form 8-K dated March 23, 1994) (1) All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. 10.2 Amended and Restated Transfer and Administration Agreement dated as of March 18, 1994 among the Company, Mattel Sales Corp., the Banks named therein and Nationsbank of Texas, N.A., as Agent (incorporated by reference to Exhibit 99.3 to the Company's Current Report on Form 8-K dated March 23, 1994) 10.3 Underwriting Agreement dated May 19, 1993 between the Company, Morgan Stanley & Co. Incorporated and Kidder, Peabody & Co. Incorporated 10.4 Stock Subscription Warrant dated as of June 28, 1991 between Fisher-Price and certain investors (incorporated by reference to Exhibit 4(c) to Fisher-Price's Report on Form 10-K for the transition period from July 1, 1991 to December 29, 1991) 10.5 Third Amended and Restated Credit Agreement dated as of March 19, 1993 among the Company, the Banks named therein, Bank of America National Trust and Savings Association, as Agent and Bank of America National Trust and Savings Association, as Collateral Agent ("Third Amended and Restated Credit Agreement") (incorporated by reference to Exhibit 99.1 to the Company's Current Report on Form 8-K dated September 29, 1993) 10.6 First Amendment to Third Amended and Restated Credit Agreement, dated as of July 19, 1993, among the Company, the Banks named therein, Bank of America National Trust and Savings Association, as Agent, and Bank of America National Trust and Savings Association, as Collateral Agent (incorporated by reference to Exhibit 99.2 to the Company's Current Report on Form 8-K dated September 29, 1993) 10.7 Second Amendment to Third Amended and Restated Credit Agreement, dated as of November 8, 1993, among the Company, the Banks named therein, Bank of America National Trust and Savings Association, as Agent and Bank of America National Trust and Savings Association, as Collateral Agent 10.8 Transfer and Administration Agreement, dated as of March 19, 1993, among Mattel Sales Corp., Mattel, Inc., the Banks named therein and Nationsbank of Texas, N.A., as Agent (incorporated by reference to Exhibit 99.3 to the Company's Current Report on Form 8-K dated September 29, 1993) 10.9 Underwriting Agreement dated July 31, 1992 between the Company, Morgan Stanley & Co. Incorporated and Kidder, Peabody & Co. Incorporated (incorporated by reference to Exhibit 10.5 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992) Executive Compensation Plans and Arrangements of the Company - ------------------------------------------------------------ 10.10 Form of Indemnity Agreement between Mattel and its directors and certain of its executive officers (incorporated by reference to Exhibit B to Notice of Annual Meeting of Stockholders of the Company dated March 24, 1987) 10.11 Form of Employment Agreement between the Company and certain executive officers (incorporated by reference to Exhibit 10.6 of Amendment No. 1 of the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1987) 10.12 Form of Employment Agreement between the Company and certain executive officers (incorporated by reference to Exhibit 10.8 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992) 10.13 Form of Amended & Restated Employment Agreement between the Company and certain executive officers 10.14 Mattel, Inc. 1993 Management Incentive Plan Highlights 10.15 Mattel, Inc. 1993 - 1995 Long-Term Incentive Plan Highlights (incorporated by reference to Exhibit 99.4 to the Company's Current Report on Form 8-K dated September 29, 1993) 10.16 Mattel, Inc. Financial Security Program Agreement for certain officers (incorporated by reference to Exhibit 10.7 of the Company's Registration Statement No. 2-95161 on Form S-1, filed January 7, 1985) 10.17 Form of Deferred Compensation Plan for Directors (incorporated by reference to Exhibit No. 10.11 of Amendment No. 1 of the Company's Annual Report on Form 10-K for the year ended December 26, 1987) 10.18 Mattel, Inc. 1990 Stock Option Plan (incorporated by reference to Exhibit A to the Notice of Annual Meeting of Stockholders and Proxy Statement of the Company dated March 15, 1990) 10.19 Amendment No. 1 to the Mattel, Inc. 1990 Stock Option Plan (incorporated by reference to the information under the heading "Amendment to Mattel 1990 Stock Option Plan" on page of the Joint Proxy Statement/Prospectus of the Company and Fisher-Price included in the Company's Registration Statement on Form S-4, Registration Statement No. 33-50749) 10.20 Form of Award Agreement evidencing award of stock appreciation rights granted pursuant to the Company's 1990 Stock Option Plan to certain executive officers of the Company ("Award Agreement") (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991) 10.21 Form of First Amendment to Award Agreement 10.22 Form of Restricted Stock Award Agreement under the Mattel 1990 Stock Option Plan 10.23 Mattel, Inc. Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.10 of the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1990) 10.24 Description of the Mattel, Inc. Deferred Compensation Plan for Officers (incorporated by reference to Exhibit 10.16 to the Mattel, Inc. Annual Report on Form 10-K for the year ended December 31, 1991) Executive Compensation Plans and Arrangements of Fisher-Price - ------------------------------------------------------------- 10.25 Form of Employment Agreement, dated August 16, 1993, between Fisher-Price and certain executive officers 10.26 Form of Employment Agreement, dated August 16, 1993, between Fisher-Price and an executive officer 10.27 Form of Employment Agreement, dated as of March 12, 1993, between Fisher-Price and Ronald J. Jackson (incorporated by reference to Exhibit 10(f)(1) to Fisher-Price's Annual Report on Form 10-K for the fiscal year ended January 3, 1993) 10.28 Form of Amendment, dated August 16, 1993, to Employment Agreement, dated as of March 12, 1993, between Fisher-Price and Ronald J. Jackson 10.29 Form of Employment Agreement, dated as of February 25, 1992, between Fisher-Price and certain executive officers (incorporated by reference to Exhibit 10(f)(2) to Fisher-Price's Form 10-K for the transition period from July 1, 1991 to December 29, 1991) 10.30 Deferred Compensation Plan for Outside Directors of Fisher-Price (incorporated by reference to Exhibit 10(g) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.31 Fisher-Price Long-Term Incentive Plan of 1991 (incorporated by reference to Exhibit 10(h) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.32 Fisher-Price Executive Incentive Bonus Plan (incorporated by reference to Exhibit 10(i) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.33 First Amendment to Executive Incentive Bonus Plan, dated as of February 12, 1992 (incorporated by reference to Exhibit 10(i)(1) to Fisher-Price's Report on Form 10-K for the transition period from July 1, 1991 to December 29, 1991) 10.34 The Fisher-Price Management Incentive Bonus Plan (incorporated by reference to Exhibit 10(j) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.35 Fisher-Price Matching Savings Plan (incorporated by reference to Exhibit 10(k) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.36 The Fisher-Price Pension Plan (1989 Restatement) (incorporated by reference to Exhibit 10(l) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.37 The Fisher-Price Profit Sharing and Retirement Savings Plan (1989 Restatement) (incorporated by reference to Exhibit 10(m) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.38 The Fisher-Price Deferral and Compensation Adjustment Benefit Plan (incorporated by reference to Exhibit 10(o) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 10.39 The Fisher-Price Salaried Employees Compensation and Benefits Protection Plan (incorporated by reference to Exhibit 10(p) to Fisher-Price's Registration Statement on Form 10 dated June 28, 1991) 11.0 Computation of Income per Common and Common Equivalent Share 13.0 Pages 27 through 53 of the Mattel, Inc. Annual Report to Shareholders for the year ended December 31, 1993 21.0 Subsidiaries of the Registrant 23.0 Consent of Price Waterhouse 23.1 Consent of Arthur Andersen & Co. 23.2 Consent of Coopers & Lybrand 24.0 Power of Attorney (on page 28 of Form 10-K) (b) Reports on Form 8-K Mattel, Inc. filed the following Current Reports on Form 8-K during the quarterly period ended December 31, 1993 Financial Date of Report Items Reported Statements Filed ------------------ -------------- ---------------- September 29, 1993 7 None October 18, 1993 5, 7 None November 3, 1993 5, 7 None November 30, 1993 5, 7 None (c) Exhibits Required by Item 601 of Regulation S-K See Item (3) above (d) Financial Statement Schedules Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties Schedule VIII - Valuation and Qualifying Accounts and Allowances Copies of Form 10-K (which includes Exhibit 24.0), Exhibits 11.0, 13.0, 21.0, 23.0, 23.1, 23.2, and the Annual Report to Shareholders are available to stockholders of the Company without charge. Copies of other Exhibits can be obtained by stockholders of the Company upon payment of ten cents per page for such Exhibits. Written requests should be sent to Secretary, Mattel, Inc., 333 Continental Boulevard, El Segundo, California 90245-5012. 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. MATTEL, INC. Registrant By: /s/ Gary P. Rolfes ----------------------- Gary P. Rolfes Senior Vice President & Date: As of March 24, 1994 Controller -------------------- POWER OF ATTORNEY ----------------- We, the undersigned directors and officers of Mattel, Inc. do hereby severally constitute and appoint John W. Amerman, N. Ned Mansour, Michael G. McCafferty, Robert Normile and John L. Vogelstein, and each of them, our true and lawful attorneys and agents, to do any and all acts and things in our name and behalf in our capacities as directors and officers and to execute any and all instruments for us and in our names in the capacities indicated below, which said attorneys and agents, or any of them, may deem necessary or advisable to enable said Corporation to comply with the Securites Exchange Act of 1934, as amended, and any rules, regulations and requirements of the Securities and Exchange Commission, in connection with this Annual Report on Form 10-K, including specifically, but without limitation, power and authority to sign for us or any of us, in our names in the capacities indicated below, any and all amendments hereto; and we do each hereby ratify and confirm all that said attorneys and agents, or any one of them, shall 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. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES --------------------------------- To the Board of Directors of Mattel, Inc. Our audits of the consolidated financial statements referred to in our report dated February 8, 1994, appearing on page 51 of the December 31, 1993 Annual Report to Shareholders of Mattel, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) and the reports of other auditors also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) of this Form 10-K. In our opinion, based on our audits and the reports of other auditors, 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 - ----------------------- Los Angeles, California February 8, 1994 SCHEDULE VIII MATTEL, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND ALLOWANCES (In thousands)

19150_1993.txt

19150_1993

1993

19150

ITEM 1. BUSINESS GENERAL Champion International Corporation was incorporated under the laws of the State of New York on April 28, 1937. References to the "Company" include Champion International Corporation and its subsidiaries at December 31, 1993, unless the context otherwise requires. The Company is one of the leading domestic manufacturers of paper for business communications, commercial printing, publications and newspapers. In addition, the Company has significant plywood and lumber manufacturing operations and owns or controls approximately 5,072,000 acres of timberlands in the United States. The Company's Canadian and Brazilian subsidiaries also own or control significant timber resources supporting their operations. The Company's business segments are paper and wood products. See Note 13 of Notes to Financial Statements on pages 37 and 38 of the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1993 (the "Company's 1993 Annual Report"), which Note is incorporated by reference herein, for information concerning the Company's business segments and operations in different geographic areas for 1991, 1992 and 1993. PAPER See the Net Sales table on page 18 of the Company's 1993 Annual Report, which table is incorporated by reference herein, for information concerning the net sales to unaffiliated customers of the various products of the paper business for 1991, 1992 and 1993. PRINTING AND WRITING PAPERS The printing and writing papers business manufactures and sells printing and writing papers, bleached paperboard and pulp. The principal domestic manufacturing properties of this operation consist of integrated pulp and paper mills at Courtland, Alabama; Canton, North Carolina; and Pensacola, Florida; and a paper mill at Hamilton, Ohio. As of December 31, 1993, these mills had an annual capacity of approximately 1,846,000 tons of pulp and 2,066,000 tons of printing and writing papers and bleached paperboard. Most of the pulp produced by the printing and writing papers business is used in its own paper mills; approximately 14%, produced at the Pensacola and Courtland mills, was sold in the open market in 1993. A portion of the fiber requirements of this business also is supplied by other Company pulp mills, and approximately 4% of its fiber requirements in 1993 were purchased from third- party suppliers. Uncoated papers produced by the printing and writing papers business are used for computer forms, copier paper and envelope papers. Coated papers are used in catalogs, magazines, brochures, labels and annual reports. In 1993, 63% of this operation's bleached paperboard production was used by the Company's DairyPak unit, which converts polyethylene-coated paperboard into milk and juice cartons and ovenable packaging. The balance either was sold to independent purchasers, primarily for conversion to cups, or was exported. The Company leases substantial portions of the Courtland mill under 10 long- term net leases which expire between 1997 and 2029. Each of these leases provides for rental payments over its term sufficient to pay interest on and to retire the industrial development or pollution control revenue bonds issued in connection with the financing of the property subject to such lease. The Company is required to purchase, or has the option to purchase, the property subject to each such lease for a nominal sum at the time the related bonds are retired. The domestic printing and writing papers business and the publication papers business jointly maintain 11 sales offices in various parts of the United States, as well as an order services office in Hamilton, Ohio, for the sale of their products to direct purchasers and through paper merchants. Certain of these sales offices are shared with the newsprint and kraft operations. Champion Papel e Celulose Ltda., a 99%-owned subsidiary ("Champion Papel"), is a major integrated manufacturer of pulp and printing and writing papers in Brazil with net sales to unaffiliated customers of (U.S.) $272,498,000 in 1993. As of December 31, 1993, this mill had an annual capacity of approximately 334,000 tons of pulp and 373,000 tons of paper. In addition to being a leading supplier of printing and writing papers in Brazil, Champion Papel exports a substantial portion of its paper production. PUBLICATION PAPERS The publication papers business manufactures and sells coated and uncoated publication papers and pulp. The manufacturing properties of this operation consist of integrated pulp and paper mills at Bucksport, Maine; Deferiet, New York; Quinnesec, Michigan; and Sartell, Minnesota. As of December 31, 1993, these mills had an annual capacity of approximately 810,000 tons of pulp and 1,250,000 tons of publication papers. A significant portion of the fiber requirements of the publication papers business is supplied by its own mills. In addition, a portion of its fiber requirements is supplied by other Company pulp mills, and approximately 26% of its fiber requirements in 1993 were purchased from third-party suppliers. The Company manufactures pulp for sale in the open market at the Quinnesec mill. In 1993, approximately 60% of the pulp production of this mill, or 215,000 tons, was sold in the open market through the Company's headquarters in Stamford, Connecticut, as well as a sales office in Appleton, Wisconsin. The balance was used in the production of paper at the Quinnesec mill and at the Company's printing and writing papers mills. The Company's publication papers are used primarily for consumer magazines, direct mail catalogs, directories, textbooks and coupons. Sales are made to direct purchasers and through paper merchants and brokers from the 11 sales offices jointly maintained by the publication papers operation and the printing and writing papers operation, and from the Hamilton, Ohio order services office. The Company leases the building which houses one of the paper machines at the Sartell mill until 2008. Thereafter, the Company has options to renew the lease for five terms of five years each. The Company also has the option to purchase the building at its then-current market value at the end of the initial term in 2008 or at the end of each five-year renewal term. The Company leases certain water pollution control facilities at the Deferiet mill until November 30, 1994. The lease provides for rental payments over its term sufficient to pay interest on and to retire the tax-exempt bonds (in the original principal amount of $7 million) issued to finance the acquisition of those facilities. The Company has the option to purchase the facilities for a nominal sum at the time the bonds are retired. NEWSPRINT The newsprint business manufactures pulp and manufactures and sells newsprint, directory paper and groundwood specialties. The manufacturing properties of this operation consist of integrated pulp and paper mills at Lufkin and Sheldon, Texas. As of December 31, 1993, these mills had an annual capacity of approximately 1,191,000 tons of pulp (which includes 150,000 tons of recycled pulp) and 952,000 tons of newsprint, directory paper and groundwood specialties. Virtually all of the newsprint operation's pulp production is used in its own paper mills; approximately 2% was sold in the open market in 1993. Most of the newsprint produced by the Company is sold in the Southwest, Southeast and Midwest. In general, sales are made directly to publishers and printers through four sales offices, three of which are shared with the printing and writing papers and publication papers operations, and one order services office. PULP For information concerning market pulp produced at the Pensacola and Courtland mills, see the section captioned Printing and Writing Papers above, and for information concerning market pulp produced at the Quinnesec mill, see the section captioned Publication Papers above. Weldwood of Canada Limited, a Canadian subsidiary in which the Company has approximately 85% ownership ("Weldwood"), manufactures bleached softwood kraft pulp at its mill in Hinton, Alberta, Canada. As of December 31, 1993, this mill had an annual capacity of approximately 424,000 tons. In 1993, approximately 29% of the mill's pulp production was used in the Company's own publication papers and printing and writing papers mills. The balance was sold in the open market through the Company's headquarters in Stamford, Connecticut, a Company sales office in Appleton, Wisconsin and a Weldwood sales office in Bad Homburg, Germany. Cariboo Pulp & Paper Company, a joint venture owned equally by Weldwood and Daishowa-Marubeni International Limited, operates a bleached softwood kraft pulp mill in Quesnel, British Columbia, Canada. As of December 31, 1993, this mill had an annual capacity of approximately 340,000 tons. In 1993, approximately 13% of Weldwood's 50% share of the mill's pulp production was used in the Company's own publication papers and printing and writing papers mills. The balance of Weldwood's share was sold in the open market through the Company's headquarters in Stamford, Connecticut, a Company sales office in Appleton, Wisconsin and a Weldwood sales office in Bad Homburg, Germany. While certain of the Company's mills purchase pulp in the open market, the Company and Weldwood overall are net sellers of pulp. In 1993, the Company and Weldwood in the aggregate produced approximately 855,000 tons of pulp for sale to unaffiliated purchasers, while the Company used approximately 314,000 tons of pulp purchased from third-party suppliers, resulting in net market pulp of approximately 541,000 tons. KRAFT The Company produces pulp, unbleached linerboard and kraft paper for multiwall and grocery bags at its mill in Roanoke Rapids, North Carolina. As of December 31, 1993, this mill had an annual capacity to produce approximately 489,000 tons of pulp, 402,000 tons of linerboard and 105,000 tons of kraft paper. All of this mill's pulp production is used at the mill. In addition, approximately 7% of its fiber requirements in 1993 were purchased from third- party suppliers. The linerboard and kraft paper produced at the Roanoke Rapids mill are sold to converters through three sales offices, two of which are shared with the printing and writing papers and publication papers operations, and one order services office. PAPER DISTRIBUTION OPERATION Nationwide Papers is the Company's wholly owned distributor of paper and paper products. Its marketing operations are carried out through 28 wholesale warehouse facilities in 18 states. In addition, Nationwide Papers operates a facility which converts rolls of bleached paperboard into sheets for sale to textile, furniture and tobacco producers. In 1993, approximately 75% of its sales were attributable to merchandise purchased from numerous manufacturers other than the Company. However, Nationwide Papers is not dependent on any single supplier for such merchandise. WOOD PRODUCTS The Company is a major producer of plywood and lumber. The Company's wood products business is conducted through its domestic wood products operations and through the wood products operations of Weldwood. The principal wood products manufacturing facilities operated by the Company and by Weldwood are summarized under Item 2 ITEM 2. PROPERTIES In 1993, the overall operating rate for the Company's domestic and foreign manufacturing facilities exceeded 98% of capacity in the paper segment, 80% of capacity for lumber and studs, and 97% of capacity for panelboard (plywood and waferboard). Production curtailments in the Company's paper segment were attributable primarily to scheduled maintenance. Production curtailments in the wood products segment were attributable primarily to log supply shortages resulting from the scarcity of timber, as well as the process of disposing of several mills. Reference is made to Item 1 of this Report for information concerning the general character, adequacy and capacity of the principal plants, timber properties and other materially important physical properties of the Company. The following lists show the location, nature and ownership of the Company's principal plants. Except as indicated, none of these plants is subject to a mortgage and all are owned in fee. PAPER PRINTING AND WRITING PAPERS (a) Integrated pulp and printing and writing papers mills: (i) Courtland, Alabama/1/; (ii) Canton, North Carolina; (iii) Pensacola, Florida; and (iv) Mogi Guacu, Brazil. (b) The Company operates a printing and writing papers mill in Hamilton, Ohio. (c) The Company operates a plant in Waynesville, North Carolina which applies polyethylene coating to bleached paperboard and which also converts roll stock into cut-size paper. (d) The Company operates five plants which convert polyethylene-coated paperboard into milk and juice cartons and one plant which converts polyethylene-coated paperboard into ovenable packaging. All of these plants are located in the United States. PUBLICATION PAPERS (e) Integrated pulp and publication papers mills: (i) Bucksport, Maine; (ii) Deferiet, New York/2/; (iii) Quinnesec, Michigan; and (iv) Sartell, Minnesota/2/. - ---------- /1/For Courtland, Alabama mill lease information, see Item 1 - Paper of this Report. /2/For Deferiet, New York and Sartell, Minnesota mill lease information, see Item 1 - Paper of this Report. NEWSPRINT (f) Integrated pulp and newsprint mills: (i) Lufkin, Texas; and (ii) Sheldon, Texas. PULP (g) The Company's printing and writing papers mills in Pensacola, Florida and Courtland, Alabama and publication papers mill in Quinnesec, Michigan also produce market pulp. (h) Weldwood operates a pulp mill in Hinton, Alberta, Canada and owns 50% of a joint venture which operates a pulp mill in Quesnel, British Columbia, Canada. KRAFT (i) The Company operates an integrated pulp, unbleached linerboard and kraft paper mill in Roanoke Rapids, North Carolina. WOOD PRODUCTS (a) The Company operates three softwood plywood plants in the United States. (b) Weldwood operates two softwood plywood plants and one specialty hardwood plywood plant in Canada. One of these plants is located on leased land. (c) The Company operates seven softwood lumber mills in the United States. (d) Weldwood operates five softwood lumber mills in Canada. One of these mills is located on leased land. (e) Each of Babine Forest Products Company and Houston Forest Products Company, joint ventures in which Weldwood has an interest, operates a mill for the production of softwood lumber in Canada. Both mills are located on leased land. (f) Weldwood operates one waferboard plant in Canada. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On January 4, 1991, a class action was brought against the Company in state court in Tennessee. The class consisted of all Tennessee residents who own or lease land around Douglas Lake or along the Pigeon River. Subsequently, the case was transferred to the United States District Court for the Eastern District of Tennessee. While the original complaint sought $5 billion in compensatory and punitive damages, immediately prior to trial the plaintiffs reduced their demand to $367.9 million. The plaintiffs originally claimed damages for both personal injury and property damage, but the personal injury claims were dismissed. The case proceeded to trial on plaintiffs' theory that discharges of hazardous materials, including dioxin, from the Company's Canton, North Carolina mill had decreased property values along the river and the lake. On October 16, 1992, a mistrial was declared when the jury was unable to reach a unanimous verdict. On May 3, 1993, the court approved a settlement of the action providing for a payment of $6.5 million by the Company. On June 1, 1993, the court's approval of the settlement was appealed. On September 18, 1992, an action was brought in the District Court of Brazoria County, Texas by 26 individuals engaged in seafood-related businesses against the Company, Simpson Pasadena Paper Company, the Gulf Coast Waste Disposal Authority and eight other corporations and individuals. The action sought unspecified damages for lost business profits, diminution in property value and mental anguish allegedly resulting from the purported discharge of dioxin into the Brazos River, Galveston Bay, the Neches River and their adjacent waters, from the Company's Sheldon and Lufkin, Texas mills, Simpson's Pasadena, Texas mill and the other defendants' mills and plants. The Company sold the Pasadena mill to Simpson in 1987 but may be liable for damages, if any, arising from wastewater discharges which occurred prior to the sale. On September 2, 1993, at the plaintiffs' request, the action was dismissed with respect to the Company's Lufkin mill. In December 1993, the action was settled for an immaterial amount. On September 18, 1992, an action was brought in the District Court of Harris County, Texas by 71 individuals primarily engaged in seafood-related businesses against the Company, Simpson Pasadena Paper Company, the Gulf Coast Waste Disposal Authority and eight other corporations and individuals. The action sought unspecified damages for lost business profits, diminution in property value and mental anguish allegedly resulting from the purported discharge of dioxin into the Brazos River, Galveston Bay, the Neches River and their adjacent waters, from the Company's Sheldon and Lufkin, Texas mills, Simpson's Pasadena, Texas mill and the other corporate defendants' mills and plants. The Company sold the Pasadena mill to Simpson in 1987 but may be liable for damages, if any, arising from wastewater discharges which occurred prior to the sale. On September 2, 1993, at the plaintiffs' request, the action was dismissed with respect to the Company's Lufkin mill. In December 1993, the action was settled for an immaterial amount. On November 9, 1992, an action was brought against the Company in the Circuit Court for Baldwin County, Alabama purportedly on behalf of a class consisting of all persons who own land along Perdido Bay in Florida and Alabama. The action originally sought $500 million in compensatory and punitive damages for personal injury, intentional infliction of emotional distress and diminution in property value allegedly resulting from the purported discharge of hazardous substances, including dioxin, from the Company's Pensacola, Florida mill into Eleven Mile Creek, which flows into Perdido Bay. However, in February 1994, the plaintiffs reduced their demand to not more than $50,000 for each class member. It is anticipated that the class, if certified, will consist of approximately 1,000 members. The parties currently are engaged in discovery. The Company and many other corporations, municipalities and individuals are defendants in three separate actions filed in the District Court of Galveston County, Texas by numerous individuals on March 8, 1993, April 20, 1993 and May 13, 1993, respectively. Each of these actions seeks compensatory and punitive damages in excess of $5 billion for personal injury and property damage allegedly resulting from the purported disposal of waste materials, including hazardous substances, into the McGinnis Waste Disposal Site located at Hall's Bayou Ranch. On July 17, 1991, an action was brought in the United States District Court for the District of Colorado against Weldwood and 14 other Canadian forest products companies purportedly on behalf of a class of United States purchasers of Canadian lumber. The action, seeking injunctive relief and unspecified treble damages, alleged a conspiracy by the defendants and others to fix freight charges for, and to sell on a delivered price basis, Western Canadian softwood lumber, thereby allegedly artificially raising, fixing, maintaining or stabilizing prices in violation of United States antitrust laws. On January 8, 1993, the action was dismissed, upon the motion of the defendants, for reasons of comity. On January 20, 1993, the plaintiff filed a notice of appeal. In February 1994, the action was settled for an immaterial amount. The Company is vigorously defending each of the pending actions described above. The Company also is involved in other legal and administrative proceedings and claims of various types. While any litigation contains an element of uncertainty, management, based upon the opinion of the Company's General Counsel, presently believes that the outcome of each such proceeding or claim which is pending or known to be threatened (including the actions described above), or all of them combined, will not have a material adverse effect on the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT/1/ John A. Ball (age 65) is a Senior Vice President of the Company, a position which he has held since March 1983. He has responsibility for corporate and marketing communications, governmental affairs, public affairs and facilities services. L. Scott Barnard (age 51) is an Executive Vice President of the Company, a position which he has held since August 1992. He has responsibility for sales and marketing for the printing and writing papers and publication papers businesses. From February 1989 to August 1992, he was Vice President-Sales and Marketing for the printing and writing papers and publication papers businesses. Gerald J. Beiser (age 63) is Senior Vice President-Finance of the Company, a position which he has held since 1975. William H. Burchfield (age 58) is an Executive Vice President of the Company, a position which he has held since November 1982. He has responsibility for the domestic printing and writing papers business. Mark V. Childers (age 41) is Senior Vice President-Organizational Development and Human Resources of the Company, a position which he has held since August 1992. From June 1991 to August 1992, he was Vice President-Organizational Development Project of the Company. From August 1988 to June 1991, he was Manager-Organizational Development at the Lufkin, Texas mill. Richard J. Diforio, Jr. (age 58) is a Senior Vice President of the Company, a position which he has held since November 1992. He has responsibility for environmental, health and safety affairs. From September 1990 to November 1992, he was Vice President-Environment, Health and Safety of the Company. From September 1986 to September 1990, he was Vice President-Environmental Affairs of the Company. Joe K. Donald (age 51) is an Executive Vice President of the Company, a position which he has held since August 1989. He heads the publication papers business. From December 1987 to August 1989, he was Vice President- Manufacturing of the printing and writing papers business. Mark A. Fuller, Jr. (age 61) is an Executive Vice President of the Company, a position which he has held since August 1980. He has responsibility for the Company's overall marketing program as well as for Nationwide Papers, Champion Export, pulp sales and sales of wood chemicals and by-products. From July 1986 to August 1989, he headed the publication papers business. Marvin H. Ginsky (age 63) is Senior Vice President and General Counsel of the Company. He was elected a Senior Vice President in May 1981. He has been the General Counsel since 1973. L.C. Heist (age 62) is President and Chief Operating Officer and a director of the Company, positions which he has held since December 1987. Burton G. MacArthur, Jr. (age 47) is an Executive Vice President of the Company, a position which he has held since January 1990. He has responsibility for the newsprint and kraft operations. From March 1989 to January 1990, he was Vice President-Management Information Services of the Company. _______________________________ /1/The term of office for each executive officer expires at the Annual Meeting of the Board of Directors of the Company scheduled to be held on May 19, 1994. Kenwood C. Nichols (age 54) is Vice Chairman and a director of the Company, positions which he has held since August 1989. He has been the principal accounting officer of the Company since July 1983. He also has responsibility for internal audit, corporate analysis, tax affairs, management information services, mineral resources, corporate security and the Company's real estate subsidiaries. From July 1983 to August 1989, he was a Senior Vice President of the Company. Richard E. Olson (age 56) is an Executive Vice President of the Company, a position which he has held since December 1987. He has responsibility for engineering, technology, manufacturing support and major projects. From December 1987 to January 1990, he had responsibility for the newsprint, domestic pulp and kraft operations. Richard L. Porterfield (age 47) is an Executive Vice President of the Company, a position which he has held since August 1992. He heads the forest products unit, which consists of domestic timberlands operations and the domestic wood products business. From January 1990 to August 1992, he was Senior Vice President- Organizational Development and Human Resources of the Company. From August 1989 to January 1990, he was Vice President-Organizational Development Project of the Company. From June 1988 to August 1989, he was Director-Participative Management and Administration of the forest products unit. Andrew C. Sigler (age 62) is Chairman of the Board of Directors and Chief Executive Officer of the Company. He was elected Chairman of the Board effective January 1, 1979. He has served as Chief Executive Officer since 1974 and has been a director since 1973. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company had 23,394 record holders of its Common Stock as of February 28, 1994. The Company's Common Stock is traded on the New York Stock Exchange. Restrictions on the ability of the Company to pay cash dividends are included in several of the Company's debt instruments and the Company's Restated Certificate of Incorporation. At December 31, 1993, the most restrictive of these limitations required the Company to maintain tangible net worth (as defined below) of at least $2.770 billion. As a result of this requirement, such amount is unavailable for the payment of dividends. Approximately $454 million of tangible net worth at December 31, 1993 was free of such restrictions. Tangible net worth is defined as shareholders' equity plus the Company's $92.50 Cumulative Convertible Preference Stock minus goodwill, unamortized debt discount and other like intangibles, all determined on a consolidated basis for the Company. For information concerning the high and low sales prices of the Company's Common Stock for each quarterly period during the last two years and the amount of dividends paid on the Company's Common Stock in each quarterly period during the last two years, see the section on the inside back cover of the Company's 1993 Annual Report captioned Common Stock Prices and Dividends Paid. Said section is incorporated by reference herein. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA There is incorporated by reference herein the table on pages 50 and 51 of the Company's 1993 Annual Report captioned Eleven-Year Selected Financial Data. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS There is incorporated by reference herein the section on pages 43 to 49 of the Company's 1993 Annual Report captioned Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA There is incorporated by reference herein the sections of the Company's 1993 Annual Report captioned Consolidated Income, Consolidated Retained Earnings, Consolidated Balance Sheet, Consolidated Cash Flows, Notes to Financial Statements and Report of Independent Public Accountants, which sections are located on pages 22, 23, 24, 25, 26 to 40, and 41, respectively, of the Company'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 See the section captioned Executive Officers of the Registrant under Part I of this Report for information concerning the Company's executive officers. For information concerning the directors of the Company, see the sections captioned The Board of Directors -The Nominees, Information on the Nominees and Directors, and Committees in the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 19, 1994. Said sections are incorporated by reference herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION There is incorporated by reference herein from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 19, 1994 the sections therein captioned The Board of Directors - Directors' Compensation; and Executive Compensation - Summary Compensation Table, Option/SAR Grant Table, Option/SAR Exercise and Year-End Values Table, Pension Plan Table, and Employment and Severance Agreements. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is incorporated by reference herein from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 19, 1994 the sections therein captioned Principal Shareholders and Stock Ownership by Nominees, Directors and Named Executive Officers. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is incorporated by reference herein from the Company's definitive Proxy Statement for the Annual Meeting of Shareholders scheduled to be held on May 19, 1994 the section therein captioned Transactions. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) FINANCIAL STATEMENTS. The following Consolidated Financial Statements of Champion International Corporation and Subsidiaries, Notes to Financial Statements, and Report of Independent Public Accountants are incorporated by reference herein from the Company's 1993 Annual Report: (b) FINANCIAL STATEMENT SCHEDULES. The following Financial Statement Schedules and Report of Independent Public Accountants on Schedules are filed with this Annual Report on Form 10-K on the pages indicated: All other schedules have been omitted since the information is not applicable, is not required or is included in the Consolidated Financial Statements or Notes to Financial Statements listed under section (a) of this Item 14. (c) EXHIBITS. Each Exhibit is listed according to the number assigned to it in the Exhibit Table of Item 601 of Regulation S-K. The Exhibit numbers preceded by an asterisk (*) indicate Exhibits physically filed with this Annual Report on Form 10-K. All other Exhibit numbers indicate Exhibits filed by incorporation by reference herein. Exhibit numbers 10.1 through 10.29, which are preceded by a plus sign (+), are management contracts or compensatory plans or arrangements. EXHIBIT NUMBER DESCRIPTION - ------ ------------ 3.1 Restated Certificate of Incorporation of the Company, filed in the State of New York on October 20, 1986 (filed by incorporation by reference to Exhibit 3.1 to the Company's Form 10-K for the fiscal year ended December 31, 1986, Commission File No. 1-3053). 3.2 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on July 18, 1988 (filed by incorporation by reference to Exhibit 4.1 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). 3.3 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on December 6, 1989 (filed by incorporation by reference to EXHIBIT NUMBER DESCRIPTION - ------ ------------ Exhibit 4.1 to the Company's Form 8-K dated December 14, 1989, Commission File No. 1-3053). 3.4 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on December 21, 1989 (filed by incorporation by reference to Exhibit 3.4 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). 3.5 By-Laws of the Company (filed by incorporation by reference to Exhibit 3(ii).1 to the Company's Form 10-Q for the quarter ended March 31, 1993, Commission File No. 1-3053). 4.1 Letter agreement dated March 29, 1991 of the Company to furnish to the Commission upon request copies of certain instruments with respect to long-term debt (filed by incorporation by reference to Exhibit 4 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 4.2 Agreement dated February 2, 1994 between the Company and Loews Corporation (filed by incorporation by reference to Exhibit 4.7 to the Company's Registration Statement on Form S-3, Commission Registration No. 33-52123). +10.1 Champion International Corporation 1986 Management Incentive Program, consisting of the 1986 Stock Option Plan and the 1986 Contingent Compensation Plan (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1986, Commission File No. 1-3053). +10.2 Amendment to Champion International Corporation 1986 Management Incentive Program (filed by incorporation by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended March 31, 1993, Commission File No. 1-3053). +10.3 Champion International Corporation Restricted Share Performance Plan, as amended (filed by incorporation by reference to Exhibit 10.2 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). +10.4 Champion International Corporation Management Incentive Program, as amended, consisting of the Amended 1976 Incentive Stock Option Plan and the Contingent Compensation Plan (filed by incorporation by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-8, Commission Registration No. 2-77129). +10.5 Resolutions of the Board of Directors of the Company adopted on August 16, 1984 amending the Amended 1976 Incentive Stock Option Plan (filed by incorporation by reference to Exhibit 10(b) to the Company's Registration Statement on Form S-14, Commission Registration No. 2-94030). +10.6 Champion International Corporation Supplemental Retirement Income Plan (filed by incorporation by reference to Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). +10.7 Supplemental Retirement and Death Payments Agreement dated as of August 1, 1964, as amended by letter agreement dated January 9, 1965, between the Company and Mr. Sigler (filed by incorporation by reference to Exhibit 10.8 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - ------ ------------ +10.8 Restated Agreement between the Company and Mr. Sigler, as amended as of February 19, 1987, providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.9 Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Sigler providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 19.2 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.10 Amendment dated as of April 21, 1988 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). +10.11 Amendment dated as of August 18, 1988 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 10.10 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.12 Amendment dated as of August 18, 1988 to Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Sigler (filed by incorporation by reference to Exhibit 10.11 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.13 Amendment dated as of September 19, 1991 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 10.12 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.14 Agreement dated as of August 18, 1988 between the Company and Mr. Heist providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 10.17 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.15 Agreement Relating to Legal Expenses dated August 18, 1988 between the Company and Mr. Heist providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.18 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.16 Amendment dated as of September 19, 1991 to Agreement dated as of August 18, 1988 between the Company and Mr. Heist (filed by incorporation by reference to Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.17 Agreement dated as of October 18, 1990 between the Company and Mr. Nichols providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 10.16 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.18 Agreement Relating to Legal Expenses dated October 18, 1990 between the Company and Mr. Nichols providing reimbursement of certain legal expenses following a change in EXHIBIT NUMBER DESCRIPTION - ------ ------------ control of the Company (filed by incorporation by reference to Exhibit 10.17 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.19 Amendment dated as of September 19, 1991 to Agreement dated as of October 18, 1990 between the Company and Mr. Nichols (filed by incorporation by reference to Exhibit 10.18 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.20 Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield providing certain severance arrangements (filed by incorporation by reference to Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-3053). +10.21 Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Burchfield providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.16 to the Company's Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-3053). +10.22 Amendment dated as of April 21, 1988 to Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield (filed by incorporation by reference to Exhibit 19.5 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). +10.23 Amendment dated as of September 19, 1991 to Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield (filed by incorporation by reference to Exhibit 10.22 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.24 Agreement dated as of August 18, 1988 between the Company and Mr. Olson providing certain severance arrangements (filed by incorporation by reference to Exhibit 10.23 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.25 Agreement Relating to Legal Expenses dated August 18, 1988 between the Company and Mr. Olson providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.24 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.26 Amendment dated as of September 19, 1991 to Agreement dated as of August 18, 1988 between the Company and Mr. Olson (filed by incorporation by reference to Exhibit 10.28 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.27 Trust Agreement dated as of February 19, 1987 between the Company and Connecticut National Bank securing certain payments under the contracts listed as Exhibit Numbers 10.8 through 10.26, among others, following a change in control of the Company (filed by incorporation by reference to Exhibit 19.11 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1- 3053). EXHIBIT NUMBER DESCRIPTION - ------ ------------ +10.28 Amendment dated as of August 18, 1988 to Trust Agreement dated as of February 19, 1987 between the Company and Connecticut National Bank (filed by incorporation by reference to Exhibit 10.29 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.29 Champion International Corporation Executive Life Insurance Plan (filed by incorporation by reference to Exhibit 10.27 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 10.30 Extract from the minutes of the meeting of the Board of Directors of the Company held on October 18, 1979 relating to the $50,000 of group term life insurance provided by the Company for non- employee directors (filed by incorporation by reference to Exhibit 10.28 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 10.31 Resolutions of the Board of Directors of the Company adopted on September 19, 1991 relating to the compensation of directors (filed by incorporation by reference to Exhibit 19 to the Company's Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-3053). 10.32 Retirement Plan for Outside Directors (filed by incorporation by reference to Exhibit 19 to the Company's Form 10-Q for the quarter ended September 30, 1992, Commission File No. 1-3053). *11 Schedule showing calculation of primary earnings per common share and fully diluted earnings per common share. *13 Portions of the Annual Report to Shareholders of Champion International Corporation for the fiscal year ended December 31, 1993, which are incorporated herein by reference. *21 List of significant subsidiaries of the Company. *23.1 Opinion and Consent of the Senior Vice President and General Counsel of the Company. *23.2 Consent of Arthur Andersen & Co. *24 Power of Attorney relating to the execution and filing of this Annual Report on Form 10-K and all amendments hereto. (d) REPORTS ON FORM 8-K. No Reports on Form 8-K were filed during the last quarter of the period covered by 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, ON THE 30TH DAY OF MARCH, 1994. CHAMPION INTERNATIONAL CORPORATION (Registrant) By Lawrence A. Fox ----------------------------------- (LAWRENCE A. FOX) VICE PRESIDENT 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 DATE INDICATED. A POWER OF ATTORNEY AUTHORIZING LAWRENCE A. FOX, MARVIN H. GINSKY AND ANDREW C. SIGLER AND EACH OF THEM TO SIGN THIS REPORT AND ALL AMENDMENTS HERETO AS ATTORNEYS-IN-FACT FOR OFFICERS AND DIRECTORS OF THE REGISTRANT IS FILED AS EXHIBIT 24 HERETO. SCHEDULE V CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT For the Years Ended December 31, 1993, 1992 and 1991 (in thousands of dollars) - ----------------- Notes: (1) Property, plant and equipment is carried at cost. (2) Effect of foreign currency translation. (3) Reclassifications and transfers to and from other accounts. (4) Cost of timber harvested charged to costs and expenses. (5) As the result of adopting, as of January 1, 1992, Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," assets formerly acquired in purchase business combinations were revalued to reflect gross values. Prior to adoption of this standard, these assets were valued net of related tax effects. S-1 SCHEDULE VI CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the Years Ended December 31, 1993, 1992 and 1991 (in thousands of dollars) Notes: (1) Reclassifications and transfers to and from other accounts. (2) Effect of foreign currency translation. (3) As the result of adopting, as of January 1, 1992, Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," assets formerly acquired in purchase business combinations were revalued to reflect gross values. Prior to adoption of this standard, these assets were valued net of related tax effects. S-2 (4) Reference is made to Note 1 of Notes to Financial Statements in the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1993, which Note is incorporated by reference herein, for the Company's policies in providing for depreciation, cost of timber harvested and amortization. The reconciliations of depreciation, cost of timber harvested and amortization, as shown above and on Schedule V, with the amounts in the statement of income follow: (5) For financial reporting purposes, property, plant and equipment are depreciated on the straight-line method over the estimated service lives of the individual assets as follows: Land improvements 2 to 20% Buildings 2 to 20% Machinery and equipment 3 to 33% Leasehold improvements are amortized over the shorter of the leases or estimated service lives. S-3 SCHEDULE VIII CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS For the Years Ended December 31, 1993 and 1992 (in thousands of dollars) - ----------------------- Note: (1) The deferred income tax valuation allowance primarily relates to general business credit carryforwards. S-4 SCHEDULE IX CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES SHORT-TERM BORROWINGS For the Years Ended December 31, 1993, 1992 and 1991 (in thousands of dollars) - ----------------------------------- Notes: (1) Variations in weighted average interest rates and in outstanding balances for 1993, 1992 and 1991 are attributable to book cash overdrafts. (2) Average amount of short-term borrowings is determined by utilizing the average month-end balances. (3) Weighted average interest rate for the year is determined by dividing average interest expense for the year by the average of month-end short-term borrowings for the year. S-5 SCHEDULE X CHAMPION INTERNATIONAL CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992 and 1991 (in thousands of dollars) Royalties, advertising costs, and amortization of intangible assets and pre- operating costs were not material. S-6 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To Champion International Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Champion International Corporation's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 17, 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(b) 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. New York, N.Y. January 17, 1994 S-7 EXHIBIT INDEX Each Exhibit is listed according to the number assigned to it in the Exhibit Table of Item 601 of Regulation S-K. The Exhibit numbers preceded by an asterisk (*) indicate Exhibits physically filed with this Annual Report on Form 10-K. All other Exhibit numbers indicate Exhibits filed by incorporation by reference herein. Exhibit numbers 10.1 through 10.29, which are preceded by a plus sign (+), are management contracts or compensatory plans or arrangements. EXHIBIT NUMBER DESCRIPTION - -------------- ----------- 3.1 Restated Certificate of Incorporation of the Company, filed in the State of New York on October 20, 1986 (filed by incorporation by reference to Exhibit 3.1 to the Company's Form 10-K for the fiscal year ended December 31, 1986, Commission File No. 1-3053). 3.2 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on July 18, 1988 (filed by incorporation by reference to Exhibit 4.1 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). 3.3 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on December 6, 1989 (filed by incorporation by reference to Exhibit 4.1 to the Company's Form 8-K dated December 14, 1989, Commission File No. 1-3053). 3.4 Certificate of Amendment of Restated Certificate of Incorporation of the Company, filed in the State of New York on December 21, 1989 (filed by incorporation by reference to Exhibit 3.4 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). 3.5 By-Laws of the Company (filed by incorporation by reference to Exhibit 3(ii).1 to the Company's Form 10-Q for the quarter ended March 31, 1993, Commission File No. 1-3053). 4.1 Letter agreement dated March 29, 1991 of the Company to furnish to the Commission upon request copies of certain instruments with respect to long-term debt (filed by incorporation by reference to Exhibit 4 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 4.2 Agreement dated February 2, 1994 between the Company and Loews Corporation (filed by incorporation by reference to Exhibit 4.7 to the Company's Registration Statement on Form S-3, Commission Registration No. 33-52123). +10.1 Champion International Corporation 1986 Management Incentive Program, consisting of the 1986 Stock Option Plan and the 1986 Contingent Compensation Plan (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1986, Commission File No. 1-3053). +10.2 Amendment to Champion International Corporation 1986 Management Incentive Program (filed by incorporation by reference to Exhibit 10.1 to the Company's Form 10-Q for the quarter ended March 31, 1993, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - -------------- ----------- +10.3 Champion International Corporation Restricted Share Performance Plan, as amended (filed by incorporation by reference to Exhibit 10.2 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No.1-3053). +10.4 Champion International Corporation Management Incentive Program, as amended, consisting of the Amended 1976 Incentive Stock Option Plan and the Contingent Compensation Plan (filed by incorporation by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-8, Commission Registration No. 2-77129). +10.5 Resolutions of the Board of Directors of the Company adopted on August 16, 1984 amending the Amended 1976 Incentive Stock Option Plan (filed by incorporation by reference to Exhibit 10(b) to the Company's Registration Statement on Form S-14, Commission Registration No. 2-94030). +10.6 Champion International Corporation Supplemental Retirement Income Plan (filed by incorporation by reference to Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-3053). +10.7 Supplemental Retirement and Death Payments Agreement dated as of August 1, 1964, as amended by letter agreement dated January 9, 1965, between the Company and Mr. Sigler (filed by incorporation by reference to Exhibit 10.8 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.8 Restated Agreement between the Company and Mr. Sigler, as amended as of February 19, 1987, providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.9 Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Sigler providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 19.2 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.10 Amendment dated as of April 21, 1988 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 19.1 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). +10.11 Amendment dated as of August 18, 1988 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 10.10 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.12 Amendment dated as of August 18, 1988 to Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Sigler (filed by incorporation by reference to Exhibit 10.11 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - -------------- ----------- +10.13 Amendment dated as of September 19, 1991 to Restated Agreement between the Company and Mr. Sigler as amended as of February 19, 1987 (filed by incorporation by reference to Exhibit 10.12 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.14 Agreement dated as of August 18, 1988 between the Company and Mr. Heist providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 10.17 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.15 Agreement Relating to Legal Expenses dated August 18, 1988 between the Company and Mr. Heist providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.18 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.16 Amendment dated as of September 19, 1991 to Agreement dated as of August 18, 1988 between the Company and Mr. Heist (filed by incorporation by reference to Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.17 Agreement dated as of October 18, 1990 between the Company and Mr. Nichols providing certain employment, severance and retirement arrangements (filed by incorporation by reference to Exhibit 10.16 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.18 Agreement Relating to Legal Expenses dated October 18, 1990 between the Company and Mr. Nichols providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.17 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.19 Amendment dated as of September 19, 1991 to Agreement dated as of October 18, 1990 between the Company and Mr. Nichols (filed by incorporation by reference to Exhibit 10.18 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.20 Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield providing certain severance arrangements (filed by incorporation by reference to Exhibit 10.15 to the Company's Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-3053). +10.21 Agreement Relating to Legal Expenses dated February 19, 1987 between the Company and Mr. Burchfield providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.16 to the Company's Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-3053). +10.22 Amendment dated as of April 21, 1988 to Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield (filed by incorporation by reference to Exhibit 19.5 to the Company's Form 10-Q for the quarter ended June 30, 1988, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - -------------- ----------- +10.23 Amendment dated as of September 19, 1991 to Agreement dated as of February 19, 1987 between the Company and Mr. Burchfield (filed by incorporation by reference to Exhibit 10.22 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.24 Agreement dated as of August 18, 1988 between the Company and Mr. Olson providing certain severance arrangements (filed by incorporation by reference to Exhibit 10.23 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.25 Agreement Relating to Legal Expenses dated August 18, 1988 between the Company and Mr. Olson providing reimbursement of certain legal expenses following a change in control of the Company (filed by incorporation by reference to Exhibit 10.24 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). +10.26 Amendment dated as of September 19, 1991 to Agreement dated as of August 18, 1988 between the Company and Mr. Olson (filed by incorporation by reference to Exhibit 10.28 to the Company's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-3053). +10.27 Trust Agreement dated as of February 19, 1987 between the Company and Connecticut National Bank securing certain payments under the contracts listed as Exhibit Numbers 10.8 through 10.26, among others, following a change in control of the Company (filed by incorporation by reference to Exhibit 19.11 to the Company's Form 10-Q for the quarter ended June 30, 1987, Commission File No. 1-3053). +10.28 Amendment dated as of August 18, 1988 to Trust Agreement dated as of February 19, 1987 between the Company and Connecticut National Bank (filed by incorporation by reference to Exhibit 10.29 to the Company's Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-3053). +10.29 Champion International Corporation Executive Life Insurance Plan (filed by incorporation by reference to Exhibit 10.27 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 10.30 Extract from the minutes of the meeting of the Board of Directors of the Company held on October 18, 1979 relating to the $50,000 of group term life insurance provided by the Company for non-employee directors (filed by incorporation by reference to Exhibit 10.28 to the Company's Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-3053). 10.31 Resolutions of the Board of Directors of the Company adopted on September 19, 1991 relating to the compensation of directors (filed by incorporation by reference to Exhibit 19 to the Company's Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-3053). 10.32 Retirement Plan for Outside Directors (filed by incorporation by reference to Exhibit 19 to the Company's Form 10-Q for the quarter ended September 30, 1992, Commission File No. 1-3053). EXHIBIT NUMBER DESCRIPTION - -------------- ----------- *11 Schedule showing calculation of primary earnings per common share and fully diluted earnings per common share. *13 Portions of the Annual Report to Shareholders of Champion International Corporation for the fiscal year ended December 31, 1993 which are incorporated herein by reference. *21 List of significant subsidiaries of the Company. *23.1 Opinion and Consent of the Senior Vice President and General Counsel of the Company. *23.2 Consent of Arthur Andersen & Co. *24 Power of Attorney relating to the execution and filing of this Annual Report on Form 10-K and all amendments hereto. 28:exhibt93.10k